JP Morgan recommends recovery play using senior tranches

According to research published by JP Morgan last week, the price of the most senior tranches of credit indices makes sense only if recoveries turn out to be as low as 23% for US investment grade names, 55% for European high grade and a mere 11% for North American high yield credits.

As the report notes, it should not be possible to sell super senior protection for more than the cost of buying single name protection to fully hedge default risk. Therefore super senior levels provide an upper bound for recovery rates in the indices. For any recovery above that number, there would be an arbitrage opportunity.

JP Morgan believes that the very low recovery implied by the CDX HY series 9 index tranche presents an interesting opportunity for investors who think actual recoveries will be higher. As the report acknowledges, there would be high transaction costs to put on the senior tranche versus constituents trade. But investors could create the same hedge with lower dealing costs by selling protection on the index and buying back protection on the 14 widest names.