“Politics has added an element of complexity to the sovereign CDS market,” said Albert Jalso, London-based portfolio manager at Russell Investments responsible for global bond strategies. “Because of the potential ineffectiveness of CDS (to provide protection against a sovereign default), investors may now be more likely to sell peripheral bonds. rather than hold on to them.”
About a dozen banks and money managers contacted declined to comment or did not return calls seeking information on their use of credit default swaps.
An unprecedented sell-off in bonds issued by Greece, Portugal, Ireland, Spain and Italy already has resulted in some of the highest costs of borrowing for peripheral eurozone countries. Even France, which had previously been viewed by investors as one of Europe's safe havens, is beginning to feel the pinch: The yield spread for French 10-year bonds compared with German bunds reached 190 basis points earlier this month.
“Some market participants have wondered if part of the reason that investors are so reluctant to step in to purchase bonds is due to a perception that CDS have lost some of their value as an effective hedging tool,” said Otis C. Casey, director of credit research at Markit in New York. “If that is indeed the case, it would seem that policymakers have collectively cut off their nose to spite their face.”
Credit default swaps are essentially derivative contracts to protect against a corporate or government default. They're most often used by banks and brokerage firms, but money managers also buy CDS contracts to hedge the associated bond exposure. In addition, some money managers use them as a proxy hedge against equity positions in the same country and to better diversify the portfolios. Others, including hedge fund managers, use them to profit from falling markets or more recently — tail-risk hedging.
Mr. Jalso said credit default swaps are typically used within Russell Investments' manager-of-managers portfolios to both hedge positions and gain exposures to sovereign debt. None of the underlying managers has Greek CDS exposure. Russell had about $42 billion in fixed-income assets under management as of Oct. 31.
Overall, managers of Russell's global government debt strategies have increased their underweight positions in peripheral Europe. Outside of using CDS as a hedging tool in government bond portfolios, managers also are reducing risk by simply selling the peripheral sovereign debt, holding more cash or overweighting other government bonds such as German bunds, U.S. Treasuries and U.K. gilts.
“Historically, we haven't used sovereign credit default swaps,” said Phil Page, London-based client manager at Cardano Risk Management BV, a specialist in solvency and risk management, including institutional advice on the use of derivatives. “We've looked into it, but they were expensive and we didn't feel there's a need for them.”
Sovereign credit default swaps can be seen as politically unpopular, because they are essentially an insurance policy against a particular government, said Mr. Page of Cardano, which oversees about £5 billion ($7.8 billion) in assets within its solvency management platform and has £15 billion in other assets under advisory in the U.K. Secondly, if governments can redefine the terms of default on sovereign debt — as proposed under the eurozone rescue plan — investor confidence in the instruments themselves will dwindle.
The International Swaps and Derivatives Association, a global financial trade organization for over-the-counter derivatives, has not issued an official ruling on the Greek debt accord, partly because final details have not been released.
However in a statement issued Oct. 31, the New York-based ISDA said that because the eurozone proposal involves a voluntary exchange, “it does not appear to be likely that the eurozone proposal will trigger payments under existing CDS contracts.”
European government leaders would prefer to avoid a Greek CDS trigger, because an involuntary default could cause “unknown ripple effects” globally, Mr. Jalso said. “So they're planning to ask investors to take a voluntary write-down in Greek cash bond holdings. While that's not ideal, the alternative could be more harmful to a wider group of investors.”
Nevertheless, investors — including some of the world's biggest banks — are under pressure from their exposures to European peripheral sovereign bonds, and the CDS contracts used to hedge that exposure are increasingly under question. In a research note issued by Fitch Ratings Ltd. on Nov. 16, the ratings agency noted that “U.S. banks could be greatly affected if contagion continues to spread beyond the stressed European markets.”
“While U.S. banks have hedged part of their European exposures through the credit default swap market, this tactic could prove problematic if "voluntary' debt forgiveness becomes more prevalent and CDS contracts are not triggered,” according to the note. In total, Fitch estimated the top five U.S. banks — Bank Of America Corp., Citigroup Inc., J.P. Morgan Chase & Co, Goldman Sachs Group Inc. and Morgan Stanley — had a total of $21.6 billion in hedges associated with Greece, Portugal, Ireland, Spain and Italy as of Sept. 30. “Fitch still believes gross direct exposure (to peripheral eurozone debt) is ultimately manageable,” according to the note.
The uncertainties in the sovereign CDS market have generally not affected the corporate CDS market, consultants said. For example, some of the managers in Cardano's stable do use corporate credit default swaps within long/short equities strategies.
“There's less nervousness (around corporate CDS) because it's much harder for corporations to define the terms of a default,” Mr. Page said. “That's not the case for governments.”