abcs of cpdos

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Cross-Product Research 35November 6, 2006

Situation Room 6

The ABCs of CPDOs

The synthetic market recently introduced a new structure, which is a rolling five-year combination of the US and European investment grade CDS indices (CDX IG and

iTraxx Main). Called a CPDO—Constant Proportion Debt Obligation—this product isinitially 15 times leveraged, with a ten-year maturity. In the first round of issuance,CPDOs offered a triple-A rated spread of approximately L+200 bps. Interest from the product has been viewed as a major factor in sending the IG and iTraxx indices torecord tights.

The CPDO investor always has five-year on-the-run IG, even though the structure has aten-year maturity date. In other words, every six months, any credit that suffers adowngrade to high yield (split-rated or worse) would be dropped out of IG, and therefore dropped out of the structure. This resulted in an S&P triple AAA rating, onthe logic that the only credit risk was that an investment grade-rated credit may defaultwithin a six-month interval.

Below we discuss the impact of CPDOs on the broader credit market, both under basecase scenarios and low probability, high impact events. To be clear, we do not expressan opinion regarding CPDOs. We simply discuss how CPDO activity may impact theoverall market.

Reserves and Leverage

CPDOs achieve their high credit rating through the accumulation of reserves (theexcess of coupon income earned over coupons paid out), which are made available tocover potential losses from future defaults. Currently, the average spread for five-year IG and iTraxx is roughly 30 bps.

1 At 15 times leverage, the funded structure therefore

earns three-month Euribor+450 bps. Now subtract a coupon of Euribor+200 bps and fees of roughly 20 bps for net income (reserves) of approximately 230 bps.

In strong credit environments, mark-to-market gains build reserves, improving theability of the CPDO to make future payments (coupons + fees). To realize these gains,

the structure buys back some index protection, reducing leverage. That is, should theCPDO no longer need as much leverage to make future payments, then it deleverages.Figure 5 and Figure 6 shows sample deleveraging, over the life of a transaction, in a base case scenario with constant index spreads and no defaults. Mark-to-market gainscome from rolldown in the credit curve. That is, the investor benefits from selling five-year index protection, which rolls down to a 4.5-year maturity by the next index roll.

150% x (34 bps for five-year IG) + 50% x (24 bps for five-year iTraxx) = 29 bps.

This is an excerpt from the

Credit Market Strategist,

November 6, 2006.

A Constant Proportion Debt

Obligations (CPDO) is a

new structure in the credit

derivatives market

Glen Taksler

(212) 933 2559

CPDOs achieve a high

credit rating through the

accumulation of reserves




Situation Room 7

Figure 5. In Strong Credit Environments, CPDOs Deleverage, to

Realize Mark-to-Market Gains

CPDO Deleverages by Buying Back Index Protection

Index Spreads Widen as CPDO Deleverages

Figure 6. Cash-In Event

If the CPDO Has Enough Value to Meet All Scheduled Coupon

Payments and Fees, the Structure Completely Deleverages

Index Spreads Widen on a Cash-In Event

0

2

4

6

8

10

12

14

16

0 1 2 3 4 5 6 7 8 9 10

Time from Trade Inception (Years)

L e v e r a g e ( X

Mark-to-market

gains allow the CPDO

to reduce leverage, by

buying back index

protection

-5%

0%

5%

10%

15%

20%

0 1 2 3 4 5 6 7 8 9 10


% o

f P a r

PV of Future Payments

NAV

CPDO completely

deleverages

Base case scenario, which assumes constant index spreads, no defaults, and 7% rolldown

every six months (see discussion of rolldown below).

Source: Banc of America Securities LLC Estimates.

Base case scenario, which assumes constant index spreads, no defaults, and 7% rolldown

every six months (see discussion of rolldown below).


