Contents

CDR Liquid Index data as at 16 October 2006

Source: Credit Derivatives Research LLC

CDR Liquid Indices
The CDR Liquid indices represent the CDS levels of the most-liquid names in their respective markets and ratings classes. Liquidity is measured by the number of bid-offers a credit receives. Index values are simple averages of on-the-run five year CDS levels.

CDR Global Market Depth™
The CDR Global Market Depth Index is a daily measure of how many names are actively traded. Liquidity is measured by the number of bid-offers a credit receives. Index values are counts of the number of names that exceed CDR's Liquidity Floor.

CDR Global Market Activity™
The CDR Global Market Activity Index is a daily measure of activity within the global CDS market. Liquidity is measured by the number of bid-offers a credit receives. Index values are simple averages of total bid-offers of all names that exceed CDR's Liquidity Floor multiplied by CDR's Global Base Liquidity Constant.

Options on the rise

No volatility, but there is more volume

Despite falling volatility, the credit options market seems to be gaining some traction at last. Investors appear to be more willing to use the instruments and in increasingly innovative ways – some have even ventured into options on tranches.

Options have always had an appeal, but have so far not lived up to their potential, according to one hedge fund manager. "Options on credit swaps make a lot of sense either as a hedging instrument or on an arbitrage basis. But the development of the market has been a bit disappointing and not met the interest we expected," he says.

Such interest is more likely to appear if volatility was to spike, but the market is not being helped by the current environment. As spreads generally grind tighter, realised volatility has fallen and implied vol has followed. At-the-money December volatility on the iTraxx Crossover, for example, is 33% – near historical lows – and is expected to decrease further.

Nevertheless, Simon Ong, head of European credit product management at JP Morgan, says: "Credit options have been active this year and we are seeing increasing liquidity as a growing number of investors are utilising the product. They are using them in a variety different ways to express directional views on spreads, their views on volatility, as well as in more complex trading strategies."

The market is even attracting the interest of more sceptical potential users. The hedge fund manager says: "While we haven't developed trading there yet, it is still an area that we think will be interesting in the future and are therefore monitoring it closely."

Increased options use is also having an impact on market technicals. Current skew curves are significantly flatter than at the beginning of this year, for example.

"Skew curves have flattened as market participants have been selling payer options with high strikes with a low volatility view and that spreads will grind tighter, combined with others buying receiver options at low strikes with the view of gap tightening in spreads," explains Ong.

Furthermore, he reports that strategies more broadly are becoming increasingly complex. "One recent trend has been to take a positive carry or theta view, i.e. on the pace of time decay in an option. Investors have been selling shorter-dated options expressing a view that there is unlikely to be a great deal of spread movement in a short period of time and their option position will increase rapidly in value as it nears expiry. This activity has been pushing down volatility more quickly in shorter dated options than in longer dated ones," Ong says.

Overall, focus remains primarily on index-based options. As Ong observes: "We see most activity in crossover of the three indices, and far less single name trades. But we also see increasing use of options on tranches as well, and have seen a number of recent trades."

Using options on tranches in the current environment has obvious attractions because the instruments provide a more leveraged way of expressing an underlying view either on volatility or on tranches. However, such a strategy is not for the faint-hearted.

The vast majority of structured credit investors currently find such products almost impossible to price. Even those with the most advanced models are not yet fully comfortable with the volatility of correlation and the dependency structure between correlation and spreads.

MP

Insider trading tackled

US trade association releases guidelines

The US Loan Syndications and Trading Association (LSTA) has issued, as an exposure draft, a comprehensive set of principles designed to help loan market participants handle confidential information. The move coincides with recent regulator concerns over what some have suggested are indications of insider trading seen in the credit derivatives markets, supposedly driven by misuse of non-public information from firms' loan businesses.

Dealers have affirmed their innocence at any kind of breakdown in what they insist are strong Chinese walls between business strands. Equally, their customers appear sanguine about the development.

