Risk Awards 2016
In the near future, when passengers arriving at Senegal's gleaming new international airport are able to motor to the country's third-biggest city, Thiés, along a newly constructed highway, few will be aware of the role played in their journey by a big, complex swap that was executed in July 2015.
The trade required 18 months of work, involved five parties – with Societe Generale Corporate & Investment Banking (SG CIB) playing the lead role in the structuring – and rested on a rare instance in which loan insurance was adapted to cover derivatives counterparty risk, slashing 50 basis points from the cost of the trade.
At the outset, there was no indication of the complications that lay ahead. In early 2014, Babacar Cissé, head of public debt in the Senegalese debt office, was seeking to raise $500 million to build two roads: the Niayes road, a 65-kilometre road network connecting remote areas of the country to the suburbs of Dakar, the nation's capital; and the AIBD-Mbour-Thiés road linking the country's new international airport (AIBD) to two major cities, Mbour and Thiés.
Cissé wanted to issue a 10-year US dollar bond and swap it into euros with a cross-currency swap. There were good reasons for this. US asset managers – the largest investors in African sovereign bonds - tend to prefer dollar-denominated debt. However, Senegal's currency – the West African CFA franc – is pegged to the euro, so swapping the debt into euros would dampen the impact of currency fluctuations on loan repayments.
When you look at a cross-currency swap of such a size and tenor for a B+ issuer, it's very challenging, and commercial banks were simply not there
Guillaume Simon, SG CIB
"When we planned for the loan repayments, we needed to have some visibility to avoid any change in the terms of the deal and any negative impact on our budget," says Cissé. "We needed something simple, and the cross-currency swap enabled us to swap the debt, which was denominated in a floating currency, for a fixed currency. This gave us greater certainty for our budget programming."
However, convincing a bank to enter into a $500 million cross-currency swap with a B+ rated counterparty would prove difficult.
"When you look at a cross-currency swap of such a size and tenor for a B+ issuer, it's very challenging, and commercial banks were simply not there," says Guillaume Simon, deputy head of the sovereign and financial institutions group within the global markets division at SG CIB in Paris, who worked on the deal. "There was no liquidity in the credit default swap (CDS) market for Senegal, so there was no opportunity to hedge the credit risk position with standard financial instruments. The capital charges associated with the trade were very high."
The capital consumption came from two main sources – the counterparty risk charge contained in Basel II, and the Basel III charge for credit valuation adjustment (CVA) that addresses future changes in creditworthiness.
Eight banks responded to Cissé's request for proposal, but the all-in cost to Senegal was high after dealers made adjustments to cover the CVA charge and the remaining capital requirement, known as capital valuation adjustment (KVA). Without CDSs that can be used to hedge counterparty exposure and reduce capital requirements, most of the banks were unwilling to take more than $50 million of the transaction.
"For counterparties [like Senegal] it's hard for a bank to unbundle the trades without any hedging of the CVA/KVA. There is no liquid CDS," says Emmanuelle Bournier, head of interest rate swaps and foreign exchange corporate engineering at SG CIB in Paris.
Some banks were willing to do larger tickets at better prices, but with a catch – Senegal would have to post collateral against the mark-to-market value of the swap, which exposed the country to liquidity risk.
The debt office was able to execute a $250 million cross-currency swap with one bank, but was unable to find a taker for the remainder – and without the swap, the project was in danger of being shelved.
Enter SG CIB: "We went to Dakar and we strongly advised the Ministry of Finance to stick with something simple; to stick with a plain cross-currency swap with no collateral. And we suggested leveraging the Multilateral Investment Guarantee Agency (MIGA) to solve the size and price issue; without their help it would have been impossible to do the deal," says Simon.
The NHSFO cover allows the banks to effectively replace sovereign risk with MIGA-implied AAA risk. So even with the MIGA premium included in the pricing, the all-in cost to Senegal was cheaper than alternative structures
Sidhartha Choudhury, MIGA
MIGA, part of the World Bank, promotes foreign direct investment by insuring deals with developing countries, but generally focuses on commercial lending. Derivatives counterparty exposure has some similarities, but plenty of differences as well.
"The swap contract Societe Generale entered into with the Republic of Senegal qualified for MIGA's non-honouring of sovereign financial obligations (NHSFO) cover because the government financial obligations under the swap agreements are unconditional," says Sidhartha Choudhury, a senior underwriter at MIGA in Washington, DC, who worked on the deal with Christopher Millward, MIGA's senior underwriter in Paris.
