Relative value in credit & equity

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1 Relative value in credit & equity IG cash credit and equity are attractive Our analysis of risk premia in credit and equity indicates that investment grade cash credit and equities are both attractively valued. On an absolute return basis, equity offers higher returns. On a riskadjusted basis, however, investment grade cash credit looks more attractive. This pattern holds in both the US and Europe. High-yield looks relatively expensive in both regions given our bleak outlook on defaults and recovery rates. Synthetic high-yield credit in Europe (itraxx Xover) looks particularly expensive with a negative risk premium. Equity and credit rallies support our views Credit and equity have rallied dramatically since the March lows, but we continue to see upside into year-end for US and European equities and IG bonds. There is significant upside for equities if risk premia revert back to long-run averages. We believe the relative outperformance of HY credit is overdone given the rising default rate. Liquidity and composition differences Our measures of risk premia ignore differences in trading liquidity; relative to equity, bonds are both harder to buy and harder to sell. Investors should also be mindful of differences in sector exposure. For example, the capital structure view that equity is riskier than HY is fallacious at the index level because the S&P 500 contains higherquality companies than the HY indexes. Risk premia across the credit and equity spectrum Risk Premia Normalized Current 20-yr Avg. St. Dev Stdevs from Avg. United States iboxx IG CRP (cash) 4.3 % 0.8 % 0.9 % 3.9 S&P 500 ERP CDX IG CRP (synthetic) iboxx HY CRP (cash) CDX HY CRP (synthetic) Europe iboxx IG CRP (cash) 4.0 % 0.7 % 0.7 % 4.8 DJ Stoxx 600 ERP iboxx HY CRP (cash) itraxx Main CRP (synthetic) itraxx Xover CRP (synthetic) (1.5) (0.8) Note: Normalized is stdevs from 20-year average PORTFOLIO STRATEGY: David J. Kostin (212) david.kostin@gs.com Peter Oppenheimer +44(20) peter.oppenheimer@gs.com Goldman Sachs International. Jessica Binder, CFA +44(20) jessica.binder@gs.com Goldman Sachs International. Nicole Fox (212) nicole.fox@gs.com CREDIT STRATEGY: Charles P. Himmelberg (917) charles.himmelberg@gs.com Lotfi Karoui (917) lotfi.karoui@gs.com Alberto Gallo (917) alberto.gallo@gs.com Annie Chu (212) annie.chu@gs.com The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to Analysts employed by non-us affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Goldman Sachs Global Economics, Commodities and Strategy Research Goldman Sachs Global Economics, Commodities and Strategy Research 1

2 Table of contents Relative value in credit and equity 3 Comparing the equity and credit risk premia 4 Calculating the credit and equity risk premia 7 Accounting for liquidity premia when comparing credit and equity 11 Anatomy of the markets 13 Appendix 1: United States equity vs. credit risk premia 15 Appendix 2: Europe equity vs. credit risk premia 16 Disclosures 17 US Portfolio Strategy David J. Kostin david.kostin@gs.com Nicole Davison Fox nicole.fox@gs.com Caesar Maasry caesar.maasry@gs.com Amanda Sneider amanda.sneider@gs.com European Portfolio Strategy Peter Oppenheimer +44(20) peter.oppenheimer@gs.com Goldman Sachs International Sharon Bell, CFA +44(20) sharon.bell@gs.com Goldman Sachs International Jessica Binder, CFA +44(20) jessica.binder@gs.com Goldman Sachs International Gerald Moser +44(20) gerald.moser@gs.com Goldman Sachs International Anders Nielsen +44(20) anders.nielsen@gs.com Goldman Sachs International Credit Strategy Charles P. Himmelberg charles.himmelberg@gs.com Alberto Gallo alberto.gallo@gs.com Lotfi Karoui lotfi.karoui@gs.com Annie Chu annie.chu@gs.com Goldman Sachs Global Economics, Commodities and Strategy Research 2

