Greek Bailout - Quantative Analysis

8/9/2019 Greek Bailout - Quantative Analysis

1/4

Quantitative Analysis

www.fitchsolutions.com 26

Special Report Greek Bailout: Containment orContagion?Reading CDS and Bond Market Signals

IntroductionAs the details of Greeces EUR45bn rescue package are fleshed out between theInternational Monetary Fund (IMF), the European Union (EU) and the Greekgovernment, European government bond markets remain volatile. A comparison ofthe credit default swap (CDS) fullterm structures of Portugal and Greece shows

that both curves have widened significantly over the last three months and indeedboth curves have inverted. The inversion implies a higher probability of default inthe near term than in the medium term, which generally happens only duringperiods of severe stress.

0

200

400

600

800

1,000

6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y 15Y 20Y 30Y

Greece 22/1/2010 Greece 23/4/2010

Portugal 22/1/2010 Portugal 23/4/2010

Chart 1: Inversion of Portugal and Greece CDS Term Structures

Source: Fitch Solutions

However, an important question remains: would any such bailout contain the recentwidening of CDS spreads and bond yields across European debt markets or are theEuropean debt markets on the cusp of a broader financial contagion? To help shedsome light on this question, Fitch Solutions has analysed recent trends in the CDSmarket.

Euro/USD Exchange Rate

Although CDS spreads on European government bonds have widened across theboard, including those on Germany and France, this information alone does notnecessarily indicate that a Greek bailout would contain recent market concerns.One approach to understanding the extent of concern over the broader impact onthe euro zone is to look at the difference between the euro and US dollar CDSspreads on Germany the anchor economy of the euro zone.

The relative percentage of the euro to US dollar quotes implies under certainsimplifying assumptions the marketimplied FX devaluation jump of the USdollar/euro FX rate in the event of a default. This indicates the incrementalamount of euros needed to buy US dollars following a potential default. Thisdevaluation jump is derived from the USD and euro CDS quotes on Germany and isillustrated in the Implied FX Devaluation Jump chart. The chart highlights that the

CDS market is increasingly concerned about the prospects of the euro, with thejump still on an upward trend, meaning that increasingly more euros are needed topay protection taken out on US dollars in the possibility of a default.

Authors

Thomas AubreyManaging Director+44 20 7682 [email protected]

Damiano BrigoManaging Director

+44 20 7682 [email protected]


2/4


Greek Bailout: Containment or Contagion?April 2010 2

0%

5%

10%

15%

20%

25%

30%

35%40%

45%

01 Jan 10 12 Jan 10 23 Jan 10 03 Feb 10 14 Feb 10 25 Feb 10 08 Mar 10 19 Mar 10 30 Mar 10 10 Apr 10 21 Apr 10

FX Devaluati on Jump 10 per. Mov. Avg. (FX Devaluati on Jump)(%)

Chart 2. Implied FX Devaluation Jump

Source: Fi tch Solutions

Indeed, the percentage difference between the euro and US dollar CDS spreads onGermany increased from 7% on 1 January 2010 to 29% on 23 April. This means thevalue of protection in euros is now 29% lower than in USD due to concerns about a

possible fall in the value of the euro. In essence, the CDS market clearly perceivesthat the bailout is unlikely to contain the funding crisis to Greece, but isanticipated to impact all euro zone economies due to concerns around the value ofthe euro.

Higher Yields to Come?Analysis of the CDS market shows relatively clearly where the concerns lie. As of 23April, fiveyear CDS spreads on Italy, Spain and Portugal all remained at relativelywide levels, trading at 138 basis points (bp), 175bp and 276bp respectively.Moreover, there remains a significant positive basis between their bond yieldsrelative to the Bund and higher CDS spreads. Italy, Spain and Portugal are alltrading with a positive basis of between 77bp and 81bp.

As Fitch Solutions highlighted in its Fitch Solutions: Corporate Versus SovereignDebt Risks Reading CDS and Bond Market Signals Special Report (dated 5February 2010 and available at www.fitchratings.com), there are valid reasons whythe CDS and bond markets price assets differently. A positive basis of over 75bpbetween the CDS spread and the underlying bond yield over the riskfree rate isunusual. Fitch Solutions estimates that just under a third of the basis between theCDS spread and bond yield over the riskfree rate can be explained by the euro/USdollar currency effect. In terms of liquidity risk, the liquidity premium is minimal,as shown in Table 1. Spain, Portugal and Italy are three of the top four mostliquidEuropean developed market entities. The rest of the basis is largely explained bythe fact that CDS investors believe that yields are likely to increase for thesecountries.