"Credit derivatives have been cited as a particular cause for concern. But if it was as bad as some are making make out, we simply would not be involved in the market. However, any guidelines that are introduced can obviously only be positive," says one structured credit investor.

"The bottom line is firms can't trade securities on insider information," comments Elliot Ganz, general counsel of the LSTA. "These principles were drafted to help identify principles, procedures and practices that will protect against the use of material non-public information by people who trade in the securities markets."

One fund manager is more cynical, however. He says: "Guidelines are all very well, as long as they're adhered to. That said, it's clearly more in everyone's interest to do so than ever before, because the non-self regulation alternative is far from ideal."

In its initiative, the LSTA says it brought together dozens of firms from throughout the loan market to develop the principles in an effort to make sure the guidelines meet the needs of large and small firms, hedge funds, banks and all other market participants. While the principles are designed to provide a clear framework for firms, they are also flexible enough to allow users to tailor their own policies to suit their particular business environments.

"We believe we've created a solid foundation with enough flexibility to address different business models to ensure that material non-public information remains isolated," observes Ganz. "A lot of people, representing many different types of institutions, recognised the importance of this project and devoted a substantial amount of time and effort to successfully develop these principles."

The document highlights a number of key concepts with respect to information in the loan market, reviews the "public" and "private" sides of information walls, and briefly considers confidentiality undertakings. Crucially, the paper warns that all prospective lenders – whether on the private side or on the public side of the market – are subject to the terms and conditions of confidentiality arrangements, whether or not they come into possession of material non-public information.

The document also outlines a number of principles and recommendations that aim to assist market participants in addressing the relevant issues:

• Loan market participants should implement and maintain information controls and related policies and procedures for handling syndicate information in order to avoid entering into securities transactions on the basis of material non-public information.
• A firm's information controls and related policies and procedures should be tailored to the nature and scope of its business activities and operations.
• Loan market participants should consider including certain key elements in their information controls, policies and procedures, such as information walls, trading restrictions, restricted lists and watch lists.

MP

"The prettiest girl at the dance"

Markit Trade Processing is the subject of this week's Provider Profile

Communicator Inc, now part of Markit Group Limited since May '06, was founded by Leo Schlinkert, ex-Salomon Smith Barney head of fixed income e-commerce, in 1999. The company was set up to help the buy and sell side communicate electronically, including the exchange of data on OTC derivatives trades.

The firm's many successes include Bond.Hub, which aggregates research from the top nine dealers on one platform for 30,000 buy-side users, and Connex, which sends over 10 million secure electronic messages between its 15,000 buy and sell-side users each month.

Leo Schlinkert

Markit Trade Processing provides derivatives counterparties with an STP tool, enabling the buy-side and sell-side to automate the processing of their OTC trades. As Schlinkert, now Executive Vice President and Head of Trade Processing and Distribution at Markit, says: "This is a solution that spans affirmation, confirmation, portfolio reconciliation and valuation."

He explains: "PIMCO and Blue Mountain co-designed the service with us, and the aim was for both sides of the deal to agree trade documentation data without manual intervention. Why have human intervention when, for example, 32 fields of documentation agree with each other? We don't provide the legal confirmation, but we do link to industry utilities such as DTCC, and remove the burden of having to manually review every trade documentation detail."

As dealers send their confirmations into the system, their clients agree each trade or make comments on exceptions. Because there are so many different trade capture systems on the buy-side, the formatting is converted to a common template before being sent to DTCC.

"This approach is good for high volume flow trading, where all fields are expected to match on both sides of the trade. However, only about 30% of bespoke credit derivatives trades are processed electronically, and the rest are manually processed, a situation that is similar in the other OTC asset classes," says Schlinkert.

Furthermore, the buy-side manages portfolio reconciliation in an entirely different way from the sell-side. Whereas dealers adopt a product perspective to address each separate asset class, their clients view their portfolios holistically. Schlinkert explains further: "A fund manager cannot go back to a pension fund and say 'I've got your portfolio reconciled and the confirmations done for equities, but not for credit.' They gave you $500m and they want to see you account for $500m, not just the $300m in equities."

