Barclays Capital analyses ResCap recovery plays

In its latest 'US structured credit weekly', Barclays Capital says that a two point widening in five-year equity tranches of the series 8 CDX IG index has been driven in part by investors buying equity protection to hedge jump-to-default exposure on ResCap, amid concerns that the company is close to violating senior debt covenants.

The researchers calculate that if ResCap defaults immediately and recovers at 40%, such a hedge would return 3.7 points. With lower recoveries, a short equity tranche trade would have a higher upside.

However, if default occurs after three months the position only breaks even assuming 40% recoveries as a result of the cost of carry and time decay.

The paper also suggests other ways of expressing a bearish view on ResCap recoveries, such as buying CDX.HY series 9 equity protection and swapping floating recoveries into fixed recoveries at 43% using recovery swaps on ResCap.