When a sovereign or corporate becomes sufficiently distressed, a flip can happen in the way the credit default swaps are quoted. According to Markit, this is happening with Portugal now, with the CDS moving from being quoted in conventional spread to upfront. This is, in some ways, a worse omen than the credit deterioration itself.

It’s the conventional spread format that’s making headlines at the moment. Trampling previous highs, the CDS has broken into uncharted territory (in the figurative sense only, as here is a chart, courtesy of Markit):

The way that quotes are presented is effectively a measure of how traders view the name and its future path. Trading conventions are incredibly sticky because whenever they move, everyone has to adjust to a new way of seeing it, relative to other credits and its own price history. It can also mean operational changes.

At the moment, Gavan Nolan at Markit tells us that about half the dealers still quote Portugal in conventional spread terms and the other half have recently moved to upfront quotes. About twelve dealers quote the CDS every day.

When it comes to presenting quotes, the logical thing to do is to always give numbers in the most easy to understand way. For example, if this had been about weight, it’s easier to conceptualise 33 pounds than it is to work out (the equivalent) 528 ounces. Once the item in question is over a certain threshold weight, pounds are the preferred unit. It’s just easier.

Similarly, once a credit becomes particularly distressed, it’s easier to think in terms of the day one “upfront” payment required to enter into a CDS contract.

Concerning Portugal, if one had bought a five-year CDS contract on Thursday, one would have parted with $3.82m per $10m notional of protection. In addition to that, 100bps would be payable per year, so about $25k per quarter. That is the reality of the mechanics of that trade.

The thing we are discussing here is how the trader presented the quote.

With Portugal, half of the dealers would have quoted a price for that contract as being “1377 @100″. The other half would have shown “38.20 +100″. The 1377(bps) is known as a “conventional spread” and the 38.20(per cent) is known as “upfront”.

This diagramme shows the the mechanics, and displays the quote in conventional spread terms:

Again, this is purely a presentational issue. The mechanics of the trade, regardless of quoting convention, are that $3.82m is paid upfront, and $25k is paid per quarter.

Conventional spread is called “conventional” because a model that everyone agreed on (a convention) is used to convert between the spread quoted and the upfront payment reality.

If the market wanted to be mega efficient in terms of display, it’d just show everything in upfront terms because that perfectly reflects reality. The reason it doesn’t is because conventional spreads are easier to compare to other asset classes, and upfronts can be negative as well as positive. Different coupons complicate the issue.

On that point, the reason upfronts can be negative is that CDS only trade using a small universe of agreed coupons (that set the fees that will be regularly due over the life of the contract): 100bps and 500bps, with a few sovereigns on 25bps.

For example, take a five-year CDS with a quoted spread of 450bps and a 500bps coupon. Since the buyer would be overpaying the seller if he paid 500bps, the seller compensates him on Day 1, to the tune of $264k (the fair value of the 50bps overpayment over five years according to the conventional model). Like so:

Again, the presentation of quotes doesn’t often migrate, so it’s interesting when they actually do. Traders are consciously or unconsciously stating that CDS on Portugal will be trading at distressed levels for long enough — and have plenty of scope to move even wider — that everyone should just as well get used to seeing them quoted in upfront terms.

And yes, Greece trades in upfront terms: 63.87 per cent for 5-year CDS as of Thursday’s close, according to Markit.

Since Portugal CDS are likely to provide headline-fodder for the foreseeable future, it’s only appropriate to examine the amount of trading activity that’s going on (data from DTCC):

The general trend of decreasing activity is consistent with the fall seen in net notional values, i.e. the overall economic position in Portugal CDS has also been declining as FT Alphaville has already demonstrated. It would appear that there was an uptick in activity that related to the S&P downgrade.

For comparison, here’s the activity for Greece CDS:

There has also been a general decrease in activity and the amount traded is less than on Portugal.

For perspective though, when measured by notional traded, Portugal was the 45th most active CDS last week, and Greece was in place 53. This is out of 896 CDS that reference a single corporate or sovereign. Put a slightly different way, CDS on Portugal represented 0.46 per cent of all activity in the market, and Greece covered 0.43 per cent.

There are a few reasons why we want to point out activity:

1) Portugal CDS are going to be used a lot in the near term as a metric of the decline in Portugal’s creditworthiness. In weeks that the contracts are not actively traded, this is less appropriate when they are more actively traded.

2) Where activity is accompanied by a decline in the overall net notional (economic positions) in the market, and that is what has been the case so far, investors may be taking profits (/recognising losses) rather than wait for a credit event to trigger or not, see: Greece. As long as the pricing mechanism is roughly in line, credit events aren’t even really all that necessary –providing that you actually think the contracts are pricing appropriately, that is…

3) Even when trading is low, however, the amount of leverage that CDS employ, and their relative liquidity, mean that they can have an outsized effect on the bond market.

Expect to hear more about Portugal CDS. Wait and see how long it takes for quotes to show up in upfront terms in the media too.

Related links:
Once bitten, twice shy on Portugal – IFR
Portuguese bonds hit as traders fear default – FT
Portugal in the crosshairs - Pragmatic Capitalism

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