The last year and a half has been particularly volatile in the emerging markets with crises in Asia, Russia, and Brazil all wreaking havoc locally and spreading, to varying degrees, to the rest of the world. The resulting swings in asset valuations have presented investors with both attractive opportunities as well as substantial risk. To alter risk profiles during this time, many institutions began using credit derivatives to reduce, change the form of, or eliminate exposures they held to borrowers and counterparties. Others have seized the occasion to add new and varied exposures at very attractive levels that fit their investment guidelines. Recent product developments provide investors and institutions with better techniques to exploit these opportunities and hedge against their potential losses.

This article outlines the two basic credit derivative products-Total Return Swaps and Credit Default Swaps-and describes applications for investors. The logical extension of these products to Credit Linked Notes is then made with additional applications outlined.

TOTAL RETURN SWAPS
In a typical Total Return Swap (TRS), a bank agrees to pay the total return of an asset or index (referred to as the reference obligation) to an investor in exchange for receiving a financing rate, usually Libor plus a financing margin. We define “bank” as the provider/market-maker of TRSs, and “investor” as any institution with debt investments.

Total return equals interest paid plus/minus the price appreciation/depreciation of the reference obligation. Just as in actual bond ownership, total return can be negative, in which case the investor would owe this amount to the bank.

A number of factors drive the financing rate, with the notable ones being the investor’s credit quality, the credit quality of the reference obligation (as evidenced by its credit spread) and the correlation between these two. A low default correlation can greatly reduce the financing rate. Thus, the TRS provides the same economics as cash-bond ownership (including interest rate exposure) without having to use cash to effect the purchase. Applications of TRSs are discussed below.

Financing
The most common usage of TRSs is for financing and leverage. As the transaction simply involves the exchange of one set of cash flows (i.e., financing) for another set (i.e., coupons +/- price change), there is no initial purchase price or principal transferred. There is, however, usually a 10% to 20% collateral requirement, or “haircut”. If a 10% haircut is required (10% of the purchase price given in cash or securities collateral), then the investor has a 90% leverage position which translates into a gearing of 10. The other 90% is borrowed and frees the cash for other investments.

TRSs can be transacted using an investor’s current holdings (the bank would purchase those bonds and simultaneously enter into a TRS) or to effect new positions (the bank would purchase bonds from the marketplace).

Balance Sheet
An increasing number of organizations are using TRSs for effective balance sheet management.

Local jurisdictions vary widely on the treatment of on-balance sheet bonds versus off-balance sheet TRSs. There may be capital, tax and accounting reasons for shifting assets off-balance sheet. In one Latin American jurisdiction, for example, TRSs do not exact mark-to-market treatment, whereas the same bonds held as cash instruments on-balance sheet would require daily valuation. There are also situations where capital requirements may be reduced if an institution is able to place TRSs in a derivatives trading account. Usually active management of the position is required in order to establish “trading account” capital treatment. In all cases, it is important to understand local regulations and prudent to verify treatment of the trade with the local regulatory body prior to transacting a balance sheet motivated position.

Creating Access
TRSs can often provide access to markets or bonds that are sometimes difficult to reach.

One such example would be the corporate loan market. Whether US- or Latin American-based, loans are an attractive asset class because of their high default recovery rates. They do, however, require a high level of back-office maintenance. This may present problems sufficiently onerous for insurance companies or asset managers to cause them to eliminate the loan asset class entirely. A loan-based TRS allows an asset manager to leverage off the capabilities of the bank’s back-office to effect his investment. Loan investments are particularly attractive investments during periods of high default risk or during contracting spread markets as loan pricing tends to lag the faster-paced bond markets.

Equity and Debt Repurchase
One of the latest applications of TRSs is by corporations seeking to repurchase their equity or debt. If a corporation thinks its stock or bonds are undervalued they may elect to conduct a buyback in anticipation of higher prices. Buybacks, of course, require large expenditures that may be needed for new or existing projects. The buyback can be effected through a TRS without the need for the company to fund large repurchases. At maturity of the TRS, the company can: (i) close out the transaction, (ii) roll into a new TRS, or (iii) purchase the physical assets as a cash investment.

CREDIT DEFAULT SWAPS
The other most commonly used credit derivative is the Credit Default Swap (CDS) or simply Default Swap. In a CDS, one party (known as the CDS seller or credit protection seller) effectively takes a long position in a reference obligation by receiving a per annum premium in exchange for insulating the protection buyer against losses if the reference obligation defaults.

Since the bonds of an issuer are generally cross-defaulted, the CDS can be considered to be a long or short default position on the reference entity, as opposed to the reference obligation. Like a TRS, there is no principal investment, so the premium approximates a “credit spread” as opposed to an all-in yield (which equals the treasury level plus a credit spread). Because of this structure, CDSs carry very little interest rate risk.

The determination of the premium is driven by multiple factors, the more significant being the credit quality of the referenced entity, the observable spreads on their cash bonds, and the duration of the CDS. The above factors form a trading range, but other forces such as repo rates on the referenced entity’s bonds and demand and supply of CDS product can play a vital role, causing premiums to shift on a day-to-day basis. Listed below are some recent applications of CDSs.

