Greek CDS Buyers Happy with 21.5 Cents on the Dollar

Greek CDS auction calms investor fears for now. But will the pattern hold for other euro zone countries in trouble?


People who bought Greek debt protection two years ago were smiling at the results of Markit’s auction on Monday, triggered by the Greek bond default. Those who were long Greek risk, holders of sovereign credit default swaps, will collect some $8 million, assuming they bought and held CDSs on a value of $10 million (notional) back when it was going for 2 percent. Provided counterparties paid their obligations over the following 24 to 48 hours, investors’ confidence in the system’s ability to successfully hedge exposure to sovereign debt is expected to give a much needed boost to markets.

The final price of the Greek bonds for the purpose of settling CDS transactions was determined by the auction, held by Markit and IntercontinentalExchange’s Creditex, to be 21.5 percent. Of course those selling protection on the bonds lost about 80 percent (there is a small difference, called the basis, between bond and CDS markets). Sellers are largely expected to pay up, since collateral is required to back the positions on a regular basis. Still, there is always the outlying possibility that a hedge fund or small bank may have gotten in over its head. CDSs in recent months may have presented a huge temptation, offered for 2790 basis points on September 1, 2011, 5467 basis points on September 15, and 7786 basis points on December 1, according to Fitch Solutions.

“Some important legal questions around sovereign CDSs have gone away,” Jamie Stuttard, the London-based head of International Bond Portfolio Management and portfolio manager for Fidelity Asset Management, tells Institutional Investor. “This actually encourages risk-taking,” Stuttard adds, “because you can hedge to them.” When market participants can lay off risk, he adds, freer movement of capital usually follows. Even people considering lending to corporations can confidently hedge the exposure in CDS markets.

But the markets are far from out of the woods on the euro zone crisis, says Stuttard, who also manages portfolios under FMR’s institutional arm, Pyramis Global Advisors. “The question to ask is who’s next?” he says, noting that CDS spreads against sovereign credit risk in Cyprus currently cost more than 10 percent to hedge against. Longer-term, Stuttard is looking toward “many very deep-rooted problems” in the EU periphery countries, which he expects to reemerge later this year or next.

For now though, European markets are happier and more relaxed than they have been for a long while. CDS spreads have come in, and they are likely to stay in until investors start looking at the fundamental and structural problems of the others, which will widen CDS spreads once more.

If Stuttard’s right, investors can relax this summer.