Contents

CDR Liquid Index data as at 5 February 2007

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.

Successor issues addressed

New products and database on offer

Continuing investor concerns over LBO risk specifically and succession entities under CDS contracts more broadly have recently generated a variety of industry initiatives. Structured product-led innovation has blazed the trail, but a documentation-based initiative is now also set to launch.

Among the range of LBO-related structured products that dealers have begun offering is Citigroup's Significant Acquisition and Increased Leverage Swaptions or SAILS (see SCI issue 20). More recently, some bankers have also been touting prices in cancellable CDS to investors – albeit to a mixed response.

However, the potential for increased legal certainty in this area – rather than skirting the issue entirely – is of more importance to many. "There are various routes you can go down on the successor front," says one bank-based credit derivatives lawyer. "Unfortunately, the project to address the successor provisions in the ISDA credit definitions has been shelved temporarily, so the market needs to find an alternative."

He continues: "From a market user point of view, you already have the RED database. But that is a live database from which you can only look at a name at any one time and say this is the picture – it doesn't give the whole story as a credit derivative's life goes through its various stages. The addition of some form of succession determination and some form of historical analysis of what a company has become would be most useful. I understand that this is something currently being worked on."

Sophia Kandylaki, vp of Markit RED, confirms: "We are developing a succession event service and would expect it to be available by the end of the first quarter."

This new service is an extension of the existing Markit RED service. "As with RED, we will work closely with a leading international law firm who will draft succession event legal opinions on request from subscribers. Markit RED will provide factual analysis such as detailed information of corporate actions, the effective date and so on. We will cover all events from LBOs to mergers and even spin-offs of a more complex nature, such as Verizon," Kandylaki says.

The new service will be offered to all RED subscribers and will, Kandylaki suggests, provide increased certainty and efficiency to the marketplace. "If everyone has access to the same information at the same time, from a single database," she says, "you will reduce discrepancies and bring greater transparency to the market".

Meanwhile, the shelved ISDA documentation project surrounding successor issues will be revisited in the reasonably near future. "The development of an ISDA successor supplement fell by the way-side and has been put off until the publication of the next set of credit derivatives definitions. Those are scheduled for later this year, so the issue will have to be looked at again soon. But I am not hopeful that even when that happens we will ever get something that completely copes with LBO risk or true refinancing risk," concludes the lawyer.

MP

CDS case overturned

US appeals court reverses potentially damaging ruling

A US appeals court has overturned a previous court decision that had been seen as potentially damaging for confidence in CDS contracts. The move has been welcomed by credit derivatives market participants.

The case involved a CDS trade in which Aon Financial Products bought US$10m of protection on the Republic of Philippines from Société Générale (SG). The two parties later disagreed over whether SG should pay out following a credit event on a non-linked trade after the default by an agency of the Philippine Government and Aon took SG to court arguing it was entitled to payment under the CDS.

In 2005 the US District Court for the Southern District of New York ruled in favour of Aon and awarded the firm US$10.1m. The decision caused concern among most derivatives market participants and in May 2006 ISDA supplied a Brief of Amicus Curiae - literally friend to the court, meaning someone not a party to a case that voluntarily provides information - in support of SG's appeal against the decision.

In that brief, ISDA argued: "While the Magistrate Judge correctly concluded that Aon's tender of a Deliverable Obligation was not a "Condition to Payment" triggering the swap, he erred in holding that its tender was irrelevant to, and independent of, SG's obligation to make payment to Aon. The clear and unambiguous language of the SG CDS mandates "delivery versus payment," i.e., simultaneous performance, by the parties once physical settlement of the swap is triggered."

The appeal was decided last Monday by the US Court of Appeals for the Second Circuit. The court ruled in favour of SG and overturned the District Court decision.

"As a matter of law and under the unambiguous meaning of the Aon/SG CDS contract, no Credit Event occurred thereunder and SG therefore did not breach that agreement by declining to pay Aon thereunder. We therefore reverse the judgment of the district court and enter judgment in favour of SG," The Second Circuit Court's opinion says.

"The Second Circuit opinion sets forth a clear-sighted appraisal of this case, upholding the principles of the ISDA documentation," comments Robert Pickel, executive director and ceo, ISDA. "Legal certainty in the use of ISDA documentation is a significant factor contributing to the rapid growth of the CDS market. The lower court ruling undermined this legal certainty by misconstruing the contractual obligations."

MP

Negative basis on the wane?

Indications suggest continued cash outperformance

Dealers report that European investor appetite for negative basis trades has diminished considerably in recent times. One of the most popular CDS positions adopted by investors over the last twelve months in the face of ever-tightening spreads has become a victim of the success of the underlying cash market.

One credit strategist observes: "The number of negative basis opportunities in Europe have declined sharply in recent weeks, due to rising swap spreads that have led cash bond spreads to outperform." Research from his bank suggests that the situation is likely to continue, with the outlook for interest rates more or less balanced in Europe.

