Credit Derivatives Handbook

Transcription

1 February 2000 Credit Derivatives Handbook Tools for the Efficient Management of Credit Risk Highlights This Handbook provides participants in the credit markets with a general introduction to the instruments of the rapidly expanding credit derivatives market. Credit derivative instruments are standard financial contracts that are now mastered by standardized International Swap Dealers Association (ISDA) documentation. Credit derivative applications are far reaching. Most importantly, many types of credit derivative applications are not available in traditional corporate bond or loan markets. The brisk growth of the market has been a result of several factors, but namely the fact that credit derivatives: (1) can offer superior economics to cash market credit instruments; and (2) allow for the efficient hedging of credit risk. Merrill Lynch & Co. Global Securities Research & Economics Group Fixed Income Strategy

2 Executive Summary The credit derivatives market has expanded more than tenfold since its inception in 1993 (See Chart 1). Several factors have contributed to the market s growth: Increased investor interest in obtaining access to new or less liquid markets; The growing sophistication of the credit markets and the resulting search for more favorable relative value transactions versus cash market trades; and The desire of corporations and investors to economically hedge longer-term credit exposure. The market has also benefited from reviews and guidelines provided by the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Bank of England (BOE) and the National Association of Insurance Commissioners (NAIC). Moreover, last year the International Swap Dealers Association (ISDA) introduced standardized documentation for Credit Derivative contracts. This Handbook provides investors, issuers, risk managers and other potential participants with an introduction to credit derivatives. Chart 1: The Growth of the Credit Derivatives Market Billions of Dollars $250 $200 $150 $100 $50 $0 Estimate for end of 2000 is $1 Trillion Q1/97 Q3/97 Q1/98 Q3/98 Q1/99 Q3/99 Source: OCC (Credit derivative volume of commercial banks) and Risk Magazine. ❶ The Evolution of the Credit Derivatives Market Credit derivatives are the natural extension of the credit market. They complete the credit market, just as their more mature interest rate and equity derivative counterparts completed their underlying markets many years ago. The underlying credits of credit derivative instruments are well represented in the cash market. In Table 1, we provide a sampling of some of the most actively traded names in the default swap market. Often, the activity in a particular credit on the derivative front is linked to an expected change in credit fundamentals, and accordingly cash market spread volatility. Credits in which there are sizable cash market or counterparty exposures are also actively traded. Table 1: Current High Volume Credits Credit/Obligor Rating Credit/Obligor Rating Ford Motor Credit A1/A JC Penney A3/BBB+ GMAC A2/A Sears Roebuck A3/A- Philip Morris A2/A Enron Baa2/BBB+ Merrill Lynch Aa3/AA- AOL Ba3/BB- Societe Generale Aa3/AA- Greece, Rep. of A2/A- Source: Merrill Lynch Despite the market s youth, it has already been tested by severe stresses; it successfully weathered both the emerging market and hedge fund crises of Volume declined in the period following these events (See Chart 1), but has since resumed a steady growth trajectory. The effect was in two respects healthy for the market as it : 1) heightened attention to documentation issues and problems; and 2) encouraged the eventual standardization of documentation that was implemented in the summer of As the market has grown, liquidity an important consideration for potential market participants has improved. While liquidity varies by instrument and credit, the most established products offer good liquidity. Document standardization has also led to an increase in market liquidity. The ability for market makers to deal through brokers with an underlying template has led to tighter bid/ask spreads in the market and improved execution for end buyers and sellers of credit protection. ❶ Who uses Credit Derivatives? Merrill Lynch turns over roughly $250 million in worldwide corporate default swaps per week, and will make a two-way market in a majority of investment grade credits. Credit derivatives on high yield credits are also becoming more popular as convertible bond investors hedge embedded credit risk to isolate equity risk. To date, the primary users of credit derivatives have been commercial banks, using default swaps to take their loans off-balance sheet. Recently, the investor base has broadened to include: money managers, mutual funds, and insurance companies. The primary area of growth has been the new sellers of credit protection such as reinsurance companies, life insurance companies and CP conduits who have come on-line for default swaps in the past six months. 2

3 CONTENTS ❶ Section Page Executive Summary The Evolving Credit Derivatives market 2 The Motivation for Credit Derivatives 4 Credit Derivative Instruments Overview to Credit Derivative Instruments Default Swaps Portfolio Default Swaps Credit Spread Options Total Return Swaps Index Swaps Structured Assets Collateralized Debt Obligations 6 Role of SPVs 21 Valuation Models 22 Regulatory Considerations 23 Tax Considerations 26 Appendix 29 3

