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Credit Markets: Dissecting the Current Pain

There is a gnawing pain in the back of your mind when thinking about going long corporate bonds. When rates rise, it is a guaranteed money loser.

So for the past few years an alternative that returned a healthy premium was found by taking the spread risk on many kinds of credit. It started with IG to IG, but settled into HY to IG as a popular way to express the view, as you could leverage this income in liquid indices. It essentially became a part of the trading DNA, so to speak.

IG HY.jpg

As you can tell from the data, after a long tightening cycle, spread widening sank in in spring 2014. Since then, it has been the year of pain for pure spread risk.

ig hy spread.jpg

This summer, there was some limited closing out of trades and repositioning began. IG CDS has outperformed cash in the presence of low volatility and a surge in primary market supply in the cash market. The low liquidity in cash markets has encouraged investor to take synthetic positions as hedges. Amid low volatility, investors have bought payer spreads on indices, looking to hedge movements of the index out of its current range. Buying 90 strikes and offsetting by selling at 110 reduced the cost of protection against spread widening while capping the downside either way. The cost was around $2K per million unit was a reasonable view.

Then real money investors stepped in to sell in late 2014. The result is that high yield is caught in a self-reinforcing sell-off. Hold on or get out of the way: ‘twas always thus.

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