Compressing Asian spreads

A chronic shortage of protection buyers in Asia has squeezed CDS spreads tighter and tighter over the year. And despite falling to historically tight levels, domestic banks – typically among the largest buyers of credit protection in Europe – are still not using credit derivatives to hedge their portfolios. Nick Sawyer reports

Studying charts of Asia’s credit default swaps markets these days is like looking at sketches of the Himalayas, with precipitous drops that would make even the most hardy of climbers break into a cold sweat. Indeed, over the course of the year, credit spreads across Asia-Pacific have trod an almost uninterrupted path downwards, with an overwhelming preponderance of protection sellers looking for yield squeezing spreads tighter on an almost week-by-week basis.

With a chronic shortage of institutions looking to buy protection, Asia’s CDS markets have been driven by technical factors of supply and demand, rather than responding to the perceived risks in specific underlying names. And no-where is this more the case than Japan. “Whether it’s good or bad news in Japan, spreads seem to tighten,” says Ralph Orciuoli, managing director and head of credit trading at Bear Stearns in Tokyo. “It’s a technically driven market.”

The CJ 50, a multi-dealer index comprising the 50 most liquid credits in Japan, began the year at around 67 basis points, but by late November was trading at 28.98bp, a compression of around 60%. More interesting, however, is the absence of any major corrections, emphasising the thirst for structured credit products by Japanese investors. Between June 4 and September 24, the index did not experience a single bounce, tightening in from 44.94bp to 31.04bp. When the correction did come on October 1, the move was a mere 0.33bp.

While not on the same scale, the Asia ex-Japan credit markets have also been steadily tightening, with Trac-x Asia, an index created by JP Morgan Chase and Morgan Stanley that tracks the 25 most liquid Asian credits, tightening in from an indicative spread of 134.90bp at the start of the year to 74.48bp in late-November.

Even with spreads so tight, returns on credit derivatives are still higher than the rates that can be observed in the cash bond market, meaning there’s a steady demand for structured credit products, pressuring spreads ever tighter. The recent record tight spreads in Japan, however, have meant that CDO structuring has slowed in the past few months. “The business will still happen, albeit at a slower pace, and it will be driven by people willing to take senior risk at pretty tight levels and people that are willing to buy the equity at reasonable levels, because as a dealer, the spreads are so tight that you really need to be able to get rid of those two risks to run the book,” says Jawahar Chirimar, senior vice-president and head of credit trading at Lehman Brothers in Tokyo.

Exacerbating this imbalance between buyers and sellers has been the retreat of hedge funds from the market, particularly in Japan. As the predominant buyers of protection in the CDS market, many were hit hard as spreads continued to compress tighter in the second half of the year. “Hedge funds got involved, had mixed results and left,” says Lee Knight, managing director, global credit derivatives trading, Asia-Pacific, at UBS in Tokyo. “And now the market has really adopted the underlying characteristics of the bond market – low turnover ratios, illiquidity and technical trading.”

“Everybody got hurt – dealers and hedge funds,” adds another trader at a US bank in Tokyo. “And now the Japanese economy seems to be improving, less people are bearish and there’s even less reason to buy protection.” The question is, how can the market address this imbalance between buyers and sellers? In markets such as Europe and the US, the CDS market really took off once domestic banks began using credit derivatives to hedge the credit risk of loans on their balance sheets. In Asia-Pacific, however, this dynamic has yet to emerge, and many dealers suggest that it is unlikely to do so in the immediate future. One of the reasons is the lack of liquid names trading in the CDS market.

While there are around 75 names trading in the Asia ex-Japan CDS market, for instance, only a handful of these can be categorised as liquid. These tend to be the high-rated, well-known Asian corporates and sovereigns with outstanding US dollar-denominated cash bonds, such as Hong Kong’s Hutchison Whampoa, the Republic of Korea, Malaysia, and the Philippines. These are exactly the sort of names that Asia’s banks want to get exposure to. In fact, with a huge pool of surplus liquidity at the fingertips of Asia’s banks and a shortage of primary bond issuance in the cash market, domestic banks are more likely to be sellers of protection to achieve a synthetic exposure to these credits rather than hedge.

The names that local banks would potentially hedge – Asia’s myriad small and medium sized enterprises (SMEs) – aren’t quoted in the CDS market. “If you look at what is being traded in the CDS market, it tends to be high-grade names with liquid underlying bonds,” says Feng Gao, head of integrated credit trading at Deutsche Bank in Singapore. “So there is a disconnect there. I’m sure the banks would love to buy protection on local SMEs on a portfolio basis, but these are not traded. I think that’s the fundamental difference from Europe. If you look at the names that are traded in Asia, these are exactly the assets that banks love and want to get hold of.”