4 Credit derivatives introduce new applications into the management of credit exposures 1. The Motivation for Credit Derivatives Credit derivatives offer a wide range of capital market applications. Participants include banks, insurance companies, total return investors, mutual funds and hedge funds. Additionally, corporations have recently begun to use credit derivatives to hedge capital market activities and business risks. Market participants are motivated to use credit derivatives for 1) relative value; 2) market access; 3) hedging and risk management; and 4) management of indirect or noneconomic costs. ❶ 1) Relative Value This is the most common application for cash-style corporate bond investors. For example, a fund manager can achieve yield enhancement through structuring synthetic corporate bonds with credit default swaps. Specifically, credit default swaps can be combined with high quality asset-backed securities to create a cheap corporate bond with negligible additional risks. ❶ 2) Create Access to both Markets and Leverage Credit derivatives provide market assess in the form of new products and leverage that would otherwise be inaccessible. Example applications include: Synthetic lending. A bank with unused and available credit lines can enter into a variety of credit derivatives to profitably use these lines, including putable, callable or step-up asset swaps and default options. Maturity shortening. Money market funds require assets with tenors of 13 months or less. A fund can buy asset backed securities of an issuer that only has longer tenor bonds through Merrill Lynch s Asset Backed Trust (ABT) program. ABTs provide attractively priced assets like credit card securities, while maintaining the guidelines of Rule 2a-7 money market funds. Duration extension. Insurance companies can manage the interest rate risk of long-dated liabilities by purchasing high duration assets not offered in the cash market. Specifically, through a Public STEERS special purpose vehicle, Merrill Lynch can offer investment grade deferred coupon certificates, which have a duration two to three times that of 100-year bonds. Tranche credit risk by seniority. Total return investors can increase expected returns by purchasing equity tranches of CBOs or CLOs. CBOs and CLOs tranche the credit risk in a portfolio of bonds or loans, offering investors the opportunity to own the excess return on a portfolio, while reducing up front investment and limiting exposure. Provide efficient leverage. A hedge fund or insurance company may gain exposure to senior secured corporate bank loans through the purchase of the equity tranche of a CLO, through a total return swap (receive) on the underlying loans or by writing options on corporate spreads or default. 4 ❶ 3) Hedging and Risk Management One of the most important contributions of credit derivatives is that they have made it possible to effectively hedge credit risk. Consider the following applications: Cash market credit portfolio. A high yield fund can hedge the fund s exposure to a macro market credit spread widening by entering into an index swap where the fund pays the total return on the Merrill High Yield Master Index and receives the Merrill Government Master Index. The swap allows the manager to get short high yield credit spreads without altering the duration of his portfolio. Hedging counterparty exposures. The growth of interest rate derivatives has lead financial institutions and corporations to manage their exposure to derivative

5 counterparties. A firm can enter into a contingent default swap under which the default swap is only in effect during those scenarios when the exposure is significant, thereby gaining credit protection for adverse scenarios at a lower cost than normal default protection. Business risks. Manufacturers that sell to retailers have concentrated credit exposure to a single industry. Many utilize factors, credit intermediaries that provide a guarantee of payment on each shipment. Because of limited capital and lack of business diversification in the factoring industry, pricing of receivables credit insurance, when available, is often significantly higher than capital markets credit pricing. As an alternative, manufacturers can purchase first loss credit protection against an entire portfolio of receivables in the form of default options linked to more liquid corporate bonds. ❶ Managing Indirect or Noneconomic Costs Credit derivatives help corporations manage indirect costs related to their business activities. Reduce interest expense. Issuers can synthetically tender for their bonds. The synthetic tender provides the economics of a long position in a company s own bonds without the potentially negative tax and book consequences that can accompany a cash market repurchase. Additionally, the synthetic tender provides cheap leverage while maintaining liquidity. Regulatory Arbitrage. Currently, the capital charges imposed on banks for the types of credit risks held on their books is not commensurate with the specific credit risk. For example, all unsecured corporate credit obligations are 100% risk weighted by the BIS. Banks can reduce the capital charge by hedging a high-rated, low margin exposure using a default swap with regulated broker dealer counterparty. Tax management. An insurance company with a large capital gain in a corporate bond position can hedge the gain by using (paying) a total return swap on the bond and receiving a floating rate cash flow. This hedge is effectively equivalent to a sale of an asset with a gain, but a tax event is averted since the bond is not sold. 5

6 Credit derivative instruments are simply financial contracts that facilitate credit risk transfer 2. Credit Derivative Instruments Credit derivatives are bilateral financial contracts that transfer credit risk from one counterparty to another. This section offers a brief introduction to each of the main credit derivative products. Credit derivatives take on the form of swaps or options and can be embedded in bonds, notes or securities issued by special purpose vehicles (trusts or companies). Merrill Lynch s credit derivatives desk is a market maker in the following products: Swaps or options with cash flows linked to the default or change in credit spread of an identified asset or basket of assets; Total return swaps on bonds, loans, indices or other assets with credit risk; and Special purpose vehicle securities (SPVs) that embed credit risk or tranche credit risk by tenor or seniority. In Table 2, we show the primary risks that are transferred by a given credit derivative product. Table 2: Credit Derivative Products and Risks Transferred Primary Risks Transferred Credit risk Credit and spread risks Credit, spread and correlation risks Credit, spread and interest rate risks Source: Merrill Lynch Products Default Swaps Credit Spread Options Putable, Callable and Remarketed Asset Swaps Portfolio Default Swaps Synthetic CDOs Total Return Swaps Index Swaps Synthetic Zero Coupon Bonds Synthetic Callable Bonds CBOs and CLOs Within the credit derivative spectrum, each product is in a different stage in the product life cycle (See Chart 2). An instrument s position in the product life cycle illustrates its relative standardization, liquidity and growth potential. Those products at the introduction and growth stages typically have higher investor profit potential yet are less liquid than products in the maturity stage. Chart 2: The Credit Derivatives Product Life Cycle Default Swaps Credit Linked Notes Total Return Swaps Index Credit Spread Swaps Swaps Portfolio Default Swaps CBOs & CLOs Asset Swaps Interest Rate/ Currency Swaps Introduction Growth Maturity Decline Source: Merrill Lynch 6

