'Toxic' by association

Some distributors in Asia are offering first-to-default retail credit notes that give sovereign exposure. But heavy mark-to-market losses and the use of collateralised debt obligations as underlying collateral in previous issues have left an indelible stain on the already damaged reputation of credit-linked notes. Matt Cameron reports

Prior to the collapse of global credit markets last year, credit-linked structured products represented only a modest slice of the average Asian retail investor's portfolio, with the bulk of products confined to Singapore and Hong Kong. In the aftermath of the crisis, credit-linked products are finding it even harder to attract retail investors' attention, and sales are almost non-existent in some markets, such as Malaysia.

However, some issuers and distributors are offering first-to-default (FTD) notes to the retail market. Societe Generale (SG) and Lehman Brothers have both structured FTD notes for distribution by Singapore and Hong Kong dealers, including DBS, Standard Chartered and Sun Hung Kai Financial. The problem is that retail demand for these products is a shadow of what it was before the crunch, and the consensus from market participants is that it could take another year to tempt back investors. While some issuers say the demand is there but has yet to take off, the market is in stalemate, with banks eager to offload their books and investors reluctant to take on the risk.

"What happened to the credit market as a result of the whole subprime debacle has had a profound effect on the retail investor," says Bruno Lee, head of wealth management at HSBC in Hong Kong. "They are still very sceptical about credit derivative products. From a distributor's point of view, we feel there are some opportunities in the US investment-grade corporate space, but for the retail customer to participate in the credit market given the current situation, it would be easier for them to look at plain-vanilla bonds or bond funds rather than going into a structured credit product."

One of the main reasons for the poor appetite is that many investors are still sitting on FTD paper that was sold in 2006 and 2007 that is linked to banks and financials. In terms of mark-to-market, these products have been severely hit because many of the financials have become riskier as a result of rating downgrades. This will no doubt play on the minds of investors, who are worried about the riskier debt they are holding. In addition, rising funding levels following issuer rating downgrades have meant many products were not called on their optional call dates, adding to the air of gloom. This means that banks are not losing any money by paying the step-up coupon, because their implied rate of funding has increased sufficiently as a result of their rating downgrade. But the fact that some products were structured using collateralised debt obligations (CDOs) as the underlying collateral instead of zero-coupon bonds has caused further damage. One FTD product traded in Singapore that used a CDO as collateral currently has a mark-to-market value of 60%, says one market participant.

But the fact that banks are issuing credit products lends weight to the argument that some demand exists, especially in Singapore. "In terms of the Asian structured credit product market, some sentiment is returning in Singapore," says Kingston Lai, head of structured products for southeast Asia at SG in Hong Kong. "However, investors are not looking at structures that are too complicated or CDO-driven. They will buy simple products that are spread-driven and nothing too fanciful."

Indeed, private banks in Singapore are showing some demand for sovereign baskets and corporate baskets, but as yet there has been a distinct lack of interest in financials.

The general consensus among retail distributors in Asia is that investors are not yet ready to buy back into credit. "Demand has not returned yet," says Somnath Mukherjee, a director in the structured solutions group at Standard Chartered in Singapore. "There might be some appetite for FTD structures linked to sovereigns because you are not playing on the credit, but rather on the probability that an India or Thailand will default. But there is not a demand for real credit-linked paper yet."

First-to-default notes

FTD products have historically been the most popular type of credit-linked note (CLN) to be distributed in Asia. FTD notes offer enhanced returns on the credit risk of a basket of corporates or sovereigns and are similar to CLNs. The key difference is that rather than taking the credit exposure of a single company, the FTD takes the credit exposure of the first name to default within a specified basket of companies. In exchange for taking this risk, the investor receives regular coupon payments.

A typical example is the SGA Series 15 Emerging Asia Retail Notes, an FTD offering in Singapore issued by SG last month. The notes, done on a reverse-enquiry basis, provide exposure to Chinese, Indian, Malaysian, South Korean and Thai sovereign and quasi-sovereign bond markets. The five-year product, distributed solely by Standard Chartered, offers the potential to receive a return of 16.5% (3.3% a year, payable semi-annually) and a 100% redemption price, provided there is no credit event, no early redemption and no exercise of the issuers' call option during the product tenor. The issuer may redeem the notes at its sole discretion every six months at 103% of the principal amount plus accrued coupon up to the relevant interest payment date.

"The last couple of months have seen a slowdown in demand for equity-related products, and investors are beginning to worry about the commodities boom coming to an end," says Vincent Tay, a director of private investor products at ABN Amro in Singapore. "Therefore, investors will start to switch into credit as an alternative asset class."

Tay says investors in Asia are generally comfortable with their respective Asian sovereign risk because a credit default event has never occurred in Asia. Countries such as Indonesia, Malaysia and Thailand were badly hit by the currency crisis in 1998, but none has defaulted on its government bonds. Sovereigns are also perceived by most investors to be more stable than corporates. Other demand seen in the market has largely been confined to reverse enquiries from private banks and forthcoming retail launches.

