Contents

CDR Liquid Index data as at 18 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.

ABX back to its lows

Fundamentals, technicals and market confusion all add to the pressure

ABX tranches experienced multi-point declines and OWIC lists kept pace with BWICs throughout last week. Higher rates, the MBA delinquency, further evidence of house price declines in FARES data from last week and weakness in key sub-prime markets (especially California) all contributed to the declines, according to analysts in JP Morgan's North America corporate research team.

The ABX 07-1 index remained down around its floors up to the close yesterday, 20 June. One trader observes: "The 07-1 triple-B minus index is back hovering around its 60 level, which appears to be some kind of psychological barrier – 60 is the lowest point it has traded since inception, but it hasn't fallen through there yet. So everybody is now waiting to see whether – if there is more bad news – it will fall through there, which would point to even greater pessimism about the second half of 2006 in home equities."

At the same time, dealers report that they are finally seeing single name CDS of ABS widening in sympathy with the index after lagging its movements considerably. This move is partly caused by the return of protection buyers to the market, either increasing existing positions or putting on new ones.

This, in turn, gives some ability for hedge funds with longstanding shorts to exit those positions. Previously, they had been so short protection that they were actually suffering from something of a bear squeeze and unable to exit their short positions (see SCI issue 40).

That ability to exit is extremely limited, according to the trader. "Certainly I think it is a significant risk for the ABX and many CDS of ABS positions that there are so many hedge funds which are US$1-2bn (or even more) short. If everybody tried to unwind their short positions in one day, then the ABX would just go back to par and nobody would have made any money after all. While the market moves we have seen are prompted by fundamental concerns, unfortunately there are still very powerful technical forces at work – it is a one-way market and the hedge funds are all shorting or all buying at the same time, which often overwhelms any fundamental views on the underlying," he says.

Another major factor occupying the ABX and associated markets over the past week has been the activity surrounding Bear Stearns Asset Management's (BSAM) High-Grade Structured Credit Strategies Enhanced Leveraged Fund. The fund is known to have suffered significant sub-prime related losses, but what is less clear is what will happen to it.

One dealer says: "Bear appears to have successfully auctioned off a large amount of high grade ABS paper, which the market absorbed relatively easily. But there has been all manner of auction lists sent out on CDOs and CDS on CDOs, and then those auctions have been pulled. There is general confusion as to whether this is coming from BSAM or somebody else."

He continues: "The market is now waiting to see whether there is a real full liquidation of this fund or whether the latest reports are to be believed that it is going to be baled out and recapitalised by its major prime brokers and dealers. In which case, the CDO portion of the portfolio can be run off over time."

Officials at BSAM failed to return calls by press time.

MP

More CPDOs to come

Long-term preparation and change in market conditions may generate more deals

New CPDO issuance has been thin on the ground in recent weeks. However, more deals are expected to come to market in the near future.

The large number of CPDOs expected to materialise once initial rating agency issues had been resolved (SCI passim) has not yet emerged. Only a handful of second-generation deals have been doing the rounds for some months, although a couple are expected to close in the next week or so.

While proposed structures are more conservative than the first generation CPDOs, they are more complex – with many involving some level of management. Consequently, the rating process is still a long one.

"There are plenty of deals being marketed, but the process still remains so challenging that I think many people have or will give up on the way. Nevertheless, the ones that make it through to the end are going to be in a good position to capitalise on the interest that is clearly out there for these structures," says one London-based hedge fund manager.

At the same time, the recent pick-up in market volatility might encourage more transactions to be prepared. "Certainly with managed deals its all about taking opportunities as and when they arise. There's been little to persuade investors for the need for dynamic management when they've been staring at the same numbers for months, but obviously this has now changed," the hedge fund manager adds.

Appreciation of current market opportunities could be a driver behind a number of private CPDOs being put together at the moment. At least two deals are likely to be sold either to one major account or an investor taking the vast majority of the paper.

Meanwhile, Moody's says it has assigned provisional ratings to the portfolio managed CPDO notes to be issued by Arlo X, a special purpose vehicle incorporated in the Cayman Islands. The transaction, dubbed Alhambra, is arranged by Barclays Capital and managed by Deutsche Asset Management.

At this stage, there are intended to be four series of Alhambra 10-year notes of a size yet to be determined. There will be two sets of triple-A rated notes in euros and US dollars paying 90bp over, and two Aa2 Class Bs in the same currencies paying 150bp.

The reference portfolio is comprised of 100 long CDS exposures referencing single name corporates, but Deutsche Asset Management can change the composition of the portfolio through time by investing into long and short single name CDS exposures. There is a 15% bucket for emerging market exposures and a 20% short bucket.

In addition to the criteria on the portfolio profile to be fulfilled, a portfolio change is allowed only if it passes a model test based on the publicly released CDOROM model completed by an add-on. DeAM will have some ability to manage the leverage, subject to a maximum which begins at 5x for the Class A notes and 6x for the Class Bs and increases to up to 20x at maturity.

The maturity of the long CDS contracts should always equal the maturity date of the transaction and there is no scheduled rolling of the maturity of the underlying portfolio.

