Credit Markets: Whats Next? Mark Attanasio Richard Cantor Joshua - - PowerPoint PPT Presentation

Credit Markets: What’s Next?

Mark Attanasio

Co-Founder and Managing Partner, Crescent Capital Group

Richard Cantor

Chief Risk Officer Moody's Corporation

Joshua Friedman

Co-Founder, Co-Chairman and Co-CEO, Canyon Partners, LLC

Mark Rowan

Co-Founder and Senior Managing Director, Apollo Global Management

Steve Tananbaum

Managing Partner and CIO, GoldenTree Asset Management

David Warren

Chief Investment Officer, Brevan Howard Credit Catalysts Fund

Michael Milken

Chairman, Milken Institute

Richard Cantor

SG Default Rate Follows HY Spread + Changes in Unemployment

Unemployment outlook, liquidity, and covenant cushions imply default rate spike unlikely

• 2%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

High Yield Spread Spec-Grade Default Rate 1-Yr Chg in Unemployment

Source: Moody’s Investors Service

Investment-Grade Default Rates Are Low For Non-Financial US Corps

Few defaults despite massive unemployment rate shock during global financial crisis

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Default within 1 Year Default within 3 Years Default within 5 Years

Source: Moody’s Investors Service

Rapid Migration Rates* for IG Non-Financial US Corps Are Low

No major accounting irregularities, litigation, or distress & few leveraging transactions

0% 1% 2% 3% 4% 5% 6% 7% 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Leveraging Transaction Industry or Company Distress Litigation Accounting Irregularity

* Rapid Migration Rates are defined as the share of investment-grade issuers downgraded by at least 5 rating notches in 12 months. Source: Moody’s Investors Service

China’s GDP Growth Rate Has Been Falling

Source: Haver, BIS, IMF

120 130 140 150 160 170 180 190 200 40 41 42 43 44 45 46 47 48 49 2006 2008 2010 2012 Investment/GDP (left scale, pp) Credit-To-GDP (right scale, pp)

Despite a High and Rising Investment Rate Funded by a Rising Debt Ratio

40 41 42 43 44 45 46 47 48 49 7 8 9 10 11 12 13 14 15 2006 2008 2010 2012 GDP Growth (left scale, pp) Investment/GDP (right scale,pp)

Managing the Deleveraging Process Will Be Challenging

Losses will likely hit private investors, bank profits, and the public sector

Source: BIS, IMF, WIND, Moody’s Investors Service

10 20 30 40 50 60 China (2012) US (2009) Japan (1990) Korea (1998)

5-Year Change in Credit/GDP, pp

1 2 3 4 5 6 Cumulative Growth in Trust Liabilities since 2007, in trillions of RMB

Steve Tananbaum

5.2% 7.4% 5.9%

Historical Default Rates for HY Bonds After 3 Years of Low Defaults

Source: Moody’s Global Speculative Grade Default Rates

0% 2% 4% 6% 8% 10% 12% 14% 16%

Global Speculative Grade Default Rates

Historical Average 4.4%

Average Default Rate 5 years after period of defaults lower than Historical Average

Loans Attractive Vs. Bonds

Source: JP Morgan as of April 17, 2014. JPM Leveraged Loan Index vs. JPM HY Domestic Bond Index. Yields are defined as yield to worst for bonds and yield to maturity for loans

High Yield Bond YTW vs. Leveraged Loan YTM The yield differential between high yield bonds and loans has narrowed materially

• 100 bps

0 bps 100 bps 200 bps 300 bps 400 bps 500 bps 600 bps 700 bps

Yield Implied Zero Spread Default Rate HY Domestic Bonds 5.33% 5.32% Leveraged Loans 5.81% 13.83% Historical Average 150 bps April 17th

• 48bps

Difference in Yields1

Emerging Market vs. Developing Economies

Source: Merrill Lynch HY Bond Index; JPM Leveraged Loan Index; GoldenTree estimates

Returns Vs. Defaults

Current Spread Default Rate Loss Severity Loss Adjusted Spread HY Bonds Leveraged Loans Student Loans Senior Debt AAA CLOs

373 bps 415 bps 175 bps 155 bps 5.0% 5.0% 0% 0% 70% 30% n/a n/a 23 bps 265 bps 175 bps 155 bps

Expected Losses

350 bps 150 bps NM NM

European Sourcing Opportunity

1. Source: RBS Macro Credit Research, September 2013 2. Source: RBS Macro Credit Research, The Revolver January 23, 2014 – European Banks: Still Too Big To Fail 3. Source: Morgan Stanley Research, Earnings reports as of April 1, 2013

646% 556% 513% 411% 312% 292% 265% 217% 200% 189% 84% Europe’s Banks Are Still Too Large

