Contents

CDR Liquid Index data as at 28 August 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.

Constant proportion flurry

Several deals brought to market

The past week has seen a flurry of CPDO and CPPI deals brought to market as issuers took advantage of wider spread levels. At the same time, one CPDO was closed out.

The emergence of these new transactions made sense to one structured credit strategist. "It's the right time for them, with spreads much wider than they were. Furthermore, these structures can only benefit from next month's index roll, which will see the removal of some highly sub-prime sensitive names such as Countrywide," he says.

Indeed, ABN AMRO has brought its latest SURF CPDO deal, with notes issued by Castle Finance I Limited under Series 12. The triple-A rated (by Moody's) paper offers a coupon of 100bp over Euribor.

In the transaction, the notes are exposed to a leveraged portfolio of 250 corporate names. The portfolio is comprised of the on-the-run 5-year iTraxx Europe Index Series and the on-the-run DJ CDX.IG 5-year Index Series, with each of the indices representing 50% of the total portfolio notional.

The portfolio size is dynamically adjusted following rules defined in the documentation: the current portfolio size is adjusted to equal the target portfolio size, subject to a maximum leverage constraint. This maximum constraint can change throughout the life of the transaction, depending on the portfolio spread level.

Additionally, UBS has arranged US$200m of M.A.V.E.N notes due 2017, which offer a coupon of 100bp over Libor. While not officially dubbed a CPDO in Moody's rating information, the notes exhibit similar cash-in and cash-out mechanisms to such a vehicle.

M.A.V.E.N notes reference a long-short portfolio of CDS on credit indices and single name entities managed by BlackRock Financial Management. The initial reference portfolio is comprised of a long CDS exposure referencing the on-the-run main iTraxx Europe and DJ CDX North America indices, and a short CDS exposure referencing the HiVol subsets of those indices.

Moreover the reference portfolio notional amount and the ratio between long and short exposures will be dynamically adjusted according to an algorithmic formula. BlackRock will manage this formula. In addition to the criteria on the portfolio profile being fulfilled, a portfolio change is allowed only if it passes a model test based on Moody's publicly released CDOROM model completed by an add-on.

At the same time, Moody's has withdrawn its ratings on the various series of UBS's TYGER CPDO notes, which primarily referenced financials. "This action was taken due to the purchase of the notes at par by the issuer as per the terms and conditions of the notes," the agency explains. The move follows Moody's putting the notes on review for downgrade as a result of recent spread widening on financial names underlying this CPDO, negatively impacting the NAV of the deal (SCI issue 52).

Meanwhile, Credit Suisse is marketing a number of CPPI notes all issued through its Magnolia Finance VI vehicle. US dollar- and euro-denominated notes dubbed Alpaca are managed by Prudential M&G, while the euro-denominated Credit Pill notes are managed by Principal Global Investors. Both series mature in 2018 and are rated Aa3 by Moody's.

In each case the notes apply the CPPI technique on a managed portfolio of credit exposures, offering full principal protection at maturity (provided by Credit Suisse International) and providing returns (in the form of deferrable coupons and a potential upside at maturity) based on the performance of the reference portfolio. The reference portfolios are comprised of long and short CDS exposures referencing mainly corporates.

The managers will change the composition of the portfolios through time. The maturities of the CDS in which the managers can invest are restricted by the documentation and will evolve depending on the weighted average spread of the portfolio.

MP

Euro CLOs show stability

Structures compare favourably with other structured credit products

Research published by the structured credit strategy team at Royal Bank of Scotland examines the structural aspects of European CLOs. In particular, it looks at how CLOs compare with other types of European cash and synthetic CDOs, in terms of rating migration of their tranches over the past 7 years, and finds that they do so favourably.

"The relatively better performance of European CLOs, in terms of rating stability, is a direct consequence of the very low historical default rate experienced by Euro CLO collateral. However, we have found that under certain specific modelling assumptions, Euro CLO tranches could withstand default scenarios much more extreme than the historical before being affected, either in terms of loss of yield and principal erosion," says Siobhan Pettit, head of structured credit strategy at RBS.

The RBS research explains that according to S&P data, over the 2000-07 period, there has never been a negative rating action on Euro CLOs tranches. This outcome becomes even more compelling if compared with the rating behaviour of other European CDO tranches: on average, around 11% of synthetic CDO tranches and 3% of cash CDO tranches have experienced some kind of negative rating action over the same period. Furthermore, since the beginning of 2007, 10 tranches of Euro CLOs, belonging to three different deals, have been upgraded.

