The COVID-19 (C19) pandemic has severely affected global markets, causing economic disruption at an unprecedented speed and on a hitherto unknown scale. News of the virus first appeared in late December 2019 and by mid-January reports emerged that it was no longer contained within China. With the spread of the virus accelerating by mid-March 2020, the US economy has been severely impacted and there are understandable concerns about the damage caused to the worldwide economy. Unemployment continues to shake the workforce, reaching levels not seen since the Great Depression. A number of small businesses have closed, either temporarily or permanently, and even large and well-known companies have declared bankruptcy.
This paper explores the effects of the pandemic on the credit derivatives market and, more specifically, how recent bankruptcies affected North American high yield (NA HY) CDS index trading, including CDX.NA.HY indices and the options on them.
To place the current situation in context, the analysis in this paper concentrates on index CDX. NA.HY.33, which comprises 100 names and was issued on September 20 2019, a few months before the first C19 cases. By mid-June 2020, nine months after the index issuance, it already had nine defaults, seven of which have had recovery auctions and two others will have their auctions at a later date. This has put HY33 on a much faster trajectory of defaults than the notorious HY9, which became very popular in structured credit trading during the last financial crisis. HY9, which became effective in September 2007, only had six defaults by April 2009 and a total of 20 defaults (out of 100 names) by December 2017, the point at which the longest-traded 10-year maturity expired.
The high concentration of defaults creates many challenges for trading systems, given they are required to account for changes in notionals, prices, spreads on dates of default announcement, auction, post-auction, and recovery settlement. For market participants who are relatively new to the HY market and did not experience the high level of defaults during and after the financial crisis, the consequence of these market events can be devastating and long-lasting.