Tranches may be a better tail hedge than options, says Morgan Stanley

Investors should consider using standard tranches on the high yield credit index as a tail-risk hedge, rather than buying credit options, says Morgan Stanley in its latest Credit Derivatives Insight report. The bank's analysts point out that buying a 25-100% tranche on the current series of CDX NA HY provides the tranche equivalent of an out-of-the-money put. In an extreme scenario akin to 2008, when the equivalent tranche widened to 950 basis points, the tranche could provide 18 points of upside. By contrast, a November expiry out-of-the-money put, priced at 117bp for a 76 strike, provides only 11 points of upside in the same scenario.

Furthermore, the tranche is not as time sensitive as the put, which would miss any sell-off that happens after the November expiry. On the other hand, the tranche has further to fall in a rally than the option, where the maximum downside is simple the 117bp premium.