With the Dubai World fiasco and the recent downgrade of Greece to BBB+ by S&P, people fear a cascading effect on other Eastern European nations just as Abu Dhabi and Qatar saw a crisis of confidence (or contagion) in their businesses when Dubai World became public with its problems.
I first thought of performing this analysis upon reading a post on Zero Hedge on CDS spreads vs Leverage that Tyler Durden posted. I thought there were other ways and different angles to explore this same topic.
To start off with some basics, a Credit Default Swap (CDS) is insurance written on debt issued by some entity. The party writing the CDS is basically guaranteeing a payout to the owner of the debt if the issuing entity decides to default. Along the same lines, Sovereign CDS is insurance written on debt issued by governments, instead of corporations. In return, the buyer of the CDS pays the issuer a series of payments (known as the “spread”) for that safety. So effectively, the CDS spread represents the riskiness of the underlying asset that’s being insured, since insuring a riskier bond would require a bigger “payment” or spread.
As such, the CDS spread acts as an effective “price” for the contract just as a stock’s price acts as a measure of value for a company. Now, just as the price of a stock is linked to something fundamentally, such as the earning power of the company or its anticipated growth, the “price” or the CDS spread on sovereign debt is also linked to the financial health of the issuing government – which can be measured by the country’s debt-to-GDP ratio as Zero Hedge analyzed it.
Profit opportunities
In the chart below, you see the 5-yr CDS spread plotted against the public debt-to-GDP ratio for 46 countries for which data was available. The data came from various sources such as the CIA World Factbook, OECD and IMF and most of it from 2008, hence slightly outdated. The CDS spread data is from Dec 15th, 2009.
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In this chart, we would expect to see those countries with a higher debt-to-GDP ratio to have a higher spread on their CDS because writing insurance on debt issued by highly leveraged countries should cost more.
Right away, you notice the outliers such as Ukraine, Argentina and Venezuela which have spreads above 1000 basis points (i.e. 10%) even though they have low debt-to-GDP ratios – these can be explained by previous defaults and highly volatile political situations. Then we notice the recent countries that have had crises of confidence such as Greece and Iceland that have an elevated spread relative to their debt levels.
But if we start looking for profit-making opportunities here, to look for spreads that we can expect to reduce or increase in the future, we see Bulgaria, Philippines and Vietnam – all 3 are developing (or becoming developed) economies with increasingly stable finances and it should get less costly to write insurance on their debt. Hence, the opportunity is to write insurance on their debt now, to get the bigger payments (spreads) now, while knowing that the riskiness of their debt should decrease!
On the other end of the spectrum, you see Japan with the highest leverage in the group and the opportunity here lies in buying insurance on Japanese debt while it’s cheap as I would expect the aging demographics and continuously stagnating economy to pressure government finances even more.
In this next chart, I used only the External Debt-to-GDP ratio, instead of using total debt, since the amount of external debt (money loaned from other countries) should be a better determinant of financial health. For example, one reason Japan had such a low spread despite a high debt load is because a majority of its debt requirements are met locally within Japan.
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Right away, you see Iceland and Ireland that became infamous for their external debt levels. The opportunity I see here is with the U.K. and Switzerland – in any crisis situation they encounter, you would see their spreads skyrocket because of the large amount of debt they owe to foreign nations, hence making their currency and economy vulnerable. So, purchase the CDS while it’s cheap and then wait for a black swan to arrive. Other than that, there’s not too much to glean from this data as I felt it was slightly inconsistent.
Digging further, I plotted the CDS spreads against the credit ratings that S&P gives to the Long Term foreign currency debt issued by these nations. This paints a much clearer picture (having left out outlier > 1000 bps) with a distinct positive slope reflecting a higher spread on nations with poor ratings.
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Over here, the opportunity lies in the spreads of countries like Turkey, Peru and Vietnam narrowing as their economies develop and become stable. Take note that even though countries like Vietnam look like they are close to where they “should” be given their S&P ratings, the ratings will improve when S&P upgrades healthy economies which will then cause a narrowing in the spreads for that nation. Alternatively, you can bet that the spreads of post-crisis countries like Iceland and Ireland would almost certainly narrow as their economies slowly regain their footing. At the same time, you have to acknowledge that S&P ratings are just a third party opinion and they could be wrong.
What are your thoughts? Which of the 3 metrics do you think makes the best connection with CDS spreads?
Disclosure: No positions in credit default swaps
Image Credit: Caveman/Grinch under a Creative Commons license.
