It has been a testing 12 months for credit houses in Asia. Mounting trade tensions, stop-start peace talks on the Korean peninsula and the unfolding Brexit crisis stoked economic uncertainty and pushed credit spreads wider as investors fretted about the rising default probabilities.
Until late 2018, rising US interest rates also weighed heavily on the marked-to-market value of structured note trades in the credit markets. On some leveraged notes, especially those that have Chinese additional Tier 1 securities and real-estate bonds as an underlying, some investors in the region are known to have incurred losses – but not Societe Generale’s clients.
“Last year, the credit market has not been easy,” says Ryan Chan, head of Greater China cross-structuring group at Societe Generale. “We have been very diligent and prudent in the credit selection process, working together with clients so they could avoid ‘knock-out’ events.”
Societe Generale’s exotic credit-structuring franchise managed to ride out the storm, aided by an activity boom in China and Japan, as well as a knack for pitching the right products at the right time.
In Japan, the bank maintained its leading position in the credit-linked note (CLN) market and launched a hybrid power reverse dual-currency (PRDC) note with an embedded credit exposure. In China, it pioneered repurchase agreement financing for banks backed by collateralised loan obligations.
Overall, the notional traded across Asia by Societe Generale’s financing solutions franchise reached 113% in 2019, a 113% year-on-year increase. Underpinning this growth is the bank’s enduring focus on alternative risk transfer (Art), the practice of the slicing, dicing and repackaging of structured products risk to create attractive payouts for sophisticated investors.
Big in Japan
Earlier this year, Societe Generale designed and marketed a new, credit derivatives-infused version of an old favourite of the Japanese retail investment market, the PRDC note.
Like many structured products marketed to retail investors in Asia, PRDC notes have a somewhat chequered history. The notes, which combine exposure to foreign exchange, interest rate differentials and domestic inflation, were once the darling of Japan’s structured products market, offering higher yields than bonds and with seemingly little risk. But they fell out of favour during the global financial crisis when an appreciating yen left dealers and investors alike nursing big losses.
A hybrid version that Societe Generale structured has helped to resurrect Japanese investors’ interest. The traditional PRDC was in essence a bet that the yen will not appreciate versus the US dollar as implied by the USD/JPY forward curve over a 20-year period. In Societe Generale’s new PRDC, this has been reduced to 10 years, with credit risk on a financial institution embedded into the payoff.
Should a credit event occur on an underlying entity, then the product would redeem in line with the recovery rate of the relevant credit default swap.
Roughly $30 million has been raised on this new PRDC product over the past 12 months, the bank says. This success owes much to the bank’s exotic credit-structuring expertise, and its cross-asset DNA, which allows the creation of tailor-made and unique exposures across asset classes.
“They are coming back to the PRDC product in the form of hybrid credit-linked notes,” says Chan. “We had good traction across the board and noticeable sizes traded in this variation.”
Another new product that has been a hit with Japan’s yield-starved retail investors is a structured fund linked to repackaged Italian government bonds, and the USD/JPY forward curve. When a policy issued by the Investment Trusts Association Japan in June 2018 opened the door for asset managers to offer single credit-risk products to clients for the first time, Societe Generale reacted promptly. The bank successfully partnered with a Japanese asset manager to distribute a very simple solution to their clients, minimising the capital at risk and offering attractive returns.
The fund has a six-year maturity and pays a fixed coupon for the first year and a digital coupon for every subsequent year if the USD appreciates against the Japanese yen. This simple, easy to understand structure with a comparatively short maturity has been a big hit with investors. As of April 2019, the fund had roughly $54 million of assets under management.
In the institutional client space, cross-currency repurchase agreements were a key area of growth for Societe Generale’s credit franchise in Japan over the past 12 months.
The main transaction was one where the bank received Japanese government bonds and paid USD cash, allowing clients to benefit from rising interest rates in the USD market. “Clients can make use of the US dollar to invest in something with higher yield,” Chan says.
In contrast to Japan, where the spotlight been on providing better yielding investments, Societe Generale’s focus in China has been on helping clients secure more cost-efficient funding. Through its proficiency in credit selection and risk management, the bank has been able to grow its asset financing business in China in the past year. For correlated asset financing, for example, the notional traded with Chinese clients hit $3.4 billion in 2019, a 113% year-on-year increase.
