CREDIT RESEARCH 1 October 2010

EUROPEAN CREDIT ALPHA

More answers than questions
Matthew Leeming
+44 (0) 20 7773 9320
matthew.leeming@barcap.com

Zoso Davies
+44 (0) 20 7773 5815
zoso.davies@barcap.com

Arup Ghosh
+44 (0) 20 7773 6275
arup.ghosh@barcap.com

This version corrects Figure 3, where the scale was incorrect on the left hand axis.
Eugene Regis
Strategic Market View: There and back again 4 +44 (0) 20 7773 9169
eugene.regis@barcap.com
Driven by mixed signals from the economic and political front credit spreads see-
sawed this week before finally ending up where they started. Risk aversion remains,
Aziz Sunderji
but largely driven by macroeconomic uncertainties, while strong corporate +44 (0) 20 7773 7881
fundamentals should provide spreads with a buffer if future growth stays anaemic. aziz.sunderji@barcap.com
Sovereign volatility continues to drive valuation dislocations and we highlight a
credit-equity normalisation trade on EDP. For investors worried about poor Dominik Winnicki
economic growth, we also recommend going long a basket of selected names with +44 (0) 20 3134 9716
counter-cyclical performance while simultaneously shorting the index as a suitable dominik.winnicki@barcap.com
trade for generating counter-cyclical alpha.
www.barcap.com

Distressed debt markets – time to grow 9

We see the European distressed debt market as growing in size. This will come from
weak borrowers who survived on forbearance measures and the low rate of Euribor
hitting maturity and amortisation points and European banks continuing with balance
sheet shrinkage. Also, with the cost of bailing out Europe’s banking systems via bad
banks increasingly interlinked to sovereign funding rates, there is further potential for
distressed assets to come from both bad banks and distressed banks.

Credit at a glance 16
Corporates generated just over 50bp of excess returns in September, led by financials
and in particular the Tier 1 part of the capital structure. Insurance, which is more
heavily weighted towards Tier 1 than banking, was the top performing sector this
month – utilities underperformed. Indices were marginally tighter week on week, while
investment grade cash was wider. Despite this, our measure of the cash-CDS basis was
broadly unchanged as single-name contracts lagged the index tightening.

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 22
Barclays Capital | European Credit Alpha

CREDIT VIEWS ON A PAGE

CREDIT STRATEGY
CATEGORY THESIS TRADE IDEAS
High Grade Monetise steep skew, hedge ƒ 1x2 payer spreads on Main to December
against moderate widening
Use bank Tier 1s to boost ƒ Despite the rally that has reduced the pick-up to senior, we continue to believe there is value in
yield or beta European bank Tier 1 as a high-beta asset class
Relative value in step-up ƒ Switch into Lafarge step-ups: LGFP €7.625% 2014 and LGFP €7.625% 2016s
bonds
Relative value trades ƒ Short corporates trading tighter than their own sovereign (only in AAA sovereigns)
between corporates and
sovereigns
Cyclical hedge in CDS ƒ Basket of cyclical shorts vs index: LMETEL (Ericsson), MICH, PUBFP, STM, VLOF, WKLNA, WPP
ƒ Basket of cyclical longs vs index: BNFP (Danone), ROSW, EXHO, TSCOLN, ULVRLN
Normalisation trades ƒ Yield/credit curves steep at front end, buy short-dated credit
ƒ Basis trades > -100bp
High Yield Relative value across ƒ We favour single-B-rated paper and expect it to compress towards BB
ratings buckets
Relative value in senior vs ƒ On capital structures of performing names with secured and unsecured bonds, unsecured tiers look
subordinated cash attractive: Buy Ardagh € ‘17, Ineos € ‘16, Europcar € ‘14 and Lecta € ‘14 against secured issues
ƒ On capital structures of performing names with term loans and pari passu secured bonds, buy the
secured bond: Buy Smurfit € ‘17/19 against term loans
Trades on issuers we expect ƒ Loans or short-duration bonds trading sub-par, which we expect to be refinanced
to refinance ƒ Short-duration paper on high-beta credits with strong liquidity
ƒ Selected name-specific 5s10s DV01 neutral steepeners for borrowers we expect to refinance
Returns are hard to find ƒ We favour bonds with cash yield above the current yield of the index
Event-driven Cash ƒ Switch into bonds that are closer to maturity to reduce sensitivity to spread widening and curve steepening
trades: LBOs ƒ Switch into bonds with protective covenants, such as change-of-control (CoC) puts and/or
step-up coupons
CDS ƒ Buy outright CDS protection on an LBO target; Buy outright CDS protection on a target and sell
protection on a correlated index
ƒ Implement a CDS steepener on a potential candidate
Equity options ƒ Long equity call options for LBO candidates

HIGH GRADE CREDIT RESEARCH

SECTORS OVERWEIGHT UNDERWEIGHT
Banks, Consumer, Industrials Telecoms, Media, Technology, Utilities, Pharmaceuticals
COMPANIES FAVOURED*: UNFAVOURED*:
OVERWEIGHT – BONDS/SELL PROTECTION – CDS UNDERWEIGHT – BONDS/BUY PROTECTION – CDS
Autos BMW (CDS), Daimler (CDS) BMW (cash), VW (cash), Volvo (cash), Michelin (cash)
Banks RBS (cash), Commerzbank (cash), UniCredit (cash) Allied Irish Banks (cash), BCP (cash), BES (cash), Dexia (cash),
Monte dei Paschi (cash)
Consumer & Retail Accor (cash), Kingfisher (cash), Rentokil (cash), Metro, BAT, Carrefour, Next (CDS), Diageo, Experian (CDS), Carlsberg (CDS)
Imperial Tobacco, Tesco (CDS), PPR (CDS)
General Industrial BAA (cash), Finmeccanica, Alstom (CDS), CRH, Clariant Metso, Akzo Nobel, Bayer, Clariant (CDS), Rolls Royce (CDS), Lafarge,
(cash), Thyssenkrupp (CDS) Sanofi-Aventis, Holcim (cash)
Insurance Stalif (cash), Llydin (T1), Eureko (bonds), Munich Re (bonds), Aegon (CDS), Hannover Re (CDS), Generali (CDS), Unipol (CDS)
Zurich (bonds)
Pharmaceuticals Roche, Novartis (cash) AstraZeneca
TMT BT Group, OTE, Telefonica, Lagardère, Swisscom (CDS), Deutsche Telekom, Vodafone, TeliaSonera, TKA, KPN, STM (CDS), FT,
Telenor (CDS), Nokia (CDS) Ericsson, Pearson** (CDS), Portugal Telecom (CDS), Wolters Kluwer
(CDS), Ericsson (CDS), WPP (CDS)
Utilities EDP, Enel, Gas Natural, Veolia Environnement, REN, Glencore, United Utilities Plc, Suez Environnement, Elia, Verbund, Edison, Fortum
Iberdrola (CDS) (CDS), EnBW (CDS), Vattenfall (CDS)
HIGH YIELD CREDIT RESEARCH
COMPANIES FAVOURED*: UNFAVOURED*:
OVERWEIGHT – BONDS/SELL PROTECTION – CDS UNDERWEIGHT – BONDS/BUY PROTECTION – CDS
Basic Industries Ardagh Glass 2016/2017/2020, Lecta 2014 (sub + snr), Clondalkin Industries 2013/2014, Norske Skog 17s
M-Real 2013, Smurfit Kappa Group 2015/2017/2019
General Industrial Evonik Degussa 13s, Evonik Industries 14s, Savcio, Lufthansa (cash), Air France (cash), Stora Enso, UPM
HeidelbergCement 2012/2014/2017/2018/2019,
Valeo (cash), GKN (CDS)
Consumer & Retail Pernod (EUR)
TMT Wind €11.0% 2015, KDG €+700 PIK 2014, Seat €8.0% 2014, Ono €8.0% 2014, €10.5% 2014, Unity €9.625% 2019,
Unity €8.125% 2017, UPC €8.0% 2016 Virgin Media £7.0% 2014
Note: Recent changes where available are in bold text; *ratings below apply to bonds and CDS (where applicable) unless specified; **Barclays Capital is acting as
financial advisor to Pearson PLC in its potential acquisition of Sistema Educacional Brasileiro's school learning systems business. Source: Barclays Capital

