Fitch Solutions: Greek Yields Show Benefit of Liquid CDS Market

29 March 2012

The recent rise in Greek government bond yields demonstrates the continuing correlation between liquidity in the sovereign credit default swap market and yields on the underlying cash bonds, Fitch Solutions says.

Yields on new Greek bonds, created as part of a debt exchange with private bondholders aimed at reducing the country's debt burden, have risen since they began trading. Press reports say some market participants attribute the rise to the unwillingness of dealers to quote CDS prices while there is a possibility that new contracts could still be technically triggered with reference to the March 9 ruling that a Restructuring Credit Event had occurred.

This would be consistent with Fitch Solutions' finding that the liquidity of sovereign CDS is highly correlated with underlying bond yields. Yields tend to fall when CDS liquidity is high, and increase when CDS liquidity falls.

In late 2010, Fitch Solutions demonstrated this pattern by combining CDS liquidity scores, based on inputs such as the tightness and depth of dealer quotes, with other inputs such as the distribution of contributor quotes, to determine a CDS liquidity premium. The relationship between this premium and sovereign yield spreads was tracked from the beginning of 2008 to the end of July 2010.

While fundamental credit considerations are a more important driver of bond yields, the correlation between yields and CDS liquidity highlighted the importance of the latter in the sovereign bond market, especially at times of stress.

As fears of a Greek debt restructuring grew last year, this relationship between CDS liquidity and yields remained intact. Between August and October 2011 liquidity on Greece CDS fell from the 21st percentile of all CDS contracts down to the 84th percentile of all CDS contracts. At the same time, 5-year bond yields more than doubled from 19% to 40%.

Fitch Solutions is a division of Fitch Group that provides data, analytical tools and related services. The October 2010 report, produced by its Quantitative Research team.

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