Contents

CDR Liquid Index data as at 20 November 2006

Source: Credit Derivatives Research

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

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

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

European LCDS debate rolls on

Portfolio managers association calls for cancellability but not all agree

The International Association of Credit Portfolio Managers (IACPM) joined in the debate over LCDS documentation this week, calling for contracts to be universally written on a cancellable basis. However, their concerns may not be at the top of the list of issues being discussed at the next dealer meeting on European LCDS.

IACPM sent a letter to ISDA calling for the inclusion of standard cancellability provisions in LCDS contracts. In its letter, the IACPM points out that risk managers use LCDS to hedge specific obligations, usually syndicated secured loans, and need to be able to cancel matching swaps contracts if the underlying loans are called.

"The syndicated secured obligations that loan portfolio managers want to hedge are frequently repaid or refinanced," explains Som-lok Leung, executive director of the IACPM. "Risk managers have to be able to cancel the related swap or there will be a mismatch between the hedge and the underlying loan asset when it's refinanced. At the very least, that can increase overall hedging costs."

IACPM is strongly encouraging ISDA to include cancellability language in the new European template and to modify the existing US documentation to include a cancellability option which is currently missing from the US version. The association argues that a more favourable provision will encourage risk managers to use the product and help the market grow.

While IACPM's arguments are valid, the difficulty with the issue is that other market participants have directly opposing views. For risk sellers, a non-cancellable provision is as attractive as a cancellable one is to risk buyers.

Nicolas Bravard, partner of Alpstar Management's hedge fund business, says: "If the contract remains cancellable, then in our view there will be limited appetite for this type of instrument. There is, of course, an issue about creating a product that primarily suits one side of the market. When you create a new product, you want it to be successful – and that may mean you have to compromise and go for the type of contract that is likely to generate the most liquidity, which in our view is non-cancellable."

He continues: "Right now what's happening in the European LCDS market is there is limited liquidity and transparency, and the launch of the indices – even though we have participated in it – hasn't been as successful as it should have been, because there is little two-way flow. It's all one way traffic because everybody wants to be long risk and nobody wants to be on the other side."

Notably, three of the potentially largest dealers in the contracts – Citigroup, Goldman Sachs and JP Morgan – who would generate more two-way flow are understood to be unwilling to become involved in the market until the European contract is made non-cancellable. "Until we get all the major dealers, it won't work. I think the most important thing for LCDS is that they can be traded actively. Then people will get more confident and the instrument will become its own asset class – and then we'll see more investors in the market," Bravard says.

While the broader consensus appears to be a move toward a non-cancellable contract, dealers are keen to stress that the overall European LCDS product discussions are not yet fully finalised and issues – as well as meetings – are ongoing. For example, another dealer meeting similar to last week's (See SCI issue 15) is expected to take place within the next seven days.

One of the issues likely to be discussed is the concern from some institutions that the proposed reference entity approach for documentation might not prove to be fully satisfactory. The fear is that, unlike the reference obligation approach, sellers would theoretically be selling protection blind and be open to taking delivery of potentially highly undesirable paper.

MP

Merrill taps Singapore retail

First principal-protected notes arrive, with more expected

Merrill Lynch launched on Monday what it describes as a first-of-its-kind Jubilee LinkGain note product in the Singapore retail investment market. The notes are targeted at investors looking to diversify their asset class allocation into the credit markets from fixed deposits, endowment plans and other traditional investment products.

"While the structure of the Jubilee LinkGain Notes is not new to the private banking sector, it is the first time that such a principal-protected credit product is made available to a wider audience," explains Tay Li Choo, vp investor client group, debt markets, Asia Pacific region at Merrill Lynch (Asia Pacific).

"Our aim is to ensure that investors in Singapore are able to benefit from the strong upside potential that these notes have to offer, and we believe that the local market is ready to embrace higher yielding credit-linked investments with the safety of principal protection," he adds.

