All hail relative value

Regulatory overhaul might form the backdrop to the credit derivatives market, but in its shadow traders are going about the daily business of making and losing money. There’s no mistaking the two major themes in the market: liquidity and volatility

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Violent swings in spreads – particularly in credit derivative indexes – reflect not only the swirl of concerns around peripheral European sovereigns, banks and weak economic growth, but issues surrounding market liquidity. According to market participants, while liquidity passes muster in the US, the European market is feeling the strain.

“Liquidity is markedly reduced in Europe,” says Stephen Siderow, New York-based president of hedge fund BlueMountain Capital, which runs relative value credit trading strategies through a $2.7 billion Credit Alternatives Fund and other portfolios. “We see similar kinds of relative value opportunities in the European market but it is easier to execute in the US. Between 15% and 20% of our risk is taken in European names, which is down from 30% to 35% previously.”

Volatility within European credit derivative indexes, which like their US equivalents are used as a major tool for hedging credit risk, has increased markedly.

“We are seeing 10% to 15% volatility moves a day even on indexes, which are supposed to be benchmarks,” says Gennaro Pucci, London-based chief investment officer of PVE Capital, which manages a global credit hedge fund in a joint venture with financial services business Matrix Group. “Credit is becoming a volatile, illiquid market. Realised volatility is 80% and the volatility implied in the option market is 100%.”

Within the European iTraxx index suite, financials indexes have become especially prone to sharp price movements, as has the sovereign credit default swap index, SovX.

Volatility

According to market participants, volatility within those indexes partly reflects the growing influence of counterparty risk management desks. Such desks have grown in presence due to hedging activity, as banks focus on managing counterparty credit risk within their derivatives books.

“Counterparty risk management desks are becoming more active in their management. They are one of the major players in the credit market at the moment,” says Pucci.

For evidence of their footprint, one need look no further than sovereign CDS. “Hedging of large counterparty exposure was one of the reasons why many sovereign CDS started to sell off,” he says. “Banks wanted to hedge the mark-to-market exposure in their interest rate swap books.”

Much of the trading activity from counterparty risk management desks – putting hedges on and taking them off – is done using indexes. And a large part of the exposures revolve around banks and sovereigns, which is accentuating volatility.

“The financials and sovereign indexes are becoming less liquid, which is a function of high volatility. Dealers are not so comfortable taking large positions,” says Pucci. “In the financials index you can trade no more than €100 million without moving the market. That is also the maximum size you can trade in SovX.”

Pucci admits the SovX single-name market is “fairly liquid”. He says: “You can trade €50 million in sovereign single-name CDS without moving the market.”

Pucci says the iTraxx Main, Crossover and CDX indexes remain liquid, while “single names also have a fair amount of liquidity unless there is a specific credit issue. It’s less if you go into the high yield world.”

iTraxx Main and its North American investment grade counterpart, CDX, illustrate the contrasting degrees of liquidity between the two markets. “Liquidity in the iTraxx Main is fine up to €250 million or €500 million,” says a credit derivatives trader at a European dealer in London. However, US market participants say trades of $1 billion or even $2 billion can be executed on CDX without moving the market.

Volatility has severely hampered directional trading strategies. However, it has been a boon for credit options as swaptions trading on credit derivative indexes has surged in recent months.

“People are happy to buy volatility,” says Pucci. “It’s a way of having exposure to this market, whereas outright exposure requires a lot of nimble trading activity. Many players prefer to take exposure to volatility, which is a limited downside strategy.

“The market is pricing 100% of the spread level of volatility, and it is fairly priced. There are active players, but realised volatility is still high, which makes the strategy quite interesting. Buying payers is a way to participate in any kind of stress, while buying receivers is a way to hedge the shorts in the book and the squeeze around.”

Relative value

Meanwhile, although conditions seem challenging for directionally driven trading strategies, the market is in a sweet spot according to hedge fund managers who focus on relative value. Although volatility remains elevated, the market is unlikely to depart radically from current spread ranges, according to these managers. Moreover, they say spreads remain wide enough – some two to three times the tight levels seen in 2007 – to provide value.

