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The Phenomenon of Coupon Destruction
December 2010
Assessing the implications of declining coupons rates on bond investors
Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities
in the United States.
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Contents
1. Coupon Destruction: The Data
2. Coupon Destruction: The Drivers
3. Coupon Destruction: The Implications
A. For Bond Markets
B. For Insurance Companies
C. For Pension Funds
D. For Global Structural Imbalances
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Section 1
oupon es ruc on: e a a
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The Phenomenon of Coupon Destruction
IG Annual Wei hted Avera e Cou ons U.S. 30-Da Commercial Pa er Yields
6
7
Tier1NonFi nancial Tier2NonFinancial
The phenomenon ofcoupon
destructionstarted developing
in 2008, when
(2006 2010 YTD)
(2006 2010 YTD)
6.0%6.1%
6.3%
5.9%6.0%
6.5%
1
2
3
4
5governments
worldwide adopteda relaxed monetarypolicy stance in
order to stimulateeconomic rowth
%
4.4%
4.2%4.5%
5.0%
5.5%
0
Jan06 Jul06 Jan07 Jul07 Jan0 8 Jul08 Jan09 Jul0 9 Jan10 Jul10
by maintaininginterest rates low...
- -
CP yields have followed a striking correlation to the
tightening of their benchmark LIBOR rates
IG coupon rates have declined substantially since
the onset of the financial crisis
4.0%
2006 2007 2008 2009 2010YTD Nov10
... ,destruction affects
all credit marketsincluding ABS, CP,
and mortgagerates
(2006 2010 YTD)
(2006 2010 YTD)
450
500
550
600
6503yrFixedCreditCard 3yrFixedPrimeAuto
7.0
7.5
8.0Conventional Jumbo
100
150
200
250
300
350400
Spread(bps
)
4.5
5.0
5.5
6.0
6.5
Yield(%)
Stability of credit performance, lower delinquencyrates, and stabilizing prepayment rates have driventhe narrowing of consumer ABS yields 4
Source: Thomson Reuters,Federal Reserve, Bloomberg
0
Jan06 Sep06 May07 Feb08 Oct08 Jun09 Mar10 Nov10
4.0
Jan06 Jul06 Jan07 Jul07 Jan08 Jul08 Jan09 Jul09 Jan10 Jul10
Excess housing supply and low government rateshave positively impacted residential mortgageyields
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Coupon Destruction in the US$ IG Bond Market
6.5
1000
1200
FixedRateNewIssueVolume FRNNewIssueVolume WeightedAverageCoupon
5.6% 6.1%6.3%
5.9%
ew ssue o ume xe vs. e g e verage oupon
The phenomenon ofcoupon
destructionaccelerated toward
historically low
5.0
5.5
.
400
600
800
60.3%47.6%
24.8%4.8% 7.9 %
95.2%92.1%
total coupons
during the courseof 2010 inparticular
US$bn
%
4.0
4.5
0
200
2006 2007 2008 2009 2010YTD
4.4%39.7%
. .
Annual AverageNew Issuance
Duration
2006: 7.4
2007: 7.6
4.8
4.9
5.0
300
350
NewIssueVolume WeightedAverageCoupon
New Issue Volume / Weighted Average Coupon (2010 YTD)
4.7%
2008: 6.6
2009: 6.4
2010 YTD: 7.2
4.3
4.4
4.5
4.6
4.7
100
150
200
250
US$bn
%
.
4.2%
4.2%
4.0
4.1
.
0
50
Q110 Q2
10 Q3
10 Oct
10 Nov
10
5Source: Thomson Reuters
.