Rival dealers concur that the Singapore market is ready for capital protected products, but do not expect a significant flow of deals immediately. "Issuance into the retail market is very much a question of timing. It's a matter of measuring the return you can offer from credit product – especially given continued credit spread tightening – relative to what return investors can get from other asset classes. Unlike institutions, retail investors don't look at products in asset class silos, so while we expect to see more deals of this kind eventually, when that happens will be market dependent," says one structurer.

Timing is also an issue for retail focussed structured credit products in the smaller markets in the region. "There have obviously been a number of retail deals in Australia and Japan, but in the main Asia Pacific area only Hong Kong and Singapore have seen offerings so far, albeit on a non-capital protected basis until now," the structurer explains.

"We will see retail deals in other countries, and a number of firms are gearing up for it. But it is a question of when we can get authorisation to offer structured credit products to the retail market. As always in Asia, everything is on a jurisdiction-by-jurisdiction basis," he adds.

Jubilee LinkGain Notes are issued by Jubilee Global Finance Limited, a special-purpose vehicle, and are credit-linked to an underlying portfolio of 135 investment-grade reference entities as rated by Moody's Investors Services and Standard & Poor's. The reference entities include names across the globe and cover 19 different industrial sectors.

The notes are denominated in either US or Singapore dollars, with values of US$5,000 and S$10,000. Both notes are scheduled to mature in March 2017. The interest coupon paid at maturity of 125% (for the S$ notes) or 200% (US$ notes) of the note principal amount is credit-linked to the reference portfolio – each time a credit event occurs the interest coupon paid at maturity is reduced.

The notes will be distributed by ABN AMRO Bank Singapore Branch, Citibank Singapore, CIMB-GK Securities, DMG & Partners Securities, Kim Eng Securities, OCBC Securities Private and UOB Kay Hian Private.

MP

iTraxx hovers on the edge

Index tightening could reverse in the short-term, while more LBO talk permeates singe names

The European CDS indices edged slightly tighter this week as the markets wound down either side of the Atlantic to take advantage of the US holiday Thursday. However, a sense began to emerge that some widening could occur, at least in the short-term.

Gregory Venizelos, structured credit strategy at Royal Bank of Scotland, observes: "The market has become a complacent bull in recent weeks, with massive supply being digested easily in both structured and conventional markets. This is all well and good in a low vol market but this kind of issuing activity poses two questions: Is it consistent with the conventional view of a soft landing and doesn't this kind of year end buying fest usually end with massive indigestion?"

He continues: "It's a case of 'enjoy it while it lasts'. Default rates are almost zero again, corporate rating changes are a thing of the past and corporate results are positive. And as the decline in the VIX indicates, there isn't any scary news out there, but even so, the M&A/LBO boom continues and the amount of leverage in both structured and unstructured deals can only grow so far. There might be a slight bias for spreads to widen from here, but any move needs volatility to pick up, and that needs a change in the macro backdrop."

Marcus Schüler, md integrated credit marketing at Deutsche Bank, concurs: "The market currently exhibits a certain kind of vulnerability, given that the technical position is outright long. We expect it to test wider levels should some kind of catalyst emerge, which could easily happen with something as relatively minor as a few participants starting to buy protection to reduce their risk."

However, Schüler adds: "At present there is no sign of a major change in direction, which would arise from a spike in volatility. We could easily continue to grind tighter if equity markets continue to remain friendly."

In single names, talk inevitably surrounded LBO activity over the past few days. ITV was the lead story in Europe with its CDS trading as low as 104bp before reversing slightly to 100-110bp Wednesday morning. Fellow TV company Carlton also saw some action narrowing to 53-58bp Tuesday after trading at a high of 90bp.

Wednesday also saw discussions around the airline sector after Quantas became a takeover target. Spreads in the sector failed to move, however, as dealers quickly realised that the there were too many permutations and potential impacts on CDS to act yet.

There was also increased focus on ICI following its £1.2bn disposal of Quest. Expectations had been that ICI would use the proceeds to reduce its outstanding debt, but it is now understood to be considering reducing its pension deficit, which had been a barrier to ICI being an LBO target in the past. Nevertheless, while speculation was strong the company's spreads again moved little.

