CDO Hedging Expands Curve Trading Liquidity
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Derivatives

CDO Hedging Expands Curve Trading Liquidity

A newly-liquid point on the yield curve for relative value curve trading has been created by a pickup in demand for seven-year collateralized debt obligations.

A newly-liquid point on the yield curve for relative value curve trading has been created by a pickup in demand for seven-year collateralized debt obligations. Derivative houses issuing the seven-year mezzanine deals are hedging the trades by selling tranche protection and the hedging has created a viable seven-year trading point on the curve, traders reported.

"The CDO supply has come in seven years and driven the tranche market," said a trading official at a European house. "There is lots more value in seven years than 10 years," agreed a structuring official in London.

Traders reported a boom in five- to seven-year and seven- to 10-year curve trades on CDX and iTraxx last month, sparked by the increase in liquidity in seven-year mezzanine deals.Olivier Renault, v.p. in the CDO research group at Citigroup in London, said the seven-year deals offer more attractive spreads and greater yield. "People have been buying this tranche like crazy because of the price you pick up for only two years extra maturity," he said.

Renault noted the cost of seven-year protection on the 3%-6% bracket of the mezzanine tranche is around 140 basis points, compared to 75 bps for five-years which traditionally is the most traded maturity. He said five-year trades continue to be the most liquid in the market, but volumes in seven-year maturities have already passed 10-years in the short time they have been traded.

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