Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 31
Barclays Capital | U.S. Credit Alpha
OVERVIEW
Fatter Tails
Jeffrey Meli Risky assets took a hit this week as concerns about macroeconomic fundamentals
+1 212 412 2127 continued to mount. As of midday on Thursday, IG14 was 7bp wider on the week, trading
jeff.meli@barcap.com just above 111bp. HY14 was down about 1.25pt since last Friday, trading around 97. As
expected in a week with sharp moves, the cash indices outperformed the weakness in CDS.
Bradley Rogoff, CFA The U.S. Credit Index was 3bp wider, although we expect it to catch up over the next few
+1 212 412 7921 trading sessions. Equities were similarly weak. The S&P500 has dropped 3.4% since last
bradley.rogoff@barcap.com Friday. Although the day-to-day correlations between stocks and CDS were choppy
(equities outperformed early in the week and then underperformed on Wednesday and
Thursday following the Fed announcement), the weekly moves are in line with the
relationship we have seen over the past several months. With a beta of 10%, a 7bp move in
the IG14 index should correspond to a 3.2% drop in stocks, meaning that on a week-to-
week basis the relationship between the two markets has been stable for some time.
Obviously, the major event in the market this week was the announcement by the Federal
Reserve that it will reinvest the proceeds from prepayments of its mortgage portfolio in 2-10y
Treasuries. Originally, the Fed planned to allow the portfolio to run down. Importantly, this
does not represent new stimulus, but rather maintains a neutral stance whereby existing
stimulus will not be withdrawn. Although the initial reaction was positive, with the stock
market reversing some of its early losses on Tuesday, the markets clearly faded later in the
week. The higher-than-expected jobless claims number on Thursday morning further
exacerbated macroeconomic concerns – claims climbed to their highest level in five months.
There are several positive takeaways from the Fed announcement. First, it shows that the
central bank is willing to adjust policy further in response to macro developments, which
should be reassuring for investors who believe the economy will continue to deteriorate.
Second, regarding credit in particular, this announcement is likely to keep Treasury rates
and, thus, all-in yields across fixed income at lower levels. Indeed, rates were lower in
13 August 2010 2
Barclays Capital | U.S. Credit Alpha
response to the news. So long as growth remains somewhat positive, even if at low levels,
and corporate fundamentals thus remain strong, we believe this would create a positive
technical backdrop for spread product in general and credit in particular. We expect that
this is true as far down the credit spectrum as BBs – the fundamentals of lower rated credits
could suffer if growth slows markedly for an extended period.
These are longer-term issues, and they underpin our more constructive medium-term base
case regarding the higher-rated parts of the market. However, the Fed announcement also
highlights how much the recovery has faded and signals that policy makers believe that the
steps taken to date (such as 0% interest rates) are not working as expected and that
additional measures may be needed. We interpret the sell-off this week as indicative of
widespread acceptance that the recovery has stalled somewhat; indeed, several forecasters,
including Barclays Capital, have revised downward their predictions for 3Q growth.
Given the tight levels of many non-financial sectors compared with pre-crisis tights, we
believe there are opportunities to create tail risk hedges against the possibility that growth
will slow enough to have a meaningful effect on credit. In the Investment Grade section, we
discuss specific cyclical sectors and single-name credits that are trading at relatively tight
spreads and continue to exhibit high betas versus the rest of the market. In the Tranches
and Options section, we compare several hedging strategies using index products.
Finally, despite the poor performance this week, the new issue market remained robust in
both investment grade and high yield (Figure 2). More than $13bn of investment grade debt
priced through Wednesday, resulting in over $45bn in issuance month-to-date. This was
the largest week on record for high yield, with more than $12bn of supply, not including the
$3.9bn from ILFC (which is a 5B credit). Most of the high yield issuance has been BB and B.
We examine high yield supply in more detail in this week’s focus article. New issues have
outperformed the U.S. High Yield Very Liquid Index by a par-weighted average of 1.57% so
far in 2010. Slightly more than half of this outperformance occurs on the first day of post-
break trading. However, performance dynamics have not been uniformly distributed, as BB
and B rated new issues have outperformed their respective quality benchmarks significantly,
while CCC and lower rated issues have underperformed on average. New issue concessions
have generally been 25-50bp. We encourage investors to consider any new issue that offers
a yield concession at the upper end of this range as a potential source of significant
outperformance.
13 August 2010 3
Barclays Capital | U.S. Credit Alpha
FOCUS
In several important ways, the new issue market has continued to follow trends that were
established in 2009, including the following:
After many years of supporting the credit-fueled M&A and LBO boom, the primary
market has turned overwhelmingly toward refinancing as the primary use of proceeds.
