Contents

Inward and onward

Structured bid and investors keep spreads narrowing

Spreads in the main US and European CDS indices have been driven tighter over the past week with (see this week's index data). To a large extent, the trend has been attributed to CPDO hedging, but that is only true in part.

"The levels we are trading at today are much tighter than where we thought we would trade, but the world has changed. The actual hedging, combined with the expectation of more hedging of CPDO structures will keep the market tight," says Marcus Schüler, md integrated credit marketing at Deutsche Bank.

He continues: "Over the last three years we have got used to the idea that credit spreads might be tighter than the fundamentals suggest because of the structured credit bid. A couple of weeks ago we were saying that the structured credit bid was much more solid than ever before, because you could take advantage of relative value in all parts of the capital structure thanks to the comprehensive range of products available – now there is another."

Schüler suggests that the effect of CPDOs on the market could be extensive. "More buyers will be brought into the market thanks to these new products. There's obviously a bit of a cannibalisation effect between triple-A rated mezz and CPDOs, but there's also the view that they will bring in additional and new demand," he says.

A report published by Citigroup's European quantitative credit strategy and analysis team notes: "We would agree that CPDOs – and the excitement surrounding them – are directly responsible for the outperformance of iTraxx relative to its intrinsics, and for the widening of the CDS-cash basis to a new, even more negative record level. But their impact should not be exaggerated."

The report argues that there are four key factors leading to this conclusion. First, CPDO structures are being issued at close to maximum leverage: investors will not have scope to buy much more within their own leverage limits if spreads widen.

Second, spreads have already tightened significantly and Citigroup has undertaken analysis that shows issuers would not achieve the 200bp target coupon with current fee and leverage rates unless spreads re-widen beyond 25bp. "This means that these new products are more likely to act like the conventional CDO 'backstops' than to drive spreads down to zero," the report says.

Third, there are some signs that the rating agencies are already backtracking on their triple-A ratings – perhaps because the mere presence of so many rule-based structures in the market could create an incentive for other market participants to lean on spreads and create forced unwinding later in the cycle. And finally, while anywhere up to US$2bn of CPDO paper has been issued so far with a market impact therefore of up to US$30bn, this compares with the US$100bn or so effect of global CSO issuance each month.

As a result, the Citigroup report says: "We think investors are overestimating the extent to which the recent rally is attributable to CPDOs, and underestimating the effect of their own change in positions. Our October investor survey shows the biggest one-month change in positions since September 2003."

It continues: "Both hedge funds and real money have gone long; the aggregate position is the largest since February 2005 – just before the March sell off. For us, this moves the goalposts: to have the market rally further, we need to see a still greater increase in positions, while any profit taking could cause a sell-off."

MP

Taiwan changes

Shifts in both the demand and supply sides

The Taiwanese regulator has confirmed that it will not ease regulations for one of the major CDO investor groups in the country. At the same time, new structures are emerging to attract new structured credit investors into the market.

Chris Hodgeman, head of structured credit marketing, Asia at ABN AMRO, says: "Taiwanese insurance companies – who have traditionally been very large buyers of foreign currency assets, including CDOs and structured credit more generally – are subject to a regulatory cap of 35% of their assets being in foreign currency. Currently, most firms are at or close to their caps and therefore their ability to invest in structured credit is curtailed. So, to return to the market they either have to grow their assets under management or, more expediently, the cap has to be increased."

The latter course, for the time being at least, has been blocked off. "Everyone in the market has been talking about the cap being increased to 50%, but the regulator – the Legislative Yuan – has just confirmed that it will keep the cap unchanged," reports Chris Lillingston-Price, head of structured credit sales, Asia at ABN AMRO

But Taiwanese insurance companies are understood to be putting together a consortium to lobby for an increased cap percentage. Even if the appeal is successful, however, an amendment is unlikely to come into force until mid-2007. In the meantime, structurers have begun looking elsewhere in order to tap investor demand.

"In the absence of the insurance companies, investment banks have been searching for different investors in Taiwan and have met with some success. The larger buyers of structured credit this year have really been the local banks," confirms Lillingston-Price.

Some Taiwanese local banks have also recently appeared as issuers of CLOs – a new product for the domestic market. "We have rated two transactions already recently and have had lots of enquiries about more," says April Chen, analyst Asia Pacific structured credit at Derivative Fitch.

She adds that issuance of CLOs backed by domestic assets is expected to increase. Most domestic banks, many of whom have exhausted their lending capacity for specific industries and obligors, deem CDO technology a solution to rebalancing their portfolios and enhancing the efficiency of their capital utilisation.

Local CLOs have so far been structured as a true sale of balance sheet loans to a special purpose trust (SPT), which then issues certificates. Such SPTs have been at the cornerstone of the majority of Taiwan's CDO market to date.

A regulatory-enforced shift of Taiwanese bond funds' holdings of failing domestic structured notes off their books has created a huge market in blended securitisations utilising overseas CDOs as a way of repackaging distressed structured debt into securities with attractive yields. Typically, the securitised pools comprise 50% Taiwanese dollar structured notes and 50% US dollar single-tranche synthetic CDOs. But how these bonds are put together is now changing too.

"We closed a couple of structured bond-related deals a couple of months ago and are working on something else at the moment, as are many other dealers in the market," concludes Hodgeman. "We know that some people are looking at principal protected-type products and, indeed, we are looking at the potential for including CPDOs as the foreign currency asset. We know that the regulator is keen on such structural innovations and a move away from what has become the commonplace use of standard synthetic CDOs as the foreign currency piece."

MP

Italian opportunities

Sovereign spreads make food for thought

The double ratings downgrade of the Republic of Italy in October caused a minor market reaction. However, since then both credit and fixed income derivatives markets have moved counter-intuitively, generating pricing anomalies.

