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Transcript of Barclays Quanto Credit Rpt
7/28/2019 Barclays Quanto Credit Rpt
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CREDIT RESEARCH U.S. Credit Alpha | 23 April 20
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 27
U.S. CREDIT ALPHA
Negative Headlines Obscure StrongFundamentals
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 attractiverelative 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........22The 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.
Ashish Shah
+1 212 412 7931
Jeffrey Meli
+1 212 412 2127
Bradley Rogoff
+1 212 412 7921
Michael Anderson
+1 212 412 7936
Matthew Mish
+1 212 412 2183
www.barcap.com
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23 April 2010 2
OVERVIEW
Negative Headlines Obscure Strong Fundamentals
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 headlinessurrounding 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 andscope 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 intra-
week 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).
Ashish Shah
+1 212 412 [email protected]
Weekly Index Changes Figure 1: One-Month Rolling Correlations Between CDX.IGand Greece/SovX/Banks-Brokers
Thursday
Close
Last
Week
Close
4-week
Average
Credit Index (bp) 128 128 132
CDX.IG.14 (bp) 89.0 87.0 86.1
High-Yield Index ($ price) 99.24 99.29 98.40
CDX.HY.14 ($ price) 100.75 100.50 99.63*
Leveraged Loan Index ($ price) 92.18 92.38 91.92
LCDX.14 ($ price) 99.75 100.38 99.20*
-20%
0%
20%
40%
60%
80%
100%
Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10
Greece/IG SovX/IGBanks-Brokers/ IG
Note: *Since Series 14 began trading. Source: Barclays Capital Source: S&P LCD, Barclays Capital
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23 April 2010 3
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 re-
priced 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.
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23 April 2010 4
FOCUS: MANAGING FX RISK IN CORPORATE BONDS
Hedging FX Risk with Cross-currency Swaps
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 riskissues, especially related to hedging peripheral risks like interest rate and FX risk. Bond
investors are not only exposed to currency risk on the fixed coupon and principal cash
flows, but in case of default are also faced with quanto risk on the recovery. Cross-
currency basis swaps are a powerful tool for modifying cash flows both across currencies
and between fixed and floating formats. In fact, these swaps are a natural extension of the
term structure of FX instruments available for hedging, with maturities of up to 30 years in
liquid currencies.
Cross currency basis swaps
As the name suggests, cross-currency swaps have interest rate payments in the two legs
set in two different currencies. To eliminate FX risk on the principal amounts these swapsalso incorporate an actual exchange of notionals in the different currencies (usually at
maturity, sometimes also at inception). The notionals in the two currency legs are usually
set in a ratio equal to the spot FX rate at inception.
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. Thus, most market
quotes are for floating/floating (basis) swaps. 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). Figure 1 shows the cash flows for a 5y
swap exchanging 3m USD Libor for 3m EUR Libor. The quote itself was at -23/-19bp,
which means the market maker pays/receives Euribor -23/-19bp versus receiving/payingUSD 3m Libor flat.
Figure 1: Cash flows for 5y EUR-USD cross currency swap, 5 March 2010
2010 2011 2012 2013 2014 2015
EUR cash flows USD cash f lows
Recv 3m Euribor - 23 bps on € 0.73 MM
Pay 3m Usdlibor flat on $ 1 MM
Pay € 0.73 MM; Recv $1 MM
Optional swap of notionals at inception
Pay $1 MM; Recv € 0.73 MM
Mandatory swap of notionals at maturity
Notionals set at spot FX rate of 1.36 on
day of inception
Note: The sizes of the bars are not to scale. Source: Barclays Capital
Arup Ghosh
+44 (0) 20 7773 [email protected]
Matthew Leeming
+44 (0) 20 7773 9320
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23 April 2010 5
Understanding the cross-currency basis spread
A floating rate note paying Libor should be priced at (or close to) par in its own currency. 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 market-
quoted basis swaps somehow price in an arbitrage opportunity as one leg pays a spread
above or below Libor. However, the apparent arbitrage vanishes provided the appropriate
swap curve adjusted by the basis is used to discount the cash flows (as is convention). There
are structural reasons for the existence of the cross-currency basis, for example:
Liquidity costs: Cross currency swaps are a powerful way for entities to raise funding in
different currencies. The net balance of demand and supply in the market for funding in
one currency over the other is expressed through the quoted spread, which can be
considered as the liquidity premium charged by the market to convert cash flows
between the currencies. The more negative the basis, the more expensive it is to raise
funding in the currency that is quoted as the liquidity benchmark.
Default concerns: Unlike most other swaps, cross-currency basis swaps involve an
exchange of principal. Thus, systemic concerns about default and counterparty risk in
different currency geographies can also affect the basis. This, however, is probably alesser concern.
Figure 2 shows the current market structure of cross-currency swaps across currencies and
maturities.
For investors who do not have a buy-to-hold view, the mark-to-market on the cross
currency swap also becomes important to consider. Figure 3 plots the time series of basis
for swaps from three currencies to USD over the past three years. The direction of the basis
correlates well with the flight to safer currencies that happened during the credit crunch. 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.
Figure 2: Cross currency market quotes, 26 February 2010
A: Cross currency basis swaps quoted vs USD Libor (flat) B: Term structure of basis swaps
-50
-40
-30
-20
-10
0
10
20
30
40
50
AUD CAD GBP EUR CHF JPY RUB
X
c u r r e n c y b
a s i s ( b p s )
1Y
5Y
10Y
The lower the spread vs USD Libor the
tighter the dollar liquidity in those markets
-40
-30
-20
-10
0
10
20
0 5 10 15 20 25 30Term (years)
X
c u r r e n c y b a s i s ( b p s )
EUR 3m Libor + spread vs USD 3m Libor flatGBP 3m Libor + spread vs USD 3m Libor flatGBP 3m Libor + spread vs EUR 3m Libor flat
Source: Barclays Capital
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23 April 2010 6
Figure 3: Cross-currency basis time series; quotes versus USD
-100
-80
-60
-40
-20
0
20
40
60
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10
X
c u r r e n c y b a s i s ( b p
s )
CAD 5y swap
GBP 5y swap
EUR 5y swap
Source: Bloomberg, Barclays Capital
Cross-border relative value in bonds
From a bond investors’ perspective, the biggest use of cross-currency swaps is in converting
cash flows of foreign currency bonds into local currencies. Since investors are usually most
familiar with domestic issuers, they often charge a premium to hold bonds of foreign
issuers, even when denominated in the domestic currency. Figure 13 highlights this
difference. The chart on the left analyses two sets of single-A issuers: those raising funds in
euros and sterling, as well as those raising funds in euros and dollars. As indicated, entities
raising funds in foreign currencies currently have to pay a credit spread premium (defined
as OAS per unit of duration) of about 20%, which is fairly stable across currency zones and
the term structure. The chart on the right looks at how spreads change across issuers and
currencies for the same universes of bonds as before. As is evident, 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.