"In this respect portfolio reconciliation is the big challenge. Right now many buy-side firms reconcile once a month, but they want to go daily, especially as derivative trade volumes grow. Statements from maybe fifteen different dealers are coming in, so you need to manage and track them. Markit's Portfolio Reconciliation is the prettiest girl at the dance right now," claims Schlinkert.

As vendors such as Markit seek to provide a full STP solution for derivatives, they recognise that capturing and processing all trades without intervention is unrealistic, or, as Schlinkert argues, undesirable. "The traders and structurers are by definition a step ahead of the operations guys since they're at the forefront of innovation, launching new products. The middle and back office will therefore follow, once it is clear what the new market or product looks like," he says.

Schlinkert cites the way in which the CDS market has changed over the last few years. "Try predicting all the new trades that have emerged on the back of this," he says. "Would a $100m back office have been necessary at the outset? So a bifurcation between flow and exotic markets has resulted, with an STP and non-STP type of trade."

He continues: "The operations guys tell traders they'll start building a system when they get to 100 trades a day, with 500 accounts. Before reaching these volumes, it is simpler to initially add manpower so that they can handle the 20 trades a day with 50 accounts."

As complex derivative instruments continue to emerge, a different set of tools is needed to help process the resulting trades. With an eye on recent concerns over the backlog of outstanding credit and equity derivatives trades, Schlinkert points out that a middle ground should be reached. "If you limit the innovative trades by demanding that automation is in place from the very start, the markets would never develop. Instead, you want to encourage an environment where operational systems are flexible enough to quickly react to new markets and new instruments," he suggests.

JW

Wilmington Trust expands CDO business

The latest company and people moves

Wilmington Trust expands CDO business
Wilmington Trust has expanded its capital markets business with the addition of collateral administration services for CDOs. The move sees Wilmington Trust forming a new subsidiary, Wilmington Trust Conduit Services, through which it will conduct most of its CDO services business.

The newly established subsidiary has recruited a capital markets team to lead the business, including Peter Vinella and Jeanette Jin. Prior to joining Wilmington Trust, the pair worked together at PVA International, a New York-based consultancy focused on capital markets and risk management. Vinella was the founder and ceo of the firm, while Jin was the president.

Eight people from their former organisation will also perform CDO operational and technology work for Wilmington Trust Conduit Services.

To complement its CDO services to the capital markets, Wilmington Trust has added Deborah McDonald to its corporate client services (CCS) client development team. She is a 28-year veteran of financial services and has led CDO business development efforts at State Street Corporation, US Bank and Wachovia.

McDonald has also worked in corporate trust business development at other major banks. She will partner with Christophe Schroeder, head of Wilmington Trust's European CCS business, to offer the company's CDO services globally to capital markets participants.

"The growth of the CDO industry has created a significant opportunity for us," says Bill Farrell, executive vice president and head of Wilmington Trust's CCS business. "This expansion leverages our core services and demonstrates our commitment to meeting the administrative needs of CDO investors and issuers now and in the years ahead."

The company's full suite of collateral administration, trustee, custodial and book-keeping services for CDOs includes compliance monitoring and testing, payment calculations and disbursements, record maintenance, trade settlement and the safekeeping of assets.

Merrill invests in credit fund
Merrill Lynch has acquired a passive, minority stake in DiMaio Ahmad Capital (D/A Capital), an alternative investment management firm specialising in credit products. D/A Capital manages several credit-oriented hedge funds, and has a substantial business in CLOs and CDOs.

As part of the deal, Merrill Lynch – through its hedge fund development and management group – has also committed proprietary capital to be invested in D/A Capital hedge funds. Further terms of the deal were not disclosed.

"D/A Capital has an outstanding group of investment professionals who specialise in innovative credit market solutions," says Dow Kim, president of the global markets & investment banking group at Merrill Lynch. "They have successfully built a valuable business, and we look forward to working together to further grow the firm by utilising the global resources of Merrill Lynch."