Bonds issued to repay outstanding debt have accounted for 61.2% of all issuance year-
to-date, compared with 17.7% for strategic use and 16.7% for general corporate
purposes (Figure 3). While in recent weeks there has been an uptick in bond deals used
to fund shareholder distributions, such deals account for only 3.6% of 2010 issuance
thus far.
Figure 1: U.S. High Yield Very Liquid Index YTD Total Return Figure 2: 2010 U.S. High Yield Gross Issuance
8.0% 12.0
6.0% 10.0
4.0% 8.0
2.0% 6.0
0.0% 4.0
-2.0% 2.0
-4.0% 0.0
4-Jan 16-Feb 31-Mar 13-May 25-Jun 7-Aug 8-Jan 19-Feb 2-Apr 14-May 25-Jun 6-Aug
13 August 2010 4
Barclays Capital | U.S. Credit Alpha
After having comprised no more than 19.7% of high yield issuance in any year for the
past two decades, secured bonds shot up to 39.7% of the total in 2009. That trend has
persisted in 2010, as secured debt represents 32.1% of high yield issuance thus far.
Much of the increase in secured debt as a percentage of the total can be traced to the
loan market. After accounting for less than a third of the leveraged loan refinancing
market during the last few years of the credit boom, the high yield market absorbed
substantially all loan refinancings in 2009 and has accounted for nearly two-thirds in
2010 (Figure 4). Roughly half of all bonds issued to take out loans in 2009 and 2010
have been secured. As a result, secured debt now represents 22% of all high yield debt
outstanding, after averaging around 10% of the outstanding total from 2005 to 2008.
Not surprisingly, the proportion of the new issue market rated CCC or lower
declined as a result of the financial crisis, from a peak of 25.2% in 2007 to 10.2% in
2009. That figure has rebounded slightly, to 13.0%, thus far in 2010. Importantly,
the trough for this cycle (so far) is nowhere near the lows reached in 2001 and
2002, when barely more than 3% of all high yield issuance carried a CCC rating.
Early July brought a period of relative strength in the high yield secondary market, seemingly
whetting investor appetite for new issuance. However, most issuers remained on the
sidelines as earnings season approached and yields remained above the April lows. The
resulting supply/demand imbalance led to a period of outstanding deal performance, with
numerous upsized issues and strong post-break trading. The price mechanism ensures that
such imbalances do not last long in the marketplace, and as we have been expecting for
several weeks, issuers are now stepping forward in droves, despite what would normally be
a seasonally quiet period in August. With a robust deal calendar that only seems to grow
larger by the day, this is an opportune time to examine what set of factors best explains new
issue performance in 2010.
Figure 3: Annual High Yield Issuance by Use of Proceeds Figure 4: Sources of Loan Refinancing
Note: Refinancing includes bond and loan takeouts funded by high yield Sources: S&P LCD, Barclays Capital
issuance. Source: Barclays Capital Leveraged Finance Syndicate
13 August 2010 5
Barclays Capital | U.S. Credit Alpha
For example, Goodyear Tire & Rubber recently placed $900mn of 8.25% senior notes due in
2020. The issue priced at 99.163 for an 8.375% YTW, despite an existing issue of the same
maturity with weaker covenants trading at a yield of 7.56%. With a duration of about 7, the
new issue concession of ~80bp should lead to substantial outperformance over time.
Fund flows into or out of high yield mutual funds immediately prior to issuance.
Credit rating.
Use of proceeds.
1
We use the VLI as a proxy for market performance, because new issues are very liquid and tend to trade actively in the
months immediately following issuance. The VLI is therefore a better benchmark than the full U.S. High Yield Index.
13 August 2010 6
Barclays Capital | U.S. Credit Alpha
It is no surprise that new issues tend to perform better in absolute terms on Day 1 if they are
fortunate enough to catch the market on a strong day. What is less immediately intuitive is
that they have outperformed strong markets to a greater extent than new issues that come
to market on weak trading days. As Figure 6 demonstrates, bonds issued on strong or very
strong days have outperformed their respective quality indices by more than 1% on the first
day of trading. Bonds issued into weak and very weak markets have still outperformed on
Day 1, but to a significantly lesser degree. 2
Several other factors appear to moderately influence first day relative performance,
although in many cases the relationship is less systematic or consistent. High yield mutual
fund flows appear to have little influence, except when the most recent weekly outflow has
been greater than $250mn. Drive-by offerings have tended to have weaker first day
performance than road shows, which is unsurprising given the divergent nature of the
marketing and pricing surrounding these deal types. Finally, issuers offering a significant
OID, in the 96/97 range, have generally had their deals trade up significantly on the break,
implying perhaps a bit too much value left on the table. Sample size is relatively small at
2
For the purpose of this analysis, we define very strong secondary markets as having a daily total return of greater
than 0.25%, strong markets as having a return of 0-0.25%, weak markets as those with a return between -0.25% and
0%, and very weak markets as those with a daily total return lower than -0.25%.
