The Japanese Credit Derivatives Market

Size Of The Market

Derivatives houses have frequently argued that the Japanese credit derivatives market has experienced tremendous growth recently. The Bank of Japan's derivatives market survey in June showed the outstanding notional volume of credit derivatives held by 18 major Japanese banks and securities houses to be USD16.4 billion (about JPY2 trillion), up 14% from June 2001. However, when compared to December 2001, the number was actually a 6.1% decrease.

The Nikkei Financial Daily reported on Sept. 30 that the outstanding notional amount of credit derivatives contracts (including guarantee format for some companies) held by five major Japanese casualty insurance companies as of March 2002 was JPY1.55 trillion (USD12.7 billion), up 80% from the previous year.

JPMorgan estimates monthly trading volume of Japanese name credit default swaps doubled to USD2.4 billion in mid 2002 from USD1.2 billion at the beginning of 2001. The number of liquid names has also increased dramatically from around 50 names to more than 100 names, in the same timeframe.

Who's Who

While there has been a continuous expansion of new entrants as dealers as well as end-users, major market participant types have not essentially changed. The market is still broadly characterized as "domestic risk takers vs. overseas hedgers".

Active dealers include around 10 major U.S. and European financial institutions. Recently, though, a few Japanese banks have entered the dealers' market. Protection sellers include: large central financial institutions taking exposure as default swaps or credit-linked notes; regional financial institutions buying CLNs; Japanese branches and subsidiaries of foreign financial institutions, and some sophisticated industrial corporations.

Large positive basis available in many Japanese reference credits in default swaps as compared to corporate bond spreads has increasingly attracted new protection sellers. Some new entrants prefer credit linked loans (CLL) principally because of organizational reasons, i.e. investments from the loan departments instead of the bond departments. For those financial institutions, CLL is one important way to increase the size of their outstanding loans.

Protection buyers include; Japanese branches and subsidiaries of foreign financial institutions hedging their credit risk portfolio; hedge funds eliminating credit risks associated with their convertible bond investments and outright credit trading and selected Japanese financial institutions managing the risk on their credit portfolio, or trading.

Standard Japanese Default Swap Trades

Market liquidity has been improved by market participants' efforts to standardize the trading format. Standard Japanese single name corporate trades follow 1999 ISDA Definitions with confirmations including three credit events, bankruptcy, failure to pay, and 1999 restructuring. The contracts classify the obligation category as borrowed money, deliverable obligation as bonds or loans, and use the convertible bond and successor supplements, but not the restructuring supplements. The 1999 restructuring is also referred to as old restructuring. While tenors range up to 10 years, the five-year sector tends to be the most liquid. The typical size of trades is JPY1-2 billion but participants execute trades of JPY5billion in liquid names. With regard to currency, Japanese sovereign and mega banks are usually traded in dollars, but industrial corporate names are increasingly traded in yen.

The number of credit events decreased from five to three after market participants' reached a consensus to avoid the relatively vague definitions of obligation acceleration and repudiation/moratorium for non-sovereign trades on Aug. 12. There has been continuous discussion on using modified restructuring instead of full restructuring, but because most domestic loans are bilateral, limitation of obligation to "multiple holder obligation" is difficult to apply. However, there has been modified restructuring trades and the premiums were roughly 10-15% lower than full restructuring trades.

 

Balance Sheet and Arbitrage CDOs

The discussion on the number of credit events has further intensified with the recent Mizuho Corporate Bank's synthetic balance sheet CLO, which reportedly only utilized two credit events, bankruptcy and failure to pay, for the underlying trades. Some Japanese investors greet this credit event reduction very favorably as one way to avoid potential moral hazard by the originating bank, but dealers might have difficulty in quoting protection bid levels to investors since the dealers market continues to trade with full restructuring.

In addition to large-scale synthetic balance sheet CLO transactions that are expected to hit the market by the March year end, we have seen increased issuance of synthetic arbitrage CDOs since the later half of last year. After September 2001, most Japanese fixed income investors took credit risk more seriously, mainly because of the Enron and Mycal failures. Some investors allegedly incurred huge losses due to CLN investments referenced to these names. In addition to these notable events, investors became more wary of taking on credit risks due to general credit deterioration in Japan and overseas. This attitude contributed to a large spread widening on Japanese corporate bonds and default swaps, which in turn contributed to increased activity in structuring arbitrage CDOs using Japanese default swap portfolios as underlying risks. Consequently, these CDO-related activities have significantly enhanced the liquidity and range of tradable names.

Japanese Default Swap Premium Levels

Now look at selected historical charts of Japanese default swap premiums.

Japanese sovereign default swaps typically move with the seriousness of Japanese financial crises. Thus, the spread tends to show widening toward a fiscal year end or a half-year end. While Moody's Investors Service downgraded Japan's rating to A2 with stable outlook on May 30, there was no significant changes around that date.

In the Japanese corporate market one of the strongest factors determing spread levels is convertible bond issuance. When issuance is announced, or even rumored, the premiums tends to widen significantly as shown in chart 2.

Also under the current "flight-to-quality" sentiments of investors, premiums tends to widen quickly with corporate governance failures. As seen in chart 3, Tokyo Electric Power (TEPCO) had been one of the most stable names in the market. However, after the nuclear power plant-related scandal surfaced in August, spreads widened significantly. While many market participants don't think TEPCO will actually go bankrupt, we continue to see the widened levels.

 

First-To-Default Investment Opportunities

The recent spread widening of high quality names including TEPCO provides an attractive investment opportunity for investors in the form of first-to-default basket trades. Under the current market (as of Oct. 16), a first-to-default basket with the six Japanese corporate names in the table above pays a floating rate coupon of six-month yen LIBOR plus 70 basis points, or a fixed-rate coupon of 1.05% p.a. Given the single digit LIBOR spreads of these high-grade names in the domestic corporate bond market, we believe the relative value of this CLN is compelling.

 

This week's Country Focus was written by Kazuhiko Toya, v.p. in the investors solutions group at JPMorgan Securities Asia in Tokyo.