In addition, the CDS market in Asia ex-Japan is denominated in US dollars, creating problems for any domestic banks that may consider hedging. There has, however, been a drive by some Asian markets to open up local credit derivatives markets over the past 18 months. Taiwan’s regulator, for instance, has awarded local currency credit derivatives licences to a handful of foreign banks, allowing credit default swaps trading and credit-linked deposits; while in May, the Bank of Thailand published guidelines allowing local commercial banks to buy and sell credit default swaps to hedge their risk.

However, the local credit derivatives markets are likely to be stymied by concerns about counterparty risk – many local banks have relatively low ratings on an international scale, meaning many foreign dealers may not have the credit appetite to buy or sell protection on or to local institutions. There is also correlation risk when, for instance, buying or selling protection to a Taiwanese bank on a Taiwanese corporate in Taiwan dollars. “Banks will first need to manage the counterparty correlation risk as they buy protection from local banks on local corporates,” explains Medes Ma, director, fixed-income and head of credit trading, Asia, at Crédit Agricole Indosuez in Hong Kong. “Local banks in Asia show interest in exposure in mainly local corporates that they know the best.”

This has meant that those financial institutions licensed to trade local currency credit derivatives have so far concentrated primarily on funded investment products such as credit-linked deposits, where the investors’ funds are paid in advance. “At the moment, activity in local credit derivatives market is all to facilitate structured products,” says Tony Au, director, structured products, Asia, at Crédit Lyonnais in Hong Kong.

At the same time, while Japan’s CDS market is denominated in yen, is more liquid and has more names trading than the rest of Asia, dealers point out that there is little motivation for local banks to actually hedge credit risk at all. With a seeming implicit guarantee from the government to rescue failed firms, defaults are few and far between. The most recent example is the government’s ¥1.96 trillion bail out package for Resona Holdings, the country’s fifth largest banking group, in May. “The most significant event of the past year was the government’s bail out of Resona. Effectively, credit risk has been nationalised,” comments UBS’s Knight.

Nonetheless, there has been some buying activity by Japanese financial institutions over the past year – most notably in the approach to the 2002 fiscal year-end in March, when several of the country’s largest banks issued synthetic balance sheet collateralised loan obligations referenced to their corporate loan books. However, this was very much motivated by regulatory capital requirements – following a drop in the Nikkei 225 stock index to 20-year lows, the banks were scrambling to maintain their capital ratios above the internationally recommended 8% level.

But with spreads so tight in Japan, reducing the basis between cash bonds and CDS, some dealers report that a handful of Japanese banks are now taking the opportunity to buy cheap protection to re-balance their portfolios. “There is a growing need for concentration risk management and capital management solutions among the country’s regional banks,” says James Mudie, general manager, markets division, at Shinsei Bank in Tokyo. “There’s always been a massive gap between where banks would actually originate loans and where hedge funds were prepared to bid for protection. Given the fact that CDS spreads have been at historically tight levels, the market is finally coming in line with the cash market, so banks are more prepared to use credit derivatives as a risk management tool, although this is in the very early stages.”

The launch of credit indexes in Asia-Pacific could make this dynamic more pronounced. With 1 basis point bid/offer spreads, the indexes offer a cost-efficient means of hedging or gaining exposure to a diversified basket of credits. And with spreads so tight, a number of Japanese banks are now looking at using indexes for hedging purposes, says Go Yajima, senior structurer in the credit derivatives department at BNP Paribas in Tokyo. “One of the biggest developments is that we are seeing Japanese final investors using the CJ 50 to hedge their portfolio, and we have a couple of clients that are studying how we could adjust the CJ 50 to fit their needs,” he says.

In fact, market participants point to the launch of indexes across the region as a potential means of generating greater trading liquidity in the CDS market in Asia. “I think [the indexes] will encourage more trading activity, such as trading the index versus CDS spreads,” says Ma of Crédit Agricole Indosuez. “So I think you’ll see more activity on the index, and when you see other derivatives referenced to the index launched, such as options and index-linked notes, then hopefully we’ll see more turnover in CDS.”

So far, only a handful of credit-linked notes and FTDs referenced to the CJ 50 Index have emerged in Japan. Both JP Morgan Chase and Morgan Stanley, however, are looking to launch funded product referenced to Trac-x. “We don’t have a funded note [referenced to Trac-x Asia or Trac-x Australia] out yet,” says Richard Cohen, vice president at Morgan Stanley in Hong Kong. “But a lot of institutions can’t do credit default swaps yet, so I think the funded note would change the nature of the market and there should be quite a bit of trading interest.”

