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Capital Markets

Structured credit debate: Innovation grows as market matures

The range of structured credit products on offer to investors has grown as they seek to increase returns in a low-yield environment. The next stage, led by CPDOs, is to create more spread-based, rated products that incorporate default and market risk.

Structured credit debate: Executive summary

• Reaction to the US sub-prime crisis shows how global credit markets have matured.

• Investors now have a wide range of products in which to express a view on credit.

• CPDOs are the starting point for a new range of products that will be spread-based and rated.

• Ratings are important to expanding the product range but investors should be cautious about investing on the basis of them.
















Structured credit debate participants


SB, Euromoney
The recent scares in the sub-prime and Chinese equity markets affected the credit markets significantly. What does this tell us about the maturity of the market?

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AB, DB It is two different things. Credit markets were significantly affected at the same time as sub-prime and equity markets were under pressure. But I don’t think there was necessarily a cause-and-effect relationship. The repricing in credit could have been mainly technical. The credit long trade was a bit overcrowded. This move was not "immatured" or exaggerated. It did not get amplified by any panic selling. We did not reach levels that would have caused any forced selling.

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LF, Calyon I would argue that the credit market is fairly mature. Just look at how the market reacted to Amaranth or other recent credit events such as Dana Corp; the market did not panic and there was clearly a very orderly settlement process. Also, the liquidity is really deep, as even in volatile times there is still a bid and offer. We were in a very different situation in 1997, 1998 or 2001. At that time, banks were still the main players in the credit arena. Now, with the further disintermediation of credit markets, the global asset allocation in credit has sharply increased and we can definitely see the difference during periods of volatility.

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DKK, Prudential M&G The fact that the market is moving shows that there is a degree of efficiency there. No-one wants to be the first to blink. You need some catalyst, and whether that was the ABX – which is immature – or Chinese equities, it pushed the market back to being efficient. We were previously in that stalemate position where nobody wanted to move first.

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DP, Cheyne The market moves were more a case of people being positioned the same way rather than dislocations caused by lack of liquidity. In fact huge volumes can trade in a day. A market counterparty I am familiar with – a leading index market maker – trades upwards of $35 billion on a busy day. Look at the equities market. People have been positioning in a similar fashion, which is why the equities markets have rallied.

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PD, Solent If the equity market goes down by 20%, everyone says: "That’s the market." If spreads widen in credit, it’s: "Oh, the market is immature." CDS have shifted trillions of dollars of credit risk from banks into other hands over the past 10 years, seamlessly. They are not given credit for this shift in the risk balance.

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JI, Henderson How big an impact would LTCM have had if there had been a true credit derivative market? And what would have been the impact of Amaranth had there not been? That’s the positive change in the market. Amaranth was glossed over in a matter of days. LTCM was a different story.

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LF, Calyon That is a reflection of a matured credit market. The newcomers in the credit market and those who have strongly increased their credit allocations (hedge funds, pension funds, asset managers primarily) do contribute to this liquidity.


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DP, Cheyne To this point, in the tranche market, there’s much less volatility than you saw in the correlation market two years ago, because there are a lot more participants at each level of the capital structure. Imbalances of prices between different tranches become transient events, as there is now usually some kind of buyer or seller at each level to exploit the opportunity.

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LF, Calyon One can even see similarities between the current sub-prime market turmoil and the adjustment in the correlation market back in 2005. Back then most dealers were positioned in the same way – being long equity risk as a result of their mezz CDO business, and when the base correlation moved down, a lot of banks were scrambling to cut the losses on their correlation books, hence creating a lot of opportunities for cheap equity or leveraged super senior. Now the market is more mature and most banks’ correlation books are more balanced along the whole capital structure. Come another correlation crisis, the market would be much more prepared than the last time. Looking at the sub-prime market, the widening and the consequential mark-to-market losses on the warehouses have pushed a lot of arranging banks to cut their losses, creating a lot of buying opportunities. Also, I believe that most banks will soon move to a model where warehousing risk needs to be actively managed and hedged, which is what we have been doing since we entered the market. It means that some banks will no longer be just ripping the carry out of the warehouse.

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AL, Derivative Fitch I agree that the CDS market has become liquid and efficient, and in some respects maybe more efficient than the bond market. But indices like CDX and iTraxx have only been in existence for a few years. It’s difficult to predict how they will behave, because you don’t have enough history.

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JI, Henderson There’s still not enough focus on fundamental credit in the derivative market. The focus is more on the derivative nature of the hedging instrument. The market has certainly developed and has real depth. It’s come a long way in a relatively short time.

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DP, Cheyne Well, I think there are houses that are very much fundamentally driven, and use credit derivatives as the most efficient way to express that view. But I do agree a lot of trading activity in the market seems driven more by macro credit views, particularly of course using indices. As event risk in credit increases, though, the importance of fundamental analysis will become more visible.

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AM, B&B Dagmar mentioned ABX. Would you say that’s one area of the market that’s still is immature?



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DKK, Prudential M&G The ABX is incredibly concentrated – it’s much less representative of the entire market than corporate credit. There are so few names in there, and you only have to look at the basis between a triple-B flat and triple-B minus – it fundamentally does not make sense. There are issues in the US ABS market and that has driven that market wider. People are trading in the ABX. People are going long/short, but for technical reasons. They’re not necessarily using it as a proxy for the ABS market.

