The Credit Default Swap Bull Market

Submitted By Michael Krause
A look at the LQD, an investment grade corporate bond fund ETF with diversified issues tells the story the last several days. Remember, every point this thing falls means billions more in increased collateral requirements and mark-to-market losses for AIG and countless other financial institutions, since their bet is on debt (sans treasuries) staying bullish.

Or the visual from MarkIt:

The right side of this MarkIt CDX Index chart says it all, but reality is much more severe. Investment grade credit spreads of a wide variety of issues are blowing out to unheard of numbers. Morgan Stanley 10 year debt is now trading 1000 basis points over treasuries, much worse than Lehman even last week. Typical investment grade debt is averaging over 300 basis points over treasuries.

The great credit default swap unwind I anticipated in January of this year may be happening now, as industry players try to beat AIG and Lehman to the punch.

This past five years of historically low risk spreads was essentially caused by redefinition of 'acceptable leverage' in a post Sarbanes-Oxley world, where off balance sheet opaque bond derivatives positions became the de facto method of amping up revenues for insurers and financial institutions of all sorts. What better way to collect free money than sell insurance on 'zero probability of default' issues, like GE? By the way, you can pick up GE AAA 10 year bonds for around 7.5% yield right now, 400 basis points over treasuries! Weren't these issues trading at 50-75 basis points just 12 months ago?

One thing is very obvious from this last chart. The CDS market started to take off right around the same time when Sarbanes-Oxley was implemented. Is this merely a coincidence?

Next a rhetorical question with an obvious answer: If the spreads continue blowing out as large players return leverage to appropriate levels, will there be enough money to simultaneously soak up a continued supply of treasury debt AND underpriced AAA corporate debt while keeping yields in the same place? Something has got to give, and my guess is bond fund managers will find the AAA corporate more attractive at these and even wider spreads. I think the spread may inevitably narrow over time, resulting in a new secular bull for high yields in long dated maturities. Against a backdrop of dollar disillusionment, excessive government debt supply, GSE addition to net US debt, a fed needing recapitalizaiton, all factors point to a short long maturity treasuries position. And we all know how those high interest rates will impact housing, credit, and business expansion.

Edit 9/18: I do not trade credit default swaps personally, and have been corrected by a reader who does that being long CDS in the industry is aligned with what I refer to with the opposite naming convention, 'being short CDS'. Formally, being long the CDS is the same as selling the credit spread, being the insurer of its risk. Being long the CDS + being long a treasury of equal duration is the synthetic equivalent as being long the underlying bond it represents. The title "CDS Bull Market" refers to the bet on the credit spread increasing being a successful one.

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