By Eric Burroughs
NEW YORK, Nov 17 (Reuters) - An ever-popular way of playing the credit markets is to make relative value bets based on the performance of a company's bonds compared to its credit default swaps or using those spreads for new strategies -- what's known as basis trades.
Basis refers to the difference in spread between two companies' default swap spreads, or the valuation of one company's bond spreads compared with the default swaps.
Credit analysts at Citigroup offered some alternatives when the default swap spreads of certain companies seem to be priced too low relative to the corporate bonds based on historical patterns.
To take advantage, an investor or speculator would buy protection in default swaps of the company in question -- the equivalent of selling a bond -- while also buying the cash bonds. Such a trade bets that the default swap spread will widen relative to the cash bond.
Citigroup analysts Glen Taksler and Jure Skarabot in a research note looked at a few companies potentially offering relative value through credit default swaps and bonds: Raytheon, Disney, ILFC, CIT Group and Time Warner.
By converting the cash corporate bond spreads to something more comparable to default swap spreads, the two strategists found that of those companies and their analysis, Raytheon and Disney seem most susceptible to playing such a trade.
The difficulty is that such a trade has "negative carry" to begin with, meaning an investor or speculator would have a money-losing position when first stepping into the trade.
The Citigroup analysts also offered a trade on the relative value of the default swap spreads and cash bonds of two different companies with a similar profile: International Lease Finance Corp., which is owned by AIG , and CIT Group .
The report noted Citigroup's credit analyst Dave MacGown recently saying ILFC owns the youngest and highest-quality aircraft felt and its balance sheet has more flexibility than CIT's, while CIT's fleet is older and as a result the company many suffer valuation impairments in future earnings.
For that reason, ILFC's default swap and bond spreads should trade 5 basis points to 10 basis points tighter than CIT's spreads. But ILFC's bond spreads are currently 6 basis points wider than CIT, while their default swap spreads are about the same.
Another popular basis trade involves buying a longer-maturity corporate bond of a company and then buying default protection for five-years in a notional size larger than the amount of bonds being held, said Alex Reyfman, global head of credit derivatives research at Bear Stearns.
Though such a position usually involves negative carry, "large increases and decreases in spread will produce large payoffs. It's like buying volatility," Reyfman said.
Such a position would have been a good one to take on a name like Ford Motor Credit, Ford's finance arm, before the recent Standard & Poor's ratings announcement, which offered a lot of opportunity for volatility, he said.
And volatile it was. After S&P put Ford's rating on review for a cut in late-October, Ford's standard default swap spread blew about 70 basis points wider to about 290 basis points. When S&P cut the rating last week but issued a stable outlook, Ford's spread rallied all the way back to 210 basis points.
"People are still looking at those opportunities," Reyfman said. For related credit market news and data, please click on the symbol:
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