In a 1994 conference presentation, David Marks, head of MTNs at JP Morgan, identified credit-linked notes as the MTN market’s next big product. Four years and a fair few conferences later, it appears his prediction is finally coming true. “Every week we’re getting more borrowers interested,” he says. As if on cue, a credit-derivatives trader appears at his shoulder to show him an idea.
A credit-linked note is usually a bond incorporating a default swap on a credit other than that of the issuer. For example, a triple A borrower can issue a note that will redeem at a predetermined sum if the Republic of Brazil defaults on any of its debt obligations. In return for taking this risk the investor will receive higher-than-normal coupon payments.
Marks is not alone in seeing 1998 as a watershed year for credit-linked notes. “They’re here,” says Mark Ames, head of MTNs at Lehman Brothers. “I don’t think there can be any debate about it.” There may be no debating the figures (issuance for the first quarter was 10 times higher than 1997, according to CapitalNet MTNWare) but for the vast majority of issuers there is still far more talk than action.
“When opportunities arise the most difficult thing to do is to find an issuer,” confirms Edward Villiers, managing director and head of new issues at Chase Manhattan. Issuers’ reservations about credit-linked notes are normally threefold: maturity uncertainty, reputation risk and credit-rating uncertainty.
Until last year, maturities on credit-linked products had generally been too short to attract many borrowers. Although notes are now being issued out as far as 20 years, a default on the underlying credit will usually cause an early repayment and the collapse of the accompanying swap. The borrower therefore has little certainty of the note’s maturity. “There are a couple of straightforward solutions,” says Henry Nevstad at Deutsche Morgan Grenfell. “You can either guarantee a minimum maturity under the swap, or put in a default contingency that pays the issuer the net present value of X basis points running from time of default until maturity to make up for any potential refinancing costs.”
The swap on a credit-linked issue is actually less risky for the issuer than on other structured trades. Arguably, this removes the logic behind issuers charging more to do structured deals than plain-vanilla transactions. The market may now be so competitive that borrowers can only demand a premium for doing the most exotic trades, but two or three extra basis points can still be made for the potentially greater swap exposure that the issuer must take on a structured note.
But as dealers point out, with a credit-linked deal any default situation goes in the issuer’s favour. Early repayment to investors is capped at par, and will often be significantly less, with the difference going to the swap counterparty. “If anything goes wrong, it is the dealer [as swap counterparty] that is owed a lot of money by the issuer, and not vice versa,” says a dealer.
The risk that issuers perceive to their reputation is far harder to quantify, and so more difficult to compensate for in pricing. While dealers acknowledge that issuers are right to be concerned about their image with investors, many consider the stigma attached to credit-linked issues is unjustified. “The concerns that borrowers now have will for many be non-issues in 12 months’ time. People will be as comfortable doing these deals as they are doing equity-linked deals today,” suggests Marks at JP Morgan.
Much of the antipathy arises from the perception that credit-linked notes exist solely as a way for unscrupulous fund managers to bypass investment rules and boost returns on their portfolios. A fund manager may not be able to buy Mexico, but he can get exposure to Mexican risk and returns through a double A rated bank name linked to Mexican bonds.
“The issue which is entirely appropriate is one that applies to every structured note: the question of investor suitability. There is no doubt that the onus is on us to ensure that the client understands the risks involved and that when they say they understand it, that is actually the case,” says Marks. That also means checking that the investor is not trying to circumvent investment rules.
For issuers, an equally tangible risk is that a credit-linked note will be rated lower than the MTN programme off which it is issued. Since early last year, Moody’s Investors Service has been rating credit-linked notes separately from MTN programmes, taking into account the likelihood of default on the underlying credit and the recovery rate for investors. According to Stephen Wilson-Smith, associate at Moody’s in London, several dozen MTNs have been assigned lower ratings over the past year, and not always with the cooperation of the issuer. One note included a disclaimer that if a “repatriation” event should occur, redemption would be in a different (restricted) currency. The issuer had not regarded this as a credit-linked issue. “We rated it lower,” says Wilson-Smith. “The issuer was upset, to the extent that it tried to withdraw the note from the market.”
Dealers argue that such a response is generally unwarranted. “You need to differentiate between deals done as classic MTNs and those done as public trades,” says Ames at Lehman Brothers. The vast majority of credit-linked notes are true private placements that are never traded in the secondary market. As a result, a lower rating will not normally affect the public perception of the credit. One way to ensure that this is the case is to issue such notes only in very large denominations that won’t be easily traded: “It gives the issuer comfort that the note won’t be splashing around in the secondary market and will stay with the institutional rather than the retail investor base,” says Ames.
An indication of the current popularity of the product is that Wilson-Smith had rated three credit-linked notes that afternoon. “I don’t think that we’re limiting the growth of the market,” he says. “Our ratings add clarity, and in the end that’s what investors want.”
But not all dealers are convinced that now is the right time to be pushing credit-linked products: “People are getting ahead of themselves,” suggests one. He points out that pricing models are still not at a stage of development that gives the market any consistency on pricing. He says that one counterparty was looking for default protection on a bond and received bids that were 40 basis points apart running over the life of the bond. “I’m going to set up an arbitrage vehicle that just buys credit-linked MTNs,” he jokes.
Another area of continuing uncertainty is capital treatment. If you have a 20% risk-weighted issuer, but the bond is linked to a 100% risk-weighted underlying credit, how do you treat the note in terms of capital adequacy?
