[Lehman Brothers] Structured Credit Strategy - Annual 2004

Structured Credit Research

Structured Credit StrategyAnnual 2004

January 2004

PLEASE SEE IMPORTANTANALYST CERTIFICATION

ON PAGE 63.

Structured Credit in 2004—A Place for Incremental Yield2003 continued to be a year of innovation for many parts of the structured credit market amidone of the best years for investment grade credit and high yield assets alike. We analyze how thedevelopments in 2003 have set the foundation for the new trade opportunities that we expectto emerge in 2004. While a tight-spread, low-volatility environment offers less obviousabsolute value opportunities, there are plenty of relative value trades within the broaderstructured credit space. Our articles explore these themes in further detail. ........................ 4

CDS and Volatility Strategies in 2003 and Outlook for 2004Our outlook for 2004 calls for a tighter range-bound investment grade basis; CDS curveflattening, with the long end outperforming the short in the next couple of months; theemergence of curve slope basis trading, which we believe will also be range bound; and agenerally low and stable volatility environment with several small and short-lived spikes .. .8

Portfolio CDS Opportunities for Credit InvestorsThe launch of numerous standardized portfolio CDS products opens new doors for investorslooking to add diversified credit exposure and to park cash. There will also be opportunities toarbitrage the difference between actual and intrinsic spreads . ........................................... 14

2003: Year of the Credit Hedge Fund; 2004: A Crowded Party?In 2003, credit hedge funds took advantage of macro and market uncertainty by providingliquidity to the market through a variety of trade constructs. With spreads at relatively tightlevels, we believe hedge funds will be playing the short side more aggressively in 2004. Unlessvolatility increases, the combination of more hedge fund capital and fewer opportunities willlead to “crowded trades,” increasing the risks in arbitrage strategies. ................................. 18

Technicals and Better Models Will Keep the Momentumin Debt-Equity Trading in 20042003 saw the growth and proliferation of debt-equity trading strategies driven by both technicaland fundamental factors. Looking ahead, we expect technically driven opportunities to persistbut diminish in magnitude as more investors focus on this trading strategy and as betterquantitative models get implemented. ................................................................................. 21

CDOs—In Pursuit of YieldOur outlook supports a constructive view for 2004 as we finish the chapter on one of the bestyears in the short history of CDOs. 2003 was the year of secondary CDOs and correlationinvesting—a trend that should continue through 2004. We expect this year to be characterizedby a yield bid as investors pursue returns in a tight credit environment featuring low defaultsand low interest rates. We also expect new issue spreads to compress as improved fundamentalsand strong technicals persuade spreads out of their inertia. ................................................ 25

Sunita [email protected]

Arthur [email protected]

Philip [email protected]

Lorenzo [email protected]

Claude [email protected]

Elena [email protected]

Ashish [email protected]

Gaurav [email protected]

Christina [email protected]

Lorraine [email protected]

continued

Lehman Brothers | Structured Credit Strategies 2004 Annual

January 21, 2004 2

Leveraged Loans Remain the CDO Asset Class of ChoiceAfter another year of strong performance, we expect CLOs to remain the asset class of choicedespite diminished arbitrage opportunities and a likely drop in issuance. Lower defaults andhigh prepayment rates should remain the key secondary valuation drivers. Subordinated CLOtranches have not rallied as strongly as senior CLO spreads in 2003 and offer better value foryield-hungry investors. ......................................................................................................... 30

A Benign Consumer and Commercial Credit Cycle Supports SF CDOsWith a positive collateral outlook for 2004 and SF CDO spreads still languishing, we findopportunities on both ends of the capital structure. We are positive on senior SF CDOtranches—in both the primary and the secondary markets, with the latter offering betterrelative value. Synthetic SF subordinates and equity are attractive instruments to take up aleveraged exposure to the historically robust higher rated SF paper. .................................. 35

A Look Ahead: Synthetic CDOs in 2004A booming single-tranche synthetics market and the launch of portfolio credit products in 2003are likely to be followed by further innovations and expansion in 2004. We anticipate anincrease in structural enhancements and further improvements in modeling technology. Thechallenge in 2004 will be to balance higher idiosyncratic risk by scrutinizing valuations andhedging appropriately. .......................................................................................................... 38

Synthetic CDO Bid Likely to Temper in 2004The synthetic CDO bid drove the CDS market much tighter in 2003, presenting manyopportunities to trade into and out of the bid. We believe that in 2004, the synthetic CDO bidwill continue to play an important, albeit tempered, role for single-name CDS spreads. .. 41

The Impact of Interest Rate Movements on CDO PerformanceInterest rate hedges pinch CDO cash flows as interest rates stay at historical lows, promptingus to search for trades that are positioned to gain from current and expected future trends. Forshort-term investors looking for mark-to-market gains, pricing inefficiencies can be utilized inthe IG senior segment, where large out-of-the-money swaps are involved. Investors looking ata medium-term horizon should consider some of the overhedged transactions from oldervintages that benefit from rising interest rates. ..................................................................... 43

European CDOs: 2004 OutlookWe expect CDOs to outperform other European asset classes in 2004, especially at thesubordinate level. Our top picks are leveraged/mezzanine loan CLOs, hedged IG CDO equitystrategies, senior tranches of Spanish SME CLOs, and the purchase of mezzanine IG syntheticprotection. We believe that the booming market for synthetic CDOs of structured finance willcontinue to evolve. ................................................................................................................ 47

January 21, 2004 3


CONTACTSGlobal Head of Credit StrategyMark Howard ........................................... 212-526-7777 ........................ [email protected]

Structured Credit StrategiesSunita L. Ganapati ................................... 415-274-5485 ........................ [email protected] M. Berd ......................................... 212-526-2629 ..................... [email protected] Ha .................................................. 212-526-0319 .......................... [email protected] Isla ............................................. 44-(0)20-7260-1482 ...................... [email protected] A. Laberge ................................... .212-526-5450 ........................ [email protected] Ranguelova ................................... 212-526-4507 ......................... [email protected] Shah ............................................ 212-526-9360 ........................... [email protected] Tazaki ........................................ 81-3-5571-7188 ......................... [email protected] Tejwani ........................................ 212-526-4484 ......................... [email protected] Celi ........................................... 212-526-4482 ............................... [email protected] Fan ............................................. 212-526-1929 ................................. [email protected]

RECENT PUBLICATIONSDecember 22, 2003 Portfolio Structured Credit Monthly, December 2003

We recap the performance of the CDO market in 2003—the year of second-ary CDOs and correlation investing. CDO valuations improved dramaticallyas collateral markets rallied through the year. Issuance went up, led by thegrowth in synthetic CDOs, and downgrade activity has begun to slow down.

November 28, 2003 Trading Correlation—Relative Value across CDO TranchesWe discuss the use of the implied correlation embedded in the price of aCDO tranche as a measure of its relative value. We show that implied cor-relation varies significantly across the capital structure giving rise to a “cor-relation smile,” which fluctuates over time.

November 24, 2003 Portfolio Structured Credit Monthly, November 2003In this edition of the Portfolio Structured Credit Monthly, we continue wherewe left off in our inaugural edition. The learning curve section furtherdemystifies portfolio credit products by trying to unravel the various riskmeasures used to hedge synthetic CDO risk. We also discuss how inves-tors could profit from some of the trends we observe in the credit markets.

November 20, 2003 Quantitative Credit Research Quarterly, Vol 2003-Q4Includes The New Lehman Brothers High Yield Risk Model; Valuation ofPortfolio Credit Default Swaptions; Forward CDS Spreads; UnderstandingDeltas of Synthetic CDO Tranches; Hedging Debt with Equity; and PricingMulti-Name Default Swaps with Counterparty Risk.

November 17, 2003 U.S. High Yield Credit (GRV 11/17/03)The HY Credit Strategy section in this week’s GRV talks about the rise inlower rated HY issuance, the upward trend in recent recovery rates, andthe effect of the increased callability of HY bonds on CDO Managers.

October 28, 2003 Portfolio Structured Credit Monthly, October 2003Our newly launched publication addresses the need for analysis and infor-mation around the broader portfolio structured credit products space. Inour inaugural edition, we demystify investments in portfolio credit productsin general and correlation produ

October 20, 2003 Simulating Portable Credit Strategies with CDS and Mirror Swaps Indices(GRV 10/20/03)Discusses the use of portfolio CDS indices as an effective replication strat-egy of the Lehman Brothers corporate index.

October, 2003 The Lehman Brothers Credit Default Swap IndexWe introduce the new Lehman Brothers CDS Index and provide a descrip-tion of its construction, rules, return calculations and its use as a researchand portfolio management tool.

October, 2003 Guide to Exotic Credit Derivatives (Risk, Oct. 2003)Explains the mechanics, risks and modeling of exotic credit derivativesincluding default baskets, synthetic CDOs and credit options.


January 21, 2004 4

STRUCTURED CREDIT IN 2004—A PLACE FOR INCREMENTAL YIELD2003 continued to be a year of innovation for many parts of the structured credit marketamid one of the best years for investment grade credit and high yield assets alike.Structured credit products are becoming much more mainstream as new applications aredeveloped, the buyer base broadens, secondary markets deepen, and bid-offers narrow.

The past year was marked by the breathtaking pace of innovations as new products andmodeling technology helped meet and create demand. Key trades in 2003 revolvedaround the following themes:

• Basis trading into and out of the synthetic CDO bid• Capital structure arbitrage trading• Macro volatility trading• Distressed cash CDOs• Correlation trading

We explore these themes in our various articles. Below, we analyze how the develop-ments in 2003 have set the foundation for the new trade opportunities that we expectto emerge in 2004.

CDS Markets ProliferateWith the CDS market becoming more and more mainstream and with the number ofnames that trade actively in the high grade CDS market expanding rapidly, the nextlogical step was the development of a CDS curve. A term structure of CDS developed ina very short window of time during the second half of 2003. This was largely driven byhigher risk appetite, the 7-year synthetic CDO bid, and the 10-year portfolio CDS bid.Today, close to half the names in the investment grade CDS market have an activelytraded curve, bringing in some of the more interesting opportunities in high grade CDSinvesting in 2004.

Following cues from the volatility of late 2002, hedge funds and proprietary trading deskstook advantage of several opportunities across the debt-equity continuum. An offshoot ofthe increased capital structure arbitrage activity, which generally takes place in lowerquality names, has been the jump in high yield CDS activity, which was originallydominated by bank loan hedgers. The increase in activity is clearly supported by lower riskaversion in the market and the desire to extend the successful high grade CDS market intohigh yield. Paradoxically, while the desire to hedge exposure to investment grade namesusing CDS rose dramatically with the deterioration in credit quality from 2000 to 2002,the opposite is true for high yield credits. The sharp fall in high yield default rates and thespectacular tightening in high yield spreads have made hedging a rational expense for highyield portfolio managers, and we expect more participation from them in 2004. Inaddition, as sourcing credit in the cash market at high dollar prices becomes less attractive,the CDS market will start to provide more appeal to HY managers.

With the increase in high yield CDS activity, the year also saw the emergence of a default swapmarket with senior secured loans as deliverable contracts. While still in its infancy, the marketis active in about a dozen names and should grow in 2004. Natural sellers of protection forsuch contracts are CLO managers, who can use them during their ramp-up or in anaggressively bid loan market for reinvestment of some of their cash proceeds. Currently, the

Sunita Ganapati415 274 5485

[email protected]

A term structure of CDS developedin a very short window of timeduring the second half of 2003.

The CDS market will start to providemore appeal to HY managers.

January 21, 2004 5


“loan” CDS is callable if the underlying reference loan is fully repaid before maturity, thusexposing investors to issue-specific prepayment risk along with the usual credit risk. It ispossible that such provisions will become less common as the investor base grows and thedocumentation of loan CDS achieves greater maturity and standardization. In general, weforesee greater activity in the budding HY CDS market and in deliverable contracts.

On the investor front, the year was dominated by hedge funds across the spectrum, butas the year progressed, the presence of traditional asset managers became more prominentin on-the-run segments. Banks, which were until two years ago the dominant players inthe structured credit space as hedgers, were significantly quieter given the benign creditenvironment. Some became better sellers of protection via CDS as IG loan volumes stayedlow. We expect this trend to increase in 2004, particularly via synthetic CDO tranches.With credit default swaps finding a more permanent place in portfolios of asset managersand insurers—the newest entrants to the CDS space—we foresee a greater need forbenchmarking and performance measurement tools. To address this need, on October 1,

2003, we launched the Lehman Brothers Credit Default Swap Index consistent with thephilosophy and methodology of our Family of Fixed Income Indices.1

Portfolio CDS and Volatility Trading Gathers MomentumSimultaneous to development in the term structure of CDS and the high yield CDSmarket, the quest for liquidity and diversification in CDS and derivatives thereof led tothe development of a slew of portfolio CDS products. The breakthrough developmentsin 2003 started with high grade and emerging market underlying and quickly encom-passed the high yield universe. Two families of products trade actively today—Trac-Xand CDX, both inside a 5 bp bid-offer, signifying their liquidity. The expansion of thesingle-name CDS market and that of portfolio CDS is expected to enhance the liquidityof both, particularly in the high yield space in 2004.

The introduction of actively traded, liquid portfolio CDS contracts also catalyzedderivatives off of these products. Some would argue that it is the demand for tradingdefault correlation and volatility in a liquid, transparent form that led to the develop-ment of traded portfolio CDS contracts. Nevertheless, during the second half of theyear, the volume of trading in receiver and payer swaptions on these portfolio CDScontracts jumped dramatically, changing volatility trading from a single-name optionsmarket to a macro-volatility market. This is the future generation of credit derivativesas the options market extends to high yield underlying.2

Correlation Trading and Secondary CDO Markets Have a Stellar YearInnovations in the CDS market drew parallels in the CDO market, with the mostnoteworthy being the boom in correlation trading. The fusion of credit derivativemodeling with CDO technology led to a roaring single-tranche synthetics market and thegrowing popularity of tranched portfolio CDS. Investors can now choose layers of risk(defined by attachment and detachment points) on customized and standardized port-folios and receive a quote on that layer. European credit investors utilized the technologyto add exposure to the credit markets via single-tranche products even as hedge funds

1 See The Lehman Brothers CDS Index Primer, October 2003.

2 See “The Lehman Brothers Guide to Exotic Credit Derivatives,” RISK magazine supplement, October 2003.

As the year progressed, the presence oftraditional asset managers became more

prominent in on-the-run segments.

The expansion of the single-name CDSmarket and that of portfolio CDS is

expected to enhance the liquidity of both,particularly in the high yield

space in 2004.

The introduction of actively traded,liquid portfolio CDS contracts

also catalyzed derivatives off ofthese products.

The fusion of credit derivative modelingwith CDO technology led to a roaring

single-tranche synthetics market.


January 21, 2004 6

were active in seeking “correlation” exposure via delta-hedged equity tranches. 2004should bring path dependency and better quantitative models into analyzing CDOs. Inaddition, the emergence of a diversified high yield CDS market is likely to lead to thegrowth of synthetic high yield CDOs and a correlation market thereof.

Another noteworthy trend is the extension of synthetics to other products with theapplication of structured credit technology to structured finance. We saw $7 billion ofsynthetic ABS issued in 2003. This market has just scratched the surface and is spurringthe development of a default swap market for ABS and cash CDOs.

For traditional cash flow CDOs, innovation was marked by the introduction of manynew structural features that appropriately allow for a shift in value from equity to debtin deteriorating credit conditions. This has brought investor confidence back into themezzanine market and created a better alignment of interests. The most dramaticdevelopment on the cash side, however, is the huge infusion of capital (Street andinvestor) that we saw in 2003, leading to significantly improved liquidity. Dislocationin valuations brought opportunistic, absolute return investors in strong force, leadingto a stellar year for returns. The market benefited from better valuation techniquesand models such as METEORSM (MontEcarlo Tranche EvaluaTOR); our recentlylaunched in-house risk-neutral simulation-based tool will bring sophistication intovaluation of these tranches in 2004. Probabilistic methods enable the pricing theoptionality embedded in tranches that are tough to analyze using traditional deter-ministic methods.

Quantitative ModelingLast but most important is the growth and availability of quantitative models foranalyzing the gamut of structured credit products. We continue to develop uniquequantitative models designed to complement the fundamental frameworks employedby portfolio managers, traders, analysts, and structurers. These quantitative modelsadd to the suite of portfolio models already delivered in POINT. A collection of newquantitative tools is now available in the Quantitative Credit Toolkit on LehmanLive.

Adding Yield in 2004With the bullishness surrounding credit and high yield spreads and the expectationof a slightly bearish interest rate environment despite a quiet Fed, the structured creditmarket offers many opportunities. Investors can isolate spreads from rates efficientlyand add leveraged exposure to credit markets. While a tight-spread, low-volatilityenvironment offers less obvious absolute value opportunities, there are plenty ofrelative value trades within the broader structured credit space. In our opinion, thekey trades for 2004 are:

• CDS—Term structure trades in IG and basis trades in HY- CDS term structure flatteners for wider names and steepeners for tighter names- Cash-CDS curve convergence trades- Negative basis trades in high yield CDS- BB CDX at a lower $ price than generic BB names for almost no spread give-up

• Volatility trades in a low vol environment.- Issuer-specific volatility trades with default swaptions and cancelable CDS- Portfolio CDO volatility skew trades and cross-sector macro-volatility trades.

The development of a default swapmarket for ABS and cash CDOs

is noteworthy.

The most dramatic development onthe cash side is the huge infusion of

capital that we saw in 2003, leading tosignificantly improved liquidity.

There are plenty of relative valuetrades within the broader

structured credit space.

January 21, 2004 7


• Debt-equity correlation trades- Selective capital structure arbitrage opportunities, particularly in newer contracts- Modeling sophistication will add incremental value

• Yield opportunities in cash CDOs as spreads lag the credit and ABS rally- Attractive senior spreads in both the primary and the secondary market, with

SF CDOs leaving the most room for tightening.- Senior tranches of lower quality SF collateral and subordinates/equity off high

quality collateral- Down in quality in CLOs- Aligning interest rate views with mismatches on the interest rate hedge.- Mezzanine tranches of European cash flow CDOs

• Correlation trading continues to offer opportunities to add leveraged exposure tocredit markets- Second-priority synthetic tranches versus CDS for traditional credit investors- With a change in market variables, we prefer VOD hedged-synthetic equity

over delta-hedged strategies we recommended in 2003

Specific articles analyze these themes in more detail.


January 21, 2004 8

CDS AND VOLATILITY STRATEGIESIN 2003 AND OUTLOOK FOR 2004Among the many uses of credit derivatives, the following three strategies have achievedmainstream acceptance: CDS-cash basis trading, CDS curve trading, and volatility trading.

In this section, we overview these strategies during 2003 and discuss our outlook for2004. The main forecasts include:

• The CDS-cash basis will become more efficient and tightly range bound as theprimary technical factors remain balanced;

• The long end of CDS spread curves will outperform the short end in the next fewmonths;

• The “curve slope basis” between CDS and cash will also be range bound, albeit moreloosely than at the 5-year maturity; and

• Volatility will find a floor and experience several small and short-lived spikes.

1) CDS-Cash BasisThe CDS-cash basis tone (i.e., the market-wide average differential between CDSspreads and the LIBOR OAS of credit bonds) has undergone several regime shifts duringthe past year and a half (Figure 1). They revealed important driving factors of the basisand these lessons will be valuable for investors in the future.

For completeness, we begin the story with the height of the credit dislocation in fall 2002.As losses in bank portfolios and other long-term credit holdings mounted, creditportfolio managers relied heavily on the CDS market for hedging. This resulted in thebiggest spike of the CDS-cash positive basis.

In late October 2002, synthetic CDOs stepped in as the ratings arbitrage became so widethat the expected returns were attractive even after accounting for an elevated level ofdefault risk. During the next eight months, November 2002-June 2003, it was the

Arthur Berd212-526-2629

[email protected]

Figure 1. CDS-Cash Basis Market Tone

bp Price ($)

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Rate Back up and Convergence

January 21, 2004 9


synthetic CDO bid that drove the CDS spreads well through the cash levels; see ourearlier reports for detailed discussion.1

Starting from July 2003, the effect of the CDO bid waned, and the leading driving factorrole was assumed by the price level of the cash bonds. As interest rates started to rise, theprice premium of the cash bonds diminished, reducing the apparent OAS premium thatbasis traders require for pairing up an off-par bond with CDS, which is equivalent to apar investment. During this time, the ups and downs of the average price of the LehmanCorporate Index had a high negative correlation with the changes of the CDS-cash basis.