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Section 2
oupon es ruc on: e r vers
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Coupon Destruction: The Drivers
ey r vers o oupon es ruc on
Driver 1 Record Government yield tightening
Driver 2 Record LIBOR tightening
Driver 3 Record IG credit spread tightening
Driver 4
7
Driver 5 Overwhelming supply/ demand dynamics in the IG bond market
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Driver # 1: Record Government Yield Tightening
. . reasury e s ey r vers
Economic recovery
Low inflation risk (continued
The significant post-financial crisis
decline ingovernment yields,
6
2yUST 5yUST 10yUST 30yUST
concern around deflation)
Monetary easing
short end, has
been a primarydriver of the
coupondestruction
5
Quantitative easing (QE2)
Flight to quality during
exogenous global events (i.e.,sovereign crisis)
QE2 and flight toquality concerns
during the Eurocrisis have also
3
%
Supply / demand dynamics
Global capital flow dynamics
been primarydrivers
2
s ruc ura m a ances
0
1
6 66 6 6 6 7 7 7 7 7 7 8 8 8 8 8 8 9 9 9 9 9 9 0 0 0 0 0 0
8Source: Bloomberg
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
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Driver # 1: Record Government Yield Tightening
10-Year U.S. Treasur Yield 10-Year German Bond Yield
4.5
5.0
5.5
4.5
5.0
(2006 2010 YTD)
(2006 2010 YTD)
Global sovereignbond yields have
followed the sametightening
3.0
3.5
4.0
3.0
3.5
4.0
%%
. .Treasuries, as
governmentsworldwide are still
using monetarypolicy to stimulate
2.0
2.5
J
an
06
A
pr06
Jul06
O
ct06
J
an
07
A
pr07
Jul07
O
ct07
J
an
08
A
pr08
Jul08
O
ct08
J
an
09
A
pr09
Jul09
O
ct09
J
an
10
A
pr10
Jul10
O
ct10
2.0
2.5
J
an
06
A
pr06
Jul06
O
ct06
J
an
07
A
pr07
Jul07
O
ct07
J
an
08
A
pr08
Jul08
O
ct08
J
an
09
A
pr09
Jul09
O
ct09
J
an
10
A
pr10
Jul10
O
ct10
- -
2 0
2.5
(2006 2010 YTD)
(2006 2010 YTD)
5.0
5.5
6.0
1.0
1.5
.
% %
3.0
3.5
4.0
4.5
0.5
Jan
06
Apr06
Jul06
Oct06
Jan
07
Apr07
Jul07
Oct07
Jan
08
Apr08
Jul08
Oct08
Jan
09
Apr09
Jul09
Oct09
Jan
10
Apr10
Jul10
Oct10
9Source: Bloomberg
2.0
2.5
Jan
0
6
Apr0
6
Jul0
6
Oct0
6
Jan
0
7
Apr0
7
Jul0
7
Oct0
7
Jan
0
8
Apr0
8
Jul0
8
Oct0
8
Jan
0
9
Apr0
9
Jul0
9
Oct0
9
Jan
1
0
Apr1
0
Jul1
0
Oct1
0
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Driver # 2: Record LIBOR Tightening
ggrega e eserves o . . epos ory ns u ons - on or
Increased banking system liquidity has driven Libor rates down, pushing issuers out of FRN issuance
Drivers: More stringent lending standards, increased regulatory capital, and consumer de-leveraging
Size of increase: US$ 960 bn since September 2008
3-month LIBOR hastightened nearly
500 bps since,
largely by the
rising cashreserves of the
banking system
5
6
1200
1400
AggregateReservesofDepositoryInsitutions 3mLibor
bn %
3-month Libor isclosel and
3
4
800
1000
US$inversely
correlated to theincrease in
reserves1
2
200
400
00
Jan
06
Mar06
May
06
Jul06
Sep
06
Nov
06
Jan
07
Mar07
May
07
Jul07
Sep
07
Nov
07
Jan
08
Mar08
May
08
Jul08
Sep
08
Nov
08
Jan
09
Mar09
May
09
Jul09
Sep
09
Nov
09
Jan
10
Mar10
May
10
Jul10
Sep
10
Nov
10
10
Note: Aggregate reserves of U.S. depository institutions refers to reserves held by all U.S. credit institutions (commercial banks, savings institutions,credit unions, and foreign banking entities) against deposits . They are reported as liabilities on their balance sheets.