The research notes not only the declining opportunities for negative basis as cash has outperformed CDS, but also that most of the out-performance emanates in the front-end of the curve. That is to say, the more swap sensitive part of the credit spectrum.

That said, the strategist adds: "Over the short-term, we expect that the printing of synthetic CDOs currently in the pipeline would help to restore some degree of performance balance, by pushing CDS tighter, particularly on more risky issuers. In that case, investors should take advantage of any negative basis trades offered."

Nevertheless, the indications are that overall trends for supply remain manageable, further boosting the attractions of cash bonds. A number of investors are still replenishing redemptions since December, and therefore have been large buyers of new issues. This has created stunning oversubscriptions for such issues, and invariably led secondary markets tighter.

A negative basis trade involves the buying of a bond and CDS protection on the same reference entity when the CDS spread is lower than the bond spread. While this situation persists, the investor receives a spread without taking any default risk.

MP

Hybrix ARM forwards launched

New US mortgage products to begin trading

Yesterday, 6 February, saw the launch of synthetic hybrid adjustable-rate mortgage (ARM) forward contracts. The new products, which will begin trading on 1 March, reference so-called Hybrix indices that enable structured credit investors to access one of the most volatile and consequently popular sectors in the US mortgage market.

Hybrix and its forwards have been created by CDS IndexCo (the consortium of 16 investment banks behind the CDX credit indices) and Markit Group. The tradable product takes the form of a quarterly forward contract on referenced hybrid pools grouped by their reset dates.

The contract buyer receives a monthly fixed rate payment from the seller accounting for spread/convexity risk, and the contracts are all cash-settled. The referenced indices roll every four months, giving a one-month overlap of indices.

The contract's fixed rate, duration and opening Z-spread are set at inception. These features are created via dealer polling one day prior to commencement of trading.

All outstanding indices expire, and forward contracts will terminate, on a pre-specified 'closing spread action date'. Markit's closing spread auction fixing produces the closing spread, which it argues ensures integrity and market-wide significance of the closing spread.

Hybrix's creators say that the new forward contracts provide a number of benefits for investors. Buyers (i.e. those who are long Hybrix) will be entering into a positive carry trade regardless of yield curve shape and obtaining diversified hybrid market exposure is easily achieved, versus a portfolio of specified pools. For sellers, the contracts will mean that they are able to short hybrid arms specifically for the first time.

Overall, it is argued that the products provide better liquidity and funding costs than the cash market. Equally, the products create an infinite supply, with the ability to increase/decrease exposure more efficiently. At the same time, Hybrix consolidates the hybrid ARM market into a few contracts, rather than transacting in the universe of specified pools.

There is the further advantage of the transparency offered by Markit public pricing and increased operational efficiency as trades will confirm over DTCC from the initial launch date for all inter-dealer trades and trades with investors who are DTCC-enabled.

Trades can be input using DTCC's existing ABX index template and will be documented using two-page confirms, referencing a standard terms supplement and annex posted at Markit.com. In addition, Markit will construct a weekly composite price per existing index, garnered from licensed dealers.

Hybrid ARMs are issued by agencies Fannie Mae and Freddie Mac, and involve the interest rate on the mortgage loan being fixed until a specified reset date and floating thereafter. Issuance volumes have grown dramatically over the past year to meet demand, leading to total outstanding issuance currently in excess of US$400bn. The dramatic growth of the market has prompted their inclusion, from 1 April, in the Lehman Aggregate Index.

MP

Opportunities knocked

CLO alternatives have limited appeal for the timebeing

There has been much talk of a new wave of interest in credit opportunities funds, particularly following the launch of Babson Capital's Fugu deal (see SCI issue 23). However, despite having a more flexible structure than conventional CLOs and able to take advantage of more volatile conditions, many feel development of the market could be limited.

Credit opportunities funds combine the best features of hedge funds and CDOs, providing an equity investor with liquidity (following the lock-up period) and permanent debt financing, believes Todd Kesselman, md, Precision Capital in New York. Equity investors can redeem their interests in hedge funds, however, a hedge fund's debt can usually be pulled at any time because its leverage is typically obtained via short-term financing.

On the other hand, both the equity and debt in a traditional CDO are locked-up. "If you think we are heading into a more challenging part of the credit cycle, you want to make sure you have term debt that cannot be pulled irrespective of the credit risk of the underlying portfolio," Kesselman adds.

Patricia Capote, director at Precision Capital, notes that credit opportunity funds are more flexible than CLOs and can invest in a wide variety of assets, including loans, high-yield bonds, emerging markets, distressed and special situations. Furthermore, they can go short and are not subject to some rating agency requirements found in a typical CLO such as weighted average rating factor or recovery rates.

