BARCLAYS - Global Credit Outlook 2016 - An Aging Cycle

Credit Research
December 2015
Global Credit Outlook 2016
An aging cycle
Bradley Rogoff, CFA
+1 212 412 7921
bradley.rogoff@barclays.com
BCI, US
PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES
Barclays | Global Credit Outlook 2016
CONTENTS
Overview
Credit Market Outlook: An aging cycle ...................................................................................... 3
We think spreads will tighten modestly in most markets, but do not expect a full-fledged rally
as macro risks remain and an additional liquidity premium creates a floor under spreads. From
a global perspective, the US is more advanced in the credit cycle than Europe, but we do not
expect the broader business cycle to turn in 2016. For all regions, we expect the focus on
liquidity to remain, as turnover ratios are well below pre-crisis levels and the bid-ask spread is
much wider.
US Credit Strategy
High Grade Strategy: Skating on thinner ice ........................................................................... 18
We expect excess returns of 250-300bp and total returns of 2.25-2.75% in 2016. Returns
should be supported by spreads starting at a relatively wide point because of elevated
supply and muted demand. While some early warning signs of an economic-cycle sell-off
have emerged, we think a recession remains too far off to move credit unless consumer
spending starts to contract.
High Yield Strategy: Dont cry over spilled oil ......................................................................... 40
The high yield market will likely face some losses from defaults mainly emanating from the
commodities sectors. Away from commodities, the market should perform well and has
sufficient cushion to absorb a significant fraction of the expected backup in rates. The
combination should produce mid-single-digit returns for the year.
Leveraged Loans and CLOs: Poised for performance ............................................................ 57
Loans enter 2016 with unusual price upside potential and will likely perform strongly. We
expect modest price appreciation of $1-2, along with nearly 5% returns from carry, which
would outweigh an anticipated increase in the default rate. We forecast 5.0-6.0% of total
returns and 4.0-5.0% of excess returns in 2016.
Municipal Credit: No pain, no gain ............................................................................................ 68
Higher Treasury rates, rich valuations and headline risks are set to make 2016 a lackluster
year for the municipal market. For tax-exempts, we expect somewhat higher ratios and
credit spreads and for taxable munis, slightly tighter spreads.
European Credit Strategy

High Grade Strategy: Imbalanced ............................................................................................. 90
Our base case is that -IG credit will remain weak in 2016 and we forecast 150-200bp of
excess returns. The key drivers of supply (US non-financials) and demand (moderately low
credit yields) are unlikely to change without an external shock. However, we believe the
distribution of potential returns is very "fat-tailed," with both downside and upside scenarios.
Sterling High Grade Strategy: Benign neglect is still neglect ............................................ 106
We expect Sterling credit to outperform -IG credit in 2016, generating 200-250bp of
excess returns. The market remains one of the few areas in credit where supply and
demand appear to be, broadly, in balance. That said, we are concerned that activity levels
are too low to ensure the long-term vitality of the -IG bond market.
High Yield Strategy: Mediocre expectations ......................................................................... 111
While we see support for European high yield based on ECB monetary policy, we are
cautious on macro trends and technical factors. Upside should be modest and returns
lower, we estimate 100-200bp total return, due to idiosyncratic headwinds and some spillover effects from the Fed hiking cycle.
4 December 2015

Leveraged Loans and CLOs: The loan-CLO rebalancing act................................................ 133
We forecast total returns of 2.5-3.5% for European loans in 2016. We expect loan spreads to
widen, given the stretched relative value versus European HY bonds and US loans, as well as
the potential for a negative CLO-loan feedback loop driven by the CLO market indigestion.
Global Hybrid Capital Strategy

Immune to what ails the world ................................................................................................ 144
We see bank hybrids as one of the bright spots in credit for 2016 as superior fundamentals
and likely benign supply/demand conditions should drive further spread tightening. We
forecast total returns of 5.5-6.5% for US preferreds, outperforming HY debt. We expect total
returns of 5.5-6.5% for EUR AT1s and 6-7% for USD AT1s.
Asian Credit Strategy

Chinese bid holding up Asia Credit ......................................................................................... 162
We forecast mild spread compression for Asia credit in 2016 and expect high grade to
outperform high yield. Tightening will likely be driven by the China high grade component,
where strong in-region demand and lower supply should offset macro concerns.
LatAm/EEMEA Corporate Credit Strategy

Valuations will recouple with fundamentals ......................................................................... 174
We expect excess returns of 0% in 2016, with underperformance driven by five forces:
sovereigns staying under pressure, low commodity prices causing fundamental
deterioration, rising refinancing needs amid tightening lending standards and outflows,
lower-than-historical fundamental buffers, and unattractive starting valuations.
4 December 2015
OVERVIEW
An aging cycle
Bradley Rogoff, CFA
+1 212 412 7921
BCI, US
We think spreads will tighten modestly in most markets, but do not expect a fullfledged rally as macro risks remain and an additional liquidity premium creates a
floor under spreads.
We forecast investment grade spreads to tighten 10-20bp in the US and 5-10bp in

Europe. The key difference is that the driver for spread tightening in Europe is
financials, and in the US, it is industrials. High grade municipal ratios are on the tight
end of fair value, and we expect modest underperformance.
Subordinated financials should post the best returns, as the financial sector has become
lower beta and there is room for compression versus senior bonds. US high yield should
still post mid-single-digit returns despite a drag from energy defaults. European high
yield is likely to end its string of outperformance as the ratio of high yield to investment
grade spreads normalizes in Europe. High yield munis appear overvalued even excluding
a potential Puerto Rico restructuring, which could add further stress.
Emerging market corporate total returns are forecast to be -1.50% in LatAm and
EEMEA, as fundamentals have weakened because of the commodity sell-off. We have
concerns about technicals as well, including elevated supply and softer institutional
and retail demand. Asia has less commodity exposure and there have been better
technicals from China demand. This should result in low single digits positive returns.
The US is more advanced in the credit cycle than Europe, but we do not expect the
broader business cycle to turn in 2016. Instead, we expect a default cycle to
materialize related to commodity credits, which should lead to elevated default rates
in emerging markets (6.5-7.0%) and the US (5.0-5.5%). Europe should remain
relatively insulated, with defaults likely to remain at about 2%.
We expect the focus on liquidity to persist, as turnover ratios are well below precrisis levels and the bid-ask spread is much wider. The increased use of CDX and
iTraxx indices by long-only investors to manage liquidity has been a major
contributor to the negative basis across credit markets.
Taking the middle path

Spreads have widened across all credit markets that we cover in 2015, and we are clearly at
a crossroads for the market. We see three likely paths that the market can take in 2016, two
of which should lead to attractive returns for credit.
1. Elevated macro volatility, combined with poor technicals from excessive supply in some
markets, has produced additional spread premiums that should dissipate fully once
volatility drops.
2. We are later in a credit cycle, particularly in the US, and should expect volatility to stay
elevated and an additional liquidity premium to remain embedded in spreads. However,
if it becomes clear that the business cycle is not facing an imminent recession in
developed markets, we think spreads should rally modestly, helped by accommodative
central banks outside the US.
3. The credit market is serving as a harbinger of the risks that have built up during the recent
period of easy monetary policy, and we are likely headed for a US-led recession that will
push spreads wide enough to erode the substantial coupon across credit markets.
4 December 2015

FIGURE 1
Key market themes and forecasts for 2016
Market
Key theme(s)
Excess return Total return

forecast (bp) forecast (bp)
Developed markets
US IG
Spreads are at a relatively wide starting point because of elevated supply and muted demand. The
imbalance should moderate, and spreads should tighten, if we see rising rates and solid economic
growth. Some early warning signs of an economic-cycle sell-off have emerged, but we think a
recession remains too far off to move credit unless consumer spending starts to contract.
250-300
225-275
EUR IG
European IG credit has become a derivative of EGB yields and US credit spreads. In the absence of a
material improvement in risk sentiment, or a re-ignition of the Q technical, the market is likely to
struggle for direction. We see potential for alpha generation in sector selection, led by financials.
150-200
(50)-0
GBP IG
Sterling credit outperformed in 2015, reflecting valuations that were cheap at the start of the year.
We expect outperformance to continue in 2016, as the market remains one of the few areas in
credit where supply and demand appear to be, broadly, in balance.
200-250
(350)-(300)
US Bank
Preferreds
We expect US bank preferreds to generate attractive total returns in 2016, outperforming HY debt,
with strong fundamentals remaining supportive of moving down the capital structure. Rates risk
should be manageable as tightening in spreads should be sufficient to absorb the increase in riskfree yields. The technical backdrop is likely to improve as well with the pace of supply slowing.
600-700
550-650
European
We think that AT1 CoCos are primed for a continuation of strong performance from 2015 with
Bank CoCos spreads looking still elevated in light of the benign macro outlook for Europe, supportive bank
credit fundamentals and manageable supply.
USD: 650-750 USD: 600-700

EUR: 750-850 EUR: 550-650
US
Municipals
Higher Treasury rates, rich valuations and headline risks will likely make 2016 a lackluster year for
the municipal market. We expect a relatively difficult start to the year, especially if the Fed is more
aggressive; municipal issuance might once again be front-loaded, and higher rates could cause
fund outflows. For tax-exempts, we forecast somewhat higher ratios and credit spreads and
project returns to be close to zero. In our view, the muni market should stabilize by H2 16.
50-100
(100)-(50)
US HY
The high yield market will likely face some losses from defaults mainly emanating from the
commodities sectors. Away from commodities, the market should perform well and has sufficient
cushion to absorb a significant fraction of the expected backup in rates. The combination should
produce mid-single-digit returns for the year.
450-550
400-500
EUR HY
We expect lower returns compared to previous years with bifurcated trends affecting the market:
Tailwinds from the ECB should be offset by headwinds coming from the Fed rate hiking cycle.
Those two drivers will be overlaid by uninspiring technical trends. Better quality bonds (BBs) should
outperform in absolute terms, as lower quality will likely suffer more from the slight index widening
that we foresee.
300-400
100-200
US Lev Loan Loans enter 2016 with unusual price upside potential and will likely perform strongly. We expect
modest price appreciation along with nearly 5% returns from carry, which will outweigh an
anticipated increase in the default rate. Potential headwinds include a slower-than-expected CLO
primary market and continued retail outflows.
400-500
500-600
EUR Lev
Loan
250-350
250-350
We expect loan prices to decline modestly, given the stretched relative value, as well as the potential
for a negative feedback loop driven by CLO market indigestion. A large sell-off is unlikely, in our
view, given stable fundamentals, a low default rate, low net supply and a sticky investor base.
Emerging market corporates

LatAm +
EEMEA
Five forces will cause this segment to be the worst-performing global credit asset class in 2016:
sovereigns staying under pressure, low commodity prices causing fundamental deterioration, rising
refinancing needs amid tightening lending standards and outflows, lower-than-historical
fundamental buffers, and unattractive starting valuations.
(25)-25
(175)-(125)
Asia IG
Tightening will be driven by the China high grade component where strong in-region demand and
lower supply will offset macro concerns. ASEAN high grade is likely to come under pressure as
domestic conditions weigh on credit fundamentals and technicals deteriorate due to higher supply.
175-225
75-125
Asia HY
In high yield ex China property, we see default rates rising and fundamentals weakening (higher
leverage, weak financing conditions, softer demand). For non-China, slowing economic growth will
weigh on margins and revenues; tighter financing conditions will put pressure on funding; and
leverage is likely to rise. The commodity-linked sectors are likely to experience the most weakness.
350-400
275-325
Source: Barclays Research
4 December 2015

We believe that the middle option is the most likely. While picking the middle road is certainly
less interesting, we struggle to find enough evidence to support either of the two extremes.
For those arguing for a fierce rally, we agree that certain technicals, such as heavy supply in US
investment grade, should dissipate over time. However, the positive effect of ECB QE on credit
spreads is waning, and we do not think the negative headlines from emerging markets will
disappear, while slower growth in China will continue to weigh on commodity-based
industries. The added uncertainty from these factors is likely to persist and should be enough
to temper returns, even if none of the risks play out in a worst-case scenario.
As far as the possibility of a recession, we believe it is a fairly low likelihood for developed
markets in 2016. Europe continues to show progress as it emerges from the sovereign debt
crisis, and slower demand from emerging markets has been offset somewhat by an
improvement in domestic consumer sentiment and competitiveness as the euro has
depreciated. Most metrics are still improving and now converging with the US. This implies
that the US is more at risk, as the economy has slowed somewhat. Recession risk in the US
may be higher than in recent years, but we believe consumer demand will allow the
economy to grow at a stable pace, even allowing for a drag from slower manufacturing
activity and reduced energy investment. Manufacturing represents only 12% of GDP,
compared with almost 70% from consumption. While the consumer benefit from lower
gasoline prices has not been immediate, as some had hoped, for most of 2015 consumption
has been running 3% higher y/y, led by high priced durable goods such as autos. We think
the combination of lower gasoline prices, improving real estate prices, and stable
employment should allow the consumer to support at least modest US growth in 2016.
Spread levels supportive for 2016 returns

Credit investors suffered through a second poor year of returns in 2015. After consecutive
years of spread widening for most corporate markets, starting spreads are at levels similar
to or wider than at the beginning of 2013, when credit last produced solid returns. If our
scenario of the middle path plays out, we think that credit investors should expect better
results in 2016. The risks of slower EM growth, lower commodity prices, rising geopolitical
tensions, and a hawkish Fed are balanced by a strong consumer, the significant pain already
experienced by commodity producers, a likely measured pace of rate increases, and, most
important, above-average spread compensation. As discussed in more detail later, we
believe some of this additional spread compensation will remain in the market to
compensate investors for higher volatility. While that may bring the Sharpe ratio down, it
should still contribute positively to returns.
In 2015, equity returns have been paltry as well. However, considering the run that equities
have been on for the past few years, this still surprised to the upside versus credit. Broadbased measures of equities such as the S&P 500 make credit look undervalued or, conversely,
equity overvalued (Figure 2). On its face, if we think the macro risks are properly balanced, this
should imply additional upside for credit returns. However, that difference is most stark in the
US, and credit versus equity performance requires further analysis before jumping to
conclusions. Equity performance has been driven by several large companies with a focus in
the technology sector (as evidenced by the significant NASDAQ outperformance). When we
instead put together an equity index of tickers that match the US Investment Grade or US High
Yield Index, we find that credit does not look quite as cheap (Figure 3). This once again
supports our view that there is modest room for credit to tighten, but most of the return will
come from the elevated level of spreads.
4 December 2015

Since the credit crisis, European high yield has consistently been at or near the top of
returns for the asset classes we cover, with the exception of 2011, when the European
sovereign crisis reached its peak. In 2016, we expect that remarkable run to come to an end,
as we think the excess spread in other markets should lead to superior returns. US high yield
is the market with the most spread, and while we forecast only 25-50bp of tightening from
the ex-energy part of the market, we expect that to be enough to register 4-5% total returns
even after a drag from energy defaults. The downside from commodities is more modest for
US investment grade, although we expect fallen angels from these sectors to pick up and
create a drag on returns. M&A-driven industrial supply has been the biggest catalyst for
spread widening in 2015. We expect slightly less pressure from supply, but not enough of a
decline to lead to substantial spread tightening. With financials trading well inside
industrials and the potential for TLAC-related issuance, we do not expect financials to lead
returns in 2016. We forecast US investment grade spreads ending the year 10-20bp tighter
for an excess return of 2.5-3.0%.
In Europe, we believe financials still have some room to tighten, and even though industrials
are trading closer to fair value, a rally in financials should allow for 5-10bp of spread
tightening and excess returns of 1.5-2.0%. Our positive view on European financials also
leaves us favorably disposed to CoCos, which we believe could post 6% total returns. That
represents the highest total return across the asset classes that we cover on par with US
bank preferreds. In both cases, we cite the lower beta of financials in recent years and
enough spread in excess of senior financials that any weakness in senior bonds due to
supply technicals should be absorbed as the spread ratio normalizes.
As mentioned above, we think European high yield is likely to underperform modestly in
2016. We anticipate 25bp of widening and a total return of 1-2%. There are potential micro
risks that we believe could be further priced in, including fundamental weakness in autos,
capital goods, and retail. From a macro level, we think the spread widening would move the
ratio of high yield to investment grade spreads much more in line with historical averages,
which we think is appropriate at this point in the cycle (Figure 4). The ratio would still be
much lower than in the US, which also makes sense to us considering the higher potential
default rates in the US due to energy.
Speaking of energy, the greatest exposure is in emerging market corporates. The huge
decline in commodity prices in the past year has caused economic growth to slow, EM
corporate fundamentals to weaken, and sovereign health to decline and has resulted in
FIGURE 2
US high yield OAS versus S&P 500, year-to-date
FIGURE 3
US high yield OAS versus matched equity portfolio, year-to-date
SPX
Equity
2150
260
250
2100
240
2050
230
220
2000
210
1950
200
190
1900
180
1850
170
400
450
500
550
600
HY Corp OAS (bp)

4 December 2015
650
700
400
450
500
550
600
650
700
HY Corp OAS (bp)

Note: Matched equity portfolio comprised of tickers that account for 56% of the High
Yield Index by market value as of December 31, 2014. Source: Barclays Research
FIGURE 4
US and Europe high yield/investment grade ratios
FIGURE 5
Emerging market/US BBB and BB ratios
6.0
2.4
5.5
2.2
5.0
2.0
4.5
1.8
4.0
1.6
3.5
1.4
3.0
1.2
2.5
1.0
2.0
2010
2011
2012
US HY/IG Ratio
2013
2014
0.8
2010
2015
2011
2012
2013
BBB Ratio
EU HY/IG Ratio
2014
BB Ratio
2015
widespread corporate and sovereign downgrades. Aside from the direct effect of lower
commodity prices, emerging markets are suffering from numerous other headwinds,
including tightening credit conditions and ongoing political/geopolitical risk. EM corporate
maturities rise substantially in 2017, and refinancing these maturities is likely to be more
expensive because demand from both retail and institutional investors is waning. Despite all
this, EM valuations are close to their historical average versus developed markets (Figure 5).
We believe the difficult backdrop justifies wider relative (and absolute) spread levels.
In contrast to the negative technicals pervasive in many credit markets, US high grade
municipals have benefited from solid fund flows and improving credit quality. The ratio of
munis to Treasuries is now on the tighter end of fair value, and we expect some weakness in
this relationship in 2016. Total returns are likely to be slightly negative, as higher Treasury
yields are the dominant factor in our forecast. Despite the negative return number, we
generally expect high grade munis to be stable in 2016. The same cannot be said for high
yield munis, where we expect ample news flow with regard to Puerto Rico. Even excluding
Puerto Rico, high yield municipals look rich versus US high yield corporates.
FIGURE 6
2016 excess return forecasts versus current spreads
2016 ExcRet f/c (bp)
900
800
EUR AT1 CoCos

USD AT1 CoCos
US Bank Pref
700
600
500
400
300
US IG
200
EUR IG
100
US HY
US Lev Loan
Asia HY
EU Lev Loan
EUR HY
GBP IG
Asia IG
LatAm + EEMEA
0
0
100
200
300
400
Spread on Nov 27, 2015 (bp)
500
600
700
Note: Current spread is OAS for all markets except for US Bank Preferreds (G-spread), USD and EUR AT1 CoCos (Zspread), and US and EU Lev Loans (3y discount margin). Source: Barclays Research
4 December 2015
Different geographies, different parts of the credit cycle

Across regions, one of the most frequent questions we receive is where we are in the credit
cycle. This question is most prominent in the US, where the present expansion has been a long
one relative to history; only when compared with the 1990s, one of the great uninterrupted
expansions in American history, does it appear to be of medium length (Figure 7). While
history is an important guide, there are some key reasons we may have departed from normal
trends following the significant recession seven years ago. First, the current boom has been
much more subdued than prior periods, as GDP growth has trended at a more modest pace,
limiting the excesses of the expansion. Second, Fed policy has been extraordinary, with the
policy rate held at 0% for an unprecedented 84 months. We have never had a full business
cycle without the Fed hiking at all. Finally, we have not seen the same excesses in leverage
through the banking or corporate sector that have been prominent in past booms, with the
notable exception of commodity-based companies.
In Europe, a growth slowdown from the credit crisis was followed by another downturn two
years later as the effects of increased sovereign risk pushed GDP growth into negative
territory again. Similar to the US, the current expansion in Europe has featured a growth rate
below historical trend. While most metrics for the two regions are converging, Europe
remains well behind in key areas such as GDP growth and unemployment. In addition,
inflation has bottomed, but is not picking up materially. Low growth and the fear of
deflation have pressed the European Central Bank into action. ECB support should help
extend the current business and credit cycles. European credit markets are less exposed to
the commodity sector, which should also be a benefit to Europe.
Commodity credit is much more of a concern for emerging markets, where 38% of corporates
are commodity based. Commodity price risk also extends to sovereigns, which generate
revenue from quasi-sovereign commodity-related corporations. While most of these emerging
market corporates and sovereigns are starting from a lower leverage position than their
developed market peers, leverage levels have grown quickly. The inflationary environment in
some countries, such as Brazil, means that emerging market economies cannot rely on the
same degree of central bank assistance that benefited the developed markets. China is
obviously a key driving factor for the global macroeconomic environment and for commodity
credit. It is important to note that any slowdown in China will weigh more directly on the
credit markets than in the past, as 15% of emerging market corporates are domiciled in China,
up from 7% in 2010.
FIGURE 7
Present cycle looks well advanced
Officially Declared US Recession
25%
FIGURE 8
Credit cycle and real cycle are linked
Recession Indicator
Fed Funds Target Rate
20%
15%
10%
Trailing 12 Months HY Default Rate
15%
12%
9%
6%
5%
0%
'71 '75 '79 '83 '87 '91 '95 '99 '03 '07 '11 '15
Time between
119 mo. 72 mo. >77 mo.
91 mo.
57 mo.
recessions:
3%
0%
'90
'95
'00
'05
'10
'15
Source: National Bureau of Economic Research, Barclays Research

Source: Bloomberg, National Bureau of Economic Research
4 December 2015
Signs of weaker fundamentals

Figure 8 shows that the credit cycle is intimately linked to the business cycle. Spreads tend
to lead a recession, and for the most part, defaults are concurrent. Above, we mentioned
that Europe still looks to have positive momentum as it emerges from the credit crisis and
that we think the strong consumer can help the US avoid a recession. However, despite the
likely absence of a recession in the US, several metrics indicate that we are later in a credit
cycle and, therefore, spreads are likely to remain well off the tights of recent years. These
late-cycle macro indicators include:
1. Central bank policy is moving toward tightening, with the market pricing in a rate hike in
December. Tightening policy typically means that spread widening is more likely than
tightening (Figure 9). However, we are currently at 155bp for investment grade corporates,
quite wide compared with the most recent tightening cycles, which began when spreads
were near multi-year tights: around 100bp in 2004, 112bp in 1999, and 54bp in 1997.
2. Bank lending standards are no longer loosening, and the most recent data point shows
slight tightening. We have seen defaults rise over the 12 months following past
tightening episodes (Figure 10).
3. M&A activity reached levels similar to the 2007 peak during 2015, although the pace of
growth has decelerated as volatility has picked up. The forward path of returns tends to
be skewed downward following peaks in M&A (Figure 11)
While most of these metrics are trending in a less favorable direction, in the past it has
typically taken at least 12 months after the peak in each metric for a recession to materialize.
As we mention above with respect to the current level of investment grade spreads, the
presence of these symptoms has pushed spreads to levels that indicate credit is a solid
investment. Although these symptoms have yet to produce evidence that they will lead to
actual corporate stress, we find the downturn in lending standards the most concerning in the
near term. This is typically the best predictor of a rise in defaults. In addition, the special
circumstances around energy could mean that we get a modest default cycle or credit cycle
without a trough in the business cycle.
Energy and mining companies are expected to lead the way with respect to defaults in 2016.
As a result, emerging market default rates are likely to be the highest in the global speculative
grade market (Figure 12). We expect these defaults to be concentrated in Latin American
FIGURE 9
Returns through the Fed policy cycle
FIGURE 10
When lending tightens, credit weakens
% Lenders Tightening Standards 12 Months Ago
Y = US Corporate: Subsequent 12 Months Excess Return
Trailing 12 Month HY Default Rate (right)
30%
Tightening Policy
100%
20%
Loosening Policy
80%
12%
10%
60%
10%
0%
40%
8%
20%
6%
0%
4%
-20%
2%
-10%
-20%
-30%
0
20
40
60
X = Cycle Age (Months)

4 December 2015
80
100
-40%
14%
0%
'92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16
Source: Federal Reserve Senior Loan Officer Lending Survey, Moodys
FIGURE 11
Heavy M&A activity tends to weigh on credit
Y =Subsequent 12 Months Excess Return
50%
FIGURE 12
Comparative default forecasts
2016 Default Rate Estimate
Current
% of Issuers
% of Par
US HY
5% - 5.5%
4.5% - 5%
Euro HY
1.75% - 2.75%
1.5% - 2.5%
EM
6.5-7%
3.5%-4%
40%
30%
20%
10%
0%
-10%
-20%
-30%
US Corporate
US HY
-40%
-50%
0% 2% 4% 6% 8% 10%12%14%16%18%20%22%24%
X = Last 12 Months M&A Volume as % of S&P 500 Market Cap
commodity producers. In our base case, the overall default rate for emerging markets should
be 6.5-7.0% by number of issuers, but only 3.5-4.0% by par amount. Our downside scenario,
which takes a more pessimistic view of emerging market economies, foreign exchange, and
commodity markets, could see defaults spike as high as the mid-teens.
Not surprisingly, the US is next in terms of our base case for default rates in 2016. We
believe the increase in commodity-related high yield corporate issuers in the past decade
could lead to two credit cycles in the next few years. The first will be in 2016, when we
estimate that defaults are likely rise to 5%, in line with the long-term average and up from
the current level of 3.4% by issuer count and 2.5% by par weighting. In the past 10 years,
energy has increased from 4% to 15% of the high yield market by par, and metals & mining
has similarly tripled to 6% from 2%. Our default forecast assumes that 80% of 2016
defaults come from these sectors. The second spike in the near future is likely to occur
whenever the business cycle reaches its trough. For the business cycle-related increase, we
do not expect the spike to be nearly as high as in 2009, when we reached a peak of 15%.
One of the main reasons for this more benign view is that we are starting from a much
better spot in terms of fundamentals. High yield corporate leverage including the
embattled commodities sectors remains well below peaks, and interest coverage is still
FIGURE 13
US High Yield Index weighted average leverage ratio
8.5
6.0
7.9
8.0
7.1
7.2
7.0
7.0
5.4
5.5
5.7
5.4
5.5
5.5
5.7 5.7 5.7 5.5 5.5

5.4
4.0
3.5
4.3
4.1
4.1
3.6
3.4
3.0
5.2
4.9
4.7 4.8
4.7
4.5
5.8
6.0
5.0
6.5 6.3 6.6
6.3
6.5
5.0
5.0
4.7
4.1
3.8
3.3
3.0
5.0
Source: S&P Capital IQ, Barclays Research
4 December 2015
3Q15
2Q15
2014
1Q15
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2000
3Q15
2Q15
2014
1Q15
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
1.5
2002
3.5
2001
2.0
2000
4.0
2002
2.5
4.5
2001
7.5
FIGURE 14
US High Yield Index weighted average interest coverage ratio
Source: S&P Capital IQ, Barclays Research
10

very solid (Figures 13 and 14). For investment grade, the same is true in terms of strong
coverage, but leverage is now at the highest point of the past decade. Of the 0.2x increase
thus far in 2015, half is due to energy. While we clearly do not view the increase in leverage
as a positive, we believe the increase is fairly minor and the overall level is still modest at
2.25x. The trend could continue, as corporate profits as a percentage of GDP (Figure 15) are
at levels similar to the prior peak in 2008 and we are already seeing some margin
deterioration. The ability to take further costs out is limited, and this is consistent with the
most recent macro data on wage growth.
In Europe, defaults have been much more benign in 2015, a trend that we expect to
continue. Default rates are only 2.1% by issuer count and 1.5% by par currently, and we
expect these rates to remain near 2% next year, with the issuer count slightly higher than
par. The lack of energy companies in European high yield is a large contributor to the
difference. In addition, Europe experienced a small jump in defaults more recently as a result
of the sovereign credit crisis. Finally, the European market has a CCC weighting of almost
1000bp less than the US. Finally, the recent earnings season in Europe has been less
concerning than the US, although it did show a loss of momentum in Q3 relative to Q1 and
Q2, with earnings growing 9% y/y.
FIGURE 15
US corporate profits as a percentage of GDP
16%
14%
12%
10%
8%
6%
4%
2%
0%
'90
'92
'94
'96
'98
'00
'02
'04
'06
'08
'10
'12
'14
Source: Bureau of Economic Analysis
The liquidity conversation has only just begun

After we provide our views on the credit cycle, client conversations inevitably gravitate
toward the state of liquidity in credit markets. These are not the most uplifting
conversations, and with good reason, as we remain at liquidity levels that are considerably
worse than the pre-crisis period. To be fair, it could also be argued that the mid-2000s were
a time when liquidity was excessively large compared with the historical norm. Regardless,
we do not expect liquidity to improve in the near term, and spreads need to compensate
investors for the more limited ability to trade.
There are many ways to measure liquidity, and we have much better data in the US than
elsewhere thanks to TRACE. Considering that the US market is generally recognized to be
the most liquid credit market in the world, we believe our estimates represent the minimum
increase in liquidity premiums over time. Using bid-offer costs, we get an increase of 55%
for investment grade and 21% for high yield versus 2007. When we combine this with
decreasing turnover ratios (Figures 16 and 17), we can attempt to calculate an additional
liquidity premium. The larger increase in bid-offer and greater decrease in turnover ratio for
4 December 2015
11
FIGURE 16
Investment grade volume and turnover
FIGURE 17
High yield volume and turnover
Amount Outstanding
Volume
Annualized Turnover (right)
$5.0 tr
1.2x
1.1x
$4.0 tr
Amount Outstanding
Volume
Turnover (right)
$2.0 tr
$1.5 tr
0.9x
$2.0 tr
0.8x
$1.0 tr
1.6x
$1.0 tr
1.4x
1.2x
$0.5 tr
1.0x
0.7x
$0.0 tr
0.6x
'06
'07
'08
'09
'10
'11
'12
'13
'14
'15
2.0x
1.8x
1.0x
$3.0 tr
2.2x
0.8x
$0.0 tr
'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
investment grade is not surprising considering that liquidity risk is a more important
component of investment grade spreads, whereas high yield tends to be driven by default
risk. In the past, we have estimated the additional spread premium from lower liquidity to
be about 25bp for US investment grade (Taking Apart the Spread Floor).
The decline in turnover and widening of bid-offer spreads are exacerbated by the increased
need for daily liquidity from mutual funds. Since 2010, inflows to credit mutual funds have
been $843bn in the US and 55bn in Europe. The well-documented decline in dealer
balance sheets has obviously hurt with respect to the mismatch of liquidity needs. While we
believe the Fed dealer inventory data understate true dealer balance sheets because of
issues with the manner in which foreign dealers report holdings and the difference in the
way gross versus net balance sheet is managed today compared with pre-crisis, the
mismatch is still significant and has only been increasing.
The technical risks in credit markets have shifted from the extreme price shock of 2008 due to
overleveraged banks to gap risk that could occur from outsized mutual fund outflows. We
attempted to calculate the potential first-mover advantage for investors that get out early in a
large outflow period for mutual funds in Mutual Funds and Credit Liquidity: Nobody Move. We
believe that in an extreme case for high yield funds, the effect could be up to 1.75pts. While
certainly not overwhelming, this can provide an incentive for investors to act early.
Our analysis assumes a portfolio similar to the market and no cash balances. In reality,
managers that provide their investors with significant liquidity have altered the way they
manage their portfolios and, at least in the US, may be forced to do so to an even greater
extent in the future. Mutual funds have increased cash balances and made greater use of
portfolio products such as CDX, ETFs, and TRS (Picking Portfolio Products Apart). They are
also less likely to own the least liquid portion of the market, which contributes in outsized
fashion to the 1.75pts mentioned above. We believe many of these tactics are effective in
decreasing the potential gap risk for the market, but they are not costless. Cash drag is one
obvious reason, as is the likely lower yields for the portfolio from excluding smaller names
that typically have embedded liquidity premiums.
The new SEC proposed rule on open-end mutual fund liquidity is likely to reinforce some of
this behavior by fund managers, but could also help solve the problem of first movers
attempting to arbitrage the NAV. The rule is in a comment period now and at the very least
will force US mutual fund managers to spend more time evaluating the liquidity of the
securities they own through a variety of mechanisms including bid-offer, depth of market,
4 December 2015
12

amount outstanding, and turnover. Specifically, funds will need to have a certain amount of
securities that they can turn into cash in three days and will not be allowed to have more than
15% of the portfolio in illiquid securities that they could not sell in seven days. They will also
need to segregate all of their securities into one of six liquidity buckets ranging from those that
can be converted into cash in one day to 30+ days. While this process may be arduous for
mutual funds, the extensive commentary on swing pricing in the document is likely to come
as a relief. We believe that allowing the NAV to be adjusted by a swing factor will go a long
way toward alleviating the first-mover problem mentioned above.
Trading the less liquid credit markets

On its face, the increased importance of liquidity to clients and regulators should cause the
most liquid securities to trade at a premium. This has historically been the case. However,
the most recent periods of volatility have seen this definition of liquidity premium compress
drastically or even turn negative (Figure 18). This is because in a falling market, the most
liquid bonds are most easily sold and also the most frequently marked to market. The prices
of less liquid, infrequently traded bonds, meanwhile, stay artificially stable. This is similar to
the problem mentioned above with respect to mutual funds: the first-mover benefit
resulting in the slow adjustment of NAV.
Investors are left with a bit of a Catch-22, as their choices are between owning less liquid
bonds without receiving a traditional liquidity premium or owning more liquid bonds and
facing higher volatility. Given the choice, we would prefer to stay more liquid, as we believe
it is easier to find signals as to when you are getting compensated for the higher volatility.
Figure 19 shows how the Very Liquid US High Yield Index tends to overshoot the rest of the
market in market swings. Adding exposure to very liquid bonds when they are cheap to the
index and reducing exposure when they are rich has been a good strategy this year.
For those concerned about a lack of liquidity, part of the answer has been to keep excess cash
or add portfolio products. The use of portfolio products by long-only investors primarily CDX
and iTraxx indices, although ETFs are increasing is a post-crisis phenomenon. This
positioning is clear if we look at DTCC data, which show substantial client longs in CDX IG and
iTraxx Main (Figures 20 and 21). In exchange for the substantial liquidity of derivative indices,
investors are often giving up spread right now, as most indices trade at a negative basis versus
the comparable cash market. Since the long positions tend to be larger in the CDX indices
than iTraxx, this could be one factor in explaining the more negative basis in the US.
FIGURE 18
The off-the-run spread premium has increased from very
low levels
FIGURE 19
High Yield Index price versus Very Liquid High Yield Index
Difference: VLI - HY (right)
US HY Price (left)
US HY VLI 800mn+ Price (left)
OAS (bp)
70
60
$110
50
$4
$3
40
$105
30
$2
20
10
$100
$1
$0
-10
$95
-20
-$1
-30
'05
'06
'07
'08
'09
'10
'11
'12
'13
'14
'15
On- vs Off-the-run OAS Diff. (Industrial; BBB)

4 December 2015
$90
-$2
'11
'12
'13
'14
'15
13
FIGURE 20
Client longs in CDX IG are substantial
FIGURE 21
as is the case with Main
Spread
$bn prot bought by clients

0
105
100
-10
95
90
-20
85
-30
80
-40
-50
-60
Jan-13
Jun-13
Dec-13
All series
130
120
110
-5
100
-10
75
-15
90
70
-20
80
65
-25
70
60
-30
60
55
Dec-14 May-15 Nov-15
Jun-14
Spread

10
CDX.IG
Source: DTCC, Barclays Research
-35
Jan-13
Jun-13
Dec-13 Jun-14
All series
50
Dec-14 May-15 Nov-15
Main
The negative basis right now is near the largest we have witnessed at a time when there
was not a funding crisis. Figure 22 shows the deeply negative basis for US investment grade,
but it is similarly negative for both US and European high yield. In European investment
grade, where the basis had been persistently positive, the basis recently touched zero
(Figure 23). When we examine the factors that affect the single-name basis, we struggle to
find a good reason CDS should trade so much tighter than cash bonds:
Liquidity preference: CDS liquidity is declining, and the synthetic CDO bid that produced
greater protection selling and liquidity pre-crisis has gone away completely. Despite the
overall lower liquidity, many index credits still have higher CDS trading volumes than
cash, and investors may be willing to pay a premium (receive a lower spread) to be able
to transact more easily. If this is a factor in the negative basis, we believe it will diminish,
as we do not expect CDS liquidity to improve in 2016.
Convexity: With CDS being an effective bullet bond and some bonds (high yield in
particular) being callable, investors may be willing to pay a premium to own a product
with a better convexity profile. However, with rates off their lows and the US High Yield
FIGURE 22
CDS-cash basis has widened significantly in US investment
grade
FIGURE 23
In Europe, the Main basis has gone from positive to flat
180
-30
95
160
-40
85
-50
75
140
120
-60
35
30
25
20
65
15
55
100
-70
80
-80
60
Nov-14
Feb-15
CDS-cash basis (RHA)

4 December 2015
May-15
IGCDX
Aug-15
-90
Nov-15
Cash equivalent
10
45
35
25
Nov-14
Feb-15
May-15
Aug-15
Main
-5
Nov-15
Cash equivalent
14

Index (where basis is substantially negative) trading below par in general, this should
not be a major contributor to a negative basis currently.
Steepness of curves: CDS curves tend to be steeper than corresponding cash curves
(particularly in high yield just inside the 5y point), meaning that on a longer time
horizon, even though CDS is tighter than cash, the expected P&L from roll and carry may
still be better (or comparable) in CDS. This could be a factor for those who are entering
CDS trades with a longer time horizon, but is less important for short-term traders.
Leverage: Selling protection is generally more efficient from a capital standpoint than
leveraging cash bonds. This was certainly a factor in pushing the basis lower pre-crisis.
We do not believe it is as big a factor today, as the use of leverage is much lower than in
the past. In fact, with the ability to finance bond shorts in the repo market diminished as
well by shrinking bank balance sheets, the desire to buy protection in a volatile market
should theoretically be higher. We see this in stressed credits. Looking at a sample set of
11 credits that trade in points upfront in CDX HY, the average basis package is $99.4
(Figure 24).
Without a clear answer at the single-name level for what is pushing the basis more negative,
we look to the CDX/iTraxx indices for a reason. We believe that the increased use of derivative
indices as a consistent long for asset managers could be part of the answer. If we look back to
the mid-2000s, the difference between the level of the index and its underlying CDS
(commonly referred to as skew) was typically flat to positive. While every index trade must
have a buyer and seller, in the pre-crisis period, the driving force was typically someone trying
to hedge credit risk as opposed to those seeking a cash substitute for long credit risk.
As the primary use has shifted, the skew has moved significantly negative (Figure 25). Since
there are accounts that arbitrage the skew, when the index trades significantly rich to
single-name CDS, they are buying protection on the index and selling protection on singlename CDS. This should be driving the single-name CDS tighter and can lead to its
disconnecting from cash, as we have witnessed recently. This is complicated by the lack of
accounts that are focused on buying basis packages, as funding costs have become more
expensive. We note that there are more basis accounts in Europe, and the basis is not nearly
as negative as in the US. While the relationship between skew and the CDS-cash basis is by
no means perfect, we think that activity at an index level is a big factor in the difference in
the basis today versus the mid-2000s.
FIGURE 24
Points upfront basis for stressed credits still makes sense
Ticker
Coupon
Maturity
Price
($)
Matched
CDS (Pt)
Package
BTU
JNY
TOY
AKS
AMD
CHK
IHRT
PKD
X
CRC
HOV
6.500
8.250
7.375
7.625
7.750
6.875
10.000
7.500
6.875
5.500
8.000
9/15/20
3/15/19
10/15/18
5/15/20
8/1/20
11/15/20
1/15/18
8/1/20
4/1/21
9/15/21
11/1/19
17.00
43.00
65.00
40.00
69.50
48.00
42.50
79.75
50.00
61.00
64.00
84.00
59.00
33.50
55.50
26.00
48.00
64.00
17.50
48.50
40.00
38.00
101.00
102.00
98.50
95.50
95.50
96.00
106.50
97.25
98.50
101.00
102.00
Average:
Note: Levels as of November 27. Source: Barclays Research
4 December 2015
99.43
FIGURE 25
Skew is negative in CDX IG, in contrast to the pre-crisis
period
10
8
6
4
2
0
-2
-4
-6
-8
-10
2004 2005 2006 2007 2011 2012 2013 2014 2015
Pre-crisis
Post-crisis
Pre-crisis average
Post-crisis average
15

For those who are less enthusiastic about credit markets, the negative basis represents a
unique opportunity to be hedged or even short. Obviously, the basis got even more negative
during the financial crisis. We think it is highly unlikely that a similar shock would occur today,
as the likelihood that the viability of major counterparties will be questioned is much lower.
Part of this is that some swaps (mostly index) are now cleared and the other part is that better
capitalized financials are now trading like the lowest beta part of the credit markets. In
addition, as mentioned above, the basis being near par for distressed issuers gives us solace
that CDS will work as a hedge when it is needed most. The 2014 update to the ISDA
definitions also sought to address potential situations where CDS investors would not get the
full value of their hedges. Finally, for those looking for liquid hedges, we highlight the only
product in our market that we believe has better liquidity today than in 2007. Credit options, or
swaptions, are an increasingly useful strategy for those with concerns about credit late in the
cycle, as reflected in increasing trading volumes in CDS options relative to indices (Figure 26).
FIGURE 26
CDS index option trading volumes have increased as a proportion of index volume
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
CDX.IG
CDX.HY
4Q 14
Main
1Q 15
2Q 15
Crossover
3Q 15
Note: Showing option trading volumes as percent of index trading volumes.

Source: Bloomberg SDR, Barclays Research
4 December 2015
16
US Strategy
4 December 2015
17
US INVESTMENT GRADE
Skating on thinner ice

US Credit Strategy
Shobhit Gupta
+1 212 412 2056
shobhit.gupta@barclays.com
BCI, US
Ryan Preclaw, CFA
+1 212 412 2249
ryan.preclaw@barclays.com
BCI, US
Jigar Patel
+1 212 412 1161
jigar.n.patel@barclays.com
BCI, US
Bruno Velloso
+ 1 212 412 2345
bruno.velloso@barclays.com
BCI, US
US Fundamental Research
Priya Ohri-Gupta, CFA
+1 212 412 3759
priya.ohrigupta@barclays.com
BCI, US
Harry Mateer
+1 212 412 7903
harry.mateer@barclays.com
BCI, US
We forecast that the US Corporate Cash Index will post an excess return of 250-300bp
and a total return of 2.25-2.75% (based on our rates teams forecasts) in 2016. Returns
should be supported by spreads starting at a relatively wide point because of
elevated supply and muted demand in the past year. Assuming we see rising rates
and solid economic growth, we expect the imbalance to moderate and for spreads to
tighten. Although our base case is optimistic, it depends on economic growth
continuing. Some early warning signs of an economic-cycle selloff have emerged,
but we think the possibility of a recession remains too far off to move credit unless
consumer spending starts to contract.
CDX outperformed cash for the third year in a row, but this is unlikely to repeat in
2016 due to the relative attractiveness of cash (as measured by the CDS-cash basis),
the already-sizable client long base in CDX, and the skewed distribution of underlying
CDX constituents.
Spreads are elevated, with valuations relatively attractive in the intermediate and
long end of the credit curve. This leaves the curve historically steep and creates the
potential for flattening with either rising rates or a weakening economy. We expect a
moderate flattening in the 10s30s (~10bp) and 5s10s (~5bp) curves.
Demand should be more supportive in 2016, with higher long-dated investment

grade yields likely to encourage insurance company buying.
We forecast $1,340bn of gross investment grade fixed-rate issuance in 2016 (-2%

y/y). We expect higher US bank issuance and modestly lower industrial issuance,
with M&A-related issuance likely to increase (though it may tail off later in the year)
but be offset by lower energy issuance and deleveraging trends in certain sectors.
2016 performance outlook

Investment grade spreads have widened 25bp year-to-date (from 130 to 155bp), generating
excess returns of -103bp. In contrast, financials widened just 10bp, for +52bp of excess
return. Additionally, longer maturities have underperformed, with 2y, 5y, 10y, and 30y paper
returning about 50bp, 30bp, -77bp and -397bp, respectively. The outperformance of
financials continues a pattern that has been in place most years since 2009, but rather than
being driven by greater tightening in bank spreads, it seems to have been caused by
industrials widening on elevated M&A-driven supply and exposure to declining commodities
(excess returns: energy -4.3%, metals & mining -10.3%).
With a moderate improvement in these factors and valuations at least in part reflecting
current macro risks, our base case for next year is for investment grade spreads to tighten
modestly (10-20bp) and produce excess returns of 250-300bp after incorporating roughly
1.5% of downgrades to high yield and a meaningful outperformance by the long end (we
expect roughly 10bp and 5bp of flattening in the 10s30s and 5s10s credit curves,
respectively). That said, risks remained skewed to the downside, and there could be
substantial widening in the event that macroeconomic data come in worse than anticipated.
Moreover, given deteriorating liquidity in the market and challenged technicals, we believe
the upside is limited even in the case that the macro environment is better than expected,
most likely capping any tightening to 20-25bp in an upside scenario.
4 December 2015
18

FIGURE 1
Spreads are a useful predictor of returns
FIGURE 2
Spreads starting in the current range are more likely to
tighten than widen
Likelihood of
1y Fwd. Spread Range
1y Exc. Ret.
Current Spread
30%
35%
20%
30%
10%
25%
30%
23%
20%
0%
15%
-10%
17%
17%
12%
10%
R = 33%
5%
-20%
1%
0%
50 - 100 100 - 140 140 - 170 170 - 200 200 - 250
-30%
0
100
200
300
400
500
600
250+
Spreads Starting from 140-170bp

Source: Moodys, Barclays Research
US Corporate Index 2016 excess return forecast

More than in the recent past, we see conflicting signals about the potential performance of
the US Corporate Index in the upcoming year. The most likely path is continued economic
growth resulting in moderate spread tightening. But we also see mounting risks that the
end of the current business cycle expansion is approaching, and while we still believe the
turn remains too far out (more than 24 months) to influence spreads in 2016, we are
attentive to signals that it may arrive sooner.
Our base-case forecast is for 10-20bp of tightening, on a continuing economic expansion
and a moderating supply/demand imbalance. We see many reasons to believe that credit
could have a strong performance year.
Spreads are an important predictor of returns, and the current level of 155bp is already
wide (about the 66th percentile). Historically, when the index has started from spreads near
these levels, it has been more likely to generate positive returns (Figure 1) and tighten than
widen (Figure 2).
We think the driver of index-level spread moves is mostly the business cycle, and data
suggest the economy remains robust. Barclays economics team does not see a recession
starting until at least 2018, and most data suggest the economy is continuing its recent
modest but steady expansion:
Job growth remains robust, with jobless claims remaining at multi-decade lows and
unemployment shrinking.
Consumer spending is strong and is likely to be supported by accelerating wage growth.

Beyond the data, we do not see a specific imbalance big enough to catalyze a recession.
Given the robust economy, we believe the spread widening in 2015 was driven by
supply/demand shifts that are likely to be no worse (and in some cases better) in 2016.
Factors that promoted the widening include:
Substantial growth in the supply of investment grade corporate bonds, most of which
was driven by issuance to fund large M&A transactions. We expect M&A volume growth
to flatten in 2016 because higher average volatility (caused by tightening Fed policy and
continuing risks from China and emerging markets) limits the potential for more
growth. For more details, please see the section on supply below.
4 December 2015
19
Low oil prices and capital outflows from China and emerging markets acted as a sort of
reverse quantitative easing that reduced demand for fixed income securities, which
pressured demand for corporates (Barclays Tuesday Credit Call: Ebb Tide for Oil Dollars).
With oil prices more stable (albeit at low levels) and capital outflows already established,
we think there is limited further downside from this technical factor.
Insurance companies, the largest single buyer of corporate bonds, did not add any net
holdings in the first half of 2015 because of low all-in yields. As yields rise, we expect
insurance buying to pick up.
Leverage has risen, but remains quite average by historical standards. Whatever the trend
for leverage, we do not believe that, in aggregate, it has much of a connection to returns:
good returns have happened in times with bad leverage, and vice versa (for more details,
see the section on fundamentals).
With all this said, however, we think the upside is modest because lower liquidity and
compositional changes have raised the spread floor. Compared with 2006 (when spreads
averaged 85-90bp), the duration of the index has increased and average quality has
declined; these changes have increased the floor by about 20bp. Furthermore, we estimate
that the liquidity premium is worth a further 20-25bp. To compute this, we compared the
spread change between 2006 and 2015 of two bond buckets that are identical across
rating/duration, but differ in liquidity. The first includes very liquid, recently issued securities
while the second has older, vintage securities. While the turnover of the first bucket has
declined post-crisis, it is still liquid enough that we assume the increase in liquidity premium
should be minimal. Meanwhile, the liquidity premium for off-the-run bonds has increased
meaningfully, which should be captured by the second bucket. The difference in spread
moves of the two buckets can be used as a proxy for an increase in the liquidity premium,
which we estimate at 20-25bp. This leaves our estimate for the current floor at 130bp (from
85bp). Although our base case calls for tightening, we think the amount of tightening is
capped (even in the best case scenario) at about 20-25bp due to these factors.
While tightening remains our base case, for the first time since the 2009 crisis, there are
clear indications that spreads might widen significantly.
The early indicators that we think are most predictive of credit on a two-year horizon have
mostly flipped over to signal widening. M&A has exceeded prior peaks, banks are tightening
their lending standards, and the Fed is poised to start tightening rates. Taken together, these
are the three conditions that have most accurately predicted widening in the past few cycles.
FIGURE 3
The combination of Fed policy tightening and decelerating job growth has been predictive of a spread widening event
Baa Corp. Spreads (bp)
700
600
500
400
300
200
100
Credit Signal
Jul-14
Nov-12
Jul-09
Mar-11
Nov-07
Jul-04
Mar-06
Nov-02
Jul-99
Mar-01
Nov-97
Jul-94
Mar-96
Nov-92
Jul-89
Mar-91
Nov-87
Jul-84
Mar-86
Nov-82
Jul-79
Mar-81
Nov-77
Jul-74
Mar-76
Nov-72
Jul-69
Recessions
Mar-71
Nov-67
Jul-64
Mar-66
Nov-62
Jul-59
Mar-61
Nov-57
Jul-54
0
Mar-56
Credit Spreads
Source: Bloomberg, Moodys, Barclays Research
4 December 2015
20

A longer-term signal that uses Fed policy and the deceleration in year-over-year growth
in payrolls also signals credit weakness. Although the combination of decelerating payrolls
and the Fed tightening policy has not been as strongly predictive in the past few credit
widening episodes, it has a long history of predicting widening cycles a year or two ahead
(Figure 3). Payroll growth has been decelerating since February 2015, and if the Fed raises
rates (as expected) in December, it would be a signal for credit potentially to weaken.
Although we have not identified a specific imbalance that could weigh on the economy,
we see plenty of smaller imbalances, and a change in the interest rate environment could
be a trigger for one we do not currently see. Another possibility is that the cumulative
effect of multiple imbalances could be larger. Factors that could cause weakness include:
Ongoing weakness in China and emerging markets.

Energy investment is declining (see the Barclays Tuesday Credit Call: The Stories We Tell
Ourselves), but the bulk of likely related job losses has not yet occurred, as less than
20% of the energy-industry jobs growth since 2003 has been unwound.
Technology start-ups and venture investments: the Wall Street Journal estimates that
there are 132 private, venture-backed technology companies worth more than $1bn1; that
is almost 60% of the number of $1bn+ public technology companies in the Russell 3000
index. That market has experienced some weakness, with investors marking down the
value of startup stakes.2
We are cautious about the potential for some as-yet unrecognized imbalance to be the
key cause of risk this cycle. Given how low interest rates have been and for how long, it
is possible that some parts of the economy have become dependent on low rates,
elevating the potential of a disruption once rates start to rise.
The signals we see in the market may or may not be connected to the economic
processes that have caused credit to sell off in the past. However, the signals are not
important; the underlying process is:
If we are seeing the early signals of deceleration in the economy, there is an elevated
likelihood of a recession starting within two years. If that occurs, we would expect
widening of up to 100bp over the next 12-24 months. But in that case, our early
warning signals would likely continue to suggest weakness, and further economic data
would turn down. In particular, we think consumer spending will start to decline prior to
any economically driven weakness in credit spreads, giving us a good signal to monitor.
On the other hand, stability or improvement in emerging markets, stabilization of global

growth indicators, a re-acceleration of payroll growth, or a pick-up in other economic
data after the Fed raises rates would suggest that spreads are likely to tighten.
Industrial fundamentals are unlikely to drive spreads in 2016

With leverage increasing over the past few years, many investors are concerned that the
year-to-date widening in spreads reflects a substantial deterioration in corporate
fundamentals. While credit quality has deteriorated in pockets of the market, most notably
in energy and metals, we remain less concerned about aggregate corporate fundamentals
for three reasons:
While aggregate total leverage has risen off its lows, net leverage (which more
accurately captures credit risk, in our view) remains in the middle of the historical range
and has generally remained within a stable 1.5-1.8x range (Figure 4).
1
2
4 December 2015
The Billion Dollar Startup Club, Wall Street Journal, February 18, 2015.
Beyond Fidelity: Even More Mutual Fund Markdowns of Tech Startups, Fortune, November 17, 2013.
21
FIGURE 4
Gross and net leverage have ticked up, but net leverage
remains in the middle of the historical range
3.0x
Index-Weighted Gross Debt/EBITDA
Index-Weighted Net Debt/EBITDA
2.8x
2.6x
FIGURE 5
The ability to cover near-term maturities with cash on hand
has increased along with the average maturity of debt
Cash % of
Maturies <=5y
140%
120%
2.4x
100%
2.2x
80%
2.0x
60%
1.8x
40%
1.6x
20%
0%
1.4x
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
Note: Net debt/one-year forward EBITDA. Calculated by taking a weighted average
of issuer-level leverage (using index market value at the end of each year).
Excluding financials and autos. Source: FactSet, Barclays Research
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
Note: Index weighted average (excluding financials and autos).
Source: FactSet, Bloomberg, Barclays Research
Other measures of credit quality look better than their historical averages, as companies
have increased the average maturity of their debt and their capacity to pay near-term
maturities with cash on hand (Figure 5).
We see virtually no relationship between aggregate leverage and credit index

performance. Even if leverage continues to rise, there is no evidence to suggest that
returns will be materially influenced by the change.
Index leverage does not drive index returns

Aggregate leverage does not influence aggregate returns
There does not appear to be any consistent relationship between aggregate leverage and
aggregate spreads or returns. A regression of returns as a function of starting spread and
leverage, for example, suggests no statistically significant relationship between leverage and
returns. Figure 6 illustrates how independent leverage is from returns. There have been good
returns when leverage has been both high and low, and bad returns in both states as well. The
extremes for both fundamentals and returns are equally ambiguous: the worst returns for
industrials were during the 2008 financial crisis, when leverage for non-financial firms was
only moderate; the best followed the crisis and happened when leverage had actually risen.
In fact, the one-year returns are virtually identical when leverage has been high or low
(Figure 7). The worst leverage for returns appears to be moderate, although that is skewed by
the moderate leverage during the 2008 crisis. In our view, the implication is that for
investment grade companies, leverage has essentially no connection to aggregate returns,
which are driven instead by economic cycles and other broad-based shifts in risk preferences.
Leverage migration
That said, independent of what is happening in the macro environment, leverage could
affect spreads as a result of migration within the index. If issuers migrate to higher leverage
and, therefore, higher spreads because of idiosyncratic factors, returns could be affected
even if the macro risk premium does not change.
4 December 2015
22
FIGURE 6
The US Corporate Index has produced good and bad returns
in both high and low leverage states
1y Fwd Ex. Ret
Net Leverage
Leverage (RHS)
12m Fwd. Return
30%
25%
2.5x
20%
FIGURE 7
US non-financial corporate index returns appear to be
unrelated to the aggregate leverage of index issuers
Median 1y
Ex. Ret.
2.0%
1.5%
15%
2.0x
10%
1.0%
5%
0%
1.5x
-5%
0.5%
0.0%
-10%
-15%
-20%
-0.5%
Low Leverage
'15
'14
'13
'12
'11
'10
'09
'08
'07
'06
'05
'04
'03
'02
'01
'00
1.0x
Source: FactSet, Barclays Research
Moderate Leverage
High Leverage
Note: Leverage states are defined by tercile. Source: FactSet, Barclays Research
We find, however, that an increase in leverage migration, absent a weakening broader macro
environment, is likely to have a limited effect on spreads. Figure 8 shows the net leverage and
average spread of industrial credit (ex-energy) in the US Credit Index. While credits with
higher leverage trade wider on average, the spread compensation does not increase
uniformly. Instead, it appears there are two broad buckets: corporates with a net leverage of
less than 1.75x (about 50% of the index by market value) that trade at 120-130bp on
average; and credits leveraged more than 1.75x that have an average spread of about 165bp.
The implication of the spread/leverage distribution in Figure 8 is that as long as a ticker
stays in one of the buckets (admittedly somewhat arbitrarily defined), the spread effect of a
leverage change is minimal. Only the credits that migrate from the low leverage bucket to
the high leverage one would see a meaningful increase in spread. This mutes the effect of
even widespread leverage deterioration: we estimate that a 10% increase in leverage across
all credits (corresponding to 0.2x increase in net leverage overall) would lead to spread
widening of only 1-2bp, corresponding to about 10-15bp of loss in excess return terms.
FIGURE 8
Net leverage and credit spreads
10x
Net Leverage
195
Average OAS (RHS, bp)
8x
175
6x
155
4x
135
2x
115
0x
95
-2x
-4x
0%
20%
40%
60%
80%
75
100%
Index Percentile (by market weight)

Note: Corporates ex-energy, metals, financials, and autos. Source: FactSet, Barclays Research
4 December 2015
23

This assumes that all credits maintain their investment grade rating. In such a scenario,
fallen angel volumes would likely also pick up. A downgrade out of the US Corporate Index
and into the US High Yield Index would lead to a more significant loss we estimate in The
Fundamental Value in Sector Spreads, October 30, 2015, that losses stemming from a
downgrade to high yield average about 10% historically. While this is significant for
individual credits, its effect on index returns is fairly muted unless fallen angel volumes are
significant. Figure 9 estimates the potential loss from fallen angels in different downgrade
volume/loss rate scenarios. As discussed in our fallen angel outlook below, we expect 1-2%
of the index (by market value) to be downgraded, which would result in 10-20bp of loss.
FIGURE 9
Potential index loss due to fallen angels under different scenarios (excess returns, bp)
Assumed Average Loss Rate For Each Downgraded Issuer
% of Index Downgraded
8%
10%
12%
2%
16bp
20bp
24bp
5%
40bp
50bp
60bp
10%
80bp
100bp
120bp
Note: Nine potential cases, by varying the potential amount of debt downgraded and potential average fallen angel
underperformance in the event of downgrade. Source: Barclays Research
Under a more stressed scenario of a 5% downgrade rate with a -12% total return rate
assumption, the potential loss is about 60bp. While that would significantly eat into the
155bp spread carry of the index, such a scenario is highly unlikely. In the past 15 years,
fallen angel volumes have exceeded 5% only twice. Furthermore, while our fallen angel
outlook is for downgrades to be elevated relative to past years, we are projecting only about
1.5% of the index to fall to high yield (Figure 10).
Fallen angel outlook

Despite this years market volatility, fallen angel volumes have been largely contained. That
said, volumes have rebounded somewhat from last years low levels (Figure 10). Fallen
angel activity has been characterized by two competing trends: a rise in commodity-related
downgrades and a decline in non-commodity and financial downgrades. These offsetting
effects have kept downgrade volumes low relative to 2012 and 2013, but indicate that
downgrades from investment grade to high yield could accelerate in 2016 if oil and metals
prices remain low.
FIGURE 10
Fallen angel volumes
$bn
160
Volume
As % of index
10%
9%
140
8%
120
7%
100
6%
80
5%
60
4%
3%
40
2%
20
1%
0%
'00
'01
'02
'03
'04 ''05 '06
'07
'08
'09
'10
'11
'12
'13
'14
'15 '16E
4 December 2015
24

Indeed, a closer look at ratings migration patterns across credit suggests that fundamental
deterioration is beginning to translate into rating agency notch downgrades (although not
yet necessarily into fallen angel volumes). Notch-level downgrades by Moodys and S&P
have crept up steadily in 2015, with the ratio of downgrades to upgrades increasing to
nearly 1.3x in 3Q15 from 1.0x entering the year. In our view, this reflects the fundamental
deterioration in certain segments of the market in 2015, as low commodity prices continue
to pressure energy and metals & mining companies and M&A activity has encouraged
leveraging in other pockets of the market.
In 2016, we believe that continued fundamental pressure in commodities, along with an
increase in M&A activity for non-commodity sectors, will drive a significant increase in fallen
angel volumes. In our base case, we project $50-55bn of debt will fall from high grade to high
yield in 2016, but with the potential for significantly higher volumes if commodity
fundamentals deteriorate even further (Figure 10; see Angels More Energetic than Stars,
November 13, 2015, for more detail on the outlook).
Major sector trends

The year-to-date performance of credit in 2015 has once again illustrated the value of
selecting sectors correctly. While the US Corporate Index as a whole has produced a -1.03%
excess return, the returns of various sectors have been much more dispersed, ranging from
metals & minings -10.10% to airlines +1.54%.
To find compelling value, we integrate our analysts views with two frameworks: absolute
sector spreads, and the path for fundamentals implied by beta-adjusted spreads.
Sector-level spread remains the starting point for relative value

In the past, we have discussed the tendency for wider-trading sectors to outperform during
periods of tightening markets (see, for example, Sector Selection Update). In contrast, when
the Corporate Index widens, we expect to see an essentially random relationship between
sector starting spreads and excess return. For the most part, 2015 has been consistent with
a widening years random dispersion (Figure 11). However, a notable exception has been
commodity-exposed sectors, which started the year at the wide end of the spread range
and have widened even further, with metals & mining (-10.10%), oil field services (-6.14%),
and midstream (-7.97%) the years worst performing industries.
Even though the widening in 2015 reduced the power of sector spread in generating relative
value, we think it should be one of the starting points for a sector selection analysis every
FIGURE 11
Returns for most sectors have been typically dispersed given index widening, but
commodity sectors started wide and have underperformed
YTD Exc Ret
2%
0%
Index Excess Return
-2%
-4%
-6%
-8%
-10%
-12%
0
50
100
150
200
250
300
350
400
Starting Sector OAS (bp)

4 December 2015
25
FIGURE 12
Current sector spread and fundamental analyst ratings
OAS (bp)
Underweight
Market Weight
Overweight
Unrated
400
350
US Corporate Index
300
250
200
150
100
0
Met. & Min.

