Look to tranches to play the double-dip flattener, says Citi

Credit curves should be flatter, say Citi in a recent research piece. In a report entitled TotalCredit: HY Curves Flattening, the bank says that the difference between three and five year spreads - 100 basis points at that time - is much greater than last time the credit markets priced in the possibility of a double-dip recession (in early 2010).

Citi acknowledges that many investors are reluctant to put on curve flatteners because of the large bid-offer cost on both sides of the trade. It suggests that high yield index tranches provide an alternative way to express the same view with relatively better execution. It suggests a flattener on the 15-25% tranche of the old CDX NA HY series 10 index, a tranche that currently trades 500bp steep. The tranche is actually a 4-15.5% tranche as a result of 13 previous defaults, and is therefore sensitive to some of the widest names in the high yield universe, such as Hovnanian, Eastman Kodak and TXU - precisely the credits that are most likely to go inverted.

The research note suggests putting on an equal notional flattener by buying "five-year" protection (maturing in two years) on the tranche and selling at the theoretical seven-year point (maturing in four years). Based on mid prices of 87.5 and 63.75 respectively, the trade would have a 23.75 point positive carry.