3 Relative value in credit and equity We analyze relative value between credit and equity in the United States and Europe. This cross-asset and cross-region comparison consolidates results found in several reports published by our Equity Portfolio and Credit Strategy teams over the past several months. This research develops measures of risk premia in equity and credit, which we denote ERP and CRP, respectively. One important ingredient is the recent work done by our Global Portfolio Strategy team to identify fair value in global equities through the development of the Goldman Sachs Dividend Discount Model (GS-DDM). A second key ingredient is the estimates of downgrade, default, and recovery rates for the US and European corporate debt markets from our Credit Strategy team. We combine the most recent estimates from these models to compare risk premia between credit and equity, between the US and Europe, and over time. Massive sell-offs in equity and credit markets do not necessarily translate into higher expected returns; investors must also assess future fundamentals. Our analysis of the underlying fundamentals suggests that expected returns in equity and IG bond markets are, in fact, quite high. Comparisons of relative value across credit and equity require difficult assessments of future fundamentals. We combine proprietary model forecasts of these fundamentals with qualitative judgments to back into annualized risk premia for equity and credit. While they are inherently different calculations, we believe the exercise comes as close to an apples-to-apples valuation methodology as one can hope. On an absolute basis, equity looks most attractive. On a risk-adjusted basis, IG cash credit looks most attractive. These assessments are true for both the US and Europe. Our key conclusions regarding relative value are the following: (1) on an absolute basis, equity looks the least expensive with US and European ERP of 5.7% and 6., respectively; (2) on a risk-adjusted basis, IG cash credit looks most attractive both in the US and Europe. IG synthetic is much less attractive that cash, reflecting the large negative CDS-cash basis currently prevailing; and (3) the recent rally in US High Yield markets has substantially reduced the appeal of HY credit both in cash and synthetic. In Europe, the picture is even worse, as the CRP on HY synthetic is even negative. Today s equity risk premium is quite high relative to history, and it is likely to revert towards the long-term average over the next few years. This shift is bullish for equities, in our view, and consistent with our year-end targets for the S&P 500 and Stoxx 600. We find that if the ERP falls back to from its current level of about and real bond yields are, both regional equity markets have significant potential upside: 57% for the US and 97% for Europe. Similarly, on a five-year basis, we think that US equities will have an annualized return of 1-1, and European equities 17%-2. These returns should exceed those produced by IG cash credit, despite the current riskweighted attractiveness of the asset class. Nearer term, we expect the S&P 500 to reach 940 by the end of the year ( upside) the and DJ Stoxx 600 to reach 235 (17% upside). Know what you are buying: market liquidity, sector exposure, and credit quality vary considerably across indices. To make an adequate comparison between credit and equity, we need to take into account the significant differences in market liquidity. We quantify the liquidity premium embedded in corporate bond yields to allow a fairer comparison with stocks by considering four metrics: (1) the CDS-bond basis; (2) the premium in credit ETFs vs. bond indices; (3) trading volumes; and (4) bid-ask spreads. Various indicators suggest that compensation for holding relatively illiquid US$ denominated investment grade credit pays anywhere between 55 and 320 bp of carry. It is also important to recognize the significant differences in the sector composition and balance sheet quality across indices. Some of the differences are striking even between similar indices. Perhaps most importantly, the Financials weighting across the indices varies significantly. Goldman Sachs Global Economics, Commodities and Strategy Research 3