13 August 2010 7
Barclays Capital | U.S. Credit Alpha
these discount levels, however, so the result may reflect idiosyncratic, rather than
systematic, issues. See Figure 13 in the Technical Appendix for a full data table, including
Day 1 absolute and relative performance across all factors.
Total high yield supply brought to market during the week of issuance.
Our baseline clearly demonstrates that secondary market strength, as reflected in the Day 1
VLI Index total return, is a statistically significant driver of new issue trading performance on
the issue date. The t-stat on the slope coefficient in the regression in Figure 7 is 4.23.
Figure 7: New Issue Day 1 Absolute Performance vs. VLI Index Daily Total Return
7%
6% y = 1.1059x + 0.0081
5% R^2 = 0.0708
4%
3%
2%
1%
0%
-1%
-2%
-3%
-1.5% -1.0% -0.5% 0.0% 0.5% 1.0%
Adding high yield mutual fund flows and total supply as additional independent variables,
either alone or in combination, does not add significant explanatory power to the regression
results. In fact, as Figure 8 demonstrates, adding these variables actually reduces the
adjusted R-squared, and none of the added coefficients is significant beyond an 80%
confidence level in any of the regression results. We therefore conclude that the effects of
constrained supply or strong mutual fund inflows are already reflected in secondary market
performance and do not need to be considered separately as performance drivers.
13 August 2010 8
Barclays Capital | U.S. Credit Alpha
Figure 8. Multivariate Regressions Using Day 1 VLI, Supply, and Fund Flows
Day 1 VLI and Supply Day 1 VLI and Fund Flows Day 1 VLI, Supply, and Fund Flows
Day 1 VLI Supply Intercept Day 1 VLI Flows Intercept Day 1 VLI Supply Flows Intercept
Coeff 1.086 0.000 0.007 1.046 0.000 0.008 1.044 0.000 0.000 0.007
Std Err 0.263 0.000 0.002 0.265 0.000 0.001 0.266 0.000 0.000 0.002
T-stat 4.132 0.761 3.375 3.947 1.285 8.185 3.930 0.251 1.062 3.506
P-Value 0.000 0.448 0.001 0.000 0.200 0.000 0.000 0.802 0.289 0.001
Adj R^2 0.065 0.069 0.066
Source: Barclays Capital
13 August 2010 9
Barclays Capital | U.S. Credit Alpha
Several other deal-specific factors have also played important roles in determining 2010
year-to-date new issue performance. Bonds with maturities of 8 years or more have
outperformed those with shorter durations, relative to both the VLI and the quality indices.
Unsecured new issues have outperformed new secured debt. Investors have generally been
inclined to hold less duration and wanted greater asset coverage, so issuers have had to
offer higher yields on longer duration and unsecured debt. As spreads have tightened over
the course of the year, investors holding longer maturity, unsecured new issues have
realized greater returns.
A final factor that appears to have influenced new issue relative performance is the issuer’s
seasoning in terms of prior access to the high yield debt market. As a group, bonds from first-
time issuers have somewhat surprisingly underperformed the VLI and the quality indices.
Investors typically demand that first-time issuers offer a higher initial yield to compensate for
their unfamiliarity. In a favorable credit environment such as the one thus far in 2010, one
might expect this initial discount to lead to subsequent strong performance. However, the
record of first-time issuers in 2010 is decidedly mixed. The median first-time issuer has
outperformed the VLI by 1.82% and the quality indices by 1.81%. However, mean relative
performance is strongly influenced by the presence of significant downside outliers. On a par-
weighted average basis, first-time issuers have been essentially flat relative to the VLI and
beaten the quality indices by only 0.56% year-to-date. Those that have encountered difficulty
in 2010 include ATP Oil & Gas, Nationstar Mortgage, Sitel, RadNet, and especially Sorenson
Communications, which trades at $47-49 after having issued at 98.10 in mid-January. As was
the case with CCC credits, the downside skew for first-time issuers underscores the critical
nature of individual credit selection for this group.
13 August 2010 10
Barclays Capital | U.S. Credit Alpha
4.4bp in any individual month). Investors who seek to use new issues as a source of short-
term outperformance will therefore need to overweight new bonds in their portfolio
substantially in order to achieve a meaningful boost relative to index performance.
