Bipolar trading for a bipolar world - Top Fixed Income ...

Deutsche Bank Markets Research

Global

Special Report

Rates Gov. Bonds & Swaps Inflation Rates Volatility

Date 9 October 2014

Bipolar trading for a bipolar world - Top Fixed Income Trades for the Autumn

________________________________________________________________________________________________________________

Deutsche Bank AG/London

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.

Research Team

Europe Sebastian Barker Nick Burns Alex Duering Paul Heaton Markus Heider Conor O’Toole Rachit Prasad Soniya Sadeesh Jerome Saragoussi George Saravelos Abhishek Singhania Bernd Volk Francis Yared Americas Steven Abrahams Aleksandar Kocic Dominic Konstam Alex Li Daniel Sorid Stuart Sparks Steven Zeng Oleg Melentyev Asia Pacific Kenneth Crompton David Plank Makoto Yamashita

Trade #1: The difficulty of “normalization” – Buy USD 3M5Y receiver spreads and bearish conditional swap spread wideners

Trade #2: Cheaper than a cheap breakeven – USD 5s10s steepener hedged by paying 20% 2Y

Trade #3: The trillion euro trade – Receive June-16 Eonia

Trade #4: Viva Italia - Buy 1.5% BTPS Aug-19

Trade #5: Flat out - GBP 5Y-10Y steepener

Trade #6: Cheaper Yen but dearer JGBs - Buy 20Y JGB on ASW basis

Trade #7: Fed up down under - AUD 6M fwd 1Y vs. 3Y steepener

Trade #8: Give me a break - Long USD 2Y fwd 2Y inflation breakevens

Trade #9: Bad Grade Good - Buy EUR single-B credit

Trade #10: Turn weakness into strength - Buy weaker Spanish and Italian covered bonds

Trade #11: Riding the ECB liquidity wave - Buy new issue CMBS

9 October 2014

Special Report: Bipolar trading for a bipolar world - Top Fixed Income Trades for the Autumn

Page 2 Deutsche Bank AG/London

Overview

The last four months have been marked by weaker growth in Europe and Emerging Market countries and downward surprises to inflation globally driven, amongst other, by materially weaker commodity prices. The US economy has remained the bright spot, with the unemployment rate reaching post crisis low, a strong rebound of growth in Q2 after a weak Q1, and the business surveys pointing to sustained momentum into Q3. In this macro environment, the divergence between central banks has been stark. The Fed is about to complete its asset purchase programme and, is expected to normalise policy in 2015. The ECB has followed up the TLTRO with its own asset purchase programme and has implicitly endorsing a EUR1trn targeted increase in its balance sheet. Bond markets have perform well, with Bund yields making new lows, the US and UK curves bull flattening and breakevens tightening significantly globally. In credit, High Yield has underperformed (especially in the US), but peripheral bond markets have remained resilient (with the exception of Greece).

Given this backdrop, we have each identified the best trades in our markets unconstrained by a top-down macro view. Two strong themes have emerged from this bottom up process: (1) yield curve are excessively flat and the current combination of expected policy normalisation in the US and the UK and depressed inflation expectations cannot be sustained (2) carry remains king in Europe thanks to an ECB which is ultimately determined to do “whatever it takes”

Fading the excess flatness of yield curves On almost any metric, yield curves are too flat, in the US, the UK and Australia. The market is pricing both policy tightening in the US and depressed inflation levels. Something will have to give. There are several (non-mutually exclusive) ways the curve could normalise back. First, inflation breakevens could normalise from depressed levels, and we express this with a long USD2Y2Y breakeven. Second, the front-end of the US curve could rally as the market prices a delay in the normalisation of monetary policy in the US, and we express this via a USD3M5Y receiver spreads. Third, one could be agnostic about what will drive the normalisation and the curve could steepen back, and we express this via a GBP5s10s steepener. Fourth, one could hedge the directionality of the curve with front-end rates and trade the excess flatness more directly. We express this view with a USD 5s10s steepener vs. a (beta weighted) short in USD2Y. The latter trade happens to also be an efficient way to proxy for a widening of breakevens. Finally, one can trade the normalisation of the USD curve via other markets and we express this via AUD 6M fwd 1Y vs.3Y steepener which has flattened as 10Y UST yields have rallied over the past few months

Carry remains king in Europe The theme in Europe remains very much focused on carry, with a particular emphasis on the impact of the forthcoming ECB intervention. The ECB is unlikely to reach its implicit balance sheet target with the measures announced so far. Its willingness to try and ultimately to do “whatever it takes”, has nonetheless important implications. Given the relative reluctance to cross the public QE Rubicon at this stage, the ECB is likely to be more aggressive in implementing its private asset purchase programmes. This should support the targeted assets, and we recommend being long the weaker covered bonds in Spain and Italy and new issue CMBS focusing on the front pay level, where liquidity is greatest and spreads range from around 90bps Dutch CMBS to around 125bps for Italian CMBS. Also, the front-end of the euro curve is only pricing a marginal increase in the overall size of the ECB’s balance sheet. Even if the ECB is unable to increase its balance sheet by the advertised EUR1trn, it should manage to accumulate more than the ~EUR200bn implied by the Eonia market. We thus recommend being long June-16 Eonia. Finally, the combination of lower front-end core rates and tighter peripheral covered bonds should together imply lower peripheral bond yields. The latter is also supported by a favourable funding dynamics thanks to positive current accounts and the support of the ECB via the TLTRO. We thus recommend being long 5Y BTPs outright.

