CDS Volumes May be a Factor of Instability

CDSs have become notorious for many reasons. Some of these perhaps arise from a misunderstanding of this opaque market. Yet, there are also very legitimate concerns. CDS trading has not mitigated, on contrary, helped proliferate the counterparty risk. Those with insider information have preferred this market as they don’t leave easily spotted tracks there. Moving CDS trading to exchanges would no doubt help in such issues. In an important issue, however, moving to exchange would not make a difference. That concerns the size or volume of CDS trading. For the sake of financial system, we all must seriously consider if there should be limits on the size of this market.


The notional amounts involved in this market are huge. While these notional amounts vary from week to week, they are in the order of tens of trillion dollars, or roughly about the same size of stock markets. As CDSs are fixed income instruments, the risk amounts are indeed a fraction of these huge notionals involved. Furthermore, most of these instruments are actually traded between dealers, with customers making only much less. Only about 10% of the notionals will remain after the netting of all contracts.

Still, CDS trading notionals are large amounts. In some cases of CDS trading, the notional amounts traded are larger than the total debt outstanding of the reference entity. For some, this is a spot-on example of tail wagging the dog. Without a direct link between the volume of the referenced debt and the corresponding CDS amount traded, it may be hard to have a stable credit market. Yves at Naked capitalism proposes that the scale of the risks involved in CDS market may be too large even for an exchange.

I list below some of the most striking discrepancies between the CDS volume and the total debt for non-financial US corporations:

Table: CDS volumes May be Multiples of Outstanding Debt

Notional CDS volumes above come from DTCC and are as of mid January 2009. I have computed the total debt outstanding by adding the loan and bond amount issued by each corporation and its subsidiaries. The total outstanding debt would be smaller in many cases, but I preferred to stay with the most conservative assumptions.

The most egregious case is for GAP. For this company with $550 million debt, market participants have bets on specific CDS contracts with total notional of $23 Billion., 42 times larger. Even after netting of all offsetting CDS, the net notional is 3 times greater than the total debt.

Moreover, the example above understates the traded volume of CDS. GAP is a component of several credit indices. The above table doesn’t include what is bet on this company using such indices. The amounts could easily double if we could take the index trading into account. Second, there could be additional amount of custom contracts not captured in the DTCC data. Third, there could be swaps on the bank loans outstanding that will amplify the bets on the debt of the company.

As a counterargument to this concern, one can note that the notional amounts involved in CDS are not very relevant. Perhaps, in the initial stages of this market, CDS was mainly a risk mitigating contract, removing the default risk. Now, CDSs are used mainly to express opinions on the direction of credit worthiness of an entity. Outright bets or hedges are not intended to be kept until their maturity, instead they would be unwound and sometimes rolled every quarter. Futures market may provide a useful analogy. Just as the futures market, most participants will close out or roll their existing contracts before the expiry date. Traded volumes can thus be greater than what is deliverable physically.

CDS market takes physical delivery issue one step further. Even after a credit event, most contracts can be settled by cash as opposed to physical delivery that was used when the market was new. Removing the physical delivery rule may be where the CDS got unhinged from the underlying debt markets. IRA’s Chris Whalen considers this one of the main weaknesses of this market:

"The basic model for a CDS contract does not really fit the needs of investors or the real economy, who are in the most simplistic terms looking for a practical way to hedge an illiquid corporate bond. Unfortunately, most corporate bonds cannot be borrowed in the securities lending market, WHICH MEANS THAT THERE IS NO TRUE CASH BASIS FOR SINGLE NAME CDS. Faced with this issue, the happy squirrels at ISDA came up with cash settlement as a way to ensure the astronomical growth of CDS - never realizing that in so doing, they were also magnifying the overall level of risk in the global financial system many times over and above the actual "basis," represented by the bonds specified in each CDS contract."


Such rationale has also been the behind the proposed plans by New York State Insurance Department Superintendent Eric Dinallo concerning the restrictions on naked CDS trades, i.e. those CDS trades not used for hedging cash positions.

Disconnect between the CDS and underlying debt may have serious implications for corporations. Their access to capital is determined in part by this market. As the trading volume and liquidity in the corporate CDS market much better than the corresponding cash debt market, CDS markets are usually the first place to reflect the pertinent news on credit prices. They affect not only credit, but also equity and volatility markets as well. We have already seen in last few months salient instances of risk perceptions to be self-fulfilling. The concerns of investors induce CDS buying and as the resulting CDS spread move further, these trigger more CDS buying. A positive feedback mechanism!

Can such instability occur at systemic level?... 1987’s stockmarket crash involved the use of index futures by portfolio insurance followers as the market dropped. In that case, the coupling and feedback mechanism between the cash market and futures market triggered a sudden drop in markets. Without rules and limitations on the size of CDS trading, it is hard to eliminate such a possibility.

Credit Spreads versus Equity Dividend Yields

Credit and equity divide the claims on the same assets of a corporation. Capital structure arbitrage tries to benefit from any mispricing between them. Yet, as often is applied, the term “arbitrage” is misnomer. Credit and equity are different markets. Mispricings discovered will often involve taking some sort of risk. Still, a careful observer can draw insights from the relative pricing between them, and might even be able to profit from them.

