Credit Innovation on Cards for Equity-Linked Markets

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Byline: Shanny Basar

In 2002 the innovation in the European equity-linked market concerned the equity side but the next step is going to be innovation on the credit side of the equation, according to HVB Group.Inderjit Bedi, head of convertible bond distribution at the German bank, says in its Convertible Navigator report: "What we are going to see next is innovation on the credit side with credit spread options, first to defaults and so forth."

However, one obstacle to the development of the equity-linked market could be the immaturity of the credit default swap market. Bedi says: "We view the credit default swap curve inversion on convertible maturities as a serious impediment to the equity-linked markets."

Convertibles investors want to hedge the credit risk from buying a bond through a default swap. However, default swaps are traditionally quoted in three- or five-year maturities. If a convertible bond is issued that does not match these maturities the number of buyers outweighs the sellers, making the default swap more expensive.

Bedi says moves in the US market to standardise dates for default swaps on a quarterly basis may help the situation.

Michael Hammond, head of international equity-linked origination at Merrill Lynch, says the absence of default swaps for specific issuers is "not a deal-breaker" as the bank successfully placed issues for Man Group, the UK-listed fund manager and Friends Provident, the UK insurer, despite the lack of default swaps.

Hammond says: "In the US, one of the biggest recent innovations has been the CoPa (contingent payment) structure, which has the objective of discouraging early conversion by investors. Taking its lead from the contingent payment debt rules this structure, along with CoCo (contingent conversion), has revolutionised the zero-coupon market in the US."

Last year, Deutsche Bank issued the first credit-linked exchangeable issue in Europe. The [euro]183m ($193m) bond was issued by Deutsche itself, exchangeable into shares of Brisa Auto-Estradas de Portugal, the Portuguese motorway toll operator.

The Portuguese government sold its remaining Brisa shares to Deutsche Bank. The bank then issued an exchangeable bond into the motorway operator which is linked to Brisa's senior unsecured credit so that although the paper is issued by Deutsche, investors will buy credit exposure to Brisa. …