[Lehman Brothers] Trading the Cash-CDS Basis in the Current Environment

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February 15, 2008

EURO CREDIT STRATEGY David Brickman 44-207-102-4928

[email protected]

Ben Bennett 44-207-102-2495

[email protected]

Giorgio Gallo 44-207-102-7721

[email protected]

U.S. CREDIT STRATEGY Sherif Hamid 212-526-6561

[email protected]

Bradley Rogoff, CFA 212-526-7705

[email protected]

Michael Anderson, CFA 212-526-4145

[email protected]

Fixed Income Research

OVERVIEW

The persistence of a large negative cash/CDS basis (i.e., cash trading cheap to default protection) has been a marked feature of the recent financial liquidity crisis. Over the past couple of weeks, the basis has narrowed significantly—although in some pockets of the credit market, it remains deep in negative territory—as synthetic credit instruments have taken the brunt of the market moves. Does this mark a trend reversal of the basis? We examine the key drivers of the basis and some of the trading opportunities that have emerged, particularly among new cash supply, LBO names, Lower Tier 2 banks, and basis/convexity trades. Generically, over the medium term, we favor negative basis trades as a way to take advantage of the expected normalization of cash spreads versus derivatives while limiting overall market-directional exposure.

We define the basis for a single entity (e.g., corporate) as the CDS spread minus the spread on the cash bond for that name. Ideally, one should use matched maturities for the CDS and the cash bond, to avoid duration mismatches.

Such trades are theoretically credit neutral because the investor is long credit risk by owning the bond, but short it through owning protection. In the current volatile market, this is viewed as attractive, high-quality risk, with potential for spread tightening—especially where the trade is initiated with a large negative basis (i.e., CDS spread much lower than the cash bond spread.

Although cash and CDS have credit risk in common, a variety of fundamentals and technicals drive the two markets. In theory, the basis should trend close to zero, but the most prominent factors today have made the basis very volatile.

For the overall U.S. investment grade (IG) market, we estimate that the basis currently averages ~ -35 bp, a 35 bp improvement over the past month, while the EUR IG generic basis has moved close to zero (Figures 1 and 2). In high yield (HY), the basis has recently moved back into positive territory after the CDX traded cheap to intrinsic early last week. In summary, a few of the key issues that have been recently influencing the basis include:

• Structured credit unwinds/hedging activity (more positive basis)

• Funding (more negative basis)

• Counterparty risk (more negative basis)

• Liquidity difficulties (more negative basis)

• Heavy cash supply (more negative basis)

Trading the Cash/CDS Basis in the Current Environment

Lehman Brothers | Trading the Cash/CDS Basis in the Current Environment

February 15, 2008 2

After the recent market move, we recommend that investors take profits on basis trades for which the basis is now materially inside of the market average, particularly where the basis has moved close to zero from being significantly negative previously. Because we believe that the market’s funding situation has not yet been cured, we think there should be more attractive negative basis levels at which to re-enter many of these trades in the future.

In the near term, we expect the basis to continue to be volatile. On the one hand, further evidence/fears of portfolio hedging and structured credit unwinds could see more index-led widening in synthetics, having a positive impetus on the basis (i.e., cash outperforming CDS). In contrast, however, continued difficult cash technicals and the potential for a short-covering rally in synthetics, particularly given the heavy short base that has been built in synthetics in recent weeks, could trigger a more negative basis.

In the following pages, we briefly explain some of the main factors that have been driving the basis recently (a more comprehensive explanation of the drivers of basis can be found in Appendix A) and then detail some of the key trades that we believe investors should find attractive in the current environment; in particular:

• Opportunities within former investment grade bonds of LBO names;

• Basis trades on recent new issues where the bond has underperformed CDS since launch;

• Buying protection on cyclical names that may come to the market in the near future;

• Negative basis packages on floating-rate Lower Tier 2 banks;

• Opportunistic basis/convexity trades in long bonds trading cheap to shorter dated CDS.

Over the longer term, as credit markets normalize, we think cash will benefit more than derivatives as funding becomes less expensive. We favor negative basis trades in investment grade credit as a way to take advantage of the expected normalization of cash spreads versus derivatives while limiting overall market-directional

1 Lehman Brothers 5-year CDS corporate BBB index spread minus Lehman Brothers 4-7y BBB corporate cash index LIBOR OAS.

Figure 1. USD Generic Basis 0

1 Figure 2. EUR Generic Basis1

-70

-60

-50

-40

-30

-20

-10

0

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

USD Generic Basis (CDS minus bond)

-30-25-20-15-10-505

10152025

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

EUR Generic Basis (CDS minus bond)

Source: Lehman Brothers Credit Strategy



February 15, 2008 3

exposure. In high yield, we believe that the basis will benefit from an increased value of dollar price discount as a result of a rising default rate.

RECENT DRIVERS OF THE BASIS

Figures 3 and 4 highlight the key fundamental and technical drivers of the basis. We provide more detail on how these affect the basis in Appendix A to this article.

Figure 3. Fundamental Factors that Make the Cash/CDS Basis…

Risk of Technical Default

Assets Trading below Par

Default Swap Spreads must be Positive

Coupon Step-ups in the Bond

The Delivery Option

…More Positive



Default Swap Spreads must be Positive


The Delivery Option

…More Positive

Accrued Interest

Assets Trading above Par

Counterparty Risk

Funding

…More Negative

Accrued Interest


Counterparty Risk

Funding

…More Negative


The following themes have been key drivers of the basis in the current environment:

• Hedging risk. Hedging of portfolios is conducted primarily via the CDS market, given its relative liquidity. So in a spread-widening environment, where investors are seeking to hedge their credit exposure further, we should expect cash to lag (outperform) synthetics and the basis to narrow (become more positive). This happened in the initial widening last summer and again over the past week or so.

