Coupon Destruction Dec 2010_Final

8/8/2019 Coupon Destruction Dec 2010_Final

1/40

The Phenomenon of Coupon Destruction

December 2010

Assessing the implications of declining coupons rates on bond investors

Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities

in the United States.


2/40

Contents

1. Coupon Destruction: The Data

2. Coupon Destruction: The Drivers

3. Coupon Destruction: The Implications

A. For Bond Markets

B. For Insurance Companies

C. For Pension Funds

D. For Global Structural Imbalances


3/40

Section 1

oupon es ruc on: e a a


4/40

The Phenomenon of Coupon Destruction

IG Annual Wei hted Avera e Cou ons U.S. 30-Da Commercial Pa er Yields

6

7

Tier1NonFi nancial Tier2NonFinancial

The phenomenon ofcoupon

destructionstarted developing

in 2008, when

(2006 2010 YTD)

(2006 2010 YTD)

6.0%6.1%

6.3%

5.9%6.0%

6.5%

1

2

3

4

5governments

worldwide adopteda relaxed monetarypolicy stance in

order to stimulateeconomic rowth

%

4.4%

4.2%4.5%

5.0%

5.5%

0

Jan06 Jul06 Jan07 Jul07 Jan0 8 Jul08 Jan09 Jul0 9 Jan10 Jul10

by maintaininginterest rates low...

- -

CP yields have followed a striking correlation to the

tightening of their benchmark LIBOR rates

IG coupon rates have declined substantially since

the onset of the financial crisis

4.0%

2006 2007 2008 2009 2010YTD Nov10

... ,destruction affects

all credit marketsincluding ABS, CP,

and mortgagerates

(2006 2010 YTD)

(2006 2010 YTD)

450

500

550

600

6503yrFixedCreditCard 3yrFixedPrimeAuto

7.0

7.5

8.0Conventional Jumbo

100

150

200

250

300

350400

Spread(bps

)

4.5

5.0

5.5

6.0

6.5

Yield(%)

Stability of credit performance, lower delinquencyrates, and stabilizing prepayment rates have driventhe narrowing of consumer ABS yields 4

Source: Thomson Reuters,Federal Reserve, Bloomberg

0

Jan06 Sep06 May07 Feb08 Oct08 Jun09 Mar10 Nov10

4.0

Jan06 Jul06 Jan07 Jul07 Jan08 Jul08 Jan09 Jul09 Jan10 Jul10

Excess housing supply and low government rateshave positively impacted residential mortgageyields


5/40

Coupon Destruction in the US$ IG Bond Market

6.5

1000

1200

FixedRateNewIssueVolume FRNNewIssueVolume WeightedAverageCoupon

5.6% 6.1%6.3%

5.9%

ew ssue o ume xe vs. e g e verage oupon

The phenomenon ofcoupon

destructionaccelerated toward

historically low

5.0

5.5

.

400

600

800

60.3%47.6%

24.8%4.8% 7.9 %

95.2%92.1%

total coupons

during the courseof 2010 inparticular

US$bn

%

4.0

4.5

0

200

2006 2007 2008 2009 2010YTD

4.4%39.7%

. .

Annual AverageNew Issuance

Duration

2006: 7.4

2007: 7.6

4.8

4.9

5.0

300

350

NewIssueVolume WeightedAverageCoupon

New Issue Volume / Weighted Average Coupon (2010 YTD)

4.7%

2008: 6.6

2009: 6.4

2010 YTD: 7.2

4.3

4.4

4.5

4.6

4.7

100

150

200

250

US$bn

%

.

4.2%

4.2%

4.0

4.1

.

0

50

Q110 Q2

10 Q3

10 Oct

10 Nov

10

5Source: Thomson Reuters

.


6/40

Section 2

oupon es ruc on: e r vers


7/40

Coupon Destruction: The Drivers

ey r vers o oupon es ruc on

Driver 1 Record Government yield tightening

Driver 2 Record LIBOR tightening

Driver 3 Record IG credit spread tightening

Driver 4

7

Driver 5 Overwhelming supply/ demand dynamics in the IG bond market


8/40

Driver # 1: Record Government Yield Tightening

. . reasury e s ey r vers

Economic recovery

Low inflation risk (continued

The significant post-financial crisis

decline ingovernment yields,

6

2yUST 5yUST 10yUST 30yUST

concern around deflation)

Monetary easing

short end, has

been a primarydriver of the

coupondestruction

5

Quantitative easing (QE2)

Flight to quality during

exogenous global events (i.e.,sovereign crisis)