“It is an excellent environment for relative value trading,” says Siderow at BlueMountain. “We don’t see a strong case for a big rally or a big sell-off. The reason is the lack of leverage in the system. The structured credit investor base that drove spreads to the tight levels seen in 2007 is not there, so we don’t envisage a massive rally. At the same time, real money investors are coming into the bond market. These are real cash buyers without leverage. As a result, any sell-off will be more about mild selling based on fundamentals as opposed to forced selling from a deleveraging event.”

Like many credit hedge fund managers, single-name relative value trading is a key focus for BlueMountain. “We like the fundamentals-driven single-name business a lot,” says Siderow. “You are paid well to pick the right single-name relative value positions. There are enough stories and enough spread to drive value. We have high conviction single-name longs, as well as a series of high conviction single-name shorts, which are usually fewer in number.”

BlueMountain’s strategies also include long/short trading of the capital structure, or going long and short instruments of different seniority in the same company. The strategy remains popular among credit hedge funds due to persistent value at the top of the capital structure.

“There is still value in more secured instruments versus senior unsecured,” says Siderow. “We will go long secured – either loans or secured bonds – and short in the unsecured part of the capital structure. We are also active in equity versus credit. We will invest in an equity position versus a short in the same company.”

Siderow adds securitisations such as auto fleet asset-backed securities or structured notes secured by aircraft also provide opportunities for capital structure trades.

Meanwhile, index arbitrage has taken on a new lease of life as volatility has increased. The strategy involves trading the index basis, or spread versus the theoretical value of the underlying single names. For example, if an index is trading wide-to-theoretical, the investor goes long the index and buys protection in underlying single names.

“Index arbitrage is still a good business,” says Siderow. “The competition has thinned out a bit, as prop desks are less active. The strategy depends more on volatility. Since April and May there has been an opportunity to put a lot more on our books.”

Along with single-name relative value trades, capital structure trading and index arbitrage, structured credit is the final bucket in BlueMountain’s credit alternatives fund. “It’s possible to find good value as a result of selling that is not necessarily driven by fundamentals, but by the need to clean up balance sheets and free up capital,” says Siderow.

Basis trading

Trading the cash-CDS basis is another strategy that aims to insulate investors from market directionality. The caveat “except in times of extreme market stress” should be added, given that cash-CDS basis strategies backfired spectacularly at the height of the credit crisis due to mass forced selling of bonds.

The cash-CDS basis has lost much of its wow factor compared with last year, but is still throwing up pockets of value. For example, in recent months, lower tier 2 bank debt has attracted attention due to large negative basis. (Negative basis is when a name’s credit derivatives spread is trading inside its cash market spread. It is arbitraged by buying credit derivatives protection together with the cash bond, in the expectation that the basis will narrow.)

“There have been some very interesting opportunities in lower tier 2 over the summer period,” says Jochen Felsenheimer, co-head of credit at Munich-based Assenagon Asset Management. “It has been possible to lock in up to 250bp of negative basis, which is a pretty attractive spread for a relatively straightforward trade. There are still opportunities, although not as many as two to three months ago. More and more people jump on the train and the basis is tightening, which is a nice feature for the trades we have on.”

Assenagon manages two dedicated credit basis Ucits funds, launched in August 2009 and January 2010, which have attracted €1 billion of inflows.

Negative basis opportunities have been most attractive in high yield. Last year, it was possible to lock in high yield negative basis ranging from 400bp to 900bp (measured as z-spread versus the credit default swap). But that feast has now gone.

“[Locking in] 900bp was exceptional negative basis, which was caused by forced sellers. People just sold everything,” says Felsenheimer. “It is still possible to find attractive opportunities in high yield, but it requires more analysis. The European credit universe is crowded right now from a basis perspective. It’s not as easy as it was a year ago.”

High yield trades in Assenagon’s portfolio include several names that have defaulted, including Belgian yellow pages publisher Truvo, which filed for bankruptcy in July. Defaults are the perfect scenario for negative basis trades, given that investors receive 100 cents on the dollar by delivering the bonds into the credit derivatives contract. 

“You are jump-to-default long in a basis trade. You take a significant profit if there is a default,” says Felsenheimer, who adds Assenagon will typically look for negative basis of at least 200bp when considering trades.

