Contents

CDR Liquid Index data as at 11 June 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.

Investor arbitrage?

Recent deals fuel suspicions over the drivers for some CDOs

Structured credit investors on both sides of the Atlantic are reporting increasing concern over the motivation and practices of some CDO issuers and managers. While the issues surrounding the lack of Chinese Walls within firms have been well rehearsed in connection with the CDS market, CDO investors are only now grasping the significance of this issue in their space.

"In a way it's a function of the evolution and success of the CDO market," says one structured credit analyst. "There is so much product out there now, which – combined with the fact that dealers tend to only trade their own CDOs and managers either have close connections with those dealers or the managers themselves increasingly run their own hedge funds – means that there sometimes is a close interrelationship between players."

In such cases there are often not-yet established prohibitions against firms trading what could be construed as their own product. This can give the impression that they have a deeper knowledge of a transaction than the rest of the market, which can cause suspicion.

A New York-based hedge fund manager observes: "One bank just last week was showing the equity piece of a managed CDO and we found out that the bank had originated a lot of the product that went into it and also helped structure the CDO. So even if they do not know every single underlying deal, they certainly know the vast majority. As such, how does that not at least present the appearance of conflict of interest?"

How much of an impact that conflict has is dependent on the structure on offer. "If you are trading triple-A names in paper you have issued, then clearly no-one is going to squawk about that. But if you trade double-B minus names or the equity tranche, certainly that is a problem," says a secondary market trader.

Equally, close association can sometimes be an advantage, according to one European structured credit investor. "What we like to see in a deal is a strong link to a bank that has good access to collateral, which can often mean a close relationship between the originator of the collateral and the structurer. This works best in CLOs, where – at the end of the day – a bank is going to be long the loans and it doesn't really matter whether they are long through the CLO or through their own portfolio," he says.

However, the investor continues: "Where I do have concerns is that increasingly you get the feeling that both banks and managers are sometimes trading against investors. For example, a bank recently came up with a CDO of ABS with the triple-As at hundreds of basis points over Libor by virtue of significant subordination. The transaction was fundamentally a complex one, but thanks to some structural window dressing it appeared to be aimed at extremely unsophisticated investors who only look at the rating and the spread."

Out of curiosity the investor looked at the numbers for the deal and found that the expected losses in the portfolio were significantly higher than average. He explains: "The bank had basically picked up the worst possible bonds in the market to build that transaction. I can understand why it might decide on a prop basis to go short those names and may even decide that going short at triple-A with a several hundred basis point cost is a pretty good trade, but what I'm not so sure it should be doing is that trade against investors who are potentially not very sophisticated."

At the same time, CDO managers report a change in market dynamics and an increase in pressure to take in specific assets. One says: "We get a lot of proposals direct from banks these days offering capital. We are obviously always keen to raise funds, but it's often couched in terms of 'how much can you buy from us?' In other words, they'll raise €100m for you and also give you €100m of assets. At that point we walk away – our reputation is too important to us. 1% per annum on €100m is not a trivial issue, but you can see why others are tempted."

He concludes: "I just don't understand how banks and some managers can be so reckless. Reputational risk should always be a consideration for everyone in the market."

MP

Monolines' CDS and bonds diverge

Differing spreads on insurers and wrapped bonds offer potential trading opportunity

Monoline insurers' CDS spreads have been heavily impacted as a result of their exposure to the US sub-prime market. However, there appears to have been no knock-on effect in the UK wrapped bond market.

A report published by Barclays Capital's securitisation research team looks into this disparity. "Given the increase in the insurers' risks, we decided to investigate whether wrapped bonds are fairly priced relative to the monolines that insure them," explains Chris Nias, quantitative securitisation analyst at Barclays Capital.

The bank's approach was to look at bond spreads and monoline spreads and to try to relate the two using the popular Copula framework. Based on this assumed form for the relationship it would then look for mispricing that could be exploited.

Under analysis of bullet bonds in the Iboxx Sterling non-gilts index, its model flagged several as being significantly overpriced, which led the report to conclude that the widening in monoline issuers had not been priced into the wrapped bond market.

Nias observes: "We priced the bonds off the insurers' credit curves and calculated the bond/monoline CDS basis. As the bonds are priced substantially inside both issuer and monoline, there is a large persistent positive basis between the bond and the insurer."

