By Malay Bansal
Newly launched TRX.II may seem complicated, but is not difficult to understand.
Markit launched TRX.II or TRX 2 indices this week. Details and various documents can be found on their website, but for those not familiar with the working of the index, or if the details on upfront payment and dynamic nature of the index are not clear, this article might help understand the mechanics and the underlying logic.
The Basic Concept
The concept is simple. Going long or buying the TRX.II (or TRX) index is similar to buying a bond. If you buy a bond, you get the coupon. Also, if the spread goes lower or tightens, resulting in lower yield, the bond price increases. Same is true with going long the TRX index. If you go long the index, you get a coupon, and if spread tightens, the value of your position goes up. And just like a cash bond, if spreads widen, the value of the position goes down.
The concept is similar, but there are some differences in implementation as the TRX is a contract (Total Return Swap contract) rather than a physical bond. For one party to go long, there has to be another party to take the short side. All that is needed for a TRX trade are the two parties wanting to take the opposite positions, and neither has to actually own or find the underlying bonds to initiate or close a position. TRX contracts will trade with quarterly expirations with a maximum length of one year. Since the contracts will be standardized, the trade may be initiated with one party taking the other side, and may be closed before expiry, if desired by either party, by doing an opposite trade with a third party. This ability to short easily is what makes it possible for loan originators to hedge their loans being aggregated for securitization.
Once they enter into a contract, at the end of every month, the short party pays the coupon equivalent to the long party. Also, if the spread is tighter at the end of month than at the beginning, then the short side pays the price appreciation calculated based on average duration and spread change to the long side, and vice versa. These payments take place at the end of every month, or till the end of contract. Each month, the spread at the beginning of the month becomes the new starting point for spread change for that month. Also this spread is the coupon that the long party gets for that month. It is paid by the short party and represents the cost of hedging.
The main purpose of the upfront payment in TRX is to handle trades initiated in the middle of the month.
For example, if someone goes long on 11th day of month, they should get the coupon only for the remaining 20 days in the month, even though the short will pay full 30 days interest or coupon at the end of the month. So, just like in cash bond, the buyer pays an accrued interest for 10 days to the short. Net result will be the short will pay and the long will get net 20 days of the coupon for that month.
Similarly, upfront payment adjusts for spread movement and traded spread. An example may help. Let’s assume the spread at the beginning of the month was 200, at the time of the trade was 230, and at the end of month was 220. In this case, spread tightened from 230 at the trade date to 220 at the end of month. So, the long party should get payment for the value of 10 basis points tightening at the end of the month. However, the standard payment mechanics will see widening from 200 at the beginning of the month to 220 at the end of the month, and will require the long party to pay the value of 20 bps. The upfront payment provides the adjustment that enables the normal end of month payments to take place in the usual manner. In this case, the upfront payment will be the value of 30 basis points (30 bps widening from 200 at the beginning of the month to 230 trade spread) paid by the short to the long. The net effect will be the long getting the value of 10 bps tightening, as he should.
Revolving Nature of TRX.II
One big difference between TRX and TRX.II is that TRX.II is a dynamic index and has a revolving underlying portfolio whereas the original TRX or TRX.I was a static index. The TRX.II will be rebalanced every quarter to include recent deals meeting the inclusion criteria. The initial TRX.II index has 18 bonds. The index rules specify a maximum of 25 bonds. Once the index reaches 25 bonds, the older bonds will be removed as new bonds are added.
The dynamic nature introduces some complexity, but key points to keep in mind are that all TRX.II trades for a specific maturity are fungible with one another and each payment calculation references spreads and average duration for the same set of index constituents. What that means is that when the index changes, the end of month spread for payment at the end of that month is based on the old index, and the starting index for next month is based on the new version of index with new bonds. To enable this, Markit provides numbers for both the old and new version of the index. Rest of the mechanism stays the same.
The spreads used for monthly settlements are calculated and provided by Markit based on spreads provided by the ten participating dealers for the underlying cash bonds. The fact that the TRX.II will settle every month to actual cash bond spreads means that it will be expected not to stray too far from cash bond spreads. The resulting high correlation with spreads on recently issued cash bonds makes the TRX.II a good hedge for loan originators.
The dealers provide spreads on the individual constituent bonds, not the spread for overall indices, which are computed by Markit. This ensures consistency between spreads for the old and new versions of the index, when the index is adjusted to include new deals.
For the more technically oriented, Markit’s calculation methodology involves using individual bond cashflows to calculate prices from the average bond spreads for each bond and then using aggregated index cashflows and average price to generate index spread, weighted average life, and duration. The end of month calculation of price change from spread change uses the averages of beginning and ending durations and index prices, which captures the majority of the convexity effect.
Outlook for TRX.II
I have asked for creation of a new TRX index for a long time (Restarting CMBS Lending, Feb 9, 2010). So I am happy to see it getting launched. I also like that Markit created a dynamic index which will always reflect spreads on new issue bonds, though that makes it more attractive to hedgers than to investors who may prefer to go long a known set of bonds.
TRX.II is a much better hedge than CMBX as it settles every month based on cash spreads and so is correlated with cash bond spreads, unlike CMBX which pays only when there are actual defaults (far into the future) and can trade purely based on technical factors with no correlation to new issue cash bond spreads. TRX.II is also a better hedge than TRX.I which references the old legacy CMBS deals and does not correlate well with new issue CMBS spreads.
One question on the minds of many people is if the index will gain traction. The general view is that the demand from originators will be there to short to hedge loans being aggregated for sale via securitization, but there may not be enough demand from the long side. It may turn out to be the other way. With spreads wide at present and few deals in the pipeline, the index may see more demand from long side than short side. Hedging of loans for spread movement today is not an almost mechanical process it used to be (CMBS Hedging Requires a New approach, July 5, 2011) and different originators favor different strategies. However, no matter what method is used, hedging has a cost. When spreads are wide and expected to tighten, many originators prefer to hedge just the interest rates and not the loan spreads. Barclays created a CMBS 2.0 index earlier in the year, but it has not been used much, partly for that reason. The TRX.II may benefit from the fact that some originators are now being pushed by their risk management groups to be fully hedged, and TRX.II will have higher correlation with actual cash bond spreads than any alternative. Also, TRX.II has ten licensed dealers. So, there may be more liquidity and more openness by their internal origination groups to use it for their hedging.