The GREENing of fixed interest
Local Government finance managers have been big supporters of the wave of collateralised debt obligation (CDO) issues that have been brought to the interest bearing securities market in recent years, attracted by the relatively high yields offered by the CDOs compared to their ratings bands. Another trend in Local Government financing is the adoption by Councils of Socially Responsible Investing (SRI) criteria, against which the suitability of investments is assessed not only on financial grounds, but with regard to their social and environmental aspects.
Sydney based investment banking firm, Grange Securities, has combined these growing trends with the launch in February of the Australian market’s first ethically based CDO transaction, with its Grange Ethical Entity Note (GREEN), a CDO-squared issue (that is, a CDO of CDOs).
Rated AA by Standard & Poor’s, the A$ floating rate note has a coupon set at 100 basis points over the three month bank bill swap rate. The structure is five underlying CDOs with pooled subordination, each of 100 equally weighted names, drawn from a portfolio of 255 corporate entities.
Where GREEN differs from other CDO issues in the Australian market is that the reference names have been selected using SRI screening methodology. The portfolio entities must be rated BB- or above: the most common rating is BBB+ (25 per cent of the portfolio).
The portfolio advisor is Milan based E. Capital Partners (ECP), a leading European SRI advisor. ECP derives an ethical investment universe, using negative screening (exclusion of companies operating in sectors that are not socially responsible), positive screening (selection of companies with high standards of corporate, social and environmental responsibility) and sector sensitive weightings.
ECP certified the initial GREEN portfolio, and will monitor it on an ongoing basis – any entities that become ineligible against ECP’s screening process will be substituted at quarterly review periods. The underlying subordination is pooled, allowing every dollar of subordination to be used. With guaranteed fixed recoveries, the subordination of each CDO can absorb seven defaults. Grange has calculated that GREEN is robust enough to withstand one instantaneous default at issue, or all BB and BB- entities downgraded one notch at issue, and still maintain its AA rating.
Backtesting by Grange shows that GREEN would not have lost principal if it had commenced on any year over the previous two decades.
Moray Vincent, Director Debt Capital Markets at Grange Securities, emphasises that ECP is managing the portfolio against ethically eligible criteria rather than from a credit perspective, but says there is “strong evidence that the ethical screening will be a positive for the credit performance.”
Vincent says Grange has been receiving strong feedback from its investor base that demand for quality SRI products very much exceeds supply, and has been looking to bring an ethically focused transaction to the market for more than a year.
“The difficulty has been finding a widely accepted index and ensuring ongoing ethical compliance,” he said. “ECP’s involvement addresses both of these issues.”
Michael Clout, Divisional Director Fixed Interest at Grange Securities, says the fact that ECP monitors the ethical compliance of the portfolio is actually a benefit to investors, because history suggests that securities in the ethical sphere actually perform better in terms of credit performance.
“Under the ethical criteria there is significant weighting to corporate governance,” Michael Clout said. “Because of this, ECP has been able to identify credits that are having issues well ahead of any problems, for example Enron, WorldCom and Parmalat. The governance queries arose well ahead of those companies being downgraded, or indeed defaulting. They’ve been able to pick up problems within those particular corporate entities anywhere from six to 18 months ahead of a downgrade or a default.”
Clout says GREEN aimed at the CDO portion of a Local Government interest bearing portfolio. “These assets particularly suit local government customers, in that the Standard & Poor’s ratings align with their specific investment guidelines,” he said.
For example, says Clout, if you look at bank floating rate notes (FRNs), the highest rated Australian bank is AA-.
“The comparison in terms of spread for a similar period would be the ANZ 2009 TCD, for example, which is trading at bank bill swap rate plus 13–14 basis points. That issue is rated AA-. Compare that to GREEN, a AA rated issue, which is paying bank bills plus 100 basis points. That’s a very attractive pricing pick up compared to a lesser rated corporate bond with a similar maturity. That’s important, because investors don’t want to be penalised financially for making the choice to invest ethically.” Michael Clout believes GREEN is well positioned to fill the gap potentially created in Local Government portfolios by the successful performance of securities with a shorter dated maturity.
“Some of the CDOs in the market have performed very well – their margins have contracted significantly – and that’s created the opportunity to take profits and switch into the ethical transaction at a higher margin,” he said.
Grange initially underwrote a transaction size of A$50 million but that amount has been covered and the firm is upsizing the transaction. GREEN settles on March 17.
“It’s pure coincidence, but that date is, of course, St Patrick’s Day,” Michael Clout said.
For further information please visit www.grangesecurities.com.au.
* Copy supplied by Grange Securities