He continues: "The basis increased as the insurers' spreads increased, but the bonds' spreads did not. This indicated to us that the bond was benefiting from substantial diversification in risk from the combination of issuer and insurer obligors; this allows the bond's spread to be substantially tighter than the insurer's. We modelled the spread on the wrapped bonds as the joint probability of default of both issuer and insurer under imperfect correlation."

Under this correlation hypothesis, the research paper argues that there could be two reasons why the bond's spread does not increase when the insurer's spread does. Either the bond issuer has become significantly less risky at the same time, or further diversification benefit has been felt; ie correlation between the two has fallen. By assuming that these two factors have in fact remained constant, the paper goes on to calculate theoretical spreads on the bonds.

The report concludes that the current spreads on the bonds do not adequately reimburse investors for the amount of risk they take on; the large fall in implied issuer spreads is not supported by any fundamental change in credit quality.

Barclays also suggests that to properly monetise this discrepancy would require investors to buy protection in asset-backed CDS on selected wrapped bonds and sell protection in corporate CDS on the associated monoline; in addition to the expected convergence, the position would also benefit from a good positive carry. The ideal position would have appropriate weightings in the two contracts to account for differences in duration of the two contracts as well as the effective delta of the monoline CDS when considered as a constituent of the wrapped bond.

MP

First CRO launched

Catastrophe risk market takes next step with actively managed CDO offering diverse underlying

Goldman Sachs, Nephila Capital and Swiss Re have closed the first ever catastrophe collateralised risk obligation (CRO) – Gamut Reinsurance. The US$310m transaction differs from previous cat bond CDOs in that it is actively managed and it can invest in a wide variety of catastrophe insurance risk instruments.

According to Goldman Sachs, increased demand for reinsurance risk capacity in the aftermath of natural catastrophe activity over the past three years provided motivation for the transaction. Furthermore, the bank observes that cedants favour collateralised cover in view of credit and rating agency concerns and that the pricing for risk in peak catastrophe zones is attractive.

Barney Schauble, a principal at Nephila, observes: "We have been a manager in this space since 1998 and the basic concept of managing a portfolio of catastrophe risk is something that we are familiar with, but structurally Gamut Re was an opportunity to access a different investor base and to continue to expand the asset class. A CRO was the next logical step in this space as has been seen in other asset classes – taking a portfolio of risk and tranching it on an actively managed basis. We felt that the three firms involved – Nephila as a long-standing manager and Goldman Sachs and Swiss Re as the leading dealers were the right firms to take that step."

That step includes Gamut Re being able to invest in a wide variety of catastrophe risk products, unlike previous CDOs in the asset class. "We can invest in cat bonds, catastrophe derivatives, and/or reinsurance contracts or where we as the manager think it makes the most sense to deploy capital over the lifetime of the transaction. That is exactly the way we manage our other portfolios – we are a meaningful participant in all areas of the catastrophe risk market, so it makes sense for the CRO to follow suit," Schauble says.

The deal has had a strongly positive response from investors in addition to those typically involved in the market – hedge funds, fund of funds, pension funds endowments. Schauble explains: "Historically there has not been much, if any, investment grade catastrophe risk out there. If you are a life insurance company, for example, this deal is interesting because you are able to invest in something that is non-correlated and has some subordination, in addition to paying you an attractive coupon relative to similarly rated instruments."

Gamut Re funds were raised through issuance of five classes of notes (rated, where indicated, by Moody's/S&P). There were two tranches of secured floating rate notes – US$60m class As, rated Aa3/A- and priced at Libor plus 140bp and US$120m class Bs, Baa3/BBB- Libor+300bp – and one rated tranche of secured floating rate deferrable note – class C US$60m Ba3/BB- Libor+700bp. The US$25m class D unrated secured floating rate notes priced at Libor+1500bp, while the unrated US$45m subordinated class E notes receive residual cash flows.

The deal has a stated maturity of 31 January 2010 and an extended maturity of 31 July 2011.

MP

CDS focus

Default swaps and implied write-downs key talking points at Barcelona

CDS was a dominant theme in the CDO panels at this week's Global ABS conference in Barcelona, thanks to recent CDS activity on UK non-conforming RMBS names and the publication of ISDA's CDS on CDOs standard terms supplement last week.

