Contents

Risk and reward

First-loss fund to capitalise on increased risk premiums

Prytania Investment Advisors has launched a new open-ended fund designed to generate high risk-adjusted returns by capitalising on the current dislocation in the structured credit market. Called Athena, the fund is expected to have a significant allocation to investments in first and second loss CDO and ABS tranches.

The motivation behind the Athena Fund is to capture some of the opportunities created by the extraordinary widening of structured finance spreads over the past nine months and the emergence of a very large risk premium in some assets. "The aim is to buy assets trading at levels we believe to be unrealistically wide, given the current state of the economy, thanks to so much bad news being priced in," explains Ulrik Walther, partner at Prytania.

He adds: "The emphasis on first and second loss positions is because they provide high absolute returns. But we may invest further up the capital structure and look at distressed opportunities."

Equity tranches tend to pay down relatively quickly and so Athena has an element of reinvestment risk (as well as the likelihood that reinvestment will occur at lower returns). Asset substitution is allowed, but the fund doesn't have to comply with any covenants. It has a lock up of three years, after which it is likely to be run off.

The initial round of subscriptions led to investors contributing US$65m to the fund, but Prytania plans to increase its size to between US$150m to US$200m in the coming months. Athena is expected to be overweight CDOs relative to ABS assets, as this is where the complexity premium is perceived to be more pronounced.

"The idea isn't to buy the market, but to identify sectors, managers, originators and structures that we like," adds Walther. "There is nothing preventing us from including synthetic assets in the portfolio, but we'll only buy them if they represent good relative value."

A widely diversified global portfolio, which more than discounts the stress that Prytania anticipates in the year ahead, should deliver a return in the region of 15% to 20% over the business cycle. The fund can use moderate leverage, but – given the cost and limited availability of term leverage and the high returns available on the assets now – the manager is unlikely to employ it in the near term.

However, while the current market dislocation provides an opportunity, it also limits the client universe. The opportunity exists precisely because many investors have retreated from the market. These investors were attracted by stable markets with stable returns, to which leverage could be applied.

There has nonetheless been a change in sentiment recently, according to Walther. With valuations beginning to stabilise and in some cases tightening, there appears to be some realisation that the market has swung too far to the other side.

"There is certainly money sniffing around for this type of fund; that is, an un-levered investment with a transparent portfolio, which is not inhibited by debt covenants," he concludes.

CS

CDS futures push

"Knee-jerk reaction" unlikely to succeed

Regulatory pressure to bolster exchange trading of CDS instruments appears to be growing. While investors are hopeful that this may increase liquidity in CDS futures, others say that it is simply the same knee-jerk reaction witnessed after previous financial crises.

The last 10 years have been all about OTC credit derivatives, but now there is an increasing focus on organising the market in terms of margin calls and exchange-based infrastructure, notes Julien Turc, head of quantitative strategy at SG (the sole market-maker for Eurex's CDS futures contract). "Exchanges should set prices and a regulator or state-supported institution should be established to support them in their efforts," he says.

But Jochen Felsenheimer, md and head of credit strategy & structured credit research at UniCredit, points out that there is a strong correlation between financial crises and discussions on introducing regulatory measures. "So it's not surprising that there is a renewed emphasis on CDS futures currently, but I think it will disappear very quickly," he says.

He adds: "In this instance though, it appears to be being driven by the desire to reduce counterparty risk – increasing transparency is a secondary concern. Regulatory authorities want to reduce systemic risk and so if Bear Stearns had failed, for example, the chances are that it would have immediately resulted in CDS going on-exchange." In any case, CDS counterparties typically already have instruments in place to reduce counterparty risk, such as bilateral collateral agreements.

While pressure from the authorities to develop a CDS trading platform and clearing facility may have increased, an exchange-traded market needs more than this to succeed. "I was very optimistic about the Eurex future being introduced because I thought it would encourage many more investors to enter the market, but it has suffered from poor liquidity – for a futures contract to succeed, it needs strong commitment from market-makers to provide continuous prices and low bid/offer spreads. In theory it's a good idea and makes sense for many clients, but it doesn't seem practical at the moment," Felsenheimer notes.

Since their launch on Eurex in March 2007, for example, there has been little activity in CDS futures due to the lack of support from dealers. "Dealers have been keen to block the development of CDS futures because they want to protect their margins: they view other parts of their businesses as more profitable. I also have a feeling that they are working on an alternative of their own," explains Jamie Grant, investment manager at AXA Investment Managers in London.

He says that a liquid CDS futures market would be very beneficial for the buy-side because the contracts are well understood by their clients and allow those firms without a mandate for CDS to hedge their credit portfolios and take directional views. "But these benefits are eroded by the illiquidity of the product – we're not going to trade something that doesn't have any support from market-makers. Perhaps it's time to revisit the contracts in the wake of the last nine months of market dislocation. We could also see more inflows in Europe if the CME contracts, for example, gain traction."

However, sources say that dealers are unlikely to change their bias against CDS futures because exchange-traded markets effectively reduce the power they enjoy in the OTC market. Others point to the fact that other established OTC markets haven't been forced on to an exchange (though some exchange trading of these instruments does occur), so it's hard to argue that CDS should be.

OTC credit derivatives remain popular because they are more flexible and cheaper to transact than futures. Some structured credit practitioners have tried to convince dealers that the increasing volumes created by having an exchange-traded contract would offset the decline in their margins, but additional demand from real money accounts in reality appears limited.

CS

Good beginnings

MCDX gains traction and new trading strategies

"The first two weeks of trading on MCDX have been constructive. Initial interest has come from hedge funds and prop desks, although we expect municipal cash investors to get more involved in the future," says Alex Roever, credit strategist at JPMorgan.

He adds: "A number of factors have contributed to the ongoing volatility in the muni market, such as restructuring of the auction rate securities market, the withdrawal of Bear Stearns and UBS - two of the top five dealers - from the muni market and also isolated credit events, such as Jefferson County, Alabama, potentially flirting with bankruptcy."

MCDX spreads have moved slightly wider since it was launched. The five-year index has been most actively traded, having launched at 38bp, widening out to the high-40s and trading around the 45bp mark, as of 27 May.

Given the index's steady start, structured credit analysts at Morgan Stanley have put forward a number of potential trading strategies that come into force when paired with corporate indices or other asset classes. They recommend going long MCDX and short CDX in an expected loss trade, either by being carry-neutral or slightly carry positive.

According to MS, the trade works for both five-year and 10-year maturities. "The liquid point for single name muni CDS is 10yrs, though MCDX has good liquidity in 5yrs as well," the analysts explain.

At the time of MS' report, 10-years on the MCDX were trading at 47bp and on the CDX at 93bp. "The corresponding expected loss, assuming a duration of 7.7 for both, is 3.6% for MCDX and 7.2% for CDX IG. When you assume a standard recovery of 80% for munis and 40% for IG corporates, this implies an 18.1% default rate in the muni market and an 11.9% default rate in corporates," they continue.

