A blend of assets

Capital guaranteed funds have been the stalwart of the equity derivatives business for the past few years, but some houses are now overlaying these structures with an element of credit risk to boost returns for investors. Nick Sawyer reports

Capital guaranteed funds have been one of the equity derivatives success stories of the past few years. Certainly, it’s difficult to argue with the figures. In Hong Kong, capital guaranteed funds accounted for a whopping 90.76% of total net sales of the fund market in 2001, driven largely by the territory’s retail investors scrambling for guaranteed returns amid a gloomy economic outlook.

But traditional capital guaranteed funds have had to work a little harder for their money over the past 12 months. In 2002, total net sales of capital guaranteed funds had fallen to 59.14%, and this figure has remained pretty stable in the first three months of 2003 at 57.63%, according to the Hong Kong Investment Funds Association. With interest rates falling lower and lower, the cost of zero-coupon bonds – which account for around 90% of the invested capital and provide the capital guarantee – have been increasing in price, meaning there is less money to spend on the option component. At the same time, volatility in the region’s equity markets has meant that the cost of options has also risen, meaning investors typically gain less participation in the upside of the equity index or basket of stocks.

As a result, banks have had to look at more and more complex equity options to boost participation for investors. But some investors in the region are also turning to structures that combine different asset classes to boost value. In particular, credit/equity hybrids are beginning to attract interest among some institutional and high-net-worth investors. “Interest rates and bond yields have come down so much that unless you structure exotic options or find ways to cheapen the cost of the option, the traditional capital guaranteed structures can look uninteresting,” says Chi-Won Yoon, managing director of equity risk management at UBS Warburg in Hong Kong. “So people are looking for yield enhancement, and using credit-linked notes as a yield enhancement play has found some interested investors.”

At its most simple level, investors can draw extra value from a capital guaranteed fund by making the principal, coupon or equity payout – or any combination of the three – contingent on a certain credit or basket of credits. By taking on credit risk, the investor earns a premium, which can be used to boost the participation in the equity index or increase coupons.

For example, by making the redemption of the principal credit contingent, the investor can earn an incremental pick-up, which can be used to boost participation. “If you issued a capital guaranteed fund linked to a Korean stock index, for instance, where the coupon and the final redemption are all linked to the Republic of Korea, then you’d be able to get more upside out of it because the client would be taking a little bit more credit risk, and that basically helps you pay for a larger option component,” says Kurt Ersoy, director, convertible securities and equity derivatives at Credit Suisse First Boston (CSFB), in Hong Kong.

Another way of approaching it is to make the equity payout or the level of participation in a stock index contingent on a particular credit or basket of credits, while maintaining the capital guarantee. By adding a credit overlay to the equity option component, investors can achieve a higher participation level as long as there is no default. If the credit defaults during the life of the structure, the investor gets a reduced or zero participation in the upside of the equity index or basket of stocks, while the principal redemption is not affected. “So, the way the credit ‘hybrids’ with the equity is that, depending on the actual credit event, it changes your participation in the payout formula,” says Roger Lam, director of equity derivatives structuring at CSFB in Hong Kong.

The equity participation can be linked to a single credit or first-to-default basket, where the investor receives zero participation if one credit defaults. Alternatively, the investor could receive a slightly lower maximum participation level, in return for protection against a certain number of defaults. For example, the participation could step down to a lower level for each default in a basket of 100 diversified credits, up to 10 defaults, for instance, at which point the investor gets zero participation. While the probability of a default occurring is higher than referencing the structure to a single credit, the severity of each default is reduced – the investor would still get some participation in the upside of the equity index, even after one or more defaults. “The beauty of this product is that depending on your risk appetite, anything can be structured,” says Feng Gao, head of integrated credit trading, Asia, at Deutsche Bank in Hong Kong.

Bankers generally believe that the products that are 100% principal protected, yet incorporate an element of credit risk on the coupon or participation, will be most popular with investors. “Capital protected products are popular because the worst that can go wrong is that the investor loses the upside on the structure,” says Ersoy. “If the capital protected element is credit-linked, then sure, the returns are much better, but the incremental risk is also higher. The product ceases to be 100% capital guaranteed.”

