The credit default swap index (CDX) is a benchmark financial instrument comprising credit default swaps (CDS) issued by North American or emerging market companies.Each CDX tracks a basket of corporate bond issuers, with each portfolio covering different areas of this market.
They serve as a barometer for credit risk in the broader economy and provide a mechanism for investors to hedge against—or speculate on—potential corporate defaults. The index's movements can signal shifts in economic sentiment before they show in other indicators, making it a crucial tool for everyone from hedge fund managers to central bankers. The CDX was the first CDS index, which was created in the early 2000sand was based on abasketof single issuer CDSs.
Key Takeaways
- The Credit Default Swap Index (CDX) is a benchmark index that tracks a basket of U.S. and emerging market single-issuer credit default swaps.
- Credit default swaps act like insurance policies in the financial world, offering a buyer protection in the case of a borrower's default.
- The index was established in the early 2000s and was the first to aggregate these otherwise over-the-counter (OTC) swaps.
- The CDX is also a tradable financial product that investors can use to gain broad exposure to the CDS market.
- Traders and investors can also use the CDX for hedging purposes more efficiently than purchasing single CDSs.
Understanding the Credit Default Swap Index (CDX)
A CDS is an over-the-counter (OTC) derivative contract that offers one counterparty protection against a credit event, such as the default or bankruptcy of an issuer. It can be thought of as insurance in the financial world. The CDXtracks and measures total returns for the various segments of the bond issuer market so that the index's overall return can be benchmarked against funds that invest in similar products.
Investors can use the CDX'strackingto monitor their portfolios against this benchmark and adjust their holdings accordingly. The CDXhelps hedge risk by protecting bond investors againstdefault, and tradersuse CDX indexes to speculate about potential changes in issuers’ credit quality.
The CDX isitself a tradable security: acredit marketderivative. However, the CDX index also functions as a shell or container, comprising a collection of other credit derivatives: CDSs.
TheCDXcontains 125 issuers and is broken down into two types ofcredits: investment grade (IG) and high yield (HY). The CDX index rolls over every six months, and its 125 names enter and leave the index as appropriate. For example, if one of the names is upgraded from below investment grade to investment grade, it will move from the high-yield index to the investment-grade index when the rebalance occurs.
S&P Global manages this CDX lineup:
- CDX North American Investment Grade
- CDX North American Investment Grade High Volatility
- CDX North American High Yield
- CDX North American High Yield High Beta
- CDX Emerging Markets
- CDX Emerging Markets Diversified
Why Invest in the Credit Default Swap Index (CDX)?
The CDX is standardized and exchange-traded, unlike single CDSs, which tradeOTC.As such, the CDX index has a high level of liquidity and transparency.
CDX indexes also maytrade atsmaller spreadsthan CDSs. Thus,investors may hedge a portfolio ofdefault swaps or bonds with a CDXmore cheaplythan if they were to buy many single CDSs to achieve a similar effect.
Finally, the CDXisawell-managed tool that is subjected to intense industry scrutiny twice a year. The existence of tools such as CDX indexes makes it easier for both institutional and individual investors totrade in complicated investment products that they otherwise might not want to own separately.
The CDX index launched in the early 2000s, a complicated time in financial markets, to help make investing in complex,high-risk (potentially high-yielding)financial products a little less complicated and a little bit safer.
Later, the LCDX was created, which is also a credit-derivative index with a basket made up of 100 single-name, loan-only CDSs. The difference is that all the CDSs in the LCDX areleveraged loans.
Although a bank loan is consideredsecured debt, the names that usually trade in the leveraged loan market are lower-quality credits.Therefore, the LCDX index is used mostly by those looking for exposure to high-yield debt, but with greater risk.
Risks of the Credit Default Swap Index
The CDX carries several risks primarily because of its inherent complexity. Investors might find it challenging to fully understand the underlying assets, potentially leading to misinformed decisions. Additionally, the counterparty risk is significant; if the issuer defaults, the buyer could face substantial losses.
Liquidity risk is another crucial aspect to consider. The CDX market can occasionally suffer from low liquidity, creating challenges for investors trying to execute trades at their preferred prices. This limitation can amplify losses during market stress when liquidity dries up, and spreads widen significantly, affecting the overall portfolio performance.
Market risk is also pertinent, as the value of the CDX can fluctuate based on changes in credit spreads and economic conditions. In volatile markets, these indexes can experience sudden price swings, resulting in heightened uncertainty and potential financial instability for investors. Such volatility might deter risk-averse individuals from investing in the CDX.
What is the Difference between CDS and CDX swaps?
A CDS is a contract on a single entity's credit risk, while a CDX is an index that aggregates many CDS contracts, representing a portfolio of credit risks.
Who Invests in CDX Swaps?
The CDX markets are predominantly engaged by institutional players like hedge funds, pension funds, and insurance companies.
Why Might an Investor Choose a CDX Over Individual CDS Contracts?
An investor might prefer a CDX for its diversification benefits and the ability to manage credit risk across a broader range of entities in a single transaction.
What Does It Mean When a CDX Rolls?
When a CDX "rolls," the current series is updated with a new set of reference entities to reflect changes in the credit market conditions.
The Bottom Line
The CDX is a crucial tool in the financial world, providing a benchmark for tracking a diversified portfolio of U.S. and emerging market credit default swaps. It offers investors broad market exposure and efficient hedging against defaults.
However, investing in CDX comes with considerable risks, including market volatility and liquidity issues, which can impact its overall performance and attractiveness.
