Quantitative Analysis 

Special Report 
Greek Bailout: Containment or
Contagion? 
Reading CDS and Bond Market Signals 

Authors 
Thomas Aubrey
Introduction 
Managing Director As the details of Greece’s EUR45bn rescue package are fleshed out between the
+44 20 7682 7226
thomas.aubrey@fitchsolutions.com International Monetary Fund (IMF), the European Union (EU) and the Greek
government, European government bond markets remain volatile. A comparison of
Damiano Brigo
Managing Director
the credit default swap (CDS) full‐term structures of Portugal and Greece shows
+44 20 7682 7268 that both curves have widened significantly over the last three months and indeed
damiano.brigo@fitchratings.com both curves have inverted. The inversion implies a higher probability of default in
the near term than in the medium term, which generally happens only during
periods of severe stress.

Chart 1: Inversion of Portugal and Greece CDS Term Structures

Greece 22/1/2010 Greece 23/4/2010
Portugal 22/1/2010 Portugal 23/4/2010
1,000

800

600

400

200

0
6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y 15Y 20Y 30Y
Source: Fitch Solutions

However, an important question remains: would any such bailout contain the recent
widening of CDS spreads and bond yields across European debt markets or are the
European debt markets on the cusp of a broader financial contagion? To help shed
some light on this question, Fitch Solutions has analysed recent trends in the CDS
market. 

Euro/USD Exchange Rate 
Although CDS spreads on European government bonds have widened across the
board, including those on Germany and France, this information alone does not
necessarily indicate that a Greek bailout would contain recent market concerns.
One approach to understanding the extent of concern over the broader impact on
the euro zone is to look at the difference between the euro and US dollar CDS
spreads on Germany — the anchor economy of the euro zone.
The relative percentage of the euro to US dollar quotes implies under certain
simplifying assumptions the market‐implied FX devaluation jump of the US
dollar/euro FX rate in the event of a default. This indicates the incremental
amount of euros needed to buy US dollars following a potential default. This
devaluation jump is derived from the USD and euro CDS quotes on Germany and is
illustrated in the Implied FX Devaluation Jump chart. The chart highlights that the
CDS market is increasingly concerned about the prospects of the euro, with the
jump still on an upward trend, meaning that increasingly more euros are needed to
pay protection taken out on US dollars in the possibility of a default. 

www.fitchsolutions.com  26 April 2010 
 Quantitative Analysis
Chart 2. Implied FX Devaluation Jump
(%) FX Devaluation Jump 10 per. Mov. Avg. (FX D evaluation Jump)
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
01 Jan 10 12 Jan 10 23 Jan 10 03 Feb 10 14 Feb 10 25 Feb 10 08 Mar 10 19 Mar 10 30 Mar 10 10 Apr 10 21 Apr 10

Source: Fitch Solutions

Indeed, the percentage difference between the euro and US dollar CDS spreads on
Germany increased from 7% on 1 January 2010 to 29% on 23 April. This means the
value of protection in euros is now 29% lower than in USD due to concerns about a
possible fall in the value of the euro. In essence, the CDS market clearly perceives
that the bailout is unlikely to contain the funding crisis to Greece, but is
anticipated to impact all euro zone economies due to concerns around the value of
the euro. 

Higher Yields to Come? 

Analysis of the CDS market shows relatively clearly where the concerns lie. As of 23
April, five‐year CDS spreads on Italy, Spain and Portugal all remained at relatively
wide levels, trading at 138 basis points (bp), 175bp and 276bp respectively.
Moreover, there remains a significant positive basis between their bond yields
relative to the Bund and higher CDS spreads. Italy, Spain and Portugal are all
trading with a positive basis of between 77bp and 81bp.
As Fitch Solutions highlighted in its “Fitch Solutions: Corporate Versus Sovereign
Debt Risks — Reading CDS and Bond Market Signals” Special Report (dated 5
February 2010 and available at www.fitchratings.com), there are valid reasons why
the CDS and bond markets price assets differently. A positive basis of over 75bp
between the CDS spread and the underlying bond yield over the risk‐free rate is
unusual. Fitch Solutions estimates that just under a third of the basis between the
CDS spread and bond yield over the risk‐free rate can be explained by the euro/US
dollar currency effect. In terms of liquidity risk, the liquidity premium is minimal,
as shown in Table 1. Spain, Portugal and Italy are three of the top four most‐liquid
European developed market entities. The rest of the basis is largely explained by
the fact that CDS investors believe that yields are likely to increase for these
countries.