Source: Bloomberg, Federal Reserve
The drop in LIBOR rates has fuelled the decline in FRN issuance to approx. 9% oftotal new issue volume in 2010 YTD
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Driver # 3: US$ IG Credit Spread Tightening
IG bond spreadtightening has
been a key driverof coupon
re prea s
1000
AFinancials BBBFinancials ACorporate BBBCorporate
US$ Market
This spreadtightening has
been articularl 700
800
900
strong among BBB
financial andcorporate names
500
600
bp
200
300
400
0
100
06
06
06
06
06
06
07
07
07
07
07
07
08
08
08
08
08
08
09
09
09
09
09
09
10
10
10
10
10
10
11Source: Bloomberg
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
Jan
Mar
May
Jul
Sep
Nov
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Driver # 4: Record Capital Flows into IG Bond Funds
Bond funds haveenjoyed record flows
in 2009-2010 asinvestors favor safer 20
40
60
)stable and attractive
return over riskierassets like equities
(80)
(60)
(40)
(20)
0
Amoun
t($bn
credit has further
depressed couponrates on recent issues
(120)
(100)
Jul-08 Aug-09 Sep-10
Taxable Bonds Equity
Sources of Bond Inflows Net Bond Inflows (2009 2010 YTD)
2009: US$ 306.7 bn Risk aversion
2010 YTD: US$ 243.5 bn
qu ty out ows
Money market fund assets
Structured roduct flows
1212Source: Investment Company Institute
2009-2010 YTD: US$ 550.2 bn IG asset cash increases
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Driver # 5: Strong New Issue Market Technicals
Net Institutional Investor Cash Flows 2011EWhile recent andestimated new issue
activity issubstantial, DBs
expected netCash flows to institutional investors
500
700
ssuance ssuanceless bond
redemptions,coupon payments
and new cashinflows into bond
$700 $438Investment grade new issues
Estimated Asset managers: US$ 40-60 bn Insurance companies: US$ 30-50 bn
Excludesgovernmentguaranteed
300
funds) for 2011 isnegative
$256U
SDbillions Pension funds: US$ 20-30 bnsecurities
100
100
300
2011ENew
Issuance
2011EUSD
Redemptions
EstCoupon
Payments
Incremental
BondFlows
Liability
Management
NetIssuance
Effect
$90 $140
$40 -$124 -$174
Source: Deutsche Bank, Thomson Reuters, Dealogic13
Note: DB estimates based on historical trends; Est coupon payments are estimated assuming ~$4.2 trillion of debt outstanding at a 6.1% average coupon; DBIG fund flows estimated by adding US$ 40-60 billion from asset managers + US$ 20-30 billion from pension funds + US$ 30-50 billion from insurancecompanies ; DB liability management estimate does not include exchanges and consents
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Breakdown of 2011-2012 US$ IG Bond Redemptions
Demand for IG debt isexpected to keep
rising in 2011 and2012, as large
2011 2012 Comment
US 438 bn US 421 bn
Breakdown of 2011-2012 US$ IG Bond Redemptions
credit mature
maturing over the next 2 years
Fixed US$ 361 bn / 82% US$ 355 bn / 84% ~80 - 85% fixed
Floating US$ 77 bn / 18% US$ 66 bn / 16% ~15 - 20% floating
Corporates US$ 239 bn / 55% US$ 215 bn / 51% Nearly even split among corporate andfinancial maturities in the next 2 years
Financials US$199 bn / 45% US$ 206 bn / 49% Nearly even split among corporate and
Av. Coupon 6.6% 6.0% Substantial drop in maturing debtcoupon rate in 2012 vs. 2011
Av. Duration 6.5 6.4 Stable average duration
* Excludes government guaranteed securities
14Source: Dealogic
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Breakdown of 2011E Coupon Payments
Item #
The substantial sizeof the total
estimated couponpayments on
2011E Coupon Payments
o a eoutstanding 1
~ . r on
Weighted average coupon ontotal IGoutstanding debt 2
6.1%
investment grade
debt will be amajor driver of
demand in 2011
Total 2011E CouponPayments 3
~US$ 256 billion Breakdown of Total Outstanding IG Debt
1
: Total outstanding debt as of December 1, 20102: Based on total outstanding debt as of December 1, 2010
Item #
% Fixed ~93%3: 2011E coupon payments = multiplication of total US$ IGoutstanding debt (~4.2 tn) + weighted average coupon ontotal US$ IG outstanding debt (6.1%)
Source: Dealogic
% Floating ~7%
% Financials ~40%
% Corporates ~60%
Average coupon 6.1%
15Source: Dealogic
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Section 3
oupon es ruc on: e mp ca ons
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Section A
or on ar e s
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IG Bonds Have Been A Top Performing Asset Class
US$ IG Bonds havebeen one of thetop performing
asset classes of
,
900
1000
AFinancial BBBFinancial ACorporate BBBCorporate
financial crisis
bps 400
500
600
700
0
100
200
p08
ct08
v08
c08
n09
b09
r09
r09
y09
n09
ul09
g09
p09
ct09
v09
c09
n10
b10
r10
r10
y10
n10
ul10
g10
p10
ct10
v10
Total Return IG Credit Performance (Q1-Q3 2010)
S O N D Ja
F M A MJu J A S O N D J
aF M A M
Ju J A S O N
-
Corp (Corporate + Financials) 10.64% 4.87%
Corp AA 9.57% 3.91%
Corp A 10.30% 4.82%
Corp BBB 12.13% 5.59%
18Sources: Bloomberg; Deutsche Bank Global Markets Research (Jim Reid)
Non - Fin 11.02% 4.75%
Fin Sen 10.01% 4.82%
Fin Sub 9.04% 5.91%
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Floating Rate Issuance Has Declined Sharply
FRN issuance has seen a dramatic drop since2006:
