Contents

CDR Liquid Index data as at 9 April 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.

More SIVs to come

Latest vehicle precursor for a number of innovative structures

Details were announced last week of the latest structured investment vehicle (SIV) under preparation: Rhinebridge Plc – a SIV incorporated in Ireland – and Rhinebridge LLC, its wholly owned subsidiary incorporated in Delaware, are to be sponsored by IKB and managed by the London branch of IKB Credit Asset Management. More such vehicles are expected in the coming months, showcasing varying degrees of innovation.

The impending launch of Rhinebridge and the expectation of more SIVs to hit the market is a result of the current spread environment combined with the vehicles' structure, according to Douglas Long, evp business strategy for Principia Partners. "From the SIV manager's point of view, because it's a leveraged business they are better positioned to take advantage of tight spreads than someone who doesn't have leverage and has to utilise capital."

He continues: "Obviously, it is harder getting returns than in a wider spread environment, but the SIV model allows you to outperform other investments if you have the appetite, experience and can source the right assets. At the same time, in a tight environment it's generally easier to find capital investors because a SIV is a proven conservative structure but, again, the leverage provides good returns relative to other products."

These factors, coupled with the fact that the market has more recently begun moving to three-tier capital structures, means that there is also a broader pool of investors who are now investing in SIVs. Although the barriers to entry are still high, launching such a vehicle is an increasingly attractive proposition.

Indeed, the proposition appears to be being widely accepted by sponsor and investor alike. Three new SIVs have been disclosed already this year before Rhinebridge – Axon Financial Funding and Cortland Capital (see SCI issue 32) and HSBC's Asscher (see SCI issue 22) – and there are rumours of more to come from firms such as AIG and Eaton Vance.

"In my view if we don't see six or seven more SIVs this year it will be disappointing," says Long. New deals may bring some diversification in terms of assets if new managers choose to leverage off experience in other sectors, but differentiation from existing structures is more likely to come in other ways.

"I don't think there will be huge amounts of innovation surrounding the assets within SIVs. Instead, I think innovation will come in the capital structure or capital model and the increasing size of deals," Long concludes.

Fitch Ratings has assigned Rhinebridge Plc's commercial paper and medium-term notes expected ratings of F1+ and triple-A respectively. The agency has also assigned its senior capital notes, mezzanine capital notes and combination notes expected ratings of triple-A, single-A and triple-B respectively.

The vehicle's unusual three-tier capital structure is designed to reduce the probability of enforcement and will allow an expected launch size of US$2.5bn. IKB has a strong co-investment commitment in the capital notes.
Although a new SIV manager, IKB has successfully advised an ABCP conduit for five years. The team has a strong track record in managing the asset classes targeted for the portfolio, which is expected to launch with a high home equity loan exposure.

Rhinebridge's portfolio will comprise approximately 33% of seasoned triple-A, double-A and single-A bonds, as well as 67% new issue triple-A bonds.

MP

ABX values

New research looks to identify fair and relative value in the ABX market

The US sub-prime sell-off has hit the ABX market particularly hard, but now – amid significant re-pricing – investors have been left not knowing where fair value is for the indices. New research from Deutsche Bank endeavours to clarify the situation.

ABX prices have been thrown hugely out of kilter – for example the 07-1 triple-B minus index has lost 29.4 points in a little more than ten weeks. "Losses of this magnitude over this brief time horizon are almost unprecedented in structured finance, where bonds are typically backed by diversified pools of assets and changes in performance trends typically take significant time to manifest themselves," explains Richard Parkus, head of structured finance synthetics research at Deutsche Bank in New York.

Nevertheless, he continues: "We believe that, for the most part, the fundamental repricing of risk that is currently playing out in these markets may well be justified by fundamentals. We also believe that as this chaotic and volatile process has unfolded, there has been, and will likely continue to be, significant relative mispricing across assets that offer compelling investment opportunities – albeit not without risk, at least in the short-run."

In a research report on the subject released last week, Deutsche Bank outlines its efforts to identify, "very approximately", where fair value may lie in the single-A, triple-B and triple-B minus indices for the 07-1, 06-2 and 06-1 ABX series. The report warns that there are no easy answers in this context.

