Eurozone insurers eye CLNs as ECB easing hits bond yields

Dealers tout hybrid credit and equity-linked notes with Eurostoxx 50 exposure

Lionel Fournier - BAML
Lionel Fournier, Citi

In the space of a year, yields on 10-year French government bonds fell from 200 basis points to a record low of 54bp by the end of January, so it's no surprise French insurers are leading the search for alternatives to their huge - but suddenly low-yielding - sovereign bond portfolios.

That might sound easy enough, but any candidate must avoid the punitive capital burden associated with direct stock market investments under Solvency II, the new prudential regime for insurers that is due to take effect from the start of next year.

One option banks are touting is to gain yield enhancement on sovereign credit exposure - a risk insurers are intimately familiar with - via hybrid notes: structured products containing both credit- and equity-linked components. Another is to invest in bond repacks - in which investors buy notes from a special purpose vehicle (SPV) set up by a bank - incorporating similar features.

"This is something we've seen gaining good traction," says Aleksandar Ivanovic, managing director in equity derivatives at Morgan Stanley in London. This is especially the case in France, says Ivanovic, where insurers are looking for alternatives to rolling over their investments in government bonds.

Some have already taken the plunge. BNP Paribas' Cardif insurance unit invests in structured notes in this mould, the insurer confirms, choosing to allocate capital as opportunities arise. Aviva France is also understood to be a big user of structured notes. Swiss Life, meanwhile, is known to be flirting with the idea of bond repacks using French sovereign debt as the underlying credit component, as are Predica - Crédit Agricole's life insurance operation - and Sogecap, a life insurer owned by Societe Generale.

A structured product including a CDS exposure to a sovereign will work very well, because there is no special penalty from a Solvency II perspective if you sell CDS on a sovereign

Lionel Fournier, head of equity and multi-asset structuring for Europe, the Middle East and Africa at Citi in London, says the bank has been showing a number of structures to insurance clients in both France and wider Europe. It has seen interest in three main categories of product, he adds.

The first is a credit-linked note (CLN) with exposure to the derivatives provider and another entity - which can be a corporate or sovereign - or a tranche of the iTraxx credit default swap (CDS) index. The second is a simple bond repack with a structured coupon linked to an equity index, or a hybrid that includes dual equity and foreign exchange conditions. The third is a bond repack with an additional credit overlay, he says.

This last iteration is gaining momentum among Citi's institutional clients, says Fournier. In this structure, an SPV sells debt and uses the proceeds to purchase collateral, with the associated cashflows then being swapped with the derivatives provider in exchange for a strip of equity or constant maturity swap (CMS)-linked coupons.

The SPV can also sell a CDS or else take some other form of exposure to a credit index, adding an additional layer of credit risk to the structure and enhancing the coupon yield.

"Typically, these structures are traded in Europe using a CDS overlay referencing the sovereign of the client's domicile," says Fournier.

Next to vanilla eurozone government bond holdings, the yields achievable on such structures look attractive. For a bond repack referencing credit and equity as described above, the annual coupon would have been around the 5.5% mark, says Laurent Besnainou, head of cross-asset solutions sales at Societe Generale in Paris. Even where they are dragged down by rock-bottom sovereign yields, a repack structure can generate a 4.5% return, he adds.

In its CLN stable, Fournier expects Citi's dual range-accrual notes to see a lot of interest this year. These are, in essence, a play on the primary impacts of eurozone quantitative easing (QE) - a weakening of the euro against the dollar and a rise in the Eurostoxx 50 - in a wrapper that allows investors to avoid trading the underlying.

"Within these notes you have two barriers: one linked to equity and the other one to forex. The derivatives provider looks at the number of days where these two conditions are satisfied and, at the end of each year, the note pays a coupon linked to the number of days where these dual conditions are satisfied," he says.

Fournier says the structure is finding favour among Asian investors. The bank has issued several notes using this structure to Asian clients in the past few months, he says.

