Has the CDS rally gone too far? | FT Alphaville

Has the CDS rally gone too far?

The credit strategists at BNP Paribas believe the recent rally in the credit default swap market – particularly among riskier credits – may have gone too far, according to a comment issued on Monday.

BNP’s anaylsts highlight the iTraxx Crossover, which they contend is not adequately compensating investors for default risk over a one-year horizon. They note (emphasis ours):

The latest Moody’s forecasts in terms of European default rates suggest that Crossover investors are being compensated from about half the expected default losses over one year – although they should still be able to breakeven over the entire life of the contract (see table below).

Baseline*    Worst case*    B/E**(XO@730bp)
1-year      19%          25%            10%
5-year      29%          35%            37%

*  Moody’s forecasts for European speculative grade default rates
** Assuming a 20% recovery rate

The reason for this is that the default cycle, according to the rating agency, is going to be very front-loaded, with defaults expected to peak in December this year and then drop sharply, leaving the five-year cumulative default rate well below its historical standards.

BNP Paribas analysis of Xover breakeven over 5-year periodBNP Paribas analysis of Xover breakeven over 1-year period
The analysts highlight two risks of the Crossover’s current levels (emphasis FT Alphaville’s):

(1) the more obvious, that Moody’s forecasts over the 5-year horizon prove to be too optimistic and default rates will match (or exceed) those seen in the latest cycle, leaving investors under-compensated by the carry

(2) that investors may have to close their long-risk positions earlier, with the carry earned over the holding period insufficient to offset the losses caused by a surge in default rates. The second risk, in particular, could cause a “long-squeeze” as default losses mount, leading to a rise in Crossover spreads.

The iTraxx Crossover was quoted at around 755bp in late trade in London  – compared with 740bps at the close on Friday – according to Markit data.

Related links:
Moody March – FT Alphaville
Brace yourselves for record corporate defaults – FT Alphaville
Will CDS spreads tumble in February? – FT Alphaville