Relative Value Trading Strategies

The following strategies can be employed using either credit default swaps or cash bonds and loans, or a combination of both cash and synthetic. In some cases a specific strategy will be easier to implement using CDS. 

This is the traditional strategy that relies on picking names that are expected to outperform the market. In fund management terms, one selects a diversified portfolio of credits, which ensures that systemic market risk (beta) is hedged away, while the performance of the fund generates excess return, or alpha. Names that are expected to outperform are trading at levels that are cheap, in relative value terms, to their industry or sector class. This is measured by the asset swap spread or ASW, as we observed earlier. 

The fund manager selects a minimum of 10 or 12 credit-risky names that are expected to outperform other names in their sector. That is, the 

The other side of credit selection is to short names that are deemed to be dear or expensive. This is problematic in the cash market, as bonds have to be short-covered, and is virtually impossible in the loan market. However, it is straightforward to short a name using CDS. So in this instance, the fund manager would run a portfolio of short credits and hedge this using sold protection in the relevant iTraxx index. 

In this strategy, the fund manager runs a position in two different credits that attempts to exploit the spread differential between the two. As it is a relative value position, one name is put on long and the other short. A pair-wise spread trade can be put on as a credit carry trade, which attempts to exploit a stable spread, and a credit directional trade, where one expects the spread to widen or narrow. Generally the pair of credits will be names from the same industrial sector. 

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