Societe Generale offers game-changing credit derivatives for insurers

Antoine Broquereau, Global Head of Financial
Engineering, FIC;
Helene Schmitt, Head of Credit Pricing Europe

Societe Generale first developed tranches on iTraxx Crossover in 2012 and they have been an important part of our credit distribution business ever since.

Last year, one of our most successful tranche was the 25-to-75 to Default (Super Senior Tranche) providing exposure to the credit market via the iTraxx European Crossover Index, which is the most widely traded of the European credit indices, composed of the 75 most liquid CDS referencing European sub-investment grade entities.

This product is aimed at investors willing to have leveraged exposure to European High-Yield (HY) corporates, but need protection against first losses. We market the tranches with the recovery fixed at 0% as it is easier for clients to understand the loss profile in the event of default and clients are happy to accept the extra risk involved in return for a better coupon.

This structure has been proved popular over the past years in a Note format, but since 2013 we have utilized the same concept to create an attractive way to fund equity exposure in an environment where this is difficult due to low interest rates and funding levels.

Source: Societe Generale

The underlying reason for its continued popularity over the years is that in the current low yield / low volatility market environment, these super senior tranche Credit-Linked Notes (CLNs) allow investors access to attractive yields through easy-to-understand products, with clear, predefined risk profiles.By doing the structure in overlay format where all the premium / coupons are paid upfront to finance an equity call, we have created a very popular product which has been offering attractive upside potential with a relatively limited downside.

Finally, as of today, we are the only bank that manages to place the entire capital structure on Xover tranches. This has enabled us to hedge our correlation position effectively, therefore being able to provide liquidity and aggressive prices to our investors.

At the end of 2014, Societe Generale has launched its first LSE listed CLN in response to investor demand for ways to access the credit market in a liquid and flexible way. The CLNs offer an alternative to standard fixed-income securities, as they can be tailored to meet the needs of professional investors (within the meaning of MiFID), particularly in accessing credit names that may not be available in GBP and in small denominations.

Those instruments are offered within the LSE’s Order Book for Fixed Income Securities, an electronic order book for bonds launched in 2010 by the London Stock Exchange, allowing investors to trade UK corporate bonds.

CLNs can be bought and sold at any time during LSE market hours just like a share. The minimum trading amount for a CLN is one unit, which costs £100 at launch and which is expected to vary over time with changing marketing conditions.

As compared with ORB bonds, and against the backdrop of lower credit quality and longer-dated products offered in the market, combined with poor cash liquidity, Societe Generale’s listed CLN offers flexibility (currency, fixed and/or floating coupons), liquidity (daily, two-way), and attractive yields (in line with the market for similar credit quality exposure).

The aim of the CLN is to provide investors with regular income over the investment period and to return the capital at maturity. Such coupon payment and the repayment of the capital at maturity are linked to the credit worthiness of a single corporate. Since 2014, Societe Generale has launched five different CLN listed on the LSE, respectively linked to the credit worthiness of Marks & Spencer plc, J Sainsbury plc, Glencore International AG, Vodafone Group plc and BP plc.

The Codeis Smart Synthetic Crossover Note was first developed against a background of increasing liquidity constraints within the Credit Market. Over the past few years, fixed income has been the asset class of choice, with rates going down and generating significant profits on the back of accommodating quantitative-easing programmes.

This trend has introduced a liquidity issue, alongside traditional risks such as spread and rate fluctuations, from both the buyer and seller side. As a consequence, the reduced liquidity has made it increasingly difficult for investors to dynamically manage their exposure to high-yield credit. Additionally, the implementation of new regulations, including new leverage ratios and balance-sheet liquidity constraints for banks, has impacted the role of market makers and contributed to the current liquidity issue on High-Yield Bonds.

In order to provide an effective solution against this liquidity issue, the Codeis Smart Synthetic Crossover Note provides investors with a liquid investment vehicle in order to actively manage a high-yield credit exposure, especially during a liquidity crisis.

The strategy avoids liquid exposure to cash bonds while maintaining an exposure to both cross-over credit risk, via the SGI Credit Europe XO Index, and interest-rate risk, via a 5Y Eonia Swap Roll swap strategy. The structure of the product is thus constructed to produce a very liquid and transparent investment vehicle which offers the client the advantage of a tailored solution.

This structure has proven popular owing to its ability to provide an efficient solution to addressing the potential liquidity issue in the High-Yield Bond market. The underlying reason for the products’ popularity is its ability to enable investors to both efficiently manage their positions, even within a liquidity crisis, and maintain an investment in High-Yield bonds through a highly liquid structure.

The Codeis Smart Synthetic Crossover Note has demonstrated a strong resilience throughout the liquidity crisis, exhibiting an attractive and stable outperformance versus its benchmark, the iBoxx liquid High-Yield Europe since mid-2008.

Societe Generale has had very good traction with insurers recently on credit derivatives, in particular CLNs and credit tranches:

• In the current low-yield environment, insurers are looking for every source of yield pick-up they can get on credit assets; on top of their diversification into private placements, loans (infrastructure, real estate etc.) which has been well-documented, they are more and more active in CLNs, through which they can capture positive basis and leverage their investments;

• With the implementation of Solvency II, insurers now have an objective framework to compare risk and cost of capital-adjusted returns of investments: using it, they can identify how CLNs and credit tranches can help them generate not only greater absolute returns overall, but also greater returns net of cost of risk and cost of regulatory capital;

• Credit spread risk is one of the biggest contributors to insurers’ solvency capital requirements under Solvency II; as a result, more and more insurers are searching for solutions to optimise this capital requirement (reducing it at a lower cost than insurers’ own cost of capital) and are looking at credit risk hedging through CDS indices, index options and index tranches for that purpose.

In terms of yield generation, the main benefits of CLNs for insurers are:

• Positive basis: insurers which have an appetite for a particular credit can get a pick-up from investing in this credit through a CDS-based instrument rather than through a bond; the pick-up is often higher than the additional cost of capital related to the higher capital charge on credit derivatives than on bonds under Solvency II, leading to a net gain through the CDS in terms of cost of capital-adjusted return;

• Limited correlation priced between the Note issuer and the reference obligor on which the insurer sells protection: with unsecured CLNs, this allows insurers to effectively buy first-to-defaults on two credit risks on which they get the sum of the two credit spreads, optimising the leverage provided by the structure;

• Same capital treatment (0% capital charge) between European government bonds and credit derivatives on European government reference entities under the Solvency II standard formula currently: secured CLNs (where the issuer credit risk is fully collateralized by assets so as to mitigate it) on European government reference entities essentially replicate the pay-off a government bond for the same capital charge but with a considerable yield pick-up (most European government reference entities exhibit a positive basis);

• Flexibility: because they can be built out of simple bricks (CDSs and funding instruments), CLNs enable insurers to access the product that matches their requirements in terms of obligor sector, rating, maturity, risk and regulatory capital budget more easily than if they only rely on the bond market (where supply is limited). 

Find out more about Societe Generale Credit-Linked Notes.

For the official story on the LSE website, click here.