Performance of the summer top trades The Fixed Income Top trades for the summer (see Appendix) have performed reasonably well. The trades have a hit ratio of 72%. For the trades where the performance was measured in bp, the average P&L was +4.3bp while for the trades where the performance was measured in % terms the average P&L was +0.1%.

The DB Fixed Income Team

9 October 2014


Deutsche Bank AG/London Page 3

Trade #1: The difficulty of “normalization” – Buy USD 3M5Y receiver spreads and bearish conditional swap spread wideners

We continue to see scope for the market to lower the cyclical terminal funds rate due to the fragility of profits and hence risk asset prices. Both the 2y1y and 3y1y rate look cheap on the curve. We favor buying OTM receiver spreads on 5y tails

As a hedge to a more aggressive Fed attempt to inject volatility into the market, we note that a modest vol premium in FV futures options allows investors to construct conditional bearish swap spread wideners at zero premium strike spreads better than the forwards. We would expect these structures to perform well if a more hawkish Fed undermines risk asset valuations and increases hedging flows in swap spreads consistent with the “Taper Tantrum” experience during 2013

Buy 3m5y OTM receiver spreads Investors can achieve 7.5:1 payout ratios by buying 3m OTM receiver spreads on 5y tails. Both the 2y1y and 3y1 rate look cheap on the curve from the perspective of a DV01 and curve neutral butterfly with risk weights derived from 10y of history.

Buy 3m5y -25/-50 receiver spread for 16bp up front

Given the strike spread and premium the payout ratio is 7.5:1. The maximum loss is the premium outlay. The maximum profit is the strike spread (adjusted to up front terms) less the premium outlay.

Figure 1: Cheapness in the 5y sector: curve neutral

2y/2y2y/4y2y butterfly

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Source: Deutsche Bank

If we are right that risk asset valuations aren’t yet “ready” for tighter policy – for example the coefficient of (log) S&P500 prices on real yields from a regression versus breakevens, real yields, and DXY has turned negative and increasingly so post crisis – then the Fed will at best be forced to hike haltingly and at worst will be prevented from “normalizing” fully even to our 2.75% estimate of equilibrium funds. This would lead the market to re-price the terminal rate lower and would favor the 5y sector of the curve, in our view.

Sell FVH5 puts versus payers swaptions A more aggressive Fed might carry on with what we perceive as attempts to increase risk premia and raise volatility to smooth the impact of prospective rate hikes.

If risk assets are not able to withstand higher rates, then the reaction could be a wobble in valuations akin to that of late spring/early summer 2013. During the Taper Tantrum of 2013 investors hedging spread product used swap spreads as a hedging vehicle, and given the lower volatility of swap spreads relative to corporate spreads, were obliged to over-hedge from the perspective of notional principal versus the underlying asset being hedged. The result could be a sharp and (bearish) directional widening of spreads much like that experienced during the Taper Tantrum. Such a market dynamic would be conducive to conditional spread wideners such as selling FV puts and buying the analogous swaption with maturity matched underlying rate.

Figure 2: Correlation of swap spreads and IG OAS

during Taper Tantrum

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Sell 1,000 FVH5 117 puts versus buy $117mm 2.155% payers expiring February 20, 2015 into swap commencing April 6, 2015 and maturing May 31, 2019 for zero premium

At the time of writing the FVH5 strike was just over 23bp OTM. Due to the vol premium of FV over swaptions, the zero premium strike spread of 10.8bp is 1.75bp better than the invoice spread, which was 12.6bp.

The risk to the trade is that spreads tighten in a sell off. The maximum loss and maximum gain are in theory unlimited provided strikes are crossed. If strikes are not crossed, i.e. the market rallies, then both options expire worthless. We recommend observing a stop level of 8bp in terms of the underlying invoice spread targeting 10bp of spread widening.

Stuart Sparks New York, +1 (212) 250 0332

9 October 2014



Trade #2: Cheaper than a cheap breakeven – USD 5s10s steepener hedged by paying 20% 2Y

USD5s10s steepener vs. pay 2Y (20% weight) to hedge the long-term negative directionality of the trade with monetary policy (i.e. USD2s5s10s with DV01 weightings -20%/100%/-100%). Current 87bp, Target 105bp, Stop 75bp.

USD5s10s is historically flat against fundamentals and long-term breakeven inflation levels are already depressed. The curve is already pricing significant spillovers from Europe and/or disinflation risks. By removing the directionality of the slope with the short rate, the trade provides a cheap long exposure to the inflation risk premium.