Banking System Assets Relative to GDP1

• European Banks Remain Overleveraged and we expect continued

deleveraging driven by Higher Capital Needs, EU State Aid Requirement, Funding Cost, Capital Markets Pressure – Basel III in full effect over the next 5 years – Asset Quality Review (AQR) & stress tests in 2014 – Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) phasing in over next few years

• €2.9 trillion further deleveraging (3–5 years)1 through equity raise

(if able), liability management, retained earnings, run-off, divestures

• 200
• 150
• 100
• 50

European Bank Assets to Be Cut2

Reduction in Assets Needed for Banks to meet Capital and Leverage shortfalls 345.8 222.4

3Q 2011 4Q 2012 European Bank Structured Product Exposure3

Structured Products’ Holding Still Significant

January 2013: Spanish Regional Debt

Source: S&P, Morgan Stanley, Bank of Spain, Barclays. Spain Ministry of Finance and Public Administration 1. North Rhone Westphalia, the largest state within Germany. 2. Data for New York is USD for GDP, Debt and Revenue statistics. 3. Spread over respective 10 year sovereign bond.

• 4. GDP data as of 3Q 2012.

Investment Thesis

• Macro uncertainty at the sovereign level often leads to volatility in asset prices of any debt with quasi-sovereign risk
• Pockets of opportunity exist in risk that is better protected than the underlying sovereign credit, often rated higher and trading at a discount
• One such opportunity is the relative value in certain Spanish Regional Debt where investors are still worried about the creditworthiness of Spain
• Some regions have credit ratings 2 notches better than the sovereign
• Regional debt is available with less than half debt/revenue ratios of Germany and US peers and better debt/revenue ratios than Italian peers
• Spanish regions have a constitutional priority to service debt over all other expenditures

Range of Regional Debt Statistics

Spain: Madrid Spain: Castilla y Leon Germany: NRW1 Italy: Lazio US: New York2 GDP (€bn) 185 58 568 177 1,159.5 Debt (€bn) 15.4 5.5 141.9 12.4 188.4 Revenues (€bn) 24.2 7.6 49.8 15.2 47.1 Debt/Revenue (%) 64 72 284 81 400 Spread (bps)3 400 610 40 160 58

Range of Regional Debt Statistics4

Germany US Italy France Spain Household Debt/GDP 59% 81% 51% 67% 86% Financial Debt/GDP 99% 87% 107% 174% 115% Non-financial Debt/GDP 95% 77% 115% 158% 181% Sovereign Debt/GDP 82% 90% 127% 90% 77% Total Debt/GDP 335% 336% 400% 487% 460%

Gazprom

Gazprom is the world’s largest natural gas producer. It owns and controls the gas pipeline infrastructure in Russia, is 50.01% state-owned and has a monopoly on Russian gas exports.

Characteristics

Security Senior Unsecured Bond 4.95% 2022 Asset Type Quasi Sovereign Bond Rating(1) Baa1*(-)/BBB- Current Price $89.6 1yr Target Return 11.5%

Investment Details

• Strong fundamentals with $78 billion in market capitalization, 2.4x EV/EBITDA, 2.4x P/E and 0.7x

net leverage

• Gazprom is ranked globally as:

–

#1 oil & gas company in terms of profitability: $38bn vs. $33bn Exxon, $22bn Chevron, and $21bn Petrochina

–

#2 in total barrels of oil equiv. (boe) production: 8.8 million boe/day

–

#3 based on reserves: 123 billion boe proven reserves valued at $229 billion

• Supplies 30% of Europe’s gas consumption (51% of sales)
• At a 2.4x multiple, the bonds offer asset coverage at 4.2x
• Bonds trade wide to Russia and global energy companies

Comparables

Asset Type Rating (Moody’s / S&P) EV/EBITDA Net Leverage @ Create Asset Coverage Z-spread (bps) Spread to Sovereign (bps) Gazprom Quasi-Sov Baa1/BBB 2.4x 0.6x 4.2x 415 134 Petrobras Quasi-Sov Baa1/BBB 5.5x 2.8x 2.0x 272 139 Repsol Int Corporate Baa1/BBB- 6.1x 1.7x 3.6x 94 (5) ENI SpA Corporate A3/A 3.9x 0.9x 4.5x 59 (158)

(1) Russian sovereign was downgraded by S&P from BBB to BBB- so we adjusted Gazprom to reflect sovereign ceiling.