1 October 2010 2
Barclays Capital | European Credit Alpha

REPORTING CALENDAR

Next Week
Date Company Release/event Economic data
Mon, 4 Oct US: Pending home sales, Factory orders
EZ: Sentix, PPI
UK: Construction PMI
Tue, 5 Oct Tesco H1 interim results US: ISM non-Manufacturing
Tui Travel Interim sales EZ: Retail sales, PMI
UK: Services PMI
Wed, 6 Oct Sainsbury Q2 sales US: ADP employment report
EZ: Q2 GDP (Final)
GE: Factory orders
Thu, 7 Oct M&S Q2 sales US: Consumer credit, Jobless claims
EZ: ECB Rates decision
GE: IP
UK: NIESR GDP Estimate, BoE rates decision, IP
Fri, 8 Oct US: Non-farm payrolls, Unemployment, Wholesale
inventories
GE: Trade balance
UK: PPI
Source: Bloomberg, company reports, Barclays Capital

The week after

Date Company Release/event Economic data
Mon, 11 Oct Securitas 9M results
Sodexo FY results
Ladbrokes Interim trading update
Tue, 12 Oct US: FOMC Minutes, Small business optimism
GE: CPI
UK: Trade balance, RPI, CPI
Wed, 13 Oct Casino Q3 sales (after mkt) US: MBA Mortgage applications, Budget
EZ: IP
UK: Unemployment report
Thu, 14 Oct Carrefour Q3 sales US: PPI, Jobless claims, Trade balance,
Diageo Interim statement EZ: ECB Monthly report
Roche Q3 sales
SABMiller Q2 sales
Suedzucker Q2 results
Syngenta Q3 sales
Fri, 15 Oct US: CPI, Advanced retail sales, Retail sales, Empire
manufacturing, U. of Mich. Confidence, Business inventories
EZ: CPI, Trade balance, Car registrations
Source: Bloomberg, company reports, Barclays Capital

1 October 2010 3
Barclays Capital | European Credit Alpha
STRATEGIC MARKET OVERVIEW
Arup Ghosh
+44 (0) 20 7773 6275
arup.ghosh@barcap.com
Matthew Leeming
+44 (0) 20 7773 9320
matthew.leeming@barcap.com
Aziz Sunderji
+44 (0) 20 7773 7881
aziz.sunderji@barcap.com
Dominik Winnicki
+44 (0) 20 3134 9716
dominik.winnicki@barcap.com
Zoso Davies
+44 (0) 20 7773 5815
zoso.davies@barcap.com
Figure 1: Peripheral European sovereigns have seen
diverging performances over the last month…
150
100
50
0
-50
While the aggregate sovereign index
-100 has stayed virtually unchanged,
European peripherals have seen a
-150
sharp divergence in performance
-200
Portugal Ireland SovX
Net 1 month spread change (bps)
Source: Bloomberg, Barclays Capital
1 October 2010
There and back again
Driven by mixed signals from the economic and political front credit spreads see-sawed
this week before finally ending up where they started. While risk aversion remains
strong we believe it is driven more by macroeconomic uncertainties, as corporate
fundamentals are the strongest they have been for a long time. This is not reflected in
current valuations, a fact that should provide spreads with a buffer if future growth
remains anaemic. Sovereign volatility continues to drive dislocations for corporate
names, and we highlight an attractive credit-equity normalisation trade on EDP, where
the CDS has been widening in tandem with its sovereign even though the stock has
barely moved. We also revisit our trade idea from last week to generate counter-cyclical
alpha. We recommend going long a basket of selected names with counter-cyclical
performance while simultaneously shorting the index as a suitable trade idea for
investors worried about poor economic growth.
Week in review
Credit continued to trade rangebound this week. Having widened by 7bp on Tuesday, the
iTraxx main index ended the week back where it started it at 110bp. A mixture of news,
both good and bad from either side of the Atlantic has led to a lack of conviction and light
trading volumes. The upshot has been cash outperformance relative to CDS, with the basis
turning more positive for investment grade names.
There has been a sharp divergence in credit views across Europe in the past few days. The
general macroeconomic picture seems to be improving; the 3m LTRO on Wednesday and
the subsequent fine tuning operation saw much lower demand than the market had
expected signalling an improved liquidity position for European banks. Stronger peripheral
sovereigns like Spain and Italy also saw good demand for their bonds in auctions. At the
same time concerns remain around the banking sector in Ireland and fiscal conditions in
Portugal, which have led to their sovereign CDS spreads widening over the past month as
other peripheral spreads tightened (Figure 2).
Figure 2: … while the sharpest changes recently have been
in the Irish sovereign CDS curve
560 The Irish finance minstry's plan for
further capital injection in Anglo Irish
540
bank was greeted by the market with
520 guarded optimisim
500
480
460
440
420
400
Spain Italy Greece 0 2 4 6 8 10
30-Sep-10 23-Sep-10
Source: Bloomberg, Barclays Capital
4
Barclays Capital | European Credit Alpha

On Thursday the Irish Central Bank unveiled a fresh recapitalisation plan for the banking
system, with additional costs expected of around €10bn in a base-case scenario and €15bn
in a “stress scenario”. Of this €4.3bn is for Anglo Irish bank, bringing net capital
requirements for the bank to €29.3bn from previous estimates of €25bn. These costs are
expected to bring Ireland’s fiscal deficit to 32% of GDP, much higher than the 3% guideline
for Eurozone countries. The Irish finance minster conceded in an interview that the large
size of Anglo Irish as a proportion of the country’s balance sheet means it is “systemically
important” and its failure cannot be contemplated. The plan reaffirms the government’s
intention to make senior bondholders whole on their investment, but seeks to impose write-
downs on subordinated bond holders as had been expected. The market reaction to the
announcement has been moderately positive, and Irish sovereign CDS curves have started
steepening in the front end. This seems to suggest that with this fresh capital injection
Ireland might be able to finally draw a line under the banking crisis that has been
threatening to plunge the country into a double-dip recession.

