BondSquawk

By Maulik Mody – Bondsquawk.com

March 9, 2011

Some investors may not know where the yield of a bond is headed, or what the price appreciation will be for a particular bond if rates fall, but they have a general view about the creditworthiness of the lenders and may want to trade based on where they think spreads are headed over time. Trading a CDS for a given issue is one way of trading the corporate credit of a company.

A Credit Default Swap (CDS) is essentially an insurance that promises the holder of a corporate (or other) bond the value the face value of the bond, less the value of the defaulted debts, in the event that the issuer defaults. In return, the CDS holder pays a percentage (called spread) of the insured amount to the protection seller every year till the bond expires or defaults. These spreads move up and down with a change in the perception of the creditworthiness of the issuer among other things, hence creating trading opportunities.

Trading in CDS however is done over the counter and is not a very liquid market. This also increases transaction costs due to wide bid-offer spreads. Another way of trading corporate credit is to trade credit default swap index (CDX), which allow investors to speculate on the creditworthiness of a basket of entities or the hedge the credit risk of a portfolio. As opposed to a CDS, a CDX is a more standardized credit security hence more liquid with tighter bid-offer spreads. Just like a CDS, the spread of a CDX typically rises when investor confidence in corporate credit falls and vice-versa. An example of an a CDX for high grade bonds is the Markit CDX North American Investment Grade Index (CDX.NA.IG), which constitutes of 125 equally weighted securities from various sectors such as Financials, energy, utilities, industrial, consume cyclical etc.

So what’s making these indices move so much in the current environment?  Many different securities have been affected by the middle-east crisis and swaying oil prices, and CDX is no exception. Concerns about rising crude prices and the effects that a decrease in oil supply can have for countries and companies is causing the spreads to widen. But more interesting is the fact that these CDX spreads are moving in tandem with oil prices. Bloomberg reported last week that the correlation between the CDX and crude futures rose to 0.7, the highest so far. Correlations vary from -1 to 1 where negative 1 means that they move exactly opposite with the same magnitude, and a positive 1 indicates the two move in lockstep.

For the credit trader, this gives a good opportunity to trade CDX using the dynamics of crude futures, and for the investor, it may be a chance to bet on the general longer term trend of credit. In either case, one can expect spreads to come down to normal levels after the Middle-East unrest is over. History is evidence that oil has, on numerous occasions, settled near its pre-crisis trading levels after any crisis that has threatened the supply of oil has subsided.