Contents

CDR Liquid Index data as at 4 December 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.

Credit bankers' earnings skyrocket

New SCI survey tracks boom in compensation

A survey undertaken by Structured Credit Investor reveals that dealers' compensation packages across structured and flow credit disciplines have ballooned this year. Ahead of the pack for 2006 are managing directors in structured credit sales, who will average a salary in excess of £125,000 and a bonus exceeding £2m.

Overall, head hunters report that credit bankers' 2006 salaries are up by 30% across the board globally over the previous year, while bonus increases are dependent on region. In the UK bonuses are up by 15-20%, by 12-15% in New York and by 17-20% in continental Europe. But Asia leads the way, with 25% increases.

It was noted that the falling dollar would nullify bonus increases for those recompensed in US dollars but based elsewhere in the world. However, the increasing use of deferred stock options in bonus payments will off-set this effect.

The Structured Credit Investor 2006 dealer compensation survey collated responses from the leading London-based executive search firms specialising in credit as to the current salary and bonus levels being paid to bankers they are placing at tier one banks. Levels were sought for structured credit trading, structured credit sales, credit flow trading and flow credit sales.

The levels were further sub-divided into three job categories ranked in terms of seniority – characterised as managing director, executive director and director. The mean of all responses was then calculated.

As mentioned above, on average the highest levels of compensation this year emanate from structured credit sales. Responses indicate that managing directors receive salaries of £127,721 and bonuses of £2,162,204. Executive directors average a salary of £114,440 and a bonus of £916,130, while the corresponding figures for directors are £96,070 and £708,730.

Next are those in structured credit trading. The survey indicates that on average managing directors receive salaries of £133,006 and bonuses of £1,781,906. Executive directors average a salary of £107,193 and a bonus of £1,076,796, while the figures for directors are £ 90,206 and £632,581.

In credit flow trading the survey indicates that on average managing directors receive salaries of £116,667 and bonuses of £1,758,333. Executive directors average a salary of £106,250 and a bonus of £762,500, while the figures for directors are £87,500 and £600,000.

Finally, in flow credit sales the survey indicates that on average managing directors receive salaries of £123,440 and bonuses of £1,316,565. Executive directors average a salary of £113,440 and a bonus of £648,645, while the figures for directors are £96,070 and £388,100.

Looking ahead, survey respondents expect 2007 to be about business consolidation, with the pressures seen in 2006 of amalgamation of structured credit into other asset classes' structured businesses unlikely to continue. As a result, if growth and P&L remain sustainable and steady next year, inflationary pressures on overall compensation are likely.

The executive search firms that took part in the survey were Elliott Ross, Exchange Consulting, Hammond Partners, Mantis Partners, Napier Scott and Watmough-Mallett. Sales personnel compensation will vary dependent on target customers, but in the interests of simplicity no differentiation has been made between different groups – hedge funds or financial institutions, for example.

30-year Italy in play

Long-dated sovereign CDS moves driven by jumbo structured trade

Italian sovereign 30-year CDS have seen an unprecedented amount of activity in recent weeks and spreads have narrowed noticeably on the back of what is thought to be a €1.8bn structured trade. Consequently, the Italian CDS curve has flattened considerably and is attracting buy-side interest.

Like anywhere else in the market, Italian CDS have been driven lower by CPDO hedging, but they appear to have also been subject to selling pressure at the ultra-long end of the curve specifically related to tailored structured trades, requiring large-scale selling of 30-year CDS.

As one dealer observes: "We've seen 30-year prices in the street for the last few months, but not seen any trades going through. However, the fact that there are prices out there and that the spread has narrowed in that time indicates some trades must have taken place."

Another dealer confirms that the 30-year CDS traded Tuesday morning at 27bp. "That means it has only come in half a basis point in the past week, but it has come a long way since the end of August when it was quoted at 46bp - it has lost over 40% of its value," he says.

This move is, the trader suggests, a direct result of an accreting 30-year structured deal. He explains: "The speculation is that one Italian region has done a structured trade in which they are financing themselves by issuing CDS. The deal is then repackaged into mortgage form and put into another vehicle, which the region can draw on over time. They have done it in much bigger size than anyone has ever traded that part of the curve before - €1.8bn, I understand - and that requires significant hedging by the structuring bank."

Dealers suggest that the hedging has been completed, given the lack of movement in the 30-year spread over the past week, and argue that it is doubtful that anyone will follow on with such a large trade. However, the flows in 30-year have meant that it has dislocated from the rate of narrowing in the 10-year, causing the 10-30y curve to flatten by 10bp since May.

This movement has led to trades and increasing interest is being seen in Italian 10-30y CDS curve trades. "Long-dated curve trading is pretty active, certainly relative to where it has been and even on an absolute basis. It's got to the stage where it has almost as much customer interest as asset swaps do on the 30-year BTP," reports one banker.

He explains: "The curve has flattened such a lot that people are looking to bet that it will now go the other way. This is rational on the basis that when an amount of hedging comes into a market, generally speaking you'll find that the curve does move back the other way because that particular supply has now disappeared - whereas demand might be constant and we will have to find out where the next level of supply is going to come from."

MP

Asian CLOs ramp up

Deals in China, Malaysia and Singapore emerge

CLO issuance across the Asia Pacific region is on the rise once more following a hiatus in recent months, with transactions in the works in China, Malaysia and Singapore.

"All of a sudden, it seems everywhere you look across the region deals are being prepped. We are hearing about CLOs either in more unusual places - notably China and Malaysia - or from new issuers," confirms one Hong Kong-based structurer.

Indeed, the second wave of seven deals under China's pilot securitisation programme is now coming close to launch. The Rmb5bn (US$638m) CLO from Industrial and Commercial Bank of China (ICBC) - which unusually packages together both consumer and corporate loans - was the primary focus last week, as the bank appointed Standard Chartered Bank to what has become a joint advisory role alongside HSBC. CLOs from Agricultural Bank of China, China Merchants Bank, Shanghai Pudong Development Bank and CITIC Bank are also in the pipeline.

