LSS unwinds may catch out correlation traders, warns BofA Merrill

Correlation traders may be overestimating the impact of an expected wave of leveraged super senior unwinds, according to Bank of America Merrill Lynch. In a recent report entitled Impact of Basel III on Correlation Trading, the bank says that much of the recent widening in super senior spreads relative to index spreads has been driven by expectations that leveraged super senior holders will be forced to unwind their trades. The unwind theory is based on the extremely unfavourably treatment of leveraged super senior CSOs by the forthcoming Basel III bank capital regime. Seven-year 15-30% CDX tranches are currently trading at around 60 basis points, and 30-100s are at around 30bp.

However, BofA Merrill’s report says that these short trades make little sense.  First, the timescale for implementing Basel III remains unclear, and it may not be enforced in the US for several years. Second, most leveraged super seniors were not bought by banks but by Canadian conduits, and are now in a vehicle called MAV, which is managed by BlackRock and are unlikely to be unwound.