US Fixed Income Markets Weekly

US Fixed Income Strategy 2 March 2012
US Fixed Income Markets Weekly

Cross Sector Srini Ramaswamy, Kimberly Harano
We expect the impact of tailwinds from the improving situation in Europe to dominate the negatives, and we retain a positive stance in most risky markets. We maintain our bias for higher rates expecting 10-year rates to move modestly higher into mid year. Bill net issuance will drop but stay positive in the coming weeks, keeping front-end Treasuries cheap versus OIS. Switch out of the 6-year sector into a combination of 4s and 8s. Stay bullish on TIPS breakevens. Stay overweight 10-year Agencies versus Treasuries. Stay biased towards wider spreads at the long end of the curve, but neutral on front-end spreads. Pay in 3.25% June 2016 maturity matched swap spreads versus receiving in 3.25% July 2016 spreads. Position for a cheapening of the belly of a ED6/7Y/25Y weighted butterfly via Eurodollar short-Sep midcurve puts and expiry matched payer swaptions. Stay neutral on rate vol but sell curve vol.
Contents
Cross Sector Overview Economics Treasuries Interest Rate Derivatives Agencies Agency MBS Non-Agency MBS CMBS ABS Corporates High Yield Short Duration CDO Municipals Emerging Markets Special Topic Forecasts & Analytics Market Movers 2 6 11 18 24 28 36 41 49 53 59 65 70 74 85 86 91 96
Governments Terry Belton, Meera Chandan, Kim Harano, Renee Park
Interest Rate Derivatives Srini Ramaswamy, A. Iglesias, P. Korapaty
MBS and CMBS Matthew Jozoff, Ed Reardon, John Sim, Brian Ye
Remain neutral on the mortgage basis owing to narrower valuations and a somewhat reduced outlook for bank / money manager sponsorship. Be down in coupon in conventionals. Be overweight 30-years vs 15-years. The rally in new issue credit CMBS will continue; single-As are our top pick. The ABS market is gathering more steam as credit investors continue to add risk. We continue to see value in subordinate auto and card ABS.
ABS and CDOs Amy Sze, Rishad Ahluwalia, Maggie Wang
Investment-Grade Corporates Eric Beinstein
High Grade credit fundamentals remain solid, but some credit metrics deteriorated in 4Q11 after several quarters of very strong results.
High Yield Peter Acciavatti, Nelson Jantzen, Tony Linares
The fundamentals for high-yield bonds and leveraged loans remain a positive catalyst in the context of valuations. Given the improved market sentiment post the second 3-year LTRO, we revise our 3-month Libor forecast from 45bp to 40bp at the end of 1Q12. However, we think it will be pressured higher before 2Q12 driven by Moodys review of bank and broker-dealer ratings and money fund reform. We discuss costs associated with holding capital on the sidelines awaiting higher yields and provide specific yield targets in a breakeven analysis. Inflows remain robust and valuations still reasonable. Higher oil prices shape our recommendations.
Terry BeltonAC
(1-312) 325-4650 terry.belton@jpmorgan.com
Short-Term Fixed Income Alex Roever, Teresa Ho
Municipals Peter DeGroot, Josh Rudolph
Emerging Markets Joyce Chang, Ben Ramsey
Special Topic: Carry and Rule-Based Investing Ruy Ribeiro
Carry strategies in bonds posted strong performance in 2011 with Sharpe ratios above 1. Bond momentum in Europe was also strong.
Srini Ramaswamy
(1-212) 834-4573 srini.ramaswamy@jpmorgan.com
AC
Indicates certifying analyst. See last page for analyst certification and important disclosures.
US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Srini RamaswamyAC (1-212) 834-4573 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC
Cross Sector Overview

The ECBs sizeable provision of term liquidity in this weeks 3-year LTRO, as well as the potential for additional long-term operations in the future if needed, support a reduction in European tail risk, which in turn has been a key driver of the rally in risky assets We expect the upcoming release of the Feds 2012 Comprehensive Capital Analysis and Review (CCAR) to also be positive for markets Economic data has generally remained supportive, though this weeks durable goods and consumer spending reports have added downside risk around our GDP report, and high energy prices are a concern For now, however, we expect the impact of tailwinds from the improving situation in Europe to dominate the negatives, and we retain a positive stance in most markets We remain biased toward modestly higher Treasury yields as we head toward mid-year
Exhibit 1: Risky assets rallied again this week
Current level,* change since 2/24/12, quarter-to-date change, and change over 4Q11 for various market variables
Current Chg from 2/24 QTD chg 4Q11 chg Global Equities (level) S&P 500 E-STOXX FTSE 100 Nikkei 225 Sovereign par rates (%) 2Y US Treasury 10Y US Treasury 2Y Germany 10Y Germany 2Y JGB 10Y JGB 5Y Sovereign CDS (bp) Spain Portugal Italy Ireland Funding spreads (bp) 2Y EUR par swap - par gov't spd 2Y USD par swap - par gov't spd EUR FRA-OIS spd USD FRA-OIS spd 1Y EUR-USD xccy basis Currencies EUR/USD USD/CHF USD/JPY JPM Trade-weighted USD Spreads (bp) 30Y CC MBS L-OAS 10Y AAA CMBS spd to swaps JULI portfolio spd to Tsy JPM US HY index spd to worst EMBIGLOBAL spd to Tsy MAGGIE (Euro HG spd to govies) US Financials spd to Tsy Euro Financials spd to govies 10Y AAA muni/Tsy ratio (level) 0.288 2.045 0.130 1.868 0.102 0.975 376 1239 361 598 91.2 23.9 35.6 30.5 -58.3 1.321 0.913 81.63 80.50 40.2 215.0 193.2 619.7 347.7 164.2 241.5 241.5 93% -0.035 0.023 -0.085 -0.075 0.006 0.029 7 78 -29 20 -2.7 -5.6 -14.8 -9.0 3.6 -0.025 0.018 1.06 -0.15 2.9 -15.0 -5.9 -9.0 -17.2 -11.5 -13.3 -18.8 0.9% 0.025 0.103 0.029 -0.025 -0.027 0.069 -6 61 -127 -154 -29.9 -22.7 -35.5 -25.2 41.6 0.029 -0.031 3.92 -1.75 -5.9 -60.0 -43.6 -104.4 -78.6 -63.7 -89.2 -110.7 -0.8% -0.032 -0.080 -0.406 -0.046 -0.017 -0.089 -1 -36 13 12 21.8 18.6 7.7 12.3 -27.3 -0.051 0.037 0.95 0.23 -0.6 -90.0 -17.6 -83.9 -38.6 16.6 -3.4 25.1 -15.6% 1369.6 2546.2 5911.1 9777.0 3.9 22.5 -24.0 129.7 112.0 229.6 338.9 1321.7 126.2 136.9 443.8 -244.9
Market views
The rally in risky assets largely continued this week, with stocks rising in the US and Europe and credit spreads tightening across the board (Exhibit 1). Funding spreads also showed improvement, with EUR and USD FRA-OIS spreads narrowing sharply. A key driver of the rally was this weeks 3-year LTRO by the ECB, which attracted higher subscriptions than expected. Eight hundred banks took down 530bn of funding from the ECB, of which we estimate 313bn consists of new funding (see Overview, Global Fixed Income Markets Weekly, 3/2/12). This sizeable provision of term liquidity, as well as the potential for additional long-term operations in the future if needed, support a reduction in European tail risk, which in turn has been a key driver of the rally in risky assets. As Exhibit 2 shows, two key metrics of the crisis we have usedsemi-peripheral CDS spreads and French bank CDS spreadshave retraced to early August 2011 levels, and the potential for some further retracement
30Y AAA muni/Tsy ratio (level) 105% 0.0% -17.1% 1.6% Commodities Gold futures ($/t oz) 1722.20 -64.10 181.30 -74.60 Oil futures ($/bbl) 106.70 -3.07 7.87 19.63 * 3/1/12 level for Europe and US corporate credit spreads, and the J.P. Morgan trade-weighted USD index; 3/2/12 level for all others.
remains. Evidence of reduced tail risk can also be seen in the pickup in primary market activity. This week, the second CMBS deal of the year (the $1bn COMM 2012LC4) priced well inside of initial guidance with all classes (including the AA and single-A subordinates)
Exhibit 2: Metrics of the European financial crisis have retraced to August 2011 levels
Semi-peripheral spreads* versus French bank CDS**; bp bp
Exhibit 3: High grade issuance in February was nearly double the 10-year average
Average gross issuance by calendar month over 2002-2011, versus 2012; $bn
450 400 350 300 250 200 150 100 Jun 11
Semi-peripheral spreads
400 350 300 250 200 French bank CDS 150 100
90 80 70 60 50 40 30
Average
2012
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Jul 11
Sep 11
Oct 11
Dec 11
Feb 12
* Average 5-year sovereign CDS for France, Spain and Italy. ** Average 5-year CDS for BNP Paribas, Credit Agricole and Societe Generale.
Source: Thomson Financial, Bloomberg, and J.P. Morgan
over-subscribed multiple times. Issuance in corporate markets has been very robust as well. As Exhibit 3 shows, issuance of US high grade corporates in February was nearly double the average over the previous ten years. Similarly, high yield saw $40.4bn of gross issuance in February, making it the third most active month on record (see High Yield). Thus, European developmentsa key catalyst of the recent risk-rallyremain a near-term positive. In the US, the approaching release of the bank stress test results is also likely to prove to be supportive of risky assets. As investors will recall, the Fed announced the 2012 review, known as the Comprehensive Capital Analysis and Review (CCAR), on November 22, 2011. In contrast to prior reviews, all U.S. bank holding companies with total consolidated assets of $50bn or more were required to participate this year, raising the total number of institutions reviewed from 19 to 31. Banks were required to submit their capital plans by January 9, 2012, and will hear back from the Fed by March 15. This years review contains 25 stress-test variables (compared to 9 variables in last years review) and includes a global market shock scenario. In Exhibit 4, we compare the stress case scenario to the baseline scenario and the J.P. Morgan forecast for a few select variables. To be sure, the stress scenario defined by the Fed is fairly extreme, compared to recent economic trends as well as our forward looking projections. However, banks capital positions have been steadily
Exhibit 4: The stress scenario in the Feds 2012 review is fairly onerous compared to our forecast
Stress scenario and baseline scenario for select variables in the Federal Reserves 2012 Comprehensive Capital Analysis and Review, versus J.P. Morgan forecast for those variables*; units as marked Stress scenario Baseline scenario J.P. Morgan forecast Real Unem- Cum HPA Real Unem- Cum HPA Real Unem- Cum HPA GDP ployment from 3Q11 GDP ployment from 3Q11 GDP ployment from 3Q11 (% ) rate (% ) (% ) (% ) rate (% ) (% ) (% ) (% ) rate (% ) 3Q11 2.46 9.09 2.46 9.09 4Q11 -4.84 9.68 -1% 2.33 9.10 0.3% 3.0 8.7 -3.8% 1Q12 -7.98 10.58 -4% 1.92 9.10 0.5% 2.0 8.3 -5.7% 2Q12 -4.23 11.40 -7% 2.22 9.00 0.8% 2.5 8.2 -0.9% 3Q12 -3.51 12.16 -10% 2.43 8.90 1.0% 3.0 8.1 0.0% 4Q12 0.00 12.76 -13% 2.63 8.90 1.3% 2.0 8.1 -2.9% 1Q13 0.72 13.00 -16% 2.69 8.69 1.5% 1.5 8.1 -4.3% 2Q13 2.21 13.05 -18% 2.81 8.48 1.8% 2.2 8.0 1.1% 3Q13 2.32 12.96 -20% 2.90 8.27 2.0% 2.5 8.0 2.0% 4Q13 3.45 12.76 -21% 2.96 8.06 2.3% 3.0 7.9 -0.9% 1Q14 3.36 12.61 -21% 2.94 7.93 2.5% 2Q14 3.71 12.36 -21% 2.95 7.78 2.8% 3Q14 4.64 12.04 -20% 2.95 7.63 3.0% 4Q14 4.64 11.66 -19% 2.94 7.48 3.3%
* The Federal Reserves projections for HPA are based on the CoreLogic National House Price Index (seasonally adjusted by Federal Reserve staff), while the J.P. Morgan forecast for HPA is based on the S&P/Case-Shiller home price index.
improving since the financial crisis. Since 1Q09, the banks under review have raised about $270bn of common equity capital, and as Exhibit 5 shows, the largest banks had an average Tier 1 common ratio of 10.7% as of the end of 2011, well above the 5% minimum level for the stress tests. Thus, given banks healthy levels of current capitalization, we think the stress test results will likely be a positive for risky asset
Exhibit 5: Given robust capitalization levels currently, we expect the results of the Feds stress tests for banks to be positive
Basel I Tier 1 common ratio, full-year 2012 dividend forecast*, full-year 2011 dividend, and projected change in dividend for the US banks in the Feds 2012 CCAR**; units as indicated Proj. Basel I 2012 chg in Tier 1 Dividend 2011 common forecast Dividend dividend ratio (% ) ($/share) ($/share) ($/share) JPMorgan Chase & Co. 10.10 1.20 1.00 0.20 Citigroup Inc. 11.80 0.20 0.03 0.17 Bank of America Corporation 9.86 0.04 0.04 0.00 Wells Fargo & Company 9.46 0.80 0.48 0.32 Goldman Sachs 12.10 1.40 1.40 0.00 Morgan Stanley 13.00 0.20 0.20 0.00 MetLife, Inc. N/A 1.05 0.74 0.31 PNC Financial Services Group, Inc. 10.30 1.80 1.15 0.65 U.S. Bancorp 8.60 0.72 0.50 0.22 Bank of New York Mellon Corporation 13.40 0.60 0.48 0.12 SunTrust Banks, Inc. 9.22 0.40 0.12 0.28 State Street Corporation 16.90 0.92 0.72 0.20 Capital One Financial Corporation 9.70 0.56 0.20 0.36 BB&T Corporation 9.70 0.80 0.65 0.15 Regions Financial Corporation 8.51 0.04 0.04 0.00 American Express 12.30 0.72 0.72 0.00 Fifth Third Bancorp 9.35 0.40 0.28 0.12 KeyCorp 11.26 0.20 0.10 0.10 GMAC LLC 8.57 N/A N/A Citizens Financial Services Inc. N/A 1.18 1.16 0.02 Comerica Inc. 10.41 0.60 0.40 0.20 Discover Financial Services N/A 0.40 0.20 0.20 Huntington Bancshares Inc. 10.00 0.16 0.10 0.06 M&T Bank Corp. N/A 2.80 2.80 0.00 Northern Trust Corp. 12.10 1.12 1.12 0.00 Zions Bancorporation N/A 0.04 0.04 0.00
Exhibit 6: Brent oil prices are back at their 2011 highs, and our Middle East crisis index remains elevated, suggesting ongoing risk of a supply shock
Middle East crisis index* versus rolling front Brent oil futures contract price; level $/bbl
10 8 6
Middle East crisis index Brent oil prices
130
120
110 4 2 0 Dec 10 100
Mar 11
Jun 11
Sep 11
Jan 12
90
* Defined as exp[0.5*(Brent oil prices 0.1075*S&P + 3.6274*JPM Trade-weighted dollar index + 0.0959*EM stocks -348.34)/4.2]. EM stocks are defined as the weighted average of Brazil, Mexico, Russia, India, China, Hong Kong, Taiwan, Korea, Singapore, Malaysia, Thailand and Indonesia benchmark stock indices in USD terms. Weights determined by market values of the indices (in USD terms) as of year-end 2011. Source: Bloomberg, J.P. Morgan
* For banks that pay quarterly dividends, full-year 2012 dividend forecast estimated as forecast for upcoming quarterly dividend*4. ** BBVA USA Bancshares, BMO Financial Corp, HSBC North America, RBC USA Holdco Corp. and UnionBanCal Corp were excluded given that their parent companies are domiciled outside of the US. Source: Bloomberg
markets. This view is somewhat supported by analyst projections: as Exhibit 5 shows, most banks that are subject to the stress test are expected to either maintain or increase dividends in 2012. Since capital plans will need to be approved by the Fed, this reflects the expectation of banks passing the stress tests and gaining approval to raise their dividends. On the US economic front, data remains supportive, although some downside risks have materialized
recently. On the positive side, labor market data continue to improve, with the four-week averages for initial jobless claims and continuing claims making fresh lows for the cycle in the latest reading. Although the ISM manufacturing survey ticked down from 54.1 to 52.4 in February, the regional activity surveys have strengthened, with the Dallas Fed, Richmond Fed and Chicago purchasing manager surveys rising more than expected. In addition, total vehicle sales rose to a 15.0mn annualized pace in February, the highest level since February 2008. On the other hand, this weeks durable goods report was disappointing, with core capital goods orders down 4.5% and core capital goods shipments down 3.1% in January. In addition, real consumption was flat in January, and past data were revised down to reflect a softer trajectory. Both of these reports add downside risk to our GDP growth forecast for 1Q12. One additional area of concern is energy prices. Brent oil futures prices have already reached their 2011 highs, and our Middle East crisis index remains elevated, suggesting ongoing risk of a supply shock (Exhibit 6). Sustained high energy prices would pose a threat to economy, though the persistent rally in equities despite the rise in energy prices suggests that investors are not yet concerned about the threat to the economy.
Thus, markets for now remain driven by tailwinds from lowered European tail risks; as we noted last week, we expect this impact to mostly outweigh the risk from the still-fluid situation in the Middle East, and we retain a positive stance in most markets. We remain overweight high grade, high yield and emerging markets. In CMBS, we believe the rally in new issue credit bonds will continue; given the outperformance of AAs this week, single-As are our top pick in the space (see CMBS). Similarly, in ABS, the most risky and esoteric bonds have benefited from the increase in risk appetite; we continue to see value in subordinate auto and card ABS, as well as certain off-the-run sectors such as US$ UK RMBS and subprime auto ABS (see ABS). In Treasuries, we remained biased toward modestly higher rates as we move toward mid-year. Technicals are now set to turn more negative, with Treasury supply increasing mid-month and investors likely to de-risk further in front of Fridays payrolls report. In addition, sponsorship from China has become more uncertain (see Treasuries).
Economic Research US Fixed Income Markets Weekly March 2, 2012 Robert MellmanAC (1-212) 834-5517 Michael Feroli (1-212) 834-5523 J.P. Morgan Chase Bank
Economics
1Q12 GDP forecast is still 2.0% but with downside risks after soft reports on consumer spending and capex Real consumer spending has stalled for three straight months, but a return to growth is expected soon Forecast looks for nonfarm payroll employment to be up 220,000 and the unemployment rate to decline to 8.2% Fiscal stimulus dollarsboth 2009 Recovery Act and other measuresare beginning to fade
Exhibit 1: Real consumer spending

%ch saar over 3 months 5
4 3 2 1 0 -1 2010 Total ex motor vehicles and parts
Total spending
2011
2012
Exhibit 2: Nominal disposable income and wage and salary income

%ch saar over 6 months, 3mma 8
The busy economic calendar this past week provided a mix of weak and strong data that is broadly consistent with the forecast for moderate growth this quarter. But the source data used to estimate real GDP have generally been weaker than expected and highlight downside risks to the forecast of 2.0% growth this quarter. In particular: Real consumer spending was unchanged in January for the third consecutive month. Available data suggest that real consumer spending this quarter will increase less than 1.0% saar, down from a forecast of 1.5% a couple of weeks ago. Core capital goods shipments plunged 3.1% samr in January, more than reversing the December surge. Even accounting for the tendency for capital goods shipments to be unusually weak in January, real business spending on equipment and software looks unlikely to reach the prior forecast of 9.0% saar growth this quarter. Private nonresidential construction declined 1.5% samr in January following gains averaging 1.2% per month through 4Q11. Preliminary figures on construction spending are often revised substantially, but for now data on business investment in structures is also tracking below the prior 10.0% saar growth forecast for this quarter.
6 4 2 0 2010
Wage and salary income
Disposable income
2011
2012
Exhibit 3: Consumer confidence and equity prices

Sa 80
Consumer confidence, Conference Board 70 S&P 500
Nsa, index 1400

1330 1260
60 1190 50 1120 1050
However, other incoming data are the strong side of expectations, including February readings on auto sales and the Conference Board measure of consumer confidence. And our favorite high-frequency indicator,
40 2010
2011
2012
initial jobless claims, declined again in the latest week. The trend in claims has been falling rapidly through February and the employment detail of business and consumer surveys has also generally surprised on the high side. Consequently, the forecast looks for February payroll employment growth of 220,000, up from an average 201,000 over the past three months. The upcoming calendar also includes the February ISM nonmanufacturing survey (Monday) and the January foreign trade report (Friday) that will help refine the current-quarter growth forecast.
Exhibit 4: ISM manufacturing exports orders and merchandise export volumes

Sa 65
%ch saar, 3m/3m
Export orders Export volumes
20 15 10
60 55
5 50 45 2010 Decline and reb ound reflect supply-chain effects ofJapan earthquake 2011 2012 0 -5
Stall in spending probably a soft patch
The latest report on January real consumer spending, with revisions, shows extreme weakness. Real consumer spending has been unchanged for the last three months, despite an increasing trend in auto sales. And the outlook for February is not much better. Unit auto sales posted another impressive gain in February, rising to 15.1mn at an annual rate from 14.1mn in January and an average 13.4mn in 4Q11. But with the CPI set to increase 0.4% to 0.5% in February, largely reflecting much higher fuel prices, real spending last month probably edged up only 0.1% samr. While actual spending numbers have been very soft lately, most incoming economic data point to a reacceleration before too long. Most important, labor market indicators suggest that growth of employment and wage and salary income is strengthening. In addition, both the Conference Board and Michigan consumer confidence surveys for February reached their highest levels in a year. Equity prices are now 12% above their 4Q11 average. And detail of this weeks minor revision to 4Q11 real GDP growth includes a fairly massive revision to the governments estimate of wage and salary income growth. Current figures based on more complete source data show that wage and salary income increased 6.6% saar in 3Q11 (was 1.5%) and 5.5% in 4Q11 (was 4.0%). But not all spending indicators are positive. Importantly, while the trend in wage and salary income has been accelerating over the past year, the trend in total disposable income has been slowing. The difference between the two series largely reflects the effects of fewer government transfers, lower interest income, and reduced farm income. The forecast for stronger real spending growth in 2Q12 also depends on the view that gasoline prices stabilize, at least in seasonally adjusted terms, before long.
Surprise: ISM mfg slips, export orders soar

Manufacturing data through January show a sharp split between the strong acceleration in manufacturing IP and the sharp slowdown in durable goods shipments and orders including for core capital goods. And the February ISM report was anticipated as a source of guidance on how manufacturing is holding up. Regional manufacturing surveys for February had generally posted increases, but the national ISM manufacturing survey turned down in February with declines in key activity components including new orders (from 57.6 in January to 54.9) and production (from 55.7 to 55.3). These declines are not dramatic, and the survey is consistent with continued but more moderate production growth ahead. While the decline in the ISM survey was a surprise against the backdrop of regional survey results, it is consistent with broad economic indicators including the recent slowing in real consumer spending and core capital goods orders and the expectation that the contribution to growth from inventories would be much less this quarter than in 4Q11. The one striking anomaly in the latest ISM manufacturing survey is the 4.5pt increase in new export orders to 59.5. This is the fourth consecutive increase in this series and takes export orders to its highest level since last April. This reading is certainly at odds with the view that real exports will slow this quarter in response to weaker demand conditions in most foreign markets. The next major test of this view is the January trade report (Friday). Based partly on the ISM survey, and partly on data on the aircraft, auto, and oil industries, the forecast looks for a 1.4% samr increase in export
volumes and a narrowing in both the nominal and real trade deficits.
Exhibit 5: Fiscal stimulus

FY, $ bn ARRA non-ARRA total stimulus funds Change in stimulus funds as % of GDP
2009 177 0 177 177 1.3
2010 323 92 415 238 1.7
2011 171 266 437 22 0.1
2012 39 247 286 -151 -1.0
2013 44 35 79 -207 -1.3
Fiscal stimulus just beginning to wane

Federal fiscal policy has been quite accommodative throughout the expansion. Some well-advertised policy choices are arriving at year-end that could change all that, most notably the expiration of the Bush tax cuts. Regardless of those year-end decisions, however, there are two other factors that will cause fiscal policy to become more restrictive in the meantime. First, stimulus dollarsnot only from the original February 2009 Recovery Act, or ARRA, but also from the many subsequent smaller stimulus packagesare beginning to fade this year. Second, though smaller in magnitude, defense spending is also set to experience a meaningful contraction. Together, these two factors will present a headwind to growth even before we arrive at the larger year-end decisions.
ARRA: American Recovery and Reinvestment Act of 2009
Exhibit 6: Fiscal thrust/drag from stimulus policies

Change in deficit impact due to fiscal stimulus, % of fiscal year GDP 2.0
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 2009 2010 2011 2012 2013
What is stimulus?
Fiscal support for an ailing economy can come in one of two forms: automatic stabilizers and discretionary fiscal actions to support the economyor what is commonly called stimulus. Automatic stabilizers include, for example, the automatic reduction in average income tax rates that takes place as incomes and effective marginal tax rates move lower. This category also includes automatic increases in outlays for income support programs such as regular unemployment benefits. The magnitude of automatic stabilizers varies from countryto-country based on institutional arrangements, but in the US, for every percentage point that the economy is operating below its capacity, the deficit will automatically increase by about 0.35%-point. By this rule of thumb, about 2.0%-points of the current deficitto-GDP ratio is due to automatic stabilizers. Stimulus occurs when policymakers actively make choices to change policy in order to provide more fiscal support to the economy. The most notable example in the current cycle is the 2009 Recovery Act, or ARRA. Not all of ARRA should be considered stimulus, however, as some componentssuch as patching the Alternative Minimum Tax to prevent a large middle-class tax hike occur every year. The only reason the AMT is not permanently extended is so that Congress can preserve an accounting mirage. For this reason, we exclude these extenders in the table on this page. More important for understanding the outlook is to remember that not all
Exhibit 7: Deficit decomposition

FY, % of GDP Deficit Automatic stabilizers Discretionary fiscal policy TARP Structural
2009 -2.1 -1.3 -1.1 -5.7
2010 -8.9 -2.3 -2.9 0.8 -4.5
2011 -8.6 -1.9 -2.9 0.2 -4.1
2012f -7.7 -1.7 -1.8 -0.1 -4.0
2013f -5.6 -1.7 -0.5 0.0 -3.4
-10.2
Note: structural includes changes in defense outlays
stimulus measures undertaken in the current cycle were contained in ARRA. Perhaps the most prominent such measure is the payroll tax holiday, which was initially conceived to offset the tax hike that took place when the Making Work Pay tax creditwhich was part of ARRAexpired at the end of 2010. However, in the years since the recession there have been numerous other smaller legislated changes to tax and spending policy to support the economy, including extending unemployment benefits, COBRA health coverage benefits, state fiscal relief, etc. A recent tabulation by the Center for Budget and Policy Priorities places the bill for these non-ARRA stimulus measure over the 2009-13 period at $640bn, almost as much as the ARRA stimulus measures impact on deficits over the same period, which is about $754bn.
Even with the recent extension of the payroll tax holiday, the amount of support provided to the economy through discretionary fiscal actions is set to contract this year, which will be a headwind to growth. The total amount of stimulus-related outlays and tax expenditures will contract by about 1% in fiscal year 2012. The exact multiplier effect of this financial measure on GDP is uncertain, but using a fairly standard multiplier of 1.0 would imply that the waning of stimulus could subtract about 1%-point from growth this year. Changes in defense outlays have been dominated by noneconomic considerations, and so they are not included in the above calculations which measures the fiscal policy response the Great Recession.
Exhibit 8: Defense outlays

% of GDP
5.0 4.5 4.0 3.5 3.0 2.5 CBO, assuming troops in Mideast Forecast OMB
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
A farewell to arms
Most discussions of how fiscal policy relates to the outlook rightly focus on the discretionary stimulus measures. However, there are other moving parts when it comes to fiscal policy. One that will become increasingly important for the US economy is defense spending. The winding down of military operations in Iraq and Afghanistan could contribute to a decline in defense spending of about 1/4%-point of GDP this year, and then contracting about 1/2%-point in both 2013 and 2014. The regional recessions in California and New England in the early 1990s serve as a reminder that welcome foreign policy developments can sometimes be accompanied by painful economic transitions. Estimating the impact of these developments is made a little more difficult by the fact that the CBOs baseline estimate for these Overseas Contingency Operations (OCOs) must assume a continuation of the troop levels in the prior fiscal year, even though most observers expect the ongoing drawdown of troops in the Mideast will continue. To allow for this possibility, CBO also constructs an alternative scenario whereby troops in that region are gradually decreased, and in that scenario defense spending declines in a similar manner to that in the OMB forecastwhich is allowed to make more realistic assumptions concerning defense policy. One potential offset is that some of these expenditures go to foreign nationals for services provided in the theater of operations. In the economic accounts, these purchases are considered imports. Such imported defense expenditures are less than $30bn, whereas the decline in defense spending over the next few years will likely amount to over $100bn. So even if defense imports fell to
Exhibit 9: Change in defense outlays

% of GDP
1.0 0.5 0.0 -0.5 -1.0
Forecast
OMB CBO, assuming troops in Mideast operations down to 45,000 by 2015 80 85 90 95 00 05 10 15
zero, this offers only a partial offset to the domestic drag that is set to occur from reductions in defense outlays.
And now, the elephant in the room

So far, this note hasnt discussed the fiscal issues that loom at the end of the year: most important of which is the expiration of the Bush tax cuts, whichif realized would increase the tax burden of the household sector by about $250bn, or about 1.5% of GDP. The J.P. Morgan forecast does not assume that this tax increase will be implemented in its entirety. It is difficult to say what will replace current law, in part because that will depend on how the November elections play out. Our uncertainty about the future tax regime is likely shared by many households and businesses, and is why we believe activity could slow around year-end as decisions are deferred until there is more clarity on the tax outlook. Even absent these year-end considerations, however, federal fiscal policyas measured by changes in discretionary fiscal actions and changes in the structural
federal deficittightened by about 0.4%-point of GDP in 2011, and looks set to tighten by 1.2%-points in 2012. The 2013 outlook is particularly hazy but our best guess is that fiscal policy will tighten by another 1.9%-points.
10
US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Terry BeltonAC (1-212) 834-4650 Meera Chandan (1-212) 834-4924 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC
Treasuries
Technicals are now set to turn more negative with Treasury supply increasing mid month and investors likely to de-risk further in front of Fridays payrolls report and sponsorship from China has become more uncertain; we maintain our bias to higher rates expecting 10-year rates to move modestly higher into mid year Despite the upcoming supply, we advise against initiating long-end steepeners and prefer to take advantage of any supply-related cheapening to initiate long-end flatteners Bill net issuance will drop but stay positive in the coming weeks, keeping front-end Treasuries cheap versus OIS Switch out of the 6-year sector into a combination of 4s and 8s Stay bullish on TIPS breakevens
Exhibit 1: Ten-year yields have held a narrow trading range since November
10-year Treasury yields*; %
2.15 2.10 2.05 2.00 1.95 1.90 1.85 1.80 1.75 Dec 11 Jan 12 Feb 12 Mar 12
*Horizontal lines indicate 1 standard deviation move around 4-month average
Exhibit 2: Supply matters: Treasuries continue to sell off into supply and rally out of supply
10-year par Treasury yields averaged in the business days around 5 and 10year auctions; 9/11-2/12; %
2.09 2.08 2.07 2.06 2.05 2.04 2.03 2.02 2.01 2.00 -8 -6 -4 -2 0 2 4 6 Business days around 5- and 10-year auctions 8
Market views
Treasury yields were mixed this week with 2- and 5-year Treasury yields falling 4 bp and 5 bp, and 10- and 30-year yields rising 1 bp and 2 bp, respectively. The directionless market reflects the competing forces of strong performance of risky assets, and strong technicals in the Treasury market driven by month-end buying, Fed purchases at the long end, and a longer than normal period (two weeks) without coupon supply in Treasuries. With this weeks modest sell-off, 10-year yields are at 1.98%, still close to the middle of the narrow trading range they have held since November (Exhibit 1). Economic data were mixed this week with labor markets continuing to show strength but activity data disappointing. January durable goods orders declined a larger than expected 4% with core capital goods and shipments now falling in three of the past four months. The ISM manufacturing survey was also weaker than expected (falling 1.7 points to a still-solid 52.4) while consumer spending data disappointed with real consumption unchanged in January following flat readings in November and December. The soft trajectory suggests
1Q12 real consumer spending is tracking below 1% this quarter. On the positive side, initial jobless claims fell again with the 4-week average reaching 354,000, a new low for the cycle. Consumer confidence was also strong with the February Conference Board index reaching its highest level in a year. Finally, motor vehicle sales were stronger than expected (15.03mm) and pending home sales data was solid rising 2% in January and 15% saar in the last six months. On balance however, the spending data are tracking weaker than expected and provide downside risk to our 1Q12 GDP forecast of 2%. With month-end behind us, technicals are now set to turn more negative with Treasury supply increasing mid month
11
Net non-commercial longs in FV, ED and TU futures contracts averaged around the number of business days around payrolls release day over the past two years; $bn
Exhibit 3: We look for investors to unwind duration longs in the front end ahead of payrolls
Exhibit 4: Commentary from the Fed has been less dovish since January
Fed sentiment index*; %
-10 -15 -20 -25 -30 -35 Nov 11 Jan 12 Mar 12

* The Fed sentiment index is computed as the cumulative sum of yield changes in 5Y Treasury futures in the 15-minute period following the first Fedspeak headline on Bloomberg, since 7/3/06. Fedspeak is defined as any speech, FOMC statement, or FOMC minutes.
255 250 245 240 235 230 225 220 215 210 -20
Source: CFTC
TU, ED and FV TU and ED
155 150 145 140 135 130 125 120 115 110 105 100 20
-15
-10 -5 0 5 10 Business days around payrolls release
15
and investors likely to de-risk further in front of Fridays nonfarm payrolls report. Intermediate Treasury yields continue to exhibit reasonably strong cyclical patterns around coupon supply with yields generally rising going into auction weeks and falling coming out of auctions. Indeed, 10-year Treasuries have rallied in 10 of the last 12 weeks out of supply and sold off in 7 of the last 12 weeks leading into supply (Exhibit 2). These supply technicals, combined with increased sensitivity to the employment report, bias 10-year rates to the upper end of their trading range next week. As discussed last week, the sensitivity of forward OIS rates to downside surprises in the unemployment rate has increased sharply in the last few months (see US Fixed Income Markets Weekly, 2/24/12) . This heightened sensitivity should lead to further de-risking next week and cause investors to reduce yield curve carry trades and unwind duration longs in the front end of the yield curve (Exhibit 3). A very subtle change in tone from the FOMC is also supportive of modestly higher rates as recent Fed speeches have suggested reduced prospects for QE3. Our Fed sentiment index, which tracks changes in 5-year Treasury yields in response to speeches by FOMC members, has increased 10 bp in the last few weeks suggesting commentary from the Fed has been slightly less dovish than during January (Exhibit 4). These speeches include testimony this week from Chairman Bernanke indicating
Exhibit 5: Recent comments by FOMC members

