Neil Mehta, Markit
The ECB’s decision to extend monthly QE purchases to investment grade corporate bonds has brought a rise in investors’ use of credit derivatives to gain credit risk exposure, with a jump in net notional outstanding in European investment grade credit indices.
Credit risk among European corporates has fallen greatly since the ECB’s decision on March 10. The Markit iTraxx Europe Main index, which compromises of 125 investment grade single name credits, has seen its five year credit default swap spread tighten to 77bp, from 91bp on March 9. The impact of QE was already made evident last year when sovereign bond purchases in Europe sapped credit risk among names such as Portugal and Spain, bringing down bond and CDS spreads.
The prospect of the ECB buying up large chunks of corporate bond issues, potentially squeezing supply in the sector, has meant investors have looked for alternative ways to take advantage of the new risk-on optimism. The Markit iTraxx Europe Main index spread was 59bp just last July, 18bp tighter than this Thursday’s, according to Markit’s CDS pricing service.
Increase in exposure
The CDS market offers a liquid alternative to cash bonds to gain risk exposure, and market activity in the European corporate bond sector saw trading volumes spike in March. According to DTCC, weekly CDS trading volumes on the on the Markit iTraxx Europe Main index rose to $233bn, from $132bn between the first two weeks of March. Volumes remained elevated throughout the month, with the week ending March 25 seeing activity hit a six month high, although this did coincide with index roll when activity typically spikes.
The increased CDS activity also give rise to the net notional outstanding (maximum possible net funds transfers between net sellers of protection and net buyers of protection) on Markit iTraxx Europe Main contracts. Having been fairly stagnant since mid-2014 at around $100bn, the figure has risen by around 20% since the beginning of March. The figure is a good representation of the size of the CDS market in question, as well as credit investors’ bias towards being long or short risk.
The spike in net notional on the Markit iTraxx Europe Main index was isolated versus other major credit indices (which rolled at the same time), suggesting the ECB’s decision may have had a pivotal impact. The Markit iTraxx Xover index and the CDX NA IG index, which represent the European high yield and US investment grade markets, respectively, saw net national outstanding either remain flat or fall in March.