Adding to the mixed economic signals in Europe is the continuing slow burn of political
uncertainty across both core and peripheral countries. Wednesday saw trade unions co-
ordinate protests across a dozen European countries. These included a day-long general strike
in Spain protesting against labour reforms and austerity measures undertaken by the current
government, as well as a demonstration in Brussels. Also on Wednesday the European
Commission proposed plans to impose fines on fiscally undisciplined member states, though
consensus on such regulations might be hard to achieve. France announced its 2011 budget
stating it intends to cut its public deficit by 1.7% of GDP, while Italy announced it should be on
track with its three-year deficit reduction programme.

Last week’s volatility and heightened uncertainty led to a couple of casualties on the
corporate issuance front. Telefonica and RCI Banque pulled proposed deals after citing
difficulties in pricing and reduced interest given the challenging market conditions. Overall
primary markets priced c.EUR7bn of debt this week, bringing the total EUR-denominated
issuance to c.EUR45bn in September, significantly behind the USD92bn of dollar-
denominated unsecured debt priced in September. The GBP6.25bn of investment grade
debt priced in September makes it the busiest month of 2010 for sterling markets.

Whither corporate spreads?

Corporate spreads in Europe are currently being driven to some extent by the market’s risk
aversion due to prevailing macroeconomic uncertainty. While we expect this to continue
over the short to medium term, over a longer horizon we expect spreads to start reflecting
the underlying fundamentals of these corporate names.

In Figure 3 we plot the time series of average net debt to EBITDA for European investment
grade corporates going back to Q1 02. We based our universe on a subset of the names
included in the Barclays Capital European Aggregate Industrials Index, and take into
account the changing cohort over time.

1 October 2010 5
Barclays Capital | European Credit Alpha

Figure 3: While average leverage seems to be at one of its lowest levels since 2002, cash
spreads do not seem to be reflecting this entirely yet

400
3

300

2 200

100

1 '02 Q1 0

'02 Q3

'03 Q1

'03 Q3

'04 Q1

'04 Q3

'05 Q1

'05 Q3

'06 Q1

'06 Q3

'07 Q1

'07 Q3

'08 Q1

'08 Q3

'09 Q1

'09 Q3

'10 Q1

'10 Q3
ND/EBITDA (LH axis) L-OAS (RH axis)

Note: The leverage and spread values here are averages for the Barclays Capital European Aggregate Industrials Index.
Source: Bloomberg, Barclays Capital

As is evident, European corporates have sharply delevered since the beginning of the credit
crisis, to the extent that average leverage now is at one of the lowest levels since 2002.
Spreads haven’t quite moved in line with this, however, and we believe that as macro
uncertainties fade and risk aversion retreats, spreads should move tighter to reflect these
improved fundamental levels. In fact, the very strong fundamentals should also buffer
spreads from widening too much in the event growth remains anaemic for a while albeit
presuming macro uncertainties do not intensify over the same period.

Has ELEPOR gone too far?

The concerns around Portugal’s fiscal conditions while driving up its sovereign spreads are
also affecting ongoing deterioration in Portugal including names such as ELEPOR, PORTEL
and BESPL. Driven by sovereign contagion these credits have been widening since early
September, but this contrasts with the relative resilience in stock prices of these companies.

CDS underperformance versus equity has been particularly strong in ELEPOR. While the CDS
has been tracking Portugal sovereign CDS very closely on the way up in September, the
stock has been trading quite firm and is now slightly above its September average (Figure
4). Judging by the two-month historical relationship between the CDS and the stock, the
equity-implied CDS spread is now c.50bp tighter than the current market level.

1 October 2010 6
Barclays Capital | European Credit Alpha

Figure 4: Sovereign weakness drives EDP wide but the stock Figure 5: P&L of the trade for data points over the recent
price barely budged past

Stock pri ce CDS spread CDS spread

(€) (bp) (bp)
2.7 350 380
LOSS
2.6 330
300
Sept ember average PROFIT Breakeven
280
2.5
250 230
2.4
200 180
2.3
130
2.2 150
2.35 2.4 2.45 2.5 2.55 2.6 2.65
01 15 29 12 26 09 23
Jul Jul Jul Aug Aug Sep Sep Stock price (€)

Equity CDS (rhs) July-August September Current

Source: Barclays Capital Source: Bloomberg, Barclays Capital

Given the unusual strength of credit-equity dislocation and the fact that we hold a positive
fundamental view on the credit, we recommend the following normalisation trade idea:

Trade idea: Sell €2mn protection on ELEPOR 5y CDS

Sell short €0.6mn worth of ELEPOR stock
Note: At the time of writing EDP 5y CDS was trading at 305bp bid and EDP stock price was at €2.504. Cost of
borrowing EDP stock is c.35bp.

If the sentiment around Portugal improves, in our view, CDS would have more room for
positive adjustment compared to the already strong stock. On the other hand, if the
weakness in Portugal sovereign CDS continues and ELEPOR keeps trading wide, the stock
should eventually catch up, as the increased cost of funding and deteriorating sentiment
start to weigh on valuation. The choice of the notional sizes of the trade legs was based on
last three months’ relationship between the CDS spread and the stock price.

Hedging smarter redux

We have previously suggested that investors concerned about poor economic growth could
generate counter-cyclical alpha by shorting selected names within strongly pro-cyclical
sectors (see European Credit Alpha, 24 September 2010). An alternative approach, which
we discuss here, is to be long counter-cyclical sectors versus the index.

A number of sectors have a strong correlation to GDP growth over the economic cycle, but
a negative beta (Figure 6). Indeed, their counter-cyclical performance is clear over several
cycles (Figure 7 and Figure 8). In particular, we highlight Healthcare, Retail and Food &
Beverages – the counter-cyclicality of Retail being driven by non-cyclical distributors such as
Tesco, Sainsbury’s and Carrefour. One advantage to being long defensive sectors versus the
index is that investors are implicitly short both financials and peripherals.

1 October 2010 7
Barclays Capital | European Credit Alpha

Figure 6: Healthcare, Retail, and Food & Beverages outperform the index in a downturn
Rsq of sector performance versus index to
GDP during downturn

Bond sector STOXX Index 2007-09 2001 1991 Average RSQ Average Beta

Healthcare SXDP 52% 27% 71% 50% -6.5

Retail SXRP 32% 68% 50% -6.3
Food & Beverage SX3P 45% 25% 25% 32% -1.9
Note: Regressions based on three-quarter performance of index versus SXXP against the percentage growth in GDP over the same three quarters. The period used are
recessions as defined by the NBER, +/-2 quarters. Source: Bloomberg, Barclays Capital

Figure 7: Retail is a strongly counter-cyclical sector… Figure 8: … as is Healthcare

Sector performance vs Index GDP growth Sector performance vs Index GDP growth
25% 3% 40% 4.5%
20% 2% 30% 4.0%

15% 1% 20% 3.5%

3.0%
10% 0% 10%
2.5%
5% -1% 0%
2.0%
0% -2% -10%
1.5%
-5% -3% -20% 1.0%
-10% -4.% -30% 0.5%
-15% -5% -40% 0.0%
Sep 06 Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09 Jun 99 Dec 99 Jun 00 Dec 00 Jun 01 Dec 01 Jun 02
Performance vs Index GDP Performance vs Index GDP
Source: Bloomberg, Barclays Capital Source: Bloomberg, Barclays Capital

We suggest investors implement this view by selling protection on a basket of names from
these sectors versus iTraxx Main – in a carry neutral format. As constituents for our basket,
we prefer names our analysts hold a neutral or sell-protection view on, and that trade
relatively wide versus the index (Figure 9). In particular we highlight Danone, Roche,
Sodexo, Tesco, and Unilever.

