This month's introduction of a tradable index for synthetic home-equity asset-backed securities has brought new long-short arbitrage strategies for hedge funds and prop desks. Among the most popular strategies have been dispersion trades of sub-indices against single-name credit-default swaps and sub-indices against sub-indices. Most major hedge funds, mutual funds, portfolio managers and dealers are engaged in this.
The ABX.HE, first traded Jan. 19, is made up of five sub-indices rated AAA through B minus, referencing baskets of single-name CDS on sub-prime residential mortgage-backed securities. The sub-indices have not yet been tranched up.
"We're starting to see some creative trades on the index," said Todd Kushman, managing director and product specialist for structured finance derivatives at Bear Stearns in New York. "A lot of people are using the index as a hedge against single-name exposure." Last week, the most active trading of this kind involved BBB and BBB minus sub-indices against single-name CDS, traders said. Looking to exploit wide spreads and high volatility at the lowest part of the index capital structure, dealers and hedge funds positioned long sub-indices and short the individual names. One trader estimated several billions of dollars in these plays was traded last week.
"It's interesting to see the link between cash, single-name and index markets," said Roy Cantu, director of ABS trading at Barclays Capital in New York. "Cash is trading the tightest, single name is in the middle and the index is on the wide side," he noted, adding the assets had respective spreads of about 250 basis points, 265 bps and 280 bps last week.
An approximately USD1 billion trade early last week was put on by an account going long AA and short AAA sub-indices. Believing the AAA sub-index was overly rich, other hedge funds and prop traders caught on to the play and arbitraged the two indices, resulting in the spread disparity disappearing by the middle of last week.
