Structured credit blossoms

The credit default swap market in Japan is being supported by a surge of interest in structured credit rather than any rise in corporate bond issuance. Laurence Neville reports on the unusual trajectory of development in the Japanese credit markets


While Japan's business community is helping to bid sayonara to 15 years of recession by adopting a more outward-looking, internationalised attitude, its domestic debt market remains steadfastly parochial. Few foreign issuers outside the sovereign and banking markets go to the expense and hassle of trying to attract Japanese investors with Samurai bonds - foreign debt sold in Japan.

The main barriers to foreign issuance are culture and language. The practicalities of registering to issue bonds in Japan - and the requirement to translate prospectuses into Japanese - limit foreign issuers' interest in tapping Japanese demand to a handful of global mega-issuers such as Ford and General Electric. In addition, the tax regime for issuers is considered largely unfavourable.

"Theoretically Japan should be a great market for international issuers," says Stephen Apted, head of debt syndicate at Daiwa SMBC Europe in London. "Once there was an active Samurai bond market and there could well be opportunities for international issuance in the future. But at the moment, the logistical hurdles of issuing in the country, combined with tight swap spreads, make yen borrowing unattractive."

Japanese investor demand is also extremely conservative. "Many Japanese investors, especially retail investors, have been burned over the past decade when they've tried to diversify into, for example, US Treasuries and Australian dollar issues," says Edward Thomas, credit trader at Nomura in London. "Necessarily it's put them off further forays into foreign bonds."

Equity holdings

Another limitation is that domestic institutional clients - the very clients that might be prepared to take greater risk by buying international names and getting a yield pick-up - have not made the wholesale switch from equity holdings to fixed income that has been seen elsewhere in the world, says Satoshi Yui, head of flow trading at BNP Paribas in Tokyo.

This is largely because the culture of liability matching that is increasing demand for credit in other markets has yet to take root in Japan. "There isn't the transparency regarding asset allocation and liability matching that exists in other developed markets because regulators have not yet made it an important issue," he says. "And, unsurprisingly, few investors have taken the initiative themselves."

Equally, the Japanese domestic market remains of little interest for international investors. Although corporate bond issuance edged up slightly to Yen6.85 trillion ($62 billion) in 2005, it was outpaced by redemptions of Yen7.41 trillion ($67 billion), according to statistics from the Japan Securities Dealers Association. Redemptions have soared as the economy has recovered and companies have used the opportunity to reduce debt.

The result of a contracting credit market has been tighter spreads. Nomura's Thomas notes that a single-A rated credit in Japan might trade at single digits over yen Libor while a similar European name, such as Philips, might trade at triple digits over yen Libor. One explanation is that Japanese credits have lower default rates than foreign names, largely due to the historical support they have enjoyed through cross-shareholdings and strong bank involvement. But the upshot of this is straightforward: "There's not much value to attract yield-hungry international investors," notes Yui.

The combination of international isolation and tight spreads might be thought to make Japan one of the world's least attractive credit markets. However the structured credit market, in contrast to corporate bond issuance, has grown rapidly in recent years: anecdotal evidence indicates that the market grew by 50% year-on-year in 2005. Indeed it could yet be the spark that, given time, ignites a broader interest in credit.


Initially the structured credit market - largely cash and synthetic collateralised debt obligations (CDOs), although there has been a parallel growth of single-name structured notes in Japan backed by Japanese government bonds and structured products using credit default swaps (CDS) - was largely focused on domestic products. Until two years ago up to 95% of names in CDOs were Japanese; investors were eager to consider new products but uneasy about straying outside their comfort zone.

However as spreads tightened and arbitrage opportunities diminished for structurers, investors began to be convinced that investing in products containing international names could be advantageous. By 2004 the Japanese market was split roughly evenly between domestic and global names in CDOs; now Japanese names constitute an average of just 10% of CDO products.

"The market for structured credit in Japan has evolved dramatically in the past three years," says Emmanuel Ramambason, head of credit trading at BNP Paribas in Tokyo. "It is still a conservative market compared with the US and Europe and is interested in investment-grade tranches. Few investors will take paper rated below double-A and the bulk is in triple-A." All products are sold with quanto options so that investors take no currency risk.

Within this context, the evolution of CDO sales in Japan has followed a similar pattern to the rest of the world - albeit with a slight lag in terms of product innovation.

In the third quarter of 2005, there was growing interest in leveraged super-senior deals as the steepening of the correlation curve in the wake of 2005's correlation blowout made super-senior relatively more attractive. The 0% default profile of super-senior made it a natural product for cautious Japanese investors. BNP Paribas, JPMorgan and UBS are among the banks that sold such deals.

