This preview has intentionally blurred parts. Sign up to view the full document

View Full Document

Unformatted Document Excerpt

Research Credit Debt Strategy September 28, 2006 Bankof America-?~ Glen Taksler 2129332559 glen taksler@bofasecurities com Guide to leveraged loan CDS ~ Leveraged loan CDS ("LCDS") allows investors to refer ence secured loans in standardized credit derivative contracts" With steady growth in the double- and single-B high yield universe, we look for LCDS to become popular among bank loan portfolios and hedge funds One of the biggest dillerences between LCDS and senior unsecured CDS is prepayment risk, In the US, LCDS trades may terminate early if a loan facility is refinanced and not replaced In Europe, the criteria are still being finalized, but are expected to be more stringent-contracts terminate if a loan facility is refinanced, regardless of whether the f'lCility is replaced LCDS increases opportunities to tr ade across the capital str ucture, In recent months, LCDS has traded cheap to the fair value spreads implied by senior unsecured CDS and assumed recovery rates, This has led to significant demand for selling protection Although we look for a tr ansition to cash settlement, cun ently, LCDS physically settles" To be deliverable into an LCDS contract, an obligation must arise under a syndicated loan agreement and trade as a loan of the designated priority (first-, second-,or third-lien) The protection buyer also must be able to create participation rights for the seller .2 2 3 3 4 4 .5 , .5 8 12 13 13 14 ' ,15 15 16 19 ~ ~ ~ Table of Contents Overview, Credit Events Early Termination (Cancelability) Settlement, Succession Language European LCDS" Comparing Loan CDS with Senior Unsecured CDS ' LCDS - Loan Basis Capital Structrue , Unwinds, LCDX ,., Collateralized Loan Obligations (CLOs), Special Features olLoan CDS The Reference Obligation and the Secured List Syndicated Secured Characteristic Settlement, Appendix A: More on the Dispute Resolution Process Appendix B: Deriving the Spread Relationship Between LCDS and Senior Unsecured CDS 20 This report has been prepared by Bane of America Securities LLC (BAS), member NYSE, NASD and SIPC" BAS is a subsidiary of Bank of America Corporation. This report is intended for sophisticated institutional investors and equivalent professionals in the fixed income market only" Please see the analyst certification and important disclosures on page 22 of this report. BAS and its affiliates do and seek to do business with companies mentioned in their research reports" As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Should investors consider this report as a factor in making an investment decision, it must be considered as a single factor only" Credit Strategy Research September 28, 2006 BankofAmerica <?~ This document assumes familiarity with both semOf unsecured CDS and the cash loan market For more on senior unsecured CDS, please see our Credit Default Swap Pnmer Second Edition January 5, 2006 Overview Leveraged loan CDS ("LCDS") allows investors to reference secmed loans in standardized credit derivative contracts. Focused on the double- and single-B bigh yield universe, LCDS trades actively on 40 to 50 Reference Entities, and is quoted for about 80 entities Sellers of protection include hedge funds, who seek quick access to leveraged loan exposure, often with lower flmding costs than a total return swap on par loans Bank loan portfolios sell protection to add exposme to issuers with underutilized credit lines Similarly, buying LCDS protection provides a more accurate hedge for loan portfolios than senior unsecured CDS. Leveraged investors may buy LCDS protection to short credit risk, without the need for a repo market Figure I compares key features of LCDS with senior unsecmed CDS: Figure 1" Overview of Loan CDS vs. Senior Unsecured CDS For US Contracts. See Main Text for Malor Differences In Europe. Size 2 MM -5 MM 2MM -10MM Cancel ability If syndicated secured facility no longer exists N/A Tenors 5 Years 1 Year - 10 Years Successor Language Relevant Obligations are Syndicated Secured Loans Relevant Obligations are Bonds and Loans Sources: lSOA; LSTA; Bane of America Securities lLC Credit Events If an Issuer defaults on Just Bonds (not Loans), there Is a Credit Event In LCDS LCDS Credit Events are Bankruptcy and Failure to Pay. Importantly, these Credit Events may occur anywhere within BOllowed Money, which includes Loans and 2 Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~., -- Bonds. In other words, if an issuer defaults on just its Bonds (not Loans), there will still be a Credit Event in LCDS Early Termination (Cancelability) LCDS may be terminated If a Syndicated Secured facility Is canceled and not replaced In the US, an LCDS contract may be terminated if a Syndicated Secured facility is canceled and not replaced within approxiinately 35 Business Days' After that day, either party may deliver an Optional Early Termination Notice to terminate (effectively, rip up) the trade.. The protection Buyer is required to pay acclUed interest up to and including the termination date Settlement LCDS physically sellles, although we look for a transition to cash selliement LCDS trades physically settle, as discussed in a special document called the Physical Settlement Rider. Generally speaking, post-Credit Event, the protection Seller is required to pay the protection Buyer the notional of the trade, provided that the protection Buyer delivers a Loan or Revolver which: ~ Arises under a syndicated loan agreement Trades as a loan of the Designated Priority (first-, second-, or third-lien)' Is a Participation Loan-i e.. , the protection Buyer can create participation rights for the protection Seller ~ ~ Under certain circumstances, LCDS trades may also cash settle We will discuss Settlement issues in more detail, in the section "Special Features of Loan CDS" Evolution to a Cash Settlement Protocol Similar to senior unsecured CDS, the market is attempting to move toward a cash settlement protocol In this process, trades typically would be cash settled. Both parties would likely retain the ability to physically settle, if desired' Eventually, this should reduce or even alleviate the need for the LCDS Physical Settlement Rider , Formally, either party must dispute that the then-current Reference Obligation satisfies the Syndicated Secured Criteria (see the section "Syndicated Secured Characteristic" in "Special Features of Loan CDS") That Dispute Resolution is designed to begin as soon as reasonably practicable and takes 2-5 Business Days. Then, the Calculation Agent begins a search for a Substitute Reference Obligation. Notice of such a search is called a Search Notice, and must be delivered promptly upon request of the Buyer or Seller. The Calculation Agent has 30 Business Days from the Effective Date of the Search Notice to find a Substitute Reference Obligation If an obligation has not been identified, either party may exercise Early Termination Also noteworthy: The specific criteria for Early Termination are that the Calculation Agent has not identified a Proposed Substitute Reference Obligation, or the Calculation Agent has identified a Substitute Reference Obligation, but that substitution has not become binding because of a Dispute Resolution Process (including a process that has begun but is not yet resolved) 2 Third-lien loans are rare According to Mark-It Partners, lCDS dealers have only indicated one credit (The Goodyear Tire & Rubber Company) with a lban that trades as a third lien J Specifically, in senior unsecured CDS, palties could buy or sell physical bonds at the cash settlement price For example, assume a $10 million notional trade is cash settled, but the protection Seller wants to receive bonds, as would happen with physical settlement The Seller would be able to buy $10 million bonds at the cash settlement price Should this type of change occur in senior unsecured CDS, we would look for a similar move in LCDS over time Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 3 Credit Strategy Research September 28, 2006 BankofAmerica ~~ Succession Language LCDS Succession language is based on Syndicated Secured Loans Succession language refers to potential changes in CDS contracts ifthe Reference Entity is merged, acquired, or undergoes some other change with respect to its corporate stmcture. In general: ~ If one entity succeeds to 75% or more of the Relevant Obligations ofthe Reference Entity, that entity will be the sole Successor for the entire Credit Derivative Transaction A $10 million trade in the original Reference Entity will now reference $10 million notional in the Successor Reference Entity. ~ If one or more entities succeeds to more than 25%, but less than 75%, of the Relevant Obligations, then each entity will be a Successor For example, a $10 million trade in the original Reference Entity will now reference $5 million notional in the original Reference Entity and $5 million notional in a Successor Reference Entity. If no entity succeeds to more than 25% of the Relevant Obligations, there will be no Successor The Reference Entity will not change ~ LCDS Succession language is based on Syndicated Secured Loans outstanding. By contrast, in senior