Contents

CDR Liquid Index data as at 4 September 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™ - temporarily shown only to 29 August
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™  - temporarily shown only to 29 August
The CDR Global Market Activity Index is a daily measure of activity within the global CDS market. Liquidity is measured by the number of bid-offers a credit receives. Index values are simple averages of total bid-offers of all names that exceed CDR's Liquidity Floor multiplied by CDR's Global Base Liquidity Constant.

Investor re-think required

Demand expected to be anaemic in the near future

The credit crunch has hit the European ABS market hard and stifled new issuance. If the market is to recover, non-ABS specialist structured credit investors will need to reappraise their approach.

"The European market has grown tenfold in terms outstandings in the last six years, which attracted an awful lot of investors into the market who do not have specialist expertise and therefore don't remember the way things used to be. Now, we've turned back six years in four weeks and a lot of the people making the investment decisions are cios who aren't investing in ABS directly. The only thing they can see is the marks and when they go down, they issue blanket sell orders," explains one ABS fund manager.

Such activity has been exacerbated by circularity, with investors engaging mark-to-market triggers on their funding or redemption features on their funds. Either their funders or end investors consequently decide to pull out, which in turn forces further selling. "The speed of it has scared people off and sent everything into a tailspin for no fundamental reason of its own," an ABS investor adds.

To some extent the whole pattern could have been predicted, according to the fund manager. "Four months ago deals were four times oversubscribed, which made you wonder a little on a market that has €500bn a year of primary issuance – that means €2tr of demand. Obviously there wasn't really that much demand – many people were inflating orders because they saw it almost as free money. But those same people have become first sellers, so they must have been seriously hurt," he says.

The trauma this pain is causing is unlikely to be fixed quickly with the lack of dedicated ABS experience involved. "A lot of people now involved in the market are non-specialised and are not necessarily committed to the asset class or to the region, so are less likely to tough it out and help us rebuild," the investor adds.

Such investor reticence has impacted on the new issue calendar. "The primary pipeline looks empty for September, where we have been accustomed to seeing deal after deal in recent years. A lot of people will wait for new benchmarks to be established when the first large deals print," says the fund manager.

But those deals could still be some way off, according to a note published this week by Deutsche Bank's Europe asset-backed securities research team. "Primary deal flow is unlikely to resume until late September or early October, in our opinion, with volumes predicted to be anaemic by comparison to recent years, reflecting the vacuum in demand that has been created by the near-complete retrenchment of conduits, SIVs and enhanced money market funds," it says.

While the SIV and credit arbitrage ABCP business models are unquestionably on a slippery slope, the analysts expect wide-scale asset liquidations to be generally averted. "SIVs can avoid forced liquidations by recapitalising their assets or liabilities (or both, in an effort to better match fund). ABCP conduits, which by contrast to SIVs are not mark-to-market sensitive, are likely to fall back onto sponsor bank balance sheets, a development that is well underway judging by the shrinkage in ABCP outstanding," the research observes.

However, it concludes: "Our premise is that there can be very little incentive to sell creditworthy assets into a distressed market for the sake of managing short-term liquidity. Exceptions may include programmes from weaker banks or non-banks and of course vehicles with sizable exposures to impaired assets. We understand that next week (September 10) will be key to the survival of this investor constituency, given the amount of funding expected to come up for roll. The writing (or epitaph, more like) is already on the wall, we think."

MP

SIV-lite restructured

Cairn deal transformed as discussions over other vehicles continue

Cairn Capital and Barclays Capital have successfully restructured the Cairn High Grade Funding I (CHGF) SIV-lite structure. The restructuring was made necessary by the closure of the ABCP market on which CHGF had relied for funding, the two companies explain.

CHGF had not engaged its market value triggers and so was in better shape than other SIV-lites, making it ideal for such a restructuring. However, Barclays Capital is understood to be in continuing dialogue with the other vehicles it has helped put together, with the aim of resolving their problems. In some cases similar restructuring is thought to still be an option.