In addition, the notes include a specified cash-in date such that exposure to the reference portfolio ends whenever the transaction's net asset value is higher than the present value of all future liabilities of the issuer. If a cash-out event occurs the credit portfolio is fully unwound and the notes redeemed at their residual value, which should be around 10% of the note notional.

MP

LCDX - the new short?

Some suggest the new US loan CDS index offers short trading opportunities

Spreads on LCDX have moved inexorably wider since launch, reaching 127.2bp at the close yesterday, 19 June, having finished its first days trading at 104.6bp on 22 May. While the move wider is in part driven by broader credit concerns, some dealers suggest it is also the first indication of what might be long-term pressure caused by a narrowing demand/supply imbalance in the cash loan market and consequent shorting opportunities.

The proposition is enhanced by the fact that the downside from being short LCDX is currently relatively low. LCDS contracts do not yet have the steep curves of their corporate CDS counterparts, meaning that the negative roll down of a short position is lower compared to other CDX indices.

There are also some potential shorting positives being highlighted in connection with the composition of LCDX. There is the possibility that some good names will come out of the index as they repay their loans - thereby increasing the ratio of lower quality names and implicitly widening the theoretical spread - which is the subject of considerable market talk at present.

Equally, there is strong speculation over the robustness of some of the other LCDX constituents. Around 25% of the names within LCDX are covenant-lite and therefore might not prove as secure in the event of a major downturn as many had assumed.

All of which has led the LCDX to trade more erratically than other indices over the past week or so - even the CDX HY has been reasonably orderly, according to traders. "LCDX has fallen in a vacuum on occasion, as I think there are not good two way flows. I don't think people are really prepared to get hit on US$100m markets multiple times. I don't see that changing until the street gets more comfortable with how LCDX performs," says one.

At the same time, the US loan calendar continues to grow at a rapid rate, making it increasingly hard for the market to digest every deal. "The market may well continue to hoover up loans, but it really feels like it's starting to run out of steam. And, if price concessions start coming to price new deals, that will make the secondary market spreads look rich," adds the trader.

Either way, if market participants decide to cut their loan positions or hedge some large new issue allocations, they will have to look at buying LCDS protection or shorting the LCDX index - particularly as selling cash loans is less of an attractive option, given the costs and difficulty in sourcing them. This, again theoretically, will add further widening pressure to LCDX.

MP

LBO exit issues

New research looks at implications for structured credit investors

While LBO speculation continues to affect the CDS markets, the exit route financial sponsors choose to take from deals can also have a significant impact. However, exit options are often missing components in generic LBO screens.

A new report from JP Morgan's European credit research team suggests that greater attention should be paid to this aspect of LBO financings. The paper endeavours to assess the broad implications for CDS investors of the three major exit options – IPO, trade sale or recapitalisation.

The concern with CDS in the context of event speculation is always whether the reference entity will have certain debt that it either issues or that it guarantees (and that guarantee is a "Qualifying Guarantee" for the purposes of the credit derivatives definitions). Increasingly with certain types of corporate activity, notably recapitalisations and – more recently – IPOs, there are concerns that the debt will get taken out and leave no deliverable obligations for the buyer of protection.

"That said, it doesn't mean that the CDS will be worthless because there is always a possibility that the reference entity will issue or guarantee other relevant debt in the future notwithstanding that the existing bonds are taken out. Increasingly, we see with certain structures that this may well be a consideration for companies particularly if there is a large CDS market where it is likely that the participants are also bond investors," the report explains.

In the context of a sale to a trade buyer or another financial sponsor the issue of whether there will be sufficient deliverable obligations under the CDS contract will depend on what the new sponsors are planning in respect of debt refinancing for the purposes of putting more debt into the capital structure.

The report says: "If under the new structure the debt obligations of the reference entity are refinanced, the value of the existing CDS contracts will largely depend on whether any new relevant debt is either issued or guaranteed by the existing reference entity, amongst other things."

Furthermore, there is the added complexity of financial assistance laws that also may dictate how these types of buy-outs are structured. The key issue for CDS investors to consider is whether the reference entity's debt will be refinanced and whether new debt will be placed in the same entity.

"If debt is issued at a different entity, the question falls back to whether the original reference entity will guarantee the new debt – and this can be constrained by financial assistance law," JP Morgan adds.

If under a new structure following recapitalisation the old debt obligations of the reference entity are refinanced, the value of the existing CDS contracts again will largely depend on whether any new relevant debt is either issued or guaranteed by the existing reference entity.

"Another feature that makes this quite problematic is the increasing use of second lien, mezzanine and PIK for refinancing/recapitalisation purposes. Problems arise because the terms governing these instruments are often private, so public-side investors will not always be armed with sufficient information to determine deliverability. Whereas with certain types of debt (e.g. senior secured loans) CDS participants may be comfortable making certain assumptions, this is perhaps not the case with newer instruments," notes the report.

Overall, the JP Morgan analysts conclude: "Companies are increasingly aware of the CDS market, particularly where the participants may also be bond investors – in which case they may take into consideration the CDS implications when deciding refinancing strategies. There has been an example where a company has put guarantees in place, having been incentivised by CDS participants."

