Current Credit Environment On the surface all looks good - - PowerPoint PPT Presentation

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Current Credit Environment On the surface all looks good - - PowerPoint PPT Presentation

May 18, 2023 427 likes •648 views

Current Credit Environment On the surface all looks good Corporate balance sheets remain healthy Corporate earnings are high Unemployment and inflation are low Default rates are at record low levels More liquid debt

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SLIDE 1

CFA Victoria

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Current Credit Environment

On the surface all looks good

  • Corporate balance sheets remain healthy
  • Corporate earnings are high
  • Unemployment and inflation are low
  • Default rates are at record low levels
  • More liquid debt market than ever
  • High investor confidence
  • New debt structures and instruments
  • A great time to be a credit investor……or is it?
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SLIDE 2

CFA Victoria

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11% 1%

Current High Yield Default Rates at Cyclical Lows

S&P Default Rate (by % of Issuers) in U.S. High Yield Market 0% 2% 4% 6% 8% 10% 12% 14% Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Source: credit\credit presentation 2007

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SLIDE 3

CFA Victoria

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+298 bps

Risk Premiums at Historic Low Levels

ML High Yield Master Spread over 10-year Treasuries

Source: credit\credit pres…(ML master …) 12/31/06

200 400 600 800 1,000 1,200 Sep-86 Sep-87 Sep-88 Sep-89 Sep-90 Sep-91 Sep-92 Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Spread in Basis Points

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SLIDE 4

CFA Victoria

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Cautious Over the Corporate Bond Market

Yield Spreads Relative to Canadas*

Source: bonds/charts/credit…/bbb&aa … 1/17/07

* Source: SC Mid-Term Bond Index

0.0 0.5 1.0 1.5 2.0 2.5 3.0 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Yield Spread (%) BBB Yield Spreads A Yield Spreads AA Yield Spreads 1.0% 0.6% 0.4%

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SLIDE 5

CFA Victoria

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Sampling of Current Risk Premiums versus Previous Peaks

Canadian BBB/BB Issuers (5-year New Issue Spreads)

Jan 2007 Sept 2002

BCE +60 +250 Telus +55 +2000 Fining +75 +250 Rogers Cable +150 +500 Cogeco Cable +175 +550 Shaw Comm. +150 +450

Global Issuers

Country Maturity Jan 2007 Sept 2002

Brazil 2012 +95 +1675 Colombia 2012 +120 +875 Mexico 2012 +70 +290 Peru 2012 +90 +775 Philippines 2010 +100 +500 Russia 2010 +70 +510 Lebanon 2016 +450 +1250 Venezuela 2018 +225 +1100 Iraq 2028 +550 N/A (deal issued Jan/06)

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SLIDE 6

CFA Victoria

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Global Liquidity Growth: Stabilizing? World Central Bank Reserves + US Monetary Base

Source: IMF, US Federal Reserve

Ongoing Support from Global Liquidity

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5 10 15 20 25 30 35 40 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Year-over-year % change

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SLIDE 7

CFA Victoria

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Volume of LBO Activity (in Billions)

Source: credit\credit presentation 2007

Announced U.S. LBO Activity $0 $20 $40 $60 $80 $100 $120 $140 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 9M 2006

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SLIDE 8

CFA Victoria

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LBO Leverage Approaching Previous Peak Levels

Source: Standard & Poor’s

Average Debt to Cashflow Ratio at Companies Acquired in LBOs

Source: credit\credit presentation 2007

3.0x 3.5x 4.0x 4.5x 5.0x 5.5x 6.0x 1999 2000 2001 2002 2003 2004 2005 1H06

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SLIDE 9

CFA Victoria

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Proportion of CCC-Rated High Yield Issuance Maintaining Peak Levels

CCC-Rated High Yield Issuance as % of Total High Yield Issuance 0% 5% 10% 15% 20% 25% 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: credit\credit presentation 2007

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SLIDE 10

CFA Victoria

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Structured Credit Products Pose Significant Systemic Risks

  • The marginal buyers of credit risk today are structured vehicles

such as collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs).