Meyrick Chapman, head of derivatives strategy at UBS, observes: "Investors could be forgiven for forgetting the downgrade because, compared to pre-downgrade levels, Italian 10-year asset swap spreads are 2.25bp tighter and Italian 10-year CDS is 2.5bp tighter."

Furthermore, compared to Germany, Italian sovereign CDS are at equal tightest levels for the last year. Over the same period, 10-year EUR rates are approximately 8bp lower than on the day of the downgrade announcement, illustrating the relatively high volatility in Italian credit both in asset swap terms and CDS.

In addition, Chapman notes that it appears the supply of credit protection causing credit market-wide spread tightening is increasingly causing instruments to become more highly correlated. A rolling monthly correlation shows that Italy is now 81% correlated to the iTraxx Europe index.

"Italy is now clearly 'expensive' compared to our 'fair value' calculation of Italian 10-year asset swaps. As long as the supply for credit protection continues, Italy will most likely perform well in both CDS and asset swaps," Chapman says.

The impact of the downgrades goes beyond the sovereign CDS and asset swaps market, according to a report released this week by Lehman Brothers European structured finance research analysts. The report notes that shortly after lowering their ratings of the Republic of Italy, Fitch and Standard & Poor's lowered the ratings on some Italian asset-backed deals that are credit-linked to the sovereign.

FIP Funding, Patrimonio Uno and CPG SCARL are among the transactions that were downgraded by the rating agencies. The Lehman report explains that the deterioration in Italy's credit quality both increases the credit risk of these deals and has a negative mark-to-market impact on them.

Consequently, the report says: "Our recommendation as to how to reduce this impact in the case of a long position in the relevant bonds is to purchase CDS protection against Italy. Given that those bonds trade significantly wider than the current cost of buying a CDS on Italy, our recommended trade implies significant positive net carry."

However, the analysts caution: "The trade also carries certain risks, such as the uncertainty of the ABS cash flows and the fact that mark-to-market changes in the CDS position might not exactly offset the mark-to-market effects of the long position in the bond."

MP

Taking a quantitative approach

Mark Boyadjian, head of Franklin Templeton's floating rate debt group and David Ardini, lead institutional portfolio manager for the group answer SCI's questions this week

Mark Boyadjian

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: The Franklin Advisers' Floating Rate Debt Group became involved in structured credit in 2000. We had already been involved in the loan asset class for three years by then through our continuously offered closed end fund – Franklin Floating Rate Trust, which targeted the retail sector.

In 2000 we launched our first CLO, Franklin CLO I, which was a US$400m cash flow arbitrage deal. The move was an obvious next step for the group as we were already investing in loans and had the necessary operations infrastructure to manage this unique asset class and investment vehicle.

At the same time, it provided us with an additional source of investment management revenue diversification away from the retail sector and involvement in a highly attractive product class. The great thing about CLOs is that they are term and non-recourse and for an asset manager or anyone in the business of managing leveraged money those two words are very attractive particularly if they are combined!

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The convergence in credit. In other words, credit is becoming a more uniform risk than in the past. There are now a large number of players investing in a wide variety of credit-related products, which are looked at uniformly from a default frequency standpoint and all those players one way or another are seeking arbitrage opportunities across those products as a whole rather than in individual silos.

Q: How has this affected your business?
A: Specific to bank loans, both very positively and slightly negatively. It has certainly broadened the appeal of the asset class and made credit investing more efficient and created new products like CDS and LCDS that enable investors to both take on and hedge credit risk with less difficulty.

On the downside, the growing number of players and levels of volume have led to new and powerful forces that influence the bank loan market. These forces revolve around the enabling relationships between hedge funds; private equity sponsors; and institutional loan investors (CLO Collateral Managers), such as us.

David Ardini

On the demand side of the equation, there is a complex and unique relationship between two types of investors. Hedge funds and CLO collateral managers typically compete against each other for bank loan investment product even though hedge funds may also be separately investing in CLO tranches that are managed by the collateral managers.

However, by and large the hedge funds are capable of expressing their investment opinions via any form of a company's capital structure. On the flip side, one of the major sources of bank loan supply has been private equity sponsors seeking the least 'expensive' source of additional capital.

As a result of the tremendous institutional interest in CLO assets, as expressed by the robust and consistent growth in CLO issuance, the demand for high spread bank loan product continues to influence the willingness and ability of the suppliers of bank loan products, as well as the CLO collateral managers in issuing additional CLO vehicles.

Given that CLO collateral managers are generally constrained by their transactions' covenants to invest in what is primarily available in the cash bank loan market, the demand for high spread has very few satisfactory alternative sources. Consequently, it appears to us that some percentage of the market's bank loan supply is enabled to occur simply in response to the CLO demand for spread and we believe that this in combination with other factors could be problematic.

Q: What are your key areas of focus today?
A: We focus on managing to a zero default rate and in the event of a default to minimise losses. That may sound trite, but is something that is achievable.

For most organisations in the bank loan asset class, research and portfolio management responsibilities are co managed and in other cases where research analysts aren't also portfolio managers, research typically reports into portfolio management. Within our group, we have completely separated the functional responsibilities as well as the reporting relationship between research and portfolio management.

We have done this because we want to mitigate the risk that research's credit opinion is not independent of the portfolio managers' influence. That is, we seek to minimise the possibility that our portfolios will experience material losses by giving our research team the mandate and responsibility to manage to a zero default rate. Our career research analysts work very hard to define the universe of credits that the portfolio managers may employ to construct portfolios that deliver upon their respective portfolios' objectives and guidelines.

Q: What is your strategy going forward?
A: What we are trying to do now and in the future is to take on a far more quantitative approach to the pricing of portfolio and loan specific risk that is based specifically upon a very powerful variable, volatility. We are doing some unique research on the impact that volatility has on individual borrower estimated default frequencies (EDF) as well as portfolio level expected losses.

