You are on page 1of 30

CREDIT RESEARCH

U.S. Credit Alpha | 23 April 2010

U.S. CREDIT ALPHA Negative Headlines Obscure Strong Fundamentals
Overview ..................................................................................................................................... 2 US credit underperformed equities but outperformed European credit as negative headlines concerning financials and Greece counterbalanced strong earnings and generally positive economics news. Focus: Hedging FX Risk with Cross-currency Swaps ......................................................... 4 For credit investors access to markets in different geographies often allows attractive relative value opportunities, but such cross-border trades also have their own set of risk issues, especially related to hedging peripheral risks such as interest rate and FX risk. We show how cross-currency basis swaps can be used to hedge these risks and go through the mechanics of the swaps. Investment Grade: Euro Credit at All-time Wides to Dollar Credit ................................. 12 A combination of secular and cyclical trends has cheapened European credit versus US credit, while the EUR-USD cross-currency swap remains dislocated and should benefit investors swapping EUR cash flows into USD. Investors can pick-up 20bp to 77bp of yield by buying EUR-denominated bonds and switching them into dollars. High Yield: Sentenced to 144a-for-Life............................................................................... 17 144a-for-life issuance is considerably higher this year relative to the index average, and we believe this feature will remain prominent. 144a-for-life industrials have outperformed the rest of the HY industrials space by about 100bp year-to-date. Leveraged Loans: Exit Loans for CLOs ................................................................................ 20 As the calendar for bankruptcy emergences becomes more visible, we expect exit financing to be a major component of 2010 loan Issuance. On average, spread on exit loans have been more than 150bp wide of the general loan new issue, making them attractive candidates for secondary CLOs. Structured Credit and Volatility: Costless LCDX Option on Short-term Defaults........ 22 The increased ability of issuers to refinance and term out debt in the current improved macro environment has caused default expectations to dip significantly in the short term. In particular, our default outlook for the LCDX.10 index is fairly benign except for a few names in the portfolio. Therefore, we recommend that investors get long 8-12% and short 5-8% in the 3y tenor.
www.barcap.com Ashish Shah +1 212 412 7931 ashish.shah@barcap.com Jeffrey Meli +1 212 412 2127 jeff.meli@barcap.com Bradley Rogoff +1 212 412 7921 bradley.rogoff@barcap.com Michael Anderson +1 212 412 7936 michael.anderson@barcap.com Matthew Mish +1 212 412 2183 matthew.mish@barcap.com

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 27

Barclays Capital | U.S. Credit Alpha

OVERVIEW

Negative Headlines Obscure Strong Fundamentals
Ashish Shah +1 212 412 7931 ashish.shah@barcap.com

Credit underperformed equities as the CDX.IG14 index widened 2bp, to 89bp (after gapping 5bp wider last Friday), and the CDX.HY14 rose ¼ point, to $100.75, as negative headlines surrounding financials and sovereigns took a disproportionate toll on credit. However, US credit continued to outperform European credit, as the iTraxx Main and Xover indices were 6bp and 8bp weaker, respectively. Financials were front and center, with large money center banks (e.g., Citigroup, Bank of America) reporting generally solid results amid robust capital markets activity and lower loss provisions. Regional banks sounded more conservative, but affirmed similar themes about credit quality and loss provisions. However, concerns about the negative rating implications of the proposed U.S. regulatory reform legislation (i.e., without the assumption of potential extraordinary government support, certain large financial institution ratings would be two to three notches lower) moved sector spreads wider, given the potential forced selling from rating-constrained investors. Lingering anxiety about the strength and scope of the SEC’s investigation into Goldman Sachs and more litigation headlines/potential spillover effects to other banks also weighed on spreads. Greece spreads were under pressure following Moody’s downgrade to A3, on review for further downgrade (from A2 negative outlook), with Greece CDS breaching 600bp intraweek from 435bp at the start of the week. The agency cited significant risk that the debt may stabilize only at a higher and more costly level than previously estimated, a somewhat discernable shift relative to what the agency outlined as the rationale for the A2 rating back in December (i.e., the proposal/execution of its fiscal initiatives, its low liquidity risk profile, and forthcoming conditional support from the EU/IMF). While investor inquiry about potential scenarios for Greece increased notably this week, credit markets in the US and Europe proved very resilient, with the correlation between Greece CDS and CDX.IG (and iTraxx Main) continuing to decline (Figure 1).

Weekly Index Changes
Last Week Close

Figure 1: One-Month Rolling Correlations Between CDX.IG and Greece/SovX/Banks-Brokers
Thursday Close 4-week Average

100% 80% 60% 40% 20% 0% -20% Nov-09

Greece/IG Banks-Brokers/ IG

SovX/IG

Credit Index (bp) CDX.IG.14 (bp) High-Yield Index ($ price) CDX.HY.14 ($ price) Leveraged Loan Index ($ price) LCDX.14 ($ price)

128 89.0 99.24 100.75 92.18 99.75

128 87.0 99.29 100.50 92.38 100.38

132 86.1 98.40 99.63* 91.92 99.20*

Dec-09

Jan-10

Feb-10 Mar-10

Apr-10

Note: *Since Series 14 began trading. Source: Barclays Capital

Source: S&P LCD, Barclays Capital

23 April 2010

2

Barclays Capital | U.S. Credit Alpha

Very strong corporate earnings provided sizeable support for the market, with an overwhelming 83% of S&P500 companies to-date beating expectations, versus 9% missing (at this point last quarter, 80% bested estimates, 13% missed). Top-line growth is surprising to the upside, with 53% of firms reporting sales above estimates, versus 30% in line and 17% below views. The positive bias is heavily geared toward cyclicals, with consumer discretionary, financials, industrials and tech posting some of the largest revenue beat-to-miss ratios. M&A activity continues to ramp up. Sectors more ripe for consolidation, e.g., telecoms, airlines, were lively as CenturyTel bid for Qwest Corp. to gain scale and US Airways dropped talks with United Airlines as the carrier is said to favor a combination with Continental Airlines. 1 The return of animal spirits among executives was evident across earnings calls, e.g. Terex’s CEO DeFeo noted the company is definitely looking for larger transactions. This theme is also bolstering high yield firms looking to increase value via monetizing assets and/or obtaining cheaper financing; e.g., Blackstone is reported to be considering restructuring Equity Office Property’s debt, and several bidders are emerging for Extended Stay. We remain constructive on credit longer term and believe fundamentals justify notably tighter levels absent financial/sovereign concerns. In our view, financial spreads have repriced to largely reflect these risks, and the sector should outperform over the long run once we get more clarity on financial reform and ratings risk. Finally, as investment themes become increasingly global, investors have shown increasing interest in cross-border opportunities but are wary of the risks associated with buying foreign-currency denominated credit. In the second of a two-part series, we show how cross-currency swaps can be used to hedge these risks. We focus on the mechanics of the trades and explain the cause of the basis between currencies. We also explain how investors can structure trades to take advantage of relative value across currencies.

For this week’s U.S. Credit - On Deck, please click here.

1

“US Air Said to See UAL Favoring Continental Merger”, Bloomberg, dated April 22, 2010.

23 April 2010

3

73 MM. especially related to hedging peripheral risks like interest rate and FX risk. Thus.36 on day of inception Recv 3m Euribor .leeming@barcap. with maturities of up to 30 years in liquid currencies. Credit Alpha FOCUS: MANAGING FX RISK IN CORPORATE BONDS Hedging FX Risk with Cross-currency Swaps Arup Ghosh +44 (0) 20 7773 6275 arup. Recv $1 MM Optional swap of notionals at inception 2010 2011 2012 Pay $1 MM. Bond investors are not only exposed to currency risk on the fixed coupon and principal cash flows. 5 March 2010 EUR cash flows USD cash flows Notionals set at spot FX rate of 1. Floating/floating cross currency swaps (also known as cross currency basis swaps ) are the most basic currency swaps and can be combined with plain vanilla swaps (in single currencies) to create fixed/floating or fixed/fixed currency swaps.Barclays Capital | U. most market quotes are for floating/floating (basis) swaps. sometimes also at inception). In fact.73 MM Pay 3m Usdlibor flat on $ 1 MM Pay € 0. The market convention is to quote basis swaps as the spread over Libor paid/received in one currency when receiving/paying Libor flat in the other currency (the liquidity reference). Source: Barclays Capital 23 April 2010 4 . which means the market maker pays/receives Euribor -23/-19bp versus receiving/paying USD 3m Libor flat. Cross currency basis swaps As the name suggests. Crosscurrency basis swaps are a powerful tool for modifying cash flows both across currencies and between fixed and floating formats.23 bps on € 0. Recv € 0. but in case of default are also faced with quanto risk on the recovery.com Matthew Leeming +44 (0) 20 7773 9320 matthew.S. these swaps are a natural extension of the term structure of FX instruments available for hedging. but such cross-border trades also have their own set of risk issues. The notionals in the two currency legs are usually set in a ratio equal to the spot FX rate at inception.ghosh@barcap. Figure 1: Cash flows for 5y EUR-USD cross currency swap. Figure 1 shows the cash flows for a 5y swap exchanging 3m USD Libor for 3m EUR Libor. cross-currency swaps have interest rate payments in the two legs set in two different currencies.73 MM Mandatory swap of notionals at maturity 2013 2014 2015 Note: The sizes of the bars are not to scale. The quote itself was at -23/-19bp.com For credit investors access to markets in different geographies often allows attractive relative value opportunities. To eliminate FX risk on the principal amounts these swaps also incorporate an actual exchange of notionals in the different currencies (usually at maturity.

