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Credit derivatives: Go easy on the curves

LBOs and technicals have boosted betting on the continuing steepness of the European credit curve. But nothing good lasts for ever and several things could upset the apple cart.

The differential between the five-year and the 10-year iTraxx Europe Index is about 23 basis points. This is close to record highs. At the end of last September, when the new Series 4 Index was rolled out, it was 19bp. Roughly half of this 4bp steepening in five months is a result of rolldown, as the five-year index tightens faster over time because of exaggerated steepness of the curve in the shorter maturities, but 2bp represents genuine steepening.

It is the result of a combination of fundamental and technical factors. First, the sharp increase in leveraged buyout business and rumoured LBO business in the past few months has pushed credit curves steeper for a lot of single names.

The curve also reflects the European credit cycle. “A steep credit curve can reflect investors’ perception that a company is most likely to default in five to 10 years, rather than in the shorter term,” says Daniel Berman, head of credit product management at JPMorgan. “The company might be cash-rich and have low short-term funding needs, but in the longer term its business profile will dominate. Therefore, while three- to five-year CDS are tight, 10-years trade much wider.”

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