LCDX Index and Tranches

Transcription

1 IACPM Spring General Meeting 2007 LCDX Index and Tranches Gaurav Tejwani Structured Credit /CDO Strategies June 2007 Please see analyst certifications and important disclosures at the end of this report

2 Agenda I. LCDX Index II. LCDX Tranches III. LCDX Analytics on LehmanLive

3 LCDX Index

4 LCDX Basics What is the LCDX Index? The LCDX Index is a portfolio CDS product composed of 100 Loan Only CDS referencing Syndicated Secured 1st Lien Loans Traded on price terms with fixed spread, like HY CDX Fixed Coupon set at 120bps Initial maturity set to June 20, 2012 (5 Years) Each of the 100 LCDS will initially be weighted equally at 1% Subject to Net Physical Settlement in the event of default Will trade on a factor if a credit is removed Roll dates April 3rd and October 3rd All names in the LCDX must be on the Syndicated Secured List published by Markit Group and be 1st Lien in priority (see Markit Website) Net Physical Settlement is the a similar auction process to that used in the unsecured CDS market Single Name LCDS LCDX Name 1 Name 2 Name 3 Name 98 Name 99 Name 100 LCDX Index Buyer (Protection Seller) Long Risk LCDX Premium Upfront Payment (Price Par) LCDX Index Seller (Protection Buyer) Short Risk Contingent Credit Protection Payments on Portfolio 1

5 Trade Conventions of LCDX (Example Only) LCDX Buyer, Protection Seller, (Long Credit) LCDX Premium (Coupon Set) Up front (Price Par) Losses from Default LCDX Seller, Protection Buyer, (Short Credit) Client buys the LCDX (sells protection) at Pays 0.5 points upfront Pays the accrued coupon from last coupon date Receives 120bps running (set coupon) Is long risk (long the credit) Is short risk (short the credit) Despite issues with respect to duration and calculating the intrinsic value of the index, trades should be seamless because they are based on price Client sells the LCDX (buys protection) at Receives 0.25 points upfront Receives the accrued coupon from the last coupon date Pays 120bps running (set coupon) Note: The example is being provided for illustrative purposes only. 2

6 LCDS Cancelability and Maturity Adjustments Maturity Adjustments Help to Account for Prepayments when Calculating Intrinsic Value Due to the cancelability of LCDS, names can be removed from the index when there is no longer secured debt of that priority lien This is often a result of a company being upgraded to investment grade (or being acquired by an investment grade company) FCX: Company took on added leverage for acquisition of Phelps Dodge and has already completed a $5.76 billion equity offering to pay down debt SVU: Management has expressed desire for investment grade status and credit agreement contains language that releases security on the loans if the company becomes IG If maturity adjustments are made for credits trading at lower spreads (since they are most likely to refinance with unsecured debt) the duration will decrease accordingly and wider spread names will have a larger weighting Impact of Spread-Based Maturity Adjustments on Intrinsic Value (1) No Adjustments (5-Year maturity for each name) Reduced Maturity to 3-Year <60bp Reduced Maturity to 3-Year <80bp 1. Source: Lehman Brothers. PV Intrinsic Mid 109bp 110bp 115bp 3

7 LCDX Convexity LCDS Cancelability also Affects Index Convexity In addition to discrepancies surrounding duration, the LCDX has a different convexity profile than other CDX indices Most bullet instruments have positive convexity for investors that go long, but this is not necessarily the case with LCDX When a name is removed due to a lack of sr. secured debt, it will generally be a higher quality name, causing the index price to decrease upon removal (unless it is fully priced in). This causes LCDX to have a poor convexity profile Additionally, the long investor will begin to receive coupons on a lower notional Initial Trade Go Long LCDX Index Price Trade Size Upfront Payment Unwind after 1 Name Drops Out Index Price Trade Size Payment Received Loss 1. Total exposure $9.9mn. $101 $10mn ($100,000) $101 $10mn (1) $99,000 ($1,000) 4

