Contents

CDR Liquid Index data as at 27 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.

Synthetic Trups CDOs moving closer?

New rating methodology may help US synthetics, but European underlying could be adversely impacted

Moody's has issued a comment paper on a revised approach for rating preferred stock and hybrid securities. As a secondary effect of the proposals, the US market could edge closer to seeing the first synthetic Trups CDO issuance.

Moody's current framework makes no distinction in rating between those subordinated bonds for which deferred coupons are cumulative and those which are not, despite the fact that non-cumulative deferrable coupons are likely to result in a larger loss given default for an investor. The rating agency's proposed new methodology seeks to address this situation by adding an additional one notch downgrade to such securities, subject to the precise characteristics of each bond.

The improved consistency and accuracy that this approach would generate should facilitate the introduction of synthetic CDOs in the asset class. "What Moody's is trying to do with its change in methodology would be very constructive towards taking a product like preferred CDS and putting it into a CDO framework," confirms one New York-based banker.

However, there is still no confirmation of a launch date for the much talked-about PCDX, the preferred CDS index (see SCI issue 3). "It's still being worked on, but I understand there will be some more details released fairly soon," the banker says.

Meanwhile, Moody's proposals have been less well-received in Europe. "We feel probably that a significant percentage of the 300 downgrades that Moody's has suggested will come about will be either euro or sterling-denominated," observes Mehernosh Engineer, senior credit strategist at BNP Paribas.

But it is not so much the impact as the methodology that is giving rise to concern. Engineer says: "After conducting detailed conversations with Moody's analysts, our belief is that if the 'Omission Risk' methodology were to be implemented, most European Tier 1 paper will be notched three times as opposed to two presently - though this would contradict a Moody's public statement stating that it would not impact Tier 1 bank debt."

He continues: "We are fine with giving a one notch for coupon deferral, but think that one notch should be given when the senior rating falls to about mid double-B, not for stronger credits. If the incremental notch were to be applied to issuers rated Ba2 and below, we would be agreeable to the methodology, as that would signify the incremental rise in probability of coupon deferral for a weaker credit. A full rating notch for a double-A credit like Siemens, for example, seems excessive in our opinion."

Moody's says that it will accept comments on the proposals until the end of December and will release its final methodology after consideration of market opinion.

MP

Zero recovery CDS mooted

Standardised products to be offered on iTraxx indices

Interest in fixed rate of recovery default swaps is picking up in Europe. As a result, moves are being made to standardise a product referencing the iTraxx indices.

Discussions over standardisation of documentation and procedures are continuing among dealers in Europe and are being lead by the firms that already trade recovery CDS with clients on an ad hoc basis. In an effort to bring about transparency and liquidity to the instruments a standard type of contract based on iTraxx Europe, Crossover and HiVol has been agreed upon.

"We have decided to have a zero recovery CDS where the protection seller pays out the notional of the swap if there's a default. Obviously that's a slightly more leveraged high beta product than the ordinary index where your expected loss is assumed to be 60% as opposed to fixed at 100%," says Richard Stuart-Reckling, credit derivatives product manager at Morgan Stanley in London.

The increased yield the product offers thanks to that leverage is an obvious attraction for investors, especially when spreads are tight. However, it is the ability to disaggregate default and recovery risk and the opportunity to hedge positions or express views more precisely that has intrigued a wide variety of market participants (see this week's Structured Credit Interview, for example)

There are other practical advantages to the contracts as well. "One of the benefits of the product is that it clearly takes care of the settlement issues you have with a normal CDS. In that, once there is a default you don't even have to do a valuation, you just know that the seller pays the notional to the buyer and that's that," says Stuart-Reckling.

Furthermore, he adds: "As the recovery rate is zero, the contract is effectively on pure default probability. So, it enables counterparties to easily work out if they are getting paid the right amount of premium for the risks that they are taking."

Nevertheless, it is important that a fully fledged recovery CDS market gets up and running at the right time. A couple of years ago dealers attempted to launch constant maturity CDS, which, for example, enabled investors who expected spreads to widen, but not default, to express their view by selling constant maturity CDS and buying normal CDS. However, the product was launched at a time when spreads were tightening dramatically and the product has since gone by the way-side.

Interest in recovery swaps is likely to get stronger, according to Stuart-Reckling. "The success of new instruments is often about where we are in the cycle in terms of default rates, recovery rates and so on. If we see a change in that, trading volumes will increase for these kinds of products," he says.

MP

iTraxx vol spikes

Increased activity and volatility drives index spreads wider as correlation investors look to mezz

Tuesday saw one of the busiest and most volatile days of the year in iTraxx index trading. For example, iTraxx Crossover exhibited four swings of 3-4bp magnitude intraday before closing 5bp wider Tuesday and opening 4bp tighter Wednesday morning.

"On Tuesday, accounts came in to sell protection at the day wides of 253bp. Volumes were very high - we estimate at least €5-6bn in Crossover and a comparable size in the main index. We expect choppy trading sessions in the short term as FX/macro factors remain the key drivers," says Gregory Venizelos, structured credit strategy at Royal Bank of Scotland.

In the correlation markets, equity tranches were well offered on Monday. Venizelos observes: "Evidently, market participants tried to go long convexity, through selling equity protection both versus the index as well as the mezzanine with a big size trading in the 5yr iTraxx equity versus mezz - the 'equity vs mezz' trade configuration makes sense given the continued recent tightening in mezz. Such long gamma plays may well continue as index volatility is most likely to pick up."

Raja Visweswaran, head of international credit strategy research at Bank of America, concurs: "Equity correlation has been rising, driving equity yields lower. Interestingly, while returns on equity pieces have been slowly eroded, loss function attribution to first-loss tranches has been rising. This suggests that compensation for risk has worsened."