Figure 4: Analysis of non-fin single-A credit spread behaviour in euro, dollar and sterling markets (90 tickers, 927 bonds)
A: Relative credit cost of non-local to local issuers (4 March 2009) B: Relative spread movement; cross issuer and currency (2005-09)
80%
100%
120%
140%
160%
Near (≤4y) Mid (>4y, ≤8y) Far (>8y)
R e l a t i v e c r e d i t c o s t ( n o n l o c a l / l o c a l )
Univ of issuers with EUR & GBP bondsUniv of issuers with EUR & USD bonds
Non-local i ssuers pay around
20% more credit spread than
similarly rated local currency
40%
50%
60%
70%
80%
90%
100%
Issuers with € & £ bonds Issuers with € & $ bonds
A v g c o r r e l a t i o n o f s p
r e a d c h a n g e s
Same issuer, different currencies
Same currency, different issuers
Bonds denominated in the same
currency have higher spread
correlation even when their
isssuers are domiciled in separate
currencies
Note: Here we have defined cost of credit as spread per unit duration. Source: Markit, Barclays Capital
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23 April 2010 7
Taken together, the charts indicate that not only do bonds by the same issuer often trade
cheaper in foreign currencies, 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. 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. Different markets often see demand for different parts of the
curve, as indicated in Figure 5. Many sterling investors, like pension funds, prefer longer-
dated assets to match longer-dated liabilities, while French investors have a preference for
the middle of the curve.
Figure 5: France Telecom cash curves – euro and sterling, 9 March 2010
0
50
100
150
0 2 4 6 8 10 12 14 16 18 20 22 24
Maturity (yrs)
C a s h s p r e a d ( b p s )
Euro bond curve
Sterling bond curve
Demand from French investors
supports the front and middle
end of the Euro curve
Demand from Sterling investors
drives down the far end of the
Sterling curve
Note: Spreads above are ASW over 6m Libor. Source: Markit, Barclays Capital
This creates a pricing differential that can be taken advantage of using cross-currency basis
swaps. Figure 6 highlights the economics of investing in the two sets of bonds marked out
in Figure 5. The spreads indicated are over 3m Libor, for a par-par swap in each case.
Figure 6: France Telecom – euro versus sterling ASW spreads, 10 March 2010
Bond Maturity Clean price Spread over native
currency
Spread over Euro
(including basis)
Bond maturity ~ 8 years
£ Frtel 8 Dec 17 7.8 yrs £122 138 bp 130 bp€ Frtel 5 5/8 May 18 8.2 yrs €114 73 bp 73 bp
Bond maturity ~ 6.5 years
£ Frtel 5 May 16 6.2 yrs £104 120 bp 109 bp
€ Frtel 4 3/4 Feb 17 6.9 yrs €108 71 bp 71 bp
Note: prices/spreads are indicative as of the date mentioned. Spreads are calculated off 3m Libor in all cases.Source: Markit, Barclays Capital
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23 April 2010 8
As indicated, 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.
A yield perspective; swapping between fixed coupons across currencies
Cross-currency swaps can also be used to modify bond cash flows to pay fixed coupons in a
different currency. This might be useful for investors looking to meet yield targets and are
indifferent to the benchmark swap rate. Also, investors with an outright view that rates will
be slower to rise than the yield curve implies, might choose to implement this view by
locking in the implied forward rate through a fixed coupon bond. These trades can be
structured in both ‘par’ or ‘market’ formats, with the investor investing par or the bond
price, respectively (see European Credit Alpha, 16 April 2010). A third format – a ‘coupon
swap’ – is also attractive in some cases. In this structure, the swap is set up so that only the
coupon is swapped instead of the full yield of the underlying bond. In effect, this means
there is no exchange of the “100 – price” amount as in the par and market structures. This
leads to much lower counterparty exposure between the buyer and seller and is often
attractive for cash rich investors. Figure 7 shows the cash flows in the par and coupon
formats for the France Telecom Sterling 8%, 2017 bond, and compares this to the Euro 55
/8%, 2016 bond.
Figure 7: France Telecom – euro vs sterling yields, 10 March 2010
Bond Dirty price Coupon Redemption Yield
£ Frtel 8 Dec 17
£ bond cash flows £124 8% £100 4.52%
€ par ASW cash flows €111 (= £100) 4.25% €111 (= £100) 4.39%
€ coupon ASW cash flows €136 (= £124) 7.59% €111 (= £100) 4.19%
€ Frtel 5 5/8 May 18
€ bond cash flows €118 5.625% €100 3.62%
Note: Prices/yields are indicative as of the date mentioned. Coupons are paid on the redemption value.Source: Markit, 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.
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. For cash-rich
investors it might make sense to analyse the trade by including the collateral-related cash
flows. In such case, the funding costs of this collateral will have a drag on the swapped net
yields indicated above. For example, in the par swap, the buyer will have to post £24
(=€26.4) points worth of collateral at trade inception. This collateral will be paid back to the
buyer over the life of the trade, amortising to zero at maturity. Through the trade the buyer
will earn Eonia on the amount of collateral posted at any given time. If these collateral cashflows are included in the accounting of the trade, the net yield on the par swap comes down
to around 3.9% from 4.39% (assuming Eonia levels stay unchanged, and the collateral
amortises linearly). In effect, instead of investing £124 in the credit, the buyer is investing
£100 in the underlying credit and £24 in a swap counterparty credit. In this case, as the
swap counterparty is better quality, the overall yield is reduced versus the outright bond
investment. This still leaves a pick-up of around 30bp over the comparable euro bond. For
the coupon swap, the net value of the collateral posted will be very small, and the effect on
the net yield of these cash flows will be much smaller.
Coupon swaps allow the investor
to swap just the fixed coupon
instead of the full
yield of the bond
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23 April 2010 9
Clean asset swaps for cross-currency trades
When using cross-currency swaps to invest in non-local currency bonds, the investor is left
with three risks: 1) credit risk on the underlying; 2) mark-to-market on the swap in case of
default; 3) quanto risk on the recovery payment in case of default. It is possible to eliminate
such risk completely using swaps that extinguish in case of a credit event. These are called
clean asset swaps, and the swap component of the trade cancels, with zero mark-to-market
in case of a credit event. In effect, 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, but also
the probability of default of the underlying credit. In this case, the seller of the swap absorbs
the potential mark-to-market in case of default of the underlying, and also pays the investor
recovery in the swapped currency as a percentage of notional. Thus the spread paid on
such a swap will be different from a normal swap package. It will typically depend on the
following factors among others: 1) the credit quality of the underlying name; 2) both swap
curves; 3) interest rate volatility in both currencies; 4) correlation between rates in the two
currencies; 5) FX rate volatility; as well as 6) correlations between the two interest rate
curves, FX rates and the default risk of the underlying.
Clean asset swaps are suitable
for investors looking to eliminate
all interest rate and FX exposure,
even that arising in case of a
default of the underlying bond
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23 April 2010 10
Appendix: Pricing cross currency swaps
Cross-currency swaps are priced exactly the same way as vanilla single-currency swaps,
with one crucial difference; the discounting of future cash flows is done off swap curves
that incorporate the full term structure of the cross-currency basis. Figure 8 presents the
cash flows of different asset swap formats, single and double currency; and fixed to floating.