A look at the CLO collateral default pattern, over the same period and for the same CLO universe, explains the rating stability: to date, only 8 deals have experienced minor collateral defaults, out of 156 rated by S&P. In Euro CLO collateral aggregate terms, that is equal to 0.03% of total collateral outstanding (€19m out of €70bn outstanding for the 156 Euro CLOs).

RBS then constructs a set of modelling assumptions with regard to the main factors that affect the performance of a CLO over the course of its life. The assumptions are hypothetical but, RBS believes, representative of a typical EU CLO deal and in line with recent market developments. The research then uses these assumptions to carry out a break-even analysis, showing the percentage of loan collateral that needs to default before the CLO tranches yield or principal start being hit.

The outcome of that analysis is also positive for the Euro CLO asset class. For example, the research says: "Given our assumptions and a credit support in the range of [31-33] %, the triple-A tranche can withstand up to 80% evenly-spread, cumulative defaults over the course of its life, before its stated yield and principal starts being affected."

Looking forward the picture may not be so rosy given that the 2005-2007 Euro loans generation has seen a general decline in credit quality. RBS says that according to S&P LCD average total debt leverage is at 5.9x, year-to-date from 4.5x in 2006. S&P also reports that overage ratios have been thinning and covenant headroom has been progressively increased, weakening the investors' early warning system.

Furthermore, Pettit says: "The private nature of the European leveraged loan market and its short history makes it difficult to be precise about future patterns, but this is certainly another strong argument in favour of manager tiering – under the present circumstances, the capacity to source the right collateral is paramount."

MP

Permacap values

Carador reveals valuation methodology

Washington Square Investment Management's permanent capital vehicle Carador plc published an interim management statement yesterday, 28 August, relating to the period from 1 April 2007 to date of publication. The statement was prepared solely to provide information to meet the requirements of the Irish Transparency Regulations, but offered an insight into how the vehicle has been coping with recent market illiquidity.

The manager's review observes: "The lack of liquidity in the market in July 2007 has created significant difficulties in valuing structured finance portfolios, with many funds stopping issuing valuations and restricting redemptions. The structure of Carador, with no leverage and a closed-ended listed format, has proven to be correct for the asset class. The fund has kept a constant dialogue with the board and pricing committee in order to implement a transparent pricing policy which adequately reflects the net asset value."

The statement goes on to cover material events and says that in July 2007, the manager referred 13 investments to its pricing committee which the manager considered incorrectly priced by the price providers for the July NAV calculation. The pricing committee convened on 16 August 2007 and decided that a pricing methodology based on fundamental analysis and internal models should be the primary criterion for investment decisions and position taking.

However, internal models are not appropriate for the purpose of NAV valuation, as these do not necessarily capture the degree of risk aversion shared by market participants. "Bank counterparties are currently the sole source of market prices. At the moment, there are no independent third-party providers of pricing services from the market area of cash CDOs. We are thus required to rely solely on counterparty quotes," the statement explains.

By providing quotes, counterparties expose themselves to the risk that investors will follow up and ask to firm up the bid as they intend to sell. Because of this, quotes are to be assumed to be biased toward the bid. In ordinary market conditions, the bid-offer spread is small and the effect is negligible, but currently the reverse is true.

The pricing committee expressed the view that a correct valuation methodology for the NAV should adequately reflect the value of the option of waiting and holding on to assets, even if their bid-offer spread is momentarily substantial. It was decided that this option is currently particularly valuable, confers robustness to the fund and its worth should be recognised fairly.

Therefore the committee proposed that in the case of the 13 investments an arithmetic average between the price provided by market counterparties and the valuation obtained using Washington Square's audited internal models should be used for the NAV calculation.

The statement also reveals that, during the period it covers, Carador sold one investment. The company purchased US$2m notional of ACA ABS 2006-02 on 29 November 2006 at a price of 77% of its nominal value and liquidated the position on 23 May 2007 at a price of 30% of its nominal value. During the holding period, Carador received US$32,104 worth of interest.

Following the publication of the statement, Carador separately announced its unaudited NAV per share as at the close of business on 31 July 2007 was €0.9106. This represents an NAV decrease of 3.61% in July.

MP

SIVs sell assets

Investment vehicles at or close to enforcement action triggers

Losses at Cheyne Finance, a SIV managed by Cheyne Capital Management, triggered an enforcement event yesterday, 28 August. Meanwhile, IKB Credit Asset Management's Rhinebridge plc has warned that it could go the same way.

