There's a Lot Going On Below the Surface of This Quiet Credit Index

Options on CDX indexes are great for hedging tail risk but tough to track.

Bernanke Needs Some Bounce in His Tail

Tail risk as illustrated by Eeyore.

Illustration by Kiersten Essenpreis

Trading Markit's CDX index has become a go-to strategy for big investors who want to take a position on corporate bonds. The CDX.NA.HY, for instance, offers investors the ability to trade a basket of credit default swaps (CDS) offering protection on a bunch of junk-rated U.S. corporate debt. With low levels of liquidity in the cash bond market, trading CDS protection through the CDX can be an easier and cheaper way to go long or short corporate credit than actually buying or selling the debt.

But there's another type of derivative that can be useful for investors wishing to express views in credit. Options written on CDS indexes basically give these investors the right to buy or sell the CDX. The popularity of these credit index "swaptions," as they're sometimes called, means that even though the CDX.NA.HY hasn't been moving much over the past couple of months, there has nevertheless been plenty of action in options tied to the index.

Here's Barclays analyst Jigar Patel with some technical details:

Markets have been relatively calm over the past two months, with CDX.HY trading in a slightly more than 1pt range. But despite the lack of movement at the index level, swaptions activity has increased in May, with month-to-date volumes as of May 27 already greater than in the first four months of 2015 (Figure 1). At the same time, the payer (put) skew has steepened, indicating greater demand for further out of the money (OTM) payers than for those that are closer to at the money (ATM) (Figure 2). In other words, there has been increased demand to hedge tail risk.

As Patel points out in the chart, getting a full picture of CDX options is tough because trade sizes reported to this particular swap data depository are capped at $110 million, "so it's not possible to get a complete picture of where activity has been greatest."

Nevertheless, there's plenty of anecdotal evidence that demand for such options has been growing. For instance, Citigroup analysts back in 2005 estimated that about $2bn worth of credit index options traded per month, or roughly $24bn over the course of the year. Last December, the same Citi analysts figured that about $1.4tn of the instruments had exchanged hands in all of 2014, compared with $573bn worth in 2013. That's a more than 5,000 percent jump over the course of a decade.

What's driving that growth? Unlike credit default swaps themselves, trading of options on CDS are not yet required to be centrally cleared -- essentially making them a cheaper way for big investors to express their views on corporate credit. You get more bang for your buck too, since options (by their nature) offer investors additional leverage. For this reason, as Patel notes above, CDS index options can be great for investors seeking protection from so-called tail risk in the corporate bond market. They typically give investors an affordable way to hedge against the risk of a big blow-up event in the credit markets. With interest rates expected to rise sometime this year, investors have been flocking to CDS index options to protect against future defaults.

So even if it looks like demand for credit protection as measured by the CDX.HY doesn't seem to be moving much, there may be a lot going on beneath the surface of one of the world's most popular credit indices.

(And, as a sidenote, isn't it nice to know there's an uncleared derivatives market that's not that easy to track and by all accounts seems to be exploding in size?)

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