"We are very excited about this strategic alliance," comments Jack DiMaio, ceo of D/A Capital. "These additional resources will allow us to accelerate our plans to expand our capabilities for investing in the global credit markets, in our efforts to capture superior returns for our investors."

D/A Capital manages approximately US$2bn in hedge fund assets and over US$1bn in structured vehicles, based in New York. The firm's principal strategies are in credit investing, offering its clients investment opportunities in various hedge fund and structured credit vehicles. Founded by Jack DiMaio and Nasser Ahmad, D/A Capital spun-out from Credit Suisse Alternative Capital in April 2005.

Deutsche restructures research
Deutsche Bank has restructured its global research platform into three globally integrated groups: global company research; global equity strategies & quantitative methods; and global fixed income strategies & economics.

The global fixed income strategies & economics group will now also contain quantitative and fundamental credit strategy, and will be headed by Marcel Cassard. Ross Jobber will become coo for global research, having previously been associate director of European company research.

Guy Ashton, currently head of European company research, will assume the new role of head of global company research. Stuart Parkinson, who was previously coo of global research, will become the new head of global equity strategies & quantitative methods.

All of these appointments will report to David Folkerts-Landau, head of global research, and take effect immediately.

MP

Innovative Cortex closes

A round up of this week's structured credit news

Innovative Cortex closes
Cortex, an unusual managed credit CPPI structure that focuses purely on index tranches, closed this week. The US$150m deal was so well-received that a tap of a further US$50m is understood to be on the cards for as early as next month.

The transaction's triple-A rated principal protection is provided by Calyon and the manager is Avendis Investment Management. Avendis describes its approach as aiming to take advantage of "dislocated synthetic CDO markets by using the growing liquidity of IG index tranches to efficiently express correlation views...leveraging Avendis' structured credit platform with its strong track record amid difficult market conditions [and] de-correlation from pure credit spread products".

The manager will take long and short exposures to corporate credits through investment grade iTraxx and CDX indices and tranches, combined with single name CDS for specific risk hedging purposes. The deal offered 7-year notes denominated in either euros or US dollars, with a choice of either total return or contingent coupons.

Meanwhile, the hitherto equally unusual CPDO structure is proliferating. Following Merrill Lynch's REDI transaction, Barclays Capital and Lehman Brothers are in the market with their version of a CPDO, while Deutsche Bank is understood to have one in the pipeline as well.

CDO issuance cruises past 2005 total
Global CDO issuance through the third quarter of 2006, at US$322bn, has exceeded full year 2005 issuance by 20%. Issuance in the third quarter of 2006, at US$117.8bn, also exceeded issuance in the third quarter of last year by 30%, according to the latest quarterly figures from the Bond Market Association.

BMA says that relatively strong corporate performance and a large supply of loans, combined with the increasing size of the investor base and the flexibility provided by synthetic structures, have led to the significant increase in issuance. Cash flow and hybrid CDOs, with issuance of US$90.1bn, accounted for over 75% of issuance in the third quarter, the largest sector in terms of structure. Arbitrage CDOs, at US$106.9bn, were the largest deal type in terms of the motivation for the transaction.

Unusual emerging market CDO for Sydbank
Citigroup has priced a rare emerging market CDO – the US$400m Evolution EM CDO, issued via its Shamrock Capital vehicle. Managed by Sydbank Asset Management, the synthetic transaction offers exposure to a portfolio of local currency debt instruments issued by emerging market sovereigns.

The deal is notable in that the US dollar value of the debt will be written off if it moves against investors and eats into the subordination. But subordination levels can also be raised if the currency appreciates.

The US$120m triple-A rated super senior Class A tranche priced at 32bp over Libor, the US$40m triple-A Class B portion at 55bp over and the triple-B notes came in at 195bp. Generous credit enhancement is provided via subordination levels (the Class As offer 70% subordination), with the notes issued in bullet format maturing in October 2009.

