Download - BarCap on Distressed Debt Markets

CREDIT RESEARCH 1 October 2010

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 22

EUROPEAN CREDIT ALPHA More answers than questions

Matthew Leeming

+44 (0) 20 7773 9320

[email protected]

Zoso Davies

+44 (0) 20 7773 5815

[email protected]

Arup Ghosh

+44 (0) 20 7773 6275

[email protected]

Eugene Regis

+44 (0) 20 7773 9169

[email protected]

Aziz Sunderji

+44 (0) 20 7773 7881

[email protected]

Dominik Winnicki

+44 (0) 20 3134 9716

[email protected]

www.barcap.com

This version corrects Figure 3, where the scale was incorrect on the left hand axis.

Strategic Market View: There and back again 4

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, but largely driven by macroeconomic uncertainties, while strong corporate fundamentals should provide spreads with a buffer if future growth stays anaemic. Sovereign volatility continues to drive valuation dislocations and we highlight a credit-equity normalisation trade on EDP. For investors worried about poor economic growth, we also recommend going long a basket of selected names with counter-cyclical performance while simultaneously shorting the index as a suitable trade for generating counter-cyclical alpha.

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.

Barclays Capital | European Credit Alpha

1 October 2010 2

CREDIT VIEWS ON A PAGE CREDIT STRATEGY

CATEGORY THESIS TRADE IDEAS High Grade Monetise steep skew, hedge

against moderate widening 1x2 payer spreads on Main to December

Use bank Tier 1s to boost yield or beta

Despite the rally that has reduced the pick-up to senior, we continue to believe there is value in European bank Tier 1 as a high-beta asset class

Relative value in step-up bonds

Switch into Lafarge step-ups: LGFP €7.625% 2014 and LGFP €7.625% 2016s

Relative value trades between corporates and sovereigns

Short corporates trading tighter than their own sovereign (only in AAA sovereigns)

Cyclical hedge in CDS Basket of cyclical shorts vs index: LMETEL (Ericsson), MICH, PUBFP, STM, VLOF, WKLNA, WPP Basket of cyclical longs vs index: BNFP (Danone), ROSW, EXHO, TSCOLN, ULVRLN

Normalisation trades Yield/credit curves steep at front end, buy short-dated credit Basis trades > -100bp

High Yield Relative value across ratings buckets

We favour single-B-rated paper and expect it to compress towards BB

Relative value in senior vs subordinated cash

On capital structures of performing names with secured and unsecured bonds, unsecured tiers look attractive: Buy Ardagh € ‘17, Ineos € ‘16, Europcar € ‘14 and Lecta € ‘14 against secured issues

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 to refinance

Loans or short-duration bonds trading sub-par, which we expect to be refinanced Short-duration paper on high-beta credits with strong liquidity Selected name-specific 5s10s DV01 neutral steepeners for borrowers we expect to refinance

Returns are hard to find We favour bonds with cash yield above the current yield of the index

Event-driven trades: LBOs

Cash Switch into bonds that are closer to maturity to reduce sensitivity to spread widening and curve steepening Switch into bonds with protective covenants, such as change-of-control (CoC) puts and/or

step-up coupons

CDS Buy outright CDS protection on an LBO target; Buy outright CDS protection on a target and sell protection on a correlated index

Implement a CDS steepener on a potential candidate

Equity options Long equity call options for LBO candidates

HIGH GRADE CREDIT RESEARCH

SECTORS OVERWEIGHT UNDERWEIGHT Banks, Consumer, Industrials Telecoms, Media, Technology, Utilities, Pharmaceuticals

COMPANIES FAVOURED*: OVERWEIGHT – BONDS/SELL PROTECTION – CDS

UNFAVOURED*: 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,

Imperial Tobacco, Tesco (CDS), PPR (CDS) Carrefour, Next (CDS), Diageo, Experian (CDS), Carlsberg (CDS)

General Industrial BAA (cash), Finmeccanica, Alstom (CDS), CRH, Clariant (cash), Thyssenkrupp (CDS)

Metso, Akzo Nobel, Bayer, Clariant (CDS), Rolls Royce (CDS), Lafarge, Sanofi-Aventis, Holcim (cash)

Insurance Stalif (cash), Llydin (T1), Eureko (bonds), Munich Re (bonds), Zurich (bonds)

Aegon (CDS), Hannover Re (CDS), Generali (CDS), Unipol (CDS)

Pharmaceuticals Roche, Novartis (cash) AstraZeneca TMT BT Group, OTE, Telefonica, Lagardère, Swisscom (CDS),

