Contents

European LCDS revamped

New documentation to bring increased liquidity

Dealers met on Tuesday 14 November to thrash out new documentation for the European loan-based CDS market. It is hoped that the new rules – a draft of which is expected to be published by the end of this month – will bring increased liquidity to the LCDS market and to its two new index products.

The new draft documentation will bring European LCDS closer to US market practice, which structured credit investors had called for (see SCI issue 10), but at the same time attempts to offer a compromise to those who are happy with current documentation. The key elements of the new proposals are that LCDS will be cancellable, as in the US, but unlike in the US they give counterparties an option to elect one of two types of approaches to defining the contract's underlying at the outset of a trade.

One approach will involve specifying a named reference entity and the other will define the reference entity as each obligor under the reference obligation from time to time. In both cases, the specified reference obligation may be one or more designated tranches, or all loans of the same lien under a facility as a whole.

For the purposes of the first approach the successor provisions will look to the reference obligation, and a substitute reference obligation will be sought if at any time the original reference obligation ceases to exist or ceases to be an obligation of the reference entity (for any reason other than via a refinancing, where the transfer of the protection to the new loan will be automatic).

It is hoped that the new documentation will bring not only new investors into the European LCDS market, but also dealers who have so far been standing on the sidelines – and thereby boost market liquidity. Notably, Citigroup, Goldman Sachs and JP Morgan have stayed away on the basis of the contract's provisions not being to their liking.

Nevertheless, dealers say that trading on the new iTraxx LevX leveraged loan CDS index has been healthy since launch two weeks ago (see SCI issue X) with an average daily volume of around €125-150m. Admittedly this pales into insignificance compared to iTraxx main volumes, which exceed €10bn a day, but is seen as a more than promising start and, again, likely to be bolstered significantly with an expected shift to the new single name documentation rules at its first roll.

Meanwhile, the subordinated version of LevX began trading on Monday, with a 450bp coupon. Like the senior index, which launched with a 170bp coupon, Sub LevX will also trade in price terms rather than spread terms.

Sub LevX is based on 35 credits. Second-lien: Amadeus, Avio, BAA, Brenntag, Cognis, Debitel, eircom, Flint, Ineos, Kabel BW, Kwik Fit, Macquairie Broadcasting, Manchester United, New Look, Orangina, Sanitec, SigmaKalon, Terreal, Weetabix, Wind. Third-lien: AA, Balta, British Vita, Casema, Edscha, Elior, Framatome Connectors, Gala, Iglo Birds Eye, Numericable, SBS, SSP, Tommy Hilfiger, Vetco International, Yellow Brick Road.

MP

Rated equity rocked

Tranche spread shift halts some deals, but Elbrus prevails

What has been dubbed by some observers as the "reverse correlation crisis" is currently having a significant impact on the synthetic CDO pipeline. Of course, there is no actual crisis, merely the opposite of what happened in May last year – overall, equity tranche spreads have narrowed as those in other parts of the capital structure have widened.

The moves are a reflection of both the current perceived unattractiveness of mezzanine tranches compared with CPDOs and the demand for selling equity protection, which is typically seen in an overall tightening spread environment. The shift in tranche spreads has come at an inopportune time for a number of dealers who were looking to tap into what is seen by many market participants as the structured credit market's next hot product and launch rated equity or combo notes. But many of these deals now look unworkable in the current tranche spread environment.

"There are a few rated equity deals that have had to be put on hold," reports one analyst. "In one case, the deal was too far down the road and had to be amended quickly instead. I understand the maturity has been extended by a year, but it's still paying the same coupon," he adds.

One transaction that did launch last week, however, was the €150m Elbrus deal via Citigroup and managed by Credaris. "Our structure still works in this environment," says Olivier Renault, credit structurer at Citigroup in London.

He goes on to explain that Elbrus was pre-hedged and so had locked in wider spreads. Furthermore, it is based on a very conservative portfolio of 165 investment grade names, which has a weighted-average rating of A2.

Renault continues: "The low beta portfolio means its spreads narrow less than the market average, which obviously benefits this structure and its launch timing. Of course, this means that spreads also widen less than the market average. But the big equity kicker that generates an expected return of 2% above the A3 norm will attract investors."

Those investors will, according to Renault, be mainly real money investors who are either rating-dependent or cannot buy outright equity. "The deal is also attractive to banks with rated capital considerations," he adds.

Elbrus is a 7-year synthetic combination of a mezzanine tranche and zero-coupon equity, and has been assigned an A3 rating by Moody's which covers both principal and interest. It has a coupon of 70bp over Libor linked to its mezzanine piece only, but the coupon is paid on the full note notional if its portfolio experiences up to seven defaults with 40% recovery and has a maturity redemption amount of up to 19.5% above par.

The deal's zero-default IRR of 6.80% is well above that for traditional A3 mezzanine (4.79%). The IRR remains at above swaps for up to four defaults.

Elbrus' manager, Credaris, and its affiliates will co-invest in Elbrus, providing a strong alignment of interest with investors. Additionally, a large portion of management fees are linked to the performance of the equity portion of the note.

MP

Synthetic CLOs spread across Asia

Balance sheet deals to finally start appearing in Asia ex-Japan

The US$187.5m Start III synthetic balance sheet CLO launched by Standard Chartered Bank (SCB) last week is the latest in a string of such deals issued by international banks to securitise their Asian loan books. While local banks have historically shied away from the sector, their stance now seems to be changing.

Start III is a partially funded synthetic balance sheet CLO referencing a portfolio of bank loans and other eligible obligations to predominantly corporates and other entities across the Asian region. It is the third transaction in the Start series to come to the market in a year. Lehman Brothers Asia and SCB are acting as co-arrangers, while Lehman Brothers International (Europe) and SCB are joint-lead managers on the deal.

The transaction represents a critical step in SCB's active portfolio management programme, and will help to inject liquidity into the bank's balance sheet, as well as increase its origination and growth capacity.

The next Asian loan book to be securitised in such a manner is set to come from a local bank. "We are now getting a lot of interest in synthetic CLOs, particularly from banks in Hong Kong and Singapore, and there are a couple of deals in the pipeline," confirms one structurer.

High levels of liquidity in the bank market have historically reduced the need for Asian banks to issue balance sheet CLOs, but the implementation of Basel II is forcing them to look more closely at managing their loan portfolios and exposures more efficiently. A number of local institutions are consequently putting the necessary procedures in place to enable them to tap the market in the future.