He continues: "While we see loss attribution worsening in equity across the tenors, the worst effect proportionately has been seen in 5 years. This is consistent with an argument for structured investors to start to consider more defensive positioning for next year. The mezzanine pieces offer a higher cushion against default and in general seem to have been overlooked as value has previously been in first-loss or higher up the capital structure."

In this context, Bank of America has updated the efficiency numbers in its proprietary credit risk modelling tool, Lighthouse (see SCI issue 3). Efficiency measures compensation per unit of risk, where risk is being measured from a Merton model/ Gaussian copula approach. The Merton model is being used to simulate spreads going into the Gaussian copula valuation tool, assuming constant market extracted base correlation.

"We have rebased our numbers to 100 and they show that the largest proportionate drops in efficiency have come from the 12% to 22% tranche areas. Meanwhile, mezzanine looks to provide a good level of efficiency relative to recent history," says Visweswaran.

MP

France eases credit capital rules

New regulation should encourage protection buyers

France's banking regulator, Commission Bancaire (CB), has agreed to repeal unpopular regulatory capital rules in connection with credit derivatives trades. It is hoped that the move will generate increased credit activity among lower tier French banks.

CB says that, with immediate effect, credit protection bought by banks through credit derivatives and recorded in the banking book will no longer need to be documented in a separate and tailored ISDA Master Agreement in order to obtain capital relief. The regulator had previously stipulated that such documentation be used under Annex 15 of its publication 'Methods for calculating international capital adequacy ratios'.

French bankers welcomed the move. "The rule changes should mean we'll see more of the smaller banks becoming involved in the credit derivatives market as protection buyers. The need to have two Master Agreements with the same counterparty was too much of a disincentive for many because of the difficulties and risks involved," says one Paris-based source.

Annex 15 had previously denied any capital relief to the buyer of credit protection if the relevant transaction was not documented separately from the rest of the deal's portfolio with the seller and adapted to reflect the terms of a guarantee by deleting most events of default and termination.

The changes, which come after two years of negotiations between the derivatives industry and CB, are intended to reflect and enhance the efficiency of financial transaction netting under French law. To this end, there is no longer a restriction on netting credit derivatives in France; French firms will, under usual conditions, be able to treat contractual netting as risk reducing; and the inclusion of credit derivatives transactions within netting Master Agreements will not render the protection ineligible for the purpose of relief from regulatory capital.

CB has yet to issue full new rules for the revised Annex 15, but it is understood that - given the previous approach is intended to be replaced - all previous regulations specifically relating to credit derivative protection buying will be removed. However, it is not yet certain whether some other regulations, such as the mandatory appointment of an independent third-party calculation agent, will be removed.

MP

Leveraging loans

This week, Nicolas Bravard, partner of Alpstar Management's hedge fund business, answers SCI's questions

Nicolas Bravard

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: We have been involved in structured credit since Alpstar's hedge fund business was established in 2002. Our hedge funds invest in the full range of levered credit products, but we also manage CLOs and derivative products on leveraged loans.

We closed our first CLO last year which combines our core competence of managing credit risk with what we regard as the most efficient way to invest in leveraged loans. CLOs are a way of expressing our views on leveraged loans that compares well to managing a market value hedge fund investing in leveraged loans.

A CLO has a cashflow structure that we feel is very interesting for leveraged loans because of the attractive spread and risk-return that we get, as well as the nature of the long-term investment process that you can have with the structure. Another positive aspect is obviously that we can generate excess return on the equity piece of a CLO.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Credit derivatives – specifically in terms of the liquidity they have achieved and the creativity potential that they provide. Liquidity in structured credit is extremely important because it gives investors confidence and the ability to act on views efficiently.

From a creativity perspective, the credit market now has to adapt to new situations and create products that are tailor-made for demand. It is very important as a portfolio manager to have tools to express different views and manage different risks.

In today's environment we have a whole range of products to choose from. Of particular interest to us are loan CDS and the development of indices – and we expect good things from the development of products that will separate default probability from the recovery rate. We have seen advances in the latter, but they have not yet taken hold because of the current economic climate – although I think that they will come back into favour as the environment changes. [See this week's news section for more on fixed recovery swaps.]

Q: How has this affected your business?
A: The range of tools and depth of liquidity means that we can now really manage market-neutral funds. Ten years ago when you were investing in high yield or investment grade there was hardly any way to hedge your portfolio, but today you can really call yourself a market-neutral fund because there are so many ways to hedge both market and credit risk.

Q: What are your key areas of focus today?
A: We are currently working on a second CLO: we should wrap it up in February, following marketing in January. After that, we are considering something more sophisticated in the loan space using a more advanced structure.

There are two possibilities: utilising either a synthetic or cashflow structure. The theoretical ease of using LCDS is attractive, but we don't think there is a great return achievable in that way just yet and, in our view, there's no point in doing a transaction just to say you have done the first – it should be all about return.

So, a single-tranche cashflow CLO transaction is the likely route. This would involve selling the mezzanine piece and basically managing a portfolio of loans on the back of that. What's very important for us is that a structured credit transaction has flexibility.

Clearly, the traditional CLO structure is interesting, but its weaknesses are the flexibility to adjust to the market environment and adjust the assets we can invest in. There is clearly a risk that some CLOs become obsolete because the market environment changes so quickly.

Q: What is your strategy going forward?
A: As I said, we will be aiming to go to the next stage in structuring loans in the form of a single-tranche deal. We believe the key area of development for us in structured credit will continue to primarily be through portfolios of leveraged loans because we have established ourselves as such a large manager of leveraged loans for different portfolios with the ability to access the primary market – which is the key to effectively structure derivatives around loans.

At the same time, we would be happy to expand our activities into other sectors if the market environment were right. For example, we certainly would consider managing synthetic high-yield or investment grade transactions, but we believe that the spreads are so tight right now that we would rather do this at a different time in the credit cycle.

