0320 US Fixed Income Markets Weekly

US Fixed Income Strategy 30 March 2012

AC Indicates certifying analyst. See last page for analyst certification and important disclosures.

US Fixed Income Markets Weekly

Cross Sector Srini Ramaswamy, Kimberly Harano With the macroeconomic backdrop largely supportive, and spread carry still attractive relative to yield curve carry, we think conditions remain supportive of risky assets. We assess the impact of a Chinese hard landing, and revisit strategies involving contingent single and dual digitals to hedge this tail risk.

Governments Terry Belton, Meera Chandan, Kim Harano, Renee Park Stay positioned for higher rates; Treasuries are likely to be rangebound in 2Q12 but at higher-than-current yield levels. Front-end belly cheapeners and curve steepeners are attractive ways to position for negative bill supply. Initiate Aug-18/ Nov-39 flatteners vs. 7s/ 30s steepeners. Stay bullish on TIPS breakevens. Add exposure to 3-year forward 2-year Agency asset swap spreads.

Interest Rate Derivatives Srini Ramaswamy, A. Iglesias, P. Korapaty Initiate maturity-matched swap spread wideners in the 5Y sector. Buy 1Mx1Y payers as a limited risk proxy for front end spread wideners. Buy payer swaption spreads on 5-year tails. Stay bearish on short-expiry volatility on intermediate tails. Look for 30-year tails to begin to richen relative to 10-year tails.

MBS and CMBS Matthew Jozoff, Ed Reardon, John Sim, Brian Ye Our survey shows that money managers remain heavily overweight MBS, limiting their potential for further significant purchases. Stay neutral, but shorten spread duration. Stay underweight super-premiums (5.5s and above). Stay underweight Ginnies versus conventionals. Add single-As and select BBBs CMBS.

ABS and CDOs Ed Reardon, R. Ahluwalia, Kaustub Samant, Maggie Wang Go down in credit in cards and autos, and look at sectors such as UK RMBS for spread pickup. Spreads in rental car ABS are attractive.

Investment-Grade Corporates Eric Beinstein We expect modest spread tightening, but with more volatility in 2Q than 1Q.

High Yield Peter Acciavatti, Nelson Jantzen, Tony Linares We do not see the latest growth scares changing our views as low rates and low defaults remain supportive of high yield, but they make the short-term risk/reward less asymmetrically favorable.

Short-Term Fixed Income Alex Roever, Teresa Ho While Libor is biased lower in the near-term, impending money fund reform and Moody’s review lead us to revise up our 3m Libor forecast to 50bp at end-June.

Municipals Peter DeGroot, Josh Rudolph Overweight the higher education sector, with a balance of highly-liquid top-tier universities and A rated private universities with valuable niche specializations.

Emerging Markets Joyce Chang, Luis Oganes We remain overweight both EMBIG and CEMBI, but reduce risk.

Special Topic: Swing shift—Better news from US labor demand and supply Michael Feroli

The US labor market is set for both demand and supply to lift materially. We expect the participation rate to rise 0.4%-pt over 2012-13, and for productivity gains to remain low, driving the unemployment rate down to 7.7% by end-2013.

Contents Cross Sector Overview 2 Economics 7 Treasuries 10 Interest Rate Derivatives 19 Agencies 27 Agency MBS 30 Non-Agency MBS 36 CMBS 39 ABS 46 Corporates 52 High Yield 57 Short Duration 63 CDO 69 Credit Derivatives 73 Municipals 76 Emerging Markets 86 Special Topic 87 Forecasts & Analytics 91 Market Movers 96

Terry BeltonAC (1-312) 325-4650 [email protected]

Srini Ramaswamy (1-212) 834-4573 [email protected]

US Fixed Income Strategy US Fixed Income Markets Weekly March 30, 2012

Srini RamaswamyAC (1-212) 834-4573 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC

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Cross Sector Overview

• We review 1Q12 performance and find that investors were compensated for taking on more risk—unless it was duration risk, which underperformed

• With the macroeconomic backdrop largely supportive, and spread carry still attractive relative to yield curve carry on a risk-adjusted basis, we think conditions remain supportive of risky assets

• However, further gains may be limited: spreads have already tightened substantially toward their 2011 best levels, and Europe is likely to become a topic of concern again

• Another risk to the spread product rally is a slowdown in Chinese growth. Should that occur, although the direct economic impact will likely be limited, we would expect to see a cheapening of high-beta currencies, leading to unwinds of carry trades, and a general risk-off trade in markets

• We assess the sensitivity of various US spread product sectors to a Chinese hard landing scenario, and revisit strategies involving contingent single and dual digitals to hedge this tail risk

Market views Markets were mixed over the past week. US equities rallied, while European equities declined (Exhibit 1). Rates fell modestly in the US and Europe, and credit spreads widened slightly. European crisis metrics were mixed as well, with sovereign CDS spreads largely narrower, while European funding spreads were wider.

Although this week’s performance was lackluster, risky assets generally performed well in the first quarter. In Exhibit 2, we plot total returns over 1Q12 versus risk (2-year standard deviation of 3-month returns). The best performing asset class by far was equities, followed by high yield, emerging markets and CMBS. As the exhibit shows, returns were very much in line with risk—with the exception of duration risk, which underperformed in the US and in Europe.

The mixed nature of markets this week likely reflects some disappointing economic data and dovish comments from Bernanke early in the week. First, housing data remained weak, with pending home sales falling 0.5% in February and the S&P/Case-Shiller Home Price Index

Exhibit 1: Markets were somewhat mixed this week Current level,* change since 3/23/12, quarter-to-date change, and change over 4Q11 for various market variables

* 3/29/12 level for Europe and US corporate credit spreads, and the J.P. Morgan trade-weighted USD index; 3/30/12 level for all others.

Current Chg from 3/23 QTD chg 4Q11 chgGlobal Equities (level)

S&P 500 1408.5 11.4 150.9 126.2E-STOXX 2477.3 -48.1 160.7 136.9FTSE 100 5768.5 -86.4 196.2 443.8Nikkei 225 10083.6 72.1 1628.3 -244.9

Sovereign par rates (%)2Y US Treasury 0.362 -0.020 0.098 -0.03210Y US Treasury 2.294 -0.008 0.351 -0.0802Y Germany 0.168 -0.029 0.066 -0.40610Y Germany 1.886 -0.080 -0.007 -0.0462Y JGB 0.114 0.001 -0.014 -0.01710Y JGB 1.040 -0.061 0.134 -0.089

5Y Sovereign CDS (bp)Spain 422 1 40 -1Portugal 1164 -84 -14 -36Italy 385 7 -102 13Ireland 575 -41 -178 12

Funding spreads (bp)2Y EUR par swap - par gov 't spd 90.3 2.2 -30.7 21.82Y USD par swap - par gov 't spd 22.1 -1.0 -24.5 18.6EUR FRA-OIS spd 32.3 2.5 -38.8 7.7USD FRA-OIS spd 33.4 0.3 -22.3 12.31Y EUR-USD xccy basis -46.2 -2.0 53.7 -27.3

CurrenciesEUR/USD 1.332 0.005 0.040 -0.051USD/CHF 0.904 -0.004 -0.040 0.037USD/JPY 81.93 -0.90 4.23 0.95JPM Trade-weighted USD 81.22 0.03 -1.02 0.23

Spreads (bp)30Y CC MBS L-OAS 32.7 -1.3 -13.3 -0.610Y AAA CMBS spd to swaps 215.0 0.0 -60.0 -90.0JULI portfolio spd to Tsy 191.7 1.9 -45.1 -17.6JPM US HY index spd to worst 632.9 8.3 -91.2 -83.9EMBIGLOBAL spd to Tsy 341.6 6.2 -84.8 -38.6MAGGIE (Euro HG spd to gov ies) 158.8 2.6 -69.1 16.6US Financials spd to Tsy 230.2 -0.1 -100.5 -3.4Euro Financials spd to gov ies 224.3 2.1 -127.9 25.110Y AAA muni/Tsy ratio (level) 92% -2.3% -2.2% -15.6%30Y AAA muni/Tsy ratio (level) 101% -1.2% -20.6% 1.6%

CommoditiesGold futures ($/t oz) 1652.20 9.70 111.30 -74.60Oil futures ($/bbl) 103.02 -3.85 4.19 19.63



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declining for the ninth straight month. Second, the durable goods report for February showed a rebound from the weakness in January, but suggested that business investment outlays are growing at a much more modest pace compared to earlier in the recovery (see “Durables report confirms moderation in capex growth,” Michael Feroli, 3/28/12). On the positive side, real consumer spending increased 0.5% in February, and the December and January numbers were revised up slightly. In addition, the University of Michigan measure of consumer confidence showed improvement in the final March reading, rising from 75.3 to 76.2. Finally, the four-week average of initial claims declined again in the latest reading, but the revised historical data bodes less positively for the March payrolls report since it now shows no change in the average level of claims between the February and March survey weeks (see “US: Jobless claims continue to trend lower, though revisions provide a slight setback,” Daniel Silver, 3/29/12).

Bernanke’s dovish comments added to the somewhat pessimistic tone in markets. He struck a cautious note regarding his assessment of economic conditions but also refrained from signaling that QE3 is imminent. These comments were not surprising to us—our baseline unemployment forecast is similar to Fed’s, and our economists expect the Fed to err on the side of caution. Nonetheless, the upcoming employment report will be key for markets. Continued declines in the unemployment rate would imply greater upside risk to the Fed’s projected path of the funds rate, even if baseline forecasts remain unchanged.

Looking ahead, we think conditions remain supportive of spread product, though near-term gains may be more limited. First, although recent economic data have been somewhat disappointing, we continue to look for growth to accelerate as we head toward the middle of the year. Indeed, the recent decline in oil prices—if it persists—is supportive of this view. Second, spread carry continues to look attractive relative to yield curve carry on a risk-adjusted basis. As Exhibit 3 shows, corporate credit, EM sovereigns and ABS currently offer higher risk-adjusted carry than duration risk in Treasuries or Agencies.

Although we remain positive on risky assets, we acknowledge that further tightening of spreads may be limited. As Exhibit 4 shows, spreads have retraced significantly toward their best levels over 1H11, when European concerns were lower. Equities are already

above their 2011 highs, while CDX.IG and CMBS spreads have retraced about 80% of their widening. On the other hand, Treasury yields have retraced the least—indeed, this lack of retracement is one factor underlying our bias toward higher Treasury rates (see Treasuries).

In addition, risks from Europe and China have the potential to weigh on risky assets. European risks are likely to pick up over the near term, as market participants focus on the upcoming French and Greek elections. In addition, economic and fiscal reform news

Exhibit 2: In 1Q12, investors were rewarded for taking on more risk—unless it was duration risk Total return over 1Q12 regressed against 2-year standard deviation of 3-month returns*; as of 3/29/12; %

* 7-10Y Treasuries and 7-10Y German bunds are excluded from the regression fit.

Exhibit 3: Spread carry remains attractive relative to yield-curve carry on a risk-adjusted basis Annualized carry/risk* for Treasuries and select spread products

* This is calculated as 0.5*spread or loss-adjusted spread, if applicable, divided by (duration * risk). Risk is the 2-year standard deviation of 3-month changes in spread. Calculation for spread products based on spreads to Treasuries, and for Treasuries, Agencies and munis it is yield minus 3-month OIS.

y = 1.77x - 0.01R² = 0.95

-5%

0%

5%

10%

15%

0% 2% 4% 6% 8%Standard deviation of 3M returns; %

EMHY

JULIMBS

AgyUS 1-3Y

DEM 7-10YABS

CMBS

US 7-10YDEM 1-3Y

S&P

0.10.20.30.40.50.60.70.8

High

Yiel

d1Y

Agy

disc

oEM

BIGL

OBAL

5Y A

AA ca

rd A

BSJU

LI F

inanc

ials

JULI

2Y

Agy

5Y A

gy2Y

Tsy

10Y

Agy

10Y

Tsy

7Y T

sy5Y

Tsy

10Y

AAA

mun

i3Y

Tsy

10Y

AAA

CMBS

30Y

CC A

gy M

BS



4

have been disappointing recently (see Overview, Global Fixed Income Markets Weekly, 3/30/12).

A second risk to the spread product rally is global economic weakness, and particularly that of weaker-than-expected Chinese growth. Last week we noted that Chinese PMI data confirm that manufacturing is losing momentum. Although it is premature to draw firm conclusions about such weakness, we do expect some weakening—we expect 7% growth in 1H12, followed by a rebound to higher-than-trend growth in 2H12. The concern for market participants is a much more significant downside surprise in Chinese growth.

