Options volumes on investment-grade credit derivative indices CDX and iTraxx have picked up dramatically in connection with issuance of constant proportion debt obligations. The most popular strategies play on the view that index spreads and volatility will trade within a tight range through the end of the year because scheduled issuance of CPDOs means many firms will be selling protection on the indices. Index spreads and implied volatility already have plummeted to all-time lows.
A variety of investors are selling December-expiry volatility, specifically out-of-the-money payer options and payer-receiver straddles. The most common strikes were 35 to 37.5 basis points on the CDX.NA.IG.7, which was trading at 34 bps Tuesday, and 27 to 28 bps on the iTraxx Europe Series 6, which was at 24 bps. Traders said investors normally sell volatility toward the end of the year, but volumes this year--particularly in the past two weeks--are about 30% heavier because of CPDOs.
"A few months ago, I saw one trade on the investment-grade index for every nine in cross-over," said Mohit Grover, index trader at Deutsche Bank in London. "Now I see three investment-grade trades for every seven in cross-over. Cross-over volumes haven't decreased, but investment-grade volumes have increased." Traders added that new investors have piled into the market and ticket sizes also have grown. Several European traders said EUR500 million trades have become standard, compared with an average trade size of EUR250 million earlier this year.
Traders are expecting a reversal toward the end of this year and into next. Investors have begun expressing interest in buying out-of-the money March-expiry payers to protect long credit portfolios in case spreads widen and volatility picks up ahead of the March index roll. If off-the-run spreads widen--as market players expect they will (DW, 11/21)--investors will benefit from the option. If spreads don't widen, all they lose is the premium, which is low because implied vols for out-of-the-money and at-the-money options are close. Market participants are abuzz about the roll, but traders said structural twists in the next batch of CPDOs could make it a non-event.