Midstream
Oil Field Services
Independent Oil
Paper
Refining
Other REITS
Cable Satellite
Packaging
Building Materials
Media
Healthcare REITS
Wirelines
Office REITS
Chemicals
Home Const.
Lodging
Life Ins.
Wireless
Supermarkets
Con. Cyc Services
Airlines
Other Utilities
P&C Ins.
Brokerage &
Automotive
Railroads
Electric
Retail REITS
Tobacco
Apartment REITS
Environmental
Aerospace/Defe
Health Ins.
Technology
Restaurants
Healthcare
Retailers
Other Fin.
Other Industrial
Pharmaceuticals
Food & Beverage
Transport.
Banking
Div. Manuf.
Cons. Products
Leisure
Integrated Oil
Const. Mach.
50
year in which we see potential for tightening. Figure 12 shows the relative sector spreads.
Spread/beta-implied fundamental outlook is a useful filter for analyst views

We compare industry-group spreads with the levels implied by their beta to the Corporate
Index and frame the difference as the losses (or gains) reflected in valuations from nearterm shifts in fundamentals and ratings. Effectively, the analysis estimates the amount of
fundamental weakening implied by each sectors spreads by comparing the actual spread to
the spread we would expect given the long-term beta. Sectors at the left end of Figure 13
are pricing the most fundamental deterioration, while spreads of sectors at the right
extreme reflect fundamental improvement. We compare this with our analysts views on
each sectors fundamentals to identify any potential mismatches.
Sectors that we think offer interesting opportunities

Metals and mining is the widest trading sector and is also priced for significant
fundamental deterioration. Despite no recent stabilization in commodity prices, we can see
how these issuers might now be starting to show signs of offering value. If the US Corporate
index were to rally sharply, it would most likely be in the context of continued growth in the
US, combined with improvement in China and emerging markets. In that case, commodity
prices are likely to stabilize, setting the stage for metals credits to also at least stabilize.
Because they trade so wide, stabilization is enough for these issuers to outperform the
market significantly because spread carry is more than double the index average. Even in
the case that commodity prices continue to fall, there are reasons to think that fundamental
deterioration will have a comparatively limited effect on spreads from here. 38% of the
index weight is in BHP and RIOLN, which are rated A1 and A3, respectively, and live on the
low end of the cost curve for their respective commodities. The next largest share is
VALEBZ, which should gain relative benefits from a new, very low-cost mine launching next
year. The worst may or may not be over, but valuations are starting to be so depressed that
value may be starting to appear regardless.
The sector rating remains Market Weight because it will still likely underperform in a general
index sell-off, but we see the risks as symmetric, and it should outperform in a broad rally.
Miners also offer better risk-adjusted upside/downside than tighter-trading commodity
sectors such as integrated oil producers.
4 December 2015
26

FIGURE 13
Many sector valuations imply significant net downgrades or deterioration in fundamentals
Implied DowngradeEquivalent Losses
15%
Underweight
Overweight
Market Weight
Unrated
10%
...valuations on the right imply

improving fundamentals
5%
0%
-5%
Valuations on the left imply

deterioration in fundamentals ...
Midstream
Met. & Min.
Other REITS
Lodging
Office REITS
Healthcare REITS
Packaging
Building Materials
Apartment REITS
Other Industrial
Retail REITS
Chemicals
Oil Field Services
Other Fin.
Home Const.
Healthcare
Other Utilities
Supermarkets
Automotive
Transport. Services
Con. Cyc Services
Restaurants
Cons. Products
Wireless
P&C Ins.
Independent Oil
Electric
Technology
Div. Manuf.
Aerospace/Defense
Brokerage & Asset
Const. Mach.
Food & Beverage
Railroads
Airlines
Paper
Pharmaceuticals
Health Ins.
Media Entertainment
Environmental
Cable Satellite
Retailers
Tobacco
Wirelines
Integrated Oil
Refining
Banking
Leisure
Life Ins.
-10%
Integrated oil producers are one of the tightest sectors and are priced in a way that implies
improving fundamentals. As a group these issuers are very large, very high quality companies,
but their fundamental situation shows more signs of deterioration than improvement.
Although the large projects they have invested in over the past decade will decline more
slowly than the faster runoff wells that are creating challenges for many high-yield producers,
they have also required enormous investments that are now unlikely to produce their
anticipated return on capital. As a result, oil majors remain short of the cash needed to both
fund future reserve growth and pay the dividends that equity investors expect. They do have
more cushion than many smaller companies, and energy analyst Harry Mateer does not see
them facing widespread downgrades. But their bonds offer very little compensation for the
difficult situation in the energy sector, and Mateer is maintaining an Underweight rating. As in
the metals and mining space, while the initial strains land more heavily on weaker issuers, the
longer low commodity prices persist, the pain finds its way even to the highest quality names.
Retailers are among the tightest third of sectors and trade with the implication of improving
fundamentals. Valuations that imply an improving outlook are difficult to reconcile with
persistent weakness in brick and mortar retail sales. A number of forces seem to be at play:
FIGURE 14
E-commerce continues to claim an increasing share of retail
sales growth
Share of Revenue
Growth
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Jan-11
Dec-11
Retail OAS relative to

Industrials (bp)
30
Total
AA
BBB
20
10
0
-10
-20
-30
-40
-50
-60
Nov-12
Brick & Mortar

Source: Bloomberg, Barclays Research
4 December 2015
FIGURE 15
Retail is trading near its two-year tights relative to the US
Industrial Index, across all ratings
Oct-13
Sep-14
Aug-15
E-Commerce
-70
Sep-13
Mar-14
Sep-14
Mar-15
Sep-15
27

one is a shift in preference from goods and toward experiences (see, for example, U.S.
Luxury, Apparel & Footwear: The State of Retail); another is that the online share of retail
sales may be approaching a tipping point in which it will claim the bulk of growth (Figure
14). While the risks of both vary across retailers, given that some have already built
successful e-commerce operations, the tight trading level of retail spreads is difficult to
reconcile with trends that are likely to result in pockets of weaker fundamentals. Indeed,
across both single-A and BBB, retail is trading tight to industrials, especially in relation to the
past two years (Figure 15). Over this time period, we have also seen high quality (AA- and
A-rated credits) decrease as a share of the sector, to 56% from 69% in 2013, diminishing
the safety that has been historically associated with the sector. Analyst Priya Ohri-Gupta
is lowering the sector rating to Underweight from Market Weight.
Among REITs (Market Weight), retail REITs trade relatively tight despite the headwinds in
the brick and mortar retail sector. They are pricing in some fundamental deterioration,
however, so it is not an obvious trade versus the index. Instead, we recommend going long
warehouse REITs (which should benefit from an increase in e-commerce) versus retail
REITs, which should continue to see increased risks around their assets.
We think that many investors believe midstream companies are isolated from the effect of
declining oil prices because their revenues are primarily fees for the use of their
infrastructure. In that framework, the midstream sector appears to be a value: if the industry
suspended growth spending and dividends, it could repay its debt in 7 years better than
infrastructure sectors such as wireless, telcos and cable companies and about the same as
electric utilities, all of which trade at least 150bp tighter. However, we think that midstream
companies have much worse longer-term prospects than other infrastructure firms unless
oil prices recover. We agree that there is some protection for contracted revenues
(especially issuers that have take-or-pay contracts); as a result, midstream firms are
currently capturing an outsized share of the economic value in the US energy sector (Figure
16). But as contracts are renegotiated (whether at their term ends or as weaker
counterparties are restructured), they will likely have their share of value pushed back
towards the low-teens percentages they averaged prior to the decline in oil prices. That
would result in about a 45% decline in EBITDA across the sector, increase leverage from an
average of 5.1x to 7.8x, and extend the payback period of debt to almost 20 years. While
that remains inside the economic life of most of the assets, it is a much less compelling
risk/reward prospect, even at wider valuations. In addition, investment grade midstream
FIGURE 16
Midstream companies are capturing an elevated share of economic value from US energy
production, but that will likely revert towards the mean as contracts are renegotiated
35
28.8%
30
25
21.4%
20
15
11.4%
11.3%
11.3%
11.1%
11.3%
2009
2010
2011
2012
2013
12.9%
10
5
0
2014
2015E
2016E
Note: Midstream segment includes investment grade and high yield companies; midstream estimates are consensus.
Source: Bloomberg, company reports, Barclays Research
4 December 2015
28

companies are continuing to build and buy capacity even as the energy industry in the US
appears to have plateaud or peaked, which is likely to accelerate the economic pressures
they face. Analyst Harry Mateer is moving the midstream sector to Underweight from his
prior rating of Overweight, and we see better value in the metals and mining sector, which
trades at even wider spreads.
A series of announced M&A deals among electric utilities has resulted in a significant
backlog of issuance in the sector. Analyst YC Koh sees a trend of the acquirers in the sector
opting in many cases to increase holding company leverage to close deals. As a result, he
expects operating company debt to outperform holding company debt.
Financial-industrial basis could come under pressure

Banks and life insurance companies are at the right extreme of Figure 13, effectively
implying a stable/improving fundamental backdrop for these sectors. Our analysts expect
that to be the case and are in fact Overweight life insurance companies. However, despite
banks strong capitalization ratios and improving asset quality, we are Market Weight the
sector on valuations. In fact, US investment grade financials (of which banks are 70%) are
trading at their tightest level to industrials since 2006, with roughly 15bp of relative
tightening so far this year (Figure 17). The shorter duration and higher average quality of
the sector have contributed to the outperformance, as BBBs and long bonds have starkly
underperformed the index so far this year. That said, the financial-industrial spread has also
tightened on a duration- and ratings-adjusted basis. In addition to stronger fundamentals
for banks, we believe this is driven by favorable technicals in the sector: year-to-date
financial supply is essentially flat y/y, while industrial issuance has nearly doubled.
We would expect these factors to begin to work against financials in the event that
industrial supply decelerates and the index begins to tighten. For example, with spreads
tightening throughout October, the basis widened nearly 10bp as BBBs and long bonds
outperformed the index. Furthermore, with 30y yields pushing 5%, some stability at these
higher levels may begin to bring in demand from yield-focused investors and support longdated valuations, which would benefit industrials.
FIGURE 17
The US investment grade financial-industrial basis has tightened meaningfully
OAS (bp)
500
Financial-Industrial Basis
US IG Financials
US IG Industrials
400
300
200
100
0
-100
-200
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
We expect the technical backdrop to become more challenged for financials given potential
TLAC-related issuance. In line with the FSBs rule, the Fed proposed a fully phased-in TLAC
(total loss absorbing capital) requirement of 18% of RWAs plus buffers that will result in
requirements of 21.5-23% for the US GSIBs. We estimate an aggregate shortfall of $125bn
4 December 2015
29

to the minimum requirement. In addition, we expect banks to operate with a management
buffer above their minimum LTD and TLAC requirements, which should add an incremental
$60bn of eligible debt for a total of about $185bn. While this requirement is for 2019, we
expect issuance to begin coming as soon as next year, which should put technical pressure
on financial spreads.
Curve positioning for 2016

Since Treasury yields reached year-to-date lows in late January, the Treasury curve has
undergone a significant bear steepening, with 2y, 10y, and 30y yields rising 45bp, 58bp, and
76bp, respectively. This has had varying implications across the credit curve. In the long
end, steep 30y Treasury yields have supported valuations: long-dated corporate yields of
about 5% tend to encourage demand from insurance companies. Over the past six months,
with 30y corporate yields stabilizing around these levels, the 10s30s OAS curve flattened
nearly 15bp (Figure 19). Meanwhile, front-end Treasuries have remained low, especially
relative to maturity-matched corporate bonds (Figure 20), which has continued to push
traditionally rates-focused investors, such as corporate treasuries, into short-dated
corporate bonds. As a result, since June, rates-driven technicals have supported spreads for
both the shortest and longest maturity bonds, driving roughly 10-15bp of
underperformance for securities in the intermediate part of the curve (Figure 18).
With this widening in 7y and 10y spreads, valuations in the intermediate part of the curve
are beginning to look more attractive; we recommend extending from short- to mediumterm paper (ie, putting on 3s7s, 5s7s, and 5s10s flatteners) to pick up incremental spread
carry. Indeed, the spread difference between 7y and 10y bonds relative to shorter-term
securities is at or near the highest level of the past fifteen years (Figure 21). Moreover, with
baseline expectations for a December Fed rate hike, the yield gap between short-dated
Treasuries and corporate bonds should continue to narrow. Indeed, 2y Treasury yields have
already increased nearly 40bp since mid-October, when the market began pricing in a
higher likelihood of a December rate hike. Intermediate bonds should outperform primarily
on a carry basis, but there is the potential for modest relative tightening (~5bp).
Despite the roughly 10bp flattening in 10s30s OAS since June, 30y securities generally look
wide, in our view. In 2016, with 10s30s OAS trading at about 40bp, and 30y corporate yields
above 5%, we see room for further flattening if all-in corporate yields increase or remain near
current levels (to roughly 30bp). Ultimately, the front end of the curve has limited room to
FIGURE 18
Intermediate spreads have widened the most relative to the
Index since June
OAS Chg since June (bp)
3y
60
5y
7y
10y
30y
FIGURE 19
10s30s curve versus 30y corporate yields
10s30s OAS (bp)
50
Since 2010
Last 6mo
50
40
40
30
30
20
20
10
10
0
Jun-15
Jul-15
Aug-15
Sep-15
Oct-15
Nov-15
Note: US corporate bonds ex-financials. Source: Barclays Research
4 December 2015
0
4.0%
4.5%
5.0%
5.5%
Corporate 25y+ YTW (%)
6.0%
6.5%
30

FIGURE 20
Short-end corporate yields are elevated relative to pre-crisis
Ratio of Corp Yld to Tsy
2003-07 Avg
2.5x
FIGURE 21
7y and 10y bonds are trading at historically wide levels
OAS(bp)
100
Current
5s10s
3s10s
3s7s
80
2.0x
60
1.5x
40
1.0x
20
0.5x
0.0x
-20
2y Ratio
5y Ratio
'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
outperform in a rally, given historically tight spreads, with significant downside risks in the
case of a Fed rate hike. Although extending to 10y and 30y bonds involves increasing spread
duration, we believe that it should outperform on a duration-adjusted basis.
On-the-run securities should continue to outperform

Liquidity in corporate bond markets remains challenging, as is evident in the declining
turnover in investment-grade bonds trading volumes have failed to keep pace with the
robust growth of the market (Figure 22). Interestingly, despite lower turnover, there was a
sharp decline in liquidity premia through June, as demonstrated in Figure 23, which shows
the difference in spreads of bonds issued more than a year ago (off-the-run) and those
issued more recently (on-the-run). Recently issued securities tend to be easier to trade,
with turnover falling significantly as bonds age; therefore, in our view, the discount for offthe-run securities is a good measure of how much investors charge for liquidity risk.
Unsurprisingly, the move in the premium is highly correlated with broader market volatility
and increased risk aversion: it has tended to spike when VIX was high and spreads were
widening, and drop as spreads were tightening. Indeed, poor liquidity tends to manifest
itself during periods of turmoil, when trading in the market is more challenged and more
FIGURE 22
Investment grade turnover has continued to decline
$trn
4.5
120%
Amount Outstanding
Volume
Annualized Turnover
4.0
FIGURE 23
The off-the-run spread premium has spiked recently
110%
3.5
3.0
100%
OAS (bp)
45
40
On- vs Off-the-run OAS Diff. (Industrial; BBB)

US Corp OAS (RHS, bp)
240
35
220
30
200
25
2.5
90%
2.0
1.5
80%
1.0
70%
0.5
0.0
60%
'06
'07
'08
'09
'10
Source: MarketAxess, Barclays Research
4 December 2015
'11
'12
'13
'14
'15
260
180
20
160
15
140
10
5
120
100
-5
2010
80
2011
2012
2013
2014
2015
Note: On-the-run defined as a bond issued less than one year ago.
31

illiquid securities experience the sharpest price corrections. Even though illiquid securities
now appear to be offering a healthier spread pick-up (roughly 25-30bp), we still do not
believe that liquidity risk has been fully accounted for in valuations. The liquidity premium is
lower than in previous years (especially as a percent of index level spreads) even though the
liquidity backdrop has worsened: at about 13% of spreads, the cushion is still significantly
below the 15-20% reached in 2011-13. In our view, the risks are skewed to the downside. If
spreads rally, off-the-run outperformance is likely to be capped given the relatively low
spread differential. If volatility remains high or there is another sell-off, illiquid securities are
likely to underperform severely, as they did late this summer.
For 2016, although the dislocation between on- and off-the-run securities has corrected
somewhat, we still believe that the upside-downside is more attractive for more liquid
securities and continue to recommend positioning in more recently issued bonds.
Outlook for M&A, supply, and demand

M&A has been a big source of supply, but may peak in 2016
A rush of mega-M&A announcements in October has pushed merger activity near all-time
peaks. Nevertheless, we think that M&A volume growth will soon peak, likely between now
and mid-2016, and then flatten or even start to decline. The view is informed by our
updated model of aggregate M&A volumes, which forecasts next years growth in M&A
based on: the change in trailing 12-month average VIX (compared with the prior quarter);
the spread between the S&P 500s average EBITDA/enterprise value and the US Corporate
Index; and US GDP growth.
The model is forecasting that M&A volume will increase slightly less than 10% in 2016
(Figure 24). That would already be a deceleration from the 23% growth as of October,
driven by a steady creep higher in the VIX index over the past year. But if that higher
volatility continues, it will likely put more pressure on deal flow. For example, if the VIX
keeps its August-October average for the next nine months, we would expect M&A growth
to turn down by slightly more than 10% in the subsequent annual forecast period. So, for
M&A to continue rising at its recent pace, volatility would have to return to much lower
levels. However, we think the factors that have raised volatility are likely to remain in place:
The anticipated transition in Federal Reserve policy to rate tightening.

Declining growth in China and other emerging market.
Related weakness in commodity prices.
Should these factors remain features of the economic landscape into 2016, we think
volatility is more likely to stay at current averages than to decline to pre oil-crash levels.
Therefore, while we expect M&A to be higher next year, it could taper off in the second half
of the year. That said, with a significant amount of issuance set to come into the market in
1H16 for deals announced so far, and with the potential for M&A volumes to increase in the
first half of next year, we expect M&A-related issuance to remain high in 2016 (see supply
outlook below and M&A-Related Supply in the Driver's Seat, August 14, 2015 for more
detail). This technical pressure should continue to weigh on spreads in the medium term,
though we expect the magnitude of the effect to be somewhat smaller than in 2015.
4 December 2015
32
FIGURE 24
Our M&A model suggests decelerating growth if VIX remains at recent averages
LTM Announced
M&A Volume ($bn)
$3
1 St. Dev. Confidence Interval

Actual M&A
Forecast
$3
Forecast at Jul-Oct Avg. VIX
$2
$2
$1
$1
$0
Dec-92
Jul-95
Feb-98
Aug-00 Mar-03
Sep-05
Apr-08
Oct-10 May-13 Dec-15
Trends in investment grade corporate bond ownership

With long-dated corporate yields reaching multi-year troughs in 2Q15, yield-driven
investors such as insurance companies have largely limited their buying of investment
grade corporates over the past year. With more traditional/stable buyer bases failing to
keep pace with the growth of supply, valuations have come under pressure, and more nontraditional and mark-to-market holders of credit (eg, mutual funds, corporate treasuries,
and foreign buyers) have picked up the slack at wider spreads (Figure 25).
Mutual funds and corporate treasuries have each gained about 1% of market share. Fixed
income mutual funds have increased corporate allocations roughly 1-2% relative to other
asset classes, with the share of investment grade rising from roughly 55% to 60%.
Meanwhile, corporate treasuries have shifted exposure from short-dated Treasuries to highquality corporates in search of higher yields as the yield gap between front-end Treasuries
Pension Funds
16-18%
16-18%
Mutual Funds
16-18%
15-17%
+1%
Banks
3-5%
3-5%
Corporate Treasuries
5-7%
4-6%
+1%
Hedge Funds
1-3%
2-4%
-1%
14-18%
13-17%
+1%
50
5.2%
45
40
5.0%
35
4.8%
30
4.6%
25
4.4%
20
4.2%
15
4.0%
10
Jul-13
Other*
5.4%
Note: *Other includes endowments, sovereign wealth funds, offshore funds,

direct holdings by households, and bonds held by foreign buyers.
Source: Bloomberg, Federal Reserve, Lipper/Thomson Reuters, SNL Financial,
HFR, BarclaysHedge, Barclays Research
4 December 2015
Jul-15
5-7%
Sep-15
5-7%
Mar-15
P&C Insurance
May-15
-2%
Jan-15
32-36%
Nov-14
30-34%
OAS (bp)
10s30s OAS (rhs) 55
US Corporate 25y+ Yld
Jul-14
Life Insurance
YTW
5.6%
Sep-14
Y/Y % Chg
Mar-14
2014 Est.*
May-14
Current Est.
Jan-14
Category
Nov-13
Estimates of ownership of investment grade corporate bonds

(% of total universe)
FIGURE 26
Long-dated corporate yield versus 10s30s OAS
Sep-13
FIGURE 25
Note: On-the-run defined as a bond issued less than one year ago.
33

and corporates has more than doubled since 2006. That said, if the Fed hikes rates in the
near term, we expect corporate treasuries to reallocate demand to government bonds as
Treasury yields rise enough to meet yield bogeys for these investors.
Compared with the same period in 2014, life insurance holds a smaller share of the market
(-2% y/y), with P&Cs share largely unchanged. To put it simply, the size of the investment
grade universe has increased sharply over the past few years, and long-dated yields have
been too low to attract enough insurance demand to keep pace. Over the past couple of
months, however, long-dated corporate yields increased substantially and have stabilized at
about 5%, a threshold that we think encourages insurance demand. If longer-dated
Treasury yields stabilize at current levels, we expect insurance to begin taking up a larger
share of the market. Indeed, anecdotal evidence seems to indicate that insurance buying
has begun to increase more recently (insurance holding data are reported with a lag). As
Figure 26 shows, higher yields have been met with a sharp tightening in the 10s30s credit
curve, which, in our view, indicates that insurance company demand has been supporting
long-dated valuations.
Investment grade issuance forecast

We expect 2016 investment grade fixed rate issuance to be lower than 2015 (Figure 27). We
forecast $1,340bn of gross fixed-rate issuance (-2% y/y), which translates to ~$700bn of
net issuance (in line with this years total). We project financials issuance to remain flat at
$365bn, driven by a pickup in US bank issuance and offset by a decline in Yankee financials
issuance. Meanwhile, we expect non-financial issuance to decrease to $685bn (-3% y/y)
and non-corporates to issue $290bn of investment grade fixed-rate debt (-3% y/y).
Year-to-date issuance stands at $1,270bn, already $125bn above 2014s full-year record
total of $1,145bn; annualizing and adjusting for seasonal variation yields a 2015 full-year
amount of $1,365bn, which would be a 20% increase y/y. Elevated industrial issuance has
been driving the y/y growth (Industrious Supply, May 29, 2015). As Figure 28 shows, while
industrial issuers have exceeded last years total by 75%, financial and non-corporate
issuance has been relatively flat y/y. Three factors have been driving growth for industrials:
a pick-up in M&A activity; the need to fund free cash flow deficits in energy; and a
commitment by large tech companies to issue low-cost debt to return cash to shareholders.
FIGURE 27
2015 investment grade fixed-rate issuance forecast ($bn)
2015
2016 gross
2016
2016 net
issuance** forecast maturities forecast
Non-fin Corp*
704
685
205
480
Financials
364
365
189
176
Non-corporates
298
290
242
48
1,366
1340
636
704
Total
FIGURE 28
Y/y change in issuance by sector
$bn
600
2014 thru October

+75%
2015 YTD
500
400
-3%
300
-1%
200
100
-29%
0
Industrial
Note: *Includes Yankees. **2015 year-to-date issuance is annualized. All
issuance data and forecasts are debt eligible for the Barclays US Credit or US
144A indices, unless otherwise specified. Source: Barclays Research
4 December 2015
Utility
Financial
Non-Corporate
Note: Year-to-date numbers are through the end of October.

34

As in previous years, we forecast fixed-rate non-financial US corporate issuance using two
approaches: a top-down forecast based on our expectation for next years operating
fundamentals; and a bottom-up forecast informed by our fundamental analysts. We then
separately forecast issuance from financials, Yankee non-financials, and non-corporates
given the idiosyncratic factors affecting supply in those parts of the market. Our top-down
forecast for US non-financials is $625bn, while our bottom-up forecast is $540bn. We
project US-domiciled non-financial issuance to fall somewhere in between: $580bn.
Combining this with our view for financials, Yankees, and non-corporates yields an overall
forecast of $1,340bn, about 2% lower than 2015 annualized issuance (see 2016 Investment
Grade Issuance Forecast November 6, 2015, for more detail on each section below).
US non-financials
The key components of our forecast include maturities, EBITDA growth, changes in
leverage, M&A activity, and supply from first-time issuers (Figure 29). To begin, we assume
that all of 2016s maturities (~$150bn) will be refinanced. Next, we assume that companies
finance debt to match expected EBITDA growth. Consensus 2016 EBITDA growth for US
domestic non-financial corporates is 6%; to keep leverage constant, companies would
increase debt 6% ($155bn). Third, we consider leverage. We do not expect changes in
leverage to have a significant effect on 2015 supply: issuers tend to add debt when EBITDA
is expected to grow and limit issuance when EBITDA is expected to shrink (see Leverage Is
Lower, but That Doesn't Mean Much, October 24, 2014). As a result, meaningful changes in
leverage are likely to be driven by EBITDA declining if the issuers as a group experience a
strong operating year, and increasing if EBITDA is weaker than expected.
Fourth, we look at M&A trends. M&A-related issuance has been the main driver of year-todate supply growth. We think M&A volumes will remain robust in 2016: our M&A macro
forecasting model (see above) predicts M&A growth of roughly 10%. There has been
$255bn of M&A-related issuance in the past 12 months. Assuming 10% growth produces
an estimate of $285bn for M&A-related supply. Finally, we consider new entrants. We
expect $35bn of issuance from this source, driven by novel tech issuers, which should
continue to issue debt to boost shareholder returns (eg, Qualcomm this year).
Combining these factors results in a gross issuance forecast for US-domiciled non-financial
firms of $625bn (6% above this years annualized issuance) and a net issuance forecast of
$475bn (3% lower than this year). Our sector-level approach yields a forecast of $540bn.
FIGURE 29
Top-down forecast for 2015 US non-financial issuance
Source of debt issuance for 2016
Amount
($bn)
Fixed redemptions
150
EBITDA growth for U.S. Non-Fins
FIGURE 30
EURUSD and GBPUSD 10y cross-currency basis swap (bp)
Spread (bp)
5
EUR
GBP
155
-5
Increase in leverage for U.S. Non-Fins
-10
First-time issuers
35
-15
M&A issuance
285
-20
Total gross issuance forecast
625
-25
Net issuance forecast (Gross - Redemptions)
475
-30
-35
-40
-45
Nov-13 Mar-14
Note: Yankee non-financials excluded. Source: Barclays Research
4 December 2015
Jul-14
Nov-14 Mar-15
Jul-15
Nov-15
35
2016 Yankee, financial, and non-corporate fixed-rate supply forecast

US banks: We forecast $170bn of fixed-rate issuance for US banks in 2016, up 10% y/y.
Maturities pick up materially in 2016 to $153bn, from $129bn in 2015. Moreover, the Federal
Reserve TLAC proposal (TLAC NPR: Wide-Ranging Implications, November 2, 2015) should
push some of the largest banks to increase senior issuance. We expect a slowdown in
the growth of regional bank issuance to partially offset the other trends.
Non-bank financials: We expect issuance to remain unchanged ($65bn), driven by

refinancing of maturities for REITs and insurance companies. The majority should come
from insurance, which should look to prefund a significant portion of 2016-17
maturities, given the sectors preference for a liquidity cushion and historically low rates.
Yankee banks: We expect Yankee bank issuance of $115bn, 10% below this years
annualized amount of $129bn, driven by a sharp decline in redemptions. USDdenominated maturities for 2016 are $72bn, $23bn lower than 2015 ($95bn).
Yankee non-financials: Year-to-date annualized Yankee non-financial corporate

issuance is $115bn. We expect the pace of new Yankee supply to slow in 2016 to
$105bn, driven mainly by a decline in non-European USD issuance. Higher Yankee nonfinancial issuance in 2015 has been mostly because of a sharp increase in supply from
European issuers, driven by more negative EURUSD and GBPUSD 10y cross-currency
basis swaps (Figure 30) and a compression in European and US corporate spreads.
Non-corporates: We estimate 2016 non-corporate supply of $290bn in 2016, slowing

marginally from this year, driven by lower EM corporate issuance.
Credit derivatives outlook

CDX outpaces cash yet again
Unless something changes in December, 2015 will mark the third consecutive year in which
CDX returns exceed those of cash (Figure 31), contrary to our expectations at the beginning
of the year. But rather than this being a case of CDX outperforming cash, it was really more
about cash underperforming CDX. The Barclays US Corporate Index has returned -103bp
in year-to-date excess returns as of November 27, compared with +2bp for CDX. As
discussed, cash was affected by poor secondary market technicals; on the other hand, CDX
actually benefited on a relative basis from investor concerns about liquidity.
FIGURE 31
2015 IGCDX versus IG cash excess returns
FIGURE 32
Client positioning in IGCDX
2.0%
Spread
105

0
1.5%
1.0%
100
-10
95
0.5%
90
-20
0.0%
-0.5%
85
-30
-1.0%
-1.5%
80
75
-40
-2.0%
70
65
-50
-2.5%
-3.0%
Jan-15
Mar-15
CDX-Cash
May-15
Jul-15
Sep-15
Cash Excess Return
Note: Returns as of November 27. Source: Barclays Research
4 December 2015
Nov-15
CDX Return
-60
Jan-13
60
55
Jun-13 Dec-13 Jun-14 Dec-14 May-15 Nov-15
All series
IGCDX
36
FIGURE 33
IGCDX market-intrinsic basis (skew)
FIGURE 34
Matched CDS-Cash basis (bp)
bp
6
4
2
0
-2
-4
-6
-8
-10
-12
-14
Jan-13
Jul-13
IGCDX Skew
Feb-14
Sep-14
Average
Apr-15
Nov-15
+/-1 Std Dev
180
-30
160
-40
140
-50
120
-60
100
-70
80
-80
60
Nov-14
Jan-15 Mar-15 May-15
CDS-Cash Basis (rhs)
Jul-15
IGCDX
-90
Sep-15 Nov-15
IGCDX.Cash
One way to illustrate this is to look at client positioning in CDX (Figure 32). Net client longs
reached a new record at the end of October, surpassing $50bn of CDX across series. The
persistence of the long base has been notable, even during periods of volatility and as the
valuation gap with cash has widened. We attribute the sizable long base to a preference for
liquidity, as CDX remains the most liquid way to gain diversified investment grade exposure.
It will be important to watch how positioning changes in 2016. Meaningful reductions in
investor longs could either be a sign of growing risk aversion among credit investors, or a
reflection of the relative value of cash becoming even more compelling. That being said,
even if positioning remains stable in 2016, we think it will be difficult for CDX to outperform
cash in 2016 given the sizable difference in valuations between the two markets.
Look for short opportunities in single-name CDS

One other effect of the historically large long base in IGCDX has been on single-name CDS
valuations. As we discussed in Carving up the Skew (November 20, 2015), the richness of
the skew (Figure 33) has provided opportunities for reverse arbitrage (buying protection on
the index and selling protection on the underlying index constituents to capture the skew).
This arb technical, in turn, has driven some of the lower beta single-names to historic tights.
We believe this creates an opportunity to buy protection on a basket of these names as a tail
risk hedge.
The basis is wide and could stay that way

Although we believe it will be difficult for CDX to outperform cash in 2016, we do not
expect the CDS-cash basis to tighten meaningfully, especially after it showed no inclination
to mean-revert in 2015 (Figure 34). Supply/demand technicals in cash likely played a part in
the underperformance of that market, while persistently long client positioning in CDX and
the selling of single-name protection by reverse arbitrage accounts helped keep a lid on
low- and mid-beta CDS spreads. There are also fewer basis-focused accounts in the market
today, due to more expensive funding and the challenges of managing multi-leg positions.
While we believe single-name CDS will remain a valuable hedging tool for credits in which
there is a potential downside catalyst, it is difficult to see the basis for the overall market
tightening unless supply technicals improve (we expect supply to be only marginally lower
in 2016) or investors meaningfully reduce their longs in CDX, which could take the skew
from rich to cheap, at which point reverse arbs may unwind (ie, become buyers of
protection). Absent one of these things occurring, it may be difficult for the investment
grade basis to tighten meaningfully.
4 December 2015
37
CDS liquidity is a mixed bag

CDX remains the most liquid way to add/remove investment grade credit exposure, but the
growing divergence with cash market valuations may make the index less appealing as a
way to express long views. That said, bid/ask spreads have remained stable at 1/2bp over
the past several years, and that seems likely to persist.
CDX options are one of the few credit products actually to grow volumes over the past
several years. While we are somewhat limited in terms of data (due to the capping of trade
volumes that are captured in the Bloomberg swaps data repository), we can still evaluate
option volumes relative to index volumes. As Figure 35 shows, option notional traded is a
significant percentage of index notional and has been rising since the end of 2014. We
believe this continued improvement in liquidity makes options a valuable hedging tool. See
Downside Options with Swaptions (April 17, 2015) for some of the more commonly used
option hedges in the market today.
The one area of the derivatives market in which liquidity has been a concern is single-name
CDS. Notably, index constituent volumes are down only slightly versus year-ago levels:
Figure 36 compares average weekly volumes for March-August 2014 and March-August
2015 using the DTCC Index Roll Reports. On average, volumes are down 10% y/y, but there
are some sectors (energy and basic materials) in which volumes have actually increased.
We believe this speaks to the continued use of single-name CDS when volatility picks up or
fundamentals deteriorate. That said, volumes are unlikely to increase for the broader CDS
market until some structural changes are implemented namely, the single-name swaps
regulation from Dodd-Frank, which is expected to introduce reporting, clearing, and some
type of exchange trading for single-name CDS.
The upside for CDX is limited

IGCDX is currently very much a tale of two markets. On the one hand, there are the lowbeta credits that trade with little volatility and have been driven tighter by reverse arbitrage
accounts. On the other hand, there are the high-beta credits from sectors that have
experienced fundamental deterioration over the past year: energy, metals, and retail. Taken
together, they create an index with many credits at the tights and wides and very few in the
FIGURE 35
IGCDX option volume as a percentage of index volume
FIGURE 36
IGCDX S25 constituent volume comparison: 2014 versus 2015
60%
Average Weekly Volume ($mn)

# of
Tickers
Mar 2014
- Aug
2014
Mar 2015
- Aug
2015
Basic Materials
104.5
129.4
23.8%
Cons Goods
16
116.3
91.0
-21.8%
Cons Services
29
99.3
86.7
-12.7%
Energy
12
97.9
107.2
9.5%
Financials
19
126.6
107.9
-14.8%
Healthcare
10
74.3
70.9
-4.6%
Industrials
16
75.0
62.1
-17.2%
Technology
133.8
99.7
-25.5%
Telco Services
154.3
154.7
0.2%
Utilities
60.9
51.7
-15.2%
101.4
91.1
-10.2%
50%
Sector
40%
30%
20%
10%
0%
4Q 14
1Q 15
2Q 15
3Q 15
Average
Source: Bloomberg SDR, Barclays Research
4 December 2015
y/y chg
38

middle of the range (Figure 37). We believe this combination, taken together with the
historically high long positioning in CDX and the wide CDS-cash basis, will limit the upside
for the index.
FIGURE 37
IG25 constituent spread distribution
# of Tickers
35
30
29
25
20
18
17
8
70-80bp
80-90bp
90-100bp
10
13
9
60-70bp
12
50-60bp
15
5
>200bp
100-200bp
40-50bp
30-40bp
<30bp
4 December 2015
39
US HIGH YIELD STRATEGY
Dont cry over spilled oil

US Credit Strategy
Bradley Rogoff, CFA
+1 212 412 7921
BCI, US
Eric Gross
+1 212 412 7997
eric.gross@barclays.com
BCI, US
Jigar Patel
+1 212 412 1161
BCI, US
Anthony Bakshi
+1 212 412 5272
anthony.bakshi@barclays.com
BCI, US
US Fundamental Research
Hale Holden
+1 212 412 1524
hale.holden@barclays.com
BCI, US
Keith Byrne, CFA
+1 212 412 7938
keith.byrne@barclays.com
BCI, US
We expect excess returns of 4.5-5.5% in 2016 as defaults in the commodities sectors

eat into coupon returns and prices decline slightly. Incorporating our rates
strategists expectation for bear-flattening in the Treasury curve, we forecast total
returns of 4-5%.
We forecast an issuer-weighted default rate of 5.0-5.5% in 2016, a substantial

increase from the current 2.8% trailing twelve-month level. We believe the parweighted rate will rise from 2.5% to 4.5-5%. The bulk of the y/y increase will come
from defaults in the energy and metals & mining sectors as the commodities credit
cycle nears its end.
Tighter spreads should offset approximately half of the expected move higher in
rates in 2016, leading to some slight price declines. The market will likely sell off on
the initial Fed move, but should recapture some of the spread widening over the
course of the year.
While BBs are rich versus history, we still expect them to outperform other parts of
the ratings spectrum on a risk-adjusted basis. However, from current levels we
believe they will underperform CCCs ex-commodities in absolute returns. At nearly
12% yield, the latter group offers good incremental compensation for the risk, and
we recommend combining BBs with hand-selected CCCs. We believe this quality
barbell has a good convexity profile whether conditions improve or deteriorate.
High yield has ample spread cushion to absorb the anticipated rate hike, and widerspread bonds typically absorb rates best, but we expect the demand technical to be
broadly negative initially. That said, in terms of positioning, the spread curve peaks
around the 3y duration point, suggesting that there isnt much benefit to going long
from an excess return perspective. Short duration should continue to trade like a
low-beta version of high yield.
We forecast gross supply of $270-290bn in 2016. M&A volumes are likely to remain
strong ($85-95bn), and we expect an increase in bond refinancing activity to $8595bn. We forecast a stable notional amount of GCP/capex issuance of $35-45bn.
We expect a significant increase in fallen angel volume next year, driven by energy
credits. In a reversal of the recent trend of more rising stars than fallen angels, we
forecast $55bn of fallen angels and $40bn in rising stars in 2016.
Derivatives are unlikely to outperform cash in 2016 due to an already-wide CDScash basis and a bifurcated spread distribution among CDX constituents. We believe
these factors should make CDX an attractive hedge and recommend incorporating
CDX options into portfolio hedging strategies. In addition, at the single-name level,
we believe the negative basis represents an attractive opportunity for those looking
to hedge or go short specific credit risk.
4 December 2015
40
Overview
2015 redux weve come a long way
Coming into 2015, the precipitous fall in oil and related decline in global growth were the
key concerns for high yield investors. In the first five months of the year oil seemed to have
found a range of $55-65, and the apparent stability sent both spreads and volatility lower;
by the end of May high beta high yield was performing solidly, with double Bs up 3.8%,
single-Bs up 4.5%, triple-Cs up 4.2%. The eventual slide to a new $40-50 range for WTI
wiped out much of the residual optimism in the energy sector, though, and a notable
preference for higher quality paper re-emerged.
As distress in energy and other commodities sectors increased, the market experienced a
broad pullback in risk appetite, and the combination of poor market performance and
widely-held expectations of an impending Fed tightening cycle only made matters worse.
With demand for risk at a weak point, companies that chose to tap the primary market in
the second half of the year were largely punished. Capital structures and even entire sectors
were repriced wider, and the jump in valuations was stunningly brisk due to the lack of
secondary market liquidity. By the early fall the high yield market had turned to negative
territory for the year, and at the end of November it had produced -2.2% in total returns for
the year on excess returns of -3.6% (Figure 1).
High yield remains volatile currently and, even excluding the energy sector, it still exhibits a
strong correlation to the price of oil (Figure 2). Indeed, while some sectors have at times
seemed like safe havens from commodity-driven volatility, energy sector performance is
closely tied to fluctuations in oil, and the rest of the market trades like a low-beta version of
the energy sector (Figure 3). The well-known relationship between high yield returns and
retail fund flows makes this a technical phenomenon, but the common factor between
energy and ex-energy is general risk appetite, which is currently tethered to concerns of
waning global growth.
While growth in China and certain other emerging markets is certainly decelerating, we
believe the US business cycle still has legs. Consumption represents nearly 70% of GDP in
the US economy, and consumption growth remains solid at 3.2% as of the third quarter.
While lower oil has been a headwind for certain segments of the economy, it has benefitted
the US consumer at the gas pump. Continued strength in the US dollar can also have a
positive net effect on US consumption given that the US tends to run a current account
FIGURE 1
Year-to-date total returns by credit quality
FIGURE 2
US High Yield spread vs. WTI crude oil price
1,200
6%
4%
90
1,000
2%
80
0.73%
0%
-2.16%
-2.52%
-2%
-4%
800
70
600
60
50
-6%
400
-8%
-10%
2-Jan
100
40
-8.02%
7-Mar
BB
4 December 2015
10-May
B
13-Jul
15-Sep
CCC
18-Nov
US HY
200
Aug-13
30
Jan-14
Energy OAS
Jun-14
Nov-14
Apr-15
Ex Energy OAS
Sep-15
WTI (RHS)
41

FIGURE 3
Daily spread change in HY energy and HY ex energy (bp)
US HY
Ex-Energy
y = 0.47x - 0.35
R = 0.69
40
FIGURE 4
CAGR of par outstanding in the US HY Index
11%
11%
'94-'08
10%
15%
30
20
11%
10%
'09-'15
10
19%
28%
0
-10
12%
10%
'12-'14
27%
27%
-20
-30
-60
-40
-20
0
20
US HY Energy
40
60
0%
80
US HY
Note: Jan 1, 2015 through Nov 20, 2015. Source: Barclays Research
10%
Ex Commodities
20%
E&P
30%
Metals & Mining
deficit. That said, the effects on global demand for US products can be more complicated.
On one hand, lower aggregate demand is a negative as it will certainly not help reduce the
slack in the economy. However, with unemployment at 5.0% and labors share of corporate
income coming off the lows, a strong US dollar could be tempering inflationary pressures
and moderating the Feds hiking plans, a positive at least for credit investors.
2016 returns forecast small portion of upside with a side of defaults

With the commodities credit cycle at an end following years of torrid growth in debt-fuelled
investment (Figure 4), we believe it is useful to separate the market into commodities
sectors (ie. energy and metals & mining) and non-commodities sectors. The average price
of bonds in the metals & mining and energy sectors is approximately $71 and $76,
respectively; further, while non-commodity CCC-rated bonds are approximately $85, metals
& mining and energy CCCs are $45 and $53, respectively. Commodities sectors are thus
much more deeply distressed, and we believe they will be the main source of defaults and
default losses in 2016.
FIGURE 5
US personal consumption growth
FIGURE 6
Business investment as a share of US GDP
8%
15%
6%
14%
4%
3.2%
12.8%
13%
2%
0%
12%
-2%
11%
-4%
-6%
Mar-00
Dec-03
Sep-07
4 December 2015
Jun-11
Mar-15
10%
'90
'95
'00
'05
'10
'15
42

Despite the end of the credit cycle in commodities, we believe other macroeconomic
indicators point to moderate GDP growth and muted inflation, an environment that has
historically been supportive of credit risk. At the micro level, credit metrics and revenue
growth trends have shown a mild but noteworthy deterioration in recent quarters. However,
while median leverage has increased, even excluding commodities, par-weighted leverage is
lower, suggesting prudence from the larger issuers and lower overall credit risk. Aggregate
coverage shows a more clearly declining trend, as does revenue growth, but both remain in
safe territory, in our view, as detailed in Going Back to Fundamentals (November 20, 2015).
Indeed, we believe that excluding commodities the market has room to tighten, absorbing
some of the backup in Treasuries that our rates strategists anticipate.
We forecast 2016 total returns of 4.0-5.0% and excess returns of 4.5-5.5%. Given the
sensitivity of energy to the price of oil and the size of the energy sector within the high yield
market (15% by par), we break this return forecast down further based on its energy and
ex-energy segments (Figure 7). This allows us to sensitize our forecast to the price of oil,
which we center on $50, close to the forward contract price at the end of 2016. Under our
base case we assume that the spread on energy, excluding defaults, will be 150bp wider if
oil achieves the forward price, because we believe the market continues to price more than
the forward strip. Excluding energy, we forecast 35bp of tightening, which corresponds to
absorption of 50-60% of the move in 5y Treasuries that our rates strategists anticipate, and
therefore translates to an increase in yield of about 25bp. Since energy returns are naturally
quite sensitive to the price of oil, especially with hedges increasingly rolling off, the overall
total return is also conditional on oil. Our total return forecast turns negative between $35
and $40, and only hits double digits if oil goes above $70.
FIGURE 7
Total and excess returns calculations for the US HY Index, with energy breakdown
Oil Price
$30.0
$35.0
$40.0
$45.0
$50.0
$55.0
$60.0
$65.0
$70.0
Default Rate
18.1%
16.6%
15.1%
13.6%
12.1%
8.3%
4.5%
4.1%
3.7%
Spread change (ex defaults)
915bp
680bp
480bp
305bp
150bp
15bp
-100bp
-200bp
-285bp
Default losses
-5.6%
-5.1%
-4.7%
-4.2%
-3.7%
-2.6%
-1.4%
-1.3%
-1.1%
Excess return
-37.3%
-26.1%
-16.5%
-8.0%
-0.5%
6.9%
13.3%
18.0%
22.1%
Total Return
-37.9%
-26.7%
-17.1%
-8.6%
-1.0%
6.3%
12.8%
17.5%
21.5%
3.1%
3.1%
3.1%
3.1%
3.1%
3.1%
3.1%
3.1%
3.1%
US HY Energy Index
US HY ex Energy Index
Default Rate
30bp
15bp
-5bp
-20bp
-35bp
-50bp
-65bp
-80bp
-90bp
Default losses
-1.3%
-1.3%
-1.3%
-1.3%
-1.3%
-1.3%
-1.3%
-1.3%
-1.3%
Excess return
3.0%
3.6%
4.4%
5.1%
5.7%
6.4%
7.0%
7.6%
8.1%
Total Return
2.6%
3.2%
4.1%
4.7%
5.3%
6.0%
6.6%
7.3%
7.7%
Default Rate
5.3%
5.1%
4.9%
4.7%
4.4%
3.9%
3.3%
3.2%
3.2%
139bp
97bp
55bp
20bp
-12bp
-42bp
-69bp
-95bp
-114bp
Default losses
-1.8%
-1.7%
-1.7%
-1.6%
-1.6%
-1.4%
-1.3%
-1.3%
-1.2%
Excess return
-2.0%
-0.1%
1.9%
3.5%
5.0%
6.4%
7.8%
8.9%
9.8%
Total Return
-2.4%
-0.5%
1.5%
3.1%
4.6%
6.0%
7.4%
8.5%
9.4%
US HY Index
4 December 2015
43
Default risk going up!

Defaults ticked up a little in 2015, with the Moodys trailing 12m issuer-weighted
speculative grade default rate edging up to 2.8% through October from 1.8% at end-2014.
The increase was more pronounced for bond issuers than loan issuers, with the bond issuer
default rate up to 3.8% from 2.0% over the same period.
We forecast a substantial increase in the default rate in 2016. Combining an econometric
model of the default environment with a bottom-up review of credits in the high yield market,
we arrive at an issuer-weighted default rate of 5.0-5.5% in 2016, and forecast a par-weighted
rate will rise from 2.6% to 4.5-5%. The bulk of the y/y increase will come from defaults in the
energy and metals & mining sectors as the commodities credit cycle nears its end.
FIGURE 8
Current econometric model forecast vs. realized issuer-weighted default rate
18%
16%
Current 12-month
model forecast:
14%
12%
4.8%
10%
8%
6%
4%
2%
0%
Feb-96
Nov-98
Aug-01
May-04
Feb-07
Realized in subsequent 12 months
Nov-09
Aug-12
May-15
Model forecast
Note: Shaded area represents 90% confidence envelope. Source: Federal Reserve, Moodys, Barclays Research
Our econometric model predicts a 4.8% default rate, with the large uptick from current
levels due to increases in both variables in the regression (Figure 8). The most recent senior
loan officer opinion survey points to a potential reversal in the long trend of loosening
underwriting standards; meanwhile, the distress rate has continued to rise since last year,
and stands at 16.8%, largely due to the aforementioned distress in commodities sectors.
A review of the issuers in the Barclays US High Yield Index in collaboration with our
fundamental analysts yields a default forecast of 5.8% if oil ends 2016 around $50. The bulk
of the distressed situations are in the energy and metals & mining sectors, and, as hedging
activity rolls off, defaults will in aggregate be very sensitive to commodity prices. Away from
commodities, defaults are much more idiosyncratic but retailers and aerospace/defense stand
out, with the former under pressure due to both secular and cyclical challenges (as discussed in
Sector Trends, below), and the latter burning cash and struggling under heavy debt burdens.
Fed up or: duration risk

While a hike in the Fed funds target rate has been in the cards for what seems like forever,
the messaging from the Fed has become increasingly clear in its intent to hike before yearend, and the consensus forecast among economists surveyed by Bloomberg is for a 25bp
increase in December.
We continue to believe that high yield investors are well protected from rates moves, with
spreads typically absorbing a significant fraction of the change in Treasury yields.
4 December 2015
44

FIGURE 9
Beta of HY OAS change to 5y Tsy change vs. spread cushion
2.5%
0.0
-0.5
-1.0
-1.5
-0.9
Ratio of performance
100 days pre vs post-hike
2.0%
-0.7
Ba: 0.72
B: 0.97
Caa: 1.66
1.5%
-2.0
-1.9
-2.5
1.0%
-3.0
-3.5
FIGURE 10
Average cumulative total returns around Fed hikes
0.5%
Current OAS/YTW = 75%
-4.0
-4.5
50-60%
60-70%
70-80%
OAS as % of Yield to Worst

-4.2
80-90%
0.0%
-100
-75
-50
-25
25
50
75
100
Days Surrounding Fed Funds Target Rate Hikes

Ba
Caa
Note: Fed hikes since 6/97 (N=23). Source: Barclays Research
Historically, the average beta between spreads and rates in months when rates rise has
been -1.0, implying full absorption of rates moves in spreads. However, the current situation
is admittedly out of sample, given more than six years of zero interest-rate policy and the
divergent courses set by the Fed and the ECB. In addition, the initial reaction to rising rates
can certainly be less positive for the asset class, driven by retail outflows. That said, with an
average high yield spread ex-energy of over 550bp, representing about 75% of average
yield, we are very comfortable with the markets ability to withstand an increasing rate
environment and expect high yield to perform well once any retail outflows abate (Figure 9).
Nonetheless, with the market focused on the imminent rate hike it is worth understanding
how high yield has performed through these events in the past. Any individual hike can be
quite different from the typical experience, but the average performance of different quality
buckets is telling and rather intuitive. High yield has performed well through tightening
events going back to mid-1997. However, in our sample period (23 rate hikes), average
double-B performance in the 100 days pre-hike is 0.7x that of the post-hike period. Single-B
performance is more balanced pre- and post-hike, while triple-C bonds actually perform
1.7x better before the hike, as rates are rising, than after (Figure 10). These results are
consistent with our analysis of spread and rates betas. However, given the spike in volatility
in the second half of 2015 and the ensuing outperformance of double-B paper, we believe
the experience could be different this time around, with double-Bs less likely to outperform
other quality buckets in absolute terms.
Shorter duration bonds have traded like a low beta version of high yield this year. As a
result, they underperformed in the rally through May, and have outperformed since. Indeed,
defining short duration as bonds with an OAD of 0-3 years, the short duration subset of US
HY produced -57bp in total returns through the end of November, compared with -2.16%
for the overall market (Figure 11). Unsurprisingly, as the markets appetite for risk has faded
the longer end of the curve has sold off hardest, and the yield curve does not offer any
obvious positioning insights (Figure 12). Meanwhile, the spread curve flattens out at around
3y OAD, suggesting that there is not much benefit to going long from an excess return
perspective, but the somewhat wider spread in the belly of the curve will likely be eroded by
flattening in the front end of the Treasury curve.
4 December 2015
45
FIGURE 11
Year-to-date short duration vs. index total returns
FIGURE 12
Yield and OAS by duration bucket, excluding commodities
300
3.5
250
3.0
200
-2%
-4%
Jan-15
< 0.5
-3%
Mar-15
May-15
Jul-15
Sep-15
US HY (0-3y OAD)
Nov-15
US HY
OAD (yrs)
Yield to Worst (%)
7.5 - 8
4.0
-1%
7 - 7.5
350
6.5 - 7
4.5
0%
6 - 6.5
400
5.5 - 6
5.0
1%
5 - 5.5
2%
4.5 - 5
450
4 - 4.5
5.5
3.5 - 4
3%
3 - 3.5
500
2.5 - 3
6.0
2 - 2.5
4%
1.5 - 2
550
1 - 1.5
6.5
0.5 - 1
5%
OAS (bp, RHS)
Note: Commodities sectors include energy and metals & mining.

Sector trends key risks and drivers of performance

Energy
With oil flirting with $40 and natural gas prices still trending lower, high yield energy credits
are unsurprisingly trading at distressed valuations. The high yield index is 15% energy by
par, and we expect the bulk of 2016 defaults to come from this sector. Away from actual
missed payments and bankruptcy filings, we also expect an increase in distressed exchange
offers. Issuers will likely tap their secured capacity to entice investors to swap, enabling
some combination of deleveraging and decreased interest costs, but these will likely come
at the expense of lower unsecured recoveries.
E&P companies have understandably responded to lower oil prices by slashing capex; our
fundamental credit analyst, Gary Stromberg, forecasts a 40% decline in capex in 2015
followed by an additional 30% decline in 2016. Management teams have also aggressively
cut operating and administrative costs, with over 20% y/y declines in LOE and G&A
expenses. That said, maintenance capex is higher than unhedged EBITDA for a majority of
the credits in the peer group in his analysis (see Key 3Q15 Themes, November 20, 2015).
Furthermore, as hedges progressively roll off and proved developed reserves are produced
out, the decline in borrowing bases which was muted in the fall will likely accelerate,
exacerbating liquidity concerns.
Oil field service firms have seen EBITDA tumble 33% in the past year as E&P companies
have pared activity back, and we expect this trend to continue in 2016. As a group, the
companies have reduced operating expenses at the same pace as EBITDA has declined, but
G&A costs have come down more slowly (-22% y/y). Credit metrics are deteriorating
quickly, with leverage estimated to be up from 3.1x in 2014 to 6.8x in 2015 and 8.7x in
2016, according to our analyst, and management teams are focused on preserving liquidity
and reducing or pushing out capex.
The performance of energy credit remains extremely sensitive to the price of oil (Figure 7),
but with fundamental trends still deteriorating and a wave of defaults likely, our credit
analyst continues to rate the independent and oil field service sectors Underweight.
However, he rates the refining sector Market Weight and midstream Overweight. With
respect to midstream credits, most have reported growth in producer volume, although a
4 December 2015
46

drop remains a risk. Capex is forecast to decline 15% y/y and could continue to drop as
infrastructure development slows. While MLP valuations have declined over the past 12-24
months, M&A activity has continued as investment grade companies look to acquire assets.
Metals & mining

The metals & mining sector is a few steps ahead of energy on the path to a default wave,
with several coal names having already defaulted out of the index, and there are very few
signs of hope, leaving our fundamental credit analyst, Matt Vittorioso, Underweight. While
Chinas commitment to promoting growth and stability is strong, and capital outflows have
started to ease there, we believe that investment-led growth, which would stoke demand
for commodities, is unlikely.
Valuations in metals & mining have decoupled from the high yield market, as the sector has
been all but left behind, even in strong risk rallies. Furthermore, continued price declines in
copper, iron ore, thermal and met coal, and steel have been met with growing supply as
producers struggle to generate cash to meet interest expense, which has in turn made it
difficult for commodities prices to reach a new equilibrium.
Retail
Dispersion is high in the retail sector, with over 50% of bonds (by par) trading below 6%, or
2% inside the overall market, but more than a quarter of the sector trading over 10% as
well. The embattled names mainly fall in the apparel and department stores categories
where several fundamental headwinds pose challenges. Management teams have cited a
laundry list of concerns, including a sluggish consumer, suggesting that the solid
consumption growth numbers for the broader economy (Figure 5) have yet to translate to
demand for more retail goods through traditional channels. Meanwhile, the stronger dollar
has likely depressed tourism spending in gateway cities, and may also have spurred
increased international travel, taking some retail consumption abroad. Lower traffic levels
due to online competition remain a longer-term secular concern, with some credits
managing the transition to omni-channel distribution better than others. As a result of
secular headwinds, deteriorating management outlooks, and the potential for further
headline risks due to a few possible defaults, our fundamental analyst, Hale Holden, is
downgrading retailers to Market Weight, and expects retailer valuations to remain
bifurcated through 2016.
Telecommunications
As the US wireless industry continues to mature, it is experiencing increasingly aggressive
price competition, led by T-Mobile (TMUS) and Sprint, in an effort to gain subscribers from
AT&T and Verizon. With its improved network performance and value-pricing, T-Mobile
has been successful with its Uncarrier strategy and consistently gained subscribers during
the past two years, capturing all the industrys growth. Under new management, during
the past year, Sprint has announced aggressively priced plans, while it is working to
improve its network performance and has had success reversing subscriber losses. TMUS is
the fourth-largest issuer in the high yield index, with about $17.6bn in bonds; has shown
very positive subscriber trends, as well as improved EBITDA margins; and is turning free
cash flow positive. Meanwhile, Sprint (largest index name, $30bn in bonds) has been
improving its network performance and reducing churn. It recently announced a 50%-off
promotion to attract new customers over the holiday season and its Leaseco structure to
finance leasing and reduce its cash burn. However, Sprint still faces significant execution
while it implements $2+bn of cost reductions and attempts to improve its subscriber growth
and reduce its cash burn. With these two issuers representing nearly two-thirds of the
sector, our fundamental analyst, Jeff Harlib, maintains a Market Weight rating.
4 December 2015
47

Wirelines remains a sector with secular headwinds in the consumer and small business
segments and disappointing enterprise performance. CenturyLink and Frontier reported
disappointing results, while Windstreams 3Q results were in line with expectations.
Strategically, these credits face continued aggressive competition from cable, as well as
wireless substitution, while other operators, such as Level 3 and Zayo Group, have posted
solid revenue and EBITDA performance, benefiting from share gains (Level 3) and
significant growth in fiber demand (Zayo); they have outperformed and trade much tighter
as a result. A key event to watch will be Frontiers closing on its acquisition of Verizons
wireline properties (in Florida, Texas, and California), expected in March 2016. Our
fundamental analyst, Jeff Harlib, is Overweight rated much of the Frontier capital structure
and Market Weight rated on the overall wireline sector.
Home construction and building materials

Home builders face several challenges going into 2016. Rising labor costs have been an
issue in several MSAs, and the decline in oil is likely to depress closings given that Texas and
other oil-rich geographies have driven a significant share of closings in recent years. Further,
the expected rise in rates should also put downward pressure on demand for new homes.
Given these trends, our fundamental analyst, Keith Byrne, is downgrading the sector to
Underweight.
On the other hand, building materials has benefitted from lower commodities prices, and
should be attractive to investors given a customer base that is almost entirely in the US, a
relative benefit given the divergence in US and non-US growth. That said, tight valuations
reflect these advantages, and our analyst therefore remains Market Weight on building
materials.
Healthcare and pharmaceuticals

Significant healthcare M&A activity has generally been well digested by investors, and
performance has been good relative to the overall high yield index. Some issuers, such as
Tenet (THC) and Community Health (CYH), have been tougher credit investments due to
shareholder friendly activity (THC) and weakness in operating metrics (CYH), while HCA,
the second largest high yield issuer ($19.5bn) has performed relatively well. While the
healthcare sector is about 150bp inside the high yield index, there is a wide dispersion
within the sector. Higher quality healthcare has been resilient and should remain solid, but
BB healthcare credits have limited upside from current levels. Meanwhile, were cautious on
some of the mid-tier names, but low-B and CCC credits have significantly repriced in the
past few months and offer attractive compensation. Combining these views, our
fundamental analyst, Shubhomoy Mukherjee, remains Market Weight on the sector.
Meanwhile, pharmaceuticals has experienced significant volatility as Valeant, the third largest
high yield issuer ($17.6bn), has been under intense pressure due to its relationship with
certain specialty pharmacies. Further, Valeants business model of continuous growth via
acquisition is likely to come under increased scrutiny well beyond the pharma sector. That
said, our analyst sees value in the issuers senior notes, which he rates Overweight. Valeant
represents 50% of the pharmaceuticals index, and the sector remains an Overweight.
Quality: the high road or the low road?

