Credit Derivatives in various forms have been used by the interbank market for a number of years. We are now seeing the use of these products increase dramatically and the range of counterparties is becoming ever more diverse. Investment banks, commercial banks, insurers, funds and corporates are now all active users of credit derivatives in their various guises.
This edition of the Learning Curve serves to highlight investment applications for the core credit derivative products. This core class is defined as credit default swaps, total return swaps and credit spread options. Instruments such as credit linked notes and synthetic securitization products have not been discussed. For each instrument, a brief definition has been provided with some examples of applications and advantages.
Credit derivatives provide the following benefits:
* Allow institutions to take on specific credit exposures that may be defined in terms of reference assets, size, maturity and currency
* Allow institutions to generate enhanced returns by utilizing credit investment strategies
* New portfolio techniques can be employed using credit products to allow users to manage their credit risk exposure.
CREDIT DEFAULT SWAPS
Quick definition
A credit default swap is a bilateral financial contract in which one counterparty (the protection buyer) pays a periodic fee, typically expressed in basis points (bps) per annum, paid on the notional amount, in return for a contingent payment by the protection seller following a credit event with respect to a reference entity. A default swap with the same maturity as the underlying is equivalent to a long position in the underlying asset with the interest-rate risk immunized.
Investment applications/advantages
Efficient way to release regulatory capital
Default swaps allow users to carry out bank loan portfolio management. Corporate loans are weighted at 100% drawn or 50% undrawn. If the same exposure is obtained via a default swap from an Organisation of Economic Co-operation and Development bank then regulatory capital falls to 20% and 10%, respectively. Credit derivatives in this context provide an instant arbitrage opportunity.
Laying-off exposures
Banks use default swaps to lay off exposures that do not meet their return criteria and use the freed capital to invest in transactions that do.
High cost of funding issues
Default swaps offer banks with high funding costs the chance to earn positive carry from high-quality assets.
Credit line issues
Default swaps are a tool that can be used to actively manage credit lines. For example, if a counterparty is overline on a U.S. bank name and has unused capacity on a European bank, then default swaps can be used to buy protection on the U.S. bank and sell protection on the European bank to gain exposure to the Eurosector.
Default event protection
Default swaps can be used when an investor owns a particular bond and wishes to protect himself from the possibility of default without liquidating the underlying position.
Leverage
Default swaps are unfunded transactions that are by definition leveraged thus they will appeal to hedge funds and insurance companies who are buyers of secondary market loans.
Diversifying concentrated portfolios
A bank may have a high degree of concentration risk in a particular sector. The bank could improve its risk/reward profile by investing in a credit/sector that has a low default correlation with its existing portfolio. To achieve this the bank buys a credit default swap on a credit that is in its existing portfolio. Simultaneously, the banks sells a credit default swap on a credit that is uncorrelated in an amount that generates revenue equal to the cost of the long default swap hedge. This also is known as revenue neutral diversification.
TOTAL RETURN SWAPS
Quick definition
Total return swaps are agreements in which the coupon and any capital appreciation on an instrument, such as a bond, are exchanged for a LIBOR-linked payment, plus any depreciation in the capital value of the underlying asset. They represent a synthetic long position, which can be compared to a long futures position when price changes are settled frequently.
Investment applications/advantages
Balance sheet management
Total return swaps allow institutions to carry out balance sheet management. For example, as opposed to buying securities which increases the size of the balance sheet, an institution can use a balance sheet provider to warehouse assets. In this instance, securities that are owned by the institution can be purchased by the balance sheet provider. A total return swap is then entered into whereby the institution retains exposure to the asset without incurring balance sheet charges.
Credit Paradox
This is the situation in which smaller institutions can find themselves when they try to build the diversified portfolios they know are most efficient. As their resources and geographical networks are limited, they specialize in particular regions and sectors, thus building up dangerous concentration risks in their portfolios. Total return swaps allow these banks to lay off risk without damaging relationships and also allow them to diversify their portfolios.
High cost of funding issues
Default swaps offer banks with high funding costs the chance to earn positive carry from high-quality assets.
Overcoming tax barriers using replication strategies
Total return swaps can provide customized replication strategies as they transfer the total economic performance of a security. This can be utilized to overcome tax barriers which preclude an institution from directly investing in a country's securities.
Synthetic high-yield debt trading
Investors can use a total return swap to gain leveraged exposure to bank loans while keeping the transaction off the balance sheet.
Capital structure arbitrage
Capital structure arbitrage is when a perceived mispricing between bank loans and subordinated debt of the same issue is exploited. For example, if the loan is yielding a higher return than comparable subordinated debt, then a total return swap can be used to exploit the opportunity by effectively going long the bank loan and shorting the subordinated debt.
Diversifying concentrated portfolios
A diversified portfolio is necessary to achieve an optimal risk/return profile. Total return swaps can be used to diversify risk without actually selling underlying loans as explained previously.
CREDIT SPREAD OPTIONS
Quick definition
Credit spread options or asset swaptions, as they are sometimes known, allow the buying and selling of an underlying credit-sensitive asset at a pre-determined price for a pre-determined period. For example, an investor may sell to an investment bank the right to sell a bond to the investor at a certain strike in the future. The strike would be set as a strike to LIBOR.
Investment applications/advantages
Directional credit spread trading
Allows institution to take a directional view on credit spreads and also to hedge exposure to downgrade risk.
Cutting up the credit curve
Allows institution to trade the term structure of credit risk by dissecting the credit curve to take on positions that would not be available in the cash market.
Yield boost
Allows institutions to boost the yield on assets they own by selling spread options. This is particularly appropriate in buoyant market environments, when credit market investors find themselves underinvested.
Credit spread volatility
Allows traders to take views on the volatility of credit spreads.
Locking in future borrowing costs
Allows borrowers to lock in future borrowing costs without inflating their balance sheet.
This week's Learning Curve was written by Bobby Console-Verma, head of online credit product sales at CreditTrade in London.
