The holders of credit default swaps on Greek debt got some relief last week when a committee of the International Swaps and Derivatives Association (ISDA) finally declared on March 9, after the European exchanges closed, that a restructuring credit event had taken place in the Hellenic Republic (Greece). But as the first default of a developed sovereign country in some 60 years, no one can be certain of how these contract holders will fare during the auction of outstanding CDS transactions on March 19.
The auction will determine what the recovery rate will be for CDS contracts. Holders are believed to be predominantly large investors like hedge funds and insurance companies, who have probably moved in and out of the swaps during the seven quarters between former ECB head Jean-Claude Trichet’s July 28 warning over speculating in CDSs and more recent EU threats and riots in Athens over proposed budget cuts.
To be sure, London and other OTC markets have been buzzing over the on-again, off-again expectation that holders of CDSs, a type of insurance or hedge against another position, would be paid. It was a concern over the past four months, according to James (Jamie) Stuttard, the London-based head of International Bond Portfolio Management and portfolio manager for Fidelity Asset Management. Stuttard says: “Some were asking, if [they don’t get paid on default] what is a sovereign CDS useful for? Those who had cash bonds and CDSs could lose both ways, and that could have been a painful position.” But Stuttard expects the declaration of a credit event and the subsequent auction will have little lasting effects on the CDS market, since it is standard protocol under ISDA and well understood by participants.
John De Clue, private client reserve global market strategist for Minneapolis-based U.S. Bank, tells Institutional Investor that Greece’s decision to insert the Collective Action Clause (CAC), which triggered the credit event, is good news for bondholders. “If Greece had left the euro zone, they would have had to abandon the euro,” which would have meant its bonds would be denominated in drachmas.
Results of a Fitch poll released on March 9, which was taken before the credit event was announced, also showed optimism among CDS investors. “Despite the uncertainty surrounding whether the treatment of Greek debt write-downs by ISDA would constitute a ‘credit event’ that triggered CDS contracts,” a majority of managers of an estimated $7.1 trillion of fixed-income assets “still regard sovereign CDSs as useful,” Fitch found.
“Although liquidity in Greece CDSs has long since dried up with the market pricing the six-month contract of Greece at over 20,000 basis points, implying an imminent default, [the poll] results point to the continued use of sovereign CDSs by investors more generally. This is reflected in CDS liquidity trends too, where developed market sovereigns are currently at their most liquid level since Fitch Solutions began tracking liquidity in March 2009,” said Thomas Aubrey, managing director of Fitch Solutions, in the poll’s release.
At TABB Group, partner and director of fixed income Kevin McPartland sees the long-lasting effects of the Greek situation as one of restructuring of sovereign CDSs. “More of a rebirth than a death,” he tells Institutional Investor. ISDA will rewrite the terms of the standard CDS contract, “just as the U.S. government wrote Dodd-Frank in part to ‘prevent the next AIG.’”
McPartland isn’t worrying about current CDS holders either. He points to data from Markit, a company that tracks CDS spreads, which shows that a holder of Greek CDSs in January 2011 — when the spread was 1,000 basis points — would have made a 400 percent return by September 2011, when the spread widened to 4,000 points. “Not such a bad investment, if you ask me,” says McPartland. “I also suspect that a substantial portion of those buying up Greek CDSs in 2011 never expected a payout and were instead placing bets on the probability of default.”
Should ISDA’s restructuring of CDS contracts include trading them on exchanges, FMR’s Stuttard would be all for it. Stuttard, who is not invested in Greek debt or its CDS, also manages portfolios under FMR’s institutional arm, Pyramis Global Advisors. “ISDA has done a very good job of navigating the first credit default of a developed sovereign in 60 years. A lot of people, including me, agree that if CDSs were to be traded on exchanges some of these uncertainties and things that today seem somewhat nebulous, would — if on exchange — would be clearer,” says Stuttard, who Plan Sponsor Europe named Fund Manager of the Year in 2011.
“But I would say on the sovereign side,” he adds, “clearly we don’t have developed governments defaulting often. So we’ll all be watching next Monday quite carefully to see what the outcome is.” Meanwhile, Stuttard expects to see CDSs do well if Greek bond prices fall further.
