While leverage is available to investors for bond and equity investments, the hunt in Asia for structured products linked to credit (credit-linked notes, or CLNs) continues. The advantage of leverage is simple, it allows yield enhancement by way of even higher returns on more risky investments or improved paybacks investment grade credits.
"CLNs, whether on real credits or credit indices have made a bit of a comeback," said a Hong Kong-based product structurer. "This market was completely dead post-Lehman, but now it's a private bank staple again. Hopefully everybody understands them better now."
While a bond offers the credit risk of an issue, CLNs add technical risk, including the occurrence of any number of specified events, such as the restructuring of an unrelated company loan by the credit in question. Furthermore, CLNs offer very little in the way of liquidity, especially when compared to bonds. As a result, a lot of banks do not push these products. "We don't sell CLNs to retail, and I'm not sure of other banks do, but we have sold them to private banks," said a Hong Kong-based banker.
"Credit-linked notes have always been popular with private banks, particularly in Europe, and especially in Geneva and Monaco," said the banker. "In Asia, we have not seen so much and have not printed any, because they see them as risky products... although private banks in Asia are getting more active in funding."
Offering leverage suits private banks, as they are generally long cash, as investors continue to skew their asset allocation towards safety first, although providing finance to their investors is not new. A simple way to make use of that cash is to offer an investor leverage on a chosen investment. "We have seen three times-leveraged CLNs offered by private banks on investment-grade credits, although are not aware of deals being completed in Asia," said the banker. One deal that neared completion was linked to an investment grade Southeast Asian financial institution, with the private bank willing to offer three times leverage.
While two- and three-times leverage has been applied to investments in bonds and loans, notably Chinese bonds, Asian investors remain cautious about CLNs, primarily due to their association with Lehman Brothers Minibonds. These products were structured as CLNs and, although most investors were eventually repaid most of their money, they were the kind of complex instruments that created mass panic when the US bank declared bankruptcy.
The question of whether leveraged CLNs are suitable and would be sold to institutional investors is less of an issue, according to the structurer. The protection for these investors and for those private banks that are offering leverage on bond and equity investments comes in the form of triggers where investors need to put up more capital or collateral if the asset's mark-to-market falls in value. Other alternatives used in Asia have included stop loss triggers, in cases where it is either impossible or impractical for investors to offer further, event-driven cash or security.
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