Speaker Comments Looking ahead, we may need to do more if the recovery falters or if inflation stays well below 2 percent. In answer to a question, Williams said another round of monetary stimulus will depend on how the economy performs but is Williams definitely not off the table. Because interest-rate changes take time to have their desired effect, Williams said he wouldnt wait until the economy reaches full employment to raise borrowing costs. "Our current expectation is the short term rate will stay low for a good bit more time. Eventually the economy will strengthen, inflation will begin to rise and the Fed will have to raise short-term interest rates," Mr. Bernanke said, cautioning that the Fed wants "to make sure banks understand their risks and they are well protected and hedged against whatever course interest rates might take." More bond purchases wouldnt be appropriate now, Lockhart told reporters after his speech. The onset of recessionary conditions and movement in the direction of deflation would be conditions that could lead to more easing, Lockhart said. The current policy is already quite accommodative both in terms of interest rates and the size of the central banks balance sheet, she said. Additional monetary stimulus could spur inflation, while less action by policy makers could risk weakening an already slow expansion and cause disinflation, she said. St. Louis Federal Reserve Bank President James Bullard expressed optimism over the economic recovery, saying he saw a real gain in the recent decline in the unemployment rate. The Fed official also distanced himself from the specific language in the central banks latest policy statement saying that he would have preferred not to include a calendar date in the statement. Way out at the end of 2014, we dont know what the economys going to look like and it over-emphasizes our forecasting ability, which isnt that good.
Date
3/2
Bernanke
3/1
Lockhart
3/1
Pianalto
3/1
Bullard
2/24
St. Louis President James Bullard said he doesnt favor additional asset purchases since inflation is above the central banks target. Inflation numbers would have to indicate further disinflation or the threat of deflation, Bullard Bullard said at the U.S. Monetary Policy Forum hosted by the University of Chicago Booth School of Business. Inflation risks are to the upside currently. Source: Bloomberg, Wall Street Journal
2/24
12
the need for banks to protect against higher rates, comments by Lockhart and Bullard indicating further asset purchases are not appropriate right now, and comments from SF Fed President Williams noting that further stimulus is data-dependent and that the Fed will begin raising policy rates before the economy reaches full employment (Exhibit 5). While the main thrust of communications from the FOMC remains that they expect policy rates to remain low until 2015, the subtle change in tone highlights the importance of upcoming data in maintaining that view. Finally, we note that this weeks newly released data on Treasury holdings of large foreign investors highlights a significant longer-term risk to the Treasury market. As discussed in more detail below, these data show China sold $155 bn of Treasuries during 2H11 with sales accelerating in the fourth quarter. To the extent this represents a more permanent desire on the part of the single largest holder of US Treasuries to diversify into other assets, the longer-term risks to the Treasury market are potentially quite large. In sum, with technicals now more supportive, risks asymmetric around payrolls, Treasury rates rich to fair value, and less-certain sponsorship from China, we maintain our bias to higher rates expecting 10-year rates to move modestly higher into mid year (Exhibit 6). To be sure, next Fridays payroll report will be key in determining the near-term direction of the Treasury market. A weaker than expected report, especially one that moves the unemployment rate higher, will result in investors reentering carry trades with rates likely to move back below the middle of the trading range they have held in the last few months. At the long end of the curve, we expect the upcoming mid-month auctions to generate increased selling pressure with many investors initiating back-end steepeners into supply. Despite the upcoming supply, we advise against initiating long-end steepeners and prefer to take advantage of any supply-related cheapening to initiate long-end flatteners. Auction cyclicals leading into 30-year auctions have become much more muted recently as Operation Twist has increasingly reduced the available float at the long end of the curve (Exhibit 7). This has meant that pre-auction steepeners have performed much more poorly while amplifying postauction flattening. As a result, we advise patience in positioning around long-end supply and are biased to
Exhibit 6: J.P. Morgan interest rate forecast

%
Actual Rates Effective funds rate 3-mo LIBOR 3-month T-bill (bey) 2-yr Treasury 5-yr Treasury 10-yr Treasury 30-yr Treasury 1Q12 2Q12 3Q12 4Q12
2 Mar 12 31 Mar 12 30 Jun 12 30 Sep 12 31 Dec 12 0.10 0.48 0.07 0.28 0.85 1.98 3.11 0.10 0.40 0.04 0.27 1.10 2.25 3.30 0.10 0.45 0.02 0.30 1.25 2.50 3.60 0.10 0.50 0.02 0.30 1.25 2.50 3.60 0.10 0.50 0.02 0.30 1.25 2.50 3.60
0.46 * 30-year Treasury yields minus 5-year Treasury yields averaged in the business days around the 30-year auction before and after Operation Twist was announced*; % 0.40 0.53 Pre Post Operation Operation Twist 0.52 Twist
Exhibit 7: Long-end supply concessions have fallen after Operation Twist
0.51 0.50 0.49 0.48 0.47 -10 -5 0 5 10
0.35
0.30
0.25
Business days around Bond auction

* Pre Operation Twist includes Bond auctions between April 2011 and September 2011. Post Operation Twist includes Bond auctions held starting October 2011
initiating long-end flatteners as we approach the bond auction. This month in particular is more supportive than usual of post-supply long-end flattening. Four out of the seven purchase operations in the 25- to 30-year sector are scheduled to occur after March 20. Moreover, purchases this month are likely to be of longer duration than typical given the Fed schedule released this week. Even if the Fed purchases $4.25bn per operation in the 6- to 8-year sector, which is the upper end of the announced range (of $3.5 to $4.25bn) for this part of the curve, purchases in the sector will comprise only 29% of total purchases in the month, lower than the target of 32% and the prior 3-month average of 33%.
13
Exhibit 8: 4s and 8s look cheap versus 6s

0.06 0.05 0.04 0.03 0.02 0.01 -0.00 -0.01 -0.02 -0.03 -0.04 -0.05 Sep 11 Dec 11
T 2.25% Nov-17 yield 0.69 * 3.25% May-16 0.4 * 3.375% Nov-19; %
Exhibit 9: Even though the pace will fall, net issuance of bills will stay positive and average $11bn/ week for the next six weeks
Projected net issuance of bills and Treasurys operating cash balance; $bn 40 38 35 Projected bill $bn 140
20 0 -20 -40
10
19
18
14
20 8 8 8
net issuance
120 100
-10
-5
80 60
Mar 12
02 Feb
-60
Proj. cash balance
-36
40 20
01 Mar
08 Mar
15 Mar
22 Mar
09 Feb
16 Feb
23 Feb
29 Mar
On the curve, we recommend switching out of the 6year sector into a combination of 4s and 8s. The 4-year sector has cheapened significantly on the curve over the past week, and the 3.25% May-16s in particular is now one of the cheapest issues on the curve (using the yield error relative to the fitted curve as a metric). In addition, the yield error of 2.25% Nov-17s and 3.375% Nov-19s are near the lows and highs the past year, respectively. Thus, we recommend switching out from the Nov-17s into a combination of May-16s and Nov-19s on a curve and level neutral basis (see Trade Recommendations). As shown in Exhibit 8, this weighted trade currently appears around 5bp mispriced. Treasury/OIS spreads are currently close to the wider end of their 1-year range. Despite attractive valuations, we are cautious on positioning for a richening of front-end Treasuries versus OIS rates, waiting instead for better entry levels in the coming weeks. Two reasons motivate this view. First, we expect net issuance of bills to stay positive in the coming weeks, with outstanding bills expected to increase another $60 bn over the next five weeks. As shown in Exhibit 9, although the pace of net issuance will slow from the levels in February, we expect it to stay positive for the next six weeks. After mid-April, however, bill net issuance should turn negative, which will then be supportive of tighter spreads between front-end Treasuries and OIS rates. Second, dealer positions in Treasuries have stayed elevated, which will likely keep GC repo and thus Treasury/OIS spreads wide. As discussed earlier this year, (see US Fixed Income Markets Weekly, 1/20/12), Treasury/OIS spreads have been highly correlated with dealer Treasury holdings, with spreads
Exhibit 10: Foreign buying of Treasuries was strong thru 3Q11 before declining in 4Q11
80 3Q11
Average monthly Treasuries (coupons and bills) purchased by foreigners; $bn
60 Year-ended June 2011 4Q11
40
20
0 Jun 06
Jun 07
Jun 08
Jun 09
Jun 10
Jun 11
All data is for the year ending June 30 except 2H11, which is quarterly data. Source: Treasury TIC
narrowing as dealers grow their short base in Treasuries. Currently, with mortgage and corporate dealer inventories extremely light, dealers are net long Treasuries, with their net position close to the longest of the last five years. The lack of a dealer short base in Treasuries combined with positive bill supply should keep GC repo rates and Treasury OIS spreads elevated in the near term.
Foreign buying of Treasuries

Treasury released details of its annual survey on foreign holdings of US securities this past week. This data is released with a significant lag, and the latest release
14
03 May
05 Apr
12 Apr
19 Apr
26 Apr
relates to the holdings at the end of June 2011. In addition, Treasury also introduced new holdings data which will be released in a more timely manner going forward, and is expected to provide more accurate country-level data. Currently this is available for Treasuries for select major holders as of September and December 2011, but will be made available on a monthly basis going forward. These two releases are important since they provide a countrylevel breakdown of holders of Treasuries, which is not otherwise available. There are three key takeaways from the release. First, the data shows that the overall pace of foreign buying was solid in the year ending June 2011, averaging $52bn/month in line with the previous two years. Foreign buying increased to $72bn/month in 3Q11, before weakening in 4Q11 (Exhibit 10). As discussed previously (see US Fixed Income Markets Weekly, 11/18/11), the pickup in 3Q11 was largely driven by a flight-to-quality bid for Treasuries from Europe as the sovereign debt crisis in Europe escalated. Second, China became a large net seller of Treasuries in 2H11. Exhibit 11 shows that China went from buying $16bn Treasuries per month to selling $26bn per month in 2H11, selling a total of $155bn Treasuries in 2H11. This is notable not only because China is the largest holder of Treasuries, but also because Chinas foreign exchange reserves were little changed over the same period (only $16bn lower), suggesting a diversification away from Treasuries into other asset classes. Finally, the data highlight that weak demand from China was more than offset by the heavy currency intervention from Japan, which more than quadrupled its pace of Treasury buying during 2H11. This buying, however, is now likely to fade with the BoJ growing its balance sheet and the Yen weakening this year. Further lackluster demand from China is therefore likely to be a significant negative for the Treasury market, potentially requiring significantly higher yields for the Treasury market to clear.
Exhibit 11: The US Treasury lost its largest client in 2H11

Country China, Mainland Japan Brazil Taiwan Luxembourg Russia Switzerland Belgium Hong Kong United Kingdom Jun'09-Jun'10 Jun'10-Jun'11 16 16 8 7 1 4 3 0 0 2 2 -1 2 1 1 4 3 -2 1 4 3Q11 -12 34 3 7 2 -1 13 14 0 -6
Average monthly net purchases of Treasuries (bills and coupons) for the top 10 Treasury holders at the end of 2011; $bn
4Q11 -39 25 0 4 8 0 -5 1 3 -2
Source: Treasury TIC
Exhibit 12: Continued declines in tail risk in Europe should support wider TIPS breakevens
10-year TIPS breakevens versus Euro Stoxx 50 index; bp level
280 260 240 220 200 180 10-year TIPS breakeven Euro Stoxx 50
3200 3000 2800 2600 2400 2200 2000
160 1800 Mar 11 Apr 11 Jun 11 Jul 11 Sep 11 Nov 11 Dec 11 Feb 12
TIPS
This week the rally in breakevens hit a speed bump as Brent oil prices declined 1.5% and shorter-maturity nominal yields fell. All in all, 5-, 10-, 20-, and 30-year breakevens narrowed 6bp, 4bp, 4bp, and 5bp, respectively.
Our views on breakevens are unchanged; we continue to look for breakevens to widen. As we highlight in the Cross Sector Overview, declining tail risks in Europe are supportive of the rally in risky assets, and we expect TIPS breakevens to widen in sympathy. As Exhibit 12 shows, TIPS breakevens have tracked European equities very closely over the past year and are likely to widen as the European situation improves. In addition, escalating tensions in the Middle East could also send oil prices higher and push breakevens wider. Over the next week, the market is likely to focus on the Fed sales operation on Monday and the employment report on Friday. First, we expect the Fed to sell around $1.34bn TIPS on Monday, which is the average sale size
15
over the past five operations. Given that the Fed owns only five issues in this sector of the curve (with holdings totaling only $5.2bn), we continue to expect the Fed to attempt to sell issues that it holds more of. Exhibit 13 shows the TIPS in the sales bucket ranked by Fed holdings. Although the employment report has less direct relevance for TIPS than, say, the CPI report, in recent months, breakevens have become more sensitive to surprises in payrolls, with 10-year and 30-year breakevens now more sensitive than front-end breakevens (Exhibit 14). Exhibit 15 shows the projected change in breakevens for various surprises in payrolls based on a 1-year regression. The analysis suggests that if payrolls surprise sharply to upside, the breakeven curve is likely to steepen, and 10year breakevens are likely to outperform if the surprise is large enough.
Exhibit 13: We expect the Fed to sell issues that it holds more of
Fed holdings ($bn Cpn 3.000 2.000 1.625 1.250 0.625 Maturity 07/15/12 01/15/14 01/15/15 04/15/14 04/15/13 of real not'l) 1.7 1.6 1.5 0.2 0.1 Fed holdings (% ) 7% 8% 8% 2% 1%
Statistics for TIPS in the sales bucket for the upcoming Fed operation; $bn
Exhibit 14: Longer-maturity breakevens have become more sensitive to payroll surprises in recent months
Rolling 12-month beta of change in breakevens (bp) on employment report release dates regressed against surprise in payrolls* (000s)
0.04 0.03 0.02 0.01 0.00 -0.01 Feb 11
5Y
10Y
30Y
Trade recommendations
Buy 4s and 8s versus 6s May-16s have cheapened dramatically over the past week, and 6s now appear very rich versus 4s and 8s on a curve and level neutral basis. We recommend switching out of 6s into a combination of 4s and 8s. Buy 69% risk, or $151.7mn notional of T 3.25% May16s (yield: 0.682%; bpv: $442/mn). Sell 100% risk, or $168.7mn notional of T 2.25% Nov17s (yield: 1.041%; bpv: $576/mn). Buy 40% risk, or $50mn notional of T 3.375% Nov-19s (yield: 1.511%; bpv: $778/mn). Weighted spread is 3.4bp. One-month weighted carry is 0bp and roll is 0.2bp. Stay in 2s/7s steepeners hedged with reds/ greens flatteners Stay overweight 100% risk, or $170.1mn notional of T 0.25% Feb-14s (yield: 0.276%). Stay underweight 98% risk, or $50mn notional of T 1.375% Feb-19s (yield: 1.381%). Stay underweight 98% risk, or 1,327 EDM3 contracts (price: 99.43). Stay overweight 100% risk, or 1,354 EDZ4 contracts (price: 98.85). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -2.1bp of yield.
May 11
Aug 11
Dec 11
* Defined as actual release minus median of Bloomberg forecast survey for change in total nonfarm payrolls. Source: Bloomberg, J.P. Morgan
Exhibit 15: with 10-year breakevens likely to widen 3bp if payrolls surprise by +100K
Projected change in breakevens on payrolls release date based on 1-year regression of change in breakevens on employment report release dates regressed against surprise in payrolls*; bp
5Y 10Y 30Y
-200 -3.8 -7.7 -5.2
-100 -2.3 -4.1 -2.5
Payrolls surprise (000s) -50 0 50 -1.5 -0.7 0.0 -2.3 -0.5 1.3 -1.2 0.2 1.6
100 0.8 3.1 2.9
200 2.3 6.7 5.6
* Defined as actual release minus median of Bloomberg forecast survey for change in total nonfarm payrolls. Source: Bloomberg, J.P. Morgan
Maintain exposure to belly cheapening trades Stay overweight 94% risk, or $307.1mn notional of T 0.25% Feb-15s (yield: 0.393%). Stay underweight 100% risk, or $157.4mn notional of T 2.75% Feb-18s (yield: 1.092%).
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Stay overweight 42% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.522%). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -0.2bp of yield. Stay overweight 75% risk, or $191.7mn notional of T 0.25% Jan-15s (yield: 0.381%). Stay underweight 100% risk, or $112.8mn notional of T 1.25% Jan-19s (yield: 1.362%). Stay overweight 54% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.522%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -4.2bp of yield. Stay underweight May-38s versus May-37s Stay overweight 100% risk, or $48.9mn notional of T 5% May-37s (yield: 2.961%). Stay underweight 100% risk, or $50mn notional of T 4.5% May-38s (yield: 2.992%). (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: +0.2bp of yield. Stay underweight on-the-run 10s versus triple olds Stay underweight 100% risk, or $50.6mn notional of 2% Feb-22s (yield: 1.983%). Stay overweight 100% risk, or $50mn notional of T 3.125% May-21s (yield: 1.824%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -0.9bp of yield. Stay in weighted 2s/3s steepeners Stay overweight 100% risk, or $219.8mn notional of T 0.125% Dec-13s (yield: 0.268%). Stay underweight 70% risk, or $100mn notional of T 0.25% Jan-15s (yield: 0.381%). (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -0.8bp of yield. Stay in weighted 4s/25s steepeners hedged with reds/10s flatteners Stay overweight 96% risk, or $156.8mn notional of T 2.125% Feb-16s (yield: 0.614%). Stay underweight 78% risk, or $25mn notional of T 4.75% Feb-37s (yield: 2.963%). Stay overweight 100% risk, or $76.4mn notional of T 2% Nov-21s (yield: 1.947%). Stay underweight 100% risk, or 2,732 EDM3 contracts (price: 99.435). (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -6.6bp of yield.
Closed trades in 2012

TRADE Nominal Treasuries 10-year duration shorts
P/L reported in bp of yield unless otherwise indicated
ENTRY
EXIT
P/L -11.1
01/20/12 02/10/12
Curve Underweight 4s versus 3s and 7s Buy 2.375% Jun-18s versus 1.875% Oct-17s 7s/30s flatteners Buy Nov-21 Cs versus Ps 4s/6s steepeners vs. reds/greens flatteners 7s/30s flatteners 3s/7s flatteners
12/09/11 10/14/11 01/06/12 09/23/11
01/06/12 01/06/12 01/27/12 01/06/12
0.9 -2.8 -14.2 -0.2 3.0 3.5 8.5
01/06/12 01/27/12 02/10/12 02/24/12 02/12/12 02/24/12
Misc. Sell 2s versus OIS 12/09/11 01/06/12 Buy 5s versus OIS 01/06/12 02/04/12 Sell 2-year Treasuries vs. JGBs swapped into USD 08/12/11 02/10/12 Buy the March CTD Bond basis 12/09/11 02/24/12 TIPS Sell 5-year TIPS on a breakeven basis
0.8 5.0 44.0 1/32nds
12/16/11 01/20/12
-12.3
Stay overweight 6.5% Nov-26s versus a weighted barbell of Aug-23s/Feb-31s Stay underweight 62% risk, or $39mn notional of T 6.25% Aug-23s (yield: 2.109%). Stay overweight 100% risk, or $50mn notional of T 6.5% Nov-26s (yield: 2.505%). Stay underweight 38% risk, or $16.5mn notional of T 5.375% Feb-31s (yield: 2.741%). (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: -3bp of yield. Stay underweight Apr-14 TIPS versus Jan-14 TIPS Stay long 100% risk, or $25mn notional of TII 2% Jan14s (yield: -1.966%). Stay short 100% risk, or $25.4mn notional of TII 1.25% Apr-14s (yield: -1.878%). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: +3.4bp of yield.
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Srini RamaswamyAC (1-212) 834-4573 Praveen Korapaty (1-212) 834-3092 Alberto Iglesias (1-212) 834-5116 J.P. Morgan Securities LLC
Interest Rate Derivatives

Our views on swap spreads across the curve remain unchangedstay biased towards wider spreads at the long end of the curve, but neutral on front-end spreads and FRA-OIS The term structure of old 7-year note asset swap spreads is dislocated in April June 2016 maturitiespay in 3.25% June 2016 maturity matched swap spreads versus receiving in 3.25% July 2016 spreads Given our medium-term bias towards higher rates, we continue to favor bearish trades with flat holding costs and/or trades that offer asymmetric exposure to higher rates; position for a conditional cheapening of the belly of a ED6/7Y/25Y weighted butterfly in a sell-off via Eurodollar short-Sep midcurve puts and expiry matched payer swaptions Stay neutral on rate volatility, but sell curve vol
Exhibit 1: In spite of the recent narrowing, there is still room for more retracement in spreads driven by the compressing influence of central bank liquidity
Current value, change over the past week, best and worst levels in 1H11 and since 2H11 in the 2Y, 5Y and 10Y maturity matched swap spreads, 10Y swap yields, 3- and 6-month forward constant maturity FRA-OIS differential, the 3M EUR/USD FX OIS basis and semi-peripheral sovereign CDS spreads*
1-week Worst level Best level Percent Current change since 7/1/2011 in 1H11 retracement 10Y swap spreads (bp) 7.7 -1.5 22.7 3.9 80% 6M FRA-OIS (bp) 31.8 -7.8 72.4 16.7 73% 5Y swap spreads (bp) 25.0 -2.7 44.9 15.8 68% 3M FRA-OIS (bp) 31.4 -6.6 66.6 15.2 68% 2Y swap spreads (bp) 26.0 -4.2 54.8 12.6 68% 3M EUR/USD xccy OIS basis (bp) -44.4 -1.9 -105.7 -4.4 61% Semiperipheral spreads (bp) 290 -30 433 126.6 47% 10Y swap yields (%) 2.12 0.04 1.90 3.83 11% * Average of Italy, France and Spain 5Y CDS spreads.
Exhibit 2: Maturity matched swap spreads in the long end of the curve have lagged the rise in fair value
Maturity matched 30-year swap spread versus fair value*; bp
-24 -26 -28 -30 -32 -34 -36 Nov 11 Fair value Actual 30Y Sswap spread Dec 11 Dec 11 Jan 12 Feb 12 Feb 12
Swaps
Swap spreads are sharply narrower over the past week, led by the front end of the curvematurity matched swap spreads are now narrower by 5-6bp in the 2- to 3year sector, by 2-3bp in the 5- to 10-year sector, and flat at the long end of the curve. The key driver has of course been the considerable further easing in funding pressures brought about by this weeks 3-year LTRO conducted by the ECB. European banks took in 529bn of 3-year term funding, with about 59% of that amount representing new funding. Given this sizeable liquidity injection, funding pressures continued to ease, measured by virtually any indicator; FRA-OIS spreads in USD as well as EUR are sharply narrower, the 3-month EUR/USD OIS currency basis is sharply wider (i.e., less negative), and 3-month USD Libor is lower by 1.5bp on the week. Looking ahead, we remain neutral on front-end spreads and FRA-OIS spreads. On the one hand, the powerful compressive influence of central bank liquidity could continue to pressure spreads narrower; despite the considerable narrowing that has already occurred, FRAOIS spreads still have room to retrace further to early 2011 levels (Exhibit 1). In addition, the upcoming
* Fair value based on a regression model of maturity matched 30-year spreads versus the 2s/30s Treasury curve, estimated duration of the aggregate VA universe, and cumulative Fed gross purchases of Treasuries. Regression since August 2010.
release of the bank stress test results in the US by the Fed could also prove to be a positive factor, as was the case in 2009 (when US banks were much less well capitalized than is currently the case). On the other hand, this is balanced by two factorsthe risk of bank ratings downgrades and the fact that FRA-OIS spreads now appear narrow to fair value, both of which we noted last week (see Interest Rate Derivatives, US Fixed Income Markets Weekly, 2/24/2012). Thus, given balanced risks, we stay neutral on FRA-OIS and front-end spreads. We remain biased towards wider swap spreads at the longer end of the curve. As equities have risen off of their late-November lows and the curve has steepened, VA duration has fallen, pushing the fair value of 30-year
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swap spreads steadily wider. In contrast, actual maturity matched swap spreads in that sector have trended mildly lower over this period (Exhibit 2), but the mispricing relative to fair value has begun to correct in recent weeks. Consequently, we remain biased towards wider swap spreads in the 30-year sector. On a relative value basis, we recommend buying old 7s in the Apr 2016 June 2016 sector versus longer maturities on a swap spread switch basis. As seen in Exhibit 3, the term structure of the old-7s swap spread curve is dislocated in this sector; the spread differential between the 3.25% June 16s and 3.25% July 16s (separated by a mere one month in maturity), for instance, is at an extreme level as seen in Exhibit 4. How much steeper can this spread curve go? This steepening is likely the result of technicals, and in principle there is of course no limit to the mispricing between these two bonds. However, it is worth noting that if the June 16s were to cheapen by a further 1.4bp, the dirty prices of both bonds (the 3.25% June 16s and the 3.25% July 16s) would be the same. In that eventuality, an investor could conduct a cash-neutral switch out of the 3.25% July 16s into the 3.25% June 16s and receive virtually identical coupon and principal cash flows, but each cash flow would occur one month sooner. Thus, we would view this as a soft bound; given over 2.5bp of upside potential in the spread switch, versus a potential downside of 1.4bp, we view the risk reward as favorable and recommend buying the 3.25% June 16s versus the 3.25% July 16s on a swap spread switch basis (see Trade recommendations).
Exhibit 3: Technical flows appear to have cheapened old 7s in the April-to-June 2016 sector, as evidenced by the dislocation in the term structure of old-7-year note spreads
Asset swap O-spreads* for old 7-year notes with maturities between Feb 2016 and Dec 2016
24.5 24.0 23.5 23.0 22.5 22.0 21.5 21.0 Cheap sector
* O-spreads refer to proceeds asset swap spread, calculated based on an OIS discount curve. For a more detailed discussion, see US Fixed Income Markets 2012 Outlook, 11/25/2011.
Exhibit 4: The June / July 2016 spread differential for old 7s is now at extreme levels
3.25% July 2016 minus 3.25% June 2016 O-spread differential*; bp
2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 Jun 11 Sep 11 Dec 11 Mar 12
* O-spreads refer to proceeds asset swap spread, calculated based on an OIS discount curve. A wider spread indicates a richer bond.
3.25% Jun16/Jul16 ASW curve
Swap yield curve

On the yield curve, we continue to favor trades that offer asymmetric exposure to higher yield levels. Recent sharp declines in the unemployment rate may well be a puzzle to economists, but they do imply greater uncertainty around current expectations for the funds rate as of some future date (say, 4Q2014). As our Treasury strategists have pointed out, the corresponding risk premium appears to not be fully priced in, and this factorin addition to othersleaves us biased towards higher rates in the medium term (see Treasuries). That said, outright bearish trades suffer from negative carry, a disadvantage since the eventual timing of any move higher in rates is very unclear at this point. Thus, bearish trades with flat holding costs, and/or trades that offer asymmetric upside
in the event of a rise in yields (relative to their downside in a rally) are both attractive in the current context. One example of a trade that offers both these characteristics is a conditional 6th ED / 7Y / 25Y put butterfly (61:61 weights on the wings) constructed using September Eurodollar short-midcurve puts and expiry matched payer swaptions. As seen in Exhibit 5, the yield spread corresponding to this weighted butterfly has been considerably directional with yield levels in recent months; yet, current option market implied volatilities
19
allow the put butterfly to be constructed at zero net premium. In addition, the weighted yield spread is currently too low relative to the level of yields, as also seen in Exhibit 5. Thus, we recommend buying 9/14/2012x7Y payer swaptions versus selling Sep shortmidcurve puts and expiry matched payer swaptions on 25-year tails (see Trade recommendations).
Exhibit 5: The 61:61 weighted 6th ED/7Y/25Y butterfly spread has been positively correlated with intermediate yield levels in recent months, and appears too low currently
6Mx7Y swap yield minus (0.61*(6Mx25Y swap yield plus 6th constant maturity ED yield)), regressed against the 6Mx7Y swap yield; %
-0.10 -0.15 -0.20 -0.25 -0.30 -0.35 -0.40 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3
6Mx7Y swap yield; %
Options
Volatility in the swaptions market dropped in the shortexpiry short-tenor sector, but nevertheless outperformed the expectations derived from the skew (Exhibit 6). The rest of the vol surface was unchanged for the week; the exception was 5-year expiries, which rose modestly. Going into the payroll report next week, we continue to remain neutral on gamma, largely because several key drivers are at levels at which our model suggests returns on selling delta-hedged straddles are likely to be flat. Market depth is at levels where it is not a significant driver of realized volatility. Other drivers are largely unchanged from last week, and while a strong employment report could push 3Mx10Y swap yields higher (aiding long gamma positions in the process), our near-term outlook on intermediate maturity yields is still only modestly higher than current levels, implying that realized volatility is unlikely to pick up significantly. While we are neutral on outright gamma on yields, we are bearish on curve volatility (between short and long term swap yields). This bearish view largely stems from our bullish view on correlation between front-end and longer-term swap yields; the potential for an increase in front-end yields in the event of a strong employment report is an additional supportive factor. First, we note that current realized curve correlations are well above implied correlations, in the 2s/10s sector, for instance. Curve correlations, while especially volatile since last summer, are typically fairly stable. The downward swings observed in realized correlations in the latter part of 2H11 were largely driven by two factors the Feds new communications policy action (initiated at the August meeting, when the Fed first indicated that it expected to hold the funds rate at current levels until mid-2013, a projection that has since been extended even further into the future), and an escalation of the European debt crisis, also in the latter part of 2H11. The first factor naturally causes front-end rates to become more immune to typical drivers of yields, thereby becoming less
Y = 0.3973 X1 - 0.9863 R = 61.45% standard error = 0.0404 period = Sep 02,11 - Mar 02,12
Exhibit 6: Swaption volatility outperformed the skew this week
Actual change in swaption implied volatility levels since 2/24/2012 for options expiring between 1 month and 5 years, on 1- to 30-year underlying swap rates, versus expected change*; abp
2 0 -2 -4 -6 -8 -10 1y tails -12 3m2y
2y tails
3m10y
Actual = Expected line 2
* Derived from the swaption skew as of 2/24/12, evaluated as twice the difference between the implied volatility at a strike equal to the ATMF rate plus the yield change over the week, and the implied volatility at a strike equal to the ATMF rate.
-4 -2 -10 -8 -6 0 Expected change in swaption implied volatility*; abp
volatile as well as less correlated to yields elsewhere on the curve. The second factor also produced a decorrelation between front-end and longer-end swap yields, as wider FRA-OIS spreads and falling longerterm yields went hand in hand. Looking ahead, our outlook is for correlations to rise, with both the factors mentioned above now turning supportive of a rise in correlations between front-end and
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longer-end swap yields. Should the recent positive tone of economic data continue going forwardparticularly the declining trend in the unemployment raterisks to the Feds soft commitment policy will continue to increase; while a near-term reversal of the Feds soft commitment is unlikely, such risks will nonetheless likely cause markets to de-anchor front-end yields to some extent and produce an increase in correlations between short and long-term yields. With respect to the second factor, the second 3-year LTRO is now behind us, FRA-OIS spreads have retraced much of their crisis widening, and will likely no longer be the dominant driver of front-end volatility; correlations between shortterm and long-term swap yields have tended to rise when FRA-OIS volatility declines relative to front-end swap yield volatility, as might be expected and as seen in Exhibit 7. Secondly, all else being equal, higher front-end rates should they occurwould result in a rise in two-year tail volatility relative to 10-year tails (Exhibit 8). This would in turn be bearish for curve volatility; at current levels of 2s/10s realized correlation and the two individual rate volatilities, curve volatility is effectively short two-year volatility, meaning that a rise in the volatility of front-end yields (which would accompany a rise in front-end yields) should depress curve volatility. Taken together, the above arguments, coupled with the fact that risks to front-end yields are biased asymmetrically higher due to the current proximity to the zero bound, argue for an outright bearish stance on curve volatility. Therefore, we now recommend selling delta-hedged 2s/10s singlelook CMS curve straddles on an outright basis (see trade recommendations).
Exhibit 7: With FRA-OIS having nearly fully retraced, FRA-OIS volatility is likely to decline as a fraction of the volatility of front-end yields, producing a rise in correlations between front-end and longer-term yields
Rolling 3-month correlation between 6Mx2Y and 6Mx10Y forward swap yields, versus rolling ratio of 3-month realized volatility on 6M forward FRA-OIS to the 3M realized volatility on 2-year swap yields
1.0 0.8 0.6 0.4 0.2 0.0 Jun 09 3M realized correlation Ratio of FRA-OIS vol to vol of 2year swap yields (inverted)
0.2 0.4 0.6 0.8 1.0 1.2 Mar 12
Dec 09
Jul 10
Jan 11
Aug 11
Exhibit 8: If front-end yields head higher from current levels, 2-year volatility is likely to increase relative to 10year volatility
6Mx2Y minus 6Mx10Y implied volatility (bp/day) versus 6Mx2Y swap rate (%)
Pay in 3.25% June 16 spreads versus receiving in 3.25% July 16 maturity matched swap spreads The swap spread curve term structure for old 7-year notes is dislocated in the Apr-June 2016 maturity sector, with the 3.25% June 16s / 3.25% July 16s spread curve now at very steep levels. In addition, we note that a further 1.4bp cheapening of the June 16s would cause the two bonds dirty prices to be the same; given identical coupons, this would mean that investors could switch into June 16s on a cash neutral basis, and earn virtually identical cash flows, each of which would occur one month sooner. We believe this should limit the further downside risk in this trade to
0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 -4.5 -5.0 0.4
Y = 4.7392 X1 - 0.8289 X1^2 - 6.2843 R = 87.41% standard error = 0.4001 period = Mar 01,10 - Mar 01,12
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
2.2
6Mx2Y swap rate (%)
around 1.4bp, resulting in a favorable risk-reward for this spread switch. Buy $100mn notional of 3-1/4% June 16 and pay fixed in $105.3 notional of a 06/30/2016 swap; sell $98mn notional of 3-1/4% of July 16 and receive fixed in $103.5mn notional of a 7/31/2016 swap @ a matched maturity spread differential of 1.3bp (defined July 16 minus June 16 maturity matched spread differential). Carry on this trade is 1.3bp over a 3-month horizon. Three month slide on the trade is 2.6bp.
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Position for a cheapening of the belly of a EDU3/7Y/25Y butterfly in a sell-off using ED midcurve puts and payer swaptions The EDU3/6Mx7Y/6Mx25Y swap butterfly (61:61 weighted) retains positive correlation with yield levels and should cheapen in a sell-off. Buy $100mn notional of 6Mx7Y payer swaptions (notification 09/14/12, maturity 09/18/19, ATMF 1.787%, strike 1.797%, premium 163.2 bp), sell 1598 0EU2 99.375 puts (midcurve option expiry 09/14/12, EDU3 @ 99.385, strike 99.375, premium 11.5bp), and sell $22.3mn notional of 6Mx25Y receiver swaptions (notification 09/14/12, maturity 09/18/37, ATMF 2.835% and strike 2.845%, premium 527.6 bp). This trade is close to premium neutral, constructed with risk weights of 61% each on the Eurodollar leg and the 6Mx25Y leg, and is expected to be profitable so long as the weighted butterfly yield spread widens as intermediate yields rise. Sell 6M single-look CMS curve straddles on the 2s/10s swap curve We believe that an improving economic outlook and reduced stresses from Europe is supportive of high realized curve correlations. An improving outlook should also result in higher front-end volatility, which, like higher curve correlations, is also bearish for curve volatility. As a result, we look to sell curve volatility. Sell $250mn notional of 6-month curve straddles on the 2s/10s CMS curve (end date 09/06/2012, ATMF CMS 2s/10s yield spread and strike at 1.64%) @ a premium of 48.5bp of notional (implied volatility 5.4bp/day). Unwind longs in the weighted Ultra-long calendar spread We unwind this trade as it was recommended around Treasury futures rollover technicals. Unwind longs in 1000 WNH2 contracts versus covering shorts in 940 WNM2 contracts (US Fixed Income Markets Weekly, 2/10/12) @ a profit of 1.9/32nds. Unwind belly richening position on the EDZ2/EDZ3/EDZ4 butterfly We stop out of this trade as it has steadily underperformed since inception. Unwind longs in 1000 EDZ3 futures versus covering shorts in 650 EDZ2 futures and covering shorts in 550
EDZ4 futures (US Fixed Income Markets Weekly, 1/20/12) @ a loss of 9.9bp of yield. Continue to receive in 10-year swap spreads hedged with 20% risk in September FRA-OIS wideners Continue to receive in $100mn notional of 2% Feb 22 maturity matched swap spreads (stay short $100mn notional of 2% Feb 22s, and continue to receive fixed in $96.2mn notional of a 2/15/2022 swap), and continue paying 20% of the risk (or $18035/bp) in September 2012 3M FRA-OIS spreads (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: 0bp of yield. Maintain 30-year swap spreads wideners Continue to pay in 4.75% of Feb 2041 spreads (stay long $100mn notional of the 4.75% of Feb 2041, and continue to pay fixed in $110.3mn notional of a 02/15/2041 swap). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 0.9bp of yield. Maintain 5-year swap spread wideners in a rally Stay long 1,000 FVM2 123.25 calls (FVM2 @ 12304, strike 123.25, expiry 5/25/2012) and stay short $129mn notional of a 05/25/12x8/31/16 receiver swaption (notification 05/25/12, swap start date 07/05/12, maturity 8/31/16, strike 1.073%, ATMF 1.098%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 1.8bp of yield. Stay long 3Mx1Y payer spreads Stay long $100mn notional of a 0.506%/0.756% 3Mx1Y payer swaption spread (1:1 weighted, notification 5/10/2012, maturity 5/14/2013, ATMF 0.506%; buy the ATMF strike and sell the A+.25 strike) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 1.2bp of yield. Maintain belly cheapening position on the 1-year forward 2s/5s/10s swap butterfly Continue to pay fixed in $100mn notional of a 1Yx5Y forward starting swap (swap start date 02/14/2013, swap end date 02/14/2018, yield 1.513%), continue to receive fixed in $138.3mn notional of a 1Yx2Y forward starting swap (swap start date 02/14/2013, swap end date 02/17/2015, yield 0.734%) and continue to receive fixed in $29.6mn notional of a 1Yx10Y forward starting swap (swap start date 02/14/2013,
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swap end date 02/14/2023, yield 2.354%) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 0.8bp of yield. Maintain conditional 2s/30s steepeners via 3-month expiry options, versus selling 3-month expiry caps on the 2s/30s CMS curve Stay long $50mn notional 3Mx30Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2042, ATMF and strike 2.883%) versus staying short $500mn notional 3Mx2Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2014, ATMF and strike 0.5275%); also stay short $998.5mn notional of 3-month expiry 1-look caps on the 2s/30s CMS curve (end date 5/8/2012, ATMF CMS 10s/30s yield spread and strike at 239.7bp) (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: profit of 0.3bp of yield. Maintain 30-year matched maturity swap spread wideners, hedged with 5-year swap spread wideners and the 5s/30s Treasury yield curve Stay long $50mn notional of 3.125% of Nov 2041s and pay fixed in $51.6mn notional of a 11/15/2041 swap; also, stay long $95mn notional of 0.875% of Jan 2017s and continue to pay fixed in $67.4mn notional of a 01/31/2017 swap (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: loss of 2.8bp of yield. Continue to receive fixed in the belly of a 3-month forward weighted 5s/10s/30s swap butterfly Continue to receive fixed in $100mn notional of a 3Mx10Y forward starting swap (swap start date 04/24/2012, swap end date 04/25/2022) and continue paying fixed in $133mn notional of a 3Mx5Y forward starting swap (swap start date 04/24/2012, swap end date 04/24/2017) and paying fixed in $21.9mn notional of a 3Mx30Y forward starting swap (swap start date 04/24/2012, swap end date 04/24/2042) (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: profit of 0.2bp of yield. Maintain synthetic conditional trade by selling 10s/30s YCSO caps versus 10Y receiver swaptions Sell $500mn notional (i.e., $50K/bp forward DV01) of single-look 6-month caps on the 10s/30s swap curve (end date 6/11/12, strike and ATMF 10s/30s CMS
Closed trades in 2012
P/L reported in bp of yield for swap spread, yield curve and miscellaneous trades, and in annualized bp of volatility for option trades, unless otherwise specified
Trade Swap spreads 10-year swp sprd widener Front end swap spread wideners via options Pay Aug 20 vs Feb 20 sprds (hedged) Yield curve 5s/10s swp sprd crv steepeners 3m fwd 1s/15s crv flatteners via rec swptns Buy belly of EDZ2/EDZ3/EDZ4 bfly Buy wtd WN calendar sprd PL in 32nds Options relative value Sell 10s/30s YCSO vs 6Mx2Y swptn strddls Buy 6Mx5Y vs 9Mx5Y swptn strddls Entry Exit P/L 01/06/12 01/06/12 01/20/12 Entry 11/04/11 01/06/12 01/20/12 02/10/12 Entry 10/28/11 01/20/12 1/20 2/3 2/3 Exit 2/3 2/3 3/2 3/2 Exit 1/27 2/10 (1.8) (4.4) 1.7 P/L (3.5) (16.1) (9.9) 1.9 P/L 18.2 (0.6)
yield spread at 60.1bp) versus buying $21.3mn notional of 6Mx10Y receiver swaptions (notification date 06/11/12, maturity date 06/13/22, ATMF and strike 2.335) (US Fixed Income Markets Weekly, 12/09/11). P/L since inception: loss of 0.4bp of yield. Stay long 6Mx30Y versus 6Mx10Y swaption straddles Stay long $43.7mn notional of 6Mx30Y swaption straddles (notification date 8/24/2012, maturity date 08/29/2042, ATMF and strike 2.849%) and stay short $100mn notional of 6Mx10Y swaption straddles (notification date 8/24/2012, maturity date 8/30/2022, ATMF and strike 2.220%) (US Fixed Income Markets Weekly, 12/09/11). P/L since inception: loss of 3.0abp.
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Praveen KorapatyAC (1-212) 834-3092 Renee Park (1-212) 834-7218 J.P. Morgan Securities LLC
Agencies
We revise our fair value target for 5-year Agency spreads versus Treasuries to be 5bp narrower at 23bp Treasury released its preliminary annual report on foreign holdings of US securities; China and Japan were the largest net sellers of Agency debt, yet we estimate foreign holdings of Agency debt has increased as a percentage of total debt outstanding FNMA reported its fourth quarter earnings this week, requesting $4.6bn in capital from Treasury
J.P. Morgan 5-year Agency spread target level and model* versus Treasuries, and current spread relative to target (bp, unless indicated otherwise; as of 3/2/2012)
Variables Intercept Fed fund expectations (% ) Agency debt foreign holdings, 3M chg ($bn) Agency debt outstanding ($bn) Liquidity factor (bp) 1-year ahead budget surplus ($bn) European debt crisis proxy Coefficient -20.0 22.4 -0.2 0.1 -5.4 0.1 11.6 T-stat -1.8 30.8 -16.8 8.1 -30.2 32.5 22.5 0.13 3.0 760 1.2 -1202 2.2 23 25 1Q12 Est.
Exhibit 1: Five-year Agencies are close to our estimates of fair value versus Treasuries
Forecasted 5-year Agency spread to Treasuries (bp) Actual 5-year Agency spread to Treasuries (bp)
Market views
Over the past week, Agencies versus Treasuries were largely unchanged with the exception of the 10-year sector, where Agencies cheapened by 2bp versus Treasuries. On the other hand, over the past week the Agency spread curve versus swaps flattened with 2-year Agencies cheapening by 5.5bp, 10-year Agencies largely unchanged, and 20-year Agencies richening by 1bp. Five-year Agencies cheapened about 3.5bp versus swaps amidst a new $4.5bn 5-year FNMA Benchmark Note was issued. The bellwether issue had an unusually low rate of central bank investor participation, and at 7% is the lowest for a new FNMA Benchmark Note since March 2002. Domestic investors took down the majority of the deal at an 88% participation rate. We remain neutral on 5-year Agencies versus Treasuries, given the current level of spreads versus our targets from our revised fair value model (Exhibit 1). Our target for the 5-year Agency versus Treasury spread is now 23bp. In our revised model, we substituted changes in Agency custodial holdings (released weekly by the Fed) with an estimate of changes in foreign holdings of Agency debt as a proxy for demand. The estimated foreign demand uses the higher frequency custody holdings data (which does not separate out Agency debt and MBS flows), as well as monthly and annual TIC data. Previously, we had estimated a relationship between monthly and annual TIC data as the annual data is the more accurate of the two series (see Agencies, US Fixed Income Markets 2012
* 5-year Agency spread versus Treasuries are modeled as (22.45 * the 18-month forward, 1-month OIS rate minus the 6-month forward, 1-month OIS rate) + (-0.23 * estimated 3month change in Agency debt foreign holdings based on central bank custody holdings) + (0.14 * FNMA, FHLMC bullet debt outstanding) + (-5.43 * 4s/5s/6s Treasury butterfly spread to 4s/5s/6s swaps butterfly) + (0.07 * 1-week moving average of 1-year ahead budget surplus expectations) + (11.56 * logarithm of average of 5-year CDS spreads of BNP Paribas, Socit Gnrale, and Crdit Agricole (over average pre-crisis levels)) - 20.02.
Exhibit 2: Weekly central bank custody holdings of Agencies have predicted monthly net foreign investor purchases of Agencies well
3-month moving average of monthly net foreign investor purchases of Agency debt and MBS from monthly TIC data ($bn), regressed against 3-month moving average of monthly changes of custody holdings of Agency debt and MBS ($bn; weekly data)
40 30 20 10 0 -10 -20 -30 -40
Y = 0.7130 X1 + 8.2913 R = 60.06% standard error = 7.7161 period = Mar 02,02 - Mar 02,12
-50
-40 -30 -20 -10 0 10 20 30 40 Monthly change of Agency debt and MBS custody holdings ($bn)
Outlook, November 25, 2011). Using this relationship, we derived a monthly series of estimated Agency debt flows as a function of monthly Agency debt and MBS TIC databut, this estimated series is available only with a lag as monthly TIC data is only available with a lag of a month and a half. To get a more current idea of flows, we estimate a relationship between Fed custody
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Exhibit 3: Over the next two months, $46bn of FDICguaranteed bank debt is scheduled to mature
FDIC-guaranteed bank debt redemptions ($bn) 59 60
Exhibit 4: Foreign investors were net sellers of $72bn of Agency debt in the year ending June 2011, and we estimate were net sellers of an additional $30bn in 2H11
Annual net purchases of Agency debt by all foreigners ($bn) versus the percentage of all FNMA, FHLMC, and FHLB debt outstanding owned by foreigners (%) $bn %
50 40 30 20 10 0 1 3 21 25 28
200 100
Net purchases of Agy debt by foreigners
35% 30% 25% 20% 15% 10%
0 -100 -200 -300 -400 %ge of all Agy debt owned by foreigners 2003 2004 2005 2006 2007 2008 2009 2010 2011 2H11
Jan Feb Mar Apr May Jun Jul 12 Sep Oct Nov Dec 12 12 12 12 12 12 12 12 12 12
holdings data and our monthly TIC flow data (Exhibit 2), allowing us to generate a weekly series of estimated Agency debt flows. Using this revised demand proxy in our fair value model, we revise our fair value target for 5year Agency spreads versus Treasuries down by 5bp to 23bp. Our revised framework also still argues for an underweight in front-end Agencies versus Treasuries with 2-year Agencies about 3bp too rich versus our fair value target of 10bp, and it still argues for an overweight in 10-year Agencies versus Treasuries with current spreads about 13bp too wide versus our estimates of fair value. Thus, we continue to stay underweight front-end Agencies versus Treasuries and stay overweight 10-year on valuations. As we discussed in last weeks publication (see US Fixed Income Markets Weekly, 2/24/12), demand has largely remained strong, based on recent monthly TIC data. In line with these recent flows, our estimate of Agency debt flows attributable to foreigners, using the procedure described in the previous paragraph, leads us to believe that foreign holdings of Agency debt have increased this past month. This incremental demand is supportive of tighter Agency-Treasury spreads on the margin. Further, with about $46bn of FDIC-guaranteed bank debt that is scheduled to mature over the next two months (Exhibit 3), the increased level of demand could persist: we expect that the proceeds of maturing FDIC-guaranteed bank debt will most likely be re-invested in Treasuries and Agency debt.
5% 0%
* Note: 2H11 net purchase figures are J.P. Morgan estimates and span July 2011 to December 2011. All other figures are for the year end on June 30. Source: TIC
On the supply side, both FNMA and FHLMC continued to shrink the size of their retained portfolios (in January by $9bn and $11bn, respectively) according to their recently-released monthly volume summaries. Also, while year-to-date FNMA and FHLMC have had negative net debt issuance of $34bn and $20bn, respectively, this has largely been driven by negative net disco issuance of $49bn for the two GSEs, combined. Looking ahead, we still expect that both GSEs will have negative net debt issuance as the size of FNMAs retained portfolio is currently $43bn above its year-end limit and FHLMC historically has continued to shrink the size of its retained portfolio despite already being under its mandated year-end cap. FHLB has had continued negative net debt issuance (predominately term debt) year-to-date of around $23bn, and we expect this to persist given that banks continue to be cash-rich.
Foreign buying update