Q: What major developments do you need/expect from the market in the future?
A: There are a number of developments to the abovementioned range of tools we would like to see. One that we expect quite soon is the introduction of high-yield index tranches.

Another thing that we would love to see is options on single names become more liquid. We are already very active in options on indices – we use them a lot in our portfolios – but we would use single name products actively too.

Most important, though, is the development of LCDS activity. We think the current European structure is not adequate and would like to see non-cancellable LCDS develop in Europe, both in single names and for the index indices.

About the company
Mignon Genève S.A., a Swiss regulated asset management company established in 1996, is an advisor to private and institutional clients, including the Alpstar Management Companies, a group of companies specialising in Hedge Funds, Funds of Funds and CLOs. Current hedge fund strategies include European credit, leveraged loans, equity long/short, and an equity quantitative strategy combining statistical arbitrage and multi-factor models.

The Group currently has over €2bn in assets with over 60 full-time professionals across its offices in Geneva, Paris, London and New York. The firm also collaborates with the Hedge Fund Research Institute at the International University of Monaco, which serves as the academic research provider of the group.

"You better be damn sure of your market views"

NewSmith Financial Solutions is the subject of this week's Provider Profile

NewSmith Financial Solutions (NSFS), the debt advisory business of NewSmith Capital Partners, offers specialist advice to investors in structured credit in connection with its core expertise – workouts and value realisation of mezzanine and equity tranche CDO investments. In addition, it advises clients on event driven structured deals.

NewSmith Capital Partners also has an asset management division entirely separate from its advisory business. This division is responsible for assets of over US$5.5bn under management, in private equity, and equity and credit hedge funds.

TJ Lim

NSFS says it stands out from the market because it avoids the traditional conflicts between advice and issuance that investors will often experience with investment banks. "Banks always have a position to sell, or buy, and so lack objectivity. For example a bank may re-structure a deal and give a client a more highly leveraged piece, thereby potentially increasing their risk profile. In addition, dealers do not have the best incentive to maximise a value realisation strategy as their goals are often to buy back positions from their clients at the cheapest possible price," says derivatives industry veteran TJ Lim, ceo and founder of NewSmith Capital Partners.

Another unique aspect of NSFS's approach is that it often participates directly in a deal when invited to do so by a client. This, says Lim, adds authenticity to the advice "When we're invited to take a small stake in a deal alongside the client they know that we believe in the prescribed course of action."

NSFS will at any one time have just a handful of clients on its books to ensure that it does not get over extended, because the work it typically undertakes is complex and time consuming. Lim explains: "We don't get involved in high grade deals, that's easier and is not where we add value. We succeed further down the capital structure, usually in unrated debt."

In this part of the structure the lack of price transparency is even more of an issue than in the market generally. As Lim explains: "A lot of people are buying equity pieces. They know what they're buying, but if they need to exit, are they going to get the best price by going back to the bank that sold it to them? It is difficult to know the value of what you have and this is where independent advice helps. Most investors generally pursue outright disposal when they should also consider other value maximisation techniques."

Although some deals require outright disposal, some merely require an amendment. Recalling the example of a recent CDO re-structuring, Lim sets out how NSFS can make a difference. "We were asked to refinance a high grade CDO in May 2005. The cash bid was in the 60s at that time, but we thought it should be trading close to par," he says.

"So the advice was not to sell in the market place. Instead, as we were representing all the equity holders, we worked closely with the collateral manger to collapse the deal and sell the assets; i.e. collapse the CDO via an optional redemption. After everything was sold all that was left of course was the equity – the return was a handsome 150%," claims Lim

NSFS says its understanding of the way in which the different tranches of the capital structure perform has been the key factor in delivering value to clients that otherwise lack a full understanding. Lim cites another such example of a client with an investment in an equity piece carried at par.

"They were disappointed that the secondary bid on their position was well less than par even though the deal was performing. Most people don't realise that over time the equity piece in CDOs generally depreciates. Although their expected return was around 12%, their distributions were in the mid-teens. The excess returns should have been used to write-down the carrying value of their asset. Many investment professionals appreciate such a phenomenon but some less experienced investors are unlikely to understand," he says.

On another deal, Lim remembers the client had a controlling block in the equity tranche of a CLO issued in early 2003. The debt structure was expensive with triple-A at Libor plus 62bp. Although the deal was performing, the CDO was building up excess cash because of the structure, which only permitted the manager to reinvest in assets if it improved the weighted average coupon.

Lim explains: "Given the significant tightening of credit spreads over the last few years, the manager found it was increasingly difficult to meet this requirement. This obviously affected the performance of the deal with the result that the cash bid in the secondary market was well below par. However, by re-financing the top tranche at much cheaper debt levels the benefit went to equity holders. Would an investment bank tell you that you have these options?"

The firm suggests this type of work is not necessarily workout advice, but "value maximisation" in today's demanding environment. "Technology has exploded, with synthetics, CDO squared and credit CPPI. With CPDO technology you may get a highly rated deal, but the leverage employed, of over x15, implies a worrying amount of exposure. The deal could easily be cashed-out which means that you could lose your entire investment. You better be damn sure of your market views," says Lim

Long term market experience and having witnessed so many market dislocations in the past leaves Lim feeling that another market dislocation may not be too far away, with investors getting into trouble chasing returns by adding leverage.

"In the recession that followed the first Iraq war after the Fed pushed rates to nearly 7% it was a one way bet for interest rates in 1993 with yields hitting historical lows. In search of higher yields, new innovations were made available to investors in products such as inverse floaters, Libor squared, power options, and index-principal swaps. Some of these products went horribly wrong in early 1994 when the Fed took a pre-emptive strike by raising rates by ¾% resulting in some high profile companies and banks getting into trouble," says Lim

And he warns that the same techniques are being used in credit today (in CDO-squared and CPDO structures, for example). "Just like the interest and FX derivative markets, the advance in credit derivatives markets today is good for efficiency of the markets. However, it is bad for people pushing innovations to the extremes in search of higher returns if the underlying arbitrage is not there."