Cheyne Capital Management reports that mark-to-market losses in the investment portfolio of Cheyne Finance have caused a breach of the vehicle's major capital loss test and therefore triggered an enforcement event. The manager says that the current position of the company is as follows: "We have drawn down on all three of our liquidity facilities; we have sufficient cash, proceeds from liquidity facilities, breakable deposits and money market funds to pay scheduled liabilities through November 2007; and we continue to try to work on a re-capitalisation or restructuring and to extend debt maturities."

Looking ahead, Cheyne says: "Market conditions remain difficult, with asset prices continuing to be marked lower. We have been actively selling assets and reducing the size of the portfolio, and have raised sufficient cash to cover projected liabilities for the next few months. We are today [28 August] entering into the defeasance process, whereby we will continue to sell assets to meet our liabilities as they come due. We hope to agree with various debt-holders or financial firms on a re-capitalisation to extend the maturity of our debt."

As a result, S&P has lowered and placed on credit watch with negative implications its credit ratings on the CP and medium-term notes issued by Cheyne Finance. At the same time, the issuer credit ratings on Cheyne were lowered and placed on credit watch negative. Meanwhile, Moody's has placed its ratings of Cheyne Finance's capital notes on review for possible downgrade.

Earlier in the week Rhinebridge sold US$176m of assets in order to manage its overall liquidity position. In a statement, its manager explains the current position of the company is that at present, it meets all tests required by the rating agencies; it has not drawn liquidity facilities and, while there has been difficulty in raising CP, the SIV has had support up until now from IKB.

However, the company warns that further liquidity support from IKB and its owners cannot be expected at this stage. Consequently, the outlook for Rhinebridge is far from positive.

"Following developments in the conduit and SIV-lite market, asset prices continue to weaken based on the fact that there are mainly sellers, in many cases, forced sellers. As we have to de-lever the portfolio, our ability to avoid test breaches becomes more limited, especially if there is no funding available to Rhinebridge. This could lead, in rapid steps, to an enforcement event. An enforcement manager will then be put in place," it says.

Meanwhile, S&P says that it expects no adverse rating actions on European or US asset-backed commercial paper (ABCP) conduits solely as a result of its recent rating actions on various SIV-lite notes (SCI issue 52). Despite reduced liquidity in the ABCP market coupled with evident stress from the volatility and uncertainty surrounding the pricing on US residential mortgage assets, the agency continues to believe that the structural characteristics of the US and European ABCP conduits – including the level and availability of credit and liquidity – are sufficient to support the ratings on the CP notes.

MP

Deriving value

Fabiana Gambarota, chief investment officer at P&G Alternative Investments, answers SCI's questions

Fabiana Gambarota

Q: When, how and why did you and your firm become involved in the structured credit markets?
A: P&G Alternative investments was incorporated in 2004 as a specialised player in asset-backed securities. However, the P&G team has been involved in the structured credit market as a unit since 2001 when we worked together at Meliorbanca.

Within Meliorbanca we launched a long only fund investing exclusively in ABS in 2001 and a European mezz ABS CDO in 2002. Both of these vehicles are still managed by the same people now at P&G.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The development of the CDS market on one side combined with the evolution of tranching and packaging techniques on the other has been overall a highly significant event. Both of these phenomena have allowed credit risk to be transferred across different players with different risk appetites. The consequent broadening and increase in the structured credit market investor base has meant that these developments are one of the major causes of the huge spread compression that has affected the credit market in recent years.

Q: How has this affected your business?
A: Being a structured credit player we have contributed to these developments. Equally, we have been a beneficiary of them – as a pioneer in the ABS CDO market they helped us to launch our first deal in 2002. In addition, we are strong believers that the CDS market will play a crucial role in the development of the CDO market in the ABS environment.

Q: What are your key areas of focus today?
A: Our primary focus is broadly similar to that when we started in 2001. Namely: European ABS mezzanine securities where the underlying risk is fragmented across a large number of debtors (mainly consumer or prime residential paper).

These days the market is offering tremendous opportunities given what we believe is a temporary lack of liquidity. Widening in spreads and large market dislocation are providing very interesting potential both in terms of relative value between asset classes as well as in bond picking.

Q: What is your strategy going forward?
A: We intend to exploit the opportunities offered by the ABS CDS market in our CDO management activities. CDS allow for long/short strategies to be implemented and this can be of value in an environment of increasing volatility in structured finance spreads. Furthermore, CDS can provide a pick up in spread relative to the cash market and they make the ramp up process much easier for European CDO of ABS.

Q: What major developments do you need/expect from the market in the future?
A: We expect an increasing role to be played by CDS on ABS in the European structured credit market and the development of tranches on the ABS indices. We also expect that new CDO collateral types will develop, such as hedge funds (CFOs), which we envisage will offer good value in relation to other collateral widely employed in recent years.

