With credit derivatives indices shooting past key levels and showing few signs of stopping — the iTraxx Crossover is trading at at 542bp and the iTraxx Europe is at 101bp — many investors have been scratching their heads about the drivers. Geraud Charpin, head of European credit strategy at UBS, explains:
The answer is simple: deleveraging. It still makes more sense for banks to liquidate than to lend. Other leveraged players face the same issue and must delever rather than invest.
Leveraged mark-to-market structures are obviously suffering as spreads widen. We have long said that this ongoing crisis is about deleveraging and that until deleveraging has happened, the market will push valuations of assets that have been levered (mostly high quality AAA type assets) lower. In pure credit we are talking about the much publicised leveraged super senior tranches as well as CPDOs (probably about $3bn of them with average 10x leverage). Restructuring, re-hedging, de-risking is going on now and driving spreads wider.
Hedge funds are also under pressure with prime brokers tightening the screws further and forcing deleveraging across the board. In HY, with prices falling like a rock, many funds are hitting stop loss and have to sell. No value buyer is doing anything more than nibbling in so far.
We are in value territory. The iTraxx index is close to 110bp when its fair value is around 40bp assuming we are going into recession! Sub bank CDS is above 160bp and Xover above 560bp. However, there is nothing stopping the widening, the bottom line is that as long as painful positions will not have been liquidated we will likely weaken further (we can’t give a ‘target’ as there is none).
The long/short investors do not have much conviction here and tend to just follow wider with small positions on which they take profit pretty quick (faster than usual). Once the ‘restructuring’ / liquidation / deleveraging is over, we suspect the market will snap back pretty fast. Unfortunately we do not know when that will be and for now we don’t see anyone with enough dry powder to take a stab at catching the falling knife.