Here's Why Spanish Bonds Are Rallying

Tyler Durden's picture

Between markedly higher yields at the Spanish T-Bill auction (which has been spun as 'successful' due to demand?),  a step in the right direction for ESM (from the German courts), and a dismal ZEW survey, finding a reason for the outperformance of Spanish bonds this morning - where 10Y bond spreads have rallied around 20bps (but remains above 7% yield) is a guess at best. However, while this fulcrum security is encouraging risk-on (reality-off) around the world, we suspect in a sorry-to-disappoint way, that the marginal bid on Spanish bonds is in fact once again the CDS-bond arbitrage trading community. Since last Monday's open (post Spanish bailout), the spread between the Spanish bonds and CDS has widened to over 100bps (from around 0bps). This underperformance of bonds relative to CDS has again and again provided an arbitrage opportunity at around these levels and given the thinness of the Spanish bond market, we suspect some renewed arbs (trying to lock in 80-100bps of 'risk-free' carry and convergence) were the real drivers of Spain's strength. So, be careful in believing what you are seeing as sometimes the whole picture is obscured when you don't know where to look - as 10Y Spanish bonds are 20bps tighter while 10Y CDS are 12bps wider. And once the spread between CDS and bonds is gone then away goes that marginal bid for bonds - so now you know what to watch for a signal of pending weakness in Spanish debt.

The spread between Spanish bonds and Spain CDS (negative means that Bonds are trading wider/cheaper than CDS; and a falling chart means bonds are underperforming CDS markets) has fallen in the last week post-Spanish bailout as bonds underperformed. Again and again, when the basis gets to around 100bps, we see the arbitrageurs step in and pick up the scraps...

and close-up the last week has seen the 'basis' - CDS spread minus Bond spread (not asset-swapped for simplicity here) - compress from a 'fair' level near 0bps to more than 100bps. This 100bps can be arbitraged by buying the bonds and then buying protection in CDS markets - thus providing a marginal bid for Spanish bonds in a market dearth of natural buyers (so sometimes those horrible hedge funds have a use eh?)

and nowhere is this more clear than the difference in price action in the last two days between CDS (lower pane) and Bond Yields/Spread (upper panes)...


The bottom-line is that as the basis reverts back towards 0-20bps then the demand for Spanish bonds at the margin from basis traders will evaporate (and in the meantime we see the local-law bonds continue to underperform non-local-law bonds).

As an addenda, please please please remember that the only way to judge European debt auctions is yield since demand is entirely biased by either a captive banking system or implict ECB support. So bid-to-cover is now practically useless as any indication of 'strength' especially when you simply consider "how much would you bid for Spanish bonds at a yield of 10%, 20%? 40%?"

Charts: Bloomberg

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RobotTrader's picture

All major averages have now cleared the 50-day EMA.

If the XLF and CYC clear it, then it is pretty much "Game Over" for the bears.

Heh, even National Bank of Greece is up 12%.


junkyardjack's picture

It was game over on June 6th, they've just been pretending to play the credits screen since then.  

Luckily there are no more carbon based life forms in the market so no one is short...

sabra1's picture

i bet you were one of those kids that sat in front of the teachers desk, snitching on your classmates, and exceeded the limitation of being hall monitor!

SmoothCoolSmoke's picture

In cash.  Just cannot make a move until Bernankie tomorrow. Even tho QE with the Dow at 12800 seems impossible. But even then there is a long list of "news" to manip the markets with:

Some G 20 BS statements

Supreme Court on HC

Greek Govt

Those can get the "pump" thru to

Earnings BS time

Seems no end to the ability to jack the markets.


GoldbugVariation's picture

Equities everywhere ramping up in a straight line since 2pm EST, commodities and bonds not doing the same, looks like market manipulation to me.  There's no particular good news, and hope of QE tomorrow would impact precious metals and bonds the most.

LawsofPhysics's picture

Gold and oil will follow as the paper (be it real or electronic) starts making its way to real goods and services (CBs have been printing in reality), doubly so if more intervention from the Fed announced.  At the end of the day over 7 billion people are still competing for real goods and services and the world has adopted ZIRP.  Now if you really believe that the is no cost associated with creating capital, especially if you don't actually create any real value, then then may I suggest a few bridges for purchase? 

junkyardjack's picture

Its a flight to quality in Equities I don't know about market manipulation.  I would think we'd see the weaker names being pumped.  Industries that are leading right now are Telecom, Healthcare, Consumer Staples and Utilities.  Seems more like people are building the stomach for more risk.  Tech is lagging which shows that people still aren't completely gung-ho for a rally but this move is definitely worrisome for anyone that is still short...

crawl's picture

Front running is on,for the past week or so.

Wait for the unicorns to reappear.

Can't imagine more QE, but in this manipulated marketplace , it's all possible if you just wish upon a star.

SmoothCoolSmoke's picture

Seems TPTB have played things pretty well going into Summer.   Pump the market, knock gas down (I paid $2.98 last night with my $.10 Kroger discount) so the sheeple can drive to thr beach, mts, etc. Sweep Egypt under the rug.  Revive the Russians as a bogeyman to worry about.



Vince Clortho's picture

So Keynes was right.  You Print forever with no downside.

Next step:  We will all be Billionaires.

slewie the pi-rat's picture

thanks.  i needed this!

Mordan I's picture

Everything will be ok as long as you do not look back.

Winston Smith 2009's picture

All right!  They can keep this game going even longer so the massive increase in debt worldwide far beyond the productivity increases to support it can result in even greater mis-allocation of capital!  And transfer as much as possible of that crap to the public balance sheet before they can't keep the game going any longer!

d_taco's picture

What Zerohedge do not want to tell you.

The failed Britisch Bank's get the same amount of emergency loans as their failed Spanish partners.

dingoj's picture

So everything has a logic. Where can I follow first hand all this CDS vs bonds action? 

robs98ss's picture

From what I gather here, the Spanish Bonds dropped at a steaper rate than they should have (presumably due to some large seller or sellers) relative to the implied risk from the credit markets.

So the way to take advantage of the spread is to buy the bond and drive up the price back to be inline with implied risk from the credit default risk.

The way to delta hedge this, just in case it all goes awry and the bond value continues to drop, is to buy CDS protection on the bonds that you just brought as well. This way if the bond continues to perform worse, the CDS protection should increase in value and you have no net loss. However, assuming the bond moves back in line with the CDS, the bond could be sold once the spread is closed for a profit.

2 Questions I would like to have answered are

1) Who was the original dumper of these bonds? I would pressume this was someone who had either inside information about a margin hike or some event that they were trying to avoid being at risk of

2) What would be the CDS implied yield of the spanish bond? I think these moves we are seeing are just noise on the continually deteriorating credit quality of the country of spain as a whole. They really have no way out of this, as the market for the bonds is going to continue to deteriorate due to the lack of performance of the economy as a whole.

I am an amateur, can someone please let me know if my understanding is incorrect and if so why?