"Fair values for the ABX indices depend critically on one's view of the likelihood of various future home price appreciation [HPA] scenarios. For this reason, we cannot provide a single estimate of fair value. What we can do is provide an estimate of fair value given a view of the likelihood of various future HPA paths," the report says.

Putting on outright long or short positions purely on the basis of this analysis (or any similar analysis) has significant risks, even if an investor is willing to commit to a view on future HPA. Deutsche bank does believe, however, that the analysis provides a sounder basis for identifying relative value (i.e. long/short) trades. Since the models apply reasonable default and prepayment behaviour in a consistent manner across bonds, the analysis should exhibit reasonable power to identify relative performance differentials, even if it is inaccurate in predicting the levels of absolute performance.

The report goes on to cite an example of a possible relative value trade. It says: "Consider the 06-2 triple-B minus index. At its current price of 71-00 (mid market), it appears to be pricing consistent with a fairly optimistic HPA scenario. On the other hand, the 06-1 triple-B index, with a current price of 93-00, is pricing in line with a much more bearish HPA scenario. Thus, going long the 06-1 triple-B index and simultaneously short the 06-2 triple-B minus index (in some proportion), looks to be an attractive relative value trade."

Parkus warns that there are other risks that must be considered. "One major risk to consider in such a trade is that some combination of interest rate cuts, loan modifications and government bailouts significantly eases the stress on the underlying bonds. The 06-2 triple-B minus could clearly benefit to a greater degree from such an outcome," he says.

There is also the opposite risk that loan performance turns out to be so catastrophically bad that both the 06-2 triple-B minus and 06-1 triple-B indices are worth close to zero. In such a case, the 06-1 triple-B index simply has further to fall than the 06-2 triple-B minus. "While we attach a fairly low probability to each of these scenarios, explicit evaluation of such risks is of paramount importance in evaluating the attractiveness of these types of ABX capital structure trades," Parkus adds.

MP

On the hedge?

Equity tranche hedging a consideration as correlation levels near their peak

Current correlation levels are close to replicating those seen during the correlation crisis. At present this is good news for investors that are long equity tranches, but hedging these positions should now be a major consideration in case overall market patterns replicate those of 2005.

"At the 3% point, over the last year we have seen correlation steadily creep up from a low of 8% up to around 17%, levels last seen during the correlation crisis in 2005. The current spread widening outlook could see this trend reverse, mirroring the correlation crisis of 2005 [and] resulting in declining correlation and rising index spreads," says Raja Visweswaran, head of international credit strategy research at Bank of America.

As correlation increases, the risk faced by the holder of an equity tranche decreases. This makes sense as higher correlation implies a lower chance that a single issuer may face default and so lowers the probability of the equity tranche facing losses, according to a new Bank of America report on the subject.

The report continues: "Another way we can look at the risk of the equity tranche is to see how much of the spread on the index is attributable to the equity tranche premium, i.e. what percentage of the spread on the index is required to compensate the equity tranche holder to take the first loss risk. To calculate this we convert the equity tranche premium which is quoted as points upfront and running spread to all running spread, multiply it by the 3% tranche width and divide the result by the spread on the index."

When the compensation percentage decreases – as it has been doing recently – the equity tranche looks rich compared to the other tranches. The recent decrease indicates increasing appetite for leveraged credit and default risk, the report says.

For delta hedged equity tranche investors the increase in correlation is beneficial because it implies less risk for the equity tranche and so reduces their hedging cost, as they need to buy less protection on the index to hedge their exposure. As correlation declines, the reverse would be true – meaning that investors should buy more index protection to hedge their risk.

The report finds that, in general, equity tranche correlation and spreads on the index move in opposite directions. The recent increases in correlation correspond to the tightening spread on the index and have benefited those investors who are long equity tranches.

However, Visweswaran warns: "With risks of spread widening on the horizon, particularly from fears of contagion from the sub-prime market and LBO risk in the retail sector, should these fears be realised we would expect correlation to decline as spreads widen. As correlation declines, delta hedged investors will have to buy more protection in a widening spread environment."