In CHGF's case, the restructuring has eliminated market value triggers and the reliance of the vehicle on the ABCP market – CHGF has now been converted into a cashflow CDO. As a result, the full notional of outstanding ABCP will be redeemed as it matures and replaced by term funding.

Barclays Capital will provide the senior financing on the restructured transaction and has fully hedged its credit exposure from the financing, which has been paid for by investors and Cairn. The restructuring received full investor consent, including the agreement to fully participate in the costs involved.

As a result of the restructuring, S&P has taken several rating actions on CHGF. Specifically: the rating on the commercial paper was affirmed at A-1+; the rating on the Tier 1 notes was reduced to D from triple-A and withdrawn, while the restructured Tier 1 notes were assigned a triple-A rating; similarly the Tier 2 notes rating was reduced from double-A and withdrawn, but the restructured notes have been awarded a double-A; and the rating on the capital notes was also reduced and withdrawn.

S&P says that the new ratings on the restructured notes reflect the new terms and conditions of these notes, as well as a new structure. The restructuring of the vehicle includes an increase in the committed liquidity from the current level of 25% to 100% of the CP outstanding.

As a result, liquidity is available to redeem the full notional of the CP as it matures. The structure has to bear the cost of the increase in committed liquidity and other restructuring costs.

Under the new structure, the Tier 1 and Tier 2 notes bear no interest, but are entitled to a rateable distribution of excess cash flows after the principal is reduced to US$1. Receipts on the underlying asset pool are used first to pay interest on the CP and liquidity facilities, and then to pay down the Tier 1 and Tier 2 note principal sequentially until the principal is reduced to US$1. Thereafter, the remaining cashflows on the underlying assets are allocated 60% to the Tier 1 notes, 20% to the Tier 2 notes and 20% to the capital notes.

Meanwhile, Moody's confirmed the Prime-1 ratings assigned to the CP issued by CHGF under the US and Euro CP note programmes. These rating actions conclude the review initiated on 23 August, the agency says.

MP

EM deals emerge

Local currency CDO and CLO launched

The past week has seen two unusual emerging market deals hit the market. Vityaz CDO I - a full capital structure rouble-denominated synthetic CDO of Russian corporates closed - while roadshows began for a CLO in China.

Vityaz CDO I, is a three-year, Rbs8.95bn synthetic CDO backed by a diversified portfolio of local currency Russian bank and corporate credits, was executed by Deutsche Bank in conjunction with Troika Dialog. The portfolio is selected and managed by Troika Dialog, a leading portfolio manager for domestic Russian corporates and financials.

The capital structure of the CDO includes equity, mezzanine and senior tranches. The portfolio comprises credit default swaps of varying maturity referencing local currency rouble-denominated obligations of the referenced entities. Troika Dialog may make substitutions to the portfolio based on certain criteria set out to maintain diversity and the credit quality of the underlying portfolio.

Yuri Soloviev, first deputy chairman of the board of Deutsche Bank Ltd, comments: "We are delighted to have worked with our partners on this innovative deal. Vityaz CDO I is a testament to both the growth in non-governmental domestic debt issuance in Russia and the increased investor appetite for such structured risk."

Investor appetite for structured risk from China is also theoretically strong. However, the second wave of deals under China's pilot securitisation programme - that had been expected to launch last December (see SCI issue 18) - is only now set to produce its first deal.

Shanghai Pudong Development Bank (SPDB) announced last week that it had received regulatory permission to issue a Rmb4.4bn CLO. Roadshowing began this week and the deal is expected to close this month. The deal's lead underwriter is Guotai Junan Securities and the trustee is Fortune Trust & Investment Co.

The SPDB deal is understood to be split into four tranches: a Rmb3.64bn senior tranche A (with an expected domestic rating of triple-A); a Rmb342m mezzanine tranche B (single-A plus); a Rmb250m mezzanine tranche C (triple-B); and a Rmb152m unrated subordinated tranche D (to be retained by SPDB).

