In Defense of Credit Indices, Part 2

When it comes to derivatives, Gillian Tett is the best-informed journalist in the mainstream financial press. Like many financial journalists, she's prone to bearishness – but in an important sense it's her job to warn of weaknesses in the architecture. So while I'm happy to dismiss Bob Lezner when he warns of the downside to credit indices, it's worth revisiting the issue now that Tett is making similar noises. (If Tett has disspeared behind the FT firewall, Yves Smith has the whole column.)

Tett's problems with credit indices in general, and the iTraxx index in particular, are not the same as Lezner's. And indeed it's not even obvious that Tett does have a real problem with them:

The derivatives "tail" to the corporate credit market, in other words, is now wagging the dog in a manner never seen before. "These credit derivatives indices are [now] the mainstays of the financial markets," says Tim Frost, co-founder of Cairn Capital, a London-based investment fund, who suggests that without the lubrication of these products, "the engine of the credit markets would have seized up weeks ago and be belching acrid smoke"...
This summer, investors have rushed to take a more defensive stance on credit, partly due to the worsening news from the US mortgage markets. In previous cycles, the only way they could have done this would have been to sell bonds or other debt assets. However, during times of stress this avenue is often closed because of a shortage of buyers. As one investment fund recently wrote in its weekly letter: "Cash credit markets have virtually ceased to function."
Consequently, asset managers increasingly turn to the arena where they can still trade - the iTraxx and CDX indices. And this has triggered a self-reinforcing cycle: precisely because investors now think credit derivatives are more liquid, they are becoming more wary of cash instruments, which is pushing even more activity into derivatives. Thus it is the price of credit derivatives indices - not bonds - which moves first in response to economic news or shifts in investor sentiment. So when investors in other sectors such as equities want to track the credit markets, the first place they look is the iTraxx or CDX.

At the margin, it's undoubtedly true that liquidity has moved out of the bond market and into the CDS market. But it's also undoubtedly true that less liquidity has been lost in the bond market than has been gained in the CDS market. Credit markets have seized up in the past, and they will seize up again in the future. The difference now is that even though credit markets have seized up in the cash market, it's still possible to put on hedges and otherwise hedge one's exposure in the CDS market.

And Smith makes an error when he goes one step further than Tett:

At some point, these derivative trades become self-referential rather than derivative. Suck enough trading volume out of the cash market and the cash prices become increasingly dubious reference points for the formation of derivative prices.

The error is that the formation of iTraxx prices, and those of other CDS indices, has absolutely nothing to do with cash prices. The iTraxx is an index of individual CDS prices, not of cash prices.

The point is that when the markets get tough, you can either use the CDS market to get an idea of where risk is being priced, or you can use nothing at all. Because with or without the CDS market, the cash market in corporate bonds is never going to be particularly useful as a pricing mechanism. during a credit crunch. CDS indices aren't perfect. But they're a darn sight better than the alternative, which is nothing.