What might such a Chinese “hard landing” mean for US markets? In order to attempt to answer this in a structured manner, we first define a hard landing scenario as referring to a 3% downside GDP growth surprise in China relative to consensus expectations; Chinese growth of about 5.3% or lower would thus represent a hard landing. To determine the direct real economy impact on the US and its major trade partners, our economists have examined each country’s export intensity to China (see “Daily Economic Briefing,” David Hensley et al, 3/22/12). As Exhibit 5 shows, such exposures are fairly minor for the US as well as the Euro area, amounting to less than 1% of GDP. Moreover, secondary economic exposures are also small—the US has minimal exposure

to the countries with the highest export exposure to China (Exhibit 6).

Thus, we think financial market channels will be the more likely avenue for impacts on US risky assets, rather than real-economy channels. Here again, a direct impact could arise if US corporate profits are significantly exposed to China. Such exposure would add downside risk to US corporate earnings and equity valuations. Although approximately 23% of corporate profits come from overseas, based on the exports data it is likely that the share of those profits coming from China is quite small. Thus, in all, it would appear that fundamental implications of a Chinese slowdown are far from dire.

However, this is not to say that such a slowdown would not threaten the US spread product rally. Far more important than fundamental impacts are the more wide-ranging impacts of shifts in market confidence and sentiment. Asian economic weakness is likely to spur a cheapening of high-beta currencies, producing unwinds

Exhibit 5: US and Euro area exports to China are minimal… Exports to China, 2010

* Euro area is the sum of Germany, France, Spain and Italy. For % of GDP, the average of each country’s figure is shown. Source: J.P. Morgan, IMF

Exhibit 6: …as are their exports to China’s major trading partners Exports to exposed countries as % of GDP, 2010

Source: J.P. Morgan, IMF

Exhibit 4: Risky asset spreads have already retraced substantially toward their best levels in 2011 Current level as of 3/29/12, worst level since 6/30/11, best level over 1H11, and percent retracement to best level; bp unless otherwise indicated

Note: For Treasuries and equities, the worst level is the minimum and the best level is the maximum; for all others it is the opposite.

$bn % of GDP Hong Kong 205.8 91.7Japan 149.6 2.7Korea 116.8 11.5U.S. 91.9 0.6Euro area* 87.1 0.8Malaysia 45.8 19.2Singapore 36.5 16.4Chile 17.4 8.5

HKG MYS SGP KOR CHL Sum U.S. 0.2 0.0 0.2 0.3 0.1 0.7 Germany 0.2 0.2 0.2 0.3 0.1 1.0 France 0.2 0.1 0.3 0.2 0.0 0.7 Spain 0.1 0.0 0.1 0.1 0.1 0.3 Italy 0.2 0.0 0.1 0.2 0.0 0.6 Japan 0.8 0.3 0.5 1.1 0.0 2.8 U.K. 0.3 0.0 0.2 0.1 0.0 0.6

Current level

Worst level since

6/30/11

Best level over 1H11

% retracement to

best levelS&P 500 (points) 1403 1099 1364 115%5Y CDX.IG spd 93 151 79 81%10Y AAA CMBS spd to swaps 220 400 170 78%10Y AAA muni/Tsy ratio (% ) 94 123 80 68%EMBIGLOBAL spd to Tsy 346 490 266 64%JPM US HY index spd to worst 633 864 501 64%5Y CDX.HY spd 577 911 380 63%US Financials spd to Tsy 252 379 167 60%JULI portfolio spd to Tsy 191.68 262.17 143.69 59%30Y Tsy y ld (% ) 3.27 2.76 4.76 25%10Y Tsy y ld (% ) 2.16 1.71 3.72 22%5Y Tsy y ld (% ) 1.01 0.71 2.40 18%



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of carry trades, and more generally spur a risk-off trade in markets.

We estimate that a 1% downside risk in Chinese growth expectations would lead to a 3.6% decline in EM currencies (Exhibit 7); a Chinese hard landing might thus be expected to produce a 10.8% weakening in EM currencies. To estimate the impact of a decline in EM currencies on US risky assets, we return to a modified version of our stylized model for spreads. We use our three standard factors—jobless claims to proxy the economy, the Fed’s securities holdings to proxy QE, and an average of French bank CDS to proxy the European crisis—and add a basket of EM currencies as a fourth explanatory variable. Based on this model, we can project the impact of a 3%-point decline in China GDP expectations (i.e., our definition of a hard landing) on risky assets. The results are shown in Exhibit 8. For reference, we compare these impacts to the standard deviation of 3-month changes over the past two years. Based on this analysis, it seems that the EMBIGLOBAL is most exposed to a decline in EM currencies, followed by US corporate credit. In contrast, CMBS, and especially equities are relatively immune to EM risks. Thus, investors can hedge against lower growth expectations in China by underweighting the sectors most exposed to China and overweighting the sectors least exposed to China. Indeed, our strategists’ views are generally in line with this analysis: although we remain

overweight, we turn more cautious on high grade, EM sovereigns and corporates, and high yield.

Alternatively, investors can position for a hard landing in China by using dual or single digital options as a tail risk hedge. We have previously identified the sectors most exposed to a hard landing in EM Asia and projected the expected changes in spreads based on a given move in EM currencies (for more details, please see Cross Sector Overview, US Fixed Income Markets 2012 Outlook, 11/25/11). In Exhibit 9, we show indicative prices for a

Exhibit 7: We estimate that a 1% downside risk in Chinese growth expectations would lead to a 3.6% decline in EM currencies EM currency basket* regressed against 1-year ahead China GDP expectations; monthly data over the past 10 years; points

* Average of USD/BRL, USD/INR and USD/MXN. ** Based on consensus forecasts in Blue Chip Economic Indicators

Exhibit 9: Single or dual digital options on the Nikkei Index appear to be the cheapest way to position for a hard landing in China Instrument, strike*, payoff if market is below or above the strike, and indicative premium** for 6-month digital or dual digital option, with USD payouts (where applicable)

* Strike is ATM forward + indicated value. ** Premia for digitals and dual digitals are only broadly indicative, and may not represent currently trade-able levels.

Exhibit 8: EM sovereigns and corporate credit appear most exposed to a hard landing in China, while equities and CMBS are least exposed Exposure to a hard landing in China* as given by our stylized model for risky assets**, 2-year standard deviation of changes in spreads/levels, and ratio of the two; bp unless otherwise indicated

* As proxied by a 2.4-point decline in the average of USD/BRL, USD/INR and USD/MXN. ** 2-year regression of spreads or levels versus the 4-week average of jobless claims (000s), the size of the Fed’s securities holdings ($bn), French bank CDS*** (bp), and the EM currencies basket ; regression uses weekly data. *** Average of 5-year CDS for BNP Paribas, Credit Agricole, and Societe Generale.

y = -0.85x + 27.14R² = 0.41

17

18

19

20

21

22

23

24

6 7 8 9 10 111-year ahead China GDP expectations; %

EM ASIA HARD LANDINGInstrument Strike Payoff if Instrument #2 Strike Payoff if PremiumNikkei Index (points) -2450 Below 9.50%Nikkei Index (points) -2000 Below Gold futures ($/t. oz) -90 Below 9.50%Nikkei Index (points) -2000 Below USD/JPY -3.2 Below 10.50%Copper price ($/m ton) -1360 Below USD/JPY -3.2 Below 13.50%USD/JPY -6 Below 16.25%WTI futures ($/bbl) -23 Below 16.50%Gold futures ($/t. oz) -120 Below 25.25%Copper fut. ($/m ton) -1720 Below 26.00%

Exposure to China hard

landingTypical

3M move RatioEMBIGLOBAL spd to Tsy 55.7 50.3 1.11US Financials spd to Tsy 59.3 54.0 1.10JULI portfolio spd to Tsy 30.5 31.9 0.96JPM US HY index spd to worst 80.6 95.0 0.855Y CDX.HY spd 93.6 130.5 0.7210Y AAA CMBS spd to swaps 35.1 71.4 0.495Y CDX.IG spd 10.6 21.5 0.49S&P 500 (points) -12.1 93.4 -0.13



6

variety of digital options on market variables that are expected to move significantly in an EM “hard landing” event. The strikes for the single digital options are based on projected moves using a “stressed” beta—that is, assuming that the sector becomes more sensitive in a stress event—while the strikes for the dual digital options are based on projected moves using more conservative, “normal” betas. Currently, the most attractive/cheapest hedges appear to be digital options involving the Nikkei Index.

Economic Research US Fixed Income Markets Weekly March 30, 2012

Robert MellmanAC (1-212) 834-5517 Michael Feroli (1-212) 834-5523 J.P. Morgan Chase Bank

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Economics

• Real consumer spending accelerated early this year, but against the backdrop of stalled real disposable income

• Durable goods report points to slower Capex growth in 1Q12; regional surveys point to reacceleration soon

• Forecasts look for March nonfarm payroll growth of 215,000, ISM manufacturing up to 52.5, auto sales of 14.4mn

This week’s GDP revision shows the government’s estimate of real growth in 4Q11 unchanged at 3.0% (saar). And February reports on real consumer spending and core capital goods shipments indicate that growth this quarter is still tracking close to the 1.5% growth forecast. The forecast looks for improvement to 2.5% growth next quarter, about equal to the 4Q11-1Q12 average. Upcoming March economic releases, including the labor market report, will condition views on economic performance toward the end of 1Q12.

Real consumer spending hit a soft patch last quarter and rose only 1.0%3m/3m (saar) through December. But real spending turned stronger early this year, up 0.2% (samr) in January and up 0.5% in February. The forecast looks for real consumer spending growth to reach 2.8% (saar) this quarter, but there are both negatives and positives for the near-term spending growth. On the negative side, the recent acceleration is occurring against the backdrop of stalled growth in real disposable income and a sharp drop in the household saving rate to only 3.7% in February from 4.6% in 3Q11. Real spending similarly outpaced real income by a wide margin last fall, followed by a few months in which consumer spending retrenched. This could well happen again. But there are also visible positive supports for consumer spending from rising equity prices and consumer confidence. March unit auto sales (Tuesday) and the income implications of the March labor market report (Friday) will help condition expectations for March consumer spending.

Core capital goods shipments, a key source data for the government’s estimate of spending on business equipment and software, increased 1.2% (samr) in February. But this gain follows a modest net decline over

Exhibit 1: Real consumer spending and real disposable income %ch saar over 3 months

Exhibit 2: Three measures of household income %ch saar over 3 months

Exhibit 3: Equity prices and consumer confidence Index, nsa; monthly average and latest UMich index. 1Q66=100

-1

0

1

2

3

4

Jan 11 Apr 11 Jul 11 Oct 11 Jan 12

Real consumer spending

Real disposable

income

-3

0

3

6

9


Wage and salary income

Disposable income

Real disposable income

55

60

65

70

75

80

1050

1150

1250

1350

1450

2010 2011 2012

S&P 500

Consumer confidence



8

the previous two months. Through the first two months of the quarter, the figure runs 4.0% (saar), below the 4Q11 average. Even assuming another solid increase in core capital goods shipments in March and help for capital spending from components not included in core capital goods (e.g., motor vehicles, software), real business spending on equipment and software is likely to moderate further from growth of 16.2% (saar) in 3Q11 and an upwardly-revised 7.5% in 4Q11 to the forecasted 5.5% growth pace this quarter.

Upcoming March reports will provide a lot more information about the economy at the end of 1Q.

Labor market report: Nonfarm payroll employment is expected to rise 215,000 in March, down from an average 245,000 over the prior three months, reflecting a little less help from mild weather and slightly less favorable technical indicators. The jobless rate is expected to hold at 8.3%.

ISM surveys: Forecasts look for fractional gains in the March ISM manufacturing (52.5) and non-manufacturing (57.5) surveys.

Auto sales: Early reports suggest unit auto sales slipped to 14.4mn in March, slightly below the Jan-Feb average.

Stronger spending, weaker income growth Real consumer spending accelerated early this year and gains continue to be concentrated in autos and other durable goods. Real spending is up at a 3.0%3m/3m (saar) pace through February, with spending on durable goods up 17.6% and combined spending on nondurables and services up at only a 1.3% pace. Of course, there is nothing unsustainable about spending growth that is concentrated in durable goods. For example, the elevated February sales pace for new car and light trucks (15.0mn) is still well below the 16.8mn average in 2000-2007 and has room to rise further.

The obstacle to continued spending growth has been tepid growth of real disposable income. Wage and salary income has increased to a nearly 5% (saar) pace over the past six months. But the rise in disposable income has been substantially less, only 3.2%. The gap reflects both weak growth of nonwage income (including interest income and farm income) and tightening of fiscal policy as measured by increased tax payments but a leveling off of transfer receipts from government. And, of course,

real disposable income has lagged nominal disposable income because of inflation.

