2012 default study

Europe

16 April 2012

2012 Default Study 5yrs of crisis - The default bark far worse than the bite...

Deutsche Bank AG/London

All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, 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. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 146/04/2011.

Special Report

Research Team

Jim Reid Strategist (+44) 20 754-72943 [email protected]

Nick Burns, CFA Strategist (+44) 20 754-71970 [email protected]

Stephen Stakhiv Strategist (+44) 20 754-52063 [email protected]

Cre

dit

G

lob

al M

arke

ts R

esea

rch

S

trat

egy

Welcome to the 14th year of this annual study where we use Moody’s default database back to 1920 to assess where current spreads are relative to default risk for each rating band. We have certainly been to both extremes in this report over the last five years of this crisis. In 2007, large parts of the HY market failed to compensate investors for average (or worst-case) default risk, whilst in 2009 we moved full circle to a point where we were pricing in the Great Depression II (and more). In 2011, it felt to us that in a world of shorter business cycles that we were ‘Entering late cycle’, a stage where the more medium- to long-term investors would start to upgrade their credit portfolios away from the lower-rated end of the HY market. 12 months on and spreads are now better value for the buy and hold investor especially if you examine the work in the main body of the report looking at defaults through this 5 year financial crisis.

Indeed we now have 5 years of default data covering the worst financial crisis since the 1930s. Remarkably we show that the defaults seen in the 5 years between 2007 and the end of 2011 have been pretty much ‘average’ relative to history albeit with some large sector divergence (e.g. financials vs. non-financials). This is all down to unprecedented intervention from the authorities. Those of a bullish persuasion might conclude that if defaults have been so contained in such a hostile environment then the longer-term investor in credit should currently take great comfort at what are essentially ‘average-to-cheap’ levels of credit spreads historically.

While we also take comfort from wider spreads and a so far proven track record of consistent intervention, the bad news is that the crisis is unlikely to be over and it is not guaranteed that the worst is behind us. As we’ll see in the section on Sovereign CDS, spreads are still in full flung crisis mode. Indeed Portugal is now in a worse spread position than Greece was when we compiled last year’s report and most European Sovereign spreads are much wider. Within SovX WE the market is currently implying 4.3 or 7.4 credit events out of the 15 sovereigns in the index assuming either a 40% or 20% future haircut. Last year we were pricing in 2.8 to 5.1 such events.

If these implied defaults come vaguely close to being realised then the next 5 years of corporate/financial defaults could easily be worse than the last 5 relatively calm years. Much may eventually depend on how much money printing can be tolerated as we are very close to being ‘maxed out’ fiscally. So investors should take great solace from the last 5 years of benign defaults and current wider than average credit spreads but not be complacent. Much of the hard work may still be ahead of us.

See you next year for our 15th anniversary edition.

16 April 2012 2012 Default Study


Table of Contents

Executive summary ........................................................................... 3

2007-2011: 5 years of extreme crisis. Where were the defaults? .. 8 Analysing Moody’s 2007 cohort ............................................................................................... 8 Actual market defaults – A focus on the indices ..................................................................... 11

Cohort analysis ................................................................................ 15

Implied defaults and default spread premiums ............................ 18 Cash market ............................................................................................................................ 18 CDS market ............................................................................................................................. 21

Sovereign CDS – Contagion, contagion, contagion ..................... 24

Methodology and raw data ............................................................ 28 Moody’s cumulative default rates ........................................................................................... 28 How we calculate spreads required to compensate for default probability? .......................... 30 Recovery rates ........................................................................................................................ 30

Results .............................................................................................. 31 1. Spreads required to compensate for defaults assuming 40% recovery rates .................... 31 2. Spreads required to compensate for defaults assuming 20% recovery rates .................... 32 3. Spreads required to compensate for defaults assuming “worst case” scenario (0% Recovery Rate) ........................................................................................................................ 33 Results in graphical form ........................................................................................................ 34

Credit trading levels against spreads required to compensate for default ............................................................................................... 36 1. Investment Grade ............................................................................................................... 36 2. High Yield ............................................................................................................................ 39

Why additional spread is required above that required to compensate for default ................................................................... 42

Data to COB 11 April 2012 with the exception of USD HY, which is to COB 09 April 2012.



Executive summary

Much of this report through its now 14 year history has concentrated on looking at long-term default history and also at discreet 5 year periods of default through time. This year’s study can now reflect back on a new 5 year cohort that covers the entire current financial crisis seen to date. In early 2007, the crisis begun as sub-prime bonds plummeted in value thus starting a chain reaction of events that led to a bank run in the UK (Northern Rock) in September 2007, the Lehman default in 2008 and the economic slump in 2009 with credit spreads at their highest levels in history. While credit has since shown remarkable powers of recovery, this crisis has subsequently morphed into a Sovereign one where we still have major global economic powers with severe doubts over their ability to pay back investors in full.

So given we now have 5 years of history covering the worst financial crisis since the 1930s, a large focus of this year’s report is to look at where defaults have been in this period and whether they have stood out relative to history. This may provide us with clues as to durability of credit and whether it is an attractive asset class going forward.

In broad terms there are two bits of good news but one large black cloud still hanging over us. In terms of the good news: firstly the defaults seen in the 5 years between 2007 and end 2011 have been remarkably ‘average’ relative to history. Secondly, spreads have widened since last year’s study where we felt that valuations relative to historic defaults were starting to look stretched. The bad news is that the crisis is unlikely to be over and although the very impressive crisis management seen so far should give us a lot of comfort, it is not guaranteed that the worst is behind us.

Anyway let’s take a quick look at the main highlights from the report.

The 5 year realised defaults since 2007 have been ‘normal’ It’s remarkable to note that despite going through the most significant financial crisis since the “Great Depression”, default rates were in general slightly below the most relevant long-term averages. In the case of the more recently established high yield market this is the data seen since the 1970s. Prior to the 1980s, the high yield market only really existed in fallen angel form and was not an established market. For IG, the market was established through most of the last century and we can therefore compare back to where the default data starts in 1920, thus allowing us to include the Depression in our analysis.



Figure 1: 5 Year Cumulative Default Rates – Crisis vs. LT Averages

0%

10%

20%

30%

40%

50%

60%

Aaa Aa A Baa Ba B Caa-C

2007-2011 Average Since 1920 Average Since 1970

Source: Deutsche Bank, Moody’s As we have explained in previous studies, the period since the 1920s probably gives us a more conservative read on IG defaults given it covers the Depression but with regards to HY the period since the 1970s is probably more representative as the HY market was only established in the last three to four decades.

Over the last 5 years we have seen cumulative default rates for Ba, B and Caa-C issuers of 8.7%, 22.6% and 50.8% respectively. This compares to LT averages of 10.1%, 25.0% and 51.8%. While Baa credit has followed a similar pattern, the higher end of the IG spectrum provides an exception to this as the cumulative default rate for Aa and A credit over the past 5 years has been 1.1% and 2.1% respectively, higher than the 0.8% and 1.3% averages based on data since the 1920s. Financials are the one area where defaults have been higher than average history but even here they have been muted. At the aggregated ratings level, even if we look at the rolling 5-year evolution of these default rates (Figure 2), it’s hard to identify that this financial crisis was any different to a normal recession in default terms. As we’ll see later the default rate of the iTraxx Crossover index between 2007-2011 was just 6.5%; based on average ratings we would have expected it to be in the 15-20% region.

Figure 2: 5 Year Cumulative Default Rates by Cohort formed between 1970 and 2007

0%

1%

2%

3%

4%

5%

6%

7%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

Aaa Aa A Baa

0%

10%

20%

30%

40%

50%

60%

70%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

Ba B Caa-C

Source: Deutsche Bank, Moody’s

So intervention has saved the day over the last 5 years as the free market level of defaults would have likely been catastrophically high without it. Herein perhaps lies the reason for the relatively low levels of defaults. It became potentially so bad in the 2007-2011 period that the authorities had little choice but to prevent the default rate of some of the world’s largest companies (mostly financials) from escalating outside of historical norms. Had they have allowed such a free market outcome then we would have likely entered into a vicious reinforcing circle of defaults in financials, and also in corporates, through the likely sustained hit to economic activity.



Perhaps studies like this have led to complacency that high rated investment grade typically sees such low levels of historical default, that over time investors have bought larger and larger quantities of these assets to a point where the whole financial system became dangerously dependent on historic default rates being accurate. The phrase ‘too big to fail’ should have been invented for the 2007-2011 period.

Credit valuations – Improved on last year’s study Figure 3 shows that the default spread premium (DSP) – i.e. the excess spread over and above average default risk – is now wider than it was a year ago when we last published, especially in Europe. For reference the DSP for EUR Bs are now 445bps wider, with the USD equivalent 126bps wider.

Figure 3: Non-Financial Default Spread Premiums for Average Historical Default Experience –Current (left) and March

2011 (right)

-200

-100

0

100

200

300

400

500

600

700

AA A BBB BB B CCC

EUR USDNo EUR CCC bonds meet

analysis criteria

-200

-100

0

100

200

300

400

500

600

700

AA A BBB BB B CCC

EUR USD

Source: Deutsche Bank. Assuming 40% recovery. Note: Default Spread Premium (DSP)=Excess spread available after accounting for average default risk. No EUR CCC data for current data.

Indeed Figure 4 shows how this default spread premium has evolved over time for single-Bs, and one can see that although spreads and the DSP are off their Q4 2011 wides, they are better value than 12 months ago.

Figure 4: Single-B Default Spread Premium

-500

0

500

1,000

1,500

2,000

2,500

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

USD EUR

Source: Deutsche Bank. Assuming 40% recovery. Note: Default Spread Premium (DSP)=Excess spread available after accounting for average default risk.

CDS market also more attractive than a year ago… CDS indices are also more attractive than they were in 2011’s report. As Figure 5 shows this is especially true for HY and Crossover. Even if we assume an extreme 0% recovery, European Crossover has the highest DSP. This time last year Crossover and CDX HY were looking stretched if average history repeated itself; especially if recoveries were lower than average.



Figure 5: CDS Index DSP assuming average future defaults – Now and Last Year assuming 40% (left) and 0% (right)

Recoveries

050

100150200250300350400450500

Mai

n

HiV

ol

Non

-Fin

Fin

Sen

Cro

ssov

er IG

HiV

ol HY

iTraxx CDX

Current 2011 Default Study

-300-200-100

0100200300400

Mai

n

HiV

ol

Non

-Fin

Fin

Sen

Cro

ssov

er IG

HiV

ol HY

iTraxx CDX

Current 2011 Default Study

Source: Deutsche Bank, Mark-it, Moody’s

… but keep an eye on recoveries On the subject of recoveries, one word of warning is that as Figure 6 highlights, they have fallen away significantly over the course of the last year or so relative to where the current default environment suggests they should be. As the chart shows recoveries normally rise in a low default environment and vice-versa, however that has not been the case in the past year as the relationship has diverged about as much as at any point in the last 10-15 years. Could it be that whilst authorities have dramatically reduced the tail risk and helped lower defaults, they have as yet failed to produce the normal post recovery economic strength that would normally boost the demand for assets? Is the anaemic recovery weakening the relationship between defaults and recoveries? It’s therefore prudent to keep an eye on recovery rates going forward, especially if the economic environment weakens again. It might be that we are in a period where an average of 40 is too high? As with previous studies we always stress the recovery rates in the report to give a range of results.

Figure 6: Global 12-Month Trailing Default Rate and Senior Unsecured Recovery Rate

10

20

30

40

50

60

700%

2%

4%

6%

8%

10%

12%

14%

16%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Global HY Default Rate and Forecast (LHS)

Global Senior Unsecured Recovery Rate (%) (RHS Inv.)


