Surge in Demand for Protection Against Default Risk on Government Bonds

Investor concerns regarding the potential outbreak of debt crises in the so-called peripheral countries of the eurozone are not only pressuring global stock markets but also significantly driving demand for credit derivatives that serve as protection against default risk on government bonds.

According to data published on the Markit ITraxx SovX Europe index, which tracks trading in credit derivatives CDS (credit default swap) on bonds from 15 European countries, last week the volume of CDS trading surged by 17 percent compared to the previous week, reported the Financial Times. CDS linked to bonds from the so-called peripheral economies of the eurozone (Greece, Italy, Spain, Ireland, Portugal) recorded record or near-record trading volumes, as banks and hedge funds increased their buying and selling of protection against investments in bonds from these countries, according to data from the Depositary Trust & Clearing Corporation.

The volume of CDS trading on government bonds from peripheral European countries nearly doubled compared to the same period last year, as record issuances of government bonds and concerns over the increasing indebtedness of these countries create turmoil in financial markets but also present opportunities for hedge funds and banks to profit. “The CDS markets linked to government bonds are now more liquid than individual European bond markets. This data is widely used as an indicator of sentiment,” emphasizes BNP Paribas strategist Mehernosh Engineer. Italy, which has one of the largest bond markets in Europe, recorded the highest volume of CDS trading among the observed countries last week, amounting to $222 billion. The trading volume of CDS on Greek government bonds simultaneously reached $76 billion. Their price touched a record 400 basis points, meaning $400,000 annually to protect $10 million of debt from potential default over the next five years.

Meanwhile, the price of CDS on Greek government bonds has decreased to 373.5 basis points, but its level still indicates that investors remain highly skeptical about the Greek government’s ability to reduce its budget deficit, which was 12.7 percent of GDP last year, to three percent by the end of 2012, thus aligning it with European regulations. Most recently, CDS on Portuguese government debt reached a record 216 basis points today, representing a cost of €216,000 on €10 million of exposure. According to Mohamed El-Erian, CEO of investment firm Pacific Investment Management, due to the continued surge in public finance deficits in numerous countries, this year will be primarily marked by the risk of default on government bonds.