Next time your friends are talking about matters financial, why not ask them whether they’ve checked the pricing of their bank's credit default swaps – and more pertinently the direction of travel for this pricing relative to other banks. Most of us will probably reciprocate with a stony-faced blank stare in reply – what on earth are you talking about?
But I think that stock market investors - private and institutional - should take more interest in the opaque world of credit default swaps, or CDSs for short. If you care about the long-term health of your bank (especially if you have a business account, with weaker Financial Services Compensation Scheme protection), you might want some sense about how ‘risky’ the markets view your bank. More pertinently, if you invest in various structured products (and funds that invest in these structures) then a bank's swap rates really are absolutely crucial – I’ll be looking at the new wave of structured product investments in much more detail this year.
At a more macro level mainstream private investors can learn much about the market’s relative perception of systemic risk by looking at credit default swaps. Put simply, if credit default swaps start increasing rapidly in price, that’s usually – though not always – a sign that investors are starting to get worried about the risk of bank defaults, which in turn could feed through into a wider market decline.
And that is precisely what happened in the last few weeks of last year - swap rates for most of the big systemic banks have increased sharply. My guess is that something is stirring deep within the workings of the globalised financial system, powered in part by increased stock market volatility but also by a worrying fact – that nearly all the major developed world central banks bar Japan’s are tightening their balance sheets at a frightening pace.
So, what is a credit default swap? In simple terms, these contracts are in effect an insurance policy on bonds issued by banks. In effect an investor can swap their exposure to a credit default risk (the bank bond not paying out) through a CDS structure. Pricing generally varies around obvious risk levels and duration – standard terms are for one and five-year durations. You can see the latest range of credit default swap pricing online – for free – at Meteor Structured Products. The link is here.
I’ve copied out a selection of the latest numbers below in the table and clearly, they are just a snapshot in time. You can see that HSBC has one-year swaps priced at 20.43 basis points of the value of the bonds, and 46 basis points for a five-year term. These rates are still fairly low by historic measures and some banks have pricing that is in excess of a hundred basis points – Deutsche Bank for instance is viewed as much riskier. Crucially these swap rates vary over time, with a live market place for pricing, so you should expect prices to move up and down a fair bit.
That said, the big story is that over the last few years of quantitative easing, swap pricing has crashed, with rates at rock bottom – some big ‘reliable’ banks have seen their one-year CDS contracts trade as low as a few single digit basis points. In effect many investors believed that the central banks would not let a systemically important bank go bust, so prices fell to historically low levels – why bother insuring your bank debt if the bank never goes bust?
But in the last few weeks everything has changed. Looking at the numbers in the table from Meteor Structured Products, taken on 12 December, and we can see that pretty much across the board one-year and five-year CDS prices have jumped very substantially through the four weeks to mid November. Most of the big banks have seen a 20% increase in pricing over the last few weeks with a few such as Deutsche and Credit Suisse experiencing an increase of over 35% over the month to mid-December. By contrast, just one entity, Santander UK, saw a decline in the pricing of its five-year swaps while Royal Bank of Canada and Natixis chalked up very small single-digit increases. For many years HSBC has offered the lowest CDS pricing for one-year swaps, usually in the single digits. Now that title belongs to Dutch bank Rabobank, whose one-year swaps are currently priced around 12 basis points – HSBC is up at 20. It’s also worth noting that over the one-year timescale, five-year swaps have shown big increases with most more than doubling in price.
Pulling back from the minutiae of these numbers, some trends become relevant, especially for fund investors. The first is that banks form a large component of most general diversified regional equity funds – anything between 20% and 40% depending on the market. For more specialised financials funds, banks are even more important. These swap prices tell you that institutional investors are starting to get much more worried about default risk – the majority of banks are now trading at the upper end of the range for both their five-year and one-year credit default swaps.
The range of rates also shines a light on a number of interesting country specific narratives. The German financial systems and especially Deutsche Bank and Commerzbank are regarded as much more vulnerable than the big French institutions – which might help pull down returns from German focused funds. In fact, rates for French bank Natixis have been declining in recent months. UK domestic banks are also seen priced at higher risk levels. By contrast, the market seems to be telling us the US banks are less risky, which speaks to the hard work done stateside by the regulators post the global financial crisis.
At a macro level, the narrative is much messier. I’d suggest that one possible explanation is that investors were too complacent in the past, and that current pricing probably represents something approaching more realistic levels. But the bears could also mount an argument for saying that this is another canary in the coalmine of default risk ahead of a slowdown.
|Bank||One Year||Five Year||Monthly Change||Annual Change||Credit Rating|
|Santander UK||19.12||59.3||-2.38||41||A -|
|Goldman Sachs Group||33.18||90.85||31.18||67.51||A|
|HSBC Bank PLC||20.43||46.4||4||22.93||AA-|
|RBS / Natwest Markets||53.87||125.46||29.71||154||A|
|Investec Bank PLC||79||note this is for 5 year CDS rates model implied||BBB|
Source: Meteor, Bloomberg, 12 December
One last vital point. These swap rates need to be put into perspective – they are just a specialised market pricing risk on a bank-by-bank basis. If you want a much more detailed picture of the general health of our big global banking system, it's worth checking out another specialist structured products provider, this time called Tempo – more details here.
This relatively new London-based firm runs a system (mainly for financial advisers) which is called Tics. This is a comprehensive look at risk in the global banking system and includes data reference points from 27 different measures, updated monthly, including bank share prices, balance sheets, regulatory definitions and much more more. I’ll try and keep readers updated on big changes in the system but currently this ‘monitoring’ system is echoing these credit default numbers: risk levels are rising, and some banks are feeling the strain. But an elite of banks still rules the roost using these measures, headed by HSBC and closely followed by Canadian bank RBC, and then JPMorgan. At the bottom of the list sits Barclays, RBS, Bank of Ireland, and Investec.
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