Credit default swaps remain tight despite falling equities

Dislocation between credit and equity markets is currently very pronounced, as bond spreads and default premiums shrug off falls in the equity market. This is a natural consequence of the current stage of the leverage cycle, Matt King, European credit analyst at JP Morgan in London, told RiskNews. Companies are currently favouring bondholders at the expense of stockholders by de-leveraging through skipping dividends, selling assets or doing rights issues, and this is keeping both bond and credit default swap spreads at tight levels.

At the same time, the pipeline of synthetic CDOs in Europe is keeping credit default swap levels very tight, said King. “There is a net selling of protection across the board, and this technical factor is also supporting the market.”

The divergence between equities and credit spread performance on some names is prompting some analysts to make trade recommendations for cheap short opportunities. Earlier this week Merrill Lynch recommended that investors buy protection on some of the high quality senior European banks. Relatively cheap protection is currently offered on European banks, including Ireland's AIB, and Denmark's Danske Bank, Norway's Den Norske Bank and Sweden's Svenska Handelsbanken. Senior five-year credit default swaps for all four banks are currently in the range of 20-28bp.

Merrill said the shorts are a way of benefiting if credit markets suffer lagged contagion from weak equity markets, and will act as a hedge against further war-related volatility. “If equity markets continue to be very volatile, sooner or later that will probably transmit itself to credit spreads as well,” Chris Francis, a credit derivatives analyst at Merrill Lynch, told RiskNews.

However, JP Morgan’s King sees credit spreads remaining quite tight, with the potential to come in further in the coming weeks. “We think equities will start to recover; war is largely priced in and further downside should be reasonably limited. Unless equities drop another 5% to 10% quickly, we would still think this de-coupling has further to go,” he said.

Credit derivatives traders in London said European insurers were currently the only sector showing strong correlation to the equity market. Five-year credit default swap spreads for benchmark name Allianz were still very wide at around 95/103bp for senior protection.

Other sectors remained relatively stable, but traders noted that towards the end of the week dealers were starting to bid up in credit default swaps, pushing spreads wider in some sectors. Utilities and chemical companies were roughly 4bp to 5bp wider on the week. The cost of credit protection for autos was also pushing wider, with five-year credit default swaps for Daimler Chrysler out around 7bp in trading yesterday, priced at around 145bp-mid today. “We are still at the bottom of the ranges seen in the volatile periods of last year, but it’s looking like the market may become more sensitive to extreme volatility again,” said one trader.

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