Systemic Risk – Monolines

Monolines are being too harshly penalized because they are viewed as systemic trades. Applying relatively severe stress scenarios, Monolines still look attractive on a risk-adjusted basis MBIA AAA 5 Year CDS AGO Stock

• Future contracted revenue streams
• Defaults by Illinois, Chicago, Puerto Rico and other below IG Muni

exposure over next 5 years (assuming 65-70% recoveries)

• After 5 years, a normalized default rate of 15bps per annum  10x

historical average

• Current average muni default rate is 3bps

Assumptions Key Statistics Asset coverage that can withstand losses up to:

• 3X reserve levels – MBIA has historically been accurate with reserve

levels

• 2X GoldenTree estimates based on structured product book

evaluation; representing a significant margin of safety Yield 10.4% Spread T+ 867bps Asset Coverage 1.7x Price $23.89 Adjusted Book Value Multiple 0.48x

European CLO: Munda CLO I

CLO Tranche Overview Issued December 2007 At-Issue Rating (Current Rating) Baa3/BBB- (Ba2/B+) Price €88.05 Yield to Worst (Discount Margin) 7.3% (E+626bps) Current Coupon E+375 bps Average Life to Worst 6.0 Years Reinvestment Period End Date January 2014 Legal Final July 2024 Underlying CLO Portfolio Characteristics Underlying Portfolio Price / Ranking 92.5% / 38.4% % Immediate Defaulted 8.7% CLO Tranche Metrics Market Value Coverage 103.0% Par Value Coverage 111.3% Base Case X/X/5 Break Point 17.8% Forward 3/X/X/5 Break Point 24.5% Forward 3/5/X/X/5 Break Point 29.3% Bear Case X/X/5 Break Point 15.1%

• Managed by Munda Asset Management, Cohen &

Company’s corporate credit asset management platform in Europe

• Cohen & Company has €1.77 billion of assets in Europe,

mainly in CDOs and separately managed accounts

• Reinvestment period end just ended in January and CLO

will begin to pay down senior debt at par

Upside Return Scenarios 17.6% 15.0% 7.3% 0.0% 5.0% 10.0% 15.0% 20.0% Base 1 Yr Spread Tightening (E+338) Bear 1 Yr Spread Tightening (E+438) Yield to Maturity

ABS CDO: Lakeside 2004-1A A-1

Opportunity to buy the 1st pay tranche of a seasoned high grade ABS CDO that is a very well protected, short duration bond.

• Attractive Return Profile:

– 18.5% return potential with attractive financing, offering positive convexity & levered exposure to

hard-to-source seasoned senior / mezzanine subprime

• High Margin of Safety against Defaults:

– 151% Market Value OC (“MVOC”) vs. 135% MVOC typical AAA CLO debt – Seasoned subprime asset performance has stabilized

• Catalyst for Additional Total Return:

– Improving housing fundamentals; home price appreciation with potential for higher prepayments – Potential ratings upgrade on Class A-1 notes opens market to broader set of investors – Potential for asset sales resulting in faster pay down

Price $93.5 Risk Adjusted Yield (Base Case) 4.5% (375bps DM) Weighted Average Life 2.0yrs Total Return Potential 18 - 22% Investment Overview Investment Thesis Class A-2 Class A-1 $141.5 Transaction Overview

Capital Structure $ Millions

46.0% 23.0% 17.0% 14.0% Seasoned Subprime (2004 or earlier) Alt A TRUPS ABS CDO

Underlying Assets (% of Market Value) - $243.5 million

Mike Milken

Increase in U.S. Corporate Cash Balances

Source: Bloomberg. Notes: Data are for cash and marketable securities. Some companies are as of Q4 2013.

15 61 23 15 22 7 25 8 8 147 133 77 62 51 37 34 18 17 20 40 60 80 100 120 140

Apple +854% GE +118% Microsoft +229% Google +303% Cisco +127% Oracle +430% Pfizer +32% Merck +121% Chevron +113%

Q4 2007 Q1 2014 US$ billions

Increase in Corporate Cash Balances 2005 to 2014

Cash holdings of publicly listed companies, percent of GDP

6% 7% 17% 8% 4% 6% 9% 6% 7% 3% 1% 3% 4% 38% 36% 35% 25% 19% 15% 14% 10% 8% 8% 8% 7% 4% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

China U.K. Japan France Spain Korea U.S. Brazil Germany Italy Russia India Mexico

Q4 2005 Q1 2014

Percent of GDP

Source: Bloomberg and International Monetary Fund. Note: Includes cash and near cash items.

Japanese Companies’ Cash Stockpiles

Source: Bloomberg.

20 3 2 11 8 7 8 37 21 15 15 15 14 11 5 10 15 20 25 30 35 40

Toyota Softbank Rakuten Sony Mitsubishi Mitsui Honda Motor

2007 2013 US$ billions

0% 20% 40% 60% 80% 100%

Banks CLOs Hedge, distressed and high-yield funds Prime rates funds, financial and insurance companies

Sources: S&P LCD / JPMorgan.

Institutional investor base for non-investment grade loans

Wealth Generation

January 2013-2014YTD 0% 10% 20% 30% 40%

Japan United States Spain Switzerland France Germany Australia

Source: Bloomberg 4/15/14.

Stock market performance by nation

World stock market performance

Source: Bloomberg, April 22, 2014.

World stock market performance

Source: Bloomberg, April 22, 2014.

World stock market performance

Source: Bloomberg, April 22, 2014.

