Correlation on the five-year investment-grade Markit iTraxx Europe index — a measure of investor fears of a system-wide crash — reached new highs of 45 percent on Tuesday.
I wouldn’t describe correlation quite that way. Correlation goes up when there’s lots of indiscrimiate selling, but it’s not necessarily a function of fears of a system-wide crash. Still, it certainly looks that way at first glance.
What’s being measured here is the value of the riskiest portion of CDOs (the equity tranche), compared to the safest portion (the super-senior tranche). One might think that in a bear market, the riskiest tranches will sell off first, while there’s a flight to the quality of the super-senior tranches. And if one thought that, at least in this market, one would be wrong.
If the correlation numbers correspond to real-world conditions, then they’re essentially saying that if any companies start defaulting, then all companies are liable to start defaulting. The equity tranche is highly profitable, so long as no one defaults. And right now no one’s defaulting, so people are holding on to their equity tranches and making decent money. On the other hand, a very large number of defaults would wipe out not only the equity tranches, but also much safer tranches too. If you’re risk-averse and scared of a huge wave of corporate defaults, then you will want to be selling your nominally low-risk bonds before the default hits. In this scenario, equity tranches stay reasonably well supported, high-grade tranches sell off, correlation goes up – and journalists feel comfortable talking about "investor fears of a system-wide crash".
On the other hand, I suspect the correlation numbers actually correspond to financial-world conditions, and are a function of much more technical factors – most importantly, the fact that super-senior tranches, long the ugly ducklings of the CDO world, were generally leveraged up to their eyeballs in order to make them vaguely attractive. All that leverage made them if anything more risky than the equity tranches, and so the fire sale of super-senior tranches right now really is a flight to quality.
There’s no shortage of evidence to this effect in Baird’s article:
Over the past six months, the credit crisis and a low corporate default rate have pushed correlation up…
"It’s a matter of leverage," said UBS credit strategist Geraud Charpin…
"In a world where leverage has to come down, the pressure is on the piece that is the most leveraged, and that’s the super-senior tranches," Charpin said.
High correlation is one of those weird things which pops out of the financial markets when you get strange bedfellows such as a credit crisis combined with a very low corporate default rate. Just as currency futures don’t predict the future movement of currencies (they’re entirely a function of interest rates), the correlation figure doesn’t really measure how likely a massively-correlated simultaneous wave of defaults is. Instead, it just kind of pops out when you get forced liquidations, like we’re seeing in the CLO and CDO markets, where Everything Must Go.
In fact, if and when recession hits and corporates actually start defaulting, I fully expect the correlation percentage to plunge. Right now we’re still in generalized-fear mode, and there’s relatively little worry about specific credits defaulting. If there are a couple of defaults and the sun still rises the following morning, we might even have a substantial relief rally. But that day could be a ways off yet.