He concludes: "As we saw during the correlation crisis in 2005, the increased demand for protection can cause further spread widening – which in turn leads to further declines in correlation, thereby exacerbating the problem. Investors should keep in mind this potential negative outlook when looking at their investment in equity tranches and the indices used to hedge them."

MP

Barclays offers new angle with Sachsen

Innovative managed cash term-funded arbitrage CDO of ABS launched

Barclays Capital is in the market with a new twist on SIV-lite technology – Sachsen Funding I. To mitigate the mismatch between the tenor of the transaction's assets and liabilities, the structure includes a market value mechanism through which the underlying assets can be sold to repay maturing commercial paper and mezzanine/capital notes.

Sachsen Funding I is a cash term-funded arbitrage CDO of ABS managed by Sachsen LB Europe, designed to take advantage of the lower cost of funding in the short-term market. The deal involves the purchase of AAA/AA rated RMBS, ABS, CMBS and CDOs of ABS predominantly denominated in US dollars up to a total portfolio amount of US$5bn that will be funded from the proceeds of issuance of US CP, mezzanine and capital notes.

CP can be issued with a maturity of up to 364 days, but is likely to be of a shorter maturity to enable the interest payments on the underlying and the CP to be matched. The issuer will also initially issue four-year MTNs.

If refinancing isn't possible during the extension period, a wind-down event will be triggered 90 days before the extended maturity date. But if the notes can be refinanced at the transaction's expected maturity, the issuer will issue a further series of MTNs with a legal final of 2022.

The WAL of the portfolio is up to seven years, so in addition to the ability to liquidate the asset portfolio to redeem maturing liabilities the structure includes breakable deposits equal to 33% of the CP balance to mitigate the asset/liability mismatch. Previous CP-funded CDOs have featured large committed liquidity facilities instead.

The breakable deposits will be funded by additional CP issuance, which will cause negative carry on this portion of the funding – but this compares favourably with the cost of committed liquidity lines.

Various triggers ensure that the structure will be managed so that the probability of repaying interest and principal will not vary during the life of the deal. If any of these triggers are breached, a restricted issuance period will occur and if the breach remains uncured the transaction will wind down. A period of restricted issuance means that Sachsen will cease to issue additional short-term liabilities, but will be allowed to invest in permitted short-term investments.

The capital structure is expected to comprise 91% A-1+ (S&P) rated CP, 5% triple-A rated tier 1 mezzanine MTNs, 2% double-A rated tier 2 mezzanine MTNs and 2% triple-B minus capital notes. While the ratings on the CP and mezzanine notes address the timely payment of interest and ultimate payment of principal at legal maturity, the capital note rating addresses ultimate interest and ultimate principal (meaning that interest on the notes can be deferred and capitalised during the transaction) on the basis of receiving a minimum 25bp coupon.

Unlike traditional CDOs, the manager will have unlimited ability to trade in the reinvestment period (subject to various tests).

MP

Spotlight on CRE CDO managers

Tiering likely to become an issue

Fears of sub-prime contagion or a broader market downturn and increasing investor sophistication are causing a greater focus on US CRE CDO managers. Ultimately, that focus could lead to tiering becoming as prevalent as it is in some other product sectors such as CLOs (see SCI issue 24).

Dan Warcholak, director, portfolio management at CWCapital Asset Management in Washington DC, believes that managers and new issues are likely to receive much greater scrutiny. "I would expect tiering ultimately to present itself, whether that is in wider spreads on securities that are being placed or trading back in the secondary market," he says.

The liquid nature of the market has meant that tiering is not a pronounced trait but will develop in the short to medium term, according to Gene Kilgore, evp of structured securitisation at Arbor Realty Trust in Uniondale, New York. He suggests this will occur in a downturn, but also due to investors' increasing sophistication about what characteristics to look for in a manager. "Tiering will occur in general, in terms of having an ongoing platform, devoted resources, personnel, technology and systems; investors will recognise and reward managers with these capabilities versus those that don't," Kilgore says.