QE2 and flight toquality concerns

during the Eurocrisis have also

3

%

Supply / demand dynamics

Global capital flow dynamics

been primarydrivers

2

s ruc ura m a ances

0

1

6 66 6 6 6 7 7 7 7 7 7 8 8 8 8 8 8 9 9 9 9 9 9 0 0 0 0 0 0

8Source: Bloomberg

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov


9/40

Driver # 1: Record Government Yield Tightening

10-Year U.S. Treasur Yield 10-Year German Bond Yield

4.5

5.0

5.5

4.5

5.0

(2006 2010 YTD)

(2006 2010 YTD)

Global sovereignbond yields have

followed the sametightening

3.0

3.5

4.0

3.0

3.5

4.0

%%

. .Treasuries, as

governmentsworldwide are still

using monetarypolicy to stimulate

2.0

2.5

J

an

06

A

pr06

Jul06

O

ct06

J

an

07

A

pr07

Jul07

O

ct07

J

an

08

A

pr08

Jul08

O

ct08

J

an

09

A

pr09

Jul09

O

ct09

J

an

10

A

pr10

Jul10

O

ct10

2.0

2.5

J

an

06

A

pr06

Jul06

O

ct06

J

an

07

A

pr07

Jul07

O

ct07

J

an

08

A

pr08

Jul08

O

ct08

J

an

09

A

pr09

Jul09

O

ct09

J

an

10

A

pr10

Jul10

O

ct10

- -

2 0

2.5

(2006 2010 YTD)

(2006 2010 YTD)

5.0

5.5

6.0

1.0

1.5

.

% %

3.0

3.5

4.0

4.5

0.5

Jan

06

Apr06

Jul06

Oct06

Jan

07

Apr07

Jul07

Oct07

Jan

08

Apr08

Jul08

Oct08

Jan

09

Apr09

Jul09

Oct09

Jan

10

Apr10

Jul10

Oct10

9Source: Bloomberg

2.0

2.5

Jan

0

6

Apr0

6

Jul0

6

Oct0

6

Jan

0

7

Apr0

7

Jul0

7

Oct0

7

Jan

0

8

Apr0

8

Jul0

8

Oct0

8

Jan

0

9

Apr0

9

Jul0

9

Oct0

9

Jan

1

0

Apr1

0

Jul1

0

Oct1

0


10/40

Driver # 2: Record LIBOR Tightening

ggrega e eserves o . . epos ory ns u ons - on or

Increased banking system liquidity has driven Libor rates down, pushing issuers out of FRN issuance

Drivers: More stringent lending standards, increased regulatory capital, and consumer de-leveraging

Size of increase: US$ 960 bn since September 2008

3-month LIBOR hastightened nearly

500 bps since,

largely by the

rising cashreserves of the

banking system

5

6

1200

1400

AggregateReservesofDepositoryInsitutions 3mLibor

bn %

3-month Libor isclosel and

3

4

800

1000

US$inversely

correlated to theincrease in

reserves1

2

200

400

00

Jan

06

Mar06

May

06

Jul06

Sep

06

Nov

06

Jan

07

Mar07

May

07

Jul07

Sep

07

Nov

07

Jan

08

Mar08

May

08

Jul08

Sep

08

Nov

08

Jan

09

Mar09

May

09

Jul09

Sep

09

Nov

09

Jan

10

Mar10

May

10

Jul10

Sep

10

Nov

10

10

Note: Aggregate reserves of U.S. depository institutions refers to reserves held by all U.S. credit institutions (commercial banks, savings institutions,credit unions, and foreign banking entities) against deposits . They are reported as liabilities on their balance sheets.

Source: Bloomberg, Federal Reserve

The drop in LIBOR rates has fuelled the decline in FRN issuance to approx. 9% oftotal new issue volume in 2010 YTD


11/40

Driver # 3: US$ IG Credit Spread Tightening

IG bond spreadtightening has

been a key driverof coupon

re prea s

1000

AFinancials BBBFinancials ACorporate BBBCorporate

US$ Market

This spreadtightening has

been articularl 700

800

900

strong among BBB

financial andcorporate names

500

600

bp

200

300

400

0

100

06

06

06

06

06

06

07

07

07

07

07

07

08

08

08

08

08

08

09

09

09

09

09

09

10

10

10

10

10

10

11Source: Bloomberg

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov


12/40

Driver # 4: Record Capital Flows into IG Bond Funds

Bond funds haveenjoyed record flows

in 2009-2010 asinvestors favor safer 20

40

60

)stable and attractive

return over riskierassets like equities

(80)

(60)

(40)

(20)

0

Amoun

t($bn

credit has further

depressed couponrates on recent issues

(120)

(100)

Jul-08 Aug-09 Sep-10

Taxable Bonds Equity

Sources of Bond Inflows Net Bond Inflows (2009 2010 YTD)

