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Aid your stock analysis with CDS spread

, October 29, 2012, 0 Comments

Financial condition of any company is the fundamental driver of both equity valuation and credit spread. If financial condition of a company deteriorates, stock price should decline and credit spread should widen. To put it other way, if financial condition of a company improves, stock price should increase and credit spread should tighten.

This fundamental relationship between stock and credit gives us a reason to correlate the movement of stock price and CDS (to know more about the CDS, please refer  “CDS De-jargonized”)   from an investment perspective and find valuation anomalies or trading opportunities between these markets.

From Indian perspective, CDS of some frequent dollar bond issuers such as ICICI Bank, State Bank of India (SBI) and Reliance Industries Ltd (RIL) trades in Hong Kong credit market. We have examined the relationship between stock price and CDS of leading names ICICI Bank, SBI and RIL in the below charts.

 

We can see that both stock price and CDS move in tandem on broader level. However, this is not always true—relationship between stock price and CDS is not always linear (stock price up, CDS spreads tighter). There are times when movement of stock and CDS level diverges from each other. For example, let us have a look at Chart 2 (green circled area). Having said this, divergence is usually temporary as is evident in Chart 2.

We can use this kind of divergence to take trading position. For example, when SBI CDS level was tightening and stock price was still going up in May-June 2012, we could have taken short position on SBI stock or could have at least avoided going long on the same. As we see in Chart 2, both stock price and CDS started moving in tandem from late July 2012.

 

Sometimes stock price or CDS may be affected by some external factors other than company’s fundamental financial condition. Looking at all three charts, we find that CDS level moved considerably wider as compared to nominal decline or increase in stock price during May-June 2012.

We should note that May-June 2012 was the time when USD/INR exchange rate was at peak of 54+ and Indian market as a whole was being considered risky by international investor community. Spread widening in this case was largely due to India going out of favor by the international investors rather than significant deterioration in the company’s fundamentals.

Here we get a hint that these CDS levels, specifically ICICI 5Y CDS which is very liquid, may be used as an Indian credit index.






About author
Rajesh Ranjan is a Chartered Accountant with Post Graduate Diploma in Investment Analysis and MBA(finance) from Asian Institute of Management (AIM), Manila. He has around nine years of experience in the field of investment research (equity and fixed income) with leading financial services firm such UBS and Guggenheim Transparent Value. ...more