US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045

Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC

AC

Collateralized Debt Obligations: 2011 Outlook

CLO prices rebounded in the second half of the year and primary supply met our $5bn target. Stay Overweight: CLOs offer some of the highest spread sector yields, and negative net supply is supportive of technicals. Risks include volatility arising from sovereign contagion and CLO-specific portfolio extension With interest rates near all-time lows and with a largely asymmetric outlook next year, CLO floaters help minimize longer-term risk to the extent investors begin to place a higher premium on floating products later in 2011. AAA CLOs are a cheap spread asset, and the combination of high current coupon and subordination in primary should be attractive to banks and real money On primary issuance, we expect $12.5bn ($1015bn) in 2011 and $25bn ($20-30bn) in 2012, but expect outstandings to decline c. $57bn to c. $337bn by 2013. Still, in a supply-constrained world CLO spreads are set to tighten, and our end2011 primary AAA target is 100-125bp or 50-75bp tighter. CLO origination will depend on banks willingness to warehouse risk, equity economics, loan supply, and financial reform, but CLOs can play a role in credit provision to the economy We review credit performance, ratings upgrades, and manager reinvestment. As loan prices recover and credit stress lessens, principal repayment likelihood is increasing down to CLO subordinate tranches. Our cumulative loss estimate has dropped to BB/BBB and on a market value basis nearly half of BBs are fully covered. CLO rating upgrades are picking up globally and this, along with positive broader performance, should attract more investors to the asset class With lower leverage and other changes, CLO primary has a future. Bond takeouts and loan refinancings only partially reduce the $575bn loan maturity wall, and more broadly the disintermediation of credit helps the banking system manage future regulatory capital and funding constraints. We summarize some of the key financial reforms (risk retention, Solvency II, Basel III) and potential interplay with the CLO markets future

Exhibit 1: CDO spread/price performance & recommendations

Sector US CLO Super Senior AAA AA A BBB BB 3-5 6-8 7-10 8-10 9-11 9-11 170 230 $80 $75 $70 $60 0 0 0 0 0 0 -20 -20 2 10 25 25 Ov erw eight Ov erw eight Ov erw eight Ov erw eight Ov erw eight Ov erw eight WAL Current Change Change YTD (years) Spread/Price vs 11/11 Recommendation

Spread to Libor (bp) / Price ($) for originally-rated categories Source: J.P. Morgan. Note: 1. CLO spreads for AA to BB are changed to dollar prices since 11/21/2008. 2. AAA is weighted average pass-through spreads. 3. Our series represents mid-quality pricing. Note: Levels as of COB 11/19/10.

Exhibit 2: CLO versus ABS spreads since 2006

bp

800 700 600 500 400 300 200 100 0 Nov-06

AAA Credit Card AAA CLO Primary AAA CLO

Nov-07

Nov-08

Nov-09

May-06

May-07

May-08

May-09

Source: J.P. Morgan. Primary AAA CLO based on observed prints in November 2010.

May-10
1

Nov-10

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
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Exhibit 3: 2010 CLO primary transactions*

2011 global CDO outlook

CLOs had a bumpy year along with broader risk markets, but activity and prices rebounded and new-issue supply met our expectations (Exhibits 3, 4 & 5). Following our downgrade in May we re-upgraded to Overweight BBs, BBBs, and single-As in October. BBs and BBBs reached our $60 and $70 targets1 and single-As are nearly at our $80 target (Exhibit 5). AAs and AAAs did not reach our 150bp and $90 targets, but are 20bp tighter and $2 higher year-to-date. Credit trends are vastly improved and collateral refinancing needs limited near to medium term. CLO rating upgrades and positive performance will continue, and our cumulative loss estimate has dropped to BB/BBB, with nearly half of BBs fully covered on a market value basis now. Fed asset purchases are likely to be broadly supportive of fixed income spread product, and diminishing market returns (Exhibits 6, 7) create demand for wider-spread sectors, such as CLOs. Our end-2011 targets are 100-125bp primary and 125-150bp secondary AAA (based on transaction, duration), $90-95 AA, $90 single-A, and $80s to $70s BBB to BB. Risks include volatility and extension but, within our economists expectation that growth will average 3.3% 2Q-4Q11 and inflation will stay tame, there is room for CLO spread tightening. Last but not least, with the asymmetric risk of interest rates around all-time lows (Exhibit 6), as an extension of loans, CLO floaters immunize longer-term rate risk. Primary CLOs offer high current income.

Date Transaction Nov -17 NZCG Funding Ltd Nov -16 ALM Loan Funding 2010-3 Nov -05 LCM Limited Partnership VIII Oct-12 Garrison Funding 2010-1 Aug-17 ICG EOS Loan Fund 2010-1 Jun-25 Golub Capital BDC LLC 2010-1 May -18 ALM Loan Funding 2010-1 May -01 Doral CLO 2010-1 Mar-30 COA Tempus CLO 2010-1

Manager Guggenheim Apollo Ly on Garrison ICG Golub Apollo Doral Financial Fraser Sulliv an

$m n Market AAA (bp) AAA Sub Leverage 600 US 400 US 300 US 300 US 1,809 Europe 300 US 323 US 450 US 513 US 175 175 160 240 110 240 170 185 190 43% 35% 34% 37% 44% 42% 30% 44% 30% 3.6 5.9 7.5 3.7 2.5 2.6 4.5 2.3 4.4

Source: J.P. Morgan, IFR, Bloomberg, S&P, Moodys, Fitch. AAA Sub = estimated hard subordination. Leverage = total size / equity size. *Includes broadly syndicated and middle market.