MS also suggests looking at MCDX as a pure risk premium trade. Given that historical default data for municipal risk are nearly non-existent (once housing and hospital revenue bonds are removed), much of the spread on MCDX can be considered to be compensation for spread volatility as opposed to actual default risk.

"In this way we consider MCDX to be somewhat analogous to the pure risk premium 30%-100% tranche in CDX IG10," the analysts note. "We like going long MCDX versus shorting CDX IG 10 30%-100%, equal notional. Given the super senior tranches' poor technicals, this tranche could widen dramatically again in a weakening environment."

Assuming current market levels, an investor would receive US$52,000 upfront to go long US$10m MCDX and pay nothing to enter a CDX IG 10 30%-100% tranche trade at 27bp. Rolldown for MCDX is much steeper than the super-senior tranche, with the trade being carry positive.

Another way to trade MCDX as a pure risk premium play is to compare it to European sovereign CDS, suggests MS. EU sovereigns have never had a default and munis have had relatively few since 1970 - and the few that have occurred had extremely high recoveries, many at par.

Away from trading strategies, a number of market participants have hinted that legal issues surrounding muni bonds could be the source of future glitches for the sector. Most municipal bonds are non-accelerating, so if a coupon payment is missed the municipality will only pay the bondholder the missing coupon and they will have to wait until final maturity for par.

"Therefore, a seller of protection could potentially be required to take delivery of a bond and have to hold it to maturity to realise par," explain the MS analysts. "Furthermore, unlike most corporate bonds, a bondholder has no claim to any of the municipality's assets, only the payability of the taxpayers or future revenue streams from the entity."

AC

Syndicated returns

Donald Uderitz, chairman and chief investment officer of Vanquish Capital Group, answers SCI's questions

Donald Uderitz

Q: When, how and why did your firm become involved in the structured credit markets?
A: Vanquish Capital Group is a boutique investment advisor that was established in 2006 and traded with its own money until January 2007, when we launched the US$58m VCG Special Opportunity Fund to focus on various structured credit opportunities. Since then, we've also launched another investment fund that focuses on structured corporate credits, which we manage for a large institutional investor.

Years ago, I was a partner in two other successful hedge funds (The III Funds and Tequesta Funds) and my 15-plus-year career has focused mainly in opportunistic structured product and credit derivative trades. In 2006, I began to identify what I thought were very interesting opportunities in the somewhat inefficient structured credit markets.

So I put my money to work taking advantage of structural and document-driven arbitrage opportunities and raised a pool of capital to do the same for investors. Like many fund managers in this space, our main focus is now on distressed structured credit, but our investment strategies tend to be quite unique.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: From a market performance point of view, obviously the collapse of the credit markets - from the sub-prime meltdown to CDOs and the ongoing contagion into corporate, municipal and consumer credits - has been a significant development. We've seen a significant re-pricing of risk with system-wide de-leveraging and a tremendous uncertainty resulting from things like questionable ratings models. But much of the negative developments of the last year and a half have played right into our strength and we have been very active raising new capital and mining for opportunities.

In terms of positive developments for the credit markets, the advent of the CDS market and synthetic indices has been significant. All of these new products have lent themselves well to more effectively managing credit risk and have provided liquidity and price visibility in credit-linked markets.

They have also created a basis with the underlying cash instruments, which enabled investors to express their convictions and/or take advantage of technical momentum in the market. Some might argue that these synthetics have contributed to the problems in the credit markets, and in some ways they have, but I think they have been a positive development for the most part.

Q: How has this affected your business?
A: The de-leveraging we're experiencing currently is presenting tremendous opportunities: providing you select the right assets, you can buy relatively low risk investments yielding high returns without taking leverage (see also separate news article).

Q: What are your key areas of focus today?
A: Again, like most fund managers in this space, we are focused opportunistically on the stressed and distressed structured credits, with our main focus being ABS and US bank syndicate loans. Our trade constructs and value propositions tend to be more unique and more akin to structured arbitrage, as opposed to directional bets based on valuation models.

Even the way we are raising capital is somewhat unique for this space. It seems that most managers are raising capital into a variety of distressed credit funds with more private equity-like terms; say two or three-year lock-ups with back-end performance fees.

But we think quite a few investors have understandably cooled to the idea of allocating capital to a discretionary fixed-income fund. So we're taking a syndicated approach to individual transactions. As part of the process, a single-purpose investment vehicle is set up to invest in a specific deal; as the vehicle winds down, the capital gains are distributed among investors and eventually it disappears when the investment pays off.

By marrying capital precisely with the investment, the advantage is that the vehicle is tailored to the specifics of the transaction and doesn't have to reinvest the proceeds. It also addresses the liquidity issues of a typical fund, which might have a mismatch between the appropriate holding period for the investment and the various liquidity gates usually offered by funds. We are able to do this because we have a tendency towards complete transparency in our investments.

For example, one of the strategies behind such a fund is to own the super-senior control rights and equity call rights of ABS CDOs; we think that owning the right to liquidate the CDOs as a portal to the underlying assets is a smart way to access cashflows that have inherent value. It is based on having a good understanding of event of default documentation, together with fundamental analysis of the underlying assets. We've done our surveillance to find the CDOs with the right portfolios and documentation, approached the dealers that hold the super-senior paper and bought tranches at the right prices.

Our first such transaction comprises 50% typical 2006/2007 sub-prime paper originally rated double-A or higher, 25% triple-A rated prime fixed-rate RMBS and 25% other CDO tranches. We're not counting on the CDO assets to provide value due to their PIKable characteristics, but the prime collateral has good subordination and is performing well.

In addition, the sub-prime collateral isn't performing as badly as people might think: the asset class has traded down to deep discounts, yet some of the underlying mortgages (around two-thirds) are still performing. There is also a structural benefit in that many sub-prime loans have high floors at around 8.5%, so - with Libor falling - the debt service for the senior notes is around 2.5%.

The resulting excess interest can thus be used to replenish the overcollateralisation and credit enhancement amounts, thereby enabling the credit risk to de-lever over time. The importance of understanding this excess interest isn't well recognised at the moment.

We have also done some comparative analysis with investing in distressed real estate and, while this enables investors to benefit from employing loss mitigation strategies, it doesn't have the liquidity that securities do.

Q: What is your strategy going forward?
A: Over the next six months to three years, certain sectors will be cleaned up, with the higher rated, better structured product faring better. From time to time, some surprise events will hit the market - such as a write-down - and the monoline and rating agency situations still have to play out. But if you navigate the market well, there will be good cherry-picking opportunities to come.

Q: What major developments do you need/expect from the market in the future?
A: We don't see the negative basis trade coming back - and this essentially drove the CDO market. Assuming the underwriting issues are corrected, one idea to replace CDOs as we know them is to combine what's good about traditional CDOs and what's good about traditional CMOs. You could merge the time/credit tranching of CMOs with the managed format of CDOs and create a better, more acceptable product.

About Vanquish Capital Group
The Vanquish Capital Group is an investment boutique dedicated to identifying above average investment and arbitrage opportunities across all levels of the US capital and fixed income markets, and developing the most efficient vehicle or platform from which to maximise the investment.