4 Comparing the equity and credit risk premia Massive sell-offs in equity and credit markets do not necessarily translate into higher expected returns; investors must also assess future fundamentals. The nearly 5 fall in equities and substantial widening in corporate spreads since October 2007 have prompted market participants to question whether current price levels already reflect much of the deterioration in fundamentals. We have a strong fundamental bias that price declines, while substantial, do not necessarily mean higher expected returns. In the equity market, traditional valuation measures provide mixed messages as P/Es are inexpensive only if Financials provisions and write-downs are excluded. In practice, however, these short-term expectations should not have a huge impact on the valuation of equities since they are inherently long-duration instruments. When valuing equities, the discount rate is more important to the overall valuation than near-term forecasts. Credit instruments have very different valuation characteristics as their maturity is fixed. This puts a higher emphasis on the short-term outlook, and our view is that default, downgrade and recovery risks are at their highest levels in decades. Compared to the last two recessions, the sluggish economic recovery that we are expecting will likely generate persistent default losses, both in IG and HY. In light of these differences in valuation characteristics, we have calculated annualized risk premia for the equity and credit markets in order to compare their relative value. For equity, we use our GS-DDM framework to forecast future dividends, and then compute the ERP as the constant premium over the government yield required to equate discounted expected future cash flows to market value. For credit, we analogously compute the CRP as the premium that equates default-adjusted cash flows to five-year bond prices. Exhibit 1 provides a summary of the different credit and equity risk premia for the US and Europe. Our main findings are the following: Equities. On an absolute basis, equity looks the least expensive with a US and European ERP of respectively 5.7% and 6.. IG Credit. On a risk-adjusted basis, IG cash credit looks most attractive both in the US and Europe. IG synthetic is unsurprisingly much less attractive than cash. This is a reflection of a large negative CDS-cash basis currently prevailing. HY Credit. The recent rally in US HY markets has substantially reduced the appeal of HY credit both in cash and synthetic. In Europe, the picture is no different where the CRP on HY synthetic is negative. Exhibit 1: Risk premia across the credit and equity spectrum; as of April 30, 2009 Risk Premia Normalized Current 20-yr Avg. St. Dev Stdevs from Avg. United States iboxx IG CRP (cash) 4.3 % 0.8 % 0.9 % 3.9 S&P 500 ERP CDX IG CRP (synthetic) iboxx HY CRP (cash) CDX HY CRP (synthetic) Europe iboxx IG CRP (cash) 4.0 % 0.7 % 0.7 % 4.8 DJ Stoxx 600 ERP iboxx HY CRP (cash) itraxx Main CRP (synthetic) itraxx Xover CRP (synthetic) (1.5) (0.8) Note: Normalized is number of standard deviations from 20-year average Goldman Sachs Global Economics, Commodities and Strategy Research 4

5 Exhibits 2-5 highlight the historical relationship between the ERP and CRP over the past 20 years in both the US and Europe. During the current bear market cycle, the ERP in both the US and Europe has risen to extremely elevated levels, well above the peaks of the past two recessions. The CRP for IG cash in both the US and Europe have also risen to levels well above the highs in recent market slowdowns. The High Yield CRP, however, are still well below the peaks from the past two recessions despite rising substantially on an absolute basis. The suppressed High Yield CRP are a reflection, in large part, of our forecast for all-time high 5-year cumulative losses. Exhibit 2: US ERP vs. CRP (Investment Grade) Exhibit 3: US ERP vs. CRP (High Yield) ERP, lhs 7% CRP (Cash IG), rhs CRP (CDX IG), rhs ERP CRP (Cash HY) CRP (CDX HY) - Exhibit 4: Europe ERP vs. CRP (Investment Grade) Exhibit 5: Europe ERP vs. CRP (High Yield) ERP, lhs 7% CRP (Cash IG), rhs CRP (itraxx Main), rhs ERP CRP (Cash HY) CRP (itraxx Xover) Goldman Sachs Global Economics, Commodities and Strategy Research 5