Figure 8: Cash flows for different asset swap formats
Bond cash flows in native currency Bond cash flows after par swap Swap cash flows
100
100
A
Buyer can choose both:
1. currency of final cash flows
2. format of coupon A (fixed/floating)
100-P
A
C
Swap is designed to have PV = 100-P, when cash
flows of both legs are di scounted off the respective
swap curves including the basis. The PV of the
foreign leg is converted using the spot FX ra te.100
100
Bond cash flows after market swap Swap cash flows
P
P
M
Buyer can choose both:
1. currency of final cash flows
2. format of coupon M (fixed/floating)
M
C
P
100
Swap is designed to have PV = 0, when cash flows of
both legs a re discounted off the respective swa p
curves including the basis. The PV of the foreign leg is
converted using the spot FX rate.
Bond cash flows after coupon swap Swap cash flows
P
100
C
P = bond dirty price
C = bond coupon (fixed/floating)
100 = bond face value
P
100
Cu
Buyer can choose both:
1. currency of final cash flows
2. format of coupon Cu (fixed/floating)
This swap is when the buyer wants exposure to the
bond in a different currency or coupon format from the
original bond, but in a non par or price structure
Cu
C
100
100
Swap is designed to have PV = 0, when cash flows of
both legs are discounted off the respective swap
curves including the basis. The PV of the foreign leg is
converted using the spot FX rate.
Source: Barclays Capital
Bond investors can use the Bloomberg ASW function to price fixed – floating cross currencyswaps as indicated in Figure 9.
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23 April 2010 11
Figure 9: Using ASW to price cross currency swaps on £ France Telecom 8, 2017
A: Swapping currencies on ASW B: ASW page 2; swapped spreads across currencies
Change reporting currency to get
swapped spread in that currency
Cross currency basis
N e t s w a p p e d s p r e a d i n
d i f f e r e n t c u r r e n c i e s
Source: Bloomberg, Barclays Capital
This function is straightforward to use, and an easy way to look up cross currency spreads.
It does however suffer from a few drawbacks, namely: 1) it uses single points on the basis
curve, instead of the full curve to price the swapped spread; and 2) it is not easy to change
the benchmark rate to 3m Libor, which is what the market uses to price and quote. For
these reasons, we recommend using the SWPM function to arrive at a more representative
spread for a cross-currency swap. Figure 10 shows how a fixed-float swap can be set up in
SWPM to solve for asset swap spreads in different currencies.
Figure 10 Using SWPM to price cross currency swaps on £ France Telecom 8, 2017
Match fixed leg characteristics to
bond (maturity, coupon etc.)
Solve for "Spread" on floating leg, such that
mark et value of the swap = (Clean price - 100)
ASW spread in
specified currency
Coupon frequency
Source: Bloomberg, Barclays Capital
SWPM can also be used in a similar fashion to calculate the fixed coupon on a par-par swap
in any currency. 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.
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23 April 2010 12
INVESTMENT GRADE: GLOBAL CREDIT - CROSS CURRENCY TRADE IDEAS
Euro Credit at All-time Wides to Dollar Credit
A combination of secular and cyclical trends has cheapened European credit versus US
credit. At the same time, the EUR-USD cross-currency swap remains dislocated andbenefits investors swapping EUR cash flows into USD, as discussed in our focus article
this week (Managing FX risk in corporate bonds ). We screen for attractive switch
opportunities from USD to EUR-denominated bonds issued by the same company with
similar maturities. US-based investors can pick-up 20bp to 77bp yield by buying EUR-
denominated bonds and switching their cashflows into dollars.
EUR credit is cheap to USD credit for the first time
Historically, USD-denominated bonds have traded cheap to EUR-denominated bonds.
This is evident from the spread history of USD and euro bond or CDS indices, although
compositional differences between the two domiciles account for some of the historical
relationship. Even when we control for differences in composition by selecting a basket of issuers with bonds in both currencies at the same maturity, the effect remains. According
to our metric, 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). This discount collapsed during
2009, and today the differential between USD and EUR bonds stands at only 10bp, or 7%
of the average spread level.
At the same time, 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, has failed to normalize and still stands at close to -25bp. In other words,
aside from relative value between USD and EUR bonds, investors continue to get paid for
swapping euro cashflows into dollars.
US
Jeffrey Meli+1 212 412 2127
Alex Gennis
+1 212 412 1370
Europe
Arup Ghosh
+44 (0) 20 7773 6275
Aziz Sunderji
+44 (0) 20 7773 7881
Matthew Leeming
+44 (0) 20 7773 9320
Figure 1: The differential in spreads between USD bonds andEUR bonds – even when matched by issuer and maturity – has collapsed
Figure 2: When the dramatic moves in the USD/EURcurrency swap basis are added, EUR credit stands at all-timecheap levels versus USD credit
0
100
200300
400
500
600
700
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
OAS (bp)
-120
-100
-80
-60-40
-20
0
20
40
60
2005 2006 2007 2008 2009
spread pickup for switching from USD to EUR
spread pickup after swapping
bp
Note: Basket based on DT, TELEFO, TITIM, VOD, GE, GS, MCD, MS, PG, andSLMA (bonds issued at least 5y ago in both currencies). Source: Barclays Capital
Source: Bloomberg, Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 13
For US investors, the message is clear: EUR-denominated bonds are at all-time cheap levels;
when the benefit of the currency swap is added, the spread pick-up for switching from USD
to EUR bonds can be substantial. 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. Given the current cheapness of converting from EUR to USD, this results in even
further spread pick-up (please see this week’s Focus for details on the cross-currency basisswap). Although European investors will not benefit from the currency basis swap, outright
cheap levels for EUR-denominated debt make this an opportune moment to repatriate USD
investments into EUR credit.
Why was USD credit cheap and what has changed?
Structural factors explained the relatively tight spreads on EUR-denominated bonds
Historically, euro-denominated corporate bonds have traded rich to USD bonds. This has
partly been a function of the structure of the two markets. In particular, European
corporates have traditionally relied on bank loans rather than public bonds for funding,
leading to a dearth of liquid bonds and a strong bid for the relatively few benchmark issues.
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, underpinning tighter spreads. In the US, domestic savings rates
are lower and retail investors have historically favoured equities.
A reversal of these same dynamic has caused euros to cheapen
We believe a number of factors have caused the USD discount to shrink, most of which are
simply reversals of the same dynamic that caused USD to be cheap for so long. Firstly, the
euro bond market has exploded in terms of issuance, reducing the structural
supply/demand imbalance. One factor behind the increased euro-denominated issuancehas been the shift from loan to bond financing for European corporates, due to the
constraints on bank balance sheets and risk tolerance. Secondly, 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). Thirdly, European assets as a
whole have been tainted by sovereign risk. 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). Importantly, the validity of this
last reason as one to shun EUR-based credit is weak.
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, as well as in the cross-currency swap market. Yankee issuance has accounted for
over half of all investment-grade, fixed rate issuance in the USD market YTD 2010, with a
large portion of Yankees coming from euro issuers. 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.