Vanquish Capital Group uses its own capital to research, develop and implement every investment strategy before inviting other investors to join in the opportunity. As a result, each one of its companies employs a strategy that is unique in its space and delivers exceptional risk-adjusted returns to the Group, as well as to its limited number of investors.

CDO business reorganised ...

The latest company and people moves

CDO business reorganised ...
Credit Suisse is reorganising its CDO business as part of wider organisational changes and personnel appointments in the Structured Products Group. According to an internal memo, the CDO business will be re-arranged to manage and reduce existing exposures, and capture attractive trading opportunities amid the market dislocation.

Mike Marriott has been appointed head of structured products. He will be responsible for CDO trading, plus all aspects of CS' RMBS and ABS businesses. Andy Kimura assumes the newly created position of head of structured products proprietary trading.

This new desk will be a dealer-facing trading effort and will take responsibility for the management and risk reduction of the legacy synthetic CDO and CDO warehouse positions. Both Marriott and Kimura will report to Gael de Boissard and Jonathan McHardy.

The CDO structuring group in London and New York will have a joint report into Structured Products and Credit.

... and staff reshuffled
Following the formation of the Global Credit business at Credit Suisse, the bank has announced the following changes.

Andy Hubbard will head US structured credit derivatives. He will have oversight of the credit swaption and US credit index tranche businesses, while also being involved with the growth of CS' high-yield index, exotics and options trading.

Tim Brennan will continue in his current leadership position in credit derivatives, reporting to Neil Yaris, head of US public high yield trading. In particular, Brennan will focus on the high yield CDS franchise and further integrate this effort with CS' cash franchise.

Steve Feinberg will continue in his role as US head of investment grade cash and CDS. He will have additional oversight in developing a credit opportunity proprietary effort.

The above will all report to Phil DeSantis, US head of credit trading.

Hannover Square adds two
Ra Sharma and Jeff D'Souza are believed to have joined Hannover Square Capital in some capacity. Sharma was previously head of primary structured credit at BNP Paribas, while D'Souza was an md in Deutsche Bank's Alternative Assets Solutions Group.

Eurohypo Asset Management acquired in MBO
Paul Rivlin and Neil Lawson-May, the former joint ceos of Eurohypo's investment banking division, have left Eurohypo and acquired Eurohypo's FSA-regulated fund management business – Eurohypo Asset Management – in an MBO. Eurohypo Asset Management is to be renamed Palatium Investment Management and will establish a series of new funds to target opportunity returns within the global real estate sector.

Palatium is already creating its first new fund, which will take advantage of the current market conditions in the preferred equity and mezzanine debt markets. This will mean that, together with its existing funds, the company will have €750m under management by the end of its first year.

Palatium, which is based in London, was established in 2005 and is regulated by the FSA as an investment manager. Palatium manages two established funds, including Glastonbury Finance 2007-1 – a £355.65m cashflow CRE CDO. The company is currently recruiting an experienced team to take the business forward.

Lawson-May comments: "Despite, and in some cases because of, current market conditions, there are still a number of truly exciting investment opportunities in real estate and real estate debt. Palatium will pursue these in the years ahead to offer investors opportunity returns in a variety of the world's real estate markets. The key factors will be our ability to identify clearly defined opportunities and manage them successfully."

Rivlin adds: "It is apparent that many institutional investors are still active in the real estate market and share our view that there are very real opportunities to create above average risk weighted returns. We are tremendously grateful for the support and encouragement that our former colleagues, clients and partners have given."

IMC increases Faxtor commitment
In a further example of parent companies stepping in to bolster their CDO manager franchise in the wake of the credit crunch, Faxtor Securities has benefited from the increased support and oversight provided by its parent, International Marketmakers Combination Holding (IMC). As a result, Faxtor is now better positioned to consolidate and grow its credit asset management business in the current challenging market conditions, according to Fitch.

IMC has reaffirmed its commitment to Faxtor through the acquisition of 22.5% minority interests from Faxtor's management, thereby becoming its unique shareholder. Furthermore, IMC intends to contribute substantially to the development of Faxtor as the core asset management platform of the group by strengthening Faxtor's management team and committing seed capital to new investment products. Management remains committed to the structured finance (SF) and CDO business, as demonstrated by the development of an un-levered European mezzanine ABS fund (see also separate news story).

Under IMC's leadership, Faxtor has made improvements to its risk management practices and increased the formalisation of its corporate governance. It now operates a global credit committee, supervised by new cio Maarten Weiss, and interacts more closely and formally with IMC to demonstrate that the risks of the business are adequately managed.

Despite poor performance of CDOs and funds exposed to US sub-prime securities, which resulted in investment write-downs, Faxtor remained profitable in 2007 and expects to be so in 2008. General ABS market disruption resulted in a decrease in Faxtor's assets under management (AUM) by 22% since mid-2007, largely driven by warehousing lines being wound down.

BONYM hires md in Europe
The Bank of New York Mellon has appointed Dean Fletcher as md of the structured products group covering Europe, Middle East and Africa for the international division of the company's global corporate trust business. Fletcher will lead the development and expansion of the firm's structured finance business across EMEA, including for CDOs. He is based in London and reports to James Maitland, head of the EMEA region for the corporate trust business.

Fletcher joins The Bank of New York Mellon from Barclays Capital, where he was global head of operational risk and new products. Prior to that he was head of risk management for JP Morgan's corporate trust unit for three years and served as head of structured finance in EMEA with JP Morgan for three years.

Securitisation veteran hired
Craig Phillips has joined BlackRock as head of its Financial Markets Advisory group, a part of BlackRock Solutions. Phillips, who has been involved in the asset-based finance markets for more than 30 years, will report to Charles Hallac, vice chairman and head of BlackRock Solutions.

Philips was previously managing member of Ptarmigan Capital, an alternative asset management firm. From 1994 to 2006, he was global head of the securitised products group at Morgan Stanley, having previously worked at Credit Suisse First Boston where he was co-head of its US securitisation group.

Integrated managers to remain legally separate
Following the integration of Omicron Investment Management with Aurelius Capital last month (see SCI issue 87), it has emerged that the two companies will remain as legally separate entities. Explaining the reasons for the integration, Laurent Proutiere, coo for Calyon Structured Credit Markets, says: "The aim of Calyon and Aurelius is to create better value for Omicron's clients and cut costs by looking at the possible synergies. With the new management in place, Messrs Klug and Exenberger will not be remaining with Omicron."

Further details regarding the future of Omicron's CDOs are expected within a few weeks. In the meantime, Proutiere confirms that a bigger team is now working on Carnuntum CDO, and adds that Calyon and Aurelius are looking to combine the strengths of Omicron and Aurelius to improve the outlook of the transaction going forward.

With respect to the Stanton CDO, which has a key-man clause, Omicron is currently in talks with investors.

Markit buys SwapsWire
Markit has completed its acquisition of SwapsWire, the electronic trade confirmation network for the OTC derivative markets. Markit expects to complete the full integration of the company by July this year.