The bank recognises not only the opportunities in this business, but also the risks.
“They [Chinese clients] love leverage, but the fact is most of the underlying collateral, which they want us to leverage upon is highly correlated with the counterparty themselves,” says Chan. “With that, it’s very important for us on the trading side to work on the risk management; to agree with our own internal risk department on a risk framework that allows us to trade the notional substantially.”
Sometimes delivering collateralised financing to Chinese clients calls for imaginative solutions, says Chan. One example from the past year is the growth repo linked to collateralised loan obligations with Chinese financial institutions. Some of these clients had been looking for an additional source of funding, but amid a slew of high-profile defaults in the shadow banking system they were finding it difficult to find counterparties comfortable with their credit risk.
Some of these financial institutions were holding collateralised loan obligations (CLOs), however. After a thorough analysis of these assets by the risk department, Societe Generale agreed to trade repos collateralised by those CLOs with the clients. This trade has now become fairly commonplace, but Societe Generale claims to have been one of the first banks off the mark.
“Chinese investors love the regular tranches; it’s quite yielding, but it’s not yielding enough. But by providing financing against the CLO, we can further enhance the return,” says Chan. “We are one of the first banks to have done that.”
Another emerging trend in 2019 that the bank has capitalised upon is the revival of global investors’ appetite for high-yield bonds in Asia, particularly those of Chinese property developers.
Accounting for roughly 30% of gross domestic product in the world’s second-largest economy, the Chinese real-estate sector is, undoubtedly, of great systemic importance. High-yield debt securities issued by companies in this sector fell out of favour in 2018 amid the escalating trade war between the US and China, and a strengthening dollar. For some investors, those risks now seem to have subsided somewhat, however, prompting Societe Generale to start market-making on the bonds.
The bank began quoting on 20 real-estate benchmarks in mid-2018 and, within the space of a just a few months, it had become one of the leading players in the market. Many of the bonds can yield a range of 5–7% for a double-B rated firm and 15% for a single-B rated.
Chan says they have seen strong demand for investing in good quality benchmarks of real-estate developers. “The market share of the 10 largest players was maybe 5% in 2006. Now it’s 30% and may climb up to 50% in the future,” he says. “The largest real-estate developers are becoming huge and they issue many bonds.”
Growth through risk reduction
The growth of Societe Generale’s credit franchise in Asia in the past year has been facilitated by a relentless focus on risk reduction, through the application of Art trades in particular.
One recent example saw the bank trade a super senior tranche of a credit-linked note in Asia, in order to offset the correlation risk associated with single-name CDS hedges of tranche CLNs.
Usually it is difficult to find investors for the more conservative, lower yielding super-senior tranche, but Societe Generale was able to transfer this risk for the first time by entering into a trade with the Hong Kong office of a global hedge fund. The hedge fund identified the trade as a way to take advantage of a market dislocation on the Eurostoxx 50 volatility resulting from structured products dealers’ hedging of autocall issuance.
The five-year CLNs were traded on the iTraxx Crossover index Series 30 and 29, offering a diversified exposure on the high-yield European credit market. The hedge fund client decided to sell the credit protection on the super-senior tranche (22.97–100%), as the seniority structure was offering sufficient loss protection in all scenarios bar the higher correlation mass-defaults scenario in which asset prices become highly correlated on the way down.
Finally to hedge this tail scenario, the client also bought long-dated, out-of-the-money put options on the Euro Stoxx 50, where the implied volatility was also compressed by the large scale issuance of autocall products. The low-cost of the hedge was a crucial selling point to the tranche CLNs trades.
“Two reasons why we are able to do this,” says Chan. “Firstly, we have a transparent flow of information within the organisation. Secondly, we have roughly a team of 20 financial engineering analysts placed across the US, Europe and Asia, and the heads of the respective teams with buy-side experience, meaning they’ve been on the risk-taking side of the business.”
“Therefore, we have a better understanding of how we can pitch these products and how we can transform the risk that sits on our book to a payoff that is interesting for the client,” he says.