FT.com
Hedging leveraged loans
Wednesday October 10, 4:45 am ET


LCDX was the newest piece of artillery in the credit derivatives armoury when the index - allowing investors to buy and sell protection on the loans of 100 US companies with high-yield, high-risk ratings - was launched by a group of banks in May. Last week it was re-shuffled for the first time. Has it been a success?

Yes and no. In six months, it has established itself as the benchmark index for leveraged loans. Hedge funds have poured in, whether because they are not set up to trade the underlying loans, or because the index is much easier to short. Total volumes traded to the end of September were about $405bn. That is almost 10 times larger than the outstanding amount of credit default swaps on US loans.

But with increased liquidity has come increased volatility. Leveraged loans used to be bought and then sat on, moving one or two basis points a day in their heaviest trading. As the new index began to slide in June, mirroring falls in the ABX index of mortgage bonds, it provided very visible evidence of a change in mood, dragging down the cash market. By the time fear really set in, in late July, brokers had sold the index down so much that some issuers' senior, secured loans - the first class to be repaid by a company in default - were changing hands at lower prices than more junior debt.

Some order has been restored. The index's first series has stabilised at around the 97 mark (100 is par value), having hit lows close to 90. The stabilising of the secondary market has also allowed banks to get some pent-up deals away at palatable discounts.

Granted, the stuttering LCDX was not the only factor in the sell-off. Funds playing arbitrage between loans and bonds pushed prices lower, as did the busy calendar of pending LBO financings. But there are concerns about the index. A product designed to provide an outlet for the dispersal of risk may have achieved the exact opposite.