The Global Credit Crunch – What does it mean for Income Investing? Andrew Smith Managing Director - Australia and New Zealand 11 th June 2008

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What are Credit Ratings? An opinion on an entity’s ability to meet its financial commitments on a timely basis – Interest – Repayment of Principal – Preferred dividends

Credit Ratings are not: recommendations to buy or sell -we do not comment of the ‘value’ aspects Credit Ratings are: like a building inspection -we opine on an entity’s soundness -not if it is a good buy

What rating agencies do Rating Agencies look for downside risk Bondholders are risk averse We are Professional Pessimists Pessimists - always looking for the downside Professional - assessing it systematically

The difference between bonds and shares Shares >Participate in growth (profits, dividends and share price can grow) >Are prepared to take risks if growth prospects are good Bonds >Do not participate in growth (a bondholder will only get back their principal), but may participate in losses. >Do not like companies taking risk if it means they may go bankrupt >Rating agencies look at companies’ ability to pay back bonds, if things go wrong

Fitch Long Term Ratings – Investment Grade >AAA - Highest Credit Quality >‘AAA’ ratings denote the lowest expectation of credit risk. They are assigned only in case of exceptionally strong capacity for timely payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events. >AA - Very High Credit Quality >‘AA’ ratings denote a very low expectation of credit risk. They indicate very strong capacity for timely payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events. >A - High Credit Quality >‘A’ ratings denote a low expectation of credit risk. The capacity for timely payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings. >BBB - Good Credit Quality >‘BBB’ ratings indicate that there is currently a low expectation of credit risk. The capacity for timely payment of financial commitments is considered adequate, but adverse changes in circumstances and in economic conditions are more likely to impair this capacity. This is the lowest investment-grade category.

>BB - Speculative >‘’BB’ ratings indicate that there is a possibility of credit risk developing, particularly as the result of adverse economic change over time; however, business or financial alternatives may be available to allow financial commitments to be met. Securities rated in this category are not investment grade. >B - Highly Speculative >‘B’ ratings indicate that significant credit risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is contingent upon a sustained, favourable business and economic environment. >CCC, CC, C - High Default Probability >Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon sustained, favourable business or economic developments. A ‘CC’ rating indicates that default of some kind appears probable. ‘C’ ratings signal imminent default. >RD - Default >Indicates an entity that has failed to make due payments (within the applicable grace period) on some but not all material financial obligations, but continues to honor other classes of obligations. >D - Default >Indicates an entity that has defaulted on all of its financial obligations. Fitch Long Term Ratings – Speculative Grade

How investors use ratings cumulative default statistics

How investors use ratings Transition matrices AAAAAABBBBBB AAA AA A BBB BB B Source: Fitch Corporate Finance Migration Rates for 2006 (%)

The basics of RMBS Housing Loans Senior Debt AAA Very safe assets Investors like security of AAA rating Junior debt (‘first loss tranche’) often acquired by bank Likely level of loss BBB

BHP Billiton Wal-Mart RMBS - BBB Nestle Tokyo Electric Senior Tranche Subordinated Tranche Junior Tranche ( 1st loss Piece) ) The Basic CDO

Savers Borrowers The subprime virus in an interconnected financial system

The Aftershock Scenario IKB LBSachsen Northern Rock US Subprime Conduits & SIVs LBOs Earnings CDO of ABS Monolines Merrill Lynch UBS WestLB Citigroup Bear Stearns Societe Generale RAMS Centro

Flight to Treasuries, not other AAA Bond Yields in US Market Source: Federal Reserve Board

Similar pattern in the Australian market Bond Yields in Australian Market* * 5-year Commonwealth Treasury Bond, 1-5 year corporate bonds Source: CEIC, RBA

Australian Residential Mortgage Performance

Australian postcode report

The Structured Finance Pendulum June 2007 acceptable market product CDOs Squared Synthetic CDOs Cash CDOs CMBS ABS RMBS <20bp more volatile less volatile

The Structured Finance Pendulum February 2008 acceptable market product CDOs Squared Synthetic CDOs Cash CDOs CMBS ABS RMBS >150bp more volatile less volatile

The Structured Finance Pendulum February 2009? acceptable market product CDOs Squared Synthetic CDOs Cash CDOs CMBS ABS RMBS more volatile less volatile

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