The USD 5s10s slope has flattened significantly since the beginning of the year. The flattening was successively driven by (1) normalization from excessively steep levels following tapering, (2) accumulation of US dollar reserves notably by China via its interventions to depreciate the CNY and (3) pricing of global disinflation risks and higher QE expectations out of Europe.

The USD slope is now at historically flat levels relative to fundamentals summarized by: (a) short term rates (b) long-term inflation expectations (which are already depressed) (c) expected fiscal deficits (d) rates volatility and risk aversion (see Figure 1). The current excess flatness could be attributed to the spillover from global monetary policy easing (e.g. ECB QE) and/or global disinflationary pressures. However, the excess flatness of the curve already exceeds the levels observed at the height of QE infinity, the market already embeds ECB QE expectations and valuations in US breakevens are already depressed (see Figure 1 and 2).

From a macro perspective, the risks to an outright steepener would come from a more aggressive pace of tightening (bear flattening) or a rise in risk aversion/disinflation (bull flattening). Given that the Fed’s favourite measure of 5Y5Y breakeven is now as low as it was at the peak of the Lehman and eurozone crises, the bull flattening risk should be reduced. Indeed, from current levels, it is unlikely that breakeven could tighten materially, or risk aversion rise without some pricing out of rate hike expectations. On the other hand, current Fed Funds pricing is more benign than the dovish centre of the FOMC’s forecast. Thus, we favour a beta weighted short in 2Y rate (20% DV01) to mitigate the bear flattening risk. The 2s5s10s -0.2/1/-1 trade is also a good and cheap proxy for the already depressed Fed 5Y5Y breakeven (see Figure 3) and it benefits from positive carry of 2bp over 3 months (unlike a long 5Y5Y CPI swap position which suffers from negative roll by -2.5bp over 3 months).

Jerome Saragoussi, New York, +1 (212) 250-3529

Figure 1: US 5s10s slope excessively flat

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Theoretical slope implied by the model (2Y rate, 5Y5Y BE, risk aversion, rates vol, expected deficit)USD 5Y-10Y swap slope


Figure 2: 2Y/5Y/10Y butterfly -20%/100%/-100%

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USD 2s5s10s -20%/100%/-100% butterfly (in bps)

Bond market conundrum

Lehmancrisis

QE2

EU crisis,Twist and QE infinity

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Figure 3: Trade provides cheap and carry efficient

exposure to US 5Y5Y BE

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9 October 2014



Trade #3: The trillion euro trade – Receive June-16 Eonia

Receive Jun-16 IMM Eonia at -2.5bp. Target: -12.5bp, Stop-loss: +2bp

ECB targets a EUR 1trillion balance sheet expansion The ECB has stated that one of the aims of its recently announced policy measures is to steer its balance sheet size back towards the levels of early 2012. This would imply an increase in balance sheet and excess liquidity of about EUR 1trillion. The measures announced so far, i.e. the TLTROs, CBPP3 and ABSPP, do not appear to be sufficient enough to achieve the target. However, Draghi’s statements suggest that the ECB remains willing to do what is necessary to achieve this target including government bond QE.

Less than half of that could result in Eonia rates at ~-15bp An increase in the ECB’s balance sheet size and excess liquidity should result in Eonia rates trade lower and closer to the ECB’s deposit facility rate. Historically, with even around EUR 500bn (EUR 350bn higher than current level) of excess liquidity in the system Eonia rates have traded at around 20% of the spread between the deposit facility rate & main refinancing rate. The current levels of -20bp and +5bp for these rates would imply that with EUR 500bn of excess liquidity Eonia could trade at around -15bp.

Trough in Eonia rates should occur later The trough in Eonia rates should occur when excess liquidity at its peak assuming that the refi and deposit facility rates remain unchanged. The current trough in Eonia rates is seen in H2 2015 at -8bp with rates rising to -2.5bp by June-16. The limited take up of the first TLTRO (EUR 83bn) and the expected slow pace of purchases of private sector assets leads us to believe that the balance sheet expansion of the ECB is likely to be slower than expected. We would recommend receiving June-16 Eonia at -2.0bp. The trade has a positive carry of 2.5bp over 3 months. We would target -12.5bp with a stop loss of +2bp.

Abhishek Singhania London, + 44 (207) 547 4458

ECB is targeting a EUR 1trillion balance sheet

expansion

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Source: Deutsche Bank, Bloomberg Finance LP

Excess liquidity at EUR 500bn could see Eonia at -15bp

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9 October 2014



Trade #4: Viva Italia– Buy 1.5% BTPS Aug-19

Buy BTPS 1.5% Aug-19 at 1.03%, target 0.90% and stop loss 1.20%

Italian sovereign should rally on further ECB easing Despite the significant rally in peripheral spreads they remain wider than other credit spreads such as iTraxx main and senior financials. Over the course of 2009, while the financial markets were still under stress but before the start of the Eurozone sovereign debt crisis Italian 5Y ASW spreads were on average ~80bp tighter than iTraxx main and senior financial spreads while at the moment Italian spreads are at the same level as these spreads. The current environment of low yields and the potential for further ECB easing remains conducive for further, albeit limited, rally in the periphery. The recent weakness in activity and inflation data over the past few months could be a concern from a medium-term perspective. However, the ECB is likely to be cognizant of the impact on lending to the real economy and inflation expectations should peripheral yields rise and hence the potential for yields to increase meaningfully should be limited.

