JP Credit Outlook 2010

Europe Credit Research 11 November 2009

European Credit Outlook & Strategy 2010

Adapting to Change

Strategy Stephen Dulake AC

Daniel Lamy AC Tina Zhang AC

Derivatives & Quantitative Research Saul Doctor AC Abel Elizalde

Economics David Mackie AC

ABS & Structured Products

Rishad Ahluwalia Gareth Davies, CFA AC

Autos Stephanie A Renegar

Consumer Products, Food & Retail Katie Ruci Raman Singla

Financials Roberto Henriques, CFA AC Christian Leukers, CFA Alan Bowe

Industrials Nachu Nachiappan, CFA Nitin Dias, CFA Ritasha Gupta

TMT David Caldana, CFA Andrew Webb

Malin Hedman

Utilities Olek Keenan, CFA

J.P. Morgan Securities Ltd.

See page 69 for analyst certification and important disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

• This year, we have taken a somewhat more thematic approach to writing the outlook for the year ahead. Specifically, we believe that a number of trends have begun to emerge over the past 12 months which are permanent or quasi-permanent in nature. In a sense then, while we have written with the market outlook for the next 12 months foremost in our minds, we believe that some of the themes we discuss will likely have a longer shelf life which extends beyond 2010.

• In terms of these trends: David Mackie, J.P. Morgan’s Head of Western European Economics, discusses how an end to the recession does not mark a return to normality; rather, that a significant portion of the loss in GDP seems to represent a permanent loss in the level of potential. Roberto Henriques writes how the regulatory capital reform process is likely to be the major transformational event and represents part of a wider strategy by governments in terms of creating mechanisms whereby they ultimately may no longer be forced providers of capital of last resort. Gareth Davies looks at the new bank regulatory landscape from the perspective of the secured lending markets; covered bonds are set to move into the ascendancy relative to classic securitisation, where we see the costs of issuing and investing rising. From a credit strategy perspective, we look at the impact of all of these changes on companies and what this means in terms of funding and liability management, for both large-cap investment grade businesses and the leveraged credit universe. The bottom-line is a lot more bond issuance, and on a multi-year basis. Finally, we examine the future of credit derivatives and see a resumption of synthetic structured credit activity as one of the ‘wildcards’ for 2010.

• From the perspective of investing in credit markets over the next 12 months, we see ourselves transitioning into a low-return environment after the exceptional gains of this year. Spreads are fairly valued and our Rates Strategy colleagues see market rates rising modestly over the coming year. We forecast high grade returns of around 3% and high yield returns of 7-8%. 2010 is, we think, an alpha year rather than a beta year for credit markets. However, low return doesn’t necessarily mean low volatility, in our view. We see the potential for risk markets to swing from pillar to post next year as market participants oscillate from fearing inflation to fearing deflation, for example. Against this backdrop, we think there’s a continued case for implementing tail hedges.

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Stephen Dulake (44-20) 7325-5454 [email protected]

Table of Contents 2010 Executive Summary ........................................................3 Making Money in 2010: It Gets Tougher from Here! ..............5 High Conviction Trades for a Low Return World.................11 A Recovery, but Not a Return to Normality..........................22 The Regulator Strikes Back...................................................26 A Future Secured? The New Rules of the Game for the Secured Lending Markets......................................................44 The Big Issue ..........................................................................50 High Yield Mark 3: Riding the Refi Wave..............................58 The Future of Credit Derivatives ...........................................65

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2010 Executive Summary This year, we have taken a somewhat more thematic approach to writing the outlook for the year ahead. Specifically, we believe that a number of trends have begun to emerge over the past 12 months which are permanent or quasi-permanent in nature. In a sense then, while we have written with the market outlook for the next 12 months foremost in our minds, we believe that some of the themes we discuss will likely have a longer shelf life which extends beyond 2010.

In terms of these trends: David Mackie, J.P. Morgan’s Head of Western European Economics, discusses how an end to the recession does not mark a return to normality; rather, that a significant portion of the loss in GDP seems to represent a permanent loss in the level of potential. Roberto Henriques writes how the regulatory capital reform process is likely to be the major transformational event and represents part of a wider strategy by governments in terms of creating mechanisms whereby they ultimately may no longer be forced providers of capital of last resort. This is a major structural change which will impact risk pricing across the entire bank liability structure. Gareth Davies looks at the new bank regulatory landscape from the perspective of the secured lending markets; covered bonds are set to move into the ascendancy relative to classic securitisation, where we see the costs of issuing and investing rising.

From a credit strategy perspective, we look at the impact of all of these changes on companies and what this means in terms of funding and liability management, for both large-cap investment grade businesses and the leveraged credit universe. The bottom-line is a lot more bond issuance, and on a multi-year basis. We forecast gross euro-dominated high grade Non-Financial issuance to be €200bn in 2010 and €180bn in 2011. This is about double the average run over the past decade. For euro high yield, we forecast €35bn of issuance in 2010. This would represent a record year.

We examine the future of credit derivatives and see a resumption of synthetic structured credit activity as one of the ‘wildcards’ for 2010. From a market structure perspective, we believe that most of the document and trading standards changes we have seen over the past year are done. The market is now likely to focus on further reducing systemic risk through the use of central clearing. We do not believe that clearing is the answer to all ills nor that take-up by clients will be a foregone conclusion.

From the perspective of investing in credit markets over the next 12 months, we see ourselves transitioning into a low-return environment after the exceptional gains of this year. Spreads are fairly valued and our Rates Strategy colleagues see market rates rising modestly over the coming year. We forecast high grade returns of around 3% and high yield returns of 7-8%. 2010 is, we think, an alpha year rather than a beta year for credit markets. However, low return doesn’t necessarily mean low volatility, in our view. We see the potential for risk markets to swing from pillar to post next year as market participants oscillate from fearing inflation to fearing deflation, for example. Against this backdrop, we think there’s a continued case for implementing tail hedges.

Stephen DulakeAC and Team

(44-20) 7325-5454 [email protected]

mailto:[email protected]

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High Conviction Trades for a Low Return World We highlight the top trades from the European Credit Research team. We group the trades under three banners: Macro and Index Trades; Industry and Single Name Trades; Tranche and Structured Credit Trades.

Macro and Index Trades • iTraxx payer spread portfolio hedge

• Long US versus Short Europe: Buy iTraxx payer sell CDX payer

Industry and Single Name Trades Industrials • Saint Gobain versus CRH relative value switch

• Sappi versus Stora relative value switch

• Lafarge versus Saint Gobain relative value trade

• Top European Chemicals shorts as M&A momentum looks set to accelerate

• Glencore versus ArcelorMittal relative value trade

Autos • Long risk Selective “280bp+” Auto Credits versus Single-Name Underweights

• FCE versus FMCC relative value switch

Property and Pubs • Long PEPR risk

• Buy subordinated bonds of Greene King, Marston’s, M&B

Financials • HSH Nordbank: Ship it in

• Buy Hypo Real Estate Tier 1

• Long RBSG Convertible Preference Shares and UT2

Consumers • Long risk Brewers Basket Trade

• Long-short Consumer versus Non-Food Retail Basket Trade

TMT • Long risk KPN versus short TI

• Long risk ITV; short risk Bertelsmann

Structured Credit Trades • Long cash CLO AAA/first-priority tranches

• Short correlation trade: sell 10y S12 super senior protection delta-hedged

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Making Money in 2010: It Gets Tougher from Here! 2009 in review: good, but it could have been better 2009 was a good year, at least in the context of reviewing the performance of our high grade and high yield bond model portfolios, as well as our credit derivative or CD Player model portfolio. To put some perspective on the performance of 2009 investment recommendations, our euro and sterling high grade model portfolios have outperformed their respective benchmarks by circa 350bp and 400bp year-to-date; our high yield model bond portfolio has outperformed by around 450bp; while our credit derivatives portfolio has returned about 40% on margin.

To get a little more granular, 2009 was, as they say, a game of two halves. Essentially, when we review our performance, we must admit that we took our foot off the gas far too soon in 2H09. While we were correct to remain defensive through most of 1Q09, our biggest wins were to add distressed European bank capital in high grade in early-to-mid March and low-dollar price high yield bonds in early-April. However, we took profits on these positions far too early. This was especially the case in Tier 1 bank capital, which we did around mid-year.

Despite taking our foot off the gas too soon, we have been able to post positive performance throughout the year. Beta – or making the right directional call on the market – was clearly the dominant influence on our returns through 1H09. If anything, beta became a net drag through 2H09. Alpha – sector and single-name credit selection and relative value-focused strategies – has therefore been the principal driver of our performance through 2H09.

On a broad sectoral basis, we generated considerable alpha from being Overweight Financials and Underweight Industrials (or Non Financials). Though this has become a somewhat mature position from the perspective of our model portfolios – we’ve essentially been positioned this way for all of 2009 – we have been able to extract incremental value over and above simply being Overweight Financials by taking advantage of relatively attractive dispersion levels within individual points of the bank capital curve. The best example of this is how we’ve re-balanced our Lower Tier 2 holdings throughout the year. Lower Tier 2 has been our single-biggest sectoral Overweight throughout 2009; initially, we entered the year with our holdings concentrated in the bullet structures; we subsequently switched into callables; the last leg to this re-balancing being focused on increasing our exposure to certain credits in quasi-distressed jurisdictions such as Germany and Ireland.

One alpha opportunity we don't feel we made enough of was the idea of buying ‘bombed out’ Cyclicals. This we highlighted in European Credit Outlook & Strategy 2009, 12 November 2008, as a potential source of outsized returns this year. While we indeed added some Cyclical risk to our model portfolios in the spring, the simple truth is the market got more comfortable, more quickly, and with more credits than we did!

European Credit Strategy

Stephen DulakeAC


Daniel LamyAC


Saul DoctorAC


Beta was clearly the dominant influence on our returns through 1H09. Alpha has been the principal driver of our performance through 2H09.


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Our CD Player portfolio has followed a similar pattern with big wins during 1H09 being replace by more mixed relative value performance through 2H09. Our monthly returns have averaged 4.1% on margin during the first ten months of 2009 and the drivers of this can be broken down in to the following themes:

Liquidity and distress normalisation: This has been our most profitable source of ideas; our strategy has consisted of going long risk highly distressed instruments with a high illiquidity premium and hedging their credit risk. Some of our trades include: negative bond-CDS basis trades; junior mezzanine tranches hedged with both iTraxx Crossover or equity tranches; and curve steepeners in Financials and other single-name credits (“refinancing steepeners”).

Out-of-the-money hedges: These hedges have allowed us to feel comfortable with the long risk positions embedded in our portfolio. Some of these hedges include: iTraxx 3s5s flattener; option payer spreads; and super-senior versus sovereigns. Even though we likely implemented some of these too soon, we nonetheless still hold some of them in our portfolio going into 2010; this is a subject we will come back to.

Relative value trades: Relative value across credit instruments has been one of the most challenging trading activities during 2009, given the strong, indiscriminate directionality of the market. Performance on this front has been more mixed. We have had some successful trade ideas in this space (e.g. LevX versus LCDX, Senior versus Sub Financials, high yield long short basket) along with some unsuccessful ones (e.g. Main versus Crossover, Financials versus HiVol).

2010 high grade investment themes #1 Alpha rather than beta One of the key themes we highlighted when we wrote the 2009 outlook 12 months ago was the possibility to achieve equity-like returns on unlevered basis. And so it has been. According to JPMorgan’s MAGGIE index, high grade corporate bonds have thus far returned a little shy of 14% in 2009.

However, if the ability to generate these sorts of returns was made possible by the imbalance between risk and reward 12 months ago, it would seem near-impossible for credit markets to repeat this sort of performance over the next 12 months. At JPMorgan, our preferred metric for looking at the balance between risk and reward is carry-to-risk. On this basis, risk and reward seem evenly balanced as we enter 2010 (see Figure 1). The bottom-line is that while we may have taken our foot off the gas prematurely in 2H09, as we look forward to 2010, we’re not about to step on it again.

Figure 1: High Grade Carry-to-Risk

0.000.250.500.751.001.251.501.75

05-Jan-99 05-Jul-00 05-Jan-02 05-Jul-03 05-Jan-05 05-Jul-06 05-Jan-08 05-Jul-09

Source: J.P. Morgan.

Trades motivated by market normalisation have been the most consistent driver of returns in our CD Player portfolio.

At JPMorgan, our preferred metric for looking at the balance between risk and reward is carry-to-risk. On this basis, they seem evenly balanced as we look forward into 2010.

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What’s our best estimate for returns over the coming 12 months? Here, we rely less on our carry-to-risk framework – which says more about the current state of play in credit markets – than we do our macro spread model. Given JPMorgan’s economists’ base-case expectations for the next 12 months, our macro spread model would put high grade corporate bond spreads little different from where they are today (see Figure 2).

Our economists have also identified two alternative scenarios for us; an upside case and a downside case. Even when we look at the probability-weighted spread forecast across these three scenarios, the forecast for spreads 12 months forward is again very little different from where they are today. This said, the contours of our economic forecasts, to borrow a term from Bruce Kasman, our Chief Economist, imply modest spread tightening in 1H10, followed by modest widening in 2H10. Returning to what this means in terms of our high grade corporate bond return expectations over the next 12 months, we note that our Rates Strategy colleagues expect euro swap rates to rise modestly over the coming year, 5-year rates by circa 25bp. Given this and current yields of 4%, we forecast high grade corporate bond returns to fall to around 3% over the coming 12 months.

Figure 2: JPMorgan's Macro Spread Model bp

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While we’ve yet to solicit any investor feedback on this 3% forecast for high grade bond returns, our sense is it will be perceived as being too conservative. We have no doubt that we will be told about the amount of cash that’s still out there, and of the inflows that many are still seeing into the various corporate bond funds. Our point is twofold: firstly, there’s some evidence that inflows are beginning to moderate. Secondly, supply is expected to remain high, not just in 2010 but also 2011; in this sense, elevated issuance levels this year were not a one-off. For Non Financials alone, we expect net bond issuance to be around €100bn in both 2010 and 2011, i.e. significantly higher than where it has been on average (see The Big Issue in this publication).

Combining a forecast that high grade spreads will be little changed year-over –year with our Rates Strategy colleagues’ view that market rates will rise modestly, we forecast returns to drop to 3%.

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#2 Dispersion If credit investing in 2010 will truly be about generating alpha, then the debate around market dispersion levels is only likely to grow (see The Dispersion Debate, 21 October 2009).

Figure 3: JPMorgan's Measures of Non Financial and Sub Bank Spread Dispersion

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Non-Fin Dispersion Sub-banks


Our take remains the same; spread dispersion, especially for Non Financials, remains excessively tight and consistent with average spread levels significantly tighter than where they are today (see Figure 3). Not surprisingly, our dispersion-based investment themes remain the same:

1. We see limited potential for further spread compression, even in the event that we see the modest spread tightening in 1H10 implied by our macro spread model; or at least the moment to engage in such a strategy has passed.

2. While Sub Financial dispersion is hardly generous, we think there's more to play for in Financials relative to Non Financials; relative dispersion levels are another reason for remaining Overweight Financials and Underweight Industrials.

3. For unfunded investors, stay short default correlation. Our preferred trade involves selling super-senior protection on a delta-hedged basis.

4. Buy protection on formerly wide-spread names. By this, we mean looking at the single-name credits which previously traded, for example, in the top-third of the spread distribution, but have now moved out of this area, to trade among the tighter or average spread names

#3 Out-of-the-money hedges We’ve previously made the case that investment grade credit is an asset which has flirted with both tails of the return (or risk) distribution over the past 12 months, before finally settling back into the body (see, for example, European Credit Outlook & Strategy, 17 September 2009). Furthermore, this isn’t at all inconsistent with what we’ve previously said about risk and return being more evenly-balanced in a carry-to-risk context. Figure 4 highlights the distribution of excess corporate bond returns over the past decade, with the negative tail populated by data points from December 2008 and the positive from June this year.

Spread dispersion, especially for Non Financials, remains excessively tight, in our view.




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Figure 4: The Distribution of Rolling 3-Month Excess high Grade Bond Returns since 2000

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Our 3% return forecast for high grade returns would seem to suggest that the transition from 2009 to 2010 simply represents a transition from a high- to a low-return environment. That returns are forecast to be moderate doesn’t necessarily mean we’re entering a benign, low-volatility environment. Far from it; risk markets could conceivably swing violently next year as participants move from fearing deflation to inflation and vice versa; or in response to the perception that policymakers are going to get less accommodative and central bank policy rates are set to rise; or concerns around sovereign solvency and different national governments' ability to fund themselves.

This is one of the reasons why, as we highlighted earlier, we’ve chosen still to carry some of the tail hedges we (perhaps prematurely) implemented in our CD Player portfolio; specifically, an iTraxx Main payer spread trade. However, we think there are a number of options open to credit portfolio managers, as we discussed previously in What Are Your Options?, 6 October 2009. Away from payer spreads on the iTraxx indices, one could consider:

1. An iTraxx Main 3s-5s flattener. Curves have historically tended to flatten dramatically in an environment of market stress.

2. Buying super-senior protection. This is, in our view, preferable and cheaper than simply buying protection on tight-spread single-name credits, as some market commentators have previously suggested.

3. Buying iTraxx SovX protection. Governments are arguably playing a monoline insurer-like role in respect of the global banking system.

4. Looking at interest rate options. A delta-hedged 3-month straddle on 5-year swap rates is highly correlated with iTraxx Main.

5. Equity options. S&P 500 puts and payer spreads are the most attractive strategies, in our view.

Our 3% return forecast for high grade returns would seem to suggest that the transition from 2009 to 2010 simply represents a transition from a high- to a low-return environment. That returns are forecast to be moderate doesn’t necessarily mean we’re entering a benign, low-volatility environment.


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2010 high yield investment themes #1 Issuance and rates to put a cap on returns We think the conditions are in place to make 2010 a record year for euro high yield issuance, with supply potentially reaching €35bn, compared with a previous high of €29bn. Aside from the need to fund a record volume, we think that the low all-in yields on offer will diminish the prospects for future returns and make the asset class vulnerable to higher interest rates. We think 2010 will be a year for coupon clipping.

The average coupon on October’s €7.35bn of new issues was only 7.3%, a function of its crossover/BB nature and a shortage of ‘true’ high yield deals; year-to-date BBs account for 50% of supply. The glut of low yielding bonds looks set to be exaggerated once more senior secured notes start to materialise, as the new benchmark for pricing these instruments is likely to start in a Euribor+400-500bp range with a Euribor floor, we believe. This equates to roughly a 7-8% yield on fixed rate instruments, the format likely to be favoured by investors.

Figure 5: Ratings Distribution of Euro High Yield Issuance

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#2 Refinancing: risk or opportunity? Own subordinated bonds in good companies Although looming principal repayments pose a threat to subordinated creditors of highly leveraged companies, refinancing can present an opportunity for bonds that are low down in good quality capital structures, we believe. Junior creditors should be able to extract concessions such as a cash consent fee and coupon boost in exchange for extending maturity; a necessary process for the terming-out of senior debt while preserving the order of repayments.

#3 In the distressed space we prefer Financials to Non-Financials Buying distressed bonds was our top trade in 2009, but we feel that valuations have in many cases gone too far, spurred by a reach for yield and lack of alternatives. As a high beta play we prefer to own certain distressed Financials: we currently hold Depfa, IKB, and HSH Nordbank LT2. Stressed bonds we do own in our model portfolio are: Cognis, Impress and Ecobat PIKs, Edcon, and Momentive.

Sectors where we still see negative fundamental trends include Airlines and Paper: our top Paper shorts are M-Real and Norske Skog, although short-term liquidity at these companies is not presently an issue. We are also bearish on the more cyclical Chemicals producers, most notably Ineos because of raw material cost pressure and new capacity coming onstream. It is probably too early to be shorting other deep Cyclicals such as NXP, as their operational gearing means that they may benefit from the macro rebound for a while longer. Our high conviction short in the Autos sector is Continental.

Please refer to European High Yield Update, published 30 October 2009 to see our most recent portfolio update.



