Wall Street Is Desperate for a Better Credit Hedge

Building a better CDS index.

In November 2014, the credit market appeared to have an argument with itself.

Spreads on markit’s north american high yield cdx index vs. barclays’s u.s. high-yield average option-adjusted spread.

Spreads on Markit’s North American High Yield CDX index vs. Barclays’s U.S. High-Yield Average Option-Adjusted Spread.

Source: Bloomberg

In one segment of the market—where the cash bonds sold by companies are traded—spreads rose sharply as investors fretted over the impact of lower oil prices on energy companies. In a more obscure corner of the market, the spread on an index comprising a type of derivative known as a credit default swap (CDS) was falling.

It was an unusual event and one that, for all intents and purposes, is not meant to happen. The CDX HY, as the index is known, is a basket of credit default swaps written on the corporate debt sold by junk-rated U.S. companies with riskier balance sheets. When the prices on such bonds fell, as they did in November, CDX HY spreads should have been blowing out as investors’ demand for protection against default surged.

For investors who had traded the CDX HY in hopes that it would help offset movement in their portfolios of cash bonds, this was not good news.

The divergence underscores Wall Street’s search for an effective way of hedging corporate bond holdings. Single-name CDSs that can protect against the default of one individual company have largely fallen by the wayside in the aftermath of the financial crisis. Indexes made up of CDSs remain a far more convenient way of trading or hedging credit, but even they have encountered problems such as bouts of waywardness from the cash market.

Disappointed with the CDX’s ability to offset losses on high-yield bonds, some investors have been turning to exotic alternatives to protect against their credit portfolios. Since late 2014 the volume of CDX traded has slumped as investors tap a smorgasbord of alternative hedging vehicles including total return swaps, credit index options known as swaptions, exchange-traded funds (ETFs), and even VIX futures tied to the expectations of volatility in the Standard & Poor’s 500-stock index. 

“For now, there is no question as to the CDX’s superior market liquidity against alternatives like ETFs and iBoxx total return swaps,” Oleg Melentyev, a credit strategist at Deutsche Bank, wrote in a recent note. “But the competition is growing rapidly and investors’ patience with episodes of weak CDX correlation with cash markets is, based on our conversations with clients, already thin.”

With corporate bond sales booming at precisely the same time investors have been voicing concern about the health of the market, demand for effective hedging vehicles has gained fresh urgency. Some are pushing for a revival of single-name CDSs, while others are revamping existing tools to better reflect the needs of the growing cash market.

Markit, the owner of the CDX HY, last week unveiled an overhaul of the index aimed at bringing it more in line with the cash market and reviving its usefulness as a hedging tool. The revamp follows months of discussions with both sell-side traders and buy-side investors, yet not everyone thinks the makeover goes far enough.

Where once the 100 CDS names included in the index were sourced from a list of the most liquid swaps, Markit is now taking into account trading volume in the cash market and outstanding debt.

“We didn’t want to force in names that have low liquidity and aren’t very relevant for the debt market,” said Shahzeb Rao, director at Markit. “The way we came up with brings in the names that hopefully are very relevant to the debt and the credit markets overall. Even if they have low CDS liquidity, they have very active trading [in the cash market] or a lot of debt outstanding.”

Ejected from the index are consumer-goods-focused companies such as Dean Foods, Cooper Tire, and Constellation; newly included are companies including California Resources, Dynergy, and Valeant.

barclays
Source: Barclays

That should in theory help better align the index with the cash market, in particular the energy sector that caused so much trouble last year. Markit has said further improvements could be made in 2016, when the CDX HY is next due for an update.

“It’s too early to tell, as all of the new credits going into the index did not previously have CDSs—and we’re just starting to get some initial indications of levels, so we’ll have to see where they trade,” said Jigar Patel, a credit analyst at Barclays. “Even though the index will be a better match for the cash market from a sector-weight perspective, the CDS-cash basis could still be an issue,” he said, referring to the difference between the two.

Even if the CDX HY's makeover is successful, many investors still criticize the index's usefulness as a hedge. Buying or selling the index may help hedge a portfolio against big moves in the overall market, but is nevertheless far less precise than simply selling a bond, or using targeted single-name CDSs to more specifically offset exposures.

At Deutsche Bank, Melentyev said the bar for success is set relatively low, as the one-week correlation between the CDX HY and the cash market “breaks down frequently.”

CDXHYcor

The correlation between the cash high-yield market and the CDX HY index is currently hovering at about 80 percent.

Source: Deutsche Bank

Moreover, he points out that the problem may be more profound in the investment-grade market that deals with debt issued by companies with stronger balance sheets. The correlation between the cash market and the CDX IG comprising CDSs tied to investment-grade bonds has declined from 0.8 to 0.3 over the past two years.

cdxigcor
Source: Deutsche Bank

“Not since the 2013 taper tantrum has CDX IG provided a useful hedge during episodes of sustained spread widening,” Melentyev said. “What has changed over the past two years is the cash market liquidity, which would suggest that some portion of the weakness in investment-grade cash is an increasing liquidity premium relative to CDSs.”

Markit said it’s planning further work on its investment-grade index.

“The industry focus was more on CDX HY, so that index was reviewed first,” said Rao. “We will also conduct a review of CDX IG methodology as part of the regular business process and make any changes that would be helpful. Any potential CDX IG changes will also have the benefit of seeing how CDX HY changes have impacted the index.”

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