An influx of demand for credit protection on ailing energy and mining names has led the benchmark index for US investment grade credit default swaps to trade at historically tight levels compared with the level implied by its 125 constituent names.
Index skew on the Markit CDX Investment Grade benchmark hit negative 15.7bp last week, according to Barclays analysis. The index traded at 101.1bp compared with an intrinsic value of 116.8bp implied by performance of constituent single name CDS contracts.
Having rarely broken beyond -6bp in recent years, CDX index skew hit a six-year peak of -17.6bp on January 22.
“Skew levels are at abnormal wides as the market has seen a sharp pick-up in demand for protection on commodity companies through single-name credit default swaps,” said Jigar Patel, credit analyst at Barclays.
“The relationship between the index and its constituents had mostly moved in tandem over the last five or six years, but a heavy bid for the riskiest credits is pushing the intrinsic value wider than the index’s traded value.”
The rush for protection has been seen in names such as Devon Energy, Freeport-McMoran, Anadarko Petroleum, and Barrick Gold – four companies that are among the 10 widest spreads in the index.
Five-year CDS referencing Devon credit is trading at a spread of 599bp, a near 60% gain over the last month, according to Markit data. Freeport-McMoran is trading at an upfront cost of 40.69% – having widened over 65% on a spread basis over the last month.
A liquidity mismatch between CDS indexes, single name contracts and the cash bond market is also seen as a driver of the phenomenon.
Spread widening that has been seen across much of the corporate bond market has failed to filter into CDS indexes to the same extent as investors increasingly use such benchmarks to express long credit positions.
Instead of buying cash bonds, which they perceive to be increasingly illiquid and riskier in times of stress, investors can sell credit protection on CDS indexes in order to get long credit exposure.
According to Depository Trust & Clearing Corporation data and Barclays research, investors have been net short the index for the last three years. The most extreme short position of just under US$55bn was recorded in December and is currently reported at US$35bn.
The dislocation may present trading opportunities for credit funds that can buy protection on the index (short credit) and sell protection on the 125 constituent names (long credit) with the expectation that the skew will normalise – or the index will come back in line with constituent values, according to Barclays.
Investors using CDS indexes to hedge credit positions have been caught out in the past, and some have expressed concern surrounding the appropriateness of the products as a viable credit hedge (see story “Crossover hedged and wedged” IFR 2089).
Last July, as the market awaited the outcome of Greece’s negotiations with creditors, iTraxx Crossover skew whipsawed from positive to negative territory over two trading days. The index rallied aggressively while bonds were largely unmoved, generating losses for index-based hedging strategies.
But analysts note that recent moves should not be any cause for alarm and many believe that CDX still represents an efficient hedging tool given almost 20bp of widening since September.
“Skew is sharply wider over the last four months, implying that the index should have widened out more than it has,” said Patel.
“It still acted as an efficient hedge for widening high-grade cash credits. The dislocation should not be a major cause for concern, but it has been a sharp change.”
