Deutsche Bank has been marketing a suite of credit volatility structures to distributors since early June and the lucky investors that bought into these products are now walking away with returns that range from 15% upwards on a one-month investment thanks to the timely July spike.
Credit spreads on the five-year iTraxx Europe index of credit default swaps (CDS) started July at about 25bp, widened to about 36bp by July 25 and then sky-rocketed to almost 70bp by July 30. A classic credit spike and exactly the kind of behaviour that Deutsche's spread wideners anticipated, though even they would concede that the sudden vindication of the strategy was a bit of a surprise.
"It proved to be a timely trade", says Olivier Destandau, a director in the institutional client group.
The team at Deutsche started with the initial idea of how to protect private banking clients, who have enjoyed very nice returns on their equity portfolios this year, from a spike in volatility and a market downturn.
"We looked at buying volatility through the VIX market but the forward markets were already a bit high so it was pretty expensive," says Destandau. "So we looked at the iTraxx high-grade index, which had been stable for most of the year at 20-30bp. We thought that would be a pretty good way to diversify and to enter into a cheap hedge in case the market turned down."
Of course, that turned out to be an inspired trade and one that few private bank clients had been offered before. In the past, investors who wanted a hedge against a credit spike had to buy credit default swaps or CDS-linked products, but the growth of the credit spread options market has provided a much more flexible tool.
"What we're now able to do is take the volatility in a credit spread and monetise it for clients," says Stefan Masuhr, a director in Deutsche's credit structuring team. "That's something which was absolutely impossible a year ago because credit spread options were in their infancy."
Because the market is now more developed and liquidity is high enough to make the trades practical, banks can now embed these options into principal-protected structures that allow investors to take a view on credit spreads, but without having to bet against corporate defaults. "It is quite a fundamental change," say Masuhr.
The spread widening trades that Deutsche put together came in three flavours: a basic widener, a capped widener and a widener that knocked out in the event of a default on the index. All three are one-year principal-protected structures referencing the five-year iTraxx Europe index.
The basic widener, put simply, is a bet that spreads will widen by at least 35bp compared to the current market level during the 12-month period. Investors get paid the leveraged difference between the widened spread and the strike û at the moment leverage of up to 18 times can be achieved. By adding a cap on his coupon the investor can achieve more leverage. In the current market, these trades are capped at about 12%, but were paying 15% before the current widening, with a leverage of 25 times.
Finally, investors who are comfortable betting against corporate defaults can go for the knock-out option, which also allows them to take advantage of greater leverage, up to 25 times. Like the basic wideners, these trades have a 35bp strike price but will knock out the coupon and only pay back the principal if any of the names on the index default.
All the trades were modelled on the credit spike caused by the downgrades of Ford and GM in May 2005, when spreads widened from a steady 30bp level to 60bp. The basic idea was to build a product that would pay out if spreads spiked like that again, which is exactly what happened in July.
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