A shortage of buyers

Spreads in Asia’s credit default swaps markets have been squeezing tighter and tighter all year, a result of the overwhelming dominance of Asian investors looking to sell protection in return for premium. In Japan, spreads on the CJ 50, a multi-dealer index tracking the country’s 50 most liquid credits, have popped below 25 basis, and despite a small rebound in late-November, there doesn’t seem to be much chance of a significant widening out.

The challenge for dealers is that even at these cheap levels, few institutions are willing to buy protection, leading to a perennial one-way market. In Europe, the credit derivatives market really sprang into life once local banks utilised credit default swaps to hedge their portfolios. So, where are the buyers in a market like Japan?

In fact, some dealers point out that there has been some buying interest in Japan over the last few months, as some of the country’s banks look to re-balance their portfolios and free up economic capital. But it’s quite a slow process, and many dealers believe that it will be some time before credit derivatives are accepted as a legitimate risk management tool by the country’s domestic financial institutions.

For instance, despite falling to a record low of 24.41 on October 22, and despite reports of sporadic buying activity from Japanese banks, the CJ 50 had still only rebounded to 28.98bp by the end of November.

Underlying the lack of buying is a fundamental question of whether Japanese banks need to pay money to protect against default. There is a clear reluctance by the Japanese authorities to allow any large domestic firm to fail – a recent example being the government’s bail out of Resona Holdings, the country’s fifth largest financial group, in May. It seems banks can afford to put credit risk on the back burner and concentrate on market risk, certainly for the larger corporates on their loan books.

It’s all contributed to a difficult environment for dealers in Japan. A number of houses have pulled out, while tight spreads make it more difficult to structure arbitrage synthetic CDO transactions that make economic sense. Instead, some dealers have been exploring new products to create extra yield. Products such as CDOs of CDOs and equity/credit hybrids, for instance, are now being pitched to Japanese investors.

And until spreads widen in Japan, it looks like banks will have to think of more and more ingenious ways of enhancing yield. Until a default is allowed to occur without the government intervening, it’s unlikely there will be large scale buying by the country’s financial institutions.