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High Conviction Trades for a Low Return World Top Trades in the Credit Market This section highlights the top trades from the European Credit Research team. We group the trades into three main sections: Macro and Index Trades; Industry and Single Name Trades; Tranche and Structured Credit Trades. In each section, we select a variety of different trades using bonds, CDS and other instruments. For each trade we highlight the main drivers, rationale and risks. Where relevant, a link is provided for each trade to the original published research note as well as details of the publishing analysts.

List of Trades Macro and Index Trades • iTraxx payer spread portfolio hedge • Long US versus Short Europe: Buy iTraxx payer sell CDX Payer Industry and Single Name Trades Industrials • Saint Gobain versus CRH relative value switch • Sappi versus Stora relative value switch • Lafarge versus Saint Gobain relative value trade • Top European Chemicals shorts as M&A momentum looks set to accelerate • Glencore versus ArcelorMittal relative value trade Autos • Long risk Selective “280bp+” Auto Credits versus Single-Name Underweights • FCE versus FMCC relative value switch Property and Pubs • Long PEPR risk • Buy subordinated bonds of Greene King, Marston’s, M&B Financials • HSH Nordbank: Ship it in • Buy Hypo Real Estate Tier 1 • Long RBSG Convertible Preference Shares and UT2 Consumers • Long risk Brewers Basket Trade • Long-short Consumer versus Non-Food Retail Basket Trade TMT • Long risk KPN versus Short TI • Long risk ITV; short risk Bertelsmann Structured Credit Trades • Long cash CLO AAA/first-priority tranches • Short correlation trade: sell 10y S12 super senior protection delta-hedged

European Credit Research

Saul DoctorAC (44-20) 7325-3699 [email protected]

Abel Elizalde (44-20) 7742-7829 [email protected]

Alan Bowe (44-20) 7325-6281 [email protected]

Katie Ruci (44-20) 7325-4075 [email protected]

Andrew Webb (44-20) 7777-0450 [email protected]

Christian Leukers, CFA (44-20) 7325-0949 [email protected]

Nachu Nachiappan, CFA (44-20) 7325-6823 [email protected]

Nitin Dias, CFA (44-20) 7325-4760 [email protected]

Olek Keenan, CFA (44-20) 7777-0017 [email protected]

Raman Singla (44-20) 7777 0350 [email protected]

Rishad Ahluwalia (44-20) 7777-1045 [email protected]

Roberto Henriques, CFA (44-20) 7777-4506 [email protected]

Stephanie A Renegar (44-20) 7325-3686 [email protected]

J.P. Morgan Securities Ltd.

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iTraxx Payer Spread Portfolio Hedge Our portfolio strategy is to look for relative value opportunities coupled with OTM hedges. One such OTM hedge, that we think is very attractive, is payer spreads on the iTraxx index. Payer spreads are formed by buying a low strike option and selling a higher strike option (Figure 6). These option strategies are low cost, but benefit if spreads rise above the lower strike. We analysed these trades in Odds On, where we showed that these trades can be seen as fixed odds trades where an investor pays an initial premium for a fixed payout if spreads are above a certain strike. Relatively wide skew currently makes this trade attractive (Figure 7).

Figure 6: iTraxx Payer Spread x-axis: Spread (bp); y-axis: P&L (‘000)

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Long US versus Short Europe Buy iTraxx Payer sell CDX Payer As spreads have declined, the differential between iTraxx Main and CDX IG has narrowed and currently stands at 17bp. While it has widened off the lows, we believe that this differential should compress further (Figure 8). Options offer an attractive way to enter this trade as implied volatility in CDX (in bp) is higher than in iTraxx Main. We buy a Main Payer at 100bp funded by selling a CDX Payer at 120bp.

Figure 8: iTraxx Main vs CDX IG Spread (bp)

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Figure 9: iTraxx Main and CDX Implied Volatility (bp) Volatility (bp)

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Analyst: Saul Doctor

Date of Entry: 1 Oct-09

The full text of this trade can be found in the below report:

CD Player: Market Themes and Relative Value Trade Ideas in the European Credit Derivatives Market published on 1st October 2009.

Analyst: Saul Doctor






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Industry and Single Name Trades Saint Gobain versus CRH Relative Value Switch € Bonds: Switch out of Saint Gobain July 2014 bonds (Baa2/BBB Z spread 154bps) into CRH May 2014 bonds (Baa1/BBB+ Z spread 172bps) £ Bonds: Switch out of Saint Gobain December 2016 bonds (Baa2/BBB Z spread 178bps) into CRH April 2015 bonds (Baa1/BBB+ Z spread 220bps) The CRH bonds trade wider despite being better rated and having a 125bps step up (only the €bonds) on sub-investment grade downgrade. While we acknowledge that CRH has a risk of a downgrade to Baa2/BBB, we think at worst it should trade in line with Saint Gobain; given the step up in the € bonds, we think these bond should trade inside Saint Gobain.

Both CRH and SGOFP have similar exposure to developed markets i.e. 85% of sales and limited exposure to emerging markets i.e. 15% of sales. However CRH has a bigger US (50% of sales vs. 12% for Saint Gobain) and smaller Europe exposure (50% of sales vs. 73% for Saint Gobain) compared to Saint Gobain. This should help CRH benefit from the US stimulus package. CRH also has a bigger infrastructure exposure (30% of sales) as compared to Saint Gobain (9% of sales).

Sappi versus Stora Relative Value switch Switch out of the Stora senior 2014 bonds (Ba2/BB+ Z spread 343bps) into Sappi senior secured € 2014 bonds (Ba2/BB+ 755bps) We prefer the Sappi to the Stora bonds as while both the bonds are similarly rated and have similar maturities, the Sappi bonds trade about 400bps outside the Stora bonds. We think Sappi has more geographical diversification, has emerging markets exposure (through South Africa) and has a less near term maturities as compared to Stora. While we acknowledge that Sappi should trade wider than Stora Enso given that Stora is bigger in size, has no covenant issues and has much larger liquidity resources, we think that the current differential is significant and unjustified.

Lafarge versus Saint Gobain Relative Value Trade Sell protection on Lafarge (long risk 5 year CDS 194bps mid price) and buy protection on Saint Gobain (short risk 5 year CDS 130bps mid price) We suggest going long Lafarge (sell protection) and short Saint Gobain (buy protection) to capitalize on Lafarge’s higher exposure to emerging markets (50% of sales) as compared to Saint Gobain (15% of sales). We think that the outperformance of emerging markets as compared to developed markets should continue in the near term which should help Lafarge perform better than Saint Gobain. We also think that the reduced risks of a Lafarge downgrade should support Lafarge spreads.

Analyst: Nitin Dias

Date of Entry: 26 August 2009

CRH Plc: H109 update published on 26 August 2009.

European Building Materials Q309 preview published on 16 October 2009.

Analyst: Nitin Dias

Date of Entry: 25 September 2009

Sappi: Global Presence and Improved Capital Structure Drive Value; Initiating at Overweight published on 15 September 2009

Analyst: Nitin Dias

Date of Entry: 9 November 2009

Lafarge Q309 update published on 9th November published on 9 November 2009




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Top European Chemicals shorts as M&A momentum looks set to accelerate Buy protection on Akzo Nobel at 79bp, BASF at 52bp, Bayer at 52bp and Solvay at 73bp (as at market open on 9 November 2009). We believe that further consolidation is likely in the European Chemicals sector following increased M&A activity in the broader market and Solvay’s recently announced intention to pursue a “sizeable” acquisition target. The combination of (i) rising valuations, (ii) improving demand dynamics and (iii) the greater desire to reduce cyclicality or consolidate market positions in response to the recent crisis are likely to trigger an increasing level of M&A activity. Relatively healthy balance sheets in the Investment Grade universe leave some companies with reasonable acquisition firepower, i.e. Akzo Nobel, BASF, Bayer and Solvay, in particular. In terms of targets, we think that acquirers are likely to focus on structural growth i.e. GDP++ growth companies and ones that also help to lower cyclicality, but the scarcity of such assets implies a price.

Glencore vs. ArcelorMittal relative value trade 1. Sell ArcelorMittal 5-year protection at 275bp (as at market open on 9

November 2009).

2. Buy Glencore 5-year protection at 235bp (as at market open on 9 November 2009).

We think that the recent widening in ArcelorMittal’s spreads is overdone and would once again go long risk. As a hedge against this, we would be short Glencore which is 40bp tighter. ArcelorMittal’s recent results and outlook commentary reaffirmed our view that the steel market recovery is underway. Although, the demand recovery will likely be more muted than expected in H209, we believe that the industry is poised for a solid FY10, as inventory channels remain lean and supply discipline is in place. The market may have been somewhat disappointed with ArcelorMittal’s Q409 guidance (EBITDA in the range of $2-2.4bn vs. our expectations of $2.2bn). Given the company’s operating leverage to steel prices, sentiment towards the company will likely rest on the direction of future steel prices. Hence, we are encouraged by the recent stabilisation in China’s HRC price, which should drive global steel prices higher. Glencore on the other hand is likely to widen on operational volatility and new issuance, which we think could be sooner than expected.

Figure 10: LTM 5-year CDS development for ArcelorMittal and Glencore

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ArcelorMittal Glencore Source: J.P. Morgan

Analyst: Nachu Nachiappan

Date of Entry: 9 Nov 2009

For further information on the rationale for this trade, please refer to: European Chemicals: M&A momentum looks set to accelerate published on 13th October 2009.

Analyst: Nachu Nachiappan

Date of Entry: 9 Nov 2009

For further information on the rationale for this trade, please refer to:

Basic Industrials Handbook 2009 published on 9 September 2009.




15



Long Risk Selective “280bp+” Auto Credits vs. Single-Name Underweights Sell Protection on GKN, Renault and Valeo/Buy Protection on Tomkins, Peugeot, and Volvo For certain higher-spread automotive names which we call them the “280+ Club”, as their 5y CDS spreads are trading at 280bp or wider, we see potential upside versus the market and other auto names in the next 3 months.

Figure 11: European Autos Pair Trade Ideas Short Risk Long Risk- 280+ Club Tomkins GKN Reasoning: Reasoning: Lack of relative value to Valeo/GKN given slight improvement in credit profile versus significant improvement at others.

JPM expects strong improvement in credit profile in 2010.

Improvement in NA production/mix may provide further upside.

Potential refinancing/forward start agreement for 2010 credit line could remove liquidity overhang. Next large cash maturity is 2012.

Peugeot Renault Reasoning: Reasoning: Payback from scrapping incentives mean more to Peugeot than Renault given revenue exposure, lack of equity earnings from more global cos.

Asset-rich nature may provide potential upside: Volvo stake could provide over €2.7bn in proceeds to delever Renault.

Positive commentary out of Nissan (earnings) and AutoVaz (gov't support) support earnings/limit cash exposure and potential dividend growth (Nissan div may be held until 2011).

Volvo Valeo Reasoning: Reasoning: Strong liquidity, but company's cash flows are risky given capacity utilization through 2010.

Strong liquidity position (EIB loan, covenants changed) supports current valuations.

We think potential ratings pressure in 2010 (currently at Baa2/s, BBB/n). Ratings mean more to funding than typical industrial given finance arm.

Company has outperformed our expectations on restructuring savings.


FCE versus FMCC Relative Value Switch Switch out of Ford Motor Credit 5y CDS (FMCC) to go long risk FCE Bank Plc 5y CDS Given the relative value between the two entities (FCE CDS is currently 625bp (bid) and FMCC is currently 580bp (offer), levels close 9 Nov. 2009) we continue to recommend going long risk in FCE and using FMCC as a hedge (picking up 45bp). Fundamentally, we believe FCE to have a more solid balance sheet than FMCC (the company is willing to have a 15% Tier 1 ratio, company was 21% at 1H09, versus a roughly 8% equity/assets ratio at FMCC) that should help to support levels. In addition, positive news out of the parent should help support FCE bonds/CDS (for example, improvement in the parent company, through access to capital and ratings upgrades, should help support FCE levels due to lessening default risk as well as its liquidity profile through better access to capital. The JPM US Credit rating on FMCC is currently Overweight.

Analyst: Stephanie Renegar

Date of Entry: 6-Nov-2009

The full text of this trade can be found in the below reports:

Earnings Drive-By, published on 5th November 2009

Analyst: Stephanie Renegar

Date of Entry: 6-Nov-2009


European HY Update published on 6th November 2009.



16



Long PEPR risk Buy PEPR € 14s @ 91 Prologis European Properties has been subject to many credit concerns over 2009 due to its very short-dated maturity profile and concerns around its parent, Prologis. However, in the last few months it has extended or refinanced a number of loans, and most recently repaid €359mn of CMBS debt ahead of schedule. This progress combined with a high quality underlying portfolio, progress towards capital raising and modest corporate leverage of c.55% makes us confident PEPR can return to investment grade over 2010. As such, despite the recovery from “distressed” levels this year, we think the bonds will be a strong performer against other strong High Yield names in 2010.

Buy subordinated bonds of Greene King, Marston’s, M&B 3. Buy GKFIN 5.702% 2034 @ 65

4. Buy MARSLN 5.6410% 2035 @ 76

5. Buy MABLN 6.469% 2032 @ 77

We believe that the UK pub industry faces a period of painful restructuring and deleveraging due to regulatory change, the need for thousands of small drink-led pubs to close or be entirely refurbished and excessive leverage that will require restructuring in some cases. However, we also believe that a clear distinction has opened between those names focused on financial engineering (Punch, Enterprise Inns and a number of privately-held names like now-defunct Globe Pubs) which have seen operating deterioration in their lower quality estates with little improvement in later 2009. By contrast, these three smaller operators have maintained a strong focus on investing in the operating businesses, and have been ahead of the curve in responding to the changing environment for UK pubs.

As a result, and encouraged by the recent reports from all three operators that their pubs are seeing a stabilization in EBITDA, we believe that these companies will be the long term strategic winners in the industry. We project that all three can avoid hitting covenants within their structures on a standalone basis, but note that they have cash flows outside the ringfence that can be diverted to help maintain ratios if necessary. In addition, two of the three have already proven access to the equity market in 2009.

HSH Nordbank: Ship it in We particularly like the Lower Tier 2 (HSHN € 4.375% 12/17 at 69.5 cents, HSHN € Float 12/17 at 64 cents) instruments, which do not allow for coupon deferral and have a fixed final maturity date.

HSH Nordbank is 85.5% owned by the governments of the City State of Hamburg and the State of Schleswig-Holstein. The two States raised their stake in July 2009 by contributing €3bn of new capital, significantly diluting the other stakeholders, JC Flowers (9.2%) and the local Savings Banks (5.3%). Furthermore, the states also agreed a risk shelter of €10bn (after a €3.2bn first loss piece) which may be used to absorb losses broadly across the loan portfolio going forward.

Analyst: Olek Keenan

Date of Entry: 29 September 2009

The most recent comment on this trade can be found in the below report:

PEPR: EGM options published on 29 September 2009

Analyst: Olek Keenan

Date of Entry: 28-Sep-09


Greene King, Marston’s Mitchells & Butlers: Initiation published on 28 September 09

Analyst: Christian Leukers, CFA

Date of Entry: 12-October-09


HSH Nordbank: Upgrading to Overweight: Ship it in published on 12th October 2009.




mailto:5.6410 2035



17



HSH Nordbank already has a significant amount of grandfathered debt guaranteed by the States of Hamburg and Schleswig Holstein outstanding, which will amount to circa €56bn as YE’09. In addition to these guarantees on existing liabilities, SoFFin has allocated €30bn of funding guarantees to HSH Nordbank of which €17bn has so far been used, including €9bn guaranteed of bond issuance. Additionally, we note that HSH Nordbank is also a participant in the Landesbank cross guarantee scheme, which is also backed by the Savings Banks guarantee scheme.

We believe that the extent of the support shown for HSH Nordbank’s compensates for the concerns around the cyclical shipping portfolio. We note that the EU in October 2009 launched an in depth investigation, expressing doubts on the pricing of this risk shelter, however we not believe this affects our call on the Lower Tier 2 debt.

Figure 12: HSHN LT2: Still a long way from par...

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HSHN € 4.375 LT2 HSHN € Float LT2


Table 1: ...and still cheap relative to peers Issuer ISIN Issue

size (m)

Price Coupon Call Mtrty

HSHN DE000HSH2H15 € 750 69.5 4.375% Feb-12 Feb-17 HSHN DE000HSH2H23 € 1,000 64 3m

Euribor+30 Feb-12 Feb-17

BYLAN XS0285330717 € 750 84.5 4.50% Feb-14 Feb-19 WESTLB DE0008079575 € 300 102 5% Dec-15

Source: J.P. Morgan. Pricing as of 1pm 9th November.

Buy Hypo Real Estate Tier 1 We recommend buying the HYPORE € 5.864% perpetual Tier 1 Trust Preferred at 17 cents. SoFFin has continued to support the restructuring program for Hypo Real Estate, announcing the first of two anticipated tranches of capital for Hypo Real Estate Group on the 4th November. The €3bn tranche, subject to EU approval, is broadly expected to be followed by a further similar-sized tranche in 2010, to support HYPORE’s restructuring, rebranding, and downsizing.

Nevertheless despite the bailout and extensive capital support, Hypo Real Estate’s institutional Tier 1 HYPORE € 5.864 is still trading at circa 17 cents. While we do not expect the coupon to be serviced in the near future, we believe that coupon payments on this security are likely to rank pari passu with those on the €1bn Stille Einlage which SoFFin is contributing to the Deutsche Pfandbriefbank entity as part of its capital injection. We do not believe the Depfa Bank Plc Tier 1 Trust Preferred securities, which are attached to the Irish entity, will rank pari with SoFFin's Stille Einlage. We note that the Trust Preferred securities cannot have their principle value written down, and that HYPORE is currently projecting to return to profitability in 2012. Nevertheless using a 12% discount rate, the securities are currently projecting over 6 years of coupon deferral, which we believe is highly unlikely given a successful restructuring.

Analyst: Christian Leukers, CFA

Date of Entry: 10-November-09

Das Kapital 2.0 : Doubling Down, published 10 November 2009


18



Table 2: Hypo Real Estate Group Tier 1's valuations assuming coupon deferrals at 12% discount rate Valuation given no. of deferrals

Issue Date

Name of instrument Coupon Call ISIN Size Price Status 1 2 3 4 5 6

14-Jun-07 Hypo Real Estate International Trust I

5.864 14-Jun-17 XS0303478118 € 350 17 Deferring 46 41 36 33 29 26

30-Oct-03 Depfa Funding II LP 6.5 30-Oct-10 XS0178243332 € 400 16 Deferring 48 42 37 32 28 25 21-Mar-07 Depfa Funding IV LP 5.029 21-Mar-17 XS0291655727 € 500 15.0 Deferring 42 37 33 30 27 24

Source: J.P. Morgan calculations, Bloomberg

Long RBSG Convertible Preference Shares and UT2 Buy RBSG Convertible Preference shares Mar 10 & Dec 10, Buy RBSG Upper Tier II securities We see opportunities in RBS given the recent price action on RBS subordinated debt where investors may have decided to take profits over the uncertainty of coupon deferral. As we mention in our previous note “Simply Subordinated” (04.11.2009) we view certain instruments in the RBS capital structure as so called "must pay" instruments given sufficient distributable profits and capital. Given the injection of £25.5bn in B shares to the holding company of RBS, RBSG plc, we believe that the group will have sufficient distributable profits and capital going forward. We believe that capital is required at the operating company level of RBS plc; therefore in order for RBS plc to have access to this capital, the proceeds from the B shares must enter a distributable account of RBSG plc. Payments on the “must pay” preference shares mentioned in our note “push” payments of the Upper Tier II securities, thus effectively making the Upper Tier II "must pay" securities.

We view the call date on the convertible preference shares to be an effective call due to the ability of the holders to opt for conversion in to common stock. We note that currently the nominal share price is at 25p as mentioned in our previous notes, however, we think that it is possible for RBS to request for a reduction in the nominal value of the shares to 10p, with 15p being converted into deferred shares to ensure that the reduction in the nominal value of the ordinary share does not result in a reduction in the capital of the company. If this occurs at the EGM then it would be positive for the convertible bonds.

