Markit's consultation on changing the selection rules for US high yield credit default swap index CDX HY in time for its September roll is good news for those who want more flexibility in choosing constituents that reflect the cash market.
The key point about the CDX HY changes, which took shape this week and could be announced on Friday, is that they are unlikely to be disruptive to trading as they will involve only a small number of new names joining the index. They will also be replacements for rather than additions to the index's 100-strong array of names.
Market participants — from both the buy and sell side — submitted comments to index owner Markit by Wednesday on proposals aimed at producing a more organic response to the changes in the US cash high yield market.
The decision to add 25 constituents to the iTraxx Crossover last year was a mistake, many market participants have since claimed. GlobalCapital understands that the first increase, of 10 names to 60, in last year's March roll was well received, but that the 15-name expansion that followed resulted in thinner index trading despite the increase being supported at the time by all dealers.
There were convincing arguments to add the names, but adding them to the Crossover didn’t increase single name CDS trading as expected, because market makers found themselves unable to provide enough support for such a big increase in that timeframe.
One regrettable consequence of adding all the names so quickly was damage to index arbitrage trading — and particularly a form known as skew trading. This is where market participants look to profit on the difference between index spreads and those of the underlying constituents. This form of arbitrage helps the index track the underlyings, and the volumes it generates improve liquidity in those single names, helping the index and its constituents act as effective hedges.
The strategy has been popular in the past, but less so in recent times, as overall volumes have dropped. Market makers soon claimed that the absence of trading in the new names killed index arbitrage plays.
Avoiding a crunch in index arbitrage will be key to the success of the new CDX HY plan.
The rationale for reforming CDX HY is sound. The changes are supposed to align the index more closely with the cash bond market. Having more flexibility to pick names that are widely traded in the cash market or have large outstanding debt is a good idea, especially if it means that each industry sector can be better represented.
At present, strict criteria that prioritise liquidity in CDS only, rather than cash trading, mean that some sectors of CDX HY, such as energy or telecoms, are hamstrung on the choices they can make — there simply aren’t many eligible options.
And it is better to tweak the index to add flexibility, rather than try to provide an ever-expanding portfolio of names to catch up with the thousands of bonds that can be found in the cash market. It would be an impossible feat for market makers — particularly amid today’s lower volumes — to provide any kind of liquidity in much more than the 100 names already in CDX HY. Nor would it be very constructive to try.
That is not to say that the Crossover, at 75 names, has gone too far. At some point it could even expand to 100.
But the lesson already learnt from that index is that expansion plans should happen more gradually, allowing those that use the index to get comfortable with the array they already have in front of them for a while.
If the reforms to CDX HY take this lesson on board, the market should welcome the changes.