MP

"You need a supplier that can match the market"

Credit derivatives pricing software firm Quantifi is the subject of this week's provider profile

Quantifi, founded in 2002 by the Australian Rohan Douglas – an ex-Citigroup head of credit derivatives research – is one of a growing number of software houses dedicated to providing structured credit pricing solutions. The firm covers the entire vertical market, from dealers to hedge funds, but claims that over two thirds of its business originates from the buy-side, including a growing number of real money investors.

Quantifi offers several versions of its proprietary systems. Quantifi Toolkit, its flagship product, is designed as an open architecture technology to allow both the sophisticated pricing of credit derivatives and integration with user's in-house systems. It is complemented by an advanced excel add-in package that allows traders to price and analyse new structures on their desktops, along with a front-office risk management system for automated marking and risk analysis.

Rohan Douglas

Differentiation from competitors in an increasingly crowded market is straightforward, claims Douglas. "Having come directly from the banking industry, Quantifi's team has a comprehensive understanding of customers' needs. Our solution is a turn-key approach – the user gets independent pricing models and can participate immediately in the market. Our open platform also allows easy integration with risk and back-office systems," he explains.

"The unique aspect of what we offer is the ability to match what the major banks do, for example carrying out advanced base correlation mapping for bespoke CDO pricing. Our goal is to provide models and pricing tools that are as sophisticated as those used internally by the major banks," adds Douglas.

The buy-side is increasingly keen to develop a cross asset platform, taking one system to trade and manage risk across an entire portfolio. While acknowledging this is often the case, Douglas also identifies a weakness in the single platform approach.

"We have yet to see a system that can truly provide a client's necessary pricing and risk management needs across all derivative products. We believe that having core strength in a single asset class and being able to easily integrate across other front office applications is the right approach. The market for structured credit is becoming increasingly complicated. You need a supplier that can match the market as it advances," he says.

To this end, Douglas credits the buy-side with a growing adoption of third party systems. "You can start with a bank's model at the outset for the first few trades, but clients quickly realise they need independent pricing, and so step away from the bank's sometimes inflexible framework. Clients have a real need for independent pricing and risk management and look towards third party solutions as they trade more," he observes.

"The market has also acknowledged that third party systems have grown in quality recently. They see the merit in having a robust framework," notes Douglas.

As the market continues to grow, participants have borrowed structures from other sectors and applied them to credit. One example of this is CPDOs, which, says Douglas, is a good example of a structure that originated in the interest rates markets and was adapted for the credit markets.

"Another way that the market has grown and evolved is the application of credit derivative structures and techniques to other asset classes. The ABX index, ABCDS, and CDOs on ABS are good examples of this. Along with new structures come the challenges of accurate pricing" says Douglas

He identifies the term structure of forward base correlation for pricing tranches as a good example of incremental improvement. "The new base correlation term structure approach for pricing bespoke tranches has been an important evolutionary step in terms of better pricing and hedge analysis, which is important for new market entrants."

Another important step in the last few years that Douglas also welcomes is the growing standardisation of high quality market data that firms such as Markit Group provides, which is available as a feed into Quantifi's software. Such advances ensure that the market is scalable.

"Despite the market doubling in size each year, it has dealt very well with new challenges. I believe the market will continue to grow in this way for quite some time. It is still only one tenth the size of the interest rate derivatives market, and when you consider that credit permeates all areas of finance, the potential is huge," says Douglas.

Real money accounts, he adds, are just starting to see the potential in structured credit, and are becoming more comfortable with market risks. "Significant real money coming into this sector would dwarf anything we've seen to date in credit derivatives," claims Douglas.

New entrants can often bring new risks, but the risk of huge buy-side losses as witnessed with institutional investment in interest rate derivatives in the early 90s – Orange County and Proctor & Gamble, to name but two – should be less than people think, Douglas argues. Provided, of course, comprehensive pricing tools are used.

"You should not take on exposure unless you can measure and understand the risks. With the leverage embedded in today's products, it is important that banks ensure their clients understand the product and have the right independent pricing and risk management systems in place," he says.

