Questions over the value of sovereign credit default swap protection have contributed to net notionals on Greece and Portugal tailing off sharply over the past few months, dealers said.
Figures from the Depository Trust & Clearing Corporation show net notional Greek CDS falling from US$6.3bn at the beginning of 2011 to US$4.6bn as of July 15 and net notional Portuguese CDS tumbling from US$7.8bn to US$6.0bn.
Over the same period, CDS referencing Greece ballooned from 999bp to 2395bp and CDS on Portugal jumped to 1128bp from 499bp, according to Markit.
“It makes sense that Greek notionals are falling. Right now, Greek CDS is trading 40 points upfront and people have doubts over whether the CDS will trigger,” said one head of European credit trading at a major house. “For people that bought CDS as hedge, the CDS has widened and the hedge has probably worked so you might as well cash in, re-mark your asset or take a provision against it and not worry about the issue that the CDS may or may not be triggered.”
In contrast to Greece and Portugal – which have seen net notionals fall by 27% and 24% respectively year-to-date – net notionals on Irish CDS have remained steady at around the US$4bn mark for most of the year. However, traders suggest this could change if Irish CDS – which closed at 1069bp on July 20 – remains wide.
“As Greece gets more distressed, people have been taking CDS positions off. Talk of bond extensions without CDS triggering makes basis players nervous and they tend to sell out. And no one else wants to take a view via CDS as volumes are too low and the bid-offer too wide,” said one sovereign CDS trader at a major house. “So the net notional outstanding on Greece has trended off quite materially, and the same thing will likely happen with Ireland and Portugal.”
Liquidity in the most distressed names remains patchy. Average bid-offer spreads on Greek five-year CDS was 233bp on July 18 compared to 30bp at the beginning of the year, according to Markit Liquidity Metrics. Average bid-offer spreads for Irish and Spanish CDS stood at 20bp at the start of 2011; they are now 77bp and 78bp respectively.
Trades are still going through, though. The head of European credit trading said his firm recently did a US$50m trade on Portugal, but successfully negotiating the wider bid-offer spreads has become more challenging.
“It’s completely normal for bid-ask spreads to increase as the spread itself widens. However, the liquidity figures illustrate the difficulty in “playing” the market. This isn’t high frequency trading where you can get in and out on small moves in spreads. Taking a view and getting in and out of these credits quickly is expensive business,” said Lisa Pollack at Markit.
This relative inactivity is also illustrated by the gross notional figures. The total amount of CDS outstanding prior to exposures being netted down have remained relatively steady this year on Greece, Ireland and Portugal. Moreover, these numbers suggest particpants have not been widely tearing up legacy positions on these countries, but have instead concentrated on balancing market risk on their books, causing net notionals to fall.
“Overall, the focus on balancing risk is far more prevalent and I expect that trend to continue as talks around debt rollovers and uncertainty over the value of CDS prevails,” said Phil Perrot, London-based head of sales at ReMATCH – a post-trade management service that helps to reduce basis and calendar risks that can accumulate in CDS market-making books.
“We’re seeing increasing demand to hedge out net notional exposures by maturity date on the wider names, although it’s much harder than it ever was because of volatility. We’re also seeing much more interest in reducing risk in the medium-beta names like Italy, Spain – requests we wouldn’t have got six months ago,” added Perrot.
Meanwhile, Spanish and Italian CDS have continued to attract bumper volumes following on from last week, as the market has turned its attention to the rest of peripheral Europe.
“We’ve seen a massive surge in volumes, especially on Italy, Spain and France,” said the head of European credit trading. “We’ve stopped trading credit, we’re now trading sentiment,” he added.
Christopher Whittall