Contents

CDR Liquid Index data as at 11 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™
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.

Asian demand returns

Issuance of sophisticated product expected through to 2008

Concerns over contagion risk from the US sub-prime crisis caused the Asia Pacific structured credit market to shut down over the summer. However, the last week has seen some signs that investor appetite is returning.

"Spreads have moved wider as a result of the sub-prime crisis and so we're seeing demand return for first-to-default structures referencing four or five exposures to Asian corporate names, as well as managed synthetic CDOs to benefit from current levels. It is possible to make some interesting investments in a dislocated market: managers have more flexibility to pick up paper which has a high return over 5, 7 and 10-year maturities," explains one head of CDO structuring in Hong Kong.

Most investors in the Asia Pacific region continue to prefer global issuance because it offers economies of scale, visibility and access to top-tier managers. But some are looking at more tailor-made structures, such as single-tranche CDOs, as they rebalance their portfolios in the wake of the sub-prime crisis.

A recent Moody's report confirms that appetite for sophisticated synthetic product is increasing in the region, off the back of the first CPDO notes to be structured in Asia ex-Japan – the A$28.9m Aa1 rated Phoenix transaction, issued by Aphex Pacific Capital (through Nomura International). The notes are exposed to a leveraged portfolio of 250 corporates via the on-the-run 5-year iTraxx Europe and DJ CDX.IG Index series, with each of the indices representing 50% of the total portfolio on a notional basis.

Analysts at the agency say that if Asian CPDO issuance develops significantly, it is likely to follow European trends towards more managed and bespoke transactions. Different features could be managed, such as assets, tenors or leverage.

Moody's also expects to rate the principal and coupons of some new CPPI transactions, as well as higher yielding CCOs, CFXOs and innovative hybrids structured in Asia through to 2008.

"Some of the initial CPDOs structured out of Europe were also placed with Asia Pacific investors, and banks in Asia have recognised the need to put more people on the ground to keep in touch with the investor base and address demand locally. That's why we anticipate more CPDO, CPPI and other innovative derivative product to be issued from the region in the future – inquiries about such paper have increased this year," confirms Myrna Fajardo, vp-senior credit officer at Moody's in Hong Kong.

Timetables for Basel II vary across Asia, but 2008 may be a turning point for the structured credit market in the region. Hong Kong, Japan, Australia, Singapore and Taiwan are at the most advanced stages; they should have implemented the IRB approach by end-2008 and South Korea by January 2009. And at end-2008, most Asian countries will have begun the implementation of the standardised approach.

Moody's says that this outcome may fuel the momentum for risk management transactions: the agency expects new cash and synthetic balance sheet CLOs in the near future and an increasing concentration of emerging market credits. A recovery in demand from Asian accounts – as elsewhere – will nevertheless take time and further volatility is expected, given the fact that financial institutions are due to release their results over the coming weeks.

The CDO head concludes: "The wake-up call from the crisis is that, while CDOs are diversified instruments, investors also need to diversify across asset classes – for example, by looking at multi-managed CLOs, CFOs or transactions with different pay-offs. Demand is returning, but only for product with the right collateral within the right structure and at the right time."

CS

SIV discrimination begins

Investors call for greater confidence in portfolio values

SIVs continue to be hit hard amid current market volatility. However, greater awareness of the need to differentiate between vehicles is being evidenced by investor demand for more portfolio details and a change in Moody's SIV methodology.

The recent decline in market values has had a worse affect on SIVs with significant exposure to CDO and US sub-prime assets, as well as those including concentrations of double-A and single-A rated collateral. "The main point about the current credit crunch is that with any secured lending, there are differences in what that security is – it is easier to refinance something that is high quality," explains Jenna Collins, portfolio manager at Cairn Capital.

"Another differentiating factor is whether a vehicle is sponsored by a bank, because they can support it in the short term. There is also the seasoning affect of older SIVs, whereby a portion of their assets were purchased before spreads began tightening in 2003/4 and so they have more of a buffer to recent declines in value," she adds.

As a measure of the sustainability of the SIV sector, the market is waiting to see whether Gordian Knot's Sigma Finance can achieve the funding levels it requires over the next two weeks. Sigma doesn't have a bank sponsor, is the largest SIV at US$52.6bn in assets under management and has significant exposure to financials.

