Source: B&B Structured Finance Ltd |
Single name credit default swaps can be used as part of a large range of relative value trading strategies. Among the simplest are basis trades. This strategy is designed to take advantage of the difference (the basis) between credit default swap spreads and cash bond or loan spreads for the same credit.
A trader puts on a negative-basis trade when the credit default swap spread is lower than the spread over Libor on a cash asset, allowing the trader to buy the bond, buy protection on the issuer of the bond and earn a positive net spread (this surplus is referred to as positive carry).
The trader either buys a floating rate asset or a fixed rate bond that has been asset-swapped into a floating rate instrument paying a spread over Libor. This trade carries no credit risk and the trader is able to earn a positive spread for taking advantage of the CDS-bond basis.
Because of the bid-offer spread, negative basis trades tend to be worth putting on only when the basis exceeds around 10bp. These opportunities have become increasingly rare as the trade has become well known.
Other single name trading strategies include convergence trades where a trader believes that the difference between the spreads of two names will decrease.
For example, if Renault spreads are wider than Peugeot spreads, and a trader believes their credit risk is very similar, the trader could sell protection on Renault and buy protection on Peugeot, expressing the view that their spreads will converge and making a gain on the overall trade. Another strategy is to sell protection on one name whose spreads the trader believes will tighten, and to use the income to buy protection on another name whose spread the trader believes will widen.
Source: B&B Structured Finance Ltd |
For names where there is a liquid market in both senior and subordinated credit default swaps (chiefly financials), traders can use single name credit default swaps to bet that the reference entity’s subordinated debt will outperform its senior debt – or vice versa – without taking an outright view on the creditworthiness of the borrower or the direction of its spreads.
The emergence of a liquid market in seven and 10-year credit derivatives, starting around 2005, has made it possible for traders to express views on spreads at different points on the credit curve (called curve trades) using single name credit default swaps. These strategies express a view not just on the likelihood of default, but on the timing of any possible default.
A popular curve trade in 2005 and 2006 has been a curve steepener. A trader who believes that an issuer’s long-term credit spreads are likely to widen relative to shorter-term spreads, causing the credit curve to steepen, might sell five-year protection and buy 10-year protection on the name, making money when five-year spreads tighten, ten-year spreads widen or some combination of the two effects. A curve flattener is the opposite bet – that spreads at different maturities will converge.