(Lehman Brothers) Structured Credit Strategy - Annual 2004

Structured Credit Research
Structured Credit Strategy Annual 2004

January 2004
Sunita Ganapati sganapat@lehman.com Arthur Berd arthur.berd@lehman.com Philip Ha philipha@lehman.com Lorenzo Isla lisla@lehman.com Claude Laberge claberge@lehman.com Elena Ranguelova eranguel@lehman.com Ashish Shah asshah@lehman.com Gaurav Tejwani gtejwani@lehman.com Christina Celi cceli@lehman.com Lorraine Fan lfan@lehman.com
Structured Credit in 2004A Place for Incremental Yield 2003 continued to be a year of innovation for many parts of the structured credit market amid one of the best years for investment grade credit and high yield assets alike. We analyze how the developments in 2003 have set the foundation for the new trade opportunities that we expect to emerge in 2004. While a tight-spread, low-volatility environment offers less obvious absolute value opportunities, there are plenty of relative value trades within the broader structured credit space. Our articles explore these themes in further detail. ........................ 4 CDS and Volatility Strategies in 2003 and Outlook for 2004 Our outlook for 2004 calls for a tighter range-bound investment grade basis; CDS curve flattening, with the long end outperforming the short in the next couple of months; the emergence of curve slope basis trading, which we believe will also be range bound; and a generally low and stable volatility environment with several small and short-lived spikes .. .8 Portfolio CDS Opportunities for Credit Investors The launch of numerous standardized portfolio CDS products opens new doors for investors looking to add diversified credit exposure and to park cash. There will also be opportunities to arbitrage 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 providing liquidity to the market through a variety of trade constructs. With spreads at relatively tight levels, we believe hedge funds will be playing the short side more aggressively in 2004. Unless volatility increases, the combination of more hedge fund capital and fewer opportunities will lead to crowded trades, increasing the risks in arbitrage strategies. ................................. 18 Technicals and Better Models Will Keep the Momentum in Debt-Equity Trading in 2004 2003 saw the growth and proliferation of debt-equity trading strategies driven by both technical and fundamental factors. Looking ahead, we expect technically driven opportunities to persist but diminish in magnitude as more investors focus on this trading strategy and as better quantitative models get implemented. ................................................................................. 21 CDOsIn Pursuit of Yield Our outlook supports a constructive view for 2004 as we finish the chapter on one of the best years in the short history of CDOs. 2003 was the year of secondary CDOs and correlation investinga trend that should continue through 2004. We expect this year to be characterized by a yield bid as investors pursue returns in a tight credit environment featuring low defaults and low interest rates. We also expect new issue spreads to compress as improved fundamentals and strong technicals persuade spreads out of their inertia. ................................................ 25
PLEASE SEE IMPORTANT ANALYST CERTIFICATION ON PAGE 63.
continued
Lehman Brothers | Structured Credit Strategies
2004 Annual
Leveraged Loans Remain the CDO Asset Class of Choice After another year of strong performance, we expect CLOs to remain the asset class of choice despite diminished arbitrage opportunities and a likely drop in issuance. Lower defaults and high prepayment rates should remain the key secondary valuation drivers. Subordinated CLO tranches have not rallied as strongly as senior CLO spreads in 2003 and offer better value for yield-hungry investors. ......................................................................................................... 30 A Benign Consumer and Commercial Credit Cycle Supports SF CDOs With a positive collateral outlook for 2004 and SF CDO spreads still languishing, we find opportunities on both ends of the capital structure. We are positive on senior SF CDO tranchesin both the primary and the secondary markets, with the latter offering better relative value. Synthetic SF subordinates and equity are attractive instruments to take up a leveraged exposure to the historically robust higher rated SF paper. .................................. 35 A Look Ahead: Synthetic CDOs in 2004 A booming single-tranche synthetics market and the launch of portfolio credit products in 2003 are likely to be followed by further innovations and expansion in 2004. We anticipate an increase in structural enhancements and further improvements in modeling technology. The challenge in 2004 will be to balance higher idiosyncratic risk by scrutinizing valuations and hedging appropriately. .......................................................................................................... 38 Synthetic CDO Bid Likely to Temper in 2004 The synthetic CDO bid drove the CDS market much tighter in 2003, presenting many opportunities to trade into and out of the bid. We believe that in 2004, the synthetic CDO bid will continue to play an important, albeit tempered, role for single-name CDS spreads. .. 41 The Impact of Interest Rate Movements on CDO Performance Interest rate hedges pinch CDO cash flows as interest rates stay at historical lows, prompting us to search for trades that are positioned to gain from current and expected future trends. For short-term investors looking for mark-to-market gains, pricing inefficiencies can be utilized in the IG senior segment, where large out-of-the-money swaps are involved. Investors looking at a medium-term horizon should consider some of the overhedged transactions from older vintages that benefit from rising interest rates. ..................................................................... 43 European CDOs: 2004 Outlook We expect CDOs to outperform other European asset classes in 2004, especially at the subordinate level. Our top picks are leveraged/mezzanine loan CLOs, hedged IG CDO equity strategies, senior tranches of Spanish SME CLOs, and the purchase of mezzanine IG synthetic protection. We believe that the booming market for synthetic CDOs of structured finance will continue to evolve. ................................................................................................................ 47
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2004 Annual
CONTACTS
Global Head of Credit Strategy Mark Howard ........................................... 212-526-7777 ........................ mhoward@lehman.com Structured Credit Strategies Sunita L. Ganapati ................................... 415-274-5485 ........................ sganapat@lehman.com Arthur M. Berd ......................................... 212-526-2629 ..................... arthur.berd@lehman.com Philip Ha .................................................. 212-526-0319 .......................... philipha@lehman.com Lorenzo Isla ............................................. 44-(0)20-7260-1482 ...................... lisla@lehman.com Claude A. Laberge ................................... .212-526-5450 ........................ claberge@lehman.com Elena Ranguelova ................................... 212-526-4507 ......................... eranguel@lehman.com Ashish Shah ............................................ 212-526-9360 ........................... asshah@lehman.com Takahiro Tazaki ........................................ 81-3-5571-7188 ......................... ttazaki@lehman.com Gaurav Tejwani ........................................ 212-526-4484 ......................... gtejwani@lehman.com Christina Celi ........................................... 212-526-4482 ............................... ccelli@lehman.com Lorraine Fan ............................................. 212-526-1929 ................................. lfan@lehman.com
RECENT PUBLICATIONS
December 22, 2003
Portfolio Structured Credit Monthly, December 2003 We recap the performance of the CDO market in 2003the year of secondary CDOs and correlation investing. CDO valuations improved dramatically as collateral markets rallied through the year. Issuance went up, led by the growth in synthetic CDOs, and downgrade activity has begun to slow down. Trading CorrelationRelative Value across CDO Tranches We discuss the use of the implied correlation embedded in the price of a CDO tranche as a measure of its relative value. We show that implied correlation varies significantly across the capital structure giving rise to a correlation smile, which fluctuates over time. Portfolio Structured Credit Monthly, November 2003 In this edition of the Portfolio Structured Credit Monthly, we continue where we left off in our inaugural edition. The learning curve section further demystifies portfolio credit products by trying to unravel the various risk measures used to hedge synthetic CDO risk. We also discuss how investors could profit from some of the trends we observe in the credit markets. Quantitative Credit Research Quarterly, Vol 2003-Q4 Includes The New Lehman Brothers High Yield Risk Model; Valuation of Portfolio Credit Default Swaptions; Forward CDS Spreads; Understanding Deltas of Synthetic CDO Tranches; Hedging Debt with Equity; and Pricing Multi-Name Default Swaps with Counterparty Risk. U.S. High Yield Credit (GRV 11/17/03) The HY Credit Strategy section in this weeks GRV talks about the rise in lower rated HY issuance, the upward trend in recent recovery rates, and the effect of the increased callability of HY bonds on CDO Managers. Portfolio Structured Credit Monthly, October 2003 Our newly launched publication addresses the need for analysis and information around the broader portfolio structured credit products space. In our inaugural edition, we demystify investments in portfolio credit products in general and correlation produ 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 strategy of the Lehman Brothers corporate index. The Lehman Brothers Credit Default Swap Index We introduce the new Lehman Brothers CDS Index and provide a description of its construction, rules, return calculations and its use as a research and portfolio management tool. Guide to Exotic Credit Derivatives (Risk, Oct. 2003) Explains the mechanics, risks and modeling of exotic credit derivatives including default baskets, synthetic CDOs and credit options.
November 28, 2003
November 24, 2003
November 20, 2003
November 17, 2003
October 28, 2003
October 20, 2003
October, 2003
October, 2003
January 21, 2004
2004 Annual
Sunita Ganapati 415 274 5485 sganapat@lehman.com
STRUCTURED CREDIT IN 2004A PLACE FOR INCREMENTAL YIELD 2003 continued to be a year of innovation for many parts of the structured credit market amid 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 are developed, 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 and modeling technology helped meet and create demand. Key trades in 2003 revolved around 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 developments in 2003 have set the foundation for the new trade opportunities that we expect to emerge in 2004.
CDS Markets Proliferate
A term structure of CDS developed in a very short window of time during the second half of 2003.
With the CDS market becoming more and more mainstream and with the number of names that trade actively in the high grade CDS market expanding rapidly, the next logical step was the development of a CDS curve. A term structure of CDS developed in a very short window of time during the second half of 2003. This was largely driven by higher 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 actively traded curve, bringing in some of the more interesting opportunities in high grade CDS investing in 2004. Following cues from the volatility of late 2002, hedge funds and proprietary trading desks took advantage of several opportunities across the debt-equity continuum. An offshoot of the increased capital structure arbitrage activity, which generally takes place in lower quality names, has been the jump in high yield CDS activity, which was originally dominated by bank loan hedgers. The increase in activity is clearly supported by lower risk aversion in the market and the desire to extend the successful high grade CDS market into high yield. Paradoxically, while the desire to hedge exposure to investment grade names using 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 the spectacular tightening in high yield spreads have made hedging a rational expense for high yield portfolio managers, and we expect more participation from them in 2004. In addition, 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 swap market with senior secured loans as deliverable contracts. While still in its infancy, the market is active in about a dozen names and should grow in 2004. Natural sellers of protection for such contracts are CLO managers, who can use them during their ramp-up or in an aggressively bid loan market for reinvestment of some of their cash proceeds. Currently, the
The CDS market will start to provide more appeal to HY managers.
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2004 Annual
loan CDS is callable if the underlying reference loan is fully repaid before maturity, thus exposing investors to issue-specific prepayment risk along with the usual credit risk. It is possible that such provisions will become less common as the investor base grows and the documentation of loan CDS achieves greater maturity and standardization. In general, we foresee greater activity in the budding HY CDS market and in deliverable contracts. As the year progressed, the presence of traditional asset managers became more prominent in on-the-run segments. On the investor front, the year was dominated by hedge funds across the spectrum, but as the year progressed, the presence of traditional asset managers became more prominent in on-the-run segments. Banks, which were until two years ago the dominant players in the structured credit space as hedgers, were significantly quieter given the benign credit environment. Some became better sellers of protection via CDS as IG loan volumes stayed low. 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 managers and insurersthe newest entrants to the CDS spacewe foresee a greater need for benchmarking and performance measurement tools. To address this need, on October 1, 2003, we launched the Lehman Brothers Credit Default Swap Index consistent with the philosophy and methodology of our Family of Fixed Income Indices.1
Portfolio CDS and Volatility Trading Gathers Momentum
The expansion of the single-name CDS market and that of portfolio CDS is expected to enhance the liquidity of both, particularly in the high yield space in 2004.
Simultaneous to development in the term structure of CDS and the high yield CDS market, the quest for liquidity and diversification in CDS and derivatives thereof led to the development of a slew of portfolio CDS products. The breakthrough developments in 2003 started with high grade and emerging market underlying and quickly encompassed the high yield universe. Two families of products trade actively todayTrac-X and CDX, both inside a 5 bp bid-offer, signifying their liquidity. The expansion of the single-name CDS market 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 of these products. Some would argue that it is the demand for trading default correlation and volatility in a liquid, transparent form that led to the development of traded portfolio CDS contracts. Nevertheless, during the second half of the year, the volume of trading in receiver and payer swaptions on these portfolio CDS contracts jumped dramatically, changing volatility trading from a single-name options market to a macro-volatility market. This is the future generation of credit derivatives as the options market extends to high yield underlying.2
Correlation Trading and Secondary CDO Markets Have a Stellar Year
The introduction of actively traded, liquid portfolio CDS contracts also catalyzed derivatives off of these products.
The fusion of credit derivative modeling with CDO technology led to a roaring single-tranche synthetics market.
Innovations in the CDS market drew parallels in the CDO market, with the most noteworthy being the boom in correlation trading. The fusion of credit derivative modeling with CDO technology led to a roaring single-tranche synthetics market and the growing popularity of tranched portfolio CDS. Investors can now choose layers of risk (defined by attachment and detachment points) on customized and standardized portfolios and receive a quote on that layer. European credit investors utilized the technology to 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.
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were active in seeking correlation exposure via delta-hedged equity tranches. 2004 should bring path dependency and better quantitative models into analyzing CDOs. In addition, the emergence of a diversified high yield CDS market is likely to lead to the growth of synthetic high yield CDOs and a correlation market thereof. The development of a default swap market for ABS and cash CDOs is noteworthy. Another noteworthy trend is the extension of synthetics to other products with the application of structured credit technology to structured finance. We saw $7 billion of synthetic ABS issued in 2003. This market has just scratched the surface and is spurring the development of a default swap market for ABS and cash CDOs. For traditional cash flow CDOs, innovation was marked by the introduction of many new structural features that appropriately allow for a shift in value from equity to debt in deteriorating credit conditions. This has brought investor confidence back into the mezzanine market and created a better alignment of interests. The most dramatic development on the cash side, however, is the huge infusion of capital (Street and investor) that we saw in 2003, leading to significantly improved liquidity. Dislocation in valuations brought opportunistic, absolute return investors in strong force, leading to a stellar year for returns. The market benefited from better valuation techniques and models such as METEORSM (MontEcarlo Tranche EvaluaTOR); our recently launched in-house risk-neutral simulation-based tool will bring sophistication into valuation of these tranches in 2004. Probabilistic methods enable the pricing the optionality embedded in tranches that are tough to analyze using traditional deterministic methods.
Quantitative Modeling
The most dramatic development on the cash side is the huge infusion of capital that we saw in 2003, leading to significantly improved liquidity.
Last but most important is the growth and availability of quantitative models for analyzing the gamut of structured credit products. We continue to develop unique quantitative models designed to complement the fundamental frameworks employed by portfolio managers, traders, analysts, and structurers. These quantitative models add to the suite of portfolio models already delivered in POINT. A collection of new quantitative tools is now available in the Quantitative Credit Toolkit on LehmanLive.
Adding Yield in 2004
There are plenty of relative value trades within the broader structured credit space.
With the bullishness surrounding credit and high yield spreads and the expectation of a slightly bearish interest rate environment despite a quiet Fed, the structured credit market offers many opportunities. Investors can isolate spreads from rates efficiently and add leveraged exposure to credit markets. While a tight-spread, low-volatility environment offers less obvious absolute value opportunities, there are plenty of relative value trades within the broader structured credit space. In our opinion, the key trades for 2004 are: CDSTerm 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.
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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 to credit 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
2004 Annual
Arthur Berd 212-526-2629 arthur.berd@lehman.com
CDS AND VOLATILITY STRATEGIES IN 2003 AND OUTLOOK FOR 2004 Among the many uses of credit derivatives, the following three strategies have achieved mainstream acceptance: CDS-cash basis trading, CDS curve trading, and volatility trading. In this section, we overview these strategies during 2003 and discuss our outlook for 2004. The main forecasts include: The CDS-cash basis will become more efficient and tightly range bound as the primary technical factors remain balanced; The long end of CDS spread curves will outperform the short end in the next few months; The curve slope basis between CDS and cash will also be range bound, albeit more loosely than at the 5-year maturity; and Volatility will find a floor and experience several small and short-lived spikes.
1) CDS-Cash Basis
The CDS-cash basis tone (i.e., the market-wide average differential between CDS spreads and the LIBOR OAS of credit bonds) has undergone several regime shifts during the past year and a half (Figure 1). They revealed important driving factors of the basis and 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, credit portfolio managers relied heavily on the CDS market for hedging. This resulted in the biggest spike of the CDS-cash positive basis. In late October 2002, synthetic CDOs stepped in as the ratings arbitrage became so wide that the expected returns were attractive even after accounting for an elevated level of default risk. During the next eight months, November 2002-June 2003, it was the
Figure 1.
bp
30
CDS-Cash Basis Market Tone