Telenor (CDS), Nokia (CDS) Deutsche Telekom, Vodafone, TeliaSonera, TKA, KPN, STM (CDS), FT, Ericsson, Pearson** (CDS), Portugal Telecom (CDS), Wolters Kluwer (CDS), Ericsson (CDS), WPP (CDS)

Utilities EDP, Enel, Gas Natural, Veolia Environnement, REN, Glencore, Iberdrola (CDS)

United Utilities Plc, Suez Environnement, Elia, Verbund, Edison, Fortum (CDS), EnBW (CDS), Vattenfall (CDS)

HIGH YIELD CREDIT RESEARCH

COMPANIES FAVOURED*: OVERWEIGHT – BONDS/SELL PROTECTION – CDS

UNFAVOURED*: UNDERWEIGHT – BONDS/BUY PROTECTION – CDS

Basic Industries Ardagh Glass 2016/2017/2020, Lecta 2014 (sub + snr), M-Real 2013, Smurfit Kappa Group 2015/2017/2019

Clondalkin Industries 2013/2014, Norske Skog 17s

General Industrial Evonik Degussa 13s, Evonik Industries 14s, Savcio, HeidelbergCement 2012/2014/2017/2018/2019, Valeo (cash), GKN (CDS)

Lufthansa (cash), Air France (cash), Stora Enso, UPM

Consumer & Retail Pernod (EUR) TMT Wind €11.0% 2015, KDG €+700 PIK 2014, Seat €8.0% 2014,

Unity €8.125% 2017, UPC €8.0% 2016 Ono €8.0% 2014, €10.5% 2014, Unity €9.625% 2019, 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 3

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 Tui Travel

H1 interim results Interim sales

US: ISM non-Manufacturing 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 Sodexo Ladbrokes

9M results FY results 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 Diageo Roche SABMiller Suedzucker Syngenta

Q3 sales Interim statement Q3 sales Q2 sales Q2 results Q3 sales

US: PPI, Jobless claims, Trade balance, EZ: ECB Monthly report

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 4

STRATEGIC MARKET OVERVIEW

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.

Arup Ghosh +44 (0) 20 7773 6275

[email protected]

Matthew Leeming +44 (0) 20 7773 9320

[email protected]

Aziz Sunderji +44 (0) 20 7773 7881

[email protected]

Dominik Winnicki +44 (0) 20 3134 9716

[email protected]

Zoso Davies +44 (0) 20 7773 5815

[email protected]

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 1: Peripheral European sovereigns have seen diverging performances over the last month…

Figure 2: … while the sharpest changes recently have been in the Irish sovereign CDS curve

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While the aggregate sovereign index has stayed virtually unchanged, European peripherals have seen a sharp divergence in performance

The Irish finance minstry's plan for further capital injection in Anglo Irish bank was greeted by the market with

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


1 October 2010 5

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 6

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

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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 7

Figure 4: Sovereign weakness drives EDP wide but the stock price barely budged

Figure 5: P&L of the trade for data points over the recent past

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Source: Barclays Capital Source: Bloomberg, Barclays Capital

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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.

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https://live.barcap.com/go/research/content?contentPubID=FC1637038


1 October 2010 8

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

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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 historical tights versus the index

Figure 10: This basket has outperformed during previous periods of poor growth

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


1 October 2010 9

DISTRESSED DEBT MARKETS

Time to grow We expect the European distressed debt market to grow as the result of excessive corporate leverage from the past decade. So far, the actual outflow of distressed assets from banks and non-bank investors has been relatively muted compared with the size of lending markets.

Eugene Regis +44 (0) 20 7773 9169

[email protected] 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 10

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

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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 issuance1.

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)

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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 11

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

Figure 15: Distressed credits – defaults vs. restructurings

). 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 16: Issuers seeking covenant relief amendments

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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 Europe2. A summary of US and European bankruptcy rules is in Figure 17.

Figure 17: European vs. US bankruptcy regimes

US Europe

Bankruptcy regime Single legal regime. Chapter 11 leads to re-organisation under operation as a going concern

No single bankruptcy provision. Some equity/ management friendly – France, Spain. Some secured lender friendly – UK, but it can be unfriendly to unsecured

Ease of coming through bankruptcy Well rehearsed. “Going concern” driven regime Not easy. Liquidation is frequent

Out of court restructuring Rare as restructuring is done through a bankruptcy court under Chapter 11.

