It is truly amazing how disconnected credit instruments are from other tradeable financial investments. The Fed released the minutes from its latest Open Market Committee meeting, which lowered the growth forecast and increased the inflation forecast. That shouldn’t be cheery at all; the stagflationary 1970s were a terrible time for equity valuations, but the US stock market perked up, commodities showed even more zip. Overnight, the Nikkei is up nearly 400 points, and the yen, a barometer of risk perceptions, has fallen to a three week low, signaling a reduction in worry.
Yet the Financial Times tells us the debt markets are in a funk. There was a further flight (if such a thing is possible) from structured products and a spike up in the price of insuring against corporate defaults.
From the Financial Times:
Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs.
The sharp jump, which rivalled the sell-off at the height of last summer’s credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.
The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered.
“There’s a domino effect taking place,” said Mehernosh Engineer, credit strategist at BNP Paribas.
The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.
This means buyers of protection through so-called credit default swaps are paying €126,500 ($185,780) annually to insure €10m worth of debt over five years.
In the US, the situation was just as bad with the investment grade CDX index hitting a record wide of 165.5bp in morning trade – more than double its level at the start of the year.
The iTraxx Crossover index, which covers mainly junk-rated European debt, bust through the 600bp barrier – up from 343bp at the start of the year. The moves are expected to affect the cost of raising new debt in the bond markets. Credit default swaps act as a proxy for the amounts real companies have to pay to borrow in the bond markets.
The way CDS spreads influence real borrowing costs has been illustrated this week by the situation at Credit Suisse.
Investors who had agreed to buy a bond from the Swiss bank the day before it announced unexpected writedowns are already looking to renegotiate price terms after the news sent its CDS contracts higher.
One funding manager at a different European bank believes the influence of CDS prices is a case of the tail wagging the dog.
“We feel we’re being unfairly penalised by the CDS market right now. It directly influences your cost of borrowing because investors up till now have wanted a return over CDS for any bonds issued,” he said.
The opacity of credit derivatives markets has contributed to problems. While most analysts and traders believe unwinding is taking place, few are sure of how much or by whom.