After two years in development, the fruits of DrKW’s credit bankers’ labours have finally been realised with the issue of €500m-worth of credit spread warrants for French supermarket operator Casino. Natasha de Teran talks to the team.
The recent credit spread warrant launched by Dresdner Kleinwort Wasserstein (DrKW) on behalf of French supermarket chain Casino was the kind of ground-breaking deal guaranteed to get bankers’ pulses racing. It was a first for the bank, for the issuer and for the global capital markets.
The credit spread warrants were linked to €500m of bonds to be issued by Casino and were designed to ensure the issuer could lock in to current attractive spread levels. The warrants give investors the option to purchase the French supermarket operator’s bonds on a set date in the future at pre-agreed terms. The warrants are effectively securitised credit call options, which settle in a similar fashion to bonds: on the warrant expiry date investors will be eligible to buy up to €500m of a new 10-year Casino fixed-rate issue, at a yield equivalent to mid-swaps plus 85 basis points.
Seeds of inspiration
The idea behind the deal germinated from discussions between two of DrKW’s credit bankers. Sean Park, managing director and global head of debt syndicate and credit trading, and Henry Nevstad, managing director and global head of structured debt and private placements, started playing with the idea two years ago.
Mr Nevstad says: “The first pitch we did to an issuer was in July 2002 and we spent a lot of time after that brainstorming trying to refine our thoughts. We were using the key idea of monetising volatility from the convertible markets and were working to apply that to credit spread volatility.”
The two bankers believe that monetising credit spread volatility is something that corporate issuers should be considering to optimise their funding strategy. Over the last few years several corporates have issued convertible bonds in a bid to profit from the value locked up in their volatile share prices. Credit spread warrants apply the same concept as that applied to bond volatility, but suffer less of the dilution downside that accompanies convertible bond issuance.
While refining their idea for an appropriate method to monetise credit spread volatility Mr Park and Mr Nevstad were also looking for a way for issuers to lock in attractive funding rates. Issuers have previously done this by issuing bonds when spreads looked attractive and reinvesting the surplus capital until needed. As credit spreads have reached record tightness over recent months, bankers across the board have been looking for alternative methods of doing so.
Credit spread advantages
The benefit of issuing credit spread warrants, as opposed to issuing debt opportunistically, is that the cost of carrying the debt on the balance sheet is avoided. Moreover, if companies issue debt prematurely, they cannot profit from the monetisation of spread volatility as they may be able to with credit spread warrants – whereas if they have issued the call warrants on their own debt, borrowers are not obliged to issue the bonds. Issuers can bank the premium and, if the option is exercised, they know their maximum funding costs, while if the option expires worthless, they have been able to mitigate the increased spread with the premium obtained from the warrant sale.
During the two years that Mr Park and Mr Nevstad were toying with the issues, the final structure of credit spread warrants gradually became clear and the duo started an intensive marketing campaign to a broad range of issuers in January this year.
Mr Nevstad says: “The initial response to the concept was overwhelmingly positive as issuers immediately recognised that the product would eliminate some of the concerns they have with other methods of pre-funding their financing needs.”
Making the project even more testing for the two bankers operating under the notoriously short-term mind-set of a capital markets department was the investor: they also needed time to get acquainted with the idea.
“Because we had been thinking about the concept for almost two years and had been steadily refining it over that period, we were very familiar with it. However, much work obviously had to be done educating counterparties and potential issuers before any deal could be done, so at some points there was an element of frustration – we saw many instances where it could usefully have been applied, but we had to wait,” says Mr Park.
Putting theory into practice
Despite the positive reaction of issuers and the gradual build-up of investor interest, it was still some time before the bankers’ efforts were to reap rewards. Unsurprisingly perhaps, it was a French issuer that first tested the waters with the new instrument. “There is a general perception that French counterparties are rather more sophisticated when it comes to derivatives than their peers elsewhere in Europe – so the fact that we ended up doing the first issue with a French issuer was not surprising,” says Mr Nevstad.
Hugues Delafon, director in the capital markets origination team at DrKW in Paris, recalls how, in September last year, Casino had told the bank it liked the market conditions and would like to take advantage of them. The company’s issue was scheduled to mature in April 2005, and it wanted to lock in the existing funding levels. However, Casino wanted to do so without the cost of the carry.
Mr Delafon says: “Along with other banks we began by working on ideas such as credit defaults swaps and iBoxx index-linked products, but none of them were entirely satisfactory. Henry and Sean had by this time been working on the credit options idea and told us about it, so we went on to develop the concept for Casino. We explained to them the difference between this and alternative structures, but were able to show them that it corresponded to what they wanted. They were immediately convinced it was the right way to do it.”
By the middle of the first quarter of this year Casino had decided to do the deal, but even then it took a while to get the project authorised by the issuer’s board and to get the company’s technology organised, draft a term sheet and price it. Despite what must have seemed like endless delays the bankers remain steadfastly upbeat about the deal process. And while a great deal of the credit must go to the bankers concerned – for their idea, their patience and their execution – some is also owed to the issuer.
“Casino is a very sophisticated issuer – the group has a very strong financing team – they know the market and available products very well. Overall it was a very smooth process from start to finish,” says Mr Delafon.
Although the bankers surprised the market with the issue – engaging in no pre-marketing activity at all – the demand for the new instrument proved strong on the day. Mr Park says that although Casino had a €500m funding requirement it wished to cover, the bank initially tested the water with €400m worth of the warrants. He says: “Once we had seen the demand was coming in strong, we increased the issue to €500m – this move also alleviated some comments about future liquidity in the warrants, which was a nice sweetener.”
Measure of success
As a testament to the bank’s overall commitment to the product, DrKW has not yet sold out of the entire position. “This is because a lot of the potential investors are not yet ready to book it. We were aware this was going to happen as we didn’t allow ourselves any pre-marketing time on the structure so it was obvious there would be a time lag on the buy side. We are now spending a lot more time educating investors,” explains Mr Nevstad.
The amount of time invested in the project appears well spent. Mr Park says the media, other issuers, investors and also the bank’s competitors showed a “gratifying amount of interest”. Moreover, just days after the transaction was completed, DrKW went on to issue 34 tranches of covered credit spread warrants. Issued in the legal entity name of Dresdner Bank AG, the issue comprised 14 individual put warrants and 14 individual call warrants on corporate names, and three puts and three calls on the iBoxx indices, all with expiry dates set in December this year. Under the terms of the call warrants, the holder has a right to purchase the underlying bond from Dresdner on the expiry date at a yield equal to mid swaps plus the strike spread. Similarly, under the terms of the put warrants, investors have the right to sell the underlying bond to Dresdner at the expiry date, at the strike spread.
Aside from the issuer’s satisfaction and the obvious financial rewards, perhaps the most satisfying by-product of the transaction came from one of DrKW’s fiercest competitors. Just hours after Dresdner came to market with the deal – and no doubt as a result of the attention surrounding it – one of the leading players in the global credit derivatives business began marketing their own version of credit spread options. Flattery indeed.