Additional structural features include the ability to adjust leverage over time by using the revolving facility at the top of the capital structure. And, in general, the maximum leverage for US credit opportunity funds is 5:1 (assets to equity), whereas CLOs can rise up to the 12:1 mark.

"Investors may think structures that are less levered and have more flexibility are very attractive given where we are in the credit cycle" says Kesselman.

While credit opportunity funds give the manager greater flexibility to trade the portfolio than a traditional CLO, their cost of capital is higher as they are less levered and liability spreads have been wider than cashflow CLOs because the universe of potential debt investors is smaller. "As a result, manager selection is critical," says Kesselman. "Investors are very focused on identifying managers that can use the added flexibility to generate a total return that makes up for the higher cost of capital."

Sara Halbard, portfolio manager at ICG in London, believes that investor appetite is key to development. "Investors will only grant such high flexibility to managers who have a track record in investing in different credit cycles. Also, investor demand is more limited than for a regular deal, as many conventional CLO investors at the equity level may not have the mandate to invest in credit opportunity funds," she says. Though Halbard sees continuing growth in Europe, she expects the number of players to remain limited as the funds are operationally intensive to maintain.

Admittedly, current market conditions are not ripe for credit opportunity funds, as they are designed to take advantage of widening spreads. But their greater flexibility will be beneficial when the market becomes more stressed.

Payson Swaffield, co-manager of Eaton Vance's bank loan funds in Boston, believes that as the equity shares of his firm's credit opportunities fund are publicly traded, this gives the fund high liquidity and longevity. "The fund has permanent capital, which you need when the credit cycle turns, and no maturity limits unlike other vehicles which typically have a seven-year tenor. In addition, hedge fund money invested in certain credit opportunity formats could be called in times of underperformance, whereas liquidity stays in our funds," he says.

HD

"People haven't addressed the market risk side of the deal"

The subject of this week's Provide Profile is RAP CD, Derivative Fitch's CDO valuation service

RAP CD is, Derivative Fitch says, the realisation of its strategic vision to provide a service for synthetic CDOs that goes beyond the traditional service offering of a ratings agency. Through customer polls the agency identified that many investors in CDO portfolios understood the credit risk but were unable to fully understand market risk. RAP CD is Derivative Fitch's tool for quantifying market risk for synthetic CDOs.

RAP CD, which was launched in July 2006 and currently covers synthetic CDO and CDO-squared, enables investors to quantify the present value of a CDO (or a portfolio of deals) and market risk, i.e. how present value changes as market data evolves. Investors such as Deutsche Postbank, TD Securities, and Shinwa are already using the system to such effect.

RAP CD is a fully hosted asp service built on Algorithmics' Risk Watch platform using in-house computer servers; while the pricing libraries are based upon the analytics of Reoch Credit, acquired by Fitch in 2006. The package is complemented by CDS data from Valuspread and Markit Group, with index tranche data, used in base correlation calculations, from GFI.

Simon Greaves

"Algorithmics' Risk Watch is an industrial strength risk engine; the Reoch models were initially developed in early 2003 and have since been continuously refined as market practices evolve. RAP CD is therefore based on proven technology. The value of RAP CD derives from packaging together independent market data, market standard analytics, the RiskWatch platform, and access to Derivative Fitch's team of market risk experts for discussion and explanation of results. We do not believe that there is anything quite like RAP CD in the market," says Simon Greaves, md at Derivative Fitch

The service provides present values, risk sensitivities such as credit spread dv01, deltas and jump to default, correlation sensitivities and a complete scenario stress testing environment. The system calculates base correlation surfaces from observable index tranches which are then mapped to bespoke tranches using dealer standard methodology. Risk can be run across an entire portfolio of deals to calculate book-level hedging requirements, claims the firm.

It is also not a requirement that only deals rated by Fitch can use RAP CD. "It does not matter who rated the deal originally, whether it was us or a competitor, the important thing is to offer investors independent valuations of their portfolios, through market standard analytics and independent data," says James Wood, md at Derivative Fitch. However, the RAP CD service is included for no additional fee for new CDO deals rated by Fitch.

Wood points out that in the last few years, investors' views of market risks have themselves evolved considerably. "Credit risk is a much longer term view, as often investors assume from the outset that they will hold a CDO to maturity. But people haven't addressed the market risk side of the deal until now because the tools simply haven't been there. More and more buy-side institutions are starting to focus on market risk whereas before they would purely look at credit risk," he says.

James Wood

One issue, says Wood, is that typically investors won't have the tools, or a quantitative team in-house to build the complex models necessary for pricing a deal, so instead rely upon information from the issuing bank.