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LF, Calyon It is extremely important to highlight the differences between ABX on the one hand and a typical managed CDO of ABS on the other. ABX has 20 names whilst a typical managed CDO of mezz ABS has more than 100 line items. On top of that ABX is static whilst a mezz ABS CDO is typically managed by a seasoned manager. It is precisely at the times of difficulty that investors need the manager to pick good from bad bonds or servicers. I am convinced that the current times will contribute to a further tiering of the asset-managers in the space.

Fundamentals versus technicals

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AM, B&B So, is the market currently trading on fundamentals or technicals?



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DKK, Prudential M&G I think the market has been and is trading technically. What has happened to credit spreads recently is not down to fundamentals. Credit derivatives have changed the credit markets, and I think that is a fundamental shift. Thinking back to the Enron and Parmalat days, it wasn’t unusual to have 100, 200 basis points of widening in investment-grade names in a relatively short period of time. Since the evolution of the credit derivatives market, it’s very difficult to comprehend a situation where that would happen, apart from idiosyncratic risk in individual names, because credit spreads are range-bound due to the structured credit bid.

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AB, DB In this current benign environment for credit, you have a proliferation of principal/prop strategies with new hedge funds and prop desk building similar positions. This is what drives market volatility rather than revision of expectations of fundamentals.


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JI, Henderson There’s just so much liquidity. Are we in a new paradigm from three or four years ago? Personally I think we are. In any widening, there’s opportunity.

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LF, Calyon I definitely think that there is a lot of liquidity, I share strongly the view that the volatility is the friend of wise investors. We have an ever-expanding structured credit investor base. We have now seen credit opportunity funds listed on stock exchanges or structured credit being wrapped as UCITS III format. Before too long, you will see CDO products regularly quoted in financial newspapers like equity products.

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AL, Derivative Fitch As part of our CPDO research, which will be published in April, we looked at proxy for the CDS indices. The CDX and iTraxx were behaving quite close to a composite single-A/ triple-B of the cash indices, but over the last three months they have tightened so much they are below the single-A cash index. So I would tend to agree that the recent widening is a technical correction rather than something more fundamental.

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AM, B&B Credit default swaps tend to be wider than bonds, off the same issuer and the same maturity, but today we see a negative basis. With the structured credit bid, will we see the negative basis more frequently?


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DP, Cheyne I think there are a couple of effects going on here. Better liquidity of CDS versus bonds will only encourage instances of negative basis. For indices, specifically the skew Alexandre speaks of is undoubtedly caused by technical effects, such as bulk selling of index protection through CPDO structures.

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BJ, Bank of America Yes, and if you minimize the cheapest to deliver option, then you still need to pay for the funding on the cash side. If your premium for funding is big, then you should have a negative basis. For example, some insurance companies look at the basis and try to capture it. If they can make 10 to 15 basis points, they would definitely buy the bond, buy the protection and keep the position, because it’s better for them than treasuries. Also, in credit, there are psychological thresholds for bespokes. For example on the double-A seven-year you should be able to achieve something like 100 basis points. So if the market tightens too much and you start to be significantly below the threshold on the double-A single tranche, you would expect the pipeline to be weaker and maybe spreads to widen a bit more. If we go much wider than that, the real money or bank portfolios will come back and trade those tranches to bring the spreads back to tighter levels. That’s the mean reversion.

What to buy at the moment?

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AM, B&B Given where we are in markets today, are there certain structured credit products that are more attractive than others?



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BJ, Bank of America All of today’s structured products have a credit position embedded in them, so before getting into any of them you should ask if there is further significant widening potential. If there is, you should wait for that widening to happen. A more technical answer would be that you should choose a product for which the downside would be limited by an out-of-the-money option or some other mitigator in case you have a real crisis on the spread.

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DP, Cheyne There are still good investment opportunities, without spread widening required as a precursor. Most sophisticated products differentiate default and spread risk. We fundamentally like default risk and feel we are paid well for it in the form of synthetic CDO equity. Of course this entails some spread risk but it is mitigated by inherent convexity in the product. In addition, a short bucket can temper spread exposure, depending on return versus volatility targets.

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LF, Calyon In a tight credit environment, any product which could benefit from future widening is a good product to get into as long as the price for that kind of short credit product is not too expensive. Short is expensive. That is why we saw some capitulation at the end of last year from those who had shorted all year long. CPDO are definitely not all equal, and they may not be the best product to behave in rising spreads, especially if you max out your leverage on day one and you may not even be able to leverage further as you have already reached the cap. Pure short credit strategies can be costly if spreads turn out to be tighter. Imagine 12 months ago, if you had executed a traditional short credit strategy, your bet would not have been effective because spreads came in further. However, any product which has a convex mark-to-market profile would have performed well, such as SOLYS, the product we just launched and that is being managed by Crédit Agricole Asset Management (CAAM).

