The Credit Conundrum- Warning - Holding Credit is not Without Risk

26th March 2009

The Credit Conundrum

Session 5: Warning - Holding credit is not without risk

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Global Equity 47%

Alternatives 3%

UK Property 4%

Cash 6% Corporate Credit

6%

Gilts 34%

Current Asset Allocation (estimate) Q4 2008 Asset Allocation End 2009?

Warning: Holding credit is not without risk

Asset Allocation

Source: Goldman Sachs Asset Management - 2008 Source: Redington Partners

Note: Includes 50%-70% duration overlay using swaps ,Gilts, and / or synthetic equity replication using futures over Gilts.

Global Equity 25%

Alternatives 3%

UK Property 4% Cash

6%

Corporate Credit 27%

Gilts 25%

Supranationals 10%

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However timing is important: Excess return over Libor – 2008


Credit, Fixed Income and Equity Returns for 2008

Source: Redington Partners

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Credit – A Long term investment


Credit – A long term investment?

Price volatility

• Liquidity worsens

• Risk aversion increases (market panics on worsening economic news)

• Default probabilities seen as rising

• VaR increases, valuations decrease, deficits rise

Downgrade risk

• Downgrades to High Yield

• Can you hold them?

• No buyers – prices falling off a cliff

• Mandate design crucial

• How long can your Portfolio Manager hold downgraded bonds?

• Fire sale prices to be avoided

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Year on Year European GDP vs. 12-month Trailing Upgrade/Downgrade Ratio

Source: Deutsche Bank


Credit – A long term investment?

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5 year cumulative implied default rates based on spreads v Govt for IG and HY bonds (£)

Source: Deutsche bank ~Default study 17th March 2009


Default rates – Sterling Corporate Bonds

Spread Implied Default rate Actual Default Rate (since 1970)

Source Sector Average 5 yr spread (bps)

Average Recovery

Zero Recovery

Worst Average

iBoxx Corporate 769 51% 33% 2.4% 0.9%

Non-Financial 397 30% 18% N/A N/A

Financial 986 60% 40% N/A N/A

AA 522 38% 23% 1.8% 0.2%

A 747 48% 31% 2.6% 0.6%

BBB 1,035 58% 39% 5.8% 1.8%

High Yield Euro HY 1,592 69% 53% 31.0% 19.3%

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Type of RMBS No. of Upgrades/Downgrades Barclays Capital rating outlook

RMBS: UK Prime 13/0 Stable

RMBS: UK NC (Subprime) 90/462 Negative

RMBS: Spanish 16/104 Negative

RMBS: Dutch 31/13 Stable to positive

RMBS: Portuguese 3/8 Stable to negative

RMBS: Irish 4/0 Stable to positive

RMBS: Greek 10/0 Stable to positive

CMBS: UK 10/91 Negative

Auto ABS: German 5/2 Stable

Auto ABS: French 0/0 Stable to positive

Auto ABS: Spanish 1/5 Negative

Auto ABS: Italian 0/0 Negative

Total 183/685

2008: Upgrades/Downgrades European ABS plus outlooks

Source: Barclays Capital 2009 Global Securitisation Annual

“Globally, given the negative fundamental trends and the possibility of rating methodology revisions by the rating agencies, we expect even more downgrades in 2009” Global 2009 ABS outlook

- Barclays Capital


Upgrades/Downgrades on European ABS

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Estimated equities returns 1998 - 2018


Projected levels required from FTSE All TR based on approx. 3% risk premium over gilts


Credit vs. Equities

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10-year Rolling Rate of Return on FTSE 100 versus 10 yr swaps (10 yr to date)



Credit vs. Equities

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Annual 20-Year returns for the UK stock market

Source: Global Financial Data, Datastream

•Shares plummeted against falling property valuations

•March 16th 2009 Brixton axed final dividend and announced new rights issue

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In 2008 Dividends axed or slashed across the board –

Losses of USD 903bn worldwide

Capital raising of USD 906bn worldwide

Property companies

Main stream blue chip corporates

Financials

•General Electric announced a 68% cut in dividend for the first time since 1938

•Dow Chemicals cut theirs by 64% for the first time since 1912

•L&G slashed final dividend by 50% on 25th March 2009

Equities - Dividends Slashed/Share dilution through Rights Issuance

•S& P predicts that dividends in US could fall by 25% in 2009. •From 1931 – 35 American dividends fell 45%.

2008

2009


Equities Outlook

Capital Structure – Order of Seniority

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Secured

•Regular coupon

•Bond /Loan redeemed at par on maturity

• Secured against named assets

•Losses only when, in event of default, the value of secured assets drops below initial valuation levels

Senior unsecured

•Regular coupon

•Redeemed at par

•Losses only in event of default

•Usually some recovery rate (historically 40% for investment grade, 15% for high yield)

Lower Tier 2

Upper Tier 2

Tier 1

•Enhanced fixed rate coupon

•Coupon may be cancelled or suspended at the discretion of the issuer

•Issues are long dated or open-ended. Callable by nature with step-up coupons

•Lower recovery rates, as lower down the capital structure

Equity

•Dividend – not guaranteed in either magnitude or existence

•Price of share – not limited to 100 redemption

•Equities take the first losses


Credit vs. Equities

Minimum Funding Level

Cone of Uncertainty

Cone of Uncertainty

FRS 17/IAS 19

BUYOUT S75

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Credit and the Flight Plan

Using Credit in your Strategic Asset Allocation – Matching, Return or Both?

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Credit – on the path to Buy-in/Buy-out

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Buyout - “Preferred” Assets

Bonds

Gilts

Sterling investment grade bonds

Overseas investment grade credit

Credit Derivatives

Structured Credit

Cash

Bank deposits

Swaps

Interest Rate

Inflation

Subject to counterparty

agreement

Equities

Exchange traded

Private


Credit – preferred assets

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Buyout – Risk Profile of investment Strategies

60 / 30 / 10 – Traditional Allocation

Interest rate and inflation hedging

Transition Growth Assets to Matching/Eligible assets

Buy-in hedge portfolio/longevity swaps

Buy-in/Buyout

High Risk

Medium Risk

Low Risk

Least Risk


Getting your ducks in a row

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The Credit Conundrum- Warning - Holding Credit is not Without Risk

Economy & Finance

Transcript of The Credit Conundrum- Warning - Holding Credit is not Without Risk