JP Credit Outlook 2010

Europe Credit Research
11 November 2009
European Credit Outlook & Strategy 2010

Adapting to Change
• This year, we have taken a somewhat more thematic approach to Strategy

writing the outlook for the year ahead. Specifically, we believe that a Stephen Dulake AC
Daniel Lamy AC
number of trends have begun to emerge over the past 12 months which Tina Zhang AC
are permanent or quasi-permanent in nature. In a sense then, while we
Derivatives & Quantitative Research
have written with the market outlook for the next 12 months foremost Saul Doctor AC
in our minds, we believe that some of the themes we discuss will likely Abel Elizalde
have a longer shelf life which extends beyond 2010. Economics
David Mackie AC
• In terms of these trends: David Mackie, J.P. Morgan’s Head of ABS & Structured Products
Western European Economics, discusses how an end to the recession Rishad Ahluwalia
does not mark a return to normality; rather, that a significant portion of Gareth Davies, CFA AC
the loss in GDP seems to represent a permanent loss in the level of Autos
Stephanie A Renegar
potential. Roberto Henriques writes how the regulatory capital reform
process is likely to be the major transformational event and represents Consumer Products, Food & Retail
Katie Ruci
part of a wider strategy by governments in terms of creating Raman Singla
mechanisms whereby they ultimately may no longer be forced
Financials
providers of capital of last resort. Gareth Davies looks at the new bank Roberto Henriques, CFA AC
regulatory landscape from the perspective of the secured lending Christian Leukers, CFA
markets; covered bonds are set to move into the ascendancy relative to Alan Bowe
classic securitisation, where we see the costs of issuing and investing Industrials
Nachu Nachiappan, CFA
rising. From a credit strategy perspective, we look at the impact of all Nitin Dias, CFA
of these changes on companies and what this means in terms of Ritasha Gupta
funding and liability management, for both large-cap investment grade TMT
businesses and the leveraged credit universe. The bottom-line is a lot David Caldana, CFA
more bond issuance, and on a multi-year basis. Finally, we examine Andrew Webb
Malin Hedman
the future of credit derivatives and see a resumption of synthetic
Utilities
structured credit activity as one of the ‘wildcards’ for 2010.
Olek Keenan, CFA
• From the perspective of investing in credit markets over the next 12 J.P. Morgan Securities Ltd.
months, we see ourselves transitioning into a low-return environment

after the exceptional gains of this year. Spreads are fairly valued and
our Rates Strategy colleagues see market rates rising modestly over the
coming year. We forecast high grade returns of around 3% and high
yield returns of 7-8%. 2010 is, we think, an alpha year rather than a
beta year for credit markets. However, low return doesn’t necessarily
mean low volatility, in our view. We see the potential for risk markets
to swing from pillar to post next year as market participants oscillate
from fearing inflation to fearing deflation, for example. Against this
backdrop, we think there’s a continued case for implementing tail
hedges.
See page 69 for analyst certification and important disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Stephen Dulake Europe Credit Research
(44-20) 7325-5454 11 November 2009
stephen.dulake@jpmorgan.com
Table of Contents
2010 Executive Summary ........................................................3
Making Money in 2010: It Gets Tougher from Here! ..............5
High Conviction Trades for a Low Return World.................11
A Recovery, but Not a Return to Normality..........................22
The Regulator Strikes Back...................................................26
A Future Secured? The New Rules of the Game for the
Secured Lending Markets......................................................44
The Big Issue ..........................................................................50
High Yield Mark 3: Riding the Refi Wave..............................58
The Future of Credit Derivatives ...........................................65
2
(44-20) 7325-5454 11 November 2009
2010 Executive Summary

AC
Stephen Dulake and Team This year, we have taken a somewhat more thematic approach to writing the outlook
(44-20) 7325-5454 for the year ahead. Specifically, we believe that a number of trends have begun to
emerge over the past 12 months which are permanent or quasi-permanent in nature.
In a sense then, while we have written with the market outlook for the next 12
months foremost in our minds, we believe that some of the themes we discuss will
likely have a longer shelf life which extends beyond 2010.
In terms of these trends: David Mackie, J.P. Morgan’s Head of Western European
Economics, discusses how an end to the recession does not mark a return to
normality; rather, that a significant portion of the loss in GDP seems to represent a
permanent loss in the level of potential. Roberto Henriques writes how the
regulatory capital reform process is likely to be the major transformational event and
represents part of a wider strategy by governments in terms of creating mechanisms
whereby they ultimately may no longer be forced providers of capital of last resort.
This is a major structural change which will impact risk pricing across the entire
bank liability structure. Gareth Davies looks at the new bank regulatory landscape
from the perspective of the secured lending markets; covered bonds are set to move
into the ascendancy relative to classic securitisation, where we see the costs of
issuing and investing rising.
From a credit strategy perspective, we look at the impact of all of these changes on
companies and what this means in terms of funding and liability management, for
both large-cap investment grade businesses and the leveraged credit universe. The
bottom-line is a lot more bond issuance, and on a multi-year basis. We forecast gross
euro-dominated high grade Non-Financial issuance to be €200bn in 2010 and €180bn
in 2011. This is about double the average run over the past decade. For euro high
yield, we forecast €35bn of issuance in 2010. This would represent a record year.
We examine the future of credit derivatives and see a resumption of synthetic

structured credit activity as one of the ‘wildcards’ for 2010. From a market structure
perspective, we believe that most of the document and trading standards changes we
have seen over the past year are done. The market is now likely to focus on further
reducing systemic risk through the use of central clearing. We do not believe that
clearing is the answer to all ills nor that take-up by clients will be a foregone
conclusion.
From the perspective of investing in credit markets over the next 12 months, we see
ourselves transitioning into a low-return environment after the exceptional gains of
this year. Spreads are fairly valued and our Rates Strategy colleagues see market
rates rising modestly over the coming year. We forecast high grade returns of around
3% and high yield returns of 7-8%. 2010 is, we think, an alpha year rather than a
beta year for credit markets. However, low return doesn’t necessarily mean low
volatility, in our view. We see the potential for risk markets to swing from pillar to
post next year as market participants oscillate from fearing inflation to fearing
deflation, for example. Against this backdrop, we think there’s a continued case for
implementing tail hedges.
3
(44-20) 7325-5454 11 November 2009
High Conviction Trades for a Low Return World

We highlight the top trades from the European Credit Research team. We group the
trades under three banners: Macro and Index Trades; Industry and Single Name
Trades; Tranche and Structured Credit Trades.
Macro and Index Trades

• iTraxx payer spread portfolio hedge
• Long US versus Short Europe: Buy iTraxx payer sell CDX payer
Industry and Single Name Trades
Industrials
• Saint Gobain versus CRH relative value switch
• Sappi versus Stora relative value switch
• Lafarge versus Saint Gobain relative value trade
• Top European Chemicals shorts as M&A momentum looks set to accelerate
• Glencore versus ArcelorMittal relative value trade
Autos
• Long risk Selective “280bp+” Auto Credits versus Single-Name Underweights
• FCE versus FMCC relative value switch
Property and Pubs
• Long PEPR risk
• Buy subordinated bonds of Greene King, Marston’s, M&B
Financials
• HSH Nordbank: Ship it in
• Buy Hypo Real Estate Tier 1
• Long RBSG Convertible Preference Shares and UT2
Consumers
• Long risk Brewers Basket Trade
• Long-short Consumer versus Non-Food Retail Basket Trade
TMT
• Long risk KPN versus short TI
• Long risk ITV; short risk Bertelsmann
Structured Credit Trades
• Long cash CLO AAA/first-priority tranches
• Short correlation trade: sell 10y S12 super senior protection delta-hedged
4
(44-20) 7325-5454 11 November 2009
Making Money in 2010: It Gets Tougher

from Here!
European Credit Strategy 2009 in review: good, but it could have been better
AC
Stephen Dulake 2009 was a good year, at least in the context of reviewing the performance of our
(44-20) 7325-5454
high grade and high yield bond model portfolios, as well as our credit derivative or
AC
CD Player model portfolio. To put some perspective on the performance of 2009
Daniel Lamy investment recommendations, our euro and sterling high grade model portfolios have
(44-20) 7777-1875
daniel.lamy@jpmorgan.com
outperformed their respective benchmarks by circa 350bp and 400bp year-to-date;
AC
our high yield model bond portfolio has outperformed by around 450bp; while our
Saul Doctor credit derivatives portfolio has returned about 40% on margin.
(44-20) 7325-3699
saul.doctor@jpmorgan.com
To get a little more granular, 2009 was, as they say, a game of two halves.
Essentially, when we review our performance, we must admit that we took our foot
off the gas far too soon in 2H09. While we were correct to remain defensive through
most of 1Q09, our biggest wins were to add distressed European bank capital in high
grade in early-to-mid March and low-dollar price high yield bonds in early-April.
However, we took profits on these positions far too early. This was especially the
case in Tier 1 bank capital, which we did around mid-year.
Beta was clearly the dominant Despite taking our foot off the gas too soon, we have been able to post positive
influence on our returns through performance throughout the year. Beta – or making the right directional call on the
1H09. Alpha has been the
principal driver of our
market – was clearly the dominant influence on our returns through 1H09. If
performance through 2H09. anything, beta became a net drag through 2H09. Alpha – sector and single-name
credit selection and relative value-focused strategies – has therefore been the
principal driver of our performance through 2H09.
On a broad sectoral basis, we generated considerable alpha from being Overweight

Financials and Underweight Industrials (or Non Financials). Though this has
become a somewhat mature position from the perspective of our model portfolios –
we’ve essentially been positioned this way for all of 2009 – we have been able to
extract incremental value over and above simply being Overweight Financials by
taking advantage of relatively attractive dispersion levels within individual points of
the bank capital curve. The best example of this is how we’ve re-balanced our
Lower Tier 2 holdings throughout the year. Lower Tier 2 has been our single-biggest
sectoral Overweight throughout 2009; initially, we entered the year with our holdings
concentrated in the bullet structures; we subsequently switched into callables; the last
leg to this re-balancing being focused on increasing our exposure to certain credits in
quasi-distressed jurisdictions such as Germany and Ireland.
One alpha opportunity we don't feel we made enough of was the idea of buying
‘bombed out’ Cyclicals. This we highlighted in European Credit Outlook & Strategy
2009, 12 November 2008, as a potential source of outsized returns this year. While
we indeed added some Cyclical risk to our model portfolios in the spring, the simple
truth is the market got more comfortable, more quickly, and with more credits than
we did!
5
(44-20) 7325-5454 11 November 2009
Trades motivated by market Our CD Player portfolio has followed a similar pattern with big wins during 1H09
normalisation have been the being replace by more mixed relative value performance through 2H09. Our
most consistent driver of returns monthly returns have averaged 4.1% on margin during the first ten months of 2009
in our CD Player portfolio.
and the drivers of this can be broken down in to the following themes:
Liquidity and distress normalisation: This has been our most profitable source of
ideas; our strategy has consisted of going long risk highly distressed instruments with
a high illiquidity premium and hedging their credit risk. Some of our trades include:
negative bond-CDS basis trades; junior mezzanine tranches hedged with both iTraxx
Crossover or equity tranches; and curve steepeners in Financials and other single-
name credits (“refinancing steepeners”).
Out-of-the-money hedges: These hedges have allowed us to feel comfortable with
the long risk positions embedded in our portfolio. Some of these hedges include:
iTraxx 3s5s flattener; option payer spreads; and super-senior versus sovereigns.
Even though we likely implemented some of these too soon, we nonetheless still
hold some of them in our portfolio going into 2010; this is a subject we will come
back to.
Relative value trades: Relative value across credit instruments has been one of the
most challenging trading activities during 2009, given the strong, indiscriminate
directionality of the market. Performance on this front has been more mixed. We
have had some successful trade ideas in this space (e.g. LevX versus LCDX, Senior
versus Sub Financials, high yield long short basket) along with some unsuccessful
ones (e.g. Main versus Crossover, Financials versus HiVol).
2010 high grade investment themes

#1 Alpha rather than beta
One of the key themes we highlighted when we wrote the 2009 outlook 12 months
ago was the possibility to achieve equity-like returns on unlevered basis. And so it
has been. According to JPMorgan’s MAGGIE index, high grade corporate bonds
have thus far returned a little shy of 14% in 2009.
At JPMorgan, our preferred However, if the ability to generate these sorts of returns was made possible by the
metric for looking at the balance imbalance between risk and reward 12 months ago, it would seem near-impossible
between risk and reward is for credit markets to repeat this sort of performance over the next 12 months. At
carry-to-risk. On this basis, they
seem evenly balanced as we
JPMorgan, our preferred metric for looking at the balance between risk and reward is
look forward into 2010. carry-to-risk. On this basis, risk and reward seem evenly balanced as we enter 2010
(see Figure 1). The bottom-line is that while we may have taken our foot off the gas
prematurely in 2H09, as we look forward to 2010, we’re not about to step on it again.
Figure 1: High Grade Carry-to-Risk
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0.00
05-Jan-99 05-Jul-00 05-Jan-02 05-Jul-03 05-Jan-05 05-Jul-06 05-Jan-08 05-Jul-09
Source: J.P. Morgan.
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(44-20) 7325-5454 11 November 2009
What’s our best estimate for returns over the coming 12 months? Here, we rely less
on our carry-to-risk framework – which says more about the current state of play in
credit markets – than we do our macro spread model. Given JPMorgan’s
economists’ base-case expectations for the next 12 months, our macro spread model
would put high grade corporate bond spreads little different from where they are
today (see Figure 2).
Combining a forecast that high Our economists have also identified two alternative scenarios for us; an upside case
grade spreads will be little and a downside case. Even when we look at the probability-weighted spread forecast
changed year-over –year with
our Rates Strategy colleagues’
across these three scenarios, the forecast for spreads 12 months forward is again very
view that market rates will rise little different from where they are today. This said, the contours of our economic
modestly, we forecast returns to forecasts, to borrow a term from Bruce Kasman, our Chief Economist, imply modest
drop to 3%. spread tightening in 1H10, followed by modest widening in 2H10. Returning to
what this means in terms of our high grade corporate bond return expectations over
the next 12 months, we note that our Rates Strategy colleagues expect euro swap
rates to rise modestly over the coming year, 5-year rates by circa 25bp. Given this
and current yields of 4%, we forecast high grade corporate bond returns to fall to
around 3% over the coming 12 months.
Figure 2: JPMorgan's Macro Spread Model

bp
250 Base Case (65%)

Upside Case (20%)
200 Dow nside Case (15%)
Actual
150
100
50
0
1999Q4 2001Q4 2003Q4 2005Q4 2007Q4 2009Q4
While we’ve yet to solicit any investor feedback on this 3% forecast for high grade
bond returns, our sense is it will be perceived as being too conservative. We have no
doubt that we will be told about the amount of cash that’s still out there, and of the
inflows that many are still seeing into the various corporate bond funds. Our point is
twofold: firstly, there’s some evidence that inflows are beginning to moderate.
Secondly, supply is expected to remain high, not just in 2010 but also 2011; in this
sense, elevated issuance levels this year were not a one-off. For Non Financials
alone, we expect net bond issuance to be around €100bn in both 2010 and 2011, i.e.
significantly higher than where it has been on average (see The Big Issue in this
publication).
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(44-20) 7325-5454 11 November 2009
#2 Dispersion
If credit investing in 2010 will truly be about generating alpha, then the debate
around market dispersion levels is only likely to grow (see The Dispersion Debate,
21 October 2009).
Figure 3: JPMorgan's Measures of Non Financial and Sub Bank Spread Dispersion
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
2004 2005 2006 2007 2008 2009
Non-Fin Dispersion Sub-banks
Spread dispersion, especially for Our take remains the same; spread dispersion, especially for Non Financials, remains
Non Financials, remains excessively tight and consistent with average spread levels significantly tighter than
excessively tight, in our view.
where they are today (see Figure 3). Not surprisingly, our dispersion-based
investment themes remain the same:
1. We see limited potential for further spread compression, even in the
event that we see the modest spread tightening in 1H10 implied by our
macro spread model; or at least the moment to engage in such a strategy has
passed.
2. While Sub Financial dispersion is hardly generous, we think there's
more to play for in Financials relative to Non Financials; relative
dispersion levels are another reason for remaining Overweight Financials
and Underweight Industrials.
3. For unfunded investors, stay short default correlation. Our preferred
trade involves selling super-senior protection on a delta-hedged basis.
4. Buy protection on formerly wide-spread names. By this, we mean
looking at the single-name credits which previously traded, for example, in
the top-third of the spread distribution, but have now moved out of this area,
to trade among the tighter or average spread names
#3 Out-of-the-money hedges
We’ve previously made the case that investment grade credit is an asset which has
flirted with both tails of the return (or risk) distribution over the past 12 months,
before finally settling back into the body (see, for example, European Credit Outlook
& Strategy, 17 September 2009). Furthermore, this isn’t at all inconsistent with what
we’ve previously said about risk and return being more evenly-balanced in a carry-
to-risk context. Figure 4 highlights the distribution of excess corporate bond returns
over the past decade, with the negative tail populated by data points from December
2008 and the positive from June this year.
8
(44-20) 7325-5454 11 November 2009
Figure 4: The Distribution of Rolling 3-Month Excess high Grade Bond Returns since 2000
35%
30%
25%
20%
15%
10%
5%
0%
-10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5 10.0
Our 3% return forecast for high Our 3% return forecast for high grade returns would seem to suggest that the
grade returns would seem to transition from 2009 to 2010 simply represents a transition from a high- to a low-
suggest that the transition from
2009 to 2010 simply represents a
return environment. That returns are forecast to be moderate doesn’t necessarily
transition from a high- to a low- mean we’re entering a benign, low-volatility environment. Far from it; risk markets
return environment. That could conceivably swing violently next year as participants move from fearing
returns are forecast to be deflation to inflation and vice versa; or in response to the perception that
moderate doesn’t necessarily policymakers are going to get less accommodative and central bank policy rates are
mean we’re entering a benign,
low-volatility environment.
set to rise; or concerns around sovereign solvency and different national
governments' ability to fund themselves.
This is one of the reasons why, as we highlighted earlier, we’ve chosen still to carry
some of the tail hedges we (perhaps prematurely) implemented in our CD Player
portfolio; specifically, an iTraxx Main payer spread trade. However, we think there
are a number of options open to credit portfolio managers, as we discussed
previously in What Are Your Options?, 6 October 2009. Away from payer spreads
on the iTraxx indices, one could consider:
1. An iTraxx Main 3s-5s flattener. Curves have historically tended to flatten

dramatically in an environment of market stress.
2. Buying super-senior protection. This is, in our view, preferable and

cheaper than simply buying protection on tight-spread single-name credits,
as some market commentators have previously suggested.
3. Buying iTraxx SovX protection. Governments are arguably playing a

monoline insurer-like role in respect of the global banking system.
4. Looking at interest rate options. A delta-hedged 3-month straddle on 5-

year swap rates is highly correlated with iTraxx Main.
5. Equity options. S&P 500 puts and payer spreads are the most attractive
strategies, in our view.
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(44-20) 7325-5454 11 November 2009
2010 high yield investment themes

#1 Issuance and rates to put a cap on returns
We think the conditions are in place to make 2010 a record year for euro high yield
issuance, with supply potentially reaching €35bn, compared with a previous high of
€29bn. Aside from the need to fund a record volume, we think that the low all-in
yields on offer will diminish the prospects for future returns and make the asset class
vulnerable to higher interest rates. We think 2010 will be a year for coupon clipping.
The average coupon on October’s €7.35bn of new issues was only 7.3%, a function
of its crossover/BB nature and a shortage of ‘true’ high yield deals; year-to-date BBs
account for 50% of supply. The glut of low yielding bonds looks set to be
exaggerated once more senior secured notes start to materialise, as the new
benchmark for pricing these instruments is likely to start in a Euribor+400-500bp
range with a Euribor floor, we believe. This equates to roughly a 7-8% yield on
fixed rate instruments, the format likely to be favoured by investors.
Figure 5: Ratings Distribution of Euro High Yield Issuance
BB B CCC NR
100%
80%
60%
40%
20%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
#2 Refinancing: risk or opportunity? Own subordinated bonds in good

companies
Although looming principal repayments pose a threat to subordinated creditors of
highly leveraged companies, refinancing can present an opportunity for bonds that
are low down in good quality capital structures, we believe. Junior creditors should
be able to extract concessions such as a cash consent fee and coupon boost in
exchange for extending maturity; a necessary process for the terming-out of senior
debt while preserving the order of repayments.
#3 In the distressed space we prefer Financials to Non-Financials

Please refer to European High Buying distressed bonds was our top trade in 2009, but we feel that valuations have
Yield Update, published 30 in many cases gone too far, spurred by a reach for yield and lack of alternatives. As
October 2009 to see our most
recent portfolio update.
a high beta play we prefer to own certain distressed Financials: we currently hold
Depfa, IKB, and HSH Nordbank LT2. Stressed bonds we do own in our model
portfolio are: Cognis, Impress and Ecobat PIKs, Edcon, and Momentive.
Sectors where we still see negative fundamental trends include Airlines and Paper:
our top Paper shorts are M-Real and Norske Skog, although short-term liquidity at
these companies is not presently an issue. We are also bearish on the more cyclical
Chemicals producers, most notably Ineos because of raw material cost pressure and
new capacity coming onstream. It is probably too early to be shorting other deep
Cyclicals such as NXP, as their operational gearing means that they may benefit from
the macro rebound for a while longer. Our high conviction short in the Autos sector
is Continental.
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(44-20) 7325-5454 11 November 2009
High Conviction Trades for a Low Return