Another possible reason for Asian banks' reticence in the sector is a historical concern that offshore investors would require a significant spread pick-up for local deals over comparable transactions from Europe or North America. However, given the current healthy appetite for Asian risk, once investors become more familiar with the originator's experience, it should be possible to achieve improved pricing.

The region's move into synthetic CLOs has been led by Australia, with National Australia Bank (NAB) and ANZ Bank both active in the market. NAB's latest US$1.6bn-equivalent Southern Cross transaction, for example, references a pool of 111 corporate loans, with 64% of the obligors domiciled in Australia and New Zealand. European, North American and Hong Kong credits made up the remainder.

And ANZ Bank's recent A$2.2bn Resonance Funding CLO, through Barclays Capital, referencing a pool of 110 corporate loans, 75% of which were extended to Australian borrowers. The deal was upsized from A$1bn and became the largest domestic capital markets placement of any type by an Australian borrower.

MP

Towards greater transparency

This week, Miguel Ramos Fuentenebro, managing partner at Washington Square Investment Management, answers SCI's questions

Miguel Ramos Fuentenebro

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: Washington Square has been involved in the structured credit markets since its launch in 2003. The philosophy of the firm has been to combine our experience in fundamental credit analysis and structured products to offer investors innovative funds with efficient risk/reward profiles. The Company has two areas of activity: managing our own transactions (both synthetic and cash), and investing in structured products managed by other managers.

So far, we have launched four managed CDOs and the first London listed diversified CDO equity fund in the market. Between now and 1Q07 we expect to close another two managed CDOs and complete the launch of an absolute return credit fund.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The development of credit derivatives has completely changed credit markets globally. It has been a positive circle where liquidity in single names has allowed managers such as Washington Square to launch and develop new structures, which, in turn, has contributed to generating additional liquidity and interest in a broader range of credits.

Q: How has this affected your business?
A: Back in 2003, we were one of the first managers looking at CDS on, for example, Indian corporates or different parts of the capital structure. Nowadays, of course, such instruments are liquid and part of many portfolios.

The success of the market and the development of index products and static deals, particularly before 2005, created a market where many investors focused on the analytical features of transactions, but ignored to a large extent the need for a fundamental analysis of the underlying assets. This created a clear opportunity for Washington Square.

Looking at the more traditional cash flow CDO market, we have seen numerous research pieces highlighting the attractive returns, volatility and correlation of the asset class, but total lack of transparency in terms of pricing.

Consequently, investors have been unable to replicate results or integrate the data in their investment allocation processes. Washington Square decided to list a diversified cash flow CDO equity fund on the London Stock Exchange.

As a result, investors can now access public information about daily returns for a cash flow CDO equity fund. We believe that this will be a key factor in making this asset class accessible to a much broader range of investors.

Q: What are your key areas of focus today?
A: We believe that structured credit products can add significant value and generate the right risk/reward profile for investors. Having said that, no structure will be successful unless the underlying portfolio performs.

We therefore continue to focus on our strengths, fundamental analysis and expertise in structured products. This allows us to use multiple instruments (different parts of the capital structure or different credit derivative/structured products) to optimise the implementation of our credit views.

For example, the 2005 credit debacle helped validate our model. We were positioned to take full advantage of the new environment, correlation crisis and spread widening. The reason we had a great year in 2005 was our strength in fundamental research and our ability to understand how credit events would affect structured products.

Q: What is your strategy going forward?
A: In our managed business, we envision a gradual move to more flexible structures, in fund format. In today's market a credit manager cannot ignore the dynamics generated by structured products. We believe that the combination of fundamental research and in depth understanding of these dynamics creates a clear competitive advantage.

For our listed funds, the aim is to create a benchmark for the market and the focus will be in increasing the investor base and size of the fund. We will seek opportunities to leverage the output from our analysis investing across the capital structure of cash flow transactions

Overall, we want to continue to leverage our strong team without losing focus on our areas of expertise. At the same time, we will keep applying our strong fundamental methodology to both our managed transactions and our investments in structured products.

Q: What major developments do you need/expect from the market in the future?
A: We are positive about the cash flow CDO market and believe the developments in this area will result in the technology being applied to new asset classes generating new opportunities. We are more concerned about developments in the synthetic market, however.

Most of the demand for synthetic products is coming from non credit investors in the form of highly rated notes linked to indices or static portfolios, creating a lot of technical pressure in indices and their components. We would obviously like to see market innovations continue, but without forgetting that at the end of the day, we are all trading credit.

About Washington Square
Washington Square Investment Management Ltd. ("Washington Square") is a London based independent credit intensive asset manager offering innovative investment products and solutions based on a wide range of underlying assets, including: credit default swaps, high yield and high grade bonds, secured and unsecured loans, mezzanine debt and certain types of equity and equity linked securities. The Company identifies credit value / financing arbitrage opportunities independently of their asset class by using proprietary research techniques and systems and applies efficient securitisation structures to enhance the risk/return profile of its funds.

"The market now needs to support trilateral and quadrilateral communication"

In this week's Provider Profile we talk to operational risk solutions provider T-Zero

Conventional wisdom has it that necessity is the mother of invention and T-Zero is proof of that wisdom at work. It is a solution that directly addresses the major challenge to a market that can seemingly only be held back by not having enough middle and back office staff to deal with failed trades.

Mark Beeston

If the market adopts his firm's solution across the board, Mark Beeston, T-Zero's president, believes that challenge will be overcome. And, almost as importantly, dealers won't be called to the Fed's office to explain outstanding CDS problems, or potentially for that matter, rates, equity or any other derivative trades ever again.

Having previously worked on derivatives desks at Deutsche Bank for 13 years, Beeston has had lots of exposure to the issues. This, he says, has given him clear insight into why all market players should embrace his firm's product, which allows counterparties to affirm a new trade or novation the moment it's entered into their systems, preventing it being sent incorrectly across myriad internal and external systems and electronic networks.

"21% of CDS trades, according to ISDA, need to be re-booked, for various reasons. There is a huge operational cost resulting from this inefficiency, and this cost is driven purely by things that don't work," says Beeston.

"A multi-layered market requires many people to be connected. There are many vendor and bank proprietary IT systems, but still no-one can get 100% efficiency. A bank may pay a vendor a million dollars each year for their system, but it still needs dozens of mid and back office staff to deal with all the problems that still result despite this investment in technology."

