IG equity correlation is too high, says Morgan Stanley

The correlation implied by equity tranches of the investment grade index is too high relative to its high yield equivalent, says Morgan Stanley in a research report published last week. The bank points out that high yield and investment trade equity-implied correlations are at a similar level, of around 50%. However, the greater volatility of high yield default rates means that junior tranches can be more valuable, and should lead to higher correlation for high yield than investment grade.

Morgan Stanley says that high yield equity correlation is probably close to fair value, but that investment grade equity tranches are too rich. For most of the history of the index tranche market 0-10% high yield correlation has typically been at least 10 points higher than the correlation implied by investment grade 0-3% tranches. A tightening of spreads on the investment grade equity tranche relative to spreads on the index would cause correlation to fall.