Collins says that in order for investors to return to the market, there needs to be greater confidence in the values of the underlying. "Accounts require greater transparency in terms of the assets in these portfolios and there needs to be more diligence about what they are lending against. In the meantime, some vehicles will disappear, others will be restructured (via a reduction in size, refinancing into longer term senior debt, or some assets being brought back onto bank balance sheets) and it is likely that certain portfolios will be unable to achieve financing in the future."

Citi last week made the headlines by releasing portfolio information about its SIV holdings – although some buy-siders commented that it needed to go into further detail still. SIVs haven't historically disclosed their holdings and anecdotal evidence suggests that Citi was loathe to do so, but some observers recognised that the move could reflect just how dire the market environment is to precipitate such action.

Indeed, in light of unprecedented market price volatility, Moody's has adapted its SIV rating methodology to model expected loss using a stressed volatility for the distribution of market prices based on the price decline observed from 1 July to 31 August 2007. With this stress, only those tranches that can sustain an additional price decline of two times the decline observed in that period will remain triple-A rated.

For example, if the portfolio market value of a SIV was par in early July and it declined 5% by the end of August, the agency now assumes that the probability of a deterioration in market prices by an additional 10% to levels below 85% is negligible (i.e. consistent with a triple-A rating). Its analysis also assumes that all asset prices move in a highly correlated manner.

For the ratings of senior notes, Moody's assumes that the probability of wind-down is 100%. For modelling capital notes, it assumes a probability of wind-down that is a function of the net asset value of capital. As a result of the change in methodology, seven SIVs are facing negative rating actions (see this week's Round up for more).

CS

Transparency rules

Central banks to play crucial role in shaping market's recovery

Investors and dealers are searching for new ways to restore confidence in the market. A renewed effort to increase transparency is key, according to both investors and regulators.

The credit crunch has hit all constituents of the market: not only have portfolio managers suffered considerable mark-to-market pain, but – on top of their direct exposure to US sub-prime and leveraged loan assets – banks have also leveraged themselves significantly via CP and liquidity lines.

For the market to get back on its feet, banks need to open up and trust each other again as counterparties, and investors need to be reassured that the market is here to stay. According to Recai Günesdogdu, managing partner at Aurelius Capital Management, central banks will play a crucial role in this process.

"Central banks have already injected some liquidity into the market, but this needs to be increased," he says. "They could perhaps also accept some assets as collateral (via repo agreements, for example) – this would show investors that selected collateral is OK to hold. Equally, as investors begin to realise that a triple-A rating doesn't always mean triple-A quality assets, they'll start questioning issuers more and requiring further information on the underlying collateral."

The European Central Bank announced yesterday, 11 September, that it proposes to address the current lack of empirical evidence on the trade-off between transparency and liquidity in the bond markets through a market-led pilot project or controlled experiment. It envisages post-trade transparency being gradually introduced by, for instance, starting with the most liquid market segment and checking against a control set of similar bonds.

The bank would support a market-led self-regulatory initiative that is committed, first, to carefully analysing the impact on liquidity of higher post-trade transparency, and second, to seeking an adequate transparency framework for the whole market – without restricting it to retail markets. Such features could flexibly evolve over time, allowing competitive market forces to play their role.

A drive towards increased transparency was backed by Michel Prada, chair of the Autorité des Marchés Financiers and head of the technical committee of IOSCO. Speaking at ESF/IMN's European CDO conference, he said that efforts should be concentrated in four areas: transparency related to ratings and their methodology; transparency concerning underlying assets; transparency relating to risk and valuation models; and transparency towards regulators concerning global market risks.

It was suggested that investors could use the current market crisis to push for renewed efforts in these areas.

"Adequate transparency standards on structures and their underlying risks, both for primary placement and secondary trading, are key pillars for the efficiency of the market," he explained. "It is all the more necessary in the case of CDOs, that the potential complexity of such products and of their underlying assets might, in some circumstances, lead to a natural asymmetry of information between market participants. Investors need to have the capacity to clearly analyse the risks attached to the products and put in place the appropriate internal systems to monitor those risks over the life cycle of their investments."

