Morgan Stanley suggests sovereign correlation trade

In a report published last week, Sovereign CDS Markets – a Corporate Perspective, the bank’s analysts argue that while failure to pay and repudiation/moratorium are classed as sovereign credit events, these are much less likely than for emerging market sovereigns and far less likely than the most likely corporate credit event: bankruptcy. The report says that restructuring and deliverability are the big drivers of value in OECD sovereign credit default swaps.

By comparison with the corporate credit default swap market, sovereign CDS is a market that currently lacks a natural seller of protection. Investors can take advantage of this with a number of trading strategies, suggests Morgan Stanley, including basis trades pairing short-dated credit default swaps with long-maturity cheapest-to-deliver bonds.

Another idea is to sell protection on baskets of sovereigns, structured so that the protection seller is on the hook for all but the first default. These 2nd-to-nth baskets are a play on the high perceived correlation of sovereign defaults, which Morgan Stanley estimates at 70% on the bid side. It suggests a trade paying 100 basis points (compared to 88bp on the SovX index) on a basket of six eurozone names, of which the widest are Greece (410bp) and Portugal (165bp). If one of the names defaults, the investor suffers no losses. After that, the contract is treated as five single name contracts on the remaining sovereigns.