Barcap recommends junior versus mezz tranche volatility trade

In its latest US Structured Credit Weekly research paper, Barclays Capital says current correlation levels represent one of the best entry points for trades that benefit from correlation volatility while remaining neutral to spreads. The analysts say that while idiosyncratic risk concerns will bring correlation levels lower in the long term, they remain agnostic about its direction in the short term.

Trades can be constructed by selling delta-hedged protection on tranches whose sensitivity to base correlation levels changes with the level of correlation, and then hedging that exposure by buying delta-hedged protection on another tranche whose sensitivity to changes in base correlation is fairly constant. The 0-3% and 3-7% tranches have constant sensitivity to base correlation, while the sensitivity of the 7-10% and 10-15% tranches changes as the correlation level changes. Barcap recommends buying delta-hedged 3-7% and selling 3.9x delta-hedged 7-10% protection to monetise correlation volatility.

The analysts assess mark-to-market performance until the expiry date by looking at the sensitivity of the trade to index spread (delta), implied volatility (vega) and time decay (theta). They say the trade is bearish and would generate positive P&L if spreads are wider than today but lower than 190bp at expiry (maximum P&L at 150bp). However, the net delta of the trade is negative, meaning the trade would have a mark-to-market loss if spreads widen in the short term. The positive theta, which eventually offsets the effect of the delta, would cause the mark-to-market P&L to converge to the payoff at expiry.

The trade is short volatility as well, they say. If implied volatility increases by 10% instantaneously, the trade would lose around 20bp. However, the effect of volatility would be reduced as it approaches the expiry date. As long as spreads stay below 190bp, the trade would eventually generate positive P&L independent of the level of volatility. Although vega and delta of the trade might have adverse effects on it, these would be offset in the next 25-50 days by positive theta, says Barcap.