But the attractiveness of leveraged super-senior was short-lived and according to bankers has been replaced by increased interest in equity tranches with built-in protection. This most recent trend is hard to substantiate - CDO sales are intensely private in Japan - but according to Ramambason: "There is huge potential demand for CPPI (constant proportion portfolio insurance)" in Japan.

While the notion of credit protection is well understood in Europe, where it is frequently used even by retail investors, bankers had a mountain to climb in convincing Japanese investors of its benefits. "Japanese clients are innately conservative," says one banker. "So if they are uncomfortable with any aspect of credit risk their first reaction is simply to reject the product rather than look for ways of making that product more secure from a capital perspective."

A similar evolution of investor attitudes explains the growing attraction of managed CDOs over static portfolios. Early CDOs sold in Japan were exclusively static portfolios: the thin spreads of domestic credit - and local investor confidence in the mainly Japanese names in the CDO - made the additional expense of a manager inappropriate and unnecessary.

But as the proportion of international assets in CDOs has increased and events such as the correlation blowout following the downgrade of Ford and GM have displayed the volatility of international names, there has been a greater willingness to pay up for the flexibility a manager brings.

The shift towards managed structures is also likely to be boosted by potential changes in risk management guidelines by the Japanese regulator, the Financial Services Agency (FSA). Bankers say that following detailed contact with regional bank investors in CDOs, the FSA has come to the conclusion that managed CDOs present lower risk than static portfolios.

Although the FSA is not expected to issue specific guidance on how managed CDOs will be treated from a regulatory standpoint, its attitude towards the product is expected to have significant consequences. "Regional banks in Japan are among the most conservative investors and will be eager to be seen to be doing the 'right' thing," says one banker. "It could remove residual hostility to managed CDOs at a stroke."


GDP: $3.91 trillion

Public debt: 170% of GDP

External debt: $1.55 trillion

Stagnating corporate bond market is dominated by domestic issuance. Structured credit is undergoing a boom, and sparking development of the CDS market.

Huge boost to CDOs?

The market for CDO sales in Japan could move into a higher gear with the recent changes to CDO accounting guidelines announced by the Accounting Standards Board of Japan at the end of March. Due to be implemented imminently, the new rules appear certain to massively increase demand for CDOs by defining certain categories of products as low risk. Some bankers estimate that demand for CDOs could double in the coming year.

The regulator had long been working on CDO accounting guidelines but its decision to exempt deals rated double-A and above from mark-to-market accounting - removing at a stroke the concern among many Japanese investors about potential earnings volatility - is a welcome surprise and could have profound consequences for the investment behaviour of Japanese institutions.

Under the proposals investors will be able to buy CDO assets rated double-A or above and, provided they are held to maturity, completely ignore changes in their market value, an idea which is intrinsically appealing to volatility-shy Japanese investors. Of course, if an investment goes below double-A, it will automatically begin to affect an investor's profit and loss statement. But given the trend towards managed transactions, that is seldom likely to be the case.

Although bankers and investors are still working out the implications of the Accounting Standards Board of Japan's move, it could open the door to a wider range of new investors, and greater investment from existing players. Insurance companies in particular are likely to take advantage of the change to substantially increase their holdings of CDOs. They have previously focused much of their substantial investment firepower on the low-yielding domestic bond market, usually government bonds.

Bankers expect existing buyers of CDOs to recognise the benefits, and reduced risks, of taking longer views and gravitate towards longer-dated issuance: out to seven or 10 years rather than five years and below, which is common to most existing CDO structures sold in Japan.

The only caveat to the rapid uptake of CDOs by investors attracted by the prospects of higher returns and no mark-to-market is the requirement of CDOs to be rated by two agencies. Costs for issuers are likely to increase as a result of the requirement, as will the time it takes to get deals to market. In addition, the huge numbers of outstanding CDOs with only one rating are unlikely to benefit from the change.

Japan's CDS market: the tail wagging the dog

In most markets around the world, it has been the growth of corporate bond issuance - and the consequent requirement by investors to hedge risk - that has led to the development of credit derivatives. By contrast, in Japan the development of CDS and other instruments appears to be driven by the growth of the structured credit market: as one banker notes, a case of the tail wagging the dog.

To be sure, the credit derivatives market is small and internationally insignificant at the moment. Figures from the Bank of Japan show that the notional amount of outstanding credit default swaps was $98 billion at the end of 2005 up from $27.7 billion a year earlier. That compares with a global market of $17.1 trillion at the end of 2005, according to the International Swaps and Derivatives Association.

Moreover, the Japanese market is overwhelmingly focused on inter-dealer transactions, which accounted for 80% of notional amounts outstanding at the end of 2005, with other financial institutions, principally institutional investors, constituting the remainder. However bankers believe structured credit investment could stimulate interest in a broader range of credit products in Japan.

