The Phenomenon of Coupon Destruction

Assessing the implications of declining coupons rates on bond investors

December 2010

Deutsche Bank Securities Inc., a subsidiary of Deutsche Bank AG, conducts investment banking and securities activities
in the United States.
Contents

1. Coupon Destruction: The Data

2. Coupon Destruction: The Drivers

3. Coupon Destruction: The Implications

A. For
o Bond
o d Markets
a ets
B. For Insurance Companies
C. For Pension Funds
D. For Global Structural Imbalances
C
Coupon D
Destruction:
t ti Th
The Data
D t
Section 1
 The Phenomenon of Coupon Destruction
IG Annual Weighted Average Coupons U.S. 30
30-Day
Day Commercial Paper Yields
(2006 – 2010 YTD) (2006 – 2010 YTD)
The phenomenon of
“coupon 6.5% 6.3% Tier 1 Non‐Financial Tier 2 Non‐Financial
destruction” 6.1%
7
started developing 6.0% 5.9%
6.0% 6
in 2008, when
5
governments 5.5%
worldwide adopted 4

%
a relaxed monetary 5.0% 3
policy stance in 2
order to stimulate 4.5% 4.4%
4.2% 1
economic
eco o cg growth
o t
by maintaining 4.0% 0
interest rates low... 2006 2007 2008 2009 2010 YTD Nov‐10 Jan‐06 Jul‐06 Jan‐07 Jul‐07 Jan‐08 Jul‐08 Jan‐09 Jul‐09 Jan‐10 Jul‐10

 IG coupon rates have declined substantially since  CP yields have followed a striking correlation to the
the onset of the financial crisis tightening of their benchmark LIBOR rates
... today,
today coupon 3-Year
3 Year Consumer ABS Spread 30-Year
30 Year Fixed Home Mortgage Yields
destruction affects (2006 – 2010 YTD) (2006 – 2010 YTD)
all credit markets
650 Conventional Jumbo
including ABS, CP, 600
3‐yr Fixed Credit Card 3‐yr Fixed Prime Auto 8.0
and mortgage 550 7.5
rates 500
7.0
450
400
Spread (bps)

6.5

Yield (%)
350
300 6.0
250
5.5
200
150 5.0
100
4.5
50
0 4.0
Source: Thomson Reuters,
Jan‐06 Sep‐06 May‐07 Feb‐08 Oct‐08 Jun‐09 Mar‐10 Nov‐10 Jan‐06 Jul‐06 Jan‐07 Jul‐07 Jan‐08 Jul‐08 Jan‐09 Jul‐09 Jan‐10 Jul‐10
Federal Reserve, Bloomberg
 Stability of credit performance, lower delinquency  Excess housing supply and low government rates
rates, and stabilizing prepayment rates have driven have positively impacted residential mortgage
the narrowing of consumer ABS yields yields 4
 Coupon Destruction in the US$ IG Bond Market
US$ IG New Issue Volume (Fixed vs
vs. FRN) / Weighted Average Coupon (2006 – 2010 YTD)
The phenomenon of
coupon Fixed Rate New Issue Volume FRN New Issue Volume Weighted Average Coupon

destruction 1200 6.3% 6.5

accelerated toward 5.6% 6.1%
historicallyy low 1000 5.9%
60
6.0
total coupons
during the course 800
5.5
US$ bn

of 2010 in 60.3%
47.6% 4.8% 7.9 %
600

%
particular 24.8%
5.0
400 92.1%
95.2%
52.4% 75.2%
39 7%
39.7% 4.5
Annual Average 200 4.4%
New Issuance
Duration 0 4.0
2006 2007 2008 2009 2010 YTD
 2006: 7.4
 2007: 7.6
 2008: 6.6 New Issue Volume / Weighted Average Coupon (2010 YTD)
 2009: 6.4
New Issue Volume Weighted Average Coupon
 2010 YTD: 7.2 350 5.0
4.9
300
4.7% 4.8
250 4 6%
4.6% 4.7
US$ bn

200 4.6

%
4.5
150 4.4
4.2%
100 4.3
4 05%
4.05% 4.2%
42
4.2
50
4.1
0 4.0
Q1‐10 Q2‐10 Q3‐10 Oct‐10 Nov‐10

Source: Thomson Reuters 5

C
Coupon D
Destruction:
t ti Th
The Drivers
Di
Section 2
Coupon Destruction: The Drivers
3 Key Drivers of Coupon Destruction

Driver 1  Record Government yield tightening

Driver 2  Record LIBOR tightening

Driver 3  Record IG credit spread tightening

Driver 4  Record capital flows into bond funds

Driver 5  Overwhelming supply/ demand dynamics in the IG bond market

7
 Driver # 1: Record Government Yield Tightening
U S Treasury Yields (2006 – 2010 YTD)
U.S. Key Drivers
The significant post- 2y UST 5y UST 10y UST 30y UST
financial crisis  Economic recovery
decline in 6
government yields,
particularly on the  Low inflation risk (continued
short end, has concern around deflation)
been a primary 5
driver of the
 Monetary easing
coupon
destruction
phenomenon 4
 Q
Quantitative
tit ti easing
i (QE2)

QE2 and “flight to

 “Flight to quality” during
%

quality” concerns 3
during the Euro exogenous global events (i.e.,
crisis have also sovereign crisis)
been primary
drivers
2  Supply / demand dynamics