unsecured CDS, Succession criteria is based on all Bonds and Loans outstanding For example, suppose all Syndicated Secured Loans succeed to a new entity, but this represents 25% or less of all Bonds and Loans outstanding at the Reference Entity Only LCDS contracts will succeed Senior unsecured CDS trades will remain with the original Reference Entity. . Succession language is a complicated topic, subject to continued debate in the CDS market For more information on Succession, please see our Credit Default Swap Primer Second Edition, January 5, 2006 European LCDS A working group Is meeting to finalize standards for Europe Currently, LCDS documentation focuses on the US market A working group is meeting to finalize standards for Europe. We note some general differences to date for European LCDS, versus the US standards shown in Figure I: ~ ~ ~ In Europe, Modified-Modified Restmcturing (MMR) is a Credit Event for both LCDS and senior unsecured CDS In Europe, Early Termination is more lenient, and may be applied if the Reference Obligation is canceled, regardless of whether it is refinanced In Europe, LCDS Deliverable Obligations are the Reference Obligation(s), or more senior loans with the same security. In the US, a Deliverable Obligation may have different security , In Europe, the protection Seller is able to opt for cash settlement at any time In the US, the Seller may elect cash settlement if an Assignment is not completed on time. In Europe, Successor provisions do not apply Trades terminate (cancel) upon a Succession ~ ~ , The US Deliverable Obligation still must arise under a syndicated loan agreement, trade with the Designated Priority, and be a Participation Loan, 4 Guide to Leveraged Loan CDS Glen Taksler 212,.933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~t? -- ~ In Europe, there is no mechanism to resolve potential disputes between counterparties The US market uses a dealer poll, described in Appendix A There are plans to create a dealer poll in Europe, although the exact form may differ from the US Comparing Loan CDS with Senior Unsecured CDS Although similar in concept to senior unsecured CDS, the fair value of LCDS contracts differs from senior unsecured CDS in several respects In this section, we discuss the LCDS - loan basis, capital structure trades, and unwind issues LCOS - Loan Basis The ubasis" is defined as the LCDS spread minus the spread on the par loan The "basis" in LCDS is defined as the LCDS spread minus the spread on the physical (cash) loan This creates an issue, as, similar to high yield corporate bonds, loans are typically quoted in dollar price It is important to consider two features when estimating the equivalent spread on a cash loan, callability (prepayment) and step featmes Callability (Prepayment) Prepayments are often suboptima!...... In principle, a call feature is easily accounted for, by using option-adjusted spread (OAS) to LIBOR But in reality, prepayments are often suboptimal The reason is that loans often trade above par, even though they are (usually) callable at par In fact, Figure 2 shows that approximately two-thirds of North American institutional facilities currently trade above par, according to estimates The "optimal" exercise, used in traditional OAS models, assmnes that a loan is called as soon as it reaches par That issuers frequently prepay loans much later, if at all, creates an as-yet unsolved problem in estimating the basis against LCDS Figure 2.. Distribution of Prices for North American Institutional Facilities Jan 02-Aug 06 Currently, 2/3 of Facilities Trade Above Par -->100 - 9 0 - 9 9 - 7 0 - 8 9 " <70 '" " c: CD:;:; C) '" c: 100% 2/3 of Facilities Currently Above Par ~~ 1::_ E= 80% 60% 40% 20% 0% ...... " JanJulJanJulJanJul- -I o c: Z '" '0 c~ 0.. 2 :::> " " '" f2: Jan- Jul- Jan- Jul- 02 02 03 03 04 04 OS 05 06 06 Data for facilities tllat trade above par are from Mark-It PartnelS while data for facilities below par are from LSTA and S&P Therefore, results may not be strictly comparable Sources: LSTA; Mark"lt Partners: Standard & Poors; Bane of Amelica Securities LLC estimates Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 5 Credit Strategy Research September 28, 2006 BankofAmerica~~ ",,,.so the market generally uses Z discount margin, to estimate the par loan spread In the interim, the market generally uses the Z discount margin ("Z-DM") to estimate the cash loan spread. Figure 3 shows how to calculate the Z-DM on Bloomberg, for an example in which a loan trades at $100875 The coupon is L+250 bps, yielding a ZDM of L+233 bps: Figure 3" Converting a Loan from Dollar Price to Spread to L1BOR Current Spread is Approximately L +233 bps. Coupon is L+250 bps" Does not account for value of call option in LCDS Sources: Bloomberg Step Features LCDS has no coupon step language Physical loans may contain step-up or step-down provisions By contrast, LCDS has no coupon step language Following a step-up, LCDS spreads should widen to reflect higher compensation to cash loan holders. An anticipated step-up should result in a wider basis, while an anticipated step-down should result in a tighter basis Voting Rights Unlike par loans, LCDS has no voting rights. Ihis factor should result in a wider basis Negative Basis Trades Currently, the LCDS market has a negative basis As shown in Figure 4 and Figure 5, currently the LCDS market has a negative basis That is, LCDS trades tighter than cash loan spreads Analogous to senior unsecured CDS, a negative basis suggests value in buying a loan and buying LCDS protection lobe clear, this basis also does not adjust for a mismatch between maturity dates (lCDS and cash maturing on different dates). It is difficult to adjust for the maturity date mismatch, because neither cash loans nor LCDS has a well-defined curve 6 Guide to Leveraged Loan CDS Glen 1aksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~~. Moreover, the basis does not adjust for prepayment For example, ifthe basis is -80 bps, then an investor who believes the call (prepayment) option value is worth less than 80 bps should consider the prepayment-adjusted basis to be negative Figure 4" LCDS is Trading Tighter than Cash Loan Spreads,,,,,, Average of Selected LCDS and Cash Loan Spreads Figure 5" "."Causing a Negative Basis Average LCDS - Cash Loan Spread 220 200 -Loans _LCDS _Basis (LCDS - Cash) -50 , - - - - - , - - - - , - - - - , - - - , - -55 _ -60 e (f) Ul 0"0 180 160 140 120 100 1-May 'l!? " i!i e -65 0- '" ~ en -75 -70 -80 1-Jun 1-Jul 1-Aug 1-Sep -85 1-May 1-Jun 1-Jul 1-Aug 1-Sep Average of AW CHTR, eve, GP, LEA, MIR, NRG, SiZ. WIN Does not adjust for maturity date mismatch or prepayment risk Source: Bane of America Securities LLC estimates Average of AW CHTR. Ole., GP, LEA, MIR NRG. SlZ, WIN, Does not adjust for maturity date mismatch or prepayment risk Source: Bane of America Securities LLC estimates, Negative Basis Case Study Consider a case study For example, consider Neiman Marcus, which cmrently has a telm loan and an unfunded revolver. The term loan trades at $100 875, or a Z-DM spread 01L+233 bps (see Figure 3), Five-year LCDS is 108 bps, Take an investor who buys both the term loan and LCDS protection The investor will receive 125 bps positive callY per annum, in three parts: ~ ~ ~ Receive L+233 bps on the loan Pay 108 bps for LCDS Fund at LIBOR (assumption) The "basis" is -125 bps (108 bps LCDS - 233 bps loan) On the loan, the investor earns the 233 bps by paying 0 875 points upfront and then receiving an L+250 bp coupon Importantly, we follow the common assumption that the protection buyer funds at LIBOR For a hedge fund that funds at L+25, cany would be 100 bps per annum (L+233 bps on the loan minus 108 bps for LCDS minus L+25 funding cost) Now consider a downside scenario in which the telm loan is prepaid at $100 lIthe revolver remains outstanding, LCDS will not cancel The investor loses 0875 points on the loan, and still needs to pay 108 bps pel annum, until matmity of the LCDS contract The present value of payments due on LCDS is about 475 points (108 bps x 4.4 dmation), for a total loss 015,625 points (0,875 points on loan + 4,75 points on LCDS) Guide to Leveraged Loan CDS Glen Taksler 212..933,,2559 7 Credit Strategy Research September 28, 2006 BankofAmerica 4-~ To reduce this cost, the investor may buy the unfunded revolver, which trades at an equivalent spread ofL+37 5 bps Net cany will now be negative 70.5 bps per annum (L+37 5 bps on revolver minus 108 bps on CDS minus LIBOR funding cost) If the loan is prepaid and the revolver is canceled, but the Syndicated Secured facility is replaced,' LCDS still will not cancel The investor may buy a loan nom the new facility to offset the cost of protection However, ifthe Syndicated Secured facility is not replaced, LCDS will terminate Any mark-to-market profit (or loss) that the investor had on LCDS will be eliminated Negative Basis Funding Issues To some degree, funding issues allow the negative basis to persist In senior unsecured CDS, leveraged investors, especially hedge funds, are large buyers of negative basis packages. That is, hedge funds often buy bonds and buy protection, when the trade is positive cany However, in par loans, lack of supply often restricts investors' ability to implement negative basis