To further protect principal, should the CPDO ever have enough value to pay all futurescheduled coupon payments and fees, the transaction completely deleverages. All proceeds are then invested in risk-free assets until the CPDO’s maturity. In Figure 6, acash-in event occurs when the red line (NAV of the CPDO) reaches the thick gray line(present value of future coupon payments and fees).

In any type of deleveraging event, notice that the CPDO needs to buy back index protection, which it had previously sold. For example, in a $100 million transaction, a

CPDO that is 15x initially leveraged would sell $1.5 billion in index protection. Should the structure later deleverage to 11x, it would do so by buying back $400 million inindex protection (15x initial leverage – 11x new leverage, times $100 million).

As such, credit investors should understand that, going forward, any time that CPDOsexperience significant mark-to-market gains, they are likely to deleverage. This should result in the structured credit market buying back index protection, sending IG and iTraxx spreads wider.

Index Rolls

Credit Quality

Since the product always invests in on-the-run IG, the index roll is very important.

Typically, a CPDO assumes constant credit quality between indices, i.e., the samecredit quality between the constituents of an old index and a new index.

However, suppose there were a few downgrades between now and the next roll. Then,credit quality would improve significantly in the new index, prompting the new indexto trade much tighter than the old index.

For example, focus on the US, temporarily ignoring the European (iTraxx) component.In the CDX IG roll from Series 4 to Series 5, eight credits dropped out of the new on-

CPDOs are likely to

deleverage following

significant mark-to-market gains

Since CPDOs always

invest in on-the-run IG,

the index roll is very

important




Situation Room 8

the-run index because of downgrades.2 Accordingly, IG5 traded tighter than IG4, even

with the six-month maturity extension. Figure 7 compares the old index spread—in thiscase, the mark on the IG4 position—versus the new index (IG5) coupon:

Figure 7. Risk to CPDO of a Negative Credit Quality Roll…Old Index Spread One Day Before the Roll vs. New Index Coupon

New Index Coupon Income Would Not Be Sufficient to Offset Mark-to-

Market Loss From Spread Widening on the Old Index

Figure 8. …Would Cause the CPDO to Deleverage Later Deleveraging in Base Case Scenario vs. Four IG4-to-IG5 Like Rolls

Mark-to-Market Losses from Improved Credit Quality of the New On-the-

Run Index Delay CPDO Deleveraging

30

35

40

45

50

55

IG3 IG4 IG5 IG6 IG7

Roll to Index

b p s

Old Index Spread (bps)

New Index Coupon (bps)

-10%

-5%

0%

5%

10%

15%

20%

0 1 2 3 4 5 6 7 8 9 10


% o

f P a r

PV of Future PaymentsNAV: Base CaseNAV: IG4-to-IG5 Like Rolls

CPDO completely

deleverages

Sources: Bloomberg; Banc of America Securities LLC Estimates. Base case scenario assumes constant index spreads, no defaults, and 7% rolldown every six

months (see discussion of rolldown below).

IG4-to-IG5 Like Rolls is similar to the base case scenario, but assumes four rolls with a -6 bp

credit quality component.


Series 4 IG has a coupon of 40 bps (the gray bar in the “IG4” section of Figure 7. Therefore, had a similar CPDO structure been in place, the vehicle would have earned

40 bps x 15x leverage = 600 bps.By the next roll date, Series 4 had widened by 11 bps (to 51 bps), resulting in a mark-to-market loss. Had the coupon in Series 5 IG been set at the same 51-bp mark asSeries 4 IG, there would have been no loss to the structure. That is because the mark-to-market loss would have been exactly offset by an expected gain in future couponincome.

3

However, due to improved credit quality, the coupon on Series 5 IG was set at 45 bps,or 6 bps tighter than the then-mark on Series 4. Reserves available to the CPDO thenwould have fallen by about 6 bps x 4.1 duration x 15x leverage, or 3.7 points.