Another CDO collateral manager adds that it is hard to rate managers until they have performed in a volatile environment. "The first real downturn will show how inefficient the market is and those managers that perform well will be there in the next cycle and the others will drop away," he forecasts.

Worryingly for some, there is an increasing trend of managers from other sectors gravitating into the CRE market either due to the need to ramp up vehicles for diversification purposes. "There are a lot of managers that do not even differentiate between a bank and a CRE loan, which essentially are very different. They need to understand the demographics, in terms of geography, types and users of property, which is really tied to the real macro economics," the manager says.

Those that have good CRE experience realise that the complexity of transactions requires very close diligence, monitoring and oversight due to the aggressiveness of some of the underwriting and lending practices currently being seen in the market, adds Warcholak.

Warcholak also says that it is important for firms to be vertically integrated, as managers are able to self-originate assets for their CDOs and not be dependent on the secondary market. This, he argues, enables better selection and design of collateral for transactions.

In addition, having strong credit culture and fundamental credit skills are essential to be able to deal with assets that ultimately become problematic. "Infrastructure and experienced people and the ability to identify those markets that are most at risk should be a differentiating factor for people when considering investing in CRE CDOs," he says.

HD

Process oriented investors

This week, Markus Kroll, principal at Palomar Capital Advisors, answers SCI's questions

Markus Kroll

Q: When, how and why did your firm become involved in the structured credit markets?
A: Palomar Capital Advisors was formed in early 2003 by veterans of the credit and securitisation markets aiming to broker, structure and manage structured credit investment products. By that time, the tremendous success of credit derivatives and the increased liquidity in the secondary market for securitised products had created opportunities for hedge funds and niche players, so we decided to take our chances. The subsequent growth of the structured credit market, the success of hedge funds focusing on structured credit and the development of our company has proven us right.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The most important development is the disintermediation of commercial banks and the break-up of the lending process into its five parts: (i) origination, (ii) risk analysis, (iii) funding, (iv) credit risk and (v) loan administration. Players have developed, specialising in a specific part of the process, thereby making the whole system more efficient and theoretically less vulnerable to systematic problems.

Within that context, the structured credit market has played a vital role in transporting credit risk to a wide range of investors with significantly different risk appetites. The most relevant development in the structured credit market is, to our mind, the ability to go short thanks to the successful introduction of CDS on a wide range of underlyings from single names, to indices to tranches of CDOs. The last of which standing the market in good stead given the recent problems in the sub-prime market.

Q: How has this affected your business?
A: We take a hedge fund approach to investing, i.e. we believe that the credit cycle is the key determinant of the performance of the market. As a consequence, hedging and shorting is key to our investment strategy.

Q: What are your key areas of focus today?
A: At Palomar, we endeavour to know all the hedge fund managers in the structured credit market. Our focus has been, and continues to be, to put multi-manager products together – which can be single strategy or multi-strategy – at whatever level of risk investors' desire.

Our two fund of funds continue to be the most important products to us and will be so for the foreseeable future. They offer, on the one hand, a broadly diversified exposure to structured credit and, on the other, a concentrated, value oriented investment opportunity. We offer both funds in leveraged, non-leveraged and capital protected format.

Q: What is your strategy going forward?
A: We are process oriented investors. We believe that thorough credit analysis together with a sound knowledge and understanding of financial engineering are critical to performing well in an environment that we expect to become more volatile in the future. As a consequence, we put continuing emphasis on assessing how well managers are positioned to perform in a stressed market, where spreads and default rates may jump and liquidity drop.

Q: What major developments do you need/expect from the market in the future?
A: We expect that the market will discriminate again much more between the players in each segment of the market. Risk premia need in all sectors to go back to a level where investors get compensated fairly for the risk they are taking. The benign credit environment will come to an end.

This offers good opportunities for the best players in the market, but will punish lesser quality participants. If we have done our homework correctly – which is what we like to believe – the increase in volatility and the discrimination between players in the market, will be rewarding for both us and our investors.