trades An investor who wants to buy a loan, but is constrained by inadequate supply in the market, will be forced to sell protection instead. This drives LCDS spreads tighter, without affecting par loan spreads. The LCDS-par loan basis therefore tightens Moreover, it is operationally more difficult to buy a par loan than a cash bond.. Standard par loan trades settle at T+7 Business Days, due to their onerous documentation and administrative details It may be difficult for a relatively small hedge fund to complete these requirements on time, if at all To gain leverage and manage administrative issues, hedge funds often buy par loans through Total Retum Swaps. In this anangement, a bank or dealer becomes the lender of record, rather than the hedge fund 6 The bank may require, say, 20% initial collateral, which allows the investor to leverage five times Cash flows and typically, voting rights, ar'e then passed through to the investor, in exchange for a funding fee This funding fee, roughly a half point on average, makes it less attractive for leveraged investors to buy LCDS basis packages As such, hedge funds (generally) are only interested in basis packages where the basis is more negative than the funding fee (eg, -50 bps). Notably, funding fees have been declining in recent months, which suggests that the basis may start to increase over time, as leveraged investors become able to buy more negative basis packages. We note that documentation impediments are particular to the par loan market. These hurdles generally do not exist for distressed loans, because of their lower credit quality (or default). Capital Structure LCDS makes it easier to trade across the capital structure LCDS creates new opportunities for trading across the capital strncture For example, consider an investor who believes that loan CDS recovery rates will be higher than overall market expectations. That investor may selll CDS protection and hedge by buying senior unsecured CDS. , The faciliry must be replaced within approximately 35 Business Days For details, please see the section "Early Termination (Cancelability)" 6 More accurately, a separate legal entity within the bank OI dealer becomes the lender of record 8 Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~~ Although similar to cash loan versus bond trades, capital structme trades are mechanically easier to execute in CDS This is because the investor may simply buy 7 protection for the short risk leg. Based on historical recovelY rates, LCDS should trade at approximately 0,,4 times senior unsecured COS spreads Assuming that LCDS and senior unsecmed CDS have the same probability of default, their spread relationship should be: SpreadLCDS = 1- R LCDS 1-RUnsrxured SpreadUnsecured Where R represents the recovery rate For details, please see Appendix B For example, historically, secured loan recovery rates are about 75%, and senior unsecured recovery rates are about 40%, according to Moody's As such: SpreadLCDS 1-RLCDS SpreadUnsccured 1- RUnsecured 1-75% 1-40% 25% =0.4 60% So that LCDS spreads should be 0.4 times senior unsecmed spreads This is an approximation because, in reality, the probability of default is higher in senior unsecmed CDS than in LCDS The reason is that Restructming is only a Credit Event in senior unsecmed CDS Figme 6 shows the ratio offair value spreads, for LCDS relative to senior unsecured CDS, based on expected recovery rates: Agure 6.. Fair Value of LCDS to Senior Unsecured CDS, Based on Expected Recovery Rates Red Circle Shows the FaIr Value Ratio of LeDS to Senior Unsecured CDS For example, with expected secured loan recovery at 75% and senior unsecured recovery at 40%, secured loan spreads should trade at O.4X senior unsecured spreads 2:' 70% (l) 15 &! -g => (l) " 60% 50% " 40% ~ <:: 3 ,~ 30% 20% e +65% 70% e 75% (J) Historical Recoveries __._-------;~---~---__._----~---, 80% 85% 90% LeOS (Secured Loan) Recovery ,- 60% Sources: Moody's; Bane of America Securities LLC estimates, I he challenge with this approach is that an investor may not have an opinion on both secmed loan and senior unsecured bond recovery rates More likely, an investor has a rough opinion on the recovery rate for just one product Using the same approach, it is possible to back out the implied recovery rate for the other product, using the ratio of LCDS to senior unsecured CDS spreads observed in the market: 7 In the bond market, an investor may short risk by bOllowing a bond on repo But there is no meaningful loan repo market GUide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 9 Credit Strategy Research September 28, 2006 BankofAmerica ~~ --,---'-------,:-"""''-x 1- RUn secured SpreadLCDS SpreadUl1secured ( ) Figure 7 illustrates this relationship: Figure 7" Implied LCOS Recovery, Based on Expected Senior Unsecured Recovery Shown for LCDS trading at O,,80X, O,,60X, or O,,40X senior unsecured spreads For example, if expected senior unsecured recovery is 40% and LeDS trades at 0 4x senior unsecured CDS implied LeDS recovery is 76% -+-080X . .060X _ _ OAOX 0 ~ 100% ~. Q) Q) CfJ > 0 <= 80% fg& 60% u- 40% ~o 1JI. , ....... .---_..__ ;.' , , ....".,,' : . , ..,." , _ _----,.-'-t--.. _..;..~! .. ' ,.. . ' . .. - . ~~ => Q) := @"CfJ ~ 20% 0% 20% 30% 40% 50% Assumed Senior Unsecured Reco""ry 60% Source: Bane of America Securities LLC estimates For example, assume that the expected senior unsecmed recovery rate is 40%, and LCOS trades at 06x senior unsecmed COS (the gray line)-about the average ratio seen in recent months Then, the implied LCOS recovery rate is 64%, An investor who believes that LCOS will recover more than 64% should consider selling LCOS protection, and buying senior unsecmed protection (and vice-versa) Recent Patterns: Seifers of LeDS Protection LCOS has consistently traded cheap to implied fair value spreads In recent months, the LCOS market has seen significant demand for selling protection, Figwe 8 and Figure 9 illustrate why Using data on 20 credits, we compare the average LCOS spread with that implied by senior unsecured CDS All the Reference Entities trade in both the secmed and unsecmed markets We assume a recovery rate of75% for LCOS and 40% for senior unsecmed CDS Since May 2006, LCOS has consistently traded cheap to implied spreads (the line in Figure 9 is always positive) That is, investors whO sell LCOS protection and buy senior unsecmed protection, default-neutral, would expect to profit, conditional on recoveries being as expected Accordingly, the market has seen steady selling of LCOS protection 10 Guide to Leveraged Loan COS Glen laksler 212,,933,,2559 Credit Strategy Research September 28, 2006 Bankof America 4-~ Figure 8" LCDS Trades Wide to Implied Spreads.." Actual LCOS vs. LCOS Implied by Senior Unsecured COS Spread Assumes 75% Recovery for LeOS, 40% for Senior Unsecured CDS Figure 9" "."LCDS Rich/Cheap Monitor Actual LeDS Minus LeOS Implied by Senior Unsecured CDS Spread Assumes 75% Recovery for LeOS, 40% for Senior Unsecured CDS -Actual LCOS -LCOS Implied by Senior Unsecured COS 150 140 (ii' Co ~ -Actual - Implied LCOS 30 ~' ~ LCDS Cheap 25 20 15 10 5 0 1-May 1-Jun 1-Jul 1-Aug 1-Sep e 130 120 110 100 90 80 1-May 1-Jun 1-Jul 1-Aug 1-Sep e LL u: ~ > '" Ol '" >;Ol Ol .2: Average of AW AVIS Ole 5lZ OTV EP GP GT HlZ EK LEA MIR NMG NRG. RRI SSCC, SOS SVU, URI WIN, ASsumes 75% recovery rate for LeOS and 40% recovery rate for senior unsecured CDS Average of AW AVIS eve 5lZ OTV EP GP GT HlZ EK LEA MIR NMG NRG RRI SSCC SOS, SVU, URI WIN, Assumes 75% recovery rate for LeOS and 40% recovery rate for senior unsecured CDS Source: Banc of America Securities LLC estimates Source: Bane of America Securities ltC estimates An Alternative Explanation: Lower Recovery Rates in the Next Default Wave? An alternative explanation is simply that the market expects lower recovery rates in the futme. As Figure 10 shows, the par amount of outstanding leveraged loans has nearly tripled since 2000 Ihis growth arguably should push down secured loan recovery rates, due to greater supply Senior unsecmed recovery rates also may decline, due to secmed loans having a higher priority in the capital stIUctme Figure 10" Par Amount of Outstanding Leveraged Loans Market Has Nearly Tripled Since 2000 Figure 11. Recovery Inversely Related to Default Rates Shown for Senior Unsecured Debt 350 liJ300 ell 70% i:' e250 '" . 200 ~ o :; " ~ 150 100 50 ~ Ol -g 40% :E '" 30% 20% &! " 50% i5 Ol 60% .2004 y =-763x + 054 R' = 0.65 ~. ..-.....,. 200;-""" 2000 2001 ijl 10% !!2 o 1996 1998 2000 2002 2004 Sep-06 Primarily institutional tranches Source: Standard and Poor s LCD; S&PjLSTA Leveraged Loan Index, 0% + - - - - r - - - - . . - - - , - - - - - - , 0.. 0% 10% 20% 30% 4.0% Global Corporate DefaUlt Rate Global corporate default rate shown for all corporates not just investment grade or high yield Source: Moody's; Bane of America Securities LLC estimates Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 11 Credit Strategy Research September 28, 2006 BankofAmerica <?