7 Credit default swaps transfer credit risk between two counterparties Credit Default Swaps Credit default swaps (default swaps) transfer the credit risk of an issuer from one party to another. The party buying protection pays a premium to the party providing protection; in exchange, the party providing protection agrees to pay an amount to the other party upon the occurrence of a credit event with respect to the issuer. In Figure 1, a counterparty is selling protection to Merrill Lynch. Figure 1: A Credit Default Swap Fee Counterparty Payment on occurrence of a credit event The reference debt obligation can take several forms Default swaps can be either cash or physically settled Default swap contracts have the following important terms: Reference Debt Obligation. The default swap contract will define the Reference Debt Obligation. This can be a bond, loan, swap contract, or any debt obligation of the Reference Credit. This section should provide for successors to the Reference Credit as well as a process to choose replacement debt obligations if the Reference Debt Obligation is called, prepaid, or otherwise ceases to exist any time during the life of the contract. Credit Event or the Event of Default. There are at least three choices for definition of the Credit Event: (a) market convention, which is a four-part definition including forced acceleration, payment default, major debt reorganization or a bankruptcy; (b) an Event of Default under the Reference Debt Obligation; or (c ) ISDA s draft standard which is similar to (b) but more extensive. The primary concern of both parties should be to choose a definition that excludes minor or technical defaults. The party providing protection would not want a false trigger to cause them to make a payment; likewise, the party buying protection would not want to forfeit that protection on the occurrence of a nonsubstantive default. Materiality. Some transactions require that for a Credit Event to have occurred, a minimum price deterioration (known as a materiality threshold) in the underlying asset should have occurred. This threshold assures the protection buyer that he will not loose the credit protection if the market deems the credit event to be immaterial. Payout. Following a credit event with respect to the underlying reference credit, the party providing protection will either agree to buy the underlying asset (if the transaction is physically settled) or will make a cash payment (cash settlement). Cash settlement is typically an amount equal to the par amount of the underling debt obligation less the then current market value of the defaulted obligation, as determined by market bids. Due to liquidity issues after default, physical settlement is the current market standard. An alternative payout structure is a digital payout, equal to a fixed amount of the notional, usually 100%. 7

8 The premium of a default swap is usually near the asset swap level of comparable cash asset Default swaps lie at the core of credit derivative products Price or premium. The party providing the credit protection receives a swap premium. This premium is agreed upon between the two parties and will generally be near spreads achievable in conventional markets for assuming floating rate exposures on the Reference Credit for the tenor of the default swap. Applications Default swaps are a basic building block of credit derivatives. One significant advantage to using default swaps in managing credit risk is the increased flexibility. Default swaps can be customized to meet specific tenor and payout requirements. Many parties use default swaps to reduce credit risk associated with illiquid or non-transferable assets, as shown in the examples below. ❶ Buyers of Protection Banks use default swaps to reduce regulatory capital. If a corporate bank loan is hedged through a default swap with another bank or other 20% riskweighted institution, the bank buying protection is able to reduce the amount of regulatory capital held from 8.0% to 1.6%. The Federal Reserve has provided guidelines as to what constitutes an effective hedge (see section entitled Regulatory Treatment of Credit Derivatives ). Corporations use default swaps to hedge business risks, such as supply contracts and receivables. If a Credit Event occurred the default swap would provide a payout which would offset the loss on the receivables or the mark to market value of the supply contracts. Commercial banks use default swaps to reduce their exposure to a particular credit without damaging long standing relationships. The default swap provides an offsetting hedge to any on-balance sheet loans, effectively nullifying the credit exposure without necessarily notifying the reference entity to whom the original loans were issued. ❶ Sellers of Protection Insurance companies currently assume credit risk through the purchase of corporate bonds financed with guaranteed investment contracts, the sale of bond insurance, and the issuance of guarantees such as surety policies. Selling default protection is analogous to the above and delivers higher returns and alternative sources of capital. Money managers seek short-dated credit exposure while borrowers tap the capital markets for long-dated financing. Selling default protection delivers the short-dated credit risk of the bank loan market, convertible bond market and vendor financing markets to these investors. [Corporate bond investors under-allocated on a primary bond offering write default swaps on the reference credit. The default swap allows the insurance company to realize the full desired exposure to the underlying company. The insurance company can allocate resources to tracking and managing the credit without worrying about its ability to get exposure to the credit.] Commercial banks sell credit protection to diversify their portfolio and finance the purchase of protection on concentrated exposure. 8

