Opportunities emerge on credit sell-off

Fri Aug 15, 2014 9:55am EDT

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(This story originally appeared on IFRe.com, a Thomson Reuters publication)

By Christopher Whittall

LONDON, Aug 15 (IFR) - The recent sell-off in European credit markets has provided a swathe of arbitrage opportunities for investors looking to use the correction as an entry point, but some analysts are advising against jumping back into cash bonds just yet.

While credit spreads widened across the board, the sell-off was particularly pronounced in the high-yield space as the iTraxx Crossover index pushed out to 299bp on August 8 - its widest level since mid-March. This came after a steady grind in for the index, which had more than halved from a high of 529bp during last year's taper tantrum to a multi-year low of 219bp in June.

Volatility has also picked up sharply as the high-yield index has become the go-to credit hedge for many traders, with at the money three-month implied volatility at 61.4% on August 7 compared to 49.6% a month before, according to Bank of America Merrill Lynch strategists.

"To me, it feels more like a risk premium correction rather than a canary in the coal mine moment. Spreads had become too rich, and they've now re-set in a healthy kind of way," said Andrew Sheets, head of cross-asset strategy at Morgan Stanley.

While the sell-off in the US junk bond market has attracted most of the headlines, the European high yield market has also been under pressure. JP Morgan strategists noted that the week of August 8 saw the largest ever outflow from European high yield funds of 664m (or 1.7% of assets under management). High yield spreads widened 40bp touching 400bp for the first time since November 2012, resulting in losses of just under 1%.

UNDERPERFORMING

Crossover had slowly pushed wider over June and July as tensions between Russia and the West increased, before the MH17 air disaster and subsequent step-up in sanctions from the US and the European Union caused spreads to jump sharply higher from 247bp on July 30 to 299bp on August 8.

The ratio of Crossover to Main index (the investment-grade benchmark) was creeping up even before then, reversing the compression between the two indices that had occurred over the first quarter of the year when Crossover had outperformed. The ratio has historically sat around 4:1, but dropped to almost 3.5:1 in mid-March, before peaking at 4.25:1 on August 8 - its highest level in over a year.

Dealers say a large part of the price action in Crossover is a result of it being a standard hedging tool for market-making desks when they are struggling to digest a lot of bonds being sold by clients.

Crossover has since whipped back to 260bp on Friday morning, showing that some protection sellers judged the move was overdone, while the ratio to Main has also fallen back slightly.

COMPRESSION TRADE

The compression trade will likely be a favourite of credit arbitragers, who will also relish the recent spike in volatility and skew. On Crossover, skew - a measure of the difference between the index and its single name underlyings - turned sharply positive as the index underperformed thanks to the raft of traders buying it as a macro hedge.

BAML credit strategists propose putting on a compression trade between Crossover and Main index (the investment-grade benchmark) on the back of these moves.

"We think that Crossover put ladders provide attractive breakevens, taking advantage of the recent spike in vols and the steepening of the put skew (steepest since early-June) that we think is now overdone," the BAML strategists wrote.

But JP Morgan strategists cautioned against heading back into the cash bond market just yet even though credit fundamentals in Europe remain strong.

"While we believe that high yield will end the year tighter than current levels we do not think that it is the right time to 'buy the dip' yet," the strategists wrote. (Reporting By Christopher Whittall, editing by Helen Bartholomew)

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