6 Recent market performance and relative value Recent market performance, in both the US and Europe, is consistent with our view that equities and IG bonds currently offer the best relative value. Performance has been remarkably similar in the US and Europe since early fall 2008, with IG and HY cash credit outperforming equities. Since the March 9 trough in equities, however, the S&P 500 and DJ Stoxx 600 have both significantly outperformed both IG and HY credit. Collectively we continue to see upside in US equities (our year-end target for the S&P 500 is 940, potential upside), European equities (our year-end target for the Stoxx 600 is 235, 17% potential upside), and both US and European IG cash credit. Year-to-date, HY bond indices have been the strongest performers. This outperformance is overdone, in our view, given that default rates are on the rise and recovery rates are declining. The annualized HY default rate jumped from 11.7% in February to roughly 19. as of the end of March, driving the 3-month moving average to 1 (See Exhibit 9). Recovery rates for unsecured bonds are also deteriorating, falling to 9% on average since December The downside risk to High Yield suggested by the default and recovery environment is consistent with our relative value work, which shows risk premia for High Yield indices below 20-year averages. Exhibit 6: S&P 500 vs. US Cash Credit Indices US$; as of April 30, Exhibit 7: DJ Stoxx vs. European Cash Credit Indices ; as of April 30, Indexed Return (100 = 1-Oct-08) iboxx IG +7% iboxx HY - S&P Indexed Return (100 = 1-Oct-08) iboxx IG + iboxx HY -1 DJ Stoxx Oct Oct Nov-08 3-Dec Dec Jan-09 4-Feb Feb Mar-09 8-Apr Apr May Jun-09 1-Jul-09 1-Oct Oct Nov-08 3-Dec Dec Jan-09 4-Feb Feb Mar-09 8-Apr Apr May Jun-09 1-Jul-09 Source: Global Sachs Global ECS Research. Exhibit 8: Recent performance of US and European indices; local currency, as of April 30, 2009 Exhibit 9: US and EUR monthly default rates over last 20 years Computed using a cohort of HY firms each month Total Return 9/30/08 to-date Year-to-date 3/9/09 to-date United States S&P 500 (24)% (2)% 29 % US 3-month moving average default rate EUR 3-month moving average default rate iboxx HY (Cash) (5) iboxx IG (Cash) 7 (3) 3 1 CDX IG (Synthetic) CDX HY (Synthetic) (8) (4) 11 Europe Stoxx 600 (24)% (1)% 23 % 1 1 iboxx HY (Cash) (16) iboxx IG (Cash) itraxx Main (Synthetic) (1) 1 2 itraxx Xover (Synthetic) (8) 5 7 () Jan-88 Jul-89 Jan-91 Jul-92 Jan-94 Jul-95 Jan-97 Jul-98 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Source: Moody s Goldman Sachs Global ECS Research. Goldman Sachs Global Economics, Commodities and Strategy Research 6

7 Calculating the credit and equity risk premia Our CRP model in a nutshell A key ingredient in computing the expected cash flows on the credit portfolio is the estimation of the term structure of losses from year 1 to year 5. To this end, we use our top-down macro model to generate our forecasts of a rating transition matrix with the following three states: IG, HY and default. The matrix effectively includes four elements: the 12-month downgrade rate from IG to HY, the 12-month upgrade rate from HY to IG, the 12-month jump to default rate from IG and the 12-month default rate from HY. Using this transition matrix, we then compute the term structure of losses for IG and HY. Exhibits 10 and 11 provide a visual inspection of the 5-year cumulative loss rates for IG and HY both in the US and Europe. For IG, our baseline scenario implies a 5-year US and European cumulative loss rates of 4. and 2. respectively. The higher US cumulative default rate reflects the better credit quality of the European IG universe. For HY, we are projecting a 5-year cumulative loss rate of 3 in both regions. These loss rates are substantially higher than the peaks that followed the last recessions. This is consistent with our view that the economic recovery will likely be sluggish over the next five years which should make defaults and downgrades more persistent compared to previous cycles. Exhibits 12 and 13 show a time series of the CRP for both cash and synthetic diversified IG portfolios. We use the iboxx IG (both US$ and ) as a proxy for IG cash while CDX IG and itraxx Main are used as benchmarks for diversified IG synthetic portfolios. As shown in Exhibit 12 and despite our draconian loss assumptions, both US and European IG cash offer a much higher compensation compared to the peaks that followed the last two recessions. This is in-line with our existing view that the current all-time high liquidity premium embedded in IG bonds largely compensates investors for future downgrade and default losses. In derivative form, the CRP is much less attractive than in cash but compares favorably to the peaks of the last two recessions (Exhibit 13). Exhibit 10: Our forecasts for the 5-year IG cumulative loss rate are much higher than the last two recessions The IG US and European 5-year cumulative loss rate 7% 5-year US IG loss rate 5-year US IG loss rate: baseline scenario 5-year EUR IG loss rate 5-year EUR IG loss rate: baseline scenario Exhibit 11: The pattern is similar for the 5-year HY cumulative loss The IG US and European 5-year cumulative loss rate year US HY loss rate 5-year US HY loss rate: baseline scenario 5-year EUR HY loss rate 5-year EUR HY loss rate: baseline scenario Looking at the HY CRP, the recent rally in the US HY market has clearly reduced the appeal of HY, both in cash and synthetic forms. With a CRP of roughly, US HY cash and synthetic expected returns are well below their peaks of the last two recessions. In Europe, the HY cash market yields a significantly higher CRP relative to the US. However, Goldman Sachs Global Economics, Commodities and Strategy Research 7