9 Product Variations Cash-only investors can access the default swap market with credit linked notes ❶ Credit Linked Notes Default swaps are off-balance sheet, leveraged instruments that offer unique advantages due to their derivative qualities. However, a distinct portion of the investor community is unable to take advantage of derivative products and must keep all instruments in funded, on-balance sheet vehicles. This segment of the investor community can access the default swap market with credit linked notes. Credit linked notes are created by combining credit default swaps with highly rated corporate and asset-backed bonds to create a separate investment vehicle. The credit linked note is exposed primarily to the reference credit with some incremental risk added by the underlying collateral. ❶ Cancelable Default Swaps Cancelable Default Swaps are default swaps with an embedded option for the protection buyer to terminate the default swap early. The cancelable default swap performs identically to a standard default swap if the option is never exercised. If the option is exercised, a final accrued payment is delivered and the swap is terminated. The early termination option is a benefit to the protection buyer as it gives the right to cancel future payments at zero cost. Early termination of standard default swaps is accompanied by a mark-to-market cost in addition to any accrued payments. The option is paid for through incremental premium over and beyond the standard default swap premium. Cancelable Default Swaps are excellent ways for companies to hedge the credit risk embedded in callable securities. Commercial banks purchase cancelable default protection to hedge bank loans which are generally callable at par. Callable bond investors can cancel their protection payments if the call feature on their underlying bond is exercised. ❶ Digital Default Swaps Digital default swaps involve the payment of a fixed dollar amount from the seller of protection to the buyer upon the occurrence of a credit event. Digital default swaps normally employ a smaller number of credit events in order to mitigate the potential for technical credit events. Digital default swaps are used to hedge exposures such as preferred stock, operating leases and counterparty exposures, which will not generate a substantial claim on a defaulted borrower. Digital default protection is also used to hedge debt instruments such as Paris Club trade debt, which is non-transferable. See Mary Rooney s research on Credit Default Swaps 9

10 Portfolio default swaps are linked to several credits Portfolio Default Swaps Portfolio default swaps segment the risk associated with a portfolio of credits among multiple investors. Portfolio default swaps are broken down into two main categories: 1) first loss swaps; and 2) first-to-default swaps. First loss default swaps measure realized losses in dollars while first-to-default swaps measure losses in discrete events. In Figure 2, a counterparty is selling a first-to-default swap outright to Merrill Lynch. Figure 2: Portfolio Default Swaps Fee Counterparty Payment on occurrence of a credit event Credit Portfolio Portfolio default swaps can be evaluated using CBO modeling techniques Portfolio default swaps can be traded outright or can be embedded in special purpose vehicles to create a funded asset. Default swaps based on portfolios use technology originated in the Collateralized Debt Obligation ( CDO ) markets. The first-to-default or first loss swaps can be compared to the equity portion of a CDO. The second-to-default and second loss tranches of portfolio default swaps are analogous to the senior tranche of securitizations such as CDOs. Buyers of portfolio default protection are motivated to retain a portion of the risk in existing portfolios and to reduce the absolute cost of hedging existing credit risk. Sellers of portfolio protection are attracted to the customized risk/return profile of the resulting exposure the non-recourse, convex, enhanced spread of first loss positions and the over-collateralized low-risk nature of second loss positions. Applications In addition to the benefits described above for single bond default swaps, portfolio defaults swaps offer investors relative value and a unique type of leverage. More over, investors cannot economically replicate portfolio default swaps in the cash markets. ❶ An Example The most common application of portfolio default swaps is the purchase of second loss protection on large loan portfolios by commercial banks. Although not necessarily explicitly rated AAA, these second loss tranches are structured to achieve premium investment grade ratings. Commercial bank buyers retain the first loss exposure to reduce the cost of the hedge that is purchased to reduce the regulatory equity supporting the portfolio. In the table below, we detail a number of these structures that have been recently transacted, referred to in the marketplace as synthetic CLOs. 10

11 11

12 Credit spread option payments are triggered by price events rather than credit events Credit Spread Options Credit spread option payments are triggered by price events rather than credit events A credit spread option is a financial contract that gives one party the right to buy or sell an underlying security at a variable price based on a predetermined spread (or strike) above a reference index (such as Treasuries or LIBOR). Credit spread options can be traded outright, or embedded in callable and putable asset swaps. Figure 3 below is a diagram of a counterparty selling a credit spread put option outright to Merrill Lynch. Figure 3: Credit Spread Options Fee Counterparty Counterparty has the obligation to buy underlying corporate bond if ML exercises its option at a specific spread (e.g. T+350 bps). A credit spread options have a higher frequency of exercise but lower severity of payoff than default swaps Credit spread options have a higher likelihood of exercise than default swaps on the same bonds. A spread option written with an out-of-the-money strike begins to resemble a default swap with respect to the likelihood of exercise. However, the magnitude of the economic loss when a written spread put option is exercised is lower on average. For example, if an investor writes a spread put option that gives Merrill Lynch the right to put an 8.5 year non-investment grade bond to them at a price equivalent of Treasuries bps, and the bond subsequently trades at T + 400, the investor has an economic loss equal to the present value of 100 bps for 8.5 years (approximately 5.8% today). This is a much smaller loss than one would expect upon exercise of a swap conditioned upon the occurrence of an event of default. In this case, the average loss on senior unsecured bonds would be 52%, according to Moody s. Both credit spread options and default swaps exist because of different investor preferences. Some investors are more averse to the likelihood of the occurrence of any loss, regardless of its size. Others concentrate on the magnitude of the possible loss versus the potential trade profit. While a credit spread option and a default swap may have the same expected gain (fee collected minus probability of a loss multiplied by the magnitude of a loss), investors may not be indifferent to the structures. Applications trading level on the option start date, but tighter than the new market level. If the credit spread does not widen, the option expires worthless and the investor retains the fee. Creating positions that are difficult or risky to create in the cash markets. Investors can lock in gains on appreciated bonds by purchasing a spread collar or create forward spread options by selling short tenor options and buying longer tenor options. 12