The responsibility for ensuring that the necessary information is delivered to investors was put squarely in the intermediary's lap. Responsibilities should be clearly identified between the trustee, servicer, asset manager, paying agent and any other transaction participants for collecting and assembling relevant market data, as well as for the publication of all information attached to the deal.

But whether the market makes a genuine recovery depends on the level of losses. "This time around the risk is more widely distributed: if everyone loses a bit, it will be OK; if lots of participants suffer severe losses, the market is unlikely to recover anytime soon. This could lead to regulators enforcing a certain level of transparency on the market to remove the asymmetry of information," concludes Günesdogdu.

CS

Loan plans

Opportunities in CLO and underlying markets indicate positive intent

Some signs of a recovery in the leveraged loan market have emerged over the past week. Traders say that there are still relative value opportunities to be had where enterprise value cover is strong and in the more defensive sectors or across names which are currently trading at a discount.

Furthermore, a number of hedge funds have been canvassing investors to gauge interest in new distressed funds designed to purchase leveraged debt from banks after they found a lack of interest from their traditional buyers. The impact of the closure of warehousing facilities is also beginning to abate – although concern regarding weighted risk assets means that a further round of suspensions could occur later in the year.

With around €90bn of loan paper on banks' balance sheets potentially impacting the capacity of private equity groups to execute new transactions, Siobhan Pettit, head of structured credit strategy at Royal Bank of Scotland, believes that a variety of strategies could be employed to shift the back-log or reduce banks' exposure to the sector. These include issuing debt at original issue discounts, assuming that managers are comfortable with a running yield rather than a cash return; accessing alternative sources of liquidity, such as investors in the Middle East and Asia (although it could take some time for them to get comfortable with the specifics of the loan market); and working on creative solutions.

"Arrangers could agree to exchange portions of their debt in order to diversify risk," Pettit notes. "But this is difficult to implement in practice as it wouldn't reduce the par value of loans outstanding, while being difficult to agree the relative value of different asset where these are not rated. Additionally, it may be possible to introduce a super senior tranche or a PIK into an existing structure. Clearly such arrangements would require the approval of the sponsor."

Meanwhile, the number of enquiries from CLO managers looking to establish total return swap structures has increased as a result of the availability of assets at sub-par but with lower cash margins. "One way of increasing a loan's yield to investors is to offer the debt at a discount," explains one manager. "At the moment, it looks like most private equity firms are trying to force banks to keep to the original underwriting terms, and the banks are having to offer at a discount. Total return structures may be better placed to take advantage of these buying opportunities than traditional cashflow CLOs, due to the cash margin covenants in place in cashflow CLOs."

The market could also see synthetic partially distributed CLOs being launched, where LCDS names are included and an unfunded triple-A tranche is issued, according to analysts at JP Morgan. The dealer could retain or hedge this portion of the capital structure via LCDX, potentially keeping triple-A CLO financing at a palatable circa-50bp range and allowing junior debt investors to monetise current illiquidity premia.

Despite solid credit fundamentals and robust structural protection, a lack of buyers continues to dominate the CLO landscape. The disruption in CP financing has caused monolines and conduit vehicles to step away from the market (it is estimated that the former accounted for between 33% and 50% of triple-A CLO paper and the latter taking down between 5% and 15%). It is hoped that banks and insurers will fill the current demand gap – although this may take some time.

Looking ahead, the loan market is expected to set a durable tone for the wider credit markets, with the pricing, syndication and post-break performance of the First Data deal an important indicator of this. Indeed, any new loans that banks underwrite are likely to include full covenants, lower leverage, more conservative structures and higher spreads.

CS

Going with the flow?

The latest company and people moves

Going with the flow?
The impact of market volatility is now fully feeding through to the jobs market. Aside from the widely reported sackings/realignment of mutual interests, a number of major banks have implemented recruitment freezes across credit or fixed income or even institution-wide. Furthermore, at least one asset management arm is believed to be re-thinking the future of its structured credit group.

Consequently, head hunters report that there are increasingly fewer inter-dealer credit moves on the cards at present. Nevertheless, there is still plenty of credit derivatives hiring demand for 2008 – although that is currently primarily focused on the flow side of the business rather than structuring.

