OVERVIEW 2
The market gave back its December and early-January gains as stocks sold off sharply
until the rally on Friday. A poor start to earnings season, especially from banks, initially
overwhelmed the positive sentiment related to government intervention, but further
government intervention late in the week partly reversed the underperformance.
FOCUS: DOES LIQUIDATING DISTRESSED
ABS CDO AND CLO DEALS MAKE SENSE? 4
ABS CDOs have suffered significant downgrades, and a considerable proportion of deals
have experienced an event of default (EOD), In the CLO market, increasing default rates
and the expected downward migration of underlying ratings are likely to amplify EOD risk.
We study the best course of action for ABS CDO and CLO investors across the capital
structure, particularly in assets that have undergone or risk undergoing an EOD.
INVESTMENT GRADE 21
We remain constructive on cash spreads over the medium term as government intervention
leads to improvement in liquidity and funding for investment grade corporate bonds. We
remain less constructive on the CDS market, given the near 300bp negative basis in the
market and more negative fundamental news expected this earnings season.
INVESTMENT GRADE: SHORT-DATED BANK PAPER 27
In an environment in which most safe, short-dated assets earn very low yields, the
demand/supply imbalance in short-dated bank paper provides an opportunity to pick up yield.
HIGH YIELD 29
The high yield market followed the equity market lower this week. When searching for
bankruptcy triggers, analysts often look at an issuer’s maturity schedule to determine
when problems could arise. However, this week, we were reminded of how important
interest payments can be. We highlight the top interest payment dates coming up.
LEVERAGED LOANS 32
Loans were flat, while LCDX continued its underperformance from last week. In general,
the recent underperformance of loans versus high yield can be explained by the lack of
bids for loans given return expectations. Expected loan returns are lower than bond
returns given declining Libor, depressed recoveries, and higher defaults.
STRUCTURED CREDIT 34
It was only a matter of time before rating agencies and regulatory bodies started rethinking
their assumptions on various structured products; the changes will likely be negative for the
synthetic CDO market. In HY, we focus on short-term fundamental-driven trades, as
investor focus has shifted to deteriorating fundamentals and near-term default risk.

THERE GOES THE BEAR MARKET RALLY
The market gave back its December and early-January gains as stocks sold off sharply
despite a modest snapback Thursday afternoon. While credit has traded lower as well, it
is still substantially tighter than its 2008 wides. The government continues to take an
active role in efforts to stabilize the financial system, but a poor start to earnings season,
especially from banks, initially overwhelmed the positive sentiment related to
government intervention. The huge loss from Deutsche Bank and news that additional
government funds will be used to support the Bank of America/Merrill Lynch merger
caused financial stocks to underperform through Thursday. Early on Friday morning, the
Treasury, Federal Reserve, and FDIC announced a deal to guarantee $118bn of assets
held by Bank of America, with BAC taking the first $10bn of losses and 10% of the next
$10bn of losses, in return for preferred stock and warrants. The Fed is providing nonrecourse
financing at OIS + 300bp, plus a 20bp guarantee fee. In a related move, the
FDIC is proposing to increase the term of TLGP issuance to ten years for banks using
the funds to support new lending. Also on Friday, Citigroup announced its intention to
split the company into two businesses.
These new government actions come after Chairman Bernanke mentioned the need for
additional asset purchases under the existing government programs and further capital
infusions for banks to stimulate lending. The second $350mn of the TARP was also
approved this week. We view these developments as positive, since we believe that
government policy has had a positive effect once funds are put to use. Specifically, we
have seen a significant normalization in the commercial paper market, with improved
demand out the maturity curve. Although sharing similar risk attributes, short-dated
financial paper remains dislocated. We explore some opportunities for front-end-focused
investors to pick up yield in this week’s publication.
Despite the sell-off in equities, there were encouraging signs in the investment grade
cash market. There was $14bn of non-guaranteed government supply, but importantly, it
was all massively oversubscribed. We point specifically to the demand for a BBB
company such as Staples as a very positive sign for the IG market. Staples bonds were up
4 points in secondary trading as well. This week’s high yield new issue, Fresenius, also
jumped 5 points on the break. As we expected following Cablevision’s success last week,
a number of solid BB issuers will likely come to market in the near term. The multicurrency
Fresenius deal also represented only the second sub-investment grade bond
issued in the European market in a year.
Focusing on the secondary market, this was a difficult week for high yield. January 15
proved to be a seminal date for a number of companies with interest payments due. Nortel
filed ahead of its coupon payment, which led to the second triggering event in HY CDX 11.
Charter did not make its interest payments and will begin a 30-day grace period and could
be the next triggering event in the index. A number of smaller companies, including
Simmons, Spansion and Young Broadcasting, did not make coupon payments either.
Smurfit-Stone Container made its $7.5mn, which moved bonds 4 points off their lows.
These actions reinforce that in today’s credit market, maturities are not necessary for a
company to file for bankruptcy protection. Nortel filed pre-emptively in order to avoid
seeking DIP financing, and as long as the DIP market remains difficult, we could see more
strategic filings.

In addition to Nortel, the market could face a triggering of CDS on Liz Claiborne
because of a modified restructuring credit event. While the extension of maturity of the
company’s partially drawn revolver appears to have occurred in conjunction with credit
deterioration and was approved by all lenders (hence binding all holders), the extension
of maturity was not necessarily a result of credit deterioration. Since this cause-andeffect
relationship is required for a triggering, we believe an actual credit event is fairly
unlikely. If it were to occur, this would be a unique event for the CDS market, because in
addition to being the first restructuring trigger under the 2003 ISDA definitions, there is
only one bond. Since the bond is a July 2013 maturity, it is possible that short-dated
holders of CDS would not even trigger. These issues highlight some of the reasons the
restructuring clause is likely to be removed from CDS contracts once trading is done
using the central clearing house.
Our focus article this week touches on another area of the structured credit market. CLO
transactions with large CCC bucket allocations and CCC haircuts in their event of default
(EOD) language are at risk of hitting EOD triggers if the current pace of
downgrades/defaults continues. At EOD, Aaa CLO investors who own liquidation voting
rights are likely to choose to liquidate and own the collateral rather than accelerate their
transaction. We find that liquidation is more cost effective and more capital efficient for
banks and insurance companies.