Exhibit 4: Cash CDO BWIC volume

$bn

FY 2009 = 31.9 bn 7 6 5 4 3 2 1 0 0.30.6 3.4 3.0 3.0 2.0 1.4 3.0 2.5 2.0 4.4 6.3

YTD 2010 = 31.0 bn

4.7 4.2 3.7 3.2 3.2 2.8 2.8 1.8 1.3

2.1 1.3

Source: J.P. Morgan

The future of the primary CLO market

We forecasted $5bn gross global CLO supply for 2010. With $4.9bn (Exhibit 3), that goal has been achieved. We expect $12.5bn ($10-15bn) in 2011 and $25bn ($20-30bn) in 2012, but supply is net negative as paydowns will accelerate and outstandings will decline c. $57bn to c. $337bn by 2014 (Exhibit 9). Still, in a supply-constrained world CLO spreads will tighten, and our end-2011 primary AAA target is 100-125bp, 50-75bp tighter than today. Primary AAA CLOs are a cheap spread asset (Exhibit 2) and the combination of historically high current coupon and subordination is attractive. CLOs have a place in the financial system. Some $575bn of US leveraged loans are due 2013-2016 and its unlikely all of this can be taken out in high yield or refinanced in new loans, absent other means of debt reduction. Our high yield strategists forecast $235bn bond and $160bn loan issuance in 2011. Even if up to a third of bonds take out loans ($80bn), this along with their 40% estimate of loan volume for refinancing purposes ($60bn) totals $140bn,
1

Exhibit 5: Single-A, BBB, BB CLO prices

$

90 80 70 60 50 40 30 Dec-09

Apr-10

Aug-10

Feb-10

Mar-10

Nov-09

Source: J.P. Morgan

leaving some $435bn of loan maturities. The October Fed Senior Loan Officer Survey, in which respondents believe lending conditions would remain tighter than their longterm average past 2011, is another supportive factor for the

Midyear 2010 CDO Outlook & Strategy, July 9, 2010.

May-10

Sep-10

Jan-10

Jun-10

Oct-10
2

Jul-10

Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10

Single-A

BBB

BB

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
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future for CLO financing. We discuss supply- and demand-side factors below. Supply-side: leveraged loan origination Loan volume is growing with year-to-date supply of $190bn ($125bn institutional) as per S&P LCD. Our High Yield strategy team expects institutional supply of $130140bn this year and $160bn in 2011 (Exhibit 10), based on increasing leveraged financings and demand for loans. LBO, M&A, and acquisition activity are picking up as capital markets recovereven in the lagging European market S&P LCD tracks 12bn sponsored launches in the last three months, the most since 3Q08. But will there be enough loans for our $12.5bn CLO supply forecast? Loan fund inflows are $8.9bn year-to-date, more than double last years, and total AUM is $45bn. There are other sources of demand including banks, but we focus on the $394bn US CLO market. Based on our model of CLO reinvestment, we expect CLOs will purchase $86bn of primary and some secondary loans next year2 with upside if CLO issuance proves higher than our forecast. So CLO demand may be around 40-50% of expected $160bn loan supply, a little higher than the 37.6% reported by S&P LCD for January to September 2010. We think this is reasonable, and our strategists note the upward bias in their supply forecast. See the High Yield Outlook and LBOs and other leveraging transactions: the pace to increase (October 29, 2010). Demand-side: CLO debt and equity Demand is picking up for CLO primary, with investors attracted to the historically high current coupon and subordination. We believe much of this years primary equity was partially or fully retained by managers, so to the extent new CLOs will become less reliant on equity retention (over and above potential requirements) CLO equity returns need to be attractive. However, CLO debt needs to be wide enough to entice buyers, so the chicken and egg of CLO asset/liability arbitrage is in play. Exhibit 8 breaks down CLO investor type since 2008 based on data provided by J.P. Morgans trading desk. The investor base is broadening with greater real money participation, which makes sense given spread tightening in Corporates and ABS. We believe primary CLO debt is cheap for a variety of investor benchmarks, though regulatory and investor development will play a part. For example, European insurance companies may find AAA CLO return on risk attractive under Solvency II, but more subordinated tranches may be punitive, and Banks may be
2

Exhibit 6: Treasury yields since 1982

14% 12% 10% 8% 6% 4% 2% 0% 1982 1985 1988 1991 1994 1997 2000 2003 2006
2009 Oct-10

2 y ear

5 y ear

10 y ear

Source: J.P. Morgan

Exhibit 7: Spread sector yields vs. current CLO yields

22% 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% Apr-08 Jan-08 Jul-08

EM

HY

BB CLO BBB CLO A CLO AA CLO AAA CLO

IG MBS Oct-08 Apr-09 Oct-09 Jan-09 Jan-10 Apr-10 Jul-09 Jul-10

Source: J.P. Morgan.

Exhibit 8: Estimated CLO investor breakdown

60% 50% 41% 40% 30% 20% 10% 0% Real Money Bank Hedge Fund 28% 39% 31% 20% 21% 12% 57% 52% 2008 2010

CLO Reinvestment & Implications for Credit Markets, October 22, 2010.

Source: J.P. Morgan. 2009 figure for January - October 2009, 2010 figure for January - November 2010. Real Money includes asset managers, insurance companies, pension funds, corporates. Based on observed client bid-side volume in secondary.

