DERIVATTVES

Assets enhutrced
byswaps...
Asset swappers are searching for ways to expand their investor
base. By repackaging the swapped assets into securities they
are finding ways to attract the smaller or more constrained
investor. Could these securities rival the Eurobond market?
Aline van Duyn reports
"Only
about
3o/o
of tll investors use asset
swaps," laments Paul Karvandi, head o[ asset
swap trading ar Paribas Capiral Markets. The
marker is restricted because rhe majoriry of
investors do not have a large enough capital
base to act directly as a swap counrerpar$1
Others are prohibited from using swaps and
some do nor have the technology.
The size of the asset srvap market is csti-
mated at around $zoo billion of underlying
principal outstanding. One of the marker
leaders, Merrill Lynch, rransacts about Sr.;
billion a monrh in assers swaps just in Europe
and Asia. Spreads in the market have tight-
ened, and this is pusl.ring bani<s to look fbr
further growth. Says Karvandi:
"The
tighten-
ing in spreads is leading to increased innova-
tion, and existing structures are being bettered
all the time."
Securirizarion is one ansrver.
"This
is the
main area o[ growth," says Ed Charles, vice
president at
.1n
Morgan. "By securitizing the
asset swaps through the use oFspecial purpose
vehicles (snvs), a whole nerv investor base rvill
be able to gain access to the asset srvap
market."
An spv can be set up to buv the securities
the bank has purchased, rvhich form rhe basis
of the asset srvap, together rvith the derivatives
wh.ich generate the cashflolvs that investors
would require. The spv can then issue bonds
whose payments match those of the asser
swap. The investor is therefore buying a 6xed-
or floating-rare bond, which is often listed and
rated. However, to date investors have still had
concerns about the srvap element in rhe spv.
"ln
a normal asset swap there is no legal
connection berween the swap and the bond,"
explains Charles. "Hence a bond default that
results in a recovery oF po/o of notional,
coupled with a large negative mark to market
on the swap, could result in the investor losing
more than his total original principal."
The newer securitized asset swaps rake
account of this worry. The most recent vehicle
to be publicly launched was an instrumenr
called Laser (liquid asset srvap with enhanced
return). Laser, launched bv Paribas Capital
Markets, offers buyers a securiry with the
48 Euromoney
I
March 1995
1r',.
Kanandi: hedging termination risk is dilficult.
enhanced yield benefits of an esset sr'vap but
no terminarion risk on the srvap. Laser r is rhe
first of a planned progrumme of such secr.rri-
ties, and the one-year 568 million lloaring-
rate-note, rated er by Moodvt, offcrs interest
payable at six-month doilar Libor plus z5 basis
poinrs (bp). This particular return rvas created
by repackrging a Swiss franc private place-
menr thrt Paribas had issued in 1986 and
rvhich had been bought bv a single investor
and later bought back by Paribas.
The Laser product is designecl to look and
feel like a Eurobond: it is rated, in bearer lorm
and has denominations as small as $r,ooo
rvhich makes it attractive to rerail invesrors.
The issuc was rhree times ove rsubscribed,
meaning rhat current holders rvould be likely
to 6nd a buyer if they did want ro liquidate
their holding. In the case of a default rhe
holder rvill take physical delivery of the under-
lying assets, the bonds. Tl.re investors do not
need to worry about any loss incurred on rhe
srvap: if its termination incurs a loss then that
is Paribas' problem.
"$/e
have found a rvay ro
hedge this risk, which is of course very
difficult to do," says Karvandi. Also, rhe hold-
ers of Laser are the unqualified orvners of rhe
underlying collateral
-
Paribas does nor have
any claim on this. "ln facr, rhis is a crucial
difference berween our vehicle and many o[
the others around," claims Karvandi. "In
many of them the swap counrerparry (such as
Banque Paribas Swaps) also has a claim to rhe
notes in the event of a default. In fact, in some
the swap counrerparry has prioriry over the
investors in rhe asset swap snv."
yn lvlorgan has also developed a securirized
asset swap programme, called Argo. This,
unusually, does not stand for anyrhing. Argo
was launched last year and like Laser is a
programme off which differenr issues can be
launched. The underlying bonds are used as
collateral, and yn Morgan has got around rhe
problem of swap risk by hedging such a loss
through rhe use of purs. This does lower rhe
yield, because puttrble swaps are expensive,
but investors then do nor need to worry about
any losses incurred on the srvap.
All the benefir, ofcourse, does not go ro the
investor. Thc asset srvap market has ahvays
provided a useful means lor banks to get illiq-
uid bonds offtheir books. Laser r's underlying
is another such example. Also, banls are able
to retain more of a margin rhan rvould be
possible iI rhe product was unsecured.
