Prof. Ian Giddy, New York University
In early 2006 high yield bond department at Allied Irish Bank in Dublin was considering alternatives for managing the credit risk of a portfolio of bonds held by the bank. The portfolio had been acquired as part of a U.S. asset management company that the bank had recently purchased. The $300 million portfolio consisted of 38 North American names, all rated BB. The list of bonds is shown in Table 1 below. For capital requirement reasons, management wished to reduce the bank's credit exposure on this portfolio to no more than $20 million. Now the high yield group was considering their options. They had boiled the choices down to three possibilities:
1. Sell the bonds. Since some of these "junk" bonds had limited liquidity, Allied's trader estimated the bank would suffer from being on the wrong side of a bid-offer spread of approximately 0.5%. Some felt that this was not an attractive choice, as the portfolio had been purchased at a higher price than its current valuation -- interest rates had risen since the acquisition.
2. Hedge the credit risk using Credit Default Swaps. Allied Irish had a credit derivatives specialist, and she recommended the use of a CDS based on the Dow Jones North American High Yield Index. A number of banks offered over-the-counter credit swaps based on this index. The pricing of such swaps, available on the web site djindexes.com, is shown below ins Table 2. The advantage of this is that it would enable Allied Irish to retain the portfolio, hedging the credit risk only for as long as desired.
3. A third alternative was for the bank to set up a special-purpose vehicle which would issue synthetic asset-backed securities. The SPV would raise $300 million, but instead of purchasing the bonds it would invest the money in high-quality eligible securities. The $300 million would be raised via the issuance of several layers of asset-backed securities. The SPV would sell credit protection to Allied Irish by means of a credit default swap. Allied Irish would pay the SPV a fee for this protection. Each funding layer would be rated in accordance with a percentage subordination ("credit enhancement"), as indicated by the Fitch Ratings matrix shown in Table 3. The costs, they estimated, would be in line with recent deals listed in a Nomura publication (see link below).
Making the Decision
1. How would each alternative work?
2. Which would be the cheapest?
Table 1. The bond portfolio, listing issuer, rating, coupon, and maturity.
Table 2. The Dow Jones Credit Default Swap indexes, and their pricing.
Table 3. Fitch Credit Enhancement Matrix.
Appendix: Nomura CDO/CDS Update.