Credit derivatives house of the year: Credit Suisse

Asia Risk Awards 2020

Chris Howe, Credit Suisse

With traditional providers of corporate financing in retreat across Asia, Credit Suisse spotted an opportunity – to use its platform to provide companies access to alternative funding that is then prepackaged through a range of capital market instruments for distribution to institutional and private bank clients. It proved to be a very successful and profitable business in the past year.

The bank has closed a number of transactions this way in 2020. The idea, they say, is simple: to bridge the gap between private credit supply and traditional capital market investor demand.

“Typically, banks will do a syndicated loan and sell it to other commercial banks, or if it is a high yielding loan they may sell it to private credit funds – but in all instances, the loan would be sold outright,” says Terence Chia, head of APAC debt market syndicate at Credit Suisse. “Here, our solution is more creative, and opens up a whole new pool of liquidity.”

A loan transaction with a corporate borrower shows just how creative. Credit Suisse underwrote the loan as principal to the client. The bank then packaged and sold on the risk across numerous sales divisions within the bank to its network of institutional and private banking clients.

This collaboration between the investment and markets division allows the bank to underwrite private loans in large sizes, while at the same time providing private credit exposure with an attractive risk premium for investors unable to invest in private loans outright.

The instruments used to sell down the risk vary according to the appetite of the end investors. It might, for example, be sold through the form of a simple credit-linked note, issued through the bank’s special-purpose vehicle platform. For investor clients that want more gearing and a higher rate of return, meanwhile, a total return swap or credit default swap might be used. 

Whatever the instrument, Chia says, the private credit exposure provides a risk-adjusted rate of return that compares very favourably against what is available on the public debt markets – especially in the current market environment where spreads and yields are compressing.

There are various layers of protection for investors in private loan deals that are not present in either public or private bond deals, he points out.

Investors are protected first by the loan covenants and early-termination triggers to cover events such as credit rating downgrades. Since Credit Suisse keeps a portion of the corporate loan on its own books, covenants are actively monitored by the bank throughout the transaction lifecycle.

“When undertaking any such transaction, we closely monitor [the performance of the borrower],” says Chia.

Private bank investors also benefit from due diligence conducted by Credit Suisse on the borrower, as well as by a group of sophisticated investors that anchor the deal alongside Credit Suisse. The bank says it uses a sophisticated model to price the loan-to-value (LTV) and funding spread for each transaction based on counterparty quality, asset quality and early-termination trigger levels.

These protections for end-investors were naturally put to the test as the spread of the Covid-19 pandemic at the start of the year wrought havoc on financial markets, crushed corporate finances and sparked a spike in defaults by borrowers across the globe.

During this very difficult period, the bank’s credit solutions business saw no losses nor any forced liquidation of underlying collateral. This ensured the impact of deteriorating credit conditions was limited, and helped avoid a negative cycle of price movements caused by the fire sale of assets.   

Even if the worst-case scenario plays out and a transaction looks to be at risk of breaching an early-termination trigger, daily monitoring of the transaction parameters allow the bank to act swiftly. A restructuring plan can then be negotiated with the client ahead of the termination event.

“This helps us avoid a liquidity squeeze in a very bad environment,” says Jacqui Zhang, head of APAC credit solutions structuring in Hong Kong. “What we want to avoid most is for a client to have to search for liquidity when there’s no liquidity available in the market.”

With falling returns in the more mainstream credit markets happening at a time of a widespread deterioration in credit quality among corporates, demand for investments with such comprehensive controls and credit mitigation measures has, understandably, been strong.

The financing solutions the bank can offer investors on the loans is also a big pull factor. Credit Suisse’s sales and trading desks offer financing on the loan assets – either with or without recourse – to both its institutional and private bank investors.

Similar deals the bank has done over the past year have been oversubscribed, with the private bank making up a large chunk of the demand.

“We’ve done numerous such transactions very successfully,” says Min Park, head of solutions sales for markets at Credit Suisse in Hong Kong. “These have been very good alpha trades.”

Such has been the success of this business for Credit Suisse that other investment banks have inevitably looked to replicate this model for originating and distributing private loans in recent months.

Credit Suisse’s unique ‘One Bank’ model, in which collaboration across investment banking, private banking, global markets and financing divisions to innovate, originate and distribute, means that few – if any – of the bank’s competitors are currently able match the bank for scale in these types of transactions, says Zhang.

“That is because to do trades like these you need to have all the stakeholders in the organisation working as one,” says Chia. “Some of the transactions we’ve done have been quite significant in size.”

A senior manager at a hedge fund client of the bank agrees that it is the One Bank philosophy that gives Credit Suisse the edge when it comes to credit solutions such as this. It is, the manager says, a key reason the bank’s structured credit financing business is one of the best in the market.

Other banks, he confirms, have started offering similar services but they lack the coordination to deliver financing on loan assets as efficiently as Credit Suisse.

“By far Credit Suisse is the most efficient,” he says. “All the way from their bankers on down to their structuring, their financing team, to the risk people – they are all very coordinated in providing a one-stop solution. It is always a very coherent conversation.”

One Bank, one winner

The benefits of multiple banking units and businesses working together as one can be seen across several other credit solutions the bank has structured in the past year. 

A convertible bond financing hedge solution, for instance, involved collaboration across the bank’s Asia-Pacific prime brokerage and credit solutions businesses and its US securities lending desk. The launch of CDS Index Skew notes is another example, with the solution involving collaboration and teamwork across the bank’s structured flow and non-flow businesses.

The convertible bond hedge financing was executed on behalf of private bank clients that were looking for financing on a convertible bond and had hedged the long equity position of the bond. To create the equity short position, the client needed to be able to borrow stock in size. To maintain it, the client had to pay a certain amount of margin on the transaction.

Ordinarily, given the illiquidity of the security, Credit Suisse would have had to have been conservative with the LTVs it charged on the transaction. However, the equity short position the client needed for its hedge offered a way to lower the cost. The solution was to bring together the various components sitting in different bank units.

First Credit Suisse’s branch in New York sourced the stock at the size required by the client. Using this borrowed stock, the client then created a short position in their prime account in Credit Suisse Prime, which then traded with the structured credit team.

Since the price volatility of the convertible bonds was effectively hedged by that equity short, Credit Suisse could provide an optimised loan-to-value on a total return swap (TRS) for the financing. With the bank looking at the both the TRS and short stock positions holistically, the investor was able to benefit from the delta hedge against the equity short position, offsetting the TRS exposure.

If the bank were to simply offer financing on the convertible bond, the transaction could be subject to up to a 50% haircut with another 10% haircut applied by prime service for the equity short.

“The overall risk of such a transaction is very low,” says Soumitra Bhattacharya, head of APAC structured credit trading at Credit Suisse in Hong Kong. “But the question is, can you give the client the right financing solution that actually makes sense for a hedged position?”

But the right financial infrastructure also needed to be in place. In order for the offsetting to work, the TRS and the short stock exposures had to be legally nettable.

“The client can hedge out close to 100% of the risk, but the question is, can you give them the financing that actually make sense from a hedge position?” says Bhattacharya.

That was made possible by the master agreement that clients agree to when joining the prime services platform. The master agreement already encompasses other obligations of the client to the bank, so that in either a repo transaction under a Global Master Repurchase Agreement or a TRS under an Isda Master Agreement separate positions can be documented as legally nettable.

“We were able to do [this transaction] because – even taking into account that the long and the short sides are sitting in two different businesses, Credit Suisse can – at a ‘One Bank’ level – look at it as a hedged position,” says Bhattacharya.