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Journal of Indexes

Swapping Your Way Into European Credits

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J.P. Morgan has introduced an index of credit exposure to Europe based on credit swaps. It is intended to solve a difficult problem for traditional bond investors: How to build a balanced investment in the European fixed-income market. It achieves much broader diversification than existing credit indexes that track outstanding bond issuance. The principle may be applicable to other credit markets.

WHY A CREDIT SWAP INDEX?

In general, derivatives provide the opportunity to tailor exposures more flexibly than traditional cash markets permit. They can provide ample exposure to any desired source of fixed income and don't need a large, liquid underlying market to do it.

To us, nowhere seems to cry louder for this alternative means of access than the market for fixed-income credit exposure faced by European investors. While there are isolated pockets of deep liquidity in certain names, the corporate market has traditionally been dominated by the notes and bonds of the banking and finance sectors. The index we are presenting serves European investment, but we believe the principle could be applied to any market with similar problems

We believe there are deep structural reasons why a satisfactory bond market may be slow to develop in Euroland. Bank loans have customarily accounted for a large part of corporate financing. While some banks are making strenuous efforts to diminish the size of their loan books, the rapid development of the collateralised debt market means that they can off-load their exposure by securitising loans, and continue to earn a return from intermediary services. As a result, they seem unlikely to cast their borrowers into the bond market.

In contrast to the Eurobond market for European corporate issuers, the universe of names behind a credit swap index can reflect much more the desires of investors. Figure 1 shows that our European Credit Swap Index comprises a much more balanced portfolio of exposures. It is also less dominated by high-grade credits, permitting somewhat better returns. The average rating of the eurobond universe for Western European issuers that we track is close to AA+, the average rating of the European Credit Swap Index is AA-/A+.

Credit swaps offer much simpler corporate exposure than the cash bond market. They go a long way towards isolating pure credit fundamentals exposure. This relative purity of individual credit swaps carries through to our Credit Swap Index, which is used to price and track a synthetic security that in effect is a proxy for the entire pan-European corporate fixed-income market. Because five years is a highly-demanded fixed-income maturity in European markets, the Index brings in new five-year credit swaps in all names every six months, selling off the old ones, which have rolled down to 4.5 years. In addition, the index tracks a cash security. It is a credit-linked note that replicates what a corporate bond investor buys, and permits the underlying portfolio of notes (for the individual names in the index) to be bought or sold in its entirety.

THE NAMES BEHIND THE INDEX

Our index will track a universe of ninety-eight names from corporate Europe formed from a union of the companies making up the Eurotop 100 and Stoxx 50 equity indexes (see Appendix for list of names), and will work largely regardless of the relative availability of bonds issued by those names.

TABLE 1: INDEX COMPARISON BY SECTOR AND RATING*
  AAA AA A BBB NR Total
Banking, Fin. & Real Est. 3 20 10 - - 33
Basic Material - - 4 - 1 5
Consumer, Cyclical   3 5 2 1 11
Consumer, Non-cyclical 3 6 4 - 2 15
Energy 1 3 - - - 4
Industrial - 4 3 1 - 8
Technology - - 5 1 2 8
Utility - 4 5 2 3 14
Total 7 40 36 6 - 98
*Number of Firms

Eurotop comprises the Financial Times' list of one hundred of the most highly capitalised firms in Europe. We eliminate certain curiosities in that Shell, Unilever and Zurich Allied all appear twice for reasons of corporate structure, but only warrant one "vote" each from the standpoint of credit exposure. We have also taken a similar view in regard to Reed International and Elsevier who own large stakes in each other. The Stoxx portfolio is a similar index of fifty corporations put together by Dow Jones, with slightly different criteria for eligibility that can potentially lead to one or two names appearing in the Stoxx list and not in the Eurotop. At the moment Nokia and KPN are the only two constituents of the Stoxx list that are not in the Eurotop.

For the present, we view replicating the membership of pan-European equity indexes as the simplest and most transparent way to present credit exposure to "Europe Inc." However, it is not necessarily the case that all and only the firms with large equity outstanding will be those that are of interest to credit investors. There may arise cases of highly-geared corporates whose equity value is too small for the Eurotop and Stoxx indexes that we may admit on a case-by-case basis. Our only proviso is that they must be expected to interest diversified-credit investors over the long term. Corporates that attract the attention of the credit swap markets only transiently, for example, those involved in distress, mergers or acquisitions, will not gain entry to the credit swap index.