2009: US$ 306.7 bn Risk aversion

2010 YTD: US$ 243.5 bn

qu ty out ows

Money market fund assets

Structured roduct flows

1212Source: Investment Company Institute

2009-2010 YTD: US$ 550.2 bn IG asset cash increases


13/40

Driver # 5: Strong New Issue Market Technicals

Net Institutional Investor Cash Flows 2011EWhile recent andestimated new issue

activity issubstantial, DBs

expected netCash flows to institutional investors

500

700

ssuance ssuanceless bond

redemptions,coupon payments

and new cashinflows into bond

$700 $438Investment grade new issues

Estimated Asset managers: US$ 40-60 bn Insurance companies: US$ 30-50 bn

Excludesgovernmentguaranteed

300

funds) for 2011 isnegative

$256U

SDbillions Pension funds: US$ 20-30 bnsecurities

100

100

300

2011ENew

Issuance

2011EUSD

Redemptions

EstCoupon

Payments

Incremental

BondFlows

Liability

Management

NetIssuance

Effect

$90 $140

$40 -$124 -$174

Source: Deutsche Bank, Thomson Reuters, Dealogic13

Note: DB estimates based on historical trends; Est coupon payments are estimated assuming ~$4.2 trillion of debt outstanding at a 6.1% average coupon; DBIG fund flows estimated by adding US$ 40-60 billion from asset managers + US$ 20-30 billion from pension funds + US$ 30-50 billion from insurancecompanies ; DB liability management estimate does not include exchanges and consents


14/40

Breakdown of 2011-2012 US$ IG Bond Redemptions

Demand for IG debt isexpected to keep

rising in 2011 and2012, as large

2011 2012 Comment

US 438 bn US 421 bn

Breakdown of 2011-2012 US$ IG Bond Redemptions

credit mature

maturing over the next 2 years

Fixed US$ 361 bn / 82% US$ 355 bn / 84% ~80 - 85% fixed

Floating US$ 77 bn / 18% US$ 66 bn / 16% ~15 - 20% floating

Corporates US$ 239 bn / 55% US$ 215 bn / 51% Nearly even split among corporate andfinancial maturities in the next 2 years

Financials US$199 bn / 45% US$ 206 bn / 49% Nearly even split among corporate and

Av. Coupon 6.6% 6.0% Substantial drop in maturing debtcoupon rate in 2012 vs. 2011

Av. Duration 6.5 6.4 Stable average duration

* Excludes government guaranteed securities

14Source: Dealogic


15/40

Breakdown of 2011E Coupon Payments

Item #

The substantial sizeof the total

estimated couponpayments on

2011E Coupon Payments

o a eoutstanding 1

~ . r on

Weighted average coupon ontotal IGoutstanding debt 2

6.1%

investment grade

debt will be amajor driver of

demand in 2011

Total 2011E CouponPayments 3

~US$ 256 billion Breakdown of Total Outstanding IG Debt

1

: Total outstanding debt as of December 1, 20102: Based on total outstanding debt as of December 1, 2010

Item #

% Fixed ~93%3: 2011E coupon payments = multiplication of total US$ IGoutstanding debt (~4.2 tn) + weighted average coupon ontotal US$ IG outstanding debt (6.1%)

Source: Dealogic

% Floating ~7%

% Financials ~40%

% Corporates ~60%

Average coupon 6.1%

15Source: Dealogic


16/40

Section 3

oupon es ruc on: e mp ca ons


17/40

Section A

or on ar e s


18/40

IG Bonds Have Been A Top Performing Asset Class

US$ IG Bonds havebeen one of thetop performing

asset classes of

,

900

1000

AFinancial BBBFinancial ACorporate BBBCorporate

financial crisis

bps 400

500

600

700

0

100

200

p08

ct08

v08

c08

n09

b09

r09

r09

y09

n09

ul09

g09

p09

ct09

v09

c09

n10

b10

r10

r10

y10

n10

ul10

g10

p10

ct10

v10

Total Return IG Credit Performance (Q1-Q3 2010)

S O N D Ja

F M A MJu J A S O N D J

aF M A M

Ju J A S O N

-

Corp (Corporate + Financials) 10.64% 4.87%

Corp AA 9.57% 3.91%

Corp A 10.30% 4.82%

Corp BBB 12.13% 5.59%

18Sources: Bloomberg; Deutsche Bank Global Markets Research (Jim Reid)

Non - Fin 11.02% 4.75%

Fin Sen 10.01% 4.82%

Fin Sub 9.04% 5.91%


19/40


20/40

Floating Rate Issuance Has Declined Sharply

FRN issuance has seen a dramatic drop since2006:

- 7.9% in 2010 vs. 60.3% in 2006

The ~500bps yielddestruction in Libor

is the main reasonfor the drop in FRN

ey ssues ssuance o o a

2006 60.3%

2007 47.6%,U.S. are expected to refrain form raising rates

until late 2011- 0.30% as of Nov. 30, 2010

- ~500bps drop in libor rates since 2006

~60% of total new

issuance in 2007 to~8% in 2010. 2008 24.8%

2009 4.8%

ample liquidity in the banking system andmaintain money market rates low

3 Month Libor Rate (January 2006 To Date)

2010 YTD 7.9%

%

20Source: Bloomberg


21/40

Sharp Uptick in Liability Management Activity

Average volumesper month have

seen a significantuptick in the last 20,000

25,000

Monthly IG LM deal volumes ($mm)

on y ea o ume an- roug ov-

5,000

10,000

15,000

Average monthlydeal volume ($mm)

2007 3,803

2008 1,874

Annual LM Deal Volumes Jan-07 throu h Nov-10 YTD

0

Jan-07

Feb-07

Mar-07

Apr-07

May-07

Jun-07

Jul-07

Aug-07

Sep-07

Oct-07

Nov-07

Dec-07

Jan-08

Feb-08

Mar-08

Apr-08

May-08

Jun-08

Jul-08

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Sep-10

Oct-10

Nov-10

2009 ,

2010 YTD 8,136

- -

100,000

120,000

Annual IG LM deal volume ($mm)

0

20,000

40,000

60,000

80,000

21

2007 2008 2009 2010 YTD

(a) Includes investment grade corporate and financial institution tenders, exchanges and consent solicitations in the Americas

executed in the US market; volumes are based on the maximum targeted amount of securities in a given transaction; excludes$30bn Freddie Mac transaction in June 2009(b) As of November 8, 2010Source: Company press releases; Bloomberg; Deutsche Bank database


22/40

Section B

or nsurance ompan es


23/40

Overview of Impact

Insurance companies have largely benefitted from the recent drop in interest rates

- Significant improvement in balance sheets due to MTM of bond portfolios

verv ew o mpac

- Issuance of debt at historically low levels

However, if rates remain low for an extended period, the Life Industry could suffer

- Lower (possibly negative) earnings and ROE

- Writedown of intangible assets and/or increase in reserves

- More expensive products with less attractive features for consumers

Over the near-term (12-24 months) Life Industry earnings will be depressed if rates remain low,but impact is manageable

- Analysts generally expect 2011 and 2012 earnings to be impacted by 5 - 10% if rates remain atcurrent levels

- Limited expected balance sheet impacts at this stage

cautious which is likely to depress share prices in the near term

- Excess capital at holding company and operating subsidiaries not being re-deployed

- Investors paying lower P/E ratios vs. historical ranges

23


24/40

Insurers Have Benefited from Low Interest Rates

Accumulated Other Comprehensive Income AOCIis a balance sheet item that includes unrealizedgains / losses from insurance company asset

ortfolios

ommen so a o op e ompan es

$10

$20

$bn

As the graph illustrates, Life Insurer book equitydropped dramatically during the financial crisis ascredit spreads widened and MTM on bondportfolios dropped$(30)

$(20)

$(10)

TotalAOCI

Total = Sum of Quarterly AOCI for MetLife, Prudential, Hartford, Genworth, Lincoln, Principal Financial Group, Protective Life,Phoenix CompaniesSource: Company Filings

However, these negative MTM balances have beeneffectively erased by the drop tightening of interestrates and credit spreads over the past 24 months

$(50)

$(40)

2007Q1

2007Q2

2007Q3

2007Q4

2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

2009Q2

2009Q3

2009Q4

2010Q1

2010Q2

2010Q3

The low interest rate environment has enabledinsurers to take advantage of cheaper financing

CommentsTotal US Life Industry Senior Debt Issuance

7.00%

8.00%

9.00%

$5

$6

$bn

Since the opening up of the debt markets in early2009, US life insurance companies have issued inexcess of $20bn in senior debt and GIC financing

The average coupon for senior debt and GIC2.00%

3.00%

4.00%

5.00%

6.00%

$2

$3

$4AverageCouponT

otalIssuance

24Source: Bloomberg. I ncludes all fixed rate debt issued by all US life and health insurers.