Meanwhile, asset mangers Oriental AMC and Cinda AMC are close to finalising their non-performing loan (NPL) CLOs. Last week, Oriental was putting together the underwriting group for its Rmb1.9bn deal. At the same time, Cinda has been marketing its Rmb4.75bn deal to investors. Both NPL transactions involve a dual-tranche structure.

And in Malaysia there is speculation that, after a six-month hiatus, banks will return to the sector next year with new CLO deals. Previous issues ran into trouble during the summer as downgrades hit and overcollateralisation ratios dropped below rating agency minimum standards.

However, dealers are confident that the local market is over these troubles and, encouraged by investor demand, expect to see CLOs of relatively significant size from major domestic banks shortly. Names being touted in the market are CIMB, Hong Leong Islamic Bank and RHB Investment Bank.

The most recent Asia-based transaction to hit the market is private equity firm Clearwater Capital Partners' CLO I issue of US$146m floating-rate notes due 2014 through Merrill Lynch. The transaction, an arbitrage CLO, is a securitisation of primarily Asian performing and non-performing loans, restructured loans and high-yield bonds.

The Singapore-based SPV will issue US$40.9m triple-A rated Class A notes, US$14.6m double-A rated Class Bs, US$7.3m single-A rated Class Cs and US$5.8m tripe-B rated Class Ds. The expected rating of the Class A and Class B notes addresses ultimate repayment of principal at maturity and timely payment of interest, while for the other classes of notes they address ultimate payment of principal and interest, including any deferred interest, at maturity.

The US$137m portfolio consists of 34 non-investment grade assets and 24 obligors with an average rating of B-/CCC+. The three largest assets make up 37% of the initial portfolio, with Malaysian assets accounting for 30%, Indonesia accounting for 27% and the Philippines accounting for 17%.

The portfolio guidelines restrict the role of the collateral manager to purchasing assets in the three-month ramp up period using unused note proceeds or principal proceeds and the sale, at its discretion, of certain assets following particular events (including selling defaulted obligations and performing credit impaired or credit improved trades). Proceeds from such sales will not be used for reinvestment, but will instead be used to sequentially pay down the notes. Following the end of the three-month ramp up period, no reinvestments can be made - meaning that the transaction is largely a static deal.

MP

Offering investors diversity

This week, Dagmar Kent Kershaw head of structured credit products at Prudential M&G, answers SCI's questions

Dagmar Kent Kershaw

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: We were one of the first entrants into the European CDO market, closing our inaugural transaction in early 2001. Prudential M&G is one of the largest institutional credit investors in Europe, and our philosophy was to leverage off the infrastructure and track record that we'd built up over many years. We have an outstanding investment platform: 148 investment professionals and around 40 credit analysts in London, in addition to a similar sized credit team in the US.

We now run €5bn in structured credit and CDOs across 18 separate programmes, but have retained our core philosophy of fundamental credit analysis. This means that we have a very clean track record – in almost six years of managing CDOs, both cash and synthetic, we have never suffered a downgrade or negative watch on any tranche.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Undoubtedly the growth in CDS. It has facilitated the growth of structured credit, which has fundamentally changed the technical drivers of the credit market. The performance of credit spreads over the last two to three years has been materially different to prior years – despite issues in specific industries, spreads have remained range bound and continued to grind tighter due to the structured bid, as well as the growing variety of applications of CDS and indices.

Q: How has this affected your business?
A: It presents opportunities in the type of products we can manage and offer to the market, and it has dramatically increased our flexibility to work more closely with existing and new investors to tailor more bespoke products.

We manage ten cash programmes and eight synthetic. On the cashflow side, there are four multi-asset class CDOs, five CLOs and one European ABS. On the synthetic side, we manage structures from plain vanilla to more complex transactions such as SPI. We offer a whole range of credit-based strategies such as debt, equity, long-only, long/short and principal-protected.

Q: What are your key areas of focus today?
A: Our structured credit business is intentionally diverse – we like the flexibility of managing multiple asset classes such that we are never a forced issuer in any particular asset class. For example, European ABS is a great asset class but it's difficult to ramp a portfolio from zero at present. We'll continue rolling out our structured credit and cash multi-asset class and leveraged loan programmes.

Q: What is your strategy going forward?
A: We like to innovate and have achieved a number of 'firsts' in Europe. We are unique in running multi-asset class CDOs. In 2006, we managed the first rated synthetic equity transaction (Bison) and our recently-priced Panther IV was the first European CDO to contain real estate B-notes. We were able to buy B-notes because we already have presence in the asset class via Prudential's own funds.

Going forward, our strategy is to utilise our deep credit platform to look across the credit markets for pockets of value which may not have been used in CDOs previously. B-notes are a prime example of such an area where we have a track record and we believe there is fundamental value.

Q: What major developments do you need/expect from the market in the future?
A: Modest spread widening! That said, we do not see major credit problems on the horizon in the mainstream credit markets.

We'd like to see continuing improvements in transparency – despite great advances, the perception of market opacity can still be offputting for first-time investors. It can be difficult to get comparable data: whilst each of the investment banks has comparable data for their own transactions, it is hard to get this data across the different banks – particularly on the synthetic side. There has been an increase in the availability of public pricing models and sources, but it would also be good to see more public pricing of secondary CDOs to facilitate trading and help liquidity.

About Prudential M&G
Following the acquisition of M&G by Prudential in 1999, the two asset management businesses of M&G and PPM (Prudential Portfolio Managers) were merged into a single unit in 2000, with M&G becoming the investment arm of Prudential plc across Europe. Today, its focus lies in fixed income, private debt, CDOs and a range of pooled funds that are used to construct both defined benefit (DB) and defined contribution (DC) pension schemes.

Prudential M&G's Structured Credit Products operation is one of the most experienced managers in Europe with over €5bn currently under management across several structured vehicles. Prudential M&G is active in both cashflow transactions and synthetic vehicles and has been managing Structured Credit Vehicles since February 2001.

"We bring order to chaos"

Credit derivatives data services firm CMA is the subject of this week's Provider Profile

Credit Market Analysis – CMA – came to market in 2001 with its real-time information product, QuoteVision. The move signalled a strategy that would immediately set the company aside from its major rivals – to bring pricing information efficiency from dealers' desks to the buy-side.