Figure 9: The names we select are relatively far off their Figure 10: This basket has outperformed during previous
historical tights versus the index periods of poor growth

Ratio of CDS spread to iTraxx Main Spread ratio of basket to yoy GDP growth,
1.00 0.8 4%
3%
0.7 2%
0.75
1%
0.6
0%
0.50
-1%
0.5
-2%
0.25 -3%
0.4
-4%
0.00 0.3 -5%
Danone

Roche

Sodexo

Tesco

Unilever

Basket

Jan Jul Jan Jul Jan Jul Jan Jul

07 07 08 08 09 09 10 10

Source: Markit, Barclays Capital Source: Markit, Barclays Capital

1 October 2010 8
Barclays Capital | European Credit Alpha

DISTRESSED DEBT MARKETS

Time to grow
Eugene Regis We expect the European distressed debt market to grow as the result of excessive corporate
+44 (0) 20 7773 9169 leverage from the past decade. So far, the actual outflow of distressed assets from banks and
eugene.regis@barcap.com non-bank investors has been relatively muted compared with the size of lending markets.

A functioning distressed market is needed to value securities potentially seen as

stressed and restructure stressed corporates. For more distressed assets to be released
to investors, the institutions that hold them may have to crystallise losses, but this
should be balanced against regulatory capital being freed up as well as the prospect of
achieving a higher price now and not being part of a restructuring process.

Sourcing distressed debt

We see the shakeout of the European leveraged finance market and forced sale of banking
assets as the key contributors to the growth in distressed debt. So far, the distressed asset
class has been slow to evolve despite the economic downturn for several reasons:

„ Some countries have created government sponsored frameworks to handle distressed

assets in banks. This has allowed banks to either hive off bad loans into a government
guaranteed “bad bank” (eg, NAMA in Ireland) or to keep them on balance sheet (eg,
RBS benefitting from the APS scheme and Spanish Cajas benefitting from the FROB
recapitalisation scheme) to be run off gradually.

„ Banking syndicates have also been generous in forbearance measures (covenant

amendments and waivers), with many 2006-07 vintage LBOs also having fewer
covenants to breach. This has reduced potential defaults, but if growth remains slow
and corporates do not delever further, it remains to be seen if such measures continue.

„ European bankruptcy regimes tend to encourage liquidation of corporate rather than

restructuring. This reduces potential recovery rates.

„ European distressed debt is much more of a private market compared with the US. If
investors want to enter a special situation, they have to sign a confidentiality agreement to
access private information and then learn about the situation before being able to build a
position. By contrast, the US market is more public with investors being able to obtain
public information more easily and start building a position ahead of any restructuring.

Over time, we expect these factors to change and the market to grow. For example,
taxpayers may be reluctant to underwrite bad banks at a time of fiscal austerity; European
bankruptcy rules may change; banking syndicates may prefer to restructure credits for a
higher recovery now rather than risk a lower one in the future.

High-yield and leveraged loans

There is a potential catalyst for growth in the distressed debt market as borrowers begin to
hit maturity/amortisation points. The 2004-07 boom in lending showed falling underwriting
standards, which we would expect to increase the chance of future restructurings. While
defaults have increased into 2009, we would argue that decisions taken by banks and
investors suppressed the default rate. We believe some defaults and restructurings that
should have happened could yet still occur.

1 October 2010 9
Barclays Capital | European Credit Alpha

Figure 11: Distribution of deals by debt/EBITDA levels Figure 12: CCC volumes, percentage of HY issuance

<3x 3.0-3.9x 4.0-4.9x 5.0-5.9x 6x and above 35% 6,000

CCC% CCC Issuance, €mn (RHS)
100%
30% 5,000
90%
80% 25%
70% 4,000
60% 20%
50% 3,000
15%
40%
2,000
30% 10%
20%
5% 1,000
10%
0%
0% 0
97 98 99 00 01 02 03 04 05 06 07 08 091H10
97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: S&P LCD Source: Barclays Capital

Figure 11 shows covenant deterioration amongst leveraged loan borrowers, with an

increasing proportion of deals being struck at leverage above 5x from 2001 to 2007. Similarly,
for high yield bonds, CCC issuance also grew (Figure 12) as a proportion of the total. The
falling proportion in 2006-07 should be taken in the context of record years for issuance 1 .

Prior issuance resulted in the maturity profile seen in Figure 13. While refinancing
conditions were easy (eg, 2005-06 vintage loan deals being refinancing in 2006-07), this
maturity mountain was easy to manage. The shutdown in the primary markets of 2008
halted this. Furthermore, for loans, the unwinds of TRS structures, market value CLOs and
subsequent lack of new CLO issuance created difficulties for some borrowers.

However, the highest quality borrowers were able to refinance in the bond markets or even
pursue IPOs. So far, c.70% of 2010 high yield bond issuance is for refinancing purposes,
including private loan structures refinancing in the public bond markets. Figure 14 shows
the change in maturity profiles. The extension in the loan space has been small relative to

Figure 13: Leveraged loan/high yield bond maturities (€bn) Figure 14: Change in maturity profiles December 2008 to
August 2010 (€bn)

50 Institutional Lev. Loans HY Bonds 14

Loans Bonds
45 12
40 10
35 8
30 6
25 4
20 2
15 0
10 -2
5 -4
0 -6
10 11 12 13 14 15 16 17 18 19 20 >20 10 11 12 13 14 15 16 17 >17
Source: S&P LCD, Barclays Capital Source: S&P LCD, Barclays Capital

1
CCC issuance in 2005 was €5.4bn in an €18.1bn total for the year. For 2006, there was €5.7bn of CCC product issued
out of a €37bn total.

1 October 2010 10
Barclays Capital | European Credit Alpha

bonds. It is the poorer quality borrowers that have yet to extend their maturity profiles in the
bond or loan markets who may face problems as they begin to hit maturity/amortisation
deadlines. The length of time it takes to enter negotiations (eg, Gala took c.18 months to
agree to a restructuring after being unable to meet amortisation payments) means that
some borrowers may not have enough time to survive ahead of amortisations/final
maturities. Some credits have bought time due to forbearance measures granted by lending
syndicates (Figure 15). This has led to a situation in which the volumes of amendments,
though falling, are now higher in Europe than the US (Figure 16).