But that’s not to say that there’s no extra value to be had on the principal without subjecting the investor to significantly more risk. In a typical capital guaranteed product, the arranging bank would issue a certificate of deposit or zero-coupon bond, which would form the principal protected element. However, that same bond would typically trade at a slightly wider spread in the secondary market than it would at issue. “Secondary market bonds are more volatile than funding rates,” says one Hong Kong-based banker.

Therefore, rather than issue a bond into the primary market, if a special-purpose vehicle (SPV) is set up to source bonds in the secondary market that are of the same rating as the issuer – or even bonds of the issuer itself – the investor can benefit from yield pick-up, says Lionel Semonin, head of structuring and solutions, Asia, at JP Morgan Chase in Hong Kong. “If you go from a bank that is issuing directly at Libor flat, to the secondary market, the paper of that bank is going to be more than Libor flat,” he says. “So there is a big opportunity in the secondary market, compared with a bank issuing its own paper. If you look at a bond in the secondary market, you could get 30, 40 or 50 basis points pick-up.”

What that means is, rather than, say, an AA-rated bank guaranteeing the capital protected element of the product and issuing its own bond at Libor flat, the capital guarantee comes from the bond of an AA-rated issuer held by an SPV and purchased in the secondary market at Libor plus 30. “So instead of a bank guaranteeing it, you have an asset as the guarantor and the asset is rated the same or even better than the bank that was guaranteeing it before,” adds Semonin. “The only difference is you get a better return and you get paid for the risk you are taking on the credit side that you were not paid for before.”

Rather than having the principal guaranteed by a single bond, the SPV could instead source a portfolio of bonds or basket of credits. So, rather than investing in a single AA-rated bond, the SPV could source 50 AA-rated credits to guarantee the principal. Even if one of the names defaults with a zero recovery rate, the investor would only lose 2% of the principal, says Mahesh Bulchandani, Tokyo-based managing director of Asian structured credit products at JP Morgan Chase. “The investor doesn’t really get any extra yield pick-up, but does benefit from the diversity. It’s classic portfolio theory. If you buy a portfolio, you’re more likely to lose money, but the loss will be less severe,” he says.

The principal could even be guaranteed by an AA or AAA-rated tranche of a synthetic collateralised debt obligation (CDO). In this case, the investor gets the diversification, but also some level of subordination before the defaults start eating into the principal, says Bulchandani. “Despite all the good intent, there can be a deteriorating credit hiding in the portfolio that nobody knows about. So the AAA-rated tranche of a CDO is quite handy because, depending on how it is structured, the investor can be cushioned against 10, 15 or 20 defaults.”

So, an investor could invest in a product where the principal is secured by a high rated credit or an AAA-rated tranche of a synthetic CDO, while the coupon and the level of participation to a basket of stocks are contingent on other tranches of the CDO or a separate basket of credits.

In terms of hedging, the arranging bank would have to manage the correlation between the equity and credit portfolios, as well as how equity market volatility causes the stocks to move in relation to the credit portfolio’s performance throughout the life of the structure. “The tricky thing is to basically look at the balance between the credit risk and the equity risk,” says Patrick Kwan, director in the debt capital markets and investment banking division at Barclays Capital in Hong Kong. “There are certain levels of correlation that need to be managed.”

However, a potential hurdle could be to find Asian investors able to invest in multi-asset products that combine views on equity and credit risk, as many of the region’s institutional investors are restricted to either fixed-income or equity investments. “The trick is to find the right investor with a mandate or the freedom to look at both credit risk and equity risk,” says Kwan. “And I don’t think we can find too many of those because most of the professional investors other than hedge funds are really limited to a single asset class.”

Nonetheless, more investors are being forced to look at alternative investments, as low yields mean that it is increasingly difficult to generate returns.

Some bankers reckon those investors more familiar with corporate defaults – commercial banks and insurance companies – would be the most likely institutional investors to invest in these products. However, with most of the demand for capital guaranteed notes in the retail market, some bankers suggest that some credit overlay – most probably a small basket of well-known household names – could eventually emerge in funds aimed at retail investors. “When it comes to local well-known companies, everybody has an opinion,” says Deutsche’s Gao. “That’s why I am very optimistic, and I think for retail, there’s definitely a market out there.”