July 8, 2013 / 8:52 AM / 6 years ago

Sovereign CDS loses relevance

(This article first appeared in the July 6 edition of the International Financing Review, a Thomson Reuters publication)

By Christopher Whittall

LONDON, July 8 (IFR) - Credit default swaps are no longer viewed as a reliable indicator of sovereign risk, traders say, as an EU ban on speculative activity has successfully eviscerated an instrument that European policymakers once blamed for exacerbating the eurozone crisis.

Portugal’s political establishment was rocked by multiple ministerial resignations last week, causing the country’s CDS to soar by more than 20% in a day to 506bp on Wednesday, its widest level in seven months, while the yield on its 10-year government bond almost reached 7.5%.

But in stark contrast to previous examples of sovereign stress, traders professed to be largely ignoring CDS spreads, as a huge drop off in volumes and liquidity has undermined the price discovery value of the product.

“People pricing sovereign risk now look at the bonds, so why would you look at the CDS if bonds are where the information lies? Back in the day it was the other way around, with CDS levels being the crucial signal - it’s a fundamental change,” said Paul McNamara, investment director at GAM.

The net notional outstanding of EU sovereign CDS has dropped by 29% over the past year, as traders removed CDS trades in advance of the ban on outright short positions kicking in last November. French CDS, which had become the favoured short-the-eurozone-crisis trade among many speculative players, has seen its net notional fall off a cliff, from US$23.5bn a year ago to US$13.7bn currently.

In its place, futures on Italian government bonds have become the weapon of choice for bearish eurozone views, with open interest on the Eurex-listed instrument more than doubling since the ban was announced in March 2012 to more than 80,000 today.

“Sovereign CDS volumes and liquidity are down massively,” said Michael Hampden-Turner, credit strategist at Citigroup. “Part of that is because investors are more optimistic about risk generally, but the EU ban has also hurt liquidity.”

“The market tends to be fairly one-way round, leaving it vulnerable to gapping spreads when there is activity. Dealers are not prepared to run big positions as there is nowhere to lay the risk off, which makes it worse. Every quarter volumes slide and CDS becomes less liquid, and that looks set to continue.”

THE NEW NORMAL

This is a marked change from the pre-ban era, when CDS trading would pick up when a sovereign became more stressed and it was viewed as an important pricing point. Dealers reported that CDS on Greece still changed hands right up until the contracts triggered in March 2012, albeit in smaller ticket sizes.

Gavan Nolan, director in credit research at Markit, wrote in a report on Wednesday that “Portugal CDS are still liquid”, noting the ban “only affects a limited number of participants and DTCC volume figures show that these names are still among the most active in the CDS universe”.

After all, Portugal CDS notional falling by US$1bn to US$3.6bn still makes it one of the larger contracts in existence.

Still, Hampden-Turner said the volatility of the basis between Portugal’s CDS and its cash bonds supports the theory that sovereign CDS have become a poor indicator of risk. The basis has whipped around violently, suggesting a wide bid-offer spread and scarce trading, or trading only possible at punitively expensive levels.

“We highlighted the risk of poor CDS liquidity in a crisis as a result of the sovereign ban. What is harder to assess is the extent to which this lack of ability to hedge in a liquid product is adding to sovereign volatility,” said Hampden-Turner.

It wasn’t just the dealer community that warned of the adverse effects of the ban. Most recently, the IMF released a report in April suggesting that it could imperil financial stability, while policymakers had ignored previous reports that there was scant evidence of sovereign CDS driving bond spreads wider.

Even so, the market has survived the latest scare in Portugal so far. Proving that sovereign CDS’s absence aggravates market sell-offs remains a tall order.

“The CDS ban means there is one less avenue to dump risk, but I don’t buy the argument it exacerbates bond volatility, which is mainly driven by fundamentals,” said McNamara. (Reporting by Christopher Whittall; editing by Helen Bartholomew)

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