However the future of all credit markets perhaps rests on the future of Sovereign credit The reality is that corporate recovery rates pale in insignificance relative to the most important driver of credit over the next few years, namely the Sovereign crisis. As we’ll see in the section on Sovereign CDS, spreads are still in full flung crisis mode. Indeed Portugal is now in a worse spread position than Greece was when we compiled last year’s report and most European Sovereign spreads are now much wider. Within SovX WE the market is currently implying 4.3 or 7.4 credit events out of the 15 sovereigns in the index assuming either a 40% or 20% future haircut. Last year we were pricing in 2.8 to 5.1 such events. If



these implied defaults come vaguely close to being realised then the next 5 years of corporate/financial defaults could easily be worse than the last 5 relatively calm years.

So overall, looking back on 5 years of crisis to date, the default rate has been surprisingly manageable and spreads are now above their long-term average. Maybe credit investors should have immense confidence in the asset class as in terms of defaults it has emerged from the worst financial crisis since the 1930s with only a few scars and body blows. That said we have to remember that this crisis in our view is far from over and it’s still possible that the worst 5 years from a default perspective is still to come across the whole rating spectrum. Much will depend on the ability of the authorities to continue to aggressively intervene. The willingness seems to remain impressively strong but can events in the future prevent actions from being as strong as they have been? Only time will tell in these unprecedented times but spread levels are at least reasonably attractive historically.

As usual there are lots of charts, tables and stats in the piece. Many of the simpler self-explanatory exhibits are included towards the back of this document so it may be worth reviewing the entire document if you are looking for a particular way for the data to be represented.



2007-2011: 5 years of extreme crisis. Where were the defaults?

Analysing Moody’s 2007 cohort

Given that it’s now 5 years since the sub-prime crisis started to percolate through into the wider financial markets, we now have a full 5 year history of defaults to analyse. Therefore in this section we take a more detailed look at these past 5 years and compare them to historic averages, other 5 year cohorts as well as looking at how indices (cash and CDS) have performed and what defaults we have seen. Has the worse financial crisis since the 1930s led to aggressive defaults relative to history and the under-performance of credit?

Crisis default rate vs. LT averages We begin by looking at the 5 year cumulative default rates over the crisis period (last 5 years) by rating band and compare them with long-term average rates, since 1920 and since 1970. As we have explained in previous studies, the period since the 1920s probably gives us a more conservative read on IG defaults given it covers the Depression but with regards to HY the period since the 1970s is probably more representative as the HY market was only established in the last three to four decades. The results of this analysis are displayed in Figure 7. It’s interesting to note that despite going through the most significant financial crisis since the “Great Depression”, default rates were in general slightly below the most relevant long-term averages. In the case of HY, as already mentioned, this is the data since the 1970s. Over the last 5 years we have seen cumulative default rates for Ba, B and Caa-C issuers of 8.7%, 22.6% and 50.8% respectively. This compares to LT averages of 10.1%, 25.0% and 51.8%. While Baa credit has followed a similar pattern, the higher end of the IG spectrum provides an exception to this as the cumulative default rate for Aa and A credit over the past 5 years has been 1.1% and 2.1% respectively, higher than the 0.8% and 1.3% averages based on data since the 1920s.

Figure 7: 5 Year Cumulative Default Rates – Crisis vs. LT Averages

0%

10%

20%

30%

40%

50%

60%

Aaa Aa A Baa Ba B Caa-C

2007-2011 Average Since 1920 Average Since 1970


In Figure 8 we actually look at the histories, by rating band, of the 5 year cumulative default rate. This is only based on data back to 1970 as we don’t have the breakdowns beyond this.



Figure 8: 5 Year Cumulative Default Rates by Cohort formed between 1970 and 2007

0%

1%

2%

3%

4%

5%

6%

7%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

Aaa Aa A Baa

0%

10%

20%

30%

40%

50%

60%

70%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

Ba B Caa-C


In many ways this serves to back-up what we have already seen in Figure 7 but also provides us with further historical context. Starting with IG we can see that for Aa and A rated credit, the default rate over the last 5 years is actually the highest rate since a cohort formed in the mid-80s. In the case of A rated credit the rate over the last 5 years (2.1%) was actually not too far off the worst 5 year period that we have data for since 1970 (2.5%). When we look further down the rating spectrum we get a very different picture. For Baa-Caa credit the crisis (over the past 5 years) has provided a default rate below not only the peak rate from the 1980s but also below that seen during the previous downturn around the turn of the century. So it’s probably fair to say that by historical standards the default rate during the crisis has not been that high. Furthermore it’s interesting to note that the default rate for A rated issuers over the crisis was actually higher than the Baa rated issuer default rate.

In terms of why this pattern of defaults has occurred we would argue that it is largely a symptom of the causes of the crisis, that being the continued increase of leverage within Western World incredibly large financial systems. So this was a crisis caused by financials and more specifically banks that has subsequently spread to governments. Ultimately unlike in the previous downturn at the turn of the century non-financial corporates have been some way from the epicentre of the crisis. In fact their actions leading up to the crisis as they looked to recover from previous downturns probably stood them in far better stead than many financial institutions. Therefore the higher rated financials suffered more than would normally be expected and have only been saved from a significantly higher default rate by previously unthinkable intervention from the authorities. The lower rated corporate on the other hand probably fared better than might normally be expected as fundamentally they were in fairly good shape. The significant intervention also probably served to compound this resilience as it has prevented the global economy from entering what would have likely been a long depression.

So it is remarkably impressive that defaults over the whole period have been so ‘average’. The free market level of defaults would have likely been catastrophic for credit investors and herein lies the reason for the relatively low levels of defaults. It became potentially so bad in the 2007-2011 period that the authorities had little choice but to prevent the default rate of financials from escalating outside of historical norms. Had they not done so then we would have likely entered into a vicious reinforcing circle of defaults in financials and also corporates through the sustained hit to economic activity.

Perhaps studies like this have led to complacency that high rated investment grade see such low levels of historical default that over time investors have bought larger and larger quantities of these assets to a point where the whole financial system is dependent on historic default rates being accurate. The phrase ‘too big to fail’ should have been invented for the 2007-2011 period.



So to date the default rate has been manageable, and maybe credit investors should have immense confidence in the asset class as in terms of defaults it has emerged from the worst financial crisis since the 1930s with only a few scars and body blows. That said we have to remember that this crisis in our view is far from over and it may be that the worst 5 years from a default perspective is still to come across the whole rating spectrum. Much will depend on the ability of the authorities to continue to aggressively intervene. The willingness seems to remain strong but can events in the future prevent actions from being as strong as they have been.

Analysing the crisis year by year Another way to look at this crisis period is on a year by year basis, looking at annual default rates for each year of the crisis and comparing them to historic annual data to see if this shows the crisis in a different light. For IG rating bands we have used data going all the way back to 1920. However for HY because there was not really an established HY market prior to the 1980s we have only focused on data back to 1980, and in the case of Caa-C rated issuers we only go back as far as 1991 due to the lack of a decent sample of issuers prior to this point. In Figure 9 we show the annual default rate for each rating band in each year of the crisis as well as where it ranks relative to the aforementioned histories.

Figure 9: Annual Default Rates Through the Crisis and their Rank Relative to History Aaa Aa A Baa Ba B Caa-C IG HY

Peak Annual Default Rate 0.0% 0.9% 1.6% 2.0% 4.9% 15.9% 45.0% 1.6% 13.1%

2007 Level 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 6.1% 0.0% 1.0%

Rank N/A N/A N/A N/A N/A N/A 16 N/A 27

2008 Level 0.0% 0.6% 0.5% 0.5% 1.2% 2.1% 14.9% 0.5% 4.4%

Rank N/A 6 6 19 12 23 10 11 11

2009 Level 0.0% 0.0% 0.2% 0.9% 2.4% 7.4% 34.0% 0.4% 13.1%

Rank N/A N/A 14 13 6 8 2 16 1

2010 Level 0.0% 0.0% 0.2% 0.0% 0.0% 0.5% 11.9% 0.1% 3.2%

Rank N/A N/A 13 N/A N/A 68 6 32 27

2011 Level 0.0% 0.0% 0.0% 0.1% 0.2% 0.1% 8.1% 0.0% 1.8%

Rank N/A N/A N/A 36 25 31 17 36 26Source: Deutsche Bank, Moody’s

Perhaps the first point to note is that for higher rated IG issuers the individual peak year for defaults was 2008, while for Baa and HY issuers it was 2009. Obviously in 2008 we had the sudden defaults of banks such as Lehman Brothers and Washington Mutual before the authorities stepped up their support and prevented a series of further bank defaults. Hence the much lower rates or zero rates post-2008. The 2008 default rate for both Aa and A rated issuers ranked 6th worst over the 92 year history although it should probably be noted in the case of Aa’s there have been only 11 non-zero rate years and for A rated issuers there have been only 20 such years. It’s worth remembering that it’s very rare for an issuer with a high IG rating at the start of the year to actually have defaulted by the end of the year.

As ever with default analysis it’s much more interesting to look at the lower-rated issuers, particularly HY. 2009 is the peak year here and in terms of the overall HY rate this was actually the worst annual default rate since 1970. In fact even if we included all of the data back to the 1920s where there wasn’t a HY market as such but some fallen angels in the 1930s, it would be the second highest annual default rate.

For HY Figure 10 probably better highlights how these 2009 annual default rates compare with history and ultimately the fact that 2009 was certainly a very negative year in terms of defaults. We have excluded the Caa-C data from the chart so as not to distort the scale for the rest of the series.



Figure 10: HY Annual Default Rates since 1980 by Rating Band

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Ba B HY


So overall, the recent cycle of defaults for HY simply look like a normal economic cycle, the likes of which we saw in the late 1980s/early 1990s and again around the turn of the century. The significant levels of intervention higher up the capital structure have spared us from what would likely have been the worst 5 years of defaults in history.

Actual market defaults – A focus on the indices

So far we have focused purely on Moody’s data. In this next section we try and provide a more practical insight into the crisis by looking at the level of default rate experienced by the various cash and CDS indices.

Cash index defaults We start this analysis by focusing on the cash indices. For IG and EUR HY we have used the iBoxx indices and for USD HY we have used the DB index. We then downloaded each of these indices at the end of 2006/beginning of 2007 and looked at which bonds from this cohort (in essence) defaulted (defaults include distressed exchanges and tenders) at some point during the next 5 years. We then calculated both issuer as well as volume weighted default rates. Essentially this analysis highlights the level of defaults a buy and hold type of investor might have endured had they invested in the index at the start of the crisis. The results are presented in Figure 11. To give these default levels some context we have also included the spread of the index at the start of 2007 and what that equated to in terms of implied default rates assuming a 40% recovery.

Figure 11: Cash Indices Implied, Issuer and Volume Weighted Default Rates (2007-

2011) IG HY

EUR GBP USD EUR USD

Index Spread 52 91 88 271 301

Implied Default Rate in 2007 5.06% 16.14% 12.69% 24.38% 32.69%

Actual 2007-11 Issuer Default Rate 2.46% 3.86% 2.48% 11.74% 14.01%

Actual 2007-11 Volume Default Rate 1.63% 3.69% 3.40% 13.20% 17.38%Source: Deutsche Bank

Before we make any remarks with regards to the outcome of this analysis it should be noted that whilst Moody’s default data is a combination of bonds and loans, the analysis here is based purely on bonds.



There are a number of points worth highlighting here. First of all in IG the actual issuer weighted defaults based on the various indices were higher than Moody’s global level of 1.5%. It should be highlighted that this would include the Irish banks where it was obviously only the subordinated debt that was affected. For HY the picture is very much different with the actual index based default rate barely half of the Moody’s level (22.1%, globally) in both the EUR and USD markets.

In terms of comparing actual defaults with implied defaults we can see that despite spreads being at fairly tight levels from a historical perspective, the actual default rates experienced were actually much lower. One caveat to this is that to calculate these implied rates we have used the average life of each index, which in all cases was longer than the 5 year crisis period. Therefore the implied rates maybe slightly over inflated. Notwithstanding this, the analysis is interesting as it highlights that a buy and hold investor in credit would have likely generated positive excess returns at the macro level through the worst financial crisis since the “Great Depression” even though spreads at the start of this period were close to their all time tights. This may not have been the case for every sector and rating band (e.g. Financials and the lower rated part of HY) but it’s certainly a statistic that would appeal to the long term holder of credit.

