Negative CDS Prices? Surely Not

Imagine someone was going to insure your house against damage from fire, natural disasters and other mishaps, but you didn’t have to pay a penny.

Sounds a bit upside-down, right?

But that is exactly the type of debate taking place in the world of credit default swaps now that around a quarter of euro area government bonds trade with negative yields. If investors are prepared to pay to hold government bonds, how cheap can CDS be? Can it be free? Indeed, could investors even be paid to buy it?

CDS aren’t technically insurance, but the analogy is helpful to understand how these instruments are meant to work.

If you take a pessimistic view on the prospects for a particular country or company, you can buy CDS protection that is designed to pay out if the country in question defaults. CDS prices rise when investors en masse think the country is at a growing risk of default. Those taking a more favorable view can sell CDS protection – essentially placing the same bet as buying a government bond issued by that country’s treasury.

So far, CDS spreads on highly-rated government bonds have fallen, but are hovering above zero. One-year German CDS currently trade at 0.03%, according to Markit, meaning it will cost $3,000 for a year to buy credit protection against $10 million of German government bonds. This compares with $7,000 in February 2014. The yield on one-year German government bonds is -0.23% compared with 0.15% a year ago.

One senior bank trader, who asked not to be named, said he could imagine hedge funds paying to sell CDS so they can exploit arbitrage opportunities.

Wolfgang Kuhn, head of pan-European credit at Aberdeen Asset Management, said he recalls seeing negative CDS back at the height of the credit boom in 2007, though he suspects it was because the bank that quoted those prices just didn’t want the position on its books.

“If we go into a situation where it’s harder to make money, we could potentially see that happen [again],” he said.

If you pay someone to buy CDS off you, then you end up sending the buyer a chunk of cash every year. Some credit experts can't see this happening and are adamant that CDS won't follow government bonds below zero.

“The [CDS] spread represents a premium paid by a buyer of protection, so it can’t be negative,” said Gavan Nolan, director of credit research at Markit.

Moreover, Mr. Nolan noted that sovereign CDS nearly always trade above government bonds, as much of the activity is driven by banks hedging exposure they have to these countries through their derivatives and loan books.

In practical terms, some seasoned traders also believe negative CDS is a non-starter.

“Why would anyone pay for someone else’s insurance policy?” said Carl Norrey, co-head of European rates trading at J.P Morgan.

Investors such as pension funds are effectively forced into buying negative-yielding bonds because they have to park their money somewhere. But the same doesn’t hold true for CDS – no one is forced to sell protection, unless it is to unwind an earlier bet. As a result, Mr. Norrey said the CDS market is floored at zero.

Then again, bond supremos once voiced similar opinions about investors never buying negative-yielding bonds, and look where we are now.

In the meantime, if bond yields fall further than CDS is able to, the CDS market will likely drift further apart from the bond market.

This could make CDS a less useful reference point. Already, the market has taken some heavy blows. In 2011, the European Union banned speculative activity in sovereign CDS, which has already dented trading volumes substantially.