Credit default swaps are essentially insurance contracts where buyers are paid out if a bond issuer defaults. These contracts are analogous to a house insurance: an insurance company will pay an owner of an insured house which has been destroyed by fire. CDSs became notorious through the GFC: some saw them as a prime cause of the turmoil as the risk was priced too cheaply; some, such as ex-Goldman Sachs trader John Paulson, bought them to make millions betting the bonds of certain US issuers would default. Sellers of CDSs collect the ‘insurance’ premium betting the company won’t default on its bond obligations.
In August ,YieldReport published an article referring to the spike in the Australian iTraxx index, which is an index of a basket of Australian CDSs and a proxy for an increase or decrease in the risk of corporate default. Being an index, iTraxx averages a basket of insurance premiums of well-known corporate borrowers but naturally within that basket there can be some large moves either way.
Wesfarmers and Woolworths are both large retailers and while they each own some different types of businesses, the bulk of their sales and profits come from groceries. So both bond and share markets treat their issued securities in a manner which is similar. Recently we have seen a difference emerge in the cost of insuring the two companies against a bond default. Historically, the cost of each company’s CDSs has been similar with movements up or down almost in tandem. iTraxx in general has been moving up so it’s no surprise the prices of Woolworths and Wesfarmers CDSs have been too. However, a quick comparison of the two over the last few months reveals a widening gap. Wesfarmers’ CDSs have moved from the around 50bps at the start of 2015 to a present price of 80bps. That is, the cost of insuring against a bond default is 80bps of the face value per annum. Woolworths on the other hand is now around 100bps. Participants in the CDS market are now clearly distinguishing between the two retailers suggesting there an increased credit risk around the Woolworths franchise.
It would seem the market believes the current strategy of Wesfarmers and Coles is superior to that of Woolworths. Woolworths has recently seen its CEO resign and its chairman step aside. Woolworths has racked up huge losses in its push to establish the Masters hardware division in order to compete with Wesfarmers’ Bunnings. There appears to be no end in sight to the losses and with new management in place the market is seeing this as increasing the risk of Woolworths’ debt.