Investors burned by index overshoot on CDS rebirth

[LONDON] A number of hedge funds were left licking their wounds on Monday following the launch of new legal documentation for credit default swap indices - the US$21trn credit derivatives market's most significant overhaul in over five years.

The introduction of the new contracts, designed to compensate protection holders more effectively for losses sustained on restructured sovereign and financial bonds, saw the iTraxx Sub Financials index widen by 58bp to 145bp by late Monday, according to Markit.

Meanwhile the addition of 15 new names saw the iTraxx Crossover index shoot 86bp wider to 332bp.

The most surprising move of the day, however, was the negative skew on the iTraxx Crossover and Main indices - which meant the indices traded cheap relative to their single-name constituents.

That dynamic tripped up hedge funds pre-positioned for the roll into the new contracts. "I don't recall seeing that on the first day of a new index," said Tim Gately, head of European credit trading at Citigroup. "People that had front-run the roll were left scrambling to cover their positions."

The biannual index roll always triggers some volatility as the market settles on the fair value of the new contract.

Generally, investors tend to buy the new index and sell the old one to move their exposure into the on-the-run contract. That causes the new contract to trade wider - or richer - than the old one.

Hedge funds, which take advantage of arbitrage opportunities that crop up with the roll, had bet on big winnings because of the magnitude of the changes to the market, which included the expansion of Crossover and the new CDS definitions.

The market also had a head-start when it came to establishing fair value of the new indices, as the new definitions for single-name CDS began to trade a fortnight ago.

Hedge funds pre-positioned for the roll by buying the index and selling the single-name underlyings - particularly in Crossover.

The strategy was based on the usual activity around the roll making the new index trade rich, which it typically does by about 10bp, compared to its single-name constituents.

The new Crossover index did widen out sharply by around 110bp compared to the old contract in morning trading, but things retraced quickly as traders thought the index looked too expensive in absolute terms and began selling protection.

The hedge fund strategy backfired spectacularly, however, as the rally that ensued sent the skew into negative territory at -6bp. "The new index looked more expensive than fair-value, so people were very keen to sell it," said one credit hedge fund manager. "The market went completely against those people who had tried to arbitrage the index roll."

Still, Mr Gately said, there were decent flows all day - even with the uncertain price action.

Now that the first day of trading is out the way, participants are looking at other opportunities the introduction of the new documentation will present.

CDS on financial subordinated debt is likely to be a major focus.

The old contract on sub CDS was exposed as barely being worth the paper it was written on, after the nationalisation of SNS Reaal last year and, more recently, Banco Espirito Santo failed to trigger the contracts.

The 2014 Credit Definitions introduce a new credit event to capture bank bail-ins and allow a wider range of securities to be delivered into CDS auction to ensure the economics of the CDS and the bond market are more closely aligned. "The new sub CDS contract is very interesting to look at, as the previous one was completely inefficient," said the credit hedge fund manager. - Reuters