Figure 14: The more liquid preferred bonds Issue Name ISIN Call Date Ccy Cpn Amt Mkt Price YTP YTC Mar 00 RBSG Convertible $ Preference Shares US780097AE13 Mar 10 USD 9.118 1000 94.5 9.7 24.7 Dec 00 RBSG Convertible £ Preference Shares XS0121856859 Dec 10 GBP 7.387 200 84 8.8 25.3 Aug 93 RBSG Upper Tier 2 XS0045071932 Aug 18 GBP 9.5 145 84 9.7 12.5 Oct 99 NatWest Upper Tier 2 XS0102493508 Jan 10 GBP 7.625 162 74 10 n/a Source: Company press release 20.10.2009, prices as of 12:00pm 09.11.2009

Analyst: Alan Bowe

Date of Entry: 4-November-09

Further information can be found in Simply Subordinated, published 4 November 2009

Figure 13: RBS 9.5 & NatWest 7.625 Price performance history

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RBS GBP 9.500 12-Aug-18

NatWest GBP 7.625 29-Jan-10



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Long risk Brewers Basket Trade Sell Protection on AB-Inbev, Carlsberg, Heineken 5y CDS, Buy protection on the iTraxx Non-Financial index. These are three of largest brewers globally. Robust pricing dynamics, to a large extent reflecting higher commodity prices, ensured continued top-line growth albeit at lower levels. Following industry-wide consolidation last year, managements are focused on preserving cash through cost controls, capex cuts and working capital efficiency with clear targets for deleveraging through internal cash generation and/or disposals. The trade stands to benefit from the outperformance of these brewers as compared to the Non-Financials.

Figure 15: Historical Performance of Non-Financials vs. Carlsberg and Heineken

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Carlsberg Heineken AB Inbev


Long-Short Consumer vs. Non-Food Retail Basket Trade Short Risk on M&S, Metro and Kingfisher. Long Risk on Imperial Tobacco, Pernod-Ricard, Heineken and AB Inbev. Since the beginning of the year, Non-Food Retail has outperformed Consumer names largely due to investors being squeezed out of popular shorts. We believe that the government stimulus has improved the overall sentiment leading to the tightening. We are bullish on Tobacco/Spirits & Brewers names reflecting deleveraging stories, strong business profiles and cash flow generation, and stable/improving credit profiles/ratings; yet we remain bearish on the UK non-food retail sector following complete lack of any news of improvement in earnings/demand.

We target 50bp of relative outperformance of the long versus short basket.

Figure 16: Long versus Short Histroical Performance

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Short Basket Long Basket iTrax x HiVol


Analyst: Katie Ruci and Raman Singla

Date of Entry: 14-July-09


European Brewers: Sector Review and Relative Value published on 14th July 2009.

Analyst: Saul Doctor, Katie Ruci

Date of Entry: 20-May-09


CD Player: Market Themes and Relative Value Trade Ideas in the European Credit Derivatives Market published on 21st May 2009.

https://mm.jpmorgan.com/servlet/PubServlet?skey=R1BTLTMwNTM3My0wLDEsTUtUQ19NT1JF&Name=GPS-305373-0.pdf

https://mm.jpmorgan.com/servlet/PubServlet?skey=R1BTLTMwNTM3My0wLDEsTUtUQ19NT1JF&Name=GPS-305373-0.pdf

https://mm.jpmorgan.com/servlet/PubServlet?skey=R1BTLTI5NDQwMi0wLDEwLEZMR1NfTU9SRQA=&Name=GPS-294402-0.pdf




20



Long risk KPN versus Short TI Switch out of TI 4.75% €2014 bonds into KPN 6.25% €2014 bonds Pick up 6bp (ASW) switching into KPN from TI. As TI announced the sale of its German broadband operations to Telefonica last week, credit spreads rallied on the back of the widely anticipated announcement. However, we believe the low-hanging fruit has been plucked, and TI will begin the process of organically de-levering from 2.9x (reported financial debt). KPN reported relatively strong Q309 earnings, and affirmed FY09 guidance. The company reported LTM leverage of 2.3x. We note that KPN 5yr CDS at 59bp (mid) trades 71bp inside of TI at 130bp (mid).

Figure 17: Long KPN vs. Short TI

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KPN EUR 6.25% Feb-2014 (ASW) TITIM EUR 4.75% May -2014 (ASW) Source: J.P. Morgan

Long Risk ITV; Short Risk Bertelsmann Sell protection on ITV 5y; buy protection on Bertelsmann 5y Based on recent commentary from ITV, ProSieben, TVN, MTG and CETV, evidence that European TV advertising markets bottomed in Q209 is increasing. In our view, a long ITV risk versus short Bertelsmann (RTL) risk makes sense as a way to play a recovery theme. We have become increasingly constructive on ITV following the successful refinancing of its near term maturities, significant cost savings, steps to address the pension deficit and an improving UK TV advertising market. We note that Bertelsmann has also taken significant costs out of its business, however RTL has lost audience share to ITV in the UK and we note German 2008 comps will be difficult as ProSieben has gained the share of ad spend it lost in 2008 at the expense of RTL. We also note the persistent headline risk around Bertelsmann making an offer for ITV (Daily Mail, 10 October). If an offer does eventually materialise, we would expect a convergence of ITV and Bertelsmann spreads.

Figure 18: Long ITV vs. Short BERTEL bp

401192

0200400600800

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02/01/09 02/04/09 02/07/09 02/10/09

ITV 5y r CDS BERTEL 5y r CDS Source: J.P. Morgan.

Analyst: Andrew Webb

Date of Entry: 23-June-09


European High Grade Telecoms Update : published on 13th October 2009.

Analyst: Andrew Webb

Date of Entry: 14-July-09

For further commentary on our improving view on ITV:

European High Yield Update: published on 16th October 2009.





21



Tranches and Options Trades Long Cash CLO AAA/first-priority tranches Buy European Cashflow CLO AAA/first-priority tranches. We upgraded to Overweight the generic AAA CLO market on May 8, 2009, when spreads were 800bp. Our early spread target was 300bp, which has now been achieved in the US and is close in Europe (400bp currently). CLO pricing has dramatically improved as default risk eases, demand meets limited supply, and most recently, as Moody’s ratings review of the sector concludes (in the US, 65% downgraded, most only 1-2 notches to Aa, 35% retained Aaa rating).

We position ourselves for further recovery as CLO spreads normalise and as investors seek alpha in lagging sectors. On November 2, 2009, we lowered our AAA target to 150bp, viewing this as achievable over the course of 2010. Unlike many broader markets, it’s challenging to have specific bond picks given the previous “buy and hold” nature of the market and more limited supply, but for new investors we would advocate first-priority bonds with at least 25-30% remaining default-adjusted par subordination and are managed by repeat managers (3-5 CLOs outstanding, or more). Given the potentially lower liquidity versus broader fixed income markets, a six to 12 month time frame, at a minimum, is realistically needed.

Short Correlation Tranche Trade: Sell 10y super senior iTraxx Series 12 protection, delta hedged Systemic concerns are still priced at very high levels in the tranche market, even though liquidity conditions have mostly normalised in credit markets. Tranche correlations look very high in an economic environment where governments and central banks have mainly focused on systemic risks (e.g. financials) rather than idiosyncratic risks (e.g. corporates). Correlations have started falling already (Figure 20), but we think they have more room to go as the risk allocated to super senior tranches should increase relative to the risk allocated to equity tranches (Figure 21). We prefer expressing our view via delta hedged long risk super senior tranches due to their lower negative spread convexity. Alternatively, investors can buy delta hedged equity tranche protection.

Figure 20: Equity Tranche Correlations – On-the-Run

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CDX IG iTrax x

Source: J.P. Morgan. 10 days moving average.

Figure 21: Tranche expected loss ratio – iTraxx 5y On-the-Run % allocation of index expected loss across the tranche capital structure.

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Equity Tranche Expected Loss Ratios

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Mezzanine ELR


Analyst: Rishad Ahluwalia

Date of Entry: 08-May-09


JPMorgan Global CDO Market Weekly Snapshot published on 2nd November 2009.

Figure 19: European AAA CLO versus comparable spreads, pre and post crisis (bp)

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Analyst: Abel Elizalde

Date of Entry: 5 Nov-09


Global Tranche Trader and The Dispersion Debate published on 5 November 2009.






22



A Recovery, but Not a Return to Normality The worst recession that Western Europe has experienced since 1950 is now over. The Euro area looks to have expanded at a decent pace in the third quarter. And although the UK continued to contract through to September, we are confident that the economy started to expand again in the fourth quarter. This expansion in economic activity is likely to be sustained for the foreseeable future.

However, an end to the recession does not mark a return to normality. The recovery in demand will be held back by a reduced appetite for debt accumulation by households and nonfinancial corporates, and tighter lending standards imposed by banks. Even though interest rates will be held at an unusually low level for an extended period, there is unlikely to be a powerful credit cycle. An additional headwind will come from the fiscal side; the need for public sector deleveraging will ensure a significant and sustained fiscal tightening which will last for several years. Meanwhile, the supply side of the economy has been severely damaged by the financial crisis and the deep recession. A significant part of the decline in actual GDP over the past year looks likely to be a permanent loss in the level of potential. In addition, the ongoing growth rates of potential GDP are likely to have declined by around half a percentage point relative to what prevailed before the crisis.

This all adds up to our theme, bouncing towards malaise. Although we expect GDP to increase in the coming couple of years by more than the consensus, the upswing will feel very muted relative to the depth of the recession and the magnitude of the policy support. Economies are bouncing, but a sense of malaise will persist for a while.

The recession just ending was a very deep one. From peak to trough, the level of GDP fell by 5.1% in the Euro area and by 5.9% in the UK. Normally after a deep recession, we would expect a strong upswing, as inventory adjustments end and as households and corporates discover that they have cut their spending on durables by too much. The muted cyclical upswing in demand that we anticipate—relative to the depth of the recession and the magnitude of the policy support—reflects the secular headwinds from a more cautious attitude toward debt accumulation, deleveraging in the banking sector, fiscal tightening, and sliding growth potential. These headwinds will influence the growth dynamic in two ways: first, the underlying trend in income growth over the medium term will be lower than in the past; and second, the cyclical dynamic of demand around growth potential is likely to be more muted than usual.

The business cycle upswing typically has two stages. First is a rebound in spending on durables from depressed levels in response to an improvement in permanent income expectations, lower interest rates and an easing of credit availability, and a bounce in output as inventory adjustments end. These changes require some accumulation of debt, reduced debt repayment, or reduced accumulation of financial assets. Second, there is a shift to expansion where households and corporates push spending to new levels by stretching beyond their current incomes in response to developments in confidence, asset prices and financial conditions. This generally involves a solid credit cycle.

European Economic Research

David MackieAC (44-20) 7325-5040 [email protected]

23



In the current environment, both of these stages are likely to be affected by the secular headwinds. On the one hand, there is likely to be a more restrained attitude toward debt accumulation, reflecting a decline in permanent income expectations, reduced expectations of rates of return on assets, and an appreciation of the greater volatility of both incomes and asset prices. On the other hand, even though the environment for banks is improving, bank lending standards are likely to remain on the tight side for an extended period. The financial accelerator mechanism whereby banks are inclined to ease lending standards in response to higher asset prices will be dampened by a renewed appreciation of the volatility of both incomes and asset prices. Also, banks are likely to remain cautious as they are gradually weaned off public support and as they have to respond to a tighter regulatory environment.

Figure 22: Global trade recovering from depressed levels Index, Global PMI export orders

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Even though the upswing in demand is expected to feel very muted relative to the depth of the recession and the magnitude of the policy support, we nevertheless have a growth forecast that is somewhat ahead of the consensus. There are a number of reasons for this. First, we are putting more emphasis on the powerful cyclical dynamics that are at work after a deep recession. For the Euro area, this involves a strong bounce back in global trade from very depressed levels and a recovery in corporate spending after severe cutbacks. Second, we believe that saving rates have moved up by enough to create sufficient free cash flow for households and corporates to delever should they feel the need to. It is also important to recognise that the easy policy stance, low interest rates and the expansion of central bank balance sheets, has eased the pressure to delever in a disruptive way. This is particularly important for the UK and Spain. Third, we would emphasise that it is the flow of new credit that matters for demand, rather than the level of bank lending standards. It is still early days, but access to credit does seem to be improving at the margin. And fourth, we would stress that the lesson from history is that the malaise from a financial banking crisis shows up more often than not in a depressed level of GDP relative to what it would otherwise have been, rather than a depressed growth rate of GDP once the cyclical trough has been reached.

24



Figure 23: Euro area bank lending starting to turn the corner %3m saar

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One critical feature of the outlook is the impact of the banking crisis and recession on both the level of potential GDP and its ongoing growth rate. It is widely recognised that banking crises and deep recessions have lasting implications for the supply side of the economy. Deep recessions cause premature scrapping of the capital stock, an erosion of existing labour skills and the discouragement of new entrants into the labour force. When dysfunction in the financial system is also part of the recession dynamic, potential GDP can be damaged by less efficient redeployment of resources from contracting to expanding sectors, and less availability of finance for productivity-enhancing research and business start-ups. Decomposing the decline in actual GDP that has been experienced over the past year into cyclical and structural components, and calibrating how the growth of potential GDP has changed, are challenging exercises, but they have enormous implications for the outlook for demand, inflation and monetary policy.

Our approach has been to examine the data on the evolution of actual GDP, various direct measures of resource utilization and the behaviour of inflation to form a consistent view of how the output gap has evolved. By definition, the fall in GDP that is not reflected in a wider output gap represents a permanent loss of potential GDP. For the Euro area, we estimate that, by the end of 2011, the permanent loss of output will amount to around 3.4% of GDP. For the UK, the permanent loss looks larger at around 6.3%. This means that the output gap is smaller than it would otherwise have been had all of the decline in GDP over the past year been cyclical.

Table 3: GDP, potential output, and the output gap over the last year Output gap in 2Q08 (%of GDP) GDP since 2Q08 (%) Output gap in 2Q09 (% of GDP) Change in output gap Change in potential Euro area 1.65 -4.78 -2.88 -4.53 -0.22 UK -0.25 -5.65 -3.46 -3.22 -2.35 Sweden 1.10 -6.46 -3.97 -5.07 -1.31 Source: J.P. Morgan

Nevertheless, there is a significant amount of slack in the Euro area and the UK. In the Euro area, we would put the output gap at around 3% of GDP, a little wider than what was seen as a consequence of the recessions of the mid 1970s, the early 1980s and the early 1990s. Meanwhile, in the UK, we estimate the output gap at around 3.5% of GDP. This is wider than what was seen in the mid 1970s and early 1990s recessions, but not as wide as what was seen in the early 1980s recession. In addition to a permanent drop in the level of GDP, our analysis suggests that growth potential has also fallen, by around half a percentage point. The sizeable output gaps point to significant disinflation in the coming twelve to eighteen months, with core inflation rates moving to the edge of deflation. But, the combination of a solid recovery in demand and a slower growth rate of potential suggests that the current output gaps will close relatively quickly.

25



Table 4: Recession damage to the level of potential output by end-2011 %q/q, saar % of GDP Euro area -3.4 UK -6.3 Sweden -4.5 Source: J.P. Morgan

The outlook for demand and supply are significantly different to anything we have seen before. This is also true for monetary and fiscal policy. Fiscal deficits have got to very extreme levels. In the Euro area this year we expect a fiscal deficit of 6% of GDP, while in the UK we expect a deficit of 12% of GDP. Deficits of this level are clearly not sustainable. While some of the deficit is clearly cyclical, and will unwind as the output gap closes, there is a large structural component which can only be eliminated by outright fiscal tightening. We expect this to begin in the UK in 2010, and in the Euro area a year later. Fiscal tightening is likely to be sizeable and to extend over several years, which will act as a headwind on demand growth.

Meanwhile, monetary policy has been driven deep into uncharted waters as a consequence of this crisis. Policy rates are close to zero and central bank balance sheets have expanded dramatically. At some point both of these dimensions of monetary policy will need to be normalised, although the timing is likely still some way off.

The ECB has tried to keep a separation in its mind between conventional monetary policy (aimed at the inflation objective) and unconventional monetary policy (aimed at dysfunctionality in the credit intermediation process). This gives a clear road map for the exit strategy. As financial markets and banks gradually heal, and the flow of credit is restored, the ECB will allow its balance sheet to shrink. This is likely to take place during the course of 2010, although the central bank will err on the side of being too generous in order to guard against exiting prematurely. But, a fading out of the provision of longer term liquidity and a return to variable rate repos will likely take place in 2010. Meanwhile, the inflation outlook is likely to remain benign until at least 2011, so the ECB policy rate is unlikely to rise until then. Having said that, the shrinking of the ECB’s balance sheet will lift the actual overnight rate (which has been trading below the policy target) and will steepen the money market yield curve, both of which could in theory be viewed as traditional monetary policy actions.

In contrast, the Bank of England has viewed quantitative easing as a natural extension of conventional monetary policy, motivated and calibrated by the objective of hitting the inflation target. Although presented somewhat differently, this would suggest an exit strategy similar to the ECB’s: shrinking the balance sheet and then hiking the policy rate. In actual fact, we believe that the Bank of England will move on both dimensions simultaneously, and somewhat earlier than the ECB. We expect the first rate hike to occur in the Autumn of 2010 along with the start of outright gilt sales. The reason why the Bank of England is likely to move on both fronts at the same time is that it will be difficult to sell the gilts it has acquired quickly. When QE ends, the Bank of England will likely own around a third of the conventional gilt market: thus, its holdings will be large relative to the underlying liquidity in the market.

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The Regulator Strikes Back Banking Sector Outlook: 2010 • In our opinion the regulatory capital reform process is likely to be a

transformational event in terms of the impact on the existing hybrid capital market. We think Tier I is the part of the capital structure that is most likely to be impacted by regulatory change given the concerted push for instruments with greater equity-like features, which we think will result in the introduction of hybrid instruments with a higher risk profile for investors.

• Given the move towards greater equity-like features amongst hybrid capital instruments, we look at the emergence of ‘super hybrids’ which within the context of the Commission of European Banking Supervisors is essentially a Tier I instrument with equity conversion features. Our base case is that these instruments have a higher risk profile with options that have a higher probability of being triggered relative to the standard coupon deferral risk and should therefore carry a higher coupon than existing Tier I structures. We look at quantifying the probabilities by analysis of probability distributions of bank solvency indicators for a peer group of large European banks.

• In our opinion the current regulatory process should be seen in the context of governments that no longer want to be forced providers of capital of last resort and therefore want to create mechanisms whereby alternative strategies will avoid the undermining of public sector finances. In the first instance this is achieved by tightening sector regulation, however the introduction of convertible hybrid instruments would ensure that there is another capital provider of last resort. Further, governments may create frameworks that will allow distressed institutions to fail with minimal collateral damage. It is in this context that we see the implementation of the 2009 Banking Act in the UK, along with ‘Living Wills’ initiatives. While better regulation should reduce the probability of distress we think that with these structural changes, the expected loss given distress will increase for bondholders.

Table 5: Recommendations Type Recommendation Rationale Senior Neutral High volumes of expected issuance together with modest absolute yield levels. Lower Tier II Overweight Preferred part of the capital structure. Limited issuance and issuer flexibility make it attractive. Upper Tier II Neutral Outlook for limited issuance as part of Tier II capital. Cumulative element supports valuations. Tier I Issued in 2009 Overweight High back-end spread makes these instruments attractive and increases certainty of call. Tier I with call in 2010-2011 Neutral Limited incentives to call, however issuance under existing regulatory capital regime should allow for

refinancing of this debt during the transition period to the new regulatory capital framework. Tier I with call post 2011 Underweight Low back-end spread, which reduces economic incentives and the greater cost of issuance of hybrid capital

under the new regulatory capital regime. Source: J.P. Morgan.

European Financials Research

Roberto Henriques, CFAAC


Christian Leukers, CFA (44-20) 7325-0949 [email protected]

Alan Bowe (44-20) 7325-6281 [email protected]

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Bank Capital: How Are We Going to Be left? In our opinion the evolution of the regulatory capital framework will be a transformational event for the sector in 2010. We expect to see the culmination of the various initiatives in terms of the redefinition of hybrid capital, with the most relevant and immediate of these being the implementation of the Capital Requirements Directive undertaken within the context of the Commission of European Banking Supervisors (CEBS). While there are a wide range of forums spanning the G20 and Basel Committee for Banking Supervision, we note that there appears to be a very consensual approach with regard to the process of regulatory capital reform. To this extent we highlight the consensus surrounding higher minimum capital requirements as well as higher quality constituents of capital, with greater emphasis on hybrid instruments that have greater equity-like features.