 Global capital flow dynamics

1 ( t
(structural
t l imbalances)
i b l )

0
06

07

08

09

10
06
06
06

07
07
07

08
08
08

09
09
09

10
10
10
06
06

07
07

08
08

09
09

10
10
May‐0

May‐0

May‐0

May‐0

May‐1
Jul‐0
Sep‐0
Nov‐0

Jul‐0
Sep‐0
Nov‐0

Jul‐0
Sep‐0
Nov‐0

Jul‐0
Sep‐0
Nov‐0

Jul‐1
Sep‐1
Nov‐1
Jan‐0
Mar‐0

Jan‐0
Mar‐0

Jan‐0
Mar‐0

Jan‐0
Mar‐0

Jan‐1
Mar‐1

8
Source: Bloomberg
 Driver # 1: Record Government Yield Tightening
10-Year
10 Year U.S. Treasury Yield 10-Year
10 Year Germany Bond Yield
(2006 – 2010 YTD) (2006 – 2010 YTD)
Global sovereign
5.5 5.0
bond yields have
followed the same 5.0 4.5
tightening
tendency as UU.S.
S 4.5
4.0
Treasuries, as
4.0
governments
%

3.5

%
worldwide are still 3.5
using monetary 3.0
policy to stimulate 3.0
economic growth 2.5
2.5

2.0 2.0
Apr‐06

Apr‐07

Apr‐08

Apr‐09

Apr‐10
Jan‐06

Jul‐06
Oct‐06
Jan‐07

Jul‐07
Oct‐07
Jan‐08

Jul‐08
Oct‐08
Jan‐09

Jul‐09
Oct‐09
Jan‐10

Jul‐10
Oct‐10

Apr‐06
Jul‐06

Apr‐07
Jul‐07

Apr‐08
Jul‐08

Apr‐09
Jul‐09

Apr‐10
Jul‐10
Jan‐06

Oct‐06
Jan‐07

Oct‐07
Jan‐08

Oct‐08
Jan‐09

Oct‐09
Jan‐10

Oct‐10
10-Year
10 Year UK Bond Yield 10-Year
10 Year Japan Bond Yield
(2006 – 2010 YTD) (2006 – 2010 YTD)
6.0
2.5
5.5

5.0
20
2.0
4.5

4.0 1.5
%

3.5 %
3.0 1.0

2.5

2.0 0.5
Apr‐06

Apr‐07

Apr‐08

Apr‐09

Apr‐10
Jan‐06

Jul‐06
Oct‐06
Jan‐07

Jul‐07
Oct‐07
Jan‐08

Jul‐08
Oct‐08
Jan‐09

Jul‐09
Oct‐09
Jan‐10

Jul‐10
Oct‐10

Apr‐06
Jul‐06

Apr‐07
Jul‐07

Apr‐08
Jul‐08

Apr‐09
Jul‐09

Apr‐10
Jul‐10
Jan‐06

Oct‐06
Jan‐07

Oct‐07
Jan‐08

Oct‐08
Jan‐09

Oct‐09
Jan‐10

Oct‐10
9
Source: Bloomberg
 Driver # 2: Record LIBOR Tightening
Aggregate Reserves of U.S.
U S Depository Institutions / 3
3-Month
Month Libor (2006 – 2010 YTD)

 Increased banking system liquidity has driven Libor rates down, pushing issuers out of FRN issuance
3-month LIBOR has
tightened nearly  Drivers: More stringent lending standards, increased regulatory capital, and consumer de-leveraging
500 bps since  Size of increase: US$ 960 bn since September 2008
2006 driven
2006,
largely by the Aggregate Reserves of Depository Insitutions 3m Libor
rising cash
1400 6
reserves of the
banking system
1200
5

1000
4
800
3-month Libor is 3
US$ bn

%
y and
closely
600
inversely
correlated to the 2
increase in 400
reserves
1
200

0 0
Mar‐06
May‐06

Mar‐07
May‐07

Mar‐08
May‐08

Mar‐09
May‐09

Mar‐10
May‐10
Jan‐06

Nov‐06
Jan‐07

Nov‐07
Jan‐08

Nov‐08
Jan‐09

Nov‐09
Jan‐10

Nov‐10
Jul‐06
Sep‐06

Jul‐07
Sep‐07

Jul‐08
Sep‐08

Jul‐09
Sep‐09

Jul‐10
Sep‐10
 The drop in LIBOR rates has fuelled the decline in FRN issuance to approx. 9% of
total new issue volume in 2010 YTD

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.
10
Source: Bloomberg, Federal Reserve
 Driver # 3: US$ IG Credit Spread Tightening
IG Credit Spreads (2006 – 2010 YTD)
IG bond spread A Financials BBB Financials A Corporate BBB Corporate
tightening has
been a key driver
1000
of coupon
destruction in the
US$ Market 900

