Bloomberg News

Default Swaps Paying Most to Bonds Since 2009: Australia Credit

September 01, 2011

Sept. 2 (Bloomberg) -- Concerns about the global economy slowing have infected Australia’s credit markets, driving price discrepancies between bonds and derivatives to the widest since March 2009.

The cost of credit-default swaps climbed faster than relative yields on corporate notes last month as Europe’s debt crisis and the U.S. credit rating downgrade spurred both gauges of investor sentiment to deteriorate. The Markit iTraxx Australia index of swaps on 25 companies surged 38 basis points to 157, more than double the increase in the U.S., creating a so-called positive basis, where the return from selling the contracts is more than the yield premium from buying the notes.

“Over August, liquidity was down, macro-economic concerns were up, and that’s created significant dislocation across credit markets,” said Chris Viol, a Sydney-based credit analyst with UBS AG. “Some Australian credit-default swaps became severely dislocated, notably the major banks and property companies, creating trading opportunities for investors to profit by selectively selling protection.”

The extra yield investors demand to hold company bonds relative to the swap rate climbed 31 basis points to 153 in August, according to Bank of America Merrill Lynch’s Australian Corporate & Collateralized Index. Average bond spreads were 27 basis points lower than default swaps on Aug. 24, the biggest discount since March 19, 2009, data compiled by Bloomberg show. Default-swaps costs were lower as recently as Aug. 2.

Selling Protection

AMP Capital Investors Ltd. has been selling default protection on Australian banks to take advantage of the positive basis, said David Carruthers, a senior money manager at the Sydney-based firm, which has about A$30 billion ($32 billion) of fixed-income assets under management.

The cost of Australian credit-default swaps is too high relative to U.S. and European contracts, Carruthers said.

“Australia is tracking very well from a corporate balance sheet perspective,” he said. “As a relative trade it makes sense to sell protection on Aussie iTraxx and buy protection on Europe or U.S.”

The outlook for the nation’s companies is “stable” and liquidity will remain solid, while revenue and earnings growth will continue, Moody’s Investors Service said in a report yesterday.

Australian retail sales rose 0.5 percent in July, the first increase in three months and more than economists forecast, led by gains in spending at department stores and restaurants, the statistics bureau said yesterday.

Australian corporate bonds have returned 7.5 percent this year, beating the 6.3 percent gain from U.S. notes and a 4.3 percent return from global company debentures, the Merrill indexes show.

Sovereign Returns

Still, they’ve been eclipsed by the nation’s sovereign notes at 9.5 percent, the best among 21 developed nations tracked by Bloomberg and the European Federation of Financial Analyst Societies.

Australia’s benchmark 10-year government bonds marked their longest rally in 20 years in August as slowdowns in the U.S. and Europe spurred investors to seek the safest assets. The 10-year yield fell 2 basis points to 4.41 percent at 11:12 a.m. in Sydney today, after dropping 43 basis points last month, the eighth month of declines.

The Australian dollar, the world’s fifth-most traded currency, was at $1.0733 as of 11:14 a.m. in Sydney. The so- called Aussie dropped 2.6 percent last month and fell below parity with the greenback for the first time since March as the European Central Bank was forced to buy Spanish and Italian bonds to staunch the region’s debt crisis, and Standard & Poor’s cut the U.S. credit rating to AA+ from AAA.

‘Developed Economy’ Recession

The global economic crisis is leading to a possible “developed economy” recession in the U.S. and Europe, which may be hard to alleviate, Pacific Investment Management Co.’s Bill Gross said Aug. 30. The world’s biggest manager of bond funds favors investing in Australia, Mexico, Brazil and Canada, along with non-dollar currencies that have strong ties to the Asian continent, said Gross, co-chief investment officer and founder of Pimco.

The average cost of five-year credit-default swaps on Australia’s four biggest banks surged 49 basis points in August to 174.7, CMA prices show. The yield premium over the swap rate on Westpac Banking Corp.’s A$1.47 billion of 7.25 percent notes due November 2016 increased 14 basis points last month to 127, according to Australia & New Zealand Banking Group Ltd. prices.

Company Default

Credit-default swap indexes are benchmarks for protecting bonds against default and traders use them to speculate on credit quality. A drop signals improving perceptions of creditworthiness, while an increase suggests the opposite.

An investor who sells a swap contract receives an annual premium in return for compensating the buyer if a borrower fails to meet its debt agreements. The risk faced is similar to that of an investor who owns a bond, in that both will suffer losses if a company defaults.

“Selling protection on CDS represents an opportunity, especially when comparing to Australian dollar-denominated cash bonds,” said Robert Mead, Sydney-based head of investment management at Pimco. It’s a way to “ improve portfolio liquidity at the same time as picking up credit spread,” he said.

The relative yield on Merrill Lynch’s U.S. Corporate Master index jumped 52 basis points last month to 207 basis points. The Markit CDX North America Investment Grade Index of credit- default swaps increased 19 basis points to 115, CMA data show.

‘Underweight Credit’

The number of default-swap contracts used to speculate on the creditworthiness of companies in the current version of the Markit iTraxx Australia index surged to 3,234, protecting a net amount of $4 billion as of Aug. 26, from 2,042 and $3.5 billion a month earlier, according to data on the Depository Trust & Clearing Corp. website.

The Merrill index of U.S. notes has 4,778 securities and a market value of $3.78 trillion, compared with the Australian index with 166 bonds and a value of A$71.7 billion.

“If you want to go underweight credit in Australia, it is problematic selling your cash bonds as you can’t always get them back when you want to,” said Scott Rundell, head of credit research at ING Investment Management in Sydney, which manages about A$15 billion of fixed-income assets. “Investors have been using credit-default swaps instead, which is why CDS has over- reacted given how well Australian companies are performing.”

--Editors: Ed Johnson, Garfield Reynolds

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To contact the reporter on this story: Sarah McDonald in Sydney at smcdonald23@bloomberg.net.

To contact the editor responsible for this story: Shelley Smith at ssmith118@bloomberg.net.


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