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Barclays Capital | U.S. Credit Alpha
23 April 2010 14
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. In addition, movements in the cross-
currency swap will affect the MTM of the trades we recommend. Although (as discussed in
the Focus article this week) the swap remains dislocated versus pre-crisis levels, there is a
risk that the swap becomes more negative, causing MTM losses. In addition, 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.
Trade recommendations
Figure 5 and Figure 6 list our most attractive switches for European and US names, in all
cases switching from a US denominated issue to a comparable euro one. All comparisons
are done from the perspective of a dollar investor, and the euro bonds are currencyswapped into dollars. The investor not only picks up spread by moving into a cheaper bond,
but also picks up the basis on the cross-currency swap, which is in their favour. In all cases
the asset swapped spread has been calculated off the 3 month Libor curve, and all bond
prices include bid-offer costs.
Figure 5: Cross currency switches (Yankee)
Ticker Description Maturity Price*
ASW spd in
local curr.
ASW spd in USD
after basis swap
Spread
pick-up
BHP EUR 4.75 04/2012 105.69 52 78 49
USD 5.125 03/2012 107.01 29 29
BRITEL EUR 5.25 01/2013 106.03 146 171 39
USD 5.15 01/2013 105.91 132 132
GSK EUR 5.625 12/2017 115.66 59 78 55
USD 5.65 05/2018 114.24 23 23
LGFP EUR 4.25 03/2016 99.52 188 208 34
USD 6.5 07/2016 109.76 174 174
MTNA EUR 8.25 06/2013 115.31 151 176 44
USD 5.375 06/2013 106.73 132 132
TELEFO EUR 3.406 03/2015 100.48 111 130 50
USD 5.855 02/2013 109.26 80 80
Note: *Accounting for bid/offer. Prices and spreads as of 22 April 2010. Source: Bloomberg, Barclays Capital
Figure 3: The surge in European issuance has diminished the
structural supply/demand imbalance
Figure 4: US mutual fund flows have been out of money
markets and into USD corporate credit
0
50
100
150
200
250
300
350
1994 1997 2000 2003 2006 2009
€bn non financial issuance
-100
-50
0
50
100
150
200
250
300
2001 2002 2003 2004 2005 2006 2007 2008 2009
U S D B
i l l i o n s
Fund flows to USD high grade bonds Fund flows to equities
Source: Dealogic Source: Lipper
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Barclays Capital | U.S. Credit Alpha
23 April 2010 15
Figure 6: Cross currency switches (US issuers)
Ticker Bond Maturity Price*
ASW spd in
local curr.
ASW spd in USD
after basis swap
Spread
pick-up
DE EUR 7.5 01/2014 117.1 92 121 77
USD 6.95 04/2014 116.5 44 44
ABIBB EUR 7.375 01/2013 113.3 92 124 59
USD 2.5 03/2013 100.4 65 65
VZW EUR 8.75 12/2015 129.1 88 118 49
USD 5.55 02/2014 109.9 68 68
FO EUR 4 01/2013 102.1 169 200 48
USD 6.375 06/2014 110.0 152 152
GE EUR 4.25 02/2014 105.4 91 119 43
USD 3.75 11/2014 102.1 76 76
JPM EUR 6.125 04/2014 112.8 83 111 43
USD 4.65 06/2014 106.6 69 69
WFC EUR 6 05/2013 110.5 86 116 38
USD 4.375 01/2013 105.3 78 78
PG EUR 4.5 05/2014 108.6 35 63 37
USD 4.95 08/2014 109.6 26 26
PM EUR 5.875 09/2015 114.9 62 90 20
USD 6.875 03/2014 115.0 70 70
Note: *Accounting for bid/offer. Prices and spreads as of 22 April 2010. Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 16
YTD2010 Fixed IG Supply ($bn) CDX.IG Curve
Govt.
Guaranteed,
$9.5, 3%
Finance,
$119.7, 37%
Utility,
$15.1, 5%
Industrial,
$79.6, 25%
NonCorp.,$96.1, 30%
-60
-50
-40
-30
-20
-10
0
10
20
30
Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10
bp
-40
-35-30
-25
-20
-15-10
-50
510
15
bp
5s10s (LHS) 5s7s (RHS)
Note: All levels on this page as of Thursday close. Source: Barclays Capital Note: A portion of the significant steepening in CDX.IG curve levels on March 20,2009, is attributable to the roll from Series 11 to Series 12. Source: Barclays Capital
CDX.IG versus VIX Basis
30
70
110
150
190
230
270
310
Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10
0
10
20
30
40
50
60
70
80
90
CD X. IG 5. 0 Mk t (L HS, bp) VIX (RHS, %)
60
140
220
300
380
460
540
620
May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10
bp
-400
-350
-300
-250
-200
-150
-100
-50
0
bp
Credi t OAS (LHS, bp) Basi s (RHS, bp)
Note: A portion of the significant tightening in CDX.IG on March 20, 2009, isattributable to the roll from Series 11 to Series 12. Source: Markit, Barclays Capital
Note: Basis defined as CDX.IG spread – corporate Libor OAS.Source: Barclays Capital
CDX.IG Mkt versus Intrinsic Par Downgrade/Upgrade Ratio
70
80
90
100
110
120
130
Aug-09 Oct-09 Dec-09 Feb-10 Apr-10
bp
CDX IG12 Mkt
CDX IG12 Intr
CDX IG13 Mkt
CDX IG13 Intr
0
5
10
15
20
25
30
A S O N D J F M A M J J A S O N D J F M
Moody's S&PDG/UG Ratio
Source: Barclays Capital Note: S&P had a par downgrade/upgrade ratio of 91.4 in January 2010. Moody’sratio was 0.4; however, Moody’s downgraded only three companies andupgraded seven companies in January 2010. Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 17
HIGH YIELD
Sentenced to 144a-for-Life
High yield was mostly unchanged through Thursday, despite increased volatility induced by
SEC charges of Goldman Sachs and renewed fears around Greece. Nevertheless, derivativesoutperformed cash, with HY14 advancing $0.25 to $100.75. Cash was $0.05 lower through
Thursday, ending at $99.24. The CDX index has also been outperforming Europe, with the
spread between HY14 and iTraxx XO compressing 53bp since the roll.
High yield companies are beginning to report first quarter earnings and, thus far, the
positive reports outnumber the negative. For most, the positive surprises remain cost-
driven, though there are some signs of better-than-expected top-line growth as well. On
Monday, Rexnord reported preliminary revenues and EBITDA well ahead of expectations.
Hanesbrands also reported a significant 1Q10 beat, driven by a combination volumes
growth and improved operating margins, and Complete Production was also ahead of
consensus on sales and EBITDA. Community Health was in line for the quarter, as was
Massey Energy, although the latter reduced guidance for the year. On the services front,United Rentals was a beat on EBITDA as used equipment margins improved, and Westcorp
beat despite lower revenues. Terex earnings were disappointing, though the company is
looking to make use of its $1.8bn cash balance and $500mn revolver to grow its machinery
and industrial products businesses via acquisitions. Standard Pacific was also weaker,
reporting its first quarterly loss in a few quarters despite no charges or impairments.
Freescale’s 1Q10 numbers were in line with the company’s pre-announcement, and the
outlook is for solid, broad-based end-demand growth.