800
This spread
tightening has
been particularly 700
strong among BBB
financial and 600
corporate names
500
bps
s

400

300

200

100

0
May‐‐06

May‐‐07

May‐‐08

May‐‐09

May‐‐10
Mar‐‐06

Nov‐‐06

Mar‐‐07

Nov‐‐07

Mar‐‐08

Nov‐‐08

Mar‐‐09

Nov‐‐09

Mar‐‐10

Nov‐‐10
Jan‐‐06

Sep‐‐06

Jan‐‐07

Sep‐‐07

Jan‐‐08

Sep‐‐08

Jan‐‐09

Sep‐‐09

Jan‐‐10

Sep‐‐10
Jul‐‐06

Jul‐‐07

Jul‐‐08

Jul‐‐09

Jul‐‐10
11
Source: Bloomberg
 Driver # 4: Record Capital Flows into IG Bond Funds
Total Bond Fund Inflows (All Credit Asset Classes)
Bond funds have
enjoyed record flows 60
in 2009-2010 as 40
investors favor safer 20
assets yielding a
Amount ($bn)
0
stable and attractive
(20)
return over riskier
assets like equities (40)
(60)
(80)
Higher demand for IG (100)
credit has further
(120)
depressed coupon
Jul-08 Aug-09 Sep-10
rates on recent issues
Taxable Bonds Equity

Sources of Bond Inflows Net Bond Inflows (2009 – 2010 YTD)

 Risk aversion  2009: US$ 306.7 bn

 Equity
E it outflows
tfl

 Money market fund assets  2010 YTD: US$ 243.5 bn

 Structured p
product flows

 IG asset cash increases  2009-2010 YTD: US$ 550.2 bn

12
Source: Investment Company Institute
 Driver # 5: Strong New Issue Market Technicals

While recent and Net Institutional Investor Cash Flows 2011E

estimated new issue
activity is
substantial, DB’s
Cash flows to institutional investors
expected net
i
issuance (issuance
(i $438 Investment grade new issues
less bond $700
700
redemptions,
coupon payments Excludes Estimated
and new cash government  Asset managers: US$ 40-60 bn
inflows into bond 500 guaranteed  Insurance companies: US$ 30-50 bn
funds) for 2011 is securities  Pension funds: US$ 20-30 bn
USD billions

negative

300
$256

100

‐100

$90 – $140
‐300 $40 -$124 – -$174
2011E New  2011E USD  Est Coupon  Incremental  Liability  Net Issuance 
Issuance p
Redemptions Payments
y Bond Flows Management
g Effect

Note: DB estimates based on historical trends; Est coupon payments are estimated assuming ~$4.2 trillion of debt outstanding at a 6.1% average coupon; DB
IG fund flows estimated by adding US$ 40-60 billion from asset managers + US$ 20-30 billion from pension funds + US$ 30-50 billion from insurance
companies ; DB liability management estimate does not include exchanges and consents

13
Source: Deutsche Bank, Thomson Reuters, Dealogic
 Breakdown of 2011-2012 US$ IG Bond Redemptions

Breakdown of 2011-2012 US$ IG Bond Redemptions

Demand for IG debt is
expected to keep
rising in 2011 and 2011 2012 Comment
2012, as large
volumes of IG Total US$ 438 bn US$ 421 bn • Over US$ 800 billion of IG credit
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 and
financial maturities in the next 2 years
Financials US$199 bn / 45% US$ 206 bn / 49% • Nearly even split among corporate and
financial maturities in the next 2 years

Av. Coupon 6.6% 6.0% • Substantial drop in maturing debt

coupon rate in 2012 vs. 2011
Av. Duration 6.5 6.4 • Stable average duration

* Excludes government guaranteed securities

14
Source: Dealogic
 Breakdown of 2011E Coupon Payments

The substantial size 2011E Coupon Payments

of the total
estimated coupon Item #
payments on
outstanding T t l US$ IG debt
Total d bt ~US$
US$ 4.2
4 2 trillion
t illi
investment grade outstanding 1
debt will be a
major driver of Weighted average coupon on 6.1%
demand in 2011 total IG
outstanding debt 2
Total 2011E Coupon ~US$ 256 billion Breakdown of Total Outstanding IG Debt
Payments 3
Item #
1: Total outstanding debt as of December 1, 2010
2: Based on total outstanding debt as of December 1, 2010 % Fixed ~93%
3:2011E coupon payments = multiplication of total US$ IG
outstanding debt (~4.2 tn) + weighted average coupon on
total US$ IG outstanding debt (6.1%) % Floating ~7%
Source: Dealogic
% Financials ~40%

% Corporates ~60%

Average coupon 6.1%

15
Source: Dealogic
C
Coupon D
Destruction:
t ti Th
The Implications
I li ti
Section 3
F Bond
For B d Markets
M k t
Section A
 IG Bonds Have Been A Top Performing Asset Class
IG Credit Spreads (September 15,
15 2008 – 2010 YTD)
US$ IG Bonds have
been one of the A Financial BBB Financial A Corporate BBB Corporate
top performing 1000
asset classes of 900
the global 800
financial crisis 700
600
500
bps

400
300
200
100
0
Occt‐08

Deec‐08

Maar‐09

Maay‐09

Occt‐09

Deec‐09

Maar‐10

Maay‐10

Occt‐10
ov‐08

Jaan‐09

pr‐09

un‐09

ov‐09

Jaan‐10

pr‐10

un‐10

ov‐10
Seep‐08

Feeb‐09

ul‐09
ug‐09
Seep‐09

Feeb‐10

ul‐10
ug‐10
Seep‐10
Ju

Ju
Ap

Ap
No

No

No
Au

Au
Ju

Ju
Total Return IG Credit Performance (Q1-Q3 2010)

Instrument Q1 Q3 2010 Performance

Q1-Q3 Q3 2010 Performance
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%
Non - Fin 11.02% 4.75%
Fin Sen 10.01% 4.82%
Fin Sub 9.04% 5.91%
18
Sources: Bloomberg; Deutsche Bank Global Markets Research (Jim Reid)
 Credit Migration as Investors Seek Yield
New Issue Volume by Rating / Weighted Average Coupon (2006 – 2010 YTD)