- 7.9% in 2010 vs. 60.3% in 2006
The ~500bps yielddestruction in Libor
is the main reasonfor the drop in FRN
ey ssues ssuance o o a
2006 60.3%
2007 47.6%,U.S. are expected to refrain form raising rates
until late 2011- 0.30% as of Nov. 30, 2010
- ~500bps drop in libor rates since 2006
~60% of total new
issuance in 2007 to~8% in 2010. 2008 24.8%
2009 4.8%
ample liquidity in the banking system andmaintain money market rates low
3 Month Libor Rate (January 2006 To Date)
2010 YTD 7.9%
%
20Source: Bloomberg
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Sharp Uptick in Liability Management Activity
Average volumesper month have
seen a significantuptick in the last 20,000
25,000
Monthly IG LM deal volumes ($mm)
on y ea o ume an- roug ov-
5,000
10,000
15,000
Average monthlydeal volume ($mm)
2007 3,803
2008 1,874
Annual LM Deal Volumes Jan-07 throu h Nov-10 YTD
0
Jan-07
Feb-07
Mar-07
Apr-07
May-07
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09
Jul-09
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
Feb-10
Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Nov-10
2009 ,
2010 YTD 8,136
- -
100,000
120,000
Annual IG LM deal volume ($mm)
0
20,000
40,000
60,000
80,000
21
2007 2008 2009 2010 YTD
(a) Includes investment grade corporate and financial institution tenders, exchanges and consent solicitations in the Americas
executed in the US market; volumes are based on the maximum targeted amount of securities in a given transaction; excludes$30bn Freddie Mac transaction in June 2009(b) As of November 8, 2010Source: Company press releases; Bloomberg; Deutsche Bank database
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Section B
or nsurance ompan es
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Overview of Impact
Insurance companies have largely benefitted from the recent drop in interest rates
- Significant improvement in balance sheets due to MTM of bond portfolios
verv ew o mpac
- Issuance of debt at historically low levels
However, if rates remain low for an extended period, the Life Industry could suffer
- Lower (possibly negative) earnings and ROE
- Writedown of intangible assets and/or increase in reserves
- More expensive products with less attractive features for consumers
Over the near-term (12-24 months) Life Industry earnings will be depressed if rates remain low,but impact is manageable
- Analysts generally expect 2011 and 2012 earnings to be impacted by 5 - 10% if rates remain atcurrent levels
- Limited expected balance sheet impacts at this stage
cautious which is likely to depress share prices in the near term
- Excess capital at holding company and operating subsidiaries not being re-deployed
- Investors paying lower P/E ratios vs. historical ranges
23
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Insurers Have Benefited from Low Interest Rates
Accumulated Other Comprehensive Income AOCIis a balance sheet item that includes unrealizedgains / losses from insurance company asset
ortfolios
ommen so a o op e ompan es
$10
$20
$bn
As the graph illustrates, Life Insurer book equitydropped dramatically during the financial crisis ascredit spreads widened and MTM on bondportfolios dropped$(30)
$(20)
$(10)
TotalAOCI
Total = Sum of Quarterly AOCI for MetLife, Prudential, Hartford, Genworth, Lincoln, Principal Financial Group, Protective Life,Phoenix CompaniesSource: Company Filings
However, these negative MTM balances have beeneffectively erased by the drop tightening of interestrates and credit spreads over the past 24 months
$(50)
$(40)
2007Q1
2007Q2
2007Q3
2007Q4
2008Q1
2008Q2
2008Q3
2008Q4
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
The low interest rate environment has enabledinsurers to take advantage of cheaper financing
CommentsTotal US Life Industry Senior Debt Issuance
7.00%
8.00%
9.00%
$5
$6
$bn
Since the opening up of the debt markets in early2009, US life insurance companies have issued inexcess of $20bn in senior debt and GIC financing
The average coupon for senior debt and GIC2.00%
3.00%
4.00%
5.00%
6.00%
$2
$3
$4AverageCouponT
otalIssuance
24Source: Bloomberg. I ncludes all fixed rate debt issued by all US life and health insurers.
the average coupon for comparable issuances inQ2 20090.00%
1.00%
$0
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
TotalFixedRateSeniorDebt AverageCoupon
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Longer-Term Potential Concerns
$16.9
50%
60%
70%
$14
$16
$18
e
$bn $bn
Insurers rely oninvestment income
for a significantamount of their
revenue. This
nnua ze nves men ncome o a as as o
$14.6
$12.0$12
$14
$16
Total $38bn
$3.3 $3.2
$4.5
$3.4
$11.8
$5.7
20%
30%
40%
$4
$6
$8
$10
$12
%R
evenue
AnnualizedNetInvestmentIncomrevenue could be
squeezed if rates
remain low
In addition,Insurers have large
$3.6 $3.5
$2.3
$4
$6
$8
$10
Q32010C
ashBalance
$2.0
$0.8
0%
10%
$0
$2
GNW HIG LNC MET PFG PL PNX PRU A VERAGE
S ou rc es : c om pan y f ili ng s, S NL. A mou nt s r ep re sen t Y TD 20 10 r es ul ts ann ua li ze d. S ou rc es : c om pany f ili ngs , S NL . Re pr es ent s t ot al c as h an d c as h equ iv al en ts r ep or te d o n GA AP bal an ce s heet s as t he e nd of Q3 201 0.
