Friday, April 12, 2013

Corporate CDS tightens to multi-year lows; bonds lag

US corporate CDS are tightening to new lows, as the Fed continues to pump liquidity into the market. The JPMorgan CDX indices which measure spreads for the "on-the-run" CDX (and include rolling into the most current series) are showing the tightest spreads in years. In fact the HY CDX spread is now at levels not seen since 2007.

Source: JPMorgan

Bond spreads have been tighter as well, but have not kept up with the action in the credit default swap market. The chart below shows how HY bond spreads performed over the same period (compared with the chart above).

Part of the reason for cash bonds' underperformance vs. their synthetic cousins is the unease with fixed rate products such as corporate bonds. Selling CDS is a way to increase corporate credit exposure without taking on rate risk (as opposed to buying corporate bonds).

The same trend is taking place in the investment grade universe. The JULI spread is JPMorgan's investment grade bond index spread, which is regressed against the 5-year IG CDX below. CDX spreads have tightened considerably more than bond spreads.

Source: JPMorgan

In the past, market participants would close this gap by buying corporate bonds, buying cheaper CDS protection and entering into a rate swap.  But with rate swaps expected to move onto the clearinghouse, there is risk of having to post margin on both the bonds (at the prime broker) and the swaps (at the clearinghouse) - making it less appealing to for traders to execute this arb. Regulation is creating a bit of a market distortion.

The upshot of the latest market moves is that credit risk appetite continues to increase, approaching the pre-crisis frothy levels. At the same time investors remain cautious on interest rates.
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