It’s also possible that these index products could be listed on the region’s stock exchanges in a bid to encourage greater trading liquidity, adds Amy Li, vice-president, Asia index and portfolio research at JP Morgan Chase in Hong Kong. “Currently, none of the Trac-x products are listed on stock exchanges. Having said that, to help further improve the liquidity of Trac-x, JP Morgan Chase and Morgan Stanley have selected Dow Jones Indexes to lead the future development of Trac-x. This more open architecture will enhance transparency of the product and ultimately work to the benefits of investors.”

Meanwhile, first-to-default on baskets of Asian and Japanese CDS have emerged in the broker market in Asia – a development that many dealers welcome as an important step to enable them to hedge correlation books and encourage greater trading volumes (see box).

But despite these developments, trading activity for the time being remains mostly one-way. Market participants point out that until there is greater primary issuance in the bond market, an expansion in the number of names available to trade, or unless there is a default somewhere in the region, spreads are likely to remain tight. “Spreads will tighten in a bit, then whether it’s Japanese banks or other dealers who are long taking profits, will step in. Then spreads widen out. If they widen out 5–10 basis points, at that point, the CDO machine starts cranking up again, people start whacking out a couple of big deals, and then spreads tighten back in,” comments one dealer at a European institution in Tokyo. “The implication is that there’s not a tremendous amount of trading opportunities, but I think that’s the reality right now.”

Structured products emerge in interdealer market The emergence of structured credit products in Asia’s interbank market could encourage greater liquidity in Asia’s credit derivatives market, say dealers. Over the past few months, two-way prices on Asian first-to-default baskets have appeared on broker screens, while some traders reckon that CDS options on Asian names will also emerge. “The theme the market is moving to is that the juice has been taken out of the single name default swaps market in terms of the yield that you can achieve,” says one dealer, who asked not to be named. “So now we are slowly getting more structured, in the same way that interest rate products became more structured in the late-1980s and 1990s.” The emergence of two-way prices on first-to-defaults (FTDs) will improve transparency in the Asian credit markets, and provide an observable market price from a compliance and accounting perspective, say bankers. Most importantly, it provides an avenue for dealers to hedge their correlation positions and free up credit limits. “This is an exciting development and for the first time allows dealers to hedge their correlation,” says Ralph Orciuoli, managing director and head of credit trading at Bear Stearns in Tokyo. First-to-default baskets referenced to Japanese and Asian names – particularly baskets comprising five or six Korean credits – have been quoted in the interbank market, while FTDs on the CJ 50, a multi-dealer index tracking Japan’s 50 most liquid credit default swaps, have also emerged. In fact, dealers expect two-way prices on more products referenced to the region’s credit indexes – the CJ 50, developed by BNP Paribas, and Trac-x Asia, Australia and Japan, developed by JP Morgan Chase and Morgan Stanley – to materialise. Indeed, in the US and Europe, two-way prices on FTDs and tranched products referenced to Trac-x and iBoxx – a credit index develop by a consortium of 11 dealers – have emerged in the interbank market. Tranched products are effectively single tranche synthetic CDOs, where a bid and offer is quoted for a particular part of the capital structure - for example, the first 0-3%. These have not yet emerged in Asia, although some dealers and brokers expect to see quotes in the broker market in the near future. Others, however, point out that tight spreads in the Asian credit markets makes it difficult to structure tranched products, particularly in Japan and Australia. “We have been asked by an increasing number of investors to study the tranched products, a Japanese CDO based on the CJ50, but it has not been issued yet,” says Go Yajima, senior structurer in the credit derivatives department at BNP Paribas in Tokyo. “The interest we see includes the lower tranche, such as the BB tranche or junior mezzanine.” In addition, the correlation of the underlying names and the small number of credits that comprise the index, particularly in the Asia ex-Japan index, means that tranched products are likely to be a challenge. “I think in Asia, the natural development will be the funded version. The tranched product will probably take a lot longer. Right now, we’ve only got 25 names in the basket, so it would be too much of a stretch if we are [to narrow] it down further,” says Amy Li, vice-president, Asia index and portfolio research at JP Morgan Chase in Hong Kong. Meanwhile, a two-way market in CDS options could also emerge in the interbank market, with one or two brokers building up structured credit desks in Asia in preparation. However, many dealers are sceptical as to how successful CDS options will be pointing out it will most likely be illiquid in the early stages, with many dealers reluctant to show their prices to the street. “There has been a lot of hype, but pricing variation from different houses may continue to deter participants for some time,” says Tony Au, director, structured products, Asia, at Crédit Lyonnais in Hong Kong.“There has been a lot of hype, but pricing variation from different houses may continue to deter participants for some time,” says Tony Au, director, structured products, Asia, at Crédit Lyonnais in Hong Kong.