Lack of new issue inclusion is only one of several factors that may cause reported index
performance to deviate from underlying market fundamentals. For example, when new issues
enter the index at the beginning of the following month, they are initially marked at the ask
side, to reflect the fact that the primary market is essentially one-sided. Subsequent marks are
at the bid side, creating another relative drag on index performance. However, these issuance-
related performance drags are offset by the handling of transaction costs and the month-end
sweep of cash balances, both of which modestly raise index performance relative to what a
real-world investor is likely to achieve, given the same credit exposures. These effects tend to
offset each other, making index performance a good representation of the overall market even
as it fails to capture post-break new issue gains. The salient point is that investors can
reasonably expect new issues to be a consistent source of short-term modest
outperformance, to the extent that they are inclined and able to participate.
13 August 2010 11
Barclays Capital | U.S. Credit Alpha
Please see Figure 14 for a full table of 2009 new issue relative and absolute performance
by category.
13 August 2010 12
Barclays Capital | U.S. Credit Alpha
Technical Appendix
13 August 2010 13
Barclays Capital | U.S. Credit Alpha
13 August 2010 14
Barclays Capital | U.S. Credit Alpha
Calculating relative performance across each dimension in the master data charts is a two-
step process. First, we compare individual issue returns with the relevant benchmark return
from the date of issuance to the present (or to year-end for 2009 issuance), to get the issue-
specific relative performance. We then group issues by category and calculate the par-
weighted average of the issue-specific relative performance values. For example, consider
the following hypothetical case in which only four bonds have been issued in 2010, and
index returns have been as follows:
VLI 6% 4%
BB 7% 5%
B 5% 3%
In this example, the two BB credits have outperformed the VLI by a par-weighted average of
1.33%, but have outperformed their quality index by only 0.33%. The two B credits have
barely outperformed the VLI, by a par-weighted average of 0.33%, but have solidly
outperformed their quality index by 1.33%. Secured bonds have outperformed the VLI by
1%, while unsecured bonds have outperformed the VLI by 0.4%.
The performance calculation of secured and unsecured bonds relative to the quality indices
merits some explanation, as this measure forms the basis of much of our analysis in this
piece. The two unsecured bonds in this hypothetical example have outperformed their
respective quality indices by a par-weighted average of 1%. Indeed, each has individually
outperformed its quality index by exactly this amount since issuance, despite the fact that
the bonds are being compared with different quality indices (one against the BB Index, the
other against the B Index) and across different periods (one was issued in January, the other
in April). Our relative return metrics are not time-weighted; rather, they strictly compare
year-to-date returns since issuance. Extending this methodology to the secured bonds in
our hypothetical example, we see that they have also outperformed their respective quality
indices by a par-weighted average of 1% (individually by 0% and 2%, with equal weighting
due to the identical par amounts).
13 August 2010 15
Barclays Capital | U.S. Credit Alpha
INVESTMENT GRADE
16-Week Beta
3
The “defensiveness indicator” in the 2009 U.S. Credit Outlook is calculated using historical sector correlations with
quarterly U.S. real GDP growth and the sector’s standard deviation of returns.
13 August 2010 16
Barclays Capital | U.S. Credit Alpha
to historical levels is tighter than the average among all non-financial sectors. Sectors
whose spreads relative to historical levels are wider than their peer group are classified as
“wide.” We also calculate a 16-week rolling beta for each sector versus the non-financial
component of the U.S. Corporate Index and show how the beta of each sector has
changed from April 2007 to today. Sectors with higher betas are more likely to
underperform during periods of growth concerns. Cyclical sectors that have become
higher beta and are trading toward their historical tights are attractive short candidates
for investors who are concerned about future growth prospects, in our view.
Sectors with rich valuations are more compelling candidates because of their asymmetric
risk profiles. Figure 2 highlights several of the more-cyclical, tighter-spread sectors and
shows that they have substantial room to widen if the aforementioned tail risks materialize,
while their potential tightening is limited, based on their historical trading ranges. For
example, the technology and transportation services sectors are only 36bp and 32bp away
from their pre-crisis tights, respectively.
Several of the more-cyclical sectors in our list have changed fundamentally since we ranked
their cyclical/defensive nature at the end of 2008. For example, we do not consider the wireline
sector an attractive cyclical short despite its higher beta. AT&T and Verizon, which comprise a
substantial part of the sector, have deleveraged and now have substantial balance sheet
flexibility to withstand an economic downturn. However, we note that event risk remains an
issue for some of the credits in the sector and may account for its somewhat wide spreads.
900
800
700
600
500
400
300
200
100
0
Tech Transport Services Pipelines Metals
Source: Barclays Capital
13 August 2010 17
Barclays Capital | U.S. Credit Alpha
We also do not consider the retail sector to be a compelling cyclical short, despite its tight
spreads. Since 2007 retailers have repaired their balance sheets and reduced leverage.