the average coupon for comparable issuances inQ2 20090.00%

1.00%

$0

2009Q1

2009Q2

2009Q3

2009Q4

2010Q1

2010Q2

2010Q3

TotalFixedRateSeniorDebt AverageCoupon


25/40

Longer-Term Potential Concerns

$16.9

50%

60%

70%

$14

$16

$18

e

$bn $bn

Insurers rely oninvestment income

for a significantamount of their

revenue. This

nnua ze nves men ncome o a as as o

$14.6

$12.0$12

$14

$16

Total $38bn

$3.3 $3.2

$4.5

$3.4

$11.8

$5.7

20%

30%

40%

$4

$6

$8

$10

$12

%R

evenue

AnnualizedNetInvestmentIncomrevenue could be

squeezed if rates

remain low

In addition,Insurers have large

$3.6 $3.5

$2.3

$4

$6

$8

$10

Q32010C

ashBalance

$2.0

$0.8

0%

10%

$0

$2

GNW HIG LNC MET PFG PL PNX PRU A VERAGE

S ou rc es : c om pan y f ili ng s, S NL. A mou nt s r ep re sen t Y TD 20 10 r es ul ts ann ua li ze d. S ou rc es : c om pany f ili ngs , S NL . Re pr es ent s t ot al c as h an d c as h equ iv al en ts r ep or te d o n GA AP bal an ce s heet s as t he e nd of Q3 201 0.

amounts of cashthat will need to

eventually beinvested

$1.7

$0.2 $0.2

$0

$2

GNW HIG LNC MET PFG PL PNX PRU

10.2x10.5x

11.3x

10

12

Insurers havehighly levered

balance sheets andmeaningful

pensionobli ations that

50%50%

60%

Investment Leverage as of Q3 2010 YE 2009 Projected Pension Obligations / Q3 Equity

5.2x

6.4x6.8x

8.1x

7.0x

4

6

8

InvestmentLeverage

would bepressured in anextended low rate

environment20%

14%

18%

24%

20%

30%

40%

PBO/Equity

25Note: Investment Leverage = Total Investments (Amortized Cost if Available) / Book Value

Sources: company filings, SNL

Note: GNWs PBO is immaterial

Sources: company filings, SNL

0

2


Investment Leverage Average Investment Leverage

0%

10%

4%

0%

10%



26/40

Projected Maturity of Life Company Fixed Income Portfolios

Bond Portfolio Breakdown by Years to Maturity for All S&P Rated North American Life InsurersAccording to S&P,

40% of lifeinsurers fixed

income portfoliosare ex ected to

0 - 5 years40%

mature within 5years

Based on S&Pprojections, the

5 - 10 years28%

traded life

companies willneed to reinvest

$368 bn of

maturing assets

Over 10 years

32%

Maturity Years Total Amount Maturing ($bn)

Projected Fixed Income Asset Maturities for Top Publicly Traded US Life Companies

years. This

amount is inaddition to the

annual premiumsand other cash

0 5 $368

5 10 $257

> 10 $294

ows t at e

companies needto invest

26

Source: Total Amount Maturing calculated as total fixed maturity portfolios as of Q3 2010 for top 8 US life companies (MET, PR U, PL, PNX, GNW, HIG, PFG, LNC) multiplied by S&P bond portfolio breakdownpercentages outlined in pie chart above


27/40

Concern Over Low Rates Impacting Lower Valuations andCausing More Conservative Posture at Life Companies

3.0

3.5

Some Insurers haveacknowledged that

the low rate

Current and Historical Price to Book Ratios

1.0

1.5

2.0

2.5

P/BRatio

causing concern and

leading them toconserve excesscapital until the

future direction of

Source: Deutsche Bank Research, Company Filings as of November 18, 2010. Ranges represent peak and trough P/B levels over the past 20 years.

0.0

0.5


ra es ecomes morecertain

Current price to bookratios are closer to

historical lows than

375%

500%

447% 440% 431%400%

500%

600%

they are to peaklevels

While RBC Ratiosand Holding

RBC Ratios as of Q2 2010 Holding Company Cash

$3,700

$3,000

$3,500

$4,000

Total $10,899mm

290%

100%

200%

300%

Company cashholdings are at

historically highlevels, no major US

Life Companies haveannounced lans to

$1,300

$800

350

$2,200

$2,500

$1,000

$1,500

$2,000

$2,500

Cash

27

Note: 350% level has been historical benchmark RBC target for AA-rated companies

Source: 2010 Q2 Earnings Transcripts for MetLife, Prudential, Genworth, Lincoln, Principal Financial Group, Protective Life, PhoenixCompanies

Source: 2010 Q2 and Q3 Earnings Transcripts for MetLife, Prudential, Genworth, Lincoln, Principal Financial Group, Protective Life,Phoenix Companies

0%

GNW

Baa3

LNC

Baa2

MET

A3

PFG

Baa1

PL

Baa2

PNX

B3

PRU

Baa2

2010

Q2

RBC

Ratio 350%

return excess capitalto investors

$49

$0

GNW

Q3

LNC

Q3

MET

Q2

PFG

Q3

PL

Q3

PNX

Q2

PRU

Q2


28/40

Ideal Outcome is a Steady Rise in Rates

Scenario Implications

Damaging from both income and balance sheet perspectives

Permanently LowRates

A prolonged low rate environment was a significant driver of life companydefaults in Japan in the late 1990s and early 2000s

