The cash-CDS disconnect
cash versus cds
The movement in cash markets in March led some observers to predict that credit markets are finally on the turn. Headlines such as “End of the party” and “Growing fears credit boom may implode” in the financial press suggested that the two-year bull run of credit may have come to a sudden end. Euro-denominated bonds widened by about three basis points in the week beginning March 7, with sterling spreads moving out by between five and 10 basis points.
A rapid rise in US Treasury yields in the previous month had led to higher yields in the longer end of the risk-free asset market, creating a reason to sell for any investor marking to market. New bond issues—in particular, the 50-year note issued by Telecom Italia (TI)—were underperforming. The TI issue came at a time when a number of issuers were tapping the long-dated (20-year plus) bond market, including Barclays and HBOS. Widespread concerns about valuations in the European telecoms sector were exacerbating the situation.
But worse was to come with the dramatic widening throughout the market as contagion spread from General Motors’ profit warning on March 16. Names such as Pemex moving 83bp and Vivendi by 24bp sent shockwaves through a market used to very tight pricing.
“The reason for cash spreads widening is clear,” says Suki Mann, credit strategist at SG CIB. “It started with the problems of the Telecom Italia issue, and then was exacerbated by GM. The market backed off across all credit sectors.”
But while GM and Ford credit default swaps (CDS) widened as people rushed to buy protection, “the CDS market in general doesn’t seem to have been affected more widely,” says Mann.
That credit default swap spreads did not widen in line with cash markets is important. On the face of it, this suggests that the CDS market is less vulnerable to the factors that have weakened cash markets. Marcus Schüler, responsible for integrated credit marketing at Deutsche Bank in London, cites the example of Henkel Group, a manufacturer of consumer packaged goods based in Düsseldorf, Germany. “Henkel is a name that continues to be well supported in CDS, as a typical CDO [collateralized debt obligation] name,” says Schüler. “The 2013 bonds, however, came under significant selling pressure over the last few weeks. This has led to a situation where the bonds now, for the first time, trade wider than CDS.”
Schüler points out that this is providing some investors with opportunities to put on basis trades between Henkel bonds and credit default swaps. “We recommend clients to take advantage of the cheap bond/CDS basis, as it provides them with free optionality—exactly what you want in times of volatility,” he says.
This growing disconnect between the cash and CDS markets could have a variety of explanations. Robert McAdie, global head of credit strategy and co-head of European credit research at Barclays Capital, believes credit default swap values didn’t suffer in recent weeks as much as cash bonds because the sell-off on cash bonds was largely profit-driven, meaning investors weren’t concerned about defaults.
“CDOs are still being structured and sold, and that demand for synthetic credit will continue to provide a net bid for credit,” he says. “We might see CDS spreads start to widen if high-yield credit quality concerns did materialize—for example, if there was default or corporate governance concerns expressed.” But while default rates remain low, CDS values should hold steady.
Raja Visweswaran, head of international research at Bank of America, says one key factor in the apparent invulnerability of CDS markets is the distinction between mark-to-market risk—i.e. the risk of the declining value of a cash portfolio—and default risk. He believes that what the first quarter has shown is a divergence between the near-term and long-term outlooks for credit.
“Relative value is moving away from credit in the near term,” he says. “But in the long term it can be argued that inflation will come about as a result of strong economic growth, which in turn could be positive for credit quality. If you expect bond yields to rise, you would expect the value of your mark-to-market position to deteriorate, but the actual default rate won’t necessarily increase.”
So with mark-to-market risk increasing and default risk stable, “it therefore makes sense to sell cash but not to panic about CDS positions,” says Visweswaran, “since the risk of default has not become greater.”
Another reason why cash spreads have widened more dramatically than credit default swaps is linked to maturity mismatches. The number of long-dated cash deals being brought to the market recently in response to investor demand for longer-dated assets, has caused some weakness in the longer end of the credit curve. Since much of the CDS market is short dated, this maturity mismatch has made credit default swaps less susceptible to downward pressure. Stephen Dulake, European credit strategist at JPMorgan, says the greater volatility on cash than on CDS (when looking at index aggregates) is partly a result of this maturity mismatch, with 30-year bonds making up a larger component of cash indices.
