“The LCDX index and the index tranches were created to bring greater price transparency to the cash collateralised loan obligation (CLO) market and the tranching of CLOs,” said Don Fewer, New York-based head of credit brokerage for the Americas at GFI, an interdealer brokerage based in New York.
"It’s typical to produce an index, get critical volume, and then produce next-generation products, such as tranches or swaptions. LCDX index tranches are the next stage of the development of the loan-only LCDS product,” said Lisa Watkinson, head of global structured credit business development at Lehman Brothers in New York.
For almost three years, dealers have been trying to standardise loan-only CDS with the ultimate aim of creating index products. Since August, several dealers, including Lehman Brothers, Goldman Sachs and Deutsche Bank, have been trading bespoke tranche products. JP Morgan, Morgan Stanley, Citi and Merrill Lynch are also expected to participate in the standardised market.
The standardised LCDX tranches will reference the same 100 equally weighted North American LCDSs as the LCDX index, which in turn references syndicated first-lien loans. Demarcation limits will be 0%-5%, 5%-8%, 8%-12%, 12%-15% and 15%-100%. The products will initially launch with five-year terms. A typical notional size is expected to be $10 million to $20 million.
The creation of index tranches offers investors a way to go long or short various parts of a loan-only capital structure. So, for example, if an investor believes the market price of the riskiest portion of the LCDX index portfolio is overvalued, while the senior mezzanine tranche is undervalued, the investor can go long the 0%-5% tranche and at the same time buy protection on the 8%-12% tranche. An intraday mid-market price for the 8%-12% index tranche was 703 basis points on October 9, according to GFI.
See also: LCDX index debuts in US