REFILE-High-yield CDS index adds 3 illiquid credits at series roll

Thu Sep 27, 2012 11:08am EDT

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By Melissa Mott

NEW YORK, Sept 27 (IFR) - The addition this week of three rather illiquid credits to a key index of high-yield credit derivative swaps has raised eyebrows in some quarters but similar moves in Europe seem to have worked out.

Lender CIT Group, CCO Holdings and energy company Calpine Corp have been picked as replacements to the CDX.NA.HY index which rolled to series 19 from series 18 overnight.

The three credits will replace Ford Motor Co, Pioneer Natural Resources and Residential Capital. Ford and Pioneer were removed after being upgraded to investment grade. Residential Capital filed for bankruptcy and had its CDS settled via an auction process.

None of the three replacements are liquid by Depository Trust & Clearing Corp (DTCC) top 1000 liquidity standards over a six month period, although each has large amounts of outstanding debt and frequently taps the market.

Moreover, the three represent a sub-sector which evens out the sector weighting methodology in the rules.

Credit default swap indices are issued on a semi-annual basis in investment grade and high yield to maintain liquidity. The high-yield index is comprised of 100 constituents which are further categorized into ten sub-sectors - telecoms, financials, consumer goods, etc.

Constituents of the index are routinely reviewed ahead of the roll and can be changed from one series to the next. The process for determining which single names can enter or exit an index is conducted by the administrator, Markit and its participating members, according to a set of established and still evolving rules based on sector, ratings and liquidity.

In March 2011, Markit changed some of the methodology, introducing CDS trade volume from the DTCC Trade Information Warehouse to determine liquidity. In high yield, it focused on weightings of sub sectors to align the liquid bond indices as a means to increase their appeal as a hedge for cash portfolios.

"The desire was to create a CDS product which mirrors the cash index, based on sector and amount of debt outstanding," said Alex Paidas, director of Corporate Communications at Markit.

A LIQUIDITY BOOST

The addition of these illiquid entities has garnered attention, although it is not a unique event. The recent roll of the iTraxx Crossover, the European high-yield index, saw the inclusion of two new entrants, Eileme 2 AB (Polkom), a unit of the Polish mobile phone company, and Schaeffler, a German ball bearing maker, which do not trade in CDS. However, both are frequent bond issuers.

And that wasn't the first time either.

Packager Ardagh, medical goods maker ConvaTec and telecoms company Sunrise were included in the Crossover series 16 and Jaguar Land Rover in the Crossover series 17.

Illiquid at the roll, the names were able to generate enough market interest to qualify them in the DTCC top 1000 liquidity list by the time the semi annual roll was to occur again, Bank of America Merrill Lynch said in a September 19 note.

The names were chosen from a supplementary list from the DTCC which classifies large bond issuers within the last 12 months, although they are not traded in CDS.

"It helps promote more diversity in the (synthetic) index, particularly as the US high-yield bond market sees less idiosyncratic events as a driver of spreads," said Tim Brunne, Director of Credit Strategy and Structured Credit Research at UniCredit.

By purchasing a basket of protection within the index, an investor is implicitly buying protection on the CDS of the single names, he said. This could also prompt an offer on a single and less liquid name.

"The market will derive a fair spread (for the single name) using the credit spreads of the bonds. A dealer might have their own idea of where the spread should be traded, which is implicit," Brunne said.

Moreover, inclusion of the three names is unlikely to negatively impact the index, but rather be reflected in the single name via wide bid / offer spreads.

Bank of America estimates spreads for CCO of 360 basis points and Calpine of 401bp using Chartered Communications 6 5/8% due January 31, 2022 and Calpine's 7 7/8% due January 15, 2023 as the underlying reference entities.

While illiquid, CIT Group is traded by a small handful of dealers and is quoted at 235bp.

Still, taking on the fresh perspective of a less liquid name is new territory for the domestic high-yield index.

For Europeans, taking on less liquid names in the Crossover index was a "topic in the last roll," according to Brunne.

The rules are interpreted in a number of different ways, he said. But by using the DTCC data for a six-month period as well as historically, the European CDS market was able to eventually facilitate a better liquidity environment in the Crossover as compared to the iTraxx investment grade index, particularly as that high-yield index is typically less flush than its investment-grade counterpart.

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