Debt Substitute
More and more investors are taking on bond risk by simply selling protection through a CDS. Like a bond, a spread (or premium) is earned in exchange for accepting the credit risk of the underlying entity. The CDS is a very “clean” way to take on risk in that the investor is not exposed to interest rate risk or credit spread deterioration. For example, a one-year CDS would provide an investor with a full year of premium and, assuming no credit event occurs, would mature without any recourse even if interest rates rise over the course of the year and/or credit spreads widen.

Creating New Maturities
CDSs are particularly effective when there are no cash bonds available that equal the tenor of an investor’s desired holding period. For example, an investor of USD Mexican sovereign risk is faced with a dearth of products in the six to 12-month sector of the yield curve. The only cash market strategy is to buy longer-term paper and accept spread widening risk. As an alternative, the investor could sell protection, receive the premium, and be at risk to a Mexican sovereign credit event. This example is even more relevant when dealing with corporate bonds, where typically there are far fewer issues available. CDSs can generally be transacted at any point along the credit yield curve.

Hedging Credit Risk – Buying Protection
Both a corporation with credit risk to its trading partners and an investor bearing credit risk through its bond portfolio can reduce their risks by buying default protection. In the bond portfolio example, selling the bonds is an alternative, but this may be unattractive for several possible reasons-tax consequences, market conditions, or simply loss of control of the bonds. A CDS is an inexpensive short-term solution to this problem. Additionally, to lock-in profits on in-the-money positions, or to obtain long-term credit relief, one can buy protection to the maturity of the underlying bonds.

Alternatively, some employ a rolling hedge strategy, for example, buying one-year CDSs to hedge longer-term bonds. This latter strategy usually results in a positive carry trade (with no credit risk to the investor) over the tenor of the swap.

CREDIT-LINKED NOTES
Investors can exploit an expanded range of investments by buying debt instruments that have embedded CDSs, with the investor typically being the protection seller. They are typically issued by banks in the form of Credit-Linked Notes (CLNs) or Credit-Linked Certificates of Deposit. Because of their similarities, we refer to both generically as CLNs. By dealing with default swaps indirectly through CLNs, the investor can participate in the higher potential returns of credit derivatives while avoiding credit and regulatory constraints involved with transacting default swaps. These notes can address the same investment applications described above for default swaps. For example, CLNs enable the investor to buy synthetic sovereign or corporate paper with maturities not available in the cash market.

In this regard, they are fully customizable to the investor’s preferences in terms of maturity and reference credits or combination of credits. Other sample applications of CLNs are described in greater detail below.

Cash/Credit Arbitrage
In a volatile market, CLNs can offer yields substantially above cash-market products creating interesting cash and credit arbitrage opportunities. For example, Mexico-based financial institutions were recently able to raise nine-month deposits at 7% and invest those proceeds in CLNs linked to the Republic of Mexico with yields above 8.5%. The note accomplished two objectives, providing both a synthetic government bond where one did not exist in the cash market and a superior yield even when compared to the longer-duration cash government bond of February 2001. Even more interesting is the implied credit arbitrage in this transaction-Mexican bank deposit liabilities bear greater credit risk than Mexican sovereign debt, hence the positive arbitrage for the bank.

Senior Secured Credit-Linked Notes
As discussed in the TRS section above, bank loans provide for relatively high recovery values in the event of default. For example, senior secured corporate bank loans recover at an average of 71% of face value, compared to only 33% for subordinated bonds. As such, loans offer a more secure way to buy high-yielding corporate credit. Furthermore, loan-based CLNs have at times offered yields surprisingly close to their subordinated cash bond equivalents. An Argentine loan-based CLN referenced to a well-known corporation traded at a spread of 200 basis points in the two-year sector when the five-year subordinated cash bond was trading at 235 bps. Clearly, the additional 35 bps earned on the bond were more than offset by its much higher duration and potential lower recovery in case of default.

Baskets
One way to achieve leverage with a CLN is through a “first-to-default note”. With this note, the investor is exposed to the risk that any one of several reference credits defaults, and in return earns a spread that is considerably higher than any one of the reference obligations. If default occurs with any of the credits, then the entire note redeems at the recovery rate of the defaulted asset.

In addition, for more risk-averse investors, several default swaps structured appropriately can produce notes whose principal is “protected” by an investment grade credit (rated BBB and above) while its coupons are linked to riskier, higher yielding credits.

The note would yield less than the risky credit alone, but more than the highly rated credit. If the riskier reference credit defaults, the principal would remain intact and the interest payments would cease but recover at a rate linked to the reference obligation recovery rate. This structure works well for those seeking higher spreads but whose investment guidelines stipulate that the principal be investment grade.

We have outlined a broad range of product applications that are by no means exhaustive.

Nor have we introduced the full range of credit derivatives. These can also get into the realm of more option-like derivatives.

Options on credit spreads have many times proven very useful to relative value investors. Typical examples include options to enter into an asset swap at a particular credit spread, put options on a bond struck at a specified credit spread, and call or put options on the difference between two assets’ credit spreads.

While such spread products can prove extremely useful, they generally require more hedging on the part of the banks, and a more defined directional view on the part of the investors.

Although a complete discussion of this class of credit options is beyond the scope of this article, their wide use confirms their value and that of credit derivatives in general.

These derivatives and credit-linked notes present investors powerful tools to respond to the hedging and investment needs encountered daily. Indeed, they are invaluable in taking advantage of the opportunities that arise in volatile markets.

-Barry Delman, Eugene Beidl and Michael Tomczak of Scotia Capital Markets