Friday, February 13, 2009

Index CDS Craziness

Tyler at Zero Hedge has an excellent post about index basis trades—arbitraging the differences in pricing between CDS indices and their single-name constituents—and how the IG11 index basis (or "skew") has exploded negative ever since Lehman. As Tyler notes, three IG11 constituents are trading on a points upfront basis, and considering that the IG11 is trading 46bps wide to the deal spread, that makes it pretty expensive to put on an index basis trade. (We'll ignore the irony of three constituents in an "investment grade" index being so distressed that they're trading on a points upfront basis.) It's also worth noting that the investment grade CDS index curves in both Europe and the US are severely inverted, and have been for a few months. Here are the spreads for the iTraxx Europe index:

And here are the spreads for the CDX IG11:
It's not surprising for CDS index curves to be inverted during times of market stress, but it's much more common for high yield indexes, and investment grade CDS index curves have never been this inverted for anything close to this long before. When the curves for the CDX IG and iTraxx Europe indexes are both severely inverted for several months, you know we're really screwed. (P.S. When the next index roll comes around in March, will we even be able to fill all 125 spots in the CDX IG index? Wouldn't everyone be happier if we just shrink the constituent pool instead of forcing garbage companies that are still technically "investment grade" like MBIA and the New York Times Co. into the CDX IG index? Just think about it.)

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