Swap Souvlaki: A comparison between Greek CDS prices and bond yields

Continuing along our featured coverage about research being done into whether or not credit default swaps are really deserving of all the blame for some of the financial crises facing governments and companies we feature highlights of a new report in ZeroHedge (who highlights research by a user named Credit Trader) entitled “What CDS Speculators? The Reason Why Greek Spreads Blew Up Is Because Of Bond Selling, Not CDS Buying”.

To summarize, they compare the movement in Greek bond prices with the movement in Greek CDS prices to see if a run-up in CDS prices really forced bond yields higher (remember a lower bond price equates to a higher bond yield).

We reproduced the 3 graphs they highlighted here for the benefit of readers

Graph 1: A comparison between the spread or difference between Greek 5-year bonds over German 5-year bonds and the spread between Greek CDS over German CDS.

Graph 2: A comparison between the spread or difference between Greek 5-year CDS over German 5-year CDS and the spread between Greek 10-year CDS over German 10-year CDS.

Graph 3: A comparison between the spread or difference between Greek 10-year bonds over Greek 5-year bonds and the spread between Greek 10-year CDS over Greek 5-year CDS.

Graph 1

Graph 2

Graph 3

The conclusion reached is that “it should be clear from these charts that CDS were not the driver of risk up or down but held their somewhat barometer-like relationship to cash quite healthily”. The graphs all seem to indicate the following point about the relationship (or lack of one) between Greece’s bonds and CDS, namely that it is not clearly evident from observed prices and yields that you can definitely say CDS is responsible for a financial crisis since in some cases bond yields keep rising (bond prices keep falling) while CDS prices have settled down and are actually falling. In addition, the Hellenic Republic’s own bond yield curve is growing more inverted and approaching levels that get more and more indicative of recessionary tendencies. The yield curve is currently giving a stronger signal than the equivalent measure derived from the CDS credit curve.

Now the question right now could be who is going to be right? It seems the CDS market may actually be pricing in a greater likelihood of a bailout by someone (EU, Germany etc?) more so than the bond market is. And on a relative basis, you are actually going to get paid more to make your bet in the bond market than you will be paid in the CDS market (not to mention the lesser chance of a media or political backlash) and we could venture to guess that there are already a number of investors out there who have realized this. The current divergence in CDS and bond spreads is actually creating another lucrative opportunity to buy bonds and buy CDS and profit from what is often referred to as a “negative basis trade”. Rather than causing a crisis, perhaps this is another example of using CDS price information to actually make a lucrative bet in bonds.

March 4, 2010 Update

According to Bloomberg, Greece just priced their new 5 billion euro 10-year bond issue today at a spread of 300 basis points over 10-year swaps for an all-in yield of 6.35% (which was about 25 basis points above its existing 10-year issue (July 2019). Greek CDS appears to have risen from about 295 basis points to 305 basis points over the day leaving the Greek CDS-bond basis at about 5 basis points.

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