Opportunities in Turbulent Markets:
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1 Opportunities in Turbulent Markets: Risk and Reward Budgeting in Below-Investment Grade Ty Anderson Global Head of High Yield Strategies
2 When the tide goes out, we get to see who s not wearing a bathing suit... 1
3 After the initial credit crunch OK, you ve got your bathing suit on, but you re no longer floating in a sea of liquidity. When your feet touch bottom, are you... 2
4 ... standing safely on the beach? Fotosearch 3
5 ... or sinking in quicksand? Fotosearch 4
6 Key questions: How divergent are technical from fundamental values? How to protect against this divergence? How to take best relative advantage? 5
7 Agenda 1 Where Are We Today and How Did We Get Here? 2 Putting Credit Risk and Opportunities Into Perspective 6
8 Volatility among all asset classes has increased as a result of credit turmoil 30% 25% 20% 15% 10% 5% 0% 7 Aug-93 Mar-94 Oct-94 May-95 Dec-95 Jul-96 Feb-97 Sep-97 Apr-98 Nov-98 Jun-99 Jan-00 Aug-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Apr-05 Nov-05 Jun-06 Jan-07 Aug-07 Mar Month rolling Annualized Volatility MTD 10/10/08 20-Month Rolling Volatility August 1993 October 10, 2008* CS High Yield S&P 500 JPM-Emg Mkts S&P LSTA Index ML Broad Corp. Mst. CS Lev'd Loan Index Source: Credit Suisse, Ibbotoson Associates, Bloomberg *CS High Yield Index and the CS Leveraged Loan Index is as of 10/09/08
9 High yield bond spreads are at all time wide levels & defaults are increasing High Yield Spread-to-Worst vs. 12-Month Trailing Default Rate* 14.00% 12.00% 1096 bp 12/31/90 12/31/86 to 10/9/ bp 10/31/ bp 10/9/ % 12.00% 10.00% 10.00% 8.00% 8.00% 6.00% Average STW: 5.62% 6.00% 4.00% 2.00% 304 bps Average Default Rate: 4.62% 271 bps 4.00% 2.00% 0.00% 0.00% Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Dec-98 Dec-97 Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 CS HY Spread to W orst Average Default Rate Average STW Moody's Trailing 12 m onth Default Rate *Default rate is as of 9/30/08. Source: Credit Suisse and Moody s Investor Services 8
10 The credit risk curve has steepened dramatically High Yield Bond Risk Curve 2,500 8/31/2006 8/31/ Basis Points (bps) 2,000 1,500 1, /31/2008 8/31/ /9/ Split BBB BB B CCC/split CCC Source: Credit Suisse as of October 9,
11 Average discounted spreads to maturity* of loans have widened in an unprecedented way May 30, 2002 to October 9, 2008 E+850 E+750 E+650 E+550 E+450 E+350 Europe US Europe/US Gap 09/10/ Prior Week Year End Year End Year End Year End Europe US E+250 E+150 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 *Discounted spread is based upon the initial spread, the current bid level and bullet repayment at the stated maturity date. Source: S&P/LSTA. European Secondary Pricing Source: Markit Loans 10
12 Agenda 1 Where Are We Today and How Did We Get Here? 2 Putting Credit Risk and Opportunities Into Perspective 11
13 Correlations between high yield and other assets are typically low CS High Yield CS High Yield 1.00 Correlations 15 years ending September 30, 2008 S&P/ LSTA* Russell 2000 JP Morgan EMGD S&P 500 MSCI EAFE ML Broad US Corp. Mst. ML 10-Yr US Tsy Lehman 1-3 Yr Tsy SP/LSTA* Russell JP Morgan EMGD S&P MSCI EAFE ML Broad Corp. Mst ML 10-Yr US Tsy Lehman 1-3 Yr Tsy ML 3-Mos T-Bill ML 3- Mos T-Bill As of September 30, 2008 *S&P/Loan Sales & Trading Association Leveraged Loan Index Source: Bloomberg, Credit Suisse, Merrill Lynch, Lehman Brothers; Correlations are historical and are no guarantee of future correlation patterns 12
14 An allocation to high yield may improve portfolio risk and return over the long-term 7.20% Investment-Grade vs. High Yield 15 years ending June 30, % 7.00% 50% high yield 50% inv grade Return 6.90% 6.80% 6.70% 6.60% 6.50% 6.40% 40% high yield 60% inv grade optimal risk/reward allocation 75% high yield 25% inv grade 100% high yield 6.30% 6.20% 100% inv grade 4.00% 4.25% 4.50% 4.75% 5.00% 5.25% 5.50% 5.75% 6.00% Risk Source: DB Advisors. High yield is the Credit Suisse High Yield Index. Investment (Inv) Grade is the Merrill Lynch Corporate Master. Volatility is measured by the annualized standard deviation in monthly returns. 13
