Contents

CDR Liquid Index data as at 16 July 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.

Rollercoaster continues

Volatility keeps heading north, but some contagion concerns reduced

The CDS index markets have continued to whipsaw over the past week, with the iTraxx crossover ballooning to 310bp at mid-day today, 18 July, having closed 20bp wider on the day at 288bp yesterday. However, market turbulence is not necessarily adversely impacting every section of the credit markets. Meanwhile, the ABX markets face yet another potential turning point in the next few days.

Short-dated option implied volatility in the European indices has continued its sharp upward drive. At Tuesday's close September 07 ATM vol stood at 91%, 92% and 89% for the iTraxx main, HiVol and crossover indices respectively –representing increases of 14%, 16% and 14% on the week.

Nevertheless, there appears to be a growing understanding that sub-prime-driven volatility does not impact all parts of the credit markets equally. One senior trader notes: "Investors now seem to have grasped that this is not about all credit and, as a result, the risk of contagion between different sectors and instruments has diminished somewhat."

Siobhan Pettit, head of structured credit strategy at Royal Bank of Scotland, concurs: "We detect an ongoing dislocation in the perception of the relative vulnerability of Euro CLOs to the current credit turmoil. We think European CLO risks are being overplayed and that buying opportunities will present themselves over coming weeks."

She continues: "So far, primary CLO widening is based on a couple of deals and so the European CLO market is yet to be tested meaningfully. With nine European CLOs in the pipeline, such a test is imminent. We expect higher rated tranches to remain well bid but for low rated tranche spreads to widen further."

This widening could offer opportunities for bargain hunting, Pettit suggests. "For investors that can deal with illiquidity and mark to market, we recommend buying top-tier managed Euro CLOs, lower rated tranches and equity in either primary or secondary," she says.

Meanwhile, in the ABX market traders have had to deal with another index tranche dipping below the 50 mark. The ABX triple-B minus 06-2 tranche joined the triple-B minus 07-1 index, with both finishing Tuesday's session at 49.09 and 45.02 respectively.

ABX traders report a fair amount of volatility over the past week and good volumes in the index, but that liquidity in single name CDS of ABS has been poor. Furthermore, they shrugged off the latest bout of hedge fund news – including Bear Stearns reporting massive drops in value in its structured credit funds and Australian fund Basis Capital suspending redemptions from its Basis Yield fund – as "as expected".

Instead, attention was focussed on tomorrow's setting of fixed rates for the next ABX series – 07-2 – which will begin trading on Friday. "Everyone is wondering whether the 07-2 auctions process will be the same as previous ones, whereby they set the fixed rates too low – and then the market opens trading where dealers believe it should be, which is not exactly good for confidence," concludes one trader.

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CFO equity outperforms

Hedge fund-related structures look set to grow

Collateralised fund obligation (CFO) investors, especially in the equity part of the structure, are seeing healthy returns thanks to current market conditions. As a result, expectations are that CFO issuance will increase.

CFO equity is currently showing significant outperformance, especially when compared to CDO equity, according to Georges Duponcheele, head of product development and quantitative structuring at BNP Paribas. "Given the current woes in CDOs due to the sub-prime effect, the contrast is all the more remarkable," he adds.

Duponcheele cites the performance of one of the CFOs arranged by his firm – ZOO HF 3 – since its launch in late January 2007 as an example. Between its launch and 13 July, ZOO 3 has experienced four strong months in terms of performance and is well ahead of expectations.

According to the manager's data, the hedge fund only portfolio compounded return, in euro terms, in the period was 5.66% (11.64% annualised). Given that part of the portfolio was invested in cash, the weighted total asset return equalled a return of 4.26% (10.53% annualised).

The result is well in excess of the target return for the asset portfolio, which was set to be 9% on an annual basis, while equity investors are also benefiting from the positive trend of the portfolio. NAV for the junior notes – which, with expenses deducted, stood at 95.07% at launch – reached 111.29% at 13 July. If this outperformance is maintained until the next payment date, the equity note coupon could be in excess of 35%.

Duponcheele explains: "CFO equity is quite different to CDO equity. While a CDO is essentially only ever a long-only credit strategy – no matter how that is diversified in terms of different single names, indices and so on – a CFO has true diversification at a strategic level. CDO equity investors are still ultimately exposed to defaults, but with CFO equity the exposure – and therefore the returns – are far more diverse and the underlying returns tend to be higher for less equivalent leverage."