Asset manager hires two
Credaris, the credit-specialist asset manager, has announced two hires.

Beth Fusco joins the firm as a high yield credit analyst from Merrill Lynch, where she spent ten years as a senior credit analyst, specialising in high yield industrials. Fusco's new position focuses on fundamental research and relative value decisions in the high yield corporate and structured credit space.

Bob Buhr, head of credit research at Credaris, observes: "We believe that in these periods of heightened volatility, superior fundamental credit research becomes even more important in identifying interesting credit risk and, along with our traders, finding the best way to exploit these opportunities."

Credaris has also recruited John McGoff as a structured credit trader focusing on standardised and bespoke CDO obligation trading. Previously, McGoff traded the global correlation book at Commerzbank Securities in London and he joins the five person structured credit team led by Gennaro Pucci at Credaris.

Quant joins investment manager
Gene Yeboah has joined Schroder Investment Management as a senior structured credit quantitative analyst. He was previously at Babson Capital.

Pricer exits
Marvin Kim, formerly an executive in credit pricing for Barclays Capital in New York, has left. His future destination is not yet known.

Sales swap
Felipa Uva has left Credit Suisse in London to join RBS as director, structured solutions sales. She reports to Chris Fenichell, md structured solution sales, which is part of RBS' debt markets financial institution sales team, RBS global banking & markets.

De Maria to DTCC
Frank De Maria is joining DTCC as managing director, business development, effective on 24 September. He will lead a cross-organisational team with responsibility for DTCC Deriv/SERV's Trade Information Warehouse, including design enhancements, industry take-up and support for all derivatives asset classes that will be serviced by the Warehouse. He will report to Peter Axilrod, DTCC managing director, business development.

Prior to joining DTCC, De Maria was global head of derivative client services & operations at Merrill Lynch. Before he joined Merrill Lynch in 2001, De Maria was coo of Soros Private Funds Management. In 1999 he served as cfo of Oversight Partner I, the consortium entity that recapitalised and liquidated LTCM.

DTCC launched the Trade Information Warehouse in November 2006 (see SCI issue 15) and, as of mid-2007, back-loading by the market's largest dealers of credit derivatives transactions that pre-date the Warehouse's launch was essentially complete, DTCC says.

El-Erian returns to PIMCO
PIMCO has announced that Mohamed El-Erian, its former md and senior portfolio manager, will return to the firm in January 2008 in a newly created position as md and co-ceo and co-cio. In his new position, El-Erian will join ceo Bill Thompson, as well as cio and company founder Bill Gross, as a member of PIMCO's senior management team.

El-Erian will return to PIMCO from the Harvard Management Company (HMC), where he has been president and ceo since October 2005. Before joining HMC, El-Erian had worked at PIMCO for seven years, where he was a highly regarded senior member of the portfolio management team. Prior to PIMCO, he had spent 15 years with the International Monetary Fund.

Rating agency adds leverage
DBRS has appointed Steven Bavaria as md, leveraged finance. He will be based in New York and will lead DBRS's entry into the leveraged finance rating business.

Prior to joining DBRS, Bavaria launched the bank loan rating business at S&P 12 years ago.

MP

Another SIV-lite set for restructuring

A round up of this week's structured credit news

Another SIV-lite set for restructuring
Barclays Capital has proposed an outline restructuring solution to the security trustee of Solent Capital's Mainsail II SIV-lite transaction.

The restructuring proposes that all CP investors will be fully paid out at par at the same time as the restructuring is implemented through the provision of an additional liquidity facility underwritten by the bank. This liquidity facility will be split into three tranches, and capital and mezzanine noteholders will be invited to participate in the junior tranche of this facility.

Barclays Capital will underwrite the liquidity facility by sourcing suitable credit protection in the form of such noteholder participation, as well as the purchase of additional credit protection via a CDS. The bank will be providing detailed proposals to all mezzanine and capital noteholders shortly.

The security trustee is evaluating the proposal and will continue to do so as further details are provided; however, based on the information it has at present, the proposal is regarded as being credible.