Slow Rise in Rates

Slow rise in rates helps to improve profitability while providing insurers with timeto manage negative MTM on assets

Slow risk in rates also minimizes policyholder disintermediation risk

Poses significant policyholder disintermediation risk policyholders likely towithdraw funds to invest in higher yielding investments thereby forcing lifecompanies to liquidate assets with MTM losses

Lar e unrealized losses from risin rates could also lead to weakened balanceSharp Rise in

Ratessheets

Above risks potentially offset by significant cash balances currently being held bylife companies

-

28

, ,profitability


29/40

Section C

or ens on un s


30/40


31/40

Pension Obligations Represent a SignificantObligation for Corporate America

Funded status ofpension plans

has been volatileand exposed

Total Number of Companieswith Defined Benefit Plans

354

Key Statistics for S&P 500 Companies ($bn)2009 Average Asset Allocation for S&P 500

Defined Benefit Pension Plans

Real Estate4%

Other10%

both interest rate

and equitymarket risk

Total Pension Liability $1,603

Total Pension Assets $1,201

Overfunded/ Underfunded) $ 402)

Equity50%

Fixed Income36%

Source: Credit Suisse research report dated September 21, 2010, Pension Headwinds

Funded Status of S&P 500 PlansFunded statusof pension

plans has been

Source: BofAML research report dated October 29, 2010, S&P 500 Pension Update

6%140%

volatile andexposed

companies toboth interest

rate and equitymarket risk

4%

5%

60%

80%

100%

120%

10yeatu

rn

2%

3%

20%

0%

20%

40%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010YTD

rTr

easuryYTM

FundedStatus,

S&P500Re

31Source: BofAML research report dated October 29, 2010 S&P 500 Pension Update, Bloomberg

0%60%

40%

FundedStatus

% S&P

500

Return 10

year

Treasury

YTM


32/40

Under Current Conditions Funding Deficits are Expectedto Persist Leading to Higher Expected Contributions

S&P 500 Projected Plan Contributions and Funded StatusContributionsare projected toexceed $160bn

over the next$bn

86%$100

wo years. venincluding these

contributions,funded status isexpected to onlyreach 82% by YE

lanContribut

ions P

rojected

Fund76%

78%

80%

82%

84%

$40

$50

$60$70

$80

$90

2012

Funded status ishi hl sensitive

ProjectedP d

Status

70%

72%

74%

$0

$10

$20

$30

2008 2009 2010E 2011E 2012E 2013E 2014E

S&P500

Projected

Plan

Contributions S&P

500

Projected

Funded

Status

S&P 500 Pension Plans Funded Status 2010E Sensitivity Analysis

to discount rateand asset

returns. A +/- 25bps change indiscount rate

-10% -5% Base +5% +10%

-50 b s $603) $544) $484) $424) $365)

funded status byapprox. 10%while a +/- 5%

change in assetreturns could

-25 bps ($562) ($503) ($443) ($383) (323)

Base ($521) ($461) ($402) ($342) ($282)

+25 bps ($480) ($420) ($360) ($301) ($241)

32Source (both charts): Credit Suisse research report dated September 21, 2010, Pension Headwinds

status by

roughly 15%+50 bps ($439) ($379) ($319) ($259) ($200)


33/40

Section D

or o a ruc ura m a ances


34/40

Coupon Destruction in the Context of GlobalStructural Imbalances

Asset Class / Metric Current Level Key Question

Question: Why are so many markets trading at historic highs, or lows withunprecedented volatility?

US$ IG Coupons Q4 2010: 4.1% Record low US$ IG coupons

Capital Flows 2008-2010 US$ IG Fund Flow: US$570 bn

Record capital flows into US$ IG bonds,emerging markets, and commodities

Government Yields (10 Year) UK: 3.24% Record low government yields

Related tocoupon

.Japan: 1.19%

Libor 3m Libor: 0.28% Record low LIBOR rates

Gold $1,384 / Oz. Record high gold prices

USD / Yen Y 83.8 / US$ 15-year high USD / Yen exchange rate

Oil / S&P 500 70% correlation 70% correlation in 2010

Oil $85.3 / Barrel Oil trading close to high since LehmanBankruptcy

European Peripheral CDSSpreads (5 Year)

Spain: 351 bpsPortugal: 538 bpsIreland: 603 bpsGreece: 966 bps

Record wide sovereign spreads andCDS

34Answer: Post-Financial Crisis Global Structural Imbalances


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The Global Structural Imbalances

Economics Leverage Capital Markets

Structural unemploymentdeficiencies

U.S. consumer debt levels Central bank monetary policies

Current account surpluses U.S. federal debt Central bank quantitative easingpolicies

2-Tier growth rates U.S. state / muni debt Fund flows into IG bonds

Chinas FX reserves Euro ean soverei n debt Fund flows into commodities

Consumption / GDP Japans sovereign debt Fund flows into emerging markets

. . . .