The composition of the cash indices, or the names included in them, has also affected the situation. “There is the fact that GM is present in the cash indices but not in iTraxx,” says Dulake. Plus: “the underperformance of the Telecom Italia 50-year issue has been transmitting volatility to European cash markets.”
Differences in liquidity levels are also important, notes Simon Ballard, senior credit strategist in the fixed-income research group at BNP Paribas. Traditionally, he says, there has been relatively limited liquidity in the European cash corporate bond market, while the evolution of the CDS market has brought about greater liquidity on many single names. And with CDS investors typically adopting more sophisticated trading strategies, credit default swap values are more stable compared with movements in the cash market.
“There has certainly been more volatility in the cash markets than in CDS over recent weeks,” says Ballard, who also cites the end of March rollover of the five-year and 10-year iTraxx contracts as having discouraged many participants from buying credit protection. Traders do not want to be active on a contract that will soon be outdated.
What happens next in the complex relationship between cash and CDS markets may prove to be more pivotal in the development of the corporate bond markets than the ‘turnaround’ in credit touted by the mainstream press.
Alok Basu, senior credit strategist at Gartmore, says that while the tightening of credit spreads in January and February was mostly justified by fundamentals, broader imbalances in the supply-demand balance have created a more complex picture. “There has been a tremendous pick-up in risk appetite, which has not been fully sated by corporate bond supply, since with company balance sheets improving there is less need for borrowing,” he says. “Investment spending is relatively weak for this stage of the growth cycle, further dampening the need for corporate borrowing. Interest rates remain low, driving down yields across the curve, so natural yield investors are not hitting their targets.”
This has boosted demand for CDO-type structures which create greater leverage in synthetically meeting the demand for yield. “There has been very strong demand for these structured products, and they are increasingly put together synthetically using credit derivatives rather than by using cash bonds in the traditional way,” points out Basu. “Investors get single-A or double-A tranches at greater spread, but the risk is higher. Once a certain level of default is reached in these structures, the move to total default is much more rapid and so the level of risk can snowball much more than in cash markets.”
This level of risk has been compounded by the fact that, as spreads have contracted, it has become harder to achieve yield targets even from CDOs without putting more high-yield assets in them. The quality of CDOs is at historically low levels, since the companies that do need to borrow in this environment are generally the ones that are least financially stable. So CDOs as a whole are more vulnerable to small changes in risk levels.
“Every time spreads widen, the CDO bid pulls them back in, since spread widening is an opportunity to put together more CDO structures,” says Basu. “But there’s a limit to how far that can go. The big uncertainty is over how much of an interest rate rise it would take to breach that limit.” If the Federal Reserve raises interest rates and investors are able to get higher yield from conventional bonds, there is no incentive to invest in riskier structured products such as CDOs. Such a situation may be triggered by steep monetary tightening by the Fed or a collapse in the US dollar.
There is another possibility: that the CDS market, which recently seems to have been cushioned from the factors that have affected cash spreads, could become more sensitive than cash to credit market volatility. Barnaby Martin, credit strategist at Merrill Lynch, says that real-money investors are increasingly using indices such as iTraxx to hedge their portfolios. “Instead of selling bonds in a downturn, they can buy index protection,” says Martin. “There are still relatively few investors doing this, but it’s a growing trend. At present, cash and CDS are generally traded by the same desk and cannot really get far out of line with each other. But if more investors choose to buy and hold bonds while synthetically selling through iTraxx, we could eventually see a situation where the CDS market is more susceptible than cash bonds to credit market volatility.” If this trend does develop, current assumptions about the relationship of cash to CDS spreads could be turned on their head.
A new paradigm?
Among credit strategists canvassed by Credit in March, the consensus is that recent spread movements do not amount to a new, weaker market paradigm. “Near-term risks argue for some caution on credit, but I don’t think the trend to credit widening will continue in the long term,” says BoA’s Visweswaran. “There has been a lack of compensation in the form of spread for credit risk, but that compensation has now improved, and as it does so the situation should stabilize.”
