Credit Default Swap Bull Market

Discussion in 'Economics' started by scriabinop23, Sep 18, 2008.

  1. There's always a bull market somewhere (tongue in cheek)...

    New blog -- this one is good, if I must say...

    A look at the LQD, an investment grade corporate bond fund ETF with diversified issues tells the story the last several days. <em>Remember, every point this thing falls means billions more in increased collateral requirements and mark-to-market losses for AIG and countless other financial institutions, since their bet is on debt (sans treasuries) staying bullish.</em>


    Or the visual from MarkIt:

    The right side of this <a href="">MarkIt CDX Index</a> chart says it all, but reality is much more severe. Investment grade credit spreads of a wide variety of issues are blowing out to unheard of numbers. Morgan Stanley 10 year debt is now trading 1000 basis points over treasuries, much worse than Lehman even last week. Typical investment grade debt is averaging over 300 basis points over treasuries.

    The great <a href="">credit default swap unwind I anticipated in January of this year</a> may be happening now, as industry players try to beat AIG and Lehman to the punch.


    This past five years of historically low risk spreads was essentially caused by redefinition of 'acceptable leverage' in a post Sarbanes-Oxley world, where off balance sheet opaque bond derivatives positions became the de facto method of amping up revenues for insurers and financial institutions of all sorts. What better way to collect free money than sell insurance on 'zero probability of default' issues, like GE? By the way, you can pick up GE 10 year bonds for around 7.5% yield right now, 400 basis points over treasuries! Weren't these issues trading at 50-75 basis points just 12 months ago?

    One thing is very obvious from this last chart. The CDS market started to take off right around the same time when Sarbanes-Oxley was implemented. Is this merely a coincidence?

    Next a rhetorical question with an obvious answer: If the spreads continue blowing out as large players return leverage to appropriate levels, <em>will there be enough money to simultaneously soak up a continued supply of treasury debt AND underpriced AAA corporate debt while keeping yields in the same place?</em> Something has got to give, and my guess is bond fund managers will find the AAA corporate more attractive at these and even wider spreads. I think the spread may inevitably narrow over time, resulting in a new <strong>secular bull for high yields</strong> in long dated maturities. Against a backdrop of dollar disillusionment, excessive government debt supply, GSE addition to net US debt, a fed needing recapitalizaiton, <strong>all factors point to a short long maturity treasuries position</strong>. <em>And we all know how those high interest rates will impact housing, credit, and business expansion.</em>
  2. Lucky


    I've been anticipating (and then watching) this CDS bull happen, and have really, really been wishing I could participate.

    Any idea how much $$ you need before you can talk CDSs with a prime broker (or whoever else deals in these)?
  3. sjfan


    First - it's a bear market, not a bull market in CDS - spreads go up, prices go down, it's a bear (I trade CDS for an institution - and for the most part it isn't called a bull or bear).

    Second - you can't. Even if you had the money, it'll take lots and lots of cash to arrange an ISDA with EACH bank you might deal with. Prime brokerages make life easier, but you obviously won't get that service unless you are about $100MM. I've heard one or two really wealth individuals (I'm talking about >$500 net worth I think) who have tried it. It wasn't easy for them but they did get some ISDAs done.
  4. Lucky


    wish there was a red cheek face smiley here :p
    (that's what I get for watching cnbc)

    Shit I've got almost more than $500! :D
    $500MM? a lil outta my ballpark ;)

    Seriously, thanks for chiming in, it's nice to hear from someone who actually works with this stuff.
    Out of curiosity, what size is a typical contract? And what would $ size be of the smaller deals?
  5. sjfan


    Depends. On index, typical trades are 5MM+ though you won't get turned down for doing 1MM+ (it used to be that on some really super senior tranche stuff it's 1 billion+ in size)

    On single name CDS, 1-2MM is about typical these days. But that really varies a lot depending on the entity.
  6. Then a hedge fund investment in Tykhe or Paulson would be the best bet if you can't get into CDS on your own...
  7. Wait up - this was a title to attract readers... but if you are long CDS (not short premium), it certainly is a bull market. If I bought a MS CDS at 100 last yr, it most certainly is worth 1000bp right now. That is a raving bull market.

    It is definitely a bear in bonds, but being long the credit spread is by definition a short bond position. If I am long the credit spread and short treasuries I am effectively synthetically short the bond (paying out its yield for the priviledge of principle depreciation).
  8. sjfan


    If you are long a contract (which means you sold protection and are long premium - meaning getting the income) and the contract went from 100bps to 1000bps, you are crushed... you now owe your counterparty 900bps x DV01 (say, around 3 for a then 5Y contract). So you are out 27%.... nice bull market you got there, being down 27%.

    The trading convention is set up that it's in the same direction as normal bond trading -> long CDS means long credit (analogous to owning the bond) and therefore a spread widening is bad for you.

    As I suspected from reading your original post, you have no idea what you are talking about.
  9. I don't trade CDS obviously, so my nomenclature is wrong then, but despite any industry convention to name being long the contract = actually short the risk, my points are clear - BUYING the credit spread is a bet it will widen, thus long risk, not short risk (betting risk will decline). Is this a pissing match?

    Thanks for the fact that CDS traders align their nomenclature with that of the bonds they are insuring. Being long the bond is in my head still 'short' the CDS, since they are betting risk premium will go down.

    My fundamental points have nothing to do with these details. If you are arguing with me over this, then you missed the point. They are two things more macro:

    1) Did sarbox have an impact on the growing market? (postulation)

    2) Widening credit spreads on genuinely great AAA will drive bond managers out of treasuries, and thus all yields will go up.

    And with respect to your input, I put on the blog:

    Edit 9/18: I do not trade credit default swaps personally, and have been corrected by a reader who does that being long CDS in the industry is aligned with what I refer to with the opposite naming convention, 'being short CDS'. Formally, being long the CDS is the same as selling the credit spread, being the insurer of its risk. Being long the CDS + being long a treasury of equal duration is the synthetic equivalent as being long the underlying bond it represents. The title "CDS Bull Market" refers to the bet on the credit spread increasing being a successful one.
  10. sjfan


    That's still wrong. long contract == long risk because a long in CDS world means selling protection. This convention has been established since the dawn of CDS trading - and of course it's arbitrary, but then so is the term bull and bear.

    Look - if you want to present your analysis of a market, you should at least understand it. To understand it, you should at least be familiar with it. You aren't even familiar with the most basic convention of a CDS contract (the convention comes from how contracts are specified and traded) - something that anyone who has had any professional contact with the instrument knows..

    I also completely disagree with your analysis, terminology aside. I think it's complete rubbish and entirely off the market when it comes to the actual dynamics of the CDS market.
    #10     Sep 18, 2008