Investors using RAP CD get full access to Derivative Fitch's in-house team of quants and market risk specialists, thereby enabling them to out-source the entire CDO risk management process to third party experts, avoiding the full cost of an in-house investment, and leaving them to concentrate on making investment decisions. This, says the firm, is a core appeal of the system. And the whole process is transparent too, as all the information about data and modelling methodologies is in the public domain, claims Derivative Fitch

"Many buy-side participants already have models for vanilla CDOs, which themselves are quite complex deals to price. But a lot of investors hold exotics deals too for example, long-short CDOs, variable subordinated CDOs, zero coupon CDOs, CPPI and legacy positions in CDO-squared deals. RAP CD will cover all of these products. Investors have not really had any good options for pricing exotic deals up to now," says Wood.

Greaves sums up the appeal of RAP CD. "For the first time investors have a truly independent third party service for evaluating the pricing and understanding the risk across their entire synthetic CDO portfolio. And as synthetic CDOs become more complex it's crucial that investors are equipped with tools to enable them to understand the market risks as well as the credit risks," he concludes.

Cohen expands into Asia

The latest company and people moves

Cohen expands into Asia
Cohen & Company has established Cohen Asia, the firm's new asset management business in the Asia Pacific markets. As part of this expansion, effective immediately, the firm also announced the appointment of Taro Masuyama as president of Cohen Asia, reporting directly to Chris Ricciardi, ceo of Cohen & Company.

Initially, Cohen Asia will focus on building Asian fixed-income asset management operations that have an emphasis on offering credit investments with a superior value proposition, the company says. The firm will also actively explore expansion of the Cohen Asia team and broadening its business activities in the Asia Pacific region over time.

Prior to his appointment, Masuyama was md and head of Asia Pacific structured credit products at Merrill Lynch, where he worked for seven years. Before that he was a vp of global credit derivatives at Bankers Trust in New York, where for five years he provided various structured balance-sheet solutions primarily to Japanese banks.

Shambayati joins Lehman
Lehman Brothers has appointed Soroosh Shambayati as head of fixed income emerging markets, Europe. Shambayati joins from Citigroup, where he worked for the past six years and was most recently global head of emerging markets credit derivatives. He will be based in London and report locally to Andy Morton, head of fixed income in Europe, and globally to Mohammed Grimeh, global head of emerging markets.

Credit Suisse hires Ryan to link fixed income and equities
Michael Ryan is joining Credit Suisse to be head of securities for its investment banking division. In this new role, Ryan will work closely with Jim Healy and Tony Ehinger - who respectively head fixed income and equities - to capitalise on the strong securities platform Credit Suisse has built, the bank says. The move is widely seen as part of an increased effort surrounding credit derivatives from the firm.

Ryan will be joining Credit Suisse mid-year and will be based in New York, where he will report to Brady Dougan, ceo of the investment banking division. Ryan joins the bank after an 18-year career at Goldman Sachs. As a partner and managing director, he was most recently global co-head of the equity products group with responsibility for all client-related products and services in the equities division at Goldman Sachs.

MP

NCCI debuts CRE CDO

A round up of this week's structured credit news

NCCI debuts CRE CDO
Wachovia is set to price the US$900m Nomura CRE CDO 2007-1, the first commercial real estate (CRE) CDO to be managed by a conduit CMBS issuer. One of the primary purposes of the CDO is to finance pipeline loans for Nomura Credit & Capital Inc (NCCI)'s CMBS programme.

The transaction involves the issuance of floating-rate notes and preferred shares secured by CRE debt. The initial portfolio will consist of 95.6% whole loans, 2.7% B notes, 1% CMBS rake bonds and 0.6% CRE mezzanine loans. More than 70% of the loans are acquisition financings, in which the sponsor has over 20% cash equity in the property.

NCCI will purchase approximately 35% of the preferred shares, while ARCap Servicing – the primary and special servicer on the deal – will purchase the remaining 65% of the preferred shares and substantially all of the non-investment grade bonds.

Compared with other recent CRE CDOs, this transaction has lower leverage – as demonstrated by the Fitch stressed DSCR of 1.11x and LTV ratio of 100.1%. It features a nine-month ramp period and a six-year reinvestment period.

Progress on CDO CDS template
A conference calI occurred last Friday with the dealers that have been working on the development of the CDO CDS documentation template under the auspices of ISDA. It is understood that during the call discussions took place over how to proceed with a modified implied writedown option. A decision is thought to have been made that would see the new ISDA CDO CDS template offer both the original implied writedown option, as well as a modified version that would be acceptable to the rating agencies.

Default risk modelling paper released
A group of industry trade associations has issued a technical paper on incremental default risk modelling. The report outlines what the associations consider to be the key points and, where they disagree with current regulatory proposals, presents what they regard as a better alternative.

The paper explains that regulators have repeatedly expressed concern at increasing levels of default risk in banks' trading books, and have asked that banks hold regulatory capital to protect against this risk in the form of an incremental default risk charge (IDRC). In particular, concern has been expressed at concentration of exposures and the possibility of achieving capital savings by moving assets from the banking book to the trading book.