Barclays Capital is also understood to be in restructuring negotiations over Avendis' Golden Key SIV-lite. But sources suggest that, under the restructuring of the Mainsail and Golden Key transactions, the CP may be paid back over several years, as opposed to that of Cairn High Grade Funding which will be paid as it comes due.

ECMBX postponed
The group of dealers behind the launch of a family of European CMBX indices has decided to postpone the index launch date of 18 September as a result of the increased recent market volatility. A re-valuation process is currently underway, including bankers taking in comments from the buy-side with a view to the dealer group holding a conference call within the next two weeks to firm up a new launch date.

While the start date is uncertain, there are not expected to be any material changes to the ECMBX products. The indices will comprise an equally-weighted basket of 20 pay-as-you-go (PAUG) CDS referencing European CMBS selected according to a defined set of rules.

The index coupon will be fixed at roll and the index will be quoted on a price basis rather than spread, due to the prepayment uncertainty. There will be indices based on triple-A and triple-B, euro and sterling denominated tranches.

Indices to tighten?
The past week has seen the usual steady flow of pre-roll CDS index constituent announcements. Market moves today, 12 September, and a number of analyst reports suggest that the new series could trade tighter after the roll on 20 September.

For example, Dresdner Kleinwort structured credit research team in London notes: "Series 9 of the investment grade index, CDX.NA.IG, will see eight name changes. In particular, three of the widest names in the current series, First Data, Residential Corp and Alltel, will be removed and the new series is therefore expected to price significantly tighter despite the six month maturity extension."

For full index details see:

http://www.markit.com/information/affiliations/cdx/index_news for the CDX indices

http://www.indexco.com for the iTraxx indices

Seven SIVs reviewed
Moody's has taken rating actions on seven structured investment vehicles, following the agency's review of its approach to the sector (see story on SIVs for more).

Moody's placed the A-1 rated mezzanine capital notes of Axon Financial Funding and the Baa2 ratings of Harrier Finance Funding's income notes on negative watch, reflecting the deterioration in market value of their portfolios and the potential impact of crystallised losses following asset sales.

It has also placed on review for possible downgrade the Prime-1/Aaa ratings of Kestrel Funding's MTN and CP programmes, as well as the Baa2 ratings of its income notes. The vehicle has breached a trigger which caused it to enter into a restricted operations mode, which means that it cannot purchase further assets.

Additionally, Rhinebridge had the Aaa ratings of its senior capital notes, the A3 ratings of its mezzanine capital notes and the Baa2 ratings of its combination notes put on negative watch, while Victoria Finance's Baa2 rated capital notes were also placed on review.

And Moody's has downgraded to Caa2 from A3 Cheyne Finance's mezzanine capital notes, as well as downgrading to Caa3 from Baa2 its combination capital notes and placing on review for possible downgrade its MTN and CP programmes. The rating action reflects the breach of a trigger which resulted in the vehicle entering an irreversible wind-down mode.

For all vehicles that now have rated debt under review for possible downgrade, Moody's will focus on the ability of the vehicles to issue new debt, the future evolution of market prices and the potential crystallisation of losses following any asset sales.

Meanwhile, Fitch has also placed Axon Financial's mezzanine capital notes on watch negative due to the continuing challenge of accessing the CP and MTN markets to refinance maturing debt. The action also takes into account losses realised from the continued sale of assets to meet maturing debt or the sale of assets if the vehicle were to enter into a restricted funding operating status. Restricted funding operating state could be triggered if the net asset value of capital and mezzanine notes fell below 50% of capital and mezzanine notional amount.

The agency notes that the manager is in discussions with third parties to secure alternative funding sources.

And unlike Moody's, Fitch downgraded Rhinebridge's CP from F1+ to F3, its MTNs from triple-A to triple-B minus and its senior, mezzanine and combo capital notes from AAA/B/BBB respectively to B/CCC-/CCC-. The move was precipitated by: the vehicle breaching an NCO liquidity trigger on 7 September; the increased likelihood of a restricted funding/enforcement event occurring in the very near future; the unknown direction the security trustee may follow should an enforcement event occur; the likelihood of increased market value losses materialising in the Rhinebridge portfolio in any forced sale scenario; its continuing inability to access the CP market; and losses realised upon the continued sale of assets to meet maturing CP.