Wage inequality / incomedistribution

Financial institutions redemptionobligations

`

Foreign currency de-valuations IG bond market coupon destruction

35

Investment grade bond coupon destruction is closely related to a number ofother post-financial crisis structural imbalances


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Structural Imbalances and Coupon Destruction

Structural Imbalance Quantification / Example Implications Destruction

Structuralunemploymentdeficiencies

2010E Unemployment rates:

U.S.:9.6%

Spain: 19.9%

General view that structural unemployment unlikelydriver of U.S. unemployment levels

However, if structural unemployment doescom rise a si nificant ortion of the unem lo ment

Cause Government tackles

unemployment bystimulatin the econom

Japan: 5.1%

UK: 7.9%

Germany: 7.05%

rate, quantitative easing and stimulus measureswould be ineffective for job creation

(QE2) driving rates down

Current accountsurpluses

2010E Current AccountBalances (% of GDP):

Over-dependence on exports for economic growthhas led to artificial currency pegs that distort trade

Cause Chinas export focused

U.S.: (3.19%)

China: 4.7%

Germany: 6.01%

(China),and global capital flows strategy drives FX reserves,UST purchases, and lowerrates

2-Tier growth rates Economic Growth: Low growth rates in developed economies have Cause . .: .

Japan: 2.7%

China: 10%

Brazil: 7.6%

Too fast economic growth in EM countries hastriggered inflation concerns and rate hikes

has led the U.S.government to use liquiditymeasures like QE2 andlower rates

Chinas FX reserves Chinese FX Reserves: Chinas policy of buying U.S. dollars as an artificial Cause

Too low

Too high

Sep. 2010: US$ 2.65 tn

6.4 Yuan/ US$

currency undervaluation strategy creates trade

imbalances and prevents global sustainable growth

China is the largest global

buyer of USTs which keepsdownward pressure onrates

Consumption / GDP U.S.: 70% (too high) Chinas low consumption rate has led the countrysoverde endence on ex orts for economic rowth

Cause

36

na: oo ow

On the contrary, U.S. industrial growth is led bydomestic over-leverage and overconsumption

strategy drives FX reserves,UST purchases, and lowerrates

Source: Deutsche Bank Global Markets Research, IMF (October 2010), Bloomberg, Reuters, International Business Times (November 2010)


37/40



U.S. excess housingsupply

7.7% vacant homes vs. 6%20-year average

1.8 mm excess vacanthomes vs. historical

Likely slow down of home price appreciation,slowing down economic recovery and job creation

Cause Weak real estate prices

caused by excess supplysu ress interest rates,.

average and slow economicgrowth

Wage inequality /income distribution

Average manufacturingwages:

China: ~US$ 2 / hour

Global labor arbitrage creates competitivemargin for counties with lower wages, potentiallyaffecting trade balances

Cause Drives Chinas exports,

FX reserves, and UST

Mexico: ~US$ 2.15 / hour

countries

Aging Populations 2009: Persons 65+represented 12.9% of U.S.population

Persons 65+ expected to

Downward rates impact: creates drag on GDPgrowth

Upward pressure: increases sovereign debt burdenswhich is inflationary over time

NA

grow to 19% of U.S.population by 2030

Foreign currencyde-valuations

Yuan/ USD: Y6.4 / US$

Following a 23 month pegto the US$

The artificial undervaluation of the Chinese Yuanhas launched attacks over its negative impact onglobal sustainable growth

Cause Drives Chinas exports,

FX reserves, and USTurchases

U.S. consumer debtlevels

U.S. consumer leverage ratio(Debt/ Income) has improvedbut still high:

2007: 1.29x

2008: 1.28x

De-leveraging phase has led to an increase insavings rates and a slowdown in consumption,creating a huge drag on U.S. GDP growth

De-leveraging occurring at pace similar to write-offs

Cause Weakened consumer

driving GDP drag andunemployment, andlower rates

37

2009: 1.25x

Source: Deutsche Bank Global Markets Research, IMF (October 2010), Bureau of economic analysis, Reuters, Bloomberg


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U.S. federal debt U.S. public debt: US$13.2tn or ~90% of GDP

Foreign holdings accountfor 30.5% of total debt 51%

Market distress over mounting debt, and deficitspending, especially among foreign holders of U.S.debt

Concern over mountin debt can otentiall

Cause Investor move away from

U.S. government debtand into IG credit.

of publicly held debt),

decrease foreign holdings of federal debt, drivingyields higher

U.S. state / munidebt

State and local debt standsat 22% of GDP (all timehigh)

Market concerns over potential defaults have risenstate and municipal funding costs, crucial to fundingdeficits

Cause Investor move away from

U.S. state/ muni debt and

Expected to reach 24% by2012

Expected US$140 bn incumulative budget gaps

Investor concerns over potential defaults, havedriven record outflows of capital from fundsspecializing in state and muni debt

n o cre

European sovereign Contagion effects:1. Greek soverei n crisis

Solvency concerns in the European periphery havewidened soverei n s reads considerabl and Cause.