Indeed, the participants in the first of Monday's CDO panels discussed various issues arising from CDS documentation. Dean Naumowicz from Norton Rose began by running through the main differences between the two ABCDS templates used in the market: the European approach that is based on traditional cash/physical settlement; and the pay-as-you-go (PAUG) template, which has became prevalent in US RMBS because the protection seller makes payments periodically, thereby more accurately reflecting characteristics of the underlying.

ISDA published in April a standard term supplement for the PAUG CDS on MBS template, which includes the option for the protection seller to physically settle, and bankruptcy, restructuring and distressed ratings downgrade as additional credit events. The move is widely seen as the spark that lit recent CDS trading on selected UK non-conforming RMBS, but it is expected that the majority of European players will migrate to the PAUG template after the forthcoming launch of the ECMBX index (see SCI passim).

In addition, ISDA published last Thursday a standard terms supplement for CDS on CDOs, with write down, failure to pay interest, failure to pay principal and distressed ratings downgrade as credit events.

However, panellists were critical about the document's provisions for implied write down. Rodrique Afota from IXIS CIB observed that the latest draft is unlikely to be the final version because basis risk incurred from implied write downs is yet to be eliminated.

"The market is headed in the right direction, although the core issue of when losses should be passed on to the CDS seller still needs to be addressed," he explained. "Implied write down language is the single biggest issue to impact liquidity of CDS on CDOs."

Michael Thompson from Wachovia Securities agreed that around 70% of the market trades implied write down with a fixed cap, but the rating agencies require counterparties to take full exposure to implied write downs in hybrid CDOs – thereby creating significant basis risk for dealers. It would be preferable if rating agencies stressed for the specific incidences of when write downs occur rather than taking a blanket approach, he said.

But it was broadly agreed that the PAUG template will facilitate the issuance of CDOs backed by a blend of US and European collateral, as well as the expansion of hybrid structures into CDO-squareds and CLOs.

The increasing importance of CDS in the CDO market is illustrated by the growing allocations being made to the instrument by CDO managers. The moderator of the following panel on synthetic securitisation, Todd Kushman from Bear Stearns, noted that his firm is spending a large amount of time restructuring CDOs to enable them to accept synthetic collateral. While rating agencies typically allow 10-20% buckets for CDS, CDO managers are asking for larger buckets (50% in some cases).

Harsh Varma from UBS pointed out that, even though all CLOs have buckets for other CDO collateral, the use of CDS in European CDOs has historically been sporadic. He confirmed that the market is now beginning to see CDS on CDOs going into these CDO buckets.

There was general agreement that the introduction of BWICs has facilitated pricing transparency in the CDS market because it is now possible to see where the average is across six to eight dealers. Additionally, according to Darryl Yawitch at Investec, the advent of CDS allows an earlier indication as to whether a bond will perform well – as was demonstrated recently in UK non-conforming, where spread tiering emerged between deals with DACs and those without.

Kushman expects CDS to continue gaining liquidity in three important sectors: ECMBX, property derivatives and UK residential mortgages. Juan Blasco at BBVA, on the other hand, reckons that single-tranche synthetic CLOs are likely to become an important growth area thanks to the advent of LCDS. However, he adds, it is important to understand the sensitivities of LCDS to rating changes, as well as to be aware of overlap across portfolios.

MP

Mayflower announces investment partnership

The latest company and people moves

Mayflower announces investment partnership
Mayflower Finance has announced a significant investment deal with a group of institutional investors – including private equity firm Equifin – and ultra-high net-worth individuals. Terms of the investment were not disclosed.

In addition to their investment, the group of investors will support Mayflower Finance in developing distribution channels for its CDO and structured credit fund products through their relationships with financial institutions, high net-worth individuals and family offices. "This investor backing signals strong support for the growth prospects of Mayflower Finance to become a leading structured credit manager in Europe," says Dirk Röthig, Mayflower's ceo.

Mayflower Finance was formed in 2006 by Röthig, Enno Balz and Christiane Elsenbach. Röthig was previously global head of securitisation and co-head of treasury and financial markets at IKB. Enno Balz, also from IKB, previously held the position of head of portfolio management. Christiane Elsenbach worked most recently as a director in structured credit marketing at Dresdner Kleinwort in London.