JW

NewSmith strengthens CDO focus

The latest company and people moves

NewSmith strengthens CDO focus
NewSmith Financial Solutions (NSFS), the debt-focused advisory business of NewSmith Capital Partners, has appointed Terence Tsang as a partner, working from its London office. Tsang joins from Merrill Lynch where he was md and head of debt markets in the Asia Pacific region, responsible for regional trading, sales, origination and principal investments.

NSFS says that Tsang's appointment reflects a further sharpening of its focus on value realisation activities through CDO workouts and event-driven structured finance. Recent transactions include workouts for major insurance companies with three large CDO portfolios comprising mainly equity and mezzanine tranches. The firm has also recently completed a number of repackagings for event-driven funds.

"[Tsang's] breadth of experience and technical expertise in complex financial products will strengthen our offering to clients in this area," says NSFS ceo, TJ Lim.

SSgA hires Richards
State Street Global Advisors (SSgA), the investment management arm of State Street Corporation, has hired Scott Richards as senior high-yield portfolio manager in its global fixed income group. Richards was previously co-head of high-yield at MFS Investment Management. He reports to Michael O'Hara, md, active fixed income at SSgA.

Richards is responsible for overseeing the management of SSgA's high-yield assets and advancing the firm's global active credit capabilities. He will also work to broaden SSgA's asset class coverage by building a leveraged loan capability, developing new products and overseeing the investment of assets in this area, including CLOs.

Richards has more than 26 years of investment experience, including 20 years managing high-yield bond portfolios. Prior to MFS, he was head of the high-yield group at Liberty Funds Group, a high-yield portfolio manager at State Street Research & Management (now BlackRock) and, before that, at Wellington Management Company, where he also led the firm's high-yield research group.

Codefarm expands with Mooren
Codefarm, the structured credit technology company, has taken on John Mooren as marketing director. Mooren will help broaden Codefarm's next-generation Galapagos offering and his appointment is a key component of a substantial overall expansion of Codefarm, the company says.

Mooren has been active in credit derivatives for more than ten years, most recently as a partner at Reoch Credit Partners (formerly Reoch Consulting), where he is still a partner. At Sungard, he was a director of product management for FRONT ARENA and helped position it as a leading credit trading and analytics solution. Prior to that, he set up the credit trading business at HypoVereinsbank.

Phelan joins Deutsche
Richard Phelan has joined Deutsche Bank as head of European high-yield research. Phelan will report to Richard Smith, head of European company research and will be based in London.

In his new role, Phelan will be responsible for building Deutsche's leveraged finance research franchise. He joins the bank from Credit Suisse, where he spent the last three years as co-head of its European high-yield research franchise, focusing on the general industrial and manufacturing sectors. Prior to this position, he was head of European high-yield research at UBS.

ClusterSeven and Panache form alliance
ClusterSeven and Panache have formed a strategic global alliance to provide specialised spreadsheet management solutions for global investment banks, hedge funds and brokerage houses. Panache is a management consulting firm providing front-to-back trade support specifically for structured and derivative products, and ClusterSeven provides enterprise spreadsheet management software.

The two companies are already working together on implementations, with Panache staff specially trained to deploy ClusterSeven's software. Panache enables quicker identification of the strengths of ClusterSeven's software package and ensures rapid implementation on a client's infrastructure, the companies say.

MP

Fitch launches default index

A round up of this week's structured credit news

Fitch launches default index
Fitch Ratings is today, 22 November, launching a new index to measure changes in the probability of default (PD) of the universe of Fitch-rated European structured finance (ESF) transactions. The index offers investors and analysts a different perspective on rating actions to those provided by the traditional measures of rating changes used by rating agencies, such as the totals of upgrades and downgrades, or the more detailed analysis provided by annual rating transition studies.

In particular, the new index:
• weights rating actions by the value of the affected tranche outstanding; and
• measures rating changes by the change in the Fitch rating factors corresponding to the new and old ratings, taking account of the extent of rating movements and the non-linearity of the traditional rating notch scale.

