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Barclays Capital Tuesday Credit Call

The Fed may do the twistwill markets dance?


Jeff Meli Jigar Patel Justin Luther September 20, 2011

Please see analyst certifications and important disclosures starting after slide 18.

Agenda
Credit Strategy Jeff Melis Piece Credit Research Jonathan Glionna Head of Global Bank Credit Research Corporate Bonds/CDS Trading Andrew Layng Financials Cash Yoni Gorelov Yankee Credit Yana Bouchkanets Barclays Capital Live Conference Call Information Tuesday, 7:45am (EST) Conference ID: 25800338 Dial-in: +1-866-644-3260 +1-706-634-9973 Replay: Live.barcap.com Credit Conference Calls

Last week, credit performance was mixed with CDS tighter and IG cash wider
CDX IG (9/129/19, bp)
140.0 138.0 136.0 134.0 132.0 130.0 128.0 126.0 124.0 122.0 9/12 135
From the wides on 9/12, IGs have tightened ~11.5bp Yest: +2.25bp

CDX IG and US Credit Index OAS (bp)


225 205 125 115 105 95 85

w/w chg: -6bp w/w chg: +4bp


Feb-10 CDX IG Aug-10

185 165 145

9/13 9/14 Intraday Range

9/15

9/16 Close

9/19

75 Aug-09

125 Feb-11 Sep-11 US Credit OAS (rhs)

CDX HY (9/129/19, $)
95.0 94.0 93.0 92.0 91.0 90.0 89.0 9/12 9/13 9/14 Intraday Range 9/15 9/16 Close 9/19
Yest: -$0.25

CDX HY and US HY Index OAS (bp)


880 780 680 580 480 380 Aug-09

w/w change in price CDX HY: +$2.40 HY Index: -$0.32 w/w chg: -5bp w/w chg: -67bp
Feb-10 CDX HY Aug-10

840 740 640 540 440 Feb-11 Sep-11 US HY OAS (rhs)

___________________________ Source: Bloomberg, Barclays Capital

Other risk assets performed well as equities rose sharply and volatility declined. Last weeks moves, however, were partially reversed yesterday amid renewed risk aversion
S&P 500 Sectors (w/w Change)
8% 7% 6% 5% 4% 3% 2% 1% 0% Cons HcareEnergy Telco Mat Stp Util S&P Fin Ind Cons Tech Disc
Underperformed Outperformed

Global Equity Indices Performance


8% 6% 4% 2% 0% (2%) (4%) S&P 500 DAX Last Week CAC 40 FTSE 100 Yesterday Nikkei

5.35%

Last weeks strong performance was partially reversed yesterday; France was a notable underperformer

VIX Intraday (since Aug 1)


50 45 40 35 30 25 20 15 8/1 8/4 8/9 8/12 8/17 8/22 8/25 8/30 9/2 9/8 9/13 9/16
VIX has continued to find support at the 30 level

10y UST Yield Intraday (%, since Aug 1)


2.90 2.70 2.50 2.30 2.10 1.90 8/1 8/4 8/9 8/12 8/17 8/22 8/25 8/30 9/2 9/7 9/12 9/15
10y yield rose 13bp last week, but largely reversed the move yesterday

___________________________ Source: Bloomberg, Barclays Capital

US macro data continue to point to a slowdown, and recent confidence surveys indicate a dampened outlook across both consumers and executives
Advance Retail Sales (m/m, sa %)
1.5 1.0 0.5 0.0 (0.5) (1.0)

Regional Business Surveys


50 40 30 20 10 0 (10) (20) Surveys continued to (30) indicate contraction (40) Jan-10 May-10 Sep-10 Philadelphia Fed

Retail sales were flat in Aug, and July was revised lower
Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Survey Actual

Jan-11 May-11 Sep-11 Empire State Manufacturing

Univ of Michigan Consumer Confidence Survey


90 85 80 75 70 65 60 55 While consumers assessment of current 50 conditions rebounded, their expectations for 6 45 months from now hit the lowest level since 1980 40 Jan-10 Aug-10 Mar-11 Current Conditions Consumer Expectations

Duke/CFO Magazine Survey: % More Optimistic


60 50 40 30 20 10 0 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 More Optimistic on US Economy More Optimistic on Own Firm

___________________________ Source: Commerce Department, Philadelphia Federal Reserve, NY Federal Reserve, University of Michigan/Thomson Reuters, Duke University/CFO Magazine, Haver Analytics, Bloomberg, Barclays Capital

