Credit-linked products continue to occupy an important niche in structured products markets and sales in 2019 year to date are on track to match last year’s 12 month total of around US$ 10.5bn globally.
Credit-linked products have been through a roller coaster ride in the last fifteen years. A variety of complex structures were seen in the lead-up to the credit crunch as spreads started to rise and issuers found inventive but seriously flawed ways to create high yielding products. These exploited rising credit spreads, choice of lower credit quality names, exotic payoffs and an exploitation of credit rating agency’s methodologies to claim inflated ratings.
The asset class was also drawn into the bubble of real estate lending through hybrid products. When the inevitable crash followed the entire sector was discredited as asset values collapsed and some products effectively disappeared. This turned investors off both credit instruments and anything structured or complex. Meanwhile the slow wheels of regulatory change started as a reaction, with AIFMD, Priips and Mifid 2 all owing their origins and motivation to better investor protection in the aftermath of the financial crisis caused in big part by such instruments.
However, markets eventually move on and simpler versions of credit instruments started to resurface. Credit spreads themselves are a big driver, in the years of the Eurozone debt crisis between 2010 to 2012, they rose significantly whereas today we see levels much lower across all sectors and markets. These changing dynamics affect product risk and target investor groups emphasising the need for prudent product selection.
Despite these problems, credit linked investments have a sound rationale when used correctly. High income seeking investments has always been a fundamental requirement for many investors. Given that investors’ requirements and income expectations vary little across market cycles, it stands to reason that when risk free rates are low, the search for income needs to be more creative. Indeed the popularity of many structured products, such as reverse convertibles and auto-calls are because they provide attractive income levels at controlled risk.
Credit linked products also offer a way to earn high yields that is independent of stock markets and far in excess of what fixed income markets can realistically offer.
The type of credit linked products varies significantly across different regions. South Korea has a high take up of credit linked notes, these are typically very short dated (three months is common) and linked to a single well-known name such as Samsung. These liquid investments give investors short term yield pickup similar to buying a corporate bond but on a cleaner basis and benefiting from the slightly higher levels that the CDS market would offer. Such products are very vanilla and low margin.
In European markets, Germany has an active credit linked market that is the biggest by notional amount. These products are also very vanilla but longer dated than those typically seen in South Korea.
Although the Scandinavian markets are smaller there has been bigger proportional take up of credit linked products for many years. In both Sweden and Finland credit linked products are very popular and many of them are linked to two of the widely used Markit credit indices - CDX North America High Yield and iTraxx Europe. Both these indices track a number of companies, 100 for the High Yield and 125 for iTraxx Europe. The iTraxx Europe is a mainstream index with the other one comprised of poorer credits. The liquidity of these indices extends to the “tranche” construction and many products in Scandinavia are of this type.
One High Yield linked product from StruckturInvest allows 15 credit events over the 5 year maturity without penalty but for each of the next 10 events, 10% of the coupon and principal is lost, leading to total loss if 25 of the companies suffer credit events. This product had a coupon of 8.9% pa. By contrast one of the Garantum distributed products linked to the iTraxx Europe Index from this year pays 4.5% pa and allows three defaults over a similar five year term. Beyond that 20% of coupon and principal is lost for each of the next five credit events. This means that once there have been eight credit events the product pays no further return. This smaller number of allowed events, which support a much lower yield is reflective of the fundamental differences between the two credit indices, just as for a pool of A versus B rated bonds.
Finally, we note that assessment of credit linked products can be difficult because their performance relies on companies avoiding default or other major credit events, rather than market neutral or bullish structured products which look to medium to strong company performance. However, the sector is still active and has its place in the investment landscape.
Disclaimer: The views, information or opinions expressed herein are those of FVC, and do not necessarily reflect the views of SRP.