Sailing towards better returns

Tight corporate credit spreads are forcing dealers to come up with new ways to offer retail investors the chance of a decent return. Structures linked to credit derivatives indexes using constant proportion portfolio insurance to gain leverage are hitting the market. But dealers are split over what should be the optimum structure. By John Ferry

With corporate spreads now at such tight levels, the task of finding payoffs that will interest investors is particularly difficult for makers of structured credit products. But it is the structured product designer’s job to innovate and create marketable products, regardless of prevailing economic conditions.

In the credit derivatives arena, that currently means encouraging investors to either leverage up their exposures or directly take on more risk. This explains the current trend towards collateralized debt obligation (CDO) squared deals, which let investors take leveraged single-tranche CDO positions, and single-tranche CDOs that incorporate higher-yielding debt.

But where does that leave retail investors who, while facing the same market conditions, have a preference for principal protection? The emergence of liquid tradable credit derivatives indices such as the Dow Jones iTraxx and CDX allows dealers to develop innovative new structures designed to address just that issue.

Two of the most talked about structures currently on the market have come from Calyon and UBS. Earlier this month, Calyon issued its first Credit Sail notes, while UBS is selling its Credit Absolute Return Strategy (Cars). The products are particularly innovative because they use constant proportion portfolio insurance (CPPI) to hedge the investments and as a mechanism to provide leverage.

Credit Sail guarantee

Credit Sail is a 100% capital-guaranteed leveraged investment in iTraxx. “Because Credit Sail is capital guaranteed it appeals to retail investors and private banks as well as pension funds,” says Löic Fery, managing director and global head of credit and CDO structuring at Calyon in London, adding that Credit Sail is being marketed globally.

Credit Sail is structured so that the proceeds from the notes are placed into a floating-rate cash deposit, providing the working cash balance for the strategy. Calyon guarantees a minimum redemption amount plus any coupons at the end of the note’s 10-year life. The present value of the guarantee is calculated daily using current interest rates, while the cash reserve calculation for the dynamic hedging is the unwind cost – Calyon calculates the cost of unwinding the portfolio on a daily basis – plus the present value of the guarantees. Income generated from the investment, which consists of interest on the cash deposit and the spread on the credit portfolio, is returned back to the cash pool, so it is a total-return strategy. Calyon says its returns target is at least 7% a year, and adds that historical back-testing shows that over a 10-year period the investment would have returned an average of 8% a year.

Leverage

“The main theme behind the strategy is leverage with control,” says Nicholas Gibbins, senior structurer at Calyon in London. “You don’t want to apply leverage blindly, but if you can have leverage with control then you are able to target high levels of return by leveraging up the investment in the credit portfolio, at the same time as managing the risk. In this case, managing risk means controlling the investment in the credit portfolio, such that you can also provide a protection of principal on the maturity date.”

CPPI is a form of dynamic hedging designed to give investors downside protection while also allowing for participation in the upside. It works by splitting an investment into two categories, risky and non-risky. In this case, the risky asset is the investment in the iTraxx and the non-risky asset is a cash deposit. The dealer sets a floor level equal to the lowest acceptable value of the portfolio. The next step is to set a ‘cushion’ level, which is the excess of the overall portfolio value above the floor.

The dealer then works out how much to allocate to the risky asset by assigning a multiple to the cushion level, with the remaining funds invested in the safe asset. This gives a leverage mechanism, because the higher the multiple the higher the participation in the risky asset. The dealer regularly re-balances the portfolio between the two risk categories in order to maximise return and preserve the return of capital at maturity, which is why the technique is referred to as dynamic hedging.

“We allow some variation in a range, but if the portfolio moves too far from what we would describe as being the target then we will adjust,” says Gibbins.

He explains further: “We have an obligation that on the maturity date we will return principal. The cost of that principal today is just the present value of 100 on the maturity date, and then whatever is left over is the free cash available in the structure that allows us to collaterise the investment in an iTraxx portfolio. We adjust this calculation every day, taking into account any mark-to-market gain or loss from the credit portfolio. It means that if spreads were to widen then the amount of available cash in the structure would fall.”

Going forward, the structure is designed to accumulate income within the strategy, which is used to add further leverage. “So there is a mechanism that controls the risk,” adds Gibbins. “It means that if we were to totally unwind the structure at any time we could afford to lock in the 100% return of principal on maturity date.”