The sector’s beta has also nearly halved during the period, in large part because some of
the more cyclical names, such as JC Penney and Macy’s, have been downgraded to high
yield and dropped out of the investment grade index. 4 In fact, several of the large
retailers, such as Costco and Wal-Mart, are actually counter-cyclical plays that can benefit
from consumers’ trading down during times of economic weakness. From the standpoint
of selecting cyclical shorts, high yield retailers may have higher sensitivity to macro
developments than the credits that remain in the investment grade retail index.
Furthermore, the wide trading levels of several of the sectors in our list have reduced their
attractiveness as cyclical shorts. Analyst Harry Mateer has recently upgraded the oil field
services sector to Overweight, in part as a result of substantial widening on the back of
the Macondo well incident, which he views as overdone (please see Sector
Recommendations: Energy, Pipelines, and Basic Industries, August 11, 2010, for details).
Investors who are concerned about a double-dip tail risk can implement low-cost shorts by
buying the CDS of select tighter-trading names in more-cyclical sectors. Figure 3 highlights
credits with CDS trading at or near its tights for the year that our analysts are Underweight
or Market Weight. We believe that these names are at risk of underperforming in case of a
protracted growth slowdown. Furthermore, the risk-reward in these names is attractive, in
our view, given that most of these companies have tight CDS spread levels and are trading
toward this year’s tights. We also include credits from sectors that we did not highlight
above but that we view as particularly exposed to renewed macroeconomic pressures, such
as Temple-Inland and CBS.
In addition to potential cyclical shorts, we highlight several more-defensive sectors for more
bullish investors looking for a lower-beta long to leverage the economic recovery (Figure 4).
This list is also ranked in the order of our defensiveness indicator, with the most defensive
4
In addition, the performance of the retail sector is highly seasonal. Spreads tend to lag in the fall ahead of anticipation
of holiday shopping results but typically recover after the winter holidays once concerns about holiday shopping
trends fade.
13 August 2010 18
Barclays Capital | U.S. Credit Alpha
sectors at the bottom. Sectors that are particularly attractive, in our view, are home
construction, supermarkets, and consumer products. The beta of the home construction
sectors has almost halved (in large part because several higher-beta names have dropped
down to the high yield index), its companies have reduced leverage and stockpiled cash, yet it
is still among the widest investment grade sectors in the index. While supermarkets and
consumer products are two other more-defensive sectors that are likely to outperform the
market in times of economic weakness, we recommend that more bullish investors approach
potential longs in the sector with caution, given the sector’s limited tightening potential.
13 August 2010 19
Barclays Capital | U.S. Credit Alpha
Govt. bp bp
Guaranteed, 30 20
Industrial,
$14.3, 3%
$156.8,
15 10
28%
NonCorp.,
$164.7, 0 0
30%
-15 -10
Note: All levels on this page as of Wednesday 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
140 50 bp bp
575 -25
130 45
500 -75
120 40
425 -125
110 35
350 -175
100 30
275 -225
90 25
200 -275
80 20 125 -325
70 15 50 -375
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10
CDX.IG 5.0 Mkt (LHS, bp) VIX (RHS, %)
Credit OAS (LHS, bp) Basis (RHS, bp)
Note: A portion of the significant tightening in CDX.IG on March 20, 2009, is Note: Basis defined as CDX.IG spread – corporate Libor OAS.
attributable to the roll from Series 11 to Series 12. Source: Markit, Barclays Capital Source: Barclays Capital
110 20
100 15
90
10
80
5
70
Jan-10 Mar-10 May-10 Jul-10 0
CDX IG OTR Intr CDX IG OTR Mkt J F M A M J J A S O N D J F M A M J J
Source: Barclays Capital Note: S&P had a par downgrade/upgrade ratio of 91.4 in January 2010. Moody’s
ratio was 0.4; however, Moody’s downgraded only three companies and
upgraded seven companies in January 2010. Source: Barclays Capital
13 August 2010 20
Barclays Capital | U.S. Credit Alpha
HIGH YIELD
While the cash market has retreated this week, it has held up remarkably well considering the
Michael Anderson, CFA
record amount of new supply that high yield issuers have priced. Through midday Thursday,
+1 212 412 7936
new issuance stands at $12.9bn, surpassing the previous weekly record of $11.7bn set in late
michael.anderson@barcap.com
March of this year. Issuers, particularly at the higher end of the quality spectrum, have taken
advantage of the lower yield environment and open primary market to come to market, with
Gautam Kakodkar
87% of the issuance coming as an add-on or drive-by. The opportunistic issuance was used
+1 212 412 7937
primarily for refinancing, as companies used 43% of proceeds to repay bank debt and 27% to
gautam.kakodkar@barcap.com
repay bonds. Notable issuers included Chesapeake ($2bn), Ally Financial ($1.75bn), Goodyear
($900mn), Peabody ($650mn), and Rite Aid ($650mn).