About Palomar
Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

In addition, it has created and runs the Palomar Structured Credit Hedge Fund Index. The performance of the Index will be published exclusively in SCI from next week.

Palomar also provides the following advisory services:

• Investment Advisory, which covers the restructuring of existing debt portfolios and advisory services related to structured credit.
• Investment Product Advisory, which includes the structuring of products tailored to specific investor needs.
• Structured Finance Advisory, which involves advising banks and debtors in structured finance transactions.

RBS hires in structured credit

The latest company and people moves

RBS hires in structured credit
The Royal Bank of Scotland has announced two senior structured credit-related appointments in its global banking and markets division. Matteo Mazzocchi joins as head of the bank's structured derivatives products group and Marc Freydefont as senior credit derivatives structurer.

Mazzocchi joins RBS in May, having previously worked at Dresdner Bank, where he was global head of credit, rates and equity derivatives structuring and trading. He will report to Symon Drake-Brockman, head of debt markets, and takes responsibility for structured and exotic products within debt markets, covering credit, rates, inflation and property derivatives.

Freydefont comes from Credit Suisse, where most recently he was a director within the synthetic CDO structuring group, originating and structuring synthetic CDOs and CPPI transactions. In his new role, Freydefont will be focusing on building RBS's presence in the credit hybrids space. He commences the job on 16 April and will report to Alberto Thomas, head of credit derivatives structuring, structured credit and equity products group.

Tomljanovic joins Cohen
William Tomljanovic has joined structured credit investment management firm Cohen & Company as an md with responsibility for new corporate initiatives. He will report directly to Chris Ricciardi, Cohen & Company's ceo.

Tomljanovic, who will be based out of Cohen & Company's New York office, previously served as evp structured finance for ACA Capital. He was also president of ACA Management, ACA Capital's asset management arm, and a member of the company's executive committee and chairman of the various structured finance collateral committees and credit committees for its structured products.

Baccouche leaves BoA
Afif Baccouche is understood to have left his position as head of credit correlation trading at Bank of America. His destination is not yet known.

Sun moves to Bear
George Sun has joined Bear Stearns as head of structured credit marketing, Asia, based in Hong Kong. He reports to Raymond Wong, head of fixed-income trading for Asia in Japan. Sun was previously in a similar role at Merrill Lynch.

Lovells elects CDO partner
Law firm Lovells has elected a record 31 new partners with effect from 1 May 2007. One of the new partners, James Doyle, specialises in structured credit.

Doyle, who will be based in London, joined Lovells as a trainee in August 1998 and qualified into the capital markets practice in September 2000. He has wide experience in structured finance and securitisations, with a focus on CDOs and other structured products.

CMA appoints product management director
CMA, the credit information specialist, has appointed Jav Bose as director, product management for CMA's price discovery service, CMA QuoteVision.

Bose has nearly 20 years' experience in trading and technology, working for investment banks including Calyon, Merrill Lynch, Deutsche Bank, UBS and HSBC. He has a track record in creating and developing trading systems and businesses that improve productivity and profitability, CMA says.

S&P teams with ICAP on market data
S&P and interdealer broker ICAP have announced an agreement to offer ICAP's global market data to S&P's clients. S&P securities evaluations will provide the ICAP data through MasterFeed, its consolidated securities reference data and end-of-day pricing feed service.

S&P says that it is enriching its evaluations with ICAP data in response to growing demands from clients who deal with complex global, multi-asset class instruments, including Asian and European credit derivatives, Asian government bonds and other fixed income products.

HD & MP

Market searches for direction

A round up of this week's structured credit news

Market searches for direction
CDS index spreads drifted generally tighter over the past week on light volumes thanks to the Easter holidays. Dealers report that investors are "looking for ideas and for direction" without success thanks to wide range views on the short-term future path of the market benchmarks. Consequently there has been greater focus on single names.

However, as one dealer explains: "It's primarily been a bit predictable. There have been lots of stories and moves on retail single names – such as Boots, Morrison and Sainsbury – but little follow up in terms of actual trading volume."

