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Emission impossible

22 Sep 2015 By Neil Unmack

Volkswagen’s credit swaps could be as flawed as its misleading regulatory tests. The German carmaker’s credit default spreads have performed much worse than equity markets following revelations that it designed software to deceive watchdogs trying to measure toxic emissions. That could be because credit investors are worrywarts. More plausibly, it highlights how volatile credit markets are in the new regulatory era.

Arguably, the news that Volkswagen had been rigging emissions tests on its cars should spook equity investors more than bondholders: the scandal will hurt earnings, but is unlikely to bankrupt the group. Yet the reaction of the credit market to the emissions scandal looks extreme. Its five-year credit default swaps have jumped over 100 basis points since Sept. 18.

Barclays estimates that Volkswagen stock’s underperformance compared with a basket of other consumer cyclical companies is equivalent to a four standard deviation event. However, the CDS move is a much more extreme 14 standard deviations. In a normal statistical distribution, a three standard deviation event has a 0.3 percent probability of occurring.

Perhaps CDS investors have a more bearish view on Volkswagen than equity markets. The current spread is consistent with a company rated BB, over three notches lower than Volkswagen’s A, according to Markit. Fitch however, reckons the financial cost of the scandal is unlikely to even cause a downgrade.

Instead, the move probably highlights how prone markets are to overshooting as tighter capital and leverage rules cause banks to scale back trading or even withdraw from the swap market. There may be ways round the problem, such as moving more trading to clearing houses, which may attract more investors and banks to the market. But right now, CDS look to be overstating the scale of even VW’s problems.


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