Financials have been hammered in the markets as the credit turmoil continues to dent sentiment for their shares. It only makes sense that investors in the credit default swap market are also betting against banks and other financials.
So recently it has cost more to insure financial companies’ senior debt against default than it does to protect their corporate clients.
But traditionally, that has not been the case. Historically, the spread on the iTraxx Financials Senior, an index of 25 financial companies, has traded about 22 basis points lower than the iTraxx Non-Financials, an index of 100 non-financial companies, according to BNP Paribas.
But in recent weeks fears of subprime losses have driven the financial index’s spread sharply wider, causing the traditional gap between the two indices to vanish – and indeed reverse:
This provides a great opportunity to profit from so-called relative value trades, according to analysts at BNP Paribas and Deutsche Bank, who are betting that the indices will bounce back to their traditional relative levels.
BNP Paribas:
From a relative value perspective, non-financials spreads have historically always traded above financials. While we believe there is still potential for further downside risks for financials from the clarity of losses and write-downs, the expectations of ‘sluggish’ growth prospects for Q4 and the first part of 2008 as indicated by Fed Chairman Bernanke does not bode well for non-financial corporates.
In such a scenario, we would expect non-financial spreads to widen and, from a relative value perspective, expect the relationship [between financials and non-financials] to reverse back towards its long-term average of 22bp.
Taking a position on this view is simple: buy credit protection on non-financials and sell protection on senior financials. Whichever direction the overall market moves, relative value traders will profit as long as the two indexes diverge towards ‘normal’ levels.
The iTraxx Non-Financials index is illiquid and thus not ideal for trading – but the main iTraxx Europe, which includes 100 non-financials and 25 financials, can be a suitable substitute.
“Until about two months ago, people wouldn’t have looked at [senior financials] versus Europe as a pair trade. Now there is a lot of interest in it from a range of clients,” Marcus Schüler at Deutsche said.
However, relative value traders remain vulnerable in the short term, Mr Schüler warned. “From a momentum and news flow perspective, there’s certainly a risk that [the Financials Senior index] could widen further.”
The spread on the iTraxx Financials Senior hovered around 55.5bp on Tuesday, about half a basis point tighter than the iTraxx Europe, according to data from Deutsche Bank.
The iTraxx Crossover, a closely watched measure of risk appetite, widened by about 3bp to 383bp, meaning it now costs €383,000 annually to protect €10 million worth of mostly junk-rated corporate debt against default in a five-year contract.