1981 2014

• 3-year loan
• $10,000 car
• 18% interest

$796* monthly payment

• 5-year loan
• $25,000 car
• 2.91% interest

$728 monthly payment

Terms of Buying a Car

Source: Bankrate. Note: 2014 data represents national overnight averages for 60 month new car loan. * = 2012 dollars

1981 2014

• 3-year loan
• $25,000 car
• 18% interest
• 5-year loan
• $25,000 car
• 2.91% interest

Interest Rates and Buying a Car

$728 monthly payment $2,006* monthly payment

Source: Bankrate. Note: 2014 data represents national overnight averages for 60 month new car loan. * = 2012 dollars

Dow Industrials: 1973-77 and 2008-14

3/28/2014

5000 7000 9000 11000 13000 15000 17000 500 600 700 800 900 1000 1100 578 on Dec. 6, 1974 6,547 on March 9, 2009 DJIA, 1973-1979 DJIA, 2008-2014

Equity market capitalization: 2009 to present

Source: Bloomberg.

Country 3/1/2009 4/15/2014 Increase U.S. (S&P 500) $6.6 T $16.9 T 155% U.K. (FTSE 100) $1.4 T $3.0 T 116% Japan (Nikkei 225) $1.6 T $2.6 T 58% Germany (DAX) $583 B $1.3 T 116% Mexico (Bolsa IPC) $115 B $337 B 193%

Many advanced economies are struggling with high debt and excessive leverage

Source: Federal Reserve Bank of St. Louis (2013). .

58% 59% 81% 90% 95% 95% 204% Germany Italy U.S. South Korea Canada Australia U.K.

Household Debt (% of GDP)

European Credit is a Bank Market

Sources: ECB

Bonds and loans as a share of total corporate debt

0% 20% 40% 60% 80% 100%

Spain Germany Ireland Portugal Italy France UK

Bonds Loans

EU vs U.S. Total Banking System Assets

(% of GDP))

Data as of 2011. Sources: World Bank’s Financial Development and Structure.

724% 723% 396% 338% 335% 309% 270% 220% 85%

Assets of the 4 Biggest Banks (% of GDP, 2013)

Sources: Bankscope, IMF WEO, Milken Institute. U.S. ratio reflects IFRS accounting treatment for derivatives; under GAAP, the ratio is 47%.

375% 313% 243% 241% 182% 181% 157% 122% 112% 65%

Sovereign Debt Defaults

Sources: This Time is Different Chartbook: Country Histories on Debt, Default, and Financial Crises, Carmen M. Reinhart / Milken Institute

• 1828
• 1898
• 1902
• 1914
• 1931
• 1937
• 1961
• 1964
• 1983
• 1986
• 1990
• 1832
• 1868
• 1911
• 1914
• 1931
• 1982
• 1999
• 2008
• 1876
• 1915
• 1931
• 1940
• 1959
• 1965
• 1978
• 1982
• 2000
• 1826
• 1848
• 1860
• 1865
• 1892
• 1898
• 1983
• 1990
• 1995
• 1998
• 2004

Brazil Ecuador

• 1839
• 1885
• 1917
• 1918
• 1947
• 1957
• 1991
• 1998

Russia

• 1826
• 1843
• 1852
• 1893
• 1932
• 2011

Greece Turkey Venezuela

• 1982
• 1986
• 1992
• 2001
• 2004

Nigeria

U.S. vs. Europe high yield debt markets

56 39 7 41 61 66 89 128 147 136 43 148 264 224 329 336 50 100 150 200 250 300 350 400 2006 2007 2008 2009 2010 2011 2012 2013 Europe U.S.

Issuance, US$ billions

Source: SIFMA. Note: Data as of Q3 2013. Europe includes Western and Eastern Europe.

Historical Growth of U.S. High-Yield Market

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1972 1976 1980 1984 1988 1992 1997 2001 2005 2009 2013

Sources: Edward Altman; FitchRatings

US$ trillions

500 1,000 1,500 2,000 2,500

1979 1984 1988 1992 1996 2000 2004 2009 2013

Index, December 1979 = 100

High Yield Treasuries Inflation

High-Yield Bonds vs. Inflation and Treasuries

March 31, 2014.

Sources: Bank of America; Merrill Lynch, March 23, 2012

Percent

• 40
• 20

20 40 60 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD

High-Yield Annual Returns 2004 - 2014

Milken Institute

Global corporate bond issuance

0.0 1.0 2.0 3.0 4.0 5.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US$ trillions

Source: Bloomberg.

Global high-yield corporate bond issuance

100 200 300 400 500 600 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US$ billions

Source: Bloomberg.

Global high-yield bond market has surpassed $2 trillion

0.4 0.8 1.2 1.6 2

Source: BofA Merrill Lynch Global High-Yield.