MP

Prytania appoints Perry ceo

The Latest company and people moves

Prytania appoints Perry ceo
Prytania Holdings, the structured finance funds management and software specialist, has appointed Malcolm Perry as its new ceo. He will be responsible for the execution of business strategy and maximising the commercial potential of the firm's investment management and software development activities.

Perry was previously global head of fixed income at Dresdner Kleinwort, responsible for the bank's credit and rates products business areas. Prior to that he was global head of the credit portfolio group at JP Morgan, responsible for the active management of the bank's retained credit portfolio and derivative counterparty credit risk.

Prytania Holdings LLP has two operating subsidiaries. Prytania Investment Advisors is a structured finance investment manager that manages the Danube Delta Fund and is now launching new funds, while Prytania Services is a developer of analytical software products designed for use by investment banks and investment managers in the structured finance market.

DB in and out
Neil Servis, who joined Deutsche Bank last June as global head of managed synthetic CDO origination and distribution, is understood to be joining Morgan Stanley in a syndication role. Meanwhile Charlotte Mesqualier is understood to be leaving HSBC, where she was a senior correlation structurer, and moving to Deutsche Bank in a structured credit marketing role.

Citi hires Wilson
Paul Wilson will be joining Citigroup in August as head of European correlation trading in Europe. He was previously a senior correlation trader at Morgan Stanley.

RBS re-jigs trading
Ben Gulliver is understood to be moving internally from credit flow trading to head up loan CDS trading at RBS. Aldous Birchall, a credit index trader, is also understood to be transferring across to trade leveraged loans and the loan index.

...and hires in credit
RBS Greenwich Capital has beefed up its credit markets unit with three hires. Peter Tchir has joined as credit and loan derivative index trader from RBS where he was head of high-yield credit derivatives and index trading, while Gary Stanco is hired in high-grade bond sales and Brett Brown as high-grade bond trader.

RBC hires Spence
Jamie Spence is understood to be joining RBC Capital Markets in Hong Kong as head of structured credit marketing from HSBC where he was head of structured credit products marketing – Asia.

Isla to BBVA
Lorenzo Isla, Barclays Capital's head of European structured credit research and strategy is understood to be joining BBVA to head up the bank's synthetic structuring business.

BarCap hires Lewicki
Pawel Lewicki is to join Barclays Capital's global quantitative analytics group as managing director and head of fixed-income modelling. Lewicki joins from JP Morgan.

BlueBay's convertibles push
BlueBay Asset Management has hired Mike Reed to set up a convertible bond unit to offer investors products across long/short, long-only and structured products strategies. Reed, who starts on October 29, was previously a partner at hedge fund Pendragon where he ran the firm's convertible arbitrage strategies. BlueBay will hire three additional convertible bond traders.

GE promotions
Eric Gould has been promoted to head of structured products from his position of senior portfolio manager for structured products at GE Asset Management. He replaces Paul Colonna, who becomes president and cio of fixed income. Elsewhere, Katy Rossow becomes head of fixed-income research from her position as senior research analyst. Rossow replaces Greg Hartch, who is now managing director in the firm's real estate business.

LGIM adds two
Legal & General Investment Management (LGIM) is strengthening its active fixed income team with two senior appointments. Georg Grodzki joins as head of credit research and Patrick Vogel joins as head of European credit portfolio management.

Grodzki was previously with RBC Capital Markets as global head of investment grade credit research. Vogel was previously with Deutsche Asset Management, Frankfurt where he was a director responsible for managing investment grade portfolios.

Ares hires for Europe
Los-Angeles based credit manager Ares Management has announced three hires and the launch of its private debt middle-market financing activities in Europe. Ares' new private debt effort in Europe will be spearheaded by Gordon Watters, who joins from Barclays Bank where he oversaw its middle market leveraged finance practice across EMEA.

Watters is joined by Mike Dennis and Eric Vimont, both directors and experienced senior members of Barclays' middle-market team. With their addition, Ares will now have ten investment professionals in its London office.

Ares expects to hire a number of additional investment professionals in London, looking to double the size of its team within the next twelve months.

The private debt business will focus on providing "one-stop" financing (senior debt, mezzanine debt and equity) to middle-market companies and private equity sponsors, alone, alongside or in partnership with other market participants.

Hedge funds form best practice group
UK-based hedge fund managers have formed a working group to review best practice and to examine the application of industry-wide standards where appropriate. The high-level working group will consult widely and will focus particularly on practices in the areas of valuation, disclosure and risk management.

The group will look at existing principles, standards and guidelines, evaluate areas which may require strengthening and suggest solutions which may include adherence to voluntary standards.

The working group includes 13 hedge fund managers, of which 11 are UK-based and will be led by Sir Andrew Large, formerly deputy governor of the Bank of England and chairman of the UK financial regulator. Those behind the initiative say it is supported by the leading hedge fund managers in Europe and the Alternative Investment Management Association (AIMA).

The working group members are representatives of the following firms: Brevan Howard, Brummer & Partners, Centaurus Capital, Cheyne Capital, CQS, Gartmore, GLG, Lansdowne Partners, London Diversified, Man Group, Marshall Wace, Och-Ziff Capital Management and RAB Capital.

