Contents

Learning curve moves steeper

Hedge funds look for yield in more complex structures

Tight spreads have recently driven investors to move into longer maturities and higher yielding tranches (see SCI issue 5), but now active trading accounts are looking to more complex structures in search of yield. At the same time, less aggressive structured credit investors are now able to access a product previously only targeted at hedge funds.

"The search for yield has caused hedge funds to move into increasingly exotic products. We have seen strong interest in a wide variety of offerings, from forward-starting and digital exposures, to constant maturity structures," says one London-based dealer at a non-European house.

"Volumes in such deals have been growing dramatically recently, as have bespoke tranches. For example, 60-100% tranche deals have increased five times over in the past few weeks," he adds.

Marcus Schüler, md Integrated Credit Marketing at Deutsche Bank, confirms: "On the structured credit side, hedge funds are using some quite exotic and sometimes illiquid products. They are willing to look at non-standard exposures, such as recovery rate exposures and forward-starting exposures, where normally it is only worth doing if you are willing to trade in large size."

However, he adds: "Hedge funds are typically very liquidity focussed for a significant proportion of their portfolio. So, when they look at flow CDS they tend to stay with the most actively traded products. For example, such funds obviously put on a lot of curve trades, which they usually do by trading 5y versus 10y in standard contracts and do not usually ask for forward-starting CDS."

While curve trades may be standard for hedge funds, investors that trade less actively do not regard them as such. However, what is in common usage for hedge funds can be often become so for the broader market in time.

Over recent months hedge funds have been buying large volumes of zero coupon equity structured products (see SCI issue 4), but such exposure has now been made available in CDO form with the closing last week of Solent Capital's Clipper deal. The CDO is a US$150m-equivalent, principal-protected synthetic deal rated triple-A by Standard & Poor's.

The Clipper notes reference the zero coupon equity tranche of a synthetic portfolio, which includes primarily investment grade credits - although it also comprises some high-yield crossover names. The notes are triple-A rated for principal only by S&P.

Credit Suisse, which led the deal, has guaranteed a portion of the coupon for the first three years of the transaction, while a portion of the remainder will be set aside during that time to shield investors from defaults. Provided the deal has performed well and Solent has managed to avoid any defaults, investors will be able to call the notes after four years, and all principal and excess interest will be returned.

MP

Futures contract still on the cards

Eurex confirms it is on course after bank talks

Eurex has confirmed that it still intends to launch the world's first credit derivatives futures contract, following meetings with industry experts in London over the past week (see SCI issue 6). However, bankers and investors remain sceptical about whether an on-exchange product will be a success.

The proposed contracts will be based on the iTraxx index, but little else has yet been confirmed. "We intend to make an announcement regarding further details before the end of this year. In the meantime, we are working closely with the key market participants to make sure that the new product best meets their needs," says Eurex spokeswoman, Candice Adam.

The contract will also have to meet the exchange's needs, notably for standardisation. Consequently, a successful introduction of ISDA's new cash settlement protocol (see SCI issue 5) and some resolution over industry talks surrounding successor entities will provide it with a boost.

At the same time, it is understood that Eurex's initial desire to have contracts that expire quarterly to match its other products has been dropped. Instead, the proposed new futures will roll every six months in line with CDS indices.

Those in favour of futures argue that taking credit derivatives out of the OTC market and on to a regulated exchange could attract new users, particularly those who have mandates prohibiting off-exchange trading. "We believe that exchange-traded credit derivatives will meet investor demand for liquidity and transparency in the credit markets and offer increased risk management opportunities for our customers. Credit derivatives will also offer a new dimension to Eurex's product portfolio," explains Adam.

However, there are many others who disagree with the concept. "A futures contract is a low priority for us – good liquidity is available in large size using current arrangements. I can see that one potential driver of an exchange product is a reduction in counterparty credit exposure, but there are other ways of addressing this issue also," says one fund manager.

Bankers are equally sceptical. "Another issue facing an exchange is the internet and new technologies rapidly reducing the exchanges' control. Banks have been heavily investing in over-the-counter trading systems for CDS in an attempt to improve them. New trading systems linking traders around the globe have reduced the benefits of an exchange; over-the-counter trades can now produce remarkable liquidity and tight spreads. After such expenditure, banks have little motivation for moving to an exchange," argues one.

Additionally, e-trading credit derivatives platform Creditex owns the patent on the mathematical technique needed for the CDS price fixings, which Eurex will need to utilise for settlement purposes. "We have had numerous requests; however, we have not licensed our IP to any exchange," notes John Grifonetti, president and coo of Creditex.

