U.S. CREDIT ALPHA：Keep On Keeping On

CREDIT RESEARCH U.S. Credit Alpha | 9 July 2010 PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 22 U.S. CREDIT ALPHA Keep On Keeping On Overview ..................................................................................................................................... 2 After selling off for nearly a month, risky assets performed well this week, with the S&P500 up more than 4.5% by close of business on Thursday. One driver of the bounce was news that the European bank stress tests will include losses on certain sovereign exposures, which gave investors confidence about the credibility of the tests. As earnings season approaches, we think corporate fundamentals will be the other key driver of performance over the next month. Investment Grade: Falling Betas Ahead................................................................................. 6 Despite recent sharp swings in equities and fairly stable credit performance, we find that, in general, the beta between equity and credit has been stable over the past year, staying in the 5-15% range and increasing only slightly during the most recent sell-off. As systemic concerns about European sovereign risks and financial reform in the U.S. wane, we expect the relationship between credit and equity returns to weaken further and the beta between the two asset classes to return to its low, pre-crisis levels. Hybrid Capital: ... They All Fall Down.................................................................................... 9 Moody's revisions to its hybrid toolkit are generally in line with changes proposed earlier. However, one key difference between the proposed and actual revisions is that cumulative subordinated securities will not receive additional equity credit for mandatory deferral triggers. Consequently, many life insurer hybrids may lose 50% equity credit, strengthening the case for liability management trades for these securities. High Yield: Better, but No Fireworks Yet ............................................................................. 13 High yield made up some lost ground as jobs data were generally positive and equities rallied. Issuer-specific news was broadly positive, although June comp-store sales were mixed. Leveraged Loans & CLOs: Loans Languish on Lower LIBOR ........................................... 17 Relative to high yield, loans began 2010 by outperforming when the market retreated and at least keeping pace during rallies. Recent performance has been spotty, although much of the underperformance has been induced by the curve. We attribute this reversal of fortune to sagging intermediate LIBOR rates. Low rates are the main reason we believe high yield will outperform loans in 2010. 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 9 July 2010 2 OVERVIEW Keep On Keeping On After selling off for nearly a month, risky assets performed well this week. The S&P500 was up more than 4.5% by close of business on Thursday – the first three-day rally since mid-April. Credit was also broadly better, particularly in CDS. The IG.14 index was 8bp tighter than last week’s close, and the HY.14 was more than 2pts higher. Cash lagged, with the U.S. Credit Index just 3bp tighter – partly because the cash index typically lags sharp moves and partly because cash had outperformed over the past few weeks and so had less room to snap back. Similarly, the relative move in equities and CDS was akin to the sell-off, with equities more volatile during the sell-off and this week on the way back up. The news flow on the macro side was relatively light this week. Jobless claims came in slightly better than expected, and the ISM composite was slightly worse than expected. Overall, the limited data releases allowed market participants to shift their focus away from concerns about a double dip. One driver of the bounce this week was news that the European bank stress tests will include losses on certain sovereign exposures – news reports cited 17% for Greek debt and 3% for Spanish debt as two examples.1 These levels are roughly consistent with the prices of these countries’ bonds. Although less severe than many market participants would like, the fact that sovereign losses are likely to be included at all adds credibility to the process and was well received by the market. The results of the stress tests are to be reported to the ECB on July 15 and released publicly on July