House of the year

Kara Lemont Sportelli

BNP Paribas

Total return swaps on the iBoxx corporate bond indexes were started last year by a working group of banks in which BNP Paribas took a leading role, alongside Markit. The French bank worked with JP Morgan and Morgan Stanley in the early development of a product that is now ready to compete with exchange-traded funds (ETFs) based on corporate bonds and is expected to become one of the next generation of flow products.

The principle behind the product is simple: corporate bond indexes, unlike equity indexes, are not directly tradable, which meant that those seeking exposure could either trade multiple individual bonds to create a portfolio – a lengthy and expensive option – or trade credit default swap (CDS) indexes, which brings with it bond-CDS basis risk.

The working group established market standards and the associated documentation for the total return swaps on corporate bond indexes in December 2011 and the first trade was done at the end of June. “Given that people could not trade corporate bond indexes such as the iBoxx or Barclays ex-Lehman Agg, and that they have been flying away from CDS and its complexity, we developed instruments to trade the bond indexes with a total return swap on these indexes,” says Denis Gardrat, head of credit derivatives structuring for Europe, the Middle East and Africa at BNP Paribas in London. “The payout is dead simple: you go long the index and you get the exact performance of the bond market.”

 The choice of iBoxx indexes includes EUR Corporates, USD Domestic Corporates, GBP Corporates, EUR Liquid HY and USD Liquid HY. BNP Paribas outlines the benefits for long risk investors as being exposure to a diversified pool of corporate credit names, while for short risk investors it is the ability to hedge existing portfolios, use the indexes to isolate alpha on managed portfolios, or express a bearish view on the bond market.

 “We started to make a market and that market is taking off, with hedge funds and insurance companies getting involved,” says Gardrat. The market makers are BNP Paribas, Credit Suisse, JP Morgan and Morgan Stanley. 

 “It is a very efficient way to go long [and short] the bond market, in a much more diversified way than you are with CDS indexes,” he says. “The iTraxx has only 125 credits, whereas this has more than 1,000 bonds. More and more ETFs are being launched on the back of corporate bonds, especially in the US. But investing in the new index is more efficient than an ETF. It is cheaper because it is unfunded, and there is no tracking error.” 

Bond ETFs in the US are generally physically backed rather than derivatives backed, which means they suffer a degree of tracking error. “Bond ETFs can’t really buy 1,000 bonds, so they tend to pick up subsets of liquid bonds, so you still have basis risk. And there are no management fees,” he says.

“We are competing with the ETF managers,” says Gardrat, who notes that the cost for the investing in the index may be as low as three basis points, far less than investing in an ETF. “The next step is creating options,” he adds.

The French bank has also moved to create simple ways for investors such as private banks to take a little more risk but also more yield. “We started from a CDS, which can be simplified by offering zero on default,” says Gardrat.

There has been a big change in the demand from private retail banking for fixed-income products – mostly credit and foreign exchange, not as much on the rates side,” says Kara Lemont Sportelli, head of fixed-income structuring at BNP Paribas in London. “Interest rates are a bit more confusing for private retail banking clients.”

The theme of simplicity was maintained when creating the Flexible Fund Stars Index, an absolute return investment strategy designed to cope in the event of “brutal market movements and erratic performances of asset classes”, according to the bank. The index tracks four European funds chosen on the basis of their “excellent global performance, track record over five years and significant assets under management (AUM)”. The chosen indexes are the Carmignac Patrimone, with €26.01 billion in AUM and performance of 6.52%, the Standard Life Investments Global Absolute Return Strategies Fund with €15.65 billion and performance of 11.8%, the Ethna-Aktive Fund with €2.73 billion and performance of 7.15%, and the BNY Mellon Global Real Return Fund with €7.81 billion and performance of 7.34%.

The index has been sold in Belgium, France, Ireland, Poland, Scandinavia and Switzerland. “It is the most European product we have seen [in the past year], which met client expectations in absolute return as opposed to equities and in looking for low volatility, shying away from the usual proprietary indexes from banks,” says Jean-Eric Pacini, London-based head of equity distribution at BNP Paribas. The product can be delivered either with or without the bank’s Isovol volatility control mechanism – without to account for the constraints imposed by Belgian regulator the Financial Services and Markets Authority (FSMA). Around €300 million of the product has been sold across Europe.

“It has been a success with institutional investors because these funds can get bad capital treatment under Solvency II,” says Bertrand Delarue, global head of flow product engineering at BNP Paribas in Paris. “We went back to clients and said, if you buy call options on this index, you will get similar returns to the fund, but a much cheaper capital charge. We have a tool which tells the client that, provided the call option is cheap enough, it wouldn’t matter if the fund goes up or down, because you save so much on the capital charge that you become indifferent to the performance. The same product can be pitched as a super safe or a leveraged investment.”

