Credit Default Swap Index (CDX): What It Is and How It Works

What Is the Credit Default Swap Index (CDX)?

The credit default swap index (CDX), formerly the Dow Jones CDX, is a benchmark financial instrument made up of credit default swaps (CDS) that have been issued by North American or emerging market companies. The CDX was the first CDS index, which was created in the early 2000s and was based on a basket of single issuer CDSs.

Understanding the Credit Default Swap Index (CDX)

A credit default swap (CDS) is an over-the-counter derivative contract that offers one counterparty protection against a credit event, such as the default or bankruptcy of an issuer. It can be thought of as insurance in the financial world.

The credit default swap index (CDX) tracks and measures total returns for the various segments of the bond issuer market so that the overall return of the index can be benchmarked against funds that invest in similar products.

Investors can use the CDX's tracking to monitor their own portfolios against this benchmark and adjust their holdings accordingly. The CDX helps to hedge risk by protecting bond investors against default, and traders use CDX indexes to speculate about potential changes in issuers’ credit quality. 

The credit default swap index (CDX) is itself a tradable security: a credit market derivative. But the CDX index also functions as a shell, or container, as it is made up of a collection of other credit derivatives: credit default swaps (CDS).

Currently, the CDX contains 125 issuers and is broken down by two different types of credits: investment grade (IG) and high yield (HY). Every six months, the underlying securities of the CDX are examined and, if appropriate, replaced with new securities. This helps to ensure that the index remains current and is not cluttered with investments that no longer exist, or which are very illiquid. 

The CDX index rolls over every six months, and its 125 names enter and leave the index as appropriate. For example, if one of the names is upgraded from below investment grade to investment grade, it will move from the high-yield index to the investment-grade index when the rebalance occurs.

Why Invest in the Credit Default Swap Index (CDX)? 

The CDX is completely standardized and exchange-traded, unlike single CDSs, which trade over the counter (OTC). As such, the CDX index has a high level of liquidity and transparency.

CDX indexes also may trade at smaller spreads than CDSs. Thus, investors may hedge a portfolio of default swaps or bonds with a CDX more cheaply than if they were to buy many single CDSs to achieve a similar effect.

Finally, the CDX is a well-managed tool that is subjected to intense industry scrutiny twice a year. The existence of tools such as CDX indexes makes it easier for both institutional and individual investors to trade in complicated investment products that they otherwise might not want to own separately.

The CDX index came into being in the early 2000s, a complicated time in financial markets, perhaps to help make investing in complex, high-risk (potentially high-yielding) financial products a little less complicated and a little bit safer.

Later, the LCDX was created, which is also a credit-derivative index with a basket made up of 100 single-name, loan-only CDSs. The difference is that all of the CDSs in the LCDX are leveraged loans.

Although a bank loan is considered secured debt, the names that usually trade in the leveraged loan market are lower-quality credits. Therefore, the LCDX index is used mostly by those looking for exposure to high-yield debt, but with greater risk.