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PD, Solent It depends what you’re trying to do. Many investors just need to invest and they were worried about spreads remaining tight. That was the biggest problem last year. So now there has been some widening, it’s a good thing for a lot of people. The other thing is that managers are really bullish about equities. They think that equities are cheap. But if equities are cheap and in a good environment for a long period, I just don’t see where the defaults are coming from, unless it’s the back end of problems with leveraged buyouts, for example. But everyone’s trying to predict this turn. It seems a bit odd to me.

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DKK, Prudential M&G In corporate-investment-grade land, the fundamentals of companies are inherently strong, there is good liquidity, debt levels are sensible and there is a degree of shareholder-friendly activity. The credit markets are generally benign. I agree that there are potential hotspots in some of those LBOs which will take a year or so to work out, but the general mainstream corporate credit markets are in pretty good shape and now is a good time to get in.

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DP, Cheyne We would concur with this view. Default rates are at a 12-year low. Corporate profitability is still healthy, with around 65% of the S&P 500 surprising to the upside in the results season. Aside from LBOs, balance sheet leverage is still low. So put this all together and you have an almost unprecedented ability to pay for debt. So from a risk point of view there are hardly better times to buy, and from a reward perspective tranches can ensure you are appropriately paid for that risk.

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PD, Solent Here’s another conundrum. Everyone says that private equity is the place to be, but that the leverage, the senior debt, of these companies is so risky, that you shouldn’t go near it. If the senior debt is risky, what’s happened to the equity? If they’ve defaulted, I’m guessing that the equity’s not there!

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AB, Deutsche Bank The environment is safe enough to recommend that people invest in credit. And one product investors are looking at is CPDOs. By playing with the leverage mechanism you can more or less create the pay-offs you want. And people can then express their views in terms of mark-to-market and default exposure, and also leverage this view by going lower into the capital structure. The other way round: with an assumption for default rate and spread range we can say if a tranche looks cheaper or richer, and also compare different tranches/strategies.

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JI, Henderson When we talk about which products investors should buy, we often overlook the manager’s willingness to manage specific products. We all sell ourselves on our track records, which we need to protect. Some products are not worth taking on for the risk/reward trade-off. We’re getting paid less for more complex products. All managers need to be careful as to what they’re willing to manage for what rate. And we still need to think about investor education. So many investors won’t invest in slightly structured product, but will throw money at private equity and emerging markets. There’s a lack of understanding and an inability by less experienced investors to go deeply into products.

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BJ, Bank of America Our clients would look at the risk by looking at the rating. Then they would look at the leverage of the product. We usually disclose very transparently the product mark to market with different spread scenarios. Based on that, some investors might decide it’s a bit too risky because they couldn’t take a mark-to-market drop of 5%, for example.

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PD, Solent As long as people aren’t buying things that are obviously flawed in the sense that with a minor tweak in the parameters they will either get a severe downgrade or high probability of loss, then I think we’re okay. You do need to be a little conservative, because it would be a setback for the market if people find things go wrong in a quicker timeframe than expected. But they’ve got to do some work and take some risk if they want some return.

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BJ, Bank of America Based on the discussion we had previously, if we don’t expect spreads to go through the roof and if we think that it’s a local volatility period, then it’s probably a good time to get in, because spreads are better and you would get better paid for a structured product.

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AM, BB What about principal-protected products?



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DKK, Prudential M&G Principal protection is interesting. A lot of investors like the idea of it, but when you show them a CPPI product, for example, they don’t want to pay for it. A quite distinct and diverse bunch of people buy CPPI-type products; some because they want a return of 200 over, some because they want a return of 1200 over. Even within the CPPI-type universe, there are a number of different strategies and products that offer you something safe, secure, with a much higher projected return.

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DP, Cheyne Yes, CPPI can lever you up as well as protect your downside – of course.



SB, Euromoney
What’s the lowest floor that you’ve see on a CPPI structure?

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DKK, Prudential M&G You can see floors of 70% or 80%, but that’s really driven by the investor. Typically the banks will offer a floor of 100%, but, one way of getting more leverage in there is by having a lower principal protection floor. It depends on the investor’s pain threshold. Again, it comes down to the risk-reward pay-off.

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LF, Calyon The floor is quite often driven by the base case assumption of getting par back, that is to say, if the strategy would likely yield a total return of 20%, then the floor could very well be set at 80% as investors would think that the worst/base case scenario is to get 100% back.

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AL, Derivative Fitch Even if you have 100% principal guarantee, if your CPPI is referencing assets that underperform, like ABX recently, then the product may cash out. Upon a cashout, the investors get their principal back, but lose the time value of money and the expected strategy returns. That’s the downside of CPPI strategies, and it is significant.

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BJ, Bank of America For a broad set of investors, principal protection would make the investment easier internally, and that’s worth something.


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AM, B&B Is that the primary reason that you find some institutional demand for CPPI?




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JI, Henderson I’m not sure exactly how much of the whole CPPI investor market is banking, but a lot of those bank investors are Basle-focused, so they’re taking risk on the 20% or 30%, but they’ll get their triple-A rating or whatever the bank rating is that will apply.

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BJ, Bank of America Basle II will be more precise on that. We don’t expect banks to see any advantage in going for principal-protected product compared with another product, because they will need to bifurcate both things.


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LF, Calyon That also explains why fully rated CPPI products (CPDO and its variants) have become popular in the last six to eight months as traditional capital-guaranteed CPPI products are not always regulatory capital-friendly to bank investors.