World
European Credit Research Top Trades in the Credit Market
AC
Saul Doctor This section highlights the top trades from the European Credit Research team. We
(44-20) 7325-3699
saul.doctor@jpmorgan.com
group the trades into three main sections: Macro and Index Trades; Industry and Single
Name Trades; Tranche and Structured Credit Trades. In each section, we select a variety
Abel Elizalde of different trades using bonds, CDS and other instruments. For each trade we highlight
(44-20) 7742-7829 the main drivers, rationale and risks. Where relevant, a link is provided for each trade
abel.elizalde@jpmorgan.com
to the original published research note as well as details of the publishing analysts.
Alan Bowe
(44-20) 7325-6281 List of Trades
alan.m.bowe@jpmorgan.com
Macro and Index Trades
Katie Ruci • iTraxx payer spread portfolio hedge
(44-20) 7325-4075
alketa.ruci@jpmorgan.com • Long US versus Short Europe: Buy iTraxx payer sell CDX Payer
Andrew Webb Industry and Single Name Trades
(44-20) 7777-0450 Industrials
andrew.x.webb@jpmorgan.com
• Saint Gobain versus CRH relative value switch
Christian Leukers, CFA
• Sappi versus Stora relative value switch
(44-20) 7325-0949
christian.leukers@jpmorgan.com • Lafarge versus Saint Gobain relative value trade
Nachu Nachiappan, CFA • Top European Chemicals shorts as M&A momentum looks set to accelerate
(44-20) 7325-6823
nachu.nachiappan@jpmorgan.com • Glencore versus ArcelorMittal relative value trade
Nitin Dias, CFA Autos
(44-20) 7325-4760 • Long risk Selective “280bp+” Auto Credits versus Single-Name Underweights
nitin.a.dias@jpmorgan.com
• FCE versus FMCC relative value switch
Olek Keenan, CFA
(44-20) 7777-0017
Property and Pubs
olek.keenan@jpmorgan.com • Long PEPR risk
Raman Singla • Buy subordinated bonds of Greene King, Marston’s, M&B
(44-20) 7777 0350
Financials
raman.d.singla@jpmorgan.com
• HSH Nordbank: Ship it in
Rishad Ahluwalia
(44-20) 7777-1045 • Buy Hypo Real Estate Tier 1
rishad.ahluwalia@jpmorgan.com • Long RBSG Convertible Preference Shares and UT2
Roberto Henriques, CFA Consumers
(44-20) 7777-4506
• Long risk Brewers Basket Trade
roberto.henriques@jpmorgan.com
Stephanie A Renegar
• Long-short Consumer versus Non-Food Retail Basket Trade
(44-20) 7325-3686 TMT
stephanie.a.renegar@jpmorgan.com • Long risk KPN versus Short TI
J.P. Morgan Securities Ltd. • Long risk ITV; short risk Bertelsmann
Structured Credit Trades
• Long cash CLO AAA/first-priority tranches
• Short correlation trade: sell 10y S12 super senior protection delta-hedged
11
(44-20) 7325-5454 11 November 2009
Analyst: Saul Doctor

iTraxx Payer Spread Portfolio Hedge
Date of Entry: 1 Oct-09
Our portfolio strategy is to look for relative value opportunities coupled with
OTM hedges. One such OTM hedge, that we think is very attractive, is payer
The full text of this trade can be spreads on the iTraxx index. Payer spreads are formed by buying a low strike
found in the below report:
option and selling a higher strike option (Figure 6). These option strategies are low
CD Player: Market Themes and cost, but benefit if spreads rise above the lower strike. We analysed these trades in
Relative Value Trade Ideas in the Odds On, where we showed that these trades can be seen as fixed odds trades where
European Credit Derivatives
Market published on 1st October
an investor pays an initial premium for a fixed payout if spreads are above a certain
2009. strike. Relatively wide skew currently makes this trade attractive (Figure 7).
Figure 6: iTraxx Payer Spread Figure 7: iTraxx Main Volatility Skew

x-axis: Spread (bp); y-axis: P&L (‘000) RHS: Skew (%); LHS: Spread (bp)
300 Low Strike Pay er High Strike Pay er 5.0% Volatility Skew (LHS) Spreads (RHS) 250
200 Pay er Spread

4.0% 200
100
3.0% 150
0
2.0% 100
-100
-200 1.0% 50
-300 0.0% 0
90 95 100 105 110 115 120 125 130 135 140 145 1-Jan-09 1-Mar-09 1-May -09 1-Jul-09 1-Sep-09 1-Nov -09
Source: J.P. Morgan. Source: J.P. Morgan.
Long US versus Short Europe

Analyst: Saul Doctor Buy iTraxx Payer sell CDX Payer
As spreads have declined, the differential between iTraxx Main and CDX IG has
narrowed and currently stands at 17bp. While it has widened off the lows, we believe
that this differential should compress further (Figure 8). Options offer an attractive
way to enter this trade as implied volatility in CDX (in bp) is higher than in iTraxx
Main. We buy a Main Payer at 100bp funded by selling a CDX Payer at 120bp.
Figure 8: iTraxx Main vs CDX IG Figure 9: iTraxx Main and CDX Implied Volatility (bp)
Spread (bp) Volatility (bp)
300 CDX IG iTrax x Main 60 10 CDX IG Iv ol bp iTrax x Main Iv ol bp

250 50
8
200 40
6
150 30
4
100 20
50 10 2
0 0 0
1-Jan-09 1-Mar-09 1-May -09 1-Jul-09 1-Sep-09 1-Nov -09 1-Jun-09 1-Jul-09 1-Aug-09 1-Sep-09 1-Oct-09 1-Nov -09
12
(44-20) 7325-5454 11 November 2009
Industry and Single Name Trades

Saint Gobain versus CRH Relative Value Switch
Analyst: Nitin Dias
€ Bonds: Switch out of Saint Gobain July 2014 bonds (Baa2/BBB Z spread
Date of Entry: 26 August 2009
154bps) into CRH May 2014 bonds (Baa1/BBB+ Z spread 172bps)
CRH Plc: H109 update published £ Bonds: Switch out of Saint Gobain December 2016 bonds (Baa2/BBB Z spread
on 26 August 2009.
178bps) into CRH April 2015 bonds (Baa1/BBB+ Z spread 220bps)
European Building Materials Q309 The CRH bonds trade wider despite being better rated and having a 125bps step up
preview published on 16 October
2009.
(only the €bonds) on sub-investment grade downgrade. While we acknowledge that
CRH has a risk of a downgrade to Baa2/BBB, we think at worst it should trade in
line with Saint Gobain; given the step up in the € bonds, we think these bond should
trade inside Saint Gobain.
Both CRH and SGOFP have similar exposure to developed markets i.e. 85% of sales
and limited exposure to emerging markets i.e. 15% of sales. However CRH has a
bigger US (50% of sales vs. 12% for Saint Gobain) and smaller Europe exposure
(50% of sales vs. 73% for Saint Gobain) compared to Saint Gobain. This should help
CRH benefit from the US stimulus package. CRH also has a bigger infrastructure
exposure (30% of sales) as compared to Saint Gobain (9% of sales).
Sappi versus Stora Relative Value switch
Switch out of the Stora senior 2014 bonds (Ba2/BB+ Z spread 343bps) into
Analyst: Nitin Dias
Sappi senior secured € 2014 bonds (Ba2/BB+ 755bps)
Date of Entry: 25 September
We prefer the Sappi to the Stora bonds as while both the bonds are similarly rated
2009
and have similar maturities, the Sappi bonds trade about 400bps outside the Stora
Sappi: Global Presence and bonds. We think Sappi has more geographical diversification, has emerging markets
Improved Capital Structure Drive exposure (through South Africa) and has a less near term maturities as compared to
Value; Initiating at Overweight
Stora. While we acknowledge that Sappi should trade wider than Stora Enso given
published on 15 September 2009
that Stora is bigger in size, has no covenant issues and has much larger liquidity
resources, we think that the current differential is significant and unjustified.
Lafarge versus Saint Gobain Relative Value Trade
Analyst: Nitin Dias Sell protection on Lafarge (long risk 5 year CDS 194bps mid price) and buy
Date of Entry: 9 November 2009 protection on Saint Gobain (short risk 5 year CDS 130bps mid price)
We suggest going long Lafarge (sell protection) and short Saint Gobain (buy
Lafarge Q309 update published on
9th November published on 9 protection) to capitalize on Lafarge’s higher exposure to emerging markets (50% of
November 2009 sales) as compared to Saint Gobain (15% of sales). We think that the outperformance
of emerging markets as compared to developed markets should continue in the near
term which should help Lafarge perform better than Saint Gobain. We also think that
the reduced risks of a Lafarge downgrade should support Lafarge spreads.
13
(44-20) 7325-5454 11 November 2009
Top European Chemicals shorts as M&A momentum looks

set to accelerate
Analyst: Nachu Nachiappan Buy protection on Akzo Nobel at 79bp, BASF at 52bp, Bayer at 52bp and
Date of Entry: 9 Nov 2009 Solvay at 73bp (as at market open on 9 November 2009).
For further information on the We believe that further consolidation is likely in the European Chemicals sector
rationale for this trade, please refer following increased M&A activity in the broader market and Solvay’s recently
to: announced intention to pursue a “sizeable” acquisition target. The combination of (i)
rising valuations, (ii) improving demand dynamics and (iii) the greater desire to
European Chemicals: M&A
reduce cyclicality or consolidate market positions in response to the recent crisis are
momentum looks set to accelerate
published on 13th October 2009. likely to trigger an increasing level of M&A activity. Relatively healthy balance
sheets in the Investment Grade universe leave some companies with reasonable
acquisition firepower, i.e. Akzo Nobel, BASF, Bayer and Solvay, in particular. In
terms of targets, we think that acquirers are likely to focus on structural growth i.e.
GDP++ growth companies and ones that also help to lower cyclicality, but the
scarcity of such assets implies a price.
Glencore vs. ArcelorMittal relative value trade
Analyst: Nachu Nachiappan 1. Sell ArcelorMittal 5-year protection at 275bp (as at market open on 9
Date of Entry: 9 Nov 2009 November 2009).
For further information on the 2. Buy Glencore 5-year protection at 235bp (as at market open on 9 November
rationale for this trade, please refer 2009).
to:
We think that the recent widening in ArcelorMittal’s spreads is overdone and would
Basic Industrials Handbook 2009
once again go long risk. As a hedge against this, we would be short Glencore which
published on 9 September 2009. is 40bp tighter. ArcelorMittal’s recent results and outlook commentary reaffirmed
our view that the steel market recovery is underway. Although, the demand recovery
will likely be more muted than expected in H209, we believe that the industry is
poised for a solid FY10, as inventory channels remain lean and supply discipline is in
place. The market may have been somewhat disappointed with ArcelorMittal’s Q409
guidance (EBITDA in the range of $2-2.4bn vs. our expectations of $2.2bn). Given
the company’s operating leverage to steel prices, sentiment towards the company will
likely rest on the direction of future steel prices. Hence, we are encouraged by the
recent stabilisation in China’s HRC price, which should drive global steel prices
higher. Glencore on the other hand is likely to widen on operational volatility and
new issuance, which we think could be sooner than expected.
Figure 10: LTM 5-year CDS development for ArcelorMittal and Glencore
3,000
2,500
2,000
1,500
1,000
500
-
Nov -08 Jan-09 Mar-09 May -09 Jul-09 Sep-09
ArcelorMittal Glencore
Source: J.P. Morgan
14
(44-20) 7325-5454 11 November 2009
Long Risk Selective “280bp+” Auto Credits vs. Single-Name

Underweights
Analyst: Stephanie Renegar Sell Protection on GKN, Renault and Valeo/Buy Protection on Tomkins,
Date of Entry: 6-Nov-2009 Peugeot, and Volvo
The full text of this trade can be For certain higher-spread automotive names which we call them the “280+ Club”, as
found in the below reports: their 5y CDS spreads are trading at 280bp or wider, we see potential upside versus
the market and other auto names in the next 3 months.
Earnings Drive-By, published on
5th November 2009
Figure 11: European Autos Pair Trade Ideas
Short Risk Long Risk- 280+ Club
Tomkins GKN
Reasoning: Reasoning:
Lack of relative value to Valeo/GKN given slight JPM expects strong improvement in credit profile in
improvement in credit profile versus significant 2010.
improvement at others.
Improvement in NA production/mix may provide further
upside.
Potential refinancing/forward start agreement for 2010
credit line could remove liquidity overhang. Next large
cash maturity is 2012.
Peugeot Renault
Payback from scrapping incentives mean more to Asset-rich nature may provide potential upside: Volvo
Peugeot than Renault given revenue exposure, lack of stake could provide over €2.7bn in proceeds to delever
equity earnings from more global cos. Renault.
Positive commentary out of Nissan (earnings) and
AutoVaz (gov't support) support earnings/limit cash
exposure and potential dividend growth (Nissan div may
be held until 2011).
Volvo Valeo
Strong liquidity, but company's cash flows are risky given Strong liquidity position (EIB loan, covenants changed)
capacity utilization through 2010. supports current valuations.
We think potential ratings pressure in 2010 (currently at Company has outperformed our expectations on
Baa2/s, BBB/n). Ratings mean more to funding than restructuring savings.
typical industrial given finance arm.
FCE versus FMCC Relative Value Switch

Analyst: Stephanie Renegar Switch out of Ford Motor Credit 5y CDS (FMCC) to go long risk FCE Bank Plc
Date of Entry: 6-Nov-2009
5y CDS
Given the relative value between the two entities (FCE CDS is currently 625bp (bid)
The full text of this trade can be
found in the below report: and FMCC is currently 580bp (offer), levels close 9 Nov. 2009) we continue to
recommend going long risk in FCE and using FMCC as a hedge (picking up 45bp).
European HY Update published on
Fundamentally, we believe FCE to have a more solid balance sheet than FMCC (the
6th November 2009.
company is willing to have a 15% Tier 1 ratio, company was 21% at 1H09, versus a
roughly 8% equity/assets ratio at FMCC) that should help to support levels. In
addition, positive news out of the parent should help support FCE bonds/CDS (for
example, improvement in the parent company, through access to capital and ratings
upgrades, should help support FCE levels due to lessening default risk as well as its
liquidity profile through better access to capital. The JPM US Credit rating on FMCC
is currently Overweight.
15
(44-20) 7325-5454 11 November 2009
Long PEPR risk

Buy PEPR € 14s @ 91
Analyst: Olek Keenan
Prologis European Properties has been subject to many credit concerns over 2009
Date of Entry: 29 September
due to its very short-dated maturity profile and concerns around its parent, Prologis.
2009
However, in the last few months it has extended or refinanced a number of loans, and
The most recent comment on this most recently repaid €359mn of CMBS debt ahead of schedule. This progress
trade can be found in the below
combined with a high quality underlying portfolio, progress towards capital raising
report:
and modest corporate leverage of c.55% makes us confident PEPR can return to
PEPR: EGM options published on investment grade over 2010. As such, despite the recovery from “distressed” levels
29 September 2009
this year, we think the bonds will be a strong performer against other strong High
Yield names in 2010.
Buy subordinated bonds of Greene King, Marston’s, M&B
Analyst: Olek Keenan 3. Buy GKFIN 5.702% 2034 @ 65
Date of Entry: 28-Sep-09 4. Buy MARSLN 5.6410% 2035 @ 76
The full text of this trade can be 5. Buy MABLN 6.469% 2032 @ 77
found in the below report:
We believe that the UK pub industry faces a period of painful restructuring and
Greene King, Marston’s Mitchells &
deleveraging due to regulatory change, the need for thousands of small drink-led
Butlers: Initiation published on 28
September 09 pubs to close or be entirely refurbished and excessive leverage that will require
restructuring in some cases. However, we also believe that a clear distinction has
opened between those names focused on financial engineering (Punch, Enterprise
Inns and a number of privately-held names like now-defunct Globe Pubs) which have
seen operating deterioration in their lower quality estates with little improvement in
later 2009. By contrast, these three smaller operators have maintained a strong focus
on investing in the operating businesses, and have been ahead of the curve in
responding to the changing environment for UK pubs.
As a result, and encouraged by the recent reports from all three operators that their
pubs are seeing a stabilization in EBITDA, we believe that these companies will be
the long term strategic winners in the industry. We project that all three can avoid
hitting covenants within their structures on a standalone basis, but note that they have
cash flows outside the ringfence that can be diverted to help maintain ratios if
necessary. In addition, two of the three have already proven access to the equity
market in 2009.
HSH Nordbank: Ship it in
We particularly like the Lower Tier 2 (HSHN € 4.375% 12/17 at 69.5 cents,
Analyst: Christian Leukers, CFA
HSHN € Float 12/17 at 64 cents) instruments, which do not allow for coupon
deferral and have a fixed final maturity date.
Date of Entry: 12-October-09
The full text of this trade can be HSH Nordbank is 85.5% owned by the governments of the City State of Hamburg
found in the below report: and the State of Schleswig-Holstein. The two States raised their stake in July 2009 by
HSH Nordbank: Upgrading to contributing €3bn of new capital, significantly diluting the other stakeholders, JC
Overweight: Ship it in published on Flowers (9.2%) and the local Savings Banks (5.3%). Furthermore, the states also
12th October 2009. agreed a risk shelter of €10bn (after a €3.2bn first loss piece) which may be used to
absorb losses broadly across the loan portfolio going forward.
16
(44-20) 7325-5454 11 November 2009
HSH Nordbank already has a significant amount of grandfathered debt guaranteed by

the States of Hamburg and Schleswig Holstein outstanding, which will amount to
circa €56bn as YE’09. In addition to these guarantees on existing liabilities, SoFFin
has allocated €30bn of funding guarantees to HSH Nordbank of which €17bn has so
far been used, including €9bn guaranteed of bond issuance. Additionally, we note
that HSH Nordbank is also a participant in the Landesbank cross guarantee scheme,
which is also backed by the Savings Banks guarantee scheme.
We believe that the extent of the support shown for HSH Nordbank’s compensates
for the concerns around the cyclical shipping portfolio. We note that the EU in
October 2009 launched an in depth investigation, expressing doubts on the pricing of
this risk shelter, however we not believe this affects our call on the Lower Tier 2
debt.
Figure 12: HSHN LT2: Still a long way from par... Table 1: ...and still cheap relative to peers
100 HSHN € 4.375 LT2 HSHN € Float LT2 Issuer ISIN Issue Price Coupon Call Mtrty
size
80
(m)
60 HSHN DE000HSH2H15 € 750 69.5 4.375% Feb-12 Feb-17
HSHN DE000HSH2H23 € 1,000 64 3m Feb-12 Feb-17
40
Euribor+30
20 BYLAN XS0285330717 € 750 84.5 4.50% Feb-14 Feb-19
WESTLB DE0008079575 € 300 102 5% Dec-15
0
Source: J.P. Morgan. Pricing as of 1pm 9th November.
Jan/08 Apr/08 Jul/08 Oct/08 Jan/09 Apr/09 Jul/09
Buy Hypo Real Estate Tier 1

Analyst: Christian Leukers, CFA We recommend buying the HYPORE € 5.864% perpetual Tier 1 Trust
Date of Entry: 10-November-09 Preferred at 17 cents.
Das Kapital 2.0 : Doubling Down, SoFFin has continued to support the restructuring program for Hypo Real Estate,
published 10 November 2009 announcing the first of two anticipated tranches of capital for Hypo Real Estate
Group on the 4th November. The €3bn tranche, subject to EU approval, is broadly
expected to be followed by a further similar-sized tranche in 2010, to support
HYPORE’s restructuring, rebranding, and downsizing.
Nevertheless despite the bailout and extensive capital support, Hypo Real Estate’s
institutional Tier 1 HYPORE € 5.864 is still trading at circa 17 cents. While we do
not expect the coupon to be serviced in the near future, we believe that coupon
payments on this security are likely to rank pari passu with those on the €1bn Stille
Einlage which SoFFin is contributing to the Deutsche Pfandbriefbank entity as part
of its capital injection. We do not believe the Depfa Bank Plc Tier 1 Trust Preferred
securities, which are attached to the Irish entity, will rank pari with SoFFin's Stille
Einlage. We note that the Trust Preferred securities cannot have their principle value
written down, and that HYPORE is currently projecting to return to profitability in
2012. Nevertheless using a 12% discount rate, the securities are currently projecting
over 6 years of coupon deferral, which we believe is highly unlikely given a
successful restructuring.
17
(44-20) 7325-5454 11 November 2009
Table 2: Hypo Real Estate Group Tier 1's valuations assuming coupon deferrals at 12% discount rate
Valuation given no. of deferrals
Issue Name of instrument Coupon Call ISIN Size Price Status 1 2 3 4 5 6
Date
14-Jun-07 Hypo Real Estate 5.864 14-Jun-17 XS0303478118 € 350 17 Deferring 46 41 36 33 29 26
International Trust I
30-Oct-03 Depfa Funding II LP 6.5 30-Oct-10 XS0178243332 € 400 16 Deferring 48 42 37 32 28 25
21-Mar-07 Depfa Funding IV LP 5.029 21-Mar-17 XS0291655727 € 500 15.0 Deferring 42 37 33 30 27 24
Source: J.P. Morgan calculations, Bloomberg
Long RBSG Convertible Preference Shares and UT2

Analyst: Alan Bowe Buy RBSG Convertible Preference shares Mar 10 & Dec 10, Buy RBSG Upper
Date of Entry: 4-November-09 Tier II securities
Further information can be found in We see opportunities in RBS given the recent price action on RBS subordinated debt
Simply Subordinated, published 4 where investors may have decided to take profits over the uncertainty of coupon
November 2009 deferral. As we mention in our previous note “Simply Subordinated” (04.11.2009)
we view certain instruments in the RBS capital structure as so called "must pay"
Figure 13: RBS 9.5 & NatWest 7.625 instruments given sufficient distributable profits and capital. Given the injection of
Price performance history £25.5bn in B shares to the holding company of RBS, RBSG plc, we believe that the
110
group will have sufficient distributable profits and capital going forward. We believe
that capital is required at the operating company level of RBS plc; therefore in order
90 for RBS plc to have access to this capital, the proceeds from the B shares must enter
70 a distributable account of RBSG plc. Payments on the “must pay” preference shares
mentioned in our note “push” payments of the Upper Tier II securities, thus
50 effectively making the Upper Tier II "must pay" securities.
30
We view the call date on the convertible preference shares to be an effective call due
Dec 08 Apr 09 Aug 09
to the ability of the holders to opt for conversion in to common stock. We note that
RBS GBP 9.500 12-Aug-18 currently the nominal share price is at 25p as mentioned in our previous notes,
NatWest GBP 7.625 29-Jan-10 however, we think that it is possible for RBS to request for a reduction in the
nominal value of the shares to 10p, with 15p being converted into deferred shares to
ensure that the reduction in the nominal value of the ordinary share does not result in
a reduction in the capital of the company. If this occurs at the EGM then it would be
positive for the convertible bonds.
Figure 14: The more liquid preferred bonds

Issue Name ISIN Call Date Ccy Cpn Amt Mkt Price YTP YTC
Mar 00 RBSG Convertible $ Preference Shares US780097AE13 Mar 10 USD 9.118 1000 94.5 9.7 24.7
Dec 00 RBSG Convertible £ Preference Shares XS0121856859 Dec 10 GBP 7.387 200 84 8.8 25.3
Aug 93 RBSG Upper Tier 2 XS0045071932 Aug 18 GBP 9.5 145 84 9.7 12.5
Oct 99 NatWest Upper Tier 2 XS0102493508 Jan 10 GBP 7.625 162 74 10 n/a
Source: Company press release 20.10.2009, prices as of 12:00pm 09.11.2009
18
(44-20) 7325-5454 11 November 2009
Long risk Brewers Basket Trade

Analyst: Katie Ruci and Raman Sell Protection on AB-Inbev, Carlsberg, Heineken 5y CDS, Buy protection on
Singla
the iTraxx Non-Financial index.
Date of Entry: 14-July-09 These are three of largest brewers globally. Robust pricing dynamics, to a large
The full text of this trade can be extent reflecting higher commodity prices, ensured continued top-line growth albeit
found in the below report: at lower levels. Following industry-wide consolidation last year, managements are
European Brewers: Sector Review focused on preserving cash through cost controls, capex cuts and working capital
and Relative Value published on efficiency with clear targets for deleveraging through internal cash generation and/or
14th July 2009. disposals. The trade stands to benefit from the outperformance of these brewers as
compared to the Non-Financials.
Figure 15: Historical Performance of Non-Financials vs. Carlsberg and Heineken

600 Carlsberg Heineken AB Inbev
500
400
300
200
100
0
Oct-08 Jan-09 Apr-09 Jul-09 Oct-09
Long-Short Consumer vs. Non-Food Retail Basket Trade

Short Risk on M&S, Metro and Kingfisher. Long Risk on Imperial Tobacco,
Analyst: Saul Doctor, Katie Ruci
Pernod-Ricard, Heineken and AB Inbev.
Date of Entry: 20-May-09
Since the beginning of the year, Non-Food Retail has outperformed Consumer names
The full text of this trade can be largely due to investors being squeezed out of popular shorts. We believe that the
found in the below report: government stimulus has improved the overall sentiment leading to the tightening.
CD Player: Market Themes and We are bullish on Tobacco/Spirits & Brewers names reflecting deleveraging stories,
Relative Value Trade Ideas in the strong business profiles and cash flow generation, and stable/improving credit
European Credit Derivatives profiles/ratings; yet we remain bearish on the UK non-food retail sector following
Market published on 21st May
2009.
complete lack of any news of improvement in earnings/demand.
We target 50bp of relative outperformance of the long versus short basket.

