Barcap suggests alternatives to outright shorts on IG10

In its latest US Structured Credit Weekly report, Barclays Capital identifies trade opportunities following the GSE conservatorship of Fannie Mae and Freddie Mac. Barcap expects the most senior tranches to tighten in the short term, while impacting equity tranches in varying ways. Although Barcap recognises outright shorts on CDX IG 10 as the simplest way to convey a bearish outlook, two disadvantages – the trade’s high carry cost and potential undesirability due to rallying spreads – call for alternatives.

Barcap suggests two options. Firstly, the analysts recommend selling 2.2x 130 December IG10 receivers and buying 1x 150 December payers. The trade’s attraction lies in its potential outperformance should the index remain between 115 to 150bp. The primary risk to consider is substantial underperformance should the spread rally below 115bp. However, according to Barcap, such an event appears unlikely until the end of the year.

Secondly, Barcap says this is the best time to sell OTM receivers and purchase OTM payers. The analysts observe that the current form of the IG10 implied volatitlity skew appears attractive. They also foresee senior index contracts to recover close to par, with the appointment of a conservator for the GSEs having limited impact.

Barcap believes index dispersion will decrease moderately as higher beta financials - in particular, Radian and MBIA - rally in the short term. Equity tranches should therefore tighten on a delta-adjusted basis. The decrease in correlation since Friday's opening suggests the market has focused on the decrease in perceived systemic risk. Five-, seven-, and 10 year IG9 equity tranches have each widened about 100bp on a delta-adjusted basis since close on Friday. Meanwhile, super-senior spreads have tightened 0.9-1.75bp on a delta-adjusted basis.

Barcap thinks deteriorating credit fundamentals should continue to cause correlation levels to drop in the long term - and would use any short-term tightening in equity tranches to reset shorts. The analysts would also use this opportunity to sell delta-hedged protection on the five-year IG.9 30-100% and 10-15% tranches - their preferred tranches for going long senior credit risk in the tranche markets.