• Structured credit unwinds. The unwinding of specific synthetic products (e.g., CPDOs) leads to CDS spreads’ widening more than cash because credit risk is being sold (reduced) via the synthetic market—i.e., demand for default protection rises (both in absolute terms and relative to cash), leading to a more positive basis. This contrasts sharply with the negative effect on the basis from the synthetic CDO bid before last summer.

• Funding. The liquidity crisis over the past eight months has made physical (cash) assets more expensive to own relative to synthetic. This is a key reason the basis moved so sharply negative in the second half of 2007. We demonstrate this later in this article by examining the return on capital (ROC) of a basis trade and looking at the sensitivity of the ROC to some of the underlying variables.

• Counterparty risk. A perceived increase in counterparty risk, illustrated by the significant spread-widening seen in financial intermediaries (banks/brokers/financial


February 15, 2008 4

guarantors), may lead investors to question the value of hedges written with such counterparties. As a result, investors could become less willing to pay as much for protection, resulting in a more negative basis.

Figure 4. Technical Factors that Make the Cash/CDS Basis…

Repo Optionality

Demand for Protection

Relative Liquidity

New Issuance

Synthetic CDO Bid

Convertible Issuance

…More Negative…More Positive

Repo Optionality


Relative Liquidity

New Issuance

Synthetic CDO Bid

Convertible Issuance

…More Negative…More Positive


• Lack of liquidity. Liquidity has declined materially, most notably in the funding-sensitive cash market. Under these circumstances, investors require more spread to hold an illiquid bond than was previously the case, and all else equal, this also implies a more negative basis.

• Heavy cash supply. In our 2008 Outlook, we emphasized the likelihood of increased issuance, particularly from the banks. As such, supply is physical, not synthetic (borrowers issue bonds, not CDS), and cash spreads are likely to widen more than CDS in this environment, pushing the basis even more into negative territory. Indeed, secondary spreads in the USD market have repriced considerably more than in the EUR market, which is largely a function of the strong issuance in the U.S., whereas year-to-date EUR corporate and financial issuance is still lower than in the same period of 2007. We recommend taking advantage of the new issue premium in cash bonds. Later in this article, we demonstrate the negative basis opportunities available as a result of supply.

OUTLOOK FOR THE BASIS

We believe there is a clear distinction between the very short-term influences on the basis, and the longer-term outlook.

• The extreme credit market volatility over the past week (even by the standards of the past eight months) makes a near-term call on the basis a very directional one.

- Further evidence/fears of portfolio hedging and structured credit unwinds could push spreads even wider, led by the indices, and hence could see a further positive move in the basis (i.e., cash outperforming CDS).


February 15, 2008 5

- That said, given the heavy short base that has been built in synthetics in recent weeks, we note the potential for a short-covering rally led by synthetics, particularly if no further negative headlines materialize. This would lead the basis to become more negative again.

- Given how far the market has moved in the past week, we would take profits on basis trades where the basis is materially inside of the market average and look to re-enter these trades at more negative levels in the future.

• Absent another leg lower in synthetics, because of cash market technicals, we expect the basis to trend more negative in the near term. Two key factors stand out:

- New bond supply, which, in the current environment, is likely to attract a signi-ficant new issue premium, leading to underperformance of cash versus CDS.

- Impending broker/dealer quarter-ends, which carry a risk of balance sheet cleaning at the end of February. Any attempts to shrink balance sheets (although likely to be much less severe than at year-end) could temporarily worsen the liquidity environment, in turn leading to a more negative basis.

• In the longer term, we still expect credit market conditions to normalize, although not before the second quarter and perhaps even the second half of 2008. We think a normalization will entail a rally in cash versus derivatives and expect the generally prevalent negative basis to correct. We also expect bank balance sheets to free up as liquidity concerns recede, which could help create an incremental bid for high quality cash assets and negative basis trades. Indeed, as discussed above, the expected return on capital of these basis trades is likely to improve significantly, particularly if haircuts on repo transactions start to fall back to the levels required a year ago.

• As curves flatten and defaults rise, the value of the dollar price discount on stressed bonds increases materially. Therefore, we believe that high yield could move into a substantially positive basis regime by the second half of 2008.

In the longer term, we think cash will benefit more as funding becomes less expensive. We favor negative basis trades to take advantage of the expected normalization of cash spreads versus derivatives while limiting overall market-directional exposure.

RETURN ON CAPITAL OF A BASIS TRADE

One of the factors that make basis trades attractive risk is that they can deliver a fairly high return on capital even if there is zero movement in the basis over time. Clearly, investors do not typically look at this trade purely as a “carry trade,” but rather anticipate a movement in the basis in their favor over a set period of time.

To demonstrate this, we calculate the return on capital (ROC) that an investor is able to achieve from a basis trade. We do this first by assuming that there is no change in the basis over time, and then again by assuming that the negative basis actually narrows in the investor’s favor (i.e., becomes more positive with cash outperforming).

Figure 5 depicts the cash flows of a simple basis trade in USD.

• The investor buys the bond (receiving the coupon) and also buys protection on the name (underlying reference entity).

• The coupon flows are swapped from fixed to floating (this is not always the case).


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• The bond is lent via repo and the investor receives the value of the bond minus a haircut.

Figure 5. Cash Flows of a Negative Basis Trade in Which Coupon Flows Are Swapped from Fixed to Floating

SWAP

CDS

INVESTOR

BOND

$100Coupon

REPO$100 - haircut

L+10 bp

Coupon

L+100 bp

70 bp


For any such trade, the rates will depend on the underlying corporate, the creditworthiness (rating) of the investor, and market circumstances. In this example, we have assumed annualized returns and that the following factors are fixed:

• A 1-week and 3-month LIBOR rate of 3.1%;

• The bond is priced at par and is swapped for a spread of LIBOR + 100 bp;

• The CDS is priced at LIBOR + 70 bp (i.e., gives a negative basis of 30 bp at the start of the transaction);

• A repo rate of LIBOR + 10 bp on the transaction;

• The haircut on the repo transaction is 10%; hence, $10 of capital upfront is required.

