European AAA RMBS Vs Corporate Bonds - ininad.co.uk

1 Institutional Investment Advisors Limited Strictly Private & Confidential Briefing Note European AAA rmbs s Corporate Bonds V 7 November 2009 1 This document is confidential and has been prepared for discussion purposes only. It should not be transmitted in any form to any person outside the recipient s organisation. It is not, is not intended to be and should not be construed as investment advice. It has been prepared on the basis of information believed to be reliable. IIA makes no warranty, expressed or implied, as to the accuracy or completeness of any of the information or opinions it contains. Institutional Investment Advisors Limited Authorised and regulated by the Financial Services Authority (Firm No. 475344) Strictly Private & Confidential 17 November 2009 2 Investment Proposition Residential mortgage backed securities (" rmbs ") represent the second largest of the European bond market sectors after sovereign issues.

2 However, at current market levels and in comparison to Corporate Bonds , selected European AAA rated senior rmbs offer Higher Yield Lower Credit Risk Lower Interest Rate Risk Technical factors abide to present investors with an opportunity to reduce both credit risk and interest rate risk and increase yield by switching from Corporate Bonds to AAA rmbs at current levels. Key Points Benchmark fixed rate bond indices exclude much of the huge rmbs market in Europe that is comprised of floating rate securities. With institutional investors increasingly using swaps to separate fixing duration from seeking return, rmbs can currently play a major role in generating the required floating rate returns in excess of LIBOR/EURIBOR. The US and European markets share an acronym " rmbs ". But there are many significant differences between the US and UK/ European rmbs markets. The rating reductions in US Non agency AAA rmbs have been extensive and dreadful.

3 There have been no downgrades in the UK Master Trust rmbs sector. Both Moody's and Bank of England have projected rmbs losses arising from the current downturn. Both find the UK MT rmbs structures to be resilient in the face of likely rises in unemployment and falling house prices. Specifically, neither expects any losses for AAA tranches under their severe cases. Moody's estimates that losses would need to be twice the levels experienced in the 1990s before any investment grade tranches were affected The period in 1990 to 1993 was made considerably more painful for borrowers by interest rates which were well in excess of 10%. This is not the case now. The investment equivalent of a "free lunch" available in switching from Corporate Bonds to AAA rmbs arises, we believe, from technical factors of which the main two are: Very heavy allocation to Corporate Bonds in 2009, in particular arising from the strong bid from retail funds, makes them now relatively The AAA rmbs sector is still recovering from the departure in 2008 of leveraged buyers (Structured Investment Vehicles, hedge funds and banks) and this has kept the sector cheap, on a risk adjusted basis, relative to Corporate Bonds .

4 1 " Corporate investment grade bond funds continue to underpin fixed income growth. Year to date inflows now stand at an all time high of 28bn." Lipper FMI Oct 2009 mutual fund report re Aug09 YTD. Strictly Private & Confidential 17 November 2009 The relative size of the European rmbs market Outstanding bond issues backed by European residential mortgage collateral (including "covered Bonds ", a distinctively European concept that includes traditional German Pfandbriefe) exceed the market value of the Euro and sterling fixed rate Corporate bond markets. Chart 1: bond Markets. Relative Market Sizes (30 Jun09, Euro Billions) 3,7467072,6358441591,3001,3943011,904666 4353,8287826 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 Euro/Europe Stg/UKUSD/USCoveredRMBSC orporateQuasi & Foreign GovernmentSovereign All data in Euro billions or equivalent. rmbs is by region of collateral not currency and includes only Agency MBS for US (non Agency rmbs is an additional 435bn).

5 All data other than rmbs are for fixed rate index qualifying Bonds . Source: All data except rmbs , Banc of America Merrill Lynch fixed rate bond indices. rmbs sourced from ESF Q2 2009 report. The European rmbs market is bigger than the Corporate bond market. Until mid 2007, the spreads available on AAA European rmbs were so low that the investor base was dominated by leveraged holders. As the following Chart 2 shows, prime AAA rmbs spreads now provide higher risk adjusted returns than are available on AA Corporate Bonds . The European rmbs market deserves the attention of any fixed income investor on the grounds of its relative size alone. It now deserves the close attention of institutional investors seeking risk adjusted value. 3 Strictly Private & Confidential 17 November 2009 European AAA rmbs Vs Euro 3 5 Year Corporate Bonds Spread Comparison The largest part of the European rmbs market is represented by UK rmbs , of which the main issuers are the Master Trusts.

