Emerging markets derivatives: The central European option
Emerging markets derivatives: Swings and roundabahts
Credit derivatives have a reputation for being illusory – everybody in the market talks about them, but few institutions use them. Latin America may be an exception. In the past few months a substantial amount of business has gone through the market. “Credit derivatives are definitely picking up,” says Kevin Murphy, director of structured products at BankBoston. “The volume that we’ve seen in Latin America over the last three to six months has just moved up dramatically. It’s been nothing short of remarkable. A key change has been the willingness of participants to go to much longer tenors on the credit side. Whereas before you seldom saw people quoting much more than six months to one year, now we’re doing trades at five and seven years. “
There is also increasing broking activity, though in a form different from that in other markets, where dealers trade with one another using brokers for anonymity. As credit derivatives are not yet a traded market – they are dealt on a matched basis – the broker market provides much of the sales and client coverage that may not be available internally. So the transactions that emerge this way often provide a natural offset to banks’ own client flows. Commoditization is some way off – as a negotiated market, credit derivatives in Latin America are still offering profitable opportunities for investment banks.
So far, total-return swaps have been the most actively traded product. They are attractive mainly to institutions with a high funding cost. Such banks find it unattractive to put on the balance sheet a high-risk asset that yields Libor plus 70 basis points when they pay Libor plus 50bp. A total-return swap allows them to improve the differential they can achieve on the underlying asset. Under its terms, A will pay counterparty B (a better credit that enjoys sub-Libor funding) Libor, while receiving Libor plus the asset spread. B has two sets of counterparty risk to worry about: the underlying asset’s and A’s. These transactions are collateralized so, if the value of the underlying asset, which is held by B, declines, A is obliged to put up cash collateral.
Credit-default swaps have also been gaining in popularity. They are similar in structure to total-return swaps except there is no exchange of Libor. B pays A the asset spread (like a premium) throughout the trade, which at its conclusion will typically settle to par. (So if there were a default and the asset was trading at 30% in the market, counterparty A would have to pay counterparty B the 70% difference.)
“One of the principal advantages of a credit-default swap is that it is a truly synthetic instrument,” says Lynette Calder, co-head of ING Barings’ new credit derivatives team in London. “The underlying asset does not have to be owned, unlike a total-return swap where it almost invariably is. A lot of the business is generated by participants reluctant, or unable for various reasons, to sell their assets, such as credit exposure arising on the back of credit-guarantee schemes. For example, a Japanese bank with a Mexican loan will possibly have 95% of the principal covered by the guarantee. It cannot sell part of the loan as it is typically deeply embedded, but it can hedge the 5% stub with a credit-default swap. This adds value to the market, as a new and liquid piece of Mexico has been created from something extremely illiquid.”
An older credit instrument has a vital role to play, Calder reckons. “While credit-linked notes have traditionally been used when there are restrictions on an asset – such as those issued by Indonesian banks – leaving the country, they can also enhance the potential value and uses of a credit-default swap,” she says. “The banking – as opposed to dealing – arms of banks are in need of funded rather than unfunded positions in order to utilize their liquidity. If you are sold a credit default swap by a participant wishing to lay off three years of a 10-year asset, it can then be embedded in a credit-linked note as a new synthetic instrument and sold on to another participant in need of a funded position. In Latin America this sort of transaction has differing effects, depending on the underlying market. In a country like Mexico it creates straightforward liquidity. In countries such as Venezuela and Uruguay, where there is far less issuance, it can provide duration liquidity, by creating a synthetic bond duration that would otherwise be unavailable.
Calder continues: “I think the next area of huge potential expansion for credit derivatives in Latin America is in options on credit spreads. Given the volatility of credit in the region, it’s a natural progression. There has already been some activity, but in many cases, when you look closely, these transactions have effectively been credit-default swaps. A true option on credit spread cannot be exercised once the underlying bond or asset is in default, but until that happens the holder has the right to buy or sell it at ‘X’ spread.”
As credit derivative activity in Latin America has started to percolate down from the sovereign to the corporate level, banks with local networks have been in the strongest position. They have also been well placed to take advantage of increasing international demand for local-currency products as spreads tighten on larger issues denominated in G7 currencies. Activity in corporate credit products is growing, although “the market is still primarily driven by sovereigns and that’s where the liquidity is”, says BankBoston’s Murphy. “Periodically investors have a specific constraint or name that they need to work on and then you’ll see those corporate names come through. I think the sort of flow that is likely to emerge in this market in the future will be from those without established local networks and relationships, who would rather not take bonds but are maybe looking for credit exposure to a range of corporate names. It also makes a lot of sense for the corporates as well. What they gain from the exercise is an effective syndication with, not 19 banks, but maybe with two or three headed by someone like ourselves managing our exposure using credit derivatives.”
No match for Bradys
Though the investor base in Latin American credit derivatives is widening, large institutional investors are not yet using them to gain market exposure. While liquidity has been improving, credit derivatives are still no match for something like Bradys. For a hedge fund with an investment horizon of a week to 10 days, crossing the bid-offer spread will ruin any potential profitability. Also, many institutions prefer a direct corporate investment or restrict use of synthetic instruments.