According to data from the latest Markit Metrics report, trade confirmation backlogs in credit derivatives stabilised in the first quarter this year to approximately 6,000 trades per dealer per month, relative to average monthly trading volumes of 25,000 trades per dealer. However, with OTC derivative markets continuing to grow at a rapid pace, market infrastructure will remain a key concern among regulators.

The integrated Markit Trade Processing (MTP) services have been re-branded as follows, with immediate effect:

• Markit Trade Manager (previously MTP) provides cross-asset class trade workflow and reporting services for buy-side clients, including links to Markit Wire and DTCC Deriv/SERV
• Markit Tie Out, which forms part of Markit Trade Manager, allows buy-side and sell-side firms to affirm the key economics of trades on trade date
• Markit Wire (previously SwapsWire) is a trade date legal confirmation service with real time messaging and trade resolution
• Markit PBWire is a widely used trade acceptance service for prime brokers and their counterparts
• Markit PortRec is an award-winning portfolio reconciliation service.

SCA appoints new cfo
SCA has appointed Elizabeth Keys as svp and cfo, effective from 1 June. Keys will succeed David Shea, who will depart from the company to pursue other opportunities. Shea will remain at SCA as an advisor until June 15.

Since August 2006, Keys has served as SCA's md, head of financial planning and analysis. In this role, she established and led the financial planning and analysis function of SCA and its subsidiaries.

Prior to her most recent role, she was cfo at XLCA, a subsidiary of SCA. In that position, she was responsible for all aspects of XLCA's financial activities, including financial accounting and reporting and strategic and business planning.

AC & CS

SIV asset/liability profiles reviewed

A round-up of this week's structured credit news

Overall, triple-A ratings made up 64.45% of the portfolio in December 2007 and 58.94% in March 2008; triple-B ratings (including triple-B plus and triple-B minus) made up 0.44% of the portfolio in December 2007 and 1.25% in March 2008; and non-investment grade ratings made up 0.46% of the portfolio in December 2007 and 1.70% in March 2008.

As of 31 March 2008, approximately US$176bn of outstanding senior liabilities remained (including senior repo funding and drawn liquidity) and approximately US$73.5bn matured between 1 January and 31 March 2008. The average monthly maturities in April, May and June were approximately US$22bn.

In addition, approximately 70% of the liabilities that are expected to mature between 1 April and 31 December 2008 were issued by bank-sponsored SIVs. As of 21 May, Abacus Investments Ltd and Cortland Capital Ltd no longer had any outstanding senior liabilities.

In contrast with the non-bank-sponsored SIVs, which faced enormous difficulties as a result of their inability to roll over their liabilities and fund their investments, and the ensuing disagreements among senior obligors on how best to proceed, Sigma continues to access the repo funding market. Therefore, in our opinion, the vehicle has thus far been able to manage through the market illiquidity.

Approximately US$35bn of SIV senior liabilities have defaulted as of March 2008. This represents around 10% of the approximately US$350bn that was outstanding in March 2007. Incidentally, an additional US$49.75bn of outstanding senior liabilities will mature after 2008.

Historically, SIVs benefited from a diverse asset base across many different asset sectors, including many ABS sectors, such as credit cards and student loans; CMBS; and RMBS. The more recent SIV sector entrants, particularly the non-bank-sponsored SIVs, generally increased their asset concentrations in RMBS and CDOs.

Those SIVs with the highest concentration of US RMBS, whether classified as Alt-A, mid-prime, or sub-prime, and ABS CDOs have generally experienced the most acute loss in market value of the securities in their asset portfolios and, therefore, a resultant drop in capital note investor net asset value. There has been unprecedented rating and price volatility for these sectors, and this reflects uncertainty with regard to the 2005-2007 vintages. In S&P's opinion, this uncertainty results from both the lending and underwriting standards that were common during those vintage years and the high leverage these vintages exhibit.

Separately, it has emerged that Standard Chartered's SIV, Whistlejacket, was involved with legal action regarding payments due to senior ABCP investors. The legal action clarified the priority of payments, restricting payment of funds raised and allowing the receiver to hold only the cash pending a restructuring of the portfolio, according to analysts at SG. Standard Chartered had attempted to provide some liquidity support to the vehicle, however, a net asset value trigger forced receivership.

Fitch reports on criteria change ...
Fitch has released a report entitled 'Global Rating Criteria for Corporate CDOs - Sample Model Impact on Existing Ratings', in which it gives further indication of the impact its updated methodology will have on existing corporate CDO ratings.

"The impact of the new rating criteria is expected to vary widely, depending on the reference portfolio and CDO structure. CDO structures with portfolio concentrations and negative asset rating migration will be most affected," says John Olert, md and head of global structured credit at Fitch.

Fitch maintains ratings on 483 corporate CDO transactions to which the new criteria will apply. The report highlights the risk drivers that are more clearly differentiated in the new criteria and demonstrates the effect in terms of rating affirmations and downgrades on the sample CDO ratings.

The rating transitions indicated in the report are based on a sample and represent model-based results; therefore the final rating actions may vary from those described in the report. "The final ratings are determined by rating committee, which considers qualitative portfolio and structural analysis, as well as quantitative model results," says Phil McDuell, md and head of structured credit for EMEA and Asia Pacific. "The final rating actions may also be influenced by any interim action on the part of the manager to reduce portfolio risk."

... while BlackRock seeks approval for rating removal
BlackRock has requested approval - via an extraordinary resolution - from investors in Palladium CDO II (Omega Capital Investments II Series 31) to ask Fitch to withdraw its ratings of the notes, leaving S&P as sole rating agency on the transaction. The modification to the amendment deeds that would result from such a move is expected to be effective as of 13 June 2008.

The news comes three days after Fitch placed the deal on rating watch negative, reflecting the agency's view on the credit risk of the rated notes following the release of its new corporate CDO rating criteria. Fitch noted that 12 names in the portfolio are now speculative-grade and two are rated triple-C plus or below. There has also been an increase in portfolio migration risk, with 7.25% of the portfolio currently on watch negative and 20.5% of the portfolio on negative outlook.

Given Fitch's view of concentration and the current credit quality of the portfolio, the credit enhancement levels are not sufficient to justify the current rating of these notes. If no significant changes are made prior to the resolution of the watch negative placement, the agency warns that the notes will suffer downgrades of between one and five notches.

Remittance reports released
Remittance reports for May (the April collection period) have been released, showing an aggregate increase in the 60 and 90+ day delinquency buckets, as well as rises in foreclosure and REO inventories. The aggregate 30-59 day delinquency bucket rose for series 07-1 and 07-2 and declined for series 06-1 and 06-2, analysts at Barclays Capital report.

Monthly aggregate 60+ day delinquencies climbed by 99bp, 201bp, 154bp and 176bp (compared with the 123bp, 191bp, 130bp and 166bp rises last month) for Series 06-1, 06-2, 07-1 and 07-2 respectively. Nevertheless, on an individual basis, the rate of growth of 60+ delinquencies fell for a majority of the trusts tracked.