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DKK, Prudential M&G Sometimes the investment rationale of particular investors seems somewhat unclear. Often it’s regulatory-driven. It may be Basle-driven, or it may be the individual regulator for that country. But there’s also a large human element in that decision-making process, which is difficult to quantify.

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LF, Calyon Very often you will also come across investors who simply are bound by investment guidelines which were set years ago when the structured credit market was in its infancy and these guidelines could be a hindrance to opportunistic investments. For example, some investors need to go for a new product approval process for any variation to a plain vanilla CSO. The value in super senior would have disappeared if the approval process takes months to complete.

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PD, Solent I still think credit managers and structurers need to do a much better job of explaining what we’re all about and what the risks are. Pension fund managers will say: "I can’t buy what you’ve shown me, it’s too risky. We’ve got 70% of our money in equities in the same companies." He won’t take a default risk on those companies, and then five years later his pension fund records a major deficit because equities have gone down by 30%. Those decisions are bizarre, but comfort and history, among other things, allow them to be happy investing in far riskier situations than we’re proposing, because they don’t quite understand credit.

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DP, Cheyne Indeed, there is much more room for transparency generally. This is both from managers, in terms of their investment portfolio and risk analytics, and from the banks, which need to be clear on where ratings are coming from and how marks are likely to perform. For instance, there is a world of difference between ratings on principal-protected product, which are derived from the ratings of the zero and will therefore be impervious to the performance of the portfolio, and the ratings of, say, rated equity or CPDOs which are derived from the structure and dependent on portfolio performance. And sometimes quite genuinely investors are not sensitive to mark to market because they are buy and hold. A CPDO might well therefore be very suitable, because they’re not concerned about the leveraged nature of the spread risk.

The pros and cons of CPDOs

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AM, BB We’ve mentioned CPDOs several times now, so let’s go into a bit more detail on this product. One of the most talked about new products has been the CPDO, a triple-A product paying Libor plus 200. Take us through the product.


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BJ, Bank of America The proper way to explain the CPDO is that investors go long credit in a 10 or 15 times levered position, and that credit position will roll for 10 years or slightly less if we’ve made enough money to pay the premium you want to be paid. It’s very simple. It’s just getting long rolling credit, and getting your probability of success from the rating agencies. So investors just have to ask: "Do I feel like getting the index market today via a 15 times levered position? Is it the right time?"

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AL, Derivative Fitch It’s simple when you explain it like that or price it, but when you model it and look at the assumptions, it’s a complex product. The product can actually be compared in risk terms to a single tranche with subordination building up through time thanks to accumulated excess spread and rolldown benefit. In addition, the product is exposed to extreme short-term spread moves similar to the leveraged super senior structures.

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AM, B&B It’s a much simpler pricing model than CPPI, for example.



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DKK, Prudential M&G It’s simpler than correlation product.



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BJ, Bank of America The value of your product is very straightforward. You just have an index position. You price that index position against the market and you know exactly what your net asset value is every day.


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Well, another way to put that is to ask whether CPDOs are an entry product to structured credit.

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PD, Solent They could be. Why not?



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LF, Calyon Credit indices are the most liquid underlyings in the credit market. Dynamic leverage products (DLPs) based on indices can be entry products for structured credit investors, as the roll mechanism certainly mitigates the default risks to a six-month short-term default risk. However, I don’t think that CPDOs are entry products since CPDO leverage is defined in a counterintuitive way; that is, the leverage increases when spreads widen. This is like playing a martingale: the more you lose, the more you put at risk. So I do not believe that CPDOs are suitable for all structured credit investors. Why use a highly leveraged product when a less aggressive structure could get you there with less probability of loss and a faster cash-in time? That is a point I am strongly putting forward in the current market. I think the risk is excessive and disagree with those investment banks that are aggressively marketing CPDOs.

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AB, Deutsche Bank My view is that you should look at CPDO as a benchmark. And it’s a paradoxical situation. You have a product that gets a triple-A rating when the pseudo manager, in the static version, is a robot that keeps rolling the portfolio and adjusts the leverage mechanically. So the robot can get the rating and not the best manager in the world because the robot is deterministic and the manager is not predictable. Static CPDOs penalize good managers!

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DKK, Prudential M&G CPDOs were invented because investors wanted triple-A products and they couldn’t get enough yield from the standard single-tranche products. So CPDOs were created purely to produce more yield.


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PD, Solent But it’s also a great product. It has allowed market risk to come into the fold of structured credit, which is fantastic. In 12 months’ time we’ll all be seeing a lot more deals, and variants on them. Eventually it’ll be changed from its present form, but it’s a good thing.

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BJ, Bank of America It will be a very significant step when all the rating agencies have the means to rate more complex products. When we can rate something other than default, then the sky’s the limit. You could devise very sophisticated strategies. The CPDO is just the starting point for a whole new range of products that would be spread-based and that will be rated.

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AM, B&B Do you see the index-based CPDOs and your managed bespoke CPDOs developing in parallel?