Finally, during early August and then again in December, we witnessed substantialvolatility of interest rate swap spreads: in August, the swings were particularly violentand fast due to sudden duration hedging pressures of MBS portfolios. While CDSspreads remained stable, a sudden move of the swap spreads manifested itself as a shiftin credit bond OAS-to-LIBOR, thereby also causing a blip in the basis. These blips arepurely optical in nature, and one should not attempt to trade the basis around them.

Our outlook for the basis in 2004 calls for range-bound and tight behavior. We believethat none of the primary driving factors that we discussed above will have much strengthduring most of the next 12 months, and, therefore, the basis should be confined to a10 bp range around the economic fair value. Perhaps only the LIBOR spreads may causeadditional “optical” basis blips, but as we already mentioned, these blips should beignored by investors.

2) CDS Curve and Forward TradingAs the CDS market matures (both in terms of efficiency and by virtue of aging) theliquidity inevitably expands from the initial fulcrum of 5-year term to both shorterand longer horizons. The increasing activity in the short end of the CDS curves isdriven in part by gradual unwinding of the trades which were put on 2-3 years ago,at much higher spreads. As spreads rallied in, investors (hedgers) sought to takeprofits (stop losses), which led to a solid two-way demand for short-term protection.We estimate that most names that are active in 5-year default market can also betraded quite easily in shorter maturities.

The growth of liquidity at the longer end of the curve is also driven by the spread rally,but for a different reason: as the credit risk subsides and spreads diminish, investors arewilling to accept longer risk horizons and are actually driven to them in search of excessspread. The synthetic CDOs are now being priced with 7-year maturity, and portfolioproducts such as Trac-X and CDX also exist in a 10-year format in addition to thestandard 5-year maturity.

As the market in CDS deepened in all maturities from 1 to 10 years during 2003, it madetrading the entire CDS term structure the newest attraction for sophisticated creditderivatives investors. By the end of 2003, the steepeners and flatteners were among themost frequent trade ideas in the works, being the best proxy for taking a forward view

1 S. Ganapati, A. Berd, P. Ha, “The Synthetic CDO Bid and Basis Convergence—Which Sector is Next?” GlobalRelative Value, March 31, 2003, and S. Ganapati, A. Berd, P. Ha, E. Ranguelova, “Revisiting the Synthetic CDOBid—What’s Next?”, Global Relative Value, May 27, 2003.


January 21, 2004 10

on CDS curves.2 Some of the most actively traded CDS curves in the US included F, GM,BA, MO, TOY, and JCP. In addition, most emerging market sovereign CDS are alsotraded across the curve.

With a more active market in CDS of various maturities, the comparisons and relative valuetrades between the CDS and cash bonds are also becoming easier to implement (see anexample of the Ford CDS and cash curve in Figure 2). Both matched-maturity (e.g., 7-yearCDS versus 7-year bond) and unmatched-maturity (e.g., 10-year bond versus 5-year CDS)basis trades have been quite popular with investors. The latter trade, in particular,incorporates a simultaneous view on both forward spread evolution and the basis evolutionand was considered an efficient way to pick up credit convexity in a tight market.

As we explained in a recent paper,3 curve trading in CDS is actually simpler than inbonds because relative value measures, particularly the forward CDS spread measures,are related to the spot spreads in a very transparent manner. In an environment ofalready tight spreads within a still-rallying market, the forward CDS trades andsteepeners/flatteners often offer the best implementation alternative for both long andshort ideas for a given credit.

Our outlook for the CDS curves in 2004 calls for continued flattening in a bullish mode(i.e., with the long end tightening more than the short end). Such an outlook isconsistent with a bullish stance in terms of forward CDS spreads. As credit spreads grindtighter, in accordance with an overall credit strategy outlook for 2004, investors shouldbecome even more comfortable in extending their horizons farther out the curve. Thiscontinued spread hunt should lead to outperformance of the long end. Coupled withgreater spread duration, this bodes very well for long credit excess returns.

Figure 2. Ford CDS and Cash Curves, As of January 9, 2003

Source: Mark-it Partners.

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2 R. McAdie, U. Bhimalingam, and S. Sen, Forward CDS Trades, November 5, 2003.

3 A. Berd, “Forward CDS Spreads”, Quantitative Credit Research Quarterly, vol. 2003-Q4

January 21, 2004 11


Figure 3 shows the distribution of the CDS curve slopes across almost 500 names inthe U.S. that have a well developed 1-10-year spread curve, according to the Mark-it Partners database. We compare the distributions of both absolute levels of the1-to-10-year slope along the curve (measured in basis points), and the relativeslope, measured in percent of the 5-year spread. For example, the average spreadcurve slope on VZ was 20 bp, with the 5-year spread equaling 41 bp, which makesthe relative slope 50%. As one can see, the distribution of the relative slopes isskewed quite heavily toward the steep end, indicating that most CDS curves haveplenty of room to flatten.

In addition to expected outperformance in a central scenario, the curve flattenerstrategy will likely be shielded from significant downside risk in a (hopefully) remotescenario of a large external event (terrorism, systemic shock of some nature, etc.), inwhich case the near-term concerns would take precedence and the short-maturityspreads would consequently underperform.

As to the comparison between the CDS and cash curves, we believe that a (somewhatindependent) basis will develop across the entire range of maturities. Since we expectthe basis overall to be tightly range bound, we think this will translate into a fairly narrowrange for the differential between the CDS and cash curve slopes, which we call a “curveslope basis.” Given the relative newness of this market, we expect the typical speed ofconvergence of outliers to be slower in the curve slope basis than it is in the “standard”5-year basis trades.

3) Volatility TradingVolatility trading experienced a long-awaited liftoff in 2003. While most of the productsalready existed in previous years, the elevated levels of issuer-specific risk and volatilityitself made investors too queasy to allocate too much risk capital to exotic options in2002. With the notable exception of the repack and put bond trades, most othervolatility products such as credit bond options and single-name default swaptions didnot yet find the critical sponsorship.

Figure 3. Distribution of CDS Curve Slopes, December 31, 2003

Source: Mark-it Partners.

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January 21, 2004 12

The new catalyst in this market was the introduction of the macro volatility products inthe form of receiver and payer swaptions on CDS portfolio products, initially usingTrac-X as the underlying and then later in the year also expanding to iBoxx CDX familyof portfolios (see an overview of the options products and their usage4 and an overviewof the underlying portfolio products in a recent publication5 and also in the subsequentsection of this report). With much more subdued overall volatility levels, investing insuch products became more of a controllable process rather than a wild and randomdraw of luck as it may have been in 2002.

Importantly, the options on the most diversified of the CDS portfolios, Trac-X 100 IGand CDX.NA.IG, began trading not only with an at-the-money strike but also on a rangeof out-of-the-money strikes on both sides of the spot spread. This allowed investors toconstruct sophisticated option strategies, such as straddles, bullish and bearish spreads,etc., to express their views on the direction and amplitude of spread changes.In addition, portfolio default swaptions typically trade to two maturities—near(3-4 months) and far (6-9 months)—allowing for calendar spread strategies in bothdirectional and non-directional (pure vol) form.

We estimate that since June 2003, there was as much as $6-$8 billion in macrovolatility products traded in the U.S. (most of it with leveraged credit investors).This is almost 10% of the notional of the underlying products—quite a strong startfor the first 9 months of market activity. There is still plenty of room to grow, evenif the growth rate in these products surpasses the respectable growth rate in theunderlying itself.

Before making a prognosis for volatility, let us review the state with respect to spreadsand volatility in which the credit market finds itself currently. Figure 4 shows theLehman Brothers Credit Index OAS versus the rolling exponentially decaying estimateof the OAS volatility with a 1-year half-life, using monthly time series spanning 14 yearsfrom January 1990-December 2003.

During this period, there were 3 distinct regimes; therefore, we break the series into thecorresponding ranges:

• The series from January 1990-December 1991 covers the first credit downturn.• The series from January 1992-July 1998 covers the benign credit cycle.• The series from August 1998-December 2003 covers the modern volatile credit

markets that started with the Russian default and that, we believe, ended with thecredit rally of 2003.

The dashed curve represents the path in the spread-volatility space traced by the marketsduring the credit rally that started in November 2002 and continued through all of 2003.

Figure 4 reflects the familiar fact that the credit downturn of 1998-2002 was muchmore severe both in terms of spread blowup and in terms of volatility compared with the

4 “The Lehman Brothers Guide to Exotic Credit Derivatives,” Risk Magazine Supplement, October 2003.

5 S. Ganapati, P. Ha, C. Celi, Portfolio Structured Credit Monthly, October 2003.

January 21, 2004 13


1990-1991 recession. Remarkably, though, the beginning and the end of the currentdownturn were very much in line with the previous recession.

The period of benign credit markets in 1992-1998 was characterized by a very tightrelationship between spreads and volatilities. The credit markets are at the entry pointof that regime right now. However, we believe that both the volatility and the spreadswill find a higher floor than the levels achieved in the mid-1990s because of thestructural changes in the market that make it “faster” and somewhat riskier for creditinvestors. A few spikes in volatility during the year should keep the relative value playersand market timers on their toes to catch them, as they will be frustratingly brief.

We believe that the macro vol products will continue to attract a growing number ofinvestors, eventually making their way into portfolios of asset managers and insurancecompanies as a valuable source of risk-adjusted return. The single name defaultswaptions will likely lag behind, but we think that eventually these products, too, willsee substantial growth, starting with a limited list of select high profile and high betanames, such as F, GM, AOL, MO, and the like, and gradually expanding the coverageas the investors get accustomed to these products. Finally, the perennial favorite—therepack trade—will continue to be a source of cheap implied volatility (even comparedwith low actual vol levels).

Figure 4. Spreads and Volatility in the Credit Cycle

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0 20 40 60 80 100 120

Jan90-Dec91Jan92-Jul98Aug98-Dec03

12/31/03

2003 Spread Rally

Jul-Nov 02


January 21, 2004 14

PORTFOLIO CDS OPPORTUNITIES FOR CREDIT INVESTORS2003 was a breakthrough year for portfolio structured credit products. A slew of productswere introduced backed by diversified credit default swap portfolios, starting with thehigh grade markets and quickly encompassing the high yield market. In 2004, we believethat a more diverse investor base—including bank loan hedgers, money managers, andhedge funds—will embrace these products and become more active in trading them.

Portfolio CDS Products Boom GloballyMany globally traded portfolio products reference cash bonds or credit default swapsin funded or unfunded formats. The cash portfolios (e.g., TRAINs, TRACERs) werelargely created as replication strategies for a cash index and were popular in 2002, whendifferent dealers sponsored a few standardized products to achieve diversification inthe volatile credit environment. These products continue to trade today in a fairly tightbid-offer market. In 2003, many dealers came together to release products referencingportfolios of liquid single-name default swaps, resulting in the launch of two broadfamilies of products—the CDX family, administered by iBoxx, and Trac-X, adminis-tered by Dow Jones. Furthermore, a volatility and correlation market has developed offof these two products (please refer to our October 2003 Portfolio Structured CreditMonthly for more details).

Standardized portfolio products have emerged as transparent indicators for the CDSmarket. Although initial trading was minimal, bid-ask spreads were as narrow as 2 bpfor iBoxx CDX and 3.8 bp for the new Trac-X on average. This is partly because ofcontractual obligations for market makers to make 5 bp markets under normal marketconditions for the Trac-X and 5% of the mid spread for CDX. In 2004, the diversifica-tion bid, increased appetite for hedging, and the quest for yield are likely to drivevolumes higher with buy-side sponsorship. The recent default of Parmalat, which waspart of the European Trac-X, was a good test for the credit event mechanismsembedded in portfolio CDS, and the smoothness of delivery post-default demon-strated the efficiency of these products.

A Two-Way Relationship with CDSThe expansion of the single-name CDS market and portfolio products is expected toenhance the liquidity of both instruments in 2004. The creation of portfolio productsin the investment grade and high yield space has already resulted in an increase inliquidity in many names that previously were not traded or were not liquid. Likewise,an increase in the number of liquid single-name CDS has made possible the existenceof portfolio CDS products. We expect the portfolio market in 2004 to be infused withnew participants such as bank loan hedgers, insurance companies, and hedge funds.

The pursuit for diversification may drive a further compression of trading spreadsrelative to the portfolio products’ intrinsic spreads1 when a “avoiding losers instead ofpicking winners” strategy2 becomes key in the expected low-yield, low-volatilityenvironment in 2004. Nevertheless, it has yet to be seen whether the high demand for

Philip Ha212-526-0319

[email protected]

Lorraine Fan212-526-1929

[email protected]

1 Intrinsic spread is defined as the simple average spread across all names in a portfolio of CDS product assum-ing a 5% haircut for NoR in the portfolio product versus ModR in the underlying CDS spreads.

2 Please see our credit strategy team’s piece: “Outlook 2004: Final Bow for Tightening or Another Curtain Call?”Global Relative Value, January 5, 2004.

In 2003, many dealers came together torelease products referencing portfolios of

liquid single-name default swaps.

The expansion of the single-name CDSmarket and portfolio products is expected

to enhance the liquidity of bothinstruments in 2004.

January 21, 2004 15


unleveraged portfolio products will result in a “portfolio bid” similar to the “syntheticbid” in the single-name CDS market.

HY CDS Market Should Receive Liquidity BoostThe introduction of portfolio products has given and will continue to give a boost to theilliquid high yield CDS market. Both iBoxx CDX and Trac-X have launched high yieldproducts, each referencing 100 entities. Similar to the case in the investment gradearena, as the number of credits in the portfolio CDS exceeds the number of currentlyliquid individual entities, more liquidity is likely to be infused into off-the-run names.For example, the HY CDX NA and the HY TRACX NA reference portfolios of 100diversified North American high yield credit default swaps, whereas only 40-50 namestrade actively in the HY CDS market. As CDX and TRACX gain liquidity, we wouldexpect the remaining, less liquid names in the portfolios to trade more actively.

Investment OpportunitiesBesides the relatively obvious investment opportunity in any index-like product to adddiversified exposure to the credit markets, we foresee four broad areas of investmentopportunity in this space:

1) Using portfolio CDS to park cash. For example, the Lehman Brothers BB Index iscurrently trading at a $108 price (T+242). However, investors could also go long theCDX BB for a lower dollar price, $105 (T+240). We believe that managers shouldbe actively investing in the BB CDX versus cash BBs in order to pay a lower dollarprice for securities with like-rated spread and risk.

2) Replicating a benchmark credit index. In Figure 1, we show that the CDX IG NA+ 5 year swaps has historically been a fairly good replication of the Lehman BrothersCredit Index, with the tracking error being minimized in benign market environ-ments. The divergence between the CDX and the index in 2H02 was due to adisproportionate widening in CDS versus cash, which is consistent with thegenerally accepted belief that in widening environments, CDS will widen earlierand to a greater extent. However, as seen in the chart, in most other environments,the CDX has been a good proxy.

Figure 1. CDX versus Lehman Brothers U.S. Credit Index

90

120

150

180

210

240

270

300

1/01 4/01 7/01 10/01 1/02 4/02 7/02 10/02 1/03 4/03 7/03 10/03

CDX + Swaps

US Credit Index

Sources: Lehman Brothers; historical CDX spreads were reconstructed using Mark-it Partners data.

As the number of credits in theportfolio CDS exceeds the number of

currently liquid individual entities,more liquidity is likely to be infused

into off-the-run names.


January 21, 2004 16

3) For investors who desire insurance against spread widening, buying protection onportfolio products offers an efficient way to execute a macro hedge. As of January12, 2004, investors could purchase protection on the CDX NA at 47.5 bp, com-pared with earning a LIBOR-equivalent spread of L+58 bp on the Lehman BrothersCredit Index (Figure 2). Investors who are currently long the market, but negativeon particular sectors, could purchase protection on individual sectors.

4) Finding arbitrage opportunities between the portfolio and single-name CDSmarkets. The tighter spreads of portfolio products compared with single-nameCDS present potential arbitrage opportunities. As we pointed out in the October2003 Portfolio Structured Credit Monthly, the trading level of a portfolio CDSproduct can differ from the average spread of its underlying entities or itsintrinsic level. In this case, investors can monetize the differential by buying

Figure 2. Portfolio Product Spreads, January 12, 2004

Product Bid OfferCDX IG 46.75 47.50CONS CDX 43.50 47.00ENRG CDX 42.00 45.00FIN CDX 32.00 35.00INDU CDX 48.00 51.00TMT CDX 56.00 58.50

Figure 3. Portfolio Product Intrinsic versus Actual Spread, bp

50

52

54

56

58

60

62

64

10/22/03 10/24/03 10/28/03 10/30/03 11/3/03 11/5/03 11/7/03

CDX Intrinsic SpreadCDX Actual Spread

55

60

65

70

75

80

10/3/03 10/8/03 10/13/03 10/16/03 10/21/03 10/24/03 10/29/03 11/3/03 11/6/03

TRACX II Intrinsic Spread

TRACX II Actual Spread

Sources: Lehman Brothers; assumes 5% haircut from ModR single-name CDS spreads when calculating intrinsicportfolio spread.

January 21, 2004 17


protection on the portfolio and selling protection in the single-name CDS marketat wider spreads. The positions may be kept until maturity, or a mark-to-marketprofit can be made if convergence occurs between the portfolio and single-nameCDS markets. Figure 3 shows that since their inception in October, iBoxx CDXNA and the new Trac-X NA have been trading consistently tighter than theirintrinsic value by 4 bp and 6 bp, respectively, on average. The first reason for thisdifference stems from the advantages of buying a diversified portfolio, as well asdemand/supply technicals and liquidity. Second, our computation of the intrin-sic levels applies a 5% haircut on the underlying CDS spreads that have beenmarked with ModR, although there is no uniform perceived value of restructur-ing. However, given that the difference between the portfolios’ trading spreadsand the underlying averages are as large as 9% for iBoxx and 14% for Trac-X, oneshould not ignore the weight of the first explanation regarding diversification.


January 21, 2004 18

2003: YEAR OF THE CREDIT HEDGE FUND;2004: A CROWDED PARTY?Credit and capital structure arbitrage strategies seemed to be the hot areas among assetallocators in 2003. Huge market opportunities, coupled with (in many cases) a market-neutral approach and diversification away from equity market-neutral strategies, weremore than enough to entice capital into credit and capital structure arbitrage strategies.As a result, 2003 saw new and existing credit hedge funds and other levered creditinvestors raising additional capital.

Just a Year Ago, the World Was a Scary Place2003 began with many investors still in shellshock from what 2002 had done to theirportfolios, and the outlook remained cloudy at best. The Bush administration wasbeating the drums of war for Iraq, and the U.S. faced a tense standoff with North Korea.The economy was limping along after a weak holiday season for retailers and an uptickin the unemployment rate.

The market backdrop was even worse. Spread levels and volatility were still high,reflecting geopolitical and economic uncertainty. The airline, utility, and telecommu-nications industries were in significant distress, with the outcomes far from certain. Apreference for liquid positions in this uncertain environment led to a significantdiscount in the market for illiquidity.

But for Hedge Funds, Opportunities AboundedDirectional and arbitrage-oriented hedge funds happily provided liquidity to a marketmore than willing to pay for it. Some used more liquid instruments to hedge their creditrisk, leaving themselves with limited downside. These trades took a number of forms:

Secured/Senior TradesOne of the most prolific and profitable trades of the year was the secured/senior trade.Investors purchased a variety of less liquid secured paper and hedged it using acombination of senior debt, senior reference CDS, and equity puts to create low risk/high return profit profiles. In a default, the value of collateral plus profits from hedgesoffset losses on the position, while if the credit survived, the trade captured significantupside and positive carry. The distressed loan market offered fertile ground for this typeof trade, as there were a number of loans trading in the 80s and low 90s. When creditmarkets stabilized, companies refinanced loans with less restrictive high yield bondsrepaying investors par. The airline ETC and EETC markets offered another source ofsecured paper—investors who were able to assess collateral value and understand bondstructure set up arbitrage positions using CDS and equity puts. Other sources of securedpaper included credit tenant leases and first- and second-lien paper on power plantsowned by distressed utilities.

