Sell December payer spreads on iTraxx Europe, says Barcap

In its Credit Strategy piece, published today, Barclays Capital recommends selling 1x2 payer spreads with a December expiry. Strategists say this provides an attractive way to the steep skew in three-month iTraxx Europe implied volatility. The bank recommends a trade which earns 11bp upfront and has positive P&L if the index is below 167bp on 15 December.

Implied volatility in iTraxx Europe options has fallen significantly since its May peak, but remains well above the levels seen before the sovereign debt crisis, as concerns around the pace of the economic recovery linger. Volatility skew has been steepening during that period and is now at the top of its two-month range. Consequently, says Barcap, it is possible to structure a 1x2 payer spread that earns positive upfront premium while offering a very wide breakeven spread.

Europe traded above 167bp only during the most violent period of the credit crisis after Lehman’s collapse, note strategists. With acute sovereign bank funding pressures alleviated to some extent, they see few catalysts for the index trading above this level over the next three months.

The trade has negative delta at inception. This means that in case of a widening before expiry, the trade could have negative mark-to-market while still being in the money.