A little understanding helps corporates jump hurdles

Banks’ and insurance companies’ use of credit derivatives continues to grow but corporate interest in the field is minimal by comparison. While there are many hurdles to overcome, some bankers expect activity to increase, reports Mark Pelham.

Corporates make limited use of credit derivatives in Europe and only a little more in the US. And, while many market participants agree that there is potential for growth, they acknowledge that recent experience shows it could be a slow adoption curve.

“There was a push last year, certainly from US corporations, to try to hedge their utility exposure,” says Femi Adewale, vice-president in the global structured products (GSP) trading group at Banc of America Securities (BAS) in London. “However, although we did see one or two institutions come in and try to hedge that exposure, activity was extremely limited.”

Corporates lack policy

The main reason for many corporates not managing their credit risk as well as they should is that they do not have any clear internal policy, says Fitzroy Thomas, principal in the GSP origination and marketing group at BAS. “If you look at interest rates, for instance, they would have a policy of, say, 50-50 split fixed/floating. But we have not yet got to the stage where corporates have a formal credit policy, which they would then need to implement,” he says.

Mr Adewale agrees that corporates will also need the infrastructure and all the support systems and risk management tools that go with trading credit. “The systems we have here, for example, are complex and take a lot of manpower and resources to run. For corporates to agree to significant spending just to monitor their credit risk probably doesn’t come high up on their list of priorities,” he says.

Most pundits believe that for credit risk management to increase in importance for corporates, they will have to acquire a greater understanding of credit derivatives themselves. But, while the instrument is at a relatively early stage of the product life cycle – where product development and user education is still paramount – Russell Schofield-Bezer, head of the corporate financial engineering group, Europe, Middle East and Asia (EMEA) at JP Morgan, argues that understanding among corporates is already growing. “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 about the credit derivatives market,” he says.

“It raises questions that are new to many chief finance officers and treasurers, such as what effect the credit default swap market has on their ability to raise funds, who is holding and trading their credit and so on. Equally, a great many banks are going out and educating their customers.”

New dynamic

This educational drive incorporates the new dynamic of the credit markets. “In the past, the bond market could really only express positive views: if someone liked a credit, they bought the bond whereas selling a bond could mean either a change of view or simply a desire to take profit. If you started out with a negative view, but didn’t own the bond, you couldn’t express it,” Mr Schofield-Bezer says.

Now default swaps enable users to express a negative view and buy credit protection, he says. The effect is that credit pricing reflects both positive and negative views – it is more transparent and efficient. Corporates are becoming aware of this and can use it when looking at the most opportune time to raise debt capital, says Mr Schofield-Bezer.

Russell Schofield-Bezer: corporates’ understanding of the credit derivatives market is increasing

If the market is expressing a negative view and credit spreads are wide, corporates now have two options if they believe that to be incorrect. They can either explain to the traditional analyst community why they disagree, hopefully persuade the market to change its views and then, as spreads come in, they can raise capital efficiently. Alternatively, they can take a proactive position before this situation arises, using a default swap to protect themselves against movements in credit spreads. “In that case, the debate starts to go into the liability management sphere, which is where treasurers are more comfortable,” he says.

Comfort zone

There are indications that corporates are becoming increasingly comfortable with the concept of credit derivatives. “We are now seeing investment banks that are strong in credit derivatives making more from corporate clients,” says Scott McDonald, a director at consulting firm Mercer Oliver Wyman, adding a caveat that although corporates are doing more business, “it’s still not a huge amount”.

Falling revenues in other sectors, he says, have facilitated most banks’ enthusiasm for corporate use of credit derivatives. As corporate clients do less transactions, there is less advisory work and so on, so banks are trying to expand their integrated offering. Clearly, says Mr McDonald, they can still talk about loans and bonds and the associated derivatives but the discussions they now have focus far more on hedging than they did in the past.

Credit exposure

“The potential difficulty is that in many cases, corporates’ credit exposures are not that big,” he says. “Consequently, I don’t expect corporate use to become a major portion of the credit derivatives business any time in the near term. It will continue to be done by banks and insurance companies because they have a far greater credit risk to manage than corporates.”

Corporate use of credit derivatives does not, however, have to focus purely on credit risk. Rajeev Misra, global head of integrated credit trading at Deutsche Bank, suggests that there are many ways for corporates to benefit from credit derivatives and they can be broadly put into four categories: credit risk management, fund raising, short-term investments and balance sheet management.

Rajeev Misra: there are many ways in which corporates can benefit from credit derivatives

For fundraising purposes, Mr Misra says firms can go to a credit derivatives desk and borrow money directly, which is ideal for mid-sized and small corporates that cannot access capital markets. “[These companies] can borrow directly from the desk and we can hedge it using credit derivatives, because in the credit derivatives market there are many more names trading than in the corporate bond market. They don’t even have to be rated because we can hedge unrated corporates. We can also arrange secured funding, where the corporate has assets, such as property, securities and equipment, that we can utilise to reduce funding and hedging costs,” he says.

Credit-linked notes

In terms of short-term investments, cash-rich corporates can look at short-term investments using credit-linked notes. “A lot of corporates have their excess cash on deposit with banks at Libor or less; instead, they could buy a credit-linked note on the bank, which would yield more. Also, they could consider buying a credit-linked note on their own name, which is one way of using their cash assets to retire some of their own debt,” Mr Misra says.

“Additionally, corporates can manage their balance sheets by, for example, taking some debt off balance sheet by doing a leaseback transaction, whereby it sells a property to a special purpose vehicle and leases it back. If they do a long-term lease, the amount the sale raises doesn’t show up as a loan. The bank can facilitate such a transaction because it is able to hedge the lease as it’s basically a senior secured credit risk,” he says.

Having a broader approach to credit risk management for corporates has had its rewards for banks. Mr Misra says the use of credit derivatives by corporates has grown substantially in all four categories in the past six to nine months and that this type of business has been Deutsche Bank’s biggest growth area this year in both Europe and the US.

However, achieving this success was not easy, he says. “It’s not as simple as, for example, dealing on behalf of or with an insurance company that wants to buy a credit-linked note. It is necessary to work with corporates’ accountants, auditors, regulators and so on. It’s quite a lot of work and you need the right structuring desk and staff to go after this business.”