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Correlation Conundrum
As Glen Taksler details below, the credit market found no respite from last week’s volatility, as
Repricing in the correlation
market may have caused correlation products in the credit derivatives market continued to significantly reprice. Concerns
the broader market index about potential spillover effects from hedge fund exposures to accelerating losses in mezzanine
to move wider, even as hedged equity strategies in ITRAXX and CDX indices led to a notable decoupling of the CDS
overall credit risk appeared indices (wider) and equity volatility (lower) as IG4 ended the day 1 bps wider while the VIX
to decline as equity
index ended 0.3 points lower. As Figure 6 below illustrates, there are few cases where the HG
volatility declined.
CDX index (excluding the impact of the autos and auto parts) and VIX decouple.
Jeff Rosenberg Figure 6. CDS Credit Spreads Decouple from Equity Market on Correlation Risk
212 933 2927 IG2, 3, 4 series indices excluding autos and auto parts vs. VIX index
IG ex Autos/Parts VIX
65 20
VIX and CDX decouple on Correlation Concerns
IG Spread (ex Autos, Series 3 to Sept 20, Series 4 from
19
60
18
55 17
16
March 21 05)
50
VIX %
15
45
14
40 13
12
35
11
30 10
N 4
4
Au 4
Ja 5
Fe 5
M 5
05
M 5
M 5
5
Au 4
Se 4
Se 4
O 4
D 4
D 4
Ja 4
5
O 4
4
-0
-0
0
l-0
r-0
r-0
0
-0
-0
0
0
-0
-0
-0
-0
-0
-0
n-
n-
b-
b-
g-
g-
p-
p-
ov
ov
ar
ar
ec
ec
ec
ay
ct
ct
Ju
Ap
Ap
Fe
N
The main reason for the potential spillover effects is the large estimated losses to the mezzanine
Fears of a broader market
selloff from unwinding hedged equity strategies (long risk in the equity tranche hedged with mezzanine tranches detailed
levered positions look below). We estimate that since April 1, this strategy is down 14 points in tranches referencing
unfounded, at least as far CDX 4 and down 6.75 points in tranches referencing iTraxx. Such large losses clearly lead to
as the bulk of adjustment concern about the potential for greater impact across the credit spectrum as levered hedge funds
has occurred within the are forced to unwind the leverage in other credit products. So far at least, these fears remain
correlation market itself,
with equity tranches unfounded as the bulk of the unwind appears to have occurred within the correlation market itself.
significantly wider and 3- Specifically, the equity tranches are significantly wider and 3-7% tranches are significantly tighter.
7% tranches significantly As Figure 7 below shows, the acceleration in losses to the mezzanine hedged equity strategy likely
tighter… reflects the impact of forced unwinds, in contrast to the first leg lower, which was prompted by an
increase in gap risk (i.e., significant individual issuer spread widening risk) to the equity tranche
following the rise in LBO risks and increased gap risk in autos and auto parts issuers.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
7
Banc of America Securities
Situation Room, May 9, 2005
P&L: IG 0-3 (Points Upfront) Hedged w ith IG 3-7 P&L: IG 0-3 (Points Upfront) Hedged w ith Index
-200
-400
P&L ($000)
-600 Initial leg lower reflected fundamental risks of rising
gap risk from LBOs, autos, & autoparts
-800
-1000
1The mezzanine tranche tightened from 228 bps to 212 bps, or 16 bps. The DV01 of the mezzanine tranche is about 4.6
($4,600 per $10 million tranche notional), and investors typically leverage 2.2 times the equity tranche (for every $10 million in
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
8
Banc of America Securities
Situation Room, May 9, 2005
We first noted this theme in our April 5, 2005, Situation Room article, “With Demand for Yield
Still Strong, Watch How You Hedge.” On days when the overall market moved wider, senior
tranches were widening less than expected, causing hedge mismatches on correlation books. We
are now seeing a similar pattern in the mezzanine: as the market moves wider, mezzanine tranches
are tightening (not widening).
