Steepening of the credit curve has led to increased demand for forward-starting single-name credit-default swaps and collateralized debt obligation tranches. Some investors are also starting to request today a fixed amount of subordination for a tranche they are signing up to buy in the future.
Forward-starting tranches can be used to set up a turn in the credit cycle position and to gain exposure to names with near-term default risk, said Sivan Mahadevan, credit strategist at Morgan Stanley in New York. The firm has started to look at the curves of crossover names or recently downgraded names, where spread widening and default are more likely, making them attractive for curve steepening plays.
Until now the contracts have been done via a two-legged long/short trade. For example, selling seven-year protection and buying two-year protection. This is equivalent to selling five-year protection two years from today. The problem with this approach is the subordination level for the seven-year tranche is uncertain and dependent on the amount of losses over the initial two-year period.
As a result, investors have started to request that a pre-determined subordination level--independent of the actual amount of losses--be set on a bespoke basket of names. Names that actually default during this period are removed from the portfolio.
So far activity to date is USD200-300 million notional in fixed subordination forward-starting tranches, according to traders in the U.S. As for why the shift is happening now, credit traders point to the steepness of the curve across most credit markets since the start of the New Year. "When the curve steepens this extreme nature can yield strange forward prices where people can find unique opportunities," said one credit trader in the U.S.
