CDS Skews and Shorts

With skews near their wides and relative value spreads decompressing, we think there are some important indicators of potential opportunity to re-enter shorts as well as playing for an increased vol environment with cheap puts in credit-land.

We discuss two approaches that provide cheap options on increased stress (they are both European interestingly) and then go on to discuss the index skew in IG and reiterate some notable lead/lag relationships that can be used by investors to better time entries.

Play the Vol
We are somewhat loath to place the big macro bets in this environment as so much rests on the words of so few but it should be clear that our view in general is more bearish than bullish (despite our more RV approach this year). We have been discussing some ideas on finding cheap shorts or cheap vol plays with a number of clients (and in this comment section) and given the outperformance of non-FINLs versus FINLs recently.

We strongly suggest Short ITRX Non-FINLs against Long ITRX FINLs (Sen) as a cheap play on increased volatility. The spread between the two is at its lowest since 12/10 and is almost 40bps tighter than its peak at year-end. FINLs spreads have remained largely flat while non-FINLs have rallied considerably during this period.

The ITRX FINLs consists of 25 major EUR financials with the majority having received either implicit or explicit government guarantees. Add to that, Buffet's investment in SwissRe (signaling private money willing to follow the government into financial debt) and we feel that the cheapness of the spread (at around 40bps) appears like a great cheap play on non-FINLs volatility and further stress in the real economy.

We have seen non-FINLs trade inside of FINLs (around 10/01 post LEH) and we think that puts a pretty decent floor under the spread (and moreover with government support we think the floor is even higher at around 20bps if spreads continue to compress). The FINLs appear to be trading a little wide of sovereigns in general and we suspect that f we see further deterioration in the EU economy, we could see non-FINLs jump back to the 70-80bps range.

Playing this via ITRX Main and ITRX FINLs requires a little finesse on the weighting to ensure that you remove the FINLs exposure from Main and still maintain its overweight so be careful. We note one more confirmation to help this trade and that is that the non-FINLs index trades significantly richer to intrinsics than the FINLs index (providing some 10-20bps of cushion if we see Main skews retrace or converge).

The other play we have been looking at is the ITRX FINLs Sen-Sub decompression. We think that in the mid-50s, getting the long the spread (buying Sub protection and selling Senior protection) seems like a cheap option to us on the uncertainty surrounding the non-majors in the FINLs index (they are not all Deutsche Bank) especially as we see further stress from the 'dislocations' in their basis books and as they become realized. It seems that a modest negative carry is more than covered by the small downside (20bps) and large upside (50-60bps) making this position feel like a cheap put on European financial stress.

Shorts and The Skew
With the IG skew reaching back up to historical wides again (intrinsics cheap to index) we try to address some of the technicals at play and look at ways to play this. The skew is somewhat frustrating and we suspect is being driven by four main themes (among others I am sure).

The first is the unwinds/tear-ups and general cleaning up of CDS-based risk. Between the uncertainty in Stimulus and Geithner's plan, and the 'new CDS' contracts, many of our clients are expressing a will to sit on their hands until the roll. Judging from the DTCC data there is a major reduction in risk in the indices relative to the single-names and particularly among the dealers and we suspect this has led to more index trade tear-ups than single-names. This one is hard to judge as the data is slow to come and is a little tough to judge (especially given the desire for the dealers to hold protection against their bond inventories to try and reduce capital currently).

The second could be related to the big basis losses that many of the dealers have faced. When they put the deals on they obviously buy single-name and buy bonds. The basis blows out huge and they get nervous and sell an index protection overlay hedge on their CDS leg while pushing bonds into banking book (out of trading book). If we start to see the basis narrowing (some forced unwinds of basis trades as well as stability in funding, collateral, cprty risk) then that could again be a trigger for resetting shorts as this would likely push the skew the other way.

The third reason is simply a reflection of more liquidity in the indices versus single-names and a 'bullish' bias to many macro investors currently - selling protection to get long corporate bonds because everyone on CNBC says that is a great deal! (sarcasm).

The last (and potentially largest) reason is likely the knock-on impact from the bespoke unwinds. The last few weeks have seen mezz spreads underperform which signals (in our view) a rise in bespoke unwinds. The unwinds have an implicit skew widening effect as banks buy back single-name protection and sell-back index protection (from the mezz hedge).

We think if you are looking to reset some shorts then tracking any pullback (rally) in mezz (delta-adjusted) as sign of protection-selling pressure easing in single-names. We would also look at the DTCC data breakdown for which sectors seems to be being unwound the largest (Full Terminations) as a way to protect against any potential short squeeze.

Skew Leads Index
We discussed the idea of a one-legged index arb last summer when we noticed that as the index skew rolls over from a peak, it signals a move in the underlying index.

The last four months or so of the IG11 contract (and before that in IG10) we have seen a range from around 0 to -55 for the skew (Index - Intrinsics) and we are considerably nearer the wides of that range today as index covering outpaced single-name. Each time the skew has pushed up to the top of the range and rolled over, we have seen the underlying index widen over the next few days (charts available).

This happened 10/16, 11/27, 1/2, and modestly on 1/28. We are pushing up against those highs again (as discussed above) and we suggest that if we see a turn back down (compression) in the skew then investors should see this as a trigger for buying index protection.

Although we have heard of one or two major dealers offering levels in the index arb package, we feel the upside of our one-legged arb with a tight stop is far greater than the operational and slippage issues involved in a big ticket index arb.