This week, Treasury released its preliminary annual report on foreign holdings of US securities as of June 30, 2011. This annual data is released with an 8-month lag and does not provide timely information about the purchasing and selling trends of foreign investors. However, this data set is known to be more
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Treasury and Agency debt and MBS holdings by the top holders of long-term Agency debt as of June 2011, change in holdings between June 2010 and June 2011, and cumulative net purchases of long-term Treasuries and long-term Agency debt and MBS since July 2011 ($bn)
Exhibit 5: The ten largest holders of Agency debt as of June 2011 decreased their holdings of Agency debt by $52bn over the prior year
Holdings as of Jun'11 Country Japan Mexico China Korea, South Hong Kong Bermuda Ireland Cayman Islands Luxembourg Taiwan Total All Countries Tsy 818 29 1,302 33 53 44 31 47 88 144 2,589 4,049 Agy 106 28 27 25 17 12 12 9 8 8 252 318
Source: TIC
Rank in Rank in Holdings as of Jun'10 2011 2010 Agy Agy Agy Agy Tsy Agy MBS debt MBS debt 152 1 737 128 106 1 0 2 31 19 0 4 218 3 1,108 62 298 2 41 4 34 26 34 3 99 5 60 13 82 7 29 6 42 14 29 6 15 7 27 11 12 8 28 8 36 9 23 9 10 9 49 8 10 12 38 10 149 14 32 5 630 2,275 304 625 712 3,343 372 713
Chg in b/w 2010-11 Tsy 81 -1 194 -2 -7 1 4 11 39 -5 315 706 Agy -21 9 -36 -1 3 -1 1 -1 1 -6 -52 -54 Agy MBS 46 0 -80 7 16 1 3 5 0 6 4 0
Net purchases since Jul'11 Agy (debt Tsy and MBS) 118 29 -1 8 -63 8 1 2 12 0 3 1 -2 -1 5 9 3 -11 -4 0 76 44 515 107
comprehensive and accurate than the monthly TIC data released by Treasury, and provides greater insight into country-specific holdings of US securities. From June 2010 to June 2011, total foreign holdings of Agency debt fell by $72bn, of which $54bn of net selling was long-term Agency debt; given a proportional drop in all Agency debt outstanding, the percentage of Agency debt held by foreign investors remained relatively unchanged (Exhibit 4). Using monthly TIC data, we estimate using the relationship between monthly and annual TIC data sets, that in the last 6 months of 2011, foreign investors continued to be net sellers of Agency debt. They sold about $30bn, and foreign holdings of Agency debt was at about 21% of total Agency debt outstanding as of year-end 2011. Over the year ending June 2011, the largest net sellers of Agency debt were China, Japan, and Taiwan, who together comprised $63bn of net selling of long-term Agency debt (offset by $9bn of net purchasing by Mexico, the largest net purchaser of Agency debt over the same period; see Exhibit 5). Although China was the largest net seller of Agency debt, its pace of selling declined, given that its holdings have now shrunk to $27bn as of June 2011. With the exception of Japan, the largest foreign holders of Agency debt hold less than $30bn, each. Foreign holders of Agency debt have dramatically reduced their holdings over the past few
Exhibit 6: FNMAs provisions for credit losses ticked up this quarter

FNMA quarterly provision for credit losses ($bn)
25 20 15 10 5 0
yearsat $318bn, foreign holdings of Agency debt have fallen by 57% since the peak of their holdings in 2007 we expect the pace of any further selling is likely to be lower, and thus have a relatively smaller impact on spreads going forward.
FNMA earnings
This week, FNMA reported their earnings for 4Q11 with a net quarterly loss of $2.4bn, an improvement over the prior quarter loss of $5.1bn. The quarterly loss was driven by a decline in net interest income, which at
26
$4.2bn was the lowest quarterly NII since 2Q10, as well as $0.8bn in derivatives losses, which was close to our expectations for $1bn in derivatives losses. The decline in NII was driven by a decline of $1.5bn of net interest income in their investments portfolio despite a slight uptick of G-fee income to 26.2bp for the year on their single family book of business. FNMA also reported a slight increase in credit related-expenses to $5.5bn (Exhibit 6). For the quarter, FNMA paid Treasury $2.6bn in senior preferred stock dividends, bringing their net worth deficit and quarterly Treasury capital draw request to $4.6bn, and reiterated that the draws the GSEs have taken from Treasury are so large they cannot be repaid under any foreseeable scenarios (quoting FHFA Acting Director Edward DeMarcos February 2012 letter to Congress). Looking ahead, FNMA stated that it expects weakness in housing and mortgage markets to continue in 2012 and continues to expect about a 32-40% peak-to-trough home price decline (via the S&P/Case-Shiller index method), unchanged from its prior projections. The GSE also stated that it expects its credit losses in 2012 to remain high, but lower than its losses in 2011. Last, FNMA highlighted Treasury Secretary Geithners statement in February 2012 that the Administration plans to release new details around housing finance and GSE wind down reform in the spring of this year, but does not expect legislation to be enacted in 2012.
Hold overweight on 10-year Agencies versus Treasuries Cheap valuations keep us constructive on 10-year Agency spreads versus Treasuries in the near term, and we continue hold this overweight. Stay overweight $50mn FHLMC 2.375% Jan-22s against $49.3mn T 2% Nov-21s @ 46bp spread. (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: 1.8bp. Hold 3s/10s Agency spread curve flatteners versus Treasuries The 3s/10s Agency spread curve versus Treasuries appears too steep relative to our fair value targets. Given attractive valuations on both legs of this spread curve trade, we recommend holding 3s/10s Agency spread curve flatteners versus Treasuries. Stay underweight on $50mn FHLMC 0.625% Dec-14s against $50.9mn T 0.25% Dec-14s @ 14.5bp spread; Stay overweight on $16.3mn FHLMC 2.375% Jan-22s against $16.1mn T 2% Nov-21s @ 46bp spread. (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: 0.1bp. Stay overweight short-dated callables compared to lockout- and maturity-matched bullets In the current low rate environment, we favor overweighting short-dated callables compared to lockout- and maturity-matched bullets as an attractive carry trade. Thus, we recommend staying overweight short-dated callables versus lockout- and maturitymatched bullets. Hold overweight on $100mn 5nc2 (1x) callables maturing Jan-17 @ 1.322% coupon. (US Fixed Income Markets Weekly, 1/6/12). P/L since inception: -3.7bp of notional. Hold overweight on $100mn 5nc6m (1x) callables maturing Dec-16 @ 1.372% coupon. (US Fixed Income Markets Weekly, 12/5/11). P/L since inception: +1.1bp of notional. Hold overweight on $100mn 2nc1 (1x) callables maturing Aug-13 @ 0.431% coupon versus $100mn FNMA 0.5% Aug-13s. (US Fixed Income Markets Weekly, 8/12/11). P/L since inception: -2.1bp of notional.
Hold underweight on front-end Agencies versus Treasuries Current tight spreads in the front end of the Agency curve versus Treasuries provide limited room for further tightening. Thus, we recommend holding an underweight on front-end Agencies versus Treasuries. Stay underweight $25mn FHLMC 0.375% Nov-13s against $24.9mn T 0.25% Nov-13s @ 6.5bp spread. (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -2.1bp.
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Matthew JozoffAC (1-212) 834-3121 Nicholas Maciunas (1-212) 834-5671 J.P. Morgan Securities LLC Brian Ye (1-212) 834-3128 Jonathan J. Smith (1-212) 834-2605
MBS
Summary The directionality of mortgage spreads remains high, reflecting mortgage investors expectations of QE3 We revise our supply/demand expectations for 2012; banks and money managers should still be net buyers, but loan growth and narrow spreads should trim their appetite for MBS Foreign investors have allowed mortgages to run off on net, and we have moved them to the supply side of the equation The FHA has introduced higher upfront and annual MIPs on new originations but has implied the possibility of grandfathered MIPs on streamline refis The new tiered MIP schedule will make WALA critical for defining the TBA deliverable BoA serviced Ginnie pools have accumulated delinquencies; look for buyout spikes in the coming months Investors should own GN II over GN Is to help mitigate buyout risk, owing to the large pools of the GN II program Remain neutral on the mortgage basis owing to narrower valuations and somewhat reduced outlook for bank/money manager sponsorship Remain underweight Ginnie 5s and above, but valuations have moved closer to fair value versus conventionals; buyout risk could rise Be down in coupon in conventionals as HARP 2.0 speeds create event risk in high coupons in the months ahead Be overweight 30-years versus 15-years Own Golds over Fannies as speeds have converged, liquidity premium too great
Exhibit 1: Directionality of mortgages reflects QE3 expectations
Slope of rolling regression of 5-day outperformance of FNCL 4s versus swaps relative to 5-day yield change of 5-year Treasury; measured in ticks of outperformance per 10bp rally in rates; (weekly moving average)
12 10 8 6 4 2 0 -2 Dec-11 Source: J.P. Morgan Jan-12 Feb-12
Views
Mortgages underperformed by several ticks over the past week as rates shot up past 2% on the 10-year note and then rallied back. The directionality of the sector has generally remained intact, reflecting the markets undulating implied probabilities of QE being priced in. As we discussed in our most recent piece, mortgage investors have assumed that QE will largely involve MBS, and thus have bid up mortgages in rallies, and vice versa. As a barometer of QE, Exhibit 1 shows a rolling 5day regression of mortgage outperformance versus weekly rate changes. Back in December there was little directionality to mortgage performance (every 10bp rally equated to about 2 ticks of mortgage outperformance versus swaps). Recently, however, as QE expectations surged, each 10bp rally was worth on the order of 10 ticks of outperformance. To put this in perspective, around Operation Twist mortgages exhibited 15-16 ticks of directionality per 10bp move in rates. Using this as an estimate of QE expectation, this implies that recent QE expectations in the mortgage market may have exceeded 50% at one point. Over the past month, however, we estimate the market has priced in a 30-40% probability of QE3.
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Exhibit 2: Money managers and banks have been the biggest net buyers recently can the pace hold?
Monthly net agency MBS flow for major market participants since January 2009 ($bn); annual flows summarized in the table below
250 200 150 100
Fed Buying (QE1)
Net Iss. GSE
$mgr / other Foreign
Treasury Banks
Fed
Buyers
$mgr Buying
MBS ($bn)
50 0
-50
-100 -150 -200 -250

Year 2009 2010
Sellers / supply
Large Net Issuance Jan-09
528 (84) 29 103
Jul-09
GSE 24 (93)
Jan-10
1,111 64 131 (47)
Jul-10
(674) 131
Jan-11
Jul-11
Jan-12
Net Iss Banks Foreign
Fed Treasury $mgr / other
(77) (259)
2011 (6) 140 (64) (91) (196) (118) 322 Source: J.P. Morgan, Fannie Mae, Freddie Mac, Federal Reserve, U.S. Treasury
Technicals remain positive for mortgages, but there are some signs of slowing on the demand side. Exhibit 2 shows the monthly net buying/selling of selected investors since January 2009. The figures for money managers/other are derived from the total net flows of other investors and the overall net supply. It is clear that the sponsorship has evolved the QE1 period in 2009, when Fed buying of over $1tn absorbed all the net supply during the year, plus another $500bn from other investors. Late 2010 and early 2011 were dominated by money manager buying (when the Libor OAS on FNCL 4s ranged from 20-30bp.) Banks bought a whopping $240bn net in 2010 and 2011 combined, as loan growth remained weak. The outlook for this year is still good, though not quite as rosy. Money manager holdings remain at 61% overweight (near the highs over the past three years), and spreads are narrow, with Libor OASs in the single-digit range for most coupons. Bank buying has been very impressive in the past two years, but increased loan growth of around $150bn net over the past year threatens
to siphon off some of that demand. And foreign investors have been net sellers (including paydowns) since the crisis, likely reflecting concerns over the dollar and the credit of GSE MBS. Looking forward, we highlight our revised expectations for 2012 in Exhibit 3. With net issuance (organic) running at negative $55bn, overall effective supply should be light this year. Incorporating the YTD Treasury sales of MBS (which are now essentially complete), as well as GSE runoff from the retained portfolios and foreign net selling, overall supply from net issuance and these sales should be just under $100bn. On the demand side, we are calling for banks to buy a healthy $75bn in MBS this year given the growth in C&I loans, but that is only half of what they bought last year. We estimate REITs will buy only about $25bn net, but this is a lower bound; if the SEC ruling on REIT leverage is resolved favorably for the industry, it is possible that this sector could buy up to $100bn in the year (fueled by around $15bn of equity raised). We have reduced our
29
money manager expectations to only $50bn (from $100bn previously) in light of the spread tightening and overweights in the market. Finally, the big wildcard remains QE3, which could add $300bn or more of buying to the equation. However, we believe the likelihood is currently around 25-30%. Given current valuation levels, we prefer to own spread duration (e.g. down in coupon, 30-years versus 15-years) rather than basis longs as a way to express a QE3 view.
Exhibit 3: 2012 flows will be dependent on money managers and banks if the Fed does not step in
Projected 2012 agency MBS net supply and demand ($bn) Source: J.P. Morgan $600
Additional REIT Buying $75bn
$500
Treasury releases foreign holdings estimates

On Wednesday, Treasury released its annual estimate of foreign holdings of U.S. securities. As of June 2011, the most recently reported date, total foreign holdings had stabilized around $710bn (down from $713bn in 2010) after falling in 2009-2010 from the 2008 peak of $772bn. Foreign official institutions, however, net sold just under $40bn, with reported balances of $404bn (down from the 2009 peak of $474bn). The foreign countries with the five largest holdings of agency MBS were all in Asia (considering mainland China and Hong Kong as separate). Mainland Chinese investors remained the largest holder of agency MBS with $218bn, although they net sold (including paydowns) $80bn, and their holdings are down from a peak of $369bn in 2008. In contrast, holdings in Hong Kong have surged, growing $90bn since 2008. It is possible that some of the swing from mainland holdings to Hong Kong may be the rise of more Chinese entities that trade in both locations. Still, the aggregate holdings of the two have still fallen more than $90bn since 2009, potentially the result of paydown runoff. The monthly flows net of paydowns over the past two years have been largely negative, although TIC acknowledges that there is some tracking error between their monthly flow estimates and their annual position surveys. 1 Still, the general picture painted by the flows data indicates that foreign investors have not been net buyers recently, and likely are not going to be a strong source of demand for agency MBS in 2012.
$400 Wildcards $300 QE3 $300bn
$200 $Mgr: $50 bn $100 Foreign: $50bn Organic: -$55bn Tsy Sales: $30bn Fed: $27bn REITs: $25bn Banks: $75bn GSE runoff: +$70bn Demand: $177bn
$0
-$100
Supply: $95bn
Exhibit 4: Total foreign holdings stabilized around $700bn while foreign official institutions net sold
Holdings of agency MBS by all parties and foreign official institutions, 6/30/2005-6/30/2011; ($bn)
900 800 Foreign official institutions holdings Total Foreign Holdings
Holdings of agency MBS ($bn)
700 600 500 400 300 200 100 0 '05 '06 '07 '08 '09 '10 '11
Source: J.P. Morgan, TIC
http://www.treasury.gov/resource-center/data-chartcenter/tic/Documents/frbul2006.pdf
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Deciphering MIP changes in Ginnies: WALA is key to TBA

Confusion reigned over the GNMA market this past week as investors digested seemingly conflicting news from the FHA. Headlines reports had focused on agencys plan to increase premiums. At the same time, speeches and statements by HUD officials indicate a separate plan to provide premium relief for legacy FHA borrowers in order to increase streamline refis. Exhibit 7 summarizes recent developments and how they should affect FHA borrowers and GNMA investors. Statutory Premium increase Insurance premiums will increase for new FHA borrowers starting in April. This includes a 10bp bump in the annual premium from 110/115bp to 120/125bp, depending on LTV. In addition, the upfront premium will go up to 1.75% from 1.00%. New borrowers include purchase loans as well as conventional to FHA refis. Existing borrowers refinancing already insured by the FHA will not be subject to the latest increases. With this announcement, the FHA has created two tiers of MIPs: one for new and another for existing borrowers. The agency isnt done. It is likely to create a third tier for legacy pre-May 2009 borrowers, in a manner similar to the GSEs HARP program. HARP for FHA: Potential grandfathering of premiums The FHA has been raising MIPs since late 2010. For a 95LTV borrower the annual MIP has increased from 50bp to 85bp in October 2010 to 110bp in April 2011. Prior to the latest adoption of a two-tiered MIP system which exempts existing borrowers from the upcoming 10bp increase, the FHA instituted a one-size-fits-all structure. Existing borrowers paid higher MIPs when refinancing. This rule effectively created huge disincentives against refinancing for FHA borrowers. For instance, a borrower with a 5.5% note rate would have saved 150bp refinancing at todays 4% prevailing rate. But if the borrower had been paying a 50bp MIP, his MIP premium would increase to 110bp after refi. The premium differential creates a 60bp disincentive to refi. On a net basis, the borrowers effective rate incentive goes down from 150bp to only 90bp. The concept of grandfathering premiums allows the borrower to keep paying the existing 50bp MIP established at the current loans origination. This is similar to the GSEs HARP
Exhibit 5: Total China holdings have fallen, but Hong Kong positions are up
400 350 China Japan Hong Kong South Korea Taiwan
Holdings of agency MBS by the five largest foreign parties (as of 6/30/2011), 6/30/2005-6/30/2011; ($bn)
Agency MBS Holdings ($bn)
300 250 200 150 100 50 0 '05 '06
'07
'08
'09
'10
'11
Exhibit 6: Net flows of agency MBS have still been negative for the past year
Gross purchases (gross buying gross selling) and net purchases (gross purchases paydowns) of agency MBS by foreign parties, Dec-09 to Dec-11
25
Foreign Purch of Agency MBS ($bn)
20 15 10 5 0 -5 -10 -15 -20 -25 Dec-09 Apr-10 Aug-10 Net Dec-10 Apr-11 Aug-11 Dec-11 Gross
Exhibit 7: The last few months have seen a flurry of discussion on MIPs
Key dates concerning FHA MIPs and the streamline refinance program
Date Event Implication 12/1/11 Secretary Donov an Testimony to HCFS 2/1/12 2/13/12 2/22/12 2/27/12 White House speech/remov al of streamline refis from 'Compare Ratio' 2013 Federal Budget Proposal HousingWire article regarding FHA Acting Commissioner Galante's speech FHA Press Release Secretary Donov an Testimony to Senate Banking Committee FHA discusses w ay s to increase streamline refis in order to reduce losses Increases streamline refi opportunities for high coupon Ginnies 10bp increase in annual MIP MIP structure changes for pre-May '09 v intages to increase streamline refi 75bp upfront and 10bp annual increases to MIPs for new FHA borrow ers FHA seeking to adjust premium structure of all streamline refi loans endorsed on or before May 31, 2009
2/28/12
Source: J.P. Morgan, HUD, HousingWire
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program, where borrowers whose houses have fallen in value are exempt from obtaining new private mortgage insurance (PMI) or can pull through existing PMI regardless of new LTV. Some investors have asked whether the FHA can afford to grandfather legacy loans. They cited the recent Congressional mandate of a 10bp g-fee increase for GSE and FHA guaranty fees, questioning how the FHA can meet the statute if it grandfathers. The legislative language around GSE g-fees and FHA premiums are markedly different. We believe that the FHA has significantly more degrees of freedom to set its premium structures than the GSEs do. Last year, when Congress enacted H.R. 3630 and used guarantee fee increases on new GSE loans to help pay for the two-month payroll tax cut extension, they required that the guarantee fee increase would: be not less than an average increase of 10 basis points for each origination year or book year above the average fees imposed in 2011 for such guarantees. 2 Essentially, the GSEs must increase g-fees on their 2012 book of business an average of 10bp from the 2011 average g-fees. In the same document, Congress required that the FHA also raise its premiums by 10bp. However, instead of requiring the increase to occur entirely in 2012, they gave the FHA a 2-year window to enact the change. During the 2-year period beginning on the date of enactment of this subparagraph, the Secretary shall increase the number of basis points of the annual premium payment collected under this subparagraph incrementally, as determined appropriate by the Secretary, until the number of basis points of the annual premium payment collected under this sub paragraph is equal to the number described in sub clause (I). The rules around FHA do not prescribe a specific yearover-year target. Thus, the agency is given considerable leeway to introduce the most recent and somewhat complicated MIP structure. The combinations of the proposed MIP changes should effectively create three borrower tiers. The first is the pre-May 2009 loansthey get to keep their
2
Exhibit 8: Potential changes would create a multitiered MIP schedule

Annual MIP at Origination (bp, left) MIP change, dis-incentive (bp, right) June '09 Sept '10: 60bps
Annual MIPs at origination (bp, left axis) and the MIP change for a borrower who seeks to refi now (bp, right axis) by origination month of current loan
140 120 100 80 60 40 20 0 May '09 and earlier: 0bps Oct '10 Mar '11: 25bps April '11 and later: 0bps 70 60 50 40 30 20 10
Feb-09
Feb-10
Feb-11
Feb-12
Oct-08
Oct-09
Oct-10
Jun-08
Jun-09
Jun-11
Oct-11
Source: J.P. Morgan
Exhibit 9: Measuring MIP impact on RVGN 4.5 (above) and 5.0 (below) float and fair value
Model payups versus the assumed deliverable on an even OAS basis (left axis, ticks) and the outstanding float (balances minus collateral pledged to CMOs, specified pools, and Fed holdings (right axis, $bn), 30-year GN Is and IIs 50 20 G1 4.5 Float (right, $bn)
40 30 20 10 0 -10 -20 50 40 30 20 10 0 -10 5 10 15 20 25 30 35 40 45 G2 4.5 Float (right, $bn) 4.5 Payup (left, ticks) 18 16 14 12 10 8 6 4 2 0 6 5 4 3 2 1 0
G1 5.0 Float (right, $bn) G2 5.0 Float (right, $bn) 5.0 Payup (left, ticks)
http://www.gpo.gov/fdsys/pkg/BILLS-112hr3630eas/pdf/BILLS112hr3630eas.pdf
-20
10
15
20
25
30
35
40
45
32
Source: J.P. Morgan
Jun-12
Jun-10
original rate, at 50/55bp. Another tier consists of new FHA borrowers who will be paying 120/125bp. Between the two groups, are those who took out loans from June 2009 to March 2012. Depending on the time of origination, these MIP rates vary from 50/55bp to as much as 110/115bp. These borrowers would still have to pay a 110/115bp MIP rate when refinancing since they will not be grandfathered under the pre-May 2009 proposal. The calculus for these borrowers is the most complicated. Loans originated between June 2009 and September 2010 carry a 50/55bp MIP. Loans from October 2010 to March 2011 are paying an 85/90bp MIP. Finally, those originated over the past year are already paying 110/115bp. Thus, if they refinance, some will see their MIP increase by 60bp, some by 25bp, and some will see no change (Exhibit 8). The effective MIP change for a FHA to FHA refi will be highly WALA dependent (Exhibit 9). Ginnie valuations are becoming more WALA dependent, particularly for cusp coupon 4.5s and 5s. In particular, loans created between June 2009 and September 2010 face a 60bp MIP hurdle and those between October 2010 and March 2011 face a 25bp MIP hurdle. TBA Ginnies are expected to be barbelled: the deliverable could include those issued since April 2011 (12 WALA and under) or older than May 2009 (over 31 WALA). Those in between should trade at payups, especially for 4.5s and 5s. In Exhibit 9, we plot the even OAS payups for these moderately seasoned pools. Indeed, given the MIP elbows, <12 WALA and 33+ WALA Ginnies have less fundamental value than the ones in between. These exhibits also show the outstanding float for each WALA bucket, net of CMO, spec pools and Fed holdings. In the 5% coupon, pre-May 2009 balances range in the tens of billions. In the 4.5 coupon, the seasoned float is just as big as in 5s. Furthermore, we argue that the WALA cutoff should be set around 31 (July 2009 originations and earlier) instead of 33 (May 2009) since the FHA cutoff is based on loan application date (when the loan officer obtains a case number) rather than closing date. For both of these coupons, the 2-month difference potentially opens up an additional $10bn in TBA float. Given the distribution of float observed in the two coupons, we believe the 4.5 TBA is less at risk than 5s. It is also implied from the float data that cusp coupon Ginnie IIs
Exhibit 10: Looming dangers of clean-up buyouts by BoA

90-days + delinquency rates and buyout CPRs for BoA serviced Ginnies, monthly since 2009
30 25 20 15 10 5 0 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Buyout CPR, left dq90+%, right 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan-12
Source: J.P. Morgan, Ginnie Mae
Exhibit 11: BoA has a large Ginnie share and high delinquency rates on higher coupons
Ginnie I and II 30-year outstanding balances and BoAs share, along with Ginnie I 30-year 90-days+ delinquency rates for the entire cohort and the BoA share, as of January 2012 Balance ($bn) 3.5 4.0 4.5 5.0 5.5 6.0 6.5 G1 30 All 16.6 76.3 165.4 103.9 51.5 34.1 10.4 BoA (%) 15% 31% 37% 25% 19% 19% 15% G2 30 All 29.8 112.6 188.5 129.1 46.7 30.5 11.9 BoA (%) 5% 10% 24% 30% 21% 21% 18% DLQ 90+ (%) G1 30 All 0.2 1.1 2.1 3.2 3.3 4.0 3.5 BoA 0.6 2.2 3.7 6.5 8.4 9.7 8.9 Source: J.P. Morgan, Ginnie Mae
are less affected than Ginnie Is. The ratio of issuance of Ginnie Is to II was close to 3:1 during 1H09 and now the inverse is true.
GNMA: The potential for BoA buyouts

Over the past few months, investors have watched the accumulation of seriously delinquent loans in Bank of America (BoA) serviced Ginnie pools with alarm. The rise in the 90+dq rate has been striking, nearly mirroring the 2009 experience, which ended with a series of cleanup buyouts that led to 15-25 CPR of buyout speeds on the aggregate universe of BoA collateral. Investors have to brace for another bout of buyouts in the months ahead. Not buying out delinquent loans is a costly undertaking. First, servicers are obligated to advance P&I on delinquent loans as long as they remain in Ginnie pools. More importantly, a servicer can lose hundreds of basis
33
points (annualized) when buyouts are delayed. The FHA reimburses originators for 100% of principal loss, but missed interest payments are generally reimbursed based on the 10-year Treasury rate. Given the cost of the delay, why has BoA avoided buyouts for so long? We conjecture that it has been done for capital reasons. Repurchasing delinquent FHA loans brings them on balance sheet. Delinquent FHA loans carry a 20% risk weight. Concerns around BoA capital adequacy was heightened late last year in the midst of the European sovereign crisis. Furthermore, the Fed was conducting its annual bank stress tests around the same time. Buyouts, or the lack thereof, may be better understood in the context of the banks desire to reduce risk weighted assets and improve capital ratios. After all, during this period of time, the bank executed roughly $30bn GN/FN swaps (decreasing its conventional MBS holdings by $30bn while adding an equivalent amount of GNMAs). In our view, the purpose of these swaps was balance sheet management. Stress tests have already been submitted (to be released soon), and the banks year-end financials have been released. We see little reason why the bank will not be able to resume repurchases. If the 2009 experience is any guide, the bank may conduct its repurchases in several lumpy chunks. Its 90+dq rates were brought down from close to 4% to under 0.5% in two buyout spikes spanning over three months. Assuming buyouts are evenly spread out over two months, they would result in 15-20CPR spikes on BoA serviced pools (more on premium coupons). Given that BoA services roughly a quarter of the outstanding Ginnies, this effect translates to 4-5CPR on the cohort, blunted but still sizeable. BoA buyouts could be reported as early as next week, but there is no way to tell with certainty. If reported speeds suggest that the servicers DQ pipeline has already been flushed, forward settle pools should benefit. Otherwise, we would steer away from TBA Ginnie Is to IIs where the adverse impact of potential BoA clean-up buyouts is curtailed.
Non-agency MBS (-$780mn), and $395.9bn mortgage loans (-$2.4bn). Freddie Mac released its monthly volume summary for January. The agency reported holdings of $212.3bn FHLMC MBS (-$11.3bn m/m), $32.4bn of non-FHLMC MBS (-$690mn), $141.4bn of non-agency MBS (-$1.2bn), and $256.4bn of mortgage loans (+$2.4bn). The Fed net purchased $6.3bn of agency MBS from January 26 through February 1. $1.45bn were in Freddies (+$300mn, w/w), $3.25bn were in Fannies (+$700mn) and $1.3bn were in Ginnies (+$200mn). Since the programs inception (October 3, 2011), the Fed has purchased $41.0bn in Freddies, $69.6bn in Fannies and $19.5bn in Ginnies. MBA Weekly Survey: For the week ending February 24, 2012, the purchase application index increased 8.2% to 175.1 and the refinance index decreased 2.2% to 4,225.4 (seasonally adjusted). Freddie Primary Survey: For the MondayWednesday period prior to March 1, 2012, 30-year conventional conforming fixed-rate mortgages averaged 3.90% (average of 0.8pts for the week), down 5bp from the previous week. Primary dealer MBS positions increased $1.8bn (w/w) to $71.4bn for the week ending February 22, 2012. Fixed-rate agency gross and net issuance were $104bn and $2bn, respectively, in January. Gross issuance month-to-date in March has been $7.9bn, including jumbos, 40-years and IOs. Fails charges totaled $158bn for the week ending February 22, 2012, a $7.9bn increase w/w. Pending home sales increased 2.0%m/m in January, while pending homes sales was revised from a 3.5% decrease to a 1.9% decrease in December.
Week in review
Fannie Mae released its monthly volume summary for January. The agency reported holdings of $214.5bn FNMA MBS (-$5.6bn m/m), $15.2bn of non-FNMA MBS (-$323mn), $73.8bn
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Exhibit 12: The Fed has bought $131bn MBS so far

Fed MBS net purchases from October 3, 2011 to February 29, 2012 ($mn) Cumulativ e Net Purchases ($MM)
Maturity 30 Year Coupon FHLMC FNMA 3.0 3.5 20,950 4.0 15,250 36,200 15 Year 2.5 3.0 3.5 4,050 1,700 5,750 41,950 350 35,950 25,250 61,550 450 5,200 2,350 8,000 69,550 5,750 13,700 4,100 1,650 5,750 8,700 5,000 13,700 GNMA GNMA2 Total 350 69,700 47,150 117,200 450 9,250 4,050 13,750 130,950
Exhibit 13: and $6bn MBS this past week.

