A plethora of synthetic collateralized debt obligation issuance in Europe is crippling liquidity in the single-name credit-default swap market. Hedging on the back of the leveraged transactions, combined with diminishing spreads, has led to an overload of protection sellers and a shortage of buyers. The problem has been around since the start of the year but caught the radar Wednesday when two large CDOs were issued, squashing credit spreads.
Players who until now have been willing to take short credit views, such as hedge funds, seem to have backed off in unison. "They are under water and don't want to take any more," one trader said. "The appetite for protection has diminished," agreed Duncan Needham, portfolio manager at Cairn Capital in London, who noted funds are not buying CDS because they don't want to overload basis risk on their books. In the last month funds including Ferox Capital Management and GLG Partners have closed credit funds (DW, 4/3).
The whole market going long has contributed to spread compression on both the indices and single names. "A lot of spreads have crushed," said Daniel Berman, credit products manger at JPMorgan in London. Spreads on the iTraxx Europe has tightened to 51 basis points from 56 bps in a matter of days, while the Crossover has moved in roughly 30 bps from the roll on March 20. One trader attributed this to the Crossover being "the hedging tool of choice".
Tightening spreads have been exacerbated by technical drivers, including the bullish bond market and record low equity volatility. "There have just been no defaults," reflected one trader.
An official at a European firm predicted respite will come because arbitrage opportunities in CDOs are decreasing with tightening spreads, so issuance should dry up. Another, however, said issuance will continue in the form of innovative structures such as forward-starting CDOs and CDOs squared. "Arrangers are always developing ways to squeeze more spread," he noted.
