Credit · C8 · 8 min

Indices and macro credit

Trade protection on a basket of companies at once, work out what one default costs, and size a hedge for a bond portfolio.

In the news: “Crossover is 25bp wider”: one number for how nervous investors are about Europe’s riskier companies.

The essentials

CDS index: Protection on a basket of companies in one trade, each an equal share. The main ones are IG (125 names) and CDX HY (100) in North America, and Europe (125) and the Crossover (75, high yield) in Europe.
When a name defaults: Only its slice pays out, and the contract carries on for the rest at a smaller size. $50m of CDX HY has $500,000 on each name: a default at 30% recovery costs a seller $350,000 and leaves $49.5m.
Fees and quoting: Indices pay a fixed yearly fee: 100 for CDX IG and 500bp for the high-yield indices. CDX HY is quoted as a price, 100 minus the upfront, so a 350bp spread with a of 4 shows as 106.
Rolls and on-the-run: Every March and September a new series starts, maturing six months after the last, with its companies re-picked for rating and liquidity. The newest series is and gets most of the trading.
Hedging with an index: The quickest hedge for a bond portfolio: buy index protection with the same . If the bonds lose $45,000 per bp and $1m of CDX IG moves $450, buy about $100m. Names outside the index leave gaps.

One default in an index

Payout = N ÷ n × (1 − R); amount left = N × (n − 1) ÷ n

N: the amount of index protection
n: the number of companies in the index
R: recovery on the defaulted company

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How it works

1. A basket in one trade

Instead of buying protection on one company, you can buy it on 125 at once, each with an equal share. That is a index. In North America the main ones are IG (125 investment-grade companies) and CDX HY (100 high-yield); in Europe, Europe (125 investment-grade) and the (75 high-yield).

2. When one company defaults

If one company defaults, only its slice pays out. Sell $50m of protection on CDX HY, where each of the 100 names is $500,000, and a default with 30% recovery costs you $500,000 × 70% = $350,000.

3. The index carries on

The defaulted company then drops out and the contract continues on the rest, for a smaller amount: $50m × 99 ÷ 100 = $49.5m. The yearly fee you receive shrinks in the same proportion.

4. Quoted in spread or in price

Indices pay a fixed yearly fee, like single-company CDS: 100bp for CDX IG and 500bp for the high-yield indices. CDX HY is quoted as a price, like a bond: 100 minus the upfront, the payment at the start that settles the gap between spread and fee. With a risky duration (years of fee) of 4 and a 350bp spread, the upfront is (3.5% − 5%) × 4 = −6 points, so the price is 106.

5. Rolls

Every March and September a new version, or series, of each index starts. It matures six months later than the last, and its companies are re-picked for rating and liquidity. That is the . The newest series is and gets most of the trading; older series still exist.

6. Hedging a bond portfolio

Indices are the quickest way to hedge a portfolio of bonds. Match , the money made or lost per 1bp of spread: if your bonds lose $45,000 per bp and $1m of CDX IG moves $450 per bp, buy about $100m of protection. Your bonds aren’t the index companies, so the hedge is imperfect.

Worked example

You sold $50m of protection on CDX HY (100 companies, 500bp fee). One company in the index goes bankrupt and its auction price is 30.

Amount on that company: $50m ÷ 100 = $500,000.
You pay $500,000 × (100 − 30)% = $350,000.
Your contract falls to $50m × 99 ÷ 100 = $49.5m.
Your fee income drops by 500bp × $0.5m = $25,000 a year.

$350,000 paid and $49.5m left: one default costs an index seller 1/100 of the loss.

Check yourself

6 quick questions on the explanation above.

Practice

New numbers every set. Misses and guesses go into your review deck.

In the interview

Answer out loud in under a minute, then compare.

How would you hedge a corporate bond portfolio quickly?
What’s the Crossover index?
What happens to an index when one of its names defaults?

Remember

Payout per default = notional ÷ names × (1 − R)

An index spreads one default across all its names, which makes it the fast way to hedge or trade a whole credit market.

Next · C9Leveraged loans and private credit

Sources

Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.