‘Panic selling’ hits credit swap derivatives market
By Paul J Davies and Gillian Tett
Published: November 5 2006 15:52 | Last updated: November 5 2006 15:52
Investment banks and hedge funds are being forced to rapidly adjust their trading strategies amid a wave of reported “panic selling” in the US and European credit derivatives market last week.
This heavy selling has driven the cost of insuring debt against default in the market for credit default swaps to record low levels – signalling either that investors are extraordinarily optimistic about the outlook for corporate debt, or that prices are so distorted that they are no longer being paid for the risks they are taking on.
Credit default swaps make up the majority of the rapidly expanding $26,000bn credit derivatives market. They offer a kind of insurance against non-payment of corporate debt with the buyer of protection paying an annual premium that is a percentage of the amount of debt covered.
When the price of CDS instruments drops, this leads to mark-to-market losses for those holding the instrument who have bought protection because they are paying a premium that is greater than the market rate.
The sharp price swings of the past week have confounded many investors who had expected to see the cost of debt insurance rise this winter, as part of a broader turn in the credit cycle.
Instead, those who have been buying protection in CDS markets - or expressing a negative view on the outlook for corporate bonds - have been wrong-footed by a so-called “perfect storm” of factors that have affected derivatives prices.
Company results have been strong, US rate expectations have shifted, and there has been a wave of CDS trading linked to a new derivatives product called “constant proportion debt obligation,” which was created by some investment banks a couple of months ago.
Taken together, these factors have pushed CDS prices lower and are believed to have caused pain at some major investment banks and hedge funds. Some of these are now apparently being forced to sell to cover their loses, which has exacerbated the market swing. “[Recent trends] have led to panic selling of CDS,” said Suki Mann, analyst at SG CIB.
Analysts warn that this “panic selling” could continue into this week. “A number of [investors] appear to have finally thrown in the towel for 2006 and with the market sensing this move, it has further deepened their pain, creating a classic short squeeze,” BNP Paribas said in a research note on Friday.
The most visible measures of credit derivatives pricing are Europe’s iTraxx and the US CDX indices. In the past two weeks, the main iTraxx index of investment grade companies has seen the cost of protection drop more than 16 per cent - or a change of 4.375 basis points to about 22.75bp, while the index of junk-rated names has fallen more than 7 per cent at 238bp, both record lows. |
