Contents

Post-roll surge

Record volumes ease spread pressure, but structured bid expected to return

The four trading days following last Wednesday's index roll saw record volumes of CDX and iTraxx index and tranche products traded, with strong two-way flow. "We've seen every kind of investor and trade in the market. From complex relative value plays to rolling vanilla positions," says one trader.

Another adds: "Volumes were far higher than around the previous rolls for two reasons. First, there are obviously more market participants than there were six months ago, all doing the usual roll trading. Second, spreads have been so tight for so long that the pressure released by the new indices enabled plenty of people to step in and put on trades that hadn't been open to them for a while."

Name substitutions and extensions in maturity mean that, post-roll, the fair value of the new indices is wider than that of their predecessors. The markets' technical drivers were added to by fundamentals, precipitating a general slight widening trend into late Tuesday. However, many observers expect the structured bid (i.e. substantial tightening pressure created by synthetic issuance and hedging) to return with a vengeance.

Dealers' synthetic CDO monthly hedging needs are already an estimated US$100bn, of which probably €40bn is in European names. And that number is expected to grow significantly if the increase in synthetic issuance around roll dates that has been the previous norm materialises. At the same time, correlation markets are likely to be additionally affected by CPPI-related activity.

"The most popular correlation position for CPPI strategies has undoubtedly been a long equity position delta-hedged with a short mezzanine tranche exposure. A key motivation for this is the substantial positive carry paid by such a trade," explains Domenico Picone, head of structured credit research at Dresdner Kleinwort.

In order to maintain a high level of liquidity and minimise rebalancing/leveraging and de-leveraging costs, a typical CPPI strategy will always have exposure to the on-the-run index. A CPPI product with a seven-year maturity would therefore roll its exposure onto the next series of indices every six months.

Most CPPI strategies have a limited period of time in which to move their positions to the new series – probably little more than two weeks from the roll date. Such demand from CPPI strategies therefore has the potential to drive down equity tranche spreads versus mezzanine in the first days of the new series, with the opposite effect occurring in the tranches of the 'old' series.

Picone says: "The effect has been seen, but not yet to a great extent. Comparing 26 to 21 September, the European indices have widened – so you would expect the equity tranches to widen by their delta. However, that has not materialised because of tightening pressure. The value has moved from equity to the mezz, which – again – is consistent with CPPIs being rolled."

The continuing extent of any such CPPI effect will, of course, depend on both the relative size of demand for tranche positions (as a proportion of the tranche market as a whole) that is driven by CPPI strategies, in addition to how the market anticipates this demand. "While CPPI issuance is difficult to track, given the private nature of such deals, we certainly expect the impact of CPPI-related trades to be substantial on the correlation market, particularly with respect to the new roll. In fact, the presence of such CPPI strategies should always be borne in mind, particularly when looking at the more leveraged end of the standardised tranche markets," concludes Picone.

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Asian caution

Credit investors in Asia ex-Japan remain hesitant about new products, despite market growth

Outside of Japan and Korea, Asia's structured credit markets are often thought of as lagging the other major financial centres. However, that characterisation is not entirely fair.

As one Hong Kong-based banker says: "We are building towards the autumn push for people to close deals in the next few months and there are a growing number of investors from the region looking to put their money to work in structured credit. Overall, there is a fairly strong pipeline of business out there, which varies from traditional CDOs all the way through to CPPI structures."

Nevertheless, the latter is yet to find large numbers of admirers. Hong Kong and Singapore are home to some of the more sophisticated investors in the region. But they also tend to be risk-averse, preferring pure CDO product – either in cashflow or synthetic format – because it has more of a track record, a well-understood ratings process and familiar arrangers.

"In both the Hong Kong and Singapore markets there are a number of investors who like the comfort they get from an established process. They are usually unwilling to be the first ones to dip their toes into the water of a CPPI or some such other 'exotic' product," says the banker.

