CDS market mulls negative spreads

4 min read
Helen Bartholomew

More than a quarter of participants in the credit default swap market believe that spreads on the instruments could move into negative territory, according to a client survey conducted by Citigroup analysts this week,

The idea that a CDS seller would pay a spread for clients to buy credit protection – effectively paying up to provide insurance – makes little sense to most market participants as it implies the seemingly impossible concept of negative default probability and negative recovery rates.

“Even in an environment with zero default probability, and 100% recovery and negative yields elsewhere, the credit spread should be bound at zero,” said Citi credit analysts Aritra Banerjee and Abel Elizalde, in a note to clients.

But as an increasing portion of the bond market heads into negative yielding territory, CDS participants are beginning to question whether those trends could eventually be mirrored in the instruments used to hedge debt holdings.

For example, five-year German government debt currently trades with a negative -0.1% yield, while five-year credit protection on the sovereign trades with a spread of around 16bp.

And according to a report from Morgan Stanley analysts earlier this month, more than US$1.5trn-equivalent of debt now trades at negative yields. That is growing as a result of the ECB’s €1.1trn QE programme as an increasing number of debt securities converge on the all-important -0.2% threshold for asset purchases.

According to the Citi survey, 27% of respondents felt that negative CDS spreads remained a possibility, though primarily as a by-product of other technical factors rather than as a consequence of the widespread hunt for yield.

From a dealer’s point of view, Citi notes that if capital charges levied on a CDS short position outweigh the value of the contract, it could force the dealer to unwind at a negative spread. From a buyer’s perspective, if the payout was lower than the cost of running the position, it could push contracts into negative territory.

“From a practical perspective, we accept that the technical highlighted above could drive a negative spread,” note Banerjee and Elizalde. “But, we think that spreads traded at those levels would be due simply to these offsets and that no new trades would be initiated there.”

Citi analysts note that negative bond yields reflect the opportunity cost of holding cash and that CDS is not in itself a yield generating instrument. While an environment of excess liquidity is driving an increasing volume of government bonds to trade with negative yields, the same factors are unlikely to push dealers into selling credit protection at negative levels.

Some respondents pointed to negative basis trades as a potential driver. In a situation where a bond is negative yielding and protection trades with a wider spread, basis trades could force a tightening of CDS spreads and such trades could continue to make sense in the event that CDS spreads tip into negative territory.

However, in that situation, Citi analysts point out that spreads should still remain positive as simply selling the bond on a stand-alone basis makes sense as a negative basis trade.

There is, however, one scenario where negative CDS spreads could make sense. Some respondents highlight a scenario in which a sovereign’s debt was rednominated into local currency following a breakaway from the eurozone. If the redenomination took place at a spot rate below market value, those bonds could recover at over 100% of par, meaning it would theoretically be valuable sell CDS even at negative levels.

Screen