Prospect of govt. bond QE favours outright long rather than spread tighteners In case of a GDP/ECB capital key weighted govt. bond QE while peripheral sovereign bond yields will rally core government bond yields could rally even further. In fact, relative to the outstanding amount of marketable debt, ECB buying is likely to disproportionately benefit Bunds relative to BTPs. Therefore, we would recommend going long BTP outright rather than on a spread vs. Germany.

Domestic banks have stayed away from this market Due to AQR/stress test related concerns domestic banks in the periphery have not been active buyers of peripheral sovereign debt over the past few months. In the current environment where the growth outlook does not look robust and yields remain low it is highly unlikely that domestic banks will be looking to reduce their holdings of sovereign debt. The additional liquidity obtained via the TLTROs should benefit the front-end of the peripheral curves. The significantly lower volatility of the total return performance of the 3Y-5Y sector vs. the 7Y-10Y sector leads us to prefer being long 5Y Italy.

We recommend going long the 1.5% Aug-19 BTP at 1.03%. We target a yield level of 0.90% with a stop loss at 1.20%. The 3M carry and roll down on the trade are +8bp and +5bp respectively.

Abhishek Singhania London, +44 (207) 547 4458

Italy still trades wider than Main and Senior Financials

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3M total return volatility of 3Y-5Y sector lower than

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9 October 2014



Trade #5: Flat out - GBP 5Y-10Y steepener

GBP 5Y-10Y Steepener. Current 55bp, Target:65bp, Stop:45bp, 3m carry +3.8bp

The 5Y10Y slope currently at the flattest levels this year (and post crisis), as the front end prices in expected hikes from the BoE, and the long end was more recently, dragged along with the flattening of EUR curves, which reflect rising deflation risks and expectations of additional easing from the ECB.

We see current valuations as asymmetric in that sell off need not flatten the curve given the starting point looks excessively rich, while conversely there is room to take out hikes should conditions deteriorate.

While the UK data has been largely resilient, there are some signs that momentum is slowing from the strong levels seen in the first half of the year; that said, the data does not signal a sharper than expected slowdown.

The risks stem from the Eurozone, where recent data indicates a slowdown in growth momentum. The MPC was already concerned over developments in the Euro-area - recent data will not be encouraging, and will likely argue for a “wait-and-see” approach to judge developments in the near term

Further disappointments in the data raise the risk that the market challenges the ECB, which is also likely to result in UK rate hike pricing being questioned, given the economic linkages. While policy failure could result in flattening of EUR slopes, there is much more to price out in terms of policy normalization in GBP curves. 2Y EUR OIS for example is flat to overnight Eonia, while the same is certainly not true in the case of GBP.

Conversely, the risk is for better data out of the UK, in particular a long awaited pick up in wage data, against an already diminished rate profile – here however, given the starting excess flatness of the slope, it should have less of a flattening impact.

Soniya Sadeesh London, +44 (207) 547 3091

Relentless flattening over 2014

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9 October 2014



Trade #6: Cheaper Yen but dearer JGBs - Buy 20Y JGB on ASW basis

20y JGBs look cheap to swaps despite recent yen depreciation, and we therefore expect cash bonds to outperform in the event that USD/JPY continues to climb. (20y ASW) Current: –3.5bp, Target: –15bp, Stop-loss: +2bp

Losses should also be limited under a "risk off" scenario given the likelihood that the BOJ would increase its JGB purchases beyond the 10y sector.

20y ASW may not look especially attractive at first glance given that it is on a rough par with its average level since the BOJ's April 2013 launch of Quantitative and Qualitative Monetary Easing (QQE). However, 20y JGBs have performed quite modestly to this point in time even as the yen has weakened, whereas one would ordinarily expect cash bonds to outperform swaps when the yen depreciates as unwinding of hedges for FX- and equities-linked notes creates a need to pay in the super-long sector(Figure1). This is perhaps a reflection of many hedges having already been unwound as USD/JPY rose sharply towards the end of last year.

However, we expect USD/JPY to keep climbing into the 115–120 range, and see ample potential for 20y JGBs to outperform swaps from this point forward given that cash bonds are liable to see greater demand from yield-conscious investors in the event that interest rates are driven higher by a rise in the expected inflation rate triggered by further yen depreciation.