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AL, Derivative Fitch It depends on what portfolio is referenced, what kind of rating is targeted, and the volatility of the spreads of the underlyings. A key issue is the liquidity. With the mechanical index strategy on iTraxx and CDX, the bid-offer is only a quarter of a basis point. With 10 times or 15 times leverage, the bid-offer has to be low, otherwise it’s just too much of an impact on the NAV. With a managed bespoke, the exposure is on single-name CDS and there the bid-offer is significantly higher, maybe several basis points, so around 10 times more than on an index. That in itself is a significant constraint on the rating. On the pro side the manager can do a better job of selecting not only the credits, but also the timing of leveraging, the rolling, and he can therefore avoid squeezes in the market.

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PD, Solent The funny thing is, this was designed to be a product that doesn’t need a manager. The whole point is that you’re eliminating credit risk by rolling into indices, rolling six-month risk, and that’s the clever part of the trade. So then to introduce credit variables and a manager is moving back towards a different product which is rateable, but is complex.

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DP, Cheyne I’d argue that a manager could add a lot of value to the product, not only in the alpha creation possible away from index credits, but particularly with this product, the manager’s market presence, and ability to execute at or through mid-market.


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LF, Calyon I can see that the immediate future of CPPI products or its variants like CPDOs lies in the managed version. True the index-based structure has limited credit risk but if you recall how the first generation credit CPPI products evolved, we would expect CPDOs to follow the same path, provided that the rating agencies are fast enough to model all the variation of having a manager to manage bespoke long or a combination of long/short portfolio.

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JI, Henderson We’re a manager but we’re also an investor, and our own fund managers were initially wary of CPDO because of the mark-to-market risk. Are the investors aware of all the underlying risks within it? The bottom line is it’s too early to say. I think the bespoke CPDO will end up looking not unlike CSO. The original index trade will stand quite separate from what the bespoke portfolios could look like.

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BJ, Bank of America Don’t forget that the first CPPIs were just index-based.



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JI, Henderson Anyone who’s currently in the static structure must seriously question why, as soon as there’s a managed alternative. If the manager can display any value added, even if it’s as simple as executing very well at the roll, then over the life of the structure they can very quickly pay for themselves in terms of the NAV that they add. But the market will dictate.

SB, Euromoney Are CPDOs designed as buy-and-hold products?

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JI, Henderson Some of the investors who bought the first derivative, in November, December, found it was three or four points onside and were happy to take profits. It was the right time of year.


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AB, Deutsche Bank There is no hidden value in the structure and the fees are very transparent. People know exactly where it trades if they want to exit. The CPDO relies on a mean-reverting assumption for spreads and the high coupon is supposed to reflect the capture of the spread volatility, and credit risk of the underlyings, over the life of the transaction. In my mind the definition of a buy-and-hold product is that you potentially won’t find the liquidity if you want to sell, so you have to keep the position to maturity. That is not the case for this first generation of index-based products.

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BJ, Bank of America But you get a 10-year rating.



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JI, Henderson Let’s assume we get significant widening at some point and have a very mature CPDO market. You’re likely to see an awful lot of paper being printed. Look beyond that another couple of years you may get positive momentum and the chance to cash in. Some structures have been put together, let’s call it cash out, so that you take your money back as opposed to staying risk-free. But what’s the sense of that? If you’re risk-free at 100 or 200, why would you want to take it back out to put it at risk at a similar spread? It’s so early in the development of the market that the fascination of the product is that there’s a lot more of it to come.

ABX possibilities

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AM, B&B People are now talking about putting ABX into CPDOs. What do you think, Alex?



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AL, Derivative Fitch With a CPDO product you need to have an underlying asset which is liquid, which can be traded, for leveraging and de-leveraging, which has some volatility – but not too much because otherwise you would cash out. I’m not sure ABX qualifies for that, given its newness. We’ve seen very little liquidity on this index, and extreme volatility. That may not be the best index reference in CPDO.

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BJ, Bank of America Firstly, liquidity is extremely poor. The bid-offer on the triple-B minus might be five points. Secondly, you can structure a CPDO on whatever you want. The issue is whether or not you want a rating on that CPDO. We have been asked to provide CPDO on ABX, but we cannot get a rating for that. What matters is the liquidity, because you need to grow, and that would be the main hurdle at the trading level.

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AB, Deutsche Bank There is obviously potential and we would like to see more investors coming to the table. From what we see, ABX is mainly an asset class for US clients and a niche product in Europe. I can see at some stage a potential for multi-market products like CDO square CPDO like structure with the inclusion of an ABX bucket but we are far from getting it rated, as Benjamin said.

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AM, B&B What do you think the scope is for cross-over and high-yield indices?



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AB, Deutsche Bank I think it’s very interesting and we are seeing blended portfolios with Main and Crossover indices trading in Europe. Again, there is a challenge because of the potential volatility of the underlyings to structured derivative products, but I think that there is a lot of value in these markets. There is also an additional problem to ascertain implied correlation for these blended portfolios as they are very barbelled. Deutsche Bank offers products with high-yield and/or leveraged loan underlyings, and there is demand coming from professional accounts that are familiar with the asset class, and the CLO structures.

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AL, Derivative Fitch The more volatility you have in the underlying, the more difficult it is in a way it is to achieve a higher rating, but some of these clients may be familiar with the product and may not need a rating, so that makes sense for them. As far as relative value is concerned, an investor who is very bullish on the credit market would be better off investing in rated equity or CPPI, which gives much more upside than a CPDO.

