The Japanese Credit Market

The Japanese credit-default swap market, as with many credit markets, has grown rapidly over the past five years. But, even in these times of tight credit spreads globally, a quick glance at indicative spread levels (Table 1) for different rating categories tells us something is different about Japan. It is fair to say both in the cash and derivative markets Japanese spreads are tighter than anywhere else relative to rating. That is true for both the cash and CDS markets. This Learning Curve looks at reasons for this phenomenon, the general credit environment in Japan and potential catalysts for change.

The CDS market currently exhibits low spread volatility and there has been a spread tightening regime so that now most credit are at all time tight levels. This is linked, we believe, to a preponderance of sellers of protection with limited other investment opportunities and lower perception of true default risk for Japanese corporates--a phenomenon known as systemic support (backing and involvement aimed at maintaining industrial and corporate credit standing by the political and economic system, consisting of the government/state organizations, financial institutions, corporate groups and others), which we discuss further below.

A recent British Bankers' Association report on the European credit derivatives market noted banks are buyers of approximately 50% of the protection. We believe this figure is substantially lower in Japan, because historically banks have not hedged credit exposures and the large synthetic balance sheet CDOs of recent years have been more for regulatory capital management than portfolio credit risk management. Thus we think there has been a lack of natural buyers of protection and this has exacerbated the continuing compression of CDS spreads. This however could be set to change.

Why Are Japanese Credit Spreads So Tight?

Japanese credit spreads have tightened substantially since the beginning of last year (Chart1). We believe the impact of improving corporate credit fundamentals has been compounded by clear evidence of robust systemic support, such as the Resona Bank bailout, as well as a very tight supply/demand balance for corporate bonds. In our view, the risk-return relationship in the Japanese corporate bond and CDS markets is currently distorted by the tight supply/demand balance and strong confidence in systemic support. The Resona bailout and the establishment of Industrial and Revitalization Corporation of Japan impressed on investors the strength of systemic support for financially troubled banks and corporates. There has been no bankruptcy of a major company with corporate bonds outstanding since the failure of MyCal Supermarket in 2001. The extremely tight supply/demand balance is because straight bond issuance volume has stagnated as companies have worked to pay down debt through such measures as cost reductions and asset sales to improve their financial profiles, further affected by competition from syndicated loans and convertible bonds (CBs) on the supply side, while in the last two years, excessively tight interest rates made Japanese debt investors shift some of their money from Japanese government bonds to corporate bonds.  

Potential Catalysts For Credit Spreads Widening

* GDP recovery could lead to a normalization of credit markets

But, with Japan in the midst of an economic recovery we see this leading to a normalization of the credit markets over the medium to long term assuming normalization of monetary policy (the ending of the Bank of Japan's "quantitative monetary easing"). Progress in normalizing bank-corporate sector relations, i.e. banks and companies avoiding excessive concentration risk and basing business relations on a reasonable risk-return tradeoff will also be a factor.

* Changing relationships between banks and their main borrowers

We also see changes in the relationship between the bank and corporate sectors. Since the mid-1990s main banks have been staving off bankruptcies among their large-lot borrowers by providing financial assistance, such as debt waivers and debt-for-equity swaps. This could be seen as an emergency measure, given their weak financial base and the dire economic environment. In our view, however, experience has now taught Japan's major banks the dangers of concentration risk in large-lot borrowers and once their financial position recovers they will no longer feel the need to postpone the bankruptcies of problem borrowers through extending financial assistance and so this systemic support will weaken in the mid to long-term. Indeed, rather than continuing to extend financial support, the main creditor banks of Daiei aggressively pushed the troubled retailer to seek restructuring support from the IRCJ.

Harsher credit assessments by investors and lending financial institutions and the normalization of financial policy, should lead to a normalization of Japan's credit market. Basle II, which is set to be introduced at the end of 2006, should also widen differentials between companies with strong and weak credits.

* Receding of systemic support is necessary condition for normalization

The receding of the systemic support that has distorted credit market pricing is, we believe, the first step to a healthy credit market.

Once financing through convertible bonds and equities has run its course and if capital expenditure and working capital requirements fuel rising demand for funding moving forward, we could see a change in the supply/demand balance from an increase in straight corporate bond issuance. In addition greater use of credit-default swaps by banks to hedge exposures, while still keeping banking relationships intact, as part of the greater focus on credit risk by the banking system will help address the somewhat one-sided nature of the current CDS market.

Syndicated loans are gaining in size and their use increasing for companies with low credit standing. The risk of default on syndicated loans is now higher than the corporate bond market, we believe. If participating banks demand a uniform cut in their claims following a syndicated loan default, both investors and lending financial institutions will likely start to sense that systemic support is receding.

From a macro credit perspective, we think being long bank credit and short certain selected corporates is a strategic way to play the credit market going forward. We would expect the credit quality of the major banks to continue to improve on the back of continued problem loan reductions, which could be accelerated through a more proactive partnership with the IRCJ. Also we would expect that rising interest rates should ultimately be positive for bank net interest margins and overall profitability. This could lead to credit spreads for banks continuing to tighten relative to corporate credit spreads. In our view the latter have been driven to excessively tight levels compared with their actual creditworthiness because of the tight corporate bond supply/demand balance and over-hyped valuations ascribed to main-bank support, bringing the risk of wider spreads over the medium to long term, in our view. 

This week's Learning Curve was written by Fumihito Gotoh, head of the Japanese credit research team at Merrill Lynch in Tokyo.