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Thursday, 27 June 2019

DERIVATIVES: Sovereign CDS soar on Portugal downgrade

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Credit default swaps referencing peripheral European sovereigns spiked in morning trading today, as participants reacted negatively to Portugal’s four-notch ratings downgrade by Moody’s late yesterday afternoon.

CDS referencing Portugal widened 118bp to record highs of 886bp according to Markit, while spreads referencing other peripheral sovereigns also ballooned following Moody’s warning that Portugal may need further bailout funds before returning to capital markets.

“People see Portugal taking the same path as Greece now, with talks about a need for a second bailout, and people are also concerned about Ireland,” said the head of European credit trading at a major European house. “Spain and Italy - the two countries that need to hold – are also looking weak, so there has been a massive contagion effect.”

The downgrade from Baa1 to Ba2 has weighed particularly heavily on Portuguese bonds, traders say. Now rated junk, the bonds are no longer eligible for some financial indices, sparking a sharp sell-off. The yield on 10-year Portuguese government bonds jumped to 12.07% from 10.95% today, according to Markit.

“From a cash perspective, the rating downgrade has forced index buyers to liquidate their positions, sending spreads dramatically wider,” said Tim Gately, European head of credit trading at Citigroup in London. “CDS has moved out sharply too, but cash continues to underperform, hurting basis holders. Other peripheral sovereigns and bank CDS have also moved wider, and it feels like people are still concerned about what peripheral risk they have on their books.”

The sharp widening in sovereign CDS has particularly frustrated traders, coming after a rare week of good news for peripheral credit.  Peripheral spreads rallied over the course of last week in reaction to the successful passage of austerity measures through the Greek Parliament, with Greek CDS narrowing from 2065bp to 1852bp – a move broadly mirrored by other peripheral CDS. The number of quotes on peripheral sovereign CDS also fell by an average of 13% over the course of the week, according to Markit Liquidity Metrics.

However, the possibility of a further bailout has sent markets into a tailspin once more today, with CDS on Greece pushing out 109bp to 2025bp, Ireland moving out 68bp to 806bp, Italy jumping 16bp to 212bp and Spain widening 26bp to 302bp.

“It’s volatile - volumes are good, but we’re not seeing any panic,” said the head of European credit trading. “There is a sense of frustration, though. We had a massive tightening last week following the Greek vote, and a week later we’re getting this new bombshell about Portugal – every time we manage to solve one country, another country goes.”

“We’re expecting Portuguese spreads to drift wider with more knock-on effects. You’d expect some of the Portuguese banks and Portuguese corporates to be downgraded in the next few weeks. But eventually things will stabilise and the market will return to grinding mode,” he added.

Dealers say they continue to keep their risk fairly light at the moment, and that there has been a general shift towards shorter-dated and more liquid products from clients given the uncertainty of how things will pan out in the short to medium term.

 “There has been a lot of talk about macro guys getting burnt trading around the volatility so I think people are trying right-size their risk,” said Gately. “There’s definitely been a move from most participants into liquid products, with less liquid relative value strategies suffering. People want to be in big liquid names that they can get in and out of – whether it’s single names or indices –and will be far more disciplined about cutting risk if they get it wrong.”

Christopher Whittall

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