The massive growth in the loan market has produced in our opinion a velocity or multiplier effect of leverage because loan assets, which are loans to levered borrowers, in and of themselves, are purchased or financed by investors who may be including them in leveraged investment vehicles as well.

We think that volatility is the key thread that weaves through this entire asset class not just the underlying assets but also the structured vehicles and the other leveraged investors that invest in them as well. So, we have been and plan to continue to look deeply into volatility – trying to estimate at a portfolio level and at the asset level the effect a shock in volatility will have on default frequency and expected losses.

One of our assumptions is that the pricing of this risk – we call it vega for now: a company's or portfolio's sensitivity in EDF or expected losses to a given change in volatility – is not efficient. We seek to combine the fundamental research work that our career analysts are performing with this volatility based overlay to allow us to further exploit mispricings and inefficiencies that others may not be focused on. This is obviously strongly connected to the structured credit market specifically because of the knock on impact it would have on where CLO transactions are marketed or valued.

Q: What major developments do you need/expect from the market in the future?
A: A primary desire would be for CLO equity investors and traders to develop a more robust secondary equity market that would allow for greater pricing differentiation between different management styles. We would also like to see the development and acceptance of a standardised default model for structured products

About Franklin Templeton
The Floating Rate Debt Group at Franklin Templeton has over US$5.3bn in assets under management as of 1 September 2006. Franklin has been managing bank loans since 1997. It currently has 14 full-time bank loan professionals working collaboratively with Franklin's equity and fixed income research platform.

The Floating Rate Debt Group is part of the Franklin Templeton Fixed Income Group, a global fixed income platform with more than 100 investment professionals and a proven track record managing both single-sector and multi-sector strategies. Leveraging a combined credit research platform, the group has the scale and breadth of expertise to provide world-class management across all key regional and domestic fixed income asset classes.

"Managers with spreadsheets expose you to the real risks"

This week's Provider Profile features fixed income analytics house Wall Street Analytics

Wall Street Analytics (WSA), formed in 1987, provides a suite of tools for CDO investors, trustees and managers in the cash and synthetic markets, via its proprietary 'CDOnet' software. As the company's name suggests it started life in the US, where its customer base is divided equally across its target groups, but has since expanded into Europe, where there is growing interest from investors.

The strong investor response in Europe is due in the main, WSA says, to European investors more regularly looking beyond the senior level, down the capital structure of a deal, and needing tools to analyse pricing and cash flows in the more volatile lower-rated pieces.

"We usually find that investors who do not invest purely in the triple-A part of the capital structure require the complexity of analytics that CDOnet can provide across their whole portfolios," says Gilbert Braganza, WSA's head of sales for Europe.

The firm's natural clients in Europe are those investors seeking a comprehensive set of deal data. WSA claims that their customers benefit from the pricing and transparency history of a 900-strong library of deals modelled and maintained in the system, of which about 20% are European.

WSA's clients use available data to test complex 'what-if' scenarios, from defaults to fluctuating interest rates and other macro-economic conditions that cause spreads to change. "We can now carry out sophisticated Monte Carlo simulations for our clients together with cashflow modelling on CDOs and CDO squared deals via our new facility – a dedicated cluster of servers housed in California – which provides the necessary processing power to stress test a portfolio," says Ian Smith, the firm's head of European development.

"Investors can model the whole portfolio, including time dependency scenarios, changes to ratings, interest rate and foreign exchange movements and so on. We help identify the risk in the capital structure across the portfolio and can isolate individual CDS exposure," Smith adds.

"Our core value lies during times of market volatility, to clients investing down the capital structure where defaults are more likely; often this will be a bank investing for its own balance sheet, or a hedge fund. 'CDOnet' allows the manager to analyse the deal; it is complemented by 'CDOcalc', a web-based tool which allows managers to showcase their portfolios to potential new investors who would like to run cash flow forecasts and the like," says Luis Amador, Global Head of CDO Analytics in New York.

WSA has identified a new trend of late amongst US clients that have previously only invested in European deals remotely, starting to open offices in London. This has been accompanied by many new start-up managers in Europe, often a private equity house or a hedge fund.

The time taken by these new managers to invest in their technological infrastructure is the key to building a stable, long term business attractive to investors. "Good management of data through technology is a must. Investors should be nervous if they see a manager using excel, so the investment in technology is rightly of great importance when a manager is rated," says Smith.

"Fitch's modelling of managers is a good move for the market. For start-ups managing even just one or two deals, it's difficult to accurately track a portfolio without good software; managers with spreadsheets expose you to the real risks. You have to build data and a testing capability into a system. New managers often don't realise the investment in time and the knowledge and complexity required; WSA's CDOnet system began in 1999 and we're adding to it continuously," adds Martin Calles, VP and Director of Research in the New York office.

WSA sees the growing creativity in embedded structures as another strong reason to invest in a system from the beginning – to catch the eye of the ratings agencies. "Ratings are biased towards technology; it makes even more sense for the managers of exotic products to get it right from the outset," concludes Calles.

As the market demands more from technology each year, the ultimate step for managers in the coming years may well be 'portfolio optimisation'. Braganza explains: "Portfolio optimisation is based upon selecting the right assets to get the maximum IRR through the manager's desired asset inputs."

A more immediate and welcome change for CDO managers would be the standardisation of trustee reports for CDOs. Smith says: "We hear that the European Securitisation Forum is working toward this, a move that would save a great deal of time for managers and investors who currently have to deal with a different set of documentation for each deal."

JW

Bear integration headed by Moffat

The latest company and people moves

Bear integration headed by Moffat
Bear, Stearns International has announced the formation of a new European capital markets group, responsible for the origination of both debt and equity transactions in the primary market. The integration of these existing business areas is designed to serve client demands for a coordinated, multi-product approach.

The group will be headed by Mark Moffat, a senior md of the firm, who will now report to the heads of fixed income and equity in Europe. Moffat will remain head of the CDO origination group.

