Loan hedgers shy away from CDS market

Despite a surge in European lending activity during the past three months, many banks have decided not to hedge their risk with credit default swaps (CDSs), according to research by Morgan Stanley.

European companies signed up for around €76 billion worth of new loan facilities during October. This is 19 times the size of bond issuance in October and double the equivalent notional for October last year.

Research by Morgan Stanley’s London-based credit derivatives strategy team suggests the sharp jump in loan activity has had “no visible impact" on credit default swaps (CDS) spreads.

Bank hedging of new loan facilities would tend to push the default swap/cash basis wider. But between August and October, the basis between five-year CDS and asset swap spreads for European non-financial corporates tightened from 50 basis points to around 20bp, for example.

While conceding that as a matter of policy, not all banks hedge loans, Morgan Stanley’s research highlights bank hedgers’ opportunistic nature. Hedging activity tends to occur before the signing of contracts or long after the announcement of the loan, so competitive pricing can be achieved.

Also, some banks use credit spread targets as a trigger for their hedging activity and enter the market once spreads tighten and reach a specified target. So it is possible that if the basis continues to narrow, hedging activity may be triggered - possibly creating a technical barrier in the credit derivatives market.