The transaction references a portfolio of 35 entities, with limits in place to ensure there are no less than 20 and no more than 50 entities included.

Confluent offers increased liquidity
Calyon has closed the third tap issuance of the debut multi-manager CDO – Confluent Senior Loans Opportunities. Managed by Crédit Agricole Asset Management (CAAM), the product is the first CLO transaction to offer monthly liquidity through redemption.

Confluent is targeting a €2.575bn highly diversified multi-managed portfolio invested mostly in European and US leveraged loans, with a minimum of 80% invested in senior secured loans. There is also a portion of private loans in the pool, issued by speculative grade borrowers with higher guarantees and controls than those of traditional high yield bonds. According to Calyon, the strong demand for the asset class at this stage in the credit cycle can be attributed to the transaction's following characteristics: the substantial floater coupon payments and the senior secured capital structure.

Arranged by Calyon, the Confluent Class B subordinated notes offered to institutional clients seek to return Euribor or Libor +450bp, with a leverage effect of approximately 2.5x on a loan portfolio that has a target volatility of 4% under Calyon's and CAAM's simulations. The leverage is provided by Calyon, which has underwritten €1.575bn of the Class A notes. With this product, the bank hopes to provide investors with the opportunity to diversify their fixed income exposure with sources of performance that are de-correlated from traditional products in the asset class (such as government or corporate bonds).

While CAAM is the "senior manager" on the deal, Confluent is sub-managed by five top-tier leveraged loan asset managers: Ares Management; AXA Investment Managers Paris; Intermediate Capital Managers; Loomis, Sayles & Company; and Morgan Stanley Investment Management.

As senior manager, CAAM selects the "sub-managers", allocates funds to them and monitors their performance. It rebalances the funds if required from one manager to another (including new sub-managers), as well as managing the fx hedging, optimising the cash in the structure, managing the leverage along with optional redemptions, and monitoring the rating. Each sub-manager manages its allocated funds in accordance with specific portfolio limitations.

This product is funded through two classes of notes, the Class A notes that provide the leverage and the Class B subordinated notes offered to institutional investors. Rated by Moody's, the Class A tranche is a triple-A revolving term note, while the Class B tranche is rated triple-B and is redeemable every month at its net asset value (NAV) under certain conditions.

Confluent has already issued €700m-equivalent of Class Bs (denominated in US dollars and euros) and will issue up to an additional €300m by the end of January 2007, based on the decision to limit the issuance of these notes to €1bn.

Fitch updates CDO criteria
Fitch Ratings has updated its global rating criteria for cashflow and synthetic CDO portfolios. The updates are part of the agency's commitment to keeping its rating criteria current, transparent and easily accessible for market participants. Specific revisions reflect Fitch's responses to recent market developments (originally published in separate reports), refinements to existing criteria and codification of existing practice.

As well as amending Fitch's cashflow assumptions, the update outlines a new CLO methodology which incorporates asset-specific recovery assumptions for leveraged loans, and summarises the agency's new interest rate stress criteria and its treatment of servicer concentration as it pertains to CDOs of structured finance collateral.

The agency's approach to rating a selection of secondary structural features frequently encountered in the European market is also outlined. These features include pro-rata pay structures, delayed draw and revolving notes, CDO equity and combination notes. It goes on to explain the use of Fitch's Default Vector Model as a CDO management tool for managers and its methodology for rating hybrid cash/synthetic CDOs.

Finally, updated criteria for synthetic CDOs have been consolidated with criteria for short positions and forward-starting CDS, synthetic CDO-squareds, use of the ABS pay-as-you-go template and criteria for managers' trading flexibility in the instruments. The amendments include a clearer description of Fitch's expectation for the number of dealers in cash valuation processes of corporate assets; the length of the valuation period for cash-settled ABS; the recovery rate treatment of banking and finance junior debt; and the use of dynamic portfolio guidelines for managed portfolios.