A growing band of investors and other financial players have begun to take note of credit default swaps and other credit derivatives as they have become more involved in structured credit investment. Although few investors would consider hedging CDO investments, the necessity of understanding the underlying constituents of synthetic CDOs has given increased prominence to CDS.

A growing acceptance?

While a growing awareness of credit derivatives is undoubtedly to be welcomed, it is of little comfort to those who would like to see the credit market in Japan develop faster. While growth has been rapid - notional volumes more than doubled in 2005 - there is little evidence of widespread acceptance of CDS or other instruments. "We are years away from a situation where fund managers are going to go to their credit committees to talk about using CDS," says one banker.

Unsurprisingly, given recent credit events involving Sanyo and Softbank (see box opposite), what little interest there is in CDS has been focused on the single-name market, where liquidity can be found out to 10 years - although Yen500 million five-year notionals are the most common instrument. However, even in the single-name market liquidity is limited and bankers say there is an absence of differentiation between credits, which hinders the uptake of CDS for hedging.

Meanwhile the Dow Jones iTraxx Credit Japan, an index referenced to 50 major Japanese entities, formed by the merger of BNP Paribas' CJ50 index and JPMorgan and Morgan Stanley's Dow Jones Trac-x Asia in 2004, is even more illiquid and is generally considered irrelevant by many financial players. Among its sub-indices, only financials show any signs of liquidity, according to bankers.

One demonstration of the lack of importance of the Dow Jones iTraxx CJ to the credit market in Japan was the collapse in volumes following Sanyo Electric's dramatic widening. Trading volumes on the index fell by 50% at the back end of 2005. "It was emblematic of the irrelevance of the index to most financial players," says one banker. "Obviously Sanyo was a major component of the index and you can understand how its widening would put some investors off. But markets are about opportunities and no one saw the opportunities - or wanted to take advantage of them - given the spread widening. A drop in volumes couldn't have happened in comparable circumstances in Europe or the US. Indeed, volumes would have gone up."

Rob Breden, head of Asia credit trading and structuring at Morgan Stanley, strikes a more optimistic note. He says there is potential for dramatic growth in both single-name and index CDS in the future as Japanese banks begin to use derivative products for credit portfolio management and to manage capital and economic risk.

Spread volatility, notes Breden, is limited by both a lack of credit events and the nature of Japanese investors: they typically have a buy-and-hold mentality and will not necessarily change their position on the back of significant good or bad news. A notable exception to this is when a credit is downgraded to junk, causing it to drop out of investment-grade portfolio mandates; this usually precipitates a swift selling reaction among Japanese investors.

Another reason for the failure of CDS to grow at a similar rate to Europe and the US is the historical opaqueness of Japanese financial institutions, which stems from an entrenched business culture of secrecy and a lack of regulatory emphasis on transparency. "Because there is less requirement for transparency, there is less incentive to hedge or to even think along such lines," says one banker. "You are essentially trying to convince people to adopt a completely different mindset."

Sanyo Electric: A case study

One of the main drivers behind credit investors' accelerated understanding of CDS has been Sanyo Electric, the Osaka-based electrical products manufacturer, whose long-standing underperformance came to a head in the last quarter of 2005.

In November 2005, Standard & Poor's cut the company's long-term credit rating to BB from BBB- and immediately precipitated a dramatic movement in the cost of protection on the name - and on the wider market. Both bonds and CDS referencing Sanyo blew out: five-year protection traded as wide as 650bp at one point compared to 200bp before the downgrade.

As one of Japan's leading credits with Yen200 billion ($1.8 billion) in outstanding debt - and a component of many Japan-sourced CDOs - concerns over Sanyo's ability to service its debt were clearly of major importance to the market.

In the end the company was bailed out by a Yen300 billion injection of capital by Goldman Sachs, Sumitomo Mitsui and Daiwa. The funds will pay for a restructuring plan that will reduce debt by 50% by 2008; five-year default protection has since recovered to 139bp. However what was most interesting about Sanyo's near collapse was how investors chose to monitor the progress of the credit as the story progressed.

"CDS spreads on Sanyo were a central focus for many investors," says BNP Paribas' Yui. "That is not to say that everyone wanted to trade CDS - they didn't. But everyone who called up wanted to know how Sanyo was quoted: a huge contrast to before Sanyo. There was also increased interest in using CDS as a hedge - again something that almost no investors had thought about a year earlier."

More recent blowouts in other names have reinforced the growing interest in CDS protection. When the highly leveraged and highly acquisitive technology company Softbank took a detour on its route to profitability and decided to buy Vodafone Japan for Yen1.66 trillion in March 2006, the market immediately reacted and the cost of protection on Softbank soared to 400bp, according to Yui. Again, there was little demand but plenty of interest in the direction of credit spreads.

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