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Europe’s junk CDS signal more credit pain ahead


© Reuters. A commuter train passes by the skyline with its financial district ahead of the European Central Bank?s (ECB) governing council meeting later this week in Frankfurt, Germany, October 25, 2021. REUTERS/Kai Pfaffenbach/File Photo

By Yoruk Bahceli

(Reuters) – The cost of hedging exposure to the bonds of junk-rated European companies has surged in recent weeks and the sell-off on the bonds themselves is catching up, a sign that more pain may lie ahead for holders of the securities.

Markit’s credit default swaps index, the iTraxx Europe crossover, effectively measures the cost of insuring against defaults on a basket of underlying high-yield bonds.

By Monday’s close this had widened 130 basis points since end-March to 470 bps, when a rally following an initial sell-off after the invasion of Ukraine started to reverse. It stands far above a peak first seen in the wake of Russia’s invasion of Ukraine.

The blowout has been less severe in the actual bonds, but they are starting to catch up with spreads moving more than CDS on some days.

The spread on the ICE (NYSE:ICE) BofA euro high-yield index — effectively the risk premium demanded by investors to hold the debt — has widened 115 bps since end-March. It rose above a peak seen in March on Monday, hitting 515 bps, with a nearly 30 bps move double that seen in CDS.

Because credit default swaps are essentially a hedging product, it’s not unusual for them to react more and quicker than the bonds, particularly to unexpected events such as war or the COVID-19 pandemic.

“Normally when you see that sort of activity, it’s an unknown known, something happens you didn’t expect and that’s why crossover moves so much, whereas what’s happened in last few weeks there’s nothing there you wouldn’t have known,” said Azhar Husain, head of global credit at Royal London Asset Management.

“It tells you there is some real fear in the market, and in a way that’s more fear… than cash (bonds) tells you.”

No doubt, credit investors have much to be concerned about. European Central Bank bond purchases, which spurred investors into junk-rated debt in search of yield, are expected to end this quarter. A growth slowdown could hit earnings at weaker companies.

Several factors may have held cash bond spreads in check.

CDS are more liquid and hence, easier to trade, whereas trading in high-yield debt often picks up only when new bonds or investment flows hit the market.

But the contrary has happened, with the junk debt market effectively shuttered for more than 10 weeks until late-April and outflows holding up.

Supply of debt has dropped sharply — BofA analysts reckon a 73% drop in issuance compared to last year implies investors are ultimately receiving cashflows from the high-yield bond market. That reduces the need to sell their holdings to meet potential fund redemptions.

Analysts see the credit sell-off as mainly driven by a repricing of the interest rates outlook so far as major central banks led by the U.S. Federal Reserve tighten monetary policy to tame accelerating inflation.

One sign is that investment-grade and high-yield bonds have delivered similar total losses this year, of around 9%, unusual in a “bear market” where more fragile companies would be expected to underperform, BofA notes.

JPMorgan (NYSE:JPM) expects high yield spreads could widen to 525 bps by year-end, citing market volatility, inflation, the Russia-Ukraine conflict and supply disruption from China’s COVID lockdowns.

Europe’s junk CDS signal more credit pain ahead

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