When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P.

Morgan Securities Ltd. stephen.dulake@jpmorgan.com

When Rates are Rising

Can Credit Markets Perform When Rates are Rising?

Stephen Dulake European Credit Strategy 7-8 October 2004

Stephen Dulake

Stephen is responsible for European Credit Strategy at JPMorgan, having joined in October 2003. Prior to that, he spent nine years at Morgan Stanley and was a member of the credit strategy team. Stephen has been voted #1 in High Grade Strategy by Institutional Investor magazine in 2002, 2003 and 2004. He has a degree in Economics from University College, London and a masters degree in Economics and Econometrics from the University of Southampton.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Perception and the volatility skateboard ramp

A stylistic representation of the year-to-date volatility distribution by risk asset class Volatility

Govt. Bonds (Risk Free)

Credit (Hybrid)

Equity (Risky)

Source: JPMorgan.

Loadsa rate volatility, loadsa equity volatility, but not a lot to shout about when it comes to credit. Thats the current consensus in investors minds with regard to 2004, at least based on our own investor dialogue. It should be noted, however, that investors are typically thinking along very different dimensions or axes when it comes to volatility in each asset class; yields in the case of government bonds, prices and not options-implied volatility when it comes to stocks, and spreads in the case of credit. We will focus on the left-hand side of the volatility skateboard ramp and the question is: is the current degree of spread inertia that we see given rate volatility the exception or the rule? And, in particular, what happens when rates are rising?

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Have we seen this interest rate indifference historically?

US investment grade and high yield bonds annual returns during interest rate changes
Investment grade corporate bonds 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 0.5% 2.3% 35.5% 9.3% 16.2% 25.4% 16.3% 1.8% 9.8% 14.1% 7.4% 18.2% 9.1% 12.4% -3.3% 21.2% 3.7% 10.4% 8.7% -1.9% 9.1% 10.7% 10.2% 6.9% High yield bonds 4.3% 10.4% 36.3% 20.3% 9.4% 28.7% 15.6% 6.5% 11.4% 0.4% -6.4% 43.8% 16.7% 18.9% -1.6% 19.6% 13.0% 12.5% 1.0% 3.1% -5.9% 5.5% 2.2% 24.4% Intermediate Treasury yield 12.5% 14.0% 9.9% 11.4% 11.0% 8.6% 6.9% 8.3% 9.2% 7.9% 7.7% 6.0% 6.1% 5.2% 7.8% 5.4% 6.2% 5.7% 4.7% 6.5% 5.1% 4.4% 2.6% 3.2% Change in Treasury 152bp 122bp -407bp 84bp -33bp -225bp -185bp 147bp 135bp -102bp -72bp -175bp -72bp -66bp 265bp -216bp 87bp -55bp -77bp 179bp -167bp -57bp -197bp 56bp

Source: JPMorgan, Ibbotson Associates. For further detail see 2003 High Yield Annual Review, Peter Acciavatti et al, January 2004.

In nine of the past 24 years, intermediate Treasury bond yields have risen. Of those nine years, investment grade corporate bond returns have only been negative twice, and high yield bond returns just once. The basic point is that even when we attempt to isolate periods when rates are rising, albeit market rates, we continue to observe the sort of indifference that we have seen year-to-date. Interestingly also is the outperformance of high yield versus high grade in each of these years. We take this issue up a little later, and debate whether this really says something about the two asset classes or about credit per se.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Return correlation across the asset classes

Fifteen years ending 2003 Fifteen years ending 2003
US 30-day T-Bill US Inter. Tsy US Long-Term Tsy LB Agg. Bond ML Corp. Master JPMorgan Global HY Index S&P 500 Wilshire 5000 Russell 2000

US Intermediate Tsy US Long-Term Tsy LB Aggregate Bond ML Corp. Master JPMorgan Global HY Index S&P 500 Wilshire 5000 Russell 2000 MSCI EAFE1

0.13 0.09 0.16 0.10 -0.11 0.08 0.05 -0.05 -0.05 0.90 0.94 0.87 0.04 0.04 0.01 -0.11 0.02 0.94 0.91 0.13 0.09 0.06 -0.03 0.00 0.96 0.21 0.17 0.15 0.03 0.07 0.36 0.26 0.24 0.14 0.12 0.48 0.52 0.58 0.36 0.98 0.73 0.63 0.84 0.63 0.53

