Daiwa Europe took the greenfield approach to the credit business. It recruited 40 staff with varied backgrounds from different firms and built from scratch a kind of credit-processing station. In one end goes a range of assets that are then repackaged and sent out in different forms.
“Whatever asset comes into the Daiwa structured finance group, we always recharacterize the risk, whether through swapping, tranching, enhancing, repackaging. It never leaves in the same shape it came in,” says managing director Robin Nydes, who has built the group up since he joined Daiwa from Bankers Trust a year ago.
Using this approach, the bank was able to sell high-risk Russian treasury bills to cautious Japanese investors and repackage Turkey’s samurai bonds as Deutschmark Eurobonds taking advantage of different perceptions of Turkish debt in Tokyo and Frankfurt. In a different kind of deal, Daiwa outbid rivals for a UK office complex because it was able to see how securitization – and the role of credit – could release value hidden to equity investors.
None of these deals is exactly rocket science and there are those who feel that the significant characteristic of the new role of credit is hype. But what is undeniably different is the speed and volume of such deals and the way banks are mass-producing them. Daiwa’s Turkish debt transaction was turned round overnight, for example, and the UK property deal took just two weeks to complete, including the securitization.
All day long the Daiwa group’s traders are active in emerging and other high-yield markets, sometimes isolating and retaining the convertibility risk in local-currency markets and passing on the pure credit risk to investors; sometimes changing maturity or duration to create credit-yield curves where none yet exists selling two-year synthetic securities where there are only six-month treasury bills. The scale and dynamism of the operation may be a model for other firms thinking of building similar credit departments that combine trading, investment banking and a lot of marketing.
The bringing together in one department of a large number of hitherto disparate functions is different, too. The Daiwa group does a range of things including credit product trading, covering developed and emerging markets and including credit derivatives; repackaging and tax-structured deals, as well as more investment banking-type activities such as principal finance, real estate and securitization. The common thread is that new economic conditions – chiefly the improving fundamentals of many emerging countries – and abundant liquidity at banks and investors all desperate for yield, has made taking a view on credit the driver of deals.
Daiwa’s approach puts it at the forefront of banks’ attempts to respond and exploit the new role of credit. But it is not alone. Other leading banks such as Merrill Lynch, Bankers Trust, Lehman Brothers, CSFB and Nomura have their own strategies. Merrill Lynch has combined most of its debt businesses into a huge global credit group. More cautiously, CSFB has merged its asset swappers and credit derivatives teams to produce a credit clearing house for the rest of the group. Bankers Trust has long played in the more credit intense businesses, which it calls credit laboratories. Now it is putting all its efforts into building a European junk bond market and creating high-yield funds. Lehman Brothers exemplifies the less excitable typical American approach, dealing in credit but only in large, liquid dollar bond issues: stuff you can put in an index. It has set up a global credit index especially for the purpose. But it is the Japanese houses Daiwa and Nomura that have excited the most comment often because of their gung-ho approach to trading and their use of principal to back up deals. Nomura’s credit traders, for example, bet large amounts on tiny price anomalies.
Do any of these firms live up to the billing “The New Masters of Credit?” Are they artists with a unique vision? Or are they involved, perhaps unwittingly, in a huge confidence trick – a market built on froth and speculation in which traders have used a new lexicon of terms to justify high-risk strategies. If so, how long will it be before the market makes a dramatic correction? What will survive of the banks’ new credit strategies after it does? Even Daiwa’s Nydes cautions that “sometime in the next year there will be a major linked-equity and credit-negative event. Things have been rosy for too long”.
Excess aplenty
Signs of excess in credit markets are abundant for anyone prepared to look for them. At Euromoney‘s recent borrowers and investors conference, Miguel Siliceo Valdespino, managing director of international finance responsible for borrowing at Bancomext, told of his confusion in preparing new bond issues at how some potential underwriters would bid to lead new issues at terms much tighter than other firms. He eventually realized that these firms were happy to own entire new issues at tight levels, taking a bought-deal view in the expectation that ever-tightening credit spreads for Mexico would produce a capital gain in a few months.
At a recent conference on European corporate high-yield bonds, a salesman talked enthusiastically about how European investors were growing judicious at understanding the returns available for taking junior positions in issuers’ capital structures. The salesman admitted that the same investors were showing no enthusiasm for researching the practicalities of bankruptcy and work-out procedures in the home markets of these new issuers.