8 we would be very cautious in adding risk on European HY cash. As detailed in our March 13, 2009, Credit Line, The credit crunch moves to Europe, we think the European HY market is poised to underperform its US counterpart. Because of its smaller size, the European HY market has a much higher exposure to contagion risk, which poses some downside risk to our European loss rate forecast. Finally and as shown in Exhibit 15, synthetic spreads, particularly in Europe, are far from compensating investors for default and recovery risks. In particular, the negative CRP on itraxx Crossover clearly shows that current spreads are too tight and are not pricing in enough credit deterioration in the European HY market. Exhibit 12: The IG cash CRP is substantially higher than the peaks of the last two recessions US and European IG cash CRP Exhibit 13: The IG synthetic CRP is however less attractive US and European IG cash CRP IG cash CRP US IG cash CRP: baseline scenario EUR IG cash CRP: baseline scenario IG cash CRP US IG synthetic CRP: baseline scenario EUR synthetic IG CRP: baseline scenario Exhibit 14: The US HY cash CRP is still not attractive by historical standards US and European HY cash CRP US HY cash CRP US Cash CRP: baseline scenario EUR Cash CRP: baseline scenario x Exhibit 15: The HY synthetic CRP does not fare better US and European HY synthetic CRP US HY cash CRP US synthetic CRP: baseline scenario EUR synthetic CRP: baseline scenario Goldman Sachs Global Economics, Commodities and Strategy Research 8

9 Our ERP model in a nutshell Based on our top-down earnings forecasts, we estimate the current implied ERP to be 5.7% for the US and 6. for Europe, which is down somewhat from the highs reached earlier this year. However, risk premia remain elevated relative to the last 20 years. For the US, the ERP has averaged 2. since 1990, briefly turning negative in 2000 at the peak of the technology bubble. For Europe, the ERP has been a bit higher, averaging 2.9% over the past 20 years. Exhibit 16 shows the equity risk premium as derived from our model using our top-down earnings forecasts for the current point. (See our recent reports, Finding Fair Value in Global Equities; Part I, February 9, 2009, and Finding Fair Value in Global Equities: Part II Forecasting Returns, March 23, 2009, for more detail.) Exhibit 16: ERPs remain well above average in both the US and Europe 7% - - Europe US Current Current Note: We have previously separated out the UK from the rest of Europe. To combine them, we use weights of 7 Europe ex-uk and 2 UK. To determine the ERP, we assume that the market is at the fair value derived from our global dividend discount model (the GS-DDM) that divides future earnings and dividend growth into four phases: Phase I (Years 1-2): Short-run earnings growth forecasts based on our top-down earnings models. (Since historical forward-looking estimates are not available for Europe, we use a 50/50 split of bottom-up forecasts and perfect information of actual growth rates. See Strategy Matters: Credit versus equity: Credit offers better value, November 14, 2008 for more details.) Phase II (Years 3-4): Fade to trend ROE (return on equity). We assume that the market gets back to trend ROE by the end of year 4 and that the earnings change to achieve this occurs equally over the two years. Phase III (Years 5-20): We assume that profits grow in-line with trend GDP growth, while the payout ratio equals the average over the past five years. Phase IV (the terminal value): In the very long run, we assume that the return on equity is equal to the cost of equity and that profits growth in line with trend GDP growth. Two of the key determinants of the equity risk premium at any point are the level at which the market is trading and near-term earnings expectations. All else being equal, the higher the market, the lower the ERP. While the relationship is not strictly linear, within this range, a 25 point move in the market implies a 10 basis point change in the ERP. Goldman Sachs Global Economics, Commodities and Strategy Research 9