8 Intrinsic Value Will Be Dependent on the Exit Rate Assumption Name Exit Rate Analysis A study by Reuters (2) suggests that 38% of issuers exit the senior syndicated secured market within 5-yrs Our analysis of CLOs found that only 6% of loans had exited the market during the first 4 years of the portfolio (~2% annual exit rate) (3) We think the CLO universe is more representative of the names that can be in LCDX, as a CLO is typically underweight low spread BB+ loans which are prime candidates for upgrade to Investment Grade Additionally, recent changes in the loan market should lower the exit rate The average company has more secured debt in its capital structure There will likely be less cash flow to repay these large loans, and the upgrade / downgrade ratio should decline Even some defaulted loans will have an effect similar to that of prepayments in LCDX, as some defaulted loans are current pay and trade above par Northwest Airlines, Inc. Delphi Corporation Calpine Generating Company, LLC Dana Corporation Recovery $ $ $ $ Default Date 9/14/ /8/ /20/2005 3/3/2006 Meridian Automotive Systems $96.00 Collins & Aikman Products Company $ Source: Lehman Brothers. 2. LCDS and loan spreads, Meredith Coffey, Gold Sheets: A Reuters Loan Pricing Corporation Publication, Vol XXI No. 10 and For more information, please refer to the Focus: LCDX Index section of the Credit Markets Weekly (Friday, May 11). 4/26/2005 5/17/2005 5

9 Constituents from the LCDX Portfolio Minimum 1st Quartile Median 3rd Quartile Maximum Standard Deviation LCDX Spread Statistics 50bp 80bp 100bp 126bp 325bp 45bp (%) 40% 30% 20% 10% LCDX Industry Breakdown (1) LCDX Portfolio Distribution by Probability of Default Rating (PDR) 0% 2% 9% 25% 26% 22% 13% Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 3% (%) 15% 10% 5% 0% 11% 11% 9% 7% 7% 6% 6% 6% 6% 5% 4% 4% 4% 3% 3% 2% 1% 1% 1% 1% 1% 1% Broadcasting and Entertainment Chemicals, Plastics, and Rubber Automobile Containers, Packaging and [_?_] Telecommunications Beverage, Food and Tobacco Electronics Healthcare, Education, and [_?_] Personal Transportation Buildings and Real Estate Printing and Publishing Retail Stores Utilities Hotels, Motels, Inns, and Gaming Leisure, Amusement, Entertainment Personal, Food, and Miscellaneous Diversified Natural Resources, Precious Ecological Grocery Mining, Steel, Iron and Non-Precious Oil and Gas Personal and Non-Durable Source: Lehman Brothers using Moody s data. Upgrade and downgrade watches are notched accordingly. Moody s only provides the CFRs and PDRs of the parent companies of some reference issuers. For the small number of issuers that do not have PDRs or senior secured loan ratings, we assume the senior secured loan rating is one notch above the PDR, which in turn is one notch above the senior unsecured rating. 1. Source: Lehman Brothers using Moody s industry classifications for structuring CDOs. 6

10 Overlap with HY CDX and CLOs, LCDX LCDX Portfolio Overlap with HY CDX and CLOs (1) LCDX Portfolio Overlap with No. of Issuers Notional % CDX.HY.8 (100) 42 42% CLO 1 (2006 Vintage) 35 21% CLO 2 (2005 Vintage) 44 25% CLO 3 (2004 Vintage) 34 25% Largest 50 Issuers in 2006-Vintage CLOs 27 54% The WARF for LCDX using Moody s Probability of Default of Rating (PDR) is 2374 (slightly below B1), which is in line with the target for recent CLOs While the overlap is about 25% of the notional of typical CLOs, LCDX covers over half of the largest 50 issuers from the 2006 vintage and this overlap will likely increase once Moody s data fully captures the exposure to giant loans recently issued Thus, we feel LCDX can serve as a good macro hedge for a portfolio of CLO tranches Source: Largest 50 names in 2006 vintage CLOs from Moody s Investors Service, as of January All others from Lehman Brothers, using trustee reports available as of April 12, No. of Issuers refers to the number of issuers found in both portfolios. Notional % refers to the % notional of CDX.HY.8 or performing assets in the CLO corresponding to the overlapping issuers. The LCDX portfolio corresponds to the latest information from Markit. 7