HD & MP

Soaring investor interest in microfinance

A round up of this week's structured credit news

Soaring investor interest in microfinance
S&P has released a special publication – Microfinance: Taking Root In The Global Capital Markets – which aims to help pave the way for microfinance institutions (MFIs) to gain greater access to global capital markets.

The report, part of an intensive collaborative effort by S&P analysts and experts in the microfinance sector, provides a framework for mainstream investors to make better informed decisions in microfinance. "The lack of consistent metrics for analysing MFIs has hindered investment at a time when microfinance is growing at a significant rate," says Cynthia Stone, md and chair of the emerging markets council, S&P. "And despite the level of interest, mainstream investors need standard metrics before they can invest in this particular sector."

The report provides recommendations for a rating methodology that can be used globally and consistently to rate MFIs within countries, across borders and across asset classes. "The main challenge facing the microfinance sector today is how to scale up and facilitate more investment that can translate into more loans for the 1.5 billion people that are financially underserved," adds Stone.

The report provides the context for the rating methodology by summarising the current state of MFI funding, reviewing the key issues in developing MFI rating methodology and outlining the minimum information recommended for producing a rating.

Microfinance provides an important framework for small loans to be offered to individuals with low incomes, typically in developing economies, to enable them to grow their businesses and increase productivity.

Speculative bond defaults dip
The 12-month trailing global corporate speculative-grade bond default rate dipped to 1.2% in May from 1.25% in April, according to an article published by S&P. The report states that as of 12 June 2007, 97 global weakest links were vulnerable to default on combined rated debt worth US$61.3bn, four fewer than the number recorded last month.

"The proportion of high-yield distressed issuers increased marginally to 0.9% in May from 0.8% in April," says Diane Vazza, head of S&P's global fixed income research group. "Distress and defaults continue to be suppressed by abundant liquidity and generous financing provisions. We forecast that the US speculative-grade default rate will increase throughout the year, reaching 2.3% by year-end 2007 and 2.5% by the first quarter of 2008."

S&P releases May SROC report
Since S&P's April 2007 SROC (synthetic rated overcollateralisation) report, 268 tranches have been subject to rating actions. The rating agency is currently undertaking a full review of the tranches for which the SROC figure as at month-end May was below 100%. The appropriate actions will be published shortly.

During May 2007, SROC figures increased by more than one bp for 19.55% of the tranches on which no rating action was taken. In April, the equivalent figure was 36.97%. By comparison, SROC figures decreased by more than one bp for 15.25% of the tranches, up from 14.04% the previous month.

For 58.61% of all tranches, SROC figures at month-end May differed from the April SROC by less than one bp. Last month, the equivalent figure was 44.29%.

The report was run using month-end numbers and before any ratings upgrades or downgrades, making it a snapshot of each publicly rated tranches' sensitivity to a rating downgrade.

S&P launches Evaluator 3.3
S&P has launched the latest version of its CDO modelling tool, CDO Evaluator Version 3.3 (E3.3). The upgrade to Version 3.3 introduces a variety of new features to the tool and incorporates either additions or revisions to certain existing assumptions.

S&P says the additional functionality makes computing of outputs easier whilst the changes made to the assumptions underlying the analytical models makes the model even more robust.

The new functionality means that CDO Evaluator can now calculate the expected recovery rate and expected loss given default (LGD) for a single-tranche synthetic CDO, model portfolios of nth-to-default swaps, model synthetic CDOs with subordination that increases over time, model reinvestment assets and includes new municipal asset types.

Notable changes have also been made to certain modelling assumptions, including revised corporate recovery assumptions for certain Asia-Pacific countries, the use of stressed default assumptions for structured assets that are pay-as-you-go and revised municipal default tables and correlation assumptions.

Quantifi adds support for pricing LCDS and synthetic CLOs
Quantifi, a provider of analytics and risk management solutions to the global credit markets, has extended the functionality of its credit derivative valuation software to include the ability to price loan credit default swaps (LCDS) and tranches on LCDS (synthetic CLOs).

Quantifi says interest in this asset class has created demand for tools which provide effective pricing and risk management. The ability to model embedded refinancing options along with the likelihood of default is key to accurately pricing these products.

The LCDS and synthetic CLO models are available with the upcoming release of Quantifi Toolkit and Quantifi XL Version 8.7.

Reuters launches hedge fund solution
Reuters is launching JRisk On Demand, a tailored risk management solution for the hedge fund industry which aims to deliver real-time risk management tools directly to the individual manager's desktop.

JRisk On Demand is a hosted ASP solution that offers real-time risk management across all asset classes. Made available via a web-browser, JRisk On Demand is a pre-configured risk management tool with advanced technology architecture and functionality, Reuters says.

It offers cross-asset risk measures, VaR and stress testing, market data scenario analysis, P&L calculation and breakdown, limit management and additional risk measures, such as hedge equivalents and bespoke requirements. The intra-day detailed reporting provided by JRisk On Demand can be accessed from any location worldwide via the desktop.