BoA hires senior loan CDS trader
Bank of America has hired Donald Whitmore as managing director and senior trader of LCDS. He is based in Charlotte and reports to Ed Hamilton, head of Par Loan Sales and Trading.

Whitmore was most recently at Wachovia Securities, where he was a managing director in the fixed income division and headed the company's proprietary trading group. He has more than 19 years' experience working in the fixed income markets, predominantly in high grade and cross-over trading.

Abbey takes on consultant duo
Abbey Financial Markets, the UK investment banking arm of the Santander Group, has appointed Hemal Popat and Martin Collins to its life and pension solutions team. They both report to Alan Thomson, head of life and pension solutions.

The duo will be working in consultancy roles advising Abbey and Santander clients on design and implementing derivative-based solutions, including credit derivatives, within their pension funds. Richard Williams, head of Abbey Financial Markets, comments: "This strengthening of Abbey and the Santander Group's pensions expertise underlines our commitment to provide cutting edge derivative solutions to the pensions marketplace."

Popat was previously a senior investment consultant at Watson Wyatt and brings extensive experience in advising corporates and trustees on managing pensions risk and designing investment strategies. Collins also joins from Watson Wyatt after 17 years as a scheme actuary and corporate consultant advising pension schemes.

Yeoh joins Bear
Allan Yeoh has joined Bear Stearns this week from Credit Suisse as co-head of structured credit trading (Europe). The other co-head is Tim Armitage.

Deutsche hires and promotes
Deutsche Bank has made three additions to its integrated investment solutions group within the global markets division. Phil Li has joined as a director, and Robert Painter and Guillermo MacLean have joined as vps.

Li will securitise non-traditional risks for distribution to institutional clients. He joins Deutsche Bank from ABN AMRO, where he was head of structuring and analytics in the asset-backed securities and CDO origination group.

Painter will structure investment products and hedging instruments for insurance companies. He joins from Conning Asset Management, a subsidiary of Swiss Re, where he was an asset-liability management advisor, developing customised investment strategies for insurance asset management clients.

MacLean will focus on developing new investment content, such as customised, investable indices, for both institutional and retail customers. He was previously a senior research analyst at Sanford C. Bernstein and a corporate development strategist at Putnam Investments.

Li and Painter report to Keith Cunningham, director, and MacLean reports to Markus Barth, director. All are based in New York.

Meanwhile, Deutsche has announced the promotions of Wolfgang Matis as head of global markets Europe and Matt Press as head of global markets Western Europe. Matis will be responsible for the global markets business in Europe and will also directly manage the global markets business in Germany, Austria and Switzerland. In his new role, Press will report to Matis and will assume responsibility for the regional management of Deutsche Bank's global markets franchise.

In addition to his increased responsibilities, Press will retain global responsibility for Deutsche Bank's structured capital markets business, in which capacity he will continue to report to Rajeev Misra, global head of credit trading.

Codefarm appoints Hagerty
Codefarm, the structured credit technology company, has hired Edward Hagerty, a seasoned financial software development manager who has worked for some of the world's largest software companies. As head of product development, one of his main priorities will be to accelerate the development of product features in response to customer requirements.

Hagerty has more than 15 years' experience in managing enterprise applications development for top international software and management consulting firms. He moves to Codefarm from Fortent (formerly Searchspace), a premier provider of information and technology solutions to the global risk and compliance market, where he was head of European product development. He has previously worked for Deloitte & Touche, Oracle, Microsoft and Price Waterhouse.

MP

Cov-lites raising CLO risks

A round up of this week's structured credit news

Cov-lites raising CLO risks
In a new report, S&P says covenant-lite loans – fuelled by the LBO wave and virtually unlimited liquidity – continue to proliferate in 2007. Though the definition of cov-lite varies, it generally applies to loans that only have incurrence tests and lack maintenance tests or financial triggers. Loan structures that lack maintenance tests can potentially hinder a lender's ability to re-price credit risk or restructure a problematic loan and mitigate potential loss.

S&P is therefore changing its CLO criteria to reflect the potential expectation of increased loss exposure on cov-lite loans. The agency says: "Our response reflects the erosion of covenant protection in syndicated bank loans, our expectation that the absence of covenant protection may result in diminished recovery prospects for loans relative to historical average secured loan experience, and the increased use of cov-lite collateral in CLOs."