Luca Peviani, md at P&G, which manages ZOO 3 concurs. "The major reason for investing in hedge funds via CDO technology can be seen with a comparison between underlyings. With loans, for example, the return is typically somewhere between 200bp and 300bp for a single-B to double-B minus asset, which equates to a return of 7-8%. Whereas when you invest in a portfolio of hedge funds, you are looking at a higher return of 9-10% with something like 2-4% volatility – which equates to the volatility of an investment grade portfolio," he says.

Despite such a compelling argument, hedge funds have not yet been fully exploited as an asset class for structured finance, Peviani says. Market conditions have so far not been right, but that appears to be changing.

As Peviani explains: "The low volatility in the market over the last few years has restricted opportunities for hedge funds, and CFOs work best when a range of funds are able to take advantage of a number of markets at the same time. Lately, with major acquisitions activity, heightened volatility and increasing interest rates, there are many strategies that are finding good opportunities. Obviously to capitalise on these you need to get the right managers in the portfolio and therefore finding the right CFO manager is also key."

With such beneficial conditions in place and the consistent performance seen this year from existing deals, it is perhaps unsurprising that more deals are afoot. As Duponcheele concludes: "There are a number of fund transactions in our own pipeline and, thanks to a lot of interest from a range of investors and managers, we understand that many other major banks are looking at these products now as well. Consequently, we expect CFO issuance to be a far more regular event in the future."

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Calyon offers Solys

New short credit strategy sees diverse investor demand

Calyon has placed with institutional investors approximately €400m of Solys notes and €180m of shares in the UCITS III-compliant Structura Solys sub-fund, two newly created short credit strategy investment instruments managed by Crédit Agricole Asset Management (CAAM). The bank acted as arranger for the notes and structured the strategy for both the notes and the sub-fund shares.

Solys has proved to be popular with a wide range of investors, according to Ally Chow, global head of credit markets product management at Calyon. "It's been one of Calyon's most widely distributed transactions in terms of the number of investors involved and their diversity – we have placed the notes and shares in the fund with more than 100 investors, ranging from corporate pension funds to small asset managers in Asia, Eastern Europe and the CIS as well as the usual places," she says.

Part of the structure's appeal is that it can be utilised in more than one way. "Investors have used either the notes or the fund as both an opportunistic investment or as a hedge for their existing credit portfolio," Chow explains.

Both Solys notes and Structura Solys involve buying protection on two tranches and selling protection on one tranche of a bespoke portfolio (consisting of iTraxx Main, iTraxx Xover indices and single name CDS). The Solys structures offer investors a way of shorting the market through a convex mark-to-market profile with an absence of negative carry.

The manager has the flexibility to adjust the Solys structures to maintain their MtM profile through active management. Investors can receive periodic coupons and will receive at maturity principal plus MtM gains, depending on the performance of the strategy. The maturity of the notes is three years based on a 7 year portfolio.

Chow says that Calyon has been working on this kind of structure for some time and had already closed some private deals before offering the notes publicly. The sub-fund was the next logical step. "We had plenty of interest in the notes, but some investors needed a fund because they were precluded from buying notes, but still wanted access to the strategy," Chow says.

She adds that those who have accessed the strategy have done well. "Solys had the perfect profile to benefit from recent market widening, which has resulted in the notes cashing in already – having launched in early March. Those returns are therefore locked in for the three-year term," Chow observes.

The fund launched in July, so has not benefited from the strong performance of the notes that were issued earlier in the year. However, Chow argues: "The fund will, of course, benefit from any further widening in its lifetime and, because of the convex characteristics of the Solys strategy, could in the right circumstances benefit from market tightening."

Looking ahead, future deals of this type are likely to come to market. "We are looking at similar structures and seeing continuing demand for other deals of this kind since the issue and cash-in of Solys," Chow concludes.

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Cat capital solution

US$500m contingent capital deal closed

In a pioneering transaction, the US insurer Farmers Insurance Exchange has acquired the right to issue US$500m of regulatory capital if it suffers a severe US natural catastrophe loss in the next five years. The so-called committed capital deal is the latest step by the (re)insurance industry to collaborate with the capital markets in financing catastrophic losses.

"The facility, provided by a syndicate of international banks and Swiss Re, complements Farmers' reinsurance strategy and is more flexible and cost competitive than other capital market or reinsurance alternatives. For insurers, this is a positive sign that additional sources of capital may be available to complement their traditional reinsurance and the growing catastrophe bond market," explains Ron Myhan, svp finance - Farmers Insurance Exchanges.