BBs are rich vs. history, but what does that tell us?
Whether we include or exclude commodities sectors, BB-rated bonds are quite rich relative
to their history. The ratio of BB spread to the overall high yield index spread is currently
0.66, compared to a 10y average of 0.72 (Figure 13). High quality high yield started 2015 a
little less rich than currently (the ratio was 0.69 at year-end), and underperformed in the
first five months of the year as volatility died down. However, as volatility picked up again in
4 December 2015
48

June the flight to safety trade resumed, and BBs have naturally benefitted. Thus, while the
relative richness/cheapness of BBs versus the overall market is an important factor to
consider, BBs can clearly continue to outperform even from a position of relative richness.
FIGURE 13
Ratio of BB OAS to US HY OAS, with and without commodities
0.85
0.80
10y average
0.75
0.70
0.65
Current
0.60
Dec-05
Nov-07
Oct-09
YE 2014
Sep-11
BB/HY
Jul-15
Aug-13
BB/HY (ex commodities)
Notes: Commodities sectors defined as energy and metals & mining. Source: Barclays Research
On average, the relative richness/cheapness of BB credit has been related to BB

performance versus other parts of high yield, but less relevant on a risk-adjusted basis.
More specifically, BBs tend to outperform CCCs and HY overall by more when the BB/HY
ratio is high, and underperform when the ratio is low (Figure 14); BBs have outperformed
single-Bs more consistently irrespective of BB richness/cheapness. On a risk-adjusted basis,
BB credit essentially always outperforms other parts of the quality spectrum, although less
so in the tails of the rich/cheap distribution (Figure 15).
Thus, history suggests that BBs will continue to outperform on a risk-adjusted basis, but
that they could underperform CCCs in absolute terms from current levels. At nearly 12%
yield, the ex-commodities part of the CCC market offers good incremental compensation
for the risk, but credit selection is clearly paramount in that part of the quality spectrum. We
believe a good strategy for 2016 is to combine the dominant risk-adjusted characteristics of
BBs with the solid compensation in hand-selected CCCs. Within CCCs we are extremely
cautious on commodities sectors, and prefer credits that generate positive cash flow (or a
FIGURE 14
Annualized excess returns of BBs relative to other segments,
as a function of the BB/HY ratio
8%
0.6
Current BB/HY ratio

falls into richest
quintile
6%
4%
FIGURE 15
Sharpe ratio of BBs relative to other segments, as a function
of the BB/HY ratio
0.5
0.4
2%
0.3
0%
0.2
-2%
0.1
-4%
-6%
0.0
1
<< BB Rich
BB - HY
3
BB/HY by quintile
BB - B
Note: Since 1997. Source: Barclays Research
4 December 2015
5
BB Cheap >>
BB - CCC
<< BB Rich
BB - HY
3
BB/HY by quintile
BB - B
5
BB Cheap >>
BB - CCC
Note: Since 1997. Source: Barclays Research
49
FIGURE 16
Average cumulative monthly total returns of rising stars
relative to high yield and investment grade (%)
FIGURE 17
Average OAS of rising star candidates (bp)
10
450
BB
400
350
300
250
BBB
0
200
-2
-11-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 UG 1
Months before and after Issuer Upgrade

2013
2014
2015
Note: Monthly cumulative returns calculated for two distinct periods before and
after the downgrade month. High yield returns used as baseline for period before
upgrade and investment grade returns used after. Source: Barclays Research
150
100
AER
CNO
STZ
CCI
DHI
LEA MWE NOKIA TOL
plausible path there). This barbell of sorts trades off some of the excess Sharpe ratio of
BBs for the historically high incremental compensation of CCCs, and has a good convexity
profile if conditions improve or deteriorate significantly.
Rising stars
Despite the volatility-driven sell-offs in high yield and investment grade this year, rising stars
continued their recent trend of outpacing falling angels, at $51bn and $36bn, respectively.
We expect this trend to reverse in 2016, with investment grade commodity credits forming
the majority of a $55bn pool of fallen angels, compared with $40bn in rising stars (see
Angels More Energetic than Stars, November 13, 2015, for details).
The performance of rising stars in 2015 has been similar to that of previous rising star cohorts.
Typically, credits outperform the High Yield Index significantly in the months leading up to the
upgrade as investors anticipate the transition and respond to the credit improvement under
way. This years rising star set notched an average 3.9% cumulative outperformance in the
year preceding the upgrade (Figure 16). However, the return benefit does not endure into the
post-upgrade months, as the credits go on to underperform the Investment Grade Index
modestly. Credits upgraded in 2015 have underperformed by an average of 0.6% in the first
six months of their investment grade status. These performance trends underscore the
importance of getting ahead of the ratings event to benefit from rising star outperformance.
However, the opportunity for spread compression appears limited among likely rising stars
next year. The majority of likely rising star candidates, as screened by our fundamental analyst
teams, are already trading inside 250bp, much closer to BBB levels (Figure 17).
Technicals: Its just a matter of supply and demand

Demand
The high yield market experienced changes in ownership structure this year amid the
commodities-led volatility. Dedicated high yield retail funds lost some ground in terms of
market share; we estimate that US-domiciled mutual funds and ETFs hold 16-19% of the
market, down 2% year-over-year, with ETFs accounting for a little over 3% (Figure 18). This
decline is unsurprising given US high yields exposure to energy and metals & mining and
4 December 2015
50
2015
16-19%
22-25%
18-24%
+7%
-4%
19-23%
14-20%
10-14%
1-3%
0-3%
unchanged
-2%
12-16%
+1%
-1%
-1%
unch
22-25%
11-15%
HY Mutual Fund and ETF
IG/Income Fund
Pensions/Sep Accts
Hedge Fund
Insurance
Offshore
CLO/Loan Fund
Other
0-2%
0-3%
18-21%
4-7%
2014
5-8%
FIGURE 18
Estimated share of US high yield bond holdings
Source: Lipper, Bloomberg, EPFR, HFR, Federal Reserve, Barclays Research
increased headlines focusing on declining liquidity in corporates, both of which have led to
significant outflows over the past 12 months. That said, retail funds that can own some
high yield (eg. investment grade funds, income funds, balanced funds, etc.) have held a
steady 22-25% share of the US high yield market, according to our estimates. This
apparently flat ownership share masks a few offsetting trends, with total assets held in
investment grade/income funds climbing 5%, from $1.03trn to $1.08trn, but their
allocation to high yield dropping from 29% to 27%.
Elsewhere in the retail universe, sources of demand include offshore funds, such as
European-domiciled UCITS funds and Japanese Toshin funds, the latter of which often
include a growth currency overlay to enhance yields. We estimate that this category has
shrunk slightly, down 1% to a range of 4-7%, driven mainly by declining AUM held in the
Toshin sub-category. Significant outflows from loan retail funds, combined with the
Volckerization of CLOs, make loan mutual funds and CLOs a smaller piece of the puzzle
this year, down 1%, to a range of 0-2% by our estimates.
The global hedge fund industry saw year-over-year asset growth of about 6% through the
second quarter of 2015, according to HFR, and we estimate that hedge funds currently
account for 14-20% of the US high yield asset base. The year-over-year decline in high yield
ownership despite a growing asset base reflects several factors namely, a decline in
allocation to credit strategies and an increase in off-index opportunities within fixed income.
Defaulted debt amounts have grown, with the Moodys Bankrupt Bond Index market value
up approximately 8% y/y, with Caesars representing the largest new addition. Other new
opportunities include Puerto Rico, and stressed issuers in emerging markets, none of which
fall in the index universe.
Institutional money, which includes pensions and other separately managed accounts, has
grown substantially over the past year, leading to a jump in this categorys share of high
yield assets. Indeed, by our estimates, pensions and other separately managed accounts
currently own 19-23% of the market. Our analysis of the Feds flow of funds release as of
the second quarter suggests that the growth has come from assets flowing into separately
managed accounts, which prominently include pension plans and endowments. The
substantial growth of this sub-category corroborates anecdotal evidence from
conversations with asset managers, with some money likely coming from European
pensions starved for yield in their local fixed income markets, as well as domestic pensions
shifting allocations toward high yield because of higher yields and elevated valuations in the
equity market.
4 December 2015
51
FIGURE 19
Annual issuance by use of proceeds
FIGURE 20
Monthly supply and high yield secondary market volatility
100%
50
80%
Monthly Supply Total ($bn)
R = 0.43
40
60%
30
40%
20
20%
10
0%
'11
'10
Refi Bonds
Refi Loans
'12
'13
M&A/LBO
'14
GCP/CAPEX
'15
Other
0
0
4
6
8
HY 1M Total Return Volatility (%)
10
12
Note: 2015 months represented by red points. Annualized standard deviations of

daily total returns over rolling one-month periods. Source: Barclays Research
Finally, Barclays Risk Solutions Group performs an annual peer group study of life and P&C
insurers that accounts for the majority of assets in their securities portfolios. Based on this
analysis, we find that insurers have gained about 1% market share in US high yield and
currently own 11-15% of the market. This slight growth makes sense given higher yields
year-over-year, which tend to attract insurers looking to match their liabilities.
Supply
Primary issuance in the first half of the year mirrored H1 14 levels, but the drop-off since,
especially among energy credits, has put the market on pace for the lowest amount of
supply since 2011. About $250bn priced through November 27, and an annualized total of
$276bn constitutes a decrease of 9% y/y.
Acquisition-related issuance has been the most common use of proceeds in 2015 at
approximately 36% (Figure 19), well above its long-term average of 25%. The spread
between earnings yields (EBITDA/EV) and financing yields, an historically useful measure of
M&A appetite, has fallen to multi-year lows following the sharp sell-off in high yield. That
said, a potentially more important factor for gauging M&A activity is broad market volatility,
which has affected all types of supply throughout the year (Figure 20). The sensitivity of
different supply types to volatility partly explains the higher percentage of M&A activity this
year, in our view. While M&A is pre-committed, other supply can be delayed for longer
periods. We expect companies to continue to look closely at acquisition options next year,
with organic growth still difficult to come by in an environment of moderate US economic
growth. However, we do not foresee a meaningful increase in M&A activity from these
already elevated levels and expect the leveraged lending guidelines to continue having a
dampening effect on LBO issuance.
The flip side of companies greater focus on acquisitions this year has been a decrease in
investment, which is reflected in the lower GCP/capital expenditures supply totals. Only 16%,
or about $35bn, of new issuance has been slated for capex, driven by a $10bn decrease in
energy capex issuance y/y. We do not expect absolute levels of capex issuance to fall further,
but there is a risk of energy capex issuance completely shutting off. That said, continued
strength evident in the economic data would ease recession fears, which could be a tailwind
to economic activity in the latter half of 2016. About $65bn of bonds has been refinanced
this year, in line with the post-crisis average of 30% of total issuance. To estimate future
refinancings, we first analyze the opportunity set, which we define as the amount of debt
4 December 2015
52
FIGURE 21
2015 issuance by use of proceeds
Div/Repo
$5bn
GCP/Capex
2%
$36bn
14%
M&A/LBO
$90bn
36%
FIGURE 22
2016 issuance forecast by use of proceeds
Other
$5bn
3%
GCP/Capex
$35-45bn
15%
Refi Bonds
$75bn
30%
M&A/LBO
$85-95bn
33%
Refi Loans
$37bn
15%
Note: Data through November 24, 2015. Source: Barclays Research
Div/Repo
$8-12bn
4%
Other
$6-10bn
3%
Refi Bonds
$85-95bn
32%
Refi Loans
$30-40bn
13%
that matures or becomes callable within the next year. This has grown from $315bn to
nearly $400bn y/y, and the pace of growth has outpaced that of the overall high yield
universe. The set now represents nearly 27% of the market, compared with 22% last year, a
logical increase given this years subdued refinancing activity. The average coupon of
callable bonds next year is 7.7%, well above the average index coupon of 6.8%. That said,
only about a third of the callable set is trading above its call price. However, we anticipate
moderate spread tightening in the ex-energy portion of the index and therefore we expect
an increase in refinancing activity.
Overall, we think this years low level of issuance will likely be followed by a moderately
stronger year in the primary market. Without any clear catalysts for a sharp increase in
supply, we forecast $270-290bn of total issuance. We expect M&A-related supply to remain
robust overall, but drop slightly as a percentage of overall issuance (Figure 22). Risks to the
upside and downside of our forecast rest largely in the performance of the broader market.
A significant tightening in the secondary market would allow a broad swath of companies
to take advantage of the large refinancing opportunity and lower capital costs. We expect
refinancings to comprise approximately 30% of overall supply.
Credit derivatives outlook

CDX outperforms yet again
HYCDX is on track to outperform cash for the third consecutive year and five out of the
last six (Figure 23). The performance is all the more remarkable given that the CDS-cash
basis started the year at already-wide levels. The disconnect at times between CDX and
the cash market led to the revamping of index rules for HYCDX for the September 2015
roll. As we discussed in A New Dawn for HYCDX (August 21, 2015), Markit decided to
update the rules governing the index in order to make it more relevant to the underlying
cash market and to address declining liquidity in single-name CDS. The new index
following the changes is much more comparable to the iBoxx HY index in terms of sector
weights (Figure 24). We think the changes to the index are a step in the right direction,
and while it will take some time to develop liquidity in the new credits, the reduction of
the sector imbalances should encourage greater use of the index as either a hedge or as
an alternative way to add long exposure.
4 December 2015
53
FIGURE 23
Annual HY cash excess returns versus CDX returns
FIGURE 24
Comparing sector weights: HY24, HY25, and iBoxx HY*
25%
14%
12%
20%
10%
8%
15%
6%
10%
4%
2%
5%
0%
-2%
Note: 2015 returns as of November 27. Source: Barclays Research
HY24
HY25
Util
Telco
Tech
Indust
Health
Fin
2013
2014
2015
HYCDX Total Return
Energy
2010
2011
2012
HY Cash Excess Return
CDX minus Cash
Basic
Mat
Con
Goods
Con
Svcs
0%
-4%
iBoxx HY
Note: *iBoxx HY data include only US and Canadian issuers.

Source: Markit, Barclays Research
Other portfolio products are on the rise

While CDX remains the most liquid high yield portfolio product, with the on-the-run index
averaging more than $30bn per week in volume in 2015, there is growing competition from
exchange-traded funds (ETFs) and total return swaps (TRS). As we discussed in Picking
Portfolio Products Apart in High Yield (May 8, 2015), TRS and ETFs have lower tracking
error than CDX as they are explicitly designed to track cash benchmarks. The biggest
drawback of these products in the past has been liquidity. TRS volumes are difficult to
measure as they are traded over-the-counter, but ETFs have shown steady growth over the
past several years (Figure 25). We expect interest in these products to continue to grow as
investors look for ways to manage the liquidity risk in their portfolios.
The CDS-cash basis remains wide

Despite starting the year at wide levels, the CDS-cash basis has not made any improvement
throughout 2015 (Figure 26). We examined some of the factors that are likely to affect the
basis in the Overview, but we struggle to find a good reason CDS should trade so much
FIGURE 25
Average weekly high yield ETF volume by year
FIGURE 26
Matched high yield CDS-cash basis
bp
0
$bn
6.0
$4.9bn
5.0
-40
4.0
$3.0bn
3.0
2.0
-20
$3.2bn
-60
$2.4bn
-80
$1.6bn
-100
1.0
-120
0.0
2011
2012
Source: Bloomberg. Barclays Research
4 December 2015
2013
2014
2015
-140
Nov-14
Feb-15
May-15
Aug-15
Nov-15
Note: Calculated using 76 constituents of HY25. Source: Barclays Research
54

tighter than cash. We recognize that there are fewer basis-focused accounts in the market
today, especially amid funding concerns and the potential difficulty with managing two legs
of a trade in an illiquid environment. So, while investors may be reluctant to buy basis
packages as a carry trade, we believe the negative basis represents an attractive opportunity
for those looking to hedge or go short credit risk. As we highlighted in the Overview, the
average basis package for a sample of stressed credits is very close to par (in contrast to the
very negative basis for the broader market), which we believe demonstrates the
effectiveness of hedging with CDS.
CDX options remain a bright spot

One of the bright spots of the derivatives market over the past several years has been CDX
options. As shown in the Overview, options volumes continue to grow relative to index
volumes, and we believe this is due to the increased use of options as a way to create
defined risk-reward payoffs. Options tend to be more attractive than buying index
protection as a tail-risk hedge, and weve also seen increased use of strategies such as put
spreads to hedge downside risk (see Downside Options with Swaptions, April 17, 2015). Our
expectation is that options volumes will continue to grow as investors seek out liquid ways
to hedge.
Single-name activity has declined

2015 was a difficult year for HY single-name CDS volumes. As we discussed in Assessing
Liquidity in High Yield CDS (October 30, 2015), volumes on average for the constituents of
HY25 have declined 31%, and the median volume is down 22% (Figure 27). But we believe
the aggregate numbers alone do not tell the whole story. For most names in HY25, CDS still
provides a pickup in liquidity relative to the cash market (Figure 28). Of the 91 constituents
of HY25 for which CDS volumes were available, 58 (or 64%) had higher reported volumes in
CDS than in cash for the eight-week period ending October 23, 2015.
Overall, however, the prevailing trend for CDS market activity has been one of declining
volumes. We think activity levels are being hampered by regulatory uncertainty (as the
market awaits the implementation of the single-name swaps regulation under Dodd-Frank)
and the new capital rules under Basel III (which have changed the economics of CDS trades
for dealers). Progress on the regulatory front and moving to a cleared environment are two
things that could support single-name CDS volumes.
# of Tickers
73.8
57.5
-22.2%
Least Liquid
DLX (7.1)
DLX (2.1)
Most Liquid
JCP (350.0)
CHK (255.1)
6
2
2 2
4 December 2015
Greater Volume in CDS

Note: Calculations based on the 91 index constituents for which volume data
were available. Source: DTCC, Barclays Research
5
2
Util
Median Weekly
Volume
13
Telco
-31.4%
Tech
58.0
Ind
84.5
17
Health
Avg Weekly
Volume
18
16
14
12
10
8
6
4
2
0
Fin
y/y
%chg
Cons Goods
Aug 2015
($mn)
Basic Mat
Aug 2014
($mn)
Energy
6m Period Ending:
FIGURE 28
Volume comparison of HYCDX S25 constituents
Cons Svcs
FIGURE 27
HYCDX S25 constituent volume comparison: 2014 vs. 2015
Greater Volume in Cash
Note: Chart includes the 91 index constituents for which both cash and CDS
volume data were available. Volumes calculated using data from the eight-week
period ending October 23, 2015. Source: DTCC, TRACE, Bloomberg, Barclays
Research
55
FIGURE 29
HYCDX spread by on-the-run series
FIGURE 30
HY25 constituent spread distribution
550
# of Tickers
25
21
18
20
451bp
13
10
400
16
15
7
600-1000bp
450
500-600bp
500
356bp
HY24
Nov-15
HY25
Note: Spread levels have been adjusted for defaults. Source: Barclays Research
>1000bp
Sep-15
400-500bp
HY23
Jul-15
300-400bp
May-15
200-300bp
Mar-15
100-200bp
300
Jan-15
0
<100bp
350
Upside for CDX appears limited

While the on-the-run HYCDX index trades nearly 100bp wider than it did at the start of
2015 (partly due to portfolio changes, and partly due to widening; Figure 29), it continues to
suffer from a very bifurcated spread distribution (Figure 30). Currently, 28% of index
constituents trade inside 200bp, 46% trade inside 300bp, and 62% trade inside 400bp. The
aggregate upside from these credits appears very limited, and as a result they are unlikely to
contribute to index tightening. At the other end of the spectrum, 13% of the index trades
wider than 1,000bp. These are stressed/distressed credits that are likely to continue trading
at very wide levels unless there is significant improvement in their fundamentals. As a result,
we believe overall upside for the index from current levels is limited. This, combined with
the very negative basis, should make HYCDX an attractive hedging vehicle in 2016.
4 December 2015
56
US LEVERAGED LOANS AND CLOS
Poised for performance

We forecast total returns of 5.0-6.0% and excess returns of 4.0-5.0% for US loans in
Bradley Rogoff, CFA
2016. We estimate returns from carry of about 4.7% and moderate price upside of $1-2.
+1 212 412 7921

We forecast a rise in loan defaults to 2.75-3.25% on an issuer-weighted basis for 2016.
BCI, US
The loan default rate is likely to be lower than that of high yield, given that most of our
anticipated increase in high yield defaults stems from commodity credits.
Eric Gross
+1 212 412 7997
We forecast a moderate increase in loan supply (ex-repricings) y/y to $250-275bn
next year. We expect M&A activity to maintain a large share of the primary market but
not rise significantly and for refinancing activity to remain subdued.
BCI, US
We forecast $70-80bn of CLO issuance in 2016. The CLO market faces a variety of
Anthony Bakshi
headwinds that will likely weigh on supply, including further risk retention-driven
manager consolidation and the negative effect of rising rates on potential equity IRRs.
+1 212 412 5272

anthony.bakshi@barclays.com
BCI, US
Overview
The loan market has returned 1.17% so far in 2015 (Figure 1), maintaining positive returns
despite trading down sharply since the late August selloff that affected most risk assets. Loans
have returned significantly more than high yield 3.3% ahead on total returns to date and
are on pace to exceed high yield returns for the first time since 2007. Loan performance has
benefited from a beta to high yield that has been below historical levels. The loan to high yield
beta has been 0.3 year-to-date, compared with 0.6 since 2007. The two markets relationship
partly depends on overall spread levels (see A Shifty Beta, May 22, 2015), but the subdued
sensitivity of loans has persisted in the higher spread environment this fall (Figure 3). Despite
the relative strength, the loan market is on pace to deliver a Sharpe ratio of less than 1 for the
first time since the crisis era (Figure 2). The driver of the decrease has been the disappointing
returns, as returns volatility this year is at a level similar to that of 2012-14.
FIGURE 1
Annual loan returns
15%
FIGURE 2
Loan Index Sharpe ratio
+51.9%
2016 forecast:
5.0-6.0%
3.5
3.0
10%
3.0
2.6
2.6
2.5
2.0
5%
1.6
1.5
1.0
0%
-29.3%
-5%
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Note: Annual returns of the S&P/LSTA Performing Loans Index.
Source: S&P LCD, Barclays Research
4 December 2015
0.6
0.4
0.5
0.0
'97-'01
'01-'06
'06-'09
'10-'12
'12-'14
'15
Note: Ratio of annualized monthly total returns of the S&P/LSTA Performing

Loans Index to annualized monthly volatilities.
57
FIGURE 3
Spread beta of loans to high yield
FIGURE 4
Cumulative retail fund flows and fund AUM since 2013
0.7
80
160
0.6
70
140
60
120
50
100
40
80
0.5
0.4
0.3
30
60
0.2
20
40
0.1
10
20
0.0
Since 2007
Since 2010
Since 2014
YTD
Since 8/20
0
Jan-13
0
Jul-13
Jan-14
AUM ($bn) (RHS)

Note: Weekly betas of changes in OAS for HY and 3y effective spread for the
Barclays Performing Loans Index. Source: Barclays Research
Jul-14
Jan-15
Jul-15
Cumulative Flows ($bn)
Source: Lipper, Barclays Research
2016 Returns Forecast

We forecast total returns of 5.0-6.0% and excess returns of 4.0-5.0% for loans in 2016.
Carry returns should be meaningful, with the market currently at a nominal spread or
coupon of 437bp, including Libor floors, and an average price of $94.62. Overall, we
estimate carry returns of 4.7% in 2016. This total incorporates a minor benefit from shortterm rates rising above the prevalent Libor floor of 100bp in the second half of 2016, as
projected by Barclays rates research team.
On top of the returns from carry, we expect modest price appreciation in the loan market.
Loans should benefit from a stable domestic economy and the markets relatively low
exposure to the energy sector, which will likely limit significant sector-driven downside. This
years selloff has resulted in a loan market with atypical potential price upside, with only
about 10% of loans currently trading above par (Figure 5). Apart from the credit crisis era,
loan prices have never before remained so far below par for a consecutive period of longer
than five months. We expect moderate domestic growth next year, which should produce
an environment conducive to $1-2 of aggregate loan price increases. Meanwhile, we
anticipate a higher default rate next year, as detailed in the next section, and estimate about
50bp of total losses from defaults. Repricing had a minimal effect on index-wide coupons
this year (about 5bp), and we expect repricing volume to remain similarly moderate (510bp) in our 2016 base case scenario.
Although our outlook is largely positive, we acknowledge an abundance of downside risks.
Despite concerns about regulatory effects on the CLO market entering 2015, the CLO bid for
loans turned out to be robust, especially in the first half. About $90bn of CLOs have been
issued, which has provided incremental net demand surpassing both amortizing structures
and the persistent retail outflows from loan mutual funds (Figure 4). Recently, however, the
trend of widening CLO secondary spreads and a halting loan primary market has coincided
with a significant slowdown in the creation of CLOs, the primary demand engine for loans.
The wide gap between expected rates of return on equity in the primary and secondary
markets has made it difficult to place new deals, while lower-tier managers have
simultaneously struggled to find AAA buyers. We anticipate slower, but still healthy, CLO
issuance of $70-80bn next year, as detailed later, in the CLO section. That said, lower
issuance, caused by unattractive economics and/or a larger-than-expected effect of risk
retention instatement, would weigh heavily on loan performance. In addition, the loan
4 December 2015
58
FIGURE 5
Loan price distribution
FIGURE 6
Loan and high yield sector exposures by par outstanding
100%
20%
90%
16%
80%
70%
12%
60%
50%
8%
40%
30%
4%
20%
10%
0%
Jan-13
0%
Jul-13
Less than 70
Jan-14
70-80
80-90
Jul-14
90-100
Jan-15
Jul-15
Par and Above
Note: S&P/LSTA Performing Loans Index Source: S&P LCD, Barclays Research
Tech
Healthcare
+ Pharma
Retail
Loans
Media
Gaming +
Lodging
HY
Note: Retail includes consumer cyclical services due to overlap in classifications.

Performing Loans Index data. Source: S&P LCD, Barclays Research
market faces potential sector risks that differ from those in high yield. Technology,
healthcare, and retail credits make up 35% of index par, compared with 20% in high yield
(Figure 6). Although there are idiosyncratic headwinds that may drive the loans of individual
credits much lower, we do not expect these sectors to face systemic challenges that would
meaningfully drag on index returns in 2016.
Default Risk
Although the default rate for high yield bond issuers is already on the rise, reaching 3.8% on
an LTM basis as of the end of October, the loan default rate is still a very mild 1.47% and
does not yet show signs of acceleration (Figure 7). The divergence certainly reflects the
difference in energy exposure across these two parts of the leveraged finance market, and,
given that most of our anticipated increase in high yield default rates is driven by
commodities sectors, we believe the divergence can persist. It also reflects a structural
difference in loan and bond default rates arising from the fact that distressed exchanges,
which count toward the default rate, are typically offered for bonds rather than loans.
Nonetheless, we forecast a rise in loan defaults to 2.75-3.25% on an issuer-weighted basis
for 2016. Similarly to high yield, we arrive at this range by combining an econometric model
and a bottom-up analysis of loan issuers. From the top down, our model relies on changes
in underwriting standards, as captured by the Feds senior loan officer opinion survey, and
the percentage of the loan market trading below $80. The top-down model currently
forecasts 3.5% (Figure 8). From the bottom up, we are slightly more constrained by the
private nature of financials in the loan market. Although this precludes us from having an
explicit bottom-up forecast, our analysis of issuers produces very few with near-term
default risk. This suggests that the econometric model forecast should be shaded lower,
and we therefore also expect the par-weighted default rate to be lower than the issuerweighted rate in 2016.
4 December 2015
59
FIGURE 7
Loan and bond issuer-weighted default rates
FIGURE 8
Modeled and realized issuer-weighted loan default rate
18%
20%
16%
16%
14%
Current 12-month
model forecast:
12%
12%
10%
3.5%
8%
8%
6%
3.80%
4%
0%
Oct-96
1.47%
May-00
Dec-03
Jul-07
US Loan Issuer
Feb-11
4%
2%
0%
Nov-04
Sep-14
Aug-07
May-10
Realized (next 12m)
US Bond Issuer
Feb-13
Nov
Forecast (next 12m)
Note: Shaded area represents 90% confidence envelope.

Source: Federal Reserve, Moodys, S&P LCD, Barclays Research
Sectors
The difference in sector exposures is an important consideration for investors determining the
relative value between loans and high yield. The largest sector trade-off between the two
markets is the substitution of outsized energy exposure (~15% of high yield par) for large tech
exposure (~16% of loan par). The concentration of tech names in the loan index has increased
steadily, while commodity exposure has remained low over the years of high unsecured
energy issuance (Figure 9). This year, the loan markets sector weightings have contributed to
its relative outperformance; while the commodity sectors have sold off to distressed levels,
tech and healthcare credits have remained above $96 (Figure 10).
We do not expect a build-up of sector-specific concerns in the largest loan sectors that
would meaningfully weigh on returns in 2016. However, there are significant idiosyncratic
credit risks that may play out. Clear Channel, for instance, is the largest media non-cable
issuer, and portions of both the tech and retail/consumer services sectors consist of
businesses facing long-term, secular decline. That said, our fundamental analysts are
generally positive on most of the large issuers in the prominent loan sectors. Therefore, our
FIGURE 9
Loan index sector exposure by par
FIGURE 10
Loan sector prices
20%
100
16%
90
12%
80
8%
70
4%
60
Nov-14
0%
'99
'01
'03
Tech
Energy
'05
'07
'09
'11
'13
Healthcare
Metals & Mining
'15
Note: S&P/LSTA Performing Loans Index. Source: S&P LCD, Barclays Research
4 December 2015
Feb-15
Tech
Energy
Perf. Index
May-15
Aug-15
Nov-15
Healthcare
Metals and Mining
Note: Barclays Loan Index sectors. Source: Barclays Research
60

view is that such stories are unlikely to add up to massive sector dislocations next year. An
accommodating economic environment in 2016, ex-energy, will likely help drive moderate
price appreciation in the major sectors, and therefore in the index overall.
Quality
A flight to quality has been evident in the loan market in 2015. Throughout the sell-off, the
demand for higher-quality paper has persisted, and BBs have held in relatively well. BBs are
currently trading at about $97, just $1 below year-end levels, compared with a market that
is down about $3 overall. As a result, BBs have tightened significantly relative to the index
and are now at their tightest since the summer of 2013 (Figure 11).
The current relative value picture leaves single-B loans poised to outperform next year, in our
view. The gap between single-Bs and BBs is at nearly 250bp on effective spread terms, the
widest it has been in four years, and a moderate domestic growth environment in 2016 should
be supportive of spread tightening in the single-B segment of the market. In addition, large
dislocations between B and BB loans have historically resulted in significant single-B
outperformance in the subsequent year. The largest spread difference between single-Bs and
BBs exceeded 200bp in each year from 2010-12; in the 12 months that followed each
instance, single-Bs returned an average of 3.3% more than double-Bs.
That said, we remain cautious on the lower tier of the single-B market and specifically prefer B
and B+ loans. Fundamental deterioration in single-Bs has become a major concern of CLO
managers eyeing their CCC bucket limits, as detailed in the CLO section, which may continue
to constrain demand for higher-yielding single-Bs. The valuation gaps between BBs and the B
and B+ segments individually look elevated on a historical basis as well (Figure 12), which
positions the higher tier of the single-B universe for outperformance in 2016.
FIGURE 11
BB Loan effective spreads relative to overall index
FIGURE 12
Effective spread gap between B and BB loans (bp)
900
90%
800
85%
700
600
80%
500
75%
400
300
70%
200
65%
100
0
Jan-12
60%
Sep-12 May-13 Jan-14
BB/Index (RHS)
Sep-14 May-15
Index (bp)
Note: Barclays Performing Loans Index. Source: Barclays Research
4 December 2015
BB (bp)
400
800
350
700
300
600
250
500
200
400
150
300
100
200
50
100
0
Jan-12
0
Sep-12 May-13
B+ - BB
Jan-14
B - BB
Sep-14 May-15
B- - BB (RHS)
61
Supply and demand

Demand
After several years of rapid expansion, the leveraged loan market stagnated this year.
Following two consecutive years of +20% y/y growth and a 9% CAGR in par outstanding
from 2010 to 2014, the size of the S&P/LSTA Leveraged Loan Index has fallen by 1% since
year-end (and increased by just 1% in par terms). The slowdown in growth is attributable to
both the fall in the average price of the index, which is currently at $94.62, and a significant
reduction in primary issuance.
Changes in the loan buyer base this year have been caused by the divergent fortunes of CLOs
and loan mutual funds, the two primary sources of demand. Primary CLO creation, currently
at about $90bn, has been a source of incremental demand for loans. Meanwhile, retail funds
have seen persistent outflows that now total nearly $17bn, or 13% of AUM, since year-end.
The probable slow nature of the Feds hiking cycle, along with the Libor floor benefit in most
loans, makes it difficult to expect any near-term catalysts for a significant rebound in retail
interest. That said, a moderation of outflows is likely, and a potential uptick in rates
expectations after the initial Fed move could generate retail demand in the latter part of 2016.
Closed-end funds, which are currently trading at historically steep discounts to NAV, also
lost share on a y/y basis, as the discounts limited the ability for new issuance. Including
closed and open-end funds and ETFs, loan-dedicated retail ownership has fallen to 12-14%.
These divergent trends have shifted the majority of loan ownership back to CLOs, which
currently represent 52-55% of the market (Figure 13).
Other public vehicles, including non-dedicated mutual funds and BDCs, also lost share this year.
BDCs own a small portion of the institutional loan market, less than $10bn by our estimates,
and are mainly interested in second liens, which have sold off sharply this year and form a small
portion of 2015 issuance. High yield and other fixed income retail funds own an amount similar
to BDCs, according to our estimates. Meanwhile, insurance portfolio ownership has risen
slightly since last year as the spread widening in loans has made it more attractive in the crossasset search for yield. That said, the sell-off has not attracted hedge funds, which have had
ample opportunities in higher-beta parts of the credit universe. The alternative investment
category now owns about 21-24% of the market, down 3pp from last year; we think a shift has
occurred within that category, from hedge funds to separate accounts.
52-55%
12-14%
21-24%
3-6%
-1%
2-4%
-1%
-3%
2-4%
2015
-5%
24-27%
1-3%
+8%
17-19%
+2%
44-46%
3-6%
2014
2-4%
FIGURE 13
Estimated share of US leveraged loan holdings
U.S./Euro CLOs
Loan Mutual Funds (Open, Closed, ETFs)
Hedge Funds/TRS/Separate Accounts
Insurance (P&C & Life)
Non-Loan Mutual Funds/BDCs
Other (Banks, etc.)
Note: Some 2014 statistics have been adjusted to reflect methodology changes.
Source: Lipper, EPFR, Bloomberg, Creditflux, CEF Connect, Intex, S&P LCD, HFR, Fund filings, Barclays Research
4 December 2015
62
FIGURE 14
Monthly loan supply ($bn)
FIGURE 15
Annual issuance by use of proceeds
100
100%
90
90%
80
80%
70
70%
60
60%
50
50%
40
40%
30
30%
20
20%
10
10%
0%
May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 Nov-15

Ex-Repricing
Repricing
2010
2011
Div/Recap
2012
2013
M&A/LBO
GCP
2014
Refi
2015
Other
Note: Excludes repricings. Source: S&P LCD, Barclays Research
Supply
The loan primary market never kicked into full gear in 2015, trailing last years issuance totals
from the beginning of the calendar year (Figure 14). About $225bn priced through November
27, ex-repricings, which annualizes to about $250bn. The market is on pace for its lowest
notional supply amount since 2011 and the lowest level as a percentage of market size (27%)
since the credit crisis. In the spring, the market environment of high prices and positive spread
tightening momentum led to a spate of repricing activity, but total repricing has still amounted
to just $61bn, a multi-year low. M&A and LBO issuance has constituted most of the subdued
supply total, combining for 62% of ex-repricing activity (Figure 15).
The most recent Shared National Credits (SNC) review sheds some light on lending trends
within this smaller universe of loan new issues. The effects of the leveraged lending
guidelines are evident in the changing distribution of new loan leverage. The share of the
new issue market with 7x or greater leverage has dropped to 2.4%, from 7.3% at the end of
last year, and no new deals were done in 3Q15 with more than seven turns of leverage . The
6-7x bucket has also shrunk materially y/y, and the 5-6x bucket has picked up most of the
slack (Figure 16), suggesting that many deals that would have had greater than 6x leverage
adjusted their financing to get onside with respect to the guidance, enabling supervised
entities to participate. Purchase multiples have continued to tick higher the average
purchase multiple for large LBOs has grown to 10.2x year-to-date, from 9.7x in 2014, and is
at the highs since at least 1997 (Figure 17). For large LBO transactions, larger equity checks
are the only way for these deals to get done without crossing into leverage territory in which
banks cannot follow. The average equity contribution in large LBOs increased to 39% in
2015 from 36% in 2014. We do not expect a significant increase in M&A and LBO issuance
in 2016, given both the larger equity checks required from sponsors and generally elevated
equity valuations at this stage of the business cycle.
In a reversal of a post-crisis trend, supply tilted heavily toward higher-quality loans in 2015.
Single-B and below-rated issuance dropped from 68% of total supply in 2014 to 50% this
year. Part of this change is, in our view, attributable to the continued shift away from LBOs to
M&A. In addition, as the valuation gap between BBs and Bs reached multi-year highs, it
became significantly more cost effective for companies to finance with higher-quality loans. In
the same vein, second-lien issuance has dropped to about $9bn at the same time that
secondary second liens have sold off precipitously, partly because of the higher exposure to
energy credits in this segment of the market.
4 December 2015
63
0%
29.0%
'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 *
< 4.0x
4.0x-4.9x
5.0x-5.9x
6.0x-6.9x
Note: 2015 data through 2Q. Source: S&P LCD, Barclays Research
7.0x
4.3x
5.8x
10.2x
3.8x
3.3x
5.5x
9.7x
5.9x
3.6x
5.3x
3.7x
3.8x
5.3x
10%
5.0x
20%
5.3x
30%
6.3x
24.8%
9.1x 8.9x 8.8x

8.5x
4.8x
40%
7.9x
3.8x
50%
7.4x
8.6x
4.0x
60%
8.2x
4.2x
27.5%
3.6x
70%
2.9x
80%
9.8x 9.5x
10
5.7x
16.3%
12
2.6x
2.4%
90%
5.6x
100%
FIGURE 17
Average Equity and Debt Multiples of Large* LBOs
2.4x
FIGURE 16
Volume-Weighted Leverage for New Loan Transactions
'04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 *
Debt/EBITDA
Equity/EBITDA
EV/EBITDA
Note: * Large defined as companies with more than $50mn in EBITDA. 2015 data
through 3Q. Source: S&P LCD, Barclays Research
The supply outlook also depends on the health of the retail and CLO markets. As discussed
above, we expect a moderation of outflows in the near term and the potential for more
significant interest from retail investors later in 2016. Our forecast for CLO issuance is $7080bn, as detailed in the final section, and this level of creation is sufficient to provide a positive
technical for the loan market, in our view. Overall, we expect a moderate rebound in loan
supply next year, to $250-275bn, ex-repricings. While a healthy pipeline of deal-related
issuance should boost issuance volumes early in 2016, we do not see a catalyst for a
meaningful rise in deal-related activity, especially as dealers look to comply with the leveraged
lending guidelines. In addition, there will be little need for refinancings in 2016, as the loan
maturity wall has been pushed back beyond 2020. While primary market activity will likely rise
from this years low levels, especially given a less volatile macro backdrop, we do not envision
an environment conducive to the mid-$300bn supply levels of 2013 and 2014.
CLO Trends
It has been a tale of two halves for the CLO market in 2015. Primary issuance was strong in
the first half, with $60bn of new structures created overall. Meanwhile, secondary levels
tightened from 2014 year-end levels that had widened due to the initial energy-driven
selloff in late 2014. But a combination of factors has slowed CLOs in recent months. The
broad market sell-off in August brought secondary trading activity to a halt as investors
expressed concerns about energy exposure and more general deterioration in collateral
quality. The wider secondary levels, in turn, created a relative value gap between potential
equity returns in existing and new issue structures, which made it much more difficult for
managers to place new deals. In addition, persistently low loan supply has decreased the
available collateral for new deals. Manager tiering has continued to be a theme in both the
primary and secondary markets there has been notable dispersion in new issue AAA levels
across recent deals, depending on the collateral manager, and secondary valuations
continue to be primarily driven by a combination of manager quality and the amount of
commodity exposure in the collateral.
4 December 2015
64
FIGURE 18
Secondary CLO spreads (bp)
FIGURE 19
CLO issuance required to offset amortization ($bn)
800
140
700
120
600
100
500
80
400
60
300
40
200
20
100
0
AAA
AA
Year-end 2014
BBB
End 1H15
Note: 2.0 deals. Source: Markit, Barclays Research
Current
BB
'11
'12
CLO Issuance
'13
'14
'15
'16
'17
'18
'19
Issuance Required to Offset Amortization
Note: Gray bar is 2016 estimate of CLO issuance. Year-to-date 2015 total.
Source: Intex, S&P LCD, Barclays Research
Despite intra-year turbulence, the market has issued a robust $90bn. Secondary levels have
remained wide of the mid-year tights but are mostly at similar or tighter levels than year-end
2014 (Figure 18). Spreads have stabilized in recent weeks, spurring a pick-up in buyer interest.
For 2016, we forecast a further reduction in CLO issuance to $70-80bn total. Issuance in this
range would be a positive technical for incremental loan demand. We estimate that total
issuance required to offset amortization is $50bn, as the large wave of 2.0 deals exiting their
reinvestment periods is still several years out and nearly 80% of CLO structures will remain in
their reinvestment periods through 2016 (Figure 19).
There are both regulatory- and demand-driven downside risks to our CLO forecast. Risk
retention will begin to be enforced at the end of 2016, and managers have been preparing
for the start date this year. Although the majority of 2015 new issues have not been
compliant, the proportion of new deals that are compliant has accelerated of late (Figure
20). Earlier in the year, there was evidence of a pull-forward effect on supply driven by
regulation, as managers chose to issue deals with 1.5-year non-call periods to leave
refinancing options open prior to December 2016. Such structures are no longer viable, and
we anticipate that the majority of new issuance will be risk-retention-compliant in 2016.
Another looming regulatory concern for CLOs is the finalization of the Fundamental Review
of the Trading Book (FRTB), which is expected by year-end from the Basel Committee for
Banking Supervision. Current FRTB documents incorporate a significant increase in bank
capital requirements for securitized products. The instatement of the framework in its
current form would constitute a negative for liquidity in the CLO secondary market.
Managers have used both the horizontal and vertical slice options in this years risk retentioncompliant deals. Horizontal slices have been used by managers and their affiliates to retain a
majority of equity tranches, while vertical slices are amenable to retention financing
agreements between CLO managers and other institutions. Meanwhile, managers that do not
have sufficient internal capital have sought a variety of partnerships. Multiple M&A deals
have occurred between experienced CLO managers and financial institutions with larger
pools of capital, and more are likely to take place in 2016. As a result of such transactions,
caused by an increase in the barriers to entry for CLO issuance, the market has started to
see clear evidence of manager consolidation. The quantity of deals issued by new CLO
managers has fallen steeply from prior years only six new managers have entered the
market in 2015, compared with 18 last year and 29 in 2013 (Figure 21). In contrast, 30
managers that issued CLOs in 2014 have not participated in the market at all in 2015.
4 December 2015
65
FIGURE 20
New issue CLOs by US risk retention compliance ($bn)
FIGURE 21
New and existing manager issuance of US CLOs 2.0 ($bn)
35
35%
140
30
30%
120
25
25%
100
20
20%
80
15
15%
60
10
10%
40
5%
20
0%
0
1Q15
2Q15
Non-Compliant
3Q15
Compliant
4Q15
% Compliant (RHS)
18
29
2013
2014
Existing Managers
2015
New Managers
Note: Numbers represent count of new CLO 2.0 managers. Excludes middlemarket deals. Source: S&P LCD, Barclays Research
Although risk retention will remain a theme in the months ahead, we think the more
pressing risk for the CLO primary market next year is investor demand. The equity arb is
currently at mid-teen levels (Figure 22), below the realized return of equity investors over
the past few years. That said, historical realized returns have been significantly enhanced by
rates remaining below forward curve-implied levels. Indeed, the recent collateral selloff has
made the implied equity return look more attractive than it has over most of the past two
years. In addition, structural changes that benefit equity holders have been evident in new
deals in 2015. Managers have boosted leverage this year, with the median equity leverage
rising from 10.7x in 2014 to 11.5x (Figure 23).
The looming start of the Feds rate hiking cycle will weigh on equity IRRs. As rates rise, CLO
debt holders will receive higher floating rates that are not matched by increases in collateral
gains that would benefit equity holders, until the prevalent 1% Libor floor is breached (see
CLO Equity Investors: You Have the Floor). On the senior liability side, we believe it has been
difficult to find large buyers of AAAs of new deals, even at wider spreads and especially for
deals brought by lower-tier managers. Although these factors have slowed creation recently,
we expect an easing of these conditions next year, allowing for a lower, but still robust,
issuance total. CLO AAAs look attractive on a relative value basis across securitized products
(see Cross Asset Outlook 2016: Relative value across securitized credit), which should spur
incremental demand for the product.
Meanwhile, tranches in the secondary market will likely continue to face collateral quality
questions in the near term. Investors have recently been concerned about the single-B
portion of the loan market, which has sold off significantly relative to BBs. A flurry of ratings
downgrades in the single-B universe would meaningfully affect the CCC bucket cushions of
existing deals, which typically have 7.5% limits. Although CLO holdings of CCCs are
currently well contained, with a market-wide share of 3-4%, further deterioration in quality
would constitute a key development for CLO secondary levels. In addition, our expectation
of a higher default rate environment will translate to steep collateral losses in some
structures. That said, we expect most defaults to occur in the commodity space, and energy
exposure in CLO collateral is relatively low, with median deal exposure of about 5% across
both energy and metals & mining. This low exposure will likely shield the majority of
structures from major default-driven losses.
4 December 2015
66
FIGURE 22
CLO equity arb
FIGURE 23
Median leverage of equity tranches in CLO new issues
20%
12.0
18%
11.5
16%
11.0
14%
10.5
12%
10%
10.0
8%
9.5
6%
9.0
4%
8.5
2%
0%
Jan-14
8.0
May-14
Sep-14
4 December 2015
Jan-15
May-15
Sep-15
'11
'12
'13
'14
'15
Note: Broadly syndicated loans only. Source: S&P LCD, Barclays Research
67
MUNICIPAL CREDIT
No pain, no gain
Mikhail Foux
+1 212 526 7849
mikhail.foux@barclays.com
BCI, US
Sarah Xue
+1 212 526 0790
sarah.xue@barclays.com
BCI, US
Mayur Patel
+1 212 526 7609
mayur.xa.patel@barclays.com
BCI, US
Higher Treasury rates, rich valuations and headline risks are set to make 2016 a
lackluster year for the municipal market. For tax-exempts, we expect somewhat
higher ratios and credit spreads and for taxable munis, slightly tighter spreads.
In our view, the first half of the year should be fairly difficult, especially if the Fed is
more aggressive; municipal issuance might once again be front loaded, and higher
rates might cause fund outflows. However, we believe that the muni market should
stabilize by the second half of 2016.
Next year, we expect $355-370bn of long-term gross municipal supply (down 7-12%
y/y) and $360bn of redemptions. This results in a roughly flat net supply forecast.
In our view, overall municipal credit quality should continue to improve, and we do
not envision widespread municipal credit troubles in 2016. That said, if and when
the next recession materializes, current problem areas could materially worsen.
Given rich valuations and potential pressures from rates, in our view, it will be
somewhat difficult to find numerous attractive relative value opportunities in 2016.
Hence, investors should spend extra time sourcing alpha.
In high grade, we do not see much value in AA credits and find better opportunities
further down the credit spectrum. We believe the muni yield curve is likely to flatten.
We like toll roads, education, strong hospitals, and selected appropriated bonds, as
well as fixed income instruments wrapped by monolines.
Muni high yield appears rich, possibly with the exception of MSA tobacco bonds; we
recommend cuspy BBB/BB-rated credits instead.
In the taxable space, we see few attractive opportunities. However, we still see value
in callable BABs, MEAG/Santee Cooper, and Chicago Water and Wastewater debt.
Risk and returns

We project next years total returns of the IG Barclays tax-exempt municipal index to be
slightly negative (-1% to -0.5%), but excess returns to be above zero (+0.5% to 1%). For
taxable munis, we forecast total and excess returns of 1-1.5% and 3-3.5%, respectively,
on the back of credit spreads moving tighter 10-15bp by the end of 2016.
Volatility ahead
We expect 2016 to be relatively difficult for municipal investors, for a number of reasons:
The Fed. Investors overwhelmingly expect a 25bp tightening move later this month, but
the trajectory of Fed tightening after that is extremely uncertain. Barclays rate
strategists expect the Fed to hike several times next year; if this comes to fruition, rate
volatility is likely, even if 10y Treasuries continue to trade in a relatively narrow trading
range (2.1-2.6%) as per our strategists forecast.
Valuations. After their 4Q rally, munis are set to start 2016 at fairly rich valuations, both
outright and compared with Treasuries. Ratios are already trading through fair valuations
at the current level of rates, and it is hard to expect any outperformance from munis in the
coming months (Figure 1). Credit spreads (especially AAs) also look fully valued (Figure 2),
meaning that if rates start rising, munis may be unable to cushion the move fully.
4 December 2015
68
FIGURE 1
Muni-Treasury ratios 2-year range
FIGURE 2
Yield-to-worst differentials (bp)
Ratio (%)
Differential (bp)
140
140
130
AA-AAA
A-AA
BBB-A
120
120
110
100
100
80
90
60
80
40
Current
70
20
60
0
Jan-12 Aug-12 Mar-13 Oct-13 May-14 Dec-14
50
2y
5y
10y
15y
20y
30y
Source: Barclays
Jul-15
Risk Analytics and Index Solutions
Regulations and headline risk. 2016 is a US election year and there will likely be many
headlines related to overhauling the tax code. Although actual action on this front is
unlikely near term, headline risk will likely remain elevated and could affect the muni
market. Meanwhile, new rules for banks and mutual funds could affect their appetite,
which could translate into higher liquidity premiums and lower liquidity.
Credit concerns. For the most part we have a pretty positive view on municipal credit,
but a number of high-profile municipal credits could continue to generate negative
headlines, with a larger effect on the broader muni market.
Lackluster returns in 2016

We project next years total returns of the Barclays tax-exempt municipal index at -1.0% to 0.5%, and forecast its excess return at +0.5-1%. To arrive to this result, we broke returns into
four components: carry, rates, muni ratios and credit spreads. To project total and excess
returns, we calculated the average rating of the index (AA) and determined the market weight
and the duration of the index falling into each of the following maturity buckets: 0-3yr, 3-7yr,
7-12yr, 12-17yr, 17-22yr and 22yr+ so the returns could be compared to the similar-weighted
Treasury index. For UST rates, we used the year-end Barclays forecasts.
The Barclays tax-exempt muni index has a carry of 2.03%, which is slightly lower than the
2.14% of the Treasury index. To determine the effect of ratios for each maturity bucket, we
regressed AAA muni yields on Treasury yields, and assumed that by the end of next year
all ratios will return to their fair values given the forecast level of rates. Helped by the
positive backdrop of the improving economy and higher rates, muni ratios will likely be
somewhat lower than the fair value forecasts, in our view. We also believe the yield curve
should bear-flatten.
We expect the 5yr, 10yr and 30 yr muni ratios to reach 77%, 93% and 102%, respectively, by
the end of next year. Currently the AAA-AA muni spread is at its post-crisis low, rallying by
10bp in 2015. We expect credit spreads to decompress slightly next year, widening by 5-7bp
so they get closer to their 12-18mo averages. Using the durations above, and the projected
rates moves for each maturity bucket, we were able to forecast the total and excess returns of
municipals in 2016 (Figure 3).
4 December 2015
69

FIGURE 3
Tax-Exempts: expected returns in 2016
Muni /
Muni Yield
UST
Treasury Ratio Change Treasury
Forecast
Forecast
Forecast
Carry
Muni
Carry
Muni
Total
Return
Muni
Excess
Return
0.12%
0.09%
-0.04%
0.01%
0.55%
0.31%
0.23%
-0.16%
0.06%
93%
0.50%
0.42%
0.38%
-0.16%
0.05%
2.75%
103%
0.47%
0.39%
0.40%
-0.19%
0.12%
2.55%
2.90%
105%
0.43%
0.32%
0.34%
-0.11%
0.21%
2.92%
3.20%
102%
0.40%
0.57%
0.57%
-0.31%
0.15%
2.14%
2.03%
-0.98%
0.60%
Maturity
Bucket
Index
Weight
Muni
Duration
Treasury
Duration
Current
UST Yield
12.9%
1.77
1.93
0.94%
1.65%
77%
0.60%
18.9%
3.78
4.60
1.64%
2.25%
77%
10
19.4%
5.67
7.87
2.18%
2.60%
15
16.6%
7.54
10.50
2.35%
20
12.6%
8.38
14.60
30
19.6%
11.12
18.70
Total
Using a similar methodology for the Barclays taxable muni index, we project total and excess
returns of 1-1.5% and 3-3.5%, respectively. As Figure 4 shows, taxable munis have been
outperforming corporates for nearly 18 months. They are still trading about 30bp wide of their
recent lows, reached in 2014; however, given that munis and corporates are subsectors of the
Barclays Credit index, we think it will be hard for taxable munis to outperform from current
levels unless long-dated high grade corporates also perform well, since credit investors
monitor relative value between the two products. Consistent with the IG corporate forecast,
we expect taxable munis to tighten about 10-15bp.
Market outlook
2015 started at rich ratios and low yields, which came under pressure in the first half of the
year from higher Treasury rates and a massive increase in supply, resulting in fund outflows.
Rates stabilized, heavy issuance diminished and outflows stopped. As it stands now,
Treasury rates are still slightly higher than where they started 2015, but tighter municipal
spreads have helped to offset this performance drag, helping munis to roughly make their
coupon for the year, returning only 2.2% year-to-date.
In our view, 2016 will have a lot of similarities with 2015. We again expect a relatively
difficult start to the year, especially if rates and ratios continue getting richer in the coming
weeks. Rates are likely to move gradually higher as investors start pricing in their
FIGURE 4
Corporates vs taxable munis
280
FIGURE 5
The winter effect on Q1 GDP
55
Diff
Taxable Munis +20y
U.S. Long Credit
240
35
GDP (%)
5
4
3
200
15
2
1
160
-5
0
-1
120
Jan-12
-25
Jan-13
Jan-14
Source: Barclays Risk Analytics and Index Solutions
4 December 2015
Jan-15
-2
1Q10
1Q11
1Q12
1Q13
1Q14
1Q15
Source: Bloomberg
70

expectations of the Feds tightening trajectory. In our view, issuance is likely to be frontloaded as municipalities will likely try to pull their deals into the first half of the year so they
can place deals before the Fed pushes rates substantially higher. Moreover, higher shortterm rates make advance refunding cheaper for issuers.
Higher rates and wider ratios could cause outflows. As discussed in Decomposing Municipal
Fund Outflows (July 22, 2015), Treasury rate selloffs tend to precede municipal outflows,
including the ones that started last spring. Hence, we believe that munis could come under
pressure in the first half of the year, but they should recover some of their losses in the
second half. Tax-exempt munis are likely to have a rather lackluster year in terms of total
and excess returns, but in our base case scenario, we do not foresee a repeat of 2013.
What is not priced in at the moment? There are several risks to the outlook:
Rates
In the muni space, everything starts and ends with Treasury rates. All large municipal
selloffs in recent history (with the exception of 2008-09) have followed Treasury selloffs,
and vice versa there have been no periods of substantial municipal volatility when rates
have been stable. With the Feds decision several weeks away, investors are highly confident
that it will tighten by 25bp. However, most investors believe that after that the Fed is likely
to take a wait-and-see approach. Markets are pricing the probability of another rate hike
before next summer at close to 50%.
We think investors may be underestimating the proximity of a second hike, for the following
reasons: for the past several years, economic activity in Q1 has been severely affected by
harsh winters (ie, 2011, 2014 and 2015) (Figure 5). However, the upcoming winter is
expected to be unusually warm as a result of the strongest El Nio effect in nearly two
decades. If true, we would expect a fairly substantial boost to economic activity in Q1,
which would look especially strong in seasonally adjusted terms. Robust economic data
might encourage the Fed to move more aggressively in the first half of the year, and capital
markets, including munis, might not be ready for such a turn of events.
Politics and regulations

We are hard-pressed to see any real threats to the tax-exemption, though many headlines
related to tax code overhauls proposed by both parties are likely. Republican presidential
candidates want to lower individual and corporate taxes, while capping deductions and
introducing valued-added taxes. Meanwhile, several months ago, Hillary Clinton said she
would reduce student debt by also limiting certain deductions. Talk on tax reform is likely to
be taken more seriously right now because the new House Speaker Paul Ryan has made it one
of his top priorities. We see a very small probability of specific actions in the near term, but
after the presidential and congressional elections, the probability of real changes will rise. The
muni market might start taking these headlines more seriously in the second half of the year,
which could affect performance.
In And the Winner Is... (23 November 2015), we discussed how new regulations could affect
the muni landscape, zeroing in on the effects of the HQLA rules for banks and the proposed
rule 22e-4 for mutual funds. If HQLA rules remain as they are and rule 22e-4 is implemented
in its current form, banks and mutual funds could change their behaviour, becoming less
aggressive in buying munis. Consequently, we would expect an increase in liquidity premiums
in the municipal space, especially for smaller issues (ie, serials) as well as lower coupon and
longer-duration bonds. More clarity on both rules should emerge in the months ahead.
Credit concerns
In our view, credit concerns are unlikely to affect the broader muni market next year, but
there are several trends worth noting. We start with Puerto Rico, where next years credit
4 December 2015
71

outcome could range from an all-out debt moratorium to a default on selected credits. We
think that the broader muni market will shrug off Puerto Rico credit events, but investors
are likely to follow very closely Puerto Ricos treatment of GOs, Commonwealth-guaranteed
debt, COFINA, and other debt. Besides PR, we are concerned about possible rating actions
on a number of high profile municipalities, similar to Moodys downgrade of Chicago in May
2015. In general, it seems that rating agencies are becoming much more aggressive in their
treatment of credits with underfunded pension liabilities, which could result in a number of
rating actions down the line, possibly spooking investors.
2016 supply forecast

We expect 2016 long-term gross municipal supply to be lower than in 2015. We forecast
$355-370bn (down 7-12% y/y) of long-term gross supply next year, including about
$325bn in tax-exempt issuance and $35bn of taxable supply. We project $360bn of
redemptions for the year, which translates to a roughly flat net supply forecast. We do not
expect an uptick in new money issuance, expecting $145bn. Meanwhile, we project
issuance attributed to refunding activity to fall to about $215bn.
Long-term municipal issuance has been strong in 2015 and, with just under a month left in the
year, has already surpassed 2014 total issuance by 10%. Current municipal supply stood at
$373bn through end-November, $35bn above the total $338bn that came to market last year.
This is in line with our $390bn supply forecast for 2015; accounting for refundings (current and
advanced) and maturing debt, net supply for the year should come in at $20-30bn (vs the $22bn average net supply of the past four years). The last time the muni market posted positive
net supply was in 2010 the last year of the Build America Bond (BAB) program.
Refunding activity is one key trend that stands out in this years issuance and has been the
reason for the y/y growth. As Figure 7 shows, while new money issuance rose slightly from
2014, refunding supply was a notable 41% higher and was the main reason for the rise in
overall municipal issuance this year. The main factor driving this growth in refunding
activity has been the prospect of the US Federal Reserve tightening monetary policy.
Going into 2015, investors expected the Fed to begin the tightening cycle in the second half of
the year and cause interest rates to rise. Consequently, there was a spike in tax-exempt
issuance in 1Q as muni issuers rushed to take advantage of historically low interest rates. Most
of the supply was attributable to refunding activity as issuers sought to refund high interest
rate bonds.
FIGURE 6
2016 supply and redemption forecasts
FIGURE 7
Issuance by capital type
($bn)
$bn
Tax-exempt supply
325
400
Taxable supply
35
350
Gross supply
360
300
Total redemptions
360
250
200
Net supply
150
2014 thru November

+25%
2015 YTD
+41%
+5%
100
50
0
New Capital
4 December 2015
Refunding
Total Issuance
Source: SIFMA, Barclays Research
72
2016 gross supply

This years issuance will come in well above average (Figure 8). Given the likely upward drift
in interest rates next year, however, we expect 2016 supply to be $355-370bn, down about
7-12% y/y, on the following factors:
FIGURE 8
Annual municipal issuance
$bn
Refunding
New Capital
400
350
300
250
200
150
100
50
2016 F
2015 F
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
Source: SIFMA, Barclays Research
Refundings: We expect total refundings to come in lower y/y at $215bn, mainly because
current refundings should be down $30bn y/y. Meanwhile, advance refunding activity
should be robust and could receive a boost if the Fed is more aggressive and the yield
curve flattens by more than expected, decreasing negative arbitrage and making advance
refundings more palatable.
Although we do not expect the rate of refunding in 1H16 to reach the levels seen in 2015,
we do think that the first half of next year, particularly the first quarter, will again be heavy.
If the Fed tightens in December 2015, issuers may rush to the market to lock in lower
rates; even if the Fed remains on hold, we still expect issuers to rush to the market, as they
did earlier this year, to get in front of the future Fed rate hike.
To calculate the refundings portion of our 2016 issuance forecast, our analysis
incorporates all new money supply that has not been refunded and that was issued in
and after 2005, callable in 2016, 2017, and the first six months of 2018. We assume that
all bonds callable next year and in the first three months of 2017 will be refunded next
year and that a portion of bonds callable in the following 18 months will also be advance
refunded. Additionally, we assume that bonds with maturities under five years will not
be refunded, despite meeting the criteria. Our analysis excludes notes and derivatives.
New money: We believe 2016 new money supply will be slightly down y/y, coming in at
$145bn. An indication of annual new money supply is the number of bond issues
appearing on ballot measures requiring voter approval. In 2015 (for 2016), there was
about $24bn in proposed new debt, almost half the $44bn that appeared on the
November 2014 ballots (for 2015), but similar to the approximately $20bn in 2013 (for
2014). Typically, there are fewer bond issues appearing on the odd year ballots,
compared with even years. We believe that new money issuance will be slightly below
the average of the past five years (Figure 8).
4 December 2015
73

Taxable supply: Year-to-date, taxable supply is running much higher than last years pace,
with $27bn issued so far this year (versus $20bn through November 2014). Looking to
2016, we expect about $35bn of supply, including index-eligible taxable issuance of $4-5bn.
Some of the factors supporting taxable issuance next year include:
Pension obligation bonds: Several large deals were already approved by voters in
November. In our view, the upward trend in rates and unfunded pension liabilities might
make issuers more inclined to issue POBs;
Healthcare taxable issuance should continue its robust pace because it is harder to
control the use of proceeds after mergers. By contrast, there are many projects that are
not allowed to be financed in the tax-exempt market;
Higher education taxable issuance should also remain strong as institutions continue
to take advantage of strong investor appetite for high-quality credits and low rates; and
P3 issuance: The forward calendar of projects should continue to grow, and a

substantial portion of funding could come in taxable form.
Notably, Hillary Clinton reintroduced the idea of a Build America Bond (BAB) program in
her latest infrastructure plan. The idea of BAB-like structures could be revisited, though
it appears to be a bit of a long-shot.
AMT supply this year stands at around $10bn, compared with the $7bn that came to market
through October 2014. The growth rate over the past five years has averaged 20% and we
assume this trajectory will continue, thus bringing our 2016 supply forecast to $13bn.
Gross supply: We expect 2016 long-term gross issuance to come in at $355-370bn, down
about 7-12% y/y. There could be an upside surprise to our forecast if the following occur:
Larger-than-expected advanced refundings if the Fed becomes more aggressive in its

hiking cycle, flattening the yield curve, and/or
Increased new money issuance, driven by spending in the infrastructure and utility
sectors.
Although, in our opinion, the above two scenarios are unlikely, they do pose a risk to our
projections and could result in an upside surprise to our 2016 forecasts.
Credit themes
In our view, overall municipal credit quality continues to improve, and we expect this to
persist in 2016. We acknowledge that credit quality (particularly, local credits) has not fully
recovered post-recession and that there are problem areas on the horizon. However,
assuming that the Fed tightens at a reasonable pace and the US economy continues to
grow at a measured pace, we do not envision widespread municipal credit trouble in 2016.
That said, if and when the next recession materializes, current problem areas or issues
could worsen.
Overall municipal credit quality continues to improve or stabilize