Using the above, we calculate the economics of the trade. In this case, we are assuming a “carry trade” only, i.e., the basis remains unchanged throughout the life of the transaction.

• The cost of funding = (bond price – haircut) x repo rate. In this case, that equates to ($100 – ($100*10%)) x (USD LIBOR +10 bp) = $90 x 3.2% = $2.88.

• The income on the trade = bond price x (LIBOR + bond spread versuss LIBOR – CDS spread) = $100 x (3.1% + 100 bp – 70 bp) = $3.40.

• Hence, the return on capital = 5.2%1F1F

2

The primary risk to the trade is that the basis widens further (i.e., the CDS tightens relative to the bond), leading to a mark-to-market loss for the investor. However, if instead the basis narrows over time, the trade is even more profitable. Assuming that the basis narrows by 10 bp over a 1-year horizon because the CDS spread widens by 10 bp (and all other variables are unchanged), this provides an additional mark-to-market gain on the trade of ~37 bp. Taking account of the $10 of capital upfront, this raises the ROC by ~3.7% from 5.2% to ~8.9%.

2 Cost of capital = (income on trade – cost of funding)/capital outlay = (3.40-2.88)/10% = 5.2%


February 15, 2008 7

Furthermore, if the basis were to contract to zero over the same time period, the mark-to-market gain would be ~109 bp, raising the ROC by 10.9%, from 5.2% to 16.1%. Hence, we can see how attractive these basis trades can be for an investor who expects the basis to contract over time. We would also note that these are leveraged returns on capital; thus, investors in these trades are likely looking for equity-like ROCs.

Swap Spread Risk

Investors do not always swap the coupon flows from the bond.,A popular alternative has been to hedge the interest rate risk by selling Treasuries instead. In this case, however, the investor is exposed not only to a widening of the basis, but also to a widening of swap spreads because of having sold Treasuries. In this situation, if swap spreads widen (i.e., Treasuries outperform the LIBOR curve) and all other things being equal (i.e., the bond spread to LIBOR and the CDS spread are unchanged), then the trade will lose money on the Treasury hedge.

The sharp widenings of swap spreads in June/July and again in Novemberwere therefore significant events that caused large mark-to-market losses on these trades. This in turn led to a partial unwind (i.e., selling protection on CDS and selling the bonds), which pushed the basis even further into negative territory.

Finally, the most recent widening in swap spreads should have a negative effect on the attractiveness of basis trades as the cost of funding the trade becomes more expensive.

Sensitivity Analysis

Appendix B details sensitivity analyses we ran for the ROC of a basis trade. We note:

• The haircut on the repo significantly affects the ROC. For example, we estimate that the haircut doubling from 5% to 10% (a reasonable proxy for events since July) would have reduced the ROC on the original trade in Figure 5 from 7.2% to 5.2%.

• Unsurprisingly, the level of the basis also makes a material difference to the ROC. Assuming a haircut of 10% on the repo transaction, a 10 bp change in the level of basis leads to a 1% change in the ROC (i.e., a more negative basis boosts the ROC).

We have also analyzed how the ROC of basis trades has changed between last July and today, by changing just two inputs: the haircut on the repo and the actual level of LIBOR (i.e., we have kept the level of the basis and all other factors constant). We calculate that a basis trade similar to our example in Figure 5 would have produced a ROC of 12.1% last July, versus just 5.2% currently, most of which is due to the increased haircut. We also note some likely negative contribution from an uptick in funding spreads, although this impact is more marginal. This provides evidence of the reduced attraction of basis trades in the liquidity crunch and further demonstrates why the negative basis has been able to persist for an extended period.

RECOMMENDED TRADES

How should investors play the basis right now? In this section, we detail some of the key trades that we find attractive in the current environment. With the recent underperformance of CDS, many of these trades are looking less profitable than they did last week, although some remain attractive at current levels. Given the extent of market volatility, we would not be surprised to see better entry levels on many of these trades in the coming weeks; we recommend that investors be opportunistic with regard to entry points.


February 15, 2008 8

There are two major tools available on LehmanLive to help investors with screening and analysis basis trades. More details can be found in Appendix C.

• The 0H0HBasis Screening Tool is a single source to easily identify basis trade opportunities using Lehman Brotherss default-adjusted credit analysis.

• The 1H1HBasis Trade Analysis Tool gives users the ability to perform P&L, risk and scenario analysis between credit products to generate relative value ideas on basis, curve, and pair trades.

In analyzing potential basis trades, we focus on bond implied CDS levels (BCDS), which account for $ price discounts and payment frequency differences, among others, versus CDS. However, given that much of the market still examines bond z-spread versus CDS to determine the attractiveness of a basis trade, we look at both measures.

Basis Trades in High Yield Fixed Rate Bonds

One of the best opportunities for negative basis trades is through the legacy bonds of recent LBOs. Typically, these bonds trade at a deep discount because of their low coupons and junior position in the capital structure. Thus, a notional-neutral basis trade will generate positive VOD (value-on-default) because the bond position will lose less than the CDS pays. Moreover, as shown by the recent curve flattening in the short end, the likelihood of near-term default has risen sharply, making the price discount more valuable.

With the recent derivative sell off, the negative basis on many names has disappeared and the z-spread on the bond is now close to the CDS spread. At a flat basis with bonds trading in the $70s or low $80s, we still believe these trades are compelling for names on which investors have a negative view. The BCDS is flat or negative on all the names in Figure 7, reflecting the importance of the discount.

