The low interest-rate environment and the tightening in Asian credits have caused many investors to start considering structured investment products for yield enhancement by taking either market risk or credit risk. Usually, a structured investment product can offer yield enhancement based on a specific market view. A LIBOR corridor is a typical example. A LIBOR corridor note will offer extra return if LIBOR evolves according to the range determined at the outset of the transaction while the downside is a loss in coupon or part of the principal if the actual market movement goes against the view. This kind of structured note is usually issued from the European medium-term note program of reputable issuers, with payment of coupon or sometimes principal linked to the evolution of one or more market parameters, such as an exchange rate or interest rate.
However, an investor can also achieve enhanced return by taking credit risk. A flexible means is to invest in a credit-linked note. The investor receives a yield pickup as long as there is no credit event during the life of the transaction.
Recently, there is a structured investment product which amalgamates both market risk and credit risk. The structure, known as a Hybrid CLN, will offer enhanced return so long as the market movement of a specific parameter is in line with the investor's view as embedded in the structure and there is no credit event in the reference entity. In other words, hybrid CLNs offer an even higher coupon according to both the market view and credit appetite of an investor.
Example Trade
Credit-Linked LIBOR Corridor
(pricing is hypothetical)
This product is an EMTN, whose coupon is linked to the performance of both the credit worthiness of the reference entity and the movement of LIBOR rates and the principal is linked to the performance of the credit worthiness of the reference entity. In this example, Hutchison Whampoa is the reference entity. A three-year plain vanilla CLN linked to Hutchison Whampoa will give a coupon of LIBOR plus 0.90% basis points a year. Separately, a LIBOR corridor will offer a coupon of LIBOR + 150bps if we consider the following range:
Year 1: 0% < 3-Month USD LIBOR < 3.50%
Year 2: 0% < 3-Month USD LIBOR < 4.50%
Year 3: 0% < 3-Month USD LIBOR < 5.50%
It does not look very attractive if we consider the CLN or the LIBOR corridor structure separately. However, if we combine the two products together, we will come up with a note with the following coupon:
3 Month LIBOR + 3.00% * n/N p.a.
where
n: Number of days when three-month USD LIBOR fixed within the predetermined range
N: Total number of days in each reference period
This product works like the normal CLN with standard International Swaps and Derivatives Association credit events, where physical delivery applies. The coupon is also subject to the LIBOR movements as determined by the formula shown above.
A similar idea can also apply to reverse floaters, capped floaters and other typical market risk related products. An investor can pick the favorable structure according to their own market view and at the same time choose the reference entity.
A Closer Look
The ideal approach to structure a hybrid CLN is to model the correlation between the market risk component and the credit risk component, price the structure and manage the risks accordingly. This is far from simple, however. Yet, there is an intuitive way to understand and possibly replicate the payoff of a hybrid CLN.
The simplest way is to put together the plain-vanilla CLN, in this case a CLN on Hutchison Whampoa, and the market risk component, i.e., the USD LIBOR corridor option. The plain-vanilla credit-linked note gives a coupon of LIBOR plus 0.90bps which will then be used for the purchase of the LIBOR corridor option. The coupon of such LIBOR corridor CLNs is higher than that of a LIBOR corridor note issued from the EMTN of a typical high-grade issuer. The enhancement in coupon will increase as you move down the credit spectrum for the credit risk component.
As the coupon of a plain-vanilla CLN will stop when a credit event takes place, there may be a negative mark-to-market in the value of the LIBOR corridor option if the value of the LIBOR corridor option is lower than the value of the option premium yet to be paid (such premium will be equal to the coupon of the plain-vanilla CLN from the moment of the credit event until maturity). In such cases, the investor may receive a cash settlement amount being the recovery value under the plain-vanilla CLN, less the unwinding cost of the LIBOR corridor option, if any.
Alternatively, such risk may be borne and managed by the issuer or arranger. In that case, the investor will no longer be exposed to the contingent unwinding cost in the market risk component in the case of a credit event. In such cases, physical settlement can be adopted.
Conclusion
An investor can generally achieve yield enhancement by investing in structured EMTNs with certain market views or in credit-linked notes according to their specific credit appetite. Now, an investor can enjoy enhanced return by taking both market risk and credit risk at the same time. Hybrid CLN can be structured according to the specific market views and credit appetite of an investor so that the return to the investor can be optimized accordingly.
This week's Learning Curve was written by Gilbert Tse, managing director, and Francois de Supervielle, v.p, in the structured derivatives department of SG Asia in Hong Kong.
