US tranche rally leads to equity opportunity, Citi says

A sharp perceived reduction in US corporate jump risk since the New Year has sparked a rally in investment grade equity tranches, but also a chance to arbitrage on-the-run indexes against their off-the-run counterparts, according to analysts at Citi.

IG CDX Series nine 10-year equity protection has rallied sharply in recent weeks, trading around 10 points tighter since December to 61 points upfront (+500 basis points running). That price implies an expectation of just 2.92 defaults before the index matures in December 2017. The on-the-run IG17 five-year index, meanwhile, is trading at 34.5 points upfront, implying a very similar 2.63 defaults, over the next 4 years.

Individual corporate spreads in IG9 are generally much wider than those in IG17, Citi says, with more than 10 names trading wider than 500 basis points running, including MBIA, Radian, and iStar. There are no names above 500 basis points in IG17. Sallie Mae, the widest, trades at 485 to 500 basis points.

Citi suggests buying protection on IG9 10-year 0-3% and selling protection on IG17 five year 0-3%.