Beeston adds that a typical dealer may have in excess of 1000 counterparties, so the staffing requirements when 21% of trades need reworking are huge. The success of the entire operation depends largely upon how rapidly clients can respond to failed trades. If the market cannot capture details of trades correctly, clients are unhappy, risk is introduced and dealers have a great deal of paperwork to get through.

This is where a third generation product comes in, claims T-Zero, to propel the market from a 79% success rate to very close to 100%. Beeston explains: "First generation STP solutions made it possible for firms to generate operational events such as payments and documents out of the door with no human intervention, but whatever went into that system incorrectly, stayed incorrect. Second generation systems allowed the market to process those events externally automatically, for example use of DTCC for legal confirmation. That allowed those same errors to be identified in a few days rather than a few weeks, but the error resolution process is still intensive and manual."

But, he continues: "If a default occurs and you're holding that failed trade and are waiting for the error to be traced, you could be losing a lot of money in the meantime. With any losses associated with failed trades, you are facing internal issues and potentially issues with your client relationship as well."

T-Zero's technology offers that third generation STP solution, allowing counterparties to affirm a trade via a Bloomberg terminal, T-Zero's own user interface or an API. It can then be sent onto multiple locations including Deriv-serv. "Banks cannot squeeze any more efficiency out of existing first and second generation STP solutions, so T-Zero is there to provide the step up to the 100% operational efficiency that is possible" claims Beeston

"If the market volume doubles again in '07, then the amount of outstanding trades doubles if efficiency stays constant. The market needs to be able to accommodate a growth rate equivalent to doubling the market each year. Our technology enables this. There is no reason for any problem to remain outstanding beyond trade date for a huge proportion of these trades. The key is adoption, and our business model and distribution via Bloomberg really is enabling that." he adds.

To this end, T-Zero will connect to anyone to allow operational efficiency to improve, whether they are a competitor or another vendor, because, says Beeston, no-one else is offering affirmation as their single, core product. "It's what we call Agnostic Connectivity, enabling our clients to fully leverage their existing infrastructure investments. We don't prescribe who or what our clients can utilise to process their business."

Connectivity is going to be further complicated next year, Beeston suggests, as prime brokers will start to play a bigger role in the market. Here, T-Zero is ahead of the curve by already providing links between the 140 plus hedge funds signed up to the service and ever increasing numbers of their prime brokers.

"The market now needs to support trilateral and quadrilateral communication at a minimum, between client, bank, prime broker and the second bank involved in a novation. This means our service becomes even more important in driving the highest standard of multilateral communication and hence trade data accuracy" observes Beeston.

The STP burden is nevertheless firmly on the sell-side, according to Beeston, with the buy-side trading less frequently, particularly newer entrants to the market. "The main thing a buy-side client cares about is the trade not being wrong, so that a week after the trade no-one tells him that he sold protection on Dura instead of buying it. Our service ensures that is the case for him, on trade date, at no cost."

For T-Zero there is also now an added challenge to deal with – the growth of other asset classes. As the credit market gets better at clearing its backlogs, so the OTC equity derivatives market's problems come more into focus.

Beeston clearly has an eye on the market's future needs. "Regulatory pressure on equities means resource will gravitate naturally away from credit. A multi-asset class solution will be required, and we have the technology, the client base and the distribution model to provide that," he concludes.

JW

BNP Paribas aims to double up arbitrage

The latest company and people moves

BNP Paribas aims to double up arbitrage
BNP Paribas is ramping up what it sees as one of the key groups within its credit operations. "We are investing more in our arbitrage business and looking to grow it strongly – our target revenues for 2007 are twice what we were targeting this year," confirms Stephane Delacote, head of structured credit trading and arbitrage at the bank.

That investment will see headcount and presence grow for the arbitrage trading group, which is part of BNP Paribas' credit non-flow trading business – structured credit trading focuses on client business, while arbitrage trades on the bank's account. Arbitrage currently has eight staff in London and three in New York, but immediate plans will see a further staff member join in New York, three more in Europe and two in Asia.

"We first launched our activities in London, New York and Paris. We will be trading very soon in Italy and Hong Kong. We see substantial value in understanding local problematics and specifics," explains Delacote.

He adds that hires for Italy are about to be made, while he has specific traders in mind for the positions available in New York and other European locations. Meanwhile, Asian hires are also currently being considered. "We regard Asia as very key, the hiring there is not done yet, but expect to see an announcement early next year," Delacote says.

Once completed, those hires will fill the current 2007 budget, but Delacote suggests that could change. "We have it in the back of our minds to expand Asia beyond Hong Kong and America beyond New York. We are thinking seriously about Korea, Japan, Canada and Brazil."

A move into Rio will be just one more step in what has been a long journey for the arbitrage group. It began in early 2004 and has since been through a number of reorganisations to reflect the rapid changes in the credit derivatives markets. It now constitutes four main functions – basis, debt-equity, relative value and correlation trading.

The latter, is the most recent piece in the jigsaw. Delacote recalls: "When we were trading and hedging for our clients as part of our structured credit trading group last year we saw the relative value opportunities available between tranches and started to take some positions mostly in the equity part of the capital structure."

He continues: "What we realised was that correlation positioning could be an activity on its own. So we reorganised the group and transferred Olivier Chermette, our head of correlation trading, into the arbitrage activity. The Correlation business is all about understanding the imbalances implied by large structural market flows and we have very similar approaches for most of our arbitrage trading activities."

That common approach sums up why the group is called arbitrage and not prop trading, according to Delacote. "It is prop trading in the sense that it is trading for the bank, but not in the traditional sense of buying because you think something is going to go up and selling because it's going to go down. We are trying to understand the structure and complexity of the market and take advantage of it where risks against rewards are significantly in our favour."

It clearly works. As Delacote concludes: "It's been a successful approach – 2006 has been the best year we have had... so far."

Hedge fund manager to lead DK credit
Dresdner Kleinwort has appointed Mark Richardson as head of credit and equity derivatives effective 1 January, 2007. He will be based in London and report to Jens-Peter Neumann, Head of Capital Markets.

Richardson is currently a partner at hedge fund WMG Limited. From 1998-2004 he was at Commerzbank where he was initially head of equity derivatives and later had a more senior role as head of derivatives, leading a fully integrated, multi-asset class global derivatives platform comprising over 500 professionals. His earlier career includes time spent at ING Barings and Bankers Trust in London and New York.