Figure 3 plots the time series of basis for swaps from three currencies to USD over the past three years. Of course spread changes can lead to either mark-to-market losses or gains for an investor depending on the direction of the initial swap. This would imply that a basis swap with notionals on the two legs set in a ratio equal to the spot FX rate should be priced fairly when both legs pay Libor flat. This would also suggest that marketquoted basis swaps somehow price in an arbitrage opportunity as one leg pays a spread above or below Libor. which can be considered as the liquidity premium charged by the market to convert cash flows between the currencies. However. There are structural reasons for the existence of the cross-currency basis. 26 February 2010 A: Cross currency basis swaps quoted vs USD Libor (flat) B: Term structure of basis swaps 50 40 X currency basis (bps) 30 20 10 0 -10 -20 -30 -40 -50 The lower the spread vs USD Libor the tighter the dollar liquidity in those markets AUD CAD GBP EUR CHF JPY 1Y 5Y 10Y X currency basis (bps) 20 10 0 -10 -20 -30 -40 EUR 3m Libor + spread vs USD 3m Libor flat GBP 3m Libor + spread vs USD 3m Libor flat GBP 3m Libor + spread vs EUR 3m Libor flat RUB 0 5 10 15 20 Term (years) 25 30 Source: Barclays Capital 23 April 2010 5 . Figure 2: Cross currency market quotes. For investors who do not have a buy-to-hold view. the apparent arbitrage vanishes provided the appropriate swap curve adjusted by the basis is used to discount the cash flows (as is convention). The net balance of demand and supply in the market for funding in one currency over the other is expressed through the quoted spread. Thus. Default concerns: Unlike most other swaps. the more expensive it is to raise funding in the currency that is quoted as the liquidity benchmark. The more negative the basis. „ Figure 2 shows the current market structure of cross-currency swaps across currencies and maturities. the mark-to-market on the cross currency swap also becomes important to consider. The direction of the basis correlates well with the flight to safer currencies that happened during the credit crunch. cross-currency basis swaps involve an exchange of principal. This.S. however. for example: „ Liquidity costs: Cross currency swaps are a powerful way for entities to raise funding in different currencies. Credit Alpha Understanding the cross-currency basis spread A floating rate note paying Libor should be priced at (or close to) par in its own currency.Barclays Capital | U. is probably a lesser concern. systemic concerns about default and counterparty risk in different currency geographies can also affect the basis.

different currencies Same currency. Source: Markit. they often charge a premium to hold bonds of foreign issuers. Barclays Capital 23 April 2010 6 . cross issuer and currency (2005-09) 100% Avg correlation of spread changes 90% 80% 70% 60% 50% 40% Same issuer. Credit Alpha Figure 3: Cross-currency basis time series. dollar and sterling markets (90 tickers. Figure 13 highlights this difference. Figure 4: Analysis of non-fin single-A credit spread behaviour in euro. as well as those raising funds in euros and dollars. ≤8y) Far (>8y) Issuers with € & £ bonds Issuers with € & $ bonds Note: Here we have defined cost of credit as spread per unit duration. The chart on the left analyses two sets of single-A issuers: those raising funds in euros and sterling. quotes versus USD 60 40 X currency basis (bps) 20 0 -20 -40 -60 -80 -100 Mar-06 CAD 5y swap GBP 5y swap EUR 5y swap Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Source: Bloomberg. The chart on the right looks at how spreads change across issuers and currencies for the same universes of bonds as before. the spreads of bonds of different issuers but in the same currency moved more closely together than the spreads of bonds of the same issuers but in different currencies. different issuers Bonds denominated in the same currency have higher spread correlation even when their isssuers are domiciled in separate currencies Relative credit cost (non local/local) 160% Univ of issuers with EUR & GBP bonds Univ of issuers with EUR & USD bonds Non-local issuers pay around 20% more credit spread than similarly rated local currency 140% 120% 100% 80% Near (≤4y) Mid (>4y. Since investors are usually most familiar with domestic issuers. Barclays Capital Cross-border relative value in bonds From a bond investors’ perspective. As is evident. which is fairly stable across currency zones and the term structure. As indicated.Barclays Capital | U.S. even when denominated in the domestic currency. entities raising funds in foreign currencies currently have to pay a credit spread premium (defined as OAS per unit of duration) of about 20%. the biggest use of cross-currency swaps is in converting cash flows of foreign currency bonds into local currencies. 927 bonds) A: Relative credit cost of non-local to local issuers (4 March 2009) B: Relative spread movement.

Spreads are calculated off 3m Libor in all cases. Credit Alpha Taken together.5 years £ Frtel 5 May 16 € Frtel 4 3/4 Feb 17 6. An investor with relevant expertise on issuers with bonds trading across different currency zones can take advantage of this kind of pricing differential using cross currency swaps. Putting the pieces together: Picking up bond spread cross currency An evaluation of the cash bond curves of France Telecom highlights the cross border trade applications of asset swaps. Figure 5: France Telecom cash curves – euro and sterling.8 yrs 8.2 yrs 6. Barclays Capital 23 April 2010 7 . Figure 6 highlights the economics of investing in the two sets of bonds marked out in Figure 5. for a par-par swap in each case. like pension funds. 9 March 2010 150 Cash spread (bps) 100 Demand from Sterling investors drives down the far end of the Sterling curve Demand from French investors supports the front and middle end of the Euro curve 0 2 4 6 8 10 12 14 Maturity (yrs) 16 50 Euro bond curve Sterling bond curve 18 20 22 24 0 Note: Spreads above are ASW over 6m Libor. Different markets often see demand for different parts of the curve. while French investors have a preference for the middle of the curve. Many sterling investors. The spreads indicated are over 3m Libor. but cross-border spreads might be more closely tied to the short-term technicals of a specific market than the long-term credit fundamentals of an individual issuer.2 yrs £122 €114 138 bp 73 bp 130 bp 73 bp Note: prices/spreads are indicative as of the date mentioned.S.9 yrs £104 €108 120 bp 71 bp 109 bp 71 bp 5 Maturity Clean price Spread over native Spread over Euro currency (including basis) 7. Barclays Capital This creates a pricing differential that can be taken advantage of using cross-currency basis swaps. Source: Markit. as indicated in Figure 5. 10 March 2010 Bond Bond maturity ~ 8 years £ Frtel 8 Dec 17 € Frtel 5 /8 May 18 Bond maturity ~ 6. prefer longerdated assets to match longer-dated liabilities.Barclays Capital | U. Figure 6: France Telecom – euro versus sterling ASW spreads. the charts indicate that not only do bonds by the same issuer often trade cheaper in foreign currencies. Source: Markit.

Source: Markit. 23 April 2010 8 . 16 April 2010). This collateral will be paid back to the buyer over the life of the trade. Also. the swap is set up so that only the coupon is swapped instead of the full yield of the underlying bond. This might be useful for investors looking to meet yield targets and are indifferent to the benchmark swap rate. Credit Alpha As indicated. the net yield on the par swap comes down to around 3. with the investor investing par or the bond price. an investor buying a sterling bond with a cross-currency swap actually picks up 40-60bp more (above swaps) than a euro bond of slightly longer maturity.39% 4. A third format – a ‘coupon swap’ – is also attractive in some cases. This still leaves a pick-up of around 30bp over the comparable euro bond. These trades can be structured in both ‘par’ or ‘market’ formats. Barclays Capital In this case by swapping cash flows from sterling to euros we believe it is possible to pick up 60-75bp more of yield compared to a euro denominated bond of similar maturity.4) points worth of collateral at trade inception. might choose to implement this view by locking in the implied forward rate through a fixed coupon bond. 2017 bond. investors with an outright view that rates will be slower to rise than the yield curve implies. in the par swap. If these collateral cash flows are included in the accounting of the trade. and compares this to the Euro 5 5 /8%. In effect. the buyer is investing £100 in the underlying credit and £24 in a swap counterparty credit. swapping between fixed coupons across currencies Coupon swaps allow the investor to swap just the fixed coupon instead of the full yield of the bond Cross-currency swaps can also be used to modify bond cash flows to pay fixed coupons in a different currency. and the effect on the net yield of these cash flows will be much smaller. In this structure. In this case.9% from 4. For example.625% €100 3.S.Barclays Capital | U. and the collateral amortises linearly). amortising to zero at maturity. In effect.39% (assuming Eonia levels stay unchanged. the buyer will have to post £24 (=€26. Coupons are paid on the redemption value. respectively (see European Credit Alpha. 10 March 2010 Bond £ Frtel 8 Dec 17 £ bond cash flows € par ASW cash flows € coupon ASW cash flows € Frtel 5 5/8 May 18 € bond cash flows €118 5. instead of investing £124 in the credit. as the swap counterparty is better quality. It is important to note that in the par (and market) format the higher counterparty exposure leads to higher collateral posting requirements where CSAs are applicable. This leads to much lower counterparty exposure between the buyer and seller and is often attractive for cash rich investors. the funding costs of this collateral will have a drag on the swapped net yields indicated above.52% 4. 2016 bond.62% £124 €111 (= £100) €136 (= £124) 8% 4. this means there is no exchange of the “100 – price” amount as in the par and market structures. Figure 7 shows the cash flows in the par and coupon formats for the France Telecom Sterling 8%.59% £100 €111 (= £100) €111 (= £100) 4.25% 7. the overall yield is reduced versus the outright bond investment. In such case.19% Dirty price Coupon Redemption Yield Note: Prices/yields are indicative as of the date mentioned. For the coupon swap. the net value of the collateral posted will be very small. A yield perspective. For cash-rich investors it might make sense to analyse the trade by including the collateral-related cash flows. Figure 7: France Telecom – euro vs sterling yields. Through the trade the buyer will earn Eonia on the amount of collateral posted at any given time.