"This is in contrast to our expectation of seasonal deterioration in sub-prime collateral performance," the analysts note. "Although some may ascribe the improved performance to borrowers' anticipation of tax rebate checks, we note that similar previous fiscal stimulus packages have had little to no effect on sub-prime mortgage performance. In fact, early stage cure and delinquency roll rates show very little reaction to the anticipated or actual receipt of tax rebates from previous fiscal stimulus."

Solid performance for European CLOs
The underlying performance of European cashflow CLO portfolios gives little cause for concern at present, according to S&P, which cites low European leveraged loan default rates as the reason.

"In a market environment where European leveraged loan default rates have remained low, managers have taken advantage of attractively priced loans in the secondary loan market," says S&P. "These two factors have been significant in maintaining stability for the CLO sector."

The agency confirms that it took no rating actions on the existing CLOs of European leveraged loans during the six months to end-March 2008, and has not downgraded any notes in the European cashflow CLOs that it rates. It says that throughout Q407 and into Q108 weakening credit markets placed S&P-rated European market value CLOs under pressure.

"However, so far, all of those transactions have found ways to avert negative rating actions," it adds.

CRE CDO closed
Lehman Brothers has closed a €2.9bn CRE CDO, dubbed Excalibur Funding 1, which has been retained and will likely be used as collateral for repo. The transaction comprises two tranches, the senior of which is rated single-A by S&P and priced at 200bp over Euribor.

The portfolio consists of real estate loans, B notes (6.4%) and CMBS tranches (10.4%). Of the loans, 70% are senior and 13.3% mezzanine.

New credit derivative ETFs launched
EasyETF has launched two new trackers of credit derivatives indices - EasyETF iTraxx Europe HiVol and EasyETF iTraxx Crossover. The products have been introduced on NextTrack, the Euronext segment dedicated to ETFs.

"EasyETF iTraxx Europe HiVol and EasyETF iTraxx Crossover provide simple and transparent access to the European credit derivatives market at minimal cost. They offer investors the opportunity to take an exposure or cover their credit portfolios, set up trading strategies or profit from the positive outlook for the credit derivatives market," says Danièle Tohmé-Adet, co-head of the EasyETF platform at BNP Paribas Asset Management.

The iTraxx Europe HiVol index is constructed on the basis of a specific group of 30 of the most volatile credit derivatives among the 125 names covered by iTraxx Europe. With a greater level of risk, iTraxx Crossover offers higher yields and volatility than iTraxx Europe HiVol. It is made up of 50 credit derivatives in European companies actively managed at the frontiers of investment grade and high yield.

SIFMA reports on CDO volumes
Global funded CDO volume fell to US$11.7bn in Q108, compared to US$47.5bn in Q407 and US$186.5b in Q107, according to the latest SIFMA Research Quarterly. Cashflow and hybrid CDO volume was US$10.67bn in Q1, compared to US$31.26bn in the fourth quarter and down 92.4% from the same period from a year ago.

The synthetic funded CDO primary market was virtually closed, with only US$0.2bn issued in Q108 compared to US$5.2bn in Q407. Market value CDO volume similarly declined to US$0.9bn in Q108 from US$11bn in Q407.

Based on CDO purpose segmentation, arbitrage CDOs represented 89.4% of global volume for the period, despite declining by 73.6% from the fourth quarter and by 93.3% from the first quarter a year ago.

Although the structured finance (SF) collateral group encompasses a wide range of collateral types, the group is dominated by mortgage-related and home equity collateral. Credit quality deterioration, diminished liquidity and weak housing market trends brought SFCDO issuance to a virtual halt, the report notes. SF CDO volume fell to US$4.7bn in the first quarter, compared to US$23.5bn in the fourth quarter, and US$101bn in the first quarter a year ago.

CDOs backed by high-yield loans were the highest collateral sector for the second consecutive quarter, despite a 56.8% linked-quarter decline to US$5.8bn in the first quarter. While there has been an up-tick in defaults in 2008 from the historically low default rate in 2007, the collateral performance outlook for CLOs will undoubtedly remain superior to that of SF CDOs. For that reason, and the fact that CDO structures are generally simpler than those of SF CDOs, CLO volumes are more likely to recover in the near term than SF CDOs.

The dollar-denominated segment of CDO issuance accounted for 58.4% of global issuance in the first quarter of 2008, despite a 77.7% decline in first-quarter 2007 to US$6.8bn. Euro-denominated CDO volume ranked second at US$3.6bn, down 73.9% from fourth-quarter 2007. The 2008 euro-denominated volume of US$3.57bn was much lower than in the first quarter of 2007, when US$47.5bn was issued.

CDO rating downgrades dominate the landscape, of which most were of the ABS or SF CDOs. As of April 15 year-to-date, there were 1,041 (US$382bn) CDO downgrades, compared to 29 (US$2.3bn) upgrades, with the majority of the downgrades linked to structured finance collateral, according to Deutsche Bank.

There were 578 triple-A rated rating downgrades (US$287bn) and 627 (US$301bn) on rating-watch negative through April 15. Furthermore, S&P downgraded 47 CDO classes to D from five SF CDO transactions. Separately, the rating agency's downward adjustment of sub-prime RMBS recovery assumptions at the end of April will, in turn, lower SF CDO ratings.

Monoline exposure analysed
Fitch says in a new report that primary financial guarantor exposure in EMEA and the Asia Pacific is limited in more traditional asset classes (like RMBS and CMBS), but features more prominently in whole business asset areas. The vast majority of financial guarantees in both regions are provided by either Ambac or MBIA, both of which have seen adverse rating action in recent months.

"Many wrapped tranches are from highly seasoned transactions in these regions," says Stuart Jennings, md of European structured finance research at Fitch. "As a consequence, many of the underlying standalone ratings absent the wrap have been upgraded over time. When some of the monolines saw their insurer financial strength ratings lowered, Fitch found that many of these tranches were not downgraded to the same degree, or even at all, due to this factor."

These comments follow a period of high profile adverse rating actions by Fitch in relation to the IFS ratings of some monoline financial guarantors. The agency says that there were only a limited number of transactions with such a financial guarantee among traditional asset classes.

In addition, the existence of indicative 'underlying' or 'standalone' ratings - based on transaction structure and asset analysis alone, without the benefit of the financial guarantee - meant many wrapped tranches in SF transactions from EMEA and Asia Pacific had not seen their ratings lowered to the same degree as the financial guarantor providing the wrap. To maximise transparency with respect to wrapped tranches in these regions, Fitch has also published a downloadable spreadsheet that gives details - including the underlying rating absent the wrap - of every wrapped SF tranche in these regions.

Mortgage asset quality assessment tool launched
Mortgage market specialist edeus has launched an asset quality assessment service that the company says will allow investors to fully understand the current risk in UK mortgage-backed asset pools, including any underlying CDOs. The service assesses 100% of the mortgage pool and takes into account up-to-date credit information on borrowers and underlying assets.

