Credit Markets Update: High correlation to equity markets continues

The credit default swap market continued to see significant volatility and trading activity in Europe this week, as the high degree of correlation to the equity markets persisted, according to traders in London today.

“The continued erosion of equity indexes and a stream of negative headlines from the US continues to unnerve investors and is edging up bids,” said one credit derivatives trader in London today. “With this kind of unease, weaker credits are suffering,” he added.

A number of names in the European credit default swap market are now being quoted on a ‘points-upfront’ basis – a well-established practice in the US markets. It means buyers of credit default swaps are required to pay at least 25% upfront for a number of distressed credits trading at levels approaching and beyond 1,000 basis points, including Vivendi Universal, Alcatel and Ericsson.

In the volatile European telecoms sector, credit default swaps contracted 5-20bp at the end of last week following an equity markets rally, but widened again on Monday.

Shortly before the market closed yesterday, Deutsche Telekom chief executive Ron Sommer resigned. This was received positively by the market, with the cost of five-year credit protection on Telekom tightening by 15bp to 310bp-mid.

Credit protection spreads on debt of other European telecoms also tightened today, due to better overall market sentiment. But telecoms analysts remain sceptical about the long-term strategy for Telekom, and claimed more credit default swaps volatility would be likely in the telco sector.

Stronger-than-expected results from General Motors, released yesterday, brought in the cost of its credit protection. GM’s five-year credit default swaps were trading at historically high levels last week due to concerns about its pension liabilities and potential plans to buy-out Fiat’s auto unit. But its strong results caused protection costs to narrow by 15bp, to 225bp-mid yesterday and helped to narrow default swap spreads for most of Europe’s auto sector.

European financials remained hard-hit in the credit markets. Credit default levels widened on Monday in response to the slump in equities and failed to recover on Tuesday. Insurers were hardest hit, with the cost of Axa senior debt protection widening 25bp, while Swiss Re widened 7bp. Traders said there were no offers on subordinated protection.

“With more negative news on the way, spreads are likely to remain volatile, especially for weak credits and exposed financials,” said another trader in London today. “And bad news from US corporates Intel, Apple and Tyco this week is likely to keep equity markets, and the credit markets, volatile,” he added.