In light of the weak data and persistently high unemployment, our economists expect the most likely outcome of the upcoming FOMC meeting will be a maturity extension of the Feds portfolio
FOMC Meeting 9/20/11-9/21/11
The debate at this weeks 2-day FOMC meeting will likely hinge on the relative risks of long-term unemployment vs. inflation Headline CPI inflation rose 3.8% y/y in August, boosted by a gain in gasoline prices. Our economists expect this factor to moderate, however core CPI still rose 2.0% y/y Long term unemployment as a percentage of total unemployment is high with nearly half of the unemployed having been unemployed for 27 weeks or longer. This poses a significant risk that this population could face a gradual erosion of marketable job skills Our economists believe the most likely FOMC meeting outcome will be a maturity extension of the Feds portfolio, or Operation Twist. Another option would be to reduce the interest paid on excess reserves (IOER). However, we view this option as less likely due to its asymmetric risk/reward profile1 Cutting IOER from 25bp would be unlikely to have a significant stimulative effect as FDIC insurance already discourages US banks from stockpiling excess reserves With short-term yields already low, cutting IOER could possibly destabilize the already stressed short term funding market
6 5 4 3 2 1 0 -1 -2 -3 2005

Core and Overall CPI (% y/y)


3.5 3 2.5 2 1.5 1 0.5 2006 CPI 2007 2008 2009 2010 Core CPI (rhs) 0 2011

Long Term Unemployed, % of Total Unemployed


50% 40% 30% 20% 10% 0% 1951

1961

1971

1981

1991

2001

2011

___________________________ 1. Fed set to ease further despite firming inflation. Global Economics Weekly, September 16th, 2011. Source: Bloomberg, Barclays Capital

Headlines out of the euro area continue to be a key driver of market activity, as mostly positive news supported the risk asset rally
Last Weeks Key Events
On Wednesday, Moodys downgraded the long-term debt rating of Societe Generale, citing funding and liquidity issues, and Credit Agricole, citing Greek exposure. Following a conference call with Greek PM Papandreou, German Chancellor Merkel and French President Sarkozy announced they are convinced Greece will remain in the Euro area The ECB announced in coordination with the Fed, BOE, BOJ, and SNB that it would conduct three USD liquidity operations with maturity of three months on Oct 12, Nov 9, and Dec 7, in addition to the existing 1-week USD liquidity operations. Following the announcement, Euro basis swaps and the 3m Euribor-Eonia spread declined Markets appeared hopeful ahead of the weekends ECOFIN meeting, However, the meeting yielded no new significant announcements
___________________________ Source: Bloomberg, Barclays Capital

iTraxx Main and SnrFin w/w Change (bp)


40 30 20 10 0 -10 -20 -30 1-Apr 29-Apr 27-May 24-Jun 22-Jul
Last week

Last week was the best week for European CDS indices since July

Largely reversed yest.

19-Aug

16-Sep

MTD Change in 5y Sovereign CDS (bp)


160 140 120 100

CDS moved wider yesterday across the core and periphery, reversing some of last weeks tightening

80 60 40 20 0 31-Aug

4-Sep

8-Sep France

12-Sep Spain

16-Sep Italy

Germany

However, concerns around the Greek debt situation remain, and virtually every potential outcome or solution appears marginal at best
Greek Government Bond Yields (%)
80 70 60 50 40 30 20 10 Jan-11 Mar-11 2y May-11 Jul-11 5y (rhs) Sep-11 30 28 26 24 22 20 18 16 14 12 10

Implications of Potential Greek Outcomes


Event / Outcome Implication th tranche (8bn) of 2010 Should provide enough funding for 6 bailout is released Greece into Dec; but only amounts to a near-term band aid PSI is successful Would put Greeces debt/GDP on a borderline sustainable path1; assumes Greece can meet fiscal targets in the future PSI is not successful Would likely result in the collapse of the 2nd bailout package and greater writedowns for the private sector; German Chancellor Merkel has said she would not let Greece go into uncontrolled insolvency Orderly assumes measures have been put in place to safeguard/recapitalize banks and stem contagion to Italy and Spain; no visibility on this yet Difficult to quantify; could be characterized by a further (severe) risk asset sell-off, a sharp rise in funding costs for sovereigns that are perceived as stressed, bank runs, and increased fear of bank failures; presumably, the market panic would spur euro area officials to take action

Dom. Deposits Households & Businesses (bn)


250 230 210 190 170 150 Sep-05

Orderly Default

Disorderly default

Feb-07

Jul-08

Dec-09

May-11

___________________________ 1. See Global Synthesis: Europe contemplates a controlled insolvency, Global Economics Weekly, September 16, 2011. Source: Bank of Greece, Bloomberg, Barclays Capital

