Once in a while, a bank launches a product that takes the market by storm. Credit Suisse certainly achieved this with the global rollout of its Collateralised Equity and Debt Obligation (Cedo) transaction. Although the product has enjoyed success worldwide, Cedo's Asian story has really stood out. Indeed, its success in Asia makes it a deserving recipient of our flagship award for the region.
Cedo is effectively a collateralised debt obligation (CDO) referenced to out-of-the-money equity barrier options, or equity default swaps (EDSs). The aim is to exploit relative value opportunities between equity and debt.
The concept of utilising EDSs in a CDO portfolio is not necessarily new. In January 2004, for example, JP Morgan launched the first rated CDO with an EDS component, dubbed Odysseus. But Credit Suisse has importantly differentiated itself through gaining an Aaa rating from ratings agency Moody's Investors Services. As a result, the bank was able to market the product much more effectively, tapping the high-net-worth market in Asia.
"Put simply, Cedo provides an equity/credit market arbitrage. There is a low correlation to credit spreads with little impact of widening spreads until a distressed situation occurs. There is also little overlap of credits with traditional CDOs," says Adam Cowperthwaite, Asia-Pacific head of structured retail products at Credit Suisse in Hong Kong. "There is also the added protection which provides limited direct exposure to overall equity markets. What's more, there is an extra feature ensuring there is no chance of an equity default in the first three years, with guaranteed coupons meaning only the notional is at risk."
There have been two Cedo transactions in Asia. Cedo 2, which was launched globally, had one tranche launched in Korea in co-operation with Woorie Asset Management. A total of $133 million was placed in Korea, representing a fair chunk of the global launch, which raised a total of $318 million. Moody's gave the transaction an A3 rating and there were fixed guaranteed coupons of 7.45% for the Korean tranche.
Cedo 3, meanwhile, was launched exclusively in Korea, again with Woorie. A total of $35 million was placed, the rating was A3 and it offered fixed guaranteed coupons of 6.47%. Both products have a six-year maturity.
It all sounds relatively straightforward so far. But while the explanation of products to investors has been aided by Credit Suisse's efforts to encourage transparency, underpinning the transaction are some complex financial engineering techniques.
The difficulty of the product rested with the use of EDSs, a similar concept to credit default swaps (CDSs). While CDSs are subject to bankruptcy and failure to pay, EDSs are triggered if the reference entity's share price falls below a predetermined barrier, usually 30-35% of its initial value.
Although the concept is similar, the risks are notably different: for a start, there is a greater chance that a stock will fall to 35% of its initial value than of a company actually defaulting. Thanks to this risk, other firms had been unable to gain a strong rating agency rating.
Credit Suisse was undeterred, however, and developed the concept of an insurance portfolio to gain the all-important rating. Instead of taking exposure to a single portfolio of EDSs, the investor becomes simultaneously short a second basket of names from similar geographical zones and industrial sectors. The effect is that, in a crash scenario, losses from the risk portfolio (caused by stock prices droping below the barrier level) are offset by EDSs in the insurance portfolio. These EDSs come into the money once they fall to 35% of their initial value. Marry this with the knowledge that investors are protected if a stock dips below the 35% barrier over the first three years of the product's six-year maturity, and Cedo proved successful in securing the strong rating.
So far, others have been unable to replicate the strategy, largely due to a lack of modelling capabilities, market participants say.
Why Credit Suisse won
Few institutions have offered a product to market that can truly be described as groundbreaking. Cedo has won fans across the world, gained that crucial agency rating, and looks set to develop even further.
The week on Risk.net, December 2–8, 2017Receive this by email