Tranches show rising fears of a systemic event, says Citi

Investors are increasingly concerned over the chances of a systemic event in the coming months, price action in structured credit markets suggests.

Tranche markets, a barometer of tail risk,  indicate rising systemic risk fears, with the distribution of expected loss shifting to senior parts of the capital structure in recent weeks. The relative loss distribution is 70% in mezzanine and senior tranches and 30% in equity, compared with a 60/40 proportion in May of this year. That means that expected loss in equity is declining relative to its senior counterparts. The spread of loss distribution is at its widest level since 2008, according to a research note published by Citi today.

"There is increasing concern over the euro zone, both in terms of the chances of a Greek default and the contagion effects we are seeing in places like France and Austria," says Pierre Bou Abboud, an analyst at Citi. "We suggest continuing to maintain hedges or a short bias."

The cost of protection on iTraxx Series 9 22-100% five-year tranches is now 17.3 basis points, compared to as low as 13.4bp on 11 November, according to Citi.

Credit options prices also suggest investors are keen to take risk off the table, with three month at-the-money implied volatility remaining elevated at an expensive 84%. 

Investor looking to protect against downside risk may consider entereing a risk reversal options trade, Bou Abboud says, which is volatility neutral and benefits from current low levels of skew. Risk reversals are cheaper than outright short positions and pay out when spreads widen or stay steady, but lose if the market rallies strongly.