Price ($)
Hedging Demand Synthetic CDO Bid 115
15
110
105
-15 Rate Back up and Convergence
100
-30 CDS Basis U.S. Corp Index Avg. Price (RHS) -45 4/02 6/02 8/02 10/02 11/02 1/03 3/03 5/03 7/03
95
90 9/03 10/03 12/03
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synthetic CDO bid that drove the CDS spreads well through the cash levels; see our earlier reports for detailed discussion.1 Starting from July 2003, the effect of the CDO bid waned, and the leading driving factor role was assumed by the price level of the cash bonds. As interest rates started to rise, the price premium of the cash bonds diminished, reducing the apparent OAS premium that basis traders require for pairing up an off-par bond with CDS, which is equivalent to a par investment. During this time, the ups and downs of the average price of the Lehman Corporate 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 substantial volatility of interest rate swap spreads: in August, the swings were particularly violent and fast due to sudden duration hedging pressures of MBS portfolios. While CDS spreads remained stable, a sudden move of the swap spreads manifested itself as a shift in credit bond OAS-to-LIBOR, thereby also causing a blip in the basis. These blips are purely 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 believe that none of the primary driving factors that we discussed above will have much strength during most of the next 12 months, and, therefore, the basis should be confined to a 10 bp range around the economic fair value. Perhaps only the LIBOR spreads may cause additional optical basis blips, but as we already mentioned, these blips should be ignored by investors.
2) CDS Curve and Forward Trading
As the CDS market matures (both in terms of efficiency and by virtue of aging) the liquidity inevitably expands from the initial fulcrum of 5-year term to both shorter and longer horizons. The increasing activity in the short end of the CDS curves is driven 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 take profits (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 be traded 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 are willing to accept longer risk horizons and are actually driven to them in search of excess spread. The synthetic CDOs are now being priced with 7-year maturity, and portfolio products such as Trac-X and CDX also exist in a 10-year format in addition to the standard 5-year maturity. As the market in CDS deepened in all maturities from 1 to 10 years during 2003, it made trading the entire CDS term structure the newest attraction for sophisticated credit derivatives investors. By the end of 2003, the steepeners and flatteners were among the most 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 ConvergenceWhich Sector is Next? Global Relative Value, March 31, 2003, and S. Ganapati, A. Berd, P. Ha, E. Ranguelova, Revisiting the Synthetic CDO BidWhats Next?, Global Relative Value, May 27, 2003.
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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 also traded across the curve. With a more active market in CDS of various maturities, the comparisons and relative value trades between the CDS and cash bonds are also becoming easier to implement (see an example of the Ford CDS and cash curve in Figure 2). Both matched-maturity (e.g., 7-year CDS 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 evolution and 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 in bonds because relative value measures, particularly the forward CDS spread measures, are related to the spot spreads in a very transparent manner. In an environment of already tight spreads within a still-rallying market, the forward CDS trades and steepeners/flatteners often offer the best implementation alternative for both long and short 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 is consistent with a bullish stance in terms of forward CDS spreads. As credit spreads grind tighter, in accordance with an overall credit strategy outlook for 2004, investors should become even more comfortable in extending their horizons farther out the curve. This continued spread hunt should lead to outperformance of the long end. Coupled with greater spread duration, this bodes very well for long credit excess returns.
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
Figure 2.
Ford CDS and Cash Curves, As of January 9, 2003
250 CDS Cash 200
150
100
50
0 6M 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y 30Y
Source: Mark-it Partners.
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Figure 3 shows the distribution of the CDS curve slopes across almost 500 names in the U.S. that have a well developed 1-10-year spread curve, according to the Markit Partners database. We compare the distributions of both absolute levels of the 1-to-10-year slope along the curve (measured in basis points), and the relative slope, measured in percent of the 5-year spread. For example, the average spread curve slope on VZ was 20 bp, with the 5-year spread equaling 41 bp, which makes the relative slope 50%. As one can see, the distribution of the relative slopes is skewed quite heavily toward the steep end, indicating that most CDS curves have plenty of room to flatten. In addition to expected outperformance in a central scenario, the curve flattener strategy will likely be shielded from significant downside risk in a (hopefully) remote scenario of a large external event (terrorism, systemic shock of some nature, etc.), in which case the near-term concerns would take precedence and the short-maturity spreads would consequently underperform. As to the comparison between the CDS and cash curves, we believe that a (somewhat independent) basis will develop across the entire range of maturities. Since we expect the basis overall to be tightly range bound, we think this will translate into a fairly narrow range for the differential between the CDS and cash curve slopes, which we call a curve slope basis. Given the relative newness of this market, we expect the typical speed of convergence of outliers to be slower in the curve slope basis than it is in the standard 5-year basis trades.
3) Volatility Trading
Volatility trading experienced a long-awaited liftoff in 2003. While most of the products already existed in previous years, the elevated levels of issuer-specific risk and volatility itself made investors too queasy to allocate too much risk capital to exotic options in 2002. With the notable exception of the repack and put bond trades, most other volatility products such as credit bond options and single-name default swaptions did not yet find the critical sponsorship.
Figure 3.
220
Distribution of CDS Curve Slopes, December 31, 2003

Slope 1-10 Year, bp Relative Slope 1-10 Year, %
165
Count of Names
110
55
0 -100 -50 -30 Source: Mark-it Partners. -20 -10 0 10 20 30 50 100 More
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The new catalyst in this market was the introduction of the macro volatility products in the form of receiver and payer swaptions on CDS portfolio products, initially using Trac-X as the underlying and then later in the year also expanding to iBoxx CDX family of portfolios (see an overview of the options products and their usage4 and an overview of the underlying portfolio products in a recent publication5 and also in the subsequent section of this report). With much more subdued overall volatility levels, investing in such products became more of a controllable process rather than a wild and random draw of luck as it may have been in 2002. Importantly, the options on the most diversified of the CDS portfolios, Trac-X 100 IG and CDX.NA.IG, began trading not only with an at-the-money strike but also on a range of out-of-the-money strikes on both sides of the spot spread. This allowed investors to construct 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 maturitiesnear (3-4 months) and far (6-9 months)allowing for calendar spread strategies in both directional and non-directional (pure vol) form. We estimate that since June 2003, there was as much as $6-$8 billion in macro volatility products traded in the U.S. (most of it with leveraged credit investors). This is almost 10% of the notional of the underlying productsquite a strong start for the first 9 months of market activity. There is still plenty of room to grow, even if the growth rate in these products surpasses the respectable growth rate in the underlying itself. Before making a prognosis for volatility, let us review the state with respect to spreads and volatility in which the credit market finds itself currently. Figure 4 shows the Lehman Brothers Credit Index OAS versus the rolling exponentially decaying estimate of the OAS volatility with a 1-year half-life, using monthly time series spanning 14 years from January 1990-December 2003. During this period, there were 3 distinct regimes; therefore, we break the series into the corresponding 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 the credit rally of 2003.
The dashed curve represents the path in the spread-volatility space traced by the markets during 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 much more 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.
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Figure 4.
OAS
300 250 200 150
Spreads and Volatility in the Credit Cycle
Jul-Nov 02
2003 Spread Rally
100 50 0 0 20 40 60 80 100 120 Jan90-Dec91 Jan92-Jul98 Aug98-Dec03
12/31/03
Vol
1990-1991 recession. Remarkably, though, the beginning and the end of the current downturn were very much in line with the previous recession. The period of benign credit markets in 1992-1998 was characterized by a very tight relationship between spreads and volatilities. The credit markets are at the entry point of that regime right now. However, we believe that both the volatility and the spreads will find a higher floor than the levels achieved in the mid-1990s because of the structural changes in the market that make it faster and somewhat riskier for credit investors. A few spikes in volatility during the year should keep the relative value players and 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 of investors, eventually making their way into portfolios of asset managers and insurance companies as a valuable source of risk-adjusted return. The single name default swaptions will likely lag behind, but we think that eventually these products, too, will see substantial growth, starting with a limited list of select high profile and high beta names, such as F, GM, AOL, MO, and the like, and gradually expanding the coverage as the investors get accustomed to these products. Finally, the perennial favoritethe repack tradewill continue to be a source of cheap implied volatility (even compared with low actual vol levels).
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Philip Ha 212-526-0319 philipha@lehman.com Lorraine Fan 212-526-1929 lfan@lehman.com
PORTFOLIO CDS OPPORTUNITIES FOR CREDIT INVESTORS 2003 was a breakthrough year for portfolio structured credit products. A slew of products were introduced backed by diversified credit default swap portfolios, starting with the high grade markets and quickly encompassing the high yield market. In 2004, we believe that a more diverse investor baseincluding bank loan hedgers, money managers, and hedge fundswill embrace these products and become more active in trading them.
Portfolio CDS Products Boom Globally
In 2003, many dealers came together to release products referencing portfolios of liquid single-name default swaps.
Many globally traded portfolio products reference cash bonds or credit default swaps in funded or unfunded formats. The cash portfolios (e.g., TRAINs, TRACERs) were largely created as replication strategies for a cash index and were popular in 2002, when different dealers sponsored a few standardized products to achieve diversification in the volatile credit environment. These products continue to trade today in a fairly tight bid-offer market. In 2003, many dealers came together to release products referencing portfolios of liquid single-name default swaps, resulting in the launch of two broad families of productsthe CDX family, administered by iBoxx, and Trac-X, administered by Dow Jones. Furthermore, a volatility and correlation market has developed off of these two products (please refer to our October 2003 Portfolio Structured Credit Monthly for more details). Standardized portfolio products have emerged as transparent indicators for the CDS market. Although initial trading was minimal, bid-ask spreads were as narrow as 2 bp for iBoxx CDX and 3.8 bp for the new Trac-X on average. This is partly because of contractual obligations for market makers to make 5 bp markets under normal market conditions for the Trac-X and 5% of the mid spread for CDX. In 2004, the diversification bid, increased appetite for hedging, and the quest for yield are likely to drive volumes higher with buy-side sponsorship. The recent default of Parmalat, which was part of the European Trac-X, was a good test for the credit event mechanisms embedded in portfolio CDS, and the smoothness of delivery post-default demonstrated the efficiency of these products.
A Two-Way Relationship with CDS
The expansion of the single-name CDS market and portfolio products is expected to enhance the liquidity of both instruments in 2004.
The expansion of the single-name CDS market and portfolio products is expected to enhance the liquidity of both instruments in 2004. The creation of portfolio products in the investment grade and high yield space has already resulted in an increase in liquidity 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 existence of portfolio CDS products. We expect the portfolio market in 2004 to be infused with new participants such as bank loan hedgers, insurance companies, and hedge funds. The pursuit for diversification may drive a further compression of trading spreads relative to the portfolio products intrinsic spreads1 when a avoiding losers instead of picking winners strategy2 becomes key in the expected low-yield, low-volatility environment in 2004. Nevertheless, it has yet to be seen whether the high demand for
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 teams piece: Outlook 2004: Final Bow for Tightening or Another Curtain Call?
Global Relative Value, January 5, 2004.
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unleveraged portfolio products will result in a portfolio bid similar to the synthetic bid in the single-name CDS market.
HY CDS Market Should Receive Liquidity Boost
As the number of credits in the portfolio CDS exceeds the number of currently liquid individual entities, more liquidity is likely to be infused into off-the-run names.
The introduction of portfolio products has given and will continue to give a boost to the illiquid high yield CDS market. Both iBoxx CDX and Trac-X have launched high yield products, each referencing 100 entities. Similar to the case in the investment grade arena, as the number of credits in the portfolio CDS exceeds the number of currently liquid 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 100 diversified North American high yield credit default swaps, whereas only 40-50 names trade actively in the HY CDS market. As CDX and TRACX gain liquidity, we would expect the remaining, less liquid names in the portfolios to trade more actively.
Investment Opportunities
Besides the relatively obvious investment opportunity in any index-like product to add diversified exposure to the credit markets, we foresee four broad areas of investment opportunity in this space: 1) Using portfolio CDS to park cash. For example, the Lehman Brothers BB Index is currently trading at a $108 price (T+242). However, investors could also go long the CDX BB for a lower dollar price, $105 (T+240). We believe that managers should be actively investing in the BB CDX versus cash BBs in order to pay a lower dollar price 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 Brothers Credit Index, with the tracking error being minimized in benign market environments. The divergence between the CDX and the index in 2H02 was due to a disproportionate widening in CDS versus cash, which is consistent with the generally accepted belief that in widening environments, CDS will widen earlier and to a greater extent. However, as seen in the chart, in most other environments, the CDX has been a good proxy.
Figure 1.
300
CDX versus Lehman Brothers U.S. Credit Index

CDX + Swaps
270 240 210 180 150 120 90 1/01
US Credit Index
4/01
7/01
10/01
1/02
4/02
7/02
10/02
1/03
4/03
7/03
10/03
Sources: Lehman Brothers; historical CDX spreads were reconstructed using Mark-it Partners data.
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3) For investors who desire insurance against spread widening, buying protection on portfolio products offers an efficient way to execute a macro hedge. As of January 12, 2004, investors could purchase protection on the CDX NA at 47.5 bp, compared with earning a LIBOR-equivalent spread of L+58 bp on the Lehman Brothers Credit Index (Figure 2). Investors who are currently long the market, but negative on particular sectors, could purchase protection on individual sectors. 4) Finding arbitrage opportunities between the portfolio and single-name CDS markets. The tighter spreads of portfolio products compared with single-name CDS present potential arbitrage opportunities. As we pointed out in the October 2003 Portfolio Structured Credit Monthly, the trading level of a portfolio CDS product can differ from the average spread of its underlying entities or its intrinsic level. In this case, investors can monetize the differential by buying
Figure 2.
Portfolio Product Spreads, January 12, 2004