Since Fitch rating factors are estimates of the 10-year PD attached to each rating level, movements in the index reflect changes in the weighted-average PD of the outstanding universe of Fitch-rated ESF transactions. The index has a base date of 31 December 2002, i.e. it has a value of 100 at that date. The index of rating change presents a pure measure of changes in credit quality in ESF transactions rated by Fitch, as reflected in rating actions excluding changes that result from new issues, retirements and exchange rate movements.

Fitch says the new index shows that rating changes have caused the weighted average default probability of the Fitch-rated ESF market to deteriorate by 23% since December 2002. The end of 2004 was the low point for ESF ratings when Fitch's index bottomed-out at 72.494; it is now 4.5% above that low point.

"The CDO sector has been the weakest of the four main sectors with a 43% worsening of default probability over the two years to the end of 2004," says Alison Ho, associate director, Fitch Ratings. "However, the subsequent recovery in the corporate credit environment has since seen a 10.9% improvement in the average credit quality of CDOs."

The new index offers a new perspective on the impact of rating changes to complement the traditional rating agency approach of a straightforward count of the numbers of upgrades and downgrades. The index weights rating actions by the value of the affected tranche outstanding and provides an estimate of the change in the weighted average PD of the Fitch-rated ESF market. The index can be split by asset class and jurisdiction.

"By weighting rating changes as it does, the new index is more representative of the effect of rating actions on the hypothetical average investor in the sector," adds Ho.

During 2007, Fitch plans to introduce a complementary weighted-average rating index, which will track the weighted-average default probability of the Fitch-rated ESF market, based on the weighted-average 10-year PD of outstanding issues. This index will reflect changes in ratings, as well as the effects of changes in the composition of the market due to new issues, amortisations, redemptions and changes in exchange rates. The agency also proposes to publish some additional analysis based on the index of rating change.

CDS growth accelerates
Growth in the market for credit default swaps accelerated to 46% in the first half of 2006 – up from 36% during the previous six months – according to the latest figures from the Bank for International Settlements (BIS). The rate of growth would have been even higher had it not been for an increase in the number of early terminations of such contracts. Multilateral terminations have had a substantial effect on the size of the CDS market, BIS says.

In the first half of 2006, contracts totalling almost US$4tr were terminated, which shaved nearly 30% from the rate of growth in the market. The corresponding figures in previous semesters were below 20%.

BIS adds that activity in the CDS market has become more evenly spread across the maturity spectrum. Although most CDS continue to fall into the maturity bracket ranging from one year to five years, growth was much stronger in the short- and long-term segments of the market.

The notional amounts of CDS with a maturity of less than one year increased by 83%, while those of instruments expiring in more than five years rose by 79%.The growth in the nearer-term segment may be explained in part by older contracts approaching expiry, whereas the sharp increase in long-term CDS points to increasing liquidity at the far end of the maturity spectrum.

Meanwhile, in a report issued this week, Derivative Fitch notes that the breadth of entities referenced by CDS continues to grow this year, with the average number of unique corporate entities referenced on any given week increasing to approximately 650 in the inter-dealer market, compared with less than 500 two years ago.

For US$-denominated contracts, trading in the inter-dealer market appeared to have been relatively flat through third-quarter 2006. However, the agency says that excluding the auto sector, trading activity actually rose by 13%.

In contrast, euro-denominated CDS trades grew by 130% in the inter-dealer market from last year. CDS trading on sovereign entities also grew at an impressive rate, with Turkey, Brazil and the Philippines showing respective increases of 228%, 65% and 48% year to date.

LevX indices rated
Derivative Fitch has published shadow ratings and recovery ratings information for the newly launched European leveraged loan indices. The weighted average long-term credit rating of the loans in the iTraxx LevX Senior Series 1 is BB/BB- (BB minus) and the average rating of the long- term credit ratings of the loans in the iTraxx LevX Junior Series 1 is B-(B minus)/CCC.

The largest difference between the two indices and their respective rating profiles is in the average recovery rates of the underlying loans. The weighted average recovery rate of the senior index is 78%, compared to an average recovery of 10% for the junior index. Poor recovery prospects for subordinated debt instruments, such as second lien and mezzanine, are largely driven by the record high leverage levels evident in all transactions that also include second lien.

