Credit default swap spreads tightened and trading volume declined in 2006, a trend market participants expect to continue in 2007 barring any major credit event. The benign credit cycle is driving the tightening of spreads as default rates reach 15-year lows. "We see no significant pick up in default rates in 2007. The credit cycle will continue to be benign and spreads will continue to be tight," said John Tierney, director of credit derivatives research at Deutsche Bank.
Tierney said CDS trading volume dropped to an estimated $11-12 trillion this year, compared with $15 trillion last year. The decline was attributed to improved credit quality in the auto sector, most notably the restructuring at General Motors Corp. and Ford Motor. For example, GM's sale of its finance unit General Motors Acceptance Corp. led to tighter spreads for both the parent company and the finance unit. According to Fitch Ratings, trading volume in the auto sector dropped 40% this year, compared to 2005. Trading in auto CDS was heavy in 2005 because both GM and Ford were downgraded from investment grade and large auto suppliers, Delphi Corp. and Dana Corp. went bankrupt. "Autos, which acted as a drag on the market earlier in the year, have outperformed and helped push spreads tighter," said Gavan Nolan, an analyst at Markit Group.
According to Fitch, for the year ending Sept. 30, the average spread on non-investment grade entities tightened 12% over 2005. "Investor demand for spread product has been strong, a result of the current low default environment and the perception that any turn in the market has been pushed back in time," said James Batterman, a Fitch analyst. "While significant risk factors, including the slowing housing market, energy prices and growing tensions in the Middle East, remain, investors have been aggressive buyers of credit, taking spreads to very tight levels," he said.
The building and materials sector showed the weakest performance in US contracts through the end of the third quarter with spreads on home builders widening the most within the sector, according to Fitch. Beazer Homes USA, Hovnanian Enterprises, KB Home and Standard Pacific Corp. performed the worst, each widening about 90 basis points.
Market participants expect new products to spur growth in the CDS market in 2007. The growth of CDS on structured products in particular is expected to affect spreads. "There has been a lot of structuring activity, notably in CDOs and CPDOs [Constant Proportion Debt Obligations], which has also caused spreads to tighten," said Nolan. CPDOs are newly created synthetic debt obligations that reference a diverse portfolio of investment-grade credits. Don Fewer, senior managing director and head of North American Brokerage at GFI Group, said CDS on CPDOs and CDOs are extremely illiquid, but he predicted a two-way deal flow by the end of 2007.
The International Swaps and Derivatives Association's introduction of several new trading templates, which standardize trade confirmation language, may also spur growth, said Batterman. These include templates for ABS CDS, loan-only CDS and recovery swaps.