It is possible that swap rates could fall further than JGB yields if economic conditions deteriorate sufficiently to drive down USD/JPY and equities. However, we would expect the BOJ to deploy further monetary easing measures under this "risk off" scenario, with such action likely to center around an increase in its JGB purchases and a lengthening of their average maturity. Supply/demand is already extremely tight in the JGB market as the BOJ's bond-buying operations continue to reduce secondary market availability (Figure 2), meaning that the central bank may see little option but to increase its purchases from the super-long sector (where its holdings are still comparatively low relative to outstanding issuance). The BOJ's purchases from the 5y–10y sector are currently equivalent to the entire amount of new issuance, whereas its purchases beyond the 10y sector are absorbing "only" around 30% of total supply (Figure 3). We therefore expect a tightening of supply/demand to drive down super-long JGB yields if the BOJ does shift further out the curve, in which case 20y JGBs might not underperform swaps. To summarize, we believe that going long 20y JGBs in asset swaps should prove lucrative under a "risk on" scenario, and that any losses should be comparatively modest if markets do move back into "risk off" mode.

Figure 1: 20YASW vs. Dollar/Yen

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10y- 2.0 0.6 30%

Note: a is ex tap auction, b is average number during 3Q14. Source: Bank of Japan, Ministry of Finance, Deutsche Securities

Makoto Yamashita Tokyo,+81 3 5156 6622

9 October 2014



Trade #7: Fed up Down Under - AUD 6M fwd 1Y vs. 3Y steepener

Pay AUD 3Y against 6M*1Y swap at +14bp, targeting a steepening of the curve to +40bp. Stop at 5bp.

RBA likely to remain unchanged until after the Fed begins tightening The RBA last adjusted the overnight rate in September 2013 when it was lowered to 2.50%. With continued softness across much of the Australian economy our economists do not think the RBA will raise the cash rate until at least 2016.

At the same time the Fed will end QE in October and is likely to begin tightening rates during 2015, in our view. With near-term AUD cash rate expectations relatively steady over the past few months, the AUD front end slope has been tracking offshore markets, ie steepening in selloffs and flattening in rallies.

Little risk of material rate hikes being priced for the next 12 months Current pricing for the cash rate through the end of 2015 is essentially neutral. We do not think the market will price significant increases to the cash rate within this period. We see housing as the biggest risk to the RBA’s current neutral stance, although the Bank recently opened discussion about possible use of macroprudential policies to target strength in that housing sector. If implemented, all other things being equal, these controls will marginally reduce the likelihood of significant tightening being priced in the near term.

6M*1Y / 3Y is a carry-effective expression of the steepening view We do not think there is sufficient value in an outright short of the Australian front end. Our preference instead is to enter a front end steepener, because although we think the front end is tightly anchored in the short term, if the Fed tightens as expected the Australian curve will also begin to price substantial rate increases beyond mid-2016, in our view. As Figure 2 at right shows, the front end slope has tended to be highly correlated with US rates of late. Through Q4 we expect the front end to become sustainably steeper.

However, with the AUD front end so flat the cost of carry is a challenge. To mitigate it, we recommend the AUD 6M*1Y / 3Y swap steepener. The trade incurs slight negative carry – about 1.5bp over three months – but the average daily move in the slope over the past year has been 1.2bp, so on a risk-adjusted basis we think the carry cost is bearable. From the current entry level of +14bp we are targeting a level of +40bp, with a stop-loss at +5bp.

The key risk is a reinvigoration of the global rally.

Figure 1: Market pricing of end-2015 rates

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Figure 2: Front end and US rates are highly correlated

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Figure 3: 6M*1Y / 3Y steepener costs 1.5bp carry / 3m

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Ken Crompton Sydney, +61 2 8258 1361

9 October 2014



Trade #8: Give me a break - Long USD 2Y fwd 2Y inflation breakevens

We like being long 2yr2yr in inflation, either through inflation swaps or TIPS. Current 2.15, Target: 2.30, Stop loss: 2.00. In the long end, some off-the-run bond TIPS look cheap in breakevens versus 10s. Current: 2bp, Target: 12bp, Stop loss: -3bp.

The 2yr2yr inflation appears attractive on a long term history, and more attractive than some longer term forwards, such as the 5yr5yr. In the long end, we think there should inflation risk premium, supporting an upward sloping breakeven curve.

Front End US Inflation Breakevens Look Attractive We believe the recent volatility has created opportunities in inflation markets. We like being long 2yr2yr in inflation, either through inflation swaps or TIPS. The 2yr2yr inflation appears attractive on a long term history, and more attractive than some longer term forwards, such as the 5yr5yr. In inflation swaps, the current spread around 2.13 on the 2yr2yr is well below the average of about 2.42 on the history from early 2012 to present. We’d target 2.30 on this trade with a stop loss at 2.00.

The 2yr2yr in TIPS looks similarly attractive, if one uses the 7/2016 and the 7/2018 TIPS. The 7/2016 to the 7/2018 breakeven curve has steepened since March 2014, while the forward breakeven rate has dropped about 40bp since late July. The 2yr2yr inflation is less correlated with energy prices than the one- or two-year breakevens. The risk in the trade is a continuing decline in energy prices and a weaker inflation outlook, which would likely take the 2yr2yr to a lower level.

Opportunities in off-the-run bond TIPS The 30-year TIPS auction later this month presents an opportunity to put on a 10s/30s breakeven curve steepener. We expect the Treasury to announce a $7 billion reopening of the 2/2044 TIPS on Thursday, October 16.