INDEX SUB-SECTORS

Since the full universe may be too broad for some investors' needs, there will also be two sets of sub-indexes calculated. One set will divide the index universe by industry sector, using the categories shown in Figure 1. The other set will divide it according to credit rating, (the lower of S&P's and Moody's) using broad rating groups (AA/Aa, for example).

CALCULATION OF THE INDEX

The form of the credit swaps in the index conforms to the recently-formulated ISDAstandard. Acredit swap (also known as a credit default swap) is usually described as a means of buying or selling protection against the credit risk of a corporation. For example, say you are a bondholder in Corporation X and bought protection with J.P. Morgan as your credit swap coun-terparty. J.P. Morgan might receive a coupon equivalent to 25bp per year (a typical recent rate) and would guarantee an agreed notional amount of principal. Under the credit swap the coupon would be paid unless and until a reference credit event occurs, such as Corporation X defaulting. At this point an exchange between the protection buyer (you, the bondholder) and the protection seller (J.P. Morgan) is triggered. For example the bond itself (probably much depreciated) can be delivered to J.P. Morgan, which is required to pay the full notional principal value in exchange. In this way the protection buyer has been immunized from the losses associated with default at the cost of 25 basis points per year.

A credit swap can also be converted into a security by means of a credit-linked note (CLN) that embodies the bond's expected yield. If you want to lay off risk you in effect sell this CLN to J.P. Morgan. If you want exposure to European interest rates, you buy it. The note can be either a floating-rate or a fixed-coupon version. The fixed-rate version is a building block in our total return calculations.

The index will be calculated weekly, based on Friday's closing credit swap spread levels for each name and published by J.P. Morgan. It will also be calculated monthly using levels on the last business day of each month. For each index, there will be calculated an aggregate swap spread level, together with a total return, based on constructing fixed-rate credit-linked notes for each name. This return series will be directly comparable with those from our existing government bond and eurobond indexes, allowing fund managers to follow them easily.

Credit swap index spreads will be quoted for a constant five-year maturity. Returns are based on buying five-year credit-linked notes and holding them for six months. Each March and September, the portfolio of notes with now four-and-a-half years to maturity is unwound, and a new portfolio of five-year notes purchased. Except in the case of default, when a name will drop out of the universe, the composition of the indexes will not change other than at these rebalancing points.

Market practice is to collateralise CLNs with AAA asset-backed securities that can currently receive spreads higher than libor due to liquidity considerations. Purchasers of CLNs - in effect, buyers of pan-European bond returns - have as a result been paid more than libor plus the credit swap spread above libor, though that result cannot be guaranteed in future transactions (where adjustments would be made if necessary).

The weight of each name in the index will be the same. The existence of different sectors provides for a certain amount of flexibility for custom weighting schemes. All figures are for euro-denominated swaps and notes.

TRANSLATING A SPREAD INTO A RETURN

At issuance, the value of each credit swap is set at zero: The value of the corresponding credit-linked note is set at par, to which there corresponds a par credit swap spread or coupon (i.e. the coupon level of the credit swap which makes its current value zero, so that the only money that changes hands is the coupon). Afive-year maturity fixed-rate credit-linked note will pay a coupon equal to the five-year funding rate, plus the par credit spread, in order to fix the initial price at par. If the note were floating-rate, its value would return to par at every coupon reset. The price of a fixed-rate note, however, can wander farther away from par.

To build a total-return index it is necessary to mark each note to market at any time it is present in the index. This calculation (Figure 2) relies on a term structure of par credit swap spread levels for each name, provided by J.P. Morgan's credit swap desk. We first interpolate a par spread from the spread levels for the remaining maturity. This par spread, combined with an assumed recovery rate, implies a probability of default. We use this default probability, in combination with the funding rate, to discount the remaining cash flows of the note. We add accrued interest to the resulting principal return, to derive the total return for the note. The resulting return on the off-market instrument depends on the assumed recovery rate. However, the dependence is minimal, because the recovery rate assumption is, in effect, common to both on-market and off-market spread calculations, and so, to a first order of approximation, cancels out.