Eric Gross
+1 212 412 7997 Second-quarter earnings season is still in full swing, and the reports remain mixed overall.
eric.gross@barcap.com On the positive side, issuers including Sequa, Tyson, Georgia-Pacific, Visant, and Education
Management reported strong quarters, with some beating expectations on both revenues
Michael Kessler and EBITDA. On the other hand, several names reported on the softer side of estimates, but
+1 212 412 3031 the majority came generally in line. While cyclical names seem to have rebounded off their
michael.kessler@barcap.com lows, earnings reports and management teams are sending mixed signals about the pace of
end-market recovery.
The number of issuers still exercising the PIK option on their toggle notes is dwindling. With
the primary market open and significant amounts of liquidity on high yield balance sheets,
issuers appear comfortable with their ability to access capital markets if needed. Earlier this
year, Surgical Care Affiliates, Hawker Beechcraft, Avaya, Momentive, and Freescale elected to
pay cash interest. This week, Clear Channel announced that it will also switch to cash pay,
despite significant 2011-14 maturities. The company will begin making AHYDO payments in
2013, which may have weighed into the decision. Also this week, Intelsat elected to pay its
next interest payment as 50% cash, 50% PIK. While most toggles issued during the 2005-07
bull market allow for the 50/50 option (in addition to 100% PIK and 100% cash pay
Figure 1: Cash and CDS Movers Figure 2: Yield to Worst of the U.S. High Yield Index
13 August 2010 21
Barclays Capital | U.S. Credit Alpha
alternatives), this is the first time an issuer has chosen that route. In addition, the Intelsat PIK
option should be more valuable to the company than for most other issuers, as it expires in
2013, while many other toggle options expire in 2011 or early 2012.
Four notable names remain among those still PIK’ing: First Data, Realogy, Claire’s Stores,
and Univision. History tells us that issuers have used the PIK option to preserve liquidity
when the primary market becomes unreliable. Therefore, unless continued heavy issuance
leads to a spike in risk aversion, we expect more issuers to toggle back to cash pay, even if
economic growth slows.
13 August 2010 22
Barclays Capital | U.S. Credit Alpha
High Yield 2010 – Supply by Sector Top On-the-Run CDX Index Names by Weekly CDS Volume
Others Change –
Industrial
13% Notional Week Ending 8/6/10
18%
Outstanding ($bn) ($mn)
Chemicals
Gross Net Gross
5%
Sprint Nextel 31.7 1.9 653.7
Media Macy's 30.2 2.2 508.8
6% Radian Group 44.2 2.2 439.3
Nat Res
16% First Data 21.3 1.1 414.5
Consumer
7% Starwood Hotels 22.1 1.6 404.9
Lennar 37.0 1.7 324.0
Healthcare Residential Cap. 26.9 1.1 315.3
7% Limited Brands 32.3 1.9 278.8
Financial
Technology Ford Motor Co 25.5 1.6 264.2
11%
Telecom ILFC 38.4 2.9 209.8
8%
9% YTD - $141.7bn
High Yield Average Institutional Trade Volume OTR HYCDX versus U.S. High Yield Index
10 $bn 110 $
9 105
8
100
7
6 95
5 90
4 85
3
80
2
1 75
0 70
Apr-10 May-10 Jun-10 Jul-10 Aug-10 Aug-09 Nov-09 Feb-10 May-10 Aug-10
Daily Volume Rolling 1-Week Average US HY - Price HYCDX - Price
On-the-Run HYCDX Spread Distribution High Yield Index Price Distribution by Par
20 % 40 %
35
16
30
12 25
8 20
15
4
10
0 5
<200
200-300
300-400
400-500
500-600
600-700
700-800
800-900
900-1000
>1000
0
< 70
70-75
75-80
80-85
85-90
90-95
95-100
100-105
105-110
>= 110
13 August 2010 23
Barclays Capital | U.S. Credit Alpha
Take Out
Bradley Rogoff, CFA The loan market was resilient despite the Fed’s revised expectations for a more modest
+1 212 412 7921 pace of economic recovery. Issuers continued to take advantage of the stability in
bradley.rogoff@barcap.com earnings to opportunistically access the primary markets, extend loan maturities, and get
covenant relief. An estimated $30bn of the S&P/LSTA Institutional Loan Index has been
Michael Anderson, CFA repaid through high yield bond proceeds this year, allowing issuers to push out their
+1 212 412 7936 2012-14 maturity walls, which currently amount to $336bn, down from $405bn at year-
michael.anderson@barcap.com end 2009. In our view, even in the absence of primary CLO issuance, higher quality
companies should be able to repay, refinance, and amend and extend their maturities
Gautam Kakodkar within the confines of the loan and bond markets, provided that they remain open to new
+1 212 412 7937 deals and amenable to extensions.
