Explaining Portugal's Disappearing Risk
Early Tuesday morning, the Portuguese 10Y bond was trading over 300bps wider than its close last Friday. Contagion from concerns in Greece and what that meant for a nation that while not in as dire a position as Greece economically was well on its way to totally unsustainable debt levels relative to what little and shrinking GDP they can garner. Market access is of course off the cards and there are reasonable chunks of debt maturing that will need to be funded. Since then the PGB has rallied an incredible 300bps, now trading a mere 5bps wider on the week as if nothing had ever happened. We know the ECB was active yesterday and it appears also today but what is also very notable and perhaps explains more of the compression is the huge drop in the basis between CDS and bonds for Portugal. The basis, as we have discussed before, was extremely wide for Portugal (a quite illiquid sovereign bond and CDS market) and we suspect at a spread between bonds and CDS of almost 850bps, it was just too tempting for hedgies not to buy the package en masse. This means they would have bought PGBs (bonds) and bought CDS protection to try and 'lock-in' the spread between the two. That demand for the basis has pushed it 200bps narrower and given the thinness of the PGB market, the marginal demand from basis traders has exaggerated that rally by the 300bps we noted above.
So Portuguese bond risk remains elevated (CDS around 1400bps and and 5Y PGB around 20% yield) but the drop in the last few days is not a risk appetite signal but reflective of an ECB-spurred risk transfer to basis traders who we assume are more confident in Portuguese bond contracts and CDS triggers than Greek bonds for now. It seems they have found another pivotal security to manipulate down to show 'improvement' as Portugal leaves the global bond indices but is mysteriously bid this week.
Portugal 10Y bonds blew over 300bps wider on Monday into Tuesday (above) - clearly well beyond the rest of its peers. There was plenty of ECB chatter early on Tuesday but it appears that basis traders (below) were also tempted back in to ride the ECB coat-tails and real-money exited. The chart below shows the spread between CDS and Bonds (Bond spread > CDS spread means negative basis) has improved by almost 200bps in the last two days as the spread was just too tempting for basis traders.
We just hope that the elite do not change their mind again on whether CDS help or hinder any sense of reality. We discussed this last year - again and again, basis traders are active and optically suggest spread compression in a virtuous circle - perhaps the proximity of a real test of CDS event triggers was enough to tempt them into the huge spread in Portugal.