If there is a greater concern about carry, this trade can be executed by buying less CDS protection than bonds and therefore giving up the positive VOD. For example, if a bond is trading at 70 and the expected recovery is 40, you can buy twice as many bonds versus CDS and still be VOD neutral (Figure 6). The primary risk to this trade is its sensitivity to assumed recoveries. Therefore, investors may want to use a conservative (i.e., low) recovery that is more likely to leave the trade with positive VOD than negative VOD.

Figure 6. How Much CDS ($ million) Should Be Purchased for Every $10 million of Bonds?

Current Bond Price

Estimated Recovery $60 $70 $80 $90 $100 20% 5.00 6.25 7.50 8.75 10.00 30% 4.29 5.71 7.14 8.57 10.00 40% 3.33 5.00 6.67 8.33 10.00 50% 2.00 4.00 6.00 8.00 10.00

Source: Lehman Brothers

Floating Rate Bonds

Similar to leveraged loans, floating rate bonds have been punished over the past month. Although the floating rate subset of the high yield market is small, the widening in cash spreads has created a negative basis in a few credits. Additionally, the average price of the High Yield FRN Index is $83.14, more than six points below the fixed rate High


February 15, 2008 9

Yield Index. Of course, there is the risk that short-term rates will fall further, thereby making the basis more negative, but given that 1-year LIBOR is only 30 bp below 3-month LIBOR, the market is clearly not expecting drastically lower rates. If rates rise dramatically, the floater could get called, but given the average FRN price, there is plenty of upside potential before entering call risk territory.

Figure 7. High Yield Bond Trade Opportunities

Ticker Issuer Coupon Maturity Offer Price Z-Spread BCDS Mid CDS CDS –

Z-Spread BCDS – CDSIAR Idearc 8 11/15/2016 73.00 910 1026 965 55 -61 CCU Clear

Channel 5.75 1/15/2013 81.00 723 742 750 27 8

HET Harrah's Entertain.

5.375 12/15/2013 67.00 998 1160 1082 84 -78

FDC First Data 9.875 9/24/2015 85.75 881 875 810 -71 -65 AT Alltel 7 3/15/2016 74.00 791 884 885 94 1 RMK Aramark Fltr 2/1/2015 87.25 600 596 585 -15 -11 CAR Avis Budget Fltr 5/15/2014 79.00 708 747 625 -83 -122

Source: Lehman Brothers, Bloomberg

New Issuance Opportunities For the past few months, the best source of consistent negative basis has been the primary market. Given funding difficulties, investors have generally demanded large new issue premia, and issuers have often been willing to widen spreads to raise needed capital. This has led to deals coming to market at significant discounts to secondary spreads and, most important, to CDS levels. Not all new issuance has been placed as basis packages (this has usually been the domain of hedge funds and some banks), but negative basis has been useful for investors to judge the relative attractiveness of issuance.

The size of the negative basis offered by new issuance has largely been a factor of the strength of the credit markets at the time; i.e., issuers have offered more premium when markets and, hence, demand have been weak, and less when conditions have improved.

• In September and early October 2007, European new issuance offered around 30 bp of negative basis for deals such as Astrazeneca 15s, E.ON 12s, or WPP 15s. In the U.S., issuance was even heavier at this time, also leading to negative basis opportunities such as the Astrazenaca 5.9 17s, which were issued 30 bp (Z spread) wide to 10-year CDS.

• As credit conditions stabilized during October, new issue negative basis opportunities diminished. In Europe, many deals priced within 10 bp of CDS, such as Johnson & Johnson 19s and Unilever 12s. This contraction was also seen in the U.S., where the WFC 5.25 12s were issued right on top of 5-year CDS.

• Since the new year, new issue basis trades have once again looked attractive, with a number of European deals offering in excess of 50 bp premium to CDS, among them Glaxo 12s and OTE 11s. In the U.S., similar opportunities existed, highlighted by the TGT 6 18s, for example, which were issued 50 bp (Z spread) wide to 10-year CDS.

Once free to trade, recent new issuance has generally outperformed CDS, with negative basis shrinking to levels comparable with those available across the broader secondary market. However, some lower rated issuance (low-A and BBB) has underperformed CDS in the secondary market. Those investors who bought the supply in a negative basis package may therefore be already sitting on mark-to-market losses. As a result, it seems


February 15, 2008 10

that the market is increasingly discriminating between such lower-rated new issuance and higher-rated (high-A and above) issuers, demanding more premium and, hence, a larger negative basis for lower-rated supply.

• Thus, lower rated new issuance should represent the most attractive opportunities for negative basis packages.

• Investors with a bearish outlook may wish to put on the CDS leg of the basis trade today, in advance of potential new issuance, buying the bond as and when supply comes to the market. Some of the best names to put on this trade are detailed in 2H2HCredit Markets Weekly, February 1, 2008, in which we highlighted cyclical names that may underperform in deteriorating economic conditions.

• For those of a more bullish persuasion, we recommend putting on new negative basis trades on recent new issuance, where the bond remains cheap to CDS (see Figure 8 for examples).

Figure 8. New Issues Trading Cheap to CDS

Ticker Maturity Size Issue DateBasis at issuance

Basis on 14 Feb Moody's S&P

USD VZ 2/15/2018 1500 7-Feb-08 -31 -25 A3 A ATTINC 2/1/2018 2500 29-Jan-08 -51 -31 A2 A

EUR SGP Oct-14 1500 26-Sep-07 -34 -62 Baa1 BBB+ WPPLN Jan-15 500 30-Oct-07 -30 -31 Baa2 BBB+ CCE Nov-10 300 30-Oct-07 -19 -24 A3 A TPG Nov-17 650 7-Nov-07 -36 -44 A3 BBB+


Within the financial new issue market, because of the nature of senior and subordinated CDS, the opportunity is limited to either the senior market or Lower Tier 2 (LT2) paper.

• Negative basis for senior new issues has generally been in the 10-20 bp range in recent months. The best opportunities exist for U.S. brokers, where negative basis has been in the 40-50 bp range (and still is for many deals).