gautam.kakodkar@barcap.com
First Data received approval for an amendment that would allow the issuance of bonds to
repay its loans, the exclusion of any junior lien debt from its senior secured leverage test,
Eric Gross
and the extension of its loan maturities in the future. FDC paid a 10bp amendment fee
+1 212 412 7997
and subsequently issued $500mn in 8.875% first-lien secured notes at 9.125% yield to
eric.gross@barcap.com
repay a portion of its $12.5bn loan burden, a quarter of which is held by CLOs. FDC also
reported strong 2Q10 free cash flow generation despite soft EBITDA. Net total leverage
Mike Kessler
crept up to 11.0x, up from 10.3x at year-end. While the TLBs trade at fair value ($86.5, 8%
+1 212 412 3031
yield to maturity) and are a potential amend-and-extend candidate, in our view, the
Michael.Kessler@barcap.com
concentration of exposure to CLOs could exacerbate economic headwinds. Rite-Aid
announced that it will refinance its $1.175bn 2012 revolver, replacing it with a lower-rate
revolver due 2015 with a springing maturity feature. The company will also opportunistic
take out its 2015 TL4 with $650mn in first-lien bonds due 2020. In addition, RAD is
seeking amendments to provide more flexibility under certain covenants. Toys ‘R’ Us
announced plans to issue $1bn in secured loans and bonds to refinance its Delaware
loans. Other issuers looking to tap the bond market to repay bank debt include DirecTV,
SPX, Tembec, and BMCA. Meanwhile, Pinnacle Foods completed a $400mn 8.25% 7NC3
bond deal priced at par to repay its TLC. This is in conjunction with the newly issued
$442mn (L+425, 1.75% Libor floor) TLD, which broke slightly north of par.
Figure 1: Estimated Institutional Loan Repayments from High Yield Bond Proceeds
$bn
Repayments of Loans from S&P/LSTA Index
10
0
Mar-09
Sep-09
Oct-09
Dec-09
Jun-10
Jul-10
MTD Aug
Apr-09
May-09
Jun-09
Jul-09
Aug-09
Nov-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
13 August 2010 24
Barclays Capital | U.S. Credit Alpha
On the distressed front, Boston Generating’s first-lien loan soared 9pts, to $96, after
Constellation Energy agreed to buy the company's gas fleet in New England. Meanwhile,
taking advantage of the flurry of issuance, Chemtura, Visteon, and AbitibiBowater are
seeking approvals for their reorganization plans, some of which will be accompanied by
loan issuance to exit from bankruptcy.
13 August 2010 25
Barclays Capital | U.S. Credit Alpha
Institutional Loan New Issue Volume LCDX Weekly New Contract Volume (4w Average)
No. of Amt
12 $bn
Leveraged Loan Deals ($mn)
0
14-Aug 23-Oct 1-Jan 12-Mar 22-May 6-Aug
Source: S&P LCD and S&P/LSTA Leveraged Loan Index, Barclays Capital Source: DTCC
1,200 bp 110 $
HYCDX
100
800
95
600
90
400
85
200 80
0 75
Aug-09 Nov-09 Feb-10 May-10 Aug-10 Aug-09 Nov-09 Feb-10 May-10 Aug-10
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
110 $ 40 %
100 30
20
90
10
80
0
<70
70-75
75-80
80-85
85-90
90-95
95-100
>100
70
Aug-09 Nov-09 Feb-10 May-10 Aug-10
HY Loans Index LCDX Current Last Month
13 August 2010 26
Barclays Capital | U.S. Credit Alpha
Junior OC Test Cushions for U.S. and European CLOs CCC Bucket Size for U.S. CLOs
0% 10% 20% 30% 40% 50% 0% 5% 10% 15% 20% 25% 30% 35%
Percent of Deals Percent of Deals
Weighted Average Life (WAL) Test Cushion for U.S. CLOs CLO Arbitrage (Assets Minus Liabilities)
-2 to -1 16%
-1 to 0 14%
0 to 1 12%
10%
1 to 2
8%
2 to 3
6%
3 to 4
4%
4 to 5
2%
5 to 6
0%
0% 5% 10% 15% 20% 25% 30% 35% 40% Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10
Par minus Liability Value as Percent of Par
Percent of Deals
U.S. CLO Spread Performance by Rating (bp) Cash Amount for U.S. and European CLOs in Our Sample
1750 U.S.
Cash ($bn) 1.84 0.15 1.99
1500
Total Par ($bn) 77.72 5.61 83.33
1250
Cash Percent 2.36% 2.70% 2.39%
1000
750 Europe
Cash (€bn) 0.55 0.06 0.61
500
Total Par (€bn) 23.08 3.31 26.39
250
Cash Percent 2.38% 1.74% 2.30%
0
Feb-03 May-04 Aug-05 Nov-06 Feb-08 May-09
Note: All figures are as of July 31, 2010, and based on a sample set of 200 U.S. and 80 European CLO deals in our universe.