Figure 16: Long versus Short Histroical Performance
600 Short Basket Long Basket iTrax x HiVol
500
400
300
200
100
0
Oct-08 Jan-09 Apr-09 Jul-09 Oct-09
19
(44-20) 7325-5454 11 November 2009
Long risk KPN versus Short TI

Analyst: Andrew Webb Switch out of TI 4.75% €2014 bonds into KPN 6.25% €2014 bonds
Date of Entry: 23-June-09 Pick up 6bp (ASW) switching into KPN from TI. As TI announced the sale of its
The full text of this trade can be German broadband operations to Telefonica last week, credit spreads rallied on the
found in the below report: back of the widely anticipated announcement. However, we believe the low-hanging
fruit has been plucked, and TI will begin the process of organically de-levering from
European High Grade Telecoms
Update : published on 13th 2.9x (reported financial debt). KPN reported relatively strong Q309 earnings, and
October 2009. affirmed FY09 guidance. The company reported LTM leverage of 2.3x. We note
that KPN 5yr CDS at 59bp (mid) trades 71bp inside of TI at 130bp (mid).
Figure 17: Long KPN vs. Short TI
300
250
200
150
100 115
109
50
0
11-May 11-Jun 11-Jul 11-Aug 11-Sep 11-Oct
KPN EUR 6.25% Feb-2014 (ASW) TITIM EUR 4.75% May -2014 (ASW)
Source: J.P. Morgan
Long Risk ITV; Short Risk Bertelsmann

Sell protection on ITV 5y; buy protection on Bertelsmann 5y
Analyst: Andrew Webb
Based on recent commentary from ITV, ProSieben, TVN, MTG and CETV, evidence
Date of Entry: 14-July-09 that European TV advertising markets bottomed in Q209 is increasing. In our view, a
For further commentary on our long ITV risk versus short Bertelsmann (RTL) risk makes sense as a way to play a
improving view on ITV: recovery theme. We have become increasingly constructive on ITV following the
European High Yield Update: successful refinancing of its near term maturities, significant cost savings, steps to
published on 16th October 2009. address the pension deficit and an improving UK TV advertising market. We note
that Bertelsmann has also taken significant costs out of its business, however RTL
has lost audience share to ITV in the UK and we note German 2008 comps will be
difficult as ProSieben has gained the share of ad spend it lost in 2008 at the expense
of RTL. We also note the persistent headline risk around Bertelsmann making an
offer for ITV (Daily Mail, 10 October). If an offer does eventually materialise, we
would expect a convergence of ITV and Bertelsmann spreads.
Figure 18: Long ITV vs. Short BERTEL
bp
1200
1000
800
600
400 401
200 192
0
02/01/09 02/04/09 02/07/09 02/10/09
ITV 5y r CDS BERTEL 5y r CDS

20
(44-20) 7325-5454 11 November 2009
Tranches and Options Trades

Analyst: Rishad Ahluwalia Long Cash CLO AAA/first-priority tranches
Date of Entry: 08-May-09 Buy European Cashflow CLO AAA/first-priority tranches.
The full text of this trade can be We upgraded to Overweight the generic AAA CLO market on May 8, 2009, when
found in the below report: spreads were 800bp. Our early spread target was 300bp, which has now been
JPMorgan Global CDO Market achieved in the US and is close in Europe (400bp currently). CLO pricing has
Weekly Snapshot published on 2nd dramatically improved as default risk eases, demand meets limited supply, and most
November 2009. recently, as Moody’s ratings review of the sector concludes (in the US, 65%
Figure 19: European AAA CLO downgraded, most only 1-2 notches to Aa, 35% retained Aaa rating).
versus comparable spreads, pre
and post crisis (bp)
We position ourselves for further recovery as CLO spreads normalise and as
AAA CLO investors seek alpha in lagging sectors. On November 2, 2009, we lowered our AAA
1,000
AAA UK Prime RMBS target to 150bp, viewing this as achievable over the course of 2010. Unlike many
800 MAGGIE Credit Index broader markets, it’s challenging to have specific bond picks given the previous “buy
600 and hold” nature of the market and more limited supply, but for new investors we
would advocate first-priority bonds with at least 25-30% remaining default-adjusted
400
par subordination and are managed by repeat managers (3-5 CLOs outstanding, or
200 more). Given the potentially lower liquidity versus broader fixed income
markets, a six to 12 month time frame, at a minimum, is realistically needed.
0
Short Correlation Tranche Trade:
Nov-07
May-08
Nov-08
May-09
Sell 10y super senior iTraxx Series 12 protection, delta hedged

Source: J.P. Morgan Systemic concerns are still priced at very high levels in the tranche market, even
though liquidity conditions have mostly normalised in credit markets. Tranche
correlations look very high in an economic environment where governments and
central banks have mainly focused on systemic risks (e.g. financials) rather than
Analyst: Abel Elizalde
idiosyncratic risks (e.g. corporates). Correlations have started falling already (Figure
Date of Entry: 5 Nov-09 20), but we think they have more room to go as the risk allocated to super senior
The full text of this trade can be tranches should increase relative to the risk allocated to equity tranches (Figure 21).
found in the below report: We prefer expressing our view via delta hedged long risk super senior tranches
Global Tranche Trader and The
due to their lower negative spread convexity. Alternatively, investors can buy delta
Dispersion Debate published on 5 hedged equity tranche protection.
November 2009.
Figure 20: Equity Tranche Correlations – On-the-Run Figure 21: Tranche expected loss ratio – iTraxx 5y On-the-Run
80% CDX IG iTrax x % allocation of index expected loss across the tranche capital structure.
70% 100%
Super Senior ELR
60%
80%
50%
40% 60%
30% Mezzanine ELR
20% 40%
10%
20%
0%
Equity Tranche Expected Loss Ratios
Sep-04 Jan-06 May -07 Oct-08 Feb-10 0%
Source: J.P. Morgan. 10 days moving average. Jan-06 Jan-07 Jan-08 Jan-09
21
(44-20) 7325-5454 11 November 2009
A Recovery, but Not a Return to Normality

European Economic Research The worst recession that Western Europe has experienced since 1950 is now over.
David Mackie
AC The Euro area looks to have expanded at a decent pace in the third quarter. And
(44-20) 7325-5040 although the UK continued to contract through to September, we are confident that
david.mackie@jpmorgan.com the economy started to expand again in the fourth quarter. This expansion in
economic activity is likely to be sustained for the foreseeable future.
However, an end to the recession does not mark a return to normality. The recovery
in demand will be held back by a reduced appetite for debt accumulation by
households and nonfinancial corporates, and tighter lending standards imposed by
banks. Even though interest rates will be held at an unusually low level for an
extended period, there is unlikely to be a powerful credit cycle. An additional
headwind will come from the fiscal side; the need for public sector deleveraging will
ensure a significant and sustained fiscal tightening which will last for several years.
Meanwhile, the supply side of the economy has been severely damaged by the
financial crisis and the deep recession. A significant part of the decline in actual GDP
over the past year looks likely to be a permanent loss in the level of potential. In
addition, the ongoing growth rates of potential GDP are likely to have declined by
around half a percentage point relative to what prevailed before the crisis.
This all adds up to our theme, bouncing towards malaise. Although we expect GDP
to increase in the coming couple of years by more than the consensus, the upswing
will feel very muted relative to the depth of the recession and the magnitude of the
policy support. Economies are bouncing, but a sense of malaise will persist for a
while.
The recession just ending was a very deep one. From peak to trough, the level of
GDP fell by 5.1% in the Euro area and by 5.9% in the UK. Normally after a deep
recession, we would expect a strong upswing, as inventory adjustments end and as
households and corporates discover that they have cut their spending on durables by
too much. The muted cyclical upswing in demand that we anticipate—relative to the
depth of the recession and the magnitude of the policy support—reflects the secular
headwinds from a more cautious attitude toward debt accumulation, deleveraging in
the banking sector, fiscal tightening, and sliding growth potential. These headwinds
will influence the growth dynamic in two ways: first, the underlying trend in income
growth over the medium term will be lower than in the past; and second, the cyclical
dynamic of demand around growth potential is likely to be more muted than usual.
The business cycle upswing typically has two stages. First is a rebound in spending
on durables from depressed levels in response to an improvement in permanent
income expectations, lower interest rates and an easing of credit availability, and a
bounce in output as inventory adjustments end. These changes require some
accumulation of debt, reduced debt repayment, or reduced accumulation of financial
assets. Second, there is a shift to expansion where households and corporates push
spending to new levels by stretching beyond their current incomes in response to
developments in confidence, asset prices and financial conditions. This generally
involves a solid credit cycle.
22
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In the current environment, both of these stages are likely to be affected by the
secular headwinds. On the one hand, there is likely to be a more restrained attitude
toward debt accumulation, reflecting a decline in permanent income expectations,
reduced expectations of rates of return on assets, and an appreciation of the greater
volatility of both incomes and asset prices. On the other hand, even though the
environment for banks is improving, bank lending standards are likely to remain on
the tight side for an extended period. The financial accelerator mechanism whereby
banks are inclined to ease lending standards in response to higher asset prices will be
dampened by a renewed appreciation of the volatility of both incomes and asset
prices. Also, banks are likely to remain cautious as they are gradually weaned off
public support and as they have to respond to a tighter regulatory environment.
Figure 22: Global trade recovering from depressed levels

Index, Global PMI export orders
60
55
50
45
40
35
30
98 00 02 04 06 08
Source: Market
Even though the upswing in demand is expected to feel very muted relative to the
depth of the recession and the magnitude of the policy support, we nevertheless have
a growth forecast that is somewhat ahead of the consensus. There are a number of
reasons for this. First, we are putting more emphasis on the powerful cyclical
dynamics that are at work after a deep recession. For the Euro area, this involves a
strong bounce back in global trade from very depressed levels and a recovery in
corporate spending after severe cutbacks. Second, we believe that saving rates have
moved up by enough to create sufficient free cash flow for households and
corporates to delever should they feel the need to. It is also important to recognise
that the easy policy stance, low interest rates and the expansion of central bank
balance sheets, has eased the pressure to delever in a disruptive way. This is
particularly important for the UK and Spain. Third, we would emphasise that it is the
flow of new credit that matters for demand, rather than the level of bank lending
standards. It is still early days, but access to credit does seem to be improving at the
margin. And fourth, we would stress that the lesson from history is that the malaise
from a financial banking crisis shows up more often than not in a depressed level of
GDP relative to what it would otherwise have been, rather than a depressed growth
rate of GDP once the cyclical trough has been reached.
23
(44-20) 7325-5454 11 November 2009
Figure 23: Euro area bank lending starting to turn the corner
%3m saar
20 Nonfinancial corporate loans
15
10
5
Household loans
0
-5
2004 2005 2006 2007 2008 2009
Source: European Central Bank
One critical feature of the outlook is the impact of the banking crisis and recession on
both the level of potential GDP and its ongoing growth rate. It is widely recognised
that banking crises and deep recessions have lasting implications for the supply side
of the economy. Deep recessions cause premature scrapping of the capital stock, an
erosion of existing labour skills and the discouragement of new entrants into the
labour force. When dysfunction in the financial system is also part of the recession
dynamic, potential GDP can be damaged by less efficient redeployment of resources
from contracting to expanding sectors, and less availability of finance for
productivity-enhancing research and business start-ups. Decomposing the decline in
actual GDP that has been experienced over the past year into cyclical and structural
components, and calibrating how the growth of potential GDP has changed, are
challenging exercises, but they have enormous implications for the outlook for
demand, inflation and monetary policy.
Our approach has been to examine the data on the evolution of actual GDP, various
direct measures of resource utilization and the behaviour of inflation to form a
consistent view of how the output gap has evolved. By definition, the fall in GDP
that is not reflected in a wider output gap represents a permanent loss of potential
GDP. For the Euro area, we estimate that, by the end of 2011, the permanent loss of
output will amount to around 3.4% of GDP. For the UK, the permanent loss looks
larger at around 6.3%. This means that the output gap is smaller than it would
otherwise have been had all of the decline in GDP over the past year been cyclical.
Table 3: GDP, potential output, and the output gap over the last year
Output gap in 2Q08 (%of GDP) GDP since 2Q08 (%) Output gap in 2Q09 (% of GDP) Change in output gap Change in potential
Euro area 1.65 -4.78 -2.88 -4.53 -0.22
UK -0.25 -5.65 -3.46 -3.22 -2.35
Sweden 1.10 -6.46 -3.97 -5.07 -1.31
Source: J.P. Morgan
Nevertheless, there is a significant amount of slack in the Euro area and the UK. In
the Euro area, we would put the output gap at around 3% of GDP, a little wider than
what was seen as a consequence of the recessions of the mid 1970s, the early 1980s
and the early 1990s. Meanwhile, in the UK, we estimate the output gap at around
3.5% of GDP. This is wider than what was seen in the mid 1970s and early 1990s
recessions, but not as wide as what was seen in the early 1980s recession. In addition
to a permanent drop in the level of GDP, our analysis suggests that growth potential
has also fallen, by around half a percentage point. The sizeable output gaps point to
significant disinflation in the coming twelve to eighteen months, with core inflation
rates moving to the edge of deflation. But, the combination of a solid recovery in
demand and a slower growth rate of potential suggests that the current output gaps
will close relatively quickly.
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Table 4: Recession damage to the level of potential output by end-2011

%q/q, saar
% of GDP
Euro area -3.4
UK -6.3
Sweden -4.5
Source: J.P. Morgan
The outlook for demand and supply are significantly different to anything we have
seen before. This is also true for monetary and fiscal policy. Fiscal deficits have got
to very extreme levels. In the Euro area this year we expect a fiscal deficit of 6% of
GDP, while in the UK we expect a deficit of 12% of GDP. Deficits of this level are
clearly not sustainable. While some of the deficit is clearly cyclical, and will unwind
as the output gap closes, there is a large structural component which can only be
eliminated by outright fiscal tightening. We expect this to begin in the UK in 2010,
and in the Euro area a year later. Fiscal tightening is likely to be sizeable and to
extend over several years, which will act as a headwind on demand growth.
Meanwhile, monetary policy has been driven deep into uncharted waters as a
consequence of this crisis. Policy rates are close to zero and central bank balance
sheets have expanded dramatically. At some point both of these dimensions of
monetary policy will need to be normalised, although the timing is likely still some
way off.
The ECB has tried to keep a separation in its mind between conventional monetary
policy (aimed at the inflation objective) and unconventional monetary policy (aimed
at dysfunctionality in the credit intermediation process). This gives a clear road map
for the exit strategy. As financial markets and banks gradually heal, and the flow of
credit is restored, the ECB will allow its balance sheet to shrink. This is likely to take
place during the course of 2010, although the central bank will err on the side of
being too generous in order to guard against exiting prematurely. But, a fading out of
the provision of longer term liquidity and a return to variable rate repos will likely
take place in 2010. Meanwhile, the inflation outlook is likely to remain benign until
at least 2011, so the ECB policy rate is unlikely to rise until then. Having said that,
the shrinking of the ECB’s balance sheet will lift the actual overnight rate (which has
been trading below the policy target) and will steepen the money market yield curve,
both of which could in theory be viewed as traditional monetary policy actions.
In contrast, the Bank of England has viewed quantitative easing as a natural

extension of conventional monetary policy, motivated and calibrated by the objective
of hitting the inflation target. Although presented somewhat differently, this would
suggest an exit strategy similar to the ECB’s: shrinking the balance sheet and then
hiking the policy rate. In actual fact, we believe that the Bank of England will move
on both dimensions simultaneously, and somewhat earlier than the ECB. We expect
the first rate hike to occur in the Autumn of 2010 along with the start of outright gilt
sales. The reason why the Bank of England is likely to move on both fronts at the
same time is that it will be difficult to sell the gilts it has acquired quickly. When QE
ends, the Bank of England will likely own around a third of the conventional gilt
market: thus, its holdings will be large relative to the underlying liquidity in the
market.
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(44-20) 7325-5454 11 November 2009
The Regulator Strikes Back

Banking Sector Outlook: 2010
European Financials Research • In our opinion the regulatory capital reform process is likely to be a
Roberto Henriques, CFA
AC transformational event in terms of the impact on the existing hybrid capital
(44-20) 7777-4506 market. We think Tier I is the part of the capital structure that is most likely to be
roberto.henriques@jpmorgan.com impacted by regulatory change given the concerted push for instruments with
Christian Leukers, CFA greater equity-like features, which we think will result in the introduction of
(44-20) 7325-0949 hybrid instruments with a higher risk profile for investors.
christian.leukers@jpmorgan.com
• Given the move towards greater equity-like features amongst hybrid capital
Alan Bowe instruments, we look at the emergence of ‘super hybrids’ which within the
(44-20) 7325-6281
alan.m.bowe@jpmorgan.com
context of the Commission of European Banking Supervisors is essentially a Tier
I instrument with equity conversion features. Our base case is that these
instruments have a higher risk profile with options that have a higher probability
of being triggered relative to the standard coupon deferral risk and should
therefore carry a higher coupon than existing Tier I structures. We look at
quantifying the probabilities by analysis of probability distributions of bank
solvency indicators for a peer group of large European banks.
• In our opinion the current regulatory process should be seen in the context of
governments that no longer want to be forced providers of capital of last resort
and therefore want to create mechanisms whereby alternative strategies will avoid
the undermining of public sector finances. In the first instance this is achieved by
tightening sector regulation, however the introduction of convertible hybrid
instruments would ensure that there is another capital provider of last resort.
Further, governments may create frameworks that will allow distressed
institutions to fail with minimal collateral damage. It is in this context that we see
the implementation of the 2009 Banking Act in the UK, along with ‘Living Wills’
initiatives. While better regulation should reduce the probability of distress we
think that with these structural changes, the expected loss given distress will
increase for bondholders.
Table 5: Recommendations
Type Recommendation Rationale
Senior Neutral High volumes of expected issuance together with modest absolute yield levels.
Lower Tier II Overweight Preferred part of the capital structure. Limited issuance and issuer flexibility make it attractive.
Upper Tier II Neutral Outlook for limited issuance as part of Tier II capital. Cumulative element supports valuations.
Tier I Issued in 2009 Overweight High back-end spread makes these instruments attractive and increases certainty of call.
Tier I with call in 2010-2011 Neutral Limited incentives to call, however issuance under existing regulatory capital regime should allow for
refinancing of this debt during the transition period to the new regulatory capital framework.
Tier I with call post 2011 Underweight Low back-end spread, which reduces economic incentives and the greater cost of issuance of hybrid capital
under the new regulatory capital regime.
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Bank Capital: How Are We Going to Be left?