MP

Trading ideas - I don't want no freedom

John Hunt, research analyst at Credit Derivatives Research, looks at a long flattener trade on Liberty Media Corp

In this article we suggest a relatively inexpensive way to take a negative view on a credit with deteriorating fundamentals – a long flattener trade, in which we buy a long-dated bond that is trading cheap to fair value and also buy 10-year protection on the name.

We expect that if the credit does deteriorate, spreads will widen much more for the CDS than for the long bond, so the trade has very significant upside. If credit spreads improve or remain constant, the improvement in the bond position will largely offset the loss on the CDS position. And if the bond returns to fair value, that will improve performance of the trade regardless of the behaviour of credit spreads.

We have analysed performance of the trade across a range of credit scenarios, and it performs well in all the circumstances we have considered.

Background research
We have been examining the determinants of long bond spreads and have found that the most important determinant of the long-bond Z-spread is the 10-year CDS spread. This single factor explains over 80% of the cross-sectional variation in long-bond Z-spreads for our sample of current long-term, fixed-coupon non-callable bonds. See Exhibit 1.

Exhibit 1

The 10-year CDS spread and the long-bond Z-spread allow us to extend the credit curve from 10 years to the maturity of the long bond. The slope of this curve is explained well by the 10-year CDS spread in both cross-sectional regressions and in our time-series analysis of selected names that have traded at a wide range of levels over the past few years. Over a wide range of credit quality, higher 10-year CDS spreads are associated with flatter curves from the 10-year CDS level to the long-bond maturity. See Exhibit 2.

Exhibit 2

This relationship suggests that the long flattener is a promising trade for names on which we take a negative view. The flattener structure captures substantial upside in the event of credit deterioration at much less expense than simply buying protection on the name.

The case for Liberty:

Deteriorating fundamentals
Gimme Credit media expert Dave Novosel maintains a deteriorating credit outlook on Liberty Media. This reflects both "considerable" risk of an adverse event, such as a corporate transaction that would increase leverage, and an apparent commitment on the part of management to direct free cash flow to share repurchases instead of debt reduction.

Our scenario analysis indicates that the proposed trade will do well in the event of a modest deterioration of credit, and will do very well in the event of a major widening of credit spreads, such as that which could accompany a major increase in leverage as a result of a transaction.

Bond cheapness
We can judge fair value for long-dated bonds by regressing long bond Z-spreads against 10-year CDS levels across our universe of long bonds, as shown in Exhibit 1. This model suggests that the Liberty 8.25s of February 1, 2030 (represented by the red data point) are trading approximately 80bp wide of CDS-implied fair value according to the model and are therefore attractive candidates for purchase as the long leg of our flattener.

Time series
Our analysis of Liberty's behaviour over time indicates that Liberty is an especially strong candidate for a long flattener. Exhibit 3 presents the time series of Liberty bond Z-spread and 10-year CDS spread from May 2002 to the present.

Exhibit 3

As Exhibit 4 depicts, the long end of the Liberty credit curve is likely to flatten if Liberty's credit either deteriorates or improves significantly from its current level. Although our quantitative analysis estimates fair values from a cross-sectional relationship that does not show this bidirectional flattening, and therefore does not capture this effect, the relationship shown in Exhibit 4 gives us greater confidence in recommending a long flattener on the name.

Exhibit 4

Scenario analysis
We consider five one-year scenarios, each defined by the change in 10-year CDS spreads: -150bp, -100bp, 0bp, +100bp, and +200bp. For each scenario, we make two assumptions.

The first is that the bond's Z-spread returns to the fair value determined by the scenario CDS spread and the current relationship between 10-year spreads and bond Z-spreads. The second is that the slope of the CDS spread curve for the name assumes the "average" shape for spreads at that level.

For example, if the 10-year CDS spread in a year is 250bp under the scenario being examined, and the current average value for the 5-year CDS spread for names trading in the vicinity of 250bp is 85% of the 10-year spread, then we would assume that the five-year spread after a year is 0.85*250 = 212.5bp.

Exhibit 5 depicts the performance of the trade under these assumptions, taking into account the bid-ask spread of the instruments, a funding cost of 45bp above Treasuries for the position, and a Treasury return on the net proceeds of the investment at time zero.

Exhibit 5

Risk analysis/hedging
The scenario analysis underlying the trade recommendation assumes that the bond Z-spread one year from today will be our fair value derived from the current relationship across our bond universe between bond Z-spreads and 10-year CDS spreads and the future value of the 10-year CDS spread. The possibility that the Liberty bond and CDS will not follow this pattern – for example, the possibility that the 10-year CDS spread will widen and the slope of the credit curve from 10 years to bond maturity will steepen – is the major risk of the trade.

If the bond, CDS, and Treasury positions roll down their respective curves with no convergence toward fair value, the trade will experience significant roll-down losses. As explained above, any convergence toward fair value would tend to offset this effect.

Under the scenario where there is no change in CDS spread, the trade has negligible net carry. This compares with negative carry of 235bp for an outright short on the name.

The positions of the CDS and bond are weighted such that the trade is DV01 neutral with respect to credit risk. As explained above, we expect that changes in credit risk will result in changes in the slope of the credit curve, but small parallel moves in the credit curve should not affect the value of the position much.

