Sovereign Credit Commentary

The sovereign CDS market has captured the headlines in recent times by highlighting fiscal deterioration in several European countries. But the past week has seen an emphatic rally, driven by a combination of technical and fundamental factors. The Markit SovX Western Europe index, a key barometer of European sovereign risk, tightened to 76basis points today.

The daily drama in the sovereign credit default swaps market seems exclusively focused on Greece, but it was not too long ago that Iceland served as the poster child in the global credit crisis. Yesterday while protests ignited in Athens, for five-year CDS protection on Iceland tightened by 14 basis points to close at 528 bps, a significant improvement from the start of the month.

The credit markets, both corporate and sovereign, continued to be captivated by the crisis enveloping Greece this week. The Markit SovX Western Europe index reached a record wide level of 112.5bp on Monday amid fears that the problems in Greece couldn’t be contained and would spread throughout the peripheral eurozone.

The European sovereign debt market has been wracked with volatility in recent weeks. February began on a somewhat quieter note. But that changed on Wednesday with spreads spiking upwards once again, and unusually Greece wasn’t the catalyst. This time it was Portugal that was driving the market wider.

Some traders in London believe five-year credit default swaps on Greece could surpass the 450 basis points mark this week, after the cost of protection on the sovereign hit a record high of 390bp today and kept climbing intra-day to 420bp.

Credit spreads in the peripheral euro zone countries widened sharply this week, pushing the Markit iTraxx SovX Western Europe index wider than the Markit iTraxx Europe index for the first time. This implies that European sovereigns are more risky than corporates.

Greece's status as the black sheep of the eurozone looks secure for the foreseeable future. But outside of the currency club, Iceland is again attracting the wrong sort of attention amid signs that it is falling foul of the international capital markets.

Five-year credit default swaps on Dubai sovereign debt are being quoted as high as 500-550bp, meaning it costs around USD500,000 a year to insure USD10 million of the emirate's debt.

The difference between sovereign and corporate CDS spreads in Europe reached its tightest point since February this week as public finances came under increasing scrutiny. Greece saw its CDS spreads widen sharply to 185bp, dragging the rest of Europe with it.

Britain’s sovereign CDS have been active this week after Fitch Ratings warned that the nation’s AAA rating is most at risk of all the premium-rated countries.

At first glance, Ireland and Greece appear to have little in common. Perhaps one could point towards their status as fringe members of the E.U.—small countries that joined the club relatively late. But they also share the unwelcome distinction of being the two least creditworthy members of the eurozone, according to their sovereign CDS spreads.

Auto-callables have been actively traded in Europe for several years and have now become an increasingly influential force in flow derivatives.