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PD, Solent I admire the enthusiasm of the market in creating CPDOs, because it indicates that people think iTraxx in its present form will be around for 10 years. In the equity markets, it works because the S&P keeps that name. Here, we’re creating new indices every six months. I can’t see that being sustainable. It’s all quite new, and to include ABX, an as yet unproven index that has seen sustained volatility from short sellers and has not yet found market equilibrium, doesn’t look that sensible.

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DP, Cheyne There is certainly an issue over investors’ assumptions about how CPDOs, will perform from a mark-to-market point of view, when you look at their sensitivity spreads, but also their sensitivity to the roll down the curve.



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PD, Solent Alex, do you think the other ratings agencies were too aggressive on CPDOs?



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AL, Derivative Fitch We have limited history on the key input parameters and the rating is sensitive to small changes to these parameters such as roll-down benefit and bid-offer spread. Also the products with 15x upfront leverage often do not sustain some plausibility checks such as widening spreads by two times the worst observed historical spread moves.

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BJ, Bank of America It’s not the first time rating agencies are rating something other than default risk. They have been rating market value CDOs for many years, and EDS. The reason there has been so much noise about the CPDO is because it’s a 10-year triple-A paying 200 over and people ask whether that kind of product should exist? And is it consistent with a triple-A corporate paying 10 over? Are the clients clear about the kind of risk they are taking when they purchase a CPDO? And what does this triple-A mean compared with another triple-A? The triple-A you would get on the single tranche is real default risk, and that’s something our clients will be familiar with. They know what triple-A on a CDO means. But triple-A on a CPDO – what does that mean?

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DP, Cheyne Do you think banks have been clear enough that despite the fact that it’s triple-A, this is 10 to 15 times leveraged and therefore clear about the commensurate spread risk associated with that?


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LF, Calyon CPPI and CPDOs share with CDOs one obvious characteristic, which is leverage, and the current market environment requires leverage to generate attractive returns in credit. But the fundamental difference is that you do not need an implied correlation input to value a CPDO. Of course, realized correlation will affect the performance of a CPDO. But the fact that these are not correlation products makes it easier for some investors to understand how they work. CPDO investors need to assess the resilience of the structure under different combination of assumptions: they need to simulate different market scenarios, including not just default risk but also spreads. Also to provide a full picture of the risk/return profile we usually test the sensitivity of the final performance to other market measures like spread volatility and tendency, bid-offer costs, roll costs, roll-down gains. Studying the behaviour of these sensitivities helps us to find the optimal minimum leverage required to achieve an optimal payoff in terms of Sharpe ratio. When we arrange deals we provide a set of "standard" scenarios to investors for a given product. The key for investors is to look at the behaviour of all the different products they are being shown under the very same scenarios.

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BJ, Bank of America The fact that the leverage was high and the fact that it’s a very simple rolling mechanism was in my view clearly stated. The way the triple-A was assessed might not have been that clearly explained.


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JI, Henderson If you’re marketing a standard 10-year CSO and you’re simultaneously marketing a bespoke CPDO portfolio to the same group of clients, what would be the spread differentiation between the two? Is it 10 basis points, 50, is it 100?


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AM, B&B Yes, because the CSO has default risk and your CPDO has market risk. What is the premium for that market risk?



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DP, Cheyne There’s no one answer. Given the sensitivity to the roll in a bespoke portfolio, there’s quite a lot of sensitivity to the market presence and market savvy of the manager to achieve good execution.


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DKK, Prudential M&G Don’t forget there is still credit risk within these things. Clearly, it is being minimized because the portfolio is refreshed because it’s rolled, but there is still jump-to-default risk. Most of us remember Enron, Parmalat and WorldCom. This is a 10-year transaction, but we’re talking about indices that have been around for a relatively short time. Things can and will default in the index within the next 10 years. The probability is low, but the impact is high, because there’s no subordination.

Management styles

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AM, B&B Are there certain management styles that lend themselves to one product rather than another? Would a more active trading style, as you might have with a hedge fund kind of manager, better suit a CPPI, compared with a CDO or even a CPDO?


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DP, Cheyne A good manager takes trading decisions depending on the fund in question. Speaking for Cheyne, we have a CDO business which is pretty much long only. We ensure that the locked-up nature of those kinds of funds is suitable for the investors we sell them to. Alongside our CDO business we have more liquid long/short strategies as well. Behind that is the same fundamental analysis, the same considerations about where spreads are going to go technically. The trading decisions that you then make may be different between different funds.

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DKK, Prudential M&G There is no one right way to manage credit. Clearly, there’s a wrong way, but within the spectrum of good management there is a whole range from the very active hedge fund type to the more traditional stuff. But the investor must fully understand the style of the manager, the style of the fund and the risk profile. Two investors can have a very different risk appetite when approaching the same product, and two different managers will arrive at different outcomes.

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JI, Henderson It’s important, regardless of style, that managers attract a suite of investors who are comfortable in the knowledge of how that manager operates. Management styles can easily be adapted to new products but, as I said before, it’s important that the manager is comfortable that the new product fits neatly into its own suite of products.

