GENEVA (HedgeWorld.com) - Conventional wisdom holds that AAA- rated securities are less risky than AA-rated securities. But that would not seem to be the case at present for credit default swaps on debt issued by financial firms.

In fact, a cursory glance at the CDS curve for an index of AAA- rated financials reveals first that the curve is inverted - the six- month curve for July 11 was at a historical high of 309.35 basis points, descending to a minimum of 196.26 basis points for the 15- year and then rising again to 202.24 for the 20-year and 217.31 for the 30-year. The data is provided by Markit, the developer of the iTraxx indexes.

Perceived short-term risk has been high and rising for financials ever since the wider investing community first became aware of the potentially contagious nature of the credit crisis, although it dropped sharply after the Federal Reserve-brokered bailout and subsequent sale to JP Morgan Chase & Co. of Bear Stearns in March. Since then, though, concern has focused on individual entities - Citigroup Inc., UBS AG, Lehman Brothers, Fannie Mae and Freddie Mac, to name but a few - pushing spreads on financial CDS baskets higher once more. It is therefore not surprising that the AAA financials CDS curve is downward sloping, although the inversion point at 15 years may seem surprisingly far out to some.

More surprising is what is happening with the AA basket. Contrary to the AAA index, the curve for the AA basket is an upward-sloping one, meaning that, as generally happens when all is well with the world and the economy, short-term risk is perceived as lower than long-term risk.

However, most mystifying of all, at least superficially, is the fact that the AA curve is below the AAA curve at every point between six months and 30 years.

On June 11, the AA six-month was priced at 83.91 basis points, and increased in reasonably steady increments up to 186.97 basis points for the 30-year. At the close of business Monday [July 14], the situation was similar, although values had reduced to some extent along both curves, with the biggest drop in AAA six-month CDS, now priced at 250.67 basis points. But on both days the AA curve, even at its highest point, never went beyond the lowest point - the 15-year on July 11 and the 10-year on July 14 - of the AAA curve. That indicates the market sees AAA-rated financials CDS as more risky than AA.

According to one credit investor who asked not to be named, the explanation for this was the larger and better capitalized banks with bigger balance sheets - in short those that enjoyed a AAA rating, at least until the credit crunch - who exposed their balance sheets to the highest-risk collateralized products when they loaded up with seemingly low-risk mortgage-backed securities and related instruments.