Morgan Stanley Joins JPMorgan in Recommending Swap Flatteners

JPMorgan Chase & Co. and Morgan Stanley are recommending investors take advantage of a record difference between the cost of short- and long-term bond insurance to hedge against Europe’s debt crisis reigniting.

It costs 44 basis points more to insure investment-grade corporate debt for 10 years than it does to buy five-year protection using the Markit iTraxx Europe Index of credit-default swaps. The gap reached 46 basis points last week and is up from five basis points at the start of 2012.

Investors can profit by buying short-dated contracts and selling longer-end protection in a so-called curve flattening trade, according to the New York-based banks. The difference between near- and long-term insurance costs has been becoming increasingly exaggerated since August, after European Central Bank President Mario Draghi vowed to do whatever’s necessary to protect the euro.

“Credit volatility and curve flatteners remain our preferred hedges,” Andrew Sheets, the head of European credit strategy at Morgan Stanley in London, wrote in a note. “The greatest risk to European credit remains a return of sovereign-led systemic risk.”

Long-term debt insurance typically costs more than short-dated protection, though Draghi’s support for the European single currency has increased the gap, or steepened the credit curve. The spread between three- and five-year default protection is also near the widest ever, at 42 basis points compared with 12 basis points in September 2011, data compiled by Bloomberg show.

Curves Inverted

The relationships became inverted at the peak of the global financial crisis in 2008, when it cost 31 basis points more to insure bonds for three years than for five, and 38 basis points more for five years than for 10. Those inverted yield curves signalled that investors perceived default risk as imminent.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A basis point on a contract protecting 10 million euros ($13 million) of debt for five years is equivalent to 1,000 euros a year.

“People are overly comfortable with short-dated risk,” said Saul Doctor, a strategist at JPMorgan in London. “Flatteners at the moment are an inexpensive hedge.”

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