Source: JPMorgan, Ibbotson Associates. For further detail see 2003 High Yield Annual Review, Peter Acciavatti et al,January 2004. 1. EAFE = Europe, Africa and Far East

When we look more explicitly at the correlation of returns across the interest rate, high grade and high yield markets, we see, in fact, that interest rate and investment grade corporate bond returns are highly correlated, while this appears much less true of interest rates and high yield returns and, indeed, high grade and high yield returns. Interest rates would seem to us to be important, at least in the investment grade market and, relating this to the market environment today, we believe this perception would certainly explain the increased level of participation in the high yield market this year on the part of traditional high grade credit portfolio managers.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Total returns and credit returns are two different things

Disaggregating high grade and high yield bond yields

l Corporate bond yields may be disaggregated into three (or more) constituent parts:

227bp 27bp 10bp

Credit

a risk free component; a swap spread component; and a credit component, which might be further disaggregated by sector, rating etc., etc.
l The total return on corporate is therefore a function of these three (or more) components

9bp

Swap Spread

330bp

311bp

Risk Free

Investment Grade Bond Yield

High Yield Bond Yield

Source: JPMorgan, based on MAGGIE investment grade credit and high yield bond indices.

The total return correlation between interest rate, high grade and high yield markets is, in our view, entirely a function of the relative size of the risk free and credit components that make up the all-in yield. In the case of high grade bonds, the risk free component dwarfs the credit component and we consequently observe high correlation between returns on these two asset classes. Interestingly, if we were to repeat this analysis, but this time calculate the correlation between interest rate returns and excess high grade corporate bond returns, the relationship all but disappears. This is the argument that we made to investors back in November 2003 when we suggested that the Fed represented a red herring risk for creditors in 2004, at least from a spread perspective (see The Bermuda Triangle, European Credit Outlook & Strategy 2004, Dulake et al, November 2003). Our inference, when all is said and done, is that credit and rates do not appear related, at least in a very obvious fashion. Where we do think policy and market rates are important for creditors is in shaping the business cycle, no more so than when we look at the valuation structure in credit markets today.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Spreads appear related to credit risk

Credit spreads, speculative grade default rates and the downgrade rate Spec. Default Rate [%] 20 18

Industrials Asset Swap Spread [bp]

140 120

Downgrade Rate
16 14 12 10 8 6 4 2 0 1981
Source: JPMorgan.

100
Ave. Downgrade Rate

80

60
Ave. Default Rate Spec. Grade

40

Spec. Default Rate

1983 1985 1987 1989 1991 1993 1995 1997

Rolling Ave. Credit Spreads

1999 2001 2003

20 0

At the expense of stating the obvious, one must relate spreads to one or more measures of credit risk in order to make a generic valuation statement. In the context of illustrating the cyclical risks inherent in the pricing of corporate bonds that we observe today, we ask the question: what sort of default and transition rate scenario do spreads currently imply? We will seek to provide an answer to this question using JPMorgans Rock Bottom spread framework. The basic premise for asking this question in the first place is the observation that spreads do not appear to be offering any sort of market liquidity premium over and above what one requires to just offset the joint risks of default and transition, the socalled Rock Bottom spread. Thats the case if we make the assumption that companies default no more often than they have on average and, interestingly, the speculative default and downgrade rates have recently fallen to their long-term averages. The reality, as my colleague Peter Rappoport has pointed out, is that calculated Rock Bottom spreads are a function of their default and transition inputs and, when based on average default and transition rates, arguably overstate the true level of credit risk that we observe today. This is long hand for saying that we should calibrate for the current position of the credit cycle, both in terms of the outlook for default rates and the level of risk aversion.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

1993-97 and the repeat of a Golden Age

Historical deviations 1980 - 2004 and long-term forecast 2004 - 2010

9rvhvsrhbd
8.00 % Dev. Ave. Default Rate 6.00 % Dev. Ave. Downgrade Rate Forecast Dev. Defaults Forecast Dev. Downgrades

