iTraxx Index- A brief explanation

In response to a recent request and the ever increasing spotlight that the iTraxx indices find themselves under I thought I’d write a quick note to try and shed some light. The indices first came into being in Europe back in June 2004 when it was felt that the bond markets would benefit from the creation of a liquid index reflecting the ever growing credit default swap market (CDS) . The index is not dissimilar to those found in the equity and traditional bond markets such as the Dow, FTSE or Merrill Lynch Bond Indices.

The iTraxx index family in Europe is principally made up of the three indices; iTraxx Europe Main, iTraxx HiVol and the itraxx Crossover. Each has its own set of rules to define which bonds are suitable for inclusion. The Main Index is composed of:
– 125 equally weighted investment grade entities,
– The HiVol 30 – the more volatile investment grade names and
– The Crossover 45 – sub investment grade names (those credits that the rating agencies believe are most at risk of default)

Each of these indices has a life of either five, seven or ten years. The indices are then created every six months (known as the roll), based on a poll which attempts to identify those bonds (subject to the criteria) that bond traders believe are most liquid and should be included (try repeating that at speed!).

The indices have proved incredibly popular amongst banks and investors alike as they offer all the benefits of a liquid instrument that enables investors to express a view on a portion of the credit markets through buying or selling the relevant index. As a result volumes have been climbing and nowadays account for a majority of trades within the credit derivatives space. Volumes this week alone are expected to be nearly €200bn!!

Until this week’s equity market sell-off we had seen nothing but an upward trending market for the indices since the previous roll back in September 2006. However, the increased volatility and price action in the equity markets has had a significant impact on the Crossover index (you’d expect this index to be the more volatile of the three) , and to a lesser degree the Main & HiVol. Interestingly so far ‘traditional’ bonds have been largely unperturbed by the increased volatility in the indices. The question many are now asking is whether the rest of the market will follow the iTraxx indices lower ?