On Monday, September 28, 2015, the North American High Yield CDX index (High Yield CDX) will be reconstituted, or “rolled”. Ten reference entities will be removed from the index, replaced by 10 new reference entities. Significantly, the 10 removed names include only one in the energy sector, whereas the 10 new names include five, increasing the energy sector weighting in the High Yield CDX by four percentage points. The five new energy sector reference entities introduced to the High Yield CDX at this roll are also likely to trade on a single-name basis. These changes create opportunities for market participants to hedge risk or trade in the energy sector using credit default swaps on a single name, macro or correlation basis.
The CDX indices are broadly used as liquid macro credit trading tools. The High Yield CDX contains 100 equally-weighted reference entities whose outstanding debt or single-name CDS, or both, is the most liquid. In addition to liquidity, sector weighting of the reference entities, relative to the iBoxx USD Liquid High Yield Index, also affects the composition of the High Yield CDX. Like all CDX indices, however, High Yield CDX cannot perfectly mirror the credit markets. Not even close. For one thing, High Yield CDX contains a constant 100 names (which can decrease as a result of corporate events or credit events), whereas iBoxx USD Liquid High Yield Index has around 1,000 bonds.
The semi-annual rolls performed in March and September are an opportunity for the index to be fine-tuned to account for corporate events and credit events that have occurred during the prior six-month period, and, more importantly, to better reflect the segment of the credit default swap market which the index is reputed to represent.
The High Yield CDX index rules provide that on each roll date a maximum of 10 names can be replaced on the basis of (decreased) outstanding debt, liquidity of single-name CDS or liquidity of issued debt of the relevant reference entities. If fewer than 10 names have been replaced based on liquidity, then additional names can be removed based on sector “over-weighting”, i.e., when a sector’s weighting in High Yield CDX is more than three percentage points in excess of the weighting of the relevant sector in the iBoxx USD Liquid High Yield index. On the other hand, sector “under-weighting” may not be cured unless removal of names creates vacancies that are not filled by inclusion of names based on liquidity. As a result, underweighting may occur from time to time, and most recently, underweighting was present in the energy sector.
Thanks to the September 28 roll, the energy sector underweighting is remedied to a certain extent by the inclusion of five new energy names in the High Yield CDX, bringing the index more in line with the iBoxx. For market participants who seek macro hedges or correlation trading, the High Yield CDX now more accurately reflects the credit risk of the energy sector vis-à-vis the broader high yield credit market. Also of interest to traders and investors may be the market expectation that the new energy names added to the CDX will be traded on single-name basis as well, providing more opportunities for hedging and directional view-taking. That, of course, is always good news.