Tullett Prebon launches Mark2Marker data service
Tullett Prebon Information, the market data division of inter-dealer broker Tullett Prebon, has released its Mark2Marker broker pricing service for mark-to-market purposes. On either an intraday or end-of-day basis, Mark2Marker offers global pricing data for the full spectrum of OTC asset classes, including credit derivatives, capital markets, energy derivatives, fixed income and foreign exchange.

Mark2Marker offers customised data sets for flexibility, delivered through secure FTP configured to exact customer specifications. Accurate pricing is available for both complex derivatives, as well as vanilla instruments.

HEAT hit by portfolio company insolvency
HEAT Mezzanine I – 2005, a German hybrid SME CLO, is set to become the latest transaction in the sector to experience a bankruptcy of one of its obligors. German fashion manufacturer Hucke has filed for "tactical" insolvency, due to potentially insufficient liquidity.

According to analysts at HSBC, Hucke is one of the better-rated portfolio companies, with a MKMV RiskCalc rating of A3.edf for both the one-year and five-year horizons (the portfolio average stands at Baa1.edf/Baa2.edf, according to the latest investor report).

The transaction advisor and the recovery manager (MBB Consult) has stated that it has been in close contact with Hucke since the company's earlier ad hoc disclosure dated 10 November 2006, announcing EBIT of €11.5m for the accounting year 2005/06. The negative figures are thought to result from restructuring costs and loss of turnover due to a negative market environment.

The managers of HEAT have been informed that the proposition of this insolvency filing is not to liquidate the company but to restructure it. At this stage no termination reason for the underlying profit participation agreement has been given, as the insolvency proceedings have not yet been opened and no cash flow has been lost to the transaction.

HEAT Mezzanine I – 2005 was hit in July by the default of one of its portfolio companies which had a MKMV rating of Baa3.edf, amounting to EUR3m (1.5% of the original balance). The pool currently comprises 31 obligors, with €217m outstanding.

MP

Trading ideas - flutterby

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, suggests a CPDO driven butterfly trade involving the DJ CDX NA IG, HVOL, and XO Series 7 Indices

Both the US and EUR credit markets have been affected by the emergence of CPDOs. The huge leverage involved has put excessive demands on IG credit indices, pushing spreads to contract tights. Notably, the direct impact of this technical bid should only be felt in the investment grade indices, but due to hedging and contagion, we have seen the other indices (HVOL and Crossover (XO)) pulled tighter also.

The rally in spread and correlation markets has dislocated the IG indices from their peer indices and opened up an opportunity to build a well-hedged portfolio of index positions across the credit quality spectrum. With spreads at such tight levels, structurers are finding it hard to engineer the deals and maintain AAA-ratings. We feel this is an opportune time to take advantage of the potential mis-pricing and benefit from any spread-widening among the indices.

We analyse the recent relationship between the US indices – Investment Grade, Hi-Vol, and Crossover, and find a significant divergence between the three over the past couple of months. We apply some regression and historical data analysis to arrive at a sensible hedge ratio between the three which provides positive carry and will benefit from any drop in demand for credit in the IG index.

A thorn in the market's side...
Before we dive into the meat of the trade, a brief discussion of the mechanics of the CPDO may be useful to understand the current and future impact of the market's appetite for spread and default risk. The current technical bid from the ramping-up of these deals is overwhelming any systemic or idiosyncratic risks that would otherwise drive risk premia higher.

The risk profile of a CPDO looks very similar to a thicker equity tranche, meaning that these instruments still have significant idiosyncratic (issuer) risk rather than being pure spread products as some have described them. They are extremely compelling for investors on a return-on-capital basis due to their AAA-rated status (and subsequently low reserve requirements).

Fundamentally, CPDOs are similar to an unfunded index investment with strict rules governing the changes in leverage over time. The main risks are related to the mechanics of the index rolls and to scenarios in which the investor has to unwind the transaction (e.g. if spread volatility is high, default risk is high and/or mean-reversion is low).