Consequently, Lim says: "Whatever the innovation, investors have to realise that there is no free lunch as the end products are such that they have to take bigger risks. I have no problem with the big boys taking risky positions – there's always less sympathy for them if the positions goes badly wrong as they should understand. But when you have CDO equity funds that are sold to the retail market you worry. Do they know what they're buying?"

A potential dislocation can also provide opportunities, Lim notes. For example, Welcome Trust recently made US$500m available to NewSmith Capital Partners for seeding of new funds, including the possibility of starting a distressed fund. Lim believes such a market move may present a timely direction for this new investment.

"We are considering a multi-strategy fund for sometime in early 2008 which mimics our balance sheet and leverages our CDO and structured credit work-out skills to buy cheap and distressed structured assets during a dislocation. Our understanding of values across the capital structure would be tremendously useful during such a period," he says.

JW

XLCA appoints Tuntono

The latest company and people moves

XLCA appoints Tuntono
XL Capital Assurance (XLCA) has hired Evelyn Tuntono as vp in its CDO group. Tuntono, who will be based in New York, will report to Sohail Rasul, senior md and head of XLCA's CDO group.

Rasul comments: "We are delighted to welcome Evelyn to our team. Her hire reflects the continued growth of our CDO business and her experience will help us continue to strengthen our CDO product offering."

Tuntono joins XLCA from Deutsche Bank, where she was a vp in its global CDO group since February 2006. Prior to this position, and since August 2000, she served as a vp with Deutsche's credit derivatives structuring division.

Before joining Deutsche, Tuntono worked at Ambac, Goldman Sachs and Moody's in a range of structured finance roles.

Tuntono's arrival at XLCA's CDO group follows the appointments of Jas Jalaf, who joined as a director in XLCA-UK's office last April, and Lina Kharnak, who joined XLCA in New York as a director in May 2006.

Stephenson exits Fitch
Kevin Stephenson, Fitch's Asia-Pacific head of structured finance and structured credit, has left the rating agency. His destination has not yet been confirmed, but he is expected to re-appear at Macquarie Bank in Sydney next year.

New head of credit indices at GFI
GFI Group has appointed Wayne Margolies as head of credit indices, North America. With the appointment, Margolies has moved to New York from London, where he was head of GFI's single-stock derivatives desk.

Creditex and CreditTrade finalise merger
Creditex and CreditTrade announced the completion of their merger this week, creating a global voice, hybrid and electronic execution platform. The transaction has received both NASD and FSA approval.

The merged entity - Creditex Group Inc - will have considerable scale, the company says, with a significant presence in North America, the UK, Europe and Asia.

The combined entity is on track to complete credit derivative transactions exceeding US$2tr in notional value this year. The new company will consolidate all electronic trading and price dissemination services onto Creditex's RealTime technology platform.

MP

Dura prices fixed

A round up of this week's structured credit news

Dura prices fixed
Yesterday, 28 November, Creditex and Markit – in partnership with 12 major credit derivative dealers – successfully conducted two Credit Event Fixings to generate cash settlement prices for senior and subordinated contracts referencing the defaulted bonds of Dura Operating Corporation. The final price was fixed at 3.5% for the subordinated bonds and at 24.125% for the senior bonds.

The Credit Event Fixings are being used as part of the 2006 Dura CDS Protocol, which is the first protocol published by ISDA that permits cash settlement of single name CDS and CDS index trades, as well as other credit derivative transactions such as index tranches, bespoke CDOs, constant maturity CDS, recovery locks, credit swaptions (single name and index) and nth-to-default baskets. The protocol was developed by ISDA in consultation with dealers and the broader market. Previous ad hoc protocols have only enabled cash settlement of index trades and tranches.

The fixings methodology is similar to that used for the Dana Corporation fixing, but has more significance since it can be used to cash settle a far broader range of instruments. Dura marks the seventh corporation for which a Credit Event Fixing has been held. Previous Fixings were held for Collins & Aikman, Delta Air Lines, Northwest Airlines, Delphi Corporation, Calpine Corporation and Dana Corporation.

Moody's explains CPDO approach
Moody's gave its first public explanation of its CPDO rating methodology at a meeting in London last week. Unsurprisingly the index roll was a central focus given the extensive market discussions about how CPDOs will perform.

Notably, Moody's said it will allow the structure to delay rolling from the current index into the new index for at least 10 days if a 'market disruption' occurs. What actually constitutes a disruption is at the discretion of the sponsor bank, but it would seem that such a clause provides CPDOs with additional flexibility.

Overall, the rating agency's approach is primarily as expected. Losses are modelled via CDO ROM, with a spread simulation being generated for each expected loss using an identical approach to that for leveraged super senior trades. Each asset is assigned a mean spread, spread volatility and mean reversion speed based on its rating, taking into account rating migrations.

Moody's indicated that its model was tested for sensitivities to mean spread and spread volatility assumptions, but that it did not specifically test for sensitivity to mean reversion speed. The rating agency stressed that the approach addresses binary default risk and not rating volatility or mark-to-market issues, and that it would consider stopping rating CPDOs if it emerged that the structures were impacting market liquidity.

Markit expands loans offering
Markit has launched a Trade Finance pricing and index service aiming to extend its coverage of the loan asset class in support of growing interest from customers. This service incorporates the pricing service recently acquired from LTP Trade.

The Markit Trade Finance pricing service will initially comprise weekly composite spreads on emerging market countries sourced from leading market participants. In addition, Markit acts as calculation agent for the Markit Trade Finance Index, formerly the LTP Trade Finance Index. Bespoke valuations for specific trade finance assets are also offered.

