Paul: Welcome to Index Ideas from FTSE Russell. I'm Paul Amery, your podcast host. In this podcast, we look into how FTSE Russell indices are built and why. We explore index ideas that can help you address real-world investment challenges. As a reminder to listeners, you can't invest in an index. And so the concepts that we explore in the podcast are not investment advice. Any reference to potential investment strategies is intended for informational and educational purposes only.
Paul: In this episode of the podcast, we look at a recent collaboration between FTSE Russell and the Montreal Exchange, or TMX. The FTSE Canada Bank Credit Spread index series was launched last year. This index series now supports TMX’s FTSE Canada Bank Credit Index futures, or BCS. This new derivatives contract was launched just over a month ago. I'm joined by Joshua Gorelik, who is director of fixed income quantitative research at FTSE Russell and by Alex Prince, who is executive director of interest rate derivatives at the Montreal Exchange. Josh and Alex, welcome to the podcast.
Josh and Alex: Thank you.
Paul: Josh, let me start with you. What is the FTSE Canada Bank Credit Spread index series?
Josh: So the Canada Bank Spread Index is FTSE Russell's innovative approach to isolate credit risk specifically for Canadian bank bonds. This is achieved by measuring the yield differential, or spread, between the basket bank bonds and their benchmark Government of Canada bonds. In short, it is a representative domestic spread product with the focus on tradeability, capacity and spread movement. Its construction is guided by three core principles: liquidity, simplicity and transparency. Ultimately, the Credit Spread index has been designed to underlie a listed cash-settled futures contract in the form of the new Canada Credit futures from TMX. These will be discussed more by Alex here.
Paul: Alex, let me move to you. So why did you at TMX choose this index series to underlie a new futures contract?
Alex: Yeah. First of all, I would say that partnering with FTSE was a natural fit as they have the expertise in the Canadian fixed income indices, and they are widely used by the domestic market. And we chose the FTSE Canada Bank Credit Spread Index because it was specifically designed to provide a direct, liquid and representative exposure to the Canadian credit market. It was created in collaboration with key industry participants to ensure its relevance and to maximise the attractiveness of the futures contracts tied to it. And although the index contains a basket of about 20 Canadian bank bonds, it closely replicates the credit spread movements of the broader FTSE Canada All Corporate bond index, while making it easier for participants to hedge in the cash market, which is important to get the initial liquidity and traction in the product.
Paul: Thank you, Alex. So Josh, why did FTSE Russell design a Canadian credit risk index using bank bond credit spreads rather than, for example, credit derivatives?
Josh: Alex kind of alluded to this already, but we do acknowledge that there are other credit derivative products out there in the market that exist. However, those products have predominantly originated from the US market, and the exposures to those products are across a broader region. Consequently, what happens is those risk measures are somewhat diluted. The spread index essentially repatriates the measurement of Canadian credit risk. In this case, we focus on the domestic banking sector, and it serves as a standardised yet tailored risk solution for Canadian market participants.
Paul: Thanks, Josh. So Alex, how do you expect market participants to use the futures contracts that are based on these indices?
Alex: Yeah. So, it can be used in many different ways. The main use case for end-users is obviously for credit risk management and hedging. So, portfolio managers can easily use the contract as a temporary overlay to add or reduce credit exposure without selling physical bonds. So that's very convenient. It can also be used by fund managers to quickly deploy capital for new mandates. Or when they receive an inflow of money, they can quickly take a synthetic long or short exposure to Canadian credit while they are building their physical corporate bond portfolio. Some will use it as portable leverage, as using the credit future instead of cash bonds frees up capital that is then available for other investment opportunities. It can be used to express a tactical view on whether Canadian credit spreads will tighten or widen in the upcoming months. So yeah, as you see, it's really suitable for many different investment strategies.
Paul: Thank you for running through those use cases. What would you say the pros and cons of the futures are by comparison with other delta one products like ETFs or swaps?
Alex: Yeah. I'd say that by design, the product isolates the credit spread risk, which is not the case for corporate bonds, ETFs, or total return swaps, for example. So it's innovative in that way. And we made it pretty simple. Each change of one basis point in the underlying credit spreads results in a change of $50 in the futures contract market value. So here, unlike other product designs, we have a direct link between the credit spread and the value of the futures contract. And then you have the benefit of price discovery transparency as this contract trades on an exchange’s electronic order book, where participants are able to see real-time prices and trades executed. And then it has also cost efficiencies over other products, as only a small margin is required to set up positions. So this is attractive for many participants. But the flip side is that it provides leverage. So, the positions have to be managed properly. And of course, since the product is centrally cleared at the CDCC. There is no counterparty default risk involved.
Paul: Thank you for explaining that. So Josh, how does the index series work? Could you run through the key construction steps for the FTSE Russell indices?