On the M&A front, CenturyTel (CTL) has agreed to acquire Qwest Communications (QUS).
The $10.6bn all-stock deal values Qwest at about $22.4bn, including $11.8bn in debt to be
assumed by CenturyTel. The combined company will have annual revenues of nearly $20bn.
Currently, CTL represents 21bp of the U.S. Credit Index by market value, with $6.3bn in
index-eligible par outstanding. Meanwhile, QUS represents 23bp with $7.1bn, and has
another $3.5bn in the U.S. High Yield Index, or 43bp by market value. However, all three
major ratings agencies have put Qwest (Ba3/BB/BB+) on watch positive; likewise, all three
have either put CenturyTel (Baa3/BBB-/BBB-) on watch negative or negative outlook.
Should QUS move to IG, the index-eligible total of $16.2bn would represent 52bp by market
Bradley Rogoff, CFA
+1 212 412 [email protected]
Michael Anderson, CFA
+1 212 412 7936
Gautam Kakodkar
+1 212 412 7937
Eric Gross
+1 212 412 [email protected]
Figure 1: Cash and CDS Movers Figure 2: HY Industrials Index Statistics
High Yield Cash
Best Px Chg Worst Px Chg
RDN 5.375 '15 85.50 +6.5 AIG 8.125 '46 93.13 -3.9
MBI 4.65 '18 55.94 +6.2 VRS 11.375 '16 92.75 -3.5
SAPSJ 7.5 '32 77.00 +6.0 SFI 5.7 '14 76.50 -3.0
High Yield CDS
Best 5y Chg Worst 5y Chg
RDN 5.0 pts -7.5 pts AKS 433 bp +34 bp
QUS_CAP 186 bp -100 bp AMR 19.5 pts +1.5 pts
HOV 8.0 pts -4.3 pts TSO 471 bp +28 bp
SEC
Registered
144a with
Reg Rights
144a for
Life
# of Issues 999 185 213
Par ($bn) 458 91 97
Price 100.60 104.00 102.00
Coupon (%) 8.26 9.20 9.60
Yield to Worst (%) 7.60 8.00 8.80
OAS (bp) 506 499 614
YTD Total Return 5.59% 5.22% 6.67%
Source: Barclays Capital Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 18
value. However, given these ratings actions, it appears more likely that CenturyTel slips to
HY. In that case, the combined entity would have $17.2bn in index-eligible debt,
representing 2.14% of the HY index by market value, and would unseat Sprint as the fifth-
largest issuer by par.
The services sector also experienced some M&A activity, as The Geo Group agreed to
acquire Cornell Companies in an all-stock transaction valued at $685mn including theassumption of Cornell debt.
In another sign of the loosening of the credit markets, 144a-for-life issuance has comprised
22% of the calendar since the beginning of March. This represents a considerable increase
over the High Yield Index's 13.7% weighting on February 26. Not all 144a-for-life deals are
created equally, however, as some are issued by public companies (US and non-US issuers).
The feature will likely remain prominent, even when the strength of the primary market
fades because of the necessary refinancing of upcoming loan maturities, which include
many small private issuers.
Not surprisingly, since the beginning of the year, 144a-for-life industrials have
outperformed the rest of high yield industrials by roughly 100bp (6.67% for 144a's with no
registration rights versus 5.70% for the High Yield Industrial Index). Although 144a's for life
have roughly the same duration and issue size (~$450mn) as registered bonds, they yield
120bp more. Nonetheless, their larger coupon leads them to be priced $1.40 higher on
average (Figure 2).
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23 April 2010 19
High Yield 2010—Supply by Sector Top On-the-Run CDX Index Names by Net CDS Outstanding
Nat Res
Industrial
Financial
Telecom
Technology
Healthcare
Chemicals
Others
Media
Consumer
YTD - $86.5bn
Notional
Outstanding ($bn)
Change –
Week Ending
4/16/10 ($mn)
Gross Net Gross Net
Radian Group 43.5 3.1 329.8 28.7
ILFC 37.1 2.9 252.6 67.3
GMAC 57.0 2.9 536.6 77.8
Sprint Nextel 32.8 2.3 91.4 (40.1)
Macy's 30.5 2.2 134.8 (71.6)
Lennar 38.6 2.2 221.7 (10.2)
Limited Brands 32.3 2.1 239.3 17.0
MBIA Inc 36.2 2.1 169.8 18.7
Weyerhaeuser 23.7 2.1 83.3 (150.4)
Temple-Inland 25.2 2.0 27.1 (7.6)
Source: Barclays Capital Source: DTCC
High Yield Average Institutional Trade Volume OTR HYCDX versus U.S. High Yield Index
01
2
3
4
5
6
7
8
9
10
Dec-09 Jan-10 Feb-10 Mar-10 Apr-10
$bn Daily Volume
Rolling 1-Week Average
50
60
70
80
90
100
110
Nov-08 F eb-09 May-09 Aug-09 Nov-09 F eb-10
$
US HY - Price
HYCDX - Price
Source: Trace, Barclays Capital Source: Barclays Capital
On-the-Run HYCDX Spread Distribution High Yield Index Price Distribution by Par
0
5
10
15
20
25
30
35
40
< 2 0 0
2 0 0 - 4 0 0
4 0 0 - 6 0 0
6 0 0 - 8 0 0
8 0 0 - 1 0 0 0
> 1 0 0 0
% Last Month
Current
0
5
10
15
20
25
30
35
40
45
50
55
< 4 0
4 0 - 5 0
5 0 - 6 0
6 0 - 7 0
7 0 - 8 0
8 0 - 9 0
9 0 - 1 0 0
1 0 0 - 1 1 0
1 1 0 - 1 2 0
> = 1 2 0
%Last Month
Current
Source: Barclays Capital Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 20
LEVERAGED LOANS
Exit Loans for CLOs
As the calendar for bankruptcy emergences becomes more visible, we expect exit financing
will be a major component of 2010 loan issuance. We have seen a number of large issuersemerge in the past few months, including Lear, Idearc, RH Donnelley and Charter. This week
Six Flags’ $770mn first- and second- lien loans allocated and traded well in the secondary
market. The $400mn first-lien has a L+400bp coupon, 2% Libor floor and a 101 soft call
premium, while the $250mn second-lien has a L+725 coupon, 2.5% Libor floor and
103,102, 101 call premiums. While the $19bn current forward calendar does not reflect the
potential exit pipeline, we expect the 2010 calendar could include Hawaiian Telcom,
Fairpoint, Smurfit Stone, WR Grace, Tronox, Chemtura, Lyondell, AbitibiBowater, Tribune,
Visteon, and Young Broadcasting. On average, spreads on exit loans have been more than
150bp wide of the general loan new issue market (Figure 2), making them attractive
candidates for secondary CLOs. On the primary CLO front, we are beginning to see some
green shoots, with Apollo testing the waters with a new $300mn vehicle with arranger
Citibank. Interestingly, we have seen shorter re-investment periods in the small sample of new deals, to make the senior tranche more attractive to investors.
