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Derivatives

iTraxx LevX--A Primer

Strong demand for leveraged loans in Europe has left primary and secondary spreads low.

Strong demand for leveraged loans in Europe has left primary and secondary spreads low. Reverse flexing of institutional tranches by arrangers has contributed to typical issuance spreads for term loan B facilities falling below 250 basis points, compared to levels of 275 bps common before. Increasing leverage in deals has left investors wary of a potential credit fallout.

Against this backdrop, the introduction of loan credit-default swap indices referencing a pool of leveraged loans in a transparent fashion seems timely. Because they provide an alternative route to gain access to the underlying market, they will help to relieve pressure on primary spreads. Structurally, loan credit-default swap index contracts allow trading of recovery expectations and prepayment risks alongside outright long or short strategies.

 

Advantages Of Leveraged Loan Indices

LCDS indices provide synthetic access to leveraged loans. They are unfunded, thus providing cheaper access than a direct investment in cash loans. Where cash settlement is possible, they also provide a regulatory advantage for investors unable to lend money through loans themselves.

LevX contracts allow hedging of the price risk on a portfolio of loans by buying protection i.e. selling the index. Where names coincide they also afford some default protection and this is usually cheaper than buying single name LCDS protection or selling the loan. In addition they also allow shorting of the loan market outright. This was previously restricted to the issuer.

Compared to the hitherto common strategy of hedging loan exposure through High Yield or Crossover bond CDS contracts, LCDS index contracts provide a better fit at a lower cost, since the bond CDS premium will be higher than the loan CDS premium for the same name. This is because of the higher recovery rate assumptions for the more senior loans. For comparison, assuming a weighted average life of three years, quotes on the iTraxx LevX Senior Series 1 around 100.85 translate to an equivalent spread of about 142 bps while the iTraxx Crossover Series 6, which has a number of names in common with the LevX Series 1, trades around 235 bps.

An active market in LevX will also benefit transparency and execution costs in the single name LCDS space, thus passing on the benefits of increased liquidity also to individual names.

 

Technical Features

The iTraxx LevX indices are price-quoted, equal-weighted contracts referencing a portfolio of 35 single-name loan CDS. The LevX Senior is composed of 1st lien credits only, whereas Series 1 of the LevX Subordinated basket consists of 20 second lien and 15 third lien single-name LCDS. The indices trade at a five-year tenor. As is the case for the established bond CDS index contracts, every six months (March 20 and Sept. 20) a new series is issued with a new fixed coupon.

Premiums are paid quarterly, accruing from the last payment date. Transactions thus take place at the dirty price. For example, should an investor decide to buy the index contract (sell protection) on a non-payment date, they would be required to pay accrued premium, as well as the difference between the quoted price of the index and par, an implication of the fixed coupon of the contract.

The profit and loss of a trade closed out at time t, from the point of the index buyer, can be simply calculated as:

FinalNotional*(Quoted Price(t)-100+AccruedPremium(t)) - InitialNotional*(Quoted Price(T0)-100-AccruedPremium(T0)) + PremiumReceived(T0,t)

 

Managing Pre-Payment Risk

In a bid to replicate the characteristics of the underlying loan, LCDS contracts under European documentation include a clause for the early termination of the agreement, should there be no more eligible deliverable obligations available. In other words, should the borrower decide to repay the loan before the maturity of the LCDS, the LCDS contract will terminate early. At the index level, this early termination or cancellation of an underlying single-name LCDS contract would entail a reduction in the index contract notional by 2.86% (or one 35th), although without any offsetting cash settlement taking place.

The inclusion of the cancellation option enables a closer match to the underlying for protection buyers hedging cash loan exposure. This comes at the price of a higher spread payable, as the cancellation option if exercised will usually be to the disadvantage of the protection seller.

Regardless of the inclusion of a cancellation feature at the contract level, the prepayment risk has to be priced one way or another. In the case of a non-cancellable contract, the coupon of a replicating loan portfolio would decrease while its duration would increase relative to the contract due to loans being refinanced at a lower spread.

Rolling into the front month contract will usually be the solution to all the potential complications discussed above. An even larger percentage of the activity than in the bond CDS indices will thus be concentrated in the on-the-run series. This strategy largely mitigates prepayment risk as every roll a new pool of loans is referenced. Since the effective weighted average life on the underlying loans is likely to be longer than six months, investors will thus rarely experience a cancellation event. This strategy is subject to sufficient primary market activity allowing for a large proportion of referenced deals being replaced at each roll.

 

Valuation Issues

Although the index contracts consist of 35 names which each carry an equal notional in the portfolio, evaluation of the basket as a whole in hedge terms requires a method to attach an appropriate risk-weighting to the underlying single-name contracts. As a result, theoretical contract spreads are typically calculated as the duration weighted average of the levels of the constituents. Since higher spreads are associated with lower durations, such a weighting will produce a theoretical spread level that is less than the simple average of the 35 single-name levels. This is amplified in the case of cancellable contracts by Weighted Average Life considerations, as early prepayment is more likely for higher yielding loans, further reducing their spread duration.

Summary Of The Rules For The Compositions Of iTraxx LevX Senior 
And Subordinated Series 1 Baskets
Rule iTraxx LevX Senior iTraxx LevX Subordinated
Constituents 35 35
Seniority 1st Lien 2nd/3rd LienIf entity has 
    both 2nd and 3rd lien 
    tranches, the larger of the 
    two by amt outstanding is taken
Minimum size (EUR) 750 100
Minimum spread of 5y  75bp 225bp
single-name CDS    
Minimum issuer rating BB+/Ba1/BB+ or below BB+/Ba1/BB+ or below
Weighting Equal-weighted Equal-weighted
Construction method Dealer poll Dealer poll
Settlement method Physical  Physical (seller's option 
  (seller's option to cash settle) to cash settle)
Recovery determination Dealer poll Dealer poll
Quoted recovery 70% n/a
Contract coupon 170bp 450bp
Quoting convention Price Price
Maturity (5y) 20-Dec-11 20-Dec-11
Early termination Cancellable format Cancellable format
Next roll date 20-Mar-07 20-Mar-07
(maturity 20-Jun-2012) (maturity 20-Jun-2012)
Source: IndexCo, Dresdner Kleinwort Debt research

 

This week's Learning Curve was written by Suraj Tanna, debt index and quant strategist, andIlan Hershkovitz, senior trader, Dresdner Kleinwort in London.

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