It is two months since massive volatility in credit tranches hit hedge funds and dealers, causing significant and unexpected losses. These investors' view on the credit markets had encouraged them to create long correlation trades. This involved taking a long position in equity tranches of the CDX and iTraxx indices while hedging delta with the index or the mezzanine tranches of the same indices.
The rise in idiosyncratic risk and resultant fall in correlation caused by GMAC's downgrade resulted in well-publicized losses for the funds and dealers, which largely copied the trade. Although many of the leveraged hedge funds were forced to unwind the trade because of mark-to-market losses, it appears that arrangers/dealers were not undermined in quite the same way and have worked their way out of their positions since May as credit spreads tightened.
"I had expected the credit tranche business to freeze up but that has not happened," says Michael Fuhrman, head of e-trading at inter-dealer broker GFI. Volumes have not quite returned to previous levels and liquidity always suffers in July and August but dealers, who at first suffered from diminished appetite after suffering substantial losses, are identifying opportunistic trades.
Fuhrman argues, given the flow pattern and price action, that unleveraged market players were unwinding their positions in June and July. Other observers suggest that a number of investors took advantage of the disorder while others simply wanted to put cash to work. Leveraged super-senior trades or constant proportion portfolio insurance products, among others, have been mentioned by credit derivative traders as offering value and being increasingly popular.
"There are still large sums of money coming to the credit market from a broader and increasingly sophisticated range of investors," says Emmanuel Rousseau, head of European structured credit derivatives at Bear Stearns.
For much of 2004 there was a constant backdrop of bespoke CDO production that helped keep a cap on spreads in the cash market. This has changed and dealers will need to look for new products.
"We are still seeing a fair bit of activity but there might be fewer investment-grade synthetic CDO deals," said Fritz Thomas, head of CDOs at Deutsche Bank.
Thomas explains that with mezz spreads at their current levels, ratings arbitrage is harder. Furthermore, the fall in correlation is a factor affecting the viability of synthetic CDO production. And correlation is unlikely to rise until dealers' and hedge funds' positions are fully unwound.