Increasing liquidity and correlation in credit index and equity volatility products has firms investigating how to arbitrage the two. Playing correlated risks in credit spreads and equity volatility is not new as funds have traded equity versus credit on single names since the '90s and on indices for several years. But, bankers are now seeing growing interest in this strategy and expect to see more attempts among dealers to capture relative value at the index level in coming months.
"Most market participants acknowledge that credit spreads and volatility are correlated," analysts at Barclays Capital wrote in a recent equity derivatives and credit strategy report. "However, it is challenging to construct a structural model to identify opportunities because the underlying assets are diversified portfolios rather than individual firms."
Jeff Meli, head of U.S. structured credit research at Barclays and an author of the report, was not available for comment.
A trader at a European bank noted hedge funds have traded forward variance swaps on the Standard & Poor's 500 against the CDX index for several years. But, the mismatch in underlying names on those indices complicates the otherwise fundamental, tradable relationship between credit spreads and variance swaps. "More people are looking at and experimenting with this," a trader at a U.S. bank said, declining to comment on the extent his firm has pursued the strategy. "The theme for next year will be tying these two together." Another trader added, "To my knowledge no dealer on Wall Street is trading it yet."
A possible solution, a trader said, could be creating and arbitraging an equity variance index mirroring the names in the investment-grade bond index. In the single-name market, traders use information from equity markets for credit pricing, forecasting and risk management. They buy cheap bonds and hedge their risk by shorting the stock, or buying cheap downside puts. If the company defaults, the investor loses the bond, but receives the option payout; if it doesn't default, the investor receives yield on the bond in excess of what he paid for the put.
Theoretically, traders could arbitrage indices the same way--by selling the IG and buying variance swaps on the variance index. But it is unclear how much demand or liquidity this kind of trading would have. Practically, traders said it would be hard to implement. Some firms are said to have tried and abandoned this strategy because of the difficulty pricing options on the names in the IG. "It's something I've looked at," another trader said. "Maybe it will happen eventually. The concept of bonds and equities together is here for the long term."
