The cost of protecting European debt against default soared to an all-time high on Thursday, bursting through levels not seen since the panic wrought by the fall of Lehman Brothers.Just four single names in the Markit iTraxx Europe index showed negligible credit improvement in early trade as credit markets digested yesterday’s steep falls on Wall Street and the grim prospect of deflation after a record drop in US consumer prices.
The five-year Europe index, composed investment grade corporate bond issuers, jumped 9 basis points to 183bp. The iTraxx Crossover of mostly junk-rated debt also soared to a high of 926bp, a rise of 33bp.
Previously the Crossover had never passed higher than 925bp, while the Europe index had never breached the 181bp mark.
Overnight in Asia credit sentiment was similarly dashed by data showing Japanese exports dropped 7.7 per cent year-on-year. The Nikkei fell 6.9 per cent and the iTraxx Japan jumped 34bp to close over the index’s historical wides.
The real question however is how far the severe stress of credit markets reflects economic reality.
Mehernosh Engineer, a credit strategist at BNP Paribas, told FT Alphaville:
What we are seeing is two very different markets. The CDS market is telling us the world is going to end tomorrow, while the cash market is telling us the real economy will get funded.
Indeed, as the Lex column points out this morning, the normal correlation between CDS spreads and cash bond prices has been blown apart in recent times.
Normally, CDS spreads trade wider than cash bond spreads. First, because investors short credit by buying default protection; that pushes CDS spreads wider. Second, corporate bonds are typically viewed as attractive to hold because they can be used as collateral for funding. That narrows spreads on cash bonds.
But corporate bond spreads are now trading higher than the corresponding CDS. Long-dated senior bonds issued by Aviva, the insurer, trade close to 260bp, while five-year CDS written on its debt trades around 190bp.
In what is known as a “negative basis” trade, CDS arbitrageurs would typically take advantage of this discrepancy by buying the bond and purchasing CDS protection on it at the same time.
This means from the start of the trade they can profit from the difference between the bond spread and the lower cost of CDS protection. They can also benefit as the spread gap, or “basis” narrows, as is expected in normal times.
These are however, far from normal times. “Why is this happening?”, asks Lex.
First, assets everywhere are being dumped in favour of cash and corporate bonds are no exception. Second, corporate bonds are no longer that attractive as collateral for funding because counterparts are demanding more onerous terms in exchange for lending out cash in return.
When this abnormality will be corrected is difficult to predict, and those who call it correctly could make large profits. But, while credit derivatives continue to price in apocalypse and European bonds look unattractive to bombed-out investors, analysts say we could see this pattern for some time to come.