Guy Hands, who built Nomura’s trend-setting principal finance business in the last two years, using securitization to outbid others on assets from pubs to rolling-stock companies, leasing companies and the homes of military personnel, has found himself regularly outbid in recent months. “Last September we bid on an asset just 75% of what it eventually sold for. There seems to be a feeling in the market that missing out on a deal is the worst thing that can happen to you.” Systems technology allows bidders to run hundreds of different simulations to test how assets will fare under different interest rate, inflation and other variables. But, rubbish in, rubbish out. Hands says: “It seems to me that some bidders are deciding what number they should bid to win and then fitting in their underlying assumptions backwards from there. There is an element of over-confidence among some individuals in the market, many of whom have only ever been investment bankers and have never traded. In consequence, they have never known that sick feeling in the pit of stomach you get when something goes wrong.” He adds: “Nomura has no intention of being dragged into a bidding war.”
Steven Blakey, managing director, co-head of global credit markets at Merrill Lynch (in partnership with Tom Gahan in New York), professes concern at trading firms’ recent enthusiasm for principal risk. “Until two years ago, the securities industry was not comfortable positioning credit risk. Now you can see a disturbing trend at many firms to position not just significant size in emerging market risk, but also illiquid corporate risk and even illiquid real assets such as property. I wonder, if every firm has the appropriate competence to properly evaluate and liquidate these assets, or the cushion of revenues to take hard decisions, if there is a downturn.”
The excess is not just in principal finance. Some asset and credit derivative traders are grumbling about the poor disclosure of leverage in some emerging market bond repackagings. Investors must be happy to be getting coupons in the high teens, but do they understand that they are not taking simple Mexico risk but two and a half times Mexico risk? They can lose everything, even if Mexico doesn’t default.
After several years of tightening credit spreads and big gains on supposedly risky debt, banks and other investors are treating bonds like equities and want to see an upside in every investment story whether it be emerging market debt or high-yield bonds. Much has been made of the importance of credit analysis in these new credit markets. In reality, many traders have been seduced by their own cleverness, and by the huge profits that have been made in recent months by simply going long credit spreads. Plenty of traders talk about a secular re-rating downwards of credit spreads in many asset classes, especially emerging markets. True, the ratings agencies may have been slow to recognize improvements in some countries. But still, this is dangerous talk. If they are right, traders will be heroes. If they are wrong, some of today’s masters of credit will be tomorrow’s fools.
Desperately seeking value
But right now the search for outright exposure and relative value is growing more intense by the day and covers a range of instruments including simple asset swaps, the basic cash market for credit and more complex credit derivatives, which may not be fully understood by all participants.
Some traders are attacking the credit markets with the same scientific vigour they once applied to interest rates and currencies. At certain firms, the high-grade credit business, which now largely consists of second- and third-generation asset swaps, is no longer a transaction-oriented business. It is now a spread-correlation business. Traders are not taking outright credit views but rather taking advantage of anomalous moves in highly correlated credits, such as in Deutschmarks between corporate paper, Pfandbriefe, Bunds and swaps.
Five years ago when asset swaps were first coming into their own, they were a vehicle for taking outright directional views. A bank taking a view that Italy was not going to go bust might be able – in the days when Moody’s rated the country single A – to pick up its bonds swapped into floating-rate assets at 150 basis points over Libor and wait for spreads to tighten. Active swap traders were over-exposed to Italy risk and happy to sell off bonds at wide enough discounts to par for asset swaps to work. Today such trades, in developed market sovereign and high-grade corporate debt, are almost impossible to find.
At Nomura, the international markets division specializes in taking very large positions in very small anomalous movements in related credits. That is the core of its investment-grade business. As well as proprietary trading, Nomura also runs a customer business. According to managing director Stephan Ludwig: “The most significant trend in Europe has been the explosive growth in the balance sheets of public-sector and quasi-public-sector banks.” These are taking advantage of their very low cost of funds which comes with the high credit ratings that spring from public ownership. Instead of ploughing that cheap capital back into corporate loans, they are taking investment-grade sovereign paper through direct purchases of bonds and synthetic assets. Banks in general are attracted to sovereign assets which attract zero regulatory risk capital weightings. “It’s been enormously attractive for them to take low risk exposure despite the thin margins,” says Ludwig.
