U.S. CREDIT ALPHA：The Waiting Is the Hardest Part

CREDIT RESEARCH U.S. Credit Alpha | 23 July 2010 PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 28 U.S. CREDIT ALPHA The Waiting Is the Hardest Part Overview ..................................................................................................................................... 2 We are not changing our constructive view on credit despite the softer outlook, but we would prefer to reduce long positions ahead of the seasonal summer slowdown. Market uncertainty is high, and liquidity will be important over the next month because news flow may not slow in conjunction with trading volumes. Nonetheless, the macro backdrop is still supportive for credit valuations. Focus: Implications of Financial Reform for Corporate Credit ......................................... 4 The Dodd-Frank Wall Street Reform and Consumer Protection Act has sparked intense focus on how the banking industry might be reshaped. The upcoming rule-writing process will determine much of the implications for credit trading and valuations, but we draw initial conclusions for CDS (basis and curves), trust preferreds, and CLO issuance (risk retention). Investment Grade: Trading Basis.......................................................................................... 11 After tightening for most of 2009 and reaching its tights for 2010 in early May, the cash-CDS basis for non-financial corporates has become more negative for the past two months. We highlight several bonds with substantial negative bases that, in our view, have room to normalize as overall spreads tighten. Hybrid Capital: Revisiting Yankee Bank Hybrids ............................................................... 14 Yankee hybrids have substantially underperformed senior debt since mid-April, resulting in 140bp of widening in the senior-hybrid basis. As a result many securities now appear cheap relative to senior debt. We highlight ACAFP 8.375s, BNP 7.195s, and RABOBK 11s – all of which trade at more than 3x senior spread – as attractive. High Yield: Debt Exchanges Strike Back.............................................................................. 18 While the volume of high yield debt exchanges remains a long way from its latest peak in late 2008 and early 2009, the recently announced Radio One, TXU, and Compton Petroleum transactions mark a slight uptick and offer potential for deleveraging. Leveraged Loans & CLOs: Tuning the CLO Machine ........................................................ 22 Issuance continues to sprout in both the middle market and traditional large corporate CLO space. In addition, CLOs continue to take advantage of undervalued CLO liabilities, having bought $900mn of CLO tranches since 2009. Options & Tranches: Taking the “Stress” Out of the Tests.............................................. 25 Investors looking to trade around stress tests results should consider pairing a ratio receiver spread in Main with a ratio payer spread in IG. We believe this trade provides an attractive payoff profile with net upfront income and would generate a profit if the two indices trade within a fairly wide range at expiry. 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 23 July 2010 2 OVERVIEW The Waiting Is the Hardest Part Many European leaders have been impatient when it comes to waiting for the scheduled Friday noon EST release of the CEBS stress tests. This week, we’ve heard comments from Greece (one failed and five passed, Dow Jones, July 22), Ireland (Bank of Ireland and Allied Irish passed, Bloomberg, July 22), Spain (all passed, El Pais, July 20), Germany (Hypo Real Estate failed, Bloomberg, July 19), Italy (all passed, Il Messaggero, July 22), etc. At this point, we will not draw conclusions from these headlines but instead focus on what we expect from the results. First, we hope to gain comfort with the test’s transparency and credibility. Although market sentiment has shifted a bit on these points, the current view of the test’s effectiveness appears relatively balanced. Obviously, too many banks passing would not be an ideal outcome. Second, we look for recapitalization plans (and a source of backstopped equity) for failing banks. Economic conditions remain uncertain, but we received some clarity from Fed Chairman Bernanke during his semi-annual Congressional testimony. His comments were mostly consistent with recent FOMC minutes. He stated that the recovery is still under way but recent data point to