2009
3

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

attracted to wide AAA CLO spreads (Exhibit 2), but this will depend on regulatory capital (see Solvency II and Basel III in Regulatory Update). But on a broad level and using ABS as an example, primary AAA Card spreads were 300bp in March 2009 and tightened to 25bp by March 2010. Non-leveraged/cash buyers pushed spreads in through the 100bp TALF financing level about halfway through this period and spreads are currently 35bp. In this context, our expectation of AAA CLO primary spreads tightening by 50bp to 100-125bp by end-2011 is reasonable. Moving to equity, in Exhibit 11 we model returns for two hypothetical CLOs: A (65% AAA / 10% AA / 5% singleA / 20% equity) and B (60% AAA / 40% equity). We assume 3% defaults, 3% Libor, 450bp first lien spread, 800bp second lien spread, and other factors. Returns are based on AAA spreads from 100bp to 200bp and 2.0x and 2.5x multiples for AA and single-A spreads. This is a simple illustration, but we make a few points: Leverage is 2.5x for CLO B and 5x for CLO A, lower than pre-crisis (10x) but CLO A demonstrates that carving the AA and single-A debt can help equity returns, depending on by how much the extra leverage outweighs the higher cost of the carve-out. CLO As returns sensitivity will be higher with the greater leverage. Our end-2011 target for primary AAAs is 100-125bp, but loan spreads may also tighten. For example, at a 100bp AAA spread we plot CLO As returns assuming various first lien loan spreads. We will discuss our loan spread outlook in greater detail but it is obvious CLO equity economics become more difficult unless loan spreads stay wide enough relative to CLO spreadsor investors accept lower equity returns. To the extent assets are sourced in secondary or primary with a discount, our projections do not incorporate asset pull-to-par, and may understate returns. Equity call scenarios, manager par building, and other factors play a part. Our flat curves for defaults and interest rates do not accurately represent sensitivities, and for interest rates we do not take into account Libor floors.

Exhibit 9: CLO gross/net supply and outstandings

$bn $bn

150 125 100 75 50 25 0 -25 -50

Annual Gross (lhs) Annual Net (lhs) Outstanding (rhs)

500 450 400 350 300 250 200 150 100 50 0 2010E 2011E 2012E 140 72 38 160 2010 E 190 200
4

2000

2001

2002

2003

2004

2005

2006

2007

2008 321

Source: J.P. Morgan. Global arbitrage and balance sheet transactions.

Exhibit 10: US institutional leveraged loan supply

$bn

450 400 350 300 250 200 150 100 50 0 1999 2000 60 46 34 59 91 153 183

387

2009

Source: S&P LCD

Exhibit 11: Hypothetical primary CLO equity yield (y-axis) versus AAA spread assumption (bp, x-axis)
16% 15% 14% 13% 12% 11% 10% 9% 8% 100 110 120 130 140 150 160 170 180 @ 425bp @ 400bp @ 375bp @ 350bp CLO B CLO A

Loan spreads and broader equity value There are a number of factors driving CLO primary economics, but asset pricing is crucial. Average primary loan yields are 6.7% currently according to S&P LCD. If high yield bond spreads tighten to our strategists T+550bp target, or a 6.75% effective yield, one scenario is loan

Source: J.P. Morgan. See accompanying text for description.

2011 E

2001

2002

2003

2004

2005

2006

2007

2008

2009

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

spreads tighten by 75bp to a 6.0% effective yield (Exhibit 12), assuming no change in rates, and loans and bonds price within recent yield relationships. Another scenario is investors place a premium on floating-rate product given asymmetric interest rate risk, and loan spreads tighten even more. Of course, CLO economics do not operate in a vacuum and it is possible liability spreads tighten, with some potential stickiness or lag. On a general level CLO equity returns in the low to middouble digits or 11-13%+ appears realistic for next years marketed equity. CLO equity is a fixed income instrument so the term-based leverage (4-6x, Exhibit 3) and returns look attractive with yields from 1-2% in Treasuries to low double digits in distressed CRE, subprime, and some other products. Beyond fixed income our asset allocation team3 projects 2011 returns of 12.5% to 15.0% for developed to EM equities and 10% to 15% for Hedge Funds and Private Equity. There are differences in liquidity and term (equities are perpetual), but low-double-digit returns for CLO equity, a fixed income instrument, hold up in this context. Conclusion: the rationale for CLOs Our CLO supply projections are a fraction of peak volumes and leveraged finance will likely continue relying on the high yield market given the significant disruption to securitization markets very recently. Further, CLO origination depends on banks willingness to warehouse risk, financial reform, and the broader supply prospects for loans. Nevertheless, CLOs can play a role in future credit provision. Again, even assuming a large portion of bond and loan activity is used to reduce loan maturities in 2011, a large part of the $575bn wall will remain, and since most 2006/2007 CLOs will start amortizing, new CLOs can help mitigate defaults and damage to economic activity. On a broader level, our FIG analysts estimate $848bn and 1.8tn of bank debt in the US and Europe comes due by end-2013 (Exhibit 13). Banks are not relying on securitization as much as in the past, but CLOs distribution channel and disintermediation can potentially ease some of the burden on balance sheets, especially as Basel III raises total capital requirements from 8% to 18% over the next few years, so holding loans on the balance sheet may be less efficient. See our MBS colleagues Outlook. Finally, we highlight the Feds recent Senior Loan Officer Survey: respondents believe lending conditions would remain tighter than their long-term average past 2011. This and broader bank deleveraging suggests a degree of disintermediation of the demand for credit is helpful. CLOs can be part of the solution.
3

Exhibit 12: Leveraged loan versus HY bond yields

20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Diff (rhs) Loans Bonds 10% 8% 6% 4% 2% 0% -2% Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10
Source: S&P LCD, J.P. Morgan

Exhibit 13: Banks debt redemption schedule

1,000 900 800 700 600 500 400 300 200 100 0 2010
Source: J.P. Morgan

US Banks ($bn)

European Banks (bn)

2011

2012

2013

Exhibit 14: US leveraged loan prepayment and default rate

16% LTM Default rate by amount of defaults 14% 12% 10% 8% 6% 4% 2% 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: S&P LCD LTM Default rate by number of Issuers Monthly repayment rate in S&P/LSTA Leveraged Loan Index

Global Markets Outlook and Strategy, November 3, 2010.