Changes to the regulatory In our opinion the evolution of the regulatory capital framework will be a
capital framework will likely be a transformational event for the sector in 2010. We expect to see the culmination of the
transformational event for the
sector in 2010
various initiatives in terms of the redefinition of hybrid capital, with the most
relevant and immediate of these being the implementation of the Capital
Requirements Directive undertaken within the context of the Commission of
European Banking Supervisors (CEBS). While there are a wide range of forums
spanning the G20 and Basel Committee for Banking Supervision, we note that there
appears to be a very consensual approach with regard to the process of regulatory
capital reform. To this extent we highlight the consensus surrounding higher
minimum capital requirements as well as higher quality constituents of capital, with
greater emphasis on hybrid instruments that have greater equity-like features.
We note a growing awareness of We think it is important to understand the context of the current regulatory reform
the failure of existing hybrid process and the guiding principles that will be applied in terms of defining the future
capital instruments in providing
issuers with the required degree
structure of regulatory capital. We think one of the key factors for this reform
of financial flexibility in distress process is the growing awareness of the relative failure of existing hybrid capital
instruments to provide issuers with the required degree of financial flexibility in
situations of distress. To this extent we note a certain disappointment with the current
generation of hybrid capital instruments given that they failed to provide issuers with
flexibility when most required, for reasons including the moral suasion of investors,
ineffective language in bond documents and the limited degree of loss absorption
provided. We note that most of the existing hybrids only provide loss absorption
effectively in the case of insolvency, which would have been an extremely
unappealing outcome for the sector. Hence, we expect that the current regulatory
reform process will address the perceived ‘lack of bite’ of the current generation of
hybrid capital instruments.
Figure 24: Bank Capital - Expected Structural Changes

Senior debt Funding, not capital Senior debt
Subordinated debt Tier III

(Short Dated) (Trading book only) Dated
Subordinated Dated ‘Super
Debt Hybrids’
Subordinated debt
Loss Absorbing
Lower Tier II
(Dated, often with a call) (Max 50% of Tier I)
Subordinated debt
Hybrids
(Qualifying dated with onerous language)

Upper Tier II
(Max 100% of Tier I) Undated ‘Super
Junior subordinated debt Innovative Tier 1 Hybrids’
(Undated with cumulative coupons)
Innovative Tier I
(Up to 15% of Tier I capital) Tier I
(At least 50% of total
Non-innovative Tier I capital)
Ordinary shares & retained
earnings
Ordinary shares & retained
(At least 50% of Tier I)
earnings (At least 50% of Tier I)
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The evolution of new classes of We think that there will be an emphasis on not only upgrading the current generation
hybrid capital may be driven by of bank capital instruments with more equity-like features, but also looking to
the fact that governments do not
want to be ‘on the hook’ in a
increase the absolute level of capital that banks will have to hold. In addition, we
time of distress think there will be pressure to allow more sources of ‘equity capital of last resort’
and effectively substituting the role that governments have played over the last 12-18
months. Given the complete failure of private markets to provide capital to the
banking sector at critical points, governments were obliged to intervene and
recapitalise the sector with often very negative consequences for public finances. We
therefore think the potential evolution of hybrid instruments with equity conversion
is a step in this direction by creating a mechanism that will effectively allow a bank
to raise higher quality capital in distress situations. It is in this context that we see the
evolution of what is currently defined as ‘super hybrids’ within the context of the
CEBS proposals.
As a result of these guiding principles, we think there will be several key outcomes
within the context of a simplification of the regulatory capital structure, namely;
• Collapsing of the intermediate tranches of the existing regulatory capital structure

that are deemed to offer very limited strength and flexibility to an issuer’s
solvency levels. Amongst these we would highlight Tier II capital, with particular
reference to dated subordinated instruments.
• Creation of a new class of bank capital that has equity conversion features, such
as ‘super hybrids’ within the context of the CEBS proposals. Given the potential
for these instruments to convert into the most deeply subordinated part of the
regulatory capital structure, we think that it is secondary where these instruments
will be initially placed within the capital structure at issuance.
• Introduction of explicit loss-absorption features for hybrid Tier I instruments.
Table 6: CEBS Proposals for Hybrid Capital Reform
Guidelines Comment
Permanence • Instruments with incentives to redeem (moderate step-up, principal stock settlement) are innovative and limited to 15% limit.
• No reclassification of innovative into non-innovative if not called.
• Supervisory approval to take account of capital, liquidity risks and business plan to ensure positive business development.
• Buy-backs, in general, subject to redemption requirements and not before 5 years unless replaced.
Flexibility of payments • Payment of coupons or dividends on hybrids can only be taken out of distributable items.
• Supervisors may require cancellation of coupons taking into account distributable items, solvency, risks, business plan to ensure
positive business development.
• Dividend pushers and stoppers acceptable provided issuer has significant flexibility to cancel payments. Dividend pushers must be
waived if in breach of capital adequacy or supervisor requires cancellation due to financial and solvency situation.
• ACSM only if issuer has full discretion to defer and must be settled without delay using core capital instruments.
Loss Absorbency • Statutory or contractual provisions to make recapitalisation more likely by reducing future outflows to hybrid holders by potentially
making a permanent or temporary write-down to principal, conversion into core capital when operational losses lead to significant
reduction of reserves impacting solvency position.
• Loss absorbency should be considered with other measures such as a rights issue.
Limits • Super hybrids (35-50%) must be convertible into core capital either in an emergency situation or at any time by the supervisor or by
the issuer.
• Mandatory conversion may be accepted.
• Emergency situation such as when significant losses result in capital adequacy breach.
• Conversion ratio must be set at issue (as a maximum) and may be reduced if share price increases, but cannot be increased if
share price decreases.
Source: J.P. Morgan, EC
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‘Super Hybrid’ Capital

The trend towards greater We think that the proposal to create ‘super hybrids’ is entirely consistent with the
equity-like features in hybrid philosophy behind the reform of the existing regulatory capital framework, with a
capital should lead to the
emergence of 'super hybrids' as
clear trend towards instruments that contain greater equity-like and loss-absorbing
a new asset class features. Under this approach, the introduction of options to convert hybrid capital
instruments into equity would be a logical development. In addition, the issuance of
these instruments would also meet the objective of creating anti-cyclical capital
buffers which could be deployed when most required by the institution. Within the
framework that is being discussed by CEBS, ‘super hybrids’ are essentially Tier I
instruments with the conversion feature triggered by reference to a solvency metric.
In our opinion these instruments raise a wide range of considerations with regard to
the existing framework of hybrid capital instruments, which will have material
consequences for both issuers and investors.
The Role of Traditional Hybrid Instruments Undermined

The equity conversion option in In our opinion the potential emergence of super hybrids as an asset class may
super hybrids makes traditional, potentially undermine the role of traditional hybrid capital instruments in the
legacy hybrid Tier I's redundant
regulatory capital framework. This is a result of the fact that the option to convert the
Tier I instrument into equity capital effectively makes the remaining optionality in
the Tier I instrument redundant. To this extent we highlight that many of the options
that are otherwise built into Tier I such as coupon deferral and extension were
devised to replicate the features of equity such as flexibility of dividend payments
and the fact that equity is undated. Consequently it would appear to us that the
inclusion of such optionality into an instrument that in any case can convert into
equity, would seem to be complete over-engineering. Why replicate equity
characteristics when you can ultimately convert to equity if required?
An overlay of equity conversion Further, we think that the equity conversion options are likely to be struck at a level
features on a traditional Tier I that would imply that they would trigger ahead of any of the remaining options with
platform would imply that this
option would effectively ‘knock-
the hybrid capital structure. If, hypothetically, a ‘super hybrid’ had to be struck with
out’ much of the underlying a 5% core Tier I trigger level, this would effectively represent a higher solvency level
options by triggering earlier than the traditional coupon deferral options which generally refer to Tier I ratios of
4%. Effectively striking a conversion option with a core Tier I of 5% will likely
imply the issuer has a corresponding Tier I ratio of 6-7%, depending on the amount
of non-core components of Tier I capital the issuer would have outstanding. As a
result, we would likely have a situation where the ‘super hybrid’ would convert while
the institution would have a Tier I ratio of 6-7%, whereas the traditional hybrid Tier I
would only trigger coupon deferral if the Tier I ratio below the minimum 4%
threshold. Essentially we see the introduction of conversion features into deeply
subordinated instruments as an overlay which will effectively ‘knock-out’ the
remaining options within these instruments. It is therefore our assumption that the
super hybrids should therefore carry a higher risk premium than existing Tier I
structures.
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We think that potentially In Figure 25 we contrast the greater probability of a conversion trigger based on a
regulators could be agnostic as core Tier I ratio versus a traditional coupon deferral trigger which will reference a
to the capital platform on which minimum Tier I capital ratio. The probability of the different options being triggered
super hybrids are issued
will be measured by the greater surface area under the respective curves. Given that
the overlay of the conversion option would effectively render redundant most of the
remaining options within the existing hybrid capital structure, we think that
regulators could potentially be agnostic as to the platform on which the conversion
features are placed. Note that in this analysis we have ignored the optional deferral
outcomes for coupon deferral given the resistance that issuers have shown to using
these mechanisms during the current crisis, with external pressures from the
European Commission ultimately forcing deferral outcomes.
Figure 25: Option Triggers: Conversion Strike versus Coupon Deferral Strike
%
0.12
0.1
0.08
Cumulative probability
of hitting Core Tier I
0.06 trigger is greater than
the current minimum
capital requirements
0.04
Current 4% Tier I
0.02 minimum
requirement
Core Tier I Trigger
0
4% 5%
Cumulativ e Probability Core Tier 1 Tier 1
Loss Absorption: In More Ways Than One

Loss absorption is provided in One of the features that regulators would ideally like to build into the construct of the
first instance by the conversion new hybrid capital regime would be the ability to absorb losses, an area where
into an asset class that can empirical evidence has shown the current generation of hybrids to provide limited
absorb losses
value to issuers. We note that ‘super hybrids’ would be in a position to provide
greater scope for loss absorption, not only in the context of being converted into
equity but also given the stock price at which they are likely to be converted. On the
latter point, we think that a conversion price that is struck at issuance will imply an
immediate loss absorption feature for super hybrid note-holder.
Loss absorption would also Our view of immediate loss absorption upon conversion is based on our expectation
work given the mechanics of the that there will be a high degree of correlation between the trigger solvency metric
strike on the equity conversion and the institution's stock price. We would expect that the course of events that
would lead to the solvency position being eroded such as large scale losses would
also result in severe pressure on the stock price as the institution's status as a going
concern would be questioned. As a result and on the assumption that the strike for
conversion would have been set at issuance, it is likely that there would be
significant loss for the super hybrid holder upon conversion given that the prevailing
market price would be materially lower.
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Figure 26: Immediate Loss Absorption for Super Hybrid Note Holders Upon Conversion
%
% 140 9 %
Stock Price Core Tier I ratio
8
120
7
100
6
80 5
60 4
Loss for note holder =
Strike level - Market 3
40
level at conversion 2
20
1
0 0
1 2 3 4 5 6
Issuers – put your money where In our opinion, the key risk driver is the conversion price, which is likely to cause
the conversion price is! tension between the interests of shareholders and bondholders. The most favorable
outcome for shareholders is to have the conversion price defined at issuance, whereas
bondholders would prefer to have the price determined at the time of actual
conversion. Given that all issuers will necessarily state that they will manage their
solvency ratios in order to avoid conversion and that this will remain a very low
probability outcome, we would challenge issuers to allow these instruments to
convert at the prevailing market price. Surely, if such an event remains beyond the
realm of possibilities then issuers could endeavor to make the product more attractive
to potential investors. We note that this would be an optimal outcome for
bondholders given that if conversion had to occur at the distressed price level then
potentially the bondholder could merely sell the delivered equity at the prevailing
market price and recover his initial bond par value.
Super hybrids would also Conversely, shareholders would benefit from conversion options struck at issuance
change the existing relationship given that the issuer would be able to raise equity in a less dilutive manner than
between subordinated debt
investors and shareholders
doing a rights issue at distressed levels. Under this scenario the issuer would be able
to raise capital equal to the sum of the notional value of the super hybrids by
effectively issuing a smaller volume of shares (Notional / Initial Stock Strike) than
they would be otherwise able to do in the market (Notional / Current Stock Price),
and this on the assumption that the current stock price on conversion will be much
lower than the conversion strike price. This would imply a change in the existing
order of play where effectively hybrid debt investors have been relatively insulated
from financial distress by other providers of capital at a more subordinated level,
either through rights issues or government-sponsored capital injections. The
emergence of ‘super hybrids’ as an asset class would in our opinion subvert the
normal course of action, which has seen subordinated investors generally being better
off than shareholders during the resolution of distressed situations in the financials
sector.
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Changes in Stakeholder Behavior

Super hybrids provide an As we have noted above, the existence of ‘super hybrids’ in the capital structure will
alternative ahead of the last tend to change the relationship between subordinated debt investors and
resort: Government capital
injections
shareholders, with cash calls less likely to have a positive response before the ‘super
hybrids’ are effectively converted. We also think that there could be impacts on a
wider range of stakeholders amongst which we would include governments. Over the
last 18 months we have witnessed an unprecedented degree of state intervention in
the global banking sector, with governments effectively becoming the provider of
capital of last resort. In a scenario where ‘super hybrids’ had to form part of the
capital structure, we think that governments would have less incentive to intervene
and would in all likelihood let the conversion mechanism work before considering a
bailout. Hence we think that there is a lower likelihood of government intervention in
the first instance given that convertible hybrid instruments will almost replace state
intervention as the provider of last resort. To a certain extent this mechanism can
almost be seen within the context of a debt for equity swap commonly seen amongst
corporate sector restructurings. However, as we have seen previously the conversion
price mechanism is likely to make such outcomes more favorable to shareholders.
Governments would also achieve one of their objectives of avoiding the punitive cost
of bailouts on public finances. We also note other legal mechanisms and frameworks
that may be implemented in order to allow governments to avoid costly banking
sector bailouts. In the section Senior Debt – Neutral we look at the impact of these
alternatives on the risk profile of the sector.
Corporate Actions
Issuer discretion in conversion While investors may take comfort from the fact that there will be a relatively simple
may be a risk for ‘super hybrid’ and transparent mechanism for conversion, we would look at the possibility of the
noteholders
trigger metric being subject to variation as a result of corporate actions that the issuer
may undertake. While it may appear that the issuers would have no discretion in
terms of triggering the actual conversion, we think that is less true given that an
issuer’s strategy with regard to capital management will ultimately decide conversion
outcomes. We think that while management may provide guidance as to the
possibility of maintaining the solvency metric comfortably above the trigger level,
this may change as the result of longer term growth strategy, which would include
potential M&A activity.
Any cash funded acquisition For instance, in the event of an issuer making an acquisition which would be entirely
which would pay a significant cash funded for an asset or business with a significant premium above book value,
premium over book value would
be sufficient to trigger a
this would likely result in a material weakness in both the core Tier I and Tier I
conversion option solvency ratios. This would be the result of goodwill which would be generated by
the acquisition, with the cash funding not generating any compensating capital. The
triggering of the conversion option would then imply that capital in the form of the
‘super hybrid’ would then be made available to the issuer. We think that under these
circumstances ‘super hybrids’ represent a cheap option on a rights issue for the
issuing bank. Furthermore, we also highlight that the solvency metric will also be
impacted by the development of risk weighted assets, and that an aggressive
downward migration of the asset base would result in downward pressure on the
solvency metric and increasing the probability of conversion.
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Gap Risk
Conversion risk is difficult to Having optionality that is tied to a solvency metric brings with it a wealth of issues
manage given that the trigger for the investor base. Firstly, the solvency metric will tend to be a discrete, and for
metric will be a discrete and the most part, unobservable variable that the issuer will only make public in line with
rarely observable metric
their standard reporting requirements. As such, this opens up these options to a
significant degree of gap risk which will leave the note holder unable to hedge the
associated market risk. Hence, we expect that the infrequency of data points may
make the management of the risk profile of these instruments more complex.
However, we acknowledge that as with most idiosyncratic credit blow-ups, there is
rarely a gradual deterioration in solvency metrics and more often than not, a low
probability high severity event may result in the triggering of the option before any
remedial action can be taken. We also note that the element of gap risk in the
triggering will imply that there are likely to be points of discontinuity in the pricing
of the ‘super hybrids’, as their valuation should react fairly rapidly as the
probabilities of conversion increase exponentially. Exiting or hedging positions in
such instruments may be problematic.
Conversion Option Valuation

We think that independently of Given our view that the conversion option embedded within ‘super hybrids’ will
the choice of host instrument for effectively override the remaining optionality within traditional Tier I instruments,
the conversion option, the risk we assume that the risk premia for these instruments should be higher than that of
premia should be higher than
that of existing Tier I
traditional Tier I instruments and will tend to approximate that of equity. While we
instruments note that the conversion option may be effectively embedded in any part of the Tier
II or Tier I part of the capital structure, we think that this will not change our
assessment of the risk profile of these instruments and we would still look to risk
premia higher than that of existing Tier I instruments. The complexity of valuing
‘super hybrids’ relates to the difficulty in assessing the probability of the option
being triggered, given that the trigger metric is a discreet and non-observable
variable. We also note that the pricing of the ‘super hybrid’ is likely to be driven by a
range of variables that also happen to be correlated amongst each other, namely:
Solvency Ratio: The value of the conversion option will be determined by the strike
and the relative degree of volatility of the solvency metric. In terms of trying to
gauge the probability of the trigger level being hit we would assume a normal
distribution for this variable using available time-series sector data.
Stock Price: While variations in the stock price will not have an impact on the
probability of the option being triggered, we highlight that it will impact the expected
loss given conversion for the note holder. This is a result of the conversion price
being fixed at the time of issuance, and any movement away from this level will
impact the value of the stock which will be delivered to the note holder upon
conversion.
Ratings: Given our assumption that ‘super hybrids’ have a higher risk profile than
traditional Tier I instruments, we expect that these instruments will invariably have a
lower rating than existing Tier I instruments. This could potentially place ‘super
hybrids’ closer to non investment grade, even from higher quality European issuers.
We would also raise the possibility that ratings agencies may have better visibility on
the solvency ratios of banks, and as such may change ratings in light of any
variations to the probability of conversion. Hence ratings will in our opinion have a
higher degree of volatility than standard Tier I instruments.
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So What Is the Probability of a Low Probability Outcome?

Assuming a normal distribution Given our base case assumption that a ‘super hybrid’, independently of being
for bank solvency variables, we overlaid on a dated or perpetual format, will have a higher risk profile than a
can derive cumulative
probabilities of trigger ratio
traditional Tier I instrument, we still need to ascribe a probability to this outcome
being breached occurring. To this extent we have take a time-series data sample of the Tier I ratios
for a universe of ten large European banks since 1999. Performing an analysis on
how their Tier I ratios evolved through time allows us to approximate the probability
distribution to a normal distribution. While we have statistically tested for this
assumption of a normal distribution, we intuitively think that a normal distribution is
a realistic assumption. Banks will generally have a target capital ratio which will
become the mean and the mode of the distribution and subsequently through time
deviations from this ratio will occur due to the dynamic process of internal capital
generation, dividend distributions or losses. Given that variations from the mean
occur we would expect banks, either through rights issues or share buy-backs, to
correct these deviations from their target capital ratio. Having generated a
representative normal distribution based on the data sample, we can then determine
the cumulative probability of the bank hitting specific pre-determined ratios.
Figure 27: Tier I Probability Distribution – Cumulative Probability of Figure 28: Tier I Probability Distribution – Cumulative Probability of
Tier I < 4% Tier I < 6%
% %
0.25 1.1 0.25 1.1
1 1
0.2 0.9 0.2 0.9
Cumulative Probability
Cumulative Probability
Probability Density
Probability Density
0.8 0.8
0.15 0.7 0.15 0.7
0.6 0.6
0.5 0.5
0.1 0.4 0.1 0.4
0.3 0.3
0.05 0.05 10.03%
0.2 0.2
0.1 0.1
0 0 0 0
1.25%
0 2 4 6 8 10 12 14 16 18 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Given our assumptions of the Using the probability distribution that we derived from our sample data, we note that
probability distribution for Tier I the cumulative probability of a bank having a Tier I ratio below 4% is 1.25%. While
ratios, the cumulative
probabilities of a bank having a
this is a relatively low probability outcome, we note that within the context of the
Tier I ratio below 6% are 10.05% current regulatory capital reform, the optionality within ‘super hybrid’ capital is not
only likely to be struck at a higher absolute ratio but is also likely to reference core
Tier I ratios. If, for example, the conversion option would be struck at a core Tier I
ratio of 5%, this would imply that for a bank with a 100bp of non-core Tier I the
equity conversion would effectively happen with the bank having a Tier I ratio of
6%. Given our assumptions of the probability distribution for Tier I ratios, the
cumulative probabilities of a bank having a Tier I ratio below 6% are 10.05% based
on our data sample. Clearly, by shifting the trigger levels higher the probabilities
have increased more than proportionally. We think that this empirical evidence
supports our initial view that the conversion optionality overlaid on any part of the
capital structure will tend to knock out any of the existing options and become the
single most relevant driver in terms of valuing the instrument.
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(44-20) 7325-5454 11 November 2009
Regulatory capital reform will We would however highlight that there may be weaknesses with this approach,
imply a material shift in terms of which uses historical data referent to a prior regulatory capital regime where issuers
the minimum regulatory levels,
which will have the effect of
were allowed to have lower absolute levels of capital. The current proposals with
shifting our normal probability regard to regulatory reform will in our opinion imply a material shift in terms of the
distribution to the right minimum regulatory levels, which will have the effect of shifting our probability
distribution to the right, with a higher mean in terms of solvency ratios. However,
our view remains that the introduction of conversion features will tend to increase the
risk profile of hybrid capital instruments.
How ‘Super’ Are ‘Super Hybrids’?

