IFR Mid East 2006 - Arbitraging GCC credit
The ever-expanding project finance pipeline in the GCC region offers opportunities, albeit with real challenges. The booming development projects and the looming liquidity are providing banks with a new asset base to diversify as well as optimise their credit portfolios. By Ghazali Inam, vice-president and senior corporate finance officer, Riyad Bank.
While banks are gearing up for a major regulatory change from Basel I to Basel II impacting on the capital requirements for virtually all assets held, the expanding base of credit assets pose a new set of requirements that would require attention sooner rather than later. This is especially relevant to the GCC banks, particularly the Saudi local banks.
In most, if not all, cases, credit financing is a trade-off between risk management and relationship management. Usually, the management of credit portfolios entails addressing the growing capital needs of client relationships; risk diversification of a single or a portfolio of assets; and enhancing economic returns. This in relation to the so-called 'efficient frontier' lends various alternatives of risk-return profile. These alternatives on the risk-return continuum are based on a set of quality criteria comprising at a minimum five factors - see Fig 1:
- Obligor and industry diversification;
- Obligor/portfolio credit rating;
- Obligation type and security;
- Portfolio maturity or average life;
- Portfolio yield.
In the context of the GCC bank market for project and quasi-corporate cum project credits, these risk factors appear to be the potential limitations. These limitations are more pronounced for the GCC banks, given the lack of empirical research and analytical templates for default and loss studies; lack of local and regional performance benchmarks such as published credit indices; and non-existence of a regional institutional framework similar to LSTA (Loan Syndications & Trading Association) in the US.
In outlining a credit portfolio's management strategy similar to those of developed markets like the US, the starting point is the review of related short-term and long-term factors. These are the factors in general that have a bearing on the market and in particular could impact the profile of an individual bank's credit portfolio - see Table 1.
Once the factors that influence the credit portfolio are highlighted, the next step lends to the decision of how to optimise a bank's existing credit portfolio. There are primarily two ways of achieving this - see Figure 2:
1. First using relative value to enhance existing portfolio return or to select a new asset. This is primarily undertaken in an established secondary market trading; or
2. Conversely, monetise the asset to release the regulatory capital.
Relative value analysis is primarily used in the secondary market trading for credit portfolio growth or contraction. The intent of relative valuation is to maximise the return on an asset or the return on the credit portfolio by identifying assets that are well priced in relation to the risk they contribute.
Spread and return analysis as part of relative valuation is one thing, but for most banks the return on regulatory capital is the key variable as a lower capital charge has a positive impact on return on capital calculation. This is in contrast to relative valuation and is undertaken by monetising the existing assets through leveraging returns as opposed to maintaining exposure through cash investments, ie, short new instruments - see Figure 3.
Relative value analysis
Relative value analysis or investing in the bank loan market allows the credit or loan portfolio managers to identify values within the marketplace based on their own economic outlook. The GCC region's heightened project financing in the bank loan market would sooner or later require using tools like relative value assessment. This is more pertinent in the ensuing secondary loan trading, where demand for a loan asset class is expected to include regional institutional investors.
The concept of relative value is well established within the corporate bond market for the selection of bonds. Relative valuation of bonds utilises three forms of analysis – sector spread analysis, issuer credit analysis and individual securities analysis. Risks included in the bonds relative valuation include volatility of interest rates and credit risk.
In the case of bank loans that are predominantly floating-rate debt instruments, the interest rate risk is not an important concern for the investor. The dominant risk of bank loans is credit risk, which is the risk that a borrower will experience financial distress and not be able to meet its contractual debt obligations. Therefore, in the bank loan's relative valuation the focus is on credit risk-adjusted returns.
Relative valuation of bank loans is a simple concept that is based on valuation metrics that incorporate several steps, including but not limited to:
1. Reviewing of both rating and industry sector analysis, as these sectors in the loan market are narrower than in the corporate bond market. For each sector an average spread return is calculated;
2 After the sectors are developed, spread analysis on expected sector performance is determined for the timeframe under consideration. An expansive list of bank loans in the market are categorised into identified sectors and the yield-to-maturity is computed for each sector. For example, for argument's sake, assume that the BB/Ba2 sector averaged 200bp over Libor, or alternatively, say a sector, such as industrial, oil and gas, etc, averaged 150bp over Libor (say for average B+/B1 ratings);
3. Identifying default outlook. Within each rating category the cyclical default expectations and their impact on total returns are highlighted. This helps in developing a target risk-weighted portfolio based on highest returns that are adjusted for cyclical defaults and losses;
4. Usually, the defaults in rating categories differ. This results in the expected cost of credit for each category to fluctuate (probability of default times loss in the event of default or LIED). Applying this based on each sector's loss volatility, the risk adjusted spread, ie the probability of default times LIED minus average current spread for the rating category, helps determine the most attractive sector;
5. Determination of the best relative value sectors leads to issuer credit analysis, ie identifying the best credit risks in each sector through peer performance analysis of each issuer in the segment and forecast expected performance for each issuer. This process enables ranking relative credit attractiveness within each sector. The ranking process for each individual loan in turn is based on additional steps:
i. First, capture loans' basic parameters – pricing, loan type, interest basis, spread, fees, credit rating, signing date, maturity, amortisation schedule, issuers industry, etc. This is necessary to model loans' cashflows and discount them properly. Additionally, it is useful to understand other loan details, such as contingent changes in pricing triggered by changes in the borrowers debt rating;
ii. Identify cashflow impact of likely performance. For instance, improved performance leads to pricing step-downs or even refinancing and vice versa; and
iii. Last, review market performance of the issuer's securities, if available, in corporate bond and equity markets. This cross-market reference provides important clues in relative valuation.