Interestingly, the
proportion of lower
rated IG debt AAA New Issuance AA New Issuance A New Issuance
issuance has
i
increased d
BBB New Issuance
BBB New Issuance Weighted Average Coupon
Weighted Average Coupon
1200 6.5

6.1% 6.3%
Key Drivers 1000
5.6% 5.9% 6.0
 Fewer high rated
issuers BBB
800 BBB
 Investor search 5.5
for yield
600
US$ bn

 Investor

%
confidence in BBB
A A BBB 5.0
corporate BBB
balance sheets 400
A
AA A A
4.5
200 AA 4.4%
AA AA
AAA AAA AA
0 AAA AAA AAA 4.0
2006 2007 2008 2009 2010

19
Source: Thomson Reuters
 Floating Rate Issuance Has Declined Sharply
Key Issues FRN Issuance (% of Total)
The ~500bps yield  FRN issuance has seen a dramatic drop since
destruction in Libor
is the main reason
2006: 2006 60.3%
- 7.9% in 2010 vs. 60.3% in 2006
for the drop in FRN
issuance from  Libor likely to remain low,
low as policy makers in the 2007 47.6%
~60% of total new U.S. are expected to refrain form raising rates
issuance in 2007 to until late 2011 2008 24.8%
~8% in 2010. - 0.30% as of Nov. 30, 2010
- ~500bps drop in libor rates since 2006 2009 4.8%
 Currently strong bank cash reserves provide
ample liquidity in the banking system and 2010 YTD 7.9%
maintain money market rates low

3 Month Libor Rate (January 2006 – To Date)

%

20
Source: Bloomberg
 Sharp Uptick in Liability Management Activity
Monthly LM Deal Volume (Jan
(Jan-07
07 through Nov
Nov-10
10 YTD)
Average volumes
per month have 25,000
seen a significant
uptick in the last Monthly IG LM deal volumes ($mm)
20,000
18 to 24 months
15,000

Average monthly 10,000

deal volume ($mm)
2007 3,803 5,000
2008 1,874
2009 8 806
8,806 0
2010 YTD 8,136
Aug-07
Sep-07

Nov-07
Dec-07

Aug-08
Sep-08

Nov-08
Dec-08

Aug-09
Sep-09

Nov-09
Dec-09

Aug-10
Sep-10

Nov-10
Apr-07

Oct-07

Apr-08

Oct-08

Apr-09

Oct-09

Apr-10

Oct-10
Feb-07
Mar-07

Feb-08
Mar-08

Feb-09
Mar-09

Feb-10
Mar-10
May-07

Jul-07

May-08

Jul-08

May-09

Jul-09

May-10

Jul-10
Jan-07

Jun-07

Jan-08

Jun-08

Jan-09

Jun-09

Jan-10

Jun-10
Annual
AnnualLM
LMDeal
DealVolumes
Volume ((Jan-07
(Jan 07 through
(Jan-07 g Nov-10
through Nov 10 YTD)
Nov-10 YTD))

120,000

100,000
Annual IG LM deal volume ($mm)
80,000

60,000

40,000

20,000

0
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, 2010
21
Source: Company press releases; Bloomberg; Deutsche Bank database
F Insurance
For I Companies
C i
Section B
Overview of Impact
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

- 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 off 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 at
current levels

- Limited expected balance sheet impacts at this stage

 The prospect of an extended low rate environment is causing insurers and investors to be
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
Insurers Have Benefited from Low Interest Rates
Total AOCI of Top US Life Companies Comments
$bn

$20   Accumulated Other Comprehensive Income “AOCI”

is a balance sheet item that includes unrealized
$10 
gains / losses from insurance company asset
$‐
$ portfolios
p

$(10)
 As the graph illustrates, Life Insurer book equity
Total AOCI

$(20)
dropped dramatically during the financial crisis as
credit spreads widened and MTM on bond
$(30) portfolios dropped
$(40)
 However, these negative MTM balances have been
$(50) effectively erased by the drop tightening of interest
2007 Q1

2007 Q2

2007 Q3

2007 Q4

2008 Q1

2008 Q2

2008 Q3

2008 Q4

2009 Q1

2009 Q2

2009 Q3

2009 Q4

2010 Q1

2010 Q2

2010 Q3
rates and credit spreads over the past 24 months
Total = Sum of Quarterly AOCI for MetLife, Prudential, Hartford, Genworth, Lincoln, Principal Financial Group, Protective Life,
Phoenix Companies
Source: Company Filings

Total US Life Industry Senior Debt Issuance Comments

$bn

$6 9.00%
 The low interest rate environment has enabled
8.00% insurers to take advantage of cheaper financing
$5
7.00%

$4 6.00%  Since the opening up of the debt markets in early

Average Coupon

2009, US life insurance companies have issued in

Total Issuance

5.00%
$3
4.00%
excess of $20bn in senior debt and GIC financing
$2 3.00%
 The average coupon for senior debt and GIC
2.00%
$1 issuances in Q3 2010 was over 300bps tighter than
1.00%
the average coupon for comparable issuances in
$0 0.00%
Q2 2009
2009 Q1