However, the expectation is that attitude will soften as familiarity, either locally or globally, with newer products establishes itself. "We are seeing little innovations all the time from some of the more adventurous market participants," notes one structurer. "CPDOs, for example, are receiving some interest – and there are more enquiries about different types of equity pieces; more illiquid credit; leveraging credit on a single name or a portfolio; and exploring other asset classes, such as ABS."

Away from the two main financial centres in the region, other Asian markets are further down the curve still. But some – including India, the Philippines, Thailand and Vietnam – are seeing business, albeit only involving small numbers of investors.

The banker notes: "Activity does happen in the smaller markets: structures are done, but investors won't look at everything available in the structured credit world. Instead, they'll probably focus on a credit they know, such as their own sovereign, and try to jazz-up the return on a single name CLN by, say, leveraging it up or adding on a range accrual – particularly as a first step into the market. From there, the country's leading banks will hopefully start to move into other more complex areas if they are permitted to do so by internal controls and local regulations."

Meanwhile, in terms of flow business in the region, the CDS markets are fairly quiet. "We are still very much focussing on whether rates will pick up and, as a consequence, widen spreads to give the market a boost," confirms one Singapore-based trader.

He adds: "There is also the hope that Asia will pick up a bit in the future, as the markets in New York and London become overly efficient and investors start to look elsewhere. But for the moment – even though recent events in Thailand have put Asia back on the map slightly – spread moves were country specific, with the Thai sovereign CDS only moving out 10bp to 44bp. And that's not a big enough jump to attract significant flows."

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Efficiently matching investors' desires

This week, Andrew Donaldson, ceo of credit-specialist asset manager Credaris, answers SCI's questions

Andrew Donaldson

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: From Credaris's perspective, participation in the structured credit market wasn't really optional – it was part of the firm's original gene code. Let me explain: the investment mandate which the firm was formed on was the management of a legacy portfolio of pretty interesting credit assets that spanned cash and synthetic, tranched and untranched risk across the capital structure. It also had a fairly significant ABS proportion which has really meant that our three core competencies that we talk about today – single name relative value, structured finance and structured credit management – were all present when the firm was established at the end of 2003.

From my personal perspective, I've been involved in the evolution of structured finance and credit derivative markets since my time in the early days of the EBRD's treasury, where we built up a pretty respectable and innovative platform to make the most efficient use of the risk capacity generated by the Bank's liquidity portfolios. The first credit derivatives we wrote there were in 1992/1993. Obviously, the structured credit market as named was not around in those days. But if you consider that market's parents as being fathered by structured finance and particularly tranching technologies, and mothered by the tremendous risk transference flexibility of credit derivatives, then I guess I've been using those base tools since then.

So structured credit isn't really seen as an isolated activity here – it's just part of what we do. Over time and as these very interesting tools are applied across different collateral classes, we think it will be seen more as a powerful technology that investors will use to shape underlying risk as opposed to a separate bucket of risk. There are obviously a number of very compelling reasons to stay involved in the market, but for me the strongest is that one – the pure power of the tools to be able to customise risk/reward profiles to efficiently match investors' desires or liability profiles. In the environment we find ourselves at the moment – where the free lunch is a long distant memory – product efficiency becomes tremendously important.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: We see major developments in this space year after year and that's tremendous, but it's a bit of a tough question when you add the "significant" test. I guess standardised documentation has to be up there as, a bit boring but, so critically important. The dramatic increase in liquidity across the sector is a bit of a double-edged sword, but on balance is unquestionably very positive and significant. Evolution and some convergence in pricing models has occurred, but that's probably more inevitable than significant.

The most significant for me are not the technical developments; it is the gradual but real change in investor awareness. It's understandably taken a while, but the glacier of aggregate investor interest is now advancing and that's the most significant development. With more plan sponsors, insurance managers and other – particularly real money – investors understanding and using structured credit to sensibly improve the risk adjusted returns of their asset bases, then this market will have finally, and very deservedly, arrived.

