Credit Default Swap Index
A credit default swap index (CDS index) is a standardized, tradeable basket of single-name CDS contracts referencing a portfolio of corporate issuers, enabling market participants to efficiently buy or sell broad credit risk exposure in a single transaction rather than accumulating individual name positions.
Key takeaways
- The two dominant families are CDX (North American, managed by IHS Markit/S&P): CDX.NA.IG (125 investment-grade names) and CDX.NA.HY (100 high-yield names); and iTraxx (European and Asian), with new series ('rolls') every six months in March and September.
- Trading occurs at a standardized coupon (100 bps for IG, 500 bps for HY) with an upfront payment (points) reflecting the difference between the standard coupon and the fair-value running spread.
- CDS indices provide liquid macro hedging tools: a portfolio manager concerned about IG credit widening buys CDX.NA.IG protection; a bank reduces loan book credit concentration efficiently by buying index protection.
- Index tranches (equity, mezzanine, senior, super-senior) slice the first-loss and residual risk of the underlying index portfolio, allowing precise positioning on correlation and credit tail risk.
- CDS indices trade at a spread that reflects average credit quality of constituents; skews between the index spread and the sum of constituent single-name spreads (intrinsic value) create relative value and arbitrage opportunities.
Explanation
CDS indices emerged in the early 2000s as the credit derivatives market sought standardization to improve liquidity and price discovery. The CDX and iTraxx families now represent some of the most actively traded credit instruments globally, with daily notional volumes comparable to or exceeding those in single-name CDS markets. The indices consist of equally weighted baskets of single-name CDS contracts: each constituent represents a 0.8% weight in CDX.NA.IG (1/125) or 1% in CDX.NA.HY (1/100).
New series are issued every six months — the 'roll' — when IHS Markit/CDXCO reconstitutes the index based on updated eligibility criteria (credit rating, trading activity, ISDA-compliant documentation). Upon a roll, the new series becomes the 'on-the-run' index (most actively traded), while prior series become 'off-the-run' with diminishing liquidity. The roll itself creates significant trading activity as market participants transition positions from old to new series, and any relative mispricing between series can be exploited.
Trading mechanics use standardized coupons to facilitate fungibility: CDX.NA.IG trades at a fixed coupon of 100 bps; CDX.NA.HY at 500 bps. Since fair-value spreads fluctuate with market conditions, an upfront payment (expressed as a percentage of notional) is exchanged at trade inception to true-up the economics. If the IG index fair spread is 60 bps but the fixed coupon is 100 bps, the protection buyer pays an upfront amount approximately equal to the present value of the 40 bps per annum excess coupon over the remaining term — effectively paying a premium for protection that is priced above market.
CDS index tranches are structured products that allocate losses from the index portfolio sequentially. The equity tranche absorbs the first losses (typically 0-3% of notional), the mezzanine tranches absorb intermediate losses, and the senior and super-senior tranches absorb only catastrophic, systemic credit events. The equity tranche is highly leveraged and sensitive to individual defaults; the super-senior tranche is sensitive primarily to simultaneous widespread defaults (systemic risk). Tranche pricing depends critically on correlation assumptions: in a high-correlation world, either few or many names default together, making the senior tranche riskier and the equity tranche (slightly) safer — the correlation smile in tranche pricing reflects how the market prices this dispersion of correlation across attachment points.
The CDS-bond basis — the difference between the CDS spread and the comparable par bond spread — can diverge significantly during market dislocations. Negative basis (CDS spread < bond spread) creates an opportunity to buy protection cheaply relative to bond yields; positive basis (CDS spread > bond spread) suggests the CDS market is pricing more default risk than the cash market. These dislocations are exploited by basis traders and reflect technical factors including bond supply/demand, collateral constraints, repo financing costs, and liquidity premiums.
Formula
Upfront Payment ≈ PV01 × (Running Spread - Standardized Coupon); Index Fair Spread = Σ(weight_i × spread_i) adjusted for correlation
Example
In March 2023, amid regional bank stress, CDX.NA.IG Series 40 widens from 75 bps to 95 bps over two weeks. A pension fund holding $2 billion in investment-grade corporate bonds buys $500 million notional of CDX.NA.IG protection as a partial credit hedge. At a fixed coupon of 100 bps and a fair spread of 95 bps, the upfront calculation is approximately: PV01 × (100 - 95) bps = $0.50/bp per $100 notional × 5 bps = $2.50 per $100 notional. The fund receives an upfront payment of approximately $12.5 million (500M × 2.5%) for buying protection below the standardized coupon, then pays 100 bps = $5 million per year in running premium. If spreads tighten back to 70 bps over the next month, the fund closes the protection position for a mark-to-market gain on the 25 bps narrowing across a 5-year duration — approximately PV01 × 25 bps × $500M notional.
Related terms
Basis Bond Correlation Credit Default Swap Credit Enhancement Credit Rating Credit Risk Default Duration Equity Equity Tranche Fungibility