• In terms of LT2 supply, the associated negative basis has often been 40-50 bp in recent months, representing attractive opportunities. However, as detailed below, the secondary FRN LT2 market offers similar, if not better options for investors, and this is where we would recommend investors put on negative basis packages.

Lower Tier 2 Trades Bank LT2 paper has underperformed other parts of the capital structure during the recent volatility (Figure 9). By dividing Tier 1 (T1) and Upper Tier 2 (UT2) bank spreads (OAS to government debt) by LT2, it is easy to see how the relative betas of the different parts of bank capital have changed.

• One might think that recent market weakness would have led to underperformance of the most subordinated parts of the capital structure, but the spread ratio of T1 to LT2 debt has actually remained wrapped around the 2x area since the correction began.

• The beta of UT2 paper has managed to outperform the LT2 beta over the period.



Figure 9. Relative Performance of EUR Bank Capital (OAS Ratios)

1.2

1.4

1.6

1.8

2.0

2.2

2.4

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

Tier 1/Low er Tier 2 Upper Tier 2/Low er Tier 2


The reasons for this LT2 underperformance are threefold:

• Investors have been able to short LT2 via the derivatives market given that subordinated CDS references this part of the capital structure. As a result, there have been bouts of significant derivatives weakness (such as earlier this week), which has translated into cash market widening.

• Because of heavy issuance, cash LT2 has underperformed subordinated CDS. This has been particularly the case in Europe, where almost the entire subordinated bank issuance in 2008 has been LT2.

• SIVs, a major source of demand for LT2 paper in recent years, have stopped buying and in some cases have been unwinding existing positions. This has mainly been felt in $-denominated floating-rate paper, where SIV buying was traditionally concentrated, although weakness has spread to other areas of the LT2 sector.

The significant underperformance of LT2 cash (particularly in the FRN market) has therefore led to attractive negative basis opportunities. However, a major consideration is that most LT2 paper is callable after an initial term (usually 5 years) at the discretion of the issuer, with a final maturity only after 10 years. The problem is therefore choosing the correct CDS maturity for the trade.

In the past, LT2 has tended to be called as soon as possible as the coupon step-up (often 50 bp) has made it economically sensible for the issuer to reissue the debt at a lower cost. That economic argument is blown out of the water in today’s environment.

That said, we still see a strong reputational risk associated with not calling the bonds on the first available date. LT2 paper tends to have debt-like characteristics (e.g., a final maturity and the non-deferability of coupons). Hence, holders of LT2 paper are also often buyers of the banks’ senior paper. Not calling the LT2 paper risks alienating this investor base, thereby increasing senior funding costs for the bank. Moreover, senior bond investors may see the decision not to call the LT2 debt as a sign that the issuer is nervous about its ability to refinance the paper, again, undermining the bank’s reputation.

Even so, we would be more confident that strong AA-rated banks would have a greater inclination to preserve their reputations in this manner than weaker banks. We would therefore concentrate on the LT2 paper of such banks when setting up negative basis trades. We would also prefer to buy paper with the maximum amount of time until first



call (as close to 5 years as possible) to give the broader financial market time to recover, bringing back into play the economic incentive to call.

Figure 10 sets out possible trades using these criteria together with the negative basis on offer (assuming the bonds are called at the first opportunity). Note that we have chosen bonds that have floating rate coupons, given that this is where the SIV selling has been concentrated. As in the case of other basis trade ideas, we would time our entry point to the trade when the cash technicals are weakest, i.e., at the time of heavy issuance.

Figure 10. LT2 Basis Trade Ideas

Ticker Call Maturity Size Coupon before Call Coupon after Call Moody's S&P Cash Sub CDS Basis

USD RBS Aug-12 Aug-17 1500 3mnth $Libor +20bp 3mnth $Libor +70bp Aa1 AA- 215 165 -50 HBOS Sep-12 Sep-17 1000 3mnth $Libor +20bp 3mnth $Libor +70bp Aa3 A+ 205 160 -45 HSBC Oct-11 Oct-16 750 3mnth $Libor +20bp 3mnth $Libor +70bp Aa3 A+ 180 130 -50 EUR BBVASM Oct-12 Oct-17 250 3mnth Euribor +25bp 3mnth Euribor +75bp Aa2 AA- 195 150 -45 KNFP Jul-12 Jul-17 1000 3mnth Euribor +20bp 3mnth Euribor +70bp Aa3 AA- 205 150 -55 SOCGEN Jun-12 Jun-17 1000 3mnth Euribor +17.5bp 3mnth Euribor +67.5bp Aa3 AA- 175 130 -45

Source: Lehman Brothers Spreads are indications from February 14, 2008.

As we have already mentioned, one of the big risks for this trade is that the LT2 paper is not called at the first date, extending the bond to a full 10-year asset. For the bonds in Figure 10, such an eventuality would reduce the cash spread by around 90 bp, sending the basis into positive territory (e.g., for the RBS Aug-17 deal, the spread to final maturity would be 120 bp over LIBOR, leaving the basis versus 5-year CDS at positive 45 bp).

For those investors particularly concerned about this extension risk, an alternative trade idea is to buy CDS protection up to the final maturity date (usually 10 years). Even though subordinated CDS curves are very flat (inverted in some cases), this would still leave such a trade running with a positive basis (i.e., costing carry). Therefore, we recommend dynamically varying the notional amount of CDS protection for the trade. However, such a trading strategy has a number of moving parts, demanding a very hands-on approach, and therefore would not suit all investors.