Notwithstanding the issues that we have raised with regard to the asset class, we
think that this is a potentially viable alternative for banks meeting enhanced capital
requirements. We also think that ‘super hybrids’ would meet many of the objectives
that regulators have with the current process of regulatory capital reform. We
highlight the key considerations on the asset class from a wide range of stakeholders.
Regulators
Regulators will prefer the Given the relatively lower degree of success of existing hybrid instruments in
flexibility and transparency of providing issuer flexibility in distress situations, we think that ‘super hybrids’ will
‘super hybrids’ relative to
previous generations of hybrids
provide a higher quality alternative in terms of loss-absorbing capital that can be
deployed when required. Additionally, the relative degree of transparency will imply
clearer outcomes in potential distress situations with the immediate conversion of all
existing instruments. This would avoid some of the unexpected outcomes where
coupon deferral language has been rendered less effective by the existence of parity
pusher language and other mechanisms that undermine coupon deferral outcomes.
We think that these asymmetric outcomes would have irked both the regulator and
the European Commission over the course of the last year. The relatively simplicity
of the conversion mechanism would avoid these situations and would give greater
certainty of outcomes.
Issuers/Shareholders
Super hybrids allow issuers to Given the higher capital requirements that the regulatory reform process will be
raise high-quality, non-dilutive pushing towards, we think that the possibility of raising non-dilutive, high-quality
capital as well as minimizing the
impact of dilution in a situation
regulatory capital will be an important incentive for issuers. We think that ‘super
of distress hybrids’ may provide issuer flexibility in coping with the negative impact on
shareholder return metrics of higher capital requirements. In order to demonstrate
this negative impact we have a taken a sample of four major European banks and re-
calculated historic RoE on the assumption that higher capital requirements would
have been in place. Given that minimum solvency metrics are likely to migrate
towards the 8-10% range we have estimated the resulting RoE that would have been
achieved by a peer group based on historic earnings. The implications are fairly
material from a shareholder perspective and would suggest that ‘super hybrids’
would be a viable way of issuers supporting their equity performance metrics. While
this simplistic analysis ignores the fact that business decisions and asset allocation
would have been vastly different under more stringent capital requirements, it
nonetheless does give some color as to how higher regulatory capital requirements
could affect issuers and shareholders.
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(44-20) 7325-5454 11 November 2009
Figure 29: The Impact of Higher Capital Requirements on RoE

%
30.0% 26% 25% 25% 25%
25.0% 22%
19% 20% 21% 21%
20.0% 17% 16% 16% 16% 16% 15%
15% 12%
15.0% 7%
15% 16% 18% 16% 10%
10.0% 14% 12% 11% 13% 13% 13% 13% 12% 7% 13%
10% 10%
5.0% 9% 8%
5% 5% 6%
0.0%
2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008
Unicredit
BBVA Barclays BNP
R oE (as reported) RoE (with 8% Core Tier 1) RoE (with 10% Core Tier 1)
Issuers can lock in the cost of In terms of the relative advantages for shareholders, we also note that by striking the
distressed capital raising on conversion option upon issuance, effectively the issuer is minimizing the potential
very favorable terms
dilution impact of capital raising in distress situations. Effectively the issuer is
locking in the cost of a rights issue on very favorable terms. While it may be a
secondary consideration for the issuers, we note that the existence of a clear trigger
would remove some of the pressure that issuers would sometimes be subject to with
regard to optionality where they have a degree of discretion. Witness the pressure
that some banks have felt in terms of servicing or calling subordinated debt, which in
most instances has only been superseded by pressure from the European
Commission.
Bondholders
The main issue for credit As we have noted with the regard to the structure and pricing of the risk of ‘super
investors will be that of hybrids’, these instruments may present issues for the traditional hybrid capital
investibility
investor base. Essentially the degree of proximity to equity may limit the range of
potential investors. In the first instance we think that this product is more likely to
appeal to a retail or equity investor base. For retail investors, we think that the appeal
of a large coupon will be decisive factor, with these investors unlikely to try to
assimilate the inherent risks of the asset class. We also think that equity investors
may find the product interesting for particular names where the equity story may be
less compelling and may therefore prefer to lock in a yield that may be above the
expected dividend yield. We also think that amongst credit investors, it is more likely
that unconstrained investors invest in this asset class.
We think that the involvement of While the above-mentioned investors may represent a reasonable proxy for the
institutional investors will be key potential investor base, we think that these constituents are unlikely to provide
for the market
sufficient depth and breadth to allow it to develop into a stand-alone asset class. The
key towards achieving this would be to make the product investible for traditional,
institutional investor base, which may imply that the features of the product need to
be tweaked in response to the constraints that these investors face. We think that it is
also worth remembering that when the current generation of hybrid Tier I
instruments first developed in 2000, it was also seen as a relatively exotic, off-
benchmark instrument before becoming a major asset class in its own right. The
reasons why Tier I flourished was that it generated a higher return for options that
were deemed to be clearly out of the money. We would not bet against history
repeating itself!
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Non-Convertible Loss Absorbing Tier I

In our opinion loss-absorbing Given some of the issues that may be raised in terms of finding an appropriate investor
Tier I may be a more acceptable base for hybrid capital instruments with conversion features, we would look to
compromise in terms of meeting alternatives such as the introduction of loss-absorbing features into the existing hybrid
regulator and investor objectives
Tier I framework as a more broadly investible product. Essentially, such loss absorbing
Tier I instruments would be similar to German deeply subordinated hybrid capital
which in addition to coupon deferral, also allows for the write-down of the notional
value of the bond in line with income statement losses for the full year. Hence, upon the
realization of a full year loss for the bank, this ‘loss amount’ is apportioned on a pari-
passu basis between equity and eligible hybrid capital instruments. In subsequent years
when the institution returns to profitability, subsequent positive results are allocated to
writing the notional value of the instruments back up to par ahead of paying dividends.
German Tier I may serve as the We note that amongst the current generation of hybrid capital instruments, it is only
template for loss-absorbing Tier really the loss-absorbing Tier I instruments issued by German banks that have
I, however we expect that there functioned to provide issuer flexibility. Importantly, these instruments seem to have
should be restrictions on
reserve allocations which have
adhered to the principle of ‘loss sharing’ being championed by the European
been done historically to Commission in its intervention amongst institutions that have benefited from bail-outs.
mitigate principal impairments While we think the structure of the German Tier I offers is more effective, we highlight
some of the flexibility open to the German banks in terms of allocating reserves to the
income statement so as to avoid principal impairment of these instruments. We expect
that with the German Tier I serving as a potential template for the loss-absorbing Tier I
structures, such reallocations of resources should necessarily be curtailed in order to
give greater effectiveness to this mechanism.
Objective and transparent As a result, we think that loss-absorbing Tier I offers a more broadly acceptable
triggers and investibility for alternative for an investor base given that there is potentially no requirement for a
credit investors are important conversion feature. Essentially, the write-down of notional allows the instrument to
considerations
behave like equity, without fundamentally changing its substance as a fixed income
instrument. Crucially for investors, they can recoup par on the instrument in subsequent
years when the issuer is profitable, assuming that default does not occur. From a
regulatory perspective, the transparency of an instrument which reacts to income
statement losses would be preferable to existing instruments which arguably need more
extreme outcomes to trigger such as a regulatory capital event. Additionally income
statement metrics serve as an objective trigger and would remove pressure on the issuer
to avoid negative outcomes for bondholders. To this extent we think that such loss,
absorbing instruments driven by clear and objective criteria in terms of the trigger
mechanisms (income statement loss rather than vague, amorphous concepts such as
‘balance sheet reserves’ or ‘distributable resources’) would make this more effective
from a regulatory perspective. Notwithstanding the relative advantages of such loss
absorbing instruments, we note that they do not replenish the solvency position of the
issuer, unlike ‘super hybrid’ instruments would provide for upon conversion.
Super hybrid and non- Given these considerations, we think that there is scope for both ‘super hybrid’ and non-
converting, loss absorbing Tier I converting, loss-absorbing instruments within the future regulatory capital structure in
will both have higher risk premia detriment of the existing generation of hybrid instruments. We have laid out our
in comparison to legacy hybrid
Tier I instruments
rationale for assuming that ‘super hybrids’ should have a greater risk premium than
traditional hybrids in terms of the greater probability of the conversion option
triggering. Similarly, for the loss absorbing, non-convertible hybrids we also expect a
higher risk premium given that the probability of triggering will also be higher than that
of traditional hybrid Tier I for the simple reason that there is a greater probability of an
institution having a loss in any given year than of there being some type of regulatory
insufficiency event.
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Capital Structure Recommendations

Our views and recommendations We highlight that our views and recommendations on the subordinated bank capital
on the subordinated bank capital market is very much the result of the transitioning to a new regulatory capital regime
market is very much the result of
the transitioning to a new
where the obvious outcome is that it will become more onerous for banks to issue
regulatory capital regime deeply subordinated hybrid capital instruments. This is a recognition that an
immediate impact of the regime change will be how issuers interact with the market
given the greater cost of issuing hybrid capital, or at the very limit, the inability to do
so. Additionally there are typically less subordinated parts of the capital structure
where we expect that there will be fewer incentives for issuance, which will also
impact our view on these asset classes.
Tier I
Tier I is the part of the capital We think that the Tier I market will be the most impacted by the regulatory capital
structure which will be most reform process given that is the asset class that will have the most change in terms of
impacted by regulatory change
product development. Our conclusion is that these changes will impact the ability or
the willingness of the issuers to refinance existing Tier I instruments as they reached
their call date. We therefore think that these considerations should necessarily have
an impact on the relative attractiveness of these instruments. As we highlight in a
recent publication ‘Hybrid Theory - The Future of Hybrid Bank Capital’ dated
October 20, 2009 we see the existing Tier I market as being split into three
categories.
Legacy Tier I Issues with Call Post 2011: Underweight

Economic rationale will dictate In our opinion, legacy capital instruments that have been issued pre-2009 will most
that post-2011 Tier I bonds will likely extend for two key reasons. Firstly, we note that the economic incentives are
not be called
not very compelling for issuers to call these instruments at the first call date given the
relatively low post-call spreads. Secondly, we also think that independently of the
economic costs, the introduction of a new regulatory capital regime will also imply
that it will become more challenging to issue new hybrid capital instruments as
replacement capital given that banks will most likely be accessing a more limited
investor base. As a result, the natural consequence would be an extension of the
current generation of instruments beyond call date. Importantly we note that issuers
will continue to benefit from regulatory treatment for these instruments through an
extended period of grandfathering.
Legacy Tier I Issues with Call between 2009-11: Neutral

Opportunistic issuance of Tier I Given the likely timeframe in terms of the introduction of a new regulatory capital
instruments up until the framework, we think that potentially some of the opportunistic issuance currently
definitive implementation of
regulatory change, will
done in the market will be with a view to refinance some of the legacy hybrid capital
potentially allow some issuers to instruments that reach their first call over the next 12-18 months. As a result we note
refinance the pre-2012 that some of the hybrid capital instruments that reach their call during this transition
instruments period may in fact be called, given that issuers will have the ability and flexibility to
refinance these instruments. We therefore reflect this outcome for the relatively short
call Tier I instruments that can be refinanced and are therefore more likely to be
called.
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Figure 30: Hybrid Tier I Capital: Impact of Regulatory Change

Bp, Issuance in €bn
Is s uance Tier I Bonds with Firs t Call
€bn
40 100% Grandfathe re d
35
30
Regulatory
25
20
15
20%
10 10%
Grandfathe red
5 Grandfathe re d
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 … 2030 … 2040
bp A v erage Pos t Call Spread of SUSI
Economic
1000 A v erage Pos t Call Spread of New ly Is s ued Tier 1's
500
0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
BUY HOLD SELL
Ne w is s ue s Bonds w ith call date s during this pe riod
New Tier I Issues Pre Regime Change: Overweight

In our opinion new issues in The new issues that are currently being undertaken are in our opinion the optimal
legacy format are the most point of the Tier I market, and where we think that there is value for investors.
attractive part of the capital Structurally these instruments have two important advantages over the legacy
structure
structures as well as the new regime hybrid capital instruments. Firstly, relative to the
legacy hybrid capital instruments, the new structures will have much higher post-call
spreads, which in our opinion will imply a higher probability of call and which will
in turn have an impact on how these instruments should be valued. Secondly, in
structural terms these instruments will also be more investor-friendly given that they
will not include more equity-like features and loss-absorption language, which is
likely to characterize the new generation of hybrid instruments.
Upper Tier II – Neutral

Upper Tier II: many risks for In our opinion Upper Tier II sits in a relatively uncomfortable position given that it is
investors with few benefits for Tier II capital and hence of less importance in the new paradigm of regulatory bank
issuers
capital. However, being issued as a potentially perpetual instrument with the ability
to defer coupon, it carries with it the risks for which investors would demand a high
premium in compensation. Hence, this would imply that issuers would have to pay a
relatively high premium for an instrument that is going to have more limited utility in
the new regulatory capital framework. We therefore envisage that issuance of these
instruments should be extremely limited, to the extent that this would most likely be
an asset class that is effectively in run-off mode.
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The liability management We think that this view is potentially corroborated by the fact that Upper Tier II was
process has shown that the part of the capital structure that experienced the highest proportion of liability
regulators see limited value in
Upper Tier II instruments
management exercises, reflecting that regulators have been content to sanction the
retirement of these instruments in return for a smaller capital gain. Hence, this would
imply that regulators also see limited application for the asset class going forwards.
For all these limitations with regard to future relevance, we highlight the cumulative
element of coupon deferral, which should insulate the investor from greater loss
scenarios. We therefore see some value for investors given that issuers may have less
incentive to keep these instruments outstanding.
Lower Tier II – Overweight

We believe that dated Under principles likely to be espoused by the current regulatory reform process we
instruments should no longer be think that Lower Tier II capital will be excluded given its dated format and limited
deemed part of the regulatory
capital structure
ability to contribute towards the loss absorbing capability of the issuer’s capital base.
In our opinion, there is unlikely to be a large volume of issuance within this asset
class given that regulators have been relatively clear that dated capital instruments
should no longer be considered part of the capital structure, as per recommendations
in the Turner Review. Apart from the restrictions from a regulatory perspective we
note that issuance of Lower Tier II has become relatively inefficient for issuers given
investors’ higher perception of extension risk. Under these circumstances, most
issuers would actually have to market Lower Tier II in bullet format, as opposed to
the more efficient callable structure, which allows an issuer to call the instrument
prior to when regulatory amortisation undermines the value of the instrument.
Weaker business case for Additionally we note that there tended to be greater volumes of issuance when the
issuance combined with the effective premium for Lower Tier II was only marginally greater in absolute terms
inefficiency of bullet format will
undermine the rationale for
versus that of senior bonds. Hence, the issuance of Lower Tier II instruments
future issuance combined funding utility with the benefit of regulatory capital treatment. This is
clearly no longer the case and there is a material premium for issuing subordinated
over senior instruments, with this premium being increased by the capital
inefficiency of the bullet format. We also note that the business case for the issuance
of Lower Tier II instruments may be undermined by some of the structural changes
which we are witnessing in the sector with the unwind of the bancassurance model.
Effectively, we think that some of the Lower Tier II issuance was previously
undertaken to mitigate the regulatory deduction of insurance operations. Given the
large scale divestment of insurance operations, we think that there will be less scope
for the future issuance of Lower Tier II instruments. In addition we think that if
regulators change the bank capital framework to the extent that only high quality Tier
I components are given regulatory treatment, we can also envisage a scenario where
the mechanics of the various regulatory deductions are also revisited. Potentially,
given that Tier II capital is perceived to be of lower regulatory value it may not make
sense to allow it to absorb deductions in lieu of Tier I capital.
Potential scarcity value with Given these considerations, which we think will contribute to a scarcity value for an
limited issuer flexibility makes asset class that offers very little in the way of flexibility for issuers, we remain
Lower Tier II very attractive -
Overweight
Overweight and see value in an instrument that for all intents and purposes is really
just subordinated senior debt. The only time where we would not want to buy Lower
Tier II would be in an environment where default probabilities would be high given
the low expected recovery rate outcomes for the asset class.
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Senior Debt – Neutral

We think that the regulatory While the regulatory reform process will not have a direct impact on senior debt
reform process will have an given its status as a funding tool, we do expect that there will be significant indirect
impact on senior debt given the
change in the perceived sector
impacts with regard to the overall risk profile of the asset class. On an entirely
risk profile superficial basis, one could argue that the net result of the regulatory capital reforms
would be to lower the risk profile of the sector. It stands to reason that the fact that
banks would have higher capital buffers would imply that the senior bondholders
would have a higher degree of subordination below them and would therefore be
better insulated from adverse outcomes. In our opinion this is not as straightforward
as it may appear at first sight and wider considerations on regulatory reform have to
be taken into consideration as well. We will explore the concept of lower sector risk
within the confines of the new regulatory framework, before looking at the technical
factors that will necessarily have an impact in terms of our recommendation on the
sector.
Low Probability of Distress, but Greater Expected Loss Given Distress

The bottom line is that To explain the above statement, we have to look at the context of the current
governments do not want to be government intervention in the banking sector and the motivations to change the
on the hook for future bank
bailouts
regulatory framework. While the initial objective will be to reduce the probability of
future distress we think that governments and regulators alike may look to create
mechanisms that minimise the potential burden on public finances of future bailouts.
We think that over the last 18-24 months public finances have been stretched as a
result of the costly interventions in the banking sector to the extent that there is a
broad recognition that such outcomes should be averted in future and that alternative
methods of dealing with distress in the sector should be contemplated.
Legislative frameworks will look The best example of this would be the approach taken in the UK with the 2009
to create the mechanisms for Banking Act which effectively creates the legal framework to deal with failures in
banks to be able to fail in an
orderly manner
the banking sector. Under this legislative framework effectively there are
mechanisms that allow for an intervention with a view to selectively split the assets
and operations of the distressed bank. The best example of such an intervention
would be Northern Rock where potentially viable core operations funded by retail
deposits will effectively be segregated from remaining operations which in turn will
be put in run-off. Crucially this will potentially result in negative outcomes for the
entire wholesale funding structure, both senior and subordinated which remain
attached to the ‘bad bank’. These types of interventions represent a more efficient
way of government intervention in the sense that the entire liability structure is not
bailed out and that there is greater ‘loss sharing’ amongst the various stakeholders.
Importantly, this implies that government support is only required for the operations
that are deemed viable and hence the failed part of the institution can be put in run-
off with the remaining stakeholders shouldering the losses. Some governments would
think that this would represent better ‘value for taxpayers’.
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‘Living Will’ provides the In tandem with these initiatives we highlight the push towards institutions having
roadmap to selective bailouts ‘Living Wills’ which will effectively provide the roadmap for the orderly unwind of
permissible under the 2009 distressed institutions. Hence, while the 2009 Banking Act provides the legal
Banking Act
framework that allows for selective bailouts amongst distressed institutions, ‘Living
Wills’ provide the specific framework for intervention at each institution and make
these easier to execute. The relevance of ‘Living Wills’ is such that they seek to
make the selective bailout as practical as possible given the relative complexity of
most major European banks, both in terms of legal structures and functions. In our
opinion even with these two elements in place, the split of a failing institution into a
‘good bank/bad bank’ will be a non-trivial strategy to implement. What is more
likely to happen is that there may be a carve-out of problem or non-strategic assets
with wholesale debt instruments, either senior or subordinated, being carved out as
well. If this happens, the net result is the cost of the bailout is minimized as public
resources are not used to support losses from problem assets or the bailing out the
bank’s entire liability structure.
The implicit value of the Under these circumstances, we think that investors may have reassess the value of
'government put' will have to be the ‘government put’ in a situation of distress. Hence, this brings us to the view that
reassessed by investors even while the probability of distress may be lower for the banking sector as a result of a
for senior debt
tighter regulatory capital framework, we think in the event of distress the expected
loss for bondholders will potentially be greater given that government intervention
may not necessarily work according to established patterns. Under these
circumstances we think this should have an impact on the pricing of risk even for the
senior part of the liability structure. A potential outcome would be that a wider
implementation of such measures internationally may result in investors no longer
having a ‘cannot fail’ view of senior debt even for large, systemically relevant
institutions. Consequently, banks could see a generalized increase in risk premia
attached to senior debt, which would encourage more efficient risk pricing of the
sector with the weakening of the implicit ‘government put’. We highlight this as an
important structural change in terms of how future government intervention
could be undertaken in the banking sector.
We maintain a Neutral recommendation on Senior debt more in light of the
main technical factors than due to the fact that this is a step change in
government and regulatory strategy which we actually think will be a longer
term consideration for risk pricing in the sector. The main technical factors that
we think will have an impact are issuance, absolute yield levels and structured credit
dynamics.
Figure 31: FIG Maturities
$Bn
Senior Covered Capital Govt-Gtee Subordinate
1,400
1,200 1,139
977 Average maturity

1,000 895 (2000-2008) : $899bn
800
600 539
400
301
200
0
2009 (Oct-Dec) 2010 2011 2012 2013
Source: J.P. Morgan. Source: DCM Analytics as on September 20, 2009; issuance in all currencies and markets by issuers with parent
nationality of operations as Germany, Austria, France, Benelux, Sweden, Finland, Norway, Denmark, UK, Ireland, Spain, Portugal,
Greece and Italy, exclude ABS, MBS, SSA’ss and public finance institutions.
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Issuance
Above average redemptions We expect that senior issuance will be maintained at a relatively high level during the
imply above average issuance course of 2010 bearing in mind that the level of redemptions is higher than average.
As we note from Figure 31: FIG Maturities, redemptions for the financials sector is
expected to be $1,139bn, which places it comfortably above the average level of
overall redemptions over the 2002-08 period with the bulk of these redemptions
being in senior funding. As a result of the potential for heavy supply we think that
valuations may be vulnerable, particularly at the longer end of the curve with
European banks that are long liquidity attempting to lengthen their duration profile
which had been shortened during the market crisis.
Absolute Yield Levels

Nice spread, disappointing yield While senior spreads may still look quite attractive compared to the historical
average, we note that on a yield basis returns look far from satisfactory with the
current yields from the asset class being very modest compared to the average
historical levels. While it may seem counterintuitive to refer to the ‘all in’ yield as a
factor in the attractiveness of the sector given that credit investors will be spread
focused, we think it is still relevant within the context of an asset class that has seen
buying from non-traditional credit investors, who may find the current yields as
distinctly disappointing. Lower demand from these non-traditional investors may
make it more challenging to refinance an above-average supply pipeline.
Figure 32: Maggie Senior Spread versus Average Figure 33: Maggie Senior Yield versus Average
Bp %
350 8
Maggie Senior Spread Average Spread Maggie Senior Yields Average Yield
300
7
250
6
200
5
150
4
100
50 3
0 2
Sep 00 Sep 02 Sep 04 Sep 06 Sep 08 Sep 00 Sep 02 Sep 04 Sep 06 Sep 08
No Structured Bid
Tight spread levels in 2004-06 A naïve interpretation of the spread chart above would imply that a combination of
are not the norm, rather an spread reversion together with a more robustly capitalised sector must surely imply a
aberration caused by structured return to much tighter level. We have already highlighted that the tighter regulatory
credit
environment is not necessarily a 'win-win' for investors and that there may be adverse
consequences in terms of changes to future government intervention in the sector.
We also highlight that one of the reasons which took spreads tighter was the impact
of structured credit activity, particularly in synthetic format which took CDS spreads
visibly tighter with a similar impact on the cash market. While we have no doubt that
markets have very short memories and can already feel structured credit bankers
straining at the leash, we think that it is unlikely that there would be a repeat of this
phenomenon. We therefore think that spread evolution for the banking sector and
spreads has to be seen within the context of material structural changes which have
occurred in the interim and which would render comparisons with previous levels as
redundant.
43
(44-20) 7325-5454 11 November 2009
A Future Secured? The New Rules of the