Credit derivatives lawyer joins ISDA
David Geen has joined ISDA as the trade association's European General Counsel based in London. In this new position, Geen will play a key role in a wide range of the association's global legal and documentation activities, ISDA says.

Geen most recently served as executive director and senior counsel in the legal department of Goldman Sachs International in London. As variously head and co-head of the legal department's derivatives group, he coordinated the legal department's coverage of the European derivatives activities of Goldman Sachs International and its affiliates.

Prior to that, Geen was a partner in the London office of Baker & McKenzie. Before joining the ISDA staff, he was an active member of many of the ISDA's documentation and market practice efforts. In particular, Geen has been a significant contributor to the Association's Credit Derivatives Market Practice Committee, where he played a key representative role during the lead up to the publication of the 2003 ISDA Credit Derivatives Definitions.

Headhunter hires
Aemilia Lovatt is joining specialist executive search firm Watmough Mallet as part of the structured credit search team, together with Caroline Landriau, who joins as senior researcher in structured credit. Both report to Simon Clarke, head of global markets for the firm.

Deutsche appoints new chief credit officer
Stuart Lewis, currently global head of the loan exposure management group (LEMG) at Deutsche Bank, will transfer to join its risk & capital management group as chief credit officer and deputy chief risk officer, with effect from 1 December. Lewis will be succeeded as global head of LEMG by Sean Kavanagh, currently head of LEMG Americas and Deputy Head of LEMG.

DBRS expands EMEA structured finance
Dominion Bond Rating Service (DBRS) has hired Arnaud Tisseyre as svp and analyst in its EMEA Structured Finance (SF) Team. His appointment follows the successful growth of DBRS Structured Finance activities in Europe and brings DBRS's EMEA SF team to 15 people, the agency says.

Based in DBRS Paris offices, Tisseyre will be responsible for analysis and projects focused on extending the DBRS SF franchise and activities in the EMEA region. In addition, he will contribute to the implementation of methodologies and rating transactions in various assets securitisations mainly in France, Spain and Italy.

Tisseyre joins DBRS from COFACE where he was head of dealing room, responsible for modelling and hedging and interest rates risks. Prior to COFACE, he Arnaud was a financial engineer at Banque Hervet and worked at Société Générale on study, pricing and IT implementation of options on asset baskets.

Hannan joins RBS
Mark Hannan joined Royal Bank of Scotland's structured credit & equity products group last week from Commerzbank. He reports to Steve Lyons, head of risk finance.

Lehman buys into BlueBay
As part of BlueBay asset management's IPO, Lehman Brothers has signed an agreement with the firm and Credit Suisse (which is acting as sponsor and sole bookrunner for the IPO) to acquire 4.99% of the ordinary shares of the company. Lehman Brothers has agreed to a one year post-IPO lock-up and standstill provisions. After one year, Lehman Brothers has agreed not to build any position over 9.99% of the ordinary shares without the prior consent of BlueBay's board of directors.

Jeremy Isaacs, Lehman Brothers Chief Executive Officer of Europe and Asia, comments: "This investment is in line with our strategy of making minority investments in leading alternative asset managers." Indeed, the move follows a number of investment banks adopting a similar strategy with credit hedge funds. For example, Merrill Lynch bought a stake in DiMaio Ahmad Capital (see SCI issue 11).

BlueBay is one of the largest independent managers of fixed income credit funds and products in Europe, with approximately US$8bn of AuM as at 30 September 2006.

BNP Paribas creates commodity securitisation group
BNP Paribas has announced the creation of 'the specialised product group' within its fixed income securitisation business to focus on the infrastructure, energy, project and commodity sectors. The group will be co-headed by Paul Chivers in London and Olivier Baratier in New York.

Chivers joins BNP Paribas from Deutsche Bank, where he was an md in the global markets structured credit trading team since January 2004. Prior to this, Chivers was global head of project and structured commodity finance at Credit Agricole Indosuez. Three additional hires have joined Chivers' team at BNP Paribas in London: Bertrand Loubières joins from Morgan Stanley; Mark Wells from DEPFA and Riccardo Eerenstein transfers from BNP Paribas' Principal Finance team.

In New York, Olivier Baratier transfers over to Fixed Income Securitisation from BNP Paribas' energy, commodity, export and project finance (ECEP) Group, where he was responsible for Structured Credit & Portfolio Management since 2001. He will be joined by Wilfried Marchand, also from BNP Paribas ECEP. The team will be looking to add additional resources over the next few months.

MP

DTCC'S warehouse goes live

A round up of this week's structured credit news

DTCC'S warehouse goes live
The Depository Trust & Clearing Corporation (DTCC) has launched its Trade Information Warehouse, creating a centralised and secure global infrastructure for the post-trade processing of OTC derivatives.

The warehouse is made up of two components: a comprehensive trade database containing the "official legal record" for all contracts eligible for automated Deriv/SERV confirmation; and a central support infrastructure that automates and standardises post-trade processes (such as payments, notional adjustments and contract term changes) over the life of each contract, which can be extended by five or more years.

Initially, the warehouse will support credit derivatives, and then expand to include other OTC derivatives products. "The warehouse represents the launch of a very innovative and important industry solution to improve process, efficiency and risk control in the global credit derivatives markets," says Dick Weil, coo of PIMCO.

The warehouse will automate many processes that occur throughout a contract's lifecycle, which today involve manual effort – including bilateral contract and cash flow reconciliation. Other post-confirmation processes, such as credit event processing and assignment processing, will be made much more efficient.

The warehouse will next year expand to support central payment calculation and a central settlement capability through links with a central settlement provider to streamline payment settlement. Also in 2007, the platform will offer customers the flexibility of electronically reconciling ("tying out") complex or non-standard contracts that cannot be legally confirmed through Deriv/SERV, replacing the customary telephone-based approach.

DTCC announced in February its plans to build the warehouse. Since then, the firm has been working with senior personnel from 19 leading global dealers and the buy-side community (including traditional asset managers and hedge funds) to develop this industry infrastructure solution. Testing of the warehouse's functionality began in September. In addition, back-loading – which involves populating the warehouse database with trade data on existing contracts – has started and will continue throughout 2007.

