Leveraged Finance

A timely guide to today’s high-yield corporate debt markets Leveraged Finance is a comprehensive guide to the instruments and markets that finance much of corporate America. Presented in five sections, this experienced author team covers topics ranging from the basics of bonds and loans to more advanced topics such as valuing CDs, default correlations among CLOs, and hedging strategies across corporate capital structures. Additional topics covered include basic corporate credit, relative value analysis, and various trading strategies used by investors, such as hedging credit risk with the equity derivatives of a different company. Stephen Antczak, Douglas Lucas, and Frank Fabozzi present readers with real-market examples of how investors can identify investment opportunities and how to express their views on the market or specific companies through trading strategies, and examine various underlying assets including loans, corporate bonds, and much more. They also offer readers an overview of synthetic and structured products such as CDS, LCDS, CDX, LCDX, and CLOs. Leveraged Finance has the information you need to succeed in this evolving financial arena.

Preface xiii

About the Authors xv

Chapter 1

Introduction 1

Part One: The Cash Market 2

Part Two: The Structured Markets 3

Part Three: The Synthetic Markets 4

Part Four: How to Trade the Leveraged Finance Market 5

Part Five: Default Correlation 6

Part One

The Cash Market 9

Chapter 2

The High-Yield Bond Market 11

The Reasons Companies Are Classified as High-Yield Issuers 11

Size and Growth of the Cash Market 13

Types of Structures 21

A Look at Ratings 22

Risk and Return for Bonds 26

What’s Priced In? 31

How About Recoveries? 35

Summary 37

Chapter 3

Leveraged Loans 39

A Tale of Two Loans 39

Introduction to Leveraged Loans 42

An Overview of Loan Terms 56

Loan Recovery Rates 65

Loan Default Rates 73

Summary 79

Part Two

Structured Market 81

Chapter 4

Collateralized Loan Obligations 83

Understanding CLOs 83

Elaborations and Details 92

Summary 104

Chapter 5

CLO Returns 105

Default and Recovery Scenarios 105

Distressed Loan Prices, Overflowing Triple-C Buckets, and CLO Returns 119

Summary 129

Chapter 6

CLO Portfolio Overlap 133

Collateral Overlap in U.S. CLOs 134

Collateral Vintage vs. Deal Vintage 142

Favorite CLO Credits 142

Single-Name Risk and Tranche Protections 146

Excess Overcollateralization and Excess Overcollateralization Delta 150

Senior and Subordinate Excess OC Deltas 151

Equity Tranches and Distressed Tranches 157

Summary 157

Part Three

Synthetic Markets 159

Chapter 7

Credit Default Swaps and the Indexes 161

What Are Credit Default Swaps? 162

Who Uses Protection, and for What? 168

Growth of the Market 168

Marking-to-Market: SDV 01 170

Credit Default Swaps Indexes 172

Contrasting the LCDX and CDX Indexes 177

Beta: A Study of Movement 178

Summary 183

Chapter 8

Index Tranches 185

Basic Mechanics of the Tranche Market 185

Loan Tranches 195

Summary 199

Part Four

How to Trade the Leveraged Finance Market 201

Chapter 9

Recessions and Returns 203

Broad Market Performance 204

Sector Performance 207

Performance by Rating 207

Summary 210

Chapter 10

Framework for the Credit Analysis of Corporate Debt 211

Approaches to Credit Analysis 211

Industry Considerations 216

Financial Analysis 220

Quantitative Models 232

Summary 233

Chapter 11

Trading the Basis 235

The Basic Basis Package 236

Constructing the Basic Package 236

Moving Away from the Basic Model 240

Adding Positive Convexity 249

Negative Convexity 254

A More Complex Basis Package 255

Hedge Ratios for CLO Hedging 259

Summary 260

Chapter 12

How Much Should You Get Paid to Take Risk? 263

Single-Name Credit Risk 263

Curve Risk 267

Basis Risk 269

Capital Structure Risk 274

Summary 281

Part Five

Default Correlation 283

Chapter 13

Default Correlation: The Basics 285

Default Correlation Defined 285

Default Probability and Default Correlation 291

Summary 309

Chapter 14

Empirical Default Correlations: Problems and Solutions 311

Empirical Results 311

Problems with Historical Default Correlations 315

Proposed Solutions 318

Summary 333

Index 335

"…a resource that will be invaluable to traditional and nontraditional investors long after the market recovers." (The Investment Professional) Stephen J. Antczak, CFA, is an Executive Director at UBS. Prior to joining UBS in 2001, he was a senior strategist at Merrill Lynch, and he has also worked at the Bureau of Labor Statistics as an economist. Antczak graduated from the University of Michigan with a BA in economics and an MBA in business economics and finance.