We think it is important to understand the context of the current regulatory reform process and the guiding principles that will be applied in terms of defining the future structure of regulatory capital. We think one of the key factors for this reform process is the growing awareness of the relative failure of existing hybrid capital instruments to provide issuers with the required degree of financial flexibility in situations of distress. To this extent we note a certain disappointment with the current generation of hybrid capital instruments given that they failed to provide issuers with flexibility when most required, for reasons including the moral suasion of investors, ineffective language in bond documents and the limited degree of loss absorption provided. We note that most of the existing hybrids only provide loss absorption effectively in the case of insolvency, which would have been an extremely unappealing outcome for the sector. Hence, we expect that the current regulatory reform process will address the perceived ‘lack of bite’ of the current generation of hybrid capital instruments.

Figure 24: Bank Capital - Expected Structural Changes Senior debt Funding, not capital Senior debt

Junior subordinated debt(Undated with cumulative coupons)

Non-innovative Tier I

Ordinary shares & retainedearnings

Subordinated debt(Qualifying dated with onerous language)

Innovative Tier ITier I(At least 50% of total capital)

(Up to 15% of Tier I capital)

(At least 50% of Tier I)

Dated ‘Super Hybrids’

Subordinated debt(Dated, often with a call)

Lower Tier II(Max 50% of Tier I)

Subordinated debt(Short Dated)

Tier III(Trading book only)

Upper Tier II(Max 100% of Tier I)

Innovative Tier 1



Dated Subordinated Debt

Loss

Abs

orbi

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Undated ‘Super Hybrids’

Senior debt Funding, not capital Senior debt

Junior subordinated debt(Undated with cumulative coupons)

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Subordinated debt(Qualifying dated with onerous language)

Innovative Tier ITier I(At least 50% of total capital)

(Up to 15% of Tier I capital)


Dated ‘Super Hybrids’

Subordinated debt(Dated, often with a call)

Lower Tier II(Max 50% of Tier I)

Subordinated debt(Short Dated)

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Dated Subordinated Debt

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Changes to the regulatory capital framework will likely be a transformational event for the sector in 2010

We note a growing awareness of the failure of existing hybrid capital instruments in providing issuers with the required degree of financial flexibility in distress

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We think that there will be an emphasis on not only upgrading the current generation of bank capital instruments with more equity-like features, but also looking to increase the absolute level of capital that banks will have to hold. In addition, we think there will be pressure to allow more sources of ‘equity capital of last resort’ and effectively substituting the role that governments have played over the last 12-18 months. Given the complete failure of private markets to provide capital to the banking sector at critical points, governments were obliged to intervene and recapitalise the sector with often very negative consequences for public finances. We therefore think the potential evolution of hybrid instruments with equity conversion is a step in this direction by creating a mechanism that will effectively allow a bank to raise higher quality capital in distress situations. It is in this context that we see the evolution of what is currently defined as ‘super hybrids’ within the context of the CEBS proposals.

As a result of these guiding principles, we think there will be several key outcomes within the context of a simplification of the regulatory capital structure, namely;

• Collapsing of the intermediate tranches of the existing regulatory capital structure that are deemed to offer very limited strength and flexibility to an issuer’s solvency levels. Amongst these we would highlight Tier II capital, with particular reference to dated subordinated instruments.

• Creation of a new class of bank capital that has equity conversion features, such as ‘super hybrids’ within the context of the CEBS proposals. Given the potential for these instruments to convert into the most deeply subordinated part of the regulatory capital structure, we think that it is secondary where these instruments will be initially placed within the capital structure at issuance.

• Introduction of explicit loss-absorption features for hybrid Tier I instruments.

Table 6: CEBS Proposals for Hybrid Capital Reform Guidelines Comment Permanence • Instruments with incentives to redeem (moderate step-up, principal stock settlement) are innovative and limited to 15% limit.

• No reclassification of innovative into non-innovative if not called. • Supervisory approval to take account of capital, liquidity risks and business plan to ensure positive business development. • Buy-backs, in general, subject to redemption requirements and not before 5 years unless replaced.

Flexibility of payments • Payment of coupons or dividends on hybrids can only be taken out of distributable items. • Supervisors may require cancellation of coupons taking into account distributable items, solvency, risks, business plan to ensure

positive business development. • Dividend pushers and stoppers acceptable provided issuer has significant flexibility to cancel payments. Dividend pushers must be

waived if in breach of capital adequacy or supervisor requires cancellation due to financial and solvency situation. • ACSM only if issuer has full discretion to defer and must be settled without delay using core capital instruments.

Loss Absorbency • Statutory or contractual provisions to make recapitalisation more likely by reducing future outflows to hybrid holders by potentially making a permanent or temporary write-down to principal, conversion into core capital when operational losses lead to significant reduction of reserves impacting solvency position.

• Loss absorbency should be considered with other measures such as a rights issue. Limits • Super hybrids (35-50%) must be convertible into core capital either in an emergency situation or at any time by the supervisor or by

the issuer. • Mandatory conversion may be accepted. • Emergency situation such as when significant losses result in capital adequacy breach. • Conversion ratio must be set at issue (as a maximum) and may be reduced if share price increases, but cannot be increased if

share price decreases.

Source: J.P. Morgan, EC

The evolution of new classes of hybrid capital may be driven by the fact that governments do not want to be ‘on the hook’ in a time of distress

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‘Super Hybrid’ Capital We think that the proposal to create ‘super hybrids’ is entirely consistent with the philosophy behind the reform of the existing regulatory capital framework, with a clear trend towards instruments that contain greater equity-like and loss-absorbing features. Under this approach, the introduction of options to convert hybrid capital instruments into equity would be a logical development. In addition, the issuance of these instruments would also meet the objective of creating anti-cyclical capital buffers which could be deployed when most required by the institution. Within the framework that is being discussed by CEBS, ‘super hybrids’ are essentially Tier I instruments with the conversion feature triggered by reference to a solvency metric. In our opinion these instruments raise a wide range of considerations with regard to the existing framework of hybrid capital instruments, which will have material consequences for both issuers and investors.

The Role of Traditional Hybrid Instruments Undermined In our opinion the potential emergence of super hybrids as an asset class may potentially undermine the role of traditional hybrid capital instruments in the regulatory capital framework. This is a result of the fact that the option to convert the Tier I instrument into equity capital effectively makes the remaining optionality in the Tier I instrument redundant. To this extent we highlight that many of the options that are otherwise built into Tier I such as coupon deferral and extension were devised to replicate the features of equity such as flexibility of dividend payments and the fact that equity is undated. Consequently it would appear to us that the inclusion of such optionality into an instrument that in any case can convert into equity, would seem to be complete over-engineering. Why replicate equity characteristics when you can ultimately convert to equity if required?

Further, we think that the equity conversion options are likely to be struck at a level that would imply that they would trigger ahead of any of the remaining options with the hybrid capital structure. If, hypothetically, a ‘super hybrid’ had to be struck with a 5% core Tier I trigger level, this would effectively represent a higher solvency level than the traditional coupon deferral options which generally refer to Tier I ratios of 4%. Effectively striking a conversion option with a core Tier I of 5% will likely imply the issuer has a corresponding Tier I ratio of 6-7%, depending on the amount of non-core components of Tier I capital the issuer would have outstanding. As a result, we would likely have a situation where the ‘super hybrid’ would convert while the institution would have a Tier I ratio of 6-7%, whereas the traditional hybrid Tier I would only trigger coupon deferral if the Tier I ratio below the minimum 4% threshold. Essentially we see the introduction of conversion features into deeply subordinated instruments as an overlay which will effectively ‘knock-out’ the remaining options within these instruments. It is therefore our assumption that the super hybrids should therefore carry a higher risk premium than existing Tier I structures.

The trend towards greater equity-like features in hybrid capital should lead to the emergence of 'super hybrids' as a new asset class

The equity conversion option in super hybrids makes traditional, legacy hybrid Tier I's redundant

An overlay of equity conversion features on a traditional Tier I platform would imply that this option would effectively ‘knock-out’ much of the underlying options by triggering earlier

30



In Figure 25 we contrast the greater probability of a conversion trigger based on a core Tier I ratio versus a traditional coupon deferral trigger which will reference a minimum Tier I capital ratio. The probability of the different options being triggered will be measured by the greater surface area under the respective curves. Given that the overlay of the conversion option would effectively render redundant most of the remaining options within the existing hybrid capital structure, we think that regulators could potentially be agnostic as to the platform on which the conversion features are placed. Note that in this analysis we have ignored the optional deferral outcomes for coupon deferral given the resistance that issuers have shown to using these mechanisms during the current crisis, with external pressures from the European Commission ultimately forcing deferral outcomes.

Figure 25: Option Triggers: Conversion Strike versus Coupon Deferral Strike %

0

0.02

0.04

0.06

0.08

0.1

0.12

Cumulativ e Probability Core Tier 1 Tier 1

Cumulative probability of hitting Core Tier I trigger is greater than the current minimum capital requirements

Current 4% Tier I minimum requirement

Core Tier I Trigger

5%4%


Loss Absorption: In More Ways Than One One of the features that regulators would ideally like to build into the construct of the new hybrid capital regime would be the ability to absorb losses, an area where empirical evidence has shown the current generation of hybrids to provide limited value to issuers. We note that ‘super hybrids’ would be in a position to provide greater scope for loss absorption, not only in the context of being converted into equity but also given the stock price at which they are likely to be converted. On the latter point, we think that a conversion price that is struck at issuance will imply an immediate loss absorption feature for super hybrid note-holder.

Our view of immediate loss absorption upon conversion is based on our expectation that there will be a high degree of correlation between the trigger solvency metric and the institution's stock price. We would expect that the course of events that would lead to the solvency position being eroded such as large scale losses would also result in severe pressure on the stock price as the institution's status as a going concern would be questioned. As a result and on the assumption that the strike for conversion would have been set at issuance, it is likely that there would be significant loss for the super hybrid holder upon conversion given that the prevailing market price would be materially lower.

We think that potentially regulators could be agnostic as to the capital platform on which super hybrids are issued

Loss absorption is provided in first instance by the conversion into an asset class that can absorb losses

Loss absorption would also work given the mechanics of the strike on the equity conversion

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Figure 26: Immediate Loss Absorption for Super Hybrid Note Holders Upon Conversion %

0

20

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60

80

100

120

140

1 2 3 4 5 60

1

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9Stock Price Core Tier I ratio

% %

Loss for note holder = Strike level - Market level at conversion


In our opinion, the key risk driver is the conversion price, which is likely to cause tension between the interests of shareholders and bondholders. The most favorable outcome for shareholders is to have the conversion price defined at issuance, whereas bondholders would prefer to have the price determined at the time of actual conversion. Given that all issuers will necessarily state that they will manage their solvency ratios in order to avoid conversion and that this will remain a very low probability outcome, we would challenge issuers to allow these instruments to convert at the prevailing market price. Surely, if such an event remains beyond the realm of possibilities then issuers could endeavor to make the product more attractive to potential investors. We note that this would be an optimal outcome for bondholders given that if conversion had to occur at the distressed price level then potentially the bondholder could merely sell the delivered equity at the prevailing market price and recover his initial bond par value.

Conversely, shareholders would benefit from conversion options struck at issuance given that the issuer would be able to raise equity in a less dilutive manner than doing a rights issue at distressed levels. Under this scenario the issuer would be able to raise capital equal to the sum of the notional value of the super hybrids by effectively issuing a smaller volume of shares (Notional / Initial Stock Strike) than they would be otherwise able to do in the market (Notional / Current Stock Price), and this on the assumption that the current stock price on conversion will be much lower than the conversion strike price. This would imply a change in the existing order of play where effectively hybrid debt investors have been relatively insulated from financial distress by other providers of capital at a more subordinated level, either through rights issues or government-sponsored capital injections. The emergence of ‘super hybrids’ as an asset class would in our opinion subvert the normal course of action, which has seen subordinated investors generally being better off than shareholders during the resolution of distressed situations in the financials sector.

Issuers – put your money where the conversion price is!

Super hybrids would also change the existing relationship between subordinated debt investors and shareholders

32



Changes in Stakeholder Behavior As we have noted above, the existence of ‘super hybrids’ in the capital structure will tend to change the relationship between subordinated debt investors and shareholders, with cash calls less likely to have a positive response before the ‘super hybrids’ are effectively converted. We also think that there could be impacts on a wider range of stakeholders amongst which we would include governments. Over the last 18 months we have witnessed an unprecedented degree of state intervention in the global banking sector, with governments effectively becoming the provider of capital of last resort. In a scenario where ‘super hybrids’ had to form part of the capital structure, we think that governments would have less incentive to intervene and would in all likelihood let the conversion mechanism work before considering a bailout. Hence we think that there is a lower likelihood of government intervention in the first instance given that convertible hybrid instruments will almost replace state intervention as the provider of last resort. To a certain extent this mechanism can almost be seen within the context of a debt for equity swap commonly seen amongst corporate sector restructurings. However, as we have seen previously the conversion price mechanism is likely to make such outcomes more favorable to shareholders. Governments would also achieve one of their objectives of avoiding the punitive cost of bailouts on public finances. We also note other legal mechanisms and frameworks that may be implemented in order to allow governments to avoid costly banking sector bailouts. In the section Senior Debt – Neutral we look at the impact of these alternatives on the risk profile of the sector.

Corporate Actions While investors may take comfort from the fact that there will be a relatively simple and transparent mechanism for conversion, we would look at the possibility of the trigger metric being subject to variation as a result of corporate actions that the issuer may undertake. While it may appear that the issuers would have no discretion in terms of triggering the actual conversion, we think that is less true given that an issuer’s strategy with regard to capital management will ultimately decide conversion outcomes. We think that while management may provide guidance as to the possibility of maintaining the solvency metric comfortably above the trigger level, this may change as the result of longer term growth strategy, which would include potential M&A activity.

For instance, in the event of an issuer making an acquisition which would be entirely cash funded for an asset or business with a significant premium above book value, this would likely result in a material weakness in both the core Tier I and Tier I solvency ratios. This would be the result of goodwill which would be generated by the acquisition, with the cash funding not generating any compensating capital. The triggering of the conversion option would then imply that capital in the form of the ‘super hybrid’ would then be made available to the issuer. We think that under these circumstances ‘super hybrids’ represent a cheap option on a rights issue for the issuing bank. Furthermore, we also highlight that the solvency metric will also be impacted by the development of risk weighted assets, and that an aggressive downward migration of the asset base would result in downward pressure on the solvency metric and increasing the probability of conversion.

Super hybrids provide an alternative ahead of the last resort: Government capital injections

Issuer discretion in conversion may be a risk for ‘super hybrid’ noteholders

Any cash funded acquisition which would pay a significant premium over book value would be sufficient to trigger a conversion option

33



Gap Risk Having optionality that is tied to a solvency metric brings with it a wealth of issues for the investor base. Firstly, the solvency metric will tend to be a discrete, and for the most part, unobservable variable that the issuer will only make public in line with their standard reporting requirements. As such, this opens up these options to a significant degree of gap risk which will leave the note holder unable to hedge the associated market risk. Hence, we expect that the infrequency of data points may make the management of the risk profile of these instruments more complex. However, we acknowledge that as with most idiosyncratic credit blow-ups, there is rarely a gradual deterioration in solvency metrics and more often than not, a low probability high severity event may result in the triggering of the option before any remedial action can be taken. We also note that the element of gap risk in the triggering will imply that there are likely to be points of discontinuity in the pricing of the ‘super hybrids’, as their valuation should react fairly rapidly as the probabilities of conversion increase exponentially. Exiting or hedging positions in such instruments may be problematic.

Conversion Option Valuation Given our view that the conversion option embedded within ‘super hybrids’ will effectively override the remaining optionality within traditional Tier I instruments, we assume that the risk premia for these instruments should be higher than that of traditional Tier I instruments and will tend to approximate that of equity. While we note that the conversion option may be effectively embedded in any part of the Tier II or Tier I part of the capital structure, we think that this will not change our assessment of the risk profile of these instruments and we would still look to risk premia higher than that of existing Tier I instruments. The complexity of valuing ‘super hybrids’ relates to the difficulty in assessing the probability of the option being triggered, given that the trigger metric is a discreet and non-observable variable. We also note that the pricing of the ‘super hybrid’ is likely to be driven by a range of variables that also happen to be correlated amongst each other, namely:

Solvency Ratio: The value of the conversion option will be determined by the strike and the relative degree of volatility of the solvency metric. In terms of trying to gauge the probability of the trigger level being hit we would assume a normal distribution for this variable using available time-series sector data.

Stock Price: While variations in the stock price will not have an impact on the probability of the option being triggered, we highlight that it will impact the expected loss given conversion for the note holder. This is a result of the conversion price being fixed at the time of issuance, and any movement away from this level will impact the value of the stock which will be delivered to the note holder upon conversion.

Ratings: Given our assumption that ‘super hybrids’ have a higher risk profile than traditional Tier I instruments, we expect that these instruments will invariably have a lower rating than existing Tier I instruments. This could potentially place ‘super hybrids’ closer to non investment grade, even from higher quality European issuers. We would also raise the possibility that ratings agencies may have better visibility on the solvency ratios of banks, and as such may change ratings in light of any variations to the probability of conversion. Hence ratings will in our opinion have a higher degree of volatility than standard Tier I instruments.

Conversion risk is difficult to manage given that the trigger metric will be a discrete and rarely observable metric

We think that independently of the choice of host instrument for the conversion option, the risk premia should be higher than that of existing Tier I instruments

34



So What Is the Probability of a Low Probability Outcome? Given our base case assumption that a ‘super hybrid’, independently of being overlaid on a dated or perpetual format, will have a higher risk profile than a traditional Tier I instrument, we still need to ascribe a probability to this outcome occurring. To this extent we have take a time-series data sample of the Tier I ratios for a universe of ten large European banks since 1999. Performing an analysis on how their Tier I ratios evolved through time allows us to approximate the probability distribution to a normal distribution. While we have statistically tested for this assumption of a normal distribution, we intuitively think that a normal distribution is a realistic assumption. Banks will generally have a target capital ratio which will become the mean and the mode of the distribution and subsequently through time deviations from this ratio will occur due to the dynamic process of internal capital generation, dividend distributions or losses. Given that variations from the mean occur we would expect banks, either through rights issues or share buy-backs, to correct these deviations from their target capital ratio. Having generated a representative normal distribution based on the data sample, we can then determine the cumulative probability of the bank hitting specific pre-determined ratios.

Figure 27: Tier I Probability Distribution – Cumulative Probability of Tier I < 4% %

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Figure 28: Tier I Probability Distribution – Cumulative Probability of Tier I < 6% %

10.03%

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Using the probability distribution that we derived from our sample data, we note that the cumulative probability of a bank having a Tier I ratio below 4% is 1.25%. While this is a relatively low probability outcome, we note that within the context of the current regulatory capital reform, the optionality within ‘super hybrid’ capital is not only likely to be struck at a higher absolute ratio but is also likely to reference core Tier I ratios. If, for example, the conversion option would be struck at a core Tier I ratio of 5%, this would imply that for a bank with a 100bp of non-core Tier I the equity conversion would effectively happen with the bank having a Tier I ratio of 6%. Given our assumptions of the probability distribution for Tier I ratios, the cumulative probabilities of a bank having a Tier I ratio below 6% are 10.05% based on our data sample. Clearly, by shifting the trigger levels higher the probabilities have increased more than proportionally. We think that this empirical evidence supports our initial view that the conversion optionality overlaid on any part of the capital structure will tend to knock out any of the existing options and become the single most relevant driver in terms of valuing the instrument.

