Volatility – and lots of it – stalked global credit derivatives markets on Friday morning.
In Europe, the benchmark Itraxx Crossover index traded as wide as 446bp before steadying around 420bp. The cost of insuring high-risk European corporate debt against default is now approaching levels not seen since the correlation crisis of May 2005, when General Motors and Ford lost their investment-grade ratings. That event triggered a broad and painful credit sell-off, and the Crossover – the key barometer of credit market sentiment – jumped to 452bp.
But Jim Reid, Deutsche Bank’s London-based credit research chief, said markets are even more uneasy now than they were then – and leverage, derivatives and structured products are to blame.
There were days in the auto crisis of May 2005 that were bad, but they didn’t feel nearly as bad as they do now…We should now be in little doubt of the power and influence of leverage, derivatives and structured products. They are not volatility dampeners but volatility magnifiers.
Reid argues that while fundamentals – including global growth and corporate balance sheets – are their strongest in decades, “the technicals are as bad as we’ve ever known them”:
Never has so much money been thrown at and been levered up in credit and never has there been such a liquid derivative market to hedge risk. So we are dealing with the unknown. The battle between fundamentals and technicals could not be more extreme.
Meanwhile, the investment-grade iTraxx Europe index jumped as much as 10bp to as much as 57bp, the biggest one-day increase since the index was created three years ago. The iTraxx Europe, like its high-yield cousin, is approaching its own “crisis level” of 60bp.
Financial names have been particularly hard hit by the market upheaval, as investors worry about their exposure to a range of problem areas from mortgage markets to the leveraged loans that fund private equity buy-out deals.
Deutsche Bank‘s risk premium, for instance, has quintupled since June 1 – soaring 12bp to a record 47.5bp. Even Australian banks have been affected: the cost of five-year default protection on the subordinated debt of Australia’s four biggest banks – National Australia Bank, Commonwealth Bank of Australia, Australia & New Zealand Banking and Westpac Banking — each increased 9.5bp to 33bp, according to Bloomberg data.
Elsewhere in Asia, Japan’s credit default swaps widened sharply, tracking similar weakness in US equities and credit markets. The iTraxx Japan Index of 50 investment-grade companies, traded as wide as 39.25, compared with Thursday’s 28.25 and 28.5. Bid/offer prices fluctuated, indicating uncertainty over where the market would stabilise.
As one market participant told Reuters:
Investors are “very confused” about the proper value of swaps…Everyone’s just throwing out prices to see where it’s going to hit. It’s a very unusual market we’re seeing here; it’s not normal.”