Debt/Equity TradesClients took advantage of credits with wide credit spreads and relatively rich equityvaluations by buying discounted bonds or selling CDS and either buying puts orshorting stocks outright. On the investment grade side, there were a number ofsituations in which CDS tightened rapidly because of synthetic CDO activity.Arbitrageurs took advantage of credits with tight CDS, high equity volatility, andlow equity valuations by either selling long-dated equity puts or buying the stock

Ashish Shah212-526-9360

[email protected]

January 21, 2004 19


outright and buying CDS. We discuss some of these relationships in more detail in“Technicals and Better Models Will Keep the Momentum in Debt-Equity Trading in2004,” in this report.

Convexity Trades—Basis with a BiasThe wide spreads on long-dated bonds and high spread volatility created an opportu-nity across the credit spectrum to set up bullish convexity trades in credits. In thesetrades, clients purchased long-dated bonds at large dollar price discounts while at thesame time purchasing 5-year CDS. If the credit deteriorated significantly, the long-dated discount bond would outperform the CDS position because its recovery floor wasclose to the discounted price. If the credit improved, investors were net long creditduration and made money. These trades were especially popular around uncertaincorporate events.

Correlation TradesThe high level of synthetic CDO issuance in mezzanine tranches over the course of theyear led dealers to be long first-loss tranches. Hedge funds saw this as a cheap source ofdefault correlation. By buying the CDO equity and trading the appropriate deltahedges, they were able to fund a market spread short while managing idiosyncratic riskby overhedging problem credits.

Distressed CDO TradesHedge funds were among the first to exploit the disconnect between credit marketprices and CDO tranche valuations at the beginning of 2003. The convergence gatheredmomentum over the second half of 2003 as CDOs began to price in the optimism in thecredit markets, leading to impressive returns for investors. Mezzanine tranches re-turned 15%-20% for stressed securities and as high as 40%-100% for distressed ones,with returns being highest for PIKing or Caa (or below) rated securities.

Volatility TradesAs if leveraged clients did not have enough trading opportunities in 2003, the dealercommunity introduced both the Trac-X and iBoxx CDX lines of portfolio CDSproducts in both the high grade and high yield markets. This was quickly followed byan introduction of options markets on the high grade portfolio products. After limitedtransaction volume, the market exploded with activity as leveraged clients beganexpressing spread volatility views and traditional accounts began using options to eitherenhance return or cover downside risk. Finally, the single-name spread volatility marketemerged, with leveraged clients using spread options to express direction views andenhance yield.

Looking to 2004:The World is Less Scary, but Holds Less OpportunityThe macro and market backdrop in 2004 could not be more different than the one lastyear. The macro environment seems much more benign, with potential volatility farfrom view. The economy is recovering, even if only modestly. Companies have shoredup their balance sheets. The dramatic decline in the dollar is helping U.S. multination-als, while foreigners seem content to continue to hold their dollar-denominated assets.And while the Fed will tighten someday, the market (and our economists) feels that itwill be a “very long time” away . . . at least in market terms.


January 21, 2004 20

The market environment seems equally benign. While spreads on bonds and CDS stillhave the ability to outperform, few people would argue that credit overall is cheap. Thesame can probably be said about the equity market, with the S&P500 trading at morethan 18x consensus 2004 estimates and the VIX trading in the mid-teens.

With Less Opportunity,Hedge Fund Effect Will be Much More PronouncedAs profitable trades become more scarce, hedge funds and other leveraged creditinvestors will be faster to identify and “arbitrage away” opportunities in the market.Ironically, as leveraged investors pursue fewer opportunities with more capital, newopportunities will be created by so-called crowded trades, or situations in which toomany short-horizon investors are taking the same position. Longer-time-horizoninvestors will benefit by taking a contrary view on these situations.

The Question Everyone Is Asking: How Will We Make Money in 2004?Without getting into specific trade ideas, here are some of the things that hedge fundsand other leveraged accounts will be considering as they enter 2004:

• 2003 performance was dominated by improving liquidity across the credit andequity markets. Expect this trend to continue as hedge funds reach for cheapilliquid credit instruments that they can hedge using CDS and equity puts.

• Leveraged investors will look to alternative markets, including ABS and MBS, forsecurities that have credit risk that can be hedged using credit and equity derivativeswhile leaving a reasonable leveraged return.

• Given the relatively tight spread starting point, expect hedge funds to be muchmore aggressive in setting up shorts on both single names and portfolio product.Many investors believe that while there are pockets of opportunity in the creditmarket, risk has been significantly priced out of the market.

• Given the high likelihood of Fed activity in 2004, leveraged investors will beadjusting their portfolios to reflect potential dislocations created by these moves.A potential deleveraging trade resulting from a flatter curve could cause consider-able spread volatility.

• As portfolio and spread volatility markets gain liquidity, expect hedge fundsincreasingly to use these markets to set up directional and arbitrage trades. While,until now, hedge funds have primarily been sellers of volatility, we expect to see thatreverse as implied volatilities drift lower.

We will discuss some of these themes in additional detail throughout the year.

January 21, 2004 21


Elena Ranguelova212-526-4507

[email protected]

TECHNICALS AND BETTER MODELS WILL KEEPTHE MOMENTUM IN DEBT-EQUITY TRADING IN 20042003 saw the growth and proliferation of debt-equity trading strategies, also known ascapital structure arbitrage. Credit hedge funds and dealer proprietary trading desksrushed to exploit apparent mispricing between debt and equity, encouraged by the eye-grabbing gains scored by some at the end of 20021. The main catalyst of the strategy wasthe maturing of the credit default swap market into a mainstream market with broadparticipation from banks, asset managers, insurance companies, and hedge funds. CDSgave arbitrageurs a new liquid and fairly standardized instrument for shorting credit.This widened the opportunities for trading debt against equity, which previously werelimited to convertible bond arbitrage.

The Macro Market BackdropAt the start of 2003, market participants were facing high equity volatility, low equityprices, and high credit spreads. In that environment, most companies were stuck in the“cuspy” region of the debt-equity relationship, where credit spreads and stock pricestend to exhibit strong correlation (consider, for example, the Ford CDS-equity scatterplot in Figure 1). This was followed by a short period of decoupling when the twomarkets reacted differently to the Iraq war. In February and early March, equities weretanking because of uncertainty about the war, while credit widened only slightly.

Subsequently, as illustrated in Figure 2, the resolution of uncertainty and improvingcompany and economic fundamentals led equity along its stellar trajectory to a 26%return for the year (as measured by the return on the S&P500), and credit spreadstightened by 80 bp (as measured by the Lehman Brothers U.S. Credit Index). Concur-rently, the debt-equity relationship was rolling down its steep section. Most issuers closedthe year with low volatility and tight credit spreads that were largely unresponsive to equityprice movements, thus making future dynamic debt-equity hedges harder to perform.

1 For more on the activity of hedge funds and other leveraged investors, please refer to “2003: Year of the CreditHedge Fund; 2004: A Crowded Party?” by Ashish Shah, in this report.

Figure 1. Ford CDS-Equity Relationship in 2003

CDS Spread (bp)

Stock Price ($)

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300

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5 6 7 8 9 10 11 12 13 14 15 16 17 18

2003 H1

2003 H2

1-Jan-03

31-Dec-03

The main catalyst of the strategywas the maturing of the

credit default swap market.


January 21, 2004 22

The Put-CDS TradeThe main strategies explored by investors last year included trading CDS versus out-of-the-money equity put options and bonds or CDS versus common stock.

The CDS versus out-of-the money put trade was the most popular debt-equity strategyin 2003. Because both instruments are fairly liquid, investors could put the trade on andthen unwind it pretty fast. Earlier in the year, when spreads were wide, we observedmostly buyers of equity puts and sellers of default protection. Later in the year, withequities on the rise, the trend reversed, and most trades involved selling puts and buyingprotection. The most widely traded names were characterized by high leverage, bigearnings surprises, or other major headline risk. Those included JPM, SUNW, MO,DCN, RTN, T, AWE, EK, and RJR. When equity options were not liquid or available,investors implemented their views by trading straight equity versus bonds or CDS.Examples include AMR, DAL, DYN, EP, and TYC.

Hedging Becomes More ChallengingStructuring the put-CDS trade has been relatively straightforward when hedged tovalue on the default. However, dynamic hedging of the strategies has proved moreelusive. Most of the existing debt-equity models are not sufficiently accurate fordynamic hedging and expose investors to substantial residual risk. The most success-ful trades of the year have been driven largely by a good understanding of technicalchanges in the marketplace.

Technical Factors Drive Opportunities in the Debt-Equity SpaceVarious technical factors create temporary decoupling of debt and equity and driveopportunities for capital structure arbitrageurs. Earnings surprises cause equity to “over-shoot,” while debt and CDS tend to lag in response. Convertible bond issues drive CDSspreads wider that corporate bond spreads because of temporary exogenous demand for

Figure 2. Debt and Equity Markets in 2003

CDS Spread (bp)

Stock Price ($)

1/02/03 to 12/31/03 Last Minimum MaximumU.S. Credit Index OAS 89 89 12/30/03 166 1/2/03S&P500 1112 801 3/11/03 1112 12/31/03Equity Volatility (VIX) 18 16 12/17/03 35 1/27/039

0

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800

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1150U.S. Credit Index OASEquity Volatility (VIX)S&P 500 (RHS)

The CDS versus out-of-the money puttrade was the most popular

debt-equity strategy in 2003.

Various technical factors create temporarydecoupling of debt and equity and

drive opportunities for capitalstructure arbitrageurs.

January 21, 2004 23


protection from equity volatility investors. Synthetic CDO issuance, on the other hand,drives CDS spreads tighter than cash because of the exogenous supply of protection.Various corporate events may also cause debt and equity temporarily to decouple oraccelerate correlation. The example below illustrates one of these opportunities.

Sun Microsystems CDS-Equity TradeOn September 29, 2003, Sun Microsystems warned the marketplace of future wider-than-expected losses. As a result, the stock price dropped 7.7%, and implied equityvolatility shot up immediately. At the same time, CDS widened by only 25 bp. Againstthe historical backdrop, as illustrated on Figure 3, this tight CDS level was inconsistentwith such a low stock price. Investors took advantage of this opportunity by buying CDSand selling put options or buying straight equity and were able to profit within a weekwhen convergence occurred.

Implications for Corporate Bond InvestorsCapital structure arbitrage activity improves the information flow between the debt andequity markets. If corporate stocks and bonds become more correlated, it couldpotentially diminish the diversification benefit of including credit in an overall investorportfolio. This should be less of a concern for investment-grade credit investors, asdebt-equity trading is largely concentrated in high-volatility names historically locatedin the high-yield or crossover space.

OUTLOOK FOR 2004Much of the low-hanging fruit has disappeared as more and more long-short investorshave begun to exploit the debt-equity relationship. Since technical factors will continueto create dislocations, profit opportunities will persist, but will become smaller and willdisappear faster, as discussed in the earlier article by Ashish Shah. In addition, fallingvolatility and shrinking spreads already call for greater accuracy from the modelsemployed in calculating hedge ratios. The race is on to improve the current structural

If corporate stocks and bonds becomemore correlated, it could potentiallydiminish the diversification benefit

of including credit in anoverall investor portfolio.

Figure 3. Sun Microsystems CDS-Equity RelationshipJanuary-September 2003

CDS (bp)

Stock Price ($)

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200

300

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2.5 3.0 3.5 4.0 4.5 5.0 5.5

9/29/03


January 21, 2004 24

and reduced-form quantitative models. However, whatever model investors settle onwhen implementing dynamic hedging, they should still consider spreading their strat-egy across many different names in order to minimize residual model risk.

Given the tight levels of spreads in investment-grade credit and our strategists’ outlookfor tightening spreads and higher equities in 2004, we expect U.S. high-grade names tooffer few opportunities for capital structure arbitrage. Most of the opportunities arelikely to arise from unexpected corporate events and rating actions. However, thegrowing high-yield CDS market will offer a wider field for debt-equity strategies.

January 21, 2004 25


CDOS—IN PURSUIT OF YIELDOur outlook supports a constructive view for 2004 as we finish the chapter on the bestyear in the short history of CDOs. 2003 witnessed a return of confidence to the asset classas CDOs rallied on the back of resurgent credit markets and strong technicals. Inaddition to the diversification bid that drove demand earlier in 2003, we expect 2004 tobe characterized by a yield bid as investors pursue returns in a tight credit environmentfeaturing low defaults and low interest rates. CDOs also provide an added incentive inthe form of low sensitivity to rising interest rates—in fact, the scenario may benefit someof the cash-strapped distressed transactions. With CDOs trading wider than other fixedincome securities and new money entering the market, technicals also support ourpositive outlook for 2004.

The innovations and expansion in the synthetic space and correlation investing anda booming secondary market marked 2003. Trading volumes skyrocketed to anestimated $15 billion, and the surge in valuations pleasantly surprised even optimisticparticipants like us. Strategic opportunities continue in 2004, although we believesecurity selection is likely to be the key to outperformance. We present our traderecommendations for the year later in this article. SF CDOs and trades related tointerest rate moves catch our eye, and we have decided to discuss them separately insubsequent sections.

On the new issue side, in contrast to the general prediction that CDO supply would shrinkin 2003, the global issuance volume of $136.5 billion1 surpassed 2002’s $92.1 billion, withsingle-tranche synthetics and structured finance CDOs dominating volumes even asinvestors shied away from HY and IG cash CDOs.

Issuance is likely to moderate in 2004 despite the quest for yield and renewed investorconfidence and clarity about consolidation concerns. The composition of CDO issu-ance in 2003 borrowed from trends observed in the past, with SF CDOs gaining groundalong with IG synthetics. This year should continue to see interest in SF CDOs,especially SF synthetics, though issuance may start to taper off toward the second half.With the transformation of synthetics into single-tranche deals, the next phase shouldsee structural features being added to these tailor-made tranches.

While growth in the synthetic markets is driven by innovation in products and technology(for details, please see “A Look Ahead: Synthetics CDOs in 2004”), the buoyancy in thecash arbitrage CDO segment reflects the spectacular rally in the underlying collateralmarkets. The Lehman Brothers Credit Index tightened from 169 bp to 89 bp, and the HYIndex price level surged from $83 at the beginning of the year to $103 by year-end. Theoutlook for 2004 continues to be positive, and our credit strategy team believes thatspreads are likely to come in further as a combination of strong technicals and improvedfundamentals drives the market. HY default rates fell to 4.9% by year-end, sharply belowtheir peak of 10.6% in February 2002 and slightly below their long-term average. Ouroutlook on the fundamentals that drive the CDO market is largely positive, as shown inFigure 1. The optimism has been reflected in the CDO market as well, with valuations

Sunita Ganapati415 274 5485

[email protected]

Gaurav Tejwani212 526 4484

[email protected]

1 Greater issuance volume can be attributed, in part, to the increased transparency in the market, which resultedin better data availability, especially in the synthetic CDO sector.Cash flow arbitrage issuance increased from$53.5 billion to $67.5 billion.

Trading volumes skyrocketed toan estimated $15 billion.

The optimism has been reflected in theCDO market as well, with valuations

climbing steeply and downgrade activitysteadily cooling down.


January 21, 2004 26

climbing steeply and downgrade activity steadily cooling down (Figure 2). A benign creditenvironment is likely to continue in 2004, though higher idiosyncratic risk could drive updowngrades for some IG CDOs.

Primary CDO Spreads Poised to Tighten in 2004The rally in collateral markets may have pushed secondary CDO spreads tighter, butprimary spreads have not discarded their inertia and are practically unchanged from a yearago. Spreads have tightened significantly across other asset classes, as shown in Figure 3,with Aaa corporates tightening from 65 bp to 23 bp over LIBOR and CMBS ending theyear at 30 bp while Aaa CDO tranches continue to be issued at an average spread of 57 bpover LIBOR. The comparison is even starker down the capital structure, as Baa corporatesand structured finance spreads came screaming in while CDO spreads remained wide. Asa result, we believe that CDO spreads are likely to compress, with Aaa’s reverting to the low40s by the second half of the year while lower-rated tranches should also tighten to morerational levels. The steepness of the CDO credit curve does not price in the improved creditenvironment or the additional protection provided by debt-friendly structural features.

Figure 2. CDO Downgrades per Month and U.S. High YieldTrailing 12-Month Default Rate

# of Transactions Downgraded HY Default Rate

0

20

40

60

80

1/98 1/99 1/00 1/01 1/02 1/03 12/030%

3%

6%

9%

12%

Rolling 3 Month Average(No of Transactions DG)

HY Default Rate

Rating Agencies Catch up to Weak Performance

Credit Cycle Improvement

Figure 1. Fundamentals Look Positive

2003 Prediction 2003 Reality 2004 PredictionHY Default Rate Lower but at a slower pace Gradual, steady drop Further drop, possibly to sub-4%

from 6.8% to 4.9% but may inch up toward year-end,given aggressive underwritingin the past few months.

IG Default Rate Moderately higher Lower than expected Will stay at low levels butprone to idiosyncratic defaults.

Recovery Rate Slow and steady improvement Senior unsecured rate up $6, to $37 Room for further increase.

Structured Finance Continued stress due to Problems through the On a path to recovery. Broadlyperformance lag. year, but buoyancy by year-end. positive amid some concerns.

We believe that CDO spreads are likely tocompress, with Aaa’s reverting to the low

40s by the second half of the yearwhile lower-rated tranches should also

tighten to more rational levels.

January 21, 2004 27


Secondary CDO Markets—Finding Value after the Big RallySecondary CDO markets have witnessed a stellar rally across the capital structure assurging collateral markets, fueled by a strong technical bid, have significantly altered themood and the valuations in the CDO market. Investors who allocated capital to CDOsusing the secondary route earlier in 2003 have witnessed substantial mark-to-marketgains on their positions. Clean senior tranches began trading through new issue levels evenas the rally gradually moved down the capital structure. In Figure 4, we estimate thereturns on various types of CDO investments based on our observation in the market.

As in other credit markets, not being wrong in 2004 assumes as much importance asbeing right did in 2003. While some CDO investors are tempted to book part of theirgains, others prefer to hold on, expecting a further rally in collateral markets. Our creditstrategy teams opines that there is room for further spread tightening in the creditmarkets, and our ABS team is also bullish as consumer credit quality stabilizes.Consequently, CDO valuations should improve further, though some sectors leavemore room for tightening than others. In addition to these fundamentals, demandtechnicals will bring in greater buoyancy as investors search for yield in a low spreadenvironment. We believe that investment opportunities continue to exist, and wesummarize our central views below.

Figure 4. Estimated Performance of CDO Investments

Indicative Levels Comparative YTDCDO Investment Dec 2002 Dec 2003 Estimated Return ReturnsClean Senior L + 80-100 L + 50-60 4%-5% ABS Aaa - 3.7%Stressed Senior L + 200-300 L + 70-80 7%-8% Corp Aaa - 3.2%Distressed Senior $75 - $85 $85-$100 10%-20%

2nd Priority (Non-PIKable) L + 125-150 L + 70-80 7%-8% Corp Aa - 4.0%

Stressed Mezzanine $50-$80 $70-$90 15%-20% Corp Baa – 11%Distressed Mezzanine $20-$50 $40-$80 40%-100% Corp B – 26%(fix the PIK) Corp Caa – 59%

* Transactions classified as clean, stressed, or distressed based on their performance state as of beginning of 2003. We typically use the term “clean” for transactions that passall par covenance tests and have a relatively clean portfolio. Stressed transactions fail some but not all tests and may pay back full principal in good scenarios. Distressedtransactions typically fail all tests, have a high WARF, and are likely to suffer a loss in most scenarios.

{

{

CDO valuations should improve further,though some sectors leave more room

for tightening than others.