13 Total return swaps allow for the exchange of an asset s cash flows between two counterparties. Total Return Swaps Total return swaps allow two parties to exchange the cash flows of an asset. These cash flows include periodic flows (interest, dividends and fees) as well as price change (appreciation/depreciation). The long party (below, Counterparty ) in a total return swap has the same cash flows as if they owned the asset directly, as shown in Figure 4. Figure 4: Total Return Swaps 1) Interest, dividends and fees paid on underlying asset. 2) Price appreciation (if any) Counterparty 1) L +/- Spread 2) Price depreciation (if any) Total return swaps can be executed on most asset types including corporate bank loans (term and revolver), corporate bonds, equities, emerging market securities, mutual funds, hedge funds and private equity funds, and indices of all types. This section will focus on total return swaps on individual assets. The following section discusses total return swaps on bond indices. Total return swaps have four uses: hedging, leverage, market access, and balance sheet management Applications Total return swaps have four general uses. They are used to: 1. Enter into hedge or short positions. Investors can pay total return on an asset or basket of assets to obtain an off-balance sheet, term short position.; 2. Obtain leverage. The list of eligible assets for total return swaps is more extensive than bank-financeable assets and includes some illiquid assets such as offshore hedge funds and private placements; 3. Access markets efficiently. Total return swaps on corporate bank loans allow non-banks to enter the loan market without establishing elaborate and costly funding and processing operations; and 4. Improve return on capital and manage balance sheet usage. Total return swaps are off balance sheet instruments for GAAP purposes. As such, any positive return on a total return swap enhances return on GAAP equity since only the mark-to-market value, if positive, is an on balance sheet asset. ❶ Examples Leveraged investment in a fund. Investors can enter into a total return swap on an investment or sector fund. The investor receives all the cash flows from the fund and enhances returns through the use of leverage. Synthetic repo. A money manager that anticipates spread tightening lacks current liquidity with which to fund investments. By receiving total return on one or more corporate bonds, the money manager can lock in the purchase price of assets while minimizing capital commitments, thereby disaggregating market timing from liquidity constraints. 13

14 Synthetic CBO. Investors can in effect create their own customized collateralized bond obligation by entering into a total return swap on a basket of high yield bonds. The investor would choose the bonds and may be required to post initial margin in the form of cash collateral or securities. Merrill Lynch can provide an out of the money put on the basket that limits the investor s loss to the initial margin amount. The net effect is similar to the leverage and limited risk inherent in an equity tranche in a CBO. The advantages of this transaction are its ease of setup, the ability of the counterparty to alter the bonds in the swap (subject to certain limitations), and the ability of the investor to customize the structure (size, put strike, fixed or floating funding). 14

15 Index swaps are swaps whose cash flows are linked to the performance of an index of secondary market bonds Index Swaps An index swap is a total return swap on an index of bonds. Merrill Lynch produces and maintains over 2,000 proprietary indices designed to help investors measure performance of various markets and their own portfolios against an appropriate benchmark. In a total return index swap, one party agrees to exchange the total return (coupons plus price change) of a specified index for another rate of return, usually LIBOR or another bond index. A simple swap is shown in Figure 5. Figure 5: Index Swaps Index Total Return Counterparty L +/- Spread Merrill Lynch makes two-sided market in 12 different bond indices, offering investors enormous flexibility in managing portfolio risk and capturing market opportunities. Typical tenor is six months to one year. These indices are (data as of January 2000) are shown in Table 5. Table 5: Fixed Income Indices Traded by Merril Lynch Merrill Lynch Index Inception Date Market Value (B) Years to Mat. Yield to Mod. Worst Duration Bloomberg Ticker No. of Issues Government Master G0A ,047 $2, % 5.1 Mortgage Master M0A $1, % 4.8 Corp./Gov t. Master B0A ,643 $3, % 5.3 Corporate Master C0A ,378 $ % 6.0 AAA Corporates C0A $ % 6.8 AA Corporates C0A $ % 5.6 A Corporates C0A ,638 $ % 5.8 BBB Corporates C0A ,278 $ % 6.2 High Yield Master J0A $ % 4.9 BB Corporates J0A $ % 5.2 B Corporates J0A $ % 4.8 European Corporates ECOR $ % 4.9 JPM Emerging Markets JPMOEMBI $ % 4.9 Source: Merrill Lynch and JPM A description of each Merrill Lynch index can be found in Merrill Lynch Index Rules and Definitions, Philip Galdi, October, Index swap applications are very similar to those of S&P 500 futures Applications Index swaps are used by investors to: 1) replicate or and enhance the total return of a specific sector of the fixed income market; and 2) hedge market risk. The following sample trades illustrate the some common uses: ❶ Examples Achieving diversified exposure. An insurance company desires diversified exposure to the high yield bond market. Cash market purchases, however, are 15