The deal has been arranged by Swiss Re and will be underwritten and syndicated by Calyon, Citi, Commerzbank and Swiss Re. Under the transaction, if the Farmers P&C Group suffers a severe Texas windstorm loss in excess of US$1.5bn, then it has the right to issue ten-year subordinated loan notes to major institutions to restore its capital base.

In what is thought to be a double-first, the transaction marks the first time that a reinsurer has co-operated with banks to provide regulatory capital to a major insurer. It is also the first time that such banks are taking a hybrid exposure of both subordinated credit risk on an insurer and also catastrophe risk.

A further unique feature of the transaction is that it has received regulatory approval from the California Department of Insurance, which has pre-approved the issuance of surplus loan notes contingent on a catastrophe event.

Tom Skwarek, an md in Swiss Re's capital management and advisory division, comments that the banks' involvement demonstrates not only a further sign of convergence between financial markets with respect to financing reinsurance risk, but also a sea-change in thinking.

"The cat bond market is the domain of institutional investors and traders, not lenders. However, this transaction combines the effects of a cat event with the fundamental credit analysis of an insurer's ability to recover from the event. Banks and Swiss Re are now providing capital to an insurer, and their assessment required them to evaluate the remoteness of the event and Farmers' anticipated credit strength post event," he says.

Farmers has agreed to pay a pre-determined standby fee over the 5-year commitment. The terms of the drawdown have not been disclosed, but Swiss Re says the risk of drawing on the full $500m would be the equivalent to a 1-in-a-250-year event.

Heike Allendorf, head of the financial institution group in Switzerland at Citi, adds: "This highly innovative transaction typifies the convergence between lending and ILS [insurance-linked securities], and reflects the growing importance of ERM and financial flexibility to insurance companies, rating and regulatory agencies. We see considerable potential in this type of structure and expect this to spark substantial interest amongst industry players."

Farmers Insurance Exchange is the principal Exchange of the Farmers Insurance Group and is managed by Farmers Group, a Zurich Financial Services affiliate. The Farmers P&C Group, which is similar to an insurance mutual, is the third largest personal lines P&C insurer in the US.

The transaction will be triggered if the group suffers a natural catastrophe loss of over US$1.5bn in Texas, Arkansas, Oklahoma or Louisiana, and is designed to supplement the exchange's own traditional reinsurance programme.

MP

Trading head to leave

The latest company and people moves

Trading head to leave
Eric Lepage will leave Calyon next month to set up his own firm. Benjamin Jacquard, global head of structuring, is to be appointed to Lepage's role of global head of credit markets trading.

Jacquard will report to Loic Fery, global head of credit markets & CDOs at Calyon. Ferry will directly manage the French bank's structuring teams. Jacquard recently joined Calyon Credit Markets team from Bank of America where he was md and global head of structured credit trading & hybrids (see SCI issue 35).

Synthetic switch
Olivier van Eyseren, senior md at Bear Stearns in synthetic credit structuring, is understood to have left to take up a similar role at Societe Générale.

Bespoke strategist hired
RBS has hired Gianluca Giurlando from the Royal Bank of Canada, where he specialised in correlation products. He joins as a senior structured credit strategist, reporting to Siobhan Pettit.

Giurlando, who will concentrate primarily on non-traded bespoke products, has previously worked at Moody's and Fitch, as a synthetic CDO analyst and at CIBC, as a CLO and RMBS structurer.

Flow credit sales move
James Townsend, a flow credit sales official from Dresdner Kleinwort, has joined Citi in London.

Structurer arrives
Sally Singer, formerly a credit derivatives structurer at BNP Paribas (see SCI issue 40), has joined Morgan Stanley's CDO team in London as a vp.

Bank strengthens cash CDOs
Société Générale Corporate & Investment Banking has hired Peter Melichar as vp of CDO origination and structuring, with a view to strengthening its European cash CDO platform. He is based in London in the CDO structuring team, managed by Tony Venutolo.

Melichar will be responsible for the structuring and origination of cash products across asset classes and structure types. Previously, he spent six years at Citi, joining in 2001 as an analyst supporting the interest rate swaps/options desk. In June 2004 he moved to Citi's European cash CDO desk as a structurer, focusing primarily on cashflow CDOs of leveraged loans and asset-backed securities.

Gulf DCM head appointed
BNP Paribas has appointed Mark Waters to a newly created position as head of debt capital markets in the Gulf region. The bank says this will bring together its origination businesses in the region for the structured finance/loan syndication and fixed income/DCM units.

Waters will be located in Bahrain, reporting within fixed income locally to Eric Josserand and functionally to Dominique Leca in London, and within structured finance, to loan syndications in London. Waters had previously been responsible for BNP Paribas' corporate and financial institution syndicated loan origination business for the region for the last five years.