In 1996 and 1997, Nomura has done $5 billion to $6 billion of such capital markets business. Nomura is not shy about mixing proprietary and customer business within the same profit-centre under the same bosses. Ludwig says: “Having a large arbitrage book facilitates customer business by providing a large pool of eligible assets which may go into and out of our customers’ balance sheets.”
For Nomura and many other credit or spread trading groups, banks are the natural customers. They are natural takers and sellers of credit risk and, during a period of slack loans growth in Europe in recent years, have grown used to seeking bonds and asset swap packages. The business has also been helped by the growth in credit derivatives. “In our experience, there has been more action than hype,” says Ludwig, in contrast to the wider market view. But he admits that much of that action has been in instruments which may have existed before the name credit derivatives was coined. “One of the beauties of the growing acceptance of credit derivatives is the relative ease with which institutions can take exposure compared with putting on actual assets which may be difficult because of their own cost of funds.”
For example it makes no particular economic sense for Korean banks funding at 50bp over Libor to make loans to second-tier Japanese banks funding at the same levels. But there is little correlation between Korean and Japanese bank risk, so taking such exposure through a default swap in return for premium income provides risk diversification. Asian banks have shown a growing appetite for synthetic assets of similar quality credits to themselves, where these can produce fee income through off-balance-sheet mechanisms.
In theory, credit derivatives should be an enormously useful tool for professional credit traders and for commercial and investment banks in general which, by the nature of their businesses, tend to be long of credit risk. Traders are trying to apply the same kind of modelling to credit spreads and credit derivatives that they used to apply to interest rates and swaps. But it is difficult. There is no constraint of supply in dealing in US interest rates. It is easy to buy or sell as a hedge large amounts of US treasury bonds. Credit is different. Individual bonds and loans have different covenants and security. It is not homogeneous. Supply is a problem.
All credit traders are intrigued by the prospect of dynamic hedging of their credit portfolios using both underlying assets and credit derivatives. But the same delta relationship between government bonds and interest rate derivatives or equity options and underlying stock does not exist between credit derivatives and real assets. Credit swaps and derivatives move in lock step. In the last six weeks asset swap levels on Thailand bonds have widened from Libor plus 30bp to Libor plus 50bp. The premium payable on Thailand default options has moved similarly within a basis point or two of the asset swap level.
No magic about it
Credit derivatives simply reflect the price at which actual credit changes hands. Some investors do not realize that there is no magic to credit derivatives. This is a disappointment in a one-way market for credit. Theoretically, credit derivatives should be a great tool for laying off credit risk. But most banks and investors today basically want to take credit risk and be paid for it. The head of Eurobond trading at one firm says: “We have clients saying can you get high-grade bond X at 30bp over Libor and when we say no they come back and ask if we can get it through a credit derivative. The answer is still no and for the same reason. That’s not where the credit trades.”
It will be some time before firms can use asset swaps – the basic cash market for credit traders and credit derivatives – to go long and short credit volatility. “I can see people quoting volatility on a spread benchmark, like high-yield bonds,” says Lincoln Benet, executive director at Daiwa. “But not on the volatility in spreads of individual credits.”
Future developments in credit derivatives are difficult to predict. “The universe of investors in credit tend to operate on a fairly generic investment basis,” says Richard Williams, director and co-head of asset trading and credit derivatives at CSFP. “Generally, they do not want to build a whole layer of structure around it. So to date there has not been the same proliferation of gearing and structuring as you see in interest rate derivatives, for example.”
But some dealers disagree. They see exactly these developments. Martin Kannengieser, executive director at Daiwa, says: “You may have derivatives where the option payer takes the loss on a spread widening from 25bp to 100bp but has protection from 100bp to infinity: infinity means default. If you are comfortable with the first 5% of the loss on a position, that reduces the cost of protection.”
Daiwa is also looking at derivatives linked to two contingent risks, such as Japanese bank credit risk and the risk of rising yen interest rates. Certain counterparties may be able to continue making profits in the event of counterparty default as long as interest rates have not also risen, so a smart trader might produce a derivative that only pays out in the event of both a default and rising rates.
