Two of a kind?

Equity default swaps

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When JP Morgan derivatives bankers first thought about marketing equity default swaps (EDSs) to credit investors last year, they tried to sell them in a tranched format. It didn’t work. Investors did not understand how EDSs worked or how they traded. “We realised we needed more EDS flow business first,” admits Martin Bertsch, head of product development for JP Morgan’s equity derivatives group in London.

Since the launch of EDSs last May, JP Morgan claims to have executed over $1 billion in notional. And now, the firm has begun to discuss publicly its first rated single-tranche collateralised debt obligation (CDO) including EDSs in the reference pool, called Odysseus. Judging from the number of other players seeking to make hay in this area — especially using EDSs in CDOs, it would seem the product is gaining some momentum in the market and investor acceptance.

EDSs have been described as bridging the gap between equity and credit by investment bankers who claim the instrument makes the two comparable. They have also been characterised as novel and new-fangled derivatives products representing the way forward for the market, borne from the mingling of ideas stemming from credit and equity derivatives bankers thrust together on combined desks.

According to JP Morgan officials, an EDS is a credit-like instrument, which in essence uses the same structure as a credit default swap except the underlying reference entity is a stock. An equity default event occurs if the closing price of the reference stock drops to or below 30% of its value at the inception of the trade. The recovery rate is usually fixed at 50% of the notional amount.

JP Morgan’s Bertsch says one of the advantages of the structure is the transparency of an equity default event – it is black or white whether there has been a default. “The beauty is, you open the newspaper, look up the stock and say yes, there has been an equity default event,” he says.

JP Morgan is positioning itself as the pioneer of equity default swaps. Bertsch believes the EDS market can never grow to the size of the credit default swap market, but in the near future it will grow to a critical mass — perhaps 20% of the CDS market. The EDS market should not take as long to take off as CDSs, says Bertsch, pointing to the CDO with EDS structure as an example of its rapid growth. Currently, JP Morgan is quoting about 350 names for EDSs.

The rated CDO format appears to be the key to marketing EDSs, because on their own, without the rating, they are too similar to deep out-of-the-money equity digital options. In fact, investors, some rival bankers and the rating agencies say EDSs are not really new at all, but a slightly new spin on digital options.

JP Morgan’s Bertsch argues that equity default swaps are a new product that mimic their credit market equivalents, because the definition of an equity default event — a 70% drop in share price from value at inception – is roughly equivalent to a credit event. “A barrier of 50% of today’s level on a stock would not be a credit event. The 30% barrier area is where credit and equity events happen. This extreme barrier is a credit-like event, and investors will get used to this concept. EDSs are designed as a product for credit investors. It is a way to translate equity into a credit product.” Defining the barrier that constitutes a credit event is the innovation JP Morgan claims makes EDSs different to digital options.

However, Peter Carr, head of quantitative research at Bloomberg, and a former Risk Quant of the Year, says the only difference between an EDS and a discretely monitored American digital option is that in the latter case, the premium is paid up front, while in the EDS, the premium is paid over time conditional on the trigger event not having occurred.

The target market for EDSs is hedge funds, institutional investors and pension funds, says Bertsch. He views the product as a way for investors to take a negative view on the equity market, as a substitute for credit default swaps or as a way to play the spread arbitrage between CDSs and EDSs. Typically, spreads on EDSs are 10 times those of CDSs.

Credit specialists contacted by Risk considered EDSs to be exclusively an equity product. “An EDS is another way to dress up equity derivatives to appeal to the credit market,” says one exotics trader at a large European bank. “A big one-day drop could make for a lot of defaults on what is described as a fixed-income investment. It’s really taking a punt on the equity market.”

Others see its attractions, but say the marketing is awry: “This is an innovative, enterprising product that will eventually go by another name in the equity department,” says a London-based credit hedge fund manager.

A structured finance expert at an insurer who has attended a JP Morgan EDS roadshow believes the product will be a hard sell to credit investors. He maintains credit and equity fundamentally trade differently and cannot be integrated into a single product. And generally, credit investors’ mandates do not permit them to stray into equity investing, he adds.

“My guess is [EDSs] will need a large marketing or sales effort to convince investors. It sounds like an equity product and there is not an obvious link to the credit side. There is quite a lot of education to be done,” says Serge Cadelli, chief investment officer at Converium, a Swiss reinsurer.

EDSs have been mentioned to Cadelli by JP Morgan, but he has not determined what advantages they might have for his balance sheet. Cadelli says he won’t reject the idea of using EDSs completely, but adds that the product was not a priority. Converium does not currently use credit default swaps either.

Gimmick

“EDS are not new. SG Equity Derivatives has traded products similar to EDSs with limits as high as 50% for years. The only new feature brought by JP Morgan is to lower the limits to 30%, which is more a gimmick than an innovation,” says Bernard Desforges, head of equity derivatives sales at SG CIB. He says SG has been selling an EDS-like product under a different name, Yield Enhancement Strategies (Yes), with strike prices for the equities around 50-60%. SG sells its version of EDSs to equity investors, and has no plans to sell them to credit investors on a single-name basis.

After JP Morgan rolled out EDSs, other banks were eager to capitalise on this seemingly new product. So far, Deutsche Bank has been the most vocal about its intentions to enter the market on both the single-name and tranched products sides of the business.

“It’s a product we have been working on for the past six months. We have done structured trades and single-name trades,” says Mark Stainton, head of exotic trading at Deutsche Bank in London. He declined to quantify the volume Deutsche Bank has done in this business.