Figure 3. Aaa and Baa Spreads:CDO versus Other Structured Finance and Corporates

CDOs(Primary) Corporate Credit Cards HEL CMBS

AaaDec 2002 55 65 20 38 47Dec 2003 57 23 17 29 30Difference +2 -42 -3 -9 -17

BaaDec 2002 305 186 196 350 140Dec 2003 308 83 100 225 90Difference +3 -103 -96 -125 -50


January 21, 2004 28

Relative Value in Senior TranchesThe spread on clean secondary paper has reached L + 45-55 bp. In comparison, ABSpaper trades significantly tighter than CDO seniors. For instance, credit cards and homeequity loans trade at 17 bp and 29 bp, respectively.

Spreads on CDOs are wider because of other factors such as liquidity concerns and adversetechnicals involved in selling the tranches at a premium over par. In addition, CDOtranches face a higher downgrade risk than ABS. But with downgrade activity slowing andpositive news about consolidation for ABS CP conduits, we remain bullish on stressed SFseniors, as they offer the highest return, while there is limited upside in Aaa CLOs. HY andIG Aaa’s have room for tightening and may be aided by improving NAVs on some of theout-of-the-money interest rate swaps. Overall, we like senior tranches at current levelsbecause of their low credit risk and relative spread to other fixed income securities.

The risk/return trade-off appears compelling given the historical performance of first-priority tranches. Our analysis using METEORSM (Mont-Carlo Tranche Evaluator),our in-house risk-neutral simulation-based valuation tool, also indicates that Aaa’s areconsistently cheap at current spread levels. The estimated default-adjusted spread issignificantly lower than the actual spread in the market—a reflection of the low creditrisk and the additional protection provided by a host of structural features.

Stressed Non-PIKable Second-Priority Tranches Offer Potential UpsideWe continue to like second-priority tranches from slightly stressed transactions in whichthe downside is limited and a potential upside arises. In an earlier trade recommendation(Capitalizing on an Upsurge in Recovery Rates,” Global Relative Value, September 8,2003), we illustrated how lower loss severities on underlying corporate debt can boostreturns on second-priority tranches that trade at a small discount.

As we expect spread tightening in senior tranches, and relatively clean second-prioritytranches offer spreads similar to those of some of the stressed senior ones, we like thelatter in comparison. On the other hand, some of the fixed-rate second-priority tranchesmay be ideal for CDO managers who wish to improve current cash flows.

Focus on Synthetic SF and CLOs in Lower-Priority TranchesMezzanine and subordinate tranches continue to trade at a discount despite the steepsurge in valuations over the past year. The yields on lower-priority tranches areconsiderably higher than comparably rated corporate bonds and loans. However, theoptionality embedded in steeply discounted tranches is limited, as the market hasstarted to price in a low-volatility environment. Also, any drop in HY valuations wouldbe magnified in leveraged investments—a 1% drop in collateral prices could lead to avaluation drop of $3-$4 for the mezzanine tranches. Since secondary market valuationsare driven by their liquidation values, the price of distressed debt also drives CDOvaluations. The Caa component of the Lehman Brothers High Yield Index, for example,is currently trading at an average price of $97. It may be prudent to hedge some of thisrisk if investors do not intend to hold the bond to maturity and are, therefore, exposedto the mark to market on the portfolio.

Subordinate debt and equity from new issue SF synthetics also appears attractive. Higher-rated SF securities have performed well in the past, and the widely expected consumer

The risk/return trade-off appearscompelling given the historical perfor-

mance of first-priority tranches.

Subordinate debt and equity from newissue SF synthetics also appears attractive.

January 21, 2004 29


credit downturn in 2003 turned out to be a soft landing. Given the robust performanceof the asset class even in the recent stressful environment, we like leveraged investmentsoff Aaa- or A-rated SF securities. For a detailed analysis of the asset class, please see “ABenign Consumer and Commercial Credit Cycle Supports SF CDOs” in this publication.

We also recommend BB CLOs as demand technicals kick in while loan transactionscontinue to outperform. Though CLO valuations are unlikely to rally strongly on betterasset valuation alone, near absence of defaults, accelerated prepayments, and immunityto interest rate movements make them appealing. We discuss our outlook for CLOs inour leveraged loan section.

Synthetics CDOs—Opportunities in Secondary Equity Trancheswhile Balancing Idiosyncratic RiskWe see relative value in secondary equity or equity-like tranches of shorter-durationsynthetic CDOs, which benefit from lower tail risk and spread tightening while com-manding a hefty liquidity premium. As we pointed out last quarter, dealers continue tobe long VOD risk and need to hedge by buying first loss protection. Moreover, moderatespread tightening in 2004 is expected to result in positive MTMs in 2004. We continue tolike synthetic ABS CDOs, particularly senior and equity tranches, because of the highspread premium for seniors and low idiosyncratic risk for equity. For traditional creditinvestors, we prefer an up-in-structure trade strategy in 2004, as finding yield will beparamount in the current low-spread environment. Senior synthetics are attractiverelative to like-rated single-name CDS, for which the average spread on single-A creditsis 29 bp. For more details, please refer to “A Look Ahead: Synthetics CDOs in 2004.”

Aligning Investments with Interest Rate MovesThough CDOs are less sensitive to interest rate movements than traditional fixedincome portfolios, the fact that interest rate hedges embedded in CDO structures arenot always perfect has led to concerns about interest rate exposures. Our economistsexpect a low interest rate environment to persist in the short run, with rising rates beinga 2005 concern. In “The Impact of Interest Rate Movements on CDOs,” we illustratehow certain IG CDO tranches may be attractive at current levels because the out-of-the-money interest rate swaps have depressed valuations. From a buy-and-hold perspec-tive, the relationships are more complex, and we explore these mechanisms as well.

ConclusionThe secondary CDO market may have witnessed a surge in valuations through 2003, butopportunities continue to exist for the discerning investor. Security selection is likelyto be the key in 2004, as asset allocation alone is unlikely to determine outperformance.The sector to watch is SF CDOs as the underlying collateral firms up and the CDOmarket eventually catches up, delivering incremental returns. Senior CDO tranches arelikely to tighten in 2004 in both the new issue and the secondary market, though someasset classes leave more room for tightening. We find investment opportunities lowerdown the capital structure as well, notably in SF CDO subordinates and Ba tranchesfrom LL transactions. Sensitivity to interest rate moves will also be an investmentconsideration as the year unfolds.

We recommend BB CLOs as demandtechnicals kick in while loan transactions

continue to outperform.

We see relative value in secondaryequity or equity-like tranches of

shorter-duration synthetic CDOs.


January 21, 2004 30

CLO 2004 OUTLOOK:LEVERAGED LOANS REMAIN THE CDO ASSET CLASS OF CHOICE

IntroductionCDO market participants are by now well aware that transactions backed by leveragedloans have generally performed much better during the latest corporate credit cycle thantransactions backed by any other asset class except structured finance CDOs, whichbehave differently because they are exposed to the consumer credit cycle. For example,the percentage of downgrades in CLOs stands at 16% at the end of 2003, versus 64% forHY CDO and 45% for cash IG CDO. It is therefore not surprising that leveraged loansremained the CDO asset class of choice in 2003, with a record $23.3 billion in arbitragecash flow CLO issuance, beating the previous record of $22.7 billion in 1999. This strongdemand confirmed the dominant position of CLO managers, which now account for62% of the new-issue loan market (up from 45% in 1999). In this section, we explore thefollowing themes:

• Elevated refinancing activity and its effect on CDO performance and valuation.• Relative value in the secondary CLO market and the need to go down in quality.• Our outlook on the new issue CLO market and structural changes likely to

become popular• Challenges for CLO managers in light of the interplay between the underlying

markets and the constraints on the CLO market.

Refinancing Activity to Continue to Upstage Defaults in 2004With declining default rates, higher recoveries, and much improved asset valuation,the main question for CLO market participants in 2003 gradually shifted from“what default scenario should I use?” to “what prepayment rates should I assume?”for CLO tranche valuation. Few were prepared for the actual levels of refinancingactivity observed in 2003, as prepayment rates on the S&P/LSTA LeveragedLoan Index reached 56%, up sharply from 38% in 2002 and 24% in 2001. Mostmanagers were unable to reinvest quickly enough to keep up with the constant flowof prepayment proceeds and saw their average cash balance swell from 5.1% inDecember 2002 to 8.6% by October 2003. We have discussed these trendsin earlier publications and explained how managers were forced to reinvest inlower spread assets or pay down the senior tranches, thus reducing the excess interestin the transaction.

The other key driver of CLO performance is the default rate for leveraged loan issuers,which is currently at 2.3% and is expected to keep drifting lower and eventually settlein the 1.0% area in the second half of the year, as per S&P estimates (Figure 1).Meanwhile, refinancing activity is likely to remain at elevated levels (Figure 2), sincemore than 58% of institutional term loans are currently trading at or above par andwithout prepayment penalties. If investors’ risk appetite for lower-rated loans re-mains high, these prepayments are likely to include a high proportion of single-Bissuers looking to refinance at lower levels (the average BB loan could currently save 80bp in spread, according to S&P). CLOs generally contain a high percentage of single-B loans in their portfolios, and this would result in a noticeable reduction in assetspread, hurting equity payments in seasoned clean transactions and accelerating therate of amortization for currently deleveraging transactions.

Claude Laberge212-526-5450

[email protected]

Christina Celi212-526-4482

[email protected]

We expect CLOs to remain the asset classof choice in terms of issuance despite

less arbitrage opportunities anda likely drop in issuance.

Low default and high-prepayment rateshould remain the main valuation drivers.

January 21, 2004 31


Secondary CLOs: The Need to Go Down in Credit QualityWith market participants increasingly using the NAV (or “break-up”) valuationmethod for CDO pricing, it is not surprising that the steady increase of loan prices in2003 fueled much of the rally in secondary CLO tranches, along with strong perfor-mance (credit and prepayment) of senior tranches. The price rally in collateral isunlikely to continue due to market technicals, given the aversion to loans trading ata substantial premium and the associated refinancing risk. The average bid price ofthe S&P single-B loan index is currently close to par ($99.44 in December 2003 versus$90.61 in December 2002), and only 5% of performing loans now trade below the“distressed” price of $80 (Figure 3). Therefore, senior CLO valuation has limitedupside from these levels. We would argue that CLO valuations, especially regardingportfolios with a large Caa basket, offer little price protection on a NAV basis if risk-aversion returns to the market. More care will have to be paid to credit risk and thedeclining interest cash flows generated by portfolio assets.

Figure 1. Default Rates

Source: Standard & Poor’s LCD (based on FridsonVision LLC default model).

0%

2%

4%

6%

8%

10%

12/98 6/99 12/99 6/00 12/00 6/01 12/01 6/02 12/02 6/03 12/03 6/04 12/04

ModelActual

Figure 2. Percentage of Loans Trading at or above Parwith No Prepayment Penalties

Source: LoanX.

0%

10%

20%

30%

40%

50%

1/02 3/02 5/02 7/02 9/02 11/02 1/03 3/03 5/03 7/03 9/03 11/03

Spread compression should be mostsignificant in subordinated tranches.


January 21, 2004 32

For the above reasons, the deleveraging senior CLO tranche, which was the great “entrylevel” trade of 2003 in an enthusiastic secondary market, does not appear as attractiveat this time. Attractive opportunities may remain for specific transactions, but webelieve that the generic senior CLO tranche theme, while still a reasonably attractivecarry trade, has been played out from a total return perspective. Investors need to lookfurther down the quality spectrum, such as subordinated CLO tranches (Ba-rated atorigination), for more attractive returns.

Pros• The fact that we expect the issuance of Ba-rated tranches to be limited in 2004 (see

next section) should make them increasingly attractive for yield-hungry investorsin a low-interest rate environment.

• CLOs are to a great extent immune to interest rate moves, as the presence offloating-rate assets alleviates the need for large interest rate swaps and, hence, thepain of out of the money swaps faced by many IG or HY CDOs.

• Secondary prices for subordinated tranches still have room to rally, since theliquidity premium should compress as investors become more and more comfort-able with the CLO asset class in general.

• The recent new-issue level for BB CLO tranches remains in the 800 bp area, makingit very attractive for yield-hungry investors.

Cons• Simplistic valuation methods such as NAV are inadequate for subordinated

tranches; investors need to become familiar with more sophisticated valuationtools and spend more time understanding the underlying assets and structureunique to each transaction.

• Stay in tranches with a healthy IC cushion, since we expect that a large single-B loanrefinancing wave could result in significantly lower asset spreads over time.

• Scrutinize tranches that derive a large portion of their valuation from high-pricedCaa basket, since subordinated tranches have the most exposure to low-qualityassets unless you intend to take on a leveraged exposure to Caa assets.

Figure 3. Percentage of Loans in the S&P/LCTA Index Trading below $80

0%

3%

6%

9%

12%

15%

1/97 7/97 1/98 7/98 1/99 7/99 1/00 7/00 1/01 7/01 1/02 7/02 1/03 7/03

January 21, 2004 33


Issuance Outlook: Expect Structural and Collateral ChangesThe compression in leverage loan spreads is likely take a toll on issuance, at least in theshort term. Our estimates indicate that seven CLOs backed by U.S. leveraged loanstotaling less than $2.0 billion in notional entered the pipeline over the past six months.Yet demand from investors is likely to remain high, given the performance of CLOsduring the latest credit cycle. As a result, we expect new issue liability spreads to keepcompressing and become competitive with secondary levels, but the CLO class of 2004is likely to be different from its predecessor in both collateral and structure types.

A. Collateral• A few recent CLOs have focused on pro-rata loans. One argument in their favor is the

reduced prepayment risk, since they usually trade at a discount to par. After a fewyears’ absence, revolver CLO tranches are likely to make a comeback, particularly asthis is a natural place for banks that are hungry for credit product to participate.

• Middle-market loans (companies with $50 million of less of EBITDA) still offerattractive spreads and have already attracted niche investors. While we expectincreased issuance in this segment, given the limited size of this market, it isunlikely to be able to handle a large influx of CLO money on a sustained basis.

• We also foresee an increasing use of loan-based CDS to help alleviate the difficultyof sourcing enough assets during the ramp-up period and the reinvestment period.Recent transactions have greatly facilitated the process for managers to include“pure” CDS rather than credit-linked notes in their portfolio.

B. Structural AspectsExpect new structural features in 2004 to help minimize funding costs and facilitate theacquisition of collateral.

• The trend toward “flatter” equity return should continue as new structural mecha-nisms divert excess interest during a credit downturn..

• Senior revolver CLO tranches are likely to be more prevalent in 2004, since manyof the assets themselves will contain revolvers. They can also take the form of creditlines available for the purchase of additional assets at later stages if the transactionis performing well. Banks looking to increase their credit exposure to loans shouldbe natural buyers in this part of the capital structure.

• With recent BB CLO new issue spreads remaining in the 800+ bp area, it is notsurprising that many recent transactions have tried to minimize or avoid suchtranches altogether in the capital structure, given their negative effect on thearbitrage of the CDO. In fact 10 out of 17 CLOs issued over the past two monthsdid not include BBs. Therefore, this creates a scarcity on the secondary market andis likely to push prices upward.

• With the expected growth of the leveraged loan CDS market, we should also expectto see “high-yield” synthetic CLOs coming to market in the later half of the year,most probably in the form of customized tranches.

Challenges for CLO Managers in 2004In 2004, CLO managers need to face tough decisions regarding the significantlyappreciated defaulted assets in their portfolios. Most managers would rather hold suchassets until completion of the workout procedures and monetize the remainingdiscount to their ultimate recovery price. But with excess interest likely to come under

The CLO class of 2004 is likely to bedifferent from its predecessor in both

collateral and structure types.


January 21, 2004 34

pressure in 2004, this is a good time to sell these “zero-coupon” assets at current highlevels and redeploy the capital in interest-bearing assets. The effect onO/C ratios should be minimal in most cases, since they are already discounted for O/Ccalculation purposes.

On the other hand, managers are unwilling to reduce their exposure to loans rated Caaand below aggressively, even if it significantly exceeds the suggested limit (usually 5%or so) permitted by the transactions. They would rather keep failing the “Caa-bucket”test than lose the assets with the highest spreads (and the least likely to refinance) andfail their “spread/coupon” test. Therefore, WARF improvements are likely to comefrom upgrades in current assets rather than reduction in more “distressed” loans.

We also recommend that CLO managers make increasing use of their “synthetic”buckets (the allowed percentage of assets in the form of CLNs, CDS, etc.) and reinvestsome of the forthcoming prepayment proceeds into loan CDS, as they often provide aneasier way to actually source the desired assets—at the cost of slightly lower spreads—and provide more flexibility in the purchase price.

Other Trends to Follow in CollateralWe applaud the planned introduction of loan CUSIPs in 2004, as it should increasethe liquidity of CLO tranches over time. The improvement in transparency will makeit much easier to monitor specific loans prices and exposure across various CLOs.Using a specific CUSIP as reference for a loan CDS should also help improve liquidityin this market as well.

Standard & Poor’s recently unveiled a recovery rate scale for loans to complement theirusual ratings (based on likelihood of default). This scale will be assigned to any loanrated by S&P going forward. Again, we see this as another step toward improvingtransparency in the loan market.

ConclusionWe believe that secondary and new-issue spreads on CLO tranches should lookincreasingly attractive for yield-hungry investors compared with almost every othertype of investments of similar ratings. Furthermore, the decline in projected defaultrates in underlying assets and the fact that they provide a natural hedge against a possiblefuture increase in interest rates all point toward another year of strong CLO perfor-mance in 2004.

January 21, 2004 35


A BENIGN CONSUMER AND COMMERCIALCREDIT CYCLE SUPPORTS SF CDOSStructured finance (SF) CDO issuance jumped 33% in 2003, making it the largest CDOasset class in terms of funded volume of arbitrage transactions, at $41.3 billion. The jumpfrom last year was dominated by synthetic SF CDOs, which accounted for $7 billion involume. Issuance rode high on the back of sustained investor confidence, given a resilientstructured finance market, and was boosted further by the receding arbitrage levels inother asset classes. Concerns about lower-quality collateral resulted in rising SF CDOdowngrades during the second half of 2003, but the widely expected downturn in theconsumer credit cycle was relatively benign, and the SF market rebounded smartly fromits 2002 lows. Consequently, only 16% of cash flow SF CDOs have been downgraded—significantly lower than the 64% for HY CDOs and on par with the much-liked leveragedloan CDO market.

Our outlook on SF CDOs is generally positive, as the underlying collateral market appearsto be on a path to recovery, as indicated by a blend of positive signals—both macroeco-nomic indicators and measures of consumer credit quality. 2003 produced smart returnsfor investors in the underlying markets, as the ABS Index OAS tightened 45 bp, to 84 bp,while the CMBS Index compressed by 32 bp to end the year with an OAS of 81 bp. Notonly is the rally likely to result in improved valuations for secondary SF CDOs, it alsoreflects the optimism in the market and the continued confidence in the asset class.

SF CDOs Adapt to an Evolving MarketplaceThe SF market continues to innovate and adapt as it learns from past experiences.Current structures offer more protection to debt holders, as excess interest trappingmechanisms have become more popular. We also observe more static transactionsbeing issued. Increasingly, debt is being sold in the CP or 2’a7 form as issuers tap intonew investor bases. The pipeline for 2004 is strong, though issuance may taper off overthe second half of the year as collateral spreads tighten and the anticipated drop incollateral supply takes effect.

Collateral from today’s typical SF CDO looks different from that of earlier vintages.First, most assets are floating rate in nature and are not necessarily focused on Baa-ratedissues. In addition, there is a renewed focus on on-the-run asset classes, consistent withinvestor appetite. Also noteworthy is the surge in synthetic SF issuance that referenceshigher-rated assets such as Aaa’s and Aa’s. The CDO bucket is also generally smaller andis typically composed of only non-PIKable tranches.

A Positive Collateral Outlook Makes Us Constructive on SF CDOsFundamentals appear to be improving, and the outlook for SF CDOs is generallypositive, though uncertainties about lower-quality services and subprime mortgageshave not completely abated.1 The outlook on CMBS products is largely positive. As aresult, SF CDOs in general should enjoy a good year. One of the primary long-termconcerns that remains is the risk of a backup in interest rates. Our economists believeit is unlikely during the first half of the year and expect only a gradual rise when it occurs.Therefore, the impact of rising rates on sub-prime mortgages is more of a 2005 concern


[email protected]

1 Our ABS strategy team maintains a strong positive outlook in 2004.


January 21, 2004 36

than a 2004 issue. The other notable risk is the effect of the continued underperformanceof older-vintage SF CDOs on investor sentiment.