Figure 8 shows the effect on deleveraging. Compared with the base case scenario (red line), which completely deleverages after approximately 4 years, a series of four successive IG4-to-IG5 like rolls would delay the cash-in time to approximately year 6.

To be clear, the current assumption of unchanged credit quality is a realistic reflectionof the current market environment, as experienced in the last roll (to IG7). But, should we see meaningful downgrades in investment grade credits, then there could be a return

2Eastman Kodak, Ford Motor Credit, GMAC, Kerr-McGee, Lear, Liberty Media, Maytag, and SRAC. A ninth credit, MBNA,

dropped out of the new on-the-run index due to M&A activity.3This is an approximation. In later years, leverage may need to be adjusted so that expected coupon income will offset losses.




Situation Room 9

to the roll environment of IG5 and earlier, when significantly improved credit qualitywould have hurt CPDOs.

Credit Curve

In fact, embedded in a typical CPDO is an assumption that spreads widen on the rolldate, providing the investor with additional coupon income (rather than a loss). This isdue to rolldown on the credit curve.

For example, take the current structure at 30 bps. Over the next six months,4 a typical

CPDO assumes that credit spreads will roll down to 27.9 bps, or 93% of their currentlevel. Subtract a 1 bp assumed transaction cost, and the investor still realizes a mark-to-market gain, from rolldown, of about 3/4 point (2.1 bps rolldown minus 1 bptransaction cost x 4.1 duration x 15x leverage).

5

Figure 9 illustrates the impact of rolldown. In the base case scenario, the credit curverolls down by 7% every six months (e.g., from 30 bps for a 5-year index maturity to27.9 bps for a 4.5-year index maturity). For illustrative purposes, we also assume onedefault in year two. The CPDO cashes in around year five:

Figure 9. Steep Credit Curves Are Good for CPDOs

Assumes One Default at Year 2

Flat Credit Curve Delays Cash-In Time, Because Investor Is Unable to Realize Mark-to-Market Gains From Rolldown

-5%

0%

5%

10%

15%

20%

0 1 2 3 4 5 6 7 8 9 10


% o

f P a r

PV of Future PaymentsNAV: Base Case Credit CurveNAV: Flat Credit Curve

CPDO completely deleverages

Base case credit curve assumes constant index spreads, one default in year 2, and 7% rolldown every six months.

Flat credit curve scenario is similar to the base case credit curve, but assumes no rolldown.

Assumes one default in year 2 with 40% recovery.


By contrast, the thick black line shows what happens if the credit curve is perfectly flat.Since the investor is unable to realize mark-to-market gains from rolldown, the cash-intime is delayed by approximately three years.

4More accurately, from one index roll date to the next.

5Duration is roughly 4.1 because the investor unwinds the old (4.5 year maturity) index.




Situation Room 10

Flatter Credit Curves on the Horizon?

Our economists look for the 3s/5s Treasury curve to move from inverted to flat over thenext six months and to slightly normal (positively sloped) near the end of 2007. Asillustrated in Figure 10, steeper Treasury curves generally suggest tighter creditscurves:

6

Figure 10. As the Treasury Curve (Eventually) Normalizes, Look for Flatter 3s/5s Credit Curves

3s/5s Credit Curve (%) vs. 3s/5s Treasury Curve (bps)

Flatter Credit Curves Hurt CPDO Cash Flows

y = 0.14x + 57.94

R2 = 0.52

52

54

56

58

60

62

64

66

68

-10 0 10 20 30 40 50 60

3s/5s Treasury (bps)

3 s / 5 s

C r e d i t ( % )

3s/5s Credit (%) Current

Spring 2005 - Curves later steepened

Dec 2004-Jan 2005

Curves later flattened

Current

Steeper

Flatter

Sources: Bloomberg; Banc of America Securities LLC Estimates.

In principle, suppose the yield that investors require to invest in a particular ReferenceEntity remains constant, even when Treasury rates change. If 3-year Treasury rates fallrelative to 5-year rates, then, to keep the yield on CDS constant, 3-year CDS must

widen. In turn, the 3s/5s credit curve flattens.

