Europes junk CDS signal more credit pain ahead

div classBodysc17zpet90 cdBBJodivpBy Yoruk Bahcelip

pReuters – The cost of hedging exposure to the bonds of junkrated European companies has surged in recent weeks and the selloff on the bonds themselves is catching up, a sign that more pain may lie ahead for holders of the securities. pdivdivdiv classBodysc17zpet90 cdBBJodiv

pMarkits credit default swaps index, the iTraxx Europe crossover, effectively measures the cost of insuring against defaults on a basket of underlying highyield bonds. p

pBy Monday‘s close this had widened 130 basis points since endMarch to 470 bps, when a rally following an initial selloff after the invasion of Ukraine started to reverse. It stands far above a peak first seen in the wake of Russia’s invasion of Ukraine.p

pThe blowout has been less severe in the actual bonds, but they are starting to catch up with spreads moving more than CDS on some days. p

pThe spread on the ICE BofA euro highyield index — effectively the risk premium demanded by investors to hold the debt — has widened 115 bps since endMarch. It rose above a peak seen in March on Monday, hitting 515 bps, with a nearly 30 bps move double that seen in CDS. p

pBecause credit default swaps are essentially a hedging product, its not unusual for them to react more and quicker than the bonds, particularly to unexpected events such as war or the COVID19 pandemic.p

p“Normally when you see that sort of activity, it‘s an unknown known, something happens you didn’t expect and that‘s why crossover moves so much, whereas what’s happened in last few weeks there‘s nothing there you wouldn’t have known,” said Azhar Husain, head of global credit at Royal London Asset Management. p

p“It tells you there is some real fear in the market, and in a way thats more fear… than cash bonds tells you.” p

pNo doubt, credit investors have much to be concerned about. European Central Bank bond purchases, which spurred investors into junkrated debt in search of yield, are expected to end this quarter. A growth slowdown could hit earnings at weaker companies. p

pSeveral factors may have held cash bond spreads in check. p

pCDS are more liquid and hence, easier to trade, whereas trading in highyield debt often picks up only when new bonds or investment flows hit the market. p

pBut the contrary has happened, with the junk debt market effectively shuttered for more than 10 weeks until lateApril and outflows holding up. p

pSupply of debt has dropped sharply — BofA analysts reckon a 73 drop in issuance compared to last year implies investors are ultimately receiving cashflows from the highyield bond market. That reduces the need to sell their holdings to meet potential fund redemptions. p

pAnalysts see the credit selloff as mainly driven by a repricing of the interest rates outlook so far as major central banks led by the U.S. Federal Reserve tighten monetary policy to tame accelerating inflation. p

pOne sign is that investmentgrade and highyield bonds have delivered similar total losses this year, of around 9, unusual in a “bear market” where more fragile companies would be expected to underperform, BofA notes. p

pJPMorgan expects high yield spreads could widen to 525 bps by yearend, citing market volatility, inflation, the RussiaUkraine conflict and supply disruption from Chinas COVID lockdowns. p

p

pp Reporting by Yoruk Bahceli editing by Sujata Rao and Emelia SitholeMatarisep

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