Q: How has this affected your business?
A: We're a young and optimistic company, so we're just looking forward to this glacier affecting us a bit more! But seriously, this is how most investment technologies evolve. There is a gradual take up by innovation junkies who attract first participants that either see the opportunity or probably more likely needs the opportunity at that time. Then, as the model gets proven and as the systems and protocols evolve more and more, investors want or decide they need to participate. That creates a lot of opportunity for innovative, experienced and independent investment advisers – and I think we're on the cusp of a new level of interest.

Q: What are your key areas of focus today?
A: It's pretty straightforward: we want to immediately externalise our successful structured credit strategy into our fund platform and complement that with some CPPI-type deals that suit some investors' needs. We want to continue to innovate in the intersection between the traditional asset-backed market and credit derivatives and structured credit technologies. We're currently involved in funds, CDOs and single deals such as CPPI structures – the reason we are relatively product ambivalent is because we understand that one of the key attractions for new entrants is that the technology allows them to truly shape their risk to most accurately match the range of their investment needs from risk profile to legal form.

Q: What is your strategy going forward?
A: That's also very straightforward: we, like some others, are trying to build a modern credit specialist asset management platform. We believe that there is a lot of ore to be mined across the very diverse landscape that we'll just bucket generically as "credit risk" but have traditionally invested in as highly fragmented asset classes. You need a few things to do this: state of the art analytical tools and a particularly diverse pool of top grade people are the two critical ones. But you also must understand that the maturing child that structured finance and credit derivatives reared – structured credit – will be pivotal in delivering the most flexible and best quality returns to our investors – so an innovative culture strikes us as being essential.

Q: What major developments do you need/expect from the market in the future?
A: I think you can sort those into two buckets: technical needs and conceptual ones. Technically, you have to be pretty impressed with recent developments on things like standard docs and terms, liquidity conditions and the pace of innovation in some of those fragmented asset classes; loan CDS and CDS of ABS would be two very good examples. We expect that pace won't slow, so new indices and standardised tranche products should evolve and we look forward to that.

Conceptually, as an optimist I expect – no, I need – those institutions which regulate investment, either officially or by proxy, to remain open minded and really explore the effectiveness that innovative investment product can deliver. Thank heavens we don't read that "derivatives" has been appointed the fifth horseman of the apocalypse quite so often these days. That said, you still get the impression that many commentators prefer the comfort of the status quo from the positivity and efficiency that a culture of innovation can deliver to satisfy end investors' needs.

Two things that the last 20 years has taught me is that change will probably happen faster than I think, and the unexpected certainly has a non-zero probability of occurring. If your culture is open to that, you're going to better equipped to deal with these realities.

About Credaris:
Credaris is a London-based credit-specialist asset manager with a successful track record in secured finance, corporate and structured credit markets. The company has approximately EUR1.2bn of capital under management. Credaris provides investors access to the dynamic and rapidly evolving credit market through tightly disciplined, strategy-specific investment vehicles. These include funds, structured products and managed accounts, depending on the needs of customers. Furthermore, it seeks to improve the risk-return profile of existing portfolios by way of active restructuring, hedging and diversification strategies. Credaris employs 25 people of which 17 are experienced credit professionals. The company was established in 2003 and seeded by HSH Nordbank. For more information about Credaris, see www.credaris.com.

"The devil's in the detail"

This week's Provider Profile centres on credit risk management specialists Point Nine Financial Technologies

Capturing a big slice of the booming credit-style hedge fund sector is risk management software provider Point Nine's mission. Hedge funds' usage of credit-based products is certainly growing quickly, although, due to their well-known dislike of disclosure, it is difficult to determine exactly how many active credit-style investors there are.

Len Fricker

Hedge funds typically outsource much of their non-core administrative activities, and often work with several strategic partners when doing so. Point Nine's appeal to the sector centres on outsourcing the management of operational risks associated with the complexities of ISDA documentation for credit derivatives trades.

