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Italian election impasse will test sovereign CDS market to the limit

CDS spreads are indicative of liquidity, not default, risk. The ban on naked shorting will drain bond market liquidity and increase volatility.

“We are coming to a fairly critical juncture in fixed income,” warned Paul Crean, co-founder and CIO of Finisterre Capital, an emerging markets fixed-income specialist, at a seminar hosted by co- hosted by London’s Imperial College and Peregrine Communications on February 12.

“This has been the hiding place for investors over the last five years. Investors have wanted to be in bonds and it has worked out very well for them. They are more concerned about protection than making money.” However, with government bond spreads now at all time lows, Crean warned it is time for investors to start facing up to reality. “At some stage the central banks will have to take their foot off the pedal and start the painful process of normalizing markets,” he said.

As that process draws closer, the performance of sovereign CDS spreads – particularly in light of the ban on naked short positions in European sovereign CDS that came into effect on November 1 – will attract fierce scrutiny. The ban has already had a substantial impact on the region’s sovereign CDS market. According to data from Citi and the DTCC, net notional outstandings of EU sovereign CDS have fallen 27% from €124 billion in mid-2012 to about €98 billion today. The market peaked at €140 billion in August 2011.

Paul Crean, co-founder and CIO of Finisterre Capital

Research published last year by Lara Cathcart, senior lecturer in finance at Imperial College, aimed to decompose sovereign bond spreads and CDS spreads into their main drivers to better understand what drives movement in each. She concluded that 73% of the risk component driving bond spreads is default risk, with 27% accounted for by liquidity risk. The momentum behind CDS spread movements is, however, far more skewed towards liquidity risk. Cathcart and her team calculate that 56% of the risk component of the CDS spread is default risk, with 44% being liquidity risk.

She therefore concludes that while sovereign bond spreads can be viewed as a proxy for the default risk of the underlying sovereign, CDS spreads are driven by trading activity and are therefore not a reliable measure of default risk.

“Sovereign CDS spreads are highly impacted by liquidity risk and may send false signals of weak creditworthiness,” she warned at the seminar. “CDS spreads do not push a country into default, but I do understand the regulators’ point of view that they may send the wrong signal.

“The regulators need to understand, however, that CDS does not just represent default risk. The liquidity of the entire bond market will be affected if CDS is blamed. Regulators should rethink their policies – CDS are a crucial part of the credit markets.”

This argument has fallen on deaf ears at the EU. Finisterre’s Crean insisted, however, that the impending normalization of the markets means that the regulators need to sit up and listen. “At the very moment this approaches, the regulators take away one of the protections we have for investing in long-term bonds,” he complains, ruefully. “It is folly. You can get exaggerated moves in CDS but there is such a strong linkage between CDS and bonds that it will be arbitraged out if it gets too wide. That is the job of the market. Hedge funds will do that.”

Money managers such as Crean worry about how the CDS market will cope in a period of renewed sovereign stress. “The banning of naked CDS in Europe will have unintended consequences,” he warned. “Liquidity will fall and volatility will increase. This has big implications for long-term borrowers in the eurozone and their ability to attract capital.”

By removing the ability to dynamically hedge a portfolio, the ban is forcing sovereign bond issuance to the five-year part of the curve – the standard CDS contract is five years. This has obvious implications for sovereign borrowers. “If I cannot hedge the risk of long-term debt, I will be less incentivized to buy it as I can’t protect my investors,” said Crean. “This forces countries to issue shorter-term debt and therefore increases rollover risk.”

Any rise in sovereign stress in Europe will result in investors scrambling to hedge their exposure in a market that is a shadow of its former self.

“CDS spreads are the symptom of a country getting into problems – not the cause,” Crean emphasized. “Look at the size of the CDS market compared to the underlying bond market in Europe – the tail cannot possibly wag the dog.”

Gross outstanding CDS contracts on Italy are $406 billion, which accounts for 20% of outstanding sovereign debt. Net exposure is $21 billion – less than 1%. “In Italy, a lot of institutional money is trying to squeeze itself into a small CDS market in order to protect itself,” warned Crean.

Finisterre, which was founded in 2002, is an emerging markets specialist, and Crean argues that one of the reasons that eurozone CDS might have behaved erratically in the past is due to the nature of investors in the product.

“Three years ago, Greece’s debt/GDP was already over 100%,” he said. “Even at that stage, its CDS spreads were trading too tightly for a country with that debt dynamic. CDS on Greece should have moved wider before it did. The people that started to move it were emerging markets investors. Developed markets investors were holding it in their rates books and had not thought about the risk of default.”

They probably are now, and the buffeting many have received since the crisis began means their sensitivity to spread movement – either in the underlying bonds or the CDS – will be acute.

“Big mutual funds have seen massive inflows and their balance sheets have got bigger and bigger,” Crean pointed out. “These funds promise daily or weekly liquidity. This is happening at the same time as the balance sheets of the liquidity providers – the banks – are shrinking. If and when the market turns, banks are going to be expected to absorb this and volatility will potentially go sharply higher.

“In banning naked CDS, the European regulators have shot the messenger.”

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