Given the many delays in the second wave of pilot deals and the poor secondary market liquidity of those deals issued in the first wave, all the firms that have approval from last year to issue CLOs will undoubtedly be looking on anxiously to see how the SPDB transaction is received. All the other approved firms - Agricultural Bank of China, China Development Bank, China Merchants Bank, CITIC Bank and Industrial and Commercial Bank of China - have strong capacity reasons to wish to shift loans off their balance sheets.

MP

Structured credit hedge funds drop again

Latest index figures show further dent in returns, but not for all sub-strategies

Both gross and net monthly returns for July 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index dipped sharply. The latest figures for the index were released this week and show a gross return of -5.9% for July, while the net return was -6.0% for the month. Seventeen of the 40 funds were able to report positive results, however.

Palomar classifies structured credit funds in eight sub-strategies, which since the semi-annual index rebalancing on 1 July for the first time includes 'short biased' funds. The worst performing sub-strategy in July was 'long junior value oriented' with an average loss of -18%, mainly due to two funds collapsing with returns worse than -80%.

Also, all 'long high grade leveraged' funds suffered on average more than -10% from the market turmoil. The best performers were the 'multi-strategy' funds, with an average gain of 3%, and 'short biased' funds with a strong 12% average return.

The dispersion of fund returns was even wider than in June, with a bottom quartile return of -44% and a top quartile return of +8%. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. The index aims to provide a monthly measure of the performance of the universe of open, investable structured credit hedge funds. The Palomar SC HF Index is calculated in two formats - as gross asset value and as net asset value.

As of 1 July, five new funds were added to the index family as a result of the semi-annual adjustment to the Palomar SC HF indices to reflect capital in- and out-flows in existing funds during the previous period and to ensure that the index constituents meet the index criteria. Two funds have been excluded due to a reduction of structured credit exposure in one case and because of closure for new investment in the other. Two closed funds that also have suspended redemptions will nonetheless remain in the index until such a disinvestment is possible or a liquidation value can be determined.

The Palomar SC HF Index is compiled and run by Palomar Capital Advisors and published exclusively by Structured Credit Investor. Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

MP

Prop desk shuts

The latest company and people moves

Prop desk shuts
Deutsche Bank has shut down its proprietary credit trading desk in London and a number of the around 20-strong team have already left the bank, including head of desk Gerry Jackson. Negotiations are understood to be continuing with remaining staff members over other jobs in the bank.

The London desk's demise is believed to have been caused by the failure of several sizeable positions that all had to be closed out underwater. Deutsche's equally significant credit prop business in New York is thought to be unaffected, however.

New president for S&P
Deven Sharma has been appointed president of S&P, having previously served as evp of investment services and global sales for the agency since November 2006. He succeeds Kathleen Corbet, who is stepping down from her position to pursue other interests.

Structurer swaps
Aime Ngarukiyintwali has left Deutsche Bank and joined WestLB as a CDO structurer. He reports to Joachim Erhardt, head of credit structuring in London.

CDO pair reunited
Cash CDO structurer Sergio Solorzano is believed to have joined Unicredit from Dresdner Kleinwort. There, he will be reunited with former boss Bob Walsh.

Derivatives head moves
JPMorgan is understood to have hired Edouard Huntziger, previously head of structured credit derivatives at SG Corporate & Investment Banking in Hong Kong. Huntziger has joined JPMorgan's credit hybrids and exotics group.

MP

Queen's Walk reports results

A round up of this week's structured credit news

Queen's Walk reports results
Cheyne Capital's permacap vehicle, Queen's Walk Investment Limited (QWIL), has announced its results for the quarter ended 30 June. It's NAV has dropped, but the company notes that it has "moved aggressively to establish a defensive portfolio in light of the deterioration in the US housing market and amidst broader concerns about the asset-backed market", which has helped mitigate any further material deterioration in the quarter compared with previous quarters (SCI passim).

As at 30 June 2007, UK mortgage, European mortgage and SME residual investments made up 93.8% of the gross-asset value of the company's investment portfolio. QWIL explains that its investments exposed to the US sub-prime market accounted for 4.2% of the gross asset value of the investment portfolio.