2009 Q2

2009 Q3

2009 Q4

2010 Q1

2010 Q2

2010 Q3

Total Fixed Rate Senior Debt Average Coupon

Source: Bloomberg. Includes all fixed rate debt issued by all US life and health insurers.
24
 Longer-Term Potential Concerns
Annualized 2010 Investment Income Total Cash as of Q3 2010
Insurers rely on $bn $bn
investment income $18 70% $16
$16.9
for a significant $14.6 Total ‐ $38 bn
$16 $14
amount of their 60%

revenue. This $14

$12
$12.0

50%
Annualized Net Investment Income
e

revenue could be $12

$11.8

Q3 2010 Cash Balance

$10

squeezed if rates 40%

% Revenue
$10

remain low $8

$8
30%
$6
$5.7
In addition, $6
$4.5 20%
$4 $3.6 $3.5

Insurers have large $4 $3.3 $3.2 $3.4

$2.3
$
$1.7
amounts of cash $2
$2.0 10% $2

$0.8 $0.2
that will need to $0 0%
$0
$0.2

GNW HIG LNC MET PFG PL PNX PRU

eventually be GNW HIG LNC MET PFG PL PNX PRU AVERAGE

Sources: company filings, SNL. Amounts represent YTD 2010 results annualized. Sources: company filings, SNL. Represents total cash and cash equivalents reported on GAAP balance sheets as the end of Q3 2010.
invested

Insurers have
Investment Leverage as of Q3 2010 YE 2009 Projected Pension Obligations / Q3 Equity
highly levered
balance sheets and
meaningful 12
11.3x
60%

pension 10.2x
10.5x
50%
10 50%
obligations that
would be 8
8.1x
40%

pressured in an
Investment Leverage

7.0x
6.8x
6.4x

PBO/Equity
extended low rate 6
5.2x
30%

environment 24%

20%
4
20% 18%

14%

2 10%
10%

4%

0 0%
0%
GNW HIG LNC MET PFG PL PNX PRU
GNW HIG LNC MET PFG PL PNX PRU

Investment Leverage Average Investment Leverage

Note: GNW’s PBO is immaterial
Note: Investment Leverage = Total Investments (Amortized Cost if Available) / Book Value
Sources: company filings, SNL
Sources: company filings, SNL
25
 Projected Maturity of Life Company Fixed Income Portfolios

Bond Portfolio Breakdown by Years to Maturity for All S&P Rated North American Life Insurers
According to S&P,
40% of life
insurers’ fixed
income portfolios 0 - 5 years
are expected to 40%

mature within 5 5 - 10 years

28%
years

Based on S&P
projections, the
top 8 publicly
traded life
companies will
need to reinvest
$368 bn of Over 10 years
32%
maturing assets
in the next 5 Source: S&P Report “Interest
Interest Rate Risk: Why Both Decreases and Increases in Rates Can Vex Insurers”
Insurers

years. This
amount is in Projected Fixed Income Asset Maturities for Top Publicly Traded US Life Companies
addition to the
annual premiums
Maturity Years Total Amount Maturing ($bn)
and other cash
fl
flows that
th t life
lif 0–5 $
$368
companies need
5 – 10 $257
to invest
> 10 $294

Total Fixed Income Portfolio Size $ 919 bn

Source: Total Amount Maturing calculated as total fixed maturity portfolios as of Q3 2010 for top 8 US life companies (MET, PRU, PL, PNX, GNW, HIG, PFG, LNC) multiplied by S&P bond portfolio breakdown
percentages outlined in pie chart above

26
 Concern Over Low Rates Impacting Lower Valuations and
Causing More Conservative Posture at Life Companies
Current and Historical Price to Book Ratios
Some Insurers have
acknowledged that 3.5
the low rate
3.0
environment is
causing concern and 2.5

leading them to
P/B Ratio
2.0
conserve excess
1.5
capital until the
future direction of 1.0

rates
t b becomes more 0.5
certain 0.0
GNW HIG LNC MET PFG PL PNX PRU
Current price to book
ratios are closer to Source: Deutsche Bank Research, Company Filings as of November 18, 2010. Ranges represent peak and trough P/B levels over the past 20 years.

historical lows than

they are to peak RBC Ratios as of Q2 2010 Holding Company Cash
levels
600% $4,000
$3,700 
Total ‐ $10,899mm
500% $3,500
While RBC Ratios 500%
447% 440% 431%
and Holding 400% $3,000
400% 375%
$
$2,500 
Company cash $2,500
$2,200 
290%
holdings are at 300%

Cash
$2,000
historically high
200% $1,500 $1,300 
levels, no major US
Life Companies have 100% $1,000 $800 

announced p plans to $500 $350

$350 
0%
return excess capital $49 
GNW LNC MET PFG PL PNX PRU $0
to investors Baa3 Baa2 A3 Baa1 Baa2 B3 Baa2 GNW LNC MET PFG PL PNX PRU
Q3 Q3 Q2 Q3 Q3 Q2 Q2
2010 Q2 RBC Ratio 350%
Note: 350% level has been historical “benchmark’ RBC target for AA-rated companies Source: 2010 Q2 and Q3 Earnings Transcripts for MetLife, Prudential, Genworth, Lincoln, Principal Financial Group, Protective Life,
Phoenix Companies
Source: 2010 Q2 Earnings Transcripts for MetLife, Prudential, Genworth, Lincoln, Principal Financial Group, Protective Life, Phoenix 27
Companies
Ideal Outcome is a Steady Rise in Rates