Week ending 2-29-2012 ($MM) Maturity Coupon Settlement FHLMC 30 Year 3.0 3.5 4.0 Total 15 Year 2.5 3.0 Total Grand Total May Apr May Apr Apr 950 350 1,300 150 150 1,450
Fed MBS purchases from February 23, 2012, to February 29, 2012
FNMA GNMA GNMA2 250 1,900 650 2,800 200 250 450 3,250 300 1,000 300 300 750 250 1,000 Total 250 3,900 1,250 5,400 200 400 600 6,000
Source: Federal Reserve
Source: Federal Reserve
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 John SimAC (1-212) 834-3124 Asif Sheikh (1-212) 834-5338 J.P. Morgan Securities LLC Abhishek Mistry (1-212) 834-4662 Kaustub Samant (1-212) 834-5444
Non-agency RMBS and Home Price Commentary

Home prices fell 4% in 2011, in line with market expectations. We expect another 3% decline in 2012 and modest nominal growth afterwards The Fed sold the remainder of the Maiden Lane II portfolio. The sales were orderly and traded into strength, in contrast to last year. The combination of this and the ECB liquidity provision alleviates technical supply concerns in non-agencies The Countrywide settlement took a step forward as the US Court of Appeals ruled that the settlement could be heard in a NY State court instead of federal court, allowing any final ruling to be binding on all parties. Anecdotally, the market is pricing in the BAC settlement more definitively Meanwhile, liquidations on Countrywide shelves have spiked as increased foreclosure activity is starting to go through the pipeline. Senior bondholders in CWALT/CWL shelves should benefit from resolution of defaults and potential settlement funds We review a January draft of the Attorney Generals settlement, which provides a menu of borrower relief efforts that servicers can choose from, although we continue to expect that the lions share of principal forgiveness will come from portfolio loans. However, investors continue to be concerned about the potential for increased principal modifications in securitized deals Contrary to news headlines, our reading of the draft seems to indicate that second liens must be extinguished if the first lien is modified. Thus, servicers will not have incentive to reduce principal in first lien securitizations if they own the second lien Default rates were flat to slightly down across the board, PrimeX prepays were lower, severities were modestly up for prime and subprime, while modifications continued to slow down in the February remits
Exhibit 1: Case/Shiller home prices end the year down 4%; expect a 3% decline in 2012
Case/Shiller national home price index history and projections
Peak to Peak to Current to Scenario Trough Current Trough Benign Base Negative Severe Positive Bullish -35.2% -35.8% -36.9% -39.1% -34.6% -34.2% -33.8% -33.8% -33.8% -33.8% -33.8% -33.8% -33.8% -2.0% -2.9% -4.7% -8.0% -12.0% -1.2% -0.6% 2011 HPA -4.0% -4.0% -4.0% -4.0% -4.0% -4.0% -4.0% 2011 4.24 2.94 1.45 2012 HPA 1.3% -1.6% -4.7% -6.8% -9.1% 3.7% 5.8% 2012 4.74 3.13 1.64 2013 HPA 2.5% 1.4% 0.0% -1.3% -3.1% 3.1% 4.2% 2013 4.89 3.19 1.70 2014 HPA 4.0% 3.7% 3.4% 2.9% 2.0% 4.0% 4.3% 2014 4.99 2.99 1.50 2.0 2015 HPA 4.3% 4.4% 4.4% 4.4% 4.2% 4.2% 4.2% 2015 5.05 2.86 1.37 2.2
Depression -41.8%
Base forecast assumptions Existing Home Sales (NAR, mm) Housing Inventory (NAR, mm) Liquidations (mm)
Net Housing Demand (mm) 1.3 1.6 1.7 Note: current is as of 11Q4. 2012-2016 HPA is yoy % change of Q4 HPI data.
Source: J.P. Morgan, Case/Shiller
Home prices fell 4% in 2011

Case/Shiller home price data came out on Tuesday and showed that national home prices ended the year down 4% in 2011 (Exhibit 1), largely in line with market expectations. We see another 3% decline in 2012 and only modest nominal growth nationally in 2013-2014. The national Case/Shiller HPI fell 3.8% in 4Q11. Both the 10-city and 20-city composites were down 1.1% in December. Only Miami and Phoenix posted positive monthly changes in the 20-city composite. Excess supply pressures will continue to be a drag on home prices.
And its gone!

Maiden Lane II posted the final sale of the portfolio on Tuesday (2/28/2012), removing one of the lingering technical what if scenarios weighing on the minds of investors. Consider how orderly the lists traded compared to last year with roughly double the volume being sold this time around (last year $10bn was sold compared to over $20bn this year). Additionally, European risk-off and regulatory capital related fears have dissipated for now. Suffice it to say that technicals are strong. The market has found an illusive pricing equilibrium as investors put money to work in the sector. Equilibrium is the key word here since we dont think prices are poised to rally much more and we continue to think that the ABX rally is overdone. Distressed floaters have found a clearing level for locked money investors (with yields ranging from 8-12%), but any meaningful tightening from current levels is likely to meet buying
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resistance. Generally, distressed investors appear to be comfortable with the risks in the sector and range of yields. Moreover, volatility in risky assets should be lower this year, relative to 2011. Consequently, we think many have abandoned all hope of a more significant pullback in prices. Despite all of these positives, we think fundamentals need to improve for pricing improve much from here. We continue to prefer fixed-rate paper and would rather layer in senior (and senior mezzanine) option ARMs as an overall recovery trade, rather than subprime floaters. Look for Countrywide paper that is levered to the $8.5bn BAC settlement. The probability of this happening has gone up (more on this later). Anecdotally, investors are trying to buy bonds assuming a 24-month payout with a 50% probability of the settlement happening. We think the payout could be sooner. Additionally, look for bonds that may not be pricing in the recent pick-up in CDRs.
Exhibit 2: Liquidation rates have spiked on Countrywide shelves
1-month CDRs for CWALT, CWL shelves and the non-agency universe
16 14 12 10 8 6 4 2 0 Jan-09 Oct-09 Jul-10
CWALT CWL All
Apr-11
Jan-12
Source: J.P. Morgan, Loan Performance
$8.5bn BAC settlement takes a step forward

The $8.5 billion BAC settlement moved a step closer to approval on Tuesday. The federal appeals court reversed a lower court decision ruling that the settlement should be heard in a NY State court rather than a federal court. 3 We think BAC prefers this scenario because approval of the settlement could bind all 530 trusts involved to the terms of the settlement (even those who did not participate in, or objected to, the settlement negotiations). The next step is for the trustee, Bank of New York Mellon, to obtain a fairness opinion from the NY state court on the settlement and then for state court approval. This would put payments to mortgage trusts sometime in mid-2013. Of course, investors could continue to seek ways to appeal and delay the settlement process. Recall that certain securities could benefit by as much as 5-10 points from the settlement (see our report from 7/8/2011). Senior Mezzanine, second pay and PENAAA subprime bonds benefit the most.
uphold the servicing changes on delinquent loans that they agreed to in the $8.5bn investor settlement (see commentary from 6/30/2011), regardless of the outcome of the cash payment component of the settlement. Hence, some delinquent loans may be processed more quickly to meet these servicing obligations. It appears some of the increased foreclosure activity is making its way through the pipeline. Liquidation rates on CWALT and CWL deals have risen about 7CDR since last summer and 2-3CDR in the past month alone (Exhibit 2). Liquidation rates across the non-agency universe ticked up 1CDR over the past two months, but this may simply reflect noise. We will have to wait a few months to see if servicers are ramping up liquidations more broadly. Regardless, the Countrywide trend appears to be real. Faster resolution of delinquent loans is a positive to senior and mezz bond holders. Recall that Countrywide was Dr. Dolittle for years, with some of the slowest 90 to FC rolls across all servicers. We all knew that this should reverse at some point. It seems like that time is now.
Countrywide/BoA liquidations rising

Liquidation rates on Countrywide deals have spiked in recent months. In October, Bank of America announced they were resuming foreclosures after resolving affidavit issues. Furthermore, BoA has stated they will continue to
3
www.tinyurl.com/bac-jpalert
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Exhibit 3: There are several potential options to receive credit in the AG settlement
A summary of options from a draft document (linked below) Option Constraints Loan type Porfolio loans 1 1st Lien Modifications Min 30% Max 12.5% Porfolio loans
Porfolio loans Investor loans Investor loans Principal forgiveness Forgiveness of forbearance Earned forgiveness for a period no more than 3 years Principal forgiveness Earned forgiveness for a period no more than 3 years Principal forgiveness Credit LTV<= 175% : $1 writedown = $1 credit LTV>175% : $1 writedown = $0.5 credit $1 writedown = $0.4 credit LTV<=175% : $1 writedown = $0.85 credit LTV>175% : $1 writedown = $0.45 credit $1 writedown = $0.45 credit LTV<=175% : $1 writedown = $0.4 credit LTV>175% : $1 writedown = $0.2 credit Performing (0-90): $1 writedown = $0.9 credit Seriously Delinq (90-180): $1 writedown = $0.5 credit Non-performing (180+): $1 wrtiedown = $0.1 credit $1 payment = $1 credit (for the amount over $1500) $1 payment = $0.45 credit
2 2nd Lien Modifications
Min 60%
Porfolio loans
3 Enhanced borrower Transition funds
Max 5%
Servicer Makes Payment Investor Makes Payment Servicer pays 2nd lien holder for release Servicer forgives deficiency Investor forgives deficiency Forgiveness of deficiency balance and release of lien on 2nd liens
4 Short Sales/Deeds in Lieu
Portfolio loans Investor loans Porfolio loans
$1 payment = $1 credit $1 writedown = $0.45 credit $1 writedown = $0.20 credit Performing (0-90): $1 writedown = $0.9 credit Seriously Delinq (90-180): $1 wrtiedown = $0.5 credit Non-Performing (180+): $1 writedown = $0.1 credit
5 Deficiency Waivers Forbearance for 6 unemployed homeowners
Max 10% Porfolio loans
Deficiency waived on 1st and 2nd liens loans Servicer forgives payment arrearages on behalf of borrower Servicer facilitates traditional forbearance program
$1 writedown = $0.1 credit
$1 = $1 credit $1 property value = $0.05 credit
7 Anti-Blight Provisions
Max 12%
Porfolio loans
Forgiveness of principal associated $1 property value = $0.50 credit and servicer doen't pursue foreclosure Cash costs paid by servicer for demolition of $1 payment = $1 credit property REO properties donated $1 property value = $1 credit
* Min is for both 1st and 2nd lien Mods. Note: 60% of $17bn is roughly $10bn the principal reduction amount of the settlement http://online.wsj.com//public/resources/documents/SettlementMenuSettlementAgreementFeb2012.PDF http://online.wsj.com/public/resources/documents/GeneralFrameworkSettlementAgreementFeb2012B.pdf http://online.wsj.com//public/resources/documents/SettlementTermSheetSettlementAgreementFeb2012.PDF Source: J.P. Morgan
AG settlement draft documents

While we wait for the finalized documents to surface, we summarize some draft documents that made their way into the public arena (Exhibit 3). These are drafts, so clearly they are subject to change and there may be
specific agreements made with individual banks. Overall, principal reductions on seriously delinquent loans should reduce defaults, and this is a positive for home prices.
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Drafted components of the $25bn AG settlement include: First lien forgiveness modifications A minimum of 30% of the $17bn in total relief funds (or $5bn) must be used to forgive principal in first liens Eligible borrowers must be underwater and at least 30+ days delinquent or at risk of default due to their financial situation. 85% of the loans must be owner occupied and below the conforming limits The modification should target a DTI of 31% and LTV less than 120%, with a payment reduction of at least 10% Below 175LTV, servicers receive 100% credit for forgiveness on portfolio loans; above that reductions only receive 50% credit down to 175LTV Forgiveness in securitizations receives less than half the credit as in portfolio (45% versus up to 100%) Forgiveness may be done on portfolio loans that have already seen forbearance; however, servicers will receive less credit (40% versus up to 100%) To the extent that the servicer is able to collect HAMP principal reduction incentives, the incentives will be deducted from any credit the servicer receives A minimum of 60% of the $17bn in total relief funds (or $10bn) must be used to forgive principal across first and second lien loans together If the first lien has been modified by a servicer participating in the settlement, a second lien held in portfolio must be modified as well Forgiveness credits range from 90% on 0-90 days delinquent to 10% on 180+ days delinquent For second liens with at least $5,000 balance and $100 monthly payment, it seems the servicer is required to extinguish the second lien. Contrary to media reports, we did not see proportional writedown mentioned in the settlement documents Smaller seconds must be modified according to the 2MP program
Refinancing Applies only to portfolio loans (and not FHA/VA) Must be current, no delinquencies in 12 months, no modification/bankruptcy /foreclosure in 24 months, fixed-rate or hybrid period >5 years, underwater, conforming, and originated before 2009 The new interest rate can be fixed for the life of the loan or for only 5 years, with the rate stepping back up to the original rate Credit is calculated by (original rate new rate) x multiplier x UPB where the multiplier is between 5 and 8, depending on the term of the loan and whether the new rate is permanent or 5 years only Any extra refinancing above and beyond was is required would receive some credit towards forgiveness targets Short sales (45% credit on portfolio, 20% on securitizations); credit is also given for transitional funds given to the homeowner Forbearance/forgiveness for the unemployed Donation of REO property to municipalities, nonprofits, or service members; cash costs for demolition of property Deficiency waivers on first and second liens
Other measures that receive credits include
Second lien forgiveness modifications in portfolio
In addition, servicers get an extra 25% credit for forgiveness and refinancing done within the first 12 months. Servicers have up to two years to complete 75% of their targets, and another year for the remaining targets. If these are not met, servicers must pay 125140% of the unfulfilled amount as a penalty. We think the incentives offered for early execution will push servicers to complete most of their targets within 2012. As we noted in past articles, major servicers have enough delinquent loans already on balance sheet to satisfy reduction targets with only a 10% reduction in balance on delinquent loans. Operationally, it may take some time, but servicers will be eager to complete as many as possible before year-end. In terms of portfolio versus securitizations, we continue to think the bulk of the activity will occur on balance
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sheet. Given the volume of seriously delinquent loans on balance sheet that are likely to incur large losses anyways, servicers will be inclined to write those loans down. Furthermore, the settlement does not preclude servicers from collecting HAMP incentive fees on forgiven loans. They do not receive credit for the incentive amount, but that is a cash payment that is potentially available to the servicer. Meanwhile, they get credit for the amount not covered by the incentive. If servicers have to incur losses on a portfolio of nonperforming loans, at least this way they can mitigate some of the losses with HAMP cash and fulfill their settlement obligations. Our reading of the treatment of second liens does not encourage forgiveness in securitizations. If principal forgiveness is done on a first lien loan in a securitization and the servicer owns the second lien, they have to extinguish the second even though they only get partial credit for the first lien (since it was not in portfolio). This is a disincentive to forgiving principal in securitizations and instead should encourage portfolio mods. Refinancing will be a smaller component to this. Assuming on average refinancings lead to a 1.5% permanent rate drop on a 30-year loan with $400,000 balance, the $3bn in settlement funds would translate to about 60,000 loans being refinanced altogether.
forward in this initiative is a good thing as it reduces distressed sales. This will benefit the hardest hit areas the most. It is not clear how much ownership, if any, Fannie Mae will retain in the properties. Regardless, the buyers will be the rental managers and must document their ability to do so during the pre-qualification process. Fannie Mae currently owns roughly 122,000 REO properties.
February Remits Commentary

Prepays were down for most indices this month. PrimeX CPRs decreased by 2pts to reach 16.3CPR and 12.6CPR for FRM.1 and FRM.2, respectively. PrimeX.ARM CPRs remained in the 8-9CPR range, slightly lower than last month. Option ARM and subprime CPRs were roughly flat on average, with most indices varying by 0.5pts or less. Alt-A prepays were lower by 0.5CPR in aggregate; the Fixed indices reduced by 0.5-2.0pts Default rates were flat to slightly lower this month. ABX default rates were lower by 1pt on average to reach 9-11CDR. Option ARMs were flat in aggregate, though the individual indices moved by +/- 1pt. PrimeX ARM.2 CDRs reduced by 3pts to reach 7CDR, the other PrimeX indices are in the 3.45CDR range, roughly flat from last month The increases in the foreclosure bucket over the last six months are starting to make their way into REO. The foreclosure bucket decreased for subprime while the REO bucket increased. This is not yet the case for option ARMs, where 90-day delinquencies continued to decrease as loans were pushed to foreclosure Loss severities rose by roughly 1 point in prime and subprime, and fell by 1pt for Alt-As. Severities remain in the 43-47% range for prime, 60-65% for Alt-A, 65-70% for option ARMs, and 75-85% for subprime Modifications slowed further, with fewer than 2,000 mods reported across our indices, compared to 2,100 and 2,200 in the previous two months. Principal reduction/forbearance comprised 16% of modifications, with an average reduction of $70,000. The average rate reduction for the 1,400 rate mods was 2.59%
REO to rental: FHFA announces a pilot sale of Fannie Mae loans 4

On Monday (2/27/2012), the FHFA announced a pilot sale of 2,490 Fannie Mae properties where Credit Suisse will act as the financial advisor. Interested investors can submit applications to pre-qualify. The investors must demonstrate their financial capacity, experience and specific plans for purchasing properties. The investors must agree to rent the properties for a specified number of years. Looking at the summary of properties being sold, 5 roughly 70% are single family. However, just over 85% of the property units are already being rented out. These are hardly the type of distressed properties that we would expect to be illustrative of future sales since the burden to find renters is avoided. Regardless, any step
4 5
http://www.fhfa.gov/Default.aspx?Page=360 http://www.fhfa.gov/webfiles/23402/FNMASFRREO20121SummaryofAssets.pdf
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Edward J. ReardonAC (1-212) 270-0317 Meghan C. Kelleher (1-212) 270-2017 Joshua D. Younger (1-212) 270-1323 J.P. Morgan Securities LLC
CMBS
Investor focus returned to the primary market this week; the second conduit deal of the year priced tight to initial guidance amid signs of strong demand; this was due, in part, to offering public subordinates We believe the rally in new issue credit bonds will continue; following the outperformance of AAs this week, single-As are our top pick in the space Issuers will likely take advantage of tighter spreads to source more collateral in primary markets, but borrowers may demand more leverage to compete with insurance companies; higher LTVs should be offset by better-quality properties and higher credit enhancement levels Legacy spreads continued to grind tighter this week; liquidity has gradually improved over the past six months; CMBS still offers compelling returns versus corporates; at the top of the stack, add exposure to wider-spread 2006/2007 A4s and A4Bs off of re-Remics More seasoned AMs have also caught a bid over the past two weeks; 2006-vintage bonds with AA and single-A current ratings should benefit from greater real money demand The visible pipeline of modifications is insufficient to noticeably extend CMBX.AMs; extensions can, however, have a significant impact on spreads We review the trajectory of recent appraisals of conduit collateral; the volume of re-appraisals and magnitude of appraisal reductions declined in 2011, though property valuations remain well below those at securitization
Exhibit 1: CMBS Spread Summary

Legacy (to Swaps): 5yr TW AAA 7yr AAA A-SB 10yr 30% AAA 10yr Mezz AAA 10yr Junior AAA Price-Based: AA A BBB BBBNew Issue CMBS (Swap): 5yr Super-Senior AAA 10yr Super-Senior AAA AA A BBB Agency CMBS: Freddie K A1 Freddie K A2 Freddie K B FNMA DUS 10/9.5 GNMA Project Loan (3.5yr)
Source: J.P. Morgan, PricingDirect
Change This Week 1 WK 1 MTH YTD 190 220 215 460 1550 -10 0 -15 -15 -50 -35 -20 -35 -40 -100 -55 -30 -60 -95 -250
41 30 9 9
0 0 0 0
0 0 0 0
0 0 0 0
100 105 250 350 500
-5 0 -100 -50 -75
-15 -10 -150 -150 -125
-20 -20 -150 -150 -115
53 74 365 75 75
-5 -3 -1 -3 0
-5 -8 -78 -8 0
-10 -11 -110 -22 -5
*Freddie K spread data as of Thursday COB
Exhibit 2: Despite a strong rally, new issue subordinates still offer better yields than corporates
Yield to maturity (LHS) and spread to 10Y swaps (bp, RHS; solid/dotted lines are 1/3/12 and 3/1/12 data, respectively 9% 600 New Issue CMBS Jan 12 Industrials 8% 500 Financials Mar 12 7% 400
6%
Investor focus returned to the primary market this week, as the $1bn COMM 2012-LC4the second conduit transaction of the yearcame to market. Overall the deal was well received, with all the offered classes multiply oversubscribed, and priced well inside of initial guidance. Though the last cashflow super-seniors priced 5bp wide of generic secondary trading levels at S+110, the junior AAAs and below all tightened considerably
5% 4% 3% AAASr AAAJr AA A Note: Corporates are the JULI 7-10 maturity bucket *From J.P. Morgan High Yield sub-index Source: J.P. Morgan 2% BBB BB*
300 200 100 0
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(Exhibit 1). Even in light of the recent rally, we continue to see value in the sector, with yields still quite attractive relative to comparable-duration corporates (Exhibit 2). In fact, only BB financials can compete with single-A new issue CMBS at a spread of S+350. We believe that tighter spreads can be attributed, at least in part, to offering public credit bonds down to the single-A levelpreviously, new issue subordinates were all 144a private placements. This in turn appears to validate the view (which we have heard anecdotally over the past few months) that investors do not in practice always require the additional disclosure that private bonds provide in order to get comfortable moving down the structure. Given this execution, we expect other deals will follow suit, offering at least the junior AAAs, and likely most of the mezzanine tranches, as public bonds. Though this weeks price action was certainly the most dramatic, new issue subordinates have had a sustained rally for several weeks (Exhibit 3). Fundamentally, we believe that tighter levels reflect the now-common refrain of improving domestic growth trends and fading tail risk out of Europe. Meanwhile, recent gains have been magnified by extremely supportive technicals: light supply (both in the primary and secondary market) amid strong demand driven by a broader reach for yield. That said, AAs and single-As off of new issue CMBS still trade quite wide of 1Q11 levels; while we do not expect a full retracement, this suggest to us that the rally has room to run. Over the past couple of weeks, we have recommended AAs in particular, which we believed were trading cheap to single-As and below. However, after the outperformance of AAs this week (100bp tighter on the week at S+250), we believe singleAs at S+350 (50bp tighter) are more appealing, and we recommend adding exposure. One of the drivers of the rally in new issue has been increased bank buying. Although these investors were net sellers through the first quarter of last year, they began to add aggressively in the second half, ultimately adding $18.4bn to their holdings relative to 4Q10 (a 40% increase to $65bn). The growth of CMBS exposure at banks has significantly outpaced overall holdings of securities, with the four largest banks by assets leading the charge (Exhibit 4). Combined with a net decline in their retained commercial real estate loan portfolio and a pickup in issuance, we expect banks continuing to add to
Exhibit 3: New issue credit bonds are still trading quite cheap to their 2011 tights
Spread to swaps (bp) 700 AA
600 500 400 300 200
100 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 Note: Lines are generic marks, squares (circles) are 2010 (2011) covers off BWICs, and open triangles are pricing levels Source: J.P. Morgan
Exhibit 4: Banks have significantly increased their exposure to CMBS over the past six months
Quarter-over-quarter change in carrying value of holdings 25% Total securities Total CMBS 20% CMBS - Big 4 15% CMBS - Other CRE loans 10%
5% 0% -5% -10% -15% 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 Source: J.P. Morgan, SNL, Federal Reserve Board -20%
their CMBS holdings this year. Cleary their appetite cannot be satisfied without looking to add substantial legacy assets, but we expect they will continue to be active in the new issue market, particularly in superseniors and potential junior AAAs. CMBS continues to offer spread and is a natural counterweight to the convexity of agency MBS holdings. One risk to our bullish view is bond supply, as more than $6bn potentially comes to market this month. Despite some deals slipping a few weeks into April, we are now entering the heaviest issuance period since the market reopened in mid-2010 (Exhibit 5). Though the combination
42
of tighter spreads and a heavy upcoming supply calendar inevitably brings back memories of last year, we believe that there are important differences. Most importantly, the introduction of 30%-enhanced, public super-seniors has dramatically expanded potential demand for the product, resulting in much broader distribution relative to private deals. Furthermore, as mentioned above, the absolute level of spreads for new issue subordinates is still significantly wider than their 2011 tights. Additionally, there has been comparatively little longerduration (712-year maturity), investment grade unsecured REIT issuance in the first couple months of 2012. At the same time, the technical environment is much more supportive, with 10-year rates roughly 150bp lower than this time last year and with the Fed explicitly on hold for the foreseeable future. Finally, credit enhancement levels for new issue are higher across the capital structure, which should give investors greater comfort with credit quality. As primary market spreads have rallied, conduit originators have become more competitive with other lenders when sourcing collateral. Using breakeven coupon spreads (the duration-weighted average spread of a generic new issue capital structure assuming a 15% Bpiece yield), we find that the rally in new issue (primarily credit bonds) has improved conduit execution by roughly 40bp in the past month to S+234, and indicative deals are now pricing 120bp tighter than they would have last November, although still roughly 40bp cheap to the tights of last February (Exhibit 6). As a consequence, things have clearly improved considerably over the past couple of months. With life insurance companies bidding aggressively on 50-60 LTV loans (down to a roughly 4% coupon), however, barring a dramatic spread tightening conduits will likely remain uncompetitive on trophy asset loans (with the exception of some single-asset/borrower deals). However, conduits continue to be able to offer more leverage (with faster execution) to borrowers than portfolio lenders. Thus the high-LTV discount, which is still significant by historical standards (Exhibit 7), creates an opening for CMBS originators to source more loans in primary markets: conduits can compete with insurance companies for better-quality assets by offering higher leverage. Rising LTVs will understandably give some investors pause. However, we do not think higher leverage pools
Exhibit 5: Gross supply in March could be the largest since the CMBS market re-opened two years ago
Face value at issuance ($bn) $7 IG unsecured REIT issuance Expected Priced/Announced $6
$5 $4 $3 $2 $1 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Note: Unsecured REIT debt with 7-12 year initial WAL from J.P. Morgan Credit Research Coverage Source: J.P. Morgan Credit Research, Commercial Mortgage Alert $0
Exhibit 6: Conduit lenders have offered higher LTVs than life insurance companies
Original LTV 80
75 70 65 60 55 50 45
LifeCo originations Conduit loans
40 Jan-10 May-10 Sep-10 Jan-11 Source: J.P. Morgan, Trepp, ACLI
May-11
Sep-11
Jan-12
Exhibit 7: Conduit lenders are more competitive on higher-leverage loans

3-month moving average of difference in coupon rate (bp) 300 (65-75% LTV) - (50-65% LTV)
250 200 150 100 50
(75-80% LTV) - (50-65% LTV)
0 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Note: 10-year term fixed-rate commercial mortgage coupon rates; excludes MF Source: JPMAM
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will necessarily be credit negative for two reasons. First, as mentioned above we expect higher LTV loans to be secured by better-quality assets. Given the outperformance of commercial real estate in the traditional gateway markets, as well as investors oftenstated desire for less exposure to secondary and tertiary markets, this should largely offset their concerns about higher leverage. Second, deal structures should evolve to offer investors, particularly in the mezzanine part of the capital structure, greater protection against losses. We believe this is most likely to impact enhancement levels for the BBB tranches and below, which are most sensitive to high-LTV outliers and benefit least from diversificationwhich in turn can offset the impact of higher pool-level leverage on the natural AAA attachment point. Away from new issue, legacy spreads also rallied this week, with benchmark A4s tightening 15bp to S+215 and 2005-vintage paper now regularly covering inside of S+100. At the same time, market liquidity continues to recover: trading volumes have been trending higher over the past six months (Exhibit 8). Although benchmark A4 spreads have broadly outperformed corporates so far this year, rallying more than 180bp from their wides of last year, we continue to believe that later-vintage paper offers compelling yields. For example, at current levels we estimate that GG10s trade at a higher yield than 70% of comparable-duration, investment grade corporates, including almost half of financials and 86% of industrials (Exhibit 9). We believe that compelling yield pick-up should lead yield-driven investors to allocate more capital and resources to the sector. Thus, while we believe that CMBS remains a high-beta asset class, we also believe that A4s have further to tighten; look for benchmark spreads to end the year at S+200. Even though virtually all A4s have tightened in recent weeks, we believe that there are still opportunities to add outperformance via bond selection, as not all have benefitted equally. For example, as the rally that began last November has progressed, the inter-quartile range for 2006/2007-vintage A4s has expanded relative to the absolute level of spreads (Exhibit 10). We believe this dynamic is beginning to reverse, at least among super-seniors. As the market continues to grind tighter, wider-spread names should outperform, and we recommend investors add exposure. We are also constructive on the junior tranches of re-securitized super-seniors, which have tightened approximately
Exhibit 8: Liquidity in the CMBS market has gradually improved over the past few months
5-day moving average of trading volume ($bn) $2.0
$1.5
$1.0
$0.5
$0.0 Sep-11 Oct-11 Nov-11 Source: J.P. Morgan, TRACE
Dec-11
Jan-12
Feb-12
Mar
Exhibit 9: Though legacy A4s have outperformed corporates in recent weeks, yields remain attractive
% of face value in buckets by yield to maturity 12%
70% < 3.25%
GG10 ~3.30%
Financials Non-financials
10% 8% 6% 4% 2%
3.0% 4.0% 5.0% Max in yield bucket Note: Corporate bond yields from JULI constituents with 4-5yrs mod. dur. Source: J.P. Morgan
0%
1.0%
2.0%
Exhibit 10: Not all super-seniors have benefitted equally from the rally in spreads
Inter-quartile range of constituent spreads as a % of index level (bp, RHS); spread to swaps (bp, LHS) 70% 400 2005 Vintage 2006 Vintage 2007 Vintage 60% Benchmark A4 (RHS) 350 50%
40% 30% 20% 10% 0% Jan-11 Mar-11 May-11 Jul-11 Source: J.P. Morgan, PricingDirect Sep-11 Nov-11 Jan-12
300 250 200 150
44
100bp over the past month or so (MSRR 2009-GG10 A4Bs covered at S+375 this week versus S+475 in midJanuary), but still offer roughly 150bp of spread pick-up versus the underlying cusips. More seasoned AMs also caught a bid over the past two weeks, with 2006-vintage bonds in particular tightening 60bp to S+370 as of Thursdays close, and with some bonds covering as tight as S+240. Broadly speaking, we believe that better-quality AMs will be the last sector to benefit directly from real moneys reach for yield. These bonds have, in many cases, remained solidly investment grade (important for ratings-sensitive clients) and commonly trade 200bp cheap to comparably-rated corporates on an all-in yield basis (Exhibit 11). We are particularly constructive on the 2006-vintage, which has better ratings stability and much better returns than more seasoned bonds from 2005 or earlier. Furthermore, the relative outperformance of A4s has created an attractive opportunity to add exposure; AMs are trading 100-200bp cheap to super-seniors by historical standards (Exhibit 12). Although there is clearly some liquidity give-up moving into this part of the capital structure, we recommend adding exposure to 2006-vintage AMs with single-A and higher current ratings. Extension risk in CMBX With 5-year loans originated in 2007 maturing this year, a number of clients have expressed concerns about the potential for extensions to negatively impact spreads, particularly in the AM part of the capital structure, which has little to no upside from modifications (since most are not projected to take writedowns anyway). However, even extending both 2012 maturities and all specially serviced loans has very little impact on the weighted average life of AMs; these bonds rely on 10-year term loans for payoff, and the specially serviced balance is not large enough to push out the duration (Exhibit 13). However, in a few years as the majority of the collateral approaches maturity, we expect a significant fraction (1030%) to receive extensions, particularly for the later seriesthough clearly ultimate outcome will depend largely on the trajectory of property prices (hence our wide range of our forecast). We believe a 12-year extension in AM bond duration is a reasonable base case. At current CMBX prices, that extension would reduce par spreads implied by 0CPR/0CDR assumptions by 100-200bp. Exhibit 14 shows the potential impact on par spreads, using current
Exhibit 11: 2006-vintage AMs offer compelling yields with solidly investment-grade current ratings
Yield for legacy AMs by vintage 10% AAA AA
BBB
Non-IG
8% 6% 4% 2% 0% 2005 Corps -1.5 -1 -0.5 2006 2007
0 0.5 1 1.5 Log(Avg. WARF*) *Log base 10 of the average WARF score for Moodys, Fitch, and S&P ratings Note: Corps is average yield in ratings buckets for bonds with 3-6yr mod. dur. Source: J.P. Morgan, Rating Agency Documents, Bloomberg, PricingDirect
Exhibit 12: 2006-vintage AMs are still trading cheap to super-seniors relative to historical norms
(AM spread) (A4 spread) for 2006-vintage cash index (bp) 600 Higher quality Avg. 500 Lower quality
400 300 200 100 0 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Note: Better-quality are 1st quartile by trading spread, lower-quality are 3rd Source: J.P. Morgan, Rating Agency Documents, Bloomberg, PricingDirect
Exhibit 13: The visible pipeline of extensions has little impact on CMBX WALs
Average life (year) for two special servicing extension scenarios for CMBX.AMs 6 No Ext
5 4 3 2 1 0
5yr
CMBX.1.AM CMBX.2.AM CMBX.3.AM CMBX.4.AM CMBX.5.AM Source: J.P. Morgan, Trepp, Markit 45
market prices for a range of risky durations. Later series will be hit harder than CMBX.1 and 2 AMs for two reasons: we anticipate fewer modifications for earlier series given better collateral quality, and the pull to par is smaller given the higher dollar prices. Special Topic: Assessing the extent of re-appraisals Though commercial real estate fundamentals have shown signs of stabilization over the past year, the recovery in property prices remains highly tiered. While trophy markets have recovered substantially since the trough, distressed prices currently sit 53% below the peak. This week, we review appraisal trends in conduit CMBS, including the trajectory of recent appraisals. Our dataset includes all 2005-2007 vintage loans (outstanding or retired) that have received at least one updated appraisal since January 2008. In total, more than 3,100 loans with a securitized balance of $67.1bn (14% of total origination volume in 2005-2007) have received at least one updated appraisal since 2008. Among these loans, subsequent re-appraisals are fairly common (Exhibit 15). While 53% of the loans in our sample have been re-appraised only once since securitization, 32% have received two updated appraisals, and 15% have received three or more. Background. There are several events that can trigger an updated appraisal, including a loan entering special servicing, modification (other than extension), 120 days after an uncured delinquency, or entering REO (for a more extensive list, see CMBS Weekly Report, January 23, 2009). During the downturn, as distress filtered through the CMBS market, an influx of loans into special servicing, serious delinquency, or REO necessitated a large volume of updated appraisals. As the market has recovered, though new delinquencies have stabilized, an increase in modification volume has kept re-appraisal volume elevated. In addition, loans that remain in special servicing typically receive updated appraisals on an annual basis, motivating the relatively high proportion of loans with at least two updated appraisals since 2008 (special servicing timelines tend to be prolonged). In fact, 85% of loans in our subset are currently seriously delinquent (90+ incl. FC/REO), modified (excluding GGP), or performing specially serviced (Exhibit 16). New appraisal reductions slowed in 2011. Most of the loans in our sample received their first updated appraisal in 2010, and the path of appraisal timing broadly mimics
Exhibit 14: Par spreads are, however, can be quite sensitive to extensions
Implied CDS spread at current prices (bp, as of 3/1/12) 450 AM1
400 350 300 250 200 150 0 0.5 1
AM3 AM5
AM2 AM4
Source: J.P. Morgan, Markit
1.5 2 Change in DV01 (yrs)
2.5
Exhibit 15: More than $30bn of loans originated in 2005-7 have received multiple appraisals since 2008
60% 50% 40% 30% 20% 10% 2 3 4 # of re-appraisals after 2008 Source: J.P. Morgan, Trepp, Bloomberg 0% 1 At least 4
Distribution of loans receiving an updated appraisal since 2008 by number of re-appraisals; (% by count)
Exhibit 16: 85% of loans with updated appraisals are delinquent, modified, or in special servicing
Distribution of loans receiving an updated appraisal since 2008 by number of re-appraisals; (% by count)
Liq'd, 4.7% Modified (exGGP), 23.9%
Retired, 0.2%
Performing, 9.4%
30 or 60 Days Delinquent, 1.2%
Perf. Spec. Serv., 7.0%
Seriously Delinquent, 53.6%
Source: J.P. Morgan, Trepp, Bloomberg