There are exceptions, but overall municipal credit quality continues to improve, in our view. A
look at rating changes over time supports this view. Moodys data show that
upgrade/downgrade ratios have generally risen over the past few years, with the number of
upgrades surpassing downgrades for the first time in several years in 4Q14 (Figure 9). This
trend of rising upgrade/downgrade ratios also holds true for revenue and tax-backed bonds.
4 December 2015
74
FIGURE 9
Ratio of Moodys upgrades to downgrades (%)
FIGURE 10
Quarterly state tax revenues, y/y change (%)
Ratio (%)
y/y inflation adjusted % change in total taxes

y/y % change in total taxes
% chg
400%
15
350%
10
300%
250%
200%
Source: Moodys
1Q15
3Q14
1Q14
3Q13
1Q13
3Q12
1Q12
3Q11
1Q11
3Q10
1Q10
3Q09
1Q09
1Q08
3Q15
4Q14
1Q14
2Q13
3Q12
4Q08
4Q11
-20
1Q11
-15
0%
2Q10
50%
3Q09
-10
1Q08
100%
3Q08
-5
150%
Source: Rockefeller Institute of Government
At the state level, overall municipal credit quality has improved gradually. Revenues have
generally risen in an environment of low economic growth. According to data from the
Rockefeller Institute of Government (RIG), with the exception of a few quarters, total state
revenues continue to exhibit y/y growth on an unadjusted and an inflation-adjusted basis
(Figure 10). Key state debt metrics have also demonstrated modest improvement
although median debt service ratios are up slightly over the past three years, key metrics,
including tax-supported debt per capita and debt as a percentage of personal income have
fallen (Figure 11).
At the local level, overall municipal credit quality trends have been mixed. RIG data show that
the four-quarter moving average of local tax collections rose 1.5% in 2Q15 (inflationadjusted); this is weak versus historical averages, but is still an improvement compared to
recent quarters. Local government data from Moodys show that debt measures are modestly
weaker. However, operating revenues have risen in the past few years and fund balance levels
have also improved, with fund balance ratios (as a percentage of revenue) largely steady or
posting slight improvement in some cases (Figure 12).
FIGURE 11
State debt metrics
FIGURE 12
Local government fund balance ratios
Median Net Tax Supported Debt per
capita - RHS
Median Net Tax Supported Debt as %
of Personal Income - LHS
%
3.0%
2.9%
2.8%
2.7%
2.6%
2.5%
2.4%
2.3%
2.2%
2.1%
2.0%
2011
Source: Moodys
4 December 2015
2012
2013
2014
Median Fund Balance as % of Revenues, Cities

Median Fund Balance as % of Revenues, Counties
%
$
29%
$1,140
$1,120
$1,100
$1,080
$1,060
$1,040
$1,020
$1,000
$980
$960
$940
28%
27%
26%
25%
24%
23%
22%
21%
2010
2011
2012
2013
2015
Source: Moodys
75
though we expect a trifurcated market

As discussed above, most of the muni market (mainly higher quality credits) appears to be
holding up well. However, some parts of the market are deviating from the trend. Names
such as New Jersey, Pennsylvania, Illinois, and Chicago (among others) have come under
pressure from pension or budgetary concerns, and this overhang could persist into 2016;
investors may wish to monitor such names for rating action. Meanwhile, Puerto Rico in
the unique situation of restructuring or attempting to restructure much of its $70bn3 in
debt is set to be closely watched by traditional and non-traditional market participants. In
our view, a trifurcated market crystallized in 2015 and is likely to persist in 2016.
Key themes
Against this backdrop, we believe investors should monitor the following key themes that
could pose risk and/or create opportunities in 2016:
Pension trends for state and local governments

Effects of lower oil prices
Effects of the Clean Power Plan
State budget impasses and opportunities for debt reliant on appropriations or state
funding
Trends in the muni high yield sector and Puerto Rico
Pension trends for state and local governments

Headlines around various public pension plans persist. Market participants have likened the
status of pension plans to a gathering storm, and longer-term trends have been
problematic. Despite this, we do not expect a widespread or full-blown pension catastrophe
to emerge in 2016. However, as highlighted later, there are certain credits for which
investors may wish to monitor the pension situation more closely.
Longer-term trends have been unfavorable, but there could be a slight improvement in
the coming years: The trajectory of public pension plans has been unfavorable since the
early 2000s. According to the Center for Retirement Research (CRR), aggregate funded
ratios (based on a sample of 150 state and local plans) decreased from 102% in 2001 to
74% in 2014, under GASB 25 standards (Figure 13). However, the pace of such declines
appears to have moderated in recent years. In fact, in 2014, funded ratios (as estimated)
actually rose slightly, to 74%, from 72% in 2013. This reflected not just the rotation out of
2009s weak market performance for smoothing calculations, but also strong investment
returns in 2014. Moreover, in both its baseline and alternative scenarios, CRR projects that
funded ratios might continue to rise or stabilize in FY15-18 (dotted lines in Figure 13),
though we note that projecting funded levels is fraught with uncertainty.
The historical numbers in Figure 13 are based on the older, GASB 25, standards, which differ
from the newer GASB 67. For example, GASB 25 allows asset-smoothing techniques and a
discount rate for liabilities based on an estimated long-term yield for the plan. Under GASB 67,
assets are marked to market and the discount rate is a blended rate that uses a long-term
expected rate of return for the period in which the plan is expected to have sufficient assets;
thereafter, payments are discounted using a tax-exempt, high-quality municipal bond index
rate. Note that indicators (such as funded ratios) appear stronger under GASB 25 than they
would under GASB 67, as the latter has more conservative or realistic assumptions.
4 December 2015
Commonwealth of Puerto Rico Financial Information and Operating Data Report, November 6, 2015.
76
FIGURE 13
Aggregate funded ratios (under GASB 25) and CRR
projections
Funded Ratios under GASB 25
Baseline CRR Projections
Alternative CRR Projections
Ratio
110%
105%
100%
FIGURE 14
Aggregate funded ratios, under riskless discount rate
Ratio
110%
100%
102%
90%
95%
90%
80%
86%
70%
85%
80%
51%
50%
70%
2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Center for Retirement Research at Boston College
59%
60%
74%
75%
70%
40%
2001
2003
2005
2007
2009
2011
2013
Source: Center for Retirement Research at Boston College
Recalculating at a lower discount rate: For the funded ratios in Figure 13, future payment
streams are discounted using rates equal to long-term expected rates of return (7.6% in
2014), which might make the picture seem better than it is. Recalculating liabilities with a
5% discount rate, CRR data show that funded ratios decrease markedly across the board
(Figure 14). However, trends still point to stabilization in recent years.
A bottom-up perspective
Although a top-down view of pension trends suggests possible stabilization, relying on a
birds-eye view of pensions would be superficial. In our view, in 2016, investors should also
monitor pensions from a bottom-up perspective by following certain credits:
New Jersey: In June 2015, the NJ Supreme Court ruled that state pension contributions are
not contractually protected. The ruling effectively allowed the Governors decision to cut
pension contributions to balance the FY15 budget and provides additional flexibility for
pension contributions. In our view, the ruling helped alleviate near-term liquidity and
budgetary pressures, though it creates uncertainty with regard to long-term unfunded
liabilities. In early September, unions petitioned the US Supreme Court to hear the case.
In a separate case, the NJ Supreme Court will determine whether the states 2011 COLA
reforms are allowed a decision could be rendered in early 2016. Previously, the states
appellate court ruled that COLAs were contractually protected, overturning a lower courts
decision. Investors should continue to track NJ pension litigation in 2016, as developments
will affect the unfunded liability picture down the road.
Pennsylvania: The last time pension reform was implemented was in 2010 via Act 120,
which put in employer contribution collars, modified benefits for new employees, and made
other changes to help amortize unfunded liabilities over 24-30 years. Moodys believes that
the state might struggle to adhere4 to its contribution schedule, thereby putting further
pressure on its unfunded liabilities.
In mid-2015, lawmakers advanced a pension reform proposal that would move new
employees to defined contribution plans. This was vetoed by the Governor, who subsequently
put forward a different plan (which included a hybrid option) that did not appear to gain
consensus. The latest tentative framework for ending the states budget impasse reportedly
4
4 December 2015
Moody's revises Pennsylvania GO outlook to negative; affirms Aa3 rating, Moodys, October 16, 2015.
77

includes pension reform5, though details are murky. Investors should keep an eye on the
status and momentum of lawmakers various pension proposals in 2016.
Illinois: In May 2015, the Illinois Supreme Court rejected the statute governing the states
pension reform, as it violated the Illinois constitutional clause that asserts that pension
benefits shall not be diminished or impaired.6 Rating agencies noted that the decision was a
credit negative, as the ruling effectively limited the states options for dealing with pension
issues. Investors should monitor the rulings implications for the states municipalities to the
extent that it might also limit their options as they attempt their own pension reform.
Chicago: Chicagos pension situation is complex; readers may wish to review our past
publications for a refresher (click here and here). The mayors budget included a proposed
property tax hike ($543mn over four years) to help address the step-up in the citys pension
contributions. In late October 2015, Chicagos aldermen approved the tax hike, which we view
as an important step in the right direction. However, the budget also assumed that the
governor and the Illinois Supreme Court would take certain actions pertaining to contribution
levels. Investors should monitor these actions if they deviate from the budget assumptions,
future required contributions would differ from the levels contemplated in the budget.
Other: Other pension situations worth watching include Kentucky. In Kentucky, pension
metrics remain weaker than in other states, and it remains to be seen how the new Republican
governor will deal with the situation.
Effects of lower oil prices

Oil prices were low throughout 2015 and are likely to remain depressed in the year ahead. This
could produce mixed effects in 2016, with lower oil prices being both a bane and a boon for
the muni market. On one hand, lower oil prices might be a headwind for revenues in oilproducing states, though many states have healthy reserves and other strengths that could
serve as financial protection. On the other hand, lower oil prices might be a tailwind for the US
economy and the toll road sector, as they encourage toll road use among commuting and
leisure drivers.
Effects on oil-producing or oil-reliant states: Oil-producing or oil-reliant states include
Alaska, Louisiana, New Mexico, North Dakota, Oklahoma, and Texas. For oil states, low or
declining oil prices have a direct negative effect on the amount of oil or gas-related
revenues collected for the General Fund. There are also indirect effects on other collected
taxes, such as the personal income tax or sales tax, depending on how reliant the economy
is on the oil industry. Unsurprisingly, some oil states drastically lowered their FY16 General
Fund revenue projections as a result of the low oil price environment.
For the aforementioned states, Figure 15 shows direct oil revenues as a percentage of
General Fund or operating revenues, and Figure 16 shows oil and gas personal income as a
percentage of total personal income. The figures indicate that Alaska ranks number one
interms of direct oil reliance, and that Oklahomas personal income is more dependent on
the oil and gas sector than some of the other typical oil states.
Although oil states will likely continue to face budgetary pressures in 2016, they also have
various strengths or protections in place to mitigate such pressures. Some states have
strong reserves; Alaska, for example, has a robust reserve balance that provides more than
3x coverage of FY14 operating revenue. Other states, such as Texas, have diverse enough
economies away from oil. North Dakota has a unique two-tiered General Fund oil and gas
tax revenue cap that is intended to limit the funds exposure to oil price volatility.
Pennsylvania Budget Standoff Continues Into Holiday Season, With Much At Stake For Taxpayers, Forbes, November
23, 2015
6
Constitution of the State of Illinois, Article XIII, Section 5. Pension and Retirement Benefits.
4 December 2015
78
FIGURE 15
General Fund Reliance on Oil Revenues
FIGURE 16
Oil and gas personal income (% of total personal income)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
AK
LA
NM
ND
OK
TX
OK
GF reliance on oil revenues
TX
AK
LA
NM
ND
US
Oil and gas personal income as % of total personal income
Source: Moodys
Source: Moodys
That said, the low oil price environment will likely continue to create uncertainty for oil
states budgets in 2016. For the coming year, investors may wish to follow names such as
Louisiana and Alaska for potential rating actions. It is unclear what rating agencies next
steps will be, though both names have negative outlooks at Moodys and S&P.
Effects on toll roads: Average retail gas prices are meaningfully lower than in past years and
are likely to remain low for the time being. This could boost the number of drivers on the
road and the number of miles driven, providing a tailwind for toll road use. Figure 17 shows
US retail gas prices versus y/y change in vehicle miles travelled. Unsurprisingly, the figure
suggests an inverse relationship between gas prices and miles travelled, though there are
(admittedly) other factors that complicate the relationship.
We believe toll roads could continue to benefit from the low gas price environment in 2016.
Low gas prices could encourage leisure drivers to drive more, boosting general road
(including toll road) use. Low gas prices may also have the effect of increasing traffic on
non-toll roads, causing some commuting drivers to shift to toll roads for shorter trip times.
FIGURE 17
Inverse relationship between gas prices and vehicle miles traveled (VMT)
$/gallon
4.0
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
-3.0%
-4.0%
-5.0%
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1991
1994
1997
2000
2003
Retail gas price ($/gallon) - LHS
2006
2009
2012
2015
VMT, y/y chg (RHS)
Source: US Energy Information Administration, Federal Highway Administration, Barclays Research
4 December 2015
79

Effects on other sectors: In our view, the lower oil price environment could also continue to
be a marginal benefit for sectors including airports, tobacco, and utilities. Lower gas prices
result in savings for consumers, which could mean more consumer spending on tobacco
products or at airports. Lower oil prices could also benefit some utilities margins, though
utilities would be affected by general trends in commodity prices (such as coal and natural
gas), rather than just oil. On the other side of the ledger, the low oil price environment could
put pressure on some local credits whose economies are dependent on the oil industry.
Effects of the Clean Power Plan

In Munis and the War on Coal, August 13, 2015, we discussed the provisions and
potential implications of the EPAs Clean Power Plan. In a nutshell, the plan focuses on
improving efficiency at existing power plants, substituting higher-emitting coal-fired power
plants with lower-emitting natural gas plants, and shifting generation to renewables. Upon
its full implementation in 2030, the plan should reduce carbon pollution from the power
sector by 32% from 2005 levels. However, the plan comes with a heavy cost the US
Chamber of Commerce has estimated the total costs of its implementation at around
$480bn, and NERAs consulting projections are even higher. Click here for a refresher.
The Clean Power Plan has faced fierce opposition from states that rely heavily on coal and
other fossil sources of fuel. Lawmakers from a number of states have introduced various
joint resolutions7 against the Clean Power Plan. If Congress were to pass a joint resolution
of disapproval (and the president signs or Congress overrides a presidential veto), the rule
would not take effect. In our view, attempts to invalidate the Clean Power Plan via joint
resolution face an uphill battle. Even if Congress passes the resolutions, President Barack
Obama is unlikely to sign, as the Clean Power Plan is a hallmark of his administration.
Overriding a presidential veto is difficult, as it requires a two-thirds vote in each legislative
body of Congress.
Overall, litigation against the Clean Power Plan could be protracted, and joint resolutions
against the plan face an uphill battle. Thus, the overhang from the EPA rule will likely
remain. Ultimately, if there are no major changes to the plan as a result of various
challenges, we see a number of possible developments in the utility sector, including heavier
utility issuance (driven by new sizable capital investments to comply with the plan),
weakening credit metrics and ratings pressure (S&P believes that some utilities might not be
able to set rates high enough to preserve credit metrics and existing ratings), and pressures
on spreads of utilities in states with aggressive emission-cut goals.
State budget impasses and opportunities for debt reliant on appropriations

State budget impasses continue in Illinois and Pennsylvania, which have been operating
without budgets since the fiscal year began on July 1. In Illinois, the impasse stems from
political gridlock between a Republican governor and a largely Democratic legislature. By
contrast, in Pennsylvania, the impasse arises from the standoff between a Democratic
governor and a largely Republican legislature. In our view, the impasses could remain an
overhang on local credit spreads in these states in the near to medium term, but could also
provide opportunities for investors who patiently await the right entry point.
Pennsylvania could end its budget impasse first: In early November, news outlets8 reported
that Pennsylvanias budget impasse could soon be coming to an end, as lawmakers and the
governors office suggested that a tentative framework was in place. According to the reports,
a final agreement could include increases in education funding, homeowner property tax
7
A joint resolution is not to be confused with a concurrent resolution or a simple resolution. If approved, a joint
resolution would have the force of law, while concurrent and simple resolutions would not. See About Congressional
Bills from gpo.gov for more details.
8
GOP leader predicts budget deal; Wolf says, 'Close', The Philadelphia Inquirer, November 6, 2015 and Pennsylvania's
budget moves forward, Pittsburgh Post-Gazette, November 9, 2015.
4 December 2015
80

relief, a sales tax hike, and pension reform. Uncertainty remains some have said that that
tentative agreement was falling apart, though in late July, Republican lawmakers affirmed that
the agreement remained intact with details remaining to be worked out.9
The Illinois budget impasse looks set to continue through end-2015. News outlets10 have
quoted the Governor and other politicians as saying that a budget deal is not likely until
January 2016, at the earliest. The governor and the legislature remain at odds over the
governors business and political reform proposals, which the governor wants the legislature
to pass before he signs off on the budget. As discussed later, we think the resolution of budget
impasses (if or when they occur) could present opportunities for certain appropriation debt.
A word on lease/appropriation debt: In general, appropriation debt has drawn increased
scrutiny over the past few months. In August, S&P and Fitch downgraded Met Pier
(McCormick Place) bonds by multiple notches, with one rating agency acknowledging that
the bonds were appropriation obligations, rather than special tax. In September, Moodys
issued a Request for Comment that discussed proposed changes to its approach for rating
lease-backed, appropriation, and moral obligation bonds. If adopted as proposed, the changes
will result in 20-25% of about 3,100 government contingent obligations being placed on
review, about half for upgrade and half for downgrade. In the coming year, we believe market
participants will likely need to continue to reassess the risk or ratings associated with
lease/appropriation debt.
Puerto Rico
Upcoming PR debt service payments are uncertain: On December 1, the GDB announced
that it paid all principal and interest payments dueon certain outstanding GDB notes.
Additionally, the press release indicated that the commonwealth would begin to redirect
certain available revenues assigned to certain public corporations (exercise the GO clawback).
As a reminder, revenues that could be subject to the clawback include certain taxes and fees
at PRHTA, PRIFA rum taxes, and PRCCDA hotel room taxes.
In terms of the next steps, market participants are focused on the status of the January 1 debt
service payments. Figure 18 shows our estimates of large debt service payments at select
entities; smaller payments are excluded.
FIGURE 18
Estimated major debt service payments for select entities (GO, GDB, COFINA, PBA, HTA,
ERS, and PRIFA)
Date
Estimated Major Debt Service Payments for Select Entities
Jan 1, 2016
$330mn GO debt service

$106mn HTA debt service
$102mn PBA debt service
$36mn PRIFA rum tax debt service
$15mn COFINA debt service
$14mn ERS debt service
Feb 1, 2016 $240mn COFINA debt service

$28mn GDB debt service
$14mn ERS debt service
Note: Figure excludes smaller debt service payments (those less than $10mn) for the abovementioned entities. Source:
Bloomberg, Official Statements, Governor Padillas Written Statement for the October 22 Senate Committee Hearing,
Commonwealth Financial Information and Operating Data Report (November 6, 2015), Moodys, Barclays Research
9
10
4 December 2015
Pennsylvania budget fights bottom line, as usual: taxes, WFMZ 69 News, November 29, 2015.
Illinois governor tours Q-C, promotes agenda, Quad-City Times, October 26, 2015.
81

Uncertainty persists as to whether the aforementioned entities will make the scheduled
payments:
The January 1 and February 1 debt service payments are mainly coupon payments; larger
debt service payments (which include principal) will occur later in the year (July 1).
We continue think it very likely that the January 1 and February 1 GO, COFINA, and PBA
(Commonwealth-guaranteed) debt service payments will be made. The Working Group
has said it will reflect, and seek to respect, Constitutional priorities for payment of the
Commonwealths public debt, suggesting that GO (and potentially Commonwealthguaranteed debt) could fare better than other parts of the debt stack. Pledged revenues to
COFINA do not constitute available resources of the Commonwealth, per legal opinions
from the Secretary of Justice, Bond Counsel, and Underwriters Counsel (though this could
be challenged).
As discussed above, Governor Padilla has stated that the commonwealth would begin to
claw back revenues assigned to certain entities; this is in line with our prior expectations
(click here and here). Given this development, we reiterate our view that certain debt service
payments (such as PRHTA and PRIFA rum tax payments) are subject to greater uncertainty.
PREPA and PRASA: We exclude PREPA and PRASA debt service payments from the figure
above, as these two entities are in unique situations. PREPA is further along in its
restructuring process than other entities, as it recently signed a restructuring support
agreement with the Ad Hoc Group of Bondholders and fuel line lenders, thereby formalizing
its prior agreements; a comprehensive restructuring now hinges on PREPAs discussions
with the monolines. PRASA was excluded from the FEGPs $18bn debt service number and
is viewed as stronger among the public corporations; the entity attempted to bring a deal in
the fall and has said it may attempt to do so again. PRASA recently negotiated a maturity
date extension (to February 29, 2016) of $75mn in certain privately placed senior lien
revenue bonds.
Relative value
Given rich valuations and potential pressures from rates, it will, in our view, be somewhat
difficult to find numerous attractive relative value opportunities in 2016. Hence, investors
should spend extra time sourcing alpha. Going into 2016, we do not see much value in AA
credits and find better opportunities further down the credit spectrum. We believe the
muni yield curve is likely to flatten as the Fed begins its tightening cycle and favor long
bonds and/or barbell strategies. Within investment grade, we like toll roads, education,
strong hospitals, and select appropriated bonds, as well as fixed income instruments
wrapped by monolines. Muni HY appears rich, possibly with the exception of MSA
tobacco, and recommend investors look at cuspy BBB/BB-rated credits instead. Finally, in
the taxable space, we see few attractive opportunities. However, some credits that we like
are MEAG and Santee Cooper, callable BABs, and Chicago Water and Wastewater debt.
Down the credit spectrum within investment grade

Within the Barclays Municipal index, we think there is value as you move down the credit
spectrum particularly in the low single-A and BBB-rated portion of the index as AAs have
outperformed. Excluding California, the yield-to-worst differential between the AA-rated
and AAA-rated parts of the muni index was 21bp, very close to the post-crisis low of 20bp.
By contrast, the rest of the investment grade universe has measurably underperformed,
especially over the past few months. Lower-rated munis are trading at wide yield differentials.
In particular, we prefer the BBB-rated portion of the tax-exempt index. Currently, the spread
between BBB-rated and A-rated munis stands at about 63bp, well off the 2015 low of 40bp
4 December 2015
82
FIGURE 19
5s30s Municipal Index yield curve
FIGURE 20
10s30s Municipal Index yield curve
bp
bp
180
110
175
105
170
100
165
160
95
155
90
150
85
145
140
Dec-14
Feb-15 Apr-15
Jun-15
Aug-15
80
Dec-14
Oct-15
Feb-15 Apr-15
Jun-15
Aug-15 Oct-15
10s30s
5s30s
reached in March. Similarly, the spread between A-rated and AA-rated munis has widened to
65bp after reaching year-to-date lows of 56bp in mid-May. In general, we think investors
should trim exposure to AAs (we would prefer AAAs instead) and focus on cheaper single-A
and BBB credits that should continue improving their credit quality.
Expecting bear-flattening
The muni curve has steepened during 2015 and we see value in longer-dated bonds going
into 2016 (Figures 19-20). Historically, when the Fed tightens, or when interest rates rise,
both the Treasury and muni curves tend to flatten, making longer bonds more attractive on
a relative value basis (Figure 21). Barclays US rates strategists expect a modest bear
flattening in the Treasury curve next year as the Fed begins the tightening cycle.
They project 2y and 5y Treasury yields to rise to 1.65% and 2.25% by end-2016, up by around
70bp and 55bp, respectively, from current levels. Their rate expectations are more moderate at
other points on the curve; 10y and 30y yields are projected to end the year at 2.6% and 3.2%,
up around 35bp and 20bp, respectively. For details, see Global Rates Outlook 2016: A small
step for the Fed, a giant leap for markets, November 19, 2015. If the Fed tightens more
aggressively in 1H16, we should see a more pronounced flattening over the same period.
We believe that the muni tax-exempt curve should bear flatten over the year. The front-end
of the curve is vulnerable, and we recommend that investors extend duration. For those
looking to keep duration in check, we recommend a barbell strategy.
FIGURE 21
Muni and Treasury 5s30s curves during periods of Fed tightening
Date
US Treasury 5s30s (bp)
AAA Muni 5s30s (bp)
Dec 86 - Feb 89
-102
-125
Feb 94 - Feb 95
-89
-35
Jun 99 - May 00
-94
-11
Jun 04 - Jun 06
-137
-113
Periods of Fed Tightening
4 December 2015
83
Sector trends
We highlight our views on selected municipal sectors below:
Toll Roads: In relative terms, we prefer longer-dated, higher-quality toll roads. The 20y
AA portion of the toll road subindex looks particularly compelling to us. It has
underperformed relative to the comparably rated, duration-adjusted revenue index; 10y
and 20y single-A toll roads also look attractive, having cheapened over the past year.
Prices of most commodities are widely expected to remain low in the near term.
Demand for oil has been robust year-to-date, but supply remains strong and inventories
continue to rise. This is expected to continue through most of 2016, and barring any
production issues at US refineries, should exert downward pressure on gasoline prices.
We believe toll roads could benefit from the low gas price environment in 2016; they
should also be helped by a mild winter, forecast to result from a strong El Nio effect.
Utilities: As mentioned earlier, the Clean Power Plan was released by the EPA in August
2015. The plan focuses on improving efficiency at existing power plants, substituting
higher-emitting coal-fired power plants with lower-emitting natural gas plants, and
shifting generation to renewable. We favor those utility providers that are better
prepared to meet the plans requirements. Please see the Fundamental Muni Outlook
section of this report for more detail on the Clean Power Plan.
We also like water utilities in California. In April 2015, Governor Brown introduced an
emergency plan to reduce state-wide water consumption by 25% vs 2013. Confronted
with lower consumption, California water utilities have been hiking rates. Although this will
not eliminate the effects of the four-year drought, we think that the current El Nio, which
tends to bring snow and rain to the western part of the US, including California, may ease
pressure to conserve water, helping water and sewer entities in this state.
Education: The education sector has underperformed this year and yields have widened
nearly 51bp since reaching year-to-date lows in early February. On a relative basis, the
sector has also underperformed the municipal bond index; the education index, which
was trading flat to the muni index at the start of the year, now trades nearly 15bp wide
and we find the sector attractive from a relative value standpoint. We are a little cautious
on low-rated higher education credits, but we find compelling value in the 10y AA-rated
and A-rated portions of the education index (Figures 22-23).
FIGURE 22
10y AA education vs. the comparable revenue bond index
YTW (%)
Diff (bp)
Diff (rhs)
Education AA 10y
Revenue Bond Index AA 10y
2.9
2.7
11
2.3
2.1
1.9
1.7
-4
May-14
Sep-14
Jan-15
May-15
4 December 2015
YTW (%)
Diff (bp)
Diff (rhs)
Education A 10y
Revenue Bond Index A 10y
3.4
16
2.5
1.5
Jan-14
FIGURE 23
10y A education vs. the comparable revenue bond index
Sep-15
3.2
60
50
3.0
40
2.8
30
2.6
20
2.4
10
2.2
2.0
Jan-14
-10
May-14
Sep-14
Jan-15
May-15
Sep-15
84
FIGURE 24
PEDFA bonds versus the comparable long muni index
FIGURE 25
CFA bonds versus the comparable long muni index
YTW (%)
PEDFA 5% 2034s
YTW (%)
4.3
Long Muni Index (22+)
4.5
4.3
4.1
3.9
3.7
3.5
3.3
3.1
2.9
2.7
2.5
Apr-14
4.1
3.9
3.7
3.5
3.3
3.1
2.9
2.7
2.5
Apr-14
Aug-14
Dec-14
Apr-15
Aug-15
CFA 5% 2042s
Long Muni Index (22+)
Jul-14
Oct-14
Jan-15
Apr-15
Jul-15
Oct-15
Hospitals: The investment grade and high yield hospital revenue sectors have generated
year-to-date positive total returns of 3.2% and 5.2%, respectively, on the back of the
Affordable Care Act. We believe that positive effects of the ACA have been mostly priced
in, and expect a much more difficult trading environment for this sector given rich
valuations, and reimbursement pressure from the managed care sector. We still find value
in the AA hospital index, which trades 27bp wide to the tax-exempt revenue index.
Meanwhile, the single-A and BBB rated indices trade at 6bp cheap and 4bp rich to similarly
rated revenue indices. We believe the AA and selected single-A healthcare credits may still
have more room to run, but we would trim exposure to rich triple-B healthcare credits.
Appropriation debt and budget impasse resolution: In Docking at Met Pier, we

highlighted Met Pier appropriation bonds, which came under pressure from the Illinois
budget impasse and an early August Event Notice showing that the July monthly debt
service deposit had not been made. After mitigating legislation was approved on August
20, appropriations resumed and long-dated Met Pier bonds outperformed. In our relative
value highlights for credits in Pennsylvania, we believe yields could face a similar
trajectory as that of Met Pier. That is, the bonds could outperform after a positive
catalyst (ie, resolution of budget impasse), though this outperformance may be delayed.
We see pockets of value in Pennsylvania, particularly for lease or appropriation debt (eg,
Pennsylvania Economic Development Finance Authority (PEDFA) and Commonwealth
Financing Authority (CFA) bonds; Figures 24-25). Long-dated yields on both have recently
underperformed the long muni index but could perform better in the near to medium term
if a budget deal is reached. An attractive entry point could emerge once the impasse ends.
High Yield: Few attractive opportunities

Healthcare, Tobacco and Cuspy BBB/BBs: Excluding Puerto Rico, HY munis have rallied over
the past few months, with yields below recent summer highs. In our view, HY munis (ex-PR)
have become rich, particularly relative to corporate HY (Figure 26). Within HY munis, the
recent rally has been driven by outperformance in HY tobacco and HY healthcare sectors
(Figure 27), each of which represents about 20% of the HY Muni Index by market value.
However, these sectors may have limited room to run in the near to medium term.
4 December 2015
85
FIGURE 26
Muni HY (ex-PR), versus Corporate HY indices
Long US HY (LHS)
US Corp HY (LHS)
Muni HY, ex-PR (RHS)
YTW (%)
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
Nov-14
Feb-15
Aug-15
May-15
FIGURE 27
Muni HY tobacco and healthcare versus Muni HY indices
5.9
5.8
5.7
5.6
5.5
5.4
5.3
5.2
5.1
5.0
4.9
Nov-15
YTW (%)
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
Apr-14
Aug-14
Dec-14
Muni HY, ex-PR
HY Tobacco
Apr-15
Aug-15
Muni HY
HY Healthcare
For tobacco, the sector rallied after the release of positive cigarette shipment volume data
and following the New York attorney generals settlement with Big Tobacco
manufacturers releasing about $550mn that had been trapped in an escrow account. For
the first time in the post crisis era, the MSA tobacco sector is trading through the HY muni
index as yields have rallied to an 18-month low. At current levels, we believe that most of
the good news is priced in. However, if positive trends in cigarette shipments continue,
tobacco yields could move even lower; alternatively, if the pickup in shipments reverses,
tobacco bonds could underperform next year. Even in the best case scenario, we think the
potential upside for MSA tobacco bonds is capped.
As discussed above, we are worried about the BB portion of the non-profit healthcare
sector, which is vulnerable at current levels, in our view.
Given the general richness of muni HY (ex-PR), investors searching for yield may wish to
consider select cuspy BBBs, ie, the second set of names in the trifurcated market described
earlier. As mentioned earlier, we like Met Pier (McCormick Place) appropriation bonds from a
relative value standpoint. The 5% 2042s trade with a YTW of 4.3%, about 61bp behind longdated BBB names and about 54bp behind the long Illinois index. Opportunistic investors could
consider some Illinois bonds. Much of the negative news has been already priced in. If a
solution to the budget impasse is reached soon, there could be a relief rally in Illinois debt.
Puerto Rico: The HY Puerto Rico index sold off mid-year following the governors declaration
that the commonwealths debt was unpayable and remarks calling for a negotiated
agreement with creditors. PR yields remained elevated thereafter on continued uncertainty
about restructuring outcomes. In our view, uncertainty about outcomes for Puerto Rico is
likely to hang over the HY muni market in 2016. However, we see little to no spillover effects to
the IG and HY muni markets.
We believe that Puerto Rico bonds would remain volatile in 2016, and at times, could look
attractive. Meanwhile, even at current levels we would consider PREPA bonds in the $60s, as
we believe the bonds have upside potential if PREPA is able to reach an agreement with
monoline insurers. We think Puerto Rico will attempt to resolve the PREPA restructuring
process in the near term as it turns its attention to the larger task of restructuring the rest of
the credit complex. We would also consider PRASA bonds; prices might hold up decently in
the near term given PRASAs exclusion from the FEGP debt service number and lower
likelihood of a PRASA restructuring in the near to medium term.
4 December 2015
86
Wrapped bonds are undervalued

Investors looking for a yield pickup often overlook monoline wrapped debt as they tend to
solely look at the underlying credit, ignoring the bond insurance. We think this is a mistake
and, in our view, bond insurers still provide considerable value to bondholders, especially as
muni credit risk has increasingly been in the spotlight. Financial performance of bond insurers
has been stable so far this year despite the weakening credit quality of their large exposures to
Puerto Rico. In particular, our fundamental analysts expect that Assured Guaranty and MBIAs
municipal insurer (National) will remain resilient this year, even as negotiations with PREPA
leave the potential for insured losses (see here for more detail). On December 1, Puerto Rico
made the National-wrapped, Commonwealth-guaranteed GDB debt service payment.
Analyzing several municipal bonds wrapped by Assured Guaranty and National, we find that
frequently investors do not assign enough value to wraps and provide several examples of
wrapped bonds that look attractive to us (Figures 28-29).
Taxable municipals
As discussed in the taxable return section, we do not expect the overall taxable muni market
to outperform in 2016. We see few attractive opportunities in the taxables, though there are
some pockets of opportunity in some areas:
Callable BABs: Callable Build America Bonds (BABs) are an area we continue to see
value as they provide the potential for yield pickup. Callable BABs look very attractive
compared to bullet BAB structures with similar tenors priced to maturity. The callables
are typically priced to their call date; however, given that an increasing interest rate
environment looks likely next year, and the federal subsidy that comes with the BABs,
the likelihood of these bonds being called is low and they should eventually kick to
maturity, in our view.
Chicago Water and Chicago Wastewater: The yield differential between the bonds and
comparable indices widened, particularly after rating agency downgrades in mid-May. The
bonds currently trade cheap to the long taxable muni index (Wastewater and Water bonds
trade 114bp and 100bp back of the index, respectively) and look attractive from a relative
value standpoint (Figure 30). Additionally, both entities have renegotiated the terms of
their triggered payments tied to swaps and bank loans, mitigating near-term liquidity risk.
Furthermore, the bonds could be treated as special revenue debt in certain scenarios. Both
of these factors should be supportive of yields and help limit potential downside.
FIGURE 28
10y Wrapped Bonds vs 10y Unwrapped Index
FIGURE 29
Long Wrapped Bonds vs Long Unwrapped Index
Municipal Index Unwrapped A 10y

Chicago BoE 5% 2025 Wrapped
Chicago GO 5% 2026 Wrapped
NJ EDA 5.5% 2025 Wrapped
OAS (bp)
4.8
Municipal Index Unwrapped A +22y

Met Pier 5% 2050 Wrapped
PR GO 5.75% 2037 Wrapped
OAS (bp)
6.5
6.0
4.3
5.5
3.8
5.0
3.3
4.5
4.0
2.8
3.5
2.3
1.8
Jan-15
3.0
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Source: Barclays Risk Analytics and Index Solutions, Barclays Research
4 December 2015
2.5
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Source: Barclays Risk Analytics and Index Solutions, Barclays Research
87
FIGURE 30
Chicago Water 2040s vs Long Taxable
OAS (bp)
FIGURE 31
MEAG and Santee Cooper versus Long Taxable Muni Index
Diff (rhs)
Chicago Water 6.742% 2040s
Long Taxable Munis
320
OAS, bp
MEAG
400
Santee Cooper
US Taxable Long
120
270
300
90
200
220
60
170
120
Nov-14
Diff (bp)
150
30
Feb-15
May-15
Aug-15
0
Nov-15
100
0
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15
MEAG & Santee Cooper: There are some utilities that may be positioned well to tackle
the requirements of the Clean Power Plan. In particular, we like MEAG (Vogtle, Georgia,
Units 3/4) and Santee Cooper (Summer, South Carolina, Units 2/3) bonds, which trade
wide relative to comparable taxable munis. We think the bonds could outperform in the
medium to longer term, assuming no material changes to the Clean Power Plan and on
the back of positive news about agreements between project owners and EPC
contractors reached in late October (Figure 31). Please see the Fundamental Muni
Outlook section of this report for more detail on the Clean Power Plan.
4 December 2015
88
European Strategy
4 December 2015
89
EUROPEAN HIGH GRADE
Imbalanced
Removal of the ECB technical at the end of Q1 revealed the underlying weakness of the
Zoso Davies
-IG credit market, which has been weighed down by cross-border issuance, despite a
strengthening of the European economy. The key drivers of supply (US non-financials)
and demand (moderately low credit yields) are unlikely to change without an external
shock; hence, our baseline is that credit markets will remain weak in 2016.
+44 (0)20 7773 5815

zoso.davies@barclays.com
Barclays, UK
Soren Willemann
Supply will not slow: Non-financial cross-border supply should constrain the ability
+44 (0) 20 7773 9983
of -IG to outperform in a widening market. More generally, both $-IG and -IG need
higher credit yields to foment demand; if interest rates fail to rise as expected,
spreads can widen further in our view.
soren.willemann@barclays.com
Barclays, UK
More alpha than beta: In our baseline, we expect the Euro Aggregate Corporate
Andreas Hetland
Index to generate excess returns of 160bp (index OAS of 130bp), reflecting carry,
roll-down and new issue performance. However, we expect major divergences at the
sector and ticker level. We favour sectors shielded from the manufacturing,
commodity and EM slow-downs.
+44 (0) 20 7773 1547

andreas.hetland@barclays.com
Barclays, UK
All tail, no body: While our baseline forecast is for the index to end 2016 only
marginally tighter, the distribution of potential returns is very fat tailed. To the
downside, US high yield defaults may accelerate or the Chinese economy decelerate
more than anticipated. Conversely, the possibility of further ECB asset purchases,
possibly including corporate bonds, creates an upside tail risk for excess returns
that will hang over the market.
FIGURE 1
Barclays 2016 -IG excess returns forecasts
Baseline
Upside
Downside
EUR Corp
1.6%
2.9%
-0.7%
EUR Industrials
1.5%
3.0%
-1.0%
Indu - AA
1.0%
1.4%
0.3%
Baseline
Upside
Downside
Indu - 1-3y
1.1%
1.8%
0.1%
Indu - 3-5y
0.5%
1.8%
-1.2%
Indu - 5-7yr
1.9%
3.6%
-0.6%
Indu - A
1.2%
2.3%
0.0%
Indu - 7-10yr
2.1%
3.6%
-1.6%
Indu - BBB
1.8%
3.1%
-2.3%
Indu - 10-20yr
2.3%
5.0%
-2.0%
FIGURE 2
Key investment themes for -IG
Strategic theme
Investment implications
Certain supply, uncertain demand

... cross border issuance will continue
-IG can't decouple from $-IG without a regime shift in supply and/or demand for credit
... yield dependent demand
Significantly higher EGB yields would be positive for credit spreads...
US credits are not yet "cheap enough" in -IG

... while much lower front-end rates could re-ignite the QE trade...
... but current yield levels are not a stable equilibrium
More alpha than beta
... a long tail of downside risks
Overweight: Banks, and domestically focused credits

Underweight: Energy, Utilities, and issuers with significant EM operations
Rising liquidity demand

Investors seek liquid exposure to credit risk
CDS-Cash basis to trend more negative, resembling developments in $-IG
4 December 2015
90
Its not getting any easier

2015 has been a challenging year for -IG, as the euphoria of Q was outweighed by slower
global growth, continued deterioration in commodity prices, stress in bellwether EM credits
and ongoing supply from US corporates in both $-IG and -IG. In our baseline case, we
expect supply to remain heavy (particularly from cross-border issuers) and global growth to
stay subdued in the face of an erratic, but gradual, tightening cycle from the Fed.
In this context, our baseline forecasts, as presented in Figure 1 and Figure 3, are modest.
Upside risks are centred on the ECB while downside risks are likely to come from overseas.
FIGURE 3
Barclays 2016 Euro Aggregate Corporate Index forecasts (OAS, bp)
Observed
(EoM)
Baseline
Upside
Downside
GDP (yoy)
1.6
1.6
2.0
1.0
CPI (yoy)
-0.1
0.9
1.3
0.6
V2X
20.4
24.0
20.0
35.0
Lending Standards*
-0.6
3.0
0.0
12.0
Inflation Expectations
1.0
1.0
1.4
0.9
Observed
(EoM)
Baseline
Upside
Downside
Euro IG
130
125
110
170
Euro IG - Indu
132
135
100
180
OAS
Indu - AA
78
75
70
95
Indu - A
102
100
80
130
Indu - BBB
163
160
135
240
Indu, 1-3
115
115
80
170
Indu, 3-5
113
130
95
175
Indu, 5-7
144
135
105
180
Indu, 7-10
144
135
115
185
Indu, 10+
148
140
115
180
Note: *Lending standards enter the model with a 3 quarter lag. Source: EoM data from Bloomberg; Barclays Research
FIGURE 4
Our model suggests that spreads have limited upside, despite the recent widening
OAS, bp
500
400
300
200
155
125
110
100
0
-100
04
05
06
Difference
07
08
Regression
09
10
Euro IG
11
12
13
Baseline
14
15
Upside
16
17
Downside
4 December 2015
91
FIGURE 5
Volatility picked up significantly in 2015
100
FIGURE 6
The Q effect could re-emerge if EGB yields continue to fall
V2X
3.5
90
Range
80
Median
Yield (%)
2.5
70
60
1.5
50
40
0.5
30
20
10
-0.5
Jan-14
0
'06
'07
'08
'09
'10
'11
'12
'13
'14
Jul-14
Jan-15
Germany
'15
Jul-15
France
Spain
Our US colleagues have written in detail about the headwinds to $-IG performance, and a
simple cross-check with our dashboard (Figure 7) supports the view that the US market is
veering towards late-cycle dynamics. In our baseline scenario, we expect the backdrop for
risk taking to be similar to 2015, with volatility remaining high over the year as a whole and
a number of peaks and troughs keeping spreads elevated (Figure 5). Though sources of
volatility are likely be centred outside Europe, we believe there are mechanisms that can
transmit these headwinds to the -IG market in particular cross-border issuance.
The downside scenario we envisage involves a broadening of the US HY default cycle into
sectors other than commodity credits, either as a result of a general downturn in the global
economy or of tighter USD funding conditions perhaps prompted by significant outflows
from the HY bond market in response to rising default rates. This is far from the firming US
GDP and credit growth forecast by our US economics and US HY teams.
Upside risks seem more numerous but less dramatic, generally consisting of a gradual unwind
of factors that drove spreads wider in 2015. For example, a rebound in commodity prices
would ease concerns with respect to energy, mining and EM credit risk. Hence, the upside
scenario would severely challenge our Overweight call on banks as they have not priced in
much of a risk-premium related to these factors. More specific to -IG, the Q bid for credit
could return after its unexpected exit at the end of Q1. EGB yields are a key determinant of
appetite for credit from rates investors (Rebasised, 25 September 2015) and with EGBs
nearing levels that have been important in the past (Figure 6), a further decline could result in
a renewed bid for short-dated, high-quality credit. Alternately, though very unlikely in our
view, the ECB could bypass the market and buy corporate bonds directly.
FIGURE 7
Our macro-risk dashboard is flagging that US credit is in the later stages of the cycle
Trigger
Current
Flag
3m Flag
SPX
Flat or falling
No Trend
Green
Green
SPX Vol
Trends higher
Rising
Red
N/A
Lending Standard
Trends higher
Rising
Red
Red
Leverage
Trends higher
Rising
Red
N/A
1yr Rates
Trends higher
No Trend
None
None
Flattening
Flattening, slowly
Red
N/A
Indicator
1y10y Rates
Note: For details of our Macro indicators and their trigger levels, see: The macro trend is your friend, 3 October 2014.
4 December 2015
92
All alpha, no beta

In our baseline scenario, -IG credit has little to offer asset allocators beyond the headline
spread. In a world of compressed returns, this may be sufficient to attract marginal demand,
but we are somewhat sceptical ex ante. Ironically, while a rising number of investors are
looking to take exposure to the asset class as a whole via CDS indices, ETFs and total-return
swaps, we believe that this shift is happening at a time when indiscriminate exposure to IG
credit is likely to produce lacklustre returns.
Specifically, we suspect that the distribution of returns in 2016 will be similar to this year,
with the majority of credits generating small positive returns, balanced against a number of
large negative price performers (Figure 8). Starting spread levels are not wide enough to
allow for significant, positive outperformance, away from credits which underperformed the
most in 2015 (Figure 9). Unfortunately, we believe it is still too soon to call a turn in the key
themes that have driven market performance in the second half of 2015, such as weakness
in base metal prices. Sometimes market drivers refuse to neatly align with calendar years
and at this juncture we are unwilling to position for a reversal of the widening trend.
This dynamic is likely to be challenging for credit managers. Our perception is that the demand
for liquidity is driving investors toward portfolio products such as CDS indices, ETFs and TRS
but broad market exposure is unlikely to generate outsized returns next year. Thus the quest for
alpha will represent a delicate balance between returns and liquidity. For long-term and
fundamentals-driven investors, this should prove to be a fertile market, but the lack of index
level returns may frustrate asset allocators and retail investors; creating the downside risk of
outflows from credit, during a year that we expect will see above-average issuance volumes.
Outsized idiosyncratic risk also suggests that, in general, the value of portfolio hedges will
remain low. If downside risks are likely to be concentrated in a small number of sectors or
credits, then the ability of a broad CDS index to hedge cash-bond portfolios is much
reduced. For example, a short risk position in iTraxx Main would have provided little comfort
to holders of VW and Glencore bonds over the summer. This, in turn, is likely to reduce the
demand to buy index protection, reinforcing the trend toward a large, stable base of
investors who are long-risk in iTraxx Main. For this reason, combined with the growing
demand for liquidity, we expect CDS indices to outperform -IG cash indices next year, with
the CSD-cash basis turning more negative. Overall, however, we expect the returns from
both to be constrained by idiosyncratic credit risk.
FIGURE 8
2015 performance was defined by underperformers
Count
100
FIGURE 9
resulting in a year where credit selection was king
GLENLN
AALLN
90
VW
80
RWE
70
BHP
60
50
ENELIM
40
UCGIM
30
FGACAP
20
BRITEL
10
THAMES
0
<-7.5 -7.0 -6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 > 2.5
Note: YTD Excess returns, by ticker. PECI Ex. Sub. Source: Barclays Research
4 December 2015
-20
-15
-10
-5
Note: YTD Excess returns, ex. Sub. Min 2.5bn MV. Source: Barclays Research
93

Somewhere between portfolio replication and single-name stock picking, we also see scope
for thematic positioning to generate excess returns versus investor benchmarks. As shown
in Figure 1, we expect lower quality credit to outperform over the year as a whole, by an
amount approximately equal to the carry advantage of triple-Bs over single-As. Viewed
through the prism of risk versus reward, however, we are more constructive on single-A
spreads, which appear to have significantly less downside in negative scenarios. Similarly,
on the spread curve we highlight the 5-7y area as having roughly the same upside potential
as longer tenors, with less downside in more bearish outcomes.
Finally, we see significant alpha potential in sector selection, which we discuss in detail later
in this European IG credit outlook.
Supply and demand: Imbalanced

The downbeat baseline forecast for -IG reflects our view that supply will exceed demand in
corporate bond markets, pressuring spreads. Given this overhang to performance, credit
will need to find new sources of demand in order to stage a significant rally.
We forecast a sizeable uptick in gross and net issuance next year, due to acceleration in
unsecured supply from European banks (Figure 10). We also expect a steady pace of supply
on the non-financial side, particularly if US credits maintain their recent appetite for M&A.
This, in turn, should keep the pressure on US issuers, relative to euro-area credits, though
they already trade with a notable spread premium in -IG. Supply from US credits should
also prevent -IG from de-coupling from the $-IG market as it did in H2 2014, as excessive
divergence is likely to be opposed by cross-border issuance.
Despite this burgeoning supply pipeline, we see demand as structurally impaired at current
yield levels. In the sterling market, we have long noted that sustained periods of low yields are
deleterious to demand from life insurance companies and the same affliction has spread to
continental Europe (Demand divergence, 2 October 2015). Demand was weak in 2015 and we
expect it to remain so next year given the likely path of EGB yields. Further, given the
increasing focus on the use of CDS indices and other portfolio products to provide liquid
exposure to credit risk, the marginal desire to add credit risk is being directed away from
bonds and toward CDS. Put another way, the liquidity premium in cash bonds has been rising
and, relative to $-IG, appears to have significant room to keep on doing so. Hence, to offset
growing supply, -IG will need to find a new source of demand. One possibility would be retail
investors, though yields seem too low to bring in significant demand for IG versus HY.
FIGURE 10
We expect net supply to accelerate again in 2015
400
FIGURE 11
but insurance and pension fund demand remains weak
bn
60
300
bn
40
200
20
100
-20
-100
-40
PF & INCO
4 December 2015
Q1 14
Q1 13
Q1 12
Q1 11
2016*
2015*
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
Forecasts are Barclays Research. Source: Dealogic, Barclays Research
Q1 10
-60
-300
Q1 14
-200
Source: ECB, Barclays Research
94

Alternately, rates investors may be pushed back into credit if yields on EGBs fall low enough,
though events at Volkswagen are likely to have left a lasting, negative impression of credit in
the minds of risk managers. Anecdotally, we have seen some signs of renewed interest in
the credit space from these investors, but another significant fall in interest rates is likely to
be a necessary pre-condition of a more full-blooded re-engagement with credit risk.
Finally, we note that the ECB has never ruled out adding corporate bonds to its asset
purchase programme. We have written about this in detail (most recently in ECB Watching:
High expectations ahead of the ECB, 30 Nov 15) and remain of the view that it is both
unlikely and undesirable. However, the boundaries of what is plausible continue to stretch
and we cannot rule out the possibility, nor deny the spread tightening that would likely
result from such an announcement. Hence, this remains an (upside) tail risk.
Issuance is coming
We forecast a sharp rise in -IG issuance next year, led by European banks. Our
headline forecast is 570bn of gross supply (+200bn net), skewed towards financials
(310bn gross, +70bn net) over non-financials (260bn gross, +130bn net). By all
measures and in all dimensions, this would be a sizeable increase relative to 2015
(+14% gross, +133% net), particularly on the financial side where net issuance is
expected to swing from negative to positive. Within non-financials, cross-border
issuance is likely to be the key driver of net issuance again, with European activity
dominated by refinancing.
European banks are the key driver of rising issuance within our framework. Specifically,
we expect them to refinance all of their maturing marketable securities next year in
some form or another. This would be a significant departure from recent years during
which they paid down 1.2trn of bonded debt, according to our estimates. To achieve
this shift, European bank net issuance will have to rise by more than 170bn versus
2015, with most of the adjustment likely to be felt in unsecured markets (from -70bn
to +70bn).
Cross-border issuance, specifically from US industrials, has been the key theme in
European primary markets this year. Non-European issuers have been attracted by a
combination of low all-in coupons, tight funding spreads (on an unswapped basis) and
the opportunity to broaden their investor base in a year when the $-IG market was
flooded by a record volume of supply. This trend is unlikely to abate in 2016, in our
view. Our US colleagues expect issuance from non-financials to be roughly flat next
year (-3% y/y), driven by a range of factors including M&A. Further, it appears likely
that the Fed will be hiking rates throughout 2016, which should result in higher yields
and higher coupons on $-IG bonds relative to equivalent -IG securities.
For full details of our 2016 Investment Grade supply outlook, please refer to: Issuance
is coming, 13 November 2015.
Barclays 2016 -IG issuance forecasts
2015 (est)
2016 (est)
y/y
Gross
Redemp.
Net
Gross
Net
Gross (%)
310
240
70
250
-70
24%
Non-Fin
260
130
130
250
130
4%
Total
570
370
200
500
60
14%
EUR (bn) Fin
Note: Forecasts are Barclays Research; bn amounts rounded to nearest 5bn, bn amounts rounded to nearest
2.5bn. Source: Dealogic, Barclays Research
4 December 2015
95
Banks: Overweight despite issuance headwinds

Following years of balance sheet clean-up, capital raising and increased regulatory scrutiny,
the banking sector has the most transparent and robust sector balance sheet in Europe, in
our view. The key challenge for banks in 2016 will be navigating rising issuance needs, as
TLAC requirements put a floor under the size of the senior-unsecured market. However, we
believe this will be a net-positive for bondholders, given the mechanics of index returns.
Our issuance forecasts imply a sizable uptick in supply next year, as European banks close
out a multi-year period of debt pay-down. The key drivers of this are: our view that the size
of the banking system will stabilise, in aggregate; and requirements for G-SIBs to maintain a
minimum amount of unsecured debt liabilities as TLAC. As European banks have significant
TLAC shortfalls (Figure 12), they will need to refinance all of their unsecured debt in 201619, pushing net financial issuance from -70bn this year to an expected +70bn next year.
A shift of this magnitude is a serious headwind to our existing Overweight rating on the
bank sector, but we believe it can be navigated given the mechanics of index returns. While
the devil is in the detail, broadly speaking we see three paths for banks to meet their TLAC
requirements: issuance of subordinated debt; issuance from a HoldCo; or subordination of
instruments by act of law. The first two options seem most likely for non euro-area banks
and imply that OpCo senior unsecured bonds will not feel much issuance pressure. In fact,
legacy bonds may be LMEd if they are set to mature beyond the grandfathering period (our
analysts explore aspects of this theme in: Leaving Behind the Legacies, 30 November 2015).
In the euro area, statutory subordination of existing senior securities seems the most likely
outcome, particularly in jurisdictions where the TLAC shortfalls are large, such as France.
Two countries have already started to move down this route (Germany and Italy), though
the legal frameworks are neither fully-formed nor in force; nevertheless, so far the impact
on senior funding spreads has been muted. This suggests that re-pricing of spreads is more
likely to occur in new securities, prior to index entry (ie, at issuance). This would not create
a performance drag, though the index may mechanically widen.
While it is counter-intuitive to view TLAC issuance as a positive for bank returns, this is what
happened when bank-capital securities were phased out and replaced by CoCos (Figure
13). Despite large headline supply, both legacy and new securities have performed well
versus the index since 2014, when CoCo issuance began in earnest.
FIGURE 12
European G-SIB TLAC needs under various scenarios
400
300
TLAC shortfall ($bn)
200
Gross supply (bn)
370
262
Total return (%)
50
10
40
30
20
10
253
188
184
122
100
0
2019
No exemption
4 December 2015
FIGURE 13
Heavy CoCo supply did not dent historical returns
2.5% exemption
2022
Statutory subordination
0
2012
CoCo supply (LHA)
2013
2014
CoCo TR (RHA)
2015 YTD
PE Bank Sub TR (RHA)
Note: Total returns prior to 2014 omitted due to lack of outstanding CoCos.
96
Non-financials: things versus not things

An unexpected feature of 2015 was the global manufacturing recession that has weighed
on both trade and growth (Figure 14). The divergence in fortunes between the service and
manufacturing economies has been a powerful explanatory variable for investment returns
this year, including: the weakness in EM currencies; US equity leadership (ie, Technology
stocks) and the underperformance of industrial credit spreads relative to financials.
One prism that we like to use for thinking about this theme is the trend in consumption
away from manufactured goods (things), toward services and toward digital goods (not
things). Many ASEAN economies are reliant upon a manufacturing base oriented toward
external demand: a model that is under attack from two directions. First, alongside its move
to a more service-oriented economy, China plans to migrate its manufacturing capacity, up
the value-add chain, challenging Korea and Taiwans position. Second, the digitalisation that
undermined paper manufacturers over the past decade now appears to be shifting ever
more consumption toward digital (ie, non-manufactured) goods. This keeps manufacturing
in a constant state of oversupply, with deflationary consequences.
The shift toward digital consumption could turn out to be a secular challenge for a broad
swath of EM economies. Along with the apparently structural decline in commodity prices
and fundamental issues of economic and political governance, EM economies are likely to
remain under pressure over the medium term. Our EM credit team expects EM corporate
default rates to rise in 2016 (to 6.5-7.0%), but also notes that bond redemptions do not pick
up significantly until 2017, providing some time for progress with necessary adjustments. In
sum, the outlook for EM growth appears to be structurally challenged and Barclays expects
associated assets to underperform next year with growth staying below trend. As noted in
Diversification detriment (30 October 2015), we expect EM exposure to be a drag on
operational performance again in 2016. This supports our Underweight ratings on the
Diversified Manufacturing and Chemicals sectors, both of which are highly exposed to EM
demand (Figure 16).
Digitalisation is creating winners and losers in other ways, such as the transformative effect
of online shopping on price transparency and the demand for physical floor space for
retailers (a bricks and mortar presence). To pick just one example, while Blockbusters
ceased to operate in 2010, essentially the same movie-rental services are now provided by
companies such as Netflix who have zero presence in terms of stores or physical media.
FIGURE 14
The slow-down in global manufacturing
normalized diffusion
index, 3mma
1.5
FIGURE 15
... has been reflected in regional performance
global manufacturing confidence

global service sector confidence
Excess return (%)
1.0
0.5
0.0
-0.5
-2
-1.0
-4
-1.5
-2.0
-6
-2.5
-3.0
-3.5
* Triangles represent latest monthly data

05
07
09
11
13
4 December 2015
-8
Jan-14
15
Jul-14
US
Jan-15
Euro area
Jul-15
UK
LatAm
97
FIGURE 16
Sector geographic exposures, by revenues
100%
Euro area
75%
Other Europe
50%
US
25%
LatAm
Asia
Utility, Distributors
Utility, Electric
REITs
Transportation Services
Supermarkets
Insurance, Life
Wirelines
Utility, Other
Media Non-Cable
Building Materials
Cons. Cyclical Services
Banking
Construction Machinery
Energy, Integrated
Automotive
Pharmaceuticals
Insurance, P&C
Chemicals
Industrial Other
Diversified Manf.
Metals and Mining
Food and Beverage
Retailers
Tobacco
0%
Other
Note: Exposures based on equal-weighted ticker-level disclosure for the Pan European Credit Index, FY14. Source: Company reports, Bloomberg, Barclays Research
This is pushing down on the life span of companies. A 2012 report by the consulting firm
Innosight noted that the average company remains in the S&P500 for c.18 years, down
from more than 30 years in the mid-90s (Figure 17). Much of this shortening is likely to be
attributable to M&A activity, but from an investors perspective this is still a risk: a 30y bond
issued today is unlikely to be an obligation of the same company at maturity. In general, we
wonder if long-dated credit should carry more risk premium, over the full credit cycle.
Power generation is a good example of this effect; power plants are huge capital projects
that take decades to repay their initial investment, leaving them exposed to regulatory and
technological shifts, as well as the unexpected decline in heavy manufacturing (Figure 18).
This has been reflected in the performance of credits such as Areva and RWE among the
worst performing non-commodity credits this year. In our view, Transportation and Utilities
are the two sectors most exposed to the risk of rapid business transformations, given that
their projects have high up-front costs and long pay-off time horizons. We are Underweight
Utilities due to the structural pressures faced by core generation assets, which are no longer
offset by valuations on peripheral issuers (European Energy & Utilities: Outlook and top
ideas for 2016, 2 December 2015). On a one year horizon, however, we are more positive on
Transportation in light of the sectors strong domestic operational focus.
FIGURE 17
The average tenure of S&P 500 companies has fallen sharply
Average tenure in S&P500 (years)
250
mn TOE
240
61
60
230
220
50
210
40
200
30
190
25
18
20
180
170
Industry
160
10
Residential
150
0
1958
1980
Source: Innosight, Richard N. Foster, Standard & Poor's
4 December 2015
2012
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
70
FIGURE 18
Annual demand for electricity has collapsed in Europe
Source: ENTSOE, Barclays Research
98
Commodities: Its not over until its over (and then its over)
Within investment grade credit, it is often the case that the worst performing sectors of a prior
period become the best performing credits in the future. Outsized examples of this mean
reversion include US issuers during the sub-prime crisis, which underperformed peer credits
by -810bp from July 2007 to March 2009, then outperformed by a cumulative +1424bp from
April 2009 and Jan 2013. This pattern has been repeated in both financials (versus nonfinancials) and peripherals (versus core) in recent years as the global-financial crisis evolved
into the euro area sovereign crisis (Figure 19). While these examples are extreme, we think the
general point that IG sector performance tends to be mean reverting is valid. The key proviso
to this observation is that not all of the securities that underperform benefit from this mean
reversion; several may be downgraded to HY before the cycle turns.
In 2015 a new theme emerged: the end of Chinas investment-driven growth model and
with it the commodities super-cycle. Reflecting the collapse in base-metal prices, the Metals
& Mining sector has underperformed by -1211bp since July 2014 and is now the widest
trading of all sectors that we rate. Based on prior credit cycles, this suggests that the Metals
& Mining sector will, eventually, become a source of outsized positive returns, but not yet.
Commodity prices are still finding a floor

Previous cyclical sector trends have lasted several years. In contrast, the underperformance
of Metals & Mining really only began to accelerate in the second half of 2015, as the forward
price of metals collapsed (Figure 20). Given the secular nature of Chinas adjustment and
expectations that mined production of industrial metals will grow next, Metals & Mining
spreads still appear vulnerable to downside shocks in commodity prices. Indeed, our
commodity team believes that metal prices are likely to bump along the bottom for most
of 2016, which is likely to result in ongoing spread volatility.
Anglo American and BHP are at significant risk of downgrades

Specific to the Metals & Mining sector of the Pan-European Credit Index (PECI), we note
that issuer exposure is highly concentrated in three key credits: Glencore; BHP; and Anglo
American (Figure 21). Hence any sector view is dominated by the fundamentals of these
three issuers.
BHP and Anglo are both rated Underweight by our fundamental analysts given continued
pressure on their balance sheets from low (and falling) commodity prices. Arguably, this
risk is already in the price of Anglo, given that its index-eligible bonds trade with an average
OAS of 572bp. However, there is the risk of further widening in the event of a downgrade to
high yield which, as noted above, is the key risk to sector performance over the full cycle.
FIGURE 19
Major credit performance cycles since 2007
Start
End
Excess
returns (bp)
Underperform
01-Jul-07
31-Mar-09
-810
Outperform
01-Apr-09
31-Jan-13
1424
Investment theme
US vs Europe
Start
End
Excess
returns (bp)
Underperform
01-Apr-10
30-Sep-12
-880
Outperform
01-Oct-12
30-Sep-15
1117
01-Jul-14
31-Oct-15
-1211
Investment theme
Peripheral vs Core
Fin vs Non-Fin
Metals & Mining
Underperform
01-Jul-08
31-Dec-11
-1691
Outperform
01-Jan-12
30-Sep-15
1291
Underperform
4 December 2015
99
FIGURE 20
The mining sector cycle likely has further to run
500
FIGURE 21
Index exposure is concentrated in BHP, Glencore and Anglo
Relative excess returns (bp)
Metals &
Miners
40%
35%
30%
25%
-500
20%
15%
-1,000
10%
-1,500
0
10
15
US vs Europe
Peripheral vs core
20
Months from start