In light of the higher loss potential and performance risk implications for CLOs, S&P is building on its existing asset-specific corporate recovery rating (RR)-based approach and aims to ensure that CLO ratings reflect this new subset of the loan market – namely loans with only incurrence tests (or no maintenance tests). For all global CLO transactions closing after August 31 2007, S&P is rolling out new "rep/warranty away" or "recovery haircut" alternative approaches for those CLO managers not yet using the RR-based platform.

S&P will now offer CLO issuers a larger selection of options with respect to broadly syndicated and middle market cov-lite loans, which it proposes defining as "incurrence test only" in a separate request for comment. The available options are: use S&P's asset-specific corporate RRs and the accompanying RR-based recovery rates, which already have a haircut "baked in"; provide a representation or warranty that excludes defined (for example, "incurrence test only") cov-lite loans; or haircut by 10% S&P's US and European/Asian tiered corporate recovery rates for any such defined cov-lite loans.

Clarification and addendum
The following paragraph was added to last week's news story – 'Funds raise market manipulation concerns' – after the first version of SCI and corresponding PDF was issued:

"Anything we do to keep borrowers in their homes like the EMC Mod Squad has the potential to negatively impact someone who is short the subprime market," says Tom Marano, global head of mortgages and asset-backed securities at Bear Stearns. "The ISDA contract states that all rights and rules of the underlying reference obligation apply. In response to a suggested change that would have modified those rights and obligations, we proposed a clarification of what the rights were in order to ensure participants understood the terms of the underlying documents. When market participants said they believed the documentation was already adequate, we withdrew our proposal."

CBOE to list five credit options
The Chicago Board Options Exchange (CBOE) on 19 June plans to launch credit default options on five individual companies: General Motors Corporation, Ford Motor Company, Lear Corporation, Hovnanian Enterprises and Standard Pacific Corp.

CBOE last week received regulatory approval from the US SEC to list and trade credit default options. Approval for CBOE's proposed credit default basket contracts is expected soon.

In the meantime, Jane Street Specialists has been appointed to be the designated primary market maker in the initial five credit default options.

The contracts are cash-settled binary call options that pay US$100,000 when the exchange confirms that a credit event, such as default on specified payment obligations, has occurred. If no such credit event occurs, the option expires with no value. Special procedures apply in the event of a succession or redemption.

Moody's extends PDR/LGD transition period
Moody's is extending the transition period for its new CLO methodology incorporating probability of default ratings (PDRs) and loss-given default assessments (LGDs).

Moody's February 2007 rating methodology, 'Moody's approach to adapting US cashflow CLO rating methodology to PDR/LGD initiative', provided that this new methodology would apply to all US CLOs closing after May 31 2007.

However, since the publication of this rating methodology, market participants have begun to provide Moody's with new comments on the framework. In response to these comments, the agency is considering revisions to the rating methodology, which will be published later this year. This revised framework will also include a new transition date for applying the methodology to all CLOs which price after that date.

Prior to the publication of this revised methodology, Moody's indicated that CLOs should continue applying its current CLO rating methodology.

Oprisk at the core of sub-prime meltdown
Research from Algorithmics, based on its database of over 7,000 operational risk case studies, indicates that the problems in the US sub-prime market stem from a core of operational risk issues, as well as the more commonly cited credit risk issues.

Many of the sub-prime mortgage product cases appearing in Algorithmics' FIRST database of loss events involve an element of insufficient operational risk processes. Primary among these processes is lax underwriting, which often involves insufficient background checks, inadequate documentation and a failure to train and supervise front-line personnel. 83% of the cases can be attributed to relationship risk, including mis-selling, suitability issues, contract obligations and regulatory and compliance violations.

Penny Cagan, an md of Algorithmics, says: "Our research has demonstrated that sub-prime issues should not be dismissed purely as credit risk events. They should be considered from the perspective of operational risk. We believe the case studies we've considered have helped to identify questions that risk managers need to ensure they can answer if they're to be able to control operational risk and help their companies achieve the best return on investment."

Collateralisation ratios stabilise for CH CDOs
Fitch Ratings says in a new report that collateralisation ratios (CRs) for CDOs of Cedulas Hipotecarias (CH) of the individual issuers have been variable, but the overall trend tends towards stability.