  • The boom in CDO issuance underpins much of the current credit

landscape including:

  • LBO-driven leveraged loans and high yield bonds
  • sub-prime mortgages
  • infrastructure financing
  • emerging market debt
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SLIDE 11

CFA Victoria

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CDO Structure

Creating Varied Levels of Credit Exposure

Super Senior 77.5% AAA LIBOR +26 bps Senior 9.0% A LIBOR +75 bps Mezzanine 2.75% BBB LIBOR +180 bps Junior Mezzanine 2.75% BB LIBOR +475 bps Equity 8.0% NR Residual cash flow

% of Capital Tranche Structure Rating Coupon

Source: Douglas Lucas, “The Evolving CDO Market” Merrill Lynch, Credit Derivatives Handbook 2006

  • Low quality debt can be repackaged to create AAA- rated securities
  • Permits investors to select desired level of credit exposure
  • However, ratings often driven by quantitative models rather than

fundamental analysis

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SLIDE 12

CFA Victoria

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CDOs – Big Business in Fixed Income Markets

Issuance ($ billions, USD) 200 400 600 800 1000 1200 2004 2005 2006 CDOs Corporate Bonds $157.4 $797.1 $249.3 $759.8 $488.6 $1,059.9

Source:SIFMA

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SLIDE 13

CFA Victoria

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So Much Rests on So Little

$1.1 trillion High Yield Market $400 billion Levered Loan Market

  • $350 billion

CLO Market

$125 bn Private Equity Uninvested Capital

  • $66 bn

CLO, Mezz & Equity

Inverted Investment Pyramid

Source: Morgan Stanley

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SLIDE 14

CFA Victoria

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  • By comparison, global corporate

bond market as at June 30, 2006 was $5.6 T.

Extraordinary Growth in Credit Default Swaps

CDS Market, National Amounts Outstanding ($ trillions, USD) 5 10 15 20 25 Dec 31 2004 Dec 31 2005 June 30 2006 $6.4 $10.2 $20.4

Source: BIS

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SLIDE 15

CFA Victoria

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CDS – What Are They?

Credit Risk Funding Risk (Swap Spread Risk) Risk Free Rate

Buy a Corporate Bond Buy a Credit Swap

“Get a Bundle of Risks” “Isolate One Risk”

Credit Risk Only

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SLIDE 16

CFA Victoria

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CDS – How Do They Work?

Protection Buyer

Before Credit Event

Protection Seller

Quarterly fixed fee/premium Zero Quarterly fixed fee/premium

Protection Buyer

Upon Credit Event

Protection Seller

Defaulted Bond Par Value Fixed Payments Stop

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SLIDE 17

CFA Victoria

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CDS and Leverage

  • CDS have dramatically improved liquidity in credit markets
  • But they also facilitate leveraged exposure to credit
  • Hedge funds are major users of CDS (possibly >50% of all CDS

trading)*

  • New structured vehicles (eg. CPDOs, CPPIs, CDPCs) involve

high degrees of leverage.

* Source: Financial Engineering News

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SLIDE 18

CFA Victoria

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Current Credit Environment – Summary

  • A number of warning signs that credit cycle entering dangerous territory:
  • record LBO activity (9 of the 10 largest LBOs in history occurred last year)
  • amount of leverage applied to recent LBOs approaching previous peaks
  • record issuance of structured credit products causing distortions in pricing
  • f credit
  • record issuance of high yield loans and CCC-rated bonds
  • At the same time, the fundamental picture growing cloudier:
  • global economy slowing
  • U.S. housing market woes
  • central banks tightening across the globe
  • Yet, risk premiums of all sorts (e.g. high yield credit spreads, emerging

market spreads and subordination premiums) are all approaching historic lows

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SLIDE 19

CFA Victoria

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Current Credit Environment – Summary (cont’d)

  • Current abundance of liquidity from Asia, petroleum producers and

hedge fund/private equity complex could allow this precarious credit environment to continue for another 12-18 months

  • Eventually, however, default rates will rise from current 20-year lows

causing an abrupt rise in risk aversion and in credit spreads

  • While corporate balance sheets are relatively healthy, the next credit

cycle could be surprisingly vicious due to:

  • role of credit derivatives and structured credit products
  • heavy issuance of secured loans making future bankruptcies or

“workouts” more complex and protracted

  • presence of hedge funds in “every layer” of the capital structure

(possibly a de-stabilizing force leading to more bankruptcies than previous cycles)

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SLIDE 20

Investment Management Presentation to CFA Victoria April 10, 2007

Presented by: Damon Williams, Vice President