Arbing Moody's Sovereign Ratings Via CDS Pair Trades
Now that sovereign CDS (and ratings) are back in vogue with everyone finally expecting the world to relapse into a double dip, Zero Hedge has compiled Moody's sovereign ratings and spread these alongside the CDS spreads in any given bucket to proposes several trade ideas taking advantage of Moody's market lagging inefficiency.
We have done this for all countries Aaa through B3, and grouped the countries by rating bucket (i.e., Aaa, Aa3, A2, Baa2, etc), taking the average spread of the countries in the bucket. Subsequently we charted the variation from the average for any given country in a particular rating bucket. The result is charted below: it should serve as a useful platform on which to build a trading portfolio used to arb Moody's ratings. The rationale is simple - as the spreads in any given bucket should, on average, be very much in line, it is possible to trade outliers that are far away from the average by incorporating them in a convergence trade. One possible trade is therefore to sell Spain CDS which at 218 bps is 154 bps wide of the Aaa average of 64. The other side of the trade could be purchasing CDS in any name that is abnormally tight to the average, such as Australia or the US. Of course, since a Moody's rating is always a lagging indicator, a likely better trade is to position for future Moody's ratings actions: in this case the trade would be to Buy Spain protection on the expectation the country gets bumped into the next lower rating bucket, Aa1 (or lower), where average spreads move progressively wider. The spread can be hedged by selling protection in a country the is a tight outlier in the expected "landing" bucket. For instance, if one believes Spain will be notched twice, to Aa2, the trade would be to Buy Spain CDS, and Sell Japan, which has an Aa2 rating. Of course, there are many other possible trades that can be created. We present a chart for all countries that diverge from the rating in the A-bucket (from A3 to Aaa), although we note that the spread expansion is not linear due to sample sizes: for example the average spread in Aa3 is 65 bps while the allegedly less risky Aa2 is 124 bps: potentially another arb would be to create a spread compression by buying the Aa2 CDS bucket and selling the Aa3 for a 60 bps spread convergence, DV01 neutral.
We will present the comparable data for B-rated countries tomorrow.
Below is the chart that shows the variation from the bucket average for the 7 A-handle countries.
Raw data for A-rateds with spread.