Product CDX IG CONS CDX ENRG CDX FIN CDX INDU CDX TMT CDX Bid 46.75 43.50 42.00 32.00 48.00 56.00 Offer 47.50 47.00 45.00 35.00 51.00 58.50
Figure 3.
64 62 60 58 56 54 52 50 10/22/03 80
Portfolio Product Intrinsic versus Actual Spread, bp
CDX Intrinsic Spread CDX Actual Spread
10/24/03
10/28/03
10/30/03
11/3/03
11/5/03
11/7/03
TRACX II Intrinsic Spread TRACX II Actual Spread
75
70
65
60
55 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
Sources: Lehman Brothers; assumes 5% haircut from ModR single-name CDS spreads when calculating intrinsic portfolio spread.
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2004 Annual
protection on the portfolio and selling protection in the single-name CDS market at wider spreads. The positions may be kept until maturity, or a mark-to-market profit can be made if convergence occurs between the portfolio and single-name CDS markets. Figure 3 shows that since their inception in October, iBoxx CDX NA and the new Trac-X NA have been trading consistently tighter than their intrinsic value by 4 bp and 6 bp, respectively, on average. The first reason for this difference stems from the advantages of buying a diversified portfolio, as well as demand/supply technicals and liquidity. Second, our computation of the intrinsic levels applies a 5% haircut on the underlying CDS spreads that have been marked with ModR, although there is no uniform perceived value of restructuring. However, given that the difference between the portfolios trading spreads and the underlying averages are as large as 9% for iBoxx and 14% for Trac-X, one should not ignore the weight of the first explanation regarding diversification.
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2004 Annual
Ashish Shah 212-526-9360 ashish.shah@lehman.com
2003: YEAR OF THE CREDIT HEDGE FUND; 2004: A CROWDED PARTY? Credit and capital structure arbitrage strategies seemed to be the hot areas among asset allocators in 2003. Huge market opportunities, coupled with (in many cases) a marketneutral approach and diversification away from equity market-neutral strategies, were more 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 credit investors raising additional capital.
Just a Year Ago, the World Was a Scary Place
2003 began with many investors still in shellshock from what 2002 had done to their portfolios, and the outlook remained cloudy at best. The Bush administration was beating 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 uptick in 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 telecommunications industries were in significant distress, with the outcomes far from certain. A preference for liquid positions in this uncertain environment led to a significant discount in the market for illiquidity.
But for Hedge Funds, Opportunities Abounded
Directional and arbitrage-oriented hedge funds happily provided liquidity to a market more than willing to pay for it. Some used more liquid instruments to hedge their credit risk, leaving themselves with limited downside. These trades took a number of forms:
Secured/Senior Trades
One 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 a combination 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 hedges offset losses on the position, while if the credit survived, the trade captured significant upside and positive carry. The distressed loan market offered fertile ground for this type of trade, as there were a number of loans trading in the 80s and low 90s. When credit markets stabilized, companies refinanced loans with less restrictive high yield bonds repaying investors par. The airline ETC and EETC markets offered another source of secured paperinvestors who were able to assess collateral value and understand bond structure set up arbitrage positions using CDS and equity puts. Other sources of secured paper included credit tenant leases and first- and second-lien paper on power plants owned by distressed utilities.
Debt/Equity Trades
Clients took advantage of credits with wide credit spreads and relatively rich equity valuations by buying discounted bonds or selling CDS and either buying puts or shorting stocks outright. On the investment grade side, there were a number of situations in which CDS tightened rapidly because of synthetic CDO activity. Arbitrageurs took advantage of credits with tight CDS, high equity volatility, and low equity valuations by either selling long-dated equity puts or buying the stock
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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 in 2004, in this report.
Convexity TradesBasis with a Bias
The wide spreads on long-dated bonds and high spread volatility created an opportunity across the credit spectrum to set up bullish convexity trades in credits. In these trades, clients purchased long-dated bonds at large dollar price discounts while at the same time purchasing 5-year CDS. If the credit deteriorated significantly, the longdated discount bond would outperform the CDS position because its recovery floor was close to the discounted price. If the credit improved, investors were net long credit duration and made money. These trades were especially popular around uncertain corporate events.
Correlation Trades
The high level of synthetic CDO issuance in mezzanine tranches over the course of the year led dealers to be long first-loss tranches. Hedge funds saw this as a cheap source of default correlation. By buying the CDO equity and trading the appropriate delta hedges, they were able to fund a market spread short while managing idiosyncratic risk by overhedging problem credits.
Distressed CDO Trades
Hedge funds were among the first to exploit the disconnect between credit market prices and CDO tranche valuations at the beginning of 2003. The convergence gathered momentum over the second half of 2003 as CDOs began to price in the optimism in the credit markets, leading to impressive returns for investors. Mezzanine tranches returned 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 Trades
As if leveraged clients did not have enough trading opportunities in 2003, the dealer community introduced both the Trac-X and iBoxx CDX lines of portfolio CDS products in both the high grade and high yield markets. This was quickly followed by an introduction of options markets on the high grade portfolio products. After limited transaction volume, the market exploded with activity as leveraged clients began expressing spread volatility views and traditional accounts began using options to either enhance return or cover downside risk. Finally, the single-name spread volatility market emerged, with leveraged clients using spread options to express direction views and enhance yield.
Looking to 2004: The World is Less Scary, but Holds Less Opportunity
The macro and market backdrop in 2004 could not be more different than the one last year. The macro environment seems much more benign, with potential volatility far from view. The economy is recovering, even if only modestly. Companies have shored up their balance sheets. The dramatic decline in the dollar is helping U.S. multinationals, 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 it will be a very long time away . . . at least in market terms.
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The market environment seems equally benign. While spreads on bonds and CDS still have the ability to outperform, few people would argue that credit overall is cheap. The same can probably be said about the equity market, with the S&P500 trading at more than 18x consensus 2004 estimates and the VIX trading in the mid-teens.
With Less Opportunity, Hedge Fund Effect Will be Much More Pronounced
As profitable trades become more scarce, hedge funds and other leveraged credit investors will be faster to identify and arbitrage away opportunities in the market. Ironically, as leveraged investors pursue fewer opportunities with more capital, new opportunities will be created by so-called crowded trades, or situations in which too many short-horizon investors are taking the same position. Longer-time-horizon investors 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 funds and other leveraged accounts will be considering as they enter 2004: 2003 performance was dominated by improving liquidity across the credit and equity markets. Expect this trend to continue as hedge funds reach for cheap illiquid credit instruments that they can hedge using CDS and equity puts. Leveraged investors will look to alternative markets, including ABS and MBS, for securities that have credit risk that can be hedged using credit and equity derivatives while leaving a reasonable leveraged return. Given the relatively tight spread starting point, expect hedge funds to be much more aggressive in setting up shorts on both single names and portfolio product. Many investors believe that while there are pockets of opportunity in the credit market, risk has been significantly priced out of the market. Given the high likelihood of Fed activity in 2004, leveraged investors will be adjusting their portfolios to reflect potential dislocations created by these moves. A potential deleveraging trade resulting from a flatter curve could cause considerable spread volatility. As portfolio and spread volatility markets gain liquidity, expect hedge funds increasingly 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 that reverse as implied volatilities drift lower.
We will discuss some of these themes in additional detail throughout the year.
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2004 Annual
Elena Ranguelova 212-526-4507 eranguel@lehman.com
The main catalyst of the strategy was the maturing of the credit default swap market.
TECHNICALS AND BETTER MODELS WILL KEEP THE MOMENTUM IN DEBT-EQUITY TRADING IN 2004 2003 saw the growth and proliferation of debt-equity trading strategies, also known as capital structure arbitrage. Credit hedge funds and dealer proprietary trading desks rushed to exploit apparent mispricing between debt and equity, encouraged by the eyegrabbing gains scored by some at the end of 20021. The main catalyst of the strategy was the maturing of the credit default swap market into a mainstream market with broad participation from banks, asset managers, insurance companies, and hedge funds. CDS gave arbitrageurs a new liquid and fairly standardized instrument for shorting credit. This widened the opportunities for trading debt against equity, which previously were limited to convertible bond arbitrage.
The Macro Market Backdrop
At the start of 2003, market participants were facing high equity volatility, low equity prices, 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 prices tend to exhibit strong correlation (consider, for example, the Ford CDS-equity scatter plot in Figure 1). This was followed by a short period of decoupling when the two markets reacted differently to the Iraq war. In February and early March, equities were tanking because of uncertainty about the war, while credit widened only slightly. Subsequently, as illustrated in Figure 2, the resolution of uncertainty and improving company 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 spreads tightened by 80 bp (as measured by the Lehman Brothers U.S. Credit Index). Concurrently, the debt-equity relationship was rolling down its steep section. Most issuers closed the year with low volatility and tight credit spreads that were largely unresponsive to equity price 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 Credit
Hedge Fund; 2004: A Crowded Party? by Ashish Shah, in this report.
Figure 1.
Ford CDS-Equity Relationship in 2003
CDS Spread (bp)

600 500 400 300 200 100 0 5 6 7 8 9 10 11 12 13 14 15 16 17 18 2003 H1 2003 H2 1-Jan-03 31-Dec-03
Stock Price ($)
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2004 Annual
Figure 2.
Debt and Equity Markets in 2003
CDS Spread (bp)

180 150 120 1010 90 940 60 30 0 1/03 2/03 4/03 5/03 7/03 8/03 9/03 11/03 870 U.S. Credit Index OAS Equity Volatility (VIX) S&P 500 (RHS) 1150
1080
800 12/03
Stock Price ($)
1/02/03 to 12/31/03
U.S. Credit Index OAS S&P500 Equity Volatility (VIX)
Last
89 1112 18
Minimum
89 12/30/03 801 3/11/03 16 12/17/03
Maximum
166 1/2/03 1112 12/31/03 35 1/27/039
The Put-CDS Trade
The main strategies explored by investors last year included trading CDS versus out-ofthe-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 strategy in 2003. The CDS versus out-of-the money put trade was the most popular debt-equity strategy in 2003. Because both instruments are fairly liquid, investors could put the trade on and then unwind it pretty fast. Earlier in the year, when spreads were wide, we observed mostly buyers of equity puts and sellers of default protection. Later in the year, with equities on the rise, the trend reversed, and most trades involved selling puts and buying protection. The most widely traded names were characterized by high leverage, big earnings 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 Challenging
Structuring the put-CDS trade has been relatively straightforward when hedged to value on the default. However, dynamic hedging of the strategies has proved more elusive. Most of the existing debt-equity models are not sufficiently accurate for dynamic hedging and expose investors to substantial residual risk. The most successful trades of the year have been driven largely by a good understanding of technical changes in the marketplace.
Technical Factors Drive Opportunities in the Debt-Equity Space
Various technical factors create temporary decoupling of debt and equity and drive opportunities for capital structure arbitrageurs.
Various technical factors create temporary decoupling of debt and equity and drive opportunities for capital structure arbitrageurs. Earnings surprises cause equity to overshoot, while debt and CDS tend to lag in response. Convertible bond issues drive CDS spreads wider that corporate bond spreads because of temporary exogenous demand for
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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 or accelerate correlation. The example below illustrates one of these opportunities.
Sun Microsystems CDS-Equity Trade
On September 29, 2003, Sun Microsystems warned the marketplace of future widerthan-expected losses. As a result, the stock price dropped 7.7%, and implied equity volatility shot up immediately. At the same time, CDS widened by only 25 bp. Against the historical backdrop, as illustrated on Figure 3, this tight CDS level was inconsistent with such a low stock price. Investors took advantage of this opportunity by buying CDS and selling put options or buying straight equity and were able to profit within a week when convergence occurred.
Implications for Corporate Bond Investors
If corporate stocks and bonds become more correlated, it could potentially diminish the diversification benefit of including credit in an overall investor portfolio.
Capital structure arbitrage activity improves the information flow between the debt and equity markets. If corporate stocks and bonds become more correlated, it could potentially diminish the diversification benefit of including credit in an overall investor portfolio. This should be less of a concern for investment-grade credit investors, as debt-equity trading is largely concentrated in high-volatility names historically located in the high-yield or crossover space. OUTLOOK FOR 2004 Much of the low-hanging fruit has disappeared as more and more long-short investors have begun to exploit the debt-equity relationship. Since technical factors will continue to create dislocations, profit opportunities will persist, but will become smaller and will disappear faster, as discussed in the earlier article by Ashish Shah. In addition, falling volatility and shrinking spreads already call for greater accuracy from the models employed in calculating hedge ratios. The race is on to improve the current structural
Figure 3.
Sun Microsystems CDS-Equity Relationship

January-September 2003
CDS (bp)
500
400
300
200
100
9/29/03
0 2.5 3.0 3.5 4.0 4.5 5.0 5.5
Stock Price ($)
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2004 Annual
and reduced-form quantitative models. However, whatever model investors settle on when implementing dynamic hedging, they should still consider spreading their strategy across many different names in order to minimize residual model risk. Given the tight levels of spreads in investment-grade credit and our strategists outlook for tightening spreads and higher equities in 2004, we expect U.S. high-grade names to offer few opportunities for capital structure arbitrage. Most of the opportunities are likely to arise from unexpected corporate events and rating actions. However, the growing high-yield CDS market will offer a wider field for debt-equity strategies.
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2004 Annual
Sunita Ganapati 415 274 5485 sganapat@lehman.com Gaurav Tejwani 212 526 4484 gtejwani@lehman.com
CDOSIN PURSUIT OF YIELD Our outlook supports a constructive view for 2004 as we finish the chapter on the best year in the short history of CDOs. 2003 witnessed a return of confidence to the asset class as CDOs rallied on the back of resurgent credit markets and strong technicals. In addition to the diversification bid that drove demand earlier in 2003, we expect 2004 to be characterized by a yield bid as investors pursue returns in a tight credit environment featuring low defaults and low interest rates. CDOs also provide an added incentive in the form of low sensitivity to rising interest ratesin fact, the scenario may benefit some of the cash-strapped distressed transactions. With CDOs trading wider than other fixed income securities and new money entering the market, technicals also support our positive outlook for 2004. The innovations and expansion in the synthetic space and correlation investing and a booming secondary market marked 2003. Trading volumes skyrocketed to an estimated $15 billion, and the surge in valuations pleasantly surprised even optimistic participants like us. Strategic opportunities continue in 2004, although we believe security selection is likely to be the key to outperformance. We present our trade recommendations for the year later in this article. SF CDOs and trades related to interest rate moves catch our eye, and we have decided to discuss them separately in subsequent sections. On the new issue side, in contrast to the general prediction that CDO supply would shrink in 2003, the global issuance volume of $136.5 billion1 surpassed 2002s $92.1 billion, with single-tranche synthetics and structured finance CDOs dominating volumes even as investors shied away from HY and IG cash CDOs. Issuance is likely to moderate in 2004 despite the quest for yield and renewed investor confidence and clarity about consolidation concerns. The composition of CDO issuance in 2003 borrowed from trends observed in the past, with SF CDOs gaining ground along 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 should see structural features being added to these tailor-made tranches.
Trading volumes skyrocketed to an estimated $15 billion.
The optimism has been reflected in the CDO market as well, with valuations climbing steeply and downgrade activity steadily cooling down.
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 the cash arbitrage CDO segment reflects the spectacular rally in the underlying collateral markets. The Lehman Brothers Credit Index tightened from 169 bp to 89 bp, and the HY Index price level surged from $83 at the beginning of the year to $103 by year-end. The outlook for 2004 continues to be positive, and our credit strategy team believes that spreads are likely to come in further as a combination of strong technicals and improved fundamentals drives the market. HY default rates fell to 4.9% by year-end, sharply below their peak of 10.6% in February 2002 and slightly below their long-term average. Our outlook on the fundamentals that drive the CDO market is largely positive, as shown in Figure 1. The optimism has been reflected in the CDO market as well, with valuations
1 Greater issuance volume can be attributed, in part, to the increased transparency in the market, which resulted
in better data availability, especially in the synthetic CDO sector.Cash flow arbitrage issuance increased from $53.5 billion to $67.5 billion.
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2004 Annual
climbing steeply and downgrade activity steadily cooling down (Figure 2). A benign credit environment is likely to continue in 2004, though higher idiosyncratic risk could drive up downgrades for some IG CDOs.
Primary CDO Spreads Poised to Tighten in 2004
We believe that CDO spreads are likely to compress, with Aaas reverting to the low 40s by the second half of the year while lower-rated tranches should also tighten to more rational levels.
The rally in collateral markets may have pushed secondary CDO spreads tighter, but primary spreads have not discarded their inertia and are practically unchanged from a year ago. 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 the year at 30 bp while Aaa CDO tranches continue to be issued at an average spread of 57 bp over LIBOR. The comparison is even starker down the capital structure, as Baa corporates and structured finance spreads came screaming in while CDO spreads remained wide. As a result, we believe that CDO spreads are likely to compress, with Aaas reverting to the low 40s by the second half of the year while lower-rated tranches should also tighten to more rational levels. The steepness of the CDO credit curve does not price in the improved credit environment or the additional protection provided by debt-friendly structural features.
Figure 1.
Fundamentals Look Positive

2003 Prediction Lower but at a slower pace 2003 Reality Gradual, steady drop from 6.8% to 4.9% 2004 Prediction Further drop, possibly to sub-4% but may inch up toward year-end, given aggressive underwriting in the past few months. Will stay at low levels but prone to idiosyncratic defaults. Room for further increase. On a path to recovery. Broadly positive amid some concerns.
HY Default Rate
IG Default Rate
Moderately higher
Lower than expected
Recovery Rate Structured Finance
Slow and steady improvement Continued stress due to performance lag.
Senior unsecured rate up $6, to $37 Problems through the year, but buoyancy by year-end.
Figure 2.
CDO Downgrades per Month and U.S. High Yield Trailing 12-Month Default Rate
HY Default Rate
12% Rolling 3 Month Average (No of Transactions DG)
# of Transactions Downgraded
80
60
HY Default Rate
Credit Cycle Improvement
9%
40
Rating Agencies Catch up to Weak Performance
6%
20
3%
0 1/98
1/99
1/00
1/01
1/02
1/03
0% 12/03
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2004 Annual
Secondary CDO MarketsFinding Value after the Big Rally
Secondary CDO markets have witnessed a stellar rally across the capital structure as surging collateral markets, fueled by a strong technical bid, have significantly altered the mood and the valuations in the CDO market. Investors who allocated capital to CDOs using the secondary route earlier in 2003 have witnessed substantial mark-to-market gains on their positions. Clean senior tranches began trading through new issue levels even as the rally gradually moved down the capital structure. In Figure 4, we estimate the returns on various types of CDO investments based on our observation in the market. CDO valuations should improve further, though some sectors leave more room for tightening than others. As in other credit markets, not being wrong in 2004 assumes as much importance as being right did in 2003. While some CDO investors are tempted to book part of their gains, others prefer to hold on, expecting a further rally in collateral markets. Our credit strategy teams opines that there is room for further spread tightening in the credit markets, and our ABS team is also bullish as consumer credit quality stabilizes. Consequently, CDO valuations should improve further, though some sectors leave more room for tightening than others. In addition to these fundamentals, demand technicals will bring in greater buoyancy as investors search for yield in a low spread environment. We believe that investment opportunities continue to exist, and we summarize our central views below.
Figure 3.
Aaa and Baa Spreads: CDO versus Other Structured Finance and Corporates
CDOs (Primary) Corporate 65 23 -42 Credit Cards 20 17 -3 HEL 38 29 -9 CMBS 47 30 -17
Aaa Dec 2002 Dec 2003 Difference Baa Dec 2002 Dec 2003 Difference
55 57 +2
305 308 +3
186 83 -103
196 100 -96
350 225 -125
140 90 -50
Figure 4.
Estimated Performance of CDO Investments

