RPT-Fitch: European spread volatility underlines limit as risk gauge

Fri May 3, 2013 4:09am EDT

May 3 (Reuters) - (The following statement was released by the rating agency)

Recent tightening of European bond and credit default swap spreads underscores Fitch Ratings' view that the volatility in market-based indicators can limit their effectiveness as a risk-assessment tool for long-term investors. These indicators can be useful for gauging risk, but tend to overreact during periods of market volatility. As a measure, they can therefore overestimate fundamental credit risk and impose opportunity costs on investors who sell or hedge positions that subsequently gain in value.

Yields on 10-year Italian sovereign bonds extended their tightening, falling below 4% following the formation of a new coalition government. The fall in yields narrowed the credit spread over German bunds to approximately 270bp, roughly half the peak reached in November 2011. Similarly, corporate CDS spreads across Europe have tightened in the last few weeks as sentiment improved.

These market moves repeat a pattern of spreads ramping up during periods of market volatility, only to revert to prior levels once sentiment improves. In these cases, wider spreads could overestimate a portfolio's credit risk, and impose opportunity costs on investors that use them as a risk limit to exit their positions. On a portfolio basis, these costs can outweigh the benefit of the occasions when widening spreads serve as a genuine early-warning signal - such as with Greece's distressed debt exchange in March 2012.

We recently published two special reports examining the relationship between market-based indicators and Fitch's Issuer Default Ratings. Our research into sovereign credit spreads showed that between 2010 and 2012, an investor in a market-weighted portfolio of Greek, Irish, Italian, Portuguese, and Spanish sovereign debt would have incurred a cumulative portfolio loss of about 12% if using a credit spread of 500bp as a sell signal. A "buy-and-hold" approach would have gained 2% over the same period, while using a downgrade to below investment grade as a sell trigger would have generated a cumulative return of 4.5%.

In another report, a comparison of CDS-implied ratings against IDRs showed how factors such as investor risk appetite, liquidity and counterparty risk and investor leverage may lead to this indicator either overestimating or underestimating fundamental default risk. In the case of the peripheral eurozone, limited risk appetite among investors has contributed to companies facing tougher financing conditions than their fundamentals would suggest. This has pushed CDS IRs down to an average of three notches below IDRs in the periphery.

For more information on this topic, please see our special reports Leading to a Loss: Market-Based Indicators and the Eurozone Crisis" and CDS Implied Ratings Versus Fitch Fundamentals" available at our website www.fitchratings.com.

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