Basis Convexity Trades, Particularly in Higher-Volatility Names 2F2F

3 Lastly, we continue to favor basis/convexity trades whereby investors buy long-dated bonds and buy protection in shorter dated 5- or 10-year CDS. Particularly in more volatile names, these constructs allow investors to benefit both from the liquidity normalization theme and from material underlying credit spread volatility. As shown below, such trades are typically set up DV01 long but with positive value on default (VOD). Thus, the trade will likely be profitable in either a material credit rally or significant credit deterioration. Given the currently prevalent (if somewhat tighter) negative basis, investors can effectively buy cheap options on the “wing” outcomes (default or normalization) and benefit further if basis continues to correct generally.

(3) For a primer on convexity trades in credit, see Structured Credit Strategies: Negative Basis Convexity Trades, September 27, 2004



Figure 11. Generic Basis Convexity Trade Payoff Profile

Credit DeterioratesCredit Rallies

Profit

Loss

Credit Defaults

Credit DeterioratesCredit Rallies

Profit

Loss

Credit Defaults

Source: Lehman Brothers, Bloomberg. Assumes 40% recovery.

For example, playing on the theme of material credit deterioration, newspapers have been faced with weakening fundamentals, as evidenced by weak 4Q07 earnings results from several of the major names in the sector, including NYT, GCI, and MNI. With respect to MNI in particular, we note that the company’s long-dated 6.875% of 2029 have been trading at a material $ discount.

In addition to the $ discount, we also note that the bonds have been trading cheap to CDS. That said, had investors bought the long bonds notionally neutral against 10-year CDS in December, after the most recent sell-off CDS widened by ~ 225 bp (~11 points) versus a ~4 point sell-off in the bonds.

From current levels, the basis/convexity package continues to be attractive. For a new position, in a scenario in which the company continues to deteriorate, investors have ~ 38 points of VOD. In scenarios in which the credit rallies materially, investors should also benefit given the positive DV01 of the overall position.

In addition to the McClatchy bonds discussed above, we believe there are a variety of other compelling opportunities in the market with which to apply this convexity trade construct. In particular, we focus on reasonably liquid long dated (~30 year) bonds deliverable into CDS. We looked for bonds that trade at a materially negative basis (-50 bp or wider) and that are currently priced below par. We highlight several of these opportunities in Figure 13.

Figure 12. Deep-Discount Long Bonds Outperform CDS as Fundamentals Deteriorate

MNI Cash & Bonds 12/14/07 MNI Cash & Bonds 2/11/08

$66 px$72 px

0

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2007 2011 2015 2019 2023 2027

MNI CDS Curve Bond Z-Spread

$65px $62px

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2007 2011 2015 2019 2023 2027


CDS ~11pts wider

Bonds ~4pts lower

Spread (bp) Spread (bp)

$66 px$72 px

0

250

500

750

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2007 2011 2015 2019 2023 2027


$65px $62px

0

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500

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CDS ~11pts wider

Bonds ~4pts lower

Spread (bp) Spread (bp)





Figure 13. Convexity Trade Opportunities

Ticker Coupon Maturity 5yr CDS Est. Matched

Mat CDS Price Z-Spread BCDS Basis

(BCDS – CDS)CDS –

Z-Spread ABK 5.95 12/5/2035 1006 622.1 62.1 526 801 -179 96 BNI 6.15 5/1/2037 77 87 95.28 161 163 -76 -74 CBS 7.875 7/30/2030 165 196.6 100.13 308 303 -106 -111 CBS 5.5 5/15/2033 140 174.6 81.0 226 252 -78 -51 CNRCN 6.375 11/15/2037 60 82.9 98.27 160 160 -77 -77 CZN 9 8/15/2031 370 400 93 507 520 -120 -107 DRI 6.8 10/15/2037 190 217 89.0 291 310 -93 -74 HD 5.875 12/16/2036 160 160 81.2 261 297 -137 -101 KSS 6 1/15/2033 150 178.9 83.2 266 292 -113 -87 KSS 6.875 12/15/2037 150 183.8 91.4 276 286 -102 -92 L 8.25 2/1/2030 340 393.3 87.3 495 526 -133 -102 L 8.5 7/15/2029 340 392.4 89.2 501 524 -132 -109 LOW 5.5 10/15/2035 97 114.3 83.7 192 209 -95 -78 LOW 5.8 10/15/2036 97 115.5 87.3 192 204 -89 -77 LTD 6.95 3/1/2033 335 325 79.3 428 497 -172 -104 LTD 7.6 7/15/2037 335 325 85.6 423 464 -139 -98 M 6.375 3/15/2037 250 292 80.8 327 374 -82 -35 MKS 7.125 12/1/2037 133 148 89.7 322 340 -192 -174 MNI 6.875 3/15/2029 840 784.3 63.6 685 1000 -215 99 MOT 6.5 9/1/2025 235 234.4 84.8 341 367 -133 -107 MOT 6.625 11/15/2037 235 248.8 82.5 338 379 -130 -89 MOT 6.5 11/15/2028 235 236.6 84.6 324 352 -115 -88 S 6.875 11/15/2028 290 304.7 83.4 384 421 -117 -80 S 8.75 3/15/2032 315 346 96.01 443 444 -98 -97 STORA 7.25 4/15/2036 320 340 86.48 372 405 -65 -32 UPMKYM 7.45 11/26/2027 265 317 86.61 399 433 -116 -82 WMT 5.25 9/1/2035 45 45 85.6 145 158 -113 -100 WY 6.95 10/1/2027 192 211.6 92.0 298 306 -94 -87 WY 6.875 12/15/2033 192 212 91.9 277 286 -74 -65




APPENDIX A—DRIVERS OF THE CASH/CDS BASIS

This appendix seeks to explain some of the determinants of the cash/CDS basis.3F3F

4 These are factors relating to the structural differences between a cash bond and a CDS, which, all other things being equal, can cause their spreads to differ.

Fundamental Reasons That the Cash/CDS Basis Can Be (More) Positive In general, the factors below make it more attractive for investors seeking to short credit risk to buy protection, rather than sell the bond. For those seeking to increase credit risk, these factors usually make it more attractive to buy bonds rather than sell protection.

