FxWirePro: Is this a necessity for CDS in euro bond market? Unwise to invite "Cowboy hedging"

We sense that the political risk into the French election is priced more appropriately in bonds (but not in currencies) than going into the Brexit and US vote.

In the remote scenario of a Le Pen Presidency with supportive government and Parliament, 10Y Bunds could approach 0bp and 10Y France-Germany 200bp, with sharply wider Bund swap spreads (54bp), FRA/OIS (20bp) and EURUSD cross currency basis (-60bp), and higher volatility (Bund implied 6bp/day).

Less extreme scenarios of Le Pen Presidency but cohabitation or extreme left Presidency will likely result in considerably less extreme outcomes.

Post-crisis rules designed to safeguard Europe’s financial system have left bank bond markets fragmented, exposing investors to more losses than ever.

The reason has to do with hedging, or rather the lack thereof. Banks are employing different approaches in different countries to meet more stringent capital requirements and many new securities aren’t explicitly covered by credit-default swap contracts, the method of insurance favored by bondholders.

The lack of a safety net in a selloff is glaring since new European regulations are expressly designed to make sure the onus of rescuing banks falls on creditors rather than taxpayers, who bore the brunt of the cost almost a decade ago. Lenders have sold about 214 billion euros ($227 billion) of new kinds of bonds since regulations started taking effect.

The credit-default swap market hasn’t kept up with the fast-moving changes in line with bank bonds. That’s a problem when you want to hedge a specific part of the capital structure.

France and Spain have created a new category of debt, known as senior non-preferred or Tier 3 that suffers losses after subordinated bonds. The U.K., Switzerland, and Ireland have taken a different approach, with banks issuing notes out of holding companies so they’re disconnected from the lender’s operations. Germany has ruled that losses can be imposed on existing senior bonds.

The credit derivatives market hasn’t kept up with the developments, creating a problem for some of the biggest asset managers and pension funds that invest in bank debt. At the same time, the market has contracted as dealers have withdrawn. Outstanding contracts on financial-company debt have dropped more than 20 percent in two years to cover a net $104 billion of borrowings, according to Depository Trust & Clearing Corp. data.

The International Swaps & Derivatives Association, which represents the credit derivatives industry, declined to comment on the effectiveness of bank-debt swaps.

It’s a major issue if the paper doesn’t get its own credit-default swap, Cowboy-hedging it with subordinated CDS will be extremely expensive and may not work well.

Being able to hedge the bonds adequately is becoming more important as the popularity of the notes soars. France’s four biggest lenders and Spain’s Banco Santander SA have announced plans to sell as much as 70 billion euros of Tier 3 debt through 2018. Investors have bought about 12 billion euros of the securities in the past two months.