10 Short-term earnings expectations can also have an impact on the calculation of the ERP. Holding other variables constant, an increase in earnings expectations would imply a higher ERP. Put simply, the higher earnings should lead to a higher price, so if the price does not adjust, the risk premium must be adjusted higher with the earnings. We stress that this relationship is not strictly linear, but note that it roughly translates into a 5 bp move in the ERP for every 5 percentage point change in earnings expectations. In reality, these two things do not tend to move independently. If expectations rise, which would push the ERP up, the market would also rally, pushing the ERP down. Exhibit 17 shows the trade-off between these two variables. Exhibit 17: Implied S&P 500 ERP based on different earnings forecasts and market levels Nominal FY1 earnings growth Market Level % 5.7% % % % 5.7% % % % % % % % % % % % % % % Stated plainly, the ERP is an estimate of the return required by investors. Similar to the way that the market can stay above or below fair value for long periods, the ERP could be higher or lower than it 'should' be based on the underlying macroeconomic environment one has to just to think back to the peak of the equity market bubble for an example of the market incorporating too low a risk premium. In our recent report Forecasting returns: 'Fair Value' Part II, March 23, 2009, we introduced a model that suggests that the two biggest drivers of the ERP are the output gap (both at home and abroad) and the previous level of the ERP. At the time of publication, the implied ERP was slightly higher than the model would have suggested in both the US and Europe. After the recent rally, which resulted in a decline in risk premia, the US and European risk premia appear very close to those suggested by our ERP model. On an absolute basis the equity risk premium is quite high today and it is likely to revert towards the long-term average at some point over the next few years. We find that if the ERP falls back to from its current level of about and real bond yields are (our "equilibrium" scenario in GS DDM), both markets have significant potential upside: 57% for the US and 97% for Europe. Similarly, on a five-year basis, we think that US equities will have an annualized return of 1-1, and European equities will have an annualized return of 17%-2. Nearer term, we expect the S&P 500 to reach 940 by the end of the year ( upside) and DJ Stoxx 600 to reach 235 (17% upside). Downside risks exist to our view. One of the largest risks for equity investors over the next few years is the prospect of deflation. While this is not our core view, it could result in significantly lower equity prices as profits fall dramatically and the equity risk premium increases (See Strategy Matters: Deflation vs. Inflation: The implications for equities, April 23, 2009). Goldman Sachs Global Economics, Commodities and Strategy Research 10

11 Accounting for liquidity premia when comparing credit and equity To make an adequate comparison between credit and equity, we need to take into account the significant differences in market liquidity. Liquidity has been a very popular term over the past months in conversations regarding the relative value of credit and equity. In this instance we refer to the broad economic meaning of the term, which essentially includes three dimensions of transaction costs: trading fees, price friction, and funding costs. Simply stated, a high liquidity environment means paying low transaction costs without moving market prices while having access to funding. Our aim is to extract the liquidity premium embedded in corporate bond yields to allow a fairer comparison with stocks. We consider four metrics: (1) the CDS-bond basis; (2) the premium in credit ETFs vs. bond indices; (3) bid-ask spreads; and (4) trading volumes. Each one captures different dimensions of the transaction costs mentioned above. We estimate liquidity premia on US$ denominated investment grade credit to be between 55 bp and up to 320 bp of carry, depending on the metric used. The CDS-Bond basis is the most comprehensive measure, in our opinion. However, we would use it as an upper boundary, since it is also driven by factors other than liquidity. These four measures of liquidity are discussed below. Exhibit 18: Comparing different measures of corporate bond liquidity Indicator CDS-Bond basis ETFs premium Bid-ask spread Trading volume Dimensions of 'liquidity' captured Trading fees, price friction and funding costs Trading fees and price friction Trading fees only Price friction only Premium on $ IG credit 320 bp 75 bp 55 bp - 1. CDS-Bond basis. One way to quantify the liquidity premium in credit assets is to examine the differential between bonds and default swaps. Cash assets require funding and have to be sourced by dealers in the secondary market. On the other hand, default swaps are unfunded and require a relatively small margin. Moreover, CDS protection can be originated at any time, as long as there are two parties willing to buy and sell. The difference in the carry investors receive between holding a bond and selling a default swap protection is commonly known as the CDS-Bond basis. When funding costs are high, the premium for holding cash increases compared to CDS and as a result the basis becomes negative. The negative basis has been gradually trending up from its lows over the past months, amid improvements in funding costs and in counterparty risk. We think the basis is indicative of corporate bonds liquidity premia although it is biased by other factors too, such as counterparty risk and the unfunded nature of CDS. Additionally, financing costs for swaps may be lower than for stocks. For these reasons, we would consider the CDSbond basis as an upper boundary measure of credit liquidity. 2. Credit ETFs premium. Credit ETFs allow investors to gain exposure to corporate bond indices without having to replicate a bond portfolio. Buying a credit ETF is therefore much cheaper than buying the individual bonds in terms of fees. A liquid ETF is also likely to have stronger market depth than most corporate bonds. We take into consideration the popular USD investment grade (LQD) and high yield (HYG) ETFs as well as the EUR investment grade one (IBCX). All three of these ETFs have been consistently trading at a premium to NAV over the past few months (excl. the sell-off around the Lehman event). The LQD for example currently trades at around price premium, which is equivalent to around 75 bp of carry. The HYG trades at 4.7 price premium and IBCX at 0.8. Goldman Sachs Global Economics, Commodities and Strategy Research 11

