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The focus for credit risk is soon to shift away from bank failures and financial collapse to corporate debt defaults, but derivatives investors are struggling to find a way to bet on that expectation.
The Markit iTraxx Europe index of investment-grade credits, which includes big bank names, has been centre stage so far in the crisis as an indicator of systemic risk. It has proven more volatile than the iTraxx Cross-over of mostly "junk"-rated corporate credits.
But many analysts say the Crossover will come to the fore and become more volatile as a key indicator of default concerns, or idiosyncratic risk.
Soren Willemann, a credit strategist at Barclays Capital, expects to see "a transition from systemic to real, fundamental risk" that will push out spreads on the Crossover index. "But when that is going to happen is not at all clear."
Defaults are hard to time and could take as long as six months to materialise in Europe.
The investor who buys protection now on the Crossover is taking a significant risk that short-term events and technical factors could lead to rallies, said a strategist who did not want to be quoted.
What's more, going short in Crossover hurts if the bet takes time to pay off, because it is relatively expensive.
Conviction
The investor must pay much more for the trade each year, currently more than 480 basis points, than on the Europe index at around 85 basis points.
"To buy protection on the Crossover you have to have conviction," the strat-egist said. "There has to be something big - real, fundamental bad news on companies - before I would switch to that index."
Early in 2007 many people who expected a downturn in the credit cycle went short on the Cross-over and long on the Eur-ope index.
"Many investors lost money on this," Willemann said. Having been burned once, "many people are wary of going into these trades again."
One reason for continued caution is that banks are likely to take more writedowns and losses and still need to raise capital, generating lingering fears of some systemic risk.
Buying options could be one way to make a longer-term bet on Crossover volatility.
"It would be good at this point to take a 12-month payer" on the Cross-over, said Benjamin Herzog, a quantitative strategist with Societe Generale in Paris. This gives the investor the right to buy protection on Crossover at a certain fixed price.
"The problem is that you won't easily find long-term options," he said. Most current options expire in September, when the iTraxx indexes roll to a new series.
After the roll, options may become available on the new Crossover that extend to March or even June 2009 depending on market conditions, Herzog said.
"We'll see if it's a good strategy to play in September," he added.
For now, Willemann and Barclays strategists Rob Hagemans and Matthew Leeming recommend using options on the Europe index, which are more liquid, for another play on volatility.
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