If Credit Sail can return 7% or 8% a year then it will be classed as a success. Fery says Credit Sail will perform particularly well if credit spreads widen in the future. “The product is designed to have a big upside in a rising interest rate or a rising credit spread environment. And even if spreads go down it will perform accordingly. The only scenario where it wouldn’t perform well is where there is a lot of spread volatility, with spreads continuously going out and coming in, because that would eat away the cash reserve through constant leveraging and de-leveraging.”

Cars combinations

As with Calyon’s product, UBS’s Cars uses CPPI technology for both hedging and as a way to gain leverage. It also accumulates income over time but its underlying construction is completely different from Credit Sail. “I think this product is unique in its form,” says Fritz Jost, managing director and global head of fixed income, wealth management products, at UBS in London. Jost describes the product as a capital-protected credit-spread floater.

Although structured by UBS, the bank has outsourced the product’s portfolio management to Henderson Global Investors, a move which Jost says gives Cars added credibility because investors can be certain the dealer isn’t selling on unwanted credit exposures. Cars combines a long credit default swaps (CDS) position with a short constant maturity CDS (CMDCS) position, resulting in an overall credit-spread-neutral investment. Jost says this gives the investor positive carry plus low volatility.

“I always argue that when wealth management clients buys a fund they are often buying a black box,” says Jost, “but with the CPPI technology you get much more clarity in terms of strategy and of course a capital guarantee as a fall-back line.”

Cars notes combine five-year CDS on iTraxx/CDX indexes – a total of 250 underlying entities – with five-year CMCDS on the same portfolio. UBS says that the result of this, as well as positive carry, is short-term rolling default risk on high-quality issuers and strategy returns that will tend to increase if credit spreads widen. “The combination of a CDS and a constant maturity CDS basically takes away a lot of the volatility,” says Jost. “And when you add in the constant proportion portfolio technology you incorporate a number of views: first, it plays the view that we will see credit spreads moving sideways then widen, and second, the format lets you not only take a view on credit spreads widening, but it also lets you avoid exposure to duration.”

Other dealers agree that credit spreads are likely to widen in future. “The constant maturity CDS product is very attractive because it fits the view, which many investors share, that looking ahead we will not experience a lot of defaults but credit spreads will probably widen,” says Marcus Schueler, head of integrated credit markets at Deutsche Bank in London.

But Lee McGinty, head of credit derivatives strategy at JP Morgan in London, warns that investors must be very sure of the view they wish to take. “If you buy a CMCDS then you have to believe that spreads are going to widen a substantial amount, as you are only getting around 70% of participation. Also, CMCDS doesn’t protect you against defaults, so the investor has to have the view that spreads are going to widen, but not to such an extent that there will be credit events.”

Neither Calyon nor UBS will issue sales figures for their products, though both say they are selling significant amounts. The future performance of the credit markets will reveal whether or not they are good investments. If a period of general credit spread widening takes place, then Cars and Credit Sail – and no doubt the many products we would see copying them – will turn out to have been sound investments. But if spreads remain tight or become extremely volatile then it will be a different story.

Constant Maturity CDS

The difference between a CMCDS and a standard CDS is that the ‘fee leg’ in the former is not constant for the life of the product, but rather is reset periodically. It means that the protection buyer in a CMCDS deal only pays a fraction of the current regular CDS spread. For example, JP Morgan in a research note gives the example of France Telecom. The CMCDS price might be quoted at 70% of the regular five-year CDS spread. If France Telecom is trading at 200 basis points at the end of a quarter, and the CMCDS is reset every quarter, then the buyer of CMCDS protection pays out 0.7 multiplied by 200 bp divided by four, which is 35 bp in that quarter. Combining the CMCDS with the CDS, as UBS has done with cars, means that the investor is effectively selling protection in the CDS while simultaneously receiving protection via the CMCDS – on the same reference entity and with the same maturity. This leads to both contingent legs of the structure cancelling each other’s duration exposure out. The result is a credit-spread swap, where the investor pays a fixed CDS spread and receives a floating CMCDS spread. UBS has therefore stripped the credit-spread duration risk out of the initial portfolio. But the investor is still exposed to reference entity credit defaults. However, UBS says that the risk of rolling short-term defaults is mitigated by the fact that the iTraxx/CDX indices are refreshed every six months, with only investment-grade or better names allowed in.