Few banks have been as radical as Daiwa either in their trading of credit or in their internal reorganization. At CSFP, the changes are on a much more modest scale. CSFP’s Williams now heads a group that combines the old asset-swap group from CSFB and CSFP’s credit derivatives traders. The desk’s remit is to be “a central clearing house for credit risk trading” within the whole group. Rather than combining groups where credit is a common theme – as, for example, Merrill Lynch has – those groups continue to operate separately. They don’t exist just for taking credit risk but pass on credit risk to Williams’s team. “Eurobonds and loans are capital-raising businesses in their own right. The primary loan business for example, may incorporate relationship factors in its pricing, Eurobonds often include some directional trade value. We want to manage the credit risk of the group without disrupting those businesses.” He adds: “If in the process of tying such groups together a firm prices all credit products to one base, that might tell the firm to stop doing certain businesses but at the cost of a valuable franchise.”
His desk takes positions in all the usual credit and spread risk markets. It takes proprietary positions in credits and buys and sell credit protection. “If the person running the loan portfolio wants to lay off credit into our book, we work on the basis of a market price,” says Williams.
The group also deals for customers, increasingly using credit derivatives. In the past banks might have sold loans or portfolios of asset swaps outright, asking leading asset-swap traders to bid for their portfolios. Bidding on such packages became quite straightforward. Now a bank may for whatever reason decide not to sell a loan or a portfolio, wishing to preserve relationships with lenders for example and instead pay a default premium to CSFP for assuming default risk. If it is lucky, CSFP can then buy that protection slightly more cheaply in the market, perhaps through a credit-linked note. Commercial bank lenders have become more sophisticated than in the past at measuring the returns from various types of client business. Some have found that there is a point where additional volumes of client business produce higher margins, so they can afford to pay a premium for the derivative that allows them to execute business which might otherwise exceed counterparty limits.
Because the credit derivative market is illiquid and not overly transparent, regular professional users have an advantage over occasional users. Recent customer trades by CSFP included selling protection to a creditor of troubled French bank Crédit Foncier. The creditor did not want to dispose of its loans but sought default protection which CSFB covered in the market. Similarly it sold a line of protection against Indonesia risk to a participant in a project-finance deal.
Increasingly takers of such risk may be institutional money managers wanting to add credit exposure following the creation of a single-currency bond market in Europe. “I cannot see many fund managers setting up bank loan processing divisions. They will want an efficient way to get loan-type exposure to names typically available only in the loan market,” says Williams.
Williams points out some of the organizational difficulties for a large bank or investment bank in drawing all its credit-related businesses together. There are obvious turf issues in many large firms where groups have operated with their own profit-and-loss accounts. Who are the old heads of credit derivatives and asset swaps going to start reporting to?
Despite the difficulties, the major houses are working hard at putting their strategies in place. In the last two months, Merrill Lynch has reorganized the lion’s share of its debt-market activities into a single global credit business, which will encompass new issues sales and trading in four previously separate areas: investment-grade bonds, high-yield bonds, emerging market debt including local currency and hard currency and structured finance. Credit derivatives will be included and used as a tool to manage credit risk around the firm. The reorganization recognizes, according to Merrill’s Blakey, “that a significant chunk of the firm’s revenues are credit-oriented. These are large and increasingly complex businesses spanning a wide range of products and initiatives.”
Definition by elimination
It almost seems easier to define the new Merrill division by what is left out. That is equities, foreign exchange, and commodities. Government bond trading and interest rate product are separately managed within debt by the liquidity and derivatives group. Almost everything else is included either fully or partially. The new division will have joint ventures with the equities division to manage convertible bonds and equity-linked debt, which at many other firms sit within equities, and with foreign exchange to manage emerging market local currency business.
Some parts of the division will be little changed, such as the investment grade Eurobond business, “though they may be given a wider universe of bonds to trade and the public new issue syndicate desk may handle more private placement business,” says Blakey. Some people will be moved from the mature parts of the business to the growing ones, notably emerging markets and European high-yield bonds.