Figure 15: Distressed credits – defaults vs. restructurings Figure 16: Issuers seeking covenant relief amendments

60 70 US Europe
Defaults Restructurings Amendments

50 60

40 50

40
30
30
20
20
10
10
0
2004 2005 2006 2007 2008 2009 Jan- 0
Aug 10 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10
Source: S&P LCD Source: S&P LCD

Forbearance measures were granted because projected recoveries on credits would have been
very low during the recession. If companies do not turn around after receiving covenant
amendments, we would not expect banking syndicates to keep amending, especially for
names close to maturity/amortisation payments. Also, given that banks are under pressure to
hold onto more regulatory capital under Basel 3, they may be more incentivised to push
names into restructuring and extract a higher recovery rather than seeing them default.
European bankruptcy regulations make the default process more complex and generally
results in a liquidation, which would lower recoveries. By contrast, the US has chapter 11
bankruptcy laws that keep a business as a going concern and arguably make the bankruptcy
process faster than Europe 2 . A summary of US and European bankruptcy rules is in Figure 17.

Figure 17: European vs. US bankruptcy regimes

US Europe

Bankruptcy regime
Ease of coming through bankruptcy Well rehearsed. “Going concern” driven regime Not easy. Liquidation is frequent
Out of court restructuring
CDS consequences
Default count consequences
Source: Barclays Capital
Single legal regime. Chapter 11 leads to re-
organisation under operation as a going
concern
Rare as restructuring is done through a
bankruptcy court under Chapter 11.
No restructuring on CDS in SNACs
Easier to file and come through bankruptcy;
hence, leads to higher default count
No single bankruptcy provision. Some equity/
management friendly – France, Spain. Some secured
lender friendly – UK, but it can be unfriendly to unsecured
Many restructurings to avoid a bankruptcy filing or avoid
eventual liquidation. UK – most favourable
CDS trades with MMR under STEC
Difficult to file and come through so constrains default
rate count

2
Chapter 7 in the US is rarely used s it results in a liquidation and cessation of operations.

1 October 2010 11
Barclays Capital | European Credit Alpha

We also see increased Euribor rates as potentially prompting more restructurings. The low
rate of Euribor has helped keep some credits alive, given that they are floating rate assets.
The current rate is still well below the average for 2005-07 when such deals actually priced.
Given that our rate strategists expect Euribor to increase to 2.05% by Q4 11 and growth to
be slow, we believe some companies that are still underperforming by then may not be able
to refinance if Euribor increases.

Figure 18: European rate history vs. leveraged loan issuance

€bn Non-Institutional Institutional %

Euribor (RHS) ECB Repo (RHS)
200 Euribor Average by Year (RHS) 6
180
5
160
140 4
120
100 3
80
60 2
40
1
20
0 0
2006 2007 2008 2009 2010

Source: Bloomberg, Barclays Capital

However, the leveraged finance market – at about €500bn outstanding – is only a part of
the future distressed debt market. The bigger opportunity will be non-levered assets sitting
on bank books from sectors affected in the recession, such as commercial property. The
holders of such assets do not necessarily have the expertise to restructure them. By
restructuring credits rather than liquidating them, distressed investors can extract value
from stressed assets that previous classes of disparate holders could not. A recent example
was Technicolor, which we discuss in the appendix.

Distressed loans at European banks

We see potentially increased amounts of distressed debt coming from the banks over the
medium term. The end result of Basel 3 is that bank assets will have to be better maturity
matched with longer-term liabilities. Capital will come from a combination of new capital,
increased deposits and, importantly, shedding assets, reducing the need to fund them. We
note, however, that the 8-year implementation plan should mean fewer immediate forced
sales of assets, thereby enabling more of them to be held to expected maturity if projected
recovery prospects improve.

Not all banks will want to sell given the capital hit they may have to take. Most loan debt is
held on the banking book and generally marked at par. If, for example, a senior loan is seen
as intrinsically worth €70 and is still paying its coupon, a bank will not force a €30 loss by
pushing for a restructuring – they would give a credit time to get a higher recovery or par.
Despite this, there are certain circumstances that could force a bank to sell:

„ A bank itself becoming distressed (eg, Anglo Irish)

„ The bank thinks the ultimate recovery could be lower than the current value.

1 October 2010 12
Barclays Capital | European Credit Alpha

The reorganisation of the European banking sector is already resulting in asset sales for
some banks across the EU. Conditional upon receiving EC approval of state aid, some banks
are shrinking via asset sales over specified time frames. For example, we expect German
landesbanks to be broadly net sellers of assets because they used their guaranteed balance
sheets to build up assets in the past decade – some of which ended up as distressed.

Banks are trying varied solutions to dispose of distressed assets outside of traditional
distressed debt investors. For example, a recent CLO from ICG saw €1.4bn of loans of
varying credit quality exit the books of RBS with the equity tranche taking up 41% of the
total deal. Existing CLOs will be hampered from investing in distressed, facing such rules as
limits on CCC-rated positions and upcoming reinvestment period deadlines. Once past
reinvestment periods, existing CLOs will have a lot less flexibility as they are forced to pay
down their liabilities from loan amortisations and recoveries.

Assets from “bad banks”

The bailout of the banking system with public money could come under pressure. The bad
banks created to buy banking assets at a discount need capital. Public finances across most
EU nations have come under pressure. For example, France, Germany, Ireland, Italy and
Spain have €2.5trn in maturities to fund through to 2015, with c.€500bn of this is from
peripherals including Greece and Spain. The ability of countries to bail out their banking
systems will link the creditworthiness of the banks to that of sovereigns.

The evolving textbook example is in Ireland following the end of the Celtic Tiger growth
period. The current yield on the Irish 10-year benchmark has risen to c.6.7%, a level not
seen since 1997. The cost of bailing out the Irish banking system to the government has
risen combined with continuing austerity measures.

The government created the National Asset Management Agency (NAMA) to buy bank
assets at a discount in exchange for government guaranteed bonds (which are eligible ECB
collateral). NAMA can manage the assets to maturity or gradually sell them down to third-
party investors. According to current plans, NAMA is expected to buy €81bn in impaired
Irish bank assets, yet there is already evidence of continued deteriorating asset quality in the
banking system since the bailout began. For example, in the case of Anglo Irish Bank, the
haircuts offered by NAMA over the first two tranches have increased from 55% to c.62%. In
the recent announcement, the haircut increased again to 67%. Such deteriorating asset
quality could either lead to assets being forced out of banks without going to NAMA or to
NAMA not being able to fund more impaired assets. A recent result of this is more active
distressed trading in Irish credits such as Quinn Group.

Conclusion
A true market in European distressed securities will develop over time. We expect some
poorly performing companies to be unable to refinance maturities and lending groups to be
less willing to use forbearance measures. The larger proportion of distressed debt will be par
bank loans, in our opinion, due to banks needing to delever and shed some assets ahead of
Basel 3 implementation and bad banks potentially unwinding holdings of distressed loans.
The size of the distressed market depends on the willingness of current asset holders to
continue to crystalise losses now or later.

