By Mike Kentz
NEW YORK, April 24 (IFR) - Demand for protection from growing credit risks in emerging markets has increased dramatically in the past six months propelled by an apparent investor belief that the worst may still not be over for the struggling asset class.
Over US$69bn of gross notional in credit default swaps referencing the five-year Markit CDX Emerging Markets Index was traded between October and mid-April, compared with just US$30bn in the preceding six-month period, according to data from Markit.
The rapid increase in the past three months came on top of a 46% rise in such swap volumes in the whole of 2014 bringing the total notional outstanding to US$1.56trn, according to the Emerging Markets Trade Association.
"The increase in EM CDS demand highlights the deep-seated pessimism investors have regarding emerging markets right now," said Donato Guarino, emerging market credit analyst at Barclays.
"The emerging market asset class is facing serious headwinds - everything from credit concerns to further currency depreciation - and investors have begun to position for a move in a big way."
The primary source of demand is coming from traditional credit investors looking to hedge the risk of an EM sell-off ahead of the Federal Reserve's planned rate hiking cycle.
The perception is that the rate hike will be negative for emerging markets - stemming primarily from memories of the taper tantrum in May 2013 when discussions of a possible tapering of Fed quantitative easing rattled markets.
Foreign exchange investors are also hedging ongoing slides in the currencies of several emerging market economies.
These investors are forced into buying sovereign CDS because there is a lack of liquidity for physically delivered foreign exchange derivatives.
The issue is a structural problem that has begun to grab investor attention as currency slides cut into credit and equity returns, according to risk advisers.
"For many small emerging market countries, and the majority of frontier market countries, their relative isolation from the global economy means a market for long-term currency forwards simply does not exist in any material size," wrote analysts from Parametric Risk Advisors in a December study of hedging currencies in EM.
"In our experience, these barriers to effective implementation mean that nearly a third of the countries in the MSCI EM Index cannot be effectively hedged."
Sovereign CDS acts as an efficient replacement hedge due to a high correlation with EM currencies. EM CDS has held an over 65% correlation to EM currencies over the past three months, according to analysts at Barclays.