Early days for indexes
Over the past six months or so, two multi-dealer indexes have emerged – the CJ 50 Index created by French bank BNP Paribas, and Trac-x Japan launched by JP Morgan Chase and Morgan Stanley. Meanwhile, single-dealer products have also been launched, such as Merrill Lynch’s Asia-Liquid Indexed Credits (Asia-Linc) and Lehman Brothers’ Japanese Corporate CDS index. The Trac-x and CJ 50 Index both comprise Japan’s 50 most liquid credit default swaps, while the Lehman Brothers’ product tracks 40 Japanese corporates. Asia-Linc, meanwhile, tracks 25 of the most liquid Asia ex-Japan credit default swaps.
The CJ 50 Index was the first multi-dealer index to emerge, launched in February using data from BNP Paribas, Bank of Tokyo-Mitsubishi and Goldman Sachs. By early August, the list of contributors had expanded to include Bear Stearns, Crédit Lyonnais, UBS and Japan’s UFJ Bank. The index, which started trading in late July, can be used to take exposure to the Japanese CDS market in a cost-effective way because of tight bid/offer spreads on the index, says Go Yajima, senior structurer in the credit derivatives department at BNP Paribas in Tokyo. “It is easier to take directional positions on the overall market performance, because by getting into a long position through CJ 50 with a 1 basis point bid/offer spread, [users] can easily take profit from the market movement, [and] can get out of the position.” On the first day of trading, July 31, transaction volumes exceeded ¥10 billion ($84 million), while on average ¥2 billion of trades were completed daily in the first week.
Meanwhile, the Trac-x Japan was established in July through the merger of Morgan Stanley’s MSJ-CDS index, launched in September 2002, and JP Morgan Chase’s Janice, launched in January this year. The index tracks the 50 most actively traded corporate and financial names, based on the two companies’ CDS trading volumes between April 2002 and March 2003. At the end of July, both companies began quoting two-way prices on the first series of the index. While there have been a few small trades, most investors and hedgers are still evaluating confirmation templates and the trade specifications, says Kazuhiko Toya, vice-president in the investor solutions group at JP Morgan Chase in Tokyo.
Along with achieving exposure to a diversified pool of credits, the indexes can be used as a hedge for both a portfolio of loans or bonds. “The credit default swap index is a very convenient way to hedge a portfolio,” says Toya, adding that JP Morgan Chase and Morgan Stanley conducted statistical analysis to work out the correlation between the Trac-x Japan with an average cash bond portfolio consisting of around 100 bonds, which showed a 0.8 correlation quotient. “So it’s not a perfect hedge but it looks like a very good tracing of the portfolio spread movement,” he says.
Unlike the two multi-dealer indexes, the Lehman Brothers Corporate Japan CDS index comes in both an equal-weighted and market value weighted format (whereby the credits in the index are weighted according to the market value of outstanding bonds). This, says Dominic O’Kane, executive director in the fixed-income research division of Lehman Brothers in London, is to cater for two different types of investors. The market value weighted index is aimed at traditional asset managers “that want to get involved in the CDS market but still want to maintain this link with the cash market,” says O’Kane.
He adds that the market value weighted index acts as a closely aligned hedge on a fixed-income portfolio. “If you were sitting on a cash portfolio and you wanted to hedge the systemic risk, doing the market value weighted CDS would be the best way to do that. That would be the best hedge as it would most closely match the underlying credit weights,” says O’Kane. Meanwhile, the equal-weighted index would appeal to credit investors such as banks and insurance companies that would prefer a benchmark without a significant concentration in any particular name.
However, it seems the idea of synthetic credit indexes has yet to really take off among the region’s asset managers. “We’ve only just started studying [credit indexes] and we haven’t decided whether to use a product like Trac-x,” says one Japanese asset manager, who asked not to be named. Another fixed-income manager at a Japanese insurance company, responsible for a ¥2 trillion portfolio, says that while he uses indexes referenced to Japanese corporate bonds to observe movements in the credit market, he would not be inclined to employ credit default swap indexes to manage the credit risk on his portfolio or to achieve exposure. “In the future we may, but right now we don’t use it because we don’t feel we have to use that,” he says.
