PROCRASTINATION IS THE thief of time. Carpe diem. For centuries, poets, statesmen and wits have warned of the dangers of delay and urged us to act now. But when it comes to issuing debt, banks are devising new tools to help corporates put off until tomorrow what they could be doing today. If corporates respond, they will be moving closer to taking trading positions in their own credit and using credit derivatives as banks and investors do.
The logic behind this is simple. Credit spreads are tight. But if issuers pre-fund and put the money raised on deposit, they pay the cost of carry and risk upsetting equity analysts and creditors, neither of whom likes to see borrowers with large amounts of spare cash.
So, can issuers capture current spread levels for their future funding without paying the cost of carry or grossing up their balance sheets? The banks say they can. Issuers just need to apply pre-hedging technology to credit.
This reflects a new way of thinking about debt. "The old view was that equity was the permanent part of your capital structure, and debt was the loose change in your pocket that comes and goes," says Eirik Winter, head of European corporate DCM at Citigroup. "The new view is that debt should be seen as a permanent part of your balance sheet. That means you should be pre-funding or pre-hedging."
Dresdner Kleinwort Wasserstein grabbed attention in May when it priced credit spread warrants based on €400 million of unissued bonds from French supermarket group Casino. A buyer of one warrant can buy e1,000 of Casino bonds from its EMTN programme on the expiry date of December 8 with a coupon and issue price that will give a yield equivalent to mid-swaps plus 85 basis points. So traditional warrants have a strike price, but these warrants have a strike spread. Investors pay for the warrants with a premium of 0.54% of the underlying notional value.
Demand for the first ever pure credit option was impressive. DrKW increased the planned 400,000 warrants by 100,000.
Casino has a future funding need and it has mitigated the cost of carry. If spreads tighten between May and December to less than 85bp and investors exercise their option, Casino has locked in current spreads. If spreads widen and investors don't exercise their option, issuing will be more expensive, but the premium that investors have paid for their warrants subsidizes that extra cost. An investor's maximum loss is set in the premium, whether spreads widen 50bp or 500bp.
DrKW's credit spread warrant should help meet demand for credit volatility from investors who cannot access the illiquid credit default swap (CDS) options market, which is restricted to professional investors who want to trade credit. There is a lack of broker activity in CDS options and two-way prices are only just beginning to emerge on products based on the Dow Jones iTraxx index.
Liquidity problems
"The CDS options market trades almost by appointment," says Henry Nevstad, head of structured debt and private placements at DrKW. With limited liquidity, the market still trades on wide bid-offer spreads and is available only on certain credits.
"Credit spread warrants are an opportunity for issuers to supply the markets with credit spread volatility and effectively to distribute it in the way they distribute bonds," says Nevstad. "In addition, the CDS options market is available only to those investors who engage in OTC derivative transactions. The credit spread warrants are tradeable securities that open this asset class to a wider investor audience." With a lack of high grade issuance this year, funds that buy warrants can call for paper if spreads trade at acceptable levels.
Some say there are hitches with DrKW's new warrants. One is that issuers look bearish on their own credit. And if investors exercise their warrants, could an issuer and its banks keep the same control of who buys its bonds and how they perform in the after-market as in a normal bookbuild deal?
"Casino is trying to get paid for taking a view on credit spreads," says one banker. Selling a credit spread warrant isn't pre-hedging. It just lets issuers earn a premium if they can outguess the market on where their spreads will go.
DrKW says this misses the point. "If Casino had issued, nobody would have said: 'This is a punt on spreads,'" says the bank's global head of debt syndicate and credit trading, Sean Park. "Every time a corporate issues, it makes a judgement on spreads. In fact, by selling a call with a 40% delta, it must only be 40% as bearish as when it issues directly."
Indeed, part of the appeal of credit spread warrants is that they let investors bet on credit volatility, where before they simply used credit default swaps to bet on whether an issuer's credit quality would rise or fall. This also appeals to issuers: because they are long their future debt they are also long their own volatility.
"Issuers can articulate much more specific strategies using options than with other instruments where you are just selling or buying," says Park.
Regarding control of the issuing process, DrKW says it will organize a bookbuilding just prior to the exercise date to work out a consensus price, and that the question is no different to arguing the merits of a bookbuilt versus a bought deal.
DrKW isn't the only bank helping clients capitalize on tight credit spreads. Deutsche Bank has developed its own Forward Issuance Facility (Fifty). If a corporate wants to roll over maturing debt in, say, 18 months, it agrees to issue at that time at a pre-agreed size and spread set today. Deutsche issues bonds under its name with a fixed coupon for the life of the bonds, which are mandatorily exchangeable into the corporate's bonds at a future date. After 18 months, the corporate issues its own debt to Deutsche.
"We have hedged ourselves because the Deutsche debt will be exchanged into the debt that the client has issued to us," explains Georgette Bailey, director, global markets, corporate structuring at Deutsche. "For the borrower, it's a forward, so spreads are locked in. But it's not an option, so there is no up-front payment, and the borrower has a legal obligation to issue the bond into us." Deutsche gets 18 months' funding and an underwriting fee.