Within credit, our analysts have re-initiated coverage on European banks with an underweight. While capital ratios and financing sources have improved, questionable asset quality limits the potential upside
European Banks Core Tier 1 %
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% UBSN CSGN ISP RBS HSBA DBK LLOY CBK

Eur. Bank Deposits (bn) and Loan/Deposit Ratio


7 6 5 4 3 2 1 1.15 1.1 1.05 1 2011H1 1.2

Core Tier 1 Ratios are improved across the board vs. 1H07

SAN

BBVA

UCG

BNP

ACA

GLE

0 2006H1

European banks have decreased their reliance on wholesale financing in favor of more stable deposit funding
2007H1 2008H1 2009H1 2010H1

1H07

1H11

Aggregate Deposits

Loan / Deposit Ratio (rhs)

Loan / Deposit Ratio, Global Comparison


120% 110% 100% 90% 80% 70% 60% 50%

Euro Area GDP and Non-Performing Loan Ratio


2,000 1,950 1,900 1,850 1,800

Bank asset quality is the primary concern

6% 5% 4% 3% 2% 1% 0%

However, they remain reliant on wholesale financing relative to other regions


1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 Europe Canada U.S. Japan

1,750 1,700 Q1 08 Q3 08 Q1 09 Q3 09 Q1 10 Q3 10 Q1 11 GDP (euro 16, bn) NPL Ratio (rhs)

___________________________ Source: SNL, Company Reports, Bloomberg, Barclays Capital For details, see European Banks: Reinitiating Coverage Underweight, by Jonathan Glionna, Miguel Angel Hernandez, and Conor Pigott, September 13th 2011.

Indeed, euro area banks continue to have significant sovereign debt exposure. This risk could potentially be mitigated using the EFSF, either through capital injections or debt guarantees
EFSF Options for Supporting Euro Banking
Recently, IMF Managing Director Christine Lagarde has called for capital injections to European banks, possibly via the EFSF1 A direct EFSF injection could position European banks to withstand large haircuts to SGIIP debt but would require ~230bn and leave many SGIIP banks semi-nationalized A guarantee would be less burdensome but would be riskier and might be too stressful on several individual countries

Exposure to SGIIP 50% Haircut, % Core Tier 1


140% 120% 100% 80% 60% 40% 20% 0% Greece Luxembourg Cyprus Spain Italy Portugal Belgium Ireland Germany France Netherlands Slovenia Austria UK Malta Sweden Finland Denmark Hungary Norway Poland Portugal / Ireland / Greece Italy / Spain Sector Aggregate

Potential EFSF Injections, % Core Tier 1


120% 100% 80% 60% 40% 20% 0% Slovenia Belgium Greece Ireland Italy Portugal Spain Austria Netherlands Finland France Luxembourg Germany Hungary Malta Denmark Poland Sweden UK Norway

Potential Commitments in a Guarantee, % GDP


350% 300% 250% 200% 150% 100% 50% 0% Iceland, '08 Ireland, '10 Italy

Private ownership of several SGIIP banking systems would be called into question following a direct injection

Potential liabilities in a guarantee could bring several nations liabilities close to levels of Ireland 2010 which required a bailout

Slovakia

Slovenia

France

Sovereign Debt

Bank Term Debt

Share of EFSF Guarantee

___________________________ 1. Lagarde sees global crisis of confidence. Financial Times, September 15, 2011. Source: ECB, Federal Reserve, Bloomberg, Barclays Capital Equity Research For details, see Thinking the Thinkable?: What saving the euro means for European banks. Barclays Capital European Banks Equity Research, September 15, 2011.

Luxembourg

Belgium

Germany

Netherlands

Estonia

Austria

Spain

Finland

Malta

Cyprus

In the UK, the ICB report was mixed for bondholders. Ring-fencing and loss absorption rules should allow banks to remain competitive, while depositor preference is a negative for unsecured bondholders
Under the ICB recommendations, capital requirements for the bank and group are similar
20% 700 6.50% 15% 500 2.00% 10% 1.50% 3.00% 2.00% 1.50% 2.50% 300 200 5% 7.00% 7.00% 100 0 0% Ring-fenced bank Basel III T1 Common G-SIFI Buffer Basel III Tier 2 Bank group Ring-Fence Buffer Basel III T1 Non-Common Bail-In Bonds Without depositor preference Bank deposits, repos, CP/CD Customer deposits Senior unsecured bonds Equity With depositor preference Covered bonds, securitisations Senior unsec. & cust. deposits Subordinated liabilities 400 7.00% 600

Depositor preference is a credit negative for unsecured bondholders


bn 800
Lloyds illustrative priority of claims

Depositor preference, when implemented, will place senior unsecured bondholders behind depositors

___________________________ Source: ICB, Company Reports, Barclays Capital For details, see European Banks: ICB Final Report Mixed for Bondholders, by Jonathan Glionna, Miguel Angel Hernandez, and Conor Pigott, September 15th, 2011.