The cash market with its broad range of maturities, duration effect and lack of uniform maturities across issuers as well as the complexities of called securities makes proper cohort analysis tough. Therefore to further our analysis we now look to the more uniform CDS market.

CDS index defaults – Returns for a buy and hold investor during the 5 year crisis For this analysis we have used the main benchmark CDS indices, i.e. the iTraxx Main and Crossover indices in Europe and the CDX IG and HY indices in the US. Essentially, in addition to calculating default rates similar to those calculated for the cash market we also look to calculate some form of return (essentially excess return over swaps), taking into account the carry as well as actual losses incurred on default, or more generally in the case of CDS a credit event.

We have made a few assumptions in order to simplify this analysis. They are highlighted in the bullets below.

The analysis is based on the constituents of the on the run index at the start of 2007. Series 9 for iTraxx and series 10 for CDX.

We sold CDS on an equal notional for each constituent of each CDS index at the point at which there were exactly 5 years to maturity (e.g. selling the contract that matures on 20 Dec 2011 on the 20 Dec 2006).

We have assumed no re-investment of coupons; therefore our returns will be somewhat understated.

Credit events/defaults are those determined by ISDA with the recovery based on the appropriate auction results.

We have calculated a number of metrics in addition to the obvious index default rate and excess return. They include the initial spread implied default rate, average recoveries and spread required to compensate for average default rate.

We start by focusing on the actual default rates of each index. Figure 12 shows the implied default rate given the starting average spread (assuming a 40% recovery rate) as well as the actual number of defaults, the default rate and the average recovery. In addition we have also shown the relevant loss rates (combining defaults and recoveries) as these are actually more comparable.



Figure 12: CDS Indices Realised and Implied Default and Loss Rates (2007-2011) Average

Initial Spread (bps)

Spread Implied Default Rate (40% Recovery)

Spread Implied Loss Rate

Actual Default Count

Actual Default Rate

Average Recovery

Actual Loss Rate

iTraxx Europe Main 28 2.3% 1.4% 1 0.8% 77.8% 0.2%

iTraxx Crossover 229 17.4% 10.4% 3 6.5% 9.5% 5.9%

CDX IG 35 2.9% 1.7% 4 3.2% 77.7% 0.7%

CDX HY 313 23.0% 13.8% 15 15.0% 23.3% 11.5%Source: Deutsche Bank, Mark-it, ISDA

Overall and in a similar vain to what we showed with the cash market, while spreads were historically tight around 5 years ago the actual default rates and more importantly loss rates are lower than those implied by the starting average spread. The most interesting index to focus on is probably CDX HY. Although the actual default rate is some way below the initial implied level, the actual loss rate was only just over 2% below the implied level. This is due to recoveries being very low over the period. So even here a buy and hold investor should have just about produced positive excess returns (essentially relative to swaps) over the period.

On the subject of recoveries, one word of warning is that as Figure 13 highlights, they have fallen away significantly over the course of the last year or so relative to where the current default environment suggests they should be. As the chart shows recoveries normally rise in a low default environment and vice-versa, however that has not been the case in the past year as the relationship has diverged about as much as at any point in the last 10-15 years. Could it be that whilst authorities have dramatically reduced the tail risk and helped lower defaults, they have as yet failed to produce the normal post recovery economic strength that would normally boost the demand for assets? Is the anaemic recovery weakening the relationship between defaults and recoveries? It’s therefore prudent to keep an eye on recovery rates going forward, especially if the economic environment weakens again. It might be that we are in a period where an average of 40 is too high? As with previous studies we always stress the recovery rates in the report to give a range of results.

Figure 13: Global 12-Month Trailing Default Rate and Senior Unsecured Recovery Rate

10

20

30

40

50

60

700%

2%

4%

6%

8%

10%

12%

14%

16%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Global HY Default Rate (LHS)

Global Senior Unsecured Recovery Rate (%) (RHS Inv.)


We now move on to our return analysis in Figure 14 where we show actual annualised returns as well as the loss relative to the initial spread and what spread you would have required in order to compensate for the actual default and recovery rate. Effectively the expected loss.



Figure 14: CDS Indices Actual Returns and Expected Losses Average Initial

Spread (bps)Actual Return

(bps, annualised)Loss Relative to

Initial Spread (bps) Spread Required to Compensate

for Realised Default/Recovery

iTraxx Europe Main 28 24 4 4

iTraxx Crossover 229 105 125 122

CDX IG 35 21 15 15

CDX HY 313 35 279 249Source: Deutsche Bank, Mark-it, ISDA

As expected given the default analysis, returns have been positive for all of the indices on a buy and hold basis. This is despite the very tight starting spreads and the fact we have had to navigate the financial and sovereign crisis. As we would expect the actual loss and the expected loss given actual default are very similar. Discrepancies would be largely due to expected losses not taking into account the timing of defaults (assumes they are spread evenly through the 5 years), which as we have already shown were predominantly in 2009.

Arguably the most interesting point to note here is that in the US the return of HY is only marginally above that of IG, highlighting a feature of the HY market that we have shown many times over the years in this report. Although IG spreads have always been above that required to compensate for the highest realised default period in history, HY does tend to have periods where it doesn’t compensate for default risk, especially at the lower rated end of the market. So although this was more of an IG crisis, the HY returns have been stressed right to their limits due to the very tight starting spreads.

One necessary caveat to this analysis is that losses were only incurred based on CDS trigger events. It is not uncommon within the cash market for investors to take fairly notable losses without triggering CDS. Therefore these returns may be higher than would likely be expected for a cash portfolio.



Cohort analysis

In this section we update our cohort analysis where we calculate spreads required to compensate for default based on actual 5 year discreet cohorts. We assume both 40% and 20% recoveries as exact recoveries by cohort are not available. We compare these levels with current spreads to see which default periods in history wouldn’t compensate investors at current spreads, as well as showing the pre-crisis tights and crisis wides. First IG.

Figure 15: IG Spreads Required to Compensate for Default Based on 5yr Cumulative

Default Rates by Cohort vs. Actual Non-Financial Spreads 40% Recovery Rate 20% Recovery Rate

Cohort Year Aa A Baa IG Aa A Baa IG

1970 0 5 17 10 0 7 23 14

1971 0 9 13 10 0 12 17 13

1972 0 4 18 10 0 5 24 14

1973 0 0 24 12 0 0 31 15

1974 0 0 22 10 0 0 29 14

1975 0 0 10 4 0 0 13 6

1976 0 0 11 4 0 0 15 6

1977 0 0 7 3 0 0 10 4

1978 10 0 17 7 13 0 23 10

1979 10 7 25 13 13 9 33 17

1980 0 10 21 11 0 13 28 15

1981 0 3 41 15 0 4 55 20

1982 0 13 31 15 0 18 41 20

1983 6 3 47 17 8 4 62 23

1984 22 18 21 20 30 24 28 27

1985 10 31 35 24 13 41 47 32

1986 15 23 72 30 20 30 96 40

1987 5 23 62 25 6 31 82 34

1988 12 17 48 21 16 23 64 29

1989 8 9 40 15 10 12 53 20

1990 0 0 8 2 0 0 10 2

1991 4 0 3 2 5 0 4 2

1992 3 0 0 1 5 0 0 1

1993 0 0 7 2 0 0 9 2

1994 0 0 8 2 0 0 11 3

1995 0 0 19 5 0 0 26 7

1996 0 2 16 5 0 2 22 7

1997 0 4 30 11 0 5 40 14

1998 0 6 41 16 0 9 54 21

1999 0 9 38 17 0 12 51 22

2000 0 11 35 17 0 15 47 22

2001 0 9 34 15 0 12 46 20

2002 0 4 24 10 0 6 32 14

2003 0 0 4 1 0 0 5 2

2004 3 17 4 9 4 23 5 12

2005 3 17 25 16 3 23 33 22

2006 12 19 15 15 16 25 20 20

2007 14 25 17 18 18 34 23 25

Current Spread

EUR 108 151 263 196 108 151 263 196

USD 92 121 219 162 92 121 219 162

GBP 120 188 279 219 120 188 279 219

Wide since 2007

EUR 197 330 545 389 197 330 545 389

USD 303 468 672 541 303 468 672 541

GBP 202 332 570 392 202 332 570 392

Tight since 2007

EUR 14 42 59 49 14 42 59 49

USD 55 78 108 93 55 78 108 93

GBP 63 82 95 84 63 82 95 84Source: Deutsche Bank



Figure 15 confirms what we have shown in all the 13 previous editions of his report, i.e. that current IG spreads (for all rating bands) compensate for all previous five-year default cycles seen since 1970. In fact, even spreads at their tights would have compensated for just about every scenario seen through observable history.

We now move on to HY where the results have tended to be far more interesting through history.

Figure 16: HY Spreads Required to Compensate for Default Based on 5yr Cumulative

Default Rates by Cohort vs. Actual Non-Financial Spreads 40% Recovery Rate 20% Recovery Rate

Ba B Caa-C HY Ba B Caa-C HY1970 87 303 170 116 404 2261971 47 47 71 62 63 941972 36 86 60 49 114 811973 39 47 57 52 63 761974 50 89 61 66 119 811975 47 120 63 63 160 841976 46 49 52 61 65 691977 35 193 61 47 258 811978 56 304 92 75 405 1221979 75 224 94 99 298 1251980 110 393 161 147 524 2151981 151 393 182 201 525 2421982 247 438 296 329 584 3941983 185 408 282 246 544 3771984 239 384 292 319 512 3901985 247 436 311 329 581 415

1986 276 515 357 368 687 476

1987 313 619 418 417 825 557

1988 309 602 417 412 803 556

1989 313 635 445 418 846 593

1990 241 576 395 321 768 527

1991 120 487 717 286 160 649 957 382

1992 32 374 509 179 42 499 679 2381993 55 254 674 145 74 339 898 1941994 63 219 298 135 84 292 397 1801995 96 219 596 177 128 292 795 236

1996 108 248 814 211 144 331 1,086 282

1997 159 376 1,304 306 212 502 1,738 409

1998 177 521 1,141 404 237 695 1,522 539

1999 138 567 1,147 455 184 756 1,529 607

2000 78 513 1,292 433 104 684 1,723 577

2001 78 440 1,260 393 104 586 1,680 524

2002 81 244 1,063 285 108 326 1,418 380

2003 38 130 724 173 51 174 965 2312004 48 111 492 135 63 149 657 1802005 117 271 640 273 156 361 853 363

2006 125 282 760 297 167 377 1,013 395

2007 110 308 852 315 146 411 1,136 420

Current Spread EUR 602 918 1,445 719 602 918 1,445 719USD 444 644 971 602 444 644 971 602Wide since 2007 EUR 1,401 2,461 6,159 1,930 1,401 2,461 6,159 1,930USD 1,234 1,825 2,992 1,857 1,234 1,825 2,992 1,857Tight since 2007 EUR 142 236 426 166 142 236 426 166USD 178 239 395 256 178 239 395 256Note: No data is shown for Caa-C prior to the 1991 cohort as there were less than 20 issuers in each cohort prior to this point. Highlighted cells indicate where index spread levels in at least one of the currencies are below those required to compensate for default. Source: Deutsche Bank



Although credit rallied strongly for most of the first quarter of this year, the back up in spreads in recent weeks means that current HY credit spreads are still somewhat wider than where we were when we published our 2011 default study a year ago. Therefore the key difference with the analysis this time round is that there are far fewer cohorts where current spreads would not have been sufficient to compensate for actual realised defaults.