Invesrors are giving up this yicld. By promor-
ing their producrs as bcing less risky than
rhose of their competitors, re tail invcstors irre
likely to give up even more yield. 1'he trade-
off benveen buying a sccurirized asscr swap
and buying a more liquid bond is rhat you are
likely to have less liquidiry. "Mosr
of rhc prod-
ucts we sell are customized for clients," savs
Steven Blakey, managing director, interna-
tional credir trading, at Merrill Lynch.
"Vc
rvill always give rhem a lair bid if rhey rvant ro
sell it. They can go to anorher securities house
with the underlying srrucrure, but rve haven'r
known anyone to sell elscwhere. Because
many of our clients use the marker as a subsri-
tute lor medium-term notes, bid/offer spreads
have ro remain quire right. But only zoolo o[
our clients look for liquidiry in rhis product."
Steers and Sires
Although the use of spvs to sell assct srvaps is
not new, the increased focus on small invesrors
is. Merrill Lynch has been parricularly innova-
tive and successful in expanding rhe asset srvap
investor base. In 199o iVlerrill launched Steers
(structured
enhanced return trusts). The
market for Sreers alone exceeds $zo billion,
illustraring rhe potential. Bur Steers are aimed
at the us marker. in facr, they can only be
bought by qualified institutional buyers
-
investors who under the src's rule r44a are
able to buy and sell unregisrered securiries
without violating the sec's regisrration rules.
For the international market, Merrill has
launched Sires (secured individually repack-
aged exchangeirble securities). The Sires
programme consists of slvs in seven different
countries. Around z5o issues have been trans-
acted in zo currencies, including rhe Thai
baht, Malaysian ringgit and the Czech and
Slovak crowns. "lt is amusing to sav rhat prod-
ucts such as rhat launched by Paribas are nerv,"
DERIVATI}tsS
'...Lfld
swaps
thatlooklike
assets
tVhy
are there so few publicized funds which
look for'absolute returns on the uading of
over-the-counter derivatives? If swap dlalers
can make money on derivatives arbitrage,
then surely rhey can incerest invesrors in
buying into dreir expertise.
Only two institutions appear to be doing
this
-
Gomex Fund Management (Bermuda)
and Kleinwort Benson, Gottex started its
Global.Swap Fund in April 1993 and by
Jrr.rary
r994had produced an absolute
return of
3o%o
on around $9o million. But
in February 1994, along with most bond-
holders, the c Swap Fund lost nearly roTo of
those gains. Since April 1994 it has managed
to claw back a
370
return.
"It could have been worse," says manag-
ing director Martin N7alton, formerly at
-
Bank ofAmerica, who joined Gottex Finan-
cial Products in summer 1994.
"Lxt Fcbru-
ary we managed to close down the whole
po"rtfolio in about r/z hours on a stop-loss
besis."
,Gottex
and Kleinrvort argue that thel
virtue ofdealing in swips rather than bonds
is that they are highly liquid in the most
popular currencies and maurities. You can
buy exactly the maturiry and coupon that
you need.
'
Moreover, if you want to take a forward
Deutschmark interest rate position against a
French franc rate position it would take four
bond transacrionb, bur only rwo swap trans-
actions. "In the bond market you're
constrained by whatt available," says
says Blakev at N1crrill. "'We have establishecl a ont: country rvas dorvngracled, lncl the othcrs Ecu Libor pltrs 6cbp, though mainlv bccausc
rvhole rangc of strch vel.ricles since 199o." wcre not. They really neecl transparencv." oF .r play on withhoiding rax. Why do thcse
Hower.er, rhe majoriw of thc Sires issues :rre , The rnain ;lsset srvap invesrors rrc b,rnk-s, diflercnccs exisr?
not mted, :rnd this rvill always be a problem rvho form abotrt 8oo/o oF the markcr.
