Creditflux - Credit Hedge Funds Step Up Tranche Trading As Cdos Make Comeback

March 2012

March 2012

Correlation desks have seen a jump in demand for structured credit exposure as high potential returns and greater risk appetite have prompted renewed interest in portfolio credit risk.

Funds including Cheyne Capital, BlueMountain and Chenavari are increasingly active traders of the tranche space, using indices and bespoke portfolios in strategies reminiscent of the pre-crisis love affair with CDOs. Besides these veteran structured credit specialists, other hedge funds without any prior involvement are also said to be becoming more active. Potential returns are large, with iTraxx series nine June 2013 equity tranches paying around 35 points upfront plus 500 basis points running, for example.

"We are finding increasing demand from investors looking to liquidate corporate bond portfolios with low absolute levels of return and position just the high quality credit risk in a leveraged format," says John Weiss, co-head of corporate credit at Cheyne Capital.

"Our focus is on constructing bespoke credit portfolios and actively managing the underlying to avoid losses from defaults and generate positive alpha."

Cheyne generally uses 0-3% or 0-6% equity tranches referencing portfolios of 125-175 diversified corporate credits that are around 80-85% investment grade with the remainder being crossover.

"We use the tranche technology as a mechanism to lock in term financing for the credit portfolio," says Weiss. "This is the only market where you can efficiently leverage 97% of a portfolio to maturity with absolutely no risk of additional margin calls or forced liquidation."

Despite the fact that some dealers have exited the correlation market, there are still a number of market makers that manage substantial correlation books and provide good liquidity on index tranches and bespoke tranches up to maturity dates of around 2017.

Away from the bespoke space, dealers have seen rising index tranche activity over the past couple of months.

"We have had enquiries from investors from the old days, who have been out of the market for two years and are looking to get back in," says Abel Elizalde, a credit derivatives strategist at JP Morgan in London.

by: B2B Strategies

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