We see real consumer spending growth accelerating to 2.8% in 2Q12, reflecting continued solid labor income growth and a slowing in inflation. Based on March energy prices to date and what is priced into the futures market, the increase in the CPI looks set to slow from 0.4% (samr) in February to 0.2% in March and 0.0% in April. But, of course, energy markets remain fluid.

Mixed signals on manufacturing The various manufacturing indicators have been giving conflicting signals so far this year, with the trend in durable goods orders slowing sharply and the trend in IP accelerating sharply. This week’s report on February durable goods orders shows generally good gains, with total orders up 2.2% (samr), orders ex. transportation up

Exhibit 4: Durable goods orders, select components %ch saar over 3 months

Exhibit 5: Capital spending plans and real spending on equipment, software Sa, simple average of 5 regional manufacturing surveys %ch saar

-8

0

8

16

24

32


Total ex transportation

Core capital goods

-40

-20

0

20

40

-20

0

20

40

05 06 07 08 09 10 11 12 13

Capital spending plans

Real spending on equipment and software



9

1.6%, and core capital goods orders up 1.2%. But these results follow two months of extreme swings in which orders, on net, declined. Consequently, the trend in durables orders, however measured, has slowed sharply over the past several months.

More timely regional Fed manufacturing surveys for March also show a slowing in orders growth. The simple average of the five surveys in hand show new orders declining to 7.6 in March from 11.2 in February. The regional survey measures are not very reliable predictors of new orders in the ISM survey, but the decline points to a modest dip in the ISM measure of new orders in March. A modest decline from last month’s 54.9 reading would still be consistent with growth in durable goods orders ex. transportation that is quite a bit stronger than actual growth of only 3.3% (saar) in the past three months. Similarly, the regional Fed survey results on capital spending plans for March, exactly equal to the 1Q12 average, look strong relative to core capital goods shipments and point to an acceleration in spending on equipment and software by the middle of the year.

News in the GDP revision: no revision Both real GDP growth for 4Q11 of 3.0% (saar) and real consumer spending growth of 2.1% were not changed in the second revision, at odds with the forecast of a large upward revision to spending on medical services. Spending on medical services was revised up, if less than expected, but this increase was fully offset by downward revisions elsewhere.

The report includes the government’s first estimate of profits for 4Q11. Adjusted profits of US corporations increased only 3.4% (saar) due to a large decline in net earnings from abroad. Domestic profits, a key influence on domestic capital spending and hiring, rose 16.3% (saar) with double-digit growth of both Financial and Non-Financial profits. And corporate profit margins, which were already elevated, rose still further.


Terry BeltonAC (1-212) 834-4650 Meera Chandan (1-212) 834-4924 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC

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Treasuries

• Stay positioned for higher rates; Treasuries are likely to be rangebound in 2Q12 but at higher than current yield levels

• We assess the impact on US rates in the event of a hard landing in China…

• …while not insignificant, the sensitivity of Treasury yields to EM weakness is small in comparison to the other key drivers of 10-year yields; we estimate that Treasury yields are likely to fall 15bp if growth in China were to moderate by 3%-pts

• Look for the balance of outstanding bills to decline by a total $100bn in the next seven weeks; belly cheapeners, longs in Treasuries versus OIS and longs in 1-year bills are attractive ways to position for negative bill supply

• Initiate Aug-18/ Nov-39 flatteners hedged with 7s/ 30s steepeners

• Stay bullish on TIPS breakevens but unwind weighted 5s/10s breakeven curve flatteners

Market views The Treasury market rallied in all but the very long end this week, with 2-year yields falling 3 bp, 5-year yields falling 6 bp, 10-year yields falling 2 bp, and 30-year yields rising 3 bp. The grinding rally was supported by slightly disappointing U.S. economic data, a more negative tone in European sovereign markets as peripheral spreads widened, and dovish comments from Chairman Bernanke who gave some (small) hope to QE3. With the move, 10-year yields are back to 2.20%, up 34bp during 1Q12, but 16 bp lower than their 2012 highs reached last week. The sell-off in Treasuries marks the first time since 2010 that Treasuries had a negative return for the quarter with the JPM US government bond index returning -131 bp of total return in 1Q12.

Economic data was generally disappointing this week with most releases falling short of consensus expectations. Housing data showed signs of weakening, with February pending home sales falling 0.5% and the Case-Shiller index declining for the ninth consecutive month. While

the durable goods report for February was broadly in line with expectations, it did show a sharp slowdown in capital spending. Q4 GDP did not get revised up in line with our expectations, and while initial jobless claims reached a new cycle low, there were upward revisions for recent weeks, making the signals related to the March employment report somewhat less optimistic than previously reported. The personal income and spending report was mixed as well, with real consumer spending increasing 0.5% in February, consistent with our Q1 forecast, but real disposable income falling 0.1%.

While the momentum trade in Treasuries has lost some steam, we maintain our bias to higher rates and recommend holding duration shorts through Friday’s payroll number (Exhibit 1). The rally in the last few weeks has pushed December 2014 OIS back to 83 bp; this is 33 bp below our estimate of fair value (see U.S. Fixed Income Markets Weekly, 2/10/12) and 43 bp below its

Exhibit 1: J.P. Morgan rate forecast %

Exhibit 2: December 2014 OIS is now 33 bp below our estimate of fair value December 2014 forward OIS rate; %

Actual 1m ahead 2Q12 3Q12 4Q1230 Mar 12 30 Apr 12 30 Jun 12 30 Sep 12 31 Dec 12

RatesEffective funds rate 0.13 0.10 0.10 0.10 0.103-mo LIBOR 0.47 0.45 0.50 0.50 0.503-month T-bill (bey) 0.08 0.04 0.02 0.02 0.02

2-yr Treasury 0.33 0.29 0.30 0.30 0.305-yr Treasury 1.04 1.15 1.25 1.25 1.2510-yr Treasury 2.22 2.30 2.50 2.50 2.5030-yr Treasury 3.34 3.40 3.60 3.60 3.60

0.50.60.70.80.91.01.11.21.31.4

Nov 11 Jan 12 Mar 12

JPM fair value



11

average level during the fall when the unemployment rate exceeded 9% (Exhibit 2). The high fair value of forward OIS reflects our outlook that, while the most likely scenario is still that the unemployment rate drops gradually over time and policy rates remain near zero through 2014, the uncertainty around the unemployment rate creates large tail risks on rates. This tail risk, along with the positive convexity of short duration positions at the current low level of rates, suggests that shorts in forward OIS are cheap put options, especially in front of this week’s employment report.

We would note that the risks of a large move in rates on Good Friday’s employment report is somewhat higher than average with bond markets open for only a half day. In the last ten years, payrolls have been released on a holiday-shortened trading day on ten different occasions, with markets 30% more volatile on these days than other payroll Fridays (Exhibit 3). This has occurred even though payroll surprises have ended up being smaller on the half-day releases.

Beyond the asymmetric risks around payrolls, mean reversion is also supportive of moderately higher rates as 10-year Treasuries have rallied and are currently 10 bp rich versus our short-term model estimate of fair value (Exhibit 4). This fair value estimate, which has declined 15 bp since March 19, incorporates the recent modest deterioration in sovereign markets in Europe. Moving the fair value of 10-year Treasury yields back below 2% would require another 80 bp of widening in semi-peripheral spreads, putting them back near the wides of

last fall. While our outlook has turned more cautious on Europe, we expect any near-term widening in peripheral spreads to be muted.

Finally, we continue to expect rates to rise as the market prices in the end of Operation Twist. As discussed last week, we expect the end of Operation Twist to cheapen 10-year rates by 25bp. Moreover, despite the relatively more dovish comments from Chairman Bernanke this week, other centrist FOMC seems to be downgrading the possibility of further monetary stimulus. Even Boston

Exhibit 3: Markets have been 30% more volatile on half-day payroll days Average change in 10-year rates on all and half-day payroll release days; calculated March 2002 – March 2012

Exhibit 5: April is historically one of the lightest months of the year for duration supply Monthly duration supply in fixed-income markets* ($bn of 10-year equivalents)

* Via MBS, Municipal, investment grade corporate, Treasuries and Agency debt Markets.

Exhibit 4: Ten-year Treasuries appear 10 bp rich versus our estimate of fair value Actual 10-year yields versus fair value* at neutral positions; %

*10-year Treasury yield fair value modeled as 1.97 + 0.357 * 5yx5y inflation swap rate (%) + 0.454 * 3mx3m OIS rate (%) + 0.178 * 1-year ahead J.P. Morgan GDP growth forecast (%) – 0.288 * J.P. Morgan positions index – 0.003704 * semi-peripheral Europe 5-year CDS spreads (bp). Assumes that J.P. Morgan positions index = 0.

6.0

6.5

7.0

7.5

8.0

8.5

All payrolls Half day payrolls

Average surprise =

77K

Average surprise =

65K

180

200

220

240

260

280

300

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

5y Average2012

1.61.82.02.22.42.62.83.03.23.4

Jun 11 Sep 11 Dec 11 Mar 12

Fair value*Actual



12

Federal Reserve President, Eric Rosengren, who is an extremely dovish (albeit nonvoting) member of the FOMC appeared to be taking a much less dovish stance in this regard. This week he suggested further monetary stimulus is now contingent on a slowdown in growth (“should growth slow down more than is expected, more policy accommodation could be advisable”). This contrasts to his speech in January which suggested stronger support for further stimulus (“Further purchases of mortgage-backed securities would in my view help provide a more rapid recovery in housing, by reducing the costs of refinancing or purchasing new homes”)1

While these factors are supportive of holding duration shorts, supply-demand technicals remain supportive of the Treasury market with rates likely to ultimately be rangebound at slightly higher than current levels. After a heavy issuance calendar in 1Q12, duration supply is now set to decline, with April historically being one of the lightest months of the year for issuance. We project total fixed income supply in April (across Treasuries, corporates, munis, MBS, Agency debt) at $231 bn 10-year equivalents or down 22% from March levels (Exhibit 5). Supply will pick up again in May and June but is still likely to be below the heavy pace during the first quarter of the year.

.

As supply slows, US commercial bank demand is likely to remain strong. Bank deposit growth during 1Q12 averaged $65 bn per month, or nearly 43% larger than the 1 Includes excerpts from March 27, 2012 and January 6, 2012 speeches.

already strong pace during 2011. These inflows have increased demand for fixed income assets, with banks purchasing an average of $26 bn per month in fixed income securities or four times their buying pace of last year (Exhibit 6). With deposit growth likely to remain strong in the near term (we attribute the drop this week to volatility in this series), strong bank demand for fixed income is a powerful factor likely to keep rates rangebound absent a significant shift in Fed expectations or a widening in European peripherals.

Exhibit 6: Strong bank demand for fixed income is a powerful factor likely to keep rates rangebound Average monthly change in commercial bank deposits, cash holdings, security holdings and C&I loans in 2011 and over the past 3 months (uses 2-week rolling averages); $bn

Source: Federal Reserve H.8 Release

Exhibit 7: Hedge funds are still close to the shortest they have been in the last year J.P. Morgan index of levered investor Treasury positions*

* JPM positions index is the weighted average of aggregate net longs held by noncommercial investors as provided by CFTC and the partial beta of hedge fund returns versus 10-year Treasury yields, converted to a z-score.

Exhibit 8: The back end of the curve has already steepened by a larger amount than normal in advance of next month’s long end supply 0.73 * 30-year yields minus 7-year yields averaged in the business days around 7-year auctions over the last year; %

4541

710

65

3

26

14

0

20

40

60

80

Deposits Cash Securities C&I Loans

2011Past 3M

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Mar 11 Jun 11 Sep 11 Dec 11 Mar 12

0.750.760.770.780.790.800.810.820.830.840.85

-10 -8 -6 -4 -2 0 2 4 6 8 10Business days around the 7-year auction

Average29-Mar-2012(Y1)



13

Finally, levered positions remain somewhat stretched with CFTC data released today showing surprisingly little rebalancing flows by speculative investors during the recent rally. Our levered investor position index remains at -1.1 indicating hedge funds are still close to the shortest they have been in the last year (Exhibit 7). A weak payroll report on Friday raises the risk of unwinds of these positions moving rates back to the lows reached earlier this week.

At the long end of the yield curve, we stay tactically neutral awaiting a better entry point to reset curve flatteners. While auction cyclicals are usually supportive of long-end steepeners into supply, the back end of the curve has already steepened by a larger amount than normal in advance of next month’s long-end supply (Exhibit 8). Moreover, as previously discussed (see U.S. Fixed Income Markets Weekly, 3/2/12), Operation Twist has muted the pattern of curve steepening into 30-year auctions while amplifying the post-auction flattening.