"The creation of this group is another step in our expansion plan for Bear Stearns in Europe," comments Michel Peretie, ceo of Bear Stearns in Europe. "Under Mark's leadership, this integrated group will greatly enhance our ability to deliver a broader array of products to our European and Middle Eastern clients."

Hearn to Lehman?
Mark Hearn is understood to be in the process of moving from structured products sales at Deutsche Bank to a similar role at Lehman Brothers. Lehman officials would not confirm the hire, however.

Rossi joins BNP Paribas
Jacobo Rossi is to join BNP Paribas' Italian credit sales desk from Barclays Capital. In his new role, Rossi will report to head of desk Stefano Rossi.

Deutsche appoints Farouze
Deutsche Bank has appointed Stephane Farouze as global head of fund derivatives structuring and origination, reporting to Richard Carson, md, head of complex equity & co-head of synthetic equity and Wayne Felson md, head of complex risk, global rates.

Farouze, who will be based in London, joins the bank from Paradigm Global Advisors, where he was a partner responsible for marketing and structuring. Previously he was at Société Générale Asset Management, where he was the global head of structuring for alternative investments.

MP

Dura protocol begins

A round up of this week's structured credit news

Dura protocol begins
The ISDA protocol for settlement of credit derivatives on bonds of bankrupt Dura Automotive Systems (see SCI passim), will be launched today, 8 November. Investors have until November 17 to sign up to the protocol, which will for the first time include settlement of single name and tranche default swaps, as well as the index trades catered for in previous protocols.

The auction to determine settlement payments on Dura protection will be held on November 28, with two Dura operating Corp. bonds auctioned – the senior 8 5/8% due 2012 and the subordinated 9% maturing in 2009. The auction will be administered by Creditex and Markit.

Moody's launches CPDO primer
Moody's has released a report – entitled "CPDOs: A Primer" – which outlines the key risks involved in constant proportion debt obligations, as well as the two conditions under which such an investment strategy would be fully unwound: a cash-in event and an unwind (or cash-out) event.

"In general, Moody's view is that noteholders in CPDO transactions are mainly exposed to spread risk – given that any increase in the spread of the indices will erode the value of outstanding TRS – and less so to default risk, as this is partly mitigated by two elements: the semi-annual roll of the indices and the excess spread," explains Mehdi Kheloufi-Trabaud, associate analyst at the agency.

Although the CPDO transactions that Moody's has rated to date have been based on the European and US synthetic credit indices for investment-grade corporates, the concept could equally be applied to subsets of these corporate indices, to ABS indices or even to a bespoke portfolio under certain conditions.

The agency is also expected to publish a rating methodology, which will describe its quantitative approach to the rating of CPDOs, as well as its treatment of CPDO documentation. In essence, however, Moody's analysis of CPDOs is based on a two-stage simulation of credit spreads: a simulation of the rating migrations of the underlying entities; and a simulation of the evolution of the credit spread of a given rating category over time.

Commodity CDOs on the rise
Standard & Poor's has responded to market interest in commodity CDOs by developing a methodology for modelling the risk of loss associated with such structures.

"In addition to giving an overview of our rating approach, the report provides details of the model we have developed for analysing commodity CDOs, called the mean-reverting jump diffusion (MRJD) model," comments Kimon Gkomozias, a quantitative analyst at the agency. "We have developed this particular model so that it provides market participants with the flexibility to change its parameters, taking into account differing views of the long-term mean, long-term speed and volatility of the commodities."

According to S&P credit analyst Katrien Van Acoleyen, there has been an increasing interest in the market over the past few months to develop CDO structures that reference a portfolio of commodity products. She says: "Commodity CDO structures provide fixed-income investors with exposure to the commodities market, giving them the opportunity to receive a risk premium by investing in a rated portfolio of commodity products."

Under such a structure, commodity risk is repackaged into a tranched format that matches the investor's risk profile. The investor is exposed to the risk of portfolio losses exceeding the subordination level of the tranche in which they have invested.

S&P has so far rated 13 commodity CDO structures globally, which reference products on commodity spot prices. "The interest in this new CDO asset class is rising as arrangers are looking to include products referencing commodity sub-index levels, as well as to structure hybrid credit-commodity structures," explains Van Acoleyen.

German mezzanine SME risk on offer
The latest German mezzanine SME CLO has hit the market: HSH Nordbank, Landesbank Baden-Wurttemberg (LBBW) and Hamburger Sparkasse (Haspa)'s €181.5m Prime 2006-1. The structure uses the limited partnership concept under Jersey law and is composed of Prime General Partner Ltd. (the general partner, incorporated in Jersey), together with the arranging banks as limited partners, incorporated in Germany.

The transaction comprises five classes of fixed and floating rated notes and an unrated portion worth €10m – a capital contribution provided by the partners to serve as further subordination to the notes. The issuer will use the issuance proceeds to purchase a €196.5m portfolio of participation rights granted to 29 German SMEs from the original lenders, based on the companies' credit quality (a weighted average rating of BBB-/BB+) and diversification, both in terms of industry and geographical sectors.

Prime is backed by two types of instruments: the Smart Mezzanine product features seven-year bullet loans with fixed annual interest rates of between 5.5% and 7.5% and a profit-dependent component of 1.5%; and Smart Mezzanine 100, which features a loss participation element that enables it to qualify as equity under German GAAP rules and has an annual coupon of 7.5% to 9.5%, dependant on profits. Nine of the obligors have participated in the Smart Mezzanine product, while 20 have participated in the Smart Mezzanine 100 instrument.

The portfolio is the least granular of any German SME CLO so far: the six largest exposures each account for €15m, around 7.6% of the pool. There have already been two defaults in the sector, with the insolvency of German toy-maker Nici in May leading to the double-B rated tranche of the CB MezzCAP deal being put on rating watch negative. That transaction had 35 obligors with a maximum exposure of 5.01%.