The CPDO starts out very simply. The investor deposits par in the CPDO note which earns LIBOR. This money is used as collateral to take a leverage exposure (10-15 times) to a credit portfolio (50% iTraxx and 50% CDX), selling protection on a notional up to 15 times higher than the note deposit. The carry of this investment is used to pay for both the coupon of the note and any mark-to-market losses incurred if the spread on the reference portfolio widens.

If spreads increase, leverage increases while if spreads decrease, leverage decreases. This 'should' lead to less volatility and a dampening of spread behaviour – selling protection as spreads widen and vice versa but obviously there is always the chance that markets can stay irrational longer than the note can stay solvent.

Current CPDOs reference the 'on-the-run' iTraxx and CDX indices, which means they have to be rolled every six months. This is critical to CPDOs as the rolling ensures that sub-investment grade names are removed from the portfolio, reducing default risk.

On the other hand, this roll ensures that mark-to-market losses and gains in the previous index are locked in (reducing coverage directly). Notably, in a 'normal' spread environment, spreads curves are upward sloping (positive roll-down for a sold protection position), so unwinding the spread position at the roll will typically generate a mark-to-market gain.

We will save our view of the risks and benefits for a future strategy article but this brief introduction should make it clear that a large amount of credit protection is and will be needed to fund these AAA-rated LIBOR+200bps coupons and while the ramping-up of these notes continues, this will have a significant impact (idiosyncratically) on the IG indices in Europe and the US.

As spreads have tightened so much in US and EUR in the IG indices, the structurers are finding it increasingly hard to maintain a high-enough carry to maintain the high coupons and AAA-rating. This will inevitably drive spreads modestly wider but we should see CPDOs bring some stability into the IG index through their increasing and decreasing leverage.

The same but different
The impact of this increased technical bid is evident in Exhibit 1 where since the last roll, the IG index has rallied significantly more than the HVOL index. This divergence seems to have been going on since the September 2006 roll – perhaps driven by anticipation of the CPDO issuance as well as an actual increase in traditional CDO issuance and its associated technical bid.

Exhibit 1

The relationship has clearly diverged between the IG and HVOL indices. It is noteworthy that the XO index has also rallied significantly during this period – far more than either of the other indices – driven by investors' need for spread, shifting down the credit quality spectrum.

These changes are fundamental and offer some insight into the impact that the technical bid has on the on-the-run indices. The XO index has tightened by over 22bps since the September roll and during this period IG has rallied significantly more on a percentage basis (8bps on a 41bps initial level) as the CDO and new CPDO issuance was so focused on the IG end of the spectrum. HVOL (which is a subset of the IG index) has only rallied 9bps from around a 90bps initial level.

The recent spate of LBO (rumours and events) has been focused on the IG and XO names and should be pulling these wider. We see two drivers of changes in these relationships.

One is that once CPDO issuance has slowed (and the initial ramping-up has stopped) the technical bid will reduce more than before as CPDO issuance has drawn investors away from traditional CDOs. While we don't see the technical bid going away any time soon, it is important to note that the issuance (or expectation of it) is what counts for the leveraged CPDO and not an ongoing investor usage.

Secondly, the continued concern regarding LBO activity must spill over into the IG indices (and already is) as these companies are generally the most attractive candidates from a steady cash-flow, large cash levels, and cheap debt financing perspective. We would expect the relationship between the three indices to converge as LBO risk is finally recognised as more than just an idiosyncratic risk impacting all credits and the technical bid from new structured credit products reduces.

Over the hedge
Given that we have discovered the relationship between the two indices appears out-of-line, we need to decide on an approach to profiting from this apparent dislocation.

There are a number of different approaches to this problem including equal-weighting, duration-weighting, and carry-neutral-weighting. We prefer to keep our trades' positive carry and are pleased that the approach we choose is both philosophically sound as well as economically so.

By regressing the two indices (XO and IG) against HVOL we can get a clearer picture of the relationship, how stable it is, and further whether it is truly out-of-line. Exhibit 2 shows the results of that regression. The blue and red points indicate the relationship that XO and IG (respectively) have to HVOL spreads.

