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Feeling Flat? Blame Commodities

06 October 2015 by lberuti

The risk premium curves of investment grade credits are typically concave, with an inflexion point at 5 years. The curves are flatter on the longer end, and steeper at the shorter end. Curves are also usually behaving homothetically, and the 10 year risk premium expressed as a percentage of the 5 year risk premium is usually a very stable number. But that only holds for “reasonable” moves, and whenever a name widens substantially it comes a point where the curve flattens (otherwise the long dated risk premia would imply a near certain default) and for the most extreme situation it even inverts. This is exactly what happened with the commodity related names (AALLN and GLEINT on the above grapple) and VW. These names explain most of the recent widening of iTraxx Main S24 (ITXEB24). They also explain why despite its moderate widening, ITXEB24 has not behaved like a typical investment grade credit. It has not steepened but rather flattened over the last 10 days. The 5 year 10 year risk premium curve of ITXEB24 has gone from 38bps (with a 5 year at 76bps) when the series 24 was launched to 34bps (with a 5 year at 86bps) yesterday.