QuoteVision has generated the firm over 100 clients from all buy-side participants; hedge funds, bank prop desks, and institutional asset management. Building on this success, CMA also offers DataVision, an end of day mark-to-market product that is based on averaged observed market prices, rather than theoretically derived pricing.

QuoteVision's appeal to its buy-side client base is based upon a simple concept. A typical buy-side trader might receive a few thousand e-mail/Bloomberg messages each day from dealers alerting them to CDS trading opportunities, which can contain a large amount of esoteric information, often written by a salesperson in their own shorthand code. QuoteVision removes all such 'noise'.

Laurent Paulhac

"QuoteVision is built upon proprietary artificial intelligence. We present the client with the pricing information they need, by asset, bid/offer and by dealer, and strip out all the unnecessary commentary and personal information in the messages. This net information is then presented via our front end GUI which orders the entire flow of information on screen," explains Laurent Paulhac, CMA's chief executive.

When the system cannot interpret a message's content, the offending section that cannot be recognised is sent to CMA's editorial team, where the suspect data is identified, corrected and validated. The system then learns how to interpret that particular type of message for future reference.

Paulhac adds: "Before QuoteVision was launched the client would be inundated with e-mails to the extent that naturally they would ignore very many of the prices offered. This is of course a hugely inefficient practice, as the trader would often miss out on the best price. Now they can simply view all prices offered on their screen, call the dealer and negotiate around the offered price."

CMA saw that the easiest route to helping their clients was to help them work with what they already had – e-mail – rather then introduce a new communication network. "E-mail is way too convenient to consider an alternative, but it lacks order. We bring order to chaos," claims Paulhac.

He continues: "We develop all our products based upon client feedback; we do not attempt to second guess the market. QuoteVision is based upon addressing the pain point between buyer and seller, using a peer to peer communication route. If a client wants a price for a new product such as Loan CDS, they will ask for it on e-mail. Immediately they will get a fairly complete market view of the price, via QuoteVision. In this respect we are not only providing pricing information but by helping alert traders to new opportunities we are also driving growth in new asset classes."

Paulhac expects that many new firms, including real money US-based accounts, are set to enter the market in 2007, after gaining approval to trade. "If there's one thing that has held many of these firms back so far, it's been the amount of high quality, transparent market data they can get access to. Based upon initial conversations with many of these institutions we know they derive a great deal of comfort from the amount of information they see in QuoteVision."

New entrants also have accurate mark-to-market requirements to fulfil, and CMA's other product, DataVision, provides an additional buy-side solution. DataVision takes end of day data from around 30 buy-side clients, based upon real, observable, tradable prices, claims CMA, and aggregates them to provide MTM data.

"We provide end of day data on around 2000 entities, and supply the data to the market at 5pm local time in London and New York via our front end and via Bloomberg. What's crucial is that our prices are wherever possible not derived, they are based upon what's been seen and traded by our consortium members for each CDS each day," says Paulhac.

Paulhac is bullish about DataVision in comparison to alternative, sometimes more entrenched and broad-based, data suppliers. "We feel that DataVision prices are far more representative of the day's trading than, for example, Markit Group's data, which is based upon back office information provided by sell-side institutions that may not be continuously updated."

He continues: "We get information from hedge funds, real money and prop desks. Our consortium provides its data based upon very exacting rules. Data is rarely derived, and so we send it out with a high degree of confidence."

Having a pure buy-side audience to support allows CMA to concentrate on clients' wider trading needs, and Paulhac has an eye on future development of CMA's product set when he outlines its strategy going forward. "We are aware that pricing is at the forefront of our clients' minds, and we continuously listen to their needs. Our clients see us as very innovative so we must react to their growing analytical trading requirements," he says.

"As we grow to support new entrants we must also help them with the learning process as inevitably they will have to deal with market events and defaults, and develop their strategies accordingly. This market has a long way to go and many new firms will participate in the future. CMA intends to be their partner of choice," concludes Paulhac.

JW

Deutsche and AXA announce new CDPC

The latest company and people moves

Deutsche and AXA announce new CDPC
Deutsche Bank and AXA Investment Managers (AXA IM) have signed an agreement to establish a working relationship to provide financial services to a Deutsche Bank-sponsored credit derivative product company (CDPC), which will be called NewLands Financial CDPC.

Deutsche Bank and AXA IM will join forces to provide all the services for NewLands Financial CDPC on formation. Deutsche Bank has committed US$125m in equity to set up the independent, bankruptcy-remote CDPC. This amount, along with further debt financing, will define the capital base of this vehicle - which is expected to be triple-A rated.

The main business objective of the CDPC will be to sell credit protection on default-remote corporate credit risk using highly rated CDOs, with the possibility of expanding into other asset classes in the future. The ratings of the CDOs will be predominantly in the junior super senior and super senior categories, with a small bucket for triple-A rated tranches. AXA IM's primary role will be to provide portfolio management services, while Deutsche Bank will provide risk management, infrastructure and operational services.

Pierre-Emmanuel Juillard, head of AXA IM structured finance division, comments: "We believe this CDPC structure is one of the most innovative and will greatly benefit from the core strengths that each partner brings to NewLands Financial."

Rajeev Misra, head of global credit and commodities at Deutsche Bank, adds: "This partnership between two key players in the credit derivatives business ensures that NewLands Financial becomes an established triple-A quality counterparty in the credit derivatives market."

Barnum to exit BlueMountain
Jeremy Barnum will be leaving his role as head of the European office of BlueMountain Capital Management by the end of this year. Some observers had suggested that the move is related to the Cablecom CDS spread spike last month (see SCI issue 13), but BlueMountain strongly disputes this and stresses that the parting is amicable.

"We mutually agreed that now was an opportune time to make the transition to new leadership in London; the team and office infrastructure are solidly built and the office is a well established and respected market leader in Europe. We thank Jeremy for his work establishing the office and agreeing to aid in the transition," says Stephen Siderow, president of BlueMountain Capital Management.

Gery Sampere, a founding partner of BlueMountain and the portfolio manager in charge of running the global long short credit and capital structure arbitrage investment books, will take over leadership of the London office.