While we are neutral overall on the long end of the curve, we favor Aug-18/ Nov-39 flatteners hedged with 7s/30s steepeners, since it appears extremely mispriced. As shown in Exhibit 9, the weighted spread of this trade currently appears too high.

Treasury rates and a China hard landing Markets have turned their attention to China in recent weeks as economic data has weakened and concerns about a potential hard landing have grown. As discussed in this week’s Cross Sector Overview, while the direct economic

effects of a China slowdown on US growth are likely to be modest, the financial market channels are likely to be larger due to their impact on sentiment and risk aversion. To estimate the impact of a China hard landing on Treasury rates, we have added an index of EM currencies to our fair value model for US Treasuries (Exhibit 10). The variable is statistically significant, and suggests that a 1 point (approximately 5%) sell-off in our index of EM currencies should lower 10-year Treasury rates by 6 bp. Using historical data over the past 10-years , moreover, we estimate that each 1% point decline in 1-year ahead consensus growth expectations for China has caused EM currencies to weaken 2.4 points. Together, these estimates suggest that a hard landing on the order of a 3% point decline in GDP for China, could move 10-year Treasury rates lower by 15 bp.

While not insignificant, we would note that the sensitivity of Treasury yields to weakness in EM is small in comparison to the other key drivers of 10-year yields. This is evident in column 4 of Exhibit 10 which shows the estimated change in 10-year yields given a two standard deviation change in each of the model’s variables. In particular, the table shows the sensitivity of US rates to European sovereign stress is 5 times larger than to stress in China; a two sigma sell-off in EM currencies should lower 10-year yields by 13 bp while a two-sigma sell-off in European semi-peripheral spreads should lower 10-year yields by 70 bp. Thus, while China is not to be ignored by Treasury investors, our focus remains primarily on Europe as the primary risk to our short duration position.

Exhibit 9: The Aug-18/ Nov-39 curve looks too steep adjusted for the broader 7s/30s curve (T 4.375% Nov-39 minus T 1.5% Aug-18 yield ) * 0.8 – (30-year – 7-year yields); %

Exhibit 10: The sensitivity of Treasury yields to EM weakness is small in comparison to the other key drivers of 10-year yields J.P. Morgan fair value model for 10-year Treasury yields, EM currencies

* Inflation expectations are 5yx5y inflation swap rate (%), US growth expectations are measured by 1-year ahead J.P. Morgan GDP growth forecast (%), Europe FTQ is measured by semi-peripheral Europe 5-year CDS spreads (bp), Lev. Investor positions are measured by J.P. Morgan positions index, and China hard landing is measured by average FX rate of Brazil, Mexico and Indian currencies.

-0.39-0.38-0.37-0.36-0.35-0.34-0.33-0.32-0.31-0.30-0.29

Nov 11 Jan 12 Mar 12

Variable Current value Beta T-statistic

2 sigma impact on 10y rates

Inflation expectations 2.93 0.384 10 17US Growth expectations 2.25 0.152 19 34

Europe FTQ 334 -0.003 -43 -70Lev. investor positions -1.2 -0.311 -23 -36

China Hard landing 21.9 -0.056 -7 -13R^2 = 80%



14

One factor muting the effect of a China hard landing on Treasury yields is that weakness in EM currencies has historically tended to slow both FX reserve accumulation and foreign demand for Treasuries. Most recently this was evident last September following a 8% sell-off in EM currencies. As a result, FX reserves fell by $120bn with foreign central banks selling $33bn of Treasuries over the period. On balance, we estimate a hard landing in China to have only a moderate impact on yields, on the order of 15bp for a 3%pt moderation in growth.

Positioning for negative bill supply Treasury reduced the size of 4-week bills by $5bn to $35bn this week, bringing the net issuance for the week ending March 29 to -$1bn. While this is a modest amount, it marks the first week of decline in the balance of bills outstanding after 11 consecutive weeks of positive net issuance. As discussed in our previous publication, our outlook is for bill issuance to turn more negative in the coming weeks. We maintain this view even though Treasury left the sizes of 3- and 6-month bills unchanged this week, primarily motivated by a lower than expected deficit in March, which is currently running 30% lower than a year ago (see discussion in following section). This will likely keep Treasury’s funding needs low, and as a result, we have revised our issuance forecast and now expect net issuance of bills to total -$100bn in the next seven weeks (versus our earlier expectation of -$80bn over this period). The bulk of the adjustment will come from smaller sizes of 4-week bills, though we also expect modest downward adjustments to 3- and 6-month bill sizes.

What is the best way to position for negative supply? Exhibit 11 shows the performance of select trades in early 2011, which was the last time the outstanding balance of bills fell by a similar magnitude. The trades include curves adjusted for the level of rates, butterflies weighted to be curve and level neutral, longs in Treasuries versus OIS, and outright longs in 1-year bills. The following observations may be made from the exhibit.

First, we expect the front end of the curve to steepen and for butterflies anchored in the very front end to cheapen. Such performance is, in part, a result of outperformance of front-end paper amid lower supply. Thus, we expect negative bill net issuance in the coming weeks to aid the performance of belly cheapening trades we have been recommending. The entry level to position for belly cheapening trades is still attractive. Exhibit 11 shows that

the 6-month z-score of a level and curve neutral 2s/5s/10s is currently -1.6.

Second, front-end Treasuries should richen versus matched-maturity OIS. While some of this richening has already occurred, these spreads are still modestly wide relative to their 6-month averages, as indicated by their 6-month z-scores.

Finally, 1-year bills have historically performed well amid declining bill supply, and we expect a similar pattern this cycle as well. Currently, bill yields are still in the upper end of their six month trading range with a z-score of 1, leaving room for further richening.

Deficit and debt ceiling outlook Today marks the end of the first half of fiscal year 2012. While details on the deficit for March have not been released yet, the deficit appears to have improved in March. Month-to-date combined individual and business tax refunds are running 19% below the same period in 2011, while tax receipts (withheld and corporate) are running 6% higher than a year ago levels (Exhibit 12). In all, we estimate that the deficit in March is running 30%

Exhibit 11: Positioning for negative bill issuance: steepeners and belly cheapening trades anchored in the front end, longs versus OIS and outright longs in 1-year bills are likely to perform well Trade performance between January and June 2011; % unless otherwise specified

* Curves are weighted to be level neutral, while butterflies are weighted to be level and curve neutral. Weights used for last 2 columns are: 0.26 * 2s - 1s; 0.16*3s - 1s; 0.28*5s - 2s; 2s - 0.87 * 1s - 0.37 * 3s; 3s - 1.2 * 1s - 0.45 * 5s; 3s - 0.91*2s - 0.31 * 5s; 5s - 1.44*2s - 0.5 * 10s Source: J.P. Morgan

Trade

Level before bills o/s started

declining in Jan'11

Chg. (%)

Chg/ 1y Std dev of

3m chg

Current level

Current 6m

zscore

Weighted curves*Wtd 1s2s curve -0.13 0.03 0.7 -0.11 -1.5Wtd 1s3s curve -0.09 0.02 0.4 -0.10 -1.4Wtd 2s5s curve 0.19 0.02 0.3 0.05 -1.4Wtd 1s2s3s bfly -0.14 0.03 0.8 -0.10 -0.5Wtd 1s3s5s bfly -0.33 0.02 0.2 -0.26 0.0Wtd 2s3s5s bfly -0.08 -0.02 -0.5 -0.08 0.6Wtd 2s5s10s bfly -0.63 0.05 0.5 -0.62 -1.6

Treasury versus OIS tradesLong 1y bills vs. OIS 0.04 -0.06 -1.8 0.01 0.6Long 2y Tsy vs. OIS 0.07 -0.04 -0.6 0.12 0.2Long 3y Tsy vs. OIS 0.03 -0.07 -0.8 0.14 0.4

Outright longs12m Tbill 0.36 -0.13 -1.1 0.23 1.0



15

below a year ago levels. Year-to-date for FY 2012, the deficit is running 13% lower than last year, versus our earlier forecast of 8%.

This leaves Treasury with $15.5tn of debt outstanding at the end of March, which is $857bn lower than the debt ceiling. Given our projections for the budget deficit and Treasury’s cash balances, we estimate that the debt ceiling will likely become binding in late January 2013, assuming no extraordinary actions are undertaken by Treasury (Exhibit 13). Indeed, Treasury could take extraordinary actions to buy some time in the absence of Congressional action, just as it did in between May and July 2011. At that time, they took extraordinary actions totaling almost $230bn, which gave them an additional 2 ½ months. Assuming that extraordinary actions result in a similar outcome, our best guess is that the debt ceiling will likely become absolutely binding by mid-April 2013.

TIPS Over the past week, TIPS breakevens narrowed modestly as risk aversion ticked up and Brent oil prices declined 2%. Surprisingly, the 5-year sector outperformed despite the decline in energy prices: all in all, 5-, 10-, 20- and 30-year breakevens narrowed 1bp, 3bp, 4bp, and 3bp, respectively.

Although TIPS have underperformed over the past two weeks, over the quarter they have generally outperformed

nominals. As Exhibit 14 shows, TIPS breakevens widened over 1Q thanks to a rally in energy prices and general “risk-on” sentiment. Over the quarter, our TIPS index delivered total returns of +0.73%, or excess returns of 1.8% over our nominal Treasuries index (on a duration-adjusted basis).

Looking ahead, we remain bullish on TIPS breakevens. Our bearish view on duration and our generally positive view on risky assets argue for wider breakevens. In addition, the technical backdrop for TIPS looks more positive now. As Exhibit 15 shows, breakevens have been

Exhibit 14: TIPS outperformed nominals in 1Q12 thanks to a rally in energy prices and risk-on sentiment 10-year TIPS breakeven versus rolling front Brent oil futures price; bp $/bbl

Exhibit 12: The earlier than usual drop in bill auction sizes is partly a result of lower tax refunds and higher tax receipts Month-to-date oya percentage change in individual and business tax refunds and receipts; %

Source: Treasury * Tax receipts for individuals include withheld Income and employment taxes only. ** Business tax receipts refers to corporation income taxes.

Exhibit 13: The debt ceiling will likely become binding by mid-April 2013, assuming Treasury uses extraordinary actions Project debt outstanding versus the debt ceiling; $bn

Source: J.P. Morgan

105

110

115

120

125

130

190

200

210

220

230

240

250

30 Dec 19 Jan 08 Feb 28 Feb 19 Mar

10Y TIPS breakeven

Brent oil futures

-19%

3%

-13%

23%

-20%

-10%

0%

10%

20%

30%

Tax refunds Tax receipts

Individual* Business**

15,400

15,600

15,800

16,000

16,200

16,400

16,600

Mar 12 Jun 12 Sep 12 Nov 12 Feb 13 Apr 13

Debt ceiling Debt outstanding

Jan'13; Without extraordinary measures

Apr'13; With extraordinary measures



16

somewhat negatively correlated with dealer positions in TIPS, with breakevens tending to trade at wider levels when dealers are more short TIPS. Thus, we think it is encouraging to see that dealer positions have declined in each of the past four weeks, with positions now at their lowest levels since July 2011. Similarly, although one week does not constitute a trend, it is encouraging to see a sharp increase in inflows into inflation-protected mutual funds after a period of lackluster flows (Exhibit 16). Thus, we remain biased toward wider breakevens over the medium term.

That being said, we also think risks have increased. Unlike the nominal Treasury market, where a China hard landing scenario is not expected to have a significant impact, the TIPS market has greater exposure due to the sensitivity of oil prices to Chinese growth. As we discuss in the Cross Sector Overview, commodities are one sector that is likely to sharply underperform in the event of a hard landing in China. As a result, we would expect TIPS to be especially hard-hit if Chinese growth fears intensify.

To see this, we first estimate the impact of a hard landing on oil prices. Based on the relationship between Chinese growth expectations and Brent oil futures prices, we estimate that a 3% decline in growth expectations would lead to approximately a $10-15/bbl decline in oil prices. To project what this would mean for TIPS breakevens, we turn to a simple model for breakevens using nominal yields and Brent oil futures prices (Exhibit 17). This analysis suggests that front-end TIPS are most exposed to

oil prices, with a hard landing in China likely to cause 5-year breakevens to narrow by 25-40bp.

As a result, we recommend unwinding our weighted 5s/10s breakeven curve flattener. After this week’s outperformance of the 5-year sector, the 5s/10s breakeven curve looks close to fairly priced relative to the level of breakevens and the 5s/10s nominal curve. Furthermore, given the risk of underperformance of the 5-year sector due to China growth fears, we recommend unwinding this trade at current levels (see Trade recommendations).