Game for the Secured Lending Markets
ABS & Covered Bonds Dichotomy lobotomy
Gareth Davies, CFA
AC 2009 has been a year of contrasts for Europe’s two secured funding markets, with
(44-20) 7325-7283 both the securitisation and covered bond markets starting the year in a state of
gareth.davies@jpmorgan.com unprecedented dislocation (primary market closure, distressed trading, deteriorating
Divergent paths for Europe's two
performance of the European consumer, further exposed to the vagaries of the rating
secured funding markets… agencies, and buffeted by regulatory surveillance).
…with covered bond markets ‘up

From the same starting point however, benchmark covered bond issuers from core
and running’… issuance jurisdictions started to tentatively place transactions with investors (albeit at
historically wide spreads) – slowly prising the market open. This initial issuance
trickle turned into a steady stream come the ECB’s decision to participate in the
market in May. Since then, issuance volumes have improved significantly (Figure
34) approaching levels comparable to those in more ‘normal’ years (YTD €152bn),
while spreads have tightened in notably (Figure 35), with prices for bonds from core
issuance jurisdictions rapidly approaching pre-crisis levels (although names from
more peripheral countries still offer significant basis to pre-crisis prices).
Figure 34: Covered bond issuance*, €bn Figure 35: Covered bond spreads, bp
500 Total issuance 200 1 - 3 Asset Sw ap Spread ECB purchase
3 - 5 Asset Sw ap Spread
5 - 7 Asset Sw ap Spread programme
400 150 7 - 10 Asset Sw ap Spread announced
10+ Asset Sw ap Spread
300 100
200 50
100 0
- -50
01/08
03/08
05/08
07/08
09/08
11/08
01/09
03/09
05/09
07/09
09/09
2002 2003 2004 2005 2006 2007 2008 2009 YTD
Source: J.P. Morgan Covered Bond Research. * Publicly issued benchmark transactions only Source: J.P. Morgan Covered Bond Research
…while securitisation markets European securitisation markets however have taken a more anaemic approach to
remain ‘stalled’ resuscitation – with much of 2009 characterised by the now familiar structure-to-repo
merry-go-round. According to our estimates, four deals amounting to some €5.5bn of
bonds have been distributed to investors year-to-date, while a further €347.7bn of
bonds have been created and retained by originators (Figure 36) – highlighting the
disparate fortunes of the two secured products.
Figure 36: European ABS issuance, €bn Figure 37: European AAA RMBS spreads, bp
1000 Public Retained 1400 Italy Spain Netherlands UK Prime
1200 UK NCF UK BTL Ireland
800
1000
600 800
400 600
400
200
200
0 0
01/08
03/08
05/08
07/08
09/08
11/08
01/09
03/09
05/09
07/09
09/09
2002 2003 2004 2005 2006 2007 2008 2009 YTD
Source: J.P. Morgan European ABS Research Source: J.P. Morgan European ABS Research
44
(44-20) 7325-5454 11 November 2009
Expectations that covered bond Table 7 shows a snapshot of some of the sources of funding available to banks and
markets will ‘trend to normal’ indicates their availability to issuers/appeal to investors as the credit crisis
without fundamental changes to progressed. Readers can see that the appeal of covered bonds has broadly moved in
the product or market
structure…
lock-step with the ability to issue unsecured financial bonds – with both formats
showing significant recovery over the course of 2009. We expect these markets to be
close to fully-functioning in 2010 for the vast majority of issuers (see The Regulator
Strikes Back, page 26).
Table 7: Bank sources of funding

Pre- Aug 07- Lehman Govt H1 H2 H1
crisis Aug 08 Failure rescue 2009 2009 2010
plans
Unsecured
Gtee’d unsecured n/a n/a n/a
Covered bonds
Securitisation
Gtee’d Sec’n n/a n/a n/a n/a n/a
Credit crisis
Green: Open
Yellow: Partially open
Red: Closed
Red/yellow: Closed, moving to partially open
Yellow/green: Partially open, moving to fully open
Source: J.P. Morgan European ABS Research
…while securitisation markets Our expectations for the securitisation markets in 2010 are however less sanguine.
look set to experience a ‘slow We continue to expect the majority of ‘issuance’ to be held by originators – despite
grind’ – with product efforts to wean issuers off their reliance on short-term repo funding and investor
modifications and (partial)
investor base transition
attempts to tighten in secondary market spreads to make new, economically-feasible
seemingly necessary issuance a possibility.
In fact, Figure 38 and Figure 39 demonstrate the issues the market faces in restarting
securitisation in Europe. The overwhelming number of originator respondents to the
latest J.P. Morgan European ABS Confidence Index say that they see securitisation
having a continued role as a consumer-lending funding tool going forward (89%),
but at the same time the majority (67%) remain unwilling to issue transactions in an
effort to reestablish the market. The secured funding market dichotomy therefore
looks set to continue well into 2010.
45
(44-20) 7325-5454 11 November 2009
Figure 38: Do you believe securitisation has a continued role in Figure 39: Would you issue a transaction at “uneconomic” spreads to
funding consumer lending in Europe?, % facilitate a restart of the public ABS markets?, %
100% Yes No May be 89% 100% Q2 Q3
82% 79%
80% 80% 67%
61%
60% 60%
36% 33%
40% 40%
11% 15%
20% 7% 6% 6% 6% 20%
4% 0%
0% 0%
Q1 Q2 Q3 Yes No Don't know
Source: J.P. Morgan European ABS Confidence Index Source: J.P. Morgan European ABS Confidence Index
Housing goes under covered

Residential mortgages likely to Owing to this, in 2010 we expect to see a short-term change in the relationship
be funded by covered bonds
while securitisation market
between the covered bond and securitisation markets in a number of countries. In
pricing remains dislocated jurisdictions traditionally more heavily reliant on securitisation markets as a funding
tool for residential mortgage books (UK, Netherlands and Spain), we expect to see
more mortgage collateral directed towards the covered bond markets. This is
symptomatic of both the current market pricing differential (approximately 100bp in
the UK and Netherlands, 200bp in Spain), and also the depth and appetite of the
respective investor bases.
Expect more ABS backed by By derivation, we believe that the European securitisation market becomes a tool
higher-yielding consumer assets increasingly used to fund higher margin (i.e. predominantly unsecured) collateral
(more akin to the structure of the US market where credit card, auto loans and
student loans form a larger proportion of issuance) – where a juicier asset yield can
be used to support the relatively higher liability cost structure of the securitisation
issued.
Hybrids are good for the environment

Covered bonds and Interestingly, structural amendments to the two distributed RMBS during 2009 have
securitisation get a little cosier also served to narrow the gap between the covered bond and RMBS product (the two
distributed auto ABS transactions however look the similar to issues pre-crisis). Both
HBoS and Nationwide issued bullet bonds with a put back to the originator at a given
maturity (100 less any credit losses on the AAA note), effectively limiting the
extension risk usually associated with a securitisation investment, while Nationwide
also introduced a fixed rate (bullet) note – both features more typical of the covered
bond world than the traditional securitisation product.
While these structural developments are unlikely to herald the permanent merger of
the two funding sources, it does blur at least some of the differences between the two
asset classes. We expect these hybrid features to be relatively common in 2010 while
the securitisation market starts its slow grind back to normality.
46
(44-20) 7325-5454 11 November 2009
Overhang hangover?
One of the more notable features of the European securitisation market since
September 2007 has been the phenomenon of structure-to-repo transactions. While
we have said many times over the life of the crisis that the ability to post ABS
collateral to the various central bank repo windows was undoubtedly “good in the
short-term…” we continue to believe that it remains “... bad in the longer-term”. By
our calculations, some €1.43trillion of ABS has been created and retained in Europe
since the initial closure of the primary markets. While their creation does not
necessarily equate to their usage at the various repo windows (originators may
structure ‘just in case’) it does indicate that these exposures have not been used to
either access long-term funding or to transfer risk away from the banking sector.
Furthermore, many of the bonds created are in a structural or collateral form that
would be difficult to divert to a (currently) more discerning investor base.
Reliance of structure-to-repo Why does this trouble us so? It is partially the fear (and increasingly, the realisation)
continues to hurt the that many originators have used the availability (and pricing advantage) of such
securitisation markets in our facilities as a way to avoid taking some of the unpleasant but necessary
opinion measures of adjusting product pricing to the new world order. While this has
undoubtedly been beneficial for the over-stretched consumer (and by derivation the
performance of outstanding ABS bonds), it has merely postponed the inevitable
product repricing issue in our view (we do not expect banks to be able to access the
securitisation market again at levels seen pre-crisis). Recent moves to tighten both
the eligibility and the price for access to both the ECB’s repo window and the Bank
of England’s SLS are yet to filter through to issuers’ funding decisions in any
meaningful way.
Looking ahead to 2010, we remain acutely aware that this €1.4trn of assets needs a
permanent home. In the main, we expect these assets to be either unwound and re-
issued into the ABS markets (in an acceptable format), to be unwound and used as
collateral for future covered bond issues (in an acceptable volume), to be funded on-
balance sheet by the originating banks or posted to the various repo windows on an
ongoing basis. None of these solutions (or any combination of them for that matter)
provides an easy answer however – especially for markets only now slowly re-
opening.
Regulators flex their muscles

2010 will be the year that sees many of the regulatory initiatives launched in the
wake of the credit crisis, come to final form – with many proposals set to be
implemented that will have a significant impact on the structure and form of the
European secured lending markets. While it remains near-impossible to assess the
exact impact of the output of these various working groups and policy committees,
we are starting to see the clear direction of the regulatory push.
Securitisation to be the main While covered bonds remain relatively untouched by additional regulatory scrutiny
focus of regulatory scrutiny and (with the exception perhaps of recent moves to elevate the discussions about asset
action encumbrance up the agenda in the UK), most regulatory action is currently centring
around the perceived weaknesses of securitisation. We can distil these various
initiatives into three broad strands:
47
(44-20) 7325-5454 11 November 2009
• Firstly, the regulatory dislike of “securitisation for securitisation’s sake”, which

can be categorised more explicitly as an aversion to both the originate-to-
distribute and resecuritisation (i.e. arbitrage) models. Here, the main instrument
of policy has been revisions to the Capital Requirements Directive (CRD) (and to
a lesser extent the ECB’s monetary operation criteria) with initiatives centring
around requiring originators to hold an ongoing economic interest in each
collateral pool they securitise; and revising capital treatments for bank investors
in situations in which originators do not comply
• Secondly, another focus (rightly in our view) has been on additional disclosure –
whether it be for rating agencies, investors, or the ECB itself. Again, disclosure
and enhanced due diligence requirements have been set out under the CRD for
bank investors
• Finally, initiatives on product design (such as Prime Collateralised Securities
(‘PCS’) proposals) – effectively looking to develop hybrid structures mimicking
the best features of both the covered bond and securitisation markets
Bottom line? Securitisation to get more expensive
European regulations to Newly-adopted EC regulations (in force for new securitisations from 2011) are set to
increase the cost of increase the cost of both securitisation issuance and investment. The new Article
securitisation for issuers… 122(a) of the CRD aims to remove what the Commission sees as ‘misalignments’ of
incentives between the interests of originators and investors. Under the new
regulations, European banks will be required to invest only in securitisations where
the issuers retain an interest of not less than 5% (through retention of a vertical slice,
a seller’s share, a first loss tranche, or equivalent exposures on-balance sheet).
Failure to satisfy these requirements will lead to a capital charge at least 250% of the
risk-weight that would otherwise have been applied for the holding (i.e. a BBB
granular securitisation position would see its riskweight rise from 100% currently to
250%).
Furthermore, the amended CRD also imposes ongoing requirements on an investing

…and also for bank investors
bank (traditionally we would estimate that bank investors made up around 1/3rd of
the European investor base – more if sponsored off-balance sheet vehicles are
included). Each investor will be required to demonstrate to their respective regulator
that it has a “comprehensive and thorough” understanding of the risks associated
with its securitisation investments, along with appropriate formal policies and
procedures for analysing and recording each investment’s risk characteristics. Banks
will also be required to perform their own stress tests at regular intervals along with
more comprehensive collateral pool performance monitoring. This will naturally
represent a significant analytical and administrative burden on investing credit
institutions.
Other regulatory moves to have an indirect impact on the secured funding markets
Other regulatory initiatives also In addition to the initiatives directly targeting the securitisation markets, there are
set to impact the secured
also macro regulatory reform initiatives (as previously discussed in The Regulator
funding markets
Strikes Back, page 26) targeting both the quantity and quality of capital required by
Europe’s banks which will have a direct impact on the cost of balance sheet usage.
Combined with the potential introduction of a leverage ratio, it could rationally serve
to limit the availability and price of credit to consumers and corporates alike,
therefore impacting both the format (covereds versus securitisation) and volumes of
secured issuance going forward, along with the performance of existing transactions
currently outstanding.
48
(44-20) 7325-5454 11 November 2009
2010 – a Secured Odyssey

While the backdrop to the secured funding markets in Europe in 2010 is somewhat
fluid, we see the health of both the securitisation and covered bond markets
improving over the course of the next twelve months – although unlike 2009, the
starting point for the two markets is fundamentally different. In our 2010 Outlook
we therefore expect to see important changes, including:
• More covered bond issuance in the short term from jurisdictions traditionally
more reliant on the securitisation markets (UK, Netherlands, Spain) – particularly
for residential mortgages
• However, over the medium to longer term, we expect this to reverse with more
securitisation (and less covered bonds) as banks look to move low margin assets
(i.e. residential mortgages) off relatively more expensive balance sheets
• Those RMBS deals that are distributed to investors, particularly from more
complex issuance vehicles (master trusts), to continue including features designed
to blur the lines between the two secured funding products
• We recognise the potential for a somewhat smaller securitisation investor base as
some banks become less axed to invest in securitisation exposures for their own
account due to changes in terms of capital charges and due diligence
requirements–further exacerbated by balance sheet size and cost constraints
• We believe investors will accept the expectations of higher due diligence
requirements around the securitisation asset class, with the resultant higher costs
impacting the minimum required return on investments (reinforcing the higher
cost of the underlying consumer products)
• Ultimately, we expect to see the provision of lower credit volumes to the
consumer, with those lines that are advanced likely to be given at a higher cost.
This will be particularly detrimental to the marginal borrower, and will be likely
to negatively impact the repayment rates of existing borrowers and structures
49
(44-20) 7325-5454 11 November 2009
The Big Issue

European Credit Strategy Executive Summary
AC
Tina Zhang 2009 has been an unprecedented year for bond market supply, as well as demand. A
(44-20) 7777-1260
tina.t.zhang@jpmorgan.com
wall of supply was met with a wall of cash, and credit markets saw historically high
returns just a few months after experiencing record losses following the collapse of
Stephen Dulake Lehman.
(44-20) 7325-5454
We saw many new themes emerge in the primary market – record levels of Non-
Daniel Lamy Financials issuance, longer maturity and lower rated issues, and an increasing
(44-20) 7777-1875
number of new unrated companies tapping the bond market.
In this essay, we argue that a number of Non-Financials issuance themes were not
“one-offs” for 2009, but are in fact the beginning of a secular trend for European
bond markets which are evolving towards a more US-like model; a theme we have
been highlighting for a while now. For 2010, we forecast €204bn of Non-Financials
bond market gross issuance, and net issuance of €100bn.
2009 Issuance In review

Gross Issuance in 2009 (€365bn YTD) has actually been on a par with that seen in
previous years (€346bn in 2008, €391bn 2007), but Net Issuance of €46bn YTD has
shown a huge improvement from 2008’s anaemic €5bn, and more importantly the
mix of Net Issuance between Financials and Non-Financials has differed
significantly from traditional trends.
Net issuance this year for Industrials has hit record highs at €140bn, whilst
2009 Overall Gross Issuance has
been similar to previous years,
Financials (unguaranteed) net issuance is at record lows of negative €115bn as banks
but the mix between Financials relied more on issuing in the government guaranteed space. This was the mirror
and Non-Financials is the mirror image of pre-crisis trends where Financials net issuance used to run at twice the pace
image of pre-crisis trends of Non-Financials. In this essay, we focus on Non-Financials issuance – for more
details on the issuance profile of European Financials, please see The Regulator
Strikes Back, page 26.
Figure 40: Euro Gross Issuance €bn Figure 41: Euro Net Issuance €bn
200 Financials Industrials 100
175 75
150 50
125
25
100
0
75
-25
50
25 -50
Financials Industrials
0 -75
1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09
Source: J.P. Morgan. and Dealogic Source: J.P. Morgan. and Dealogic
50
(44-20) 7325-5454 11 November 2009
New Issues have been a significant and reliable source of outperformance for
investors this year, driving a virtuous circle that has kept demand for new issues high
and preventing the new issue machine from breaking down, even as new issue
premia to secondaries have collapsed.
On average, Industrials new issues this year rallied over 3% in the month following
their issue and we estimate that compared to a Non-Financials € IG benchmark, the
effect of just buying new issues before they enter the benchmark at the end of each
month has been around 30bp of outperformance YTD. This is assuming that that a
New Issues have enhanced
fund's allocation in new issues is proportionate to the market value of new issues
investor performance this year.
The effect purely from buying versus the market value of the benchmark. For every extra 5% of the portfolio
new issues before they enter the allocated to buying each month's Industrials new issues rather than secondaries,
benchmark at the end of each funds get on average, an extra 30bp of "free" outperformance.
month has been around 30bp of
outperformance YTD
New Issue performance has been relatively insulated from moves in the broader
market, and even as new issue premia collapsed towards zero and as credit curves
steepened, the new issue yield curve has been flattening over the past few months
(i.e. longer term issues have been offering less premia than front end issues).
Figure 42: New Issue Indices Figure 43: New Issue premia to secondaries and dispersion in premia
Our New Issue indices show on average, how much new issue spreads have
tightened versus spread at reoffer, bp
40 Senior Financials New Issue Index 150 Av erage New Issue
Premia to Secondaries,
Industrials New Issue Index
0 bp
100 Standard dev iation
-40
-80
50
-120
-160 0
Jan-09 Mar-09 May -09 Jul-09 Sep-09 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09
Collapsing new issue premia, combined with continued retail inflows meant that the
search for yield (which initially remained confined to higher quality credits) opened
the way for more BBB and unrated issuance, as well as longer dated issues. Table 8
shows that over the second half of 2009, 15% of all Non-Financials new issues
were unrated deals compared to 1% earlier in the year and 2008. At the same time,
37% of deals in 2H09 were dated 10 years or more, compared to just 10-12% in
the first half and 2008 (see Table 9). Consequently, there has also been a significant
divergence in the average duration of new issues, which rose from around 4.5 to 6.5
in the past 3 months, with the duration of the benchmark which has stayed around
4.3.
51
(44-20) 7325-5454 11 November 2009
Table 8: Non-Financials Issuance: Ratings Figure 44: 2009 Non-Financials Issuance by Rating (rolling 2 month, €bn)
composition 2008 vs 2009 100 AAA AA A BBB Unrated
2008 1H09 2H09
AAA 9% 6% 0% 80
AA 15% 21% 18%
A 56% 45% 37% 60
BBB 19% 28% 30%
Unrated 1% 1% 15% 40
Total 20
€133bn €190bn €55bn
volume
Source: J.P. Morgan. 0
Jan-09 Apr-09 Jul-09 Oct-09
Table 9: Non-Financials Issuance: Maturity Figure 45: 2009 Non-Financials Issuance by Maturity bucket (rolling 2 month, €bn)
composition 2008 vs 2009 100 1-3 3-5 5-7 7-10 10+ Duration (rhs) 7.0
2008 1H09 2H09
1-3 7% 4% 4% 80
6.0
3-5 21% 28% 4%
5-7 35% 35% 36% 60
7-10 25% 23% 18% 5.0
10+ 12% 10% 37% 40
Total 4.0
€133bn €190bn €55bn 20
volume
Source: J.P. Morgan. 0 3.0
Jan-09 Apr-09 Jul-09 Oct-09
The fact that Non-Financials and lower rated credits are becoming a greater
proportion of total issuance is consistent with the European credit market becoming
more US-like, a theme that we have been highlighting for a while and one that we
expect to continue to play out over the next few years as corporate borrowers
continue to reduce their dependency on bank loans.
In contrast, the IG loan market

Whilst bond market supply has been booming this year, the story has been very
has been shrinking. IG loan different for the loan market. As banks have sought to trim the size of their balance
supply used to outpace that of sheets, loan market issuance for investment grade companies has fallen considerably
bonds by a factor of 3. However, and net issuance over the past 2 years has totaled negative €100bn. Pre-crisis, annual
over the past 2 years, Net Investment grade loan supply was on average, about 3 times that of bond supply, but
Issuance for Non-Financials in
the loan space has totaled
for the first time since 2000 (the earliest data we have on the Euro IG loan market)
negative €100bn. this year’s investment grade bond supply looks likely to exceed that of loans. 2009
loan volumes are just 35% of the peak in 2006, and not surprisingly, acquisitions-
related financing has shrunk the most (down 74%, or €120bn), followed by
refinancings (down 64%, or €89bn) as corporates have been tapping the bond market
instead.
52
(44-20) 7325-5454 11 November 2009
Figure 46: Historically IG Non-financials Gross Issuance in Loans has exceeded Bonds (€bn)
500
IG loans IG Bonds
397 400
377
400
275
300 236 245
209 207 205
200 155 145 139
133
103 103 109
82 78 64 75
100
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: J.P. Morgan and Loan Analytics
US Structural changes in 2001

We believe that the current shift by companies to using relatively more bond market financing than loan market financing is
comparable to structural changes in the US market in 2001. With a poorer economic climate, many prominent non-financial
issuers of Commercial Paper programs were downgraded from Tier 1 to A-2. Because the size of the A-2 market was
considerably smaller (at that time money market funds could only hold up to 5% of their portfolios in non-Tier 1 CP), many
issuers withdrew from the CP market.
With historically low yield levels (at the time) and a flat Treasury yield curve, many companies took the opportunity to
switch from issuing CP to raising longer term bond financing at rates similar to that at the short end. As Figure 47 and
Figure 48 show, there was a concurrent decline in the CP market and a rise in bond issuance in 2001. The proportion of all
deals dated longer than 7 years also rose from approximately 24% in 2000 to 45% at the end of 2001.
Although government yield curves have steepened considerably over the course of 2009, there is still some readacross
between the situation in 2001 to the current environment, as absolute yields are still very low and the credit yield curves
remains relatively flat.
Figure 47: US Non-Financial CP Outstanding $bn Figure 48: US Non-Financial IG bond issuance (rolling 6-month) $bn
400 300
350 250
300
200
250
200 150
150
100
100
50 50
0 0
1995 1997 1999 2001 2003 2005 2007 2009 1995 1997 1999 2001 2003 2005 2007 2009
Source: Federal Reserve Source: J.P. Morgan.
53
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Permanently shaken, or just stirred?

