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? CFA Victoria - 1 -
Current High Yield Default Rates at Cyclical Lows S&P Default Rate (by % of Issuers) in U.S. High Yield Market 14% 12% 11% 10% 8% 6% 4% 1% 2% 0% 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 CFA Victoria - 2 -
Risk Premiums at Historic Low Levels ML High Yield Master Spread over 10-year Treasuries 1,200 1,000 Spread in Basis Points 800 600 400 +298 bps 200 0 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 Source: credit\credit pres…(ML master …) 12/31/06 CFA Victoria - 3 -
Cautious Over the Corporate Bond Market Yield Spreads Relative to Canadas* 3.0 BBB Yield Spreads A Yield Spreads 2.5 AA Yield Spreads Yield Spread (%) 2.0 1.5 1.0 1.0% 0.6% 0.5 0.4% 0.0 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 * Source: SC Mid-Term Bond Index Source: bonds/charts/credit…/bbb&aa … 1/17/07 CFA Victoria - 4 -
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) CFA Victoria - 5 -
Ongoing Support from Global Liquidity Global Liquidity Growth: Stabilizing? World Central Bank Reserves + US Monetary Base 40 35 30 Year-over-year % change 25 20 15 10 5 0 -5 -10 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: IMF, US Federal Reserve CFA Victoria - 6 -
Volume of LBO Activity (in Billions) Announced U.S. LBO Activity $140 $120 $100 $80 $60 $40 $20 $0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 9M 2006 Source: credit\credit presentation 2007 CFA Victoria - 7 -
LBO Leverage Approaching Previous Peak Levels Average Debt to Cashflow Ratio at Companies Acquired in LBOs 6.0x 5.5x 5.0x 4.5x 4.0x 3.5x 3.0x 1999 2000 2001 2002 2003 2004 2005 1H06 Source: Standard & Poor’s Source: credit\credit presentation 2007 CFA Victoria - 8 -
Proportion of CCC-Rated High Yield Issuance Maintaining Peak Levels CCC-Rated High Yield Issuance as % of Total High Yield Issuance 25% 20% 15% 10% 5% 0% 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: credit\credit presentation 2007 CFA Victoria - 9 -
Structured Credit Products Pose Significant Systemic Risks The marginal buyers of credit risk today are structured vehicles � such as collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs). The boom in CDO issuance underpins much of the current credit � landscape including: LBO-driven leveraged loans and high yield bonds � � sub-prime mortgages infrastructure financing � � emerging market debt CFA Victoria - 10 -
CDO Structure Creating Varied Levels of Credit Exposure % of Capital Tranche Structure Rating Coupon Super Senior 77.5% AAA LIBOR +26 bps Senior 9.0% A LIBOR +75 bps Mezzanine 2.75% BBB LIBOR +180 bps Junior Mezzanine 2.75% BB LIBOR +475 bps Equity 8.0% NR Residual cash flow � Low quality debt can be repackaged to create AAA- rated securities Permits investors to select desired level of credit exposure � However, ratings often driven by quantitative models rather than � fundamental analysis Source: Douglas Lucas, “The Evolving CDO Market” Merrill Lynch, Credit Derivatives Handbook 2006 CFA Victoria - 11 -
CDOs – Big Business in Fixed Income Markets Issuance ($ billions, USD) 1200 $1,059.9 CDOs 1000 Corporate Bonds $797.1 800 $759.8 600 $488.6 400 $249.3 200 $157.4 0 2004 2005 2006 Source:SIFMA CFA Victoria - 12 -
So Much Rests on So Little Inverted Investment Pyramid $1.1 trillion High Yield Market $400 billion Levered Loan Market -$350 billion CLO Market $125 bn Private Equity Uninvested Capital -$66 bn CLO, Mezz & Equity Source: Morgan Stanley CFA Victoria - 13 -
Extraordinary Growth in Credit Default Swaps CDS Market, National Amounts Outstanding ($ trillions, USD) � By comparison, global corporate 25 bond market as at June 30, 2006 was $5.6 T. $20.4 20 15 $10.2 10 $6.4 5 0 Dec 31 2004 Dec 31 2005 June 30 2006 Source: BIS CFA Victoria - 14 -
CDS – What Are They? Buy a Corporate Bond Buy a Credit Swap “Get a Bundle of Risks” “Isolate One Risk” Credit Risk Credit Risk Only Funding Risk (Swap Spread Risk) Risk Free Rate CFA Victoria - 15 -
CDS – How Do They Work? Before Credit Event Quarterly fixed fee/premium Quarterly fixed fee/premium Protection Buyer Protection Seller Zero Upon Credit Event Fixed Payments Stop Protection Buyer Protection Seller Defaulted Bond Par Value CFA Victoria - 16 -
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 CFA Victoria - 17 -
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 � of 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 CFA Victoria - 18 -
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) CFA Victoria - 19 -
Investment Management Presentation to CFA Victoria April 10, 2007 Presented by: Damon Williams, Vice President
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