Trade recommendations • Initiate Aug-18/ Nov-39 flatteners hedged with 7s/

30s steepeners The Aug-18/ Nov-39 curve currently looks 5bp too steep adjusted for the broader 7s/30s curve. We recommend positioning for a reversal in this mispricing.

− Buy 80% risk, or $25.6mn notional of T 4.375% Nov-39s (yield: 3.258%; bpv: $2051/mn).

Exhibit 16: Flows into inflation-protected mutual funds increased this week after a period of lackluster flows Weekly flows into inflation-protected mutual funds; $mn

Source: EPFR Global

Exhibit 15: Dealer positions in TIPS are now at their lowest level since July 2011 Primary dealer positions in TIPS versus 10-year TIPS breakevens; $bn bp (inverted axis)

Source: Federal Reserve Bank of New York Exhibit 17: Front-end TIPS are likely to underperform

significantly if oil prices decline due to fears of a hard landing in China Statistics for breakevens regressed against nominal yields and rolling front Brent oil futures prices over the past year

-400

-200

0

200

400

600

25 May

22 Jun

20 Jul

17 Aug

14 Sep

12 Oct

09 Nov

07 Dec

04 Jan

01 Feb

29 Feb

28 Mar

140

160

180

200

220

240

260

280-4

-2

0

2

4

6

8

Mar 10 Jul 10 Oct 10 Jan 11 May 11 Aug 11 Nov 11 Feb 12

Dealer positions in TIPS

10Y TIPS breakeven(inverted axis)

Beta T-stat Beta T-stat Intercept R-sq5Y 33.5 22.0 2.51 23.1 -139.4 87%10Y 23.6 22.1 1.65 17.6 -26.1 84%30Y 26.4 22.6 1.09 9.9 19.8 79%

Nominal y lds (% ) Brent oil fut ($/bbl)



17

Sell 80% risk, or $85.9mn notional of T 1.5% Aug-18s (yield: 1.456%; bpv: $611/mn). Sell 100% risk, or $35.9mn notional of T 3.125% Feb-42s (yield: 3.345%; bpv: $1828/mn). Buy 100% risk, or $100mn notional of T 1.5% Mar-19s (yield: 1.612%; bpv: $656/mn). Weighted spread is -29bp. One-month weighted carry is 0.3bp and roll is 0.5bp.

• Maintain tactical duration shorts − Stay short 100% risk, or $100mn notional of T 2% Feb-

22s (yield: 2.22%). (US Fixed Income Markets Weekly, 3/23/12). P/L since inception: -2.6bp of yield.

• Stay long the June CTD ultra-long bond basis − Stay long the T 4.375% Feb-38s June factor weighted

basis (@ net basis of -1/32nds). (US Fixed Income Markets Weekly, 3/23/12). P/L since inception: -0.25/ 32nds.

• Unwind weighted 5s/10s breakeven curve flatteners The 5s/10s TIPS breakeven curve now looks close to fairly valued. Furthermore, given the risk of a steepening of this curve due to increased fears around Chinese growth, we recommend unwinding this trade at current levels.

− Unwind short 100% risk, or $25mn notional of TII 0.125% Jan-22s (yield: -0.125%). Unwind long 60% risk, or $34.1mn notional of TII 0.125% Apr-16s (yield: -1.244%). Unwind long 60% risk, or $17.2mn notional of T 2% Feb-22s (yield: 2.218%). Unwind short 20% risk, or $12.1mn notional of T 2% Apr-16s (yield: 0.806%). (US Fixed Income Markets Weekly, 3/23/12). P/L since inception: +3.3bp of yield.

• Stay underweight 2.625% Jun-14s versus 1.5% Dec-13s and 2.125% Dec-15s

− Stay overweight 86% risk, or $136.7mn notional of T 1.5% Dec-13s (yield: 0.316%). Stay underweight 100% risk, or $122.3mn notional of T 2.625% Jun-14s (yield: 0.392%). Stay overweight 22% risk, or $16.5mn notional of T 2.125% Dec-15s (yield: 0.710%). (US Fixed Income Markets Weekly, 3/16/12). P/L since inception: +0.8bp of yield.

• Stay overweight 2-year Treasuries versus OIS − Stay overweight 100% risk, or $101.1mn notional of T

0.25% Nov-13s versus 100% risk, or $100mn notional matched maturity OIS at a spread of 11.1bp. (US Fixed Income Markets Weekly, 3/16/12). P/L since inception: 0bp of yield.

• Maintain 2s/6s steepeners hedged with 9th/11th Eurodollar flatteners

− Stay overweight 100% risk, or $475.6mn notional of T 0.25% Feb-14s (yield: 0.326%). Stay underweight 33% risk, or $50mn notional of T 2.875% Mar-18s (yield: 1.317%). Stay underweight 100% risk, or 3,725 EDM4 contracts (price: 98.990). Stay overweight 85% risk, or 3,166 EDZ4 contracts (price: 98.665). (US Fixed Income Markets Weekly, 3/9/12). P/L since inception: +0.8bp of yield.

• Stay in 2s/7s steepeners hedged with reds/ greens flatteners

− Stay overweight 100% risk, or $170.1mn notional of T 0.25% Feb-14s (yield: 0.326%). Stay underweight 98% risk, or $50mn notional of T 1.375% Feb-19s (yield: 1.592%). Stay underweight 98% risk, or 1,327 EDM3 contracts (price: 99.395). Stay overweight 100% risk, or 1,354 EDZ4 contracts (price: 98.665). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -1.8bp of yield.

• Maintain exposure to belly cheapening trades − Stay overweight 69% risk, or $151.7mn notional of T

3.25% May-16s (yield: 0.834%). Stay underweight 100% risk, or $168.7mn notional of T 2.25% Nov-17s (yield: 1.24%). Stay overweight 40% risk, or $50mn notional of T 3.375% Nov-19s (yield: 1.735%). (US Fixed Income Markets Weekly, 3/2/12). P/L since inception: +0.4bp of yield.

− Stay overweight 94% risk, or $307.1mn notional of T 0.25% Feb-15s (yield: 0.501%).



18

Stay underweight 100% risk, or $157.4mn notional of T 2.75% Feb-18s (yield: 1.294%). Stay overweight 42% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.764%). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: +0.2bp of yield.

− Stay overweight 75% risk, or $191.7mn notional of T 0.25% Jan-15s (yield: 0.483%). Stay underweight 100% risk, or $112.8mn notional of T 1.25% Jan-19s (yield: 1.573%). Stay overweight 54% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.764%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -4bp of yield.

• Stay underweight May-38s versus May-37s − Stay overweight 100% risk, or $48.9mn notional of T

5% May-37s (yield: 3.188%). Stay underweight 100% risk, or $50mn notional of T 4.5% May-38s (yield: 3.222%). (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: +0.5bp of yield.

• Stay underweight on-the-run 10s versus triple olds − Stay underweight 100% risk, or $50.6mn notional of

2% Feb-22s (yield: 2.217%). Stay overweight 100% risk, or $50mn notional of T 3.125% May-21s (yield: 2.054%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -0.5bp of yield.

• Stay overweight 6.5% Nov-26s versus a weighted barbell of Aug-23s/Feb-31s

− Stay underweight 62% risk, or $39mn notional of T 6.25% Aug-23s (yield: 2.357%). Stay overweight 100% risk, or $50mn notional of T 6.5% Nov-26s (yield: 2.747%). Stay underweight 38% risk, or $16.5mn notional of T 5.375% Feb-31s (yield: 2.973%). (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: -3bp of yield.

Closed trades in 2012 P/L reported in bp of yield unless otherwise indicated

TRADE ENTRY EXIT P/LNominal Treasuries10-year duration shorts 01/20/12 02/10/12 -11.1

CurveUnderweight 4s versus 3s and 7s 12/09/11 01/06/12 0.9Buy 2.375% Jun-18s versus 1.875% Oct-17s 10/14/11 01/06/12 -2.87s/30s flatteners 01/06/12 01/27/12 -14.2Buy Nov-21 Cs versus Ps 09/23/11 01/06/12 -0.24s/6s steepeners vs. reds/greens flatteners 01/06/12 01/27/12 3.07s/30s flatteners 02/10/12 02/24/12 3.53s/7s flatteners 02/12/12 02/24/12 8.54s/25s steepeners hedged with reds/10s flatteners 01/27/01 03/16/12 -25.75s/30s weighted flatteners 03/09/12 03/23/12 8.85s/10s weighted flatteners 03/09/12 03/23/12 5.12s/3s weighted steepeners 01/27/12 03/23/12 1.3

Misc.Sell 2s versus OIS 12/09/11 01/06/12 0.8Buy 5s versus OIS 01/06/12 02/04/12 5.0Sell 2-year Treasuries vs. JGBs swapped into USD 08/12/11 02/10/12 44.0Buy the March CTD Bond basis 12/09/11 02/24/12 1/32nds

TIPSSell 5-year TIPS on a breakeven basis 12/16/11 01/20/12 -12.310s/30s breakeven curve steepener 03/09/12 03/16/12 4.7Underweight Apr-14 TIPS versus Jan-14 TIPS 02/24/12 03/16/12 5.4Weighted 5s/10s breakeven curve flattener 03/23/12 03/30/12 3.3


Srini RamaswamyAC (1-212) 834-4573 Praveen Korapaty (1-212) 834-3092 Alberto Iglesias (1-212) 834-5116 J.P. Morgan Securities LLC

19

Interest Rate Derivatives

• Upside risks to FRA-OIS as well as broader credit spreads are growing, driven by concerns around the viability of deficit targets and potential downgrades in Europe

• At the same time, corporate issuance is poised to tactically decline as we enter earnings season and blackout windows, and intermediate maturity spreads are likely to exhibit asymmetric exposure to yield levels—initiate maturity matched swap spread wideners in the 5-year sector

• Front-end spreads remain highly correlated to swap yields—buy 1Mx1Y payers as a limited risk proxy for a front-end swap spread widener

• Continue to position for yield curve renormalization—a simple variant that takes advantage of low yields / implied volatility as well as the steep skew is to buy payer swaption spreads on 5-year tails

• Stay bearish on short-expiry volatility on intermediate tails, outright as well as versus longer expiries

• Look for 30-year tails to begin to richen relative to 10-year tails

Swaps Swap spreads narrowed for most of this week, before reversing course on Friday to finish the week close to unchanged. Maturity matched swap spreads are narrower by 0.5bp in the 2- to 5-year sector, and unchanged across the rest of the curve relative to last week’s closing levels. These moves in spreads came amidst a modest decline in yields and elevated issuance—financial issuance this week was about $7bn.

Going forward, we now look for swap spreads to be biased wider, as numerous factors are now lining up to support such a view. First, European developments are likely to turn more negative in the near term; Friday’s underwhelming Eurogroup announcement, upcoming French elections, as well as growing concerns regarding the feasibility of attaining deficit targets, are all causing a rise in European exogenous risk (see Overview, Global

Fixed Income Markets Weekly, 3/30/2012). This creates increased upside risk to FRA-OIS spreads, which have stabilized near six-month lows, particularly given slightly positive slide in FRA-OIS widening trades (Exhibit 1). Second, this week’s risk-off sentiment also points to growing risk of a “hard landing” in China. To be sure, this is not our baseline expectation–our economists expect a moderate slowing to around 7% in 1H12, followed by a rebound in 2H12, and European risks are

Exhibit 1: With FRA-OIS having stabilized near 6-month lows and carry on wideners now positive, European developments could pose upside risk to FRA-OIS 3-month forward constant maturity FRA-OIS spread, versus the 3-month Libor/OIS minus 3-month forward FRA-OIS spread differential; bp

Exhibit 2: The beta of 5-year swap spreads with respect to Treasury yields is expected to rise in a sell-off and fall in a rally, implying that intermediate spreads will likely be biased wider in a sharp rally or a sharp sell-off Estimated effective beta between 5-year swap spreads and 5-year Treasury yields, projected at various yield levels; bp per 1%

5-year Treasury yield; %

-40

-20

0

20

40

60

80

Sep 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12

FRA-OIS

3M slide on wideners

-40

-30

-20

-10

0

10

20

30

0.8 0.9 1 1.1 1.2 1.3 1.4



20

much more significant for US rates markets (see Treasuries). Nonetheless, the risk of a sharp slowdown in Chinese growth adds downside risk to Treasury yields, especially when combined with rising European risks. Should intermediate Treasury yields decline by a significant amount, we would expect swap spreads to widen. Last week, we analyzed the directionality of swap spreads with Treasury yields, and noted that we would expect swap spreads to become positively correlated with yields as 5-year Treasury yields rise above 1.12% or so. The same analysis also suggests, however, that if yields decline significantly from here, swap spreads would become increasingly counter-directional (Exhibit 2; see also Interest Rate Derivatives, US Fixed Income Markets Weekly, 3/23/2012).

