A role reversal

Credit risk

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Five years after the Asian financial crisis, credit spreads have once again blown out dramatically, default rates have rocketed and canny investors are shifting assets across the Pacific in search of a safe haven. Only this time, it is the US that has suffered a string of defaults, while much of Asia has weathered the storm and remained comparatively stable.

Following a succession of accounting shenanigans and the defaults of several high profile firms over the past year, such as US energy giant Enron and telecommunications company WorldCom, default statistics in the US do not make pretty reading. In the second quarter of 2002, there were a total of 253 downgrades and 82 upgrades globally, according to ratings agency Standard & Poor’s (S&P). The US accounted for 64% of the downgrades, and contributed 67 of the 133 defaults at the end of the quarter, making up $68.5 billion in defaulted debt. Europe has also had a rough time, recording 40 downgrades and 11 upgrades over the same period, with 10 defaults accounting for $6.4 billion in debt.

In comparison, the Asia-Pacific region has faired relatively well, with 14 downgrades and 11 upgrades in the second quarter, a result of an improving economic cycle in the region since the crisis in 1997/98. While credit spreads have whipped about in the US and Europe, Asia has maintained a degree of stability, and in fact Asian bonds have been among the top performers globally. Asian investment-grade corporates have returned 11% in the year to early September, compared with a return of 1.2% for US BBB corporates and 5.2% for European corporates, according to US investment bank Merrill Lynch (see table A below).

Meanwhile, the JP Morgan Asia Credit Index (JACI), a composite index that measures the performance of Asian bonds, has returned 11.38% in the year to September. Average spread levels on the JACI are where they started in January at around 200 basis points over Libor after tightening in by 30bp during the first half of the year (see figures 1 and 2 right).

In the credit default swap (CDS) market, Asian credits have, for the most part, had a calmer ride than comparable European and US names too. Five-year protection on Hong Kong-based telecom- munications company Hutchison Whampoa, for example, widened to a high of 210bp in early August from 130bp at the start of the year, following the collapse of WorldCom and concerns surrounding the colossal costs of 3G licences. But this compares favourably with France Telecom, which widened to around 650bp in June, having begun the year at 150bp.

As a consequence of this stability, Asian high-grade credits are starting to establish themselves as something of a safe haven, and there have been noticeable capital flows from the US and emerging markets such as Argentina and Brazil into the region, say bankers. “With a series of accounting scandals in the US, especially in the telecom sector, we have seen more US and European investors returning to buy Asian bonds, especially the high-quality Asian credits,” says Linda Bui, director of Asian fixed-income research at Merrill Lynch in Hong Kong.

Adds Bernie Peh, director of credit research at Barclays Capital, based in Hong Kong: “We will always see Asia benefit from some flows whenever event risk is heightened in other markets such as the US, and we’ve certainly seen Asia benefit from that in the past few months.”

In fact, the economic fundamentals of most Asian countries have been improving slowly since the crisis, evidenced by recent upgrades to South Korea (to A– from BBB+ in July by S&P), Malaysia (to BBB+ from BBB in August) and Thailand, whose BBB– rating was given a positive credit outlook in August.

There have also been a succession of upgrades to corporates and banks, particularly in South Korea, including Korea Development Bank, Korea Electric Power and Hyundai Motor. “In the US, investors are clearly concerned about their credit exposure, because the bombs are still going off both from a default perspective and an accountancy scandal perspective,” says John Woods, head of fixed-income research at HSBC in Hong Kong. “But, frankly, if you were going to go bust in Asia, you probably would have done already, so there’s a greater degree of comfort in the default risk of bond issuers in Asia.”

Other than the improving credit cycle throughout much of the region, Asian credits have been supported by the vast levels of excess liquidity in the domestic banking system – the so-called Asian bid. With domestic banks still reluctant to extend loans to Asian corporates since the Asian crisis, the Asian bond market is the main conduit for soaking up bank liquidity, says Alison Murray, vice-president of fixed-income research at Merrill Lynch in Hong Kong. “That’s because there hasn’t been a great deal of loan growth in a lot of key markets in the region. Unless that credit growth situation changes significantly, then you’re going to have that supply of liquidity looking for a home.”