amounts of cashthat will need to
eventually beinvested
$1.7
$0.2 $0.2
$0
$2
GNW HIG LNC MET PFG PL PNX PRU
10.2x10.5x
11.3x
10
12
Insurers havehighly levered
balance sheets andmeaningful
pensionobli ations that
50%50%
60%
Investment Leverage as of Q3 2010 YE 2009 Projected Pension Obligations / Q3 Equity
5.2x
6.4x6.8x
8.1x
7.0x
4
6
8
InvestmentLeverage
would bepressured in anextended low rate
environment20%
14%
18%
24%
20%
30%
40%
PBO/Equity
25Note: Investment Leverage = Total Investments (Amortized Cost if Available) / Book Value
Sources: company filings, SNL
Note: GNWs PBO is immaterial
Sources: company filings, SNL
0
2
GNW HIG LNC MET PFG PL PNX PRU
Investment Leverage Average Investment Leverage
0%
10%
4%
0%
10%
GNW HIG LNC MET PFG PL PNX PRU
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Projected Maturity of Life Company Fixed Income Portfolios
Bond Portfolio Breakdown by Years to Maturity for All S&P Rated North American Life InsurersAccording to S&P,
40% of lifeinsurers fixed
income portfoliosare ex ected to
0 - 5 years40%
mature within 5years
Based on S&Pprojections, the
5 - 10 years28%
traded life
companies willneed to reinvest
$368 bn of
maturing assets
Over 10 years
32%
Maturity Years Total Amount Maturing ($bn)
Projected Fixed Income Asset Maturities for Top Publicly Traded US Life Companies
years. This
amount is inaddition to the
annual premiumsand other cash
0 5 $368
5 10 $257
> 10 $294
ows t at e
companies needto invest
26
Source: Total Amount Maturing calculated as total fixed maturity portfolios as of Q3 2010 for top 8 US life companies (MET, PR U, PL, PNX, GNW, HIG, PFG, LNC) multiplied by S&P bond portfolio breakdownpercentages outlined in pie chart above
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Concern Over Low Rates Impacting Lower Valuations andCausing More Conservative Posture at Life Companies
3.0
3.5
Some Insurers haveacknowledged that
the low rate
Current and Historical Price to Book Ratios
1.0
1.5
2.0
2.5
P/BRatio
causing concern and
leading them toconserve excesscapital until the
future direction of
Source: Deutsche Bank Research, Company Filings as of November 18, 2010. Ranges represent peak and trough P/B levels over the past 20 years.
0.0
0.5
GNW HIG LNC MET PFG PL PNX PRU
ra es ecomes morecertain
Current price to bookratios are closer to
historical lows than
375%
500%
447% 440% 431%400%
500%
600%
they are to peaklevels
While RBC Ratiosand Holding
RBC Ratios as of Q2 2010 Holding Company Cash
$3,700
$3,000
$3,500
$4,000
Total $10,899mm
290%
100%
200%
300%
Company cashholdings are at
historically highlevels, no major US
Life Companies haveannounced lans to
$1,300
$800
350
$2,200
$2,500
$1,000
$1,500
$2,000
$2,500
Cash
27
Note: 350% level has been historical benchmark RBC target for AA-rated companies
Source: 2010 Q2 Earnings Transcripts for MetLife, Prudential, Genworth, Lincoln, Principal Financial Group, Protective Life, PhoenixCompanies
Source: 2010 Q2 and Q3 Earnings Transcripts for MetLife, Prudential, Genworth, Lincoln, Principal Financial Group, Protective Life,Phoenix Companies
0%
GNW
Baa3
LNC
Baa2
MET
A3
PFG
Baa1
PL
Baa2
PNX
B3
PRU
Baa2
2010
Q2
RBC
Ratio 350%
return excess capitalto investors
$49
$0
GNW
Q3
LNC
Q3
MET
Q2
PFG
Q3
PL
Q3
PNX
Q2
PRU
Q2
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Ideal Outcome is a Steady Rise in Rates
Scenario Implications
Damaging from both income and balance sheet perspectives
Permanently LowRates
A prolonged low rate environment was a significant driver of life companydefaults in Japan in the late 1990s and early 2000s
Slow Rise in Rates
Slow rise in rates helps to improve profitability while providing insurers with timeto manage negative MTM on assets
Slow risk in rates also minimizes policyholder disintermediation risk
Poses significant policyholder disintermediation risk policyholders likely towithdraw funds to invest in higher yielding investments thereby forcing lifecompanies to liquidate assets with MTM losses
Lar e unrealized losses from risin rates could also lead to weakened balanceSharp Rise in
Ratessheets