25
30
35
Fins vs non-fins
Metals & Mining vs index
Note: For date-ranges refer to Figure 19. Source: Barclays Research
5%
0%
VALEBZ
RIOLN
AALLN
GLENLN
BHP
Note: Market Value weights in PECI Metals & Mining. Source: Barclays Research
Market Weight versus an Underweight in Energy

Overall, the Metals & Mining index looks cheap, and a significant amount of pessimism is
already baked into prices, based on the forward curves of major base metals. However, price
momentum is still negative so we believe that a Market Weight rating is appropriate. Our
bias is to watch for signs of performance reversing, but we are circumspect on timing.
In our view, a more interesting way to position for renewed weakness in commodity prices
at this point in time is via the energy complex, for three reasons. First, significantly more
downside is priced into Metals & Mining credits than Energy credits based on year-to-date
performance (Figure 22). The Energy sector still trades 15bp tight to the PECI (in OAS), even
with oil prices near decade-lows. Further, the forward curve for oil remains upward sloping
(Figure 23), suggesting a reasonable amount of optimism over future oil prices despite
record-high levels oil inventories, both offshore and (increasingly) floating at sea. If Europe
and/or the US enjoy a mild winter this year then the overhang of oil in storage could grow
further, pushing down on WTI and Brent prices in the near term.
FIGURE 22
Energy has outperformed the Metals & Mining sector
600
OAS, bp
OAS, bp
FIGURE 23
supported by optimism over the future price of oil
160
150
500
140
400
130
Price, $/bbl
60
55
120
300
110
200
100
100
0
Jan-15
65
50
45
90
80
Apr-15
Jul-15
Metals & Miners (LHA)

4 December 2015
Oct-15
Energy (RHA)
40
0
20
WTI
40
60
Brent
100

Second, while the secular shift in Chinas economic model is well understood (and in our
view, significantly priced into financial markets), we are less sure that the extent to which
OPEC has lost its ability to influence oil prices is widely appreciated. Put simply, we place
more weight on Chinas ability to spur investment (if required to maintain target growth
rates) than OPECs ability to lift oil prices, given that marginal pricing power has shifted to
US tight oil producers. In light of the very-large budget deficits projected for GCC countries
next year (our EM economists forecast Saudi Arabias budget deficit at 13.8% of GDP in
2016), it is likely that several OPEC countries will continue to pump as many barrels as
possible, at almost any price, in order to fund their domestic budgets.
Indeed, it is notable that, aside from the GCC countries, which are often pegged to the USD,
oil producing countries such as Russia have seen the fall in their currencies more than offset
the drop in oil prices (in USD). Hence, the cost curve continues to fall and does not put an
obvious floor under oil prices. This is less the case for base metals, where the AUD and CAD
have outperformed the RUB and the BRL. Thus, while marginal production costs are falling
globally, this process has been more rapid in energy than metals.
Last, we note that global miners have already recognised the need to cut dividends and
shore up their balance sheets. In contrast to this, the integrated oil companies that
dominate the European Energy sector remain committed to their generous dividend
policies, even if that requires the issuance of debt. In our view, and in the view of our
analysts, they would need to come under sustained pressure (ie, spread widening) before
changing their dividend policy.
Overall, we view the Energy sector as priced for a much more benign outcome despite the
clear, long-term shift in price dynamics and relative inflexibility of dividend policies. Given
that the sector already trades tight to the overall PECI, we recommend an Underweight in
the space, particularly against the Metals & Mining sector.
Other sector views

Aside from the themes highlighted in the preceding sections, in Figure 24 we update and
present in full our ratings on the major corporate sectors of the PECI.
Underweight Autos: Despite the significant underperformance, we remain Underweight the
autos sector. Our fundamental analysts believe that a sustained recovery in spreads will not
come until there is greater clarity on the scale of both NOx and CO2 emissions misreporting
across the industry, which could take several quarters to arrive.
Overweight Transportation: While we have long-term concerns about the creditworthiness
of infrastructure projects, we note that the Transportation sector is highly domestically
focused (ie, insulated from EM risk) and heavily weighted toward sterling bonds. For these
reasons, we maintain our Overweight recommendation.
Market Weight Insurance: Insurance continues to trade wide of the index due to issues of
composition (ie, a high proportion of subordinated debt). Given the high beta nature of the
index and our conservative outlook for 2016 we remain Market Weight. Greater clarity on
Solvency II ratios, and resulting issuance of capital securities would increase our comfort on
the sector, but will take several quarters to emerge, at which point we will likely reassess.
TMT Overweight Wirelines. As we anticipated coming into 2015, M&A has not proven to
be a drag on the performance of investment grade Telcos. We believe this will remain the
case and like the cash-generative nature of the businesses, which minimises their need to
fund at inopportune times in a market that we view as oversupplied.
4 December 2015
101
FIGURE 24
European Investment Grade sector ratings
Index Weights
OAS
(bp)
OAD
Barclays
Index Rating
Barclays
Sector
Rating
Chemicals
97
5.0
A2/A3
UW
1.1%
0.0%
80.7%
0.0%
30.1%
3.7%
4.6%
16
Finance Companies
103
6.0
A1/A2
1.5%
2.6%
2.6%
0.0%
5.7%
10.3%
38.4%
Pharmaceuticals
105
7.5
A1/A2
2.2%
0.0%
30.4%
5.4%
24.9%
9.7%
23.0%
14
Aerospace/Defense
106
5.9
A2/A3
UW
0.2%
0.0%
52.3%
0.0%
24.9%
0.0%
33.9%
Food and Beverage
107
6.5
A2/A3
MW
2.3%
1.2%
47.1%
0.7%
48.4%
0.0%
13.1%
24
Diversified Manufacturing
109
5.9
A2/A3
UW
1.2%
0.0%
54.9%
2.6%
20.4%
0.0%
4.0%
17
Consumer Non-Cyclical
111
6.6
A2/A3
UW
7.2%
1.4%
38.7%
1.8%
40.2%
2.9%
18.6%
63
Total
113
6.0
A1/A2
100.0%
7.4%
30.9%
5.6%
34.1%
10.3%
22.3%
Banking
117
4.6
A2/A3
OW
21.9%
7.8%
37.6%
0.6%
25.4%
22.2%
16.3%
88
Building Materials
121
4.4
BAA1/BAA2
UW
0.9%
12.3%
70.5%
0.0%
93.2%
0.0%
9.7%
10
Retailers
121
9.0
A1/A2
MW
0.6%
0.0%
17.1%
0.0%
41.5%
0.0%
55.1%
Energy
124
5.9
A2/A3
UW
3.0%
22.5%
47.9%
0.6%
17.5%
9.8%
11.7%
16
Transportation Services
128
6.3
BAA1/BAA2
OW
2.5%
22.9%
35.1%
0.0%
78.3%
3.2%
29.9%
33
Media Entertainment
138
5.8
BAA1/BAA2
MW
0.7%
0.0%
53.9%
0.0%
100.0%
5.6%
12.4%
14
Utility
139
6.8
BAA1/BAA2
UW
7.7%
32.4%
29.7%
1.1%
69.8%
6.6%
42.5%
57
Wirelines
141
6.7
BAA1/BAA2
OW
4.4%
16.7%
42.0%
0.0%
88.6%
5.0%
26.5%
16
Supermarkets
142
4.8
BAA1/BAA2
MW
0.9%
2.0%
86.8%
0.0%
81.3%
0.0%
10.0%
Automotive
145
4.3
A3/BAA1
UW
3.5%
4.3%
75.6%
0.0%
36.7%
6.8%
13.7%
23
REITS
156
6.3
A3/BAA1
1.9%
2.3%
49.2%
0.7%
57.3%
3.2%
29.2%
35
Wireless
158
5.5
A3/BAA1
1.0%
0.0%
2.2%
51.5%
64.2%
8.6%
30.3%
Insurance
246
6.4
A3/BAA1
MW
4.4%
8.4%
44.8%
0.7%
53.0%
69.1%
35.0%
50
Metals and Mining
434
5.6
A3/BAA1
MW
1.1%
0.0%
0.0%
4.5%
58.0%
8.8%
21.1%
Sector
Index weight
Peripheral
Core
EM
BBB
Sub
GBP
Number of
issuers
4 December 2015
102
CDS-cash basis break on through to the negative side

The other key theme for credit, globally, this year, has been secondary market liquidity. This
has become an ever more important topic for investors, and is changing the nature of credit
investing. In particular, investors are increasingly using CDS indices to express long-risk
positions in order to maintain liquidity, as this allows them to maintain their cash balances.
This is a theme we expect to continue into 2016.
CDS-cash basis has decreased over the year, which we attribute to relative weakness in
cash stemming from supply-demand imbalances and an increased usage of CDS indices to
take risk in the market. We anticipate that these developments will continue in 2016, and in
deriving our forecasts for iTraxx Main and SenFin, we assume that the CDS-cash basis will
move from positive in early 2015, to flat EOY 2015 to negative EOY 2016.
Looking ahead by looking in the rear-view mirror

In a year of generally poor performance for IG credit, CDS has done relatively well, with the
CDS-cash basis for Main vs. a constituent-matched basket falling significantly over the year
(Figure 25) from the persistent positive basis seen in prior years, to about flat currently.
The move in CDS-cash basis has been supported by trends in both the cash and derivatives
markets. As discussed in detail above, the supply-demand dynamics of cash have been
weak this year and we expect this to persist into 2016; hence the cash leg of the CDS-cash
basis is unlikely to assist in a re-widening in the basis.
At the same time, we have seen a shift in the fundamental use of CDS indices, from a
portfolio hedging product (with investors being short risk in aggregate) to a credit-risk
proxy (with investors being persistently long risk as an aggregate). In our view, this reflects
a change in how investors construct their portfolios, reflecting their demand for secondary
market liquidity and the impaired ability of broker dealers to facilitate that. Amid challenging
liquidity conditions, the CDS indices iTraxx Main in particular remain the preferred place
to add risk, evidenced by investors (non-dealers) increasing their long-risk base, selling
protection to dealers (Figure 26). This trend accelerated in H2 15, with significant protection
selling after the risk flare in September, taking the long risk base to historical highs.
FIGURE 25
CDS-cash basis dropping in a weakening market, reflecting
cash underperformance
30
95
25
85
20
75
65
55
-5

4 December 2015
Jun-15
Sep-15
iTraxx Main
85
-10
25
Sep-14
Mar-15
90
10
Dec-14
-5
35
Cash equiv
Spread
95
$bn prot bought by investors

10
15
45
FIGURE 26
as investors increasingly use iTraxx Main as a way to
access beta in IG credit, adding risk longs over the year
80
75
70
-15
65
-20
60
-25
55
-30
Nov-13
May-14
Nov-14
All series
May-15
Main
50
Nov-15
Note: Showing amount of protection bought (positive) or sold (negative) by nondealers across all series of iTraxx Main. Source: DTCC, Barclays Research
103

To the extent that the relative strength of CDS over the year has been an expression of a
preference for liquidity which we believe to be the case we find this justified, as the
ability of iTraxx Main (and CDS indices in general) to function as a transmission of risk
remains intact. In periods of meaningful widening and tightening, the sensitivity of spreads
to $1bn of protection bought/sold by investors has not deteriorated and may even have
improved over time (European Credit Alpha, 20 November 2015, Figure 27).
With anecdotal evidence suggesting that the trend of increasing participation in CDS
indices (and options) will continue next year, we do not expect these developments to
reverse. Therefore, we expect that CDS strength, relative to cash indices, will continue in
investment grade.
One tactical caveat to our positive view on CDS indices is summarised well by looking at the
recent development in index-intrinsic skew (Figure 28). Having traded in a generally narrow
range around +/-4bp, more recently we have seen the skew dropping to -9bp. Whereas the
reason for the drop in skew is clear (investors selling protection Figure 26), at the outset it is
less clear why the skew has not corrected. Anecdotal evidence suggests that balance sheet
constraints either at the end-investor directly or via prime broker accounts are hampering
execution of skew trades (to enforce convergence of the skew towards zero), or at the very
least, the point at which such trades become compelling has moved out.
If the natural mechanism for mean reversion in skew is weakening, we might expect to
see a wider trading range for skew going forward. This could restrain the performance
of the CDS index as investors may be wary to sell protection 9bp tighter than where
single-names are marked. However, with the possible addition of new entrants in skew
trading (at wider skew levels), we find it likely that mean reversion of the skew towards
zero (or at least a less negative number) will occur, albeit from more extreme levels and
potentially with a slower speed of mean reversion.
FIGURE 27
iTraxx Main has maintained its ability to act as a
transmission mechanism for risk
9
8
FIGURE 28
but its popularly long makes structural issues in singlename CDS markets and balance sheet constraints evident
8
bp mv in spread per $1bn

position changed
5
4
-2
-4
-6
Nov-12
Jan-13
Mar-13
May-13
Jun-13
Jun-13
Aug-13
Oct-13
Jan-14
May-14
Jul-14
Oct-14
Dec-14
Apr-15
May-15
Jun-15
Jul-15
Aug-15
Sep-15
Oct-15
Widening
Tightening
Note: Showing spread sensitivity to shifts in investor positioning over longer

periods of spread moves, see European Credit Alpha, 20 Nov 2015. Source:
DTCC, Barclays Research
4 December 2015
-8
-10
Nov-12 Apr-13 Sep-13 Feb-14 Jul-14 Dec-14 May-15 Oct-15
104
CDS index forecasts: negative basis and SenFin-Main compression

Based on our forecasts for IG financial and non-financial derived in previous sections, we
present our forecasts for iTraxx Main and SenFin in Figure 29. For completeness, we also
include the forecast for iTraxx Crossover, which are derived separately in the HY section.
Our forecasts for CDS build upon:
Our forecasts for the Euro Aggregate cash indices (Figure 3).
An assumption that CDS will outperform cash by c.10bp (half as much as in 2015).
An assumption that index-skew will remain at -5bp (iTraxx Main) and -3bp (SenFin).
Interpretation of results
With our forecasts for cash indices and assumptions for CDS made above, there are a
number of implications for our forecasts for Main and SenFin (Figure 29).
In our baseline, Main will be at 65bp EOY16, and 50bp in our upside scenario, but 95bp
in the downside.
In line with our assumption that industrial spreads will not move much, the majority of
our assumed tightening in Main in the baseline case, some not from the NonFin part,
but from our assumption of financial cash outperforming next year. In fact, we estimate
that SenFin will be at 50bp 15bp inside Main in our baseline case.
Across scenarios we expect SenFin to outperform Main in particular in a downside

scenario with lower economic growth which, in the first instance, is likely to hurt
non-financial credit the most, and also bearing in mind the meaningful long-risk
base in Main (Figure 26), which is in contrast to SenFin where investors carry a
short risk position.
FIGURE 29
Spread forecasts for CDS indices
FIGURE 30
SenFin-Main recent evolution and in EOY 2016 scenarios
Actual
Baseline
Upside
Downside
Main
70
65
50
95
SenFin
69
50
45
75
Cross
292
310
260
410
Key RV measures
SenFin-Main
-2
-15
-5
-20
Cross/Main
4.16
4.77
5.20
4.32
Change from current
70
60
50
40
30
20
10
0
Main
-5
-20
+25
-20
SenFin
-19
-24
+6
Cross
+18
-32
+118
-30
Jan-13
Jan-14
SenFin-Main
SenFin-Main
-14
-4
-19
Cross/Main
+0.61
+1.04
+0.16
4 December 2015
-5
-10
-15
-20
Jan-15
Baseline
Jan-16
Upside
Jan-17
Downside
Note: The Baseline and Upside scenarios coincide. Source: Barclays Research
105
STERLING HIGH GRADE STRATEGY
Benign neglect is still neglect

The sterling market may prove to be an island of balance next year, adrift in an ocean of
Zoso Davies
oversupply. Issuance volumes were unusually low in 2015 and we have pencilled in a
similarly light supply calendar for 2016 which, coupled with steady demand, augers well
for performance relative to both - and $-IG. That said, we are concerned that activity
levels are too low to ensure the long-term vitality of the -IG bond market.
+44 (0)20 7773 5815

Barclays, UK
Andreas Hetland
A rare specimen: Unlike its larger cousins, we believe that supply and demand are
+44 (0) 20 7773 1547
broadly in balance for -IG. This has been achieved via depressed primary market
volumes, which significantly undershot our forecasts in 2015. Having found a
semblance of balance, we expect the market to revert to more normal dynamics:
with coupon inflows and a steady trickle of investment from life assurers and
pension funds supporting spreads.
Barclays, UK
A prisoners dilemma: The success of sterling asset managers in growing their assets
under management long ago outstripped the -IG markets capacity to absorb them.
While broader mandates bring advantages in terms of risk diversification, liquidity
and market capacity for investors, the shift of activity into USD and EUR markets
detracts from -IG liquidity, both in primary and secondary markets. The importance
of matching adjustments under Solvency II will only add to the already challenging
liquidity profile of sterling credit.
One more time: We believe that the impact of a UK referendum on EU membership

will be more akin to the UK elections than the Scottish referendum, with GBP the
primary victim of any negative sentiment ahead of the vote. Uncertainty should
stymie -IG supply, but we believe UK issuers will underperform if the out
campaign begins to pull ahead.
FIGURE 1
Barclays 2016 -IG excess returns forecasts
Baseline
Upside
Downside
GBP Corp
2.3%
3.8%
-2.8%
GBP Non-Fins
1.6%
4.0%
-4.7%
Baseline
Upside
Downside
1-3yr
1.5%
2.1%
0.6%
3-5yr
2.4%
2.7%
0.8%
5-7yr
2.3%
3.3%
0.3%
AA
1.4%
2.6%
-1.3%
7-10yr
2.1%
3.4%
-2.3%
1.9%
3.4%
-2.5%
10-20yr
2.6%
4.6%
-5.3%
BBB
2.7%
4.4%
-3.5%
20yr+
2.7%
4.9%
-6.2%
FIGURE 2
Key investment themes for -IG
Strategic theme
Investment implications
Balanced technicals
... weak supply can be met by stable demand
-IG likely to outperform -IG and $-IG over the full-year
A prisoners dilemma
... investors seek liquidity in $-IG and -IG
Diversification increases portfolio liquidity, but reduces -IG market activity

Dedicated, actively managed -IG capital is vital to the market's long-term viability
Voter fatigue
... UK is likely to vote on its future in the EU
The currency is likely to bear the brunt of any risk-off sentiment

UK issuers should underperform if the "out" campaign gathers positive momentum
4 December 2015
106
A rare example of balance

In contrast to both the $- and -IG markets, -IG issuance will be significantly lower in 2015
than in 2014. This has resulted in -IG outperforming other IG credit markets, though only
in fits and starts; a strong Q1 was unwound in its entirety during the summer, as credit
spreads sold off globally, but -IG outperformed in Q4 as demand firmed, supported by
principal and coupon repayments to bondholders. We expect that supply will remain weak
next year (Figure 3), which should keep the -IG market in balance given the firming of
demand that we have seen over the second half of 2015.
Turning to the demand side, we remain constructive for next year though not outright
bullish. With Solvency II coming into force from 1 January 2016, and with no unpleasant
surprises for the UK pensions and savings industry in the Chancellors autumn statement,
some sizable overhangs to investment have now dissipated. Specifically, we expect that the
bulk of adjustments to credit portfolios in response to Solvency II have already been made,
suggesting that the marginal flow will be investment of positive inflows of cash. In particular
coupon flows to bondholders should remain robust and will likely underpin positive demand
dynamics next year (see Coupon ebb and flow, 20 November 2015)
That said, we expect the influence of Solvency II to persist, though likely not in the way that
most investors anticipate. While countless words have been spilled with respect to the
capital optimisation problems under Solvency II, we view the liquidity implications as even
more important. Specifically, given the strong benefits of matching adjustments, a largerthan-ever segment of -IG will be passively held to maturity. The capital incentives for
insurers to manage large blocks of their investment portfolios passively will negatively affect
liquidity in secondary markets (this is not specific to credit). In our view, this is probably the
most important, but least discussed, effect of Solvency II on credit markets; particularly one
such as sterling, where Solvency driven investors are dominant.
With secondary market liquidity likely to suffer under Solvency II, primary market activity
will be more important in gauging the health of -IG markets. Grow or die is a well used
maxim in business and, in our view, the growth rate of the -IG market is low enough to
bring into question the long-term vitality of sterling corporate bonds markets. With key
segments of the -IG bond market likely to be less active in secondary markets under
Solvency II, it is more important than ever that primary market volumes are maintained at or
above current levels. Next year will be an important test, in this respect.
FIGURE 3
We expect supply to remain modest
80
FIGURE 4
while demand has been recovering, albeit gradually
bn
Fin
Non-Fin
70
20
bn
15
60
10
50
5
40
30
20
-5
10
-10
Source: Dealogic, Barclays Research
4 December 2015
2016*
2015*
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
07
08
09
Life Assurance
10
Retail
11
12
13
P&C Assurance
14
15
Pension Funds
Total
Source: ONS, Barclays Research
107

Despite these sombre undertones, the 12-month outlook for sterling credit is resolutely
positive given the markets innate ability to control its own destiny with respect to issuance
volumes even if this risks being self-defeating in the long run. Supply and demand are likely
to remain near an equilibrium, which is a more positive outlook than we can muster for -IG
unless the ECB technical (or the ECB directly) asserts itself as a source of demand. Valuations
look attractive on a cross-currency basis, both outright and swapped, versus both -IG and
$-IG. Based on this rationale we shifted our view on -IG to Overweight (within the PECI) in
October and we maintain that bullish view on the asset class into H1 2016.
Fundamentally, our economists have pencilled in weaker growth and higher inflation for the
UK next year which is a gloomy backdrop for risk assets, but we think that this has already
been more than priced in at current spreads levels. Aside from the tail risk of the UK
referendum on EU membership (discussed below) negative shocks to the UK outlook are
likely to come from aboard, and hence -IG credit should have a lower beta to bad news.
The main risk to our call is that the ECBs dovish policy stance regains traction on -IG
markets, but that is more likely to happen in the second half of the year, if at all.
The liquidity dilemma

A prisoners dilemma is one in which each individual is incentivised to act in a way that
leads to suboptimal outcomes for the group as a whole, due to an inability to co-operate.
For example, a successful UK asset manager may quickly grow their AUM to levels that
outstrip the ability of the -IG market to provide sufficient market liquidity for new
investments or to manoeuvre the portfolio in a timely manner. In response, the manager
may attempt to relax their investment constraints or open new funds which have a broader
investment mandate, enabling them to access other pools of liquidity. In doing so, the
liquidity of sterling credit is further undermined as activity is shifted abroad, which is
ultimately detrimental to all.
While difficult to quantify, the behaviour described above is a trend that we have observed
across the UK AM community over recent years. Since January 2009, -IG AUM has grown
by c.27bn, while general corporate bond funds have grown c.57bn. The result has been a
dispersion of market activity into other asset classes, particularly $-IG. While an individual
manager can enhance a bond portfolios liquidity this way (along with other benefits such
as name and sector diversification, access to a broader pool of investors and so on), the
result has been a falling proportion of activity in -IG bond markets. By definition, this
reduces the liquidity of sterling credit in a self-reinforcing cycle.
This dynamic becomes even more important, and deleterious, against the aforementioned
backdrop of falling activity within Solvency II portfolios, as asset managers are the next
most important group of market participants in -IG. While the market as a whole would
benefit from co-ordination of various participants (analogous to the prisoners dilemma),
there are understandable regulatory constraints preventing that from happening. Hence,
investors find themselves in an un-coordinated race to find a solution that preserves the
integrity of the sterling corporate bond market.
Of course, it is easier to identify a problem than solve it; nevertheless, recognition of the
issue helps. One factor that may help would be an influx of demand for sterling corporate
bonds, resulting in an acceleration of primary market activity. As negative as the scenario
we have described may appear, it can equally run in reverse where an uptick in liquidity
generates greater confidence in the asset class, resulting in further inflows and activity that
enhance market liquidity. Inflows of new investment and primary deals are the most likely
catalyst for this, in our view. Dedicated pools of sterling investment also help, both by
providing demand but also by ensuring there is a core base of investors active in the market
and with a vested interest in maintaining its integrity.
4 December 2015
108
Multi-coloured swap-shop
Another facet of Solvency II that has probably not received the attention it deserves is the
choice of discount curves. Because Solvency II is based on the Libor curve, the matching
adjustment mechanism heavily incentivises receiving swaps over holding gilts. This has
resulted in a dramatic tightening of government bond asset swaps, particularly at the long
end (ie, government bonds have underperformed the Libor curve). Swap spreads now trade
negative in both USTs and Gilts beyond tenors of 5-10 years. Given that, in theory, Libor
represents an unsecured borrowing rate for banks, this is historically unusual.
That said, this reversal of the normal risk hierarchy has been a well-known feature of the
ultra-long gilt market for many years, usually explained with reference to LDI hedging
activity versus the Libor swap-curve. This suggests that the growing influence of Solvency II,
combined with the constrained balance sheets of non-Solvency investors, can explain much
of the recent movements in global government asset swaps. Given the price-insensitive
nature of these flows, and the inability of other investors to oppose them, our rates team
does not expect swap spreads to widen meaningfully in the near term.
All of the preceding arguments should, at least in theory, apply equally to corporate credit.
Hence, Solvency-based investors are likely to use the swap curve, rather than the gilt curve,
as their benchmark for measuring credit spreads from the start of next year. This would
make credit significantly more attractive, as much of the spread tightening versus gilts in Q4
has been offset by the tightening of swap-spreads: the credit spread to Libor (L-OAS) has
rallied significantly less than the spread to Gilts (OAS) (Figure 8). This should be supportive
of demand for -IG from Solvency II investors at the beginning of 2016 (as valuations have
not richened much within the Solvency II framework). It is also positive for performance as
measured in excess returns, as swaps are unlikely to give back their gains versus gilts,
keeping OAS spread relatively tight.
More generally, and on a positive note, while Solvency II investors may shift a significant
portion of the investor base toward L-OAS metrics as a measure of credit valuations, we
believe retail money will remain primarily benchmarked versus gilts. The result is, therefore,
a broader variety of investor opinions on credit valuations, which would benefit market
formation and liquidity. Yield, OAS and L-OAS based investors are a healthy mix of valuation
perspectives, which should support differentiated investment activity.
FIGURE 5
Gilt swap-spreads have tightened
FIGURE 6
exaggerating spread widening versus the swap curve
YTD
change, bp
190
bp
180
170
-5
160
-10
150
-15
140
-20
130
-25
120
-30
110
Jan-15
-35
5y
4 December 2015
10y
30y
Apr-15
OAS
Jul-15
Oct-15
Libor-OAS
109
Tyranny of the ballot box

History may not repeat itself, and we certainly hope that our research does not, but this is
our third consecutive Sterling Credit Outlook in which the key domestic focus for -IG has
been matters of democracy, rather than economics or finance. This hat-trick of ballot-box
votes gives us two prior templates for the UKs referendum on EU membership, which is
likely to be held in H2 2016 (though no firm date has been set, hence we cannot promise
that this section of the outlook is not destined to become a permanent feature).
In our view, the UK referendum is likely to share features with the Scottish referendum and
this years general election. Most important, we believe that any negative sentiment towards
the UK and sterling assets that develops ahead of the vote will primarily stress the currency
rather than spreads. GBP has had a good run this year against most currencies, other than
the omnipotent USD; in particular, it has appreciated against both commodity currencies
(AUD, CAD, RUB) and those that are tied to the ECBs policy stance (EUR, SEK, NOK, CHF).
Hence, there is plenty of room for sterling to weaken if sentiment towards the UK sours in
line with our FX teams outlook for the GBP (GBP: Competing forces).
Any negativity on the currency is likely to be reinforced by a dovish BoE. The MPC has
gradually unpicked the ties between its policy stance and the FOMC, both through verbal
guidance on the likely timing of its first hike and by explicitly deferring the run-off of APF
holdings until after the policy rate has reached a level of around 2%. This opens the door to
a continued dovish stance if uncertainty spikes ahead of a referendum. At the same time,
we would expect primary market issuance to slow in credit markets. Hence, credit spreads
and yields may, counter intuitively, outperform against other markets in the run-up to the
referendum much as they did ahead of the general elections this year.
On the other hand, as with the Scottish referendum (perhaps even more so), there is the
risk that polls indicate a high likelihood of an out vote ahead of the vote; polls have been
volatile and seem likely to remain so (Figure 9). In our view, indications that the out camp
is gathering momentum would be clear negative for sterling credit, primarily due to the
regulatory and operational uncertainty that would descend upon major domestic investors
(similar to events in 2013). UK issuers are likely to underperform in all currencies in this
scenario, given the potential effect on businesses and, perhaps more worryingly, the lack of
mitigating actions that they can commit to ahead of time given that it is still far from clear
what the UKs relationship with Europe would look like outside the EU.
FIGURE 7
Polls remain too close to call on the UK referendum
FIGURE 8
hence, the GBP appears overvalued, given its recent
strength
YTD change(%)
60
20
55
50
15
45
10
40
35
30
0
25
20
-5
15
10
Jan-14
Jul-14
Remain in EU
Source: Various Polling Institutions
4 December 2015
Jan-15
Leave EU
Jul-15
Jan-16
Undecided
-10
Jan-15
GBPUSD
Apr-15
Jul-15
GBPEUR
Oct-15
GBPJPY
GBPAUD
Source: Bloomberg
110
EUROPEAN HIGH YIELD STRATEGY
Mediocre expectations
Tobias Zechbauer
+44 (0)20 7773 6790
tobias.zechbauer@barclays.com
Barclays, UK
Soren Willemann
+44 (0) 20 7773 9983
Barclays, UK
James K Martin
+44 (0)20 7773 9866
james.k.martin@barclays.com
Barclays, UK
While we see support for European high yield based on ECB monetary policy, we are
cautious on macro trends and technical factors. Upside should be modest and
returns lower, due to idiosyncratic headwinds and some spill-over effects from the
Fed hiking cycle.
We forecast 2016 excess returns of 3-4% for European High Yield, translating into a
total return of 1-2% taking into account our expectation of moderately rising rates.
High yield spreads are slightly wider in our baseline scenario. We forecast a year-end
OAS of 455-475bp for the Barclays Pan European HY ex-Financials index. This
equals a spread widening of about 25bp from current levels.
Better quality bonds (BBs) should outperform in spread terms, as lower quality
should suffer more from the slight index widening that we foresee.
Fundamentals for the index have been marginally deteriorating over the year.
Favourable lending conditions during the past few years lead to a slight increase in
leverage, and interest cover decreased modestly. We see a softening in EBITDA
margins, but not to the extent that there is a major change in our view based on the
overall bottom-up data.
Sector dispersion increased in 2015, with a meaningful divergence in returns for

European non-financial high yield companies. Different spread levels and volatilities
will keep sector selection on the priority list. Our key Overweights are
Communications, Debt Collectors, and Gaming. We are Underweight on Automotive,
Leisure, and specific parts of Energy.
2016 will likely have bifurcated trends affecting European high yield: on the one
hand are some tailwinds from the ECB, while on the other are headwinds from the
Fed hiking cycle. We expect those two main drivers to be overlaid by uninspiring
technical trends.
We forecast a 1.75-2.75% issuer-weighted default rate for HY bonds in 2016 (1.52.5% par weighted) still near historical lows, but slightly higher than the current rate.
While loose monetary policy should keep defaults lower, the reduction in primary
liquidity for highly leveraged securities could spell trouble for issuers that need to tap
the high yield market.
We expect slightly lower gross bond issuance in the European high yield market in
2016. Euro-equivalent volumes from corporates should be 75-85bn, down 5% over
the year, including 50-60bn in euro, about 10bn in sterling, and about 15bn in
USD. We foresee positive net issuance that will lead to continued index size growth.
Demand for European high yield remains dominated by mutual funds. We do not
anticipate significant directional fund flows, though we note the risks inherent to
retail-driven demand. We expect overall demand growth to remain low, and see a
supply-driven demand in 2016.
We believe the strong run of CDS relative to cash in HY will come to an end in 2016,
with many of the drivers for the drop in CDS-cash basis being weakened; if anything,
the basis appears biased to increase. Coupled with a more conservative view on HY
cash relative to IG cash, our forecasts for iTraxx Cross imply a decompression vs.
iTraxx Main in all scenarios for year-end 2016.
4 December 2015
111
FIGURE 1
European high yield annual returns with 2016 forecast
25%
FIGURE 2
2010-15 cumulative returns by fixed income asset class
+59%
80%
20%
73%
70%
15%
10%
60%
5%
50%
0%
47%
44%
37%
40%
-5%
-10%
30%
-15%
20%
-20%
Underlying Gov. Bond Return
2016
YTD 2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
Spread Return
32%
27%
21%
10%
-31%
-25%
35%
0%
Europe US HY
HY
EM Europe US IG
US Global US Tsy
Hard
IG
Munis Agg
Ccy
After years of great performance, lower returns expected

In the five years after the financial crisis, European high yield has been one of the best
performing fixed income asset classes. Since January 1, 2010, the Barclays Pan Euro High Yield
Index has delivered a cumulative total return of 73%, far outpacing the returns of other credit
and government bond indices (Figure 2). The fact that European high yield was able to
achieve such performance despite enduring a second recession in 2012 illustrates the returnsgenerating power of wide credit spreads in combination with abundant central bank liquidity.
In 2016, we believe this impressive run of outperformance for European high yield is going
to soften. While the higher-quality spectrum of European high yield should continue to
benefit from the accommodative ECB environment, we believe that the spread upside for
the lower-quality segment is limited. With about 22% of the market being call constrained
(Figure 3), we expect this source of return to be less important for 2016, while most of next
years return is set to come from carry.
FIGURE 3
Percentage of par trading to its next call
40%
35%
30%
25%
FIGURE 4
Starting yield versus realized total return by year
12M Total Return
40%
30%
20%
20%
10%
15%
0%
10%
2012
2006
2015
2016 Est
-10%
Note: Based on average monthly data. Source: Barclays Research
4 December 2015
2005
19992010
2004
2013
2014
2007
2011
2002
2001
2000
5%
0%
2008 2009 2010 2011 2012 2013 2014 2015
2003
-20%
0%
5%
10%
Starting YTW
15%
20%
Note: Chart does not show 2008 and 2009 outliers. Source Barclays Research
112

However, index yields appear set to begin 2016 at one of lowest starting points in recent
history: our cash index is yielding 4.8% as of late November, just slightly above the 4.6% at
the end of 2014 (Figure 4). As such, valuations no longer suggest material outperformance
potential for European high yield.
In 2016, central bank policy will likely diverge on each side of the Atlantic, with different
implications for credit markets. With a first hike expected to be implemented by the US
Federal Reserve, we expect slight spill-over effects to Europe as investors start to realize that
the low yield environment will not continue endlessly. Although the ECB is set to extend its
asset purchases of European government bonds (see Interest Rates Outlook: A transatlantic
divide), there is essentially no more room for lower rates to boost high yield returns. As
Figure 1 shows, rates have been a contributor to high yield total returns in 10 of the past 11
years. Meanwhile, asset price volatility associated with the Fed rate hike will likely limit any
tightening impulse in European credit spreads.
2016 outlook for high yield spreads

Our 2016 returns outlook is driven by the same core assumptions described in the
Economic Outlook: Preparing for Fed lift-off. As a starting point, we take our economists
forecasts for GDP growth (1.6% y/y by Q4 16), inflation (CPI at 1.0% y/y), and inflation
expectations (directionally higher). Although hardly robust in an absolute sense, these
would represent approximately stable economic growth. Inflation would increase
moderately from the low levels during 2015. Lending standards with a 4-quarter lag are also
applied to our forecast model, meaning that the current value of -6% (ie, 6% more
respondents reporting loosening than tightening) is utilized. We assume in our baseline
scenario that lending standards do not loosen further from current accommodative levels.
FIGURE 5
2016 baseline and alternate scenarios with year-end spread forecasts
Scenario Description
Current
Baseline
Upside
Downside
GDP (%, y/y)
1.5
1.6
2.0
1.0
CPI (%,y/y)
0.1
1.0
1.3
0.6
24 (V2X)
Similar
Slightly lower
Higher
Lending Standards (%,4Q Lag)
-6
Broadly
unchanged
Unchanged
Tighter
Inflation Expectations
1.0
Stable
Slightly higher
Slightly lower
OAS (bp)*
440
455-475
360-380
530-550
Volatility
Note: * Pan European High Yield ex Financials index. Source: Barclays Research
In our view, volatility will be similar going into 2016. On the one hand, continued ECB
purchases will suppress it. However, this is likely to be offset by macro risks such as
geopolitical influences and some spill-over effects from the hiking cycle in the US. The
model inputs for our baseline scenario are summarized in Figure 5.
4 December 2015
113
FIGURE 6
Barclays Pan-Euro HY ex-Financials Index OAS with forecast
OAS (bp)
900
FIGURE 7
B/BB spread ratio with forecasts
2.6
2.4
800
700
2.2
600
2.0
500
1.8
400
1.6
300
1.4
200
1.2
100
0
'06
'07
'08
OAS
'09
'10
'11
'12
Post-Crisis Tights
'13
'14
'15
'16
Pre-Crisis Tights
1.0
2009
2010 2011 2012

B/BB Ratio
Upside
2013
2014
2015 2016
Baseline
Downside
In combination, these inputs lead us to derive a year-end 2016 spread forecast for the
European high yield cash market of 455-475bp. This represents only a small amount of
widening relative to current levels, still comfortably wider than the post-crisis tights (Figure 6).
By quality segment, we believe that the B/BB spread ratio will move slightly up, to about 2x
in our baseline forecast. In spread terms, we expect an outperformance of BBs vs. the lower
rating buckets. BBs are disproportionately held by investment grade managers, owing to the
presence of numerous large fallen angels and other national champion issuers. The
current share of BBs in the European high yield ex-Financials index is more than 60%. This
is a significant portion of the market taking into account the different buyer base of this
segment. We expect the demand from IG managers to support the BB rating bucket.
For 2016, we foresee that the accommodative ECB technical will not extend into the B and
CCC rated portion of Euro high yield, as IG managers typically do not hold credits below the
BB rating bucket. As a result, the spread pickup for moving down in quality from BBs to Bs
surged over the past 12 months to levels more than two standard deviations away from the
average ratio that has prevailed during the post-crisis period (Figure 7). For 2016, we expect
the lower rating bucket to widen more than the overall index. A decent performance on the
excess return side is still possible, driven solely by carry. In our view, only an upside scenario
involving greater-than-expected growth and inflation will be sufficient to make lower quality
outperform on a spread basis.
Transforming the spread forecast into total returns

Deriving a total return forecast from our year-end spread target involves assessing the
contributions from four other sources: rates (used along with spreads to determine
aggregate price change), carry (in the absence of price moves), defaults (to estimate credit
losses), and new issuance (new issue premiums can make a significant contribution to
market returns). As Figure 8 shows, government bonds are expected to detract from total
returns in 2016, as Bund yields at the short end move higher from the currently negative
territory. For US Treasuries (Figure 9), we expect short rates to increase even more due to
the expected Fed hike in December, as detailed in our Interest Rates Outlook: A transatlantic
divide. We look at the rates move considering a duration of about 4 years for the European
and US high yield indices excluding financials. The influence of Gilts on European high yield
is limited, as sterling issues account for only about 19% of European high yield.
4 December 2015
114
FIGURE 8
Current and forecast Bund curve
FIGURE 9
Current and forecast US Treasury curve
%
%
1.5
3.0
10y
+ 40bp
1.0
2.5
2y
+ 70bp
2.0
5y
+ 40bp
0.5
2y
+20bp
0.0
10y
+ 60bp
5y
+ 70bp
1.5
1.0
0.5
0.0
-0.5
0
2
Current
6
8
Q4 2016 Forecast
10
2
Current
8
6
Q4 2016 Forecast
10
As a starting point, we use the current index yield of 5.1% for the Pan European High Yield
ex-Financials index and then subtract 100bp for credit losses by taking the midpoint of our
1.5-2.5% par-weighted default forecast and a blended recovery rate of 45% (see the
ensuing section on fundamentals for details behind our default outlook). Our modest
spread widening forecast of 25bp translates into 90bp of index price deterioration taking
into account the index duration, and new issues contribute another 20bp through the
realization of new issue premiums and higher carry relative to market averages. Summing
up these factors results in excess returns forecasts of 3-4% for European high yield in 2016
(Figure 10). Using interpolated data from Figure 8 and again taking into account the index
duration, we arrive at a total return forecast of 1-2% in our baseline scenario.
FIGURE 10
2016 excess and total return forecast
Excess and Total Return Decomposition
Baseline
Upside
Downside
Starting Yield
5.1
5.1
5.1
Default Losses
-1.0
-.70
-3.2
Index Price Change
-0.9
2.8
-3.7
New Issue Contribution
0.2
0.2
0.15
Excess Return Forecast
3-4%
7-8%
-1-2%
Total Return Forecast
1-2%
6-7%
-1-0%
455-475
360-380
530-550
OAS Forecast (bp)

4 December 2015
115
The upside scenario: Positive news from growth and ECB tailwinds lead to
tighter spreads
While the somewhat uninspiring growth forecasts in our baseline scenario would likely
prove insufficient to drive a significant rally in European HY spreads, a persistently dovish
ECB could plausibly jumpstart GDP and inflation more dramatically than we anticipate.
Indeed, our Equity Strategy team cited Continental Europe as having the best prospects for
EPS expansion in its 2016 outlook Under new leadership. Chief among their reasons for
optimism is the continued depreciation of the euro; our FX team sees EURUSD hitting 0.95
by Q3 16. The avoidance of deflation, coupled with less-than-expected volatility effect from
Fed rate hikes, could lead to another year of European HY credit outperformance.
The persistence of low commodity prices should also prove beneficial to European high yield.
Unlike the US market, European high yield issuers do not have the same exposure to the energy
sector. In fact, the retail and autos sectors, which comprise a significant part of the Pan-European
index, likely benefit from these depressed prices; in our 2016 Commodity Markets Outlook: A
drawn-out bottom, we forecast only a $2/bbl increase in the price of oil through Q4 16.
Further depreciation in oil and the euro, coupled with some ECB-inspired growth, could push
GDP growth to 2% and drive inflation north of 1%. In this scenario, investors would once
again find some of the best global credit performance in the European high yield market. If all
these conditions arise, we forecast excess returns similar to 2013 levels of 7-8%.
The downside scenario: Lower eurozone growth leads to investor concerns

While an upside scenario has become plausible, a downside scenario that involves lower
realized growth and inflation cannot be ruled out. In our downside case, investor confidence
deteriorates, despite the ECBs effort to revive the eurozone economy, and disinflationary
pressures resurface. As mentioned in the Economic Outlook: Preparing for Fed lift-off, more
than 90% of the developed market countries that our economics research team covers had
less than 1% CPI inflation as of September. This trend could continue should commodity
prices fail to stabilize and lead to a realization of the downside scenario.
To model such an outcome, we use a downside scenario involving 1% GDP growth, low
inflation of 0.6%, slightly lower inflation expectations, and higher volatility. Support for the
overall high yield index would be the continued sponsorship of BB rated fallen angels and
national champions, which we believe would widen only moderately. However, the
decompression at the end of 2014 would almost certainly continue, resulting in stronger
underperformance for B and CCC rated credit. We would expect credit losses from defaults
to increase as higher spreads put pressure on the lower-rated companies. For the downside
scenario, we believe that a spread widening in of 100bp or more would result in returns that
struggle to stay above 0% for the full year.
2016 trading themes: Bifurcated trends to drive high yield

We expect 2016 to have bifurcated trends affecting European high yield: On the one hand
are some tailwinds from the ECB, while on the other are headwinds from the US, where the
Fed appears set to start the rate hiking cycle. Those two main drivers will likely be overlaid
by uninspiring technical trends.
ECB tailwinds likely will not extend into lower-rated high yield
In theory, ECB support affects investment grade rated bonds and pushes some of their
investors out to the BB segment in search for yield. With the BB rating bucket accounting for
about 60% of the market value of European high yield, the asset class overall should receive
a small technical benefit. However, in 2015, accommodative ECB policy did not have the
same positive effects on total returns as in the previous year, especially in investment grade.
While the ECB technical is certainly not a negative, demand from outside traditional high
yield investors appears to have already saturated the market.
4 December 2015
116

The performance of high yield credits that can be held by investment grade managers is
driven by a predictable ECB-related technical, while that of lower-rated credit is likely to be
volatile and depends on ECB policies translating into real economic growth; we recommend
positioning for the ECB technical by overweighting long duration euro-denominated noncallable BBs. We believe investment grade managers will not be concerned about duration
risk in 2016 and will seek to boost portfolio returns by reaching out the curve in the BB
credits they own. As observed during September 2015, a supportive central bank policy
sometimes cannot overcome changes in sentiment that lead to smaller sell-offs across the
European credit complex. We expect 2016 to contain a similar pattern of a favourable ECB
environment, but headwinds that affect market stability.
Weak technicals lead to strong tail risks

Slightly higher default rates, positive net supply, and a retail-heavy demand base do not provide a
particularly stable technical landscape for 2016, in our view. While none of these factors is
particularly negative, we do not think they provide robust support in the event of a realized tail
risk, such as sector contagion. Last year, Phones4U drove the entire retail segment wider, and
this year, Abengoa affected other companies with a similar profile, notably Isolux. These
idiosyncratic events, as well as the macro risks mentioned earlier, can have an exponentially
severe effect, given the delicate technical environment in European high yield.
The Atlantic spill-over: US HY to affect Europe, despite segregated markets

Excluding financials, the US high yield bond market currently offers about 3.3% more yield and
190bp more spread than European high yield. A large portion of this difference can be
attributed to compositional differences between issuers in the regions. The sectors with high
exposure to commodities namely Basic Industry and Energy carry about twice as much
market weight in the US as they do in the European high yield index. Another driver is the
different share of BBs in the European index (about 61%) vs. the US (about 35%). Despite
these differences, the performance of US and European HY remain linked (Figure 11).
While one could argue that cross-holdings of investors from the US are fairly low, we see
significant spill-over from the US to Europe. This can be observed from the correlation
between index returns in Europe and the US (Figure 12). Although European high yield is
less exposed to oil price moves and lower commodity prices, we think the condition of the
US HY market will continue to be a driver of high yield returns in Europe.
FIGURE 11
Monthly returns for US HY and PE HY
FIGURE 12
Rolling 12m correlation between US HY and PE HY
10%
1
0.9
y = 0.95x
0.8
0%
0.7
-5%
Source: BRAIS, Barclays Research
4 December 2015
2015
2014
2013
2012
10%
2011
5%
2010
0%
US HY TR
Last 10 years
From Jan '14
2009
-5%
2008
0.5
2007
-10%
-10%
0.6
2006
PEHY TR
5%
Rolling 12m correlation

117
Fundamentals marginally poorer, defaults slightly increasing

Fundamentals have been deteriorating slightly over time, based on marginally higher net
leverage combined with lower interest coverage, according to recent Moodys data (Figure
13). The favourable low interest rate environment for issuers over the past few years has
encouraged running high leverage levels. Figure 13 shows that leverage has increased over
the past five years, but net leverage has increased only 0.5x, which is moderate. Some
companies leverage increased based on rising pension obligations as rates in Europe
declined, leading to higher accounting-driven pension deficits on the balance sheet. Overall,
we think that index fundamentals will not move spreads in one direction or the other.
This does not mean that credit risk is no longer a significant component of leveraged
finance investing on an individual issuer or sector level. Unexpected blowups drove a
dramatic underperformance in CCC credit during the second half of 2014, whereas the
absence of any notable defaults, as well as insulation from macro risks, helped lower-quality
total returns through most of 2015. However, the current environment shows that large
capital structures can quickly eliminate returns from investing in lower-quality credit.
Should Abengoa default, its index-eligible debt would add about 0.7% to the annual parweighted default rate. According to Moodys, the final trigger for a default could be a formal
insolvency filing, a distressed exchange, or a non-payment of the bonds.
As detailed in our 2016 default outlook, we incorporate our fundamental analysts views and a
macro model to establish our default forecast. The two indicators in our model currently point in
different directions (Figure 14). Owing to ongoing ECB support, lenders have reported looser
lending standards throughout 2015; this predicts a lower default rate than even the current level.
However, the recent commodity and EM-driven volatility has not left highly leveraged European
names completely unscathed, despite European high yield being relatively well insulated from
these factors. A recent spike in names trading at distressed levels (we define this as bonds with a
price below 70) moves our model to forecast a higher default rate in 2016 of 1.75-2.75% issuer
weighted/1.5-2.5% par-weighted.
FIGURE 13
Fundamental trends for European high yield corporates
14%
12%
10%
FIGURE 14
Bank lending standards vs. stressed bonds
5.0x
30
4.0x
25
8%
3.0x
6%
2.0x
1.0x
4%
2%
0%
2010
2011
2012
Net debt/EBITDA
2013
EBITDA/interest
EBITDA margin
Source: Moodys Financial Metrics, Barclays Research
4 December 2015
0.0x
2014
Tighter
(looser)
Lending
Standard
% of issuers
with bonds
below 70
30%
25%
20
20%
15
15%
10
10%
5%
0%
-5
-5%
-10
2007
2009
2011
% bonds px <70 (RHA)
Source:
-10%
2013
2015
Lending Standard (LHA)
ECB, Moodys, BRAIS, Barclays Research
118
FIGURE 15
Sector returns for European high yield 2014 vs. 2015 YTD
10%
2015 (YTD)
Total Returns
2014
FIGURE 16
Euro high yield total returns by rating quality bucket
2015 YTD
Energy
Basic Industry
Capital Goods
-5%
PE HY x Fin
-10%
Comms
0%
Healthcare
-6%
Autos
5%
Utility
-2%
Retailers*
10%
Cons. non-cyc*
2%
Transport
15%
Cons. cyc*
6%
Note: * Adjusted sectors. Source: BRAIS, Barclays Research
2015 (YTD)
20%
2014
-10%
-15%
BB+
BB
BB-
B+
B-
CCC+ CCC CCC-
Individual sector trends to drive high yield performance

So far in 2015, there has been a considerable difference in returns of individual sectors
(Figure 15). A comparable pattern occurred last year, when Retailers had the worst return
with -7%, while Communication outperformed with +8%. This year, Consumer Cyclical is
leading the table so far with a total return of 8%, followed by Transportation with 6%. The
laggard is Energy, with a negative total return of -9%.
By quality segment, as Figure 16 shows, dropping down in quality this year has been
rewarded, as total returns have increased for every ratings notch that has been given up, with
the exception of the two rating notches CCC- and Bs. The BB rating bucket returned 2.3% on
average, a slightly lower return than for the B bucket, with 4.1%. The CCC rating bucket
posted a total return of 5.9%. In Europe, the single notch rating classes are not as robust as
the US, so individual rating performance is heavily influenced by idiosyncratic stories.
Index size matters for the different rating classes, as the largest notional volumes of the
European high yield ex-financials index reside in the BB rating bucket, which accounts for
about 61% of the market value. Single Bs sum to 33% of the index and CCCs account for a
further 6%. Thus, giving up quality means getting exposed to less liquidity, narrower
universes, and more individual credit stories.
Overview of European High Yield sectors

Figure 17 gives a sector-level overview of the European high yield index for industries that
are covered by our fundamental research analysts, including market value shares, current
analyst recommendations, spread levels, and duration. For 2016, we expect a similar picture
of different sector returns, as individual sectors are influenced by specific drivers. Trading
ranges across sectors have differed significantly during 2015 (Figure 18) and we expect no
convergence of sector spreads into 2016. We highlight selected sector trends using input
from our fundamental analysts.
4 December 2015
119
FIGURE 17
Key statistics for industries covered by our fundamental research analysts
Sector Statistics
Industry
Barclays % of Total
Avg
Sector
Market YTW OAS
Credit
(%) (bp) OAD Rating
Rating
Value
Pan Euro High Yield

Pan Euro HY x Fins
Relative Valuation1
Strategy Considerations
% Call
Constr.
Total
vs Index vs Model
Return
%
Peripheral OAS2
OAS3 Breakeven4
100%
4.4
420
3.7
BA3
18%
33%
73%
4.6
440
3.7
BA3
23%
27%
8%
3.2
325
3.4
BA3
27%
39%
Automotive
UW
-115
Basic Industry
MW
6%
4.6
473
3.5
BA3
17%
9%
33
-3
(1)
Capital Goods
MW
13%
4.2
422
3.3
BA3
20%
39%
-18
26
(11)
Communications
OW
-11
17%
4.3
406
4.6
BA3
18%
41%
-34
Energy
UW
1%
11.0 952
5.1
BA2
0%
58%
512
Food and Beverage
MW
2%
4.4
406
2.7
B1
40%
7%
-34
Gaming
OW
2%
5.0
486
3.1
BA3
33%
30%
Healthcare
MW
3%
4.8
473
2.9
B1
42%
2%
Leisure
UW
1%
6.1
567
2.5
B2
40%
24%
Other Industrial
MW
2%
5.9
582
2.9
B1
23%
18%
Retailers
MW
2%
7.0
637
3.8
B1
34%
Transportation
MW
2%
5.0
497
3.1
B2
36%
27%
4.0
368
3.8
BA2
5%
50%
2%
7.0
633
3.6
B2
41%
Pan Euro High Yield Fins

Debt Collectors/other Fin
1
OW
-19
(42)
(6)
127
-81
(9)
46
37
12
33
16
127
49
59
143
-21
46
0%
197
14
65
0%
57
-7
14
16%
265
82
Note: Relative value versus the benchmark index (PEHY ex-Fins Index/PEHY Financials Index for Debt Collectors). Calculated as sector OAS minus benchmark OAS,
not quality adjusted. 3Calculated as sector OAS minus the sectors aggregate modelled OAS, based on our proprietary high yield spread model. 4Calculated as the
amount of relative spread (tightening)/widening required to achieve the same total return as the index, offsetting the current difference in yield. 5Energy sector
recommendation refers to the Repsol hybrids, which are the major constituent of the sector. Source: BRAIS, Barclays Research
Communications (OW, 17% of index market value)

The Communications sector is admittedly one of the tighter overall trading 34bp inside the
index, but benefits from increased liquidity and is trading attractive to its one- and two-year
range. Performance this year has not been exceptional in relation to other sectors, even
allowing for potential additional outperformance.
The European HY TMT market should continue to benefit from marginal growth, strong
margins and meaningful free cash flow during the coming fiscal year, as discussed in
European HY Research - European HY TMT Q3 15 estimates: Sector trends and themes. We
believe that consolidation and convergence will continue to play an important part in
shaping the operating profile of the credits under coverage, as well as their balance sheets.
Convergence will be focused in corporates existing footprint, as opposed to cross-border
activities, in our opinion. We do not see significant scope for de-leveraging in the sector
during 2016, given continued capital expenditure needs, as well as the ability of several
issuers to upstream funds freely to their respective parents.
Taking into account those considerations, our fundamental analyst, Daniel Rekrut, has an
Overweight rating on the sector.
Capital Goods (MW, 13% of index market value)

The European HY Capital Goods sector is cyclical, but highly diversified by industry. At one
extreme are distressed Spanish EPC names such as Abengoa and Isolux and above-average
peripheral exposure, balanced by a significant proportion of the index comprised of BBs
(64%), including fallen angels (16%), which offer higher quality at the expensive of
significant negative carry to the index. We see a lack of rising star potential, with the notable
4 December 2015
120
FIGURE 18
Major sectors with 12- and 24-month spread ranges
OAS, bp
1,000
1 year OAS spread range

2 year OAS spread range
Current OAS
Average OAS over 1 year
800
600
400
200
Automotive
(BA3/B1)
Communications
(BA2/BA3)
Capital goods
(BA2/BA3)
Utility
(BA2/BA3)
Consumer Non-Cyc*
(B1/B2)
Basic Industry
(BA2/BA3)
Healthcare
(BA3/B1)
Transportation
(B1/B2)
Retailers*
(BA2/BA3)
Consumer cyclical*
(B1/B2)
Energy
(BA2/BA3)
1,000
900
800
700
600
500
400
300
200
100
0
Note: * Adjusted sectors. Source: BRAIS, Barclays Research
exception of Finmeccanica, while the more cyclical names can be reasonably expected to
remain volatile.
For 2016, we expect global demand to remain sluggish. Investment trends are set to remain
relatively weak, albeit varying by geography (the US has more upside potential) and subsector (defence to benefit from increased budgets relative to previous assumptions, in view
of a perceived increase in the security threat). Additionally, industrial sectors of key
emerging markets such as China and Brazil are expected to remain weak. We expect input
costs to remain muted, assuming the continuation of a low energy cost environment, which
is especially supportive of sectors such as building materials. Pricing is expected to remain
weak, reflecting a still relatively deflationary environment, with the exception of certain
markets (eg, US construction). The volatility that the sector experienced is set to persist,
which, given the highly diversified international footprint of constituents, adds an element
of uncertainty to translated earnings. The low growth environment could encourage further
restructuring, consolidation and portfolio management initiatives. The higher quality BB
names are particularly well positioned to consider M&A opportunities, following the
consolidation across the cement sector that has had both positive (Lafarge returned to IG)
and negative (HeidelbergCement remains stranded at BB+) consequences.
Our fundamental analysts, Darren Hook and Maggie ONeal, have a Market Weight rating
on the sector. However, the sector is very fragmented and single credit trajectories matter.
Automotive (UW, 8% of index market value)

Going into 2016, we remain constructive on global light vehicle demand, targeting 3.5% y/y
growth owing to solid demand in the US, Europe and China (due to the 50% cut in purchase
tax until end-2016). In addition, we expect some large companies such as FCA, Peugeot SA,
Schaeffler, and Jaguar Land Rover, which together account for 65% of the HY Autos index,
to benefit from at least a one-notch upgrade due to net deleveraging and/or improved
operating performance.
However, the recent emissions crisis at Volkswagen has resulted into several, still ongoing
investigations by national air pollution authorities across all carmakers, as detailed in
European HG Research: Volkswagen - Yet more findings...CO2 issues emerge. We believe
that the investigations of the German and US authorities, which are reviewing VW as well as
other carmakers, are likely to conclude by end-January 2016. Should any additional findings
surface on VW and/or any other carmaker, these would likely weigh further on Autos
4 December 2015
121

valuations. Also, emissions testing process are being reviewed to move from lab tests to real
driving (road) tests, which will add additional costs for the carmakers to be compliant, as
discrepancies in tests are currently 400-500%. Therefore, capex and R&D costs will remain
high/increase in the next five years, due to increased EM capacity requirements to
accommodate rising demand, as well as tougher CO2 emission regulations and changes in
emissions test procedures. Therefore, we believe that retained cash flow growth will be
moderate due to high capex/ R&D costs and, potentially, increased dividend payments.
Even though the automotive sector benefits from superior liquidity and high average ratings
of BA3/B1, it is one of the tightest from a spread perspective and is currently under pressure
on the back of the ongoing emissions crisis investigations. Therefore, our fundamental
analyst, Christophe Boulanger, is Underweight on the sector. However, he could become
more constructive should emissions investigations result in no additional findings for the
industry and also depending on sector valuations at the time of the review.
Basic Industries (MW, 6% of index market value)

For Chemicals, which makes up a large share of the Basic Industries segment of the index,
we see continued weak demand caused by volumes that have been stagnant y/y. As wrote
in European HG/HY Chemicals: Active portfolio management a continuing theme, a key
weakness stems from emerging markets, especially recession-hit Brazil and China. Recent
sales growth has been driven by favourable currency effects due to a weak euro, although
this tailwind has been fading in H2 15. Restructuring and efficiency initiatives have been the
key drivers of earnings progress, as highlighted by Akzo and Lanxess. The stagnant demand
backdrop, combined with a lacklustre outlook, helps explain the acceleration in portfolio
management and M&A initiatives across the sector.
Our fundamental analysts, Darren Hook and Maggie ONeal, are Market Weight rated on
Basic Industries. The sector comprises several sub-sectors such as Chemicals, Metals and
Mining, and Paper, so industry drivers affect every sub-sector in a different way.
Healthcare (MW, 3% of index market value)

The European HY Healthcare index trades 33bp wide to its benchmark index. Given the lower
average credit rating and some issuer-specific pressures, we consider this a fair differential. To
date in 2015, the Healthcare subsector has widened by approximately the same amount as
the high yield index. In this context, the level for the subsector appears relatively benign.
However, its movement has been driven by divergent performance across various
components of the index, with some significant individual issuer spread movements over the
year, as detailed in European HY Research - European HY Healthcare: Progress report. At one
end of the scale, Unilabs (diagnostic testing) delivery of strong operational trends in 2015 has
driven strong spread tightening. On the other hand, Four Seasons Health Care (residential
elderly care) has had a material widening of spreads, as operational pressures have led its
EBITDA to decline substantially, to below its annual coupon costs (European HY Research:
Four Seasons Health Care - Winter is coming).
We believe that idiosyncratic credit evolution will remain relevant in 2016, given the broad
mix of services provided by the index constituents (including diagnostic testing, residential
care of various specialism, dental care and medical device manufacturers, among others)
and the range of different drivers therefore affecting each. However, with c.50% of the
bonds in the Healthcare index currently callable or becoming callable over 2016 and
issuance likely, call constraints should drive cash price stability for this portion of the index.
In terms of general themes, demand trends for the diagnostic testing businesses are likely to
remain robust, while pricing pressure should persist. Operators are likely to continue to
target regular bolt-on M&A and opportunistically consider larger deals while focusing on
delivering cost efficiencies and the synergy opportunities from previous M&A. For
residential care providers in the UK, persistent margin erosion is likely to remain, particularly
4 December 2015
122

in light of the introduction of the UK national living wage in April 2016. With care providers
and local authorities alike digesting the recent spending review, we believe visibility on how
potential additional funding intended for the sector may feed through to offset these
additional costs remains low at this stage. However, we expect continued active portfolio
re-focusing from providers in 2016.
Based on that, our fundamental analyst Jonathan Horner has a Market Weight rating on the
Healthcare sector.
Retailers (MW, 2% of index market value)

The Retail sector was one of the most volatile sectors over the past two years. Troubles
started when in the latter part of 2014, markets became nervous when UK phone retailer
Phones4U surprisingly declared bankruptcy after major telecom providers decided to stop
selling their contracts through the company. At the beginning of this year, high yield retail
sector spreads tightened again, driven by a technical factor: Tesco became a fallen angel
when it was downgraded to high yield in January 2015 (European High Yield: Little things no
longer enough). During the course of this year, investors were concerned about the liquidity
of retailers such as Hema, Takko, and Matalan, which is addressed in Liquidity in focus.
Current trends, as mentioned in Barclays UK Spend Trends: Signs of an oil dividend show
that consumer demand continues to be affected by weather patterns, so we think that stock
positioning and multi-channel offers remain key. On that basis, we remain more positive on
the UK retail sector, despite the milder weather in November, and see opportunity for
growth through menswear. Conversely, we are cautious on Q4/Q1 performance for French
retail names (European HY Research: Alain Afflelou (AAFFP) - FY results review: Blurred
outlook - maintain Underweight) following the Paris attacks and their potential effect on the
retail sector, as discussed in Euro Area Focus: Gauging the economic impact of terrorism.
Taking into account those factors, our fundamental analyst Karine Elias has a Market
Weight rating on the Retail sector.
Gaming (OW, 2% of index market value)

