The introduction of the euro has had a marked impact on Europe’s debt markets and corporate financing. For some time, Europe’s top-tier companies have been able to fund themselves more cheaply through the capital markets than through banks. The impact on traditional bank lending has become greater as second-tier and even smaller international companies opt increasingly for direct funding as the cheaper and more efficient option.
The disintermediation that has occurred as capital markets have provided borrowers with a cheaper means of finance than traditional bank lending has structurally changed the European debt market. A dramatic reduction in lending margins and a considerable deterioration in credit quality in traditional bank-lending books helped spur the growth of the corporate bond market. As the credit environment evolved and investor demand for credit exposure flourished, liquidity, market and credit risk all took on a new meaning. These changes created a burgeoning demand for innovative instruments designed to both enhance return and manage growing volumes of credit risk.
To meet these demands, credit asset managers increasingly abandoned the traditional buy-and-hold strategy in favour of active management, focusing on identifying opportunities through bottom-up issue selection. However, once a particular issue is selected, managers must then search for the best credit instrument and legal structure in which to invest in terms of liquidity, seniority and maturity. This search for the optimal credit vehicle enhances the portfolio’s risk, capital and return dimensions. Bond, loan and credit derivatives’ exposures to the same names may now be managed as a single portfolio.
Bonds – traditional tools of the trade
Bonds have traditionally been the credit instrument used to meet increased investor demand. The efficiency of government markets has increased and the growing complexity of corporate markets has created further opportunities.
Corporate bonds provide the opportunity to choose from a variety of sectors, structures and credit-quality criteria. More recently, various complex structures have been embedded into corporate bonds in response to institutional investor demand. In terms of legal structure, however, corporate bonds are contracts with covenant packages, which protect either the issuer or the investor when credit issues arise. The market has further developed with new credit tools, such as credit derivatives, which can enhance a portfolio’s risk-return profile.
The market for collateralised bank loans has increased dramatically in recent years and is now viewed as a distinct asset class. Using loans can be beneficial compared to other credit instruments in that they are the most senior position and shortest maturity within the Capital Structure and can enhance a credit portfolio by providing collateral protection. Loans are the ideal legal structure given their highly tailored, negotiable covenant packages, and in the event of default, may have higher recovery rates compared to corporate bonds.
Asset-Backed Securities, for example, provide diversification by offering opportunities in otherwise inaccessible loans, which generally cannot be included in European credit portfolios. That is, access to the ABS/MBS market provides investors with synthetic exposures to risks not directly available on traditional bond markets, thus increasing return potential. Additionally, ABS/MBS have demonstrated a high degree of rating stability compared to corporate bonds, due to their tailored credit quality features.
The major risk associated with loans is liquidity risk, which must be actively managed. Innovative tools such as credit derivatives can actually enhance liquidity, creating substantial opportunities whereby both buyers and sellers of risk benefit from the associated efficiency gains.
The credit derivatives toolbox
Innovative tools, such as credit derivatives, enhance liquidity and create substantial opportunities whereby both buyers and sellers of risk can benefit. Credit derivatives provide portfolio managers with new ways of shaping a portfolio. Credit derivatives are instruments traded on financial markets, which enable the credit risk inherent in loans, bonds or other risk assets or market risk positions to be transferred between contracting parties without transferring the ownership of the underlying asset.
The rapidly growing ABS market is bringing investors new sources of credit assets. The credit derivatives market does even more by repackaging credit exposures from the large pool of risks that do not naturally lend themselves to securitisation, either because the risks are unfunded (off-balance sheet) or because they are not intrinsically transferable.
Popular examples of credit derivatives include credit-default swaps, total-return swaps and credit-linked notes. Basket credit-default swaps and spread options, which all contain some kind of optionality, are further examples of credit derivatives. The credit-default swap is the cornerstone of the credit-derivatives market and is the most liquid, straightforward and commonly used credit derivative.
In a credit-default swap, the contract buyer purchases credit protection and is ‘short’ the credit exposure. The seller sells credit protection and is ‘long’ the credit exposure. If the underlying debt security defaults, then the contract buyer typically has the right to put back the underlying asset to the seller at par. Defaults include failure to pay a scheduled interest or principal payment; bankruptcy or insolvency and receivership.
Put simply, Counterparty A is selling protection and Counterparty B is buying the protection against the default of the third party.
For the investor, credit derivatives offer numerous advantages. They may enhance returns by taking advantage of basic trade opportunities and allow the risk of a particular credit to be quickly hedged. Credit derivatives can be created for any maturity date as agreed between the buyer and seller of protection and can be transacted in any currency as agreed between counterparties. Furthermore, credit derivatives can provide access to issuers that do not issue in capital markets.
Innovative tools for innovative products
Although some plan sponsors and other institutional investors do not allow their asset managers to use credit derivatives to put on positions (some do not even allow them for hedging), the credit-derivative technology has changed the way institutional investors invest in the credit market. Credit derivatives are being used to create collateralised bond obligations (CBOs) and collateralised loan obligations (CLOs) or, more generally, collateralised debt obligations (CDOs). Synthetic CDOs typically use credit derivatives to improve balance-sheet management.
Among the latest product innovations stemming from the use of credit derivatives is AXA Investment Managers’ highly successful Jazz CDO I deal – a €1.5bn synthetic CDO backed by investment-grade credit, combining what were formerly two separate types of transactions: cash flow CDOs and synthetic CDOs. Jazz CDO I is actively managed with underlying bonds, loans and credit-default swaps, and consists of an equity tranche (4%) and the following debt tranches: Super Senior (82%), AAA (5%), AA (5%), A (1%) and BBB (2%).
The Jazz CDO I deal is free of restrictions that previously prevented managers from going short; the first time a cash flow CDO is allowed to buy protection. This cutting-edge deal allows a portfolio manager who thinks spreads are going to widen in the short term to buy protection in the credit-default swap market, with the possibility to unwind that position when spreads widen.
European credit markets have come a long way, creating the demand for a wide variety of products that can be tailor-made to meet the needs of investors and portfolio managers alike. As investors become increasingly sophisticated, an explosion of innovative tools have enabled them to increase their credit exposure while limiting losses in the wake of credit events.
Furthermore, the recent credit events that have rocked the market have highlighted the need to manage growing volumes of credit risk efficiently. Managers who have the flexibility to pick and choose the optimal credit tool are able focus on identifying the most cost-efficient way of obtaining exposures to balance the risk and return in their portfolios.
Jean-Pierre Leoni - Head of Credit Fixed Income
Melissa Tessier - Product Manager, at AXA Investment Managers