Dura protocol adherence proceeds
The adherence process for ISDA's 2006 Dura CDS Protocol appears to be running smoothly, with 145 firms signed up as at 14 November. With only a few days to run, numbers are lower than previous protocols – in the most recent example, 340 institutions signed up to ISDA's Dana CDS index protocol in March.

However, the lower numbers were expected – despite the fact that the latest protocol is the first to incorporate settlement of single name and tranche default swaps – because Dura is a less widely traded name than its predecessors. The Dura protocol adherence process runs to 17 November and is scheduled to be followed by an auction on 28 November.

Investors welcome GUS 2013 bonds restructuring plan
Tuesday's announcement of Experian's proposed revised restructuring plans for its GUS 2013 bonds and consequent effect on the CDS referencing them has been welcomed by bondholders – in particular, the investor group that has been lobbying since GUS`s decision to split or de-merge itself into two separate companies to change the company's original restructuring proposal for its bonds.

Deniz Akgul of Cairn Capital, one of the leading firms in the bondholder group, comments: "Cairn will be voting in favour of Experian's proposal. Its plan to pay a fee of 75 cents to bondholders, and to offer them a choice of a coupon step-up of 200bp or a put at par is a good deal for bondholders. It offers substantially better terms than those tabled back in the spring."

Akgul continues: "Importantly, it also fulfils Experian's wish to take account of the needs of the credit swap market by ensuring a bond deliverable into credit swaps will remain available in the event of a subsequent change of control of the company. The technique of offering bondholders a coupon step-up as an alternative to the more traditional 'put at par' is an important innovation. We hope and expect coupon step-ups will be used more widely to ensure stability in the credit swap market."

Experian's original restructuring proposal was for 50 cents and a put at par. Holders of the 2013 bonds wanted a larger consent fee for waiving their rights to accelerate the bonds, and wanted to ensure that at least one GUS bond issue remained outstanding following the de-merger so that CDS contracts written on the company would still have value.

Novel convertible bond CDO offers Indian exposure
Barclays has launched ARLO IV – Ganges Synthetic CDO Series 2006. The transaction is a synthetic CDO of 60 Euro and foreign currency convertible bonds issued by corporations either domiciled in India or where the majority of their business is in India. The transaction enables Barclays Bank to buy protection on the underlying portfolio, the size of which is estimated to be US$300m.

Moody's has assigned a Aa3 rating to the US$174m Class A notes, A3 to the US$60m Class Bs and B2 to the US$30m Class Cs. Most of the reference entities in the portfolio are not publicly rated by Moody's, so the rating agency used a quantitative mapping approach and a qualitative review of ICICI's internal rating process to give credit to those non-rated reference entities. Using the mapping approach, Moody's determined that the credit quality of the initial portfolio is consistent with a Ba3 rating.

The portfolio manager is ST Asset Management and the portfolio advisor is ICICI Bank Limited (Singapore Branch). Any replacements in the reference portfolio will have to pass certain conditions, including passing the Moody's CDOROM Manage-to-Model test.

Fitch considers commodities-linked credit obligations and SiVs
Derivative Fitch has published its approach for analysing and rating commodities-linked credit obligations (CCOs), following the same move by Standard & Poor's last week (see SCI issue 14). The report details the principal risks of the CCO product, as well as Fitch's analytical methodology.

"We have seen very significant interest globally in commodities-linked structures, but these products present non-standard risks, in particular fat tails and volatility clustering. Fitch has had to develop a completely new analytical approach for CCOs," says Lars Jebjerg, director in Derivative Fitch.

Separately, Fitch has also issued a report on SiVs. It says that qualitative assessment of the manager and structural protection play a hugely important role in its assessment of the vehicles. These factors help the agency to assess whether the targeted senior ratings can be assigned, what level of credit enhancement this entails and the achievable rating of the capital (lowest tranche) notes.

The report outlines a large number of considerations on which the qualitative assessment will focus, including management style and strategy, portfolio management and treasury capabilities and experience, risk analytics and system robustness. Fitch also describes the quantitative tools and assessments that it performs to determine the financial risk profile of the vehicle.

First euro high-yield CPPI
Rozavel notes, the first managed CPPI product referencing European high-yield assets, has been brought to market through JP Morgan. The transaction is managed by high-yield expert Crédit Agricole Asset Management (CAAM) and aimed at institutional investors.

The notes offer a 100% principal protection at maturity, while being linked to the performance of a European corporate high-yield strategy managed by CAAM.
The deal offers significant manager flexibility, including a range of allowable strategies and – aside from the principal protection – leverage of up to a maximum of six times (either on the long or short side). Equally, CAAM is not restricted on the instruments it can use, with a mandate to invest in CDS, cash bonds and loans.

MP

Trading ideas - keeping my interest

Dave Klein research analyst at Credit Derivatives Research suggests a long butterfly trade on Kinder Morgan Inc

We are normally hesitant to put on trades involving LBO/MBO credits. It is difficult to compare LBO names to their peers because their curves behave so differently. We see steepness in early maturities and flatness in longer maturities.

This was certainly the case with Kinder Morgan Inc. (KMI). When KMI announced an MBO in the late spring, spreads blew out considerably. Late in the summer, rumours (later confirmed) that KMI's management had agreed to protect existing debt holders spurred a rally. While there continues to be significant risk in trading KMI, we are now comfortable applying our relative value models and taking advantage of a curve trade opportunity.

KMI continues to be one of the most liquid CDS names. More importantly, the volatility in pricing levels for the KMI term structure has triggered a number of our fair-value models. We find that both a 3s-5s flattener and 5s-10s steepener on KMI have positive carry and are trading wide to fair value. Furthermore, our butterfly fair value model (which judges fair pricing for five-year risk given threes and tens), we find that KMI's five-year sits wide of fair value compared to its wings.

Given the excellent liquidity across the term structure of KMI and the positive economics of the package, we feel a duration-hedged 3s-5s-10s butterfly offers good relative value while being generally hedged against parallel or twist moves in the curve.

Hot wings
To estimate the fair value of the 3-5-10 butterfly, we model the 5 year bid level as a linear combination of the 3 and 10 year offer levels. This is undertaken across the universe of credits whose 3's and 10's are close in value to KMI, and the output of the regression is shown in Exhibit 1.

Exhibit 1

For each issuer, we produce an expectation of the five-year CDS bid level. This is compared to the current market five-year CDS bid level in Exhibit 1. The regression has an R-squared of over 99% and so we can be quite confident of its findings.