15 Liquidity gap or armageddon indicator? High Yield Spread-to-Worst vs. 12-Month Trailing Default Rate* 14.00% 12.00% 1096 bp 12/31/90 12/31/86 to 10/9/ bp 10/31/ bp 10/9/ % 12.00% 10.00% 10.00% 8.00% 8.00% 6.00% Average STW: 5.62% 6.00% 4.00% 2.00% 304 bps Average Default Rate: 4.62% 271 bps 4.00% 2.00% 0.00% 0.00% Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Dec-98 Dec-97 Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 CS HY Spread to W orst Average Default Rate Average STW Moody's Trailing 12 m onth Default Rate *Default rate is as of 9/30/08. Source: Credit Suisse and Moody s Investor Services 14
16 Wider spreads offer high yield bond opportunities As spread levels touch the 900 bp level, high yield bonds may offer attractive medium-term returns High yield bonds can offer equity-like returns with lower volatility 1990s Credit Crisis 1 Start date Spread (bps) 1-yr return 2-yr return 3-y return Feb % 23.08% 20.20% Sep % 28.40% 24.04% 2000 Economic Downturn 2 Start date Spread (bps) 1-yr return 2-yr return 3-y return Oct % -0.45% 8.95% Nov % 4.10% 10.88% Jun % 9.82% 10.45% Sep , % 14.08% 13.76% Jun % 15.58% 13.79% Jul % 17.96% 15.37% 1 Source: Credit Suisse. Start date is as of month-end. Returns are annualized. 2 Source: JP Morgan. Start date is as of month-end. Returns are annualized. 15
17 Loans have been more volatile vs. their long-term average Annualized Volatility High-Yield Bonds Leveraged Loans Jan 1992 Sep % 2.49% Jul 2007 Sep % 6.91% Difference +2.71% +4.42% 12% Annualized Volatility of Calendar Year Returns January 1, 1992 YTD September 30, 2008 Annulaized Volatility 10% 8% 6% 4% 2% 0% High-Yield Bonds Leveraged Loans YTD 2008 Source: Credit Suisse High Yield Index and the Credit Suisse Leveraged Loan Index 16
18 It s hard to explain some market moves fundamentally High Yield Bonds and US Leveraged Loans Actual vs. Implied Default Rates 1 Market Implied Loan Default Rate Market Implied High Yield Bond Default Rate Realized Loan Default Rate Realized High Yield Bond Default Rate Past performance is not an indication of future results. 1 Source: Goldman Sachs as of 6/30/08 17
19 Is there protection on the downside?* May 30, 2002 to October 9, Historical Recovery on Defaults: 82.04%** 74.0 Europe US 70.0 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 * Source: S&P/LSTA. European Secondary Pricing Source: Markit Loans ** Moody s Global Corporate Finance: Corporate Default and Recovery Rates, February
20 Credit quality positioning makes a difference through the cycle Rolling 12-Month Credit Quality Tier Performance vs. Default Cycle 40% Up-quality trade is beneficial early in the cycle 12/31/86 to 9/30/08 Lower-quality outperforms later in the credit cycle 20% 12-Mos. Roling Default Rate 30% 15% 20% 10% 10% 5% 0% 0% -5% -10% -10% -20% Rolling 12-mos default rate -15% -30% Excess return: Middle-tier vs. Lower-tier -20% -40% Excess return: Upper-tier vs. Middle-Tier -25% Excess Return As of September 30, 2008 Source: Moody s Investor Services; Credit Suisse High Yield Index 19
21 Concluding thoughts Technicals win short term; fundamentals medium term The case for diversification and averaging in Economic outlook increases fundamental risks: Priced in? Below investment-grade markets are not monolithic: Risks vary significantly by sub-segment and by issuer 20
22 Investment implications Near-term volatility suggests caution, but- On any fundamental or historical basis, below investmentgrade assets are cheap A below investment-grade allocation as part of a broader portfolio strategy makes sense Individual security selection can help moderate risk. It can keep you... 21