Total returns of fixed-rate CLNs are much more volatile than those of floating rate, because of their greater interest rate duration. Floating-rate notes show very little volatility in returns due to their small interest-rate duration. Practically all their return would be due to carry, and unless and until the underlying credit defaults they behave in a similar fashion to cash.

TRADING THE INDEX

Bid and offer credit swap spreads for most names in the universe are around 5 basis points apart. However, in the case of a rebalancing, where a 4.5-year credit swap or floating-rate note is sold in return for a 5-year swap or note the transaction costs only about 2 basis points. This compares favourably to bid-offer spreads in the eurobond market which are commonly 2 to 5 bp of yield for liquid bonds rated AA. (Italy is rated AA and the spread for a large, new issue would typically be 1 bp.)

Recasting credit swaps into fixed-rate credit-linked notes lets us compare our index directly with conventional bond indexes. The same access to credit can be achieved with a floating-rate CLN. Due to its shorter interest rate duration, rebalancing costs will be lower than for the fixed-rate CLN.

The index also provides a tool for active managers not available via conventional means - the ability to short credit. If an investor has a bearish view on a particular sector, or on the asset class as a whole, this index allows them to take the "other side" on an index trade, in effect selling the CLN.

HISTORICAL PERFORMANCE

The credit derivative market is still young. We have put together indicative historical credit swap data for a large proportion of the names in our universe dating back to the beginning of 1999. The total-return series for fixed-rate CLNs based on these data together with those of the EMU government bond index and the euro investment-grade credit index of 5-year maturities are displayed in Figure 3. Investors in the credit swap index would have experienced much the same return patterns as direct investors in the cash bond market.

Despite the fact that this was a turbulent year for spread markets, the spread for our flagship index was always within the range 21-24 basis points. Why the lack of volatility? It was not because there was no movement in the spreads of individual names. Figure 4 shows a histogram of the annual volatility of spread changes experienced by the names in our universe. The median volatility was 6.3 bp per year, with highs of over 30 bp per year for takeover protagonists Olivetti, Telecom Italia, Mannesmann and Vodafone.

This median volatility is in line with credit fundamentals. Using the rating-transition matrix for 1999 and associated asset swap spread levels (Table 2), we can make our own "theoretical" estimate of volatility for names in each rating category. In Table 3, we compare the P&L volatility to which historical probabilities of credit quality changes would give rise, with the actual P&L volatility on individual names' credit swaps. The two sets of figures are quite similar. In particular, there is no tendency for the theoretical volatility to exceed actual volatility.

TABLE 2: 1999 CREDIT MIGRATION PROBABILITIES (%) AND SPREADS (BP)
5y euro       from  
asset swap   AAA AA A BBB
spread levels   1 2 3 4
  to        
1 AAA 93.7% 0.6% 0.0% 0.0%
13 AA 6.1% 82.1% 7.6% 0.0%
37 A 0.3% 17.2% 90.5% 5.9%
77 BBB 0.0% 0.1% 1.9% 93.9%
200 BB 0.0% 0.0% 0.0% 0.0%
380 B 0.0% 0.0% 0.0% 0.1%
600 CCC 0.0% 0.0% 0.0% 0.0%
2000 D 0.0% 0.0% 0.0% 0.0%

TABLE 3: SPREAD RETURN VOLATILITY FOR INDIVIDUAL NAMES (BP PER YEAR OF DURATION)
  AAA AA A BBB
Theoretical estimlate 4.0 6.2 11.1 8.7
1999 actual 5.7 6.2 10.2 17.9

The volatility of index spread changes was only 3.3 bp in 1999, compared with a 6bp average for individual names. We put this difference down to diversification. Figure 5 shows a histogram of the (approximately 5000) correlations of spread changes between all the different pairs of names in the universe. The histogram is concentrated at zero, around which it is quite symmetric, a sign the changes in spread levels of each name are largely independent of what is happening to the other names.

This propensity to diversify credit risk and reduce volatility provides a very strong rationale for using the index to take on credit exposure by using swaps or floating-rate CLNs.

 

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