Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a negative basis trade on MeadWestvaco Corp

The paper and packaging industry offers solid basis opportunities, with a few companies' CDS trading at discounts to their cash underlying. The most difficult question we face is choosing which issuer to go with.

MeadWestvaco (MWV) issued a 10-year bond back in August, which went out with a substantial negative basis. At the time, we recommended that clients buy the bond hedged with CDS. Though the negative basis has tightened since issuance, there is plenty more room to go.

Given our negative view on MWV's CDS, we believe the cash market accurately prices the company's credit risk. This will ultimately lead to further compression of the bond's negative basis.

Based on comparables, the MWV negative basis trade is the most attractive of the group. Pactiv Corp, MWV, International Paper and Weyerhaeuser bonds all trade at noticeable discounts to their CDS; however, MWV's tight CDS spread combined with its 300+ z-spread on its 2019 issue makes it the top pick (see exhibit below).

Pactiv's five-year CDS is at a similar level to MWV's (near 80bp); however, Pactiv's 6.4s of Jan 2018 bond trades with a z-spread closer to 220bp, leaving a much tighter negative basis package. We are neutral to positive on Pactiv's CDS and would actually prefer to own its bond outright rather than in a negative basis package.

On the riskier end, though IP and WY bonds trade with z-spreads roughly 50bp-75bp wider than MWV's, both companies' CDS are close to double that of MWV's. The negative basis on the Weyerhaeuser bond is roughly equivalent to that of MWV's in absolute terms; however, the lower spread issuer offers the better risk/reward characteristics.

From a fundamental standpoint, we hold a negative view on MWV's CDS spread at 80bp. MWV's CDS could easily trade much more in line with International Paper's.

MWV's debt/EBITDA of 4x, interest coverage of 3x and earnings margins of 9% all fail to top IP's. That being said, from the positive angle MWV's liquidity is solid, with US$623m in cash to total debt of US$2.4bn (see exhibit below). The bond market more accurately assesses the MWV's credit risk, which will eventually result in a tightening of the negative basis on the 10-year bond.

Based on our CDS-implied valuation approach, the MeadWestvaco Corp 7 3/8s of September 2019 bond fair value is US$122.50 against a purchase price of US$106.00. The bond trades with a cash-CDS basis of -198bp.

The position is default-neutral. There is a slight maturity mismatch because the bond matures on 1 September 2019 and the CDS expires on 20 December 2019, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

Position

Buy US$10m notional MeadWestvaco Corp. 10 Year CDS protection at 105bp.

Buy US$10m notional (US$10.6m cost) MWV Corp. 7 3/8s of September 2019 at US$106 (T + 311bp; z-spread of 306bp) to gain 201bp of positive carry.

The appropriate interest rate is dependent on the portfolio in which the trade is held. Customised rate hedge information is available upon request.

For more information and regular updates on this trade idea go to: www.creditresearch.com

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Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).