Indicative Levels Dec 2002 Dec 2003 L + 80-100 L + 50-60 L + 200-300 L + 70-80 $75 - $85 $85-$100 L + 125-150 $50-$80 $20-$50 L + 70-80 $70-$90 $40-$80 Estimated Return 4%-5% 7%-8% 10%-20% 7%-8% 15%-20% 40%-100% Comparative YTD Returns ABS Aaa - 3.7% Corp Aaa - 3.2% Corp Aa - 4.0%
CDO Investment Clean Senior Stressed Senior Distressed Senior 2nd Priority (Non-PIKable) Stressed Mezzanine Distressed Mezzanine (fix the PIK)
Corp Baa 11% Corp B 26% 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 pass all 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. Distressed transactions typically fail all tests, have a high WARF, and are likely to suffer a loss in most scenarios.
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2004 Annual
Relative Value in Senior Tranches
The risk/return trade-off appears compelling given the historical performance of first-priority tranches.
The spread on clean secondary paper has reached L + 45-55 bp. In comparison, ABS paper trades significantly tighter than CDO seniors. For instance, credit cards and home equity loans trade at 17 bp and 29 bp, respectively. Spreads on CDOs are wider because of other factors such as liquidity concerns and adverse technicals involved in selling the tranches at a premium over par. In addition, CDO tranches face a higher downgrade risk than ABS. But with downgrade activity slowing and positive news about consolidation for ABS CP conduits, we remain bullish on stressed SF seniors, as they offer the highest return, while there is limited upside in Aaa CLOs. HY and IG Aaas have room for tightening and may be aided by improving NAVs on some of the out-of-the-money interest rate swaps. Overall, we like senior tranches at current levels because 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 firstpriority tranches. Our analysis using METEORSM (Mont-Carlo Tranche Evaluator), our in-house risk-neutral simulation-based valuation tool, also indicates that Aaas are consistently cheap at current spread levels. The estimated default-adjusted spread is significantly lower than the actual spread in the marketa reflection of the low credit risk and the additional protection provided by a host of structural features.
Stressed Non-PIKable Second-Priority Tranches Offer Potential Upside
We continue to like second-priority tranches from slightly stressed transactions in which the 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 boost returns on second-priority tranches that trade at a small discount. As we expect spread tightening in senior tranches, and relatively clean second-priority tranches offer spreads similar to those of some of the stressed senior ones, we like the latter in comparison. On the other hand, some of the fixed-rate second-priority tranches may be ideal for CDO managers who wish to improve current cash flows.
Focus on Synthetic SF and CLOs in Lower-Priority Tranches
Mezzanine and subordinate tranches continue to trade at a discount despite the steep surge in valuations over the past year. The yields on lower-priority tranches are considerably higher than comparably rated corporate bonds and loans. However, the optionality embedded in steeply discounted tranches is limited, as the market has started to price in a low-volatility environment. Also, any drop in HY valuations would be magnified in leveraged investmentsa 1% drop in collateral prices could lead to a valuation drop of $3-$4 for the mezzanine tranches. Since secondary market valuations are driven by their liquidation values, the price of distressed debt also drives CDO valuations. 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 this risk if investors do not intend to hold the bond to maturity and are, therefore, exposed to the mark to market on the portfolio. Subordinate debt and equity from new issue SF synthetics also appears attractive. Subordinate debt and equity from new issue SF synthetics also appears attractive. Higherrated SF securities have performed well in the past, and the widely expected consumer
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credit downturn in 2003 turned out to be a soft landing. Given the robust performance of the asset class even in the recent stressful environment, we like leveraged investments off Aaa- or A-rated SF securities. For a detailed analysis of the asset class, please see A Benign Consumer and Commercial Credit Cycle Supports SF CDOs in this publication. We recommend BB CLOs as demand technicals kick in while loan transactions continue to outperform. We also recommend BB CLOs as demand technicals kick in while loan transactions continue to outperform. Though CLO valuations are unlikely to rally strongly on better asset valuation alone, near absence of defaults, accelerated prepayments, and immunity to interest rate movements make them appealing. We discuss our outlook for CLOs in our leveraged loan section.
Synthetics CDOsOpportunities in Secondary Equity Tranches while Balancing Idiosyncratic Risk
We see relative value in secondary equity or equity-like tranches of shorter-duration synthetic CDOs.
We see relative value in secondary equity or equity-like tranches of shorter-duration synthetic CDOs, which benefit from lower tail risk and spread tightening while commanding a hefty liquidity premium. As we pointed out last quarter, dealers continue to be long VOD risk and need to hedge by buying first loss protection. Moreover, moderate spread tightening in 2004 is expected to result in positive MTMs in 2004. We continue to like synthetic ABS CDOs, particularly senior and equity tranches, because of the high spread premium for seniors and low idiosyncratic risk for equity. For traditional credit investors, we prefer an up-in-structure trade strategy in 2004, as finding yield will be paramount in the current low-spread environment. Senior synthetics are attractive relative to like-rated single-name CDS, for which the average spread on single-A credits is 29 bp. For more details, please refer to A Look Ahead: Synthetics CDOs in 2004.
Aligning Investments with Interest Rate Moves
Though CDOs are less sensitive to interest rate movements than traditional fixed income portfolios, the fact that interest rate hedges embedded in CDO structures are not always perfect has led to concerns about interest rate exposures. Our economists expect a low interest rate environment to persist in the short run, with rising rates being a 2005 concern. In The Impact of Interest Rate Movements on CDOs, we illustrate how certain IG CDO tranches may be attractive at current levels because the out-of-themoney interest rate swaps have depressed valuations. From a buy-and-hold perspective, the relationships are more complex, and we explore these mechanisms as well.
Conclusion
The secondary CDO market may have witnessed a surge in valuations through 2003, but opportunities continue to exist for the discerning investor. Security selection is likely to 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 CDO market eventually catches up, delivering incremental returns. Senior CDO tranches are likely to tighten in 2004 in both the new issue and the secondary market, though some asset classes leave more room for tightening. We find investment opportunities lower down the capital structure as well, notably in SF CDO subordinates and Ba tranches from LL transactions. Sensitivity to interest rate moves will also be an investment consideration as the year unfolds.
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2004 Annual
Claude Laberge 212-526-5450 claberge@lehman.com Christina Celi 212-526-4482 cceli@lehman.com
CLO 2004 OUTLOOK: LEVERAGED LOANS REMAIN THE CDO ASSET CLASS OF CHOICE
Introduction
We expect CLOs to remain the asset class of choice in terms of issuance despite less arbitrage opportunities and a likely drop in issuance.
CDO market participants are by now well aware that transactions backed by leveraged loans have generally performed much better during the latest corporate credit cycle than transactions backed by any other asset class except structured finance CDOs, which behave 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% for HY CDO and 45% for cash IG CDO. It is therefore not surprising that leveraged loans remained the CDO asset class of choice in 2003, with a record $23.3 billion in arbitrage cash flow CLO issuance, beating the previous record of $22.7 billion in 1999. This strong demand confirmed the dominant position of CLO managers, which now account for 62% of the new-issue loan market (up from 45% in 1999). In this section, we explore the following 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 2004
Low default and high-prepayment rate should remain the main valuation drivers.
With 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 refinancing activity observed in 2003, as prepayment rates on the S&P/LSTA Leveraged Loan Index reached 56%, up sharply from 38% in 2002 and 24% in 2001. Most managers were unable to reinvest quickly enough to keep up with the constant flow of prepayment proceeds and saw their average cash balance swell from 5.1% in December 2002 to 8.6% by October 2003. We have discussed these trends in earlier publications and explained how managers were forced to reinvest in lower spread assets or pay down the senior tranches, thus reducing the excess interest in 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 settle in 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), since more than 58% of institutional term loans are currently trading at or above par and without prepayment penalties. If investors risk appetite for lower-rated loans remains high, these prepayments are likely to include a high proportion of single-B issuers looking to refinance at lower levels (the average BB loan could currently save 80 bp in spread, according to S&P). CLOs generally contain a high percentage of singleB loans in their portfolios, and this would result in a noticeable reduction in asset spread, hurting equity payments in seasoned clean transactions and accelerating the rate of amortization for currently deleveraging transactions.
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Figure 1.
10% 8% 6% 4% 2% 0% 12/98
Default Rates
Model Actual
6/99
12/99
6/00
12/00
6/01
12/01
6/02
12/02
6/03
12/03
6/04
12/04
Source: Standard & Poors LCD (based on FridsonVision LLC default model).
Figure 2.
Percentage of Loans Trading at or above Par with No Prepayment Penalties
50% 40% 30% 20% 10% 0% 1/02
3/02
5/02
7/02
9/02
11/02
1/03
3/03
5/03
7/03
9/03
11/03
Source: LoanX.
Secondary CLOs: The Need to Go Down in Credit Quality
Spread compression should be most significant in subordinated tranches.
With market participants increasingly using the NAV (or break-up) valuation method for CDO pricing, it is not surprising that the steady increase of loan prices in 2003 fueled much of the rally in secondary CLO tranches, along with strong performance (credit and prepayment) of senior tranches. The price rally in collateral is unlikely to continue due to market technicals, given the aversion to loans trading at a substantial premium and the associated refinancing risk. The average bid price of the 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 limited upside from these levels. We would argue that CLO valuations, especially regarding portfolios with a large Caa basket, offer little price protection on a NAV basis if riskaversion returns to the market. More care will have to be paid to credit risk and the declining interest cash flows generated by portfolio assets.
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Figure 3.
Percentage of Loans in the S&P/LCTA Index Trading below $80
15% 12% 9% 6% 3% 0% 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
For the above reasons, the deleveraging senior CLO tranche, which was the great entry level trade of 2003 in an enthusiastic secondary market, does not appear as attractive at this time. Attractive opportunities may remain for specific transactions, but we believe that the generic senior CLO tranche theme, while still a reasonably attractive carry trade, has been played out from a total return perspective. Investors need to look further down the quality spectrum, such as subordinated CLO tranches (Ba-rated at origination), 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 investors in a low-interest rate environment. CLOs are to a great extent immune to interest rate moves, as the presence of floating-rate assets alleviates the need for large interest rate swaps and, hence, the pain of out of the money swaps faced by many IG or HY CDOs. Secondary prices for subordinated tranches still have room to rally, since the liquidity premium should compress as investors become more and more comfortable with the CLO asset class in general. The recent new-issue level for BB CLO tranches remains in the 800 bp area, making it 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 valuation tools and spend more time understanding the underlying assets and structure unique to each transaction. Stay in tranches with a healthy IC cushion, since we expect that a large single-B loan refinancing wave could result in significantly lower asset spreads over time. Scrutinize tranches that derive a large portion of their valuation from high-priced Caa basket, since subordinated tranches have the most exposure to low-quality assets unless you intend to take on a leveraged exposure to Caa assets.
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The CLO class of 2004 is likely to be different from its predecessor in both collateral and structure types.
Issuance Outlook: Expect Structural and Collateral Changes
The compression in leverage loan spreads is likely take a toll on issuance, at least in the short term. Our estimates indicate that seven CLOs backed by U.S. leveraged loans totaling 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 CLOs during the latest credit cycle. As a result, we expect new issue liability spreads to keep compressing and become competitive with secondary levels, but the CLO class of 2004 is 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 few years absence, revolver CLO tranches are likely to make a comeback, particularly as this 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 offer attractive spreads and have already attracted niche investors. While we expect increased issuance in this segment, given the limited size of this market, it is unlikely 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 difficulty of 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 Aspects
Expect new structural features in 2004 to help minimize funding costs and facilitate the acquisition of collateral. The trend toward flatter equity return should continue as new structural mechanisms divert excess interest during a credit downturn.. Senior revolver CLO tranches are likely to be more prevalent in 2004, since many of the assets themselves will contain revolvers. They can also take the form of credit lines available for the purchase of additional assets at later stages if the transaction is performing well. Banks looking to increase their credit exposure to loans should be natural buyers in this part of the capital structure. With recent BB CLO new issue spreads remaining in the 800+ bp area, it is not surprising that many recent transactions have tried to minimize or avoid such tranches altogether in the capital structure, given their negative effect on the arbitrage of the CDO. In fact 10 out of 17 CLOs issued over the past two months did not include BBs. Therefore, this creates a scarcity on the secondary market and is likely to push prices upward. With the expected growth of the leveraged loan CDS market, we should also expect to 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 2004
In 2004, CLO managers need to face tough decisions regarding the significantly appreciated defaulted assets in their portfolios. Most managers would rather hold such assets until completion of the workout procedures and monetize the remaining discount to their ultimate recovery price. But with excess interest likely to come under
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pressure in 2004, this is a good time to sell these zero-coupon assets at current high levels and redeploy the capital in interest-bearing assets. The effect on O/C ratios should be minimal in most cases, since they are already discounted for O/C calculation purposes. On the other hand, managers are unwilling to reduce their exposure to loans rated Caa and 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) and fail their spread/coupon test. Therefore, WARF improvements are likely to come from 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 reinvest some of the forthcoming prepayment proceeds into loan CDS, as they often provide an easier way to actually source the desired assetsat the cost of slightly lower spreads and provide more flexibility in the purchase price.
Other Trends to Follow in Collateral
We applaud the planned introduction of loan CUSIPs in 2004, as it should increase the liquidity of CLO tranches over time. The improvement in transparency will make it 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 liquidity in this market as well. Standard & Poors recently unveiled a recovery rate scale for loans to complement their usual ratings (based on likelihood of default). This scale will be assigned to any loan rated by S&P going forward. Again, we see this as another step toward improving transparency in the loan market.
Conclusion
We believe that secondary and new-issue spreads on CLO tranches should look increasingly attractive for yield-hungry investors compared with almost every other type of investments of similar ratings. Furthermore, the decline in projected default rates in underlying assets and the fact that they provide a natural hedge against a possible future increase in interest rates all point toward another year of strong CLO performance in 2004.
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2004 Annual
Gaurav Tejwani 212 526 4484 gtejwani@lehman.com
A BENIGN CONSUMER AND COMMERCIAL CREDIT CYCLE SUPPORTS SF CDOS Structured finance (SF) CDO issuance jumped 33% in 2003, making it the largest CDO asset class in terms of funded volume of arbitrage transactions, at $41.3 billion. The jump from last year was dominated by synthetic SF CDOs, which accounted for $7 billion in volume. Issuance rode high on the back of sustained investor confidence, given a resilient structured finance market, and was boosted further by the receding arbitrage levels in other asset classes. Concerns about lower-quality collateral resulted in rising SF CDO downgrades during the second half of 2003, but the widely expected downturn in the consumer credit cycle was relatively benign, and the SF market rebounded smartly from its 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 leveraged loan CDO market. Our outlook on SF CDOs is generally positive, as the underlying collateral market appears to be on a path to recovery, as indicated by a blend of positive signalsboth macroeconomic indicators and measures of consumer credit quality. 2003 produced smart returns for 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. Not only is the rally likely to result in improved valuations for secondary SF CDOs, it also reflects the optimism in the market and the continued confidence in the asset class.
SF CDOs Adapt to an Evolving Marketplace
The SF market continues to innovate and adapt as it learns from past experiences. Current structures offer more protection to debt holders, as excess interest trapping mechanisms have become more popular. We also observe more static transactions being issued. Increasingly, debt is being sold in the CP or 2a7 form as issuers tap into new investor bases. The pipeline for 2004 is strong, though issuance may taper off over the second half of the year as collateral spreads tighten and the anticipated drop in collateral supply takes effect. Collateral from todays 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-rated issues. In addition, there is a renewed focus on on-the-run asset classes, consistent with investor appetite. Also noteworthy is the surge in synthetic SF issuance that references higher-rated assets such as Aaas and Aas. The CDO bucket is also generally smaller and is typically composed of only non-PIKable tranches.
A Positive Collateral Outlook Makes Us Constructive on SF CDOs
Fundamentals appear to be improving, and the outlook for SF CDOs is generally positive, though uncertainties about lower-quality services and subprime mortgages have not completely abated.1 The outlook on CMBS products is largely positive. As a result, SF CDOs in general should enjoy a good year. One of the primary long-term concerns that remains is the risk of a backup in interest rates. Our economists believe it 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
Our ABS strategy team maintains a strong positive outlook in 2004.
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than a 2004 issue. The other notable risk is the effect of the continued underperformance of older-vintage SF CDOs on investor sentiment. The market compensates SF CDO investors by attaching an additional discount to SF CDOs given their complexity. Our enthusiasm for SF CDOs is driven by the following 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 compared 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-quality collateral, given the remaining risk related to lower-quality consumer and commercial assets, unless interest diversion features provide sufficient structural protection. When it comes to higher-risk positions, traditional ABS investors have an advantage because of their expertise in understanding the underlying portfolio. Other investors looking for greater yield should consider leveraged positions on higher-quality collateral using synthetic 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 Seniors and Clean Second-Priority Secondary SF CDOs
Investments in higher-priority SF CDOs are especially attractive for those who wish to roll over from our 2003 recommendationthe senior deleveraging trade. This is our top relative value pick for secondary investors. First-priority tranches from stressed tranches or clean second-priority tranches trade around than L+90 bp, with some as wide as L+300, and we recommend them over new issue mezzanine tranches. Given the risk of rising interest rates and its effect on sub-prime MBS quality, we recommend conservatism toward mezzanine ABS CDOs. However, many older vintage SF CDOs have sizeable out-of-the-money interest rate swaps, and accelerated prepayments have left them considerably overhedged, making them favorably inclined toward higher interest rates. Senior or second-priority tranches enjoy sufficient subordination to cushion credit problems, while the risk of rising interest rates is partly offset by the performance of the interest rate hedges embedded in the structure,2 making them more attractive than similar-spread new issue mezzanine paper.
Secondary SF CDO Market Activity Is on the Rise
While more activity is observed in trading secondary SF CDOs, there are dissimilarities between 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.
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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 valuation as corporate debt, adding uncertainty to the CDO valuation process.
2) Relative Value in SF CDO Seniors as Primary Spreads Remain Wide
Consistent with our overall bullish view on Aaa CDOs, SF CDO seniors should benefit the most as the market discards its current inertia and spreads compress. Currently, Aaa SF CDOs are issued 5-10 bp wider than other CDOs, with the average being 59 bp over LIBOR. We believe spreads are unlikely to be sustained at current levels, as CDOs in generaland SF CDOs in particularare one of the few spread sectors that continue to lag the other fixed-income markets. Given that not all concerns have been alleviated on the collateral side, we suggest going up in quality on SF CDOs backed by lowerquality collateral.
3) Down in Quality on Leveraged Exposure to Higher-Quality Collateral
Investors can obtain leveraged exposure to highly rated collateral through synthetic SF CDO subordinates and equity tranches and, where available, cash deals with senior money market tranches. Aaa SF products (ABS, CDOs, CMBS) are consistently cheap to their model values and risk profiles. For example, as discussed in CDOsIn Pursuit of 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 add yield to collateral with low idiosyncratic risk. In summary, we believe that within the CDO space, SF CDOs offer select opportunities to pick up incremental yield.
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37
2004 Annual
Sunita Ganapati 415-274-5485 sganapat@lehman.com Philip Ha 212-526-0319 philipha@lehman.com
A LOOK AHEAD: SYNTHETIC CDOS IN 2004 2003 was marked by unprecedented innovation in synthetic technology at a surprisingly rapid rate. In this article, we provide a preview of what to expect in 2004 and suggest a few trade ideas that reflect our belief of whats to come. In a nutshell, the synthetic CDO market experienced a dramatic growth and learning phase in 2003, highlighted by the widespread issuance of tailored, single-tranche synthetics; the emergence of standardized portfolio CDS products and tranches off of those portfolios; and the adoption of delta-hedging technology. European issuance dominated in 2003. A combination of factors has helped make Europe the global synthetic hotspot, including a more derivatives-oriented investor base and a strong desire to gain access to diversified corporate credit risk (please refer to European CDOs: 2004 Outlook for more details). Tailored single-tranche CDOs, propelled by derivatives-hedging technology and demand for mezzanine exposures from yieldhungry investors, grew in popularity and accounted for 493 of the 585 synthetic arbitrage transactions that we tracked during the year. In total, global issuance jumped from $15.6 billion in 2002 to $36.2 billion in 2003.
Product Developments for 2004
In a nutshell, the synthetic CDO market experienced a dramatic growth and learning phase in 2003.
The development of a HY and loan-only deliverable CDS market has already resulted in the issuance of two synthetic single-tranche HY transactions
The synthetic sector benefited from the enhanced liquidity in the single-name default swap market and the wider adoption of derivative-hedging technology in 2003. The expansion of the synthetic market is likely to continue in 2004, especially with the advent 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 diversified credit exposures. Notably, each of the product suites has added a version that references high yield issuers. While the initial trading of these tranched products was minimal and almost 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 has already resulted in the issuance of two synthetic single-tranche HY transactions, with another in the pipeline. We expect this trend to continue in 2004.
Figure 1.
Global Synthetic Arbitrage CDO Issuance
# of Transactions
80
60
Syndicated Tailored Tranche
40
20
0 1/01 4/01 7/01 10/01 1/02 4/02 7/02 10/02 1/03 4/03 7/03 10/03
12/03
* Funded tranches only. ** 2003 numbers are large because of the increased amount of data available on tailored-tranche CDOs.
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Investors have been drawn to ABS CDOs in search of higher yielding spreads, diversity, and low idiosyncratic risk.
The rapid growth of the synthetic ABS CDO market is expected to carry on into the new year, continuing the trend seen in 2003.1 Issuers have primarily been banks and other financial institutions with large senior SF holdings that have synthetically securitized their portfolios for a combination of risk-reduction and arbitrage purposes. Investors have been drawn to such structures in search of higher yielding spreads, diversity, and the fact that ABS structures minimize idiosyncratic risk in exchange for a larger degree of systemic risk. 2003 was also notable in that the evolution of synthetics2 toward path-dependent structures dwindled at the expense of single-tranche synthetics with minimal structural enhancements. Covenants such as OC and IC triggers divert cash from one set of tranches to another in poorly performing scenarios. CDOs incorporating such tests are referred to as path-dependent structures. This trend away from path dependencies can be most directly attributable to the shift away from fully syndicated transactions, where all the risk is placed into the capital markets, to single-tranche synthetics, where the risk can be dynamically hedged. The addition of structural features, path dependencies, and portfolio management introduces modeling complexities, making dynamic risk management of single tranches more difficult. We believe that path-dependent structures will be shown out again in 2004, as portfolio loss modeling and hedging techniques improve and tight spreads and still-elevated levels of idiosyncratic risk will cause investors to want more downside protection.
Improvements in Valuation
Structural evolution of synthetics and path-dependent structures dwindled at the expense of single-tranche synthetics with minimal structural enhancements.
The market is using a flat implied correlation estimate, which does not properly account for the cross-sectional pair-wise correlations between individual credits.
Another development that we believe will occur in 2004 is an evolution in modeling complexity with regards to calculating portfolio loss distributions, as well as pricing tranches. One such change that does not involve much calculation complexity is a change in the convention of using a flat implied correlation between names to price tranches versus a positive/negative shift in the historical correlation matrix of a portfolio to price tranches. We believe this will occur early in 2004. Currently, the market is using a flat implied estimate, which does not properly account for the crosssectional pair-wise correlations between individual credits and, thus, inaccurately prices the actual risk of a portfolio. In some cases, this results in the creation of illusory relative value borne out of mathematical simplification. In an upcoming report, we will present the case for using a positive/negative shift in the historical correlation matrix of a portfolio versus a flat implied correlation. In addition to a change in the way implied correlations are quoted, we also believe that the new year will bring other changes in the way portfolio loss distributions are calculated. Currently, the market has overwhelmingly used Gaussian distributions when calculating portfolio losses. However, as historical data suggest, defaults do not occur in such normal distributions. Thus, tail events are not being accounted for and properly priced into tranche valuations. Instead, we believe that loss distributions would be more accurately calculated using T-distributions.
1 2
Please see CDO Monthly Update, July 2003, for more details on synthetic ABS CDOs. Please see Evolution of Synthetic Arbitrage CDOs, November 5, 2002, Ganapati, Ha.
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Our Relative Value Picks
We favor shorter duration secondary synthetics, particularly from equity or equity-like tranches, because of their lower tail risk, complemented by pickup in spreads/liquidity premium.
The key to success in 2004 will be to balance higher idiosyncratic risk, which has not yet fully 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-like tranches, because of their lower tail risk, complemented by pickup in spreads/liquidity premium. As we have written over the past several months, dealers continue to be long VOD risk and, thus, have a need to buy first-loss protection on both primary and secondary paper. Several secondary CDOs have traded in the last quarter, with large spread pickups due to the lack of liquidity in this market. The current situation in the secondary synthetic market is similar to that of the secondary cash market at the beginning 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 in positive MTMs, given the current tight-spread, low-vol environment, we do not believe that 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 degree than spread compression). We also prefer an up-in-structure trade strategy in 2004, as finding yield while avoiding losers will be paramount in the current low-spread environment. Senior synthetics are attractive relative to like-rated single-name CDS, where the average spread on singleA CDS is a mere 29 bp and Baa CDS is 56 bp. The 7%-10% tranche of CDX NA is trading at 75 bp/83 bp, and the 10%-15% tranche is trading at 35 bp/43 bp. Furthermore, the addition of subordination and diversity makes the story for higher-quality synthetic paper all the more compelling. Other trades that we like include mezzanine and equity tranches of synthetic ABS CDOs, because of the low idiosyncratic risk inherent in SF collateral and a higher spread pickup relative to other like-rated securities (please refer to A Benign Consumer and Commercial Credit Cycle Supoprts SF CDOs). In the mezzanine arena, we prefer synthetics with structural features such as triggers that add downside protection in case of an economic downturn.
We prefer an up-in-structure trade strategy in 2004, as finding yield while avoiding losers will be paramount in the current low-spread environment.
Money is better spent hedging VOD risk than spread risk.
The popularity of delta-hedged package trades should continue in 2004. Given our view that idiosyncratic risk will remain elevated and credit spreads should tighten moderately in 1H04, we believe that money is better spent hedging VOD risk than spread risk. VOD hedging is more an art than a science. Most often, such hedges are executed by buying more protection on wider names while under-hedging tighter names in the portfolio. The development of the tranched CDX/ Trac-X market has largely been a positive, even though the trading volume appears to be limited. However, the growth of this market in 2004 should provide more transparent pricing and help to infuse more liquidity into the correlation space.
January 21, 2004
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2004 Annual
Philip Ha 212-526-0319 philipha@lehman.com
SYNTHETIC CDO BID LIKELY TO TEMPER IN 2004 The synthetic CDO bid had an overwhelming effect on the single name CDS market in 2003, as discussed in the section CDS and Volatility Strategies. Often, single name CDS would tighten despite no corresponding tightening on the cash side, resulting in an overall negative basis in the market. There were several opportunities to trade into and out of the CDO bid. Entering 2004, the nature and effect of the synthetic CDO bid has changed, and we discuss our outlook below. The shift from fully syndicated deals with rated tranches to tailored single tranche synthetics could cause the synthetic bid to temper this year. In a fully syndicated transaction, 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 each credit.1 This causes the technical effect of the CDO bid to be lower, as the total notional of protection sold is only a fraction of what it was in the past. The boom in single tranche CDO issuance in 2003 absorbed some of this differential in notional value, keeping the synthetic bid strong. An expected slowdown in synthetic issuance in 2004 should moderate 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 analyzing sectors 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 the technical bid was driven by three variables: ratings, spread, and diversity. Throughout the year, we identified many names and sectors from these metrics that benefited disproportionately from the synthetic bid.
The shift from fully syndicated deals with rated tranches to tailored single tranche synthetics could cause the synthetic bid to temper this year.
We expect a shift from a spread-ratings trade-off to a spread-correlation one a trend already visible.
Today, many single tranche synthetics are unrated; thus, the credit rating of the underlying CDS contract is less important (rating agencies use asset ratings to measure its default probability). Furthermore, the traditional account base which is typically ratings dependent has been replaced by hedge funds and specialized CDO/CDS funds that are not as ratings dependent. As a result, we expect a shift from a spread-ratings trade-off to a spreadcorrelation onea trend already visible during the last several months of the year. Current market standards for pricing correlation products made low to negatively correlated names with the highest spread the most attractive for synthetic CDOs. The way that current correlation models operate, these names helped to create the most value in terms of pricing tranches cheap to their actual correlations. Not surprisingly, it was these names that were most often found in synthetics in the second half of the year and experienced a larger degree of spread tightening versus the broader markets. As correlation models evolve and as the market refines its flat implied correlation approach to pricing tranches, there will be several arbitrage opportunities in the short term. Additionally, the use of structural default models such as those from Moodys KMV and specialized credit analysis models such as Lehman Brothers ESPRI in analyzing CDO portfolios will make such measures more worthy of watching, particularly 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 ConvergenceWhich Sector is Next? Global Relative Value, March 31, 2003
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In summary, we believe that in 2004, the synthetic CDO bid will continue to play an important, albeit tempered role on single name CDS spreads. Given the large number of negatively correlated, wide spread names that CDOs ramped up in 2H03, we believe that some reversal of this is likely, especially as dealer books have probably become more exposed to lower spread, higher correlation names.
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2004 Annual
Gaurav Tejwani 212 526 4484 gtejwani@lehman.com
THE IMPACT OF INTEREST RATE MOVEMENTS ON CDO PERFORMANCE As interest rate increases become more of a risk, it is important to understand the effects that interest rates have on CDOs. At first glance, it appears that rate changes should be largely irrelevant, given that most CDOs are floaters. However, apart from the direct impact on fixed-rate bond valuations, interest rates affect even floating-rate notes through potential mismatches on the interest rate hedges built into the structure. In addition, there are indirect consequences via prepayment due to refinance activity and the co-movement of interest rates and default rates. Though the relationship between CDO performance and default rates is well understood, estimating the effects of interest rates on CDOs is not a trivial task. We explore these relationships and consider how CDOs perform in different scenarios. The need for interest rate hedges within CDO structures arises when most of the assets are fixed-rate bonds while the liability notes are floating rate. The use of predetermined interest rate hedge schedules that match the expected amortization of liability tranches may be relatively inexpensive compared with balance-guaranteed swaps, but often leaves a potential mismatch, as shown in Figure 1. CDO structures have been tested with exceptionally low interest rates for a prolonged period 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 was actually realized (Figure 2) illustrates how the interest rate swaps embedded in most structures have continued to move further out of the money, compounding the problems in cash-strapped CDOs. Low rates alone should not significantly alter the value of a tranche if the hedge performs as per expectations, i.e., if cash flows to the interest rate swap simply offset the cash outflows to floating-rate liability tranches. In reality, there may be a mismatcheither positive or negative, depending on the actual notional of the performing assets and liabilities compared with the amortization schedule that was envisaged 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 other determinants such as default rates, prepayments, refinance activity in the credit markets, and the managers ability to reinvest principal proceeds when the need arises.
Figure 1.
Typical CDO Structure with an Embedded Interest Rate Swap
Equity Fixed Mezz Tranche Floating Mezz Tranche
Fixed Assets
Mismatch Hedge Reqmt Interest Rate Swap Natural Hedge
Senior Tranche (Floating)
Floating Assets
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Figure 2.
Forward LIBOR Curve as of January 2000 and Realized Interest Rates
Forward LIBOR curve as of January 2000
Realized Interest Rates
0 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 12/03
From an investors perspective, even when trades are not driven by changes in interest rates, it is important to align investment decisions with expected interest rate moves to maximize value. For mark-to-market investors, we suggest exploiting the drawbacks of current valuation practices popular in the market.
MTM Investors Can Benefit from Relatively Nascent CDO Valuation Techniques
Using the liquidation value or NAV of a tranche as a key input for valuation may at times be misleading.1 The NAV is calculated by comparing the value of the underlying securities, adjusted for the mark-to-market on the interest rate hedge, with the notional of 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-themoney 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 the hedge, thus shielding senior tranches from the effects of the hedge. The negative mark to market on the hedge would be realized immediately only if the transaction were liquidated and should, therefore, not significantly affect senior tranche pricing.2 The mechanism is easily demonstrated in transactions in which each successive payment period leads to a sudden rise in NAV of the trance as the mark to market of the interest rate hedge falls.
Trade Idea 1First-Priority IG CDO Tranche Involving a Large Negative Mark to Market on the Interest Rate Hedge
For illustrative purposes, we consider Solar IG CDOa 2000 vintage investment grade transaction 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 million overnight as the payment was made, thus improving the NAV on all the tranches. Similar changes 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 to
use NAV as the key input creating inefficiencies.