Market value, US$ trillions

U.S. high-yield bond market

Market value 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1971 1975 1979 1983 1987 1991 1996 2000 2004 2008 2012

Source: Edward Altman; BofA Merrill Lynch U.S. High-Yield Master II Index (market value); data as of April 2014.

US$ trillions

Global real short-term interest rates

Source: Datastream, IMF, Milken Institute. Note: 3-month interest rates: Canada, China, France, Germany, Italy, Japan, United Kingdom, United States; Weighted by GDP.

• 3
• 2
• 1

1 2 3 4 5 1996 1998 2000 2002 2004 2006 2008 2010 2012 2013 Q4 3-month real interest rate, percent

Real short-term interest rates

Sources: Datastream, OECD Statistics, Oxford Economics.

Percent

• 6
• 4
• 2

2 4 6 8 10 12 1998 2002 2006 2010 China Japan U.S. Eurozone UK Percent

Central bank assets

2 4 6 8 10 2006 2007 2008 2009 2010 2011 2012 2013 BoE BoJ Fed ECB US$ trillions

Source: Datastream.

Central bank target interest rates in advanced countries remain low

Source: Bloomberg.

1 2 3 4 5 6 2007 2008 2009 2010 2011 2012 2013 2014 Policy rate, percent United Kingdom Eurozone Japan United States

Seven-year asset class real return forecasts

As of April 2013 5.4 4.3 2.5 2.1 1 0.7 0.5 0.3

• 0.4
• 1.3
• 2.3
• 5
• 6
• 5
• 4
• 3
• 2
• 1

1 2 3 4 5 6

Timber Emerging equity Emerging debt U.S. high quality equity Int'l large cap equity Inflation linked bonds U.S. bonds Int'l small cap equity Cash U.S. large cap equity Int'l hedged bonds U.S. small cap equity Percent

Source: GMO.

10-year U.S. Treasury yield

Source: Bloomberg.

2 4 6 8 10 12 14 16 18 1964 1971 1978 1985 1992 1999 2006 2013 Percent Average: 6.6 percent

Long-term U.S. Treasury yields have dropped

Treasury yield curves 1 2 3 4 5 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y Percent 1/1/14 3/28/14

Source: Bloomberg.

Foreign holdings of U.S. Treasuries

Three largest holders 200 400 600 800 1,000 1,200 1,400 2007 2008 2009 2010 2011 2012 2013 Japan Belgium US$ billions China

Source: Datastream.

Markets are pricing in lower sovereign yields in a year

10-year sovereign bonds

1 1.5 2 2.5 3 3.5 2012 2013 2014 U.K. 1 year forward rates, percent Eurozone U.S.

Source: Bloomberg.

Total U.S. credit market debt

10 20 30 40 50 60 70 '45 '49 '53 '57 '61 '65 '69 '73 '77 '81 '85 '89 '93 '97 '01 '05 '09 '13 US$ trillions Total credit market debt outstanding GDP Debt/GDP (1950-1980): 1.5 Debt/GDP (2013): 3.5+

Source: Federal Reserve, BEA. Note: Total credit market debt includes that owed by domestic nonfinancial, the financial sectors, and the rest of the world.

U.S. corporate bond issuance

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 YTD Investment Grade High Yield Issuances, US$ trillions

Source: SIFMA.

U.S. corporate bond average maturity extended

6 7 8 9 10 11 12 13 14 1996 1999 2002 2005 2008 2011 2014 Years

Source: Bloomberg.

U.S. high-yield corporate bond yield

5 10 15 20 25 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Percent

Source: Bloomberg. Note: Bank of America Merrill Lynch U.S. HY Master II.

100 200 300 400 500 600 700 2006 2007 2008 2009 2010 2011 2012 2013 2014 Basis points A rated

Source: Bloomberg.

Corporate bond spreads near lows

Corporate bond spreads over U.S. Treasuries BBB rated

IG corporate bond spreads: U.S. vs Eurozone

75 125 175 225 275 325 2010 2011 2012 2013 2014 Option-adjusted spreads, bps U.S. IG EUR IG

Source: Bloomberg.

The premium paid for high-yield corporate bonds in U.S. and Eurozone

150 250 350 450 550 650 750 2010 2011 2012 2013 2014 Option-adjusted spreads, bps U.S. IG-HY spread EUR IG-HY spread

Source: Bloomberg.

Default levels remain low

2 4 6 8 10 12 14 16 18 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Historic global single B default rates, percent

Sources: Bloomberg, Bond Vigilantes.

LT avg: 5.2% 10-yr avg: 1.9%

High-yield credit rating upgrades have outnumbered downgrades

1 2 3 4 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Ratio of credit rating upgrades to downgrades LT average: 0.7 Q4 2013: 1.2

Sources: Bloomberg, Datastream, JPMorgan, IIF.

Negative bias fell to a new low in Q4 2013

5 10 15 20 25 30 35 40 45 50 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Proportion of high-yield companies with negative credit outlooks Q4 2013: 12%

Source: S&P.

