Growing use of credit index tranches by private banks is driving demand for additional features that bump up the spread on first-loss protection structures by eliminating credit default swap recovery payouts in the event of a default.
Private banks, particularly in the Nordic region, have jumped into senior tranches on key CDS benchmarks such as iTraxx Main and Crossover that offer protection against the first 20% of losses. According to some dealers, private bank clients are now using zero-recovery features as standard practice, both to boost the spread and remove complexity for their own high net worth clients.
“In a default situation the recovery on CDS is defined by a protocol that is well understood by experts, but it is a process that is difficult to understand for many end users,” said Antoine Broquereau, global head of financial engineering at Societe Generale. “Ultimately we’re paying the investor to agree on a zero recovery, which means they can achieve a yield pick-up and it simplifies the product for end users.”
Zero-recovery structures were a common feature of synthetic collateralised debt obligations but fell out of favour after the structured credit market imploded during the global financial crisis.
Tailor-made
The zero-recovery feature started to stage a return around 12 months ago as part of a wider trend towards more tailored products.
“It’s clear that investors are actively looking at different formats for trading credit and tranches can be an efficient way to express very different views,” said Saul Doctor, EMEA head of credit strategy at JP Morgan. “The zero-recovery feature presents an interesting way to avoid taking the first loss, while increasing returns from the second loss.”
He said that there is a range of alternative features that are back on the credit tranche agenda as leveraged credit plays gain traction once again.
Changes to attachment and detachment points provide more bespoke exposure to parts of the capital structure. Tranchelets, which provide more granular leveraged credit exposure by further slicing traditional tranches, made a surprise comeback last year, having been relegated to obscurity in the wake of the crisis.
Investors are also showing renewed interest in trading alternative formats, such as principal-only notes whose final payout is reduced for each default.
SG’s Broquereau believes that increased use of the zero-recovery feature highlights greater conviction that levels of default may remain at lower levels than some had previously feared.
According to Moody’s, the corporate credit cycle has turned and the global speculative-grade default rate is set to reach 4.3% in July, surpassing its long-term average for the first time since 2010.
The ratings agency forecasts a speculative-grade default rate of 4.7% over the next 12 months from a current level of 3.7%, largely due to weakness in the commodity and oil & gas sectors, which have accounted for half of the 18 defaults since the start of the year.
Growing interest in structured credit transactions also reflects ongoing equity market malaise, with investors left struggling to determine the direction of global stock markets.
After shedding over 10% in the first six weeks of this year, the S&P 500 is currently trading flat compared with end-December levels, while the EuroStoxx 50 is down 6% in the year to date, having lost as much as 17% at one point.
“Investors are looking more closely at credit markets, which is a sign that they know what they want to do and that is a big change from last year.” said Broquereau. “It is also very much linked to equity as these sorts of trades are the first choice for high net worth clients when it becomes difficult to see direction in the equity market.”
Limitations
Dealers remain confident that leveraged credit activity through tranche structures will not reach the magnitude of the pre-2008 structured credit heyday. Basel III capital rules make the structures difficult to manage for all but the most diversified credit desks.
“It’s punitive for banks to originate these products if they can’t complete the capital structure. Just being exposed to one tranche carries very onerous capital charges,” said JP Morgan’s Doctor.
“People are always trying to innovate and look for alternative investors to take all parts of the capital structure, but the challenge is to line everyone up at the same time.”