Gary Jenkins, head of fundamental credit strategy at Deutsche Bank, and colleague Jim Reid, head of credit strategy, say that while spreads have been tight in historical terms, they are roughly where they should be given low defaults and low bond yields. As for whether March’s spread widening heralds weaker credit markets or was a short-term phenomenon, they suggest the answer lies somewhere between the two. “We believe spreads will be wider in two years’ time than they are now, both as a result of mean reversion and because credit conditions are unlikely to stay as strong as this indefinitely. But we don’t see the recent widening as evidence of a sudden collapse in credit quality or in the demand for credit.”
Jenkins and Reid are confident it won’t be credit quality as such—with the honorable exception of GM—that causes problems this year. “Spreads are more likely to be driven by what happens on US Treasury yields. That in turn has been driven by lower demand for credit, and the low yield environment is not going to last forever,” says Reid.
Ballard of BNP Paribas says fundamentals and technicals on European corporate credit remain robust, and “in historical terms this remains a low yield environment.” Ballard says it is probably the case that credit spreads did tighten too far and too fast in the first two months of 2005, but BNP Paribas does not consider the recent widening to be the first sign of a bear market. Instead, it views it as a short-term correction. “People have been worrying that spreads are a bit too tight, and have decided to take some chips off the table and see how things develop,” he says.
Ballard argues that the fundamentals suggest some continued underpinning of corporate bonds. “Corporate earnings growth is slowing, but it is still positive. Balance sheets are strong and default rates remain low,” he says. Meanwhile, “the Fed is not expected to be overly hawkish on interest rates, and while the European Central Bank will probably hike rates 50 basis points by the end of this year, there is still no reason for undue concern,” he suggests. But as a note of caution over longer-term credit quality, Ballard notes that “the percentage of higher-risk issuance within the high-yield market has been steadily growing in recent months.”
On the technical side, investor demand for yield remains strong. “In a low rate environment, fund managers who are looking to hit yield targets have had to move down the credit curve in favor of corporate bonds—hence the outperformance of the high beta end of the credit curve, in particular triple-B rated assets,” says Ballard. Other technical factors include “the amount of cash on the sidelines”, he adds. “Investors have a lot of cash to put to work, and during this spread rally have been forced increasingly to look further down the credit curve in search of spread pick-up and incremental yield.” The emergence of 50-year issuance, as well as flows out of high-yield into emerging market debt, have been positive indicators in terms of investor risk appetite.
Set against these factors is the consideration that investors are taking higher yields into account. “Increasingly, as the year progresses and government markets sell off, investors will be able to hit their yield target with a higher-rated asset,” predicts Ballard. “So we may see migration up the credit curve, and a steepening of the credit curve in the second half of this year.”
Ballard says the widening of spreads in mid-March shows that investors were testing the water, but he believes spreads could now consolidate around current levels once the current volatility surrounding GM and the auto sector abates. Longer-term, though, “with future interest rate rises, we may see further modest widening in the third and fourth quarters, and I would certainly expect spreads to be wider by the end of this year than where we started.”
As for the specific challenge posed by GM, most strategists seem to agree that even a downgrade of the auto giant by the rating agencies, and its move from investment-grade to junk status, would not present serious systemic issues for the corporate bond market. “I don’t see GM having a wide effect in Europe,” says JPMorgan’s Dulake. “Until recently, the conventional wisdom was that a GM downgrade would create a nightmare scenario for European credit. But in fact those sectors in Europe that face similar problems to GM—such as airlines, for example—have already been trading at wider spreads.”
Nor does Dulake believe GM’s move into the high-yield sector would necessarily be hugely significant for that market segment. “Although it will be considerable in terms of sheer size, most high-yield investors are benchmarked to constrained indices and therefore can only hold a certain volume of any given credit,” he says.
Martin at Merrill Lynch also points out that while there has certainly been a dramatic sell-off of GM bonds, some benchmarked accounts need to have a non-zero allocation to GM. “Our credit survey in January highlighted that money from forced selling following a negative outlook or downgrade to high yield would likely be reinvested back into credit,” he says. “We expect the demand/supply imbalance to therefore remain favorable for European credit.”
Suki Mann of SG CIB agrees that the problems at GM do not represent a turning point for credit. “GM shouldn’t present longer-term problems for European credit, and the money exiting GM should in theory flow back into credit markets,” although he notes that this hasn’t happened yet. “The market will ride out this volatility and tighten again, although not at the same rate as in the first two months of this year.”
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