Emerging market credit derivatives are experiencing a resurgence after

turbulent times. Current activity is led by sovereign names and

investors looking for yield pick-up, but corporate names and liability

management are in the wings. Natasha de Teran reports.

Emerging market investors are a valiant bunch. To the casual observer

it seems that no sooner do they begin to enjoy a period of sustained

heady returns than there is a blow-up. Yet time after time they return,

providing a vital source of funding for cash-strapped economies and

tidy returns for themselves.

In the aftermath of the 1998 crisis, however, it seemed that investors

and banks had decided to retreat from these turbulent markets forever.

But, true to form, many have since gone back – and with good reason:

returns have soared. JP Morgan’s Emerging Markets Bond Index Plus was

up 24% in the period from January 1 to November 7. According to

Massachusetts-based Emerging Portfolio, which tracks fund inflows from

its universe of 5000 international funds, dedicated EM bond funds have

drawn in a record amount this year. Almost $3bn of new assets were

invested in dedicated bond funds in the nine months ending September

29, adding 29% to beginning-of-year assets.

The approach is a little different this time round, though; on

returning to the emerging markets, both banks and investors have

equipped themselves with a far wider armoury of hedging tools –

assuaging some of the concerns of their risk management departments.

The strong interest in EM bonds has not come alone: credit derivatives

(CDs) have also begun to take off strongly this year. In May, the

Emerging Market Trader’s Association (EMTA) published its first report

on EM CD activity, which revealed that volumes had reached $23bn during

the first quarter. Growth during the second quarter was even stronger,

when the market more than doubled in size, to reach $49bn.

Deutsche Bank

The biggest player in the EM CD market is believed to be Deutsche Bank.

The bank claims to have been counterparty to 33% of the entire

interdealer EM default swap market during the first nine months of this

year – accounting for $7.8bn out of the $23bn that was traded in that

market. In addition, the bank has transacted another $22bn notional of

CDs with clients. According to Colin Fan, global head of emerging

market credit derivatives at Deutsche, overall there is a 80:20 split

between external and local players in the

EM CD market. He puts down the predominance of external counterparties

to problems of counterparty credit exposure when dealing with local EM

counterparties.

Ten-fold increase

Mr Fan attributes much of the growth of the EM CD market to the

structured product side of the business, which has increased 10-fold

over the last two years. This year, he says the bulk of activity has

come from hedge funds and other investors looking for yield pick-up,

rather than hedging. However, now that spreads have become increasingly

tight, investors and other users have begun to look at EM credit

derivatives from the liability side. Mr Fan says: “The next stage will

come from the accelerated growth in hedging tactics and strategy.”

Despite the rapid growth of the CD market and the bullish performance

of emerging equities, the bulk of protection is still written on

sovereign, not corporate, names.

According to Sean Bates, head of Latin America integrated credit

trading at Deutsche Bank in New York, the liquid credits in the

interdealer EM CD market tend to be the major sovereign and some

quasi-sovereign names. He says that this is because most of the liquid

tradeable EM debt is still in the form of bond issues of these

entities.

Even so, investors can still hedge corporate exposures. Adam Jones, the

London head of emerging market credit derivatives trading at Goldman

Sachs, says that instead of using the illiquid corporate CD market,

many investors and banks will hedge their exposure by buying protection

on the sovereign, and carrying the basis.

Regional differences

However, things vary from region to region. According to Mr Jones, in

eastern Europe, less than 5% of the interdealer market is in corporate

names, whereas in Latin America, where there are a lot of

quasi-sovereign entities, the corporate market accounts for 5%-10% of

volumes.

Michele Maffei, head of European Middle Eastern and African (EMEA)

emerging markets structuring and product management at JP Morgan, says

that within the EMEA region, South Africa has one of most liquid and

transparent CD markets, along with Poland, Turkey and Russia, but that

Russia is the most liquid. “The Russian CDS market is traded entirely

offshore and has very diverse involvement with lots of prop accounts,

mutual funds, real money investors and hedge funds involved on both

sides. This wide involvement has encouraged the market’s liquidity, and

brought spreads right in,” he says.

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Michele Maffei: wide involvement has encouraged the market’s liquidity

Adding to Russia’s attractions, corporate CDs are beginning to gain

traction locally. The Russian corporate external debt market, which has

until now been a fraction of the size of the sovereign, has seen

issuance pick up, as the natural resource sector has begun to tap the

debt markets. Mr Maffei says that issuers such as Gazprom, TNK and

Sibneft are now beginning to get quoted in the CD market as well.

Over the next couple of years Mr Maffei expects to see dramatic growth

in Russian business. Russia is slowly converging into a G10 framework,

which has been encouraging investors to move into the sovereign. Once

the sovereign spreads compress, he says, investors will move into

quasi-sovereign exposure, and then eventually into the corporate market.

In comparison to Russia, the Polish market is deemed much less

interesting, by both banks and investors, being both less liquid and

less volatile. Again, 98% of business is in the sovereign, with very

little in the corporate names.

Elsewhere in the EMEA region, JP Morgan sees a small amount of activity

in Egypt, Tunisia, and Morocco. Although there are now just a handful

of trades going on in these countries, the bank expects the market to

develop further, as investors are now looking to build up portfolios

with these credits in them. Mr Maffei says this interest is coming from

real money investors who are looking for diversification.

Latin America

One of the more volatile markets in recent years has been the Latin

American market, where only a handful of entities are truly active.

The Latin American CD market is more diverse than many others in the

emerging markets, owing to the plethora of quasi-sovereign issuers. But

according to Mr Bates, corporate credit risk in Latin America exists

primarily in the form of bank loans and OTC counterparty credit

exposures. He says that banks with exposure in the region are now

beginning to manage the risk in their loan books by buying protection

on specific borrowers or on highly correlated sovereign names. Since

default protection spreads typically exceed lending margins, banks

often defray the cost of this strategy by using part of a credit line

to sell protection on other names.

“OTC derivative desks are also beginning to use CDs to dynamically

manage high-risk counterparty exposures arising from movements in

interest rates or FX. We have recently seen a surge in growth of this

sort of activity, both from the larger international banks as well as

some locals,” says Mr Bates.

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Sean Bates: liquid credits in the interdealer EM CD market tend to be the major sovereign and some quasi-sovereign names

Rewards for commitment

Trading EM CDs certainly demands commitment on the side of banks. As

well as a raft of traders and sales people to service the effort, banks

need solid infrastructure to assure sound risk management. But for

those who have made the investment, the rewards pay off.

Because the scale of Deutsche’s activity in the region has enabled it

to identify and access both assets and investors, the bank is able to

conduct a good proportion of its business in the less liquid corporate

names. Mr Bates says: “To trade corporate protection demands a lot of

dexterity. You need to know where to source protection and where to buy

attractive risk in various forms. What has benefited our operation is

our concept of integrated credit trading – having all credit businesses

together on the same desk enables us to find opportunities across many

forms and packagings of the same risk.”

One notable development in the region, which bodes well for the future

development of the market, is the growing awareness of the CD market

among locals. Mr Bates says that despite the lack of liquidity in the

corporate CD market, many corporates in Latin America are very aware of

CD pricing and closely follow where the CDs referencing their name are

trading relative to their borrowing rates. If the trend continues, and

spreads elsewhere, it may not be long before the corporates, too, begin

to enter the market.

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