One of the simpler ways of checking pricing information between credit and equity markets involves mapping credit spreads versus dividend yields. For instance, the following graph shows the 5y CDS spreads versus indicated dividend yields of select US corporations as of mid January 2009:

Should we expect any simple relationship between the credit spreads and dividend yields? Let’s look at the market by segmenting into three parts: high spread, medium spread and low spread companies:

• On the high spread segment of the market, dividend yields may range from very high to zero. These are all stressed companies running a serious risk that their dividend would have to be cut. We would expect companies whose debt trades at high spreads would have high dividend yields reflecting this risk (like CIT, XL), unless they have already taken action to cut it down.

• On the low spread segment of the market, is natural to see low dividend yields. Companies placed here, by and large, are those that do not have serious issues with any debt payment. Stability in their profits would usually allow them to plow their earnings back to business. This is especially so if they are in the growth markets as opposed to mature markets. A new crop of corporations in this segment involve those whose credits are backstopped by government.

• In the medium spread markets, we would observe companies exposed to an event risk, such as an impending merger or acquisition (for example CTL, DOW). These can have high or low dividend yield depending on the expected structure after the event.

Still, the relationships between the credit spreads and dividend yields seem to be more complex than the basic relationships described above. There are some companies with relatively high dividend yields in all segments even without obvious event risks. MO and CBS are some examples that stand out.

Is there any inconsistency between the equity and credit markets for these companies? If we exclude the special cases, such as those corporations with unstable dividend payment policy or near term liquidity issues, would we be left with hard to explain cases, or potential mispricings?

First thing to note is that each example may have very good reasons to have its credit and equity trade at those prices. Capital structure is often complex. Existence of bank loans above the senior debt and any subordinated debt and preferreds between the senior debt and common equity would affect the pricing relative to equity. Credit claims can range from debt due immediately to those with 50 years maturity and those with equity warrants or hybrids or converts. All of this means, a sweeping generalization would be misleading.

It may yet be possible though to discover some “information” reflected in one market but not the other. A proof of that would use a trading strategy based on historical data. The first step in creating such a trading strategy would involve taking the CDS spreads, normalizing them by index spreads and mapping them against the dividend yield and equity prices. Second step is the creation of a mechanical trading rule that focuses on outliers. Third step involves the elimination of false signals by excluding the special cases.

Before looking at the results of such a trading strategy, let’s review whether such a trading strategy would make sense fundamentally. The most basic relationship between the credit and equity is through Merton’s capital structure model. The key model of this insight is that the equity owners have a call option on the balance sheet of a company. Equity is then priced a call option on the value of the assets of the company.

where A signifies the value of assets, F signifies the face value of equity and σ_A is the volatility of assets. Asset volatility is again determined through the Black-Scholes formula from the equity volatility:

d2 above is a measure of distance-to-default, and N(-d2) signifies the risk-neutral probability of default. Thus, the part of credit spreads due to expected loss can be derived in the Merton framework. This model yields a simple inverse relation between the credit spreads and indicated dividend yields.

There are, of course, many many issues with this model which is based on extremely simplified assumptions. (For example, insolvency does not necessarily lead to default in real world). This basic model has been enhanced in many directions by researchers. Some involve the use of non-zero barriers and pricing of knock-and-out options. Some involve stochastic volatility. Some focus on distance to default and a more elaborate representation of capital structure (such as in KMV models).

However, the basic Merton model is still useful in the sense that, it reminds us the following:

Asset/equity volatility is a key parameter in the debt-equity relationship.

Going back to our question on whether there is any mispricing, it is clear that we cannot ignore the equity volatility if we try to exploit information from one market in another.

Thus, we must modify the above trading strategy by incorporating the equity volatility as a parameter for the beginnings of a model...

Buyers and Sellers of US Treasuries

Foreign Central Banks have sold a very large amount of US Treasury securities in November 2008. The selling of US Treasuries by foreigners has reached $23 Billion in that month, the largest outflow since January '78:

Who are selling and who are buying the US Treasuries? US TIC data shows the trends:

In the last 12 months,

• China has bought over $200 B of US Treasuries, increasing its inventory by 45%.
• UK has also bought over $200 B; this represents a doubling of their inventory.
• Inventory has also doubled in off-shore banking centers that added $100B.
• Oil exporters and Russia account for another $100 B increase.
• Japan has kept its inventory nearly the same over this period.

Those who reduced their inventory in November 2008 are: Japan, Brazil, Russia, Korea, Luxembourg. I guess Luxembourg’s action must be at least partly related to unwind of structured transactions that include Treasuries in them.


Pricing Review:
The following chart shows the yield of 10Y US Treasury note. After spending most of 2008 in the range of 3.5 – 4.0% yield, its yield suddenly started dropping in mid November 2008, pretty much straight until 2% at the year end.