1 October 2010 13
Barclays Capital | European Credit Alpha

Appendix: Thomson/Technicolor case study

The Technicolor restructuring is an interesting case study in how distressed credits can
restructure after insolvency. It involved multiple classes of debt, hybrid equity and equity.

In July 2009, the company, which had been seen as in distress for some time, agreed to a
restructuring proposal with its creditors. The pre and post restructuring capital structure is
displayed in Figure 19. The restructuring saw debt and hybrid holders lose principal, with
debt holders also getting extended and equity holders accepting dilution.

A debt for equity swap, the subsequent issue of an ORA instrument that payable as equity in
December 2010 and 2011 and the pledging of disposal proceeds as a disposal note wiped
out c.€1.3bn in debt. Technicolour also pledged disposal proceeds from various asset sales
that were repayable in equity/cash. Following this, the new debt saw extended terms
through to 2015-16 and the hybrid was stripped of its coupons after a payment of c.€0.05
to note holders (the hybrid is redeemed in full on any liquidation of the company and the
payment avoided nuisance lawsuits).

Figure 19: Technicolor (old Thomson) restructuring

Pre restructuring €mn Reinstated debt post restructuring €mn

Syndicated facility 1739 Holders of the old syndicated facility TL E+500bp, 7% amortising 306
received new loans and received
equity/ORA Instruments/DPN rights. Debt
and equity/ORA/Disposal notes valued at
the same share as this class of debt in the
old company. TL E+600bp 2016 bullet 643
Holders of the old PPNs received new PPN Sr notes 9%/9.35%/9.55% $/£/€
Old private placement notes (PPN) 1100 notes and equity/ORA Instruments/DPN amortising (new PPN) 194
rights. Debt and equity/ORA/Disposal notes
valued at the same share as this class of Sr notes 9%/9.35%/9.55% $/£/€ bullet
debt in the old company. (new PPN) 407
New term loans and senior notes are senior
Total debt* 2839 unsecured and pari passu Total reinstated debt 1550
Cash (511) Cash (400)
Hybrid 500 Hybrid bought out at €0.05
Net debt 2828 PF net debt 1150

Post restructuring Equity €

Equity price was €0.66 a share and fully

Rights issue (D/E swap)
ORA (D/E swap) 2010/11 10% PIK
Disposal note (10% PIK Dec 2010)
Reinstated debt 2015
Note: * Restructuring plan used March 2009 FX rates, which differ from balance sheet numbers.
Source: Company filings, Barclays Capital
underwritten by creditors via debt sell-off,
(350) open to shareholders.
Issued to credits as debt for equity swap
maturing in December 2010 and December
2011 with holders option to extend by one
(639) year. Company can repay 23% in cash.
Issued to creditors to be repaid from
disposal proceeds and in shares of Thomson
(300) options at prevailing market price.
1550

1 October 2010 14
Barclays Capital | European Credit Alpha

Debt recovery in this case (at time of restructuring) was c.55% for both the RCF and PPN
holders (they were pari) before factoring in equity received under the debt for equity swap,
ORA and rights to disposal proceeds under the disposal note. However, the original equity
holders have been heavily diluted by the debt holders who received equity. The ultimate
recovery for debtholders is also dependent on future equity and debt price direction in the
restructured entity.

Rather than push through a liquidation that may have destroyed value, the restructuring has
resulted in a more sustainable capital structure, reducing net debt to EBITDA to 2.4x, down
from 4x at end-2008. Though interest cover has fallen to 3.8x from 6.3x over the same
period, this reflects the current higher cost of capital traded off for a longer life of debt, also
giving it extra ability to refinance further on if the credit story continues to improve.

1 October 2010 15
Barclays Capital | European Credit Alpha

CREDIT AT A GLANCE

Zoso Davies
+44 (0) 20 7773 5815
zoso.davies@barcap.com
Rob Hagemans
+44 (0) 20 7773 6509
rob.hagemans@barcap.com
Dominik Winnicki
+44 (0) 20 3134 9716
dominik.winnicki@barcap.com
Corporates generated just over 50bp of excess returns in September, led by financials – in
particular the Tier 1 part of the capital structure. Insurance, which is more heavily weighted
towards Tier 1 than banking, was the top performing sector this month – utilities
underperformed.
Indices were marginally tighter week on week, while investment grade cash was wider.
Despite this, our measure of the cash-CDS basis was broadly unchanged as single-name
contracts lagged the index tightening. This drove the skew more negative on Main and
Crossover. Index curves steepened, but only marginally, and slopes remain near the top of
their historical ranges. High-yield cash continues to outperform, while sterling cash
underperformed and now looks cheap to USD-credit on a historical basis.
September issuance was the third highest monthly total this year, but average by
historical measures – and significantly below the USD100bn of new deals in the US
market. Financials issued c.EUR30bn of debt and non-financials c.EUR20bn, of which
c.EUR5bn was hybrid debt.

Figure 20: Barclays Capital Euro Aggregate Corporate Index performance by sector
MTD excess m/m spread Excess return Excess return
Sector returns (%) 29 Sept OAS(bp) 21 Aug OAS(bp) change 3mth (%) 12mth (%) % of index

Insurance 2.19 331 367 -36 4.7 5.4 5.2

Brokerage 0.82 266 280 -13 1.5 5.2 0.2
Banking 0.77 231 244 -13 2.4 1.7 42.1
Senior 0.14 173 172 1 1.2 0.2 30.2
Lower Tier 2 1.30 292 324 -32 3.5 3.6 8.2
Upper Tier 2 0.98 441 447 -6 2.8 4.7 0.7
Tier 1 5.77 603 705 -102 12.5 10.7 3.0
Transportation 0.72 203 214 -11 -0.4 2.8 2.0
Capital Goods 0.51 173 179 -6 1.3 2.5 4.8
Basic Industry 0.49 152 158 -6 1.2 2.3 3.9
REITS 0.35 172 177 -5 1.0 3.8 0.4
Finance Companies 0.35 203 206 -3 1.5 3.4 2.9
Other Finance 0.34 265 279 -14 1.5 2.4 0.5
Technology 0.27 148 149 0 1.0 1.9 0.6
Consumer Cyclical 0.16 143 140 3 1.1 2.7 6.3
Natural Gas 0.09 148 143 5 0.9 0.0 1.9
Consumer Non-Cyclical 0.08 112 110 2 0.7 1.9 8.9
Other Utility 0.02 134 122 12 0.7 2.5 1.4
Energy 0.00 104 101 3 1.2 0.6 3.0
Communications -0.01 161 158 3 1.1 1.0 9.5
Electric Utility -0.13 140 126 14 0.5 0.3 5.9
Financials 0.88 240 254 -14 2.6 2.2 51.4
Corporates 0.52 193 199 -6 1.7 1.9 100.0
Source: Barclays Capital

1 October 2010 16
Barclays Capital | European Credit Alpha

Figure 21: CDS indices tightened this week… Figure 22: … but spreads remain in a narrow range

w/w spread change (bp) Main, Sen.Fin, Crossover (bp)