Assuming a normal distribution for bank solvency variables, we can derive cumulative probabilities of trigger ratio being breached

Given our assumptions of the probability distribution for Tier I ratios, the cumulative probabilities of a bank having a Tier I ratio below 6% are 10.05%

35



We would however highlight that there may be weaknesses with this approach, which uses historical data referent to a prior regulatory capital regime where issuers were allowed to have lower absolute levels of capital. The current proposals with regard to regulatory reform will in our opinion imply a material shift in terms of the minimum regulatory levels, which will have the effect of shifting our probability distribution to the right, with a higher mean in terms of solvency ratios. However, our view remains that the introduction of conversion features will tend to increase the risk profile of hybrid capital instruments.

How ‘Super’ Are ‘Super Hybrids’? Notwithstanding the issues that we have raised with regard to the asset class, we think that this is a potentially viable alternative for banks meeting enhanced capital requirements. We also think that ‘super hybrids’ would meet many of the objectives that regulators have with the current process of regulatory capital reform. We highlight the key considerations on the asset class from a wide range of stakeholders.

Regulators Given the relatively lower degree of success of existing hybrid instruments in providing issuer flexibility in distress situations, we think that ‘super hybrids’ will provide a higher quality alternative in terms of loss-absorbing capital that can be deployed when required. Additionally, the relative degree of transparency will imply clearer outcomes in potential distress situations with the immediate conversion of all existing instruments. This would avoid some of the unexpected outcomes where coupon deferral language has been rendered less effective by the existence of parity pusher language and other mechanisms that undermine coupon deferral outcomes. We think that these asymmetric outcomes would have irked both the regulator and the European Commission over the course of the last year. The relatively simplicity of the conversion mechanism would avoid these situations and would give greater certainty of outcomes.

Issuers/Shareholders Given the higher capital requirements that the regulatory reform process will be pushing towards, we think that the possibility of raising non-dilutive, high-quality regulatory capital will be an important incentive for issuers. We think that ‘super hybrids’ may provide issuer flexibility in coping with the negative impact on shareholder return metrics of higher capital requirements. In order to demonstrate this negative impact we have a taken a sample of four major European banks and re-calculated historic RoE on the assumption that higher capital requirements would have been in place. Given that minimum solvency metrics are likely to migrate towards the 8-10% range we have estimated the resulting RoE that would have been achieved by a peer group based on historic earnings. The implications are fairly material from a shareholder perspective and would suggest that ‘super hybrids’ would be a viable way of issuers supporting their equity performance metrics. While this simplistic analysis ignores the fact that business decisions and asset allocation would have been vastly different under more stringent capital requirements, it nonetheless does give some color as to how higher regulatory capital requirements could affect issuers and shareholders.

Regulatory capital reform will imply a material shift in terms of the minimum regulatory levels, which will have the effect of shifting our normal probability distribution to the right

Regulators will prefer the flexibility and transparency of ‘super hybrids’ relative to previous generations of hybrids

Super hybrids allow issuers to raise high-quality, non-dilutive capital as well as minimizing the impact of dilution in a situation of distress

36



Figure 29: The Impact of Higher Capital Requirements on RoE %

22%26% 25% 25%

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RoE (as reported) RoE (with 8% Core Tier 1) RoE (with 10% Core Tier 1)BBVA Barclays BNP Unicredit

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2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

RoE (as reported) RoE (with 8% Core Tier 1) RoE (with 10% Core Tier 1)BBVA Barclays BNP Unicredit


In terms of the relative advantages for shareholders, we also note that by striking the conversion option upon issuance, effectively the issuer is minimizing the potential dilution impact of capital raising in distress situations. Effectively the issuer is locking in the cost of a rights issue on very favorable terms. While it may be a secondary consideration for the issuers, we note that the existence of a clear trigger would remove some of the pressure that issuers would sometimes be subject to with regard to optionality where they have a degree of discretion. Witness the pressure that some banks have felt in terms of servicing or calling subordinated debt, which in most instances has only been superseded by pressure from the European Commission.

Bondholders As we have noted with the regard to the structure and pricing of the risk of ‘super hybrids’, these instruments may present issues for the traditional hybrid capital investor base. Essentially the degree of proximity to equity may limit the range of potential investors. In the first instance we think that this product is more likely to appeal to a retail or equity investor base. For retail investors, we think that the appeal of a large coupon will be decisive factor, with these investors unlikely to try to assimilate the inherent risks of the asset class. We also think that equity investors may find the product interesting for particular names where the equity story may be less compelling and may therefore prefer to lock in a yield that may be above the expected dividend yield. We also think that amongst credit investors, it is more likely that unconstrained investors invest in this asset class.

While the above-mentioned investors may represent a reasonable proxy for the potential investor base, we think that these constituents are unlikely to provide sufficient depth and breadth to allow it to develop into a stand-alone asset class. The key towards achieving this would be to make the product investible for traditional, institutional investor base, which may imply that the features of the product need to be tweaked in response to the constraints that these investors face. We think that it is also worth remembering that when the current generation of hybrid Tier I instruments first developed in 2000, it was also seen as a relatively exotic, off-benchmark instrument before becoming a major asset class in its own right. The reasons why Tier I flourished was that it generated a higher return for options that were deemed to be clearly out of the money. We would not bet against history repeating itself!

Issuers can lock in the cost of distressed capital raising on very favorable terms

The main issue for credit investors will be that of investibility

We think that the involvement of institutional investors will be key for the market

37



Non-Convertible Loss Absorbing Tier I Given some of the issues that may be raised in terms of finding an appropriate investor base for hybrid capital instruments with conversion features, we would look to alternatives such as the introduction of loss-absorbing features into the existing hybrid Tier I framework as a more broadly investible product. Essentially, such loss absorbing Tier I instruments would be similar to German deeply subordinated hybrid capital which in addition to coupon deferral, also allows for the write-down of the notional value of the bond in line with income statement losses for the full year. Hence, upon the realization of a full year loss for the bank, this ‘loss amount’ is apportioned on a pari-passu basis between equity and eligible hybrid capital instruments. In subsequent years when the institution returns to profitability, subsequent positive results are allocated to writing the notional value of the instruments back up to par ahead of paying dividends.

We note that amongst the current generation of hybrid capital instruments, it is only really the loss-absorbing Tier I instruments issued by German banks that have functioned to provide issuer flexibility. Importantly, these instruments seem to have adhered to the principle of ‘loss sharing’ being championed by the European Commission in its intervention amongst institutions that have benefited from bail-outs. While we think the structure of the German Tier I offers is more effective, we highlight some of the flexibility open to the German banks in terms of allocating reserves to the income statement so as to avoid principal impairment of these instruments. We expect that with the German Tier I serving as a potential template for the loss-absorbing Tier I structures, such reallocations of resources should necessarily be curtailed in order to give greater effectiveness to this mechanism.

As a result, we think that loss-absorbing Tier I offers a more broadly acceptable alternative for an investor base given that there is potentially no requirement for a conversion feature. Essentially, the write-down of notional allows the instrument to behave like equity, without fundamentally changing its substance as a fixed income instrument. Crucially for investors, they can recoup par on the instrument in subsequent years when the issuer is profitable, assuming that default does not occur. From a regulatory perspective, the transparency of an instrument which reacts to income statement losses would be preferable to existing instruments which arguably need more extreme outcomes to trigger such as a regulatory capital event. Additionally income statement metrics serve as an objective trigger and would remove pressure on the issuer to avoid negative outcomes for bondholders. To this extent we think that such loss, absorbing instruments driven by clear and objective criteria in terms of the trigger mechanisms (income statement loss rather than vague, amorphous concepts such as ‘balance sheet reserves’ or ‘distributable resources’) would make this more effective from a regulatory perspective. Notwithstanding the relative advantages of such loss absorbing instruments, we note that they do not replenish the solvency position of the issuer, unlike ‘super hybrid’ instruments would provide for upon conversion.

Given these considerations, we think that there is scope for both ‘super hybrid’ and non-converting, loss-absorbing instruments within the future regulatory capital structure in detriment of the existing generation of hybrid instruments. We have laid out our rationale for assuming that ‘super hybrids’ should have a greater risk premium than traditional hybrids in terms of the greater probability of the conversion option triggering. Similarly, for the loss absorbing, non-convertible hybrids we also expect a higher risk premium given that the probability of triggering will also be higher than that of traditional hybrid Tier I for the simple reason that there is a greater probability of an institution having a loss in any given year than of there being some type of regulatory insufficiency event.

In our opinion loss-absorbing Tier I may be a more acceptable compromise in terms of meeting regulator and investor objectives

German Tier I may serve as the template for loss-absorbing Tier I, however we expect that there should be restrictions on reserve allocations which have been done historically to mitigate principal impairments

Objective and transparent triggers and investibility for credit investors are important considerations

Super hybrid and non-converting, loss absorbing Tier I will both have higher risk premia in comparison to legacy hybrid Tier I instruments

38



Capital Structure Recommendations We highlight that our views and recommendations on the subordinated bank capital market is very much the result of the transitioning to a new regulatory capital regime where the obvious outcome is that it will become more onerous for banks to issue deeply subordinated hybrid capital instruments. This is a recognition that an immediate impact of the regime change will be how issuers interact with the market given the greater cost of issuing hybrid capital, or at the very limit, the inability to do so. Additionally there are typically less subordinated parts of the capital structure where we expect that there will be fewer incentives for issuance, which will also impact our view on these asset classes.

Tier I We think that the Tier I market will be the most impacted by the regulatory capital reform process given that is the asset class that will have the most change in terms of product development. Our conclusion is that these changes will impact the ability or the willingness of the issuers to refinance existing Tier I instruments as they reached their call date. We therefore think that these considerations should necessarily have an impact on the relative attractiveness of these instruments. As we highlight in a recent publication ‘Hybrid Theory - The Future of Hybrid Bank Capital’ dated October 20, 2009 we see the existing Tier I market as being split into three categories.

Legacy Tier I Issues with Call Post 2011: Underweight In our opinion, legacy capital instruments that have been issued pre-2009 will most likely extend for two key reasons. Firstly, we note that the economic incentives are not very compelling for issuers to call these instruments at the first call date given the relatively low post-call spreads. Secondly, we also think that independently of the economic costs, the introduction of a new regulatory capital regime will also imply that it will become more challenging to issue new hybrid capital instruments as replacement capital given that banks will most likely be accessing a more limited investor base. As a result, the natural consequence would be an extension of the current generation of instruments beyond call date. Importantly we note that issuers will continue to benefit from regulatory treatment for these instruments through an extended period of grandfathering.

Legacy Tier I Issues with Call between 2009-11: Neutral Given the likely timeframe in terms of the introduction of a new regulatory capital framework, we think that potentially some of the opportunistic issuance currently done in the market will be with a view to refinance some of the legacy hybrid capital instruments that reach their first call over the next 12-18 months. As a result we note that some of the hybrid capital instruments that reach their call during this transition period may in fact be called, given that issuers will have the ability and flexibility to refinance these instruments. We therefore reflect this outcome for the relatively short call Tier I instruments that can be refinanced and are therefore more likely to be called.

Our views and recommendations on the subordinated bank capital market is very much the result of the transitioning to a new regulatory capital regime

Tier I is the part of the capital structure which will be most impacted by regulatory change

Economic rationale will dictate that post-2011 Tier I bonds will not be called

Opportunistic issuance of Tier I instruments up until the definitive implementation of regulatory change, will potentially allow some issuers to refinance the pre-2012 instruments

39



Figure 30: Hybrid Tier I Capital: Impact of Regulatory Change Bp, Issuance in €bn

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35

40

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 … 2030 … 2040

Issuance Tier I Bonds with Firs t Call

BUY HOLD SELL

Bonds w ith call dates during this periodNew issues

100% Grandfathered

20% Grandfathered 10%

Grandfathered

€bn

0

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

A v erage Pos t Call Spread of SUSIA v erage Pos t Call Spread of New ly Iss ued Tier 1's

b p

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omic

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 … 2030 … 2040

Issuance Tier I Bonds with Firs t Call

BUY HOLD SELL

Bonds w ith call dates during this periodNew issues

100% Grandfathered

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A v erage Pos t Call Spread of SUSIA v erage Pos t Call Spread of New ly Iss ued Tier 1's

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New Tier I Issues Pre Regime Change: Overweight The new issues that are currently being undertaken are in our opinion the optimal point of the Tier I market, and where we think that there is value for investors. Structurally these instruments have two important advantages over the legacy structures as well as the new regime hybrid capital instruments. Firstly, relative to the legacy hybrid capital instruments, the new structures will have much higher post-call spreads, which in our opinion will imply a higher probability of call and which will in turn have an impact on how these instruments should be valued. Secondly, in structural terms these instruments will also be more investor-friendly given that they will not include more equity-like features and loss-absorption language, which is likely to characterize the new generation of hybrid instruments.

Upper Tier II – Neutral In our opinion Upper Tier II sits in a relatively uncomfortable position given that it is Tier II capital and hence of less importance in the new paradigm of regulatory bank capital. However, being issued as a potentially perpetual instrument with the ability to defer coupon, it carries with it the risks for which investors would demand a high premium in compensation. Hence, this would imply that issuers would have to pay a relatively high premium for an instrument that is going to have more limited utility in the new regulatory capital framework. We therefore envisage that issuance of these instruments should be extremely limited, to the extent that this would most likely be an asset class that is effectively in run-off mode.

In our opinion new issues in legacy format are the most attractive part of the capital structure

Upper Tier II: many risks for investors with few benefits for issuers

40



We think that this view is potentially corroborated by the fact that Upper Tier II was the part of the capital structure that experienced the highest proportion of liability management exercises, reflecting that regulators have been content to sanction the retirement of these instruments in return for a smaller capital gain. Hence, this would imply that regulators also see limited application for the asset class going forwards. For all these limitations with regard to future relevance, we highlight the cumulative element of coupon deferral, which should insulate the investor from greater loss scenarios. We therefore see some value for investors given that issuers may have less incentive to keep these instruments outstanding.

Lower Tier II – Overweight Under principles likely to be espoused by the current regulatory reform process we think that Lower Tier II capital will be excluded given its dated format and limited ability to contribute towards the loss absorbing capability of the issuer’s capital base. In our opinion, there is unlikely to be a large volume of issuance within this asset class given that regulators have been relatively clear that dated capital instruments should no longer be considered part of the capital structure, as per recommendations in the Turner Review. Apart from the restrictions from a regulatory perspective we note that issuance of Lower Tier II has become relatively inefficient for issuers given investors’ higher perception of extension risk. Under these circumstances, most issuers would actually have to market Lower Tier II in bullet format, as opposed to the more efficient callable structure, which allows an issuer to call the instrument prior to when regulatory amortisation undermines the value of the instrument.

Additionally we note that there tended to be greater volumes of issuance when the effective premium for Lower Tier II was only marginally greater in absolute terms versus that of senior bonds. Hence, the issuance of Lower Tier II instruments combined funding utility with the benefit of regulatory capital treatment. This is clearly no longer the case and there is a material premium for issuing subordinated over senior instruments, with this premium being increased by the capital inefficiency of the bullet format. We also note that the business case for the issuance of Lower Tier II instruments may be undermined by some of the structural changes which we are witnessing in the sector with the unwind of the bancassurance model. Effectively, we think that some of the Lower Tier II issuance was previously undertaken to mitigate the regulatory deduction of insurance operations. Given the large scale divestment of insurance operations, we think that there will be less scope for the future issuance of Lower Tier II instruments. In addition we think that if regulators change the bank capital framework to the extent that only high quality Tier I components are given regulatory treatment, we can also envisage a scenario where the mechanics of the various regulatory deductions are also revisited. Potentially, given that Tier II capital is perceived to be of lower regulatory value it may not make sense to allow it to absorb deductions in lieu of Tier I capital.

Given these considerations, which we think will contribute to a scarcity value for an asset class that offers very little in the way of flexibility for issuers, we remain Overweight and see value in an instrument that for all intents and purposes is really just subordinated senior debt. The only time where we would not want to buy Lower Tier II would be in an environment where default probabilities would be high given the low expected recovery rate outcomes for the asset class.

The liability management process has shown that regulators see limited value in Upper Tier II instruments

We believe that dated instruments should no longer be deemed part of the regulatory capital structure

Weaker business case for issuance combined with the inefficiency of bullet format will undermine the rationale for future issuance

Potential scarcity value with limited issuer flexibility makes Lower Tier II very attractive - Overweight

41



Senior Debt – Neutral While the regulatory reform process will not have a direct impact on senior debt given its status as a funding tool, we do expect that there will be significant indirect impacts with regard to the overall risk profile of the asset class. On an entirely superficial basis, one could argue that the net result of the regulatory capital reforms would be to lower the risk profile of the sector. It stands to reason that the fact that banks would have higher capital buffers would imply that the senior bondholders would have a higher degree of subordination below them and would therefore be better insulated from adverse outcomes. In our opinion this is not as straightforward as it may appear at first sight and wider considerations on regulatory reform have to be taken into consideration as well. We will explore the concept of lower sector risk within the confines of the new regulatory framework, before looking at the technical factors that will necessarily have an impact in terms of our recommendation on the sector.

Low Probability of Distress, but Greater Expected Loss Given Distress To explain the above statement, we have to look at the context of the current government intervention in the banking sector and the motivations to change the regulatory framework. While the initial objective will be to reduce the probability of future distress we think that governments and regulators alike may look to create mechanisms that minimise the potential burden on public finances of future bailouts. We think that over the last 18-24 months public finances have been stretched as a result of the costly interventions in the banking sector to the extent that there is a broad recognition that such outcomes should be averted in future and that alternative methods of dealing with distress in the sector should be contemplated.

The best example of this would be the approach taken in the UK with the 2009 Banking Act which effectively creates the legal framework to deal with failures in the banking sector. Under this legislative framework effectively there are mechanisms that allow for an intervention with a view to selectively split the assets and operations of the distressed bank. The best example of such an intervention would be Northern Rock where potentially viable core operations funded by retail deposits will effectively be segregated from remaining operations which in turn will be put in run-off. Crucially this will potentially result in negative outcomes for the entire wholesale funding structure, both senior and subordinated which remain attached to the ‘bad bank’. These types of interventions represent a more efficient way of government intervention in the sense that the entire liability structure is not bailed out and that there is greater ‘loss sharing’ amongst the various stakeholders. Importantly, this implies that government support is only required for the operations that are deemed viable and hence the failed part of the institution can be put in run-off with the remaining stakeholders shouldering the losses. Some governments would think that this would represent better ‘value for taxpayers’.

We think that the regulatory reform process will have an impact on senior debt given the change in the perceived sector risk profile

The bottom line is that governments do not want to be on the hook for future bank bailouts

Legislative frameworks will look to create the mechanisms for banks to be able to fail in an orderly manner

42



In tandem with these initiatives we highlight the push towards institutions having ‘Living Wills’ which will effectively provide the roadmap for the orderly unwind of distressed institutions. Hence, while the 2009 Banking Act provides the legal framework that allows for selective bailouts amongst distressed institutions, ‘Living Wills’ provide the specific framework for intervention at each institution and make these easier to execute. The relevance of ‘Living Wills’ is such that they seek to make the selective bailout as practical as possible given the relative complexity of most major European banks, both in terms of legal structures and functions. In our opinion even with these two elements in place, the split of a failing institution into a ‘good bank/bad bank’ will be a non-trivial strategy to implement. What is more likely to happen is that there may be a carve-out of problem or non-strategic assets with wholesale debt instruments, either senior or subordinated, being carved out as well. If this happens, the net result is the cost of the bailout is minimized as public resources are not used to support losses from problem assets or the bailing out the bank’s entire liability structure.

Under these circumstances, we think that investors may have reassess the value of the ‘government put’ in a situation of distress. Hence, this brings us to the view that while the probability of distress may be lower for the banking sector as a result of a tighter regulatory capital framework, we think in the event of distress the expected loss for bondholders will potentially be greater given that government intervention may not necessarily work according to established patterns. Under these circumstances we think this should have an impact on the pricing of risk even for the senior part of the liability structure. A potential outcome would be that a wider implementation of such measures internationally may result in investors no longer having a ‘cannot fail’ view of senior debt even for large, systemically relevant institutions. Consequently, banks could see a generalized increase in risk premia attached to senior debt, which would encourage more efficient risk pricing of the sector with the weakening of the implicit ‘government put’. We highlight this as an important structural change in terms of how future government intervention could be undertaken in the banking sector.

