Falling ICICI CDS spreads signal firm equity market

Credit spreads, as measured by credit default swaps (CDS) rates, are falling, indicating increasing risk appetite among global investors.

The ICICI Bank CDS, which is widely traded in the Asian CDS market, has seen its five-year spreads fall by 250 basis points (bps) since January last year to 235 bps now.

The fall in CDS spreads indicates that global investors’ view of ICICI Bank’s credit risk has improved. In other words, an investor of ICICI Bank bonds who wants to hedge credit risk, has seen hedge costs come off by 250 bps over the last one year.

This is reflected in the equity markets as well.

The stock price of ICICI Bank has gone up 70% since January last year, while the Sensex and Nifty have returned over 25%.

The close correlation between credit spreads and equity prices indicates the risk appetite of investors.  The higher the risk appetite of global investors for credit spreads, the higher the FII inflow into equity markets.

FIIs have invested $18 billion in Indian equities so far this calendar.

The question going forward is, will the credit spreads continue to drop for issuers such as ICICI Bank?

For the record, ICICI bank is rated BBB- by S&P, which is the lowest investment grade.
The fact that the CDS spreads of ICICI Bank are falling indicates that investors believe ICICI Bank’s credit risk is better than what was priced in by the CDS market. Hence, as the credit perception of ICICI Bank improved, more and more investors came in to receive the CDS spreads.

Receiving CDS spreads refers to the willingness of an investor to give protection to an ICICI Bank bondholder in return for a yearly payout, which is the CDS spread.

A protection seller was receiving a payout of 480 bps every year, or `4.80 for every `100, on ICICI Bank in January 2012.

The protection seller is receiving 235 bps, or `2.35 per `100, in January 2013.

But will the protection seller be willing to provide protection at lower spreads going forward? The answer is yes, as there will be a demand for higher yields going forward, given the yields of government bonds across US, Germany and Japan are at extremely low levels.

Five-year bond yields in the US, Germany and Japan are at levels of 0.80%, 0.55% and 0.20%, respectively.

The fact that the Fed, ECB and Bank of Japan are expected to maintain interest rates at record low levels and are expected to continue buying bonds to pump liquidity into the markets will keep bond yields down at the short end of the curve. The lower bond yields will drive investors to seek higher yields elsewhere and that will prompt interest in credit spreads of issues such as ICICI Bank.

In the medium term, falling credit spreads of ICICI Bank will also reflect in firm equity markets, given that both are driven by risk appetite.

In the longer term, the exit policies adopted by the central banks will impact credit spreads negatively. However, at this point of time, exit policies of central banks look a long way off and investors will do well to be bullish on risk assets.

Arjun Parthasarathy is the editor of  www.investorsareidiots.com, a website for investors.