Qualitative factors in the analysis of SIVs explained
Fitch has released a report outlining several risk capital coverage ratio measures that it uses to assess the sensitivity of a structured investment vehicle (SIV) to downgrades or defaults, as well as to movements in credit spreads.

Both the structural protection and qualitative assessment of the manager and the vehicle play an important role in assessing whether the targeted senior ratings can be assigned, what level of credit enhancement this entails and the achievable rating of the SIV capital notes. The considerations on which the qualitative assessment will focus include management style and strategy, portfolio management and treasury capabilities, and experience, risk analytics and system robustness.

The quantitative assessment will help determine the financial risk profile of the vehicle. As well as observing compliance with the capital, liquidity, diversification, interest rate and FX sensitivity limits, Fitch uses a Monte Carlo model, stress tests and capital ratios to determine the risk appetite of SIVs.

Like any operating company, a SIV's financial risk profile may undergo short-term changes. But the vehicles also tend to run with a significant amount of buffer capital and can pursue several strategies to achieve a particular financial risk profile (including reducing leverage and changing reserving policy). Therefore, when assessing a SIV it is important not to "overquantify" the assessment – particularly if the analytical tools do not capture all the various strategies that a manager may adopt to address a particular challenge.

Deutsche Bank brings unusual SME CLO
Deutsche Bank is in the market with SMART SME CLO 2006-1, a transaction that transfers the credit risk – via two CDS – on a pool of €2.9bn loans made to its SME clients across Germany, Italy and Spain.

The transaction consists of €87m Aaa rated Class A notes due 2016, €118.9m Aa2 Class Bs, €45m A2 Class Cs, €49.3m Baa2 Class Ds and €58m Ba2 Class Es. There is also an unrated Class F tranche worth €84m.

The deal involves Deutsche Bank entering into two CDS contracts – a senior CDS with a given counterparty and a junior CDS with the SPV. Under the senior CDS, the bank will receive the senior swap cash settlement amounts if the Class A notes are fully written down and additional losses occur in the reference portfolio. The junior CDS provide protection for losses occurring in the reference portfolio up to an amount equal to the total initial amount of notes issued by the SPV, subject to losses exceeding the first loss threshold amount.

The notes will be redeemed in bullet on the scheduled maturity date on a sequential basis taking into account the deferred funding amount, which is equal to the outstanding defaulted amount of the reference portfolio at the scheduled maturity date. Principal allocation on the notes/principal reduction of the notional amount of the senior CDS is fully sequential and the loss allocation is done in full reverse sequential order.

Third cat bond for Foundation Re
BNP Paribas has arranged US$247.5m of natural catastrophe bonds for Foundation Re II to finance a new, multi-year reinsurance cover for Hartford Fire Insurance Company. The risk was tranched into two classes of notes.

The Class A notes (rated double-B plus by Standard & Poor's) will generate up to US$180m in the event of severe US hurricanes during the period to 17 November 2010. The Class G notes (single-B) will generate up to US$67.5m for hurricanes, earthquakes and tornado/hailstorms in the US during the two calendar years to 31 December 2008.

The performance of the bonds is dependent on the impact of Property Claim Services' (PCS) Insured Industry Property Loss Estimates on a customised index. Goldman Sachs was the lead manager and sole bookrunner for the deal.

Fitch examines default experience of rated securitisations
Fitch Ratings has released a study examining the default experience of global structured finance securities that it has rated during the period 1991 to 2005. The paper finds a strong relationship between Fitch's structured ratings and default risk, with investment grade rated issues exhibiting significantly lower default rates over one and multiple-year periods than speculative grade rated bonds.

Over the 15-year period ending in 2005, the average annual default rate across investment grade structured bonds was 0.13%, while the speculative grade average annual default rate was 3.4%. Within the broad investment grade rating categories, the triple-B pool experienced the highest average annual default rate of .41%. The highest average annual speculative grade default rate was the triple-C rate of 24.9%.

The majority of Fitch-rated global structured finance defaults over one and multiple-year horizons came from low rated issues. Over a one year period, for example, speculative grade ratings – while representing only 16% of issues – accounted for nearly 85% of total defaults.

In total, 1,027 Fitch-rated global structured finance defaults were recorded over the period 1991 to 2005, with the majority occurring since 2001 – coinciding with the last economic downturn. Defaults peaked in 2003 at 287 and declined to 103 in 2005.

The ABS sector accounted for the majority (55%) of defaults over the 15-year period, concentrated in the manufactured housing, home equity loan and franchise loan sectors.

MP

Trading ideas - trial separation

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a negative basis trade involving Pulte Homes Inc

The basis, or cash-CDS differential, tends to move on the back of a number of technical and fundamental factors. The most notable, over the past few months, are the impact of the structured credit technical bid (driving supply for CDS protection) and loan issuance and its hedging (driving demand for CDS protection).

Neither of these major forces impact the bond market directly – but clearly there is an arbitrage-based relationship between the two that needs to be kept in line. This week, we look at a negative basis trade on Pulte Homes Inc (PHM).

Based on our survival-based valuation approach – which implicitly judges how rich or cheap bonds are relative to the CDS curve – PHM's bonds are all trading cheap to the CDS market. This is seemingly driven by the technical bid (from new structured credit issuance such as CPDOs) and more bewildering a seemingly unstoppable belief among CDS traders and investors that the housing slump will be short-lived – yes, we know we sound like a broken record.

Every time homebuilder spreads push wider they get hit and pull tighter. This is one reason we have taken more conservative curve or basis trades among these credits – looking for relative rather than absolute value – our crystal ball is as good as yours on the macro big-picture. The technical bid in CDS obviously does not affect the bond market directly and so we see a noticeable discrepancy between bond and CDS spreads on 'like' credits.

Looking specifically at PHM's bonds, the 5.2's of Feb 2015 bond is about $0.70 cheap to fair value. Exhibit 1 indicates the 'price-based' term structure of PHM and shows that the premium bonds seem 'more' mispriced than the discount bonds relative to the CDS market. We note that not all bonds have traded recently and so some of the levels will not be executable.