The industry recognises these concerns, the report says, and is happy to work with regulators to design an approach which captures these risks. "However, we believe that some of the proposals made by regulators would lead to an IDRC which does not accurately reflect the default risk in a traded portfolio, is not risk sensitive, and is not aligned with banks' internal risk management processes," the associations note.

The paper was prepared for the International Swaps and Derivatives Association (ISDA), the Institute of International Finance (IIF) and the London Investment Banking Association (LIBA) by a technical working group comprising representatives from the associations, as well as market practitioners.

US CRE CDOs continue solidly
US CRE CDO performance continued its solid pace to end 2006 with a strong upgrade to downgrade ratio, according to a new report from Derivative Fitch. The rating agency expects this trend to continue throughout 2007.

The Fitch-rated CRE CDO universe increased to 113 transactions as of year-end 2006 – up from 90 as reported in the agency's September performance report – due to the addition of hybrid and synthetic CRE CDO transactions to the numbers, as well as the incorporation of 13 deals rated in the fourth quarter. Of note, nine of the 13 newly rated transactions were CRE loan (CREL) deals – bringing the total issuance of CREL deals to over 52% of all CRE CDO and ReREMIC issuance in 2006.

In the fourth quarter, Fitch upgraded 19 tranches and affirmed 71 tranches, with no tranches being downgraded. Overall, the year-end statistics are strong: Fitch upgraded 196 tranches in 39 CRE CDOs and ReREMICs, and downgraded only three tranches in two transactions. One transaction, G-Force 2003-1, was called late in the fourth quarter which had the effect of removing nine tranches as upgrades; otherwise, the upgrade to downgrade ratio would have been even stronger.

Fitch has observed that CREL CDOs have tended to maintain their reinvestment cushions, with four deals being affirmed in the fourth quarter. One of the deals had slightly more reinvestment flexibility. However, upgrades during the reinvestment period are unlikely, given that pool quality can change as new collateral is added. Fitch's ratings reflect migration to the worst case covenants.

First tradable tranche fixings completed
Creditex and Markit Group announced the successful completion of the first electronic tradable tranche fixings on Monday 5 February. The fixings took place on 31 January at 11:30 GMT.

Sixteen leading credit derivatives dealers participated in the fixings, which follow the same methodology as the weekly iTraxx fixings. Going forward, tradable tranche fixings will be held on the last business day of every month and are intended to enable market participants to mark their positions to market, as well as provide a benchmark reference and settlement rate for structured products.

Moody's publishes exotics guide
Moody's Investors Service has released guidelines for modelling so-called exotic synthetic CDOs via its CDOROM modelling tool. The guidelines are detailed by the rating agency in a report which aims to list a number of the non-standard features of synthetic CDO transactions that the agency has gathered from the market, and to fully describe how these features may be modelled in CDOROM.

For instance, while CDOROM is a single-period model – the timing of defaults being determined in each simulation, but the expected loss being computed with all losses treated as a single occurrence – the report shows CDOROM may be used as a multi-period analytical tool, using a CDO-squared with specific maturities for each sub-CDO.

MP

Trading ideas - planes, trains, and no automobiles

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a curve flattener for Bombardier Inc

Even though spreads have tightened dramatically in IG, XO, and HY names over the past year, CDS curves have moved steeper (on average), leaving the economics of curve trades harder to swallow. We have noticed a number of fundamentally improving credits that have indeed tightened but their curves have remained steep (if not steepened) and feel that curve flatteners are now a 'safer' alternative to outright longs in a market with minimal risk premia.

Bombardier Inc (BOMB) is just such a name. The global operator in the fields of aerospace, rail transportation equipment, and financial services has seen recent results indicating the company is on the right track (excuse the pun!). While overall third quarter results were mixed, consolidated EBITDA improved a healthy 12%. New orders and pricing for business jets remained strong, despite lower deliveries hampered by a strike.

The last twelve months has seen BOMB spreads trending tighter, following the overall trend in the market – with a modest pullback mid-2006. Whether this is driven by systemic flows picking up yield by selling protection or technical flows from structured credit market participants is unclear but certainly as spreads have tightened we have seen a continuing steepening of the curves across our universe.

This strange behaviour (steepening with tightening) can potentially be explained by the inflows of traders looking for carry through steepening trades (which will pull the short-end tighter and long-end wider). Nevertheless, BOMB is a member of the DJ.CDX.NA.HY 7 Index, and this index has seen significant spread compression over the past few months to all-time tight levels currently.

Exhibit 1 shows the short-end of the curve for BOMB. It is evident that one-, three-, and five-year maturities have all seen significant tightening over the past six months. Three- and five-year CDS have tightened by around 130bp over this period. This is a slight out-performance over the CDX HY index during the same period and while our more macro view remains that XO and HY credits will lead any spread decompression on the back of a pick-up in equity vol, we see BOMB as a solid performer in any sell-off.

