Investing in First-to-Default Baskets

by: J.C. Kommer

According to Jane Baird, “a simple form of structured credit - the first-to-default (F2D) basket - has attracted investor demand this year, while the market shuns collateralized debt obligations (CDOs) and other complex products.”

The idea of a F2D is to buy or sell credit protection on a small number of names instead of one, and a credit event will trigger a pay-out after the first default and the contract will then terminate. The premium will depend on the correlation between names, the lower it is, the higher the premium is and vice-versa with the boundaries at the sum of the premium at 0 correlation and highest single name spread at perfect correlation. So if you want to sell protection on a AAA name like Ambac (ABK) [no laughing, please], you could do a single name CDS at X bp, or put on a F2D basket with Ambac, GM (NYSE:GM), Humana (NYSE:HUM), etc. and end up with a higher premium, the difference being that you don’t know the F2D name or care.

A good book on Credit Derivatives I may have mentioned before: Credit Derivatives: Risk Management, Trading and Investing by Geoff Chaplin. An even better one, but in French: Dérivés de crédit vanille et exotiques : Produits, modèles et gestion des risques by Yann Braouezec and Jérôme Brun.

Back to Jane Baird (Reuters):

First-to-default baskets (FTDs) are old-time products that were popular in 2001 and 2002 with the growth of the credit default swaps market and before the rise of CDOs.

Investors use them as a tool to boost returns on the sale of protection in credit default swaps contracts, i.e. bets that companies are not likely to default over a set number of years.

“We put out a note on one-year first-to-default and right away got lots of enquiries. Investors liked them because they are short-dated, simple and will quickly bear fruit,” said Michael Hampden-Turner, a credit strategist at Citigroup (NYSE:C).

Bear Stearns (NYSE:BSC) credit derivatives strategist Alberto Gallo has seen significant demand for FTDs from Asian investors.

“Since everything is widening out without distinguishing between credits, this presents an opportunity for an investor who can discriminate between good and bad names,” he said.

In the typical FTD, the investor picks five investment-grade company names. He commits to cover the loss if any one of the five companies defaults on its debt, and only one. If that happens, the FTD terminates, and he no longer has exposure to the other four names.

As a general rule of thumb, the premium on a FTD is about 60 to 80 percent of the sum of the spreads of the constituent CDSs, Hampden-Turner said. So in a FTD of five names with an average spread of 100 basis points, the premium will be in the range of 300 to 400 basis points, depending on the diversity of the basket, he said.


If the five names are very similar, such as from the same country and/or the same industrial sector, the return could fall to 30 to 40 percent of the added spreads, Gallo said.

In that case, the investor takes less risk, because he is betting on only one country or industry, rather than on five unrelated countries or industries, he explained.

Gallo compared it to traversing a minefield. If the mines are bunched together along one path, they are easier to avoid.

Analysts typically compare FTDs to the equity tranches of synthetic CDOs.

CDOs are larger portfolios of credits that have been divided into tranches, or slices, with varying degrees of risk. The equity tranche is the riskiest slice, which is exposed to the first few defaults and is usually wiped out when losses reach 3 percent of the portfolio.

“The main difference is that with the FTD, you are selecting the names yourself, and it is a manageable number of names,” said Matt Leeming, a credit strategist with Barclays Capital.

The FTD is, therefore, easier to understand. The investor relies largely on traditional, bottom-up analysis of the creditworthiness of the companies involved.

Equity tranches are usually much riskier. In a CDO based on the Markit iTraxx Europe investment-grade index, for example, the tranche loses with one default out of 125 companies.

The risks also are more difficult to assess, and people invest in them based mostly on views of the economy or on trading strategies, not so much on basic credit analysis.

They pay correspondingly higher returns — more than 48 percent upfront currently for the standardized equity tranche of the five-year iTraxx.

FTDs are popular now partly because, “people are concerned about the macro environment but feel comfortable with picking some names themselves,” Hampden-Turner said.


The market risk of an FTD is that spreads on the underlying CDS will widen. While the investor who holds them to maturity ultimately is unaffected, he may have to take writedowns on the resulting declines in value in the interim.

One way to mitigate the spread risk is to pick short-term three-year or even one-year contracts, analysts said, though liquidity can be a problem for one-year deals.

As FTDs approach maturity, their values tend to rise. “The more time that goes by, the more of a cushion you get against mark-to-market volatility,” Gallo said.

The short term also is attractive because the CDS yield curve has flattened on expectations defaults will start to rise. That means returns are relatively high at the short end.

“A number of one-year deals are being marketed. Investors are comfortable with that duration,” Barclays’ Leeming said.

Bear Steans in a recent report recommended FTDs as one of several strategies suited to the credit crisis.

“With credit trading at historical highs and with extremely flat curves, investors who have strong views on single names or sectors can use short-dated first-to-default baskets to boost their returns,” wrote Gallo, Abel Elizalde and Kunal Shah.

Investors return to simple structured credit tool