Remember a month or so ago when we told you there was evidence that CDS spreads may influence bond yields?
“Influence” is a strong word. It was more about which one leads the other. In our previous post, we gave an overview of a study which presented evidence suggesting that when spreads reach distressed levels, the degree to which the CDS spreads lead bond yields increases.
One way to examine this is look at the CDS bond basis — a calculation which takes the CDS spread and subtracts the asset swap spread of the bond (ASW).
FT Alphaville’s more recent thoughts around this can be summarised by one word: bunga.
Let’s take a look then at the latest moves in the CDS-bond basis for Italy and France. Data courtesy of Markit. The series are up to and including yesterday’s close.
The lines on the chart are of the asset swap spread (ASW) minus the respective CDS spread. There is more than one way to calculate this basis, and we wanted to give you both. In part because it illustrates just how much Italy has detached from core countries like France. Excerpts from Markit’s methodology:
…the Actual basis report takes individual bonds as a starting point, calculates the asset swap spread for those bonds and subtracts this from the CDS spread calculated to the exact maturity date of the bond.
…the Theoretical basis report takes an evaluated bond curve and calculates the par coupon for a theoretical bond with maturity matching that of the CDS. The asset swap spread is then calculated and subtracted from the CDS spread to provide the basis. The coupon on the bond is changed on a daily basis to keep the bond at par, ensuring that the asset swap spread is not distorted by premium or discount.
In other words, “actual” means that a real benchmark bond is used (for Italy in this case a bond that matures in September 2021 that has a 4.75 per cent coupon) and it’s subtracted from the CDS spread, where the CDS spread is of a tenor matched to that bond. The “theoretical” means that a par bond is constructed from a curve, the ASW of it calculated and subtracted from the CDS spread.
The widening of Italy’s actual basis from its theoretical basis is largely down to the sovereign’s bonds no longer trading at par. This means that the coupon needed to get a theoretical bond up to par increases, and the ASW increases along with due to the higher coupon required (and par pricing).
But why does France have a higher basis than Italy? Let’s drill down to the component parts:
FT Alphaville Credit Geek Box
The CDS spreads in the above chart, and hence in the basis, are for trades denominated in euros. This, of course, is not the dominate trading convention for sovereign CDS. The usual trading convention dictates the use of US dollars, given the high correlation between the euro and the fate of the countries that use it. In other words, CDS protection in euros won’t likely be worth much when you need it the most, hence most of the trades are in dollars.
Moving along! Here’s Leon Sinclair of Markit’s Evaluated Bonds Team to explain a bit more about the chart:
The low ASW of France is indicative of their status as a safe haven asset. However, this has more recently been called into question given the large contingent liability arising from the EFSF that will strain the sovereign’s balance sheet, putting pressure on their greatly coveted AAA-rating. The CDS spreads, however, reflect this pressure and increased demand for the contracts as a hedging instrument, both for the bonds and the French economy more generally.
So France is safe-haveny, but not quite as much as it was, while CDS aren’t exactly something you invest in when all you want to do is go back to bed with a water bottle and only re-emerge when the whole sovereign crisis has been resolved. And fair enough, frankly.
Meanwhile, with Italy, it looks like the bonds, as measured by their ASW, have been catching up to where the CDS are, and it’ll be worth watching where we come out over the next week. On the one hand, many Italian bonds appear to be trading in a vacuum. It’s hard to tell if the CDS are too.
Italy CDS actually saw very busy trading last week. It was the most active single-name out there with 580 contracts traded over a notional of $6,952m, according to DTCC data. The next most active was France, with 365 contracts over $5,787m. This isn’t too strange, since they are the biggest names out there in terms of overall positions anyway.
However, those data points are already stale and we’re going to have to wait until next Tuesday night to get this week’s activity numbers. In the meantime though, a good proxy is available in form of daily activity data on the Markit iTraxx SovX Western Europe, because trades on individual sovereigns are often hedged with this index:
On Monday and Tuesday this week, there were only eight trades on each day, with notional amounts of $66.5m and $90.9m traded respectively. Similar activity drops were not spotted in the major corporate indices. With both markets feeding back on themselves — margins on the rise for the bonds will push yields further and CVA desks presumably having to step in to buy more CDS protection (or short the bonds), also exacerbating the moves — it would appear that we’re in death spiral territory.
Has the sovereign market gone to ground? FT Alphaville can wish for decisive action from politicians, but frankly hiding under the desk seems like a better strategy. See you on the other side… we hope.
Related links:
CDS, Wanted: Banned or less naked - FT Alphaville
Stocks, Euro Sink as Italy Yields Reach Record - Bloomberg
Quantos: when CDS met the monetary union – FT Alphaville