5.3 PRODUCT MECHANICS AND APPLICATIONS
5.3.6 Credit-linked notes
Another form of equity-linked structure is the synthetic equity warrant, also known as a cov- ered equity warrant (this warrant is distinct from the bond/equity warrant package we describe in Chapter 8, which is an instrument that leads to the flotation of new shares). The synthetic warrant is akin to a long-dated third party call (or put) option that can be floated independently, or embedded in a host note. The original synthetic warrant structure was developed in the Euromarket of the 1980s, when Swiss investors sought a greater amount of participation in the Japanese markets without assuming any currency risk. Accordingly, US investment banks issued Swiss franc denominated synthetic warrants to investors, and hedged their exposures through a combination of the actual dollar or yen warrants and foreign exchange contracts.
Since that time, equity warrants have expanded to include a variety of options, including knock-outs, lookbacks, and spreads.
Equity-linked structures generally feature a modest level of secondary liquidity, primarily from the underwriters/dealers responsible for structuring the deals. In general, however, the securities are intended as “buy and hold” investment strategies. Publicly issued notes are listed on one or more exchanges; those that are listed must adhere to specific exchange requirements related to minimum distribution size, financial standards, and so forth.
$ Reference
asset
Credit protection
P&I
Investor Note
issuer Credit
protection Premium
Bank Figure 5.7 Basic CLN
asset’s value pre- and post-default, or it delivers the reference asset and receives the post-default market price. This basic structure is illustrated in Figure 5.7.
CLNs can be created using total return swaps (TRSs), credit spread options, credit spread forwards, or default swaps, which we discuss in greater detail in Chapter 10. For purposes of this chapter, we note that TRSs are contracts that provide the total return receiver with the economics (coupons plus capital appreciation) of a reference credit asset, in exchange for payment of deprecation plus a LIBOR spread. A default swap provides the buyer with protection against one or more credit reference defaults in exchange for a premium payment;
similarly, the credit spread option provides the buyer with a payment if the spread on a reference credit widens or tightens. The credit forward involves the forward purchase/sale of a credit spread reference between two parties.
The TRS-linked CLN replicates the economic returns of a credit-risky asset by combining the TRS with a fixed- or floating-rate host bond. For instance, an investor can purchase a CLN that pays a LIBOR spread based on a bank’s credit; the spread is greater than might be obtained by purchasing the bank’s liabilities directly, because the bank uses the CLN vehicle to receive the total return of an underlying asset, paying the spread in exchange; this structure is illustrated in Figure 5.8. Alternatively, the investor can receive the total return of a risky asset through the CLN vehicle. The bank pays the vehicle the total return, which passes it on to the investor, creating for the investor an exposure to the economics of the risky reference asset. TRS-linked CLNs can also be based on an index or basket of credits, rather than a single reference, providing for a greater level of diversification. Banks often favor this structure, as it allows for hedging of single or multiple credit references through creation of a synthetic, rather than actual, short position.
Any of the structures noted above can be leveraged to provide investors with the opportunity of increasing returns. Setting the notional value of the TRS greater than the face value of the reference bond creates leverage. The note coupon is thus equal to (leverage factor * TRS
$
Reference asset
Total return LIBOR+
spread
LIBOR+ spread
Investor Note
issuer Total return
Bank Figure 5.8 TRS-based CLN
margin)+LIBOR. If the leverage factor is large enough, a cap generally is included in order to limit losses on the face value of the note (e.g. to avoid negative redemption value); the maximum an investor can lose is thus principal invested.20
The credit spread note, which embeds a credit spread call or put option (unilateral), or forward (bilateral), in a host security, creates an exposure to the spread movement of a reference asset.
An investor purchasing the note monetizes a view on expected versus implied forward credit spreads. Thus, if the note is created using a call option, the investor anticipates a tightening of spreads; if a put option is used, then a widening of spreads is expected. In exchange for purchasing the put or call, the investor pays a premium through a lower-coupon yield. A note created using a forward, rather than an option, features bilateral flows. Thus, if the investor expects a tightening (long the forward) and the reference spread tightens, principal redemption increases; if the reference spread widens, the principal redemption decreases. The credit spread in a note is always defined as the yield to maturity of the reference security, less the yield of the risk-free benchmark; this allows the interest rate risk of the position to be eliminated. As with the TRS-based note above, leverage can be added by increasing the face value of the structure;
alternatively, creating an off-market spread can enhance yield. The note can also be based on the average spread of a basket of credits, rather than a single reference, and can also include maturity mismatching (as discussed below).
