The uptake of credit derivatives by corporates is lukewarm at best but Natasha de Teran finds bankers bullish about the future of this market.

Although the corporate sector has long been trumpeted as a potential user of the credit derivatives (CDs) market, bankers marketing the instruments to corporates have often found themselves poorly rewarded for their efforts. With the exception of a few more sophisticated users, bankers say that precious few corporates are yet using the instruments.

Stefano Paschetto, head of credit and rate derivative marketing Europe at BNP Paribas in London, says that his bank has seen more interest recently from corporates – they want to know which instruments they could use, how they can use them and what they can hedge with them. But he says: “The reality is that, while they are all very interested to hear about it and discuss it, they actually trade disappointingly little.”

Others agree. Russell Schofield-Bezer, head of the corporate financial engineering group at JP Morgan in London, says that as more corporates look to diversify their investor base and extend the maturity of their debt by utilising the bond market, they are increasingly hearing more about the CDs market. Even so, he adds: “Education still remains the central theme with respect to corporate dialogue on this topic.”

Bankers undeterred

All the same, bankers are not deterred by the slow take-up of the corporate sector. Marc Badrichani, managing director in charge of corporate structuring at Deutsche Bank in London, says that just as corporates are now the biggest users of interest rate swaps, so he believes they will become some of the biggest users of CDs in the future. “That said, we are still in the very early stages, and it will be another year or so before we see activity widen to include a larger group of corporate users.”

Lloyd Greensside, structured credit marketer at ABN AMRO in London, says that although demand has hitherto been low, there is definitely more interest now from the more sophisticated corporates and from those who are more involved in other day-to-day hedging processes. “Overall they are becoming more aware of the credit risks in their business and are actively looking for ways to hedge or to take advantage of it. Because credit spreads have narrowed so much, getting paid for that risk is getting increasingly difficult, but on the other hand it is becoming much cheaper to buy protection,” he says.

It is surprising that corporates have not been involved in the market earlier, particularly since the launch of credit indices such as iBoxx. Mr Greenside says the kind of risks they could hedge through CDs arise from every transaction with future cashflows, including inter-company payments, lease agreements, insurance contracts and derivative hedges. “Additionally, the current level of credit spreads has led to some clients seeking to explore ways of hedging their own issuance spread by buying protection on iBoxx indices or a correlated basket of reference entities,” he says.

Learning curve

The reasons that corporates have held back from using CDs are varied. Mr Schofield-Bezer puts it down to education. He says that even some of the corporates whose names are actively traded in the credit default swap (CDS) markets are still learning about how the market works and how it affects them.

Mr Paschetto says that many are put-off because the names they want to trade are very illiquid, while, for others, it can be a question of cost. Sometimes corporates are also worried that the wrong message could be sent out and be interpreted as a lack of confidence in a supplier or a region. Mr Paschetto adds: “Corporates can be risk averse – even though they are taking much bigger risks elsewhere in their business.”

One of the most common explanations for corporates’ reserve is the accounting treatment any such hedging will receive. Ines de Dinechin, head of corporate sales at SG CIB in Paris, says that this is partly because the new accounting rules are not precise about whether these strategies will qualify for hedge accounting treatment. She says: “We don’t believe there is a difference between hedging a credit spread and an interest rate spread, and are trying to convince the larger auditors to accept these as qualifying hedges.”

In the meantime bankers have to deal with the accounting quagmire themselves – not providing opinions, but attempting to work out the treatment of hedges prior to their implementation. Mr Badrichani says: “We don’t do transactions without looking at their accounting impact. It is no longer just about hedging a risk or taking a view; you need to ensure you will get satisfactory accounting treatment before engaging in a trade.”

1660.photo.jpg

Russell Schofield-Bezer: ‘Corporates still learning about how the market works’

1661.photo.jpg

Stefano Paschetto: ‘More interest recently from corporates’

Beyond accounting

Invariably, the first thing corporates want to know when looking at such strategies is how they will be able to account for them, says Mr Schofield-Bezer. In response to this, he says JP Morgan has developed Heat, an analytical framework that analyses the hedge effectiveness of a trade and assesses the future impact of the hedge on the balance sheet.

In the hope that corporates will eventually overcome the accounting difficulties and catch on to the many benefits offered by CDs, bankers have developed a wealth of strategies.

Although Mr Schofield-Bezer admits it is still the exception rather than the rule, some corporates have begun to use CDs to forward hedge spread movements in advance of a bond issue – by buying CDS protection on their own names to lock in tight spreads. One problem they face in doing this is caused by the lack of liquidity in the underlying name – even on some of the most liquid names you would invariably distort the market and push spreads out if you were to buy $1bn-worth of protection ahead of a bond issue. He adds: “Many banks are now suggesting index-based hedges – this is really just a proxy hedge as it hedges the sectoral, but not the individual risk.”

There are slightly more sophisticated examples. SG’s Ms de Dinechin says that corporates will sometimes overlay more sophisticated structures that enable them to gain from any upside over the hedging period. “These might include the corporates buying a cap on the credit spread, which they finance by selling a floor so that they effectively have a collar – a maximum level at which they will issue, and a minimal level they will benefit from,” she says.

Mr Paschetto has also proposed

corporates link triple-A collateralised debt obligations (CDOs) to interest rate swaps (IRSs) to reduce the cost of debt. In a trade like this the bank would do an IRS with the corporate who would pay the floating leg, but instead of paying Libor (London Inter-bank Offered Rate) flat, they could pay Libor -50bp by taking risk on a triple-A tranche of a CDO or a basket of high-quality names for the tenure of the swap. “So far they have been less receptive to ideas like this, thinking that they should not be taking on additional credit risk,” he says.

Tailored to fit

Mr Badrichani points out that some corporates are beginning to use CDs to hedge their overseas or emerging market risks – not on a general basis, but to answer specific financing needs. For instance, if a corporate has an investment in a risky emerging market that it wants to finance, it might buy protection on the emerging market itself, and pass this on as a package with the asset to the bank it is seeking funding from. He says that in this way, the risk facing the lender is limited purely to the asset’s risk, and isolated from the emerging market’s risk.

Ms de Dinechin says there is not much of evidence yet of corporates using CDs to hedge supplier risk – one of the main areas that bankers had originally thought they might employ the instruments. This, she says, is mainly because of the costs involved.

Bankers are less surprised that corporates have used them to hedge out their counterparty risk with their lenders. Mr Paschetto says that this is because most of the time the counterparty risk is from the banks to the corporates as, with a few exceptions, the banks tend to have higher ratings.

Other bankers disagree. ABN AMRO’s Mr Greenside maintains that this sort of hedging is becoming more and more important. Corporates, particularly the larger ones, often have a huge amount of transactions with their preferred counterparties and are now beginning to come up against line restrictions. “[Corporates] are becoming aware of the embedded credit risk and sooner or later they will have to hedge against that or find new counterparties. Take, for example, the corporate which has been buying forward or cross-currency euro/dollar at exchange rates from 0.90. This trade would now leave them heavily in-the-money, with the consequent contingent credit risks should their counterparties default or their spreads widen,” he says.

Despite the lack of uptake from the corporate sector, bankers are adamant that involvement will grow. And now they have a whole arsenal of strategies to show corporates, they are more likely to succeed.

Mr Greenside believes that the growth of credit hybrid products will lead to the development of more and more applicable products and solutions for corporate liability hedging. He says: “I would expect to see a tremendous boost in the applications of credit derivatives for corporates and in their use of the instruments because of hybrid products.”

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter