Credit Index Buying Triggers Record Spread Widening

Credit derivatives traders reported phenomenal volumes of buying on the European iTraxx indices last week, causing spreads on the index to widen to record levels. The credit spread of benchmark index iTraxx Europe Crossover widened 95 basis points, moving from 310bps at close on April 4 to a record 405bps at close on April 11.

Traders said real-money buyers turned to the index as liquidity on single-name credit-default swaps dried up. Hedge funds were also active in the sector. Many funds were long the equity tranche of collateralized debt obligations and had hedged this by going short the mezzanine tranche. Last week however they were caught short, as in spite of widening across the index, the mezzanine tranches tightened. One trader noted panic connected to hedge funds' tranche plays was driving other investors into protection buying strategies.

Michiko Whetten, a quantitative credit analyst with Nomura Securities in New York, explained the ratings downgrade on General Motors Corp. and Ford Motor Co. credits by Standard & Poor's earlier this month made the indices more volatile, but poor hedge fund returns may also have played a part, as funds found themselves over-leveraged and in need of unwinding some of their positions (DW, 5/2). "It's a volatile time and people have different views," said Marcus Schüler, integrated credit marketer at Deutsche Bank. "Some people are concerned about the volatility and are selling, while others are taking advantage and buying," he noted.