Exhibit 1

The tightening of spreads over this period was accompanied by a lacklustre performance of the curve's steepness. We would expect that the curve should flatten (quite considerably given the movement in spreads) as levels fall but as we see in Exhibit 1, the three-to-five differential (mid-to-mid) has in fact remained somewhat stable and excessively high. This compares with the HY index having flattened significantly over this period, providing a first indication of BOMB's curve being out of line.

The economics of the curve trades (flatteners and steepeners) have changed considerably over these past six months. Current fives-tens, fives-sevens, and sevens-tens steepeners are generally negative carry trades. Noting that the short-end of the curve has been equally hit, we find that in fact three-fives has indeed begun to provide significant opportunities for positive or neutral carry and roll-down flatteners.

Not fair
Across all of our curve trade model screens, we find that BOMB trades steep to fair value. Exhibit 2 provides some insight into the level and consistency of this steepness. Exhibit 1 showed the mid-to-mid curve differential for the three-to-five year CDS as being fairly stable over the past six months. In fact, when we view the actual prices of steepeners and flatteners, i.e. accounting for bid-offers, we notice that the curves have moved moderately during this period.

Exhibit 2

The curve differentials (steepeners and flatteners) did not begin to flatten until mid-December but since then they remain significantly steep to fair value and have not flattened considerably. We also note that the curve basis has tightened considerably over the past month as bid-offer spreads across BOMB's curve have tightened – significantly improving the economics (roll-down) of the flattener.

At over 20bp steep to fair value the flattener is not only wide on a standalone basis but also on a peer group basis. Obviously the curve can steepen further, but given the historical behaviour of credits in the HY space, the current levels of credits in this space, and the historical behaviour of BOMB's curve, we feel there is limited downside from further steepening of the BOMB curve.

Notably, if things go 'very' wrong for BOMB and it starts to trade back to late 2005 levels, then we generally see curves flatten out as credits trade on price versus spread. This 'hump' shaped curve could potentially be a source of upside also for our flattener trade – but we would have to deal with some P&L volatility on the way.

It's all downhill from here
Our models are constructed on mid-to-mid levels to provide us with as much consistency as possible across the curve – especially when trying to compare investment grade and high-yield names together. In reality we must ensure that the relationship still holds when bid-offers are accounted for.

Our data provider, aggregating a number of dealers' runs on a real-time basis throughout the day and offering us a critical eye on the actual intra-day trading, provides us with exceptionally tight markets in many of the market's most liquid names – as we received best bids and best offers. We use this 'latest' bid and offer to drive Exhibit 3.

Exhibit 3

This model provides a much more real-world approach to judging how effective our trade could be. The green line (approximately) divides the credits into positive and negative carry trades – steepeners positive to the right (below) and flatteners positive to the left (above). This line is approximate as it does not account for the slight convexity differential as spreads widen, but is certainly useful in deciding where to trade.

Compared to this broad universe of IG, XO, and HY credits, we notice some interesting relationships that we can take advantage of in our BOMB flattener. First, the shape of the fair-value curve (dotted lines) is very different when we include the high-yield names. The traditional 'shape' of the investment grade curve model is monotonically increasing but asymptotic to some moderately high curve slope as we move to around 200-300bp.

Including the entire credit spectrum (IG and HY) we find the extraordinary 'hump' shape seen in Exhibit 3 (dotted lines). This reflects the general flattening that we see as credits start to trade on price (in bond-land) rather than spread and so CDS rates will generally level out across the curve as credits become distressed.

This universe has a bifurcation though as we can see with the number of credits trading steep to the curve in the mid-spread level. This divergence is clear when we analyse the individual credits – poor-performing HY credits will exhibit a steepening and then flattening to inverter curve shape as their spread widen while LBO/highly levered 'solid' credits will continue to steepen as their spreads widen. This leads to an interesting positively convex trade for credits trading in the XO region that have low LBO risk – whether spreads tighten or widen, curves will generally flatten.

Secondly, of interest from Exhibit 3, is the position of the hump's peak. Currently, given our universe of HY and IG names, it is clear that BOMB is sitting slightly tight of the peak level of the curve, but its curve level is right at the apex of around 65bp, i.e. if BOMB's three-year risk should widen from here, we would expect it to flatten, moving down the curve to the right as it becomes more distressed. On the other hand, if BOMB's three-year risk were to tighten, we would again expect the curve to flatten as it drifted left down the curve (the more traditional expectation in credit markets).

Thirdly, we note that BOMB is one of the steepest non-LBO-rumoured credits in its spread region – there appears only very limited downside from any potential widening (given the hump-shaped fair value curve). This curve explains well over 75% of the variance in the three- and five-year maturities relationship – indicating a good chance that BOMB will follow our curve as spreads narrow and tighten.

