The latest rise in volatility in Euro markets has spread through the markets causing a severe re-pricing in sovereign bonds and pushed equity markets significantly lower. In this environment credit has been extremely resilient with spreads tightening further. We all know that higher the beta, the better the spread performance.
Going forward we look ahead to high beta sectors and HY to remain the best performers as they offer the higher yields, better breakevens, higher carry and more spread tightening potential.
One should compare the implied volatility of a particular underlying currency with its own range and it is erroneous to compare implied volatility of 2 different crosses and concluding a currency with lesser volatility as cheaper currency.
The volatilities implied by credit index options have risen across the board in Europe over the past two months on concerns over Greece. Meanwhile, credit spreads have remained stable, and realized volatility has decreased on all indices. The volatility skew has increased on credit indices and is particularly high for the Main and the X-Over which indicates higher risk aversion priced by credit options.
Buy US CDX High Yield protection against EUR X-Over protection:
The risk associated Euro is largely exogenous and is connected to Grexit and Brexit. UK and side-line debt represent almost half the names in the European index, so these risks are serious. So far however neither bad news on Greece nor the UK elections have driven spreads wider.
We recommend investors a Buy $100m CDX high yield protection at 346 bps and sell EUR 90m of ITRX X-Over protection at 344 bps.
We remain bullish on credit in both the US and Europe over the year as a whole. However we suppose that the contraction in Europe will outpace the tightening in the US, and capital gains on long European positions will more than offset the small negative carry on a switch.
