Cash & Loans Advice Blog

Remember about the role you play in a credit

When we work in partnership, it is important that we honor our word and do what we agreed to do. When we do this, we demonstrate in action that we are willing to deliver what we’ve promised. Thus we enable others to feel confident that we will do our part and to concentrate on keeping up their end of the agreement.

Failing to do our part undermines the alliance. Rather than working to complete the task, time must be spent to rebuild the trust in the relationship. Over time, the partnership will dissolve because one party or the other will no longer find value in the relationship.

A primary reason partnerships are formed is to help us accomplish a task we do not have the skills to do ourselves. It is important that partners accurately assess their competencies and technical capabilities— both their strengths and weaknesses. When a partner is caught offguard by the other’s failure to deliver what he promised, this has serious repercussions on both the task and relationship elements of the alliance. It undermines the trust in the alliance and, consequently, the relationship.

Make sure you use the proper credit strategy

Basis trades/Convertible bond hedging: As an example the basis for Fiat widened massively following issuance of a 2.2 billion convertible and deteriorating credit sentiment at the end of 2001. It is worth mentioning that the negative basis trade (long cash, long protection) is not entirely risk-free. If the bond is actually restructured at the time of default it is no longer deliverable. The risk-free positive basis trade cannot be set up till maturity because one is not able to lock in the repo rate of the bond (short cash, short protection).

Capital structure arbitrage: These might be strategies where investors take a position in a default swap versus an equity put option. If equity is undervalued, CDS levels are tight and debt is rich the following strategy appears to be appropriate. For example, selling out-of-the-money puts versus buying protection allows to position for a rally in the stock/declining equity volatility and to “hedge” this opinion against the risk of the widening of spreads on the company’s debt. The option premium earned is used to fund the CDS, with positive or negative carry. It is important to realize that this is not a pure arbitrage or risk-free trade.

Improving credit quality and decreasing spreads

The factors that drive the widening and the tightening of the basis are explained below:

Factors that pull protection tighter (negative basis):

• Strong demand from protection sellers because of the unfunded nature of CDS and a lack of desired exposure/liquidity in the debt market.
• Synthetic CDOs can drive default swap spreads tighter because the manager needs to sell protection in order to buy synthetic credit risk into these structures.
• The existence of a default swap curve in 1, 3, 5 and 10 years can offer investors a broader range of maturities to construct a better portfolio.
• Assets trading above par, that is, the protection seller is exposed to a lower amount than the cash investor.
• Improving credit quality and decreasing spreads/basis volatility (CDS _ high beta instrument).

When a credit curve is steep

On the other hand, if one has a negative short-term view on a credit but believes it to survive for the next 5 years, its credit quality will improve significantly. This view can be expressed via buying a long-dated 30-year par asset swap and buying 5-year protection on the single name thereby creating a long forward spread position (or buying short-dated default protection and selling longer dated default protection). This position would benefit from a flattening of the credit curve.

A steep credit curve implies a steep forward credit curve. A forward default swap is buying or selling protection for the given maturity at a given point in the future at the forward CDS spread. For example, Munich Re senior 2-year protection is at 21 bp and the 7-year protection trades at 34 bp. Selling 2-year protection and buying 7-year protection results in a 5-year CDS two years forward (2 _ 5 spread) at a level of 40 bp.

How to pick the right credit option

Directional trades: This refers to a situation where the CDS market can be used to take a low-cost bearish view because of a negative basis. If the basis is positive and has widenend for “technical” reasons, it possibly represents an opportunity from a hedging-driven market dislocation. Next post provides an example for Siemens.

Spread trades: Investors who are positive about France Telecom relative to Vodafone can express this outperformance view via selling protection in France Telecom versus buying protection in Vodafone. Depending on the chosen credits this could result in high positive carry trades.

Curve trades/Forward trades: As an issuer’s credit quality deteriorates, the spread curve of the issuer moves from being upward-sloping to inverted. Default curve inversion may present an opportunity to shorten maturity and enhance yield. Curve inversion in the default market also allows investors to purchase forward protection at lower levels. This can be achieved by buying longer dated protection and selling shorter dated protection.

Building credit loyalty online

The internet makes it easier to achieve three key elements of customer loyalty: making it easy for customers to do business with you, satisfying your customers and ensuring that they come back. Furthermore, this can be accomplished at a fraction of the normal cost and, by building greater customer loyalty, sales costs are often reduced. There are several factors in building customer loyalty online.

Customers will come back to a website if they feel comfortable and believe it is relevant to them, but more needs to be done to develop customer loyalty. Customers must feel that the website is simple, helpful and intuitive; in other words, it must be easy to use.

The website must be responsive, understanding what customers want without marching them along a predetermined course. (This can be bad enough when a sales person does it; when a computer steers you in an unwanted direction it is particularly annoying.)

The information should be accurate as well as immediate. Customers should be offered the chance to question or change choices before confirming details without worrying that the service will be incorrect.

The website should be valuable, offering an element of service that is unique and cannot be found elsewhere, with options that are likely to suit the target customer. If an organisation can include all this in its website, the likelihood is
that returned shipments, adjustments to orders and dissatisfied customers will decrease, combining cost reduction with an increase in customer loyalty.

Reducing sales costs and improving credit efficiency

The internet enables sales people to have the latest, most up-to-date information to promote sales. This might include product information, testimonials, details of special offers and customer or market intelligence.

This information is particularly valuable when in-depth product information is needed, and it can be provided directly to distributors as well as the salesforce.

The internet allows products to be evaluated quickly and easily without assistance, which can be particularly valuable for complex products or rapidly evolving markets. As a result, product and technical experts can be used for greater value-added activities. Furthermore, if the sales system is effective, complex, customised price quotations can be prepared for customers, possibly without sales people intervening. This has various advantages: it provides an immediate response to customers’ enquiries, reduces the lead time for sales, ensures accurate hand-over of order details, and saves time and effort in taking and transmitting orders. In effect, everything is done better, more quickly and more costeffectively. It also provides accuracy, another hidden benefit of the internet. This not only increases speed but also leads to great reductions in waste. Furthermore, depending on the industry and product, it can lead to reductions in inventory costs as products are made to order.