7

That said, even though some credit curve flattening may be on the horizon—whichwould delay CPDO cash-in time—we would not expect the extreme case illustrated bythe perfectly flat credit curve in Figure 9.

IG (and iTraxx) Intrinsics “Permanently” Cheap to Intrinsics?

The index “basis” is defined as the intrinsic spread on underlying components minusthe index spread. Since CPDO investors buy credit risk which is directly linked toindex spreads, dealers need to sell index protection, driving the intrinsics minus index basis wider. Indeed, as shown in Figure 11, the basis is near one-year wides:

8

6 Following general market convention, the credit curve is shown in percent (three-year spreads trade at 53% of five-year spreads)rather than basis points (three-year spreads trade 26 bps tighter than five-year spreads). As such, a lower number means a steepercredit curve—for example, a 3s/5s curve at 53% (three-year spreads well below five-year spreads) is steeper than a 3s/5s curve at90% (three-year spreads almost the same as five-year spreads).7For more details on the general framework, please see, “Expect Continued Steepening in CDS Curves: The Impact of the

Treasury Market on Credit Default Curves,” June 30, 2005. Note that the outlook has changed from steepening (in June 2005) toflattening.8To improve readability, Figure 11 starts after the May 2005 correlation crisis. Yet, we caution that during the correlation crisis,

intrinsics traded in a range of 6 bps tighter than the index, to 12 bps wider than the index, which is far wider than current levels.

Steeper Treasury curves

generally suggest flatter

credit curves




Situation Room 11

Figure 11. IG and iTraxx Intrinsics Cheapening to the Index

Intrinsics – Index in Rolling on-the-Run IG and iTraxx

-6-5-4-3-2-10123456

20-Sep-05 20-Dec-05 20-Mar-06 20-Jun-06 20-Sep-06

I n t r i n s i c s - I n d e x ( b p s )

IG iTraxx

Intrinsics cheap

Index cheap

Source: Mark-It Partners; Banc of America Securities LLC estimates.

For leveraged investors, we would suggest selling IG intrinsics and buying index protection. The investor earns roughly 2.5 bps, and is hedged against any futuredefaults (Bankruptcy and Failure to Pay). In older index series, the basis is even moreattractive, at 2.6 bps in IG6, 3.0 bps in IG5, and 3.5 bps in IG4.

We caution that the investor remains long Modified Restructuring risk, because theintrinsics—where the investor is long risk—trade with Modified Restructuring, whilethe index—where the investor is short risk—trades with No Restructuring. However,the market typically assesses Restructuring risk to be at most 2% of index spreads (i.e.,2% of roughly 34 bps for IG7, or 0.7 bps). As such, we believe that “index arb”investors are more than adequately compensated in the current environment.

New Roll Technicals

Finally, we point out that credit market investors should look for strong technicals infuture rolls. In previous rolls, the credit market looked at the change in credit quality,the shape of the credit curve, and an adjustment for Modified Restructuring (intrinsics)vs. No Restructuring (index). Going forward, CPDOs will need to buy back old on-the-run index protection, and sell new on-the-run index protection. This technical will produce flatter, possibly inverted, rolls between indices.

Accordingly, for non-CPDO investors who are current sellers of index protection, itmay make sense to unwind existing positions well in advance of the roll (before CPDOinvestors buy back protection). After the roll, index protection sellers should consider re-establishing their positions quickly, before the CPDO market sells new on-the-runindex protection and drives spreads tighter.

Similarly, for non-CPDO investors who are current buyers of index protection, it maymake sense to wait for CPDO roll technicals to set in to the market, allowing indexspreads to widen. Post-roll, index protection buyers should consider waiting for theCPDO market to sell new on-the-run index protection, to re-establish a market short ata tighter index spread.

