Societe Generale has begun marketing structured credit products to institutional investors in Asia and Japan, and believes managed 'constant proportional portfolio insurance' (CPPI) strategies will prove popular in 2006, says Francis Repka, regional deputy CEO for corporate and investment banking in Hong Kong.
Tight spreads in global credit are driving a trend among institutions to embrace structured products. "Most institutional investors allocate to fixed income and they need yield enhancement," he says, adding this trend will continue even if interest rates continue to rise. He believes as long as interest rates remain below 5%, investors will be hungry for enhancing returns.
CPPI structures are designed to protect principal as well as provide leverage proportional to the success of the underlying investment strategy. Repka says these products have only been around for a year or so.
Structured products emerged in the late 1990s as tools for banks to offload credit risk on their balance sheets to investors via securitization. By 2001 investment banks were appointing external fund managers to add value to the underlying asset portfolio. Since then new asset classes and structures such as CDO-squared have emerged, making structured products an asset class unto itself. The global low-yield environment makes these attractive to investors looking for diversification without breaching guidelines regarding credit quality, Repka says.
CPPI structures protect 100% of principal, but are also actively managed in order to increase leverage when the underlying strategy performs well and decrease leverage when market trends are negative, says Edouard Huntziger, financial engineer at SG.
Clients put in $100 and the bank works out what portion of that needs to be invested in triple-A rated securities, or deposits in order to ensure the principal grows to $100 by maturity. The remaining cushion is then geared up to 30 times synthetically using SG's balance sheet, resulting in a nominal sum that is then invested by the external fund manager, allowing investors to benefit from scale. Also, unlike many structured products, the degree of leverage in CPPI deals is usually held constant, provided underlying market conditions are good, unlike other products which tend to build in a decline of leverage.
Huntziger says past CPPI structures have added 150bp to 250bp over 10-year swap levels, depending on the underlying assets and the skill of the fund manager.
Although he declined to say which fund managers SG uses, he says the universe is limited, as the bank prefers managers that excel in all areas of credit research and have a long history, because they manager needs to perform well over the life of the CPPI product, which is typically seven or 10 years.
SG also stress tests portfolios to ensure that the one-day losses from a worst-case scenario are less than the original cushion of principal given to the underlying fund manager.
Repka believes that credit structures such as CPPI transactions fit in an institution's portfolio by providing principal protection but also allowing the underlying manager to engage in an array of active trading strategies typical of aggressive hedge funds. The managers achieve diversification via credit, duration and interest-rate plays as well as by investing in other structured products such as CDO tranches.