We’ve seen CDS curves in Greece, Spain, Portugal – and BP — invert this year.
But before Lehman Brothers collapsed, those kind of CDS curve flattening and inversions (which suggests CDS investors are pricing in a higher chance of default in the short-term) were relatively rare. Before the bank went under, CDS curves had a tendency to steepen in times of stress — mostly because of Leveraged Buy-Out fears, which meant issuing more debt/changing the debt structure.
Anyway BNP Paribas’s Rajeev Shah is questioning whether CDS curves may be flattening/inverting too quickly now — what with sovereign stress and multiple tail risk fears. The bank says:
The brutal flattening and then inversion of CDS curves shortly after Lehman, was principally a manifestation of the fact that liquidity vanished overnight. To the point that even healthy IG corporates came to the precipice of distress (think GE) being unable to refinance. It thus comes as no revelation that CDS curves have correlated closely to financial conditions over the financial crisis – see for example chart 1 for iTraxx Main 5/10s vs the US Financials Conditions Index (FCI in short).
So are CDS markets now over-reacting to negative news?
BNP Paribas have done a basic regression study of CDS curves for major indices against the US FCI.
The iTraxx Main, which includes the 125 investment-grade names in markets (corporates and financials), Crossover, which covers the 50 most liquid European high-yield credits, and Senior and Subordinated Financials, which are pretty self-explanatory. The bank also looks at the CDX IG, a North American-oriented CDS index which includes 125 investment-grade names.
The findings are in this table — but we’ll have BNP Paribas summarise:
* The curve estimates for iTraxx Main and Senior & Sub Fins (column 6) are higher than their actual current level (column 4), so they are trading flatter than the FCI implies. Amongst the three, iTraxx Senior Fins stands out the most, since its current valuation of -8bp (column 7 in bold) is near the lows of the 1-year valuation range.
* The curve estimates for iTraxx Crossover and CDX IG are lower than their actual current level, so they are trading steeper than the FCI implies. The valuation signal though is weak in both cases. In the case of Crossover it is a mere 5bp, which barely registers vs the bid/ask. In the case of CDX IG it is ~15bp and in the middle of its 1-year range. Yet one factor that could drive the CDX IG curve flatter is that concerns of a significant slowdown in the US are clearly rising.
So according to BNP Paribas, it’s the CDS indices most affected by the possibility of contagion from sovereigns (iTraxx Sen/Sub Fins and iTraxx Main) that are trading flatter — i.e. worse — than what pure financial conditions would imply.
So cheer up CDS investors, BNP Paribas says things aren’t as bad as you think.
Though, err, for iTraxx Crossover and CDX IG investors, they’re apparently worse.
Related links:
Of CVA and sovereign CDS – FT Alphaville
CDS market doesn’t believe in Greece containment – FT Alphaville
More than you probably ever wanted to know about CDS… – The Long Room