Of perhaps slightly more substance was continued focus on DaimlerChrysler's (DCX) CDS as traders absorbed the latest news on potential buyers for the firm that was announced last Thursday. DCX is widely seen as a potentially highly significant test case for succession entity risk ahead of the re-working of ISDA's credit definitions, which is scheduled to begin later this year (see SCI issue 25).

Also attracting more than a flurry of interest in the past few days was WestLB. Trading on the back of stories about the bank's alleged €100m equity trading loss and consequent speculation over its risk management shortcomings pushed WestLB's CDS spreads wider.

JDA rumbles on
Moody's has released the outcome for the 46 banks which were on review for downgrade following its refinements to its controversial joint default analysis (JDA – see SCI passim). The net result was most banks were left one notch above their pre JDA levels, which had been what was expected before the heavily criticised moves by the rating agency in February.

The three Icelandic banks that the recent controversy initially revolved around find themselves dropped as analysts had expected by three notches to Aa3 from Aaa. OTP, Fortis Bank and KBC Bank were all dropped two notches to Aa3, Aa2 and Aa2 respectively. Meanwhile, notable among the banks dropped by one notch were: ABN AMRO Bank to Aa2, ING Bank to Aa1 and Nordea Bank to Aa1.

Moody's reports on rating differences
The average rating differences on securities rated by Moody's and at least one other competitor could vary substantially by rating level and across structured finance categories, Moody's Investors Service says in its 2007 US structured finance rating comparison report.

"As you would expect, there are differences in credit rating opinions among the structured finance sectors. These differences and their frequencies increase moving down the rating scale," says Moody's md Gus Harris. "Importantly, and consistent with last year's conclusions, the average differences for all rating levels does not give a complete representation of the extent of the differences because of the weight assigned to the Aaa rating levels."

On the one hand, if a jointly rated security is rated Aaa by Moody's, there is a 98% likelihood that the other rating agency – S&P and/or Fitch – has also given it this rating. On the other hand, the percentage of same ratings drops to 60% for S&P and 55% for Fitch when the Moody's rating is not Aaa.

The difference in ratings becomes most pronounced for below-investment grade securities, Moody's observes. At each of these rating levels, when the agency's rating is lower, the average of the gap in ratings of jointly rated securities closely approaches or exceeds two notches.

Differences vary significantly across the different sectors of structured finance. Moody's also continues to observe that differences in ratings tend to increase over time with the seasoning of the security. This reflects the variations in financial markets, rating practices, and monitoring practices over time, Moody's says.

Called Comparing Ratings on Jointly-Rated US Structured Finance Securities: 2007 Update, the study is based on Moody's database of 71,000 tranches rated by Moody's as well as S&P or Fitch or both.

MP

Trading ideas - loans and lines

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a pairs trade between Sallie Mae and Union Pacific

Our basic approach to our monthly relative-value pairs trading ideas is to look for convergence between fundamental and technical indicators or strength or weakness and position ourselves to take advantage of these views. We update these views monthly and in the past three months we have commented on the increasing alignment between the debt and equity markets' views on default risk.

This month the trend has continued with risk ranks from both markets regrouping. The sell-off in spreads and pull-back in equity is in line with our views on the two-step unwind of the credit cycle as we notice that an increasing number of credits are disengaging idiosyncratically as LBO concerns rear their ugly head.

Our universe is now well over 400 credits as we have included a number of XO and HY names as bid-offer spreads tighten. All of these names are covered by Gimme Credit's Credit Scores, and have publicly traded equity. These two restrictions lie at the heart of our relative-value framework.

The universe we monitor for this trade continues to grow as fundamental coverage expands. The addition of further names was expected to broaden the dispersion further and hopefully produce more opposed pairs – it did but the actual extremes of dispersion have fallen.

Outperforming the market
We believe that a superior way to outperform the broad credit market is to combine strong fundamental analysis with detailed technical (or quantitative) modelling.

Fundamental analysis is undertaken by Gimme Credit. On a daily basis, each analyst reviews each credit and assigns a score of -1, 0, or +1 based on expectation of balance sheet performance over the coming months. This credit score is not a relative value measure and is not designed to judge whether the market has fully priced in the fundamental outlook. These scores should be thought of essentially as meaning deteriorating, stable, and improving fundamental outlooks respectively.