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

CLO performance review and outlook

CLOs underlying leveraged loan and high yield markets witnessed a phenomenal improvement this year. Loan prices gained five points on average to $95 and high yield bond issuance embraced its all-time high, $271bn, last week. Even loan supply of $119bn is more than triple last years. It is important to note that a significant portion of issuance in both bonds and loans refinanced existing loans: 23% of bond ($62bn) and 37% of loan ($44bn) issuance refinanced existing loans and the loan maturity wall sharply declined. Prepayments soared to a 25% annualized rate in October, the highest since 2008 (Exhibit 14), as leveraged companies took advantage of improving capital markets. As liquidity in the high yield bond and leveraged loan markets improved, the loan default rate plunged from 9.6% in end-2009 to 2.3% (Exhibit 14). We discuss credit performance in CLO assets and liabilities, including CCC and defaulted asset balances, tranche subordinations and OC coverage, cumulative loss projections, ratings upgrades, and manager reinvestment. Loan maturity wall steadily declining with limited refinancing risk 2011-2012 In Exhibit 15 we refresh the maturity distribution of CLO loan collateral. Near-term refinancing needs have fallen as pre-2013 maturities declined and only $36bn US CLO collateral (11%) needs to be refinanced in 2011 and 2012, compared to $100bn (29%) as recently as 13 months ago. In the broader loan universe, the amount of loans set to mature by 2012 sharply reduced from $139bn to $78bn year-to-date with support from improved primary loan market conditions as well as defaults, amendments, extensions, and takeouts via bonds. While there is still some $575bn of loans due 2013-2016, refinancing risk in 2011 to 2012 poses little risk to CLO credit performance in the near to medium term. Defaults and recovery in more detail Our high yield strategists believe technicals and primary market conditions are supportive of lower defaults and forecast 1.5% and 3% loan default rates for 2011 and 2012, which are around the current 2.3% default rate by principal (and already the lowest since November 2008). Although CLO defaulted assets are not the same as loan market default rates because of the management option and other factors, they do roughly track the broader decline. Currently, the average defaulted asset balance in US CLOs is about 2.6%, compared to 6.5% at the end of last year, or nearly a two-thirds decline. As shown in Exhibit 16, nearly half of US CLO portfolios in our universe now hold only 2-4% of defaulted assets.

Exhibit 15: CLO underlying asset maturities

40% 35% 30% 30% 25% 20% 15% 15% 10% 5% 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 1% 1% 2% 2% 9% 4% 10% 3% 5% 0.4% 15% 14% 22% 27% 37% Underly ing maturity in US CLOs Underly ing maturity in Euro CLOs

Source: J.P. Morgan, INTEX data as of Nov 9, 2010. European Arbitrage transactions only.

Exhibit 16: YoY change of defaulted asset tiering among US CLOs (x-axis: defaulted balance, y-axis: frequency)
60% 50% 40% 30% Nov -10 20% 10% 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% More Nov -09

Source: J.P. Morgan, INTEX data as of November 16, 2010. 537 transaction sample.

Leveraged loan recoveries continue to climb, and recoveries measured by price have converged to the historical average.4 Based on price 30 days after default, the average first lien recovery rose from last years 50% to 72.2% this November. In fact, this is above Moodys longterm average of 65.6% and some 10% higher than last years recovery rate, on an adjusted basis (which uses year-end prices instead of 30 days after default). For second-lien loans, the average recovery is 13.3% this year, based on prices 30 days after defaults, and is lower than 27% observed last year. The difference comes from a handful of second lien obligors that recovered at a particularly high level last yearover 65% for the likes of Charter Communications, Crusader Energy, Wilton Holdings, Integra Telecom (etc.). While recoveries are heavily issuer- and sector-based down the capital structure
4

Default Monitor, November 1, 2010.

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
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Exhibit 17: CCC bucket distribution in US CLOs (x-axis: CCC balance, y-axis: frequency)