It is believed that Eurex will pursue other providers if Creditex, as expected, refuses to budge on the issue. In the meantime, the other exchange considering listing credit derivatives futures contracts – the Chicago Mercantile Exchange – has not yet revealed any such plans and declined to comment.

JD

Third party managers

This week, Marcus Klug, md of Omicron Invest Management, answers SCI's questions

Marcus Klug

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: Our team began by working at UNIQA Alternative Investments, which was the structured credit investment management arm of UNIQA insurance group in Austria. We started investing in CDOs back in 1999 purely because we wanted to diversify away from interest rate risk into credit risk.

We realised that in terms of maximising our diversification in the shortest time possible, CDOs, thanks the exposure they offer to very large portfolio of credit, were the best solution for us. Furthermore, they are an ideal way to express your views – depending on how you see it; if you buy CDO equity you are also effectively writing a put on the high yield market. In 2002, in addition to our principal investment activities at UNIQA we launched a third-party investment franchise and became a CDO squared and ABS CDO manager.

In November 2005, we set up Omicron Invest Management so that we could continue that third-party business given that our management contracts with UNIQA had expired at the end of October. We felt they were not ready to go to the second step of development necessary for structured credit asset management for third parties to become a core strategy. The team that was involved in third party asset management at UNIQA subsequently moved over to Omicron and investors have chosen to transfer all our previous CDO mandates to Omicron and Cambridge Place – we continue to manage a US$500m CDO of CDOs and a structured credit opportunities fund.

Q: In your view, what has been the most significant development in the European credit markets in recent years?
A: The development of the synthetic market; meaning both the synthetic corporate market for such deals as CSOs or tranche trading and also the development of the synthetic market on ABS, including single asset-backed default swaps utilising the pay as you go ISDA confirms and so on. We believe that the latter will provide a dramatic boost to traded volumes in the secondary market because once it is possible to trade on a synthetic basis and not necessary to own or move the physical instrument, volumes tend to grow quickly.

Q: How has this affected your business?
A: Synthetics give us more opportunity to source or reference assets – if you are restricted to the cash market the universe is a lot smaller than if you can go to the synthetic market. Equally, the growth in corporate synthetics has widened the number of users and providers in the market and would hope that beneficial effect would also be seen with ABS.

Q: What are your key areas of focus today?
A: We are involved in the CDO market globally and buy mostly cashflow CDOs on either a cash or synthetic basis. We also trade US asset-backed CDOs and are active in the European RMBS and CMBS markets across all rating categories.

Q: What is your strategy going forward?
A: CDOs and MBS are the cornerstones of our business and with the partnership with Calyon/Credit Agricole [see below] we have added a European leveraged loan portfolio management team. We feel this is very complementary to our investments in CLO tranches and we will continue to focus on the structured credit and non-investment grade credit markets.

Q: What major developments do you expect/need from the market in the future?
A: We expect that the ABS market will experience the same effect as has been seen with corporate bonds and the introduction of CDS, which then developed from CDS to tranche and correlation trading. In the ABS market people are moving from the physical ABS instrument to synthetically referenced bonds and from there we will see a move to tranche trading on the ABS index. We believe it is only a matter of time before there is a fairly liquid ABS tranche market.

Innovation has always been pretty good in our markets, but there are always structural changes that would be useful to better reflect those innovations. For example, it would be helpful if the ABX index becomes a bit a bit broader; there are currently only 20 names, but the plan is to extend it to 50 names, which makes sense, but ultimately it will have to be broadened further. It would also be helpful if the ratings agencies would be more progressive with synthetic credit risk exposures and fine-tune their correlation models and assumptions as some of these are too simplistic in their approach.

About Omicron Invest Management
Omicron manages about US$2bn in assets for institutional investors globally focusing on CDOs and MBS across the entire ratings scale. The firm was founded by Marcus Klug and Manfred Exenberger in 2005 and was acquired by Calyon this year. The partners continue to run the business and Omicron's investment process is completely independent from Calyon's investment activities.

The Omicron CDO management platform includes ten investment professionals for CDOs and MBS, a leveraged loan management team of five professionals and 20 support staff. The team has developed risk analytics to model CDOs and European MBS transactions and employs a comprehensive fundamental and quantitative credit underwriting process.

MP

"Money is often the last reason for moving"

In this week's provider profile, SCI talks to Piers Benbow, head of fixed income search at Hammond Partners

Head-hunting firms have long been viewed as the estate agents of the financial community – moving (intellectual) property around the market each year, without much of a thought for who gets burned and taking huge fees for the privilege. While this may be a true picture of some of the bigger search firms with large numbers of temporary staff looking to make a quick buck, it is perhaps not such an accurate portrayal of some of the more professional niche boutiques.

