Traders eye expensive options as they look to get creative

Dan Alderson

Deputy editor

Credit market volatility trades may look exceptionally expensive, but that is not stopping them being a prized tool for investors on a number of fronts — from hedging longer-term macro risks, through pre-March index roll positioning, to cross-asset relative value plays.

“Implied volatilities are now at the top of the 10-year percentile and close to resistance levels at around 70%,” notes Paola Lamedica, credit strategist at BNP Paribas.

In particular, European credit volatility has increased markedly over that of equity, when offsetting the EuroStoxx 50 against iTraxx Europe and Crossover, or the EuroStoxx Banks index against the iTraxx Senior Financials basket.

“It’s true that options are expensive right now, but some strategies still work and can offer more creativity than index tranches,” says Cara Roche, portfolio manager at Zais Group.

“You can do a lot of different things and go beyond straight credit, into say ETFs and equity — playing the beta between them. The credit volatility skew has flattened, so it’s somewhat less attractive to do spreads, and it’s notoriously tough to hedge geopolitical risks, but tail protection is certainly bid and the question then is, when does rates risk become credit risk?”

“Implied volatilities are now at the top of the 10-year percentile”

Paola Lamedica, Credit strategist | BNP Paribas

The volatility skew has flattened by 15% in one-month iTraxx Europe, but only 3% in CDX IG, according to Lamedica. This reflects that out-of-the-money hedges increase and skew flattens when volatility rises, as traders view it mainly through the prism of daily break-even values, she argues.

“The breakeven of a 130% moneyness (90bp) option in Main has risen to 4bp, which has proven to be a strong resistance especially since 2017,” she adds.

Another stand-out, if expected, feature is that calendar spreads — trades that allow investors to profit if index levels remain relatively unchanged over a period of time — have inverted with market stress, notes Lamedica.

Intraday trading ranges had become calmer as Creditflux went to press — although Russia/Ukraine developments threatened to build on the previous rates-led volatility.

“Payer spreads and put spreads still look interesting, and certainly we saw non-credit investors flock recently to buy tail hedges,” says Kelley Baum, credit trading head at III Capital Management.

“Options expiries will start to gain focus if investment grade indices widen past the 75bp or 80bp strikes, given the level those players came in.”

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Global credit funds & CLO's

March 2022 | Issue 243

Published in London & New York.