Matching Bond Portfolio Weights to a CDS Index

Summary

The document asks how to choose bond positions that replicate the issuer exposures of an equally weighted CDS index. Its two-issuer example contrasts investing equal bond notionals, which produces unequal market-value weights when the bonds trade at different prices, with choosing notionals inversely proportional to bond prices to make the cash invested equal across issuers.

It frames the central question as whether index weights should be matched by bond notional or by market value. The example illustrates the arithmetic but does not resolve which measure corresponds to CDS exposure. A definitive comparison would require specifying what “exposure” means and considering features such as credit risk measures, accrued interest, bond seniority, and maturity alignment. The document is therefore useful as a portfolio construction question and illustration, not as a complete replication method.

Key ideas

• An equally weighted CDS index assigns the same index weight to each issuer.
• Equal bond notionals can create unequal market-value weights when bond prices differ.
• Adjusting notionals for bond prices can equalize cash invested across issuers.
• The example raises, but does not answer, which weighting best matches CDS credit exposure.

Tags

# Construction of bond portfolio represented by a CDS-Index


# Construction of bond portfolio represented by a CDS-Index












Markit publishes investable basket CDS indices. These are indices intended to track the credit risk of a basket of issuers (e.g. in the case of iTraxx Europe Series 24 these are 125 names) in an investable way. The weight of each name in the index in this case is 0.8%.

How can I construct a bond portfolio that has a similar credit exposure. How do I choose the weights? Is it correct to invest the same notional into bonds of each issuer? Then notional*traded price gives me weights for each bond that differ from 0.8%.

Say as a toy example I have an index with 2 issuers. Then they are weighted 50%/50% in the index. For issuer 1 I have a bond A with a matching maturity that trades at 90. For issuer 2 I have a bond B that trades at 110.

What is the equivalent of investing 1 Mio EUR in the basket? In the basket case I have an exposure of 500K EUR to issuer 1 and the same for issuer 2.

In the portfolio case I can invest a notional of 500K in bond A which costs 450K and a notional of 500K in bond B at a price of 550K which gives a weighting of 45% to 55% in the portfolio.

On the other hand if I invest a notional of approx 555 555 into A (at a price of 90) and 454545 in B (at a price 110) then I get a 50%/50% weighting.

Which one corresponds better to what a basket CDS represents?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.