Many fixed-income players seem to be speaking in code. They use terms such as ABX, CMBX, CDX, CDS, MBS, and LCDX. What on earth are they talking about? This article will explain the alphabet soup of credit derivative indices and give you an idea of why market participants might use them.
- The world of credit derivatives is smattered with various acronyms, but ultimately all credit derivatives do is provide some sort of insurance against a credit event.
- A credit derivative's value is based off the price and credit risk embodied by some underlying security or issuer, known as the reference obligation.
- Several benchmark indices have been established to create greater transparency and liquidity in the otherwise opaque and esoteric world of credit derivatives.
Digging into Derivatives
To understand credit derivative index products, one first needs to know what a credit derivative is. A derivative is a security the price of which depends on or is derived from one or more underlying assets. Thus, a credit derivative is a security in which the price is dependent on the credit risk of one or more underlying assets.
What does this mean in layman's terms?
The credit derivative, while a security, is not a physical asset. As such, derivatives are not simply bought and sold, as are bonds. With derivatives, the purchaser enters a contract that allows him or her to participate in the market movement of the underlying reference obligation or physical security.
Credit Default Swaps
A credit default swap (CDS) is a type of credit derivative. Single-name (only one reference company) credit default swaps were first created in 1994 but did not trade in any significant volume until the end of that decade. The first CDS index was created in 2002 and was based on a basket of single-issuer credit default swaps. The current index is known as the Credit Default Swap Index (CDX).
As the name implies, in a single-name CDS the underlying asset or reference obligation is a bond of one particular issuer or reference entity. You may hear people say that a CDS is a "bilateral contract." This just means that there are two sides to the swap trade: a buyer of protection and a seller of protection. If the reference entity of a CDS experiences what is known as a credit event (such as a bankruptcy or downgrade), the buyer of protection (who pays a premium for that protection) can receive payment from the seller of protection. This is desirable because the price of those bonds will experience a decrease in value due to the negative credit event. There is also the option of physical, rather than cash, trade settlement, in which the underlying bond or reference obligation actually changes hands, from the buyer of protection to the seller of protection.
What can be a little confusing but important to remember is that, with credit default swaps, buying protection is a short, and selling protection is a long. This is because buying protection is synonymous with selling the reference obligation. The market value of the buy protection leg acts like a short, in that as the price of the CDS goes down, the market value of the trade goes up. The opposite is true of the sell protection leg.
The Major Indices
The major tradable benchmark indices in the credit derivatives space include CDX, ABX, CMBX, and LCDX. The CDX indices are broken out between investment grade (IG), high yield (HY), high volatility (HVOL), and emerging market (EM). For example, the CDX.NA.HY is an index based on a basket of North American (NA) single-name high-yield credit default swaps.
The CDX index rolls over every six months, and its 125 names enter and leave the index as appropriate. For example, if one name is upgraded from "below investment grade" to IG, it will move from the HY index to the IG index when the rebalance occurs.
The ABX and CMBX are baskets of credit default swaps on two securitized products: asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS). The ABX is based on ABS home equity loans, and the CMBX on CMBS. So for example, the ticker ABX.HE.AA denotes an index that is based on a basket of 20 ABS Home Equity (HE) credit default swaps whose reference obligations are 'AA'-rated bonds. There are separate ABX indices for ratings ranging from "AAA" to "BBB-." The CMBX is also broken down into indices by ratings but is based on a basket of 25 credit default swaps that reference CMBS securities.
The LCDX is a credit-derivative index with a basket made up of single-name, loan-only credit default swaps. The loans referred to are leveraged loans. The basket is made up of 100 names. Although a bank loan is considered secured debt, the names that usually trade in the leveraged loan market are lower-quality credits. (If they could issue in the normal IG markets, they would.) Therefore, the LCDX index is used mostly by those looking for exposure to high-yield debt.
All of the above indices are administered by IHS Markit. For these indices to work, they must have sufficient liquidity. Therefore, the issuer has commitments from the largest dealers (large investment banks) to provide liquidity in the market.
How the Indices Are Used
Different fixed-income participants use various indices for different reasons. They also vary as to what side of the trade they are taking: buying protection or selling protection. For portfolio managers, single-name credit default swaps are great if you have specific exposure that you would like to hedge. For example, let's say that you own a bond that you believe will suffer a price decline due to the issuer's credit deterioration. You could buy protection on that name with a single-name CDS, which will increase in value if the price of the bond declines.
What is more common, however, is for a portfolio manager to use a credit-derivative index. Let's say you want to gain exposure to the high-yield sector. You could enter a sell protection trade on the CDX.NA.HY (which, if you remember from earlier, would effectively function as a long in high yield). This way, you don't need to have an opinion on certain credits; you don't need to buy several bonds either—one trade will do the job, and you'll be able to enter and exit it quickly. This highlights the main advantages of indices and derivatives in general: the liquidity feature of indices is an advantage in times of market stress. With the CDS indices, you can increase or decrease exposure to a broad category quickly. And, as with many derivatives, you don't have to tie up your cash when entering the trade.
Some market participants are not hedging at all; they are speculating. This means that they will not own the underlying bond at all, but will instead enter the credit derivative contract naked. These speculators are usually hedge funds, which do not have the same restrictions on shorting and leverage as do most other funds.
The Bottom Line
Who are the typical users of the securitized product indexes? It could be a portfolio manager looking to quickly gain or reduce exposure to this segment, or it might be another market participant, such as a bank or financial institution that issues home equity loans. Both parties could use ABX in their hedging strategies.
New credit derivatives are being developed. Demand will determine what is innovated next, so it's always a good idea to keep track of with tools such as IHS Markit.