The credit skew market’s surprise package

Mediobanca’s €1.6 billion in issuance makes small Italian investment bank a market titan

Some dealers could issue a stack of complex, credit arbitrage-based debt without anyone batting an eyelid – BNP Paribas, Citigroup and Credit Suisse, for example, are all big players in what are known as skew notes.

But Mediobanca? The 5,000-employee investment bank is said to be among the market’s top five skew note players, issuing at least €1.62 billion ($1.83 billion) since 2016 – equivalent to nearly a tenth of the Italian firm’s bond funding.

The bank is tight-lipped about the business, and other dealers are reluctant to talk about a firm that has become a big credit default swap (CDS) client. Skew notes are a leveraged bet on credit derivative anomalies, so behind the issuance figures are mountains of CDS notionals.

The sheer size of the Mediobanca programme makes it noteworthy, but there are other sources of intrigue. The bank issues the notes from its balance sheet, for example – a practice that other dealers are said to have recently abandoned on the advice of their auditors. It also fully guarantees the notes’ coupon payments and principal at maturity, which might make its notes more attractive than those of its rivals. Credit structuring specialists at two other banks say they are not able to guarantee their own skew notes, again blaming their auditors.

It’s not clear whether the difference arises from Italian interpretation of international accounting standards – as another skew issuer speculates – or from some kind of secret structuring sauce.

A spokesperson for Mediobanca declined to comment on how the bank accounts for its skew notes, saying only that it has all the necessary approvals: “Mediobanca undertook a comprehensive review of all its issuance programmes. This review included several legal and accounting opinions, issued by top-tier firms, and has been validated by risk, accounting, compliance, legal, internal and external auditors.”

Another source of potential drama is the gap risks issuers face when issuing the notes. First, a move in the underlying CDSs could leave the issuer with a bigger loss than investor principal would absorb, although this would only be an issue if the investor sought to redeem the notes before they matured. A further issue is the fact the notes are such a large proportion of Mediobanca’s bond funding. In both cases, though, experts say the bank appears not to be taking undue exposure.

Dynamics of a skew note

Skew notes are packages of CDS index arbitrage trades, which exploit mispricing between CDS indexes and their underlying constituents. In theory, an index should perfectly match changes in the value of its constituent names; in practice, heavier use of the index means it can temporarily become cheap or expensive relative to the underlying single-name CDSs.

So-called positive skew emerges when an index is overpriced while its single names are underpriced. Arbitrageurs will then sell the index and buy the single names. When the skew is negative, they do the opposite. When the skew, or basis, disappears under the weight of arbitrage money, the arbitrageurs can unwind their positions at zero cost and walk away with the skew premium.

These trades were a staple of the credit hedge fund world until the arrival of mandatory clearing for CDS indexes attached additional costs to one leg of the deal. Notes allow investors to tap the same arbitrage in a more convenient format, albeit in a slightly different way.

Instead of unwinding and taking profit when the basis returns to normal, the positions are held to maturity. The profits instead come from selling protection at a high level and buying it back at a low level. In other words, the issuer receives higher premiums from the sold protection positions than it pays to buy protection on the same underlyings.

It earns the difference between the two at each regular payment through the life of the note. These profits are used to finance the coupon on the note, which can either be fixed or linked to a floating rate like Euribor.

As long as investors hold the skew note to maturity, they will receive their coupons and won’t be exposed to movements in the skew. And the rewards aren’t insignificant.

For example, for the Markit CDX North America HY S29 5Y index, the skew averaged around –8 basis points in 2018 (figure 1). The negative basis coupled with leverage of up to 40 times means the coupon on a five-year skew note could be up to 100bp above the issuing bank’s funding rate, depending on the referenced credit index and the amount of leverage.

Between March 2016 and October 2018, Mediobanca issued 17 skew notes with a total notional size of €1.62 billion, according to information the bank published on the Luxembourg Stock Exchange.

“All these Mediobanca issuances are private placements, offered only to professional qualified investors, and the majority were [traded with] primary broker-dealers. These issuances are tailored to the requirements of the specific investor,” the bank spokesperson says.

The Italian bank’s interim six-month report, ending December 31, 2018, includes in-depth disclosures on its use of credit derivatives. The bank’s trading book had purchased €22.1 billion notional of CDS protection and sold €30.4 billion notional, and was €1.4 billion out-of-the-money on the positions at time of reporting.

But dealer sources caution against reading too much into the numbers, and note the bank is an active user of CDSs away from its skew note programme. The bank’s spokesperson also says the numbers include credit derivative trades related to certificates.

Mediobanca isn’t afraid to issue in large size. In March 2018 it issued €500 million of senior preferred notes, referencing a range of Markit CDX and iTraxx indexes worth billions in notional.  

Guaranteed ratings

One of the marketing documents for the issue, called the base prospectus, states that the principal and coupons are “unconditionally and irrevocably guaranteed” by Mediobanca, provided investors hold the notes to maturity. If investors unwind early and the mark-to-market of the CDS hedges is negative at that point, it will eat into the principal.

This guarantee appeals to buy-and-hold investors, such as private banks, pension funds and insurers, which are looking for exposure to bank funding risk but with principal protection.

Admittedly, the chances of the principal of a non-guaranteed note taking a hit is very low if the product is held to maturity. But there may be another advantage for investors.