Third, our credit strategists have turned more cautious on high grade credit spreads. Although credit spreads–as a barometer of broader risk appetite in markets–have always been one factor (among several others) in our model for swap spreads, they have become a much more important driver of swap spreads recently. This is because the structural drivers of swap spreads–Fed funds expectations, budget deficits and/or Treasury supply–have all become highly stable in recent months, leaving swap spreads much more sensitive to credit spreads. Indeed, FRA-OIS and CDX.IG, along with a measure of Fed purchase expectations, are the most important variables in our model for 5-year maturity matched swap spreads over the past two years (Exhibit 3). As also seen in the exhibit, our model currently suggests that 5-year swap spreads are considerably narrow to fair value, by nearly 4.5bp, which ranks among the most significant mispricings in recent years.

Fourth, issuance-related swapping activity–which has been a source of spread narrowing pressure in recent weeks–is likely to slow down tactically in coming weeks as we approach earnings season and issuance blackout periods. Finally, also tactically, next week brings about $15bn of 10-year equivalents in Fed purchases of long-end Treasuries, with no sales until the week after. The tactical rise in the pace of Fed buying is on the margin an additional support for wider swap spreads.

In sum, upside risks to CDX.IG and FRA-OIS, the asymmetric exposure of spread wideners with respect to yield levels, coupled with the tactical effects of an expected decline in corporate issuance in coming weeks and a pickup in the pace of the Fed’s Treasury purchases,

all combine to leave us bullish on intermediate maturity swap spreads. We therefore recommend initiating 5-year maturity matched swap spread wideners hedged for rates (see Trade recommendations).

At the front end, payer swaptions (and payer spreads) remain attractive ways to gain one-sided exposure to front-end spread widening. As seen in Exhibit 4, maturity matched swap spreads in the 2-, 3- and 5-year sectors are all highly correlated to 1-year swap yields,

Exhibit 4: At the front end, swap spreads remain highly correlated to yields, making payer swaptions attractive as limited risk approaches to initiating spread widening exposure Maturity matched 2-, 3- and 5-year swap spreads, versus 1-year swap yield; bp

1-year swap yield; %

Exhibit 3: Intermediate maturity swap spreads now appear narrow to fair value 5-year maturity matched swap spread and J.P.Morgan model estimate of fair value*; bp

* Model based on 2-year regression of 5-year maturity matched swap spread versus 3-month forward constant maturity FRA-OIS, CDX.IG, the rolling 1-year ahead budget deficit expectation, and the rolling 1-month-ahead expected amount of Fed purchase of Treasuries, in 10-year equivalents.

20

30

40

50

60

0.4 0.5 0.6 0.7 0.8

2Y 3Y 5Y

10

20

30

40

50

Apr 10 Sep 10 Jan 11 Jun 11 Nov 11 Mar 12

Actual Model



21

with virtually no distinction between sectors when 1-year swap yields decline below 60bp (they are currently near 50bp). Moreover, implied volatility on 1-year tails is near historic lows, making payer swaptions very attractive as limited risk proxies for front-end swap spread wideners. Therefore, we now recommend buying 1Mx1Y payer swaptions (see Trade recommendations).

Swap yield curve On the swap yield curve, we continue to recommend exposure to yield curve renormalization trades. These trades are broadly premised on the notion that markets are underpricing the (highly asymmetric) upside risk to the Fed’s projections of the funds rate.

To be sure, Bernanke’s comments earlier this week stressed the Fed’s policy patience as well as its cautious attitude towards the stronger tone of labor market data. This was not unexpected–indeed, our economists have highlighted that the Fed would likely prefer to err on the side of caution, and our own model forecast is still broadly in line with the Fed’s projections. Nonetheless, it remains true that the decline in the unemployment rate in recent months has increased the dispersion around projections for 2013 and 2014; given the asymmetric nature of monetary policy in a zero rate regime, this growing dispersion translates into growing upside risk to the Fed’s projections of the funds rate. Indeed, forward OIS rates remain low after adjusting for term premium (Exhibit 5), and our Treasury strategists estimate that December 2014 forward OIS rates are too low to the tune of 30-40bp (see Treasuries). In other words, the case for yield curve renormalization remains intact, and we recommend maintaining such exposure in spite of Chairman Bernanke’s dovish comments this week.

In addition to the trades we have already recommended on this theme, we recommend taking advantage of the recent decline in yields to initiate similar exposure via simpler–and limited risk–payer swaption spreads. Should forward OIS rates rise by 40bp towards fair value, we estimate that 5-year swap yields could rise by 30bp, or to 1.55%. A simple way to position for this is to buy 1:1 notional weighted payer swaption spreads centered around the expected level of the 5-year swap yield–specifically, we recommend buying 3Mx5Y payers struck at 1.45% (the recent high in 5-year swap yields) versus selling a payer swaption struck at 1.65% (see Trade recommendations). The ratio of potential reward to risk is attractive in such trades, thanks to low yield levels,

low ATMF implied volatility levels as well as the considerable steepness of the implied normal skew in the 5-year tail sector.

Options Implied volatilities fell across the entire volatility grid over the week even despite the rise on Friday; shorter expiries (on intermediate and longer tenors) fell about 0.4-0.7bp/day, while intermediate expiries fell by 0.2-0.3bp/day. Short volatility positions have been profitable this past week (Exhibit 6). For the month, short expiry vols on intermediate tenors, and intermediate expiries on short to intermediate tenors was up 0.2-0.4bp/day,

Exhibit 5: Forward OIS rates remain below estimated term premium, implying that upside risks to the Fed’s projections of the future funds rate are significantly underpriced Forward 3M OIS rates at various forward horizons, minus estimated term premium*; bp

* Premised upon the fact that risks to the future path of short rates are predominantly one-sided (i.e., they can only go up), we estimate term premium as the cost of a caplet on each forward rate. For our purposes, we ignore the basis between OIS rates and Libor rates.

Exhibit 6: Short volatility positions underperformed this past week P/L* from short straddles in various options instruments since 3/23/12 and current levels of volatility; bp of notional**

* Returns calculated using the J.P. Morgan Volatility Index, which assumes daily delta rebalancing and zero transaction costs. Options are re-struck at the start of each month. ** Adjusted to a theta-neutral amount of 6Mx10Y swaptions.

-20

-15

-10

-5

0

9M 1Y

1Y3M

1Y6M

1Y9M 2Y

2Y3M

2Y6M

2Y9M 3Y

Return Return

Theta Adj** Gamma PL Vega PLCurrent

Implied VolCurrent

Realized Vol

6M2Y 6 61 -0.3 6.2 2.4 3.16M5Y 17 40 -2.4 19.4 4.5 5.66M10Y 33 33 1.6 31.4 5.8 5.96M30Y 74 34 3.5 70.9 5.8 5.7Front FV 16 31 -21.0 37.1 4.2 5.0Front TY 25 24 -14.2 39.1 5.6 5.7Front US 44 21 15.9 27.6 6.1 5.6



22

whereas longer tenors continued their underperformance, and were down around 0.3bp/day.

Going forward, our views remain unchanged this week–we continue to recommend short volatility exposure in shorter expiries. Our model for delta-hedged returns from short 3Mx10Y straddles currently projects about 45bp of total return (assuming a short duration swap overlay to hedge the inherent directional exposure of even delta-hedged vol positions), which is over twice the standard error of our model. We therefore believe the case for maintaining short gamma positions remains intact going forward.

One risk to our short gamma view is the upcoming Payrolls report, particularly since it occurs on Good Friday. The employment report has gained greater significance in recent months given the downward trend in the unemployment rate and its potential significance for monetary policy (albeit only on a forward basis). Given that context, on top of the lower liquidity that is likely to characterize the condensed trading session on a holiday, there is a possibility of large outsized moves occurring on the day.

We are certainly mindful of this risk. Since 1995, there have been four other instances when payrolls data were released on Good Friday; on average, the 1-day move in 10-year rates on these days has averaged 1.9 times the ex-ante implied volatility in the sector (Exhibit 7), although the average is somewhat skewed by the 1996

episode. Currently, this would suggest the potential for a 10- to 11bp move in the 10-year sector on Payrolls Friday. The gamma loss from such a 1-day move would be the equivalent of a 0.15bp/day move in implied vol in the 3Mx10Y sector; however, implieds have tended to decline by more than that amount in the aftermath, as was the case in the past three episodes (Exhibit 8); 1996

Exhibit 9: Implied volatility in the 3Yx10Y sector remains slightly cheap to fair value 3Yx10Y swaption implied volatility versus J.P.Morgan model estimate of fair value*; bp/day

* Model fair value based on 3-year regression of 3Yx10Y implied volatility versus 6Mx10Y implied volatility, 10Y inflation swap rate, the reported net convexity of the two GSEs, and the rolling 1-month ahead expected QE-related purchase of duration by the Fed, in $bn 10-year equivalents.

Exhibit 7: The Good Friday payrolls report could cause significant moves in yields Ratio of the absolute 1-day change in 10-year yields on a Good Friday payrolls report day, to the ex-ante implied volatility*;

* Dates used are 4/1/94, 4/5/96, 4/2/99, 4/6/07 and 4/2/10. Absolute changes are divided by the 1Mx10Y swaption implied volatility as of the day before Payrolls.

Exhibit 8: The tendency of implied volatility to decline in the aftermath of a Good Friday payrolls report is an offset to the risk of an outsized move 3Mx10Y implied volatility averaged around Good Friday payrolls reports*; bp/day

# business days around Good Friday Payrolls day * Dates used are 4/2/99, 4/6/07 and 4/2/2010. The 1994 experience was excluded due to non-availability of data. The 1996 episode was an exception, as noted in the text, and is not included in the average above. However, even here implied vol declined within the time window spanned in the chart above.

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

2010 2011 2012

swaption(3yx10y,calc=bpvol)Model

1.0

1.5

2.0

2.5

3.0

3.5

1994 1996 1999 2007 2010

Average

5.1

5.2

5.3

5.4

5.5

-5 0 5 10



23

was the exception, with 3Mx10Y implied volatility initially rising 0.3bp/day, but even there implied volatility declined sharply and quickly, finishing 0.25bp/day lower two weeks after the day of the employment report.

Thus, while we are mindful of the risk of an outsized move next week on Friday, we believe current valuations and the decline in implieds that will likely follow are an offset; therefore, we recommend maintaining short gamma exposure. Further out the expiry curve, in the intermediate expiry sector, 3Yx10Y implied volatility continues to look cheap relative to fair value, to the tune of about 0.2bp/day (Exhibit 9). Effectively, we recommend underweighting gamma both on an outright basis as well as versus longer expiry sectors.

Looking across tails, the relentless cheapening of 30-year tails versus 10-year tails finally appears to be coming to an end–6Mx30Y swaption implied volatility has remained stable relative to 6Mx10Y for little over a week. While it is hard to generalize based on the last week’s experience, we nonetheless believe that there are good reasons to expect 30-year tails to begin to reverse course.

A key driver of the cheapening of 30-year tails has likely been the supply of volatility on long tenors, mainly in the form of callable zero coupon bonds with long maturities. Thus, taking a view on the 10s/30s tail switch requires a view on expected supply of these callable zeroes. To that end, we modeled the observed supply of callable zero coupon bonds; our model is shown in Exhibit 10.

Three points are worth making in this regard. First, we project about $14bn of callable zero issuance over the next three months, which is similar to the pace observed over the past three months. Thus, the headwinds of supply are not likely to intensify further. Second, more tactically, there is some evidence that callable zero issuance in April tends to slow from the pace in March (Exhibit 11); if this proves correct going forward, supply technicals might turn favorable. Last, 30-year tails remain considerably cheap to 10-year tails (Exhibit 12), even after adjusting for the current pace of callable supply (Exhibit 13), which, as already noted, is not expected to intensify. Thus, we continue to see value in 30-year tails versus 10-year tails going forward, and recommend maintaining overweights in 6Mx30Y versus 6Mx10Y.

Exhibit 11: Historically, callable zero supply has tended to decline going into spring Deviation in monthly callable zero issuance over 10-year average (in $bn)

Months

Exhibit 10: Issuance of zero-coupon callable supply can be explained by curve, monthly redemptions and semi-peripheral spreads Statistics on regressing issuance of long-dated zero-coupon callable notes against the 3-month moving average of the 2s/30s swap curve, total monthly redemptions, and semi-peripheral spreads; 5-yr regression

* We use semi-peripheral spreads a barometer of European risk overall; this is because European supranationals have been the most active issuers in this space over past few years, and their issuance activity can vary with broader perceptions of European risk. Semi-peripheral spreads defined as average of 5Y CDS spreads of France, Spain and Italy.

