With more than a third of European government bond yields trading in negative territory, it may only be a matter of time before credit default swaps trade through zero too.

About a third of 200 market participants surveyed by Citi last month believe this could happen, which would, at its simplest, mean one institution paying another institution for the privilege of insuring it against a bond default.

Even in this QE-supported market, a really bad credit is still not being bought. What is being bought, and is disproportionately tight on a spread basis, is double-B rated credit Louis Gargour, LNG Capital

It’s a seemingly crazy situation, but in a credit market distorted by quantitative easing and negative rates, anything may be possible.

Aritra Banerjee and Abel Elizalde, Citi’s credit derivative strategists in London, say: “From discussions with our own traders, we understand that CDS have indeed traded at negative levels” before.

This is thought to have happened in 2007, at the height of the credit boom, and with German one-year CDS currently trading just above zero on the equivalent and negative yielding Bund, negative CDS looks to be within touching distance again.

However, Banerjee and Elizalde are not so convinced, mirroring the opinions of most of the survey’s respondents. “Intuitively and theoretically, negative CDS spreads make no sense, and would imply either a negative recovery or probability of default, which is of course impossible,” they say. “More generally, why would you pay someone to give them insurance?”

Upside down

While seemingly unlikely, it is striking that negative CDS is being talked about at all, and forms part of a broader effort to understand the upside down characteristics of parts of the cash bond and derivative markets.

Specifically, the spread differential or basis between cash bonds and swaps has entered uncharted territory as a result of the negative yield environment, says Søren Willemann, head of European credit strategy at Barclays, who adds the dynamics of this “are not yet fully understood”.

Since at least last year many European high-grade corporate bonds have traded much tighter than their equivalent CDS, creating a spread differential known as a positive basis. In contrast, many high-yield bonds have traded far wider than their equivalent CDS, creating a negative basis, and one deepened partly by the effects of QE.

In high grade, for example, there is positive basis of 96 basis points between UK headquartered mining company Anglo American’s triple-B rated 2022 bonds and its equivalent CDS, according to Bank of America Merrill Lynch research, published on March 11.

The positive basis is around 54bp on French utility GDF Suez’s outstanding A-rated 2022 bonds. In high yield however, the negative basis is as wide as 93bp on Portugal Telecom’s double-B rated 2018 bonds, to as low as 5bp on Arcelor Mittal’s similarly rated 2018 bonds. This creates two potential arbitrage trades for investors. The first – for a positive basis – is to sell the cash bond and sell swap protection on the same name if the basis is expected to narrow. The second is to buy the bond and protection on the same name if the basis is expected to widen.

Aside from the impact of QE, there are a number of factors giving rise to these potential arbitrage opportunities. In high grade, one of the main reasons is simply that demand for these bonds is outstripping supply – particularly from financial institutions. At the same time, few investors have a mandate or are comfortable trading CDS, in turn helping to create the positive basis. 

In high yield however, the main drivers of the negative basis are the lack of liquidity in cash bonds, the use of call options, and greater desire and ability among investors, a large proportion of which will be credit hedge funds, to take a view on credit synthetically and therefore trade CDS.

Concentrated demand

For Louis Gargour, managing partner, CEO and CIO of credit hedge fund LNG Capital, call options have brought about much of the pricing distortion in the European high-yield bond markets as these options in effect limit the upside potential for investors. This is concentrating demand at particular parts of the curve.

“Even in this QE-supported market, a really bad credit is still not being bought,” he says. “What is being bought, and is disproportionately tight on a spread basis, is double-B rated credit. These credits are now too expensive, which is why single-B rated credits offer a better opportunity.”

BAML credit strategist Souheir Asba agrees that some of the best negative basis opportunities in high yield in mid-March were in single-B rated credits, specifically companies such as Portugal Telecom, Fiat and Finnish packaging and biomaterials company, Stora Enso. 

An alternative approach is to sell high-grade CDS in the expectation that the positive basis there will narrow or converge.

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