Fricker explains further: "When you enter into a contract with counterparty, you need to capture every attribute of the trade within the paperwork. There are around 300 such attributes to each trade in the ISDA documentation, relating to areas such as legal and economic data, cash flows, and so on. Many are relatively standardised items, but nevertheless, in theory a default can result from a change in just one or two of these attributes. You need to be able to store and locate any cause of a change in a contract. A prime broker intermediating a deal between two hedge funds must be especially cautious."

Fricker points to the growing sophistication of both users of credit derivative instruments, and of the products themselves, as good reasons to be thorough with such documentation risk. Nevertheless, Point Nine's risk management system Finance Belt encompasses far more.

"We support not only the documentation, but users can also store curves, undergo stress testing and drill down into new deals, both within Finance Belt and on their own spreadsheets," Fricker explains. "Allowing users to import spreadsheets is a useful feature as most people undergo a lot of analysis on their own, but want to store results in the system. Cash flow reports are also generated which can then be handed off to T-Zero and then the DTCC."

The advantages of an all-encompassing risk management approach for hedge funds are clear to Point Nine. Fricker expresses strong views on how fund administrators and prime brokers left investors unsupported during the credit derivatives sectors' biggest fall out, in 2005.

"The default models employed to manage exposure to the auto sector's credits up to May 2005 were all wrong, that is now accepted. The devil's in the detail, and investors had no idea how exposed they were until the downgrade occurred to General Motors and the unravelling started. Regular mark-to-market is crucial, and in this complicated, dynamic sector you need NAVs coming in on a daily basis; monthly reporting, which is what administrators were supplying, is simply not enough," he maintains.

Fricker also cites the common theme of product transparency as a major contributory factor toward investors' inability to isolate potential problems. He explains: "There are pricing issues; dealers don't want full transparency, but they know they need to encourage the development of better models otherwise new investors won't get involved in the market. Investors need to be able to book and price CDS and the bespoke tranches they trade, and they require sophisticated analytics for CDO pricing."

With so many software firms now being attracted to the technology and pricing needs of the structured credit investor, a small firm should in theory find it tough competing with the larger established players for a share of this market. Fricker, however, sees a huge opportunity.

"The market we're targeting – hedge fund investors in credit derivatives and fixed income – is under-provided for," he says. "Hedge fund administrators have so far failed to come up with anything approaching a risk management system for their clients in credit. Prime brokers are also looking for a partner in this sector, so we have three ways into the market and therefore good opportunities to be a full partner."

Furthermore, he argues: "Our technology is based on an asp model, so the costs to the hedge fund are much lower than alternatives such as Summit or Calypso. We can go live relatively quickly with a client via the asp route – they're often faced with a year's build from other vendors."

At the same time, Point Nine is not intending to restrict itself to one type of structured credit investor. As Fricker concludes: "We're not just going to focus on the hedge fund sector. Other types of institutional investors active in credit derivatives are in the main using spreadsheets, so opportunities exist to help all buy-side players come to terms with the challenges they face."

JW

PIMCO targets France

The latest company and people moves

PIMCO targets France
PIMCO has named Marco Grzesik as head of business development for France. Grzesik will be based in Paris and Munich, and will report to Joe McDevitt, md and head of PIMCO Europe.

Grzesik comments: "This is an exciting opportunity to broaden our reach in one of the key markets in Europe. In an environment where alpha is proving increasingly hard to capture, we are committed to offering products that embrace a broad range of fixed income assets available in order to make our clients' assets work harder."

Grzesik is a vp of PIMCO and will work closely with Matthieu Louanges, evp and senior portfolio manager, who has extensive experience in the French marketplace. Grzesik and Louanges will work with the sales teams of Allianz Global Investors (AGI) across France to best position PIMCO in the French marketplace.

