Investors poured into the LCDX index during its first days of trading last week, as hedge funds jumped at the opportunity to short the leveraged loan market and dealers looked to hedge exposure. Trading volume in the LCDX index reached $11.1 billion on Tuesday, when it was unveiled, according to Markit Group.
By Wednesday's close, investors had pushed the LCDX index to 100.53. Although it had traded downward from Tuesday's close of 100.63, a fundamental view on initial pricing points to a more bullish perception of corporate credit risk.
The introduction of the LCDX index - nearly a year after single-name LCDS began trading with standardized documentation - is widely expected to boost liquidity in both the synthetic loan sector and in secondary leveraged loan and CLO trading.
Among the key players expected to implement trade strategies on the LCDX are CLO warehouse managers, and dealers looking to hedge accumulated risk stemming from a surge in outstanding syndicates. Of course, those looking simply to make relative value trades are expected as well. Nearly all market participants last week expected hedge fund involvement in the majority of trades.
"Hedge funds have continuously looked at this market as a way to gain accessibility," said Alan Alsheimer, executive director at Goldman Sachs, speaking during a Markit-hosted conference call on Monday.
As was - and in some cases still is - the case in the HEL sector, there was much speculation last week regarding what effect the expected increase in LCDS trading will have on cash leveraged loan and CLO spreads. Those active in the cash leveraged loan and CLO markets are largely different from those, such as hedge funds, expected to dominate the LCDS market. But most analysts last week predicted spillover effects on pricing.
Spreads to be determined
As of last week, the jury was still out as to how exactly cash spreads would react. And the introduction of tranched LCDX trading expected in mid-to-late June added yet another unknown.
"Overall, we think markets will segment, with real money accounts focusing on rated CLOs, and fast money' accounts - hedge funds, prop desks, etc. - relatively more involved in non-rated index trading," JPMorgan Securities analysts wrote last week. Aside from technical spread impacts from relative value trades, market participants and JPMorgan analysts pointed out that hedge fund types make up between 20% and 40% of the CLO equity and cash-loan markets, a factor which will also influence spreads.
Market participants discussed a handful of potential trading strategies last week. Because the index comprises 100 equally weighted names, one of the most natural trades would be to go long on the index and short on a handful of specific names, Alsheimer said. Since each name is equally weighted, one loan defaulting would have a relatively benign effect on the index. Alternatively, an investor with a bearish view on corporate credit could go short the index and long on a handful of names.
In terms of hedging for CLOs, the index could be useful, given the comparable credit quality of the two products. However, CLO collateral is generally more diverse than that of the index. According to JPMorgan, 56 of the top 100 credits underlying a sampling of 93 U.S. high yield CLOs from 2006 were present in the LCDX, but those 56 names only made up an average 24% of the CLOs' collateral pools.
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