When the CDX Rolls

I spoke this morning to Marc Barrachin of Markit, the company which owns and runs most of the benchmark CDS indices. Markit recently delayed, for a second time, the biannual "roll" where the components of its indices are updated to reflect changes in the markets. So I was very interested to ask Marc what was going on.

We talked mainly about Markit’s flagship product, the investment-grade CDX index. But when that rolls, lots of other indices roll as well, including the emerging-markets and high-yield indices. The IG index is now entering its eleventh incarnation: IG 11 will be the new on-the-run benchmark, taking over from the current bechmark, which is IG 10.

"The new on-the-run series tends to represent more accurately what the investment-grade corporate CDS landscape is," says Barrachin. "It’s a better hedge, a better representation, and liquidity concentrates in the new on-the-run."

Having said that, IG 10 is hardly the same now than it was at inception. When it was created, six months ago, it included Fannie Mae, Freddie Mac, and Washington Mutual. All three of those credits have now had "credit events": their CDS have been triggered, and those names are now awaiting an auction to determine the recovery rates and how much sellers of protection will have to pay out. Needless to say, it’s extremely rare, if not unprecedented, for three investment-grade credits to suffer a credit event in the space of six months.

When the index rolls, any components of IG 10 which lost their investment-grade credit rating are taken out of the index, and replaced with new investment-grade credits. So apart from Frannie and WaMu, other credits such as Liz Claiborne, Sprint Nextel, and Brunswick are no longer in IG 11. In their place are new credits such as Xerox, Staples, Time Warner Cable, and UPS. The new constituents were set a couple of weeks ago; that hasn’t changed.

Given that the old index includes non-investment-grade names while the new index is all-investment-grade, there’s likely to be some spread tightening when the benchmark CDX index rolls from IG 10 into IG 11. But remember to look at the spread and not the price of the index: the prices aren’t going to be comparable, since the coupon on which the price is based is increasing, to a spread of 170bp from a spread of 150bp. So if IG 10 was trading at 100, that would imply a spread of 150bp; if IG 11 trades at 100, that implies a spread of 170bp. That coupon, too, has already been set and won’t change.

Why has the roll from IG 10 into IG 11 been delayed? The first time round it was because of uncertainty surrounding the aftermath of Lehman’s collapse, and questions over AIG. (AIG is a component of both IG 10 and IG 11; it still has an investment-grade credit rating.) The second time, there were worries about what might happen to Wachovia, not to mention the bailout plan and the credit event at WaMu.

"Rolling on a Monday when you have a high level of uncertainty is not ideal," says Barrachin, since traders want to be comfortable with the index that they’re trading and be able to roll quite smoothly out of the old index and into the new one. When there’s a lot of volatility in the market, that’s more difficult. The decision to delay the roll is taken by a vote of CDS market makers: there are 12 now eligible to vote.

If things go according to plan and there isn’t a third delay, then the roll is now scheduled to take place this Thursday, rather than on a Monday. Mondays are just too risky, these days: you never really know what’s going to happen over the course of a weekend.

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