Grzesik joined PIMCO in 1999 and has most recently been based in Munich, where he worked as a product manager for emerging markets, global bonds and StocksPLUS products.

Moody's completes investment in China
Moody's has completed its acquisition of a 49% share of China Cheng Xin International Credit Rating Co. Ltd. (CCXI) from China Cheng Xin Credit Management (CCXCM), after receiving approval from the country's Ministry of Commerce and obtaining the updated business license of CCXI from the State Administration of Industry and Commerce. Terms and conditions of the transaction were not disclosed; however, Moody's will have the ability to increase its ownership over time, as permitted by Chinese authorities.

The companies also announced the appointment of Min Ye as ceo and Bruce Fan as cfo of CCXI. Ye is currently Moody's md of the Asian Structured Finance Group and Moody's representative director for China. He has been with Moody's since 1994, when he started as a structured finance analyst with Moody's New York office.

Fan joined CCXCM as chief information officer in 2003, and since then has held a number of senior management positions. Most recently, he was vice chairman of the company's credit business management committee.

CCXCM, established in 1992, was the first nationwide domestic credit rating agency created with the approval of the People's Bank of China. In 1999, CCXCM separated its credit rating business from its other businesses and established CCXI. CCXI, headquartered in Beijing with a staff of over 40 professionals, specialises in providing rating opinions on corporate bonds, convertible bonds, financial institutions, structured finance and short-term financing paper.

Moody's will provide management expertise, technical support on rating methodologies and analyst training based on its globally recognised company and structured finance credit rating experience. As a licensed domestic credit rating agency, CCXI will continue to provide domestic ratings reflecting relative credit risk within China, while Moody's will continue to provide globally comparable ratings for cross-border financings. Moody's and CCXI also plan to offer joint ratings to global issuers in the local Chinese markets.

Commerzbank hires head of Asia credit trading
Commerzbank Corporates & Markets (CBCM) has hired Michael Hyde as its head of credit trading, Asia. Hyde will be based in Singapore, where he has worked for the last 11 years.

In his new role, Hyde will be responsible for setting up an Asian credit portfolio in order to provide CBCM's European clients with products that give them the opportunity to access Asian markets. He will report to Eckhard Arndt, head of credit trading at CBCM.

Hyde joins CBCM from Rabobank, where he was executive director for debt derivatives, having joined the bank in 1998 to set up its structured credit trading initiative. Prior to this, he held positions based in Singapore at Bank of America – where he worked as head of Asian credit trading – and Standard Chartered Bank, as joint global head of trading.

Berkshire Hills names chief risk officer
Berkshire Hills Bancorp has hired Shepard Rainie as svp and chief risk officer. Rainie will be responsible for credit risk, derivatives, loan review and compliance.

Rainie spent 23 years with Bank of America and its predecessor banks, serving the last two years as senior vice president, credit review at BofA. In that position, he led a team of examiners and strategic risk assessment officers covering wealth and investment management, business banking and principal investing.

Send all your people moves to John Donnelly

BBA and Fitch predict continued credit derivatives growth

A round up of this week's structured credit news

BBA and Fitch predict continued credit derivatives growth
The British Bankers' Association (BBA) has released its bi-annual survey of the credit derivatives market. It confirms the increase in volumes revealed by ISDA (see last week's SCI) and adds predictions for continued growth.

The growth of the global credit derivatives market has outperformed the expectations of the 2004 BBA survey, which predicted a market size of US$8.2tr by 2006. This year's survey (based on responses from major dealers) estimates that by the end of 2006 the size of the market will be US$20tr.

Banks this year now consider that at the end of 2008 the global credit derivatives market will have expanded to US$33tr. And this growth is only expected to continue.

The report adds: "It is not just the size of the market that has continued to grow, but also the diversity of products. The expansion of index trades, tranched index trades and equity-linked products – to highlight but a few – have created an unprecedented variety of traded products in the credit derivatives market."

