House of the Year in Credit Derivatives: Credit Suisse

A booming private credit market threatens to push banks even further, as assets under management in direct lending funds top $1.2 trillion.

Credit Suisse has, however, identified an opportunity to stem disintermediation. The bank draws on its expertise in credit structuring and derivatives to develop a range of financing, leverage and risk management tools for private credit funds.

This diversification away from crowded public markets, where banks have competed on aggressive funding terms, appears to be paying off. When a sell-off in the credit market in the last quarter of 2021 and the first quarter of 2022 left the Asia-Pacific (Apac) region’s credit business with gaping wounds, Credit Suisse’s structured credit business did not recorded no losses.

“We were in a pretty good position from a risk management perspective,” says Soumitra Bhattacharya, the bank’s head of Apac structured credit trading in Australia.

“It has allowed us to stay in the financing market this year, even though many competitors have backed down. We were always able to offer solutions to customers and help them navigate the market.

After a regulatory crackdown on leverage in China’s domestic housing market triggered a sell-off of developers’ assets, the bank deepened its structuring toolkit to find innovative ways to provide stable funding to developers. holders of bonds issued by troubled Chinese property developers. A renewed focus on idiosyncratic hedging instruments also proved to be the right move for clients when a shift in high yield credit markets rendered macro hedges ineffective.

Asian credit markets hit an inflection point in 2022 after a decades-long bull run. Soaring inflation and falling growth have sent stocks and bonds falling in tandem, forcing investors to rethink the traditional construction of a 60/40 stock and bond portfolio.

“In this environment, private credit has presented itself as an excellent complement to the standard portfolio to improve the Sharpe ratio in an inflationary environment,” says Jacqui Zhang, head of Apac financing and solution structuring at Credit Suisse in Hong Kong. Kong.

We could actually source bonds that many of our competitors probably can’t.

Soumitra Bhattacharya, Credit Suisse

Recent private credit growth has outstripped that of traditional bond markets. Assets invested in private debt funds are expected to more than double to $2.7 trillion over the next five years, according to hedge fund data firm Preqin.

The Apac region represents a small fraction of private credit assets under management globally, but Credit Suisse expects exponential growth as companies seek alternative and stable forms of financing. There is no shortage of players looking to invest in the space: returns are significant thanks to the illiquidity premium associated with private assets, while largely variable-rate financing provides a buffer against inflation.

The big names are multiplying. Blackstone plans to increase its private credit investments in Asia tenfold, and KKR raised $1.1 billion for a fund focused solely on the region.

“As more money moves into the private credit space, we will see growing demand for financing solutions,” says Zhang.

She adds that these funds are looking for more sophisticated tools, based on derivatives, to help them achieve their return objectives: “The use of leverage allows funds to achieve their return objectives with lower-yield, but higher-quality, rather than engaging in riskier trades. ”

Many transactions are structured with options or warrants, allowing investors more upside participation and improved returns.

The complete life cycle

Credit Suisse aims to cover the full life cycle of private credit, from origination to eventual exit of investments.

With crowdfunding, the bank makes loans to funds secured by undrawn commitments from investors and liquidity providers. These loans are typically used to meet the funds’ short-term capital needs during the early stages of the life cycle.

When a fund matures and invests in private debt securities, the bank uses the net asset value (NAV) facilities backed by the granting of loans guaranteed by the fund’s investment portfolio. A hybrid structure provides flexible, longer-term financing by automatically switching loans from the capital call structure to NAV financing as the fund draws on its commitments and expands its portfolio.

“Some of our customers who were with us at the capital financing stage did so because they knew we would be able to offer the hybrid installation down the line,” says Bhattacharya.

Credit Suisse also offers a range of swap facilities, including interest rate and currency swaps, which allow funds to hedge interest rate and currency risks in their underlying investments.

The renewed emphasis on private credit provided crucial cover when Asia’s credit bubble burst in late 2021. A few months earlier, Credit Suisse had noticed skewed risk pricing in public markets as banks consolidated under increasingly aggressive financing conditions. He says he has remained disciplined in risk-taking, choosing not to compete on risk terms and instead focusing on fundamentals and risk mitigations in his line of credit products.

On total return swaps, which provide synthetic exposure to debt securities or portfolios of single-name bonds, the bank has included triggers related to price declines, rating downgrades or events credit. More stringent covenants were included in loan documentation to limit leverage. Certain loan agreements have been structured to be deliverable in credit default swaps (CDS(s) to minimize basis risk when exposures were hedged by CDSs.

Credit Suisse has strengthened the coverage it provides to buy-side clients by expanding its “special lending” business. This sources bonds from long-only clients, such as securities lenders and private banks, and lends them to money managers who need short positions in high-yielding names as cover. The limited liquidity of these instruments means that Credit Suisse has been able to generate passive income for lenders to supplement their portfolio returns. Borrowers benefited from stronger protection than typically found in macro-hedging instruments such as Asian investment grade indices or Chinese sovereign debt. CDSs, which had proven to be adequate during periods of low volatility.

“On the hedging side, it works very well to be able to create short positions,” says Bhattacharya. “For the customers who hold the bonds, it creates a pretty good stream of passive income.”

He notes that the bank typically paid 6-8% of borrowing costs for high-demand bonds, and that figure was as high as 10% in some cases.

“Our main advantage is being able to find these bonds because we have global relationships with long-only clients,” adds Bhattacharya.

“We could actually get bonds, which a lot of our competitors probably can’t.”

For clients stuck with portfolios of tanking bonds issued by Chinese property developers, Credit Suisse offered leveraged equity notes. Euroclear-able notes filled a gap for clients seeking stable funding on distressed dollar-denominated bond portfolios.

By sharing a percentage of the upside with Credit Suisse, clients could lock in fixed-rate leverage for terms matching their bond maturities. If the bonds mature at par, Credit Suisse receives a percentage of the upside, and if defaults materialize beyond the initial investment, the bank suffers a second-order loss.

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