Above risks potentially offset by significant cash balances currently being held bylife companies
-
28
, ,profitability
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Section C
or ens on un s
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Pension Obligations Represent a SignificantObligation for Corporate America
Funded status ofpension plans
has been volatileand exposed
Total Number of Companieswith Defined Benefit Plans
354
Key Statistics for S&P 500 Companies ($bn)2009 Average Asset Allocation for S&P 500
Defined Benefit Pension Plans
Real Estate4%
Other10%
both interest rate
and equitymarket risk
Total Pension Liability $1,603
Total Pension Assets $1,201
Overfunded/ Underfunded) $ 402)
Equity50%
Fixed Income36%
Source: Credit Suisse research report dated September 21, 2010, Pension Headwinds
Funded Status of S&P 500 PlansFunded statusof pension
plans has been
Source: BofAML research report dated October 29, 2010, S&P 500 Pension Update
6%140%
volatile andexposed
companies toboth interest
rate and equitymarket risk
4%
5%
60%
80%
100%
120%
10yeatu
rn
2%
3%
20%
0%
20%
40%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010YTD
rTr
easuryYTM
FundedStatus,
S&P500Re
31Source: BofAML research report dated October 29, 2010 S&P 500 Pension Update, Bloomberg
0%60%
40%
FundedStatus
% S&P
500
Return 10
year
Treasury
YTM
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Under Current Conditions Funding Deficits are Expectedto Persist Leading to Higher Expected Contributions
S&P 500 Projected Plan Contributions and Funded StatusContributionsare projected toexceed $160bn
over the next$bn
86%$100
wo years. venincluding these
contributions,funded status isexpected to onlyreach 82% by YE
lanContribut
ions P
rojected
Fund76%
78%
80%
82%
84%
$40
$50
$60$70
$80
$90
2012
Funded status ishi hl sensitive
ProjectedP d
Status
70%
72%
74%
$0
$10
$20
$30
2008 2009 2010E 2011E 2012E 2013E 2014E
S&P500
Projected
Plan
Contributions S&P
500
Projected
Funded
Status
S&P 500 Pension Plans Funded Status 2010E Sensitivity Analysis
to discount rateand asset
returns. A +/- 25bps change indiscount rate
-10% -5% Base +5% +10%
-50 b s $603) $544) $484) $424) $365)
funded status byapprox. 10%while a +/- 5%
change in assetreturns could
-25 bps ($562) ($503) ($443) ($383) (323)
Base ($521) ($461) ($402) ($342) ($282)
+25 bps ($480) ($420) ($360) ($301) ($241)
32Source (both charts): Credit Suisse research report dated September 21, 2010, Pension Headwinds
status by
roughly 15%+50 bps ($439) ($379) ($319) ($259) ($200)
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Section D
or o a ruc ura m a ances
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Coupon Destruction in the Context of GlobalStructural Imbalances
Asset Class / Metric Current Level Key Question
Question: Why are so many markets trading at historic highs, or lows withunprecedented volatility?
US$ IG Coupons Q4 2010: 4.1% Record low US$ IG coupons
Capital Flows 2008-2010 US$ IG Fund Flow: US$570 bn
Record capital flows into US$ IG bonds,emerging markets, and commodities
Government Yields (10 Year) UK: 3.24% Record low government yields
Related tocoupon
.Japan: 1.19%
Libor 3m Libor: 0.28% Record low LIBOR rates
Gold $1,384 / Oz. Record high gold prices
USD / Yen Y 83.8 / US$ 15-year high USD / Yen exchange rate
Oil / S&P 500 70% correlation 70% correlation in 2010
Oil $85.3 / Barrel Oil trading close to high since LehmanBankruptcy
European Peripheral CDSSpreads (5 Year)
Spain: 351 bpsPortugal: 538 bpsIreland: 603 bpsGreece: 966 bps
Record wide sovereign spreads andCDS
34Answer: Post-Financial Crisis Global Structural Imbalances
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The Global Structural Imbalances
Economics Leverage Capital Markets
Structural unemploymentdeficiencies
U.S. consumer debt levels Central bank monetary policies
Current account surpluses U.S. federal debt Central bank quantitative easingpolicies
2-Tier growth rates U.S. state / muni debt Fund flows into IG bonds
Chinas FX reserves Euro ean soverei n debt Fund flows into commodities
Consumption / GDP Japans sovereign debt Fund flows into emerging markets
. . . .