If we focus on the data where we have assumed a 20% recovery USD Caa spreads at current levels would have compensated in eight of the 17 periods covered in this year’s analysis, up from only two of 16 from our 2011 report. It is a similar story for B rated credit where the last year of widening in current spreads means that current levels would now only not have compensated on nine out of the 38 analysed cohorts, which is half of the 18 observations from last year’s study. If we assume a 40% recovery then only Caa spreads at current spreads would not have compensated for every 5 year cohort through history. In terms of Ba rated credit there are no cohorts that required a wider spread than current levels when assuming either a 40% or a 20% recovery.

So overall there are far fewer cohorts where spreads required to compensate for default are wider than current levels relative to last year. Although as you move down the rating bands there is a notable pick-up in instances still, particularly for the tighter USD HY market.



Implied defaults and default spread premiums

We have so far looked at what has happened to defaults over the last 5 years of crisis and how this period compares with other 5 year default cycles through history. In this next section we give a more forward looking feel as we assess the value of current spread levels relative to defaults to try and identify the best strategy for a buy and hold investor on a default risk adjusted basis. Essentially we look to calculate spread implied default rates as well as looking at default spread premiums (DSP), which we define as the difference between current spreads and the spread required to compensate for average default. We first focus on the cash market before moving on to look at the CDS indices in both Europe and the US. We have focused on non-financial credit as financials, specifically banks, remain at the mercy of authorities and therefore making strong assertions with regards to defaults can be very difficult.

Cash market

Non-Financial implied defaults As with the cohort analysis we will focus on the 5 year tenor. In order to achieve this we have included all of the non-financial bonds with between 4 years and 6 years to maturity within the iBoxx indices. We calculate the IG implied default rates including only the senior bonds due to the lower recoveries and deferrable nature of corporate hybrid bonds. Three different recovery assumptions have been used in our analysis (0%, 20% and 40%). The implied default rates are then compared with an appropriate average five-year cumulative default rate from Moody’s annual study as well as the worst five-year periods observed since 1970. We have highlighted the cells where the implied default rate is lower than the worst and average experience (darker shading) as well as those where the implied default rate is lower than the worst but higher than the average (lighter shading).

Figure 17: iBoxx 5yr Cumulative Spread Implied Default Rates Based on Different

Recovery Assumptions for Non-Financial IG and HY Bonds

Implied 5yr Cumulative Default Rate Actual 5yr Cumulative Default

Rates (since 1970)

5yr Spread 0% Recovery 20% Recovery 40% Recovery Worst Average

EUR IG Non-Fin 212 9.9% 12.0% 15.3% 2.4% 1.0%

AA 113 5.1% 6.2% 7.8% 1.8% 0.4%

A 159 7.5% 9.1% 11.5% 2.5% 0.8%

BBB 280 13.1% 15.9% 20.2% 5.8% 1.9%

HY Non-Fin 741 31.4% 37.9% 47.7% 31.6% 21.3%

BB 636 27.7% 33.4% 42.0% 23.0% 10.1%

B 1,018 40.2% 48.0% 59.3% 41.1% 25.0%

GBP IG Non-Fin 221 10.6% 12.7% 16.0% 2.4% 1.0%

AA 134 7.3% 8.9% 11.2% 1.8% 0.4%

A 162 7.9% 9.5% 11.9% 2.5% 0.8%

BBB 276 13.0% 15.6% 19.5% 5.8% 1.9%

USD IG Non-Fin 154 7.4% 9.0% 11.4% 2.4% 1.0%

AA 86 4.3% 5.2% 6.5% 1.8% 0.4%

A 108 5.2% 6.3% 8.0% 2.5% 0.8%

BBB 210 10.0% 12.1% 15.2% 5.8% 1.9%

HY Non-Fin 643 27.8% 33.4% 41.6% 31.6% 21.3%

BB 477 21.1% 25.4% 31.8% 23.0% 10.1%

B 704 30.3% 36.2% 44.8% 41.1% 25.0%

CCC 984 40.0% 48.2% 60.2% 66.3% 51.8%Source: Deutsche Bank, Moody’s



So far in 2012 spreads have rallied fairly aggressively with Q1 providing very strong returns across the credit universe. That said overall spreads remain fairly wide in a historical context and therefore for the most part are still pricing in levels of default in excess of anything we have seen through history. As we have highlighted over the years IG credit will always tend to imply higher defaults than are actually realised.

HY credit provides far more interesting observations. While EUR HY spreads imply higher defaults than the worst observed default rates when assuming recoveries of 20% and 40% across all rating bands, this is only true for BB credit within the USD HY credit space. For USD B credit we have to assume a 40% recovery and in the case of USD CCC credit we would have to see recoveries in excess of 40% in order to have an implied level greater than the worst actual level and for recoveries of 20% or less then implied levels are also below the LT average.

All in all though, and especially assuming average recovery rates, with the exception of USD CCC credit, it seems that current spreads are implying fairly high default rates relative to history, which is in contrast to what we showed last year when we felt that credit spreads were essentially at late cycle levels. What this doesn’t necessarily help us assess is where we should invest within the rating spectrum. For that we calculate what we have previously called the default spread premiums (DSP), which we will discuss in the next sub-section.

Non-Financial default spread premiums To calculate DSPs we subtract from current levels the spread required to compensate for default based on different default assumptions. In our analysis we have used the average level, the worst 5 year period (highest rate) and the best 5 year period (lowest rate). The idea of this is that it gives us a framework to assess the best risk adjusted rating bands from a buy and hold perspective.

We start by looking at EUR credit and in Figure 18 we look at DSPs assuming a 40% recovery and a 0% recovery. Even though the latter is extremely unrealistic it gives us a range of possible outcomes. We have excluded C-rated bonds due to the small sample size in Europe.

Figure 18: EUR Non-Financial Default Spread Premiums for Average, Worst (highest) and Best (lowest) Default

Experience Assuming 40% (left) and 0% (right) Recoveries

0

200

400

600

800

1,000

1,200

AA A BBB BB B

Average Best Worst

-200

0

200

400

600

800

1,000

AA A BBB BB B

Average Best Worst

Source: Deutsche Bank

Given where current spreads are if we assume a 40% recovery then it still seems that the buy and hold investor should be compensated for taking risk, even if we were to see defaults approaching the worst observed 5 year cycle. Therefore on a risk adjusted basis single-B credit looks the most attractive. Even if we assume 0% recoveries then we would probably have to see something approaching the worst observed 5 year period before we would look



to re-rate towards IG credit on a buy and hold basis. So overall for EUR non-financial credit single-Bs do on the whole look the most attractive on a default risk adjusted basis.

As we can see in Figure 19, for USD credit the results are slightly different. Here we also have a large enough sample to include CCC credit, although on a risk adjusted basis it looks less attractive than the higher end of IG. Away from CCCs if we assume a 40% recovery and average defaults then single-B credit is still just about the most attractive risk adjusted part of the credit spectrum. If we assume worse than average defaults then we would argue that it makes sense to re-rate towards BB credit and maybe even BBB credit. When we assume a zero recovery level then BB and IG credit looks more attractive than single-B credit unless we see a very benign default environment over the next 5 years. The closer we get to the worst observed default rate the more attractive IG credit starts to look. So overall for USD credit, as has been the case for some time, BB credit looks to be the sweet spot from a risk reward basis given the uncertain times we live in.

Figure 19: USD Non-Financial Default Spread Premiums for Average, Worst (highest) and Best (lowest) Default

Experience Assuming 40% (left) and 0% (right) Recoveries

-400

-200

0

200

400

600

800

AA A BBB BB B CCC

Average Best Worst

-1,400-1,200-1,000

-800-600-400-200

0200400600800

AA A BBB BB B CCC

Average Best Worst


In Figure 20 we track the DSP for USD HY credit through time to see how the current levels stand relative to history. This analysis is based on the whole index rather than just the 4-6 year band and we compare market spreads to spreads required to compensate for average default assuming a 40% recovery. When we published last year CCC credit actually had a negative DSP and therefore we would argue it did not offer sufficient protection from default over an average cycle. So given that the DSPs across the rating bands are all positive now, valuations have certainly improved since we last published but we are still some way short of where we were at the peak of the crisis in 2008/09. For single-B and CCC credit the current level of DSP is below the long-term average while for BB credit the current level is about 10-15bps above the average level and is also higher than the DSP for single-B and CCC credit. This probably backs-up what we have shown in the previous paragraph that BB credit looks to still be the sweet spot on a risk adjusted basis in the USD market.



Figure 20: USD HY Default Spread Premiums Using Average Historical Default Rates

-1,000

-500

0

500

1,000

1,500

2,000

2,500

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

BB Corp B Corp CCC CorpOver compensates for default

Under compensates for default

Source: Deutsche Bank. Assuming 40% recovery. Note: Default Spread Premium (DSP)=Excess spread available after accounting for average default risk..

CDS market

We now turn our attention to CDS, which arguably provides us with a purer way of assessing default risk given the unfunded nature of the product. As we did with the cash market we will look at what level of default is being implied by current spreads as well as trying to assess the level of DSP.

Implied default rates across the term structure To start with, rather than focusing purely on the 5 year tenor, we actually look at the various CDS indices (iTraxx and CDX) and calculate implied cumulative default rates across the term structure. We then compare them with historical averages and also the worst-case experience based on appropriate series and durations from Moody’s default study. For the iTraxx Main and CDX IG indices we use the IG series and for iTraxx Crossover and CDX HY we use the HY series. For iTraxx HiVol rather than sticking with the IG series it would be more appropriate to use BBB default rates. When looking at Figure 21, as with the cash market, the darker shaded areas highlight indices and tenors where current spreads imply lower defaults than for either the worst-case or average scenarios while the lighter shaded areas imply defaults lower than the worst-case but higher than the average scenarios. Un-shaded areas imply default rates higher than both the worst and average scenarios. Interestingly with spreads having widened out in the last few weeks there are no combinations of tenor and recovery that give an implied default rate below the LT average. There are though combinations where the implied default rate is below the worst case but above the average. This is the case for iTraxx Crossover and CDX HY at the 3 year tenor under all recovery assumptions analysed. This is not necessarily a huge surprise given the shape of the curve. The 5 to 10 year part of the curve is fairly flat in both indices while the 3 to 5 year part of the curve is very steep as demand for short dated protection remains fairly limited. For iTraxx Crossover we are only about 10bps off of the all time steepest level for the 3s5s curve.



Figure 21: CDS Implied Cumulative Default Rates and Issuer Default Counts Spread Implied Cumulative Default

Rates Cumulative Default Count Actual Cumulative Default Rates

(since 1970)

Spread 0%

Recovery 20%

Recovery40%

Recovery0%

Recovery20%

Recovery40%

Recovery Worst Average

iTraxx Main 3yr 115 3.4% 4.2% 5.6% 4.2 5.3 7.0 1.3% 0.5%

5yr 141 6.8% 8.5% 11.1% 8.5 10.6 13.9 2.4% 1.0%

7yr 150 10.0% 12.3% 16.0% 12.4 15.4 20.1 3.5% 1.6%

10yr 156 14.4% 17.7% 22.9% 18.0 22.1 28.6 5.3% 2.6%

HiVol 3yr 165 4.8% 6.0% 7.9% 1.4 1.8 2.4 3.1% 0.9%

5yr 201 9.6% 11.8% 15.4% 2.9 3.5 4.6 5.8% 1.9%

7yr 211 13.7% 16.9% 21.8% 4.1 5.1 6.5 8.3% 2.9%

10yr 215 19.3% 23.5% 30.1% 5.8 7.1 9.0 10.1% 4.6%

Crossover 3yr 574 15.8% 19.4% 25.0% 7.9 9.7 12.5 23.9% 13.8%

5yr 673 28.6% 34.3% 42.9% 14.3 17.2 21.5 31.6% 21.3%

7yr 676 37.7% 44.6% 54.6% 18.8 22.3 27.3 35.7% 26.9%

10yr 681 49.4% 57.3% 67.9% 24.7 28.7 33.9 43.9% 33.6%

CDX IG 3yr 73 2.2% 2.7% 3.6% 2.7 3.4 4.5 1.3% 0.5%

5yr 102 5.0% 6.2% 8.2% 6.2 7.7 10.2 2.4% 1.0%

7yr 116 7.8% 9.7% 12.7% 9.8 12.1 15.9 3.5% 1.6%

10yr 130 12.1% 14.9% 19.4% 15.2 18.7 24.3 5.3% 2.6%

HY 3yr 556 15.4% 18.8% 24.3% 15.4 18.8 24.3 23.9% 13.8%

5yr 625 26.8% 32.3% 40.6% 26.8 32.3 40.6 31.6% 21.3%

7yr 625 35.4% 42.1% 51.8% 35.4 42.1 51.8 35.7% 26.9%

10yr 610 45.6% 53.3% 63.8% 45.6 53.3 63.8 43.9% 33.6%Source: Deutsche Bank. Note: HiVol compared to BBB default rates.

