* Cash/CDS basis hits record wides
* Investors hunt for liquidity to cover long positions
By Christopher Whittall
LONDON, June 28 (IFR) - A choppy European credit market may
have kept issuers on the sidelines of late, but it has gifted a
raft of trading opportunities for credit hedge funds as a large
basis has opened up between cash and synthetic markets.
One credit fund manager told IFR he would be postponing his
summer holiday to take full advantage of the bonanza, with
lucrative arbitrages also cropping up between index and
single-name CDS contracts, as well as the various credit
Buyside investors scrambling to cover long credit positions
have been the main driver of the market shift, as they have
hoovered up USD15bn of net protection on iTraxx Main - the
benchmark for European investment-grade credit - over the past
two weeks, according to data from the DTCC.
This has caused the index to shoot to its widest level since
November, while cash markets have lagged behind.
"There are competing narratives for why the CDS market has
been weak versus cash. Either fears over higher rates are
leading to a sea change in the market and bond outflows, or it's
a more normal sell-off," said Andrew Sheets, head of European
credit strategy at Morgan Stanley.
"It seems likely that investors are trying to
reduce exposure via CDS, which doesn't have interest rate
exposure, instead of selling their cash bonds, which do. That
makes us think that fear of higher rates isn't the main driver."
The liquidity of CDS indices has made them the hedging
weapon of choice for many real-money managers, who can rarely
find the liquidity in cash markets needed to shift large chunks
of credit risk during times of stress. As a result, the basis
between cash and CDS has widened by about 25bp since iTraxx Main
reached its recent wide of 132bp on June 24.
A handful of banks now offer iBoxx total return swap
packages, giving investors a clean way to arbitrage the basis by
selling the cash bonds while going long credit through the CDS
"It's been very good lately. When Crossover hit 520bp, we
sold the cash via TRS and went long via the index. As Crossover
tightened 40bp, the bonds tightened 25bp, so we captured 15bp,"
said one hedge fund manager.
The most dramatic move has been in the iTraxx sub financials
index, where many investors had taken the view that proposed
changes to the contracts to incorporate bail-in legislation
would make sub CDS worthless. Dealers say sub financial CDS has
snapped back in line with where it had been trading before these
concerns took hold, burning some participants in the process.
THE MAIN SHOW
Despite credit volatility picking up, dealers say liquidity
has held up, allowing investors to take views. "The big
difference between now and five years ago is dealers' balance
sheets are much smaller, so most of the pain has been on the
buyside, not the sellside, during those moves wider," said the
European head of credit trading at a major house.
Traders say the Main index had become a proxy to hedge
everything from emerging market risk to credit options positions
that some had previously sold in order to boost returns. The
bellwether index was consequently 21 times over-bought compared
with iTraxx Crossover, and had outperformed most other indices
as it tightened back to 115bp on Friday (June 28).
Arbitrage opportunities remain, including the index skew
between the Main index and its underlying single-name
constituents, but many of these will probably be ironed out
before too long.
"I don't think this is a new normal - the basis
should narrow. If things get materially worse, people will need
to de-risk their bond exposure and cash spreads will catch up;
if it improves, indices will look like an attractive and liquid
way to put risk back on as they are trading wide to intrinsic
value," said Sheets.
(Reporting by Christopher Whittall; editing by Helen
Bartholomew, Matthew Davies)