Record trading volumes in single-name credit default swaps referencing Italy and Spain have taken place in the first half of the week as participants scrambled to cover exposure to the euro zone periphery.
One head of European credit trading at a major house said the sharp moves wider had blindsided many market participants, who weren’t expecting the recent Portugal and Ireland downgrades from Moody’s.
“Some people had added risk after the Greek austerity vote and got caught off guard,” he said. “Tuesday was one of the biggest volumes of the year on both CDS and cash. For the first time I really saw some genuine panic from clients looking to reduce risk, and at the same time some other guys thinking we’re at the wides of the last year and there are opportunities.”
Italian CDS spreads ballooned from 219bp on July 7 to 300bp at close of trading on July 11 and Spanish CDS widened 44bp to 346bp over the same period, according to Markit.
“It’s been a wild couple of sessions. From the 215bp print on Friday morning, Italy hit 345bp in intra-day trading - that’s the most seismic move I’ve seen on this book in the last ten years. A lot of records are being broken right now and it’s really forced the hands of the euro ministers,” said one sovereign CDS trader at a major dealer.
The uncertainty in the market is reminiscent of the trading environment leading up to Lehman Brother’s default, according to the sovereign CDS trader, pointing to the wide range of 310bp to 385bp that CDS on Spain traded within on Tuesday (July 12). However, traders are taking heart from the fact that these price moves are on the back of genuine trades, reporting hefty flows in single-name CDS going through.
“The main thing is that volumes are materially higher than normal - it’s not just vacuum trading, which I think is the reassuring thing,” said the sovereign CDS trader. “On Tuesday we did 400% of our average day volumes - a range of accounts are involved in it right now.”
ITALY, SPAIN LIQUIDITY
While liquidity declines in CDS referencing Greece, Portugal and Ireland, dealers report volumes in Italy and Spain have remained strong. According to Markit Liquidity Metrics, quotes for Italian CDS hit 198 on July 11 compared to 131 a week before.
“Single-name CDS liquidity has been good on Italy and Spain where clips of $10m, $20m or even $50m are conceivable,” said Benjamin Jacquard, global head of credit trading at BNP Paribas in London. “For the very wide names, trades will be more like $5m, and they’re trading with a large upfront premium, consistent with them being very volatile instruments.”
The strong volumes in Italy CDS, in particular, are an indication of the sheer size of the investment class in the country, dealers say. Along with Spain, Italy has long been thought of as largely decoupled from the rest of the periphery and features in many investors’ trading benchmarks.
The breakdown of the cash market in Italian and Spanish government bonds at the beginning of the week also had a role in boosting CDS volumes. As Italian spreads ballooned wider in a two-hour period on Tuesday (July 12) morning, traders reported that they were unable to get quotes in 5million size BTP’s, while rumours circulated that the MTS trading platform had suspended two-way pricing in Italy and Spain.
A spokesperson for MTS denied the rumours, saying no bonds were suspended. Also, Jacquard at BNP Paribas argued there was sufficient liquidity for participants to offload Italian government bonds if they wanted.
“Buying the CDS to cover the bonds would not be the simplest way [to reduce exposure to Italy],” he added. “But if you have something other than cash bonds - such as exposures a bank CVA desk has - then using the CDS would make sense. And actually in a positive way, you do that to keep open your capacity to trade with counterparties from the country you are hedging.”
But the head of European credit trading indicated dislocations in the bond markets may well have spurred interest in buying protection in single-name CDS. “Conditions were difficult in the cash market,” he said, highlighting rumours that the Bank of Italy had purchased €500m of Italian government bonds to restore calm to the market.
Meanwhile, credit indices also saw sharp upticks in volumes in the first half of the week. The average daily number of trades on the Markit iTraxx SovX Western Europe index has risen to 307 over the past five trading days compared to 68 normally, according to Lisa Pollack at Markit. Tuesday also saw new records for the iTraxx Europe index of investment grade corporates, with 625 trades and a notional of €32bn.
“Index liquidity…[has been] decent, with clips of $30-50m. Investors won’t just use SovX to hedge though, because it’s driven by the wider names, making it volatile and unsuitable for hedging specific names,” said Jacquard.
Reporting by Christopher Whittall, additional reporting by Adam Parry