* CDS net notional double on back of China fears
* PIMCO a major liquidity provider on the contract
* Concern over default protection persists
By Christopher Whittall and Eric Burroughs
LONDON, July 18 (IFR) - Trading in China sovereign credit default swaps has more than doubled in the past year as fears over slowing growth and rising corporate defaults in the world's second largest economy have helped transform the contract into the go-to Asia hedge for macro investors.
The net notional outstanding in China CDS now stands at US$14.1bn according to the DTCC - a leap of 109% compared to a year ago. The country is now the third largest single-name CDS contract in the world by net notional, despite having only a handful of small outstanding bond issues. Chart link.reuters.com/jaw42w
China's lack of external debt has led some investors to dismiss the CDS as a purely speculative instrument, highlighting that it is unlikely to provide any default protection.
But this has not prevented the contract from building a critical mass of liquidity, as global managers such as bond behemoth PIMCO have become more active in the contract amid rising fears over an economic slowdown, property bubble and the country's shadow banking system.
"As China became the main cause of concern for global growth at the start of the year, we have seen a lot more macro accounts get involved in China CDS as a cheap and efficient way to hedge their cross-asset exposure," said Salih Unsal, a Hong Kong-based credit trader at Citigroup.
"The China (CDS) sovereign curve is arguably now one of the most liquid credit products in the region. Whether it's hedging or speculative activity, it's the easiest way to take a view on Asia."
Prominent real money managers such as PIMCO have become heavily involved in the market. At the end of the first quarter, PIMCO's Total Return Fund had sold protection of about US$3bn notional of China sovereign debt - or about a fifth of net notional overall - backing up participants' assertions that is has become the biggest source of liquidity in the market.
In general, much of the spike in trading activity has occurred this year, with China net notional rising by over US$5bn, or 59%, since January.
This has come at a time when European sovereign CDS activity has fallen off a cliff in the face of a ban on speculative positions, while trading in other emerging market CDS such as Brazil and Mexico has steadily risen.
In China's case, the low level of its CDS spreads has attracted burgeoning interest as a cheap tail risk hedge for Asia and emerging markets.
Five-year protection currently trades at 76bp. This is tight relative to other large EM economies: Brazil changes hands at 151bp, South Africa at 190bp and Russia at 215bp. And in Asia, there are few other liquid hedges available for macro investors looking for portfolio hedges.
The resulting snowball effect for liquidity in China CDS has seen bid offer spreads halve in the past 18 months to 2bp, and typical ticket sizes double to around US$100m.
"A lot of EM investors are looking for a so-called cheap tail hedge and, given the low spreads, China CDS currently has much less negative carry than other shorts," said one Singapore-based macro hedge fund manager.
But some investors find the lack of a tradeable, underlying Chinese sovereign debt market troubling. CDS only trigger payouts to protection holders under pre-determined scenarios such as an enforced reduction in the sovereign's overall debt pile or a delay in repayments.
Another issue is that the recompense CDS holders can glean from such credit events are calculated using the value of outstanding bond issues.
Thomson Reuters data reveal only four outstanding Chinese bonds that would be deliverable into a CDS auction. One of these issues is due to mature later this year. After that, there is a 2015 local currency bond of RMB10bn in size, a US$100m dollar bond due 2027 and a US$400m private placement maturing in 2096.
"The default protection angle has always been very weak in my opinion. There's just about nothing to deliver and nothing that would trigger it, so it's unlikely to help you at all," said the hedge fund manager.
And unlike other EM countries - such as Indonesia with its deteriorating external current account - the manager expressed concern over the lack of 'forced buyers' on China CDS during a market downturn.
"It's a purely speculative investment," he said. "You only buy it because you think someone will buy it from you later at a higher price."
Others play down these concerns, though. And with a lack of liquid alternatives for hedging macro Asia risk, Chinese CDS trading is only likely to increase.
"People are not realistically betting on China defaulting. It's more of a mark to market hedge - that's why it trades at around 70bp outright," said Unsal. "If there really was a China default, people would have bigger worries than a lack of CDS deliverable obligations." (Reporting by Christopher Whittall, Eric Burroughs; editing by Alex Chambers)