Market Economics | Interest Rate Strategy - BNP PARIBAS ...

What’s the call?
It is relatively hazardous to take a view in this market;
the underlying trend remains negative for the
weakest members of the Eurozone and for the EUR
currency which does not bode well for SOVX and
MAIN as well as for FIN SEN and SUB indices. That
being said, a lot of efforts are made by officials to
stop the bleeding and a momentarily snapback is
very likely to come in the next days.
For us, the index which should continue to
outperform is XO as it should remain relatively more
immune to developments in PIIGS. We nevertheless
note that some High-Yield names like Irish Eircom
and Spanish Codere, ONO and Sol Melia have
recently underperformed the market.
All in all, we continue to expect the XO/MAIN ratio to
decrease and see the risk/reward of the “Long risk
XO / Short risk MAIN x5” trade, which is a disguised
bearish call on MAIN, more attractive than an outright
short on MAIN.
Update on FIN SEN vs. FIN SUB
It is probably the pair trade on which we have the
highest level of conviction given (1) its very attractive
entry level and (2) its relative lack of directionality.
Regarding the entry level, we view a very favourable
risk/reward in the decompression trade at x1.50. The
downside is probably limited to x0.10 while its upside
can be as high as x0.30 if the ratio catches up with
SUB/SEN levels prevailing when the SEN index was
trading in the 130-150 range.
Moreover, the widest member of the basket (BESPL)
is already trading at a SUB/SEN ratio of x1.17, a 2-
year historical low and an already very compressed
level where hedgers could start thinking about buying
SUB protection rather than SEN keeping in mind that
all the debt deliverable into the SEN CDS can also
be delivered into the SUB. That being said, UK
single-names RBS and HBOS, with SUB/SEN ratio
between x1.6 and x1.7 have some room to compress
further.
Regarding directionality of the trade, the long-term
history of the ratio has shown that the SUB/SEN ratio
is a non-directional play. It is evidenced on Chart 3
which displays the value of the SUB/SEN ratio
against the absolute level of the SEN index. It is less
valid if we consider the past month (orange dots on
Chart 3) which shows a relatively resilient regime in
which the SUB/SEN ratio decreases as the SEN
index widens and inversely. The very basic
explanations for this new regime are 1/ hedging
needs are putting more pressure on SEN CDS than
on SUB CDS and 2/ the slight outperformance of LT2
vs. Senior in cash (2-week spread changes of iBoxx
LT2 and SEN indices of 20% and 23% respectively).
What’s the call?
Chart 3: SUB/SEN Ratio vs. FIN SEN in Past 12
Months
-
SUB/SEN ratio
2.20
2.10
2.00
1.90
1.80
1.70
1.60
1.50
2.0
1.9
1.8
1.7
1.6
1.5
y = -0.0026x + 1.8623
1.4
35 55 75 95 115 135 155
FIN SEN
12M-3M
3M-2M
Chart 4: SUB/SEN in Past 4 Years
iTraxx Sub / Sen (s13)
Q1 (6m)
Median (6m)
Q3 (6m)
1.40
12/05 4/06 8/06 12/06 4/07 8/07 12/07 4/08 8/08 12/08 4/09 8/09 12/09 4/10
Chart 5: 1.5 x FIN SEN – 1 x FIN SUB History
20
-20
-40
-60
-80
-100
-120
-140
09/08 11/08 01/09 03/09 05/09 07/09 09/09 11/09 01/10 03/10 05/10
Source: BNP Paribas
The attractiveness of the entry level prompts us to
jump in the SUB/SEN decompression trade (Long
risk EUR15m SEN vs. Short risk EUR10m SUB). At
the time of writing, entry levels are 160 for SEN and
235 for SUB. Starting from these levels, we see
about 20bp potential in the trade.
Update on XO vs. MAIN
We have been pushing the outperformance of the
XO index relative to the MAIN since the beginning of
April (8-Apr) via a compression trade “Long risk XO /
Short risk MAIN x5”. The trade is now 85bp in the
Last
1M
Pierre Yves Bretonniere 7 May 2010
Market Mover Non-Objective Research Section
55
www.GlobalMarkets.bnpparibas.com