2
The exception being cash-strapped highly distressed CDOs with little or no excess interest. All proceeds are used to pay down the senior tranche, directly exposing them to cash outflows to the hedge.
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pronounced for transactions with a large mark to market on the hedge. Investors may find IG CDOs to be more attractive candidates for the trade. First, historical relationships suggest that IG prices are more sensitive to interest rate movements than HY prices. Consequently, investors should expect reasonably stable3 NAVs interspersed with positive jumps on each payment date. Also, IG CDOs are often structured with an out-of-themoney 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 IG seniors to perform well as credit quality continues to improve.
Buy-and-Hold Investors Should Align Their Investment Strategies with Their Holding Periods
From a longer-term perspective, it is important to consider the effects of the interest rate environment on the intrinsic value of a CDO via a potential mismatch on the interest rate hedge, as explained earlier. Our economics team believes that interest rates are likely to stay low in 2004, especially during the first half, and should gradually rise through 2005. Figure 3 summarizes the performance of CDOs under various default and interest rate scenarios. Understanding this relationship becomes critical as we migrate from a high 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 low interest rates (top left). Most CDOs are slightly underhedged at inception, but high defaults and prepayments have pushed many of them into an overhedged state, as swap schedules were set in stone while hedge requirements dropped.
Stable from an interest rate perspective only, as interest rate hedges offset collateral price movements somewhat. However, defaults or changes in credit view would continue to affect NAVs.
Figure 3.
CDO Performance Under Various Default and Interest Rate Scenarios

Low Defaults High Defaults
Low Interest Rate Underhedged DealsBest scenario. Good performance backed by favorable interest rates Underhedged DealsDefaults cause transaction to underperform, though interest rate hedge helps. Gradually migrate to overhedged state Overhedged DealsWorst scenario. Large payment on hedge compounds the problems of deteriorating collateral
Overhedged DealsLow defaults outweigh negative value of the hedge Likely scenario in 2004 High Interest Rate Underhedged DealsLow defaults outweigh negative value of the hedge
Underhedged DealsCash flowstrapped transaction as interest rates hurt. Gradually migrate to overhedged Overhedged DealsDefaults cause transaction to underperform, though interest rate hedge softens the blow
Overhedged DealsBest scenario Likely scenario in 2005-2006
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Trade Idea 2Long-Term Investments in Overhedged Deals Such as HY or SF Transaction from 1999-2001 Vintages
Overhedged transactions include those for which large prepayments or failing par covenants caused accelerated deleveraging, hence reducing the floating-rate senior tranche size. A surge in refinancing activity also brought in additional principal proceeds that were used to pay down senior notes, either because transactions were out of their reinvestment position or because managers find it increasingly difficult to find attractive assets amid a stellar market rally. We recommend such CDOs from older vintages that have been subject to early deleveraging, positively positioning them toward rising interest rates. For those willing to take on higher risk exposures, some of the distressed CDOs also gain from rising rates because of the presence of deleveraging senior notes alongside PIKing subordinates. However, higher sensitivity to interest rates is exhibited by the most subordinate performing tranche, which is exposed to higher credit risk as well. A lowdefault environment should ease credit concerns, but high leverage exposures to distressed collateral do not suit all risk profiles, and we recommend a dose of caution in security selection.
January 21, 2004
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2004 Annual
Lorenzo Isla 44-20-7260-1482 lisla@lehman.com
EUROPEAN CDOS: 2004 OUTLOOK

