CDS And Credit Spreads In Perspective

Last Updated: 26 May 2024

It’s true that the risk of default continues to rise, Paul. But the sharp uptick in CDS spreads and credit spreads must be put in perspective.

Let’s start with credit spreads themselves.

The FT article you mentioned on “spiraling credit costs” for National Grid and Daimler tells the tale. In that article, there is a table comparing the BoE base rate and the average cost of corporate loans for August 2007 and October 2008; in other words, the spread between “risk-free” assets and corporate bonds before and after the credit crisis. The point of the table is that the credit spread widened over the 14months ending October 2008 by 59%, from 150 basis points to 239 basis points. That sounds shocking.

But the interesting thing is that the actual interest rate corporations paid for debt fell during that period, from 7.15% to 6.89%. The reason the spread increased was that the BoE base rate fell further, from 5.75% to 4.50%.

As you know, the base rate has since fallen still further, down to just 2.0% today. I suspect the cost of capital will fall further on an absolute basis, even if it rises on a relative basis. That’s not to say we shouldn’t worry about credit spreads—they are an excellent indicator—but it’s a simple reminder that there are two sides to the calculation.

Regarding CDS spreads, I wonder if part of the premium is being driven by the disappearance of many (perhaps most) of the players that used to sell credit insurance. Not only have Lehman Brothers and Bear Stearns disappeared, but many of the hedge funds that used to be big players in this market have seen huge withdrawals and/or closed up shop altogether. I’m guessing that CDS costs are, to some extent, artificially high because of the rapid removal of most of the large providers of CDS insurance over the past six months.

In a normal market, we might expect others to fill the space left by these exiting firms, particularly if there is a profit to be made. But proprietary trading desks are tremendously risk-averse right now, as investment banks hoard their capital, and there is simply no money available for new hedge funds to move into this space.

The CDS market is forecasting economic conditions that would make the 1930s look like a walk in the park. I’m guessing (and hoping) that they are overreacting.

Which may explain, at least partly, why investors are betting that spreads will tighten in the ETF market.

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  • Luke Handt

    Luke Handt is a seasoned cryptocurrency investor and advisor with over 7 years of experience in the blockchain and digital asset space. His passion for crypto began while studying computer science and economics at Stanford University in the early 2010s.

    Since 2016, Luke has been an active cryptocurrency trader, strategically investing in major coins as well as up-and-coming altcoins. He is knowledgeable about advanced crypto trading strategies, market analysis, and the nuances of blockchain protocols.

    In addition to managing his own crypto portfolio, Luke shares his expertise with others as a crypto writer and analyst for leading finance publications. He enjoys educating retail traders about digital assets and is a sought-after voice at fintech conferences worldwide.

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