Scenario Implications

 Damaging from both income and balance sheet perspectives

 Likely leads to significant changes in product pricing and features

Permanently Low
Rates
• A prolonged low rate environment was a significant driver of life company
defaults in Japan in the late 1990s and early 2000s

 Ideal scenario

 Slow rise in rates helps to improve profitability while providing insurers with time
Slow Rise in Rates to manage negative MTM on assets

 Slow risk in rates also minimizes policyholder disintermediation risk

 Poses significant policyholder disintermediation risk – policyholders likely to

withdraw funds to invest in higher yielding investments thereby forcing life
companies to liquidate assets with MTM losses

 Large
g unrealized losses from rising
g rates could also lead to weakened balance
Sharp Rise in sheets
Rates
 Above risks potentially offset by significant cash balances currently being held by
life companies

 Longer-term,
Longer term, however, a higher rate environment will help life company
profitability

28
F Pension
For P i Funds
F d
Section C
Overview of Impact
Overview of Impact

 Pension plan obligations represent a significant liability for corporate America and, in some
cases, represent a liability that is larger than a company’s entire book value

 Companies
p with large
g pension
p obligations
g have been adversely
y affected by
y the low interest rate
environment

- Drop in interest rates has increased pension liabilities leading to larger funding deficits

- Larger deficits have led to higher pension contribution requirements

 The effects of the low rate environment have been partially offset by positive equity returns,
which has helped to increase the value of pension assets

- However, market performance has not been enough to fully offset the drop in rates and volatile
equity markets going forward could pose additional risks to the solvency of US pension plans

 If rates remain low or decrease, pension obligations could continue to increase leading to large
deficits and increased pension contribution requirements

- Under the current rate environment, Analysts expect pension contributions to jump dramatically in
2011 and beyond

30
 Pension Obligations Represent a Significant
Obligation for Corporate America
Funded status of 2009 Average Asset Allocation for S&P 500
pension plans Key Statistics for S&P 500 Companies ($bn)
Defined Benefit Pension Plans
has been volatile
Total Number of Companies Real Estate
Other

and exposed with Defined Benefit Plans

354 4%
10%

companies to
both interest rate Total Pension Liability $1,603
and equity
market risk Fixed Income
Total Pension Assets $1,201 36%

Equity
50%

( )
Overfunded/(Underfunded) $(402))
$(

Source: Credit Suisse research report dated September 21, 2010, “Pension Headwinds” Source: BofAML research report dated October 29, 2010, “S&P 500 Pension Update”

Funded status Funded Status of S&P 500 Plans

of pension
plans has been 140% 6%

volatile and 120%

exposed 5%
companies to 100%

both interest 80%

rate and equity 4%

10‐yeaar Treasury YTM
eturn

market risk 60%

Funded Status, S&P 500 Re

40% 3%

20%
2%
0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010YTD
‐20%
F

1%
‐40%

‐60% 0%

Funded Status % S&P 500 Return 10‐year Treasury YTM

Source: BofAML research report dated October 29, 2010 “S&P 500 Pension Update”, Bloomberg
31
 Under Current Conditions Funding Deficits are Expected
to Persist Leading to Higher Expected Contributions
Contributions S&P 500 Projected Plan Contributions and Funded Status
are projected to
exceed $160bn $bn
over the next $100 86%
t
two years. E
Even $90 84%
including these $80

Plan Contributions
82%

Projected Funde
contributions, $70
80%
funded status is $60
expected to only $50 78%
reach 82% by YE $40 76%

ed Status
Projected P
2012 $
$30
74%
$20
$10 72%

$0 70%
2008 2009 2010E 2011E 2012E 2013E 2014E
Funded status is S&P 500 Projected Plan Contributions S&P 500 Projected Funded Status
highly sensitive
to discount rate S&P 500 Pension Plans Funded Status 2010E – Sensitivity Analysis
and asset
returns. A +/- 25
bps change in -10% -5% Base +5% +10%
discount rate
could change -50 bps
p ($603))
($ ($544))
($ ($484))
($ ($424))
($ ($365))
($
funded status by
approx. 10% -25 bps ($562) ($503) ($443) ($383) (323)
while a +/- 5%
Base ($521) ($461) ($402) ($342) ($282)
change in asset
returns could
+25 bps ($480) ($420) ($360) ($301) ($241)
move funded
status by +50 bps ($439) ($379) ($319) ($259) ($200)
roughly 15%

Source (both charts): Credit Suisse research report dated September 21, 2010, “Pension Headwinds” 32
F Global
For Gl b l Structural
St t l Imbalances
I b l
Section D
 Coupon Destruction in the Context of Global
Structural Imbalances
Question: Why are so many markets trading at historic highs, or lows with
unprecedented volatility?