Structured Credit as a Yield Enhancement Strategy in Credit Portfolios in 2004
One of the consequences of the extraordinary amount of liquidity in the financial system over the past two years is the stingy reward currently offered by spread product for exposure to credit risk. Tight credit spreads, negative short-term interest rates, low interest 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 buyand-hold investors in 2004. In 2004, we expect the search for yield to continue to dominate among fixed income investors. This, together with the fact that CDOs compare favorably with the underlying asset classes, where the reward for going down in credit quality has decreased, should increase the demand for CDOs. We believe that moving to CDOs while keeping the same level 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 over LIBOR. 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 achieve a spread of 190 bp (350 bp) over LIBOR with European CLOs, our favorite sub-asset class. 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, the pickup offered by CLOs/CDOs of ABS (in the 60 bp (120 bp) area) is substantial. A common yield-enhancing strategy, moving into investment grade synthetic CDOs at the single-A (triple-B) level, is currently rich in implied correlation terms: a Baa3 backed by an investment grade index offers a spread in the 200 bp area, 32 bp tighter than the spread implied by historical correlation numbers.1 Below, we propose better alternatives with a similar risk profile. Our central call that CDOs offer an attractive avenue to take on more credit risk and that demand 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/mezzanine loans to tighten the most, especially double-B tranches, which currently trade in the 775850 bp area. Wide spreads and the significant improvement in the structural protection awarded to mezzanine investors make double-B rated CLO tranches more attractive than equity. At the single-A/triple-B level, the spillover demand away from synthetic investment grade CDOs should tighten CLO spreads. We also expect triple-A tranches of European CLOs to tighten from the low sixties to the mid-forties and triple-A rated Spanish SME CLOs to tighten as well. These are also our top picks at the senior level.
Subordinate CDO Investors Benefit from Short-Term Negative Real Interest Rates
Another reason we currently favor CDOs is that they give subordinate investors the ability 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, November 2003, for an analysis.
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European CDOs have floating assets, the floating component represents a far smaller proportion of the asset coupon than of the liability cost. Hence, in a low LIBOR environment, CDOs give subordinate investors the ability to take on cheap leverage. By moving into CDOs, investors would sacrifice liquidity and increase both mark-tomarket volatility and the tail risk of their investment. However, we expect CDOs to outperform outright investments in the underlying, as aggregate default risk2 has dropped sharply: expected default risk in a stylized global investment grade CDO portfolio was 76 bp at the beginning of the year, and it is currently 34 bp. We also believe that we are in a favorable environment for credit. For instance, a steep yield curve has historically provided support for credit.3 The decrease in diversifiable default risk hides the fact that idiosyncratic risk remains high: despite tighter spreads across the board, forward-looking measures of default risk have not dropped in line with spreads for the riskier reference entities.4 Hence, the remuneration per unit of default risk has worsened for the riskier names. Hence, we believe that the main risk for the performance of synthetic CDOs is a bifurcation in the credit market in which the credit quality of the worst reference entities deteriorates.
Our Picks in the Synthetic Investment Grade CDO Market
Within the synthetic IG market, we outline our favorite picks, which take into account the current shift of value from mezzanine to equity and current tighter spreads, which have 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, by which the investor sells protection in an equity tranche and simultaneously buys protection in the single-name CDS market. We recommend that investors hedge the value on default risk of the riskier names, which disproportionately affect the performance of the equity tranche.5 As we discussed above, this protection can be bought at a relatively cheaper price. The overall position has significant carry, is long spread convexity, and can be adjusted to achieve the desired level of risk by choosing the amount of protection bought. A combination note made up of equity and senior tranches can be structured to achieve the same rating/amount of default risk as that of a mezzanine tranche and offers better value.6 The main downside to this strategy is its higher mark-tomarket 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, dated January 2004.
4 When we sort investment grade reference entities by their KMV edfTM, the median edfTM has dropped roughly in
line 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 capital structure of synthetic investment grade CDOs.
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Hybridsin which credit risk is combined with other asset classes, primarily interest rate risk, but also foreign exchange and commodity riskare an alternative to boost yields. We like inflation-protected CDOs, which should outperform in a low-rate environment and/or if current reflationary policies generate inflation during the life of the trade. Principal-protected CDOs involving subordinated tranches, a popular strategy among European insurers, are more likely to make use of hybrids because the drop in yields has increased the cost of protection. Also, by using inflation-linked swaps, some investors may achieve a better alignment of assets and liability risks. Stressed secondary synthetics offer significant value. These are attractive because of the large amount of stressed/distressed synthetic investment grade paper from the 2000 and 2001 vintages. In 2003, investors paid little attention to these bonds because of the value offered in the primary market and because fewer investors had the technology to assess their relative value. Despite the larger idiosyncratic risk associated with them (they tend to be referenced to a lower number of reference entities, some of which trade at wide spreads), we believe that they offer significant value with respect to the primary market and should outperform primary CDOs in a benign credit environment.
2003: Record Issuance, Record Performance
In April 2003, we suggested that investors rotate into CDOs, as we expected structured credit to outperform at the turn of the cycle (see European CDOs: Review and Outlook [op.cit.]). Since then, the asset class has performed well against outright credit investments. This was in sharp contrast to the severe underperformance of the CDO asset class in 2002 and supported issuance (public and private), which set a new record (EUR62.8 billion, a growth of 5%). The majority of this has been concentrated in investment grade CDOs: in 2003 alone, 503 of such transactions priced in Europe, most of which were bespoke single-tranche CDOs. Synthetic7 structured finance issuance grew by 51% (87 CDOs, or EUR7.5 billion). We expect 2004 to be a year of further growth in this subset of the market, due to tight spreads and the fact that this is a compelling use of the synthetic CDO technology, which allows investors to leverage 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 of correlation desks have significantly altered the dynamics in the credit derivatives market: this technical effect has tightened spreads in the single-A/triple-B category and has 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 have increased the trading risk associated with buying protection on single-tranche CDOs. Correlation desks increasingly use tranches based on standardized CDS portfolios to risk manage their books.
Includes both arbitrage and balance sheet CDOs
7 8
For an analysis, see European Synthetic CDOs Impact on the Underlying Default and Cash Markets, dated October 2002, and the previous section on the CDO bid in this report.
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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 CDO Equity Strategies (op.cit.). Besides an outright purchase of protection, selling CDO equity protection and buying protection are efficient strategies to short credit. The inclusion of high yield, crossover, or emerging market risk in traditional static investment grade portfolios should be an increasingly common strategy to respond to tighter spreads. Given the increasing ability to measure the delta exposure of CDO tranches among the investor community, we expect more investors to dynamically handle idiosyncratic risk and/or to implement long-short strategies to isolate the optionality embedded in CDO tranches. Managed synthetics have grown and now represent 17% of the market. We expect this growth to continue as dealers are increasingly able to buy protection on bespoke managed single-tranche CDOs. We expect single-tranche CDOs to be used increasingly by bank loan portfolio managers as an alternative to buy protection in the single-name CDS market. The low cost of protection at the mezzanine level makes this an attractive option. Equity collateralized obligation (ECO) will become more common. ECOs are backed by equity default swaps (EDS), in which the triggering of a credit event is driven by the crossing of a predetermined price barrier. EDS are essentially equity put options. Their suitability for CDOs comes from the fact that they offer an alternative source of relative value: equity volatility. In addition, the liquidity of the equity derivatives market tends to be more balanced between buyers and sellers, whereas the lack of buyers of protection in certain names means that the CDS trades tighter than what is suggested by the default risk.
Leveraged/Mezzanine Loan CLOs and SME CLOs Concentrate the Supply Away from Synthetics
Leveraged/mezzanine loans are our favorite picks in the European market. Institutional tranches of European leveraged/mezzanine loans are among the few asset classes that have 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% of equity (3.3% in 2002), according to Standard & Poors LCD data. In the second half of 2003, the weighted average spread of European institutional tranches of leveraged loans was 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 improvement in the pricing (and liquidity) of European loans has been caused in part by the increasing importance of institutional investors, which have a 20% market share in the European market. These are the other reasons we are overweight CLOs: European bankruptcy and insolvency regimes favor senior secured investors. This translates into significantly lower defaults and more rating stability than comparable 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. The European 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 issued EUR7.0 billion of bonds, most of which have come out of Spain, a market that has exhibited a strong performance in line with the performance of its economy.
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Overall cash flow balance sheet issuance has grown by 58%. The largest SME market continues to be Germany, with an outstanding volume of EUR27 billion. In 2003, three German SME CLOs have been issued, one of which had a notional of EUR1.4 billion and opened the door to what might become the largest European cash flow market in Europe. Among the seasoned transactions, we expect considerable divergence in performance as the recoveries stemming from the severe default environment of the past few quarters are worked out, which should eventually lead to rating actions.
CDO Rating Performance
The improvement in the fundamentals of the underlying markets has translated into a drop in the number and the severity of the rating actions in the European market: the number of tranches downgraded by S&P in 2003 has dropped to 18% (29% in 2002), while 4% of the outstanding notes were upgraded (1% in 2002). This trend has accelerated in the 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 grade market, especially the 2001 and 2002 vintages. The amount of rating actions has slowed significantly, thougha trend that we expect to continue in 2004. In particular, distressed tranches 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 in 76 European CDOs rated by Standard & Poors, of which they downgraded 17. Performance in the cash flow market has been much better, with only four transactions of 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 in the high yield market credit quality; for example, Moodys trailing 12-month European high yield default rate has dropped from 19.2% to 7.5%. To date, no European cash flow CDO 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 CDO investments in 2004: Wider credit spreads would make CDOs underperform, especially at the subordinate level. Thus, hedged CDO equity strategies make sense for both those subordinated investors who believe the probability of a spread widening is large and those who are very sensitive to mark-to-market volatility. Corporate leverage, the upgrade/downgrade ratio, and defaults have all improved in the corporate credit market during 2003. However, the market has rallied even more, and idiosyncratic risk, the main risk to CDOs, remains an issue. Our credit strategists believe that an improvement in the economic environment is needed for this situation to change, especially in Europe. Hence, a bifurcation in the performance of the underlying asset class would hurt CDOs the most. As we discussed above, investment grade synthetics are a candidate, as well as cash CLOs. Sluggish growth and the regional/industry concentration of SME portfolios could hurt SME CLOs. Despite the improvement in pricing and liquidity in institutional tranches of leveraged loans, leverage has been rising in the past few quarters. If the LBO pipeline fails to materialize, CLOs will suffer, too.
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APPENDIX A.
PORTFOLIO CREDIT PRODUCT SPREADS

Lehman U.S. CDS Indices
bp
Global Europe Japan 85 US Baa All US
Lehman CDS Indices

bp 55
50 45 40 35 30
76
67
58
49 25 20 10/1/03 10/16/03 10/31/03 11/15/03 11/30/03 12/15/03 12/30/03 40 10/1/03 10/16/03 10/31/03 11/15/03 11/30/03 12/15/03 12/30/03
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 of the index, October 1, 2003.
Investment Grade TRAINS

bp
350 300 250 200 150 100 L Year 10 Year 5 Year
BBB and High Yield TRAINS

bp
500 HY BBB 400
300
200
100
50 0 1/02
0
4/02 6/02 9/02 11/02 2/03 4/03 7/03 10/03 12/03
5/03
6/03
7/03
8/03
9/03
10/03
11/03
12/03
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 Moodys and B- by S&P The 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* Mid

bp
300 250 200 New TRAC-X 100 Mid Old TRAC-X 100 Mid
iBoxx CDX.NA.IG*
250
200
150
150
100
100 50 0 6/02 8/02 10/02 1/03 3/03 5/03 8/03 10/03 12/03
50
0 6/02 8/02 10/02 1/03 3/03 5/03 8/03 10/03 12/03
*TRAC-X North America and TRAC-X North America BBB are products of JPMorgan Chase 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.
* Prior to 10/22/03 historical intrinsic spreads are estimates based on historical single name spread data.
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APPENDIX B.
SUMMARY OF LEHMAN BROTHERS CDS INDEX PERFORMANCE
Summary of Lehman Brothers CDS Index (Equal Weighted), as of December 31, 2003
Number Issuers* 250 6 14 97 133 161 17 18 27 23 36 20 11 9 0 36 27 8 1 53 20 6 8 14 5 n/a Current Spread 43.6 14.4 13.9 25.9 60.1 47.9 47.0 37.0 57.5 64.6 33.0 47.4 68.7 28.0 0.0 42.7 41.6 45.6 0.0 30.5 23.6 29.0 36.9 36.2 38.6 n/a Contract Rate 57.5 18.8 16.9 32.0 80.8 61.7 58.5 49.5 65.4 87.2 42.0 70.0 93.5 31.3 0.0 60.7 66.7 44.5 0.0 41.9 32.6 35.0 55.2 50.4 48.6 n/a QTD Spread Change -13.9 -4.4 -3.0 -6.1 -20.7 -13.9 -11.4 -12.5 -7.9 -22.6 -9.0 -22.6 -24.8 -3.3 0.0 -18.0 -25.1 1.1 0.0 -11.5 -9.0 -6.0 -18.2 -14.2 -10.0 n/a QTD Total Return 0.79 0.28 0.14 0.39 1.18 0.80 0.62 0.70 0.50 1.51 0.52 1.15 1.25 0.23 0.00 1.00 1.32 0.05 0.08 0.61 0.51 0.34 0.98 0.73 0.45 n/a
USD Composite (EQ) Aaa (EQ) Aa (EQ) A (EQ) Baa (EQ) Industrial (EQ) Basic Industry (EQ) Capital Goods (EQ) Communications (EQ) Consumer Cyclical (EQ) Consumer Noncyclical (EQ) Energy (EQ) Technology (EQ) Transportation (EQ) Industrial Other (EQ) Utility (EQ) Electric (EQ) Natural Gas (EQ) Utility Other (EQ) Finance Institutions (EQ) Banking (EQ) Brokerage (EQ) Financial Cos. (EQ) Insurance (EQ) Reits (EQ) Financial Other (EQ)
Quality A3/BAA1 AAA/AA1 AA2/AA3 A1/A2 BAA2/BAA3 A3/BAA1 A3/BAA1 A3/BAA1 BAA1/BAA2 BAA1/BAA2 A2/A3 A3/BAA1 A3/BAA1 BAA1/BAA2 NA/NA BAA1/BAA2 BAA1/BAA2 A3/BAA1 NA/NA AA3/A1 A1/A2 A1/A2 AA3/A1 AA3/A1 BAA1/BAA2 n/a
Credit01 4.63 4.67 4.67 4.65 4.61 4.62 4.62 4.64 4.59 4.61 4.64 4.64 4.60 4.64 0.00 4.64 4.66 4.60 0.00 4.65 4.66 4.64 4.65 4.65 4.63 n/a
*Number of issuers in the returns universe
Summary of Lehman Brothers CDS Index (Market Weighted), as of December 31, 2003
Market Weight* 100.00 6.50 6.76 38.25 48.49 62.69 3.95 5.61 15.43 16.98 10.16 5.65 2.75 2.18 0.00 7.77 6.40 1.37 0.00 29.53 9.78 6.63 8.81 2.83 1.02 n/a Current Spread 48.6 18.5 14.1 27.0 74.5 60.6 46.0 36.7 58.2 101.2 36.2 38.9 52.4 29.7 0.0 42.1 42.1 42.3 0.0 24.9 19.2 29.0 25.8 28.6 38.6 n/a Contract Rate 67.3 32.2 20.2 33.4 105.4 82.7 54.5 48.7 66.8 156.0 44.2 52.7 71.2 34.4 0.0 64.4 69.3 41.2 0.0 35.5 28.8 34.9 40.7 41.6 49.1 n/a QTD Spread Change -18.7 -13.8 -6.1 -6.5 -30.8 -22.1 -8.5 -12.0 -8.6 -54.8 -8.0 -13.8 -18.8 -4.6 0.0 -22.2 -27.2 1.0 0.0 -10.6 -9.7 -5.9 -14.9 -13.0 -10.6 n/a QTD Total Return 1.01 0.76 0.26 0.39 1.66 1.18 0.50 0.68 0.55 2.78 0.46 0.67 0.98 0.30 0.00 1.22 1.45 0.03 0.08 0.58 0.52 0.36 0.80 0.68 0.56 n/a
USD Composite (EQ) Aaa (EQ) Aa (EQ) A (EQ) Baa (EQ) Industrial (EQ) Basic Industry (EQ) Capital Goods (EQ) Communications (EQ) Consumer Cyclical (EQ) Consumer Noncyclical (EQ) Energy (EQ) Technology (EQ) Transportation (EQ) Industrial Other (EQ) Utility (EQ) Electric (EQ) Natural Gas (EQ) Utility Other (EQ) Finance Institutions (EQ) Banking (EQ) Brokerage (EQ) Financial Cos. (EQ) Insurance (EQ) Reits (EQ) Financial Other (EQ)
Quality A3/BAA1 AAA/AA1 AA2/AA3 A1/A2 BAA2/BAA3 A3/BAA1 A3/BAA1 A3/BAA1 BAA1/BAA2 BAA1/BAA2 A2/A3 A3/BAA1 A3/BAA1 BAA1/BAA2 NA/NA BAA1/BAA2 BAA1/BAA2 A3/BAA1 NA/NA AA3/A1 A1/A2 A1/A2 AA3/A1 AA3/A1 BAA1/BAA2 n/a
Credit01 4.63 4.68 4.67 4.65 4.60 4.61 4.62 4.64 4.59 4.60 4.63 4.64 4.62 4.64 0.00 4.65 4.66 4.61 0.00 4.66 4.67 4.64 4.67 4.66 4.63 n/a
*Market Weight for statistics universe as of 12/31/2003.
January 21, 2004
53
2004 Annual
APPENDIX C.
GLOBAL CDO ISSUANCE STATISTICS
Historical Global CDO Issuance By Deal Type and Collateral Type, $ Billion
Arbitrage Cash Flow DealType Struct Fin EM HY Bonds IG Bonds Lev. Loans Other Unknown Struct Fin EM HY Bonds IG Bonds Lev. Loans Other Struct Fin EM HY IG Other Unknown Total Total Total Total DealType Total Total Total Total 1995 0.4 0.5 0.1 0.2 1.2 1.2 1995 1.0 1.0 2.2 1996 1.1 3.3 2.5 2.3 1.8 0.8 9.2 2.6 11.8 1996 7.0 7.0 18.7 1997 0.1 4.5 9.4 5.9 0.4 1.0 0.8 2.3 0.6 20.3 4.7 25.1 1997 26.3 3.3 29.6 54.7 1998 0.4 3.3 12.6 1.2 15.1 1.6 5.2 1.0 2.0 8.1 34.2 16.3 50.5 1998 33.0 5.6 38.6 89.1 1999 5.5 1.9 22.4 1.4 23.3 0.8 2.5 2.8 4.0 1.4 0.7 57.7 8.9 66.7 1999 28.2 5.8 34.0 100.6 2000 10.6 0.6 16.8 6.0 19.6 0.5 2.6 6.7 1.4 0.2 1.0 0.1 2.4 0.1 54.1 11.0 3.5 68.5 2000 19.4 11.2 30.6 99.1 2001 15.8 1.0 15.7 7.2 18.4 3.1 0.9 2.1 0.3 1.1 8.0 0.1 61.3 3.3 9.1 73.7 2001 13.6 12.9 26.5 100.2 2002 23.0 0.8 1.2 4.7 21.4 6.5 0.4 0.8 0.4 1.5 0.0 16.1 0.1 0.4 58.0 1.3 18.1 77.4 2002 15.6 12.8 28.3 105.7 2003 36.4 1.1 0.9 23.8 7.9 2.2 7.9 0.1 0.0 32.3 0.3 70.1 2.2 40.6 113.0 2003 19.5 10.7 30.2 143.2
Market Value
Synthetic
Cash Flow Market Value Synthetic All Arbitrage Balance Sheet Cash Flow Synthetic All Bal Sheet All CDOs
*Synthetics include only funded portions. **Please note that historical issuance data may have been updated due to additional data.
Global Arbitrage CDO Issuance by Month

