U.S. CREDIT ALPHA：Not Time to Get Naked Short Credit

CREDIT RESEARCH U.S. Credit Alpha | 21 May 2010 PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 27 U.S. CREDIT ALPHA Not Time to Get Naked Short Credit Overview ..................................................................................................................................... 2 All roads have led to the euro recently, as markets were highly correlated during most of the down trade. Regulation and financial reform served as a destabilizing factor at a time when capital markets needed government support. With fundamentals still strong and balance sheets much improved for industrial companies, we still see value in credit, and outside of a very near-term trade, we would look to other asset classes for outright shorts. Focus: Loans versus Bonds Relative Value ........................................................................... 6 Loan technicals remain decidedly positive, and we view any sell-off in the leveraged loan market as a buying opportunity. We believe that loans offer better risk-adjusted value than bonds and will receive an additional boost in a rising rate environment. Although we remain constructive on credit valuations, some investors may prefer to move up in the capital structure as a way to avoid significant volatility. Investment Grade: Can’t Take My Eyes Off of Europe...................................................... 13 Although our base case over the long term remains constructive on investment grade credit, given the improving macroeconomic and fundamental environment in the U.S., we expect the de-risking trade to continue to weigh on spreads in the short term. High Yield: Private Equity and Strategic M&A Face Off.................................................... 17 Private equity and strategic M&A activity was brisk this week, which we believe signals confidence in the resilience of the high yield recovery and, in the case of the leveraging transactions, in the primary market’s ability to provide significant levels of financing. Leveraged Loans: Choppy Waters Reach the Loan Shoreline ......................................... 20 With only one week left in May, leveraged loans have a steep hill to climb if the asset class is to extend its 16-month streak of positive total returns. The slowdown in high yield bond issuance has important implications for leveraged loans as relative value shifts to high-coupon, near-par loans from discounted loans that will no longer benefit from issuers’ tapping bond investors to repay loans. Structured Credit and Volatility: Negatively Skewed Strangle Hedged by a Receiver .......................................................... 22 We recommend that investors sell a 130-180 Sep expiry IG.14 skewed strangle and hedge the downside risk of a potential rally by buying a 90 receiver. The trade provides an attractive payoff profile for investors who are bearish to mid-September but do not want to be exposed to the risk of spread tightening in the next four months. Jeffrey Meli +1 212 412 2127 jeff.meli@barcap.com Bradley Rogoff, CFA +1 212 412 7921 bradley.rogoff@barcap.com Michael Anderson, CFA +1 212 412 7936 michael.anderson@barcap.com www.barcap.com Barclays Capital | U.S. Credit Alpha 21 May 2010 2 OVERVIEW Not Time to Get Naked Short Credit All roads have led to the euro recently, as markets were highly correlated during most of the down trade. Regulation and financial reform served as a destabilizing factor at a time when capital markets needed government support. As a result, liquidity has become scarce across a number of markets, including most prominently the interbank funding market. Clearly, a week like this one does not cause us to change our stance that volatility will remain elevated. The sell-off appears to have more legs, as there are few potential positive catalysts on the horizon. Therefore, we would concentrate on staying nimble by keeping positioning light and waiting until funding and currency markets stabilize before substantially adding to risk (even if this means missing the bottom). With fundamentals still strong and balance sheets much improved for industrial companies, we still see value in credit, and outside of a very near-term trade, we would look to other asset classes for outright shorts. There are a number of reasons we expect the sell-off to persist in the short term. From a technical standpoint, fund flows are likely to remain negative for riskier asset classes. Mutual funds entered this down trade with modest cash balances. While most managers would like to add at these more attractive valuations, they may, in fact, be forced to sell more liquid securities to raise cash. With dealers attempting to maintain light invent