2. Irish sovereign crisis3. Spanish banking system4. Portuguese fiscal worries

increased wholesale funding costs

Contagion effect to large foreign holders ofsovereign debt

Has driven significant euro exchange rate volatility

European governmentdebt and into more stableIG credit

Ja ans soverei n IMF expects Japans gross Even though Japans debt / GDP is massive, more NAdebt public debt to reach 226%

of GDP by 2010E

than 90% of Japanese govt bonds are held by

domestic investors

Rates artificially low for nearly 2 decades

Central bankmonetary policies

Fed funds rate: 0.25%

ECB main refi rate: 1.0%

Monetary easing drives government yields down

Slow growth outlook suggests U.S. core rates to

Cause Low government yields

38

remain low in the mid-term are a primary driver ofcoupon destruction

Source: Bloomberg, IMF (October 2010), Bureau of economic analysis. Whitehouse Budget of the U.S.


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Central bankquantitative easingpolicies

QE2 details:

US$ 600 bn thru Q2 2011

Average duration: 5-6 years

Potentially beneficial for U.S. economic growth andjob creation

Direct impact on the dollar (as treasury yields drop)

Cause QE2 bond purchases

have driven, and willcontinue to exert

rec mpac on go an equ es nves orsseeking higher yielding assets)

Transfer of capital into EM as dollar falls

downward pressure onrates

Fund flows into/ outof IG bonds

2008-2010: US$ 570 bn ofIG bond inflows

IG credit has benefited from investor preference forsafe assets yielding stable returns

Both a cause andconsequence

mm in the week endingNov. 17 vs. US$ 4.1 bn theprevious week

,US bond funds recently

Lower rates driveoutflows

Fund flows into

commodities

Total commodity fund inflows

slowed to US$1.2 bn in

QE2 and lower interest rates have driven investors

towards commodities like gold

Consequence QE2 and low IG coupons

c o er vs. . n nAugust

However, riskier commodities have been negativelyimpacted by Chinese rate fears and euro zone woes

drive less risk averseinvestors towardscommodities

Fund flows intoemerging markets

YTD flows into EM equityfunds: US$ 81.9 bn vs. US$83.3 billion in 2009

Lower yielding assets and slower economic growthin developed economies have driven capitaloutflows to emerging markets

Consequence QE2 and low IG coupons

drive less risk averse

YTD flows into EM bond

funds: US$ 46.4 billion vs.US$9.5 billion in 2009

investors towards EM

U.S. banks cashreserves

YTD aggregate U.S. bankcash reserves: US$ 1.04 tn

Tighter regulation and more stringent lendingpolicies have driven an increase in bank cash

Cause Bank liquidity drives

39

January 2006 aggregateU.S. bank cash reserves:US$ 44.3 billion

Strong liquidity among U.S. banks has maintainedinterbank lending rates at substantially low levels

or rates own

Source: Federal Reserve, Investment Company Institute


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Underfundedpension liabilities

Approx. total aggregateunfunded liability of all state-sponsored pension plans inthe U.S. is ~US$ 3 trillion or

Growth in unfunded pension liabilities creates anegative feedback loop, where state governmentsmust borrow further to meet requirements

Potentiall hi her taxes and service cuts ma follow

Cause Market concerns over

state public financesdrives investors out of

US$ 27,000 per household,

adding to investor concern over public finances, andrising funding costs

state debt and into IGcredit

IG bond marketcoupon destruction

2008: 6.3%

2009: 5.9%

2010 YTD: 4.4%

Lower yields, rallying credit spreads, and highdemand for IG credit have driven coupon rates torecord lows

Highly related tomany of the globalstructural

Nov. 10: 4.2% Further liquidity measures (QE2) will likely suppress

interest rates at their current lows

Events such as the European debt crisis have driveninvestors towards more stable assets like IG credit

imbalancesdescribed above

40Source: The Crisis in Local Government Pensions in the U.S.. Robert Novy-Marx and Joshua Rauh, Thomson Reuters

Coupon Destruction Dec 2010_Final

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