0102030405060708090

100


Spain 5Y CDS Bond basis Italy 5Y CDS Bond basis Portugal 5Y CDS Bond basis

Chart 3. Italy, Spain and Portugal USD Yield Basis

Source: Fitch Solutions, datast ream


3/4



Table 1: Liquidity Scores of Developed Market Sovereign Names

Entity Liquidity Score Global Percentile Rank

Spain 7.38 6Italy 7.42 7Austria 7.50 9France 7.62 12Portugal 7.72 15Belgium 8.03 22Ireland 8.08 24Greece 8.15 26Germany 8.24 28Sweden 8.40 32UK 8.76 41


The Impact on the UKSo what impact does the euro zone crisis appear to be having on the UK? Further,has the prospect of a hung parliament in the forthcoming UK general election led toan increase in perceived risk within the CDS market?

Firstly, the CDS bond basis on the UK has fallen dramatically since 1 January from36bp to par on 23 April ie, there is no basis between the bond yield over the Bundand the CDS spread. This means that CDS investors believe that the current yieldswhich the UK can obtain in the market are where the CDS market expects them tobe. UK fiveyear yields over the Bund did close higher on 23 April at 0.73% up from0.63% on Monday 19 April. In the Fitch Solutions: Corporate Versus Sovereign DebtRisks Reading CDS and Bond Market Signals report, Fitch Solutions correctlypredicted that once the Bank of England halted quantitative easing in the first weekof February, bond yields would rise and CDS spreads would fall. Intervention in the

bond market created a great deal of uncertainty in the CDS market throughout 2009and January 2010.

One other factor which shows the CDS markets view that current yields are notexpected to rise significantly is the lower level of liquidity of the UK sovereign CDS.Table one shows that the UK is one of the least liquid European sovereign CDStrading in the 41st percentile. An increase in liquidity would indicate increasingsigns of uncertainty over yield levels.

30

40

50

60

70

80

90

100


0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

UK 5Y CDS USD UK 5 Year Bond Yield over Bund

Chart 4. UK USD CDS vs UK Bond Yield

(bps)

Source: Fitch Solutions, datastream

Secondly, although the UK still trades wider than France and Germany at 72bp compared with 65bp for France and 43bp for Germany the difference betweenthe spreads has narrowed considerably. On 1 January, the UK was trading at 80bp

with France and Germany significantly lower at 32 bp and 27 bp respectively. Notonly does the CDS market believe default risk for the UK has fallen since thebeginning of 2010, but that relative to France and Germany risk has significantlyimproved.


4/4



20

40

60

80

100


France 5Y CDS USD UK 5Y CDS USD Germany 5Y CDS USD

Chart 5. UK, France, Germany USD CDS


ConclusionThe analysis highlights that the CDS market does not believe that the forthcoming

bailout of Greece will contain current concerns surrounding euro zone governmentdebt financing. Indeed, the widening differential between the US dollar and theeuro curves, as well as the widening spread levels, indicate that there are stillconcerns about the euro zone across the board. This suggests that the CDS marketperceives this is a broader euro zone issue and not just a matter for Greece.

Conversely, the CDS market does not currently expect the financial contagion tospread beyond the euro zone. The recent narrowing of UK spreads relative toFrance and Germany shows this to be the case. Furthermore, the fact that the UK isin the throes of a general election, which could result in a hung parliament,suggests that the CDS market does not expect this possible outcome to increase riskand the cost of funding for the UK as some commentators have argued.

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READTHESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK:HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS . IN ADDITION, RATING DEFINITIONS ANDTHE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE ATWWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROMTHIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST,AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSOAVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE.

Copyright 2010 by Fitch Solutions, Inc. and Fitch Solutions, a division of Fitch Ratings Ltd and its subsidiaries. One State Street Plaza,NY, NY 10004. Tel.:(212) 9080500. Information is for recipients internal business use only. Reproduction or retransmission in whole or inpart is prohibited except by permission. All rights reserved. All of the information has been obtained from sources Fitch Solutions believes

are reliable, but Fitch Solutions does not audit or verify the truth or accuracy of the information. The information is provided as iswithout any representation or warranty of any kind. The information is not indicative of the opinions, commentaries, or analyses of Fitchratings analysts, and are therefore separate and distinct from rating analyst activity, actions and opinions. Fitch Solutions is not engaged inthe offer or sale of any security. This is not a recommendation to buy, sell, or hold any security. Fitch Solutions is not providing you any

financial or investment advice and is not responsible for any underwriting or investment decision resulting from use of the information.
http://www.fitchratings.com/creditdesk/public/ratings_defintions/index.cfm?rd_file=intro

Documents

Greek Bailout - Quantative Analysis