This exposure is via a mortgage-backed residual position and two CDOs –Cheyne High Grade CDO and Cheyne ABS Investments. The percentage of the collateral exposed to the US sub-prime market in the High Grade CDO and ABS Investments I is approximately 56.9% and 63.6%, respectively.

A CDO, backed by US leveraged loans, accounts for the balance of the portfolio (2.0% of the gross asset value of the company's investment portfolio) – Cheyne CLO Investments l. Overall the company's net leverage has been reduced to 3.0% as at 30 June 2007 from 25.9% as at 31 March 2007.

In accordance with the company's valuation procedures, the fair value of its investments has been evaluated on the basis of performance, observable market data and the investment manager's expectations regarding future trends. After giving effect to the fair value write-downs taken in the quarter, the NAV of the company has decreased to €7.01 per share as at 30 June 2007 from €7.24 per share as at 31 March 2007 (a decrease of 3.2%).

QWIL has also secured a four-year term financing facility to reduce financing risk and continues to have cash available for the purpose of buying back shares. It has already purchased 991,354 ordinary shares for cancellation and has obtained authority from its shareholders to purchase up to a further 14.99% of its issued share capital, as well as proposing a tender offer to purchase at least 10% of the company's share capital (24.99% maximum). Details of the tender offer will be made available shortly.

Fitch downgrades Rhinebridge's notes
On Friday 31 August Fitch downgraded Rhinebridge Plc's – the SIV managed by IKB Credit Asset Management – US$130m mezzanine capital notes to single-B from single-A. The mezzanine notes remain on rating watch negative (RWN).

The following Rhinebridge Plc and Rhinebridge LLC programmes remain on RWN: US CP: F1+; US MTN: triple-A; Euro CP: F1+; Euro MTN: triple-A; senior capital notes: triple-A.

Fitch says its rating action is based on: the continuing inability of Rhinebridge to access the CP market to refinance maturing CP; the relatively limited availability of committed liquidity to cover maturing CP, the use of which would put the SIV at risk of breaching a liquidity test; and losses realised upon the continued sale of assets to meet maturing CP or upon the sale of assets if the vehicle were to enter restricted funding operating status.

Fitch notes that Rhinebridge is in discussions with third parties to investigate and secure funding sources alternative to the ones mentioned above. However, as of the time of the action no alternative option had been secured.
In light of uncertainty in Rhinebridge's ability to secure continued funding in the CP market, it may be forced to sell assets and/or draw upon committed liquidity.

The vehicle is subject to certain net cumulative outflow (NCO) tests. If it draws upon its committed liquidity and does not maintain a sufficient amount of unused committed liquidity, it would be in breach of these NCO tests.

If an NCO breach remains un-cured for five business days, this will lead Rhinebridge into a restricted funding operating state, where it will be unable to issue further senior funding until the breach is cured. In this situation, Rhinebridge would need to sell assets to meet maturing liabilities.

Rhinebridge's portfolio currently comprises 16% CDOs, 59% RMBS, 14% monoline-wrapped global RMBS, 1% CMBS and 10% cash. The portfolio has a geographic exposure of 87% to the US, 9% to the UK and 4% to the rest of Europe and Australia. Currently, 83% of Rhinebridge's portfolio is rated triple-A equivalent, 14% rated double-A equivalent and 3% rated single-A equivalent.

Codefarm launches portfolio re-optimisation service
Codefarm, the structured credit technology company, has launched Galapagos Manager, an online service that enables managers of synthetic CDOs to protect and improve the performance of deals under management.

Using powerful optimisation techniques and integrated market data feeds and models, the service suggests changes to portfolios that leverage the credit opinion of CDO managers by minimising risk and maximising yield. Codefarm says that by streamlining and automating the substitution selection, Galapagos Manager highlights opportunities that conventional analysis and intuition could miss.

"With experts forecasting continuing volatility in the credit market, our release of Galapagos Manager could not be more timely," comments John Mooren, marketing director of Codefarm. "Early pre-launch users of Galapagos Manager are finding that it is giving them a real competitive edge during the current period of market turbulence. Galapagos Manager is the ideal tool to help managers through such times. Its speed and flexibility enable frequent and rapid re-optimisation of portfolios, and will completely transform portfolio management."