Outside of the 3 year tenor for Crossover and HY there are only a few other combinations that imply a lower default rate than the worst case. They are for both iTraxx Crossover and CDX HY the 5 year tenor when assuming 0% recovery and for CDX HY at the 7 year point assuming a 0% recovery. So in contrast to last year when many more cells were highlighted for the most part credit looks to provide fairly decent margins against default risk for the buy and hold investor.

As with the cash market it makes sense to assess where the best risk adjusted value lies within the CDS index space.

CDS index DSP In this section we take a more detailed look at the actual rating breakdown (by notch) of each of the indices. To keep things simple we focus only on the 5 year tenor here.

In Figure 22 we look at the rating breakdown of the indices and then calculate an average cumulative default probability for each index based on its issuer ratings – not issue ratings. This is then used to calculate required compensation and then the excess compensation provided. This will likely be more accurate and more micro as we are using rating notches rather than using broad rating bands as we did when analysing the cash market.



Figure 22: Benchmark iTraxx and CDX Index DSPs

Average Issuer Rating

Rating Implied Default Rate

Actual Spread

Default Spread Premium (DSP)

Family Index 0% Recovery 20% Recovery 40% Recovery

iTraxx Main A3-Baa1 1.34% 141 115 120 125

HiVol Baa1-Baa2 1.89% 201 163 170 178

Non-Fin A3-Baa1 1.45% 115 86 92 98

Fin Sen A2 0.89% 246 228 231 235

Crossover Ba3-B1 17.67% 673 284 362 440

CDX IG Baa1-Baa2 1.93% 102 63 71 79

HiVol Baa1-Baa2 1.89% 201 163 170 178

HY B1-B2 24.02% 625 76 185 295Source: Deutsche Bank

When we performed this analysis a year ago we showed that HY indices no longer offered the widest default adjusted spreads (DSP). However a year later and notable weakness since mid-March has seen the HY indices look the most attractive on a risk adjusted basis. From our analysis the only exception to this is the CDX HY index assuming 0% recovery, where HiVol offers the widest risk adjusted spread. In Europe financials continue to offer better risk adjusted spreads than non-financial IG. However as we have often stated the financial sector remains very much at the mercy of authorities and if their ability to manage any problems is compromised then we would likely see further aggressive spread widening in financials relative to non-financials.

So overall while we may have been concerned by the lack of compensation being offered through the cycle a year ago, we are now at levels that once again look attractive for the buy and hold investor through a 5 year cycle. That said, given the state of the macro backdrop there may be many twists and turns to come and therefore we could see some notable volatility. A recession will still likely bring much wider spreads than current levels. However we are now compensated far better for the default risk again.



Sovereign CDS – Contagion, contagion, contagion

European Sovereign funding remains one of the key issues for financial markets going forward despite all the best intentions of the authorities. In the context of this note, we are not going to spend time focusing on funding needs or even different sovereigns’ ability to access the bond markets. Here we are simply looking at what current sovereign CDS spreads imply in terms of default probability or as is probably more appropriate in the case of sovereigns, credit event probability. The fact that Greece CDS was triggered in the end following the restructuring means that sovereign CDS is still a relevant financial product as there were fears that had it not been triggered it may have questioned the entire validity of the sovereign CDS market.

Whilst the focus of this section is on Western Europe, we also look at the CEEMEA and Asia Pacific indices for comparison purposes. In Figure 23 we look at the five-year CDS implied credit event probability for each of the three sovereign indices assuming different levels of recoveries or haircuts as may be more appropriate when talking about sovereigns. It is obviously worth noting that a haircut is not the only action that would trigger the CDS, but it is more difficult to assess the probabilities of maturity extensions or coupon amendments or any other type of trigger event. For Greece we actually saw a combination of all of these actions.

Since we have seen such a focus on Sovereign CDS, especially dealing with Greece and the restructuring of its debt, 5 year Western European spreads are more than 100bps wider compared to 2010 as seen in Figure 24.

Figure 23: Sovereign CDS Index Implied Cumulative Default Rates and Issuer Default Counts (2011)

No. of Constituents

5yr Spread

Implied 5yr Cumulative Default Rates based on Different Haircuts

Implied 5yr Cumulative Default Count based on Different Haircuts

Index 50% 40% 30% 20% 50% 40% 30% 20%

iTraxx SovX WE 15 274 24% 29% 37% 50% 3.59 4.35 5.50 7.44

iTraxx SovX CEEMEA 15 290 25% 30% 38% 52% 3.78 4.56 5.75 7.74

iTraxx SovX Asia Pacific 10 135 13% 16% 20% 29% 1.26 1.55 2.01 2.86Source: Deutsche Bank, Mark-it

Figure 24: Sovereign CDS Index Implied Cumulative Default Rates and Issuer Default Counts (2010)

No. of Constituents

5yr Spread

Implied 5yr Cumulative Default Rates based on Different Haircuts

Implied 5yr Cumulative Default Count based on Different Haircuts

Index 50% 40% 30% 20% 50% 40% 30% 20%

iTraxx SovX WE 15 165 15% 19% 24% 34% 2.28 2.80 3.61 5.08

iTraxx SovX CEEMEA 15 206 19% 23% 29% 40% 2.79 3.41 4.36 6.04

iTraxx SovX Asia Pacific 10 123 12% 14% 18% 26% 1.15 1.42 1.85 2.64Source: Deutsche Bank, Mark-it

The first point to note is that the five-year implied cumulative probability of a credit event amongst the Asia Pacific region is only marginally wider than 2010. As already stated the 5 year spread for WE has widened by more than 100bps, implying about 1.5-2.5 sovereigns more are priced to experience a credit event. To give these levels some historical context it is also worth noting that the average spread of the 15 constituents of iTraxx CEEMEA hit its wide (above 900bp) in March 2009, it currently stands at around 300bps (600bps tighter) although clearly close to 100bps wider than where we were a year ago. At the same time the average spread of the iTraxx SovX WE index was as wide as c.160bp in March 2009, but has actually been more than double this level recently. This highlights the relative weakness



within the developed world over the last couple of years as sovereigns have ultimately taken on the burden of supporting the bloated Western financial system. The surprisingly low levels of financial defaults seen earlier in the study is manifesting in a different form with Sovereigns under severe stress.

If we assume a future haircut of 40%, then the Western European market is implying 4.4 defaults. If the haircut level falls to 20% then we are pricing in 7.4 credit events, which means we are pricing in the risk of credit events across and even beyond the peripherals (with Greece having left the index there are now just four, although Cyprus has been added). Clearly this is somewhat simplistic as some may eventually require deeper restructurings (Greece being the current example), thus impacting the analysis at index level but it does highlight the stresses for Western European sovereign funding

In Figure 25 we take a closer look at the implied credit event probabilities for each of the constituents of the iTraxx SovX WE index. Here we assume a 50% haircut and a 25% haircut and look at the cumulative probabilities across the curve.

Figure 25: iTraxx SovX WE Sovereign CDS Implied Cumulative Default Probabilities Implied Cumulative Default Rates

Spreads 50% Haircut 25% Haircut

1yr 2yr 3yr 4yr 5yr 1yr 2yr 3yr 4yr 5yr 1yr 2yr 3yr 4yr 5yr

Cyprus 1,362 1,320 1,273 1,225 1,182 23.8% 41.0% 53.4% 62.5% 69.3% 42.0% 65.2% 78.3% 85.9% 90.6%

Portugal 1,339 1,491 1,347 1,238 1,162 23.5% 44.9% 55.4% 62.9% 68.7% 41.5% 69.7% 80.1% 86.2% 90.2%

Ireland 513 605 609 591 580 9.8% 21.5% 30.6% 37.7% 44.0% 18.6% 38.4% 51.9% 61.1% 68.6%

Spain 333 419 459 469 477 6.4% 15.4% 24.1% 31.3% 38.0% 12.5% 28.5% 42.3% 52.8% 61.5%

Italy 293 362 402 416 428 5.7% 13.5% 21.4% 28.3% 34.8% 11.0% 25.1% 38.3% 48.6% 57.5%

Belgium 141 182 212 231 248 2.8% 7.0% 11.9% 16.9% 22.0% 5.5% 13.5% 22.5% 30.9% 39.1%

France 89 117 138 159 181 1.8% 4.6% 8.0% 12.0% 16.6% 3.5% 8.9% 15.3% 22.5% 30.4%

Austria 70 97 121 143 161 1.4% 3.8% 7.0% 10.8% 14.9% 2.8% 7.5% 13.6% 20.4% 27.6%

Netherlands 58 70 82 96 114 1.2% 2.8% 4.8% 7.4% 10.8% 2.3% 5.4% 9.4% 14.3% 20.4%

Denmark 51 63 80 96 113 1.0% 2.5% 4.7% 7.4% 10.7% 2.0% 4.9% 9.2% 14.2% 20.2%

Germany 10 20 34 53 72 0.2% 0.8% 2.0% 4.1% 7.0% 0.4% 1.6% 4.0% 8.1% 13.5%

Finland 26 35 43 54 66 0.5% 1.4% 2.6% 4.2% 6.4% 1.1% 2.8% 5.1% 8.3% 12.4%

UK 12 20 29 48 66 0.2% 0.8% 1.7% 3.7% 6.4% 0.5% 1.6% 3.5% 7.3% 12.3%

Sweden 13 21 28 38 47 0.3% 0.8% 1.7% 3.0% 4.6% 0.5% 1.6% 3.4% 5.9% 8.9%

Norway 3 7 11 15 21 0.1% 0.3% 0.7% 1.2% 2.1% 0.1% 0.6% 1.3% 2.4% 4.1%Source: Deutsche Bank, Mark-it

It’s interesting to note that we could probably split European sovereigns in to four tiers. The first being those under the most pressure in terms of funding (Cyprus and Portugal) where the implied five-year cumulative probability of a credit event is above 50%, or in this case closer to 70% when assuming a 50% haircut. Of these countries, we have seen Portugal’s 1yr spread widen more than 3x from 407 in our 2011 report to 1,339. The 5yr spread has also more than doubled from 500 in our 2011 report to 1,162. Portugal’s 5yr default probability assuming a 25% haircut was 63.2% in 2011’s study and 39.4% for a 50% haircut.

The second tier includes names where funding pressures are elevated, although perhaps not to an extent where they may be unmanageable yet (Ireland, Spain and Italy). Implied five-year cumulative credit event probabilities are between 30% and 50% (assuming a 50% haircut).

The third tier includes names that perhaps we should keep an eye on if things start to deteriorate (Belgium, France and Austria). Implied default are between 15% and 30% when assuming a 50% haircut.



Finally we have those countries where, at least for the time being, the risks for the sovereign currently appear limited and implied five-year cumulative credit event probabilities are below 11% (assuming a 50% haircut).

Although Greece has been excluded from this analysis as it is no longer a part of the current series of SovX WE, it is interesting to compare where Portugal is today to where Greece was when we last published this report. Figure 26 below shows that Portugal is actually operating at wider spreads than we saw a year ago for Greece. Looking at 5 year CDS, the market has also given Portugal an implied default probability of 90.2% assuming a 25% haircut, compared with Greece which was at 87.6% a year ago.