Many restructurings to avoid a bankruptcy filing or avoid eventual liquidation. UK – most favourable

CDS consequences No restructuring on CDS in SNACs CDS trades with MMR under STEC

Default count consequences Easier to file and come through bankruptcy; hence, leads to higher default count

Difficult to file and come through so constrains default rate count

Source: Barclays Capital

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


1 October 2010 12

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

02006 2007 2008 2009 2010

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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 13

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 14

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

Figure 19: Technicolor (old Thomson) restructuring

. 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).

Pre restructuring €mn Reinstated debt post restructuring €mn

Syndicated facility 1739 TL E+500bp, 7% amortising 306

Holders of the old syndicated facility 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

Old private placement notes (PPN) 1100 Sr notes 9%/9.35%/9.55% $/£/€ amortising (new PPN) 194

Holders of the old PPNs received new PPN notes and 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.

Sr notes 9%/9.35%/9.55% $/£/€ bullet (new PPN) 407

Total debt* 2839 New term loans and senior notes are senior 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 €

Rights issue (D/E swap) (350)

Equity price was €0.66 a share and fully underwritten by creditors via debt sell-off, open to shareholders.

ORA (D/E swap) 2010/11 10% PIK (639)

Issued to credits as debt for equity swap maturing in December 2010 and December 2011 with holders option to extend by one year. Company can repay 23% in cash.

Disposal note (10% PIK Dec 2010) (300)

Issued to creditors to be repaid from disposal proceeds and in shares of Thomson options at prevailing market price.

Reinstated debt 2015 1550

Note: * Restructuring plan used March 2009 FX rates, which differ from balance sheet numbers. Source: Company filings, Barclays Capital


1 October 2010 15

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 16

CREDIT AT A GLANCE

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.

Zoso Davies +44 (0) 20 7773 5815

[email protected]

Rob Hagemans +44 (0) 20 7773 6509

[email protected]

Dominik Winnicki +44 (0) 20 3134 9716

[email protected]

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

Sector MTD excess returns (%) 29 Sept OAS(bp) 21 Aug OAS(bp)

m/m spread change

Excess return 3mth (%)

Excess return 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



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

1 October 2010 17

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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

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IG, OAS (bp) Sub. Fins, HY, OAS (bp)

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

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


1 October 2010 18

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

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Figure 29: September has been the third busiest month, YTD

Figure 30: HY issuance picked up late in the month

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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

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1 October 2010 19

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

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Figure 35: Credit and equities remain range-bound

Figure 36: Cross-asset beta and correlation have stabilised

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90 day Correlation of w/w changes

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

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1 October 2010 20

Returns

Figure 39: Barclays Capital Euro Aggregate Corporate Index – performance by rating and maturity

MTD excess returns (%)

29 Sept OAS(bp)

21 Aug OAS(bp)

m/m spread change

Excess return 6mth (%)

Excess return 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


Figure 40: 2010 July total returns, Pan European 3% High Yield Index

Total return (%) Δ OAS (bp)

Jul 2010 YTD LTM OAS (bp)

MAD (yrs)

OAS/ MAD Jul 2010 YTD

% Creditindex

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



1 October 2010 21

Index volatility update

Figure 41: Realised volatility keeps dropping

Figure 42: Payer skew edged up as risk aversion increased

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Figure 43: Main volatility still in a downward trend

Figure 44: Credit volatility falling versus other asset classes

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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 22

EUROPEAN CREDIT RESEARCH ANALYSTS

Matthew Leeming Credit Strategy +44 (0)20 7773 9320 [email protected]

Zoso Davies Credit Strategy +44 (0)20 7773 5815 [email protected]

Arup Ghosh Credit Strategy +44 (0)20 7773 6275 [email protected]

Rob Hagemans Credit Strategy +44 (0)20 7773 6509 [email protected]

Eugene Regis Credit Strategy +44 (0)20 7773 9169 eugene.regis@ barcap.com

Aziz Sunderji Credit Strategy +44 (0) 20 7773 7881 [email protected]

Dominik Winnicki Credit Strategy +44 (0)20 3134 9716 [email protected]

Robert Jones Head, European Fundamental Credit Research +44 (0)20 7773 9857 [email protected]

Neil Beddall Utilities +44 (0)20 7773 9879 [email protected]

Darren Hook Industrials +44 (0)20 7773 8970 [email protected]

Jeroen Julius Banks +44 (0)20 3134 9642 [email protected]

Brian Monteleone Insurance +44 (0)20 3134 9685 [email protected]

Sam Morton High Grade TMT +44 (0)20 7773 7844 [email protected]

Justin Ong Consumer/Retail +44 (0)20 3134 9687 [email protected]

Daniel Rekrut High Yield TMT +44 (0)20 7773 5980 [email protected]

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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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