Credit players have started dividing and trading small portions of the equity slice in credit derivative indices. Index equity tranches with narrow risk exposure are being bought by holders of collateralized debt obligations to more effectively hedge bespoke tranches. One trader at a U.S. house in London said he had seen trades with attachment points of 2-3% or 3-4%.
While few trades have been done on this basis to date, they are expected to find legs with a wide set of CDO investors this year, said Gregorios Venizelos, credit analyst at ABN AMRO in London. "Hedging tailored tranches is an issue for all CDO holders because they can rarely find a standard tranche hedge with perfect attachment points," he noted.
Coined tranchelets, the trade was first mooted by hedge funds in the summer, said Lorenzo Isla, head of European structured credit strategy at Barclays Capital in London. They were pitched as a relative value trade when U.S. auto sector uncertainty moved correlation assumptions, affecting pricing models used by credit desks. Funds were able to pick up value by shopping around for prices from dealers and comparing these with prices calculated from their own models, taking advantage of any discrepancies. "It has come from sophisticated funds that run their own models and can pinpoint these opportunities," said a trader.
One marketer predicted interest from hedge funds to continue picking up because models used by firms to price the sliced up equity tranches continue to be disparate and there are pricing differences to exploit. Continued auto-sector worries are also likely to boost interest in index equity-tranche plays, because the equity tranche is the most sensitive to potential downgrades. Tranchelets will bring greater transparency to the equity slice of the capital structure, said another marketer, and this will make it easier to buy or sell default exposure in a more precise way.