The market compensates SF CDO investors by attaching an additional discount toSF CDOs given their complexity. Our enthusiasm for SF CDOs is driven by thefollowing factors:

• The imminent recovery in the consumer credit cycle.• Currently depressed valuations of SF CDOs relative to collateral and tightening

spreads on other assets classes, which should bring in favorable demand technicals.• Relatively low exposure to interest rate swap mismatches in newer vintages com-

pared with HY or IG CDOs.• A gradual improvement in liquidity and access to information.

Overall, we recommend going up in quality when dealing with mezzanine-qualitycollateral, given the remaining risk related to lower-quality consumer and commercialassets, unless interest diversion features provide sufficient structural protection. Whenit comes to higher-risk positions, traditional ABS investors have an advantage becauseof their expertise in understanding the underlying portfolio. Other investors looking forgreater yield should consider leveraged positions on higher-quality collateral usingsynthetic SF subordinates and equity and high-quality cash CDOs.

Based on our views, we have three trade recommendations for 2004.

1) Selective Opportunities in Stressed Seniorsand Clean Second-Priority Secondary SF CDOsInvestments in higher-priority SF CDOs are especially attractive for those who wish toroll over from our 2003 recommendation—the senior deleveraging trade. This is ourtop relative value pick for secondary investors. First-priority tranches from stressedtranches or clean second-priority tranches trade around than L+90 bp, with some aswide as L+300, and we recommend them over new issue mezzanine tranches. Given therisk of rising interest rates and its effect on sub-prime MBS quality, we recommendconservatism toward mezzanine ABS CDOs. However, many older vintage SF CDOshave sizeable out-of-the-money interest rate swaps, and accelerated prepayments haveleft them considerably overhedged, making them favorably inclined toward higherinterest rates. Senior or second-priority tranches enjoy sufficient subordination tocushion credit problems, while the risk of rising interest rates is partly offset by theperformance of the interest rate hedges embedded in the structure,2 making them moreattractive than similar-spread new issue mezzanine paper.

Secondary SF CDO Market Activity Is on the RiseWhile more activity is observed in trading secondary SF CDOs, there are dissimilaritiesbetween credit CDO and ABS CDO secondary markets:

• The secondary SF CDO market is smaller than that for corporate CDOs.• Liquidity and transparency in SF CDOs are still relatively limited and lag other

CDO sectors.

2 For an in-depth discussion, see “Impact of Interest Rate Movements on CDOs,” in this publication.

January 21, 2004 37


• Analytics continues to be a challenge given the two structural layers involved,making valuation a non-trivial exercise

• The underlying collateral does not enjoy the same liquidity or uniform valuationas corporate debt, adding uncertainty to the CDO valuation process.

2) Relative Value in SF CDO Seniors as Primary Spreads Remain WideConsistent with our overall bullish view on Aaa CDOs, SF CDO seniors should benefitthe most as the market discards its current inertia and spreads compress. Currently, AaaSF CDOs are issued 5-10 bp wider than other CDOs, with the average being 59 bp overLIBOR. We believe spreads are unlikely to be sustained at current levels, as CDOs ingeneral—and SF CDOs in particular—are one of the few spread sectors that continueto lag the other fixed-income markets. Given that not all concerns have been alleviatedon the collateral side, we suggest going up in quality on SF CDOs backed by lower-quality collateral.

3) Down in Quality on Leveraged Exposureto Higher-Quality CollateralInvestors can obtain leveraged exposure to highly rated collateral through synthetic SFCDO subordinates and equity tranches and, where available, cash deals with seniormoney market tranches. Aaa SF products (ABS, CDOs, CMBS) are consistently cheapto their model values and risk profiles. For example, as discussed in “CDOs—In Pursuitof Yield,” our METEOR model consistently values the default-adjusted spread (DAS)on clean senior tranches at 10 bp, compared with the current market level of L+50 bp.Taking on a leveraged exposure to Aaa- or Aa-rated securities is an attractive way to addyield to collateral with low idiosyncratic risk.

In summary, we believe that within the CDO space, SF CDOs offer select opportunitiesto pick up incremental yield.


January 21, 2004 38

A LOOK AHEAD: SYNTHETIC CDOS IN 20042003 was marked by unprecedented innovation in synthetic technology at a surprisinglyrapid rate. In this article, we provide a preview of what to expect in 2004 and suggest afew trade ideas that reflect our belief of what’s to come.

In a nutshell, the synthetic CDO market experienced a dramatic growth and learningphase in 2003, highlighted by the widespread issuance of tailored, single-tranchesynthetics; the emergence of standardized portfolio CDS products and tranches off ofthose portfolios; and the adoption of delta-hedging technology. European issuancedominated in 2003. A combination of factors has helped make Europe the globalsynthetic hotspot, including a more derivatives-oriented investor base and a strongdesire to gain access to diversified corporate credit risk (please refer to “EuropeanCDOs: 2004 Outlook” for more details). Tailored single-tranche CDOs, propelled byderivatives-hedging technology and demand for mezzanine exposures from yield-hungry investors, grew in popularity and accounted for 493 of the 585 syntheticarbitrage transactions that we tracked during the year. In total, global issuance jumpedfrom $15.6 billion in 2002 to $36.2 billion in 2003.

Product Developments for 2004The synthetic sector benefited from the enhanced liquidity in the single-name defaultswap market and the wider adoption of derivative-hedging technology in 2003. Theexpansion of the synthetic market is likely to continue in 2004, especially with theadvent of tranched portfolio products such as CDX and Trac-X (please refer to“Portfolio CDS Opportunities for Credit Investors” for our outlook on this market).These allow transparent valuation benchmarks and facilitate hedging of diversifiedcredit exposures. Notably, each of the product suites has added a version that referenceshigh yield issuers. While the initial trading of these tranched products was minimal andalmost exclusive to dealers, they are expected to provide an avenue for growth in 2004.Furthermore, the development of a HY and loan-only deliverable CDS market hasalready resulted in the issuance of two synthetic single-tranche HY transactions, withanother in the pipeline. We expect this trend to continue in 2004.

Sunita Ganapati415-274-5485

[email protected]

Philip Ha212-526-0319

[email protected]

Figure 1. Global Synthetic Arbitrage CDO Issuance

# of Transactions

* Funded tranches only.** 2003 numbers are large because of the increased amount of data available on tailored-tranche CDOs.

0

20

40

60

80

1/01 4/01 7/01 10/01 1/02 4/02 7/02 10/02 1/03 4/03 7/03 10/03

Syndicated

Tailored Tranche

In a nutshell, the synthetic CDO marketexperienced a dramatic growth and

learning phase in 2003.

The development of a HY and loan-onlydeliverable CDS market has already

resulted in the issuance of two syntheticsingle-tranche HY transactions

12/03

January 21, 2004 39


The rapid growth of the synthetic ABS CDO market is expected to carry on into the newyear, continuing the trend seen in 2003.1 Issuers have primarily been banks and otherfinancial institutions with large senior SF holdings that have synthetically securitizedtheir portfolios for a combination of risk-reduction and arbitrage purposes. Investorshave been drawn to such structures in search of higher yielding spreads, diversity, andthe fact that ABS structures minimize idiosyncratic risk in exchange for a larger degreeof systemic risk.

2003 was also notable in that the evolution of synthetics2 toward path-dependentstructures dwindled at the expense of single-tranche synthetics with minimal structuralenhancements. Covenants such as OC and IC triggers divert cash from one set oftranches to another in poorly performing scenarios. CDOs incorporating such tests arereferred to as path-dependent structures. This trend away from path dependencies canbe most directly attributable to the shift away from fully syndicated transactions, whereall the risk is placed into the capital markets, to single-tranche synthetics, where the riskcan be dynamically hedged. The addition of structural features, path dependencies, andportfolio management introduces modeling complexities, making dynamic risk man-agement of single tranches more difficult. We believe that path-dependent structureswill be shown out again in 2004, as portfolio loss modeling and hedging techniquesimprove and tight spreads and still-elevated levels of idiosyncratic risk will causeinvestors to want more downside protection.

Improvements in ValuationAnother development that we believe will occur in 2004 is an evolution in modelingcomplexity with regards to calculating portfolio loss distributions, as well as pricingtranches. One such change that does not involve much calculation complexity is achange in the convention of using a flat implied correlation between names to pricetranches versus a positive/negative shift in the historical correlation matrix of aportfolio to price tranches. We believe this will occur early in 2004. Currently, themarket is using a flat implied estimate, which does not properly account for the cross-sectional pair-wise correlations between individual credits and, thus, inaccuratelyprices the actual risk of a portfolio. In some cases, this results in the creation of illusoryrelative value borne out of mathematical simplification. In an upcoming report, we willpresent the case for using a positive/negative shift in the historical correlation matrix ofa portfolio versus a flat implied correlation.

In addition to a change in the way implied correlations are quoted, we also believe thatthe new year will bring other changes in the way portfolio loss distributions arecalculated. Currently, the market has overwhelmingly used Gaussian distributionswhen calculating portfolio losses. However, as historical data suggest, defaults do notoccur in such normal distributions. Thus, tail events are not being accounted for andproperly priced into tranche valuations. Instead, we believe that loss distributionswould be more accurately calculated using T-distributions.

1 Please see CDO Monthly Update, July 2003, for more details on synthetic ABS CDOs.

2 Please see Evolution of Synthetic Arbitrage CDOs, November 5, 2002, Ganapati, Ha.

Investors have been drawn toABS CDOs in search of

higher yielding spreads, diversity,and low idiosyncratic risk.

Structural evolution of synthetics andpath-dependent structures dwindled at the

expense of single-tranche synthetics withminimal structural enhancements.

The market is using a flatimplied correlation estimate,

which does not properly account for thecross-sectional pair-wise correlations

between individual credits.


January 21, 2004 40

Our Relative Value PicksThe key to success in 2004 will be to balance higher idiosyncratic risk, which has not yetfully played out, by scrutinizing valuations. In light of this view, on a relative value basis,we favor shorter duration secondary synthetics, particularly from equity or equity-liketranches, because of their lower tail risk, complemented by pickup in spreads/liquiditypremium. As we have written over the past several months, dealers continue to be longVOD risk and, thus, have a need to buy first-loss protection on both primary andsecondary paper. Several secondary CDOs have traded in the last quarter, with largespread pickups due to the lack of liquidity in this market. The current situation in thesecondary synthetic market is similar to that of the secondary cash market at thebeginning of 2003. Valuations in such paper present a favorable risk-return trade-off.Furthermore, as we expect a moderate degree of spread tightening in 2004, resulting inpositive MTMs, given the current tight-spread, low-vol environment, we do not believethat a continuation in spread tightening will lead to a decrease in default correlations,which would reduce the value of delta-hedged equity tranches (though to a lesser degreethan spread compression).

We also prefer an up-in-structure trade strategy in 2004, as finding yield while avoidinglosers will be paramount in the current low-spread environment. Senior synthetics areattractive relative to like-rated single-name CDS, where the average spread on single-A CDS is a mere 29 bp and Baa CDS is 56 bp. The 7%-10% tranche of CDX NA is tradingat 75 bp/83 bp, and the 10%-15% tranche is trading at 35 bp/43 bp. Furthermore, theaddition of subordination and diversity makes the story for higher-quality syntheticpaper all the more compelling.

Other trades that we like include mezzanine and equity tranches of synthetic ABSCDOs, because of the low idiosyncratic risk inherent in SF collateral and a higher spreadpickup relative to other like-rated securities (please refer to “A Benign Consumer andCommercial Credit Cycle Supoprts SF CDOs”). In the mezzanine arena, we prefersynthetics with structural features such as triggers that add downside protection in caseof an economic downturn.

The popularity of delta-hedged “package” trades should continue in 2004. Given ourview that idiosyncratic risk will remain elevated and credit spreads should tightenmoderately in 1H04, we believe that money is better spent hedging VOD risk thanspread risk. VOD hedging is more an art than a science. Most often, such hedges areexecuted by buying more protection on wider names while under-hedging tighternames in the portfolio.

The development of the tranched CDX/ Trac-X market has largely been a positive, eventhough the trading volume appears to be limited. However, the growth of this marketin 2004 should provide more transparent pricing and help to infuse more liquidity intothe correlation space.

We favor shorter duration secondarysynthetics, particularly from equity or

equity-like tranches, because of their lowertail risk, complemented by pickup in

spreads/liquidity premium.

We prefer an up-in-structure tradestrategy in 2004, as finding yield while

avoiding losers will be paramount in thecurrent low-spread environment.

Money is better spent hedging VOD riskthan spread risk.

January 21, 2004 41


Philip Ha212-526-0319

[email protected]

SYNTHETIC CDO BID LIKELY TO TEMPER IN 2004The synthetic CDO bid had an overwhelming effect on the single name CDS market in2003, as discussed in the section “CDS and Volatility Strategies.” Often, single nameCDS would tighten despite no corresponding tightening on the cash side, resulting inan overall negative basis in the market. There were several opportunities to trade intoand out of the CDO bid. Entering 2004, the nature and effect of the synthetic CDO bidhas changed, and we discuss our outlook below.

The shift from fully syndicated deals with rated tranches to tailored single tranchesynthetics could cause the synthetic bid to temper this year. In a fully syndicatedtransaction, protection is sold on the entire notional value of each credit in the portfolio,while in a single tranche synthetic, protection is sold only on the delta amount of eachcredit.1 This causes the technical effect of the CDO bid to be lower, as the total notionalof protection sold is only a fraction of what it was in the past. The boom in single trancheCDO issuance in 2003 absorbed some of this differential in notional value, keeping thesynthetic bid strong. An expected slowdown in synthetic issuance in 2004 shouldmoderate the effect of the bid and, more importantly, change its nature.

In a research report published March 2003,2 we laid out several measures for analyzingsectors and individual names that were the most and least attractive to synthetic CDOs.At that time, the synthetic market was mainly driven by ratings arbitrage and thetechnical bid was driven by three variables: ratings, spread, and diversity. Throughoutthe year, we identified many names and sectors from these metrics that benefiteddisproportionately from the synthetic bid.

Today, many single tranche synthetics are unrated; thus, the credit rating of the underly-ing CDS contract is less important (rating agencies use asset ratings to measure its defaultprobability). Furthermore, the traditional account base which is typically ratings depen-dent has been replaced by hedge funds and specialized CDO/CDS funds that are not asratings dependent. As a result, we expect a shift from a spread-ratings trade-off to a spread-correlation one—a trend already visible during the last several months of the year. Currentmarket standards for pricing correlation products made low to negatively correlatednames with the highest spread the most attractive for synthetic CDOs. The way thatcurrent correlation models operate, these names helped to create the most value in termsof pricing tranches cheap to their actual correlations. Not surprisingly, it was these namesthat were most often found in synthetics in the second half of the year and experienced alarger degree of spread tightening versus the broader markets.

As correlation models evolve and as the market refines its flat implied correlationapproach to pricing tranches, there will be several arbitrage opportunities in the shortterm. Additionally, the use of structural default models such as those from Moody’sKMV and specialized credit analysis models such as Lehman Brothers’ ESPRI inanalyzing CDO portfolios will make such measures more worthy of watching, particu-larly as the ratings arbitrage trade becomes less prevalent.

1 Please see Portfolio Structured Credit Monthly, November 2003.

2 S. Ganapati, A. Berd, P. Ha, “The Synthetic CDO Bid and Basis Convergence—Which Sector is Next?” GlobalRelative Value, March 31, 2003

The shift from fully syndicated deals withrated tranches to tailored single tranchesynthetics could cause the synthetic bid

to temper this year.

We expect a shift from a spread-ratingstrade-off to a spread-correlation one—

a trend already visible.


January 21, 2004 42

In summary, we believe that in 2004, the synthetic CDO bid will continue to play animportant, albeit tempered role on single name CDS spreads. Given the large numberof negatively correlated, wide spread names that CDOs ramped up in 2H03, we believethat some reversal of this is likely, especially as dealer books have probably become moreexposed to lower spread, higher correlation names.

January 21, 2004 43


THE IMPACT OF INTEREST RATE MOVEMENTSON CDO PERFORMANCEAs interest rate increases become more of a risk, it is important to understand the effectsthat interest rates have on CDOs. At first glance, it appears that rate changes should belargely irrelevant, given that most CDOs are floaters. However, apart from the directimpact on fixed-rate bond valuations, interest rates affect even floating-rate notesthrough potential mismatches on the interest rate hedges built into the structure. Inaddition, there are indirect consequences via prepayment due to refinance activity andthe co-movement of interest rates and default rates. Though the relationship betweenCDO performance and default rates is well understood, estimating the effects of interestrates on CDOs is not a trivial task. We explore these relationships and consider howCDOs perform in different scenarios.

The need for interest rate hedges within CDO structures arises when most of the assetsare fixed-rate bonds while the liability notes are floating rate. The use of predeterminedinterest rate hedge schedules that match the expected amortization of liability tranchesmay be relatively inexpensive compared with balance-guaranteed swaps, but oftenleaves a potential mismatch, as shown in Figure 1.

CDO structures have been tested with exceptionally low interest rates for a prolongedperiod of time, even as default rates remained high before dropping precipitously in 2003.The comparison between the forward LIBOR curve as of January 2000 and what wasactually realized (Figure 2) illustrates how the interest rate swaps embedded in moststructures have continued to move further out of the money, compounding the problemsin cash-strapped CDOs. Low rates alone should not significantly alter the value of atranche if the hedge performs as per expectations, i.e., if cash flows to the interest rate swapsimply offset the cash outflows to floating-rate liability tranches. In reality, there may bea mismatch—either positive or negative, depending on the actual notional of theperforming assets and liabilities compared with the amortization schedule that wasenvisaged at inception. Though most CDOs are underhedged (short LIBOR) to start with,it is possible for them to become overhedged state (long LIBOR), depending on otherdeterminants such as default rates, prepayments, refinance activity in the credit markets,and the manager’s ability to reinvest principal proceeds when the need arises.


[email protected]

Figure 1. Typical CDO Structure with an Embedded Interest Rate Swap

}Fixed Assets

Floating Assets

Equity

Fixed Mezz TrancheFloating Mezz Tranche

Senior Tranche(Floating)

Mismatch

Natural Hedge

Interest RateSwap

HedgeReqmt


January 21, 2004 44

From an investor’s perspective, even when trades are not driven by changes in interestrates, it is important to align investment decisions with expected interest rate moves tomaximize value. For mark-to-market investors, we suggest exploiting the drawbacks ofcurrent valuation practices popular in the market.

MTM Investors Can Benefit fromRelatively Nascent CDO Valuation TechniquesUsing the liquidation value or NAV of a tranche as a key input for valuation may at timesbe misleading.1 The NAV is calculated by comparing the value of the underlyingsecurities, adjusted for the mark-to-market on the interest rate hedge, with the notionalof the outstanding liability tranches. As a result, the NAV of the senior tranche is“penalized” to the same extent as the mezzanine tranche to adjust for an “out-of-the-money” interest rate swap. In reality, the excess interest that flows through to the equity(or if the equity tranche is written off, the preceding debt tranche) is used to “pay off” thehedge, thus shielding senior tranches from the effects of the hedge. The negative mark tomarket on the hedge would be realized immediately only if the transaction were liquidatedand should, therefore, not significantly affect senior tranche pricing.2 The mechanism iseasily demonstrated in transactions in which each successive payment period leads to asudden rise in NAV of the trance as the mark to market of the interest rate hedge falls.

Trade Idea 1—First-Priority IG CDO Tranche Involvinga Large Negative Mark to Market on the Interest Rate HedgeFor illustrative purposes, we consider Solar IG CDO—a 2000 vintage investment gradetransaction with an interest rate swap that is out of the money by a whopping $65 million.On the last payment date, the value of the hedge improved by more than $13 millionovernight as the payment was made, thus improving the NAV on all the tranches. Similarchanges in NAV can be observed in most transactions, though the effects are more

1 Market participants make adjustments to the valuation if the transaction carries high excess interest, but tend touse NAV as the key input creating inefficiencies.