Markets are pricing in further ECB easing

3-month Euribor futures 1 2 3 4 2013 2014 2015 2016 2017 2018 2019 Euribor 3M, 3/28/14 Percent Euribor 3M, 12/31/13

Source: Bloomberg.

German sovereign bond spreads have tightened

Spread of 10-year Bunds over 2-year Bunds

• 50

50 100 150 200 250 2008 2010 2012 2014 Bps

Source: Bloomberg.

European peripheral sovereign default risks have fallen

Sovereign 5-year credit default swap rates 40 140 240 340 440 540 640 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Index, 100=4/18/13 Portugal Italy Ireland Spain

Source: Bloomberg.

Corporate default risks across the EU have fallen

5-year credit default swap rates 50 60 70 80 90 100 110 120 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Index, 100=1/18/13 Euro HY Euro IG

Source: Bloomberg. Note: The Markit iTraxx Europe index is composed of entities incorporated in the EU and EFTA member countries.

Nonbank direct loans to European companies increase

10 20 30 40 50 60 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Deal count

Source: Deloitte.

France 25% U.K. 50% Germany 11% Rest of Europe 14% Deal location

Most European alternative lending deals are LBO-related

5 10 15 20 25 30 35 40 45 50 LBO Dividend recap Refinancing Bolt-on M&A Growth capital U.K. Euro Deal purpose, percent

Source: Deloitte.

Unitranche is a popular structure for European direct lending

5 10 15 20 25 30 35 40 45 50 Senior Unitranche Second lien Mezzanine PIK/other U.K. Euro First lien Deal structure, percent

Source: Deloitte. Note: “PIK” refers to payment in kind lending.

EM corporates are raising more international debt

100 200 300 400 500 600 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 Latin America & Caribbean Asia & Pacific Europe Africa & Middle East Outstanding, US$ billions

Source: BIS. Note: Non-financial corporate international debt securities outstanding.

China’s debt is on the rise

• 10

10 20 30 40 50 60 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 RMB trillions Non-bank debt Bank loans

Source: Datastream. Note: “Non-bank debt” refers to entrusted loans, trust loans, bank acceptance, and corporate bond financing.

Decline in China’s NPL to total loans ratio

5 10 15 20 25 30 35 40 10 20 30 40 50 60 70 80 Total loans RMB trillions Non-performing loans, percent of total

Sources: Economist, Bloomberg.

China relies on increasing domestic credit to support growth

2 4 6 8 10 12 100 110 120 130 140 1997 2000 2003 2006 2009 2012 Percent of GDP Current account balance Domestic credit to private sector Percent of GDP

Source: World Bank.

China dim sum bond issuance

By country 5 10 15 20 25 30 35 40 45 2011 2012 2013 2014 US$ trillions China Hong Kong Other

Source: Bloomberg.

CNYs onshore-offshore funding costs converge

6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 Percent Onshore CNY Offshore CYN

Source: Bloomberg.

Financial issuers have dominated the dim sum bond market

5 10 15 20 25 30 35 40

Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014

Issuance, US$ billions Other sectors Financials

Source: Bloomberg.

A bulk of total lending goes to support Chinese real estate

Top 10 industries 5 10 15 20 25 10 20 30 40 50 60 70 US$ billion Percent

Source: Bloomberg. Note: “M&M” refers to metals and mining, and “Govt” refers to local and regional government. Only loans from ICBC, Bank of China, BoAg, BoCom, China Construction Bank, China Merchants, Minsheng, Everbright, and Citic are included.

Total loan tranche size (left) Market share (right)

China’s biggest maturing loans concentrated in real estate

64 14 42 41 17 5 19 10 20 30 40 50 60 70 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Percent of total expiring loans

Source:

Importance of China’s property market to wider economy

16 33 20 26 39 5 10 15 20 25 30 35 40 45 GDP Fixed asset investment Outstanding loans New loans Government revenues Property market, percent of each category

Source: Nomura.

Non-loan credit extension has accelerated substantially

China, moving 12-month average 2 4 6 8 10 12 14 16 18 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 RMB billions RMB loans Alternative financing Social financing

Sources: PBOC, Datastream.

Chinese banks’ wealth management products continue to rise

Assets under management 20 40 60 80 100 120 Q3 2010 Q1 2011 Q3 2011 Q1 2012 Q3 2012 Q1 2013 Q3 2013 CNY billions

Sources: CEIC, Standard Chartered.

WMP Deposits

Lack of access to bank loans for small and medium-sized enterprises in China

99 60 80 10 1 40 20 90 20 40 60 80 100 Proportion of enterprises GDP Proportion of employees Access to bank loans Small and medium-sized enterprises Large enterprises Percent

Sources: China Association of Small and Medium Enterprises, Milken Institute.

Puerto Rico bond yields

10-year municipal bond yields 2 4 6 8 10 12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 Percent Puerto Rico B AA A

Source: Bloomberg.