23 April 2010 9 . 3) quanto risk on the recovery payment in case of default. with zero mark-to-market in case of a credit event. In effect. In this case. but also the probability of default of the underlying credit. Thus the spread paid on such a swap will be different from a normal swap package. and the swap component of the trade cancels. 2) both swap curves. 5) FX rate volatility. It is possible to eliminate such risk completely using swaps that extinguish in case of a credit event. the swap leg becomes a credit-linked swap and takes into account not only the direction and likelihood of rate and FX changes in the future. 2) mark-to-market on the swap in case of default. as well as 6) correlations between the two interest rate curves. even that arising in case of a default of the underlying bond When using cross-currency swaps to invest in non-local currency bonds. These are called clean asset swaps. FX rates and the default risk of the underlying. 4) correlation between rates in the two currencies.S. It will typically depend on the following factors among others: 1) the credit quality of the underlying name. Credit Alpha Clean asset swaps for cross-currency trades Clean asset swaps are suitable for investors looking to eliminate all interest rate and FX exposure.Barclays Capital | U. and also pays the investor recovery in the swapped currency as a percentage of notional. the investor is left with three risks: 1) credit risk on the underlying. 3) interest rate volatility in both currencies. the seller of the swap absorbs the potential mark-to-market in case of default of the underlying.

The PV of the foreign leg is converted using the spot FX rate. format of coupon M (fixed/floating) 100 Bond cash flows after coupon swap This swap is when the buyer wants exposure to the bond in a different currency or coupon format from the original bond. 100 C M P M P C P P = bond dirty price C = bond coupon (fixed/floating) 100 = bond face value P Buyer can choose both: 1. A 100 A 100 C Buyer can choose both: 1. Figure 8: Cash flows for different asset swap formats Bond cash flows in native currency Bond cash flows after par swap Swap cash flows Swap is designed to have PV = 100-P. The PV of the foreign leg is converted using the spot FX rate. the discounting of future cash flows is done off swap curves that incorporate the full term structure of the cross-currency basis. format of coupon A (fixed/floating) 100-P 100 100 Bond cash flows after market swap Swap cash flows Swap is designed to have PV = 0. and fixed to floating. Figure 8 presents the cash flows of different asset swap formats. when cash flows of both legs are discounted off the respective swap curves including the basis. 23 April 2010 10 . currency of final cash flows 2. 100 Cu C Buyer can choose both: 1. but in a non par or price structure 100 Cu Swap cash flows Swap is designed to have PV = 0.S. single and double currency. The PV of the foreign leg is converted using the spot FX rate. when cash flows of both legs are discounted off the respective swap curves including the basis. with one crucial difference. currency of final cash flows 2.Barclays Capital | U. format of coupon Cu (fixed/floating) 100 P Source: Barclays Capital Bond investors can use the Bloomberg ASW function to price fixed – floating cross currency swaps as indicated in Figure 9. Credit Alpha Appendix: Pricing cross currency swaps Cross-currency swaps are priced exactly the same way as vanilla single-currency swaps. when cash flows of both legs are discounted off the respective swap curves including the basis. currency of final cash flows 2.

100) Source: Bloomberg. 2017 Match fixed leg characteristics to bond (maturity. For these reasons. Credit Alpha Figure 9: Using ASW to price cross currency swaps on £ France Telecom 8. namely: 1) it uses single points on the basis curve. which is what the market uses to price and quote. Barclays Capital This function is straightforward to use.Barclays Capital | U. swapped spreads across currencies Change reporting currency to get swapped spread in that currency Cross currency basis Source: Bloomberg. coupon etc. 2017 A: Swapping currencies on ASW B: ASW page 2.) ASW spread in specified currency Coupon frequency Solve for "Spread" on floating leg. and an easy way to look up cross currency spreads. instead of the full curve to price the swapped spread.S. It does however suffer from a few drawbacks. and 2) it is not easy to change the benchmark rate to 3m Libor. In this case the calculation of the currency swapped spread takes into account the term structure of both swap curves as well as the full basis swap curve. Barclays Capital SWPM can also be used in a similar fashion to calculate the fixed coupon on a par-par swap in any currency. Figure 10 Using SWPM to price cross currency swaps on £ France Telecom 8. such that market value of the swap = (Clean price . we recommend using the SWPM function to arrive at a more representative spread for a cross-currency swap. 23 April 2010 Net swapped spread in different currencies 11 . Figure 10 shows how a fixed-float swap can be set up in SWPM to solve for asset swap spreads in different currencies.

CROSS CURRENCY TRADE IDEAS Euro Credit at All-time Wides to Dollar Credit US Jeffrey Meli +1 212 412 2127 jeff. Even when we control for differences in composition by selecting a basket of issuers with bonds in both currencies at the same maturity.com Matthew Leeming +44 (0) 20 7773 9320 matthew. Credit Alpha INVESTMENT GRADE: GLOBAL CREDIT . the spread pick-up for swapping USD for EUR cashflows by entering a currency basis swap. which (at the 5y tenor) reached extreme levels near -50bp at the height of the crisis. This is evident from the spread history of USD and euro bond or CDS indices.gennis@barcap.meli@barcap.com A combination of secular and cyclical trends has cheapened European credit versus US credit.com Aziz Sunderji +44 (0) 20 7773 7881 aziz. aside from relative value between USD and EUR bonds.sunderji@barcap. and SLMA (bonds issued at least 5y ago in both currencies).ghosh@barcap. VOD. as discussed in our focus article this week (Managing FX risk in corporate bonds).leeming@barcap. EUR credit stands at all-time cheap levels versus USD credit bp 60 40 20 0 -20 -40 -60 -80 -100 -120 2005 2006 2007 2008 2009 4-6y bonds of a selected baset of names in dollars 4-6y bonds of the same basket in Euros Note: Basket based on DT. has failed to normalize and still stands at close to -25bp.com Alex Gennis +1 212 412 1370 alex. the EUR-USD cross-currency swap remains dislocated and benefits investors swapping EUR cash flows into USD. We screen for attractive switch opportunities from USD to EUR-denominated bonds issued by the same company with similar maturities. GS. Figure 1: The differential in spreads between USD bonds and EUR bonds – even when matched by issuer and maturity – has collapsed OAS (bp) 700 600 500 400 300 200 100 0 2005 2006 2007 2008 2009 Figure 2: When the dramatic moves in the USD/EUR currency swap basis are added. Barclays Capital 23 April 2010 12 . Source: Barclays Capital spread pickup for switching from USD to EUR spread pickup after swapping Source: Bloomberg. and today the differential between USD and EUR bonds stands at only 10bp. US-based investors can pick-up 20bp to 77bp yield by buying EURdenominated bonds and switching their cashflows into dollars. At the same time. the effect remains. According to our metric. TELEFO. At the same time. PG. investors continue to get paid for swapping euro cashflows into dollars. MCD.com Europe Arup Ghosh +44 (0) 20 7773 6275 arup. although compositional differences between the two domiciles account for some of the historical relationship. TITIM. USD bonds traded 30-50bp cheap (50-100% of the average EUR spread) before the credit crunch and 50-100bp cheap (30-50% of the average EUR spread) throughout the volatility of 2007 and 2008 (Figure 1).S. This discount collapsed during 2009. or 7% of the average spread level. USD-denominated bonds have traded cheap to EUR-denominated bonds. In other words.Barclays Capital | U. GE. MS. EUR credit is cheap to USD credit for the first time Historically.