In order to try and identify value, we overlay quantitative techniques. Our quantitative analysis is based on a number of models and parameters. These models range from simple to complex and span from intra-sector to cross-asset class.

Identifying the trade
Armed with our two measures of default risk, one from the equity market and one from the CDS market, we can begin to examine any relationships. At first, as has been found by many practitioners, the results appear disappointing. Given the risk neutral nature of the CDS market models and the real-world nature of the equity market models, relating the two is not simple.

We take a different and unique angle of attack. Instead of comparing absolute levels of default risk, we will compare relative ranks. It is reasonable to expect that an issuer with a high ranking CDS level (wide CDS level) relative to its peers should also have a high ranking equity-implied default probability (high default risk). We compute percentile rank scores for each issuer based on each measure and look for inconsistencies.

In our search for outliers we normally look for rank differences of greater than 40 percentage points between the equity and CDS markets. In previous month's analyses, we have had to drop that differential to as low as 20 percentage points for deteriorating credits in order to encompass enough names to generate the 'pairs' trade. This month, given our extended universe and slightly tighter debt-to-equity dispersion, we are forced to revert to a 30 percentage point differential.

We note that there are only a few candidates in each of our 30% differential ranges and highlight that with the number of opposed credits in each segment. This is especially evident in the high-ranked CDS-implied default risks where there is considerable 'capital structure change' and the equity-implied model is unable to cope well with these changes. More importantly, an analysis of Exhibit 1 also shows that the upper right and lower left corners are seeing more clustering than usual – especially in the upper right.

Exhibit 1

This portion of the chart (upper right) is where investors in both markets agree that the issuer is a high risk. It is interesting that the tendency for investors across the two markets to agree on the demons but be less in sync on the angels could be simply a reflection of momentum traders in both markets chasing the idiosyncratically risk-challenged issuers and ignoring the stable or low-event risk names.

We also note that in the upper left quadrant there are a number of credits with low equity risk ranks ('good' credits) but high CDS risk ranks ('bad' credits). These reflect the increasing number of LBO-prone names and the divergence that we see in the case of an LBO.

Traditionally we would expect spreads to tighten as equity prices rise and vice versa but in the case of an LBO it is quite different. Equity prices rise due to the premium that private equity will pay to get the deal done but spreads will sell-off dramatically at the merest whisper of an LBO as the company is expected to raise leverage considerably. This raises a critical issue in our selection criteria and one that we will see is very relevant this month.

An equity-implied rank significantly lower than the CDS-implied rank should be interpreted as: the CDS premium is higher than its default risk would deserve, relative to its peers. On a relative basis, we would expect these names to tighten in relative to their peers, based on our historical analysis of this asset selection process.

Exhibit 1 graphically displays the individual issuers, their equity- and credit-implied default risk rank and their fundamental outlook. We look for credits with major rank differentials (top left segment or bottom right segment) that converge with our fundamental outlook, i.e. a green triangle (improving fundamentals) in the green shaded area (tightening expected from quantitative models). The blue dotted line joins the two issuers – notice the deteriorating name is just inside our 30% segment – this is the least significant divergence in four months.

A further point of interest is the migration of all issuers towards the bottom-left to top-right diagonal – i.e. getting closer to agreement between the two markets as spreads widened out this month. It is perhaps especially noticeable at the extremes (as we mentioned above) – top-right clusters of deteriorating credits and bottom-left clusters of improving credits. It is maybe not so surprising that the first credits to become more aligned in risk between the two markets would be the most extreme – very strong or very weak credits – but we still significant dispersion over any argument of market alignment.

Exhibits 2, 3, and 4 provide the list of the names (Deteriorating, Stable, and Improving fundamental outlooks respectively) analysed in this report and highlight the important next step – convergence between the technicals and the fundamentals. The default probability-implied five-year CDS rate and market price five-year CDS is displayed, with their relative ranks shown. Each table is sorted by Rank Difference – from most technically deteriorating (at the top) to most technically improving (at the bottom).

