In recent years, the CDS market has experienced exponential growth. It was therefore not particularly surprising when market participants were confronted with settlement issues requiring their immediate attention. The fact that the notional value of traded credit derivatives in some cases far exceeds the amount outstanding of the relevant corporate bonds, caused concern among the investing community, along with fears about the effects of credit events on this new market. Alarmed by these events, regulators now scrutinise the CDS market more closely. Fortunately, regulators and market participants have cooperated and are addressing successfully the most urgent problems – the backlog of unsettled trades and cash settlement for some defaulted names. Implementation of an auction process has managed to avoid bottlenecks and extreme market distortions.
The attendant media coverage of these events and the Chapter 11 filing by Delphi, the American supplier to the automobile industry, has caused much concern amongst traders, analysts and investors.
However, there is a rapidly growing group of sophisticated institutional investors that understand credit. They are aware of credit risk and the impact of credit events on their portfolios and have learned how to use credit derivatives to hedge their positions or gain exposure to a credit with single name CDS, thus enhancing efficiency and reducing the cost of their portfolio management.
CDS indices
Providing market standards to facilitate investment, trading, hedging and to help improve market liquidity through indices is an important part of our business rationale. The tradable iTraxx indices are used by investors to hedge entire or partial portfolios in one easy transaction, rather than achieving the same effect with numerous single name CDS transactions. Positions can easily be rolled forward or closed as required in only one transaction.
These indices are easy and efficient to trade. Investors can express their bullish or bearish views on credit as an asset class, while having the low costs associated with static portfolios and the flexibility to actively manage credit portfolios. The indices enable investors to trade credit risk separately from interest rate and/or currency risk.
While investors use CDS indices to trade large positions in credit names without having direct exposure to the underlying securities, these same instruments permit other participants, such as speculators and arbitrageurs, to take part in this market. Taking a long position in, say, iTraxx Europe – the main investment grade index of 125 equally-weighted names – without exposure to a cash bond position, offers upside potential in case of underlying credit deterioration. Arbitrageurs can exploit spread differentials between the CDS, equity and cash markets. The result is additional liquidity provided by hedge funds and arbitrageurs, and an easier/more efficient risk diversification or market exposure for the buy-side.
Since iTraxx was introduced, the basis between Euro cash bonds and CDS has been greatly reduced. Trading desks have increased their trading volumes substantially, and hedge funds seeking to profit from price inefficiencies between the CDS and cash bond markets have helped tighten the cash/synthetic gap. There is also significant correlation of default risk in the indices, enabling more efficient pricing in the form of tighter bid-offer spreads. This shows their role in the standardisation of credit derivatives.
Correlation also exists between CDS spreads and equity prices. Spreads tend to widen when stock prices fall and vice versa. Not surprisingly then, stock index returns and volatility are significantly correlated with iTraxx index spreads; spreads increase (decrease) with rising (falling) stock volatilities, based on observations of three-month historical volatilities.
As the market has developed and liquidity in credit has improved, it has become possible to trade tighter ranges and higher volumes, and enter and exit relative value and curve trades at lower costs. Short biased managers and momentum traders can use volatility trades in sub-sectors according to their fundamental view of a specific sector. In addition, there is the benefit of timing flexibility and low cost structure provided by index baskets. Active managers can implement a credit duration strategy, largely independent from the primary and secondary cash markets. Managers can manage their portfolios with three separate components: credi duration, interest rate duration and relative value trades.
iTraxx tranches were initially traded to serve mark-to-market purposes and help book runners manage their P&L. Tranches are also being used to trade/hedge correlation risk. Given that the underlying portfolio is agreed with a fixed maturity date, market-makers of iTraxx indices also quote standard tranches from an equity or first loss to the most senior tranche.
Volume and liquidity are expected to develop further, based on the assumption that cash players, who cannot currently be active in the CDS market for regulatory reasons, will participate as the products become more widely accepted. The added challenge to managing these securities is their leverage and the necessity of understanding the ‘greeks’. Therefore, managing exposure and hedging across different bond seniorities requires more use of standardised instruments.
Futures and options
As markets evolve they tend to become more complex, and the CDS index market will be no exception as it progresses towards a functioning future and options market. Futures and options give investors the possibility of assuming leverage and reducing rebalancing costs (delta hedging).
Particularly iTraxx credit futures could bring yet more participants to the market, since exchange traded products will increase confidence among investors. Dealers will be involved in committing liquidity to a futures product and are working on tradable fixings for the index to provide a base to develop options and more exotic products.
iTraxx options would give the right to buy or sell at a future date current standard iTraxx CDS at an agreed price, thus allowing credit risk managers to trade volatility more effectively.
Using option models will allow managers to price spread indices, as the option price would reflect expected spread volatility. Historical iTraxx volatility, or the tails of the distribution of iTraxx spread returns, is lower (i.e. thinner tails) than for single-name CDS, due to diversification within the indices. Options are also a way of hedging against spread widening, without facing higher costs, especially for managers who want retain their in-the-money holdings after the spread tightening of recent years.
The liquidity and transparency provided by the indices has paved the way for new products, such as iTraxx tranches and standardised first-to-default baskets. This in turn lays the foundation for further development of exchange-traded futures contracts and options that will provide a new dimension for buy-side organisations to manage credit risk.
When the markets needed a benchmark for credit risk, iTraxx provided the tool that enabled trading and portfolio hedging and has established itself as a market standard. By adding liquidity and transparency iTraxx has proven that credit risk itself is an asset class of its own with as much complexity as other more established markets such as equity.
The success could not have been achieved without the goodwill and cooperation of investment banks, but especially not without the input from investment managers, who, after identifying the need for indices and hedging instruments, will continue to expect to be provided with products and opportunities to serve their needs.
Christoph Stübbe is senior marketing manager at International Index Company.
