Bond market/CDS dislocation revisited?

From another thread:

(Edited for clarity)

I noticed a piece on some of the US banks:
ritholtz.com/blog/2009/06/ba … -going-on/

I had some random ponderings on this:

  • I presume prices move based on demand?
  • So, is the threat of inflation/recovery (whether just expectations or not) and the increased likelihood of reduced central bank liquidity/increased interest rates causing bondholders to dive back into insurance?

My recollection is that the spike in CDS prices was the first tangible indicator of the dislocation in summer 2007, but also that they have spiked in the near past without much coming of it (quarter ends, for example).

think i posted on this before but i know i cant find it…

Yeah: There is sometimes a dislocation between the two in the short term.

Arbitrage would indicate that over the medium term this disparity should tend to zero…but this can be a slow process.

There are a few reasons for this.

Say soverign debt vs soverign cds cover.

There is more participants in the market for debt and hence this large pool of buyers will push down the yield somewhat. On the flip side, their isn’t as many sellers of insurance, so they can squeeze a higher margin.

Writer of protection can attempt to disuade the market by pricing up the insurance - they dont want to do more. Or perhaps they have shorted the underlying to “cover” themselves and thus want to lock in a spread.

I feel, lately, that the main driver is liquidty. It is easier to bet on the credit quality of a debt issuer via cds for a variety of reasons.
No capital outlay (bar small premium)
No balance sheet issues
Can be more liquid as seller will usually g’tee to close out your position if you so wish…

Other technical reasons that I can outline if anyone is so inclined to research…

How easy would it be take a short position in Irish bonds?

If the majority of the Irish bonds purchased are being repo’d with the ECB, is there enough bonds on the market to make it liquid?

well its probably easier to short the credit…buy a cds.

but you can find the bonds to short sell if you so wish, you can even finance this position somewhat via RevRepos…

Markets still seem to be pricing in a just under 1 in 5 probability of default over 5 years.

Default wrt to CDS isn’t a case of someone “not” paying.
Default covers an array of things from debt restucturing to delay in any payment of any monies, be it coupon or principal, such things as a technical default, a soft default, debt default…blah-de-blah…

See the ISDA doccumentation on these, this area has become quite contentious lately, CDS buyers claiming default as Issuer delayed repayment by 1 month but has now repaid in full…