The market’s favourite financial weapons of mass destruction, credit default swaps, are again on trial. Chaos in the sovereign markets has exposed flaws in the instrument’s use as a sovereign default risk management tool.
With Italian government bonds now yielding nearly 6%, it is no longer clear how to benchmark risk or return. "The violent market moves we saw in August have challenged the whole paradigm of investing: the market doesn’t seem to agree any more that government bonds are the risk-free benchmark," says Brett Tejpaul, head of distribution for UK and Ireland and head of European credit sales at Barclays Capital in London. "This change is both seismic and recent, and with volatility in CDS and government bond curves more violent than it has ever been, it’s become very challenging to assess credit performance." The expectation that CDS would provide a neat indicator capable of distilling all relevant credit risk information into a single spread seems suddenly so 2007.
In early October, German five-year CDS hit a new record of 118bp just weeks after 10-year Bund yields fell to a record low of 1.85%.
This raises broader questions that are unlikely to be resolved quickly.
Risk transfer
"If you buy sovereign default protection from a financial institution in expectation of collecting, who are you going to collect from?" asks a CDS trader. "There is so much interoperability between financial institutions and governments that it’s hard to know who would be insulated from a government default. It’s like buying insurance on an airplane from an airline. The risk transfer fails when you need the insurance the most."
| "The elevated Greek CDS basis shows that a segment of the market still believes that even if they get the aid, it will likely be the last round and that the situation is unsustainable in the long term" |
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The weakness exposed by this correlation will be most harshly demonstrated with reference to Greece. As Euromoney went to press, five-year Greek sovereign CDS were trading at 62 points upfront, according to Markit data. Investors looking to buy credit protection on Greek sovereign debt must hand over $6.2 million to insure $10 million of underlying exposure, in addition to annual premium payments of $100,000. Otis Casey, credit analyst at Markit, says: "At this level, CDS spreads imply a 100% probability that Greece will default with recoveries of around 35% to 40%."
However, those that bought protection on Greek debt hoping to collect when it finally fell out of the eurozone will probably come away empty-handed. Although it is increasingly likely that the EU will force Greece to restructure its debt pile in some way over the coming months, there is a growing consensus among banks and investors that the most likely outcomes will fail to trigger the CDS.
"Greece has significant latitude to avoid triggering a CDS credit event, if it so desires," reckoned JPMorgan analysts in a recent note. "Most likely Greece will pursue a combination of mild voluntary restructuring at a later date in combination with continued structural reforms and asset sales. In this case Greece could avoid a CDS trigger relatively easily."
Regardless of whether or not restructuring will trigger the CDS, markets continue to endorse elevated credit risk premiums as indicated by the 1,150 basis points basis between Greek CDS spreads and Greek government bond yields.
"We are at a tipping point one way or the other. Even though the vast majority of participants expect that Greece is going to receive the next round of aid and that the EFSF will be up and running, we are still waiting for formal confirmation that it will receive funds in time to meet its October payment dates," said Casey in late September. "The elevated Greek CDS basis shows that a segment of the market still believes that even if they get the aid, it will likely be the last round and that the situation is unsustainable in the long term."
CVA
It’s not yet clear what the holders of the €3.8 billion outstanding in Greek CDS will do if default protection is not triggered. JPMorgan estimates that counterparty valuation adjustment (CVA) desks, which use CDS contracts to manage a banks’ credit exposure to its trading counterparties, account for as much as 30% of net outstanding notional in sovereign CDS contracts. Anecdotal reports suggest that these participants began unwinding Greek CDS hedges in July, following the Isda announcement that voluntary restructuring would not trigger CDS. Indeed, sovereign CDS’s apparent failure to deliver on its risk transfer promise when most needed has led to calls for investors to abandon the instruments as risk-management tools, with the uncomfortable implication that default, not typically associated with optimal outcomes, would be good for the market.
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| basis between Greek CDS spreads and government bond yields |
Fortunately, the net volume of Greek CDS outstanding is relatively small compared with the total volume of Greek debt outstanding, which the Hellenic Republic’s finance ministry says is approximately €340 billion. This indicates that the majority of bond holders are not using Greek CDS to hedge cash bond positions, or that they are using other approaches, such as buying protection on sovereign CDX indices, or shorting government bonds.
"Instinctively I trust cash prices not CDS," says a London-based head of fixed income with an institutional asset manager. "While they have worked as a flag for trouble in the eurozone periphery and they make good headlines, I see no real purpose in taking insurance against sovereign default. They are therefore, in my view, only a trading instrument, not a cast-iron protection against a failure to pay coupons or redeem bonds at par. The ECB’s determination to avoid any Greek event being called a default further muddies the waters."
With maxed-out credit spreads implying certain default, it’s probably safe to surmise that few investors are buying Greek CDS for risk-management purposes at these prices. Markit’s Casey says that liquidity in the single-name market has fallen. Instead, some dealers are advocating a bet that basis spreads will tighten further as the realization sinks in that default won’t trigger CDS. This basis trade too involves taking short positions in both CDS and cash bonds, which, when combined with the hedging flows, creates downward technical pressure on the market.