What makes Blakey think the reorganization is worthwhile? “We see a lot of credit markets as being incorrectly priced. On the one hand we are focusing on new issues from countries and sectors where improving credit has not been fully recognized. Elsewhere, where commercial banks have driven spreads to unrealistic lows we are looking to get short through a number of structures. The vast majority of credit providers are putting assets on their balance sheets at the wrong levels and don’t have a market-to-market methodology to validate them.” Blakey takes the view that credit will get more interesting as more non-bank investors get involved and as investors build portfolios supplementing loans and asset swaps with credit derivatives. He adds: “The credit business is becoming more complex not because specific credits themselves are getting more complex, but because of the myriad ways in which institutions can now express their views on credit spreads and default scenarios.”
At Bankers Trust the focus of attention is the development of a European junk bond market. Gopal Menon, senior managing director, oversees a number of credit products, including leveraged loans, project finance and real estate, as well as asset swaps, credit derivatives, high yield and so on, which he calls the firm’s credit laboratories. “These are really trading books, which we have seeded and grown as new businesses and which increasingly interact and feed off one another.” These trading books, which the firm pulled together early last year, are less visible to the firm’s outside clients than its new-issue origination teams and sales people. But they are influencing other parts of Bankers Trust. For example, its sales force is no longer separated between specialists in bonds and in loans. “That’s a convergence that will happen at many firms, though for now we believe only a few institutions are organized like that,” says Menon.
“Our job as laboratory technicians is creating products. Finding relative-value product is getting harder, but we are seeing some very interesting applications for what we are doing.” For the moment, Bankers Trust is trying to channel the creativity of its laboratory technicians in one single direction: towards the creation of a European high-yield bond market. Partly to this end it is setting up what it calls enhanced investment funds to enable investors constrained by their lack of credit expertise to gain exposure to these new markets. “We are on an interesting journey in Europe,” says Menon. “Today the European high-yield bond market is not even 1% of the US market. Our leveraged lending and credit laboratories are the base from which to reach that goal.”
Lehman’s way
Lehman’s approach to credit trading in Europe is fairly straightforward: an outgrowth of credit trading in New York. The group deals in cash bond markets, assets swaps and credit derivatives with a focus on big, liquid assets. It has produced a global credit index by simply combining its US corporate bond index and its Eurobond index, including all public fixed-rate dollar-denominated credit bonds in the two markets with maturities of at least one year, outstandings of at least $100 million and investment-grade ratings. In future, it may include more investment-grade bonds from emerging markets. Even though there is a diversity argument for including high-yield bonds, it does not because its clients include a lot of regulated investors, such as US pension fund money which cannot stray into below-investment-grade paper.
The firm makes straightforward recommendations, which to the European ear, sound like those of an equity strategist. It recommends being underweight bonds of basic industry, capital goods and consumer cyclical industry sectors, because these should suffer first in any economic downturn. Being late in the economic cycle, it prefers the bonds of energy companies because that sector is less cyclical and airline bonds because the credit fundamentals of airlines are improving. In sovereign bonds it is underweight the high-grade countries – on the grounds that spreads could hardly tighten any further – but it recommends certain BBB-rated countries – so-called cross-over credits – such as Croatia and Slovenia.
This is credit trading in a simple, easy to understand form. But it is more than just bond trading. The firm has seen a lot of activity in asset swaps including forward asset swaps, a class of instrument that some firms class as a credit derivative and some don’t. Forward asset swaps have two potential advantages for a bank or other similar investor. If a bank has a credit line of say eight years for a borrower but cannot find actual assets of that length, they are a way to use up that unused credit limit. They also take advantage of generally steep forward credit curves by locking in wider spreads in the future than are generally available today.
Lehman Brothers uses the example of a forward asset swap on a notional ¥15 billion of National Bank of Hungary (NBH) bonds, the 5.2% bonds of July 2005. Today eight-year NBH bonds trade on an asset-swap basis at Libor plus 70bp and three year bonds at Libor plus 30bp. By agreeing to buy the NBH asset in three years’ time, an investor can lock in a spread of Libor plus 95bp for the remaining five years of the maturity, that is 25bp more than eight-year assets yield today. The risk for the investor is that Hungary’s credit fundamentals deteriorate over the next three years and spreads widen by more than 25bp. But the downside is not unlimited. If NBH defaults in the next three years, it does not have to buy the asset.
Investors may use forward asset bets for enhanced outright bets on a credit improving. Recently investors have been buying Polish spreads forward in expectation of the BIS risk weighting on Polish assets falling to zero in the next two to three years, something not yet reflected in tightening spreads.