Josh: So it's a great question. So as a starting point, we rely on the FTSE Canada Corporate Financial Bank Bond index, which itself is a subset of the broader FTSE Canada Universe Bond index. As a very first step, we apply a screen based on liquidity considerations. The remaining universe of bonds are then divided into four cohorts: determined by one, seniority, as measured by junior or senior, as well as remaining term, as measured by short versus long. Within each cohort, we then select the most recently issued bond per issuer. These bonds will then be used to construct what we call a reference basket. In this process, we start from well over 100 bonds across approximately 15 bank issuers to then 60 bonds across maybe six issuers post liquidity screen. And then finally, we select approximately 20 bonds across those same six issuers, which make up our reference basket. Constituents of the reference basket are determined at a quarterly basis at the end of February, May, August, and November. Their initial weights are determined based on their relative market caps for the bonds, while the pars remain fixed until the end of the quarter for the next reset. Each time the reference basket resets, though, a new credit spread index is created based on those constituents. The credit spread indices are then designed to mirror, determine the future contracts which they underlie. These have expiries in March, June, September and December. As alluded to earlier, each bank bond in the credit spread index is mapped to a Government of Canada bond with the mapping scheme provided by Candeal.
Josh: Using the yield to worst differential between each bank bond and its corresponding government bond,we can then calculate a bond spread and then roll that spread up into an index level credit spread measure based on the weightedaverage spread using the bank bond weights.
We consider liquidity as you mentioned. To start, this is an investment-grade index and it is designed to exclude those less liquid and non-homogenous bank bonds. So to do this we screen out things such as convertible bonds, floating rate notes and convertible notes. We rely on size as a measure of liquidity as well. We require at least two bonds per issuer. And those bonds are subject to a minimum outstanding amount of at least 1 billion Canadian dollars. Further, we apply an additional screen around term, with a minimum remaining term of at least one and a half years. Lastly, as previously mentioned, we select the bonds per issuer in each cohort, where we focus on those that have been most recently issued. In doing so, we determined that they're the most liquid and representative of prevailing market conditions.
Paul: Thank you Josh. Alex, it’s been just over a month since you launched the futures contract on TMX. What data have you collected so far on the trading volumes of the index futures?
Alex: Yeah, sure. So yes, as you mentioned, the contract was successfully launched on April 8th. And we have partnered with two market makers—TD and BMO—to ensure that they are market posted out there with robust sizes and attractive bid-ask spreads. And since the launch of the product, other participants have also joined and are playing an active role in quoting the product and providing market depth. And the result of that is that we have about 200 contracts quoted within a bid-ask spread of 1.5 basis points on screen. And the top of book is often less than that. So we are pretty pleased with what liquidity looks like at the moment. And it is starting to trade nicely. We see clips of 20, 25 contracts being executed during the day, as well as some block trades. So it's picking up and we know that many clients and end-users are still in the process of being set up to be able to trade. So we expect more clients to come in and test the product in the coming weeks and months as they are getting more familiar with the underlying index and the futures contract itself.
Paul: And Alex, how does this new index future add to the derivatives that are already available for the Canadian fixed income market’s yield curve?
Alex: The first thing is that it fills a gap and a need in the market as there was no efficient Canadian credit risk hedging tool in the market before. Participants were using different proxies like CDX product. But the correlation to Canadian credit was not very good. So we hope that the credit futures becomes the primary tool to manage Canadian credit risk going forward. So the contract complements the existing MX listed yield curve. It sits in the short to medium segment of the curve between our two-year and five-year bond futures with a duration of 3.5 years. And also, by adding a new liquidity point, it contributes to the overall enhancement of yield curve construction and price discovery in the domestic Canadian market. And it's also a product that facilitates the access to Canadian credit for international investors looking to diversify their portfolio.
Paul: Thanks, Alex. So, Josh, where can our listeners to the podcast go to find out more about this new index series?
Josh: Sure. So more details can always be found on our website, lseg.com, and do a quick search for the FTSE Canada Bank Credit Spread index series. Alternatively, kind of go through the scenic route through lseg.com by clicking through FTSE Russell, then benchmarks and indices, FTSE Canada fixed income and ultimately the Canada Bank Spread Index series. I'd highly recommend the latter, as you can see some of our other amazing products and research developed by the FTSE Russell team.
Paul: Thank you. And Alex, any concluding thoughts on this new index series and the associated futures contract?
Alex: Yeah, sure. I would encourage participants to get more familiar with the index and the futures contract and see if there's a way to include this in their daily activities. And we believe that a successful product would clearly benefit the entire marketplace. So do not be afraid to contact us or FTSE if you have any questions. Me and Josh are here to help.
Paul: Thank you very much. Josh, any concluding thoughts from you?
Josh: I would just like to re-emphasise that, we designed a great, amazing product, highly innovative. The basket closely tracks the financial sector as well as the broader corporate sector, as measured by comparable yields, durations and spread correlations exceeding well above 90%. I mean, ultimately, this is a credit spread index. It provides a standardised gauge of credit market conditions in Canada. Not only can it be used as a key risk measure for asset allocation models, but it could also be used as a pricing tool in financial contracts such as listed derivatives described by Alex today. And this is an efficient way to manage Canadian credit risk.
Paul: Well, Alex and Josh, thank you very much for joining Index Ideas.
Paul: And that's it for this episode. If you've enjoyed the conversation, then please follow us and give us a rating or review on your podcast app of choice. If you'd like to get in touch with the show, you can do so via the email address
[email protected]. But for now, from me, Paul Amery. Goodbye.