6. Finally, a list of highest-to-lowest risk adjusted return is prepared, which leads to adjusting the credit portfolio and in developing strategies to improve returns.
Metrics for relative valuation
The following is an example of relative valuation for three sample bank loans. These three sample loans are adjusted for coupon step-up/down options and price premiums or discounts (assuming the three loans are trading in the secondary loan market). Assume that all three loans run to maturity. The Superior Co Term Loan (TL) B at a price of 101-1/8 has a superior return over its weighted average life (WAL) with a 279bp adjusted spread. This loan returns the investor 70bp per annum in higher coupon. Discounting (discount the difference since the spread benefit is over time and the premium is upfront) this higher coupon over the WAL of the Average Co TL and Superior Co TL A indicates the Superior Co TL B loan is worth 1.75 points more in price than Average Co TL and 2.02 points more than Superior Co TL A. As the price differential is 1.250 and 1.375 respectively, the Superior Co TL B is viewed as a better relative value - see Table 2.
In relative valuation, the expected returns are significantly impacted by investors' view of average life. This is because most bank loans are typically callable any time at par. Therefore, credit portfolio managers may adjust WAL to determine the break-even price. In the above example, if the three loans are considered outstanding for only three years instead of their WAL, the adjusted spread shifts as shown in the last column of the above table of relative valuation metrics. Once again, the 53bp adjusted higher spread in Superior Co TL B is discounted over three years, resulting in a break-even price differential of 1.38 and 1.66 over Average Co TL and Superior Co TL A respectively. This once again shows a better relative value for Superior Co TL B at the indicated price differential of 1.250 and 1.375.
Various instruments are available to a credit portfolio manager to monetise the existing assets on the books and enable the aligning of capital requirements of financial instruments with their economic risk. The concept of securitisation and derivatives is employed to trade or hedge the underlying credit risk of the existing assets. Monetising offers a spectrum of options ranging from a simple passing on of cashflows from underlying assets to complex structures utilising credit derivatives.
The collateralised loan obligation (CLO) is a securitisation of a portfolio of bank loans comprising both investment and non-investment grade loans. An investment vehicle is set up to acquire bank loans with the proceeds of issuance of asset-backed debt and equity securities. Debt securities issued by the vehicle are repaid by the cashflow generated from amortisation of the portfolio of bank loans.
A more complex trade is employing credit derivatives, which are important risk management and investment tools. Basically, there are three types of products, depending on the risk transferred. These are: 1) total return swaps; 2) credit default swaps; and 3) credit-linked notes (CLN). These are bilateral financial contracts that allow credit risk to be isolated from other risks and from the instrument with which it is associated and passed from one counterparty to another. These instruments aim to achieve active risk management, rational pricing and systematic liquidity as these instruments liquefy credit positions, albeit with a liquidity premium over spreads that is conceptually similar to interest rate swap exposure.
Traditional credit risk management tools are inefficient, such as old fashioned or early forms of credit derivatives (economically similar to credit default swaps but legally different), guarantees, letters of credit, insurance and other risk management tools that employ diversification, collateral, loss reserves, mark-to-market, re-insurance, shorting, or loan participation (similar to total return swaps). On the contrary, credit derivatives exhibit essential characteristics of successful derivative products by isolating risk and encouraging active risk management. These instruments provide bank credit (loan) portfolio managers with an alternative to manage risks. Some of the salient features of these instruments that are relevant to loan portfolio managers include:
- Enlarge market for loan asset class – total return and default swaps;
- Permit sell down without encountering relationship issues;
- Allow structuring to adjust maturity, amount or position in the capital structure;
- Can be bought or sold individually or in baskets by identifying specific obligor or industry;
- Provide opportunity for banks to optimise portfolio;
- Reduce regulatory capital allocated to the risk based on regulatory guidelines if credit derivatives are properly structured;
- Lower operating cost for non-banks compared with the operations cost of managing a loan portfolio. Also, capital allocated to a credit derivative can be lower than in the cash market;
- Last the physical asset does not have to be owned by either swap counterparty as the loan is an index - default risk is viewed as fungible - see Figure 4.
Similarly, from a purchaser's point of view (external issues) the main consideration is fair value in terms of market comparables, reinvestment alternatives and complex structures. However, these asset monetising instruments are effective tools for loan portfolio managers and provide new opportunities to manage risks and improve returns without stressing relationships with the issuer.
The two strategies of arbitraging and trading credit portfolios give portfolio managers efficient tools to adjust and optimise their credit positions. These are important tools, particularly in the expanding project finance, bridge loan and corporate and quasi-corporate loan portfolios in the GCC region. These tools provide effective means to overcome limitations resulting from regulatory stipulations such as loan to deposit ratios and other requirements and constraints.