Galapagos Manager is built on the platform of Galapagos Structurer, the online service that uses evolutionary computing technology to structure highly optimised CDOs and enhance spreads. By integrating pricing and rating models and data feeds along with parameters such as SROC targets, churn limits, loss triggers and removals limits, Galapagos Manager can continuously evaluate and re-optimise deals. It offers substitution suggestions that take a wide range of factors into account, including price, ratings, compliance tests and trading costs.

European CDO of ABS issuance up in Q2
In most cases, spreads on CDO of ABS tranches were down slightly on mezzanine ABS, but have widened for both high-grade ABS and CDO-squared compared with the same period in 2006, according to the latest quarterly report on the European cash CDO market published by S&P.

In terms of CDO of ABS issuance, Q2 2007 was particularly active, compared with the slower second quarter of 2006 (three transactions), with a marginal increase over 2005 (six transactions).

In line with Q1 2007, transactions that closed in the second quarter comprised mostly mezzanine ABS and high-grade ABS. RMBS, CMBS and to a lesser extent CDO tranches continue to be the dominant asset classes. These asset classes have traditionally been attractive because of the higher spread levels, particularly in the CDO tranches.

For the second half of 2007, S&P expects any new cash CDO of ABS transactions to come mainly from repeat managers, and reflect the trends in structures observed over 2006.

Lack of efficiency and speed will hurt securitisation
Security and efficiency are top priorities in securitisation, while the effect of the sub-prime market will last well over six months, according to the first securitisation research poll conducted for IntraLinks, the provider of online workspaces. The survey respondents were key players in the securitisation market in the US, Europe and the UK.

The vast majority of respondents think that the sub-prime problem will have a long-term effect on the securitisation industry, with only 15% thinking the effect would last less than six months. More than half of respondents (53%) believe that the performance of assets will have the greatest impact on the securitisation industry, since investors are becoming increasingly nervous in relation to securitised products.

The majority of professionals (64%) who took part in the poll expect commercial mortgages to see the greatest increase in activity in the coming year. Following the recent market correction, there is growing awareness in the industry that players will shy away from purchasing bonds and that an increasing number of CDOs may fold if defaults rise.

Confidentiality and speed are considered increasingly important in structured finance transactions. Most firms have a policy against distributing confidential or client information by email (77%).

Almost all respondents rate the confidential (91%) and speedy (85%) exchange of documentation as crucial in deals. As a consequence, the usage of online workspaces is becoming ever more common.

European SME securitisations bouyant
While 2007 has started slowly, 2006 was a good year for European SME securitisations. The cumulative issuance amount was just below €50bn, almost 57% of which was fully funded. Germany and Spain have taken an early lead in the field of SME transactions securitisation, and their position appears as dynamic as ever, says Moody's in a new report.

"As of Q1 2007, Germany and Spain remained the two main drivers of growth in the European SME securitisation market, which now includes 12 countries," says Marie-Jeanne Kerschkamp, a Moody's md and co-author of the report. "Only four SME transactions closed in Q1 2007, amounting to a cumulative €8.4bn. While these figures appear relatively modest, it is important to note that year-beginnings tend to be very quiet. Of the 130 European SME transactions closed so far, only 18 closed in the first quarter while 71 transactions closed in the last quarter."

Between 1998 and the end of Q1 2007, some 30 transactions worth €165bn of SME loans were securitised in Europe, including 36 transactions worth €49.2bn in 2006. 2006 was a very good year for the German SME market, with 14 new transactions totalling more than €19bn of risk transfer (one third funded).

In terms of transactions closed and funded amounts, Spain maintained its leading position in 2006 with 14 transactions closed totalling €17bn. State support initially played a role in those two markets (with the PROMISE programme in Germany and the FTPYME and FTGENCAT programmes in Spain), but they now appear to have gathered a momentum of their own, Moody's observes.

iTraxx SDI-75 will not roll
International Index Company (IIC) has announced that following consensus among market participants, the iTraxx SDI-75 index will not be rolled into a new series in September 2007.

