- Previous research in emerging-market sovereign debt suggested that credit-default swaps (CDS) were generally a better source of price discovery than spreads computed from bond prices.
- Since the COVID-19 crisis, the cash bond market appears to have made strong inroads as the better source for investors to compare relative value and risk.
- Increasing trade volumes in ETFs may be partially drawn from the same liquidity pool as CDS, contributing to the increasing efficiency of the cash bond market over the CDS market.
Credit investors use spreads to compare relative value and risk between regions, sectors and issuers. Several previous studies of emerging-market (EM) sovereign debt showed that credit-default swaps (CDS) tended to be a better measure of value compared to spreads computed from bonds, which may have been traded infrequently.1
Our analysis shows that this regime may have broken down since the COVID-19 crisis; and in the period since May 2020, bond option-adjusted spread (OAS) has generally been a timelier measure of credit relative value. The decline in trading volume of EM sovereign CDS in the years since the 2008 global financial crisis, along with the steady rise in volume of emerging-market-bond ETFs, might have contributed to this increase in the relative efficiency of bond-price discovery.2
What Was the Better Measure, CDS Spread or Bond-Implied OAS?
Credit spread for EM sovereign debt as quoted on the CDS market and implied by bond prices. The IHS Markit CDX Emerging Markets Index’s country weights are used for calculating the average. The March-April 2020 period is shaded red. Source: IHS Markit for CDS spreads, J.P. Morgan for prices of emerging-market sovereign bonds.
Credit spreads reflect the premium investors require as compensation for bearing credit risk. In a market with significant price transparency, CDS spreads should generally approximate the OAS on the underlying bonds.3 This was the case for EM sovereign debt over the period of analysis until March 2020. As the COVID-19 crisis hit, the basis between the average CDS and bond spread widened to around 100 basis points and stayed elevated for weeks.
More recently, the two markets came closer to alignment, and the basis narrowed below pre-COVID-crisis levels, but the risk of dislocation is worth considering. Different spreads reflect different views on the relative value of the underlying credit, but how can investors have determined whether CDS spreads or bond OAS was the more reliable market measure?
Comparing the Effectiveness of CDS and Bond Spreads
We applied a statistical methodology to measure the efficiency and timeliness of CDS and bond spreads.4 We focused on EM countries with significant outstanding debt in hard currencies (USD and EUR) and examined the behavior of bond and CDS spreads in three subperiods to separate the effects of the COVID crisis. In the exhibit below, we categorize countries according to whether bond or CDS spreads were the timelier source of price discovery.
Which Market Provided More Timely Information in EM Countries?
Number of countries where CDS spread or bond OAS seemed to have provided more timely information in the pre-COVID-crisis (January 2016 to February 2020), COVID-crisis (March and April 2020) and post-COVID-crisis (May 2020 to April 2021) periods. Source: IHS Markit for CDS spreads, J.P. Morgan for emerging-market sovereign-bond prices.
In the period from January 2016 to February 2020 (pre-COVID-crisis), CDS appears to have provided more timely information on the market in many EM countries. In the two volatile months of March and April 2020 (COVID crisis), CDS seems to have lost its dominance. Note that in the same period, the increase in bond OAS was more significant than in CDS spreads. From the second half of 2020 (post-COVID-crisis), the bond market appears to have strengthened in importance, with only one counterexample in our sample set.
Is ETF Trading Taking Volume from CDS?
The structural change might have been linked to the drop in sovereign-CDS trading volume and the increasing popularity of alternatives. In emerging markets, trading volume in CDS historically has been significantly higher than in ETFs.5 The trading dynamics of the two markets have been different, however, with CDS volume’s having fallen significantly and ETF volume’s having increased. The growth in ETFs as trading vehicles might have consequences for the diminished price discovery in CDS. If ETFs offer an efficient trading alternative, the need to transfer credit risk through CDS might decrease. At the same time, ETF trading might boost the liquidity of the underlying bond market and contribute to the efficiency of bond-price discovery.6
ETF Volume Rose as CDS Volume Fell
Traded notional value of EM sovereign CDS and dollar-traded volume in the iShares J.P. Morgan USD Emerging Markets Bond ETF relative to their respective reported levels of the fourth quarter of 2019. Source: IHS Markit, Refinitiv
Investors in EM bonds may wish to consider the liquidity of all sources of price discovery, including CDS and ETFs, when assessing which market measure conveys information first.
1See, for example: Raja, Zubair Ali, Procasky, William, and Oyotode, Renee. 2020. “The Relative Role of Sovereign CDS and Bond Markets in Efficiently Pricing Emerging Market Sovereign Credit Risk.” Journal of Emerging Market Finance 19, no. 3 (December): 296-325.
2Aldasoro, Iñaki, and Ehlers, Torsten. 2018. “The credit default swap market: what a difference a decade makes.” BIS Quarterly Review (June): 1-14.
3Bond and CDS spreads may diverge occasionally because of transaction costs, liquidity considerations and price uncertainty that might make it costly for arbitrageurs to step in and close the gap.
4Relative timeliness of the two markets is classified by a measure of the informational content in CDS spreads and bond OAS. We classify the CDS market as more timely if the bond market is significantly more likely to adjust to CDS movements (and vice versa). A vector-error-correction model is calculated based on the 1-day returns of the 5-year tenor of the CDS curve and the 5-year OAS calculated from the hard-currency (USD or EUR) sovereign curve over the risk-free curve for USD or EUR. For a detailed documentation of the methodology, please see: Palladini, Giorgia, and Portes, Richard. 2011. “The Information Content of Euro-area Sovereign CDS Spreads.”
5In the fourth quarter of 2019, traded notional value in EM sovereign CDS was USD 265 billion, compared to the USD 22 billion in traded volume of the iShares J.P. Morgan USD Emerging Markets Bond ETF, which is the biggest ETF for EM sovereign bonds. Source: IHS Markit, Refinitiv
6“Index Investing Supports Price Discovery.” BlackRock, April 2019.