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January 2021 | Issue 230
News
Convexity pushes high yield bond basis to the forefront
Dan Alderson
Deputy editor
Compression had become the watchword of the market as Creditflux went to press, providing justification for high yield versus investment grade macro plays, wide-end long positioning and selective tight-end shorts. But the more important driver, say some relative value investors, was convexity.
This was a particularly salient theme for high yield bond versus CDS basis in November given strong market performance, sources observe. With most high yield bonds embedding call options, these became subdued by negative convexity on rising above par as investors refocused from full maturities to first-call dates.
“This effect is mostly found when the market is already expensive and high beta bonds outperform in a sharp up move,” says Gilles Frisch, portfolio manager at Axiom Alternative Investments.
Such calls are absent from CDS indices, so they behave like bullet bonds, keeping their full upside as duration increases.
“CDX HY duration went from 4.48 on 30 October to 4.85 on 30 November,” says Frisch. “iBoxx HY duration went from 3.29 to 2.83 across the same period. It means from here investors’ long HY bonds have a very limited upside but still credit risk downside, while HY CDS investors still have full upside.”
CDX HY vs HYG ETF ($)
Pinch to zoom image
For Frisch, this negative convexity is important when designing a long/short portfolio. He aims for positive convexity on long double Bs as well as on short single B/triple C names, where he chooses bonds with prices around par and aggressive call structures.
“I see the risk/reward as very asymmetric today in favour of a short high-beta strategy,” he says.
A portfolio manager at another firm voices similar concerns about high beta credit and advocates short biased trades. Opportunities at time of press included playing basis in the sub and senior structures of European names. On wide-end Crossover constituents, such as French equipment firm Loxam, this could mean going long senior bonds and hedging with subordinated CDS.
“In case it goes tighter we don’t pay much for the hedge,” he argues, “but if it deteriorates or defaults you get the difference between senior and sub.”
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Global credit funds & CLO's
January 2021
| Issue 230Published in London & New York.
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