Tranches show Dubai-driven systemic risk spike, says BofA Merrill

In its latest credit research, Bank of America Merrill Lynch examines the heightened risk aversion across markets on fears of contagion from widening in Dubai CDS spreads. The move follows news that the Dubai government has authorised the restructuring of entity Dubai World, leading to creditors of the latter being asked to agree to a standstill agreement. As a consequence, spreads on iTraxx Europe and Crossover are circa 7bp and 24bp wider on the week now, retracing back to early October levels.

As credit markets determine the inter-market implications, iTraxx index tranches indicate that systemic risk among European corporates is on the rise, say analysts. Over the week, 0-3% longs would have made a significant 1% across tenors versus delta, with implied equity tranche correlation now 3.5% up from its early November series nine low. This positive performance has come at the expense of more senior tranches, with five-year super-senior around 0.7bp wider delta-adjusted.

The scale of the move was initially surprising. Since the default of Lehman Brothers, it has been customary for junior tranches to widen (and hence senior spreads tighten) vs. quoted deltas in periods where credit has traded softer. This is largely because of quoted deltas to the index assuming uniform moves in underlying credits, not accounting for the typically higher beta of wider constituents.