Credit spreads as measured by the CDS (Credit Default Swaps) rates are falling indicating increasing risk appetite amongst global investors. ICICI Bank CDS, which is widely traded in the Asian CDS market, has seen its five year spreads fall by 200 bps over the last one year. Five year ICICI bank CDS trades at spreads of 280bps as of January 2013 against levels of 480bps seen in January 2011.
The fall in CDS spreads of ICICI Bank indicates that global investor view of the credit risk of ICICI Bank has improved. In other words an investor of ICICI Bank bonds wanting to hedge credit risk has seen hedge costs come off by 200bps over the last one year. The sharp fall in CDS spreads of ICICI Bank is reflected in the equity markets as well.
The stock price of ICICI Bank has gone up by 70% since January 2012 while the Sensex and Nifty have returned over 25%. The close correlation between credit spreads and equity prices indicate the risk appetite of investors. The higher the risk appetite of global investors for credit spreads, the higher the FII inflow into equity markets. FII’s have invested USD 18 billion in Indian equities in calendar 2012.
Chart 1. ICICI Bank CDS spread, ICICI Bank Equity and Sensex movements
The question going forward is will credit spreads continue to drop for issuers such as ICICI Bank? ICICI bank is rated BBB- by S&P, which is the lowest investment grade. The fact that the CDS spreads of ICICI Bank is falling indicates that investors believe that ICICI Bank’s credit risk is better than what is was priced by the CDS market. Hence as the credit perception of ICICI Bank improved, more and more investors came in to receive the CDS spreads. Receiving CDS spreads is the willingness of an investor to give protection to an ICICI Bank bond holder in return for a yearly payout, which is the CDS spread.
A protection seller was receiving a payout of 480bps every year or Rs 4.80 for every Rs 100 on ICICI Bank in January 2012. The protection seller is receiving 280bps or Rs 2.80 per Rs 100 in January 2013. Will the protection seller be willing to provide protection at lower spreads going forward? The answer is yes as there will be a demand for higher yields going forward given the yields of government bonds across US, Germany and Japan are at extremely low levels. Five year bond yields in the US, Germany and Japan is at levels of 0.80%, 0.55% and 0.20% respectively.
The fact that the Fed, ECB and Bank of Japan are expected to maintain interest rates at record low levels and are expected to continue buying bonds to pump in liquidity into the markets will keep down bond yields at the short end of the curve. The lower bond yields will drive investors to seek higher yields elsewhere and that seeking of higher yields will prompt interest in credit spreads of issues such as ICICI Bank.
In the medium term, falling credit spreads of ICICI Bank will also reflect in firm equity markets given that both are driven by risk appetite. In the longer term, the exit policies adopted by central banks will impact credit spreads negatively. However at this point of time exit policy of central banks look a long way off and investors will do well to be bullish on risk assets.