High-grade corporate credit spreads are likely to appear a lot tighter later this month, and some strategists on Friday said that may be a good time to short the market.
Dow Jones on September 20 will recreate its widely followed high-grade CDS index of 125 credits. Eight names, including GM's General Motors Acceptance Corp and Ford's Ford Motor Credit, are expected to be tossed out because they fell to junk status in recent months, based on either Moody's Investors Service or Standard & Poor's.
The index is recreated every six months to keep its maturity at or near five years. That is also the time when fallen angels are removed and replaced with other generally tighter-spread high-grade names.
The new high-grade index may be a more appealing short for some investors because it will consist primarily of names that already have tight spreads, with less ability to tighten further, said Michael Johnson, director of credit research at BNP Paribas in New York.
"On a risk-return basis, I would rather short the new index than the old one," Johnson said. "It will also be a cheaper short."
In general, the index is widely traded as a proxy for the high-grade credit market.
"Absolutely, it may make sense to short the new index," said Gregory Peters, head of credit research at Morgan Stanley. "There are a lot of risks and uncertainties arising, such as the effects from the hurricane."
Spreads across the fixed-income landscape are historically tight now, Peters said. "That will ultimately unwind," he added.
The other six names that are expected to drop out of the index are Lear Corp, Eastman Kodak, Liberty Media, Maytag Corp, Sears Holdings' Sears Acceptance and Kerr-McGee Corp.
Sixteen participating dealers vote on which high-grade credits might be used as replacements.
Dow's current high-grade index reflected a 50.98 basis point spread on Thursday, near its recent average level.
It is difficult to predict the difference between the new and old index because the old index sometimes will begin to trade in anticipation of the new index's expected level, an analyst said.
In an August 30 research note, Lehman Brothers said the intrinsic spread on the new index may be about 5 basis points tighter than the existing index. After adjusting for maturity differences, the difference may be 1 to 2 basis points, Lehman said.