The alphabet soup of credit derivative indexes

Many fixed-income players seem to be speaking in code. They use terms like ABX, CMBX, CDX, and LCDX. What on earth are they talking about? This article will explain the alphabet soup of the credit derivative indexes and give you an idea of why different market participants might use them.

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 whose 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.

The credit default swap (CDS) is a type of credit derivative. Single-name (only one reference company) CDSs were first created in the mid-1990s 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 CDSs. The current index is known as 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 credit default swap 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 CDSs, 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 tradable indexes include: CDX, ABX, CMBX, and LCDX. The CDX indexes are broken out between investment grade (IG), high yield (HY), high volatility (HVOL), crossover (XO) 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 CDSs. The crossover index includes names that are split rated, meaning they are rated "investment grade" by one agency and "below investment grade" by another.

The CDX index rolls over every six months, and its 125 names enter and leave the index as appropriate. For example, if one of the names 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 CDSs 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, the ticker ABX.HE.AA, for example, denotes an index that is based on a basket of 20 ABS Home Equity (HE) CDSs whose reference obligations are 'AA'-rated bonds. There are five separate ABX indexes for ratings ranging from "AAA" to "BBB-." The CMBX also has the same breakdown of five indexes by ratings, but is based on a basket of 25 CDSs, which reference CMBS securities. (For related insight, see "Behind the Scenes of Your Mortgage.")

The LCDX is a credit-derivative index with a basket made up of single-name, loan-only CDSs. 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 indexes are issued by the CDS Index Company and administered by Markit. For these indexes 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.

Different fixed-income participants use the various indexes 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 CDSs are great if you have specific exposure that you would like to hedge. For example, let's say that you own a bond which 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 indexes and derivatives in general: The liquidity feature of indexes is an advantage in times of market stress. With the CDS indexes 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.

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, but you can keep track of new developments on Markit's website. (For related insight, see "Speculating With Exchange-Traded Funds.")