Source: Barclays Capital
13 August 2010 27
Barclays Capital | U.S. Credit Alpha
Trade Details
The trade involves two legs: buying $100mn IG9 7y 10-15% tranche protection at 3.50pts
upfront (ref: 135bp) and selling an equal notional of IG9 10y 15-30% tranche protection at -
0.46pts upfront (ref: 143bp). Prices are based on levels on August 11, 2010. The IG9 7y
tranche matures in December 2014, and the 10y tranche matures in December 2017. The
trade requires an upfront payment 3.96pts, and because the 100bp coupons of the two
tranches offset each other, does not have any carry costs until December 2014. The trade
requires an upfront payment of 3.96pts and, because the 100bp coupons of the two
tranches offset each other, has no carry costs until December 2014. After this time, the
trade has a positive carry of 100bp through December 2017 (although we expect it to be
unwound before the first leg matures).
Converting all the coupons into upfront terms, the total cost of the trade is only 1.10pts.
This is less than half the total (upfront + carry) cost of buying 7y 15-30% protection
outright. Figure 1 shows the P&L performance of the trade since September 2007 (inception
of IG9) to present. Figure 2 shows the tranche expected losses (EL) since January this year,
along with the breakevens.
Figure 1: P&L (in $mn) of the Trade since September 2007, Assuming Current Cost Structure
P&L ($ mn)
$25 The trade has performed very
well during periods of macro
$20 stress and spread widening
A loss greater than cost has occurred only
$15 assuming current cost and 2007
conditions. The trade can be unwound
$10 should such normailzation occur
$5
$0
-$5
Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10
13 August 2010 28
Barclays Capital | U.S. Credit Alpha
At current levels, the trade has an annual cost of 27.5bp. To evaluate the cost-effectiveness
of this hedge, we consider some alternatives:
Buy senior protection outright: The total cost of IG9 7y (December 2014) 15-30%
protection is 2.39pts (equivalent annual cost is 60bp) for a maximum payoff of
$11.1mn. That is, it costs more than two times the cost of our trade and produces only a
little more than half of the payoff at the peak. The 10-15% tranche at the same maturity
costs almost 7x the cost of our trade and produces only 1.6x the payoff at the peak.
Buy index protection outright: CDX IG14 5y costs 109bp annually and would have
produced a maximum payoff of around $9.33mn (assuming it reaches widest spread
level on IG9 5y over the past three years). There is also considerable downside risk in
case of a tightening from current levels (as seen earlier this year). However, in the case
of a few defaults, holders of index protection will be able to collect realized losses,
whereas holders of senior tranches will not.
Buy deep out-of-the-money (OTM) payers: Since most options expire within six
months, investors looking for longer-term tail risk hedges will have to roll positions. For
example, buying the 120 Dec IG14 payer costs 69.3bp (ref: 107.75). The annualized cost
is 207.9bp, which is greater than the cost of the index. The difference in cost, 65bp
(=207.9-107.8), stems from the asymmetric nature of option payoffs. Part of the high
cost is also due to current implied vol (65%) being somewhat elevated (given recent
sovereign credit and growth concerns) compared with its April lows (51%). Unless
investors expect significant widening by year-end, options can prove expensive.
Figure 2: Tranche Expected Losses (EL) since January 2010 Figure 3: Entry Cost of Trade since January 2010
8% 1.5
1.0
7% Breakeven 0.5
6% Current 0.0
Negative P&L -0.5
5% -1.0
4.00% 5.00% 6.00% 7.00% 8.00% Jan-10 Mar-10 May-10 Jul-10
IG9 7y10-15% tranche EL (%)
13 August 2010 29
Barclays Capital | U.S. Credit Alpha
13 August 2010 30
Barclays Capital | U.S. Credit Alpha
Alex Gennis
alex.gennis@barcap.com
+1 212 412 1370
Michael Kessler
michael.kessler@barcap.com
+1 212 412 3031
13 August 2010 31
Analyst Certification(s)
We, Jeffrey Meli, Bradley Rogoff, Michael H Anderson, Gautam Kakodkar, Shobhit Gupta, Praveen Korapaty, Hari Manappattil, Eric Gross, Mike Kessler and
Alex Gennis, 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, is or will be directly or indirectly 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 Capital
Research 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 Capital
may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or
an affiliate thereof (the "firm") regularly trades, 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 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 permitted
and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to
determine 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 potential
interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information
was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are
historical 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 research
products, whether as a result of differing time horizons, methodologies, or otherwise.
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 or
Pan-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 or
Pan-European Credit Index, as applicable.