Exhibit 1

Importantly, the bonds that we pick out are reasonably liquid and currently active – as evidenced by our data from Bloomberg's CBBT and Market Axess's Bond Ticker. PHM is consistently active in the credit derivative markets and has liquid cash bonds. Based on our analysis of bond cheapness and market activity, the 5.2's of Feb 2015 is viable for the long bond leg of our negative basis trade.

We must now look at the actual spreads to judge whether we are actually trading at a negative basis, and, maybe more importantly, can position ourselves with positive carry.

Comparing the bond z-spreads (for the active bonds) with the CDS term structure, Exhibit 2 shows that all the bonds are indeed trading wide of CDS. Importantly, we must note that the bond is trading wide of its interpolated maturity-equivalent CDS which reflects our second basis adjustment discussed above. We also note that PHM's z-spread curve is flatter than its CDS curve. 

Exhibit 2

The PHM CDS curve has some interesting features – aside from its relative steepness, the 3s-5s part of the curve has been driven exceptionally steep. This, we believe, is driven by investors looking for a cheap LBO hedge as the homebuilders pop up on many fundamental screens. Unfortunately for us, there is little liquidity in the bonds in this area, but we have seen solid two-way pricing on Bloomberg's ALLQ screens for the 5.2's of 2015.

Exhibit 3 also shows that the historical basis between the 7Y CDS and the 2015 bond has remained wide for much of the last few months, after pulling tighter during the early months of 2006. The technical bid has much to do with this but we note that in early 2005, these instruments traded close to zero basis.

Exhibit 3

Given that we have identified the PHM 5.2s of Feb 2015 bond as trading cheap to the CDS market (from our survival-based framework) and its z-spread as being wide of on- and off-the-run CDS levels, we must ensure that we account correctly for any premium or discount at which the bond is trading.

As we discussed previously, we must adjust for the impact of loss given default differences between the bond and CDS market. This maximum 'gearing' effect is translated into our adjusted basis and carry calculations.

At current levels, the package has a raw basis of -16.8 basis points, and a positive carry of 22.5 basis points. This shows the impact of correctly adjusting our bond-CDS comparison for bond price and curve steepness.

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

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

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

We have seen different approaches discussed as to how to solve this dilemma but we prefer to 'keep it simple'. A practical approach is to hedge the bond's default risk with the most liquid (and closest in maturity) CDS according to the average of current and final bond price adjustments.

Our initial hedge amount should be based on a minimisation of expected loss in default– we calculate the initial hedge as (Bond Price – Recovery)/(Par – Recovery). For a bond trading at $110 and assuming a 40% recovery, the initial hedge amount should (110-40)/(100-40)=117%. We should buy $11.7mm protection for each $10mm of face value bond we buy.

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

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

Utilising Gimme Credit's Credit Scores – which reflect the fundamental outlook for the issuer, we adjust our single CDS hedge. If the outlook is improving then we will prefer to hedge only 100% of face value to maturity. If the outlook is deteriorating then we would hedge at our maximum current hedge amount (117% in our example). If the outlook is stable then we will choose our mid-point optimal hedge (108.5% in our example).

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

In our specific trade today, the bond is trading at $95.25 (best ask) and so our minimum hedge would be (95.25 – 40)/(100-40) = 92.1%. Obviously, our maximum hedge (given the discount bond) would be 100%. Given our deteriorating fundamental outlook for PHM and the fact that it is often difficult to transact in odd lot size, we feel it is more realistic to assume a 100% hedge.

Adding in mid-dated CDS to balance the hedge is possible and we are happy to discuss the use of a second CDS position with any investors who prefer to be more 'perfectly' hedged. Since the bond is within 12 months of the current 7 year on-the-run CDS maturity and trading relatively near par, we strongly suggest the single CDS to bond 100% hedge and a less frequent but vigilant re-hedging program. We can generate a forward-based price projection for the bond based on the CDS curve – to show how we expect the bond price to drop (premium) or rise (discount) until maturity – which may help some investors with their hedging strategies.

The second (and often overlooked) hedge is the simple interest rate hedge on the bond. Our basis trade is positioned to benefit from any convergence of the credit risk perspectives of the cash and CDS markets and further, the bond is cheap on the basis of its CDS curve (only credit-risk based).

We therefore must ensure that our bond is hedged against interest rate movements and the impact these will have on the price of the cash instrument. Note that the CDS is exposed to interest rate movements but only in the discounting of cashflows and this interest rate sensitivity is minimal (and we ignore it in this case).

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

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

Given the cheapness of PHM's bonds, negative basis and positive carry of our overall position, we suggest this negative basis trade (long bond and long protection) as a default-neutral way to pick up 18 basis points and more importantly potentially realise the bond's relative value differential.

Risk analysis
This position is close to default-neutral and spread duration-neutral. There is a slight maturity mismatch which is driven by the need for liquidity in CDS but this does not concern us as we expect convergence long before our CDS position matures and the curve steepness between maturities is not a major factor.

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

Exhibit 4

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

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

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

PHM shows reasonable liquidity in the seven-year maturity and bid-offer spreads are generally less than 5 basis points.

Recent bids and offers (seen on Bloomberg's ALLQ) for the 2015 PHM bonds have been reasonable and there is liquidity in both directions. This trade possesses a fair amount of liquidity risk. We recommend the bond leg of the basis be worked first, looking for a price below $95.94 (our model fair-value).

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

We note that recent news comments and our own fundamental screens point to the homebuilders as potential LBO targets (suppressed stock prices, strong balance sheets, consistent free cash flow, and low leverage) and while we agree that on paper this is true, we feel that private equity is unlikely to go after such a highly cyclical business at this potential turning point in the economy.

