This article discusses the construction of notes derived from iBoxx indices, the basis between cash and credit-default swaps and what types of clients these instruments are aimed at. The first notes were introduced this summer by ABN AMRO and Deutsche Bank.
Innovation In Bond Indexing
iBoxx is a new family of independent and transparent fixed income indices covering the euro and sterling government and credit markets. Pricing is contributed by its seven shareholder investment banks, including ABN AMRO, Deutsche Bank and Morgan Stanley, with the indices being calculated and published by Deutsche Börse.
Constructing
iBoxx 50 Notes
The iBoxx 50 note references a basket of 50 investment-grade corporate credit-default swaps. It is important to note that the reference portfolio is static and that there is no tranching or leverage involved--this type of product is often described as a linear basket.
The portfolio weightings were derived from the July 2002 EUR Corporates Non-Financials Overall Index ("Overall Index"). After eliminating BBB minus issuers on negative watch from the Overall Index, the top 50 issuers by aggregate bond market capitalisation are then weighted according to their bond market capitalisation. Although the portfolio is static, investors can reduce tracking error by trading out of the old note and into a new note that ABN plans to issue every six months.
The top 50 issuers represent over 80% of the credit risk in the Overall Index and portfolio weightings reflect the market concentrations in the auto, telecom and utilities sectors.
The end result is a note that enables investors to broadly capture the composition of the corporate Eurobond market and, as credit trading tends to concentrate on the three sectors mentioned above, the note also moves in line with the general moods of the credit markets.
Taking Advantage Of Basis Pick-Up
In general credit-default swap levels are wider than their cash bond equivalents. This is referred to as positive basis. One reason for the basis is that protection buyers can deliver the cheapest bond or loan, but supply and demand imbalances for single name credit default swaps recently have driven the basis to historic wides.
The graph shows the bid-spread of iBoxx 50 against a portfolio of equivalent bonds. The basis has been particularly wide during this three month period. In December last year this basis would have been close to zero. During a spread widening environment the basis will also increase.
Who Has
Been Involved?
The illiquidity in the underlying cash markets was a driver for investors to use iBoxx 50 as the note carries a commitment provision of a 5bps bid/offer spread.
Hedge funds and bank proprietary desks have used the iBoxx 50 note as a hybrid corporate credit future, utilising the liquidity commitment to express macro credit views in an efficient manner. The asset managers have used the note to allocate new funds into corporate credit immediately, while they identify their long term portfolio strategy. Insurance companies have used the instruments to enhance yield on their investment portfolios by capturing the portfolio basis inherent in buying the note. A high degree of liquidity and a rules based approach are vital to the success of iBoxx notes.
This week's Product Focus was written by Andrew Feachem (left) and Alistair Mullen who are responsible for marketing credit derivatives into Europe at ABN AMRO in London.
For further information on iBoxx indices please visit www.iboxx.com
