Counterparty selection
At Gilliat Financial Solutions we understand the importance of distinguishing between investment, credit and counterparty risk in our products. While investors understand the elements of protection provided against falls in the assets backing their plans, counterparty risk is something that should also be addressed.
As an independent investment specialist, we are free to transact with many counterparties. This enables us to seek out the most suitable counterparty for each given product in terms of risk and return.
The counterparty, with whom Gilliat transacts when structuring an investment, issues financial instruments and assets which deliver the investment returns linked to the product.
The capital protection element of the structured product often takes the form of a Bond, a form of corporate IOU, from a financial counterparty – generally an Investment Bank or other large financial institution. This bond promises to pay any interim fixed coupons and, in addition, to pay back a set amount on a future date to coincide with the maturity of the structured product. The quality of the bond, and thus the safety net of the investment, depends on the ability of the counterparty to repay the bond at the end of the term. In addition to the bond, other financial instruments are purchased or sold to reflect the required performance of the structured product. Within our product range, we maintain an active approach to monitoring the risk to clients’ investments that might result from counterparty failure.
Assessing counterparty risk is both an objective and subjective process using both rating and financial analysis together with qualitative assessments of management and market opinion.
Credit Rating Agencies
Our process starts when we monitor the ratings awarded to our counterparties by the leading agencies. This involves not only taking account of the current rating, but also taking note of the status of this rating, whether it is stable or on watch and how it has fluctuated historically.
The ratings assigned, in the form of letters, are used as a guide to indicate the level of risk, or possibility of default. The credit rating assigned to a counterparty will affect the price it has to pay when raising funds. This higher cost of funding often feeds through into better headline rates on a structured product. It is important to remember that this is a reflection of the counterparty risk being taken.
At the time of transacting any structured product, the counterparty, whose assets will represent the credit risk on this product, must meet certain minimum criteria:
- Counterparty and parent company must carry an investment grade rating BBB- or better with S&P and Fitch, Baa3 or better with Moody's.
- Government of parent company's domicile must be rated the same or better than the UK by at least one of the three main rating agencies.
The table below shows a comparison of the investment grade credit rating symbols of the three major Credit Rating Agencies.
For further information on the definitions of ratings assigned by each agency please see the following websites:
| Moody’s | Standard & Poor’s | Fitch |
| Aaa | AAA | AAA |
| Aa1 | AA+ | AA+ |
| Aa2 | AA | AA |
| Aa3 | AA- | AA- |
| A1 | A+ | A+ |
| A2 | A | A |
| A3 | A- | A- |
| Baa1 | BBB+ | BBB+ |
| Baa2 | BBB | BBB |
| Baa3 | BBB- | BBB- |
Financial Statements
Having made ourselves comfortable with the credit ratings assigned, we then look at the financial statements and ratios. Financial statements show the position of a company at a specific point in time and over a set period in the past. In addition, the statements provide an indication as to the viability of the company in the future. We consider both trends in figures and financial ratios in our assessment of financial health. We monitor capital, liquidity and earnings figures to build up a clear picture of the health of the counterparty.
Capital
We consider capital ratios as an indication of a company’s strength and ability to absorb potential losses. In particular we focus here on Tier 1 capital which is shareholder’s funds plus perpetual non-cumulative preference shares as a percentage of risk-weighted assets and off-balance sheet risks measured under the Basle rules. This figure should be at least 4%. We also track the Capital Adequacy ratio which measures Tier 1 and Tier 2 capital and should be at least 8%.
Liquidity
Liquidity, or asset-liability management, is an important element of the overall assessment of the Counterparty’s soundness. In assessing liquidity we look particularly at their ability to fund themselves under periods of stress. For example, what percentage of the company’s funding is provided by a retail deposit base thus reducing the requirement to fund in the wholesale market. It is also important to see the extent to which they are reliant on “confidence sensitive” funds to finance illiquid assets.
Earnings
We monitor such ratios as return on assets and earnings per share as well as the cost to income ratio as an indication of how the Counterparty is performing amongst its peers as well as whether performance is improving or declining.
Qualitative assessment
This includes areas such as the experience and commitment of the Counterparty to the retail structured product market, the experience of its management and the makeup of its customer base. This latter point is particularly important, as access to funding through retail deposits rather than relying solely on wholesale funding can be a major factor in times when credit is being squeezed.
Suitability
This covers the ability of the Counterparty to provide products in a form that is suitable for our client base. It addresses areas such as provision of tax wrappers, use of third party paper, collateralisation and secondary market liquidity amongst others.
Market opinion
Finally, we listen to what the market is telling us about the perception of a Counterparty. Here indicators such as share price movement and volatility, corporate bond yields, credit default swap rates, probabilities of default and market intelligence can all add valuable background information.
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