U.S. municipal bonds issuance

50 100 150 200 250 300 350 400 450 500 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 YTD Issuance, US$ billions

Source: SIFMA.

U.S. municipal bond holdings

Outstanding 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 Individuals Mutual Funds Banking Institutions Insurance Companies Other US$ trillions

Source: SIFMA.

U.S. average municipal bond maturity

15 16 17 18 19 20 21 22 1996 1999 2002 2005 2008 2011 2014 Years

Source: SIFMA.

Banks vs. non-bank banks

G-20 countries 400 800 1,200 Total assets, percent of GDP Non-bank banks Banks

Source: Financial Stability Board.

Assets of non-bank financial intermediaries

G-20 member countries 10 20 30 40 50 60 70 80 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$ trillions

Source: Global Shadow Banking Monitoring Report 2013, Financial Stability Board.

U.S. commercial bank lending and leasing grow

• 100
• 80
• 60
• 40
• 20

20 40 60 80 100 120 2007 2008 2009 2010 2011 2012 2013 Quarterly change, percent

Source: FDIC.

Stronger U.S. demand for commercial and industrial loans

• 80
• 60
• 40
• 20

20 40 60 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Percent of banks reporting stronger C&I demand Small firms Medium and large firms

Source: FDIC.

Fewer U.S. banks increased lending rates

• 80
• 60
• 40
• 20

20 40 60 80 100 120 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 Percent of banks increasing loan rates over cost of funds To medium and large firms To small firms

Source: FDIC.

U.S. commercial and industrial loan standards

• 40
• 20

20 40 60 80 100 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 Percent of banks tightening C&I lending standards To medium and large firms To small firms

Source: FDIC.

European companies have borrowed more from U.S. loan market

By currency of loan deal 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 USD EUR GBP Other Percent

Source: Bloomberg. Note: Loans include first lien leveraged loan tranches, excluding revolvers and term loan A.

U.S. vs. European leveraged loan performance

55 60 65 70 75 80 85 90 95 100 105 2007 2008 2009 2010 2011 2012 2013 2014 Index, 100=1/1/07 Europe U.S.

Source: S&P, Bloomberg. Notes: S&P/LSTA U.S. Leveraged Loan Index, S&P European Leveraged Loan Index.

U.S. vs. European leveraged loan issuance

50 100 150 200 250 300 350 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 US Euro US$ billions

Source: Bloomberg.

European leveraged loan issuance

By currency of issuance 20 40 60 80 100 120 140 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 EUR GBP USD Other US$ billions

Source: Bloomberg.

More subordinated debt issuance in Europe

By largest issuers 10 20 30 40 50 60 70 80 90 100 2007 2008 2009 2010 2011 2012 2013 2014 YTD Other U.K. France Italy Spain Germany US$ billions

Source: Bloomberg.

Covenant-lite loans increase in the U.S.

100 200 300 400 500 600 2010 2011 2012 2013 2014 Covenant-lite Other leveraged loans Number of loans

Source: Bloomberg.

Global CDOs outstanding

200 400 600 800 1,000 1,200 1,400 1,600 2006 2007 2008 2009 2010 2011 2012 2013 CDO CLO SF Other US$ billions

Source: SIFMA.

Re-emergence of CMBS

Commercial mortgage-backed securities issuance, U.S. and non-U.S. 50 100 150 200 250 300 350 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US$ billions U.S.

Source: Bloomberg.

Non-U.S.

Fannie, Freddie, and Ginnie Mortgage debt outstanding

1 2 3 4 5 6 7 1990 1995 2000 2005 2010 US$ trillions Ginnie Mae Freddie Mac Fannie Mae

Source: SIFMA.

Investors are buying corporate bonds while dealers retreat

100 200 300 400 500 600 700 800 900 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 IG and HY bonds, US$ billions Dealer inventory Including ETFs Mutual fund assets

Sources: Citi, ICI, NY Fed, Bloomberg, Haver Analytics, U.S. Department of the Treasury.

Fixed income capital costs increase under Basel III

1 x 1 x 1 x 1 x 3.4 x 5.0 x 0.0 x 1.0 x 2.0 x 3.0 x 4.0 x 5.0 x 6.0 x Investment grade High yield Basel I Basel II Basel III Risk-weighted asset charges

Sources: Citi, U.S. Department of the Treasury.

Fewer large trades in bond markets

20 40 60 80 100 2005 2006 2007 2008 2009 2010 2011 2012 2013 Block trades (>$5m) Block trades ($1-$5m) Percent of total traded volume

Sources: FINRA TRACE, Milken Institute.

Block trades of bonds are becoming smaller

5 10 15 20 25 30 35 2005 2006 2007 2008 2009 2010 2011 2012 2013 Average block trade size, U.S. IG, US$ millions

Sources: Citi, FINRA TRACE, Bloomberg, U.S. Department of the Treasury.