Figure 26: Sovereign CDS: Greece Mar 2011 versus Portugal Apr 2012 Implied Cumulative Default Probabilities

Spreads 50% Haircut 25% Haircut

1yr 2yr 3yr 4yr 5yr 1yr 2yr 3yr 4yr 5yr 1yr 2yr 3yr 4yr 5yr

Greece (2011) 1,115 1,158 1,167 1,091 1,045 20.0% 37.1% 50.3% 58.2% 64.8% 36.0% 60.4% 75.3% 82.5% 87.6%

Portugal (2012) 1,339 1,491 1,347 1,238 1,162 23.5% 44.9% 55.4% 62.9% 68.7% 41.5% 69.7% 80.1% 86.2% 90.2%Source: Deutsche Bank, Mark-it

Another way to look at these implied default rates is to translate them into implied ratings based on Moody’s average levels. Obviously Moody’s data is based on corporate defaults but since such a robust database for Sovereign defaults, particularly developed market sovereigns, does not exist then it’s probably the best we can do. In Figure 27 we highlight the implied ratings assuming the different haircuts and compare them with the actual sovereign issuer ratings (all three agencies). Specifically we show the rating notch differential between the lowest actual rating and the upper bound of the implied rating.

Figure 27: Sovereign CDS Actual and Implied Credit Ratings

Actual Rating Implied Rating Rating notches: Lowest Actual vs.

Implied Upper Bound

Moody's S&P Fitch 50% Haircut 25% Haircut 50% Haircut 25% Haircut

Cyprus Ba1 BB+ BBB- Caa3-Ca-C Lower than Ca-C -8 -9

Portugal Ba3 BB BB+ Caa3-Ca-C Lower than Ca-C -6 -7

Ireland Ba1 BBB+ BBB+ B3-Caa1 Caa3-Ca-C -5 -8

Spain A3 A A B3-Caa1 Caa2-Caa3 -9 -11

Italy A3 BBB+ A- B3-Caa1 Caa2-Caa3 -6 -8

Belgium Aa3 AA AA B1-B2 B3-Caa1 -10 -12

France Aaa AA+ AAA Ba3-B1 B2-B3 -11 -13

Austria Aaa AA+ AAA Ba2-Ba3 B2-B3 -10 -13

Netherlands Aaa AAA AAA Ba2-Ba3 B1-B2 -11 -13

Denmark Aaa AAA AAA Ba2-Ba3 B1-B2 -11 -13

Germany Aaa AAA AAA Ba1-Ba2 Ba2-Ba3 -10 -11

Finland Aaa AAA AAA Baa3-Ba1 Ba2-Ba3 -9 -11

UK Aaa AAA AAA Baa3-Ba1 Ba2-Ba3 -9 -11

Sweden Aaa AAA AAA Baa3-Ba1 Ba2-Ba3 -9 -11

Norway Aaa AAA AAA Baa2-Baa3 Baa3-Ba1 -8 -9Source: Deutsche Bank, Moody’s, S&P, Fitch

There are two interesting points to make. The first is that despite the fact that seven of the 15 countries analysed have AAA ratings or equivalent with all three of the major agencies, the highest implied rating is a low- to mid-BBB. So as has been the case for many quarters now, it would certainly appear that the market is assessing these sovereigns on a somewhat different basis to the rating agencies. However, we must remember that we are using corporate default histories to get the implied ratings.



The second point is that despite the large range of spreads across the various names, if we assume a 25% haircut, then the rating notch differential between implied and actual is 7-13 notches across the board. France, Austria and Denmark have the largest discrepancy here with a 13 notch difference, Portugal is trading closest to its implied rating out of the group.

So overall it is clear that the market continues to price in the increased possibility of credit events amongst Western European sovereigns and the focus has arguably extended beyond just the peripheral countries. It is the second and third tier countries (Spain, Italy and perhaps even Belgium) that will dictate how severe this crisis will be and whether it becomes a macro event that impacts the historical default database for Sovereigns, Financials and Corporates in the years to come. We are indeed on the brink of a unique period for defaults if either the authorities pull back from their current levels of support for the financial system or if the cycle ends thus removing their ability to fight the underlying structural problems.



Methodology and raw data

Now we have gone through the conclusions we will spend a little time going through the methodology and the raw data. The spread required to compensate for default is calculated using the expected loss for each rating band given historic default and different assumed recoveries. The starting point for such calculations is the rating agencies’ historic databases on default. In this report, we concentrate on Moody’s default data, as they have the longest standing series of such data. The data covers two periods 1) 1920-2011 and 2) 1970-2011. As we will see the results are different depending on whether you use the longer or shorter time period and on whether you are talking about IG or HY. For completeness we have included both time periods in our analysis, but have made observations over which is perhaps the more realistic to use going forward.

Moody’s cumulative default rates

Figure 28 and Figure 29 show Moody’s historical average cumulative default rates over the period from 1970 and 1920 respectively.

Figure 28: Moody’s Average Cumulative Default Rates 1970-2011 Years Aaa Aa A Baa IG Ba B Caa-C HY All

1 0.0% 0.0% 0.1% 0.2% 0.1% 1.1% 4.2% 17.0% 4.5% 1.6%

2 0.0% 0.1% 0.2% 0.5% 0.3% 3.1% 9.9% 28.6% 9.3% 3.3%

3 0.0% 0.1% 0.4% 0.9% 0.5% 5.4% 15.6% 37.9% 13.8% 4.8%

4 0.0% 0.2% 0.6% 1.4% 0.7% 7.9% 20.5% 45.4% 17.8% 6.1%

5 0.1% 0.4% 0.8% 1.9% 1.0% 10.1% 25.0% 51.8% 21.3% 7.2%

6 0.2% 0.5% 1.1% 2.4% 1.3% 12.1% 29.2% 56.4% 24.3% 8.2%

7 0.2% 0.6% 1.3% 2.9% 1.6% 13.9% 33.2% 60.1% 26.9% 9.0%

8 0.3% 0.7% 1.7% 3.4% 1.9% 15.7% 36.6% 64.2% 29.3% 9.8%

9 0.4% 0.8% 2.0% 4.0% 2.3% 17.5% 39.7% 68.5% 31.5% 10.5%

10 0.5% 0.9% 2.3% 4.6% 2.6% 19.4% 42.5% 72.5% 33.6% 11.2%

11 0.6% 1.0% 2.6% 5.4% 3.0% 21.2% 44.9% 75.8% 35.5% 11.8%

12 0.7% 1.1% 2.9% 6.1% 3.4% 23.2% 47.2% 78.0% 37.4% 12.4%

13 0.8% 1.3% 3.2% 6.9% 3.8% 25.0% 49.3% 80.6% 39.1% 13.1%

14 0.8% 1.5% 3.5% 7.8% 4.2% 26.8% 51.5% 81.5% 40.8% 13.7%

15 0.9% 1.6% 3.9% 8.6% 4.6% 28.6% 53.4% 82.3% 42.5% 14.3%

16 0.9% 1.8% 4.3% 9.5% 5.1% 30.3% 54.8% 83.8% 43.9% 14.8%

17 1.0% 2.0% 4.8% 10.3% 5.6% 31.8% 56.0% 84.2% 45.2% 15.4%

18 1.0% 2.2% 5.4% 11.0% 6.0% 33.1% 57.4% 84.2% 46.3% 16.0%

19 1.0% 2.6% 5.9% 11.7% 6.5% 34.4% 58.4% 84.2% 47.3% 16.5%

20 1.0% 3.0% 6.4% 12.3% 7.0% 35.5% 59.4% 84.2% 48.3% 17.0%Source: Moody’s



Figure 29: Moody’s Average Cumulative Default Rates 1920-2011 Years Aaa Aa A Baa IG Ba B Caa-C HY All

1 0.0% 0.1% 0.1% 0.3% 0.2% 1.4% 3.9% 14.3% 3.9% 1.5%

2 0.0% 0.2% 0.3% 0.9% 0.5% 3.3% 8.9% 24.1% 7.9% 3.2%

3 0.0% 0.3% 0.6% 1.5% 0.9% 5.4% 13.9% 31.5% 11.8% 4.7%

4 0.1% 0.5% 1.0% 2.3% 1.3% 7.7% 18.3% 37.2% 15.2% 6.2%

5 0.2% 0.8% 1.3% 3.1% 1.8% 9.8% 22.3% 41.7% 18.2% 7.4%

6 0.2% 1.1% 1.7% 3.9% 2.3% 11.8% 25.7% 45.1% 20.9% 8.5%

7 0.4% 1.4% 2.1% 4.6% 2.7% 13.7% 28.9% 47.7% 23.2% 9.5%

8 0.5% 1.7% 2.5% 5.4% 3.2% 15.5% 31.6% 50.0% 25.4% 10.5%

9 0.7% 2.0% 3.0% 6.2% 3.8% 17.2% 33.9% 52.3% 27.3% 11.3%

10 0.8% 2.4% 3.4% 7.0% 4.3% 19.0% 36.0% 54.3% 29.2% 12.2%

11 1.0% 2.8% 3.9% 7.8% 4.8% 20.6% 37.9% 56.3% 30.9% 13.0%

12 1.1% 3.2% 4.4% 8.6% 5.4% 22.2% 39.8% 58.4% 32.5% 13.8%

13 1.3% 3.6% 4.8% 9.4% 5.9% 23.7% 41.5% 60.3% 34.1% 14.5%

14 1.3% 4.0% 5.2% 10.1% 6.4% 25.1% 43.1% 62.2% 35.5% 15.2%

15 1.3% 4.4% 5.7% 10.8% 6.8% 26.3% 44.5% 64.1% 36.8% 15.8%

16 1.4% 4.6% 6.1% 11.5% 7.3% 27.4% 45.9% 65.9% 38.1% 16.4%

17 1.5% 4.8% 6.5% 12.1% 7.7% 28.6% 47.1% 67.5% 39.3% 17.0%

18 1.5% 5.0% 6.9% 12.6% 8.0% 29.7% 48.2% 69.0% 40.4% 17.5%

19 1.6% 5.4% 7.2% 13.1% 8.4% 30.7% 48.9% 70.3% 41.3% 17.9%

20 1.7% 5.6% 7.6% 13.6% 8.7% 31.6% 49.5% 71.6% 42.2% 18.4%Source: Moody’s

The data compiled since 1920 shows a higher incident of default for IG than the period starting at 1970. For IG overall the default rate is almost double out to 10-years for the period 1920-2011. For HY the reverse is true. The period since 1970 has seen a notably higher incident of default especially in single-Bs and Caa-Cs.

This causes us some dilemmas as to which dataset to use. Figure 30 guides us to some degree as to why there are differences.

Figure 30: Moody’s Historic Annual Default Rates: IG (left) and HY (right)

0.0%0.2%0.4%0.6%0.8%1.0%1.2%1.4%1.6%1.8%

1920

1926

1932

1938

1944

1950

1956

1962

1968

1974

1980

1986

1992

1998

2004

2010

IG

0%2%4%6%8%

10%12%14%16%18%

1920

1926

1932

1938

1944

1950

1956

1962

1968

1974

1980

1986

1992

1998

2004

2010

HY

Source: Moody’s

IG defaults were extraordinarily high during the 1930s which on a statistical average outweighs the equally extraordinary period between 1941 and 1969 where there were no investment grade defaults. For HY defaults the 1930s period is not as much of a statistical outlier, as the 4 spikes since 1970 came far closer to approaching the 1930s experience than we saw in the investment grade arena. On closer analysis of the data it becomes clear that the HY defaults seen in the 1930s were largely fallen angels from the IG world. So a HY market was artificially created and while a good number of them defaulted, the market was fairly dormant until the early 1980s.

We would probably conclude that the period since 1970 is a more appropriate data set for HY given that the HY market has evolved so rapidly over the last couple of decades. However for



IG we are going to be using both periods. For completeness though, we use both sets of data and contrast the results.

How we calculate spreads required to compensate for default probability?