-~ Moreover, as shown in Figure II, a high global default rate would likely result in lower senior unsecured recovery rates, should we see a return to such an environment. These expectations would support a tighter LCDS-to-senior unsecured CDS spread ratio, even without a change in expected secured loan recovery rates 8 The current LCDS~senior unsecured CDS spread relationship would be supported by the following recovery rate expectations: 65% secured loan-35% senior unsecured, 60% secured loan-30% senior unsecured, or 55% secured loan~20% senior unsecured Unwinds Due to prepayment risk, unwinds in LCDS are typically quoted in price, not spread Due to prepayment risk, unwinds in LCDS are typically quoted in price, not spread Here's why Consider an investor who has earned 20 bps, after accounting for the bidoffer spread In senior unsecured CDS, an unwind is straightforward. Cash flows are exchanged on the present value of the 20-bp profit to maturity, 01 roughly $80,000 per $10 million notional (20 bps profit x $4,000 DVOI for a typical high yield credit) By contrast, in LCDS, an investor must consider prepayment risk A higher assumed prepayment speed will result in a shorter duration (DVOI) and lower present value Figure 12 illustrates the approximate DVOI used in LCDS unwinds, for both first and second lien contracts: Figure 12. Approximate DVD1 used in LCDS Unwinds First Lien Uses Roughly the Same DVOl as Senior Unsecured CDS (Little-No Prepayment Penalty) Second LIen Uses Roughly 40% of the Senior Unsecured OVOl (Significant Prepayment Penalty) Actual prepayment penalty varies by Reference Entity 5000 o ':;:; ~ g) 4000 0 > 0 o z 3000 c. 0 ~':': ~ c.~ ~ E 2000 1000 'E ---------Leos Universe - - First Lien -Second Lien o+---~---~--~---~--~ o 100 200 300 400 500 Spread (bps) Rrst lien OVOl shown as the OVOl to matUlity Second lien OVQl shown as the OVOl to maturity multiplied by 40% Source: Bane of America Securities LlC estimates In general, the market assesses only a minor prepayment penalty on first lien loans In general, the LCDS market assesses only a minor prepayment penalty on first lien loans For second lien loans, the market generally multiplies the DVOI to maturity by 40% In other words, for a five-year second lien loan, the market generally assumes repayment around year two. 8 The correlation between default and recovery tates is generally restricted to senior unsecured bonds, with a correlation of-85% since 2000, Secured loan recoveries are not very related to default rates, with a conelation of just -20% since 2000, according to Moody's data and our estimates 12 Guide to Leveraged Loan CDS Glen 1aksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica~~ Due to the risk of cancellation, Investors with a significant markto-market profit In LCDS should consider unwinding a trade and Immediately reinstituting the position Due to the risk of cancellation, investors with a significant mark-to-market profit in . LCDS should consider unwinding a trade and immediately reinstituting the position Although the investor pays the bid-offer spread (transaction cost), the unwind allows the investor to realize profits.. The investor will keep those profits should LCDS later cance1 9 For example, suppose an investor sold protection and now shows a $500,000 mark-tomarket gain. If LCDS cancels, the investor will lose the entire mark-to-market gain, and instead show zero realized P&L. To mitigate this risk, the investor should consider unwinding the trade, which allows him to realize the entire mark-to-market gain If the investor remains bullish, he may institute a new trade, selling plOtection at the cunent level Now, ifLCDS cancels, the investor will keep the original $500,000 gain, and only risk losing a (smaller) mark-to-market gain on the new trade LCDS cancellability also has geographical implications Assuming that the final version of EUlOpean LCDS documentation permits cancellation following the prepayment ofa Reference Obligation (regardless of whether it is refinanced), the riskreturn profile may be more favorable for protection sellers on US credits The reason is that, as credit quality improves, an issuer may force a refinancing, by threatening to prepay otherwise European LCDS contracts will cancel, erasing any mark-to-market profits for the protection seller By contrast, US LCDS contracts will continue, with mark-to-market plOfits continuing to accrue LCDX The market plans to launch a 100-name Index of LCDS contracts In late 2006, the market plans to launch a 100-name index of LCDS contracts, called "LCDX " Similar to the CDX indices for senior unsecured investment grade ("CDX 10"), senior unsecured high yield ("CDX BY"), and ABS ("ABX"), key features are expected to be as follows: ~ 100 first-lien LCDS contracts as Reference Entities. Although not all of these entities are regularly quoted in the single-name LCDS market, there is an expectation that trading volumes will implOve over time (similar to CDX BY and the development of high yield senior unsecured CDS) Broad diversification aclOss sectors and ratings categories (no formal requirements) Semi-annual rolls Quoting convention in dollar price, not spread (similar to the senior unsecured high yield index) Cash settlement, or potentially a fixed recovery rate ~ ~ ~ ~ Collateralized Loan Obligations (eLOs) Over time, we expect hedging flom synthetic collateralized loan obligations (CLOs) to become a major source ofLCDS protection selling A CLO carves up leveraged loan risk into a large, relatively safe piece, concentrating portfolio risk into a small slice Typically, long positions in higher quality (senior) portions ofthe CLO market are held by longer-term, hold-to-maturity investors, such as insurers The corresponding short 'Naturally, if the investor is no longer bullish (for a sell LCDS position) or bearish (for a buy lCDS position), the investor should not reinstitute the trade after an unwind Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 13 Credit Strategy Research September 28, 2006 BankofAmerica ~o? .... position is typically held by dealers and hedge funds To offset their risk, dealers usually buy cash loans As the LCDS market evolves, we would look for that hedging to transition flam cash to LCDS. In other words, a strong synthetic CLO market should result in significant demand for selling LCDS protection W However, we expect this transition to be very gradual, for two reasons: ~ The negative basis has made hedging with LCDS unattractive That is, cunently, selling protection in LCDS would result in a lower spread than buying a loan Early termination-Following a loan prepayment, the designated Reference Entity will fall out of a CLO A hedge using cash loans reflects these dynamics. That is, risk will terminate on both the CLO and the hedge sides of the transaction By contrast, US LCDS contracts will continue, assuming the loan facility is refinanced The dealer would now have an unhedged long risk position in LCDS, making a hedge with LCDS less attractive. ~ We look for hedging activity with LCDS to occm more quickly in Europe, where LCDS contracts ar'e expected to terminate if a loan facility is canceled, regardless of whether it is refinanced Special Features of Loan CDS LCDS uses a Physical Settlement Rider In addition to the 2003 ISDA Credit Derivatives Definitions, LCDS uses a Physical Settlement Rider ("LCDS Rider"), The LSTA publishes the rider, which is intended to be used with fue Syndicated Secured Loan Credit Default Swap Standard Terms Supplement ("LCDS Standard Terms"), published by ISDA Figure 13. Key Documents Surrounding Loan CDS Sources: ISDA; LSTA; Bane of America Securities LlC W lobe clear, a CLO does not reference a pool of LCDS contracts, Instead, a CLO references a set of Reference Entities and, for each entity, a Loan 14 Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica 4-~ The Reference Obligation and the Secured List In senior unsecured CDS, confirms typically designate a Reference Obligation, which establishes the seniority of the trade.. A bond (or loan) used to physically settle a trade must be pari passu or better than the Reference Obligation 11 LCOS trades often do not specify a Reference Obligation, or specify "Secured List" By contrast, LCDS trades often do not specifY a Reference Obligation, or specifY "Secured List" Under these circumstances, the Reference Obligation becomes a Loan of the Designated Priority-e g, first or second lien-as specified on a list (the "Relevant Secured List") Currently coordinated by Markit Group Limited, the list is designed to specifY obligations that are deliverable into the trade Formally, these obligations are called Syndicated Secured Obligations of the Designated Priority. The list is available electronically at http://www markit com. Ihe list is not exclusive, so a protection Buyer is allowed to attempt delivery of an obligation that is not on the list, ifhe believes it to be Deliverable Dealers have informally agreed only to specify a Reference Obligation on a confirmation ifthere is no Secured List at the time of the trade. Importantly, the Relevant Secured List takes precedence over any Reference Obligation specified in the LCDS Confirmation, unless the parties expressly agree otherwise 12 This precedence applies regardless of whether a Secured List exists at the time of a trade Syndicated Secured Characteristic To deliverable be Into an LCOS contract, an obligation must be uSyndicated Secured" lobe deliverable into an LCDS contract, an obligation must be "Syndicated