Credit derivatives house of the year: Credit Suisse

Asia Risk Awards 2022

Jacqui Zhang and Soumitra Bhattacharya, Credit Suisse

A booming market for private credit is threatening to push banks further to the sidelines, as assets under management in direct lending funds surpass $1.2 trillion.

Credit Suisse, however, has identified an opportunity to stem the disintermediation. The bank is leaning on its credit structuring and derivatives expertise to develop an array of financing, leverage and risk management tools for private credit funds.

This diversification away from crowded public markets, where banks have competed on aggressive financing terms, seems to be paying off. When a violent credit market selloff in the final quarter of 2021 and the first quarter of 2022 left credit businesses in the Asia-Pacific (Apac) region with gaping wounds, Credit Suisse’s structured credit business did not post any losses.

“We were in a fairly good spot from a risk management perspective,” says Soumitra Bhattacharya, the bank’s Australia-based head of Apac structured credit trading.

“That allowed us to stay in the financing market this year, even as many competitors pulled back. We were still in a position to offer solutions to clients and help them navigate the market.”

After a regulatory clampdown on leverage in China’s domestic housing market triggered a selloff in developers’ assets, the bank delved deep into its structuring toolkit for innovative ways to deliver stable financing to holders of bonds issued by distressed Chinese property developers. A renewed focus on idiosyncratic hedging instruments also turned out to be the right call for clients when a deviation in high-yield credit markets rendered macro hedges ineffective.

Asia’s credit markets hit an inflection point in 2022 after a multi-decade bull run. Soaring inflation and declining growth sent equities and bonds falling in tandem, forcing investors to rethink the traditional 60:40 stock-bond portfolio construction.

“In this context, private credit has presented itself as a great addition to the standard portfolio to improve upon the Sharpe ratio in an inflationary environment,” says Jacqui Zhang, head of Apac financing and solutions structuring at Credit Suisse in Hong Kong.

We could actually source bonds which many of our competitors probably cannot

Soumitra Bhattacharya, Credit Suisse

The recent growth in private credit has outpaced that of the traditional bond markets. Assets invested in private debt funds are expected to more than double, to $2.7 trillion, over the next five years, according to hedge fund data firm Preqin.

The Apac region represents a small fraction of the private credit assets under management globally, yet Credit Suisse anticipates exponential growth as companies seek alternative, stable forms of financing. There are no shortage of players looking to invest in the space: yields are chunky thanks to the illiquidity premium associated with private assets, while the largely floating-rate financing offers an inflation buffer.

Big names are bulking up. Blackstone plans a tenfold increase in its Asian private credit investments, and KKR has raised $1.1 billion for a fund focused solely on the region.

“As more money moves into the private credit space, we will see increasing demand for financing solutions,” says Zhang.

She adds that these funds are seeking more sophisticated, derivatives-based tools to assist in hitting return targets: “Employing leverage enables funds to meet their return targets with lower-yielding – but higher-quality – assets, rather than going into riskier deals.”

Many deals are structured with options or warrants, allowing investors to participate in further upside and enhance returns.

The full lifecycle

Credit Suisse aims to address the full lifecycle of private credit, from inception to eventual exit of investments.

With capital call financing, the bank extends loans to funds secured by undrawn commitments from investors and liquidity providers. These loans are typically used to address funds’ short-term capital needs in the early stages of the lifecycle.

As a fund matures and invests in private debt instruments, the bank uses net-asset-value (NAV)-backed facilities to extend loans secured by the fund’s investment portfolio. A hybrid structure offers longer-term, flexible financing by automatically switching lending from the capital call structure to NAV financing as the fund draws down on its commitments and builds the portfolio up.

“Some of our clients who were with us at the capital financing stage did so because they knew we’d be able to offer the hybrid facility down the line,” says Bhattacharya.

Credit Suisse also offers a range of swap facilities, including interest rate and cross-currency swaps, which enable funds to hedge interest rate and foreign exchange exposures in their underlying investments.

The renewed focus on private credit provided a crucial hedge as Asia’s credit bubble burst in late 2021. A few months earlier, Credit Suisse had noticed distorted risk pricing in public markets as banks herded into ever more aggressive financing terms. It says it remained disciplined when it came to risk-taking, choosing not to compete on risk terms and instead focusing on fundamentals and risk mitigants across its range of credit products.

On total return swaps, which provide synthetic exposure to single-name debt instruments or portfolios of bonds, the bank included triggers linked to price drops, rating downgrades or credit events. Tighter covenants were included in loan documentation to restrict leverage. Some lending agreements were structured to be deliverable into credit default swaps (CDSs) to minimise basis risk when the exposures were hedged with CDSs.

Credit Suisse has upped the hedging it provides to buy-side clients by expanding its ‘specials lending’ business. This sources bonds from long-only clients, such as security lenders and private banks, and lends them to portfolio managers that require short positions in high-yield names as a hedge. The limited liquidity in these instruments means Credit Suisse was able to generate a passive income for lenders to supplement their portfolio yields. Borrowers benefited from more enhanced protection than would typically be found in macro-hedging instruments such as Asia investment-grade indexes or China sovereign CDSs, which had proven adequate during low-volatility periods.

“From the hedging side, it works really well to be able to create the short positions,” says Bhattacharya. “For the clients that hold the bonds, this creates a fairly good stream of passive income.”

He notes that the bank was typically paying 6–8% in borrowing costs for bonds in high demand, and that the figure rose to as much as 10% in some cases.

“Our main edge is being able to source those bonds because we have global relationships with long-only clients,” adds Bhattacharya.

“We could actually source bonds which many of our competitors probably cannot.”

For clients stuck with portfolios of tanking bonds issued by Chinese property developers, Credit Suisse offered leveraged upside participation notes. The Euroclear-able notes filled a gap for clients seeking stable funding on portfolios of distressed dollar-denominated bonds.

By sharing a percentage of the upside with Credit Suisse, clients could lock in fixed rate leverage for terms matching their bond maturities. If the bonds mature at par, Credit Suisse receives a percentage of the upside, and if defaults materialise beyond the initial investment, the bank takes a second-order loss.