12 Exhibit 19: CDS-Bond basis improving but still negative basis = avg of CDS and bond spreads for index members CDX IG CDX HY itraxx Europe itraxx Xover 1-Mar Dec Oct Aug-08 Exhibit 20: ETFs on IG (LQD, IBCX) and HY (HYG) credit have been trading at a premium to NAV LQD HYG IBCX Apr-06 9-Mar Jan Nov-08 Source: Goldman Sachs Global ECS Strategy. Source: Bloomberg, and Goldman Sachs Global ECS Strategy. 3. Bid-ask spread. Fees for trading corporate bonds are on average higher than for stocks. We compared bid and ask prices on stocks and bonds in the US IG and HY market, where bond data is available. The median bid-ask spread for stocks is 7 bp, while commissions for bonds are around 62 bp (high yield bonds tend to have higher costs). This equals an average premium of 55 bp. 4. Trading volume. Exhibits 21 and 22 compare the average value traded in the corporate bond market vs. stocks in the S&P 500 index. According to data provided by SIFMA, around 0.3 of the corporate bond market value has on average been traded every day, since For stocks, the turnover relative to market capitalization is higher at 0.69% per day and has been rising over the past few quarters. A higher turnover means investors can trade higher quantities of stocks with a lesser impact on price. In the bond market instead, it generally takes longer to establish long or short positions without generating price moves. Exhibit 21: Avg. % daily volume for US corp. bonds Corporate bond traded volumes have been fairly constant, around 0.3 of the market is traded every day, according to data provided by SIFMA Exhibit 22: Avg. % daily volume for S&P 500 stocks Stocks trading volumes are on average higher than bonds, as a percentage of market capitalization. We show the total average value traded for S&P 500 members, by month Source: SIFMA and Goldman Sachs Global ECS Strategy. Source: Bloomberg, and Goldman Sachs Global ECS Strategy. Goldman Sachs Global Economics, Commodities and Strategy Research 12

13 Anatomy of the markets When looking across assets for dislocations, trades or relative value, it is important to recognize the significant bottom-up differences between the indices pertaining to sector composition and balance sheet quality (as measured by credit rating), and liquidity (as previously discussed). Some of the differences are striking even between similar indices. For example, there are large sector differences between the US investment grade cash index (iboxx IG) and the US IG synthetic index (CDX IG). Sector composition The sector skews between the different US and European indices are quite pronounced. It is of course important to note these differences because they imply very different exposures and could lead to significant differences in performance. One sector that stands out is Financials, which makes up a large part of the investment-grade credit indices, but a much lower percentage of the equity indices, particularly in the S&P 500. The Information Technology sector also has dramatically different weightings across indices. Technology is the largest sector in the S&P 500, at 1 of the total market capitalization, and is less than 7% of every other index we examine in both the credit and equity markets. There are also significant differences between the sector composition of the cash and synthetic IG indices. In the US, Consumer Discretionary is the largest component of both synthetic indices (IG and HY) but is a much smaller percentage of the cash IG and HY indices. Consumer Discretionary stocks are also the largest component of the itraxx Xover index in Europe and the second largest component of the itraxx Main. The cash credit indices in Europe have much less exposure to Consumer stocks. Within Europe, there is a skew towards defensives sectors in the equities indices, driven by higher weightings in Health Care and Energy. The credit indices have much lower weightings in these two sectors but do have meaningful exposure to Telecom and Utilities. The high-yield index has a very large skew towards cyclical sectors, with Consumer Discretionary, Materials and Industrials representing approximately 8 of the index. Exhibit 23: Sector composition of selected equity, cash credit, and synthetic credit indices in the US and Europe Sector weightings as of April 30, 2009 Sector breakdown (% of total index market cap) United States Europe Equities Cash Credit Synthetic Credit Equities Cash Credit Synthetic Credit S&P 500 iboxx IG iboxx HY CDX IG CDX HY Stoxx 600 iboxx IG iboxx HY itraxx Main itraxx Xover Consumer Discretionary 9% 1 23 % 39 % % Consumer Staples Energy Financials Health Care Industrials Info Tech Materials Telecom Services Utilities Note: bolded cells highlight the largest sector in each index Source: FactSet and Goldman Sachs Global ECS Research. Goldman Sachs Global Economics, Commodities and Strategy Research 13