We prefer to trade the most divergent pairs across this universe. This month HOT is the most technically rich credit with a fundamentally deteriorating outlook, but with the resignation of the ceo, relatively high LBO Viability Score, and significantly increased event risk; we are dropping HOT as our long. We prefer to go with second place Union Pacific (UNP), which has been hit with LBO contagion (from CSX) and some economic worries to widen significantly beyond its risk.

Our decision on the short side is relatively easy. SLM Corp or Sallie Mae (SLM), last month's short, remains at the top of the list. Even with the sell-off in SLM's spreads recently, it remains significantly tight to its risks (even with government backing) and we feel fundamentally is exposed to some of the lowest quality assets in the lending industry.

We recommend a pairs trade between Union Pacific Corp. (Improving) and SLM Corp. (Deteriorating). We are pleased that the relative-value trade has generous carry without us being exposed to any curve trades (as we have had to resort to in the past). At current levels the sold UNP protection (long credit at 66bps) and long SLM protection (short credit at 39bps) position generates 27bps positive carry.

Risk Analysis
This 'pairs-trade' carries a direct risk of non-convergence. In other words, there is the possibility that the names will not tighten and widen as expected. However, based on historical performance of the technical indicators, the cushion provided by the positive carry, and the conviction of the fundamental analysts, we believe these risks are well mitigated.

Liquidity
Both SLM and UNP offer good liquidity in the CDS market. UNP is a member of the CDX IG8 index but they both consistently rank in the top 100-200 issuers by quoted volume on a daily basis. They also have tight bid-offer spreads, regularly less than five basis points and sometimes down to three basis points. We see no concerns with execution of this trade.

Fundamentals
This trade is based on the convergence between our fundamental analysts' recommendation and our unique model-based outlook. For more details on the fundamental outlook for each of SLM and UNP, please refer to Gimme Credit.

UNP: The Unified Plan has benefited route network productivity measures and asset efficiency. Record results. Favourable earnings outlook due to strong industry fundamentals.

SLM: SLM is the dominant player in the rapidly-growing student loan market. The company recently completed a seven-year privatisation process. Credit risk is not the primary concern, as much of the portfolio is federally-guaranteed, though SLM is expanding its non-guaranteed business. Political risk is an issue, as Congress continues to scrutinise the cost of student loan programs.

The recent widening in many railroad credits (albeit with a sell-off in equities in the last few days) is driven by a combination of LBO contagion from CSX rumours and pure economic worries. While we cannot ignore the big-picture economic concerns (we also cannot judge that particularly effectively), we can judge the LBO rumours.

Summary and trade recommendation
A bottom-up analysis of the most liquid (CDS-based) investment grade credits combined the fundamentals with the technical outlook from CDR's proprietary models to highlight anomalies across the market. The increase in volatility and liquidity over the last few weeks together with enhanced fundamental coverage has allowed us to extend our universe to over 400 IG, XO, and HY credits.

While debt and equity markets have generally trended in the same direction, we note that there has been significant divergence in the extremes of our distribution over the past few weeks, particularly in the more moderate credits - with 7 cheap and 21 rich credits this month compared to 14 and 14 respectively last month. Contrarily, the body of the debt-to-equity dispersion has tightened which means that we have to leave the buy/sell zones wide again this month to ensure enough candidates.

The two most outstanding names, in terms of relative value and strong convergence between technicals and fundamentals, are Union Pacific Corp (improving credit ratios, favourable industry conditions and oversold LBO risk) and SLM Corp. (aggressive capital management policies, weak tangible capital ratios and exposure to political and regulatory risk) – Improving and Deteriorating outlooks respectively – both of which were in the top five last month (reassuringly consistent).

At current levels a matched maturity trade offers close-to-duration neutrality and generous positive carry.

Buy $10mm notional SLM Corp. 5 Year CDS protection at 39bps and

Sell $10mm notional Union Pacific Corp. 5 Year CDS protection at 66bps to gain 27 basis points of positive carry

Exhibit 2

Exhibit 3

Exhibit 4

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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).