In Q107, the majority of issuers showed an increase in both their eligible collateralisation (EC) and total collateralisation (TC) levels. The increase has been caused by lower CH issuance and larger mortgage books. This is compared to the 57% of issuers who saw their EC levels fall in Q406, although their TC levels increased in the same period.

The report also highlights two significant developments for CDOs of CHs: a draft law being considered by the Spanish parliament relating to the legal framework around CH and, separately, impact from a potential decline in the Spanish housing market.

Moody's reports on granular SME transactions
Originators of loans to SMEs in EMEA are increasingly tapping the capital markets using securitisation – most prominently in Germany and Spain – either for funding purposes or for capital relief. In a new special report, entitled 'Moody's approach to rating granular SME transactions in Europe, Middle East and Africa', Moody's focuses on consistency with CDO of SMEs, how to derive the asset parameters to be used in a cashflow model and discusses the main structural features of EMEA SME transactions and their impact on the rating analysis.

"Securitised SME portfolios tend to be very heterogeneous in terms of number of assets, concentrations, collateral types and structures. As a consequence, Moody's methodology has confronted the issue of using a common framework for a family of transactions which are often very different among themselves," says Jan Groesser, Moody's assistant vp and co-author of the report.

The first part of the report focuses on the analysis of the asset side and, in particular, on the way Moody's determines the default distribution and the recovery rate to be used in the cashflow model. The key element in the analysis of the risk of a portfolio of SME loans is the determination of the appropriate default distribution, which reflects the expected default behaviour of the portfolio during the life of the transaction.

The second part of the report describes the main structural features of SME transactions, with the aim of providing guidance on how Moody's evaluates these elements within its rating analysis.

Banks more likely to fail than default
Banks across the globe are significantly more likely to fail than they are to default on their financial obligations as they often receive support from third parties in times of stress, a new Fitch study of more than 1,700 banks over a 17-year period shows.

To add greater transparency and to ensure bank failure is consistently recorded, Fitch has added a sixth rating category to its Individual Rating scale. The report also provides for the first time the mapping of Fitch's Individual Ratings to Issuer Default ratings (IDR), adding further transparency to its rating methodology.

The study notes that banks are nearly 10 times more likely to fail than they are to default. Bank failure is twice as likely as corporate default risk, yet the overall bank default rate is lower than the corporate default rate because of the provision of external support. Fitch is the only major rating agency with a dedicated rating scale (Support Ratings) to assess the probability that such support will be provided.

From 1990 to 2006, there were 117 bank failures, according to the study of 1,768 banks in 101 countries. Of these, 12 went on to default on their financial obligations. Overall, 5.9% of banks failed within five years, with 0.7% defaulting compared with 3% of corporates defaulting.

Fitch expects failure rates to decline as banking systems in many countries move beyond the restructuring of the 1990s and early 2000s. By contrast, default rates may increase as more regulators look to market solutions to address bank failure.

These themes are further explored in two forthcoming research reports, which will look at support in practice in emerging markets and developed countries.

Moody's launches US CRE CDOs surveillance reports
Moody's says that it will publish monthly enhanced monitoring reports for US CRE CDOs. The reports, available to Moody's CDO and CMBS research clients, will combine data from trustees, collateral managers and Moody's databases to report on an initial set of 26 commercial real estate transactions.

The rating agency says it plans to expand the reports to cover the entire universe of Moody's-rated CRE CDOs by autumn 2007 and is seeking feedback on what data would best meet the market's needs.

MP

Trading ideas - oranges and lemons

Dave Klein, research analyst at Credit Derivatives Research, looks at a positive-carry short on Deutsche Telekom

When we have a fundamental outlook on a credit, we prefer to put on positive-carry, duration-neutral curve trades. In general, this means putting on flatteners when we are bullish and steepeners when we are bearish.

Flatteners can be difficult to put on simply because their roll-down often works against us. With the current steepness of credit curves, positively economic steepeners have been positively difficult to find recently.

Of course, we can always put on an outright trade (long or short a credit) and accept that we are not hedged against parallel curve shifts. Indeed, if our fundamental view is strong enough, an outright trade might be preferable as we expect to capture plenty on the upside.