Covenant amendments and maturity extensions continue to flow. HIT Entertainment
completed a credit facility amendment allowing for the total leverage covenant to be
replaced by a new first-lien leverage covenant. In exchange, the company paid a fee of
295bp and the coupon was increased from L+225bp to L+525bp. The revolver was also
downsized from $77mn to $52mn, with the balance being termed out. Meanwhile, ILFC
amended two of its revolvers (totaling $4.5bn) to allow for the extension of their maturities.
On the M&A front, Calpine’s exit term loan softened 1pt after the company announced that it
was acquiring the Conectiv fleet (4.5GW) from Pepco Holdings for $1.65bn The company
expects to fund the acquisition with new bonds, a $1.3bn 7y term loan, and cash on hand.
The purchase gives Calpine access to the eastern Pennsylvania/Jersey/Maryland market, the
one attractive area in which it did not have a foothold. Also, Reynolds Group is in the market
seeking an amendment to allow for the issuance of a $750mn add-on term loan. The loan,
together with a $1bn bond offering, will finance the acquisition of Evergreen Packaging.
Figure 1: Exit Financing Volume Figure 2: Exit Financing Spreads
0
5
10
15
20
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
2 0 0 5
2 0 0 6
2 0 0 7
2 0 0 8
2 0 0 9
2 0 1 0
Deal Size New Money
($bn)
200
400
600
800
1,000
1 9 9 8
1 9 9 9
2 0 0 0
2 0 0 1
2 0 0 2
2 0 0 3
2 0 0 4
2 0 0 5
2 0 0 6
2 0 0 7
2 0 0 8
2 0 0 9
2 0 1 0
Pro Rata Institutional
(bp)
Note: Institutional plus pro-rata volume. Source: Barclays Capital, S&P LCD Source: Barclays Capital, S&P LCD
Bradley Rogoff, CFA
+1 212 412 [email protected]
Michael Anderson, CFA
+1 212 412 7936
Gautam Kakodkar
+1 212 412 7937
Eric Gross
+1 212 412 [email protected]
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Barclays Capital | U.S. Credit Alpha
23 April 2010 21
Institutional New Issue Volume LCDX Weekly New Contract Volume (4w Average)
Leveraged Loan
No. of
Deals
Amt
($mn)
Trailing 1m Launches 49 23,050
Forward Calendar 44 19,190
Year-to-Date 126 48,890
0
2
4
6
8
10
12
17-Apr 12-Jun 7-Aug 2-Oct 27-Nov 22-Jan 19-Mar
$bn
Source: S&P LCD and S&P/LSTA Leveraged Loan Index, Barclays Capital Source: DTCC
OTR LCDX Historical On-the-Run Spreads OTR HYCDX versus LCDX
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
Jun-08 Oct-08 Feb-09 Jun-09 Nov-09 Mar-10
bp
60
65
70
75
80
85
90
95
100
105
110
Oct-08 Jan-09 May-09 Aug-09 Dec-09 Mar-10
$HYCDX
LCDX
Note: Current market assumes 55% recovery on LCDX.Source: Barclays Capital
Source: Barclays Capital
OTR LCDX versus Loan Index Price History Loan Index Price Distribution by Par
50
60
70
80
90
100
110
Jul-08 Nov-08 Feb-09 Jun-09 Sep-09 Jan-10
$HY Loans Index
LCDX
0
10
20
30
40
50
< 6 0
6 0 - 7 0
7 0 - 8 0
8 0 - 8 5
8 5 - 9 0
9 0 - 9 5
9 5 - 1 0 0
> 1 0 0
% Current
Last Month
Source: Barclays Capital Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 22
STRUCTURED CREDIT & VOLATILITY
Costless LCDX Option on Short-term Defaults
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. Inparticular, our default outlook for the LCDX.10 index is fairly benign except for a few names
in the portfolio. Therefore, we believe short-dated junior LCDX.10 tranches offer attractive
P&L profiles. Except for the equity tranche, we think that all have enough cushion against a
few surprise defaults until the maturity date.
Sell $10mn 5-8% at 62pts, Buy $11.4mn 8-12% at 96.25pts (3y LCDX.10)
We recommend that investors get long the 3y LCDX.10 8-12% tranche by buying $11.4mn at
96.25pts and enhance the P&L profile of the tranche by shorting the 3y LCDX.10 5-8% tranche
by selling $10mn at 62pts. Both tranches have 14 months to maturity on June 20, 2011.
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. In other words, the trade is constructed to be costless toinvestors if the LCDX.10 index avoids any defaults in the next 14 months.
The LCDX.10 index has experienced 21 credit events to date. This includes 16 defaults and
5 cancellations. The 5-8% and 8-12% tranches are currently 0.00-1.13% and 1.13-6.20%
tranches of the current 79-name LCDX.10 portfolio. The 5-8% tranche currently has a
factor of 0.2983.
The 5-8% tranche trades in all-upfront form. The 8-12% tranche trades in upfront plus 500bp
annual running coupon. 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. At the trade’s inception,
investors would pay $1.13mn upfront for selling the $10mn 5-8% tranche. They would
receive $0.43mn upfront and $0.57mn annually for buying the $11.4mn 8-12% tranche.
Figure 1 shows the trade’s potential P&L profile under various loss scenarios for the LCDX.10
index by June 20, 2011. Investors would neither make nor lose money if no defaults occur in
the portfolio. The trade starts losing money only if more than 2.45% losses occur. Assuming a
Batur Bicer
+1 212 412 [email protected]
Figure 1: Performance of the Recommended Trade
-5
-4
-3
-2
-1
0
1
2
3
0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5%
Cumulative Losses in LCDX.10
Net 8-12% 5-8%PV of Cash Flows ($mn)
Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 23
60% recovery rate, which is in line with the average recovery rate of 55.6% for the previously
defaulted 16 names in the portfolio, this means that more than 5 names need to default in the
next 14 months for the trade to lose money. In our view, this is unlikely.
Maximum potential upside is almost $3mn (more than four times the upfront amount of
$0.70mn paid by investors) if cumulative losses reach 1.1% by the maturity date. This
corresponds to the best-case scenario in which the 5-8% tranche is totally wiped out whilelosses do not cause principal loss to the 8-12% tranche.
Market Recap: Synthetic Tranches and Credit Options
The IG.9 ref levels remained unchanged in 5y and increased 2bp and 4bp in 7y and 10y
tenors, respectively. 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 1.5%.
The HY.10 ref levels remained unchanged in 3y and decreased 0.5pts in 5y and 7y tenors.
The significant outperformance of the short-dated 3y 10-15% equity tranche continued this
week as the tranche rallied 3.2% w/w on both an absolute and delta-adjusted basis. Theabsolute tranche price increased 19.5pts m/m.
The LCDX.10 index ref levels remained unchanged in 3y and decreased 0.25pts in the 5y
tenor. The delta-adjusted changes in tranches were muted across the capital structure
except the 5y 15-100% tranche, which generated a w/w delta-hedged P&L of 1.9%.