Such firms are often set up with the aim of 'partnering' with a few high profile investment bank clients, with a mandate to provide them with the high calibre talent that the banks require to justify their own eye-watering fees. One of those firms is Hammond Partners, which started in 2002 aiming to provide highly specialist search and selection to banks and, occasionally, funds.

Piers Benbow

This high level of search service is a long-term process, not a quick fix. It usually starts before year end, in October, when Hammond Partners refreshes its market knowledge and starts short-listing who is both suitable and available, and the all important - expectations of compensation.

"It can be up to a six month process these days," explains Benbow. "Banks are realistic that they'll inevitably lose some of their top talent – and in addition to this replacement they're looking to staff up across many disciplines. It's a long process that requires patience and dedication. Sales and marketing have been particularly active in recent times, witnessing huge churn."

This churn is theoretically good news for the search industry, but there is a downside. "Banks are increasingly aggressive in bidding-back key employees. We can spend six months to find the right person, agree the package, then the current employer matches the new package, or increases it – in some cases more than doubling their last year's compensation – and all our hard work goes to waste. You can see why we only want to work with sophisticated users of search, who are prepared to invest the time and effort in ensuring a quick and efficient process," Benbow says.

However, the rewards are significant when a search does work out. "We charge around 30% - it used to be 33% - and some firms go as low as 25% to win a mandate. Depending on the level of seniority the fee tends to be capped at between £150- £250,000," reports Benbow.

That cap looks set to come increasingly in to play given expectations for salaries for the next round of hiring, in spring 2007. Benbow says: "The market is more technical than ever and candidates have to be of the highest calibre; expectations are sky high as 2006 is proving to be a stellar year. We expect to see packages in the region of US$2m for structurers and marketers, and north of US$3m for some of the top structured credit traders."

Prices being bid so high can mean only one thing – demand outstripping supply. There is currently a dearth of talent. In recent years hedge funds have had an attraction that banks have found difficult to resist. But in some instances there is a drift back to the sell-side from the buy-side.

The big funds are now in reality small banks, so when someone goes over to a hedge fund, they are finding that the attraction of working in this sector isn't quite what they expected. The founders have all the control, but the infrastructure is weaker than in a bank, and with so many hedge funds chasing a return, there are fewer arbitrage opportunities in the market as well.

"The pressure is also enormous for hedge funds – a long only institutional fund can fall 3% in a year and as long as it is in line with the market, that's generally accepted. However, a top hedge fund is expected make double digit positive returns in the same market place, potentially up to a 15% swing, and investors are quick to reallocate their funds if the returns are not being made," explains Benbow.

As a consequence, his firm is seeing a steady flow back to the sell-side, where the platforms, distribution and pressure may be better. This is especially true of structured credit, where the infrastructure is that much more vital to success.

"So you can see why money is often the last reason for moving. It's increasingly formulaic, structurers, marketers and traders now have a clearer understanding of their payout than ever before with both employer and employee being aware of each others' position; in an efficient market place – the money is a given," observes Benbow.

There is still however a great deal of movement between the sell and buy side involving senior positions, and not just with successful traders starting their own funds. Benbow explains: "We have seen a significant number of senior sell-side individuals move into fund management. This is often a life-style choice, where the pressure is lower, but the job is still demanding. Asset gathering, fund management and marketing positions become attractive to those who have given 20 years to the City and want a better balance in their lives."

While fund managers also have the ability to poach young talent out of banks as they are inevitably cheaper in their early to mid 20's, Benbow doesn't see much of a lure for these candidates. "For these young guns, money and prestige tends to be the headline incentive. At the end of the day, what up and coming twenty-something banker would chose Gartmore when Goldman is also knocking on their door?"

JW

Wachovia grows European CDO platform

The latest company and people moves

Wachovia grows European CDO platform
Wachovia Securities has expanded the capabilities of its European fixed income platform through a series of hires. "We have invested in some significant talent that will round out our capabilities in certain key areas of the business," says Atul Bajpai, ceo for Wachovia Corporate and Investment Bank in Europe, the Middle East and Africa. "We are maintaining a careful, measured approach to expansion, focusing on those areas where we excel as a company and can add the most value for our clients."

Brian Zwerner, md and head of global structured rates and correlation credit at Wachovia, adds: "Our goal is to extend our market-leading Global Rates and CDO platforms from the US to Europe." To this end, Hans-Peter Schoech has joined the bank's global rates group as director and head of structured rates and hybrids.