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CPDO attracts more investors

A round up of this week's structured credit news

CPDO attracts more investors
Alhambra CPDO is still generating considerable investor interest, according to the deal's arranger Barclays Capital. The transaction, which has a target size of US$300m, has had two successful prints already (making it the first fully managed bespoke CPDO), and is scheduled to have further closings in July and August.

Saad Ali, a director in Barclays Capital's European credit derivatives structuring team, reports that most interest has been in Aaa and Aa2 rated Notes. Furthermore, having a full managed deal has proved both popular and effective.

"The portfolio has remained quite stable – it has not widened as much as the indices, which shows clearly the value of having a manager," Ali says.

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

Current market conditions have also enabled an increase in Alhambra's coupon. For example, initially the triple-A rated notes were paying +90bp over, but now it is +110bp.

Rapid market growth continues
Fitch Ratings said yesterday, July 17, that the credit derivatives market continues to expand at a remarkable pace, while concern grows about how the market would deal with an eventual downturn. The total amount of credit derivatives bought and sold reached nearly US$50tr at year-end 2006, an increase of 113% over the US$23.4tr reported for year-end 2005.

"Leading the charge for the growth in the credit derivatives market are the traded indices, which, for the first time, surpassed single name CDS in volume last year, even though single name usage itself continued to expand rapidly," says James Batterman, senior director, and co-author of Fitch's fifth annual Global Credit Derivatives report. The agency estimates that US$22.2tr of index products was bought and sold by year-end 2006, compared with US$20.0tr in single-named CDS.

Despite the current benign corporate credit environment, a number of market participants expressed concern over how smoothly the market can deal with an eventual downturn in the credit cycle, Fitch says. Specifically, some of these worries included liquidity in the event of a downturn, the impact that unwinding of system leverage can have on volatility and settlement following a credit event. Nonetheless, survey respondents expect the credit derivatives market to continue its expansion, with CDOs, LCDS and the traded indices cited as the biggest growth vehicles for 2007.

On the surface, banks globally appear to have become somewhat more conservative in terms of their credit exposure, ending 2006 at US$304bn net protection bought – although 20 of the 44 banks surveyed, or 45%, were net sellers of protection. The global insurance and monoline industries continued to be key net sellers of protection at US$395bn and US$355bn, respectively, at year-end 2006.

Permacap vehicle adds financing facility
Cheyne Capital's Queen's Walk Investment Ltd (QWIL – SCI passim), the closed-end investment company listed on the London Stock Exchange that invests in and manages a portfolio of subordinated tranches of ABS, has entered into a four-year revolving €135m financing facility arranged and placed by Deutsche Bank.

Tom Chandos, chairman of QWIL's board of directors, comments: "We believe this longer-term facility provides a very significant benefit to the company, as it eliminates the liquidity risk of short-term borrowings. It puts the company in a stronger financial position with a stable source of financing for the future."

More rating agency action on sub-prime CDOs
Late last Wednesday, 11 July, Moody's put 184 CDO tranches on review for possible downgrade. On Thursday, Fitch put 33 classes from 19 SF CDOs on rating watch negative and revised its SF CDO methodology. Then, S&P expanded its roster of CDOs on credit watch last Monday, 16 July.

Moody's announced that it has put 184 tranches of 91 CDOs backed primarily by RMBS on review for possible downgrade. The rating actions affect securities with an original face value of approximately US$5bn, representing roughly 0.5% of the total Moody's rated CDO of ABS universe.

The rating agency says that these CDO rating actions primarily reflect its recent rating actions on RMBS assets associated with first lien sub-prime mortgages from the 2006 vintage, the second lien loans of the 2005/2006 vintage as well as the structures of the individual transactions. The majority of rating actions taken impacted securities currently rated Baa or lower. There were also 37 single-A, 15 double-A and 8 triple-A rated tranches placed on review.

Fitch Ratings says it has placed 33 classes from 19 SF CDOs on rating watch negative (RWN) for potential downgrades. It also maintains RWN on eight classes of four SF CDOs, which were placed on RWN on June 22 2007.

Fitch rates approximately US$54.4bn notes from 160 US mezzanine SF CDOs and approximately US$39.6bn notes from 41 US high-grade SF CDOs. These actions, combined with the four CDOs placed on RWN on June 22 2007, affect approximately US$803m of paper.

