GE, Goldman Bond Spreads: Unrealistic and Unsustainable 19 comments
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Following the recent decline in Libor rates, the yield (10%) on Warren Buffett’s preferred stock investment in General Electric (GE) and Goldman Sachs (GS) is now appearing to be entirely in line with the evolving reality of corporate debt: that effective interest rates should incorporate perceptions of default risk. But bond traders in the US marketplace are obviously unwilling to accept that credit default swap spreads should be playing an integral role in determining yields for longer-dated General Electric and Goldman Sachs maturities.
To reconfirm a trend witnessed in the recent financing structures for FirstEnergy Corp. (FE), Nokia (NOK) and Nestle [NESN.VX], Borse Dubai Ltd., the state-owned operator of exchanges, is now in talks with bankers to refinance $4.2 billion of loans at a cost of 6%-plus over Libor, a cost derived from the CDS spread on Borse Dubai, in addition to the cost of funds. Last year, Borse Dubai was able to raise money at a margin of 1.1% over Libor when it purchased Sweden’s OMX AB.
Late Tuesday, General Electric’s 2012 and 2013 (GE.HDS and GE.HDJ) bonds were yielding 6.05% and 6.39% respectively. Goldman 2012 [GS.KW] changed hands around 7.50%. But if buyers had factored in credit default swaps, they would be demanding an additional spread of 150-200 basis points, at the very least, on both issuers. Some market-makers have been justifying the yields on GE, Goldman and other investment grade bonds from the prism of further Fed action to lower benchmark rates. Such action, however, would be predicated on more bad news on the domestic and global front, news which would drive CDS spreads higher anyway.
The fact that CDS traders continue to price GE credit default swaps in the 420-450 range is already an indication that the derivatives segment of the market doubts the viability of GE’s superior credit rating. Any suggestions that a deep, prolonged recession will force GE to revise its guidance for 2009 earnings will certainly cause a breach of the critical 500 level within short order. In that case, the potentially positive influence of Fed rate cuts on GE bond yields will be nullified.
On Tuesday, CEO Lloyd Blankfein claimed that Goldman Sachs was “as well positioned as any” financial services company to meet the challenging near-term environment. Mr. Blankfein failed to provide any supporting analysis for his targeted 20% return on equity as and when the markets “revert to normal”. When and if the 20%-return prospects are visible to investors on the horizon, Goldman CDS spreads may well narrow within 250 basis points. Until then, Tuesday’s yields represent a significant pricing misalignment. Without doubt, prudence dictated vagueness in a climate where Mr. Blankfein is not alone in being overwhelmed by the sheer power of the unknown.
It is exactly that unknown element or variable risk (in pricing terms), which an efficient CDS mechanism should seek to capture; details governing credit and rating events in the Borse Dubai, FirstEnergy, Nokia or Nestle swaps have not been disclosed, though sources close to the transactions point towards tighter mark-to-market rules, rigid credit and rating parameters and, finally, even clauses implying changes in agreed-upon CDS spreads under certain specific conditions.
Disclosure: Author holds short positions in GE and GS
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This article has 19 comments:
I am no expert in CDS. That said, I find it impossible to believe that the heightened risk aversion that permeates every other part of the financial economy has left this part untouched. Just as banks' appetites for risk in their loan portfolios has decreased markedly, so should that of sellers in the CDS market. In the face of the failure of AIG, the risk profile for CDS should certainly be different than it was before.
The result of this should be greater costs to insure the debt of all companies. I would love to see a comparison of the "average" CDS rate today vs. three months ago, six months ago, and a year ago.
Also, I advise readers to be mindful, when making investment decisions, of the markets behind the numbers. The CDS market is extraordinarily thin, with very few sellers, especially when compared to the corporate bond market. The thinner the market, the more likely pricing errors will occur. I suggest that any discrepancy not due heightened risk aversion is more likely due to a pricing error not in the bond market, but in the CDS market.
Thanks
If I allocate capital to CDS arbitrage rather than speculation, will I actually receive the spread? Only if the counterparty pays as he owes. Gee, that is the same risk as in the corporate credits themselves.
When the CDS writers were expected to be effectively zero risk AAAs, you could track the default risk of a corporate with its CDS rates. Now you can't. The CDS rates reflect two layered tiers of risk - first that the CDS contract counterparty simply doesn't pay, and second what happens on the underlying.
In principle this extra risk could cut either way. But what has actually happened is major writers of CDS risk, notably AIG, have blown out, and capital to arb this stuff is gone. It is therefore a writers market, and the risk of CDS contract default is layered on top of the fair value of the underlying corporate.
Making conclusions about bond values based on the CDS market is like making conclusions about house fires based on the homeowner's insurance market. A lot of variables have changed in the last few months.
The spread between what CDS is saying someone will demand to insure against default; vs interest, which is what someone is demanding in yield (which (in theory) should include default risk) is an interesting angle.
Either CDS folks are wrong and/or bond people are wrong. In any other period, the two should converge and agree. The fact that they're not says something:
1. There's something artificially suppressing bond yields
2. There's something increasing the inherent risk in CDS market itself, that is showing up as a general increased CDS rates for everything that needs insurance. In other words: AN INCREASED CHANCE OF SYSTEMIC FAILURE.
Insurance fails or have a loss when everything being insured fails at once; and to guard against such large scale loss, premiums (for everything) have to increase when such risks increase. Think how much insurance went up when Katrina occurred and caused widespread losses.
These two pieces of data tells a story with these 2 numbers:
that *IF* there's no systemic failure, then GE bonds should be at it's face value. CDS is saying there's a general heightened risk of systemic failure, and GE's vulnerability is rather high.
> Based on the thinking behind the article, would you expect him to
> be invested any other way? Are you as skeptical of somebody who's
> bullish and long?
My comment was based on the conclusion that the thinking behind the article was shallow and inconclusive. This is a "short & distort" article like many that appear on this site. The concept that bond buyers don't factor credit default risk into their pricing decisions is ridiculous. Could it possibly be that the CDS market pricing is off-base?
Are you having a senior moment and forgot your earlier comment? "The CDS market is extraordinarily thin, with very few sellers, especially when compared to the corporate bond market. The thinner the market, the more likely pricing errors will occur."
Nope. Just because I think the author's wrong doesn't mean I can't think that you're wrong, too.
On Jan 13 12:50 PM BS Detector wrote:
> "Are you having a senior moment and forgot your earlier comment?"
>
>
> Nope. Just because I think the author's wrong doesn't mean I can't
> think that you're wrong, too.
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