Wage inequality / incomedistribution
Financial institutions redemptionobligations
`
Foreign currency de-valuations IG bond market coupon destruction
35
Investment grade bond coupon destruction is closely related to a number ofother post-financial crisis structural imbalances
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Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example Implications Destruction
Structuralunemploymentdeficiencies
2010E Unemployment rates:
U.S.:9.6%
Spain: 19.9%
General view that structural unemployment unlikelydriver of U.S. unemployment levels
However, if structural unemployment doescom rise a si nificant ortion of the unem lo ment
Cause Government tackles
unemployment bystimulatin the econom
Japan: 5.1%
UK: 7.9%
Germany: 7.05%
rate, quantitative easing and stimulus measureswould be ineffective for job creation
(QE2) driving rates down
Current accountsurpluses
2010E Current AccountBalances (% of GDP):
Over-dependence on exports for economic growthhas led to artificial currency pegs that distort trade
Cause Chinas export focused
U.S.: (3.19%)
China: 4.7%
Germany: 6.01%
(China),and global capital flows strategy drives FX reserves,UST purchases, and lowerrates
2-Tier growth rates Economic Growth: Low growth rates in developed economies have Cause . .: .
Japan: 2.7%
China: 10%
Brazil: 7.6%
Too fast economic growth in EM countries hastriggered inflation concerns and rate hikes
has led the U.S.government to use liquiditymeasures like QE2 andlower rates
Chinas FX reserves Chinese FX Reserves: Chinas policy of buying U.S. dollars as an artificial Cause
Too low
Too high
Sep. 2010: US$ 2.65 tn
6.4 Yuan/ US$
currency undervaluation strategy creates trade
imbalances and prevents global sustainable growth
China is the largest global
buyer of USTs which keepsdownward pressure onrates
Consumption / GDP U.S.: 70% (too high) Chinas low consumption rate has led the countrysoverde endence on ex orts for economic rowth
Cause
36
na: oo ow
On the contrary, U.S. industrial growth is led bydomestic over-leverage and overconsumption
strategy drives FX reserves,UST purchases, and lowerrates
Source: Deutsche Bank Global Markets Research, IMF (October 2010), Bloomberg, Reuters, International Business Times (November 2010)
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Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example Implications Destruction
U.S. excess housingsupply
7.7% vacant homes vs. 6%20-year average
1.8 mm excess vacanthomes vs. historical
Likely slow down of home price appreciation,slowing down economic recovery and job creation
Cause Weak real estate prices
caused by excess supplysu ress interest rates,.
average and slow economicgrowth
Wage inequality /income distribution
Average manufacturingwages:
China: ~US$ 2 / hour
Global labor arbitrage creates competitivemargin for counties with lower wages, potentiallyaffecting trade balances
Cause Drives Chinas exports,
FX reserves, and UST
Mexico: ~US$ 2.15 / hour
countries
Aging Populations 2009: Persons 65+represented 12.9% of U.S.population
Persons 65+ expected to
Downward rates impact: creates drag on GDPgrowth
Upward pressure: increases sovereign debt burdenswhich is inflationary over time
NA
grow to 19% of U.S.population by 2030
Foreign currencyde-valuations
Yuan/ USD: Y6.4 / US$
Following a 23 month pegto the US$
The artificial undervaluation of the Chinese Yuanhas launched attacks over its negative impact onglobal sustainable growth
Cause Drives Chinas exports,
FX reserves, and USTurchases
U.S. consumer debtlevels
U.S. consumer leverage ratio(Debt/ Income) has improvedbut still high:
2007: 1.29x
2008: 1.28x
De-leveraging phase has led to an increase insavings rates and a slowdown in consumption,creating a huge drag on U.S. GDP growth
De-leveraging occurring at pace similar to write-offs
Cause Weakened consumer
driving GDP drag andunemployment, andlower rates
37
2009: 1.25x
Source: Deutsche Bank Global Markets Research, IMF (October 2010), Bureau of economic analysis, Reuters, Bloomberg
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Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example Implications Destruction
U.S. federal debt U.S. public debt: US$13.2tn or ~90% of GDP
Foreign holdings accountfor 30.5% of total debt 51%
Market distress over mounting debt, and deficitspending, especially among foreign holders of U.S.debt
Concern over mountin debt can otentiall
Cause Investor move away from
U.S. government debtand into IG credit.
of publicly held debt),
decrease foreign holdings of federal debt, drivingyields higher
U.S. state / munidebt
State and local debt standsat 22% of GDP (all timehigh)
Market concerns over potential defaults have risenstate and municipal funding costs, crucial to fundingdeficits
Cause Investor move away from
U.S. state/ muni debt and
Expected to reach 24% by2012
Expected US$140 bn incumulative budget gaps
Investor concerns over potential defaults, havedriven record outflows of capital from fundsspecializing in state and muni debt
n o cre
European sovereign Contagion effects:1. Greek soverei n crisis
Solvency concerns in the European periphery havewidened soverei n s reads considerabl and Cause.
