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.

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