What it means
A credit default swap is a contract in which one party pays a regular fee to another in return for protection if a company fails to repay its debt. An iTraxx index bundles many such contracts into a single tradable product.
Buying protection on the index is like insuring a whole basket of companies at once. The indices are made up of equally weighted companies chosen by trading activity.
The Main index covers a basket of well-regarded European companies, and the Crossover index holds a smaller basket of companies on the borderline between investment grade and lower grades. Because the baskets are standardised, the products trade easily and prices are visible to everyone.
The price is quoted as a spread in basis points, where one basis point is one hundredth of a percentage point. A spread of 65 basis points means that insuring $10,000,000 of debt costs $65,000 a year.
When investors fear defaults, the spread rises, and when confidence returns, it falls. The indices are renewed every six months, in March and September, in what the market calls a roll.
Companies that have been downgraded or have fewer trades may be removed and replaced, and a new series number is created. Traders move from the old series to the new one, and each series has a fixed life.
For a business, iTraxx is useful as a barometer. Treasurers watch it to judge the cost of borrowing in the bond market, since corporate bond spreads tend to follow credit index spreads.
Banks and funds use it to hedge their credit exposure quickly without selling individual bonds. Remember that an index is not the same as any one company.
The spread reflects the average view across the basket, so a single company can be doing much better or worse than the index suggests.
In practice
Real-world examples.
Example
A corporate treasurer planning a bond issue checks the iTraxx Main index each morning. When the spread jumps, she delays the issue by a week to avoid paying a higher coupon. She records the reasoning for the board.
Example
A bank holds a large portfolio of loans to European companies. To reduce its exposure without selling the loans, the risk manager buys protection on the index. The cost is recorded as a hedging expense.
Example
A hedge fund expects credit conditions to worsen and buys protection on the Crossover index. It later sells the position at a profit when spreads widen. The fund reports the gain as part of its trading result.
Formula
Calculation
Annual cost of protection = notional x spread
Approximate change in value for a spread move = change in spread x notional x risky duration
Suppose a fund buys protection on $10,000,000 notional at 65 basis points. Annual cost = 10,000,000 x 0.0065 = $65,000. Suppose spreads widen by 25 basis points, which is 0.0025, and the risky duration (the approximate number of years of protection payments at risk) is 4. The gain in value to the protection buyer is 0.0025 x 10,000,000 x 4 = $100,000.Case study
Seen in the real world.
Alderbank Insurance is an illustrative, fictional insurer with a large bond portfolio. The chief risk officer worried that a sudden downturn in European credit markets would reduce the value of the bonds.
She considered selling some bonds, but the trades would be expensive and would alter the long-term allocation. Instead, she proposed buying protection on a credit index, which would gain in value if spreads rose and would partly offset losses on the portfolio.
The hedge cost a regular premium, which the finance team treated as an insurance expense. When spreads widened later in the year, the gain on the index softened the fall in the bond portfolio. The illustrative lesson is that an index hedge is a blunt tool that reduces risk quickly, but it does not match any one bond exactly.
Watch out
Common mistakes.
- Reading the spread as the probability of default, when it also includes compensation for risk and market liquidity.
- Assuming the index tells you about a specific company, when it is an average across a basket.
- Ignoring the roll, when the index series changes every six months and comparisons across series need care.
Questions
People also ask.
What is a basis point?
One hundredth of one percentage point, so 65 basis points is 0.65%.
What is the difference between Main and Crossover?
Main covers higher-rated European companies, while Crossover covers companies that sit near the line between investment grade and lower grades and so trades at wider spreads.
Who uses iTraxx?
Banks, insurers, asset managers, hedge funds and corporate treasurers use it to hedge credit risk or to take a view on credit conditions.
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