Further success has come with the Premium 7, which was one of the biggest placements with French independent financial advisers (IFAs) and a sign of the recovery in equity-linked products. Cyrus Conseil was the main IFA network distributing the product. Observation of the Euro Stoxx 50 index over 20 days boosts the safety element of the eight-year product, which offers potential annual returns of 7%. “It was a natural evolution for people who have been doing autocallables and were concerned about ‘one touch and you are out’,” says Pacini. “It’s relatively simple, but the flavour of the market is in its simplicity, safety and robustness”.

The bank’s structured products team has also had great success in Greece, playing an important role in the private sector involvement (PSI) for Greece’s sovereign debt restructuring, while helping its clients take advantage of the unwinding of asset swaps by investors willing to participate in the PSI (see page 31). Local client references also praised its general service in equity derivatives.

BNP Paribas also received praise from clients in Russia: “BNP was not that competitive in Russian products but this year it has become much better” says one local distributor. “It’s like two completely different banks when compared to last year.”

In Italy, the bank delivered high yield and the benefit of upside potential with BTP (Buoni del Tesoro Poliennali) 10-year secured certificates for Banca Mediolanum. The bank considered BTPs as the best combination of risk and reward to distribute through its private bank network. “The idea involves a legal framework and architecture for issuance,” says an official at Banca Mediolanum in Milan. “We started talking to banks about the idea two years previously, but BNP Paribas had the base prospectus that allowed them to issue this kind of secured certificate.”

The product, which took the Euro Stoxx 50, S&P 500 and Nikkei indexes as underlyings, comprised a BTP strip for the capital protection and an equity-linked option provided by BNP Paribas Corporate and Investment Banking, which was collateralised with G-7 and eurozone government bonds. The bank does not guarantee the invested capital, which is subject to the BTPs not defaulting. The strategy leverages on the BNP Paribas warrants and certificates issuance programme, thereby avoiding the cost and complexity associated with special purpose vehicles. 

“The yield is good because the goal of the operation is to provide the capital protection of a structured product with a government bond issued by the Republic of Italy and an equity exposure through an option,” says the Banca Mediolanum official.

The first private placement was launched a year ago, with the 10-year maturity preferred by investors, raising roughly €40 million. There has also been one issue of €4 million in the four-year maturity. “With BNP, I managed to collateralise the option exposure with government bonds from the euro area,” says the official. “In relation to the BTPs, if I have a credit event on the Republic of Italy, the BTP will be cash-delivered – that is, cashed out by BNP Paribas – to the client. This is a key selling point because the client can decide what to do with the bond. If there is a credit event and they don’t have the bond, they have to wait for a credit derivative definition about the recovery rate of the BTPs.”

Over the past year, BNP Paribas decided to make a subtle, yet important adjustment to the collateral it uses for all of its swaps, deciding to switch to German government bonds. “People reacted well to the fact that we were very transparent about what we were doing, acknowledging that French government bonds for BNP are good collateral except in the case of tail risk,” says Delarue.

Collateral was also brought into discussion when a UK insurance company requested an idea on how to play a meltdown in the eurozone. “We looked at all the tail-risk products out there, as well as fixed income and alternatives, and settled for a put on 2013 dividends,” says Delarue. “We advocated a 90% strike put on dividends, which is super cheap because it is a very low-volatility asset. We had capacity to offer to the client – why would we sell tail-risk otherwise? – and were happy to recycle the position in a trade with them. When delivery time came, there was the question of whether BNP Paribas would be around to pay the put if there was a meltdown in the eurozone, so we resorted to collateralised warrants in US dollars. Despite the fact that the enquiry was targeted to an event that could be very bad for BNP, they came to us because they liked the idea and they liked the execution.”

Client references are also appreciative of the bank’s volatility and risk management strategies as well its Smart Derivatives technology platform.

The bank’s leading development in risk management is its Curve Alpha Zero Correlation strategies, which includes a risk-management layer that aims to neutralise the correlation between a commodity alpha strategy and a long-only exposure to commodities. Curve alpha strategies mean being long a beta-enhanced version of a benchmark commodity index that is generally invested in futures contracts with a longer maturity than the one included in the benchmark index, and being short the benchmark index, such that the Curve Alpha strategy captures the outperformance of the beta-enhanced version compared to the benchmark index.

The correlation between the front month and the longer maturity contracts is not perfect, so the bank provides a zero-correlation mechanism: on a daily basis, depending on the realised beta of the strategy, a small positive amount of the benchmark index is added on top of the strategy, neutralising the negative over time.

Commoditising transaction and function costs have come in the form of Smart Derivatives, a web platform for structured products that provides investment strategies, primary trading, secondary trading and client portfolios. The bank now has around 50 clients worldwide (more than 35 of which are in Europe) and this number is growing by the day. The bank provides as many as 60,000 pricings per month via the Smart Derivatives platform.