(Update to add more details)
By Helene Durand
LONDON, July 29 (IFR) - Fears that credit default swaps would not provide protection against a sovereign default as previously hoped could be one of the reasons behind some of the recent sell-off in Eurozone peripheral sovereign cash bonds, bond market participants said this week. Hopes that the release of the second Greek bail-out package last Thursday would calm the markets have not materialised and instead on Friday, sovereign yields are much higher than they were a week ago. According to TradeWeb, Spain’s 10-year yields are at 6.075% from 5.69% a week ago while Italy’s are at 5.905% from 5.373%. “Market volumes and liquidity are pretty thin right now and there is reason to think that there is some technical pressure on Spain and Italy,” said a fund manager in London. “Part of the pressure is due to the fact that some people who thought they were hedged have realised they might not be, given what has happened with Greece and they are therefore reducing their exposure by selling cash bonds. The price action is not really as a result of the perception of those credits. Especially in the case of Italy, nothing has changed from six months ago.” Another fund manager in London said he had heard the same rumour. “I have heard that because some people were worried about their hedges, they are selling the sovereign cash bonds,” he said. “I don’t know whether that’s the real reason behind the moves that we have seen in recent days. There were also rumours a week ago that there was some domestic selling out of Italy and that would be very worrying.” He added that one area of worry was banks’ trading desks. “Where these desks would have hedged themselves through CDS in the past, risk management could well be saying that they can’t be used as a hedge anymore.”
Analysts at CreditSights warned that this could indeed happen in a note published this week.
“The fact that the deal is not a credit event greatly undermines the efficacy of sovereign CDS as a speculative tool, one of the EU’s stated goals (note that it also undermines the efficacy of sovereign CDS as a legitimate hedging toll, but the EU doesn’t seem particularly fussed by this),” they wrote.
They added that the EU strategy could come back and haunt the sovereigns and the banks “in that the erosion of the usefulness of sovereign CDS as a hedging tool could also drive a contraction in gross exposure (versus net) and that would mean tighter limits on cash holdings, contingent cash commitments, collateral and cross-border lending generally.”
DESTABILISING FACTOR Meanwhile, a flow sales banker at a global bank said while it might not be the direct cause of the pressure, it was a factor. “It is a destabilising factor,” he said. “We’re not seeing Credit Valuation Adjustment (CVA) desks selling heavily. But it is a fear for some of those people. In this market any flow has an exaggerated effect. They don’t want to get caught short of a summer tightening. Anything that adds to the uncertainty is unhelpful.” One focus of the second Greek bail-out package is to secure private sector burden-sharing while avoiding the trigger of CDS. “My understanding from the reports is that any debt rollover will be voluntary,” David Green, general counsel at ISDA told IFR last week. “Assuming that is the case, any kind of voluntary rollover isn’t going to trigger CDS as it won’t bind all bondholders. That’s always been their aim, I think, to avoid a credit event.” But while the inability of CDS to protect against default risk could be one factor behind the move, broader concerns about whether the stronger Eurozone sovereigns can foot the bill for the weaker ones is also playing on the minds of investors. “One of the concerns right now is that the EFSF won’t have enough firepower to provide support to Spain and Italy if that was required,” said the fund manager. “Getting ratification of the EFSF’s new powers is the weak link in the solution being proposed. There is also a concern that should the size of the EFSF grow to support Spain and Italy, the size of the contingent liabilities for France and the Netherlands could lead to a downgrade of their Triple A ratings.” (Reporting by Helene Durand, Editing by Ciara Linnane)