Credit Distortions Push Structured-Note Sales Higher in Europe

Distortions between bonds and derivatives that BNP Paribas SA and JPMorgan Chase & Co. say will be a feature of European markets in 2013 helped push sales of debt-linked structured notes to a four-year high last year.

Germany’s DZ Bank AG and Landesbank Baden-Wuerttemberg together with UBS AG of Switzerland led sales of $42.7 billion in Europe and Asia in 2012, according to data compiled by Bloomberg. That compared with $40.2 billion the previous year, and was the most since $55.1 billion of issuance in 2008.

Investors are piling into corporate bonds searching for higher-yielding alternatives to government securities, pushing yields on company debt to record lows. The cost of insuring against company defaults in the derivatives market hasn’t fallen at the same speed, so investors get more from selling credit-default swaps than from buying bonds, a so-called positive basis.

“A big positive basis makes credit-linked notes a very attractive substitute for bonds,” said Rainer Overbeck, head of structured credit trading at DZ Bank in Frankfurt. The lender sold the most debt-linked structured securities in 2012, at $9.9 billion, Bloomberg data show.

When the cost of default protection exceeds the extra yield investors demand to hold a company’s bonds over the swap rate, or the z-spread, investors can profit by buying credit-linked notes that lock in the difference, said Overbeck.

Daimler Notes

Daimler AG, the maker of Mercedes-Benz cars and trucks, was the most popular corporate reference credit for the notes last year. Banks sold 16 securities worth $972 million tied to the company’s debt, according to data compiled by Bloomberg.

Five-year credit-default swaps on Daimler exceeded the z-spread on the company’s $2 billion of debt coming due in November 2013, which is the main reference bond for the notes, by 166.1 basis points on Sept. 27, the most since at least the beginning of 2006, Bloomberg data show. The difference is now 111.42 basis points.

Steelmaker ArcelorMittal is the company whose debt was most frequently tied to by structured notes in 2012, with 62 notes worth $554 million, Bloomberg data show. The basis between its five-year default swaps and its $1.49 billion of debt coming due in June 2018, the main reference bond for the notes, reached the most in three years on May 17 at 182.3 basis points, Bloomberg data show. It’s now negative 61.8 basis points.

Shell Basis

The cost of contracts protecting debt from default exceeded a measure of yields on about 400 investment-grade bonds from Royal Dutch Shell Plc to Paris-based yogurt-maker Danone SA by an average of 31.6 basis points in December, up from 24.9 in September, according to data compiled by Morgan Stanley. That compares with an all-time low of minus 116 basis points in 2008 and an average of 12.8 in January 2012. The data refer to corporates that are members of Markit Group Ltd.’s iBoxx indexes and also have an investment-grade rating and a liquid CDS contract.

“The positive bond-CDS basis prevalent in European investment-grade companies continues to make the switch from cash bonds to CDS attractive,” said Denis Gardrat, the head of European credit structuring at BNP Paribas in London.

BNP Paribas, JPMorgan and Credit Suisse Group AG are among banks recommending positive-basis trades in 2013.

Record-low yields on corporate bonds, which have helped create a positive basis for many European corporates, may cause investors to turn their backs on credit this year, said Gardrat.

Corporate bond yields plunged to a record 1.91 percent on Dec. 31 from 4.4 percent at the start of 2012, Bank of America Merrill Lynch’s Euro Corporate Index shows. Yields have since risen to 2.01 percent.

Credit-linked notes tend to have higher yields and tailored maturities that may not be available in the bond market, and as such the securities will prove popular among investors searching for yield, said Nordine Farsi, head of structured credit trading at Landesbank Baden-Wuerttemberg in London.

Investors in credit-linked notes suffer losses if the bank issuing the securities or the reference entity defaults.

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