Traditional due diligence checks around 15% of the original mortgage pool using information available at the point of origination. But edeus' asset quality assessment service checks borrowers' current credit scores, their current ability to service their loans and the current debt-to-value ratios on underlying assets. Investors can use the resulting information to purchase assets at discounted prices or to give evidence of asset values for balance sheet purposes.

Alan Cleary, md of edeus, comments: "Mortgage-backed assets are complex, opaque and mistrusted - that's why the market has so deeply discounted their value. But our new service brings transparency to residential mortgage-backed securities - it's the cure to the credit crunch. Billion pound asset-backed write-downs have reflected the market's lack of understanding of these products. No-one knows what risk mortgage-backed assets represent."

The service utilises the edeus suite of scorecards; cards are tailored to each segment of the mortgage market and are already proven in the origination arena. The service will use a true risk-based affordability algorithm, the original declared income and current bureau data provided to give an indication of the maximum loan affordable by the borrower - a more robust measure than traditional income multiples. An automated valuation assesses the current value of the underlying assets in the security and the up-to-date debt-to-value ratio.

BIS reports on CDS growth
Latest figures from the BIS indicate that the OTC derivatives market showed relatively steady growth in H207. Growth remained particularly strong in the CDS space, with volume increasing by 36% to US$58trn over the same period, although this growth rate slowed from the 49% recorded in the first half of the year.

At a cumulated US$6trn in the second half, multilateral terminations of CDS contracts almost doubled from US$3.2trn in the first half and shaved approximately 14% off the growth rate in this market, notes the BIS.

Growth in the notional amounts of multi-name CDS (40%) again outpaced that in single-name contracts (33%). By credit rating (single-name instruments), CDS contracts on firms with ratings below investment grade and without ratings increased by 54% and 24% from the previous half's 31% and 9% respectively, while growth in contracts on firms with investment grade slowed to 32% from 49%.

Notional amounts of all categories of OTC contracts rose by 15% to US$596trn in the second half of 2007.

DBRS implements changes
DBRS has confirmed the changes it has made across its Canadian structured finance units in recent months in response to conditions in global credit markets, continued challenges in the US sub-prime mortgage market and the inability of several Canadian non-bank ABCP issuers to roll over maturing obligations in August 2007. The changes encompass improved transparency and disclosure, the implementation of a global liquidity standard (GLS), the abolition of US sub-prime in Canadian ABCP conduits, a revised leveraged super-senior methodology and the introduction of a new rating committee processes for criteria changes.

The agency will publish comprehensive monthly disclosures of asset classes and performance metrics for all DBRS-rated Canadian ABCP conduits and term ABS. Investors and other stakeholders will be able to determine the nature of the underlying assets on a conduit-by-conduit basis and perform their own analytics based on the performance of the assets.

If new kinds of assets are added to ABCP conduits, DBRS will disclose this and provide a summary of the nature of these new asset types and their related risks. DBRS will decline to rate ABCP conduits where this level of information is not forthcoming.

DBRS announced in September its updated criteria for rating Canadian ABCP conduits and outlined its new GLS. It has worked with market participants since then to convert all Canadian ABCP conduits supported by market disruption-based liquidity to GLS.

As of 1 April 2008, Canadian ABCP programmes rated R-1(high) that were not GLS compliant were placed under review with developing implications. Non-GLS-compliant programmes will retain this status until they have successfully converted to GLS or the programme has been otherwise restructured or wound down.

DBRS has also made changes to its rating approach to take a more conservative view of other rating agencies' ratings with respect to certain US mortgage-backed securities. It applies internal credit assessments that highly discount assumptions of repayment of such securities.

There is currently no exposure to US sub-prime mortgages in DBRS-rated Canadian ABCP conduits. Due to this revised approach, there is no expectation of future exposure to US sub-prime MBS in Canadian ABCP conduits either.

The agency has also published a revised LSS methodology that establishes a more conservative approach to rating such transactions. This revision, which has been applied to current ratings as well as to certain provisional ratings, requires significantly more remote triggers in order for an LSS transaction to be rated in a given rating category. The revised methodology incorporates data observed throughout the credit/liquidity crisis that started in 2007.

Finally, DBRS has implemented significant changes to the rating committee process by creating a Structured Finance Criteria Committee (SFCC) that oversees criteria related to any structured finance product. The SFCC has representation from the heads of each structured finance unit, as well as the DBRS global head of rating committee. All new or revised structured finance criteria must be approved by the SFCC.

The DBRS code of conduct has recently been updated to describe practices related to minimising conflicts of interest between analysts and clients, and implements recommendations received from international organisations such as the Committee of European Securities Regulators (CESR) and the International Organization of Securities Commissions (IOSCO). In addition, the agency is examining the development of rating scales and factors for structured finance ratings that communicate specific risk factors in a fashion that complements the letter-based and ordinal ranking scales currently in use.

SEC rating agency probe
Following the handling of the sub-prime crisis and the recent report of computer errors at Moody's (see last week's issue), the US Securities & Exchange Commission is looking into the workings of the three main credit rating agencies.
Letters have been sent to Moody's, S&P and Fitch, asking for clarification on aspects of their methodology, analysts at BNP Paribas note.

The SEC's Erik Sirri reportedly explained: "We asked them to explain the policies and procedures used to detect errors in ratings of structured finance products and to tell us about any errors that they found in structured finance products over the last four years, including steps that they followed to correct the problem." The SEC is expected to formally propose new rules concerning credit rating agencies on 11 June.

Misys to integrate Markit loan pricing
Misys has achieved Certified Alliance Partner status under Markit's certification programme and will integrate Markit's loan pricing service into Misys Loan IQ. The combined offering will enable mutual clients of the two companies to automatically price loans from the Misys Loan IQ platform, which will ultimately boost their credit quality assessments and risk management on commercial loans.

Markit Loans is widely regarded as the most accessible and comprehensive loan pricing data in the market, the two companies say, while Misys Loan IQ provides an integrated solution covering the entire life cycle of a loan - from origination and deal tracking to agency servicing and secondary trading. Misys Loan IQ currently handles one-third of the world's syndicated loans and half of the world's secondary loan trades. Further to the integration, mutual clients will be able to view underlying dealer quotes of contributed prices directly from the Misys Loan IQ platform.

AC & CS

Summer trade winds

Structured credit trade recommendations for H208 are offered by Gregorios Venizelos and RBS' structured credit strategy team

While we may be in the eye of the storm, namely between the financials' systemic shock and a broader macro deterioration, we think it is timely for investors to consider the opportunities available across the structured credit space. Of course, the much improved market tone recently by no means signals an end to hostilities. So any opportunities need to be examined through the filter of fundamental views, and trades have to be structured taking into account investors' concerns and constraints.

'Structured' being the keyword, we think that structured products are well suited to this scenario. Namely, they offer the ability to incorporate funding and principal protection, control the degree of leverage (even dynamically), shield from mark-to-market moves and tailor the degree of spread and default exposure, to name the more apparent.

