Wednesday, February 25, 2009

The Inversion Of Corporate and Sovereign Risk, Or The Sovereign Basis Trade

The recent spillover of the threat of an Eastern European collapse, and its gradual spread into the Eurozone, has manifested itself best in the dramatic widening of sovereign CDS. The so-called socialization of risk had resulted in a tightening of corporate and bank default risk at the expense of the respective sovereign domiciles. Recently, however, the continued widening in sovereign risk has led to a more circular relationship with financial risk, as after the initial knee jerk reaction leading to financials being perceived less risky (or tighter) late last year, bank CDS have started moving wider yet again. And while non-financial corporates have seemed relatively insulated from a correlated move wider with sovereigns, the biggest threat of another significant risk flaring is probably concentrated the most in corporate risk. As we show below, there are many corporate CDS which trade paradoxically at levels notably tighter than their respective sovereigns, presenting an opportunity for daring investors to put on converging basis trades where a sovereign is the long-risk leg.

Why has sovereign risk skyrocketed?

As we noted last Friday, US Sovereign CDS for the first time ever passed the psychological barrier of 100 bps after trading in the 60s two months ago. The primary reason for this, at least domestically, has been the rapid increase in public sector debt to compensate for the deleveraging in the private sector. As credit risk has become more socialized in the U.S., the overall riskiness associated with leverage has shifted from the individual and corporation (which still have a lot of risk), onto the balance sheet of the sovereign.

And the U.S. is not alone, as it offloads private sector risk to its balance sheet: most foreign sovereigns are encountered with the same challenges and are responding as much as they can (many with the assistance of U.S. swap lines) by levering their own balance sheets. As the investing public has figured out this shift, trading in sovereign CDS has exploded and current outstanding gross notional and # of CDS contracts has hit record levels as seen in the table below (sourced from DTCC).

Empirically this is obvious when the historical progression of sovereign CDS trading levels is mapped out (again, the higher the number, the greater the perceived risk).

And for CDS traders out there, the structural difference between corporate and sovereign CDS, is that while both types of contracts include Failure To Pay, and Restructuring as credit events, Western European corporates account for Bankruptcy as the third gating event, while Western European sovereigns account for Repudiation/Moratorium.

Implications for non-Sovereign Risk

The two main categories here include financial companies and non-financial corporates. When the U.S. started opening up swap lines in October last year, and foreign central banks pledged huge sums to support a financial system in crisis, the immediate reaction was to bring financial risk significantly tighter. However, as the situation has not improved and more and more capital has had to be allocated in the form of senior debt guarantee programs and fiscal stimuli packages, the inverse correlation between sovereign and financial risk has disinverted, which is especially obvious over the past month, and the widening correlation has again become positive and approaching 1. All this is mapped out on the graph below: note the rapid rise in the orange line which represents the iTraxx Subordinated Financial Index over the past month, which is finally moving to catch up to the ever increasing sovereign risk.

Curiously, non-financial companies' risk has, to date, been impacted much less by deteriorating sovereign risk. The immediate explanation for this phenomenon is that while banks are again perceived as government risk, corporates are benefiting from the dramatic improvement in private capital raising in both debt and equity markets. The bottom line is that most corporates have not needed government support so far. The financial to non-financial divergence can be traced by looking at the opposite paths of the green and the orange line over the past two months in the chart below (green line represents the popular European HiVol index excluding sub financials).

One can argue that it is only a matter of time before non-financial CDS has a dramatic move wider as the weakness in both the government and the financial sector are understood to not be isolated threats. This is made much more obvious when once considers that there are numerous corporate names that have pushed tighter than their sovereign spreads! The table below lists all examples, but the biggest outliers are Telefonica whose 5 year CDS trades at 117 bps, compared to Spain at 148 bps, OTE is at 132 bps, compared to Greece at 254, Carrefour at 83 versus 91 for France, and Safeway at 55 versus 156 for the UK. Intuitively the thought experiment of having a UK sovereign default (for example) which would not implicitly or explicitly result in the bankruptcy of a company such as Safeway is unfeasible. But that's not all - the CDS to bond dislocation is evident in this love triangle as well: Tesco which also trades tighter to UK CDS (implicitly less risk than the UK), recently issued two bonds, both of which priced at 250 bps over Gilts. The confusion is complete: CDS and bonds of one and the same company imply it is both less and more risky than its sovereign!

The obvious trading implication would be to put on basis packages using the sovereign as the long-risk leg, and the corporate as the short-risk. The idea is that either corporates will quickly overtake sovereign risk as the credit markets continue thawing, or, in the worst case, will converge as default risk for the sovereign is perceived as the "lowest common denominator" below which all "less risky" names will also end up in default.

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Anonymous said...

I do not understand why CDS spreads for the US are increasing.

The US does not have currency exposure as relates to debt repayment. The US can always print money to retire any maturing debt obligations, thus avoiding default.

While it is true the repayment may be with worthless paper, the obligations are still repaid, hence no default.

What am I missing?

Anonymous said...

This piece was brillant!!!! Very solid. Much like a classic stub or convergance trade. Like Ben Graham's short GM long Dupont in the 20s-30s or today's long emc short vmw... or the deadly suicidal Porsche-VW trade. Please keep up the great posts. I thoroughly enjoy your ideas as well as the classic humor (aig = black hole, santelli = spartacus).

BTW, you should put a pay-pal tip jar out on your site. Your ideas such as SRS (I haven't figured out if that is how I want to play the coming CMRE downturn) may make people some more $$$ if they haven't already.