Schoech is based in London and reports to Zwerner. Prior to joining Wachovia, Schoech was a director at Dresdner Kleinwort, where he built the hybrid derivatives business as part of the exotic interest rate desk.

Mo Noubir and Arsene Lahoud have also joined the global rates team and are based in London. Noubir joins as director and head of European quantitative analysis and reports to Paul Romanelli, managing director and head of quantitative analysis. Noubir joins from Dresdner Kleinwort, where he was a vice president in the global derivatives product development group.

Lahoud joins as senior quantitative analyst and reports to Noubir. He moves to Wachovia from Goldman Sachs, where he was a quantitative strategist in the fixed income, currency and commodities division.

Schoech, Noubir and Lahoud join other key hires made in the Wachovia global rates group over the past year, including Nigel Dyble as md and head of global rates in London, Nordine Farsi as director and head of European structuring and Lei Zhang as a vp in the correlation credit group.

Alcentra adds three in London
Asset management firm Alcentra has hired three new members of staff for its European operations. Derek Jackson joins as an executive director and senior analyst covering stressed and distressed debt opportunities. He was previously at Kroll Talbot Hughes, where he was a senior manager advising classes of creditors and distressed companies on restructurings, turnarounds and distressed valuations.

John Griffith arrives as an assistant vp in the firm's transaction management team. Prior to joining Alcentra, he was a hedge fund supervisor for AIB/BNY fund management Ireland. Natalia Tsitoura has also joined Alcentra as an associate and analyst covering healthcare and general industrial credits.

Jackson and Tsitoura report to David Forbes-Nixon, cio and head of European operations. Griffith reports to James Algar, head of transaction management.
Alcentra was formed in March 2002 through the acquisition of Imperial Credit Asset Management from Imperial Credit Industries in the United States and in March 2003, through the acquisition of Barclays Capital Asset Management Limited from Barclays Bank in Europe. In January 2006, Alcentra became a subsidiary of The Bank of New York.

Bristow joins Goldman
Andrew Bristow, formerly head of asset-backed securities trading at HSBC in London, is to join Goldman Sachs. Bristow's precise role and start date are not yet known, but it is understood he will report to Mitchell Resnick who runs Goldman's structured products syndicate. While at HSBC, Bristow worked on both cash and synthetic deals.

Send all your people moves to John Donnelly

Smooth roll despite market nervousness

A round up of this week's structured credit news

Smooth roll despite market nervousness
Traders caught the jitters on the days running up to the index rolls today, 20 September, but the processes themselves appeared set to go without a hitch at close of business Tuesday.

The index markets have rallied over the last month as is normal coming in to the roll, but then on Monday and Tuesday market nervousness increased. As the roll date approached, some traders became less willing to buy protection in anticipation of a switch to the new on-the-run indices, but by doing so felt more exposed to widening, which occurred amid unusually high levels of trading for a period surrounding the roll.

As a result, levels moved around dramatically. For example, iTraxx Crossover widened by 8bp in a couple of hours Monday, before reversing in the same timeframe. Analysts pointed to a knee-jerk reaction to a liquidation rumour on hedge funds and to some investors getting long protection ahead of upcoming numbers

International Index Company (IIC) nevertheless announced on 19 September the successful completion of the rolls of iTraxx indices in Europe and Asia from its perspective. It also confirmed that Norges Bank and Bank of Montreal have become newly licensed market makers, bringing the total number of market makers to 38 on iTraxx.

Eight constituents were replaced in the main iTraxx Europe index, twelve in HiVol, seven in Crossover and nine in the Sterling SDI-75 index. One entity changed in the Australia index, four in Asia ex-Japan and four in the iTraxx Japan index. The smooth transition was attributed to the ordered way in which the roll now occurs.

"The name changes were as expected," says Marcus Schüler, md Integrated Credit Marketing at Deutsche Bank. "For example, with the 14 names going in and out of the Crossover index it was fairly easy to predict 13 if you knew what was trading, combined with spread and ratings changes. The only one that was tricky was Infineon dropping out due to liquidity reasons and there was no way to predict that."

At the time of writing, trading had not begun in the US, but the expectation was that all would proceed as planned – despite some confusion caused by a few last-minute changes. The new CDX IG7, HV7 and XO7 indices each have between 6 and 8 name changes, compared with their predecessors.

CDS hit US$26tr
ISDA has announced the results of its Mid-Year 2006 Market Survey of privately negotiated derivatives. According to the Survey, the notional amount outstanding of credit derivatives grew by 52% in the first six months of the year to US$26.0tr, from US$17.1tr.