According to estimates by Barclays Capital, Asian banks have excess liquidity levels of around $700 billion, while foreign exchange reserves across the region grew by an average of $13.5 billion a month in the first half of 2002. Asian credits have been the primary beneficiaries. “Often investors have limitations as to how much credit exposure they can take to credits outside of the region, so that’s why the huge increase in excess liquidity in Asia remains channelled to a large extent into Asian bonds, often even on a country-by-country basis,” says Pieter van der Schaft, director of economic research at Barclays Capital in Hong Kong.

Consequently, Asian credit spreads have remained tight and relatively stable, even during the US accounting scandals earlier in the year and the global sell-off in equities in June and July. While there was some reaction to the events in the US, shown by the 30bp widening in spreads in the JACI from June to September, Asian credits have continued to be supported by the local bid, with domestic investors jumping into Asian names as soon as spreads widen, particularly in the short end of the curve. “You don’t have quite the same degree of volatility, because you’ve got this untapped demand that comes in and buys Asian bonds every time spreads blow out,” says Abdul Hussain, director and head of credit research at Credit Suisse First Boston in Singapore.

While spreads on Asian sovereign, quasi-sovereign and high-grade corporates are often tight relative to similarly rated credits in the US and Europe, Asian investors are willing to pay for scarce Asian dollar bonds. Lim Heong Chye, executive director at DBS Asset Management in Singapore, says: “I don’t really see [tight spreads] as a problem. Investors in Asia are more familiar with Asian names, so they are more receptive to Asian credits.”

This local bid has been supported by international investors, which are to some extent willing to accept the tight spreads of Asian credits in exchange for the stability the region currently offers. This has been particularly supportive in the long end, where Asian yield curves remain relatively steep. “The region has generally been underweight in most global portfolios because of its tight spreads,” says Bernhard Eschweiler, managing director and head of credit and rates research, Asia, at JP Morgan Chase in Singapore. “And the degree to which it has been underweight has declined, and in some places, investors are seeing Asia as a safe haven, and have significantly increased their allocation.”

A flood of new Asian bond issuance pencilled in for the fourth quarter of this year should fulfil some of this demand for Asian credit. A jumbo Kingdom of Thailand deal, estimated at up to $1 billion, is due in the fourth quarter, while a $650 million issue from Korea Electric Power and a $300 million Republic of Philippines deal were launched in September. But Barclays

Capital reckons that the estimated $10 billion–11 billion in expected supply until the end of the year will be easily swallowed up by the local bid, although there may be temporary widening in certain sectors or markets in the event of heavy supply. “Nevertheless there is a very strong level of liquidity, which should be able to absorb the supply quite easily,” says van der Schaft.
As such, some bankers are recommending investors consider the credit default swap market to overcome the lack of supply in the physical market. By selling protection in the CDS market, investors effectively achieve synthetic credit exposure to the particular name in a maturity of the investor’s choosing.

Credit default swaps on Asian names have, in some cases, been trading wider than similar maturity cash bonds. Increased credit concerns in June following the revelations of accounting misdeeds at WorldCom, combined with fears that more revelations would surface, sent Asian investors and banks scrambling to pick up credit protection, causing CDS spreads to widen further. At the same time, there was continued local support for cash bonds, leading to a widening in the basis between cash and CDS on some names in July. While this trend has reversed somewhat since August, there are still opportunities, bankers say. “There’s such large demand for the cash product for investment reasons, while the credit derivatives became an escape boat for concerns around some of the global credit and accounting concerns, which added to the widening of spreads between the cash and derivatives product,” says JP Morgan Chase’s Eschweiler.

Many of the large institutional investors in Asia – particularly in Hong Kong and Singapore – are already utilising credit default swaps in their portfolios, both to purchase and to write credit protection.

However, there are still many institutions in the region that do not have internal mandates or back-office processing and valuation systems in place to allow them to sell credit protection.

“There is a growing interest because of the lack of supply and low yield levels in the physical market. But it is something where the mill grinds very slowly in terms of internal approvals,” says Eschweiler.

With credit spreads likely to remain stable as a result of the Asian bid, the region’s high-grade bonds will continue to attract capital flows from more volatile markets.

But investors are constantly balancing between stability and higher returns. As US and European markets stabilise – and credit spreads are already recovering from the volatility in July and August – the attraction of higher returns in global markets will likely outweigh the stability of Asian high-grade names for some investors.

“I think the Asian spreads are artificially tight because of liquidity,” says one fixed-income manager at a major asset management company in Singapore. “If you look at it objectively, comparing a similar rating with the US, I don’t think you are very well compensated.”

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