Last Updated: 1 April 2023
Matt, I didn’t mean to write riddles in the last blog…
I deliberately didn’t delve into the reasons for CDS spreads and bond yield spreads diverging, as it’s quite a complicated area and I’m not sure I’m equipped to explain it.
But with ETF buyers increasingly offered a range of investment exposures to different parts of companies’ capital structure – to preferred stock (in the US), senior debt (via corporate bond ETFs and pure credit ETFs), and subordinated debt – and such exposure being given both through direct holdings of bonds, and via credit derivatives, it’s worth exploring some of these technicalities, or at least being aware of them.
Even if you’re an equity ETF investor and are not really interested in bonds, you need to be keeping an eye on these funds, as all these categories of investor – senior and subordinated debt and preferred – have first call on the assets of a company, ahead of you. In extremis, in a bankruptcy, it’s the bondholders who will almost certainly end up with ownership of any restructured entity, not you.
In theory the yield offered via a credit derivative on a company’s senior debt (for example), and the yield given by the senior debt itself ought to be the same. If not, and the CDS-offered yield is higher, you could make a risk-free profit by buying a bond and insuring it.
In practice there has been exactly this type of divergence in recent months – for example you could buy a bond on company A at a yield spread of 300 basis points, then insure it (remove the credit risk), via a CDS, for say 500 basis points, and receive 2% a year in “risk-free” money. The inverted commas are justified, as many bank and hedge fund traders appear to have swallowed big losses from doing this in the last few months, as the “basis” – the discrepancy between the bond yield and the CDS-derived yield – has proved far from predictable.
There may be solid reasons for the existence of the basis – relating to the counterparty risk inherent in CDS, regulatory risk (the risk that the regulator might change the CDS rules), bank balance sheet constraints, central bank distortions (interested readers can go here and here for a further discussion of this).
But when I pointed out that the CDS-derived credit spreads on sovereign issuers may diverge from the spreads between the same issuers’ bond yields, I didn’t mean to imply that the CDS market was unreliable or inaccurate. It is how it is and, as we know from the last two years in financial markets, CDS have been the single most accurate indicator of trouble ahead for firms under financial strain, giving advanced warning in the case of Bear Stearns, Lehman and AIG, to name just a few. So when the CDS spreads on sovereign names begin to diverge wildly, it certainly deserves our attention.
As for whether bond yields for sovereign issuers are low or not, it depends how you look at it. For the US, UK and German governments to be selling ten-year bonds at around 3% a year, or even Ireland at 6%, looks like a relative bargain for the issuers concerned, when compared with the historical level of yields.
Then you look at some of the forecasts for the change in nominal GDP this year – in other words the cash value of current economic output, without adjusting for inflation, and you see numbers like minus 5.2% for the US from Roubini (that’s right, nominal GDP could shrink by over 5%) – and then you realise that the debt burden on governments, who will be suffering from a major shrinkage of tax revenues and a vast new burden of social outlays – will be rising exponentially. For government solvency not to be questioned, you need nominal GDP to return to an upward trajectory pretty quickly from 2010 onwards.
In fact all the recent government interventions in the economy – from cutting rates to almost zero, to the rescue packages for the financial sector, to the recently-announced policy of quantitative easing in the UK – should be seen as desperate attempts to revive the current-money (nominal) level of economic output. Whether this comes in the form of inflation or a revival in real economic activity is a secondary concern to those implementing these policies.
If the attempts fail, then the debt burden on the economy will quickly become unsustainable and we will be facing a huge wave of defaults, including by governments. So the pick-up in sovereign CDS spreads is a very reasonable advance warning of the risks ahead, even if most investors’ money is on the muddle-through option working – in other words that state interventions will eventually bear fruit.