CDX/iTraxx 2020 Annual Review – Indices, Tranches and Swaptions
In 2020, CDS index return performance was extremely volatile in H1 as the Covid-19 pandemic unfolded. In the second half of the year, returns were considerably subdued, and attempted to recoup losses with mixed results.
CDS index volume activity was greater than usual in 2020, driven by the increase in trading as a result of the volatility in March and April. While returns were lackluster, the increased trading activity concurrent with volatility supported the case for CDS indices as instruments for price discovery and ease of market access. The high liquidity and the ability to easily trade CDS indices appealed to investors during choppy markets. This was most strongly visible in the untranched and tranched trading volumes.
Of the 11 credit events that took place in CDX HY in 2020, Noble Energy was the only entity to default in H2. The credit event occurred towards the start of the second half, determined by the ISDA DC on July 31. The iTraxx Crossover saw 4 credit events in 2020, all of them in H2, the last one being Europcar Mobility Group in December.
Investment grade and high yield markets reacted similarly in the US and Europe. CDX HY ended the year down 4.59%, while the maximum drawdown saw the index down as much as 20.16% on March 23. iTraxx Crossover finished the year up 42 basis points; however, had a maximum drawdown of -18.46% on March 18. CDX IG and iTraxx Europe ended the year flat, with CDX IG up only 21 basis points versus no change for iTraxx Europe, with maximum drawdowns of -4.20% and -4.00%, respectively. CDX EM notched a negative 7 basis point return for the year with a maximum drawdown of -10.88%. iTraxx Asia ex-Japan was the best performer of the CDS indices - after losing a maximum -4.98% on March 23, the index went on to close the year with a 4.24% return, as the Asia Pacific succeeded to lockdown their economies early in the pandemic.
The index skew is calculated as the basis between the tradable index spread and a theoretical index spread, which is a weighted average of the spreads of the CDS single names that constitute the index. Due to their strong liquidity, the indices are widely preferred to express macro views, while the single names act as effective instruments to gain exposure to idiosyncratic risk or managing counterparty risk. This results in a natural tendency towards a negative index skew. In times of market stress, specific single names could experience a one-way market leading to excessive widening of names and driving up theoretical spreads if they happen to be index constituents.
The average skew across CDX IG and iTraxx Europe were -10 and -5 basis points, respectively. The index skews reached their lowest on March 24 for CDX IG, -62bp, and April 13 for iTraxx Europe, -21bp. The maximum skews were 1bp and 4bp, occurring on March 12.
In high yield, CDX HY and iTraxx Crossover averaged skews of -17bp and -5bp, respectively, bottoming out on March 12 at -132bp and -68bp. CDX HY and iTraxx Crossover saw significantly greater volatility in skews, reaching highs of 49bp and 71bp on March 12, respectively.
CDX EM and iTraxx Asia ex-Japan differed from the corporate CDS index markets in their tendency towards positive skews during the pandemic volatility. The minimum skews for CDX EM and iTraxx Asia Ex-Japan were -14bp and -4bp, while the maximum skews were 100bp and 66bp, respectively. Their skews averaged 0bp and 3bp, respectively.
The CDS index curves give a good sense of how the market is pricing in near-term defaults relative to long-term defaults. For example, the 5s10s curve is calculated as the 10Y spread minus the 5Y spread. A decrease in curves due to the 5Y spread widening is an indication of a higher default probability in the near-term resulting in the 5Y and 10Y spreads being closer to each other.
The CDX IG 5s10s curve began the year at 45bp and ended the year only 4bp less at 41 bp. In between, the curve averaged 37bp, and hit a low of 16bp on March 20, driven by outpaced widening in the 5Y.
iTraxx Europe 5s10s began the year at 41bp and ended the year at 38bp. Like the CDX IG 5s10s, the minimum iTraxx Europe 5s10s curve value was 16bp.