The rating actions reflect Fitch's view that no alternative sources of funding will now be found for Rhinebridge and a sale of assets or further liquidity draw will be required to meet maturing liabilities.

The portfolio has experienced a price decline of approximately 5%; a portfolio price decline of approximately 8.5% would cause a breach of a major capital test and could lead the vehicle into enforcement. However, the portfolio could withstand a 12% price deterioration without impacting upon the senior capital notes and a price deterioration of 17% without impacting upon the CP investors.

New CDPC rated
Moody's has assigned a provisional counterparty rating of Aaa to Quadrant Structured Credit Products; a provisional rating of Aaa to Quadrant's senior subordinated 2007 deferrable interest auction rate notes, series A; and a provisional rating of Aa2 to Quadrant's subordinated 2007 deferrable
interest auction rate notes, series B.

Quadrant is a credit derivative product company organised in Delaware that will invest in a diversified portfolio of single name and static tranches of corporate credits through the CDS market. Quadrant is majority owned by Magnetar MQ and minority owned by Lehman Brothers Holdings and certain members of Quadrant's management team.

Magnetar MQ is advised by Magnetar Financial, which is an alternative asset manager. As of 31 December 2006, Magnetar had assets under management of approximately US$4bn.

Rating volatility examined
DBRS has published a commentary on the analysis of rating volatility in the structured credit market. The research discusses the impact of leverage and portfolio and structural effects, and shows how model risk can increase rating volatility.

Moreover, the article demonstrates the importance of rating volatility analysis in developing reliable rating and surveillance tools, as well as helping to improve the transparency of the meaning and future performance of ratings. The responsibility of rating agencies is to be as transparent as possible about the potential of one security to display more rating volatility than another, especially when both have the same rating.

DBRS calls for more information and transparency to be provided on the meaning and expected future performance of ratings. Focusing on the structured credit market, the research shows how rating volatility can be measured, mitigated and communicated to the market.

Three potential options for communicating rating volatility are assessed in the paper. First, a new rating scale for more volatile structured credit is discounted as unworkable because it would lead to more confusion. Second, DBRS says that making all ratings mean the same thing might be appealing in principle, but it is not possible given the number of different factors driving the risk of each underlying portfolio and the variety of liability structures.

Third, DBRS suggests that a "3-D view of risk" might be a workable solution. This would imply the adoption of a three-dimensional approach, in which ratings remain one-dimensional (addressing default risk), but the other two dimensions (recovery risk and volatility) are analysed separately and communicated to the market in parallel as separate pieces of information.

CPDO gloom overdone?
Research published by Royal Bank of Scotland's structured credit strategy team last week seeks to address recent criticism of CPDOs. "We believe that the doomsday slant accompanying the majority of press reports on CPDOs is rather unwarranted, though maybe understandable," it says.

To counterbalance the negative reporting certain observations need to be made (once more), RBS argues. These include: the risk equivalent of CDPOs issued so far is, by RBS estimates, no higher than €30bn and that, while certainly there are market scenarios which can force a CPDO to cash out, this can be said for practically any structure, no matter how defensive it is.

Nonetheless, RBS concedes that a major feature of the index-based long-only CPDO structure is that it aims to shield from defaults by substituting deteriorating credits in the portfolio, which is achieved via rolling into a fresh, cleansed, iTraxx/CDX portfolio every six months. Indeed, this defence mechanism against defaults can prove quite costly.

Yet RBS notes that this is not a CPDO-specific issue but rather a well-known dilemma for any credit portfolio: is it economically preferable to trade-out of deteriorating credits at a cost (the earlier one trades-out the lower the cost) or to just let the portfolio take its due defaults? Navigating an optimal route between the two approaches is by no means a trivial task.

Specific to the current CDPO structures, if only a bunch of credits in the portfolio suffer downgrades and exhibit spread widening during the six-month period, and are subsequently removed from the new portfolio, the CPDO is hurt twofold: it sustains negative mark-to-market due to the spread widening; and it rolls into a tighter spread (as the wider credits are replaced by tighter credits), giving it a lower chance to recoup the MTM loss through higher excess spread.

