After falling out of favor during and after the crash of 2008, the market for derivatives like credit indexes is enjoying a heady run. Even if they don't plan on using their own money to invest in them, investors and financial professionals would do well to understand the basic characteristics and quirks of these vehicles.
Single Name, nth-to-Default?
Broadly defined, credit indexes are exchanges on which "nth-to-default" credit default swaps that lack leverage or certain other preconditions may be traded. As such, they're viewed as a relatively simple means of gaining access to the profit potential in a given basket of credits.
Credit default swaps trade under specific ticker symbols on their "home" credit indexes. Since gaining widespread acceptance towards the end of the 1990s, these securities have permitted their holders to benefit from changes in the value of the bonds, loans, credit arrangements or other contracts that underlie them. As "single name" vehicles, they offer exposure to a single company's basket of credits.
Roll Dates
One of the most important features of credit indexes is their propensity to "roll over" at predetermined dates. These events generally occur on a semiannual basis and result in the piecemeal reordering of individual swaps within a given index. Depending on the size of the index and the popularity of its constituents, a rollover may involve the replacement of anywhere from one or two to 30 or 40 credit default swaps in a given credit index. Although traders and brokers have some input as to the changes that occur on roll dates, final listing and weighting decisions are generally made by each index's administrator. For most credit indexes, the liquidity of an individual name is an important determinant of its desirability as a listed vehicle.
Major Players
In the United States, there are four major credit indexes that can be traded with reasonable liquidity:
Multiple credit indexes also exist in other countries and regions, including:
- Europe
- Japan
- "Non-Japan" Asia
- Australia
- Certain emerging markets
The exact number of credit issues within each index is variable. For instance, the CDX consists of five sub-indexes that each feature 25 individual names that have been grouped according to their creditworthiness. Meanwhile, the LCDX has 100 names. The other two U.S. indexes are considerably smaller.
Common Uses, Benefits and Cautions
As an important feature of the global securities markets, credit indexes have a wide range of uses. Like other investment vehicles, they offer tremendous profit potential as well as significant risks that investors must work hard to understand and quantify.
Many managers of bond-heavy investment portfolios regularly dip into credit indexes to hedge risky bets. By buying into a position in the credit default swap that underlies a given bond, they receive compensation in the event that the bond declines in value or enters default. If their bond avoids default, they lose the premium that they've paid.
In other cases, traders or hedge fund managers "sell protection" on potentially risky high-yield bonds that they believe will avoid delinquency. As long as the bond doesn't enter default, these traders get to keep the premium that they've received and can move onto the next trade when the bond matures. Alternatively, they can simply sell out of the trade as the underlying bond's value rises. Of course, this exposes them to a significant amount of risk in the event of default.
Although they're full of promise, credit indexes aren't for finance novices. They also aren't for the faint of heart. Before entering either side of a trade on a credit index, investors must do their own due diligence and be sure to understand what they're getting into.
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