The Delivery Option

This feature comes from the optionality embedded in a CDS in case of a default, as the protection buyer has the ability to choose between a large number of deliverable assets (possibly cheaper than the bond he is already holding). Hence, all else equal, investors should expect a relatively higher spread on the CDS, leading to a positive basis.


The legal structure used in the purchase of the default protection usually includes more events defined as “default” than is the case with the cash bond (e.g., restructuring). All else equal, this gives the basis a positive bias.


While holders of bonds with step-up clauses can benefit in case of credit deterioration, CDS cannot. This means that, all else equal, investors should prefer to buy step-up bonds rather than sell CDS relatively, making the basis more positive.

Default Swap Spread Must Be Positive

Any insurance costs money. Hence, buying default protection must cost more than zero, even when the cash bond is very highly rated. The basis therefore is generally positive for high quality names (which may trade close to, or below, LIBOR).


A CDS is a par asset: it compensates the protection buyer for the entire notional amount, which is not the case with cash bonds. All else equal, bonds trading below par should pay a lower spread than the default swap because the bond investor is paying less than the CDS investor for the same amount of notional exposure.

Fundamental Reasons That the Cash/CDS Basis Can Be (More) Negative Funding

Unlike cash bonds, default swaps are unfunded transactions that lock in an effective funding rate of LIBOR. The funding cost of the institution looking to go long or short the credit therefore plays a role in determining the more efficient strategy—cash bond or default swap. Assuming that most market participants fund above LIBOR, they should be willing to accept narrower default swap spreads than cash spreads. This decreases the basis, all else being equal.

4 These are amended extracts from “Explaining the Basis: Cash versus Default Swaps,” May 2001.



Accrued Interest

In standard CDS contracts, the accrued premium is paid until the default date. Compare this witih cash, where the investor stops receiving coupons upon default and only has a claim in bankruptcy for accrued interest. The effect of this is to make the basis more negative.

Counterparty Risk

While a cash bond is a straightforward transaction between the issuer and the buyer, a CDS introduces an additional counterparty—the protection seller. Protection buyers will therefore tend to pay a lower spread as compensation against counterparty risk.


As discussed earlier, with assets trading below par, CDS compensates the protection buyer for the entire notional amount, which is the not the case with cash bonds. All else equal, bonds trading above par should pay a higher spread than the default swap because the bond investor is paying more than the CDS investor for the same amount of notional exposure.

Technical Reasons That the Cash/CDS Basis Can Be (More) Positive Convertible Issuance

Convertibles provide a cheap source of equity volatility. Some equity investors buy convertibles and hedge out the risk in the default swap market. This buying of protection increases CDS spreads and, hence, the basis (all else equal).

Repo Optionality

Repo funding is usually done at or close to LIBOR. If the asset goes special (i.e., demand for the asset significantly outstrips supply), then its repo rate will decrease, which is favourable for the asset owner. The cash investor has repo optionality that is not present in the default swap. This causes the default swap basis to widen.


Some cash bonds are difficult to short in the cash market, and investors will prefer to buy protection on the name instead, which has the effect of widening the CDS spread relative to cash. Liquidity concerns and the growth of the structured credit market have meant that most short credit trades are now conducted via CDS rather than in cash.

Technical Reasons That the Cash/CDS Basis Can Be (More) Negative New Cash Issuance

New bond issues often come to market with a new issue (spread) premium, particularly in times where borrowers need to raise a significant amount of capital, as well as in times of heightened risk aversion—both of which are currently applicable. Since this issuance is in bond (or loan) format, this tends to increase the bond spread relative to the CDS.

Note, however, that (in a “normal” market environment), new cash issuance is often seen as a driver of a more negative basis. This is because investors and dealers will often buy protection in order to hedge against new supply and, in the absence of a significant new issue premium, this tends to widen the CDS relative to cash.

Synthetic CDO Bid

Over the past couple of years, the synthetic CDO bid has been a key driver of tighter spreads and a more negative basis. Demand for CDOs was fueled by the tight spread and low yield environment. When a bank originates a synthetic CDO, it is effectively



creating a short credit risk position for itself and usually seeks to hedge this short by selling credit protection in the market. This selling of protection drives CDS spreads tighter, both in absolute terms and relative to the cash market, all else being equal.

Relative Liquidity

The liquidity of the cash and the default markets are very different. In particular, CDS have historically been much more liquid than cash bonds. This acts as a strongly negative bias for the basis.



APPENDIX B—SENSITIVITY ANALYSIS FOR RETURN ON CAPITAL

How sensitive is the return on capital to underlying assumptions? We have run some scenario analyses to quantify the sensitivity of the ROC for a basis trade in which coupon flows are swapped from fixed to floating (i.e., Figure 5). As in that example, we have assumed annualized returns and that the following factors are fixed unless otherwise stated: • A 1-week and 3-month LIBOR rate of 3.1%; • The bond is priced at par with a spread of LIBOR +100 bp; • The CDS is priced at LIBOR + 70 bp (i.e. gives a negative basis of 30 bp at the start

of the transaction, which does not change throughout the life of the transaction); • A repo rate of LIBOR + 10 bp on the transaction; • The haircut on the repo transaction is 10%; hence, $10 of capital upfront is required. Using the above, we can calculate the economics of the trade. As before, for the sensitivity analysis, we are assuming a “carry trade” only, i.e., assuming that the basis remains unchanged throughout the life of the transaction. 1. Varying the haircut/margin.

Figure 14 shows how ROC changes if we vary the haircut on the repo part of the transaction (keeping all other variables unchanged). Haircuts are usually c.5-20% depending mainly on the quality of the collateral but also on the credit quality of the investor counterparty. On average, haircuts for IG bonds have more than doubled in the past nine months, and in some cases have tripled. This has slashed the ROC of these trades.