We propose a Treasury bond hedge for interest rate risk. This hedge is duration-matched to the corporate bond, so small parallel changes in the interest curve likewise should not affect the position's value.

There is some execution risk given the maturities of the bond and CDS, but the bond and CDS show acceptable liquidity, as described below.

The trade is not neutral with respect to default, but the recommended CDS position over-hedges the bond position against such an event, so the position would benefit in the event of a jump to default.

Liquidity
The Liberty bond and CDS both show acceptable liquidity. The bond bid-ask is a bit high at US$1.84, but there is a healthy quantity (about US$1bn) of the bond outstanding and the bond shows good availability in dealer inventory. The CDS spread is 10bp, which is not out of the ordinary for CDS spreads at these levels.

Summary and recommendation
We recommend a relatively inexpensive way to take a negative view on the credit of a firm with deteriorating fundamentals and significant event risk. By putting on a flattener rather than shorting the credit outright, we can take the position with no net carry instead of paying 232bp. We can reap major gains if credit deterioration causes the long end of the Liberty credit curve to flatten or invert – a pattern that we observe across a wide range of credits.

Moreover, Liberty's history suggests that the long end of its credit curve may flatten even if Liberty's credit improves from its current level, so the position may gain if credit moves in either direction. In addition, the bond is trading cheap to our fair-value model and the prospect of a return to fair value further sweetens the trade.

Buy US$10m of Liberty Media LLC 8.25s of 2/1/2030 @ US$97.37 and

Buy US$14m of Liberty Media Corp 10Y CDS at 235bp and

Sell US$12m of Treasury 4.5s of 5/15/17 @ US$94.53

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).

Comparing TLCDX to CLOs

Standardised LCDX tranches are examined in conjunction with both CLOs and the tranched HY CDX index by Eduard Trampolsky and Mikhail Foux of the structured credit products strategy group at Citi

Following the successful introduction of the Leveraged Loan Index (the LCDX) in the US last month, dealers are set to start actively making markets in the tranched LCDX Index (TLCDX) in the near future. We think that the timing of this new tranched product is almost perfect and it is likely to be well received by the investor community. Depth, trading volumes, and tight bid-offers of the LCDX Index have even surpassed some optimistic expectations, which in our view should serve as a good base for liquidity and the cheapness of delta hedging of the TLCDX.

We will discuss the main features of the TLCDX and compare its merits to that of the tranched HY CDX Index and cash CLOs, the only structured product previously available for corporate loan investors.

Comparing the TLCDX to the tranched HY CDX

By its construction, the TLCDX is similar to the tranched HY CDX Index. Both indexes are equally weighted and have the same number of components (100). Their compositions have substantial overlap as well: slightly less than 45%; defaults are cash-settled via an auction process; their indexes roll twice a year; and the single-name contracts of their composites trade with No Restructuring provisions.

However, there are certain important differences between the two. First, the LCDX is composed of first-lien loans, which are senior to unsecured debt and thus have a higher recovery (investors normally assume an average 75% first-lien recovery versus 40% for bonds). Second, LCDS contracts are cancellable if the first-lien facility is called. As of now, the common market practice is to assume that these events are equivalent to defaults with 100% recovery and the thickness of the TLCDX super-senior tranche is decreased off the top (15-99% instead of 15-100%).

Although it is not set in stone just yet, the equity tranches of the TLCDX should trade with points up front and zero running spreads, similar to the equity tranches of the HY CDX Index. Initially we would expect the 5-yr TLCDX to be liquid, but with time a term-structure similar to that of the HY CDX Index could develop.

The TLCDX tranches have been set and agreed upon by market participants (see Figure 1). Interestingly enough, the number of defaults necessary to wipe out TLCDX and HY CDX tranches is somewhat similar, assuming the first-lien loan recovery of 75% and a bond recovery of 40% (see Figure 2).

It is relatively hard to determine the correlation skew of a new product before its inception. However, some dealers have already started providing indicative index prices and have even done some trades in the "grey" market. In Figure 1 we present indicative levels of the TLCDX tranches to the best of our knowledge. We also show tranche spreads implied by the HY correlation skew. They are substantially different from the indicative tranche levels, especially for some senior tranches, which are substantially affected by the LCDS's cancellability feature.

For junior tranches, we can show simple "off-the-cuff" calculations that explain the current market levels relatively well. We assume that the probabilities of default implied by the equity tranches of the HY CDX and TLCDX are similar.¹ The 0-10% tranche of the HY8 trades at 70 points up front. Assuming a 40% recovery, tranche spreads imply 7/(1-0.4) = 11.7 defaults.

Matching the implied default assumption to that of the TLCDX 0-5% and assuming a recovery of 75%, we determine that the tranche should trade at 11.7*(1-0.75) / 5 = 58.3 points up front, which is pretty close to what we observe in the marketplace. Similar logic allows us to say that the 5-8% tranche of the TLCDX should trade at 18.8 points up front. We get our 540bp level if we assume a DV01 of 3.5.

For our analysis we will use the market implied TLCDX tranche levels.

The TLCDX versus CLOs – choose your weapon

The TLCDX and a representative (average) CLO portfolio share a number of common features, but there are also significant differences that we will discuss. Figure 3 summarises the major similarities and differences of the LCDX and CLO portfolios.