MP

Trading ideas - lifts, cars and homes

Tim Backshall chief credit derivatives strategist at Credit Derivatives Research suggests a negative basis trade involving ThyssenKrupp AG

Basis trades are often seen as the bread and butter trades of many credit traders. The systemic rise and fall of credit quality often exhibits itself quite differently in each of the cash and synthetic credit markets. The basis, or cash-CDS differential, tends to move on the back of a number of technical and fundamental factors.

Our survival-based valuation framework – which implicitly judges how rich or cheap bonds are to the CDS curve – allows us to screen our universe of CDS tenors and bonds for the cheapest bonds. The cheapest bonds (relative to the CDS curve) provide a good platform for any negative basis trades that we may feel are warranted – since we are buying the bond and our model says the bond is cheap.

Given that we have a list of 'cheap' bonds, we must then move to judging the basis between the cash and synthetic markets. We could simply buy the cheap bonds and buy protection in a 'close' maturity – hopefully locking in the relative value between the two markets. But there are a number of complications and preferences that we add to the list to ensure the most profitability.

These adjustments are combined into our adjusted basis figure. This adjusted basis provides a critical measure of the 'true' curve-based basis. If this adjusted basis is negative – i.e. bond z-spreads are wider than CDS – then we are satisfied that we have a strong candidate for a default neutral negative basis trade. A cheap bond whose basis is wide is what we are looking for and our analysis provides the steps to find that.

Our CDS-implied Bond Prices (CDSIBPs) are generated daily and all of the cheap bonds are then overlaid with our adjusted basis analysis. This provides us with a list of well-qualified negative basis trade opportunities. The critical next step is to look for execution ability. We are very confident of execution in the CDS market but the bond market is not so transparent and certainly not so liquid.

The Real Deal
Based on our survival-based valuation approach, ThyssenKrupp AG's (TKAGR) bonds are cheap to the CDS market. Specifically, the 4.375's of March 2015 bond is over EUR0.20 cheap to fair value. Exhibit 1, below, indicates the 'price-based' term structure of TKAGR and indicates that TKAGR bonds are trading both rich (shorter dated bond) and cheap (longer dated bond). Please note that both bonds have traded very actively recently and so these levels are very transparent.

Importantly the bonds that we pick are reasonably liquid and currently active –TKAGR is very active in the credit derivative markets and has very liquid cash bonds.

Based on our analysis of bond cheapness and market activity, the 4.375's of March 2015 is viable for the long bond leg of our negative basis trade. We must now look at the actual spreads to judge whether we are actually trading at a negative basis, and, maybe more importantly, can position ourselves with positive carry.

Comparing the bond z-spreads (for the active bonds) with the CDS term structure, Exhibit 2, below, shows that the bonds are indeed trading wide of CDS. Importantly, we must note that the bond is trading wide of its interpolated maturity-equivalent CDS (seven year) which reflects our second basis adjustment discussed above.

Exhibit 1

Exhibit 2

TKAGR's CDS curve is 'well-behaved' and has no serious inflexion points. There is also excellent liquidity in the seven-year on-the-run maturity. Additionally, we see solid two-way pricing on Bloomberg's ALLQ screens for the 4.375's of March 2015.

Exhibit 3

As seen in Exhibit 3, TKAGR's seven-year CDS has followed the broad market's trend this year as have the bonds with the higher beta nature of the CDS market showing through in the basis. As spreads tightened the CDS outperformed and as it sold off most recently, again CDS pulled closer to the bonds, though still wide. The current raw basis is around 20 basis points – which is about 10 basis points from its wides but the basis has been close to zero in the past. Given that the bond is falling in maturity all the time as opposed to the CDS in the Exhibit, we would expect the basis to converge but we do not and hence we see more of an opportunity to exploit the apparent mis-pricing.

Given that we have identified the TKAGR 4.375's of March 2015 bond as trading cheap to the CDS market (from our survival-based framework) and its z-spread as being wide of on- and off-the-run CDS levels, we must ensure that we account correctly for any premium or discount that the bond is trading at.