The guarantee is also the primary consideration behind how the notes are rated, say those who have provided a ratings assessment on some of the securities, meaning the structured notes can achieve the same rating as the parent. This might make the products more attractive to investors who have restrictions on the ratings of the products they can invest in.

“I rate based on the guarantee from the parent so that’s what I look at, and my assessment that the parent would honour if the subsidiary doesn’t, for example. So it’s really based on our assessment that the parent would step in based on the guarantee,” says Francesca Vasciminno, a senior director at Fitch Ratings in Milan.

Fitch has rated the long-term senior debt of both Mediobanca Spa group and the Luxembourg entity at BBB.

Some accountants say a guarantee on a skew note also allows investors to record the notes at book value in their accounts, avoiding the large mark-to-market swings brought on by the volatility of the underlying derivatives. Others dispute this or are uncertain.  

Similarly, Mediobanca itself may be able to account for the guaranteed skew notes on an accrual basis rather than marking them to market, concealing the occasional volatility of the instruments (see box: Accounting ambiguity).

Some market participants say they haven’t been able to fully guarantee credit skew notes because it would not be approved by their auditors. This is hazy territory. Risk.net spoke with two financial instrument accounting specialists, who offered opposite views on the correct treatment.

For issuance [made] within one year, to do 10% of that flow in structured notes wouldn’t be surprising. But for it to be 10% of your entire outstanding debt, it’s probably a little bit on the high side

Richard Barnes, Standard & Poor’s

A credit trader at a European bank agrees there is little consensus on the matter: “If a note is principal protected, the valuation is not expected to differ – from an accounting standpoint – from a vanilla note. But these notes typically involve a high level of leverage and the valuations [of the underlying derivatives positions] could be volatile. So the market value could be quite different from a vanilla package.”

Mediobanca may be doing brisk business issuing guaranteed skew notes, but the proportion of funding the bank receives from skew notes has raised eyebrows. The notes make up 8.4% of the bank’s total debt pile.   

“For issuance [made] within one year, to do 10% of that flow in structured notes wouldn’t be surprising. But for it to be 10% of your entire outstanding debt, it’s probably a little bit on the high side,” says Richard Barnes, a senior director at rating agency Standard & Poor’s.

This isn’t necessarily a problem if the products are prudently structured and managed. For dealers with large books of skew notes, one ever-present concern is gap risk. This risk arises if the issuer unwinds a loss-making product early if the leveraged skew position at that point is so underwater that it wipes out more than the note’s proceeds, and the dealer is left with a loss. Gap risk is higher the more leverage is applied.

However, some market participants note that Mediobanca’s products are moderately leveraged at 20 times, which makes losses unlikely.

According to analysis by one dealer, for a 25 times-levered skew note on the North American CDX investment grade index, a basis of 80bp would be needed to destroy the mark-to-market value of the note and exhaust the investors’ principal. But the highest the skew reached in the last 10 years is around 20bp, the analysis showed.

Even during the 2008 financial crisis, skew topped out at around 40–50bp, which meant only half the capital would have been exhausted for a skew note with the same leverage of 25 times.

Others point out that overindulging in skew notes is not a problem as long as the bank can manage its issuance.

“It depends on the risk management strategy or the risk-pricing capacity of the bank. If they have the capacity, they can have 10–20% [of skew note funding],” says Robert Fiedler, founder and adviser at consultancy Liquidity Risk Corporation.

For instance, a treasurer would need to clearly explain to investors the notes were strictly hold-to-maturity investments and that an early exit by the investor could lead to losses. Once they understand that, one market participant says, it’s an ideal funding scenario, as the bonds are with an investor who is not going to sell them.

Accounting ambiguity

European banks have argued in the past that in order to issue skew notes at all, it is essential a bank gets accrual treatment for them under International Financial Reporting Standard 9. If the bank fails, it runs the risk of big swings in profit and loss if the skew moves the wrong way temporarily.

It is far from clear that skew notes must be marked-to-market under IFRS 9, however. Some accounting experts believe that if the cashflows are not impacted by the derivatives embedded in the note and the instruments are held to maturity, marking-to-market is not required. Others argue that since the notes have embedded derivatives that could modify the cashflows of the notes, they have to be marked-to-market.

Some accounting sources suggest Mediobanca’s full guarantee on both the coupon and principal payments of the skew notes allows them to use accrual accounting, as the cashflows are considered certain. But this can differ depending on the auditor and the jurisdiction. Accounting standards are broadly split between the US generally accepted accounting principles and IFRS, which are used in the rest of the world. But IFRS has national versions, meaning treatment can vary.

One Germany-based auditor, for instance, says you can also argue that any products with structured underlyings should automatically be marked-to-market.

“If you [as the issuer] want to classify something as amortised cost, then you have to have the appropriate business model – this being the entity’s [the buyer’s] clear and documented intent to hold the investment [to maturity] to collect the contractual cashflows – and the appropriate financial instrument [the note] which has a non-structured cashflow, that is no leveraging, no indexation to non-interest variables or other features discussed in the relevant accounting standard IFRS 9. So you have to meet both criteria to get the amortised cost treatment,” he says.

“As soon as you have a structured note or structured feature in there, that changes the cashflows – in that case you immediately have fair value accounting, irrespective of what the business model is.”

Editing by Lukas Becker and Olesya Dmitracova