Secured" Ihis means any obligation that: ~ Arises under a syndicated loan agreement, and lrades as a loan of the Designated Priority (first-, second-, or third-lien) under the then-current trading practices in the loan market. Importantly, note that Syndicated Secured is a trading standard, not a legal standard ~ Either party may dispute the Calculation Agent's determinations Ihe Calculation Agent determines whether an obligation satisfies these criteria However, either party may dispute the obligation, by providing notice to the other party and the Calculation Agent 13 The party may dispute whether: ~ ~ The then-current Reference Obligation satisfies the Syndicated Secured criteria, Ihe relevant Proposed Substitute Reference Obligation satisfies the Syndicated Secured criteria This type of dispute may occur if the Reference Obligation is refinanced U Reference Obligations establish the seniority, not the security, of a trade For example, if a CDS trade is on senior unsecured debt, a senior unsecured bond may be delivered, even if the Reference Obligation is senior secured. The bond delivered simply must be pari passu or better in seniority to the senior secured Reference Obligation In US high yield CDS, this example arises with Lyondell, for example.. Also note that, in summer 2006, there was discussion surrounding the removal of Reference Obligations on senior unsecured CDS trades. As of the time of this publication, Reference Obligations are still used in standard confirms 12 If the Reference Obligation changes as a result of the Relevant Secured List, the Calculation Agent is not obligated to notify parties of the change U Typically, the Calculation Agent is the bank or broker-dealerin a transaction In the case of two banks or broker-dealers, the Calculation Agent usually is the protection Seller This suggests that, in practice, only the non-bank or broker-dealer (or protection Buyer in the case of two banks or broker-dealers) would file a dispute notice Guide to Leveraged Loan COS Glen Taksler 212,,933,,2559 15 Credit Strategy Research September 28, 2006 BankofAmerica ~~ ~ One or one or more of the relevant Proposed Relevant Obligations satisfies the Syndicated Secured criteria This type of dispute is relevant, for example, in determining a potential Succession Event In the case of a Credit Event, a proposed Deliverable Obligation satisfies the Syndicated Secured Criteria This type of dispute must be registered by the protection Seller" ~ The disputing party is called the "Search Disputing Party," and typically must deliver notice within 3-4 Business Days following the Calculation Agent's determination For details on the dispute process, please see Appendix A: More on the Dispute Resolution Process Settlement Currently, single-name LCOS trades are physically settled Currently, single-name LCDS trades are physically settled. Similar to senior unsecured CDS, a Credit Event entitles the LCDS protection Buyer to par (the notional amount of the trade), in exchange for the delivery ofa physical loan There are several features of LCDS settlement that differ substantially from senior unsecured CDS: ~ Settlement Timeline Participation Loans Delayed Settlement A Market Standard Indemnity ~ ~ ~ Settlement Timeline Figure 14 illustrates the settlement process for lCDS: Figure 14. LCOS Settlement Tlmellne Credit Event Occurs Notice of Physical Settlement ("NaPS") 30 Calendar Days After E\<9nt Determination Date Protection Buyer refPonsible for delivery Physical Settlement Date 30 Business Days After Notice of Physical Settlement ~ .~----,c------r------j""'>--,...-----r----,------,-<, 0+ 10 20 Event Determination Date Usually T+O or T+1 Business Days Effective date of Credit Event Notice and Notice of Publicly Available Information Either party may deliver Sources: ISDA; Bane of Amelica Securities LLC I +- 30 + 40 50 60 70 NaPS Fixing Date 3 Business Days After NOPS If Protection Buyer wishes to re";se NOPS, must do so by this date Maximum Number of Calendar Days following Credit E\<9nt Following a Credit Event, either party may deliver a Credit Event Notice and Notice of Publicly Available fnformation The effective date is called the Event Determination Date, and is usually effective the same day or one Business Day after the Credit Event " If a third party disputes a proposed Deliverable Obligation, the Seller may be forced to dispute the same proposed Deliverable Obligation on other trades Ihis situation may arise where the original protection Seller subsequently bought protection liom the third party, even ifthe original Seller believes the obligation is Deliverable 16 Guide to Leveraged Loan COS Glen Taksler 212.,933,,2559 Credit Strategy Research September 28, 2006 Bankof America -.t? s- Date Thirty calendar days later, the protection Buyer must deliver a Notice of Physical Settlement ("NOPS"), stating which obligation(s) the Buyer intends to deliver for Physical Settlement LCDS has a longer settlement process than senior unsecured CDS So far, the process has been the same as for senim unsecured CDS" But at this point, the two contracts differ Senior unsecured CDS typically settles T+3 Business Days after the Notice of Physical Settlement By contrast, because of a more diflicult process surrounding the transfer ofloans (for instance, required consent of the original loan Bonower), the LCDS settlement process continues: ~ After a Notice of Physical Settlement is delivered, the Buyer has three Business Days to revise it The third day is called the NOPS Fixing Date The LCDS protection Buyer is only permitted one revision to the Notice of Physical Settlement (By contrast, in senior unsecured CDS, there is no limit to the number of revisions) If for some reason the Buyer cannot deliver a loan from either attempt, or the Deliverable Obligations are successfully disputed on both attempts, then protection becomes worthless As such, the protection Buyer must be careful about which obligations it specifies" The Physical Settlement Date is 30 Business Days after delivery of the Notice of Physical Settlement" ~ ~ Participation Loan An LCDS Deliverable Obligation must be a Participation Loan" Most US Loans satisfy this criteria In addition to Syndicated Secured, an LCDS Deliverable Obligation must be a Participation Loan This means a loan for which the protection Buyer can create participation rights for the protection Seller, through Assignment, Participation, or Subparticipation. Most US loans satisfY this criteria:" ~ Assignment: The protection Seller becomes the direct signatory to the loan, and receives interest and principal directly flom the Administrative Agent of the loan agreement Assignments usually require consent ftom both the Bonower and the Administrative Agent The Buyer must attempt to make delivery by Assignment, and has a 13 Business Day grace period beyond the Physical Settlement Date to do so Participation: If an Assignment is unsuccessful, the parties may execute a participation agreement (the then-current form, as published by the LSTA) The protection Buyer remains the lender under the loan agreement, but the Seller takes a participating interest The protection Seller is not entitled to voting rights. The Participation must settle within 14 Business Days after the ~ " For more details, please see "The Finer Details of CDS Contracts" in our C,edit Default Swap Fnme, Second EditIon, January 5,2006. '" Tcchnically, the protection Buyer may be able to revise a NOPS more than once, provided he does so before the NOPS fixing date (3 Business Days after the original NOPS was delivered) Such a scenario may arise in the case ofa clerical error "Note that the Physical Settlement Date is 30 Business Days after the Notice of Physical Settlement, not 30 Business Days after the NOPS Fixing Date '" If; for example, a credit facility agreement stated that a loan could be assigned, but did not allow for a Participation, then that loan would not be deliverable into an LCDS contract Such restrictions are rare in the US loan market Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 Bank of America ~~ Assignment was planned to settle The Seller may refuse to settle by Participation, in wbich case the trade must cash settle" ~ Subparticipation: Delivery of an interest in a Participation, where the Buyer owns the loan agreement through a Participation, and the Seller Participates through the Buyer. Uke a Participation, the protection Seller is not entitled to voting rights lithe cheapest-to-deliver loan trades above par, the tIade is terminated, and no cash flows are exchanged In Europe, the finalized criteria may be more lenient, allowing the protection Seller to opt for Cash Settlement at any time Revolvers Revolvers are deliverable Into LCDS contracts In contrast to senior unsecured CDS, Revolvers are deliverable into LCDS contIacts 20 However, the outstanding principal balance--that is, the sum of all funded and unfimded commitInents of a Revolver~may not exceed the Physical Settlement Amount (the sarne as the LCDS notional, except for Delayed Settlement, discussed below)" Delayed Settlement The protection Buyer must pay Delayed Compensation, If LCDS settles after the designated Physical Selllement Date Ifthe protection Buyer does not settle by Assignment or