The Exhibit clearly shows that KMI is trading (y-axis) wider than our fair value model would imply. If the modelled bid level is below the 5 year market level, we expect the 3-5 leg to flatten or the 5-10 leg to steepen.

This is an indication that the five-year body is trading cheap to the three-ten wings and a butterfly is potentially applicable. In order to consider the potential driver of any relative-value pick-up we next look at the individual legs of the trade – a fives-tens steepener and 3s-5s flattener.

Nice legs
Our fair value butterfly model has shown that there is some relative-value across the term structure of KMI, but we analyse each leg below to discover where the expected change might come from.

The fives-ten curve is flat to fair value, as seen in Exhibit 2. Our fair value curve model for US credit shows that the current levels for a steepener (which is the equivalent leg) are just above the solid black line (as seen by the green square). The 5-10's steepener leg is 9bps above fair value and has positive carry and excellent roll-down.

Exhibit 2

The threes-fives curve, on the other hand, is significantly steep to fair value. Exhibit 3 shows that compared to its peer groups, KMI sits almost 18 basis points too steep for a flattener (our butterfly's equivalent leg). Whatever the reason for the steepness, our flattener leg is extremely steep to fair value and offers significant relative value. 

Exhibit 3

Before moving on to the economics of the trade, we consider the behaviour of KMI within our 3-5-10's Fair Value model over time. Exhibit 4 charts the difference between market 5 Year bid and the model expected value.

Exhibit 4

First, we note that, as shown earlier, our model indicates that the 5's are trading above fair value. Second, we see that, over the past few months, KMI's 5's have traded both above and below the model's fair value.

It is important to note that KMI's MBO altered the credit profile significantly and, until recently, we would be less reliant on our fair value model given the stress on the credit. With recent positive credit announcements by the company, we feel more comfortable with this trade.

Trade economics
Three of our models indicate that the trade is warranted, but we must consider the actual economics of the trade. The carry of the DV01-neutral butterfly is often more important than the expected behaviour of individual legs of the trade.

In the case of our DV01-hedged butterfly, we find around 25.5 basis points of positive carry, which along with around 10 basis points of MTM relative value we would expect provides some significant upside, given the nature of the butterfly trade. Additionally, over the next year we would expect to gain about 90 basis points of MTM roll-down, primarily due to the flatness of the 5-10's leg, even if the KMI curve did not move. Taken together, these gains more than offset the 15 basis points of bid-offer spread we must cross on our trade.

The butterfly trade is hedged (for small moves) against both parallel shifts as well as twists to the credit curve. Although we have a deteriorating fundamental view on the credit, we are exploiting the relative 3-5-10 levels to pick up carry, roll-down and relative-value.

Risk analysis
The butterfly is constructed to be duration- (and slope-) neutral with 3-5-10 weights of 1.5-2.5-1.0 based on the respective DV01s. Given our deteriorating fundamental outlook, we prefer to be hedged against both shifts and pivots.

Though three years, this position is default neutral (we are long protection in $25mm and short protection $25mm). The following table (Exhibit 5) provides a more complete picture of the expected P&L impact of shifts and twists in the term structure of KMI.

Exhibit 5

As is clear, the parallel shifts and curve twists do generate some P&L (due to convexity differences) but these are minimal for moderate movements and the carry earned (and MTM relative-value realisation and roll-down) outweighs this.

KMI's MBO also provides a higher level of risk in this trade. We discuss the fundamentals below. From a technical standpoint, KMI has rallied since the MBO announcement in the late spring. This has caused the 3-5's leg to flatten and the 5-10's leg to steepen. If the curve reverses itself and the 3-5's steepen again and 5-10's flatten, we will incur a significant loss.

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

In general, the biggest challenge to a butterfly is the ability to unwind the trade profitably. With three legs, we must cross three bid-offer spreads. As stated earlier, we face about 15 basis points of bid-offer spread that is offset by healthy carry, MTM roll-down and MTM relative value gain.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk as KMI has excellent liquidity in the credit derivatives markets. We see quite a bit of volatility in indicative levels for KMI. We only recommend the trade if the 3s-5s-10s levels are close to those stated here. If the 3s-5s flattens, the trade will lose much of its profit potential.

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. KMI is one of the most liquid US credits and has small bid-offer spreads.

Fundamentals
This trade is technical in nature and is not based on any fundamental outlook. Since KMI is currently undergoing an MBO, we would not be comfortable putting on the trade without keeping an eye on the fundamentals. KMI has several projects that must be funded over the next few years which could apply stress to the company's financials.

However, some of these projects can be completed in stages and potentially could provide cash flow for debt servicing. Given the possibility of delays, it is unclear how this will play out.

Normally, we would avoid applying our fair value models to LBO/MBO candidates because their credit profile does not match that of their peers. However, KMI's recent announcement concerning existing debt gives us confidence to consider this trade.

Summary and trade recommendation
While normally LBOs/MBOs are outliers in our fair value credit models due to leverage, KMI calmed fears and rallied the credit markets with its intention to protect current debt holders. Even so, we cannot ignore the expected $7 billion in new MBO debt. Given our deteriorating fundamental outlook, we would like to put on a 5-10's steepener.

However, we believe the 3-5-10's butterfly offers better economics as well as hedges us against curve twists and shifts. There is always the risk that management will reverse itself and the 3-5's will steepen and 5-10's will flatten, going against us on both legs, but we believe that risk lessens daily as KMI executes on its plan.

The excellent liquidity in the CDS curve provides us with an interesting relative-value play. Using our 3s-5s-10s fair value model, we find the 5 year CDS to be wide of fair value given its 3 and 10 year levels. Given the steepness of the 3s-5s leg, we view the butterfly as a strong trade candidate. Excellent carry, roll-down and the potential profit of a return to fair value strengthen the economics of the trade.

Buy $15mm notional Kinder Morgan Inc. 3 Year CDS protection at 66bps and
Sell $25mm notional Kinder Morgan Inc. 5 Year CDS protection at 123bps
Buy $10mm notional Kinder Morgan Inc. 10 Year CDS protection at 183bps to gain 25.5 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).

CPDOs: the good, the bad, or the ugly?

Siobhan Pettit, Matthew Wiesner, and Gregorios Venizelos of the structured credit strategy team at the Royal Bank of Scotland examine current CPDO structures and their impact on the credit markets

In recent weeks the market has struggled to digest the latest innovation in structured credit, the Constant Proportion Debt Obligation (CPDO). In our view, CPDOs have both been overly praised for the benefits they can bring to yield-hungry investors, and overly criticised for recent volatility in CDS markets.