Some off-the-run bonds look cheap versus 10s in breakevens. The ten-year TIPS to the 1/2029 TIPS breakeven spread was briefly inverted early last week. It is very rare that this breakeven curve is inverted; it only happened briefly in late 2012, and then the breakeven curve steepened back. The fair value of the spread should be positive, as there is usually a inflation risk premium over the long run. The five-year average of the breakeven spread is +12bp. Over the long run, the spread is likely to gravitate towards that level. We recommend investors look for a good entry level to be long that breakeven curve.

Alex G. Li New York, +1 (212) 250-5483

Figure 1: 2yr2yr inflation swaps look cheap on a

historical basis

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2yr2yr inflation swaps

Source: Bloomberg Finance LP and Deutsche Bank

Figure 2: 2yr2yr TIPS breakevens look attractive

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2yr2yr fwd TIPS BE


Figure 3: 10yr TIPS to 1/2029 breakeven spread was

briefly inverted last week

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30

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10/1/09 10/1/10 10/1/11 10/1/12 10/1/13 10/1/14

10yr TIPS to 1/2029 TIPS BE Spread


9 October 2014



Trade #9: Bad Grade Good - Buy EUR single-B credit

We recommend buying EUR single B credit at current index level spread of 610bp, we target 450bp with a stop loss at 690bp

Recent weakness in credit and specifically HY has been most acutely felt in single-Bs, with weakness both in relative and absolute terms.

The EUR iBoxx non-fin single-B index is at its widest level since early October 2013 and has now widened by around 185bps since the year’s tights back in June. The moves in yields have been slightly less extreme, rising just over 150bps from the year’s lows (Figure 2).

Looking at spreads relative to their own histories, having been inside the tightest quartile in June, single-B credit spreads are now wider than their long-term median (Figure 3). It is the only non-financial sector where this is the case. Spreads have to tighten around 140bps to get back inside the tightest quartile.

To further emphasise the relative weakness the spread ratio relative to BB credit has risen to 2x following the recent sell-off (Figure 4) - close to the highs of the relationship over the past decade.

For the longer-term more buy-and-hold focused investor single-Bs now offer a wider default spread premium than all rating bands except CCCs, although the CCC subset is a small one and can therefore be swayed by one or two more distressed bonds.

Overall there is evidence to suggest that single-Bs are the current sweet spot for credit investors in Europe. With aggregate spreads back above 600bps and all-in yields close to 6.5% single-Bs may prove hard to ignore in a still yield constrained environment where BBs barely offer 3% yields and IG credit with the exception of sub financials is below 2% on average.

In Figure 1 we provide the single-B rated bonds that our HY credit analysts recommended in their recent Top Picks note (“European HY one-stop: 2014 Top Picks”, 29 Sep 2014).

Figure 1: HY Analysts’ Single-B Top Picks Ticker Coupon Maturity Call Price Yield OAS*

LECTA 3ME+550 15 May 18 05 Nov 14 98.00 6.20

LOXAM 7.000 23 Jul 22 23 Jul 17 95.25 7.98 723

TAKKO 9.875 15 Apr 19 15 Apr 16 80.00 16.96 1,613Source: Deutsche Bank. * - vs. Bunds

Nick Burns London, (+44) 20 754-71970

Figure 2: iBoxx EUR Non-Financial Single-B Spreads

(bps) and Yields since 2013

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Spreads (LHS) Yields (RHS)

Source: Deutsche Bank, Mark-it

Figure 3: EUR Non-Fin Credit Spreads – Percentage of

Time at Current Spreads or Tighter

0%

10%

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60%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct

A BBB BB B

In the tightest quartile


Figure 4: Single-B Spread Ratio vs. BBs

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2004 2006 2008 2010 2012 2014

BB vs. B

Source: Deutsche Bank, Mark-it

9 October 2014



Trade #10: Turn weakness into strength - Buy weaker Spanish and Italian covered bonds

Buy Multi-Cedulas IMECDI 4% Mar 2021 (A1/-/A-) versus single Cedulas BBVASM 3.5% Oct 2020 (A1/AA-/-/AH) with a pick-up of 85bp. Take profit at a pick-up of 35bp, with a stop at 105bp.

Buy Multi-Cedulas AYTCED 4.75% May 2027 (A3/BB/BBB) versus single Cedulas SANTAN 4.625% May 2027 (A1/-/AA) with a pick-up of 65bp. Take profit at a pick-up of 25bp, with a stop at 85bp.

Buy OBG MONTE 2.875% July 2024 (Baa3/-/A) versus OBG UCGIM 3% Jan 2024 (A2/-/AA-) with a pick-up of 45bp. Take profit at a pick-up of 15bp, with a stop at 60bp.

Buy OBG BANCAR 3.875% Oct 2018 (Ba1/-/BBB+) versus UCGIM 1.875% Jan 2019 (A2/AA/AA-) with a pick-up of 45bp. Take profit at 15bp with a stop at 60bp.