MP

Moody's publishes PAUG methodology

A round up of this week's structured credit news

Moody's publishes PAUG methodology
Moody's yesterday published a new methodology explaining its approach to rating pay-as-you-go (PAUG) CDS that reference structured finance securitisations.

PAUG settlements differ significantly from cash and physical settlements in that, on the occurrence of a floating amount event, the protection seller is required to pay an amount to the protection buyer that corresponds to the actual cash flows or non-payments of the underlying structured finance reference obligation. The amount paid by the seller is subject to reimbursement by the buyer if the cashflows of the underlying reference obligation are subsequently reversed.

"Floating amount settlements in PAUG swaps can behave very differently from cash and physical settlements, so our rating process assesses their unique risks," explains Moody's senior analyst Pooja Bharwani, author of the report.

Moody's rating approach focuses primarily on floating amount events defined in the ISDA Dealer Form for Mortgage Backed Securities – failure to pay principal, interest shortfall, writedown and implied writedown.

The rating agency cites implied writedown as the most problematic of the floating amount events, as it potentially exposes the cash and synthetic investors to different economic terms, as well as credit risks associated with the counterparty. An implied writedown under the Dealer Form is triggered when the outstanding principal amount of the reference obligation (plus all tranches of the related issuer that are pari passu or senior to that reference obligation) exceeds the amount of assets of the issuer. In such cases, the notional amount of the CDS would decrease and reduce future CDS premiums without affecting payments to a cash investor in the underlying reference securitisation.

The methodology points to counterparty risk as being one of the important factors in analysing floating amount events. In a PAUG swap, the obligation of the buyer to make payments upon a subsequent reversal of cashflows on the underlying reference obligation introduces counterparty risks. Mitigants generally depend on the amount at risk to the counterparty and the duration of the exposure.

Moody's is generally comfortable with physical settlement following a credit event, providing the CDO has the ability to accept physical delivery and the deal would not be forced to sell the asset upon delivery. However, concerns remain over adequate liquidity in the deal to pay for delivered obligations and a potential basis mismatch upon the delivery of fixed rate assets.

Trade associations speak out against insider trading
A group of eleven trade associations is understood to be preparing to issue a statement reaffirming the association members' commitment to promote fair and competitive markets and to reinforce the message that inappropriate use of material non-public information is not tolerated. The associations are also expected to stress that their members have long had appropriate policies and procedures in place for handling material non-public information, and for fully complying with securities laws and regulations.

Nevertheless, the associations will argue that it is important to maintain a focus on this issue since even the perception of misuse has the potential to erode confidence in the integrity, as well as the liquidity and efficiency of the securities and derivatives markets on which their members rely. The associations involved are: Asia Pacific Loan Market Association; American Securitization Forum; Asian Securities Industry and Financial Markets Association; European High Yield Association; European Securitisation Forum; International Association of Credit Portfolio Managers; International Swaps and Derivatives Association; Loan Market Association; The Loan Syndications and Trading Association; Managed Funds Association; and Securities Industry and Financial Markets Association.

Synthetic CDOs remain stable
Reports released this week by Fitch and Standard & Poor's confirm that no credit events were called on corporate obligors referenced by synthetic CDOs in Q306.

Fitch's synthetic CDO index showed stable credit quality in Q306, with the absence of credit events balancing out a deterioration in the index's WARF by 3.7% – slightly more than the average deterioration of 2.8% per quarter. Indeed, the weighted average credit quality of the index was less stable in Q306 than Q206, when the index WARF deteriorated by 1.9%, but more stable than Q106 when the index WARF deteriorated by 6.4%.

The slight increase in WARF deterioration in Q306 compared to Q206 reflects the distribution of downgrades. In Q306 widely referenced names such as VNU and Ford Motor Company were downgraded, while fewer widely referenced names were downgraded in Q206. The poor performance of Q106 is related to the Dana Corp credit event in March 2006.

The index also shows that vintage 2003 was the worst performing vintage in Q306, while Vintage 2005 was the worst performing vintage in 2006 to date. Both vintages have large exposures to the BT Group, currently the 18th most widely referenced name in the index, which was downgraded in Q306. Furthermore, Vintage 2005 had the largest exposure to Dana Corp of any vintage.

Ford has now replaced VNU as the most widely referenced speculative-grade name in the index, at 0.34% of total index notional. Overall, the most widely referenced name remains AT&T, individually accounting for 0.51% of total index notional.

There have been 1.25 upgrades for every one downgrade in Q306, a figure that rises to 1.34 upgrades for every downgrade in 2006 to date. There has been an increase in the 'B' bucket in Q306, which contributed to the increase in WARF deterioration relative to Q206.

Analysts at S&P note in their report that the passing of another quarter with no new credit events triggered in synthetic CDOs is testament to an ongoing benign corporate credit environment. The agency says that in rated synthetic CDOs, the cumulative average recovery rate on reference obligors triggering credit events from the beginning of 2000 has been about 38%.

Data relating to synthetic CDO credit events corresponding to the bankruptcy of Dura Automotive Systems will be included in the fourth-quarter edition of S&P's report. But the agency points out that the Dura event is notable because of the new optional settlement mechanism that has been widely adopted by the market.

Calyon brings CPDO twist
Calyon has launched R-Evolution, a dynamic portfolio insurance trade that includes some CPDO features. Rated triple-A by Moody's, the product offers leveraged exposure to the CDX and iTraxx investment grade indices.

R-Evolution offers lower leverage than a typical CPDO – at about eight times – which means that, should spreads widen, the mark-to-market impact of such a move will be almost halved compared with a higher levered product. Yet the product's cash-in mechanism is the same as that of CPDOs, with the investor being paid a coupon and principal at maturity.

R-Evolution is set to close later this month, with tenors of seven and 10 years. The seven-year notes are expected to offer a coupon of 90bp over Libor and the 10-year 180bp to 200bp over.

MP

Trading ideas - loanly at the bottom

Dave Klein, research analyst at Credit Derivatives Research, looks at a curve steepener for iStar Financial Inc

The holiday season is upon us and although we would love to spread bullish good cheer, we just cannot help feeling that many spreads are still too tight and ready for a sell-off. With the release last week of independent research firm Gimme Credit's Bottom Ten, we find opportunity aplenty for bearish trades.