For example, the trade in the original example (Figure 5) with a negative basis of 30 bp has a ROC of 5.2% using a 10% haircut on the repo transaction. The ROC rises to 7.2% if a 5% haircut is applied, but drops to 4.5% with a 15% haircut and to 4.2% with a 20% haircut.

Figure 14. ROC Sensitivity of Basis Trade to Haircut Changes at Various Basis Levels

0%

5%

10%

15%

20%

0% 5% 10% 15% 20% 25%Haircut (% of bond market price)

Basis = -45 bp Basis = -30 bp Basis = -15 bp

Return on capital (annualized)


2. Varying the repo spread

Figure 15 shows how the ROC changes if we vary the repo spread alone on the transaction—i.e., the lending spread over and above LIBOR for the collateral—but keep everything else unchanged. As you would expect, a lower spread over the repo rate (effectively a lower cost of funding) increases the ROC and vice-versa.



For example, the original trade, with a negative basis of 30 bp, has a ROC of 5.2% using a spread over the repo rate (LIBOR) of 10 bp. Reducing this spread over the repo rate to zero (i.e., using LIBOR flat), boosts ROC to 6.1%. Conversely, a doubling of the spread (i.e., increasing the repo rate charged to LIBOR +20 bp) reduces the ROC to 4.3%.

Figure 15. Sensitivity of ROC of Basis Trade to Changes in Repo Rate

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

0 2 4 6 8 10 12 14 16 18 20

Repo spread over Libor (bp)



3. Varying the level of the basis.

Figure 16 shows how ROC changes if we vary the level of the basis available on the trade. In this example, we have kept the bond spread constant (again per the original example in Figure 5) but varied the CDS spread to change the basis level. Figure 16 demonstrates that it is possible to earn a positive return on capital when the basis is close to zero, or even when the basis is mildly positive (i.e., CDS spread higher than the bond spread). This is because of the use of leverage in the trade and is for the most part unrelated to the basis. Therefore, the sensitivity of the ROC to the basis level will be very dependent on the leverage of the transaction (i.e., haircut on the repo). In our original example, using a 10% haircut and a basis of -30 bp provided a ROC of 5.2%. Utilizing the same 10% haircut, a 10 bp change in the level of the basis leads to a 1% change in the ROC. A basis of -40 bp would increase the ROC to 6.2%, while a basis of -20 bp would reduce the ROC to 4.2%.

Figure 16. Sensitivity of ROC of Basis Trade to Changes in Levels of Basis Alone

-4%

-2%

0%

2%

4%

6%

8%

-50 -30 -10 10 30 50Basis (bp)





APPENDIX C—BASIS ANALYSIS TOOLS ON LEHMANLIVE

There are two major tools available on LehmanLive to help investors with screening and analysis of basis trades.

The 3H3HBasis Screening Tool is your single source to easily identify basis trade opportunities using Lehman Brothers' default adjusted credit analysis. Key features include:

• A multi-input search engine that enables you to efficiently isolate basis trades based on your specific criteria including rating, sector, maturity, and volume.

• The ability to click on a bond from your search results to view the Bond/Issuer Analysis Screen, which includes historical basis data, CDS term structures, basis summary information, and Lehman Brothers Research specific to the credit so you can effectively evaluate a proposed basis trade.

• The ability to click on a bond from your search results to utilize Lehman Brothers’ Basis Calculator to conduct more in-depth basis analysis using Lehman Brothers’ Survival Based Pricing Model.

• Customize your results by selecting and sorting your data columns so you can easily focus on the information that is the most relevant to your analysis. Save your customized searches and results tables for future basis searches.

• Access Universe Rankings to evaluate the widest and tightest basis trades relative to other bonds in your search.

The Basis Screening Tool 4H4HUser Guide explains these features in details.



The 5H5HBasis Trade Analysis Tool gives users the ability to perform P&L, risk and scenario analysis between credit products to generate relative value ideas on basis, curve and pair trades. Key features include:

• A comprehensive scenario analysis on proposed or existing basis trades allows you to easily solve for carry, mark-to-market and P&L for your customized basis, horizon date and curve trade scenarios.

• The ability to calculate individual risk metrics for each leg of a designated trade as well as view an aggregated trade summary that displays risk metrics, including Credit Delta, Credit Gamma, IR Delta, and IR Gamma for the entire trade.

• Scenario curves can easily be customized by specific maturity or use a parallel shift to determine a trade's potential outcome.

• Launch specific trades that were based on results of a search from the 6H6HBasis Screening Tool (BST) to conduct scenario analysis and view risk measures on a single trade.

• Easily load and modify an existing trade or create a new trade.

The Basis Trade Analysis Tool 7H7HUser Guide explains these features in detail.

For more information on these tools, please email [email protected].

Analyst Certification The views expressed in this report accurately reflect the personal views of David Brickman, Ben Bennett, Giorgio Gallo, Sherif Hamid, Bradley Rogoff and Michael Anderson, the primary analysts responsible for this report, about the subject securities or issuers referred to herein, and no part of such analysts' compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Important Disclosures Lehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. Lehman Brothers generally does and seeks to do investment banking and other business with the companies discussed in its research reports. As a result, investors should be aware that the firm may have a conflict of interest. To the extent that any historical pricing information was obtained from Lehman Brothers trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Lehman Brothers' global policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. To obtain copies of fixed income research reports published by Lehman Brothers please contact Valerie Monchi ([email protected]; 212-526-3173) or clients may go to https://live.lehman.com/. Company-Specific Disclosures "CDX" and the names of the CDX indices referred to herein are service marks of CDS IndexCo LLC and have been licensed for use by Lehman Brothers. The CDX indices referred to herein are the property of CDS IndexCo LLC and are used under license. 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[Lehman Brothers] Trading the Cash-CDS Basis in the Current Environment

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