"This exactly demonstrates the CDPO sensitivity to idiosyncratic risk," RBS observes. "Yet current market conditions have gone beyond idiosyncratic spread blow-ups."

Caliber NAV drops
Cambridge Place Investment Management's Caliber vehicle last week announced its latest net asset value per share. As at 31 July, Caliber's unaudited NAV was US$1.61, against a NAV of US$5.55 at 30 June. The fall in the NAV reflects severe market disruption during July, Caliber explains.

CS

Trading ideas - break out the disinfectant

Dave Klein, research analyst at Credit Derivatives Research, looks at an outright short on Clorox Company

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

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

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

In today's trade, we express our deteriorating outlook for the Clorox Company (CLX) in an outright short position. Given CLX's CDS curve steepness and the volatile gyrations of credit indices, this is the best trade available and possesses reasonable economics. We would love to find a positive carry position, but we believe the upside of a naked short on CLX (going long protection) outweighs the benefits of hedging with a credit index at this time.

Go short
We have scored CLX using our Multi-Factor Credit Indicator (MFCI) model along multiple factors. Most factors (fundamental outlook, LBO-viability, spread/default probability) indicate that CLX is trading too tight. Additionally, CLX has indicated that it might target higher leverage, which would drop its Spread/Leverage score.

Exhibit 1 charts CLX's CDS performance since the beginning of 2006. CLX rallied significantly through 2006 and has since sold off. Spreads spiked at the end of August when S&P lowered its rating on CLX to triple-B plus from single-A minus, but have since recovered.

Exhibit 1

Given our negative view for CLX, we want to be short the credit. We can take this position either by shorting bonds or buying CDS protection.

In order to evaluate opportunities across the term structure, we compare CDS levels to adjusted bond z-spreads, which we believe is the most straightforward way to compare the two securities. We do not see sufficient liquidity and amount outstanding in CLX's bonds to recommend them as a short.

Exhibit 2 compares CLX's market CDS levels to our fair value CDS levels. In order to estimate CDS fair values, we regress each tenor (3s, 5s, 7s, 10s) against the other tenors across the universe of credits we cover. This results in a set of models with extremely high r-squareds.

Exhibit 2

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

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

Although we are facing negative carry and roll-down, we choose not to hedge with a credit index at this time due to CLX's idiosyncratic relationship to the CDX. If a positive-carry trade is desired, an equal-weighted buy CLX protection/sell CDX protection will accomplish this. The short CLX/long CDX trade is more of a pairs trade than a positive-carry short in our estimation.

Risk analysis
This trade takes an outright short position. It is un-hedged against general market moves, as well as against idiosyncratic curve movements.

Additionally, we face about 5bp of bid-offer to cross. The trade has negative carry, which means we face a double challenge of paying carry and fighting curve roll-down. We believe that the challenge is worthwhile, given CLX's current levels, its levels of a few weeks ago and our fundamental outlook for the credit.

Entering and exiting any trade carries execution risk and CLX has reasonable liquidity in the CDS market at the 5y tenor.

Liquidity
Liquidity is a major driver of any longer-dated trade – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets. CLX has reasonable liquidity in the CDS market at the 5y tenor. Liquidity may be an issue after the roll later this month.

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

Craig Hutson, Gimme Credit's Household Products expert, maintains a deteriorating fundamental outlook on CLX. He notes that CLX has a heavy reliance on North America and has shifted its financial policies recently and may target higher leverage. Craig further notes that CLX "could be more acquisitive and will be more shareholder-friendly".

We note that CLX scores a relatively high 3.7/5 on our LBO-viability screen, although we have not heard any recent private equity rumours surrounding the name and current market conditions would not indicate an imminent move in this direction.

Summary and trade recommendation
Although CLX has recovered a bit since its spike at the end of the month, we see little on the positive side for this credit. Given the potential for increased leverage and more shareholder-friendly polices, we maintain a deteriorating outlook on the company.

With the majority of factors in our MFCI model pointing to credit deterioration, we seek the best short trade available in the face of significant liquidity challenges. Given our negative outlook for CLX and its recent CDS rally, we feel an outright position presents the best opportunity for trading this name.

Buy US$10m notional the Clorox Company 5y CDS protection at 36bp to pay 36bp of carry

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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).