By Christopher Langner
LONDON, May 11 (IFR) - China saw its first-ever corporate credit default swap auction on Wednesday, but don’t expect it to become a commonplace event nor will the payout of credit protection on the troubled Chinese timber company Sino-Forest herald an increase in CDS hedging.
Firstly, the region has relatively little CDS outstanding and those contracts are mostly on sovereign and high-grade companies.
“The market is just not mature enough yet,” said one portfolio manager for a large asset-management company in Hong Kong.
Most dollar bonds in Asia are Reg S only, and heavily owned and traded by private banking accounts which rarely hedge with CDS.
And those that do hedge their corporate bets usually do so by buying CDS on the sovereign: the net notional outstanding on the six most-traded sovereign CDS in Asia grew 18% in the past year.
“Even in 2006 and 2007, when CDS hedging was big in Europe and the US, there was very little of it in Asia,” said a fund manager based in Hong Kong.
The market’s immaturity leaves investors without appropriate options to offset losses when the market goes south, however. And hedging with sovereign CDS sometimes could be very dangerous if the macro conditions differ from the company’s own dynamics.
A hypothetical trade illustrates the danger. If holders of the bonds of widely-traded Chinese property giant Longfor, for example, hedged their exposure with China CDS, they would have gotten badly burned last year.
Longfor 2016s, dropped from 84 to 70 between September 30 and October 5 last year, amid the European debt crisis and governance fears unleashed by the troubles at Sino-Forest.
It was a 16.6% price loss for bondholders that week alone. However, it could have been a lot worse if they had attempted to hedge exposure with China’s five-year CDS. The contract went from 195bp to 164bp in the same period.
Meanwhile, if instead of investing in Longfor, an account had chosen Country Garden for which CDS actually exists - even if highly illiquid, it would have been able to book a handsome profit by hedging its exposure with the credit derivative.
Ideally, investors would like to always have the ability to offset potential losses on debt holdings so well. But that rarely is the case in Asia.
As for Sino-Forest, the auction was fairly uneventful. CDS payouts were broadly in line with the final bonds price at 29 cents on the dollar. The 12 participating dealers in the CDS auction run by Creditex and Markit set an initial market midpoint of 28.625. The net open interest to sell off US$36.05m in physical requests then pushed up the final settlement price marginally.
Yet, in spite of the small size of the auction, it was a good reminder that it is always good to have recourse to the insurance on CDS.
And with a few of the high-yield companies from China heading down restructuring lane, it would be nice to have that possibility on the table. That may still be far away, though.