We maintain a Neutral recommendation on Senior debt more in light of the main technical factors than due to the fact that this is a step change in government and regulatory strategy which we actually think will be a longer term consideration for risk pricing in the sector. The main technical factors that we think will have an impact are issuance, absolute yield levels and structured credit dynamics.

Figure 31: FIG Maturities $Bn

0

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800

1,000

1,200

1,400

2009 (Oct-Dec) 2010 2011 2012 2013

Senior Covered Capital Govt-Gtee Subordinate

301

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539

Average maturity (2000-2008) : $899bn

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539

Average maturity (2000-2008) : $899bn

Source: J.P. Morgan. Source: DCM Analytics as on September 20, 2009; issuance in all currencies and markets by issuers with parent nationality of operations as Germany, Austria, France, Benelux, Sweden, Finland, Norway, Denmark, UK, Ireland, Spain, Portugal, Greece and Italy, exclude ABS, MBS, SSA’ss and public finance institutions.

‘Living Will’ provides the roadmap to selective bailouts permissible under the 2009 Banking Act

The implicit value of the 'government put' will have to be reassessed by investors even for senior debt

43



Issuance We expect that senior issuance will be maintained at a relatively high level during the course of 2010 bearing in mind that the level of redemptions is higher than average. As we note from Figure 31: FIG Maturities, redemptions for the financials sector is expected to be $1,139bn, which places it comfortably above the average level of overall redemptions over the 2002-08 period with the bulk of these redemptions being in senior funding. As a result of the potential for heavy supply we think that valuations may be vulnerable, particularly at the longer end of the curve with European banks that are long liquidity attempting to lengthen their duration profile which had been shortened during the market crisis.

Absolute Yield Levels While senior spreads may still look quite attractive compared to the historical average, we note that on a yield basis returns look far from satisfactory with the current yields from the asset class being very modest compared to the average historical levels. While it may seem counterintuitive to refer to the ‘all in’ yield as a factor in the attractiveness of the sector given that credit investors will be spread focused, we think it is still relevant within the context of an asset class that has seen buying from non-traditional credit investors, who may find the current yields as distinctly disappointing. Lower demand from these non-traditional investors may make it more challenging to refinance an above-average supply pipeline.

Figure 32: Maggie Senior Spread versus Average Bp

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Maggie Senior Spread Average Spread


Figure 33: Maggie Senior Yield versus Average %

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Maggie Senior Yields Average Yield


No Structured Bid A naïve interpretation of the spread chart above would imply that a combination of spread reversion together with a more robustly capitalised sector must surely imply a return to much tighter level. We have already highlighted that the tighter regulatory environment is not necessarily a 'win-win' for investors and that there may be adverse consequences in terms of changes to future government intervention in the sector. We also highlight that one of the reasons which took spreads tighter was the impact of structured credit activity, particularly in synthetic format which took CDS spreads visibly tighter with a similar impact on the cash market. While we have no doubt that markets have very short memories and can already feel structured credit bankers straining at the leash, we think that it is unlikely that there would be a repeat of this phenomenon. We therefore think that spread evolution for the banking sector and spreads has to be seen within the context of material structural changes which have occurred in the interim and which would render comparisons with previous levels as redundant.

Above average redemptions imply above average issuance

Nice spread, disappointing yield

Tight spread levels in 2004-06 are not the norm, rather an aberration caused by structured credit

44



A Future Secured? The New Rules of the Game for the Secured Lending Markets Dichotomy lobotomy 2009 has been a year of contrasts for Europe’s two secured funding markets, with both the securitisation and covered bond markets starting the year in a state of unprecedented dislocation (primary market closure, distressed trading, deteriorating performance of the European consumer, further exposed to the vagaries of the rating agencies, and buffeted by regulatory surveillance).

From the same starting point however, benchmark covered bond issuers from core issuance jurisdictions started to tentatively place transactions with investors (albeit at historically wide spreads) – slowly prising the market open. This initial issuance trickle turned into a steady stream come the ECB’s decision to participate in the market in May. Since then, issuance volumes have improved significantly (Figure 34) approaching levels comparable to those in more ‘normal’ years (YTD €152bn), while spreads have tightened in notably (Figure 35), with prices for bonds from core issuance jurisdictions rapidly approaching pre-crisis levels (although names from more peripheral countries still offer significant basis to pre-crisis prices).

Figure 34: Covered bond issuance*, €bn

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Source: J.P. Morgan Covered Bond Research. * Publicly issued benchmark transactions only

Figure 35: Covered bond spreads, bp

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ECB purchase programme announced

Source: J.P. Morgan Covered Bond Research

European securitisation markets however have taken a more anaemic approach to resuscitation – with much of 2009 characterised by the now familiar structure-to-repo merry-go-round. According to our estimates, four deals amounting to some €5.5bn of bonds have been distributed to investors year-to-date, while a further €347.7bn of bonds have been created and retained by originators (Figure 36) – highlighting the disparate fortunes of the two secured products.

Figure 36: European ABS issuance, €bn

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2002 2003 2004 2005 2006 2007 2008 2009 YTD

Public Retained

Source: J.P. Morgan European ABS Research

Figure 37: European AAA RMBS spreads, bp

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UK NCF UK BTL Ireland

Source: J.P. Morgan European ABS Research

ABS & Covered Bonds

Gareth Davies, CFAAC (44-20) 7325-7283 [email protected]

Divergent paths for Europe's two secured funding markets…

…with covered bond markets ‘up and running’…

…while securitisation markets remain ‘stalled’

45



Table 7 shows a snapshot of some of the sources of funding available to banks and indicates their availability to issuers/appeal to investors as the credit crisis progressed. Readers can see that the appeal of covered bonds has broadly moved in lock-step with the ability to issue unsecured financial bonds – with both formats showing significant recovery over the course of 2009. We expect these markets to be close to fully-functioning in 2010 for the vast majority of issuers (see The Regulator Strikes Back, page 26).

Table 7: Bank sources of funding

Pre-crisis

Aug 07- Aug 08

Lehman Failure

Govt rescue plans

H1 2009

H2 2009

H1 2010

Unsecured

Gtee’d unsecured n/a n/a n/a

Covered bonds

Securitisation

Gtee’d Sec’n n/a n/a n/a n/a n/a

Credit crisisGreen: Open

Yellow: Partially open

Red: Closed

Red/yellow: Closed, moving to partially open

Yellow/green: Partially open, moving to fully open

Pre-crisis

Aug 07- Aug 08

Lehman Failure

Govt rescue plans

H1 2009

H2 2009

H1 2010

Unsecured

Gtee’d unsecured n/a n/a n/a

Covered bonds

Securitisation

Gtee’d Sec’n n/a n/a n/a n/a n/a

Credit crisisGreen: Open


Red: Closed


Yellow/green: Partially open, moving to fully open

Green: Open


Red: Closed


Yellow/green: Partially open, moving to fully open Source: J.P. Morgan European ABS Research

Our expectations for the securitisation markets in 2010 are however less sanguine. We continue to expect the majority of ‘issuance’ to be held by originators – despite efforts to wean issuers off their reliance on short-term repo funding and investor attempts to tighten in secondary market spreads to make new, economically-feasible issuance a possibility.

In fact, Figure 38 and Figure 39 demonstrate the issues the market faces in restarting securitisation in Europe. The overwhelming number of originator respondents to the latest J.P. Morgan European ABS Confidence Index say that they see securitisation having a continued role as a consumer-lending funding tool going forward (89%), but at the same time the majority (67%) remain unwilling to issue transactions in an effort to reestablish the market. The secured funding market dichotomy therefore looks set to continue well into 2010.

Expectations that covered bond markets will ‘trend to normal’ without fundamental changes to the product or market structure…

…while securitisation markets look set to experience a ‘slow grind’ – with product modifications and (partial) investor base transition seemingly necessary

46



Figure 38: Do you believe securitisation has a continued role in funding consumer lending in Europe?, %

82% 79%89%

7% 6% 6%11% 15%6%

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Q1 Q2 Q3

Yes No May be

Source: J.P. Morgan European ABS Confidence Index

Figure 39: Would you issue a transaction at “uneconomic” spreads to facilitate a restart of the public ABS markets?, %

36%

61%

4%

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67%

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100%

Yes No Don't know

Q2 Q3

Source: J.P. Morgan European ABS Confidence Index

Housing goes under covered Owing to this, in 2010 we expect to see a short-term change in the relationship between the covered bond and securitisation markets in a number of countries. In jurisdictions traditionally more heavily reliant on securitisation markets as a funding tool for residential mortgage books (UK, Netherlands and Spain), we expect to see more mortgage collateral directed towards the covered bond markets. This is symptomatic of both the current market pricing differential (approximately 100bp in the UK and Netherlands, 200bp in Spain), and also the depth and appetite of the respective investor bases.

By derivation, we believe that the European securitisation market becomes a tool increasingly used to fund higher margin (i.e. predominantly unsecured) collateral (more akin to the structure of the US market where credit card, auto loans and student loans form a larger proportion of issuance) – where a juicier asset yield can be used to support the relatively higher liability cost structure of the securitisation issued.

Hybrids are good for the environment Interestingly, structural amendments to the two distributed RMBS during 2009 have also served to narrow the gap between the covered bond and RMBS product (the two distributed auto ABS transactions however look the similar to issues pre-crisis). Both HBoS and Nationwide issued bullet bonds with a put back to the originator at a given maturity (100 less any credit losses on the AAA note), effectively limiting the extension risk usually associated with a securitisation investment, while Nationwide also introduced a fixed rate (bullet) note – both features more typical of the covered bond world than the traditional securitisation product.

While these structural developments are unlikely to herald the permanent merger of the two funding sources, it does blur at least some of the differences between the two asset classes. We expect these hybrid features to be relatively common in 2010 while the securitisation market starts its slow grind back to normality.

Residential mortgages likely to be funded by covered bonds while securitisation market pricing remains dislocated

Expect more ABS backed by higher-yielding consumer assets

Covered bonds and securitisation get a little cosier

47



Overhang hangover? One of the more notable features of the European securitisation market since September 2007 has been the phenomenon of structure-to-repo transactions. While we have said many times over the life of the crisis that the ability to post ABS collateral to the various central bank repo windows was undoubtedly “good in the short-term…” we continue to believe that it remains “... bad in the longer-term”. By our calculations, some €1.43trillion of ABS has been created and retained in Europe since the initial closure of the primary markets. While their creation does not necessarily equate to their usage at the various repo windows (originators may structure ‘just in case’) it does indicate that these exposures have not been used to either access long-term funding or to transfer risk away from the banking sector. Furthermore, many of the bonds created are in a structural or collateral form that would be difficult to divert to a (currently) more discerning investor base.

Why does this trouble us so? It is partially the fear (and increasingly, the realisation) that many originators have used the availability (and pricing advantage) of such facilities as a way to avoid taking some of the unpleasant but necessary measures of adjusting product pricing to the new world order. While this has undoubtedly been beneficial for the over-stretched consumer (and by derivation the performance of outstanding ABS bonds), it has merely postponed the inevitable product repricing issue in our view (we do not expect banks to be able to access the securitisation market again at levels seen pre-crisis). Recent moves to tighten both the eligibility and the price for access to both the ECB’s repo window and the Bank of England’s SLS are yet to filter through to issuers’ funding decisions in any meaningful way.

Looking ahead to 2010, we remain acutely aware that this €1.4trn of assets needs a permanent home. In the main, we expect these assets to be either unwound and re-issued into the ABS markets (in an acceptable format), to be unwound and used as collateral for future covered bond issues (in an acceptable volume), to be funded on-balance sheet by the originating banks or posted to the various repo windows on an ongoing basis. None of these solutions (or any combination of them for that matter) provides an easy answer however – especially for markets only now slowly re-opening.

Regulators flex their muscles 2010 will be the year that sees many of the regulatory initiatives launched in the wake of the credit crisis, come to final form – with many proposals set to be implemented that will have a significant impact on the structure and form of the European secured lending markets. While it remains near-impossible to assess the exact impact of the output of these various working groups and policy committees, we are starting to see the clear direction of the regulatory push.

While covered bonds remain relatively untouched by additional regulatory scrutiny (with the exception perhaps of recent moves to elevate the discussions about asset encumbrance up the agenda in the UK), most regulatory action is currently centring around the perceived weaknesses of securitisation. We can distil these various initiatives into three broad strands:

Reliance of structure-to-repo continues to hurt the securitisation markets in our opinion

Securitisation to be the main focus of regulatory scrutiny and action

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• Firstly, the regulatory dislike of “securitisation for securitisation’s sake”, which can be categorised more explicitly as an aversion to both the originate-to-distribute and resecuritisation (i.e. arbitrage) models. Here, the main instrument of policy has been revisions to the Capital Requirements Directive (CRD) (and to a lesser extent the ECB’s monetary operation criteria) with initiatives centring around requiring originators to hold an ongoing economic interest in each collateral pool they securitise; and revising capital treatments for bank investors in situations in which originators do not comply

• Secondly, another focus (rightly in our view) has been on additional disclosure – whether it be for rating agencies, investors, or the ECB itself. Again, disclosure and enhanced due diligence requirements have been set out under the CRD for bank investors

• Finally, initiatives on product design (such as Prime Collateralised Securities (‘PCS’) proposals) – effectively looking to develop hybrid structures mimicking the best features of both the covered bond and securitisation markets

Bottom line? Securitisation to get more expensive Newly-adopted EC regulations (in force for new securitisations from 2011) are set to increase the cost of both securitisation issuance and investment. The new Article 122(a) of the CRD aims to remove what the Commission sees as ‘misalignments’ of incentives between the interests of originators and investors. Under the new regulations, European banks will be required to invest only in securitisations where the issuers retain an interest of not less than 5% (through retention of a vertical slice, a seller’s share, a first loss tranche, or equivalent exposures on-balance sheet). Failure to satisfy these requirements will lead to a capital charge at least 250% of the risk-weight that would otherwise have been applied for the holding (i.e. a BBB granular securitisation position would see its riskweight rise from 100% currently to 250%).

Furthermore, the amended CRD also imposes ongoing requirements on an investing bank (traditionally we would estimate that bank investors made up around 1/3rd of the European investor base – more if sponsored off-balance sheet vehicles are included). Each investor will be required to demonstrate to their respective regulator that it has a “comprehensive and thorough” understanding of the risks associated with its securitisation investments, along with appropriate formal policies and procedures for analysing and recording each investment’s risk characteristics. Banks will also be required to perform their own stress tests at regular intervals along with more comprehensive collateral pool performance monitoring. This will naturally represent a significant analytical and administrative burden on investing credit institutions.

Other regulatory moves to have an indirect impact on the secured funding markets In addition to the initiatives directly targeting the securitisation markets, there are also macro regulatory reform initiatives (as previously discussed in The Regulator Strikes Back, page 26) targeting both the quantity and quality of capital required by Europe’s banks which will have a direct impact on the cost of balance sheet usage. Combined with the potential introduction of a leverage ratio, it could rationally serve to limit the availability and price of credit to consumers and corporates alike, therefore impacting both the format (covereds versus securitisation) and volumes of secured issuance going forward, along with the performance of existing transactions currently outstanding.

European regulations to increase the cost of securitisation for issuers…

…and also for bank investors

Other regulatory initiatives also set to impact the secured funding markets

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2010 – a Secured Odyssey While the backdrop to the secured funding markets in Europe in 2010 is somewhat fluid, we see the health of both the securitisation and covered bond markets improving over the course of the next twelve months – although unlike 2009, the starting point for the two markets is fundamentally different. In our 2010 Outlook we therefore expect to see important changes, including:

• More covered bond issuance in the short term from jurisdictions traditionally more reliant on the securitisation markets (UK, Netherlands, Spain) – particularly for residential mortgages

• However, over the medium to longer term, we expect this to reverse with more securitisation (and less covered bonds) as banks look to move low margin assets (i.e. residential mortgages) off relatively more expensive balance sheets

• Those RMBS deals that are distributed to investors, particularly from more complex issuance vehicles (master trusts), to continue including features designed to blur the lines between the two secured funding products

• We recognise the potential for a somewhat smaller securitisation investor base as some banks become less axed to invest in securitisation exposures for their own account due to changes in terms of capital charges and due diligence requirements–further exacerbated by balance sheet size and cost constraints

• We believe investors will accept the expectations of higher due diligence requirements around the securitisation asset class, with the resultant higher costs impacting the minimum required return on investments (reinforcing the higher cost of the underlying consumer products)

• Ultimately, we expect to see the provision of lower credit volumes to the consumer, with those lines that are advanced likely to be given at a higher cost. This will be particularly detrimental to the marginal borrower, and will be likely to negatively impact the repayment rates of existing borrowers and structures

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The Big Issue Executive Summary 2009 has been an unprecedented year for bond market supply, as well as demand. A wall of supply was met with a wall of cash, and credit markets saw historically high returns just a few months after experiencing record losses following the collapse of Lehman.

We saw many new themes emerge in the primary market – record levels of Non-Financials issuance, longer maturity and lower rated issues, and an increasing number of new unrated companies tapping the bond market.

In this essay, we argue that a number of Non-Financials issuance themes were not “one-offs” for 2009, but are in fact the beginning of a secular trend for European bond markets which are evolving towards a more US-like model; a theme we have been highlighting for a while now. For 2010, we forecast €204bn of Non-Financials bond market gross issuance, and net issuance of €100bn.

2009 Issuance In review Gross Issuance in 2009 (€365bn YTD) has actually been on a par with that seen in previous years (€346bn in 2008, €391bn 2007), but Net Issuance of €46bn YTD has shown a huge improvement from 2008’s anaemic €5bn, and more importantly the mix of Net Issuance between Financials and Non-Financials has differed significantly from traditional trends.

Net issuance this year for Industrials has hit record highs at €140bn, whilst Financials (unguaranteed) net issuance is at record lows of negative €115bn as banks relied more on issuing in the government guaranteed space. This was the mirror image of pre-crisis trends where Financials net issuance used to run at twice the pace of Non-Financials. In this essay, we focus on Non-Financials issuance – for more details on the issuance profile of European Financials, please see The Regulator Strikes Back, page 26.

Figure 40: Euro Gross Issuance €bn

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Figure 41: Euro Net Issuance €bn

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Tina ZhangAC (44-20) 7777-1260 [email protected]


Daniel Lamy (44-20) 7777-1875 [email protected]

2009 Overall Gross Issuance has been similar to previous years, but the mix between Financials and Non-Financials is the mirror image of pre-crisis trends

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New Issues have been a significant and reliable source of outperformance for investors this year, driving a virtuous circle that has kept demand for new issues high and preventing the new issue machine from breaking down, even as new issue premia to secondaries have collapsed.

On average, Industrials new issues this year rallied over 3% in the month following their issue and we estimate that compared to a Non-Financials € IG benchmark, the effect of just buying new issues before they enter the benchmark at the end of each month has been around 30bp of outperformance YTD. This is assuming that that a fund's allocation in new issues is proportionate to the market value of new issues versus the market value of the benchmark. For every extra 5% of the portfolio allocated to buying each month's Industrials new issues rather than secondaries, funds get on average, an extra 30bp of "free" outperformance.

New Issue performance has been relatively insulated from moves in the broader market, and even as new issue premia collapsed towards zero and as credit curves steepened, the new issue yield curve has been flattening over the past few months (i.e. longer term issues have been offering less premia than front end issues).

Figure 42: New Issue Indices Our New Issue indices show on average, how much new issue spreads have tightened versus spread at reoffer, bp

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Figure 43: New Issue premia to secondaries and dispersion in premia

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Collapsing new issue premia, combined with continued retail inflows meant that the search for yield (which initially remained confined to higher quality credits) opened the way for more BBB and unrated issuance, as well as longer dated issues. Table 8 shows that over the second half of 2009, 15% of all Non-Financials new issues were unrated deals compared to 1% earlier in the year and 2008. At the same time, 37% of deals in 2H09 were dated 10 years or more, compared to just 10-12% in the first half and 2008 (see Table 9). Consequently, there has also been a significant divergence in the average duration of new issues, which rose from around 4.5 to 6.5 in the past 3 months, with the duration of the benchmark which has stayed around 4.3.