46
Year of First Re-Apprais al
that of CMBS fundamentals (Exhibit 17). As distress became more widespread and delinquencies and special servicing inflows rose through 2009 and 2010, the volume of initial re-appraisals also ramped up. While just $2bn of loans from 2005-2007 loans received a first reappraisal in 2008, this figure jumped to $18.5bn in 2009 and $29.3bn in 2010. As CMBS fundamentals have stabilized and the volume of distress has slowed, the balance of loans receiving an initial re-appraisal also declined, to $16.9bn in 2011. The magnitude of appraisal reductions has declined over time. Exhibit 18 shows the initial appraisal reduction versus the property value at securitization, by loan vintage and year of re-appraisal. In 2008, appraisals were down 20-40% in aggregate, depending on vintage, with the 2007 vintage experiencing the worst declines. In 2009, aggregate appraisal reductions worsened as property prices declined precipitously and market liquidity dried up. The vintage curve also flattened, with the 2005, 2006, and 2007 vintages down 44%, 45%, and 47%, respectively. 2010 saw continued deterioration in appraisals, with initial re-appraisals down by as much as 54% in aggregate for the 2007 vintage (heavily influenced by the Beacon Seattle & D.C. Portfolio). However, re-appraisals in 2011 have shown modest improvement across vintages, a supportive sign of the slow recovery in commercial real estate. Appraisal reductions show a wide distribution. Among loans that received their first re-appraisal in 2011, appraisals were still down 52% in aggregate, though the distribution spans from -10% to -90% (Exhibit 19). For loans with multiple appraisals, appraised values have improved over time. We isolated the universe of 20052007-vintage loans that had been re-appraised at least two times since 2008, which totaled $30.4bn, or 47% of our initial subset. To evaluate the evolution of appraisals for these properties, we looked at the change in appraised value between each loans first updated appraisal and last updated appraisal. Overall, appraisal values are improving off their worst levels in 2009 and 2010. Of loans that received their last appraisal in 2011, 37% experienced more than a 5% jump over their first reappraisal (Exhibit 20). This is an improvement over performance for loans last appraised in 2009 and 2010, as just 25% and 27% of loans that received their last re-
Exhibit 17: Over 70% of loans with updated appraisals received their first re-appraisal in 2009 or 2010
Balance of loans receiving first updated appraisal by loan vintage and year of re-appraisal
2008 2009 2010 2011 $0 $3 $6 $9
2005 2006 2007
$12
($bn) Source: J.P. Morgan, Trepp, Bloomberg
Exhibit 18: 2011 showed signs of improvement, but appraisals remain down significantly
2005 2006 2007
Aggregate % change in first re-appraisal value versus value at securitization, by loan vintage and year of first re-appraisal
0%
% Change vs. Secur. App. Value
-10% -20% -30% -40% -50% -60% 2008 2011
2009 2010 Year of first re-appraisal Source: J.P. Morgan, Trepp, Bloomberg
Distribution of % change in first re-appraisal value versus securitization, % by count, first re-appraisal in 2011; dotted line represents aggregate change
Exhibit 19: The distribution of appraisal reductions is broad

25% 20% 15% 10% 5% 0% % change from securitization Source: J.P. Morgan, Trepp, Bloomberg
47
appraisal in 2009 and 2010, respectively, saw at least a 5% increase over their first re-appraisal. In addition, though the balance of loans with a re-appraisal in 2012 is still small, 41% of loans with updated appraisals in 2012 are up more than 5% relative to their first re-appraisal. Conversely, the volume of re-appraisals was down more than 5% versus their first re-appraisal is declining, from a peak of 51% for loans last re-appraised in 2010 to 41% in 2011, and 29% in 2012.
Exhibit 20: The volume of up re-appraisals is increasing

Down more than 5% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2009 Between -5% and 5%
Distribution of last re-appraisals by year of last re-appraisal, % change versus first re-appraisal; (% by balance)
Up more than 5%
2011 2010 Year of last re-appraisal Source: J.P. Morgan, Trepp, Bloomberg
2012
48
US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Amy SzeAC (1-212) 270-0030 Kaustub Samant (1-212) 834-5444 J.P. Morgan Securities LLC
Asset-Backed Securities
The ABS market is gathering more steam as credit investors continue to add risk Bonds that lagged previously, such as last cash flow AAAs, FFELP and private credit student are seeing greater investor demand and better bids Spreads in off-the-run ABS sectors have rallied in line with the broader credit markets; the most risky and esoteric ABS assets are also benefiting from the improvement in high-yield corporates We continue to see value in subordinate auto and card ABS, as well as certain off-the-run sectors such as US$ UK RMBS and subprime auto ABS
Exhibit 1: 3-year minus 1-year AAA prime auto loan ABS spread differential
(bp)
30 20 10 0 Jan-10
19
Jul-10
Jan-11
Jul-11
Jan-12
Source: J.P. Morgan
Exhibit 2: Prime auto loan ABS: 3-year AAA indicative spreads versus A-4 new issue pricing spreads
(bp) 50
45 40 35 30 25 20 Sep-11 TOAT BMWOT HAROT FORDO HAROT NAROT HART Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Indicatives New Issue A-4 Pricing Spreads HART ALLYA
Market views
The rally in the ABS market continued this week with lots of activity in primary and plenty of liquidity in secondary. The positive mood was reminiscent of August 2011, before European sovereign debt events erupted and investors took flight. Pricing has improved notably on recent new issues, which are still well oversubscribed. Note that demand for auto loan ABS A-4 tranches has come back strong as investors have started gaining confidence and moving out the maturity spectrum. As a result, the spread differential between the l- and 3- year AAA prime auto loan ABS spreads has narrowed since late last year to 19bp currently (Exhibit 1). This is still wider than the 10-15bp seen during 2010 and 1H11. The sustained low rate environment and low all-in yields continue to limit spread tightening potential. In addition, new-issue pricing levels have improved and have caught up to benchmark indicatives in secondary (Exhibit 2). The spreads on the auto ABS money market tranches have tightened significantly as well. While the yields on the money market tranches are still attractive relative to comparable ABCP rates, the pickup is diminishing (Exhibit 3). On AAA benchmark prime auto ABS, value has been mostly extracted and additional upside is limited. Hence, we prefer going down in credit into non-prime and subordinates. This week, various subordinates on previously closed auto ABS transactions priced as issuers came to market to take advantage of the exceptional
ALLYA
Source: J.P. Morgan, IFR
Exhibit 3: Prime auto loan ABS money market tranche yields and spreads versus ABCP rates
0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Jul-10 7 4 1 -2 -5 -8 Oct-10 Jan-11 Apr-11 ABCP 90 day (rates %, left) Prime Auto Loan ABS Money Market Tranche (yield %, left) Prime Auto Loan ABS Money Market Tranche Spread (bp,right) Jul-11 Oct-11 Jan-12 -11
Source: J.P. Morgan, Federal Reserve Board
investor demand. We see value in these subordinates, which have rolled down in average life, been upgraded,
49
and now offer attractive spread pickup. For example, a seasoned 1.27 year prime auto ABS class D rated Aa1/BBB priced at EDSF +100bp, a rare and cheap triple digit spread for such a short, fundamentally solid bond. Bids have been getting stronger across asset classes. In particular, off-the-run ABS bonds have seen better demand consistent with the broader rally in the credit markets. The franchise ABS deal marketing this week as well as subordinates, private credit student loan ABS and UK RMBS in secondary have all benefited from this positive sentiment. For example, high quality investment grade ABS such as subordinate auto ABS and senior private credit student loan ABS spreads have, for the most part, narrowed along with the CDS spread tightening of the high yield ABS sponsors (Exhibit 4 and Exhibit 5). Specifically, we like auto subordinates due to their upgrade potential. The strength in the recovery of the auto industry and that of the auto ABS sponsors (e.g., Ford Credits positive rating outlook) should also support future performance. We prefer subordinate auto ABS and US$ UK RMBS over private credit student loan ABS. We expect the private credit student loan sector will remain more vulnerable to weak labor market and financial market volatility. In addition, private credit student loan spreads have recovered very quickly, ahead of other ABS sectors and credits.
Exhibit 4: Subordinate auto ABS versus Ford Credit CDS spreads (3-year)
(bp)
200 150 100 50 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
600 500 400 300 200 100
Single-A Prime Auto ABS (left) Ford Credit (Ba1/BB+) CDS (right)
Exhibit 5: Private credit student loan AAA ABS versus SLM CDS spreads (3-year)
(bp)
450 400 350 300 250 200 150 Jan-10
700 500 300 100
Jul-10
Jan-11 Jul-11 Jan-12 AAA Private Credit Student Loan ABS (left) SLM (Ba1/BBB-)CDS (right)
Week in review
$4.6bn of new issue came to market including $1.2bn auto lease transaction, $1.3bn across two prime auto loan deals, a $500mn retail card, a $160mn timeshare and a $450mn US$ UK card. Separately, various subordinate tranches from three previously closed transactions were priced and sold. Year-to-date supply stands at $32.3bn. The pipeline remains full with some transaction already in premarketing this week. Supply in February ended at $16.9bn as compared to $10bn in February 2011. March, as quarter end, should be another heavy issuance month. This week, single-A fixed credit card ABS spreads tightened 5bp, while subprime auto subordinates tightened 10bp to 50bp. AAA FFELP student loan spreads narrowed 5bp across the board, with the long end getting some more interest. In addition, AAA 3-year and 7-year private credit student loan ABS spreads tightened 10bp and 50bp, respectively.
Source: J.P. Morgan
Fitch upgraded the subordinate notes of NSLT 2003-1 Class B to AA from A+ due to the consistent increase in parity. Total parity increased from 100.48% to 103.05% in December, and is expected to continue to increase through the remaining life of the trust. Fitch also upgraded the subordinate notes of NSLT 2004-3 Class B from BBB to A due to sufficient credit enhancement levels to cover Fitch's basis factor stresses.
50
Exhibit 6: ABS spread performance

Spread to benchmark (bp)
Current Benchmark Credit Card - Fixed Rate 2-yr 3-yr 5-yr 10-yr B-Piece (5-yr) C-Piece (5-yr) 2-yr 3-yr 5-yr 10-yr B-Piece (5-yr) C-Piece (5-yr) Auto - Prime 1-yr 2-yr 3-yr B-Piece EDSF Swaps Swaps Swaps 6 15 25 90 0 0 0 0 7 17 28 97 6 15 25 90 8 20 32 105 Swaps Swaps Swaps Swaps Swaps Swaps Libor Libor Libor Libor Libor Libor 6 12 25 45 80 120 8 13 25 38 85 120 0 0 0 0 -5 0 0 0 0 0 0 0 8 13 25 45 88 125 9 14 25 38 87 125 6 12 25 45 80 120 8 13 25 38 85 120 10 14 25 45 90 135 12 16 25 38 90 135 Stranded Assets 2-yr 3-yr 5-yr 10-yr Auto - Subprime 1-yr 2-yr 3-yr AA 3-yr A EDSF Swaps Swaps Swaps 40 65 100 170 0 0 -10 -20 43 68 132 216 40 65 100 170 45 70 160 250 Swaps Swaps Swaps Swaps 8 13 28 60 0 0 0 0 10 15 29 56 8 13 28 40 12 17 30 60 1-wk Avg 10-week Min Max Student Loans (FFELP) 3-yr 7-yr AAA 3-yr 3-yr AAA 5-yr AAA Libor Libor Libor Libor Libor 40 85 190 160 170 -5 -5 -10 0 0 49 95 217 160 170 40 85 190 155 165 55 100 235 160 170 Benchmark Current 1-wk Avg 10-week Min Max 03/01/12 Change 03/01/12 Change
Private Credit Student Loan Global RMBS (UK Bullet)
Credit Card - Floating Rate
Note: Tier 1 names represented by above. Source: J.P. Morgan
Exhibit 7: AAA cross sector spreads (3-year)

(bp)
Exhibit 8: Cross-sector yields (%)

10 8 6 4
5-year AAA Card ABS and Treasury, JULI Financials, FNMA Current Coupon 30-year
300 200 100 0 Jan-10
Current 13 27 40 115 145
Credit Card ABS Prime Auto Loan ABS FFELP Student Loan ABS JULI AA Bank (1-3 year) CMBS
Treasury AAA Card ABS Agency MBS Financials
Current 0.9 1.4 2.9 4.0
2
Jul-10 Jan-11 Jul-11 Jan-12
0 Jul-07
Apr-08 Jan-09 Oct-09 Jul-10
Apr-11 Jan-12
Source: J.P. Morgan
Source: J.P. Morgan
51
Exhibit 9: 2-year fixed-rate AAA ABS spread to swaps

(bp)
Exhibit 12: 3-year floating-rate AAA ABS spread to Libor

(bp)
50 45 40 35 30 25 20 15 10 5 0 Jan-10
Prime Auto Credit Card Subprime Auto (Right)
Jul-10
Jan-11
Jul-11
Jan-12
80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00
80 60 40 20 0 Jan-10
Credit Card Prime Auto Student Loan
Current 13 27 40
Jul-10
Jan-11
Jul-11
Jan-12
Exhibit 10: 5-year fixed-rate AAA ABS spread to swaps

(bp)
Exhibit 13: 5-year fixed-rate AAA ABS spread to Treasuries

(bp)
55 50 45 40 35 30 25 20 15 Jan-10
(bp)
Current Credit Card 25 Stranded Asset 28
80 60 40 20 Jan-10 Current 51 54 Jan-12
Credit Card Stranded Asset
Jul-10
Jan-11
Jul-11
Jan-12
Jul-10
Jan-11
Jul-11
Exhibit 11: 3-year single-A fixed-rate ABS spread to swaps

180 160 140 120 100 80 60 40 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Credit card Prime Auto Subprime Auto (Right) 350 300 250 200 150 100 50 0
Exhibit 14: 3-year floating-rate AAA ABS spreads to Libor

(bp)
450 400 350 300 250 200 150 100 50 0 Jan-10
US$ UK RMBS Private Credit Student Loans
Jul-10
Jan-11
Jul-11
Jan-12
52
High Grade Strategy and Credit Derivatives Research US Fixed Income Markets Weekly March 2, 2012 Eric BeinsteinAC (1-212) 834-4211 Dominique D. Toublan (1-212) 834-2370 Miroslav Skovajsa (1-212) 834-5154 Anna Cherepanova (1-212) 834-3220 J.P. Morgan Securities LLC
Corporates
High Grade credit fundamentals remain solid, but some credit metrics deteriorated in 4Q11 after several quarters of very strong results There are three main themes we take away from the analysis of corporate performance in 4Q11: First, both revenue and EBITDA reached new decade peaks in 4Q11 but the growth pace has slowed Second, profit margins have contracted meaningfully as quarterly growth in revenue outpaced EBITDA And third, Capex is growing faster than EBITDA, which is putting downward pressure on free cash flow and limiting the increase in cash on balance sheets
Exhibit 1: Revenue growth moderated this quarter

9 8 7 6 5 4 3 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
Total Rev enue, LTM $tn Total Rev enue, Qtrly * 4 4Q10 4Q11 3Q11
Source: J.P. Morgan
Exhibit 2: as has EBITDA growth

1.8 1.6 1.4 1.2 1.0 0.8 0.6 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 $tn Total EBITDA, LTM Total EBITDA, Qtrly * 4 3Q11 4Q11 4Q10
High Grade credit fundamentals remain solid, but some credit metrics deteriorated in 4Q11 after several quarters of very strong results. Revenue and EBITDA quarterly growth pace slowed in 4Q11 and profit margins came under pressure for many sectors in our analysis. Despite the slowdown in overall improvement, total debt levels and interest expense moderated. Leverage has remained in a narrow range, ticking up to 1.90x from 1.86x in 4Q10 and up from 1.89x in 3Q11. Cash is not growing but it remains at a record high. Interest expense is stable as companies are benefitting each quarter from the replacement of high coupon debt with newly-issued low coupon bonds and loans. Also, J.P. Morgan expects US growth at 2.3% in 2012 versus 1.7% in 2011. With this forecast of modestly accelerating growth, it is unlikely that credit metrics will deteriorate meaningfully. There are three main themes we take away from the analysis of corporate performance in 4Q11: 1. Revenue and EBITDA both reached new decade peaks in 4Q11 but the pace of growth has slowed. Revenue for Non-Financials in our index was up 11%y/y but just 1%q/q. EBITDA growth was 8%y/y and 0.2%q/q. Note that equity analysts expect revenue annual growth to be just 2.7%y/y in 1Q12, down from 9.4% in 4Q11 and 18% in 3Q11, so they expect a continuation of the slowing trend. If this proves correct, it is likely that
Source: J.P. Morgan
Exhibit 3: Profit margins have come off their peak with Domestic Telecoms skewing the results negatively, but most sectors also saw margin contraction over the quarter
25.0% 24.0% 23.0% 22.0% 21.0% 20.0% 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
4Q11
EBITDA/Revenue, LTM EBITDA/Revenue, single quarter (not LTM)
3Q11 4Q10
Source: J.P. Morgan

53
HG corporate revenue and EBITDA trends will be soft in 1Q12 as well. 2. Profit margins have contracted meaningfully as revenue quarterly growth outpaced EBITDAs. Margins have been under pressure for three consecutive quarters, decreasing to 23.6% in 4Q11 from 24.4% in 4Q10 and 24.1% in 3Q11. Quarterly metrics show that profit margins in 4Q11 are the lowest they have been in the four years of quarterly history available. The decline in profit margins was driven by Domestic Telecoms, where AT&Ts and Verizons subsidy to Apple for the iPhone 4S hurt near-term margins. Excluding the Domestic Telecoms sector, margins were still down in quarterly and annual terms, and were down in a majority of sectors. The decline in margins was driven by slower revenue growth as well as some pressures from energy costs (see page 12 for more detail). 3. Capex is growing faster than EBITDA, which is putting downward pressure on free cash flow and limiting the increase in cash on balance sheets. Until recently EBITDA grew faster than Capex. This was possible because capacity utilization was low and companies were cautious about Capex expansion. Now US capacity utilization is approximating its pre-crisis level so more investment is required as revenue and EBITDA growth are slowing. As a result, FCF fell 1%q/q but is still up 7%y/y. Cash on balance sheets grew 1%q/q and is up 5%y/y.
Exhibit 4: Capex has recovered from its decline due to the crisis, increasing 3%q/q and 13%y/y
700 600 500 400 300 200 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 $bn 3Q11 Total Capex , LTM Total Capex , Qtrly * 4 4Q10 4Q11
Source: J.P. Morgan
Exhibit 5: The quarterly decline in FCF is driven by increasing Capex and slower EBITDA growth
800 700 600 500 400 300 200 100 0 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
$bn
3Q11
Total FCF, LTM Total FCF, Qtrly * 4
4Q10 4Q11
Credit Metric Trends Revenue

4Q11 Revenue increased 11%y/y (+$755bn) and 1%q/q (+$78bn), reaching a new decade high, using last twelve month (LTM) data. The 1%q/q increase in revenue was the slowest quarterly growth rate in four quarters, however. All but one sector in our analysis posted positive annual growth, with Cable/TV and Energy posting a 23-25% y/y revenue increase. Companies in the Cable/TV sector posted the largest annual increase of 25%y/y (+$22bn) and quarterly increase of 6%q/q (+$6bn). Subscriber metrics in Cable/TV remained solid in 4Q11 and unit growth exceeded expectations. Revenue for the Energy sector increased 23%y/y (+$432bn) and 1%q/q (+$29bn) as companies benefited from stronger crude prices, which helped offset weaker natural gas price environment. Regarding the Retail sector, sales trends have held up
54
Source: J.P. Morgan
Exhibit 6: Total debt grew 0.3%q/q and 5%y/y, reaching a new decade high of $2.5tn
2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
4Q11 $tn Total Debt 3Q11 4Q10
Source: J.P. Morgan
relatively well considering weak consumer sentiment and stubbornly high unemployment. The only sector with annual revenue decline was Yankee Telecoms, down 1%y/y (-$4bn) but up 1%y/y (+$2bn).
Exhibit 7: Interest expense has moderated due to persistently low yields and moderation in total debt growth
120 110 100 90 80 70 60 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
4Q11 $bn
Total Interest Exp., LTM Total Interest Exp., Qtrly * 4
3Q11 4Q10
EBITDA
EBITDA in 4Q11 increased only 0.2%q/q (+3bn), reaching a new decade high. However, EBITDA is still up 8% (+$119bn) from 4Q10. The quarterly increase has been modest, the slowest since 3Q09. The slowdown in EBITDA growth for HG companies in our analysis was mostly driven by the Domestic Telecoms sector, where EBITDA declined 16%q/q (-$13bn) as a result of the iPhone 4S launch that created near-term pressure on earnings. Excluding Domestic Telecoms, EBITDA grew 1%q/q (+$16bn) and 9%y/y (+$124bn), in LTM terms. On a quarterly basis, EBITDA rose 2.1% in 3Q11, 3.2% in 2Q11, 2.6% in 1Q11 and 2.9% in 4Q10, so the 1% EBITDA growth ex. Domestic Telecoms in 4Q11 indeed represents a slowdown in what had been a strong trend. EBITDA quarterly growth in most sectors was flat to slightly positive, with Energy having the largest increase of 3% (+$11bn). Annual EBITDA growth continues to be driven by commodity sectors, with Chemicals up 26% (+$6bn), Metals/Mining up 23% (+$19bn), and Energy up 22% (+$70bn). Companies in the Chemicals sector benefited from better pricing and passthrough of raw material costs. In addition, agricultural chemical companies benefited from strong demand for fertilizers. EBITDA annual growth in the Energy sector was mostly due to higher oil prices, with 4Q11 crude average of $94 versus $85 in 4Q10. Lower commodity prices (ex. crude oil) and deterioration in global sentiment are the two risks that may temper earnings growth in the commodities sectors going forward. Outside of commodity-related sectors, Cable/TV, Diversified Media, and Railroad/Shipping saw around 10-15%y/y LTM EBITDA growth.
Source: J.P. Morgan
Exhibit 8: Cash balances are likely to moderate or even decline as more companies engage in share buybacks and dividend payouts, while FCF generation is moderating
850 750 650 550 450 350 250 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
4Q11 $bn Total Cash 4Q10 3Q11
Source: J.P. Morgan
large acquisitions funded with cash. Barrick acquired Equinox for $7.5bn and BHP bought Petrohawk in 2011. Outside of the Metals/Mining sector, Cable/TV had 20%y/y growth, Diversified Media 15%, and Technology 14%. While companies could certainly look to be opportunistic given the current rate environment, in Diversified Media we think only Viacom (in the middle of its $10bn share buyback program and modestly underlevered) could look to potentially do something sizeable in the near term. In the Technology sector, we expect companies to maintain current levels of debt as balance
Debt
Total debt for the companies in our analysis grew 0.5%q/q (+$12bn) and 7.0%y/y (+$160bn), reaching a new decade high of $2.4tn. However, the pace of debt growth has slowed significantly. Half of the sectors in our analysis had a quarterly decline in total debt levels. Metals/Mining had the largest annual growth with 28% (+$25bn), driven by Barrick Gold (+100%, +$7bn) and BHP Billiton (+57%, +$9bn). Both companies made
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sheets remain solid with substantial cash hoards and light near-term maturity profiles. In annual terms, debt levels grew for all but one sector. Consumer Products total debt declined 6%y/y (-$4bn), driven by Beam (-55%, -$2bn) as it continued to tender bonds in an effort to keep credit metrics inline through two large spin-off/divestiture transactions. Going forward, we expect companies to continue issuing due to historically low yields but, with cash levels already at a decade high, the pace of debt growth is likely to slow.
Exhibit 9: Leverage has ticked up from last quarter back to the level last seen in 1Q11
2.7x 2.5x 2.3x 2.1x 1.9x 1.7x 1.5x 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
Debt/EBITDA, LTM
Interest Expense
Interest expense was nearly unchanged over the quarter, increasing 1%q/q and declining 0.4%y/y using quarterly metrics. On a LTM basis, interest expense increased 1%q/q and 1%y/y. Interest expense have moderated as higher yield debt matures and companies issue new debt with much lower coupons. In every quarter, this replacement of high coupon debt pressures interest expense to continue to decline, even if yields rise from todays very low levels.
Source: J.P. Morgan
Exhibit 10: Interest coverage improved from 4Q10 but remains below its best level of the past 10 years which was 22x in 1Q05
22.0x 20.0x 18.0x 16.0x 14.0x 12.0x 10.0x 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10
EBITDA/Interest expense, LTM
Cash
Cash on balance sheets increased only 0.6%q/q (+$4bn) and 5%y/y (+$29bn). Even though cash levels are at a new decade high, modest increase in quarterly levels indicates a slowdown in the pace of cash growth, which was to be expected given the increased share buybacks and dividends for many HG companies. The 0.6%q/q cash growth rate for the companies in our analysis is below the two year average of 1.8%. Chemicals and Metals/Mining were the two sectors with the largest increase in cash over the quarter, but seasonality accounts for most of the lift. Companies in Chemicals on average increased cash by 48%q/q (+$5bn) driven by Dow and Du Pont. However, the quarterly increase tends to be seasonal and looking at the annual rate cash balances have actually declined 13%y/y ($2.5bn). Domestic Telecoms had the largest quarterly decrease in cash (-24%, -$5bn), driven by AT&Ts $3bn break-up fee owed to Deutsche Telekom after the failure of T-Mobile acquisition and its use of cash to redeem maturing bonds. Share buybacks and dividends are an important use of cash. 4Q11 data on buybacks is not complete yet, so it is unclear how this trend has impacted cash positions.
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Source: J.P. Morgan
Historically, companies buy back more shares when stocks rise. It is likely that some of the moderation in cash balances is due to an increase in payments to shareholders.
Capex
Capex expenditures in 4Q11 increased +3%q/q (+$19bn) and +13%y/y (+$65bn) for the companies in our analysis based on LTM numbers. Capex has now reached a new decade high after recovering from the entire decline of about $95bn due to the crisis. Metals and Mining had the largest annual increase in Capex, increasing 62%y/y (+$18bn). For companies in
this sector spending is expected to increase further but companies are to remain selective with capital allocations. Transportation had the second largest increase in Capex, +27% (+$3bn) driven by active purchases of railcars and locomotives in the fourth quarter. Transportation was followed by Capital Goods (+22%, +$2bn) and Non-Food Retail (+20%, +$4bn), where companies were able to generate growth internally through increases in Capex. For Energy companies, capital spending is poised for a moderate increase as companies accelerate investment in liquids projects and trim spending for natural gas and downstream. Most sector constituents expect to fund Capex with internal cash flows and divestitures of noncore assets. US capacity utilization went from 81% pre-crisis to 67% at the depth of the crisis in June 2009. It now stands at 78.6%, so the amount of spare capacity has declined, contributing to the pickup in Capex. Note, however, that the Capex figures below come from company statements and represent Capex spending globally, while the US capacity utilization figures are domestic only and represent a broader universe than the companies in our study. Still, we believe the same message still applies. Less spare capacity is contributing to the pickup in Capex spending.
Profitability
Profit margins (EBITDA/Revenue) in 4Q11 declined over the quarter and year, using LTM data. Margins have been under pressure for three consecutive quarters, decreasing to 23.6% in 4Q11 from 24.1% in 3Q11 and 24.4% in 4Q10. Quarterly metrics show 4Q11 profit margins at the lowest they have been in the four years of quarterly history we have available. The decline in profit margins was driven by Domestic Telecoms, where AT&Ts and Verizons subsidy to Apple for the iPhone 4S hurt near-term margins. This is a one-off event that skews the results for the sectors in our analysis and, in the long term, we believe strong smartphone sales will help drive data revenue and ARPU (average revenue per unit) for AT&T and Verizon. Excluding Domestic Telecoms, LTM profit margins are at 23.3%, down from 23.3% in 3Q11 and down from 23.7% in 4Q10. Looking at quarterly profit margins excluding Domestic Telecoms, profit margins at 22% are the lowest they have been since 4Q09. Pressure on margins can be seen in other sectors as well. Cable/TV also had profit margins decline over the quarter and year due to higher programming costs. Higher sourcing and input costs were headwinds for retail margins in the second half of 2011 but we believe this should start to abate as 2012 progresses. Companies in the Consumer Products sector saw profit margins decline over the year as did companies in Food/Beverages and Food/Drug Retail sectors, due to higher input and commodity costs. Companies in the Food/Beverages sector, for example, have tried to pass on higher costs to the consumer through price increases but found that volumes suffered, hurting margins.
Free cash flow

Free cash flow decreased 1%q/q (-$6bn) from the new decade high reached in 3Q11 but increased 7%y/y (+$37bn), using LTM numbers. In quarterly terms, free cash flow declined 11%q/q (-$20bn) and increased 11%y/y (+$16bn). The quarterly decline in free cash flow is driven by increasing Capex and slower pace of EBITDA growth. EBITDA grew just 0.2%q/q (+$3bn) while Capex 3% (+$20bn). Energy and Transportation were the two sectors which drove the annual increase in free cash flow. Energy posted 80%y/y (+32bn) improvement in FCF due to companies such as Royal Dutch Shell, Marathon Oil, and Spectra Energy benefiting from higher production, substantially higher crude prices, and better refining environment. While free cash flow annual growth was mixed across the sectors, quarterly most sectors posted a decline in LTM terms.
Leverage
Leverage (Debt/EBITDA) for the companies in our analysis is at 1.90x, up from 1.89x last quarter and 1.87x in 4Q10. Over the past year leverage has been quite stable after rising during the crisis and then declining. Leverage remains above the pre-crisis level, despite higher EBITDA due to more debt on company balance sheets. Leverage declined from the post-crisis peak of 2.14x in 3Q09 but has recently ticked back up to a level seen in 1Q11. Domestic Telecoms drove the increase in leverage due to the decline in EBITDA as a result of the iPhone 4S launch. Looking at leverage across sectors, the results appear mixed, with about half of the companies reporting quarterly increases in
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leverage. For the Healthcare sector, it is still important to continue monitoring companies appetite for adding leverage to accomplish shareholder-friendly activities, as evidenced by recent actions from Amgen.
Interest Coverage
Interest coverage (LTM EBITDA/Interest expense) improved to 15.7x from 15.2x in 4Q10 but remains below its best level of the past 10 years, which was 22x in 1Q05. This is because debt levels are considerably higher today than in 2005, while EBITDA is stronger but not by much. The rise in interest coverage was driven by EBITDA. Over the quarter, interest coverage declined slightly to 15.7x from 16.1x, mostly due to softer EBITDA results from Domestic Telecoms. However, on an annual basis, interest coverage improved for 14 of the 18 sectors in our analysis on the back of stronger EBITDA growth and slightly lower interest expense. Interest coverage improved the most in annual terms for companies in the Chemicals, Capital Goods, and Food/Beverages sectors driven by improvements in EBITDA and significant declines in interest expense.
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North America High Yield Research US Fixed Income Markets Weekly March 2, 2012 Peter AcciavattiAC (1-212) 270-9633 Tony Linares (1-212) 270-3285 Nelson R. Jantzen, CFA (1-212) 270-1169 Alisa Meyers (1-212) 834-9151 J.P. Morgan Securities LLC
High Yield
High-yield bonds and loans continue to benefit from a decline in perceived risks around Europe and improving macroeconomic sentiment, which continue to offset the risk of any flaring up in the Middle East. These better conditions for risk assets led us to raise our 2012 return forecasts for bonds and loans earlier in February to 13.7% and 8.8%, respectively, and each has now returned 5.8% and 3.1% year-to-date, including 0.8% for bonds and 0.3% for loans this week Importantly, the fundamentals for high-yield bonds and leveraged loans remain a positive catalyst in the context of valuations. Default expectations did not change in the past 12 months, while high-yield bond and loan spreads widened from an average of 535bp and 503bp in 1H11 to 636bp and 616bp today, respectively. Given the swift fall in yields year-todate (-120bp bonds and -70bp loans), 6.8%-pts of the 7.9% of expected return for bonds over the balance of the year will be accounted for by income, and 4%-pts of the 5.7% by loans Of course demand for the high-yield asset class remains an important theme, with demand for highyield coming from retail (HY ETFs $5.7bn; actively managed retail funds $8.5bn year-to-date) and sources not measured by Lipper FMI. Specifically, institutional accounts (especially overseas pensions, endowments, and insurance companies) and core plus accounts, continue to allocate more to the highyield asset class. A good technical backdrop also carries over into the loan space supported by bondfor-loan takeouts, repayments, and a modest increase in CLO origination The feedback loop of strong demand and improving liquidity is firmly back. This week, 25 issues totaling $14.8bn priced, bringing Februarys issuance to $40.4bn, making it the third most active month on record, trailing only the $40.5bn in March 2010 and $45.7bn in May 2011. Bond volume has now risen to $67.3bn year-to-date, more than all of 2H11s issuance ($64bn) and comparable to $55bn in the first 2 months of 2011. For institutional loans, primary market conditions continue to improve after a very slow start to the year. February registered the highest volume of issuance at $19.1bn since May 2011, bringing year-to-date volume to
$25.1bn, but still less than half the activity over the comparable period a year ago ($57.2bn) This week we introduced a suite of Leveraged Loan indices, including the J.P. Morgan Leveraged Loan Index (LILI), the J.P. Morgan Liquid Loan Index (LQLI), and the J.P. Morgan Second Lien Loan Index (SLLI)
Credit strategy update

