01 Dec 2004, Julian Evan, Credit
Pimco’s head of emerging market debt, Mohammad El-Erian, recently revealed one way Pimco has stayed within the top 10 performing EM managers for the last three years: selling protection via credit default swaps. In his latest emerging markets letter, El-Erian says one of the most profitable trades for his fund has involved selling protection, via credit default swaps (CDS), on bonds that don’t exist.
His colleague, Curtis Mewbourne, vice-president of emerging market portfolio management, explains, “A company or country may have no bonds maturing in the next year. However, for some reason, a bank or trader wants to buy one-year protection through a one-year CDS.” For example, a bank might have reached its credit limit with a client and wants to free up some short-term lending capabilities, or a trader may need a short-term hedge to meet his volatility-at-risk requirements.
Mewbourne says such players may be willing to pay as much as 100 basis points on a short-maturity CDS, even when the risk of the borrower defaulting is clearly very low, because it has no debt maturing that year. “It’s a market imperfection,” he says. “People are willing to pay an uneconomic amount because of regulatory or investor segmentation reasons.”
Pimco has been an active user of CDS for some time, both for hedging, relative-value trades and structural trades like the one described above. Its CDS portfolio is between $5 billion and $10 billion. The question is to what extent other fixed-income institutional investors are following Pimco’s lead.
Jonathan Bayliss, a quantitative strategist at JPMorgan, has been speaking to many investors in the process of compiling a survey on the use of CDS by the market. He says, “CDS are increasingly used by institutional investors. The reason is they’re a cheaper way to buy emerging market risk than bonds because of the way the market is segmented.” Currently there are not enough sellers of CDS protection because retail investors only want to buy cash bonds and many institutional investors are not yet set up to trade in CDS. “Those that can trade in CDS are able to get a good pickup over the bond,” says Bayliss.
Nick Sagna, a director on UBS’s CDS emerging market desk, says, “The spread between the CDS and the underlying bond on, say, the Turkey 15-year is 65bp. On the Russia 30 it’s 20bp. It used to be much higher: at one point last year the Turkey spread was 300bp.” In other words, investors prepared to take emerging market exposure by selling credit default swap protection instead of buying the bonds would earn more, sometimes 300bp more.
Some institutional investors don’t like CDS because for some emerging market names they are still less liquid than bonds—but that could change. The British Bankers’ Association estimates the market will grow from $3.5 trillion in 2003 to $5 trillion in 2004 to $8.2 trillion in 2006.
Goodbye to bonds?
According to an Emerging Market Trade Association survey published in May 2004, Karim Abdel-Motaal, global head of emerging markets research at Morgan Stanley, told the EMTA that he was “very confident credit derivative volumes will continue to increase and will eventually overtake bond volumes”. He added that within five years, “when one refers to the credit market, one will essentially be speaking of credit default swap curves.”
UBS’s Sagna thinks some institutional investors are already moving over to CDS. “Two or three years ago I visited a real-money account in Europe which was just starting to use CDS,” he says. “Then, it accounted for maybe 25% of his portfolio. I met him recently, and he’s stopped using bonds altogether.” Sagna says CDS are a much cleaner and more flexible way of buying emerging market risk than bonds.
The growing trend of investors trading in both bonds and CDS is illustrated by banks deciding to merge their bond and CDS desks, according to Sagna. He says, “JPMorgan and Bank of America have already merged their desks, and Deutsche Bank and UBS are about to.”
However, some institutional investors are still hampered from using CDS for regulatory reasons. Paul Pawelka, fund manager at Raiffeisen Asset Management, says, “It’s not clear if we’re allowed to use CDS by Austrian law. We’re in the process of getting authorization to buy them if we hold the underlying bond.” Pawelka says Raiffeisen will probably make its first CDS trades in the next few months, but it will begin in high-grade debt and only gradually move into emerging market debt.
Many market participants welcome the growth of credit derivatives as an effective way to diversify risk in the market. Rating agency Fitch contended in a report in September 2003 that credit derivatives were a “positive development for the global financial system”, while Federal Reserve chairman Alan Greenspan also said they had added to the resilience of the global market.
Some emerging market investors, however, remain unimpressed. Raphael Kassin, fund manager at ABN Amro Asset Management, says, “I hardly use them at all. Banks get a nice spread from peddling CDS products. I prefer cash.”
A report by former IMF researcher Romain Rancière also highlighted potential problems the growth of the CDS market could raise for emerging markets. Rancière noted that, unlike in the corporate sector, a degree of uncertainty exists in emerging markets about the recovery rate of defaulted debt, which has made pricing CDS difficult. He also suggested there might be moral hazard in banks buying protection on loans they had made to a sovereign. If the loans were big enough, the banks could decide whether to push it into default or not, based on their protection. “In this situation, banks which have bought protection are clearly on both sides of the trade,” said Rancière.