14 Quality composition One of the most common questions we are asked when discussing credit vs. equity is why equities have not sold off more given that high-yield defaults are expected to increase significantly. The simple answer is that while equities are below credit in the capital structure, very few publicly traded companies, particularly large cap companies, have high yield-rated credit. Indeed, the equity indices are dominated by investment-grade firms close to 9 of the S&P 500 and 9 of the EuroStoxx50 is rated IG. Exhibit 24: Quality composition of selected equity, cash credit, and synthetic credit indices in the US and Europe Credit ratings as of April 30, 2009 Credit Rating / Quality Characteristics (% of total index) United States Europe Equities Cash Credit Synthetic Credit Equities Cash Credit Synthetic Credit S&P Credit Ratings S&P 500 iboxx IG iboxx HY CDX IG CDX HY Stoxx 600 iboxx IG iboxx HY itraxx Main itraxx Xover Investment Grade AAA AA A BBB Total 87 % 99 % 0 % 97 % 3 % 80 % 100 % 0 % 94 % 11 % High Yield BB B CCC CC C D Total 4 % 1 % 100 % 3 % 97 % 2 % 0 % 100 % 1 % 78 % Not Rated NR 9% 19% 1 Not Rated includes companies with no debt outstanding, not rated and not covered by Standard & Poor s. Source: FactSet, Bloomberg and Goldman Sachs Global ECS Research. Goldman Sachs Global Economics, Commodities and Strategy Research 14

15 Appendix 1: United States equity vs. credit risk premia Exhibit 25: US ERP vs. CRP (Investment Grade) Different scales Exhibit 26: US ECRP (Investment grade) Equity risk premium less credit risk premium ERP, lhs 7% CRP (Cash IG), rhs CRP (CDX IG), rhs % ERP vs. IG Cash ERP vs. IG Synthetic Equities inexpensive relative to IG - Equities expensive relative to IG - Exhibit 27: US ERP vs. CRP (High Yield) Exhibit 28: US ECRP (High Yield) Equity risk premium less credit risk premium ERP vs. HY Cash ERP vs. HY Synthetic Equities inexpensive relative to HY - ERP - CRP (Cash HY) CRP (CDX HY) - - Equities expensive relative to HY - Goldman Sachs Global Economics, Commodities and Strategy Research 15

16 Appendix 2: Europe equity vs. credit risk premia Exhibit 29: Europe ERP vs. CRP (Investment Grade) Different scales Exhibit 30: Europe ECRP (Investment grade) Equity risk premium less credit risk premium ERP, lhs 7% CRP (Cash IG), rhs CRP (itraxx Main), rhs % ERP vs. IG Cash ERP vs. IG Synthetic Equities inexpensive relative to IG Equities expensive relative to IG - Exhibit 31: Europe ERP vs. CRP (High Yield) Exhibit 32: Europe ECRP (High Yield) Equity risk premium less credit risk premium ERP CRP (Cash HY) CRP (itraxx Xover) ERP vs. HY Cash ERP vs. HY Synthetic Equities inexpensive relative to HY - Equities expensive relative to HY - Goldman Sachs Global Economics, Commodities and Strategy Research 16

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