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This episode aired on BloombergTV on Jan 17, 2013

Credit Default Swap Indexes

Credit Default Swap Indexes are liquid baskets of individual company CDS that afford investors exposure to a broad range of credit default obligations, generally grouped by bond quaity.

Q. Credit Default Swap Indexes are back in the news because of the compensation issues at JPMorgan, but also because of the news about Dell. Let’s start with that… why does the news that Dell might go private drive up the costs of the credit default swaps on its bonds?

A. As you know, a credit default swap is essentially an insurance policy that pays out if a bond defaults. To go private, Dell will have to raise a lot of money to buy back its publically traded shares– and to do that, most likely, it will have to borrow pretty much the maximum of what it can. That’s the typical private equity buyout template. Of course, if it does that, the risks of default on existing debt go way up… hence the cost of insurance against default does, too.

Q. OK. That’s for Dell itself. Now, how about these credit default swap indexes– these are baskets of individual company credit default swaps?

A. Right. Every six months, a bunch of bankers get together and select a basket of credit default swaps that will be used as the index– sort of like picking a new set of stocks to make up the Dow Jones. There are different “series” of the CDS, some for investment grade names– those are called the IG series– and some for high yield names, the HY series. Then, you can buy and sell that index– the instruments are standardized are pretty liquid.

Q. So, there’s more liquidity in the CDS index contracts than there is in the underlying individual names, like Dell?

A. Much more, partly because the individual CDS are not nearly as standardized. Now, some people think that can lead to manipulation of the index prices, since the prices of the underlying CDS instruments are not really subject to a fully transparent or liquid market, and can be moved around pretty easily by a determined trader. Those are the kinds of shenanigans that were at the heart of the whole London whale episode.

Q. OK, but for the overall health of the bonds markets, these credit default swap indexes are good places to look?

A. Yes. For example, you can look at how the current series of HY versus IG is trading: if HY doesn’t demand much of a premium over IG, people feel pretty good about things; but when they get nervous, the spread between them will usually increase.