BOMB is seen to trade, based on 3Y (88-98) and 5Y (165-172) bid-offers at 67/84 i.e. a long flattener can be put on at 67bp – this was time-stamped from dealer runs at 10:30am ET. – confirming it as a tradable level, although we did see some dispersion among dealers on levels as three-year risk was trading. The flattener is steep to fair value for the US universe (solid green line in Exhibit 3) by almost 30bp.

Three legs are better than two
The flattener, duration-weighted at a ratio of about 1.4-to-1 offers us solid positive carry and positive roll-down. Buying the three-year protection at 98bp and selling five-year at 165bp (duration-weighted) pays us around 28bp (on the five-year notional) of positive carry.

The duration-weighted flattener is therefore a way of earning a small premium to short jump-to-default risk. With a long US$14m leg and short US$10m leg, we are exposed to default. If BOMB jumps to default, we stand to gain US$2m (based on a 50% recovery rate). For credits, such as BOMB, where there is no imminent threat of default or specific event driving spreads over the three to five year period, this 'option' on default can be quite profitable.

An alternative, that in this case we prefer, is to monetise this option. Given the risk of widening but not default, we feel that selling short-dated protection into this position (to neutralise the default risk) offers us increased carry at minimal risk with a buy and hold breakeven analysis that provides some significant positive entry points into a three-year forward two-year position.

The 28bp per year negative carry equates to 84bp over the first three years or US$84,000 gain. At the end of that period, we would be left with a two-year outright short protection position at 165bp. Exhibit 4 shows that the implied three-year forward two-year rate (incorporating curve steepness and survival probabilities) is around 300bp – significantly higher than the current 2Y at 72bp and certainly impacted significantly by the steepness of the curve.

Exhibit 4

If the investor, as we recommend, sells short-dated (one-year) protection in an amount to hedge default risk, currently trading at 42.5/57.5, then we would add in 17bp of additional carry per year to our small gain – assuming we roll the default hedge each year. This additional 51bp or US$51,000 of carry (assuming short-dated spreads remain where they are) means our position, ignoring roll-down and flattening profits, gains around US$135,000 over the three years and again leaves the two-year short protection position.

Given the carry gain, as long as two-year protection can be bought for less than 233bp (165bp plus (135bp of carry divided by two for the two-years remaining)), then we will have a profit. This 233bp two-year protection position seems extremely high, given the current level of 57.5/72.5bp, and is our worst case scenario, as we would like to see BOMB flatten and offer us some performance before that. Clearly, we do not expect the 300bp implied forward rate to be realised.

The three-legged flattener, though unorthodox, takes advantage of the bullish sentiment we have for BOMB and reflects the 'overdone' nature of the steepening we have seen on both a standalone and peer-group basis. The flattener in threes-fives augmented by the short protection default hedge offers significant carry and good breakevens along with moderate downside protection.

Risk analysis
The combination of duration-neutral flattener and short-protection short-dated position leaves the package moderately long duration – i.e. exposed moderately to any spread widening in the short-end. The trade is default risk neutral, as designed, and given the steepness of the curve has limited downside in case of any further steepening.

Liquidity
BOMB, a member of the DJ.CDX.NA.HY Series 7 index, is regularly among the top 300 quoted credit trades by dealers on a daily basis – especially recently. Bid-offer spreads are narrowing to around ten and five basis points in the three- and five-year maturities respectively, and about fifteen in the one-year. The one-year does not worry us as we intend to hold that position.

Fundamentals
This trade is somewhat impacted by the fundamentals. The technical steepness of the credit reflects more technical buying but is significantly overdone given the positive fundamental outlook that a detailed analysis offers.

Summary and trade recommendation
As spreads have tightened in IG, XO, and HY credits, economically attractive (positive carry and roll-down) curve trades have been hard to structure. Curves have moved steeper as investors bought short-dated credit and sold long-dated (bought steepeners).

This curve shift has pushed a number of flattening (bullish) trades to become viable and BOMB, a fundamentally improving credit, provides just such an opportunity. The 'planes-and-trains' company seems 'on the right track' with strong new orders in the transportation segment and a favourable market environment for business jets somewhat offsetting the weak regional jet business.

Technically, we notice that the relationship between three- and five-year risk for the entire US credit universe has a hump-shape, and BOMB's curve sits near the apex, with expectations of a flattening no matter what direction spreads take off in. BOMB's threes-fives curve is excessively steep on both a standalone and peer group comparison and a duration-neutral curve flattener offers us significant carry and roll-down with only moderate downside. Monetising our net long protection position by selling 1Y protection to neutralise default risk adds in more carry and roll-down and improves implied forward breakevens considerably.