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When comparing US banks to European banks, it is interesting to note that sub-senior spreads in US banks have compressed, while spreads in European banks have widened
US Banks, 1/01/2009, OAS (bp)
600 500 400 300 200 100 0 BAC Senior C GS Sub Holdco

US Banks, 9/16/2011, OAS (bp)


600 500 400 300 200 100 0 BAC Senior C GS Sub Holdco
Narrower spreads reflect the limited benefit of seniority under Dodd-Frank

Average Sub-Senior Spread: 91bp

Average Sub-Senior Spread: 54bp

Euro Banks, 1/01/2009, OAS (bp)


900 800 700 600 500 400 300 200 100 0 DB Senior
___________________________ Source: Barclays Capital

Euro Banks, 9/16/2011, OAS (bp)


900 800 700 600 500 400 300 200 100 0

Average Sub-Senior Spread: 216bp

Average Sub-Senior Spread: 301bp

RBS LT2

ISPIM

DB Senior

RBS LT2

ISPIM

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In the US, GDP growth expectations for 2011 have fallen, yet IG revenue expectations have not. However, this is not unusual, especially when viewed in a historical context
Factors Influencing IG Revenue Growth
There is an inherent selection bias in a given IG credit index population reflecting the strength of those firms relative to the economy as a whole IG constituents estimate revenue growth as a nominal dollar series, so inflation can influence revenue growth vs. real GDP growth IG constituents also derive revenues from overseas. In a declining dollar environment, this should cause revenue growth to outpace nominal GDP growth

Historical Revenue Growth vs. GDP Growth


15% 10% 5% 0% -5% -10% -15% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 IG Rev. Growth - Nominal GDP Growth Average 0.0% -0.2% 5.7% 6.6% 4.0% 3.5% 6.4% 11.1% 6.2%

Average excess revenue growth for IG firms vs. nominal GDP growth is 2.9%

-12.3%

Composition of Rev Growth


12% 10% 8% 6% 4% 2% 0% 1Q11 Real GDP Growth 2Q11 Inflation 3Q11E FX 4Q11E Excess Growth
7% 6% 5% 4% 3% 2% 1% 0%

2012E Revenue Growth vs. GDP Growth

2012 revenue growth expectations are tracking much more closely with GDP growth expectations than in 2011

Sep-10 Dec-10 Mar-11 Excess Growth Nominal GDP Est.

Jun-11 Sep-11 W. Avg. Revenue Growth

___________________________ Source: Factset, Capital IQ, Bloomberg, Barclays Capital For details see: Investment Grade: Revenue and GDP: More Than Meets the Eye, US Credit Alpha, September 16, 2011.

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In addition, given the strength of corporate fundamentals, it appears spread levels are not reflecting the current state, but rather appear to be indicating an increasingly binary outcome for IG credit
US IG Corporate Index Fundamentals
Summer 2011 Start Date of Comparable Sell-off Spread At Sell-off Start Spread 30d After Sell-off Start Subsequent Wide Spread in Credit Cycle Net Leverage at Sell-off Start Peak Net Leverage (ex. Financials) Cash / ST Debt Cash / Total Debt Upgrade / Downgrade Ratio 7/26/11 152 213 NA 1.2x NA 5.1x 32.0% 1.87 2008 Credit Crisis 6/17/08 237 283 618 1.2x 1.6x 3.4x 10.7% 1.18 2001/2002 Credit Downturn 6/21/02 172 201 266 1.9x 1.9x 3.1x 14.0% 0.67

US IG Corp Index OAS (bp)


580 480 380 280 180 Feb 22, 07
82bp Jan 18, 08 219bp Mar 18, 08 298bp Jun 16, 09 303bp Jun 10, 10 198bp Dec 3, 08 618bp

Current spread levels do not reflect IG fundamentals, but rather appear to be indicating an increasingly binary outcome: either the debt crisis is resolved and spreads tighten to reflect fundamentals, or the situation worsens and US credit trades wider with Europe

Sep 16, 11 220bp

80 Jan-07

Apr 15, 10 139bp

Apr 11, 11 136bp

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

___________________________ Source: Capital IQ, Barclays Capital For details, see Focus: Beginning or End of the Sell-Off?, US Credit Alpha, September 9, 2011.