We must adjust for the impact of loss given default differences between the bond and CDS market. This maximum 'gearing' effect is translated into our adjusted basis and carry calculations. At current levels, the package has a raw basis of -15 basis points, and a positive adjusted carry of 18 basis points.

Over The Hedge
There are two significant risks that need to be hedged in a bond-CDS negative basis trade. The first is default, which can be accounted for primitively in the adjustments we suggested previously to the CDS leg notional amount. In a perfect world, we would suggest frequent re-hedging of the CDS leg to account for changes in the bond price, but this is impractical in reality.

The approach most frequently used by practitioners is to hedge based on the price of the bond. A bond trading at $110 would mean we buy 1.1 times the notional protection as we bought face value of the bond. A bond trading at $90 would mean we buy 0.9 times the notional protection as we bought face value of the bond. This approximation is, somewhat surprisingly, close to optimal in terms of a single CDS static hedge.

This default risk hedge amount – based broadly on the bond price change – is important to understand in that if the bond is trading a premium (over par) then we will be over-hedged in the CDS as the bond pulls 'down' to par over time. Correspondingly, if the bond trades at a discount (under par) then we will be under-hedged as the bond pulls 'up' to par as maturity approaches.

We have seen different approaches discussed as to how to solve this dilemma but we prefer to 'keep it simple'. A practical approach is to hedge the bond's default risk with the most liquid (and closest in maturity) CDS according to the average of current and final bond price adjustments. Our initial hedge amount should be based on a minimisation of expected loss in default– we calculate the initial hedge as (Bond Price – Recovery)/(Par – Recovery). For a bond trading at $110 and assuming a 40% recovery, the initial hedge amount should (110-40)/(100-40) = 117%. We should buy $11.7mm protection for each $10mm of face value bond we buy.

This hedge will, obviously, be over-hedged as the bond pulls to par at maturity. We would want to hold a 100% weighting in the CDS as we get close to maturity. So we simply average our initial and final hedge amounts – (117-100)/2= 108.5% - to arrive at our 'simple' initial hedge. We therefore buy $10.85mm protection for each $10mm of bond face value we buy. This hedge is, on 'average' our most optimal hedge.

We have a slightly more directional perspective on this hedge. Given that we are basically hedging the impact of default on our position, if we felt strongly that the credit was unlikely to default, then we would prefer to receive more carry for more default risk. Vice versa, if we felt that fundamentals were weakening and the credit was more likely to default, then we might prefer to be slightly over-hedged.

Once this hedge is put on, we will monitor bond price levels and default risks to ensure that our hedge is still 'close' to default neutral. This is more reasonable than adjusting frequently and paying the bid-offers, and even more importantly can often provide more carry in the short-term on a credit that is a low default risk.

The second (and often overlooked) hedge is the simple interest rate hedge on the bond. Our basis trade is positioned to benefit from any convergence of the credit risk perspectives of the cash and CDS markets and further, the bond is cheap on the basis of its CDS curve (only credit-risk based). We therefore must ensure that our bond is hedged against interest rate movements and the impact these will have on the price of the cash instrument. Note that the CDS is exposed to interest rate movements but only in the discounting of cashflows and this interest rate sensitivity is minimal (and we ignore it in this case).

Investors could choose to asset swap the bond to minimise the interest rate sensitivity but we suggest otherwise. The asset swap has a number of shortcomings (not the least of which are lack of liquidity, premium/discount bond price errors, and default cash flow timing mismatches). We suggest buying the bond outright – benefiting from the most positive carry – and hedging interest rate risk on a portfolio basis.

We assume that many investors will not be carrying a single bond exposure and therefore it is more efficient to manage overall interest rate risks in a portfolio context. Also, assuming that investors will be over-, or under-weight issuers against their bogeys (in the traditional fixed income shops), this portfolio-based interest rate risk management allows for a more direct allocation of funds that reflects the interest rate 'view' of the manager.