of highly leveraged companies, we expect CLO defaulted balances to decline further. This trend is also supported by the lack of distress, as measured by CCCs. CCC/distressed assets CCC/low-rated performing asset balances continue to decline and on average US CLOs have reached 8.9% compared to 15.5% a year ago (Exhibit 17). Similar to defaulted assets, managers may have sold CCCs to manage OC haircuts and par losses, but the CLO trend echoes broader upgrades: since October 2009, the S&P LSTA index observes more upgrades than downgrades each month, and a record low downgrade to upgrades ratio this month of 0.45.5 In CLOs, price changes are another driver of CCC bucket changes over time, and will influence the trend in 2011. After a dramatic price recovery in CCC assets last year, prices retreated to the $40s earlier in the year with sovereign stress, and have since recovered to $76 on average. Prepayment, reinvestment, and bond extension Before turning to OC coverage and portfolio loss projection, we summarize prepayments and CLO manager reinvestment.6 Annualized loan prepayment rates have been in a 15-25% range over the last few quarters (Exhibit 14) and we estimate US CLOs received about $66bn cash flows from prepays for reinvestment this year. If we consider both prepayments and collateral sales, CLO reinvestment may be as high as $105bn for FY 2010, and the effective CLO reinvestment rate may actually be closer to 38% for the year. Our analysis estimates current outstanding US CLOs have reinvestment potential of $86bn, $68bn, $47bn, and $23bn for 2011, 2012, 2013, and 2014 or a cumulative $224bn to 2015 (Exhibit 18). The evidence suggests CLO managers are taking advantage of portfolio WAL test headroom and reinvesting into new-issue loans, which commonly have five- or six-year maturities and higher coupons with Libor floors. This effectively increases excess spread to equity and fees, but may also be creating extension risks. In fact, S&P states that existing CLOs bought about 37.6% or $45bn of $120bn new-issue loans in 2010 YTD. If both prepayment and issuance continue to climb we think reinvestment of cash inflows (from prepayments, sales) into new-issue loans with longer maturities may lead to further extension, though sensitivities will vary. On the other hand, as we will discuss in the trading themes, CLOs that exit reinvestment periods now or recently will likely experience fairly rapid paydowns in such a high
5 6

30% 25% 20% Nov -10 15% 10% 5% 0% 0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30% 33% More Nov -09

Source: J.P. Morgan, INTEX data as of November 16, 2010. 537 transaction sample.

Exhibit 18: Reinvestment expiry calendar and estimated reinvestment capacity of current outstanding US CLOs
$bn
120 100 80 60 40 20 1 0 2006 2008 2010 2012 2014 2016 2019 6 9 13 3 28 61 48 60

Based on current outstanding CLOs only

88

CLOs ex iting reinv estment period per y ear

Total Reinv estment Capacity

Source: J.P. Morgan, INTEX data as of November 16, 2010.

Exhibit 19: US CLO O/C cushions as of Nov 2010

Class E/F (BB) Average YoY Change Failing deals / Ratio Passing deals / Ratio Class D (BBB) Average YoY Change Failing deals / Ratio Passing deals / Ratio Class C (Single-A) Average YoY Change Failing deals / Ratio Passing deals / Ratio Senior Class Average YoY Change Failing deals / Ratio Passing deals / Ratio 6 413 14 333 9.61% 3.82% 1% 99%
7

2.47% 3.24% 17 152 3.73% 3.54% 23 364 6.10% 3.37% 4% 96% 6% 94% 10% 90%

S&P LCD Report, November 11, 2010. Collateralized Debt Obligations, October 22/29, 2010.

Source: J.P. Morgan, INTEX data as of November 15th, 2010. In a sample of 419 US CLOs.

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

prepayment environment, suggesting shorter AAA bonds pricing may overstate extension risks and there may be relative value opportunities. OC cushions and par losses Lower defaults and CCCs, higher prices of these assets, and manager par-building through reinvestment contributed to a significant improvement in CLO OC and cash flow performance (Exhibits 19 and 20 US, 29 Europe). In Exhibit 19 we make a one-year comparison and determine a 3.2-3.8% year-on-year increase in OC cushions across the US CLO capital structure. Based on mid-November reporting, 90% or 152 out of 169 US CLOs in our sample are passing their lowest OC tests, compared to only 48% (80 out of 165) a year ago. As many CLOs will be able to reinvest next year, we think OC accumulation will continue but at a slower pace, as loan prices are at or near par and defaults and distress are much lower than a year ago. CLO portfolio price update As concern about Europes sovereign crisis abated, leveraged loan and high yield bond prices came around and the average bid price of loans has risen nearly four points from July lows ($91.3) to $95.14 as of last week, or a total price gain of 4.7 points year-to-date. This marks the highest price level since October 2007. CLO weightedaverage portfolio prices increased from the high $80s/low $90s at the end of 2009 to $93.1 at present, which suggests lower loss expectations. Exhibit 21 shows the distribution of weighted average prices across 521 US CLO portfolios. CLO cumulative loss projections: Rating transitions versus market value coverage We recalibrate our loan-level loss model to refresh portfolio cumulative expected loss projections, using a typical transaction, current collateral ratings, and a variance of the 2002-2005 corporate credit rating transition matrices that simulates our base case CDR curve (6% for 12 mths, 4% thereafter). We assume various flat annual prepayments of 0% to 30%, and recoveries of 60% and 20% for senior secured and second lien/high yield bonds, respectively. As Exhibit 22 shows, based on todays forecasted losses, the broad-based improvement in loan ratings and reduced defaults/CCC bucket suggests minimal impairment risk for most of the CLO structureassuming that loan ratings downgrades are finished and stabilized current ratings are a fair predictor of future risk.

Exhibit 20: Average US CLO OC cushions

12% 10% 8% 6% 4% 2% 0% -2% Dec-09 Oct-09 Aug-09 Sep-09 Apr-10 Aug-10 Nov-09 Sep-10
1% >75 >77.5 >80 >82.5 >85 >87.5 >90 >92.5 >95

Senior OC Cushion Subordinate OC Cushion Nov -10 9.61% Nov -10 2.70%

Feb-10

Mar-10

Jan-10

Jun-10

Oct-10

Jul-09

Jul-10

Source: J.P. Morgan, Intex data as of November 16, 2010

Exhibit 21: Distribution of weighted average portfolio price in 521 sample US CLOs (average = $93.1)
45% 40% 35% 30% 25% 20% 15% 10% 5% 0% >97.5 More 7% 8% 0% 14% 27% Frequency 42%

Source: J.P. Morgan, INTEX, LPC price as of November 5, 2010

Exhibit 22: CLO loan-level cumulative loss (y-axis) versus years under various CPRs*
30% AAA 25% 20% 15% 10% 5% 0% Start Year 1 Year 2 Year 3 Year 4 Year 5 AA 0% CPR 20% CPR 10% CPR 30% CPR

Single-A

BBB BB

Source: J.P. Morgan. *Assumes current portfolio rating composition of a typical vintage CLO and a variance of the 2002-2005 corporate credit rating transition matrices to simulate CDRs (6% for 12 mths, 4% thereafter. Horizontal lines are indicative tranche subordinations.