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

Summary and trade recommendation
The overwhelming impact of the synthetic-market-specific technical bid has driven the aggregate basis in US credits close to recent wides. One of the sectors to be hit most is the homebuilders, where continued strength in the CDS market (now trading close to two-year tights) has driven the CDS-bond basis to recent wides.

Specifically, PHM's bonds are all trading cheap to its CDS curve, based on our CDS-implied Bond Valuation model. The traditional z-spread-to-CDS raw basis is negative and our 'curve and bond price'-adjusted basis remains negative and shows positive carry.

With a deteriorating fundamental outlook, we feel a default-neutral negative basis trade is an excellent opportunity to earn modest carry while waiting for the bonds to converge to fair value. We recommend a basis package using a single CDS static hedge to pick up 18 basis points of carry. Furthermore, the recent spate of LBO rumours (including the homebuilders) may be somewhat offset by the poison put protection of this bond and potential par take-out in the event of a PTP transaction.

Buy $1mm notional Pulte Homes Inc. 7 Year CDS protection at 72bps

Buy $1mm notional ($0.953 mm cost) Pulte Homes Inc. 5.2% of Feb 2015 bonds at a price of $95.25 (z-spread of 90bps) to gain 18 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).

Credit range accruals - part 1

In this series of three articles, Shreepal Alex Gosrani, Emiliano Formica and Domenico Picone of the structured credit research team at Dresdner Kleinwort examine range accrual structures in a credit context

Range accrual structures have been a feature of the interest rate derivatives market for some time and have seen wide acceptance among many classes of investors who are looking to boost yield by exploiting a range view. Here, we look at how such a technology can also be applied in a credit context where the yield that investors can attain depends on the evolution of a credit index.

A range in this case refers to a set of limits with respect to which the reference process is monitored. Range accruals are structured notes whose coupons depend on whether this range condition is met, in which case, the coupon accrues. In the case of credit range accruals, the payoff is a function of whether a reference index lies within a range over a pre-determined period. Until now this structure has been applied widely to interest rate ranges or corridors. In such a case, if the specified interest rate fixes within the range for the period, then the coupon payable to the investor accrues.

More specifically, in the interest rate case, the rate is usually observed with respect to the range on a daily basis. The payoff on the note accumulates for each day in the period that the reference rate (e.g. LIBOR), from an agreed source (e.g. Reuters), fixes or lies within the range. This accrued coupon is then paid out to the investor in arrears on the coupon dates (e.g. quarterly or semi-annually).

In the case of a credit range accrual note, the underlying reference could, for example, be the on-the-run 5Y iTraxx Europe series. In such a case, depending on the exact specification of the note, for each day or week the index lies within a range, the payoff to the product accrues. In this paper, we use the 5Y iTraxx for a reference index as the basis for our analysis using daily observation as the specification of the product.

The product is principal-guaranteed and the risks borne by the investor are coupon-specific risks. In this way, the investor can attain an exposure that is purely a function of credit spread evolution. The choice of the reference credit instrument would also be flexible.

It helps to use an options analogy to describe the payoff. Clearly it can be seen that the investor benefits when the iTraxx trades within the prescribed range. In this case, the investor receives an outsize coupon. In return for this yield pick-up above a benchmark, the investor has effectively sold a series of credit spread options to the issuer. These can be considered as double barrier or corridor options.

More specifically, these options are double one-touch (DOT) options. The two barriers are the levels of the specified range limits and if the reference fails to breach the range, then that particular option expires worthless and the coupon accrues to the investor. This is done on a daily basis, and so the payoff is a function of such digital options that expire daily. If the spread breaches the range, then the coupon for that day does not accrue.

If the iTraxx index, in the case of the credit range accrual, remains within the range, the investor gains a higher-than-market coupon. Since the reference is observed daily, the investor needs to assess on how many fixings (days) will the iTraxx remain within the range for a break-even assessment – with respect to a benchmark fixed income investment (which we undertake in a later section).

Why invest in a credit range accrual note?

Globally credit spreads are currently low and volatility in spreads limited. Therefore, outperformance by direct investment in today's credit market is more challenging. As such, to provide an enhanced return for investors, credit structured products, which offer a yield pick-up, are an attractive way to gain exposure to credit markets.

A range accrual note that is referenced to the underlying liquid iTraxx index can be attractive to both seasoned credit investors and those new to the credit market. It can pay a high coupon and the principal is guaranteed.

This product, above all, allows investors to exploit the range-bound nature of the iTraxx index spread, that is to say, iTraxx remaining in the range would enable significant yield pick-up. In comparison to direct synthetic investment in the iTraxx index either by way of a swap or a CLN, investors' principal is protected from degradation due to defaults in the iTraxx portfolio.

Spread history
In the case of of iTraxx, we look at the spread history of the 'on-the-run' series. We see that in the two years since iTraxx Europe started trading, the index has remained in a range of 25-55bp except on two days in 2005. The highest close has been 57bp (17 and 18 May 2005, and the lowest has been 26bp in early September 2006).

The leverage is generated within the structure
This indicates an opportunity for investors to profit from a continued sideways movement in the credit market. Here, the leverage gained by the investor is not due to increased credit risk from a thinner CDO tranche or from moving down the capital structure (popular recent methods for enhancing otherwise depressed yields), but from taking on market risk to coupons. In other words, the leverage is generated within the structure of the issue rather than from heightened exposure to default risk.

Spread volatility
Here we show the spread history making use of iBoxx corporate A-rated swap spreads as a proxy before iTraxx started to trade in 2003. Since early 2004 (except for the correlation dislocation of May 2005, see Structured Credit Products in 2005/06, 22 February 2006 for more detail), we see the emergence of more muted volatility regime with respect to that of 2001 to 2003. We expect this to continue and thus range notes are more appealing as there is less chance of a barrier being breached.