Fitch also revised its CDO rating methodology to reflect the increased default risk evidenced in US sub-prime RMBS bonds issued since 2005. The higher delinquencies and losses being realised in the late 2005 and 2006 vintage sub-prime RMBS is a clear departure from the historical performance of earlier vintages for this asset class, the agency says.

The revised rating methodology modifies Fitch's CDO modelling assumptions by increasing the default probability by 25% for US sub-prime RMBS bonds issued since 2005. A new version of Fitch's VECTOR will be made available to the market in the near future that directly incorporates these revisions. This revised rating methodology will apply to all SF CDOs as of July 13 2007.

Meanwhile, S&P followed up on its actions last week (see SCI issue 47) by placing its ratings on various classes from 19 cashflow and hybrid CDOs on credit watch with negative implications.

S&P says it has reviewed the results of preliminary cashflow analyses for these transactions and compared them to the scenario default rates (SDRs) generated by its CDO Evaluator model to determine whether the credit enhancement afforded by the CDO structures remains adequate to support the tranches at their current rating levels, given the impact of the RMBS rating actions on the portfolios.

iTraxx total return indices launched
International Index Company has launched iTraxx total return indices, which measure the performance of holding the respective on-the-run iTraxx CDS contracts with the remaining notional invested in money market instruments. The indices will start trading with 5-year maturities and will have the same composition as the existing iTraxx CDS indices.

David Mark, ceo of IIC, comments: "The indices will enable investors to evaluate the investment performance of credit products from an independent source. iTraxx total return indices are another important step in expanding the iTraxx benchmark family of indices. We have seen strong demand for exchange-traded funds which will be provided by two market leading ETF organisations and will be followed by a wide range of other products in the future".

iTraxx total return indices reflect a long credit position – i.e. selling credit protection through iTraxx credit default swaps – while simultaneously investing the remaining funds in money market instruments. The indices invest in the on-the-run iTraxx series that they track. Markit will act as calculation agent for the indices.

GAO commends CDS dealers
A US Government Accountability Office (GAO) report concludes that the 14 largest credit derivatives dealers dramatically reduced the number of total confirmations (outstanding more than 30 days) to 5,500 trades as of October 2006. The 5,500 outstanding confirmations represent a 94% reduction from the previous backlog of more than 150,000 unconfirmed trades that had accumulated between 2002 and 2005, GAO observes.

"It is an enormous relief that these sophisticated markets have traded in 19th-century mechanics for modern information technology, and not a moment too soon," said Rep. John D. Dingell, chairman of the committee on energy and commerce, pointing to sub-prime woes haunting credit markets. "We look forward to additional progress, and commend the joint regulatory action and industry response as a model for tackling similar problems in global markets."

Energy and commerce committee leaders followed up the report with a letter to the chairman of the Federal Reserve, the chairman of the SEC and the comptroller of the currency. The letter commended the joint regulatory action and actions to date by the dealers, but strongly urged further steps to reduce backlogs, improve automation and increase the reporting of standardised data. The Congressmen asked to be notified if progress lags, and promised to follow up on technology matters as needed.

ESF welcomes Solvency II
The European Securitisation Forum (ESF) has welcomed the draft Solvency II Framework Directive released by the European Commission on July 10 for its recognition of securitisation and derivatives, together with reinsurance, as eligible risk mitigation techniques for insurance and reinsurance undertakings regulatory capital relief purposes.

ESF says that this is the outcome which it has worked for during the past year through various advocacy initiatives with CEIOPS and the EU Commission.

Rick Watson, md and head of the ESF, comments: "The actual technical details of the new regime for securitisation and derivatives as risk mitigation techniques will be hammered out in the implementing Directives, and the ESF will continue monitoring these developments through its Solvency II Working Group".

ISDA publishes iTraxx protocol
ISDA has published a protocol created to make amendments to the standard documentation for single tranche transactions that reference either Series 4 or Series 5 of the iTraxx Europe index (Relevant Transactions).

Many Relevant Transactions entered into after 20 September 2006 will have been documented incorporating the Standard Terms Supplement, in which case adherence to the Protocol will not affect such Relevant Transactions. However, adherence to the Protocol would be appropriate for purposes of any Relevant Transaction that has been documented by reference to a previous version of the Standard Terms Supplement that was published on September 19 2005.

The Protocol is open to ISDA members and non-members alike. The adherence period for the Protocol runs from July 16 to July 30 2007.

First European CDPC paper priced
A US$300m 3-tranche senior debt floating rate notes Reg S issue was priced last week for Channel Capital, the first European Credit Derivative Product Company. The notes mature in July 2037 and the lead manager was Calyon.

