Morgan Stanley has switched to using credit-default swap spreads instead of cash bond spreads as inputs to its in-house model used to predict whether a company's debt is cheap or expensive. The firm uses the results of the model to suggest relative-value trade ideas for clients and proprietary traders.
The market standard for comparing protection prices across corporates is to look at CDS spreads with five-year maturities, so the shift means the firm no longer has to adjust for durations and maturities across different bond issues within the model, explained Gregory Peters, head of U.S. credit strategy in New York. CDS spreads now often price in risk premium more quickly than cash bonds, so cash-only investors will still be able to use the model to identify trade ideas, he noted.
It could not be determined whether other firms had also formally made a similar shift, but CDS officials said most clients are already doing basis trades that put cash versus CDS and are requesting more trade ideas based on these technical factors rather than credit fundamentals. Shrinking returns on cash have pushed portfolio managers to allocate more money to these strategies.
"We are all trying to find these trades first, some firms are more quant driven," said one CDS trader about the U.S. firm's model. Morgan Stanley has put a particular emphasis on producing relative-value ideas and other traders were not surprised to hear that the firm was out in front promoting their model.