Investors willing to add leverage through structured credit products should consider playing the credit derivatives indices. Glen Taksler, credit derivatives strategist Banc of America Securities in New York, said the start of the year will see index spreads move sideways with a bias toward tightening, but the widest constituent credits will tighten faster
He also expects some credits to widen significantly relative to the overall index. He cited as evidence Bombardier, GMAC, Delphi and Ford Motor Credit, which have already traded at least 125 basis points wider than the investment grade intrinsic average.
Based on this forecast, Taksler recommended investors, particularly hedge funds, consider selling protection on the 7-10% tranche of the index. "The 7-10% tranche in the 10-year sector offers significant roll down potential that investors have taken advantage of in light of the recent steepening in the investment-grade credit curve." He added this has been a popular play since late last year. Alex Reyfman, a managing director and global head of credit derivatives research at Bear Stearns in New York, agrees. "If spreads tighten selling the 7%10% tranche outright is a good strategy," he said.
The strategists, however, disagree on how to trade the junior end of the index. Taksler recommended selling the delta-hedged 0%-3% equity tranche. The trade is a positive carry and investors can take advantage of positive convexity to overall market spread movement, he explained.
Reyfman disagrees. He said if the 0-3% tranche underperforms relative to its hedge, that positive carry may not be enough. "We propose buying the 0-3% tranche and then selling a lot more of the index," he explained, referring to a recommendation made by Bear Stearns in a December research paper. "In other words, hedge the underlying single name notional, a position that is much larger than the delta hedge because you're selling so much of the index," he said. Bear Stearns have been pitching the trades to hedge funds, proprietary desks, bank loan books and some insurance companies.