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Should the Republic of France really be trading as a credit two notches above junk?
Five-year credit default swaps on the French sovereign were trading at 110bps at pixel time, according to Markit.
In other words: if youâ??re taking the CDS market at face value, France is more of a credit risk than Thailand (100bps), South Korea (95bps), the Peopleâ??s Republic of China (70bps) and Brazil (107bps) if not yet Mexico (110bps). And yes, the spread implies a Baa2 rating, versus the ratings implied by French government bond spreads, or assigned by the credit rating agencies â?? both of which remain at a solid AAA.
If you take the market at face value. Although even if you donâ??t, it may still depend on what view you take of the credit risks to the eurozoneâ??s core sovereigns from a) bailing out the blocâ??s periphery b) bailing out their own banking systems should various tail risks (national defaults, peripheral banking crises, eurozone exits) become real.
Moodyâ??s (yep, a rating agency) poured cold water on what the CDS say on Thursday, at any rate. As capital markets analyst Jerry Tempelman writes (emphasis ours):
We believe that the bond- rather than the CDS-implied rating is more representative of France's underlying credit profile, and that the eight-notch differential reflects technical factorsâ?¦
CDS spreads are generally wider than bond spreads, because market participants tend to hedge against tail risk by buying CDS protection rather than by shorting bonds. In addition, investors buy CDS protection to hedge credit exposure to French entities other than the national government, such as sub-sovereign entities and even financial institutions and corporations where such exposure cannot be hedged directly.
The â??itâ??s hedgingâ?? argument is a familiar one. For instance, surveys of sovereign CDS traders bear it out. Also, the fact that sovereigns donâ??t post collateral in their derivatives transactions (big FX or interest-rate swaps on their debt, for instance) often leads their bank counterparties to construct synthetic hedges using CDS.
But the â??itâ??s also indirect hedging of other namesâ?? is curious when you think about it. Obviously, tail risk for a French bank right now is likely going to come from events in the periphery. So this is coming back to eurozone-heightened credit risk in the end, you could argue.
Funnily enough, France might not have borne the worst brunt of that risk being repriced in the CDS market in terms of percentage changes within its spreads.
Presenting this chart from CMA Datavisionâ??s latest Global Sovereign Debt Credit Risk Report, looking back on the last three months of 2010 (click to enlarge):
Nor is this just about the eurozone core. Hereâ??s a line from the report:
The UK CDS widened 13% this quarter following the bail out of Ireland "â?? its exports to Ireland being greater than its exports to the whole of South Americaâ?¦
Last, and least, CMAâ??s top ten riskiest sovereign CDS names of the last quarter, in terms of spread and cumulative probability of default (click chart to enlarge):
Iraq is actually an incredibly illiquid sovereign credit, of course. Not that this may console those two newcomers there.
Related links: Fitch on how sovereign CDS helps fund deficits â?? FT Alphaville Ireland, Portugal market-implied ratings take a tumble â?? FT Alphaville The neo-medieval trade - FT Alphaville Belgians are still waffling â?? FT Alphaville
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