The Roof, The Roof, The Roof Is On Fire!!

Tyler Durden's picture

Via Peter Tchir of TF Market Advisors

So, I admit that I have dubious taste in music.  But what is going on in Greek CDS is extremely important to watch, and take advantage of.

Somehow CDS always attracts analogies to home insurance.  It is most often written about in terms of being able to buy insurance on your neighbor's house and then set it on fire.  I never thought that was a particularly good analogy, but now we have Greece on fire, and the insurance is potentially being cancelled.  The EU is doing all it can to avoid triggering a CDS Credit Event.  The banks, some of whom would benefit from a Credit Event, appear to be going along with the plan.  They are too scared of their regulators to go against them.  Is this totally coercive?  Yes, but it doesn't matter, so long as there is nothing in the bond documentation that can force a holder to agree to a plan if enough other holders agree, then it is a "voluntary" Restructuring and NOT a Credit Event.

Just because the outcome defies what you would expect a CDS contract to do, doesn't mean the conclusion is wrong.

There are lots of reasons the CDS contracts still have value - nothing is actually finalized, even after the deal, there will be legacy bonds around that Greece may not pay on, ultimately triggering a Failure to Pay Credit Event.  Those are valid reasons, but there is also an element of inertia at play.  We have become conditioned to believe a certain thing about CDS - that it is meant to protect bondholders and basis package holders in particular from losses.  It is hard to throw out conceptions of what CDS is meant to do and how free markets are meant to function, but we are seeing it play out.

On the back of this, there are some good trades, and some bad trades.

I would be unwinding basis packages for all sovereign debt.  If you are at a bank or a bank hedging desk, I would be selling bonds/loans and selling protection.  Everything you thought about CDS and how the hedges would work is potentially irrelevant.  Yes, there are reasons to believe that there may yet be NoR Credit Events on Greece and others, but there was a reason sovereign CDS retained Restructuring as a Credit Event - because that was the most likely way to get triggered.  Restructuring is still the most likely way that a sovereign will handle a debt problem, but it will be done in a way to avoid triggering CDS.

I think this is a landmark event.  It isn't fully reflected in the price because bank hedging desks tend to have a more formal process to change how they operate than a prop desk would.  Meetings will occur, but eventually the decision will be made to reduce the basis on bank hedging desks.  It is too logical of a conclusion not to arrive at.  There are also, allegedly a lot of "interest rate" or "bund" traders who have the basis on.  Their knowledge of CDS is dwarfed by their position size, and they may be in denial stage, saying this cannot be the case.  Hedge funds, which can own bonds outside of the IIF agreements may want to keep on their trades.  They can hold the bond and wait until maturity where they either get paid, or can trigger the CDS if they don't get paid, but I think if you sell CDS, you will be able to reload the trade at much better levels.

The Greek basis package is taking a beating today.  The Greek 5 year bond looks to be up 2 points today, from just under 38 to just under 40.  The 5 year CDS is 8 points better on the day (54 down from 62).  The FX moves dulls some of the pain, but that is a big move on a basis package. Sovereign CDS already has a wide basis - the CDS trades wider than the bonds.  I would expect that to invert, possibly dramatically, where the CDS will trade much tighter than the bonds.  I also expect the curves could get steeper again, as the risk of a Credit Event has probably been pushed off. Again, no details yet, but after having gone through all the machinations to avoid a Credit Event, I doubt they will default on legacy bonds in the very near future.  More likely they will find another way to avoid paying par on the bonds without triggering a Credit Event - I've heard suggestions that a bond repayment tax could be created and withheld.  Not sure if that is really possible, but I wouldn't underestimate the willingness of the EU to do everything in their power to avoid a Credit Event, no matter how ridiculous or unfair it may seem.

UPDATE: Most European Sovereign Basis are back to early August levels with only FRA remaining as a positive basis.

In the summer of 2007, the "basis" for corporate bonds experienced a decent size move.  It went from being able to buy bonds and buy CDS and "pick" 15 bps, to about 35 bps on average.  Some basis package buyers loaded up, seeing more  potential "net income" than they had in awhile, with the conviction that it would move back.  Other people (my boss at the time included) saw this as a serious change in the status quo.  Banks, and investment banks in particular, were going to reduce their inventory of bonds.  The funding costs of banks made it less attractive for them to hold bonds.  The basis continued to grow until 100 was the norm, and ultimately reached a peak the day in 2008 when Citadel had an investor call that was impossible to get on because of overload, that talked about their "basis book".