$ bn 14
12 10 8 6 4
Global Synthetic* CDO Issuance

# of transactions 75 Syndicated Tailored Tranche 60
45 30 15
2 0 12/01 3/02 6/02 9/02 12/02 3/03 6/03 9/03 12/03 0 1/01 6/01 11/01 4/02 9/02 2/03 7/03 12/03 *Funded tranches only. ** Increases in 2003 numbers are partly due to an increased amount of data available on Tailored Tranche CDOs.
1999-2003 YTD Global Arbitrage CDO Issuance

11%
Global CDO Issuance versus ABS and CMBS Issuance, 2003

$ bn 200
Market Value Synthetic Cash Flow
20% 3%
23% 37% 10% 39% Struct. Fin. IG Syn Lev Loan Other IG Cash HY Bond EM 160 120 80 40 1% 0
174.6
36% 2% 2%
30% 27% 9% 1% 3% 10% 25% 26% 22% 8% 7% 1% 2002 3% 10% 2003 18% 27%
103.8 79.8 63.8
105.9
40% 34% 3% 1999 1% 2000
30.7
1% 2001
HEL
Credit Cards
CMBS
Auto
Arbitrage CDO
Balance Sheet CLO
January 21, 2004
54
2004 Annual
APPENDIX D.
CDO SPREAD STATISTICS

CDO Spreads* Over LIBOR for A Rated Classes and Lower
bp
900 750 Ba Baa A 798
CDO Spreads* Over LIBOR For Aa-Rated Classes and Higher

bp 160
Aa Aaa 121
120
600 80 57 40 150 0 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 0 1/98 7/98 1/99 7/99 1/00 7/00 1/01 7/01 1/02 6/02 12/02 6/03 12/03 450 300 308 175
*Spreads on CDO tranches are calculated by taking a weighted average of all new transactions issued during each month. The weighted average is calculated across collateral types (high yield, investment grade, emerging market, ABS).
Aaa CDOs vs. Other Structured Finance

bp
80 CDOs CMBS HEL Credit Cards 57
A CDOs vs. Other Structured Finance and Corporates

bp
240 200 160 120 CDOs HEL Credit Cards CMBS Corp
60
175 135
40 30 29 20 17
80 40 0 53 45 44
0 1/01 6/01 10/01 3/02 7/02 11/02 4/03 8/03 12/03
1/01
6/01
10/01
3/02
7/02
11/02
4/03
8/03
12/03
Baa CDOs vs. Other Structured Finance and Corporates

bp
400 CDOs HEL Credit Cards CMBS Corp
Ba CDOs vs. CMBS and Corporates

bp
900 750 CDOs CMBS Corp
798
300
308
600
225 200
450 300
425
100
100 90 83
150 0
187
0 1/01 6/01 10/01 3/02 7/02 11/02 4/03 8/03 12/03
1/01
6/01
10/01
3/02
7/02
11/02
4/03
8/03
12/03
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.
January 21, 2004
55
2004 Annual
APPENDIX D.
CDO SPREAD STATISTICS (continued)
Historic New Issuance CDO Spreads by Collateral Type

Aaa CDO Spreads to LIBOR Q4 02 LL CDO 53 HY CDO 60 IG Cash CDO 58 IG Syn CDO 68 CF SF CDO 53 Q1 03 56 75 65 Q2 03 55 65 55 74 64 Q3 03 56 96* 57 Q4 03 55 50** 61 59
Secondary vs. Primary Aaa CDO Spreads and the HY Index

CDO Spreads (bp)
115
LB HY Index OAS (bp)

Primary Secondary* HY OAS 800
100
700
Baa CDO Spreads to LIBOR LL CDO 291 308 322 310 302 HY CDO 375 400 IG Cash CDO 400 IG Syn CDO 312 367 276* 392 CF SF CDO 287 359 347 336 330 *Average based on 2 data points. **Value based on 1 data point.
85
600
70
500
Indicative CDO Spreads by Collateral Type, December 31, 2003

New Issue CDO Spreads to LIBOR Lev. Loans Aaa 52 Aa 95 A 160 Baa 300 Ba 800 SF CDOs 62 130 170 330 825
55
400
40
300
1/03 2/03 3/03 4/03 5/03 6/03 7/03 8/03 9/03 10/03 11/03 12/03
* Based on an average of trades done on senior tranches during the month by Lehman Brothers.
All Arbitrage CDO Downgrades per Month

1998 - 2003
bp 75
Total # of DGs per Month # of First Time DGs per Month Rolling 3 Month Average (# of Total DGs) Rolling 3 Month Average (# of First Time DGs)
Arbitrage CDO Downgrades by Asset Class

1995 - 2003
# of Transactions 300
Performing 48 250 200 36 150 Downgraded
60
60
45
30
24 100
15
12
50 0 HY Bond IG Synthetic Lev Loan Struct Fin IG Cash EM
0 1/98 10/98 7/99 4/00 1/01 10/01 7/02 4/03
0 12/03
Includes all Rating Agencies Includes all Arbitrage CDOs (Cash Flow, Market Value, and Synthetic) Source: Moodys Investor Service, Standard & Poors, and Fitch Ratings
*Includes only Cash Flow Arbitrage CDOs, except for IG Synthetic. IG Synthetic CDOs include only publicly rated transactions. Source: Moodys Investors Service, Standard & Poors, Fitch Ratings, and Lehman Brothers calculations.
January 21, 2004
56
2004 Annual
APPENDIX E.
CREDIT QUALITY INDICATORS
List of Corporate Defaults for Issuers in Moodys Rated Universe, 2003

Defaulted First ($U.S. mn) Debt Rating Rated 1 Year Prior (Date/Rating) to Default Moodys Broad Industry Moodys Specific Industry Classification Default Date
Domicile
JANUARY Cybernet Internet Services International Inc. 150 Cenargo International Plc 175 Corporacion Durango, S.A. de C.V. 435 XM Satellite Radio Inc. 938 Vantico Group S.A. 235 Sun World International, Inc. 115 FEBRUARY ASARCO Incorporated Maxxim Medical Group, Inc. British Energy plc Brown Jordan International, Inc. NTELOS Inc. iPCS, Inc. UbiquiTel Operating Co. American Lawyer Media Holdings, Inc. AES Drax Energy Limited DDi Corp. MARCH Cable Satisfaction International, Inc. Magellan Health Services, Inc. Precision Partners, Inc. Transportadora de Gas del Sur S.A. Lumbermens Mutual Casualty Company Atlas Air, Inc. HealthSouth Corporation HomeGold Financial Inc.
10/29/1999 6/10/1998 7/13/1994 9/11/2000 7/17/2000 4/3/1997
Caa2/Ca B1/B1 B1/B2 Caa2/Caa2 B3/Caa1 B3/B3
Industrial Transportation Industrial Industrial Industrial Industrial
Software Ocean Shipping Forest Products/Paper Media Chemicals Agriculture
Germany United Kingdom Mexico United States Luxembourg United States
Jan 02 Jan 15 Jan 15 Jan 28 Jan 29 Jan 30
650 435 629 330 605 300 640 63 405 200
9/16/1963 11/2/1999 9/16/1996 8/2/1999 7/12/2000 7/13/2000 3/28/2000 12/17/1997 4/20/2001 2/14/2001
Aa/Ca B2/B2 A2/A3 Ba3/Ba3 B3/B3 Caa1/Caa1 B3/B3 B3/Caa3 Ba3/B2 B1/B1
Industrial Industrial Public Utility Industrial Industrial Industrial Industrial Industrial Public Utility Industrial
Metals/Mining Healthcare Services/Equip. Electric Generation Co. Furniture/Fixtures Telecommunications Telecommunications Telecommunications Printing/Publishing Electric Electronics
United States United States United Kingdom United States United States United States United States United States United Kingdom United States
Feb 01 Feb 11 Feb 14 Feb 18 Feb 18 Feb 24 Feb 24 Feb 27 Feb 28 Feb 28
150 2,160 100 300 700 1,915 5,193 125
2/25/2000 6/14/1979 3/8/1999 10/11/1995 6/28/1996 8/6/1997 5/12/1989 8/29/1997
Caa1/Caa2 Industrial Cable T.V. B/B2 Industrial Hospitals/Nursing B1/Caa3 Industrial Metals/Mining B1/Ca Industrial Gas Transmission A3/Baa1 Insurance Insurance: Property & Casualty B3/B1 Transportation Air Freight Ba1/Ba1 Industrial Hospitals/Nursing B3/Caa2 Other Non-Bank Mortgage Finance
Portugal United States United States Argentina United States United States United States United States
Mar 03 Mar 11 Mar 15 Mar 18 Mar 25 Mar 28 Mar 28 Mar 31
APRIL Air Canada 1,251 Fleming Companies, Inc. 3,693 Eagle Food Centers, Inc. 85 J. Crew Group, Inc. 142 General Chemical Industrial Products Inc. 100 Jackson Products, Inc. 115 Leap Wireless International, Inc. 893 MTS, Inc. 110 MAY Neenah Corporation Neenah Foundry Company Millicom International Cellular S.A. Allegiance Telecom, Inc. Grupo TMM, S.A. Mississippi Chemical Corporation Uruguay, Oriental Republic of WCI Steel, Inc. National Equipment Services, Inc. Penn Traffic Company JUNE Grupo Iusacell, S.A. De C.V. WestPoint Stevens Inc. IWO Holdings, Inc. J.B. Poindexter & Co., Inc. New World Restaurant Group, Inc.
9/14/1993 4/11/1983 4/12/1993 9/29/1997 4/12/1999 4/14/1998 2/14/2000 4/15/1998
B1/B3 Baa1/Ba3 Ba3/B2 Caa2/Caa3 B1/Caa1 B1/Caa2 Caa2/Caa2 Ba3/Caa3
Transportation Industrial Industrial Industrial Industrial Industrial Industrial Industrial
Airlines Wholesale-Food Retail-Grocery Chain Apparel Chemicals Hardware/Tools Telecommunications Retail-Department Stores
Canada United States United States United States United States United States United States United States
Apr Apr Apr Apr Apr Apr Apr Apr
01 01 07 09 15 15 19 29
150 465 2,074 650 400 200 8,199 400 925 1,000
4/14/1997 11/20/1998 5/20/1996 10/26/1999 4/23/1993 11/7/1997 10/15/1993 12/29/1992 11/18/1997 4/14/1987
B1/Caa1 B1/Caa2 B1/B2 B3/Caa2 Ba2/B2 Ba1/B3 Ba1/Ba2 B1/Caa3 B1/B3 B1/B3
Industrial Industrial Industrial Industrial Transportation Industrial Sovereign Industrial Industrial Industrial
Automotives Steel Cellular Telephone Telecommunications Ocean Shipping Chemicals Sovereign Steel Leasing Retail-Grocery Chain
United States United States Luxembourg United States Mexico United States Uruguay United States United States United States
May 01 May 01 May 08 May 15 May 15 May 15 May 15 May 23 May 28 May 30
350 1,550 160 100 295
10/4/1999 11/17/1993 1/23/2001 4/13/1994 6/15/2001
B1/B1 B1/Ca Caa1/Caa1 B2/B3 Caa1/Caa1
Industrial Industrial Industrial Industrial Industrial
Telecommunications Textiles Telecommunications Diversified Restaurants/Fast Food
Mexico United States United States United States United States
Jun 01 Jun 02 Jun 04 Jun 12 Jun 15
JULY Aurora Foods Inc. 1,175 Texas Petrochemicals Limited Partnership 225 Newmont Yandal Operations Limited 300 @Entertainment, Inc. 545 Azteca Holdings, S.A. de C.V. 405 American Cellular Corporation 1,232
1/24/1997 6/17/1996 3/24/1998 6/25/1998 6/11/1997 5/4/1998
B1/Caa1 B1/B3 Ba2/Ba2 B3/Caa3 B3/Caa1 Caa1/Caa2
Industrial Industrial Industrial Industrial Industrial Industrial
Food/Soft Drinks Chemicals Metals/Mining Broadcasting Cable T.V. Telecommunications
United States United States Australia United States Mexico United States
Jul 01 Jul 01 Jul 04 Jul 07 Jul 14 Jul 15
January 21, 2004
57
2004 Annual
APPENDIX E.
CREDIT QUALITY INDICATORS
List of Corporate Defaults for Issuers in Moodys Rated Universe, 2003

