If the London Whale trade was selling CDS in tranches and in whole on IG9 and then more, and then more in an attempt to corner the entire market and then crashing and burning spectacularly due to virtually unlimited downside, Goldman’s top trade #5 for 2014 is somewhat the opposite (if only for Goldman): the firm is inviting clients to sell CDS on the junior Mezz tranche (3%-7%) of IG21 at 464 bps currently, where Goldman “would apply an initial spread target and stop loss of 395bp and 585bp, respectively. Assuming a one-year investment horizon, the breakeven spread on this trade is roughly 554bp (that is, 90bp wider than where it currently trades).” In other words, Goldman is going long said tranche which in an environment of record credit bubble conditions and all time tights across credit land is once again, the right trade. Do what Goldman does and all that…
From the full report:
Top Trade Recommendation #5: Go long risk on 7-year CDX IG21 junior mezzanine tranche
- Today we reveal our fifth Top Trade recommendation for 2014: Go long risk (sell protection) on the 7-year CDX IG21 junior mezzanine tranche.
- The tranche currently trades at a spread of 464bp.
- We set an initial spread target of 395bp, and a stop loss of 585bp.
- The trade is designed to benefit from several of our key credit themes for 2014: carry, low volatility and roll-down.
- The key macro risk to this trade would be a less friendly mix of growth, inflation and policy than we expect…
- …which would push volatility and risk premia higher.
- On the micro side, balance sheet re-leveraging remains our top risk for next year
We recommend going long risk (selling protection) on the 7-year CDX IG Series 21 junior mezzanine tranche (the 3-7% portion of the loss distribution). As of yesterday’s close, selling protection on the tranche involves receiving an upfront payment of 22.5 points and an annual coupon of 100bp, which is equivalent to a running spread of roughly 464bp per year (see Section 5 below for a brief description of the mechanics of index tranches). We would apply an initial spread target and stop loss of 395bp and 585bp, respectively. Assuming a one-year investment horizon, the breakeven spread on this trade is roughly 554bp (that is, 90bp wider than where it currently trades).
In addition to an annualized carry of 464bp, our spread target would imply potential mark-to-market gains of roughly 350bp over the course of the year. Assuming no default losses on the tranche, our spread target translates into unlevered, annualized returns of 814bp. Note that the zero loss assumption is not unrealistic considering that the maximum 1-year investment grade loss rate over the past 40 years was 0.36% in 2008, according to data from Moody’s. Our own forecast for the 1-year BBB loss rate also barely exceeds 10bp.
The trade benefits from carry, roll-down and low volatility
The trade is designed to capture several of our key credit themes for 2014:
- A carry-friendly world. As we discussed in our 2014 Global Credit Outlook (see “A carry-friendly world,” Global Credit Outlook 2014, November 22, 2013), we think credit carry strategies remain attractive relative to many sources of risks, such as defaults, downgrades or potential shifts in market sentiment. With ‘plain vanilla’ credit assets trading at their post-crisis tights, we also expect demand to rotate to more complex assets that can offer incremental carry, such as the junior mezzanine IG tranche.
- Low macro volatility. The choice of a tranche that is relatively low in the capital structure is partly informed by our view that macro volatility is likely to continue to hover around current low levels in 2014. In our view, the friendly macro mix of growth, inflation and policy that we envisage should help keep volatility and risk premia at low levels. More importantly, the risks to this benign view look balanced to us. On the growth side, we think the scope for a growth ‘melt-up’ (or melt-down) remains limited by constraints on credit growth (while the risk of a melt-down has been reduced by de-risking and de-leveraging). On the inflation side, we expect inflation to stay below the Fed’s 2% target until the economy comes closer to full employment. Owing to the evident difficulty of pushing growth and inflation to levels consistent with full employment, we expect monetary policy to remain committedly dovish (more on this below). All in all, this should anchor macro volatility.
- Roll-down and spread duration. Even though total returns on synthetic credit instruments are ‘technically’ not directly linked to movements in rates, they are nonetheless sensitive to broad ‘duration risk’ repricing. In contrast to many investors we encounter who are worried about the risk of a ‘rate shock’ in 2014 as large as 2013, we expect the 10-year to be at 3.25% by year-end.