Amstel jumbo CLO readied
ABN AMRO is in the market with Amstel 2006, the latest synthetic balance sheet CLO to launch ahead of the implementation of Basel II. The transaction will allow the bank to free up regulatory capital under both the current and new capital accords on a portfolio of corporate loans worth €10bn during a two-year replenishment period via credit-linked notes and a €8.87bn super senior CDS.

The deal references a portfolio of 400 names, with up to 25% sub-investment grade credits allowed in the pool – although these must be rated at least double-B minus. ABN AMRO is expected to publicly offer half of the €230m unrated equity tranche (while retaining at least 25% to align its interest with investors), with Merrill Lynch joint-bookrunner on this slice.

Unusually, Amstel 2006 uses a cashflow structure to provide investors with a given payment profile. The deal uses a clean-up call option rather than a step-up, but because such a call with a purely sequential payment structure would have reduced the efficiency of the risk transfer, a series of overcollateralisation triggers have been incorporated which allow for pro-rata repayment down to a pool factor of 40. If the OC trigger is breached, excess spread will be diverted to a reserve account that sits above the equity notes to support the rated notes in the event the equity is written off.

Debut market value CLO for Deerfield
Deerfield Capital Management has closed its first European CLO, Coltrane, through Bank of America. The six-tranche transaction uses a new market value platform dubbed structured enhanced return vehicle trust (SERVES) and was increased from an expected €300m to €450m following strong investor demand.

The first European market value CLO to focus on par loans, Coltrane is designed to provide a stable and attractive return to the holders of the €45m triple-B and €3.75m double-B notes and at the same time allow greater management flexibility than standard cashflow CDO structures. The market value of the portfolio is calculated weekly, and then tested against the threshold value event trigger, which is designed to ensure that the single-A rated noteholders can be paid.

Bank of America has underwritten the €142m revolving and €281.5m senior notes. The revolver can be drawn during the ramp-up period to reduce negative carry, as well as during the six-year reinvestment period to purchase additional collateral in the event of a default up to the point that the notional of the liabilities exceeds the asset portfolio notional by 10%. Any drawing will be repaid through excess spread.

The portfolio includes a 15% bucket for mezzanine and second lien loans, although the manager is targeting a total of 10%. There is also a 10% bucket for sterling loans to be hedged through perfect asset swaps.

Danish diversification opportunity
A diversification opportunity emerged last week with the launch of Mare Baltic – a €1bn-equivalent static cashflow CDO backed by Danish collateral.

Series 2006-1 of the Mare Baltic structured note programme, a protected cell company incorporated in Guernsey, comprises two tranches: €169.95m triple-A rated Class A notes and DKr883.9m triple-B rate Class B notes. The transaction has a legal final maturity of 2014, with the ratings reflecting the risk of the cash flow diminishing as a result of defaults on the underlying collateral and its legal structure.

The deal is backed by payments received from a portfolio of loans made to a number of Danish commercial and savings banks and from the Copenhagen branch of HSH Nordbank in its role as hedge counterparty.

MP

Trading ideas - safety from shocks

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, suggests a pairs trade involving TRW Automotive Holdings and Tenneco

As investors come to terms with renewed weakness in the housing market and weigh their fears of inflation, default risk remains firmly in the back seat in credit portfolios. The one sector where default risk still haunts us is the Automotive sector, but even there we have seen a new ebullience that things may well be improving. As GM moved to a stable fundamental outlook over the last few weeks, we began to look closer at potential relative value opportunities within this volatile sector.

Two names that have been remiss from headlines recently (for good reason) are TRW Automotive (TRW) and Tenneco (TEN). These sound performers have had their share of volatility but have consistently performed well recently and while both have stable-to-improving fundamental outlooks, we feel there is some room for a potential relative-value trade here.

Because of the US auto makers' production cuts, just like many others in the sector, TEN and TRW recently took down 2006 sales and earnings guidance. Our expectation is that these two credits may well be the only bright spots in a quarter that is expected to be a disaster for most of the auto sector.

TEN designs, manufactures, and markets emission control and ride control products and systems for the automotive original equipment market and the aftermarket. The Company's products include shocks and struts, shock absorbers, mufflers, and performance exhaust products, as well as noise, vibration, and harshness control components. TEN's geographic, customer, and platform diversity make it one of the most stable and strongest credits in the auto supplier sector and recent results (for the third quarter) were decent.

TRW supplies automotive systems, modules, and components to global automotive vehicle manufacturers and related after-markets. The Company's products include active and passive safety related products. TRW's products are primarily used in the manufacture of light vehicles. With strong credit ratios and products that are in demand, TRW is still the best-looking credit in the high yield auto supplier sector. The company had actually raised guidance twice this year. So this new lower earnings guidance is still higher than the guidance it gave when it started the year.

So, on the face of it, both credits look strong and certainly among the most attractive in the auto sector. This safety net is what we plan on exploiting. While the two credits are at the better end of the scale in automotive suppliers, their spreads trade a significant distance apart and our view is that picking up this differential is worthwhile and offers good upside if things continue to improve for TEN, and only modest downside as both credits are likely impacted by similar systemic shocks.

The key differential is competition. While both companies operate in competitive environments, TRW faces very strong competition from several big, healthy competitors like Bosch, Autoliv, Continental, and eventually Delphi. TRW's low leverage will allow the company to weather short-term industry volatility but we see TEN's upside, as the new diesel business comes on line next year (due to changes in emissions standards), as being modestly better.

We see three scenarios. Business as usual means both companies drift along at current levels with no strong industry push either way, in which we earn the differential and roll-down. Best case is that TEN's new diesel business takes off and it significantly outperforms pushing spreads tighter, giving us upside in the convergence. Worst case is TEN's Q4 results are weak but in this case we feel that, given its relative strength, if TEN looks bad then the rest of the sector will get hit and spreads will likely move together wider.

