CMBX indices are widely referenced market instruments among structured credit investments. Yet, we find that a large portion of investors are operating on partial information in regards to the various uses of CMBX and the potential benefit from active management.
Definition of CMBX
Each CMBX index is a basket of credit default swaps (CDS) on a static basket of CMBS and provides investors with a means of obtaining diversified exposure to specific rating categories within the reference pool. A majority of the 20 primary dealers make active markets in CMBX, making the indices liquid and accessible. The transparency of widely quoted markets and bid/ask spreads that are narrower than bonds in the cash market provide investors with an efficient and versatile tool for expressing varying views in CMBS.
Mechanics of CMBX
CMBX contracts are structured to closely follow the cash flow of the underlying deals, according to Internal Swaps and Derivatives (ISDA) “pay-as-you-go” (PAUG). In this CDS format, the buyer and seller make two-way payments over the life of a contract. The performance of the contracts is structured to provide investors with a means of expressing a positive or negative view on the basket of bonds in the basket of reference securities.
CMBX buyers “sell protection” by taking on risk associated with the CMBS portfolio and profit when the reference pool performs better than the implied performance at the time of purchase. In essence, they are exhibiting a bullish view.
CMBX sellers “buy protection”, and pay an upfront fee and fixed premium to index buyers in exchange for payments to cover losses in the event of any writedowns or shortfalls. They are either aiming to hedge or express a bearish view.
Source: CMBX The Long and Short of It, CRE Finance Council 2014
CMBX can be used to hedge a portfolio against credit exposure as well as systemic market movements. Credit risk on a portfolio can be mitigated through taking a short position in a tranche with similar characteristics as the portfolio. However, basis risk increases over time as the credit performance of the specific securities referenced by the CMBX and those held in the portfolio drive the respective outcomes. To hedge market risk, newly issued series are an effective tool given their high correlation to market indices like the S&P 500. The correlation is driven by ease of access and low capital commitment, allowing investors to quickly and efficiently express a risk-off view to protect against a systemic sell-off in credit markets. The chart below illustrates the relationship between the S&P 500 and the A tranche of the CMBX.6 series (CMBX.6.A). It demonstrates how tactical short positioning as sentiment shifts provides a means to cushion the downside.
During major market drawdowns, there are opportunities for hedging by shorting CMBX.
With the observed relationship between a benchmark index like the S&P 500 and certain CMBX indices, it is logical that there would also be opportunities to profit from directional moves in broad markets on major shifts in sentiment. Investors can go long or short in CMBX accordingly to reflect their expectations for market performance. As an example, taking a view based on a technical indicator like the RSI to gauge the potential for a directional move in the broader market, one can implement a CMBX strategy with the aim of profiting from near term shifts in sentiment. Examples of such moments are annotated in the graph.
In the rebound period following major market corrections, there are opportunities for directional long trades.
CMBX can also be traded using a relative value strategy, where opportunities arise from dislocations in the pricing of different tranches within a given series. As an example, we developed and tested the effectiveness of a multilinear regression model to predict CMBX.6.AA. We chose CMBX.6.A and CMBX.6.AAA as our explanatory variables. As shown in the chart, relationships between highly correlated tranches can be modeled and used to signal relative value trades. Statistically significant dislocations serve as potential opportunities.
CMBX is a multi-faceted tool that provides investors with efficient means for achieving a range of objectives. Those well versed with this product can utilize it in the active management of a portfolio to add incremental returns across a dimension of market environments. It is a useful tool for opportunistic investors to include in their alpha sources.
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