Portfolio managers are driving innovations in credit derivative markets, and developments in CDSs and CDOs offer new avenues for banks to shed credit risk. By Rasheed Saleuddin.
At one time, a loan portfolio manager’s role was simple. At first, the task was simply to measure credit risk. The portfolio manager may have had some say over whether to do a deal or not based on this analysis, but not very often. Once a credit decision was made, hedging was limited to loan sales and loan participations. In theory, a portfolio approach was followed, but the reality was that it was exit clients that were hedged.
Then there was securitisation. Though securitisation is thought of as a risk transfer tool, such transactions often do not reduce credit risks for originating banks. As such, these structures are used mostly to manage regulatory capital (and/or lock in term funding).
Recently, though, the credit derivatives market’s growth has resulted in the number of tools available to bank loan portfolio managers growing exponentially. This has thrust credit managers into the spotlight because hedging products require ever-increasing levels of sophistication to evaluate and implement.
Instruments such as constant maturity credit default swap (CMCDS), single tranche collateralised debt obligations (CDO) of asset-backed securities (ABS) and vertical portfolio swaps are adding value for portfolio managers who are demanding increased flexibility in their hedging programme.
Indices: speed and liquidity
The introduction and subsequent development of liquid markets in tradeable CDS indices finally provided at least an approximate and systematic risk hedge for corporate portfolios. The dual advantages of liquidity and transparency are particularly attractive to the larger banks, but suit many market participants, both investors and hedgers.
The iTraxx and CDx indices, each comprising 125 of the most liquid traded investment grade corporate credits, enable banks to execute quickly (either short or long) to take advantage of sudden changes in expected global and systematic credit riskiness (or expected changes). For banks with exposure to the underlying names, the index can also provide some idiosyncratic risk protection but not necessarily to the degree that is required (it is take it or leave it, due to the standardisation).
Index tranches
Perhaps the most relevant derivative of the indices for the purposes of this discussion is the tranched index market. (For an explanation of the single-tranche concept, see figure 1 download file.)
The tranched markets still offer liquidity and transparency but with the added flexibility to hedge or invest in various levels of the capital structure. This transparency ensures that marking to market, and simplified deltas (for risk calculations) are easily available.
For example, assuming a portfolio manager wishes to pay €29,500 in hedge costs, the simplest choice is to buy protection on the iTraxx index (see below Buying protection, example 1).
In addition to the spread risk hedge, the manager also has default protection on each individual name in the iTraxx portfolio. This may be valuable to the extent that the manager has credit exposure to the underlying names, but otherwise this may be wasted cost if the bank does not have exposure to any specific iTraxx credit. The tranched market offers another alternative. Assuming that the same hedger has the same €29,500 to spend, they can get more BP01 if they take some correlation risk and eliminate the jump-to-default benefit that might not be required (see below Buying protection, example 2).
A similar technique can be used to create zero cost combinations, which will benefit from spread widening for those that do not have the budget for hedging.
Bespoke single tranche CDOs
While the availability of tranched portfolio risk transfer tools, such as iTraxx tranches, have increased flexibility for hedgers (allowing loan portfolio managers to move away from always executing delta-1 hedges), portfolio managers need to hedge exact target portfolios and in relatively large sizes. For this, older technology (previously catering to the investment community) is being used, this time to hedge credit risk as measured by both regulatory and economic capital.
Bespoke single-tranche CDOs (referencing a pre-selected portfolio of liquid corporate credits) have been around for many years as investor-driven transactions, where the dealer counterparty responded to demand for rated tranches of portfolios of credit risks, but on the investors’ own terms. The dealer provided the required customised credit risk (names, term, subordination, etc) and hedged the correlation and jump to default risk in the vanilla CDS markets.
The CDO offered investors subordination to protect against some idiosyncratic risk (so an investor only had to avoid most losers and not necessarily pick winners) while using leverage to enhance the returns. Many bank portfolio managers are as familiar with this technology as investors, having often been investing in single tranche CDOs as part of a zero-cost strategy to help pay for (single-name) concentration risk hedges. What is relatively new is that banks are beginning to use this technology to hedge their portfolios of less liquid credit risk.
The bespoke market to reduce regulatory capital (Basel I, that is) held for corporate portfolios has been going on for some time, although it is a relatively poor risk reduction technique.
Typical portfolio
Take a typical portfolio of credit risk, for example: Basel I trade: bespoke 3%-100% CDO tranche. The loan manager chooses a portfolio of (again) liquid names (a bespoke CDO) to which the bank has exposure and then finds the highest regulatory capital reduction at the lowest cost.
Taking the 3% attachment point up to the last loss (100% detachment point), a dealer is able to quote a price based on the market prices of the underlying CDS and the (proprietary) correlation assumption. Assuming that the current price for the 3%-100% tranche using the market’s correlation assumptions for a representative corporate portfolio is 10bp per annum for five years, then the total portfolio yields 51bp.
So, according to the market, the 3%-100% tranche has approximately one-fifth of the risk of the 0%-100% tranche. However, the regulatory capital benefit is substantially greater. Simply, a linear portfolio of rated investment grade corporate credit risk attracts an 8% of 100% capital charge. This yields 50bp (for example), so the gross return on regulatory capital (ROC) is 6.25%. For 10bp less, the bank in question can put up 3% capital (that is, deduction on the 0%-3% tranche) plus 20% of 8% on the 97% of the portfolio hedged. So the gross ROC is now significantly higher at 40/4.55 = 8.8%.
The amount of economic risk that is hedged depends on the bank’s own expected default probabilities and the default correlation used, not to mention the risk model.
Even without the model, it is easy to identify two possible negatives to this trade: only liquid names can be hedged and only losses above 3% are being mitigated (so some idiosyncratic risk remains).
This is where it starts to get interesting. If one or both of these hurdles can be cleared, it will result in a perfect product for loan portfolio managers: bespoke single tranche CDOs or vertical hedges on illiquid portfolios.
BUYING PROTECTION EXAMPLE 1 Buying protection in €10m of Series 5 iTraxx 5 year @ 29.5bp Annual cost of hedge (12M carry): €29,500 BP01 (value of 1bp change in yield): +€4,656/bp i.e. 1bp widening => +4.656k mark-to-market EXAMPLE 2 Client buys protection in €5.6m of 3%-6% tranche Series 5 iTraxx 5 year @ 52.75bp Annual cost of hedge (12M carry): €29,540 BP01 (value of 1bp change in yield): +€11,733/bp i.e. 1bp widening => +11,733k mark-to-market 2.52x better SPD01 Leverage: 4.5x