The US$150m 7-year triple-A rated Class A notes (Moody's/S&P) priced with a coupon of 65bp over three-month Libor, the US$100m 5-year double-A Class Bs came at 120bp and the US$50m 7-year triple-B senior capital printed at 275bp.

MP

Trading ideas - shrink to fit

Dave Klein, research analyst at Credit Derivatives Research, looks at an outright long on Levi Strauss & Co

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.

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 this trade, we express our positive outlook for Levi Strauss & Co (LEVI) in an outright short protection (long credit) position. Given LEVI's curve flatness, this is the best trade available and possesses nice economics.

Go long
With our improving outlook for LEVI, we want to be long the credit. We can take this position either by buying bonds or selling CDS protection. Exhibit 1 compares LEVI 5-year on-the-run CDS performance to the on-the-run CDX HY.

Exhibit 1

Although highly-correlated, we see that LEVI sold-off a bit more than the CDX HY recently. Even with the recent rally, we believe there is still upside to be captured by going long LEVI.

In order to evaluate opportunities across the term structure, we compare CDS levels to bond z-spreads, which we believe is the most straightforward way to compare the two securities. Exhibit 2 compares LEVI's market CDS levels as well as our fair value CDS levels.

Exhibit 2

We have focused on selling CDS protection for today's trade. Given our improving outlook, we'd expect the CDS curve to flatten although LEVI is wide enough spread-wise to make curve behaviour a bit unpredictable. In order to estimate CDS fair values, we regress each tenor (1's, 3's, 5's, 7's, 10') against the other tenors across the universe of credits we cover.

This results in a set of models with extremely high r-squareds. In our case, we see that almost all of LEVI's CDS are trading close to this cross-sectional fair value except for the illiquid 1-year. Since we only see reasonable liquidity in the 5-year tenor, we choose to sell protection in that maturity noting that it is slightly cheap (wide) to fair value.

Trade economics
Given that we see 5s as the most liquid maturity, we drill down and look at the trade economics. Specifically, we look at carry, roll-down and the bid-offer spread of each potential trade. LEVI's 5s have a steep bid-offer of 20bp.

Additionally, the roll-down on the 5s is positive. We estimate that the trade will break even in 6 months time even if LEVI sells off by over 40bp. Exhibit 3 details the trade economics of selling 5-year LEVI CDS protection.

Exhibit 3

Risk analysis
This trade takes an outright short protection (long credit) position. It is unhedged against curve movements. Additionally, we face 20bp of bid-offer to cross. The trade is significantly positive carry which protects the investor from any short-term mark-to-market losses.

Entering and exiting any trade carries execution risk, but this is not a major risk as LEVI has reasonable liquidity in the credit derivatives markets.

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. LEVI has reasonable liquidity in the CDS market at the 5-year tenor with a bid-offer of 20bp.

Fundamentals
This trade is based on our improving fundamental outlook. Taking an outright short protection (long credit) 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 bullish view on the credit is the driver of this trade.

Kim Noland, Gimme Credit's Apparel expert, recently issued a report ("Green Jeans", July 16, 2007) on LEVI. Kim believes the company is making progress in generating more free cash flow.

Additionally, Kim maintains an outperform recommendation on LEVI's senior notes and a sell recommendation on its 5-year CDS. Although the company has not commented on a potential IPO and shareholder-friendly dividend, Kim notes that LEVI bond prices have been less volatile than other retail and apparel credits. Kim further notes that LEVI would merit an improving credit score if it did not face an increase in capital spending.

LEVI scores positively on many factors in our Multi-Factor Credit Indicator (MFCI) model. Its spread/rating, spread/default risk and spread/leverage factors all point to a rally when compared to its peers. Since the company is private, an LBO is not a risk (although an IPO is).

Summary and trade recommendation
It has been some time since we recommended an outright long position. With LEVI's continued turnaround, we are ready to ignore the recent market sell off and put on a bullish trade. The company scores high on our Multi-Factor Credit Indicator model (spread/rating, spread/default risk, spread/leverage), pointing towards a continued rally in CDS levels.

Although LEVI is well off its wides, we believe there is still upside to selling CDS protection. Excellent carry, roll-down and the potential profit of a rally strengthen the economics of the trade. Given our improving outlook and the current wide levels for LEVI, we feel this outright position presents the best opportunity for trading this name.

Sell US$10m notional Levi Strauss & Co. 5-year CDS protection at 355bp to gain 355bp of positive carry

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

Copyright © 2007 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).