Moral judgements aside, the rapid rise of CPDO 'technology' is as phenomenal as it is unexpected, and creates a promising new framework for leveraged credit arbitrage. There is ample room for evolution in the types of strategies that could be expressed via CPDO: long-short index or tranche plays, equity only, curve strategies, or any combination thereof ... the sky's the limit.

We are less sanguine, however, about the long-only index-based strategies that drove the creation of CPDO technology, particularly with respect to potential for mark-to-market and ratings volatility. It seems clear that the main selling point of these strategies is that they carry a rated coupon. Which is to say, we think by focusing too intently on acronyms and leverage mechanics, investors risk missing the forest for the trees.

CPDOs also seem to present investors with a dilemma, at least in their current form. On the one hand, they can choose the attractive, rated yield from the highly leveraged long-only plays. On the other, they can look for value in more flexible, managed strategies, but without the rated coupon. The holy grail remains a managed strategy that can provide principal protection and a rated coupon.

In the current environment, we are wary of long-only leverage, and prefer the flexibility of a managed framework. What's more, in the absence of a rated coupon, we think managed strategies are more compelling when paired with the returns profile of CPPI (principal protection, unlimited upside).

CPDO vs. CPPI: faux amis
Both CPPI and CPDOs are general frameworks for expressing leveraged investment strategies, rather than investment strategies in and of themselves. This may seem obvious to investors in CPPI products, which have been in existence for decades and have spanned a variety of asset classes (equity, credit, commodities, and real estate). It is less apparent for the CPDO framework, which is brand new and so far has been applied exclusively to long-only investment strategies in the most liquid CDS indices.

Under both structures, investors provide an initial deposit to the sponsor bank, which essentially acts as a margin account intended to collateralise the leveraged risk strategy. Generally CPPI intends to put only a portion of the margin account at risk (always leaving enough so that principal can be repaid at maturity). By contrast, CPDO puts most of the margin account at risk. Why this is the case is a function of the two frameworks' very different goals.

The main goal of CPPI is to maximise returns without putting principal at risk. The primary aim of CPDO is to put as much principal at risk as is needed to meet yield targets. Thus, the different nature of these goals translates into very different leverage mechanics as well as risk return profiles.

Generally speaking, leverage in CPPI is determined by applying a leverage factor to something usually called the cushion, or reserve. The cushion is the positive difference between the NAV of the portfolio (initial principal deposit plus the MtM of the risky strategy) minus the cost of guaranteeing principal (this can be thought of as the cost of a zero coupon bond that accrues to initial invested principal by the strategy's maturity).

So, if a strategy has a leverage multiple of 30x, the portfolio NAV is 100, and the cost of a zero is 80, the total leverage = 30*(100-80)=600, or the initial principal is 6x leveraged. All else being equal, as the NAV increases, leverage increases. The flipside is also true: as NAV decreases (say to 90), so does leverage (30*(90-80)=300, or 3x initial principal). Similarly, the cost of the guarantee has an impact on leverage.

Managed CPPI framework

Source: RBS

Leverage in CPDOs is driven by an entirely different concern – meeting the rated yield target. The leverage concept in a CPDO is a function of what is defined as the 'shortfall'. This is simply the difference between the present value of promised note payments (interest + principal, discounted at the forward curve) minus the portfolio NAV.

Unlike CPPI, the amount of leverage in the CPDOs currently in existence is not defined as a multiple of the shortfall. Rather, the extent of the shortfall defines that amount of leverage that can be applied to the strategy.

For simplicity's sake, let's just assume that leverage is fixed at 10x initial notional when the shortfall is 20, 5x notional when the shortfall falls to 10, and 15x notional when the shortfall is 30 or above. So with NAV of 100, and a PV of note payments of 120, leverage would be 10x. If the NAV were to fall to 90, and the PV held constant at 120, leverage would rise to 15x, and so on. So, as the NAV falls, investment strategies expressed through the CPDO framework (as we currently know it) are forced to put on leverage.

CPDO framework

Source: RBS

The benefit or risk of the leverage achieved in CPPIs or CPDOs are defined by the cash out/unwind events. CPPI strategies generally trigger an unwind event once the NAV of the portfolio falls below some buffer over the cost of the principal guarantee (zero coupon). Fitting with CPPI's goal of optimising returns, no cash out event is triggered if the portfolio NAV rises. Another way of putting this is that CPPI offers principal protection, and potential for unlimited upside.

Here, too, CPDO offers the opposite. The standard so far for these transactions is to be structured with both an unwind event, and a cash out event. The unwind event is triggered when the portfolio NAV falls below some percentage of the initial investment, say 10%. Triggering this event would cause the structure to be liquidated, potentially with total loss.

The cash out generally is triggered when the portfolio NAV equals the present value of the promised interest and principal payment. In this way, CPDOs are built to seek greater leverage until the earlier of: the yield target being met; a maximum leverage cap being reached; or a loss incurred. For this reason, CPDOs can be viewed as offering a fixed upside and the potential for total loss.

The contrast between these two leverage mechanics and their consequences could hardly be more pronounced. But how that contrast is framed can give different impressions as to which strategy is the wiser to pursue. For example, CPPI-based strategies can be described as buying into a rising market, and selling as the market falls (buy high, sell low), and CPDOs as selling into rising markets, and buying into falling markets (buy low, sell high).

Alternatively, we can frame the comparison in gambling terms: when the chips are down, CPPI strategies take money off the table. CPDOs double down. Which do you prefer?

The reason simple analogies above are of limited help is because the returns promised by both strategies depend not only on fluctuations in NAV, but also the magnitude of the changes, when they occur, and in what order. In other words, they are path dependent. This makes them more difficult for rating agencies to analyse than structures that are sensitive to standard, directional stresses, for example, the types of stresses that are applied to leveraged super senior products.

The role of the raters
One question that has been in the market is whether the rating agencies have sufficiently captured the probability of those path dependencies in their analysis of CPDOs. All three agencies have come out with articles generally describing either their approach to rating the long-only CDS index based CPDOs currently seen in the market or outlining the main economic risks, namely: default risk; spread risk; roll and liquidity risks; and interest rate risk.