BBA continues: "As predicted in the previous survey, hedge funds have become a major force in the credit derivatives market, their share of volume in both buying and selling credit protection having almost doubled since 2004. Banks still constitute the majority of market participation."

Meanwhile, Fitch Ratings' latest annual survey of the credit derivatives markets finds that in a single year, index and index-related credit derivative product volume grew by more than 900% - reaching US$3.7tr, constituting 31% of gross sold positions. Overall, the agency found that the notional amount of outstanding credit derivatives contracts rose from US$5.3tr sold at year-end 2004 to nearly US$12tr at year-end 2005.

The report illustrates that, while banks continue to transfer credit risk to the global insurance and financial guarantor sector, the amount of protection purchased was down significantly at 37%, or US$159bn, from last year. That said, the industry did not move in concert with many large European banks that shifted from being net protection buyers to flat or even net protection sellers, particularly in the case of several UK/Swiss banks, while North American institutions were generally stable in terms of their net exposure.

For the first time Fitch's survey has also attempted to gauge expectations regarding growth for the market overall, as well as for specific product areas. Growth expectations varied from very robust to moderate or even slow.

Potential areas for future stagnation included vanilla CDS, CDO-squared transactions and options on CDS, followed by first-to-default baskets. However, growth was expected across newer structures in the market, including CDS of ABS and loan-only CDS.

Barclays updates CRE CDO primer
Barclays Capital has released an update of its Commercial Real Estate CDO primer (see SCI issue 6), which summarises its observations at a recent CMSA-Europe conference, namely:

• Synthetic CRE assets can also be included in European CRE CDO collateral pools.
• More realistic assumptions regarding Herfindahl index, asset and liability spreads in a numerical example presented at the conference might reduce IRR for CRE CDO managers, making issuance less attractive.
• Despite having (so far unsuccessfully) processed European CRE CDO transaction proposals for over a year, rating agencies remain optimistic in their issuance forecasts. The consensus forecast was for two to three European CRE CDO deals before year-end and approximately ten deals in 2007.
• The first European CRE CDO deals are expected to have conservative structures, ratings and pricing in relation to subsequent deals – making them more attractive to investors, but less so to managers.
• Investors require full due diligence on manager, structure and collateral assets, as well as robust ongoing reporting.

Pan-European SME CDOs continue to perform
Fitch Ratings says the European SME CDO market continued to be stable in Q206, with a reduction in the amount of outstanding defaults across most markets.

In its latest Pan-European SME CDO Performance Tracker, Fitch says Italian SME CDOs achieved a reduction of the outstanding default volume, as one transaction started to work out loans. However, German transactions – as a result of the default of Nici AG, a maker of soft toys, earlier in the year – have shown a sharp increase in outstanding defaults. Overall, SME CDO realised loss levels have remained relatively stable.

Four new issuances were seen in the German market: all of them belong to the mezzanine and schuldschein CLO segment. In the last quarter, Fitch has rated two additional transactions in Spain and one in Italy. Furthermore, the Bulgarian market saw its first SME CLO transaction, ProCredit Company.

T-Zero surpasses 100 buy-side clients
T-Zero, the credit derivative affirmation and connectivity provider, has announced that more than 100 buy-side firms have signed on to use its services, reflecting an accelerated pace of adoption. Launched just over a year ago, T-Zero was expecting to hit the 100 client goal by year-end. But strong interest by the buy-side is resulting in a substantially faster sign-up rate, the company says.

T-Zero's expectation is that it will continue to exponentially increase its buy-side user base over the next several months, as more dealers, prime brokers, fund administrators and other service providers connect to the service. Available as either a stand-alone system or through the Bloomberg Professional service, T-Zero enables financial professionals to affirm, allocate, novate and terminate trades with their counterpartys in real time.