IIC says: "After its successful start in November 2005 the iTraxx SDI-75 index served its purpose in introducing UK asset managers and other domestic investors to credit derivatives as a new asset class. These market participants are now adequately served by the very deep pools of liquidity available in the iTraxx Europe indices."

MP

Trading ideas - juicy spreads

John Hunt, research analyst at Credit Derivatives Research, looks at a negative basis trade referencing Liz Claiborne

The market's continuing lack of concern with LBO risk has created opportunities to pick up bonds with change of control covenants at a discount. The Liz Claiborne 5s of July 2013 present such an opportunity – they are trading cheap to fair value even without the covenant, and given that Liz Claiborne's LBO score ranks in the top 10% of our universe, there is a good chance that the covenant will add even more value to the position.

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 Liz Claiborne Inc 5s of January 2013 bond is trading cheap to fair value. Exhibit 1 presents the price-based term structure of the company's bonds and indicates that the January 2013 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

Risk
The position is default-neutral. There is a maturity mismatch because the bond matures on July 8, 2013 and the CDS expires on September 20, 2012, 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. Exhibit 3 presents a number of sensitivity calculations for the bond for investors who are interested in more sophisticated hedging strategies.

Exhibit 3

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 0.4bp of notional per 1bp of parallel curve widening, using the linear DV01 approximation. We note that parallel widening of the bond and CDS curves is unlikely in the event of a rumoured or actual merger or LBO because of the bond's change of control covenant.

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.

The recommended CDS is in the 5-year maturity, so we are confident of executability despite the current liquidity challenges in the market.

The bond shows decent availability at the recommended level. Although the bid-ask spread is wide (€0.87), this amount is less than the bond's cheapness to its CDS-implied fair value.

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.

Liz Claiborne, Inc. is not covered by Gimme Credit. The company's commercial paper and senior unsecured debt were recently downgraded by Moody's, with senior unsecured debt rated at Baa3, the lowest investment grade rating. After lowering its earnings guidance and suffering a decline in stock price, Liz Claiborne reported second-quarter results at the high end of its revised range.

Although the current (liquidity starved) environment is not entirely conducive for discussing buyout risk, we remain confident that LBO risk will resume in the future (as buyouts were still active in the past with rates and spreads considerably higher). Liz Claiborne remains one of the highest ranking credits in our fundamental LBO viability screen and an opportunity to pick up a cheap short on this name is definitely worthwhile.

Apart from the obvious fact that equity prices have been beaten down (making Liz Claiborne a cheaper purchase), other factors that improve LBO viability include relatively low required sponsor equity, attractive premium valuation, low capex intensity, and although FCF is quite volatile, relative to its total debt, it has been relatively calm. The equity options market also implies a relatively high likelihood of a corporate action with the Options-based LBO score at 4.0.

Summary and trade recommendation
We recommend a negative basis trade on a bond with a change of control covenant that would be trading cheap to its CDS-implied price even without the covenant. Because Liz Claiborne is a strong candidate for LBO based on its fundamentals (scoring in the top 10% of our universe of buyout candidates), the covenant stands a good chance of adding value to the position if LBO premiums increase.

The bond is trading fairly close to par, so that the opportunity to put the bond in the event of a change of control is not as valuable as it would be if the bond were deeply discounted. Nevertheless, the covenant should cause the bond to retain value if an event appears likely, while the CDS leg of the trade should benefit.

Buy €10m notional Liz Claiborne Inc 5 Year CDS protection at 70.75bp

Buy €10m notional (€9.82m cost) Liz Claiborne Inc 5s of July 2013 at 98.21 (z-spread of 84.3bp) to gain 13.6bp of positive carry

Sell €9.6m notional DBR 3.75s of July 2013 at a price of 98.00 (€9.42m 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).