But structured product dealers are entering a crowded market when it comes to yield-enhancing instruments. Alternatives salespeople are hawking their wares loudly, with insurers eyeing infrastructure debt, mortgage pools, corporate loan portfolios and insurance-linked securities, among others.

Exotic structures

Overall, traded volumes of CLNs remain small, as do the typical entry ticket sizes: Societe Generale says it has transacted bond repacks at clips of between €50 million and €100 million and traded notionals of €1 billion in 2014. 

The pattern of interest also differs when it comes to product tenor. Notes with a maturity of five years or fewer referencing the euro/US dollar exchange rate and the Eurostoxx 50 are designed to appeal to opportunistic players betting on eurozone QE shaping the market for years to come. Longer-term notes of between 10 and 15 years' duration, meanwhile, are better suited to strategic investors, say market participants.

"The structure of our equity payoffs are quite simple, as are the structures on the credit side as these are strategic investments designed to provide a good yield over 15 years. Hybrid notes are more for tactical investors," says Besnainou.

Other firms are experimenting with more exotic structures. Federal Finance Gestion, an asset management subsidiary of France's Crédit Mutuel, sold over €600 million of equity-linked products to its sister company, Suravenir, in 2014. The insurer's goal was yield enhancement - but going forward, it is expected to diversify its portfolio of structured products to include bond repacks, designed as a play on potential future rises in interest rates.

The firm closed several deals using these structures at the end of 2014 and the beginning of this year, he adds. Yields vary depending on the structure of each product, but Stéphane Cadieu, chief investment officer at Federal Finance Gestion in Paris, explains that bond repacks of this nature structured in the second half of 2014 targeted a return of 3-5%.

The company is also exploring the use of equity-linked notes with payoffs dependent on index dispersion. Here, investors buy a note where the underlying cashflow is determined by the return on a series of options linked to the three best-performing and three worst-performing stocks in an index. This strategy allows firms to take advantage of the divergent performance between countries, and heightened volatility.

Cadieu says these structures are attractive from a dealer's perspective because the options for dispersion strategies are cheap. "We think the timing is good to invest in dispersion products. The price of options today suggests dispersion will be low and we think that will not be the case, as it wasn't in the past, and we see a lot of dispersion in terms of macroeconomics between countries. We see it as an inefficiency, and that's why we are taking the opportunity to invest in these kinds of products," says Cadieu.

Solvency II incentive

As with all investment decisions being taken by European insurers today, the future regulatory costs incurred under Europe's Solvency II framework - scheduled to go live on 1 January 2016 - is one of the prime considerations.

Principal-protected notes with an equity-linked coupon are attracting particular interest from insurers, say dealers, because they offer exposure to equities without taking on the burden of a hefty capital charge slapped on physical investments.

Insurers using an internal model to calculate their Solvency II capital requirements will qualify for a lower charge than that prescribed by the standard stress if their models are approved for use by their regulator.

"On the credit side, a structured product including a CDS exposure on a sovereign will work very well, because there is no special penalty from a Solvency II perspective if you sell CDS on a sovereign, whereas the penalty on corporate CDS is double that for the reference entity bond," says Societe Generale's Besnainou.

Besnainou adds that the Solvency II charge on these products can be further reduced through features that reset the equity indexation on an annual basis, rather than persisting with the value agreed on the strike date. "In these products the capital charge can be as little as 5% compared to 39%. With products that lack a reset feature, the charge will typically be around 20%," he says.

The relative value of investing in such a structure also depends on the holding firm's accounting practices and internal capital allocation to credit risk. Under French generally accepted accounting principles (Gaap), a bond repack is treated as a vanilla bond in line with article 332/19, and is reported at book value. An insurer using international financial reporting standards (IFRS), however, would have to mark to market, introducing earnings volatility on the balance sheet.

Similarly, though there is no capital charge for sovereign risk in the Solvency II standard formula, more sophisticated firms are known to be considering introducing one into their own internal capital models. Depending on the amount of risk capital these firms assign to French sovereigns, it could diminish the attractiveness of both bond repack and CLN structures.

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