Among them, iStar Financial Inc. (SFI) stands out as a credit that has tightened considerably over the past few months and whose curve is flatter than what we deem to be fair value. Given our deteriorating fundamental outlook on the company, we believe a 5s-10s steepener on SFI presents an excellent opportunity.

How flat is too flat?
To estimate the fair value of the 5s-10s steepener, we model the 10 year offer level as a linear combination of the 5 year bid levels. This is undertaken across the universe of credits whose 5's are close in value to SFI. For each issuer, we produce an expectation of the ten-year CDS offer level. This is compared to the current market ten-year CDS bid level in Exhibit 1.

Exhibit 1

Values that lie below the black line are flatter than fair value and values that lie above the line are too steep. The orange box indicates SFI's current ten-year market level vs. fair value.

Differentiated differentials
SFI has reasonable liquidity in the CDS market across the curve and now trades actively in five-, ten-, three- and seven-year maturities. Bid-offer differentials and liquidity are acceptable in the 5's and 10's.

The curve differential (between five- and ten-year CDS) has remained largely constant, as seen in Exhibit 2. Given how constant the differential has been, it is our deteriorating fundamental outlook that fuels our expectation for a curve steepening.

Exhibit 2

Mid-to-mid absolute differentials have remained modestly low (compared to SFI's peer group) and consistent at around 25bps for the past year. This differential has made the 5s-10s steepener a modestly positive carry trade. At present, SFI is near the flat end of its 5s-10s differential, leading us to expect (when combined with out fair value model) that the name is a good candidate for a steepener.

The real deal
While we maintain a deteriorating fundamental outlook for SFI, any negative view could obviously be implemented with an outright short, but, as we have stated before we prefer positive carry trades (and relative-value opportunities) that are somewhat market neutral and, given the possibility of a takeover by a higher-rated company, we see a little too much downside for the naked short. We still prefer the steepener as our positively economic short trade (especially when our market bias is to the widening and steepening side) when we are concerned on downside and so investigating the 5s-10s relationship provides us with both relative-value and positive carry.

One more item of note with the steepener is that it buys us time (at these maturities) – if we are modestly negative on the credit but do not expect a major move soon, it does not cost us to maintain a position that benefits from over-performance. The position provides us with a cushion on our timing of any negative view and offers good upside from just rolling down the steep curve (if nothing happens).

Moving from the mid-to-mid (rough) curves to the bid-offer adjusted curves in Exhibit 3 paints a much clearer picture of where SFI's curve is trading. The differential between the standalone levels and the peer group's fair value points to an interesting divergence in 5s-10s.

Exhibit 3

The differential has been both positive and negative over the past few months. In the case of a steepener, a negative differential indicates the curve is too flat. Since the middle of July, our fair value model has indicated the SFI is too flat when compared with its peers.

Risk analysis
This trade is duration-weighted to ensure positive carry as well as to reduce our exposure to absolute levels. We are therefore hedged against short-term movements in absolute spread levels, profiting only from a curve steepening between the fives and tens.

The carry cushion protects the investor from any short-term mark-to-market losses. This trade has positive roll-down thanks to the curve shape and tightness of bid-offer.

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

Liquidity
Liquidity is a major driver of any trade – i.e. the ability to transact effectively across the bid-offer spread in the 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 SFI and the bid-offer spread costs.

Bid-offer spreads have narrowed to around four and five basis points in five- and ten-year CDS respectively. While we would like to see bid-offer spreads lower (who wouldn't?), we believe we can still cross these levels and have a profitable trade.

Fundamentals
This trade is significantly impacted by the fundamentals. The technical flatness of the credit and negative economics are helped by a potentially negative systemic outlook which, in our view, overwhelms the stable idiosyncratic performance of the credit.

Kathleen Shanley, Gimme Credit's Financials expert, maintains a deteriorating outlook for SFI. SFI received ratings upgrades after reducing its reliance on secured debt. However, the company has become a more frequent issuer of unsecured debt and Kathleen is concerned that rapid growth combined with the move into mezzanine loans from more traditional products could lead to future loan losses. iStar was recently included in Gimme Credit's Bottom Ten, a list of issuers considered most likely to underperform over the next six months.

Summary and trade recommendation
The holiday season is upon us and although we would love to spread bullish good cheer, we just cannot help feeling that many spreads are still too tight and ready for a sell-off. With the release today of Gimme Credit's Bottom Ten, we find opportunity aplenty for bearish trades. Given the relative flatness of SFI's 5s-10s CDS curve, we believe a positive-carry steepener trade is the safest way to express our deteriorating fundamental outlook on the company. Modest carry and the potential profit of a return to fair value strengthen the economics of the trade.

Sell $17mm notional iStar Financial Inc. 5 Year CDS protection at 41bps and

Buy $10mm notional iStar Financial Inc. 10 Year CDS protection at 62bps to gain 7.7 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 2

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

Different definitions of the reference corridor might be available to investors to match their different views about future spread levels and volatility. In this paper we test and analyze the performance of two types of credit range accrual: static and dynamic. In the former, the upper and lower barrier are defined in terms of absolute value (i.e. 20bp – 60bp) and remain fixed¹ throughout the life of the product while in the latter the barriers are defined in relative terms (i.e. -20% and +20% of the current spot level) and are periodically re-adjusted, typically every six months when the index rolls over.

Static credit range accrual
The static range accrual clearly entails a view on the long-term index volatility and on future levels of the index and, therefore, is suitable for those investors that expect the index to move largely sideways. Naturally, this structure will be sensitive to changes in the market forward curve and future spread volatility.

Dynamic credit range accrual
The dynamic range accrual, on the contrary, constitutes a bet on short-term volatility and forward short-term volatility. Since the corridor is frequently readjusted to the current spread level, the product is expected to be rather insensitive to changes in the market expectations about future spread levels. This type of structure is suitable, instead, for those investors that have a view only on the volatility of the index but no view about its long-term drift. The chart below illustrates the two types of barriers applied to the historical series of the index.