Other investment banks are approaching EDSs with less enthusiasm — at least as a single-name trade. A BNP Paribas derivatives banker says his firm is not putting a lot of resources towards EDSs. “It’s not a huge priority for us. Equity default swaps have some merits, and there is some money to be made on them, but they won’t dominate the market this year,” he adds.

Yield pickup for CDOs

What many investments banks are looking at is synthetic single-tranche CDOs using EDSs as a portion of the reference pool. Now that CDS spreads have tightened and there is less arbitrage to be had from straight investment-grade credit CDOs, CDOs of asset-backed securities and to some extent CDOs of leveraged loans. Even a 10% allocation to EDSs in a CDO’s reference pool can add significant yield pick-up.

“CDO bankers are trying to figure out how to make money this year with spreads being so tight,” says a Citigroup CDO banker. He says Citi is not looking at using EDSs in single-tranche trades at the moment.

Bertrand Fitoussi, head of structured credit at SG, says: “The ability to add EDSs in a bucket in a synthetic CDO gives the opportunity to benefit from using names that are not liquid in the CDS market and adding a yield pick up.”

Bank of America (BoA) and ABN Amro are among the banks considering using EDSs in CDOs. An ABN official says there is curiosity from investors for a CDO with an EDS component, and the bank is studying the product’s merits. “CDOs with EDSs deserve resources and time, but I am not 100% convinced by the concept,” he says.

Using EDSs in a single-tranche deal can bring more flexibility in terms of choosing reference names for the portfolio, simply because there are more equities to pick from than credits, says a BoA CDO structurer. “We haven’t issued a deal yet, but we are taking (the product) quite seriously,” he adds.

Rating is the key

Putting EDSs into a rateable format such as a CDO is key to bringing the product to credit investors who view it as an equity play on a standalone basis. “I see EDSs as being widely accepted. Obtaining a rating is a big step. The rating makes the tranched product available to more investors,” says JP Morgan’s Bertsch.

“Currently, we are underestimating the potential benefits of this product. This is the innovation in the landscape, because it’s the first time we are seeing equity in a rated form. Rated, tranched EDSs are completely new. And the rating is the key innovation because it broadens the asset classes we can put into a CDO,” Bertsch adds.

SG’s Fitoussi says: “We have done trades on unrated portfolios of EDS, but to have access to a very big market of fixed-income investors in Europe, there needs to be a rating on a product.”

Moody’s Investors Service rated JP Morgan’s e30 million Odysseus CDO in February. That Aa2-rated single-tranche deal had a e1.2 billion notional portfolio comprised of 90% CDS and 10% EDS. Bertsch says JP Morgan has also done unrated trades of portfolios backed by 100% EDS, although these have been on a smaller scale.

Standard & Poor’s and Fitch Ratings are also developing rating methodologies for CDOs using EDSs in the reference pool. The depth of historical data available on the equity market was cited as the main factor in developing a ratings approach to the product. Here again, all three agencies view EDSs in the same way as credit investors: deep out-of-the-money equity digital options. And all the rating agencies agreed that a 70% drop in equity price is not comparable to a credit event.

“The probability of the 30% barrier being hit is significantly higher than a credit event occurring. The 30% barrier is like being downgraded to a very low rating, akin to a migration to a low credit status, but not necessarily a credit event,” says Paul Mazataud, a managing director at Moody’s.

Positing that a 70% drop in share price is the equivalent to a credit event is a dangerous way to think, says Perry Inglis, managing director in structured finance ratings at Standard & Poor’s in London. A credit event would be further out of the money than the 70% drop in share price that triggers an EDS, he adds.

But Bloomberg’s Carr also stresses that it should not be ruled out that the 70% barrier (from price at inception) might not be breached when a credit event, such as a restructuring, occurs.

Moody’s was able to rate the Odysseus deal by using ratings as a predictor of a stock hitting the 30% barrier. For example, over five years, single-B-rated names’ stock prices drop by 70% at a 12% frequency.

S&P has developed its ratings methodology for CDOs with EDSs by plotting an equity event curve for each underlying equity in an EDS — which shows the likelihood of the EDS being triggered over the period of its contract – and from this, S&P can imply a rating. S&P has based its ratings methodology on a portfolio of 90% CDSs and 10% EDSs. Beyond that asset mix, S&P would have to reassess its methodology, says Inglis.

However, single CDSs and single EDSs are completely different, notes Kai Gilkes, head of analytics at S&P. Equity volatility makes EDSs unrateable. “We wouldn’t rate single EDSs, as event risk is too high, but we can model portfolio long-term performance,” says Gilkes.

Fitch Ratings is in the process of developing its ratings approach for CDOs with EDSs. “Some analytical challenges that need to be dealt with before rating a CDO with EDS will be to understand the relationship between a substantial drop in share price and a company becoming stressed and triggering a credit event. The second leg of that is adequately understanding the risk of a very distressed equity market producing stress across a portfolio of EDSs,” says Richard Gambel, managing director at Fitch.

All marketers in capital markets activities try to find new ways to push products. What remains to be seen is whether EDSs are widely adopted by credit investors or are limited to a yield-enhancing role in CDOs. Increasingly, investors are looking at the arbitrage between equity and credit, and EDSs could be another tool for that.

But the alternative argument is that a handful of banks are effectively revamping an equity barrier option that bears little reflection of a real credit event in the CDS market to punt yield-enhanced (for that, read large deal margin) CDOs to investors. The rating agencies appear behind the game, so perhaps the product is most likely to find favour as yet another ratings agency arbitrage opportunity.

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