Credit players in Europe struggling to ramp up returns on bespoke mezzanine tranches of notes tied to the iTraxx index were dealt another blow last week when spreads on the 3-6% slice unexpectedly drew in.
The price of protection on the tranche reached three-month tights and some dealers say it is no longer cost effective to add leverage to mezz deals, meaning investor appetite for the slice is likely to drop off. "Bespoke mezzanine correlation products are certainly going to be less inviting for investors," said one correlation trader.
On the flip side, traders say the drop in corporate mezzanine yields will boost demand for more exotic structures. Michael Hampden-Turner, credit strategist at The Royal Bank of Scotland in London, explained this is further fuel for investments such as constant proportion portfolio insurance and structures referencing underlying other than corporate CDS, such as leveraged loans and asset-backed securities.
On Thursday, default spreads on seven-year iTraxx Europe 3-6% had dipped to 169.5 basis points, a drop from 232 bps at the end of June. At the five-year tenor, yields moved to 64 bps from above 80 bps a few months ago. "This is a big move," said one trader.
Officials said huge volumes of 3-6% CDS protection selling triggered the tightening, but there was no consensus among traders who was behind the selling or why. While one said a number of European hedge funds were in the driver's seat, this view was dismissed by a senior buyside trader. "People blame the hedge funds when they don't know what is going on," he said, adding, "Selling is coming from across the whole Street."
Traditionally, investors are long protection/short the underlying in mezzanine tranches to protect against a spike in volatility, but this week's protection selling spree goes against that trend. "People are obviously bullish on the underlying market and coming into the roll when volatility is low, they are taking off shorts rather than adding them," speculated one correlation trader.