While TEN's improvement may be delayed until next year, we are happy to earn the spread differential while we wait and potential roll-down of the long TEN, short TRW position.

The same but very different
This trade is very much fundamental-based – with TEN's new business and geographic diversity poised to outperform TRW's strong but highly competitive position. In looking at the entire industry, we thought it useful to compare curves from a relative-value perspective to see if better differentials were possible across the curves, or indeed different names.

Exhibit 1

Exhibit 1 shows the CDS curves for many of the best-known HY and IG auto credits. The diversity, competition, parts, and supply of these credits is very different but there is a clear divide between the string and the weak with JCI at the better end of the spectrum and F and COOPER at the worst.

TRW and TEN sit in the sweet spot of the sector, both in the crossover space and offer the best risk-reward profile in our view. This is a conservative pairs trade with an expectation of modest performance from the spread differential but possible upside from any idiosyncratic improvement in TEN. Exhibit 1 also shows that comparing the two curves indicates that the 5Y spread differential is the widest across the two curves.

Focussing on just the performance of the five-year CDS, Exhibit 2 shows that we are currently at or close to the most divergent these two credits have ever been. The two credits have been within 50bps of each other for most of the last two years but the recent sell-off in TEN and stability in TRW has driven the differential close to 100bps.

Exhibit 2

A modest rally in TEN recently has pulled the differential back although it still sits at the high-end of its two-year range. With a differential of more than 50bps (when adjusted for bid-to-offer), and a modestly positive trend, we remain confident of the upside potential and modest downside risk.

Combining both our fundamental views with a historical and cross-sectional analysis of the auto credits leaves us with a conservative pairs trade. Relatively wide spreads differentials, positive roll-down differentials (TEN's curve is steeper than TRW's), and 'best-in-class' expectation in the HY autos sector provide a market-neutral trade that benefits from continued strength overall or idiosyncratic differentiation between TEN and TRW, while sector-wide weakness is likely to hit both credits in a similar manner (as evidenced by the historical spread behaviour).

There is one more subtle adjustment that needs to be made. Given the difference in spreads, and our requirements that the pair is as close to market neutral as possible, we need to adjust for DV01 differences. This adjustment means a modestly larger short protection position in TEN than long protection position in TRW – which actually improves our overall carry and roll-down economics.

Risk analysis
This trade is duration-weighted, ensuring positive carry as well as to reduce our exposure to systemic sector levels. We are therefore hedged against short-term movements in absolute spread levels, profiting only from the convergence of the two credits' spreads.

The carry cushion protects the investor from any short-term mark-to-market losses. This trade has modest positive roll-down upside. The scenario analysis discussed above offers some insight into the potential actions we would expect given both idiosyncratic and systemic (sector-wide) impacts.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk with these credits in this maturity as they are increasingly liquid.

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 these credits and their bid-offer spread costs.

TRW is a member of the DJ CDX NA HY series 7 index and while TEN is not, both credits are highly liquid – appearing in CDR's Top 200 most liquid credits regularly. Bid-offers in 5Y CDS average between 10 and 20bps.

Fundamentals
This trade is based almost entirely on the fundamentals of the sector and individual names. While TRW sits in the sweet spot of automotive parts, helped by government pressure to incorporate more safety equipment, it faces a great deal of very strong competition. TEN, on the other hand, has been a consistent performer due to its geographic, platform, and customer diversity. Demand for TEN's new diesel products, driven by changes in emissions standards could boost sales and EBITDA substantially.

Our scenario analysis highlights three potential outcomes. In a worst case scenario, TEN's Q4 results are weak but we would expect everyone else's results to be weak and all spreads to widen – so the trade goes sideways. Status quo would mean good pick-up and roll-down, and a best-case would be TEN's continued outperformance due to its new business as TRW faces increased competition.

Summary and trade recommendation
As investors have shifted their focus to more macro-economic issues recently but remain staunchly ignorant of default risks, we decided to look at probably the most default-risk prone sector (Automotive suppliers) for potential relative-value opportunities. While none of the credits in this volatile sector are immune to the recent production cuts, TEN and TRW stand out as two potential bright spots among the HY names.

Both credits have improving fundamental outlooks, with TRW looking to benefit from improvements in its diesel business (on the back of new emissions standards) and TEN continuing to improve on the back of government mandates for more safety equipment in cars. The two credits trade at a significant differential (at historical wides) and based on our scenario analysis, we see limited downside from systemic weakness and good upside as strong competition impacts TRW while TEN's new business boosts sales and EBITDA.

The sector-neutral trade generates good carry and modestly positive roll-down as we adjust for DV01 neutrality.

Buy US$10m notional TRW Automotive Holdings Corp. 5 Year CDS protection at 135bps and
Sell US$11mm notional Tenneco Inc. 5 Year CDS protection at 190bps to gain 74 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).

FTD baskets and correlation - part 3

In this final part of a series of three articles, Shreepal Alex Gosrani, Priya Shah and Domenico Picone of the structured credit research team at Dresdner Kleinwort suggest practical correlation trading examples utilising emerging markets baskets

Currently, the market for emerging markets FTD baskets is in the developing stages with the majority of structures being tailored for specific investor needs. Historically, spreads on emerging market sovereigns have generally been more volatile and, due to higher default risk, generally much greater then developed regions' CDS spreads.

However, as emerging market CDS volumes have grown, spreads and volatility have generally decreased. Although relative to developed CDS indices, such as the iTraxx and CDX, the spreads on emerging market sovereigns still remain relatively high; volatility is now generally on par with these indices.

The following chart shows how spreads have evolved, providing a comparison between various emerging markets sovereign CDS spreads. The table thereafter details the volatility (as measured by annualised standard deviation of spread returns) and the correlation of CDS spreads, based on available spread history from 6 June 2003 to 19 September 2006.

