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LONDON, Oct 14 (Reuters) - The spread curve of Europe's main credit derivatives index inverted for the first time in its history this week, indicating a higher cost for buying credit protection in the short term as dealers priced in the potential for a shock default by an investment grade company.
The five-year Markit iTraxx Europe index ITEEU5Y=GF, at around 121 basis points, was 5 basis points wider than the 10-year index ITEEU10Y=GF on Tuesday, said Graham Rennison, a quantitative credit strategist at Barclays Capital.
Inverted spread curves often indicate that investors see a heightened risk of default in the near term. Ten-year spreads are tighter, because of expectations the default cycle will pass and spreads tighten over the long term.
The curve inversion in this case is being driven by the one-year to three-year end, Rennison said.
"There has been an increase in the buying of short-dated protection on single names as people are concerned about jump-to-default risk," he said.
One complication in the Barcap analysis by Rennison and Ulf Erlandsson was that the five-year index is the only liquid index on the curve. The 10-year also has some liquidity, but there is no one-year index, and trading of other maturities is scant at best.
The analysts made calculations for the one-year index based on levels for one-year credit default swaps (CDS) on single names, and they used dealers' indicative prices in the absence of actual trades on the illiquid maturities.
Even though some of the indexes are illiquid, "the pattern is real and too striking to be just a statistical anomaly," Rennison said.
The inverted curve may indicate dealers are charging more to take short-term jump-to-default risk, rather than investors are actually paying more to buy it.
Current spreads make it an expensive proposition for an investor to buy protection against the off chance of a default by an investment-grade borrower.
When the front end of a curve rises, then it no longer pays off to hold steepener trades, which are long the back versus the front, and investors also exit the back end, Rennison said.
Spread curves tend to flatten when spreads are widening at times of market panic. Conversely, they tend to steepen when spreads are narrowing.
Either way, "what we expect from now on is that you are going to see more activity at the front end of the curve, even for investment-grade companies," Rennison said.
With its recent inversion, the Europe investment-grade index joins the iTraxx Crossover indexes ITEXO5Y=GF, made up of 50 mostly "junk"-rated European credits.
The Crossover curve first inverted in January and has swung back and forth since then. The five-year Crossover was more than 30 basis points wider than the 10-year on Tuesday, Rennison said.
The U.S. investment-grade CDX index has also been inverted off and on for roughly a year, he said.
Editing by Andrew Callus