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.
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.
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.