The discussion of these risks is usually framed by the dominant structure in the market: a 15x leveraged exposure to a synthetic portfolio evenly split between the 5 year iTraxx EUR IG and CDX N.A. IG indices, with a 10 year maturity, and carrying a rating that addresses both the timely payment of interest and principal.

Thus, the rating on the structure must address the likelihood that it can withstand defaults on the index, the mark-to-market impact of spread movements, fluctuations in interest rates, and the impact of rolls on the indices.

The general approach seems to be to subject the CPDO structure to defaults in line with rating agencies' standard default models, and spread evolutions similar to those used to rate leveraged super senior transactions. For example, to rate the initial structures, S&P assumes the structure is subject to portfolio default risk as modelled by its CDO Evaluator model, and a spread process similar to that used for leveraged super senior transactions, assuming a long term mean of 40bp for the first year of the transaction, 80bp thereafter, a volatility of 25%, and a mean reversion speed of 40%. S&P assumes a bid-offer on the roll dates (when the CPDO is forced to roll into a new index) of one basis point.

Following the end October tightening, these assumptions started to get greater scrutiny by the market. Some corners called into question the validity of overlaying the long-term mean assumption of 80bp from Leveraged Super Senior-land to a portfolio of iTraxx EUR IG and CDX N.A. IG exposures (35bp and 48bp average spread, respectively, since inception).

What's more, given the attention on CPDOs, the market is expecting a less accommodative roll than recently experienced, especially if CPDOs dealers lack flexibility to manage it efficiently. The concern is that a costly roll into a low-spread index could leave long-only CPDOs facing lower NAVs, higher shortfalls, capped leveraged, and not enough income to generate the funds necessary to cover the rated payments.

CPDOs and the market
When it comes to the CDS indices and flow tranche markets, we think that CPDO activity can be a significant contributor to market direction but not to the point where the tail is wagging the dog. It's true, the strong tightening witnessed in CDS indices at the end of week 23 October was intensified by a CPDO print, but the market had already been in a strong bullish mode. Likewise, the transient mid day spread gap out on 8 November was precipitated by concerns about the rating stability of the CPDO platform, but the back drop was that a correction from all time tight spreads felt overdue anyway.

Still, the impact of CPDOs is not trivial. Compare the footprint of a €1bn notional long only index based CPDO deal leveraged 15x, thus a delta equivalent notional of €15bn, to our estimate of combined daily average volume of €15-20bn for the three main iTraxx indices (we would expect an even higher combined figure for the three main CDX indices). Even though daily CDS index markets show increasing depth, a typical CPDO deal ramped up over a couple of days could easily match current daily index volumes, and for that reason alone the market should take note.

So what will be the impact of this potential for increased flows? From a broader perspective, we think the advent of CPDOs will liven up the index roll dates. Indeed, given that the CPDO exposure needs to be rolled into the on the run series every six months, the cost of this roll is of crucial importance to the value of a CPDO structure.

One key issue facing the rolls is the sheer volume of roll notional that CPDO volume could imply. Though accurate estimates of completed and forthcoming CPDO issuance are difficult, it is conceivable that just a few index backed CPDO deals will necessitate the roll of a notional that is comparable to a week's worth of 'roll notionals' under normal circumstances (i.e. double up the normal volume) over just a few days.

This raises concerns as to whether iTraxx and CDX dealers would be capable and/or prepared to manage such a bottleneck, and if so at what transaction costs? A typical quote of 0.25bp bid/ask for a €200m ticket is not likely to be achievable for a €5bn transaction.

Other factors affecting the roll are:
• Changes in underlying names from the off-the-run index to the on-the-run index.
• The steepness of single name CDS curves vis-à-vis the 6 month maturity extension from the old to the new index. The steeper the curves the higher the increase in the new index spread.
• The differential in the index basis to theoretical between the new and old indices.

Changes in names to the new index almost always reduce risk because non-investment grade names are removed through the roll. As a result, the change-in-name risk tends to support a lower spread on the new index compared to the old index.

In contrast, the maturity extension resulting from the roll of the old index into the new supports an increase in spreads, at least in normal conditions. In fact, CPDOs in some respect are structured to capture this beneficial aspect of the roll.

Finally, the norm so far during the rolls has been for the index coming off-the-run to tighten to its intrinsic value, and for the on-the-run index to widen to its intrinsic value. This movement generates a positive basis to theoretical spread differential between new and old index, thus augmenting the roll spread.

In normal conditions, we estimate that the net impact of a 'typical' index roll would add 1.5bp of excess spread to a long-only index-based CPDO. This begs the question as to what constitutes 'normal conditions.' For example, the net effect of these three components has meant that so far the iTraxx has always rolled on a positive spread differential. This has not always been the case for CDX: In September 2005, the CDX rolled 4bp tighter mid/mid, when auto names and a few other fallen angles were removed from the on the run basket.

This highlights some of the technical risks facing CPDOs. For example, in case of spread widening on the run up to the roll, the exact type of spread widening would be central to the impact on the NAV of the deal.

A worst case scenario would be downgrades and significant spread widening in only a handful of names in the index basket, names which would be subsequently removed from the new basket. Thus the CPDO would not only suffer the negative MTM due to the spread widening but would also have to roll into a new index most likely trading tighter (thus no extra spread to counter the MTM loss).

In addition, the more sudden such a widening the worse for the structure, as it may not have time to adjust leverage. This plainly demonstrates the CPDO exposure to idiosyncratic risk. In contrast, a systematic widening would be benign to the CPDO as the MTM losses would be offset by the higher spread of the new index.

The nature of the basis to theoretical spread differential going into the roll could also affect CPDO returns. It is possible that at the roll date a CPDO dealer would seek to unwind the exposure over a few days ahead of the roll by buying protection in the old index, in order to manage the transaction costs. This could drive the old index wider to its fair value thus disturbing or even reversing the basis to theoretical dynamic described above (the heavy selling of protection in the new index would make matters worse in that respect).

Following these concerns about the CPDO roll cost, the inevitable question becomes: given the reputation risk involved, how will CPDO dealers manage the product roll? Will there be a temptation to try to cap the spread widening of potential blow ups? Will there be an inclination to position in curve steepeners in order to enhance the calendar spread of the roll. For the astute CDS market players this may well create some relative value opportunities.

© 2006 The Royal Bank of Scotland. This Research Note was first published by The Royal Bank of Scotland as part of 'Structured Credit Matters' on 10 November 2006.