"The NHSFO cover allows the banks to effectively replace sovereign risk with MIGA-implied AAA risk. So even with the MIGA premium included in the pricing, the all-in cost to Senegal was cheaper than alternative structures. This is due to the high capital charges banks need to book on a credit exposure to Senegal and the lack of a CDS market to otherwise hedge the risk," Choudhury adds.
The MIGA warranty slashed 50 basis points from the cost to Senegal of executing the remaining $250 million cross-currency swap with SG CIB and two other banks – Citi and Standard Chartered – who beat off competition from other banks that had been invited to bid on the remaining $250 million.
Societe Generale was awarded the mandate of co-ordinating bank, while Citi and Standard Chartered were participating banks. Once the terms of the guarantee were fully agreed, Societe Generale co-ordinated the execution of the transaction with Senegal and the two other banks.
"The challenging thing was, when you structure a derivative, its value can vary. While MIGA's policies are traditionally designed for loans where the amount is fixed, the swap value can vary every day. So it took a few months to develop the proper structure, and we decided upon the mechanism that was most viable for everyone," says Simon.
The deal was important for MIGA too, marking only the second time it has guaranteed a swap transaction. "NHSFO cover on loans is a rapidly growing part of our portfolio, although thus far we have only covered two swaps on a standalone basis. MIGA cover on swaps makes the most sense when the country counterpart is sub-investment grade – however, we cannot offer the NHSFO product generally to countries with ratings below BB–. The MIGA product for swaps is less price-competitive for highly rated countries, since there are generally other ways to hedge the counterparty risk," says Choudhury.
SG CIB, Citi and Standard Chartered all pay a semi-annual ‘running fee' to MIGA for the warranty. The fee is calibrated to the amount of value-at-risk exposure the banks choose to insure. In this case, all three banks elected to insure $100 million of exposure.
MIGA reinsured a portion of that exposure in the private market.
In the event of a loss, the indemnity provided by MIGA is capped to the mark-to-market value of the swap at the point of default, with the banks retaining a piece of the loss.
The MIGA warranty allowed the banks to partially offset both the CVA and the capital charge for counterparty risk.
"We see this capability as a key additional we bring to the table, since the private market would have been unlikely to have participated in this transaction on its own. With MIGA fronting and structuring the product, reinsurers are reassured by its track record of minimal claims payments as part of the World Bank Group, as well as the rigorous underwriting process we have to effectively understand and manage the risks," says Choudhury.
SG CIB's capital markets team was appointed as the book runner for the issuance, alongside Citi and Standard Chartered. The deal was seven times oversubscribed, with asset managers making up more than 90% of the investors, 50% of which came from the US.
Senegal is paying a 6.25% coupon on the bonds.
"The whole deal took longer than expected for different reasons," says SG CIB's Simon, who made regular trips to Dakar to manage the transaction over an 18-month period. "First, we started discussions way ahead of the issuance because we knew it would be complex. The second part was about the due diligence done by MIGA. It's very detailed, and they go on the ground, see the sites, and check if people are being displaced. One of the roads was crossing a forest, so they were checking the environmental impact, for example."
MIGA has a long list of terms and conditions that must be met before it sanctions any deals of this kind. The agency's mandate is to help facilitate infrastructure projects, but it must also take steps to avoid any political or reputational risks. Therefore, it worked closely with the Senegalese government to design and approve the project.
The $500 million issuance was Senegal's third foray into the debt capital markets since 2009. Previously, it relied on concessional debt, which allows developing countries to borrow at below-market rates.
Of the three banks involved in the deal, Cissé reserves special praise for SG CIB, picking out the bank's role in structuring the trade.
"Based on our previous experiences, we came to the conclusion that the success of an issuance is partly due to a bank's network. In terms of the syndication, we needed to get access to a leading player in each region around the globe. One of our goals was to diversify our investor base and to find a bank that had a strong presence in Europe – with its main activities being in Europe – as well as a good footprint in other regions, especially in the US because the debt was issued there," says Cissé. "So one of the reasons we selected Societe Generale was due to its strong presence in those regions. But far greater still than that, what really appealed to us were the structuring terms."
The successful completion of the deal has put SG CIB in a good position to structure similar transactions for other sovereign issuers, says Simon.
"We've managed to recreate a similar transaction with another emerging sovereign issuer since, using another AAA supranational bank, clearly demonstrating that this efficient structure gives better access to hedging instruments for non-investment-grade issuers," he says.