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Buy IG9 10yr protection and Sell IG18 protection against it
The market has been fixated on the IG9 10 year index for weeks. It is trading extremely rich to intrinsic value. Using a spread of 126, we still see it being at least 10 bps rich. IG18 which had been trading 7 bps rich at the start of last week is now only about 1 bp rich. It looks like the trade would be paying 126, vs selling 100.50. We would be outright short IG9 10yr, but with the recent move, we think the risk of a bounce is too high so prefer this trade.
Although IG9 10 year is trading very rich, anyone who attempted to short this, either outright or versus IG18 has been hurt. It has been a painful trade, but is also a reason IG18 traded so rich post the March 20th roll as many funds put on this trade prematurely. I think we finally have a catalyst.
Bloomberg broke a story claiming that one party in particular is responsible for the trade. From what I can tell, they have some things a little wrong, but the gist of the story matches what I’m hearing in the market. I believe one counterparty in particular has been selling “tranches” of IG9 in size rather than selling the index itself. That does make a difference, and I actually think selling the tranches are a good trade, but it doesn’t materially affect the dynamics of the trade we are looking at here.
The big seller is likely to slow down the selling pressure on that index. Regardless of how smart the trade is (and the tranche angle is particularly compelling) there is likely to be pressure to stop adding to the trade. No firm wants to be on the front page of newspapers about taking too much risk, especially exotic derivative risk as opposed to making lots of mortgage loans. If that selling pressure eases, you will see hedge funds attack this index. There are even some other weak longs in the index, as they saw the momentum, and in spite of the fact that the index was trading extremely rich, they got long this index under the assumption the support would make it harder to go wider than the on the run index.
I don’t think the alleged big seller will be forced out of positions, because I do think the bulk of the risk remaining on the books is in tranche format, and I think it is both compelling and a longer term structural view, rather than a quick in and out on the index itself. But an index that is more than 10 bps rich is susceptible to spread moves wider, and just the absence of an incremental big seller should be enough to push it towards fair value.
The maturity date of IG9 10 year also helps push the trade towards fair value. IG 9 10 year, has a maturity date of Dec. 2017. On the September CDS roll, it will have the same maturity has IG19, and will be the “on the run” date for single names – making the arb far easier to implement. That is an unusual feature of this index – the roll down, normally a problem for the “arbs” actually helps in this case. Once the index moves to trading to the “on the run” date, it will be very hard for it to maintain the richness.
So we really like being short IG9 10yr. We would sell IG18 against it for now as market does seem at risk of a bounce tighter. The actual arbitrage would be a better trade, but that is hard for anyone not already set up to do that. The lack of a big seller, a few weak longs, and the roll towards being “on the run” should all be enough to push this index towards fair value. The fact that a lot of the risk at the big counterparty is in tranches rather than straight index is another useful feature in our opinion as there is less “need to defend” the position.
I think the tranche itself is an attractive trade, but that’s another story. IG9 is actually the most active index in the tranche market. It was the “on the run” index heading into Lehman, and the tranche market has never fully recovered, but there were so many old tranche trades and synthetic cdo’s outstanding that IG9 tranches have continued to trade as a way to largely manage those residual risks, and more recently as a way to pick up spread in a tight spread envir