May-10

Nov-10

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

Exhibit 23: Average CLO MVOC and subordinations

Looking over the past 20 months, our projected three-year cumulative collateral loss has fallen from 19% in April 2009, which threatened AAs and some AAAs (and implied EOD in some CLOs), to 15.3% in November 2009 (BBB/single-A), to 5-6% at present (BB/BBB, Exhibit 22). From a relative value perspective, comparing cumulative loss projections with haircut par subordinations suggests BBBs with strong par subordinations ( 10%) look very principal protected even under the most unfavorable prepayment scenario (0% CPR). This echoes sufficient MVOC coverage observed in a sample of 400 US BBB CLO tranches (Exhibit 23), in which the average BBB MVOC is 102.3% and 82% of the sample has over 100% MVOC. Thus, there is greater back-ended principal option value in BBBs and many BBs, and in any case our assetlevel analysis may be conservative. Turning to MVOC more fully, we survey 489 US CLOs and calculate average par subordination and MVOC of all tranches, grouped by original Moodys rating. Based on November 5 loan prices, average MVOC ratios for US AAA to BB tranches are 128.7%, 117.3%, 108.7%, 102.3%, and 99.5%. Even BBs are largely covered under current loan prices now; nearly half of BBs have over par coverage. This seems to confirm the previous, non-marketbased finding of our loss projection when we used rating migrationsthat CLOs are principal protected down to BBB. Finally, echoing the price pickup in CLO mezzanine bonds, we note the average MVOC of BBs and BBBs already surpasses the average coverage of even single-As in September 2009, which was about 98.4% back then. Exhibits 24 to 26 illustrate single-A, BBB, and BB MVOC distribution. CLO ratings performance As a result of improved credit performance, OC rebuilding, structural deleveraging, and other factors, CLO liability ratings have generally been on an upgrade trend this year.7 Exhibit 27 shows monthly CLO upgrade counts by region. The trend noticeably accelerated after May, when the average number of tranche upgrades rose from 22 to 90 per month, and upgrades in Europe have been catching up since October (Exhibit 29 shows the OC cushion improvement in Europe CLOs). Overall, the pickup in upgrades is reversing the downgrade trend that took place in 2009, when Moodys downgraded 85% of CLO tranches (by notional) 4.9 notches on average
7

2009 Sep Par Subordination (Defaulted at MV) AAA AA A BBB 23.4% 17.8% 12.0% 7.1%

2010 Nov Par Subordination (Defaulted at MV) 26.8% 19.8% 13.8% 8.3%

2009 Sep MVOC 114.5% 106.4% 98.4% 93.6%

2010 Nov MVOC 128.7% 117.3% 108.7% 102.3%

BB 5.1% 5.7% 90.7% 99.5% Source: J.P. Morgan, INTEX, LPC. Sample of 489 US CLOs, MVOC based on loan prices as of Sep 29th, 2009 and Nov 4th, 2010. *Average Par Sub (adjusted by defaults) includes the defaulted assets at the market value.

Exhibit 24: Single-A CLO MVOC (x-axis) distribution

70% 60% 50% 40% 30% 20% 10% 0% 35% 55% 75% 95% 115% 135% 155% 175% 195% Single-A

Source: J.P. Morgan, INTEX, S&P LCD, Moodys

Exhibit 25: BBB CLO MVOC (x-axis) distribution

70% 60% 50% 40% 30% 20% 10% 0% 35% 50% 65% 80% 95% 110% 125% 140% 155% 170% 185% 200% BBB

Source: J.P. Morgan, INTEX, S&P LCD, Moodys

Exhibit 26: BB CLO MVOC (x-axis) distribution

60% 50% 40% 30% 20% 10% 0% BB

Collateralized Debt Obligations, September 12, 2010.

35% 50% 65% 80% 95% 110% 125% 140% 155% 170% 185% 200%

Source: J.P. Morgan, INTEX, S&P LCD, Moodys

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

Exhibit 27: Monthly CLO upgrades by region

between March and October 2009, and S&P followed suit and downgraded its CLOs by an average of 3-4 notches. As of November 12, circa 13% and 12% of outstanding par of the US CLOs and European CLOs have been upgraded by at least one rating agency. In addition, on November 8 S&P placed 415 tranches of 146 US CLOs ($39bn, or another 13% of US CLOs) on positive rating watch, and will look to complete its review within 90 days.8 It is uncertain how many CLO liabilities will be upgraded all the way back to their original rating, but at the very least we expect modest upgrades will continue to the extent credit conditions remain benign. Exhibit 28 breaks down the distribution of cumulative US CLO tranche upgrades by original rating bucket since September 2009. Upgrades have centered on mezzanine (single-A to BBB originals), which comprise about 52% and 45% of Moodys and S&Ps total upgrades. There are some observed differences: compared to Moodys, S&P upgraded more original AAAs, at least so far this year. The impact of rating changes will depend on investor type, but since many investors incorporate ratings into riskbased capital, upward momentum is positive. We think the positive ratings story will be a major factor in attracting investors to CLOs, as ratings drive risk capital decisions for banks and insurance companies. Conclusion: improving performance = price rises The likelihood of principal repayment for CLO mezzanine and subordinate tranches (BBBs, BBs) is increasing as leveraged loan prices recover and defaults and distress lessen. We reiterate our Overweight with the risk to this view how longer-term loan refinancing in 2013-2016 plays out. A key part of this risk is financial reform and regulatory changes, which may impact the availability of future credit, and we turn to this below.

