New Credit Risk Tools
IN PRINT ARCHIVE CIR Winter 2000
|New Credit Risk Tools|
|by Craig Shepherd and Alain Belanger|
As government issuance declines, both individual and institutional investors must consider corporate investments as a larger part of their fixed income portfolios. These investments, which include corporate bonds and loans, provide enhanced yield to compensate investors for the credit risk inherent in these debt obligations. Credit risk must be managed as part of an overall program, just as any other risk exposure.
Investors' exposure to credit risk will increase in the years to come. Defaults in the first half of 2000 have reached levels not seen since the recession of the early 1990s. More market participants than ever will find themselves exposed to losses due to credit risk. This creates tremendous performance opportunities, but also introduces increased risk in an area that will be relatively new to some investors.
Here we introduce three credit-derivative instruments being utilized by market participants to reduce, increase and/or diversify their exposure to credit risk.
Credit default swaps
Terms can be customized to match specific needs, but the market is currently attempting to standardize the contracts to promote ease of trading. Greater trading potential will mean more liquidity and tighter pricing.
The Default Swap market in Canadian names is in the early stages of development. However, interesting transactions have been completed and opportunities continue to develop.
Total return swaps
Total Return Swaps can also provide a means of leveraging the investment by providing funding for the investor (possibly up to 100%, although some initial margin is usually required).
Total Return Swaps can be a valuable tool in the quest for diversification by providing access to new investments and asset classes. Securitized products
Diversification remains the best way to insure against significant losses due to credit exposures. The most efficient way to participate in a large and diversified pool of assets with one purchase is to buy a note from a CBO, CLO or CDO (Collateralized Bond/Loan/Debt Obligation respectively) structure. CDO collateral has traditionally been composed of a mixture of bonds and loans but more recently, "second generation" structures have also included CBO/CLO/CDO notes themselves. CLOs, in particular, offer investors the opportunity to invest in the performance of a non-traditional class of assets: corporate and commercial loans. Access to Bank Loans expands the Universe of credit counterparties. In addition, Bank Loans have had higher historical recovery rates than similarly ranked bonds, thus making the risk/reward comparison attractive.
In a single purchase, a CLO or CDO note can provide access to as many as 25 to 150 obligors from a wide variety of industries. The notes issued are divided into tranches corresponding to different subordination levels. Subordination provides noteholders significant protection from losses in the underlying loan pool. It is typical that the structure sponsor and/or manager retains at least a portion of the equity or "first loss" tranche. Spreads paid to each tranche are commensurate to their risk, thus providing further opportunity for customization to investors' risk/reward preferences.
Figure 3 illustrates a simplified CLO structure.
Craig Shepherd is Managing Director and Alain Belanger is Director of Credit Trading & Structuring at Scotia Capital in Toronto.