2 SovX, HiVol (bp)
1 600 Main (111) 1200
SovX (156)
0 500 1000
Sen. Fins (144)
-1 HiVol (175)
400 Crossover (513) 800
-2
-3 300 600
-4
200 400
-5
-6 100 200
Main

HiVol

Crossover

Sen. Fins

Sub. Fins

SovX
0 0
2007 2008 2009 2010 2011

Note: Spread changes measured between Wednesdays. Source: Markit Source: Markit

Figure 23: In cash, IG spreads widened while HY tightened Figure 24: HY spreads have outperformed year to date

w/w spread change, bp IG, OAS (bp) Sub. Fins, HY, OAS (bp)
30 400 1800
25 350 1600
20 1400
300
15
1200
10 250
5 1000
200
0 800
-5 150
600
-10 100 400
-15 50 200
-20
0 0
Sen. Fins

LT2

Tier 1

Financials

Industrials

Utilities

HY Index

HY 3% ex.
Pan Eur

2007 2008 2009 2010 2011

Fins

Sen. Financials (173) Non-Fins (144)

Sub. Financials (377) Pan Eur HY Index (525)

Note: Spread changes measured between Wednesdays. Source: Barclays Capital Source: Barclays Capital

Figure 25: USD cash outperformed this week Figure 26: Sterling credit looks cheap to USD, historically

w/w spread change, bp BBB non-financials, L-OAS

14 700
EUR (155)
12 600 GBP (199)
USD (172)
10 500

8 400

6 300

4 200

2 100

0 0
EUR GBP USD 2007 2008 2009 2010

Note: Spread changes measured between Wednesdays. Source: Barclays Capital Source: Barclays Capital

1 October 2010 17
Barclays Capital | European Credit Alpha

Figure 27: Basis was broadly unchanged this week Figure 28: The sub-fins basis continues to normalise

w/w change in basis, bp cash-CDS Basis, bp

10 100
8 48
50
6 9
4 0 4
2 -16
-50 -27
0
-2 -100
-4
-6 -150
-8 -200
€ IG non-

£ IG non-

€ IG sen-

€ IG sub-

High Yield
Aug 09 Nov 09 Feb 10 May 10 Aug 10
fins

fins
fins

fins

€ IG non-fins € IG sen-fins High Yield

£ IG non-fins € IG sub-fins
Source: Markit, Barclays Capital Source: Markit, Barclays Capital

Figure 29: September has been the third busiest month, YTD Figure 30: HY issuance picked up late in the month

IG Issuance, EUR bn *, Issuance MTD HY Issuance, €bn *, Issuance MTD

120 10
100
8
80
6
60
4
40
2
20

0 0
Dec

Sep*
May
Nov

Jan

Jun
Sep

Feb

Aug
Mar

Apr
Oct

Jul
Dec

July

Sep*
May
Nov

Jan

Jun
Sep

Feb

Aug
Mar
Apr
Oct

2009 2010 2010

Financials Non-Financials Monthly Issuance

Source: Dealogic, Barclays Capital Source: Dealogic, Barclays Capital

Figure 31: Implied vol took another leg lower this week Figure 32: Realised volatility continues to trend lower

Annualised 140% Main (43%)

110% HiVol (52%)
Crossover (50%)
120% SenFin (57%)
100%
SovX (52%)
90% 100%
80%
80%
70%
66%
60% 60%
50%
43% 40%
40%
30% 20%
Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Jan Apr Jul Oct Jan Apr Jul
Realised Implied 09 09 09 09 10 10 10

Source: Markit, Barclays Capital Source: Markit, Barclays Capital

1 October 2010 18
Barclays Capital | European Credit Alpha

Figure 33: Curves steepened marginally this week Figure 34: Index 3s5s remain near historical highs

w/w spread change, bp Crossover slope, bp Main slope, bp

3 150 30

100 20
50 10
2
0 0

-50 -10
-100 XO 3s5s (76) -20
1 XO 5s10s (5)
-150 Main 3s5s (27) -30
Main 5s10s (11)
-200 -40

0 -250 -50
Main 3s5s Main 5s10s XO 3s5s XO 5s10s 2006 2007 2008 2009 2010 2011

Source: Markit, Barclays Capital Source: Markit, Barclays Capital

Figure 35: Credit and equities remain range-bound Figure 36: Cross-asset beta and correlation have stabilised

Stoxx 50 90 day Beta 90 day Correlation

5600 of w/w changes of w/w changes
5100 2000-2007 Cycle 0.15 0.2
2007-2009 Cycle
4600 2009-Present 0.10 0.0
4100 Current Spread
3600 0.05 -0.2

3100 0.00 -0.4

2600
-0.05 -0.6
2100
-0.10 -0.8
1600
1100 -0.15 -1.0
600 2002 2004 2006 2008 2010
0 100 200 300 400 500 Beta, BarCap Eur. Agg. Corp OAS to SX5P
Barclays Capital EUR Agg. cash index (OAS) Correlation, BarCap Eur. Agg. Corp OAS to SX5P

Source: Markit, Bloomberg, Barclays Capital Source: Markit, Bloomberg, Barclays Capital

Figure 37: Skew on Main turned negative this week… Figure 38: … but was broadly unchanged on Crossover

Skew (bp) Skew (bp)

16 50
14
12 40
10 30
8
6 20
4
10 9.6
2
0 0
-2
-3.0
-4 -10
Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10

Skew of Main 25 day rolling average Skew of Crossover 25 day rolling average

Source: Markit, Barclays Capital Source: Markit, Barclays Capital

1 October 2010 19
Barclays Capital | European Credit Alpha

Returns

Figure 39: Barclays Capital Euro Aggregate Corporate Index – performance by rating and maturity
MTD excess 29 Sept 21 Aug m/m spread Excess return Excess return
returns (%) OAS(bp) OAS(bp) change 6mth (%) 12mth (%) % of index

Rating
Aaa 0.02 100 99 1 0.2 -0.3 3.2
Aa 0.16 137 136 1 1.1 0.9 22.5
A 0.50 188 196 -8 1.7 1.9 49.4
Baa 0.95 267 275 -8 2.6 3.4 24.9
Maturity
1-3y 0.46 185 196 -12 0.3 1.9 29.3
3-5y 0.49 195 200 -4 -0.3 1.7 31.3
5-7y 0.66 199 202 -3 -0.8 2.7 19.1
7-10y 0.72 214 215 -1 -1.6 1.9 14.4
10y+ -0.01 158 157 1 -2.6 2.1 5.9
Source: Barclays Capital

Figure 40: 2010 July total returns, Pan European 3% High Yield Index
Total return (%) Δ OAS (bp)
OAS MAD OAS/ % Credit
Jul 2010 YTD LTM (bp) (yrs) MAD Jul 2010 YTD index

Overall 3.2 9.3 23.9 530 3.9 134 -84 -38 100.0

Ba 2.4 8.0 18.1 388 4.0 96 -65 12 57.8

B 3.6 9.3 21.5 620 4.1 152 -93 16 29.6
Caa 5.3 15.6 51.5 902 3.2 281 -159 -198 11.9
Ca-D 13.0 -0.3 62.4 2065 3.6 575 -243 168 0.7