11 Changes to the LCDX between Rolls Loan Defaults All Secured Loans for a Ref. Entity Go Away The Default Swap protection payment is triggered by the following Credit Events for Loan-Only CDS Bankruptcy Reference Entity becomes insolvent or is unable to pay its debts Failure to Pay Failure of the reference entity to make due payments on Borrowed Money (which includes Bonds and Loans), taking into account grace period provided in the security Within 30 days of the Event Determination Date, an auction will be held to determine the recovery value of the loan for cash settlement If all secured loans go away, the LCDS is cancelled after 30 business days a waiting period observed to search for a new loan reference obligation that is a valid successor Secured Loans can go away in 3 ways Paid Down The entire facility is paid down Security Falls Away The security backing the loan is removed or the issuer is upgraded to IG and the loan become unsecured Name is removed from the Syndicated Secured List Information becomes public that violates the criteria for a reference obligation to be on the SSL Special Case: Refinancing In this case, a dealer poll is conducted to determine if the new ref ob meets the SSL inclusion criteria and is a valid successor to the old facility. If no agreement is reached, the name will be removed Resulting Cash Flows Resulting Cash Flows The LCDX Index Buyer will pay the LCDX Index Seller the protection payment (1-Recovery) for the defaulted credit The LCDX Index Seller will pay the LCDX Index Buyer the accrued interest on the LCDS of the defaulted credit The LCDS of the defaulted credit will be removed from the LCDX, which will now trade with one less name and a factored down notional, resulting in a lower coupon payment (fixed spread x notional) At the end of the 30 business days, if no replacement has been found, the LCDS will be cancelled and the LCDX Index Seller will pay accrued interest to the LCDX Index Buyer The cancelled LCDS will have its Index weighting changed to 0 The LCDX will now trade with a factored down notional, resulting in a lower coupon payment (fixed spread x notional) There is no protection payment associated with a cancelled LCDS contract in single name LCDS or the LCDX 8

12 Users of LCDX We Expect a Variety of Investors and Trades for LCDX LCDX can be used as an effective hedge or a cheap way to gain exposure to the loan market We expect some of the key users to include Cashflow CLO Warehouses, CLO funds, CLO desks, long-only CLO investors looking for alternatives, and hedge funds Low spreads make the product somewhat unappealing for CLO managers With 42 names overlapping between HY CDX and LCDX, there could be opportunities for relative value plays in LCDX using implied recovery values Spread HYCDX / Spread LCDX (1-Unsecured Recovery) / (1-Senior Secured Recovery) Investor Type Long-Only CLO Investors Loan Warehouses CLO Funds CLO Desks Hedge Funds Direction Long (Protection Seller) Short (Protection Buyer) Short (Protection Buyer) Short (Protection Buyer) Both Purpose Alternative to CLOs and Other Funds for Accessing Senior Secured Loans Hedging Hedging Hedging Cheap Macro Shorts, Relative Value of Senior Secured vs. Unsecured Recoveries 9

13 LCDX Tranches

14 LCDX Tranches Will Start Trading Soon LCDX Tranches Will Trade in a Manner Broadly Similar to CDX and itraxx Tranche Name Equity Junior Mezzanine Senior Mezzanine Senior Super Senior LCDX Tranche Description and Expected Levels (with Index at Par) Tranche Attachment Detachment Points 0 5% 5 8% 8 12% 12 15% % Our Expectation on Opening Levels (1) $60 $ bp bp bp 6 12bp No clarity yet on trading date and exact format, documentation, etc. We anticipate that many market participants would like to see a 15 30% tranche % should trade at extremely tight spreads assuming ~70% recoveries Source: Lehman Brothers. 1. Pricing is based on Index trading at par. We do not take into consideration Exit Risk of underlying issuers. 10

