One of the more surprising credit market trends in recent times has been the rebirth of synthetic bespoke tranches – formerly known as collateralized debt obligations (CDOs).
However, as banks start to gear up, events in the US credit markets might be about to bring the renaissance to a premature end.
| Rising dispersion has become an enduring theme, and one area where its impact is strongly felt is in the tranche markets|
The meltdowns in CDOs of asset-backed securities that contributed to bank failures during the financial crisis seemed to consign highly leveraged structured credit to history. However, during the past 18 months, the market has found a way back, meeting investor demand for higher returns and helping banks manage their regulatory capital obligations.
The structures to date have been simple, with static pools of underlying credits – unlike the managed portfolios of pre-crisis vintage – in standard four- or five-year maturities, matching the growing tranche market based on iTraxx and CDX indexes.
In the standardized market, equity tranches on the CDX IG index trade at a delta of around 15, meaning that for each basis-point move in the underlying index they move 15bp up or down. That structural leverage is attractive in a low-interest rate, late-credit-cycle environment. In addition, there have been zero investment-grade defaults during the past five years.
Not surprisingly, investor interest has been piqued, and around $20 billion of bespoke tranche deals were printed last year, according to banker estimates; tiny compared with the market’s peak, but enough for dealers to start rehiring and printing research.
Banks involved include Citi – a lead player in the revival – Morgan Stanley, Goldman Sachs, BNP Paribas and Société Générale.
Investor demand has focused on the junior part of the capital structure, where four-year maturities recently offered spreads of around 950bp and 220bp for equity and mezzanine tranches, according to Morgan Stanley pricing.
The bespoke space can offer even higher returns because portfolios can be hand-picked, and often contain investment-grade and high-yield credits. Many of those mixed-rating deals are shorter-dated, with managers taking a cautious approach to an asset class still seen as dangerous by some.
Given recent volatility in US credit, and particularly the energy market, that caution might be seen to have been prescient, with some borrowers showing signs of strain. That has been evidenced by increased levels of spread dispersion, which means that while the CDX IG index has hovered around the 62bp level in recent weeks – and CDX HY has tightened by around 10% – individual companies, particularly in energy and retail, have seen sharp declines in prices.
The rise in dispersion has been most apparent in the non-financial BBB sector, where the upgrade/downgrade ratio has fallen to 0.8 times, compared with 2.5 times in early 2014. Again, the main problem is US energy companies, with 61% of the sector comprising BB-rated credits, and energy companies accounting for almost a fifth of BBB-rated bonds.
With oil prices touching six-year lows in recent weeks, companies such as Transocean and Avon Energy are trading substantially wider, while recently issued junk bonds of oil producer Energy XXI have fallen as much as 10%.
Those kind of moves have left index dispersion at its highest level since the financial crisis, according to Morgan Stanley, with the seven widest names in the CDX IG index trading at spreads of more than 300bp.
“Rising dispersion has become an enduring theme, and one area where its impact is strongly felt is in the tranche markets, and particularly those parts of the capital structure most exposed to declines in correlation,” says Sivan Mahadevan, head of US credit and global credit derivatives strategy at Morgan Stanley in New York.
“If you look at history, the current period is a bit like it was 10 years ago, when auto companies got downgraded while the rest of the market was in relatively good shape.”
One of the impacts of the rise in dispersion, and aligned decline in correlation, is a sharp sell-off in equity tranches, reflecting increased concerns over idiosyncratic risk. CDX IG five-year 0% to 3% tranches were recently trading at an upfront cost of 28.2% of notional (plus 500bp running), compared with 18% of notional in November.
|We could see further weakness in energy markets, which could affect some of the vulnerable energy names in the IG index|
Anindya Basu, Citi
HY markets, meanwhile, have seen three recent defaults (TXU, Caesars and RadioShack) and HY equity tranches lost nearly 12% last year, according to Citi pricing.
Still, some analysts believe the recent price declines comprise an opportunity.
“Post-crisis, most investors like to take tranche positions unhedged, because they want the leveraged exposure, but of course there is always a risk of blow out,” says Anindya Basu, a credit strategist at Citi in New York.
“Still, now we think that there may be an opportunity to go long equity tranches in investment grade, with some downside protection using the underlying index as a delta hedge.”
Basu’s rationale for a more constructive attitude is that base correlations are showing signs of stabilizing – at around 50%, compared with 60% at the same time last year – and that most of the spread widening in the energy space might already be done, even if the sector sees downgrades.
In addition, as the trickle down from European Central Bank quantitative easing finds its way into US credit markets, equity tranches are likely to benefit disproportionately because of their structural leverage.
Still, Basu acknowledges there are risks.
“We could see further weakness in energy markets, which could affect some of the vulnerable energy names in the IG index, leading to equity tranche underperformance,” he says.
Meanwhile, while long-equity investors have been hit by the recent correction, those on the other side of the trade have enjoyed the opposite effect. New York-based hedge fund Rion Capital saw a positive net performance in January, after taking short correlation positions over the course of the past year.
“Idiosyncratic events have finally contributed to increased dispersion and lower implied correlation in the tranche market,” says Rion founder Ga’ash Soffer. “This has been the main driver of the funds’ performance over the past three months.”
Ga’ash believes the coming months will bring further opportunities, where the market has failed to price idiosyncratic risk in investment-grade indexes.
“We plan on adding exposure to these trades, as we continue to think that defaults will hit the market sooner than many anticipate,” he says.