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First to Default Note 101

07/08/2005

Nomura International plc answers this week's 101 on the First to Default Note 1- What is a First to Default Note (FDN)? The buyer of a First to Default Note receives a premium for taking risk on a pre-defined basket of reference credits. If any entity of this basket of reference credits suffers a credit event, the owner of the First to Default Note receives bonds of the defaulted entity in exchange for the note proceeds, and the transaction terminates. A credit event on any of the underlying reference credits will trigger a termination event. Credit events are defined by ISDA (International Swaps and Derivatives Association Inc.) and usually include bankruptcy, failure to pay and restructuring. The entire principal of a First to Default Note is at risk, and the risk is similar to being long all credits but only being exposed to loss on one. The premium on the note depends on the spread of, and default correlation between, components of the basket: When the correlation is high, assets tend to default together and basket pricing is similar to the spread of the widest (most likely to default) credit. When correlation is low, single defaults are unlikely to lead to further defaults so that basket pricing is similar to the sum of all component spreads. It is hard to measure default correlation as there is limited historical data. Market participants tend to use either a sectoral or equity price correlation as a guide. FDNs are traded as OTC contracts and can have various maturities and number of underlying credits, though a FDN with a five-year maturity and 5 credits is the most common. 2- What are the most usual situations where a FDN can be used by an institutional investor? Institutional investors can use an FDN in the following situations: In order to achieve a higher return on their investment than if they invested into a single credit. This may be especially attractive during periods when credit spreads are particularly tight overall. To increase the yield on a portfolio of bonds subject to a minimum credit rating level. To trade a particular view on correlation. As default correlation is hard to measure, an investor may have a substantially different view on the correlation value than that priced in a FDN. If an investor thinks that the implicit correlation from a FDN is too low, he will be inclined to purchase this FDN. 3- How can a FDN fit within an institutional fixed-income portfolio? Let us consider for instance an investor who can only invest into credit with a minimum rating of AA. A traditional approach to direct yield enhancement would emphasize seeking to identify relative value by purchasing undervalues AA rated assets in the primary or secondary markets to enhance portfolio performance. However, the capacity to enhance yield in this manner is limited by strong competition to identify relative value opportunities and the generally efficient structure of the markets. A FDN where the default of the note is linked to a basket of several AA credits strictly obeys the investor's investment guidelines while allowing him to achieve a significantly higher return.

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