Historic correlation
There is a wide dispersion in the correlation amongst the various regions. In general, the emerging market spread returns have very low correlation with the CDX and iTraxx indices, whilst Argentina is fairly highly correlated with the majority of the regions investigated, in particular with the other Latin American countries. Comparing these historical correlations with implied FTD basket correlations is not straightforward as generally, these baskets' liquidity is still growing.

The market data we have indicates that implied correlation also shows some dispersion, depending on the underlying credits, but on average, currently tends to lie between 50-80% for 5-year CDS. Historically, correlation between emerging market regions has been driven by systematic risk factors, but we believe that idiosyncratic risk will play an increasingly important role in the future and so foresee the potential for a drop in correlation in EM baskets or portfolios.

Basket description
Consider now a four name Latin American FTD basket based on sovereign CDS for the Ecuador, Argentina, Venezuela and Brazil, each with a notional amount of $10m. The spreads for each of these CDS (as of 23 September 2006) are shown below.

Although correlation between Ecuador and the other three regions has generally increased, it still remains lower then the correlation between the other three regions which is currently between 65-80%. Of the four entities in the basket Ecuador and Argentina are the most default risky, based on their higher spreads. However, Venezuela and Brazil have experienced greater volatility in their spread returns over 2006.

The following tables details some features of such an EM FTD basket that we proceed to use for our analysis of trading strategies, with carry shown on an annual basis.

EM FTD correlation trading

In this section we present three trades that can take advantage of correlation views by making use of FTD basket default swaps.

Short correlation long convexity strategy
The investor can use the FTD basket to monetise a view on correlation. To remove the risk of spread changes, a dynamic delta-hedged strategy should be undertaken, thereby leaving the investor exposed to the correlation of the basket.

Market implied correlation is currently high
For emerging markets baskets of the type described above, we see current market implied correlations at relatively high levels and, generally, at the high end of the historical range. An investor sharing this view can monetise by buying protection on a FTD basis, and then delta-hedging, with the aim of benefiting from a drop in basket correlation. Suppose the current market correlation view for this basket is 70%, which is perceived to be too high by the investor. By buying protection and delta-hedging his position using single-name CDS, the investor benefits from a drop in correlation as shown in the following chart (where spreads are held unchanged) where we focus on the return achieved over six and 12 month horizons.

Alternate CDS hedge calculation
The above analysis assumes that the delta-hedging is undertaken based on the market view of correlation, i.e. the investor calculates hedge ratios based on a 70% basket correlation. An investor with a short correlation view on one or all of the names in the basket can further benefit by creating the delta-hedge based on this personal correlation view.

For example, suppose the investor believes that Ecuador's correlation with the other entities is 60% as opposed to the market view of 70%. Hedging Ecuador at the lower correlation value would result in a larger delta and, thus a reduction in the negative carry of the delta-hedged portfolio. The impact of the negative carry is reduced further if all entities are hedged assuming a lower basket correlation. Below, we show the impact of the correlation assumptions on the hedge notionals.

The following chart compares the MTM changes over 6 months for a portfolio hedged at the market correlation of 70%, a second portfolio in which Ecuador is hedged at a lower correlation of 60% and a third strategy in which all the entities in the basket are hedged at 60%. The benefits, although small, are evident for a wide range of correlation changes.

Time decay
In the above two charts the investor does not profit until the correlation drops by approximately 5% in six months. This is because of the impact of the credit curves of the four entities, which are not flat. As time elapses the investor is also affected by the roll down in the CDS curves and the resulting impact on the FTD spread, hence the reduction in the MTM value at zero correlation (and zero spread) change. To reduce this impact the portfolio must be dynamically re-balanced on a regular basis and it is from this dynamic re-balancing that gains can be more attractive.

Convexity – dynamically monetising iGamma
These strategies are correlation strategies that depend on dynamic first-order spread hedging. For changes in individual spreads the protection buyer benefits from iGamma convexity. He sells more protection as the spread of a single name rises (its delta rises) and then buys back some protection as delta falls with the spread locking in a gain through the dynamic delta-hedging. This is particularly effective to take advantage of the volatility associated with a distressed name.

Systematic risk
The investor is exposed to gamma (systematic) risk from portfolio-wide spread changes and, also to the impact of multiple defaults. A dynamically hedged short correlation strategy can take advantage of currently observed high implied correlations, though we bring to investors' attention that dynamic credit market participation is necessary to exploit this strategy.

Short correlation synthetic senior trade
If an investor has exposures to a various credits in a portfolio, by buying FTD protection he is able to engineer a first-loss layer of protection and thus leave himself a senior exposure as he is only exposed to the risk of multiple defaults.

By using this idea of senior tranche-like exposure, an investor can take advantage of a short correlation view by buying protection on an FTD basket and selling 100% of the protection on the single CDS names, thereby gaining attractive net carry and being protected from the first default in the portfolio, and hence synthesising a senior credit risk exposure (on a basket of his choice).
This position can be likened to a senior tranche on a synthetic CDO. In the same way as a senior tranche, such this trade has a short correlation exposure.

Correlation and spread risks
Through this trade the investor is exposed to the risk of correlation rising, as shown in the following chart. However, the impact of a rise in correlation is mitigated to a point, by the sizeable carry on the protection selling CDS leg as the investor sells 100% of each underlying asset. This is so as to enable creation of the synthetic senior exposure on the portfolio of the four names.

In a straight delta-hedged strategy the holding in each asset would be governed by its delta and would therefore be much lower. Thus the investor is over-hedged relative to a delta-hedged situation and, as such, is subject to spread risk as well as correlation risk. The carry of the trade is compensation for the possibility of multiple defaults to which the investor is exposed – representative of a senior position.

With this strategy although the risk of correlation rising is slightly cushioned, the portfolio is not delta-hedged, and therefore the investor remains exposed to changes in the spreads of the underlying credits as well as to those of correlation.

