And in pictures:
The EMEA region has led this underperformance:
Huh? Are investors discriminating against South African, Turkish and Russian sovereign credit given their links to the crashing euro-zone? This argument based on economic fundamentals sits awkwardly with the fact that sovereign CDS spreads in all three countries have actually narrowed while bond spreads have widened.
What’s more, as CS analysts said in the report:
| Although there are some genuine concerns about the creditworthiness these countries – such as slow growth and the possibility of higher budget deficits in South Africa, Turkey’s large current account deficit and the fall-out from the Russian parliamentary elections in early December – the first two of these problems are not new, and the third was resolved relatively swiftly by late December. |
Instead, the underperformance of sovereign dollar debt – in the EMEA region, in particular – could be down to technicals. Specifically, it’s down to lower investor risk tolerance and inventory reduction, reckons Credit Suisse.
As Saad Siddiqui, the bank’s EMEA strategist, told us:
Since the start of the financial crisis of 2008, CDS have tended to outperform bonds in a sell-off. That’s probably down to reduced risk tolerance on the part of financial intermediaries and increased funding costs of carrying cash inventory.
The investment community as a whole is long cash instruments and flat CDS. Investors, therefore, can reduce risk either by selling bonds or by hedging their exposure with the CDS, therefore, widening out the bond-CDS basis. The degree of inventory reduction has been particularly pronounced in the fourth quarter of last year, as significant market volatility coincided with banks’ need to delever. |
In other words, EMEA banks have reduced their cash bond exposures in the EMEA region, given the need to repair balance sheets, thus, accounting for the underpferrmance of sovereign dollar bonds versus their CDS cousins.
What’s more – based purely on anecdotal evidence – real-money investors, who typically snap up EMEA cash bonds, seem to have been caught out by the rally, while hedge funds, which often prefer to snap up credit default swaps rather than the cash bonds, have been in spirited risk-on mode.
But this is based on guess-work, as Siddiqui says:
| This theory is mostly anecdotal. Another reason for the poor performance of cash instruments could be down to the jump in the primary markets in January as investors are focusing on new deals with new-issue concessions rather than on the illiquid secondary market. |
So for those investors that don’t want to take a view on the direction of credit spreads but rather a view on the relative direction of credit spreads, here are a couple of relative value trade recommendations:
| We think the best risk-reward for a ‘catch-up’ trade lies in bond-CDS basis trades in South Africa, Turkey and Argentina EUR Discounts. (EUR Discounts are the cheapest external bond in Argentina.)
We would expect these trades to perform well if positive risk sentiment continues and bonds outperform CDSs. We think that even in a risk-off scenario, bonds in these markets have the potential to outperform CDSs as the bond-CDS basis is currently at levels that are extreme by historical standards. Moreover, in the case of Argentina, in a sell-off scenario, we would expect CDS to underperform Discounts on the back of the already low price of the bonds (see below for more details on the trade recommendation).
Exhibit 4 shows, in basis points, the bond-CDS basis for a selection of liquid benchmark sovereign bonds. The bases for Turkey 30s, Russia 30s and South Africa 22s have widened sharply to extremely negative levels since late December; by around 35 bps for both TU 30s and RU 30s, and by around 55 bps for the ZA 22s. The bases for Brazilian 21s and Mexico 22s have outperformed (i.e. widened relatively little). In Exhibit 6, we also show that the EUR Discounts-CDS basis has widened by 85bps to -220bps, underperforming other external bonds.
Exhibit 5 shows the z-scores of the bond-CDS basis for liquid benchmark bonds across a number of sovereigns.1 On the z-score measure, the sovereign issuers whose bond-CDS basis stands out are South Africa, Turkey, Indonesia and Argentina. We recommend taking advantage of the historically extreme levels of bond-CDS basis on the ZA 22s, TU 30s, and AR EUR Disc bonds, in particular.
|
 |
 |
Ultimately, EM portfolio managers could massively under-perform their peers if they load up exclusively on EM sovereign bonds if the
EM FX rally continues, a boon for local currency credit, and US Treasuries sell-off by year-end, which would drag down returns from EM sovereign dollar bonds.