Yesterday, I looked at the gaps in the market implied ratings of bonds and credit default swaps on the Dow Industrials, focusing on the financials. For a more complete look at the state of non-equity markets for financial securities, I assembled a similar database for all components of the SPDR Financial ETF (XLF) that had a 1% or greater weighting. This totaled 24 companies, for a combined 70% of the index. Of those 24 companies, complete data was not available for three: Aflac (AFL), PNC, and Chicago Merc (CME).

As indicated in the chart below, the credit default swap (CDS) market consistently prices these stocks as being riskier, or lower-rated, than the bond market - which the CDS market is based off of. On average, the bond market is pricing these financials one full letter grade lower at -3.2, with the CDS market another bump-and-a-half down at a -4.7 gap. Further, as the chart indicates, the market does not believe that Moody’s (MCO) rating on any of these stocks is too low - not one company had a positive ratings gap on either its bond price or CDS price.

The winner for biggest combined negative ratings gap (basically, the company the market says is most overrated) is Wachovia (WB) at -16, with both the bond market and CDS market saying the bank isn’t even investment grade. Wachovia is closely followed by Morgan Stanley (MS) at -14, another company the market isn’t buying an investment grade rating of, and then a two-way tie for third place between Citigroup (C) and AIG at -12; the only implied non-investment grade rating there is the swaps on AIG. The only other company to get a non-investment grade implied rating is Merrill Lynch (MER); most others are stuck at some form of Baa for the CDS-implied.

A sign of broad market stress? I’d say so.

I think there are parallels to be drawn between the CDS market and the equity options market, specifically in terms of puts - after all, a CDS is basically a put on a bond. Numerous studies have noted that equity puts are consistently overpriced, as implied volatility is a few points higher than eventually realized volatility (the reason you should be short variance swaps). When you combine the current noted lack of liquidity in the CDS market with its use as a hedging derivative, I’ll venture that’s enough to modestly overprice contracts and allow for some economic value to be created by writing swaps.
All in all, this is another reason why I like Primus (PRS) and continue to circle the wagons around that position.

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