The Gaming sector was influenced by country specific risks in Greece and Italy and
therefore was volatile during the course of the year. We continue to see changes in
regulations and higher taxes as headwinds for the sector and expect further increases in
taxes in Italy, as described in European HY Research: SNAI - Risks outweigh rewards.
Our fundamental analyst Karine Elias has an Overweight rating on the Gaming sector.
Debt collectors (OW, 2% of index market value)

Although not part of the corporate segment of the Pan-European High Yield index, the debt
collector industry is a segment where we see continued EBITDA growth and favourable
industry tailwinds. As noted in European HY Research - Debt collectors: Sector initiation and
outlook: Good times for bad debt, debt purchasers acquire defaulted consumer debt at a
significant discount to face value and seek to make recoveries of about double the purchase
price over 7-15 years. They operate in the later stages of the debt cycle, when debtors have
already failed to pay and have not been making payments for some time. We think debt
collectors will continue to outperform, underpinned by continued EBITDA growth, high and
rising barriers to entry, and solid supply of portfolios supporting ERC expansion.
Supported by those favourable trends, the sector has an Overweight rating from our
fundamental analyst Alisa Senderovic.
Energy (UW - on Repsol Hybrids, 1% of index market value)

The European High Yield energy sector looks attractive not only based on its historic trading
range and the recent-sell off, but also from a liquidity perspective. Although the weak oil
4 December 2015
123

price environment is unlikely to change during the short term, the average rating of BA2/
BA3 allows for additional deterioration taking into consideration the absolute spread level.
Repsol hybrids (REPSM) account for a large share of the European high yield energy sector
and we expect an additional 3bn of supply over 2016 (as part of the 5bn hybrid
programme to which Repsol has committed). As discussed in European HG Research:
Repsol (REPSM) - IG ratings remain finely balanced, Underweight, this could put technical
pressure on spreads. Moreover, our fundamental analysts believe that continued oil and gas
price weakness could result in Repsols senior rating being downgraded to sub-IG at S&P;
this would lead to a two-notch downgrade of Repsol hybrids to B+. S&P allows sub-IG
hybrid issuers equity credit for longer (up to 15 years before a material 75bp step-up, vs. 20
years for IG issuers); in our view, this increases extension risk, with Repsol more likely to call
the current outstanding hybrids in 2026 and 2030, versus 2021 and 2025.
Our fundamental team rates only the investment grade part of the sector, as highlighted in
European Energy & Utilities: Outlook and top ideas for 2016; however, our analyst Srinjoy
Banerjee has an Underweight rating on the Repsol hybrids that account for the majority of
this sector in the high yield index.
Technicals pointing at lower index growth

The solid return rates of European high yield compared with other fixed income asset
classes has led to significant index growth. Including financials, the index-eligible par
amount outstanding has grown approximately 350% since the beginning of 2009 (Figure
19.). Away from previously existing issuers, this has predominantly come from three
sources: non-financial fallen angels, first-time issuers (many of which are former loan-only
credits coming to the bond market for refinancing), and financials (mainly bank capital
securities, as well as some senior bonds from peripheral banks). Above and beyond indexeligible amounts, more than EUR80bn in euro-equivalent in high yield rated CoCos has been
issued, further swelling the investment opportunity set.
However, as was the case for returns, we forecast much slower market growth for European
high yield. In fact, this process has already begun, as some of the factors that have driven
growth in the past are waning. In particular, the demand dynamics of the loan and bond
markets are shifting in ways that should elicit a supply response, while upgrades have begun
to outweigh downgrades at the IG/HY ratings threshold. As a result, the y/y growth rate for
non-financial high yield par outstanding has fallen to just 6%, the lowest level in six years.
FIGURE 19
Annual growth of Barclays Pan-Euro HY (excl. fins) index
300
Market Value (bn)
y/y growth
250
200
60%
100
50%
90
40%
80
30%
20%
150
10%
100
0%
50
2016*
Market Value (LHA)
4 December 2015
Volume (bn)
70
60
50
40
30
-10%
20
-20%
10
-30%
y/y growth rate (RHA)
Note: *Barclays forecast. Source: BRAIS, Barclays Research
FIGURE 20
European HY bond annual issuance by currency
2008 2009 2010 2011 2012 2013 2014 2015 2016*
Note: *Barclays forecast. Source: S&P LCD, Bloomberg, Barclays Research
124
Supply still high, but lower index growth expected

After years of record levels, the growth of the HY bond market has begun to plateau more
recently. While we still forecast a growing European high yield bond market in 2016 (4050bn in issuance excluding refis), we see annual market growth being even lower than in
years past. However, a stable M&A market (according to our forecast in Buying cost cutting),
as well as about 40bn in bonds trading above par that are callable in 2016, should buoy gross
issuance, as reflected in our gross forecast of 75-85bn. Other considerations include:
Upcoming maturities and the share of debt that is callable over the next year are
approximately in line with last years figure.
Bond-to-bond refinancing is less attractive than last year and could slightly reduce the
share of callable debt that opportunistically refinances.
We expect a lower share of loan-to-bond refinancing after the revival of the CLO market
and solid demand for loans in this segment.
The current yield differential in high yield between Europe and the US will make the
European market more attractive for issuers. However, there is only a limited set of
companies that tap both markets; thus, we expect a limited effect.
The expected start of the Fed hiking cycle in December should drive volatility higher,
which would affect the US as well as Europe. As a result, market access could become
slightly more difficult during specific periods.
Supply by credit quality should shift towards BB issuers

While BB names make up about 60% of total HY bond market volume in Europe, these
issuers historically contribute only about 40% of annual new issuance. This ties back to the
trends in M&A/LBO and refi discussed earlier; B issues made up nearly 70% of refis in 2013
and 2014, mostly debut issuers, as well as 7/8 of all M&A volume in that period. While B
issuers should continue to dominate new deal volumes, BB issuers have already overtaken B
refis in 2015, and we expect refis to contribute an even larger portion of gross supply in
2016. CCC issuance diminished significantly in 2015, and the reduction in bond market
liquidity will likely continue to present a challenge for highly leveraged issuers.
Currency dispersion should be consistent with 2015

In 2015 so far, European high yield corporate supply has amounted to 55bn in euro, 6bn
in sterling, and 15bn in USD. Most USD supply came from large capital structures, such as
Fiat (FCAIM), Virgin Media (VMED) and UPC (UPCB), which opportunistically refinanced in
the first half of 2015. For 2016, we expect issuance to be split across 50-60bn in EUR,
about 10bn in GBP, and about 15bn in USD (Figure 20). The European market still should
look appealing to cross-border US issuers, but the number of companies that have access to
both markets is still limited.
4 December 2015
125
High M&A volumes have already been financed, lower activity expected
M&A activity has moved broadly sideways during 2015, along with LBOs. Even IPO activity
has failed to pick up, despite the ramp-up in stock market valuations during H1 of this year.
The key constraint remains the lack of growth prospects, with global GDP forecasts
consistently revised lower over 2015. Corporate activity is likely to remain lacklustre until
the outlook for economic growth improves materially, so we forecast a similar amount of
M&A/LBO activity in 2016. In addition:
While volumes have not picked up, spreads have been more responsive to corporate
actions. This is notable, as corporate activity has been focused upon ratings defence
and synergy extraction, neither of which is as negative for credit spreads as overtly
leveraging transactions. The announcement and execution (or not) of disposals will be a
key focus for stressed credits in particular, in the mould of Repsol and Tesco.
Synergy extraction is likely to remain a significant part of the rationale for M&A.
Against a backdrop of weak top-line growth, bottom-line growth will need to come
from margin expansion. Synergy-generating mergers are one way to pursue this. We see
these deals as negative for credit from two perspectives. First, credit markets remain
unreceptive to primary issuance; hence, supply associated with corporate activity is
likely to pressure secondary spreads. Second, over the long term, we question whether
corporate management is being too optimistic: realised synergies tend to disappoint
once a deal is consummated, which may pressure credit spreads 12-18 months later.
M&A activity by sector was driven by Industrials, Real Estate, and Pharmaceuticals
during the year. The outlook across sectors is predominately influenced by large single
deals. Looking at the number of already announced transactions, the Industrial sector
and Real Estate are likely to remain at the forefront.
The LBO market has been a touch more active in Europe this year but the volumes
remain low compared with pre-crisis levels. While funding availability is not an issue,
three key headwinds have constrained volumes: strong strategic M&A and IPO markets
and challenging LBO deal economics. We do not see catalysts for these headwinds to
disappear and expect LBO volumes to remain subdued in the coming months.
IPOs have not accelerated this year, despite the sharp rise in European stock prices in
H1. This may reflect the transitory nature of their gains so far, but based on the historical
relationship, we would have expected IPO volumes to be 40bn higher this year.
Stabilisation in risk assets may bring out more deals in Q4, but if that fails to materialise,
owners may pursue trade sales (ie, M&A) over IPOs as their preferred exit strategy.
FIGURE 21
Annual M&A activity involving European companies
2.0
European Target, European Buyer

European Target, non-European buyer
Non-European Target, European Buyer
$trn
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Dealogic, Barclays Research
4 December 2015
126
Rising stars and fallen angels not a big driver of index structure changes
Downgrades have slowed dramatically over the past year as the headwinds of recession and
European sovereign downgrades have abated. Earnings growth appears to have finally
turned the corner in Europe and non-financials continue to reduce gross debt positions in
aggregate. Against this backdrop, rating upgrades have outnumbered downgrades over the
past twelve months, in both IG and HY.
However, the pool of potential rising stars has been thinned by previous migrations to IG.
Further, although we can identify only a few potential fallen angels, the relative size of their
capital structures outweighs that of the rising star candidates. Hence, despite the positive
momentum in the European economy, we expect fallen angel volumes (10-15bn) to
outweigh those of rising stars (5-10bn) next year.
In our view, 2016 fallen angel volumes will likely stem from larger capital structures coming
under ratings pressure for idiosyncratic reasons; we do not expect a broad de-rating of
European credit next year. At the same time, the measured growth that our economists
forecast is unlikely to be enough to foster a large number of upgrades. With only a few
previously IG peripheral credits expected to return to IG this year, rising star volumes are
also likely to be anaemic. The clearest risk to our forecasts is if commodity prices fall further,
resulting in one or more large commodity credits being downgraded to high yield. While
many issuers would suffer in this scenario, a name such as Anglo American seems most at
risk in the view of our analysts. Given the volume of indexed bonds outstanding (8bn), this
would be a significant index transition, similar to Tesco in 2015 (9bn).
FIGURE 22
Rising star and fallen angel candidates covered by our
analysts
2016 non-financial rising star candidates
FIGURE 23
Annual European rising star/fallen angel volumes (with
2016 forecast)
30
ENELIM (hybrid)
ENEL SPA
FNCIM
Finmeccanica Finance SA
HEIGR*
Heidelberg-cement AG
LHAGR
Deutsche Lufthansa AG
PEUGOT
Banque PSA
-10
TKAAV (hybrid)
Telekom Austria AG
-20
TTMTIN*
Jaguar Land Rover
-30
UPMKYM
UPM-Kymmene Corporation
2016 non-financial fallen angel candidates

REPSM
Repsol Intl Finance
TDCDC
TDC A/S
Note: *Denotes that the timeframe for an IG upgrade exceeds the 12-18 month
horizon. Source: Barclays Research
4 December 2015
20
Volume
(bn)
10
-40
'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16
Fallen Angels
Rising Stars
Forecast Range
127

FIGURE 24
Pan-European high yield index by type of security
350
Amount Outstanding (bn)
HY Financials
300
Instruments from IG rated Financials
250
200
Financial Fallen Angels
150
Corporate Fallen Angels
100
"Core" HY Corporates
50
B3 and below/Distressed Issuers
2009
2010
2011
2012
2013
2014
2015
Demand stable, but will likely not overcompensate supply

The multifarious issuers that contribute to the European high yield bond market naturally
attract a diverse set of investors (Figure 25). Mutual funds once again controlled the largest
interest in European high yield bonds in 2015, with insurance/pension and IG funds also
contributing significantly.
Mutual funds increase their share

As we outline in Demand: its (mostly) mutual, the overwhelming ownership of European high
yield debt by mutual funds is a sign of market maturity, but also carries with it certain risks.
Namely, in periods of mass redemptions, the liquidity consumed by mutual funds can push
market momentum downward. While in our view this is a very low probability event for 2016,
mutual fund flows will continue to be an important indicator of market liquidity and stress.
IG, or not IG?

One of the unique features of the HY market in Europe is the amount of involvement from
IG investors. The large number of fallen angel corporates and the subordinated instruments
from IG financial issuers generate a disproportionate amount of interest from IG investors
who would otherwise not be involved in the market. Our expectation of further growth of
subordinated financial issuance, as well as fairly balanced rising star/fallen angel volumes in
2016 aligns with our view that these investors should continue to have a significant
presence in the European high yield market.
FIGURE 25
Estimated holdings of European high yield (2014 vs 2015)
Estimated Holdings
Difference
FIGURE 26
Annual cumulative European HY fund flows (excluding ETFs)
8
7
2014
2015
European HY Mutual Funds
28%
32%
4%
Global HY Mutual Funds
2%
1%
-1%
Insurance/Pension Funds
25%
25%
0%
IG Funds
15%
18%
3%
Hedge Funds
15%
12%
-3%
CLOs
5%
4%
-1%
Other
10%
8%
-2%
Source: EPFR, ECB, Bloomberg, Intex, BRAIS, Barclays Research
4 December 2015
Flows($bn)
6
5
3
1
-1
-2
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2015
2014
2013
2012
2011
Source: EPFR
128
Derivatives: 2015 likely the last good CDS vintage

We believe the strong run of CDS relative to cash in HY will come to an end in 2016, with
many of the drivers for the drop in CDS-cash basis being weakened or, at the very least, not
strengthened. Coupled with a more conservative view of HY than IG cash, our forecasts for
Cross imply a decompression vs Main in all scenarios for year-end 2016.
2015: Yet another great year for CDS relative to cash

2015 turned out to be yet another strong year for CDS. On a roll-adjusted basis, the
Crossover index is 45bp tighter since the beginning of the year, whereas the Barclays HY 3%
issuer-constrained ex-financial index is 50bp wider over the year. Even though the cash
index started the year at a wider level, on a percentage level the underperformance is clear:
Cross is 13% tighter over the year, cash 13% wider.
This is reflected in the development of the CDS-cash basis (Figure 27), which has gone from
-40bp in the beginning of the year to about -140bp presently. From the chart, it is also clear
that the relative performance has come about not so much because CDS has tightened, but
because cash has widened. This is a similar development to investment grade, with its
supply/demand-imbalances, although we see those in HY cash as less pronounced.
On the CDS side, although no material long risk base has developed in Cross (Figure 28),
there appears to have been unwinding of short-risk positions in off-the-run indices (the
light blue bars dropping), which likely contributed to the relative strength of Cross.
Many drivers of the negative basis, none pointing to a further drop

We see three principal drivers of the negative CDS-cash basis, none of which points to a
further drop in 2016, and some indicating that the direction is likely to be an increasing
CDS-cash basis.
Liquidity preference
One interpretation of the index being tighter than intrinsics, which are in turn tighter than
cash (the basis) is that of liquidity preference: the index is the most liquid, followed (for
some names) by single-name CDS, then cash. The widespread use of the index and its
liquidity is illustrated well by the strong relationship between fund flows and changes in
investor positioning in Cross. We analyse these linkages in detail in European Credit Alpha,
23 October 2015, showing that HY fund trading activity in Cross (as a substitute for cash
bond investments) is a material driver of overall investor positioning in Cross.
FIGURE 27
CDS-cash basis turned even more negative over the year,
driven mainly by weakness in cash
520
0
-20
480
-40
440
-60
400
-80
360
-100
-120
320
$bn prot bought by investors

8
Spread
400
375
350
325
300
275
-140
280
240
Jan-15
FIGURE 28
whereas there has been reduction in off-the-run index
short-risk positions in Crossover
Mar-15
May-15

4 December 2015
Jul-15
Sep-15
Cross
-160
-2
-180
-4
Nov-14
Nov-15
HY ex-fin
250
225
Feb-15
All series
May-15
Aug-15
On-The-Run
Nov-15
Cross
129

This ranking of liquidity will naturally lead to the indexs trading tighter, as investors are
willing to give up carry vs cash in return for better liquidity. As single-name CDS liquidity is
mediocre, this causes a negative skew and a negative CDS-cash basis.
While this makes sense to explain the current CDS-cash basis, we see none of the factors
attributing to a further drop in the CDS-cash basis. We do not expect liquidity in HY cash
bonds to deteriorate further, whereas single-name CDS liquidity remains challenging (in
aggregate). So although the liquidity in the Cross index may improve, the intrinsic arbitrage
link to the single-names itself partly impaired by balance sheet constraints will likely
prevent the index from continuing to tighten vs. cash.
Steeper curves in CDS relative to cash

One reason for investors to accept a negative basis is that CDS curves are generally
steeper than in cash (Figure 30), meaning that the 1y expected return for a CDS position in
a given name can be comparable to that of a cash position, even if the CDS is tighter at the
outset. The CDS curves are steep partly because counterparty risk desks have limited
demand for short-dated protection, mostly related to the credit and business cycle, with
limited concerns of company defaults.
This pattern is unlikely to be reinforced, so CDS curves are unlikely to steepen further
(thereby leading to a more negative CDS-cash basis). In fact, should the cycle turn earlier
than expected (bearing in mind that we have an optimistic, if uninspiring, forecast for GDP
growth in Europe), curves could bear-flatten and the basis could move higher.
Convexity
One oft-cited reason for the negative basis is that with risk-free yields low, many bonds are
trading to next call already, so mechanically the bond spreads cannot tighten. This makes
CDS (loosely interpreted as a bullet bond) more appealing as a long risk position for a
particular catalyst, justifying a negative CDS-cash basis. We illustrate such an example for
SUNCOM (Figure 31); following the announcement of an IPO, CDS tightened, but the 18s
bond was already trading to its next call, so mechanically could not rally.
On the hedging/negative basis side, few investors are interested in buying a callable bond
and buying protection to the call date, as this is a negatively convex trade: on the tightening
side, as in the example above, and on the widening side with the risk of a non-call of the
bond and the CDS maturing.
FIGURE 29
Positioning in Cross, as well as skew, suggests large
inflows/outflows affect demand for protection
300
200
Position chg, $mn

DTCC
Skew
Skew chg, bp
Investors increase sell Cross
protection to put large
inflows to work
100
FIGURE 30
HY CDS curves are often steeper than cash curves
4
3
2
1
0
-1
-100
-2
-200
-300
Investors trim buy back Cross protection

to raise cash in outflow periods
-3
-4
0 to
10 to 20 to 40 to 60 to 80 to 90 to
10%
20%
40%
60%
80%
90% 100%
Weekly retail fund flows, percentile buckets
Note: See European Credit Alpha, 23 October 2015, for a full description of the
methodology employed. Source: EPFR, DTCC, Barclays Research
4 December 2015
60
Curve (bp)
50
40
30
20
10
0
TITIM SHAEFF FCAIM TSCOLN MTNA TKAGR FNCIM
Cash 4s5s curve
CDS 4s5s curve
130
FIGURE 31
CDS often have superior convexity properties
Price
108.0
CDS Points Upfront

-20
IPO
announced
107.5
107.0
106.5
-16
-12
105.5
104.5
-18
-14
106.0
105.0
FIGURE 32
A CDS-cash basis decrease is often related to bonds trading
above par, but the relationship currently is tenuous
-10
Call Price
-8
-6
104.0
Jun-14
Aug-14
Oct-14
Dec-14
Feb-15
SUNCOM 8 1/2 18s
5yr CDS (RHA, Inverted)
80
60
Basis (bp)
40
% of names
trading above 110
(reversed scale)
20
0
-20
-40
-60
-80
-100
0%
5%
10%
15%
20%
25%
-120
-140
30%
Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15 Sep 15
CDS-cash basis
% of HY bonds trading above 110
In general, the convexity argument relates to risk-free yields being low and, in turn, bond
prices high. While this was an important factor previously, with the rebound in risk-free
yields in H2 15 and general sell-off in HY credit, the proportion of HY bonds trading at a
price above 110 has decreased materially (Figure 32) and is below 10% currently.
Our rates strategists expect the 5y Bund to end 2016 at +20bp vs. -20bp currently (Figure
8); if that comes to fruition, the convexity argument would be even less relevant.
CDS index forecasts: Cross/Main decompression

Based on our forecasts for the HY cash index derived in previous sections, we present our
forecasts for iTraxx Crossover in Figure 33. For completeness, we also include the forecast
for iTraxx Main, which is derived separately in the IG section.
Methodology and assumptions

To forecast Cross spread levels for year-end 2016, we employ a similar methodology to that
detailed in the Investment Grade section: we rely on the forecasts for cash indices in our
three scenarios (base/upside/downside), and based on the empirical relationship between
the cash and CDS indices, we can forecast where Cross will be in each scenario.
In line with the discussion above, we do not assume that the CDS-cash basis will shrink
further, but is likely to stay at similar levels. If anything, we see it increasing (CDS
underperforming cash), but this is likely to happen only if the economic situation
deteriorates or if rates increase significantly. We also assume that the current index-intrinsic
skew of -30bp will normalize to -15bp, similar to levels for most of 2015.
Interpretation of results
With these assumptions, we present our forecasts for Cross in Figure 33. We derive three
key points from them:
Fitting with our conservative view on European HY in 2016, we expect Cross to be at

310bp at year-end 2016 in our base case, about 20bp wider than currently.
In the upside scenario, Cross can reach 260bp, around the tights in H1 15, whereas spreads
could reach 410bp in our bear case, similar to the peak in the September 2015 sell-off.
4 December 2015
131
In all scenarios, we expect the Cross/Main ratio to increase: Cross will likely compress vs
Main (Figure 34). This is driven partly by our assumptions in cash markets that IG will
tighten marginally (driven by financials) and HY will be marginally wider, but also by our
assumption that the CDS-cash basis for IG credit (currently hovering around zero) could
move negative in 2016. As discussed above, we see limited scope for the CDS-cash
basis to drop materially in HY, leading us to expect Cross/Main to increase in 2016.
FIGURE 33
Spread forecasts for CDS indices
FIGURE 34
Cross/Main: Recent evolution and in year-end 2016 scenarios
Actual
Base
Faster recovery
Downside
Main
70
65
50
95
Cross
292
310
260
410
4.16
4.77
5.20
4.32
Ratio
Cross/Main
Change from current

Main
-5
-20
+25
Cross
+18
-32
+118
+0.61
+1.04
+0.16
Cross/Main
6.0
5.5
5.0
4.77
4.5
4 December 2015
4.32
4.0
3.5
Jan-13
Note: This figure has the same content as Figure 29 in the European HG section
for Main and Cross, but reproduced here for convenience.
5.20
Jan-14
Cross/Main
Jan-15
Base
Jan-16
Upside
Jan-17
Downside
132
EUROPEAN LEVERAGED LOANS AND CLOS
The loan-CLO rebalancing act

We expect European institutional leveraged loans to return 2.5-3.5% on a total return
Dominik Winnicki, CFA
basis in our base case for 2016. We expect loan spreads to widen, given the stretched
relative value versus European HY bonds and US loans, as well as the potential for a
negative CLO-loan feedback loop driven by the CLO market indigestion. That said, we
do not see conditions for a large sell-off thanks to stable fundamentals, a low expected
default rate, neutral net supply and a sticky institutional investor base. Even though we
expect some widening in loan spreads in 2016, we think that loans should continue to
look fairly attractive from a risk-return perspective.
+44 (0)20 3134 9716

dominik.winnicki@barclays.com
Barclays, UK
James K Martin
+44 (0)20 7773 9866
Barclays, UK
The CLO 2.0 era in Europe continues; however, the growth rate of the asset class this
year has disappointed amid the increased market volatility, deterioration in CLO
creation economics and some concerns around the availability of collateral as the
supply in the leveraged loan market also disappointed. Liability spreads widened
even though the collateral quality trends remained stable. We think the supply relief
should come from a widening in leveraged loan spreads.
Leveraged loans: Mean reversion

Standout performance in 2015
European institutional leveraged loans returned 6.0% this year an impressive performance
given the volatility in the broader credit market, but generally in line with historical returns
in the sector (Figure 1). In fact, leveraged loans did not exhibit nearly as much turbulence as
comparable classes of credit in the second half of 2015 (Figure 2). Their standout
performance was helped by a sticky investor base, primarily made up of CLO managers and
institutional investors, and the lack of the same macro or commodity-driven exposure that
weighed on bond issuers during H2 this year.
Loan valuations starting to look stretched...

The by-product of the strong performance in leveraged loans is that now loan yields look
low compared with yields offered by single-B rated HY bonds in Europe (Figure 3). Clearly,
bonds suffered more since the commodity sell-off accelerated again during the summer
FIGURE 1
European leveraged loan total returns
20%
Total return
8%
43%
15%
10%
10%
5%
FIGURE 2
Year-to-date returns versus comparable asset classes
4%
10%
5% 6% 6%
6%
9%
4%
6%
4%
1%
0%
2%
-1%
-5%
-10%
0%
-30%
-15%
Cumulative total return
-2%
Source: S&P CIQ LCD, Barclays Research
4 December 2015
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
-20%
Jan
Feb Mar Apr May Jun

Euro lev loans
PE HY ex-fin BB
Jul
Aug Sep Oct Nov

PE HY ex-fin B
AT1 CoCos
133
FIGURE 3
Euro leveraged loans versus single-B bonds
13
FIGURE 4
European versus US leverages loans
Yield (%)
1,100
12
1,000
11
900
10
9
800
700
7
6
600
500
4
2011
Discount margin (3-year)
2012
2013
Euro lev loans
2014
2015
PEHY ex-Fin B
Note: For loans we calculate yield as a sum of the average 3-month discount
margin in the S&P ELLI index and 5-year EUR swap rate. For HY we use yield-toworst. Source: Barclays Research
400
2011
2012
2013
2014
European lev loans
2015
US lev loans
and concerns around EM growth intensified. As a result, we are currently looking at one of
the worst relative valuations in loans versus bonds in the post-crisis period.
The relative value versus US leveraged loans looks equally unattractive. The US LLI index now
offers a discount margin of 615bp, ie, 80bp above the level offered by the ELLI Index (Figure 4).
The weakness in the US was driven by a combination of a sell-off in US HY and a deterioration in
loan supply conditions, partly related to a significant slowdown in CLO formation in H2 15.
...and the CLO-loan supply engine has been sputtering recently

While the stable institutional investor base is one of the unique strengths of the European
leveraged loans market, its heavy reliance on CLO buying may be a negative if this demand
slows down. Indeed, new CLO creation and, in line with it, the demand for loans from CLO
managers slowed markedly in H2 15. As we discuss in more detail in the CLO section of this
report, we attribute the weakness in CLO supply to a dislocation between collateral spreads
and liability spreads in the CLO market which opened up during the summer. We think that
this dynamic in CLOs will continue to pressure the loan spreads. Either new issue loan
spreads widen to make CLO creation economical or CLO creation will continue to dissipate,
reducing demand for loans and driving spreads wider anyway.
However, a large sell-off in leveraged loans is unlikely

Outside a moderate spread widening on rich valuations and risks stemming from CLO
demand, we are constructive on the outlook for the leveraged loans market and do not see
conditions for a major sell-off. We base this view on an expectation that fundamentals will
remain stable in 2016, with defaults contained near historically low levels, net supply
remaining neutral, demand staying very sticky and the attractive risk-return profile of the
asset class. We discuss these drivers in more detail further in this report.
In our base case, we assume that loan prices will drop by 1pt from the recent average of
97.0 (corresponding to a 50bp widening in three-year discount margin terms from the
recent 535bp level). With that assumption and taking into account our 2016 default
forecast of 1.5-2.5% (assuming 30% loss given default), we estimate our base case total
returns for leveraged loans in a 2.5-3.5% range.
4 December 2015
134

FIGURE 5
Baseline return expectations for European leveraged loans
Current levels*
Leveraged loans
2016 forecast
3yr DM
Price
3yr DM
Price
Total return
535bp
97.0
585
96.0
2.5-3.5%
Note: * Current levels as of 27 November 2015. Source: Barclays Research
Not overly concerned about fundamentals

The rating composition of the S&P ELLI index has been fairly stable this year, with a slight
increase in the size of the BB bucket and a modest increase in the not-rated bucket at the
expense of single-Bs (Figure 6). The drop in the share of the sub-single-B buckets has been
particularly comforting from the default risk perspective.
We also think that the high level of diversification in the European leveraged loan market is
one of its advantages (Figure 7), especially if we compare the asset class to some of the
other high-yielding sectors in European fixed income, such as AT1 CoCos (100% banks)
or corporate hybrids (50% utilities). Notably, loans in Europe have no exposure to Energy or
Metals & Mining industries.
The macro backdrop in Europe should remain mildly supportive in 2016. Our economists
forecast 1.6% growth for the euro area (in line with 1.5% expected for 2015) and a mild
slowdown in the UK from 2.4% in 2015 to 1.9% in 2016. In that context, with the support
from the ECB likely intensifying next year, we view the macro environment as benign,
although we would stop short of saying that it will be supportive of highly levered issuers.
Last, but not least, we believe the spillover of leveraged loan guidelines imposed by the US
regulators into the lending standards in the European loan market is positive for the
valuations and stability of the asset class at the margin. On the flipside, these regulatory
constraints may subdue loan issuance.
Expect a low default rate

The trailing 12-month default rate in European leveraged loans has dropped quite
dramatically in 2015 from 3.7% in December 2014 down to 2% in November 2015 (by
count of issuers in the S&P ELLI index). In fact, defaults on loans are now close to the precrisis lows recorded in 2007 (Figure 8).
FIGURE 6
S&P ELLI index rating breakdown
FIGURE 7
Loan index sector breakdown
100%
90%
Industrial
Equipment,
3%
80%
70%
60%
Telecommu
nications,
3%
50%
40%
30%
20%
10%
0%
2010
2011
BBB
2012
BB
2013
CCC
2014
CC-D
2015
NR
Note: Breakdown by facility rating. Source: S&P CIQ LCD, Barclays Research
4 December 2015
Containers
& Glass
Products,
4% Publishing,
4%
Electronics/
Electric, 5%
Cable
Television,
12%
Sub 3%
sectors,
24%
Healthcare,
12%
Business
Equipment
& Services,
11%
Food
Products,
6%
Chemical &
Plastics, 8%
Retailers
(Other than
Food &
Drug), 8%
135

Historically, bank lending standards and market-price-based signals are highly correlated
with the default rate in loans with a 12-month lag. Currently, both of these metrics are near
multi-year lows, suggesting that the default rate in leveraged loans should remain close to
the depressed current levels. In particular, we believe central bank accommodation will
continue to support benign lending standards through 2016. Further, the size of the CCC
bucket in the ELLI index has now decreased to c.2%, which limits the scope for a pick-up in
defaults in the near term. We also see little refinancing pressure for loan issuers in 2016
(with the maturity wall now pushed out to 2021) and the proliferation of the covenant-lite
format, in our opinion, reduces the overall risk of defaults at the margin, as issuers now
have a bit more space for manoeuvre in times of stress.
Overall, we think 1.5-2.5% is a reasonable range for the leverage loan default rate in 2016.
While a variety of indicators point to the default rate staying at a very low level, in line with
this years 2%, we think there is limited scope for the rate to drop much lower. At the same
time, we do see default risks from a potential spike in volatility and deterioration in funding
conditions, should the global macro outlook continue to weaken.
Weak net supply to continue

European leveraged loan supply slowed down in 2015, with c. 43bn worth of institutional
loans issued as of the end of November following 49bn issued in 2014 (Figure 9). Once
again, the supply turned out to be too weak to reverse the contraction trend of the
European loan market that has been ongoing since the 2008 peak.
Looking into 2016, we expect gross supply in European leveraged loans to pick up slightly
to 45-50bn with no major changes in the LBO, M&A and IPO dynamics compared with
2015 in our base case, but a small upside from increased bond-to-loan refinancings and a
further drop in the loan-to-bond dynamic. Correspondingly, we expect the overall size of the
market to stabilise at the current level (measured by the size of the ELLI index) with neutral
net supply.
Demand still sticky, but weak CLO supply poses risk

The investor base for European leveraged loans has been one of this markets mainstays. As
we show in Figure 10, there is virtually no retail participation in this market (leveraged loans
do not qualify as an eligible asset for UCITS funds in Europe). In the institutional loans market
specifically, demand continues to be dominated by CLOs and credit funds, as demonstrated by
primary market shares in Figure 11. This favourable demand structure has been the primary
FIGURE 8
S&P ELLI default rate (by issuer count)
12%
FIGURE 9
Loan supply by purpose
160
ELLI default rate
Volume, bn
140
10%
120
100
8%
80
6%
60
40
4%
20
2%
2010
Source: S&P CIQ LCD
4 December 2015
2011
2012
2013
2014
2015
LBO
M&A
Refinancing
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
0%
2009
Recap
Source: S&P CIQ LCD
136
FIGURE 10
European leveraged loan primary market share
FIGURE 11
Institutional loan primary market share
100%
100%
80%
80%
60%
60%
40%
40%
20%
20%
CLO Managers
Finance Companies
European Banks
Non-European Banks
Insurance
Credit Funds/SMAs
Institutional Investors
Securities Firms
High Yield Retail Funds
Mezzanine Funds
2015
2014
2013
2012
2011
2010
2008
2007
2015
2014
2013
2012
2011
2010
2008
2007
2006
2005
2006
2005
0%
0%
driver behind the relatively low volatility of loan returns this year. As mentioned above, while
we do not expect the stickiness of the investor base to drop in the foreseeable future, we are
concerned about the recent weakness in CLO issuance. As we detail in the CLO Outlook
section below, the recent drop in CLO formation has put the European CLO market back on a
declining trajectory. Should that dynamic continue, with CLO 2.0 supply unable to make up for
CLO 1.0 amortisations, the demand for loans would suffer.
Attractive risk-return profile

Even though we expect some widening in loan spreads in 2016, we think that loans should
continue to look fairly attractive from a risk-return perspective. Given the strong
performance and very low volatility of returns in European loans, it is natural that loans have
been by far the most attractive asset class across European credit in 2015 on a risk adjusted
basis. Looking at current yields in loans and HY bonds, and assuming that return volatilities
in 2016 remain in line with 2015 levels, loans would again outperform HY by a wide margin
on a risk adjusted basis, as we show in Figure 12. In addition, it is worth keeping in mind
that floating coupons (although subject to floors) will come in handy at some point in the
future when rates in Europe start to move upwards, even if this is highly unlikely in 2016.
FIGURE 12
Compensation per unit of risk
Euro Lev Loans
PE HY ex-Fin B
PE HY ex-Fin BB
Yield
5.5%
6.2%
3.6%
St. dev. of weekly total

returns (LTM)
1.8%
3.4%
2.4%
3.0
1.8
1.5
Ratio
For loans we calculate yield as a sum of 3-month discount margin and 5-year EUR swap rate.
4 December 2015
137
European CLOs: Dis-arbed

The CLO 2.0 era in Europe continues; however, the growth rate of the asset class this year
has disappointed. Year-to-date 2015 supply amounted to 12.5bn below 2014s 14.5bn
and below our forecast of 15-20bn (Figure 13). The issuance was strong in H1 15 and
supply was on track to surpass 2014 by a meaningful margin; however, it dropped
significantly in the summer amid the increased market volatility, deterioration in CLO
creation economics and some concerns around the availability of collateral as the supply in
the leveraged loan market also disappointed.
With a slowdown in issuance, but still very strong repayment rates, the total size of the
European CLO market (1.0s + 2.0s) started to shrink again in Q3 (Figure 14). Recall that the
market peaked at 97bn in 2009 and has since then shrank by a third, as a growing proportion
of CLO 1.0s were entering their amortisation phases mirroring the fast decline in the size of
the European leveraged loan market. The emergence of 2.0 issuance in late 2014 and early
2015 was strong enough to neutralize the acceleration in 1.0 amortisations. With the
slowdown in H2 15, the 2.0 supply is now again too weak to offset the acceleration in 1.0
amortisations, as now all 1.0s outstanding have moved into the amortisation phase This
dynamic should put pressure back on the loan market, as it depends heavily on CLO demand.
Supply relief to come from wider collateral spreads

The economics of issuing a CLO are among the key factors at play in this dynamic. The
problem lies in the dislocation between the CLO liability spreads and the collateral spreads
that opened up in H2 15. As we show in Figure 16, liability spreads widened to the 2.0-era
wides, while the widening in collateral spreads has been much less pronounced. This led the
CLO 2.0 equity arbitrage to drop towards the lower end of the historical range. Naturally, the
less attractive expected equity returns, measured by the arb, incentivize the equity
investors to hold off pricing deals.
FIGURE 13
European CLO supply
120
Volume, bn
35
Total balance outstanding (bn)
100
30
80
25
4 December 2015
2015
2014
2013
2012
2011
2010
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
CLO 1.0
2009
2008
2007
20
2006
10
2005
40
2002
15
2004
60
20
2003
40
FIGURE 14
The size of European CLO market
CLO 2.0
138
FIGURE 15
European CLO notional in reinvestment phase
100
FIGURE 16
CLO liability spreads vs. collateral spreads
240
Notional in reinvestment phase (bn)
DM (bp)
DM (bp)
600
90
80
70
220
550
200
500
180
450
60
50
40
30
20
10
1.0
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
160
Jan 13
400
Jul 13
Jan 14
Jul 14
Jan 15
Jul 15
Weighted avg liabilitiy spread
2.0
Collateral spread (rhs)
The widening in CLO liability spreads has been driven primarily by the weakening relative
value from the AAA investors perspective. US CLO AAAs widened substantially in H2 15
together with the broader leveraged markets in the US amid the commodity rout (Figure
17). During the same period, corporate credit spreads doubled and recent primary activity in
other ABS asset classes also saw wider levels. The widening in European AAAs in that
context is not surprising and they are unlikely to tighten without a meaningful turnaround
in the markets relevant to the AAA investors.
An area from which relief is more likely to come is collateral spreads. As we noted in the
European Leveraged Loans section above, we expect loan spreads to widen in 2016 (we
forecast 50bp widening from current 535bp as a base case), given the stretched relative
value versus HY bonds and US loans as well as the potential for a negative CLO-loan
feedback loop driven by the CLO market indigestion. A moderate widening like this would
improve CLO economics and should be a positive for CLO creation. We think that the recent
widening of new issue spreads in the leveraged loan market signals that the adjustment is
already under way.
FIGURE 17
US vs. European CLO 2.0 secondary AAA spreads
180
FIGURE 18
CLO collateral default rates
6%
DM (bp)
170
Default rate
5%
160
4%
150
140
3%
130
2%
120
1%
110
100
Apr 13
Oct 13
Apr 14
Europe
4 December 2015
Oct 14
Apr 15
Oct 15
0%
2008
2009
2010
2011
1.0
US
2012
2013
2014
2015
2.0
139

A caveat to this view is that if the widening in loans is too aggressive, indicating a significant
stress in the market rather than just technical pressure on spreads, the CLO issuance would
likely suffer even more. However, we do not see the conditions for a large sell-off in loans at
this point thanks to a number of supportive factors: stable fundamentals and a low
expected default rate, stable institutional investor base and neutral net supply.
Ultimately, we view the issues with CLO economics as transitory with the most likely path
forward via collateral spreads moderately underperforming liability spreads. Even without
that, the recent series of successful deal placements in Europe shows that issues related to
CLO economics can be resolved at current levels. Overall, we expect the CLO supply in 2016
to increase towards the 15-20bn range.
Collateral trends in Europe remain supportive

As we noted above, we expect a moderate widening in European leveraged loans this year
in our base case. That said, we do not foresee a substantial deterioration in loan market
fundamentals. The quality of the CLO 2.0 collateral remains strong, while the 1.0 collateral
quality appears to be stabilizing. There have been no defaults so far in CLO 2.0s, while the
default rate for 1.0s has been dropping in line with the default rates in the broader European
leveraged loan market (Figure 53). The trend should remain in place given the very low
expected default rates in European leveraged loans in 2016. Second, the share of CCC rated
collateral in CLO 2.0s remains very low (below 1%; Figure 19), though this is not surprising
given that we are still at the early stages of the life cycle for the sector. Finally, average
collateral ratings measured by Moodys WARF have so far proven stable (Figure 20) and,
when compared to the path of CLO 1.0 collateral ratings over the past decade, the longterm rating downside appears to be materially lower for 2.0s.
Regulatory crosswinds
A number of regulatory issues still hang over the CLO market in Europe. On the risk
retention front, the focus currently is on the future of the originator structures. The final
draft of the European Commissions STS Securitisation Regulation published in September
was more positive than previous drafts. Assuming that the regulation ultimately turns out to
be supportive (the ruling is expected in mid-2016), the availability of the structure would
create the potential for additional CLO formation from smaller managers. In the meantime,
those willing to use the originator format may be reluctant to come to the market amid
uncertainty about future compliance of their deals.
FIGURE 19
Share of CCC rated collateral
18
FIGURE 20
Collateral rating trends
3,200
Share of CCC-rated collateral (%)
16
3,000
14
2,800
12
10
2,600
2,400
6
4
2,200
2
0
2008
Weighted-average rating factor
2009
2010
2011
1.0
4 December 2015
2012
2013
2014
2015
2,000
2008 2009 2010 2011 2012 2013 2014 2015
2.0
1.0
2.0
140

A topic that is likely to garner more attention in the coming months is the Fundamental
Review of the Trading Book (FRTB), which the Basel Committee for Banking Supervision is
planning to finalise by the end of 2015 with the rules expected to come into force in 2019.
The goal of FRTB is to refine the market risk framework governed currently by the Basel 2.5
rules, ie. the rules that specify how much capital banks will have to hold against their
trading book positions. It is similar to what Basel 3 meant for the credit risk framework (the
framework governing the capital requirements for the banking book). Crucially, for
securitisations (including CLOs), the internal models for calculating RWAs will no longer be
available and all calculations will have to be done under the new Standardised Approach.
According to the analysis of the quantitative impact study conducted by industry bodies
(ISDA, GFMA, IIF), the results show a 2.2 times increase in capital from Basel 2.5. Given
the large impact of the proposed rules on market risk RWAs (our equity analysts estimate a
10-fold jump in capital requirements for market risk from application of floors to modelled
RWAs), we think we have not yet seen the final version of the rules. That said, should the
requirements for securitisations remain unchanged the substantial pick-up in capital
requirements for CLO bank desks would weigh on the liquidity and supply of the product.
4 December 2015
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142
Global Hybrid Capital
4 December 2015
143
GLOBAL HYBRID OUTLOOK
Immune to what ails the world

US Credit Strategy
Shobhit Gupta
+1 212 412 2056
BCI, US
European Credit Strategy
Dominik Winnicki, CFA
+44 (0)20 3134 9716
Barclays, UK
We see bank hybrids as one of the bright spots in credit for 2016 in the US and Europe.
With stagnant global growth and deteriorating credit fundamentals weighing on nonfinancial credit valuations, bank capital has performed well, owing to issuers high
capitalization ratios. This trend should continue in 2016 as superior fundamentals and
likely benign supply/demand conditions drive further spread tightening. We are less
optimistic about US insurance and European corporate hybrids.
US preferreds: We forecast US bank preferreds to generate 5.5-6.5% total returns in

2016, outperforming HY debt on an absolute and a beta-adjusted basis. Rates risk
should be manageable: we expect tightening in spreads to absorb the increase in
risk-free yields. Bank fundamentals remain strong, and with the pace of supply
slowing, the technical backdrop should improve as well.
US insurance hybrids: Short-call hybrids have dropped nearly 13pts, on average, this
year but should remain under pressure, with many securities still not fully reflecting
extension risk. We believe that the best opportunity in insurance hybrids remains in
the long non-call securities.
European bank capital: We forecast 5.5-7% total returns for European bank AT1
CoCos and 1-2.5% for European LT2s. We think these asset classes are primed for a
continuation of strong performance from 2015, with spreads still looking elevated in
the light of the benign macro outlook for Europe, supportive bank credit
fundamentals and manageable supply.
European corporate hybrids: We forecast 2.5-3.5% excess returns for corporate

hybrids in 2016. We think more spread widening is due (after adjusting for
idiosyncratic stories from 2015), as the asset class has, in our view, not priced in
enough premium for weaker fundamentals, unstable ratings and high negative
convexity.
Preferreds and CoCos: Where did the volatility go?

Capital securities of US and European banks have generated attractive total returns this
year. US bank preferreds have returned 6%, while European bank AT1 CoCos have done
even better, returning more than 7% (Figure 1). Both sets of securities have outperformed
HY debt. Preferreds (most of which are rated BB) have generated better total returns than
BBs (even excluding energy credits). Similarly, both USD and EUR AT1s have outperformed
corresponding B-rated bonds (while most CoCos are also rated BB or higher, we compare
them to B-rated debt given the similar volatility profile of the two).
4 December 2015
144
FIGURE 1
Year-to-date total return
8%
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
Preferreds
USD BBs ex
Energy
USD AT1s
EUR AT1s
USD Bs ex
Energy
EUR B ex Fins
In addition to the better performance of subordinated financials, what is perhaps even more
positive is the significant decline in volatility. As concerns about slowing global growth and
deteriorating credit fundamental have mired non-financial credit valuations, banks have
benefited from a safe-haven status, owing to their strong balance sheet and high
capitalization ratios. This has extended to bank capital securities as well, which is reflected
in a substantial decline in return volatility for preferreds and CoCos compared with HY
bonds (Figures 2 and 3). Comparing CoCos with Bs, while the average volatility of the two
asset classes was similar prior to the summer, it has diverged meaningfully since then as B
valuations have come under pressure from widening in energy credits and idiosyncratic
factors (such as the downgrade of Sprint). In fact, CoCo valuations have remained relatively
stable even in the face of potentially meaningful negative developments for the issuer (for
instance, DB).
We expect CoCo and preferred spreads to rally in 2016, supported by a strong fundamental
backdrop and improving supply/demand technicals. The move in spreads should offset the
expected increase in risk-free yields with both sets of securities generating attractive total
returns. We expect USD CoCos to outperform EUR CoCos and US preferreds in total return
terms. The rally in bank capital securities compared with HY this year means that the basis
between the two has compressed meaningfully. We believe this will reduce the gap in
FIGURE 2
Preferred volatility relative to US BB
8
7
FIGURE 3
CoCo volatility relative to Bs
11
Average total retun volatility

(%, 3 mth rolling, annualized)
10
Average total retun volatility

(%, 3 mth rolling, annualized)
9
6
2
1-Jan
20-Feb
11-Apr
31-May
Preferreds
4 December 2015
20-Jul
US HY BB
8-Sep
4
Jan 15
Mar 15
EUR AT1
May 15
USD AT1
Jul 15
Euro HY Bs
Sep 15
US HY Bs
145

performance between the two asset classes on a total return basis in 2016 in fact, our
return forecast for preferreds is only 50bp more than for US HY. That said, we expect both
preferreds and CoCos to be significantly more attractive on a risk-adjusted basis.
Specifically, we believe that the volatility in this space will remain subdued relative to HY.
With our macro economists forecasting a modest growth environment high yield credit may
face more fundamental pressure than banks given the strong capitalization of the latter.
Combined with the significant commodity exposure of USD HY, we expect the volatility of
HY debt to be higher than preferreds and CoCos in 2016.
In addition to a strong fundamental backdrop, bank capital securities are also likely to
benefit from more favorable supply/demand technicals. Supply in US preferreds will likely
slow down after a very active last three years while the buyer base for CoCos continues to
grow as the product matures. As we approach the beginning of the Fed hiking cycle, we
believe that rates risk in the space is also manageable. Preferred and CoCo spreads are wide
enough relative to senior parts of the capital structure such that tightening in spreads
should absorb any increase in risk-free yields.
Away from bank capital, the performance of other subordinated securities has been less
compelling. Short-call insurance hybrids have come under significant pressure some
securities are down as much 20pts YTD as extension risk has weighed on valuations.
Despite the move lower, we believe some of the worst-performing securities still do not fully
reflect extension risk; we continue to favor longer non-call hybrids in that space. Worsening
fundamental backdrops for many corporate hybrid issuers have caused the asset class to
underperform with spreads widening more than 55bp YTD. Despite the move, hybrids look
somewhat expensive relative to peer sectors, in our view, and we expect corporate hybrids
spreads to widen in 2016.
US bank preferreds
As credit spreads widened on the back of elevated supply and concerns about a
deteriorating fundamental backdrop, financials outperformed industrials given lower supply
and significantly stronger fundamentals of the former. The financial-industrial basis
compressed nearly 20bp this year (through November). The outperformance extended to
the subordinated parts of the capital structure with preferreds tightening about 10bp
relative to senior bank debt. Preferreds generated 6% in total returns, significantly higher
than high yield bonds (Figure 1).
2016 outlook: a repeat performance

We forecast US bank preferreds to generate 5.5-6.5% total returns in 2016. We expect
preferred spreads to tighten about 50bp, which should be sufficient to absorb the increase
in risk-free yields. Bank capitalization ratios remain high and continue to be supportive of
moving down the capital structure. Banks significant capital buffers over current MDA
requirements mean coupon cancellation risk is minimal in the medium term. At the same
time, supply should also slow down significantly from the pace of the past few years (see
the Supply section), which should create a positive technical.
4 December 2015
146
FIGURE 4
Preferred yields have compressed versus BBs
FIGURE 5
and BBs ex-energy
6.5%
1.6%
6.5%
6.0%
1.2%
6.0%
5.5%
0.8%
5.5%
1.6%
1.4%
1.2%
1.0%
0.8%
5.0%
0.4%
5.0%
4.5%
0.0%
4.5%
4.0%
Jan-15
-0.4%
4.0%
Jan-15
Mar-15
May-15
Difference (RHS)
Jul-15
Sep-15
Preferreds
Nov-15
BBs
0.6%
0.4%
0.2%
0.0%
Mar-15
May-15
Difference (RHS)
Jul-15
Sep-15
Preferreds
Nov-15
BBs ex Energy
Despite the positive technical and fundamental backdrop, we believe that preferred yields are
unlikely to trade too far inside the current level of about 6%. Valuations are already near the
tighter end of the 6-7% preferred yield range prior to the crisis. While this is justified given the
significantly better credit quality of banks and the lower rates currently (although the
cumulative and dated structure of capita securities issued pre-2008 did afford better
protection to investors), we believe it limits the room for a further rally. As does the relative
year-to-date outperformance of preferreds relative to BBs. The basis between the two has
compressed meaningfully, from as much as 100bp wide earlier in the year to close to zero
now (Figure 4). Even excluding energy credits, the basis between preferreds and BBs has
tightened 80bp (Figure 5). Preferreds still offer better risk-adjusted return than HY, in our view,
but the lower spread pick-up could limit the extent of outperformance in these securities.
With the Fed likely to begin the hiking cycle in December, we would expect the corresponding
sell-off in Treasuries also to keep preferred yields from moving tighter. To be clear, we are not
expecting preferred yields to rise as the Fed hikes tightening in spreads should absorb the
increase in risk-free rates, in our view. While many investors remain concerned about a sell-off in
the space as rates rise similar to the 2013 taper tantrum when institutional securities were
FIGURE 6
Preferred price* vs Treasury yields: May-December 2013
FIGURE 7
Preferred price* vs Treasury yields: 2014-today
Px Change
Px Change
2.0%
2.0%
1.5%
1.5%
1.0%
1.0%
0.5%
0.5%
0.0%
0.0%
-0.5%
-0.5%
-1.0%
-1.0%
y = -3.1x
R = 15%
-1.5%
-2.0%
-0.2%
-0.1%
0.0%
0.1%
10y Tsy Yield Change

*Preferred price based on PGF, an ETF of preferreds.
4 December 2015
0.2%
y = -0.45x
R =1%
-1.5%
0.3%
-2.0%
-0.2% -0.2% -0.1% -0.1% 0.0% 0.1% 0.1% 0.2% 0.2%
10y Tsy Yield Change
*Preferred price based on PGF, an ETF of preferreds.
147
FIGURE 8
Preferred spreads still appear wide (bp)
FIGURE 9
Preferred/senior spread ratio
4.5
500
475
4.0
450
3.5
425
3.0
400
2.5
375
350
Jan-15
Mar-15
May-15
Jul-15
PerpNC5
Sep-15
Nov-15
2.0
Jan-15
Mar-15
PerpNC10
May-15
PerpNC5
Jul-15
Sep-15
Nov-15
PerpNC10
down about 7pts on average we believe such a scenario is unlikely. The move in 2013 was
driven in large part by very rich valuations going into the summer of that year. Indeed, the
average coupon of US bank PerpNC10 securities issued in Jan-May 2013 was about 5%, nearly
100bp tighter than current levels. This resulted in elevated sensitivity to rates during the MayDecember 2013 period (Figure 6). However, since then, as valuations have normalized, the
relationship between preferred prices and Treasury yields has been much weaker (Figure 7), a
trend we expect to continue next year.
Preferreds also continue to trade significantly wide of senior debt, suggesting that there is
sufficient room for compression in spreads to offset any increase in risk-free yields. The
preferred/senior spread ratio for PerpNC5 and NC10 securities is 4.2x and 2.9x, respectively
(Figures 8 and 9). This is much wider than our fair estimate of 2-2.5x11.
Relative Value
We expect both the NC5 and NC10 securities to generate similar total returns of 5.5-6.5% in
2016. Our rates strategists are forecasting a significant flattening in the Treasury yield curve
as the Fed begins the hiking cycle 5y and 10y Treasury yields are expected to increase by
60bp and 35bp, respectively, causing the 5s10s curve to flatten 25bp. While this exposes
NC5 securities to higher rates risk, they are also significantly cheaper than NC10 paper.
Indeed, short-call preferreds trade nearly 40bp wider, in spread terms, and yield only about
15bp less than NC10 paper despite having five years less to the first call date (Figure 10).
The much higher preferred/senior spread ratio (of more than 4x) means that tightening in
spreads in NC5 securities should be able to offset a move higher in rates.
FIGURE 10
Money-center bank preferred valuations
Price
Yield
Spread
Reset Spread
PerpNC5
$ 99.3
5.8%
430 bp
386 bp
PerpNC10
$ 100.4
5.9%
390 bp
363 bp
In terms of our best picks, we continue to favor high reset preferreds issued by the large
money-center banks. Figure 11 highlight select PerpNC5 and PerpNC10 securities with high
backend spreads.
11
4 December 2015
1 Please see New capital, new opportunities, December 11, 2013.
148

FIGURE 11
Select high coupon preferreds
Security
Next Call Date
Reset Spread
Price
Yield to Call
Nov-20
L+447.8 bp
$ 101.6
5.7%
PerpNC5
C 6.125
C 5.95
Aug-20
L+409.5 bp
$ 99.4
6.1%
GS 5.375
May-20
L+392.2 bp
$ 99.8
5.4%
GS 5.7
May-19
L+388.4 bp
$ 100.9
5.4%
JPM 5.3
May-20
L+380 bp
$ 100.3
5.2%
MS 5.55
Jul-20
L+381 bp
$ 99.9
5.6%
BAC 6.1
Mar-25
L+389.8 bp
$ 101.0
6.0%
C 5.9
Feb-23
L+423 bp
$ 98.8
6.1%
JPM 6.75
Feb-24
L+378 bp
$ 108.5
5.4%
PerpNC5
Source:
Bank fundamentals: still strong

Bank fundamentals remain robust with continued growth in capital ratios in 2015. While
revenues remain under some pressure (see U.S. Banks 3Q15 Earnings Review: Market
Volatility Takes Toll, November 6 2015), asset quality has continued to improve.
Nonperforming assets and net charge-offs both declined in Q3 15 are now 17% and 8%
lower y/y, respectively. At the same time, a rise in equity, combined with a flat balance
sheet, has resulted in higher capital ratios. The ratio of tangible common equity to tangible
assets rose to 8.3% while our bank analysts estimate that the fully phased-in Basel III
Common Equity Tier 1 capital ratio rose to 11%.
Given increased regulatory scrutiny in the form of higher capital requirements, stress testing
and macroprudential regulation, we believe improvements in fundamentals are unlikely to
be reversed in the medium term. Regulatory changes have generally been positive for bank
creditors requiring banks to hold more capital. There have been two exceptions, although
we do not believe that they will have a meaningful effect on preferred valuations in 2016:
1. Supply on the back of TLAC-requirements could put pressure on senior valuations.
However, we believe that any weakness in senior debt is unlikely to extend to preferreds.
Preferred valuations look very cheap to senior (the spread ratio is significantly wider
than our fair estimate of 2-2.5x) and should be able to absorb any widening in senior
spreads. To put this into context, a 40bp widening in senior debt when preferreds are
unchanged would only bring down the spread ratio to 2.5x, still at the wider end of our
estimated fair range.
2. Restrictions on the maximum amount of capital distributions and other discretionary
payments a bank can make if it has breached the Capital Conservation Buffer increase the
risk of missed coupons if capital ratios deteriorate meaningfully in the future. However,
this requirement is still being phased-in, which combined with banks high capitalization
ratios means that the buffer to coupon cancellation is very high in the medium term. As a
result, we believe that deferral risk is minimal over the next few years.
4 December 2015
149
Supply: Slowing down, finally

U.S. banks have issued $25bn of preferred securities (including both retail and institutional
deals) so far in 2015, with nearly 80% of that coming in the first half of the year. Supply has
been more muted recently, with only $5bn of preferreds being issued in H2 15.
For 2016, we are forecasting $10-15bn of preferred issuance, which would bring total US
bank preferreds outstanding to about $150bn, or 1.6% of RWAs. We have historically based
our preferred supply forecasts on the expectation that the industry would target AT1 capital
equivalent to 1.5% of RWAs at the 30 largest banks. Under this methodology, the industry
needs $14bn of incremental preferreds, of which just $2bn is from the G-SIBs. However, our
supply forecast accounts for two main factors that we believe could add a combined $3040bn of incremental issuance over the next several years on top of what is required to reach
the 1.5% level:
FIGURE 12
AT1 capital has reached or exceeded 1.5% at most of the G-SIBs
2.2%
2.0%
1.8%
1.6%
1.4%
1.2%
1.0%
STT
GS
MS
JPM
WFC
BK
BAC
Top 30
Source: Company reports, Barclays Research
1. Inflation in RWAs and assets under the Feds stress test: For a bank that is CCAR
constrained under risk-based capital metrics, an optimized capital structure would
include AT1 capital equal to 1.5% of stressed RWAs. If the Fed might reasonably be
expected to assume a banks RWAs will grow by 10% over the stress horizon, then it
would make economic sense for that bank to maintain AT1 at 1.65% of its fully phasedin RWAs (1.5% x 110%).
Given GS, MS and JPM are now at 1.7-1.9% of RWAs (Figure 12), we believe they have
largely built this buffer already. If other moneycenter banks choose to reach similar
levels, that would imply $5-10bn of issuance above that required to reach 1.5%. CCAR
has been less of a binding constraint for most regional banks and we believe that the
regionals will continue to move toward 1.5% over time. We believe this surplus is likely
to be maintained to the extent that CCAR remains a binding constraint.
2. The first wave of first call dates on preferred securities begins in 2018, and we believe
some issuers may choose to prefund those redemptions to take advantage of the lower
yields. However, not all of these securities will be redeemed on the first call date. We
assume that fixed-for-life securities with a coupon higher than 6.5% and fixed-to-float
securities with a reset wider than 325bp (corresponding to a reset/senior spread ratio of
~2.5x) will be called. Based on the above assumptions, we expect $12-15bn of
redemptions per year in 2018-20 (Figure 13).
4 December 2015
150
FIGURE 13
Likely redemption schedule for preferreds
BAC
$mn
GS
JPM
MS
WFC
Others
14,700
16,000
12,689
14,000
13,990
12,855
11,750
12,000
10,000
8,000
5,900
4,669
6,000
4,000
2,000
1,750
2,600
500
0
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
Note: Assumes refinancing of preferreds with coupons at least 6.5% or reset spreads at least 325bp.
Demand
We expect demand for preferred securities to remain robust. Even though preferred yields
have compressed relative to BBs, we believe the former offer better risk-adjusted returns.
This should keep HY demand for the space elevated. This is especially the case as the
significant commodity exposure of the HY index is likely to keep valuations volatile.
There remains a concern about retail outflows on the back of rising rates similar to the 2013
taper tantrum when, for instance, the shares outstanding of PFF (an ETF of retail preferreds)
dropped more than 23% as Treasuries sold-off. However, given the more attractive
valuations currently, we believe any sell-off/outflows in preferreds on the back of an
increase in yields should be limited. In fact, with yields of 5-6%, the tax-adjusted yield
(accounting for the QDI-treatment) is 6.75-8%, which should be compelling, given the
overall low Treasury yields.
US insurance hybrids
While subordinated financial securities in general have generated attractive returns this
year, this has not been the case for insurance hybrids, particularly short-call paper. As
extension risk concerns have grown, short-call insurance securities have dropped about
13pts on average this year. The two Lincoln National (LNC) hybrids and RGA 6.75s have
been among the worst performers, falling 20pts each (Figure 14). The decline in valuations
is generally in line with our view as we discussed in Insuring Against Extension Risk and
Revisiting Insurance Hybrids: Market Correction Not Enough, we believed insurance hybrids
were not fully reflecting extension risk.
4 December 2015
151
FIGURE 14
Year-to-date price change for select short-call insurance hybrids
$0
-$5
-$10
-$15
-$20
-$25
LNC 7
RGA 6.75
LNC 6.05
SFG 6.9
XL 6.5
HIG 6.505
PGR 6.7
LIBMUT 7
Despite the move lower, we remain cautious on short-call insurance paper in aggregate. We
believe that some of the worst-performing insurance hybrids the two LNC hybrids,
Reinsurance Group (RGA) 6.75s, StanCorp (SFG) 6.9s, and Hartford (HIG) 6.505s are
exposed to further extension risk. They will continue to receive 100% S&P equity
treatment12 even after the first call date and we expect them to be left outstanding, a view
corroborated by recent management commentary. Priced to maturity, the hybrids yield 5.76.3%, corresponding to a spread of 275-325bp. This appears tight on a hybrid/senior
spread ratio basis, suggesting further potential downside for these securities. We also
remain concerned about technicals for the hybrids post-extension. Many of the hybrids are
currently held by insurance companies, and it is unclear if they would be holders of longdated, low-coupon floating-rate instruments. Any ensuing selling could push valuations
below fair value.
Some short-call hybrids do appear cheap on a fundamental basis, although valuations are
likely to remain volatile. For instance, the CB 6.375s, PGF 6.7s and LIBMUT 7s lose S&P
capital treatment on the first call date, increasing the likelihood they are redeemed then.
They offer attractive yield to call but their potential negative convexity the upside if
redeemed is much lower than the downside from extension means that valuations will likely
remain under pressure in the near term. Further, while the XL 6.5% and CGLLN 7.249%
hybrids will likely be extended past the first call date in 2017, we think they could be
redeemed in 2025 and offer attractive yield to call in that scenario.
We believe that the best opportunity in hybrid insurance remains in the long non-call
securities. They offer an attractive spread pickup over senior debt and are obviously not
exposed to the same extension risk concerns like the short-call paper, in our view. This
includes LIBMUT 7.8s, MET 7.875s and 9.25s, and high coupon PRU hybrids.
12
4 December 2015
Or in the case of HIG 6.505s, remain eligible to receive equity treatment
152
European bank capital

