Back in early/mid 2007, just as the subprime bubble was bursting but Wall Street was desperate for the party to go on, when VIX was flirting with single digits (killing the swaption market due to lack of vol), when record, multi-billion LBOs were a daily thing, and when corporate bond spreads barely registered any risk on the horizon, there was one dominant trade for those credit traders who saw the writing on the wall (as they usually do 3-6 months ahead of their equity trading peers): going long cheap index puts while funding the cost of carry by selling a steep long end and pocketing the roll down.
That trade is back.
According to Citigroup's Credit Index group led by Anindya Basu, "nearly every single investor conversation we have had recently has been about how difficult it is to make money in the current environment."
There are good reasons for investors to be concerned – the two big elephants in the room are showing no signs of leaving. The Greece saga continues to drag on with headlines driving markets, and mixed economic data out of the US is causing considerable uncertainty around the timing and pace of Fed rate hikes
Citi adds that,"investors need to put money to work, but almost all investors lack conviction, bemoan the lack of opportunities given how tight spreads are, and continue to worry about market liquidity."
Those investors must have read what Citi's Matt King said two weeks ago, [11]namely that the market as we know it no longer exists courtesy of central banks (something Zero Hedge has said since 2009).
So what is the best way to position/trade in the current environment? Citi's answer is putting the 2007 trade back on again: "Under these circumstances, we believe that option hedges funded by the substantial roll down of mezzanine tranches can be very attractive."
This is how those who just have to invest other people's money are advised to do so via Citi:
... the markets are awash in liquidity – recent fund flow data indicates continued inflows into corporate IG funds, and even HY funds have seen a reversal of some of the outflows (see Figure 1) – in fact, YTD, both IG and HY funds have experienced net positive inflows. So investors are now faced with the difficult choice of finding opportunities to generate alpha in markets that appear overpriced, while contending with the possibility of liquidity shocks when a sell off happens.
[12]
Now, no one seems to disagree that put (payer) options could potentially provide the best hedges for such situations, if we could only find a way to pay for them. The problem is that in a tight spread environment such as now, investors have to be conscious about how much they can allocate to their hedging budget. One way to make this work is to move the put option strikes significantly out of the money, but that can often make the hedge less effective, especially if we need protection from the daily mark-to-market volatility.
We believe that the steepness of current credit curves offers a way out (see Figure 2 (left)) – the carry from rolling down such steep curves, combined with some form of cheap leverage could potentially be enough to fund closer to ATM puts. From that perspective, we favor selling protection (going long) in index tranches which have steeper curves than the underlying indices (see Figure 2 (right)) – for example, IG 3-7% 3s5s are 63% of the 5y spread, compared to IG index 3s5s at 42% of the 5y. Similarly, HY 15-25% 3s5s are 55% of the 5y spread compared to HY index at 29% of the 5y.
[13]
At the present time, it is our view that the mezzanine index tranches provide the most attractive vehicle for funding close-to-ATM option shorts. In addition to benefitting from the inherent (non-recourse) structural leverage, these tranches can also shield investors from actual default risks, which can be an important factor in an environment where idiosyncratic or sector specific (e.g. energy) risks are dominant.
Combining the tranche and the option legs is advantageous in the following way. As spreads tighten, the trade benefits from the long tranche leg, while the option leg expires worthless. As spreads widen, the trade gains from the option leg and while mark-to-market losses on the tranche legs are partially compensated by the roll down. This can provide positive convexity.
How to structure the trade:
The details of our proposed trade are shown in Figure 3. We recommend buying December expiry 60 strike IG payers funded by selling protection in the 5y IG23 3- 7% tranche. We show the performance of the trade under different spread scenarios upon expiry in Figure 3 (red line). The trade is efficient in the sense it demonstrates positive convexity – upon option expiry, the P&L remains positive regardless of the direction of spread moves over a wide range of spreads. We chose a slightly in-the-money strike at 60bp since this exhibits better projected performance relative to strikes that are closer to the ATM 65bp strike.
In effect, this trade can be thought of as a “payer spread” – selling protection on the IG23 3-7% tranche can be considered as selling an OTM payer option on defaults. In other words, we are long an ATM (technically in-the-money for this trade) payer option on IG in the conventional manner, but we are selling an OTM “default payer” option to fund this. The roll down characteristics of this “payer option” makes it anattractive way to fund the payer spread, rather than using a standard payer option.
Whether Citi is merely looking for "clients" to take the opposite side of its own trade, or is legitimately pitching a funded, and deeply convex "fat tail" trade is unclear, but the fact that the very same trades that the entire hedge funds community (at least those who made money into the crash before both legs of the trade blew up) are starting to show up again is likely a cause for concern for those who are convinced the artificial, centrally-planned status quo of the past 7 years will continue indefinitely.
As for Citi's convictionless clients who "suffer" under the repressive, low vol regime: be happy you still have a job. Because just like Bill Gross, you may have identified both the trade and the timing of the "short (or long) of the century", but if you execute it incorrectly and find yourself in a liquidity vacuum, your suffering will be the result of no longer having a job, artificial market conditions nowithstanding.
