When do you know that Wall Street has officially succeeded in turning back the clock 5 years? When the market’s collective mind state has been reconditioned to the point where analysts feel comfortable creating research notes with titles like this one: “Keep Calm and Lever Up.” That was the title of Citi’s 2015 outlook piece and it served as a precursor to several missives the bank has released over the past two months wherein Citi strategists pound the table (hard) on why now is the time to wade into synthetic tranches.
Well, just two weeks after the bank introduced the concept of “trickle down QE [9]” and explained how it could theoretically be used to convince (read: dupe) investors into selling protection on Crossover mezz tranches, the good folks at Citi are out today with yet another reminder that ECB asset purchases (which, as we’ve explained repeatedly, simply can’t be executed in the amount promised) will be the catalyst that makes synthetic exposure to euro HY a good idea:
What do we need for the synthetic structured credit market (tranches) to really take off? Two things:
Tight spreads – ECB QE is taking us there and we expect this to continue.
Low volatility – This is key: for investors to add synthetic leverage (to an already long risk portfolio) they need to feel confident about MtM vol. Adding leverage is adding potential MtM vol, so when vol is high investors are reluctant to lever up even if spreads are tight. This is, we believe, what has happened so far: ECB QE pushing spreads tighter but limited interest in tranches due to high implied and realised volatility (mostly as a result of the events around Greece).
So breaking that down, look for CB asset purchases to compress spreads making long credit positions attractive, but only if nothing happens that might introduce a significant amount of volatility because, if you’ve taken on synthetic leverage you don’t want the market to move violently against you because someone sneezes in Greece or because Russia decides to make another land grab in Eastern Europe.
The problem: absolutely nothing that has happened on the geopolitical stage over the past 60 or so days should give anyone any confidence that the various and sundry “fluid” situations unfolding from Ukraine to the Middle East will be any semblance of predictable.
So when Citi notes that you’ll likely be ok outside of the equity tranches because “investors looking to lever up will [want to] minimise the impact on the tranche performance of idiosyncratic surprises – not that investors may believe the likelihood of idiosyncratic surprises is high but they probably don’t want to take a large exposure to something they probably are not experts on,” we would ask if most investors really believe they have a better read on the future path of European and/or Middle Eastern politics than they do on the risk of single-name (idiosyncratic) defaults. Our guess is no.
In closing, Citi takes the rhetoric up another notch and flat out predicts a synthetic structured product renaissance:
If volatility (both implied and realised) continues falling and the market gets more comfortable with the probability of a Greek default and/or the potential impact of one in the general credit market, we expect the demand for synthetic structured credit products to increase aggressively across all investors, not only hedge funds.
Here’s a pretty picture followed by Citi’s description of what it shows us:
The red square is where we were in 2006 – when investors couldn’t get enough levered synthetic tranches. We’re getting there.
And we can’t wait.