Charles River and Princeton Financial integrate
Charles River Development and Princeton Financial Systems (PFS) have launched a new web services-based integration between the Charles River Investment Management System and the Princeton Financial Services accounting system (PAM). The integration of the two systems results in the seamless flow of real-time data and enables the buy-side to simplify and reduce the total cost of post-trade operations in the middle- and back-office, the companies say.

"This real-time interface makes daily operations remarkably efficient, while supporting a variety of asset classes, including derivatives, and providing advanced, real-time processing for position updates, intraday cash flows, cancel and replace orders, intraday corporate actions and synchronised trade updates," says Brian Buchinski, md, Product Management, PFS.

MP

CDOs - picking longs and shorts

Ratul Roy, global head of CDO strategy, and Ed Trampolsky, an associate in CDO strategy, at Citigroup in New York examine the opportunities offered by CDS of CDOs

The growing CDS of CDO market offers participants the opportunity to buy and sell protection on tranches of CDO deals, typically mezzanine-rated tranches, synthetically. Given the breadth of asset types that CDOs are able to securitise, this new market facilitates taking bull and bear views on CDO collateral, vintage, and even manager.

With no robust repo market, expressing short views with cash bonds had been almost impossible. Even for long-only investors, the CDS market has benefits, as participants obtain leverage by selling unfunded protection.

Investors may also be able to diversify across CDO asset classes and vintages where no cash bonds are readily available. With so much to choose from, investors are interested in picking the most suitable longs and shorts from the various protection bid and offer lists that are available to them. This article provides a few pointers on making the right choices.

Develop a collateral, vintage, and manager view
The first aim is to formulate a bull or bear view on the collateral. Better still, to do so in the context of a particular vintage and, if possible, the known performance history of the CDO manager (if it is a managed deal). If an investor is particularly bearish on recently originated residential mortgages, buying protection on a 2006-originated mezzanine ABS CDO may be the best choice for someone who wants to use the CDO route.

If the protection can be bought on a transaction managed by someone with a poor track record, the probability of exercising the protection some day increases. In fact, the lack of tiering in CDO liability spreads from deals with different managers may provide opportunities to buy protection relatively cheaply in such circumstances.

Likewise, an investor especially bullish on loan collateral originated in 2004 (when new issue LBOs were probably at lower multiples than today) may want to sell protection on CLO deals from 2004. A word of caution, however: prepayment may make the collateral today look substantially different from the day when the CDO was closed. The point is particularly valid for CLOs –borrowers have been repaying their loans rapidly in the recent few years.

The CDS market should also enable taking views on managers. A manager's track record should reveal how its deals performed compared to its peers from the same origination period for its equity and debt tranches.

As CDO investors are aware, a deal that was a poor equity investment may have performed very well for its debt tranches (because, for example, the manager was too conservative in picking its collateral portfolio). The opposite is also very possible. One indicator for manager and deal comparison may be the migration of deal performance characteristics (for example, average collateral rating and tranche coverage ratios) over time.

State of deal health
Taking a bottom-up view of the collateral and vintage as we have described above needs to be done together with an analysis of CDO performance of that vintage. Comparison of deal overcollateralisation (OC) and interest coverage (IC) cushions can also provide valuable insights to the relative strength of vintages. Figure 1 shows a comparison of OC and IC cushions for CLO and mezzanine ABS CDOs originated between 2003 and 2005.

Other deal features will also have an influence. In particular, if some portfolio characteristics, for example, average spread or collateral rating are breached or close to being breached, there will be constraints on the manager to trade. This may then lead the deal to breaking other hard triggers, which divert cash flows among tranches and cause a payout under the CDS.

Though vintage data as shown above provides valuable insights, the state of the specific reference bond is even more important. Breach of triggers for the specific tranche (or any other tranche within the CDO) can lead to amortisation of the tranche or other tranches. If the specific tranche amortises, the CDS notional can change.

Moreover, if any other tranches prepay, that can have an impact on the subordination below the reference bond of the CDS contract. Further, trigger breaches can lead to the bond deferring interest or PIKing, which can lead to a payout on a CDS contract.