15 Comparison With Other Structures 50% 40% 30% 100% (Unofficial) 35% 100% ~11 bp Aaa 43% 100% ~23 bp 1 2 bp Aaa 29% 43% ~30 bp Par 30% 20% 10% 0% Reference Obligation Number of Constituents Portfolio Spread (bp) Default Based On Issuer Exits 1st Lien Market Cashflow Triggers (OC/IC) Manage Type Portfolio MTM Gains/Losses Legal Maturity Source: Lehman Brothers. 15% 30% (Unofficial) bp 12% 15% bp 8% 12% bp 5% 8% bp 0% 5% $60 65 LCDX CDX HY CLO Senior Secured 1st Lien Loans Mostly Senior; Subordinate for Some Mostly Senior Secured 1st Lien Loans 100 Low-Mid 100s Borrowed Money Cancellation/Amortization No Static Shared Across Tranches 5 Years 25% 35% ~82 bp 15% 25% ~316 bp 10% 15% ~$34.3 ~230 bp Ba 8% 12% ~425 bp 0% 10% ~$ Mid-High 200s Borrowed Money None No Static Shared Across Tranches 5 10 Years Baa 12% 15% Aa 21% 29% ~42 bp A 15% 21% ~85 bp Equ i ty 0% 8% 12% 14% IRR to Maturity Typical Low-Mid 200s Specific Security Reinvest Proceeds/Amortization Yes Managed Almost all to Equity (+Call Option) Years 11

16 Comparison With Other Structures 50% 40% 30% 100% (Unofficial) 35% 100% ~11 bp Aaa 43% 100% ~23 bp 1 2 bp Aaa 29% 43% ~30 bp 30% Par 20% 10% 0% Reference Obligation Number of Constituents Portfolio Spread (bp) Default Based On Issuer Exits 1st Lien Market Cashflow Triggers (OC/IC) Manage Type Portfolio MTM Gains/Losses Legal Maturity Source: Lehman Brothers. 15% 30% (Unofficial) bp 12% 15% bp 8% 12% bp 5% 8% bp 0% 5% $60 65 LCDX CDX HY CLO Senior Secured 1st Lien Loans Mostly Senior; Subordinate for Some Mostly Senior Secured 1st Lien Loans 100 Low-Mid 100s Borrowed Money Cancellation/Amortization No Static Shared Across Tranches 5 Years 25% 35% ~82 bp 15% 25% ~316 bp 10% 15% ~$34.3 ~230 bp Ba 8% 12% ~425 bp 0% 10% ~$ Mid-High 200s Borrowed Money None No Static Shared Across Tranches 5 10 Years Baa 12% 15% Aa 21% 29% ~42 bp A 15% 21% ~85 bp Equ i ty 0% 8% 12% 14% IRR to Maturity Typical Low-Mid 200s Specific Security Reinvest Proceeds/Amortization Yes Managed Almost all to Equity (+Call Option) Years 12

17 Expected Ratings Tranche 0 5% 5 8% 8 12% 12 15% % 15 30% (Unofficial) % (Unofficial) Estimated Ratings for 5-Year LCDX Tranches Moody s Current Method for Floating Recovery Ca Ca Ca Caa1 Baa1 Baa3 Aaa S&P Current Method for Floating Recovery NR CCC- B- BB+ BBB+ BBB+ AAA Moody s 70% Fixed Recovery Ca Caa2 Ba1 Aa2 Aaa Aaa Aaa S&P 70% Fixed Recovery NR CCC B+ A- AAA AAA AAA Moody s PDR, LGD (1) and CLO Recovery Tiering Ca B1 Baa3 A2 Aaa Aaa Aaa LCDX tranches are not likely to be publicly rated by the agencies, as is the case with CDX or itraxx tranches. However, we can use rating agency models to determine their implied ratings Using a floating recovery assumption, these ratings turn out to be surprisingly low. For e.g., the 12 15% tranche attains a Caa1/BB+ rating based on the current rating agency models: in other words, it is rated worse than the index itself The reason lies in rating agency assumptions of defaults, and more importantly, recoveries. Moody s, for e.g., uses senior unsecured ratings for modeling default probabilities of floating-recovery LCDS. Moreover, the haircuts on loan recoveries are substantially below the current market expectations of 70 75% Source: Lehman Brothers % haircuts on LGD recoveries. 13

