Structured credit strategists at Morgan Stanley review correlation performance themes of the last six months and implications for the future in their latest research note. They point out that in the tranche space investors are braced for a cyclical slow-down.

"Correlation is considerably higher, but it's mostly junior mezzanine that has borne the brunt of the sovereign volatility," the Morgan Stanley strategists explain. "The basis is extremely positive, especially in Europe - another indication that a systemic crisis is less on the minds of investors than the overall growth concerns. CDS client volumes have made an impressive rebound in 2010."

However, the strategists suggest that the events in the Gulf of Mexico and the impact on what was considered a defensive sector have caught many investors unaware. In the research note, they attempt to draw some lessons from the episode.

"By definition, hedging an idiosyncratic event is difficult, but buying protection on equity tranches, first-to-default baskets and short-end curve flatteners are some options. Despite a good entry point in terms of correlation, wide spreads and tails saturated with financials and cyclicals make index equity tranches less viable hedges than bespoke non-financial portfolios," the strategists comment.

Meanwhile, they believe that long mezzanine risk is a good play on continued recovery, with attractive relative and absolute valuations. "We recommend iTraxx S9 seven-year 12%-22% in Europe and IG9 seven-year 15%-100% in US as our preferred systemic hedges. Europe has underperformed the US in many parts of the market and we like long iTraxx 22%-100% versus CDX 15%-100% to play for a cross-Atlantic normalisation."