16 inefficient, expensive and difficult to accomplish in size for many individual issues. The insurance company enters into a six-month swap with Merrill Lynch where Merrill Lynch pays quarterly the total return on the High Yield Master index and the insurance company pays a LIBOR-based spread. The insurance company pays a LIBOR-based funding spread (which varies according to market demand for each index swap) but does not pay any bid/offer costs on the 829 underlying high yield bonds and does not put any assets on their GAAP balance sheet. Hedging systemic market risk. A fund has the mandate to generate returns above LIBOR by investing in a variety of investment grade fixed income assets and can buy asset swaps or overlay swaps to achieve its objective. The fund manager buys investment grade corporate bonds using the in-house expertise in the fund manager s credit department and then enters into an index swap with Merrill Lynch where the fund manager pays the total return on the Corporate Master index and receives a LIBOR-based spread. The manager has historically outperformed the index and if he continues to do so would generate a return above LIBOR with reduced systemic corporate market risk. Managing execution risk. Similar to the use of S&P futures by equity money managers, fixed income investors may pay or receive on index swaps to immediately subtract or add risk to the broader corporate market. The index swap is then unwound as suitable bids and offerings are sourced on desired underlying issues. 16

17 Structured assets are among the oldest form of credit derivative Cheaply priced corporate zeros can be structured from secondary market current pay bonds Structured Assets The growth of the credit derivatives market had created the ability for dealers to create new synthetic corporate bonds. This market s growth has helped investors gain access to specific bond characteristics not available in the cash markets. Synthetic corporate bonds can be created to match a specific maturity, coupon type, or seniority independent of the offerings of the cash market. The following are two examples of structured assets available as unique investment opportunities. Synthetic Zero Coupon Bonds A synthetic zero coupon bond is a security that has similar risk/return characteristics to a directly issued corporate zero coupon bond but has better relative value. Stripped coupon securities exist to bridge the gap between investor and issuer preferences. Most issuers do not sell zero coupon bonds for one of three reasons: (a) because of the proportionately large face amount required to achieve a fixed funding objective; (b) because in positive yield curve environments many issuers pay a higher interest rate on zero coupon bonds; (c) because the accreting nature of zero coupon bonds increases a company s leverage ratios unless the company retires debt each year. The most basic structure is a synthetic zero coupon bond maturing on a fixed date. A special purpose vehicle is established to purchase a coupon bearing corporate bond and issue multiple classes of certificates each representing a single coupon payment or the final principal payment. An investor can purchase the synthetic zeros that fit their specific maturity needs. Absent any provision to the contrary, the entire principal claim would accrue to the benefit of the principal holder in the event the underlying bond is redeemed or is in default and is accelerated. Therefore, synthetic zero coupon bonds provide for allocation of any proceeds upon redemption or acceleration to each class based upon accretion schedules using the yield to maturity of each class on the issue date. Applications Investors purchase synthetic zero coupon bonds for several reasons, including: to increase duration and gain convexity; to obtain higher yields versus directly-issued zero coupon bonds; and to meet custom tenor and coupon targets. Synthetic zero coupon bonds are issued by a special purpose vehicle specifically designed to mimic the structural flexibility of medium term notes. The investor can thus set duration, convexity, call features, and maturity. When stripped, 100-year corporate bonds provide insurance companies with sizable duration and convexity ❶ Example An insurance company needs $100 million of 11.4-year duration assets to realign its portfolio with its benchmark index. Traditionally, this would be accomplished by buying $100 million 30 year corporate bonds, which in this example have a duration of 11.4 years and yield T+100 bps. Alternatively, the insurance company can purchase $38 million of a deferred coupon trust certificate that has a duration of 30.1 years and yields US T bps. The deferred coupon investment has a 0% coupon for years one through 20; at the end of year 20, the investor takes delivery of a 100-year coupon bond. On a dollar-weighted basis, $38 million of the trust certificate has the same duration as $100 million of 30-year coupon bonds and almost two times the convexity (for a 62% smaller investment amount). The insurance company also gets a return on cash of an additional 25 basis points versus current coupon 100-year bonds. 17

18 Table 6: Attributes of Various Fixed Income Investments Duration Convexity Yield Spread 30 Year Current Coupon % T % 30 Year Zero Coupon % T % 100 Year Current Coupon % T % 100 Year Deferred Coupon % T % Source: Merrill Lynch The option embedded in a synthetic callable bond trades at a higher implied volatility than a cash market callable Synthetic Callable Bonds A synthetic callable bond is a security that has similar risk/return characteristics to a directly issued corporate callable bond but has better relative value. Most investment grade corporate issuers prefer bullet funding and have a weak bid for the call option imbedded in callable securities. Therefore, callable securities tend to be priced expensively. A synthetic callable bond investor owns a trust certificate that evidences beneficial interest in (a) a non-callable bond and (b) a written covered call option. The certificate offers a higher yield than a callable bond sold directly by the corporate issuer because of the relative cheapness of non-callable bonds to callable bonds. Advantages Synthetic callable bonds have several advantages over directly issued callable bonds, including: They often trade at a higher yield for comparable credit/interest rate risk. They offer flexible investment terms. The investor can set the call price, call frequency, the coupon and maturity to better meet their risk and yield requirements. The much wider selection of credits increases the investor s ability to diversify. The majority of investment grade corporate issuers do not issue callable bonds. Callable bond investors can diversify into those issuers that only have non-callable bonds. ❶ An Example Corporation XYZ, an A rated issuer, funds itself by selling 10 year non callable bonds. The company swaps the fixed rate to a floating rate of LIBOR+20 bps. XYZ will issue callable bonds (generally non-call two years; callable every six months thereafter ) if a dealer or investor inquires, but has a funding target below LIBOR for this structure (XYZ swaps the callable issue to a floating funding rate) because XYZ has a preference for bullet funding. Investors that want the higher yield that callables offer do not buy callable bonds issued by XYZ since none are outstanding. The synthetic callable bond fills this void. A grantor trust purchases an XYZ 10-year non-callable bond (which, as noted is 25 bps per annum cheap to a prospective XYZ callable bond) and sells a call option on this bond to Merrill Lynch or another investor. 18

