CDS Prices Trend Calls Another Downturn in Equities

The recent range-bound activity in the CDX investment grade index (IG-11) is helping a number of Wall Street's fund managers to make the case for a market bottom. But a look beyond the CDX and iTraxx indices, to the real (trading) CDS marketplace, will suggest that another equity market downturn is on the cards in the near term.

The IG-11, for example, has been hovering around a 200 basis-points spread in recent trading sessions. This spread, however, no longer represents actual or implied CDS trading prices. Yields on longer-maturity bonds for General Electric (GE), Citigroup (C) and Morgan Stanley (MS) are implying credit default swap spreads of around 300 basis points, or higher depending up what credit spread (as distinct from default risk) one assigns to highly rated issues.

Given that Citigroup itself has started pricing loans on a system which incorporates a credit spread and the cost of CDS contracts over and above a particular benchmark, it is fair to assume that businesses will incur higher borrowing costs, regardless of lower Libor or treasury rates, and regardless of the overnight-indexed-swap (OIS) or treasury-Libor (TED). If the Citigroup pricing structure gathers currency, wider CDS spreads must begin to negatively (and directly) impact upon corporate profitability.

In reality, it is extremely difficult, if not impossible, for GE, Citigroup or Morgan Stanley to buy 10-year CDS coverage of any size even at 400 basis points. One on hand, those pricing risk are concerned that the true extent of the crisis on Wall Street has yet to unravel. On the other hand, they fear that the severity of the global recession may force a widening of spreads anyway, towards 500 basis points in early 2009.

As of today, CDS market-makers have not dared to announce losses on positions established on sovereign risks like Argentina, Bolivia, Venezuela, Ukraine, Iceland, Hungary, Pakistan and South Korea. But it is more than evident that the CDX emerging market index (EM-10), at its current levels of 640-680 basis points, is totally out of tune with core perceptions amongst risk-offset providers. Pakistan CDS spreads plunged from 200 to 3,500 basis points this year alone. Spreads for Ukraine widened by 100% (from 1,000 to 2,000 basis points) within days last month. Market-makers for Russia, India, Indonesia and Turkey (to name just a few sovereigns) have gone into hiding, offering only indicative quotes through model-driven CDS matrix websites.

The inference to be drawn from the state of the CDS universe is that doubts relating to the shape of the emerging economies through the rest of the decade are intensifying with each passing day. Regardless of what emerging-market bulls on Wall Street are saying, CDS prices for the emerging market spectrum may be reflecting the type of broad and fundamental developing-country risk which equity analysts do not generally incorporate into their valuations. Also, it is virtually impossible to visualize a scenario where exchange-traded emerging market funds (EEM) can move sharply in one direction and emerging market CDS prices in the other.

With time, the case for CDS prices to be considered as key components in assessments of shareholder value is likely to get stronger. For the present, however, Wall Street may well succeed, to the cost of retail and institutional investors, in its attempts to retain the illogical disconnect between the value of equity and the price of debt.

Stock position: Short GE.

Comments

[venividivici:]

Very interesting article.

2008 Nov 04 09:44 AM

[Tom Armistead:]

There is a disconnect somewhere: however, it is possible that the disconnect lies in the relationship of CDS spreads to the actual risk of default.

Perhaps the CDS spreads on GE are too high, driven by speculation or a desire to hedge against a deep recession.

2008 Nov 04 02:38 PM

[Dr A J:]

It used to be relatively simple,buy low sell high,.Now there are so many trading vehicles that even the pros don't understand,CDS just one of them.

2008 Nov 05 08:22 AM

[gregm:]

How can you say based on three issuers, all which are outliers, financials service companies and are part of the IG-11 index spread a better indicator of systemic credit risk than the index? Is the stupididity of your comment apparent yet?

Why mention Citi's proprietary pricing system? It is not universally used nor is it likely to become so. Do you know what levels it is pricing at, i.e is it indicating spreads are thin? If the system was relevant, this is kind of criticial to your thesis.

Credit spreads are the qunatification of default risk, they cannot be seperated.

If a base rate drops borrowing cost deop period. Spreads may not but overall cost does.

Whay do you metion the TED spread, it a measurse of liquidty as much, if not more that risk. Are you aware it is not a pricing benchmark.

"On the other hand, they fear that the severity of the global recession may force a widening of spreads anyway, towards 500 basis points in early 2009." What???? have you seen where spreads were about two weeks ago? You think 500bps is a downside scenario?

Current levels indicate nothing regarding where EM debt will be for the rest of the decade. We are in the middle of a credit debacle and you are saying current spreads are indicative of a normalized market?Pure ignorance.

Cost of debt is already a key component in the creation of shareholder value. Have you any conception of corporate valuation basics such as a firm's WACC?

2008 Nov 06 08:09 PM