Sovereign CDSs not to blame for fiscal woes, say dealers

robert-stheeman

Sovereign credit default swaps (CDSs) are not to blame for the budget woes of European governments, say market participants, despite calls from politicians and regulators to ban the instruments.

The sovereign CDS market has attracted increasing attention over recent months, highlighted by the fiscal problems faced by countries such as Greece. Five-year sovereign CDSs referencing Greece were trading at 340.1 basis points on March 1, according to London-based data vendor Markit. Politicians have lashed out at the market as a result, with French finance minister Christine Lagarde and others calling for curbs or an outright ban on sovereign CDSs.

Nonetheless, market participants play down the importance of sovereign CDSs, saying they bear little relation to the level at which governments are able to borrow. “Sovereign CDS spreads are of limited relevance to sovereign risk, especially for those countries able to service debt in their own sovereign currencies,” says Robert Stheeman, London-based chief executive of the UK Debt Management Office.

Sovereign CDS indexes often trade at roughly the same level as corporate CDS. For example, on March 1, the five-year Markit iTraxx Europe index of investment-grade CDSs was trading at 84bp, according to Markit. On the same day, the five-year Markit iTraxx SovX Western Europe index, representing sovereign CDSs on 19 European countries, was trading 0.25bp higher at 84.25bp. But, market participants say, this doesn't mean  European governments are riskier than their corporates – instead, the spreads show how easily sovereign CDSs can be moved by technical factors such as liquidity.

Sovereign CDSs bear little relation to true probability of default, says William Porter, the London-based head of European credit strategy at Credit Suisse. Although corporate CDSs are often referred to as the tail wagging the bond-market dog, this is not the case for sovereign CDSs. “The sovereign CDS market is the tail on the government bond-market dog. If you look at open positions on Greece, for example, there are about €10 billion of net positions against a government bond market that is in the order of €300 billion,” he says.

Sovereign CDS spreads are of very limited relevance to sovereign risk, especially for those countries able to service debt in their own sovereign currencies

Supply and demand factors are also important. One reason sovereign CDS spreads might appear particularly high is the buying of protection by banks attempting to hedge credit portfolios with exposures to weaker sovereign borrowers.

“Sovereign CDSs will be volatile because they are an expression of the pure risk premium and, because they are volatile, they will extract a risk premium. So they are utterly circular in some respects. That gives them nice, trending characteristics and it gives you a direct play on risk premiums in the market,” says Porter. This makes them useful for investors in search of macro hedges for credit or even equity portfolios, he says. Sovereign CDSs are also popular among structured credit investors looking for a more diversified way of increasing their yields than corporate credit.

“It is easy to see why regulators and politicians have toyed with the idea of banning sovereign CDS,” write Citi analysts in a note to clients on March 2. However, they suggest a ban is unlikely to be effective.

Traders in sovereign CDSs take their cues from the government bond market, they point out. Opportunities for arbitrage only exist when CDS spreads are tight relative to bonds and not the other way around, they add. A ban could also backfire, with market participants seeking to hedge sovereign exposures forced to sell or short government bonds instead.

Consequently, critics of sovereign CDSs would be better off focusing on underlying fiscal problems, they write: “As the proverb implies, we would do better to spend our time addressing the defects the mirror shows up than blaming the mirror. After all, banning mirrors does nothing at all to make the world a prettier place.”

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