Spreads versus sovereigns are likely to tighten further - sovereign QE as key risk We expect peripheral covered bonds to continue to outperform sovereign bonds. However, given the recent strong outperformance of peripheral covered bonds versus sovereign bonds and the fact that our economists expect sovereign QE in the next six months, we focus on further spread convergence between covered bonds of weaker and stronger peripheral banks instead of spreads between peripheral covered bonds and sovereign bonds. In case of sovereign QE, the strong outperformance of peripheral sovereign bonds versus covered bonds could easily reverse.

Buy covered bonds of weaker Spanish and Italian banks versus issues of stronger banks While numerous details of practical execution of CBPP3 seem uncertain, most strikingly how the ECB will purchase retained covered bonds, we expect the ECB to be aggressive. Consequently, we expect even further spread convergence between lower and higher rated covered bonds in peripheral countries.

While Multi-Cedulas IMCEDI 3.5% 3.5 June 2020 (-/BB+/-) provides the highest pick-up of all Multi-Cedulas versus Santander single Cedulas (A1/-/AA), given that CBPP3 excludes covered bonds that do not have at least one BBB- rating (outside Greece and Cyprus), we recommend, for example, buying IMCEDI 4% March 2021 (A1/-/A-), rated comfortably inside the CBPP3 rating spectrum.

As we expect further spread convergence between Italian covered bonds, we recommend buying Monte Dei Paschi and Banca Carige covered bonds versus Unicredit covered bonds.

Figure 1: Multi-Cedulas AYTCED May 2027 with pick-

up versus single Cedulas Santan May 2027

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AYTCED 4.75 25-MAY-2027

SANTAN 4.625 04-MAY-2027


Figure 2: OBG Monte Dei Paschi July 2024 with pick-

up versus OBG Unicredit Jan 2024

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MONTE 2.875 16-JUL-2024 UCGIM 3 31-JAN-2024 BTPS 4.5 01-MAR-2024


Bernd Volk Zürich, +41 44 227 3710

9 October 2014



Trade #11: Riding the ECB liquidity wave - Buy new issue CMBS

We recommend buying new issue CMBS. Specific bonds we think are attractive for applying this trade are: DECO 2014 GNDL A, MODA 2014-1 A, DECO 2014- TLPX A, WSTSTR CORP.

New Issue Floating Rate CMBS The ECB’s recent statements of intent to commence purchases of select European ABS in Q4 should have both first order (on the securities purchased) and second order (the securities not purchased) effects. While markets have inevitably risen ahead of the implementation, we still feel there are opportunities in the sector. In our view the most pronounced of these are taking advantage of the second order effects, using leverage.

Leveraged Trades against CMBS In our view the ideal ABS instrument to apply leverage against possesses the following characteristics:

Short organic duration (to mitigate against MTM effects);

Relatively high coupon (both to provide positive carry and to mitigate MTM effects);

Floating Rate (to mitigate interest duration risk);

A track record of price stability.

Ideally, the instrument should also theoretically fall into the parameters of the ECB’s ABS Purchase Programme (Non Financial Private Sector Entities, theoretical ECB Repo Eligibility, Investment Grade Ratings), but price today with little or no probability of inclusion, thus providing embedded optionality.

In our view new issue CMBS is the best fit of these parameters (Euro bonds are theoretically acceptable at the ECB’s Repo window), with post 2013 Issues having exhibited the pricing stability absent in their pre 2007 brethren.

Detailed Terms We prefer to focus on the front pay level, where liquidity is greatest and spreads range from around 90bps for UK and Dutch CMBS, to around 125bps for Italian CMBS. On the leverage side, we prefer to focus on rolling 3 month Repos, where dependent on rating and the specific bond financing terms will typically range from 10-15% haircut, and running cost of 3M Euribor + 70b to 80ps. Applying this against Italian CMBS, would on the assumption of flat pricing, generate an annualised margin over 3M Euribor of around 463bps. Clearly capital appreciations/reductions are magnified by the application of leverage – for example a 25bp tightening in spreads would boost returns to 1100bp. Specific bonds we think are attractive for applying this trade are: DECO 2014 GNDL A, MODA 2014-1 A, DECO 2014- TLPX A, WSTSTR CORP.

Figure 1: GRF 2013-1 – Price History

99100100101101102102103103104104105105106106

Jun-

13Ju

l-13

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Bid PxA B C D E

Source: Deutsche Bank, Markit Note: Bid Prices as per first trading day of month

Figure 2: DECO 2014 GNDL – Price History

99

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Jul-1

4

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-14

Sep

-14

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Bid Px

A B C D E

Source: Deutsche Bank, Markit Note: Bid Prices as per first trading day of month

Figure 3: CMBS Repo Annualised Indicative Returns

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-1 -0.5 0 +0.5 +1

bps (over 3M Euribor)

Capital Appreciation/(reduction) scenarios (pts)

Source: Deutsche Bank Note: Assumes bond trading at 125bps over 3M Euribor, and repo terms of 14% haircut and running costs of 70bps over 3 month Euribor

