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"Investors are looking at bank A, for example, that might be offering 130% participation and comparing it with another bank, B, that is offering 110% participation, but they’re asking what their chances are of actually getting their money back with bank A"
Shane Edwards, Royal Bank of Scotland |
"More people are paying attention to credit risk than before, so it is true that the subset of investors that are being particularly prudent has increased," says Alberto Cherubini, head of exotic equity derivatives at Citi in London.
Whereas in the past many investors, especially retail investors, would have been primarily focused on the payoff that the structured note provides, with credit markets looking so shaky attention is now also being focused on the creditworthiness of the seller of the note. This could provide a boost to institutions seen by the credit rating agencies as top-notch, because the high ratings these banks have actually makes it more difficult for them to structure products as competitively as lesser-rated banks.
A lot of principal-protected notes are structured as a zero-coupon bond plus a derivative, such as a call option for example. The use of a zero-coupon bond means the bank’s credit funding spread affects the pricing it can achieve on that credit. "When we’re offering zero-coupon bonds to clients we’re essentially borrowing their money – they’re giving us 100 now and we agree to give it back whenever their investment matures," says Shane Edwards, London-based head of equity derivatives structuring at Royal Bank of Scotland Global Banking & Markets. "So when we’re borrowing money from them we’re paying them a rate of interest. At a high-quality bank that might be Libor, for example, or Libor plus 10 or 20 basis points, at the moment. A much lower rated institution might have to pay, say, Libor plus 80bp or 90bp per annum on that same borrowing. That essentially means there’s a lot more funding available for them to use, and they can use that money to give higher participation in a derivative."
So compared with a highly rated bank, when a lesser rated institution prices a zero-coupon bond into a structured note, there will be more money left over to invest in risky assets. Depending on the type of payoff being structured, the lesser-quality institution can use this extra money to offer either higher coupon returns or a higher percentage participation rate on a risky asset index.
Issuer rating
Edwards explains further: "Normally as an end client, you figure all banks are pretty safe, and you’re not that interested in the issuer rating – you just think about who is giving you the most participation on a product. Now that the market is so credit focused, investors are looking at bank A, for example, that might be offering 130% participation and comparing it with another bank, B, that is offering 110% participation, but they’re asking what their chances are of actually getting their money back with bank A. They might conclude that they’re a lot safer with bank B even though that bank is offering less participation."
With credit markets in turmoil it might not be as easy for, say, a regional European bank with a single-A rating to structure and sell notes. However, the near collapse of Bear Stearns has set alarm bells ringing for investors when it comes to the big dealing houses too. Massive falls in the share prices of some of the world’s biggest banks over the past six months reflect continued uncertainty about banks’ exposures to asset-backed securities. And with investor confidence in the credit rating agencies at an all-time low, many will be asking whether a top-notch rating should be taken as a sure-fire sign that their investments are safe.