Don't generalise

The need to avoid contaminating SIVs and conduits with SIV-lites is discussed by Domenico Picone and Priya Shah of the structured credit research team at Dresdner Kleinwort

Recent news has focused on the ABCP market, with many conduits, SIVs and SIV-lites being pushed into the limelight. With maturing CP they are finding it difficult and expensive to roll their new programmes, and have been turning to liquidity providers and sponsors for rescue. Sponsors won't provide funding help for everyone. If the credit crisis persists, differentiation will be the key!

The sub-prime fallout and the resulting credit crunch have brought structured finance in the limelight in recent months. While many investors have got some exposure to structured finance assets, whether directly or indirectly, very few have a thorough understanding of the actual structural mechanics, risk/return dynamics and the underlying collateral composition. Instead investors have relied heavily on ratings when making decisions, with structured finance assets being particularly attractive due to the high yield received relative to traditional assets with equivalent ratings.

The recent credit turmoil has however highlighted how reliance on credit ratings is not sufficient. Credit rating agencies have been criticised in recent weeks about their slow and, in some cases, lack of response in relation to the sub-prime crisis.

While the aim of this Research Note is not to evaluate the accuracy of the rating methodologies, it is worth pointing out that ratings are just an indication of the credit quality of the security, and hence likelihood of default. While future collateral market value and liquidity are modelled for market value dependant structures, such as MV CDOs and SIVs, the final structured tranche rating only gives an indication of the default likelihood for a buy-to-hold investor.

Whether and at what price the investor is able to sell the tranche before maturity is not considered in the rating and is dependant on market supply/demand conditions at the time. Market value and liquidity risk therefore need to be considered separately by investors.

This is evident in the current markets, with the credit contagion having affected liquidity and depressed market values for structured credit assets. While there is no doubt that several securities are suffering large defaults, the lack of activity and volatility in the last couple of weeks is to some extent also as a result of general risk aversion and lack of understanding of structured credit assets.

Cashflow and risk/return dynamics of structured assets can be complex, however not all these assets are 'bad' and in default. There are still some securities which are performing as expected and in the current market environment it is possible to find some 'good bargains at discount prices'.

However, assets classified under the same structured finance umbrella differ significantly and reliance on ratings is not sufficient. It is now ever more important to carry out thorough due diligence on each individual security and gain a better understanding of the structure, cashflow mechanics and underlying collateral characteristics for each deal separately.

Arbitrage vehicles

Conduits
Conduits were initially established by financial institutions to provide off-balance sheet financing for their own or client assets, providing regulatory benefits and cheaper funding due to the higher rating of the conduit compared to the sponsor's own balance sheet. Funded primarily in the short term market, the growth in conduits has led to the expansion in the asset backed commercial paper (ABCP) in the last few years, with ABCP issuance reaching US$1.15tr by the end of June 2007.

Although initially developed as a financing tool, the range of assets held by conduits has since grown. Conduits now hold a broad range of assets including trade receivables, consumer debts, auto and equipment leases and credit securities. Recently credit arbitrage conduits have become popular and now account for almost 30% of the market.

Investing primarily in highly rated structured finance assets, these structures are aimed at exploiting the arbitrage generated by investing in long term highly rated assets while funding cheaply in the short term CP market. On initial glance, arbitrage conduits therefore sound very similar to arbitrage term securitisation, such as CDO of ABS, with short term liability funding. However, there are some important distinctions between these two sectors, as detailed in the table below.

Structured investment vehicles (SIVs)
Within the structured arbitrage space, SIVs have been another growth area in recent years with a market size of over US$300bn as at June 2007. Similar to arbitrage conduits, SIVs invest in a portfolio of highly rated, highly diversified structured finance assets.

However, unlike conduits, SIVs do not require a 100% liquidity line as they are structured similar to operating companies and tend to use their capital and available leverage dynamically. Due to the tiered funding from a combination of short term CP, medium term notes (MTN) and subordinated capital notes, the credit enhancement and required liquidity facilities can be adjusted regularly and depend on the performance and liquidity of the underlying collateral. Collateral credit, market and liquidity risk and the manager's ability in managing these risks are therefore important considerations for a SIV investor.