4.00

2.00

0.00

-2.00

-4.00

-6.00 1980 1984 1988 1992 1996 2000 2004 2008E 2012E

Source: JPMorgan estimates

Our approach is to initially consider the valuation implications of the sort of default and downgrade environment that we saw between 1993 and 1997. This, from a (recent) historical perspective, arguably represents the best creditors might expect; a Golden Age, you might say, from a default and downgrade perspective. Of course, we might say that the 1993-97 period was very different; the credit market was highly bifurcated pre-EMU, corporate leverage was lower and what data we have suggests to us that spreads were tighter, and things like shareholder pressure were yet to manifest themselves. Nonetheless, if we assume that we see a repeat of the 1993-97 period over the next 4-5 years, what we think this would mean is the default rate initially declining a full 5-6 percentage points below its long-term average before mean reversion takes place. Our empirical analysis shows that the elements of the rating transition matrix used in the Rock Bottom spread methodology are well correlated with two variables. The overall rate of downgrades explains most of the variance in high-grade transition probabilities, with individual correlations of around 80%. The speculative grade default rate, in turn, contains the most information about the variance in lower ratings transition probabilities. In consequence, we dont lose much information by only focusing on forecasting these two parameters and translating these views into adjustments to the average annual transition matrices and, as weve noted previously, the adjustments we make are based on the assumption of a full-blown re-run of the 1993-97 period. (This approach to re-calibrating default and transition matrices is described in more detail in: Rock Bottom Spread Mechanics, Peter Rappoport, 25 October 2001).

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Rock- versus Rock-Rock Bottom spreads

Credit cycle-adjusted Rock Bottom spreads by sector
Excess Spread in bp
Industrials - Autos - Basic Industry - Capital Goods - Consumer Cyclical - Consumer Non-cyclical - Energy - Media - Property & Real Estate - Technology - Telecoms - Tobacco - Transport - Utilities -30 -20 -10 0 10 20 30 Rock-Rock Bottom Excess Spread Rock Bottom Excess Spread
Source: JPMorgan.

Market Spread Industrials - Autos - Basic Industry - Capital Goods - Consumer Cyclical - Consumer Non-cyclical - Energy - Media - Property & Real Estate - Technology - Telecoms - Tobacco - Transport
40

Rock-Rock Bottom Excess Spread 8 34 4 15 0 -2 13 -11 7 2 3 8 3 3

Rock Bottom Excess Spread 0 23 -4 9 -10 -8 3 -20 -2 0 -6 -6 2 -3

45 82 37 40 42 28 51 34 48 14 55 63 9 34

- Utilities

Euphemistically, we refer to these cycle-adjusted Rock Bottom spreads as Rock-Rock Bottom spreads. From just offsetting average historical rates of default and transition, we observe that in a scenario in which the default and transition experience of 1993-97 repeats itself, market spreads today compensate an additional 8bp above what we have defined as Rock-Rock Bottom levels. We might debate whether the 8bp market liquidity premium that we observe today is correct given current market conditions. Its arguably lower than what weve typically seen on average, but this is where things start to look to us decidedly grey rather than black-and-white. The liquidity premium might itself be a function of where we are in the credit cycle and degree of visibility associated with fundamentals, and also things like the level of risk aversion and market technicals.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Rock-Rock Bottom spreads by rating and maturity

Rock-Rock Bottom spreads by rating
Spread in bp 80 Rock-Rock Bottom Spread 70 60 40 50 40 30 20 20 10 10 0 AAA
Source: JPMorgan.

Rock-Rock Bottom spreads by maturity

Spread in bp 60 Rock-Rock Bottom Spread 50 Rock Bottom Spread Market Spread

Rock Bottom Spread Market Spread

30

0 AA A BBB 1y - 3y 3y - 5y 5y - 7y 7y - 10y > 10y

Weve also calculated Rock-Rock Bottom spreads by broad rating category and maturity bucket. Where do we stand on valuations today? Our generic statement is that valuations look full, if not more than full. In our view, the credit market is priced for a repeat of the golden 1993-97 period. We might also think of this scenario in economic growth terms, as well as the deviation of the default rate from its long-term average. Specifically, we might say that spreads today are priced for a repeat of the 1993-97 in economic growth terms, which would imply US GDP growth running at real rates circa 3.5%-4.0% for the next 4-5 years. We dont have forecasts that far out but, for what its worth, JPMorgans economics team are forecasting full-year US GDP growth of 4.3% this year and 3.6% next year.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Arent you simply trying to justify a credit bubble?