19 CDOs tranche the cash flows generated by a pool of underlying assets Collateralized Debt Obligations Collateralized Debt Obligations (CDOs) are special purpose vehicles designed to tranche the cash flows generated by an underlying collateral pool. CDOs is the umbrella term for two main products, Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs). The underlying collateral pool for CBOs generally consists of high yielding bonds (sometimes emerging market issues); the underlying collateral pool for CLOs consists of leveraged bank loans. The collateral pool is selected and managed by an experienced asset manager. The portfolio is financed through the issuance of multiple tranched classes of securities, much like an asset-backed security. A typical CDO will have a high rated investment grade floating rate senior secured liability, a lower rated investment grade subordinated tranche, and an unrated junior subordinated note. Figure 6 illustrates the basic CDO structure. Figure 6: Collateralized Bond Obligation Portfolio of High Yield Bonds/Loans Net Cash Flows Senior Debt Tranche Subordinated Tranche Cash Flow Waterfall Equity CDO equity can offer high expected returns and efficient leverage The potential payoffs offered by CDO equity mimic a call option on the underlying portfolio Benefits and Advantages CDOs segment the investment risk associated with the corresponding underlying assets between different classes of investors. In particular, the unrated junior subordinated tranche ( the Equity ) represents a leveraged non-recourse investment in high yield assets. Projected returns for the Equity can range from 15% to 50% depending on the capital structure of the SPV. As the investment in the Equity is non-recourse, its holder is not subject to capital calls from the CDO vehicle. This type of financing is not currently available through any other type of market instrument. Stated alternatively, the Equity holder is effectively long a put option on the portfolio of assets and long a leveraged position in the portfolio of assets. Thus, the Equity can be viewed as owning a long-term synthetic call option on the portfolio. A diagram illustrating this concept is provided in Figure 7. 19

20 Figure 7: Equity Ownership in a CBO or CLO Return ($) Long Position Synthetic Call Option on Portfolio Initial Investment Value Portfolio Default Option ❶ Examples A total return investor that seeks low-rated securities has several options. On a financed basis, these include: the use of cash market leverage (margin loan); a total return swap on a basket of securities or loans; and the purchase of the Equity of a CDO. The Equity benefits from term leverage, automatic reinvestment, simple booking and professional management. An insurance company that owns a portfolio of high yield and emerging market bonds can sponsor a CDO and deposit those assets into the vehicle. The manager would retain all or part of the Equity, and could invest the proceeds from the assets sold into new high yield issues, or could opt for lower risk assets for this portion of his portfolio. An insurance company that has an objective of improving return on NAIC capital owns AA rated corporate bonds that have been asset swapped to LIBOR flat. The insurance company sells the bonds, terminates the related interest rate swaps, and then buys a senior tranche of a Merrill Lynch CDO that is rated AA. This CDO senior tranche yields LIBOR + 35 bps, for a pickup of +35 bps using the same amount of NAIC capital. A bank that owns a portfolio of loans has the objective of improving return on equity capital. The loan portfolio has a regulatory capital requirement of 8%. The bank buys default swap protection on the portfolio of loans from an SPV and, subject of the necessary regulatory approvals, treats the loan portfolio as fully hedged and reduces the capital charge to zero. The SPV issues CBO tranches of debt to cover the default swap protection which are distributed by Merrill Lynch. The bank purchases the most junior tranche (equity tranche), and sets aside 100% regulatory capital against this. To the extent that the size of the equity tranche is smaller than 8% of the loan portfolio, the regulatory capital requirement has been reduced. See Brian McManus research on Collateralized Debt Obligations 20

