Greek solution unlikely to trigger CDS <p>
Hedges unwound over summer; significant latitude to avoid trigger
With five-year Greek sovereign CDS trading at 62 points upfront in late September, investors looking to buy credit protection on Greek sovereign debt must hand over $6.2 million to insure $10 million of underlying exposure, in addition to annual premium payments of $100,000. Otis Casey, credit analyst at Markit, says: “At this level, CDS spreads imply a 100% probability that Greece will default with recoveries of around 35% to 40%.”
However, those that bought protection on Greek debt hoping to collect when it finally fell out of the eurozone will probably come away empty-handed. Although it is increasingly likely that the EU will force Greece to restructure its debt pile in some way over the coming months, there is a growing consensus among banks and investors that the most likely outcomes will fail to trigger the CDS as they will be deemed voluntary.
“Greece has significant latitude to avoid triggering a CDS credit event, if it so desires,” reckoned JPMorgan analysts in a recent note. “Most likely Greece will pursue a combination of mild voluntary restructuring at a later date in combination with continued structural reforms and asset sales. In this case Greece could avoid a CDS trigger relatively easily.”
Regardless of whether or not restructuring will trigger the CDS, markets continue to endorse elevated credit risk premiums as indicated by the 1,150 basis points basis between Greek CDS spreads and Greek government bond yields.
“We are at a tipping point one way or the other. Even though the vast majority of participants expect that Greece is going to receive the next round of aid and that the EFSF will be up and running, we are still waiting for formal confirmation that it will receive funds in time to meet its October payment dates,” said Casey in late September. “The elevated Greek CDS basis shows that a segment of the market still believes that even if they get the aid, it will likely be the last round and that the situation is unsustainable in the long term.”
It’s not yet clear what the holders of the €3.8 billion outstanding in Greek CDS will do if default protection is not triggered. JPMorgan estimates that counterparty valuation adjustment (CVA) desks, which use CDS contracts to manage a banks’ credit exposure to its trading counterparties, account for as much as 30% of net outstanding notional in sovereign CDS contracts. Anecdotal reports suggest that these participants began unwinding Greek CDS hedges in July, following the Isda announcement that any voluntary restructuring will not trigger CDS. Indeed, sovereign CDS’s apparent failure to deliver on its risk transfer promise when most needed has led to calls for investors to abandon the instruments as risk-management tools, with the uncomfortable implication that default, not typically associated with optimal outcomes, would be good for the market.
Fortunately, the net volume of Greek CDS outstanding is relatively small compared with the total volume of Greek debt outstanding, which the Hellenic Republic’s finance ministry says is approximately €340 billion. This indicates that the majority of bond holders are not using Greek CDS to hedge cash bond positions, or that they are using other approaches, such as buying protection on sovereign CDX indices, or shorting government bonds.
“Instinctively I trust cash prices not CDS,” says a London-based head of fixed income with an institutional asset manager. “While they have worked as a flag for trouble in the eurozone periphery and they make good headlines, I see no real purpose in taking insurance against sovereign default. They are therefore, in my view, only a trading instrument, not a cast-iron protection against a failure to pay coupons or redeem bonds at par. The ECB’s determination to avoid any Greek event being called a default further muddies the waters.”
With maxed-out credit spreads implying certain default, it’s probably safe to surmise that few investors are buying Greek CDS for risk-management purposes at these prices. Markit’s Casey says that liquidity in the single-name market has fallen. Instead, some dealers are advocating a bet that basis spreads will tighten further as the realization sinks in that default won’t trigger CDS. This basis trade too involves taking short positions in both CDS and cash bonds, which, when combined with the hedging flows, creates downward technical pressure on the market.