Which Nations Are Next? The Credit Market Answers

The debate about the usefulness of sovereign credit default swaps (SCDS) intensified with the outbreak of sovereign debt stress in the euro area. SCDS can be used to protect investors against losses on sovereign debt arising from so-called credit events such as default or debt restructuring.

Although CDS that reference sovereign credits are only a small part of the sovereign debt market ($3 trillion notional SCDS outstanding at end-June 2012, compared with $50 trillion of total government debt outstanding at end-2011), their importance has been growing rapidly. With the growing influence of SCDS, questions have arisen about whether speculative use of SCDS contracts could be destabilizing – and this caused regulators to ban non-hedge-related protection buying.

The prohibition is based on the view that, in extreme market conditions, such short selling could push sovereign bond prices into a downward spiral, which would lead to disorderly markets and systemic risks, and hence sharply raise the issuance costs of the underlying sovereigns. The IMF’s empirical results do not support many of the negative perceptions about SCDS. In particular, spreads of both SCDS and sovereign bonds reflect economic fundamentals, and other relevant market factors, in a similar fashion. Relative to bond spreads, SCDS spreads tend to reveal new information more rapidly during periods of stress, admittedly with overshoots one way or the other. Given the current apparent ‘stability’ in many nations’ bond market spreads, the chart below suggests an alternative way of judging what the credit market thinks – the volume of protection bid – and in this case some interesting names emerge.

Do Sovereign CDS Lead or Lag – the answer is both…

The Hasbrouck statistic shows whether SCDS or sovereign bond markets move faster to incorporate news: when the statistic is higher than 0.5, SCDS lead the price discovery process; otherwise, bonds lead. Statistics are estimated from a panel vector error correction model using rolling two-year windows of daily data. Resulting series are smoothed using a one-month moving average.

The chart below shows at what times SCDS lead and what times bonds have lead…


Vertical lines indicate events related to the global financial and sovereign debt crisis (upper panel) and to the EU’s ban on naked short sales of SCDS instruments (lower panel) as follows:

  1. Bear Stearns collapse (March 14, 2008).
  2. Lehman Brothers bankruptcy (September 15, 2008).
  3. EU debt crisis intensifies in October 2010 ahead of Ireland’s financial aid request.
  4. European Commission consultation on short selling (June 14, 2010).
  5. European Commission short selling regulation proposed, banning naked short sales and SCDS protection sales (September 15, 2010).
  6. European Parliament adopts short selling regulation (November 15, 2011).
  7. Final Version of EU short selling regulation published (March 24, 2012).
  8. EU short-selling regulation becomes effective (November 1, 2012).

But since the ban, most notional amounts have been reduced – as the regulators forced ‘speculators’ or some might call ‘price discoverers’ out of the market – leaving behind only those who have ‘legitimate’ need for hedging. There is one stand-out – Italy! Italy notional hedges remain as high as ever…

And so while prices may be manipulated or managed or smoothed – thanks to insatiable demand from domestic pension funds and banks who can re-collateralize for free money at the ECB, there is another ‘signal’. Instead of purely the relative prices (or spreads) of the CDS market, it is perhaps more useful to judge just how much of the sovereign bond market is being hedged as a measure of the market’s fear of a restructuring event…

As is clear above, the relationship between credit rating (perhaps an independent measure of sovereign riskiness) and the outstanding CDS protection relative to the bond market is quite tight. There are a few outliers – Greece (private holdings are low and no official sector will ‘hedge’), Egypt/Argentina/Venezuela (highliughted in green – have been in trouble for months/years and hedgers have largely unwound profitable hedges or have unwound the underlying exposure since these markets are priced for the event already. The most obvious standouts are where the hedgers hold a massive amount of protection relative to the nations’ bond market (highlighted in red). These include Latvia, Hungary, Peru, Panama, and Ukraine.

Finally, of the world’s so-called advanced economies, New Zealand stands out in a worrying manner – is this a second derivative, highly convex cheap bet of China’s collapse?


Charts: IMF


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