But Chu Kok Wei, vice-president of structured products and derivatives at CIMB in Kuala Lumpur, says he has seen no retail structured credit products in the Malaysian market this year. "Retail investors have a herd mentality," he says. "It will take quite a contrarian view and the retail investor would have to be somewhat of a hero to go against the crowd and invest in credit."

Credit is a strange animal, says Chu, in that it will take quite an attractive yield for retail investors to sit up and take note. "But in order for an attractive yield to be achieved, the credit will need to be highly toxic," he adds. "This is coupled with the fact that in credit products, technically speaking, the upside is also capped. Most products pay a set yield of, say, Libor plus 300 basis points, but the downside is leveraged exponentially. Therefore retail investors may be averse to investing."

Exacerbating retail investor reluctance to dabble in credit are the credit notes issued during the past two years. Many investors bought a high percentage of FTD paper in 2006 and 2007 linked to finance companies and banks, and hence are now holding paper with a very poor mark-to-market. Furthermore, a substantial proportion of the paper issued will not have been called by the issuers at their optional call dates. This is because, despite the step-up coupons issuers will have to pay, the coupon rate is below their now-increased cost of funds. For example, a note that paid a step-up coupon - say 5% a year for the first two years and 7% a year for the next five - would still be attractive if a bank were funding itself at around 8%. This means investors are stuck in debt they are worried about, and which looks ugly in terms of mark-to-market value.

The poor performance of several banks means some of the issuers are using very high implied funding rates in structured products. This is having a real effect on products across all asset classes. One issuer says a group of Taiwanese investors bought notes from a US securities house six months ago. Subsequent to the downgrading of that dealer, the investors asked for a mark-to-market and found the value of the securities had dropped significantly, because the funding cost and implied funding had gone up, which forces down the value of the product.

Poor value

A further thorn in credit's side, which could explain retail's lacklustre demand, is that some FTD issues are offering relatively poor value. One product in Singapore is paying 5.3% a year for 4.75 years. This is roughly equivalent to Libor plus 100 basis points. But the underlying collateral alone is likely to yield more than this. The collateral will be bonds issued or guaranteed by one or more of the following: Bank of America, Barclays, Citi, Credit Suisse, JP Morgan, Royal Bank of Scotland, Standard Chartered, UBS, Wachovia and Wells Fargo. According to data from Bloomberg, all but one of these issuers' five-year credit default swaps would cost more than 100bp, implying a potential yield on their five-year debt of higher than Libor plus 100bp.

Theoretically, the issuer could, for example, use UBS bonds as collateral and get a yield of around 5.6% from the bonds, but only pay out 5.3% a year on the FTD notes. Not only would the investor be getting less than the yield on the collateral, but would also effectively be getting no value for the credit risk on the issuer (who is the swap counterparty), no value for the embedded issuer-call option, and no value for the headline FTD feature. "It makes one wonder if Singapore retail investors thinking about buying these might be better off just buying straight bonds in the market," says one issuer.

Dampening investor appetite even further is the fact that some notes issued to retail investors used CDOs as the background collateral as a bond flow. These products may look poor in terms of mark-to-market. "Given that the FTD names in the majority of issues were international banks, and the mark-to-market prices of the CDO collateral will, in many issues, also have taken hits, it is almost certainly the case that note valuations will have been negatively affected," says Adam Cowperthwaite, head of Asia-Pacific structured retail products at Credit Suisse in Hong Kong.

That is a view echoed by ABN Amro's Tay. "Some retail credit-linked products, such as first-to-default notes with underlying exposure to CDOs, are taking hits on mark-to-market," he says. "There will be varying degrees of valuation, but don't be surprised if the worst valuation is as low as 60%. Investors will also be cautious when investing in a credit-linked product that has some CDOs as collateral, and may not want any CDO exposure at all." Other market participants say they expect some nasty surprises in terms of how badly mark-to-market values have moved.

Downsizing

One very popular FTD series sold in Singapore and Hong Kong that uses CDOs as background collateral is the Minibond, structured by Lehman Brothers. The product, linked to a basket of corporates, was the first ever FTD paper sold in the retail market in Singapore and attracted a lot of attention from investors. But many were unaware that the background collateral was a CDO of ABSs and did not understand the inherent risk. The local regulator, the Monetary Authority of Singapore, asked that all risks be highlighted to investors. The product is issued by special-purpose vehicle Pacific International Finance.

Minibonds have experienced devaluations in terms of mark-to-market, and one Singapore distributor has even stopped selling the products. That said, one of the most recent series of the Minibond range launched in Hong Kong in January attracted a record HK$2.2 billion ($280 million) - double that of the previous issue. This could possibly signal the start of the return of proper CLN paper in Asia.

HSBC's Lee says opportunities do exist in investment-grade and high-yield credit, but volatile bond prices and fear on the part of retail investors have stopped HSBC from selling products. "In terms of investment grade, although there are some good opportunities, bond prices are still volatile," he says. "The catch is that when everything settles down and investors lose the fear, the opportunity might be gone."

The bank is recommending high-grade investment bonds of around five to 10 years, adds Lee, but will advise investors to take on more high-yield products when the market settles a little in three to six months' time.