About P&G Alternative Investments
• P&G was created by a senior team of professionals with long market experience in order to provide asset management services in the alternative investment space to institutional investors.
• P&G is fully owned by its management team and is an independent player operating in a total alignment of interest with its investors.
• The company was authorised (March 2005) to operate as an asset manager under Italian Law.
• P&G is the investment manager of P&G Low Volatility Fund, P&G ABS Fund, P&G Selection Fund, Zoo ABS II, Zoo HF III and Zoo ABS IV. The first CDO of ABS launched by the ABS team, Zoo ABS I, paid off in April 2007 and delivered an IRR to the equity tranche of 15.28%.
• Company's AUM are approximately €1bn.

ABS correlation trader hired

The latest company and people moves

ABS correlation trader hired
Chris Carman, who latterly ran ABS correlation trading at Citi, is believed to have left to join Barclays Capital. The bank declined to comment.

Trader swaps
Martin Lawrence, formerly a credit trader at West LB, is understood to have joined Commerzbank in a similar role. Officials at Commerz declined to comment.

Senior exits
Edward Cahill, head of the European CDO division at Barclays Capital, and his second in command John-Paul Parker are understood to have resigned last week. Both were closely involved with the bank's SIV-lite business.

US bank cuts back
RBS Greenwich Capital has cut back head count within its CDO group. "We have resized our CDO business to meet market demand. We intend to continue to be an active player in the CDO market going forward and are confident that we have the necessary resources and team in place to meet future demand," says Fred Matera, md and head of CDOs for RBS Greenwich Capital.

The bank did not confirm details, but it is thought that around ten staff - including traders, structurers and marketers - have left.

Bear appoints Europe head
Yves Leysen has been appointed head of fixed income for Bear Stearns in Europe, having previously been co-head alongside John Moore. With Moore moving to his new role as ceo of Asia, Leysen has taken on sole responsibility for the management of Bear Stearns' fixed income business.

Leysen has been with Bear Stearns for six and a half years, building up the firm's businesses in mortgages, securitisation and distressed debt, among others.

Lehman shuts BNC
Lehman Brothers has announced that market conditions have necessitated a substantial reduction in its resources and capacity in the sub-prime space. As a result, the firm is closing its BNC Mortgage subsidiary. The firm continues to originate mortgages in the US through its Aurora Loan Services platform.

The closure affects approximately 1,200 employees in 23 US locations. In connection with the closure, the firm will record all related after-tax charges, including severance, real estate and technology costs, of approximately US$25m, and a 100% after-tax goodwill write-down of approximately US$27m.

MP

Listed fund seeks liquidity

A round up of this week's structured credit news

Listed fund seeks liquidity
Carlyle Group's permacap vehicle Carlyle Capital Corporation (CCC) listed on the Irish Stock Exchange has announced that it has taken several steps to create additional liquidity in the event of continued market volatility. The Company sold certain assets and has strengthened its credit lines with its repurchase agreement counterparties.

John Stomber, ceo of CCC, says: "This additional liquidity will help us better weather the market conditions we are facing. We have determined that it is in the best interest of our investors to maximize our liquidity by selling certain assets, following careful consideration with our Investment Committee and Board of Directors. We intend to keep our high quality AAA‐rated US agency mortgage backed securities issued by Fannie Mae or Freddie Mac, representing approximately 95% of our assets, and benefit from their substantial inherent value, but have sold certain non‐mortgage backed investments to help sustain a suitable liquidity position."

CCC says that to provide additional liquidity, it has taken the following actions: sold its interests in four CLOs sponsored by the Carlyle Group at CCC's cost to certain affiliates of the Carlyle Group; sold its interests in mezzanine debt securities at CCC's cost to certain affiliates of the Carlyle Group; sold a substantial portion of its bank loans at or above CCC's book value; CCC was released from its commitment to fund US$75m to one of the Carlyle Group's distressed debt investment funds; and CCC has affirmed with certain of its lenders collateral levels that reflect the high quality of its triple-A rated US agency issued floating rate capped mortgage backed securities.

The asset sales total approximately US$900m, or less than 5% of total assets, and will provide between approximately US$140m and US$150m after meeting all CCC's obligations for the associated debt. CCC estimates a realised loss from asset sales of between approximately US$30m and US$40m. This loss will be partially offset by net interest income, but will result in a loss for the third quarter.

"Given the expectation of a net loss in the third quarter, it is unlikely the Company will pay a dividend for the third quarter of 2007, as the Board believes the Company should focus on preserving capital and rebuilding its liquidity cushion," CCC says.

