The CDS indicator

The correlation between the behaviour of credit default swaps and cash bonds has given investors a number of opportunities to exploit, as John Caserta discovers

Credit default swaps have emerged as a useful tool in determining investment strategies in the cash bond market. Research has shown that despite several deviations, these credit derivative instruments generally lead spread performance for cash bonds. As single-name default contracts have developed as tools to anticipate sentiment in the debt market, new research by Lehman Brothers suggests that portfolio credit default swap products, such as the tradable Dow Jones CDX indices, provide an indicator for spread performance in the broader cash arena.

Similar to other market-based indicators such as Treasuries and equities, credit derivatives can be used to gauge both the spread performance of the cash market and short-term market sentiment. While analysts cite numerous reasons for the close relationship between the cash and credit default swap (CDS) markets, the enhanced liquidity inherent in trading credit derivatives is the fundamental quality that makes it a good leading indicator for cash spreads.

“Via credit default swaps, investors can go long or short without having to find the underlying asset, making them more accessible and easier to trade,” says Elena Ranguelova, structured credit strategist at Lehman Brothers. This enables investors, such as hedge fund managers, to enter and exit the derivatives market quickly and easily.

Ian Marsh, professor of finance at the Cass Business School in London, also emphasises the importance of liquidity in recent research conducted with Roberto Blanco and Simon Brennan from the Bank of England. The research relates to the time lag between the cash and CDS markets, which makes credit default swaps a valuable tool in assessing market sentiment. While macro variables such as interest rates tend to have an immediate impact on credit spreads in the short term, CDS prices are more vulnerable to firm-specific information.

However, research conducted by the Stanford Graduate School of Business emphasises an inherent problem in the use of single-name default contracts. According to the research, by 2001, companies such as Enron and Southern California Edison were highlighting the need to diversify away from concentration in single-name risks. Morgan Stanley saw a solution to this problem in the equity markets.

Large diversified baskets of tradable stocks, such as exchange-traded funds (ETFs) and the Nasdaq-100 Index Tracking Stock, were major drivers behind the development of Morgan Stanley’s Tracers and, eventually, Synthetic Tracers products, which launched in 2002.

Synthetic Tracers is a tradable portfolio of 50 equally weighted, investment-grade credit default swaps. Lisa Watkinson, global credit index product manager at Morgan Stanley, notes that prior to the development of tradable baskets of CDSs, investors seeking exposure in the corporate bond market would have to create their own portfolio, a technical and expensive process. Yet, a basket of tradable credit default swaps isolates creditworthiness without the technicalities, says Watkinson.

Synthetic Tracers eventually developed into the Trac-x index, which met some competition from a consortium of banks that launched the iBoxx CDX index. To the delight of many investors, the banks behind the indices announced the merger of both Trac-x and iBoxx CDX this past April into one index known as the Dow Jones CDX.

Ranguelova at Lehman Brothers notes that while iBoxx CDX will essentially undergo a name change, the changes for the Trac-x index will be more significant. Although Trac-x will continue to trade, there will be no new roll for the index, which will directly impact its liquidity.

A cash guide

According to Lehman Brothers, the Dow Jones CDX can be used as an indicator for spread performance in not only the broader credit derivative market, but the cash market as well. In her research with Lorraine Fan, credit analyst at Lehman Brothers, Ranguelova notes that investors have used portfolio CDS products such as the CDX.NA.IG and HVOL as a very liquid way to take a long or short position in the credit market. Deviations from the intrinsic values tend to signal bullish or bearish short-term market sentiment.

“The fact that there will be just one high-yield CDS index product going forward means that a broader participant base will be using a single product, making it a more liquid, concentrated test of market sentiment,” says Geoff Kelley, senior vice president and portfolio manager at Putnam Investments. Managing director of North America credit derivative and quantitative research at JPMorgan, Eric Beinstein, notes that the merger between Trac-x and iBoxx is a natural progression in the development of credit derivative indices that are far more liquid.

“As the credit derivatives market has developed and grown, it has taken on a parallel role as a market for assuming or shedding credit risk. This creates a natural and close relationship – albeit not a perfect one – between premiums in the credit derivatives market and spreads quoted in the cash bond market,” says Roger Merritt, managing director in the credit policy group at Fitch Ratings.

Yet, analysts at Fitch also note that the performance of credit derivatives may send “false positives” to those who use it as a monitor for market sentiment in the credit market. Specifically, the research cites several cases in which CDS spreads widened only to tighten again within a year.

Fitch points to France Télécom as the spreads that cried wolf. According to Fitch, the company’s CDS widened to 730bp during late June 2002, a spread performance which echoed that of WorldCom three months before its financial demise. Yet, Fitch maintained a BBB+ rating, indicating that spreads were only part of the complex credit picture. By December 2003 France Télécom’s CDS traded at 63bp.

Some have gone as far as to suggest that spreads may provide a more accurate picture of creditworthiness than credit ratings. Yet Fitch contends that CDS spread performance is merely one instrument for determining fixed-income investment strategies. Fitch notes that while long-term investors tend to look at credit ratings, risk managers and traders looking to take a short position in credit are more likely to place emphasis on market-based indicators.

While analysts and researchers continue to investigate the existing relationship between credit derivatives and the cash bond market, the consolidation of CDS portfolio products continues to increase liquidity and pricing transparency, giving investors a more refined market-based indicator to incorporate into their investment strategies.

How close are the index and its components?