Asset Class / Metric Current Level Key Question

US$ IG Coupons Q4 2010: 4.1% • Record low US$ IG coupons

Capital Flows 2008-2010 US$ IG Fund Flow: US$ • Record capital flows into US$ IG bonds,
Related to 570 bn emerging markets, and commodities
coupon Government Yields (10 Year) UK: 3.24% • Record low government yields
destruction Germany: 2.67%
2 67%
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

g close to high
g since Lehman
Bankruptcy

European Peripheral CDS Spain: 351 bps • Record wide sovereign spreads and
Spreads (5 Year) Portugal: 538 bps CDS
Ireland: 603 bps
Greece: 966 bps

Answer: Post-Financial Crisis Global Structural Imbalances

34
 The Global Structural Imbalances
Economics Leverage Capital Markets

Structural unemployment U.S. consumer debt levels Central bank monetary policies
deficiencies

Current account surpluses

p U.S. federal debt Central bank q
quantitative easing
g
policies

2-Tier growth rates U.S. state / muni debt Fund flows into IG bonds

China’s
C a s FX reserves
ese es European
u opea so
sovereign
e e g debt Fund
u d flows
o s into
to commodities
co od t es

Consumption / GDP Japan’s sovereign debt Fund flows into emerging markets

U S excess housing supply

U.S. U S banks cash reserves
U.S.

Wage inequality / income Financial institutions’ redemption

distribution obligations

Aging Populations ` Underfunded pension liabilities

Foreign currency “de-valuations” IG bond market coupon destruction

“Investment grade bond coupon destruction” is closely related to a number of

other post-financial crisis structural imbalances

35
 Structural Imbalances and Coupon Destruction
Relevancy to Coupon
Structural Imbalance Quantification / Example Implications
Destruction
Structural 2010E Unemployment rates:  General view that structural unemployment unlikely Cause
unemployment  U.S.:9.6% driver of U.S. unemployment levels  Government tackles
deficiencies  Spain: 19.9%  However, if structural unemployment does unemployment by
comprise a significant portion of the unemployment stimulating
g the economyy
 Japan: 5.1% rate, quantitative easing and stimulus measures (QE2) driving rates down
 UK: 7.9% would be ineffective for job creation
 Germany: 7.05%

Current account 2010E Current Account  Over-dependence on exports for economic growth Cause
surpluses Balances (% of GDP): has led to artificial currency pegs that distort trade  China’s export focused
 U.S.: (3.19%) (Chi ) d global
(China),and l b l capital
it l flflows strategy drives FX reserves,
UST purchases, and lower
 China: 4.7%
rates
 Germany: 6.01%

2-Tier growth rates Economic Growth:  Low growth rates in developed economies have Cause
(too low or too high)  U.S.:
US 2 2.8%
8% driven capital outflows to emerging markets  Slow economic recovery
Too low
 Japan: 2.7%  Too fast economic growth in EM countries has has led the U.S.
triggered inflation concerns and rate hikes government to use liquidity
 China: 10% Too high measures like QE2 and
 Brazil: 7.6% lower rates

China’s FX reserves Chinese FX Reserves:
 Sep. 2010: US$ 2.65 tn
 6.4 Yuan/ US$
 China’s policy of buying U.S. dollars as an artificial Cause
currency undervaluation strategy creates trade  China is the largest global
imbalances and prevents global sustainable growth buyer of UST’s which keeps
downward pressure on
rates

Consumption / GDP  U.S.: 70% (too high)
 China: 40% (too low)
 China’s low consumption rate has led the country’s Cause
overdependence on exports for economic growth  China’s
China s export focused
 On the contrary, U.S. industrial growth is led by strategy drives FX reserves,
domestic over-leverage and overconsumption UST purchases, and lower
rates

36
Source: Deutsche Bank Global Markets Research, IMF (October 2010), Bloomberg, Reuters, International Business Times (November 2010)
 Structural Imbalances and Coupon Destruction
Relevancy to Coupon
Structural Imbalance Quantification / Example Implications
Destruction
U.S. excess housing  7.7% vacant homes vs. 6%  Likely slow down of home price appreciation, Cause
supply 20-year average slowing down economic recovery and job creation  Weak real estate prices
 1.8 mm excess vacant caused by excess supply
homes vs. historical suppress
pp interest rates,,
average and slow economic
growth

Wage inequality / Average manufacturing
income distribution wages:
 China: ~US$ 2 / hour
 Mexico: ~US$ 2.15 / hour
 “Global labor arbitrage” – creates competitive Cause
margin for counties with lower wages, potentially  Drives China’s exports,
affecting trade balances FX reserves, and UST
 Has created increased capital outflows to EM purchases
countries

Aging Populations  2009: Persons 65+
represented 12.9% of U.S.
population
 Persons 65+ expected to
grow to 19% of U.S.
population by 2030
 Downward rates impact: creates drag on GDP NA
growth
 Upward pressure: increases sovereign debt burdens
which is inflationary over time

Foreign currency  Yuan/ USD: Y6.4 / US$  The artificial undervaluation of the Chinese Yuan Cause
“de-valuations”  Following a 23 month peg has launched attacks over its negative impact on  Drives China’s exports,
to the US$ global sustainable growth FX reserves, and UST
p
purchases

U.S. consumer debt U.S. consumer leverage ratio  De-leveraging phase has led to an increase in Cause
levels (Debt/ Income) has improved savings rates and a slowdown in consumption,  Weakened consumer
but still high: creating a huge drag on U.S. GDP growth driving GDP drag and
2007: 1.29x  De-leveraging occurring at pace similar to write-offs unemployment, and
lower rates
2008: 1.28x
2009: 1.25x

37
Source: Deutsche Bank Global Markets Research, IMF (October 2010), Bureau of economic analysis, Reuters, Bloomberg
 Structural Imbalances and Coupon Destruction
Relevancy to Coupon
Structural Imbalance Quantification / Example Implications
Destruction
U.S. federal debt  U.S. public debt: US$13.2  Market distress over mounting debt, and deficit Cause
tn or ~90% of GDP spending, especially among foreign holders of U.S.  Investor move away from
 Foreign holdings account debt U.S. government debt
for 30.5% of total debt (51%  Concern over mounting debt, can potentially and into IG credit
of “publicly held” debt) decrease foreign holdings of federal debt, driving
yields higher

