Ellington is bearish HY credit

http://www.valuewalk.com/2015/11/ellington-management/

“There is a silver lining to all this doom and gloom,” the hedge fund writes. “Despite all of these warning signs, the window of opportunity is still wide open, with market prices and implied volatilities now back around where they were before the market swoon during August and September.” In particular, the fund looks to

Ellington cites opportunities in single name credit default swap derivatives, with a particular mean reversion trade in mind.

The S&P LSTA Leveraged Loan 100 Index, which is a total return index designed to track the performance of the largest institutional leveraged loans, has declined almost 5.9% since June, while the CDX HY S24 index has declined by only 0.1%. These indices, which measure similar risks, tend to move in tandem. Most of this divergence has taken place since late September. In October alone, CDX HY S24 returned 3.5%, compared to -0.6% for the S&P Leveraged Loan 100 Index. This outperformance coincided with by far the strongest month ever for high yield ETF flows.18 Using single-name CDS data, we are able to separate out the components of this outperformance since June to better understand whether we think it will revert. Nearly a third of this outperformance (1.23% of the 4.05% difference) is a move in the basis between the CDX HY index and its constituents.

Ellington calls the move “purely technical, reflecting an unusually large premium at which CDX HY currently trades to its constituents.” The differing trading levels “has historically mean-reverted, especially when the basis is greater than 1 percent of net asset value.” Today the variance stands at to 2 percent of asset value. The conclusion the report makes is “two factors are at work: not only has single-name CDS outperformed the leveraged loan market, but the CDX HY index has outperformed single-name CDS.” When prices mean revert from their historical averages, a counter trend is often anticipated, particularly when fundamental performance drivers haven’t materially dislocated. “The price differential creates a large wedge between CDX HY and leveraged loans, which supports our thesis that synthetic corporate credit is especially overpriced today.”