Sovereign CDS liquidity snaps

Posted by Tracy Alloway on Dec 03 11:55.

Did the events of last week in Dubai really send jitters through emerging markets?
Here’s something to ponder in the emerging vs developed market debate — an issue aptly summed up in Deutsche Bank’s 2010 outlook on Wednesday. On Thursday, Fitch Solutions has provided an update of its sovereign CDS liquidity indices — and they show that liquidity in CDS for developed markets surpassed that of emerging markets in the last week of November:
As a recap, and in general, the more liquid a sovereign CDS is, the more it is showing signs of financial stress, possibly combined with a significant amount of outstanding national debt and/or changes in its capital structure. Relatively liquid CDS is also a hint that there is agreement within the market about present value, but disagreement about future value due to heightened uncertainty surrounding the country. According to Fitch the liquidity scores of assets have historically traded between four at the most liquid end and 29 at the least liquid end.
Here’s what Fitch says in their Thursday update:Liquidity on the Developed Market Sovereign CDS index surpassed that of the Emerging Market Sovereign CDS index in the last week of November despite the concerns surrounding the debt restructuring of Dubai World. This highlights that the CDS market now sees more uncertainty around the future of developed economies in aggregate than emerging ones. Although the top 10 most liquid sovereigns are all from the emerging market index, overall liquidity in this index has only marginally increased compared with the significant increase in the developed market index. The increase in liquidity of the developed market index has been driven by persistent market uncertainty about the strength of economic recovery, and the sustainability of higher levels of debt to GDP in combination with lower tax revenues.
You can see the full country-by-country breakdown in the table below. Austria, Ireland, Finland and Sweden look to have had the biggest increases in CDS liquidity over the last year. While Australia, Iceland and the UK look to have had the biggest decreases:
If you’re wondering why the UK and Iceland have had the biggest decreases in liquidity, Fitch Solutions’ offers up an explanation based on its CDS market-implied ratings, which provides a sort of market indicator, using CDS spreads, to indicate which rating band an entity is trading in.
On that basis implied ratings look like this:
And so Fitch concludes:
Over the last year, Austria’s five‐year CDS spread has widened relative to its peers and its CDS market implied rating has fallen from trading in the ‘AAA’ band back in January 2009 to now trading as a ‘AA‐’, down three notches. Given this negative trend over the year, the market is clearly uncertain about the future direction of the CDS on Austria, hence the increase in liquidity. The same goes for Ireland, whose five‐year CDS spread was trading with a CDS market implied rating of a ‘AA’ sovereign back in January but is now trading at ‘BBB’, down six notches.
Conversely, liquidity has fallen in the CDS of those sovereigns reflecting greater certainty within the CDS market over the future direction of their CDS spreads. The volatility surrounding Iceland appears to have come to an end as it has been trading for the last year around the ‘B+’ CDS market implied rating band. The UK has also shown a dramatic decrease in liquidity over the year. The main driver behind this is the fact that the CDS on the UK has been trading in a ‘AA’ CDS implied rating band relatively consistently since March this year, after falling two notches in February, when it was last trading in the ‘AAA’ rating band. However, in the last two weeks of November, that trend appeared to reverse with signs of increasing liquidity, largely driven by the relative widening of the five‐year spread which is now at 66bp and approaching the median spread for a ‘AA‐’ sovereign at 69bp.
Which basically means that the CDS market has been giving the UK an implied rating two notches below its official designation by Fitch Ratings of AAA.
It’s only in recent weeks that the CDS market thinks the UK’s future looks a bit more in doubt — inching towards that implied rating of AA-.

Related links:
Deutsche Bank ponders all things sovereign - FT Alphaville
Oh the sovereign liquidity! - FT Alphaville
Could sovereign debt be the new subprime? - Gillian Tett, FT