Participation by the Physical Settlement Date, then the Buyer must pay delayed compensation Delayed compensation consists of acclUed LCDS interest flom (and including) the Physical Settlement Date to (but excluding) the Delayed Settlement End Date, plus a penally. The exact details of the penally are still being finalized. Market Standard Indemnity In senior unsecured CDS, Counterparly risk ends as soon as a trade is terminated (regardless of whether a Credit Event has occUlred) The protection Buyer must Indemnify the protection Seller against potential deficiencies In the documentation used to transfer a loan By contIast, in LCDS, the protection Buyer continues to have Counterparly risk after settling a tIade on a Credit Event In particular, if the protection Seller suffers damages because its physical delivery documentation is inconsistent with standard market practice at the time of the transfer, then the Seller may pursue a claim against the Buyer 22 "If the protection Buyer fails to Settle a Participation on time, the protection Seller may demand Cash Settlement up to, and including, the fifth Business Day following the planned Participation Settlement Date Moreover, if the protection Buyer still has failed to deliver within 15 Business Days of the planned Participation Settlement Date, then the tIade automatically reverts to Cash Settlement '" Technically, a Revolver may be delivered into senior unsecUled CDS, if the protection Buyer is willing to indemnify the Seller against any potential futuIe drawdowns, to the Seller's satisfaction " The outstanding principal balance is determined as of the earlier of the Delivery Date and the Notice of Physical Settlement ("NOPS") Fixing Date, as described in Figute 14. In the case ofmulticUlrency Revolvers, the outstanding principal balance is converted to the base cUlrency of the Revolver " Although a gray area, it may be argned that, if there are multiple standard market practices at the time of tIansfer, the protection Buyer may choose any of them. That is, the Market Standard Indemnity does not afford the protection Seller reCOUlse for the choice of one market standard over another For example, in Worldcom, there was a dual standard: some debt traded with litigation rights, and other debt traded without litigation rights It may be argued that either standard would have been acceptable 18 Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~<? .... The logic is as follows. In the cash loan market, parties typically negotiate terms of delivery in the LSTA Purchase and Sale Agreement ("PSA"), which takes time By contrast, LCDS trades are designed to be settled along a fixed timeline, as was illustrated in Figure 14. The Market Standard Indemnity is designed to eliminate the need for negotiation of documentation, and therefore allow LCDS to settle on time Appendix A: More on the Dispute Resolution Process In the case of a dispute, a Polling Agent conducts a poll as to whether the Syndicated Secured criteria was satisfied as ofthe relevant day. The Polling Agent is the Secured List Publisher (currently, Markit Group Limited), if a Relevant Secured List existed as of the relevant day, and the Calculation Agent otherwise There are two Polling Questions: ~ Does the Relevant Obligation (i) constitute a currently outstanding loan (including any unfunded lending commitment) with respect to which the Reference Entity is a direct obligor or guarantor and (ii) arise under a syndicated loan agreement and trade under then-current trading practices in the primary or secondary loan market on the Relevant Day as a loan with a priority of at least third lien? If so, as of the Relevant Day, as what priority of loan did the Relevant Obligation trade under then-current trading practices in the primary or secondary loan market (ie, first lien loan, second lien loan or third lien loan)? ~ The initial list of Participants (eligible voters) is: Bank of America, Bear Stearns, Credit Suisse, Deutsche Bank, Goldman Sachs, IP Morgan, Lehman Brothers, Menill Lynch, Morgan Stanley, Royal Bank of Scotland, TD Securities, and UBS , Responses must be received within five business days. However, the Polling Agent may close the poll early, after the second business day, provided that a Quorum of at least three responses has been received, and the results could not be changed regardless of how remaining Participants vote Results are as follows: ~ An "Affirmative" poll result means that the Disputed Obligation satisfies the Syndicated Secured criteria. This requires a 75% threshold iffour or more responses to the poll are received, or a 100% threshold ifthree responses are received 23 ~ A "Negative" poll result means that the Disputed Obligation does not satisfy the Syndicated Secured criteria No Quorum (fewer than three responses, when the Secured List Publisher~ e.g , Markit~is the Polling Agent) ~ In the event of a Negative result: for the transfer of physical loans under LCDS contracts Importantly, the definition of standard market practice is determined at the time that a dispute is resolved " However, if the Polling Agent is the Calculation Agent, then a 100% threshold flOm two respondents sullices The logic is that the Calculation Agent may act as one of the respondents, and already has argued that the obligation is Syndicated Secured Additionally, if the Calculation Agent receives one or no responses, then the Calculation Agent may determine whether the Disputed Obligation is Syndicated Secured. This determination is binding, absent manifest or obvious error Guide to Leveraged Loan CDS Glen 1aksler 212..933.,2559 19 Credit Strategy Research September 28, 2006 BankofAmerica ~~ ~ ~ For the then-cUlrent Reference Obligation or a Proposed Substitute Reference Obligation, the Calculation Agent must attempt to identify a new obligation For a Proposed Relevant Obligation, the Calculation Agent must make any determinations without regard to that Proposed Relevant Obligation For a Proposed Deliverable Obligation, the Buyer may revise its Notice of Physical Settlement ("NOPS") within three business days However, the Buyer may only revise its NOPS once Should the Buyer revise its NOPS and the revised Proposed Deliverable Obligation is successfully disputed, the Buyer will not be able to deliver anytbing into the LCDS contract Protection becomes worthless 24 ~ To coordinate multiple disputes, the Polling Agent is only required to conduct one poll Ihat is, if a poll already has been conducted with respect to the same Loan, Reference Entity, Designated Priority, and relevant day, the results become a "Benchmark Poll," and the results are binding for other standard LCDS trades Appendix B: Deriving the Spread Relationship Between LCDS and Senior Unsecured CDS Assuming that LCDS and senior unsecured CDS have the same probability of defimlt: Probability of default in LCDS = Probability of default in senior unsecured CDS Or: 25 SpreadLCVS I-R ,CDS Spread,CVS SpreadUnsecured SpreadUnsecured 1- RUn secured Where R represents the recovery rate.. Reananging: 1- R Lcvs 1- RUnsccured In other words, suppose an investor expects to lose half as much on leveraged loan CDS, relative to senior unsecUled CDS, following a Credit Event. Then, the fair value of leveraged loan CDS is half the spread of senior unsecured CDS As noted in the main text, this formula is an approximation because, in reality, the probability of default is higher in senior unsecured CDS than in LCDS The reason is that Restructuring is only a Credit Event in senior unsecured CDS ~ I echnically, the protection Buyer may not revise its NOPS if the Deliverable Obligation was fIrst identifIed in a NOPS after the NOPS Fixing Date The NOPS Fixing Date is the third Business Day after a Credit Event Notice and Notice of Physical Settlement have been delivered. For more details on a NOPS, please see, "The Finer Details of CDS Contracts" in our Credit Default Swap Primer Second Edition, January 5, 2006 "For more details, please see "Implied Probability of Default" in our Credit Defauit Swap Pnmer Second Edition, January 5, 2006 20 Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~~ Guide to Leveraged Loan CDS Glen 1akoler 212,,933,,2559 21 Credit Strategy Research BankofAmerica -~ September 28, 2006 REG AC - ANALYST AND FIRM CERTIFICATION The research analyst whose name appears on the front page .of this research report certifies that: (1) all of the views expressed in this research report accurately reflect his or her personal views- about any and all of the subject securities. or issuers; and (2) no part of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research report To the extent that any of the views expressed in this report have been produced as a.result of the application of the Credit OAS quantitative proprietary model, Bane of AmcricaSecUIities LLC (BAS) and its affiliates certify that (1) the views expressed in this report accurately reflect the Credit OAS quantitative model as to the securities and companies mentioned in the report and (2) no part of the firm"s compensation from any company mentioned in this report was, is Ot will be, directly or indirectly, related to the views or results produced by the Credit OAS quantitative modcl, For a description of the Credit OAS proprietary