Refinancing in Crossover

Debt repayment schedule and refinancing for iTraxx Crossover constituents and the implications for the CDS curve are examined by Andrea Cicione, credit strategist at BNP Paribas

The strong correction we have seen in the credit market over the past few weeks has raised concerns over the impact that risk aversion and credit deterioration could have on refinancing. Several companies that had planned to come to the market with new deals – either bonds or loans – faced significant pressure from investors to revise the conditions at which they were issuing, both in term of spreads and covenants. Most decided to wait.

This is primarily a US problem, caused by a combination of (1) the sub-prime meltdown, (2) the sheer size of the deals pipeline, and (3) the US supply-demand dynamics, namely the bias towards cov-lite deals.

Or at least this is what European issuers like to believe. The reality is that although the primary market in Europe has so far proven to be quite resilient, a combination of a knock-on effect on sentiment and shift of liquidity to the US may well start to have an impact on Europe too.

With this backdrop in mind, we looked at the debt repayment schedule for companies in the iTraxx Crossover index, to assess how much debt will need to be refinanced in the short term. This is critical: although firms have the option to postpone going to the market if they have to raise funds for an acquisition or a big capital expenditure, they do not have as much flexibility when it comes to refinancing debt falling due.

Debt repayment schedule is not extremely front-loaded – but...
Our analysis shows that the amount of debt – bonds plus loans – maturing over the next three years, relative to the total amount outstanding, is less than 20%. In absolute terms, it means that roughly €46bn worth of high-yield debt will need to be refinanced by the end of 2009. (See table 1.) Considering that the annual size of this market is about €25bn, it seems that the task is not impossible.

However, there are two major risks that need to be taken into account. The first is that we have only considered the debt that will need to be refinanced, ignoring entirely plans that companies may have to raise more debt than they currently have. The additional supply coming from LBOs and leverage increase could put pressure on, and quickly saturate, the existing demand for HY debt, particularly if this starts to fall as liquidity dries up and risk appetite decreases.

The second risk to consider becomes very clear looking at Chart 1. Most of the debt maturing between now and 2009-2010 is made up of loans. As loans are typically floating-rate, they leave the issuer much more exposed to interest rate risk than bonds. Although HY/Crossover credit spreads have fallen since 2004 by about 100bp, interest rates have been steadily increasing: the result has been a net increase of average interest paid of approximately 100bp in Europe and 300bp in the US. As leverage increase and credit deterioration begin to have a lasting effect on spreads, the compounding of higher rates and wider spreads will put significant pressure on the ability of sub-investment grade and crossover companies to meet their obligations.

The aforementioned risks pose a serious threat to firms in HY/Crossover. However, the issuers' ability to tap the market and stay solvent will depend more on how much they will decide to stretch themselves in term of leverage, and the overall health of the economy going forward, rather than the capacity of the markets to absorb the debt that will have to be refinanced over then next 3 years.

Impact on single-name steepness
Turning to the individual Crossover constituents, we believe that debt distribution should have an impact on the steepness of the CDS curve. If a company has mostly long-term debt outstanding, it is quite unlikely that it will default anytime soon: all it has to do is meet the interest payments, while facing little refinancing risk in the near term. We should therefore expect a relatively tight short-end of the CDS curve, and a wider long-end – in other words, a steep curve.

On the other hand, a firm with mostly short-term debt outstanding will have to come to the market more often: if the lending conditions tighten, or if the company's credit worthiness deteriorates, it will be difficult to get finance and the company will be subject to a higher risk of default. As a consequence, short-term spreads will be relatively wide, with the long-end not much wider – i.e. the curve will be relatively flat. (See chart 2.)

Comparing debt distribution to curve steepness interesting observations can emerge (again, see table 1). For example, M-Real will have to refinance more than €1bn between 2007 and 2008, yet the very short-end of its curve (1Y3Y) is extremely steep. By contrast, TUI's 1Y3Y is relatively flat, despite having no debt due in 2007 but almost 40% of its debt maturing in less than two years. Discrepancies between debt distribution and curve shape that cannot be justified by other factors or credit stories may signal attractive trading opportunities.

The earlier, the flatter
Intuitively speaking, it seems reasonable that issuers with mostly long-term debt outstanding should have a steep CDS curve, while companies with mostly short-term debt should have a flatter curve. In order to test this hypothesis, we have run several cross-sectional regressions between the debt repayment schedule of the single iTraxx Crossover companies and their respective CDS curves' steepness.