We view European bank AT1 and LT2 valuations as attractive at current levels in the
context of a benign macro outlook for Europe, supportive bank fundamentals and
manageable supply. In our baseline scenario for 2016, we see total returns of 5.5-6.5%
and 6-7% for EUR and USD AT1s, respectively. For EUR LT2s, we see 1-2% excess return
in our base case.
European bank capital securities performed strongly in 2015 despite numerous spikes in
volatility and weakness in non-financial credit. AT1 CoCos recorded total returns of c.7%
year-to-date (on a EUR-hedged basis; Figure 15). The bulk of the performance was driven
by carry, as yields both in EUR and USD AT1s dropped only 20bp from the levels at the
beginning of the year. Mirroring the dynamics in AT1s, LT2 spreads are currently roughly
flat year-to-date, with an excess return of c.2% (Figure 16).13
AT1s outperformed non-financials

In one of the key relative value shifts this year, European AT1 CoCos have strongly
outperformed single-B rated corporates. The outperformance started in July and represents
a major break out from the strong historical relationships between these higher-beta credit
sectors. This outcome is, however, not surprising if we consider the key drivers of the selloff that ensued after the resolution of the Greek crisis in early July: the Chinese stock market
crash and rising concerns around the Chinese slowdown; broader EM weakness and
concerns around global growth; reignition of the commodity rout; and uncertainty around
the US rates. In contrast to many higher-leveraged corporates, major European banks
generally do not have significant direct downside exposures to any of these risk factors
(with the exception of select banks, including SANTAN, HSBC and STANLN).
Notably, in contrast to the performance in AT1s versus high-beta corporates (and a similar
outperformance in bank senior debt versus IG corporates), European bank LT2s have traded
in line with their non-financial comps. As we show in Figure 71, the sector has performed
roughly in line with BB-rated non-financial debt and corporate hybrids14.
FIGURE 15
Year-to-date total returns in CoCos and HY
8
FIGURE 16
Bank LT2s vs. BB non-financials and corporate hybrids
6
Cumulative total return (%)
-2
-2
Cumulative excess return (%)
-4
Jan
Feb Mar Apr May Jun
Jul
Aug Sep Oct Nov
EUR AT1s
PE HY ex-Fin B
USD AT1s
US HY ex-Energy B
Jan
Feb Mar Apr May Jun

LT2s
Corp hybrids
Jul
Aug Sep Oct Nov

PEHY ex-Fin BB
Corp hybrids ex-story
Note: LT2s represent a basket of LT2s issued by European banks in the past
three years of at least 500mn in EUR, USD or GBP. PEHY refers to the Barclays
Pan-European High Yield Index. Corporate hybrids denote a broad basket of
European corporate hybrids across currencies. Source: Barclays Research
13
We use a custom LT2 index that combines IG and HY rated bonds issued in size of at least 500mn in EUR, USD or
GBP as a more accurate reflection of the liquid part of the asset class.
14
In relative value versus corporate hybrids we look at the hybrids index excluding story names, ie, the issuers that have
recently seen a large spike in idiosyncratically driven volatility: COFP, ORGAU, REPSM, RWE, STOAU, VATFAL, VW.
4 December 2015
153
Banks fundamentals remain well positioned for the current environment

We think that banks remain well positioned to weather the current macro headwinds. The
profitability in the sector remains underwhelming with ROEs constrained at <5% in Q3 15
(under pressure from falling NIMs, slowing fee income and volatile investment banking, but
supported by lower loan loss provisions and cost cuts). However, asset quality continues to
improve, banks have continued to de-risk their balance sheets and their appetite for risk
remains limited. In particular, apart from select cases, European banks generally have fairly
limited exposure to EM economies and commodity-related businesses. We estimate that a
median exposure to EM in proportion to total loan books across major European banks is
10%, while median exposure to commodity-related sectors is 5%.
Ultimately, the bulk of European banks exposure lies in Europe and asset quality is closely
linked to the growth environment in the region. We expect modest expansion in Europe to
continue in 2016. Our economists forecast 1.6% growth for the euro area (in line with 1.5%
expected for 2015) and a mild slowdown in the UK from 2.4% in 2015 to 1.9% in 2016. In
that context, with the support from the ECB likely intensifying next year, we view the macro
environment as benign for bank debt.
FIGURE 17
Fully loaded CET1 ratios
12.5%
Fully-loaded CET1 capital ratio
12.0%
11.5%
11.1%
11.0%
10.5%
10.3%
10.5%
10.7%
11.7%
11.7%
Q414
Q115
12.0%
12.1%
Q215
Q315
11.3%
10.8%
10.0%
9.5%
9.0%
Q213
Q313
Q413
Q114
Q214
Q314
Source: Company reports, Barclays Research
The most compelling argument in favour of bank debt remains capital and regulatory
scrutiny. Bank capital levels continue to scale new historical highs (Figure 72) and they
remain under constant upward pressure from regulation.
On one hand, the regulators in some jurisdictions have been taking advantage of the macro
prudential tools available under Basel 3. For example, most recently, the Bank of England
has hinted that a lifting of the counter-cyclical buffers may be necessary to curb what
increasingly appear to be excessive levels of lending in the UK. This would put Britain on a
path already taken by Nordic regulators Swedish and Norwegian regulators recently
announced that counter-cyclical buffers will increase from 1% to 1.5% in 2016.
On the other hand, regulators continue to tinker with the capital framework itself. The most
significant changes to the capital regime still ahead are the review of credit risk RWAs,
nicknamed Basel 4, the Fundamental Review of the Trading Book (which is designed to
tackle the market risk RWA framework) and ECB consultation on national discretions in
calculating capital. These reforms are going to increase bank RWAs and reduce the
regulatory capital, negatively affecting capital ratios and, in turn, likely driving a further
build-up in CET1 capital. While this is not great news for bank stocks, for bank debt holders
it means even thicker equity cushions protecting their principal.
4 December 2015
154

However, the process of getting there could pose some risks to AT1 CoCos, given that a
drop in capital ratios caused by the reforms would bring the capital ratios closer to coupon
cancellation and conversion triggers. We think that concerns about this risk have
contributed to the recent underperformance in Swedish AT1s, where the potential for a
drop in capital ratios is the highest. However, in practice, we believe that the changes would
be phased in gradually and the transition should be manageable for the banks.
In a somewhat similar vein, another tail risk for AT1 investors comes from the ECBs pillar 2
requirements. We still do not know the exact size and mechanics of the ECBs target capital
ratios. A lack of clarity on that front creates uncertainty about the actual size of capital
cushions the eurozone banks have over the regulatory requirement and, as a result, increase
the tail risk of coupon cancellation. An example of how the inclusion of the pillar 2 capital
requirement in the MDA calculation can create a material risk for an AT1 is DNB. In its Q3
results, the bank announced that it will be required to meet a total CET1 capital requirement
of 15% (including a 1.5% pillar 2 buffer) by the end of 2016, versus the current much lower
ratio of 13.1%, with the full amount of regulatory minimum counting towards the MDA
calculation for the DNB AT1s.
Return forecast
Accounting for the above factors (a benign macro outlook for Europe, supportive bank
fundamentals and manageable supply), we believe spreads in European bank capital are
attractive at current levels. AT1 spreads currently at 590bp and 490bp for EUR and USD
AT1s, respectively, are 50bp wide of the levels seen before the summer and more than
100bp wide of the historical tights reached in 2014, prior to the broad high-beta credit selloff in H2 14. At the same time, LT2 spreads at 220bp (for EUR LT2s) are c.35bp wide of the
pre-summer levels.
Against that backdrop, we forecast a tightening in spreads in 2016: 25bp for EUR AT1s,
50bp for USD AT1s and 20bp for LT2s. Note that the stronger tightening in USD is driven by
our expectation of deepening government yield divergence between Europe and the US. We
summarize our implied total and excess return forecasts in Figure 18.
FIGURE 18
Baseline return expectations for European bank capital
Current levels*
AT1s
LT2s
2016 forecast
Spread
Yield
Excess return
Total return
EUR
590bp
6.2%
7.5-8.5%
5.5-6.5%
USD
490bp
6.5%
7-8%
6-7%
EUR
220bp
2.7%
2.5-3.5%
1-2%
USD
260bp
4.6%
3.5-4.5%
1.5-2.5%
GBP
290bp
4.8%
4.5-5.5%
1.5-2.5%
Note: * Current levels as of 27 November 2015.We used average g-spread for USD AT1s, z-spread for other sectors.
Supply to remain at 2015 levels

On the supply front, bank capital came on the lower side of our 2015 expectations with
32bn issued so far in AT1s and 15bn net supply in LT2s (34bn gross supply). Looking
ahead, we see room for another 64bn of AT1 issuance before the major European banks
reach the limits defined by the combination of the 1.5%-RWA allowances under Basel 3
minimum capital requirements, minimum leverage ratio requirements, pillar 2 requirements
and the self-imposed AT1 cushion targets (Figure 19). We expect at least half of that
shortfall to be made up in 2016 which leads us to a base case of 30-35bn of new AT1
issuance in 2016.
4 December 2015
155

In LT2s we anticipate 30-35bn in issuance in 2016, including 10-15bn of positive net
supply, driven by a continued build-up in T2 capital cushions. The risks to our forecast are
skewed heavily to the upside by the uncertainty around the final format of TLAC-eligible
debt in France, Italy and Spain.
FIGURE 19
Future potential issuance
25
Further potential issuance
20
Already issued (AT1 + T2)
15
10
5
0
Bank of Ireland
Swedbank
SEB
SHB
Danske
Nykredit
KBC
Nordea
Intesa Sanpaolo
Commerzbank
StanChart
ING
Unicredit
BBVA
RBS
Lloyds
Soc Gen
Rabobank
Credit Agricole
Deutsche Bank
Santander
Credit Suisse
BNP Paribas
UBS
HSBC
Corporate hybrids
Despite a material widening in 2015, we think that hybrids continue to look marginally
expensive relative to peer sectors BB non-financials and bank LT2s. In our base case
for end-2016, we assume a slight widening in corporate hybrids spreads, which implies
an excess return of 2.5-3.5%.
QE trade overrun by idiosyncratic risk

On the surface, corporate hybrids have performed very poorly this year with near zero excess
returns (Figure 20) clearly disappointing the bullish market expectations that dominated at
the beginning of 2015. Following a period of strong performance in Q1 on the back of the QE
trade and its subsequent unwind in Q2, the asset class started underperforming other sectors
over the summer, driven by a string of negative idiosyncratic stories.
First, energy names (ORGAU, STOAU and REPSM, in particular) came under severe pressure
in July amid the renewed sell-off in oil. Around the same time, conventional power
generators, including RWE and VATFAL, saw downgrades and substantial re-pricing across
the capital structures amid ongoing deterioration in power prices and the uncertainty
around the costs of the nuclear cleanup in Germany. COFP hybrids sold off aggressively in
September, dragged down by its significant exposure to retail in Brazil. Lastly, the markets
were stunned in September by the VW emissions scandal, which pushed hybrids off a 15pt
cliff. The hybrids from all of these issuers taken together (accounting for 18bn of paper)
lost 7.5% on an excess return basis this year and contributed -1.7pp to the excess return of
the whole asset class.
4 December 2015
156
FIGURE 20
YTD total returns in corporate hybrids and peer sectors
6
FIGURE 21
Corporate hybrids (ex-story names) vs. BB non-financials
450
Cumulative excess return (%)
Z-spread (bp)
Spread diff (bp)
250
400
4
200
350
300
150
250
200
100
150
-2
100
50
50
-4
Jan
Feb Mar Apr May Jun

LT2s
Corp hybrids
Jul
Aug Sep Oct Nov

PEHY ex-Fin BB
Corp hybrids ex-story
0
2013
0
2014
Diff
Hybrids "ex-story"
2015
PEHY xF BB
An inherently unstable asset class

These events highlighted two important features of the corporate hybrid market. First,
hybrid issuance is dominated by companies that are under significant rating pressure, either
because of operational weakness or debt-funded M&A. This automatically increases the
chances that a mitigating strategy, which hybrids are usually a part of, will not work, leading
to downgrades and poor performance. Second, hybrids have negative convexity relative to
senior debt due to extension risk. This downside risk is particularly high in hybrids issued
over the past one to two years with relatively tight reset spreads, given that the bar for these
securities to start pricing an extension scenario is relatively low in case the self-help strategy
does not work out.
Unattractive versus BB non-financials and bank LT2s

The very sharp sell-off in the names that have recently come under stress shows that the
negative convexity in hybrids generally has been underestimated by the market. However,
the reaction in the hybrids that were not directly affected by idiosyncratic stories was fairly
muted. As we show in Figure 75, the corporate hybrid index (adjusted for the story names)
performed in line with its peer sectors (bank LT2s and BB non-financials) in terms of excess
return. When we look at spread performance of those hybrids versus BB non-financials, we
see only a 10bp widening versus the H1 15 average differential (Figure 21). We think that
the lack of more meaningful underperformance makes the risk-reward in hybrids
unattractive relative to LT2s and BB non-financials.
Return forecast
Looking into 2016, given that we are projecting a modest tightening in LT2s and a slight
widening in BB non-financials, in our base case we assume hybrids (excluding the story
names) will widen by 10bp from current levels. We do not think a top-down forecast for the
story hybrid names currently makes sense and we recommend looking at these securities
on a case-by-case basis.
4 December 2015
157

FIGURE 22
Base-line return expectations for European corporate hybrids
Current levels*
Corporate hybrids*
2016 forecast
Spread
Yield
Spread
Yield
Excess return
Total return
350bp
3.7%
360bp
4.2%
2.5-3.5%
0.5-1.5%
Note: * For the purposes of our projection we exclude the story hybrids from the composite (COFP, ORGAU, REPSM,
RWE, STOAU, VW). Source: Barclays Research
Key fundamental trends

Energy (12bn hybrids outstanding). With oil and gas prices tracking YTD lows, and the
forward curve implying weak prices through to 2019, we see heightened rating risk for the
Energy sector going into 2016. We see an oil price recovery scenario as broadly priced into
spreads (with the exception of Origin (Overweight), where we think spreads price in
$40/bbl or lower Brent prices). We believe Repsol (Underweight) spreads are the most
vulnerable.
Peripheral Utilities (7bn). We expect stable earnings, supported by significant exposure to
regulated earnings, and a still gradually improving ratings trajectory in 2016. Our analysts
hold an Overweight on Gas Natural and EDP (where we think positive rating momentum
will continue into 2016, provided there is no slippage in Portugals sovereign rating).
Central/ Northern Utilities (10bn). We see the risk of rating downgrades in the Central &
Northern European space as elevated in 2016. Weaker realised power prices, while
continuing to be an operational headwind, have been addressed by issuers through
significant self-help programmes and, following downgrades in 2015, are now factored into
current ratings. We think policy risk will be the main driver of rating action in 2016 for the
German Utilities, with nuclear decommissioning and continued efforts to reduce CO2
emissions the key challenges. Dong Energy and TenneT are operational bright spots in the
space; both high-growth businesses benefitting from Europes renewable build out.
French/UK Utilities (25bn). As with the Central & Northern European utilities, we see
rating pressure as likely to persist in the French & UK unregulated energy space in 2016. We
expect deteriorating commodity and power prices to weigh on Engie, Centrica and SSE
earnings, while significant investments (eg, Hinkley Point and Areva NP) and loss of
regulated French revenue hampers EDFs medium-term path to neutral FCF. We also see
risks for the UK energy supply sector, with the final report of the Competition & Market
Authority review due in April 2016. In contrast, we expect water and waste utilities Suez
Environnement and Veolia to exhibit rating stability; benefitting from improving earnings
through volume growth and efficiency measures.
Asset class set for continued growth

The three key factors driving the growth in corporate hybrids remain in place. First, we
continue to see plenty of issuers facing rating pressures either due to operational weakness
(most recently, energy and metals and mining sectors) or potential leveraging M&A activity
(various sectors, but most prominently TMT). Second, hybrids continue to offer relatively
cheap capital, given that hybrid yields remain fairly low on a historical basis (and are
certainly attractive when the only alternative would be a capital raise). In fact, hybrid
funding should continue to look attractive to issuers as long as rates remain low in Europe.
Finally, investor appetite for new hybrid issuance remains robust as demonstrated by
continued strong demand in the primary market, even in cases where the issuers are facing
truly challenging fundamental outlooks. In that context, we forecast gross supply in a 1525bn range, driven by 15-25bn of net supply, while the 3bn of redemptions expected in
2016 (Figure 24) are likely to be only partially replaced with new hybrids.
4 December 2015
158
FIGURE 23
Corporate hybrid supply
FIGURE 24
Hybrid redemption profile
Amt issued (bn)

17.5
Total amt issued (bn)

125
Redeemed
Amount issued
Old-style supply
Total (rhs)
15.0
12.5
10.0
100
7.5
50
30
25
-5.0
20
10
-7.5
0
4Q15
2Q15
4Q14
2Q14
4Q13
2Q13
4Q12
2Q12
4 December 2015
4Q11
2Q11
4Q10
2Q10
4Q09
58
50
40
0.0
-2.5
Amount (bn)
60
75
5.0
2.5
70
12
16
8
0
2016
2017
2018
2019
2020
2021+
159
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4 December 2015
160
Asian Credit Strategy
4 December 2015
161
ASIA CREDIT STRATEGY
Chinese bid holding up Asia Credit

Krishna Hegde, CFA
+65 6308 2979
krishna.hegde@barclays.com
Barclays Bank, Singapore
Avanti Save, CFA
+65 6308 3116
avanti.save@barclays.com
We forecast mild spread compression for Asia credit in 2016 and expect high grade
to outperform high yield. Tightening will likely be driven by the China high grade
component, where strong in-region demand and lower supply should offset macro
concerns. ASEAN high grade is likely to come under pressure as domestic conditions
weigh on credit fundamentals and technicals deteriorate due to higher supply.
China credit makes up 40% of Asia high grade. Expectation of sustained CNY
depreciation versus USD could result in increased in USD balances in China/Hong
Kong, strengthening the demand technicals for USD bonds of Chinese SOEs. In
addition, we do not expect slowing economic activity in China to weigh on the
creditworthiness of high grade issuers, given that they are mostly government
owned and national champions or leaders in their respective sectors. Though credit
metrics may deteriorate, we expect markets to remain comfortable with the
prospects of state support.
Away from China, the borrowing environment is likely to become more challenging,
with tighter lending conditions exacerbated by deteriorating credit fundamentals.
The slowdown in EM Asia growth and reduced inflows into the regions local
currency debt markets have accelerated this shift away from accommodative
conditions. We expect more defaults in 2016, with vulnerabilities especially high
among commodity companies. We think four to six high yields corporates could
default next year.
We expect lower issuance levels in 2016, driven by a weaker macro environment, a

stronger USD and lower flows into the asset class. China is likely to remain the
dominant issuer, though supply here is likely to be even more high-grade biased.
Banks in the region are likely to be more aggressive lending in USD, making the loan
market more attractive for many high grade issuers.
Across sovereigns and corporates in the region, we expect USD-denominated supply

to total USD125-130bn, lower than the 2015 tally but slightly higher than 2012-13
levels. Unlike in previous years, we expect net supply to be substantially lower as a
result of more than USD50bn of redemptions.
We expect the buyer base for Asia credit to change in 2016. Specifically, we expect
greater demand from China- and Japan-based investors as others scale back their
activity.
With the size of the Asia credit (USD-denominated) universe being 70% larger than
European high yield and 50% the size of US high yield, we expect global credit
investors to allocate more to Asia credit independent of other emerging markets over
the coming years. We expect financials to be the entry point of choice for global credit
investors looking to dip their toes into Asia. Similarly, we think strategic Chinese SOEs
are likely to continue to find a place in global portfolios. We expect the performances
of China real estate companies to stabilise, given improving fundamentals and a
supportive technical backdrop. India and Indonesia also look better positioned
compared with other EM peers and are likely to attract flows, in our view.
4 December 2015
162
Uninspiring returns for 2016

We forecast Asia credit to generate a total return of 75-125bp and excess return of 200-250bp
in 2016 (Barclays expects the 10y US Treasury to be 2.6% by end-2016). We expect a mild
spread compression in high grade, led by the China component, while we see high yield
spreads widening 20-30bp (Figure 1). We expect Asia credit (IG and HY combined) spreads to
decompress against US credit (Figure 2).
China high grade to drive Asia spread compression

China credit makes up 40% of the Asia high grade universe (Figure 3). Therefore, our
spread view on China credit is a big driver of our overall expectation of Asia high grade
performance.
Our fundamental outlook for China high grade issuers is benign. These issuers are
largely state owned (central/provincial/municipal government) and national champions
or leaders in their respective sectors. Therefore, we think Chinas gradual economic
slowdown is unlikely to lead to a significant credit deterioration. On the other hand, the
governments growing focus on SOE and financial sector reforms should improve credit
profiles. Some moderation in credit metrics is likely (especially in the commodity and
banking sectors), but credit ratings are likely to remain stable, in our view.
Expectations of sustained CNY depreciation versus the USD could result in increased USD
balances in China/Hong Kong (Figure 6), strengthening the demand technicals for USD
bonds of Chinese SOEs. In 2016, we expect increased demand from China insurers, asset
managers and commercial banks. Given this, we believe bonds that are directly
issued/guaranteed by Chinese SOEs could continue to see strong demand next year. At
the same time, given the liquidity backdrop in the banking system, we think the loan
market will likely compete with bonds as an attractive funding source, also limiting supply.
We expect high yield spreads to widen

In high yield ex-China property, we see default rates rising and fundamentals weakening
(higher leverage, weak financing conditions, and softer demand). For non-China, slowing
economic growth will likely weigh on margins and revenues, while tighter financing
conditions could put pressure on funding, with leverage also likely to rise. We think the
commodity-linked sectors are likely to see the most weakness.
FIGURE 1
Returns for Asia Credit
FIGURE 2
Asia credit versus US IG
Asia Credit
Asia IG
Asia HY
Total return (%)

2013
-1.46
-2.49
1.46
2014
8.3
8.92
6.05
YTD-2015
2.9
2.36
5.33
0.75-1.25
0.75-1.25
2.75-3.25
2013
1.36
0.61
3.42
2014
3.63
3.57
3.63
YTD-2015
1.55
1.02
3.87
2016F
2-2.5
1.75-2.25
3.5-4
2016F
Excess return (%)
4 December 2015
OAS, bp
550
500
450
400
350
300
250
200
150
100
50
Jan-11
Jan-12
Jan-13
US Credit
Jan-14
Jan-15
Asia Credit
163

In the China segment, the outlook is bifurcated. Several companies (which are able to
access cheaper funding onshore) are looking to buy back bonds/repay offshore debt
following the depreciation of the CNY. Furthermore, softening growth and an easing policy
stance offer a benign environment for the large property developers. At the same time, we
think event risk (positive and negative) has risen among corporates geared to the old style,
investment-led economy. For instance, Anhui Conch recently announced a plan to increase
its stake in West China Cement to 51%, which could lead to an IG rating for the latter (see
West China Cement: IG rating a possibility; upgrade to Overweight, 30 November 2015),
while Shanshui Cement is proposing a voluntary wind up of the company, which would
potentially leave very little residual value for offshore bond holders (see Shanshui Cement The nuclear option; maintain Underweight, 11 November 2015).
While technicals in high yield look slightly better for next year, given that we expect lower
supply, the demand outlook is not upbeat.
We expect a modest widening of 20-30bp in Asia HY in 2016. The weak outlook is
balanced by valuations; most bonds of companies with financing or operational pressures
are already trading at 60-70.
Asia to fare better than other emerging markets

We expect Asia credit to outperform LatAm and EEMEA, driven by both stronger
fundamentals and better technicals. In particular, commodity-linked names make up a
smaller proportion of Asia credit compared with the rest of EM; most Asian countries are
beneficiaries of lower oil prices; and while fundamentals are set to moderate as growth
slows, we do not expect a widespread deterioration in credit quality.
We believe one reason that technicals for Asia credit are supportive is because of a regional
investor base. We expect strong demand from China banks, insurers and asset managers
for Chinese high grade credit. In addition, supply is likely to be lower. This is in contrast with
the rest of EM, where the demand outlook is heavily dependent on EM fund flows, typically
from developed market-domiciled investors.
Tug-of-war between global and regional themes

Several global macro themes are at play going into 2016: monetary policy divergence;
weakening outlooks for emerging economies; a strengthening USD; and Chinas economic
rebalancing. While these are familiar and may present a benign environment, we expect
these trends to turn more challenging as the year progresses.
FIGURE 3
Composition of Asia high grade
FIGURE 4
Estimated non-FDI capital flows
SG TH TW
MY 4% 3% 0%
4%
PH
5%
USD bn
100
CN
40%
IN
8%
Estimated non-FDI capital flows*

Change in FX purchase position
150
50
0
-50
HK
10%
-100
-150
ID
12%
4 December 2015
-200
Sep-10
KR
14%
Capital outflow
Sep-11
Sep-12
Sep-13
Sep-14
Sep-15
* Estimated capital flows = change in FX purchase position - trade

balance - net direct investment + change in FX deposits
Source: Haver Analytics, Barclays Research estimates
164

Themes that most affect Asia credit are the expected Fed lift-off and the pace of further
hikes, and softening growth in regional economies.
Fed lift-off and the pace of hikes

1. We expect EM fund inflows to slow in 2016. This would have a two-pronged effect on
Asia credit. First, it would dampen demand, especially the non-China segment. Second,
it would affect regional (ex-China/Hong Kong) dollar liquidity, which should tighten
most in systems that have benefited from large capital flows via foreign purchases of
local bonds and foreign bank lending. We expect financing conditions to become more
challenging for corporates in Asia ex-China. The China segment is largely sponsored by
onshore demand and is unlikely to be affected by slowing fund flows
2. Currency depreciation (against the dollar) will likely weigh on corporate debt service and
coincide with tighter availability of USD funding. Central banks are likely to mop up any
excess liquidity to build foreign reserves. A depreciation in the CNY is likely to have
positive implications for China credit because corporates would look to redeem/repay
dollar debt and refinance onshore to avoid higher all-in debt service costs, and a
depreciating currency would likely accelerate flows to USD (or HKD). These monies are
invested in China credit through commercial banks, asset managers and retail.
Softening regional growth and policy response

Regional economic activity is set to slow and weigh on corporate fundamentals further. For
one, subdued demand in Asia ex-China would continue to erode earnings capacity.
Pressures are likely to be most intense in the commodity and capital goods segments. In
addition, the ability to fund should weaken with rising funding costs and banks rationing of
credit. This dynamic is likely to intensify, as global commercial banks are withdrawing or
slowing lending in emerging economies following stricter regulations on risk weights and
the transition to Basel IV.
Defaults set to rise as credit cycle advances

For each of the past three years, a minority of bonds priced at 90 or below at end-December
have defaulted in the following year. In most cases, the bonds had been trading at stressed
levels for extended periods before a default. Conversely, we have not seen any instances of
default in the past three years where a bond was trading at more than 90 at year end.
Figure 6 captures all of the defaults seen among Asian high yield corporates over the past
three years. We acknowledge that our screen will not capture bonds that trade above 90 at
year-end and default next year. However, that has not happened during the past three
years. Furthermore, we note that the Asia credit market has matured over the past several
years, and the mix of issuers has changed significantly; in our view, a longer history of
offshore bond defaults is not directly relevant to this exercise.
FIGURE 5
Fluctuations in proportion of market that defaulted not in sync with economic conditions
Number of
issuers
Notional amount of
bonds that
defaulted
subsequently
Number of
defaults
2,822,500
1,422,500
2013
7,409,310
12
1,869,310
2014
10,598,415
19
2,759,310
Notional amount of HY corp bonds

outstanding trading below 90 at
end of previous year
2012
4 December 2015
165

Looking into details, we see multiple examples where an issuer has undertaken an
opportunistic cash tender offer at a deep discount to create value for equity and reduce the
balance of bonds outstanding subsequently going on to pay out the holdouts at par. In a
minority of situations (ie, Hidili) industry conditions have deteriorated subsequent to a
tender offer and holdouts were faced with a default situation.
Further, we find that in many situations (Glorious Properties and China Oriental Group are two
recent examples), an analysis of financial statements and an assessment of operating conditions
would not have been sufficient to assess the prospects that a stressed company would default.
On the flip side, there are examples of strategic default both in the loan and bond markets.
Given the nature of bankruptcy laws in many Asian countries, equity holders are able to
preserve and, in some cases, generate value even as debt holders take losses. As a result, credit
investors sometimes choose to agree to a restructuring that results in an NPV haircut but leaves
management intact rather than risk even larger losses through a formal procedure.
Given both these outcomes - we believe there is significant merit in the conventional wisdom
among Asian credit investors that willingness to pay is as important as ability to pay.
In Figure 7, we list a number of companies whose bonds are trading at 90 or below. We
think 4-6 high yield corporate issuers could default over next year, which would be a
modest uptick from previous years. To assess default risk, we consider few principles that
have held true in recent years:
Domestic sources of liquidity are likely to remain available, despite mild financial stress
and adverse operating conditions. As a result, we think domestic short-term debt is
likely to be rolled over and, hence, is unlikely to cause defaults.
Some companies could utilise low bond prices to restructure debt proactively, even
though their liquidity could be adequate. The assessment of default/restructuring risk in
such cases becomes a judgement call on options available to management to preserve
equity value/increase the runway for outlasting adverse operating conditions.
It is very difficult to predict corporate malfeasance and its ramifications, given disclosure
levels.
Against this backdrop, for corporates that have medium/high default/restructuring risk,
Commodity price declines are the biggest contributor to default risk.

Indonesian corporates are most likely to restructure debt proactively.
4 December 2015
166

FIGURE 6
Corporate issuers with bonds trading at 90 or below as of 2 December 2015
Par amount of bonds
in index (USD mm) Comments
Mongolia Mining
Corp (MONMIN)
600
USD173mn of long-term loans due in the next 12 months against cash of USD70mn. The company
indicated on its earnings call that its ability to refinance will be dependent on approval of the Tavan
Tolgoi project. This has been under consideration by the Mongolian Parliament since early 2015 but
the timing of a vote has not been announced.
Honghua Group
(HONHUA)
200
CNY1.1bn of cash against CNY3.2bn of short-term debt; however, it has CNY12.4bn unutilised (but
unsecured) bank lines.
Anton Oil (ANTOIL)
250
CNY274mn of cash and CNY696mn of short-term debt as of June 2015, and large cash outflow of
CNY770mn in LTM June 2015. Given current low oil prices, the company may find it more difficult to
access incremental funding.
Indika Energy*
(INDYIJ)
800
Liquidity likely to deteriorate in 2016, as dividend income likely to drop significantly from the
USD98mn expected in 2015. Annual interest costs of approximately USD65mn and LTM June 2015
capex of USD61mn. A further deterioration in the companys outlook might prompt it to propose a
restructuring of its USD bonds.
MNC Investama*
(BHITIJ)
365
Weak holdco liquidity position could prompt opportunistic debt restructuring, even though the group
has funding options. In 2008, Global Mediacom, a key subsidiary, reduced its stake in PT Mobile-8,
triggering the change-of-control put on Mobile-8s USD bonds, which it was not able to redeem and
therefore resulted in a default.
Rolta (RLTAIN)
373
Has INR2.9bn of short-term debt, of which INR2.5bn is long-term debt coming due in the next 12
months, against IDR5.5bn of cash at end-March. Its bonds fell after it was the subject of a shortsellers research report in April 2015.
China Fishery
Group (CFGSP)
288
Cash of USD41mn against short-term debt of USD295mn at end-August. Revenues could be hit by
reduced catch due to El Nio. In a stock exchange announcement, the company said it has started
discussions with certain bank lenders regarding additional funding and amendments to its existing
borrowings.**
Gajah Tunggal*
(GJTLIJ)
500
Potential for opportunistic restructuring due to deteriorating liquidity, based on guided EBITDA of
USD110-120mn, annual interest expense of USD50mn and guided 2015 capex of USD100mn.
Annual renewal of bank lines in August 2016 is also a potential stress point.
MIE Holdings*
(MIEHOL)
700
Liquidity remains adequate following recent equity funding and potential asset sales. Non-renewal of
secured bank lines or continued low oil prices (< USD50/bbl) could raise liquidity stress beyond 2016.
Noble Group*
(NOBLSP)
2,009
Golden Eagle Retail

Group (GERGHK)
Vedanta
Resources*
(VEDLN)
Risk increases if weak 2H15 cash generation prompts lenders not to renew bank lines in 2Q16. We
believe Noble will have to shrink its operations if access to liquidity is limited.
400
Had c.CNY1.5bn of cash and CNY2.79bn of liquid investments at end-1H15; short-term debt was
CNY644mn.
3,350
Inability to repay 2016 maturities could result in a default scenario, although that is not our base
case.
Japfa Comfeed
Indonesia (JPFAIJ)
225
IDR244bn of long-term loans due in 2016 and IDR1.5trn of domestic bonds due in early 2017 against
IDR780bn of cash.
Global A&T
Electronics
(GATSP)
625
USD177mn of cash against USD0.3mn of short-term debt at end-September. However, ongoing legal
dispute is a default risk if the court reverses its initial decision in favour of the company.
JSW Steel* (JSTLIN)
500
Depends on large undrawn credit facilities (c.INR60bn) to cover its short-term debt (c.INR43.3bn at
FYE March 2015), given its relatively small cash position (c.INR19bn). It purchases raw materials by
issuing acceptances (INR108.9bn, part of trade payables) that are backed by its bank facilities.
Glorious Property
(GLOPRO)
400
Weak liquidity, with cash of CNY1.0bn against short-term debt of CNY21.8bn as at June 2015. Sales
remain weak, although they rose 15.6% y/y, to CNY3.3bn, in 9M15 from a low base. However, the
company repaid a USD300mn bond due in October 2015.
Lodha Developers
(LODHA)
200
At end-March, the company had INR100bn of short-term debt, including INR89bn of term loans and
INR9.6bn of debentures, against INR4.3bn of cash at the parent guarantor level.
Alam Sutera*
(ASRIIJ)
460
No large near-term maturities; only IDR18.75bn (USD1.4mn) due in November 2016.
Yingde Gases*
(YINGDZ)
668
Near-term funding needs addressed with syndicated loan and onshore bond issuance; weaker-thanexpected receivable collections could result in funding pressure.
Note: *Under credit coverage, for current ratings see Asia Credit Alpha, 27 November 2015. **According to Bloomberg, HSBC said on 26 November 2015 that it asked
the Hong Kong High Court to wind up China Fishery Group and appoint a liquidator. Source: Company data, Bloomberg, Moodys, Barclays Research
4 December 2015
167
Drivers of supply have shifted decisively

Over the past few years, monetary policy in the US has been very accommodative. US
Treasury yields have been low and emerging markets have received significant inflows, in
both hard and local currency. Generically, strengthening emerging market currencies and a
wide offshore/onshore yield differential made it attractive to issue offshore debt without
fully hedging.
Corporates across many sectors, comfortable with the macro backdrop and their own
growth outlooks, embarked on ambitious expansion plans. Since their balance sheets were
starting from a healthy level, investors were comfortable lending to them. Finally, domestic
banking systems in many countries were also flush with liquidity, providing comfort on
alternative funding avenues.
Many of these factors changed decisively this year, which is likely to affect supply.
The growth outlook is more challenging.

Corporate balance sheets in many segments are stretched.
Demand for Asian corporate and sovereign debt has weakened and risk premia increased.
Given expectations of further USD strength, the all-in cost of unhedged USD debt has risen.
The redemption pipeline is heavy in 2016 and will be a key driver of supply, in our view.
We expect USD125-130bn of USD-denominated bond issuance in 2016, across sovereigns,
financials and corporates. Among these, sovereigns are likely to see a y/y increase while
corporate issuance shrinks.
By country, we expect the trend of China accounting for the largest portion of supply in Asia
ex-Japan to continue. However, we expect the proportion of issuance from China to be
lower than in 2014-15.
Corporates
We expect corporate issuance in Asia to decline further y/y in 2016, with the high yield
China sector having the sharpest decline. We see the key themes in corporate issuance next
year as the following:
A substantial proportion of issuance will be for refinancing requirements. We expect bond

issuance to be used to pay down bank debt and upcoming bond maturities. We expect the
refinancing theme to be relevant across India, Korea, Hong Kong and select Chinese issuers.
Chinese high yield companies, especially property, are likely to move away from offshore
issuance significantly. The onshore bond market has shown an ability to fund size and
tenor. While onshore spreads may not be sustainable and are likely to reset wider with
more supply, we think a backdrop of USD strength has made offshore issuance
substantially less attractive.
Oil & gas, which has been a prominent fixture in previous years, is likely to take a back
seat. We expect companies in the sector to continue to cut capex and be more selective
about M&A.
Financials
In 2016, we think financial sector bond supply ex-China is likely to be mainly for refinancing
senior debt and capital instruments. The key change versus 2015 is likely to come from
China, where we expect the financials issuer base to diversify further, with insurance and
leasing companies accounting for a higher proportion y/y. We expect issuance in Korea to
increase y/y, mainly due to a significant maturity pipeline.
4 December 2015
168

Away from China/Korea/India, we expect issuance to be a mix of refinancing and
opportunistic supply, as banks look to extend their foreign currency liability profiles. Bank
capital issuance will continue to be heavily biased towards onshore markets, given the lower
risk premia available there, in our view.
Sovereigns
We expect Asia sovereign supply to increase y/y in 2016. This is likely to be driven by:
Refinancing external debt maturities (c.USD8bn will mature in 2016).

Funding fiscal positions: countries such as Sri Lanka, Vietnam and Mongolia are looking
for alternative funding sources, given various hurdles to fund domestically, including
debt caps, while those such as Indonesia may look to boost economic growth through
fiscal expansion.
Building foreign reserves and buffers for balance of payments positions (especially given
the risk of further capital outflows from domestic markets).
Overall, we believe that as EM flows slow, the demand for local currency bonds will also
fade, which would make it difficult for countries to continue to fund themselves locally
(especially those with a high reliance on foreign purchases). In turn, this will likely increase
their foreign commercial borrowings. A risk to our 2016 estimates is a sharp deterioration in
market conditions that could lead to preference for bi-/multi-lateral borrowing instead.
China buyers central to Asia credit demand outlook

We expect the buyer base for Asia credit to change in 2016. Specifically, we expect greater
demand from China- and Japan-based investors as others scale back their activity. In
contrast, we expect muted demand from traditional investors in Asia credit. Global
institutional investors are likely to see better potential returns in other assets and will be
wary of weakening credit cycles in the region. Commercial banks (ex-China) are likely to
experience tighter USD liquidity, which would likely reduce their appetite to invest in Asian
credit. Similarly, Asian insurers (eg, Taiwan, Korea) are unlikely to be large buyers. Their
allocations to overseas products have stabilised in recent quarters.
Low JGB yields and a need for diversification will be key drivers for Japanese investors to
increase allocations to Asia. We expect high grade credit to benefit from these flows.
A growing source of demand is China-based investors. Banks are likely to continue to

buy China credit. We expect increased allocations from insurance, given low bond yields
onshore, asset managers raising funds onshore and in Hong Kong, and private/retail
flows from Chinese investors.
4 December 2015
169

FIGURE 7
Demand outlook for 2016
Investor base
Motivation for buying
Changes expected in 2016
Global institutional
fixed income
(including EM)
1. Structural allocations to EM assets.

2. Search for yield.
3. Relative value of Asian sovereigns vs.
LatAm/EEMEA and varying fundamentals.
1. Institutional strategic allocations into EM are likely to slow,

driven by a weakening fundamental outlook for EM. An
expected turn in the credit cycle is also likely to increase the
premium required to invest in EM as default and potential
recovery outlooks are reassessed.
2. Expect incremental dollars to be deployed away from EM assets.
This is likely to happen when domestic liquidity in several EM
countries is tightening and economic activity softening.
3. There is a risk of EM outflows, especially if credit deterioration
becomes widespread.
4. Relative value considerations may put Asia at a disadvantage.
5. We expect this change in demand most to affect sovereign and
high grade corporates/financials that are part of global EM
benchmarks.
Commercial banks Treasury desks
1. Generate returns on deposits (especially foreign 1. Philippine banks to continue to buy ROP bonds. A rise in US
currency) or park USD liquidity.
yields will likely raise their demand for ROPs.
2. ASEAN banks: We expect domestic liquidity to tighten across
most banking systems. We also do not expect USD liquidity to
improve next year; hence, any pressure on capital flows could
exacerbate weak liquidity conditions. Furthermore, central
banks are likely to mop up any excess USD liquidity. Thus,
demand for credit from these banks will likely be lower.
Asian
Insurance/pension
companies
1. Oriented towards all-in yields for asset-liability

matching.
2. Cross-currency basis swaps could make
swapped yields more attractive than
government bonds in some markets.
1. Taiwan: This investor base has been participating in long-dated

high grade corporates and sovereigns. We expect limited
incremental bid from this segment because most large lifers
already hold substantial amounts of Asia credit (close to limits, in
some cases) and we expect them to find better yields in other
markets (eg, US IG and HY).
2. Korea: These investors have sponsored Korean credit and high
grade corporates. The pace of overseas fixed income
investment has stabilised. While we expect demand for Korean
names to remain, incremental allocations to EM credit could
slow, given expected volatility in credit fundamentals.
3. Malaysia/Thailand: Lower yields in local currency bonds have
pushed these investors into offshore credit. Amid interest rate
rises and higher FX volatility, we expect the appetite for offshore
bonds to diminish. But banks are unlikely to unwind existing
positions, in our view.
Official institutions,
SWFs, government
related entities
1. Reserve investment to get spread.
1. Shrinking current account surpluses and widening budget to

lower reserves available for investment.
2. We expect countries to use their reserves to defend (or act as
buffers) against FX volatility.
3. Finally, countries that built reserves or investment vehicles on
returns generated from oil (or other commodities) will have to
start unwinding or slow down investments.
Private banks
1. Pool of assets has continued to grow steadily.

However, we are mindful that there could be
some setbacks if growth outlooks in the region
turn sharply or funding costs jump (both would
create negative wealth effects).
2. Allocations to credit vs. equity are a theme.
3. Access and availability of leverage enhance
yields on high grade bonds and funds.
Key drivers: 1) rising US Treasury yields to dampen potential total

returns; 2) leverage offered is likely to be scaled back. In addition,
cost of leverage likely to rise; 3) alternative asset classes such as
equities and developed market credit could attract some allocations
away from Asia credit; 4) regulatory scrutiny on hybrid structures
marketed to this client base is likely to curb demand for such
products.
4 December 2015
170

Investor base
Motivation for buying
Changes expected in 2016
Banks
1. Low JGB yields. Limited loan demand with low

NIMs.
2. Level of USDJPY basis influences swapped
yields.
1. Increased investment in short-dated Asia investment grade

bonds.
2. Increased appetite for loans to Asian corporates, especially
investment grade with state links.
Insurance
1. Low onshore bond yields.

2. Appetite depends on USDJPY view for
unhedged portion and USDJPY basis for the
hedged portion.
1. Increased investment in Asian investment grade bonds

(typically ex-China). Based on previous pace, we think
~USD1.5bn of net investment per year is possible.
Pensions
1. Diversification away from JGBs, similar to GPIF's 1. Investment in hard currency EM mandates that filters into Asian
change.
credit. GPIF bond mandates announced in early October had
EM benchmarks.
2. Expanding investable universe to include EM.
Japan
China
Banks
1. Increased USD deposits (Figure 1).

2. Funds raised by issuing USD bonds offshore,
pending deployment in loans.
3. Ability to lend to familiar corporates at higher
spreads than onshore.
1. Continued appetite for bonds issued by Chinese borrowers. We

do not expect any increase in their purchases.
2. Some diversification into non-Chinese issuers.
Insurance
1. Low onshore bond yields, given easing of

monetary policy.
2. Intention to diversify investments, with
regulators giving permission.
1. Increased investment in Asian investment grade bonds,

especially Chinese.
2. Decrease in yield targets, given lower yield of domestic
alternatives.
Asset Managers
1. Funds raised onshore and in Hong Kong for

offshore fixed income products.
2. Funds raised in bond market.
1. Increased appetite for bonds issued by Chinese borrowers.

2. Some diversification into non-Chinese issuers, especially in high
yield.
Private banks
1. Increased AUM as a result of outflows from

China.
1. Increased appetite for bonds issued by Chinese borrowers.

2. Some diversification into non-Chinese issuers, especially in high
yield.
Sector and security selection driven by China-related

technicals
With the size of Asia credit (USD-denominated) being 70% larger than European high yield
and 50% the size of US high yield, we expect global credit investors to allocate more to Asia
credit independent of other emerging markets over the coming years. Given our expectation
that secondary market liquidity will remain challenging, we believe identifying investable
segments of Asian credit is a priority for many global investors.
In Figure 8, we identify key characteristics of these segments.
Asia credit continues to tilt more towards investment grade, with an increasing proportion
of high grade issuance from China. With the demand from Chinese investors (who have a
preference for Chinese credits) expected to remain intact next year, we retain a favourable
bias towards many Chinese sectors. We expect financials to be an entry point of choice for
global credit investors looking to dip their toes into Asia. While the Chinese economy is
likely to continue to slow and rebalance, we expect valuations of senior bonds of large
Chinese banks to be resilient. Similarly, strategic Chinese SOEs (energy and utilities owned
by central SASAC) are likely to continue to find a place in global portfolios. Away from
China, Korean credit has typically enjoyed substantial global credit sponsorship, but with
low net supply and tight valuations, the opportunity looks limited to diversification needs.
Among Chinese private sector corporates, we expect real estate companies to be stable,
given improving fundamentals and a supportive technical backdrop. Chinese internet
companies also appear attractive in pockets.
4 December 2015
171

Indonesia and India came under pressure during the 2013 taper tantrum. Since then, both
countries have gone through a political cycle ending with a positive shift in government. On
the policy front, both have built external buffers and shown improved policy responses to
external pressures (through structural policy changes), although India has done more on
structural reforms than Indonesia. Given this, we do not expect high grade credit in these
countries to be pressured by a Fed lift-off. The ratings trajectory for India remains positive
and stable for Indonesia. Compared with global EM peers, we think both countries are
stronger in terms of external vulnerability and macro dynamics. Therefore, we expect EM
allocations to be supportive for these segments even as the overall pool of EM flows slow.
FIGURE 8
Sector statistics
Asia HY corps
(ex-China prop)
China HY
property
China IG
property
China IG
SOEs
China
internet
China/
HK financials
Financials exChina/HK
Amount Outstanding,
USD bn (*)
55.2 (62%)
34.2 (38%)
19.1 (4%)
82.3 (17%)
18.2 (4%)
74.3 (15%)
78.4 (16%)
2015 YTD issuance,

USD bn (^)
8.7 (15%)
7.1 (21%)
2.2** (12%)
24.7 (40%)
3.3 (22%)
32.6 (76%)
14.7 (18%)
Index Rating
BA3/B1
BA3/B1
BAA2/BAA3
A1/A2
A1/A2
A3/BAA1
A2/A3
OAS (bp)
609
606
243
173
153
176
134
OAD
3.57
2.50
4.60
5.80
4.63
4.14
3.62
Note: * Size as proportion of benchmark index. Benchmark for IG sectors is the EM Asia USD High Grade Credit index, while benchmark for HY sectors is the EM Asia
USD Credit Corporate HY index. ^ Gross index-eligible issuance as proportion of size of sector at end-2014. ** Includes Global Logistics Properties bond issuance.
Note: As of 1 December 2015. Source: POINT, Barclays Research
4 December 2015
172
Latin America and EEMEA Credit

Strategy
4 December 2015
173
LATAM/EEMEA CORPORATE CREDIT
Valuations will recouple with fundamentals

We expect 2016 to be a tough year for LatAm and EEMEA corporate credit: our forecast
is for excess returns of 0%. To put this in context, our return forecast for LatAm/EEMEA
is the lowest among the 12 segments we cover within our global corporate credit
strategy team. This weak performance will be driven by five forces:
Aziz Sunderji
+1 212 412 2218
aziz.sunderji@barclays.com
BCI, US
The macro and sovereign backdrop will likely remain weak and some large sovereigns
Badr El Moutawakil
such as Turkey and Brazil could be downgraded.
+44 (0) 20 7773 2902

badr.elmoutawakil@barclays.com
Barclays, UK
Ongoing low commodity prices should continue to degrade company fundamentals.

Some protective buffers have been eroded. Vulnerability is therefore higher than a
year ago.
Technicals are set to deteriorate: refinancing needs are rising, while liquidity is
becoming increasingly scarce and expensive.
Valuations are not sufficiently rewarding, especially compared with US credit.

Despite this challenging outlook, we think there are still sensible longs in more resilient
countries and companies.
Our key forecasts and recommendations

Supply: We expect supply to rise moderately, to about $90bn (2015 YTD $80bn),
especially in the second half of the year, as companies look to prefinance 2017 maturities.
Defaults: LatAm/EEMEA corporate defaults on an issuer-weighted basis should almost

double from the current 3.8% to 6.5-7%, but driven by smaller companies. Our parweighted default forecast is a more benign 3.8%15 (vs. 2.7% in 2015).
Country risk: Geographically, our preferred countries are Mexico, Peru, and Russia. Brazil
and Turkey are more vulnerable; we expect both to receive further downgrades in 2016.
FIGURE 1
Fundamentals are deteriorating: Leverage will remain above
historical levels if our commodity forecasts are realized
FIGURE 2
Valuations are not sufficiently rewarding: LatAm/EEMEA
spread ratios vs US credit are back to long-run median levels
Net debt /EBITDA
2.2
3.3
2.0
2.3
2.1
1.9
1.8
2.8
1.7
1.5
1.6
2.3
1.3
1.4
1.8
1.1
0.9
1.2
0.7
1.0
Q2-15
Q4-14
Q2-14
Q4-13
Q2-13
Q4-12
Q2-12
Q4-11
Q2-11
Q4-10
Q2-10
Q4-09
1.3
0.5
'10 '11 '12 '13 '14 '15
BBB
'10 '11 '12 '13 '14 '15

BB
Note: the comparison is based company ratings at each point historically (which
may be different from the rating today). Source: Barclays Research
15
3.1% at the index level. Our 2016 default forecast is described in detail in Global EM Corporate Credit: Rising defaults
will continue in 2016. Most large HY companies are quasi-sovereign, and we do not think any of those will default.
4 December 2015
174
Sectors: Banks in every major EM country outperformed non-financials in 2015. We

think financials will come under more scrutiny in 2016. We recommend underweighting
those that trade tight to their sovereign and/or may experience fundamental
deterioration. In the commodity space, we think oil companies (such as LUKOIL) are
likely to fare better than miners (such as CDEL).
Trading themes: We recommend shorting/underweighting richly valued commodity

credits (TAQAUH), domestically focused companies in slow-growing economies
(EVRAZ, AEFES), banks that are too compressed to their sovereigns (BCOLO), and firms
that are overly shareholder friendly (PGILLN). We prefer commodity credits where
fundamental buffers are still strong (SCCO), and domestically oriented names in
stronger economies (AMXLMM).
Our excess returns forecast for 2016 is 0% for LatAm and EEMEA corporate credit. Spreads
should widen from current levels (by 75bp in our forecast), but two factors should keep
returns from falling meaningfully into negative territory:
Carry remains relatively insulating. LatAm/EEMEA spreads are in the top 15% of
historical levels since 2007. This cushion should offset the widening of 75bp we expect
over the coming year. Of course, if our spread widening forecast is too conservative,
carry will not be able to keep excess returns from turning negative. This is not a tail risk.
Based on current valuations, breakeven spread widening after incorporating a
conservative estimate of defaults is 80bp. There has been at least 80bp of widening in
more than one-third of y/y spread changes observed since 2007 (based on monthly
samplings in LatAm/ EEMEA credit).
Governments are standing behind their companies, especially the 40% of the market
comprising quasi-sovereigns. In particular, governments generally safeguard their quasisovereigns (which is where the worst deterioration has been) from default risk. This is
the main reason our 2016 par-weighted default forecast is only incrementally higher
than todays level, despite ongoing low commodity prices and an aging credit cycle16.
FIGURE 3
Our LatAm and EEMEA corporate credit returns forecast
All
IG
HY
Current Spread (bp)
500
300
825
End 2016 forecast
575
350
925
Duration
5.0
6.0
4.0
Treasury yield change
+60
Assumed recovery Rate (%)
25
--
25
Price
96
--
87
1.25%
--
3.1%
100
--
225
2016 Excess return (%)
-1.0
2.25
2016 Total return (%)
-1.5
-2.5
0.5
Assumed default rate

Credit loss (bp)
Our forecast for LatAm/EEMEA is the lowest of the 12 segments we cover in global
corporate credit. We elaborate on the five key drivers behind our forecast.
16
4 December 2015
For context, our par weighted US high yield 2016 default forecast rises more (from 2.5% to 4-4.5%)
175
Driver 1: The sovereign foundation for EM corporate/quasi

risk is weaker
EMs vulnerabilities today are different than they have been historically. In the past, large
sovereign debts in foreign currencies have become unsustainable, leading to capital controls,
bank runs, and defaults. Today, no country that hosts a large corporate bond market is in such
a position. The bulk of debt is now issued by companies not governments (the USD corporate
bond market is now twice as large as the USD sovereign bond market), and the largest issuers
have USD revenues. But theres the rub: EM companies have revenues in USD because they
are exporters, mainly of commodities. The risk exposure has therefore shifted from sovereigns
to corporates. The vulnerability has shifted from USD exposure to commodity exposure.
In this respect, EM is more vulnerable than DM: not only does a greater proportion of the EM
market comprise commodity producers (~40%) than US IG (~15%) or US high yield (~25%),
but EM economies are much more interlinked with commodities than developed market
countries. Here, we explore the myriad ways lower commodity prices are affecting countries
and weakening the sovereign foundation for taking EM corporate credit risk. We also highlight
the countries that are poised to make it through this period better than others.
Growth effect
Figure 4 shows just how meaningful the recent slowdown has been in a historical context.
Using a basket of the largest EM countries today and weighting each ones contribution to
overall EM growth by the size of its economy in each year, we can see that the recent
slowdown is highly anomalous outside of global recessions. This is perhaps the most
foundational and broad-reaching effect of lower commodity prices.
FIGURE 4
EM economic growth has rarely been this low outside of global recession periods
10
Grey boxes denote

global recessions
Median non -recession

growth rate
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Note: Based on average growth rate of Brazil, Russia, India, China, Turkey, Korea, South Africa, Argentina, Mexico. Each
countrys contribution to the global EM growth rate weighted by the size of the economy in that year. Global recessions
identified by the IMF. Source: Haver Analytics, Barclays Research
It is not the direct effect of lower prices (which would come through net exports) that is
dampening growth because imports have in many places contracted even more than
exports and because trade remains a smaller component of EM GDP. Instead, the
component of growth that has contributed the most to the slowdown is investment.
Unsurprisingly, companies are scaling back in an environment of low prices and low growth.
This parallels the drop in corporate bond issuance, which is running at 65% of the last 5y
average levels.
4 December 2015
176

The outlook is not encouraging. This year, global EM growth is likely to end up at 4.1%. Next
year, we expect this to accelerate very modestly, to 4.4%. Indeed, the most timely coincident
indicators of economic activity have yet to recover: PMIs show depressed (though stable)
levels. Large contributors to EM growth such as China are below 50, indicating contraction in
manufacturing activity. Our growth forecasts are most below consensus in Brazil, Colombia
and Qatar.
FIGURE 5
Russia is the only EM country where manufacturing confidence is positive and growing
3m change
3
2
Korea
Russia
Taiwan
China
Turkey
-1
Singapore
-2
India
-3
Brazil
Poland
SOAF
Czech
-4
42
44
46
48
50
52
54
56
Current manufacturing business confidence

Source: Haver Analytics, Barclays Research
The less timely but slow-burning indicators that tend to move in the same direction for
multiple quarters if not years at a time also suggest cause for tempered growth expectations.
Key long-run indicators suggest EM conditions will remain tough

Tightening lending standards
In the US, lending standards from senior loan officers are a strong predictor of growth
and HY default rates. EM does not have any single data series going back far enough to
establish predictive ability. Nevertheless, the signs are not good: the IIFs series shows a
sharp tightening in standards, especially in Latin America. This is being driven by many
factors, especially low demand for loans, tighter funding conditions, and expectations
of higher non-performing loans. The data do not bode well for growth or defaults.
Global EM bank lending standards
Credit loosening Credit tightening
60
55
50
45
40
Q3 15
Q2 15
Q1 15
Q4 14
Q3 14
Q2 14
Q1 14
Q4 13
Q3 13
Q2 13
Q1 13
Q4 12
Q3 12
Q2 12
Q1 12
Q4 11
Q3 11
Q2 11
Q1 11
10Q4
10Q3
10Q2
10Q1
09Q4
Source: IIF, Barclays Research
4 December 2015
177

Rising unemployment, declining real wages
Though unemployment is a lagging variable, it has a long cycle: once it turns, it tends
to go in the same direction for quarters, if not years. Troublingly, unemployment is
rising in many large EM countries, especially Brazil and Russia. Moreover, weaker
currencies and imported inflation amid weak domestic growth are leading to declining
real wages. A weak consumer has implications for the health of domestically focused
companies and banks. Indeed, loan books are deteriorating in these regions, due partly
to the consumer and not just corporates suffering from weaker commodities.
Fiscal effect
Lower commodity prices are also having a large effect on fiscal dynamics. In many countries,
commodity exporting companies (mostly quasi-sovereigns) are major contributors to
government budgets. The oil & gas sector contributes 60% to government revenue in Abu
Dhabi, 50% in Russia, 30% in Mexico, and 20% in Colombia. In Chile, copper accounts for
20% of government revenue. In many countries, though external debt is low, government
debt is higher than it has been in the post-crisis era and governments are being pressured to
cushion the downturns with more spending even as they take in less revenue. This is
especially problematic for those facing elections or generally discontented populations. The
implication for quasi-sovereigns is that their sovereign backing is not as strong as it once was.
In some cases quasis are being pulled into sharing more of the fiscal burden; the recent
windfall tax on Russian oil and gas companies is a case in point. We do not think any major
quasi-sovereign will fail for lack of government support, but we do think this is yet another
source of pressure on EM companies, especially quasi-sovereigns.
Ratings effect
Most governments have low external debt, so default risk is low. Deteriorating fiscal dynamics
are a slow-burning problem. The more acute concern is that in some cases, the deterioration is
resulting in sufficient erosion (typically along with other factors, especially tricky politics and/or
geopolitics) that rating agencies are downgrading sovereigns. What is particularly worrying is
that the sovereigns most at risk of being downgraded are the ones that never made it that far
into IG territory to begin with.
FIGURE 6
The long-running sovereign upgrade cycle, which pulled so
many corporates into IG, has reversed
USD bn
Sovereign rating each

year starting in 2006
Upgrade
150
Current rating in
dark blue
High
Yield
FIGURE 7
pulling corporates back down into high yield
100
50
0
-100
Investment
Grade
-150
-200
Downgrade
-50
$175bn of EM corp/quasis
downgraded due to sov rating
action
-250
'07
'08
'09
'10
'11
'12
'13
'14
'15
Corporate rating change due to corporate specific factors
BR
COL
4 December 2015
MEX
PER
RUS
SOAF
TURK
Corporate rating change due to sovereign rating change

178

As they do so, they pull corporates and quasi-sovereigns down with them. In 2015, most
Russia and Brazilian companies fell into high yield not primarily from any fundamental
deterioration (though this was also occurring), but because the country ceiling was
downgraded. Index exclusion following a sovereign downgrade remains a critical concern
for some Brazilian issuers that remain IG but will fall into HY with a Fitch or Moodys
downgrade to the sovereign, such as BANBRA, BNDES, CAIXBR, BRAKSM, or EMBRBZ.
Turkey is in a similar situation: with a sovereign downgrade from Moodys or Fitch, the
sovereign and its banks would be excluded from global IG indices17.
Fallout from weaker currencies

Weakening terms of trade for EM countries, exacerbated in some cases by capital outflows,
are causing drastic falls in EM currencies.
Overall, this has been a major help for EM corporates: EM commodity exporters have the
majority of revenues in dollars but costs in local currencies, so benefit from weaker FX. This is
an important advantage for EM commodity producers over their DM peers (along with quasisovereign status in some cases and generally lower costs). Indeed, one of our concerns for
2016 is that commodity prices could continue to fall without a concurrent drop in EM FX. This
is perhaps a growing risk as EM currencies though not as weak they have been during EM
crises historically are now in some cases substantially undervalued, according to our fair
value models (Figure 8). Nevertheless, so far, weaker currencies have overall been helpful.
But there are some specific ways in which weaker currencies are also causing having
important negative effects. We highlight three:
It is resulting in imported inflation. Global EM inflation has risen to 5.1% in 2015 and is
now above target in Brazil (8.9%), Russia (15.5%), and Turkey (7.6%). This is
complicating the central bank policy response. In a stagflationary environment, the
incentive is to cut rates to support growth and keep the currency weak to help fiscal
balances and exports. But this also results in more inflation, and the potential for
financial instability from a weak currency. There is no easy solution. Just as the fiscal
policy response is hampered by already large deficits and higher debt burdens (albeit in
local currencies), the monetary policy response is being constrained by weak currencies
and inflation.
Weak currencies also have a direct effect on some corporates, though we argue this is
exaggerated and affects only a small proportion of the market (see Emerging Market
Credit: Rapid Growth, Larger Size: Putting the Risks in Context). But companies such as
Efes, Coca Cola Icecek, Turk Telekom, VimpelCom, TMK, Russian Railways, Petrobras,
Gol, and Oi have at least moderate mismatches (debt/revenue/costs) that are causing
them some pain.
Banks could also be affected. Most do not have material open FX positions on their
balance sheets, but some (eg, Turkish banks) use a lot of external funding which could
become more expensive to repay with depreciating domestic earnings. Capital ratios could
also suffer from FX volatility: FX-related RWAs increase when the local currency
depreciates, if the proportion of capital held in USD is lower than the ratio of RWAs in USD,
capital ratios fall amid currency depreciation. NPLs could also rise as loans extended to
local borrowers in USD may be vulnerable to asset quality deterioration if the borrowers do
not have FX streams of revenue or hedges in place. The system that appears most
vulnerable to these risks is Turkey (especially the weaker capitalised Vakifbank and Yapi
Kredi). Though there are various mitigants in place, it seems likely that, at the very least,
17
The Brazil and Turkey sovereigns would be excluded from both the Barclays Global Aggregate index and the more
widely followed Barclays US Aggregate index. At risk corporates/quasis appear only in the Global Agg index, with the
exception of BANBRA 3.875% 2017s and 3.875% 2022s, and BRASKM 6.45% 2024s, which are also in the US Agg.
4 December 2015
179
FIGURE 8
By some metrics (our BEER model results shown here), most
LatAm currencies now fundamentally undervalued: it is not
clear if they will depreciate more with weaker commodities...
Currency misvaluation according to our BEER model
FIGURE 9
and considerations such as financial stability and inflation
may induce tighter policy, leading to stronger currencies
Consideration
Cut
30%
Growth
20%
Fiscal balance
10%
Exporters
0%
-10%
-20%
Hike
Financial stability
Inflation
-30%
-40%
-50%
BRL
COP
MXN
CLP
Now
Jun-99
Note: The details of our BEER model can be found here.