The asymmetry of our initial spread target and stop loss of 395bp and 585bp, respectively, reflects the ‘right-skewness’ of spreads at this stage of the cycle. It also reflects our view that 2014 is likely to remain a credit carry-friendly environment featuring better growth, low inflation, low volatility and accommodative monetary policy.
In addition to being long spread duration, the trade is also designed to benefit from a curve ‘roll-down’. More specifically, the 395bp target embeds roughly 45bp of roll-down as the original 7-year contract will become a 6-year contract a year from now, in addition to a modest 24bp of ‘pure’ spread tightening. The 45bp roll-down assumes that the 7-year spread will ‘roll’ towards the current 6-year contract (which we proxy by the December 2019 CDX IG Series 19). The 24bp of ‘pure’ spread tightening is consistent with our forecast of modest spread tightening for the broad IG market. Finally, the rather wide stop loss, 585bp, is meant to allow for transitory shocks, our benign view on the fundamental drivers of volatility notwithstanding.
Two key risks: An unfriendly mix of growth, inflation and policy, and re-leveraging
The first risk to our trade recommendation is that the mix of growth, inflation and policy turns out to be less friendly than we expect, and thus pushes volatility and risk premia higher. There are two possible drivers for such an outcome. First, spreads could widen in response to QE tapering. We would view this as an opportunity to add risk, since our baseline view is that QE tapering is likely to be accompanied by a much more dovish dose of forward guidance. But the task of communicating this new policy mix to the market may be complicated by the market’s temptation to equate ‘tapering’ with ‘tightening’. In our view, it will most likely make sense to fade spread widening due to fears of policy tightening, provided of course that the underlying macro conditions remain visibly intact (hence our rather wide stop loss).
A second potential macro catalyst for higher volatility and risk premia is concern over earlier-than-expected rate hikes in response to either better growth or higher inflation. While such ‘bouts of fear’ are possible, in our judgment major central banks are likely to try and counter them, since most developed-market economies are still struggling to generate enough aggregate demand to close their output gaps and restore growth to pre-crisis trends. Fiscal headwinds in many economies are set to ease (Japan excluded), and monetary policy in these economies should remain very accommodative. In short, growth should improve, and we consider it an acceptably low risk that the Fed will need to hike earlier than expected in response to either better growth or higher inflation than we forecast.
On the micro front, corporate balance sheet re-leveraging is our top risk for 2014 (just as it was for 2013). A key risk to our trade is therefore a significant increase in idiosyncratic risk beyond what’s currently priced in. As we have discussed on several occasions, we expect better growth over the next few quarters to flow through to top-line growth and earnings (a trend that is already evident), and we think this will help stabilize and perhaps even reverse some of the recent trends in debt-to-EBITDA ratios. And we remain sceptical of the popular concern that corporate leverage could rise sharply simply because corporate bond yields are low. That said, the idiosyncratic risk of ‘active’ re-leveraging remains high for some firms and sectors due not only to low bond yields but also to struggling ROEs and activist shareholders, and especially for companies that have underperformed their peers.
Credit tranches 101
Tranches allow investors to gain exposure to a particular portion of the index’s loss distribution and are defined by attachment and detachment points (3 and 7%, respectively in the case of our trade recommendation). Losses affect the tranches according to their seniority in the capital structure. An investor who sells protection on the 3-7% tranche is only responsible for cumulative losses between 3% and 7% of the index (125 names in the case of CDX IG). In other words, once cumulative losses reach the 7% detachment point, the tranche notional is exhausted.
Upon each credit event, the tranche notional is reduced by the incremental loss amount. For example, assuming a first default occurs with a recovery rate of 40% (loss-given default of 60%), the equity tranche (0-3%) is adjusted for the reduced notional to ($1-60%/125 or 99.52 cents). The equity detachment point is now 2.986% (99.52% times 3%). The original notional of the other tranches remains unchanged but now has a smaller cushion against further losses.
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