Liquidity is moving toward Treasuries

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 Treasury Federal Agency Securities Agency MBS Other Distribution of daily market turnover, percent

Sources: Citi, SIFMA, U.S. Department of the Treasury.

Investors moving away from Treasuries

• 40
• 20

20 40 60 80 100 120 2008 2009 2010 2011 2012 Govt IG HY Net mutual fund sales, US$ billion

Sources: Citi, ICI, Haver Analytics, U.S. Department of the Treasury.

Total net assets and number of ETFs

200 400 600 800 1,000 1,200 1,400 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Total net assets, US$ trillions Count 1940 Act ETFs (left) Non-1940 Act ETFs (left) Number of ETFs (right)

Source: ICI. Note: The majority of ETFs are 1940 Act ETFs, which are regulated by the SEC under the Investment Company Act of 1940.

Demand for ETFs has increased

Net issuance of ETF shares 20 40 60 80 100 120 140 160 180 200 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$ billions Non-1940 Act ETFs 1940 Act ETFs

Source: ICI. Note: Most ETFs are 1940 Act ETFs, which are regulated by the SEC under the Investment Company Act of 1940. “Net issuance” refers to the total dollar amount of shares issued/created by an ETF sponsor, less the total dollar amount of shares redeemed by the ETF sponsor.

Issuance of ETF shares

By investment classification 28 10 42 30 8 35 10 24 46 3 58 14 52 53 9 10 20 30 40 50 60 70

Broad-based domestic equity Domestic sector equity Global/International equity Bond and hybrid Commodities

2010 2011 2012 US$ billions

Source: ICI. Note: Most ETFs are 1940 Act ETFs, which are regulated by the SEC under the Investment Company Act of 1940. “Net issuance” refers to the total dollar amount of shares issued/created by an ETF sponsor, less the total dollar amount of shares redeemed by the ETF sponsor.

Bond funds are the majority of the closed-end fund market

Percent of closed-end fund total net assets Domestic equity 26% International equity 12% Domestic taxable bond 21% Domestic municipal bond 34% International bond 7% Total closed-end fund net assets: $265 billion, as of 2012

Source: ICI. Note: Net assets are total assets minus total liabilities.

Closed-end fund total net assets have increased

50 100 150 200 250 300 350 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 US$ billions Bond closed-end funds Equity closed-end funds

Source: ICI. Note: Net assets are total assets minus total liabilities.

Household net investments in funds, bonds, and equities

• 1100
• 900
• 700
• 500
• 300
• 100

100 300 500 700 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Funds Directly held bonds Directly held equities US$ billions

Source: ICI. Note: Net new cash flow and reinvested interest and dividends are included.

Funds channel investment to stock, bond, and money markets

5 10 15 20 25 30 35 40 45

U.S. corporate equity U.S. and international corporate bonds U.S. Treasury and government agency securities U.S. municipal securities Commercial paper

Percentage of total fund holdings Mutual funds Other funds

Source: ICI. Note: As of 2012.

Cash flow into bond funds is highly related to bond returns

• 10
• 5

5 10 15 20

• 2
• 1

1 2 3 1998 2000 2002 2004 2006 2008 2010 2012 Percent of total net assets Percent Total return

• n bonds (right)

Net new cash flow (left)

Source: ICI.

Source: Bloomberg.

1 2 3 4 5 6 2000 2002 2004 2006 2008 2010 2012 2014 Net debt-to-EBITDA

S&P 500 leverage has fallen

US households reduce financial obligations

Debt service ratio as a percent of disposable income

Sources: Federal Reserve Board, IHS Global Insight.

4 5 6 7 8 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Percent Consumer debt Mortgage debt

Household debt falls

Percent of disposable personal income 9 10 11 12 13 14 1997 1999 2001 2003 2005 2007 2009 2011 2013 Percent

Sources: Federal Reserve, IHS Global Insight.

US consumer outstanding credit

Extended to household and personal expenditures, annual change

Sources: Federal Reserve, IHS Global Insight.

• 6
• 4
• 2

2 4 6 8 10 12 14 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Percent, annual change

The composition of the U.S. household debt balance

2 4 6 8 10 12 14 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Mortgage Auto loan HE revolving Credit card Student loan Other US$ trillions

Source: IHS Global Insight.

Historical trend of U.S. household financial obligation ratio

US household financial obligation ratio 13 14 15 16 17 18 19 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Percent of disposable income

Source: IHS Global Insight.

U.S. debt outstanding by sector (% of GDP)

20 40 60 80 100 120 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Percent Households Government Financial sector Non-financial business

Source: Federal Reserve.

U.S. corporate profits hit record high

0.0 0.5 1.0 1.5 2.0 2.5 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 US$ trillions

Source: BEA, Bloomberg. Note: U.S. corporate profits without IVA and CCA profits before tax, seasonally.