New Issues have enhanced investor performance this year. The effect purely from buying new issues before they enter the benchmark at the end of each month has been around 30bp of outperformance YTD

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Table 8: Non-Financials Issuance: Ratings composition 2008 vs 2009

2008 1H09 2H09 AAA 9% 6% 0% AA 15% 21% 18% A 56% 45% 37% BBB 19% 28% 30% Unrated 1% 1% 15% Total volume €133bn €190bn €55bn


Figure 44: 2009 Non-Financials Issuance by Rating (rolling 2 month, €bn)

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Table 9: Non-Financials Issuance: Maturity composition 2008 vs 2009

2008 1H09 2H09 1-3 7% 4% 4% 3-5 21% 28% 4% 5-7 35% 35% 36% 7-10 25% 23% 18% 10+ 12% 10% 37% Total volume €133bn €190bn €55bn


Figure 45: 2009 Non-Financials Issuance by Maturity bucket (rolling 2 month, €bn)

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The fact that Non-Financials and lower rated credits are becoming a greater proportion of total issuance is consistent with the European credit market becoming more US-like, a theme that we have been highlighting for a while and one that we expect to continue to play out over the next few years as corporate borrowers continue to reduce their dependency on bank loans.

Whilst bond market supply has been booming this year, the story has been very different for the loan market. As banks have sought to trim the size of their balance sheets, loan market issuance for investment grade companies has fallen considerably and net issuance over the past 2 years has totaled negative €100bn. Pre-crisis, annual Investment grade loan supply was on average, about 3 times that of bond supply, but for the first time since 2000 (the earliest data we have on the Euro IG loan market) this year’s investment grade bond supply looks likely to exceed that of loans. 2009 loan volumes are just 35% of the peak in 2006, and not surprisingly, acquisitions-related financing has shrunk the most (down 74%, or €120bn), followed by refinancings (down 64%, or €89bn) as corporates have been tapping the bond market instead.

In contrast, the IG loan market has been shrinking. IG loan supply used to outpace that of bonds by a factor of 3. However, over the past 2 years, Net Issuance for Non-Financials in the loan space has totaled negative €100bn.

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Figure 46: Historically IG Non-financials Gross Issuance in Loans has exceeded Bonds (€bn)

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US Structural changes in 2001 We believe that the current shift by companies to using relatively more bond market financing than loan market financing is comparable to structural changes in the US market in 2001. With a poorer economic climate, many prominent non-financial issuers of Commercial Paper programs were downgraded from Tier 1 to A-2. Because the size of the A-2 market was considerably smaller (at that time money market funds could only hold up to 5% of their portfolios in non-Tier 1 CP), many issuers withdrew from the CP market. With historically low yield levels (at the time) and a flat Treasury yield curve, many companies took the opportunity to switch from issuing CP to raising longer term bond financing at rates similar to that at the short end. As Figure 47 and Figure 48 show, there was a concurrent decline in the CP market and a rise in bond issuance in 2001. The proportion of all deals dated longer than 7 years also rose from approximately 24% in 2000 to 45% at the end of 2001. Although government yield curves have steepened considerably over the course of 2009, there is still some readacross between the situation in 2001 to the current environment, as absolute yields are still very low and the credit yield curves remains relatively flat. Figure 47: US Non-Financial CP Outstanding $bn

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Figure 48: US Non-Financial IG bond issuance (rolling 6-month) $bn

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Permanently shaken, or just stirred? In our view, some of the unprecedented changes we have seen this year will become permanent fixtures in the primary bond market. In this section we aim to quantify issuance dynamics for investment grade Non-Financials over the next year.

We construct top-down Non-Financials issuance forecasts based on our views regarding the amount of redemptions in both the bond and loan market that will need to be refinanced, and how this refinancing will be distributed between bonds and loans.

Figure 49 shows historical investment grade corporate net supply, (i.e. bond and loan net issuance), which has traditionally always been positive, although due to lacklustre net issuance in the loan market over the past 2 years, overall corporate net supply has been very flat. We construct some estimates of gross corporate supply using redemptions data over the next few years (so called "old money").

Figure 49: IG Non-Financials Net Supply : Bond and Loan gross issuance and redemptions €bn

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Bond (Issuance) Market Maths Step 1: Our starting block is the fact that there is €104bn of bond market redemptions in 2010 and €88bn in 2011. We acknowledge that some of the 2010 redemptions may have already been refinanced this year and so we assume an average of the 2010 and 2011 maturities will be refinanced next year (i.e. €96bn).

Step 2: Historically, net issuance in the bond market alone has been consistently positive. In other words, the European bond market has experienced a relatively steady pace of growth, until this year when growth accelerated due to the reallocation of corporate supply away from the loan market. Excluding this year’s figure, net issuance previously (i.e. overall "new money" being supplied into the market, mainly from traditional bond market issuers) averaged around €30bn per year.

Step 3: In contrast, “new money” in the loan market is unlikely to bounce back to the heady amounts seen from 2005-2007 and in our view, will remain at the extremely muted levels seen this year, as banks continue to pare back their balance sheets. In the spirit of providing a conservative estimate, we pencil in zero “new money” for the loan market into our forecast.

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Step 4: Loan market issuers are traditionally more forward looking than bond market issuers and tend to look to refinance 1-2 years' ahead of time. Hence, instead of looking at 2010 loan redemptions, we instead take an average between 2011 and 2012 redemptions which comes to €261bn. However, some of these maturities include back-up facilities, which are liquidity lines that may not have been drawn or may be downsized, whereas acquisitions or capex-related financing will need to be fully rolled over. Based on conversations with our colleagues in Syndicate and Debt Capital Markets, we think that a reasonable estimate is to shrink the portion of loan redemptions related to Refinancing or Working Capital by a third, which reduces our previous figure to €214bn.

Step 5: Adding together all of the numbers generated in the previous steps gets us to a total gross corporate supply figure of €340bn. We now need to consider how much of this will come in the bond market. As mentioned above, the corporate supply split between bonds and loans has in the past, been roughly 25:75, with the exception of 2009, where it has been 60:40. We think the 2009 ratio is more likely than not going to be a permanent fixture going forward, rather than a blip. Splitting the €340bn accordingly, gives us a Non-Financials bond market gross issuance forecast of €204bn for 2010.

This means that net Non-Financials bond market issuance in 2010 will be €100bn, making both the gross and net numbers considerably higher than historical averages.

Applying the same logic and the same steps to 2011 yields a gross issuance forecast of €181bn and net issuance of €93bn – in other words, we believe that issuance in the European high grade market is likely to shift to a significantly higher run rate for some time to come.

Although our Financials analysts believe that Financials (unguaranteed) issuance is also likely to run at historically high levels (for more details please see The Regulator Strikes Back, page 26), due to the extent of issuance that we are expecting to shift from the loan market, it is unlikely that Financials will regain its traditional dominance over Industrials over the next 2 years.

Risks surrounding our forecast The main downside risk lies in market conditions – even though the primary market showed great resiliency this year, it can still be vulnerable to a significant deterioration in secondaries and investor confidence in general.

Another downside risk may be if the bank lending market makes a comeback, but we do not think that this is the direction that banks want their balance sheets to go in, and if companies can tap bond market liquidity as easily as they have done this year, their dependency on, and hence demand for bank lending will fall. Even if the ratio between bond and supply was tempered slightly to 50:50, Non-Financials bond issuance would still be at historically high levels.

Our High Grade Big Issuer forecasts show only a small decline in leverage is expected in 2010 – approximately half of this is likely to be due to a real reduction in net debt, and half is due to improvements in EBITDA. At the same time free cash flow is expected to rise significantly, however, this may feed into funding delayed capex plans rather than paying off outstanding debt with cash.

Figure 50: 2010 and 2011 Non-Financials Issuance Forecasts €bn

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Downside risks to our forecast include a deterioration in market conditions and the possibility of a revival in bank lending

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Table 10: Euro High Grade Big Issuer Aggregate Forecasts 2008 2009e 2010e Revenue (% change YoY) 4% -2% 4% Adjusted EBITDA (% change YoY) -4% -5% 6% Capex (% change YoY) 13% -11% 3% Dividends (% change YoY) 14% -9% 4% Free Cash Flow €mm 14,439 7,326 14,668 Net Debt / Adjusted EBITDA 2.0x 2.3x 2.1x Source: J.P. Morgan.

In our opinion, the risks are more balanced to the upside, as our overall forecast for net corporate supply remains negative, which would be a rarity for the European corporate market. As the economic environment improves, capex and business investment are likely to start rising and so we could expect more issuance for these purposes. Furthermore, the majority of any pick up in M&A activity is likely to feed through to the bond market, although the timing and magnitude of this is difficult to predict.

Thoughts on Ratings and Sector profiles The main driver of our elevated issuance forecasts is not existing bond market issuers becoming more leveraged themselves, rather the shift by traditional loan market issuers into the bond space. The vast majority of these issuers are typically unrated and have never entered the credit market before (for example, Adidas, Campari, Lagardere, OMV, Neste Oil, etc, had near term loan maturities and all issued for the first time in credit markets this year). Hence, even a slight increase in the percentage of these issuers refinancing in the bond market instead could raise the proportion of unrated issuers above the 2H09 15% run rate.

However, according to results and comments from our latest European High Grade Investor Survey (published 3 Nov), 58% of respondents have not bought any unrated deals, citing benchmark exclusion as the main reason. In order to access a broader investor base, these previously unrated issuers do need to attain an investment grade rating. Given the fact that most of the unrated deals that came in Q3 have been considered “crossover” credits, and that historically, bond ratings tend to have downward drift (even during upturns in the cycle), we could see the credit quality of investment grade benchmarks deteriorate, although this is likely to be a slow burn process.

An increasing proportion of BBB issuers would also be commensurate with the European bond market becoming more US like. The current ratings composition of the European IG benchmark is actually very similar to what it was in the US in 2000. It took almost 2 years in the US for the percentage of BBBs in the benchmark to rise to their peak – a 20 percentage point increase (although this was partly due to a large number of downgrades in 2002). If we apply a 20 percentage point increase in the weighting of BBBs in the European benchmark (at the expense of single-A), then cash spreads today would be approximately 10-15bp wider.

The sectoral composition of the loan market also appears to have a heavier weighting towards Cyclicals, in particular Basic Industry, Consumer Cyclicals and Property. Although some of the Basic Industry issuers such as Lafarge and Arcelor Mittal have already dealt with some of their refinancing needs, even if we exclude these names, the proportion of Basic Industry loan redemptions would still be twice the weighting of the sector in current investment grade benchmarks.

However, we believe that the risks are in fact more skewed to the upside as net corporate supply (bonds+loans) remains negative and we expect capex and M&A to pick up

The main driver of our elevated issuance forecasts is not existing bond market issuers becoming more leveraged themselves, rather the shift by traditional loan market issuers into the bond space

Given that most of the unrated deals that came in Q3 were “crossover” credits, and bond ratings tend to have downward drift, we could see a higher proportion of BBB issuers



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Figure 51: Sectoral differences between IG Benchmarks and Loan markets

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Could Corporate Hybrids make a come-back? Many issuers still regard their investment grade ratings as sacrosanct and hence M&A related transactions are likely to be structured in the most ratings friendly way. To this end, we may well see corporate hybrids from “cuspy” investment grade issuers returning to credit markets, which could test market confidence.

Demand versus Supply Unfortunately, data availability on investor inflows (in particular institutional flows) is much poorer than that on bond supply. According to data from Thomson Reuters Lipper Feri, from January to August 2009, Euro investment grade funds have received $37.2bn of net retail inflows, and interestingly, the proportion of all new issues that are ‘retail-sized’ increased from 29% in 2008 to 45% in 2009.

We have been saying for a while now that we expect retail inflows to moderate to circa $1-2bn per month (compared to peaks of around $7bn per month from May to July), as all-in-yields at 4% look increasingly unattractive. Whilst we do not expect the volume of 2009 retail inflows to be repeated in 2010, judging by our investor conversations and our high grade surveys, we may see institutional inflows become relatively more significant.

However, in the absence of a data source for European institutional fund flows, it is difficult to quantify the effect of bond supply on spreads in a robust way, which is a complex relationship at the best of times. Suffice it to say, the fact that the US market experiences higher issuance volumes and has more BBB rated credits, can partly explain why US investment grade benchmark spreads have traded consistently wider than their European counterparts.

Figure 52: USD and EUR IG Benchmark ASW spreads

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High Yield Mark 3: Riding the Refi Wave Conditions are in place for a record supply year The European high yield market has been around for a little over a decade, but it is already set for its second makeover, with a cycle characterised by private equity buyouts giving way to an extended period of refinancing and balance sheet restructuring.

One of the greatest changes we expect to see over the coming few years is a broadening in the pool of euro high yield issuers, an advance likely to be welcomed by investors, who have at times suffered with the lack of diversity in the market. This forced some to reach outside their comfort zone into other asset classes such as EM corporates and more recently Financials, via their inclusion in several benchmark indices.

Aside from Financials, we see two main sources of new entrants to the high yield space: leveraged borrowers refinancing loans, and new crossover or quasi-investment grade issuers. The latter group has already expanded as a result of investment grade downgrades during 2008-9, making corporate issuers a more permanent fixture in the European market. Terming-out leveraged loans is a process that has only just begun and is likely to persist for many years. Given that excessive loan market liquidity artificially constrained bond issuance during the boom years, in our view there is scope for the high yield market to grow sharply as it becomes the dominant source of leveraged funding.

Barring a material change in the market environment, the conditions are certainly in place to exceed the record for a calendar year of €29bn in 2006. We would not be surprised to see volumes hitting €35bn for FY 2010, quite a bit higher than the median response of €20bn from our recent survey.

Figure 53: Euro High Yield Amount Outstanding, €bn

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Figure 54: Euro High Yield Issuance, €bn

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Daniel LamyAC (44-20) 7777-1875 [email protected]


Tina T Zhang (44-20) 7777-1260 [email protected]

The European high yield market has been around for a little over a decade, but it is already set for its second makeover

There is scope for the high yield market to grow sharply as it becomes the dominant source of leveraged funding

https://mm.jpmorgan.com/stp/t/c.do?i=9A091-D93&u=a_p*d_342597.pdf*h_-100asnj

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Source 1: Leveraged loan refinancing Maturity cliffs in the leveraged loan market are closer than many believe, in our opinion, a problem we discussed in I'm a Lender, Get Me Out of Here, 17 September 2009. Our calculations show that 23% of senior secured loans outstanding by notional will come due by the end of 2012, jumping to 44% a year later (Figure 55). Using a total market size of €250bn, this equates to €58bn maturing by 2012 and €110bn by 2013.

Figure 55: Estimated European Senior Secured Loan Maturity Profile

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Figure 56: Euro High Yield Bond Maturity Profile

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As market conditions continue to improve, we think more companies will attempt to term-out their debt in the bond market, a process that is already well underway in the US. However, as we have noted previously, there are numerous constraints when it comes to extending liability profiles, among others:

• Preserving the order of repayments in multi-layered capital structures. Unlike the simple Revolver + Term Loan + Bond structure in the US, European leveraged capital structures have evolved to look like RC + TLA/B/C + Second Lien and/or Mezzanine and/or PIK. The greater number of tranches and layers of debt instruments is likely to make refinancing harder, as it requires dealing with all parts of the capital structure at once if the order of repayments is to be preserved.

• High threshold for consenting lenders. The Yell transaction highlights the difficulty that can arise in trying to get broad agreement on a voluntary out-of-court debt restructuring. It only takes a handful of hold-outs to prevent the transaction taking place, unless the other lenders are happy to allow a small amount of debt to remain on the original repayment terms. For better quality credits, a fee and margin boost may be enough to compensate for this kind of ‘leakage’, for stressed companies another solution may be needed.

• Logistical obstacles to extending maturity. Some lenders face disincentives to rolling into longer-dated loans: for example certain banks’ accounting treatment could force the recognition of losses through the income statement, rather than in reserves. CLOs may face restrictions to the extent that they are outside of their reinvestment period, or if the new loan matures beyond the legal final maturity of the vehicle.

There are numerous constraints when it comes to extending liability profiles

https://mm.jpmorgan.com/stp/t/c.do?i=8702D-E4E&u=a_p*d_325663.pdf*h_-3s1vrs8

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An incremental approach to refinancing Although the time frame for terming-out debt piles is shortening, we think many borrowers will attempt to transform their capital structures in several stages, particularly those with the most debt to roll. There are several reasons for taking an incremental approach: to avoid overstretching capacity in the bond market; a desire to keep relationship banks as lenders; and to delay the increase in funding costs.

Having a mixture of senior secured bonds and loans in a capital structure poses a number of questions. Do the new bonds benefit from the same security package and covenants as the loans? Will bondholders have access to the same level of disclosure that banks normally receive, or will there be an information asymmetry? How will voting rights be assigned, particularly as it pertains to enforcing on security or a future restructuring? It’s too early to speculate on what the conventions will become, though bondholders are in a strong negotiating position at present.

Source 2: Crossover credits and Fallen Angels Fallen Angels have accounted for the bulk of non-Financial high yield supply over the past couple of years, accounting for €11.6bn of index eligible paper downgraded during 2008 and €16.4bn so far in 2009, we estimate.

Although the pace of downgrades to sub-investment grade should moderate going forward, many of these new entrants are likely to be repeat issuers. This will serve to increase the share of corporate (non-sponsored) supply in the high yield market, making it a permanent fixture. A corollary to this trend – and the expected wave of senior secured supply – is a higher average rating profile in the primary market. This is already becoming evident: so far in 2009 BBs have enjoyed a 50% market share, with no CCC supply at all.

The past few months have also witnessed a number of infrequent or first-time unrated issuers coming to market, such as Evonik, Hella, Rallye and Air France. We expect more companies that traditionally financed themselves exclusively in the bank market to follow suit, opting to diversify their sources of funding. Over time, however, demand for unrated product may fade because of the restrictions that benchmarked investors face.

Figure 57: Ratings Distribution of Euro High Yield Issuance

0%

20%

40%

60%

80%

100%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

BB B CCC NR


This will serve to increase the share of corporate (non-sponsored) supply in the high yield market, and make it a permanent fixture.

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No consensus over the role of Financials in high yield The role of bank capital in a dedicated high yield bond portfolio still divides the investor base, based on our various discussions this year. Our recent survey shows a wide variation in the amount of high yield portfolios allocated to Financials (see Figure 58). Despite the fact that Financials now constitute up to 26% of high yield indices by market value and 31% by notional (Figure 59), fewer than 20% of survey participants had more than a 20% allocation to the sector.

Figure 58: HY Investor Allocations to Financials Financials weighting, x-axis; Percent of investors, y-axis

0%

5%

10%

15%20%

25%

30%

0%-5% 6%-10% 11%-15% 16%-20% 21%-25% 26%-30% >30%

Source: J.P. Morgan. Taken from European High Yield Quarterly Survey: 4Q09

Figure 59: Financials Weighting in High Yield Indices Financials Weighting in iBoxx EUR HY Indices by Notional and MV

0%

10%

20%

30%

40%

Jan '03 Jan '04 Jan '05 Jan '06 Jan '07 Jan '08 Jan '09

Market Value Notional

Source: J.P. Morgan, iBoxx.

One reason for the relatively low weightings is that a large proportion of investors have already changed their benchmarks to exclude various types of bank capital. Some removed only undated instruments, while others did not want any exposure to the sector.

Although our index does not contain Financials, the asset class has been a useful source of outperformance for our model portfolio both this year and in 2008. We still see certain opportunities, particularly in ‘distressed’ lower tier 2: we currently own Depfa, IKB and HSH Nordbank.

Market outlook: most of the upside has been booked The high yield market taught us this year that even the most optimistic expectations can be surpassed: even though we were early buying low dollar price bonds in April, we certainly didn’t envisage 70% returns, and took profits too early. We stick with our cautious view on the asset class in light of the diminishing returns on offer. Granted we could be positively surprised again, however, spreads are much narrower as we move into 2010: 750bp on the J.P. Morgan Euro HY Index, but only 650bp on the iBoxx Non-Financials1 index which includes FRNs.

