Invest Skeptically

Markit provides authoritative quotes for standardized structured finance and credit indices used in the credit derivatives markets. As these represent the cost of buying/selling credit default swap (CDS) protection against a basket of credits they can be a useful data point in evaluating the level of fear in the marketplace. As 2007 has taught us, fear can lead to low liquidity, high volatility, and high correlation (i.e. fear in the credit markets can affect your stock portfolio as well).

Here’s a brief–and greatly simplified–summary of some popular indices:

• The CDX.NA family of indices represent North American (mainly U.S.) corporate credits. The “.HY” stands for High Yield, “.IG” stands for Investment Grade, “.HVOL” stands for High Volatility, and “.XO” stands for Crossover (credits between high yield and investment grade). They are quoted in spread, which represents the premium in bps you would have to pay to buy protection on the index. For example, a spread of 76 on the CDX.NA.IG means you pay 0.0076% annually to buy default protection on the 125 names in the index. The index is “rolled” every six months which creates a new series.
• The iTraxx Europe indices are similar to the CDX.NA but for European credits.
• The ABX-HE (CDS on Home Equity ABS) indices are for CDS protection on tranches of subprime mortgage securities. As with the corporate credit indices, these are rolled every six months. Because of the nature of the underlying product, the labelling and quoting is a little bit different. The caption, “ABX-HE-BBB 07-2,” means its the ABX-HE index of BBB subprime RMBS tranches created in the second half (July) of 2007. It is important to remember that this is an index of BBB tranches from different subprime securitizations. So the exposure is to, say, 20 individual tranches but possibly thousands of underlying mortgages. Because of the timing of the roll this index would be mainly comprised of RMBS issued in the first half of 2007. If ABX-HE-BBB 07-2 quotes at a price of 22, this means you would pay 78% (=100%-22%) upfront (i.e. on day 1) and then 500 bps (or 5%) annually to buy CDS protection on this index. Sound expensive?
• The CMBX is similar to the ABX but for CMBS securities. It is quoted in spread.

One important caveat about these “indices” is that they are created based on the relatively high liquidity of the underlying names. They do not necessarily serve as a broad credit market proxy. For example, the CDX.NA.IG only has 125 names in it.