Index rules amended
The International Index Company has published revised rules for the European iTraxx indices with effect from the next series. Notably, in future, financial entities will be eligible for the iTraxx Crossover index.

In addition, the minimum public debt rule for the index has been further specified, as follows: "Only entities with more than €100m publicly traded securities at close of business five business days before the roll date in a currency that is deliverable into a European CDS contract will be included. For new issues of the relevant entities, the settlement date of the issue will be considered. Private placements will not be considered."

European corporate quality damaged
The percentage of speculative-grade ratings in Europe increased to a record high of 18% at the end of the second quarter of 2007 from 8% in 1997, according to a report published by S&P. In recent years, a highly favourable cost of borrowing and rising risk appetite among investors has changed the leverage profile of rated European entities. Continuing changes in corporate risk orientation and greater comfort among asset managers towards risk indicate that this downward shift is not likely to reverse.

S&P says that the advent of private-equity sponsors in the past three years has changed the landscape for European ratings and introduced new complexities, particularly for non-financials. In contrast with the U.S., sponsor-led activity provides the predominant source of deals in the European leveraged markets.

Appeal applauded
Three industry trade associations have applauded Monday's decision by Judge Shira A. Scheindlin of the US District Court for the Southern District of New York in Springfield Associates v. Enron Corp. Her decision reverses a Bankruptcy Court decision that threatened to disrupt the robust secondary market in claims against companies in bankruptcy, the associations say.

The case arose out of Springfield's secondary market purchase of US$5m of Enron bank debt originally held by Citibank. Enron brought an adversary proceeding against Springfield seeking to equitably subordinate its claim based solely on Citibank's alleged inequitable conduct and receipt of avoidable transfers. There is no allegation that Springfield itself engaged in any improper conduct or received any avoidable transfer.

The Enron bankruptcy court accepted Enron's argument, issuing a decision holding that improper conduct or receipt of an avoidable transfer by a prior holder of a claim taints the claim itself, rendering it worthless in the hands of a subsequent--and a wholly innocent--purchaser.

The negative and dramatic adverse market implications of the bankruptcy court's decision were called to Judge Scheindlin's attention, on appeal, by a joint amicus submission by the Loan Syndications and Trading Association, the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association.

Monday's decision by Judge Scheindlin vacates the bankruptcy court's decision. Judge Scheindlin's opinion describes the bankruptcy court's opinion as "overreaching," and notes that it "resulted in (an) outcry from commentators and amici curiae, who have expressed great concern that (the decision) will wreak havoc in the markets for distressed debt." Her opinion makes clear that equitable subordination and disallowance are "personal disabilities" that do not transfer with claims when they are sold. She therefore holds that the purchasers of claims "are protected from being subject to the personal disabilities of their sellers.

Judge Scheindlin's decision does draw a distinction between sales and "pure assignments" (such as when a surety that pays a claim is subrogated by operation of law to the rights of the original obligee), finding that a transferee that acquires a claim by "pure assignment" may take it subject to the personal disabilities of the original transferor. Her opinion makes clear, however, that "sales of claims on the open markets are indisputably sales" such that "(e)quitable subordination and disallowance arising out of the conduct of the (transferor) will not be applied to good faith open market purchasers of claims."

EM able to ride out crunch
A new report from Fitch Ratings says that emerging market sovereigns are, by and large, well placed to ride out the disruption in global credit markets in the near-term without any impairment to sovereign credit quality, thanks to healthy buffers of external liquidity. The agency explains that though EM asset prices have fallen sharply, Fitch judges that EM sovereign credit fundamentals are sufficiently robust to withstand the current volatility in global financial markets.

With the switch to local capital markets for fiscal funding and healthier sovereign external balance sheets, Fitch estimates that EM sovereigns only need to raise a further US$7bn from international capital markets over the remainder of 2007. This additional borrowing will be from emerging Europe, including Turkey, where external liquidity pressures are more significant than elsewhere.

Private sector (including quasi-sovereign) external debt maturing over the next 17 months is estimated to total US$380bn (compared to just US$43bn for sovereigns), much of which has been borrowed by entities with ratings lower than their sovereign.

With international reserve assets exceeding US$3.2tr (US$2.1tr excluding China), EM central banks are well-placed to supply foreign currency in the event that EM private sector borrowers face a sustained lock-out from international capital markets.

Record flows of capital into emerging market economies in recent years – gross financial market flows to EM exceeded US$480bn in 2006 – suggest potential for substantial outflows of capital that would pressure local financial markets and currencies if the 'flight to safety' were to intensify.

