CDS spreads are a front runner for equities
Investors should track ICICI Bank CDS spreads for future direction of markets, given that it has become a lead runner for direction of Indian equities.
Credit Default Swap (CDS) markets is a lead indicator for direction of equity markets. The pure and simple reason that equities and other risk assets including currencies follow the CDS is because CDS traders are the quickest on the ball to either put in or pull out risk from the market.
CDS is mostly an unhedged derivative game, where players buy and sell protection on credits without any natural hedges behind them. At the end of 2007 the CDS positions outstanding globally was USD 58 trillion, which came down to USD 42 trillion at the end of 2008 as per BIS (Bank of International Settlements), post the credit crisis bust. Total world debt at end of 2007 was around USD 95 trillion, which if interpolated with CDS outstanding of USD 58 trillion, implies that every second debt outstanding was hedged. This of course is not true and it would be reasonable to assume that more than 75% of the outstanding CDS trades were speculative and not hedged with underlying bonds.
Closer home, ICICI Bank CDS, which trades in the Hong Kong CDS market where all Asian credits trade has given good leads on where the Sensex is headed. The sharp rise in CDS spread on ICICI Bank from levels of 60bps in beginning of 2007 to 200 bps in end 2007 pointed to rising global risk aversion. The Sensex, which peaked out at end 2007 started following the rise in ICICI Bank CDS spreads in 2008, by falling steadily from peaks. The height of the crisis saw ICICI Bank CDS spreads go up to 1600bps levels and the Sensex falling by 50% from peaks.
Recently, ICICI Bank CDS spreads rose from 240bps to 420bps in the July-December 2011 period. The rise in credit spreads was accompanied by a fall in the Sensex and the Indian Rupee by over 15% each. Credit markets were quick in spotting the risk to ICICI Bank credit on the back of the sovereign debt crisis in Europe and also on the back of domestic issues of rising non performing assets.
ICICI Bank is favoured by regional CDS traders to air their views on credits. The bank has USD denominated bond outstandings of around USD 8 billion and is a well accepted credit by global investors. ICICI Bank bonds are also seen as the most liquid of Indian USD denominated bonds. In a sense ICICI Bank CDS acts like an Indian credit index, which is amplified as speculative activity increases. If India is in or out of favour with markets, it gets reflected in ICICI Bank CDS spreads.
The CDS spread levels itself may have nothing to do with the underlying credit quality. ICICI Bank is rated AAA in local currency ratings and carries a higher rating than the Indian government in the foreign currency ratings. The sharp rise in ICICI Bank credit spreads in the recent past is seen as India going out of favour with markets.
CDS is a derivative that transfers credit risk from one entity to another. The seller also called the protection seller in the transaction assumes credit risk from the buyer also called the protection buyer. The seller receives annual premiums (in bps) from the buyer for taking on the credit risk. The buyer in turn receives full payment from the seller in the event of default. A rise in CDS spreads indicates bearishness on the credit while a fall in CDS spreads indicates bullishness on the credit.