Greek haircut decision casts doubt on future of CDS

The 50% haircut on Greek debt agreed at the EU summit last week has called into question the future of credit default swaps (CDS)as a hedging tool for bondholders.

The EU said the haircut is voluntary, meaning it will not be classed as a sovereign default, so holders of CDS – which are meant to insure against such an event – may not receive payouts.

At $3.7bn, the net notional value of CDS on Greek government debt is relatively small, but policymakers have been anxious to avoid triggering a credit event for fear of contagion elsewhere in Europe.

“The question is, how does the CDS market react to this? If the authorities do not make it a default event then sovereign CDS becomes irrelevant. What is the purpose of people hedging if those hedges do not materialise?” said Bryn Jones, manager of the Rathbone Ethical Bond fund.

Peter Harvey, manager of Cazenove’s Strategic Bond fund, said bondholders may become more discerning in their use of swaps.

“I do not think the announcement is going to make sovereign CDS redundant, but it will make investors give more thought to what it is for and when it is appropriate.”

While the EU has already moved to ban naked short selling of CDS this month in an attempt to confine its usage to hedging, calling into question the use of CDS as a whole could deepen funding problems for other peripheral eurozone nations.

“If CDS no longer provides an effective hedge against the peripheral sovereign debt crisis, then an increasing number of institutional mandates are likely to be reconstituted to exclude these peripheral government bonds, which will reduce private sector demand and deepen the crisis,” said Stuart Thomson, chief economist at Ignis.

M&G’s Mike Riddell said a loss of credibility for CDS would have “absolutely huge implications” for European banks which have reduced net exposure to peripheral sovereign debt using the swaps.

“What will be really interesting is whether or not the banks’ use of sovereign CDS as an effective hedge in accounting definitions remains allowable,” Riddell said.
Tensions remain elsewhere in the European government bond market.

While many other aspects of the plan were hailed as a positive step and prompted a surge in risk assets, Spanish and Italian bond yields are still at historic highs.

An auction of 10-year Italian debt on Friday produced a euro-era record yield of 6.06%.