SIV-lites (a.k.a. SIV-CDO)
Like arbitrage conduits, SIVs are predominantly structured to take advantage of the returns achieved by leveraging the spread received on assets with long maturity and funding these assets cheaply through shorter term liabilities. However, in addition to the short term CP and MTN, SIVs also have a subordinated capital note which, being the first loss piece is relatively more expensive. With increased credit asset demand over 2005 and 2006, credit spreads have steadily declined reducing the profitability of SIV structures.

This reduced arbitrage has therefore encouraged the development of SIV-lite structures, a blend of the SIV and MV CDO strategies, but with more leveraged investment predominantly in the higher yielding structured finance sectors such as RMBS and CDOs. Capital notes are also issued only at the outset and the strategy is no longer perpetual but has a fixed investment period and scheduled amortisation, similar to a CDO. Short term funding is also more biased toward CP as opposed to MTN.

CP investor base

Money market funds and corporations have been the largest investors in the US CP market (including ABCP issued by conduits and SIVs), holding 28.6% and 26.6% of outstanding US CP as at end June 2007. Over time, the source of the CP demand has also broadened with foreign investors becoming progressively more involved in this asset class.

More recently, as a direct effect of the continuing turmoil in the credit markets and general investor risk aversion, the asset allocation of several money market funds and corporations has changed and switched towards less risky and better understood fixed income products, which has resulted in a drop in Treasuries yields while CP funding has become more expensive and limited.

As arbitrage Conduits, SIVs and SIV-lites invest primarily in structured finance assets, albeit highly rated, traditional CP investors are backing away from this sector, which has caused a drop in the outstanding ABCP and financial CP of US$180bn over a two week period in August (see chart on the right below). ABCP funding has dried up and the required yield on the limited paper that is available has increased substantially and challenged their economics (see chart on the left below).

Current market developments

Conduits, SIV-lites and to a smaller extent SIVs faced with maturing CP, are therefore finding it difficult and expensive to roll their CP contracts. In such a disrupted market conduits have been able to turn to their liquidity providers and sponsors.

In contrast, SIV-lites have no substantial liquidity lines nor 'committed' sponsor, and due to the drop in market value of the assets, these structures are unable to find funding and have no alternative but to sell assets. As a result, rating actions on the CP and capital notes of four SIV-lites have been taken by S&P. However, in only two instances were the SIV-lites rating actions due to the portfolio being put into liquidation, and the breach of NAV and liquidity tests.

The exception is Duke High Grade 2 Funding, because the vehicle is funded through repos and MTNs and has no CP outstanding. The repo funding beyond June 2008 has not been confirmed; however, according to S&P, this time horizon is long enough for the manager to look for alternative funding and liquidity sources.

Ranking our concerns

SIV-lites: They have already shown their weaknesses: they are too exposed to the US residential mortgage sector, have limited liquidity line support, lack a bank-sponsor, are primarily funded through CP and have a modus operandi based on funding long-duration assets with short-term liabilities. However, their market share is too small on its own to have a huge impact on the structured credit market overall, even if they all were to liquidate their portfolios.

Conduits: As the cost of CP funding has rocketed, structures with a bigger allocation to CP are next on the front line. Conduits are more exposed to structured finance, in particular arbitrage conduits, and are more at risk than others. Being unable to fund in the CP market, they will turn to liquidity providers and sponsors.

Bank-sponsor programmes are in a relatively less risky position than non-bank-sponsor programmes. Will bank sponsors be able and willing to provide funding support as long as the credit crunch persists? Even though this is ultimately a credibility test for the sponsoring banks their support needs to be seen and tested for however long the credit crunch lasts.

SIVs: If ABCP and MTN investors continue to back away from this sector we may see more SIVs being affected in the near future. Two thirds of SIVs' senior debt is in MTN programmes with an average WAL between eight to nine months. This time leaves the managers a limited but critical period to look for alternative funding and liquidity sources. Once more, bank-sponsor programmes are better equipped to sustain the current credit market deterioration.

© 2007 Dresdner Kleinwort. All Rights Reserved. This Research Note was first published by Dresdner Kleinwort on 29 August 2007.