Charts 3 and 4 plot the Crossover constituents' steepness of the short end of the CDS curve against the percentage of total debt (bonds and loans) due within five years, and between five and ten years, respectively. We have used a "relative" definition of steepness (spread difference divided by the 5Y spread) to filter out the effect of absolute levels on steepness. The scatter plot looks dispersed, but this simply reflects the idiosyncratic nature of single-name curves. In fact, the regression lines exhibit a definite slope and their coefficients are statistically significant (t-stats are -2.5 and 2.7 for charts 3 and 4, respectively).

To further verify these results, we grouped the fifty Crossover constituents in quintile baskets, sorting them by 5Y spread, and ran the regressions using baskets' averages. Not only has this greatly reduced the influence of single-name idiosyncrasy, it has also let us use the (more intuitive) absolute steepness as a dependent variable, rather than the relative one.

The results shown in charts 5 and 6 corroborate our thesis and show a distinct (and statistically significant) relationship between steepness and debt distribution. (T-stats for the coefficient are -3.1 and 3.9 for chart 5 and 6, respectively). Grouping companies in baskets has eliminated most of the individual-name variance from the regression and, in this set-up, the debt repayment schedule explains about 80% of the variance in the baskets' steepness.

Aside from debt repayment schedule, there are other factors that are used typically to explain the steepness of the CDS curve. The most commonly acknowledged by those who are familiar with Merton-like structural models of credit is asset volatility. The problem with asset vol is that it is not observable, so equity vol is often used as a proxy – the higher the vol, the steeper the curve. Within the Crossover index, however, it is difficult to test how much explanatory power this variable would have: several companies are private and do not have traded equity, and most of them do not have traded options from which to back out implied equity volatility.

Another measure that we thought could contribute to explain the slope of the curve is earnings momentum. In order to assess whether firms with improving earnings have flatter curves, we have regressed steepness against EBITDA growth. Our analysis showed that the relationship is weak, and the regression coefficient is not statistically different from zero.

In conclusion, all our findings seem to confirm the intuition that there exists a relationship between the steepness of the CDS curve and the time distribution of debt maturity: the more front-loaded the repayment schedule is, the flatter the CDS curve. If the debt distribution/CDS steepness relationship breaks down by a significant amount for a given company (either over time, or relative to comparable firms) a trading opportunity might emerge – as long as the anomaly is not justified by a specific credit story.

(All charts shown in this article focus on the 1Y3Y steepness, as this is the most sensitive section of the curve; however, all conclusions apply to 3Y5Y and 5Y10Y as well.)

A bearish flattening may be on the way
Apart from being useful to take a view on the steepness on individual companies' curves based on their debt repayment schedule, can our findings help predict what the Crossover index curve will do in the future?

Going back to chart 1, it looks clear that although the aggregate refinancing schedule for Crossover does not look like a major threat today (only €44bn of debt is due between now and the end of 2009) it will become increasingly worrying over time, when the big bulk of debt due between 2010 and 2014 (€153bn, more than twice as much the amount due over the next three years, on average) will approach maturity.

What are the implications for the Crossover curve? Assuming that the refinancing pattern that Crossover companies have followed recently does not change dramatically, the debt distribution is likely to turn from something similar to the top-left picture of chart 2 to something like the bottom-left picture, more front-loaded. As a result, all else being equal, the Crossover curve could follow a bearish flattening trend, with the short-end of the curve underperforming the long-end.

From a fundamental standpoint, this makes sense. Over the past 2-3 years, we have seen exactly the opposite trend in the index, as companies have reduced the overall amount of debt on their balance sheets. This deleveraging has reduced the risk of an immediate default and as a result the 5Y maturity has outperformed the 10Y (see chart 7).

When companies started gearing up again, the increased risk has been reflected mainly in the 10Y because the additional debt issued, falling due several years in the future, did not materially increase the likelihood of defaults in the short run. The result of all this has been a steady increase in Crossover steepness.

As larger and larger amounts of debt finally approach maturity, the so-far unchallenged steepening trend experienced by Crossover may come to an end. As chart 8 shows, the 5Y10Y spread continued its unabated rise despite the recent market correction, but the 10Y/5Y ratio seems to have topped up, and has come down significantly over the past 2-3 weeks.

The widening we have seen in the index, and the resulting correction in the 10Y5Y ratio, has had strong technical motivations – Crossover being the only instrument, together with LevX, available to investors and banks to hedge the loans pipeline as well as deteriorating CDO/CLO positions – but we believe that the perception of short term risk is beginning to be priced in the spreads.

© 2007 BNP Paribas. All rights reserved. This Research Note was first published by BNP Paribas in two parts within its Credit Driver publication on 6 July 2007 and 13 July 2007.