Liquidity and flexibility
Credit indices offer quick, easy and liquid access to the credit markets in a single bond.
Index tracking funds have been an excellent addition to the marketplace, providing an attractive option for those investors who do not want to take the risk of selecting the best fund manager, or have not wanted to pay the high fees associated with active managers. Their low costs and a well-understood long-term return make so-called passive management an essential addition to the investor’s armoury. However after three years of languishing equity returns, investors are turning increasingly to corporate bonds. What place is there for index trackers or passive management in the world of corporate credit? One new and innovative solution is the credit derivative index. Indices are not funds, but single notes which offer exposure to the broad credit market. Their returns are based on the performance of credit default swaps (CDS) on the names in the index. CDS usage is growing at an exponential rate and the liquidity they offer has been regularly observed, particularly in the after-math of September 11. Since CDS are used by a wide range of professional investors, including portfolio managers, hedge funds, loan portfolio managers and issuers, investment grade credit derivatives are highly liquid instruments. This means that investors have the opportunity to get out of their investments without heavy penalties, and that the costs associated with investment are low. One such European index is the JECI-100, launched by JPMorgan in March this year. JECI has been trading with a 3 to 4 basis point bid/offer and is Moodys rated. The indices can be designed to track standard corporate bond indices. The chart below demonstrates the returns of the JPMorgan JECI-100 index against their Maggie European aggregate bond index. The most liquid corporate bond issuers – typically the most active, familiar names – are therefore usually included. These would include names such as BT, DaimlerChrysler, RWE and Barclays. The liquidity and flexibility of the indices allows investors to take pure sectoral views, such as exposure to financials or corporates only. For active investors, exposure to the broad market can be put in place and unwound rapidly. Money can be put to work quickly where spreads are wide, while investors take time to decide which individual credits they want to invest in. Moreover, credit derivative indices are flexible hedging vehicles for investors who wish to protect themselves against the possibility of sudden credit spread widening. Investors can express negative views by shorting a single bond. By including a broad selection of credits and industry sectors, these indices can provide strong diversification, with limited exposure to the default of any individual name. This was previously impossible to attain with small transaction sizes without buying into a fund and paying the associated fees. For the investor wanting low-cost access to the broad credit market, a credit derivative index could be the perfect way to enter the market whilst gaining exposure to the broadest selection of companies. Lee McGinty is vice-president of the Index Strategy Group at JPMorgan
