New York: Underneath the surface of a burgeoning calm in credit markets lies a fat-tailed monster: Options traders preparing for a sell-off that would spark a surge in risk premiums to levels not seen in two years.
Spreads in the cash market for US corporate bonds have begun to reduce, tracking a relief rally in stocks after a tough year for the vast majority of asset classes. But fears linger in credit derivatives, with benchmark indexes implying a higher chance of a major surge in spreads.
Options on Markit’s CDX North American Investment Grade Index — a basket of credit default swaps on 125 North American companies — are pricing a 9 per cent probability of the benchmark trading at or wider than 125 basis points in the next two months, according to analysts at JPMorgan Chase & Co. That’s compared to just a 3 per cent chance back in November and would be more than 40 basis points above the index’s current level — equivalent to the highs seen in early 2016, when worries over a slowdown in China and a slump in the price of oil sent spreads soaring.
The distribution of probabilities implied by the options market is “becoming increasingly fat-tailed” which “indicates an increase in market expectation of a tail event,” JPMorgan analysts wrote in a note sent to clients last Friday.
Trading in options on indexes of credit default swaps is said to have exploded in the years since the financial crisis as investors reached for convenient tools to hedge a broad rally in credit and often complained about a lack of liquidity in the underlying cash market.
While options trading has been growing exponentially, Citigroup Inc. in September estimated volume at just 4 per cent of total investment-grade trading with the vast majority of activity still centred on cash and CDX products.