In the current environment, there is even greater onus on policymakers in emerging markets to ensure they respond in a timely and appropriate manner as events unfold. While exchange rate flexibility and reserve cover may have given policy makers more latitude than in previous crisis periods, greater foreign participation in local asset markets has raised the premium on effective monetary policy management.

Distress ratio spikes
The US distress ratio experienced its largest monthly increase since February 2003, according to an article published by S&P. The agency says that after five straight months at less than 1%, the distress ratio increased to 2.9% in August from 0.9% in July. Distressed credits are defined as speculative-grade rated issues that have option-adjusted spreads of more than 1,000bp relative to Treasuries.

S&P explains that the current bout of market volatility affected all basis-point thresholds, triggering visible re-pricing of spreads; the speculative-grade bond spread moved up 104bp to 427 since July's report. The total number of rated companies with issues trading at distressed levels rose to 148, up markedly from 57 a month earlier.

"Distress in the US leveraged loan market also rose, but was less affected than corporates," notes Diane Vazza, head of S&P's global fixed income research group. At the end of July (the latest data available), the share of performing loans trading at prices of less than 80 cents on the dollar increased to 0.63%, the highest level since November 2005.

In the US, the consumer products, retail/restaurants and finance company sectors displayed the highest distress rates as a share of total speculative-grade rated issues, each recording ratios in excess of 4%. Despite widespread increases in distressed issues, four sectors (notably health care) had fewer issues trading at distressed levels.

CDO issuance up 75%
The European Securitisation Forum has released its half-year issuance report and finds that half-year European securitisation volume surged to €280.6bn – an increase of nearly 70% on €168bn issued the same period a year ago. RMBS accounted for 56.9% of total issuance in the first half of this year; and CDO issuance was the second highest ranking product sector, contributing €53.9bbn – an increase of nearly 75% on the amount issued in the first half of 2006.

Leveraged loan CDOs stable
The performance of CDOs of leveraged loans was stable in the second quarter, with no new defaults recorded in this period, according to S&P's latest periodical for that sector (see also this week's news story on the subject). During the second quarter, no rating actions were taken by the agency on any of the CLO transactions currently outstanding. Notably, ten tranches of European CLOs spread across three transactions were upgraded in July 2007, and none were downgraded.

CLO funding costs rose between April and June, with stated spreads on double-B rated mezzanine notes moving out by as much as 55bp, reflecting increasing caution among structured finance investors. By contrast, new issue leveraged loan spreads continued to tighten in the quarter, loan structures became increasingly aggressive, and covenants tended to loosen as demand for paper from institutional investors outstripped supply.

Risk aversion overdone?
A new report published by S&P examines various aspects of the current liquidity squeeze.

"For at least two years, Standard & Poor's Ratings Services has argued that investors were too complacent about risk. Now, they are over-reacting in the opposite direction. How much and how far they'll over-react remains to be seen. History suggests that the credit markets will normalise fairly quickly, but that could still be months away," says David Wyss, md and chief economist at the agency.

"Liquidity will re-emerge when the repricing of risk actually reaches a new level," adds Jean-Michel Six, S&P's chief economist for Europe.

The report notes that "issuance in the US has fallen off a cliff" and, although both high-quality and high-yield offerings have felt the chill in the markets, speculative-grade issuance that S&P rates has nearly frozen. Investment-grade offerings, while also lower, have fared comparatively better.

"The market will still consider more conventional, soundly structured deals at higher rates," the agency says.

S&P addresses misconceptions
S&P has published an article that aims to clarify some of what it believes are the misconceptions that surround the rating of structured finance securities, and responds to many of the questions that have been raised about the rating process.

"By directly addressing the primary concerns that have been raised, we hope to provide insight into the role of the rating agencies and our processes," says Ian Bell, md and head of European structured finance at S&P. "The article we have published responds to these concerns by addressing in some detail such topics as our interaction with issuers in our rating process, our fee structure, our ability to rate complex new structures, the meaning of our ratings, and the transparency of our methodologies."

MP

Trading ideas - Labor Day (bond) sale

John Hunt, research analyst at Credit Derivatives Research, looks at a negative basis trade referencing Macy's

Macy's, Inc has been the subject of LBO rumours and ranks in the top 5% of firms according to CDR's fundamental LBO score. The market seems to be discounting LBO risk at the moment, as evidenced in the case of Macy's by a major decline in stock prices and CDS spreads since the height of LBO rumours in July.

