There’s a small irony that might be lost on western governments. As they prepare legislation to clamp down on the credit default swap market, which, they claim, creates systemic risk, the very same instrument is becoming the tool of choice in hedging the ultimate of all systemic risks, sovereign default.
Since October, the net amount of credit default swaps outstanding on 54 governments from Japan to Greece has jumped 14%, compared with just 2.6% for all other contracts, consisting of investment-grade and high-yield companies, according to the Depository Trust & Clearing Corporation. The increase is largely driven by European sovereigns, with contracts on Portugal up 23% and on Spain up 16%. As the IMF points out in its Global Financial Stability Report, the financial system is still fragile, with sovereign debt posing a risk to markets.
Traders say that sovereign volumes have gone through the roof since the beginning of the year. Whereas as recently as December they made up 5% of trading volumes, they now constitute about 20% of daily volumes, according to Deutsche Bank. Part of that is explained by the introduction of a sovereign CDS index in January by index provider Markit iTraxx, which enables investors to hedge their indexed bond portfolios against a similar synthetic index. When similar indices were introduced in the corporate markets in 2004, volumes took off. Anecdotal evidence suggests that real-money investors are using derivatives to hedge their bond portfolios and the rise in trading isn’t just a bunch of hedge funds looking to feed off the negative sentiment and corner the CDS market, as they have often been accused of doing in the past.
As banks are at pains to point out in the debate about regulatory reform, for the most part credit derivatives provide a useful tool to hedge market risk, and the debt market is set to become much busier and more volatile as companies and sovereigns battle to attract investors’ capital. Sovereign debt markets might well be the deepest and most liquid of all debt markets but that is not the case for all issuers.
So what does the CDS market say about the potential for default? The biggest story in town has been Greece’s emerging debt crisis. Current prices on the sovereign’s five-year CDS suggest that there’s a 30% chance the country could default on its debts over the next five years. For Portugal there’s a 20% chance, and for Spain it is 18%.
Just how worried investors are about sovereign debt can be shown by comparing the European sovereign credit index with the European investment-grade corporate index. They have just converged, implying that the market sees a similar level of credit risk. Go back to late 2007 and the same thing happened when bank credit risk converged with corporate risk. Some said at the time that bank risk was overstated. They were wrong.