So activity has centred on participants providing protection, those without investment restrictions (preferring unfunded investments), those that get more favourable capital treatment for over-the-counter (OTC) investment rather than one directly on the balance sheet, or investors that prefer the convenience of the OTC structure. Despite this, observers such as Murphy expect continued growth. “Credit derivatives are a product that takes off exponentially as you add another player to the market,” he says.
Much of the liquidity in Latin American credit derivatives originates in the US, where investors prefer relatively subtle means of managing cash-market exposure. So far it has been driven by the higher yield of Bradys over Eurobonds. As Brady exchanges are taking place, the market is assuming a more conventional term structure, which will bring the credit derivative market to a standard, more developed phase. Superficially that sounds like bad news for the market, as it appears to be losing its biggest driver. But more innovative structures will appear as the market comes to be based on a more liquid, Eurobond curve. If spreads continue to tighten, the market will move closer to investment-grade status and will spill over to reach a new group of investors that have not previously bought into emerging markets. Credit derivatives will benefit, as there will be multiple opportunities to provide this new investor group with tailored exposure.
Daniel Sivolella, head of marketing for emerging-market fixed-income derivatives at JP Morgan in New York, appreciates the potential for credit derivatives in Latin America. “One of the most interesting things that we’ve seen in the last six months in Latin America has been more interest in the traditional use of credit derivatives for liability management,” he says. “Credit derivatives originally appeared because a lot of people had tied up credit lines that they were looking to redistribute in a more even and balanced way, by swapping different exposures and diversifying. By contrast, the birth of credit derivatives in emerging markets was as an investment management tool. But now the banks are starting to realize the potential credit derivatives have for the more effective management of their Latin American loan portfolios. This in turn could be a driver for the market there to extend further into a greater number of corporate names as well as convertibility.”
Says Shahriar Shahida, global head of emerging market debt at Paribas in New York: “I think finally that you’re seeing Brady bond, and emerging debt markets generally, gaining a status that I believe they have deserved for many years. A much broader base of global investor is starting to take the market seriously. Because of this substantial surge in interest, two things have happened. Firstly credit spreads have naturally contracted in a major way, and secondly financial engineers have been focusing on a variety of ways of offering investors customized risk-return instruments. As credit derivatives have evolved over the last year to 18 months, you have seen probably 70%-85% of the activity centred on emerging-market fixed-income products. There’s no denying that credit derivatives have become one of the hottest topics in Latin American derivative markets. The attraction is that they allow a diverse range of investors to take advantage of so many opportunities. Credit derivatives can offer many advantages to investors, such as the ability to customize their optimal credit and/or forex exposure, obtain off-balance-sheet financing, and take advantage of tax/credit arbitrage.”
The effect of this activity has been to bridge the gap between the Brady market and the new-issue Eurobond market, while in a corporate context it allows investors to move easily up and down the capital structure from the most senior to the most junior. As Latin America has the bulk of the focus in the cash market (outside Asia) it has picked up a similar status in the credit derivative markets. On the back of this, it is envisaged that in the coming year there will be sharp expansion in the range of participants and product types.
Forget and forgive
“It took some time for people to forget and forgive after the Mexican peso crisis,” says Shahida, “but as the post-mortems were conducted and new systems of control were put in place, the general acceptance of these markets and their legitimacy was actually strengthened. As people became more comfortable with the cash market, new issues and investor participation exploded. The logical next step was a requirement for customized exposure, such as in a particular currency. Though the market has not as yet spawned any particularly esoteric credit derivative products, I think that it is inevitable that these will come.”
With some Latin American countries lacking a continuous yield curve, the formation of these through new financial products seems probable. As these countries approach their liability management with more rigour and complexity, and provide investors with a broader set of tools, liquidity and the number of different currency requirements will increase.
If spreads continue to tighten, participants may move to more exotic structures to enhance yield. Leverage will play an increasingly important role in these structures, combined with spread-default risk and spread-type options. There has been a large amount of business done in buying the shorter end of the market and leveraging it to maturity, as the Brazilians have done with IDUs (a short floater). Clients seem to like the short, safe aspect of these instruments and are willing to accept the leverage.
A London investment banker also notes the dramatic shift of global investors back into Latin America. “The typical emerging market portfolios have for a couple of months been switching out of Asia and back into Latin America and eastern Europe. As spreads come down in eastern Europe, Latin America is gaining even more of the focus. This has been especially apparent among those G7 investors with a particular affinity for Latin America, such as France and Spain, and also Italy and Portugal where there is experience of a high-yield environment.”
Though spread compression has not been so severe in Latin America as in eastern Europe, it has become sufficiently significant for some investors to consider issues in local currencies. Though these typically only make up some 5% of the Latin American total, the London banker feels reasonably certain that the proportion will increase.
Latin America has some peculiarities that make the application of credit derivatives more challenging. As a significant number of the local currencies are not freely convertible this raises the question what happens should “freely” become “absolutely”. Says a London banker: “In a lot of other countries it’s not such a problem. You understand that there is a convertibility issue, but you know that it is extremely unlikely. In Latin America it’s just that much more possible. Despite that, I think that we’ll see increasing growth in Latin American credit products and their further extension into the corporate sector. A rise in global interest rates is perhaps the one thing that could still cause the market to dry up. If Emu doesn’t go through or if the Fed starts hiking rates in August, then things could grind to a halt. Credit is a funny animal that people only chase when they have to.”