Paul Heaton, CFA London, +44 20 754 70119

9 October 2014



Appendix Trade Recommendat ion P&L Notes

1 Short 6M5Y ATMF Payer vs long 2x ATMF +20bp -7.5bp

2 Long BTP 4.5% Mar-24 vs Bund 1.5% May - 24 +13bp

3 Pay belly of JPY 5Y*2Y /5Y*5Y/10Y*10Y +3bp

4 Long 10yr GBP vs EUR -17bp Stopped out

Short Dec 15 Short Sterling +20bp Reached target

5 Vanilla 3Y fwd 10s30s Steepener +15bp

Buy 3Y expiry 10s30s CMS spread cap ratio 1x2 35bp/65 bp +0.5bp

6 10s30s TIPS Steepener +15bp

7 Buy 10yr HICP swap -7bp Stopped out

Long 5yr EUR real rate vs short 5Y USD real rates +19bp

Long BTPei16 vs nominal BTP - tightening on ASW +9bp

8 Buy 5yr Canada paper swapped into EURIBOR +14bp

9 Long 30yr 4% MBS paa-through, -0.3% Total return

Inverse interest only MBS 2.9% Total return

Buy AAA private student loan ABS 0.1% Total return

10 Long DALRA 4-X C 15.0% Total return

11 Buy single cov bonds of weaker Italian banks vs Multi Cedulas +11bp

Buy single Cedulas of weaker Spanish banks vs Multi-Cedulas trading with a pick up. 1.2% Total return

Buy HAA FRN March 15 -2.2% Total return

Buy HAA 4.25% Oct 2016 -15.8% Total return

12 Overweight US HY BBs vs BBBs with a 4-6yr option adjusted duration constraint on both sides -33bp

13Buy US IG A rated financials vs non financials with a 5-6yr option adjusted duration constraint on both sides

+4bp

14 Sell $100mn 3M5Y straddles at 29bp vs buy $100mn 3M5Y 22bp OTM payers at 7bp +16bp

Sell $100mn 6m5Y 40bp OTM payers vs buy $463 6m1Y ATMF payers at zero cost +3bp

Buy $100mn 3m5Y ATMF receivers, sell $100mn 3m5Y ATMS reecievers, sell $100mn 3m5y 17.5bp OTM payers at zero net cost

0bp

Hit rat io 72%

A verage P&L for t rades with performance measu red in bp 4.3bp

A verage P&L for t rades with performance measu red in % 0.1%

Trade performance of Top trades for the summer (12 June to 3 October)

9 October 2014



Appendix 1

Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Francis Yared

9 October 2014



Regulatory Disclosures

1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

2. Short-Term Trade Ideas

Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at theSOLAR link at http://gm.db.com.

3. Country-Specific Disclosures

Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where at least one Brazil based analyst (identified by a phone number starting with +55 country code) has taken part in the preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless "Japan" or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Qatar: Deutsche Bank AG in the Qatar Financial Centre (registered no. 00032) is regulated by the Qatar Financial Centre Regulatory Authority. Deutsche Bank AG - QFC Branch may only undertake the financial services activities that fall within the scope of its existing QFCRA license. Principal place of business in the QFC: Qatar Financial Centre, Tower, West Bay, Level 5, PO Box 14928, Doha, Qatar. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Business Customers, as defined by the Qatar Financial Centre Regulatory Authority. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation. Kingdom of Saudi Arabia: Deutsche Securities Saudi Arabia LLC Company, (registered no. 07073-37) is regulated by the Capital Market Authority. Deutsche Securities Saudi Arabia may only undertake the financial services activities that fall within the scope of its existing CMA license. Principal place of business in Saudi Arabia: King Fahad Road, Al Olaya District, P.O. Box 301809, Faisaliah Tower - 17th Floor, 11372 Riyadh, Saudi Arabia. United Arab Emirates: Deutsche Bank AG in the Dubai International Financial Centre (registered no. 00045) is regulated by the Dubai Financial Services Authority. Deutsche Bank AG - DIFC Branch may only undertake the financial services activities that fall within the scope of its existing DFSA license. Principal place of business in the DIFC: Dubai International Financial Centre, The Gate Village, Building 5, PO Box 504902, Dubai, U.A.E. This information has been distributed by Deutsche Bank AG. Related financial products or services are only available to Professional Clients, as defined by the Dubai Financial Services Authority.

9 October 2014



Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements.

GRCM2014PROD032968

David Folkerts-Landau

Group Chief Economist Member of the Group Executive Committee

Guy Ashton

Global Chief Operating Officer Research

Marcel Cassard Global Head

FICC Research & Global Macro Economics

Richard Smith and Steve Pollard Co-Global Heads Equity Research

Michael Spencer Regional Head

Asia Pacific Research

Ralf Hoffmann Regional Head

Deutsche Bank Research, Germany

Andreas Neubauer Regional Head

Equity Research, Germany

Steve Pollard Regional Head

Americas Research

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