2 The exception being cash-strapped highly distressed CDOs with little or no excess interest. All proceeds areused to pay down the senior tranche, directly exposing them to cash outflows to the hedge.

0

2

4

6

8

10/95 6/96 2/97 10/97 6/98 2/99 10/99 6/00 1/01 9/01 5/02 1/03 9/03

Forward LIBOR curve as of January 2000

Realized Interest Rates

Figure 2. Forward LIBOR Curve as of January 2000and Realized Interest Rates

12/03

January 21, 2004 45


pronounced for transactions with a large mark to market on the hedge. Investors may findIG CDOs to be more attractive candidates for the trade. First, historical relationshipssuggest that IG prices are more sensitive to interest rate movements than HY prices.Consequently, investors should expect reasonably stable3 NAVs interspersed with posi-tive jumps on each payment date. Also, IG CDOs are often structured with an out-of-the-money swap, thus amplifying the impact of hedges via a large (negative) mark to market.Last, but not least, as default rates are the primary determinants of value, we expect IGseniors to perform well as credit quality continues to improve.

Buy-and-Hold Investors Should AlignTheir Investment Strategies with Their Holding PeriodsFrom a longer-term perspective, it is important to consider the effects of the interest rateenvironment on the intrinsic value of a CDO via a potential mismatch on the interestrate hedge, as explained earlier. Our economics team believes that interest rates are likelyto stay low in 2004, especially during the first half, and should gradually rise through2005. Figure 3 summarizes the performance of CDOs under various default and interestrate scenarios. Understanding this relationship becomes critical as we migrate from ahigh default, low interest rate environment (top right) to a low default, high interest rate(bottom left) by way of the current transition state, involving low defaults and lowinterest rates (top left). Most CDOs are slightly underhedged at inception, but highdefaults and prepayments have pushed many of them into an overhedged state, as swapschedules were set in stone while hedge requirements dropped.

3 Stable from an interest rate perspective only, as interest rate hedges offset collateral price movements some-what. However, defaults or changes in credit view would continue to affect NAVs.

Figure 3. CDO Performance Under Various Defaultand Interest Rate Scenarios

Low Defaults

Low Interest Rate

Underhedged Deals—Best scenario.Good performance backed by favorableinterest rates

Overhedged Deals—Low defaultsoutweigh negative value of the hedgeLikely scenario in 2004

High Interest Rate

Underhedged Deals—Low defaultsoutweigh negative value of the hedge

Overhedged Deals—Best scenarioLikely scenario in 2005-2006

High Defaults

Underhedged Deals—Defaults causetransaction to underperform, though interestrate hedge helps. Gradually migrate tooverhedged state

Overhedged Deals—Worst scenario.Large payment on hedge compounds theproblems of deteriorating collateral

Underhedged Deals—Cash flow-strapped transaction as interest rates hurt.Gradually migrate to overhedged

Overhedged Deals—Defaults causetransaction to underperform, though interestrate hedge softens the blow


January 21, 2004 46

Trade Idea 2—Long-Term Investments in Overhedged DealsSuch as HY or SF Transaction from 1999-2001 VintagesOverhedged transactions include those for which large prepayments or failing parcovenants caused accelerated deleveraging, hence reducing the floating-rate seniortranche size. A surge in refinancing activity also brought in additional principalproceeds that were used to pay down senior notes, either because transactions were outof their reinvestment position or because managers find it increasingly difficult to findattractive assets amid a stellar market rally. We recommend such CDOs from oldervintages that have been subject to early deleveraging, positively positioning themtoward rising interest rates.

For those willing to take on higher risk exposures, some of the distressed CDOs also gainfrom rising rates because of the presence of deleveraging senior notes alongside PIKingsubordinates. However, higher sensitivity to interest rates is exhibited by the mostsubordinate performing tranche, which is exposed to higher credit risk as well. A low-default environment should ease credit concerns, but high leverage exposures todistressed collateral do not suit all risk profiles, and we recommend a dose of cautionin security selection.

January 21, 2004 47


Lorenzo [email protected]

EUROPEAN CDOS: 2004 OUTLOOK

Structured Credit as a Yield Enhancement Strategyin Credit Portfolios in 2004One of the consequences of the extraordinary amount of liquidity in the financialsystem over the past two years is the stingy reward currently offered by spread productfor exposure to credit risk. Tight credit spreads, negative short-term interest rates, lowinterest rates, volatility, and an equity risk premium in the 400 bp area all make CDOs,which still trade at wide levels in the cash flow market, an attractive asset class for buy-and-hold investors in 2004.

In 2004, we expect the search for yield to continue to dominate among fixed incomeinvestors. This, together with the fact that CDOs compare favorably with the underlyingasset classes, where the reward for going down in credit quality has decreased, shouldincrease the demand for CDOs. We believe that moving to CDOs while keeping the samelevel of default risk offers a better risk-return profile than investing in lower rated bonds.As an example, consider the case of an A-rated CDS portfolio currently yielding 27 bp overLIBOR. By going down in credit quality, investors could pick up 31 bp (342 bp),depending on whether they invest in triple-B (double-B) CDS.

By moving into structured credit at the single-A (triple-B) level, investors can achievea spread of 190 bp (350 bp) over LIBOR with European CLOs, our favorite sub-assetclass. CDOs offer structured finance investors a similar trade-off at the triple-A(double-A) rating level face: with ABS/MBS spreads within the 30 bp (60 bp) area, thepickup offered by CLOs/CDOs of ABS (in the 60 bp (120 bp) area) is substantial. Acommon yield-enhancing strategy, moving into investment grade synthetic CDOs atthe single-A (triple-B) level, is currently rich in implied correlation terms: a Baa3backed by an investment grade index offers a spread in the 200 bp area, 32 bp tighterthan the spread implied by historical correlation numbers.1 Below, we propose betteralternatives with a similar risk profile.

Our central call that CDOs offer an attractive avenue to take on more credit risk and thatdemand for CDOs will be favored by the search for yield should tighten new issue spreads.We expect mezzanine tranches of cash flow CLOs backed by European leveraged/mezzanineloans to tighten the most, especially double-B tranches, which currently trade in the 775-850 bp area. Wide spreads and the significant improvement in the structural protectionawarded to mezzanine investors make double-B rated CLO tranches more attractive thanequity. At the single-A/triple-B level, the spillover demand away from synthetic invest-ment grade CDOs should tighten CLO spreads. We also expect triple-A tranches ofEuropean CLOs to tighten from the low sixties to the mid-forties and triple-A ratedSpanish SME CLOs to tighten as well. These are also our top picks at the senior level.

Subordinate CDO Investors Benefitfrom Short-Term Negative Real Interest RatesAnother reason we currently favor CDOs is that they give subordinate investors theability to take advantage of negative short-term real interest rates: although most

1 See our report, Trading Correlation, A Guide to Assessing Relative Value across CDO Tranches, November2003, for an analysis.


January 21, 2004 48

European CDOs have floating assets, the floating component represents a far smallerproportion of the asset coupon than of the liability cost. Hence, in a low LIBORenvironment, CDOs give subordinate investors the ability to take on cheap leverage.

By moving into CDOs, investors would sacrifice liquidity and increase both mark-to-market volatility and the tail risk of their investment. However, we expect CDOs tooutperform outright investments in the underlying, as aggregate default risk2 hasdropped sharply: expected default risk in a stylized global investment grade CDOportfolio was 76 bp at the beginning of the year, and it is currently 34 bp. We also believethat we are in a favorable environment for credit. For instance, a steep yield curve hashistorically provided support for credit.3

The decrease in diversifiable default risk hides the fact that idiosyncratic risk remainshigh: despite tighter spreads across the board, forward-looking measures of default riskhave not dropped in line with spreads for the riskier reference entities.4 Hence, theremuneration per unit of default risk has worsened for the riskier names. Hence, webelieve that the main risk for the performance of synthetic CDOs is a bifurcation in thecredit market in which the credit quality of the worst reference entities deteriorates.

Our Picks in the Synthetic Investment Grade CDO MarketWithin the synthetic IG market, we outline our favorite picks, which take into accountthe current shift of value from mezzanine to equity and current tighter spreads, whichhave prompted investors to look at alternative avenues to generate yield:

• Equity continues to offer the best risk-return profile across the capital structure.Our favorite trade in the synthetic market is made up of hedged CDO strategies, bywhich the investor sells protection in an equity tranche and simultaneously buysprotection in the single-name CDS market. We recommend that investors hedgethe value on default risk of the riskier names, which disproportionately affect theperformance of the equity tranche.5 As we discussed above, this protection can bebought at a relatively cheaper price. The overall position has significant carry, islong spread convexity, and can be adjusted to achieve the desired level of risk bychoosing the amount of protection bought.

• A combination note made up of equity and senior tranches can be structured toachieve the same rating/amount of default risk as that of a mezzanine tranche andoffers better value.6 The main downside to this strategy is its higher mark-to-market volatility.

2 We define default risk as the mean KMV expected default risk (edfTM) for the median reference entity in the portfolio.

3 See the European Quantitative Credit Insights section within European Corporate Credit Outlook 2004, datedJanuary 2004.

4 When we sort investment grade reference entities by their KMV edfTM, the median edfTM has dropped roughly inline with spreads since autumn 2002. However, 90th percentile edfTM has dropped significantly less than spreads.This is more pronounced for European corporates.

5 See trade 2 in Hedged CDO Equity Strategies (op. cit.) for an analysis of this strategy.

6 See our report Trading Correlation (op. cit.) for a discussion on how to evaluate relative value across the capitalstructure of synthetic investment grade CDOs.

January 21, 2004 49


• Hybrids—in which credit risk is combined with other asset classes, primarilyinterest rate risk, but also foreign exchange and commodity risk—are an alternativeto boost yields. We like inflation-protected CDOs, which should outperform in alow-rate environment and/or if current reflationary policies generate inflationduring the life of the trade. Principal-protected CDOs involving subordinatedtranches, a popular strategy among European insurers, are more likely to make useof hybrids because the drop in yields has increased the cost of protection. Also, byusing inflation-linked swaps, some investors may achieve a better alignment ofassets and liability risks.

• Stressed secondary synthetics offer significant value. These are attractive becauseof the large amount of stressed/distressed synthetic investment grade paper fromthe 2000 and 2001 vintages. In 2003, investors paid little attention to these bondsbecause of the value offered in the primary market and because fewer investors hadthe technology to assess their relative value. Despite the larger idiosyncratic riskassociated with them (they tend to be referenced to a lower number of referenceentities, some of which trade at wide spreads), we believe that they offer significantvalue with respect to the primary market and should outperform primary CDOs ina benign credit environment.

2003: Record Issuance, Record PerformanceIn April 2003, we suggested that investors rotate into CDOs, as we expected struc-tured credit to outperform at the turn of the cycle (see European CDOs: Review andOutlook [op.cit.]). Since then, the asset class has performed well against outrightcredit investments. This was in sharp contrast to the severe underperformance of theCDO asset class in 2002 and supported issuance (public and private), which set a newrecord (EUR62.8 billion, a growth of 5%). The majority of this has been concentratedin investment grade CDOs: in 2003 alone, 503 of such transactions priced in Europe,most of which were bespoke single-tranche CDOs. Synthetic7 structured financeissuance grew by 51% (87 CDOs, or EUR7.5 billion). We expect 2004 to be a year offurther growth in this subset of the market, due to tight spreads and the fact that thisis a compelling use of the synthetic CDO technology, which allows investors toleverage the large spread premia of senior tranches of structured finance securities.Despite the suitability of synthetic structured finance CDOs on a buy-and-hold basis,their leverage induces significant mark-to-market volatility.

Synthetic investment grade issuance and the associated risk management activity ofcorrelation desks have significantly altered the dynamics in the credit derivativesmarket: this technical effect has tightened spreads in the single-A/triple-B category andhas increased the intra-industry volatility while decreasing aggregate spread volatility.8

We expect this to be less relevant in 2004:

• We expect lower issuance in 2004 because tight spreads and low spread volatility haveincreased the trading risk associated with buying protection on single-tranche CDOs.

• Correlation desks increasingly use tranches based on standardized CDS portfolios torisk manage their books.

7 Includes both arbitrage and balance sheet CDOs

8 For an analysis, see European Synthetic CDOs’ Impact on the Underlying Default and Cash Markets, datedOctober 2002, and the previous section on the CDO bid in this report.


January 21, 2004 50

In 2004, we expect the following trends to prevail in the synthetic investment grade market:

• CDOs are more likely to be used to express widening views (see trade 1 in Hedged CDOEquity Strategies (op.cit.). Besides an outright purchase of protection, selling CDOequity protection and buying protection are efficient strategies to short credit.

• The inclusion of high yield, crossover, or emerging market risk in traditional staticinvestment grade portfolios should be an increasingly common strategy to respondto tighter spreads.

• Given the increasing ability to measure the delta exposure of CDO tranches amongthe investor community, we expect more investors to dynamically handle idiosyn-cratic risk and/or to implement long-short strategies to isolate the optionalityembedded in CDO tranches.

• Managed synthetics have grown and now represent 17% of the market. We expectthis growth to continue as dealers are increasingly able to buy protection onbespoke managed single-tranche CDOs.

• We expect single-tranche CDOs to be used increasingly by bank loan portfoliomanagers as an alternative to buy protection in the single-name CDS market. Thelow cost of protection at the mezzanine level makes this an attractive option.

• Equity collateralized obligation (ECO) will become more common. ECOs are backed byequity default swaps (EDS), in which the triggering of a credit event is driven by thecrossing of a predetermined price barrier. EDS are essentially equity put options. Theirsuitability for CDOs comes from the fact that they offer an alternative source of relativevalue: equity volatility. In addition, the liquidity of the equity derivatives market tends tobe more balanced between buyers and sellers, whereas the lack of buyers of protection incertain names means that the CDS trades tighter than what is suggested by the default risk.

Leveraged/Mezzanine Loan CLOs and SME CLOsConcentrate the Supply Away from SyntheticsLeveraged/mezzanine loans are our favorite picks in the European market. Institutionaltranches of European leveraged/mezzanine loans are among the few asset classes thathave not tightened in the past few quarters. Mezzanine loans’ cash pay averaged 10.1%over LIBOR in 2003 (8.9% in 2002), and warrants represented, on average, 3.8% ofequity (3.3% in 2002), according to Standard & Poor’s LCD data. In the second half of2003, the weighted average spread of European institutional tranches of leveraged loanswas 293 bp, 36 bp wider than in the U.S., as reported by LCD. In the same period in 2002,they paid an average spread of 294 bp, or 60 bp tighter than in the U.S. This improve-ment in the pricing (and liquidity) of European loans has been caused in part by theincreasing importance of institutional investors, which have a 20% market share in theEuropean market. These are the other reasons we are overweight CLOs:

• European bankruptcy and insolvency regimes favor senior secured investors. Thistranslates into significantly lower defaults and more rating stability than compa-rable unsecured debt.

• The outlook for private capital in Europe in the form of leveraged buyouts is bright,which should ultimately enhance the risk-return profile of leveraged loans. TheEuropean mezzanine loan asset class should benefit the most in this environment.

• The other big high yield subsector is made up of loans to SMEs, which have issuedEUR7.0 billion of bonds, most of which have come out of Spain, a market thathas exhibited a strong performance in line with the performance of its economy.

January 21, 2004 51


Overall cash flow balance sheet issuance has grown by 58%. The largest SME marketcontinues to be Germany, with an outstanding volume of EUR27 billion. In 2003, threeGerman SME CLOs have been issued, one of which had a notional of EUR1.4 billionand opened the door to what might become the largest European cash flow market inEurope. Among the seasoned transactions, we expect considerable divergence inperformance as the recoveries stemming from the severe default environment of thepast few quarters are worked out, which should eventually lead to rating actions.

CDO Rating PerformanceThe improvement in the fundamentals of the underlying markets has translated into adrop in the number and the severity of the rating actions in the European market: thenumber of tranches downgraded by S&P in 2003 has dropped to 18% (29% in 2002), while4% of the outstanding notes were upgraded (1% in 2002). This trend has accelerated inthe second half of the year and is expected to continue in the first half of 2004.

The bulk of rating actions has been concentrated in the synthetic investment grademarket, especially the 2001 and 2002 vintages. The amount of rating actions has slowedsignificantly, though—a trend that we expect to continue in 2004. In particular, distressedtranches should improve as they benefit from the passage of time. On the negative side,downgrade risk is very concentrated, as highlighted by the fact that Parmalat was in76 European CDOs rated by Standard & Poor’s, of which they downgraded 17.

Performance in the cash flow market has been much better, with only four transactionsof the 70 rated by S&P experiencing rating actions. This is in sharp contrast to 2002,when high yield CDOs underperformed severely. This is a result of the improvement inthe high yield market credit quality; for example, Moody’s trailing 12-month Europeanhigh yield default rate has dropped from 19.2% to 7.5%. To date, no European cash flowCDO of ABS or CLO has experienced a downgrade.

What Are the Risks in 2004 for CDO Investors?These are the negative events that, in our view, would be most damaging to CDOinvestments in 2004:

• Wider credit spreads would make CDOs underperform, especially at the subordi-nate level. Thus, hedged CDO equity strategies make sense for both those subor-dinated investors who believe the probability of a spread widening is large andthose who are very sensitive to mark-to-market volatility.

• Corporate leverage, the upgrade/downgrade ratio, and defaults have all improvedin the corporate credit market during 2003. However, the market has rallied evenmore, and idiosyncratic risk, the main risk to CDOs, remains an issue. Our creditstrategists believe that an improvement in the economic environment is needed forthis situation to change, especially in Europe. Hence, a bifurcation in the perfor-mance of the underlying asset class would hurt CDOs the most. As we discussedabove, investment grade synthetics are a candidate, as well as cash CLOs.

• Sluggish growth and the regional/industry concentration of SME portfolios couldhurt SME CLOs.

• Despite the improvement in pricing and liquidity in institutional tranches ofleveraged loans, leverage has been rising in the past few quarters. If the LBOpipeline fails to materialize, CLOs will suffer, too.

January 21, 2004 52


APPENDIX A. PORTFOLIO CREDIT PRODUCT SPREADS

Lehman CDS Indices

bp

Lehman U.S. CDS Indices

bp

The CDS Index consists of 440 names (250 US, 150 European, and 40 Japanese) with an average rating of A2/A3. We show the data following the official inception date ofthe index, October 1, 2003.

TRAC-X North America* Mid

bp

Investment Grade TRAINS�

bp

BBB and High Yield TRAINS�

bp

The 5, 10, L year, and BBB IG TRAINS are static portfolios each consisting of approximately 20 bonds in the Lehman Brothers Credit Index.HY TRAINS is a static portfolio currently composed of 68 HY bonds in the Lehman Brothers HY Index, rated at least B3 by Moody’s and B- by S&PThe jump in 5 year TRAINS in May 2003 was due to a change in the benchmark from the 5yr TSY to the 3yr TSY.

*TRAC-X North America and TRAC-X North America BBB are products of JPMorganChase Bank and Morgan Stanley & Co. Incorporated.**Prior to 5/1/03 (old 100) and 10/3/03 (new 100) historical intrinsic spreads are estimates based on historical single name spread data.

iBoxx CDX.NA.IG*

* Prior to 10/22/03 historical intrinsic spreads are estimates based on historical singlename spread data.