What happens when the index rolls?
To ensure reference to the most liquid index, the range accrual can be constructed to continually reference the current on-the-run series. This being the case, when the index rolls, there has to be an adjustment in the corridor or range specified, thus accounting for the revised composition and the maturity extension of the new on-the-run series.

Static credit range accrual
On the day of the roll the corridor, statically defined at inception, can be adjusted to the new series according to a number of rules. Here we propose two types of adjustment: the first looks at the new spot level upon index roll, while the second is related to the forward spread.

? Adjusting the barriers to the spot level – On the day of a roll, the corridor is shifted by the difference between the spread of the new series and the spread of the old series observed on the previous day. For example, let us assume that at inception the range was fixed at 20bp – 60bp and that the day before the roll to the new series the index was trading at 45bp. If then, on the day of the roll, the new series were at 47bp, the corridor would be shifted upwards by 2bp and, therefore, the corridor would now be set to 22bp – 62bp. In this way the possible jump in the spread level due to the new constituents of the series and to the maturity extension does not affect the final calculation of the accrued coupon.

? Adjusting the barriers to the forward level – Alternatively, on the day of a roll, the corridor can be shifted by the difference between the forward² of the new series and the forward of the old series observed on the previous day. The concept is exactly the same as the previous case. Using the same example, we can assume that at the inception the range were fixed at 20bp – 60bp and that the day before the roll to the new series the index were trading at 45bp. In this case, however, we are not interested in the spot level of the index but in the forward spread. Let's assume, therefore, that the forward in five years with a tenor of five years implied from the spot term structure was F(5,5)=78. If then, on the day of the roll, the forward for the new series were at 81 (F(5,5)=81), the corridor would be shifted upwards by 3bp and, therefore, the corridor would be set to 23bp – 63bp. These adjustments are clearly proportional to movements in the slope of the spot term structure that are likely to occur when the index rolls to the new series. With a steeper credit curve the corridor tends to be shifted upwards whereas with a downward sloping term structure the corridor tends to be shifted downwards.

In terms of expectation, this mechanism guarantees the optimal adjustment in order to minimize the probability for the index to breach the corridor. This is clearly true if the index moves in the future according to current market expectations i.e. according to the forward spread implied by the spot term structure. However, it is worth noting that historically the index has, on occasion, behaved differently from what was predicted by the forward curve (see the Back-testing section).

Dynamic credit range accrual
For a dynamic credit range accrual, when the index rolls, the barriers are reset to the same proportional levels as at the outset of the trade. For example, let's assume that at the inception the index is trading at 45bp, the upper barrier is fixed at +20% and the lower barrier at -20%. With these values the corridor would be 36bp – 54bp³. If, on the day of the roll to the new series, the index trades at 60bp, the upper and lower boundary of the corridor are readjusted relative to this new spread level. Therefore, the new range for the six subsequent months would be 48bp – 72bp⁴.

As such, the iTraxx will not breach the corridor upon roll purely as a result of the change to the new series. Adjustment for the roll of the index constitutes a discontinuity. This is because the range accrual follows the progress of the on-the-run series and this ensures that the product always references a high-quality investment grade portfolio. The note always references the on-the-run series and so has a constant maturity exposure.

Protection against higher volatility
It is worth noticing that, as opposed to what happens for the static credit range accrual, with a dynamic structure the width of the corridor does not remain constant throughout the life of the product but tends to grow as the index does. The upper and lower barrier is defined as a percentage of the current spread level and, therefore, the higher the index level on the day of the roll, the wider the range for the subsequent six months. In the previous example, with an index trading at 45bp the width of the range was 18bp, but on the next roll date, where the index was trading at 60bp, the corridor widened to 24bp.

This interesting feature gives to the investor a further protection against a higher volatility that is typically observed when the index trades at higher levels. Typically, when the index starts to rise the market tends to get nervous and as a consequence the volatility tends to be higher (downside volatility). The graph in the next page clearly illustrates this characteristic: during March 2005 – June 2005 the iTraxx from a level of around 30bp rose to a level of 57bp and the realised daily volatility⁵ (green line) consequently grew from around 2% to a level of 8%. This behaviour must not be considered as a rule but rather as a possibility that an investor should take into account.

Liquidity
Rolling to the new index each six months does raise a problem for modelling the product as there is the added uncertainty of the composition of the new portfolio. However, this feature of the structure ensures liquidity and also has risk implications with respect to ratings transition.

Probability of being downgraded to sub-investment grade
The fact that the credit range accrual can be constructed to continually reference the current on-the-run series has some important consequences for the risk of migrating from investment grade to sub-investment grade.

The 5Y iTraxx portfolio has an implied rating of Baa1-Baa2. According to the Rating Transition tables for structured finance products published by Moody's (period 1983-2004)⁶, the probability that such a product with a Baa rating is downgraded to sub-investment grade (including defaults) over a period of five years, is 22.58%. However, the same scenario has a much lower probability if it is calculated between the two roll dates of six months, and it is 3.30%.

Alternatively, being exposed to IG names (rated from Aaa to Baa) over six months has a probability of being downgraded to sub-investment grade (including defaults) of 8.24%, whereas over a period of five years, the same probability jumps to 32.1%.

Hence, by keeping the on-the-run series only as the reference exposure to the note, this transition risk is mitigated somewhat over six months, in contrast to a static portfolio underlying a standard five year portfolio credit product.

A variant of the dynamic range accrual
A possible variant of the dynamic credit range accrual might be a structure where the corridor is periodically adjusted by a factor that is proportional to the volatility realised in the previous period. For example, let's assume that the range resets when the index rolls over (every six months) and let M be a proportional factor set to 10 at the inception. On the day of the roll to a new series, we look at the volatility realised in the past six months and at the current index spread and use these values to calculate the new corridor. If the index is trading at 45bp and the realised volatility is 2% then the lower barrier is set at 36bp⁷ and the upper barrier at 54bp⁸.

However, if the volatility realised in the past 6 months were 4%, applying the same calculation, the corridor would be reset at 27bp – 63bp. Clearly, the higher the volatility the wider the corridor and vice versa. This type of product gives to the investor a further protection against unexpected and undesired periods of high volatility. However, during periods of persistent low volatility the range tends to be tight and the opportunities of additional profit are clearly reduced. We have not investigated further this type of structure since we are of the opinion that an investor fearing high future volatility is very unlikely to direct his attention to this type of product.