Tailored trades

Nevertheless, opportunities are becoming scarce, requiring investors to be more creative. “One year ago a bank simply sold you the basis package. Now you might want to construct a trade using more than one counterparty,” he says. “One counterparty might be skewed to sell protection, the other might be axed to sell the bond. It’s putting offers and axes together to find opportunities that might not be obvious at first glance.”

He adds: “There are probably even some basis packages that one can buy at –190bp in high yield and crossover, but these involve specific bonds that are not benchmark bonds. If we’ve made enough return and the basis is almost gone we will consider unwinding and investing in a new trade. That makes a very important contribution to returns. Two-thirds of our performance is directly linked to running basis income and one-third to active management.”

According to Felsenheimer, a lack of liquidity in the cash market isn’t necessarily a barrier to unwinding trades. “We sell a package. Selling negative basis is easier than selling the bond alone. You can always find someone. There’s a much more liquid market for selling basis.”

While Assenagon’s first fund focuses on the corporate bond-CDS basis, the second fund can invest in a broader range of assets, including convertibles, loans and asset-backed securities. Currently, 99% of the portfolio is allocated to corporate bond-CDS basis trades. There is a 0.5% allocation to convertible bonds.

“The convertible basis is not as attractive currently,” says Felsenheimer. “Equity valuations are too high. If there is a sell-off in equities, then the convertible basis definitely becomes more attractive.”

Changes to capital adequacy rules as a result of Basel III could lead to broader opportunities for cash-CDS basis trades. “Basel III will result in natural sellers of specific assets, especially ABS,” he says. “There are more attractive opportunities still in plain vanilla bonds, but that might change quite quickly.”

Although designed to be market-neutral, the strategy can still be subject to volatility. “If there is a widening in negative basis we lose from a mark-to-market perspective,” he says. “Adverse movements might be ugly for a Ucits fund with a daily mark-to-market requirement. However, there is no change to the locked-in profit. If we’ve bought negative basis at –200bp we know we will earn 20% in 10 years.”

Curve trading

Credit derivative curves are another example of long-short trading, either on indexes or in single names, which can attract significant flows. However, hedge funds appear to be less active than prop desks, at least in relation to index curve trading. “Hedge funds are not really playing the curves,” says a trader at a European bank, based in London. “They are more willing to play some stories by looking at high yield single-name curves.”

“We have shied away from a lot of curve trading,” says Siderow at BlueMountain. “It involves greater levels of complexity. There is enough to do in more straightforward single-name relative value trading rather than looking to get involved in curves to express that view.”

Curve trading can be particularly active when indexes are moving to newly composed on-the-run series.  The focus is on curve steepeners, which involve selling protection at the shorter end of the curve and buying protection further out. The reason is rolldown – the beneficial mark-to-market effect of contracts shortening in length over time – which encourages curve buying. The index rollovers in September were accompanied by the usual buying frenzy.

“People are buying curves, which have massively steepened. The proximity of the index roll is supporting curves,” says Pierre-Yves Bretonnière, relative value strategist at BNP Paribas in London. “Dealers do not really take into account the roll of the contracts until each roll date. So a specific CDS tends to take the full impact of the three months [rolldown] around the roll date. That’s creating appetite for the curves before the roll and potentially profit-taking after.”

Steep curves were encouraging new trading strategies ahead of the index roll in September, namely trading the forwards curve. In contrast to curve steepeners outright, which are duration-weighted (more protection is sold than is bought), forwards curve trading involves buying and selling protection in equal amounts.

“Forwards present more attractive entry levels to play the upper side of the [spread] range, as the 3/5-year and 5/10-year forwards are extremely steep,” says Bretonnière. “We are seeing some accounts trading on the idea. The level of the forwards is close to historical highs. For example, the iTraxx Main 5/10-year forward has been at the upper limit of a resilient trading range of between 90bp and 130bp. It has been trading at the same level as we saw in the worst periods of the crisis, in December 2008, when the five-year Main was 210bp. We see that as a good opportunity to go long the forward.”

The trade plays the range rather than taking a directional view on credit, which is in keeping with the broader mantra. Credit derivatives and credit derivatives-cum-cash trading is alive and well, albeit in the face of diminished European liquidity. But for now, directional trading has been pushed to the sidelines. Instead, it’s a case of long live relative value strategies.

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