BNP Paribas’ structuring team is meeting growing demand with some innovative approaches. Edward Russell-Walling explains.

The French have a deserved reputation for philosophical and mental agility. So it is not entirely surprising that, when it comes to innovation in the complex world of structured credit, French banks are often at the front of the pack. While these derivative-based products grow no less complicated, some of them – thanks to structuring teams like the one at BNP Paribas – are becoming more flexible and easier to manage.

Though investors have for some time been able to use collateralised debt obligations (CDOs) to customise their credit exposure, credit default swaps (CDSs) have transformed the market. By making it possible to take short as well as long positions, CDSs have enabled more sophisticated credit trading strategies and opened the gates to the creation of synthetic CDOs and related forms of structured credit. These have proved so popular that the size and number of synthetic deals has now overtaken those in the cash market. And while central bankers continue to worry about the spreading of submerged credit risk, banks such as BNP Paribas continue to innovate.

More strategies

“The impact of the CDS market has been phenomenal,” says Hervé Besnard, head of credit structuring at BNP Paribas Corporate & Investment Banking. “Traditional asset managers can use CDS techniques to do new things, to create more strategies for the benefit of their investors.”

Executing these strategies effectively has become more difficult, however, especially for smaller players. Credit is now a heavily resource-intensive asset class. In the early days of CDSs, there was a finite universe of names (all investment grade) and tenors were a standard five years. Today there are many more liquid names, extending into high-yield and emerging market territory, while tenors have lengthened to 10 years, which is why major credit asset managers employ very large teams of analysts.

As Mr Besnard points out, if you are a small pension fund or bank wishing to invest in credit, and you want to get it right, you can’t afford a large team of analysts. “So there is a need for them to buy a third-party managed transaction,” he says.

At the same time, the job of the structurers has become more important. “There is a variety of demand – because different asset managers have a variety of strategies,” he says. “The carry trade wants long only. Diversified portfolio managers want more alpha, because they believe the market can go both ways. Others are interested in protection. We find ways to link clients with strategies.”

Offering protection

The result is a divergence in product architecture between mainstream CDOs, usually fully rated, and protection vehicles such as constant proportion portfolio insurance (CPPI), which provide a capital guarantee. While CPPIs are generally unrated, BNP Paribas launched the first rated transactions in 2005, managed by Credit Agricole Asset Management and called Dynamo I and II. They were also the first to target institutional investors and surprised onlookers by attracting $910m.

Last year the bank launched Axiom, a long-short dynamic proportion portfolio note that has gone on to become the largest managed CPPI to date. The long-short strategy was designed to make Axiom largely independent of the credit cycle, generating returns from diversified relative value trades in a wide range of credit instruments. Investors were able to customise by currency, maturity and coupon type. With an initial size of $515m, Axiom has since been tapped six times with additional notes and two UCITS III funds, attracting a total of $1.125bn. The notes and funds are managed by AIG Global Investment Group, whose affiliates invested $50m of their own money in the notes.

The main product stream, however, is CDOs. Here, another big change in the market has been the transition from static to managed deals. “To arrange a seven to 10-year transaction, when the portfolio and structure are actively managed, you first have to build a robust relationship with the asset managers,” observes Nicolas Christen, BNP Paribas head of CDO structuring. “Infrastructure is also key, with systems that allow transparency, so that when the manager changes the portfolio, he is assured he will receive a fair price.”

A recent CDO transaction that pushed out the frontiers was Waypoint, a ‘multi-maturity’ deal managed by Solent Capital. “It’s quite a mature market, but we are still trying to do things differently and to enhance our products,” Mr Christen explains. “With Waypoint, the multi-maturity element gives more flexibility to the manager, allowing room for them to use their skills and giving investors some potential upside if spreads widen.”

About ?260m in rated Waypoint notes have been issued, in a transaction that matures in 2015. Within the portfolio itself, the manager can select reference entities with shorter maturities than the tranche maturity date, leaving room for future replenishment. That is a standard feature in many cash structures but rare for a synthetic CDO, in which the maturity of all the assetsm is usually the same as the tranche maturity.

“Synthetic corporate CDOs have gained wide acceptance because of some of their advantages compared to cash deals – like the ability to tailor the product to very specific risk/return objectives, the efficient funding and the modelling simplicity,” says Mr Christen. “But being forced into a bullet portfolio was a clear disadvantage. That is now being addressed.”

While a bullet structure makes modelling easier, it obliges managers to choose assets for one maturity only, instead of having the flexibility to adjust maturities to their view of the risk for different investment horizons. With Waypoint, Solent can adjust the maturity for each asset – and thus the average life of the portfolio – based on its fundamental credit views, relative value on the credit curves, and even its general view on market spreads, to deliver higher performance.

“It adds an extra dimension to the role of the CDO manager,” says Mr Christen. “They can also use the multi-maturity feature to be defensive – for example, reducing the maturity of credits for which they expect some deterioration, rather than completely removing the name, which would be more expensive for the structure.”

The multi-maturity and flexibility themes are extended in Dyneo, the first dynamic CDO, designed (as the bank puts it) “for an uncertain credit environment”. Dyneo, managed by Crédit Agricole Asset Management, uses a long-short strategy, and reference entities in the portfolio can have up to three different maturity dates. A new feature is a dynamic bucket, allowing the manager to include further risky assets after the issue date, adjusting the structure to market conditions.

Another feature is ‘dynamic subordination’, whereby the manager will be able to monetise or demonetise the notes threshold or step-up premium into or from the trading account. BNP Paribas believes that Dyneo will take synthetic CDO management a step closer to credit fund management.

Range of options

“We strongly believe in innovations that give asset managers more flexibility to manage portfolios and to generate value,” says Mr Christen. “This sort of innovation quickly gets widely accepted, since it enhances the product – and, at the end of the day, the manager doesn’t need to use them if he sees no need to do so. But in an uncertain credit market, it’s good to have options.”

The bank believes the structured credit market will continue to grow. “As the universe of names expands, staying on top of market evolution and risks is getting more difficult for small players,” says Joe Lovrics, head of Europe, Middle East and Africa structured credit sales. “They have to delegate to those with the resources to manage that asset class on their behalf. That’s why growth will continue.”

Innovation will also continue. A new deal – about which the team is saying little – tackles the problem of mark-to-market volatility for buy and hold investors. It also optimises the regulatory capital implications for bank investors and behaves more like a loan. “We are finding ways to address these problems,” says Mr Lovrics.

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