Exhibit 2

Both relationships are extremely strong with r-squareds over 75%. There are fewer points for the XO index as it has been trading for only around a year. Exhibit 2 shows that the XO index trades at around a 2.6x multiple of HVOL and IG trades at around a 0.31x multiple of HVOL – with excellent explanatory power.

The most recent time period is highlighted in the black oval in Exhibit 2. Both IG and XO have fallen significantly below historical expected levels driven by CPDO technical bid and spread-demand respectively. This can simply be interpreted as the IG and XO indices are trading 'too tight' versus the HVOL index.

This leaves us with a view that if we can buy protection on IG and XO and sell protection on HVOL, then any mean reversion would be profitable for us. This is straightforward but care must be taken to ensure that we are not over-fitting the relationship.

We suggest a hedge portfolio of 0.15 units of XO and 1.3 units of IG against 1 unit of HVOL. Exhibit 3 shows the behaviour of this portfolio against the HVOL index itself.

Exhibit 3

At a ratio of 8.6x, our trade is consistent with recent historical averages and stands to benefit greatly from a pull to long-term means. This ratio means we would sell 1 unit of XO protection and buy 8.6 units of IG protection. If we calculate the XO index based on the 8.6x IG index multiple, Exhibit 4 indicates the behaviour of the relationship.

The hedge has three attractive features: 1) at current levels it is positive carry, 2) it is generally a good hedge through time and across significant spread levels, and 3) the hedge outperforms as spreads widen. Points one and two provide us with comfort if things stay the same or get moderately worse but the third point provides room for significant outperformance. If spreads widen moderately (as we expect) the hedge will significantly outperform the HVOL index as the relationship falls back into line with its historical behaviour.

Risk analysis
The calming down of the structuring activity should favour a tightening of the spread between the long and the short position. In the case of moderate spread tightening, investors will be covered with the carry cushion.

In case of moderate spread widening, the relationship should converge, as it is already close to its highs, and any reversion back to its means will have a positive P&L outcome and the spread pick-up should be cashed in as well. A spread blow-out should be good for us also, as IG is likely to suffer more given its incomprehensibly optimistic levels currently.

The trade, however, is not an arbitrage. The trade will generate a loss in case of tail events. If the structuring activity keeps its current pace or even becomes more intense, the downward pressure on the CDX IG will adversely affect the trade.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk as these indices are among the most liquid in the world.

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 CDS markets. These indices are among the Top 5 most liquid credits in the CDS market and have very tight bid-offer spreads.

Fundamentals
This trade is technical in nature and is not based on any fundamental outlook, although a pick up in LBO activity as we forecast from our fundamental overview is likely to cause an offset to any spread tightening and may spill over into systemic risk – good for our position. We would also see any slowing in CPDO issuance (or technical bid) as positive for our position.

Summary and trade recommendation
CPDO structurers are finding it hard to generate enough carry from today's exceptionally tight IG levels to maintain AAA-rate high-coupon issues. The recent spread and correlation rallies, driven by the expectation of future CPDO issuance, have stalled momentarily as spreads in EUR and US have reached rock-bottom.

The high (15x) leverage that these vehicles use combined with the focus on the 'on-the-run' IG indices in US and Europe, has caused a modest dislocation between the IG, XO, and HVOL indices in both regions. The historical relationship between both the IG and XO indices and the HVOL index has shifted significantly with both IG and XO now significantly 'too tight' relative to the HVOL index. A regression-based hedge portfolio (of IG and XO) has excellent explanatory power, should outperform the HVOL index in moderate to steep spread widening, and provides positive carry.

At current levels we are at all-time divergence between the portfolio and index and we expect to benefit from reversion. Our view that structuring activity is unlikely to accelerate further and that LBO risk must begin to become less idiosyncratic and more systemic, leads to a 'credit quality butterfly' in US indices.

Buy $13mm notional DJ CDX NA IG Series 6 5 Year CDS protection at 34bps and
Buy $1.5mm notional DJ CDX NA XO Series 6 5 Year CDS protection at 146bps and
Sell $10mm notional DJ CDX NA HVOL Series 6 5 Year CDS protection at 79bps to gain 13 basis points of positive carry

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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).