On Monday, we highlighted how BNP Paribas believed sovereign credit spreads were widening because markets were adjusting to the idea that central banks might soon remove liquidity measures implemented over the crisis.
Over at the Deus Ex Macchiato blog, however, another interesting point on the matter is raised by David.
To wit, while sovereign CDS may be widening because central bank liquidity is about to be removed, CDS products that are linked to credit-widening pay-out triggers — quite separate to full default protection on a credit event — should be dampening those effects. As David explains:
…there is a popular credit derivatives product which packages up a leveraged sovereign CDS in a note. Essentially the buyer of the note gets an enhanced return in exchange for selling CDS on a multiple of their notional at risk. The catch with these products is that they do not just trigger on an ordinary credit event: in order to protect the selling bank, they also trigger on spread widening.
Thus for instance one popular version of the product in 2008 year paid Libor plus 1% or so in exchange for seven times leveraged exposure on Spain, with a trigger if the Spanish sovereign CDS spread hit 100 — a level it is perilously close to today.
These notes are reasonably subtle products in that they can seem to the naive like simple speculations on sovereign default — and no one expects Spain to default. But the spread trigger means that they are in fact rather sophisticated forms of credit spread option. The note issuers hedge by selling sovereign CDS on the other side. All else being equal, this should act as a brake on spread widening, as note buyers take advantage of better spreads to sell more CDS.
The curious thing then, according to David, is who are the buyers of sovereign CDS on the other side, and more important: who is paying these high prices for sovereign protection, especially on the better quality names?
Related links:
CDS report: Is Greece the only sovereign on a slippery slope? - FT Alphaville
The US government’s toxic borrowing strategy – FT Alphaville