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Notably, cash has underperformed both CDS and equities in the current sell-off
US IG Corp OAS vs. IG Cash-CDS Basis(1) (bp)
225 215 (40) 205 195 185 175 165 155 145 (90) 135 125 Jan-10 (100) Sep-11 120 100 1000 (70) (50)

US IG Corp OAS vs. S&P 500


IG Corp OAS (bp) 300 280 260 240

Basis is the most negative its been since Jan 10

(30)

Relative to historic performance over the past two years, IG cash has significantly underperformed equities

Sep 16th
(60) 220 200 180 160 140

(80)

Apr 23rd, 2010

May 2nd
S&P 500

May-10

Sep-10

Jan-11

May-11

1050 2010

1100

1150

1200

1250

1300

1350

1400

IG Corp OAS

Cash-CDS Basis (rhs)

Jan 2011 - July 2011

Aug 2011 - Present

___________________________ 1. Basis defined as CDX IG OTR spread minus US IG Corp OAS. Source: Bloomberg, Barclays Capital

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One potential explanation for the underperformance is that IG supply has been robust and new issue concessions have risen
IG and HY Weekly Supply ($bn)
45 40 35 30 25 20 100 15 10 5 0 7-Jan 50 200

HPQ Outstanding vs. New Issue Spread (9/13,bp)


300

While the primary markets have been effectively closed for HY, IG supply remains robust

250

New issue concessions have risen and have contributed to the widening of secondary spreads

150

0 1.55% '14 2.35% '15 2.65% '16 3.00% '16 4.3% '21 4.375% '21

11-Feb

18-Mar

22-Apr HY

27-May

1-Jul IG

5-Aug

9-Sep

Oustanding

New Issue

___________________________ Source: Barclays Capital

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Another potential explanation is that the cash index continues to have a significant financial weighting, especially when compared to equities
US IG Corp Index Sector Weightings (%)
Utility 10% Industrials 11% Financial 43%

S&P 500 Index Sector Weightings (%)


Other 10% Financials 22%

Consumer Discr 11%

Industrial 47%

Tech 15%

Jan 2007

Consumer Staples 9% Healthcare 12%

Jan 2007
Energy 10%

Utility 11%

Industrials 10%

Other 10%

Financials 14%

Sep 2011
While the weighting of financials in the IG Corp Index has declined by ~19% since Jan 07
Consumer Discr 11%

Sep 2011
the decline in the equity weighting has been even greater (~39%)

Financial 35%

Tech 20%

Industrial 54%

Consumer Staples 11% Healthcare 12%

Energy 12%

___________________________ Source: Bloomberg, Barclays Capital

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In Summary
Last week, IG cash underperformed the broad risk asset rally as both CDX IG and the S&P experienced their best week since the beginning of July Macro data in the US continue to support the notion of a slowdown as August retail sales were flat, July retail sales were revised lower, and both the Empire State and Philly Fed surveys indicated contraction Risk asset performance continues to be dictated by news out of the euro area. A somewhat better tone to the headlines supported positive performance last week Our base case continues to be that there will be an orderly resolution of the European sovereign debt crisis. However, given the lack of clarity around a concrete plan to address contagion and questions around the level of political will to address the crisis, our conviction level remains low The situation appears increasingly binary, were either we will avoid a near-term major systemic event and spreads will rally strongly, or we will see something akin to the fall of 2008 before officials step in decisively. We recommend investors focus on areas of the market where the upside-downside is appealing

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Date: Thursday, 13 October 2011 at 4:30pm EST Venue: Barclays Capital 745 Seventh Avenue, New York City 4:30pm-4:35pm 4:35pm-4:55pm 4:55pm-5:40pm Agenda: Opening Remarks (Paul Degen, Co-Head of US Credit Sales) Market Outlook (Larry Kantor, Global Head of Research)

Barclays Capital Live Demonstration (Yana Bouchkanets, Barclays Capital Live Sales) A cocktail reception will be held after the Demonstration

RSVP: Yana Bouchkanets, at +1 212 526 5537 or email yanabouchkanets@barcap.com by Friday, 23 September 2011. We look forward to seeing you there.

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Analysts Certifications and Important Disclosures


Analyst Certification(s) We, Jeff Meli, Jigar Patel and Justin Luther hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgi-bin/all/disclosuresSearch.pl or call 212-526-1072. Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or an affiliate thereof (the firm) regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and/or short position in such securities and/or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firms fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise.

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Disclaimer
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Disclaimer (contd)
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