Thirdly. the message is clear: EUR-denominated bonds are at all-time cheap levels. euro-denominated corporate bonds have traded rich to USD bonds. In the US. with a large portion of Yankees coming from euro issuers. European assets as a whole have been tainted by sovereign risk. The issuer angle The robust pace of Yankee issuance in the US market over the past several months provides further evidence of the dislocations in the relationship between USD and EUR credit markets. due to the constraints on bank balance sheets and risk tolerance. European corporates have traditionally relied on bank loans rather than public bonds for funding. Yankee issuance has accounted for over half of all investment-grade. A reversal of these same dynamic has caused euros to cheapen We believe a number of factors have caused the USD discount to shrink. Credit Alpha For US investors. Investors need not take exposure to euros in order to benefit from the spread pick-up offered by EUR-denominated bonds – they can enter into a cross-currency basis swap to convert their EUR-denominated coupon payments into USD cashflows. In particular. the spread pick-up for switching from USD to EUR bonds can be substantial. reducing the structural supply/demand imbalance. this results in even further spread pick-up (please see this week’s Focus for details on the cross-currency basis swap).S. Why was USD credit cheap and what has changed? Structural factors explained the relatively tight spreads on EURdenominated bonds Historically. 23 April 2010 13 . leading to a dearth of liquid bonds and a strong bid for the relatively few benchmark issues. One factor behind the increased euro-denominated issuance has been the shift from loan to bond financing for European corporates.Barclays Capital | U. Firstly. the euro bond market has exploded in terms of issuance. when the benefit of the currency swap is added. The same calculation that indicates EUR bonds are cheap relative to USD bonds from an investor’s perspective leads issuers to prefer tapping the US primary market. underpinning tighter spreads. as well as in the cross-currency swap market. fixed rate issuance in the USD market YTD 2010. Although European investors will not benefit from the currency basis swap. Given the current cheapness of converting from EUR to USD. Retail participation in credit markets has also been stronger in Europe: large domestic savings bases in Germany and France are channelled via savings banks into primary and secondary credit markets. outright cheap levels for EUR-denominated debt make this an opportune moment to repatriate USD investments into EUR credit. the validity of this last reason as one to shun EUR-based credit is weak. most of which are simply reversals of the same dynamic that caused USD to be cheap for so long. This has partly been a function of the structure of the two markets. Indiscriminate selling of EUR-based assets has cheapened them to USD assets — even compared with bonds issued by the same companies (see US Alpha 26 March 2010. on Yankee Utes). domestic savings rates are lower and retail investors have historically favoured equities. Secondly. Importantly. the retail bid for credit has been very strong in the US (fund flows attest that the wall of cash in money market funds went straight into IG credit. skipping US equities entirely).

75 USD 5. causing MTM losses.25 USD 5.625 USD 5.73 100. and all bond prices include bid-offer costs. The investor not only picks up spread by moving into a cheaper bond.65 EUR 4. many of the drivers of the divergence between the US and European credit markets are long-term in nature and could dislocate further before reverting.S.125 EUR 5.855 Maturity 04/2012 03/2012 01/2013 01/2013 12/2017 05/2018 03/2016 07/2016 06/2013 06/2013 03/2015 02/2013 Price* 105. Source: Bloomberg.25 USD 6. In addition. movements in the crosscurrency swap will affect the MTM of the trades we recommend. In all cases the asset swapped spread has been calculated off the 3 month Libor curve. Figure 5: Cross currency switches (Yankee) Ticker BHP BRITEL GSK LGFP MTNA TELEFO Description EUR 4.76 115.24 99.406 USD 5.Barclays Capital | U.26 ASW spd in local curr. there is a risk that the swap becomes more negative.52 109.91 115. Credit Alpha Figure 3: The surge in European issuance has diminished the structural supply/demand imbalance €bn non financial issuance 350 300 Figure 4: US mutual fund flows have been out of money markets and into USD corporate credit 300 250 200 USD Billions 150 100 50 0 -50 -100 2001 2002 2003 2004 2005 2006 2007 2008 2009 250 200 150 100 50 0 1994 Source: Dealogic 1997 2000 2003 2006 2009 Fund flows to USD high grade bonds Source: Lipper Fund flows to equities Risks The obvious risks regarding credit deterioration and interest rate volatility that apply to a USD issue also apply to EUR issues swapped into USD.31 106.15 EUR 5. Trade recommendations Figure 5 and Figure 6 list our most attractive switches for European and US names.375 EUR 3.01 106. All comparisons are done from the perspective of a dollar investor. Barclays Capital 23 April 2010 14 . and the euro bonds are currency swapped into dollars.25 USD 5.69 107. Although (as discussed in the Focus article this week) the swap remains dislocated versus pre-crisis levels.03 105.5 EUR 8. Prices and spreads as of 22 April 2010.66 114.48 109. In addition. in all cases switching from a US denominated issue to a comparable euro one. 52 29 146 132 59 23 188 174 151 132 111 80 ASW spd in USD after basis swap 78 29 171 132 78 23 208 174 176 132 130 80 50 44 34 55 39 Spread pick-up 49 Note: *Accounting for bid/offer. but also picks up the basis on the cross-currency swap. which is in their favour.

75 USD 5.9 115.0 105. 92 44 92 65 88 68 169 152 91 76 83 69 86 78 35 26 62 70 ASW spd in USD after basis swap 121 44 124 65 118 68 200 152 119 76 111 69 116 78 63 26 90 70 20 37 38 43 43 48 49 59 Spread pick-up 77 Note: *Accounting for bid/offer.9 102.75 EUR 6.3 108.95 EUR 7.4 102.8 106.95 EUR 5. Credit Alpha Figure 6: Cross currency switches (US issuers) Ticker DE ABIBB VZW FO GE JPM WFC PG PM Bond EUR 7.6 114.55 EUR 4 USD 6.375 EUR 4.5 USD 4.875 Maturity 01/2014 04/2014 01/2013 03/2013 12/2015 02/2014 01/2013 06/2014 02/2014 11/2014 04/2014 06/2014 05/2013 01/2013 05/2014 08/2014 09/2015 03/2014 Price* 117.6 109.5 USD 6.1 110.1 109.5 113.5 EUR 8.1 116.65 EUR 6 USD 4.375 USD 2.875 USD 6.3 100.1 112.S.6 110.4 129.25 USD 3.125 USD 4.Barclays Capital | U. Prices and spreads as of 22 April 2010.5 105. Source: Barclays Capital 23 April 2010 15 .375 EUR 4.0 ASW spd in local curr.

$9. bp) VIX (RHS.IG on March 20.0 Mkt (LHS.Barclays Capital | U. 3% CDX.5.4 in January 2010. bp) bp 0 -50 -100 -150 -200 -250 -300 -350 -400 310 270 230 190 150 110 70 30 Jun-08 90 80 70 60 50 40 30 20 10 0 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 CDX. 25% bp 15 10 5 0 -5 -10 -15 -20 -25 -30 -35 -40 Nov-08 Mar-09 5s10s (LHS) Jul-09 Nov-09 Mar-10 5s7s (RHS) 30 20 10 0 -10 NonCorp. Source: Markit.IG Curve bp Industrial. bp) Basis (RHS. Source: Barclays Capital CDX. Source: Barclays Capital 23 April 2010 16 . however. $119. Source: Barclays Capital Note: A portion of the significant steepening in CDX. Barclays Capital Note: Basis defined as CDX. $79. Moody’s downgraded only three companies and upgraded seven companies in January 2010.IG spread – corporate Libor OAS. $15.1.IG Mkt versus Intrinsic bp 130 120 110 100 90 80 70 Aug-09 Par Downgrade/Upgrade Ratio DG/UG Ratio Moody's S&P CDX IG12 Mkt CDX IG12 Intr CDX IG13 Mkt CDX IG13 Intr 30 25 20 15 10 5 0 Oct-09 Dec-09 Feb-10 Apr-10 A S O N D J F M A M J J A S O N D J F M Source: Barclays Capital Note: S&P had a par downgrade/upgrade ratio of 91. $96. Source: Barclays Capital CDX. 2009. %) Note: A portion of the significant tightening in CDX.7. Guaranteed. Credit Alpha YTD2010 Fixed IG Supply ($bn) Govt. is attributable to the roll from Series 11 to Series 12.IG 5.IG curve levels on March 20. 37% Note: All levels on this page as of Thursday close. 2009. 5% -20 -30 -40 -50 -60 Jul-08 Finance.6.S. 30% Utility.4.. Moody’s ratio was 0. is attributable to the roll from Series 11 to Series 12.IG versus VIX Basis bp 620 540 460 380 300 220 140 60 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 Credit OAS (LHS.1.