Redefining the battleground
With the clear-up in triple-A and super-senior assets underway but by no means complete (investor evacuation was at its most severe there), there are still opportunities to be had and cheap 'default remote' assets to be found. This is just as well, as CDO issuance is likely to remain far below the 2006/early-2007run-rate, and will be motivated more by risk transfer than arbitrage. Having said that, we have seen arbitrage-driven leveraged loan and CLO market activity in the past few weeks.

Structured credit products designed to offer non-recourse leverage financing, protect the principal invested and shield from mark-to-market volatility should attract the lion's share of investors' favour. And in terms of underlying risk, high quality, simple/transparent and (as much as possible) liquid assets will be in demand. Lack of liquidity will most likely be tolerated only for alternative assets that have little correlation with traditional credit risk.

Investors (as well as issuers) have hopefully learned a few lessons from the credit crunch fallout. As a result, we expect that investors - both new or those looking to return to structured credit - will ask for a few boxes to be ticked:

• Efficient financing (more so for leverage)
• Accounting/reg cap relief (e.g. MTM immunisation)
• Principal protection
• Low leverage (and non-recourse)
• Liquid underlyings
• Structural simplicity
• Default-remote tranche risk
• Credit analysis to the fore
• Low correlation of returns to 'traditional' credit risk.

One of the factors behind the structured markets' freeze post-credit crunch has been the scarcity of investment mandates that would accept illiquidity and volatility of valuation, even for assets that are fundamentally cheap. To address such constraints, bank desks have worked hard to provide structuring solutions that can shield from MTM volatility and/or achieve regulatory capital relief often in addition to providing 'cheap' term funding.

Deals of this type, based on better quality and preferably liquid underlyings and with a typical holding period of 18 months to three years, should perform well. They should be able to weather any further market volatility going forward, given that the 'non-MTM' feature should shield them from forced unwinds. In addition, the fact that banks are very motivated to clear assets off their balance sheets means that 'MTM wrapped' solutions can be offered over a wide variety of assets.

The combination of bank asset clearance (it will be a slow process) and liquidity provisions by the central banks ("in Fed we trust") should start easing the pressure on banks' balance sheets. As fears of a systemic meltdown start ebbing away on the back of that, implied correlation levels are most likely to recede. It remains to be seen though to what extent such a 'normalisation' of correlation can help rev-up the bespoke tranche market, which is currently on idle.

Another major factor at play amid gridlocked balance sheets and urgent capital requirement remedies for banks is the implementation of Basel II. Conceived during a period of ever more sophisticated risk models (read false sense of accuracy) and broader distribution of risk across capital markets (read false sense of diversification), its path to implementation now appears complicated.

We discuss here briefly factors that can affect supply/demand dynamics and thus the relative value between tranched risk:

• Basel II will make off balance sheet vehicles less economical, as implicit or explicit guarantees (liquidity backstops) will receive a capital charge. This puts all but the last nail in the coffin of SIVs etc, and can become a driver of further unwinds of surviving SIVs (albeit at a less hasty pace hopefully).
• Implemented on an IRB basis, Basel II capital requirements will be lower than current, at a time when thin capitalisation (read inadequate) has wreaked havoc across the financial sector. A case for more conservative self-regulation now to prevail over Basel II, or at least a much slower and considered adoption?
• The IRB approach favours senior versus junior tranche risk even more than previously, pushing banks further towards retaining senior risk at a time when regulators would like to see the reverse (i.e. banks retaining more junior risk) in an effort to encourage them towards higher underwriting standards in (re)securitisations.
• This same skewing of risk weightings may encourage the restructuring of unsold lower rated junior tranche risk into a higher rated CDO-squared tranche. This may well be prevented in future though, as regulatory initiatives also seem to be focusing on making resecuritisation capital charges more punitive (to avoid another fiasco like the resecuritisation of sub-prime RMBS).

Recommendations
We rehearse here the investment themes that we think will take centre stage over the next six to 12 months:

Playing the credit cycle
• Default-remote senior tranches of corporate risk are the place to be in an environment of accelerating defaults (as is the case in the US). The prime example is triple-A CLO risk but also super-senior unsecured risk. The robustness and outperformance of these tranches will become more and more obvious as defaults materialise.
• In expressing the view of a deteriorating credit cycle, triple-A CLO risk versus unsecured CDS of cyclical credits trading at the tights of their recent range can be an efficient bearish trade.
• Investors who espouse the view that monetary authorities are officially the guardian angels of (big) banks should be looking to load up on big bank debt (e.g. sell protection in iTraxx Financials) on any spread weakness.
• A turning cycle means one thing: credit fundamentals to the fore. In addition, high spread volatility can make the pay-out from single-credit calls worth the risk. Fundamental credit views can then be levered up through first-to-default baskets (the simplest form) or through a full-blown portfolio of long/shorts leveraged via a principal protected structure (e.g. DPI).
• With any window of (relatively) stable market conditions invariably leading to new issuance, we think that curve steepeners in some of the tighter (less likely to invert) names make sense. Thanks to their positive carry (particularly at current flat curve levels), steepeners can also be packaged into a leveraged note format.

Relative value
• Triple-A SF and SC spreads are set to remain notably wider than their pre-crisis levels, due to reduced investor demand and the requirement for juicier risk and liquidity premiums. The implication though is that investors need to be selective rather than indiscriminate in picking up the triple-A bargains; e.g. opt for a good versus a not as good CLO manager, even at the expense of a few basis points or for a seasoned versus a recent vintage RMBS.
• A prime example of a technically driven market dislocation, the market-implied recovery rate for LevX (based on LevX and Xover spreads and an unsecured recovery rate of 40%) has been below 40% on average since last summer, versus a more sensible 64% average pre-crisis. This clear underperformance of LevX versus Xover has been due to loan de-risking (loan books, warehouses, MV CLOs loan TRSs). As defaults start to occur, this dislocation should revert towards pre-crisis levels and LevX should outperform Xover.
• More 'creative' basis trades across the capital structure, as well as across SF asset classes (as synthetic instruments proliferate) may become popular.  Such trades will aim to capitalise on relative value dislocations driven by technical factors, e.g. loan risk unwind. A couple of examples: long senior CLO risk against a short in the CDX HY index or a CDX HY tranche; long prime European RMBS CDS risk against a short in unsecured IG CDS risk.

Mark-to-market considerations
• Low-levered funds and/or un-levered CLOs have already attracted investor interest, not only because they mitigate the market value pain in volatile markets but also because (at least part of) the lack of leverage can be compensated through the pull-to-par benefit of assets bought at (potentially deep) discount.
• Market value (including TRS) structures will be considered with a lot of skepticism but still have a role to play when non-recourse leverage is required. In that case, a good understanding of the underlying collateral and the structure behaviour under stress is essential. Case in point in current market conditions: it may make sense to print LSS when CDS IG spreads are at 130bp with 250bp as a spread trigger, but more risky to print LSS when CDS IG spreads are at 60bp with 180bp as a spread trigger.

