The Bull Market in Credit Default Swaps

A look at the LQD, an investment grade corporate bond fund ETF with diversified issues, tells the story the last several days. Remember, every point this thing falls means billions more in increased collateral requirements and mark-to-market losses for AIG (AIG) and countless other financial institutions, since their bet is on debt (sans treasuries) staying bullish.

click to enlarge

Or the visual from MarkIt:

The right side of this MarkIt CDX Index chart says it all, but reality is much more severe. Investment grade credit spreads of a wide variety of issues are blowing out to unheard-of numbers. Morgan Stanley 10 year debt is now trading 1000 basis points over treasuries, much worse than Lehman even last week. Typical investment grade debt is averaging over 300 basis points over treasuries.

The great credit default swap unwind I anticipated in January of this year may be happening now, as industry players try to beat AIG and Lehman to the punch.

This past five years of historically low risk spreads was essentially caused by redefinition of 'acceptable leverage' in a post Sarbanes-Oxley world, where off balance sheet opaque bond derivatives positions became the de facto method of amping up revenues for insurers and financial institutions of all sorts. What better way to collect free money than sell insurance on 'zero probability of default' issues, like GE (GE)? By the way, you can pick up GE AAA 10 year bonds for around 7.5% yield right now, 400 basis points over treasuries! Weren't these issues trading at 50-75 basis points just 12 months ago?

One thing is very obvious from this last chart. The CDS market started to take off right around the same time when Sarbanes-Oxley was implemented. Is this merely a coincidence?

Next a rhetorical question with an obvious answer: If the spreads continue blowing out as large players return leverage to appropriate levels, will there be enough money to simultaneously soak up a continued supply of treasury debt AND underpriced AAA corporate debt while keeping yields in the same place? Something has got to give, and my guess is bond fund managers will find the AAA corporate more attractive at these and even wider spreads. I think the spread may inevitably narrow over time, resulting in a new secular bull for high yields in long dated maturities.

Against a backdrop of dollar disillusionment, excessive government debt supply, GSE addition to net US debt, a fed needing recapitalizaiton, all factors point to a short long maturity treasuries position. And we all know how those high interest rates will impact housing, credit, and business expansion.

Disclosure: Short ETFs mentioned in this article

Comments

[investor88:]

A useful article supported by facts. We are still in a bear market.

2008 Sep 18 08:47 AM

[Mark McHugh:]

I can't ever recall seeing bigger price spreads on puts than there are on LQD right now.

I have no doubt that you are right about TLT as well. But, it seems like this "flight to quality" craziness might have some legs yet. I bring this up because I have managed to lose money being 100% right before. I've got a bad feeling I'm gonna manage to screw this one up too.

Thanks for alerting us to data that almost everyone else ignores.

2008 Sep 18 12:03 PM

[Mark McHugh:]

Shorted TLT at the open today, should have done it yesterday.

2008 Sep 19 09:53 AM

[Michael B. ...:]

I'm actually long 30 yr bond puts. That is my only relevant position.

2008 Sep 19 11:35 AM

[Dave Wright:]

I've been anticipating the longer end moving higher as well. It seems the only logical conclusion to the vast increases we're seeing to the US National Debt due to all these measures by the Fed and Treasury. I also think there may be a move by Foreign Central banks to pull money out of US Treasuries and Agencies. I took a sizeable position in TBT this morning.

My only concern is other "measures" by the Fed to artificially suppress the long end to keep mortgages and refis available.

2008 Sep 19 03:35 PM