Long correlation short senior trade
In this trade, the investor purchases CDS protection in each name of a basket of credits. He then sells FTD protection on the basket, and although such a trade would generally entail a negative carry, he benefits from gamma risk and also, if correlation in the basket rises, he sees a gain on the FTD position. Moreover, if there is a market wide shock to the basket, then he benefits in the case of multiple defaults. He is exposed to a drop in correlation and a rise in iGamma risk.

Alternative FTD basket trades

Reduce concentration risk by purchasing FTD protection
An investor who is concerned about the idiosyncratic risk arising from his holding in a concentrated Latin America portfolio can purchase protection at a lower premium using this FTD basket. The FTD basket provides a cheaper alternative for shorting the credit risk on the names which he has a bearish outlook on.

Assuming that the FTD basket is priced at inception with a correlation of 80%, the following chart shows how the FTD protection buyer's MTM value will change if all spreads in the underlying basket change over the next six and 12 month holding periods.

If the investor's view regarding a bearish market outlook is realised, underlying spreads would increase resulting in a MTM gain. However, the investor is still exposed to the risk of multiple defaults as well as to a drop in underlying spreads resulting from an improvement in credit quality of the basket names. Finally, as the investor currently has exposure to the names he selects for the basket, by entering into such a transaction he is effectively creating a senior tranche type holding, by purchasing first-loss protection.

Yield enhancement strategy
As previously discussed a protection seller can benefit from the yield enhancement and leverage offered by selling protection on a FTD basket. Maximum yield benefit can be achieved by having a diversified basket (with lower default correlation) as well as a relatively homogeneous portfolio. An investor, who therefore believes that the current basket is well diversified and/or that spreads are likely to decrease and converge across the four names, can monetise on this view by entering into a long FTD credit risk position on this basket by selling protection.

As shown in the chart above, the protection seller will benefit from a decrease in the underlying spreads. Potential risks include an increase in spreads, and the payout resulting from an entity defaulting. From roll down the investor has some protection from a potential widening in spreads as can be seen in the chart above. This trade is an interesting alternative to moving down the credit curve to lower rated exposures for yield, as it can be structured to retain exposure to only investment grade entities.

Conclusion

In this paper we have aimed to provide a concise primer on the mechanics of a FTD basket, focusing in particular on an emerging markets basket. The various factors affecting the spread, the risks faced by the investor and the various trading strategies that can be undertaken by the investor, depending on his motivation for entering into a FTD transaction, have been discussed.

Recommended FTD trading strategies
Although a FTD transaction can be undertaken to short or long the credit risk on a basket of names, in our view it is a highly effective method for trading correlation of bespoke baskets that reflect the investor's needs and views.

Reducing concentration risk
This strategy is suitable for an investor who, in his current investment portfolio, is already exposed to the basket of names and wants to mitigate some of the credit risk on his existing portfolio. The investor is not only concerned about all the entities defaulting per se (in which case a better strategy would be to purchase CDS on these names), but is more concerned about spreads on individual names widening. By purchasing FTD protection an investor can then benefit from any increase in these underlying spreads. As the investor already owns each of the names in the portfolio this strategy also ensures that he has effectively created a senior risk exposure that allows his portfolio to benefit from first-loss protection.

Correlation trading
An investor who wants to undertake a correlation trading strategy, believing that the market view on the basket correlation is too high/low, can aim to monetise on his view by buying/selling FTD protection. In order to pursue a correlation strategy the investor needs to delta-hedge his FTD position by entering an offsetting position on CDSs of the names in the basket, thereby immunising his position from small changes in the underlying spreads.

We have shown how delta-hedging can be undertaken either at the market correlation implied delta, or using a delta calculated using the investor's view on correlation, either for a single name or the entire basket It should be noted however that the individual entity deltas are not constant but influenced by various factors, such as underlying spreads, correlation and maturity, and therefore the delta-hedged portfolio does need to be regularly re-balanced to ensure that a pure correlation exposure is retained.

From an FTD protection buyer's perspective this would entail selling more CDS protection when the spread (and hence the delta) on a name increases and reducing the CDS exposure to a name by buying protection back at a lower level when the spreads fall, thereby benefiting from the spread differential obtained, as the investor is selling high and buying low when hedging. This is done dynamically to exploit CDS spread volatility.

An alternative way to short correlation is by way of synthesising a senior exposure on a basket of credits by buying FTD protection and selling 100% protection on the CDS names. Using this trade, the investor takes on spread risk (he is exposed if spreads rise) but is compensated with attractive carry and he can take advantage of a drop in basket correlation.

Yield enhancement and leverage
The FTD spread is greater then any of the individual single name CDS spreads on the basket which is key motivator for an investor to sell protection using an FTD basket. The investor benefits from the leverage achieved on the same trade notional.

Recommendations for EM basket correlation trades
Making use of our conclusions above, and using the four name Latin American basket as an example, we have discussed each of the above strategies in detail, highlighting the various risk and returns faced by the investor.

In our view, relative to historic correlations, current market implied basket correlations are at relatively high levels and to profit a short correlation strategy can be used. We do not expect emerging market risk to increase per se, but we expect idiosyncratic risk factors to have a greater influence in the future. We therefore believe that future correlation is likely to decrease and would therefore recommend that the investor purchase protection on an FTD basket, in a delta-hedged way, to exploit such a view, with a six month horizon. To limit the risk of spread changes over time we would advise a dynamic delta-hedging strategy be undertaken by the investor, thereby permitting him to profit from individual spread volatility (which is would be more probable under a lower correlation regime).

For entities such as Ecuador, which historically has also been less correlated with other emerging market countries, delta-hedging can be undertaken calculating deltas using the lower correlation view of the investor, thereby gaining benefit from a reduction in the negative carry.

© 2006 Dresdner Kleinwort. This Research Note was first published by Dresdner Kleinwort on 3 October 2006.