During the past week in IG index options, 3m implied volatility increased 2.0%, to 52.8%,
while 3m realized volatility declined 1.3%, to 39.2%. The risk premium, which we define as
the basis between the implied and realized volatility levels, increased 3.3%, to 13.6%. The
term structure of implied volatility flattened significantly, with the 3m-1m implied volatility
basis decreasing to 2.6% from 6.3%. The implied volatility skew steepened slightly. The
implied volatility basis between 115% and 85% normalized strikes (assuming that the ATM
strike is 100%) increase to 2.6% from 2.0%.
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Barclays Capital | U.S. Credit Alpha
23 April 2010 24
Junior OC Test Cushions for U.S. and European CLOs CCC Bucket Size for U.S. CLOs
0% 10% 20% 30% 40% 50%
> 5%
2.5% to 5%
0% to 2.5%
-2.5% to 0%
-5% to -2.5%
< -5%
Percent of Deals
U.S. Europe
0% 5% 10% 15% 20% 25% 30% 35%
> 20%
17.5% to 20%
15% to 17.5%
12.5% to 15%
10% to 12.5%
7.5% to 10%
5% to 7.5%
2.5% to 5%
0% to 2.5%
Percent of Deals
Weighted Average Life (WAL) Test Cushion for U.S. CLOs CLO Arbitrage (Assets minus Liabilities)
0% 5% 10% 15% 20% 25% 30% 35% 40%
5 to 6
4 to 5
3 to 4
2 to 3
1 to 2
0 to 1
-1 to 0
-2 to -1
Percent of Deals
0%
2%
4%
6%
8%
10%
12%
14%
16%
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10
Par minus Liability Value as Percent of Par
U.S. CLO Spread Performance by Rating (bp) Cash Amount for U.S. and European CLOs in Our Sample
0
250
500
750
1000
1250
1500
1750
2000
2250
Feb-03 May-04 Aug-05 Nov-06 Feb-08 May-09
AAA AA A BBB Reinvestment Period
In Post Total
U.S.
Cash ($bn) 2.26 0.10 2.36
Total Par ($bn) 80.23 3.50 83.73
Cash Percent 2.82% 2.83% 2.82%
Europe
Cash (€bn) 0.58 0.05 0.63
Total Par (€bn) 24.81 3.16 27.97
Cash Percent 2.35% 1.58% 2.27%
Note: All figures are as of March 31, 2010 and based on a sample set of 200 U.S. and 80 European CLO deals in our universe.Source for all figures: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 25
Tranche Bid Offer DeltaLevel
Change
Delta
Adjusted
Return
Level
Change
Delta
Adjusted
Return
Index 89 0 -7
0-3% 37.875 38.375 8.2 -0.94 1.0% -9.63 8.0%
3-7% 1.625 2.125 7.0 1.25 -1.3% -2.50 1.2%
7-10% -7.875 -7.625 3.7 -0.25 0.2% -0.50 -0.2%
10-15% -0.625 -0.375 1.8 -0.13 0.1% -0.13 -0.2%
15-30% -1.97 -1.89 0.7 0.04 0.0% 0.07 -0.2%
30-100% -2.33 -2.25 0.4 -0.05 0.1% 0.13 -0.2%
Index 111 2 -4
0-3% 57 57.5 4.7 -0.25 0.8% -7.75 6.9%
3-7% 9 9.5 5.8 0.38 0.1% -7.13 6.1%
7-10% -8.5 -8 3.7 -0.13 0.4% -3.13 2.4%
10-15% 1.375 1.625 1.9 -0.13 0.3% -0.75 0.4%
15-30% -1.87 -1.77 0.9 0.25 -0.2% 0.53 -0.6%
30-100% -3.16 -3.06 0.5 0.05 0.0% 0.31 -0.4%
Index 123 4 -1
0-3% 66.875 67.375 2.7 0.63 0.2% -5.63 5.5%
3-7% 19 19.5 4.8 0.44 0.8% -8.00 7.7%
7-10% -2 -1.5 4.2 -0.50 1.5% -4.50 4.1%
10-15% 5.625 5.875 2.2 -0.38 0.9% -2.50 2.3%
15-30% -1.8 -1.64 1.1 0.22 0.0% 0.28 -0.4%30-100% -4.14 -3.98 0.6 0.19 0.0% 0.54 -0.5%
Index 104.5 0 0.75
0-10%
10-15% 76 77 10.8 3.13 3.2% 19.50 10.1%
15-25% 102.875 103.25 3.5 -0.19 -0.2% 2.06 -0.5%
25-35% 105.5 106 0.3 0.00 0.0% 0.00 -0.4%
35-100% 105.5 106 0.1 0 0.0% -1 -0.7%
Index 105 -0.5 1
0-10%
10-15% 34 34.5 2.3 1.75 3.2% 8.50 6.8%
15-25% 79.5 80.5 3.3 -1.00 0.5% 5.75 2.8%
25-35% 101.875 102.875 1.9 -0.88 -0.1% 1.38 -0.5%
35-100% 112.25 113.25 0.5 0 -0.2% 0 -0.6%
Index 102 -0.5 1.5
0-10%10-15% 13.5 15.5 0.9 0.25 0.9% 3.25 2.0%
15-25% 58.5 60 2.3 0.00 1.1% 4.00 1.3%
25-35% 90.75 91.75 1.9 -0.50 0.4% 2.88 0.4%
35-100% 114.75 115.75 0.8 -1 -0.2% 1 0.0%
Index 102 0 0.25
0-5%
5-8% 62.25 63 7.1 -0.13 -0.1% 11.38 6.8%
8-12% 95.25 96.25 11.0 -0.75 -0.8% 0.38 -1.5%
12-15% 103.5 104.25 2.9 -0.13 -0.1% -0.38 -0.9%
15-100% 105.25 105.625 0.4 0.00 0.0% -0.19 -0.3%
Index 102.25 -0.25 0.25
0-5%
5-8% 25.75 26.75 1.2 -0.75 0.0% 4.50 3.9%
8-12% 63.375 64.375 5.8 -0.63 0.5% 2.38 1.3%
12-15% 92.5 93.5 4.3 -0.88 0.0% 0.50 -0.3%15-100% 110.75 115.5 0.8 1.75 1.9% 1.88 1.7%
Strike Type Price Imp Vol Strike Type Price Imp Vol
80 REC 10 48.9% 70 REC 9 49.4%
85 REC 18 50.4% 80 REC 20 50.2%
90 REC 29 51.8% 90 REC 39 51.9%
90 PAY 40 51.8% 90 PAY 73 51.9%
95 PAY 30 52.6% 100 PAY 53 52.1%
100 PAY 23 54.5% 110 PAY 38 53.4%105 PAY 17 55.3% 120 PAY 29 55.4%
Normalized Volatility Skew of 3m On-the-run IG Options
3m ATM On-the-run IG Realized vs Implied Volatility
Term Structure of Implied Volatility for ATM IG Options
5 y C
D X . I G . 9
7 y C D X . I G . 9
1 0 y C D X . I G . 9
3 y C D X . H Y . 1 0
5 y C D X . H Y . 1 0
Weekly Monthly
S w a p t i o n S e p - 1 0
I G . 1 4 R e f = 8 9 . 5
7 y C D X . H Y . 1
0
3 y L C D X . 1 0
5 y
L C D X . 1 0
S w a p t i o n J u n - 1 0
I G . 1 4 R e f = 8 9 . 5
10%
30%
50%
70%
90%
110%
130%
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
Realized Volatility
Implied Volatility
49%
50%
51%
52%
53%
54%
55%
80% 90% 100% 110% 120%Normalized Strikes
22-Apr
15-Apr
25-Mar
40%
42%
44%
46%
48%
50%
52%
54%
56%
0 1 2 3 4 5 6 7Months to Maturity
22-Apr
15-Apr25-Mar
Note: W/w changes constitute the difference in market closing levels between April 15 and April 22, 2010. M/m changes constitute the difference in levels betweenMarch 25, and April 22, 2010. Calculations ignore carry and defaults. Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 26
ANALYST RATING CHANGES
Last four weeks
HG/HY Sector Issuer From To Date Changed
HG European Utilities Thames Water Utilities Underweight Market Weight 4/22/2010HG TMT Time Warner Cable Overweight Market Weight 4/19/2010
HY Gaming MGM Mirage (unsecured notes)
Overweight Market Weight 4/19/2010
HG TMT Bertelsmann Market Weight Overweight 4/9/2010
HG Technology Oracle Corp Overweight Market Weight 3/26/2010
HG European Basic Industries Evonik Industries Initiating Coverage Overweight 3/25/2010
HG Energy, Pipelines & Basics Chemicals Metals & Mining Oil Field Services Eastman Chemical
Market Weight
Overweight
Overweight
Overweight
Underweight
Market Weight
Market Weight
Market Weight
3/23/2010
3/23/2010
3/23/2010
3/23/2010
HY Industrials CNH 7.75% Notes Market Weight Overweight 3/22/2010
HG European Utilities Enel SpA $US Paper Market Weight Overweight 3/22/2010
Source: Barclays Capital
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Barclays Capital | U.S. Credit Alpha
23 April 2010 27
U.S. CREDIT STRATEGY
Global
Ashish Shah
+1 212 412 7931
Investment Grade
Jeff Meli
+1 212 412 2127
Shobhit Gupta
+1 212 412 2056
Hari Manappattil
+1 212 412 7922
Alex Gennis
+1 212 412 1370
Matthew Mish, CFA
+1 212 412 2183
Praveen Korapaty
+1 212 526 0680
High Yield & Leveraged Loan
Bradley Rogoff, CFA [email protected]
+1 212 412 7921
Michael Anderson, CFA [email protected]
+1 212 412 7936
Gautam Kakodkar [email protected]
+1 212 412 7937