It needs to be highlighted that the spreads calculated are spreads based on the maturity of the indices. That would imply we need to calculate the spreads required to compensate the cumulative default probabilities over that time period. The formula we use assumes constant instantaneous hazard rate, which is determined by the spread to that maturity. We then integrate the continuously compounded survival probability to get the cumulative survival probability over time. As such, the formula can be used to calculate the spread from cumulative default probability or vice versa. We get the cumulative default probabilities from the Moody’s database and calculate the compensation spreads from them.

)1/(1 RSTeD −−−=

where D is the cumulative default probability over time T and S is the Spread to that maturity and R is the recovery

Solving for spread S,

)1ln()1( DTRS −−−=

Recovery rates

In terms of recovery we have used a selection of different rates throughout the note, generally focusing on 0%, 20% and 40%. However in Figure 31 (for comparison purposes) we publish a table showing average senior unsecured recovery rates for different rating bands. We have already shown how recovery rates can fluctuate depending on different macroeconomic backdrops, which is why we include the range of different recovery scenarios. Recoveries are a very important factor when trying to assess losses in the case of default and therefore calculate the spread required to compensate for default.

Figure 31: Moody’s Senior Unsecured Recovery Rates by Rating (1982-2011) Years Prior to Default

Year 1 Year 2 Year 3 Year 4 Year 5 Average

Aaa 3.3% 3.3% 61.9% 75.6% 36.0%

Aa 37.2% 39.0% 38.1% 44.0% 42.3% 40.1%

A 31.8% 42.7% 44.3% 42.7% 42.3% 40.7%

Baa 41.4% 42.3% 42.4% 43.0% 42.9% 42.4%

Ba 47.1% 45.5% 44.4% 43.4% 42.9% 44.7%

B 37.9% 36.8% 36.8% 37.2% 37.8% 37.3%

Caa-C 35.7% 35.6% 35.3% 35.3% 35.3% 35.4%

IG 38.9% 42.0% 42.7% 43.0% 43.0% 41.9%

HY 37.4% 37.1% 37.1% 37.4% 37.7% 37.3%

All Rated 37.4% 37.5% 37.7% 38.0% 38.4% 37.8%Source: Deutsche Bank



Results

1. Spreads required to compensate for defaults assuming 40% recovery rates

i. Default data since 1970

Figure 32: Spreads Required to Compensate for Default (bp) 40% Recovery Rate

Years Aaa Aa A Baa IG Ba B Caa-C HY

1 0 1 4 11 5 67 258 1,120 278

2 0 2 6 15 8 94 313 1,013 293

3 0 3 8 18 10 111 338 954 298

4 1 4 9 21 11 123 345 907 294

5 1 4 10 23 12 127 346 877 287

6 2 5 11 24 13 129 346 831 278

7 2 5 11 25 14 128 346 788 269

8 2 5 12 26 15 128 341 770 260

9 3 5 13 27 15 128 337 771 253

10 3 5 14 29 16 129 332 774 246

11 3 5 14 30 17 130 325 774 240

12 3 6 15 32 17 132 319 758 234

13 4 6 15 33 18 133 314 756 229

14 4 7 15 35 18 134 310 722 225

15 4 7 16 36 19 135 305 692 221

16 4 7 17 38 20 135 298 682 217

17 4 7 17 38 20 135 290 651 212

18 4 7 18 39 21 134 284 615 207

19 3 8 19 39 21 133 277 582 203

20 3 9 20 39 22 131 271 553 198Source: Deutsche Bank

ii. Default data since 1920


Years Aaa Aa A Baa IG Ba B Caa-C HY

1 0 4 6 17 9 82 238 923 237

2 0 6 9 26 14 100 279 826 247

3 1 7 12 31 17 112 299 756 251

4 1 8 14 35 19 120 304 697 248

5 2 10 16 38 21 124 302 648 242

6 2 11 17 40 23 126 297 600 234

7 3 12 18 41 24 126 292 555 227

8 4 13 19 42 25 126 284 520 219

9 4 14 20 43 26 126 276 493 212

10 5 15 21 44 26 127 268 469 207

11 5 15 22 44 27 126 260 452 201

12 6 16 22 45 28 125 254 439 197

13 6 17 23 46 28 125 247 427 192

14 6 18 23 46 28 124 241 417 188

15 5 18 23 46 28 122 236 410 184

16 5 18 24 46 28 120 230 404 180

17 5 17 24 46 28 119 225 397 176

18 5 17 24 45 28 118 219 390 172

19 5 17 24 44 28 116 212 384 168




2. Spreads required to compensate for defaults assuming 20% recovery rates



Aaa Aa A Baa IG Ba B Caa-C HY

1 0 2 5 14 7 90 344 1,493 371

2 0 3 8 20 10 125 417 1,350 391

3 0 3 10 24 13 148 451 1,273 397

4 1 5 12 28 15 164 460 1,209 392

5 2 6 13 30 16 170 461 1,169 383

6 2 6 14 32 18 172 461 1,108 371

7 3 7 15 33 19 171 461 1,050 359

8 3 7 17 35 19 171 455 1,027 347

9 3 7 18 36 20 171 449 1,027 337

10 4 7 18 38 21 172 443 1,032 328

11 4 7 19 40 22 174 433 1,032 319

12 4 8 19 42 23 176 426 1,011 312

13 5 8 20 44 24 177 418 1,008 306

14 5 9 20 46 24 178 413 963 300

15 5 9 21 48 25 180 407 923 295

16 5 9 22 50 26 180 397 909 289

17 5 9 23 51 27 180 387 868 283

18 5 10 25 52 28 178 379 820 276

19 4 11 26 52 28 177 369 777 270





1 0 6 8 23 13 109 318 1,230 316

2 0 8 12 35 19 133 372 1,102 330

3 1 9 16 42 23 149 399 1,009 334

4 2 10 19 46 26 160 405 929 330

5 3 13 21 50 29 165 403 864 322

6 3 15 23 53 30 168 396 800 312

7 4 17 24 54 32 168 390 740 302

8 5 18 26 55 33 168 379 693 292

9 6 18 27 57 34 168 368 657 283

10 7 19 28 58 35 169 357 626 276

11 7 20 29 59 36 168 347 603 268

12 7 22 30 60 37 167 338 585 262

13 8 23 30 61 37 166 329 569 256

14 7 24 31 61 38 165 322 556 250

15 7 24 31 61 38 163 314 547 245

16 7 24 32 61 38 160 307 538 239

17 7 23 32 61 37 159 300 529 235

18 7 23 32 60 37 157 292 520 230

19 7 23 32 59 37 154 283 511 224




3. Spreads required to compensate for defaults assuming “worst case” scenario (0% Recovery Rate)




1 0 2 6 18 9 112 430 1,866 464

2 1 3 10 25 13 157 522 1,688 489

3 0 4 13 30 16 185 564 1,591 496

4 1 6 15 35 19 205 574 1,512 490

5 2 7 16 38 21 212 576 1,461 478

6 3 8 18 40 22 215 576 1,385 464

7 3 8 19 42 23 214 576 1,313 448

8 4 9 21 43 24 213 569 1,284 434

9 4 8 22 45 25 214 561 1,284 421

10 5 9 23 48 27 215 553 1,290 410

11 5 9 24 50 28 217 542 1,290 399

12 6 10 24 53 29 219 532 1,263 390

13 6 10 25 55 30 221 523 1,261 382

14 6 11 26 58 31 223 517 1,204 375

15 6 11 27 60 32 225 509 1,153 369

16 6 11 28 63 33 226 497 1,137 362

17 6 12 29 64 34 225 484 1,085 354

18 6 12 31 65 35 223 474 1,025 345

19 6 14 32 65 35 222 461 971 338





1 0 7 10 29 16 136 397 1,538 395

2 0 10 15 43 23 166 465 1,377 412

3 1 11 20 52 29 186 499 1,261 418

4 2 13 24 58 32 200 507 1,162 413

5 3 16 26 63 36 207 503 1,080 403

6 4 19 29 66 38 210 495 1,000 390

7 5 21 31 68 40 210 487 925 378

8 6 22 32 69 41 211 474 866 365

9 7 23 34 71 43 210 460 821 354

10 8 24 35 73 44 211 447 782 345

11 9 26 36 74 45 210 434 753 335

12 9 27 37 75 46 209 423 731 328

13 10 28 38 76 47 208 412 711 320

14 9 29 38 76 47 206 402 695 313

15 9 30 39 76 47 203 393 683 306

16 9 29 39 76 47 201 384 673 299

17 9 29 39 76 47 198 375 662 293

18 9 29 40 75 46 196 365 650 287

19 9 29 39 74 46 193 354 639 280




Results in graphical form

Investment Grade

Figure 38: Spread Required to Compensate for Default (bp) with a 40% Recovery Rate: Based on Data since 1970

(left) and 1920 (right)

05

101520253035404550

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Aaa Aa A Baa IG

05

101520253035404550

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Aaa Aa A Baa IG




0

10

20

30

40

50

60

70

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Aaa Aa A Baa IG

0

10

20

30

40

50

60

70

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Aaa Aa A Baa IG


Figure 40: Spread Required to Compensate for Default (bp) with a 0% Recovery Rate: Based on Data since 1970 (left)

and 1920 (right)

0

10

20

30

40

50

60

70

80

90

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Aaa Aa A Baa IG

0

10

20

30

40

50

60

70

80

90

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Aaa Aa A Baa IG




High Yield



0

200

400

600

800

1,000

1,200

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ba B Caa-C HY

0

200

400

600

800

1,000

1,200

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ba B Caa-C HY




0

200

400

600

800

1,000

1,200

1,400

1,600

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ba B Caa-C HY

0

200

400

600

800

1,000

1,200

1,400

1,600

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ba B Caa-C HY


Figure 43: Spread Required to Compensate for Default (bp) with a 0% Recovery Rate: Based on Data since 1970 (left)

and 1920 (right)

0200400600800

1,0001,2001,4001,6001,8002,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ba B Caa-C HY

0200400600800

1,0001,2001,4001,6001,8002,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ba B Caa-C HY




Credit trading levels against spreads required to compensate for default

Whilst we have formed most of our conclusions in earlier sections of this note the following section takes a more detailed graphical look at the spreads required to compensate for default probability assuming different recovery rates against historic index level spreads. We also include here a fuller compilation of default spread premium charts.

We have used the iBoxx family of indices for IG bonds, which includes EUR, USD and GBP indices. For the HY universe we use the iBoxx EUR HY index and DB USD HY index. Whilst we show average compensation levels for IG using average default rates over both time horizons (1920-2011 and 1970-2011), for HY we just focus on the 1970-2011 period as we feel this better represents the recent growth of the corporate HY market and the era of leveraged finance (see page 29 for a full explanation why).

For IG we have also included a line for Non-Financials across all rating bands given the relative underperformance of financials, particularly subordinated financials during the crisis.