The foreign central bank purchases cannot explain the move of this magnitude! It is not a result of diminishing supply either as late 2008 was a period of increasing supply of US Treasury debt. This rally stemmed from the purchases by private sector: Banks were trying to reshape their balance sheet by moving from risky assets to US government debt (I would never call them risk-free!) in order to present a soothing balance sheet by the year-end.


Future Trend:
Given the fast drop in oil prices, we should not expect more buying of US Treasuries by oil exporters that we saw in 2007. Don’t know why UK doubled their US Treasury inventory, but it shouldn’t be easy for them to repeat this as they are a spender. Amid the increasing signs of discomfort with US debt by Chinese officials, Chinese buying of US Treasuries is already slowing down. Yves at naked capitalism discusses this issue pointing out that Chinese kept buying US Treasuries to prevent RMB appreciating too much against $. (Append: Later, though, she concurs with Brad Setser who claims China will keep buying US Treasuries as the reduction in their exports will be smaller than the reductions in their imports).

It is hard to see the foreigners buying more US Treasuries in 2009. Of course, we have a big buyer right here in US that plans to buy whatever US Treasury must sell. Fed!

Time to Invest in High Yield Mutual Funds?

High yield valuations are very compelling. Is it time to invest in this asset class?

In mid October 2008, when the markets were crashing pretty hard, this asset class was one of the worst afflicted. At that time, my view was that High yield values were cheap but they would get cheaper yet. Everyone was selling at that time regardless of the value.

In a post titled, "Are Record Junk Bond Defaults & Outflows Growing Into Opportunities?", John Ogg mentioned some closed-end funds and ETNs such as PHK, HIX, HYV, HYG, JNK. He did not suggest buying them, but mentioned that they would be great buying opportunity at some point. Have we arrived that point?

Here are some performance results for these funds:

* PIMCO High Income Fund (PHK): $3.81 on Dec 17 '08 versus $7.04 on Oct 17 '08. An almost 50% drop in last two months since Ogg's post. On top of the 50% drop from 52-week high he mentioned at that time.

* Western Asset High Income Fund II Inc. (HIX): $4.33 on Dec 17 '08 versus $5.88 on Oct 17 '08. 27% drop on last two months.

* BlackRock Corporate High Yield Fund V, Inc. (HYV): $5.33 on Dec 17 '08 versus $6.94 on Oct 17 '08. 23% drop in that period!

* iShares iBoxx $ High Yield Corporate Bd (HYG) $67.70 now vs $70 then!

* SPDR Lehman High Yield Bond (JNK): $27.89 now vs $32.25 then!

* A mutual fund: T Rowe Price High Yield fund (PRHYX) for comparison purposes: $4.45 vs $5.03 then!


First observation: Closed-end funds have lost much more value than ETNs in last two months or a mutual fund. In fact, the drop in PIMCO's closed end fund is striking (PHK).

Second observation: PIMCO's high income fund (PHK) has been on the news with its GMAC/GM exposure. As GM struggles for its survival and GMAC finds it difficult to convert to bank holding company, this fund has gotten attention with its stand on GMAC debt conversion. Question: Has PHK more exposure to these companies than its peers? Available information indicates that's not the case!

Third observation: Earnings. PHK's P/E is about half of the other two closed-end funds, which are near 4.5. P/E by itself does not mean much, but in comparison PHK looks cheap.

Now: Is it time to buy into these? It is well known that high yield default rates are going up. Pretty much all of this is reflected in price already. PHK's crash shows that, an investment entered on the basis of cheapness, can lose a lot more, especially if it is subject to headline risk.

Corollary of this is that, a long position that lost value due to headline risk will have more of upside potential than downside risk.

For in depth analysis, we look at the discount to NAV, liquidity and more, return profile and the expected technicals especially related to year-end.

Still, at the first glance, it is not hard to say that the risk return potential is compelling for a long position on PIMCO High Income Fund (PHK).

Disappointment with CDS Markets

Sorry State of CDS Markets as summarized by John Dizard of Financial Times:

"Effectively, there isn't any CDS market now."

David Goldman, an old friend and credit strategist turned private investor, still goes through the credit run sheets from the dealers. "The business looks like the window of a Brezhnev-era Soviet butcher shop. Mouldy scraps hanging in the window. Old women lining up at 4am to try and buy credit protection on General Motors. What are reported as trades are really ways to establish prices to satisfy the auditors."

For several years, I have been among those calling for thoughtful, prudent, moderate steps for the reform of the credit default swaps market. They should be put on exchanges, put through central clearing houses, settlement backlogs reduced and then eliminated . . . etc.

I was wrong. The global credit default swaps market should just be liquidated, the contracts allowed to expire and the booby traps defused.

There are three possible defences for treating the CDS market as a going concern: its support for capital raising, its utility for price discovery and its role as a risk-management tool. All have melted like so many Lehman deal cubes in waste incinerators...

Introduction to this Blog

First post here! This blog will talk about my views and outlook on financial markets focusing, drawing from my experience in trading and risk management.

My focus will be credit markets! This is where I have cut my teeth!

I have written similar investor letters before; this is the first time I will make my views available to public. I hope to learn from this!

I expect to post a couple of times a week, more or less.

Your comments and suggestions would be very much welcome.