$bn
160 140 120 100 80 60 40 20 Dec-09 Oct-09 Aug-09 Sep-09 Apr-10 Aug-10 Sep-10 Feb-10 Mar-10 Jan-10 Jun-10 Oct-10 Jul-09 Jul-10 Nov MTD Nov-09 May-10 Av g 22/mth Av g 90/mth Europe US

Source: J.P. Morgan, Moodys, S&P. As of November 12, 2010.

Exhibit 28: Distribution of US CLO tranche upgrades by original rating, September 2009 to November 2010
35% 30% 25% 20% 15% 10% 5% 0% AAA AA Single-A BBB By S&P BB 19% 15% 13% 26% 31% 26% 21% 19% 13% 14%

By Moody 's
Source: J.P. Morgan, Moodys, S&P.

Exhibit 29: Europe CLO O/C cushions (November 2010)

Class E/F (BB) Average YoY Change Failing tranches / Ratio Passing tranches / Ratio Class D (BBB) Average YoY Change Failing tranches / Ratio Passing tranches / Ratio Class C (Single-A) Average YoY Change Failing tranches / Ratio Passing tranches / Ratio Senior Class Average YoY Change 21 120 7.80% 1.85% 7 131 5% 95%
10

-0.43% 1.19% 48 70 1.38% 1.19% 34 101 4.04% 1.35% 15% 85% 25% 75% 41% 59%

Regulatory Update
In our midyear outlook we discussed a number of financial reforms that may affect CDOs and broader financial markets. We summarize some of the developments. Risk retention Skin in the game regulations vary and are at different stages, as in the US regulators are about halfway through a
8

Collateralized Debt Obligations, November 12, 2010.

Failing tranches / Ratio Passing tranches / Ratio

Source: J.P. Morgan, INTEX data as of November 15th, 2010. Sample of up to 138 Euro CLOs.

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

270-day consultation period (during which the DoddFrank bill mandates regulatory studies), while in Europe CRD 122a takes effect for new securitizations in January 2011. Both legislations propose 5% retention, though CRD 122a is aimed at regulated bank investors, who are responsible for retention compliance by the originator or sponsor (non-compliance carries capital charges). This is different from the US approach, which does not target bank investors. In Europe, final guidance following a recent consultation is due and the AFME, BBA, and ISDA have proposed how to better fit CLOs into CRD 122a9 given lack of clarity in some of the provisions. In the US the Mortgage Bankers Association10 and others have commented on the need for a careful approach; we highlight the Feds study to Congress:11 Overall, the study documents considerable heterogeneity across asset classes in securitization chains, deal structure, and incentive alignment mechanisms in place before or after the financial crisis. Thus, this study concludes that simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the Actnamely, to improve the asset-backed securitization process and protect investors from losses associated with poorly underwritten loans. The CLO market awaits clarification, but to the extent CLO managers may be required to retain some of the risk, this will likely curtail issuance, depending on whether firms have enough capital for the retention. InsuranceSolvency II Solvency II is a revised risk capital regime for European insurance companies. Consultation12 has ended and a response is due in April 2011. One of the fundamental principles is that insurers should have enough buffer to cover obligations over a one-year period with a 99.5% confidence level, a one in two-hundred-years event. This buffer is the Solvency Capital Requirement (SCR) covering a) market risk, b) default risk, c) life-insurance risk, d) health insurance risk, and e) non-life insurance risk. The market risk component tends to be the largest contributor to the
Response to CEBS CP40 Consultation Paper on Guidelines to Article 122a of the Capital Requirements Directive, AFME/BBA/ISDA, October 1, 2010. 10 Summary of Federal Reserve Credit Risk Retention Report, MBA, October 20, 2010. 11 Report to the Congress on Risk Retention, Board of Governors of the Federal Reserve, October 19, 2010. 12 QIS5 Technical Specifications, CEIOPS, July 5, 2010.
9

Exhibit 30: Hypothetical primary CLO return on capital under Solvency II standard model
Spread assumption (bp) AAA 100 110 120 130 140 150 160 170 180 190 200 AA 200 220 240 260 280 300 320 340 360 380 400 Single-A 250 275 300 325 350 375 400 425 450 475 500 Return on Capital AAA 11.5% 12.7% 13.8% 15.0% 16.1% 17.3% 18.4% 19.6% 20.7% 21.9% 23.0% AA 2.0% 2.2% 2.4% 2.6% 2.8% 3.0% 3.2% 3.4% 3.6% 3.8% 4.0% Single-A 2.5% 2.8% 3.0% 3.3% 3.5% 3.8% 4.0% 4.3% 4.5% 4.8% 5.0%

Source: CEOIPS, J.P. Morgan. Assumes 35-100% AAA, 30-35% AA, 23-30% Single-A attachments, 5 year portfolio WAL, 50% BB / 50% single-B ratings.

