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The first half of the year resulted in significant credit
volatility, with CDS indices playing a key role in investors'
ability to manage credit exposure. As during the Global Financial
Crisis, market disruption led to a surge in CDS index trading due
to their ability to withstand large trading sizes. This came
through in index volumes across CDX and iTraxx that were
significantly greater YoY, along with large increases in tranched
index trading. Interesting technical factors also emerged within
the CDS indices, as index skews and curve shapes shifted during the
period. The following will provide a global overview of CDS index
performance across IG and HY markets in the first half of 2020,
covering returns, credit events, changes in curve shape and index
skew as well as the latest trading volumes.
Performance
CDS indices began the year on a calm note, spiralling downward
towards the end of February due to coronavirus impact that tore
through risky assets. However, extraordinary intervention by the
ECB and Fed caused first half performance to land well above their
maximum drawdowns, shown in the first table below. Investment grade
credit outperformed high yield in both North America and Europe.
However, European HY credit exhibited a stronger recovery than
North American HY, with iTraxx Crossover returning 7.98% higher
than CDX.NA.HY (-6.42% versus -14.40%, respectively). This rebound
occurred after similar maximum drawdowns hit both iTraxx Crossover
and CDX.NA.HY (-18.61% and -20.73%, respectively). Notable to the
path divergence across the Atlantic is the fact of the on-the-run
CDX.NA.HY index experiencing seven credit events YTD versus zero
credit events for the current iTraxx Crossover index.
iTraxx Asia ex-Japan IG was the only CDS index to notch a
positive first half with a return of 1.35%. Landing between IG and
HY performance, CDX.EM returned -5.04% in the first half of the
year on a maximum drawdown of -11.11%.
Index Skew
Across the CDX and iTraxx, index skews have responded
differently to the volatility fuelled by the Covid-19 crisis. The
index skew is calculated as the basis between the tradable index
spread and the theoretical spread, constructed using the underlying
basket of CDS single names. The differences in the movements of the
index spreads and underlying single names can be attributed to
several factors. One is the user base of the two instruments. Due
to their strong liquidity, the indices are widely preferred
instruments to express macro views while the single names act as
effective instruments to gain exposure to idiosyncratic risk or
managing counterparty risk. The indices tend to be more liquid and
therefore also attract users that do not trade single names.
Another factor could be that 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 North American and European corporate investment grade
indices displayed a consistent negative skew in H1 2020, barring a
very brief period in March where iTraxx Europe exhibited a positive
skew. The decrease and subsequent increase in the skew were much
more drastic in CDX.NA.IG compared to iTraxx Europe. This can
partly be attributed to the eight fallen angels in the
CDX.NA.IG index compared to three in iTraxx Europe.
The high yield corporate indices went through bouts of positive
and negative skews during the volatile months of March and April.
The index skews sank to their lowest points on 25th of March,
dropping to -141 basis points and -68 basis points for CDX.NA.HY
and iTraxx Crossover, respectively.
The CDX EM and iTraxx Asia ex-Japan indices showed yet another
unique trend during the period of market stress, where the skews in
both indices spiked to +70 basis points and +60 basis points,
respectively. The CDX EM index is a pure sovereign index whereas
the iTraxx Asia ex-Japan index is a combination of sovereigns and
corporates.
Curves
The CDS index curves give a good sense of how the market is
pricing in near-term defaults relative to long-term defaults. 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 the 5Y
and 10Y spreads being closer to each other.
At the onset of market volatility in the beginning of March, the
CDX.NA.IG 5s10s curves dropped drastically from 48 basis points to
below 20 basis points. Starting with the US credit markets entering
a recovery phase following the Fed's intervention, the curves began
on a gradual upward trend.
The iTraxx Europe 5s10s curve has been on a similar path,
falling sharply from 46 basis points to 16 basis points. Following
the ECB's action to kickstart the recovery through its EUR 750
billion Pandemic Emergency Purchase Program (PEPP), the curve has
made its way back to 40 basis points at the end of H1 2020.
CDX HY Credit Events
The first half of the year had a record number of Credit Events
occur within CDX High Yield. Ten credit events occurred across
CDX.NA.HY indices, seven of which occurred within the on-the-run
Series 34 index. Of the names to experience credit events, 40% took
place in Energy, 40% in Consumer Services and 20% in
Telecommunications Services.
CDX EM Credit Event
CDX Emerging Markets was the only other CDS index to experience
a Credit Event in the first half of the year, with the
Argentine Republic failing to make bond payments on May
22, after a one-month grace period on payments due in April.
However, the event appeared largely anticipated, with the index
price not reacting to the initial missed payment nor the failure to
pay before the end of the grace period. Like CDX HY and IG, CDX EM
posted its maximum drawdown on March 23, hoisted by the
announcement of the Fed's SMCCF initiative. This was the second
credit event for the Argentine Republic following their Failure to
Pay in 2014.
CDS Index Volumes
The robust liquidity of CDS indices was reiterated in the wake
of the Covid-19 pandemic. CDS indices were vital instruments to
manage credit risk at a time when the underlying bond market
liquidity was shaky at best.
The following are the H1 2020 notional traded for each
index:
CDS Index Tranche Volumes
The solid liquidity of the CDS indices has guided strong volumes
in CDS index tranches as well. The H1 2020 notional traded was USD
175 billion, which is almost 80% of the notional traded in all of
2019.
The following are the H1 2020 notional traded for tranches on
each index:
Conclusion
The CDS indices were central to investors navigating credit
instability in the first half of the year. Index volumes increased,
absorbing high demand due to their high liquidity and
representativeness. Further, the CDS indices launched new series
towards the end of March to high demand, which was during the
tumultuous market period just prior to strong central bank
intervention. While the nature of the credit market in the second
half of the year remains unknown, the CDS indices continue to be an
efficient and cost-effective tool to navigate exposure.
Posted 24 July 2020 by Nicholas Godec, CFA, Index Product Manager, Tradable Indices and
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