I am not bullish on sovereign credit in Europe but I would not express that view through CDS and particularly not short dated CDS (less than a year).

At its most basic level, a bond is a contract, a loan is a contract, and a Credit Default Swap is a contract.  It is the differences in those contracts that provide differences in value under certain circumstances.  A subtle but important feature of the IIF plan is that they want the new bonds documented under English law - why, because the contract affords bondholders more protection (a valid reason why CDS can remain better bid than it would otherwise).

There is mass capitulation in the CDS market today.  I think in sovereign CDS that move tighter is warranted and is only just beginning (bonds won't move to the same extent at all).  I am less sure that the move in XOVER and Main should be followed.  Part of the move there is people who are on the wrong side of the sovereign move, trying to make up some losses by selling CDS whenever and wherever they can.  I don't believe any of this is a real solution so would not be getting long credit in general, and definitely not in a product where the move already reflects pain in SOVX rather than fundamentals.

There are other areas where I would focus my attention.  The CDS market will be on its heels.  The basis move in particular is catching people off guard.

I think moves in MAIN/XOVER may be short lived, but already are pricing in too much of a spillover effect from SOVX.  I would be looking at selling Muni CDS on big General Obligation Issuers.  Muni CDS trades "Old Restructuring" so it might be harder to manipulate events around a Credit Event here, but I would expect them to try.  With US economic data having been above the worst fears, sellers of CA and NY CDS should experience little resistance.  I would think that is a fast macro trade that could play out well.  There are enough people who believe the fundamentals are improving, they trade relatively wide, and government (FED) support is likely if they got in trouble, and the case that governments would work to avoid a Credit Event at all costs is pretty strong.  The fact that all of those line up in the muni market is why I think selling some CDS there is better risk/reward than piling on the MAIN/XOVER bandwagon (it is much harder to get the will or ability to manipulate a corporate default than it is for a sovereign).

At the other extreme, I would look for some thinly traded names that get dragged along for the ride by the "index arb" crew.  This is definitely harder, as you need to do some more credit work, and possibly face more mark to market volatility as the index arb game isn't going away, but I think with the right selections there is some pretty good money to be made.

Let's take a quick look at The McClatchy Company.  According to DTCC there is $15 billion gross CDS on the name, and just under $1 billion in net.  It is in HY17 so in addition to the fact it has been a long standing CDS name, it is part of the "arb" trade.  MNI has a total of $1.8 billion of debt.  A $125 million loan coming due in 2013 and a small bond coming due in 2014 that has already been reduced to only $111 million outstanding through repurchases (it is so nice to talk about millions instead of billions and trillions).  In 2017 the company has the bulk of the debt coming due, but 5 year CDS, wouldn't expire in December 2016.  The 5 year CDS is quoted at 34, and the 3 year is quoted at 20.  So you would receive that up-front and receive 500 bps - whoever is buying protection on this has big negative carry.  My gut feel is that on a name like this, where the outstanding CDS is big relative to the bonds (CDS net is about 50% of total debt), where there are minimal near term maturities, and a lot of traders will have positions just from "swinging em around all day" as market makers, you could push this CDS dramatically tighter in a short period of time.  This isn't relying on a technical issue with whether a Credit Event is possible, it is relying on the view that anyone short CDS is in pain from a mark to market, the basis is less relevant than ever, and with no debt coming due, and a marginally improving economy, the resistance to some off the run date selling would be minimal.  You can probably hit a 20 bid on 3 year CDS, and by tomorrow that dealer will be begging to get out at 15 since there is no real liquidity.  Clearly credit fundamentals play more of a roll in this trade than the others, but you can probably safely bet that less than half the dealers know the fundamentals and will respond to price action more than anything.  I am sure there are many similar names in the HY index world that could be crushed tighter.

I would also look at LCDX.  I think it offers some value after the recent run-up in HY17 and HYG.

I remain bearish and doubt that this rally has much staying power since the plan doesn't actually fix anything, and it isn't even yet clear if it actually works in the near term.  The sentiment has also changed dramatically and there are far more bulls than just a few days ago so the market is potentially now overbought.  But for some long positions that play the technicals to maximum advantage I would target selling CDS where dealers are most vulnerable and the realization of what has happened in Greek CDS isn't fully priced.