Bond-Swap Divide Deepens Amid Europe Distortion: Credit Markets

Bond-Swap Divide Deepens Amid Europe Distortion
The Holcim cement factory in Dotternhausen, Germany. Photographer: Wolfgang von Brauchitsch/Bloomberg

Investors seeking shelter from the debt crisis that started in Greece and forced Spain to seek a bailout are distorting credit markets by fueling record disparities between bonds and derivatives.

The cost of credit-default swaps insuring investment-grade European companies from steelmaker ArcelorMittal to cement maker Holcim Ltd. exceeded a measure of bond yields by as much as 61 basis points in May and 44 last week, according to Morgan Stanley. That compares with an all-time low of minus 135 in 2008. There was almost no difference in January.

Traders are accumulating bond insurance on concern Greece’s exit from the euro would traumatize Europe’s economy and as this weekend’s elections leave the nation’s future in the balance. A shortage of corporate bonds is at the same time driving down yields as banks and investors take advantage of the liquidity from the European Central Bank’s lending program to snap up the notes as an alternative to government debt.

“The CDS view is much more realistic because it’s correlated with sovereigns,” said Jochen Felsenheimer, a managing director in Munich at Assenagon Credit Management, which oversees 1.85 billion euros ($2.3 billion). “The distortion provided by the ECB is fully reflected in cash bond spreads, so cash is wrong.”

Euro-Era Record

The divergence between corporate bonds and credit-default swaps is another example of disruption in markets as Europe’s crisis deepens, with Spanish 10-year government note yields surging to a euro-era record of 7 percent today.

Sales of investment-grade, non-financial company debt fell to 27.6 billion euros this quarter from 73.7 billion euros in the first three months of 2012, according to data compiled by Bloomberg.

Yield premiums over benchmark government securities shrank 19 basis points since the start of the year to 174, Bank of America Merrill Lynch’s EMU Corporates, Non-Financial index of 872 bonds shows. The index has lost 0.72 percent this month.

The Markit iTraxx Europe Index of default swaps on 125 investment-grade companies has increased 61 basis points since March 19 to 174 basis points.

“For many corporates, there is no euro crisis,” Felsenheimer said. “This crisis is a sovereign debt crisis. The new safe haven is the corporate segment.”

Market Stress

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing by 2.7 basis points to a mid-price of 120.4 basis points as of 11:48 a.m. in New York, according to prices compiled by Bloomberg.

The index typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of bond market stress, fell 0.7 basis point to 26.46 basis points as of 11:48 a.m. in New York. That’s the lowest level on an intra-day basis since April 4 for the gauge, which narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, with 31 trades of $1 million or more as of 11:51 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Positive Basis

The distortion in European credit markets is prompting analysts at Morgan Stanley and Barclays Plc to recommend positive basis trades in which investors sell bonds and default swaps. The bets will pay out should the gap between the price of swaps and the so-called z-spread on the bonds narrow.

When the cost of default swaps exceeds the z-spread, the relationship is known as a positive basis, and the reverse is called negative basis. The z-spread is the extra yield investors demand to hold bonds over the swap rate.

The difference between credit-default swaps and the z-spread on Luxembourg-based ArcelorMittal’s $1.49 billion of 6.125 percent bonds due in June 2018 narrowed to 4.5 basis points, from 184 basis points in May.

The positive basis on Holcim’s 600 million euros of 4.375 percent December 2014 bonds fell to 203 basis points, from 236 in May, the highest since October 2011, Bloomberg data show.

Structured Notes

The basis on other bonds remains elevated, and Barclays is recommending a positive basis trade on ArcelorMittal’s 1 billion euros of 4.625 percent notes due November 2017. The difference between five-year default swaps and the z-spread on those was 225, up from 170 at the end of May and nine in August.

The dislocation is fueling a surge in the sale of debt-linked structured notes, with securities linked to corporate or sovereign bonds accounting for 52 percent of sales this year, the most since at least 1999, Bloomberg data show. That compares with a 34.6 percent share in the same period of 2011.

Deutsche Bank AG and UBS AG issued $133 million of structured notes linked to Holcim debt since May 18 and six lenders sold 31 credit-linked notes totaling $235.6 million referencing ArcelorMittal this year, Bloomberg data show.

“Many private banks and distributors in Europe who have traditionally focused on equity investments have begun to look at credit and foreign-exchange products in recent months as equity markets continue to provide unattractive returns,” said Benjamin Hammond, a credit derivatives structurer at BNP Paribas SA in London.

Lehman Collapse

The current positive basis contrasts with a negative basis of as much as 135 basis points in November 2008, when the global financial crisis triggered by the collapse of Lehman Brothers Holdings Inc. caused corporate bond yields to rise at a faster pace than the cost of credit-default swaps.

Unlike the resulting banking crisis, when panicked investors dumped company bonds, the current supply shortage has made some reluctant to sell securities in case they can’t buy them back when sentiment improves.

“There is a risk of selling a bond and not getting it back, but we think CDS often pays enough to offset this,” said Andrew Sheets, head of European credit strategy at Morgan Stanley in London. “There are a number of reasons why CDS should trade some amount wider than cash, but the basis is much wider than that difference should be.”

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