The credit default CLN, which packages a host bond with a credit default swap (CDS), is similar in form and function to the credit spread note, but generates a payoff that relates only to the default of the reference asset (while CLNs referencing the default of a single reference asset are most common, they can also be created using basket swaps, or first-to- default basket swaps). The default note allows an end-user to invest in default risk (through the embedded sale of the CDS) and an issuer, such as a financial intermediary, to hedge default risk (through the embedded purchase of the CDS). Notes issued by corporates, rather than financial institutions, generally include back-to-back swaps between the corporate issuer and
20In fact, such an “extreme” risk profile is relatively unusual; most structures have some degree of principal protection (e.g.
50–90 %).
Principal at maturity (no default) Principal – default payment at maturity (default)
Investor
Enhanced coupon
CDS
CDS CDS
premium Note
issuer
Bank
Figure 5.9 Default-based CLN
the bank, in order to transfer the CDS. Under the standard structure, the note provides the investor with an enhanced yield based on the value of the CDS being sold, along with par redemption at maturity if no default occurs, or par redemption less a default payment if an event occurs. The default payment can be set as a percentage of recovery, or the change in the reference asset price between issue date and the default date. The default event can be defined specifically or generally, though the industry’s move towards standardized definitions typically means that bankruptcy, restructuring, cross default, failure to pay, repudiation, and moratorium are included. Figure 5.9 summarizes the default-based CLN structure.
The CLN market features a number of variations on the basic structures noted above. For instance, a CLN may include a knock-out feature, which pays the investor a lower return if the reference asset trades above or below a particular spread. This is simply a package of a bond, a credit forward (providing payout within a range), and two digital options (creating the upper and lower range boundaries). Thus, a note might redeem principal at 120 % of face value if the reference spread trades between 75 and 100 bps, but only 100 % if it trades below 75 or above 100 bps. The enhanced return that is generated when the spread is in the range is created through the investors’ sale of the two digital options. Assuming that the bond is issued through a company, rather than an SPE or asset repackager, the note issuer, which buys the digital options from the investor, sells them to a dealer in order to lower its all-in cost of funds.
The callable credit default note is an extension on the standard default CLN. This structure, which is a package of an FRN, CDS, and issuer call option, functions just like a default note, but gives the issuer the right to call the note back at regular intervals (generally every quarter or semi-annual interest payment date). If the bond is not called, the coupon steps up to a higher predefined margin over LIBOR. Through this structure the issuer determines, on each call date, whether or not to preserve the default protection; if the note is not called, it may indicate that the reference credit is deteriorating, meaning that the cost of protection via the higher coupon is justifiable. A further variation is the principal-guaranteed credit default note, which allows the investor to participate in the credit risk exposure without placing principal at risk; this can be structured as a risk-free bond and a call option on the credit reference. Another extension is a default CLN linked to the credit performance of the asset and continued convertibility in a local marketplace. This structure, which is often applied to local currency emerging market
$ Trust receipts with
customized coupons/principal
Repackaging vehicle (SPE)
Derivatives Coupons and principal
Reference assets Bank
Investors
Figure 5.10 Repackaged bond flows
bond investments, where capital controls present an additional dimension of risk, features a coupon/principal payout that is a function of default and restricted convertibility. If either event occurs, principal redemption is adjusted.
Repackaged bonds comprise the second main sector of the overall CLN market, and have proven popular because of their payout flexibility. The repackaged (or synthetic) bond essen- tially is a securitized form of the asset swap, packaging credit-risky securities with derivatives into a synthetic bond.21Issuance via an SPE, rather than a corporate or supranational conduit, creates greater flexibility and cost savings (e.g. no third party issuer compensation is required).
In order to structure a repackaged bond, a bank determines investor demands and then acquires relevant credit-risky assets in the primary or secondary markets that it believes are trading cheap to theoretical value (e.g. assets that are perceived to be out-of-favor as a result of ma- turity or coupon). The bank then sells the assets to the SPE/trust, which enters into one or more derivatives with the bank to reshape the cash flows to a profile required by investors. The new cash flows are repackaged into notes/trust receipts, which are placed with investors; the proceeds from the note issuance are used to fund the initial purchase of assets. The resulting synthetic notes give investors access to customized credit-linked asset returns. Repackaging can be based on new and seasoned assets: primary market transactions involve repackaging of newly issued bonds, while secondary market transactions center on repackaging outstanding bonds, or reverse engineering structured notes/CLNs back into “vanilla” form. Figure 5.10 illustrates the basic repackaging process.
