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Cash bond/CDS: Necessity breeds invention

The credit crunch fundamentally altered the cash bond/CDS dynamic. As more and more managers are forced to turn to CDS to hedge their bond portfolios, will we ever see a return to highly liquid cash markets? Jethro Wookey reports.

AFTER YEARS OF excess liquidity flooding the European secondary bond markets, the US sub-prime disaster has coursed through trading channels. Over the past three months, credit fundamentals have broken down, and liquidity has contracted severely in the cash bond and loan markets. This time last year, investors were buying up debt instruments as fast as originators could devise ever more diverse structures for them, as tight spreads and the search for yield drove much of the buy side to look for more value-added areas to invest in. Now many of these complex instruments have gone from semi-liquid to practically solid and are responsible for significant mark-to-market losses. The crunch has already claimed its share of banking stars and has not yet reached the end of its trail of destruction. The primary debt markets have stuttered and stalled as volatility has increased dramatically.

But secondary trading continues to flow in some sectors of the market, namely in credit default swaps (CDS) and credit indices, a significant amount as a direct result of hedging and speculation brought about by the rise in volatility that did for the cash market. Although the credit indices are very active, there is some contention about their suitability as a hedging tool.

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