NEW YORK, May 11 (IFR) - Ever since mortgage unit Residential Capital LLC missed a $20 million interest payment on its unsecured 6.50% note due 2013 on April 17, synthetic and bond market sentiment have brightened on its parent, Ally Financial.
Ally had already piqued interest before that when it extended several credit facilities for a month, instead of a year as it had done in the past.
The appearance that Ally was loosening its parental support of the struggling unit, and perhaps readying some sort of action for ResCap, led two key measures of Ally’s relative value - credit default swap credit curves and the CDS-cash basis - to show an improved view of the credit which is now gaining traction.
CDS credit curves, constructed by plotting short- to long-term maturities on a graph, convey a fundamental outlook. An upward and steeper sloping curve signals a positive view, while a downward or flatter curve indicates growing credit risk.
Combining shorter-dated maturities gives an immediate view, while longer-dated tenors express a broader view.
CDS compression for Ally debt has been impressive since April 17 - five-year CDS has tightened by about 40 basis points (bp) to 350bp, while 10-year CDS has tightened 40bp to 365bp.
That has pushed the 5s10s curve to 12.03bp on May 9 from 9.24bp on April 17. The increase, while modest, demonstrates a slowly growing perception that credit risk has diminished. To express the positive developments, investors sell five-year protection and buy 10-year protection.
The opposite is seen in ResCap, whose 5s10s slope is heavily inverted (-3,000bp) with five-year CDS marked roughly at 20,000bp and ten-year spreads about 17,000bp.
The 20,000bp is the conventional “running spread” quotation. The switch from running spread to points upfront commonly occurs around 500bp.
So as the CDS spread widens to that level, the convention changes as investors pay present value (or upfront) with the rest paid in the convention 500bp running spread. Hence, ResCap is quoted as 69 /70 pts upfront +500bp.
Ally’s other CDS curves have steepened in the three-week timeframe as well. The 7s10s is 6.08bp versus 2.17bp, while 3s5s have edged up to 43.19bp from 41.73bp.
Not only has Ally’s CDS sharply narrowed since April 17, the so-called z-spread on some of its debt instruments has contracted significantly. Simply put, a z-spread measures market sentiment toward a bond. The price of a bond increases as it declines.
Investors look at the relationship between synthetic and bond in the CDS-cash basis.
The CDS-cash basis extrapolates the perception of funding costs and credit risk, among other things. A negative basis reflects a deterioration in risk, while a positive basis can indicate a healthier credit.
Ally has experienced a persistent negativity in its CDS-cash basis for some time. It has been partially influenced by ResCap’s myriad of problems - dwindling liquidity, litigation worries, weak operating performance and bad loans, to name a few.
But the recent mix of CDS tightening along with a collapse in some z-spreads has condensed the CDS-cash basis, lessening its persistent negativity and signaling a richening of the individual bond.
Since April 18, Ally’s CDS-cash basis has begun to significantly relax its negative view. It is seen across a variety of tenors, including two-year, five-year and 10-year CDS and respective underlying reference bonds.
The z-spreads were taken from the 4.50% maturing February 2014, the 5.5% due February 2017 and the 7.50% due September 2020.
In three-weeks, the z-spread on the 2014s has dropped 100bp to 299bp, on the 2017s it has dropped 99bp to 362bp, and on the 2020s roughly 62bp to 368bp.
With the z-spread below CDS, it has provoked vivid tightening in the CDS-cash basis across the tenors. The five-year basis has retraced its negativity and pushed into positive territory on May 9 at 7.4bp. On April 17, it was (-50.8bp).
Tightening has been also been dramatic in the 10-year CDS-cash basis. It too has steepened and is 12.8bp compared to (-25.34bp).
The two-year CDS-cash basis is less liquid and therefore prone to vacillations, but two-year CDS narrowed about 60bp to 264bp since April, and the z-spread has dropped to under 300bp to slice the basis in half to around (-35.37bp).
The shift in sentiment could stall in the very short term as five-year CDS has delved below a three-month range of 400-635bp. Though opinion has improved, CDS buying might be sparked by the range breach as well as potentially approaching headwinds.
However, the z-spread on the 2017s continues to decline in steady and sometimes robust volume.
The instrument’s outperformance is likely to persist and maintain the positive basis even if CDS buying surfaces ahead of anticipated pressure.
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