Exhibit 12: Short-expiry 30-year tails are near their cheapest levels (relative to 10-year tails) in the past three years 6Mx30Y minus 6Mx10Y implied volatility spread model residual* (bp/day)

* Model residual based on 2-year regression of 6Mx30Y minus 6Mx10Y implied vol spread against 6Mx10Y swap yield and the 6M forward 10s30s yield curve.

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0

5

10

15

1 2 3 4 5 6 7 8 9 10 11 12

Factor (3-month moving avg) Coefficient T-stat ProjectedIntercept 1.4 0.92s/30s swap curve (%) 5.4 5.9 2.5Monthly redemptions ($bn) 1.6 4.0 5Semi-peripheral spreads (%) -2.3 -3.0 3.7R-squaredStd errorProjected (in $bn; over quarter) 14.3Current (in $bn; over quarter) 14.0

5.266%

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

2010 2011 2012

residualcurrent level



24

Trade recommendations • Position for wider 5-year swap spreads

Given the asymmetric exposure of spread wideners to yield levels and the upside risk to CDX.IG and FRA-OIS we recommend initiating old 5-year maturity matched swap spread wideners hedged with a duration short in Treasuries (9.7% risk weight).

− Pay in 0.875% of Feb 2017 spreads at a maturity matched swap spread of 23.5bp, and sell 9.7% of the risk in old 5s. (Buy $90.3mn notional of the 0.875% of Feb 2017, and pay in $98.5mn notional of a 02/28/2017 swap). Carry on this trade is 0.5bp over a 3-month horizon. Three month slide on the trade is -1.8bp.

• Buy 1Mx1Y payer swaptions

We recommend buying payer swaptions at the very front end of the curve to gain one-sided exposure to wider swap spreads.

− Buy $500mn notional of a 1Mx1Y payer swaption (notification 4/30/2012, maturity 5/2/2013, strike and ATMF 0.5%) @ a premium of 3.5bp of notional.

• Buy 3Mx5Y payer spreads

We recommend this trade as a limited risk way to position for a rise in 5-year yields as part of a broader renormalization in the yield curve, taking advantage of currently low yields, ATMF implied volatility levels as well as the steepness of the implied normal skew in the 5-year tail sector.

− Buy $100mn notional of a 1.45%/1.65% 3Mx5Y payer swaption spread (1:1 weighted, notification 6/29/2012, maturity 7/3/2017, ATMF 1.395%; buy the 1.45% strike and sell the 1.65% strike) @ a premium of 28.75bp of notional.

• Maintain 5-year swap spread wideners in a sell-off − Stay short 1,000 FVM2 121.25 puts (FVM2 @ 122-

03+, strike 121.25, expiry 5/25/2012) versus staying long $120.9mn notional of a 05/25/12x8/31/16 payer swaption (notification 05/25/12, swap start date 07/05/12, maturity 8/31/16, strike 1.3947%) (US Fixed Income Markets Weekly, 03/23/12). P/L since inception: loss of 0.5bp of yield.

• Continue to pay in 2.625% April 16 spreads versus receiving in 2.25% March 16 maturity matched swap spreads

− Stay long $100mn notional of 2-5/8% Apr 16s and continue to pay fixed in $103.2 notional of a 04/30/2016 swap; stay long $102.7mn notional of 2-1/4% Mar 16s and continue to receive fixed in $105.2mn notional of a 3/31/2016 swap (US Fixed Income Markets Weekly, 03/23/12). P/L since inception: profit of 0.1bp of yield.

• Maintain 3Yx1Y / 3Yx3Y steepeners hedged with

1Y and 5Yx2Y yields − Maintain 3Yx1Y/3Yx3Y swap curve steepeners

hedged with 20% risk weighted 3Mx1Y and 5Yx2Y swap yields (US Fixed Income Markets Weekly, 03/23/12). P/L since inception: loss of 2.2bp of yield.

• Stay short Greens versus FVM2 futures − Stay short 1000 Green packs (i.e., stay short 1000 each

of EDM4, EDU4, EDZ4 and EDH5), versus staying long 2079 FVM2 futures contracts (US Fixed Income Markets Weekly, 03/23/12). P/L since inception: loss of 3.1bp of yield.

• Maintain 3Y / 7Y steepeners hedged with weighted

2Y / Blues flatteners − Maintain 3Mx3Y/3Mx7Y swap curve steepeners

hedged with weighted 3Mx2Y/3Yx1Y curve flatteners (0.646/0.334 weights) (US Fixed Income Markets

Exhibit 13: Longer tenor callable supply is weighing on longer tenor options 1-month moving average of 6Mx30Y minus 6Mx10Y implied volatility spread model residual* versus quarterly zero coupon callable supply ($bn of redemption notional)

Zero coupon callable supply ($bn of redemption notional)

* See previous exhibit.

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

6 8 10 12 14 16 18 20

Y = -0.0362 X1 + 0.4336R² = 53.85%standard error = 0.1182period = Mar 30,11 - Mar 30,12



25

Weekly, 03/16/12). P/L since inception: loss of 3bp of yield.

• Stay long 3Mx5Y receiver spreads − Stay long $100mn notional of a 1.347%/1.13%

3Mx5Y receiver swaption spread (1:1 weighted, notification 06/18/2012, maturity 06/20/2017; stay long the 5Y spot 1.347% strike and stay short the 1.13% strike, ATMF at 1.464%) (US Fixed Income Markets Weekly, 03/16/12). P/L since inception: profit of 2.9bp of yield.

• Maintain EDM4 / EDU5 flatteners hedged with

EDH5 / EDM6 steepeners − Stay long 1000 EDU5 futures versus staying short

1000 EDM4 futures and also stay long 1000 EDH5 futures versus staying short EDM6 futures(US Fixed Income Markets Weekly, 03/16/12). P/L since inception: profit of 0.5bp of yield.

• Maintain 30-year swap spreads wideners − Continue to pay in 4.75% of Feb 2041 spreads (stay

long $100mn notional of the 4.75% of Feb 2041, and continue to pay fixed in $110.3mn notional of a 02/15/2041 swap). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 0.3bp of yield.

• Maintain 5-year swap spread wideners in a rally − Stay long 1,000 FVM2 123.25 calls (FVM2 @ 123-

04, strike 123.25, expiry 5/25/2012) and stay short $129mn notional of a 05/25/12x8/31/16 receiver swaption (notification 05/25/12, swap start date 07/05/12, maturity 8/31/16, strike 1.073%, ATMF 1.098%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 2bp of yield.

• Stay long 3Mx1Y payer spreads − Stay long $100mn notional of a 0.506%/0.756%

3Mx1Y payer swaption spread (1:1 weighted, notification 5/10/2012, maturity 5/14/2013, ATMF 0.506%; buy the ATMF strike and sell the A+.25 strike) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 1.7bp of yield.

• Maintain belly cheapening position on the 1-year

forward 2s/5s/10s swap butterfly − Continue to pay fixed in $100mn notional of a 1Yx5Y

forward starting swap (swap start date 02/14/2013, swap end date 02/14/2018, yield 1.513%), continue to

receive fixed in $138.3mn notional of a 1Yx2Y forward starting swap (swap start date 02/14/2013, swap end date 02/17/2015, yield 0.734%) and continue to receive fixed in $29.6mn notional of a 1Yx10Y forward starting swap (swap start date 02/14/2013, swap end date 02/14/2023, yield 2.354%) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 1.1bp of yield.

• Maintain conditional 2s/30s steepeners via 3-month

expiry options, versus selling 3-month expiry caps on the 2s/30s CMS curve

− Stay long $50mn notional 3Mx30Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2042, ATMF and strike 2.883%) versus staying short $500mn notional 3Mx2Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2014, ATMF and strike 0.5275%); also stay short $998.5mn notional of 3-month expiry 1-look caps on the 2s/30s CMS curve (end date 5/8/2012, ATMF CMS 10s/30s yield spread and strike at 239.7bp) (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: profit of 3.6bp of yield.

• Maintain 30-year matched maturity swap spread

wideners, hedged with 5-year swap spread wideners and the 5s/30s Treasury yield curve

− Stay long $50mn notional of 3.125% of Nov 2041s and pay fixed in $51.6mn notional of a 11/15/2041 swap; also, stay long $95mn notional of 0.875% of Jan 2017s and continue to pay fixed in $67.4mn notional of a 01/31/2017 swap (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: loss of 3bp of yield.

• Maintain synthetic conditional trade by selling

10s/30s YCSO caps versus 10Y receiver swaptions − Sell $500mn notional (i.e., $50K/bp forward DV01) of

single-look 6-month caps on the 10s/30s swap curve (end date 6/11/12, strike and ATMF 10s/30s CMS yield spread at 60.1bp) versus buying $21.3mn notional of 6Mx10Y receiver swaptions (notification date 06/11/12, maturity date 06/13/22, ATMF and strike 2.335) (US Fixed Income Markets Weekly, 12/09/11). P/L since inception: loss of 0.6bp of yield.

• Stay long 6Mx30Y versus 6Mx10Y swaption

straddles



26

− Stay long $43.7mn notional of 6Mx30Y swaption straddles (notification date 8/24/2012, maturity date 08/29/2042, ATMF and strike 2.849%) and stay short $100mn notional of 6Mx10Y swaption straddles (notification date 8/24/2012, maturity date 8/30/2022, ATMF and strike 2.220%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 7.4abp.

• Stay short 6M single-look CMS curve straddles on

the 2s/10s swap curve − Stay short $250mn notional of 6-month curve

straddles on the 2s/10s CMS curve (end date 09/06/2012, ATMF CMS 2s/10s yield spread and strike at 1.64%) (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: profit of 4.3abp.

• Stay long delta-hedged 3Mx2Y swaption straddles

layered with a duration long − Stay long $100mn notional of 3Mx2Y swaption

straddles (notification date 6/11/2012, maturity date 6/13/2014, ATMF and strike 0.620%) and continue to receive fixed in $28.6mn notional of a 3Mx2Y forward starting swap (swap start date 6/13/2012, swap end date 6/13/2014) (US Fixed Income Markets Weekly, 03/09/12). P/L since inception: loss of 0.9abp.

• Stay short delta-hedged 3Mx10Y swaption

straddles layered with a duration short − Stay short $100mn notional of 3Mx10Y swaption

straddles (notification date 6/11/2012, maturity date 6/13/2022, ATMF and strike 2.189%) versus paying fixed in $20mn notional of a 3Mx10Y forward starting swap (swap start date 6/13/2012, swap end date 6/13/2022) (US Fixed Income Markets Weekly, 03/02/12; upsized hedge 03/16/12). P/L since inception: loss of 5.3abp.

• Stay short 6Mx10Y straddles versus 5Yx5Y

straddles − Stay long $100mn notional of 5Yx5Y swaption

straddles (notification date 3/27/2017, maturity date 3/28/2022, ATMF and strike 3.405%) versus staying short $22.3mn notional of 6Mx10Y swaption straddles (notification date 9/26/2012, maturity date 9/26/2022, ATMF and strike 2.475%) (US Fixed Income Markets Weekly, 03/02/12; upsized hedge 03/23/12). P/L since inception: loss of 2.4abp.