0-3y 1.9 6.8 18.8 439 1.8 238 -100 -125 24.2
3-4y 2.9 8.7 24.7 584 3.3 175 -86 -37 24.4
4-5y 4.6 11.6 27.6 639 4.4 146 -126 34 21.4
5-6y 3.7 10.0 24.4 490 5.4 91 -37 -18 21.9
6y+ 2.6 10.5 25.7 463 7.1 66 -64 27 8.1

Energy 5.7 12.6 17.1 417 5.3 79 -125 -76 0.7

Electric 5.7 13.7 20.3 472 5.2 91 -138 -71 0.8
Technology 5.1 18.8 25.2 605 3.9 153 -123 -112 1.8
Transportation 4.1 10.0 26.8 458 4.0 115 -109 -32 5.3
Communications 3.7 6.9 20.8 663 4.5 149 -92 36 20.8
Basic Industry 3.4 11.3 32.7 543 3.7 145 -81 -140 16.8
Other Industrial 3.1 11.0 27.1 606 4.0 152 -91 15 4.8
Capital Goods 2.8 7.4 25.5 513 3.9 130 -92 -21 15.3
Consumer Non-Cyclical 2.7 8.6 15.1 366 4.3 84 -64 -8 8.9
Consumer Cyclical 2.6 10.1 23.3 482 3.4 142 -73 -69 24.7
Other utility -0.9 8.0 6.2 350 6.3 56 11 130 0.2
Source: Barclays Capital

1 October 2010 20
Barclays Capital | European Credit Alpha

Index volatility update

Figure 41: Realised volatility keeps dropping Figure 42: Payer skew edged up as risk aversion increased

Volatility Volatility Skew

(%) 120% 0.2
160
100% 0.15
140
80%
120 0.1
100 60%
0.05
80 40%
60 0
20%
40
0% -0.05
20
Sep Nov Jan Mar May Jul
0
09 09 10 10 10 10
Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
3M ATMf implied vol Receiver skew (rhs)
3M Implied 3M Realised 1M Realised Payer skew (rhs)
Source: Barclays Capital Source: Barclays Capital

Figure 43: Main volatility still in a downward trend Figure 44: Credit volatility falling versus other asset classes

Volatility Volatility Normalized

(%) (%) volatility
90 80 1.9
85 75 1.7
80 1.5
70
75
1.3
70 65
1.1
65 60
0.9
60
55 0.7
55
50 50 0.5
30/06/2010 30/07/2010 30/08/2010 Jan Feb Mar Apr May Jun Jul Aug Sep
Main 3M ATM IG 3M ATM (rhs) Main SX5E EUSW5 EURUSD

Source: Barclays Capital Note: 3m implied volatilities normalised to 4 January level. EUSW5 represents 3m
implied volatility in 5y swaptions.
Source: Bloomberg, Barclays Capital

1 October 2010 21
Barclays Capital | European Credit Alpha

EUROPEAN CREDIT RESEARCH ANALYSTS

Matthew Leeming Zoso Davies Arup Ghosh

Credit Strategy Credit Strategy Credit Strategy
+44 (0)20 7773 9320 +44 (0)20 7773 5815 +44 (0)20 7773 6275
matthew.leeming@barcap.com zoso.davies@barcap.com arup.ghosh@barcap.com
Rob Hagemans Eugene Regis Aziz Sunderji
Credit Strategy Credit Strategy Credit Strategy
+44 (0)20 7773 6509 +44 (0)20 7773 9169 +44 (0) 20 7773 7881
rob.hagemans@barcap.com eugene.regis@ barcap.com aziz.sunderji@barcap.com
Dominik Winnicki
Credit Strategy
+44 (0)20 3134 9716
dominik.winnicki@barcap.com

Robert Jones
Head, European Fundamental Credit Research
+44 (0)20 7773 9857
robert.jones@barcap.com
Neil Beddall Darren Hook Jeroen Julius
Utilities Industrials Banks
+44 (0)20 7773 9879 +44 (0)20 7773 8970 +44 (0)20 3134 9642
neil.beddall@barcap.com darren.hook@barcap.com jeroen.julius@barcap.com
Brian Monteleone Sam Morton Justin Ong
Insurance High Grade TMT Consumer/Retail
+44 (0)20 3134 9685 +44 (0)20 7773 7844 +44 (0)20 3134 9687
brian.monteleone@barcap.com sam.morton@barcap.com justin.ong@barcap.com
Daniel Rekrut
High Yield TMT
+44 (0)20 7773 5980
daniel.rekrut@barcap.com

1 October 2010 22
Analyst Certification(s)
We, Matthew Leeming, Zoso Davies, Arup Ghosh, Eugene Regis, Aziz Sunderji and Dominik Winnicki, hereby certify (1) that the views expressed in this
research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part
of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report.

Important Disclosures
For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital
Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgi-
bin/all/disclosuresSearch.pl or call 212-526-1072.
Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital
may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or
an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt
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or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted
and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to
determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including,
but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the
profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential
interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information
was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are
historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document.
Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis,
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Explanation of the High Yield Sector Weighting System

Overweight: Expected six-month total return of the sector exceeds the six-month expected total return of the Barclays Capital U.S. High Yield 2% Issuer
Capped Credit Index, or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, as applicable.
Market Weight: Expected six-month total return of the sector is in line with the six-month expected total return of the Barclays Capital U.S. High Yield 2%
Issuer Capped Credit Index or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, as applicable.
Underweight: Expected six-month total return of the sector is below the six-month expected total return of the Barclays Capital U.S. High Yield 2% Issuer
Capped Credit Index or the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, as applicable.

Explanation of the High Yield Research Rating System

The High Yield Research team employs a relative return based rating system that, depending on the company under analysis, may be applied to either
some or all of the company's debt securities, bank loans, or other instruments. Please review the latest report on a company to ascertain the application of
the rating system to that company.
Overweight: The analyst expects the six-month total return of the rated debt security or instrument to exceed the six-month expected total return of the
Barclays Capital U.S. 2% Issuer Capped High Yield Credit Index, the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, or the
EM Asia USD High Yield Corporate Credit Index, as applicable.
Market Weight: The analyst expects the six-month total return of the rated debt security or instrument to be in line with the six-month expected total
return of the Barclays Capital U.S. 2% Issuer Capped High Yield Credit Index, the Pan-European High Yield 3% Issuer Capped Credit Index excluding
Financials, or the EM Asia USD High Yield Corporate Credit Index, as applicable.
Underweight: The analyst expects the six-month total return of the rated debt security or instrument to be below the six-month expected total return of
the Barclays Capital U.S. 2% Issuer Capped High Yield Credit Index, the Pan-European High Yield 3% Issuer Capped Credit Index excluding Financials, or
the EM Asia USD High Yield Corporate Credit Index, as applicable.
Not Rated (NR): An issuer which has not been assigned a formal rating.
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 Barclays Capital is acting in an advisory capacity in a merger or strategic
transaction involving the company.
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