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LF, Calyon Some products are structured with a view to allowing the managers to trade quite actively. This is certainly the case if the strategy of the product is to take trading decisions in response to the movements in spreads, volatility or correlations. Also, products which allow a short bucket or short tranche would by definition require a higher degree of trading or monitoring, as a name or tranche could be a good shorting opportunity today but not next weeks or months ahead. We also see trends where a fund-of-funds concept could be appealing to investors. We arranged a multi-manager CLO fund last year in which there is a senior manager and five sub-managers. The senior manager acts as a gate keeper that monitors the performance of the sub-managers, potentially removing sub-managers from the structure if they do not perform. Investors certainly welcome the idea of having the performance police in the deal rather than resorting to the trustee through any noteholders’ action when it is too late.

SB, Euromoney In equity markets, the longer-term trend has been for active management to be disparaged and for replication strategies and indexing strategies to come more to the fore. Why is active management favoured in credit?

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PD, Solent Because there are some great managers around!



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DKK, Prudential M&G As a credit investor, I would argue that the fixed-income markets are more rational than the equity markets. They’re less sentiment-driven and therefore managers can add value.


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BJ, Bank of America In credit, investors have very specific criteria, and that’s why I don’t think you will see benchmarking like you see on the index side. So the management style is very important for our clients. They look for defensive management for rated products and more active management for first-loss products.

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DP, Cheyne In equities the return distribution is something of a bell curve, around the medium. But in credit you’re either going to earn a small amount or completely lose your shirt, and over 10 years, if, as a manager, you can avoid those one or two defaults, statistically, it makes an awful lot of difference to the return. Secondly, being short credit is quite an efficient instrument compared with being short equities. Your losses are theoretically limitless being short equities. If you’re short credit, it’s just a premium that you stand to lose.

The power of ratings agencies

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AM, BB The role of the ratings agencies in this market is a big talking point. Do investors rely too heavily on ratings, and are the ratings agencies qualified to rate all the risks they rate?


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DKK, Prudential M&G The power that the rating agencies have over individual companies and, frankly, over the markets, is a hot topic at the moment. Looking back to May 2005, that chain of events, the downgrade of the autos, was the first real test of the structured credit markets. It was all triggered by one analyst at S&P.

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AL, Derivative Fitch The CDS spread for GM and Ford showed that these companies were no longer priced as investment grade. The market was anticipating the downgrade and the rating action was just part of a chain of events, rather than the cause of these losses.

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DP, Cheyne I have a lot of sympathy for that. The point of having a manager is to make decisions on things other than just the rating. One should also consider the extent to which that rating comes from a lot of conditions around how the portfolio is structured and managed. One of the things experienced structured credit managers look out for is the extent to which we would have to manage deal criteria versus manage to our real credit view.

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LF, Calyon Let’s not forget that ratings are based on historical default data which is backward looking and therefore it should always be only one of the numerous indicators of credit quality. Past performance is not always an indicator of the actual performance. I believe that investors should believe in market efficiency, so they should look more at spreads than rating to look at credit quality. But then there is the issue of idiosyncratic risk versus industry risk: a good asset manager will be able to pick the right credits in underperforming industries, so that he will benefit from spread pick-up while not deteriorating the intrinsic credit fundamental of a portfolio.

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JI, Henderson The agencies do themselves no favours at times. Consider Moody’s recent approach to rating bank credits. Let’s be realistic, though – without them the structured product market would never have developed at the pace it has; that is, the existence of ratings is a huge factor in the historical growth of the market.

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BJ, Bank of America Do rating agencies ever give credit to a manager? Do they say: "This should be AA, but I’m going to rate it AA+ because you are a good manager?"


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AL, Derivative Fitch We have been giving credit for the managers for a long time now in CDOs. We have an assessment called a CDO asset manager rating, the CAM rating. There’s a scale from one to five, one being the best, five being the worst. We rate more than 60 managers worldwide, and for managers that achieve a CAM of one, two or three, we give credit for the manager’s strength by lowering the Rating Default Rate for the various target ratings

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AM, B&B It sounds as though rating agencies are moving away from their strengths and what they do best, which is evaluating default risk?


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AL, Derivative Fitch Historically, rating agencies rated default risk, because on a cash bond that’s what investors are most concerned about. But we have to serve investor needs, and with the derivatization of the credit market, they want us to look at market risk now. Investors might be comfortable with credit risk in a CPDO, but they’re not comfortable with mark-to-market volatility. So we need to evolve, and that’s why last year we created Derivative Fitch to serve the derivative market. We now offer not just a credit rating, but also pricing services to evaluate the market risk in products. Our pricing and market risk platform is called RAPCD.

SB, Euromoney One issue, though, is the extent to which ratings criteria, which to some extent are artificial, are driving product development. If that were true it would not be good for the market or investors. What are your views?