Credit market investors

should look for strong

technicals in future rolls




13 Situation Room

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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 (212) 933 2927

Head of Credit Strategy Research

Michael Contopoulos (212) 933 3372 Lighthouse Portfolio Strategy & Analytics

Hans Mikkelsen (212) 847 6468 High Grade

Clemens Mueller (212) 933 2577 High Yield

Olivera Radakovic (212) 933 2496 Index, Strategy

Adam Roffman (212) 933 2076Collateralized Debt Obligation Strategy

Glen Taksler (212) 933 2559 Derivatives Strategy

Mingsung Tang (212) 847 6083 Lighthouse Portfolio Strategy & Analytics

Xiaodong Zhu (212) 847 5489 Lighthouse Portfolio Strategy & Analytics

High Grade Research

Gregory Ransom, CFA (212) 847 5773

Head of High Grade Research Basic Industries

Stan August (704) 388 5373 Domestic Banks, Brokers, European Banks

Michael J. Barry (212) 933 2547 Insurance

Andrew Bressler, CFA (202) 442.7454Washington Healthcare

Christopher N. Brown, CFA (704) 386 2524 REITs, Retail, Leisure, Homebuilding

Kevin Christiano (212) 933.2485 Media, Telecommunications

Dennis P. Coleman, CFA (212) 847 6224 Energy, Pipelines, Master Limited Partnerships

Todd Duvick, CFA (704) 388 5053

Food & Beverage, Supermarkets, ConsumerJohn Guarnera (704) 683 4878

Domestic Banks, Finance Companies

Douglas Karson (212) 933 2405 Aerospace/Defense, Manufacturing, Autos

Faith N. Klaus, CFA (704) 386 8440 Electric Utilities, Independent Power

David K. Peterson, CFA (704) 386 9419 Healthcare

High Yield Research

Larry Bland (212) 847 6502

Head of High Yield Research

Healthcare, Deathcare

Philip Birbara (212) 847 5473Chemicals

Andrew Brausa (212) 847 6481 Building Materials, Homebuilding

Kevin Cohen, CFA (212) 933 2721 Paper & Packaging, Metals & Mining

Melissa Ford, CFA (212) 847 5577 Restaurants, Supermarkets

Ana Goshko (212) 847 5936Telecommunications, Towers

Douglas Karson (212) 933 2405 Autos

James Kayler, CFA (212) 847 5223Gaming, Lodging & Leisure

Kelly J. Krenger (212) 847 6410 Energy

Manish A. Somaiya (212) 933 3455 Aerospace/Defense, Industrials, Services

Eric Toubin, CFA (212) 847 6498

Technology, Food & Beverage

Stephen Weiss (212) 933 2298Cable/Satellites, Broadcasting/Publishing, Theaters

International Credit Strategy Research

Raja Visweswaran, CFA +44 (20) 7174 5459

Head of International Credit Strategy Research, BASL

Eve Cabrillac +44 (20) 7174 1517 European Credit Strategy, BASL

James Carey +44 (20) 7174 5314 European Credit Strategy, BASL

Ivy Li, CFA +852 2847 6346

Asian Credit Strategy, BASAL

John Schofield +44 (20) 7174 1518 European Credit Strategy, BASL

The persons listed on this directory have the

title “research analyst”. Unless otherwise

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 LLC (BAS) except as noted

above.

BAS (United States)

Banc of America Securities LLC9 West 57

thStreet

New York, New York 10019

Tel. Contact: 800 627 1804

BASL (United Kingdom)

Banc of America Securities Limited5 Canada Square

London E14 5AQ, England

Tel Contact: +44 (20) 7174 4000

BASAL (Hong Kong)

Banc of America Securities Asia Limited42/F Two International Finance Centre

8 Finance Street, Central, Hong Kong

852 2847 6346 214 North Tryon StreetCharlotte, North Carolina 28225Tel. Contact: 888 279 3457

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