To paraphrase the famous bard, “something is rotten in Portugal”. And the odor could be emanating from the credit default swaps market.
Whereas the five-year bond yields of the troubled euro-zone nations of Ireland, Italy, and Spain all appear to be fairly priced when compared with their CDS spreads, Portugal’s looks way out whack. That may say as much about how Greece’s approach to its debt restructuring has undermined confidence in the market for default insurance as it does about people’s fear that Portugal is the next domino to fall after Greece.
Portuguese five-year CDS are trading at 1220 basis points, while the five-year yield on Portugal’s sovereign debt yields a whopping 16.69%. If it followed the normal pattern, the country’s five-year bond yields would be lower than 12.20% or its CDS spread would be higher than 1669 points. Usually, there’s a premium to the CDS spread, and the higher it is the greater the perceived default risk.
Certainly, the other three members of the euro zone’s community of struggling peripheral sovereigns contain this pattern, with the CDS premia growing in relation to perceived risk for each country. Italy’s five-year yields trading on Thursday were yielding 3.53% while its CDS spread was at 366, Spain’s numbers came in at 3.60% and 395, respectively, and Ireland’s data are at 5.28% and 609.
So what gives with Portugal?
Could this be the signal that investors no longer believe they’ll be adequately compensated in the CDS market if there is a default?
The current debate over Greece’s debt restructuring and whether the expected use of collective action clauses to coerce holdout bond holders into a loss-making deal will trigger payments on Greek CDS has watered down the value of this form of default insurance. This could stem from investors’ doubts that the all-powerful International Swaps and Derivatives Association will rule fairly when it is asked to consider whether an essentially involuntary bond swap represents a default. ISDA’s much-awaited decision on that matter could come as soon as Thursday, if Greece decides it doesn’t have enough voluntary participants in its offering–say, less than 90%–and so opts to exercise the coercive CACs option.
If an obvious subversion of bondholder rights is not sufficient to trigger CDS, what does it say about the value of these instruments for other countries, and in particular those that are seen as a real default risk, such as Portugal.
If Greece defaults and it no longer makes sense to “pay up” for default insurance, then perhaps investors see no point in buying Portuguese CDS and instead are hedging Portuguese country risk the old-fashioned way: by selling the underlying bonds. Maybe the Portuguese CDS discount to its yields is in fact priced correctly.
If that’s the accurate reading, however, it’s something that should worry ISDA, whose members dominate the CDS market. Is the Greece-Portugal nexus a harbinger of this market’s demise?