with $6.1bn. despite increased volatility induced by SEC charges of Goldman Sachs and renewed fears around Greece.kakodkar@barcap.75 76. Standard Pacific was also weaker. though there are some signs of better-than-expected top-line growth as well.00 499 5.75. Credit Alpha HIGH YIELD Sentenced to 144a-for-Life Bradley Rogoff. the index-eligible total of $16.0 Worst AIG 8.60 506 5.0 pts Chg -7. thus far. the positive surprises remain costdriven.125 '46 VRS 11. QUS represents 23bp with $7.5 pts 471 bp Chg +34 bp +1. Hanesbrands also reported a significant 1Q10 beat.5 '32 High Yield CDS Best RDN QUS_CAP HOV 5y 5. Freescale’s 1Q10 numbers were in line with the company’s pre-announcement.7 '14 Px 93.05 lower through Thursday.65 '18 SAPSJ 7. However. United Rentals was a beat on EBITDA as used equipment margins improved.5 pts +28 bp Px 85.26 7.0 pts 186 bp 8.9 -3.com Eric Gross +1 212 412 7997 eric. and Westcorp beat despite lower revenues. with the spread between HY14 and iTraxx XO compressing 53bp since the roll.8bn cash balance and $500mn revolver to grow its machinery and industrial products businesses via acquisitions. For most. derivatives outperformed cash.375 '16 SFI 5. CTL represents 21bp of the U. Currently. and Complete Production was also ahead of consensus on sales and EBITDA. although the latter reduced guidance for the year. On Monday.60 8. all three have either put CenturyTel (Baa3/BBB-/BBB-) on watch negative or negative outlook.80 614 6. reporting its first quarterly loss in a few quarters despite no charges or impairments.00 9.4bn. Cash was $0.00 Chg +6. The combined company will have annual revenues of nearly $20bn.22% 144a for Life 213 97 102. Rexnord reported preliminary revenues and EBITDA well ahead of expectations. High Yield Index. ending at $99.0 Figure 2: HY Industrials Index Statistics SEC Registered # of Issues Par ($bn) Price Coupon (%) Yield to Worst (%) OAS (bp) YTD Total Return 999 458 100. On the services front.8bn in debt to be assumed by CenturyTel.2bn would represent 52bp by market Figure 1: Cash and CDS Movers High Yield Cash Best RDN 5.67% Source: Barclays Capital Source: Barclays Capital 23 April 2010 17 .13 92. driven by a combination volumes growth and improved operating margins. Meanwhile.rogoff@barcap. Should QUS move to IG. and the outlook is for solid. including $11. the positive reports outnumber the negative.94 77.3bn in index-eligible par outstanding.com Michael Anderson. The CDX index has also been outperforming Europe. or 43bp by market value. broad-based end-demand growth.Barclays Capital | U. with HY14 advancing $0. all three major ratings agencies have put Qwest (Ba3/BB/BB+) on watch positive. On the M&A front. CenturyTel (CTL) has agreed to acquire Qwest Communications (QUS).com Gautam Kakodkar +1 212 412 7937 gautam.S. and has another $3.com High yield was mostly unchanged through Thursday.2 +6.50 55. Terex earnings were disappointing.5bn in the U.60 8.5 +6.anderson@barcap.24.S. Community Health was in line for the quarter.20 8. as was Massey Energy.S.5 -3. likewise. CFA +1 212 412 7936 michael. High yield companies are beginning to report first quarter earnings and.6bn all-stock deal values Qwest at about $22. though the company is looking to make use of its $1.5 pts -100 bp -4. Credit Index by market value.59% 144a with Reg Rights 185 91 104. Nevertheless.25 to $100.3 pts Worst AKS AMR TSO 5y 433 bp 19. CFA +1 212 412 7921 bradley.gross@barcap.375 '15 MBI 4.50 Chg -3. The $10.00 9.

Not all 144a-for-life deals are created equally. 144a-for-life industrials have outperformed the rest of high yield industrials by roughly 100bp (6. Although 144a's for life have roughly the same duration and issue size (~$450mn) as registered bonds. 144a-for-life issuance has comprised 22% of the calendar since the beginning of March.40 higher on average (Figure 2). Credit Alpha value. they yield 120bp more. In that case.14% of the HY index by market value. the combined entity would have $17.2bn in index-eligible debt. Nonetheless. as The Geo Group agreed to acquire Cornell Companies in an all-stock transaction valued at $685mn including the assumption of Cornell debt. their larger coupon leads them to be priced $1.67% for 144a's with no registration rights versus 5. The feature will likely remain prominent.7% weighting on February 26. it appears more likely that CenturyTel slips to HY. The services sector also experienced some M&A activity. This represents a considerable increase over the High Yield Index's 13. 23 April 2010 18 .Barclays Capital | U. In another sign of the loosening of the credit markets. since the beginning of the year. which include many small private issuers. Not surprisingly. even when the strength of the primary market fades because of the necessary refinancing of upcoming loan maturities. given these ratings actions. However.70% for the High Yield Industrial Index). and would unseat Sprint as the fifthlargest issuer by par. however.S. representing 2. as some are issued by public companies (US and non-US issuers).

S.3 27.0 32.9 2.6) (10.3 2.1 Net 28.8 252.7 25.6 32.2) 17.1 57.$86.Price Feb-09 May-09 Aug-09 Nov-09 Feb-10 Source: Trace. Barclays Capital Source: Barclays Capital On-the-Run HYCDX Spread Distribution 40 35 30 25 20 15 10 5 0 200-400 400-600 600-800 800-1000 <200 >1000 % Last Month Current High Yield Index Price Distribution by Par 55 50 45 40 35 30 25 20 15 10 5 0 % Last Month Current < 40 40-50 50-60 60-70 70-80 80-90 90-100 100-110 110-120 Source: Barclays Capital Source: Barclays Capital 23 April 2010 >= 120 19 .3 36.3 77.1 2.8 30.1 2.6 91.7 239.7 (150.S.8 83.2 2.8 (40.5bn Source: Barclays Capital Financial Limited Brands MBIA Inc Weyerhaeuser Temple-Inland Source: DTCC High Yield Average Institutional Trade Volume 10 9 8 7 6 5 4 3 2 1 0 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 $bn Daily Volume Rolling 1-Week Average OTR HYCDX versus U.9 2.1) (71.0 Change – Week Ending 4/16/10 ($mn) Gross 329. Credit Alpha High Yield 2010—Supply by Sector Others Media Top On-the-Run CDX Index Names by Net CDS Outstanding Notional Outstanding ($bn) Gross Radian Group 43.1 2.2 2.Barclays Capital | U.5 38.7 67.2 ILFC Net 3.8 221.4 134.0 18.1 2. High Yield Index 110 $ US HY .2 23.4) (7.Price 100 90 80 70 60 50 Nov-08 HYCDX .5 37.6) Nat Res Consumer Industrial Chemicals GMAC Sprint Nextel Macy's Lennar Healthcare Technology Telecom YTD .6 536.3 169.

WR Grace. spreads on exit loans have been more than 150bp wide of the general loan new issue market (Figure 2). we are beginning to see some green shoots.65bn The company expects to fund the acquisition with new bonds. 2. CFA +1 212 412 7936 michael. While the $19bn current forward calendar does not reflect the potential exit pipeline. Reynolds Group is in the market seeking an amendment to allow for the issuance of a $750mn add-on term loan. In exchange.com Eric Gross +1 212 412 7997 eric. Visteon. We have seen a number of large issuers emerge in the past few months.com Michael Anderson. Tronox. the company paid a fee of 295bp and the coupon was increased from L+225bp to L+525bp. a $1.5GW) from Pepco Holdings for $1. we expect exit financing will be a major component of 2010 loan issuance.102. and Young Broadcasting. Fairpoint. Covenant amendments and maturity extensions continue to flow. Credit Alpha LEVERAGED LOANS Exit Loans for CLOs Bradley Rogoff. ILFC amended two of its revolvers (totaling $4. Tribune.anderson@barcap.gross@barcap. The revolver was also downsized from $77mn to $52mn.5% Libor floor and 103. making them attractive candidates for secondary CLOs. Idearc. CFA +1 212 412 7921 bradley.5bn) to allow for the extension of their maturities. Source: Barclays Capital. we have seen shorter re-investment periods in the small sample of new deals. 101 call premiums.com As the calendar for bankruptcy emergences becomes more visible. Smurfit Stone. The $400mn first-lien has a L+400bp coupon. with the balance being termed out. S&P LCD Institutional Note: Institutional plus pro-rata volume.S. and cash on hand. RH Donnelley and Charter. to make the senior tranche more attractive to investors. Figure 1: Exit Financing Volume 20 ($bn) Figure 2: Exit Financing Spreads 1. The loan.rogoff@barcap. Lyondell. On average. Calpine’s exit term loan softened 1pt after the company announced that it was acquiring the Conectiv fleet (4. will finance the acquisition of Evergreen Packaging. we expect the 2010 calendar could include Hawaiian Telcom. Also. with Apollo testing the waters with a new $300mn vehicle with arranger Citibank.3bn 7y term loan. On the M&A front. The purchase gives Calpine access to the eastern Pennsylvania/Jersey/Maryland market. AbitibiBowater.kakodkar@barcap.com Gautam Kakodkar +1 212 412 7937 gautam. including Lear.Barclays Capital | U. together with a $1bn bond offering. S&P LCD 23 April 2010 20 . 2% Libor floor and a 101 soft call premium. Meanwhile. This week Six Flags’ $770mn first.and second. while the $250mn second-lien has a L+725 coupon.lien loans allocated and traded well in the secondary market. On the primary CLO front. HIT Entertainment completed a credit facility amendment allowing for the total leverage covenant to be replaced by a new first-lien leverage covenant. Interestingly. Chemtura. the one attractive area in which it did not have a foothold.000 (bp) 15 10 800 600 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 400 200 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Deal Size New Money Pro Rata Source: Barclays Capital.