credit evaluation model, including the data input into the model, please see Introduction to Lighthouse: Credit Option Adjusted Spread, PortfOlio Analytics and Data Analysis, dated May 12,2006. IMPORTANT CONFLICT OF INTEREST DISCLOSURES The analyst and associates responsible for preparing this research report receive compensation that.is based upon various factors. These include (i) the overall profitability of BAS and itS affiliates, (ii) the profitability of the fixed income department of BAS and its affiliates and (iii) the profitability of BAS, and its affiliates from the fix~d income security asset class covered by the analyst or associate A portion of the profitability of BAS and its affiliates, their fixed income department and each security asset class is generated by investment banking business Resear'ch analysts and associates do not receive compensation based upon revenues generated from any specific investment banking transaction BAS and affiliate policy prohibits research persomiel from disclosing a rating, recommendation or investment thesis fOt review by an issuer prior to the publication of a research repmt containing such rating, recommendation or investment thesis Materials prepared by BAS and affiliate research personnel arc based on public information BAS and its affiliates prohibit analysts, their associates and members of their households from maintaining a financial interest in the securities or options of any company that the analyst covers except in limited circumstances as permitted by BAS and affiliate policy, Any such direct securities ownership by the analyst(s) preparing this report is disclosed above, The absence of any such disclosure means that the analyst(s) preparing this report does(do) not have any such direct securities ownership in his or her covered companies mentioned in this report Such persons may own diversified mutual funds BAS and its affiliates are regular issuers of traded financial instruments linked to securities that are mentioned in this report BANC OF AMERICA SECURITIES RATINGS DISCLOSURES BAS High Grade and High Yield Research employ a BuylNeutrallScll rating system and these recommendations carry a time horizon of six months Buy: Spreads and I or total returns are likely to outperform sector averages over the next six months; the company has improving credit fundamcntals and/or it is trading at a notable sprcad eonecssion relative to bonds of comparable risk within thc scctor Neutral: Spreads and / or total returns are likely to perform equal to or near sector averages over the next six months; the company generally has solid credit fundamentals and/or it is trading in line relative to bonds of comparable risk within the sector Sell: Spreads and / or total.reti.uns are likely to underperform sector averages over the next six months; the company may havc weakening credit fundamentals and/or it is trading at a notable spread premium relative to bonds of' eomparable'riskwithin the sector High Grade and High Yield Research use the foliowing rating system with respect to Credit Default Swaps (CDS), Buy: We recommend that investors buy protection in CDS, thercfore going short credit risk; Neutral: We are neutral on CDS and expect performance in line with sector performance; Sell: We recommend that investo~ sell protection in CDS, therefore going long credit risk High Grade Research also employs a formal structure to define sector performance, usingOverweightlMarketWeightlUnderwcight. The sector recommendation time horizon is determined by the expected performance over the next six months but sector recommendation changes may occur at any time bascd upon sector analysis and relative value Overweight The sector is expected to outperform excess spread retwns of High Grade corporate indices, namely the BAS Broad Market Index (BAS BMI} over the next six months Market Weight: The sector is expected to perform in line with excess spread returns of High Grade corporate indices, namely the BAS BMI, over the next six months . Undcrweight: The sector is expected to underperform exccss spread rcturns of High Grade corporate indices namely the BAS BMI, ovcrthe next six months Rating Distribution' Coverage Universe Buy Hold Recommendations 145 342 Pet, Investment Bankin"g Clients Recommendations Pct.** 41 46 ~ 28 Buy 59 64 Hold 157 ~ ~ 8 ~ ~ * For the purposes of this Rating Distribution, "Hold" is equivalent to our "Neutral" rating '+ Percentage of recommendations in eaeh rating group that are investment banking clients As of7/l/2006 Further information on any security or financial instrument mentioned herein is available upon request, 22 GuIde to Leveraged Loan CDS Glen Taksler 212,,933,,2559 Credit Strategy Research September 28, 2006 BankofAmerica ~~ Disclaimers This document is being provided to you based on the fact that you are a Qualified Institutional Buyer under Rule 144A of the Securities Act of 1933 or equivalent sophisticated institutional investor or professional in the fixed income market. Recipients who arc not institutional investors or murkct professionals should seek the advice of their independent financial advisor before considering information in this report in connection with any investment decision or for a necessary explanation of its contents I'hls report has been prepared as part of independent research activity or quantitative analytics and not in connection with any proposed offering of securities ot as agent of the issuer of any securities. This report has been published indep.endently of any issuer of securities mentioned herein None of BAS, its affiliates or their analysts (collectively, BofA) have any authority whatsoever to make any representation or warranty on behalfofthe issuer(s), This report is provided for infonnation purposes only and is not an offer or a solicitation for the purchase or sale of any financial instrument Any decision to purchase or subscribe for securities in any offering must be based solcly on existing public information on such security or the information in the prospectus or other offering document issued in connection with such offering, and not on this report BofA may have issucd, and may in the future issue, a trading. call regarding a security that is the subject of this report I rading calls arc short term trading opportunities based on market events or catalysts, while ratings reflect investment recommendations based on l2-month period relative to the relevant coverage universe Because trading calls and ratings reflect different assumptions and analytical methods, trading calls may differ directionally from the rating on a security. In addition, BofA may have issued and may in the future issue, other reports that arc inconsistent with and reach different conclusions from" the infonnation presented in this report Those reports reflect the different assumptio.ns, views and analytical methods of the persons who prcpared them and BofA is under no obligation to ensure that such other reports are brought to the attention of any recipient of this report. Securities recommended, offered or sold by BofA are not insured by the Federal Deposit Insurance Corporation, are not deposits or other obligations of any insured depository institution (including Bank of America, N A ) and are subject to investment risks, including the possible loss of the principal amount invested lhe information contained in this report'(with the exception of the infonnation set forth under the captions "Regulation AC Certification" and "Important Disclosures) has been obtained from and is based on sources believed to be reliable, but we do not guarantee its accuracy or completeness and it should not be relied upon as such. All opinions" projections and estimates constitute the judgment of the author as of the date of the report and are subject to change without notice. Prices also arc subject to change witllOut notice. BofA is under no obligation to update this report and BofA's ability to publish research on the subject company(ies) in the futurc is subject to applicable quiet periods You should therefore assume that BofA will not update any fact, circumstance or opinion contained in this report Investing in non-U S securities may entail certain risks. The securities of non-U,S issuers may not be registered with, nor be subject to, the reporting requirements of the U.S Securities and Exc~ange Commission, There may be limited information available on foreign securities, In general, foreign companies are not subject to uniform audit and reporting standards, practices and requirements comparablc to those of U.S. companies. In addition, exchange rate movements may have an adverse effect on thc value of an investment in a foreign stock and its corresponding dividend payment for U. S investors. Investors who have received this report from BAS or an affiliate may be prohibited in certain states or other jurisdictions from purchasing securities mentioned in this reportfi'om BAS or its affiliate(s) Investments in general, and derivatives (that is, options. futures, warrants, and contracts for differences) in partieular,.involve numerous risks, including, among others, market risk, counterparty default risk and liquidity risk. Derivatives arc not suitable investments for all investors, and an