CDS as a measure of credit risk

Credit default swap spreads have recovered in 2009 but remain elevated relative to pre-crunch levels, says Colm Doherty at Thomson Reuters.

Since the onset of the credit crisis and subsequent global recession, all areas of the credit markets have been marked by volatility and massive spread widening. Credit default swaps in particular have garnered much attention both as a guide to the credit risk of a particular entity and for their role in the problems roiling the financial system. CDS are also considered leading indicators, at times moving ahead of equities. Significantly, their use as a measure of counterparty risk has hit the headlines in the past year.

Focusing on the role of CDS as a measure of credit risk, the last couple of years have been a rollercoaster ride. Spreads on the CDS indices first spiked in 1Q08 before JPMorgan rode to the rescue of Bear Stearns. Spreads then settled back down before hitting unprecedented heights in the last few months of 2008 following the Lehman Brothers collapse and the government rescue of American International Group (AIG). 1Q09 saw another period of widening spreads as continued worries about the banking system, the deepening recession, and rising defaults caused enormous market stress.

CDS spreads tighten

Spreads have narrowed in the last couple of months as the credit markets have improved somewhat, but still remain well above the levels seen pre-credit crisis. The CDX North America IG index peaked at 277 bps in the latter part of last year, narrowed early in 2009 to 189 bps, before jumping back up to 261 bps in March. It settled back down to 156 bps in mid-May (Fig. 1). The European and Asian indices have followed a similar pattern. The iTraxx Europe index hit 215 bps in early December 2008, narrowed to 145 bps in February 2009, jumped back to 207 bps in March, before tightening more recently to 134 bps. In Asia, the iTraxx Japan index peaked at 570 bps in March, but has since dropped to 240 bps.

Single names have also, not surprisingly, been marked by volatility. Looking at the distribution of Thomson Reuters CDS par spreads, there has been a big shift in the last couple of years. Based on a cohort of roughly 1,000 entities tracked by Thomson Reuters over the last year and a half, 74% had a five-year senior CDS spread of less than 100 bps at the end of 2007, but by the end of 2008, this number had fallen dramatically to only 15% (Fig. 2). At the same time the share of CDS spreads in the 100-500 bps category spiked from 22% to 58% of the universe, while the 500+ bps category had jumped from 4% to 27%.

So far in 2009, spreads have reversed course and the share of sub-100 bps CDS in this cohort has increased to 30% as of mid-May. Nevertheless, the spread tightening has been nowhere near enough to make up for the ground lost in 2008. Fig. 3 illustrates this point. It shows that 98% of CDS spreads widened in 2008, while year-to-date 2009 has seen 20% of CDS spreads widening and 80% tightening.

Moreover it shows major differences when looking at the magnitude of the spread changes: for example 54% of CDS widened by at least 500 bps in 2008. In comparison, only 28% have narrowed by the same magnitude in year-to-date 2009. The net effect is that while the pendulum has swung the other way this year, the overwhelming majority of single-name CDS spreads are still wider then they were at the beginning of 2008.

Fig. 4 looks at the CDS spread performance of a selection of the top reference entities. In general we see the familiar trend of spreads having recently narrowed from their highs set in 2008 and early 2009, though they still remain well above their historical levels. Notably, the list of names with the largest net notional outstanding according to DTCC numbers is dominated by sovereigns and financials, with the top five currently comprising Italy, General Electric Capital Corporation, Spain, Germany and Brazil.

Variable performance

On an industry basis there has been a wide variation in CDS performance. While CDS spreads have generally widened across industry segments, the auto parts and airlines sectors currently have the widest spreads (Fig. 5). This is not surprising considering the pressures facing the auto industry, highlighted by the Chrysler bankruptcy and the continued struggles of General Motors. The average vehicle parts senior five-year CDS spread is currently at 1,908 bps, while the automakers (excluding the sky-high General Motors spread) are at 472 bps. Airline spreads currently average 935 bps.

Sovereigns also became more of a concern this year as recessionary pressures have taken their toll across the globe. The benchmark United States CDS jumped as high as 95 bps in February but has since settled back down to 30 bps. At the riskier end of the sovereign universe, the Thomson Reuters Emerging Europe index peaked at just over 1,000 bps in March, but has since tightened significantly to 449 bps.

Counterparty risk has also hit the headlines in the last 18 months. Following the demise of Bear Stearns, the worries over American International Group exposure, and the Lehman Brothers collapse, counterparty risk became much more of a concern. Indicative of this, the Thomson Reuters Counterparty Default Senior Index (an index now comprising 13 banks) peaked at 318 bps in mid-September. Concerns have subsided somewhat more recently, and the index is now at 174 bps (Fig. 6). The riskier subordinated index peaked at 467 bps in early March - when the headlines were dominated by questions over the survival and possible nationalisation of some banks - and has now tightened to 303 bps in mid-May as fears have eased.

- Colm Doherty, V.P. Senior Market Analyst, Thomson Reuters; 001-646-223-6821; [e-mail]; online.thomsonreuters.com/getahead/; www.thomsonreuters.com.

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