CDS report by Markit’s Gavan Nolan ― 2009/01/24 11:06
CDS update: “Credit and equity, at least in the banking sector, are no longer entwined”
Posted by FT Alphaville on Jan 23 19:18.
This CDS report was written by Markit’s Gavan Nolan
It will come as no great surprise, even to the those living in blissful ignorance of hardship, that the UK is in recession. But official confirmation came today, and the figures were even worse than expected. The UK contracted by 1.5% in the final quarter of 2008, following on from the 0.6% fall in the third-quarter. The 1.5% figure was the worst since the supply shock recession of 1980, and capped an awful week for Britain. Banks are in turmoil, with the government’s second bailout receiving an ice-cold reception from the markets.The implications for credit investors? It has become increasingly clear that credit and equity, at least in the banking sector, are no longer entwined. Equity investors have borne the brunt of the collapse in trust of UK banks. Stock prices in Barclays and Lloyds have declined by 50% this week, while RBOS has seen a 65% fall. Bank CDS spreads have widened significantly. But they are still in strong single A territory, and are some way off the record wide levels reached in September. Why the dichotomy? All of the government’s measures have been directed towards strengthening bank balance sheets so they can be in a position to lend. Bankruptcies are the last thing the authorities want. But the capital increases have come at the expense of stock holders in the form of equity dilution. Though bank spreads are set for more volatility until the structure of the industry becomes clearer, credit and equity in the banking sector look set to continue down diverging paths.
In the broader market, the stasis in banking has had damaging consequences. The Markit iTraxx Europe index has widened but it has outperformed the Markit iTraxx Crossover (see chart above). At first glance, the prevalence of financials in the main index would make this trend surprising. But the fundamentals of government support, as outlined above, limit any widening. Crossover, on the other hand, contains credits at the sharp end of the economy, most of which don’t have the benefit of state backing. About half of the names are trading upfront, indicating high near-term risk of default. Many of these names are facing funding problems, with the European high yield market all but closed (Fresenius, a strong BB credit, is the only name to have raised funds). The default of LyondellBasell has highlighted the dangers to investors and has caused an increase in protection buying on single names. Idiosyncratic risk is now receiving a lot of attention. The widening in the index has been more than matched by widening in single names (see chart below). Defaults are set to rise and fundamental analysis of business and financial risk will be rewarded.