U.S. state / muni  State and local debt stands  Market concerns over potential defaults have risen Cause
debt at 22% of GDP (all time state and municipal funding costs, crucial to funding  Investor move away from
high) deficits U.S. state/ muni debt and
 E
Expected
t d to
t reach
h 24% b
by  IInvestor
t concerns over potential
t ti l defaults,
d f lt have
h into IG credit
2012 driven record outflows of capital from funds
 Expected US$140 bn in specializing in state and muni debt
cumulative budget gaps

European sovereign Contagion effects:
debt 1. Greek sovereign crisis
2. Irish sovereign crisis
3. Spanish banking system
4. Portuguese fiscal worries
 Solvency concerns in the European periphery have Cause
widened sovereign spreads considerably and  Investor move away from
increased wholesale funding costs European government
 Contagion effect to large foreign holders of debt and into more stable
sovereign debt IG credit
 Has driven significant euro exchange rate volatility

Japa s so
Japan’s sovereign
e eg  IMF expects
p Japan’s
p g
gross  Even though
g Japan’s
p debt / GDP is massive,, more NA
debt public debt to reach 226% than 90% of Japanese gov’t bonds are held by
of GDP by 2010E domestic investors
 Rates artificially low for nearly 2 decades

Central bank  Fed funds rate: 0.25%  Monetary easing drives government yields down Cause
monetary policies  ECB main refi rate: 1.0%  Slow growth outlook suggests U.S. core rates to  Low government yields
remain low in the mid-term are a primary driver of
coupon destruction

38
Source: Bloomberg, IMF (October 2010), Bureau of economic analysis. Whitehouse Budget of the U.S.
 Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example
Central bank QE2 details:
quantitative easing  US$ 600 bn thru Q2 2011
policies  Average duration: 5-6 years
Fund flows into/ out  2008-2010: US$ 570 bn of
of IG bonds IG bond inflows
 Inflows dropped to US$ 457
mm in the week ending
Nov. 17 vs. US$ 4.1 bn the
previous week
Fund flows into Total commodity fund inflows
commodities slowed to US$1.2 bn in
October vs
vs. US$1
US$1.3
3 bn in
August
Fund flows into  YTD flows into EM equity
emerging markets funds: US$ 81.9 bn vs. US$
83.3 billion in 2009
 YTD flows into EM bond
funds: US$ 46.4 billion vs.
US$9.5 billion in 2009
U.S. banks cash  YTD aggregate U.S. bank
reserves cash reserves: US$ 1.04 tn
 January 2006 aggregate
U.S. bank cash reserves:
US$ 44.3 billion
Source: Federal Reserve, Investment Company Institute
Relevancy to Coupon
Implications
Destruction
 Potentially beneficial for U.S. economic growth and Cause
job creation  QE2 bond purchases
 Direct impact on the dollar (as treasury yields drop) have driven, and will
continue to exert
 Direct impact on gold and equities (investors
downward pressure on
seeking higher yielding assets)
rates
 Transfer of capital into EM as dollar falls
 IG credit has benefited from investor preference for Both a cause and
safe assets yielding stable returns consequence
 However
However, declining yields have slowed inflows into  Inflows drive lower rates
US bond funds recently  Lower rates drive
outflows
 QE2 and lower interest rates have driven investors Consequence
towards commodities like gold  QE2 and low IG coupons
 However, riskier commodities have been negatively drive less risk averse
impacted by Chinese rate fears and euro zone woes investors towards
commodities
 Lower yielding assets and slower economic growth Consequence
in developed economies have driven capital  QE2 and low IG coupons
outflows to emerging markets drive less risk averse
investors towards EM
 Tighter regulation and more stringent lending Cause
policies have driven an increase in bank cash  Bank liquidity drives
reserves Lib rates
Libor t ddown
 Strong liquidity among U.S. banks has maintained
interbank lending rates at substantially low levels
39
 Structural Imbalances and Coupon Destruction
Structural Imbalance Quantification / Example
Underfunded Approx. total aggregate
pension liabilities unfunded liability of all state-
sponsored pension plans in
the U.S. is ~US$ 3 trillion or
US$ 27,000 per household
Relevancy to Coupon
Implications
Destruction
 Growth in unfunded pension liabilities creates a Cause
negative feedback loop, where state governments  Market concerns over
must borrow further to meet requirements state public finances
 Potentially higher taxes and service cuts may follow, drives investors out of
adding to investor concern over public finances, and state debt and into IG
rising funding costs credit

IG bond market  2008: 6.3%  Lower yields, rallying credit spreads, and high Highly related to
coupon destruction  2009: 5.9% demand for IG credit have driven coupon rates to many of the global
record lows
 2010 YTD: 4.4% structural
 F
Further
th liquidity
li idit measures (QE2) will ill likely
lik l suppress
 Nov. 10: 4.2% imbalances
interest rates at their current lows
described above
 Events such as the European debt crisis have driven
investors towards more stable assets like IG credit

40
Source: “The Crisis in Local Government Pensions in the U.S.”. Robert Novy-Marx and Joshua Rauh, Thomson Reuters