0

100

200

300

400

500

5/03 6/03 7/03 8/03 9/03 10/03 11/03 12/03

HY

BBB

0

50

100

150

200

250

300

6/02 8/02 10/02 1/03 3/03 5/03 8/03 10/03 12/03

New TRAC-X 100 Mid

Old TRAC-X 100 Mid

0

50

100

150

200

250

6/02 8/02 10/02 1/03 3/03 5/03 8/03 10/03 12/03

20

25

30

35

40

45

50

55

10/1/03 10/16/03 10/31/03 11/15/03 11/30/03 12/15/03 12/30/03

Global

Europe

Japan

40

49

58

67

76

85

10/1/03 10/16/03 10/31/03 11/15/03 11/30/03 12/15/03 12/30/03

US Baa

All US

0

50

100

150

200

250

300

350

1/02 4/02 6/02 9/02 11/02 2/03 4/03 7/03 10/03 12/03

L Year10 Year5 Year

January 21, 2004 53


Summary of Lehman Brothers CDS Index (Equal Weighted), as of December 31, 2003

QTD QTDNumber Current Contract Spread TotalIssuers* Quality Spread Rate Change Return Credit01

USD Composite (EQ) 250 A3/BAA1 43.6 57.5 -13.9 0.79 4.63Aaa (EQ) 6 AAA/AA1 14.4 18.8 -4.4 0.28 4.67Aa (EQ) 14 AA2/AA3 13.9 16.9 -3.0 0.14 4.67A (EQ) 97 A1/A2 25.9 32.0 -6.1 0.39 4.65Baa (EQ) 133 BAA2/BAA3 60.1 80.8 -20.7 1.18 4.61

Industrial (EQ) 161 A3/BAA1 47.9 61.7 -13.9 0.80 4.62Basic Industry (EQ) 17 A3/BAA1 47.0 58.5 -11.4 0.62 4.62Capital Goods (EQ) 18 A3/BAA1 37.0 49.5 -12.5 0.70 4.64Communications (EQ) 27 BAA1/BAA2 57.5 65.4 -7.9 0.50 4.59Consumer Cyclical (EQ) 23 BAA1/BAA2 64.6 87.2 -22.6 1.51 4.61Consumer Noncyclical (EQ) 36 A2/A3 33.0 42.0 -9.0 0.52 4.64Energy (EQ) 20 A3/BAA1 47.4 70.0 -22.6 1.15 4.64Technology (EQ) 11 A3/BAA1 68.7 93.5 -24.8 1.25 4.60Transportation (EQ) 9 BAA1/BAA2 28.0 31.3 -3.3 0.23 4.64Industrial Other (EQ) 0 NA/NA 0.0 0.0 0.0 0.00 0.00

Utility (EQ) 36 BAA1/BAA2 42.7 60.7 -18.0 1.00 4.64Electric (EQ) 27 BAA1/BAA2 41.6 66.7 -25.1 1.32 4.66Natural Gas (EQ) 8 A3/BAA1 45.6 44.5 1.1 0.05 4.60Utility Other (EQ) 1 NA/NA 0.0 0.0 0.0 0.08 0.00

Finance Institutions (EQ) 53 AA3/A1 30.5 41.9 -11.5 0.61 4.65Banking (EQ) 20 A1/A2 23.6 32.6 -9.0 0.51 4.66Brokerage (EQ) 6 A1/A2 29.0 35.0 -6.0 0.34 4.64Financial Cos. (EQ) 8 AA3/A1 36.9 55.2 -18.2 0.98 4.65Insurance (EQ) 14 AA3/A1 36.2 50.4 -14.2 0.73 4.65Reits (EQ) 5 BAA1/BAA2 38.6 48.6 -10.0 0.45 4.63Financial Other (EQ) n/a n/a n/a n/a n/a n/a n/a

*Number of issuers in the returns universe

Summary of Lehman Brothers CDS Index (Market Weighted), as of December 31, 2003

QTD QTDMarket Current Contract Spread TotalWeight* Quality Spread Rate Change Return Credit01

USD Composite (EQ) 100.00 A3/BAA1 48.6 67.3 -18.7 1.01 4.63Aaa (EQ) 6.50 AAA/AA1 18.5 32.2 -13.8 0.76 4.68Aa (EQ) 6.76 AA2/AA3 14.1 20.2 -6.1 0.26 4.67A (EQ) 38.25 A1/A2 27.0 33.4 -6.5 0.39 4.65Baa (EQ) 48.49 BAA2/BAA3 74.5 105.4 -30.8 1.66 4.60

Industrial (EQ) 62.69 A3/BAA1 60.6 82.7 -22.1 1.18 4.61Basic Industry (EQ) 3.95 A3/BAA1 46.0 54.5 -8.5 0.50 4.62Capital Goods (EQ) 5.61 A3/BAA1 36.7 48.7 -12.0 0.68 4.64Communications (EQ) 15.43 BAA1/BAA2 58.2 66.8 -8.6 0.55 4.59Consumer Cyclical (EQ) 16.98 BAA1/BAA2 101.2 156.0 -54.8 2.78 4.60Consumer Noncyclical (EQ) 10.16 A2/A3 36.2 44.2 -8.0 0.46 4.63Energy (EQ) 5.65 A3/BAA1 38.9 52.7 -13.8 0.67 4.64Technology (EQ) 2.75 A3/BAA1 52.4 71.2 -18.8 0.98 4.62Transportation (EQ) 2.18 BAA1/BAA2 29.7 34.4 -4.6 0.30 4.64Industrial Other (EQ) 0.00 NA/NA 0.0 0.0 0.0 0.00 0.00

Utility (EQ) 7.77 BAA1/BAA2 42.1 64.4 -22.2 1.22 4.65Electric (EQ) 6.40 BAA1/BAA2 42.1 69.3 -27.2 1.45 4.66Natural Gas (EQ) 1.37 A3/BAA1 42.3 41.2 1.0 0.03 4.61Utility Other (EQ) 0.00 NA/NA 0.0 0.0 0.0 0.08 0.00

Finance Institutions (EQ) 29.53 AA3/A1 24.9 35.5 -10.6 0.58 4.66Banking (EQ) 9.78 A1/A2 19.2 28.8 -9.7 0.52 4.67Brokerage (EQ) 6.63 A1/A2 29.0 34.9 -5.9 0.36 4.64Financial Cos. (EQ) 8.81 AA3/A1 25.8 40.7 -14.9 0.80 4.67Insurance (EQ) 2.83 AA3/A1 28.6 41.6 -13.0 0.68 4.66Reits (EQ) 1.02 BAA1/BAA2 38.6 49.1 -10.6 0.56 4.63Financial Other (EQ) n/a n/a n/a n/a n/a n/a n/a

*Market Weight for statistics universe as of 12/31/2003.

APPENDIX B. SUMMARY OF LEHMAN BROTHERS CDS INDEX PERFORMANCE

January 21, 2004 54


APPENDIX C. GLOBAL CDO ISSUANCE STATISTICS

Global Arbitrage CDO Issuance by Month$ bn

Historical Global CDO Issuance By Deal Type and Collateral Type, $ Billion

Arbitrage DealType 1995 1996 1997 1998 1999 2000 2001 2002 2003Cash Flow Struct Fin - - 0.1 0.4 5.5 10.6 15.8 23.0 36.4

EM 0.4 1.1 4.5 3.3 1.9 0.6 1.0 0.8 -HY Bonds 0.5 3.3 9.4 12.6 22.4 16.8 15.7 1.2 1.1IG Bonds 0.1 - - 1.2 1.4 6.0 7.2 4.7 0.9Lev. Loans 0.2 2.5 5.9 15.1 23.3 19.6 18.4 21.4 23.8Other - - - - 0.8 0.5 3.1 6.5 7.9Unknown - 2.3 0.4 1.6 2.5 - - 0.4 -

Market Value Struct Fin - - 1.0 5.2 2.8 2.6 0.9 - -EM - - 0.8 1.0 - - - - -HY Bonds - 1.8 2.3 2.0 4.0 6.7 2.1 0.8 -IG Bonds - - - - - - - - -Lev. Loans - 0.8 0.6 8.1 1.4 1.4 - - -Other - - - - 0.7 0.2 0.3 0.4 2.2

Synthetic Struct Fin - - - - - 1.0 1.1 1.5 7.9EM - - - - - 0.1 - - 0.1HY - - - - - - - 0.0 0.0IG - - - - - 2.4 8.0 16.1 32.3Other - - - - - 0.1 0.1 0.1 0.3Unknown - - - - - - - 0.4 -

Cash Flow Total 1.2 9.2 20.3 34.2 57.7 54.1 61.3 58.0 70.1Market Value Total - 2.6 4.7 16.3 8.9 11.0 3.3 1.3 2.2Synthetic Total - - - - - 3.5 9.1 18.1 40.6All Arbitrage Total 1.2 11.8 25.1 50.5 66.7 68.5 73.7 77.4 113.0

Balance Sheet DealType 1995 1996 1997 1998 1999 2000 2001 2002 2003Cash Flow Total 1.0 7.0 26.3 33.0 28.2 19.4 13.6 15.6 19.5Synthetic Total - - 3.3 5.6 5.8 11.2 12.9 12.8 10.7All Bal Sheet Total 1.0 7.0 29.6 38.6 34.0 30.6 26.5 28.3 30.2

-All CDOs Total 2.2 18.7 54.7 89.1 100.6 99.1 100.2 105.7 143.2

*Synthetics include only funded portions. **Please note that historical issuance data may have been updated due to additional data.

1999-2003 YTD Global Arbitrage CDO Issuance

Global Synthetic* CDO Issuance# of transactions

Global CDO Issuance versus ABS and CMBS Issuance, 2003

$ bn

*Funded tranches only. ** Increases in 2003 numbers are partly due to an increasedamount of data available on Tailored Tranche CDOs.

0

2

4

6

8

10

12

14

12/01 3/02 6/02 9/02 12/02 3/03 6/03 9/03 12/03

0

15

30

45

60

75

1/01 6/01 11/01 4/02 9/02 2/03 7/03 12/03

Syndicated

Tailored Tranche

1%

2%9%

10%3%

8%

27%

26%

22%

1% 1%3%

40%34%

25%

3% 1%7%

1%

10%

2%

36%30%

3%10%

18%27%

20% 23%37%

11%

39%

1999 2000 2001 2002 2003

Struct. Fin.IG SynLev LoanOtherIG CashHY BondEM

79.8

103.8

63.8

174.6

105.9

30.7

0

40

80

120

160

200

HEL Credit Cards CMBS Auto ArbitrageCDO

BalanceSheet CLO

Market Value

Synthetic

Cash Flow

January 21, 2004 55


APPENDIX D. CDO SPREAD STATISTICS

Aaa CDOs vs. Other Structured Finance

bp

A CDOs vs. Other Structured Finance and Corporates

bp

Baa CDOs vs. Other Structured Finance and Corporates

bp

Ba CDOs vs. CMBS and Corporates

bp

CDO Spreads* Over LIBOR For Aa-Rated Classes and Higher

bp

CDO Spreads* Over LIBOR for A Rated Classes and Lower

bp

CMBS spreads are fixed rate collateral to swaps, all other spreads are to LIBOR.All CMBS, Corporate, and A and Baa Credit Card spreads are 10 year spreads. Aaa Credit Cards are 7 year, Aaa HEL are 3 year, and A and Baa HEL are 5 year.

*Spreads on CDO tranches are calculated by taking a weighted average of all new transactions issued during each month. The weighted average is calculated acrosscollateral types (high yield, investment grade, emerging market, ABS).

121

57

0

40

80

120

160

1/98 7/98 1/99 7/99 1/00 7/00 1/01 7/01 1/02 6/02 12/02 6/03 12/03

Aa

Aaa

57

3029

17

0

20

40

60

80

1/01 6/01 10/01 3/02 7/02 11/02 4/03 8/03 12/03

CDOsCMBSHELCredit Cards

175

135

534445

0

40

80

120

160

200

240

1/01 6/01 10/01 3/02 7/02 11/02 4/03 8/03 12/03

CDOsHELCredit CardsCMBSCorp

225

308

100

8390

0

100

200

300

400

1/01 6/01 10/01 3/02 7/02 11/02 4/03 8/03 12/03

CDOsHELCredit CardsCMBSCorp

798

308

175

0

150

300

450

600

750

900

1/98 7/98 1/99 7/99 1/00 7/00 1/01 7/01 1/02 6/02 12/02 6/03 12/03

BaBaaA

798

425

187

0

150

300

450

600

750

900

1/01 6/01 10/01 3/02 7/02 11/02 4/03 8/03 12/03

CDOsCMBSCorp

January 21, 2004 56


Historic New Issuance CDO Spreads by Collateral Type

Aaa CDO Spreads to LIBORQ4 02 Q1 03 Q2 03 Q3 03 Q4 03

LL CDO 53 56 55 56 55HY CDO 60 - 65 - 50**IG Cash CDO 58 - 55 - -IG Syn CDO 68 75 74 96* 61CF SF CDO 53 65 64 57 59

Baa CDO Spreads to LIBORLL CDO 291 308 322 310 302HY CDO 375 - 400 - -IG Cash CDO 400 - - - -IG Syn CDO 312 367 276* - 392CF SF CDO 287 359 347 336 330*Average based on 2 data points. **Value based on 1 data point.

APPENDIX D. CDO SPREAD STATISTICS (continued)

Indicative CDO Spreads by Collateral Type, December 31, 2003

New Issue CDO Spreads to LIBORLev. Loans SF CDOs

Aaa 52 62Aa 95 130A 160 170Baa 300 330Ba 800 825

Secondary vs. Primary Aaa CDO Spreads and the HY Index

CDO Spreads (bp) LB HY Index OAS (bp)

All Arbitrage CDO Downgrades per Month1998 - 2003

bp

Includes all Rating AgenciesIncludes all Arbitrage CDOs (Cash Flow, Market Value, and Synthetic)Source: Moody’s Investor Service, Standard & Poor’s, and Fitch Ratings

Arbitrage CDO Downgrades by Asset Class1995 - 2003

# of Transactions

*Includes only Cash Flow Arbitrage CDOs, except for IG Synthetic. IG Synthetic CDOsinclude only publicly rated transactions.Source: Moody’s Investors Service, Standard & Poor’s, Fitch Ratings, and LehmanBrothers calculations.

* Based on an average of trades done on senior tranches during the month byLehman Brothers.

40

55

70

85

100

115

1/03 2/03 3/03 4/03 5/03 6/03 7/03 8/03 9/03 10/03 11/03 12/03

300

400

500

600

700

800PrimarySecondary*HY OAS

0

15

30

45

60

75

1/98 10/98 7/99 4/00 1/01 10/01 7/02 4/03

0

12

24

36

48

60

Total # of DGs per Month# of First Time DGs per MonthRolling 3 Month Average (# of Total DGs)Rolling 3 Month Average (# of First Time DGs)

12/03

0

50

100

150

200

250

300

HY Bond IG Synthetic Lev Loan Struct Fin IG Cash EM

Performing

Downgraded

January 21, 2004 57


APPENDIX E. CREDIT QUALITY INDICATORS

List of Corporate Defaults for Issuers in Moody’s Rated Universe, 2003

Defaulted Debt Rating Moody’sFirst Rated 1 Year Prior Broad Moody’s Specific Default

($U.S. mn) (Date/Rating) to Default Industry Industry Classification Domicile DateJANUARYCybernet Internet Services International Inc. 150 10/29/1999 Caa2/Ca Industrial Software Germany Jan 02Cenargo International Plc 175 6/10/1998 B1/B1 Transportation Ocean Shipping United Kingdom Jan 15Corporacion Durango, S.A. de C.V. 435 7/13/1994 B1/B2 Industrial Forest Products/Paper Mexico Jan 15XM Satellite Radio Inc. 938 9/11/2000 Caa2/Caa2 Industrial Media United States Jan 28Vantico Group S.A. 235 7/17/2000 B3/Caa1 Industrial Chemicals Luxembourg Jan 29Sun World International, Inc. 115 4/3/1997 B3/B3 Industrial Agriculture United States Jan 30

FEBRUARYASARCO Incorporated 650 9/16/1963 Aa/Ca Industrial Metals/Mining United States Feb 01Maxxim Medical Group, Inc. 435 11/2/1999 B2/B2 Industrial Healthcare Services/Equip. United States Feb 11British Energy plc 629 9/16/1996 A2/A3 Public Utility Electric Generation Co. United Kingdom Feb 14Brown Jordan International, Inc. 330 8/2/1999 Ba3/Ba3 Industrial Furniture/Fixtures United States Feb 18NTELOS Inc. 605 7/12/2000 B3/B3 Industrial Telecommunications United States Feb 18iPCS, Inc. 300 7/13/2000 Caa1/Caa1 Industrial Telecommunications United States Feb 24UbiquiTel Operating Co. 640 3/28/2000 B3/B3 Industrial Telecommunications United States Feb 24American Lawyer Media Holdings, Inc. 63 12/17/1997 B3/Caa3 Industrial Printing/Publishing United States Feb 27AES Drax Energy Limited 405 4/20/2001 Ba3/B2 Public Utility Electric United Kingdom Feb 28DDi Corp. 200 2/14/2001 B1/B1 Industrial Electronics United States Feb 28

MARCHCable Satisfaction International, Inc. 150 2/25/2000 Caa1/Caa2 Industrial Cable T.V. Portugal Mar 03Magellan Health Services, Inc. 2,160 6/14/1979 B/B2 Industrial Hospitals/Nursing United States Mar 11Precision Partners, Inc. 100 3/8/1999 B1/Caa3 Industrial Metals/Mining United States Mar 15Transportadora de Gas del Sur S.A. 300 10/11/1995 B1/Ca Industrial Gas Transmission Argentina Mar 18Lumbermens Mutual Casualty Company 700 6/28/1996 A3/Baa1 Insurance Insurance: Property & Casualty United States Mar 25Atlas Air, Inc. 1,915 8/6/1997 B3/B1 Transportation Air Freight United States Mar 28HealthSouth Corporation 5,193 5/12/1989 Ba1/Ba1 Industrial Hospitals/Nursing United States Mar 28HomeGold Financial Inc. 125 8/29/1997 B3/Caa2 Other Non-Bank Mortgage Finance United States Mar 31

APRILAir Canada 1,251 9/14/1993 B1/B3 Transportation Airlines Canada Apr 01Fleming Companies, Inc. 3,693 4/11/1983 Baa1/Ba3 Industrial Wholesale-Food United States Apr 01Eagle Food Centers, Inc. 85 4/12/1993 Ba3/B2 Industrial Retail-Grocery Chain United States Apr 07J. Crew Group, Inc. 142 9/29/1997 Caa2/Caa3 Industrial Apparel United States Apr 09General Chemical Industrial Products Inc. 100 4/12/1999 B1/Caa1 Industrial Chemicals United States Apr 15Jackson Products, Inc. 115 4/14/1998 B1/Caa2 Industrial Hardware/Tools United States Apr 15Leap Wireless International, Inc. 893 2/14/2000 Caa2/Caa2 Industrial Telecommunications United States Apr 19MTS, Inc. 110 4/15/1998 Ba3/Caa3 Industrial Retail-Department Stores United States Apr 29

MAYNeenah Corporation 150 4/14/1997 B1/Caa1 Industrial Automotives United States May 01Neenah Foundry Company 465 11/20/1998 B1/Caa2 Industrial Steel United States May 01Millicom International Cellular S.A. 2,074 5/20/1996 B1/B2 Industrial Cellular Telephone Luxembourg May 08Allegiance Telecom, Inc. 650 10/26/1999 B3/Caa2 Industrial Telecommunications United States May 15Grupo TMM, S.A. 400 4/23/1993 Ba2/B2 Transportation Ocean Shipping Mexico May 15Mississippi Chemical Corporation 200 11/7/1997 Ba1/B3 Industrial Chemicals United States May 15Uruguay, Oriental Republic of 8,199 10/15/1993 Ba1/Ba2 Sovereign Sovereign Uruguay May 15WCI Steel, Inc. 400 12/29/1992 B1/Caa3 Industrial Steel United States May 23National Equipment Services, Inc. 925 11/18/1997 B1/B3 Industrial Leasing United States May 28Penn Traffic Company 1,000 4/14/1987 B1/B3 Industrial Retail-Grocery Chain United States May 30

JUNEGrupo Iusacell, S.A. De C.V. 350 10/4/1999 B1/B1 Industrial Telecommunications Mexico Jun 01WestPoint Stevens Inc. 1,550 11/17/1993 B1/Ca Industrial Textiles United States Jun 02IWO Holdings, Inc. 160 1/23/2001 Caa1/Caa1 Industrial Telecommunications United States Jun 04J.B. Poindexter & Co., Inc. 100 4/13/1994 B2/B3 Industrial Diversified United States Jun 12New World Restaurant Group, Inc. 295 6/15/2001 Caa1/Caa1 Industrial Restaurants/Fast Food United States Jun 15