2. Irish sovereign crisis3. Spanish banking system4. Portuguese fiscal worries
increased wholesale funding costs
Contagion effect to large foreign holders ofsovereign debt
Has driven significant euro exchange rate volatility
European governmentdebt and into more stableIG credit
Ja ans soverei n IMF expects Japans gross Even though Japans debt / GDP is massive, more NAdebt public debt to reach 226%
of GDP by 2010E
than 90% of Japanese govt bonds are held by
domestic investors
Rates artificially low for nearly 2 decades
Central bankmonetary policies
Fed funds rate: 0.25%
ECB main refi rate: 1.0%
Monetary easing drives government yields down
Slow growth outlook suggests U.S. core rates to
Cause Low government yields
38
remain low in the mid-term are a primary driver ofcoupon destruction
Source: Bloomberg, IMF (October 2010), Bureau of economic analysis. Whitehouse Budget of the U.S.
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Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example Implications Destruction
Central bankquantitative easingpolicies
QE2 details:
US$ 600 bn thru Q2 2011
Average duration: 5-6 years
Potentially beneficial for U.S. economic growth andjob creation
Direct impact on the dollar (as treasury yields drop)
Cause QE2 bond purchases
have driven, and willcontinue to exert
rec mpac on go an equ es nves orsseeking higher yielding assets)
Transfer of capital into EM as dollar falls
downward pressure onrates
Fund flows into/ outof IG bonds
2008-2010: US$ 570 bn ofIG bond inflows
IG credit has benefited from investor preference forsafe assets yielding stable returns
Both a cause andconsequence
mm in the week endingNov. 17 vs. US$ 4.1 bn theprevious week
,US bond funds recently
Lower rates driveoutflows
Fund flows into
commodities
Total commodity fund inflows
slowed to US$1.2 bn in
QE2 and lower interest rates have driven investors
towards commodities like gold
Consequence QE2 and low IG coupons
c o er vs. . n nAugust
However, riskier commodities have been negativelyimpacted by Chinese rate fears and euro zone woes
drive less risk averseinvestors towardscommodities
Fund flows intoemerging markets
YTD flows into EM equityfunds: US$ 81.9 bn vs. US$83.3 billion in 2009
Lower yielding assets and slower economic growthin developed economies have driven capitaloutflows to emerging markets
Consequence QE2 and low IG coupons
drive less risk averse
YTD flows into EM bond
funds: US$ 46.4 billion vs.US$9.5 billion in 2009
investors towards EM
U.S. banks cashreserves
YTD aggregate U.S. bankcash reserves: US$ 1.04 tn
Tighter regulation and more stringent lendingpolicies have driven an increase in bank cash
Cause Bank liquidity drives
39
January 2006 aggregateU.S. bank cash reserves:US$ 44.3 billion
Strong liquidity among U.S. banks has maintainedinterbank lending rates at substantially low levels
or rates own
Source: Federal Reserve, Investment Company Institute
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Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example Implications Destruction
Underfundedpension liabilities
Approx. total aggregateunfunded liability of all state-sponsored pension plans inthe U.S. is ~US$ 3 trillion or
Growth in unfunded pension liabilities creates anegative feedback loop, where state governmentsmust borrow further to meet requirements
Potentiall hi her taxes and service cuts ma follow
Cause Market concerns over
state public financesdrives investors out of
US$ 27,000 per household,
adding to investor concern over public finances, andrising funding costs
state debt and into IGcredit
IG bond marketcoupon destruction
2008: 6.3%
2009: 5.9%
2010 YTD: 4.4%
Lower yields, rallying credit spreads, and highdemand for IG credit have driven coupon rates torecord lows
Highly related tomany of the globalstructural
Nov. 10: 4.2% Further liquidity measures (QE2) will likely suppress
interest rates at their current lows
Events such as the European debt crisis have driveninvestors towards more stable assets like IG credit
imbalancesdescribed above
40Source: The Crisis in Local Government Pensions in the U.S.. Robert Novy-Marx and Joshua Rauh, Thomson Reuters