Growth in credit products lets investors express sector-specific views as dispersion ticks higher

Kelley Baum

Head of credit derivatives III Capital Management/AVM

Investors can use ETFs, volatility dispersion swaps or even bond baskets to trade dispersion

Over the past few months, investors have expressed concern about inflation and slowing growth. Many market practitioners believe this will shake up credit markets — potentially leading to overall spread widening but, even more, leading to dispersion both between and within sectors. In light of this, relative value traders are focused on finding the best ways to express dispersion views.

Using tranches to capture dispersion

Traditionally, a view on dispersion can be expressed in credit tranche markets. If you buy protection on equity or junior mezz tranches versus selling protection on the index, you benefit if dispersion increases as more risk is priced into the lower parts of the capital structure. For example, if the two widest names in the index widen by 50 basis points while the two tightest names tighten by 50bp, the average spread at the index level is unchanged, but the equity tranche became riskier given its effective exposure to only a portion of the underlying names.

If one or two sectors experience outsized stress relative to the rest of the market, these shifts could lead to meaningful value redistribution across credit tranche capital stacks. Implied correlation is at average to low levels, so combined with low dispersion it seems like a fair but not especially compelling time to add this strategy in tranches.

Equity traders have also been focused on dispersion themes. Investors have long been able to trade equity sector, style and thematic ETFs and index products. Volatility dispersion trades have become more prevalent recently. Dealers are pitching equity volatility dispersion swaps, where an investor can short index volatility against going long single name volatility on a subset of the index.

Trading baskets in cash credit has traditionally been challenging due to trading that is segregated name by name with different individual traders, as well as high bid/offer spreads. But credit ETFs have become a liquid way to access the cash credit markets over the past decade, with the market caps of HYG and LQD now around $30 billion and $40 billion, respectively.

More recently, portfolio trading, where investors can buy or sell baskets of five to 100-plus bonds, has become more popular and liquid. This capacity originally targeted real money investors, who were looking for beta while minimising bid/offer and maximising liquidity. But as the dispersion themes have become more popular and widely explored, relative value traders have utilised portfolio trading baskets to drill down on sector-specific dispersion views.

In both CDS and cash bond markets, various dealers have come up with tradeable, trackable baskets of credits reflecting themes like supply chain upside/downside and reopening, sectors like energy and TMT, and ratings groupings like triple Bs, double Bs and rising stars.

We’ve already started to see some previously mentioned macro forces impact relative pricing in credit markets. Energy price spikes have contributed to Europe’s underperformance relative to the US recently in both the IG and HY markets.

Energy fuels widest credits in CDX HY

In derivative markets, US CDX HY has decompressed over the past quarter vs CDX IG as growth concerns have weighed on high yield companies. But some of the widest credits in CDX HY are energy companies, like Talen Energy and Transocean, and with the recent rise in energy prices, these companies may outperform.

In cash markets, US HY is more exposed to telecoms and energy relative to CDX, and less exposed to consumer cyclicals, while IG cash has higher exposure to financials and less exposure to industrials and basic materials than CDX does. And over the past few months, US HY cash has started to compress vs IG cash.

The growth in credit portfolio products is an exciting trend that lets investors express thematic and sector-specific views. And with the potential for increased dispersion coming from macro headwinds that disrupt certain sectors, in addition to fundamental trends like the growth in the triple B market leading to the potential for more fallen angels, it’s auspicious that the tools have become available to express these views.

Share this article:

${prev-page}

${next-page}

Browse more Creditflux newsletters

Global credit funds & CLO's

November 2021 | Issue 240

Published in London & New York.