Source: Barclays Capital Source: Barclays Capital OTR LCDX versus Loan Index Price History 110 100 90 80 70 $ HY Loans Index LCDX Loan Index Price Distribution by Par 50 40 30 20 10 % Current Last Month 60 0 60-70 70-80 80-85 85-90 90-95 <60 95-100 50 Jul-08 Nov-08 Feb-09 Jun-09 Sep-09 Jan-10 >100 21 Source: Barclays Capital Source: Barclays Capital 23 April 2010 . of Deals 49 44 126 Amt ($mn) 23.190 48.400 1.S.600 1.Barclays Capital | U.000 800 600 400 200 0 Jun-08 Oct-08 Feb-09 Jun-09 Nov-09 Mar-10 OTR HYCDX versus LCDX 110 $ 105 100 95 90 85 80 75 70 65 60 Oct-08 Jan-09 May-09 Aug-09 Dec-09 Mar-10 HYCDX LCDX Note: Current market assumes 55% recovery on LCDX. Barclays Capital Source: DTCC OTR LCDX Historical On-the-Run Spreads 1.050 19.800 bp 1. Credit Alpha Institutional New Issue Volume No.200 1.890 LCDX Weekly New Contract Volume (4w Average) 12 $bn 10 8 6 4 2 0 17-Apr 12-Jun Leveraged Loan Trailing 1m Launches Forward Calendar Year-to-Date 7-Aug 2-Oct 27-Nov 22-Jan 19-Mar Source: S&P LCD and S&P/LSTA Leveraged Loan Index.

25pts (3y LCDX. our default outlook for the LCDX. Credit Alpha STRUCTURED CREDIT & VOLATILITY Costless LCDX Option on Short-term Defaults Batur Bicer +1 212 412 3697 batur. In other words.5% 3. At the trade’s inception.10 5-8% tranche by selling $10mn at 62pts.com The increased ability of issuers to refinance and term out debt in the current improved macro environment has caused default expectations to dip significantly in the short term.10 Source: Barclays Capital 23 April 2010 22 . The 5-8% and 8-12% tranches are currently 0. They would receive $0. 2011.13mn upfront for selling the $10mn 5-8% tranche.25pts and enhance the P&L profile of the tranche by shorting the 3y LCDX.4mn 8-12% at 96.2983. This includes 16 defaults and 5 cancellations. The trade starts losing money only if more than 2.0% 0.bicer@barcap.13% and 1. The LCDX.20% tranches of the current 79-name LCDX. investors would pay $1. In particular.00-1.43mn upfront and $0.5% 1.13-6.10 index avoids any defaults in the next 14 months. We choose the notionals of both legs of the trade such that the net PV of all the cash flows to maturity would be zero. Both tranches have 14 months to maturity on June 20. 2011.4mn 8-12% tranche.10) We recommend that investors get long the 3y LCDX.10 index is fairly benign except for a few names in the portfolio.5% Net 8-12% 5-8% Cumulative Losses in LCDX. Therefore. Figure 1 shows the trade’s potential P&L profile under various loss scenarios for the LCDX.4mn at 96.0% 1.10 tranches offer attractive P&L profiles.45% losses occur. Buy $11. Except for the equity tranche. we think that all have enough cushion against a few surprise defaults until the maturity date. The annual payment is based on the full notional of the tranche but could decrease if the tranche has a principal loss due to defaults. Investors would neither make nor lose money if no defaults occur in the portfolio. The 5-8% tranche trades in all-upfront form.10 8-12% tranche by buying $11.57mn annually for buying the $11.10 index has experienced 21 credit events to date.0% 2. the trade is constructed to be costless to investors if the LCDX.Barclays Capital | U. The 5-8% tranche currently has a factor of 0. The 8-12% tranche trades in upfront plus 500bp annual running coupon.10 index by June 20. Assuming a Figure 1: Performance of the Recommended Trade PV of Cash Flows ($mn) 3 2 1 0 -1 -2 -3 -4 -5 0. Sell $10mn 5-8% at 62pts. we believe short-dated junior LCDX.5% 2.10 portfolio.S.0% 3.

which generated a w/w delta-hedged P&L of 1. respectively. During the past week in IG index options. this means that more than 5 names need to default in the next 14 months for the trade to lose money. Market Recap: Synthetic Tranches and Credit Options The IG. which is in line with the average recovery rate of 55.6%.6% from 6. The HY. to 13. to 52.3%.9%.25pts in the 5y tenor. to 39.1% by the maturity date.9 ref levels remained unchanged in 5y and increased 2bp and 4bp in 7y and 10y tenors. 3m implied volatility increased 2. The risk premium. which we define as the basis between the implied and realized volatility levels.3%.5pts m/m. this is unlikely.S.Barclays Capital | U. The absolute tranche price increased 19. The term structure of implied volatility flattened significantly.10 ref levels remained unchanged in 3y and decreased 0. The implied volatility basis between 115% and 85% normalized strikes (assuming that the ATM strike is 100%) increase to 2. The significant outperformance of the short-dated 3y 10-15% equity tranche continued this week as the tranche rallied 3.10 index ref levels remained unchanged in 3y and decreased 0.5pts in 5y and 7y tenors. Maximum potential upside is almost $3mn (more than four times the upfront amount of $0.6% from 2. The delta-adjusted changes in tranches were muted compared with previous weeks. The biggest mover of the week was the 10y 7-10% tranche with a w/w delta-hedged P&L of 1.6% for the previously defaulted 16 names in the portfolio.8%. The LCDX.70mn paid by investors) if cumulative losses reach 1. with the 3m-1m implied volatility basis decreasing to 2. Credit Alpha 60% recovery rate.2% w/w on both an absolute and delta-adjusted basis.2%. In our view.0%.5%. The delta-adjusted changes in tranches were muted across the capital structure except the 5y 15-100% tranche. This corresponds to the best-case scenario in which the 5-8% tranche is totally wiped out while losses do not cause principal loss to the 8-12% tranche. increased 3. while 3m realized volatility declined 1.0%. The implied volatility skew steepened slightly.3%. 23 April 2010 23 .

and European CLOs < -5% -5% to -2.S.63 27.S.23 2.83% 2.5% to 0% 0% to 2. CLO Spread Performance by Rating (bp) 2250 2000 1750 1500 1250 1000 750 500 250 0 Feb-03 May-04 Aug-05 Nov-06 Feb-08 May-09 AAA AA A BBB Cash Amount for U.5% 2.S.5% 12.5% 2.5% to 10% 10% to 12.5% to 5% > 5% 0% 10% 20% 30% 40% 50% U. CLOs 0% to 2.5% to 15% 15% to 17.26 80.82% 0.S.5% to 5% 5% to 7. 2010 and based on a sample set of 200 U.58% 0.S.81 2.16 1.50 2. and European CLOs in Our Sample Reinvestment Period In U.5% 17.S. CLOs -2 to -1 -1 to 0 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 5 to 6 0% 5% 10% 15% 20% 25% 30% 35% 40% CLO Arbitrage (Assets minus Liabilities) 16% 14% 12% 10% 8% 6% 4% 2% 0% Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Percent of Deals Par minus Liability Value as Percent of Par U.S. Credit Alpha Junior OC Test Cushions for U.05 3. Cash ($bn) Total Par ($bn) Cash Percent Europe Cash (€bn) Total Par (€bn) Cash Percent 0. Source for all figures: Barclays Capital 23 April 2010 24 . and 80 European CLO deals in our universe.5% to 20% > 20% 0% 5% 10% 15% 20% 25% 30% 35% Percent of Deals Percent of Deals Weighted Average Life (WAL) Test Cushion for U.S.5% -2.97 2.35% 0.82% Post Total Note: All figures are as of March 31.73 2.5% 7. Europe CCC Bucket Size for U.Barclays Capital | U.58 24.10 3.S.36 83.27% 2.