Given the cheapness of TKAGR's bonds, relatively wide basis and positive carry of our overall position, we suggest this negative basis trade (long bond and long protection) as a default-neutral way to pick up 15 basis points and potentially realise the bond's relative value differential.

Risk Analysis
This position is close to default-neutral and spread duration-neutral. There is a slight maturity mismatch since the bond matures in a bit more than seven years. This does not concern us as we expect convergence long before our CDS position matures.

Exhibit 4

We do, notably, understand that many investors would still prefer to understand the interest rate risks associated with this position. Exhibit 4 shows the overall and key-rate sensitivities for the bond that can be used to specifically hedge any residual interest rate risk and offers the investor some more insights into the price sensitivities of the position.

The trade has moderate positive carry – given the current levels. This carry cushion protects the investor from any short-term mark-to-market losses.

Since this bond is Euro-denominated, it does carry currency-risk for non-Euro-denominated books. Please note that all spreads have been priced according to European swap rates.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk with TKAGR CDS in this maturity as it is increasingly liquid. Our largest concern is execution in size in the bond markets.

Liquidity
Liquidity is a major driver of any longer-dated trade – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets. Our data on liquidity, created from the volume of bids, offers, and trades we see each day, provide us with significant comfort in both the ability to enter a trade in TKAGR and the bid-offer spread costs.

TKAGR shows excellent liquidity in the seven-year maturity and bid-offer spreads are narrowing to around 3 basis points.

Recent bids and offers (seen on Bloomberg's ALLQ) for the 2015 TKAGR bonds have shown excellent liquidity in both directions. We recommend the bond leg of the basis be worked first, looking for a price below EUR95.31 (our model fair-value).

Fundamentals
While this trade is technical in nature and not necessarily impacted by fundamentals, we must confirm there are no surprises in the short-term that could cause divergence between cash and CDS markets such as LBOs. The trade is based on the bond market being mis-priced relative to the CDS curve, rather than an expectation of general curve movements.

We believe that TKAGR's FCF (after capex, dividends) has a chance to remain positive through-the-cycle due to TKAGR's lower exposure to spot steel prices than certain other steel players and also due to an increased group share of more stable service-revenues as compared to previous years. We believe that in case of a larger acquisition, TKAGR would likely take mitigating steps to protect its investment grade status. TKAGR's announcement on July 3 to buy back up to 5% of its shares is credit neutral, as we believe that TKAGR would use these treasury shares for acquisitions, if necessary, to maintain its ratings.

There are no major concerns with this stable/deteriorating outlook, especially given the technical nature of the trade, the timing expectation of a correction in the bond market, and the expectation of CDS and bond markets reacting similarly to 'good' or 'bad' news, we are comfortable that the trade makes sense and that there is little potential for major differentials between cash and synthetic credit.

Summary and Trade Recommendation
The index roll's impact on the relationship between bonds and CDS has largely been unwound now and while bonds remain modestly rich (on average) to CDS, we note that opportunities for basis trades are beginning to resurface in BBB-land.

BBB- rated TKAGR's diversified industrial base combined with ongoing M&A rumours has left the longer-dated bonds trading relatively cheap to its CDS curve, based on our CDS-implied Bond Valuation model. The traditional z-spread-to-CDS raw basis is negative and our 'curve and bond price'-adjusted basis remains negative and shows positive carry.

Given a deteriorating fundamental outlook (driven by event risk concerns), we feel a default-neutral negative basis trade is an excellent opportunity to earn modest carry while waiting for the bonds to converge to fair value. With market realities, and the bond trading reasonably close to par, we recommend a slightly over-hedged basis package using a single CDS static hedge to pick up 16 basis points of carry.

Buy EUR1mm notional ThyssenKrupp AG 7 Year CDS protection at 64bps and
Buy EUR1mm notional (EUR0.971mm cost) ThyssenKrupp AG 4.375% of March 2015 bonds at a price of EUR97.083(z-spread of 80bps) to gain 16 basis points of positive carry.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2006 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).

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