Market eyes emerging market CDS index expansion

Participants hope changes will help transform single-name volumes into greater index activity


Industry participants are hoping that updates to the main emerging market credit default swap (CDS) index and the creation of two sub-indexes will encourage more activity while boosting relative value trading.

Sovereign CDS contracts are among the most highly traded single names and emerging market countries make up the lion’s share of that activity, accounting for eight of the 10 most-active contracts in the six months to late August, according to average weekly figures provided by the Depository Trust & Clearing Corporation (DTCC).

But trading in the CDX EM, the index comprised of emerging market sovereigns, has consistently lagged the North American and European corporate indexes, where average daily volumes in available untranched versions significantly overshadow the EM index.

Market participants hope that several updates will change that situation by giving emerging market investors more options to trade and hedge their exposure. Chief among these changes is the launch on September 27 of two 11-name sub-indexes based on sovereign credit ratings.

“We heard demand from a number of market participants that these distinct flavours of EM credit would be useful as a new tool that investors can trade. Now you can target the rating slice that you’re looking for,” says Nicholas Godec, head of fixed income tradables at S&P Dow Jones Indices. S&P Global owns the CDS index administrator IHS Markit.

The main index will continue to contain sovereigns with both investment grade and high-yield credit ratings. Previously, investors with primarily investment grade sovereign bond holdings may have had to pay extra for an imperfect hedge with the main index because of its high-yield constituents, which typically cost more to insure against default.

The new indexes – CDX EM IG and CDX EM HY – also create an opportunity for relative value trading where users can express views on the difference between emerging market credit rating buckets or between emerging and developed market credit risk, says Jigar Patel, a credit derivatives strategist at Barclays.

“The hope is that you can think of these things as being more of a macro representation – investment grade versus high yield. That’s what we see in the US with the corporate indices,” he says.

For the moment, the size of the indexes means they will sit somewhere between the macro index products and single-name contracts where idiosyncratic drivers move prices. Eventually, expanding the indexes will make them trade more like macro-driven products.

“There was real demand to create these sub-indices, so hopefully there will be follow-through in terms of activity,” says Patel.

Traders already use single-name contracts to trade emerging markets, and do so more actively than they trade the index. Average daily volumes for contracts referencing Brazil, Mexico, South Africa and Turkey totalled $1.3 billion notional in the three months ending June 23, according to DTCC daily averages. The figure exceeded the average daily volumes traded on all CDX EM series over that period and reflected nearly double the number of trades.

The four most-active corporate CDS contracts saw combined average daily volumes of $650 million in that period.

The latest EM index series, which rolled on September 20, added Morocco and Nigeria to take the number of constituents to 22. The changes follow the addition of Bahrain and the Dominican Republic to the index in March. Contracts are eligible for the index if the referencing country has at least $3 billion in outstanding US dollar-denominated sovereign debt or $2 billion in sub-sovereign debt.

Expanding the main index helps create trading activity in the constituent contracts as traders look to take advantage of price discrepancies between the index and its underlyings, known as skew.

Average daily volumes in Dominican Republic and Bahrain CDSs, for instance, grew from $2.5 million and $7.5 million, respectively, in the three months before their March inclusion in the index to $5 million and $10 million in the three months afterwards, DTCC figures show.

The index expansion comes during a period of subdued volatility, but Patel hopes that consistent dealer presence will encourage traders to turn to the new products when volatility rises.

“Volatility overall has been pretty low across markets, and volumes for macro products are down versus last year when volatility was high. You need to see volatility pick up to create interesting relative value opportunities, and dealers need to be out there making markets to accommodate the demand that I think will come with volatility,” he says.

DTCC figures from the second quarter show that the most-active EM index series saw roughly the same number of dealers quoting as there were for the most-active indexes comprising North American and European corporates. The figures have declined in the past five years for all indexes, and the EM index often saw fewer participating dealers.

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