This CDS report was written by Markit’s Gavan Nolan
In the past, CDS spreads and stock prices have endured a steady, if inverse relationship. When one goes up the other comes down and vice versa. However, in recent weeks this relationship has become increasingly fractured. Today, for example, the major stock indices were lower earlier while the Markit iTraxx Europe index was tighter. The ratio of names in the index that have tightened compared to those that have widened is around 5 to 1.
This seemingly illogical behaviour has become increasingly common during the recent turmoil. The bank bailouts, which favoured bondholders over shareholders, accounted for some of the dichotomy.
But technical factors are also pertinent. Volkswagen is a notable example. The car maker’s spreads have widened along with the rest of the auto sector. A European economy heading for recession bodes ill for cyclical credits. But its stock price has defied gravity and risen in tandem with CDS spreads. The reasons behind this irregular movement appear to be related to Porsche’s attempted takeover of the German car maker. Exploiting German takeover rules, Porsche bought call options on VW shares. The sheer scale of the hedging and short covering that resulted from this transaction pushed up VW’s shares to stratospheric levels. Normality has returned with a vengeance the past few days, with the stock price coming back into line.
Despite the onslaught criticism that CDS have received in the current crisis, it is evident that in some circumstances they can be the best indicator of the fundamental health of a company.