Market Snapshot: European Dispersion And The CDS Roll

Next week, credit derivatives will roll from December to March maturities. The last couple of days have seen increasing dispersion across sovereign, and corporate equity and credit markets in Europe. The modestly bullish bias to credit index moves, while not totally dismissible as optimism, is likely to have a number of technical drivers implying that investors should not read too much into the compression. Liquidity has dropped notably in both single-name and index products recently and credit derivative dealers have increased the spread between the bid and the offer accordingly - this means the roll adjustment may be even more expensive this time around and for traders with a book full of single-name CDS, positioned more short, the bias will be to sell index protection to 'hedge' some of that roll-adjustment. The other technical is the indices swung once again from rich to cheap into the middle of this week (meaning the indices trade on a cheap basis to the cost of the underlying components) and so heading into a roll, arbitrageurs will want to rapidly take advantage of this - especially in the high-beta XOver and Subordinated financials space. So, all-in-all there has been some optimism in credit markets the last two days but as-ever we pour some sold water on the excitement as all-too-likely this is driven by roll and arb technicals, as opposed to a wall of risk-hungry buyers.

 

Since the 11/25 lows, sovereign spreads are generally tighter but are well off the best levels of last week. However, the last few days have seen extreme pessimism across assets (and spillover selling into sovereigns) and yesterday and today some renewed comfort - especially in Italian and Spanish 'anchor' spreads. Whether the ECB is active is unclear, though the velocity of intraday moves do not suggest significant intervention, we do see CDS-Cash basis moving wider again suggesting those traders are providing some bid under sovereigm bonds.

 

Across European credit and equity markets, dispersion has risen significantly. Stocks have remained 'preferred' over credit but the underperformance of XOver (high-yield) and Financials (Sub over senior) suggest the major compression from 11/25 to 12/6 was more an opportune time to set out some cheap shorts than to get aggressively long. This risk-on rally of the last two days is seeing some high-beta credit participation but not as much as one would expect were the ECB's LTROs to really have signaled the all-clear on banks.  

 

Critically, we should also bear in mind that 12/20 will be the CDS roll and so movements in these indices (especially relative to the intrinsic or fair-value) could be misleading as dealers reposition and traders prepare for the rolls (or more likely index positions are used to hedge the roll). The chart above shows the difference between index and intrinsic value for XOver and Sub financials - the two highest beta and widest trading and best performing indices of the last 2 days. The point being that the sell-off of the last week or so had swung index spreads from very rich levels (too tight or bullishly positioned relative to the 'value' of the index) to now too cheap (too wide or expensive relative to intrinsics). This close to the roll, arbitrageurs will look to snap up that differential - or more simply, it is indicative that underlying hedgers are more comfortable holding short-hedges through the roll than broad index positions - neither of which suggest a greatly risk hungry bias to market participants.

The spread between senior and subordinated spreads compressed from around 150bps on 11/25 to 200bps on 12/7. As hope faded and the reality that fiscal union is a long way off and bank balance sheets aren't saved yet (sub-specific downgrades, lack of govt support, capital inadequacy), then we decompressed significantly. The last two days have seen modest compression (bullish) in the spread but obviously we are a long way from being saved and along with the need to roll next week (and the explicit cost to that), it seems the path of least resistance is tighter for now as we suspect hedgers are holding for post-roll positioning.