Establish trade objective – tranche, timing, and CDS documentation
In addition to a bull or bear collateral view, one needs to establish the purpose of the trade, which should then lead to more specific requirements. Most protection sellers today are other vehicles, such as CDOs² for whom the biggest objective is making positive carry. Between default and spread (or mark-to-market) risk, most CDO vehicles are structured around default risk up to the maturity of the reference tranche.

The vehicle can unwind the trade at its market value at any point but will usually do so as a defensive measure in times of credit stress. The specific tranche, that is, triple-B or single-A, will depend on the vehicle's guidelines. Though at least four variations of the CDS on CDO contract are currently available, most CLO trades are done using Variable Cap, No Implied Writedown documentation (which more closely simulates an unfunded cash bond purchase). Investors executing ABS CDO default swaps also have a choice of doing Fixed Cap, Implied Writedown documentation. The premia will differ.

Protection buyers are more varied, and because every short involves negative carry, hedgers need to carefully consider their alternatives. Some of the key alternatives to consider include:

• Seniority of reference tranche. More junior protection, for example, at a triple-B level, will become valuable earlier than that at single-A, but in the interim costs significant carry. On the other hand, even if single-A requires less carry, protection payout as a result of tranche default may never materialise as the tranches are well insulated.

• Default versus spread hedge. As opposed to long-term protection from severe collateral deterioration (and the tranche not repaying par), the hedger may be more interested in short-term protection against widening of liability spreads. In such a case, the single-A reference bond above may turn out to be just as good over a short time horizon (after which the trade needs to be unwound). For shorter trades, the market's bid-offer spread will also be a key consideration.

• CDS form: writedown or not, type of cap. If there is a choice available, the decision between having implied writedown or not will have to factor any premium differences between the two contracts and whether one version imposes a Fixed Cap (which offers less protection if the reference bond defers interest, PIKs) versus a Variable Cap. Protection sellers who expect the CDO to PIK without really having a dramatic drop in OC would prefer the Variable Cap option, which makes good all shortfall (a Fixed Cap limits payout to the premium) in case of interest deferral.

• Ability to terminate early. Finally, protection buyers able to unwind their trade with no cost after a limited period have a valuable option for which they may be willing to pay an increased premium.

Having decided on a collateral and vintage view as well the CDS form, the question arises as to which is the right bond to go long (or short) among its peers.

Break-even analysis shows up bond differences
Certainly, not all deals are created the same and their performance may vary, even if tranches have the same ratings. The potential performance dispersion is particularly visible when deals have experienced some seasoning, that is, two or more years old. Analysis of cash flows of Baa2/BBB rated tranches from seven similar CLO deals closed in 2003 under the same scenario reveals that while tranches of some deals start PIKing only under very stressful default scenarios, others start PIKing at moderately low default rates (Figure 2). A counterparty that has the market knowledge, systems, and market access to discriminate among deals and source the desirable transactions will outperform.

Break-even analysis is an important, but not the only step. For example, the past performance of the deal (and hence one estimate of its future trajectory) and predicted manager behaviour, though more qualitative, are important too. Likewise, the deal may have structural features that help it to avoid deferring interest (leading to lower likelihood of a payout under the CDS). We describe these below.

Structure
In addition to running statistical tests on the cash flows of the CDO tranches, the participant should be able to qualitatively assess the strength of the tranches, as the future course of defaults may not mirror one of the stress scenarios. We add that no single structural feature is good or bad. The combination of all structural features, the quality of management, and the overall default environment will dictate the ultimate performance of the CDO bonds.

The key aspects to consider are: coverage ratios; turbo and pro rata features; and interest payments. These plus other factors are considered in depth in the full version of this paper – contact your Citigroup representative for a copy.

© 2006 Citigroup Global markets. This Research Note was first published on 19 September 2006, as part of a 'Global Structured Credit Strategy' report of the same date.