Levered versus unlevered credit
iTraxx main [bp] 70 65 1800 60 30% 55 50 45 40 35 30 25 20 Sep03 Dec03 Mar04 Jun04 Sep04 800 5% 0% Jan04 Apr04 Jul04 0% 1200 1600 25% 1400 20% 15% 10% 1% 2% 3% iTraxx 0-3% tranche [bp] 2000

their relationship and default correlation

ATM Correlation 40% 35% 4% iTraxx / iTraxx 0-3% tranche 5%

1000

600 DJ iTraxx main index DJ iTraxx equity tranche spread [bp]

ATM Correlation iTraxx spread / iTraxx 0-3% tranche spread

Source: JPMorgan.

By way of playing devils advocate, one thought that crossed our mind is that were simply following the path to ruin that we saw in the equity market during the bubble 1999-2000 period, simply trying to justify ever-higher valuations or, in a credit market context, ever-tighter spreads. We hope were not doing that. Wed also say that a significant difference between the credit market today and the equity market back in 1999-2000 is that it doesnt appear to be pricing in a scenario in which default and transition rates fall to new, all-time lows; a golden scenario, yes, but a credit bubble, no, at least in our view.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

Is the cyclical glass half-full or half-empty?

Euro credit cyclical premium and the eurozone business cycle Cyclical Premium in bp 50bp PMI 35

40 Cyclical Premium (12bp) 25bp 45

0bp

50

55 -25bp 60 PMI (53.9) -50bp Sep-99

Source: JPMorgan.

65 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04

We dont have sector spreads going back to the 1993-97 period, but we do want to revisit the idea that the credit market is priced for 3.5%-4.0% growth over the next 4-5 years. The cyclical premium is here defined as the asset swap spread differential between cyclical and noncyclical Industrials. Currently, the premium stands around pick-up 12bp, and has been nudging wider recently. This is higher than the longer term average of give-up 5bp and, from a business cycle perspective, a negative premium is not at all uncommon when the economy is expanding and, for example, things like the composite Purchasing Managers Index are reading above 50. Strip out the Auto sector, however, and its a different kettle of fish altogether. Excluding Autos, the cyclical premium is negative 2bp, slightly more generous than long-term average. What this means, metaphorically speaking, depends upon whether you think the credit market glass is half-full or halfempty. The Full-ists would agree that cyclicals arent cheap, but make the case that they arent rich either with the premium essentially where it should be given the business cycle. The Empty-ists, on the other hand, would cite the absence of a material cyclical buffer, or cushion, at a time when risks on this front seem to be rising. Where do we ally ourselves? The answer is that the risk-reward characteristics associated with the cyclical bloc look to us to be skewed asymmetrically against being aggressively overweight, based on the current pricing structure.

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When Rates are Rising Can Credit Markets Perform When Rates are Rising? Stephen Dulake J.P. Morgan Securities Ltd.

The moral of the story is: be defensive

Euro model portfolio active positions and active position changes November 2003-September 2004
Industrials Financials Public Sector -6 % -4 % -2 % 0% 2% 4% 6% Banks T1 Insurance Sen Insurance Sub Autos Basic Industry Capital Goods Consumer Cyclical Consumer Non Cyclical Energy Media Property & Real Estate Technology Telecoms Tobacco Transport Utilities -4 %
Source: JPMorgan.

Bank Senior Banks LT2 Banks UT2

Financial Nov 03 US Brokerage -4 % -2 % 0% Sep 04 2% 4%

AAA AA Nov 03 Sep 04 -2 % 0% 2% 4% A BBB -10% -5% 0% 5% 10%

The bottom-line from an asset allocation perspective is that we remain defensively positioned, but not underweight within the context of our model corporate bond portfolio, and underweight the cyclical bloc in particular.

Copyright 2004 J.P. Morgan Chase & Co.All rights reserved. JPMorgan is the marketing name used on global equity research issued by J.P. Morgan Securities Inc. and/or its affiliates worldwide. J.P. Morgan Securities Inc. (JPMSI) is a member of NYSE and SIPC. This presentation has been prepared for our institutional clients and is for information purposes only. Additional information available upon request. Information has been obtained from sources believed to be reliable but J.P. Morgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) does not warrant its completeness or accuracy. Opinions and estimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMorgan may act as market maker or trade on a principal basis, or have undertaken or may undertake an own account transaction in the financial instruments or related instruments of any issuer discussed herein and may act as underwriter, placement agent, advisor or lender to such issuer. JPMorgan and/or its employees may hold a position in any securities or financial instruments mentioned herein.

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