Ever wonder why one of the world’s largest economies, with one of the world’s largest pools of funds, is but a mere blip in the vast world of credit default swaps? As is starkly illustrated in Wednesday’s FT:
Volumes of CDS outstanding on Japan itself and on Japan Tobacco are much smaller than those for J. Sainsbury and also for Halyk Bank of Kazakhstan, according to DTCC trade data warehouse.
Yes, really.
So why are CDS not big in Japan?
There’s an element of chicken-and-egg about all this: Japan’s CDS market is not deep or well-developed compared with its counterparts, not least because companies have often looked to their banks directly for loans rather than tapping capital markets. Recently, however, Japanese CDS, which have traditionally experienced tighter spreads than their US and European counterparts, have been trading wider and, as the FT notes, don’t look to be narrowing soon.
This might be interesting because, as Fortis observed in a note this week, some analysts feel that recent increases in CDS spreads in both US and European markets have reached unsustainable levels and are due for a correction – sharpish.
As FT Alphaville noted, Fortis believes four of the major CDS indices – the iTraxx Crossover and Main, and the CDX High Yield and Investment Grade – which all recently hit record highs, show a ‘bubble-like formation in spreads’.
The iTraxx Japan index usually moves in line with the US’s CDX IG and iTraxx Euro Main but, since late last year, it has been consistently trading wider than the US and Europe.
The iTraxx Japan’s closing price on Tuesday was 322bp compared with Monday’s close for the CDX IG of 208.5bp and the iTraxx Euro Main’s 165.5bp, according to UBS figures.
As noted, the corporate bond market is small compared with the US and Europe keeping volumes of CDS outstanding on Japan itself very low. Unlike in other more developed markets, Japanese banks rarely use CDS for hedging purposes because the spreads are wider than their net interest margins from loans, making them too costly to purchase, Fumihito Gotoh, head of credit research for Japan at UBS, told the FT.
This leaves overseas investors such as hedge funds as the main operators in Japan’s CDS market. But as many face redemptions or repatriate funds, market volume has thinned further and increased volatility.
Meanwhile, bankruptcies in Japan are rising and the level of publicly listed companies filing for court protection in November hit the highest since the end of second world war. However, many of these companies have been relatively new businesses from the real estate sector and don’t have CDS in the iTraxx Japan index – so while rising bankruptcies may have had some impact on the index, it’s not the only reason for the recent trends, according to Gotoh.
Concludes the FT:
The outlook does not look particularly bright either. “There probably won’t be much significant tightening for the first half of 2009 as we are expecting poor macro indicators,” Mr Gotoh said.
“If the US government contains the problem, institutions are more willing to provide money for the economy that could be a strong driver to lower the spread.”
The dysfunctional nature of Japan’s CDS market does not seem to be reflected in its corporate bond market. Mr Gotoh estimates that A-rated Japanese companies are raising funds in the domestic corporate bond market at about 100bp above Libor. In the US and Europe, such companies need to spend about 400bp-500bp above Libor.