If the structured note market is founded upon investors desire for high yields in a low volatility and low credit spread world, then would the credit crisis that began nearly a year ago undermine its very existence?
It would have been an extreme view to take, but when the crisis first erupted it wasnt unthinkable. Just 12 months ago when credit spreads were tight and market volatilities were low, structured note investors were being driven down the credit curve in order to find meaningful yields.
Meanwhile, investment banks had themselves been taking an ever-larger share of issuance in the structured note market as they provided more flexibility and responsiveness than third-party borrowers were able to show.
While many observers expected the credit crisis to reverse that process as part of a wider flight to quality, the peak in spread differentials between issuers sometimes 200bp for active names became too tempting for investors to ignore.
The dilemma for structured note investors has been epitomised by Lehman Brothers, for much of the last year perceived as the broker/dealer most likely to fail after Bear Stearns. But that hasnt prevented the bank from finding huge demand for its self-led structured notes, particularly dollar range accruals sold in Asia.
"Investors have had a pretty simple choice: do they think that the US broker/dealer issuer is going to go bust?" explains an interest rate trader at a US bank in London. "If the answer is yes then they will buy triple-A agencies but if the answer is no then theyll put the money in and take the spread and its the easiest thing in the world. Because of credit spreads and volatility its been very easy to show a 10% or 12% coupon on a range accrual."
That combination of an attractive funding level and a high price for the options in a note has proved difficult for investors to resist, and Lehman hasnt been the only investment bank issuer to have experienced a surge in demand for its range accruals.
UBS has had its own problems, with around $40bn of writedowns and losses in the last year, though its strong double-A rating has never seemed at risk, and its MTN team has also found strong demand for the same product, says Evie Christodoulidou, head of EMEA MTNs for the bank in London.
"Weve seen huge volume in dollar range accruals issued in our own name this year which is a reflection of our pricing levels. We are currently one of the better value issuers in the European sector in that were paying more. The Asia-based private banks have been out in force hunting for good value and that has been us," she says.
Making the wrong choice?
Structured note dealers at institutions with less of a need for liquidity and tighter credit spreads have often struggled to compete with the wider funding levels offered by their peers treasury departments, but worry that investors may be making the wrong choice.
"People are getting a little more conservative about taking credit exposure on a name in a structured view only for the structured view to come out right and the credit to come out wrong. In a recent example for instance, a product was up 20 points on the structured angle and 30 points down on the issuer angle and thats a nasty thing to get wrong," says Chris Jones at HSBC.
"Buying US broker/dealer names blindly without considering the credit relative value is like saying sovereigns dont default or US investment banks dont default. Guess what? They do. Investors will eventually run up against concentration limits on those names. Lets hope its before they default."
But what is relative value in credit in a world in which rating agencies are no longer trusted and investors can factor in the possibility of state support? Many have been swayed by the attractive spreads embedded within structures, says the US investment bank interest rate trader. "If youre comparing the difference between a Lehman funded trade and some of the weaker double-A names, the balance, the risk-reward between having a far higher coupon and far higher return on only a slightly weaker credit, means that a lot of the paper that is printed in the broker name world is taken away from some of the weaker double-A names.
"You can argue that if investors are scared about credit theyre going to go for triple-A issuers. But if theyre prepared to take a punt, you can argue that there is very little difference between a strong single-A and a weak double-A apart from the numbers that theyre posting. For that reason I dont think weve seen a large amount of weak double-A issuance in the recent past if someones going to buy credit they might as well take advantage of it properly."
The surge in self-led paper has given some commercial bank issuers a hard time, but overall structured sales for some have remained constant enough, notes one leading issuer.
"Clearly we have been losing some business to investment bank self-led issuance," says Jacques Lumb, head of MTN funding at Commonwealth Bank of Australia in London. "There are some houses that have brought us almost nothing in the last six to 12 months, but thats understandable given the pressures they have been facing. There are also houses from whom weve been seeing a lot more business possibly because their ratings are no longer strong enough for investors."
Not all issuers, though, were as responsive to the new pricing paradigm as CBA and other leading issuers, and many clung to the notion that structured investors could be persuaded to buy a note regardless of the underlying funding level they would receive.
"The accusation you can level at many structured issuers is that theyre very late benchmarking their spreads and moving to changes in CDS. Sometimes I find myself staring in disbelief, expecting to see a level of plus 50bp and instead getting -10bp," says an MTN dealer based in London, a refrain constantly repeated by MTN dealers across the market over the last year.