"-I-he
Asset srvaps rre nor 11 leveraqed product likc
lor the sm:rller investors. Merrill declined to m:rrket is mainly driven bv bank liquidin," the srructured nore. Lamenrs onc esscr swap-
relcase more details on S.ires, explaining thar it sa1,s Dorfman. Bur othcr investors includc per:
"-l-he
firsr re:rcrion of many new
is a proprietarv product. corporate treasuries
-
also invesring cxcess cusromers is thar esser srvaps cotLld lead ro
Mosr other phycrs have also uscd spvs. cash
-
fixed-incomc fund managcrs, insurancc losses Iike those suliered lrom srructured
"They
are part of tl're armoury," says
Jonathan
cornpanies, pcnsion funds and hedee funds. notes. BLrr the product is,,.ery diffe rcnt.'i'hcre
Nlany investors are not even ar the stage.r'here
rhey can understand the risks involved in an
,rrit ,r""p. Yields available on ilsser swaps arc
often in excess ol those available on more
convenrional securities. For example, thcre are I
a. number of wal.s for an invesror ro gain :rccess ;
to Republic of lrrly paper. Irrly hes jusr r.riscd
rcu5 billion in the syndicated loan market: rhe ,
return is six-rnonth Ecu Libor plus Sbp. But
by taking a verv illiquid Republic of Iralv
bond lrom the dollar market and execuring a
currency and intercst retc- swap, a rerurn of
Ecu Libor plus r;bp can be achieved. Iralian
c'rus (lixed-rare Ecu notcs) give a rerurn of
Dorfman, executive director ]t Nlorgrn Sran-
iey. Nlorgan Stanley launched a $3oo million
vehicle in
Januarl,called
Eagle Pier rvhich is a
"black
box" strucrure. This means that the
speci{ics of thc underlying assets are nor
knorvn. Investors are roid thar they rvill be
debt securities issued by one or more Euro-
pean Ljnion srates.
Tliese notes heve a triple-.r. rating, btrt
sometimes this m:ry not be enough reassur-
ance For investors.
"smaller
invcsrors may 6nd
it too complicared to rvork throueh the crerlir
implications each rime," says one banker.
"They
may rvorry abour rvhat would happen if
50 Euromoney
I
March 1995
Konstantin von Schweinirz, head of deriva-
tives at Kleinwort. "If you short a bond
youie risking liquidiry problems peculiar to
that bond."
Gottex's c Swap Fund specializes in'iela-
tive value trading ofthe orco cunencies
along the yield curve," says Valton. It takes
swap, cap, floor, futures, option and swap
tion positions, in maturities of up to ro
years, but typically it will hold a position for
"berween
one hour and six months", before
ripping up the swap or assigning it, sap
\W'aiton.
Kleinwort's Derivative Products Fund
does arbitrage in swaps, forwards and
options. Its test portfolio, begun with real
money in
January
r9gr, produced a rerurn in
Deutschmarl<s of
340/o.
But the real fund
could not have gone live at a worse time.
Starting at par in February
ry94and
dipping
to below
98
by May it did well to climb back
ro
99.650/o
ofis value by the year-end. "The
fund went through a sffess test in its 6rst
year," says von Schweinirz. "\7e can pride
ourselves on our stop-loss policy. It worked
well.
tVe
were able to ger out of structures
we'd got into."
Gottex has attracted $zoo million of
funds and expects that to rise to $loo
million by the end of
ry95.
Kleinwort has a
more modesr omr5 million in its op Fund.
\7hy dont these nvo have any rivals? The
entry costs are high. Gottex spent two ye,us
and $4 million on a risk management system
before it went live. It esmblished credit lines
and dealing relationships with nine bank
counterparties. Gottex invests in very short-
term aee and ee-rated bank certificates of
deposit and posts some of that with counter-
party banks as collateral. "'We have a daily
reconciliation with the banks," says Walton.
The c Swap Fund seldom uses the services of
swap brokers, despite the existence of Gottex
brokerage operations in Swiaerland and
Germany. "We'd only use a broker as a last
resort to assign something a little more pecu-
liar such as a swaption, a cap or a floor," says
Valton.
The Kleinwort op Fund has the advantage
of Kleinwortt long ercperience as a swap
dealer. Kleinwort was a founder member of
the International Sraps & Derivatives Asso-
ciation (lsoe) in r98y. The fund has coilater-
alized margin lines wi*r other banla. "'We
can deal with Kleinrvorr Benson as a coun-
terparty," says von Schweinie, "but we prob-
ably do that for less than roTo of our
transactions." As might be expected the fund
is strong on risk management. "lt's
more
important for us to be able to ger out of a
transaction than to get in. That's what we
tell our co unterparries,' says von S chweinirz.
"Stop losses are triggered automatically. But
once ir's triggered there's nothing to stop you
putting on the position again."
This is not a fund for retail investors,
more for Swiss private bank clients, or for
small banlcs themseives beginning ro experi-
ment with derivatives. The minimum invesr-
ment is Dmjoo,ooo or $35o,ooo.
The Global Swap Fund takes a minimum
investmenr of Ecur million. Gottex also has
other fun& under management which it
invcsts in a para.llel way. It runs an intercsr
rate strategt/ fund for Ermitage, a London-
based fu nd-of-funds manager.
Fees are about the same for the Gottex
and Kleinwort funds. The c Swap Fund
charges zo/o ayear for management, pius
zoo/o of aoy performance above rhe bench-
mark of Ecu Limean plus r.z5olo.
Kleinwort's op Fund charges z.5o/o ayear
plus r5% to z5o/o of the absolute return.
