“Recently Fullermoney did an excellent survey of sovereign European Bond yields. The bond picture has become much more complex with some yields (Greece) staying high while others (e.g. Spain) coming down nicely. The CDS market however continues to show stress with high spreads in many countries. Spain is a good example where bond yields have come down but the CDS spreads continue to show stress. Could you or someone in the collective explain this divergence? I have read many explanations such as; the CDS market is not liquid and not accurate to an opinion that price discovery takes place in the CDS market and the Bond market follows.

“I would appreciate your comments.”

Eoin Treacy's view My comment – Thank you for this topical question which others may also find of interest. CDS are generally less liquid than the instruments they are based on. It should also be noted that CDS are a tool for market manipulation. During the financial crisis in 2008 it was not uncommon for aggressive institutional traders to initiate short positions in bank shares then bid up the price of CDS. The heightened CDS spread influenced investor sentiment towards the default probability of the base instrument. A similar situation has been evident in sovereign bond CDS spreads for peripheral Eurozone debt.

An additional important consideration is with the ability of CDS to pay out in the event of a sovereign default. The International Swaps & Derivatives Association (ISDA) ruled that Greece's technical default would not result in additional cash flows for those holding CDS on Greek debt. As a result Greek CDS no longer trade. Following this ruling, investors seeking to hedge their exposure to European debt, or wanting to express a bearish attitude were left with little choice but to short the bonds of the countries concerned. As a result spreads widened considerably following the ISDA ruling. (Also see Comment of the Day on August 8th).

The sovereign bond markets are not immune from manipulation either. The ECB has been actively engaged in purchases of Greek, Irish, Portuguese, Italian and Spanish debt. The ECB's lending of more than €450 billion in 3-year notes and loosening of collateral rules has also helped to create an arbitrage between the bonds of peripheral countries and the ECB's AAA rated paper.

It is probably correct to assume that the CDS market still reflects the heightened stress evident in the respective country sovereign bond markets. Sovereign bond spreads are probably a better indication of what is actually being done to address the problems.