• CLO portfolios are more diversified on average. A representative CLO has as many as 150 different issuers, compared to 100 entities in the LCDX. In addition, the LCDX portfolio has a much higher industry concentration. The top five industries (by Moody's classification) represent as much as 47% of the portfolio, compared to an average of 38% for the CLO portfolio, making the TLCDX somewhat more prone to industry risk. CLO portfolios face more single-name risk, since as much as 5% of the entire portfolio can be concentrated in the top two issuers.

• Although it has a somewhat lower diversification, the LCDX is comprised of the most liquid names in the leveraged loan universe. This makes hedging or the execution of dispersion trades much easier. In regard to portfolio quality, the weighted average rating factor (WARF) of the TLCDX is 2300. This is quite similar to that of an average CLO portfolio, which is between 2250 and 2450.

• Another significant difference between cash CLOs and the TLCDX is that the portfolio of the latter is more homogenous, with 100% of the entities referring the first-lien loans. In contrast, CLO portfolios on average have 85-90% of their portfolio in the first-liens, with the rest comprised of the "spread enhancers" – such as second-lien loans, middle-market loans, tranches of other CLOs and, in some cases, high-yield bonds, which are required to enable arbitrage in CLOs. Although they generally offer wider spread, recovery in default on these assets should be lower.²

• Finally, some recently closed CLOs were structured to take advantage of the credit cycle through short baskets in their portfolio.

Attachment and detachment points of the TLCDX closely resemble those of a representative cash CLO structure, with attachment points of 15-100 tranche, approximately equal to the credit enhancement level of a double-A rated CLO tranche. Note that even though there are no explicit attachment and detachment points for CLO liability tranches, we use the overcollateralisation levels (OC) of the tranches to derive the subordination measured through their asset coverage. 

Next, we go over some important structural differences between CLOs and the TLCDX.

Waterfall versus coupon payment
CLO asset proceeds are distributed through the cash waterfall – a complex set of rules such as overcollateralisation, interest coverage, and interest diversion tests, all of which guide the distribution. These tests are put in place to protect senior note holders, and it is generally the case that only senior tranches are guaranteed their coupon. Junior tranches – rated single-A through double-B – will pay in kind (PIK) if not enough interest was generated in the period and equity holders only get paid after all current and deferred interest has been paid to rated tranches.

In contrast, in the absence of a credit event (default) on the reference assets, holders of each tranche of the TLCDX are guaranteed a fixed coupon. Note that, as we mentioned earlier, the 0-5% tranche of the TLCDX is likely to trade with points upfront, as is the case with the HY.CDX.

Writedown
The other important difference is in the treatment of credit events. Similar to the CDX and TABX, the TLCDX tranches are written down. In cash CLOs the tranches are not written down, assuming the entire balance of the tranche until the final payment. If investors decide to invest in tranches of CLOs on a synthetic basis – that is, through CDS on CLOs, there is an option to choose a fixed cap-implied writedown, in which case protection sellers have to pay any implied writedowns on the tranche.³

Bullet maturity versus amortisation
In a regular CLO transaction we usually define three periods – a non-call period, a reinvestment period, and a legal maturity of the deal – that are usually four, six, and 14 years, respectively. After the end of the reinvestment period, tranches are amortised starting from the most senior. Thus, the weighted average life of tranches ranges from approximately seven years for senior tranches to 12-13 years for equity holders (assuming 30% CPR, 2% CDR, and 75% recovery for loans). In the case of the TLCDX, however, all tranches have a five-year bullet maturity, making the cash flows more predictable.

Optional redemption
In addition, CF CLO structures have an optional redemption feature – that is, the equity holders can call the deal after the non-call period, which can sometimes be as short as three years. This usually happens if the deal could be refinanced at tighter spreads. This may prove to be disadvantageous to senior-tranche holders, who will face tighter spreads than in the original deal.

Comparing Tranche Performance

Junior tranches
For our return analysis we will use market-implied TLCDX coupons. We will start by comparing returns of the TLCDX, HY CDX, and CLO equity tranches under various default assumptions.

Figure 5 shows returns of the equity tranches assuming various constant default scenarios – a common practice in CLO structuring. Though constant default scenarios are somewhat simplistic, they give an initial indication of the relative strengths of the structure.

Figure 5. Returns of CLO Equity Versus the TLCDX 0-5% Tranche and HY CDX 0-10% Tranche 

Because of its higher coupon, the TLCDX 0-5% tranche outperforms CLO equity in the milder default scenarios (up to about 2 CDR). However, in the more severe scenarios, CLO equity is the clear winner: Investors will be able to recoup their initial investment even in a case where the annual defaults are 4% throughout the life of the transaction. This is because, contrary to index products, CLO equity holders do not have their notional written down and may continue receiving excess spread even in moderate to severe defaults scenarios.

We will now refine our analysis. The timing of defaults is critical to the performance of CLO equity. Let's see how this affects returns of the two tranches. In our scenarios, we assume defaults to be flat at 1% CDR, then to spike for five years, and then revert to 1% CDR afterwards.