Defaulted First ($U.S. mn) Debt Rating Rated 1 Year Prior (Date/Rating) to Default Moodys Broad Industry Moodys Specific Industry Classification Default Date
Domicile
JULY (continued) Loral Cyberstar, Inc. Loral Space & Communications Ltd. Mirant Americas Generation, LLC. Mirant Corporation International Utility Structures Inc. AUGUST CANTV Finance Ltd. DVI, Inc. GEO Specialty Chemicals, Inc. Hollywood Casino Shreveport Oglebay Norton Company Radio Unica Corp. Satelites Mexicanos, S.A. de C.V. High Voltage Engineering Corporation Horizon PCS, Inc. SEPTEMBER Tricom, S.A. Twin Laboratories Inc. Cone Mills Corporation Northwestern Corporation OCTOBER American Plumbing & Mechanical, Inc. Piccadilly Cafeterias, Inc. NOVEMBER Alamosa (Delaware), Inc. DECEMBER International Wire Group, Inc. Iron Age Corporation Iron Age Holdings Corporation Metallurg Holdings, Inc. Airtrain Citylink Limited Tiete Certificates Grantor Trust Solutia Inc. Congoleum Corporation
1,542 1,139 2,800 2,570 95
1/23/1997 1/14/1999 4/16/2001 7/12/1999 1/26/1998
B2/C B1/Ca Baa3/Ba1 Baa2/Ba1 B2/WR
Industrial Industrial Public Utility Public Utility Industrial
Telecommunications Equipment Aircraft/Aerospace Electric Holding Co. Diversified Energy Holding Co. Steel
United States United States United States United States Canada
Jul 15 Jul 15 Jul 15 Jul 15 Jul 31
100 155 120 189 450 158 645 135 470
1/22/1997 1/10/1997 7/15/1998 7/29/1999 1/13/1999 3/1/1999 1/22/1998 10/23/1979 9/18/2000
Ba2/B2 B1/B1 B1/B1 Caa1/Caa1 B1/B3 Caa1/Caa3 B3/B3 Ba/Caa2 Caa1/Caa1
Industrial Finance Industrial Industrial Industrial Industrial Industrial Industrial Industrial
Telecommunications Finance-Non Captive Chemicals Casinos Metals/Mining Broadcasting Media Miscellaneous Telecommunications
Venezuela United States United States United States United States United States Mexico United States United States
Aug 01 Aug 01 Aug 01 Aug 01 Aug 01 Aug 01 Aug 01 Aug 15 Aug 15
200 100 100 995
10/25/1999 5/1/1996 3/9/1995 9/6/1957
B3/Caa1 B1/Caa1 Baa2/Caa1 Ba/Baa2
Industrial Industrial Industrial Public Utility
Cellular Telephone Dominican Republic Sep Research/Development Labs United States Sep Textiles United States Sep Utility/Diversified Holding Co. United States Sep
02 06 15 15
125 75
4/30/1999 11/15/2000
B1/B1 B3/Caa2
Industrial Industrial
Construction Food/Soft Drinks
United States United States
Oct 04 Oct 29
1,234
2/2/2000
Caa1/Caa3
Industrial
Telecommunications
United States
Nov 11
392 100 45 121 1,050 100
6/1/1995 4/16/1998 4/16/1998 7/14/1998 12/13/2000 4/11/2001 8/28/1997 1/19/1994
B1/B3 B1/B2 Caa1/Caa3 Caa1/Ca Ba1/B3 Ba1/B3 Baa2/B2 B1/Ca
Industrial Industrial Industrial Industrial Transportation Finance Industrial Industrial
Mechanical Components Shoe Manufacturer Shoe Manufacturer Steel Transit Finance-Non Captive Chemicals Building Materials
United States United States United States United States Australia Brazil United States United States
Dec 01 Dec 04 Dec 04 Dec 12 Dec 15 Dec 15 Dec 17 Dec 31
*Universe is restricted to Moodys rated corporate universe.
January 21, 2004
58
2004 Annual
APPENDIX E.
CREDIT QUALITY INDICATORS (continued)
U.S. High Yield Trailing 12 Month Default Rates by Rating Category and Collateral Type
25% Caa-C HY B Ba
U.S. Investment Grade Trailing 12-Month Default Rate
1.25%
Baa Investment Grade
20%
1.00%
15%
14.6%
0.75%
10%
0.50%
5%
4.9% 2.2% 1.3%
0.25% 0.0% 1/92 1/94 1/96 1/98 12/99 12/01 12/03
0% 8/95 9/97 10/99 11/01 12/03
0.00% 1/90
Sources: Moody's Investor Service and Lehman Brothers Calculations.
Sources: Moody's Investor Service and Lehman Brothers Calculations.
Moody's Investment Grade and High Yield Downgrade to Upgrade Ratios

8 Investment Grade High Yield 6
Comparison of Consumer Credit, CMBS, and Corporate Credit Quality

10%
8%
3-Month CC Charge-Offs 60+ Day CMBS Delinquencies + Cumulative Liquidations Corp Default Rate 6.5%
6%
4
4%
2
2%
2.2% 2.1%
0
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
0% 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02 *The corporate default rate includes both US IG and HY credit. Source: Moodys Investor Service and Lehman Brothers calculations. 12/03
Source: Moodys Investors Service.
Default Rates for Baa Rated Corporates

4% Market Implied KMVs EDF Credit Measure Historical
Default Rates for B Rated Corporates

40% Market Implied KMVs EDF Credit Measure Historical
3%
30%
2%
20%
1%
10%
0% 7/96 1/98 7/99 1/01 6/02 12/03
0% 7/96 1/98 7/99 1/01 6/02 12/03
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 the average 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.Historical default rates are Lehman Brothers calculations using Moodys Investors Service data.
January 21, 2004
59
2004 Annual
APPENDIX F. TOP 20 TIGHTEST LINKED CDS AND EQUITY IN 2003*
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Name Cendant Corp Simon Property Group LP Sears Roebuck Acceptance Corp McDonalds Corp CIT Group Inc. Park Place Entertainment Corp Marriott International Humana Inc Dow Chemical Co Ford Motor Credit Georgia Pacific American Express Co Morgan Stanley Dean Witter & Co Federated Department Stores Cap One Bank Hartford Financial Services Tyco Computer Associates Goodrich Deere & Co
Ticker CD SPG S MCD CIT PPE MAR HUM DOW F GP AXP MWD FD COF HIG TYC CA GR DE
Moodys Rating Industry Baa1 Diversified/Conglomerate Service Baa2 Buildings and Real Estate Baa1 Finance A2 Personal, Food and Miscellaneous Services A2 Banking Ba1 Leisure, Amusement, Entertainment Baa2 Hotels, Motels, Inns and Gaming Baa3 Insurance A3 Chemicals, Plastics and Rubber A3 Automobile Ba3 Diversified Natural Resources A1 Banking Aa3 Finance Baa1 Retail Stores Baa2 Banking A3 Insurance Ba2 Diversified/Conglomerate Manufacturing Baa3 Electronics Baa3 Aerospace and Defense A3 Farming and Agriculture
Equity Price 12/31/03 ($) 22.27 46.34 45.49 24.83 35.95 10.83 46.20 22.85 41.57 16.00 30.67 48.23 57.87 47.13 61.29 59.03 26.50 27.34 29.69 65.05
CDS Goodness 12/31/03 of Fit** (bp) (%) 50.0 96 38.5 94 37.5 94 22.0 93 42.0 93 175.0 93 46.5 93 40.0 91 43.5 91 165.0 90 252.5 89 20.0 88 29.0 88 44.5 88 65.5 88 25.5 87 100.0 87 75.0 87 52.5 87 20.5 87
Equity Price Change Y-o-Y (%) 113 36 90 54 83 29 41 129 40 72 90 36 45 64 106 30 55 103 62 42
CDS Change Y-o-Y (bp) -225.0 -76.5 -317.5 -33.0 -143.0 -125.0 -58.5 -120.0 -99.5 -267.5 -307.5 -39.0 -33.5 -50.5 -389.5 -47.5 -425.0 -362.5 -207.5 -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.
APPENDIX G. U.S. EQUITY SECTOR CORRELATIONS, %
Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Infomation Technology Telecommunication Services Utilities
Energy 35.9 21.1 17.8 16.3 14.6 6.9 14.6 14.6 6.6 14.0
Mater 21.1 25.1 19.6 18.6 14.7 7.5 14.7 17.3 9.2 9.9
Indus ConsDiscr ConsStap Health 17.8 16.3 14.6 6.9 19.6 18.6 14.7 7.5 18.7 17.0 14.5 7.5 17.0 17.8 13.6 7.3 14.5 13.6 18.0 7.8 7.5 7.3 7.8 5.2 14.7 13.4 12.8 6.5 16.6 17.5 9.8 7.8 10.1 11.4 9.8 5.9 11.7 10.5 14.3 6.7
Finan 14.6 14.7 14.7 13.4 12.8 6.5 14.6 12.7 8.7 11.4
InfoTec 14.6 17.3 16.6 17.5 9.8 7.8 12.7 29.4 14.8 6.4
Telecom 6.6 9.2 10.1 11.4 9.8 5.9 8.7 14.8 16.1 7.7
Util 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 Index Please refer to the Quant Toolkit for the default correlation calculator, which enables you to translate the equity correlations into default correlations.
January 21, 2004
60
2004 Annual
APPENDIX H. QUANTITATIVE CREDIT TOOLKIT VIA LEHMANLIVE
Credit investors can benefit from active use of quantitative tools in navigating the increasingly more complex credit universe. Fundamental analysis is still the core of credit investing, but quantitative analysis 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 new relative value opportunities due to market segmentation and dislocations. Quantitatively oriented investors can take advantage of these opportunities to generate consistent excess returns.
Lehman Brothers continues to develop unique quantitative models designed to complement the fundamental frameworks employed by portfolio managers, traders, analysts, and structurers. These quantitative models add to the suite of portfolio models already delivered in POINT. A collection of new quantitative tools is now available in a Quantitative Credit Toolkit on LehmanLive. The tools are organized in four functional groups designed to answer common sets of questions.
Importantly, these tools are integrated with each other in terms of the underlying data and methodologies. This allows users to combine them in numerous ways to solve a variety of problems.
The table below shows some of the typical uses of the Quantitative Credit Toolkit by investor type.
Spread Tools Asset Managers Issuer selection with OneScore or ESPRI Sector and security selection with Spread Tools Trade analysis with Time Series Plotter Assess spread blowup risk with ESPRI Global loan book analysis with CurveLab Trade analysis with Time Series Plotter Hedge Funds Identify value relative to the curve with Issuer Spread Tool Identify candidates for shorting using ESPRI Tool
Security Valuation Tools Bond pricing and risk analysis with Bond Calculator
Credit Analysis Tools Use Implied Default Probability Tool to find relative value across sectors
Correlation Tools Use Equity Correlation model for global portfolio analysis
Insurers
Scenario analysis for CDO Tranches using the CDO Calculator Access Lehman CDO Research and Surveillance Reports
Use Implied Transition Matrix for downgrade risk management 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
Banks
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 DebtEquity relative value trading Use Default Correlation Tool for basket hedging
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2004 Annual
BIBLIOGRAPHY
Trading Correlation Relative Value Across CDO Tranches Lehman Brothers, November Isla L, Greenberg A, Schoegh L, 2003 Hedged CDO Equity Strategies Fixed Income Research, Lehman Brothers, September Isla L, 2003 State of the Secondary CDO Market Lehman Brothers, September Ganapati S, Laberge C and Tejwani G, 2003 Simulating Portable Credit Strategies with CDS and Mirror Swaps Indices Global Relative Value Weekly, Lehman Brothers, October Berd A and Ha P, 2003 The Lehman Brothers Credit Default Swap Index Lehman Brothers, October Berd A, Descle A, Golbin A, Munves D and OKane D, 2003 The Co-Movement of Interest Rates and Spreads: Implications for Credit Investors Lehman Brothers, June Berd A and Ranguelova E, 2003 Digital Premium Journal of Derivatives, Volume 10, Number 3, Spring Berd A and Kapoor V, 2003 The Synthetic CDO Bid and Basis Convergence Which Sector is Next? Structured Credit Strategies, Lehman Brothers, March Ganapati S, Berd A, Ha P and Ranguelova E, 2003 Extreme Events and Multi-Name Credit Derivatives In Credit Derivatives The Definitive Guide, Risk, London Mashal R, Naldi M and Zeevi A, 2003 Measuring Portfolio Credit Risk with Default Experience Statistic (DES) Credit Ratings: Methodologies, Rationale and Default Risk, RiskBooks Berd A, 2002 The Dependence Structure of Asset Returns Quantitative Credit Research Quarterly, Lehman Brothers, December Mashal R, Naldi M and Zeevi A, 2002 Evolution of Synthetic Arbitrage CDOs Structured Credit Strategies, Lehman Brothers, November Ganapati S and Ha P, 2002
Quantitative Credit Research Quarterly, 2003 Q4 - November 2003 Forward CDS Spreads Hedging Debt with Equity Pricing Multi-Name Default Swaps with Counterparty Risk The New Lehman Brothers High Yield Risk Model Understanding Deltas of Synthetic CDO Tranches Valuation of Portfolio Credit Default Swaptions Q3 - August 2003 Estimating Implied Default Probabilities from Credit Bond Prices Lehman Brothers OneScore:Combining Fundamental and Quantitative Credit Views Leveraging the Spread Premium with Correlation Products Up-front Credit Default Swaps Q1/2 - May 2003 Buy-and-Hold Credit Portfolios and CDOs Leverage and Correlation Risk of Synthetic Loss Tranches Systematic Variations in Corporate Bond Excess Returns The Restructuring Clause in Credit Default Swap Contracts Valuation of Credit Default Swaps Berd A Naik V, Trinh M, Balakrishnan S and Sen S Mashal R and Naldi M Chang G Schloegl L and Greenberg A Pedersen C Berd A, Mashal R and Wang P Pomper M, Trinh M, Epps M and Balakrishnan S OKane D, Schloegl L and Greenberg A OKane D and Sen S Dynkin L, Ganapati S and Hyman J Mashal R, Naldi M and Pedersen C Naik V, Trinh M and Rennison G OKane D, Pedersen C and Turnbull S OKane D and Turnbull S
Beyond CADR: Searching for Value in the CDO Market Quantitative Credit Research Quarterly, Lehman Brothers, September Mashal R and Naldi M, 2002 CDO Equity in a Portfolio Context Quantitative Credit Research Quarterly, Lehman Brothers, September Ganapati S and Tejwani G, 2002 The Case for Structured Finance CDOs Lehman Brothers, July Ganapati S and Tejwani G, 2002 Extreme Events and Default Baskets Risk June, pages 119122, June Mashal R and Naldi M, 2002a Managing Risk Exposures in CDO Tranches Quantitative Credit Research Quarterly, Lehman Brothers, May Berd A and Tejwani G, 2002 Spread Premium for Portfolio Tranches Quantitative Credit Research Quarterly, Lehman Brothers, January OKane D and Schloegl L, 2002 Synthetic CDOs How are They Structured? How do They Work? CDO Monthly Update, Lehman Brothers, November Ganapati S, Ha P and OKane D, 2001 Leveraging Spread Premia with Default Baskets Quantitative Credit Research Quarterly, Lehman Brothers, October OKane D and Schloegl L, 2001 State of the CDO Market: Addressing Recent Headlines Lehman Brothers, August Ganapati S and Ha P, 2001 CDOs: Market, Structure, and Value Lehman Brothers, June Ganapati S and Reyfman A, 1998 A Guide to First-to-Default Baskets Quantitative Credit Research Quarterly, Lehman Brothers, February Reyfman A and Chang J, 2000 Modeling Credit: Theory and Practice Lehman Brothers, February OKane D and Schloegl L, 2001
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Lehman Brothers Fixed Income Research analysts produce proprietary research in conjunction with firm trading desks that trade as principal in the instruments mentioned herein, and hence their research is not independent of the proprietary interests of the firm. The firms 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 firms trading and capital markets revenues. 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, Claude Laberge, Elena Ranguelova, Ashish Shah, and Guarav Tejwani, the primary analysts responsible for this report, about the subject securities or issuers referred to herein, and no part of such analysts compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. The research analysts responsible for preparing this report receive compensation based upon various factors, including, among other things, 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 copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 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 Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services.
PublicationsL. 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 approved by 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 in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell or as 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 without the written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some 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 consult his 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 future results. 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, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 2004 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction.

(Lehman Brothers) Structured Credit Strategy - Annual 2004

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Structured Credit Research

Structured Credit Strategy Annual 2004

PLEASE SEE IMPORTANT ANALYST CERTIFICATION ON PAGE 63.

Lehman Brothers | Structured Credit Strategies

January 21, 2004

Lehman Brothers | Structured Credit Strategies

November 28, 2003

November 24, 2003

November 20, 2003

November 17, 2003

October 28, 2003

October 20, 2003

January 21, 2004

Lehman Brothers | Structured Credit Strategies

Sunita Ganapati 415 274 5485 sganapat@lehman.com

The CDS market will start to provide more appeal to HY managers.

January 21, 2004

Lehman Brothers | Structured Credit Strategies

January 21, 2004

Lehman Brothers | Structured Credit Strategies

January 21, 2004

Lehman Brothers | Structured Credit Strategies

Specific articles analyze these themes in more detail.

January 21, 2004

Lehman Brothers | Structured Credit Strategies

Arthur Berd 212-526-2629 arthur.berd@lehman.com

CDS-Cash Basis Market Tone

-15 Rate Back up and Convergence

90 9/03 10/03 12/03

January 21, 2004

Lehman Brothers | Structured Credit Strategies

January 21, 2004

Lehman Brothers | Structured Credit Strategies

Ford CDS and Cash Curves, As of January 9, 2003

250 CDS Cash 200

0 6M 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y 30Y

Source: Mark-it Partners.

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Lehman Brothers | Structured Credit Strategies

Distribution of CDS Curve Slopes, December 31, 2003

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Lehman Brothers | Structured Credit Strategies

January 21, 2004

Lehman Brothers | Structured Credit Strategies

Spreads and Volatility in the Credit Cycle

2003 Spread Rally

100 50 0 0 20 40 60 80 100 120 Jan90-Dec91 Jan92-Jul98 Aug98-Dec03

January 21, 2004

Lehman Brothers | Structured Credit Strategies

Philip Ha 212-526-0319 philipha@lehman.com Lorraine Fan 212-526-1929 lfan@lehman.com

Global Relative Value, January 5, 2004.

January 21, 2004

Lehman Brothers | Structured Credit Strategies

CDX versus Lehman Brothers U.S. Credit Index

270 240 210 180 150 120 90 1/01

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Lehman Brothers | Structured Credit Strategies

Portfolio Product Spreads, January 12, 2004

Portfolio Product Intrinsic versus Actual Spread, bp

CDX Intrinsic Spread CDX Actual Spread

TRACX II Intrinsic Spread TRACX II Actual Spread

55 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