Source: Zeitort/ullstein bild via Getty Images

Building a Better Credit Hedge Is Proving Much Harder Than Expected

A derivatives index on corporate bonds has been rallying as the underlying market deteriorates.

Credit investors hoping that the revamp of a popular derivatives index would make it a better hedge for their portfolios of corporate bonds say they've been left disappointed.

Markit, the owner of the CDX High-Yield, unveiled an overhaul of the derivatives index in September aimed at better aligning it with the cash bonds sold by junk-rated companies with more fragile balance sheets. The CDX HY, as the index is known, is comprised of credit default swaps (CDS) written on a basket of 100 junk-rated companies which act similarly to insurance contracts to protect investors from losses in high-yield corporate debt.

But the CDX index has been rallying in recent weeks at precisely the same time that prices for cash corporate bonds have been deteriorating, causing a number of investors to be caught wrong-footed and exacerbating the recent downturn in debt, according to market participants.

"Last year saw CDX HY perform poorly as a hedge for high-yield cash leaving investors frustrated as they were hurt on both sides of the trade (down on cash, down on the hedge). It was believed that the mismatch in constituents was largely to blame," Credit Suisse analysts led by Fer Koch said in a note published on Thursday. "However another year has passed, and investors are basically in the same frustrating position—high-yield cash is down this year, while CDX HY is up!"

Source: Credit Suisse

Wall Street's search for an effective credit hedge has gained fresh urgency thanks to newfound nervousness in credit markets ahead of the first U.S. interest rate hike in almost a decade, which is now expected to occur at next week's meeting of the Federal Reserve. At the same time, the credit market has shown signs of weakness with distress spreading in energy companies suffering from the effects of a 60 percent drop in the price of oil, as well as the weakest CCC-rated corporations.

"It is safe to say there is a degree of frustration with the CDX product as a hedge," said Peter Tchir, head of macro strategy at Brean Capital. "Last year it didn't have enough energy or CCC-rated exposure so outperformed most portfolios, and this year, even with all the changes, it continues to outperform the market. [High-yield exchange-traded funds] HYG and JNK are both at multiyear lows, the IBOXX HY index is close to the lows set in October, and CDX is well above its September lows."

The CDX has long been touted by analysts as an easier way of trading corporate credit at a time when the wider bond market is suffering from a dearth of liquidity, or ease of trading. Trading volumes in derivatives indexes have increased at the same time that traditional hedging instruments, such as single-name CDS that cover just one company, have decreased. The need for a hedge to offset positions in the ballooning and illiquid corporate bond market has spurred investors to experiment with alternative ways of protecting their portfolios, including volatility options on U.S. equities.

Markit's revamp of the CDX followed months of discussions with both sell-side traders and buy-side investors. Where once the 100 CDS names included in the index were sourced from a list of the most liquid swaps, Markit now also takes into account trading volume in the cash market and outstanding debt.

However, Credit Suisse analysts say the index still has less exposure to the stumbling oil and gas sector than the cash market, and the majority of the energy industry's pain has occurred in smaller companies that do not have as much CDS written on their respective bonds. 

Source: Credit Suisse

They also cast doubt on the efficacy of such swaps as a whole, citing an increase in "soft credit events," which occur when bond investors might face losses on their corporate debt but do not necessarily receive a payout from CDS contracts. According to the analysts, commodity-related cash defaults have more than doubled over the past 12 months but only half of these have triggered payouts to CDS buyers as troubled companies pursue debt exchanges or restructurings.

Still, other market participants pointed out that the current divergence in the CDX index and underlying cash bonds, while frustrating for some investors, could prove a temporary dislocation as the market repositions. 

A spokesman for Markit did not immediately return a request for comment.