18 Pricing LCDX Tranches The BC Approach Break Even Levels for Different Base Correlation Assumptions Flat Base Correlation Parallel Shift to CDX HY Base P1 HY Skew Correlation Skew P2 P3 Skew Skew (10%) +10% P4 Skew +20% Tranche F1 15% F2 25% F3 35% F4 45% Our Expectation (1) 0 5% (All Upfront) (1) $72.7 $67.2 $62.4 $57.9 $67.0 $72.5 $62.2 $57.7 $60 $65 5 8% 701bp 723bp 727bp 722bp 656bp 631bp 664bp 660bp bp 8 12% 192bp 281bp 343bp 389bp 229bp 167bp 273bp 305bp bp 12 15% 32bp 87bp 144bp 197bp 76bp 42bp 107bp 133bp bp 15 30% (1) 1bp 6bp 16bp 30bp 33bp 18bp 51bp 73bp 40 60bp (1) Remember! In reality base correlation is an output We try flat base correlation levels as well as parallel shifts to HY base correlation skews The scenario with HY skew shifted upwards is a good starting point Senior tranches should trade wider than AAA CLOs Mezzanines should be in line with CDX HY tranches with similar risk profiles Equity tranche pricing should initially be in line with recent bespoke observations Source: Lehman Brothers. 1. The 15 30% is not a standard tranche as of now. We show all upfront price for the 0 5% tranche. In reality, it may trade as a combination of upfront and running spread. Pricing is based on an Index trading at par. We do not take into consideration the Exit Risk of the underlying issuers. 14

19 Relative Value Constructs Various Relative Value Arguments Will Shape Trading Strategies and Also Determine Pricing Levels Benchmarking to Cash CLOs Comparison to CDX HY tranches with similar risk profile i.e., correlation pricing Historical default experience i.e., buy and hold risk All of the above will play a role based on investor type (CLO investors vs. correlation hedge funds); and based on the investment horizon 15

20 Relative Value Historical Default Rates Performance of Senior Tranches is Robust During Credit Cycles but Junior Tranches Can Get Impaired Historical 5-Year Buy and Hold Cumulative Loss on a Portfolio With Similar Rating Distribution as LCDX % Portfolio Loss 15% AAA AA BBB 10% BB 5% 0% Cohort S&P 5yr Cohort Moody's 5yr Cohort Caa Contribution Source: Lehman Brothers, Moody s, S&P. Note: Calculations assume a recovery rate of 70%. 16

21 Relative Value With Respect to CDX Tranches Relative Value across Different Indices Subordination as Multiple of Index Tranche Rating Level Delta Tranche Exp. Loss As % of Index Index Expected Loss (1) Historical Avg. Loss (2) LCDX 0 5% NR $60 $ % % CCC/Caa bp % % B+/Ba bp % % A-/Aa bp 2.0 3% HY8 0 10% NR $ % % CCC+/Caa3 $ % % B+/Ba3 316bp % % AA/A1 82bp 0.8 3% 2.3 Systemic shorts will consider carry per unit of leverage (i.e., spread divided by delta) Tranches with similar risk profiles will draw natural comparisons for e.g., the LCDX 8 12% tranche and the HY CDX 15 25% tranche Equity tranche comparison is a view on timing and number of defaults Source: Lehman Brothers, Moody s, S&P. 1. Delta calculations for the LCDX do not take into consideration the Exit Risk of the LCDS reference obligations from the loan market. 2. We calculate the historical default rates as the average obtained from using the default data from Moody s and S&P. 3. The ratings for LCDX tranches were calculated using 70% fixed recoveries. 17