Callable credit range accrual
The note can also be issued as a callable structure whereby the investor sells the right to call the note to the issuer. The issuer holds the right to call at zero additional cost on a quarterly basis. In return for this, the investor receives an enhanced yield over the standard non-callable structure.
If the market expects the iTraxx spread to remain range-bound, then the coupon on a non-callable standard credit range accrual is likely to be limited. The investor's coupon can be enhanced by selling a call option to the issuer that comes alive after a non-call period. Clearly if called, the investor is subject to re-investment risk.

What happens when there is a credit event in the reference index?
The spread that is observed with respect to the prescribed corridor is the 125-name iTraxx Europe spread. If there is a default then the spread monitored is that of the index that includes the defaulted entity. If there is no spread available, then the spreads of 124 names would be used in conjunction with the recovery of the defaulted entity. This is because the credit range accrual is structured such that it continually references the current on-the-run basket.

Clearly, if there is a default in the on-the-run series, the effect will be to cause the index spread to move wider and, thus increase the probability of there being observations outside the range. As such, the investor is subject to the impact of default risk, but it is important to understand that this risk only impacts the performance of the coupon on the range accrual note and not its principal, which is guaranteed by the collateral (see diagram on page eight). This is a key difference with respect to traditional synthetic (funded or unfunded) investment in the iTraxx.

Risks

It is important to understand the inherent risks in the credit range accrual structure as outlined in this paper. The risks affecting such a structure are different to those relating to an investment (protection selling) in iTraxx (unfunded or otherwise). We look at the risks in the usual structured product framework here.

Price risks
If we consider the daily credit range accrual note, we know that the coupon grows for each day that the iTraxx lies within the range prescribed at outset. This clearly means that like any other portfolio CDS investment, the structure is sensitive to the credit market. This price sensitivity is driven by the fact that no coupon accrues on those days when the iTraxx trades outside the range.

Additionally, the range accrual is open to MTM risks. If the implied forward iTraxx at a point in the life of the trade changes to show that the 5Y spread is more likely to trade outside the range, the investor's range accrual position will suffer in MTM terms.

Equivalently, if the structure is placed and the forward curve subsequently suggests that the future iTraxx spread movement will remain limited, i.e. that it will stay in the range, then there will be an increase in the value of the position.

Call risks
Once again, for the purposes of illustration let us consider the daily version of the credit range accrual. In such a note, when it is callable, the investor attains an improved coupon as he has sold the right for the note to be called by the issuer at zero additional cost.

As such, if the iTraxx actually remains in the range as set out at inception, and if the forwards indicate that it will continue to do so, then the issuer will face an incentive to call the note at zero additional cost. The investor will then receive a bullet payment and will face a re-investment risk. Thus we can see that the callable version will not attain as high a MTM valuation as the investor is always subject to the risk that the note be called.

On the other hand, if the iTraxx trades outside the range or if the implied forward spreads indicate that it will, then the issuer has no incentive to exercise the embedded call and, the investor could be holding a note that is paying lower than a benchmark.

Coupon risks and leverage
The inherent risk here for the investor is the uncertainty surrounding the actual coupon that he will receive at the end of each quarter. In comparison with a standard fixed income investment, there is no foreknowledge about how much return the investor will attain.

However, this is where the leverage is generated in the structure. The note yields more in return for this increased market risk. This is in contrast to the other methods of yield enhancement already mentioned and well documented elsewhere (such as thinner synthetic tranches or moving down the capital structure of a CDO), whilst retaining exposure to the performance of a highly liquid credit index made of investment grade names.

Pricing model and estimation

Pricing model
We price the trade as a function of the implied forward spreads in the market, the volatility and the size of the prescribed range using a Monte Carlo methodology that is explained in detail in the appendix.

Model - GARCH mean-reverting jump diffusion process
We modelled the iTraxx as a GARCH⁹ mean-reverting jump diffusion process. We applied various statistical tests in order to examine whether this model was appropriate to describe the evolution of the index. iTraxx returns are characterized by positive skew¹⁰ and high kurtosis¹¹ and, therefore, are far from being normally distributed (see chart below).

As a consequence, the index spread cannot be modelled as a simple mean-reverting process and it is necessary to equip the model with a jump diffusion component. Other specific analysis showed evidence of mean reversion in the historical series of the index supporting, in this way, the choice of this particular model.

Heteroskedasticity – non-constant volatility
Furthermore, just looking at the path followed by the iTraxx in the last two years we can notice that the volatility has not remained constant over time. This characteristic is confirmed by some econometric tests that showed the presence of heteroskedasticity¹². To model this actual property of the series we opted for a GARCH(1,1) process that is used to describe the evolution of the mean reversion volatility over time. The chart below compares the GARCH volatility process (grey line) with a constant volatility process (dashed line) for the historical data series of the index.

Jump diffusion
Regarding the jump diffusion process, it is worth noticing that we have decomposed jumps into a positive and negative component. Jumps in the index spread are typically due to either defaults or changes in the distribution of the underlying default probability.

However, while positive jumps of the spread can be caused by both factors, a negative jump can only be produced by a favourable movement in the default probability. For this reason we believe that positive and negative jumps tend to follow different distributions in terms of arrival intensity and jump size. More details about the model are available in the appendix.

Jump parameters
To estimate jump parameters like average jump size, jump volatility and jump arrival frequency we used the so called 'Recursive Filter Method' that under the assumption of infrequent and not too large jumps was proved to be more reliable than the more common Maximum Likelihood Estimation.

Reversion speed and long-term mean
The model parameter estimation required additional analysis to get around problems like unreliable historical information and lack of standardised option prices on the index. The iTraxx index is a very young financial instrument that has been quoted only for the last 2-3 years and therefore its historical series is not long enough for an unbiased estimation of model parameters like the reversion speed and the long-term mean.

To address this problem we used the iBoxx CORP A as reasonable proxy of the iTraxx. Although the two processes do not match perfectly, they are showed to follow the same economic cycle.