The left section of Figure 6 shows returns of the tranches assuming that defaults spike after two years. Note that CDR values on the horizontal axis correspond to the value of the default spike. The right section shows the difference between the internal rate of return (IRR) of the 0-5% tranche versus CLO equity for a variety of default spikes and different default starts.

Figure 6. Returns of Tranches as a Function of Timing Defaults

The further back in time that we go for defaults, the more the 0-5% tranche benefits (because of its shorter maturity and higher coupon). In effect, if defaults are very back-loaded – say, they kick in after three years – the 0-5% tranche has a higher IRR for any reasonable default spike assumptions. CLO equity, on the other hand, generates better IRR in front-loaded scenarios.

CLOs, particularly equity, are also prone to prepayment/reinvestment risk. Thus, if no defaults occur, there might be more spread tightening ahead, similar to what occurred in February through March 2007, when many loan issuers were able to refinance or negotiate loan modification, resulting in up to 50bp lower spreads. In such a case, there will be less excess spread to CLO equity – thus resulting in a lower IRR. Of course, if spreads widen, CLOs would reap the benefits.

Finally, as we have mentioned, single-name concentration in CLO may be high, diminishing CLO returns if some of the largest assets in the portfolio default. But with five industries – each containing almost 10% of the TLCDX portfolio – correlated defaults may have a devastating effect on the 0-5% tranche.

So which is the better of the two investment alternatives? In our view the 0-5% tranche is a more aggressive investment suited for investors who believe that defaults will be low or significantly back-loaded. This investment may also be suitable for those who anticipate that second-lien recovery will be low in case of defaults (remember that CLOs include 5-10% of second liens on average) and would like to stay with an all first-lien portfolio. However, if the credit cycle turns sooner rather than later and defaults pick up in a year or two from now, CLO equity – despite all its structural complexities and inherent risks – is likely to be the winner of the two.

In effect, not all loan portfolios are the same⁴ and overlap between a standard CLO portfolio and the TLCDX is unlikely to exceed 40%. Thus, some CLO managers are likely to exceed projected performance⁵ and investors would be wise to perform due diligence on the manager, its track record, and the credit selection process. After all, the equity market shows that while exchange-traded funds (ETFs) are popular, some portfolio managers routinely beat the market.

Senior tranches
When considering senior tranches, factors such as portfolio layering and reinvestment risk do not have as much of an effect on tranche returns, which are mostly driven by portfolio credit performance and the respective spreads of tranches. Figure 7 shows returns for tranches of the TLCDX and CLO.

Figure 7. Returns on Senior Tranches in TLCDX and CLO

As we can see, tranches of the TLCDX with a similar level of credit support break (lose yield) much earlier than respective tranches of CLOs. For example, the 5-8% tranche of the TLCDX will have 0% IRR at 5.3% CDR compared to 9.5% CDR for a comparable double-B rated tranche of the CLO. This is a result of all the early warning features installed in CLOs, such as IC and OC triggers, interest diversion tests, and the turbo feature (although rare in a CLO) that uses a portion of excess interest proceeds to amortise mezzanine tranches, thus decreasing the WAL of that tranche and enhancing the yield. But those protections come at a cost – coupons on the TLCDX 5-8% tranche are significantly wider than comparable CLO tranche coupons.

As in the case with equity, more aggressive debt investors should consider tranches of the TLCDX (but recall that concentration in several industries may be a problem). For more conservative investors, CLO debt tranches may be a better option.

Additional consideration to keep in mind is that we performed our analysis assuming funded investment in tranches. Investors in TLCDX can make their investment on an unfunded basis, committing little or no collateral – this is almost nonexistent in CLOs. However, investments in the TLCDX tranches will have to be marked to market, a drawback that investors were able to avoid by investing in CLO tranches.

Conclusion
The introduction of the tranched LCDX will be a welcome development for CLO investors. It gives them a much-needed tool to hedge their tranche investments. In addition, some investors may prefer an index alternative because of its higher liquidity as well as the liquidity of underlying loans.

Traditional investors looking for higher returns, albeit with higher risk, may also consider investing in tranched products. The disadvantage of the TLCDX is likely to be its high price volatility: The product will likely attract hedge funds and fast money and will be required to be marked to market.

Finally, if the TLCDX index becomes the average among all portfolios, there will be some portfolios that will do much better. CLOs managed by the best managers are likely to significantly outperform the TLCDX index in a distressed environment, and this is something that investors need to remember.

Notes
1. This is based on the overlap of the composition and traded spread levels – not a big stretch for the junior tranches.
2. See Second-Lien Loan Recovery – Case Study, Moody's, April 7, 2007.
3. For more information on CDS on CDO please refer to Credit Default Swaps on CDOs, Ratul Roy, Citi, June 19, 2006.
4. CLO Portfolio Overlap, Not What You Might Expect, Jeffery Prince and Jonathan Sontag, Citi, April 27, 2005.
5. On CLO Manager Selection in Spread Widening Environment, Jeffrey Prince and Ed Trampolsky, Citi, May 17, 2006.

© 2007 Citigroup Global markets. All rights reserved. This Research Note was first published by Citigroup Global markets on 12 June 2007.