JULYAurora Foods Inc. 1,175 1/24/1997 B1/Caa1 Industrial Food/Soft Drinks United States Jul 01Texas Petrochemicals Limited Partnership 225 6/17/1996 B1/B3 Industrial Chemicals United States Jul 01Newmont Yandal Operations Limited 300 3/24/1998 Ba2/Ba2 Industrial Metals/Mining Australia Jul 04@Entertainment, Inc. 545 6/25/1998 B3/Caa3 Industrial Broadcasting United States Jul 07Azteca Holdings, S.A. de C.V. 405 6/11/1997 B3/Caa1 Industrial Cable T.V. Mexico Jul 14American Cellular Corporation 1,232 5/4/1998 Caa1/Caa2 Industrial Telecommunications United States Jul 15

January 21, 2004 58


JULY (continued)Loral Cyberstar, Inc. 1,542 1/23/1997 B2/C Industrial Telecommunications Equipment United States Jul 15Loral Space & Communications Ltd. 1,139 1/14/1999 B1/Ca Industrial Aircraft/Aerospace United States Jul 15Mirant Americas Generation, LLC. 2,800 4/16/2001 Baa3/Ba1 Public Utility Electric Holding Co. United States Jul 15Mirant Corporation 2,570 7/12/1999 Baa2/Ba1 Public Utility Diversified Energy Holding Co. United States Jul 15International Utility Structures Inc. 95 1/26/1998 B2/WR Industrial Steel Canada Jul 31

AUGUSTCANTV Finance Ltd. 100 1/22/1997 Ba2/B2 Industrial Telecommunications Venezuela Aug 01DVI, Inc. 155 1/10/1997 B1/B1 Finance Finance-Non Captive United States Aug 01GEO Specialty Chemicals, Inc. 120 7/15/1998 B1/B1 Industrial Chemicals United States Aug 01Hollywood Casino Shreveport 189 7/29/1999 Caa1/Caa1 Industrial Casinos United States Aug 01Oglebay Norton Company 450 1/13/1999 B1/B3 Industrial Metals/Mining United States Aug 01Radio Unica Corp. 158 3/1/1999 Caa1/Caa3 Industrial Broadcasting United States Aug 01Satelites Mexicanos, S.A. de C.V. 645 1/22/1998 B3/B3 Industrial Media Mexico Aug 01High Voltage Engineering Corporation 135 10/23/1979 Ba/Caa2 Industrial Miscellaneous United States Aug 15Horizon PCS, Inc. 470 9/18/2000 Caa1/Caa1 Industrial Telecommunications United States Aug 15

SEPTEMBERTricom, S.A. 200 10/25/1999 B3/Caa1 Industrial Cellular Telephone Dominican RepublicSep 02Twin Laboratories Inc. 100 5/1/1996 B1/Caa1 Industrial Research/Development Labs United States Sep 06Cone Mills Corporation 100 3/9/1995 Baa2/Caa1 Industrial Textiles United States Sep 15Northwestern Corporation 995 9/6/1957 Ba/Baa2 Public Utility Utility/Diversified Holding Co. United States Sep 15

OCTOBERAmerican Plumbing & Mechanical, Inc. 125 4/30/1999 B1/B1 Industrial Construction United States Oct 04Piccadilly Cafeterias, Inc. 75 11/15/2000 B3/Caa2 Industrial Food/Soft Drinks United States Oct 29

NOVEMBERAlamosa (Delaware), Inc. 1,234 2/2/2000 Caa1/Caa3 Industrial Telecommunications United States Nov 11

DECEMBERInternational Wire Group, Inc. 392 6/1/1995 B1/B3 Industrial Mechanical Components United States Dec 01Iron Age Corporation 100 4/16/1998 B1/B2 Industrial Shoe Manufacturer United States Dec 04Iron Age Holdings Corporation 45 4/16/1998 Caa1/Caa3 Industrial Shoe Manufacturer United States Dec 04Metallurg Holdings, Inc. 121 7/14/1998 Caa1/Ca Industrial Steel United States Dec 12Airtrain Citylink Limited - 12/13/2000 Ba1/B3 Transportation Transit Australia Dec 15Tiete Certificates Grantor Trust - 4/11/2001 Ba1/B3 Finance Finance-Non Captive Brazil Dec 15Solutia Inc. 1,050 8/28/1997 Baa2/B2 Industrial Chemicals United States Dec 17Congoleum Corporation 100 1/19/1994 B1/Ca Industrial Building Materials United States Dec 31

*Universe is restricted to Moody’s rated corporate universe.

APPENDIX E. CREDIT QUALITY INDICATORS

List of Corporate Defaults for Issuers in Moody’s Rated Universe, 2003

Defaulted Debt Rating Moody’sFirst Rated 1 Year Prior Broad Moody’s Specific Default

($U.S. mn) (Date/Rating) to Default Industry Industry Classification Domicile Date

January 21, 2004 59


APPENDIX E. CREDIT QUALITY INDICATORS (continued)

U.S. High Yield Trailing 12 Month Default Rates by RatingCategory and Collateral Type

U.S. Investment Grade Trailing 12-Month Default Rate

Moody's Investment Grade and High Yield Downgrade toUpgrade Ratios

Comparison of Consumer Credit, CMBS, and CorporateCredit Quality

Sources: Moody's Investor Service and Lehman Brothers Calculations. Sources: Moody's Investor Service and Lehman Brothers Calculations.

Source: Moody’s Investors Service. *The corporate default rate includes both US IG and HY credit.Source: Moody’s Investor Service and Lehman Brothers calculations.

Default Rates for Baa Rated Corporates Default Rates for B Rated Corporates

Market implied default rates are 1-year implied default probabilities using the Lehman Brothers Implied Transition Matrix Model; The KMV EDF Credit Measure is based on theaverage statistic for the Lehman Brothers Credit Indices; The Baa and B KMV EDF measure was calculated on a subset of 75% and 50% of each respective Index.Historicaldefault rates are Lehman Brothers calculations using Moody’s Investors Service data.

14.6%

4.9%

2.2%1.3%

0%

5%

10%

15%

20%

25%

8/95 9/97 10/99 11/01 12/03

Caa-CHYBBa

6.5%

2.2%2.1%

0%

2%

4%

6%

8%

10%

12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02 12/03

3-Month CC Charge-Offs60+ Day CMBS Delinquencies + Cumulative LiquidationsCorp Default Rate

0.0%0.00%

0.25%

0.50%

0.75%

1.00%

1.25%

1/90 1/92 1/94 1/96 1/98 12/99 12/01 12/03

Baa

Investment Grade

0%

1%

2%

3%

4%

7/96 1/98 7/99 1/01 6/02 12/03

Market ImpliedKMV’s EDF Credit MeasureHistorical

0%

10%

20%

30%

40%

7/96 1/98 7/99 1/01 6/02 12/03

Market ImpliedKMV’s EDF Credit MeasureHistorical

0

2

4

6

8

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Investment Grade

High Yield

January 21, 2004 60


APPENDIX G. U.S. EQUITY SECTOR CORRELATIONS, %

Energy Mater Indus ConsDiscr ConsStap Health Finan InfoTec Telecom UtilEnergy 35.9 21.1 17.8 16.3 14.6 6.9 14.6 14.6 6.6 14.0Materials 21.1 25.1 19.6 18.6 14.7 7.5 14.7 17.3 9.2 9.9Industrials 17.8 19.6 18.7 17.0 14.5 7.5 14.7 16.6 10.1 11.7Consumer Discretionary 16.3 18.6 17.0 17.8 13.6 7.3 13.4 17.5 11.4 10.5Consumer Staples 14.6 14.7 14.5 13.6 18.0 7.8 12.8 9.8 9.8 14.3Health Care 6.9 7.5 7.5 7.3 7.8 5.2 6.5 7.8 5.9 6.7Financials 14.6 14.7 14.7 13.4 12.8 6.5 14.6 12.7 8.7 11.4Infomation Technology 14.6 17.3 16.6 17.5 9.8 7.8 12.7 29.4 14.8 6.4Telecommunication Services 6.6 9.2 10.1 11.4 9.8 5.9 8.7 14.8 16.1 7.7Utilities 14.0 9.9 11.7 10.5 14.3 6.7 11.4 6.4 7.7 18.7

*Estimates a matrix of generic equity correlations as a function of country and industry using the US component of the MSCI G7 IndexPlease refer to the Quant Toolkit for the default correlation calculator, which enables you to translate the equity correlations into default correlations.

APPENDIX F. TOP 20 TIGHTEST LINKED CDS AND EQUITY IN 2003*

Equity Equity Price CDSPrice CDS Goodness Change Change

Moody’s 12/31/03 12/31/03 of Fit** Y-o-Y Y-o-YName Ticker Rating Industry ($) (bp) (%) (%) (bp)

1 Cendant Corp CD Baa1 Diversified/Conglomerate Service 22.27 50.0 96 113 -225.02 Simon Property Group LP SPG Baa2 Buildings and Real Estate 46.34 38.5 94 36 -76.53 Sears Roebuck Acceptance Corp S Baa1 Finance 45.49 37.5 94 90 -317.54 McDonald’s Corp MCD A2 Personal, Food and Miscellaneous Services 24.83 22.0 93 54 -33.05 CIT Group Inc. CIT A2 Banking 35.95 42.0 93 83 -143.06 Park Place Entertainment Corp PPE Ba1 Leisure, Amusement, Entertainment 10.83 175.0 93 29 -125.07 Marriott International MAR Baa2 Hotels, Motels, Inns and Gaming 46.20 46.5 93 41 -58.58 Humana Inc HUM Baa3 Insurance 22.85 40.0 91 129 -120.09 Dow Chemical Co DOW A3 Chemicals, Plastics and Rubber 41.57 43.5 91 40 -99.5

10 Ford Motor Credit F A3 Automobile 16.00 165.0 90 72 -267.511 Georgia Pacific GP Ba3 Diversified Natural Resources 30.67 252.5 89 90 -307.512 American Express Co AXP A1 Banking 48.23 20.0 88 36 -39.013 Morgan Stanley Dean Witter & Co MWD Aa3 Finance 57.87 29.0 88 45 -33.514 Federated Department Stores FD Baa1 Retail Stores 47.13 44.5 88 64 -50.515 Cap One Bank COF Baa2 Banking 61.29 65.5 88 106 -389.516 Hartford Financial Services HIG A3 Insurance 59.03 25.5 87 30 -47.517 Tyco TYC Ba2 Diversified/Conglomerate Manufacturing 26.50 100.0 87 55 -425.018 Computer Associates CA Baa3 Electronics 27.34 75.0 87 103 -362.519 Goodrich GR Baa3 Aerospace and Defense 29.69 52.5 87 62 -207.520 Deere & Co DE A3 Farming and Agriculture 65.05 20.5 87 42 -31.5

*The above names were sorted from a sample of 190 mostly investment-grade names that traded actively at the Lehman Brothers CDS desk in 2003.**The goodness of fit measures the quality of an exponential fit between CDS spreads and equity prices.

January 21, 2004 61


APPENDIX H. QUANTITATIVE CREDIT TOOLKIT VIA LEHMANLIVE

Credit investors can benefit from active use of quantitative tools innavigating the increasingly more complex credit universe. Funda-mental analysis is still the core of credit investing, but quantitativeanalysis can add significant breadth, consistency, and timeliness.The growth of credit derivatives, portfolio credit products, CDOs,secondary trading in bank loans, and other products leads to newrelative value opportunities due to market segmentation and dis-locations. Quantitatively oriented investors can take advantage ofthese opportunities to generate consistent excess returns.

Lehman Brothers continues to develop unique quantitative modelsdesigned to complement the fundamental frameworks employedby portfolio managers, traders, analysts, and structurers. Thesequantitative models add to the suite of portfolio models alreadydelivered in POINT. A collection of new quantitative tools is nowavailable in a Quantitative Credit Toolkit on LehmanLive. Thetools are organized in four functional groups designed to answercommon sets of questions.

Importantly, these tools are integrated with each other in termsof the underlying data and methodologies. This allows users tocombine them in numerous ways to solve a variety of problems.

The table below shows some of the typical uses of the QuantitativeCredit Toolkit by investor type.

Spread Tools Security Valuation Tools Credit Analysis Tools Correlation Tools

Ass

et

Man

ager

s Bond pricing and risk analysis with Bond Calculator

Use Implied Default Probability Tool to find relative value across sectors

Use Equity Correlation model for global portfolio analysis

Insu

rers

Issuer selection with OneScore or ESPRI Sector and security selection with Spread Tools Trade analysis with Time Series Plotter

Use Implied Transition Matrix for downgrade risk management

Ban

ks

Assess spread blowup risk with ESPRI Global loan book analysis with CurveLab

Scenario analysis for CDO Tranches using the CDO Calculator Access Lehman CDO Research and Surveillance Reports

Use the suite of transition matrix models for loan and revolver risk management

Analyze the importance of extreme joint events in credit with Equity and Default Correlation Tools

Hed

ge F

unds

Trade analysis with Time Series Plotter Identify value relative to the curve with Issuer Spread Tool Identify candidates for shorting using ESPRI Tool

Emerging market bond options valuation Distressed CDO Tranche relative value analysis with CDO Calculator and Monte Carlo model

Use the Mark-to-Market Matrix and the Potential Exposure Profile models to estimate the risks of arbitrage trades

Use Equity Correlation model as input for Debt-Equity relative value trading Use Default Correlation Tool for basket hedging

January 21, 2004 62


BIBLIOGRAPHY

Quantitative Credit Research Quarterly, 2003

Q4 - November 2003Forward CDS Spreads Berd AHedging Debt with Equity Naik V, Trinh M, Balakrishnan S and Sen SPricing Multi-Name Default Swaps with Counterparty Risk Mashal R and Naldi MThe New Lehman Brothers High Yield Risk Model Chang GUnderstanding Deltas of Synthetic CDO Tranches Schloegl L and Greenberg AValuation of Portfolio Credit Default Swaptions Pedersen C

Q3 - August 2003Estimating Implied Default Probabilities from Credit Bond Prices Berd A, Mashal R and Wang PLehman Brothers OneScore:Combining Fundamental and Quantitative Credit Views Pomper M, Trinh M, Epps M and Balakrishnan SLeveraging the Spread Premium with Correlation Products O’Kane D, Schloegl L and Greenberg AUp-front Credit Default Swaps O’Kane D and Sen S

Q1/2 - May 2003Buy-and-Hold Credit Portfolios and CDOs Dynkin L, Ganapati S and Hyman JLeverage and Correlation Risk of Synthetic Loss Tranches Mashal R, Naldi M and Pedersen CSystematic Variations in Corporate Bond Excess Returns Naik V, Trinh M and Rennison GThe Restructuring Clause in Credit Default Swap Contracts O’Kane D, Pedersen C and Turnbull SValuation of Credit Default Swaps O’Kane D and Turnbull S

Trading Correlation – Relative Value Across CDO TranchesLehman Brothers, NovemberIsla L, Greenberg A, Schoegh L, 2003

Hedged CDO Equity StrategiesFixed Income Research, Lehman Brothers, SeptemberIsla L, 2003

State of the Secondary CDO MarketLehman Brothers, SeptemberGanapati S, Laberge C and Tejwani G, 2003

Simulating Portable Credit Strategies with CDS and Mirror SwapsIndicesGlobal Relative Value Weekly, Lehman Brothers, OctoberBerd A and Ha P, 2003

The Lehman Brothers Credit Default Swap IndexLehman Brothers, OctoberBerd A, Desclée A, Golbin A, Munves D and O’Kane D, 2003

The Co-Movement of Interest Rates and Spreads: Implications for Credit InvestorsLehman Brothers, JuneBerd A and Ranguelova E, 2003

Digital PremiumJournal of Derivatives, Volume 10, Number 3, SpringBerd A and Kapoor V, 2003

The Synthetic CDO Bid and Basis Convergence – Which Sector isNext?Structured Credit Strategies, Lehman Brothers, MarchGanapati S, Berd A, Ha P and Ranguelova E, 2003

Extreme Events and Multi-Name Credit DerivativesIn Credit Derivatives The Definitive Guide, Risk, LondonMashal R, Naldi M and Zeevi A, 2003

Measuring Portfolio Credit Risk with Default Experience Statistic (DES)Credit Ratings: Methodologies, Rationale and Default Risk, RiskBooksBerd A, 2002

The Dependence Structure of Asset ReturnsQuantitative Credit Research Quarterly, Lehman Brothers, DecemberMashal R, Naldi M and Zeevi A, 2002

Evolution of Synthetic Arbitrage CDOsStructured Credit Strategies, Lehman Brothers, NovemberGanapati S and Ha P, 2002

Beyond CADR: Searching for Value in the CDO MarketQuantitative Credit Research Quarterly, Lehman Brothers,SeptemberMashal R and Naldi M, 2002

CDO Equity in a Portfolio ContextQuantitative Credit Research Quarterly, Lehman Brothers,SeptemberGanapati S and Tejwani G, 2002

The Case for Structured Finance CDOsLehman Brothers, JulyGanapati S and Tejwani G, 2002

Extreme Events and Default BasketsRisk June, pages 119–122, JuneMashal R and Naldi M, 2002a

Managing Risk Exposures in CDO TranchesQuantitative Credit Research Quarterly, Lehman Brothers, MayBerd A and Tejwani G, 2002

Spread Premium for Portfolio TranchesQuantitative Credit Research Quarterly, Lehman Brothers, JanuaryO’Kane D and Schloegl L, 2002

Synthetic CDOs – How are They Structured? How do They Work?CDO Monthly Update, Lehman Brothers, NovemberGanapati S, Ha P and O’Kane D, 2001

Leveraging Spread Premia with Default BasketsQuantitative Credit Research Quarterly, Lehman Brothers, OctoberO’Kane D and Schloegl L, 2001

State of the CDO Market: Addressing Recent HeadlinesLehman Brothers, AugustGanapati S and Ha P, 2001

CDOs: Market, Structure, and ValueLehman Brothers, JuneGanapati S and Reyfman A, 1998

A Guide to First-to-Default BasketsQuantitative Credit Research Quarterly, Lehman Brothers,FebruaryReyfman A and Chang J, 2000

Modeling Credit: Theory and PracticeLehman Brothers, FebruaryO’Kane D and Schloegl L, 2001

Lehman Brothers Fixed Income Research analysts produce proprietary research in conjunction with firm trading desks that trade asprincipal in the instruments mentioned herein, and hence their research is not independent of the proprietary interests of the firm. Thefirm’s interests may conflict with the interests of an investor in those instruments.

Lehman Brothers Fixed Income Research analysts receive compensation based in part on the firm’s trading and capital marketsrevenues. Lehman Brothers and any affiliate may have a position in the instruments or the company discussed in this report.

The views expressed in this report accurately reflect the personal views of Sunita Ganapati, Arthur Berd, Philip Ha, Lorenzo Isla, ClaudeLaberge, Elena Ranguelova, Ashish Shah, and Guarav Tejwani, the primary analysts responsible for this report, about the subjectsecurities or issuers referred to herein, and no part of such analyst’s compensation was, is or will be directly or indirectly related to thespecific recommendations or views expressed herein.

The research analysts responsible for preparing this report receive compensation based upon various factors, including, among otherthings, the quality of their work, firm revenues, including trading and capital markets revenues, competitive factors and client feedback.

Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copiesof these reports and their certifications, please contact Larry Pindyck ([email protected]; 212-526-6268) or Valerie Monchi([email protected]; 44-(0)207-011-8035).

Lehman Brothers usually makes a market in the securities mentioned in this report. These companies are current investment banking clients of LehmanBrothers or companies for which Lehman Brothers would like to perform investment banking services.

Publications—L. Pindyck, B. Davenport, W. Lee, D. Kramer, R. Madison, A. Acevedo, T.Wan, V. Monchi, C. Rial, K. Banham, G. Garnham

This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approvedby Lehman Brothers International (Europe), regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area.This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed inAustralia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material is distributed in Korea byLehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell oras a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner withoutthe written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and itshould not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed hereinreflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale insome states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consulthis Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested.Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of futureresults. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, performinvestment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. © 2004 LehmanBrothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers’ entity in your home jurisdiction.

Documents

[Lehman Brothers] Structured Credit Strategy - Annual 2004