03 Aug 2011, Michael Watt, Risk magazine
If you take the word of the credit default swap (CDS) market, Australia’s companies were roughly one-quarter riskier on July 12 than they had been on May 2, following an eye-catching surge in spreads, notionals and trading activity on Markit’s iTraxx Australia credit index. But dealers warn against taking this activity at face value: some say the index is being used to hedge exposure to China, while others say it’s tied more to the eurozone’s sovereign debt woes. Still others try to bridge the divide by arguing the iTraxx is being used as an all-purpose proxy hedge, but if that’s true, some note, perhaps it’s not a particularly good hedge for anything.
“This is often the problem with proxy hedges,” says Richard Cohen, head of Asia-Pacific credit trading for Credit Suisse in Hong Kong. “For instance, you could hedge a Chinese equity portfolio with a Chinese sovereign CDS position. I can easily think of a situation where the equity portfolio loses 40% of its value, but the CDS spreads don’t widen enough to make up the loss.”
The fact that this debate is happening at all might seem a bit surprising. Until mid-June, the iTraxx Australia had been stuck between 100 and 110 basis points for the whole year, crawling back and forth at no more than a few points a day. Then something changed. Between June 8 and June 23, the index zig-zagged up to its then-peak for the year, 123bp, before plummeting back to 108bp just five days later. Six days after that, on July 12, sentiment had apparently reversed again, with the iTraxx soaring to a new peak of 126bp – 24% higher than it had been at the start of May and higher than at any time since September last year. Higher spread levels and dramatically increased volatility coincided with a surge in notionals and activity (see figure 1).
1. iTraxx Australia
So, what is going on? The index has a heavy bias towards large banks and commodity producers and, given the close economic ties between Australia and China, some dealers suggest the index is being used to hedge against a slowdown in the Chinese economy, the argument being that Australia’s big companies will look less creditworthy in most scenarios where China begins to falter.
China’s gross domestic product currently looks impressive – it was up 9.5% year-on-year in the second quarter, and 9.7% in the first quarter – but there are enough risk factors to embolden the sceptics. Inflation has been on the rise, breaking 6% in June and pushing the People’s Bank of China (PBOC) into a series of interest rate hikes – in the most recent increase in early July, the benchmark one-year lending rate was pushed out 25bp to 6.56%.
Traders say sentiment about the country is finely balanced. “If you look at the actual data around the Chinese economy, it’s not that bad. Inflation is high, but it’s not out of control,” says Rohan Thakrar, a senior credit trader at Royal Bank of Scotland (RBS) in Singapore. “But there are concerns about a Chinese property bubble and how that will affect the wider Asian economy. The other big worry is whether Chinese policy-makers can manage the inevitable slowdown efficiently or whether they’ll bring the whole thing down with a crash by hiking interest rates too high, too quickly?”
A slowdown in China would not be pleasant news for Australia. Over the past few years, China’s booming demand for commodities has helped spur the Australian economy. It is this relationship that some traders believe is behind the sudden popularity of the Australian corporate CDS index.
“We’ve been seeing hedge funds, bank desks and other types of macro fund managers trying to short sovereigns or market instruments whose performance is well correlated to China. The iTraxx Australia fits that bill pretty well. The countries are closely linked from a trade perspective, especially in commodities. If demand from China goes down, the Australian economy will be the first to feel the pinch,” says Jay Parshottam, head of Asian credit trading for Citigroup in Hong Kong.
But some traders are not convinced that bearish views on China explain the rise in the iTraxx Australia. “You could argue people are using it to specifically hedge or speculate on China but, if you wanted to do that, you may be better off using the Australian dollar, and we haven’t seen much activity there. The carry for an Aussie dollar short is expensive, but I would argue that the correlation with China is higher and the payoff from the hedge would be much more profitable,” says Credit Suisse’s Cohen.
An alternative explanation for the index’s recent behaviour can be found in Europe’s debt crisis, he argues. The Australian index widened significantly on July 12 – from 118bp to 126bp, a 7% jump – at the same time that markets were panicking about Italian credit risk. By July 11, Italian CDS spreads had blown out to 300bp, more than 100bp higher than they had been six days earlier, and yields on 10-year Italian government bonds had hit a eurozone-era high of more than 6%.
“I get the sense that much of the activity on the index is being driven by events in Europe as much as events in China. Although the Australian banks don’t necessarily have exposures to peripheral eurozone sovereigns, they have historically relied on wholesale funding, much of which is sourced in European markets or provided by European banks,” says Cohen. Australia’s four largest banks – ANZ, Commonwealth Bank of Australia, National Australia Bank and Westpac – are constituents of iTraxx Australia, as is Macquarie Bank.
If sentiment from both China and Europe is influencing the Australian index, some traders note that it may not be a great way to hedge against or short either market. According to Sanjay Garodia, head of flow credit trading for Asia at Deutsche Bank in Singapore, there is no real historical precedent to suggest broad market indexes in Asia are good hedges for further panic in Europe, or a hard landing in China. “Banks are usually the best barometer of a country’s economy. For instance, there are three or four big Chinese banks on which CDS does trade. They would probably be a better proxy for a hard landing in China.”
Despite the unreliable correlation between these 25 Australian companies and external events like the eurozone debt crisis, the Australian index and Markit’s iTraxx Asia ex-Japan investment grade index (see figure 2) are seen as useful tools by traders, says Citi’s Parshottam. “If you’re looking to hedge against very specific events, these two instruments will put you at a disadvantage because they’re influenced by lots of different things. But they are a useful hedge for a diversified portfolio. The high liquidity of the two means you can always get a reliable price, and you can always trade out of them very easily,” he says.
2. iTraxx Asia ex-Japan
Credit Suisse’s Cohen sees it similarly: “Because of its high liquidity and Australia’s strong connection with Asia, Europe and the US, the iTraxx is widely used by traders to take a view on events in any of these regions. For a number of years, it has been very strongly correlated with risk-on, risk-off feelings. Spreads on the index often push up when people are generally bearish about prospects in China, Europe and the US.”
The recent spike in Japanese sovereign CDS notionals (see figure 3) is also down to general bearishness on the global economy, Cohen says. “The jump in Japan was basically guys scrambling to put a tail risk hedge on their books as the news from Italy deteriorated, and as the US debt ceiling negotiations rumble on. As with the Australian index, Japan has often been the place to go with these sorts of positions in the past,” he says.
3. iTraxx Japan
Perhaps the final question is what all of this means for the companies in the iTraxx Australia – where names like Qantas Airways and betting giant Tabcorp are apparently being used as protection against risks as diverse as eurozone debt woes and Chinese inflation. If the index widens as a result, will it have a knock-on impact on the individual names?
“Some individual names will certainly be penalised through association, in terms of their own CDS spreads, if the index does widen out,” says Parshottam at Citi. “However, I don’t think it has an appreciable effect on their cost of borrowing, unless the spread moves are really big. The cash market is a slightly different world. In the past we’ve seen cash bond yields move in a completely different direction than the CDS spread. I’m not convinced that you could conclude that it would suddenly become harder for these guys to raise funds.”