Index roll prompts clearout

The latest series of the Dow Jones CDX and iTraxx credit derivatives indices started trading on September 20, with dramatically different portfolios for the investment-grade and high-volatility CDX indices. The CDX HY index is expected to roll on October 6, 2005.

The indices are recreated every six months to keep their maturities at or near five years, which is the standard credit default swap (CDS) contract, and to replace names that no longer meet the criteria. Names are dropped if ratings from either Moody's or Standard & Poor's fall to junk status. Participating dealers also vote on which names to include based on which are the most actively traded.

Dow Jones replaced nine names in its high-grade CDS index. The nine new names in the high-grade index are The Gap, IAC, Knight Ridder, Limited Brands, Marsh & McLennan, Radio Shack, Sara Lee, Toll Brothers and Sabre Holdings. The nine dropping out of the index are Eastman Kodak, Ford Motor Credit, General Motors Acceptance Corp, Kerr-McGee, MBNA, Liberty Media, Lear, Maytag and Sears Roebuck Acceptance Corp.

The new high-grade CDX series 5 index began trading at 47 basis points and the roll from series 4 to series 5 opened initially at 3-4bp. By removing several risky credits from the investment-grade index, traders expect the index to be less volatile and trade at tighter spreads. One of the biggest differences seen was the narrowing of the widest single name credit in the index from 471.9bp (General Motors Acceptance Corp) to 359.1bp (American Axle).

Dow Jones also replaced 15 names in the 30-name high-volatility investment-grade CDS index, the most replacements that this index has seen since inception. The new series 5 high-volatility index began trading roughly 19bp tighter than series 4. Michael Mutti, credit strategist at Bear Stearns, says: "Given the number of changes between investment grade and high-vol series 4 and 5, we don't believe there will be as many investors rolling protection from series 4 and series 5 as there have been in the past."

The CDX index consortium also launched a new 35-name index called the Crossover (XOVER) index on the day of the roll. Criteria for the new index are a triple-B rating from one of S&P or Moody's and a double-B rating from the other. Ford Motor Credit and GMAC are in this index as are several other members of the series 4 high-volatility index, including Liberty Media, Kerr-McGee, Eastman Kodak, Lear Corp and Sears. Twenty-one of the 35 crossover issuers are also in the double-B sub-index of the high-yield index.

Mutti says: "While there is clearly some overlap, the double-B index will have a funded product as well as an unfunded version so traditional high-yield index investors may find the double-B better suited to their needs. Another notable difference is that the crossover index has Ford Motor Credit and GMAC, whereas the double-B index has Ford Motor Company and General Motors Company." At the end of the first day of trading, the index was quoted at 223-224bp.

In the European iTraxx indices, there were very few changes to index composition, so strategists say the story in Europe's credit derivatives markets was much more of a technical one, as those long protection tried to sell it ahead of the roll. This resulted in a short squeeze that drove the market tighter in spite of negative headlines such as the Chapter 11 filings from Delta and Northwest Airlines and M&A activity in Europe.