CDX HY 3s5s was the only curve to average a negative skew for the year (-4bps), reaching a low of -171bp on April 9. It is worth noting that the on-the-run CDX HY index had a sizable 8 credit events occur in 2020. Curve volatility was especially high, scoring a maximum positive 72bp skew six days earlier on April 3.
iTraxx Crossover 3s5s also exhibited curve volatility, logging a minimum 29bp on September 4 and a maximum 72bp on March 20 and averaging 46bp for the year.
CDS index volumes in 2020 were higher than they have been in the last six years. CDS indices touched $25 trillion in notional traded in 2020, out of which about $15 trillion was in the first half of the year. The volatility in March and April drove up index volumes, resulting in a strong first half.
Unlike the untranched indices, CDX/iTraxx tranches roll only once in September, so prior to the September 2020 roll, the on-the-run tranches were on Series 33 for CDX and Series 32 for iTraxx. Tranches are most commonly traded on indices at the 5Y tenor.
On the IG front, the equity and mezzanine tranche spreads for CDX IG were wider than those of iTraxx Europe. However, the corresponding senior and super senior tranche spreads were narrower for CDX IG relative to iTraxx Europe. This could partly be attributed to the respective tranche sizes as the attachment points of standard senior and super senior tranches of iTraxx Europe are lower than those of CDX IG, implying smaller cushions protecting them. Across tranches on both indices, the spreads seem to have reverted to the pre-Covid levels in 2020.
Tranche spreads on the CDX HY index were especially unique owing to the string of credit events, mostly in the first half of 2020. The standard equity tranche of CDX HY index trades with attachment and detachment points of 0 and 15%, respectively. The losses from the 11 credit events in CDX.NA.HY S33 amounted to over 10%, largely reducing the cushion protecting the upper tranches. On the other hand, iTraxx Crossover, which only had 2 credit events in Series 32 prior to the September roll, suffered losses amounting to about 1.3%. The standard equity tranche of iTraxx Crossover index trades as a 0-10% tranche.
The year 2020 also saw a rise in CDX/iTraxx tranche volumes with over $270 billion in notional traded. As it can be seen from the chart below, there is a consistent upward trend in CDX/iTraxx tranche volumes over the last six years. The steady liquidity of the underlying iTraxx/CDX indices, especially in times of distressed markets, has supported the growth of non-linear products referencing the indices. Further, the level of standardization in the tranche market in terms of standard attachment/detachment points, coupons, and roll dates is also a contributing factor in the growth of the CDX/iTraxx tranche market.
Credit market volatility in the first half of 2020 was reflected in the surge in premiums for swaptions on CDX/iTraxx indices at the 5Y tenor. The surge was visible in the swaptions on both IG and HY indices. For the HY indices, the maximum premiums were at about 500 bps for receiver swaptions and at about 600 bps for payer swaptions, whereas for the IG indices, they were at about 100 bps for receiver swaptions and at about 150 bps for payer swaptions. The premiums consistently decreased from April onward, barring spurts in October and November, potentially owing to the US election results and Covid-19 vaccine timing. The premiums finished the year at slightly higher levels relative to their pre-Covid levels.
In both IG and HY indices, the premiums for the payer swaptions were consistently higher than those of the respective receiver swaptions, reflecting a higher cost for downside hedging. This could also be an indicator of credit spread widening expectations, as receiver swaptions expire worthless when the index spread at maturity is wider than the strike level.
The CDX/iTraxx Swaptions maintained steady volumes in 2020, with about $4.4 trillion in notional traded. While the 2020 volume number is marginally lower than the 2019 high of $4.8 trillion in notional traded, the CDX/iTraxx Swaptions have remained resilient in one of the most volatile years for credit markets in recent times. CDX/iTraxx Swaptions also benefit from standardization such as strike level conventions and standard trading documentation.
It is safe to say that in 2020 we witnessed one of the most uncertain years for credit markets in recent history. While the year was spent in the backdrop of the Covid-19 pandemic, there were also other notable events such as the US elections, Brexit negotiations, and vaccine developments to name a few, that made 2020 a unique year. The demand for liquid instruments continues to grow as we progress in 2021, and the range of CDX/iTraxx products offer market participants efficient and cost-effective tools to navigate exposure.
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