Some institutional investors are concerned that the growth of CDS-based products, particularly as used by hedge funds, has increased the volatility of emerging markets. They point to the increasing popularity of credit derivative indices, such as iTraxx and CDX, which are tailor-made to provide credit exposure to emerging markets. The next step, say market participants, is to launch exchange trading of futures on CDS indices as a means to further increase liquidity.
But even the more CDS-savvy investors wonder if such index-linked CDS help or hinder the market. Mewbourne at Pimco thinks they may have been one cause of the plunge in emerging market debt in April. He says, “There have certainly been some negatives [to the growth of the CDS market]. CDS-based index products, which create a basket of risk without differentiating between the credits in the basket, tend to turbo-charge the market both on the up and the down.”
Mewbourne also says, however, that the lack of credit differentiation inherent in such products leads to the mispricing of some credits, which creates attractive opportunities for more active investors.
But while institutional investors remain suspicious of the new trading techniques of hedge funds, the growth in the use of structured credit by both hedge funds, banks and now institutional investors underlines the extent to which trading plays once considered exotic are now used not just by hedge funds, but right across the market. Banks are behaving more and more like hedge funds through their large proprietary desks, and through the use of derivatives such as CDS to take large, risky positions.
Now, within emerging markets, the more sophisticated investors are following Pimco’s lead to use CDS and synthetic CDOs for relative value and what El-Erian describes as structural alpha trades—selling protection to people who need to buy it for regulatory reasons.
Pimco was also one of the first emerging market managers to launch a synthetic CDO of emerging market debt, which it did in 2002. Mewbourne says the company also uses FX and interest rate derivatives not just to hedge risk but also to take positions.
All this makes a recent statement by Pimco’s chief investment officer, Bill Gross, that Alan Greenspan is “clearly off-base” in his enthusiasm for derivatives a little incongruous. Gross claims the growth of derivatives through CDOs, CDS and other such structures portends “the likelihood of another LTCM debacle at some point”. However, his own fund is probably at the forefront of the use of derivatives by institutional investors. Perhaps other investors should do as Pimco does, rather than as its chief investment officer says.
|Emerging market CDOs back in fashion |
While the volume of CDOs has boomed over the last three years, emerging market CDOs made up a fraction of that volume. Katherine Frey, vice-president of CDO ratings at Moody’s, says, “Emerging market CDOs were more common before the Asian crisis. Surprisingly few have been launched since, considering the ones that are out there have on the whole performed very well.”
But, after a quiet 2003, emerging market CDOs may be coming back into fashion. A number of European fund managers, including Ashmore Investment and Fortis, are now preparing CDOs. Frey from Moody’s says, “It may be because previous CDOs are now in the amortization phase.” Neither Ashmore nor Fortis returned calls.
Some European fund managers launched CDOs earlier this year. Danish bank Sydbank, for example, launched a managed synthetic CDO in May, with a reference portfolio made up of 30 emerging market sovereigns. The real growth in EM synthetic CDO issuance, however, has been in Asia. Deutsche Bank offered a rare synthetic CDO in local currency out of Taiwan in September. The $2.6bn-equivalent CDO offered tranches in both US dollars and Taiwan dollars.
The deal was one of several billion-dollar synthetic CDOs launched out of Asia in the last two years. Others include UOB Asset Management’s $1.7bn transaction and a $1bn deal by the Agricultural Bank of China, both of which were launched in 2003.
The size of such deals has not sated investor appetite, however. Diane Lam, director of structured finance ratings at Standard & Poor’s, believes there is still “untapped potential in Asian markets for synthetic CDO transactions”.
The growth in Asian CDOs is being spurred by regulatory changes in several domestic Asian markets. For example, in May Taiwan’s insurance regulator ruled that local insurance companies could invest up to 5% of their assets in synthetic CDOs. Regulators in Thailand and the Philippines are considering passing similar measures.
The use of credit derivatives as a whole is also growing faster in Asia than anywhere else at the moment. The region accounts for 41% of all emerging market credit derivatives, according to the Emerging Market Trade Association, with South Korea alone accounting for 12% of total emerging market reported volume.
Why should managers consider launching synthetic CDOs? Curtis Mewbourne, vice-president of emerging market portfolio management at Pimco, which launched a synthetic emerging market CDO in 2002, says, “Synthetic CDOs allow some types of investors to access emerging markets who wouldn’t be able to otherwise, such as banks and insurance companies.” CDOs can be structured so as to provide investment-grade exposure to emerging market debt.
Frey of Moody’s also believes synthetic CDOs are easier to structure than cash CDOs. However, she says some managers prefer to use cash structures because it increases the volume of assets they have under management.
Some investors are wary of synthetic CDOs because of the perceived opacity of risk in their structures. One German investor, HSH Nordbank, is suing Barclays Capital over $151m it invested in two synthetic CDOs which performed badly after launch. HSH Nordbank’s claims against Barclays Bank are partly made in connection with the accuracy of pricing information it received. However, emerging market CDOs have performed better than high-yield CDOs. Frey says, “They’ve been fairly stable in terms of ratings migrations, unlike high-yield CDOs.”
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