Perhaps there is good reason for the view that big LBOs are unlikely in the short term – the 18% price reduction for the sale of Home Depot's wholesale supply unit to a group of LBO investors is the latest piece of news supporting that position – but we don't think LBO risk is gone for good. Given the market's rapidly changing perceptions, now is a good time to look for "bargain" LBO protection.

The Macy's Retail Holdings Inc. 5.9s of December 2016 offer just such a bargain. The bond includes a change-of-control put at 101 that could protect investors from credit decline in the event of an LBO or merger, and the bond-CDS basis went to high positive levels (200+bp) when the LBO rumours were at their height. The basis has declined dramatically since then, and in fact the bond price would now be cheap to CDS-implied fair value even without the change-of-control put. We believe that this situation presents a buying opportunity for the change-of-control bonds.

Basis trade basics
The underlying idea of the negative basis trade is that credit risk is overpriced in the bond market relative to the CDS market. The investor buys a risky bond – and thus is paid to take credit risk on the issuer – while paying for credit risk in the CDS market by buying protection on the issuer. Eventually, the prices for credit risk in the two markets should converge, resulting in an arbitrage-like profit. In the interim, the investor should earn positive carry, because the credit spread that is collected in the credit market is greater than the spread that is paid in the CDS market.

The credit risk implied by market prices in the CDS market can be inferred in a fairly straightforward fashion from the CDS spread curve, as discussed in the Trading Techniques section of the CDR Website. The price of credit risk in the bond market is sometimes measured by the z-spread – the amount that must be added to the risk-free curve to cause the discounted present value of the bond's promised cash flows to equal the bond's current price.

A "quick and dirty" comparison of how the bond and CDS markets are pricing a bond's credit risk can be done by simply looking at a bond's z-spread and the CDS spread for an instrument of matching maturity. In fact, the "basis" is defined for our purposes as the CDS spread minus the bond z-spread.

While the z-spread often is a good measure of how the market prices a bond's credit risk, the z-spread approach implicitly makes the incorrect assumption that all the bond's promised cash flows definitely will be received, and received on time.

The z-spread is not a good measure of credit risk price when bonds are trading at or near distressed levels and/or are trading away from par. For that reason, we prefer to extract the probabilities of default implicit in CDS spreads and use those probabilities to arrive at a CDS-implied bond price. If the bond trades in the market below the CDS-implied price, we say it is "cheap" compared to its CDS-implied market value. If the bond is trading above CDS-implied price, we say it is "rich."

Because bond and CDS maturities usually do not match exactly, interpolation is usually required to perform the comparison. The details of this computation are explained in the Trading Techniques section of the CDR website. We then compare the market price of the bond to the CDS-implied bond price to determine whether the bond is trading rich or cheap to the CDS-implied level.

Constructing the negative basis trade position
We generally construct negative basis trades so that they are default-neutral – that is, so that the CDS fully hedges against bond losses in the event of default. This ensures that we are selling the same amount of default risk in the bond market as we are buying in the CDS market. In doing so, we take account of the fact that the CDS payoff in default is defined relative to the notional amount, while the loss on a bond in default depends on its pre-default price.

Thus, a CDS and a bond with the same notional amount will pay off different amounts in default if the bond is trading away from par. For example, consider a bond and a CDS each with US$100 notional. If the bond is trading at US$110 and recovery value in default is US$40, the bondholder will lose US$70 in default and the CDS protection buyer will gain only US$60, so the investor will have to buy more than US$100 in CDS protection to hedge against default. If the bond is trading at US$90, then the bondholder will lose only US$50 and the CDS protection buyer will gain the same US$60, so less than US$100 notional of CDS protection would hedge against default.

Given that bonds pull to par over their life if they do not default, we typically construct our positions so that the CDS hedges a bond price halfway between the current market price and par, although we may adjust the hedge amount upward or downward if we maintain a bearish or bullish fundamental view on the credit.

Another consideration in constructing the position is that a liquid CDS usually will not be available in an interpolated tenor that matches the maturity of the corporate bond. We construct the trade using a CDS of the closest available liquid tenor. Because CDS premiums vary with tenor (generally, longer-dated CDS have higher spreads), the mismatch between CDS and bond maturity will affect trade characteristics such as carry and roll down. We generally recommend only trades that have positive carry.

We also present a simple duration-matched position in a government bond to hedge interest rate risk. This risk could also be hedged with an interest rate swap, but we understand that government bonds are the most useful hedging instrument for most investors. We understand that most investors will prefer to hedge interest-rate risk at the portfolio level in any event.