Douglas J. Lucas has been a Group Managing Director and Director of Ratings Research at Moody's Investor Service since November 2008. Prior to that, he was head of CDO Research at UBS. Lucas has a BA magna cum laude in economics from UCLA and an MBA with Honors from the University of Chicago.

Frank J. Fabozzi, PhD, CFA, CPA, is Professor in the Practice of Finance and Becton Fellow at Yale University's School of Management, Editor of the Journal of Portfolio Management, and Associate Editor of the Journal of Structured Finance and the Journal of Fixed Income.

The financial crisis that began in 2007 has prompted unprecedented volatility in asset valuations and left many wondering how to overcome its challenges. Given this extreme investment environment, investors need to make decisions that enable an appropriate risk/return profile, and the leveraged finance market can be a very important option in this regard. Nobody understands this area better than the author team of Stephen Antczak, Douglas Lucas, and Frank Fabozzi. And now, with Leveraged Finance, they help both experienced and aspiring market professionals gain a better understanding of today's high-yield corporate debt markets.

Leveraged Finance doesn't attempt to predict the future of markets or the ultimate outcome of this crisis. It was written to put the principles of the leveraged finance market in perspective. With this reliable resource as your guide, you'll quickly become familiar with the tools available in the leveraged finance market, how they are related to assets and investment opportunities in other markets, and how to apply these concepts in the real world.

In the past, the assets within the leveraged finance market fell into one of two categories: cash bonds or cash loans. But times have changed. With the introduction of products such as credit default swaps, synthetic indexes, and index tranches, leveraged finance investors have many tools to work with and assets to consider. This book attempts to tie the various pieces that comprise the leveraged finance market together. Its fourteen chapters are divided into five comprehensive parts:

• Part One covers the cash markets, which include high-yield bonds—also known as speculative-grade or junk bonds—and leveraged loans
• Part Two takes a look into the structured market, focusing on one type of collateralized debt obligation—collateralized loan obligations (CLOs)
• Part Three examines the relatively young synthetic markets, which include credit default swaps (CDS), traded credit indexes, and index tranches
• Part Four reviews trading strategies that investors can employ within the leveraged finance market
• Part Five addresses default correlation—the phenomenon that the likelihood of one obligor defaulting on its debt is affected by whether or not another obligor has defaulted on its debts

Those with the knowledge and skill to participate in the leveraged finance space stand to benefit from the many opportunities that the current environment is creating. Filled with in-depth insights and expert advice, Leveraged Finance will help you identify and take advantage of these opportunities.

Leveraged Finance is a comprehensive guide to the instruments and markets that finance much of corporate America. Presented in five sections, this reliable resource—which contains the in-depth insights of Stephen Antczak, Douglas Lucas, and Frank Fabozzi—covers topics ranging from the basics of bonds and loans to more advanced issues such as valuing credit default swaps, default correlations among collateralized loan obligations, and hedging strategies across corporate capital structures.

Additional topics touched upon include basic corporate credit analysis, relative value analysis, and various trading strategies used by investors, such as hedging credit risk with the equity derivatives of a different company.

Along the way, this reliable resource:

• Presents real-market examples of how you can identify investment opportunities and express your views on the market or specific companies through trading strategies
• Examines various underlying assets-loans, corporate bonds, and much more
• Offers an overview of synthetic and structured products such as CDS, LCDS, CDX, LCDX, and CLOs

Written in a straightforward and accessible style, Leveraged Finance has the information you need to succeed in today's dynamic financial arena.