22 Relative Value vs. CLOs CADR Analysis CLO Debts Would Appear Much More Robust While Paying Higher Spreads Differences in maturity Differences in asset spread levels Static vs. managed DM vs. CADR (5 Years) DM vs. CADR (5 Years) 2.50% 5.00% 2.00% 4.00% DM 1.50% 1.00% DM 3.00% 2.00% 0.50% 1.00% 0.00% Source: Lehman Brothers. 0% 5% 10% 15% 20% 25% 30% CADR LCDX 15%-30% CLO Aa (21%-29%) CLO A (15%-21%) CLO Baa (12%-15%) 0.00% 0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% CADR LCDX 12%-15% LCDX 8%-12% CLO Baa (12%-15%) CLO Ba (8%-12%) 18

23 Relative Value vs. CLOs CADR Analysis CLO Equity Can Be Compared With The 0%-5% And 5%-8% LCDX Tranches We show CLO equity IRR to a 5-year call and to maturity Equity IRR vs. CADR (5 Years & Maturity) 30% 25% 20% IRR 15% 10% 5% 0% 0% 1% 2% 3% 4% 5% CADR LCDX 0%-5% LCDX 5%-8% CLO Equity to 5Y Call CLO Equity to Maturity Source: Lehman Brothers, assuming flat LIBOR at 5%. 19

24 Likely Investors and Their Broad Trading Strategies for Each Tranche Equity and Mezzanine (0%-5%, 5-8%) We ve already witnessed some activity involving equity tranches on bespoke portfolios very similar to LCDX. We expect most of the attention from hedge fund to be focused on selling protection in this area since it provides an efficient way to leverage senior secured loans in an unmanaged format Those taking a correlation view may decide to go the other way. For example, some market participants argue that the base correlation on CDX HY and LCDX equity should be similar, and will consider convergence trades (likely involving delta-hedged equity protection on the two respective indices). In addition, we expect long-short trades on HY CDX vs. LCDX tranches based on recovery rate views Over time, CLO equity funds and other long-equity-only CLO investors could migrate to the 0-5%+5-8% combo as a short-term way to retain CLO-like exposure Source: Lehman Brothers. 20

25 Likely Investors and Their Broad Trading Strategies for Each Tranche Mezzanine and Senior (8%-12%, 12%-15%) Those looking to short LCDX in a more efficient manner will likely consider the 8% 12% tranche given its attractive carry per unit of leverage We also expect to see some technicals driven by the bespoke bid from insurance companies much like we see in the CDX IG mezzanines. We believe that the most efficient tranche, to sell protection on, for an insurance company from a capital requirement perspective would be the 12% 15% tranche Source: Lehman Brothers. 21

26 Likely Investors and Their Broad Trading Strategies for Each Tranche Senior and Supersenior (15%+) We do not expect these tranches to look great initially vs. CLOs. They are likely to be either ignored by investors focusing on the lower tranches or shorted in long CDS on CLOs, short 15% 30% LCDX kinds of trades After a while, we expect the technicals to be very similar to HY CDX tranches, with more cross-market pair trades between the two products, increasing technicals further Source: Lehman Brothers. 22

27 LCDX Analytics on LehmanLive

28 LCDX Analytics on LehmanLive Page LCDX Calculator Keyword LCDX Information Current LCDX and Single Name LCDS Levels Average, PV01 and Intrinsic Spreads Effectively Establish Fair Value Leveraged Loans Market Monitor LLMM Single Name Loan and LCDX Information and Levels HY Market Monitor HY LCDX Levels Structured Credit Market Monitor SC LCDX Levels 23

29 LCDX Analytics on LehmanLive 24

30 LCDX Analytics on LehmanLive Our Publication is also Available on the LCDX page on Lehmanlive 25

31 Regulation AC Disclaimer Analyst Certification The views expressed in this report accurately reflect the personal views of Claude Laberge, Bradley Rogoff and Gaurav Tejwani, the primary analysts responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst s compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Important Disclosures Lehman Brothers, Inc., and / or an affiliate thereof (the firm ) regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm s proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. 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