Our strategy for both the CDS and the Treasury hedge is strongly influenced by a desire for simplicity. Perfect hedging would require adjustment of the CDS and Treasury positions over the life of the trade. We are happy to discuss such strategies with clients, and we also provide a set of sensitivities to help clients implement more sophisticated hedging strategies.

Trade specifics

Bond cheapness
Based on our valuation approach, the Macy's Retail Holdings Inc. 5.9 of December 2016 bond is trading cheap to fair value. Exhibit 1 presents the price-based term structure of the company's bonds and indicates that the December 2016 bond is trading cheap to fair value, even without taking its put feature into account.

Exhibit 1

Exhibit 2 compares the bond z-spreads with the CDS term structure, and shows that the recommended bond is indeed trading wide of the closest-maturity CDS. 

Exhibit 2

Exhibit 3 illustrates the z-spread and CDS levels basis between the 10-year on-the-run CDS and the bond over the past year. The basis generally has been positive, and increased dramatically when Macy's was the subject of LBO rumours earlier this year. Since then, the basis has decreased, and today the basis is negative. Because the change-of-control put constrains the bond credit spread and not the CDS spread, we would expect the basis to increase significantly in the event of further LBO or merger rumours.

Exhibit 3

Risk
The position is default-neutral. There is a slight maturity mismatch because the bond matures on December 1, 2016 and the CDS expires on September 20, 2017, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

As with any bond-CDS basis trade, investors should ensure that the bond is a deliverable obligation for the CDS.

We provide a suggested simple, duration-matched Treasury position to hedge interest rate risk.

The trade has positive carry given current levels, and this carry should cushion the investor from short-term mark-to-market losses.

In its default-neutral construction, the trade is slightly long the firm's credit – the position loses approximately 0.1bp of notional per 1bp of parallel curve widening, using the linear DV01 approximation. Although Gimme Credit maintains a "Deteriorating" fundamental credit score on Macy's, Inc, the amount by which the position is long credit is not enough to concern us, especially because it is somewhat likely that any credit deterioration would relate to a merger or LBO – a result that we believe is likely to benefit the position.

Exhibit 4

Execution risk is a factor in any trade; this risk is discussed in more detail in the Liquidity section below.

Liquidity
Liquidity – i.e., the ability to transact effectively across the bid-offer spread – is a major driver of any longer-dated transaction. Our data on liquidity, created from the volume of bids, offers, and trades we see each day, provide us with significant comfort in both the ability to enter the trade and the bid-offer spread costs.

CDS liquidity for maturities other than five years is a challenge in the current market environment, and Macy's is no exception. However, market information we have received supports our view that the trade can be executed at the recommended level.

The Macy's December 2016 bond has shown high average daily volume in the recent past: US$7.8m for the past 15 days to 27 August, US$3.5m for the past 30 days to 27 August and is a fairly large issue (US$1.1bn). Our market information suggests that the transaction can be accomplished at the recommended level.

Fundamentals
As explained, our negative basis trades are based on the assumption that the bond is mispriced relative to the CDS. They are not premised on an expectation of general curve movements. While the trade is technical in nature and not necessarily affected by fundamentals, we review the firm's fundamentals briefly.

Carol Levenson, Gimme Credit's Retail expert, maintains a "Deteriorating" fundamental score on Macy's. Carol points to the company's continuing expenses for integrating the May department store chain and an uncertain environment for mid-level department stores more generally. Carol also views shareholder pressure for speedy stock buybacks or other bondholder-unfriendly action as a cause for concern.

Summary and trade recommendation
We recommend a negative basis trade on a bond with a change-of-control put at US$101 issued by Macy's, which has been viewed as a strong candidate for an LBO. Although the market seems to view LBOs as generally unlikely at the moment, Macy's fundamentals-based LBO score is in the top 5% of our universe, and we do not view LBO risk as having been permanently banished.

If LBOs do come back, bondholders will be happy for the protection offered by the change-of-control put at US$101, and we would expect a major shift toward the positive in the bond-CDS basis, which is what we saw the last time Macy's was the subject of LBO rumours. The fact that the bond would be trading cheap to CDS-implied fair value even without the poison put feature just makes the trade that much more attractive.

Buy US$9m notional Macy's, Inc. 10 Year CDS protection at 116bp

Buy US$10m notional (US$ 9.59m proceeds) Macy's Retail Holdings Inc. 5.9 of December 2016 bonds at 95.945 (T + 190bp; z-spread of 125.5bp) to gain 18bp of positive carry

Sell US$8.7m notional U.S. Treasury 4.75s of August 2017 at a price of US$101.20 (US$8.85m proceeds) to hedge bond interest rate exposure

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).