Sell US$4m notional Bombardier Inc 1 Year CDS protection at 42.5bp and

Buy US$14m notional Bombardier Inc 3 Year CDS protection at 98bp and

Sell US$10m notional Bombardier Inc 5 Year CDS protection at 165bp to gain 45bp of positive carry

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2007 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).

ABX tranches - all systems go

In advance of the scheduled 14 February launch of ABX tranches, Siobhan Pettit, Gregory Venizelos and Matthew Wiesner of the structured credit strategy team at the Royal Bank of Scotland provide a mini primer on the products

Standardised tranches of the North American ABX index (TABX) are expected to start trading in mid February. ABX is an index of North American Home Equity Loan CDS instruments.

The main benefits expected from trading these tranches are:

• An increase in liquidity in the synthetic ABS space. To compare, when 7 and 10Y maturities of corporate CDS index tranches started trading in earnest, post May 2005 blow up, extra liquidity inevitably spilled over into the 7 and 10Y underlying iTraxx and CDX indices.

• New opportunities for leveraged returns in the synthetic ABS space, particularly suited to fast money accounts (hedge funds, bank prop desks). Standard terms of execution and transparent marking to market are crucial factors to that effect.

• Price discovery for the hitherto elusive correlation parameter for ABS assets. Given the size and growth rate of the synthetic ABS market, this is a big matter. Correlation assumptions are fundamental in valuing bespoke ABS tranches.

Underlying baskets
There will be two classes of tranches, those referencing the triple-B credits, and those referencing the triple-B minus credits of the ABX indices. Because that entails just 20 credits per index vintage per rating (too few for efficient tranching), the tranches will span both the current and previous ABX index vintages (i.e. the on the run plus the most recent off the run) and comprise 40 credits.

So the first series of ABX tranches will reference ABX.HE 06 2 (1H 06 vintage) and ABX.HE 07 1 (2H 06 vintage) and thus be concentrated in the 2006 vintage, which has been the weakest in ABS for some time (5-7 years). Two observations to make here:

1) To the extent that it becomes the norm going forward, and providing that ABX tranches do indeed attain strong liquidity (highly likely), this twin vintage set up is almost as good as an implicit guarantee that the first-previous off the run indices habitually maintain good liquidity post roll.

Alternatively, there will be a strong market incentive for dealers to try and increase the number of the ABX index constituents to 40 as soon as feasible, so that the current tranche index series only references the current index series (as is the case in the corporate CDS indices).

2) Mapping correlation between a standard tranche market, based on a portfolio of 40 credits, onto bespoke ABS tranches based on portfolios of 100-150 credits, will most certainly be a very interesting (read non trivial) exercise, to say the least.

Tranched structure
The triple-B tranches will be attached/detached at 0, 3, 7, 12, 20, 35, 100%.

The triple-B minus tranches will be attached/detached at 0, 5, 10, 15, 25, 40, 100%. The deeper subordination and thicker tranching reflect the higher risk in this portfolio.

In terms of hedging bespoke CDS tranches, the focus of activity is expected to be in the 3 to 40% part of the capital structure initially.

Instrument structure
The ABX tranches will be in unfunded (swap) format. Amortisations are to be applied in a sequential order, e.g. 20% amortisation in the triple-B minus portfolio will reduce the 40-100% tranche by 1/3rd. Write downs and principal shortfalls are to be applied in a reverse sequential order, e.g. 8% write downs will evaporate the 0-5% tranche and 3/5ths of the 5-10% tranche. Interest shortfalls will not be taken into account.

Pricing structure
Similar to corporate CDS indices (and unlike CDS index tranches, except equity) all ABX tranches are set to trade at fixed coupons. Thus all ABX tranches should launch priced at par, except from the equity tranche where the coupon will be set to 500bp (as in corporate CDS tranches and in order to lessen mark to market volatility) and the tranche will thus price at a discount.

The fixed coupon feature is intended to make the tranches resemble bond instruments and thus appeal to bond investors. The consequence of that is that tranches in the junior part of the capital structure will trade with significant up front premiums. Apart from the fact that significant up fronts will be exchanging hands regularly, up front pricing is inherently more exposed to prepayment risk.

Quoting convention
The ABX tranches will be quoted on price like the ABX indices, rather than a running spread, with par minus discount price being the up front premium. Further, quoted prices will be based on delta exchange at index mid, i.e. a tranche position is packaged together with the appropriate hedge in the underlying index in order to neutralise spread exposure.

Given the wide bid/ask, at least in the early stages, this has significant implications in terms of trading naked tranche exposure. For such cases, market pricing will work in favour of or against a naked position, depending on which side of the trade (long or short tranche risk) one wishes to take.

In conclusion
We think that exciting times lie ahead for the ABS correlation markets. Please watch this space for developments and further commentary.

© 2007 The Royal Bank of Scotland. This Research Note was first published by The Royal Bank of Scotland on 15 January 2007.