High-yield bonds and loans continue to benefit from a decline in perceived risks around Europe and improving macroeconomic sentiment, which continue to offset the risk of any flaring up in the Middle East. These better conditions for risk assets led us to raise our 2012 return forecasts for bonds and loans toward the beginning of February to 13.7% and 8.8%, respectively, and each has now returned 5.8% and 3.1% year-to-date. Given the swift fall in yields year-to-date (-120bp for bonds and -71bp for loans), 6.8%-pts of the 7.9% of expected return for bonds over the balance of the year will be accounted for by income, and 4%-pts of the 5.7% by loans. Importantly, Greece is still being viewed as a unique and contained problem (evident in Spanish and Italian bonds) and instead the positive implications of massively accommodative central banks (namely the ECB, Fed, and BOJ), a healthy corporate bottom line, and an improving economic picture in the US (15.1mn, saar; 4week initial claims 354,000) are all redirecting attention away from what seems to be the most immediate impediment, rising oil prices. And importantly, the
Exhibit 1: Asset class returns
2010 High-Yield Bonds Lev eraged Loans Inv estment Grade Bonds Emerging Market Bonds 10-Year Treasury Dow Jones Industrials S&P 500 Russell 2000 By Rating BB-rated bonds B-rated bonds CCC-rated bonds BB-rated loans B-rated loans 14.08% 14.27% 20.19% 7.71% 11.69% 6.56% 6.12% 0.26% 2.50% 0.35% 2.49% 3.31% 5.31% 1.56% 2.81% 2.52% 2.38% 3.85% 0.65% 0.54% 5.17% 5.81% 9.54% 2.24% 3.44% 15.05% 10.02% 8.92% 12.04% 8.27% 14.06% 15.06% 26.86% 2011 Jan-12 3.12% 2.22% 2.09% 1.76% 0.79% 3.55% 4.48% 7.06% Feb-12 2.55% 0.75% 0.82% 2.95% -1.07% 2.89% 4.32% 2.39% YTD 5.75% 3.05% 2.93% 4.76% -0.29% 6.55% 9.00% 9.63%
5.73% 1.60% 8.46% 8.47% 16.96% 8.38% 2.11% -4.17%
CCC-rated loans 18.93% -7.69% 7.08% 3.45% 10.80% Sources: J.P Morgan; Bloomberg Note: Performance for bonds is measured using our J.P Morgan Global HY index whereas performance for loans is measured using our J.P Morgan Leveraged Loan index. YTD returns through February 29.
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New-issuance ($bn)
fundamentals for high-yield bonds and leveraged loans remain a positive catalyst in the context of valuations. Default expectations did not change in the past 12 months, while high-yield bond and loan spreads widened from an average of 535bp and 503bp in 1H11 to 636bp and 616bp today. Of course demand for the high-yield asset class remains an important theme, with this weeks $565mn retail inflow, the lightest year-to-date, bringing the current streak of inflows to 13. Now, 9 of the 10 largest weekly inflows on record have occurred since the beginning of 4Q11, with 5 occurring this year. While the HY ETFs have played an important role, accounting for $5.7bn of $14.2bn year-todate, demand for high-yield has also come from many other sources, including actively managed retail funds ($8.5bn year-to-date) and sources not measured by Lipper FMI. Specifically, institutional accounts (especially overseas pensions, endowments, and insurance companies) and core plus accounts, continue to allocate more to the high-yield asset class. A good technical backdrop also carries over into the loan space, still carrying a 5% current yield and being one of the few products offering floating rate protection. With modest retail outflows of $232mn year-to-date (versus outflows totaling $10.8bn in 2H11), technicals remain robust supported by bond-for-loan takeouts, repayments, and a modest increase in CLO origination. And with demand for high-yield product high, new-issuance is responding. This week 25 issues totaling $14.8bn priced bringing Februarys issuance to $40.4bn, making it the third most active month on record, only trailing the March 2010 ($40.5bn) and May 2011 ($45.7bn). For perspective, this is about four times the monthly average in 2H11. And so the virtuous circle of strong demand and improving liquidity is firmly back. Including a 3-week stretch of issuance in late January and early February that totaled $35bn, volume has now risen to $67.3bn year-todate, more than all of 2H11s issuance ($64bn) and comparable to $55bn in the first two months of 2011. For institutional loans, primary market conditions continue to improve after a very slow start to the year. For example, after pricing a total of $8.4bn during the years first six weeks, issuers have priced 37 institutional loans for $16.7bn in the past three weeks ($3bn this week). February registered the highest volume of issuance at $19.1bn since May 2011, bringing year-to-date volume to $25.1bn, still less than half the activity over the comparable period last year ($57.2bn).
Exhibit 2: High-yield bond issuance for February was the third highest on record; issuance of institutional loans improved
$50 $40 $30 $20 $10 $0 7 1 Apr-11 Jul-11 Jan-11 Mar-11 Jun-11 Feb-11 May-11 50 44 33 22 34 27 14 20 18 17 16 8 7 6 108 46 38 High-yield bonds Leveraged loans 24 26 19 10 10 4 Nov-11 Dec-11
40
Oct-11
Jan-12
Aug-11
Source: J.P Morgan
Exhibit 3: Yields for HY bonds and institutional loans

20%
HY Bonds - Yield to Worst Leveraged Loans - Yield to Maturity
15% Yield (%) 1-Mar-12 7.24%
10%
Sep-11
Apr 09
Apr 10
Jan 09
Jan 10
Jan 11
Apr 11
Source: J.P Morgan Note: Yields for high-yield bonds are represented by the yield to worst on our J.P Morgan Global High Yield Index. Yields for leveraged loans are represented by the yield to maturity on our J.P Morgan Leveraged Loan Index
This week, stocks continued to rally, up another 0.4%, closing above last years high (1,363). For their part, highyield bonds and loans returned +0.8% and 0.3%, respectively, and are 5.8% and 3.0% higher year-to-date. Meanwhile, high-yield bond yields fell 19bp week-overweek to 7.24%, and are now within 49bp of their all time low on May 11, 2011 (6.75%). The yield to maturity for our recently launched J.P Morgan Leveraged Loan Index declined 5bp to 6.70% and stands 70bp lower year-to-date. As for other asset classes this week, 10-year Treasuries, emerging markets, and high-grade bonds returned -0.4%, +0.9%, and +0.4%, respectively. For spreads, high-yield
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Jan 12
Oct 09
Oct 10
Oct 11
Jul 09
Jul 10
Jul 11
5%
1-Mar-12 6.70%
Feb-12
bond and loan spreads finished 18bp and 4bp tighter at T+636bp and L+616bp, respectively. Also, the CDX.HY, LCDX, and CDX.IG tightened 5bp, 50bp, and 4bp to 542bp, 283bp and 93bp, respectively. By rating, CCCs returned 1.5% for the week, while Bs and BBs returned 0.7% and 0.8%, respectively, and with CCCs 9.5% higher year-todate, they are outperforming Bs and BBs by 370bp and 430bp, respectively. February Market Monitor Highlights Recall the following excerpt published in our Market Monitor on March 1, which provides the highlights for February. Follow this link to the full report. Recap: Accommodative central banks and improving data keep the train rolling For February, high-yield bonds and loans continued to benefit from improving macro conditions and abating tail risks. Greece is still being viewed as a unique and contained problem and instead the positive implications of massively accommodative central banks (namely the ECB, Fed, and BOJ), healthy corporate earnings, and steadily improving economic data are dictating trading. Intra-month, a deal was struck between Greece and its creditors (official and private) while the PBoC in China decided to further increase liquidity in order to cushion the fallout from a stall in the housing market. Global data continues to gradually improve, including PMIs, labor markets, auto sales, capital goods orders and shipments, and manufacturing output. With tail risks diminishing, the upside risks seem to be coming into play and this is benefiting risky markets. But as threats ramp up with regard to Iran, the move up in the price of oil (+18% year-to-date) seems to be getting closer to becoming the largest immediate potential pitfall. Nevertheless, the actions of the ECB and EMU to solve the liquidity problems of European banks and peripheral sovereigns, the Fed providing an extra year of low for long policy in the US, and China letting its foot off the break have altogether provided markets necessary breathing room. So while risks remain and a flare up in the Euro area crisis could easily bring these positive conditions to a halt, the implications of recent aggressive central bank moves (especially LTRO), US economic momentum (particularly labor markets), and the corresponding drop in market volatility (VIX -25% year-todate), have all combined to redirect investors attention away from the European debt crisis and toward fundamentals, which remain a positive catalyst.
In terms of Februarys performance, high-yield bonds and loans returned +2.6% and +0.8%, respectively, versus +3.1% and +2.2% in January. With high-yield bonds and loans returning 5.8% and 3.0% year-to-date, 2012 is the best start to a calendar year since 2001 (5.5% bonds and 3.7% loans). It was also the third best return for HY bonds in the past 17 months (versus Octobers 5.9% and Januarys 3.1%). By comparison, the S&P 500 returned 4.3% in February and has now bounced 26% since its early October low, while 10-year Treasuries, emerging market bonds, and high-grade bonds returned -1.1%, 3.0%, and 0.8%, respectively. At 4.0%, the yield on the J.P. Morgan JULI High-Grade index is at an all-time low. And not surprisingly, CCC-rated bonds benefited the most from higher equity prices, returning 3.9% in February, outperforming Single-B and BB-rated bonds by 147bp and 133bp, respectively. High-yield bond yields decreased 50bp in February to 7.25%, their lowest since late July and within 50bp of their record low on May 11 (6.75%). Yields on our Global HY index are 119bp lower year-to-date, versus 71bp lower for the yield to maturity (6.69%) on our recently launched J.P. Morgan Leveraged Loan index. High-yield bond and loan spreads finished 60bp and 14bp tighter at T+639bp and L+618bp, respectively. The CDX.HY, LCDX, and CDX.IG tightened by 16bp, 18bp, and 8bp to 552bp, 297bp, and 94bp, respectively. For high-yield bonds, we lowered our year-end yield target in February by 110bp to 7.0% and we boosted the full-year 2012 return forecast to 13.7% from 9.4%. With high-yield bonds already 5.8% higher year-to-date, this implies an additional 7.9% return between now and year-end. Using our 7% yield forecast and our rates teams forecast for the 5year Treasury yield to end 2012 at 1.25%, our expected year-end spread target dropped 135bp to 570bp from 705bp, now 80bp lower than yesterdays close. Importantly, default expectations have not changed in the past six months, while high-yield bond spreads have widened from an average of 575bp in July to 654bp today. For loans, the asset class benefits from the same positive fundamentals and valuations as high-yield bonds. We raised our 2012 full-year return forecast to 8.8% from 7%, leaving a 5.8% total return between now and year-end. We also lowered our year-end spread target to L+575bp from L+660bp. Of course, demand for the high-yield asset class remained an important theme throughout the month. Remarkably, nine of the ten largest weekly retail inflows on record have occurred since the beginning of 4Q11, five of them in 2012s first eight weeks. After bringing in $8.8bn for January, high-yield bond funds saw an additional $4.7bn
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come in for February (excluding monthly reporting funds and the final week), extending the current streak of consecutive weekly inflows to 12. Year-to-date the HY asset class has now seen $13.5bn of inflows, which is comparable to last years full-year total of $15.6bn. While the HY ETFs certainly played an important role ($5.3bn year-to-date), demand for high-yield has been coming from all angles inflows into actively managed funds are also very high ($8.2bn), and anecdotally, very strong demand has been coming from institutional accounts not measured by Lipper FMI (pensions, endowments, insurance, core plus accounts, hedge funds etc). And these thoughts too can carry over into a loan space still carrying a 5% current yield and being one of the few products offering floating rate protection. With modest retail outflows of $168mn year-to-date (versus outflows totaling $10.8bn in 2H11) including inflows in five of this years first eight weeks, technicals remain robust, supported by bond-for-loan takeouts, repayments, and a modest increase in CLO origination ($3.7bn year-to-date). Outflows for loan funds total $10.8bn since the end of July, but most of that was front loaded, and retail inflows and outflows have been very modest over the past five months. As for supply, new-issue volumes remain high year-to-date after a very slow 2H11, reflecting the large inflows into the asset class and sharp drop in yields. And outside a midmonth volatility/holiday induced slowdown, February clearly maintained that momentum. All in, Februarys volume totaled $40.4bn, making it the third most active month on record, only trailing the March 2010 ($40.5bn) and May 2011 ($45.7bn). For perspective, this is about four times the monthly average in 2H11, and included $15.9bn priced in the first week of February, the most active weekly volume since the week ending August 12 2010 ($22bn). Including a 3-week stretch of issuance that totaled $35bn, volume now totals $66bn year-to-date, more than all of 2H11s issuance ($64bn) and comparable to $55bn in the first two months of 2011. For institutional loans, primary market conditions continue to improve after a very slow start to the year. For example, after pricing a total of $8.4bn during the years first six weeks, issuers have priced 37 institutional loans for $16.7bn in the past three weeks. Februarys $19.1bn of issuance was the most since May 2011, bringing year-to-date volume to $25.1bn, which still stands at less than half the activity over the comparable period a year ago ($57.2bn). As for defaults in February, four companies defaulted totaling $1.0bn in bonds and institutional loans, following four defaults in January totaling $2.1bn. This marked the fourth consecutive month in which at least four companies
and $1bn in debt defaulted. This months defaults included DirectBuy Holdings, LSP Energy, Global Aviation, and TCO (Tensar). Reflecting the increase in activity of late, 23 companies and $18.9bn in bonds and loans have defaulted over the past six months, compared with 5 companies and only $3.7bn in the six months prior. Still, defaults remain very low by historical standards and are expected to remain that way. The par-weighted high-yield bond default rate remained essentially unchanged at 1.90% month-overmonth, and is up from 1.73% from December 31 and from 0.82% a year ago. Despite this, the default rate remains well below the 25-year average of 4.2%. The issuer weighted default rate for bonds increased to 2.28% from 2.19% last month. For loans, the par-weighted default rate increased marginally to 0.52% from 0.49% in January, and is now down from 1.26% a year ago. Including distressed exchanges, the default rate is a slightly-higher at 0.63%. Meanwhile, the issuer-weighted loan default rate remained unchanged at 1.00%. Finally, the leveraged credit default rate ticked up slightly to 1.40% from 1.38% at the end of last month and 0.91% at the halfway-point last year. This default rate, first introduced in our Credit Strategy Weekly Update from January 6, combines both the high-yield bond and leveraged loan markets. Over the next two years, we continue to expect high-yield bond and loan default rates to fall between 1.5% and 2.0%, below their 4.1% and 3.8% long-term averages. Default Monitor Highlights Recall the following points published in our Default Monitor on March 1, which provide the highlights for February. Follow this link to the full report. In February, four companies defaulted totaling $1.0bn in bonds and institutional loans, following four defaults in January totaling $2.1bn. This marked the fourth consecutive month in which at least four companies and $1bn in debt defaulted. Over the last six months, 23 companies and $18.9bn in bonds and loans have defaulted, compared with 5 companies and only $3.7bn in the six months prior. The par-weighted high-yield default rate remained essentially unchanged at 1.90%m/m, and is up from 1.73% from December 31 and from 0.82% a year ago. The default rate now marks the highest default rate since October 2010. Despite this, the default rate remains well below the 25-year average of 4.2%. For loans, the parweighted default rate increased marginally to 0.52% from
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0.49% in January, and is now down from 1.26% a year ago. The leveraged credit default rate ticked up slightly to 1.40%, from 1.38% at the end of last month and 0.91% at the halfway-point last year. Looking ahead, we continue to expect high-yield bond and loan default rates to remain well below their 4.2% and 3.8% long-term averages over the next two years. Specifically, we forecast the high-yield bond default rate to end 2012 and 2013 at 1.5% and 2.0%, respectively, and the leveraged loan default rate to end both 2012 and 2013 at 2.0%. High-yield bond and loan primary market activity This week, 25 high-yield bonds priced for $14.8bn versus just 7 bonds for $2.5bn last week. This was only the fifth time since the start of 2011 that weekly issuance exceeded $14bn, which includes $15.9bn that priced in the first week of February. All in all, Februarys issuance totaled $40.4bn, making it the third most active month on record, only trailing the March 2010 ($40.5bn) and May 2011 ($45.7bn). For perspective, this is about four times the 2H11 monthly average. Year-to-date, dollar-denominated high-yield new issuance totals $67.3bn, tracking well above our full-year 2012 forecast of $225bn. The non-dollar market remained active this week, with two more bonds priced for dollarequivalent $1.1bn, bringing Februarys volume to $6.8bn. This compares to just $1.0bn last month and makes Februarys volume the highest since $8.7bn priced in May 2011. Year-to-date, non-dollar deals total dollar-equivalent $7.8bn, which tracks closely with last years volume ($44.6bn). This weeks highlights included three transactions greater than $1bn, including Clear Channel Worldwide Holdings Incs $2.2bn Senior Subordinated deal, Linn Energys $1.8bn deal, and UR Financing Escrows $1.325bn Senior Notes. Clear Channel Worldwides $2.2bn 8NC-3 (B3/B) deal was split between $1.925bn Series A and $275mn Series B issues. Drawing significant investor demand, the Series A notes upsized by $925mm and the Series B notes upsized by $25mm from their original launch amounts. Refinancings made up 39% of activity this week, which compares to 55% of activity year-to-date. Lower-quality issuance (bonds rated Split B, CCC, or non-rated) made up just 4% of issuance, which compares to 17% year-to-date. Eight bonds for $2.6bn priced this week to take out loans. The resurgence in bond-for-loan new issue activity has seen the volume of such deals rise from 7 deals for $1.9bn in
2H11 to $15.7bn year-to-date. Thus, bond-for-loan volume quarter-to-date tracks closely with 47 bond-for-loan deals priced at $23.8bn in 1Q11. In February, activity continued to broaden out to more diverse issuers and more aggressive issuance profiles. For instance, lower-quality issuance as a percentage of total issuance now totals 17% year-to-date from 12% in 4Q11 (18% in all of 2011). Similarly, new issue volumes priced by defensive issuers declined from 46% in 4Q11 to 39% while that for cyclical issuers rose from 33% in 4Q11 to 42% year-to-date. As for seniority, Senior and Senior Secured volume as a percentage of all issuance is somewhat below last years levels. Senior (30%) and Senior Secured (65%) issuance combined represent 95% of all activity yearto-date, a slight decline from 98% in all of 2011 and 100% of activity in 4Q11. Importantly, most issuance continues to be used for refinancing, (55% of activity year-to-date) versus acquisition financings, which makes up 18% of issuance year-to-date. For reference, refinancing activity made up 44% of activity in 4Q11 and 55% in all of 2011, while acquisition financings made up 27% of issuance in 4Q11 and 22% in all of 2011. Leveraged loan primary market activity continues to improve. This week 10 loans priced for $3.0bn, bringing Februarys volume to $19.1bn. This makes February the most active month since May of 2011, when $38.2bn priced and brings the year-to-date volume to $25.1bn. Nevertheless, despite the uptick, year-to-date volumes are still only half of those in the first two months of last year. An interesting observation from this weeks activity is that almost all deals priced were slated for refinancing purposes. In fact, all but one transaction priced this week was for refinancing purposes. The one exception was an $80mn dividend deal for Hyland Software. The forward calendar holds 32 loans for $13.8bn. In terms of the trends seen year-to-date, the rally in the secondary market and the shortfall in supply have fueled deal oversubscriptions, reverse-flexes, and return of more opportunistic transactions. However, demand has been bifurcated based on credit quality with the more aggressive structures emerging for stronger credits. After no dividend deals priced in January, the volume of deals jumped to $4.5bn, bringing their year-to-date contribution to 18% of all activity. This compares to just 9% of all activity last year. In terms of other trends, second-lien volume is already $1bn year-to-date or 4% of activity, versus 3% of all deals priced last year. However, LBO issuance has yet to pick up;
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Weekly fund flows ($mn)
year-to-date volume of LBO deals totals $2.4bn or 10% of issuance. This compares to $7.3bn in the first two months of 2011 and 16% of total issuance volume last year. Additionally, cov-lite issuance volume totaled $2.3bn in February bringing the year-to-date total to $3.4bn or 14% of activity, still significantly below last years contribution of 24%. And importantly, issuers continue to work down the maturity wall; year-to-date, 57% of activity was aimed at refinancing, closely in line with 59% of all activity last year. High-Yield Bond and Loan Flows High-yield bond funds reported inflows totaling +$565mn this week, versus inflows the prior seven weeks totaling +$837mn, +$1.77bn, +$1.79bn, +$1.60bn, +$1.88bn, +$1.35bn and +$1.79bn. It was also a 13th consecutive inflow for the asset class, which last happened between December 2010 and early March 2011 (14 consecutive weeks). Inflows for HY bond funds now total $5.45bn for February (excludes monthly reporting funds), versus $8.8bn for January and $5.2bn for December. The breakdown for this weeks number is an inflow of +$424mn for the HY ETFs (75%) and +$141mn for actively managed funds, versus +$173mn (20%) and +$664mn last week. The HY ETFs now account for $5.7bn, or 40% of the $14.2bn moving into HY in 2012. The $5.7bn for the ETFs exceeds inflows for all of 2011, whereas $8.5bn of inflows YTD for actively managed funds comes close to the $9.9bn for all of last year. Leveraged loan funds had outflows of -$70mn this week, versus outflows totaling -$132mn last week. Outflows for loan funds total $11bn since the end of July, but most of that was front loaded. Year-to-date, inflows into high-yield bond funds are +$14.2bn, versus $15.6bn for all of 2011, while outflows from leveraged loan funds are -$232mn, versus +$13.9bn for full-year 2011.
Exhibit 4: HY bond funds have seen 13 consecutive weekly inflows

4,400 3,600 2,800 2,000 1,200 400 -400 High-yield bonds Leveraged loans
-1,200 -2,000 -2,800 8-Jun 22-Jun 6-Jul 20-Jul 3-Aug 17-Aug 31-Aug 14-Sep 28-Sep 12-Oct 26-Oct 9-Nov 23-Nov 7-Dec 21-Dec 4-Jan 18-Jan 1-Feb 15-Feb 29-Feb -3,600
Source: Lipper FMI
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Alex Roever CFAAC (1-212) 834-3316 Teresa Ho (1-212) 834-5087 Chong Sin (1-212) 834-2611 J.P. Morgan Securities LLC
Short-Term Fixed Income

Given the improved market sentiment after the second 3-year LTRO, we are altering our 3-month Libor forecast to 40bp from 45bp at the end of 1Q12. However, we think it will be pressured higher before 2Q12 The two main drivers that could push Libor higher later are Moodys review of bank and brokerdealer ratings and money fund reform The latest FDIC Quarterly Banking Profile revealed that total deposit balances have risen by more than $1tn over the last six quarters and now registers $10.2tn as of the end of last year The extension of the Transaction Guarantee Program (TAG), which provided unlimited insurance coverage for non-interest bearing transaction accounts, was a major contributor to the rise in deposit balances Currently, the TAG program is set to expire at the end of this year. If Congress decides not to extend the program beyond 2012, it could instigate some $1.2tn of a shift in cash liquidity, leaving investors and banks scrambling to find suitable investments or funding alternatives respectively To extend the program requires Congress to reopen and amend the Dodd-Frank Act, something the policymakers have been reluctant to do. Given that it is also an election year, we place a low probability of an extension going through While we think Moodys review of bank and broker-dealer ratings would be a negative for the VRDOs affected, the good news is we think exposure is likely limited. We estimate there is approximately $20bn of VRDOs currently held by money market mutual funds that could be downgraded to Tier 2 status, severely limiting money funds ability to continue owning these securities
Exhibit 1: As the result of the most recent 3-year LTRO, the total amount of liquidity provided by the ECB to the Eurosystem is at an all-time high
Combined ECB MRO and LTRO balances
bn 1200 1000 800 600 400 200 Jan 08
1129.22 896.50
869.75
872.92
Sep 08
May 09
Jan 10
Sep 10
May 11
Jan 12
Source: Bloomberg
larger in terms of size and over 50% more borrowers than the ECBs previous largest-ever repo operation: the December 2011 3-year LTRO which lent out 489bn. As a result of this most recent LTRO, the total amount of liquidity provided by the ECB to the Eurosystem is at an all-time high (Exhibit 1). So what are all these banks doing with all of this cash? We know European bank deposits at the ECB, the Fed 6 and other central banks have been growing, and we expect the latest LTRO will feed this stockpiling of cash. Many banks have maturing debts to pay and want to have cash on hand. Others, the ECB is hoping, will use their cash to purchase higher yielding sovereign and non-sovereign debt, leading to lower yields and improved credit conditions across the Eurozone. Since lenders most love borrowers who do not need the money, the funding markets are generally feeling better about European banks short-term debt as the ECB has provided a longer-term substitute for short-term borrowings. Thanks to the two 3-year LTROs, over 1tn of the funding provided by the ECB is in place until 2015. Given the stability of the funding, investor willingness to lend in shorter tenors is understandably eroding. As we noted after the release of the January 2012 MMF holdings, there was evidence that money fund investors started to reenter trades with some Eurozone banks. We expect the
Whistling past the graveyard?

On Leap Day, February 29, the ECB completed its largest repo ever, temporarily taking in illiquid assets from banks, and giving them fresh Euros in return. This second 3-year LTRO saw 529.5bn lent to 800 financial institutions, 8%
6 For more on foreign bank cash and the Fed, see US Fixed Income Markets Weekly: Short-Term Fixed Income, February 24, 2012 by A. Roever, T. Ho, and C. Sin
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February holdings data (due out next week) to show that this trend was building even before the last LTRO. The effect has also been visible in Libor and its various proxies. Post-LTRO, 3-month Libor overcame a stall in its year-to-date decline and began to contract again. We think a sentiment shift in ED futures led the way as some traders unwound shorts, and others took outright longs based on the strength of the ECBs support. Yields on June ED futures plunged 11bp this past week, and although the Commitment of Traders Report showed a decline in net longs prior to the LTRO, the price action is convincing. With market sentiment swinging an unaccustomedly positive tone, we are altering our 3-month Libor forecast to 40bp at the end of 1Q12, but we think it will be pressured higher before 2Q12. Although market tone is good for now, we think the market is whistling past the graveyard of weaker funding. There are two main drivers of our view that will become more prominent in the next 2-3 months: 1. Moodys review of bank and broker dealer ratings. We discussed this at length in our last weekly and will not rehash the discussion. 7 The crux of the matter is that the rating agency is taking a decidedly more negative approach to financial institutions and is likely to cut the ratings on several significant capital markets participant before the end of May. Ratings matter to market liquidity, governing market access to funding, possibly triggering ratings-contingent clauses for collateral posting and otherwise influencing the amount of credit an institution can and will provide. Money market reform. Another topic we have written extensively about is closer to becoming a reality. 8 SEC staffers have suggested a proposal that should be circulating in the next two months. The public friction between regulators and the fund management industry is already escalating, and we think that there is a fair risk of negative headlines that could lead some shareholder pull-back from money funds, even before the proposed rule is published. And given the rhetoric, the argument may only grow more heated once a proposal emerges. The fund shareholders reaction to the debate matters because they vote with their dollars and a decrease in prime fund outstandings means less funding for borrowers in
the money markets, including global financial institutions. Sure, the LTRO may have taken care of the ECBs banks for now, but the prime money funds provide $850-900bn of credit to banks in Canada, Australia, Japan, Switzerland, the UK, Sweden and other countries. Funding conditions for banks in each of these countries could be negatively affected by a regulation-driven pull-back by money fund shareholders. To be clear, we are not anticipating a shareholder run on the funds. A steady drumbeat of negative Eurozone headlines lead to sustained fund outflows and massive drop in Eurozone bank funding last year without the funds experiencing a run. But, if it happened there, it could happen elsewhere
Deposits: Coming, Coming, Gone?

This past week, the FDIC released its Quarterly Banking Profile for 4Q11. What is staggering about the report is its mention of the growth in total deposit balances at insured financial institutions. Over the last six quarters, total deposit balances have risen by more than $1tn and now register a whopping $10.2tn as of year-end. The pace of inflows was consistent, rising each consecutive quarter. But, that may all change when the unlimited FDIC insurance coverage expires at the end of the year. Deposit inflows may turn into deposit outflows, and cash investors and banks alike may be scrambling to find suitable investment or funding alternatives respectively. For sure, the growth in deposit balances has largely been a byproduct of the Dodd-Frank Act. In general, the act has made deposits a much more attractive investment relative to other asset classes. Beyond increasing the maximum deposit insurance amount from $100,000 to $250,000 permanently, the repeal of Reg Q also permitted banks to pay interest on demand deposit accounts owned by a full spectrum of customers including corporations that use their DDAs to conduct their day-to-day activities. More importantly, Congress enacted into law the continuation of the Transaction Account Guarantee (TAG) program for non-interest bearing transaction accounts which provides unlimited insurance coverage until December 31, 2012. So far, the extension of the TAG program seems to have had the greatest impact in contributing to the rise in deposit balances. According to the report, domestic noninterest bearing transaction accounts grew $569bn since the end of 2010 and now register a balance of $1.58tn. Of that amount, $1.4tn is above the regular $250,000 FDIC limit and receives the temporary unlimited insurance coverage.
2.
See US Fixed Income Markets Weekly: Short-Term Fixed Income, February 24, 2012 by A. Roever, T. Ho, and C. Sin 8 See US Fixed Income Markets Weekly: Short-Term Fixed Income, February 10, 2012 by A. Roever, T. Ho, and C. Sin
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Comparatively, the impact of the repeal of Reg Q has had less of an influence in the rise of deposit balances, although there is no way to be sure since the FDIC does not break out interest-bearing versus non-interest-bearing DDAs. While the FDIC data show indeed that overall demand deposits went up by $328bn, it is uncertain whether the growth was indeed driven by investors desire to earn yield on their demand deposits (Reg Q) or their desire to place cash at non-interest bearing DDAs that also functioned as transaction accounts (consequently receiving the unlimited insurance coverage). Our suspicion is that it is more of the latter, as the opportunity cost to obtain full insurance coverage is miniscule given the low deposit yields. But the value of having coverage is tremendous in the current credit environment. Not surprisingly, the biggest beneficiaries of the new deposit regulations were large financial institutions. Of the 7,357 banks that the FDIC insures, there are 17 institutions with assets greater than $100bn (Exhibit 2). Collectively, they represent about 60% of total bank assets. Yet, these 17 banks experienced nearly 80% of the rise in noninterest bearing transaction deposit balances over the past year and held roughly $1.2tn of those liabilities as of yearend. In spite of the banks not necessarily wanting the deposits in the first place (the new FDIC assessment methodology penalizes banks with greater liabilities), the deposits have nonetheless become a substantial source of funding. As Exhibit 3 shows, the expansion of their balance sheets since December 2010 was almost entirely funded by those liabilities. The portion of temporarily-insured deposits financed 14% of their assets as of year-end 2011. Wholesale funding, on the other hand, declined $225bn, mostly in unsecured and secured debt and FHLB advances which the FDIC categorizes as other borrowed funds. The same trend holds true at the holding company level too, as in general domestic financial institutions sought to reduce their reliance on wholesale funding. The extension of the TAG program has clearly benefited both cash investors and banks alike. But with the program set to expire at the end of this year, it also has the potential to instigate a large shift in liquidity, reversing the benefits that have been set in place. For one, investors who previously parked their cash at banks for the unlimited insurance may no longer view those deposits as an attractive investment. They may in the coming months determine that it is best to redeploy their money, presumably into other cash-like alternatives, such as
Exhibit 2: Of the 7,357 banks that the FDIC insures, there are 17 institutions with assets greater than $100bn. Yet, they experienced nearly 80% of the rise in non-interest bearing transaction deposits
Banks with assets greater than $100bn as of December 2011 No. Name Assets ($bn) 1 JPMorgan Chase Bank, National Association 1933 2 Bank of America, National Association 1619 3 Citibank, National Association 1289 4 Wells Fargo Bank, National Association 1161 5 U.S. Bank National Association 330 6 PNC Bank, National Association 263 7 The Bank of New York Mellon 256 8 State Street Bank and Trust Company 212 9 HSBC Bank USA, National Association 206 10 TD Bank, National Association 189 11 SunTrust Bank 171 12 Branch Banking and Trust Company 169 13 Capital One, National Association 133 14 Regions Bank 123 15 Fifth Third Bank 115 16 RBS Citizens, National Association 107 17 Goldman Sachs Bank USA 104 Top 18 8382 Total US Bank Assets 13883 % of Total US Bank Assets 60%
Source: FDIC, J.P. Morgan
Exhibit 3: The expansion of bank balance sheet over the past year was almost entirely funded by deposits
Banks with assets greater than $100bn and their balance sheets $bn 12/31/2011 12/31/2010 Assets 8,382 7,726 Liabilities 7,458 6,861 Deposits 5,975 5,153 Interest bearing 4,342 4,092 Noninterest bearing 1,633 1,061 Transaction 1,167 718 Nontransaction 465 343 Wholesale 1,483 1,708 FF purchased and repo 330 400 Trading liabilities 306 278 Other borrowed funds 467 671 Subordinated debt 108 123 All other liabilities 271 237 Capital 924 865
Source: FDIC, J.P. Morgan
$ Chg 656 597 822 250 572 449 123 (225) (70) 28 (204) (14) 35 59
money market funds. The rationale behind the move is that if the government insurance were to go away, the credit quality of uninsured deposits at isolated banks (currently facing sovereign, economic, and downgrade risks) may be riskier than money funds that diversify their portfolios across a full spectrum of credit products. All else equal, money funds may seem to be the best alternative investment.
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However, the situation is complicated by the upcoming money fund reform which has the potential to destroy the very intrinsic values of money market fundsthose being the stable NAV and the same day full redemption feature. Currently, the SEC has yet to propose the reforms (we hear it should be available in the next two months). For now, our best guess is that they will be only targeted at prime money funds and not at government funds. This distinction is important, because if credit and liquidity were really a concern for investors, they could in theory park their cash in government money funds that are unaffected by the new regulations. Doing so though could raise a host of issues for fund managers that are currently earning little to no yield on their portfolios due to the prolonged low interest rate environment. From the banks perspective, the end of the TAG program may force banks to replace some $1.2tn of deposits with other sources of funding. This was made all the more challenging in light of the potential Moodys downgrades and money fund reform. In particular, we estimate the four largest banks by assets (JPM, BAC, C, WFC) hold roughly $810bn of temporarily insured deposits. However, three of those banks are currently on watch to be downgraded. Two are at risk of being downgraded to a short-term rating of P2. If Moodys does follow through with their actions, it may limit their ability to replace their lost of deposit funding with market based borrowing. Ultimately, the simplest thing for policymakers to do may be just to extend the guarantee program and avoid any type of market disruptions. But that is much easier said than done. The extended coverage was introduced in the DoddFrank Act, and the law would need to be reopened and amended, something Congress has been reluctant to undertake. Given that it is also an election year, we place a low probability of this happening.
While we think a Moodys rating action would be negative for the VRDOs affected, the good news is we think exposure is likely limited. Approximately $20bn of VRDOs currently held by money market mutual funds could be downgraded to Tier 2 status, severely limiting money funds ability to continue owning these securities. An additional $6bn in VRDOs under review by Moodys are likely to keep their Tier 1 status following a Moodys downgrade, primarily by virtue of having toplevel short-term ratings by S&P and Fitch. While investors are unlikely to experience credit losses related to prospective downgrades, the money funds universe of eligible securities will contract, intensifying competition for those securities that remain eligible, pushing these yields lower. In taxable MMFs, a retreat from VRDOs will create greater demand from prime MMFs for T-bills, agency discos and repo, influencing these yields lower. For more on the potential ramifications, please see our note Moodys ratings review spells trouble for short duration municipal debt, March 2, 2012.
Coming attractions
The ECB is scheduled to meet on Thursday, March 8. Although our European economists think the ECB has room to cut rates by another 50bp, they think the ECB is unlikely to move next week given Ewald Nowotnys comments. Nowotny is the ECB Governing Council member and he said this week that he does not see much merit in cutting the main policy rate below 1%. This view also seems to be shared by many of the ECB colleagues. Next Friday, we get the employment report for the month of February. Consensus is calling for the change in nonfarm payrolls of 210,000 with an unemployment rate of 8.3%. J.P. Morgan is forecasting a slightly higher number of 220,000 and a lower unemployment rate of 8.2%. The Fed will release the Flow of Funds report for 4Q12 on Thursday. As usual, we will look for details to understand how corporations have managed their cash in the past three months.
Moodys and VRDOs

