Private banking survey 2006
Twelve months ago the European constant maturity swap-linked tier 1 market was in the midst of an unprecedented boom. Now it is dead in the water, with investors left holding a product they should never have bought in the first place.
For European financial borrowers, the CMS deals provided a low-cost funding opportunity. For yield-hungry retail and high net-worth investors, fixed upfront coupons of around 6% had great appeal, even if a perpetual, callable and highly structured security was not a normal investment product. Between the beginning of 2004 and the end of the first quarter of 2005, over €17 billion of euro-denominated CMS-linked paper was issued. Of this, €4.9 billion was issued in the form of vanilla floating rate notes, €9 billion was lightly structured with a higher coupon, and €3.33 billion took the form of yield curve steepeners.
Dazzled by the high upfront coupons, investors were either unaware of or willing to ignore the implicit risks involved in these highly complex and illiquid products. CMS-linked products are beneficial in a steep interest rate curve environment. Could unsophisticated investors have predicted a flattening of the two- to 10-year curve from around 180 basis points in March 2004 to just 50bp at the end of 2005, or understood what that would mean for their investments?
Take pity on investors that purchased these securities. They face unrealized losses of capital of around 20%, and there is little they can do to unwind their positions. “We have a market trading in the low 80s, and if you really wanted to deal in size you’d find that price little more than an aspiration,” says a senior debt capital markets banker.
The question, as is often the case when it comes to structured products, is whether these CMS-linked products should have been sold to unsophisticated investors, and who should take responsibility: is it the issuer, the structurer/investment bank, the intermediary or investor themselves?
It’s a grey area that allows everyone to pass the buck. As one lead manager of several CMS tier 1 deals tells Euromoney: “Hopefully, the people selling these deals to the end retail investor explained how these deals could perform if the curve flattened.” Often, it seems, it is a forlorn and misplaced hope.
Opting out
Some of the leading financial issuers in Europe drove the boom in CMS tier 1 supply, led by Groupe Crédit Mutuel (which issued €1.8 billion of deals, according to Dealogic), Deutsche Post (€1.45 billion) and Deutsche Bank (€1.22 billion). It was a derivative-led business, and banks such as BNP Paribas and Deutsche Bank that have strong derivatives franchises were at the vanguard. Since September 2004, BNP Paribas has been the bookrunner on €2.1 billion of CMS-linked deals, and Deutsche Bank has led a little under €2.1 billion of new issues.
Not all investment banks chose to participate in the market. Some had a problem modelling the swaps needed to take a forward view on the interest rate curve. Others took issue with the whole concept. One such bank was Credit Suisse First Boston.
“We had real concerns about the boom in tier 1 CMS-steepener products. We had a view that raising permanent capital by way of a perpetual, highly structured interest rate instrument to be sold to retail clients was not appropriate,” says Anthony Faulkner, head of FIG capital markets at Credit Suisse First Boston. “Our private banks shared this view, as did several issuers. These deals were a very interesting case study on how the market can work to provide a short-term result that is less desirable in the long term.”
Tier 1 issuance has historically been a strategic consideration for treasurers, but there was an unseemly scramble among issuers, encouraged by investment bankers, to take advantage of market conditions that prevailed at that time.
Not all issuers were seduced. A treasurer at one of Europe’s largest financial institutions says: “Without trust you can forget about a long-term presence in the market. That’s why we haven’t done certain deal structures. We have completely abstained from the CMS market. Good deals only work out if both sides are happy.”
But traditional means of exerting pressure on treasurers to issue were certainly applied. “I’ve been approached by every major bank saying company ABC has been doing CMS deals, so you should as well,” says the treasurer. “But we didn’t see any value in these instruments. They are clearly not in the interests of investors that don’t tend to look closely at the fine print. We are one of the largest retail financial companies in Europe. These deals could end up in our client base, and it would have meant disaster for all of our other banking and insurance business if the deals had gone sour.”
The logic unravels
There was some logic to the idea of using CMS-linked coupons. In a low interest rate and low volatility environment investors were in search of yield, and linking a bond’s spread to a 10-year maturity provided investors with just that.
There was also increased interest in floating-rate products generally due to fears of higher rates and widening credit spreads, but the traditional short-end floating-rate benchmark was unattractively low. Three-month Euribor was only marginally above 2% in early 2004. A bank that issued tier 1 perpetuals with a call in year 10 would only provide a spread of 100bp or so over Euribor – still not attractive compared with high interest cash deposit bank accounts.
As the curve was steep, structurers looked for a long-end floating rate benchmark, and the answer was found in the constant maturity swap 10-year reference rate that re-fixes semi-annually. At the beginning of 2004, when the first deals were launched, the difference between three-month Euribor and 10-year CMS stood at around 250bp.