"The problem is that investors are not blind if they are seeing CDS at plus 150bp and can see that they are only getting a structured funding level at plus 50bp then buying the note is nonsensical."
Agencies step up
Tiering of credit has become a big feature of the structured note market over the last year not just within the self-led, investment bank sector, and between investment banks and third party issuers but also between banks of all stripes and the sovereign, supranational and agency sector.
Here, though, the flight-to-quality effect has given conservative-minded investors a clear reason to stick with the borrower community, while higher interest rate volatility and therefore higher yields on structures has partly compensated them for the expensive credit that they are buying.
"Some investors are allergic to having non-triple-A issuers because of the credit issue," says Kentaro Kiso, head of frequent borrowers and MTNs at Barclays Capital in London. "But although it is much more expensive, you are compensated for the credit spread by higher volatility in the market when you structure an issue. Also, investors know that theres a clear difference, that theres an underlying intrinsic reason for the difference in price.
"The double-A banks are very cheap now and theres much bigger tiering in the market. On one side you have banks paying 60bp or 70bp for term money, on the other you have supra/sovereigns paying Libor minus so investors decision making is getting very black and white. There are two different markets."
For the second-tier, mostly quasi-sovereign agencies, structures have, if anything, become more important to their funding plans as spreads on their benchmark issuance have risen
"The difference between the public and private markets has got bigger for the cheaper triple-A issuers who see the MTN market as an even more important source of funding and some havent done any strategic benchmark funding at all this year," Kiso says.
Municipality Finance, for instance, is on course to meet its annual funding target exclusively from MTNs and private placements.
"Weve been benefiting on the demand side," says Timo Ruotsalainen, head of international funding for the borrower in Helsinki. "In the whole of 2007 we did 200 transactions and were on 135 already this year so were on track to break a lot of records. In volume terms, we did Eu2bn in 2007 and were on Eu1.35bn so far this year with a target of Eu2.8bn."
However, the very top tier of sovereign issuers have become too expensive as a result of the flight-to-quality seen in their secondary benchmark bonds. Some, like Cades, have hardly issued a structure as a result (see box).
"For borrowers that have public deals trading very expensively, to get arbitrage they have to make private deals even more expensive still, but I think that its a bad idea to close the window. If youre in you have to be in big to make your costs back," says Kiso.
It is another of the ironies of the post-crunch world that the interest rate-linked structured note market now moves to the rhythm of the credit markets. Where, once, the link between the two was purely and simply the motive force for investors unable to achieve any kind of realistic yield in vanilla bonds by adding an interest rate view, now the two are intertwined far more closely."The structured market is still being driven by the wider crises in credit markets and swap markets, though investor appetiteseems to be returning in more strength since the second quarter," says Jonathan Rogers, head of interest rate structuring, Europe, at Lehman Brothers in London. "Credit is an important driver of the structured market, not just for which issuers and investors will favour but if credit spreads are volatile then may tend to take a wait and see attitude."
Cades gets expensive
Widening swap spreads and higher spreads between Euribor rates and Eonia over the last year have led to higher costs for some sovereign agencies funding in Euribor in relation to their government owners. That has made these borrowers increasingly expensive in Euribor terms, putting the brakes on MTN issuance but increasing the attractiveness of borrowing indexed on Eonia, explains Pierre Hainry, deputy head of capital markets at Cades in Paris.
"In commercial paper we can raise funds at Eonia minus 20bp or minus 30bp, which can be around Euribor minus 100bp and it is just not possible to issue private placements, even structures, at these levels," he says.
That means the borrower all but stopped issuing MTNs since last August.
"We are still displaying levels for MTNs but they are extremely expensive compared to the levels we were displaying before July 2007," he adds.
At the same time as being forced out of the new issue private placement market, Cades funding costs based on Euribor rose on its entire portfolios of floating rate debt.
To compensate, the borrower engaged in a programme of floating for fixed rate swaps for its existing debt.
"We decided to offset the Euribor paid by entering into a programme of cancellable swaps in which we receive the Euribor minus margin the rate we pay on the micro hedge swap of the issue and we pay a fixed rate and where the counterparty has the choice to cancel the swap later," Hainry says. "With this kind of product, we can reach fixed levels far below vanilla swaps levels as we are selling volatility. This strategy enabled Cades to greatly reduce the cost of MTNs already issued."Hainry says that around 10% of Cades floating rate portfolio has been synthetically transferred to fixed rate as a result.