1 We use the iBoxx main Non-Financials cum Crossover index

https://mm.jpmorgan.com/stp/t/c.do?i=8E10F-D90&u=a_p*d_332058.pdf*h_37hmtjmi

https://mm.jpmorgan.com/stp/t/c.do?i=8E10F-D90&u=a_p*d_332058.pdf*h_37hmtjmi

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With spreads at what are moderate levels historically, it’s not yet clear to us that high yield is priced for perfection in the way that it was towards the peak of the credit cycle. Nonetheless, valuations are already beginning to discount an environment of falling defaults and lower volatility. Our macro model tells us that the decline in default rates that many expect to happen in 2010 is almost in the price already (Figure 60). That leaves precious little buffer for downside risks – if 2008 was about owning optionality against tail events, it seems as though market participants are entering 2010 short those same options. Our sense is that investors are Overweight high yield and have run their cash balances down to 3-4% over the course of the year. Given our assessment of the distribution of risks, we think the asset class looks overvalued and that this year’s performance has eaten into future returns. Looking forward at the possible performance outcomes can we expect in 2010, earning a low double-digit return now seems like the best we can hope for; clipping a coupon is more likely, in our view.

Figure 60: High Yield Spread Model

0bp

500bp

1000bp

1500bp

2000bp

Jan '90 Jan '95 Jan '00 Jan '05

Spreads Spread Model Source: J.P. Morgan.

The upside case: is 13% as good as it gets? Let’s start with a realistic best case scenario, where the global recovery takes hold and stimulus can be removed, albeit tentatively. In this case expectations of default risk continue to slide, exerting downward pressure on spreads. At the same time, two offsetting factors come into play: namely a surge in primary issuance and higher interest rates; in particular, government bond yields climb as risk aversion fades. Let’s suppose that spreads contract by 200bp, of which 100bp is due to risk-free yields, then we would expect our index to return close to 13%. From this we subtract default losses and add back the effect of any new issue premium; for simplicity let’s assume these cancel out.

A lot of downside risks remain Although we don’t expect markets to melt-down in the manner of late-2008, going into 2010 there are still a number of risk factors. Our core concern – shared by investors in our latest survey – is that economic recovery stalls once fiscal programmes start to wind down, clearly a negative outcome for leveraged companies reliant on growth. What happens beyond this is very uncertain, as it depends on policymakers and what actions they are prepared to take to jump start activity. Further fiscal packages may refocus attention on the sustainability of budget deficits and sovereign credit risk; more non-standard monetary policy could unseat inflation expectations.

Nonetheless, valuations are already beginning to discount an environment of moderating defaults and lower volatility

Earning a low double-digit return now seems like the best we can hope for; clipping a coupon is more likely, in our view.

https://mm.jpmorgan.com/stp/t/c.do?i=9A091-D93&u=a_p*d_342597.pdf*h_-100asnj

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Table 11: Which of the following do you see as the greatest risk to high yield returns in 2010? a) Higher interest rates 21% b) Unexpected number of defaults 4% c) Weak economy 43% d) Disappointing corporate operating performance 24% e) Too much primary market issuance 6% f) Other 1% Source: J.P. Morgan European High Yield Credit Investor Survey, 9 November 2009

The second greatest concern investors have for 2010 is corporate operating performance. Based on our sector analysts’ forecasts, any improvement in credit metrics over the next year is going to come from higher margins – the by-product of aggressive cost reduction – rather than top line growth. In fact, projected revenue growth does not exceed 5% in any of the subsets in Table 12.

Table 12: Average European High Yield “Big Issuer” Forecasts by Sector, Revenue and Rating No. of Revenue, %oya Adj EBITDA, %oya Free Cash Flow, €mm Net Debt, Change €mm Net Debt / Adj EBITDA

companies 2009 2010E 2009 2010E 2008 2009 2010E 2009 2010E 2008 2009 2010E Aggregate 51 -13% 0% -12% 7% 448 368 424 -161 -129 3.8 x 4.0 x 3.6 x Sector Cable 5 -3% 2% -1% 4% -142 90 173 -234 -162 4.8 x 4.5 x 4.2 x Chemicals 4 -40% 3% 3% 19% -16 -9 84 -29 -75 6.9 x 6.6 x 5.4 x Food 4 6% 4% 15% 11% -60 46 120 14 -75 4.6 x 4.0 x 3.4 x General Industrials 12 -14% 1% -25% 8% 49 25 77 -330 -73 4.0 x 4.5 x 3.9 x Media 7 -10% 1% -16% 7% 60 41 71 20 -69 4.7 x 5.6 x 5.1 x Retail 4 -2% 1% -11% 4% 226 198 57 -35 16 4.6 x 5.0 x 4.9 x Telecoms 6 -2% 0% 0% 7% 178 129 248 -45 -231 4.3 x 4.3 x 3.7 x Revenue < €1,000m 8 -6% 5% -21% 12% -4 -15 22 10 -10 4.0 x 5.1 x 4.5 x €1,000m - €5,000m 31 -8% 1% -9% 8% 28 66 93 -87 -79 4.3 x 4.6 x 4.1 x > €5,000m 12 -15% 0% -13% 6% 191 176 240 -466 -336 3.4 x 3.6 x 3.2 x Rating BB 6 -6% -1% -16% 3% 209 309 228 -212 104 1.7 x 1.9 x 1.9 x B 29 -9% 2% -10% 10% 43 59 129 -197 -215 4.1 x 4.3 x 3.6 x CCC 13 -30% 2% -3% 6% 36 37 64 -27 -20 6.8 x 7.0 x 6.5 x NR 3 -4% 0% -6% 3% 128 183 95 -237 -63 1.0 x 0.4 x 0.3 x Source: J. P. Morgan estimates, company data. Some sectors are excluded because of too few companies.

Default forecast: steady as she goes We stick with our 6-7% target for 2010 We are comfortable with our 6% target for European high yield default rates in 2009, even though some measures show a slightly greater figure to-date. Stripping out the eastern European corporates not in our index, and ignoring some of the opportunistic “distressed” exchanges that we don’t feel can be justified as defaults, then we suspect that the final tally may even come in below 6%! Nonetheless, the spirit of our argument was that the European market would take its pain over a longer timeframe than the US, given the willingness of lenders to allow struggling businesses time to earn their way out of trouble, for example by amending covenants (Figure 61). The flip-side is that defaults are likely to remain stickier in Europe - tracing out a plateau rather than a peak, hence our 6-7% default forecast for 2010.

The flip-side is that defaults are likely to remain stickier in Europe - tracing out a plateau rather than a peak, hence our 6-7% default forecast for 2010

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Figure 61: European Leveraged Loan Covenant Amendments

0

510

1520

25

1Q06 1Q07 1Q08 1Q09

Source: S&P LCD.

“Amend and Extend” has been successful in allowing some of the deep Cyclicals to ride out the trough in the economy and allow them to catch the upswing. Ineos is a great example of this, even though it’s too early to say that liquidity concerns will not materialise again. This theme has led some commentators to conclude that default rates could fall sharply in 2010, remaining low for some years as companies use the current market environment as an opportunity to term-out their liabilities further.

There are however a number of situations where no amount of delay will change the ultimate outcome. Take industries in secular decline such as Directories: even though a Truvo (World Directories) does not have liquidity or covenant problems, a restructuring is likely sooner, rather than later, we believe. Other businesses that are leaking cash because of excessive debt loads and weak operating performance will also need to take corrective action; Wind Hellas is a topical case in point. These two cases have been well-flagged for some time now, but we believe there will be a steady drip of other casualties despite the best intentions of lenders.

Speaking of lender behaviour, it is quite possible that senior lenders begin to take a harder line in the future than they have done so far. Earlier in the year, low equity multiples and uncertainty over bankruptcy outcomes made it risky not to give solvent companies covenant waivers and amendments; booking a fee and margin uplift was a relatively safe option. Now valuations are higher and more experience of the court-mandated restructuring is available, particularly in jurisdictions like the UK which are viewed as being friendly to secured creditors. On this note, it will be interesting to see whether the UK Government refines the tools for dealing with insolvent companies, such as allowing an automatic stay and the means to put in new super-priority financing, as discussed in correspondence with the European High Yield Association earlier this year.

“Amend and Extend” has been successful in allowing some of the deep Cyclicals to ride out the trough in the economy and allow them to catch the upswing

Earlier in the year, low equity multiples and uncertainty over bankruptcy outcomes made it risky not to give solvent companies covenant waivers and amendments

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The Future of Credit Derivatives • Product standardisation, CDS auction settlement, standard coupons, model

changes and central clearing all featured heavily on investors’ minds over the past year. 2009 was a year of standardisation in the CDS market which saw the biggest changes to the structure and documentation of credit derivatives since the CDS Standard Terms and Conditions in 2003.

• The coming year will see more central CDS clearing as market participants look to further reduce systemic risk in the system. As we move into 2010, we believe that most of the document and trading standards changes we have seen over the past year are done. The market is now likely to focus on further reducing systemic risk through the use of central clearing. We do not believe that clearing is the answer to all ills nor that take-up by clients will be a forgone conclusion.

• On the structured credit side, we believe that the structured credit machine will start to hum again in 2010. In last year’s outlook, we said that primary issuance of CSO was unlikely in 2009 as investors with hereditary positions would concentrate on restructuring and unwinding. With the market trading at less distressed levels and investors searching for yield in a low rates environment, the Phoenix may yet rise.

Product Standardisation and CDS Auctions Big Bang Possibly the biggest change to CDS over 2009 came from document standardisation in the form of the Big Bang and Small Bang protocols. In order to facilitate easier netting of outstanding notionals and reduction of CDS contract counts, the product documentation was standardised in three main areas. i) Auction settlement was mandated to ensure that contracts netted down following a credit event. ii) The determination committee was created to oversee CDS credit and succession events and to ensure that the same rules applied to all CDS contracts. iii) The effective date of a CDS contract was changed from a fixed date to a dynamic look-back period. (CD Player).

Small Bang The one area that the Big Bang did not deal with was how to use the auction following a restructuring credit event. This was more of an issue for Europe and the US, where restructuring is seen as a less frequent event and is no longer considered a credit event in standard trades. The Small Bang protocol dealt with holding an auction following a restructuring credit event and the bucketing of contracts (CD Player). This was put to the test in October when the auction to settle the Thomson restructuring event was held. While the time taken to settle the event was longer than usual given the ongoing restructuring event and private nature of the company, the auction itself went smoothly with a large amount of bonds delivered on the day being bought.

CDS Auctions High defaults in 2009 led to a large number of CDS auctions being held (Figure 62). In the US 25 auctions were held, while fewer defaults in Europe saw 8 auctions being held for European CDS. Recent defaults look likely to lead to further CDS auctions before the year is out although default rates are likely to have peaked. Overall we believe that these auctions allowed the market to remain liquid and efficient through a period of great market stress.

Credit Derivatives & Quantitative Research

Saul DoctorAC (44-20) 7325-3699 [email protected]

Abel ElizaldeAC (44-20) 7742-7829 [email protected]




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Figure 62: CDS Auctions by Quarter Number of Auctions

Number of Auctions

0

3

6

9

12

15

Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009

US EU


Standard Trading Terms and Model Changes Trading Terms Traditionally CDS were traded as Par instruments with the market spread and the fixed contract coupon being equal at the start of the trade. 2009 saw a change to this convention with the introduction of standard coupons for CDS trades. In the US the standard coupons of 100bp for investment grade and 500bp for high yield were chosen. In Europe, a larger array of fixed coupons is available 25bp, 100bp, 300bp, 500bp, 750bp and 1000bp to allow greater flexibility and the option of smaller upfront payments.

Restructuring as a credit event was also dropped from the standard US investment CDS contracts although it is still a credit event in the standard European contract.

Models Model changes played a big role for many a quant over the past year. The standard J.P. Morgan CDS model was replaced by the ISDA CDS Standard Model with the source code made freely available by ISDA. The main changes related to using a flat clean spread curve for CDS valuation and a 40% fixed recovery rate to imply a quoted spread.

Clearing One of the main drivers behind the move towards CDS product standardisation was the push by regulators throughout the world that derivatives, including CDS, be cleared through a central clearing counterparty. Following the default of Lehman Brothers, concerns about systemic risk in the financial system were highlighted and Central Clearing was raised as one way to solve this issue.

Currently, a portion of new CDS index trades are being cleared through the ICE Trust in the US and ICE Clear in Europe for trades done between members of the clearing house, primarily CDS dealers. (Other offerings for dealer and client clearing are also being examined.) Single name CDS clearing along with clearing of client positions is scheduled for Q4 2009. Clearing is not intended to replace the standard trading execution of CDS trades, however, once execution has taken place, the trade will novate and both counterparties will face the clearing house.

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The main benefit of clearing is that it allows protection of margins and collateral and also enables greater portability of positions. If one counterpart to a trade defaults, the other counterpart no longer becomes an unsecured creditor as their margin and collateral is already held in a segregated account on the clearing house. Additionally positions can be moved more easily moved from one clearing member to another since both face the clearing house and not each other.

We believe that clearing should be offered but not forced on investors who may have concerns regarding the focus of risk in one central body, the margining of positions in a segregated account and the ability to net trades of different assets on different clearing houses.

Synthetic Structured Market: 2010’s Wildcard Pressure to deliver returns in a low yield environment 2009 will not be forgotten, but is unlikely to be repeated. The levels of un-levered yield available to credit investors during 2009 will not exist in 2010. Similarly, the speed and strength of the market rally since March will not drive investors’ returns during 2010. However, the pressure on market participants to deliver returns will be higher than ever, after the losses during 2007 and 2008. Given the demand for “enhanced” credit returns during 2010, the synthetic structured market has much to offer investors going forward in our view.

The new structures need to address previous weaknesses and exploit the relative value in the current environment On the offer side, the new synthetic structured credit market needs to address investors’ concerns regarding the synthetic structures issued back in 2004-2006, both in terms of MtM and rating levels.

We think 2010 can be called “The year of the structurers”: they need to balance investors’ concerns over previous structures (MtM volatility, collateral, counterparty exposure, capital charges...) with the relative value in the current credit markets (emerging markets, financials, sovereigns...).

Structures will likely be more stable and less “optimised”: more diversified underlying portfolios, higher subordinations, thicker tranches and shorter maturities. The need for ratings will have to be revisited in a new world where all rating agencies have substantially revised and made their rating methodologies more conservative.

Products will need to target the current pockets of value in the credit markets: traditional corporate portfolios will be combined with or replaced by EM corporates, sovereigns, financials, (basis packages?) …

During 2010, the market will test the ability of structurers to meet investors’ concerns and demands via synthetic structured products. We are already seeing the first steps of this process: the first approaches from the investor community as well as the first structures from the dealers. We expect these dynamics to continue and to experience an initial trial-and-error phase where investors and structurers align demands, concerns, structures, risk and returns.

Demand will be there …

… and supply will be offered ...

… until both ends meet, probably after an iterative process which brings supply and demand one step closer at a time.

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Who’s a buyer? It is difficult to see the same buyers of CSOs during 2003-07 returning to the market first this time around. Banks may face less pressure to generate returns than to increase their capital base; additionally they are the most rating sensitive investors and, as a consequence, we do not think they will participate in the first round of synthetic structures. However, those banks that have outperformed their peers and have pockets of cash to put at work may be tempted by the new CSOs. Less rating sensitive investors such as insurance companies and asset managers are our most likely candidates to lead the demand for synthetic structures.

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Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures

Important Disclosures for Credit Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on J.P. Morgan’s website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406)

Explanation of Credit Research Ratings: Ratings System: J.P. Morgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months, the recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended risk position is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan’s Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating.

Valuation & Methodology: In J.P. Morgan’s credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral) based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit rating agencies and the market prices for the issuer’s securities. Our credit view of an issuer is based upon our opinion as to whether the issuer will be able service its debt obligations when they become due and payable. We assess this by analyzing, among other things, the issuer’s credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital investment). We also analyze the issuer’s ability to generate cash flow by reviewing standard operational measures for comparable companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuer’s balance sheet relative to the operational leverage in its business.

J.P. Morgan Credit Research Ratings Distribution, as of September 30, 2009

Overweight Neutral Underweight

EMEA Credit Research Universe 21% 53% 26% IB clients* 74% 74% 62%

Represents Ratings on the most liquid bond or 5-year CDS for all companies under coverage. *Percentage of investment banking clients in each rating category.

Analysts’ Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors and overall firm revenues. The firm’s overall revenues include revenues from its investment banking and fixed income business units.

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In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. 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Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. 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General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any

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disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMSI distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

“Other Disclosures” last revised October 26, 2009.

Copyright 2009 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.

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JP Morgan European Credit Research

Head of European Credit Research & Strategy Stephen Dulake Team Assistant www.morganmarkets.com/analyst/stephendulake Laura Hayes 125 London Wall (44 20) 7777-2280 6th Floor [email protected] London EC2Y 5AJ

High Grade and High Yield Research Groups

Energy and Infrastructure Emerging Market Corporates ABS & Structured Products Olek Keenan, CFA Victoria Miles Rishad Ahluwalia (44-20) 7777-0017 (44-20) 7777-3582 (44-20) 7777-1045

[email protected] [email protected] [email protected] www.morganmarkets.com/analyst/olekkeenan www.morganmarkets.com/analyst/victoriamiles www.morganmarkets.com/analyst/rishadahluwalia

General Industrials Allison Bellows Tiernan, CFA Gareth Davies, CFA

Nachu Nachiappan, CFA (44 20) 7777-3843 (44-20) 7325-7283 (44-20) 7325-6823 [email protected] [email protected]

[email protected] www.morganmarkets.com/analyst/allisonbellowstiernan www.morganmarkets.com/analyst/garethdavies www.morganmarkets.com/analyst/nachunachiappan

Nikolay Zhukovsky, PhD Support Analyst Nitin Dias, CFA (44-20) 7777-3475 Advait Joshi

(44-20) 7325-4760 [email protected] [email protected] [email protected] www.morganmarkets.com/analyst/nikolayzhukovsky

www.morganmarkets.com/analyst/nitindias Financials Credit Derivatives & Quantitative Research

Ritasha Gupta Roberto Henriques, CFA Saul Doctor (44-20) 7777-1089 (44-20) 7777-4506 (44-20) 7325-3699

[email protected] [email protected] [email protected] www.morganmarkets.com/analyst/ritashagupta www.morganmarkets.com/analyst/robertohenriques www.morganmarkets.com/analyst/sauldoctor

Support Analyst Christian Leukers, CFA Abel Elizalde

Nirav Bhatt (44 20) 7325-0949 (44-20) 7742-7829 [email protected] [email protected] [email protected]

www.morganmarkets.com/analyst/christianleukers www.morganmarkets.com/analyst/abelelizalde

TMT – Telecoms/Cable, Media & Technology Alan Bowe Support Analyst David Caldana, CFA (44 20) 7325-6281 Harpreet Singh

(44-20) 7777 1737 [email protected] [email protected] [email protected] www.morganmarkets.com/analyst/alanbowe

www.morganmarkets.com/analyst/davidcaldana Credit Strategy Autos & General Industrials Stephen Dulake

Andrew Webb Stephanie Renegar (44-20) 7325-5454 (44-20) 7777 0450 (44-20) 7325-3686 [email protected]

[email protected] [email protected] www.morganmarkets.com/analyst/stephendulake www.morganmarkets.com/analyst/andrewwebb www.morganmarkets.com/analyst/stephanierenegar

Daniel Lamy Malin Hedman Support Analyst (44-20) 7777-1875

(44-20) 7325 9353 Nirav Bhatt [email protected] [email protected] [email protected] www.morganmarkets.com/analyst/daniellamy

www.morganmarkets.com/analyst/malinhedman Tina Zhang

Support Analyst Consumer & Retail (44-20) 7777-1260 Amir Kumar Katie Ruci [email protected]

[email protected] (44-20) 7325-4075 www.morganmarkets.com/analyst/tinazhang [email protected] www.morganmarkets.com/analyst/katieruci Raman Singla (44-20) 7777-0350 [email protected] www.morganmarkets.com/analyst/ramansingla

Research DistributionTo amend research distribution, please contact Laura Hayes our Credit Research Administration, contact details above.

J.P. Morgan research is available at http://www.morganmarkets.com








Documents

JP Credit Outlook 2010