1. Investment Grade

i. Euro

Figure 44: iBoxx Euro Index Spread Histories vs. Default Compensation Spreads: AAA (left) and AA (right)

0

50

100

150

200

250

300

350

1999 2001 2003 2005 2007 2009 2011

AAA Corp 1920-, 0%

1920-, 40% 1970-, 0%

1970-, 40%

0

50

100

150

200

250

300

350

400

1999 2001 2003 2005 2007 2009 2011

AA Corp AA Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%


Figure 45: iBoxx Euro Index Spread Histories vs. Default Compensation Spreads: Single-A (left) and BBB (right)

0

100

200

300

400

500

600

700

1999 2001 2003 2005 2007 2009 2011

A Corp A Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%

0

100

200

300

400

500

600

700

1999 2001 2003 2005 2007 2009 2011

BBB Corp BBB Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%




ii. Dollar

Figure 46: iBoxx Dollar Index Spread Histories vs. Default Compensation Spreads: AAA (left) and AA (right)

0

50

100

150

200

250

300

350

400

450

1999 2001 2003 2005 2007 2009 2011

AAA Corp 1920-, 0%

1920-, 40% 1970-, 0%

1970-, 40%

050

100150200250300350400450500

1999 2001 2003 2005 2007 2009 2011

AA Corp AA Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%


Figure 47: iBoxx Dollar Index Spread Histories vs. Default Compensation Spreads: Single-A (left) and BBB (right)

0

100

200

300

400

500

600

700

1999 2001 2003 2005 2007 2009 2011

A Corp A Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%

0

100

200

300

400

500

600

700

800

1999 2001 2003 2005 2007 2009 2011


1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%


iii. Sterling

Figure 48: iBoxx Sterling Index Spread Histories vs. Default Compensation Spreads: AAA (left) and AA (right)

0

100

200

300

400

500

600

1999 2001 2003 2005 2007 2009 2011

AAA Corp 1920-, 0%

1920-, 40% 1970-, 0%

1970-, 40%

0

100

200

300

400

500

600

1999 2001 2003 2005 2007 2009 2011

AA Corp AA Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%




Figure 49: iBoxx Sterling Index Spread Histories vs. Default Compensation Spreads: Single-A (left) and BBB (right)

0

100

200

300

400

500

600

700

800

1999 2001 2003 2005 2007 2009 2011

A Corp A Non-Fin

1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%

0

200

400

600

800

1,000

1,200

1999 2001 2003 2005 2007 2009 2011


1920-, 0% 1920-, 40%

1970-, 0% 1970-, 40%


iv. Default spread premium (DSP)

Figure 50: AAA (left) and AA (right) Default Spread Premium

0

100

200

300

400

500

600

1999 2001 2003 2005 2007 2009 2011

EUR USD GBP

050

100150200250300350400450500

1999 2001 2003 2005 2007 2009 2011

EUR USD GBP


Figure 51: Single-A (left) and BBB (right) Default Spread Premium

0

100

200

300

400

500

600

700

800

1999 2001 2003 2005 2007 2009 2011

EUR USD GBP

0

200

400

600

800

1,000

1,200

1999 2001 2003 2005 2007 2009 2011

EUR USD GBP




2. High Yield

i. Dollar

Figure 52: Dollar BB Spread History vs. Default Compensation Spreads

0

200

400

600

800

1,000

1,200

1,400

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

BB Corp 1970-, 0% 1970-, 40%


Figure 53: Dollar Single-B Spread History vs. Default Compensation Spreads

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

B Corp 1970-, 0% 1970-, 40%


Figure 54: Dollar CCC Spread History vs. Default Compensation Spreads

0

500

1,000

1,500

2,000

2,500

3,000

3,500

2000 2002 2004 2006 2008 2010 2012

CCC Corp 1970-, 0% 1970-, 40%




ii. Euro

Figure 55: Euro BB Spread History vs. Default Compensation Spreads

0

200

400

600

800

1,000

1,200

1,400

1,600

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

BB Corp 1970-, 0% 1970-, 40%


Figure 56: Euro Single-B Spread History vs. Default Compensation Spreads

0

500

1,000

1,500

2,000

2,500

3,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

B Corp 1970-, 0% 1970-, 40%


Figure 57: Euro CCC Spread History vs. Default Compensation Spreads

0

1,000

2,000

3,000

4,000

5,000

6,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

CCC Corp 1970-, 0% 1970-, 40%




iii. Default spread premium (DSP)

Figure 58: BB Default Spread Premium

0

200

400

600

800

1,000

1,200

1,400

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

USD EUR


Figure 59: Single-B Default Spread Premium

-500

0

500

1,000

1,500

2,000

2,500

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

USD EUR


Figure 60: CCC Default Spread Premium

-1,000

0

1,000

2,000

3,000

4,000

5,000

2000 2002 2004 2006 2008 2010 2012

USD EUR




Why additional spread is required above that required to compensate for default This piece has only ever aimed to look at the spread required to compensate for default. In effect it is the first building block in assessing where credit should trade as defaults are the only way a buy and hold investor actually loses money in credit relative to the risk free investment. In reality there are other important factors that need to be taken into consideration. The unparalleled volatility and stress in credit markets over the last five years should be testament to why additional protection is perhaps needed over and above pure default risk. However trying to put a number to this becomes increasingly subjective and open to interpretation. For those wanting to explore further, these are some of the factors that need to be considered for those not buying and holding to maturity. Return over risk-free alternative

Clearly one does not invest in credit to only get a return equal to the risk-free (i.e. government bonds). We need additional spread for it to be worth holding credit on a risk-reward basis.

What is the risk-free these days?

The Sovereign crisis has severely compromised the notion of a risk-free rate to benchmark credit. Implied default rates relative to the risk-free may be less meaningful than ever before. It’s not clear how we price this in, if for no other reason that the Sovereign market is highly influenced by the authorities. Although the risk-free has been compromised, the level of intervention seen so far has been extra-ordinary.

Liquidity

Credit is less liquid than government bonds (although in many countries these are also more illiquid post crisis) and gets progressively less liquid the further you move down the credit curve. Liquidity also tends to reduce significantly in times of increased volatility. In this crisis this has certainly been one of the biggest problems with cash credit as an asset class. Those that are not strictly buy and hold would expect a premium to reflect this. In addition some of the bull market structured products have seen their liquidity dry up completely. This either needs to be factored into spreads or the product needs to be seen as a buy and hold vehicle in times of market stress.

Cost of credit investing

Clearly the further you move along the credit curve the more intensive you need to be in analyzing credit. Therefore the cost base is higher and requires a higher reward than simply that compensating you for default risk. Management fees also have to be paid out of returns.

Ratings transition risk

Some investors can only own bonds down to a certain rating category and may be forced sellers if a bond is downgraded through this lower limit. So we probably need a premium for risk of downward rating migration, especially in these troubled times.

Uncertainty and timing of recovery rate

In an event of default the amount and timing of recovery is uncertain.

Short-term performance targets

Investment grade rarely fails to compensate for default risk over the medium to long run, but investors are increasingly measured on a short-term basis. They therefore need some cushion to protect against mark to market volatility.

These are all factors beyond the remit of this report. The buy and hold investor has less need to worry about these factors. Hopefully this report should show the crucial default building block that credit spreads are built around.



Appendix 1 Important Disclosures

Additional information available upon request

For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.

Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Jim Reid/Nick Burns/Stephen Stakhiv



Regulatory Disclosures

1. Important Additional Conflict Disclosures

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

2. Short-Term Trade Ideas

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

3. Country-Specific Disclosures

Australia and New Zealand: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively. Brazil: The views expressed above accurately reflect personal views of the authors about the subject company(ies) and its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. EU countries: Disclosures relating to our obligations under MiFiD can be found at http://www.globalmarkets.db.com/riskdisclosures. Japan: Disclosures under the Financial Instruments and Exchange Law: Company name - Deutsche Securities Inc. Registration number - Registered as a financial instruments dealer by the Head of the Kanto Local Finance Bureau (Kinsho) No. 117. Member of associations: JSDA, Type II Financial Instruments Firms Association, The Financial Futures Association of Japan, Japan Securities Investment Advisers Association. This report is not meant to solicit the purchase of specific financial instruments or related services. We may charge commissions and fees for certain categories of investment advice, products and services. Recommended investment strategies, products and services carry the risk of losses to principal and other losses as a result of changes in market and/or economic trends, and/or fluctuations in market value. Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", "Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless “Japan” or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation.

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

GRCM2012PROD025488

David Folkerts-Landau Managing Director

Global Head of Research

Guy Ashton Head Global Research Product

Marcel Cassard Global Head Fixed Income Research

Stuart Parkinson Associate Director Company Research

Asia-Pacific Germany Americas Europe

Fergus Lynch Regional Head

Andreas Neubauer Regional Head

Steve Pollard Regional Head

Richard Smith Regional Head

Principal Locations

Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ Tel: (44) 20 7545 8000

Deutsche Bank AG New York 60 Wall Street New York, NY 10005 United States of America Tel: (1) 212 250-2500

Deutsche Bank AG Hong Kong Filiale Hongkong Intl. Commerce Centre 1 Austin Road West Kowloon, Hong Kong tel: (852) 2203 8888

Deutsche Securities Inc. Japan 2-11-1 Nagatacho Sanno Park Tower Chiyoda-ku, Tokyo 100-6171 Tel: (81) 3 5156 6770

Deutsche Bank AG Frankfurt Große Gallusstraße 10-14 60272 Frankfurt am Main Germany Tel: (49) 69 910 00

Deutsche Bank Ltd. Aurora business park 82 bld.2 Sadovnicheskaya street Moscow, 115035 Russia Tel: (7) 495 797-5000

Deutsche Bank AG Singapore One Raffles Quay South Tower Singapore 048583 Tel: (65) 6423 8001

Deutsche Bank AG Australia Deutsche Bank Place, Level 16 Corner of Hunter & Phillip Streets Sydney NSW 2000 Tel: (61) 2 8258 1234

Deutsche Bank Dubai Dubai International Financial Centre The Gate, West Wing, Level 3 P.O. Box 504 902 Dubai City Tel: (971) 4 3611 700

Subscribers to research via email receive their electronic publication on average 1-2 working days earlier than the printed version.

If you would like to receive this or any other product via email please contact your usual Deutsche Bank representative.

Publication Address: Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ Tel: (44) 20 7545 8000

Internet: http://gmr.db.com Ask your usual contact for a username and password.

Global DisclaimerThe information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively "Deutsche Bank"). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Deutsche Bank makes no representation as to the accuracy or completeness of such information.

Deutsche Bank may engage in securities transactions, on a proprietary basis or otherwise, in a manner inconsistent with the view taken in this research report. In addition, others within Deutsche Bank, including strategists and sales staff, may take a view that is inconsistent with that taken in this research report.

Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a recipient thereof in the event that any opinion, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. Prices and availability of financial instruments are subject to change without notice. This report is provided for informational purposes only. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy. Target prices are inherently imprecise and a product of the analyst judgement. As a result of Deutsche Bank’s March 2010 acquisition of BHF-Bank AG, a security may be covered by more than one analyst within the Deutsche Bank group. Each of these analysts may use differing methodologies to value the security; as a result, the recommendations may differ and the price targets and estimates of each may vary widely. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own informed investment decisions. Stock transactions can lead to losses as a result of price fluctuations and other factors. If a financial instrument is denominated in a currency other than an investor's currency, a change in exchange rates may adversely affect the investment. Past performance is not necessarily indicative of future results. Deutsche Bank may with respect to securities covered by this report, sell to or buy from customers on a principal basis, and consider this report in deciding to trade on a proprietary basis.

Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the "Characteristics and Risks of Standardized Options," at http://www.theocc.com/components/docs/riskstoc.pdf . If you are unable to access the website please contact Deutsche Bank AG at +1 (212) 250-7994, for a copy of this important document.

The risk of loss in futures trading, foreign or domestic, can be substantial. As a result of the high degree of leverage obtainable in futures trading, losses may be incurred that are greater than the amount of funds initially deposited.

Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor's home jurisdiction. In the U.S. this report is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this report is approved and/or communicated by Deutsche Bank AG Frankfurt authorized by the BaFin. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange and regulated by the Financial Services Authority for the conduct of investment business in the UK and authorized by the BaFin. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. This report is distributed in Singapore by Deutsche Bank AG, Singapore Branch, and recipients in Singapore of this report are to contact Deutsche Bank AG, Singapore Branch in respect of any matters arising from, or in connection with, this report. Where this report is issued or promulgated in Singapore to a person who is not an accredited investor, expert investor or institutional investor (as defined in the applicable Singapore laws and regulations), Deutsche Bank AG, Singapore Branch accepts legal responsibility to such person for the contents of this report. In Japan this report is approved and/or distributed by Deutsche Securities Inc. The information contained in this report does not constitute the provision of investment advice. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). Additional information relative to securities, other financial products or issuers discussed in this report is available upon request. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting.

Copyright © 2012 Deutsche Bank AG

2012 default study

Documents