Are Credit Default Swaps Spreads High in Emerging Markets
An Alternative Methodology for Proxying Recovery Value

Contributor Notes

Author’s E-Mail Address: Msingh@imf.org

In times of distress when a country loses access to markets, there is evidence that credit default swap (CDS) spreads are a leading indicator for sovereign risk than the EMBI+ sub-index for the country. However, it is not easy to discern the variables that determine the level of CDS spreads in Emerging Markets (EM); traders only quote the CDS spreads and not the inputs that are required to calculate such spreads. This note provides some evidence from Argentina and Brazil that reveals inconsistency between theory and practice in pricing CDS spreads in EM. This note suggests an alternate methodology that links CTD (cheapest-to-deliver) bonds to recovery values assumed in CDS contracts. Furthermore, special features that pertain to CDS contracts (repo specialness, short squeezes by central banks) may also magnify the financial distress of a sovereign.

Abstract

In times of distress when a country loses access to markets, there is evidence that credit default swap (CDS) spreads are a leading indicator for sovereign risk than the EMBI+ sub-index for the country. However, it is not easy to discern the variables that determine the level of CDS spreads in Emerging Markets (EM); traders only quote the CDS spreads and not the inputs that are required to calculate such spreads. This note provides some evidence from Argentina and Brazil that reveals inconsistency between theory and practice in pricing CDS spreads in EM. This note suggests an alternate methodology that links CTD (cheapest-to-deliver) bonds to recovery values assumed in CDS contracts. Furthermore, special features that pertain to CDS contracts (repo specialness, short squeezes by central banks) may also magnify the financial distress of a sovereign.

An Alternative Methodology for Proxying Recovery Value in Credit Default Swap Contracts

In times of distress when a country loses access to markets, there is evidence that credit default swap (CDS) spreads are a leading indicator for sovereign risk than the EMBI+ sub-index for the country. However, it is not easy to discern the variables that determine the level of CDS spreads in Emerging Markets (EM); traders only quote the CDS spreads and not the inputs that are required to calculate such spreads. This note provides some evidence from Argentina and Brazil that reveals inconsistency between theory and practice in pricing CDS spreads in EM. This note suggests an alternate methodology that links CTD (cheapest to deliver) bonds to recovery values assumed in CDS contracts.

I. Correlation between Recovery Value And Probability Of Default

The assumptions underlying the correlation between recovery value r, and the probability of default p is key to understanding CDS spreads. At a theoretical level, it is clear that CDS spreads are a joint function of the r and the p where both r and p are determined jointly; in other words, the correlation between r and p is not zero.2 Discussions with traders in EM reveal that in practice r is usually fixed at roughly 20 cents of the face (or par) value. Mathematically, using r as a constant will result in the correlation of r and p to be zero. Also, empirically evidence from the corporate literature has shown (not surprising) that r is inversely correlated to p. The correlation between r and p cannot be zero in EM when theory and corporate literature suggest that r and p are negatively correlated.

Figure 1 shows CDS spreads (s) =f (r, p) and explains how CDS works in 3 components: r is the recovery value at default, p is the probability of default; and s is the premium per dollar of notational protection from time zero to T that solves the following equation:

0Tsp(t)[u(t)+e(t)]dt+s(10Tp(t)dt)u(T)=0T[1r(1+A(t))]p(t)v(t)dt

Where

article image
Figure 1.
Figure 1.

Credit Default Swap in Practice

Citation: IMF Working Papers 2003, 242; 10.5089/9781451875836.001.A001

Source: Bloomberg, L.P.

II. An Alternate Methodology: The Cheapest-to-Deliver Bonds For Argentina and Brazil

A CDS contract usually refers to a few bonds in a “basket” of bonds at the time of the contract, allowing the protection seller a valuable option to deliver the cheapest bond upon a default (or, a credit event). These cheapest-to-deliver (CTD) bonds—or reference bonds—are generally priced at a discount to other similar bonds due to their illiquidity, denomination, legal jurisdiction, and other special features (interest-capitalization). Figure 2, illustrates the case of Argentina where, at default, bond prices varied considerably between 24 cents and 38 cents, with the euro denominated issues priced higher owing to large retail ownership in Europe.

Figure 2.
Figure 2.

Argentine Bonds at Default

Citation: IMF Working Papers 2003, 242; 10.5089/9781451875836.001.A001

Figure 3 illustrates Argentine CDS spreads and decomposes them into their two components r and p. In this example, r is not assumed to be a constant and the CTD bond is a proxy for r; the Argentine 2018 was used in most contracts as the CTD bond along with the Argentine samurai/yen issues. Note that bond prices do not necessarily collapse at default. The prices of the Argentine CTD bond actually rose from about 24 cents to 28 cents owing to the cross default clauses when the Argentine default occurred.

Figure 3.
Figure 3.

Argentine Default Probabilities Using Cheapest-to-Deliver Bonds

Default Probabilities from the Credit Default Swap spreads and the cheapest to deliver bond

Citation: IMF Working Papers 2003, 242; 10.5089/9781451875836.001.A001

source: Merrill Lynch and staff estimates

Another example illustrates that Brazil’s CTD bonds were a better proxy for r. The CTD bond increased about 30 percent from 37 cents to the dollar to 49 cents to the dollar in the month surrounding the election in October, 2002 (figure 4). This increase led to CDS spreads to tighten from more than 4,500 basis points to less than 3500 basis points during the period. Holding recovery value constant (at say 20) would force the CDS spreads to be driven only by the probability of default. However, consistent with the derivation of the CDS equation, the 1,000 bps tightening in CDS contract around the elections was also caused by the roughly 30 percent increase in the price of the CTD bond

Figure 4.
Figure 4.

Brazilian CDS Spreads (2002)

Citation: IMF Working Papers 2003, 242; 10.5089/9781451875836.001.A001

III. Implication of CDS Spreads For Distressed Emerging Markets

Mispricing of CDSs magnifies the financial distress of a sovereign. During July/August 2002, the EMBI+ sub-index for Brazil widened to just over 2,000 bps. During the same period, the CDS spreads for Brazil reached 4,500 bps, largely owing to squeeze on some short bonds (the 2004s and the EIs) and other factors such as repo specialness.3 CDS spread widening were leading indicators to sell-offs in the underlying bonds i.e., CDS market were driving the EMBI+ sub index (the “tail wags the dog”). Recent experience with bonds traded on the mature markets (Weyerhauser, Ford etc) also indicate that CDS spreads provide valuable information (about insider trading, etc) and are a leading indicator of financial distress. CDS spreads are also more volatile than the spreads on the underlying asset—CDS contracts require the insurer to cover the loss to par (that is par minus recovery value), while at default the bondholder’s loss is the value of the bond minus its recovery value (where, for distressed assets, the value of bond is well below par). In other words, the likelihood of loss is significantly larger for a CDS insurer than for an investor holding a particular bond.

This note concludes (i) that not linking recovery value to CTD bonds may lead to overpricing CDS spreads; and (ii) conjectures that there are special features that pertain to CDS contracts (repo specialness, short squeezes by central banks) that magnify the financial distress.

Are Credit Default Swaps Spreads High in Emerging Markets: An Alternative Methodology for Proxying Recovery Value
Author: Mr. Manmohan Singh