This week, we released a separate note analyzing the implications of Moodys review of financial institution ratings on short duration Muni debt. Moodys announced on February 21 that it would review the ratings of over 1,000 municipal obligations with ratings tied to certain financial institutions. On February 15, the rating agency announced a review of 17 global capital markets intermediaries (GCMIs) and a number of large international banks. Many of these institutions actively involved in the tax-exempt money markets may have their credit ratings lowered.
Trading Themes
We favor staying with high-quality assets and look for directional moves or relative value within sectors, as the
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current risk-reward tradeoffs present minimal value in todays low interest rate environment. Overweight MBS repo versus bills While both products satisfy money fund requirements, the spread between MBS repo and 3-month bills has steadily widened since the beginning of the year. Currently, the pick-up over 3-month bills is approximately 15bp versus 3-5bp in 1H11. Overweight ABCP versus bank unsecured CP/CD Despite Europes financial conditions, underlying US credit fundamentals remain solid. Our ABS strategists believe that even weak economic growth (1.8% GDP in 2012) will be sufficient to support decent ABS credit trends. As such, we favor ABCP conduits backed by traditional asset classes (autos, trade, equipment), all of which already have built in credit and liquidity enhancements. This pick-up over bank unsecured ranges from 15bp to 20bp. Overweight 2-year Treasuries Front-end rates should trend lower in 2012 driven by declining front-end supply, further policy rate guidance by the Fed that flattens term premium, an increase in excess reserves following QE3, and the end of Operation Twist. This environment should be supportive of lower 2-year yields and push them close to 17bp in 1Q. Overweight 13-year callables versus NC agencies Given the Feds pre-commitment policy, front-end rates are likely to remain anchored at current low levels. As such, short-dated callables will continue to be called and remain attractive relative to lockout- and durationmatched bullets. Our Agency strategists calculate that over 75% of Agency callables with call dates in the next two months are in-the-money. Overweight 13-year ABS versus agencies Both asset classes are rated AAA, but ABS trade much wider than Agencies. For example, AAA-rated 2-year auto ABS is offered at the equivalent of swaps +17bp versus 2-year agency at swaps-24bp. Consequently, ABS should provide a safe haven to investors looking for relatively higher-yielding cash surrogates. Overweight 2-year floaters versus fixed Short floaters are cheap to fixed. The 2-year part of the yield curve for floaters looks especially attractive for a roll down trade. The spread pickup to extend from 1- to
2-year FRN ranges from 60bp in corporates to 110bp in banks.
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Rishad AhluwaliaAC (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC
Collateralized Debt Obligations

In a second consecutive week of heavy CLO issuance, AMMC priced its $410mn CLO (AAA at L+149bp) and INGIM its $362mn CLO (AAA at L+145bp), bringing year-to-date supply to $3.7bn. The CLO pipeline may be $2.5-3.0bn or higher We see value in primary AA and single-A given the high current coupon and high par subordination. Primary CLO debt is an attractive carry trade for those seeking current income As we have maintained since our 2012 outlook publication, this year we believe primary AAA spreads will hit L+125bp and supply will reach $20bn. Risks to our forecasts include higher bank capital charges, the limited investor base in primary mezzanine, and erosion in the arbitrage unless stickier CLO spreads catch up with tightening leveraged loan spreads Although leveraged loan mutual fund flows have moderated, our High Yield strategy team notes market technicals have improved since the start of the year thanks to repayments, bond-for-loan takeouts and surging CLO new-issue activity. CLO asset purchases will continue to influence loan technicals With the ECBs 529bn LTRO2, Europe is again in the news. We update views on the Europe-US CLO basis. We had previously highlighted value in European CLO AAAs and AAs, and also see opportunities in strong single-As We measure 2.9bn cash in European CLOs, so CLOs able to reinvest could rebuild OC and excess spread by participating in European new issue loans and senior secured FRNs
Exhibit 1: Global CLO Secondary Spreads and Recommendations

Sector WAL (years) Spread vs 02/23 US CLO Super Senior AAA AA A BBB BB Euro CLO AAA AA A BBB BB 6-8 7-10 8-10 9-11 9-11 250 600 875 1400 2000 0 0 0 0 0 -30 -150 -325 -150 -150 25 150 500 500 650 3-5 6-8 7-10 8-10 9-11 9-11 165 185 335 500 750 1000 0 0 0 0 0 0 -25 -35 -115 -115 -100 -175 20 -10 100 165 200 225 YTD 2010
Current Change Change Change Recommendation
Ov erw eight Ov erw eight Ov erw eight Neutral Neutral Neutral Ov erw eight Ov erw eight Neutral Neutral Neutral
Spread to Libor or Euribor (bp) for originally-rated categories Source: J.P. Morgan. Note: 1) Between November 21, 2008 and December 9, 2010, AA to BB spreads are estimated using simplified duration and other assumptions; thereafter, indicative spread levels are used. 2) AAA is weighted average pass-through spreads. 3) Our series represents mid-quality pricing in secondary trading.
Exhibit 2: Europe-US CLO spread basis (AAA, AA; bp)

500 450 400 350 300 250 200 150 100 50 0
AA
AAA
Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11
Source: J.P. Morgan.
Exhibit 3: Europe-US CLO spread basis (A to BB; bp)

1,200 1,000 800 600 400 200 0
Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11
BB BBB A
-200
Source: J.P. Morgan.
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CLO primary & loan market technicals

In a second consecutive week of heavy CLO issuance, AMMC priced its $410mn CLO (AAA at L+149bp) and INGIM its $362mn CLO (AAA at L+145bp), bringing year-to-date supply to $3.7bn. The CLO pipeline is difficult to measure, but may be $2.5-3.0bn or higher. We see value in primary AA and single-A given the high current coupons and high par subordinations. Primary CLO debt is an attractive carry trade for those seeking current income. As we have maintained since our 2012 outlook publication, this year we believe primary AAA spreads will hit L+125bp and supply will reach $20bn. Risks to this view include higher bank capital charges (see note on the SSFA, January 20), the limited (though growing) investor base for primary mezzanine, and potential erosion in the arbitrage if loan spreads further tighten (unless stickier CLO spreads also tighten). On a broader note, although loan mutual fund flows have moderated (AMG: -$70mn outflow this week), our High Yield strategy team notes market technicals have improved since the start of the year. This is due to repayments, bond-for-loan takeouts and the surge in CLO new-issue activity, which has occurred alongside fairly light loan volumes ($25.1bn year-to-date). As loan fund flows remain moderate, CLO asset purchases will continue to be an important influence on loan technicals. See our High Yield strategy teams daily J.P. Morgan Leveraged Loan Index data for the latest loan spread views.
Exhibit 4: Global loan LTM default rates

12% 10% 8% 6% 4% 2%
Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11
Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12
Passing 35 30 25 20 15 10 5 0 <5.0% 5.0-7.5% 7.5-10.0% 10.0-12.0% >12.0% Passing Near Failing Near Passing Failing Failing Substantially Failing
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US (S&P/LSTA Loan Index) Europe (S&P European Loan Index)
0%
Source: S&P LCD. 12-month trailing.
Exhibit 5: Share of ELLI rated CCC/CC

14% 12% 10% 8% 6% 4% 2% 0%
Source: S&P LCD. Based on par amount outstanding.
Exhibit 6: Distribution of European CLO CCC bucket
A Focus on Europe
Europe is in the spotlight with the ECBs 529bn LTRO2, and we update views on the Europe-US CLO basis. We observe interest into European CLOs as investors look to take advantage of the wider spreads. Relative value summary We have highlighted European AAs and AAAs, but also see value in strong single-As. Many original single-As are IG-rated which is useful to funds with ratings restrictions. Single-A yields of 10-12% are attractive in the context of par subordination (16-18%, on average). We are more cautious on BBBs, BBs and equity citing sovereign tail risks, the prospect of par erosion, and other issues. On the other hand, we measure 2.9bn cash in European CLOs, so CLOs able to reinvest could rebuild OC and excess spread by participating in European new issue loans and senior secured HY FRNs.
Source: J.P. Morgan, Intex.
There has been a small (varied) reduction in the basis Since late 2011, the AA basis narrowed 75bp but the 250bp premium in European AA CLOs is still attractive for the risk, in our opinion. On the other hand, the AAA basis has remained about the same (Exhibit 2). Lower down, given the rising credit stress, it is not surprising that there has been little reduction in the basis (Exhibit 3).
European CLO BBB/BB spreads may or may not compensate for the risk (very CLO-dependent) Our view on more subordinated European CLO risk is similar to our strategists broader view on European High Yield. They note that versus the US, euro HY trades between 100bp cheap for BBs to more than 300bp cheap for CCCs. Whether this premium is excessive, largely depends on ones view on Euro area tail risks, but arguably lower-rated credits deserve a larger spread premium than those that are higher rated, since they are the most exposed if the European macro data deteriorate once again. 9 European CLO average par subordinations for BBBs (10-12%) and BBs (7-10%) may be exposed to future credit stress, depending on the outlook and CLOspecific views. Below, we list some points to consider. There has been an increase in defaults and restructurings, whereas in the US loan default rates are near zero (Exhibit 4). Our European High Yield strategy team maintains its 2% default rate projection for bonds this year, but believe loan default rates will be higher, possibly 4-6% or even higher in a sovereign tail-risk scenario. In addition, collateral has experienced ratings downgrades. The S&P LCD European Leveraged Loan Indexs CCC/CC proportion increased from 8.0% as recently as late October 2011 to 12.0% by early January (Exhibit 5). The ratio has since dropped by a little, but is still in double-digit territory suggesting an elevated level of stress. CLO CCC buckets have also increased: based on a sample of 98 European CLOs, the average CCC bucket is about 10.1% (Exhibit 6), up from 7-8% a few months ago. It is difficult to predict CCC buckets as European loans are mostly shadow rated, but a few managers have told us they expect buckets to reach low teens in a base case to mid/high teens in a stress scenario. Again, macro outcomes will be a driver, as will the overall level of liquidity in the European leveraged credit market. There is significant tiering in European CLOs. Exhibit 7 plots the distribution of subordinate OC cushion for 138 European CLOs, as of current reporting and as of November 2011. The average dropped 0.50% to +1.25% in February from +1.86%
High Yield Talking Points, February 22, 2012.
Exhibit 7: Distribution of European CLO subordinate OC cushion: Feb 2012 versus Nov 2011 reporting
50 40 30 20 10 0 Failing Feb-12 Nov-11 Passing
<-3% -3 to -2%-2 to -1% -1 to 0% 0 to 1% 1 to 2% 2 to 3%
>3%
Source: J.P. Morgan, Intex.
Exhibit 8: Sampled stressed European loan credits and observed CLO concentrations
Rank Obligor 2 Eircom 3 Yell Group 4 Pages Jaune 6 Cortefiel 7 European Directories 8 Fitness First 9 Seat Pagine 10 Iridium 11 Iberotrav el 12 Frans Bonhomme 13 Nocibe 14 Truv o 15 Trav elport 16 Telepizza 17 Moliflor Loisirs 18 Moniteur 19 Hilding Anders 20 Trav elodge
a
CLO Amount*
Price** Moody 's Industry 76.00 Retail Store
1 Viv arte
1,535,852,256 1,039,785,607 900,299,374 814,498,595 785,911,674 495,715,623 452,715,123 392,894,365 315,684,320 287,749,572 266,579,272 263,701,595 235,587,374 218,141,846 199,505,276 186,248,595 157,138,990 147,384,791 145,752,799 132,056,049
55.00 Telecommunications 35.50 Media: Adv ertising, Printing & Publishing 68.00 Media: Adv ertising, Printing & Publishing 94.50 Utilities 55.50 Retail Store 11.00 Media: Adv ertising, Printing & Publishing 64.88 Hotel, Gaming & Leisure 65.00 Media: Adv ertising, Printing & Publishing 70.00 Chemicals, Plastics & Rubber 64.00 Transportation: Consumer 67.00 Chemicals, Plastics & Rubber 73.00 Retail Store 44.60 Media: Adv ertising, Printing & Publishing 84.00 Transportation: Consumer 72.75 Bev erage, Food & Tobacco 63.00 Hotel, Gaming & Leisure 72.50 Media: Adv ertising, Printing & Publishing 73.00 Consumer goods: Durable 82.00 Hotel, Gaming & Leisure
5 Charterhouse Inuit
Source: J.P. Morgan, CLO trustee reports, LPC, Markit.*All assets found in CLOs (term loan, restructured super senior/PIK, etc). **Bid price (usually term loan) where available, as of February 22, 2012. aOpCo A3 price.
Exhibit 9: Distribution of European CLO WAPP

25 20 15 10 5 0 <80 80-85 85-86 86-87 87-88 88-89 89-90 >90
Source: J.P. Morgan, LPC.
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last November and the ratio of passing tranches dropped from 83% to 68% of our universe. But the number of small fails (better than -2.0%) has nearly tripled to 29from 12, so some of these could start passing through near-term de-levering (etc.). Conclusion Investors seeking yield in European CLOs should be comfortable with AAAs, AAs and strong single-As but should carefully pick their points lower down. In Exhibit 8, we list some of the stressed credits and CLO concentrations. Some are in sectors with earnings pressures (Media, Retail, etc.) and there are names that are exposed to peripheral countries (Ireland, Spain). Finally, while portfolio price is not a perfect measure of risk, in Exhibit 9 we provide the current European CLO Weighted Average Portfolio Price (WAPP) to get a sense of how the market is pricing the risk. The average WAPP is 86.70, close to the loan index price of 84.50, but there is variation suggesting divergent mezzanine tranche market value coverage.
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Peter DeGrootAC (1-212) 834-7293 Josh Rudolph (1-212) 834-5674 J.P. Morgan Securities LLC
Exhibit 1: Next week will be the highest supply of the year
Municipals
We expect $9.5bn of long term municipal bond issuance next week or the highest weekly volume since mid-November 2011 Weekly reporting municipal bond funds saw inflows of $356mn, with long-term funds losing $49mn, suggesting that inflows have been moderating We discuss cost associated with holding capital on the sidelines awaiting higher yields and provide specific yield targets in a breakeven analysis Taxable municipal bond spreads have tightened and transaction activity has been strong, both benefiting from favorable conditions in the taxable fixed income space We follow up on the topic of tax-deductibility of municipal bonds by reviewing some relevant history of legislation and case law impacting tax exemption. We articulate potential constitutional arguments that might be employed to defend muni tax-exemption in the future, if necessary, although this would be an uphill legal battle
Weekly municipal bond issuance ($bn)

15
Tax-exempt * *
Taxable
Next week
10
5 * 0 *
* * * J J A S O N 2010 D J F M A M J J 2011 * * * * *
* * * ** * J F M 2012
A S O N D
* Holidays Source: Bloomberg CDRA
Exhibit 2: Another nearly $1bn of inflows this week

Flows in to (out of) municipal bond mutual funds; $mn
Supply ticks up and fund flows taper, but considerable capital remains on the sidelines
This weeks $8.2bn in new issue supply was absorbed by the market with modest lift to ratios in an unchanged Treasury rate environment. An abundance of capital from the nearly $12bn of YTD fund inflows helped to absorb the $2bn State of California offering. Despite the low level of rates, tax-exempt/Treasury ratios only cheapened by one percentage point, from 95% to 96% in 10yr, and from 104% to 105% in 30yr. Issuance next week may exceed $9.5bn or the highest since 11/14/2011 ($12.2bn) (Exhibit 1). The largest offering will be a $1.5bn refunding from Puerto Rico, followed by high-grade deals from NYC Water ($500mn) and the State of Maryland ($922mn). While issuance is likely to remain well-subscribed in the near term, as investors enjoy finally being able to draw
Source: Lipper FMI
Fund flows Fund Assets Type of funds Actual 4-wk. avg. Actual 4-wk. avg. All term muni funds 920 1,350 533,995 531,669 New York 25 24 34,030 33,930 California 94 104 49,840 49,677 National funds 765 1,085 366,495 364,605 High Yield 12 224 51,883 51,447 Intermediate 204 273 124,923 124,469 Long Term 165 633 308,730 307,575 Tax-exempt money market -2,083 -967 287,546 289,418 Taxable money market -6,790 1,063 2,341,442 2,342,856 Taxable Fixed Income 4,494 7,508 3,158,904 3,143,883 Equity 3,240 2,304 5,845,863 5,797,986
down upon ample cash balances, the continuation of high supply and low absolute rates will eventually pressure ratios, perhaps alongside the seasonal pressures from diminished redemption cash flow and tax-return liquidity demands. For the period ending 2/29/2012, weekly and monthly reporting municipal bond funds registered inflows of $920mn, following last week's $939mn in inflows. For the year, net cash inflows have been approximately $12bn. Investors favored intermediate funds ($204mn) and longer-dated funds ($165mn) but High-yield funds ($12mn) also enjoyed positive capital flows. Weekly reporting municipal bond funds saw inflows of $356mn suggesting that, more recently, inflows have been moderating. Intermediate funds enjoyed inflows of $113mn and high-yield funds took in $12mn. Possibly the most salient statistics was the $49mn in outflows from long-term municipal bond funds. This was the first weekly outflow for longer-dated funds in 2012.
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With the Fed on hold can investors afford to sit on the sidelines?
Many investors have stockpiled cash while awaiting higher yields. There is certainly some rational for not rushing into the market while yields are hovering near all-time lows. That said, the decision to stay in cash does come with a cost. Delaying the purchase of new bonds, in anticipation of higher rates, costs the investor lost carry and compound interest. Generally speaking, the amount of return forfeited by staying in cash versus being fully invested is a function of the yield spread between cash rates and the target investment, as well as the amount of time spent uninvested. As such, yield-oriented investors typically have higher opportunity cost associated with maintaining large cash balances. An investor who decides to delay the purchase of 5yr AAA bonds, for a 6-month period in the hope that yields will rise, would need yields to increase by just 12bp (over those 6 months) in order to catch up with the return on an investment made today. If the investor remains in cash for a full year, yields would need to rise by 25bp to break even with the return of a bond purchased immediately. Extending the stay on the sidelines to two years would require a 55bp jump in yields to match the investment return an investment today in 5yr AAA bonds. The investor would have been better off putting capital to work when it was received, if rates do not rise to the aforementioned levels (Exhibit 3). The higher the yield in the target investment the larger the opportunity cost for staying in cash. An investor waiting for spreads to widen before investing in A rated bonds would leave more on the table, over similar periods of time, relative to high-grade buyers. Yields would need to be 20bp higher, in six-months, to achieve the same return as an investment in 5yr A rated bonds today. Delaying the purchase of 5yr A rated investments, for two years would require a 112bp increase in yields to catch up with that investment, over the full term of the bond (Exhibit 4). The return forfeited by delaying investments in the 10yr portion of the curve is generally lower than delaying 5yr purchases. The curve would have to rise from 10bp to 70bp for capital held in cash for 6-months to 2-years, in order to break even with an investment in bonds purchased today.
Exhibit 3: The longer investors wait, the more of an adjustment is needed to break even
Increase in AAA yields needed to break even, bp
60 50 40 30 20 10 0
5yr 5yr, AAA MMD, yields have to go up by 25bp in one year, for an wait and invest strategy to break even 20yr
10yr 30yr
6m
12m
18m Time spent in cash
24m
Source: JP Morgan
Exhibit 4: Investors targeting higher yields have a greater the opportunity cost for staying in cash
Increase in A yields needed to break even, bp
120 110 100 90 80 70 60 50 40 30 20 10 0
5yr 5yr, A MMD, yields have to go up by 46bp in one year, for an wait and invest strategy to break even 20yr
10yr 30yr
6m
12m 18m Time spent in cash
24m
Source: JP Morgan
Investors of 20yr and 30yr bonds would need relatively small increases in yields to compensate for holding cash while awaiting higher yields or wider spreads. In fact, the curve would need to increase by 10bp over the next 6-months, for an investment to be equivalent to a bond purchased today. Investors willing to sit in cash for a longer period of time (two years) awaiting an entry point, for 20yr or 30yr bonds, would require up to a 52bp increase in longer-dated yields to break-even over the remaining life of the investment. Needless to say, there are no guarantees that yields will rise over the near term, particularly given the Feds position on keeping short rates locked down until at least
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mid-2014. There are also other defensive strategies besides moving into money markets. For investors who typically target the longer portion of the curve, premium non-callable bonds in the 7-10yr range and short calls with final maturities of 7-15yr can improve liquidity and provide greater rolldown return, even if yields rise in the future. Holding premium bonds with short-calls is considered defensive, given the Feds bias and the strong probability the bonds will be called. Even given the scenario where bonds are not called, the market for AA bonds inside of 10 years is highly liquid. These structures are positively convex, as they move toward the coupon, given the active retail and SMA demand.
Exhibit 5: Taxable spreads have tightened

Spread over UST, bp
180
AA
160 140 120 100
AAA
1/3 1/8 1/13 1/18 1/23 1/28 2/2 2/7 2/12 2/17 2/22 2/27
Taxable market performing strongly

Taxable municipal bond spreads have tightened and transaction activity has been strong, both benefiting from favorable conditions in taxable fixed income. Our corporate strategists believe the key drivers remain in place for tighter spreads over the medium term, based on strong investment flows and better macroeconomic conditions. Investor appetite for spread product in the taxable fixed income market retains strong. Mutual fund and ETF data highlight accelerating demand at the start of this year. High-grade managers highlight that the demand is focused on the short end, due to near-zero yields on government bonds, and in the long end, largely from pension funds and insurance buyers. The macro environment limits downside risk, given the successful execution of the LTRO program, strongerthan-expected economic data in Europe, and solid growth in the US. We believe the absence of strong downside risks rather than the presence of strong growth is more important for ongoing spread tightening. The taxable municipal space, trading activity has been very robust YTD 2012 (Exhibit 5). The 4-week average trade count was above the 12-month average for each of the last 6 weeks. The last 4 weeks had an average of 597 taxable trades above $1mn, compared to an average of 498 weekly trades for the past year. Also, the reported par value of trades was $1.85bn per week versus $1.65bn per week for the last 12 months.
Source: S&P, JP Morgan
Exhibit 6: Taxable liquidity is up this year

4-week rolling average trade count
700 600 500 400 300
Current week For Year
Note: Complete trade volume data is available until 2/14/2012 Source: S&P, JP Morgan
In addition to higher trading volumes, the spreads of taxable municipal bonds to Treasurys have tightened this year from 161 to 130bps for AAA taxable municipal bonds and 131bp to 109bps for AA taxable municipal bonds (Exhibit 6). The spreads of taxable municipal bonds to similar structure corporate bonds have tightened far less dramatically with longer dated AAA taxable municipals tightening from 33 to 18bps and the spread for AA municipals remaining largely unchanged moving from 3bp to 2bps.
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Mar 11 Mar 11 Apr 11 May 11 May 11 Jun 11 Jul 11 Jul 11 Aug 11 Sep 11 Sep 11 Oct 11 Nov 11 Nov 11 Dec 11 Jan 12 Jan 12
The legality of repealing tax exemption

In last weeks research note, we estimated that the provision in Presidents budget that would limit the tax-deductibility of municipal bond interest income for high-income taxpayers would have a fundamental impact on yields of only 5-14 basis points. We also cautioned, however, that the impact could be greater as liquidity evaporates and investors charge steeply for increased tax risk, fearing that Pandoras Box of retroactive changes to tax-exemption has been opened. In any case, the provision stands little chance of going anywhere before the election. After November, however, no fiscal deficit reduction measures will be off the table. Thus, this week we follow up on this topic by reviewing the historical legal debate over whether the federal government has the constitutional right to tax municipal bond interest income. The most recent ruling on the matter (Baker in 1988) definitively warned that the owners of state [and local] bonds have no constitutional entitlement not to pay taxes on income they earn from the bonds, and States [and localities] have no constitutional entitlement to issue bonds paying lower interest rates than other issuers. Instead, the States must find their protection from congressional regulation through the national political process. However, some leading municipal bond attorneys contend that future Courts could and should decide differently than the Baker Court 10 by simply changing the emphasis from the person being taxed to the effect that the application of federal income tax to municipal bonds would have on states and localities. Given the recent rise of fringe popular movements (Occupy Wall Street on the left, Tea Party on the right) this might also be an opportune time to review the history of legislative and judicial battles emanating from US class warfare, and their unintended consequences on muni tax exemption. The history of municipal bond tax exemption is a 200year story of legal wrangling over US federalism, most of which was not supposed to have anything to do with municipal bonds. Most of the important cases,
10 See The Battle Over Tax Exemption of Interest on State and Local Government Debt Obligations by James Spiotto of Chapman & Cutler LLC.
from McCulloch, to Pollock, to the Sixteenth Amendment, to Baker, were intended to be more about income taxes than municipal bonds. That is, the lawmakers and judges involved in these cases were primarily focused on the establishment, constitutionality, and enforcement of income taxes, rather than on the provision of internal fiscal transfers. For clients interested in our views on why muni bonds are tax-exempt and how a future legal defense of tax-exemption might be framed, the remainder of this research note will review some relevant history of legislation and case law impacting tax exemption. J.P. Morgan takes no legal or policy view on these measures and this note is only the interpretation of J.P. Morgan Research and is not the opinion of J.P. Morgans Legal Department. Clients should consult their counsel as to any legal implications. McCulloch v. Maryland (1819): Power to tax, power to destroy; tax-exemption is born As difficult as it may be to imagine, central bankers were even less popular 200 years ago than they are today. The US was born as a rag-tag band of colonial interests that resented and distrusted the concentration of power. In fact, this precise wariness is exactly what motivated the establishment of the US systems of checks and balances and dual sovereignty that ensure the division of power. In 1811, when the nation was only 35 years old, this sentiment was still alive and well. As such, Congress declined to renew the charter of the Bank of the United States as it expired that year. But only five years later, in order to alleviate the credit strains that came in the aftermath of the War of 1812, Congress created a new central bank called the Second Bank of the United States. This federal bank would be empowered to regulate the currency issuance and speculative activities of state banks. Many local farmers, bankers and politicians, the Occupy Wall Street crowd of their day, resented the powerful moneyed interests symbolized by this new federal bank. Thus, when the bank established a new branch in Baltimore, the Maryland state legislature fought back by levying a new tax on the transactions made at any bank not chartered by the state legislature (at the time, the Second Bank of the US was the only such bank in Maryland). James McCulloch, cashier of the new Baltimore branch, refused to pay the tax and appealed to the US Supreme
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Exhibit 7: Broad-based US federal income taxes were not constitutional until 1913
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1800 1850 McCulloch Civil War Pollock 16th Amendment WWI WWII
Top income tax rate in the US, %. Events impacting the level of tax rates are shaded blue; events discussed in this note impacting muni tax exemption are shaded red.
Cold 1981 War tax cuts 1988 tax reform, Baker
Bush tax cuts
Source: Tax Policy Center, J.P. Morgan
1900
1950
2000
Court. In a unanimous decision, the justices agreed the activities of the bank were indeed constitutional and not a violation of the Tenth Amendment because central banking provides a necessary and proper public good and while the states had entered into the constitution with their sovereignty intact, the federal government though limited in its powers, is supreme within its sphere of action as per the Supremacy Clause of the Constitution. This McCulloch ruling also established the doctrine of intergovernmental tax immunity by observing that the power to tax involves the power to destroy. In this case, that meant Maryland had no right to destroy the federal bank branch in Baltimore. In the Pollock case, 75 years later, the Supreme Court would employ this same doctrine to rule that the federal government does not have the right to destroy states access to capital through the taxation of income earned on state bonds. Pollock v. Farmers Loan & Trust Co. (1895): Income tax thrown out; muni tax exemption reaffirmed The US federal income tax is only about 100 years old (Exhibit 7). It was first enacted in a highly progressive form (only applying to the richest 0.1% of the population) in 1894 by the Populist Party, led by William Jennings Bryan, reigniting the division between the moneyed class and the working class. When Farmers Loan & Trust Co. complied with the new tax, one of the companys shareholders, Charles Pollock of Massachusetts, appealed to the US Supreme Court, hiring eminent Wall Street lawyer Joseph Choate to
argue against the new federal income tax. In a controversial 5-4 decision, the income tax was declared unconstitutional because it was not apportioned based on the states respective populations, as the constitution required all direct taxes must be 11. The Pollock ruling also explicitly declared that income earned on state and local government bonds could not be taxed by the federal government, because such taxation would effectively be a direct tax on the states themselves, which would violate the McCulloch doctrine of intergovernmental tax immunity. Additional case law extended this doctrine to provide immunity from sovereign-to-sovereign taxation via taxes on employee wages (Collector v. Day, 1871), governmental leases (Burnet v. Coronado Oil, 1932), and government purchases from vendors (Indian Motorcycle Co. v. United States, 1931). Each of these immunities from federal taxation enjoyed by the states was similarly enjoyed viceversa by the federal government from state taxation. The
11 A direct tax generally means a tax imposed on a person (or property), rather than imposed on a transaction (such as an excise or sales tax or a VAT, all of which are indirect taxes). The US Constitution required that direct taxes must be imposed proportionally to population (not income). Income taxes can be either direct (if the income is earned from property) or indirect (if the income is earned from labor). Thus when Pollock made this particular distinction among income taxes of different sources, the highly progressive 1894 tax was effectively nullified, because the top 0.1% of the population generated most of their income from property, not labor, meaning that the law was levying a direct tax in proportion to income, rather than in proportion to population, which was unconstitutional.
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unconstitutionality of taxes that in any way burden another sovereign became known as the burden theory. This was the high point in US history of the strength of the legal defense of muni bond tax-exemption. With time, the security of intergovernmental tax immunity would be substantially weakened by the overruling of each of the three cases above (wages, leases, vendors). But first, tax-exemption would take an unintended critical blow by the particular language of the nations sixteenth constitutional amendment. The Sixteenth Amendment (1913): Income taxes broadened to include everything It was not until 1913 that the populist forces militated against the moneyed interests to actually change the US Constitution, allowing the federal government to tax income from whatever source derived, including property, without having to apportion the tax among the states according to population. The intention of the Sixteenth Amendment was to extend the income tax to apply to income earned on property, not just labor. However, Governor Hughes of New York pointed out that the phrase from whatever source derived could conceivably extend to municipal bond interest as well. The key senators who supported the amendment eased the concerns of Hughes by declaring on the senate floor that that was not their intention (more on this later). In order to further address the concerns of state and local politicians, Congress expressly included the taxexemption of income earned on municipal bonds into the federal income tax code the 1913. But this new taxcode approach to muni tax-exemption ended up being far less secure some 70 years later, when the Supreme Court clarified that whatever Congress gives, it can also take away. South Carolina v. Baker (1988): Tax-exemption is a gift from Congress Once again, in 1982, the fate of tax-exemption was to be impacted by new legislation that was intended to have nothing to do with municipal bonds. The country was in recession, which was depressing federal revenues and thus widening the budget deficit. Congress decided it could raise tax receipts without increasing tax rates, by
introducing tougher enforcement of tax rules (mostly by changing corporate and investment accounting rules). Importantly, the 1982 legislation attempted to crack down on tax evasion by outlawing bearer bonds. But given that it was a tax bill, rather than explicitly outlawing them, the bill made bearer bonds uneconomic financial instruments by repealing their tax deductibility. 12 This was the first time that we know of when tax exemption was used as a stick to accomplish an unrelated Congressional goal. This tactic was contemplated more recently in the PEPTA bill that would repeal tax-exempt issuance for state and local governments unless they publish the value of their unfunded pension liabilities discounted at Treasury yields. The constitutionality of using muni tax exemption as a federal stick was challenged by the State of South Carolina in 1987 (the defendant being James Baker, in his capacity as US Treasury Secretary). South Carolina argued that the law violated both the US Constitution and precedent US Supreme Court case law: 1. Tenth Amendment: Reserves for the states any powers not granted to the federal government nor prohibited to the states by the Constitution. In this case, South Carolina was arguing that by coercing states into enacting legislation and taking administrative actions to effectuate the registration of bonds, the federal government infringed upon the states sovereign power to issue debt obligations as they see fit, as reserved by the Tenth Amendment. Pollock ruling: Explicitly stated that income earned by state and local government bonds could not be taxed by the federal government, based on the McCulloch doctrine of intergovernmental tax immunity.
2.
In a 7-1 decision, the Supreme Court rejected both of these two appeals, thus declaring that municipal bond interest is not immune from non-discriminatory indirect federal income taxes.
12 For corporate bearer bonds, interest paid by issuers would no longer be deductible by the issuer. For municipal bearer bonds, interest earned by investors would no longer be exempt from the personal income tax. The effect of the law was to indirectly outlaw bearer bonds by encouraging both corporate and municipal bonds to be registered upon issuance.
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With regard to the Constitutional challenge (#1 above), the majority cited a precedent decision holding that the Tenth Amendment limits Congressional authority to regulate only the structure of state activities, not the substance of state activities. That is, the Amendment only protects states if the national political process operates in a defective manner to the disadvantage of a particular state. This distinction prevents the Tenth Amendment from being invoked to throw out any federal legislation just because a particular state is unhappy with its substance. Given that South Carolina was not deprived of any right to participate in the national political process, nor was it singled out in a way that left it politically isolated and powerless, in this case the state is afforded no protection under the Tenth Amendment. The High Court went on to say that the States must find their protection from congressional regulation through the national political process, not through judicially defined spheres of unregulable state activity. To leave no doubt about constitutionality, the justices also pointed out that any requirement that states wishing to engage in certain activity must undertake administration and sometimes legislative action to comply with federal standards regulating that activity is a commonplace that presents no constitutional defect. Otherwise a state could immunize itself from any federal regulation by simply codifying the manner in which it engages in those activities. The more controversial aspect of the Baker decision was its explicit overruling of Pollock after 93 years of precedent (#2 on the previous page). The court explained that after the ruling was written in 1895, Pollock has been effectively overruled by subsequent case law which substantially weakened the McCulloch doctrine of intergovernmental tax immunity: In 1938, the court upheld the constitutionality of a federal tax on corporate income derived from a state lease. This case, Helvering v. Mountain Producers Corp., overturned Burnet v. Coronado Oil. The following year, the court overruled Collector v. Day by allowing states to levy nondiscriminatory income taxes on federal employees. The ruling declared that the theory that a tax on income is legally or economically a tax on its source is no longer tenable and the purpose of the immunity was not to confer benefits on the employees or
to give an advantage to a government by enabling it to [pay lower wages than private companies]. The Supreme Court went on to proclaim that the Constitution presupposes the burden of taxes being felt by another sovereign as merely being but the normal incident of the organization within the same territory of two governments, each possessing the taxing power (Graves v. New York ex rel. OKeefe, 1939). Two years later, in 1941, the court upheld a state sales tax on a federal contractor, even though the financial burden was entirely passed on to the federal government. Baker cited this case (Alabama v. King & Boozer) to demonstrate the thoroughness with which the Court abandoned the burden theory.
These three critical judgments were made by the Supreme Court in just four years, from 1938 to 1941, but were consistently upheld, even when part of all of the burden of the tax falls on another sovereign government. The reaffirming cases included US v. City of Detroit (1958), US v. County of Fresno (1977), US v. New Mexico (1982), and Washington v. US (1983). Of the four original governmental costs that were once immune from being burdened by any taxes levied by another sovereign (employees, leases, vendors, bonds), only bond interest was yet to be explicitly overruled. That changed with Baker, which indicated that there should be no distinction between taxes on capital versus taxes on labor. Just as Graves ruled that public employees have no constitutional entitlement not to pay income taxes (and governments no entitlement to pay lower wages), Baker ruled that the owners of state bonds have no constitutional entitlement not to pay taxes on income they earn from the bonds, and States have no constitutional entitlement to issue bonds paying lower interest rates than other issuers. This was not to say that the intergovernmental tax immunity doctrine is entirely dead. But the bar for unconstitutional taxation has been raised. No longer does any burden placed on another government exhibit an unconstitutional power to destroy. Instead, a tax is only unconstitutional if it either (i) is imposed directly on the government, or (ii) discriminates against the government. Because the federal income tax is imposed directly on bondholders (not states or localities) and is charged on all types of interest (not just muni bonds), Baker
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found that Congress can constitutionally tax muni bonds of they so choose. The constitutionality of impacting (rather than grandfathering) existing securities was not addressed by Baker, because Congress had not contemplated that in their 1982 tax law. Counter-arguments against Baker In the event that Congress decides to curtail municipal bond tax-exemption in the future, issuers and bondholders might attempt to launch a legal defense based on one of two potential arguments, both of which are premised on the notion that the cost of capital is different than other governmental costs, such as the cost of labor. That is, both approaches argue that payments to municipal bond investors are different than payments to state and local employees, vendors, and lessors. 1. Bonds are different because taxing their income would have tangible adverse effects.
in public markets the way capital costs are does not mean that labor costs are not substantial. Surely teachers, firefighters, and police officers would accept lower pay (or smaller pensions) if they did not have to pay any federal income taxes, even if the difference is a bit harder to measure than publicly traded bond yields. 2. Bonds are different because the Sixteenth Amendment was ratified under the explicit understanding that its not intended to allow the taxation of muni bond interest income.
Another approach to defending tax-exemption is based on the historical circumstances surrounding the ratification of the Sixteenth Amendment. This argument has been articulated by James Spiotto, of Chapman and Cutler LLP. In order to change the US Constitution, two thirds of Congress has to propose the amendment, at which point it is distributed to the Governors for them to formally introduce to their respective legislatures. The proposed amendment only becomes part of the constitution when it is ratified by three-fourths of the states. In 1910, when New York Governor Hughes submitted the Sixteenth Amendment to the legislature in Albany, he objected to the phrase, from whatever source necessary because it might make municipal bonds taxable. He warned, to place the borrowing capacities of the state and its government agencies at the mercy of the Federal taxing power would be an impairment of the essential right of the State. When Hughes concerns began to receive currency in other states, Senators in Congress who supported the amendment (Root, Borah, Brown, Hull) responded by saying that this was not the intention, purpose or goal of the Sixteenth Amendment. Spiotto points out that their response was announced on the Senate floor and the issue was clearly presented to the national conscience at that time. Hughes did not similarly object to the states employees being taxed and no other similar clarification was publicly offered by the Congressional originators of the Sixteenth Amendment regarding any state costs other than municipal bonds. Spiotto also points out that five years later, when Hughes was an associate justice of the US Supreme Court, he assented to the upholding of the 1913 income tax, with the High Court writing that the Sixteenth Amendment
In her dissent to the decision made in Baker, Justice Sandra Day OConnor argued that the majoritys focus on the decline of the intergovernmental tax immunity doctrine was misplaced, given that such a decline should have no bearing on the constitutionality of a federal income tax on state and local government bonds. She pointed out that constitutional principles do not depend upon the rise or fall of particular legal doctrines. Focused on the wrong issue, the Court shirks its responsibility because it fails to inquire into the substantial adverse affects on state and local governments that would follow from federal taxation on the interest on state and local bonds. OConnor argued that these adverse effects of a federal income tax applying to municipal bonds may strike at the heart of state and local governmental activities. In her view, the substantial impact on the governmental cost structure differentiates capital from labor. She cites Helvering v. Gerhardt (1938) as allowing federal taxes on state employees because the burden on the state is so speculative and uncertain that the tax would not afford tangible protection to the state government. That contrasts with municipal bonds, whereby the cost of capital is impacted by 28-35%, according to the Baker Court. Her argument here might be a bit weak, however, because states spend more of their revenues on labor than on capital. Just because labor costs are not visibly priced
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does not purport to confer power to levy taxes in a generic sensean authority already possessed and never questionedor to limit and distinguish between one kind of income tax and another, but that the whole purpose of the amendment was to relieve all income taxes, when imposed, from apportionment. All of this suggests that the states ratified the Sixteenth Amendment under the guise that they were conferring no new taxing power upon the federal government. Bakers failure to address the constitutionality of Congress subsequently levying new taxes that burden the states might allow future Supreme Courts decide differently. The potential weaknesses of this argument lie in the plain language of the Amendment that includes all sources of income in the tax base. Moreover, some of these same Senators (Brown and Hull) also argued elsewhere that since the income tax was nondiscriminatory, it would not be unconstitutional to tax muni bond interest income. Both of the two arguments rest on the premise that municipal bonds have a special role in state and local governments ability to fund infrastructure and provide essential governmental services, which is protected by the constitutional safeguards and state autonomy that the US Supreme Court is constitutionally entrusted to enforce. By granting the federal government the power to destroy the states access to affordable capital, the court may have left the door open for further erosion of state sovereignty. To quote one eminent constitutional scholar, No one expects Congress to obliterate the states, at least in one fell swoop. If there is any danger, it lies in the tyranny of small decisionsin the prospect that Congress will nibble away at state sovereignty, bit by bit, until someday essentially nothing is left but a gutted shell. The real question, therefore, is this: short of its prohibition of Armageddon, does the Constitution grant the states any judicially enforceable protection from Congress? 13
13
Laurence H. Tribe, American Constitutional Law, 5-20 at 381 (2d ed. 1988).
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Trading recommendations
Overweight AMT bonds Particularly airports with limited competition, manageable leverage, and robust liquidity in growing service areas (US Fixed Income Markets Weekly, December 16, 2011). Overweight A-rated and BBB-rated credits, particularly intermediate term structure Spread product should perform well given investor penchant for yield in the protracted low rate environment, with limited lower-rated supply, high reinvestment capital (December-February) recent mutual fund inflows, and the existing wide A/BBB spreads Investors should consider using conservative 1:1 leverage in the intermediate sector of the curve to generate higher returns than investing in 30-year high-grade bonds, with similar curve risk, far greater roll down and a more liquid exit strategy (US Fixed Income Markets Weekly, August 19, 2011). Overweight California taxables versus both Corporates and Treasuries We expect the spreads over Treasuries to tighten another 10-20bp (US Fixed Income Markets Weekly, June 12, 2011). Cross-market value opportunities Large shifts in Treasury yields will engender relative value opportunities. Cross-over investors should monitor base level municipal values relative to Treasury bonds and alternative spread product Liquidity conditions in March-May may create opportunities to purchase Munis at cheaper levels For the 3-month period, gross issuance is expected to be +$95bn (vs. +$55bn in 2011) and net issuance to be +$30bn (vs. -$30bn in 2011). If rates rise, liquidity could also suffer from fund outflows Overweight the 20182022-year sector of the taxexempt yield curve to capture out-sized curve roll and strong liquidity The belly of the curve offers a return of 229bp 324bp given a parallel shift of the curve. These
points on the curve exhibit better liquidity, tax-risk, and interest rate risk versus similar performing maturities. Investors with higher yield mandates may look to the 2026-2036 based on a similar analysis. Overweight three defensive credit sectors: 1) special tax bonds with clean flow of funds, reliable rule of law, abundant coverage, and a broadbased revenue stream; 2) water and sewer bonds with conservative structures, healthy financial metrics, growing and prosperous populations, autonomous and experienced management, and sound regulatory compliance; and, 3) electric utility bonds with lower debt burdens and lean cost structures located in healthy economies (US Fixed Income Markets Weekly, August 12, 2011; US Fixed Income Markets Weekly, August 19, 2011; US Fixed Income Markets Weekly, August 26, 2011) Overweight two offensive credit sectors: 1) airports with limited competition, manageable leverage, and robust liquidity in growing service areas; and, 2) established toll roads with manageable leverage, tight flows of funds, ample liquidity, strong demographics and independent toll-setting regimes (US Fixed Income Markets Weekly, September 30, 2011; US Fixed Income Markets Weekly, September 23, 2011)
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Supply forecast
Monthly tax-exempt bond issuance; $bn Monthly tax-exempt net supply/(redemptions); $bn
50 40 30 20 10 0
Annual total: 5yr avg. $410 2011 $290 2012 $350
Source: Bond Buyer, J.P. Morgan
25 20 15 10 5 0 -5 -10 -15 -20 -25

