Global credit funds & CLO's
January 2021
| Issue 230
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January 2021 | Issue 230
Opinion Credit derivatives
Virus-impacted sectors may suffer greater distress in Europe than in the US
Kelley Baum
Head of credit derivatives III Capital Management/AVM
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Investors may take different paths to capture positive convexity in US and European credit markets in 2021
Finding the intersection of dislocation and value is the key to trade construction — and finding convexity is crucial as uncertainties remain about the roll-out of a coronavirus vaccine and political outcomes both in Europe and the US.
Long risk positions in credit, especially investment grade, are naturally negatively convex (upside can be constrained as credit spreads can only tighten so much, while downside can be closer to unlimited in low recovery default scenarios). But the credit option and tranche markets allow investors to access positive convexity.
Buying options is positively convex as the delta increases when the option is closer to in-the-money. In tranche markets, both long risk positions in equity tranches and short risk positions in senior tranches offer positive convexity — as spreads widen, the delta gets smaller in equity tranches, while the delta increases on senior tranches. So constructing a short risk position in credit using options or tranches doubles up on positive convexity.
Tranche correlation accounts for dispersion
The natural next step is to compare these markets: can investors source convexity more efficiently in one versus the other, and does implied volatility on options look rich relative to implied correlation on tranches?
CDX IG implied volatility and senior correlations are both close to average levels over a five-year period. In iTraxx Europe, senior correlations are slightly high over a one-year horizon and even higher over five years, implying convexity is expensive in that index. Implied volatility, on the other hand, is a bit below its five-year average, so options appear to be a relatively cheap convexity source in Europe.
But tranche correlation doesn’t just encapsulate the value of convexity, as option implied volatility does — portfolio dispersion also factors into correlation. While shorts in senior tranches provide positive market convexity, they have negative single name convexity — meaning that if spreads widen while dispersion stays the same, shorts in senior tranches should outperform their delta. However, if dispersion rises, shorts in senior tranches could underperform their delta even in a spread widening scenario as more of the risk across the capital stack gets priced into the equity, especially if certain names approach default.
Dispersion has characterised credit portfolios in 2020. On one hand, central banks are buying corporate bonds, taking the tail out of credit markets and driving spreads on default-remote credits back to the tights. On the other, certain sectors (travel, leisure, retail) are still reeling from the impact of lockdowns, and may experience even more stress if the virus accelerates again as potential complacency about social distancing and other precautionary measures takes hold, despite multiple vaccines being on the horizon.
Dispersion is likely to increase in Europe
Although dispersion has risen in the US and Europe in 2020, it has been more pronounced in the US. In 2021, this is likely to reverse, with dispersion more likely to increase in Europe compared to the US. Partly, this is because dispersion is already at that relatively higher level in the US, and partly because the recent positive vaccine news may lead to further tightening in some wide US IG credits. There also seems to be more social will to endure severe or extended lockdowns in Europe compared to the US, which could lead to higher distress and default rates if there isn’t a commensurate fiscal response. Medium-term political risk may also now be higher in Europe, as leaders struggle to coordinate responses in the midst of rising deficits.
Putting those together, virus-impacted sectors may endure more distress in Europe in this next phase, while in the US, credits that are already distressed may be more stable or potentially tighten.
As a result, tranche convexity in the US — with fair correlations and potentially lower dispersion risk compared to Europe — looks like an efficient convexity source in 2021. But in Europe, where dispersion may increase and recent correlations imply tranche convexity is already more expensive than option convexity, the latter may be more efficient.
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