Bodr funds say they allow redemptions
monthly. "\7e offer investors monthly deal-
ing at last month's close," says \f'alton of
Gottex. A market source relates, however,
that it took him six months ro get out of the
Gottex fund, and that he found the prospec-
tus uninformative
I'et
complex.
-2J
is no leverage effecr of any sorr ancl rhe final
risk is that of the ur-rderlying crcclir yoLL are
buying." There is no need lor invcstors ro have
a vierv on intercsr ntes or currcncy move-
menrs. "lIyou ere heppl,buying a bond issued
bv Ford you
shouid be happy buying an asser
sw'ap package on Ford,'' says Karvandi.
A given credir can be availablc at diFicrent
vair-res in differenr markers because the indi-
vic{ual rnarkers lre driven by differcnr firctors.
Thcy r-rsually have dissimilar invesror bases,
geographically and in rerms of invesrment
criteria. For exlmple, most E,uroycn investors
are
Japancse
insriturions. l7hen rhese insriru-
DERIVATIYES
tions are buying, Euroyen paper will become
more expensive and yield less. An issuer thar
has bonds available in both Euroyen and other
currencies may become relarivelv cheaper else-
lvhere as a result.
Asset swap investors are
rypically
more
concerned with currency and interest rate
trends than they are with views on the credit
of the issuer. An investor is likely to be looking
at a ro-year European Investmenr Bank (ern)
Eurolira bond because he wants ro-year Lira
il,lT;JL,
because he particularly wants the
The swap market can move in a different
way to the underlying cash market. For exam-
ple, if interest rate changes are expected, swap
spreads will be driven lower when rates are
expected to decline and will rviden when thev
are expected to rise.
A-lthough opportunities may arise [or
buying a top-rated credit more cheaply due to
these considerarions, the best value opportu-
i-rities arise when bonds lower down the credit
scale are considered. Historicai[,]', spreads on
At\-rated securities are less volatile than those
ofrveaker credits because the spreads for lorver
rated issuers tend to be much more sensitive to
changes in perceived crediovorth.iness. Thev
are also influenced by the general economic
outlook.
"Because
many comPanies have
already improved their performance," savs
Dorfman, "the bulk of gains due to an
improvement in the economic environment
have already been seen."
Because rhe investor base lor lower rated
issuers is generally more limired, there tends ro
be less liquidiry
-
an opportuniry for assec
sweppers.
The slower movement of credit spreads in
the syndicated loan market offers an arbitrage
berween bonds asset-swapped into floating-
rate instruments and loans.
"Many times yield
spreads
[in
syndicated loans] are totaliy unrep-
resentative of those available in other markets
for a given credit risk," says Karvandi. The
Dorfinan: a move into corporate paper.
surge in syndicared lending during the last
year has created many opportunities, increas-
ing the number of names, especially lower-
rated corporates, on which asset swaps can be
based. "A marked change has been the willing-
ness ofinvestors to buy corporate paper," says
Dorfman. "As capital ratios at banks have
improved, banks are more able to commit
capital to gain exposure to corporate debt."
The asset swap market will therefore
continue to provide alternatives for investors.
As more products are developed to appeal to
the average Eurobond investor, they will also
become easier to trade. Some bankers even
talk of crearing a market in securitized asser
swaps which would provide an alternative to
Eurobond investment. "There
could be giobal
issues," says one. "If there were billions of
cheap French franc bonds and if these were
repackaged and issued, there would be lors of
liquidiry."
But others remain sceptical. "spvs will
always be tougher for investors to understand
than Eurobonds," says one us banker. "I'm
not sure that retail investors will ever really
understand how they work." I
BANCO
POPULAR
ESPANOL
Headquarters: 34 Velazquez St.
28001 MADRID - Spaln
Telephone: (341) 520 70 00
Telex: 44351BPE M
Telefax: (341) 577 92 OB
CONSOLIDATED
FIGUHES
as of December 31, 1994
(Amounts in millions)
Shareholders' Equity
and Minority lnterests. .Ptas. 293,439
Customer Funds.
TotalAssets
Loans and Discounfs. . . . .
Net lncome
Net Return on Average Equity (ROE).
Net Return on Average TotalAssets (ROA)
Number of employees. . . . .
Number of branches
Exchange rate at December 31, 1994: US $
1
=
(us
$ 2,227)
Ptas.2,355,816
(us
$ 17,882)
Ptas. 3,246,937
(us
$ 24,647)
Ptas. 1,891,076
(us
$
14,s55)
Ptas. 58,597
(us
$ 445)
22.85%
1.97 %
12,052
1
,810
131 .739 ptas.
Euromoney
I
March 1995 53