The annual growth rate for credit derivatives is 109%, from US$12.4tr at mid-year 2005. For the purposes of the Survey, credit derivatives comprise credit default swaps referencing single names, indexes, baskets and portfolios.

The survey collects and aggregates notional amounts outstanding as of the reporting date, adjusted for double counting of inter-dealer transactions. ISDA surveys its Primary Membership twice yearly on a confidential basis. In this survey, 101 firms provided data. All major dealers responded.

WSA launches combined cash and synthetic platform
Wall Street Analytics (WSA) has launched the first single portfolio management and analytical platform for structured finance professionals who fund their credit risk exposures through both cashflow and synthetic CDOs.

Until now market participants in both cashflow and synthetic CDOs have had to rely on multiple platforms. WSA's new tool will enable clients to greatly increase efficiency by meeting their trading, pricing and risk management needs with one product while simultaneously reducing costs and vendor risk, the company says.

WSA says its new module incorporates the latest valuation models for bespoke CDOs, in addition to the existing functionality to manage, reverse engineer, structure and monitor cashflow CDOs. The module uses the 'semi-analytic technique' for pricing synthetic CDO tranches, allowing users to value bespoke tranches using the market spreads and base correlation curves of the standard tranches of iTraxx and CDX. Additionally, users can obtain 'The Greeks' performance statistics to optimise the composition of the basket of reference credits when structuring a transaction, and to evaluate collateral trades such as name substitutions due to a deterioration in the credit worthiness of a given set of reference assets.

HSH Nordbank is one of WSA's first clients to use the new module. "WSA has provided the right solution for us. They were open to customising their software to fit our needs when we only needed to analyse CLOs and have now improved CDOnet based on our input and their own research, delivering a tool that we use to monitor a portfolio that has grown in size to include a large number of synthetic CDOs backed by default swaps on loans and ABS," explains a portfolio manager of structured credit investments at HSH Nordbank in New York.

Fitch tackles CPPI and CRE CDOs
Fitch Ratings has released a criteria paper on credit constant proportion portfolio insurance (CPPI) notes and constant proportion debt obligations (CPDO) notes.

"The criteria paper comes in response to the growing presence of credit CPPI structures on the derivatives market, the recent emergence of CPDO structures, and the increasing demand from investors for a rating that addresses both the principal and a stated coupon," says Alexandre Linden, director in Fitch's European synthetic CDO team.

"Until recently, credit CPPI deals have either been unrated or assigned principal-only ratings that addressed only counterparty risk," explains Linden. "However, Basel II is now driving the demand for a rating on principal and coupon, which requires modelling the CPPI strategy as described in the criteria paper."

CPDOs are a recent innovation in the credit market, answering the growing need for a rated coupon (see SCI issue 2). "CPDOs are essentially a variant of credit CPPI; the main differences being a fixed coupon with no upside and different leverage rules," observes Richard Hrvatin, md in Fitch's US CDO group. "Like credit CPPIs, CPDOs give leveraged exposure to credit portfolios, although they do not offer principal protection to investors."

Meanwhile, in a report released last week, Fitch Ratings said that it expects the increasing importance of securitisation techniques for the financing of European commercial real estate to lead to a wave of issuance secured on this asset class. Lenders are exploring ways to sell the subordinated debt on their books and one way to achieve this is through Real Estate (RE) CDOs, which are firmly established in the US structured credit market and are set to jump the Atlantic to Europe.

Fitch observes that current market conditions are driving the transfer of B-notes to the non-bank sector. Basel II is likely to accelerate that transfer, as it will become more expensive for banks to hold B-notes on their books.

"Although this is an unproven exit strategy in Europe, there appears to be demand for the development of an actively-managed RE CDO sector among would-be managers and bankers seeking their share of the returns of a potentially highly lucrative business model. Demand is also present among investors seeking diversified exposure to a previously inaccessible cross section of high-yielding subordinated European real estate products," Fitch notes.

IIC to buy Goldman's credit indices
Goldman Sachs has sold its credit indices to International Index Company (IIC). Following a brief transition period, the indices currently known as the GS $ InvesTop Index and the GS $ HYTop Index will be administered by IIC under the names iBoxx $ Liquid Investment Grade Index and iBoxx $ Liquid High Yield Index. The companies expect to complete the transition by November 1, 2006.

Additionally, as a result of this transaction, Goldman Sachs will become a shareholding member of IIC. Terms of the transaction were not disclosed.

MP