In our view, some of the unprecedented changes we have seen this year will become
permanent fixtures in the primary bond market. In this section we aim to quantify
issuance dynamics for investment grade Non-Financials over the next year.
We construct top-down Non-Financials issuance forecasts based on our views

regarding the amount of redemptions in both the bond and loan market that will need
to be refinanced, and how this refinancing will be distributed between bonds and
loans.
Figure 49 shows historical investment grade corporate net supply, (i.e. bond and loan
net issuance), which has traditionally always been positive, although due to
lacklustre net issuance in the loan market over the past 2 years, overall corporate net
supply has been very flat. We construct some estimates of gross corporate supply
using redemptions data over the next few years (so called "old money").
Figure 49: IG Non-Financials Net Supply : Bond and Loan gross issuance and redemptions €bn
500 397 400 Loan Supply
377
400 Bond Supply
275 245
300 207 205 Loan Redemptions
133 139 Bond Redemptions
200 103 75 103 109
100 64 Bond + Loan Net Issuance
0
-100 -34 -53 -50 -82 -63
-200 -121 -103 -112 -97 -113 -104 -88
-128
-300 -191 -180
-265 -228
-400 -318
2003 2004 2005 2006 2007 2008 2009 2010 2011
Bond (Issuance) Market Maths

Step 1: Our starting block is the fact that there is €104bn of bond market
redemptions in 2010 and €88bn in 2011. We acknowledge that some of the 2010
redemptions may have already been refinanced this year and so we assume an
average of the 2010 and 2011 maturities will be refinanced next year (i.e. €96bn).
Step 2: Historically, net issuance in the bond market alone has been consistently
positive. In other words, the European bond market has experienced a relatively
steady pace of growth, until this year when growth accelerated due to the reallocation
of corporate supply away from the loan market. Excluding this year’s figure, net
issuance previously (i.e. overall "new money" being supplied into the market, mainly
from traditional bond market issuers) averaged around €30bn per year.
Step 3: In contrast, “new money” in the loan market is unlikely to bounce back to the
heady amounts seen from 2005-2007 and in our view, will remain at the extremely
muted levels seen this year, as banks continue to pare back their balance sheets. In
the spirit of providing a conservative estimate, we pencil in zero “new money” for
the loan market into our forecast.
54
(44-20) 7325-5454 11 November 2009
Step 4: Loan market issuers are traditionally more forward looking than bond
market issuers and tend to look to refinance 1-2 years' ahead of time. Hence, instead
of looking at 2010 loan redemptions, we instead take an average between 2011 and
2012 redemptions which comes to €261bn. However, some of these maturities
include back-up facilities, which are liquidity lines that may not have been drawn or
may be downsized, whereas acquisitions or capex-related financing will need to be
fully rolled over. Based on conversations with our colleagues in Syndicate and Debt
Capital Markets, we think that a reasonable estimate is to shrink the portion of loan
redemptions related to Refinancing or Working Capital by a third, which reduces our
previous figure to €214bn.
Figure 50: 2010 and 2011 Non- Step 5: Adding together all of the numbers generated in the previous steps gets us to
Financials Issuance Forecasts €bn a total gross corporate supply figure of €340bn. We now need to consider how
300 much of this will come in the bond market. As mentioned above, the corporate
204
181
supply split between bonds and loans has in the past, been roughly 25:75, with the
200 136 121 exception of 2009, where it has been 60:40. We think the 2009 ratio is more likely
100 than not going to be a permanent fixture going forward, rather than a blip. Splitting
the €340bn accordingly, gives us a Non-Financials bond market gross issuance
0
forecast of €204bn for 2010.
-100
-104 -88 This means that net Non-Financials bond market issuance in 2010 will be
-200
€100bn, making both the gross and net numbers considerably higher than
-300 -228 historical averages.
-318
-400
Applying the same logic and the same steps to 2011 yields a gross issuance forecast
2010 2011 of €181bn and net issuance of €93bn – in other words, we believe that issuance in
Loan Supply the European high grade market is likely to shift to a significantly higher run rate for
Bond Supply some time to come.
Loan Redemptions
Bond Redemptions Although our Financials analysts believe that Financials (unguaranteed) issuance is
also likely to run at historically high levels (for more details please see The Regulator
Strikes Back, page 26), due to the extent of issuance that we are expecting to shift
from the loan market, it is unlikely that Financials will regain its traditional
dominance over Industrials over the next 2 years.
Risks surrounding our forecast

The main downside risk lies in market conditions – even though the primary market
showed great resiliency this year, it can still be vulnerable to a significant
Downside risks to our forecast deterioration in secondaries and investor confidence in general.
include a deterioration in market
conditions and the possibility of
a revival in bank lending
Another downside risk may be if the bank lending market makes a comeback, but we
do not think that this is the direction that banks want their balance sheets to go in,
and if companies can tap bond market liquidity as easily as they have done this year,
their dependency on, and hence demand for bank lending will fall. Even if the ratio
between bond and supply was tempered slightly to 50:50, Non-Financials bond
issuance would still be at historically high levels.
Our High Grade Big Issuer forecasts show only a small decline in leverage is
expected in 2010 – approximately half of this is likely to be due to a real reduction in
net debt, and half is due to improvements in EBITDA. At the same time free cash
flow is expected to rise significantly, however, this may feed into funding delayed
capex plans rather than paying off outstanding debt with cash.
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(44-20) 7325-5454 11 November 2009
Table 10: Euro High Grade Big Issuer Aggregate Forecasts

2008 2009e 2010e
Revenue (% change YoY) 4% -2% 4%
Adjusted EBITDA (% change YoY) -4% -5% 6%
Capex (% change YoY) 13% -11% 3%
Dividends (% change YoY) 14% -9% 4%
Free Cash Flow €mm 14,439 7,326 14,668
However, we believe that the Net Debt / Adjusted EBITDA 2.0x 2.3x 2.1x
risks are in fact more skewed to Source: J.P. Morgan.
the upside as net corporate
supply (bonds+loans) remains In our opinion, the risks are more balanced to the upside, as our overall forecast for
negative and we expect capex net corporate supply remains negative, which would be a rarity for the European
and M&A to pick up
corporate market. As the economic environment improves, capex and business
investment are likely to start rising and so we could expect more issuance for these
purposes. Furthermore, the majority of any pick up in M&A activity is likely to feed
through to the bond market, although the timing and magnitude of this is difficult to
predict.
Thoughts on Ratings and Sector profiles

The main driver of our elevated issuance forecasts is not existing bond market issuers
The main driver of our elevated becoming more leveraged themselves, rather the shift by traditional loan market
issuance forecasts is not
issuers into the bond space. The vast majority of these issuers are typically unrated
existing bond market issuers
becoming more leveraged and have never entered the credit market before (for example, Adidas, Campari,
themselves, rather the shift by Lagardere, OMV, Neste Oil, etc, had near term loan maturities and all issued for the
traditional loan market issuers first time in credit markets this year). Hence, even a slight increase in the percentage
into the bond space of these issuers refinancing in the bond market instead could raise the proportion of
unrated issuers above the 2H09 15% run rate.
However, according to results and comments from our latest European High Grade
Investor Survey (published 3 Nov), 58% of respondents have not bought any unrated
deals, citing benchmark exclusion as the main reason. In order to access a broader
investor base, these previously unrated issuers do need to attain an investment grade
rating. Given the fact that most of the unrated deals that came in Q3 have been
Given that most of the unrated
considered “crossover” credits, and that historically, bond ratings tend to have
deals that came in Q3 were
“crossover” credits, and bond
downward drift (even during upturns in the cycle), we could see the credit quality of
ratings tend to have downward investment grade benchmarks deteriorate, although this is likely to be a slow burn
drift, we could see a higher process.
proportion of BBB issuers
An increasing proportion of BBB issuers would also be commensurate with the
European bond market becoming more US like. The current ratings composition of
the European IG benchmark is actually very similar to what it was in the US in 2000.
It took almost 2 years in the US for the percentage of BBBs in the benchmark to rise
to their peak – a 20 percentage point increase (although this was partly due to a large
number of downgrades in 2002). If we apply a 20 percentage point increase in the
weighting of BBBs in the European benchmark (at the expense of single-A), then
cash spreads today would be approximately 10-15bp wider.
The sectoral composition of the loan market also appears to have a heavier weighting
towards Cyclicals, in particular Basic Industry, Consumer Cyclicals and Property.
Although some of the Basic Industry issuers such as Lafarge and Arcelor Mittal have
already dealt with some of their refinancing needs, even if we exclude these names,
the proportion of Basic Industry loan redemptions would still be twice the weighting
of the sector in current investment grade benchmarks.
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Figure 51: Sectoral differences between IG Benchmarks and Loan markets

35% Current IG Benchmark Sector Composition 2011 Loan Redemptions by Sector
30%
25%
20%
15%
10%
5%
0%
Autos Basic Capital Consumer Consumer Energy Media and Property Telecoms Transport Utilities
Industry goods Cy c Non Cy c Tech
Could Corporate Hybrids make a come-back?

Many issuers still regard their investment grade ratings as sacrosanct and hence
M&A related transactions are likely to be structured in the most ratings friendly way.
To this end, we may well see corporate hybrids from “cuspy” investment grade
issuers returning to credit markets, which could test market confidence.
Demand versus Supply

Unfortunately, data availability on investor inflows (in particular institutional flows)
is much poorer than that on bond supply. According to data from Thomson Reuters
Lipper Feri, from January to August 2009, Euro investment grade funds have
received $37.2bn of net retail inflows, and interestingly, the proportion of all new
issues that are ‘retail-sized’ increased from 29% in 2008 to 45% in 2009.
We have been saying for a while now that we expect retail inflows to moderate to
circa $1-2bn per month (compared to peaks of around $7bn per month from May to
July), as all-in-yields at 4% look increasingly unattractive. Whilst we do not expect
the volume of 2009 retail inflows to be repeated in 2010, judging by our investor
conversations and our high grade surveys, we may see institutional inflows become
relatively more significant.
However, in the absence of a data source for European institutional fund flows, it is
difficult to quantify the effect of bond supply on spreads in a robust way, which is a
complex relationship at the best of times. Suffice it to say, the fact that the US
market experiences higher issuance volumes and has more BBB rated credits, can
partly explain why US investment grade benchmark spreads have traded consistently
wider than their European counterparts.
Figure 52: USD and EUR IG Benchmark ASW spreads
500 EUR USD
400
300
200
100
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
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High Yield Mark 3: Riding the Refi Wave

Conditions are in place for a record supply year
The European high yield market has been around for a little over a decade, but it is
European Credit Strategy
already set for its second makeover, with a cycle characterised by private equity
AC
Daniel Lamy buyouts giving way to an extended period of refinancing and balance sheet
(44-20) 7777-1875 restructuring.
Stephen Dulake One of the greatest changes we expect to see over the coming few years is a
(44-20) 7325-5454 broadening in the pool of euro high yield issuers, an advance likely to be welcomed
by investors, who have at times suffered with the lack of diversity in the market.
Tina T Zhang This forced some to reach outside their comfort zone into other asset classes such as
(44-20) 7777-1260 EM corporates and more recently Financials, via their inclusion in several benchmark
tina.t.zhang@jpmorgan.com
indices.
The European high yield market Aside from Financials, we see two main sources of new entrants to the high yield
has been around for a little over space: leveraged borrowers refinancing loans, and new crossover or quasi-investment
a decade, but it is already set for grade issuers. The latter group has already expanded as a result of investment grade
its second makeover downgrades during 2008-9, making corporate issuers a more permanent fixture in the
European market. Terming-out leveraged loans is a process that has only just begun
There is scope for the high yield
and is likely to persist for many years. Given that excessive loan market liquidity
market to grow sharply as it artificially constrained bond issuance during the boom years, in our view there is
becomes the dominant source of scope for the high yield market to grow sharply as it becomes the dominant source of
leveraged funding leveraged funding.
Barring a material change in the market environment, the conditions are certainly in
place to exceed the record for a calendar year of €29bn in 2006. We would not be
surprised to see volumes hitting €35bn for FY 2010, quite a bit higher than the
median response of €20bn from our recent survey.
Figure 53: Euro High Yield Amount Outstanding, €bn Figure 54: Euro High Yield Issuance, €bn
120 TMT Bubble Buy out Boom Refi Wav e 30
100
80 20
60
40 10
20
0 0
Jan '99 Jan '01 Jan '03 Jan '05 Jan '07 Jan '09 1998 2000 2002 2004 2006 2008
Non-Financials Financials
Source: J.P. Morgan, iBoxx. Taken from constrained indices
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Source 1: Leveraged loan refinancing

Maturity cliffs in the leveraged loan market are closer than many believe, in our
opinion, a problem we discussed in I'm a Lender, Get Me Out of Here, 17 September
2009. Our calculations show that 23% of senior secured loans outstanding by
notional will come due by the end of 2012, jumping to 44% a year later (Figure 55).
Using a total market size of €250bn, this equates to €58bn maturing by 2012 and
€110bn by 2013.
Figure 55: Estimated European Senior Secured Loan Maturity Profile Figure 56: Euro High Yield Bond Maturity Profile
35% Institutional Debt 20%
30%
25% All Senior 15%
20%
10%
15%
10% 5%
5%
0% 0%
2009 2010 2011 2012 2013 2014 2015 2016 2017 2009 2011 2013 2015 2017 2019
Source: J.P. Morgan, S&PLCD. Source: J.P. Morgan.
As market conditions continue to improve, we think more companies will attempt to

There are numerous constraints term-out their debt in the bond market, a process that is already well underway in the
when it comes to extending
liability profiles
US. However, as we have noted previously, there are numerous constraints when it
comes to extending liability profiles, among others:
• Preserving the order of repayments in multi-layered capital structures.

Unlike the simple Revolver + Term Loan + Bond structure in the US, European
leveraged capital structures have evolved to look like RC + TLA/B/C + Second
Lien and/or Mezzanine and/or PIK. The greater number of tranches and layers
of debt instruments is likely to make refinancing harder, as it requires dealing
with all parts of the capital structure at once if the order of repayments is to be
preserved.
• High threshold for consenting lenders. The Yell transaction highlights the
difficulty that can arise in trying to get broad agreement on a voluntary out-of-
court debt restructuring. It only takes a handful of hold-outs to prevent the
transaction taking place, unless the other lenders are happy to allow a small
amount of debt to remain on the original repayment terms. For better quality
credits, a fee and margin boost may be enough to compensate for this kind of
‘leakage’, for stressed companies another solution may be needed.
• Logistical obstacles to extending maturity. Some lenders face disincentives to

rolling into longer-dated loans: for example certain banks’ accounting treatment
could force the recognition of losses through the income statement, rather than in
reserves. CLOs may face restrictions to the extent that they are outside of their
reinvestment period, or if the new loan matures beyond the legal final maturity
of the vehicle.
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An incremental approach to refinancing

Although the time frame for terming-out debt piles is shortening, we think many
borrowers will attempt to transform their capital structures in several stages,
particularly those with the most debt to roll. There are several reasons for taking an
incremental approach: to avoid overstretching capacity in the bond market; a desire
to keep relationship banks as lenders; and to delay the increase in funding costs.
Having a mixture of senior secured bonds and loans in a capital structure poses a
number of questions. Do the new bonds benefit from the same security package and
covenants as the loans? Will bondholders have access to the same level of disclosure
that banks normally receive, or will there be an information asymmetry? How will
voting rights be assigned, particularly as it pertains to enforcing on security or a
future restructuring? It’s too early to speculate on what the conventions will become,
though bondholders are in a strong negotiating position at present.
Source 2: Crossover credits and Fallen Angels

Fallen Angels have accounted for the bulk of non-Financial high yield supply over
the past couple of years, accounting for €11.6bn of index eligible paper downgraded
during 2008 and €16.4bn so far in 2009, we estimate.
Although the pace of downgrades to sub-investment grade should moderate going

This will serve to increase the forward, many of these new entrants are likely to be repeat issuers. This will serve to
share of corporate (non- increase the share of corporate (non-sponsored) supply in the high yield market,
sponsored) supply in the high
yield market, and make it a
making it a permanent fixture. A corollary to this trend – and the expected wave of
permanent fixture. senior secured supply – is a higher average rating profile in the primary market. This
is already becoming evident: so far in 2009 BBs have enjoyed a 50% market share,
with no CCC supply at all.
The past few months have also witnessed a number of infrequent or first-time
unrated issuers coming to market, such as Evonik, Hella, Rallye and Air France. We
expect more companies that traditionally financed themselves exclusively in the bank
market to follow suit, opting to diversify their sources of funding. Over time,
however, demand for unrated product may fade because of the restrictions that
benchmarked investors face.
Figure 57: Ratings Distribution of Euro High Yield Issuance

BB B CCC NR
100%
80%
60%
40%
20%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
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No consensus over the role of Financials in high yield

The role of bank capital in a dedicated high yield bond portfolio still divides the
investor base, based on our various discussions this year. Our recent survey shows a
wide variation in the amount of high yield portfolios allocated to Financials (see
Figure 58). Despite the fact that Financials now constitute up to 26% of high yield
indices by market value and 31% by notional (Figure 59), fewer than 20% of survey
participants had more than a 20% allocation to the sector.
Figure 58: HY Investor Allocations to Financials Figure 59: Financials Weighting in High Yield Indices
Financials weighting, x-axis; Percent of investors, y-axis Financials Weighting in iBoxx EUR HY Indices by Notional and MV
30% 40% Market Value Notional

25%
30%
20%
15% 20%
10%
10%
5%
0% 0%
0%-5% 6%-10% 11%-15% 16%-20% 21%-25% 26%-30% >30% Jan '03 Jan '04 Jan '05 Jan '06 Jan '07 Jan '08 Jan '09
Source: J.P. Morgan. Taken from European High Yield Quarterly Survey: 4Q09 Source: J.P. Morgan, iBoxx.
One reason for the relatively low weightings is that a large proportion of investors
have already changed their benchmarks to exclude various types of bank capital.
Some removed only undated instruments, while others did not want any exposure to
the sector.
Although our index does not contain Financials, the asset class has been a useful
source of outperformance for our model portfolio both this year and in 2008. We
still see certain opportunities, particularly in ‘distressed’ lower tier 2: we currently
own Depfa, IKB and HSH Nordbank.
Market outlook: most of the upside has been booked

The high yield market taught us this year that even the most optimistic expectations
can be surpassed: even though we were early buying low dollar price bonds in April,
we certainly didn’t envisage 70% returns, and took profits too early. We stick with
our cautious view on the asset class in light of the diminishing returns on offer.
Granted we could be positively surprised again, however, spreads are much narrower
as we move into 2010: 750bp on the J.P. Morgan Euro HY Index, but only 650bp on
the iBoxx Non-Financials1 index which includes FRNs.
1
We use the iBoxx main Non-Financials cum Crossover index
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Nonetheless, valuations are With spreads at what are moderate levels historically, it’s not yet clear to us that high
already beginning to discount an yield is priced for perfection in the way that it was towards the peak of the credit
environment of moderating cycle. Nonetheless, valuations are already beginning to discount an environment of
defaults and lower volatility
falling defaults and lower volatility. Our macro model tells us that the decline in
default rates that many expect to happen in 2010 is almost in the price already
(Figure 60). That leaves precious little buffer for downside risks – if 2008 was about
owning optionality against tail events, it seems as though market participants are
entering 2010 short those same options. Our sense is that investors are Overweight
high yield and have run their cash balances down to 3-4% over the course of the
year. Given our assessment of the distribution of risks, we think the asset class looks
Earning a low double-digit return
overvalued and that this year’s performance has eaten into future returns. Looking
now seems like the best we can
hope for; clipping a coupon is forward at the possible performance outcomes can we expect in 2010, earning a low
more likely, in our view. double-digit return now seems like the best we can hope for; clipping a coupon is
more likely, in our view.
Figure 60: High Yield Spread Model

2000bp
1500bp
1000bp
500bp
0bp
Jan '90 Jan '95 Jan '00 Jan '05
Spreads Spread Model
The upside case: is 13% as good as it gets?

