Time Frame: Medium-Term | Update Schedule: Weekly | Source: Markit
Construction:
Over the past few years, one of the fastest-growing derivatives markets is that for credit default swaps (CDS). A CDS allows the various parties to swap the exposure of default of the underlying credit (i.e. bond).
For example, the investor of a relatively risky bond might be uncomfortable that the issuer of the bond could default on their payments. To hedge that risk, the investor buys a CDS.
When they buy the CDS, the investor pays another trader (the seller) a periodic payment. That other trader then takes on the risk that the issuer of the bond will default. If that happens, then the seller is responsible for paying the bond investor an agreed-upon amount.
This allows the original investors to offset some of their risk, it allows the seller to generate a stable flow of income, and it allows the bond market to enjoy more liquidity. Of course, just like selling options, the seller of a CDS takes on possibly large risks, and a major system-wide event could trigger a massive wave of trouble since this market has become so huge.
The indicator as posted to the site tracks an index created by Dow Jones which monitors the spread between credit default swaps on high-yield (i.e. junk) bonds and Treasury securities. The higher the index, the wider the spread...this means that credit investors are more and more worried about defaults and are willing to pay higher prices for default protection.
We expect it to track volatility measurements like the VIX quite closely as times of fear should see this index spike higher and times of complacency should see it become very subdued. In that sense, it is a contrary indicator.
