Seasoned triple-A tranches of collateralized loan obligations are giving investors an opportunity for spread play via negative basis trades. In a negative basis trade, the spread on a bond is wider than the spread on a credit default swap and a bond holder tries to capture the net spread by going long on the cash bond and hedging credit risk through a CDS contract.
Triple-A CLOs with two years or less left before they can be called away should be trading 10 or more basis points tighter than the current 25 basis points over LIBOR, according to David Yan, senior collateralized debt obligation analyst at Credit Suisse First Boston. If the bonds are called, the 25 basis point spread would be exceptionally high for a short bond. In addition, the bonds are performing well and it's unlikely they would incur losses in a very short time period.
Investors can take advantage of the seasoned tranches' cheapness by buying the bond while hedging against default risk through buying credit protection. Considering CDS spreads are around 10 basis points, this trade would reap 13-15 basis points for investors, Yan estimated.