Credit derivatives: Investors’ hunt for value begins


Rachel Wolcott
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Liquidity remains the primary challenge in the present environment, meaning that few credit managers have ventured beyond the relatively liquid credit derivative indices. Managers including BlueCrest, Cairn Capital, CQS and Pimco are all seeking to take advantage of the unique opportunities the dislocation in the credit market has created, say market participants.

"It’s tough to put on trades and cross significant bid offers other than in the most liquid of instruments," remarks one credit manager. "Most are focused on doing slow-burn trades with little risk and making a quick turn in the highly liquid stuff." Accordingly, most of the action is focused on trading the indices, index options and index tranches.

One of the most profitable and popular trades over the past 12 months has been to go long the equity tranche, while shorting the super-senior tranches. Being long equity was popular a year ago when equity correlation was at historically low levels. Also because correlation was low, super-senior tranches offered very low spreads. That trade has now become crowded, sparking concerns of huge losses in the event that too many players decide to exit simultaneously. Some managers have therefore started to build long positions in super-senior tranches, which look good value as overall credit spreads remain wide, meaning that defaults would have to spike beyond all known historical parameters for investors not to make a return. These investors are effectively making money on liquidity as opposed to default risk. Super-senior is attractive because correlation is historically high, because of an imbalance between offers and bids at the top of the capital structure, and fears of systemic risk. For instance, five-year iTraxx index correlation on the 0% to 22% tranche has risen from 50% at the start of 2007 to 90% currently. There has been talk that some of the larger US investors have taken advantage of the dislocation and bought senior CDX tranches outright. But going long super-senior, while profitable, requires a strong stomach for market volatility. Many managers are staying away from long-only trades, opting for hedged trades that are less prone to volatility.

London-based Cairn Capital is one such credit manager, and recently launched a structured credit fund to capitalize on dislocations in credit derivatives, options and asset-backed securities.

"There are definitely opportunities," says Andrew Jackson, Cairn’s head of quantitative research. "There is no doubt in my mind that there are things you should be doing right now. You can start scaling into trades that you want to have a larger size on in three months’ time. You have a nibble, you do it carefully and you do it in the most liquid instruments you can."

"That’s being very rigorous in the way we are managing the fund but also being very cognizant about risk management around the fund," says Jackson. "One of the things we’ve done is to find as much positive gamma as we can, as cheaply as we can, to protect us against significant volatility in the market. We’ve paid up in terms of carry in the fund to protect us against potential huge tightenings or widenings."