Risk neutrality
Moreover, the long-term mean estimated on the historical data series is not risk-neutral so it cannot be used to price derivative products. On the iTraxx, however, there is only one standard option quoted in the market that cannot be used alone to imply the risk-neutral drift.

For this reason we opted to calibrate the model to the market forward curve implied by the spot term structure. By iteratively adjusting the long-term mean of the process we found the value that minimised the distance between the real and the simulated forward curve and we considered this value as a good approximation of the risk-neutral drift. Please refer to the appendix for further details about the minimisation procedure we used to calibrate the model to the forward curve.

Simulation of the forward
The process described above has been developed to simulate the spot level of the spread and therefore it cannot be used directly to simulate the evolution of the forward. However, the same model can be adjusted to simulate the entire term structure of the index from which the desired forward can be easily implied.

The whole term structure can be seen as a vector of correlated spreads with different maturities where each spread is simulated with the same Garch mean reverting jump diffusion process. Clearly, in this case, the random components of the processes cannot be assumed independent but must be correlated to each other, similar to when simulating interest rate forwards. In this report we have restricted our scope to the simulation of the 5Y iTraxx.

Longer dated index CDO options
Finally, we would like to point out the fact that since a range accrual position is short spread volatility, and its maturity would be longer than current spread options, we believe that such a trade could help develop the market of longer dated index CDS options.

Estimation
The parameters of our model have been estimated with a GARCH (1,1) regression, and some other proprietary tools such as a recursive filter method as well as optimisation techniques. We explain these methods in further detail in the appendix. Their values are in the table below and this constitutes our "base case". The figures in the table below are absolute numbers unless otherwise indicated.

Back-testing

Static credit range accrual
Let us assume that two years ago a hypothetical investor entered into a static credit range accrual contract traded in swap format with a maturity of two years. With a corridor fixed at 25bp-60bp, the product, according to our proprietary model, would have had a coupon equal to LIBOR+238bp (see table below).

The spreads reported in the table refer to a static range accrual where the barriers are adjusted according to the spot level of the index on the date of the roll to the new series. Here, for the purposes of illustration, we assume that these spreads are valid also for the static range accrual where the corridor is adjusted to the forward spread. We have clearly assumed that two years ago we had the same market conditions of today.

We start by assuming that the corridor is adjusted on each roll date according to the current spot level of the index. Despite these small adjustments of the reference range that would have occurred every six months in our back-testing period, the iTraxx traded within the corridor throughout the life of the contract and the investor would have received a net spread of 238bp.

Adjusting the corridor according to the five year forward spread¹³, however, we can notice that the investor would have lost part of the net profit obtained with the previous product. Instead of 238bp for the best case scenario, he would have realised only a profit of 163bp. By increasing the width of the corridor, we can see that the difference in terms of profit from the best-case scenario tends to decrease, as the impact of the barrier adjustments on the performance of the product tends to be lower (see the third and fourth columns in the table below).

Notice that in both cases, the choice of such a corridor is unlikely to be attained today since the index spread seems to have just reached its lowest level and is expected to widen again somewhat in the future. The net profit in the table below is calculated as the difference between the simulated coupon from our model and the realised historical coupon (i.e. with respect to the spread evolution of the last two years). Note that these levels refer to a product with a two year maturity.

The chart below illustrates the evolution of the two types of static barriers (adjusting to the spot and forward spreads respectively) over the last two years with the range set to 25bp-60bp at inception. When the corridor is re-adjusted to the spot (green line) the spread does not breach the boundaries throughout the life of the product.

The corridor re-adjusted to the forward (grey line) has been pushed upwards by an increasingly steeper spot term structure resulting in a number of days where the index has been observed outside the range. During the period of tightening that has characterized the evolution of the iTraxx in the last few months, the index has breached the lower barrier reducing the coupon realised by the investor.

Dynamic credit range accrual
Let's assume now that the same investor, two years ago, opted for the dynamic range accrual with the barriers fixed at -30% and +30% of the current index level. Our proprietary model, for a product with these characteristics, returns a coupon equal to LIBOR+55bp.

This product is clearly less risky than the other since the periodic adjustment of the range to the contemporary spread level makes the structure less sensitive to the drift of the index. In the last two years the index breached the dynamic corridor on only nine days thanks to the low volatility regime that characterised the evolution of the index during the last year. The investor even in this case would have made a net profit of 50bp with respect to Libor.
In summary, over the past two years we have seen that the credit range accrual has performed profitably, whether structured with dynamic or static barriers.

Adjusting the range to realised volatility
Back-testing the performance of the dynamic range accrual with the corridor proportionally adjusted to the realised volatility, we noticed that the product failed to fully exploit the favourable market condition observed since June 2005. During a period of low volatility the dynamic barriers tend to be tighter and, therefore, the probability of observing the iTraxx trading outside the corridor tends to increase with a consequential deterioration of the performance.
Let's assume the same characteristics of the first two structures but with the range determined by the multiplier M=7. Our proprietary model, for this product, returns a fair coupon of LIBOR+177bp. The index, for the last two years, breached the barriers for 159 days giving the investor an extra profit of 39bp that is 22%.

Notes
1. Typically the static range is only slightly re-adjusted on the day of the roll to the new series. See next section.
2. In this report we have used the notation F(5,5) to describe a forward that starts in five years and has tenor of five year. Clearly, any kind of forward can be used for the adjustment.
3. 45bp*(1-20%) =36bp and 45bp*(1+20%) =54bp
4. 60bp*(1-20%) =48bp and 60bp*(1+20%) =72bp
5. The realised daily volatility is calculated on a window of 20 days.
6. We use this for the purposes of comparison.
7. 45bp*(1-M*2%) =45bp*(1-20%) =36bp
8. 45bp*(1+M*2%) =45bp*(1+20%) =54bp
9. Generalized Autoregressive Conditional Heteroskedasticity model.
10. Skewness is a measure of symmetry, or more precisely, lack of symmetry.
11. Kurtosis is a measure of whether the data are peaked or flat relative to a normal distribution.
12. In statistics, a sequence or a vector of random variables is heteroskedastic if the random variables in the sequence or vector have different variances.
13. With a tenor of five years.

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