Default Swap Trade Costs Jump to Two-Year High: Australia Credit

Traders of credit derivatives in Australia are demanding the highest premiums for taking risk in more than two years amid concern Europe’s sovereign debt crisis will spark a global financial meltdown.

The gap between prices to buy and sell the Markit iTraxx Australia index of credit default swaps averaged 3.7 basis points this quarter, the most since the three months ending June 2009 and up from 1.5 in the same period a year ago, according to CMA data. That’s equivalent to $3,700 on a $10 million contract and compares with a so-called bid-offer spread of 1 basis point in the U.S. and 1.1 in Europe, CMA data show.

“Liquidity in credit-default swaps has noticeably decreased,” Jason Watts, Sydney-based head of credit trading at National Australia Bank Ltd., said on Dec. 5. “Bid-offer spreads have widened in sympathy with the general market volatility. The approaching year-end also makes people even less willing to take risk.”

The Australian index, which gauges perceptions of corporate bond risk, has ranged this year from a low of 100 basis points in January to 239 basis points in October, the biggest gap since 2009 after the collapse of Lehman Brothers Holdings Inc. caused credit markets to freeze worldwide. Yield premiums on corporate debt surged to 286 basis points on Dec. 2, the highest since July 2009, according to a Bank of America Merrill Lynch index.

Trading Revenue Falls

Westpac Banking Corp. and Australia & New Zealand Banking Group Ltd. said last month that trading revenue slumped in the six months to Sept. 30 as European leaders failed to contain the region’s fiscal crisis.

The third quarter was the worst for trading and investment-banking revenue at the biggest Wall Street firms since the depths of the financial crisis in 2008, excluding accounting gains.

JPMorgan Chase & Co., the second-largest U.S. bank, reported on Oct. 13 about a 33 percent profit decline, excluding a $1.9 billion accounting benefit, for the period as earnings from investment banking and trading slumped.

Australian bond fund managers have increased their cash holdings to 8.6 percent, the highest since July, according to a Deutsche Bank AG survey released Dec. 5. In the U.S., the 22 primary dealers of government securities that trade directly with the Federal Reserve reduced inventories of corporate debt due in more than a year to as low as $49.5 billion in the week ending Oct. 26, the least since April 2003, Fed data show.

‘No Desire’

The gap between the bid and ask yields on Commonwealth Bank of Australia’s A$1.35 billion of 6.25 percent bonds due in September 2013 was at 13 basis points as of 12:54 p.m. in Sydney, from 7 at the start of November, ANZ prices show.

“Both local and especially overseas banks have pared back trading risk appetite,” said Nick Bishop, a money manager in Sydney at Aberdeen Asset Management Plc, which managed $264.6 billion globally as of Sept. 30. “Coming into year-end, in what has been a really nasty year for some, there is no desire to trade any material volumes.”

Australia’s benchmark 10-year bond yield dropped to a record 3.793 percent low on Dec. 9, from a 2011 high of 5.835 percent on Feb. 8. It rose 6 basis points to 3.86 percent in Sydney today, or 179 basis points more than similar-maturity Treasuries.

Australia’s dollar, the world’s fifth-most traded currency, bought $1.0186 as of 1:02 p.m. in Sydney.

Corporate Spreads

The extra yield investors demand to hold Australian corporate bonds instead of similar maturity government debt rose 39 basis points since the start of November to 284 last week and reached 286 on Dec. 2, the highest since July 2009, according to Bank of America Merrill Lynch indexes.

Australia is headed for its worst annual jobs growth in 15 years, boosting prospects central bank Governor Glenn Stevens will extend interest-rate cuts into 2012 as inflation eases. Stevens will reduce the key rate to 3 percent by July, cash-rate futures show, matching the lowest borrowing costs since 1960.

Payrolls gained 44,700 through the first 11 months of this year, on pace for the smallest increase since 1996 after a record 362,300 additions in 2010, government data released Dec. 8 show. The report contrasted with figures the previous day showing the biggest six-month gain in economic growth since March 2007.

ANZ announced second-half profit that missed analyst forecasts last month. Earnings from the bank’s so-called global markets unit, which includes its fixed income, commodities and capital markets, trading and balance sheet operations, slid 30 percent to A$516 million in the 12 months ended Sept. 30, according to a regulatory filing.

‘Hard Hit’

Westpac’s trading income also tumbled 30 percent in the same period, to A$558 million, the Sydney-based lender said on Nov. 1.

“Banks aren’t holding much inventory in these conditions, and corporate bonds are especially hard hit,” Mat McCrum, the investment director at Melbourne-based Omega Global Investors Pty, which manages A$2 billion, said in a telephone interview on Dec. 5. “You still see some good offers from forced sellers but if you are looking specifically for a certain issuer or a certain line of bonds, they’re hard to find.”

Annual turnover in Australian credit derivative trading totaled A$222.7 billion in the year ended June 30, compared to A$176.5 billion of trading in non-bank corporate debt securities, according to an Australian Financial Markets Association report released in October, based on surveys of banks.

CDS Liquidity

The top eight survey respondents accounted for 99.7 percent of the credit derivative trading volume, up from 90.4 percent in the 12 months ended June 30, 2007, the report states.

In Australia, the iTraxx credit-default swaps index “remains the most liquid instrument to express a credit view,” said Aberdeen’s Bishop. “Even there however, if you have off-the-run contracts for example, you may struggle to get timely and competitive quotes from some counterparties.”

Bid-offer spreads typically increase when market makers become less willing to deal in securities, sapping liquidity from the market.

The spread on credit-default swap contracts on Commonwealth Bank, the nation’s biggest lender, jumped as high as 15 basis points on Oct. 18 from 3 on June 23, while the spread on Westfield Group swaps surged 15 basis points this half to 20, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

The equivalent spread on the Australian index rose 1.9 basis points last month to 5.7 basis points on Nov. 30 after reaching 8 on Oct. 4, the highest since May 2009, CMA data show.

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