Default rates suggest LCDX and HY tranche plays, says Barcap

In its latest US Alpha Anticipator research, Barclays Capital recommends CDX HY and LCDX tranche plays for buy and hold investors based on their view of default rates in the two indices.

For severe defaults, Barcap recommends buying 5-8% protection on LCDX series 10, while average defaults suggest a 3-5 year HY curve steepener in the 10-15% tranche. Alternatively, for average or severe defaults investors could look to buy three-year LCDX 0-5% protection or buy five-year LCDX 5-8% protection.

Barcap warns that although the first two trades outperform significantly under their respective default scenarios, there is substantial downside to the trades if the default expectation is not realised. On the other hand, the third trade outperforms in both default scenarios, but the potential maximum upside is smaller.

Barcap also recommends selling 2.3x 140 December receiver credit options and buying 1x 160 December payers on IG10. The analysts view this trade as a cost-efficient alternative for outright index shorts, which have a high carry cost associated with them. As long as IG10 spreads remain above 126bp, Barcap thinks the option trade provides a better P&L profile compared with an outright short. The trade has negative vega but the positive delta would more than offset the vega effect in case of a widening scenario, says Barcap.

Looking across at Europe, Barcap says that investors wanting to short correlation should consider either selling five-year super-senior protection and over-hedge the delta with the 10-year index, or else entering a five-ten year equity steepener with an underweight five-year leg.