1390 -330
1290 -350
1190 -370
Carry ($000)
1090 -390
Difference
990 -410
890 -430
790 -450
690 -470
590 -490
1-Apr-05 12-Apr-05 23-Apr-05 4-May-05
Carry: IG 0-3 (Points Upfront) Hedged with IG 3-7
Carry: IG 0-3 (Points Upfront) Hedged with Index
Diff (right)
equity tranche notional sold, the investor buys $22 million in mezzanine tranche notional). This results in a loss of –16 bps x
4.6 DV01 x 2.2 leverage, or 1.6 points.
2 At 50 points upfront plus a 5% running coupon, the equity tranche premium is equivalent to about 18.5% (50 points x 3.7
DV01 + 5% running coupon). The index hedge reduces carry by 9.4% (63 bps five-year CDX IG x 14.9 leverage). The investor
is left with about 9% annual carry, or $900,000 per $10 million equity tranche notional.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
9
Banc of America Securities
Situation Room, May 9, 2005
Figure 9. Hedged with Index, Equity Lost 6 Points… Figure 10. ...but Hedged with Mezz, Equity Lost 15 Points
Actual vs. Expected 0% - 3% Premium, Based on Leverage Actual vs. Expected 0% - 3% Premium, Based on Leverage
Thick blue line shows performance of delta hedge with index Thick blue line shows performance of delta hedge with mezzanine
50 7 50 15
48 48 13
46 46
5 11
44
44 9
Difference
4
Difference
42
42 7
3 40
40
5
2 38
38
3
36
1
36
34 1
34 0
32 -1
32 -1 1-Apr-05 12-Apr-05 23-Apr-05 4-May-05
1-Apr-05 12-Apr-05 23-Apr-05 4-May-05 Expected (with Rehedging): IG 0-3 (Points Upfront) Hedged with IG 3-7
Expected (with Rehedging): IG 0-3 (Points Upfront) Hedged with Index Actual Premium: IG 0-3
Actual Premium: IG 0-3 Diff (right)
Diff (right)
3We assume a 15% initial margin requirement for an investor who sells equity tranche protection and hedges with the
mezzanine. Initial margin requirements are higher than for the index hedge because of the risk that the mezzanine tranche may
move differently from correlation model expectations. Initial margin requirements vary significantly among investors due to
differences in counterparty risk.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
10
Banc of America Securities
Situation Room, May 9, 2005
900
0
800
-200 700
600
-400
P&L ($000)
500
Difference
-600
400
-800 300
200
-1000
100
-1200
0
-1400 -100
1-Apr-05 12-Apr-05 23-Apr-05 4-May-05
P&L: IG 0-3 (Points Upfront) Hedged w ith IG 3-7 P&L: IG 0-3 (Points Upfront) Hedged w ith Index
Diff (right)
We see a similar pattern in Europe, where this strategy may have been more prominent. Since
April 1, 2005, investors who sold equity tranche protection hedged with the (iTraxx) index lost
about EUR 270,000 per EUR 10 million tranche notional—no small loss. But despite higher carry,
investors who hedged with the mezzanine tranche lost about EUR 675,000.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
11
Banc of America Securities
Situation Room, May 9, 2005
Economic Research
German Industrial Output: A Slippery Slope
German industrial It is hard to find reassuring German figures these days. Today’s data were no exception, but we
production declined 0.8% think the headline figures overstate the underlying situation.
