High Yield CDX Rolls

Tomorrow morning (September 27th), the HY CDX 17 will begin trading and will replace the HY CDX 16 as the on-the-run high yield synthetic index. Many hedge funds and other investment advisers will establish new positions in this index (as an outright call on credit spreads from a long/short/hedging perspective or index arbitrageurs) and will reduce or eliminate position in the HY CDX 16 as the index becomes more illiquid relative to the on-the-run index.

This "CDX roll" happens two times a year. In effect, certain credits are added to the 100 member index while others are removed from the index. This year, the methodology for additions / deletions was dramatically overhauled. Previously, a dealer poll was conducted to add / remove credits. The new methodology utilizes a system whereas the existing index is "screened" through three filters, and depending on the outcome, credits are dropped and others are added. Dealer input is still involved during the process to accommodate certain technical aspects that may not get captured by the more quantitative screening process.

Similar to the old methodology, the first screen is to determine whether a credit is even eligible for inclusion in a high yield index. This can happen for a few reasons:

• The company has been upgraded
• Two high yield companies have merged making inclusion redundant
• A takeover / takeout
• A default
• An orphaned credit (i.e. there are no obligations to deliver into a CDS contract).

For this roll specifically, 5 credits are being removed from the HY16 for one of the above reasons:

• Qwest
• Macy's
• Temple Inland
• Domtar
• Nalco

For credits that are removed in Step #1, replacements must be the most liquid names (Using a 6 month analysis of records at DTCC to determine liquidity) in the least represented (i.e. most underweight) sectors. We start with the MOST underweight sector and add until we replace credits from Step #1. For this roll in particular, the credits to be added (and the Markit specific industry) are:

• Health Management Associates (Healthcare)
• Seagate (Technology)
• Bausch & Lomb (Healthcare)
• Sunoco (Oil & Gas)
• R.R Donnelley (Industrial)

After Step #1 in completed, the second step / filter revolves around removing illiquid credits from sectors that are "overweight" relative to the iBoxx USD Liquid High Yield Index. If the current HY CDX (i.e. CDX 16) has a sector that is overweight by more than 300 basis points, the least liquid credit in that index will be removed. Like the first step, the replacements from here are the most liquid credits from the most underweight sectors (pro forma for the additions / deletions up to this point). In this particular roll, Georgia Pacific and Mediacom will be removed and will be replaced by Vulcan Materials and SRAC (Sears Roebuck Acceptance Corp). SRAC, despite being affiliated with Sears (i.e. retail) is classified as a financial - color me surprised.

The third step in the addition / deletion methodology looks at ratings of the existing index relative to the aforementioned iBoxx USD Liquid High Yield Index on an issuer weighed basis. There are three buckets: BB, B, CCC. Again if there is a 300 basis point discrepancy, the least liquid credit in the most overweight rating category is removed and the most liquid name from the most underweight rating category is added. In this step, Univision, a CCC credit, was removed and Springleaf Finance Corp, a single B credit, was added. Initially, Liz Claiborne was to be removed (according to the September 14th provisional changes released by Markit). Dealers apparently voted this down as Liz is a very liquid, high beta CDS name that has very few underlying cash bonds.

Finally, though not really part of the screening process, if an issuer has an affiliate that is more liquid than the existing entity in the current CDX, the more liquid affiliate will replace the more illiquid entity. In this particular roll, the holding company of Avis (Avis Budget Group, Inc) will replace Avis Budget Car Rental and TCEH (Texas Competitive Electric Holdings) will replace Energy Future Holdings.

10 credit roll is definitely large. For reference, the credits that are leaving trade around 350 basis points today and the ones coming in trade at 600 basis points. Because of weaker credits being included and extending the portfolio 6 months, this index (which also has a 500 running spread) will trade lower than the HY16. One can calculate the theoretical difference between the two indices, which most dealers are placing around 2.5 points. It will trade slightly wider than that (i.e. the roll market) as those using the HY Index as a hedge will cover their legacy position and establish new ones in the HY17 (supply / demand technical imbalance). If the technicals get too far from intrinsic value, I'd still expect arbitrageurs to keep the market in balance. I will note that many people I've talked to that use the HY index as a hedge have already covered their position to simply get ahead of any nasty roll technicals.

If you are interested in learning more of the CDX Index rules, Markit has a document outlining all the gory details here: CDX Index Rules