Zero Hedge

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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