Some arbitrageurs are taking advantage of an inversion in the credit-default-swap curve for U.S. banks in a bet that they can make a profit and remain hedged against any debt defaults.
Typically, the cost of credit-default swaps over one year is cheaper than over five years, creating a steepness in the CDS curve. But in times of distress, as is currently the case, that curve can invert, pushing CDS spreads wider in the short end.
CDS are insurance-like contracts for the debt market. The swaps pay protection buyers face value if a borrower fails to meet its obligations, less the value of the defaulted bonds.
Derivatives traders have been selling CDS going out one to three years, while buying the coverage over longer maturities, ranging from five to 10 years.
They are betting that mounting pressures on U.S. banks will ultimately ease in the longer term when market volatility dies down and that spreads will normalize.
Near term, many are looking to remain hedged amid continued concerns about the financial health of the banking sector, although some are simply selling short-term protection outright to pick up juicy premiums.
One-year CDS on Bank of America Corp. reached 460 basis points Wednesday, while five-year spreads widened less, to 385 basis points - still close to the record five-year close of 390 basis points in March 2009, according to Markit data. A move of one basis point translates to $1,000 in the annual cost of protecting $10 million of the underlying bonds.
Bank of America's "market value is out of sync with its book value," one CDS trader said. "But our takeaway it that it'll come back into balance."
The bank has been under intense pressure in recent weeks as investors have been concerned about its capital levels.
Bank of America's shares rebounded Wednesday after a number of analysts said they felt the sell-off has been overdone.