Exhibit 31: CLO credit curves (spread multiples, bp)

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 Apr-10 Aug-10 Feb-10 Mar-10 Sep-10 Jan-10 Jun-10 Oct-10 Jul-10 May-10 Nov-10
11

BBB/AAA

Single-A/AAA

AA/AAA

Source: J.P. Morgan. AA to BBB spreads estimated from published prices (Exhibit 1).

SCR.13 For structured products, it is a look-through approach based on portfolio, tranche attachment/detachment, expected tenor, market value, and other variables. In Exhibit 30 we calculate simplified return on capital for primary CLOs using the standard model. There are a number of parts and the calculation is sensitive to the assumptions, but on a general level senior CLO tranches look attractive versus more subordinated tranches as the higher charges outweigh the wider spreads. Note our illustration is based on an idealized transaction and internal models may also play a role.

13

Appendix I: Calculating the Capital Charge under Solvency II, European Credit Outlook & Strategy 2011, November 11, 2010.

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

BanksBasel III While specific capital charges for CLOs are not changing, from a broader funding and leverage perspective Basel IIIs focus on bank capital is a game changer in how banks will fund themselves. Our FIG analysts14 believe Basel III will be materially negative in increasing the average cost of regulatory capital as the proportion of minimum total capital15 increases significantly, from 8% to nearly 18%. Simply put, higher capital requirements may lead to less optimal return on capital for certain assets, with possible implications for loan origination underlying securitization, given effects on bank balance sheets. On the other hand, the deadline for final implementation is several years away in 2018, and many banks are already taking steps to improve their capital base. See our MBS colleagues Outlook for additional comment.

to real money and banks, given the spread pickup (Exhibit 2). Position for AAA primary spreads to tighten 50bp to 100-125bp by end-2011. Shift into floating note exposure Interest rates look set to remain low near term given drags on growth, but our economists expect improving growth conditions beyond 1Q11. There is potential upward pressure on rates and this risk is asymmetric from a long-term perspective. To the extent investors begin to place a higher premium on floating-rate products later next year, CLO floating-rate debt stands to benefit. Buy mezzanine and subordinate tranches, as CLO credit curves flatten Improving credit performance and rating upgrades support further price appreciation in mezzanine and subordinate CLO tranches, which offer some of the highest yields in fixed income markets. We believe principal option values will climb as lower expected losses are priced in reflecting higher repayment probabilities. We upgraded back to Overweight in October: BBBs and BBs reached our end-2010 targets ($70, $60) with single-As nearly there ($80). CLO credit curves (Exhibit 31) will modestly flatten over the year and our end2011 targets are $80s/$70s for BBBs/BBs. Pick up the global CLO basis European CLOs price wider than US CLOs, and we see attractive risk-adjusted opportunities in first to second priority tranches. European AAs and mezzanine AAAs are cheap, with 7-10% yields and very high credit subordination (approximately 20%+ AA, 25%+ mezzanine AAA). The weaker recovery in European loans and headline risks in EMU peripherals (Ireland, Greece, Portugal, and Spain) are key risks. Consider equity We are attracted to CLO equitys high yields, some of the highest in corporate credit today, along with firstloss credit derivatives (e.g., mid-teen yields for 0-3% CDX tranches). Given the high degree of leverage, sensitivities will vary. One point to consider is Libor floors have been helpful for returns, but the trend is for declining floors in new-issue loans, and the effect knocks out as interest rates rise. Further, CLO manager reinvestment becomes restrictive once CLOs start amortizing, and equity valuations based on very low default rates

Trading themes
We believe the Feds asset purchases are likely to be broadly supportive of fixed income spread products. Diminishing yields encourage demand for CLOs, which have lagged the broader rally. CLOs negative net supply is very supportive of technicals. The macro outlook and sovereign contagion are some of the broader risks and at the time of writing, markets were volatile around events in Ireland. A specific risk is extension as CLO managers reinvest, which clouds tranche payment timing. Ultimately, the search for yield, improving performance, and low supply will lead to spread tightening. We stay Overweight across the capital structure. Buy CLO primary Our top pick is CLO primary debt given the higher income, greater credit enhancement, and lower leverage than legacy transactions. Current primary AAA spreads of 170-175bp, single-A spreads of 275-300bp, and BBB spreads of 575-600bp are attractive, but the point is the spread is nearly all current coupon. The higher income suggests lower volatility of returns than legacy CLOs, which are more dependent on back-ended principal. Primary has higher subordinations, which along with other features, suggests ratings and structural resilience, depending on collateral. Recent AAA subordinations average 32-35% (Exhibit 3) and single-As 21-24%, versus legacy AAAs of 22-25%. AAAs should be attractive
The Future of Hybrid Bank Capital: The Impact of Basel III on the Hybrid Capital Market, October 6, 2010. 15 Includes Core Tier 1, Non-Core Tier 1, Tier II, and new Capital Conservation and SIFI Buffers.
14

12

US Fixed Income Strategy US Fixed Income Markets 2011 Outlook November 24, 2010 Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
AC

may not accurately project longer-term cash flows. See CLO Equity: Whats in the Price? (October 1, 2010). Select shorter-duration AAAs While views around extension risk impact AAA valuations, WAL test headroom and sensitivities will vary, and there may be relative value in identifying bonds. For example, we observed rapid paydown of AAAs that had recently exited reinvestment, so to the extent prepayments remain high in 2011, there could be unlocked value in some of the transactions that will be exiting reinvestment next year. See A Question of Extension (October 29, 2010). Any upside in shorter-term AAAs obviously depends on whether investor yield targets are low enough for such risk, and within this, changes in short-term rates.

13

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