In today's trade, we express our deteriorating outlook for Deutsche Telekom (DT) in a positive-carry short position. Given the DT's CDS curve steepness, this is the best trade available and possesses reasonable economics.

Go short
We have scored DT using our Multi-Factor Credit Indicator (MFCI) along multiple factors. Most factors (spread/probability default, spread/leverage, LBO-viability) indicate DT is trading too tight. Only spread/rating indicates DT is trading slightly too wide.

Exhibit 1 charts DT's CDS performance over the past year. DT has rallied considerably over the past eight months and is now sitting nears its one-year tights.

Exhibit 1

Given our negative view for DT, we want to be short the credit. We can take this position either by shorting bonds or buying CDS protection. In order to evaluate opportunities across the term structure, we compare CDS levels to adjusted bond z-spreads, which we believe is the most straightforward way to compare the two securities.

Clearly, DT's z-spread curve is trading steeper than its CDS curve. Exhibit 2 compares DT's market CDS levels to our fair value CDS levels and adjusted bond z-spreads.

Exhibit 2

In order to estimate CDS fair values, we regress each tenor (3s, 5s, 7s, 10s) against the other tenors across the universe of credits we cover. This results in a set of models with extremely high r-squareds.

Since we have a negative view on DT, we base our tenor decision on more than just fair value and consider roll-down and bid-offer as well. Specifically, we look at carry, roll-down and the bid-offer spread of each potential trade.

We view the 5s as the best potential maturity, and we drill down and look at the trade economics. DT's 5s have a bid offer of 2bp and negative roll-down.

Given the negative carry and roll-down, we choose to hedge with the iTraxx Europe Series 7 index, of which DT is a member, selling a little bit more protection on the index given the relative levels of DT and the iTraxx.

As long as the difference between iTraxx and the DT does not tighten by more than 0.5bp, we expect to unwind this trade profitably in 6 months' time. Exhibit 3 outlines the economics of this trade.

Exhibit 3

Risk analysis
This trade takes a positive-carry short position. It is hedged relative to the iTraxx Europe Series 8 index but is unhedged against idiosyncratic curve movements. Additionally, we face about 2.5bp of bid-offer to cross. The trade has positive carry which protects the investor from any short-term mark-to-market losses. Entering and exiting any trade carries execution risk and DT has reasonable liquidity in the CDS market.

Liquidity
Liquidity is a major driver of any longer-dated trade – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets. As stated earlier, DT has reasonable liquidity in the CDS market across the term structure and is a member of the iTraxx Europe 7.

Fundamentals
This trade is based on our deteriorating fundamental outlook. Taking a short protection position by its nature means we are placing a lot of faith in our fundamental view of the credit. While we have chosen a security and tenor that we believe offers the best opportunity for profit, our bearish view on the credit is the driver of this trade.

Dave Novosel, Gimme Credit's Telecoms expert maintains a stable fundamental outlook and sell recommendation on DT. Dave notes that DT's broadband and fixed line segments have continued to struggle. Dave believes that T-Mobile USA remains DT's growth driver and that FCF is declining due to spectrum purchases and capital expenditures. Dave is sceptical that DT's expected acquisition of France Telecom's Orange wireless unit in the Netherlands will provide a large growth opportunity.

We note that DT scores a relatively high 3.8/5 on our LBO-viability screen although we have not heard any recent private equity rumours surrounding the name as a whole.

Summary and trade recommendation
With DT's expected acquisition of France Telecom's Orange wireless unit in the Netherlands, we consider a credit that has experienced four consecutive quarters of profit decreases and is looking for new growth opportunities. Our Multi-Factor Credit Indicator model points to a sell-off for the credit and we are happy to jump in while the company sits near its CDS tights.

After analysing both the bond and CDS markets for the best opportunity, we have settled on buying 5 year protection on DT hedged with selling iTraxx Europe Series 7 protection. Reasonable carry and the potential profit of a widening credit strengthen the economics of the trade. Given our negative outlook for DT, we feel this outright position presents the best opportunity for trading this name.

Buy US$10m notional Deutsche Telekom AG 5 Year CDS protection at 22bp and

Sell US$12m notional iTraxx Europe Series 7 5Y protection at 21.125bp to gain 3.35bp of positive carry

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

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