TRY
RUB
Source: Barclays Reseach
funding costs could increase. Peruvian banks are also at risk in this respect. Though
external funding is virtually nil, roughly 50% of their assets and liabilities are dollardenominated. The proportion of lending in USD has collapsed recently, reducing FX credit
risk, but it is still relevant in our view (see EM Banks: Peruvian Banks 1H15 Results:
Recovery to support banks' results but not necessarily bond valuations).
So which regions look safest and riskiest?

Taking all of these factors into consideration, in our view, the safest jurisdictions in LatAm
and EEMEA for taking risk are:
Peru, which is a mining-dependent economy but has been able to overcome falling
prices by increasing production (Figure 22). We expect Peru to grow the fastest among
LatAm countries in 2015 and again in 2016. The country has enormous FX reserves, and
a former weakness bank lending in USD has been at least partially addressed. With
lower inflation and stronger fiscal metrics than LatAm peers, Peru has the policy
flexibility to deal with a period of continuing low metals prices, in our view.
Mexico, which remains a rare EM country that is tied to a developed market (the US)
rather than China and whose economy is geared towards manufacturing rather than
commodities. Moreover, though the government derives a quarter of revenue from oil,
central bank gains from the depreciating MXN and extensive oil hedges mitigate this.
We believe energy reform will continue to progress, albeit with more favourable terms
for investors and less favourable terms for the government. This should continue to
bolster growth.
Russia, where the recession appears to be nearing the bottom of the cycle. The recovery
is likely to be very shallow, particularly if oil prices stay low for an extended period and
recover only partially. But financial markets have stabilised, and the CBR has finally rolled
its 12m FX repo facility, removing a tail risk for local demand (Russia credit: Linking
banks' FX liquidity to local demand for Russian Eurobonds). Commodity exporters
balance sheets remain resilient, and the significant correlation between the RUB and oil
prices continues to be a natural hedge for the energy companies.
4 December 2015
180

We think the most vulnerable areas are:
GCC: In the Middle East, low oil prices continue to weigh on external and fiscal positions,
weakening sovereign balance sheets and eroding reserves and buffers. This has led to
significant drawdown of government deposits, leading to tightening liquidity in banks,
which is weakening the local bid that has underpinned tight GCC valuations for several
years. This is one of our long-standing fears that now appear to be crystallizing (see GCC
Macro and Credit Update: Reassessing the 'safe haven' status, March 2, 2015). Higher
sovereign and bank supply and further rating downgrades are additional pressures.
Brazil: We expect a downgrade from Moodys or Fitch (the two agencies that still have
Brazil as IG) before the end of H1 16. The probability of default is low because Brazil has
low hard-currency debt service costs and high hard-currency reserves, but economic
and political momentum is deeply negative. Moreover, technical fears due to potential
forced selling and the lack of positive political or economic catalysts will likely linger on
the credit. For corporates, our biggest concern is the expanding Lavo Jato investigation
that continues to ensnare more companies, the systemic risk from Petrobras (even
though in our baseline forecast the government backstops the company if and when
needed), and the risk of the sovereigns repricing meaningfully wider on a downgrade.
Turkey: The election outcome has reduced near-term domestic political uncertainty.
However, given the risks to the medium-term outlook and following the election-related
outperformance of Turkish spreads, we maintain our underweight recommendation on
Turkish sovereign credit. Turkish corporates are in decent shape, but we are more
concerned about the banks. Overall, despite pockets of fundamental resilience, we think
the whole Turkey credit complex, including corporates, will widen if sovereign spreads
come under pressure.
4 December 2015
181
FIGURE 10
Key statistics for countries hosting large corporate bond markets in LatAm and EEMEA
LATAM
EEMEA
Brazil
Mexico
Chile
Colombia
Peru
Russia
Turkey
SOAF
UAE
Qatar
Barclays 2016 GDP forecast (% y/y)
-2.8
2.5
2.3
2.1
3.8
0.0
2.9
1.8
3.5
5.0
Consensus 2016 (% y/y)
-1.2
2.8
2.5
2.9
3.9
0.2
3.0
1.7
3.4
5.4
2015 GDP (% y/y)
-3.8
2.5
2.0
2.7
3.1
-3.7
2.8
1.4
3.4
4.3
Fuel % of exports
9.2
10.7
0.9
69.4
14.5
71.2
3.8
11.0
64.8
87.8**
Ores and metals % of exports
14.4
2.9
56.4
1.1
45.8
4.7
4.1
25.9
0.9
0.3
Openness (trade as % of GDP)
26.0
66.0
66.0
38.0
46.0
51.0
60.0
64.0
186.0
82.0
-0.4
-1.1
3.3
-2.4
-0.1
2.0
-5.1
-5.9
Economy
Vulnerability
Current Account + FDI (% GDP, 4Q trailing)
Gross external debt (USD bn, 2016f)
364
470
149
108
67
486
365
134 (15)
281
143
External debt ( % GDP)
29.6
34.3
57.9
26.0
3.1
36.7
52.5
40.6
71.8
79.9
International reserves (USD bn, 2016f)
369
183
42
46
59
396
105
52
86
45
105.4
42.6
26.1
47.7
97.7
30.6
34.3
32.6
30.6
31.4
Primary Balance (% GDP), fc 2016
-1.1
-0.5
-2.0
-1.5
-0.5
-2.3
0.4
0.1
-1.9
-1.8
2016 Barclays Fiscal strength score
4.25
5.00
6.50
5.75
6.25
7.25
5.25
4.25
World Bank governance score, 2016
Credit growth (%), latest reading
12.0
5.9
10.8
12.4
16.8
16.0
16.5
9.5
3.6
13.0
Credit growth 10y Avg
15.4
7.6
11.4
14.7
11.9
24.6
20.7
10.8
24.0
30.3
-3.4
-1.7
-0.5
-2.4
6.7
-8.6
-4.2
-1.2
-20.4
-17.3
Complex YTD total return (%)
-7.1
-2.1
0.5
-7.0
-0.3
23.9
1.1
0.7
1.9
3.6
Complex OAS (bp)
609
291
258
410
243
250
277
358
183
121
Sov: 10Y OAS estimate
420
153
84
230
173
340
256
260
141
95
120
FX reserves as % of External debt

Fiscal
Banking system
Difference
Valuations
Sov: 10Y CDS

Sov: S&P rating
Sov: Moody's rating
Sov: Fitch rating
450
204
162
276
232
316
299
308
252
BB+ NEG
BBB+
AA-
BBB
BBB+
BB+ NEG
BB+ NEG
BBB-
AA*
AA
Baa3
A3
AA3
Baa2
A3
Ba1 NEG
Baa3 NEG
Baa2
Aa2*
AA2
BBB- NEG
BBB+
A+
BBB
BBB+
BBB- NEG
BBB-
BBB NEG
AA*
--
Quasi: average OAS
664
307
246
376
227
377
345
518
185
138
Corp: average OAS
683
377
304
810
310
489
312
420
211
142
Note: *UAE rating is based on Abu Dhabi. ** Qatar export as relative to Natural gas. For UAE and QATAR, current account balance is ex-FDI.*** Source: Bloomberg, Haver Analytics, WDI, World Bank, National Statistics offices,
Moodys, S&P, Fitch, Barclays Research. Prices as of Dec 1 2015.
4 December 2015
182
Driver 2: Low commodities weakening fundamentals

The popular image of the EM corporate credit asset class has been thoroughly tarnished over
the past year. That said, identifying the correct drivers of the deterioration is important. Not all
segments are as tarnished as others, and understanding the drivers has asset allocation
implications. For example, FX mismatches are concerns for only for a relatively small subset of
the asset class (as argued above). More bond issuance has also not been problematic: EM
companies have historically been less leveraged than US companies at the same rating. From a
macro perspective, EM capital markets are disproportionately small compared with the
contribution of these economies to the stock of global GDP (see Emerging Market Credit:
Rapid Growth, Larger Size: Putting the Risks in Context, March 27, 2015).
Instead, the problem lies in the expansion of the asset class combined with the drop in
commodity prices. More bond issuance was not a problem until the end of 2014. At that
point, commodities plunged and EBITDA began to contract. While metals prices had been
steadily declining, it was the sharp drop in oil that had a major effect, as 29% of the asset
class is oil producers, while only 9% is metals and mining companies.
Thus, it is not really FX mismatches, or more issuance alone, that are the sources of the
deterioration in EM credit (proxied by rising leverage). It is the denominator in the net
leverage equation, ie, earnings, which have plunged since mid-2014 (~20%) and caused net
leverage to rise by 0.5x.
We forecast commodities staying low, with only oil recovering, and only modestly, and even
then not really until the second half of 2016 (see Commodity Markets Outlook: A drawn-out
bottom). To that end, we expect much of the 2015 fundamental deterioration story to
continue to unfold over 2016.
FIGURE 11
FX mismatches affect only a small part of the market: The
EM corporate bond market by sector (sectors in dark blue
benefit from weaker FX)
Basic Mats
9%
FIGURE 12
The expansion of the market is in itself not problematic: EM
capital markets remain small compared with EM GDP
Utills
8%
Developed
Market
bond
53%
TMT
8%
Energy
25%
Industrial
5%
Fins
36%
4 December 2015
Consumer
6%
Developed
Market
stocks
30%
Diversified
3%
Emerging
Market
bonds
11%
Emerging
Market
stocks
6%
183

FIGURE 13
The fall in commodity prices will not soon be reversed
Copper
Units
2012
y/y
2013
y/y
2014
y/y
2015
2016
forecast
y/y
12-16
drop
US$/t
7948
-8%
7326
-6%
6865
-20%
5504
2%
5625
-29%
Gold
US$/oz
1668
-15%
1412
-10%
1266
-8%
1159
-9%
1054
-37%
Silver
US$/oz
31.1
-23%
23.8
-20%
19
-15%
16.2
-2%
15.8
-49%
Platinum
US$/oz
1547
-4%
1483
-7%
1379
-20%
1110
4%
1150
-26%
Palladium
US$/oz
641
13%
723
11%
799
-8%
735
5%
775
21%
WTI
US$/bbl
94
4%
98
-5%
93
-45%
51
16%
59
-37%
Brent
US$/bbl
112
-3%
109
-8%
100
-44%
56
13%
63
-44%
US$/mmbtu
2.82
32%
3.73
14%
4.27
-35%
2.76
7%
2.95
5%
US Nat Gas
Note: We do not officially forecast iron ore, but our mining analysts assume $56/t in 2015 and $50/t in 2016, ie, a falling fundamental fair value. See Commodity
Markets Outlook: A drawn-out bottom. Source: Bloomberg, Ecowin, Barclays Research
The effect of all of these factors the direct hit from commodities and the indirect hit of
slower growth is tangible in EM corporate fundamentals.
Leverage
EM companies have been steadily leveraging up since 2010. This reflects, to us, open capital
markets amid strong EM fundamentals and supportive developed central bank liquidity
programmes. Indeed, funding costs were falling during this time: the average yield to worst
was below the average coupon for almost all of 2010-14. But this increase in leverage was not,
until recently, troublesome. EM companies started from a low base of leverage and were less
leveraged than their US peers at every rating level.
But that has now changed. The sharp drop in oil at the end of 2014, combined with the fact
that almost a third of the global EM corporate market comprises oil producers, has resulted
in EM leverage soaring, in absolute terms and also in relation to US peers. Whether looking
at aggregate markets (EM vs. US IG and US HY), broken down by rating bucket, or on a
ratings-matched basis (EM vs. a rating matched combination of US IG and HY), EM has
fundamentally underperformed US peers.
FIGURE 14
EM leverage increased faster in EM than DM over the past couple of years in As, BBBs, and Bs
DM
EM
2.9
B rated leverage ratio
EM
6.2
3.7
5.7
3.2
2.5
4.7
4.2
2.3
3.2
2.1
2.2
2.7
2.2
2015LTM - Q2
1.7
2014
2015LTM - Q2
2014
2013
2012
2015LTM - Q2
2014
2013
2012
2011
1.7
2010
2015LTM - Q2
2014
2013
1.7
2012
1.7
2011
1.9
2010
1.9
3.7
2011
2.1
2.7
2010
2.3
EM
5.2
2.7
2.5
DM
2013
2.7
DM
2012
EM
4.2
2011
DM
BB rated leverage ratio
BBB rated leverage ratio

3.1
2010
A rated leverage ratio

2.9
4 December 2015
184
Rising defaults will continue in 2016

One consequence of the weaker macro environment is a rise in the default rate. In 2015,
defaults in emerging markets have come from various regions, driven by a range of factors.
Lower commodity prices, weaker growth, FX volatility, more stringent bank lending
standards and fraud have all been important drivers. This year, Kaisa Group, OAS
Investment, Ukreximbank, DTEK Finance and Berau Coal Energy have been among the
largest EM corporate defaults on hard currency bonds.
These deleterious trends will likely continue to drive the EM default rate higher. We expect
commodity prices to remain under pressure. Meanwhile, growth should pick up only slowly
and unevenly, and the Fed lift-off will likely lead to a continuation of FX volatility.
Furthermore, the most recent studies show that EM bank lending conditions tightened in
Q3 15 to their weakest level since Q4 11 and that some banks have had a significant rise in
NPLs. Domestic and external funding conditions also worsened. We believe that these
factors, alongside a higher cost of funding, will contribute to higher EM defaults in 2016.
Our methodology for forecasting defaults is based on a screen of the EM high yield
universe. We identify companies that meet four out of five fundamental and price-based
criteria indicating a degree of distress these criteria are shown in Figure 17. We calibrated
the criteria to reflect the characteristics of companies that have historically defaulted.
In our central scenario based on this methodology, the global EM corporate high yield default
rate rises to 6.5-7.0% (issuer-weighted). This is above the long-run average EM HY default
rate (4.1%), substantially above the current LTM default rate (3.8%), and above our 2016
default forecast for US HY (5.0-5.5%, see US Credit Focus: 2016 Default Outlook). For
EEMEA/LatAm, we expect the issuer-weighted default rate to reach 7.6% of the HY universe
(vs 3.8% now), while the par-weighted rate should be close to 3.8% (vs 2.7% now).
FIGURE 15
Leverage has soared since the middle of 2014
FIGURE 16
and earnings continue to fall as commodity prices tumble
Quarterly EBITDA, Y/Y changes
Net debt /EBITDA

3.3
2.8
2.3
1.8
Commodity prices
30%
140
20%
130
10%
120
0%
110
-10%
100
-20%
90
-30%
Source: Moodys, Bloomberg, Barclays Research
4 December 2015
Q2-15
Q4-14
Q2-14
Q4-13
Q2-13
Q4-12
Q2-12
Q4-11
Q2-11
Q4-10
Q2-10
Q4-09
1.3
80
Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q2-15 Q3-15
EBITDA change
Bloomberg Commodity index (RHS)
Source: Moodys, Bloomberg, Barclays Research
185

FIGURE 17
Criteria for establishing risk of default
Cash/ST debt
below:
Price below:
Yield to Worst
higher:
Type of
company
Rating below:
70%
75
7.0
Private only
Central
85%
80
6.5
Private only
CCC
Less stringent
100%
85
6.0
Private + Quasi
Criteria set
Stringent
We also calculate pessimistic and optimistic variants of our central forecast by using more and
less stringent criteria, respectively. The outlook is asymmetric: in our optimistic scenario, the
default rate falls modestly, to 2.2%, but in our pessimistic scenario, it surges to 16%.
Our par-weighted (ie, by the debt outstanding of the issuer) forecast is substantially lower
than the issuer-weighted forecast (ie, each issuer carrying an equal weight). In other words,
we expect a similar volume of debt to default in 2016 as in 2015, but a much higher number
of credit events.
The reason is that the smaller issuers are particularly at risk:
FX risk is more of a problem for smaller companies. Investors have generally been
reluctant to lend large amounts of dollars to companies that have no natural dollar
revenue streams. Those that tend to have access to dollars are typically large commodity
exporters, and those that lack dollar revenues tend to be smaller (with less debt).
Smaller companies have fewer avenues for liquidity. This is especially a factor in Asia,
where liquidity is critical to distinguishing high yield property companies.
Most of the larger high yield companies are quasi-sovereigns, which benefit from state
support and as a result have much lower default risk. This is especially true now that
Russian quasis and most Brazilian quasis have been downgraded to high yield.
FIGURE 18
Our global EM corporate HY 2016 default forecasts: the
outlook is asymmetric to the downside
20.0%
16.0%
16.7%
5.0%
14%
12%
15.0%
10.0%
FIGURE 19
In our central scenario, defaults rise much higher than the
2012-15 average rate, but remain below 2009 levels
10%
Current LTM
default rate
8%
6.7%
2.2%
4.3%
3.8%
6%
4%
0.0%
Par
Issuer
Par
Issuer
Par
Issuer
weighted weighted weighted weighted weighted weighted
Optimistic
Central
Pessimistic
Note: Current LTM default rate refers to the issuer-weighted rate. Forecast
based on all EM HY HC universe, not only for index-eligible securities.
4 December 2015
2%
0%
2009
2012-2015 Average
Par Weighted
2016 Forecast
Issuer weighted
186
Driver 3: Buffers have been run down, vulnerability is higher

Volatility goes both ways, and our approach is to consider that commodity prices may rise
or fall substantially in 2016. But in our view, the effect of a rise in commodity prices would
not be as beneficial as a further fall in prices would be punitive. The reasons are fourfold:
Buffers are lower

First, there has been some weakening in fundamental buffers. Some companies have coped
with the downturn in commodity prices that accelerated at the end of 2014 by funding out
of cash buffers (rather than tapping the market). Cash has also declined due to companies
tendering for bonds that are trading well below par to reduce interest costs and remove
short-term maturities. Overall, we see the aggregate cash in large EM companies as stable
(and higher than it has been historically), but this masks dispersion among the names. Onethird of companies experienced smaller cash buffers in Q2 15 than a year earlier. We think
that if commodity prices drop further, an increasing proportion of companies will fall into
negative free cash flows and have to tap into cash reserves, and those that have already
been doing so will find that buffer less plentiful than it has been.
Second, companies have coped by slashing capital expenditures. In many cases, they were
approaching the end of their natural, pre-planned cycles, but many firms truncated their
multi-year capex plans in response to the deterioration in prices. Indeed, in the aggregate,
capex grew only 3% in Q2 15 y/y, vs. average annual growth of 8% in the prior five year to Q3
14. We think EM firms will find it tough to cut capex further, especially since this would eat
into future production volumes. Moreover, capex cuts risk denting unemployment and growth
and creating wider destabilizing effects. Indeed, this is one tenet of our EM bank analysts in
equities cautious stance on EM banks (see EM Banks: EM corporates - Tough times ahead).
That said, some other buffers remain. EM companies continue to be cost leaders, and this
has been helped by depreciating EM currencies. As a result, many continue to increase
production in their global markets. For example, Peru will bring online the most new copper
volume in 2016, one reason we think the country and its primary producer, Southern
Copper will be better able to cope with the downturn (see Peru: An unusually calm
election year). Meanwhile, companies such as Vale, with almost 100% of revenue in USD
but 80% of costs in BRL, are improving their already impressive position on the global cost
curve. Bloomberg forecasts that Brazil will contribute one-quarter of new iron ore supply in
2016, largely at the expense of Australia.
FIGURE 20
Overall, corporate liquidity has been stable
FIGURE 21
Companies have already scaled back capex substantially
(Cash + Mkt Sec) / ST Debt
EM Corporate Capex growth (2013 Q2 = 100)
5.0
Note: based on a sample of major EM companies

Source: Moodys. Barclays Research
4 December 2015
2015LTM - Q2
2015LTM - Q1
2014LTM - Q4
2014LTM - Q3
2014LTM - Q2
2014LTM - Q1
2015LTM - Q2
2015LTM - Q1
2014LTM - Q4
2014LTM - Q3
2014LTM - Q2
2014LTM - Q1
2013LTM - Q4
2013LTM - Q3
2013LTM - Q2
2.0
2013LTM - Q4
3.0
2013LTM - Q3
4.0
2013LTM - Q2
108
106
104
102
100
98
96
94
92
90
Note: based on a sample of major EM companies

Source: Moodys. Barclays Research
187
Africa
Chile
Asia Americas Europe

Pacific
Source: Bloomberg
Arrium
Brockman
Citic Pacific
Cliffs Natural
Gindalbie/Ansteel
Peru
Mt. Gibson Iron
Hancock
250
Atlas Iron
Vale
500
Cazaly Resources
750
Timis Mining Corp
70
60
50
40
30
20
10
0
Rio Tinto
1,000
Fortescue
New iron ore supply cash cost
BHP
tonnes of additional copper supply coming online in 2016
Anglo American
FIGURE 23
Vale remains a cost leader
BHP/Vale
FIGURE 22
Peru set to bring on the most copper in 2016
Source: Bloomberg
FX may not weaken uniformly with further price falls

Weakening FX has been a major support for EM companies facing lower commodity prices
and a differentiator vs. DM peers, allowing EM companies to drop costs (in local currency)
and cushion margins. However, this tailwind may not persist. Our FX strategists find that
many commodity currencies are already priced below fair value, according to their BEER
models. Our asset allocation team recently came to a similar conclusion, working from a
different angle (risky asset correlations versus China proxies for growth). A key risk for EM
corporate fundamentals is that EM currencies stabilize (or rally) even while commodities
continue to drop.
This risk may be more acute for companies selling commodities out of countries where the
currency is tied to a different commodity. For example, if our forecasts are realized, oil will
bounce in the second half of 2016 but metals prices will remain low. Petrocurrencies such
as the ruble should rally because they are more correlated with oil than metals. Oil
companies will benefit from higher oil prices, and some of this will be offset by the stronger
ruble. But miners domiciled in Russia will suffer on both fronts: their commodity will not be
experiencing stronger prices and they will be negatively affected by the stronger currency.
We think this is a particular risk for miners more than energy companies because there are
simply more miners in petrocurrency countries than there are energy producers in miningtied currency countries.
FIGURE 24
If oil rallies but metals prices continue to fall, petrocurrencies such as the RUB would
likely rally, which could hurt miners domiciled in such countries
BRL
Copper
Oil
-83%
CLP
PEN
-95%
-93%
RUB
COP
ZAR
KZT
NGN
ZMW
-76%
-97%
Platinum
-91%
-49%
-90%
-93%
Zinc
Silver
Gold
Iron ore
-87%
-69%
-84%
-86%
-85%
Note: 18-month correlation. Source: Barclays Research
4 December 2015
188
Banks to come under pressure, as well

EM banks have outperformed non-financials since the commodity plunge at the end of
2014. This makes sense: one-half of EM non-financials are either energy or metals/mining
companies suffering from falling prices for their output, while EM banks remain at arms
length from the immediate effect of lower commodity prices.
But we believe there are good reasons this could now change, and EM banks could begin to
catch up with their non-financial peers.
First, EM banks are immune to only the first-round effects of lower commodity prices. In
some commodity economies, they are the ultimate lenders to the commodity producers. If
producers come under strain, banks eventually should begin to feel the pressure as well. We
feel that Brazilian banks are particularly vulnerable from this perspective.
Second, FX volatility has reached extreme levels in many EM economies. In all major EM
banking systems, banks are prevented from taking significant balance sheet FX risk
(especially being short dollars). But they retain other forms of deleterious exposure to FX
volatility. Not least, some have lent domestically in dollars to borrowers who may have no
natural or synthetic currency hedge (see our section of FX risks for more details on how
weak currencies could affect banks).
Third, funding sources may come under increasing pressure. Turkish banks are heavily
funded using internationally syndicated dollar-denominated loans. Much of this is at short
tenors. If sentiment towards Turkey sours, this flow of funding may become more
constricted, although banks have historically seen high rollover ratios, including during the
financial crisis.
Fourth, EM credit growth has been slowing for several years. Borrowers who have
historically been able to roll over financing may find it increasingly difficult to do so. This is
taking place while free cash flow generation is slowing. Indeed, pulled funding lines were
the cause of several LatAm defaults this year. This may pressure NPLs upwards. Many of
these borrowers are not widely represented in the bond markets, so such defaults do not
necessarily cause a proportionally equal weight on non-financial bond performance. In
some markets, especially Russia and Turkey, it is not the corporates alone but also
consumers who appear to be driving NPLs higher. Unemployment and NPLs are lagging
indicators, and we may be only at the very beginning of the deterioration.
FIGURE 25
In every major EM country but Qatar, banks have
outperformed non-financials YTD
FIGURE 26
Credit growth has slowed across EM; such slowdowns are
often followed by rising defaults
y/y credit growth rate
YTD total return (%)

25
Current rate
Maximum rate between 2004-09
75%
20
15
50%
10
5
0
25%
-5
-10
-15
Malaysia
Korea
South Africa
Mexico
Brazil
India
China
Indonesia
Saudi Arabia
Russia
Turkey
Russia
China
CORPORATE
Peru
India
Qatar
4 December 2015
Chile
UAE
Turkey
S.Africa
Mexico
Colombia
Brazil
BANK
0%
Source: Haver Analytics, IIF, Barclays Research
189

Finally, bank ratings remain closely tied to that of the sovereign country in which they
reside. This is especially true in emerging markets, where many of the largest banks are
quasi-sovereigns. Thus, as sovereigns are coming under increasing ratings pressure
(Turkey, Brazil, etc), so too should the banks.
We recommend treading lightly in EM banks, but some segments should be more immune
to these headwinds and still offer compelling spreads. In particular, we continue to favour
old-style subordinated bank debt, from the strongest national champion issuers, such as
BBVASM (see EM Corporate Credit Top Picks, September 11, 2015) and VTB 22s. In Russia,
we also believe that banks with excess USD liquidity may buy back some of the new-style
subordinated debt, which continues to trade below par. In this context, we recommend
SBERRU 5.25% 23s, which are also attractive in their own right, offering a 120bp z-spread
pick-up compared with the old-style securities, despite the low risk of conversion.
Driver 4: Weakening technicals

Both the supply and demand sides of technicals are becoming more challenging.
On the supply side, EM companies have a benign maturity schedule in 2016, but a much
more challenging path in the ensuing years. Comparing the current debt profile of the asset
class to that which existed a few years ago (Figure 27), the proportion of debt coming due
within three years is much higher. Companies will likely try to come to market in 2016 to
prefund these maturities.
They may find a less receptive market than they have historically, for several reasons. First, a
greater proportion of EM issuers have dropped into high yield. The HY investor base is a
fraction of the size of the investment grade one. Indeed, the upgrade cycle from the late
1990s until the mid-2000s pulled corporates and quasi-sovereigns into IG and allowed
them to access a wider investor base; that process is now in reverse.
FIGURE 27
The amount of corporate bonds maturing within three years
is twice as high as it was in 2012
EM Corp ex Asia maturity breakdown , since 2012
2012
$61bn
$89bn
$192bn
$45bn
2013
$82bn
$131bn
$280bn
$66bn
FIGURE 28
Corporate redemptions are limited for 2016, but will pick up
in 2017 and 2018
USD bn
equiv
90
80
70
32
32
60
50
2014
$105bn
$125bn
$301bn
$88bn
40
20
30
2015
$126b
0%
$130bn
20%
1-3Y
$278bn
40%
3-5Y
60%
80%
5-10Y
10Y+
Source: Bloomberg, Bond Radar, Barclays Research
4 December 2015
$99bn
100%
20
10
55
48
29
0
2016
2017
EEMEA
2018
LATAM
Note: Accounting for HC bonds only. Source: Bondradar, Barclays Research
190
FIGURE 29
US insurers were adding EM to their portfolios in 2009-13,
but have now stopped
$bn
FIGURE 30
European asset allocators are decreasing their exposure to
EM corporate credit
% of respondents decreasing holdings of EM corporate bonds
600
500
35
400
30
300
25
200
20
100
15
10
0
2006 2007 2008 2009 2010 2011 2012 2013 2Q14 2014 2Q15
US life insurance holdings of EM bonds
5
0
US P&C insurance holdings of EM bonds
2012
Source: SNL financial (includes local bonds)
2013
2014
2015
Note: The findings are based on the views of 4,000 wholesale and institutional
fund selectors in continental Europe, who are buying mutual funds or creating
centralized portfolios for banks, pension funds, endowments, private banks or
funds of funds. Source: Expert Investor Europe
Second, institutional investors, who hold the vast majority of EM corporate bonds, have
turned from buyers on weakness to sellers on strength. This can be seen in the most recent
fund flow data provided by EPFR (see our most recent flows tracker). In our view, this is a
critical and overlooked aspect of the technical picture for EM corporates. We think the
motivation for these fund outflows is the fundamental deterioration in EM corporate
fundamentals, combined with unappealing valuations versus other asset classes (ie,
essentially our thesis in this outlook). While these could turn back into inflows, we think this
would be contingent on a turn in the perceived trajectory for commodities, which we do not
expect, at least in 2016.
Thus, companies will need to come to market in 2016 but will find this more difficult, or at
least more expensive. Indeed, the yield to worst on our EM corporate index now exceeds the
FIGURE 31
For the first time, funding costs for EM companies are going
up rather than down (yield on secondaries > avg. coupon)
%
FIGURE 32
LatAm/EEMEA corporate HC supply reached its lowest level
since 2010, equivalent to 50% of 2014 volumes
USD bn
7.0
200
6.0
160
5.0
120
4.0
92
71
80
3.0
2.0
40
1.0
0.0
Nov-09
68
2010
Nov-10
UST Equivalent
4 December 2015
Nov-11
Nov-12
Nov-13
EM Corp ex Asia OAS
Nov-14
Coupon
91
94
67
99
40
70
59
2011
113
31
2012
2013
2014
2015
EEMEA
LATAM
Potential additional supply for remainder of the year
Note: Data for EEMEA and LatAm for 2015 as of October 2015. The $8bn is an
extrapolation of the Q4 supply trend as a percentage of the full year observed
since 2012. Source: Bondradar, Barclays Research
191

average coupon; in other words, the marginal funding cost for the average EM corporate is
higher than the average. For the first time since the rapid growth of the asset class began in
2010, funding for EM companies is getting more expensive.
Supply outlook
We forecast ~$35bn for LatAm corporates, versus $31bn year-to-date in 2015, and $20bn
of redemptions in 2016. We forecast ~$50bn for EEMEA corporates, versus $40bn year-todate in 2015, and $29bn of redemptions in 2016.
FIGURE 33
LatAm/EEMEA corporate bond hard currency issuance forecast
LatAm
EEMEA
Non-Financial Issuance from Earnings Growth
$10bn
$8bn
Financial Issuance
$4bn
$6bn
Near-Term Maturities
$20bn
$29bn
Offerings from Debut Issuers
$2bn
$10bn
Estimated 2016 Corporate Bond Gross Issuance
$36bn
$53bn
For LatAm, we believe the degree to which Petrobras will be able to access capital market
will be a big determinant of overall volumes. We believe the company can avoid further
tapping the market this year. However, PETBRA will issue in 2016, if possible, given very
meaningful funding needs (see LatAm Oil & Gas: Petrobras (PETBRA): Initiating at
Overweight: From Black Hole Back to Black Gold, October 21, 2015).
Driver 5: Valuations are not sufficiently rewarding

We continue to believe EM credit is overvalued versus US credit. This publication has spelled
out the numerous ways in which lower commodity prices are affecting EM credit, at the
corporate fundamental level and the systems in which EM companies operate, but this has
not been reflected in valuations. EM companies across all rating buckets except single-A
trade at the long-run median spread ratios versus US credit.
Spreads also did not completely adjust for the deterioration of credit metrics: spread per turn of
leverage is lower today than at the end of 2014 for BBBs and BBs (the majority of EM credit).
FIGURE 34
Aside from the A-rated segment, Global EM corporate/quasi spread ratios are back to long run median levels versus US
credit; spread per turn of leverage is a mixed picture, generally much smaller in BBBs but more compelling in Bs
1.7
2.2
1.6
2.0
1.5
1.8
1.4
1.2
1.0
4 December 2015
2.2
2.0
1.8
1.6
1.1
1.2
'10 '11 '12 '13 '14 '15
2.4
1.9
1.3
1.1
0.9
2.1
1.5
1.4
1.0
2.6
1.7
1.6
1.3
2.3
0.9
1.4
0.7
1.2
0.5
'10 '11 '12 '13 '14 '15
BBB
1.0
'10 '11 '12 '13 '14 '15
BB
'10 '11 '12 '13 '14 '15

B
192

Spread per turn of leverage in EM has also been decreasing
DM BBB
EM BBB
182
DM BB
EM BB
252
162
122
102
152
102
42
22
102
52
52
22
2
2014
2015LTM - Q2
2013
2012
2011
2010
2015LTM - Q2
2014
2013
2012
2011
2010
2009
2015LTM - Q2
2014
2013
2012
2011
2010
2009
2009
2014
62
2015LTM - Q2
42
2013
82
2012
62
202
152
2011
82
252
202
142
2010
102
DM B
EM B
302
2009
DM A
EM A
122
Even within some commodity segments, especially miners, EM companies (even standalone
ones) do not look sufficiently compelling versus DM peers. Though EM companies benefit
from weaker FX, they also suffer from residing in economies that face lower commodity
prices, and from a weaker macro and sovereign backdrop.
FIGURE 35
Even standalone miners such as Vale do not yet appear cheap to global peers (in this
simple model, Vale is 100bp too tight, Southern Copper is 50bp too tight)
Spread (bp)
1,800
1,600
FM CN (B)
1,400
TCK (BB+)
1,200
1,000
FCX (BBB-)
800
AA (BBB-)
600
400
200
0
0.00
GLEN (BBB)
VALE (BBB)
SCCO (BBB)
RIO (A-)
BHP (A-)
2.00
CDEL (A+)
4.00
6.00
8.00
10.00
12.00
Gross leverage
To be fair, there is an enormous amount of dispersion within EM right now. In particular,

Brazil is trading extremely wide to US credit. The figures below show current average BBB
spreads and BB spreads across developed markets and all the major EM countries. But it
also shows that, based on long-run trading relationships, most EM segments are too rich.
4 December 2015
193
FIGURE 36
BBB valuations: Where EM BBBs trade versus where they
normally would, based on long-run relationship to US BBBs
850
Fair value for EM BBBs based on long run median

spread ratio to US BBBs
FIGURE 37
BB valuations: Where EM BBs trade versus where they
normally would, based on long-run relationship to US BBs
850
650
650
450
450
250
250
50
50
Fair value for EM BBs based on long run median

spread ratio to US BBs
RUSSIA
BRAZIL
TURKEY
CHINA
COLOM
INDON
PERU
CHILE
MEXICO
INDIA
UAE
ALL EM
USA
EUR
RUSSIA
BRAZIL
TURKEY
CHINA
COLOM
INDON
PERU
CHILE
MEXICO
INDIA
UAE
ALL EM
USA
EUR
FIGURE 38
Corporate versus sovereign differential: middle of the range,
overall
FIGURE 39
with an enormous variation across countries: Mex, Brazil
corps wide to sov, Turkey, Russia tight (4y ranges shown)
165
155
145
Brazil downgrade
Taper tantrum
Russia turmoil
135
125
115
105
95
85
TURKEY
RUSSIA
ALL
COLOM
PERU
INDON
Jun-15
QATAR
Jun-14
BRAZIL
Jun-13
Global EM Corporate vs Sovereign spread
MEXICO
75
Jun-12
Note: Based on 4 years of history. We match each EM corporate to its tenormatched sovereign, if the corporate or quasi is within one rating notch of the
sovereign at each sampling point. We include new issues as they come to
market, but exclude downgraded names from the entire series to avoid
substantial changes in sample constituents over time. Source: Barclays Research
Moreover, we find EM companies to be overvalued versus EM governments. In most

countries, corporates and quasis (ratings matched versus sovereigns) are trading in the
middle of historical ranges. Further compression is unlikely, since corporate fundamentals
are deteriorating.
Strategies: Short themes

The two big sectors: Energy versus Metals & mining
We think energy producers will fare fundamentally better than steel companies and miners:
Our oil outlook is more optimistic than our (and the consensus) metals outlook. We
think oil will bounce 13% between now and the end of 2016. By contrast, we expect
4 December 2015
194

copper to rise only 2% (with risks tilted to the downside). We do not forecast iron ore,
but our mining equity analysts factor in the yearly average price of iron ore dropping
12% in 2016. Indeed, the oil outlook is more tied to supply/demand factors that have a
better chance of correcting sooner than metals, which are more tied to the long run
structural reorientation of the Chinese economy.
Commodity companies facing weaker prices have benefited from depreciating EM

currencies. One of our concerns for 2016 is that commodity prices continue to drop
without currencies following suit. We think this is more of a risk for miners and steel
companies than oil and gas producers. Taking Russia as an example: the ruble is 97%
correlated with oil but only 86% correlated with iron ore. Should those commodities move
in opposite directions, the currency would be more likely to follow oil. In such a case,
Russian miners would come under pressure, energy firms less so. Moreover, there are
many more mining companies in petrocurrency countries than there are energy
companies in countries whose currencies are more tied to metals prices.
Short commodity producers pricing an overly benign outlook

A year after the sharp drop in the commodity complex, energy and mining credits are now
much cheaper. Our base case forecast is for stability in metals and a gradual rise in oil prices.
But downside risk exists in both segments, and we think it makes sense to look to short or
avoid credits that are tied to energy or metals prices but that are still priced for perfection:
TAQAUH is doubly exposed to lower energy prices. First, its oil and gas assets, from which
it derived about 35% of its total revenues in 9M15, have undergone an immediate decline
in profitability and cash flow generation amid lower oil prices. They also face a subdued
outlook due to the investments cuts conceded by the group that will likely affect its
production levels and reserves replacement cycle in the medium term. We expect
TAQAUH's last 12-month net leverage (net debt/EBITDA) of 6.8x recorded as of Q3 15 to
inch further up, above 7.0x at YE15, as a result of its weaker oil and gas EBITDA. Second,
TAQAUH bonds should suffer indirectly from the effect of lower prices on the local
technical bid: Abu Dhabi government deposits were previously flush with proceeds from
lucrative oil exports and used in part to buy local company issuance, particularly from
quasi-sovereigns such as TAQAUH. This technical bid is now fading, as seen in the gradual
repricing of the bonds in the short end of the curve in the past few months. Though a
systemically important quasi-sovereign in a strong jurisdiction (Abu Dhabi), TAQAUH,
trading below 250bp (60bp through PEMEX, another oil quasi sovereign in an A-rated
jurisdiction), is not pricing in these twin threats from lower oil, in our view.
With higher cash costs (C1 of $1.36/lb in Q1 15), declining ore grade and the need to spend
to maintain its production from falling, Codelco screens as the least prepared to lower
copper prices. Were copper prices to fall to an average of $1.59/lb in 2016, CDELs EBITDA
would turn to negative $108mn and its debt load would become unsustainable. Moreover,
its net leverage metrics would come under significant pressure even if copper were to
average at $2.27/lb in 2016, even when no dividends and no growth capex are assumed.
PEMEX: Low oil prices have been compounded by a fall in production that has led to
leverage increasing more than 1.0x since YE14. Production challenges will likely be
exacerbated by the need to reduce capex in the short and medium term to avoid
increasing the debt burden even further. Despite being one of the lowest-cost producers
globally and well positioned to benefit from Mexicos long-awaited energy reform,
management has estimated that every USD1/bbl decrease in oil price results in a
USD164mn decrease in aggregate top line results. $5/bbl lower, for example, would
represent over a 15% reduction in quarterly EBITDA.
4 December 2015
195
Short domestically oriented companies in economies that have slowed: they

have both earnings and FX risks
AEFES, the Turkey-based beverage company, derives revenues primarily from selling to
consumers in Russia and Turkey (estimated at 75-80% for beer operations and about 60%
at the consolidated level when including Coca Cola Icecek). As such, it is exposed to the
slowing growth in both of those countries and the resulting growing pressure on
consumer demand, especially in Russia. The group balance sheet is also exposed to an
unfavourable FX mismatch due to earnings essentially denominated in TRY and RUB and
debt mostly denominated in USD, generally un-hedged for FX variations. We also think the
bond is susceptible to underperform due to its exposure to event risks, including a
possible further worsening in the diplomatic relations between Turkey and Russia
following the recent imposition of economic sanctions on Turkey by Russia (AEFES has
significant exposure to Russia, with about 35-40% of its beer revenues, 10-14% at the
consolidated level).
RURAIL: Russian Railways earnings in USD terms have fallen with currency
depreciation, which has pushed up net leverage, while cash flow is constrained due to
still-high capex commitments. Although the group is receiving government funding for
key projects, we think that questions about the source of funding for its March 2017
USD maturity ($1.5bn) will come into focus in 2016, given that cash coverage of shortterm debt typically runs below 100%. While we expect Russian banks to help Rurail
refinance this debt, flat spreads to credits with a large stream of FX revenues and lower
leverage, such as Lukoil and Norilsk Nickel, leave us preferring exposure to latter. We
keep our recommendation on Rurail as UW.
KTZ: Like its Russian peer, Kazakhstan Temir Zholy (Kazakh Railways) has seen its
earnings compress in USD terms as a result of the devaluation of the tenge, as well as a
significant slowdown in freight volumes. This is pushing up leverage materially and has
raised ratings risks, with all three credit ratings at Moodys (Baa3), S&P (BB+) and Fitch
(BBB) on negative outlook. Any loss of IG status could trigger technical effects, on top of
the spread widening already driven by fundamental effects. As a result, we maintain our
UW rating on KTZ going into 2016.
EVRAZ faces growing challenges within the global steel sector. Benchmark CIS steel
prices have fallen a further 15% in Q4 15, and spot sits 5% below this level. As the most
leveraged name within the mainstream steel segment in Russia (alongside Severstal and
NLMK), Evraz is likely to have compression of the cash flow headroom because of capex
and interest expenses. Our equity team has reduced its estimate for Evraz's 2016
EBITDA to $1.2bn (from $1.5bn, see European Steel: At the edge), which could take net
leverage towards 5x. In addition, Evraz faces $2bn of USD eurobond maturities in 201718, while international loan and bond markets remain subdued.
Short banks that are deteriorating and trade <50bp off their sovereign
Senior bank spreads are now extremely compressed to their underlying sovereigns. In
low beta LatAm countries such as Peru, Chile and Mexico, the spread is in some cases as
low as 30bp. We think this is a mispricing of risk, and it has arisen due to market
segmentation effects. We do not think there is room for more compression (unlike in
Europe, we do not expect EM banks to trade inside their sovereigns); on the other hand,
we think gradual NPL deterioration (as per the above regarding banks) will cause a
repricing wider. We would single out the following banks are trading too tight to their
sovereigns and having a reasonable chance of fundamental deterioration over the
coming year: BCP 23s, BCOLO 21s and BBVASM 24s. Turkish banks as a whole also
screen very rich to the sovereign.
4 December 2015
196
FIGURE 40
Most bank capital structures are now relatively compressed
610
510
410
310
210
110
10
FINBN
YKBNK
HALKBK
VAKBN
EXCRTU
ISCTR
10Y SENIOR
AKBNK
RUSSIA
GARAN
CRBKMO
RSHB
VTB
VEBBNK
SBERRU
PERU
BKMOSC
BINTPE
BCOCPE
MEX
BCP
10Y SOVEREIGN
BBVASM
COLOM
BSANTM
DAVIVI
BCOLO
BANBOG
CHILE
SANT
BCICI
CORBAN
BANCO
CAIXBR
ITAU
BNDES
BANBRA
SANBBZ
BRADES
BRAZIL
TURKEY
10Y SUB
Short overly shareholder-oriented firms

40% of our index is quasi-sovereign, and creditors have historically fared better than
shareholders in firms in which the government owns a substantial stake. But in the
private-company non-financial world (~20% of our index), some firms are taking
actions that favour shareholders and expose creditors to growing risks. In some cases,
these are underpriced. Polyus Gold fits the bill here. The largest shareholder in Polyus
Gold recently made an offer for the 60% shares it did not own, funding the purchase via
a $5.5bn bridge loan. We see a risk that the balance sheet of Polyus could be used to
absorb some of the financing costs of this transaction, with S&P already warning that
any sizeable additional debt could lead to a multi-notch downgrade of its current BB+
credit rating. The recent decline in gold prices could also be a drive of spread widening.
Pemex is also at risk in this respect (the government being the shareholder).
Strategies: Long themes

Long strong commodity credits
We recommend credits that have the fundamental resilience to make it through a prolonged
period of low commodity prices. These are the babies that have been thrown out with the
bathwater. We look for traits such as global leadership in costs, strongly beneficial FX
mismatches (the majority of revenues in USD and majority of costs in local currency), ample
cash to short-term debt ratios and/or strong market access, and contained capex programmes:
SCCO: Southern Copper is better positioned to withstand lower metals prices, given its
industry-lowest cash cost (C1 cash costs of $1.12/lb in Q2 15), long reserve life and
exposure to the weaker MXN and PEN, which together accounted for c.56% of total
costs. With current net leverage at 1.6x, the lowest cash cost in the industry, and a welloutlined project pipeline, SCCOs net leverage should remain manageable even under
scenarios in which the copper price is much lower than spot.
LUKOIL: We see Lukoil as offering attractive pickup over the Russia sovereign (c175bp in
the 2023s, for example), on which we are tactically positive, going into 2016. Lukoil
continues to benefit from a strong liquidity position, given recent asset sales and cash
inflows from Iraq to refund historical capex. Maturities are light in 2016, and although
the group has to begin to address 2017 debt, we see options for the company to return
to the eurobond market or continue to borrow from Russian banks. Leverage is
moderate at 0.9x and cash well in excess of short-term debt (c300%).
4 December 2015
197
GMKNRM: We see Norilsk Nickel as one of the most defensive metals and mining credits
in our Russia coverage universe. While it, like other commodity producers, is seeing topline pressure on account of materially lower nickel, copper and precious metals prices,
its cash flow and credit profile are underpinned by its low cost position, boosted by the
weaker RUB. Liquidity is strong, with all of its 2016 maturities now addressed, and in the
event of a rebound in both oil and the RUB, we think base metals prices are more likely
than steel to rise on account of structural overcapacity, leaving Norilsk bonds well
placed to outperform.
Domestically-oriented names in stronger economies

BBVASM: We continue to recommend moving down in the capital structure of BBVASM,
which is our benchmark bank in the LatAm space. Despite our belief that senior bonds
offer little upside relative to MEX, we continue to believe that investors should buy
BBVASM 6.008 old-style T1 bonds and BBVASM 21/22s old-style subordinated bonds.
Strong fundamentals and favourable technicals should continue to support valuations of
old-style securities.
AMXLMM: We believe AMXLMM is well placed to maintain its strong competitive

position across the region, given its well-invested network and broad service offering,
despite the operational headwinds from asymmetric regulation, adverse currency moves
and challenging macro conditions in many of its core markets that have weighed on
profitability in recent quarters and are not expected to abate in the near term. We expect
the company to continue to generate meaningful positive FCF, particularly in light of
lower capex needs from 2016 onwards, having completed many of its large-scale capital
intensive projects in recent years, and believe it is committed to preserving its current
ratings. As such, we expect management to exercise financial discipline with respect to
shareholder distributions/buybacks so as to restore net leverage towards it internal
target of c.1.5x over the medium term. In our view, current spreads are attractive
versus broadly similarly rated DM peers, including Verizon.
4 December 2015
198
RESEARCH CONTACTS
Bradley Rogoff, CFA
Head of Credit Strategy
+1 212 412 7921
BCI, US
United States
Shobhit Gupta
Investment Grade Credit Strategy
+1 212 412 2056
BCI, US
Andrew Abramczyk, CFA

Macro Credit Strategy
+1 212 412 1162
andrew.abramczyk@barclays.com
BCI, US
Anthony Bakshi
High Yield and Leveraged Loan Credit
Strategy
+1 212 412 5272
anthony.bakshi @barclays.com
BCI, US
Eric Gross
High Yield and Leveraged Loan Credit
Strategy
+1 212 412 7997
BCI, US
Jigar Patel
Credit Derivative Strategy
+ 1 212 412 1161
BCI, US
Ryan Preclaw, CFA

+1 212 526 3083
ryan.preclaw@barclays.com
BCI, US
Bruno Velloso
bruno.velloso@barclays.com
+1 212 412 2345
BCI, US
Sren Willemann
Head of European Credit Strategy
+44 (0) 20 7773 9983
Barclays, UK
Zoso Davies
+44 (0)20 7773 5815
Barclays, UK
Andreas Hetland
+44 (0) 20 7773 1547
Barclays, UK
James Martin
High Yield Credit Strategy
+44 (0)20 7773 9866
Barclays, UK
Dominik Winnicki
Credit Strategy
+44 (0)20 3134 9716
Barclays, UK
Tobias Zechbauer
High Yield Credit Strategy
+44 (0)20 7773 6790
tobias.zechbauer@barclays.com
Barclays, UK
Badr El Moutawakil
EM Credit Strategy
+ 44 (0)20 7773 2902
badr.elmoutawakil@barclays.com
Barclays, UK
Aziz Sunderji
EEMEA/LatAm Corporate Credit
Strategy
+1 212 412 2218
aziz.sunderji@barclays.com
BCI, US
Sebastian Vargas
LatAm Sovereign Credit Strategy
+1 212 412 6823
sebastian.vargas@barclays.com
BCI, US
Mayur Patel
Municipal Credit Research
+1 212 526 7609
mayur.xa.patel@barclays.com
BCI, US
Sarah Xue
Municipal Credit Research
+1 212 526 0790
sarah.xue@barclays.com
BCI, US
Europe
Asia-Pacific
Krishna Hegde, CFA
Head of Asia Credit Research
+65 6308 2979
krishna.hegde@barclays.com
Avanti Save, CFA

Credit Strategy
+65 6308 3116
avanti.save@barclays.com
LatAm/EEMEA corporate credit strategy

Andreas Kolbe
Head of EM Credit Strategy,
EEMEA Sovereign Credit Strategy
+ 44 (0) 20 313 43134
andreas.kolbe@barclays.com
Barclays, UK
Municipal Credit
Mikhail Foux
Head of Municipal Credit Research
+1 212 526 7849
mikhail.foux@barclays.com
BCI, US
4 December 2015
199
Analyst Certification
We, Bradley Rogoff, CFA, Shobhit Gupta, Harry Mateer, Priya Ohri-Gupta, CFA, Jigar Patel, Ryan Preclaw, CFA, Bruno Velloso, Anthony Bakshi, Keith Byrne,
CFA, Eric Gross, Hale Holden, Mikhail Foux, Mayur Patel, Sarah Xue, Zoso Davies, Andreas Hetland, Soren Willemann, James K Martin, Dominik Winnicki,
CFA, Krishna Hegde, CFA, Avanti Save, CFA, Badr El Moutawakil, Aziz Sunderji and Tobias Zechbauer, 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:
Barclays Research is a part of the Investment Bank of Barclays Bank PLC and its affiliates (collectively and each individually, "Barclays"). Where any
companies are the subject of this research report, for current important disclosures regarding those companies please send a written request to: Barclays
Research Compliance, 745 Seventh Avenue, 13th Floor, New York, NY 10019 or refer to http://publicresearch.barclays.com or call 212-526-1072.
Barclays Capital Inc. and/or one of its affiliates does and seeks to do business with companies covered in its research reports. As a result, investors
should be aware that Barclays may have a conflict of interest that could affect the objectivity of this report. Barclays Capital Inc. and/or one of its affiliates
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). Barclays trading desks may have either a long and / or short position in such securities, other
financial instruments and / or derivatives, which may pose a conflict with the interests of investing customers. Where permitted and subject to
appropriate information barrier restrictions, Barclays fixed income research analysts regularly interact with its trading desk personnel regarding current
market conditions and prices. Barclays fixed income research analysts 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
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extent that any historical pricing information was obtained from Barclays 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. The Investment Bank's Research Department produces various types of research including, but not limited to, fundamental
analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research may differ from
recommendations contained in other types of research, whether as a result of differing time horizons, methodologies, or otherwise. Unless otherwise
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Barclays
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Procedures,
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ORANGE SA
Other Material Conflicts: Barclays Bank PLC and/or an affiliate is acting as lead financial adviser to Deutsche Telekom AG in relation to BT Group PLCs
possible acquisition of EE Limited, which is jointly owned by Orange SA and Deutsche Telekom AG. The ratings, price targets and estimates for Orange SA
do not include this potential transaction.
Explanation of the Barclays Research Sector Rating System

Overweight (OW):
For sectors rated against the Barclays U.S. Credit Index, the Barclays Pan-European Credit Index, the Barclays EM Asia USD High Grade Credit Index or the
Barclays EM USD Corporate and Quasi-Sovereign Index, the analyst expects the six-month excess return of the sector to exceed the six-month excess
return of the relevant index.
For sectors rated against the Barclays U.S. High Yield 2% Issuer Capped Credit Index, the Barclays Pan-European High Yield 3% Issuer Capped Credit Index
excluding Financials, the Barclays Pan-European High Yield Finance Index or the Barclays EM Asia USD High Yield Corporate Credit Index, the analyst
expects the six-month total return of the sector to exceed the six-month total return of the relevant index.
Market Weight (MW):
Barclays EM USD Corporate and Quasi-Sovereign Index, the analyst expects the six-month excess return of the sector to be in line with the six-month
excess return of the relevant index.
expects the six-month total return of the sector to be in line with the six-month total return of the relevant index.
Underweight (UW):
Barclays EM USD Corporate and Quasi-Sovereign Index, the analyst expects the six-month excess return of the sector to be less than the six-month
excess return of the relevant index.
expects the six-month total return of the sector to be less than the six-month total return of the relevant index.
Sector definitions:
Sectors in U.S. High Grade Research are defined using the sector definitions of the Barclays U.S. Credit Index and are rated against the Barclays U.S. Credit
Index.
Sectors in U.S. High Yield Research are defined using the sector definitions of the Barclays U.S. High Yield 2% Issuer Capped Credit Index and are rated
against the Barclays U.S. High Yield 2% Issuer Capped Credit Index.
LAST PAGE
Sectors in European High Grade Research are defined using the sector definitions of the Barclays Pan-European Credit Index and are rated against the
Barclays Pan-European Credit Index.
Sectors in Industrials and Utilities in European High Yield Research are defined using the sector definitions of the Barclays Pan-European High Yield 3%
Issuer Capped Credit Index excluding Financials and are rated against the Barclays Pan-European High Yield 3% Issuer Capped Credit Index excluding
Financials.
Sectors in Financials in European High Yield Research are defined using the sector definitions of the Barclays Pan-European High Yield Finance Index and
are rated against the Barclays Pan-European High Yield Finance Index.
Sectors in Asia High Grade Research are defined on Barclays Live and are rated against the Barclays EM Asia USD High Grade Credit Index.
Sectors in Asia High Yield Research are defined on Barclays Live and are rated against the Barclays EM Asia USD High Yield Corporate Credit Index.
Sectors in EEMEA and Latin America Research are defined on Barclays Live and are rated against the Barclays EM USD Corporate and Quasi Sovereign
Index. These sectors may contain both High Grade and High Yield issuers.
To view sector definitions and monthly sector returns for Asia, EEMEA and
https://live.barcap.com/go/RSL/servlets/dv.search?pubType=4511&contentType=latest on Barclays Live.
Latin
America
Research,
go
to
Explanation of the Barclays Research Credit Rating System

For all High Grade issuers covered in the US, Europe or Asia, and for all issuers in Latin America and EEMEA (excluding South Africa), the credit rating
system is based on the analyst's view of the expected excess return over a six-month period of the issuer's index-eligible corporate debt securities* relative
to the expected excess return of the relevant sector, as specified on the report.
Overweight (OW): The analyst expects the six-month excess return of the issuer's index-eligible corporate debt securities to exceed the six-month
expected excess return of the relevant sector.
Market Weight (MW): The analyst expects the six-month excess return of the issuer's index-eligible corporate debt securities to be in line with the sixmonth expected excess return of the relevant sector.
Underweight (UW): The analyst expects the six-month excess return of the issuer's index-eligible corporate debt securities to be less than the six-month
expected excess return of the relevant sector.
Rating Suspended (RS): The rating has been suspended temporarily due to market events that make coverage impracticable or to comply with applicable
regulations and/or firm policies in certain circumstances including where the Investment Bank of Barclays Bank PLC is acting in an advisory capacity in a
merger or strategic transaction involving the company.
Coverage Suspended (CS): Coverage of this issuer has been temporarily suspended.
Not Covered (NC): Barclays fundamental credit research team does not provide formal, continuous coverage of this issuer and has not assigned a rating
to the issuer or its debt securities. Any analysis, opinion or trade recommendation provided on a Not Covered issuer or its debt securities is valid only as of
the publication date of this report and there should be no expectation that additional reports relating to the Not Covered issuer or its debt securities will be
published thereafter.
For all High Yield issuers (excluding those covered in EEMEA or Latin America), the credit rating system is based on the analyst's view of the expected total
returns over a six-month period of the rated debt security relative to the expected total return of the relevant sector, as specified on the report.
Overweight (OW): The analyst expects the six-month total return of the debt security subject to this rating to exceed the six-month expected total return
of the relevant sector.
Market Weight (MW): The analyst expects the six-month total return of the debt security subject to this rating to be in line with the six-month expected
total return of the relevant sector.
Underweight (UW): The analyst expects the six-month total return of the rated debt security subject to this rating to be less than the six-month expected
total return of the relevant sector.
For all issuers in South Africa, the credit rating system is based on the analysts view of the expected total return over a six-month period of the issuers
rand-denominated fixed rate notes or floating rate notes (as applicable) relative to the South African Credit Fixed Market Index (CFIX95) or the South
African Credit Floating Market Index (CFL020), respectively.
Overweight (OW): The analyst expects the six-month total returns of the issuers rand-denominated fixed rate notes or floating rate notes (as applicable)
to exceed the six-month expected total returns the South African Credit Fixed Market Index (CFIX95) or the South African Credit Floating Market Index
(CFL020), respectively.
Market Weight (MW): The analyst expects the six-month total returns of the issuers rand-denominated fixed rate notes or floating rate notes (as
applicable) to be in line with the six-month expected total returns the South African Credit Fixed Market Index (CFIX95) or the South African Credit
Floating Market Index (CFL020), respectively..
LAST PAGE
Underweight (UW): The analyst expects the six-month total returns of the issuers rand-denominated fixed rate notes or floating rate notes (as
applicable) to be below the six-month expected total returns the South African Credit Fixed Market Index (CFIX95) or the South African Credit Floating
Market Index (CFL020), respectively..
*In EEMEA and Latin America (and in certain other limited instances in other regions), analysts may occasionally rate issuers that are not part of the U.S.
Credit Index, the Barclays Pan-European Credit Index, the Barclays EM Asia USD High Grade Credit Index or Barclays EM USD Corporate and Quasi
Sovereign Index. In such cases the rating will reflect the analysts view of the expected excess return over a six-month period of the issuers corporate debt
securities relative to the expected excess return of the relevant sector, as specified on the report.
Barclays legal entities involved in publishing research:
Barclays Bank PLC (Barclays, UK)
Barclays Capital Inc. (BCI, US)
Barclays Securities Japan Limited (BSJL, Japan)
Barclays Bank PLC, Tokyo branch (Barclays Bank, Japan)
Barclays Bank PLC, Hong Kong branch (Barclays Bank, Hong Kong)
Barclays Capital Canada Inc. (BCCI, Canada)
Absa Bank Limited (Absa, South Africa)
Barclays Bank Mexico, S.A. (BBMX, Mexico)
Barclays Capital Securities Taiwan Limited (BCSTW, Taiwan)
Barclays Capital Securities Limited (BCSL, South Korea)
Barclays Securities (India) Private Limited (BSIPL, India)
Barclays Bank PLC, India branch (Barclays Bank, India)
Barclays Bank PLC, Singapore branch (Barclays Bank, Singapore)
Barclays Bank PLC, Australia branch (Barclays Bank, Australia)
Disclaimer:
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Credit Research

Global Credit Outlook 2016

Barclays | Global Credit Outlook 2016

European Credit Strategy

Barclays | Global Credit Outlook 2016

Global Hybrid Capital Strategy

Asian Credit Strategy

LatAm/EEMEA Corporate Credit Strategy

Barclays | Global Credit Outlook 2016

We forecast investment grade spreads to tighten 10-20bp in the US and 5-10bp in

Taking the middle path

Barclays | Global Credit Outlook 2016

Excess return Total return

USD: 650-750 USD: 600-700

Emerging market corporates

Source: Barclays Research

Barclays | Global Credit Outlook 2016

Spread levels supportive for 2016 returns

Barclays | Global Credit Outlook 2016

HY Corp OAS (bp)

HY Corp OAS (bp)

Barclays | Global Credit Outlook 2016

Source: Barclays Research

Source: Barclays Research

EUR AT1 CoCos

Barclays | Global Credit Outlook 2016

Different geographies, different parts of the credit cycle

Fed Funds Target Rate

Trailing 12 Months HY Default Rate

Source: National Bureau of Economic Research, Barclays Research

Barclays | Global Credit Outlook 2016

Signs of weaker fundamentals

Y = US Corporate: Subsequent 12 Months Excess Return

Trailing 12 Month HY Default Rate (right)

X = Cycle Age (Months)

Source: Federal Reserve Senior Loan Officer Lending Survey, Moodys

Barclays | Global Credit Outlook 2016

Source: Barclays Research

5.7 5.7 5.7 5.5 5.5

6.5 6.3 6.6

Source: S&P Capital IQ, Barclays Research

Source: S&P Capital IQ, Barclays Research

Barclays | Global Credit Outlook 2016

Source: Bureau of Economic Analysis

The liquidity conversation has only just begun

Barclays | Global Credit Outlook 2016

Source: Barclays Research

Barclays | Global Credit Outlook 2016

Trading the less liquid credit markets

On- vs Off-the-run OAS Diff. (Industrial; BBB)

Source: Barclays Research

Barclays | Global Credit Outlook 2016

$bn prot bought by clients

$bn prot bought by clients

Source: DTCC, Barclays Research

Source: DTCC, Barclays Research

CDS-cash basis (RHA)

CDS-cash basis (RHA)

Source: Barclays Research

Barclays | Global Credit Outlook 2016

Barclays | Global Credit Outlook 2016

Note: Showing option trading volumes as percent of index trading volumes.

Barclays | Global Credit Outlook 2016

Barclays | Global Credit Outlook 2016