At the end of July, the International Index Company launched the Dow Jones iTraxx Credit Default Swap Index for Australia. The Index is one of the six Asian indices, which were introduced by the IIC and replace the old Trac-X Australia index. The move in Asia and Australia is part of a wider exercise to combine the existing Dow Jones Trac-x and iBoxx Indices globally. The IIC itself was set up by the leading banks dealing in credit default swaps to administer the various credit default swap indices. The launch of the Australian index is important because it provides participants in the credit default swap market with a single, unified and transparent benchmark for the pricing of credit risk relating to the Australian market. The purpose of this article is to explain how the Index is constructed, the benefits of the Index to market participants and how the Index is traded.
How The Index Is Constructed
The Index is constructed on a rules-basis in which names are selected based on trading volumes. This ensures it represents the most liquid and traded part of the credit default swap market for Australian credit. This approach should be contrasted with the old iBoxx indices, which would include or exclude names based on subjective criteria rather than objective measurable parameters, including trading volumes. The Australian index contains 25 names with each name representing an equal 4% of the index. This is different from conventional equity indices in which the component stocks are usually weighted based market capitalisation.
To construct the index, market-makers are firstly asked to submit a list of the most liquid traded names to the IIC. Currently there are around 20 banks which are licensed market-makers. The IIC then aggregates the volume-ranked lists from each market-maker to compute the final liquidity rankings. The top 25 names are selected by the IIC from the aggregated lists to form the Index. In order to ensure the index reflects current market conditions, it is reconstituted semi-annually, each March and September, and a new series of is then issued.
The current index comprises 25 names from various sectors, including the banking, mining and telecommunications industries. Unlike the European indices administered by the IIC, the Australian index is not broken down to sub-sectors. This is probably due to the fact that the credit default swap market for Australian names is not deep enough for each sector to have an adequate number of representatives. Conceivably there could be a bias toward a particular industry if that industry experiences high volumes of trading (for example, due to industry-wide factors) during the period leading up to the reconstitution of the index. This also means that investors have to trade the entire index and do not have the option of trading sub-sectors.
The Benefits Of The Index To Market Participants
Market participants who trade credit default swaps will benefit from this index. In essence, it is a proxy for the general direction of credit spreads in the Australian market. Investors with a view on credit spreads can utilise index-linked products as an efficient way to execute their views. For example, an investor who had a negative outlook on the Australian credit markets previously would have to short lots of bonds or buy protection on those names via single-name credit default swaps. This is an expensive and onerous exercise, however, not least due to the repeated transaction costs and the relatively illiquid secondary bond market in Australia. Single-name credit default swaps also usually trade at much higher bid-offer spreads than the indices. A more efficient option for the investor would be to enter into a single credit default swap, which references the index and provides a synthetic exposure to those names.
Investors will also be able to take a view on the recovery rate of the general Australian credit market and trade recovery swaps based on it. Recovery rates of a reference obligation after the occurrence of a credit event can vary from highs of 90% (for credits such as Railtrack) to less than 10% (as in the case of Parmalat). Counterparties usually trade recovery swaps by adjusting the reference price of the confirms so that it is not set at the usual 100%, but at the agreed recovery rate. Under a recovery swap, once a credit event has occurred, the protection buyer delivers the deliverable obligations to the protection seller as per normal, but receives the pre-agreed recovery rate instead of par value. Recovery swaps based on the index allow investors to take a view on this variable risk in relation to the general Australian credit market.
The index could serve as a benchmark for investors to measure the performance of pension and mutual funds, especially those funds that invest in bonds. Bond fund managers who under-perform the index would in essence be destroying value for their unitholders who would have been better off investing in a fund that tracked the index. In addition to that, as the index reflects the price of pure credit risk in Australian names, it could also serve as a benchmark for corporates to determine the margins at which they should borrow either through banks or the capital markets.
The Index will also serve as an important tool for arrangers of synthetic CDOs involving Australian names. Constructing the portfolio of reference entities for synthetic CDOs could be simplified if the reference portfolio tracks the index. Because the index is reconstituted semi-annually, the reference portfolio will be dynamic, but need not be managed. This will help solve an important concern with managed synthetic CDOs, that is the element of manager risk in the selection of reference entities. Having the CDO reference the index reduces this risk and enables the noteholders to monitor the portfolio easily. The noteholders would be exposed to a diversified and objectively-chosen portfolio, which is selected independently in a transparent manner.
Managers of cash arbitrage CDOs involving Australian collateral could also utilise the index to reduce ramp-up risk. During the ramp-up period there is a chance of negative carry because managers usually invest the proceeds from the notes issued in high-quality assets (which have a lower yield than the interest cost of the notes) while sourcing the desired collateral. An alternative for the manager would be to sell protection on this index to obtain a return that is significantly higher than those high-quality assets. Noteholders would not necessarily suffer undue risk as the risk profile of the index would be comparable with what the noteholders expected, that is exposure to Australian credit. Once the managers are in a position to buy the collateral they can close-out their position and purchase the collateral.
How The Index Is Traded
The index is traded on a five-year basis on standard credit default swap documentation. It has a market value that fluctuates and differs from its fixed rate, which is set at the launch. The market value depends, of course on the market-makers' view of the Australian credit market. For example, the fixed rate for the index was set at 35 basis points, but the mid-market could be 30bps. Therefore an investor seeking to buy AUD100 million of exposure to the index would receive the 35bps per annum quarterly on a AUD100 million notional from a market-maker, but would have to pay the present value of the difference between the fixed rate and the market value of the index on a notional of AUD100 million, which is 5bps, to the market-maker. This amount is paid through an upfront payment on a T+3 basis. The market standard method of settlement is physical settlement (except in limited circumstances) and the credit events and reference obligations are fixed, which ensures that trading is executed quickly and efficiently.
The Index trades over-the-counter as per other credit default swaps. Increased liquidity, however, could see futures and options listed and traded on derivatives exchanges in the same manner as derivatives of equity indices.
Conclusion
The launch of the index reflects a continuing development in the credit default swap market for Australian names. It allows investors to properly trade a diversified basket of Australian credits based on standardised contracts within certain pre-agreed parameters. It will also serve as an important factor in the development of a more commoditized, liquid and substantive credit default market in Australian names. In the initial stages, fund managers will probably use the index as a tool to manage their cash bond position. It can be predicted with reasonable certainty, however, that some investors will utilise it as a cheap and efficient mechanism to construct a synthetic bond portfolio position and that enterprising traders will trade derivatives on the index just as they would on equity indices.
This week's Learning Curve was written by Jason Norman Lee, a senior associate in the banking and finance department at Allens Arthur Robinsonin Sydney.