For professional traders, credit markets are good ones to trade because there are so many different types of bonds and other debt instruments outstanding for the same and similar issuers. Their trading levels may partly be determined by technical market factors, as well as by changing views of the issuer’s credit risk. That helps the credit investor search for relative value and it helps the smart trader to pick up debt cheaply in one market and sell it on again in another.
One large flow in recent months has been for restructured Latin American debt being sold in continental Europe to private clients and public bank investors. Traders have been picking up Brady bonds, many with complex amortization schedules, or zero coupons and other locally issued dollar-denominated instruments such as Argentine bocones and re-packaging them, often through special-purpose vehicles which own the dollar bonds and then issues new notes, into Deutschmark-denominated bullet maturity bonds which are sold to retail buyers in Germany.
It’s a flow that complements the stream of new issues of emerging market debt in Deutschmarks and takes advantage of strong demand in Europe for high-yielding debt bonds. The flow isn’t exclusively from Latin America. European buyers have enthusiastically bought repackaged Russian dollar-denominated MinFin bonds and Russian treasury bills, or GKOs, swapped into dollars.
Earlier this year, following a downgrade for Turkey, traders in the new structured finance unit at Daiwa Europe in London noted that Japanese institutions were panicking about Turkey, whereas in Germany, the price of its debt had remained stable. A large block of yen bonds from a Turkey samurai issue were offered in Tokyo and Daiwa was able to buy these cheaply enough to allow it to repackage the bonds through a special purpose vehicle and sell them as Deutschmark Eurobonds. These bonds yielded 100bp more than a Dm750 million new issue for Turkey launched at the same time by Commerzbank.
The trade was turned around overnight. Daiwa’s Kannengieser says the firm could have squeezed more profit from the trade by adding further elements of structure risk. “In some repackagings there might be a residual risk relating to the yen/Deutschmark exchange rate, or there might be an element of leverage whereby the investor receives a higher coupon but risks losing principal if the market value of the underlying samurai bond issue falls below a certain level.” This was a simpler trade. “We took a conservative stance. Basically, it would require a default by Turkey to trigger losses for buy and hold investors in the new notes.”
Another highlight transaction of Daiwa’s was the bidding on and purchasing of the head office of UK insurer Sun Life in Bristol. Daiwa bid higher than a select group of traditional property buyers on the basis of its plans to securitize the key asset, a 30 year lease-back to Sun Life. Nick Richards, who runs the asset finance part of the business, says: “We monetized the lease through a £77 million bond issue sold to traditional long-dated sterling bonds investors.” The bonds were rated AA minus by Fitch and the deal was oversubscribed at 74bp over gilts, where it looked attractive against similar maturity insurance company bonds, especially considering the underlying security of the building. It’s a classic traders’ arbitrage, with equity investors, property investors and bond buyers putting different values on the same asset.
Celerity and loads of cash
Speed is one element in Daiwa’s credit strategy, another is being able to commit large amounts of capital quickly. Head-hunters are regularly phoning Daiwa’s members asking how to build similar outfits. Rivals say firms should be prepared to budget several tens of millions of dollars in the first year of trying to build such a team.
The group has its own analytics research group and it has its own distribution. Occasionally, it cooperates with Daiwa’s bond salesforce, but its activities are radically different from the rest of Daiwa. It would like to integrate more. Certainly Japanese clients are a useful group of investors taking different views on credit markets. The group has devised principal-protected structures for Japanese investors seeking exposure to US high-yield bond markets for the first time. Such investors don’t know much about particular issuers and want diverse portfolio exposure. They may be happy with an extra 100bp of annual yield over their conventional investments as long as they can be sure that the full amount of their original yen investment will come back.
Much of the group’s activity requires taking principal risk but Nydes says: “Buying assets at cheaper than inherent value may require positioning for some months, but in 95% plus of cases we already have the end-game in view. That’s how we identify the value.”
It all sounds wonderful – too good to be true? Maybe. The new masters of credit are rather like modern artists whose unusual forms are lauded by critics but are yet to pass the test of time. A crash could find them lacking in substance, leaving behind a period characterized by an ability to impress contemporaries rather than producing works of true merit.