More exotic instruments and alternative assets
• The iTraxx and CDX index correlation tranches can be used in structured trades to express specific views on spread direction or the timing and severity of the default cycle. In case of the latter, buying protection in senior mezz tranches of CDX or LCDX takes advantage of tranche optionality in respect to portfolio losses, and will give increasingly positive mark-to-market as defaults (and thus losses) pick up and the level of expected losses moves closer to the tranche attachment point. Such a trade can be expressed across the debt capital structure too, funding a short risk position in the 25%-35% CDX HY tranche, for example, through a long risk position in the 12%-15% LCDX tranche - taking advantage of the underperformance of LCDX risk during the loan de-risking process earlier in the year.
• Volatility has attracted increasing attention since last summer and has re-emerged as an asset class in its own right. Fund of funds, in Asia in particular, have looked into including volatility strategies in their portfolios, often through direct use of volatility instruments – given the dearth of dedicated funds. As for making such volatility strategies pay off, there is always of course the decision to be made by the manager as to whether volatility is too expensive to be used as a hedge (so rather sell volality instead) versus the likelihood of further market shocks causing significant draw downs in fund of fund portfolios. Specific to CDS spreads, range accruals and spread wideners are quite simple instruments for accessing volatility.
• Another fall-out from the brutal re-pricing in SF/SC risk is the rotation of investment capital towards alternative asset classes, which exhibit more robust fundamentals and (hopefully) uncorrelated returns compared to credit risk. Aside from the obvious emerging market assets (as the strength in EM economies appears still undeterred by the credit crunch) and the expected secular bull run in commodities, other asset classes that are likely to receive considerable interest are fund of fund exposure, counterparty risk and last but not least insurance-type risk - namely longevity/mortality exposure.

© 2008 The Royal Bank of Scotland. All Rights Reserved. This Research Note is an excerpt from Structured Credit Strategy, first published by The Royal Bank of Scotland on 20 May 2008.

Trading idea: caught in headlights

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a pairs trade on Deere & Co and FedEx Corp

Finding relative value in high quality investment grade issuers can be difficult. This trade looks to do that by means of a capital goods pairs trade.

By selling protection on FedEx and buying protection on Deere & Co, we see potential for spread compression coupled with positive carry as a good way to generate return. Both issuers have solid credit profiles that will be subjected to similar recessionary stress in coming years.

However, the equity market sees the risk of the two issuers to be of different magnitudes and our structural model of default risk shows there to be a wide differential of spread compensation between the two issuers. Deere also requires a significantly greater debt level than FedEx to finance its capital arm: it requires substantial new financing over the next few years. Though the new issue market has been strong in past weeks, most recent issues have weakened and we believe this will continue as demand drops.

Basis for credit picking
The MFCI model attempts to replicate the thought process of a fundamental credit analyst. We know this is an extremely arduous task; however, the output provides a great way to select intrasector pairs trades.

The MFCI model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit). Exhibit 1 lists all the factor scores for both Deere and FedEx. Deere's higher debt levels and weak market implied factors weigh heavily on its overall rank.

Exhibit 1

While we see the main driver of return for the trade to be its positive carry, we see potential for tightening of its spread differential. Due to the issuers' different market-implied levels, we believe the two spreads will eventually collapse, with FedEx tightening through Deere's spread.

Spread compensation
Another relative-value measure we use to compare issuer risk/return profiles is SPD (spread per unit default probability). As its name suggests, SPD is the amount of spread (in basis points) that we earn for each unit of default risk that we take. This simple risk-to-reward ratio is akin to the complete MFCI model but limits its scope to only one factor used within the model, BDP.

The hybrid structural model shows FedEx's default probability decreased at a much higher rate than implied by its credit spread since last summer. Therefore, the default risk compensation we receive from a long credit position in FedEx has increased, making it a good time to take a long credit exposure to FedEx.

Exhibit 2

Deere's SPD levels have been significantly less than FedEx's (Exhibit 2). Recently the SPDs of the two issuers, when viewed on a relative scaling, have diverged, making this an opportune time to enter the trade (Exhibit 3).

Exhibit 3

Debt levels
Deere requires large levels of debt to finance its capital arm and it has been increasing its overall debt level over the past few years. Since the beginning of 2000, its debt level has gone from US$10bn to almost US$25bn, while FedEx debt maintained a relatively constant level (Exhibit 4).

Exhibit 4

The new issue market's robustness in recent weeks is a good sign for Deere. However, the most recent issues have started to hit waning demand and we believe this will continue.

Deere has almost US$10bn of debt retiring over the next few years that will need to be refinanced in a much less friendly credit market than a few years back. We don't necessarily think they will have trouble refinancing; however, there is a certain element of risk associated with its financing needs that must be taken into account.

Positive carry
After finding trades that make fundamental sense, we also like to ensure that the 'technicals' point in the same direction. Though fundamentals tend to dominate price discovery in the long run, the market can remain irrational as long as it needs to. Exhibit 5 shows the range of the historical carry for the pairs trade.

Exhibit 5

After giving up bid/ask spreads for both sides of the trade, we are able to put the trade on with a carry of 21bp, which is right in the middle of the historical mid-range of 5bp-45bp. We see potential for this to collapse back towards the low of 5bp and now is a good time to get into the trade, as the spread differential has been tightening over the past few weeks.

Risk analysis
This pairs trade carries a direct risk of non-convergence. In other words, the spread differential may not tighten as expected. However, based on historical performance of the technical indicators, we believe the risk is minimal.

Liquidity
Liquidity should not be an issue for this trade since both names are investment grade issuers. The credits have historical bid/offers of 5bp-10bp for the five-year tenor and, depending on the market environment, trading out of the pairs trade should not have a large negative P&L impact.

Fundamentals
This trade is significantly affected by the fundamentals. For more details on the fundamental outlook for each of DE and FDX, please refer to Gimme Credit.

Deere (analyst: Carol Levenson) – Credit Score: 0 (Stable)
Strong industrial financials, global agriculture and commodity cycle sensitive, a stable credit profile, but we suspect balance sheet strengthening is over and cash will be returned to shareholders at a moderate pace.

FedEx (analyst: B. Craig Hutson) – Credit Score: 0 (Stable)
Global market leader in delivery services. Challenging environment, with high fuel costs and weak domestic demand. Excellent historical track record. Substantial lease payments and significant infrastructure spending represent large cash outlays.

Summary and trade recommendation
Finding relative value in high quality investment grade issuers can be difficult. This trade looks to do that by means of a capital goods pairs trade. By selling protection on FedEx and buying protection on Deere & Co, we see potential for spread compression coupled with positive carry as a good way to generate return.

Both issuers have solid credit profiles that will be subjected to similar recessionary stress in coming years. However, the equity market sees the risk of the two issuers to be of different magnitudes and our structural model of default risk shows there to be a wide differential of spread compensation between the two issuers.

Deere also requires a significantly greater debt level than FedEx to finance its capital arm: it requires substantial new financing over the next few years. Though the new issue market has been strong in past weeks, most recent issues have weakened and we believe this will continue as demand drops.

Sell US$10m notional FedEx Corp 5 Year CDS protection at 66bp.

Buy US$10m notional Deere & Co 5 Year CDS protection at 45bp to receive 21bp of carry.

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

Copyright © 2008 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).