investor may lose all principal invested and in some cases, may incur unlimited losses It may be difficult to sell an investment and to obtain reliable infonnation about its value or the risks to which it is exposed Past performance of securities loans or other financial instruments is not indicative of future perfonnanee This report is not prepared as or intended to bc invcstment advicc and is issued without regard to the spccifie investment objcctives, financial situation or particular needs of any specific recipient, In the event. that the recipient received this report pursuan.t to a contract bctwcen thc recipient and BAS for the provision of research services for a separate fee. and-in connection therewith BAS may be deemcd to be acting as an investment adviser, such status relates, if a,t alL solely to the person with" whom BAS has contracted directly and does not extend beyond the delivery of this report (unless otherwise agreed specifically in writing by BAS) BAS is and continues to act solely as a broker-dealer in connection with the execution of any transactions. including transactions in any sCC\lrities mentioned in this report Neither BofA nor any officer or employee ofBofA accepts any liability whatsoever for any direct indirect or consequential damages or losses arising from any use of this report or its contents BofA does not provide tax advice. Accordingly, any statements contained herein as to tax matters wcrc neither writtcn nor intended by the sender or BofA to be used and cannot be used by any taxpayer for thc purpose of avoiding tax penaltics that may be imposed on such taxpayer If any person uses or refers to any such tax statement in promoting, marketing or recommending a partnership or other entity,. investment plan or arrangement to any taxpayer, then the statement expressed above is being delivered to support the promotion or marketing of the transaction or matter addressed and the recipient should seek advice based on its particular circumstances from an independent tax advisor Notwithstanding anything herein to the contrary, any party hereto (and any of its cmployees represcntatives and othcr agents) may disclose to any and all persons without limitation of any kind the tax treatment or tax structure of this transaction With the exception of information rcgarding BofA, materials prepared by BofA research personnel are based on public information, Facts and views presented in this material have not been reviewed by, and may not reflect infonnation known to professionals in other business areas of BofA including investment banking personnel To EUf'opean and A sian Customers Ihis report is distribu~ed in Europe by Banc of America Securities Limited and in Asia by Banc of Amcric~ Securitics Asia limited 1'0 u.s. Customt'f'S." BAS has accepted responsibility for the distribution of this report in the. United Statcs to BAS clients, but not to the clients of its affiliate, Banc of America Investment Services, Inc. (BAl) Transaetion.s by U.S persons (other than BAI and its clients) in any security discussed herein must be carried out through BAS BAS provides research to its affiliate, BAI BAI is a registered broker-dealer member NASD and SIPG and is a nonbank subsidiary of Bank of ~mcrica N A 1'0 u.K. Customtrs. This document has been approvcd for distribution in the United Kingdom by Bane of America Securities Limited, which is'authorized and regulated by the Financial Services Authority for the conduct of investment business in thc Un.ited Kingdom. Prices, values or income ascribed to investments in this report may faIl against your interests, The investments may not bc suitable for yQ:u, and if in any doubt, yc:m should seck adviee from an investment advisor, Changes in rates of exchange may have an adverse effect on the value, price or income from an investment. Levels and basis for taxation may change. The protection provided by the U K. regulatory regime, including the Financial Services Compensation Scheme do not apply in general to business coordinated by BAS or its affiliates from an office outside of the Unitcd Kingdom . . These disclosures should be read in conjunction with the Banc of America Sccurities limited general policy statement on the handling of research ~onflicts-availableupon reqll,est . To German (us/orne,s, In Gcrmany, this report should be read as though BAS has acted as a member of a consortium that has underwritten the most recent offering of securities during the past five years for companies covered in this report and holds 1% or more of the share capital of such compa;nies To Canadian Customers, The contents of this report are intended solely,for the use of, and only may be issued or passed on to, persons to whom BAS is entitled to distribute this report under applicable Canadian securities laws, In the province of Ontario, any person wishing to effect a transaction should do so with BAS, which is registered as an International Dealer. With few exceptions, BAS only may effect transactions in Ontario with designated institutions in foreign securities as such terms are defined in the Securities Act (Ontario) To Hong Kong Custome, \ Any Hong Kong p'erson wishing to effect a transaction in any securities discussed in this report should contact Banc of America Securities Asia Limited To Customers in Other Count,ies. Ihis report, and the securities discussed herein,. may not be eligible for distribution or sale in all countries or to certain categories of investors In general, this report may be distributed only t9 professional and institutional investors This report may not be reproduced or distributed by any person for any purpose without the prior written consent of BAS Please cite source when quoting All rights are reserved 2006 Bank of America Corporation Guide to Leveraged Loan CDS Glen Taksler 212,,933,,2559 23 Banc of America Securities - Debt Research Directory Paula Dominick, Global Head of Debt and Equity Research (212) 847 5322 Credit Strategy Research Jeffrey A. Rosenberg, CFA Head of Credit Strategy Research (212) 933 2927 High Yield Research La"y Bland Head of High Yield Research International Credit Strategy Research Michael Contopoulos Lighthou~e (212) 933 3372 Analyti(;'~ Portfolio Strategy & Hans Mikkelsen High Grade (212) 847 6468 (212) 933 2577 (212) 933 2496 Clemens Mueller High Yield Olivera Radakovic Index Strategy Adam Roffman (212) 9332076 Restaurants S'upermarkets Collateralized Debt Obligation S'trategy Ana Goshko Glen Iaksler (212) 933 2559 Telecommunications Towers Derivatives' Strategy Douglas Karson Mingsung lang (212) 84'7 6083 Autos Lighthouse Portfolio Strategy & Analytic ~ James Kayler, CFA Xiaodong Zhu (212) 847 5489 Gaming Lodging & Leisure Lighthous'e Portfolio Strategy & Analytics Kelly J Krenger Energy +44 (20) 71745459 (212) B47 6502 Raja Vlsweswaran, CFA Head of International Credit Strategy Research BASL Healthwre Deathcare Eve Cabrillac +44 (20) 7174 15 I7 Philip Birbara (212) 847 5473 European Credit Strategy BA S'L Chemicals James Carey +44 (20) 7174 5314 Andrew Brausa (212) 847 6481 European Credit Strateg;. BA SI Building Materials Homebuilding Ivy l.i +85228476346 Kevin Cohen, CFA (212) 933 2721 A yian Credit Strategy BA SAL Paper & Packaging Metals & Mining John Schofield +44 (20) 71741518 Melissa Ford, CFA (212) 847 5577 European Credit Strategy BA SL (212) 847 5936 (212) 933 2405 (212) 847 5223 (212) 847 6410 (212) 933 3455 (212) 847 6498 (212) 933 2298 Broadw~tinglPubLishing High Grade Research Gregory Ransom, CFA Head of High Grade Research Manish A Somaiya Eric Toubin, CFA Technolo~ (212) 847 5773 Aerospace/Defeme Industrials ServiceY Basi( Industries Stan August Michael J Barry Insurance Domestic Banks Brokers European Banh Food & Beverage Theater;s (704) 388 5373 Stephen Weiss (212) 933 2547 (202) 442 7454 (704) 386 2524 (212) 933 2485 (212) 847 6224 (704) 388 5053 (704) 683 4878 (212) 9332405 Manufacturing Autos Cable/Satellites Andrew Bressler, CFA Wayhington Healthcare Christopher N Brown CFA RElTs Retaif Leiwre Homebuilding Kevin Christiano Media Telecommunications Dennis P Coleman, CFA Todd Duvick, CFA John Guarnera Domestic Banks. Einanee Companies Energy Pipelines Ma.ster Limited Partner;ships Food & Beverage Supermarkets Consumer Douglas Karson Aero~pacdDefense faith N Klaus, CFA (704) 386 8440 Electric. Utilities Independent Power David K. Peterson, erA (704) 386 9419 Healtheare The persons listed on this directory have the title "research analyst"" UnleSs othemise noted, any other contributors named on the front cover of this report- but not indicated above have the title "research associate". All research analysts are employed by Banc of America Securities LtC (BAS) except as noted above" BAS (United States) Bane of America Securities LLC 9 West 57'~ Street New York New York 10019 Tel Contact: 800 627 1804 214 North hyon Street Charlotte, North Carolina 28225 Tel Contact: 888 279 3457 BASL (United Kingdom) Bane of America Securities Limited 5 Canada Square London El4 5AQ, England Tel Contact: +44 (20) 7174 4000 BASAL (Hong Kong) Bane of America Securities Asia Limited 42/F Two International Finance Centre 8 f'inance Street, Central, Hong Kong 85228476346 ... View Full Document

End of Preview

Sign up now to access the rest of the document