Ratings

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DKK, Prudential M&G I don’t think structures are being driven by ratings criteria. Rating equity was unusual – people wanted to buy the product but they needed a rating. But most of the time the banks have their sales guys on the ground talking to investors, getting feedback. Investors are saying they want a triple-A product but they need more than 50 basis points, or that they really want to buy equity, but need a rating. So those products are being structured in response to a demand from investors. It makes sound commercial sense for the banks to do this. But if investors didn’t want this product then they wouldn’t sell, and we wouldn’t be having this discussion now. So, for example, CPDOs have sold and investors have bought them, so you can’t say that these products are not being structured to meet a particular demand. Clearly there is a demand.

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LF, Calyon I agree. If the products don’t answer the demand from investors, they will not sell. CPPI/CPDO products and rated equity are products clearly designed with clients’ problem in mind. Some products such as equity default swaps or constant maturity CDS may be considered as interesting but too expensive so they did not take off as much as the others. Demand certainly drives success.

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BJ, Bank of America The rating is not driving the investment. The rating is just a criterion and if you don’t get the rating you cannot go to the next step, but the rating is one risk assessment among others.


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It’s the hurdle above which the product has to jump before it gets to the next stage. And just because one of the investor needs is a rating, that doesn’t mean ratings don’t distort the market and the structures. If the arbitrary need for a triple-A rating was removed, then structures would be different.

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BJ, Bank of America Correct, but the next stage is very strict as well and the mark-to-market sensitivities, the rating sensitivities, all those kind of risk criteria will be taken into account very carefully by most investors today.


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PD, Solent Ratings are a good thing. In a world with no ratings every single buyer would have to do their own independent company research in massive detail. Blind reliance on ratings is not good, but on the whole ratings are a good market standard.


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DKK, Prudential M&G Buying on rating is a very dangerous strategy, whether it be in the structured market, or in the corporate market. No investor should buy purely on the rating, but if a bank took a CPDO out to investors and it was an unrated product the audience of investors would be significantly smaller.

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AB, Deutsche Bank At least we can now offer rated product at spreads that more or less match expectations, and that’s probably due to ABX, CPDO and even the classical mezz widening with the underlyings. The question is not whether we can sell without a rating, because institutional investors need the rating. It’s whether we can provide enough spread or enough return for a specific investment-grade rating. Six months ago it was a bit difficult. Now we can.

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AM, B&B You don’t get Libor plus 200 for a triple-A for nothing. As we get more and more structured it’s important to be able to separate what the risks are and assess whether you are getting compensated enough for those risks.


The future?

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AM, BB Finally, then, what do you expect to see in the market over the next 12 months? What would you like to see and what are the potential challenges?


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AB, Deutsche Bank We’re going through interesting times. It’s normal for the credit derivative market to be driven by innovation, and it’s normal for this innovation to be tested by market conditions. The challenge will be to see how all the structures that have been issued in the past 18 months will withstand a bit more volatility. From that we’ll see which players and structures will survive, and that will probably lead us to the next wave of innovation, including new technology, and introducing managers to the game, getting a rating for non-predictable behaviour and discriminating between managers the most successful ones. I expect the innovation to be in that direction. And I think it’s also very much market-driven. If the market stabilizes close to current levels, plus or minus 10%, we will continue to see an increase in liquidity and volumes. But spreads were to widen or even tighten by more than that the state of the credit world will change and we will need to reconvene this discussion because things could be radically different.

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AL, Derivative Fitch I expect to continue to see a trend in the derivatization of the credit market. The challenges for us are to adapt quickly to innovations and to develop better tools to rate and report not just the credit risk but also the market risk in the underlying assets and the rated liabilities themselves. We have already come a long way with the creation of Derivative Fitch and the RAPCD platform. CPDOs are a very positive development in that they challenge us to improve our modelling and understanding of complex products.

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DKK, Prudential M&G In recent weeks and months we have seen ideas becoming more highly structured in a bid to realize value in a tight spread environment. And the recent widening gives us the ability to access both highly structured transactions and simpler transactions, so that means more choice to investors. We think the credit market is benign this year, so it’s a good time to be investing in credit. We’d like to see a nice steady-as-she-goes market in 2007, because there are a lot of existing and new investors interested in this market, and a stable environment is the most conducive market condition for them to come in.

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JI, Henderson I like to think that we at Henderson are rather predictable, in that we retain a consistent credit fundamental focus in our management style, while remaining on the side of market developments, and I’d like more of the same. The volatility clearly makes that a little bit more difficult to achieve, but volatility’s a good thing. I think alpha will be imported into more and more structures. The widening is welcome. I’d like more of it, ahead of doing more product.

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PD, Solent I would say that the key is to remain innovative. The universe of buyers of rated paper is growing. As the universe of investors and risk appetite grows and as the ratings agencies find ways of assessing and rating different forms of market risk so structures and the risk transferred by structures will continue to evolve. So remain innovative, that would be my theme.

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LF, Calyon Innovation is definitely key in an ever changing environment. Innovation, however, needs to be also responsive to what the market and clients want. I think there will continue to be new products trying to meet demand for efficient regulatory capital products or to take advantage of certain temporary dislocations in the market. Existing investors want new structures as their process of hunting for yield and diversified assets. Newcomers who could have been in the cash market only are now starting to look more at structured. For example, the LCDS will also add another potential asset class in the CDO underlying as there is potentially a lot of value in this segment. The structurers’ brains are working hard on getting the next big thing that would add value for investors.

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AM, BB Thank you all very much.

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