21 Credit derivatives can be securitized using special purpose vehicles SPVs can be used to transform credit derivatives into synthetic, rated assets 3. The Role of Special Purpose Vehicles Special purpose vehicles (SPVs) facilitate asset repackaging by embedding credit derivatives in SPVs, allocating cash flows, or by tranching credit risk. Many investors are unable or unwilling to enter into interest rate swaps, default swaps, currency swaps or other derivatives directly. For some, credit availability is an issue; for others it is the additional resources required to document and manage separate derivative positions. SPVs accommodate investors needs for various coupons, credit ratings, maturities, and volume, all in the form of a security. SPVs are generally structured to avoid entity-level tax. The Global Credit Derivatives group at Merrill Lynch utilizes several SPVs, including: STructured EnhancEd Return TrustS (public and private STEERS ) Asset Backed Trusts (ABTs) Secured, Individually Repackaged & Exchangeable Securities (SIRES, Limited.) Loan Co. s CBOs and CLOs Each of the SPVs above are a series of bankruptcy remote trusts or companies that are established to purchase assets, use swaps and options, and thereby create a customized coupon, as shown below in Figure 8. The certificates or notes can be individually rated by one or more of the major ratings agencies (Moody s, Standard & Poor s, Fitch, and Duff and Phelps). The rating of an SPV will typically reflect the rating on the underlying security along with some consideration given to the rating of the derivative counterparty. Figure 8: Special Purpose Vehicle Customized Coupon Trust Bond Coupon Securities Bond Coupon Customized Coupon Investor Applications Investors utilize SPVs to increase market access. SPVs allow investors to buy a security with a customized coupon, currency, call features and tenor without entering into swaps, options or other over the counter derivatives directly. Use of SPVs also allows investors to benefit from efficiencies of scale. Because an SPV can hold multiple assets, bonds can be aggregated and purchased in a single, large transaction. The SPV coupon can be one aggregate round coupon, eliminating the need to process frequent and varying cash flows. ❶ Examples A corporate bond investor is looking for high yielding instruments with strong corporate names. America Online issues a subordinated zero-coupon 21

22 convertible bond at a high yield. Default swaps offer an opportunity for investors to purchase credit exposure directly, without worrying about the zero-coupon accretion or the embedded equity option. However, due to restrictions in their charter, the investor is unable to use derivative instruments as investment opportunities. Therefore, the investor purchases a STEERS with an embedded AOL default swap. The investor achieves a high yielding synthetic AOL bond that meets all charter restrictions despite the lack of any plain vanilla AOL bonds in the market. A money market fund cannot buy a five-year credit card asset backed security according to the Rule 2a-7 guidelines that govern money market fund investments. The fund could, however, purchase an ABT trust certificate that evidenced beneficial ownership in (a) those same securities and (b) a derivative contract with Merrill Lynch that converts the tenor of the security from five years to one year using a put option (which adheres to the guidelines for the fund). The investor has increased the fund s access to new investments and will often achieve a yield pickup over similarly rated investments. Merrill makes a secondary market in ABTs. ❶ Documentation Grantor trust transactions (e.g., STEERS and ABTs) and special purpose companies (e.g., SIRES and Loan Co. s) have similar documentation. The transactions are described in an offering memorandum and supplement. There are also documents that establish the vehicle: a trust agreement for trusts and incorporation documents for special purpose companies. 22

23 Credit models fall within two general groups: arbitrage free and econometric Econometric models are tools to evaluate, rather than derive, market prices Standard modeling techniques simulation, trees, and Black Scholes can be applied to credit derivative pricing problems 4. A Review of Valuation Models Credit models can be broadly separated into comparative pricing models (also known as arbitrage-free models) and econometric models (also known as equilibrium models). In the context of comparative pricing, one tries to derive the price of a new financial instrument from existing instruments in the market. The derivation typically assumes that the credit referenced can be freely traded with little friction (bid/ask spread), high liquidity (daily hedges), and the availability of short positions. Econometric models try to predict default rates based on historical information on default rates for different economic environments and current economic information. Most models proposed in the literature use comparative pricing methodologies (sometime called arbitrage-free pricing). However, longterm buy and hold investors use econometric models. Econometric models require significant data and sophisticated techniques to analyze the data. The models are typically used to produce buy/sell options and their output may not match observed market prices. However, they provide a useful tool for making decisions on the relative value of various bonds. The key to choosing between these two types of models is whether one is more concerned about estimating intrinsic value (equilibrium models) or value relative to current market prices (arbitrage-free models). Another important question when implementing a model of credit risk is the technique to be used in the determination of actual prices. The common approaches are closed form (formulaic) solutions, tree frameworks, and Monte Carlo simulations. Closed form solutions are convenient to use and provide quick intuition on important variables, but usually are too simple or too inflexible to be practical in valuing complex securities. Tree frameworks provide more flexibility and are computationally feasible if the problem can be solved with a recombining binomial or trinomial tree. Finally, Monte Carlo simulation provides the most flexibility and is useful for solving non-markov models (i.e. those that are pathdependent and require a non-recombining tree). However, Monte Carlo analysis is slow and computationally intensive. A brief bibliography of credit modeling literature is presented in Figure 9. Figure 9: Selected Reading Credit Derivative and Risky Bond Valuation Black, F., and Scholes, M., 1973, The Pricing of Longstaff, F. A, and Schwartz, E. S., 1994, A Options and Corporate Liabilities, Journal of Political Simple Approach to Valuing Risky Fixed and Floating Economy (81), Rate Debt, working paper, University of California, CA. Duffie, D, and Singleton, K., 1996, Modeling Term Structures of Defaultable Bonds, working paper, Stanford University, CA. Jarrow, R., Lando, D., and Turnbull, S., 1994, A Markov Model for the Term Structure of Credit Spreads, working paper, Cornell University, NY. Merton, R. C., 1974, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, The Journal of Finance (29), Nielsen, T. N., Saá-Requejo, J., and Santa-Clara, P., 1993, Default Risk and Interest Rate Risk: The Term Structure of Default Spreads, working paper, INSEAD, France. 23