Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on Valero Energy Corp

Valero Energy's CDS has been on a roll this month. After the company's CDS hit tights in April along with equity highs, both securities sold off with the rest of the market.

Recently, Valero's CDS recovered, while its equity remained at the low end of the tight channel in which it traded since March 2009. Now is an excellent time to take advantage of the company's credit-equity disconnect.

Exhibit 1 charts Valero's five-year CDS and equity price (reversed axis) over the past six months. Throughout most of the period, the two securities traded in line with each other, improving and deteriorating together. However, since late June, VLO's equity deteriorated to close to recent lows, while its CDS showed strong improvement.

Exhibit 2 charts Valero's market and fair CDS levels (y-axis) versus equity share price (x-axis). The square shows current market levels. The yellow triangle indicates current fair values for equity and CDS based on their recent trading relationship.

Our empirical equity-CDS model clearly points to an increase in share price, coupled with a widening of CDS spread, as indicated by the green arrow. Our directional credit model points to CDS widening in line with our empirical fair value based on weak interest coverage and earnings. Some factor rankings in the directional model will likely change with the release of the company's earnings.

Exhibit 3 provides another view of our equity-CDS model's estimate of fair value, charting market and fair CDS levels over the past six months. Since late April, VLO's equity initially outperformed its credit but recently lagged as its CDS rallied. Valero's equity is outperforming and we expect earnings results will be a further catalyst to bring credit and equity back together.

Risk analysis
The main trade risk is that the name begins trading under a different regime and the current equity-CDS relationship no longer holds. Each CDS-equity position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a different than expected market value and the stock price might not fall as assumed.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position.

Government actions: Bailouts, stimulus packages and other governmental interventions have distorted the credit-equity relationship among certain names.

Mark-to-market: Relative mispricing may persist and even further increase, which could lead to substantial return fluctuations.

Position

Buy 72,800 shares Valero Energy Corp @ US$17.53.

Buy US$10m notional Valero 5Y CDS @ 180bp.

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).