Chart 3. Italy, Spain and Portugal USD Yield Basis

Spain 5Y CDS Bond basis Italy 5Y CDS Bond basis Portugal 5Y CDS Bond basis

100
90
80
70
60
50
40
30
20
10
0
01 Jan 10 12 Jan 10 23 Jan 10 03 Feb 10 14 Feb 10 25 Feb 10 08 Mar 10 19 Mar 10 30 Mar 10 10 Apr 10 21 Apr 10
Source: Fitch Solutions, datastream

Greek Bailout: Containment or Contagion?

April 2010  2 
 Quantitative Analysis

Table 1: Liquidity Scores of Developed Market Sovereign Names

Entity Liquidity Score Global Percentile Rank
Spain 7.38 6
Italy 7.42 7
Austria 7.50 9
France 7.62 12
Portugal 7.72 15
Belgium 8.03 22
Ireland 8.08 24
Greece 8.15 26
Germany 8.24 28
Sweden 8.40 32
UK 8.76 41
Source: Fitch Solutions 

The Impact on the UK 

So what impact does the euro zone crisis appear to be having on the UK? Further,
has the prospect of a hung parliament in the forthcoming UK general election led to
an increase in perceived risk within the CDS market?
Firstly, the CDS bond basis on the UK has fallen dramatically since 1 January from
36bp to par on 23 April — ie, there is no basis between the bond yield over the Bund
and the CDS spread. This means that CDS investors believe that the current yields
which the UK can obtain in the market are where the CDS market expects them to
be. UK five‐year yields over the Bund did close higher on 23 April at 0.73% up from
0.63% on Monday 19 April. In the “Fitch Solutions: Corporate Versus Sovereign Debt
Risks — Reading CDS and Bond Market Signals” report, Fitch Solutions correctly
predicted that once the Bank of England halted quantitative easing in the first week
of February, bond yields would rise and CDS spreads would fall. Intervention in the
bond market created a great deal of uncertainty in the CDS market throughout 2009
and January 2010.
One other factor which shows the CDS markets’ view that current yields are not
expected to rise significantly is the lower level of liquidity of the UK sovereign CDS.
Table one shows that the UK is one of the least liquid European sovereign CDS
trading in the 41st percentile. An increase in liquidity would indicate increasing
signs of uncertainty over yield levels.

Chart 4. UK USD CDS vs UK Bond Yield

UK 5Y CDS USD UK 5 Year Bond Yield over Bund
(bps)
100 1.0
90 0.9
80 0.8
70 0.7
60 0.6
50 0.5
40 0.4
30 0.3
01 Jan 10 12 Jan 10 23 Jan 10 03 Feb 10 14 Feb 10 25 Feb 10 08 Mar 10 19 Mar 10 30 Mar 10 10 Apr 10 21 Apr 10

Source: Fitch Solutions, datastream

Secondly, although the UK still trades wider than France and Germany at 72bp —
compared with 65bp for France and 43bp for Germany — the difference between
the spreads has narrowed considerably. On 1 January, the UK was trading at 80bp
with France and Germany significantly lower at 32 bp and 27 bp respectively. Not
only does the CDS market believe default risk for the UK has fallen since the
beginning of 2010, but that relative to France and Germany risk has significantly
improved.

Greek Bailout: Containment or Contagion?

April 2010  3 
 Quantitative Analysis
Chart 5. UK, France, Germany USD CDS

France 5Y CDS USD UK 5Y CDS USD Germany 5Y CDS USD

100

80

60

40

20
01 Jan 10 12 Jan 10 23 Jan 10 03 Feb 10 14 Feb 10 25 Feb 10 08 Mar 10 19 Mar 10 30 Mar 10 10 Apr 10 21 Apr 10

Source: Fitch Solutions 

Conclusion 
The analysis highlights that the CDS market does not believe that the forthcoming
bailout of Greece will contain current concerns surrounding euro zone government
debt financing. Indeed, the widening differential between the US dollar and the
euro curves, as well as the widening spread levels, indicate that there are still
concerns about the euro zone across the board. This suggests that the CDS market
perceives this is a broader euro zone issue and not just a matter for Greece.
Conversely, the CDS market does not currently expect the financial contagion to
spread beyond the euro zone. The recent narrowing of UK spreads relative to
France and Germany shows this to be the case. Furthermore, the fact that the UK is
in the throes of a general election, which could result in a hung parliament,
suggests that the CDS market does not expect this possible outcome to increase risk
and the cost of funding for the UK as some commentators have argued.

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Greek Bailout: Containment or Contagion?

April 2010  4