Repackaging trades are often used to create relative value opportunities for investors. For instance, this approach has been used in emerging market countries that have floated bonds under the Brady program.22The repackaging vehicle purchases Brady bonds of a target country, attaches a currency swap related to the target country’s currency, and passes the combined flows to investors via a note; after accounting for the value of the Brady principal and interest
21The use of a single bond, rather than a bond and swap package, generally is regarded by issuers as convenient and efficient. Such convenience generally commands a premium, with the SPE charging the investor a slight premium for mechanically arranging the package.
22The Brady program is a debt restructuring framework, where sovereign nations with rescheduled bank loans and their creditor banks agreed to swap outstanding troubled loans for a new series of dollar-based bonds backed by rolling coupon guarantees and a US Treasury zero coupon bond covering principal redemption, all in order to create a liquid obligation; banks exchanging their loans accepted a discount for a higher-yield bond, or preserved par, but accept a lower coupon. The Brady programs have been extended to countries such as Mexico, Brazil, Argentina, Poland, Venezuela, and others, and have proven very successful.
$
$ High-grade
bonds P&I Total return on
reference credits
Investor Note
issuer Total return on reference credits Interest on
high-grade bonds Reference Bank
credits Total return on reference credits
Figure 5.11 Leveraged TRS bond on portfolio of reference credits
protection, the yield on the package provides a relative value pickup versus straight local currency sovereign issuance.
Repackaging vehicles are also used for maturity shortening trades, a very popular strategy that allows investors to create an optimal investment horizon by decoupling the maturity of the reference asset from a desired maturity horizon. Under this process, the repackaging vehicle purchases a medium- or long-dated credit asset, and then arranges a credit derivative transaction (e.g. TRS, CDS) with a bank, synchronized to the investor’s preferred horizon. For instance, in a TRS version of the trade, the investor receives periodic coupons from the security until trade maturity, after which the asset, which may still have several years remaining until maturity, is sold in the secondary market. If the asset has gained in value, the investor receives principal plus the gain; if it has depreciated, the repackaging vehicle withholds the differential from the principal redemption. A further structure provides investors with a return based on a leveraged portfolio of reference credits: the repackaging vehicle issues notes to investors and uses the proceeds to purchase high-grade assets, and then arranges a TRS with a bank based on the desired portfolio of reference credits, receiving the total return in exchange for paying the coupon flow on the asset pool. The vehicle forwards the total return on the reference assets received from the bank through a structured coupon; in order to leverage the returns, the notional of the TRS is made larger than the face value of the bonds. At maturity, the notes pay off a principal amount that is linked to the value of the reference assets in the TRS; any appreciation is paid in the form of enhanced redemption, while any depreciation results in discounted redemption. This repackaged leveraged TRS note is depicted in Figure 5.11.
Repackaged notes, like CLNs, can be used to manage convertibility risk. For instance, an SPE can purchase a sovereign nation’s local currency obligations and issue dollar-denominated notes to investors in exchange (which pay dollar coupons and principal through an FX swap arranged between the SPE and a bank). The SPE then arranges a separate note with a bank, where final redemption is based on the onset of a convertibility event; if an event occurs, the bank receives a lower redemption amount (i.e. it bears the convertibility risk) and the investor receives the full redemption amount (i.e. it receives the benefit of convertibility protection).
Note that the investor continues to bear the sovereign nation’s default risk, as payout depends only on the convertibility event.
Synthetic bonds are a further extension of the CLN family, and can be used to replicate an issuer’s existing bonds. Though synthetic bonds are similar to asset repackagings arranged through an SPE, they feature several key differences: the structures are arranged by banks that are seeking to hedge risks, rather than investors seeking return opportunities (meaning the deals are often much larger in size); and, the transactions generally are launched in the public, rather than private placement, markets, allowing a certain level of liquidity to build. For instance, a bank may issue a $100 m synthetic bond on reference credit ABC through a repackaging SPE or trust; the investor purchases the note, and the SPE uses the proceeds to buy a high-grade asset, such as US Treasuries. The bank, through a TRS with the SPE, pays the investor the total return on the ABC bond and receives the return on the underlying US Treasuries; the investor thus receives principal and interest on the $100 m ABC credit as long as no default occurs. In the event of a default by ABC, the bank pays investors a discounted redemption price (via the SPE), based on market quotes. Investors face various dimensions of risk through the synthetic bond: default risk on ABC’s credit, counterparty risk on the bank supplying the TRS flow through the SPE, and default risk on the underlying notes representing the SPE’s obligations.
Pension and investment funds, hedge funds, insurance companies, and other financial insti- tutions are all active buyers of CLNs. Some investors acquire a variety of notes, including those that are not principal-protected or which are of lower credit quality; others face investment restrictions and are only permitted to purchase principal-protected instruments or unleveraged structures.