4% -0.5 3.5 25 .5 93.9 15-100% 105.5 15.5% -0.63 0.33 -2.25 0.50 1.8 15-25% 102.38 0.5 Index 123 0-3% 66.13 -0.14 Ref = 89.1% -0.1% 2 -0.8 7-10% -8.25 0.10 3.13 0.5 -8 3.00 7.375 1.2 15-30% -1.5 4. Credit Alpha Weekly Delta Level Adjusted Change Return 0 -0.625 2.5 0.06 0.00 -0.88 1 0.50 1.9 30-100% -3.3 25-35% 90.0% 1.IG.125 7.8 Index 102 0-5% 5-8% 62.25 -0.10 Note: W/w changes constitute the difference in market closing levels between April 15 and April 22.0 7-10% -7.53 -0.625 1.50 2.97 -1.625 5.25 -1.75 -1.2% -0.75 6.14 Ref =89.1% -0.8% 2.5 80.4 Index 102.75 26.375 64.3 15-100% 110.1% -0.625 0.38 -0.2% -0.375 5.875 2.5% -0.3 15-25% 79.8% 0.05 0.63 8.4% 52% 51% 50% 49% 80% 90% 100% 110% Normalized Strikes 120% 22-Apr 15-Apr 25-Mar 5y LCDX.5 60 2.3% -0.25 2.1 Index 105 0-10% 10-15% 34 34.2% 0.50 -0.75 Strike 70 80 90 90 100 110 120 3.3% 55% 54% 53% 0.25 11.5 0.9% 0.375 8.50 2.7% Tranche Bid Offer Delta 3m ATM On-the-run IG Realized vs Implied Volatility 130% 110% 90% 70% 50% 30% 10% Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Realized Volatility Implied Volatility Index 89 0-3% 37.8 Strike Type Price Imp Vol 80 REC 10 48.10 0.2 10-15% 5.0% 0.75 1.3 25-35% 101.625 -0.06 0.875 67.0% -0.3% 1.38 -0.5% -0.25 3.25 105.8% 95 PAY 30 52.9% 52.50 2.13 6.25 0.8 12-15% 92.25 0-5% 5-8% 25.00 0 -0.8% -0.19 0.28 -0.38 0.9% 85 REC 18 50. Calculations ignore carry and defaults.0% 0 3.25 11.25 4.13 0.13 0.5 Swaption Jun-10 IG.2% -4 -7.5 25-35% 105.14 -3.5 4.13 2.38 0.10 Normalized Volatility Skew of 3m On-the-run IG Options -0.5 4.2% 0.5% -8.1% 0.6 Index 104.19 0.2% 0.1% 0.4% 0.88 1.0 12-15% 103.04 0. M/m changes constitute the difference in levels between March 25.9 35-100% 112.77 0.HY.8% 90 PAY 40 51.3% 10y CDX.75 -0.9% 51.64 1.16 -3. and April 22.625 3.2% -0.375 2.2 3-7% 1.0% Monthly Delta Level Adjusted Change Return -7 -9.2% 51.25 113.5 1.9% Type REC REC REC PAY PAY PAY PAY 3.50 4.9 Term Structure of Implied Volatility for ATM IG Options 56% 54% 52% 50% 48% 46% 44% 42% 22-Apr 15-Apr 25-Mar 40% 0 1 2 3 4 5 Months to Maturity 6 7 5y CDX.2% 0.5% -0.9 15-30% -1.5 106 0.75 115.IG.2% 2.75 115.75 0.1 30-100% -4.4% 0.13 -0.5% 0.5 104.3% 0.00 2.75 0.38 0.2 8-12% 63.2% -0.7% -4.S.8 -1.75 -0.4% 55.75 1.2% 0.25 63 7.94 1.87 -1.5 4.00 -1 1 8.4 Index 111 0-3% 57 57.5 2.875 1.8% -0.75 91.6% 7y CDX.50 1.9 35-100% 114.0% 6.13 0.9% 1.25 0.5 5.8 15-30% -1.4% -1 -5.75 19.9 15-25% 58.44 0.19 0.8 7-10% -2 -1.25 0.5% 0.3% -0.875 102.5 Index 102 0-10% 10-15% 13.25 -0.88 0 -0.22 0.4% 50.54 -0. 2010.6% 0. Source: Barclays Capital 23 April 2010 Swaption Sep-10 IG.9% -0.3% 0.6% 100 PAY 23 54.63 -0.8% -0.5% -0.5% 105 PAY 17 55.3% 0.IG.7% Imp Vol 49.3 35-100% 105.13 -0.5 0-10% 10-15% 76 77 10.0% 0.1% -3.8% -1.4% -0.75 1.5 3.HY.05 0.4% -0.7 10-15% 1.00 -0.2% 0.2% 6.25 4.31 -0.1% 53.50 5.7 3-7% 9 9.50 -1 0 -0.7 10-15% -0.9% 1.875 -7.5 0.88 Price 9 20 39 73 53 38 29 10.89 0.25 96.1 8-12% 95.1% -0.00 -0.875 38.0% 4 0.63 5.0% 3y LCDX.5 106 0.375 1.9 7y CDX.07 -0.38 0 1.4% 0.1% -2.HY.0% 0.0% 1.4% 90 REC 29 51.9 5y CDX.7 3-7% 19 19.0% -2.98 0. 2010.13 -0.4% -0.1% 0.9% -7.0% 1.875 103.10 3y CDX.Barclays Capital | U.7 30-100% -2.

S. Credit Alpha ANALYST RATING CHANGES Last four weeks HG/HY HG HG HY Sector European Utilities TMT Gaming Issuer Thames Water Utilities Time Warner Cable MGM Mirage (unsecured notes) HG HG HG HG TMT Technology European Basic Industries Energy.75% Notes Enel SpA $US Paper Market Weight Market Weight Overweight Overweight 3/22/2010 3/22/2010 Source: Barclays Capital 23 April 2010 26 . Pipelines & Basics Bertelsmann Oracle Corp Evonik Industries Chemicals Metals & Mining Oil Field Services Eastman Chemical Market Weight Overweight Initiating Coverage Market Weight Overweight Overweight Overweight Overweight Market Weight Overweight Underweight Market Weight Market Weight Market Weight 4/9/2010 3/26/2010 3/25/2010 3/23/2010 3/23/2010 3/23/2010 3/23/2010 From Underweight Overweight Overweight To Market Weight Market Weight Market Weight Date Changed 4/22/2010 4/19/2010 4/19/2010 HY HG Industrials European Utilities CNH 7.Barclays Capital | U.

com +1 212 412 1370 High Yield & Leveraged Loan Bradley Rogoff.Barclays Capital | U.rogoff@barcap. CFA michael. CFA bradley.com +1 212 412 7922 Alex Gennis alex.com +1 212 412 3697 23 April 2010 27 .S.kakodkar@barcap.anderson@barcap.com +1 212 412 2183 Shobhit Gupta shobhit.korapaty@barcap.shah@barcap. CFA matthew.gennis@barcap.mish@barcap. CREDIT STRATEGY Global Ashish Shah ashish.com +1 212 412 7931 Investment Grade Jeff Meli jeff.com +1 212 412 7937 Eric Gross eric. Credit Alpha U.S.com +1 212 526 0680 Hari Manappattil hari.bicer@barcap.com +1 212 412 2127 Matthew Mish.com +1 212 412 2056 Praveen Korapaty praveen.com +1 212 412 7997 Structured Credit & Volatility Batur Bicer batur.manappattil@barcap.com +1 212 412 7936 Gautam Kakodkar gautam.gupta@barcap.com +1 212 412 7921 Michael Anderson.meli@barcap.gross@barcap.

New York. hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was.Analyst Certification(s) We. All levels. the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. Yana Bouchkanets and Joanie Genirs. To the extent that any historical pricing information was obtained from Barclays Capital trading desks. Shobhit Gupta. Barclays Capital is acting as financial advisor to The Geo Group (GEO) in the potential acquisition of Cornell Companies Inc. Bradley Rogoff. investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report. the overall performance of the firm (including the profitability of the investment banking department). 745 Seventh Avenue. Any reference to Barclays Capital includes its affiliates. Michael H Anderson. As a result. equity-linked analysis. but not limited to. The rating on Qwest Communications has been temporarily suspended due to Barclays Capital's role. Important Disclosures For current important disclosures regarding companies that are the subject of this research report. Gautam Kakodkar.com/research/cgibin/all/disclosuresSearch. 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 rating and price target on The Geo Group have been temporarily suspended due to Barclays Capital's role. Barclays Capital produces a variety of research products including.barcap. (Q). Where permitted and subject to appropriate information barrier restrictions. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products. methodologies. the firm makes no representation that it is accurate or complete. Eric Gross. and the potential interest of the firms investing clients in research with respect to.pl or call 212-526-1072. NY 10019 or refer to https://ecommerce. The firm's fixed income research analyst(s) receive compensation based on various factors including. fundamental analysis. Hari Manappattil. prices and spreads are historical and do not represent current market levels. Matthew Mish. Alex Gennis. some or all of which may have changed since the publication of this document. the profitability of. and trade ideas. is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Ashish Shah. (CRN). whether as a result of differing time horizons. or otherwise. Jeffrey Meli. but not limited to. please send a written request to: Barclays Capital Research Compliance. the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of. . the asset class covered by the analyst. the quality of their work. quantitative analysis. Barclays Capital and/or an affiliate thereof (the "firm") regularly trades. The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments. Company-specific Disclosures Barclays Capital is acting as financial advisor to CenturyTel Inc. The estimates in this report do not incorporate this potential transaction. Batur Bicer. Barclays Capital does and seeks to do business with companies covered in its research reports. 17th Floor. (CTL) in the potential acquisition of Qwest Communications International Inc. which may pose a conflict with the interests of investing customers. prices or spreads. The estimates in this report do not incorporate this potential transaction.