Nonetheless, some asset managers agree that credit default swap indexes will be a useful tool, primarily for gaining diversified exposure to the region’s credit markets in a single trade. “The benefit is if you have a small pool of money you can get instant diversification,” says one executive director at an asset management company in Singapore. “That’s a big advantage.”
As yet, the most active traders of the credit indexes have been banks, largely using the product for portfolio management as well as hedging the risks on synthetic collateralised debt obligation (CDO) portfolios. “There are always left over tranches of CDOs done in the past, with names that are not hedgeable and those names are there in the CJ 50. So you can sell protection on the CJ 50 to try and get some exposure on those names,” says Ranodeb Roy, Tokyo-based managing director at Merrill Lynch.
In April, Merrill Lynch launched its own credit index product, a five year CDS based on a portfolio of 25 of the most liquid Asian credits. The first Asia-Linc was launched at the end of April with a spread of 125bp and new Asia-Lincs will be launched every six to 12 months. While the index can by used by market participants wanting to take exposure to the Asian credit markets or to hedge their portfolios, Asia-Linc is also aimed at hedge funds and proprietary traders looking to put on out-performance swap trades or pursue capital structure arbitrage strategies. “[The] concept came from what existed in the US and Europe, where there were Tracers and Trac-x, and there was no such index in Asia,” explains Roy. “The concept of having an index that is liquid and has a tight bid/offer spread and allows trading accounts, prop accounts, hedge funds and banks to trade was basically the reason why we launched the product.” While Roy declined to comment on the transaction volumes of the index, he notes that the bank has seen reasonable two-way flow, primarily with hedge funds and prop trading accounts based largely in London, US, Hong Kong or Singapore.
While it is still early days for the new credit indexes, banks are typically looking to launch products off the back of the indexes, including options and funded products such as credit-linked notes. First-to-default and CDOs referenced to the indexes are also expected to emerge, although there’s some difference of opinion as to whether structuring CDOs would be popular with investors due to the small number of names that comprise the indexes. “People want more granularity in their portfolio,” says one banker, who asked not to be named. “They don’t want one loss, because if you’ve got 50 names in your portfolio, a single loss means that you will lose 2% when there’s a default if you had a zero recovery, and that’s too much name-specific risk,” he says. “People would rather have 100 names because each default actually has a lower impact.”
However, JP Morgan Chase’s Toya argues that while the Trac-x Japan index may have fewer underlying names than a normal CDO portfolio, it still has a weighted average rating factor of Baa2 from Moody’s Investors Service and a Moody’s diversity score of 32, which is good enough to create tranches of notes referenced to the index.
Ralph Orciuoli, managing director and head of credit trading at Bear Stearns in Tokyo, adds that while 50 names is probably the minimum required to structure a CDO, the quality of the credits that comprise the CJ 50 Index makes up for the small size of the portfolio. “It’s a good-quality portfolio. Unlike a 100 to 200 name deal where a number of weak names may linger with inevitable credit events, the 50 names are solid. Using the Moody’s rating, the weighted average rating factor is between Baa1 and Baa2, and applying Ratings & Investment (R&I) ratings to the same calculation puts the rating well into the A range. The good quality offsets the fact that it’s only a 50-name pool. And portfolios rated A by R&I means the potential Japanese investor base is quite a large universe.”
But despite the benefits of credit indexes, the emergence of several products within a few months has led to suggestions that the market for index products is already crowded. Some bankers point out that trading and arbitrage opportunities could emerge between the various indexes, but Orciuoli notes that for an index to really evolve in terms of product development, strong liquidity is paramount. “The issue is not whether there is room in the market for two or more indexes – there is. The issue is whether there is room for one highly liquid index. I think the answer might be no in Japan. Things may get a little bit crowded.”
However, for the time being, there’s little sign of consolidation between the various index providers. JP Morgan Chase and Morgan Stanley are believed to have turned down an invitation to contribute to the CJ 50 Index, and while BNP Paribas announced in April that it would make markets in the Trac-x Europe CDS index, BNP’s Yajima says there are no plans for the banks to do the same for the Trac-x Japan.
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