In terms of spreads, we see that the cycle is at a low point and, as such, we see some widening to come although we don't foresee a return to the unstable period of 2001-03.

Dynamic vs. static range accrual structures
In spite of anticipated widening, we expect the iTraxx to remain range-bound and a range structure offers a way to monetise this view. In a spread-widening environment bespoke tranches suffer a MTM loss so, in comparison, a range note can be a viable alternative especially if the investor expects spreads to move largely sideways and a dynamic range structure as presented here benefits from barriers that reset every six months, in contrast to static barriers.

Factors to consider

The main factors influencing the payoff to such a structured note are size and flexibility (static or dynamic) of the determined range, forward index levels and the volatility of index spreads.

? Size of the range – when the range is large, there is less chance of the iTraxx being observed outside the range. Hence the investor can expect to accrue plenty of coupon on a quarterly or semi-annual basis. However, if the range specified is too large, then the spread offered over the benchmark (Libor) will naturally be more limited. When this range is more restricted, the scope for a yield pick-up for the investor is greater. The structure can be arranged such that the investor receives a higher coupon. Clearly if a range of, say, 25-55bp were used then the potential coupon would not be as large as in the case of a tighter corridor of say 30-45bp. Also important is whether the barriers dynamically reset every six months with respect to the on-the-run prevailing spread or whether they are static and fixed from the outset of the trade.

? Forward index levels – forward levels implied from the spot CDS market can be interpreted as the market's expectation of future spread levels. If implied forward spreads on iTraxx are showing that there may be trading outside a certain range and the investor believes that the iTraxx will continue in a range, the yield pick-up can be enhanced even further. The range accrual trade effectively permits the investor to make a play on the implied forward curve. We explain in the appendix how we calculate the forward spreads from the spot market. Below we illustrate the implied forward iTraxx curve with a tenor of five years (based on market prices as of 18 July 2006).

? Volatility of the index spread – in general, when volatility is high, it is more likely that the iTraxx might be observed outside the specified range. When spread volatility is less pronounced, as it is now, then there can be a higher return for the investor, since there is less probability that the spread will be observed outside the range, and hence more coupon is likely to accrue. Clearly, when spread volatility is expected by the market to be high, the investor can earn a more enhanced coupon for a range-bound view.

The impact of the forward curve and volatility
The interest rate market is generally showing flat curves currently. This would mean that investors will not receive a substantial premium for expressing a range-bound view. CDS curves by comparison are steep and this means that range notes in credit can pay a considerable yield over a benchmark to investors.

A steep curve in credit implies forward levels that mean credit spread options (as mentioned earlier) show increasing moneyness with increasing maturity.

In other words, the market thinks the iTraxx more likely to breach the barriers. So in return for this, the investor should enjoy a substantial yield over Libor.

However, we believe that a part of the steepness of the credit curve is due to investors demanding a premium in return for the risks associated with the relative infancy of the market. As such, future spreads may not actually be at levels predicted by the implied forwards. A way to exploit this view is by way of a range accrual on credit.

More on spread volatility
Returning to the subject of spread volatility, as we mentioned, the credit process not breaching the range is akin to a short position in a series of options. The investor is certainly short volatility at the near end.

However, the fact that the implied forwards show that the market expects a breach in the future, the investor would benefit from a rise in spread volatility to raise the probability of the underlying credit index coming back into the range. So the overall volatility position, taking the term structure into account, is not so clear-cut. The effect when considering the dynamic resetting barrier is different in that the investor is short six month (the time between rolls) volatility but long-term volatility (beyond six months) does not have the same impact.

Trade mechanics

We describe here examples in the format of a swap and a note issue. In the format of a note, the issuing bank would receive proceeds from the investor at inception and then the underlying index would be observed according to the pre-determined frequency to see if it breaches the specified range with the coupon on the note being calculated as described above.

In the format of a swap, the investor would pay Libor and receive the range accrual coupon (which is defined below). In such a case there would not be an exchange of proceeds or cash at the outset as the swap is constructed such that it has zero value at the beginning. The diagrams below depict the variations.

The underlying reference index is the on-the-run 5Y iTraxx Europe spread and the specified range is 20-80bp. The maturity of the trade is five years and the coupon is given by the following expression:

where O is the number of days in a period on which iTraxx Europe closed in the range; N is the total number of days in the period. The coupon might be paid semi-annually or quarterly. Clearly other credit indices and maturities can be specified. Coupon observations would take place daily or weekly and would be paid in arrears as with other structured notes.

Credit range accrual note
In the format of a note, the issuer would offer a coupon of on a note notional. The principal proceeds would be guaranteed by the collateral and the risk faced by the investor would be that of uncertainty of coupon payments. In the diagram below we illustrate the mechanics of the range accrual note where the range coupon is given by:

iTraxx credit range accrual note structure - source: Dresdner Kleinwort

Credit range accrual swap
In this case, the arranging bank is the swap counterparty and the investor pays and receives the following legs each period:

Naturally, the best case for the investor would see a net return of 70bp and in the worst case a net return of minus-LIBOR. In the following diagram, we illustrate the credit range accrual in terms of a swap. If the iTraxx is observed outside the range on everyday, then the investor faces the net return of minus-LIBOR. On the other hand, if the iTraxx is observed in the range everyday in the interval, the investor has a net return of 70bp.

iTraxx credit range accrual swap structure - source: Dresdner Kleinwort

In a later section we explain the pricing and break-even levels with respect to various scenarios of a credit range accrual based on iTraxx Europe.

Coupon calculation example
Using the following table as an illustration, we explain a coupon calculation to evaluate the actual return to the investor in terms of a credit range accrual note referring to iTraxx Europe 5Y, and for simplicity in this illustrative case we assume monthly observation.

© 2006 Dresdner Kleinwort. All Rights Reserved. This Research Note was first published by Dresdner Kleinwort on 10 October 2006.