mom in March, but was
still up 1.0% qoq German seasonally adjusted industrial output declined a larger-than-expected 0.8% mom in March
Lorenzo Codogno following an unrevised 2.1% drop in February. Courtesy of a 2.8% surge in January, the quarter is
+44 20 7174 4101 still up a healthy 1.0% following a 0.1% monthly drop in the previous quarter. This will likely
allow a nice contribution to GDP growth in 1Q 2005, which—according to our estimates—is
likely to end up rising at least 0.6% qoq (the first estimate is out on Thursday). Due to the
declining monthly profile, however, 2Q 2005 will start on a very weak basis. According to our
4For more details, please see “The Impact of LBOs on Structured Credit: Balancing Wider Spreads With Demand for Yield,”
April 1, 2005.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
12
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,
Banc of America Securities Limited and Banc of America Securities LLC (BAS) 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 or will be, directly or indirectly, related to the views or results produced by the Credit OAS quantitative model. For a
description of the Credit OAS proprietary credit evaluation model, including the data input into the model, please see Credit Market Strategist: “A
Hundred Years of Flight, One of Lighthouse and Credit OAS”, dated December 23, 2003.
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Banc of America Securities — Research Directory
David Goldman, Head of Debt Research (212) 933 2926
Credit Strategy Research High Yield Research High Grade Research
Jeffrey A. Rosenberg (212) 933 2927 Larry Bland (212) 847 6502 Timothy K. Patrick (704) 386 2363
Head of Credit Strategy Research Head of High Yield Research; Global Head of High Grade Research;
Healthcare, Deathcare Automotive
Investment Grade
Jerry S. Bennikutty (704) 388 5213 Ryan B. Bailes, CFA (212) 847 6781 Stan August (704) 388 5373
Metals & Mining, Building Products, Homebuilding Domestic Banks, Insurance, Brokers
Neal Jordan (704) 388 8038
Ana Goshko (212) 847 5936 Matthew J. Bartlett (704) 388 1897
High Yield Wireline Telecommunications Media & Entertainment, Telecommunications
Olivera Radakovic (212) 933 2496
Nathan Hudson, CFA (212) 847 6945 Andrew Bressler, CFA (202) 624 4639
Susan Wu, CFA (212) 847 5337 Automotive, Paper & Packaging Washington Healthcare
Portfolio Strategy James Kayler, CFA (212) 847 5223 Christopher N. Brown, CFA (704) 386 2524
Elizabeth A. Bram (212) 933 2715 Gaming, Supermarkets REITS, Retail, Supermarkets, Leisure
Michael Contopoulos (212) 933 3372 Kelly J. Krenger (212) 847 6410 Todd Duvick, CFA (704) 388 5053
Mingsung Tang (212) 847 6083 Energy Food & Beverage, Consumer
Yulia Yudelevich (212) 933 3238 Ronald W. Phillis (212) 933 2295 Faith N. Klaus, CFA (704) 386 8440
Consumer Products, Retail Electric Utilities, Independent Power
Xiaodong Zhu (212) 847 5489
Tuan Q. Pham, CFA (212) 847 6435 David K. Peterson, CFA (704) 386 9419
Derivatives Strategy Chemicals Aerospace/Defense, Healthcare, Manufacturing
Glen Taksler (212) 933 2559
Eric D. Toubin, CFA (212) 847 6498 Peter G. Plaut (212) 847 5690
Technology, Industrials Global Financial Institutions
International Research
Michael S. Weiner (212) 583 8478
Raja Visweswaran, CFA +44 (20) 7174 5459 Interest Rates Research
Wireless Telecommunications, Towers
Head, International Research
Stephen Weiss (646) 313 8820 Gerald Lucas (212) 933 2846
James Carey +44 (20) 7174 5314
Cable/Satellites, Broadcasting/Publishing, Theaters Head of US Treasury/Agency Strategy
European Credit Strategy
Lynne E. Wertz (212) 933 2216 Steve Mansell +44 (20) 7174 1505
Ivy Li +852 2847 6346
Food & Beverage, Restaurants Head of European Interest Rate Strategy
Asian Credit Strategy
George D. Goncalves (212) 933 2593
Inge-Lise Peetz +44 207 174 4583 Cross-Product Research US Treasury/Agency Strategy
European Financial Institutions
Michael Cloherty (212) 933-2039
John Schofield +44 207 174 1518
Senior Strategist
European Credit Strategy