6 Chart 2: UK AAA rmbs Spreads versus Euro 3-5 Year AA rated Corporate Bonds 16075050100150200250300350400450 Dec 99 Dec 01 Dec 03 Dec 05 Dec 07 Dec 09 rmbs Secondary MarketsRMBS New IssuesEuro 3 5 Yr AA Corps Source: UK rmbs data from market sources, spreads in bp over LIBOR for Euro denominated Master Trust 5 yr AAA issues. Euro Corporate bond index data from Banc of America Merrill Lynch Research (ER22, asset swap spreads Vs LIBOR data to 13 November 2009) Euro 3 5 year AA rated Corporate spreads have returned to February 08 levels, prior to the intense crisis of late 2008 Prime AAA UK 5 year rmbs spreads have also retreated, but only as far back as Sep 08 levels UK AAA rmbs spreads currently exceed average similar maturity AA Corporate bond spreads by around 85 basis points 50bps on a portfolio of 100million with 4 years average life has a PV of nearly 2 million This is the picture using the full AA Corporate bond index in 3 5 years.

7 However, Spreads on 3 5 year Corporate Bonds are currently flattered by financials that dominate the index. While the 3 5 year AA index has only a few bank subordinated issues, the EU has pointed out that banks provided with state aid "should consult the Commission before making announcements to the market concerning Tier 1 and Tier 2 capital transactions" and such "transactions" are understood to include coupon payments. Subordinated financials comprise some 14% of the overall Euro Corporate index and 38% of the spread weight. Chart 3 below shows that spreads on industrials are now much narrower on average around 33 basis points. Spreads on prime AAA UK 5 year rmbs are currently some 120 130 basis points wider than those available on 3 5 year AA industrial Corporate Bonds . 4 Strictly Private & Confidential 17 November 2009 Chart 3: UK AAA rmbs Spreads versus Euro 3-5 Year AA rated Corporate Bonds 16 November 2009 16074813373867912787020406080100120140 AAA rmbs AA 3 5Yr Corps AA 3 5Yr FinancialsAA 3 5Yr IndustrialsAA 3 5 Yr UtilitiesASW SpreadVs rmbs Source: UK rmbs data from market sources, spreads in bp over LIBOR for Euro denominated Master Trust 5 yr AAA issues.

8 Euro Corporate bond index data from Banc of America Merrill Lynch Research (ER22, asset swap spreads Vs LIBOR data at 16 November 2009) US Vs UK Rating experience reflects major differences in collateral and structure In summary, the rating experience of US non Agency deals has been dreadful to date, especially for deals originated in 2006 and 2007 ("vintages")(Chart 4). European deals have proved in general robust. In the UK, the largest part of the European rmbs market, there have been no downgrades in the Master Trust rmbs sector. The only negative rating action in the past year was Fitch changing its outlook to negative on 26 BBB tranches of the Granite MT, due to performance deterioration. Chart 4: Downgrades of US Non Agency AAA rated rmbs by vintage, to August 2009 0%20%40%60%80%100%2000 2001 2002 2003 2004 2005 2006 2007 Prime ARMAlt A ARMS ubprimeUK Master Trust rmbs Source: Banc of America Merrill Lynch Research 5 Strictly Private & Confidential 17 November 2009 UK rmbs Master Trusts: Losses to date, expected losses & break points In a report dated 2 September 20092, Moody's have updated their detailed analysis of expected losses in the main UK rmbs Master Trusts.

9 Chart 5: UK rmbs Master Trusts. Losses and breakpoints 0%5%10%15%20%25%30%Projected Exp. LossCumulative LossAaa Break Points Aa Break Points Source: Market data from individual Master trusts, Moody's. * Deals have elements of Non Prime Cumulative losses to date, (green triangles), are very low indeed and will have been absorbed by excess spread retained in the Master Trusts. Moody's projections of expected losses for the Master Trusts (red crosses) are set out in their report of 2 September 2009 and based on their estimates of the impact of the downturn on these Master Trusts. The level and range of values is low in relation to the protection provided to senior debt tranches. Moody's have also calculated for each Master Trust the "break points" for the senior notes (gold balls for AAA, silver squares for AA). The break point is defined as the minimum overall level of losses required before each tranche would experience a loss of either principal of interest.

10 The level of the break points varies between the Master Trusts as a function of both the quality of the underlying collateral and their structure. Moody's estimates of Master Trust losses required to "break" their AAA or even AA tranches in all cases substantially exceed Moody's current projections of expected losses. 2 Moody s: "Assessing the potential performance of UK MTs in current housing downturn" 2 Sep 09 6