Confidence of a speedy war in Iraq sparks rise in protection selling

Growing confidence that the US could achieve a swift victory in the pending war in Iraq promoted an increase in sellers active in the credit default swap (CDS) market. Traders said spreads were now contracting in line with the equity market rally.

They added that overall sentiment in the CDS market this week was driven by reactions towards political news of the pending war in Iraq. At the start of the week, liquidity in the CDS market was quite thin, with dealers reducing risk across the board ahead of potentially volatile markets in the run-up to war.

But traders said the cost of credit protection for the most active and volatile names contracted today, following a bolstering of political support for a US-led attack on Saddam Hussein's Iraqi regime. The credit derivatives market was led by positive sentiment in Europe’s equity markets, which surged higher in late morning trading today, following reports that US troops had moved into the demilitarised zone separating Iraq and Kuwait.

“People are now looking forward to a quick resolution of the Iraq conflict,” said one trader. “The risk premium on the market has declined and now there are more sellers in the market. This is causing a contraction in spreads, which could well go tighter through the course of the week.”

The cost of protection for France Telecom and Deutsche Telekom debt was 20bp tighter on the week at around 200bp-mid. Other active names, including auto Ford and engine-maker Rolls Royce, were 15bp to 20bp tighter for the week, trading today at 530-mid and 290bp-mid, respectively.

Meanwhile, the cost of credit protection for Bayer debt tightened by more than 100bp to 179/185bp after the embattled German pharmaceutical was cleared of liability in a drug lawsuit yesterday. The cost of protection for Bayer widened out by around 50bp to around 250bp-mid last week as the case intensified. Credit derivatives traders in London said demand for credit protection on Bayer had earlier intensified with five-year CDSs for Bayer widening by up to 40bp, reaching 290/310bp on Monday morning.

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