Let’s start with a realistic best case scenario, where the global recovery takes hold
and stimulus can be removed, albeit tentatively. In this case expectations of default
risk continue to slide, exerting downward pressure on spreads. At the same time, two
offsetting factors come into play: namely a surge in primary issuance and higher
interest rates; in particular, government bond yields climb as risk aversion fades.
Let’s suppose that spreads contract by 200bp, of which 100bp is due to risk-free
yields, then we would expect our index to return close to 13%. From this we subtract
default losses and add back the effect of any new issue premium; for simplicity let’s
assume these cancel out.
A lot of downside risks remain

Although we don’t expect markets to melt-down in the manner of late-2008, going
into 2010 there are still a number of risk factors. Our core concern – shared by
investors in our latest survey – is that economic recovery stalls once fiscal
programmes start to wind down, clearly a negative outcome for leveraged companies
reliant on growth. What happens beyond this is very uncertain, as it depends on
policymakers and what actions they are prepared to take to jump start activity.
Further fiscal packages may refocus attention on the sustainability of budget deficits
and sovereign credit risk; more non-standard monetary policy could unseat inflation
expectations.
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Table 11: Which of the following do you see as the greatest risk to high yield returns in 2010?
a) Higher interest rates 21%
b) Unexpected number of defaults 4%
c) Weak economy 43%
d) Disappointing corporate operating performance 24%
e) Too much primary market issuance 6%
f) Other 1%
Source: J.P. Morgan European High Yield Credit Investor Survey, 9 November 2009
The second greatest concern investors have for 2010 is corporate operating
performance. Based on our sector analysts’ forecasts, any improvement in credit
metrics over the next year is going to come from higher margins – the by-product of
aggressive cost reduction – rather than top line growth. In fact, projected revenue
growth does not exceed 5% in any of the subsets in Table 12.
Table 12: Average European High Yield “Big Issuer” Forecasts by Sector, Revenue and Rating
No. of Revenue, %oya Adj EBITDA, %oya Free Cash Flow, €mm Net Debt, Change €mm Net Debt / Adj EBITDA
companies 2009 2010E 2009 2010E 2008 2009 2010E 2009 2010E 2008 2009 2010E
Aggregate
51 -13% 0% -12% 7% 448 368 424 -161 -129 3.8 x 4.0 x 3.6 x
Sector
Cable 5 -3% 2% -1% 4% -142 90 173 -234 -162 4.8 x 4.5 x 4.2 x
Chemicals 4 -40% 3% 3% 19% -16 -9 84 -29 -75 6.9 x 6.6 x 5.4 x
Food 4 6% 4% 15% 11% -60 46 120 14 -75 4.6 x 4.0 x 3.4 x
General Industrials 12 -14% 1% -25% 8% 49 25 77 -330 -73 4.0 x 4.5 x 3.9 x
Media 7 -10% 1% -16% 7% 60 41 71 20 -69 4.7 x 5.6 x 5.1 x
Retail 4 -2% 1% -11% 4% 226 198 57 -35 16 4.6 x 5.0 x 4.9 x
Telecoms 6 -2% 0% 0% 7% 178 129 248 -45 -231 4.3 x 4.3 x 3.7 x
Revenue
< €1,000m 8 -6% 5% -21% 12% -4 -15 22 10 -10 4.0 x 5.1 x 4.5 x
€1,000m - €5,000m 31 -8% 1% -9% 8% 28 66 93 -87 -79 4.3 x 4.6 x 4.1 x
> €5,000m 12 -15% 0% -13% 6% 191 176 240 -466 -336 3.4 x 3.6 x 3.2 x
Rating
BB 6 -6% -1% -16% 3% 209 309 228 -212 104 1.7 x 1.9 x 1.9 x
B 29 -9% 2% -10% 10% 43 59 129 -197 -215 4.1 x 4.3 x 3.6 x
CCC 13 -30% 2% -3% 6% 36 37 64 -27 -20 6.8 x 7.0 x 6.5 x
NR 3 -4% 0% -6% 3% 128 183 95 -237 -63 1.0 x 0.4 x 0.3 x
Source: J. P. Morgan estimates, company data. Some sectors are excluded because of too few companies.
Default forecast: steady as she goes

We stick with our 6-7% target for 2010
We are comfortable with our 6% target for European high yield default rates in 2009,
even though some measures show a slightly greater figure to-date. Stripping out the
eastern European corporates not in our index, and ignoring some of the opportunistic
“distressed” exchanges that we don’t feel can be justified as defaults, then we suspect
The flip-side is that defaults are
that the final tally may even come in below 6%! Nonetheless, the spirit of our
likely to remain stickier in
Europe - tracing out a plateau argument was that the European market would take its pain over a longer timeframe
rather than a peak, hence our 6- than the US, given the willingness of lenders to allow struggling businesses time to
7% default forecast for 2010 earn their way out of trouble, for example by amending covenants (Figure 61). The
flip-side is that defaults are likely to remain stickier in Europe - tracing out a plateau
rather than a peak, hence our 6-7% default forecast for 2010.
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Figure 61: European Leveraged Loan Covenant Amendments

25
20
15
10
5
0
1Q06 1Q07 1Q08 1Q09
Source: S&P LCD.
“Amend and Extend” has been successful in allowing some of the deep Cyclicals to
“Amend and Extend” has been ride out the trough in the economy and allow them to catch the upswing. Ineos is a
successful in allowing some of great example of this, even though it’s too early to say that liquidity concerns will
the deep Cyclicals to ride out the not materialise again. This theme has led some commentators to conclude that
trough in the economy and allow default rates could fall sharply in 2010, remaining low for some years as companies
them to catch the upswing
use the current market environment as an opportunity to term-out their liabilities
further.
There are however a number of situations where no amount of delay will change the
ultimate outcome. Take industries in secular decline such as Directories: even though
a Truvo (World Directories) does not have liquidity or covenant problems, a
restructuring is likely sooner, rather than later, we believe. Other businesses that are
leaking cash because of excessive debt loads and weak operating performance will
also need to take corrective action; Wind Hellas is a topical case in point. These two
cases have been well-flagged for some time now, but we believe there will be a
steady drip of other casualties despite the best intentions of lenders.
Speaking of lender behaviour, it is quite possible that senior lenders begin to take a
harder line in the future than they have done so far. Earlier in the year, low equity
Earlier in the year, low equity multiples and uncertainty over bankruptcy outcomes made it risky not to give solvent
multiples and uncertainty over companies covenant waivers and amendments; booking a fee and margin uplift was a
bankruptcy outcomes made it relatively safe option. Now valuations are higher and more experience of the court-
risky not to give solvent
mandated restructuring is available, particularly in jurisdictions like the UK which
companies covenant waivers
and amendments are viewed as being friendly to secured creditors. On this note, it will be interesting
to see whether the UK Government refines the tools for dealing with insolvent
companies, such as allowing an automatic stay and the means to put in new super-
priority financing, as discussed in correspondence with the European High Yield
Association earlier this year.
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The Future of Credit Derivatives

Credit Derivatives & Quantitative • Product standardisation, CDS auction settlement, standard coupons, model
Research
changes and central clearing all featured heavily on investors’ minds over
AC
Saul Doctor the past year. 2009 was a year of standardisation in the CDS market which saw
(44-20) 7325-3699 the biggest changes to the structure and documentation of credit derivatives since
saul.doctor@jpmorgan.com the CDS Standard Terms and Conditions in 2003.
AC
Abel Elizalde
(44-20) 7742-7829 • The coming year will see more central CDS clearing as market participants
abel.elizalde@jpmorgan.com look to further reduce systemic risk in the system. As we move into 2010, we
believe that most of the document and trading standards changes we have seen
over the past year are done. The market is now likely to focus on further reducing
systemic risk through the use of central clearing. We do not believe that clearing
is the answer to all ills nor that take-up by clients will be a forgone conclusion.
• On the structured credit side, we believe that the structured credit machine
will start to hum again in 2010. In last year’s outlook, we said that primary
issuance of CSO was unlikely in 2009 as investors with hereditary positions
would concentrate on restructuring and unwinding. With the market trading at
less distressed levels and investors searching for yield in a low rates environment,
the Phoenix may yet rise.
Product Standardisation and CDS Auctions
Big Bang
Possibly the biggest change to CDS over 2009 came from document standardisation
in the form of the Big Bang and Small Bang protocols. In order to facilitate easier
netting of outstanding notionals and reduction of CDS contract counts, the product
documentation was standardised in three main areas. i) Auction settlement was
mandated to ensure that contracts netted down following a credit event. ii) The
determination committee was created to oversee CDS credit and succession events
and to ensure that the same rules applied to all CDS contracts. iii) The effective date
of a CDS contract was changed from a fixed date to a dynamic look-back period.
(CD Player).
Small Bang
The one area that the Big Bang did not deal with was how to use the auction
following a restructuring credit event. This was more of an issue for Europe and the
US, where restructuring is seen as a less frequent event and is no longer considered a
credit event in standard trades. The Small Bang protocol dealt with holding an
auction following a restructuring credit event and the bucketing of contracts (CD
Player). This was put to the test in October when the auction to settle the Thomson
restructuring event was held. While the time taken to settle the event was longer than
usual given the ongoing restructuring event and private nature of the company, the
auction itself went smoothly with a large amount of bonds delivered on the day being
bought.
CDS Auctions
High defaults in 2009 led to a large number of CDS auctions being held (Figure 62).
In the US 25 auctions were held, while fewer defaults in Europe saw 8 auctions being
held for European CDS. Recent defaults look likely to lead to further CDS auctions
before the year is out although default rates are likely to have peaked. Overall we
believe that these auctions allowed the market to remain liquid and efficient through
a period of great market stress.
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(44-20) 7325-5454 11 November 2009
Figure 62: CDS Auctions by Quarter

Number of Auctions
15 US EU
Number of Auctions
12
0
Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009
Standard Trading Terms and Model Changes

Trading Terms
Traditionally CDS were traded as Par instruments with the market spread and the
fixed contract coupon being equal at the start of the trade. 2009 saw a change to this
convention with the introduction of standard coupons for CDS trades. In the US the
standard coupons of 100bp for investment grade and 500bp for high yield were
chosen. In Europe, a larger array of fixed coupons is available 25bp, 100bp, 300bp,
500bp, 750bp and 1000bp to allow greater flexibility and the option of smaller
upfront payments.
Restructuring as a credit event was also dropped from the standard US investment
CDS contracts although it is still a credit event in the standard European contract.
Models
Model changes played a big role for many a quant over the past year. The standard
J.P. Morgan CDS model was replaced by the ISDA CDS Standard Model with the
source code made freely available by ISDA. The main changes related to using a flat
clean spread curve for CDS valuation and a 40% fixed recovery rate to imply a
quoted spread.
Clearing
One of the main drivers behind the move towards CDS product standardisation was
the push by regulators throughout the world that derivatives, including CDS, be
cleared through a central clearing counterparty. Following the default of Lehman
Brothers, concerns about systemic risk in the financial system were highlighted and
Central Clearing was raised as one way to solve this issue.
Currently, a portion of new CDS index trades are being cleared through the ICE
Trust in the US and ICE Clear in Europe for trades done between members of the
clearing house, primarily CDS dealers. (Other offerings for dealer and client clearing
are also being examined.) Single name CDS clearing along with clearing of client
positions is scheduled for Q4 2009. Clearing is not intended to replace the standard
trading execution of CDS trades, however, once execution has taken place, the trade
will novate and both counterparties will face the clearing house.
66
(44-20) 7325-5454 11 November 2009
The main benefit of clearing is that it allows protection of margins and collateral and
also enables greater portability of positions. If one counterpart to a trade defaults, the
other counterpart no longer becomes an unsecured creditor as their margin and
collateral is already held in a segregated account on the clearing house. Additionally
positions can be moved more easily moved from one clearing member to another
since both face the clearing house and not each other.
We believe that clearing should be offered but not forced on investors who may have
concerns regarding the focus of risk in one central body, the margining of positions
in a segregated account and the ability to net trades of different assets on different
clearing houses.
Synthetic Structured Market: 2010’s Wildcard

Demand will be there … Pressure to deliver returns in a low yield environment
2009 will not be forgotten, but is unlikely to be repeated. The levels of un-levered
yield available to credit investors during 2009 will not exist in 2010. Similarly, the
speed and strength of the market rally since March will not drive investors’ returns
during 2010. However, the pressure on market participants to deliver returns will be
higher than ever, after the losses during 2007 and 2008. Given the demand for
“enhanced” credit returns during 2010, the synthetic structured market has much to
offer investors going forward in our view.
… and supply will be offered ... The new structures need to address previous weaknesses and exploit the relative
value in the current environment
On the offer side, the new synthetic structured credit market needs to address
investors’ concerns regarding the synthetic structures issued back in 2004-2006, both
in terms of MtM and rating levels.
We think 2010 can be called “The year of the structurers”: they need to balance
investors’ concerns over previous structures (MtM volatility, collateral, counterparty
exposure, capital charges...) with the relative value in the current credit markets
(emerging markets, financials, sovereigns...).
Structures will likely be more stable and less “optimised”: more diversified
underlying portfolios, higher subordinations, thicker tranches and shorter maturities.
The need for ratings will have to be revisited in a new world where all rating
agencies have substantially revised and made their rating methodologies more
conservative.
Products will need to target the current pockets of value in the credit markets:
traditional corporate portfolios will be combined with or replaced by EM corporates,
sovereigns, financials, (basis packages?) …
… until both ends meet, During 2010, the market will test the ability of structurers to meet investors’
probably after an iterative concerns and demands via synthetic structured products. We are already seeing
process which brings supply
and demand one step closer at a
the first steps of this process: the first approaches from the investor community as
time. well as the first structures from the dealers. We expect these dynamics to continue
and to experience an initial trial-and-error phase where investors and structurers align
demands, concerns, structures, risk and returns.
67
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Who’s a buyer?
It is difficult to see the same buyers of CSOs during 2003-07 returning to the market
first this time around. Banks may face less pressure to generate returns than to
increase their capital base; additionally they are the most rating sensitive investors
and, as a consequence, we do not think they will participate in the first round of
synthetic structures. However, those banks that have outperformed their peers and
have pockets of cash to put at work may be tempted by the new CSOs. Less rating
sensitive investors such as insurance companies and asset managers are our most
likely candidates to lead the demand for synthetic structures.
68
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Analyst Certification:
The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily
responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with
respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report
accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research
analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst(s) in this report.
Important Disclosures
Important Disclosures for Credit Research Compendium Reports: Important disclosures, including price charts for all companies
under coverage for at least one year, are available through the search function on J.P. Morgan’s website
https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406)
Explanation of Credit Research Ratings:

Ratings System: J.P. Morgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months, the
recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the
recommended risk position is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next
three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan’s
Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating.
Valuation & Methodology: In J.P. Morgan’s credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral)
based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit
rating agencies and the market prices for the issuer’s securities. Our credit view of an issuer is based upon our opinion as to whether the
issuer will be able service its debt obligations when they become due and payable. We assess this by analyzing, among other things, the
issuer’s credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital
investment). We also analyze the issuer’s ability to generate cash flow by reviewing standard operational measures for comparable
companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuer’s balance sheet relative to
the operational leverage in its business.
J.P. Morgan Credit Research Ratings Distribution, as of September 30, 2009

Overweight Neutral Underweight
EMEA Credit Research Universe 21% 53% 26%
IB clients* 74% 74% 62%
Represents Ratings on the most liquid bond or 5-year CDS for all companies under coverage.
*Percentage of investment banking clients in each rating category.
Analysts’ Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various
factors, including the quality and accuracy of research, client feedback, competitive factors and overall firm revenues. The firm’s overall
revenues include revenues from its investment banking and fixed income business units.
Other Disclosures
J.P. Morgan is the global brand name for J.P. Morgan Securities Inc. (JPMSI) and its non-US affiliates worldwide. QIB ONLY
Options related research: If the information contained herein regards options related research, such information is available only to persons who
have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation’s Characteristics and Risks of
Standardized Options, please contact your J.P. Morgan Representative or visit the OCC’s website at
http://www.optionsclearing.com/publications/risks/riskstoc.pdf.
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(44-20) 7325-5454 11 November 2009
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disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as
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Copyright 2009 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or
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JP Morgan European Credit Research

Head of European Credit Research & Strategy
Stephen Dulake Team Assistant
www.morganmarkets.com/analyst/stephendulake Laura Hayes
125 London Wall (44 20) 7777-2280
6th Floor laura.x.hayes@jpmorgan.com
London EC2Y 5AJ
High Grade and High Yield Research Groups

Energy and Infrastructure Emerging Market Corporates ABS & Structured Products
Olek Keenan, CFA Victoria Miles Rishad Ahluwalia
(44-20) 7777-0017 (44-20) 7777-3582 (44-20) 7777-1045
olek.keenan@jpmorgan.com victoria.miles@jpmorgan.com rishad.ahluwalia@jpmorgan.com
www.morganmarkets.com/analyst/olekkeenan www.morganmarkets.com/analyst/victoriamiles www.morganmarkets.com/analyst/rishadahluwalia
General Industrials Allison Bellows Tiernan, CFA Gareth Davies, CFA

Nachu Nachiappan, CFA (44 20) 7777-3843 (44-20) 7325-7283
(44-20) 7325-6823 allison.bellows@jpmorgan.com gareth.davies@jpmorgan.com
nachu.nachiappan@jpmorgan.com www.morganmarkets.com/analyst/allisonbellowstiernan www.morganmarkets.com/analyst/garethdavies
www.morganmarkets.com/analyst/nachunachiappan
Nikolay Zhukovsky, PhD Support Analyst
Nitin Dias, CFA (44-20) 7777-3475 Advait Joshi
(44-20) 7325-4760 nikolay.x.zhukovsky@jpmorgan.com advait.s.joshi@jpmorgan.com
nitin.a.dias@jpmorgan.com www.morganmarkets.com/analyst/nikolayzhukovsky
www.morganmarkets.com/analyst/nitindias
Financials Credit Derivatives & Quantitative Research
Ritasha Gupta Roberto Henriques, CFA Saul Doctor
(44-20) 7777-1089 (44-20) 7777-4506 (44-20) 7325-3699
ritasha.x.gupta@jpmorgan.com roberto.henriques@jpmorgan.com saul.doctor@jpmorgan.com
www.morganmarkets.com/analyst/ritashagupta www.morganmarkets.com/analyst/robertohenriques www.morganmarkets.com/analyst/sauldoctor
Support Analyst Christian Leukers, CFA Abel Elizalde

Nirav Bhatt (44 20) 7325-0949 (44-20) 7742-7829
nirav.x.bhatt@jpmorgan.com christian.leukers@jpmorgan.com abel.elizalde@jpmorgan.com
www.morganmarkets.com/analyst/christianleukers www.morganmarkets.com/analyst/abelelizalde
TMT – Telecoms/Cable, Media & Technology Alan Bowe Support Analyst

David Caldana, CFA (44 20) 7325-6281 Harpreet Singh
(44-20) 7777 1737 alan.m.bowe@jpmorgan.com harpreet.x.singh@jpmorgan.com
david.caldana@jpmorgan.com www.morganmarkets.com/analyst/alanbowe
www.morganmarkets.com/analyst/davidcaldana Credit Strategy
Autos & General Industrials Stephen Dulake
Andrew Webb Stephanie Renegar (44-20) 7325-5454
(44-20) 7777 0450 (44-20) 7325-3686 stephen.dulake@jpmorgan.com
andrew.x.webb@jpmorgan.com stephanie.a.renegar@jpmorgan.com www.morganmarkets.com/analyst/stephendulake
www.morganmarkets.com/analyst/andrewwebb www.morganmarkets.com/analyst/stephanierenegar
Daniel Lamy
Malin Hedman Support Analyst (44-20) 7777-1875
(44-20) 7325 9353 Nirav Bhatt daniel.lamy@jpmorgan.com
malin.b.hedman@jpmorgan.com nirav.x.bhatt@jpmorgan.com www.morganmarkets.com/analyst/daniellamy
www.morganmarkets.com/analyst/malinhedman
Tina Zhang
Support Analyst Consumer & Retail (44-20) 7777-1260
Amir Kumar Katie Ruci tina.t.zhang@jpmorgan.com
amir.x.kumar@jpmorgan.com (44-20) 7325-4075 www.morganmarkets.com/analyst/tinazhang
alketa.ruci@jpmorgan.com
www.morganmarkets.com/analyst/katieruci
Raman Singla
(44-20) 7777-0350
raman.d.singla@jpmorgan.com
www.morganmarkets.com/analyst/ramansingla
Research Distribution
To amend research distribution, please contact Laura Hayes our Credit Research Administration, contact details above.
J.P. Morgan research is available at http://www.morganmarkets.com
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JP Credit Outlook 2010

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JP Credit Outlook 2010

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Europe Credit Research

European Credit Outlook & Strategy 2010

• This year, we have taken a somewhat more thematic approach to Strategy

months, we see ourselves transitioning into a low-return environment

See page 69 for analyst certification and important disclosures.

2010 Executive Summary

We examine the future of credit derivatives and see a resumption of synthetic

High Conviction Trades for a Low Return World

Macro and Index Trades

Making Money in 2010: It Gets Tougher

On a broad sectoral basis, we generated considerable alpha from being Overweight

2010 high grade investment themes

Source: J.P. Morgan.

Figure 2: JPMorgan's Macro Spread Model

250 Base Case (65%)

Source: J.P. Morgan.

Non-Fin Dispersion Sub-banks

Source: J.P. Morgan.

Source: J.P. Morgan.

1. An iTraxx Main 3s-5s flattener. Curves have historically tended to flatten

2. Buying super-senior protection. This is, in our view, preferable and

3. Buying iTraxx SovX protection. Governments are arguably playing a

4. Looking at interest rate options. A delta-hedged 3-month straddle on 5-

2010 high yield investment themes

#2 Refinancing: risk or opportunity? Own subordinated bonds in good

#3 In the distressed space we prefer Financials to Non-Financials

High Conviction Trades for a Low Return

Analyst: Saul Doctor

Figure 6: iTraxx Payer Spread Figure 7: iTraxx Main Volatility Skew

200 Pay er Spread

Long US versus Short Europe

300 CDX IG iTrax x Main 60 10 CDX IG Iv ol bp iTrax x Main Iv ol bp

Industry and Single Name Trades

Top European Chemicals shorts as M&A momentum looks

Long Risk Selective “280bp+” Auto Credits vs. Single-Name

FCE versus FMCC Relative Value Switch

Long PEPR risk

HSH Nordbank already has a significant amount of grandfathered debt guaranteed by

Source: J.P. Morgan.

Buy Hypo Real Estate Tier 1

Long RBSG Convertible Preference Shares and UT2

Figure 14: The more liquid preferred bonds

Long risk Brewers Basket Trade

Figure 15: Historical Performance of Non-Financials vs. Carlsberg and Heineken

Long-Short Consumer vs. Non-Food Retail Basket Trade

We target 50bp of relative outperformance of the long versus short basket.

Long risk KPN versus Short TI

Long Risk ITV; Short Risk Bertelsmann

ITV 5y r CDS BERTEL 5y r CDS

Tranches and Options Trades

Sell 10y super senior iTraxx Series 12 protection, delta hedged

A Recovery, but Not a Return to Normality

Figure 22: Global trade recovering from depressed levels

Table 4: Recession damage to the level of potential output by end-2011

In contrast, the Bank of England has viewed quantitative easing as a natural

The Regulator Strikes Back

Bank Capital: How Are We Going to Be left?

Figure 24: Bank Capital - Expected Structural Changes

Subordinated debt Tier III

(Qualifying dated with onerous language)

Source: J.P. Morgan.

• Collapsing of the intermediate tranches of the existing regulatory capital structure

‘Super Hybrid’ Capital