Source: Bond Buyer, IDC, J.P. Morgan
Annual total: 5yr avg. +$87 -$73 2011 +$4 2012
Interest rate forecast

Yield, %
Treasury 2yr 5yr 10yr 30yr AAA tax-exempt 2yr 5yr 10yr 30yr
1Q12 2Q12 3Q12 4Q12 Current Forecast Forecast Forecast Forecast 0.27 0.22 0.30 0.30 0.30 0.84 1.98 3.11 0.90 2.25 3.30 1.25 2.50 3.60 1.25 2.50 3.60 1.25 2.50 3.60
AAA tax-exempt yield / Treasury yield (% ) Min Max Mean St. Dev. 2yr 94.32 83.66 165.05 134.13 27.17 5yr 82.81 73.33 115.90 94.94 11.92 10yr 96.30 88.09 106.72 95.03 4.20 30yr 105.05 102.17 128.85 112.06 8.50 AA corporate yield - AA tax-exempt yield (bp) Min Max Mean St. Dev. 3-5yr 84.56 76.21 101.70 90.41 6.31 5-7yr 109.66 103.54 161.09 131.02 16.92 7-10yr 122.63 122.63 174.45 156.23 11.39 25yr 99.13 68.22 121.60 97.09 16.04
Z-score 3mo 12mo -1.5 -1.0 -1.0 -0.6 0.3 -0.1 -0.8 -0.5 Z-score 3mo 12mo -0.9 -1.4 -1.3 -1.9 -3.0 -1.0 0.1 0.7
Source: J.P. Morgan
0.26 0.70 1.91 3.27
0.31 0.88 2.24 3.64
0.47 1.19 2.45 3.91
0.47 1.19 2.45 3.91
0.47 1.19 2.45 3.91
Source: J.P. Morgan
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Emerging Markets Research US Fixed Income Markets Weekly March 2, 2012 Joyce ChangAC (1-212) 834-4203 Ben Ramsey (1-212) 834-4208 J.P. Morgan Securities LLC
Emerging Markets
The rally continues, although at a slower pace Valuation in EM is still reasonable and inflows remain robust Higher oil prices shape our recommendations
Market views
The EM rally continued as February turned to March, although the pace has slowed slightly in recent weeks. USD sovereigns led the way in February, with the EMBIG returning 2.95% on the month and standing at 4.76% yearto-date by February-end (a figure that had extended to 5.03% as of March 1 close). The EMBIG spread had dipped to 347bp as of todays session, 142bp tighter since the recent peak on October 4, 80bp tighter on the year, and 66bp tighter since end-Jan. By piercing the 350bp-spread level for the first time since early August, the EMBIG spread has now moved to our mid-year target. EM corporates lagged sovereigns in February, returning 2.25% on the month with a 45bp tightening to 390bp (385bp as of March 1), but still boasting a 5.05% year-to-date performance as of yesterday. We maintain our mid-year spread forecast for the CEMBI Broad at 375bp. The GBIEM Global Diversified (USD unhedged) had returned 10.5% as of end-February, following a monthly performance of 2.86%once again largely on the back of EM currency strength. The FX component of the index is 7.6% higher year-to-date, with the currency outperformance most noteworthy in EMEA (just under 10.7%) and Latin America (+8.7%). Valuation in EM is still reasonable. EM FX has retraced 42% from its 1-year strong/weak range, compared to EM equities, which are 65% retraced. Retracement for the EMBIG and CEMBI is 68% and 57% respectively, so also not appearing too stretched. GBI-EM yields in turn have retraced more at 87%, so it is not surprising that they have widened modestly as the rally in global markets paused, in particular as higher oil prices and firm EM growth point to reflation risks. Still, we continue to believe that the pickup of EM yields versus DM yields is a medium-term driver of lower yields in select EM markets. Finally, technical data looks more positive as well, particularly for EM sovereigns.
Inflows remain robust. EM bond flows continue at a steady pace with $798mn of inflows this week, with local currency funds in particular experiencing a pick-up in the US/European retail space. We estimate year-to-date inflows to dedicated EM fixed income at $11bn, with local EM funds now accounting for $1.7bn. Although larger inflows overall continue going to external funds ($680mn) versus local currency funds ($118mn), there was a divergence between US/European funds versus Japanese funds this week. In Japan, the rotation out of local currency (-$338mn) into hard currency (+$249mn) remains in place, while in US/Europe, local funds saw a meaningful pick-up this week with $425mn in inflows, outpacing hard and blend funds (+$401mn and +$61mn, respectively). The last time local inflows exceeded hard currency inflows was four months ago. Our EM Client Survey for February also indicates that investors positions are short versus benchmarks, perhaps due to recent strong inflows. Several of our specific EM recommendations are oriented toward capturing higher energy prices. In EM sovereigns, we have been recommending long Venezuela since August, and the recent run-up in oil has added to idiosyncratic drivers pointing toward regime change to contribute to a 250bp tightening of spreads this year (see below). Our recommended overweight in Russian quasisovereign VEB is also energy related, although the rationale for being long also reflects strong fundamentals and attractive valuations. Within EM corporates, our move to overweight the CEMBI Broad early last month emphasized increasing exposure to European (non-Middle Eastern) oil and gas producers. In local markets, we moved OW the Russian ruble (RUB) and recommended a long RUB versus a basket position in early February and we have also been recommending long the Mexican peso for some time as it has lagged cyclical markets. Though valuations still are rich in the Colombian peso, we move this position to neutral now in part due to the continued rise in oil. To the extent that oil prices feed through further to EM inflation, we like linkers in Brazil and Chile.
Stay overweight Venezuela. Despite a booming 13.7% return for Venezuelas EMBIG sub-index in February and a 21.9% return year-to-date, the prospects of regime change in Venezuela amid 900bp spreads (still the fourth highest in the EMBIG) and rising oil keep Venezuela compelling. Watch for potential issuance to slow the rally, but provide possible entry points.
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Rule-Based Investment Strategies US Fixed Income Markets Weekly March 2, 2012 Ruy M. RibeiroAC (44-20) 7779-2217 J.P. Morgan Securities Ltd.
Special Topic:
Rule-Based Investing Quarterly;
Overweight carry, but look for tail protection 14

with an excess return of 12% and it is up another 12% so far this year. In Special Topic 1, we take a closer look at the portfolio benefit of adding these strategies to standard portfolios of equities, credit and also cross-carry strategies. We believe the current environment is favorable for carry-based or yield-seeking strategies. Our preference is also due to our strategists views that the macro environment will be calmer than last year and that monetary policy will remain on stand by for a while. In Special Topic 2, we update the analysis of a particular bond curve strategy that uses changes in monetary policy as a signal for trading the curve. In this version, we use a bond carry strategy whenever monetary policy is on hold. Investors with diversified exposure to carry strategies across asset classes did quite well last year. A strategy that allocates equal risk to four carry/slide strategies in equities, bonds, commodities and currencies delivered strong performance last year despite the market volatility (Exhibit 2). While we believe that this performance is likely to continue, it is a good idea to consider portfolios of carry and tactical long volatility strategies.
In this publication, we review the performance of RBI strategies. This quarter we also take a closer look at two special topics: 1) the portfolio benefits of tail-risk strategies, and 2) bond curve and carry trading on monetary policy signals In Equities, high dividend yield stocks continue to outperform while still showing unusually negative correlation to other value factors. Low risk/beta strategies remain strong performers In Rates, carry strategies in bonds posted strong performance in 2011 with Sharpe ratios above 1. Bond momentum in Europe was also strong In Commodities, slide/carry strategies finished the year with positive performance but the outlook is challenging as the main markets move into backwardation In FX, carry posted positive returns, but combinations of carry and forward carry had much stronger performance In 2012, the outlook remains favorable for yieldseeking/carry strategies, but tail-risk strategies can enhance returns in the event of macro or geopolitical tail events
Equities
In Equities, high dividend yield equities continued to attract investor interest. While most value-related factors had a bad year, dividend-based strategies were strong last year. Historically, the correlation between dividend yield and book-to-market factor returns (a standard value factor) has been quite high. Using US data since 1927, we find a correlation of around 0.60. But this correlation has recently turned negative, showing -0.07 for 2011 and -0.15 for 20102011. In the US, our dividend yield long-short factor was up 17.5% and globally it was up 22.5%, while most of the other value-related factors posted negative returns. Equity Size and Equity Value lost 5.00% and -0.42%, respectively (Fama-French HML was down almost 7%). Strategies that select stocks using risk-based criteria also had a good year. A strategy that overweights low-volatility stocks within the S&P 500 outperformed the US benchmark index by 12.7% in 2011. Other strong performers were price
Outlook
The demand for tail-risk protection continues to increase. As we pointed out last quarter, the cost of protection can sometimes be quite high, so it is wise to avoid these costs by taking advantage of the shape of the VIX futures curve. Strategies that not only benefit from tail events but also exploit the distortions in the VIX futures curve finished the year with stellar performance (Exhibit 1). Our J.P. Morgan Macro Hedge US Index finished the year
14
This is an abridged version of Rule-Based Investing Quarterly; Overweight carry, but look for tail protection, by Ruy Ribeiro, 02/29/2012. Full publication is available on Morgan Markets.
86
momentum, earning momentum, net analyst revisions and ROE-based strategies. Our simple Short Equity Vol strategy has recovered very strongly since the losses in July and August due to the large difference between implied and realized volatility. But not all versions had poor performance. A version of the strategy with daily-overlapping monthly variance swaps, which uses them in multiple countries and takes positions conditional on the spread between implied and realized volatility, did a lot better avoiding the losses in July and August (Volemont Index). This strategy was up 19.2% last year while the simple US version with monthly swaps was down 1.4%.
Exhibit 1: Tail-risk strategy

400 350 300 250 200 150 100 50 0 Feb-09 Aug-09 Feb-10
J.P. Morgan Macro Hedge US Index (cumulative excess returns)

J.P.Morgan Macro Hedge (JPMZMHUS Index) VXX US Equity VOLT LN Equity
Rates
Bond Carry finished the year with strong performance across strategies: be it long-only or long-short. The long-short cross-market version that trades the 10-year point of the curves using swaps was up 5.2% with a Sharpe ratio of 1.18. A simple bond curve strategy that trades on monetary policy when central banks are active, but switches into money market term premia otherwise, was up 1.8% last year. See Special Topic 2 for more details and analysis of an alternative version. Bund Momentum, a strategy that takes advantage of the serial correlation in the German bond markets, had a very strong year with a Sharpe ratio of 1.77. The other versions did not do as well with modest losses. The low volatility of money market rates, as central banks are committed to a low-for-long policy, is not favorable for money market momentum strategies.
Aug-10
Feb-11
Aug-11
Source: J.P. Morgan, Bloomberg. VOLT LN Equity prior to launch is based on the underlying index.
Exhibit 2: Cross-market carry strategy

Quartet Balanced Index (cumulative excess returns)
104 103.5 103 102.5 102 101.5 101 100.5 100 99.5 99 Dec-10 Jun-11 Dec-11 J.P.Morgan Quartet Balanced
Exhibit 3: Bond curve strategy

120 115 110 105 100 95 90 Dec-09 Jun-10
CurveTrader M+ Index (cumulative excess returns)
J.P.Morgan CurveTrader M+
Dec-10
Jun-11
Dec-11
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Special Topic 1: Benefit of tail-risk strategies

As we pointed out in the last edition, VIX futures strategies that are long VIX futures (but tactically longshort to minimize the carry cost of the long VIX positions) did quite well last year (Exhibit 1, previous page). Here we analyze the portfolio benefit of adding a tail-risk strategy to different portfolios. How do we measure how much to add? In this analysis, we use a simple skewness-based model. One motivation for investing in a tail-risk strategy is to improve the skewness of a portfolio. Tail-risk strategies likely have positive skewness, while equities, credit or carry-based indices tend to show negative skewness. We create a combined zero-skewness portfolio by adding the tail-risk strategy to a portfolio targeting an overall zero skewness and lower volatility. The portfolio is re-selected every day using data available two days earlier, so this is a feasible strategy as we do not use future data. If there are two solutions due to negative coskewness, we pick the one with lowest volatility (not necessarily optimal as it ignores negative co-skewness). We require at least one year of data for estimation and do not allocate to the tail-risk strategy before this period. As the allocation is conservative in the beginning of sample (equities did not seem that negatively skewed in 2006...), we also show the portfolio with a constant allocation to tail-risk rule where the allocation is equal to the average allocation of our dynamic model. We analyzed the performance of this zero-skewness portfolio using the S&P500 and Macro Hedge indices. Exhibit 4 shows that the zero-skewness S&P 500 portfolio has outperformed the standard S&P 500. The Sharpe ratio of the zero-skewness strategy is 0.34 versus 0.08 for the S&P 500 in 2011. Since end-2006, we find that the Sharpe ratio of the zero-skewness strategy was 0.21 versus -0.07 for the S&P 500. The strategy had lower realized volatility than an equity-only investment (21.7% versus 26.8% since 2006). The combination of S&P 500 and an effective tail-risk strategy based on VIX futures is expected to work, but the same is also true for other portfolios with negative skewness. We tested the effect of adding the tail-risk strategy to a high-yield portfolio and also to a portfolio of carry strategies across asset classes. We use the same methodology and find similar benefits. In the credit case, the full-sample Sharpe ratio of the zero-skewness
Exhibit 4: S&P 500 and zero-skewness S&P 500 portfolio

(cumulative excess returns)
150 140 130 120 110 100 90 80 70 60 50 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11
Source: J.P. Morgan, Bloomberg, S&P. We require one year of data to estimate the zeroskewness allocation and allocate zero to tail-risk strategy before that date.
Zero-skewness strategy Original portfolio Average Portfolio
Exhibit 5: High yield and zero-skewness high yield portfolio

170 150 130 110 90 70 50 Dec-06 Zero-skewness portfolio Original Portfolio Average Portfolio
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Source: J.P. Morgan, Bloomberg, Iboxx. We require one year of data to estimate the zeroskewness allocation and allocate zero to tail-risk strategy before that date
Exhibit 6: Cross-asset carry and zero-skewness crossasset carry

130 125 120 115 110 105 100 95 Dec-06 Zero-Skewness Strategy Original Portfolio
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Source: J.P. Morgan, Bloomberg. We require one year of data to estimate the zero-skewness allocation and allocate zero to tail-risk strategy before that date 88
strategy is 1.13 versus 0.50 for the high-yield credit-only strategy. In the case of the carry strategy (risk-weighted portfolio of four carry strategies across asset classes), the Sharpe ratio of the zero-skewness strategy is 1.48 versus 1.03 for the carry-only strategy and 1.04 for Macro Hedge. In all cases, we improve the skewness of the investments.
Exhibit 7: Carry strategy based on monetary policy

210 190 170 150 130 110 90 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10
Source: J.P. Morgan, Bloomberg.
Simple Carry
Macro-based carry
Special Topic 2: Carry and macro in bond curves

Carry-based trades are profitable in many markets across different asset classes, but they are not always profitable. By construction, carry strategies pay off when the markets do not move as anticipated by forward rates or at least the change is smaller than implied by forwards. As no news is good news for carry strategies, this investment approach is particularly interesting when direction is unclear, macro is boring and tail-risks are small. Not all carry strategies are likely to suffer when this scenario changes, but some do. In order to illustrate this point, we revisit a paper published in 2007 that looked at the interaction between bond curve trades and macro conditions in single markets (A simple rule to trade the curve, Panigirtzoglou, 2007). In this paper, a carry-based curve position is implemented whenever we do not see changes in policy rates in the recent past (e.g., past year). Otherwise, the strategy tries to exploit directly the effect of the change in policy rates. We look at a modified version of the strategy, in which we focus on the application to the US and on the 2s-10s segment of the curve, as the 2-year point of the curve is particularly sensitive to changes in policy rates. We apply roughly the same assumptions used in that paper and trade using bond futures with monthly rebalancing. The main difference is that we use a carry-based approach to select which position along the curve where we earn term premium (multiple points of the curve and only select positive carry positions). While cross-country bond carry has done quite well in the past years, single market versions have been more unstable, yet, making carry conditional on macro signals (monetary policy) has been a good idea (Exhibit 7). This shows that single-market carry can be particularly profitable when macro conditions are supportive.
Exhibit 8: Trading the curve on monetary policy

150 140 130 120 110 Macro-based curve trading 100 90 Dec-00
Dec-02
Dec-04
Dec-06
Dec-08
Dec-10
Exhibit 9: Combining carry and curve trading

190 180 170 160 150 140 130 120 110 100 90 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Simple Carry Combined Strategy
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An alternative is to trade the curve when policy is active. In this case, we can add a flattening trade if we have been in a tightening mode, or go for steepeners if the central bank is easing.(Exhibit 8). The natural extension is to combine both ideas and use the macro-driven signal to switch on curve trading when monetary policy is active, otherwise we focus on carry/term premia (Exhibit 9). This version is the one with the highest Sharpe ratio (1.26). There are other approaches that have worked quite well. For instance, one of these approaches is to focus on term premia on the front end of the curve if monetary policy is on standby. As an example, Exhibit 3 shows the performance of the J.P. Morgan CurveTrader M+ index, which uses this alternative approach.
Exhibit 10: Commodity slide

104.5 104 103.5 103 102.5 102 101.5 101 100.5 100 31-Dec-10 31-Mar-11 30-Jun-11 30-Sep-11
Commodities
As we pointed out last quarter, commodity momentum strategies had a mixed year with performance heavily dependent on the particular model used. This is a clear reflection of the lack of a persistent trend in commodity markets. Conditions will remain challenging for these strategies. Commodity Slide, which is long the most backwardated (or least contangoed) point of the forward curve and short the front contract, finished the year with positive returns, but performance has been disappointing since the middle of the year. We have seen a significant change in the shape of the futures curves since early last year (particularly in the oil-related curves) that has hurt the performance of most curve optimizing strategies (Exhibit 10). This move towards backwardation is negative for most versions of the strategy. See Profiting from slide in commodity curves, Ribeiro, 2009 for other versions. Our relative value commodity strategy that uses both equities and futures finished the year down 0.8% while the S&P Global Natural Resources index was down 15.2% (our equity-only commodity index was down only 5.4%) and the S&P GSCI index was up 0.35%
Exhibit 11: FX carry

120 115 110 105 100 95 90 Dec-2010 Mar-2011 Jun-2011 Sep-2011
policy can be a positive going forward. Performance has been strong since the turn of the year. Forward carry, driven by changes in rate spreads, did only slightly better, but the combination of the two ideas worked much better more than doubling the returns of the simple FX carry strategy.
FX
Simple FX carry strategies had a very volatile period in 2H11. The persistence in the monetary
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US Fixed Income Strategy US Fixed Income Markets Weekly March 2, 2012 Srini RamaswamyAC (1-212) 834-4573 J.P. Morgan Securities LLC
Forecasts & Analytics

Interest Rate Forecast
Mar 2, 2012 Mar 31, 2012 1Q12 Rates Effective funds rate 3-month Libor 3-month T-bill (bey) 2-year T-note 5-year T-note 10-year T-note 30-year T-bond Curves 3m T-bill/3m Libor 2s/5s 2s/10s 2s/30s 5s/10s 5s/30s 10s/30s 40 57 171 284 114 227 113 36 83 198 303 115 220 105 43 95 220 330 125 235 110 48 95 220 330 125 235 110 48 95 220 330 125 235 110 0.10 0.48 0.08 0.28 0.85 1.98 3.11 Forecast 0.10 0.40 0.04 0.27 1.10 2.25 3.30 Jun 30, 2012 2Q12 Forecast 0.10 0.45 0.02 0.30 1.25 2.50 3.60 Sep 30, 2012 3Q12 Forecast 0.10 0.50 0.02 0.30 1.25 2.50 3.60 Dec 31, 2012 4Q12 Forecast 0.10 0.50 0.02 0.30 1.25 2.50 3.60
* Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation.
Swap spread forecast*

Mar 2, 2012 Apr 1, 2012 1M Forecast 2-year sw ap spread 5-year sw ap spread 10-year sw ap spread 30-year sw ap spread 25 26 8 -30 25 26 8 -27 May 31, 2012 3M Forecast 24 27 8 -25 Aug 29, 2012 6M Forecast 24 28 9 -22
*Forecast uses matched maturity spreads
91
Economic forecast
%ch q/q, saar, unless otherw ise noted 11Q2 Gross Domestic Product Real GDP Final Sales Domestic Final Sales Business Inv estment Net Trade (% contribution to GDP) Inv entories (% contribution to GDP) Prices and Labor Cost Consumer Price Index Core Producer Price Index Core Employ ment Cost Index Unemploy ment Rate (%, sa) * Q4/Q4 change 1.3 1.6 1.3 10.3 0.2 -0.3 4.4 2.4 6.0 3.1 2.8 9.0 11Q3 1.8 3.2 2.7 15.7 0.4 -1.4 3.1 2.5 4.2 4.0 1.0 9.1 11Q4 3.0 1.1 1.1 2.8 -0.1 1.9 1.3 1.9 2.2 1.0 1.7 8.7 12Q1 2.0 1.9 2.0 6.6 -0.1 0.1 2.3 1.9 1.5 3.3 2.0 8.2 12Q2 2.5 2.7 2.8 8.1 -0.1 -0.2 1.6 1.5 1.5 1.2 2.0 8.2 12Q3 3.0 2.9 2.8 8.1 0.1 0.1 1.4 1.4 1.5 1.2 2.0 8.1 12Q4 2.0 2.1 2.2 6.5 -0.1 -0.1 1.5 1.4 1.5 1.2 2.0 8.1 13Q1 1.5 1.5 1.4 4.5 0.2 0.0 1.6 1.4 1.5 1.3 2.0 8.1 2010* 3.1 2.4 2.9 11.1 -0.5 0.7 1.2 0.6 3.8 1.4 2.0 2011* 1.6 1.5 1.4 7.6 0.1 0.1 3.3 2.2 5.6 2.9 2.0 2012* 2.4 2.4 2.5 7.3 -0.1 0.0 1.7 1.5 1.5 1.7 2.0 -
Financial markets forecast

Financial markets forecast
Credit Spread 10Y sw ap spread* FNCL 4 OAS** 10Y AAA 30% CMBS (2007 vintage)** 3Y AAA Credit Cards fixed** JULI portfolio spread* High Yield Index* Em erging Market Index* Corporate Em erging Market Index (Broad)*
* spread to Treasuries ** spread to swaps
Current 8 -8 215 12 193 623 348 385
Mid-year 2012 9 0 225 11 175 625 350 375
Current S&P* ($) Brent** ($/bbl) Gold** ($/oz) EUR/USD USD/JPY

** 2Q1 quarterly average fo recast 2
Mid-year 2012 1430 112.0 1825 1.34 76
1373 125.5 1721 1.33 82
* S&P 500 fo recast is a year-end 201 fo recast 2
Gross fixed-rate product supply*

350 300 250 200 150 100 50 0 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Agency Corporate MBS CMBS ABS
92
* amount in $ billions
Client surveys
Duration Feb 27, 2012 Feb 21, 2012 3-month average Long 26 17 18 Neutral 60 68 68 Short Changes 13 21 15 21 14 17
Treasury Client Survey

20 10 0 -10 -20 Longs minus shorts
Credit
Corporate Bond Weighting Feb 27, 2012 1.52 Jan 10, 2012 1.48 3-month average 1.43
Cash Position 1.03 0.84 0.97
Spread Outlook 0.94 1.75 1.56
-30 Jan 11
Mar 11
Jun 11
Sep 11
Nov 11
Feb 12
Credit Client Survey

1.8 1.6 1.4 1.2 1.0 0.8 Oct 08 Corporate Bond Weighting
*Corporate bond w eighting index is the ratio of the sum of ov erw eights and neutral positions to the sum of underw eights and neutral positions; the cash position index is the ratio of the sum of high and medium cash positions to the sum of low and medium positions; the spread outlook index is the ratio of the sum of positiv e and neutral outlooks to the sum of negativ e and neutral outlooks. 6 3 7 4 8 5
MBS February 2012 January 2012 3-survey average
Overweight 61% 64% 63%
Flat Underweight 28% 11% 23% 13% 28% 9%
Jun 09
Feb 10
Oct 10
Jun 11
Feb 12
MBS Investor Survey

60% 40% 20% 0% -20% -40% -60% Sep 09 Feb 10 Jun 10 Nov 10 Mar 11 Jul 11 Nov 11 Feb 1 Overweight - Underweight
93
US Fixed Income Strategy US Fixed Income Markets Weekly New York, March 2, 2012
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95
Market Movers
Monday Tuesday Wednesday Thursday Friday
5 Mar
ISM nonmanufacturing (10:00am) Feb 55.5 Factory orders (10:00am) Jan -1.8%
Dallas Fed President Fisher speaks on the economy in Dallas (1:20pm) Dallas Fed President Fisher speaks on the economy in Houston (7:30pm)
6 Mar
7 Mar
ADP employment (8:15am) Feb Productivity and costs (8:30am) 4Q revised 0.8% (0.5%oya) Unit labor costs 2.5% (2.9%oya) Consumer credit (3:00pm) Jan
8 Mar
Initial claims (8:30am) w/e prior Sat 350,000
Announce 3-year note $32 bn Announce 10-year note (r) $21 bn Announce 30-year bond (r) $13 bn
9 Mar
Employment (8:30am) Feb 220,000 Unemployment rate 8.2% Average weekly hours 34.6 International trade (8:30am) Jan -$48.3bn Wholesale trade (10:00am) Jan
12 Mar
Federal budget (2:00pm) Feb
Auction 3-year note $32 bn
13 Mar
NFIB survey (7:30am) Feb Retail sales (8:30am) Feb Business inventories (10:00am) Jan JOLTS (10:00am) Jan FOMC meeting
Auction 10-year note (r) $21 bn
14 Mar
Import prices (8:30am) Feb Current account (8:30am) 4Q
Auction 30-year bond (r) $13 bn Chairman Bernanke speaks in Nashville, TN (9:00am)
15 Mar
Initial claims (8:30am) w/e prior Sat PPI (8:30am) Feb Empire State survey (8:30am) Mar TIC data (9:00am) Jan Philadelphia Fed survey (10:00am) Mar
Announce 10-year TIPS (r) $13 bn
16 Mar
CPI (8:30am) Feb Industrial production (9:15am) Feb Consumer sentiment (9:55am) Mar preliminary
19 Mar
NAHB survey (10:00am) Mar
20 Mar
Housing starts (8:30am) Feb
Chairman Bernanke speaks in Washington, D.C. (12:45pm) Minneapolis Fed President Kocherlakota speaks in St. Louis (5:30pm)
21 Mar
Existing home sales (10:00am) Feb
22 Mar
Initial claims (8:30am) w/e prior Sat FHFA HPI (10:00am) Jan Leading indicators (10:00am) Feb
Auction 10-year TIPS (r) $13 bn Announce 2-year note $35 bn Announce 5-year note $35 bn Announce 7-year note $29 bn Chairman Bernanke speaks in Washington, D.C. (12:45pm) St. Louis Fed President Bullard speaks in Hong Kong (8:00pm)
23 Mar
New home sales (10:00am) Feb
Unless otherwise expressly noted, all data and information for charts, tables and exhibits contained in this publication have been sourced via J.P. Morgan information sources. __________________________________________________________________________________________________________________________ Analyst Certification: The strategist(s) denoted by (AC) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed.

US Fixed Income Markets Weekly

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US Fixed Income Strategy 2 March 2012

US Fixed Income Markets Weekly

Governments Terry Belton, Meera Chandan, Kim Harano, Renee Park

Interest Rate Derivatives Srini Ramaswamy, A. Iglesias, P. Korapaty

MBS and CMBS Matthew Jozoff, Ed Reardon, John Sim, Brian Ye

ABS and CDOs Amy Sze, Rishad Ahluwalia, Maggie Wang

Investment-Grade Corporates Eric Beinstein

High Yield Peter Acciavatti, Nelson Jantzen, Tony Linares

Short-Term Fixed Income Alex Roever, Teresa Ho

Municipals Peter DeGroot, Josh Rudolph

Emerging Markets Joyce Chang, Ben Ramsey

Special Topic: Carry and Rule-Based Investing Ruy Ribeiro

Cross Sector Overview

Exhibit 1: Risky assets rallied again this week

450 400 350 300 250 200 150 100 Jun 11

Source: Thomson Financial, Bloomberg, and J.P. Morgan

Middle East crisis index Brent oil prices

110 4 2 0 Dec 10 100

Exhibit 1: Real consumer spending

Exhibit 2: Nominal disposable income and wage and salary income

Wage and salary income

Exhibit 3: Consumer confidence and equity prices

Nsa, index 1400

60 1190 50 1120 1050

Exhibit 4: ISM manufacturing exports orders and merchandise export volumes

%ch saar, 3m/3m

Export orders Export volumes

Stall in spending probably a soft patch

Surprise: ISM mfg slips, export orders soar

Exhibit 5: Fiscal stimulus

2009 177 0 177 177 1.3

2010 323 92 415 238 1.7

2011 171 266 437 22 0.1

2012 39 247 286 -151 -1.0

2013 44 35 79 -207 -1.3

Fiscal stimulus just beginning to wane

ARRA: American Recovery and Reinvestment Act of 2009

Exhibit 6: Fiscal thrust/drag from stimulus policies

Exhibit 7: Deficit decomposition

2009 -2.1 -1.3 -1.1 -5.7

2010 -8.9 -2.3 -2.9 0.8 -4.5

2011 -8.6 -1.9 -2.9 0.2 -4.1

2012f -7.7 -1.7 -1.8 -0.1 -4.0

2013f -5.6 -1.7 -0.5 0.0 -3.4

Note: structural includes changes in defense outlays

Exhibit 8: Defense outlays

Exhibit 9: Change in defense outlays

1.0 0.5 0.0 -0.5 -1.0

OMB CBO, assuming troops in Mideast operations down to 45,000 by 2015 80 85 90 95 00 05 10 15

And now, the elephant in the room

-10 -15 -20 -25 -30 -35 Nov 11 Jan 12 Mar 12

TU, ED and FV TU and ED

-10 -5 0 5 10 Business days around payrolls release

Exhibit 5: Recent comments by FOMC members

Exhibit 6: J.P. Morgan interest rate forecast

Exhibit 7: Long-end supply concessions have fallen after Operation Twist

0.51 0.50 0.49 0.48 0.47 -10 -5 0 5 10

Business days around Bond auction

Exhibit 8: 4s and 8s look cheap versus 6s

T 2.25% Nov-17 yield 0.69 * 3.25% May-16 0.4 * 3.375% Nov-19; %

Proj. cash balance

Average monthly Treasuries (coupons and bills) purchased by foreigners; $bn