Anonymous said...

Many of the companies you mentioned are multinationals (for example Telefonica owns most of the south american mobile market, Carrefour owns stores all around Europe), so it would make sense that the risk would be more less.

lewy14 said...

Right, 'cause we all know that when a nation defaults on its debt, every single corporation domiciled in that country also defaults. Always.

Oh wait. Maybe it doesn't.

The simple way of looking at this is that the sovereign CDS market simply makes no sense for countries which can print their own money.

The UK sovereign CDS are probably held by European banks to satisfy some banking regulations which are the result of some severe cranial-rectal impaction.

Given that the CDS/Bond signals for UK corporates vs UK sovereign doesn't make sense... really, which market do you think suffers from delusion/dislocation/inefficiency? 'Cause you're right, one of them has to...

Anonymous said...

Over the top on this one! Keep up the great work.

Vasastan said...

Although I agree with lewy14 that the sovereign default=corporate default statement was a bit oversimplified (or underexplained), this was easily the best analysis piece I have read in the past weeks. Generally excellent blog, too.

Anonymous said...

"BTW, you should put a pay-pal tip jar out on your site. Your ideas such as SRS (I haven't figured out if that is how I want to play the coming CMRE downturn) may make people some more $$$ if they haven't already."

Yeah, you've heard of "Pay for View," this would be "Pay for your view."- Good idea.

Anonymous said...

few thoughts/comments/questions on an old post (re: "some more facts about how the cds market..."):

1)how do you get to your $2.6 trillion net notional estimate?

2) having been a CDS market maker in a past life, the net exposure market makers have is far from negligible. I'm sure risk has come way down in recent months, but the most successful desks were able to do so by keeping massive positions on the books. Sure, some offsetting trades to keep overall DV01s on specific single names close to home, but LOTS of curve and jump to default risk. very difficult to unwind or hedge...esp. given decreased market volumes

3) TD - how do you address the populist critique -- i.e. the insurance holder does not have to own the insured asset, and thus has every incentive to gang up on a name, spread rumors, and push the value of CDS spreads out...Soros et al. don't have a firm handle on the CDS market, but I haven't found the right argument to knock out this criticism...b/c in part, I've seen a lot of the rumor mongering take place.

4) think declining CDS volumes probably have strong neg correlation with increasing margining requirement, which I imagine will be even higher still when we move to central clearing...I agree with you that cash/cds basis will be a lot less negative than it is. But question is why do u necessarily assume cash bond spreads are indicative of true fundamental value? CDS I think will be wider b/c it will become more expensive to trade, so will catch up with bonds which are more expensive to trade and harder to sell/hedge once you own them (proverbial hot potato)...I guess would you mind explaining to me what you meant by: "counterparty premium is manifested by an artificial tightening in single-name CDS vis-a-vis matched maturity bonds" it just that b/c there's a greater chance the cds i buy from you is worthless so I'll pay you less for it?

Tyler Durden said...

good questions:

1) get it directly from DTCC which breaks down the net position on the 1000 top single-names. This is a recent thing, they did not use to do this before November.

2) agreed. the new clearinghouse will all be on fixed upfront fees (100 and 500 bps) instead of running spread, which will add to the complications of generating a new generation of on the run contracts.

3) how is this any different from ganging up on a stock and shorting it to hell? CDS is merely a liquid way of shorting bonds. That's all it is. before it was impossible to actively express negative sentiment about pieces in the cap structure above equity. This is all CDS allowed. Keep in mind you still can't short loans as cash product, and nobody in their right mind trades LCDS which compounds the risk at the CDS reference entity level.

4) the clearing house will present two offsetting forces: elimination of counterpary risk, pushing spreads wider as anecdotally (and via neg basis) the average counter party risk is about 30 bps in IG and 250 bps in HY. this will be offset by the upfront collateral posting and elimination of basis, however as most accounts trade with this embedded as is, the first part will be much more impactful. I am not saying cash bonds are the truth per se, although it is definitely somewhere inbetween the two spreads. and the answer to the last part is yes. PBs are decimating HF counterparties by the hundreds as we speak, leaving many to force unwind positions. counterparty risk will not go away until clearinghouse is established. once it is - buy buy buy CDS, as that has been the main technical keeping levels artificially tight.

Anonymous said...

You are totally my hero, and currently the source of every half-intelligent thing i have to say about credit...thx for your responses.

I see central clearing as inevitable, but wonder how much we actually move to a exchange traded model. have to imagine the TCC and dealer consortium will fight tooth and nail to keep things status quo (has been far too lucrative). So far I've seen CMDX (CME/Citadel) offer a request for quote function, which allow you in essence to shop bids/offers around without the normal ignominy you earn when dealing with OTC dealers, but haven't heard anything from TCC side. Do you know if any of the electronic trading platforms have gotten traction on trading CDX products?

I'm actually trying to get myself into a regulatory role so that we don't have to deal with some of the non-sense that comes from the pseudo-experts...

thx again

Tyler Durden said...

not sure about clearinghouse status but be aware on March 20 all CDS moves to a standardized contract...traders calling that day The Big Bang. for a very long version of what the contract will entail go to

Anonymous said...

thanks for pointing that out. not surprising given that dealer desks have been variously noted as "pirate ships" or "den of thieves". will be good longer-term and has been a long time coming. have some outrageous anecdotes re: dealer mischief in pricing off-market CDS but doesn't seem the proper forum. who's curve shapes are they going to use? MarkIt? That could be trouble...