S.S. Underweight: Expected six-month excess return of the sector is below the six-month expected excess return of the Barclays Capital U.Explanation of the High Grade Sector Weighting System Overweight: Expected six-month excess return of the sector exceeds the six-month expected excess return of the Barclays Capital U. bank loans. as applicable. or the EM Asia USD High Yield Corporate Credit Index.S. the Pan-European Credit Index. the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials.S. Not Rated (NR): An issuer which has not been assigned a formal rating. Credit Index or Pan-European Credit Index. the ratings are relative to the Barclays Capital U. Market Weight: The analyst expects the six-month total return of the rated debt security or instrument to be in line with the six-month expected total return of the Barclays Capital U. Credit Index or Pan-European Credit Index. Explanation of the High Grade Research Rating System The High Grade Research rating system is based on the analyst's view of the expected excess returns over a six-month period of the issuer's index-eligible corporate debt securities to the Barclays Capital U.S. as applicable. 2% Issuer Capped High Yield Credit Index. Overweight: The analyst expects the issuer's index-eligible corporate bonds to provide positive excess returns relative to the Barclays Capital U. depending on the company under analysis. Market Weight: The analyst expects the issuer's index-eligible corporate bonds to provide excess returns in line with the Barclays Capital U. High Yield 2% Issuer Capped Credit Index or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials. as applicable. as applicable. or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials. as applicable. Not Rated (NR): An issuer which has not been assigned a formal rating. or the EM Asia USD High Yield Corporate Credit Index. Overweight: The analyst expects the six-month total return of the rated debt security or instrument to exceed the six-month expected total return of the Barclays Capital U. Underweight: Expected six-month total return of the sector is below the six-month expected total return of the Barclays Capital U. 2% Issuer Capped High Yield Credit Index. Please review the latest report on a company to ascertain the application of the rating system to that company. as applicable. 2% Issuer Capped High Yield Credit Index. Credit Index. .S. Rating Suspended (RS): The rating has been suspended temporarily due to market events that make coverage impracticable or to comply with applicable regulations and/or firm policies in certain circumstances including where Barclays Capital is acting in an advisory capacity in a merger or strategic transaction involving the company. or the EM Asia USD High Grade Credit Index over the next six months. or the EM Asia USD High Yield Corporate Credit Index.S.S. or the EM Asia USD High Grade Credit Index over the next six months. or the EM Asia USD High Grade Credit Index over the next six months.S. Rating Suspended (RS): The rating has been suspended temporarily due to market events that make coverage impracticable or to comply with applicable regulations and/or firm policies in certain circumstances including where Barclays Capital is acting in an advisory capacity in a merger or strategic transaction involving the company. Credit Index. Underweight: The analyst expects the six-month total return of the rated debt security or instrument to be below the six-month expected total return of the Barclays Capital U. Credit Index. as applicable. Credit Index or Pan-European Credit Index. the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials. the Pan-European Credit Index.S.S. the Pan-European Credit Index or the EM Asia USD High Grade Credit Index. as applicable. Market Weight: Expected six-month excess return of the sector is in line with the six-month expected excess return of the Barclays Capital U. Explanation of the High Yield Sector Weighting System Overweight: Expected six-month total return of the sector exceeds the six-month expected total return of the Barclays Capital U. or other instruments. Credit Index or Pan-European Credit Index. the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials.S. Credit Index. as applicable. as applicable. High Yield 2% Issuer Capped Credit Index. Explanation of the High Yield Research Rating System The High Yield Research team employs a relative return based rating system that. High Yield 2% Issuer Capped Credit Index or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials. For Japan and Australia issuers.S.S. as applicable. Market Weight: Expected six-month total return of the sector is in line with the six-month expected total return of the Barclays Capital U. the Pan-European Credit Index. may be applied to either some or all of the company's debt securities. Underweight: The analyst expects the issuer's index-eligible corporate bonds to provide negative excess returns relative to the Barclays Capital U.

Barclays Capital recommends that investors independently evaluate each issuer. tax. Sheikh Zayed Road. It is directed at. Please be advised that any discussion of U.S.S. 15 Alice Lane. at 745 Seventh Avenue. The analyst recommendations in this report reflect solely and exclusively those of the author(s). Absa Capital is an affiliate of Barclays Capital. In Japan. Registered Number: Kanto Zaimukyokucho (kinsho) No. or any other financial. London. Additional information regarding this publication will be furnished upon request. and/or one or more of its affiliates as provided below.S. The views in this publication are those of Barclays Capital and are subject to change. accounting. directors. partners. This communication is being made available in the UK and Europe to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005. It is a subsidiary of Barclays Bank PLC and a registered financial instruments firm regulated by the Financial Services Agency of Japan. retirement. Barclays Bank PLC is registered in England No.S. Diplomatic Area. may from time to time act as manager. Qatar. which may differ substantially from those reflected. Japan. This material is distributed in Malaysia by Barclays Capital Markets Malaysia Sdn Bhd. and such opinions were prepared independently of any other interests. co-manager or underwriter of a public offering or otherwise. The value of and income from any investment may fluctuate from day to day as a result of changes in relevant economic markets (including changes in market liquidity). and Business Customers as defined by the QFCRA. security or instrument discussed in this publication and consult any independent advisors they believe necessary. Accordingly. Other research reports are distributed to institutional investors in Japan by Barclays Capital Japan Limited. This publication is provided to you for information purposes only. Barclays Bank PLC Frankfurt Branch is distributing this material in Germany under the supervision of Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin). person wishing to effect a transaction in any security discussed herein should do so only by contacting a representative of Barclays Capital Inc. Sandton. investment. and therefore should only be relied upon by. legal. Doha. 00018) is authorised by the Qatar Financial Centre Regulatory Authority. in connection therewith accepts responsibility for its contents. nor any affiliate. . Barclays Bank PLC-QFC Branch may only undertake the regulated activities that fall within the scope of its existing QFCRA licence. Barclays Capital and its affiliates and their respective officers. IRS Circular 230 Prepared Materials Disclaimer: Barclays Capital and its affiliates do not provide tax advice and nothing contained herein should be construed to be tax advice. Tokyo 106-6131. the Investment Banking Division of Absa Bank Limited. This information has been distributed by Barclays Bank PLC. advice as defined and/or contemplated in the (South African) Financial Advisory and Intermediary Services Act.: 13/952/2008. trading.. and (ii) was written to support the promotion or marketing of the transactions or other matters addressed herein. Neither Barclays Capital. deal in. and Barclays Capital has no obligation to update its opinions or the information in this publication. an authorised financial services provider (Registration No. or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. persons who have professional experience in matters relating to investments. Barclays Bank PLC in the UAE is regulated by the Central Bank of the UAE and is licensed to conduct business activities as a branch of a commercial bank incorporated outside the UAE in Dubai (Licence No. 6. Absa Capital. Past performance is not necessarily indicative of future results. in the U. Registered Office: Al Jazira Towers. Principal place of business in Qatar: Qatar Financial Centre. 10th Floor. partners and employees. Burj Dubai Business Hub. Registered Office: Building No. 37 of 2002.: 13/1844/2008. Minato-ku. but Barclays Capital does not represent or warrant that it is accurate or complete. nor any of their respective officers. Office 1002. Non-U. Barclays Bank PLC in the Dubai International Financial Centre (Registered No. Hamdan Street. The information in this publication is not intended to predict actual results. brokers or commercial and/or investment bankers in relation to the securities or related derivatives which are the subject of this publication. the information contained in this publication has been obtained from sources that Barclays Capital believes to be reliable. © Copyright Barclays Bank PLC (2010).S. Absa Bank Limited is regulated by the South African Reserve Bank. is distributing this material in South Africa.This publication has been prepared by Barclays Capital. Dubai City) and Abu Dhabi (Licence No. Johannesburg. West Bay. persons should contact and execute transactions through a Barclays Bank PLC branch or affiliate in their home jurisdiction unless local regulations permit otherwise. Prices shown in this publication are indicative and Barclays Capital is not offering to buy or sell or soliciting offers to buy or sell any financial instrument. the investment banking division of Barclays Bank PLC. Barclays Capital is authorized and regulated by the Financial Services Authority ('FSA') and member of the London Stock Exchange. directors. by you for the purpose of avoiding U. tax matters contained herein (including any attachments) (i) is not intended or written to be used. including persons involved in the preparation or issuance of this document. in the capacity of principal or agent. is distributing this material in the United States and. hold or act as market-makers or advisors. No part of this publication may be reproduced in any manner without the prior written permission of Barclays Capital or any of its affiliates. PO Box 2734. Related financial products or services are only available to Professional Clients as defined by the DFSA. 0060) is regulated by the Dubai Financial Services Authority. Registered office 1 Churchill Place. tax-related penalties. Barclays Capital Japan Limited is a joint-stock company incorporated in Japan with registered office of 6-10-1 Roppongi. Barclays Capital Inc.org). E14 5HP. and cannot be used. including those of Barclays Capital and/or its affiliates. QFC Tower. 1026167. This publication is not.finra. you should seek advice based on your particular circumstances from an independent tax advisor. Barclays Bank PLC-DIFC Branch. 143. nor is it intended to be. Abu Dhabi). may only undertake the financial services activities that fall within the scope of its existing DFSA licence. The securities discussed in this publication may not be suitable for all investors. Barclays Bank PLC in the Qatar Financial Centre (Registered No. Any U. PO Box 15891.: 1986/004794/06). New York. US registered broker/dealer and member of FINRA (www. foreign exchange research reports are prepared and distributed by Barclays Bank PLC Tokyo Branch. New York 10019. Gauteng 2196. The investments to which it relates are available only to such persons and will be entered into only with such persons. Subject to the conditions of this publication as set out above. Any South African person or entity wishing to effect a transaction in any security discussed herein should do so only by contacting a representative of Absa Capital in South Africa. Other than disclosures relating to Barclays Capital. All rights reserved. actuarial or other professional advice or service whatsoever.