Eric Gross [email protected]
+1 212 412 7997
Structured Credit & Volatility
Batur Bicer
+1 212 412 3697
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Analyst Certification(s) We, Ashish Shah, Jeffrey Meli, Bradley Rogoff, Michael H Anderson, Matthew Mish, Alex Gennis, Eric Gross, Shobhit Gupta, Batur Bicer, Hari Manappattil,
Gautam Kakodkar, Yana Bouchkanets and Joanie Genirs, hereby certify (1) that the views expressed in this research report accurately reflect our personalviews about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly orindirectly related to the specific recommendations or views expressed in this research report.
Important Disclosures For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays CapitalResearch Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgi-bin/all/disclosuresSearch.pl or call 212-526-1072.Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capitalmay have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/oran affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debtsecurities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and /or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permittedand subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel todetermine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including,but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the
profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potentialinterest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing informationwas obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads arehistorical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document.Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis,and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of researchproducts, whether as a result of differing time horizons, methodologies, or otherwise.
Company-specific DisclosuresBarclays Capital is acting as financial advisor to CenturyTel Inc. (CTL) in the potential acquisition of Qwest Communications International Inc. (Q).
The rating on Qwest Communications has been temporarily suspended due to Barclays Capital's role. The estimates in this report do not incorporate
this potential transaction. Barclays Capital is acting as financial advisor to The Geo Group (GEO) in the potential acquisition of Cornell CompaniesInc. (CRN). The rating and price target on The Geo Group have been temporarily suspended due to Barclays Capital's role. The estimates in this report
do not incorporate this potential transaction.
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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.S. Credit Index orPan-European 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.S. Credit
Index or Pan-European Credit Index, as applicable.Underweight: Expected six-month excess return of the sector is below the six-month expected excess return of the Barclays Capital U.S. Credit Index orPan-European Credit Index, as applicable.
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-eligiblecorporate debt securities to the Barclays Capital U.S. Credit Index, the Pan-European Credit Index or the EM Asia USD High Grade Credit Index, asapplicable.Overweight: The analyst expects the issuer's index-eligible corporate bonds to provide positive excess returns relative to the Barclays Capital U.S. CreditIndex, the Pan-European Credit Index, or the EM Asia USD High Grade Credit Index over the next six months.
Market Weight: The analyst expects the issuer's index-eligible corporate bonds to provide excess returns in line with the Barclays Capital U.S. Credit Index,the Pan-European Credit Index, or the EM Asia USD High Grade Credit Index over the next six months.
Underweight: The analyst expects the issuer's index-eligible corporate bonds to provide negative excess returns relative to the Barclays Capital U.S. CreditIndex, the Pan-European Credit Index, or the EM Asia USD High Grade Credit Index over the next six months.
Not Rated (NR): An issuer which has not been assigned a formal rating.
Rating Suspended (RS): The rating has been suspended temporarily due to market events that make coverage impracticable or to comply with applicableregulations and/or firm policies in certain circumstances including where Barclays Capital is acting in an advisory capacity in a merger or strategictransaction involving the company.For Japan and Australia issuers, the ratings are relative to the Barclays Capital U.S. Credit Index or Pan-European Credit Index, as applicable.
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.S. High Yield 2% IssuerCapped Credit Index, or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, 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.S. High Yield 2%Issuer Capped Credit Index or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, as applicable.
Underweight: Expected six-month total return of the sector is below the six-month expected total return of the Barclays Capital U.S. High Yield 2% IssuerCapped Credit Index or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, as applicable.
Explanation of the High Yield Research Rating System The High Yield Research team employs a relative return based rating system that, depending on the company under analysis, may be applied to eithersome or all of the company's debt securities, bank loans, or other instruments. Please review the latest report on a company to ascertain the application of
the rating system to that company.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 theBarclays Capital U.S. 2% Issuer Capped High Yield Credit Index, the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, or theEM Asia USD High Yield Corporate Credit Index, as applicable.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 totalreturn of the Barclays Capital U.S. 2% Issuer Capped High Yield Credit Index, the Pan-European High Yield 3% Issuer Capped Credit Index excludingFinancials, or the EM Asia USD High Yield Corporate Credit Index, as applicable.
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.S. 2% Issuer Capped High Yield Credit Index, the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, orthe EM Asia USD High Yield Corporate Credit Index, as applicable.
Not Rated (NR): An issuer which has not been assigned a formal rating.Rating Suspended (RS): The rating has been suspended temporarily due to market events that make coverage impracticable or to comply with applicableregulations and/or firm policies in certain circumstances including where Barclays Capital is acting in an advisory capacity in a merger or strategictransaction involving the company.
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