23 ... out of the quicksand Fotosearch 22
24 ... and on the beach! Fotosearch 23
25 Important notes DB Advisors is the brand name for the institutional asset management division of Deutsche Asset Management, the asset management arm of Deutsche Bank AG. In the US, Deutsche Asset Management relates to the asset management activities of Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company; in Canada, Deutsche Asset Management Canada Limited (Deutsche Asset Management Canada Limited is a wholly owned subsidiary of Deutsche Investment Management Americas Inc); in Germany and Luxembourg: DWS Investment GmbH, DWS Investment S.A., DWS Finanz-Service GmbH, Deutsche Asset Management Investmentgesellschaft mbh, and Deutsche Asset Management International GmbH; in Australia, Deutsche Asset Management (Australia) Limited (ABN ); in Hong Kong, Deutsche Asset Management (Hong Kong) Limited; in Japan, Deutsche Asset Management Limited (Japan); in Singapore, Deutsche Asset Management (Asia) Limited (Company Reg. No N) and in the United Kingdom, RREEF Limited, RREEF Global Advisers Limited, and Deutsche Asset Management (UK) Limited; in addition to other regional entities in the Deutsche Bank Group. This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates, gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute Deutsche Bank AG or its affiliates judgment at the time of issue and are subject to change. This document is only for professional investors. This document was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. No further distribution is allowed without prior written consent of the Issuer. The forecasts provided are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. For Investors in the United Kingdom: Issued in the United Kingdom by Deutsche Asset Management (UK) Limited of One Appold Street, London, EC2A 2UU. Authorised and regulated by the Financial Services Authority. This document is a non-retail communication within the meaning of the FSA s Rules and is directed only at persons satisfying the FSA s client categorisation criteria for an eligible counterparty or a professional client. This document is not intended for and should not be relied upon by a retail client. 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An investment with Deutsche Asset Management is not a deposit with or any other type of liability of Deutsche Bank AG ARBN , Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank AG Group. The capital value of and performance of an investment with Deutsche Asset Management is not guaranteed by Deutsche Bank AG, Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank Group. Investments are subject to investment risk, including possible delays in repayment and loss of income and principal invested. For Investors in Hong Kong: Interests in the funds may not be offered or sold in Hong Kong or other jurisdictions, by means of an advertisement, invitation or any other document, other than to Professional Investors or in circumstances that do not constitute an offering to the public. This document is therefore for the use of Professional Investors only and as such, is not approved under the Securities and Futures Ordinance (SFO) or the Companies Ordinance and shall not be distributed to non-professional Investors in Hong Kong or to anyone in any other jurisdiction in which such distribution is not authorised. For the purposes of this statement, a Professional investor is defined under the SFO. For investors in MENA region This information has been provided to you by Deutsche Bank AG Dubai branch, an Authorised Firm regulated by the Dubai Financial Services Authority. It is solely directed at wholesale clients of Deutsche Bank AG Dubai branch, who Deutsche Bank AG Dubai branch is satisfied meet the regulatory criteria as established by the Dubai Financial Services Authority. I (12/08) 24
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