Closed trades in 2012 P/L reported in bp of yield for swap spread, yield curve and miscellaneous trades, and in annualized bp of volatility for option trades, unless otherwise specified

Trade Entry Exit P/LSwap spreads10-year swp sprd widener 01/06/12 1/20 (1.8)Front end swap spread wideners via options 01/06/12 2/3 (4.4)Pay Aug 20 vs Feb 20 sprds (hedged) 01/20/12 2/3 1.7Rec in 10Y swp sprds (hedged) 02/24/12 3/16 2.5Pay 3.25 Jun16 vs rec 3.25 Jul16 swp sprds 03/02/12 3/16 0.9Yield curve Entry Exit P/L5s/10s swp sprd crv steepeners 11/04/11 2/3 (3.5)3m fwd 1s/15s crv flatteners via rec swptns 01/06/12 2/3 (16.1)Buy belly of EDZ2/EDZ3/EDZ4 bfly 01/20/12 3/2 (9.9)Buy wtd WN calendar sprd PL in 32nds 02/10/12 3/2 1.9Rec in belly of 3M fwd wtd 5/10/30s swap bfly 01/20/12 3/16 2.7Sell belly of EDU3/7Y/25Y bfly via options 03/02/12 3/23 4.7Reds/10Y steepeners vs 2Y/Blues flatteners 03/09/12 3/23 6.0Options relative value Entry Exit P/LSell 10s/30s YCSO vs 6Mx2Y swptn strddls 10/28/11 1/27 18.2Buy 6Mx5Y vs 9Mx5Y swptn strddls 01/20/12 2/10 (0.6)


Praveen KorapatyAC (1-212) 834-3092 Renee Park (1-212) 834-7218 J.P. Morgan Securities LLC

27

Agencies

• Stay overweight 10-year Agencies versus Treasuries and underweight front-end Agencies versus Treasuries

• Forward spreads are cheap to fair value and offer attractive carry, along with similar risk—we recommend adding exposure to 3-year forward 2-year Agency asset swap spreads, by overweighting 5-year Agencies versus an equal-notional amount of 3-year Agencies on a swap-spread switch basis

Market views Over the past week, the performance of Agencies was mixed versus both Treasuries and swaps. On the spread curve versus Treasuries, 2- and 10-year Agencies richened by 2.5bp and 0.5bp, respectively, while 5-year Agencies cheapened by 2.5bp. On the spread curve versus swaps, the performance of Agencies was similarly mixed with 2- and 10-year Agencies richening by 1.5bp and 0.5bp, respectively, whereas 5-year Agencies cheapened by 2bp. Looking ahead, we continue to hold our overweight 10-year position on still-attractive valuations. We also remain underweight front-end Agencies versus Treasuries. Over the past few months, 2-year Agencies have not broken out of their tight range versus Treasuries (Exhibit 1) and continue to appear about 5bp too rich versus our estimates of fair value on both a spread to Treasuries and spread to swaps basis (Exhibit 2). For those investors seeking shorter spread duration exposure in this asset class, given the current rich valuations of front-end Agencies, we recommend looking at forward spread exposure as an alternative. For instance, investors should consider a 3-year forward 2-year Agency asset swap in lieu of spot 2-year Agency asset swap exposure for a couple of reasons. First, at about -18bp, spot spreads versus swaps appear rich according to our fair value estimates; by contrast, the 3-year forward 2-year Agency asset swap, which has similar spread duration, appears about 12bp cheap relative to our estimates of fair value (Exhibit 3). Next,

while forward spreads are typically more volatile, as can be seen in Exhibit 4, the 2-year standard deviations of both the spot 2-year and the 3-year forward 2-year rate are roughly comparable. Further, tail behavior both in terms of maximum historical price gains and losses, as well as percentiles appear similar, with the forward spread appearing to trade in a tighter range. All of this

Exhibit 1: In recent months, 2-year Agencies have traded in a tight range, near the richer end of our valuations 2-year hot-run Agencies z-spread to Treasuries (bp)

Exhibit 2: J.P. Morgan Agency spread fair value table J.P. Morgan Agency spread target levels* versus Treasuries and swaps, and current spreads relative to targets (bp), as of 3/30/12

* Based on the J.P. Morgan model of 5-year Agency spreads versus Treasuries, which are modeled as (22.95 * the 18-month forward, 1-month OIS rate minus the 6-month forward, 1-month OIS rate) + (-0.23 * estimated 3-month change in Agency debt foreign holdings based on central bank custody holdings) + (0.14 * FNMA, FHLMC bullet debt outstanding) + (-5.42 * 4s/5s/6s Treasury butterfly spread to 4s/5s/6s swaps butterfly) + (0.07 * 1-week moving average of 1-year ahead budget surplus expectations) + (11.39 * logarithm of average of 5-year CDS spreads of BNP Paribas, Société Générale, and Crédit Agricole (over average pre-crisis levels)) - 16.16.

0

5

10

15

20

25

30

35

Jun 11 Sep 11 Dec 11 Mar 12

Mat./ Curve vs. Tsy vs.

swaps vs. Tsy vs. swaps vs. Tsy vs.

swaps2y 10 -14 5 -18 5 53y 14 -12 11 -11 3 05y 23 -5 20 -3 3 -210y 35 28 43 33 -8 -420y 39 49 51 61 -12 -12

2s/3s 3 2 6 7 -3 -52s/5s 13 9 15 16 -3 -73s/5s 9 7 9 9 0 -2

3s/10s 22 40 32 44 -10 -410s/20s 4 20 8 29 -4 -8

CurrentTargets Proj. - Curr.



28

suggests that forward spreads, in addition to being cheap to our estimates of fair value, are an attractive way to gain shorter spread duration exposure. There is however, a significant difference between the two risk exposures. For instance, 2-year Agency asset swap spreads over the last two years have richened when the European crisis has escalated, whereas 3-year forward 2-year asset swap spreads have widened during these episodes (Exhibit 5). Why have forward spreads widened in these episodes? One way to think about forward spread exposure is as a levered exposure to Agency spread curve flatteners versus swaps, which steepen during recurrences of the European crisis, and as a short exposure to FRA-OIS, which also tends to widen during a crisis (Exhibit 6). In an escalation of the European crisis, there is a marginal offset from the FRA-OIS exposure, but it is not sufficient to overcome the steepening in the Agency asset swap spread curve. By contrast, spot 2-year Agency spreads to swaps have a much greater short exposure to FRA-OIS, and richen during periods when the European crisis escalates. Looking ahead, while our European strategists are cautious, they do not expect a significant escalation of the European crisis in the very near-term. Further, even in the event of an escalation similar to that seen this past fall, the maximum widening of forward spreads from

Exhibit 5: Spot Agency asset swap spreads richened during the European crisis while forward spreads widened Spot 2-year Agency spreads versus swaps (bp) versus 3-year forward, 2-year Agency spreads versus swaps (bp); European crisis periods are circled

Exhibit 3: The 3-year forward, 2-year Agency spread appears about 12bp cheap relative to our estimates of fair value… 2-year Agency asset swap spreads* at spot, 1-year forward, 2-years forward, and 3-years forward (bp) versus J.P. Morgan fair value estimates** of 2-year Agency asset swap spreads (bp)

* 2-year forward spreads calculated using par spreads, while spot refers to the hot-run spread. ** See footnote of Exhibit 2 for model details.

Exhibit 4: …and offers similar levels of maximum downside risk as the spot 2-year Agency asset swap spread Characteristics of 2-year Agency spreads on asset swap (bp), 2-year Agency spreads versus Treasuries (bp), and 3-year forward, 2-year Agency spreads on asset swap (bp)

* Price gains and losses are in bp of yield, and are calculated over a 1-year history as deviations of spreads from current levels, given nearly identical spread durations.

Exhibit 6: The 3-year forward, 2-year Agency asset swap spread has levered exposure to the 3s/5s Agency spread curve versus swaps and widening exposure to FRA-OIS Regression statistics of the daily change in 3-year forward, 2-year Agency asset swap spreads (bp) regressed against the daily change in the 3s/5s Agency spread curve versus swaps (bp), and the daily change in FRA-OIS (bp); regression over 1 year, as of 3/30/12

-40-30-20-10

01020304050

Mar 10 Sep 10 Mar 11 Sep 11 Mar 12

2-year Agencies versus swaps (bp)3-year forward, 2-year Agencies versus swaps (bp)

-20

-10

0

10

20

Spot 1Y fwd 2Y fwd 3Y fwd

2Y

2Y FV

2Y Agy vs. swaps

2Y Agy vs. Tsy

3Y fwd 2Y Agy vs. swaps

Current -18.3 6.2 17.1Fair value est. -14 10 52Y standard dev iation 7.2 5.0 7.62M standard dev iation 2.3 1.0 3.3Max historical gain* 19.4 2.9 15.3Max historical loss* 14.4 25.4 10.95th percentile gain 12.1 1.1 8.45th percentile loss 11.8 15.1 7.23M carry + slide 4.1 2.1 2.6

Variable Coefficient T-statIntercept 0.001 0.02Daily chg in 3s/5s Agencies versus swaps (bp) 2.0 38.2Daily chg in FRA-OIS (bp) -0.2 -5.7

R-squared 85%



29

current levels was about 11bp. Given our outlook and overall risk characteristics, comparable carry on forward spreads, and attractive valuation make it relatively more attractive to spot exposure. Investors can effectively gain this forward spread exposure by going long 5-year Agencies, and short an equal notional of 3-year Agencies, both on an asset swap basis (see Trade recommendations). Trade recommendations • Initiate equal notionals of long 5-year Agencies and

short 3-year Agencies on an asset swap basis Current tight spreads in the front end of the Agency curve versus swaps make them unattractive on valuations. Forward spreads are more attractively valued with similar spread duration and largely comparable volatility.

− Initiate overweight on $25mn FHLMC 1.25% May-17s against matched-maturity asset swap @ -0.6bp spread; Initiate underweight on $25mn FHLMC 0.5% Apr-15s against matched-maturity asset swap @ -11.4bp spread. (One-month carry = -0.1bp).

• Hold underweight on front-end Agencies versus Treasuries Current tight spreads in the front end of the Agency curve versus Treasuries provide limited room for further tightening. Thus, we recommend holding an underweight on front-end Agencies versus Treasuries.

− Stay underweight $25mn FHLMC 0.375% Nov-13s against $24.9mn T 0.25% Nov-13s @ 4.5bp spread. (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -5.1bp.

• Hold overweight on 10-year Agencies versus Treasuries Cheap valuations keep us constructive on 10-year Agency spreads versus Treasuries in the near term, and we continue hold this overweight.

− Stay overweight $50mn FHLMC 2.375% Jan-22s against $49.3mn T 2% Nov-21s @ 41.5bp spread. (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: 7.0bp.

• Hold 3s/10s Agency spread curve flatteners versus Treasuries The 3s/10s Agency spread curve versus Treasuries appears too steep relative to our fair value targets. Thus, we recommend holding 3s/10s Agency spread curve flatteners versus Treasuries.

− Stay underweight on $50mn FHLMC 0.625% Dec-14s against $50.9mn T 0.25% Dec-14s @ 11bp spread; Stay overweight on $16.3mn FHLMC 2.375% Jan-22s against $16.1mn T 2% Nov-21s @ 41.5bp spread. (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: 1.4bp.

• Stay overweight short-dated callables compared to lockout- and maturity-matched bullets In the current low rate environment, we favor overweighting short-dated callables compared to lockout- and maturity-matched bullets as an attractive carry trade. Thus, we recommend staying overweight short-dated callables versus lockout- and maturity-matched bullets.

− Hold overweight on $100mn 5nc2 (1x) callables maturing Jan-17 @ 1.322% coupon. (US Fixed Income Markets Weekly, 1/6/12). P/L since inception: -3.1bp of notional.

− Hold overweight on $100mn 5nc6m (1x) callables maturing Dec-16 @ 1.372% coupon. (US Fixed Income Markets Weekly, 12/5/11). P/L since inception: 5.1bp of notional.

− Hold overweight on $100mn 2nc1 (1x) callables maturing Aug-13 @ 0.431% coupon versus $100mn FNMA 0.5% Aug-13s. (US Fixed Income Markets Weekly, 8/12/11). P/L since inception: 0.8bp of notional.

• Hold switches between select pairs of Agency bonds

versus maturity-matched Treasuries Several switches allow investors to shorten up duration exposure with some yield pick-up. We recommend switching out of select longer-maturity rich Agency bonds into select shorter-maturity cheap Agency bonds on a spread-to-Treasuries basis.

− Hold overweight on $10.7mn FNMA 5.375% Jun-17s against $11.4mn T 2.5% Jun-17s @ 21bp spread; Hold underweight on $10mn FHLMC 5.125% Nov-17s against $10.7mn T 2.25% Nov-17s @ 15bp spread. (US Fixed Income Markets Weekly, 3/16/12). P/L since inception: -4.2bp.


Matthew JozoffAC (1-212) 834-3121 Brian Ye (1-212) 834-3128 Nicholas Maciunas (1-212) 834-5671 Jonathan J. Smith (1-212) 834-2605 J.P. Morgan Securities LLC

30

MBS

• Our investor survey shows money managers remain heavily overweight MBS, limiting their potential for further significant purchases

Summary

• Meanwhile, mortgage price action reflects QE3 implied probability falling to roughly 20%

• The biggest source of MBS sponsorship going forward is likely to be REITs

• Typically REIT purchases have coincided with equity raises, which have generally occurred when price / book ratios are over par

• Based on changes in REIT equity prices and mortgage performance we estimate that REIT equity issuance could reach $5 billion in 2Q, possibly resulting in $20-30bn of MBS purchases

• We examine valuations on the soon-to-be traded 125+LTV pools; HARP collateral exhibits exceptional prepay convexity leading to intrinsic value that is potentially points over TBA

• However, 125+LTV pools are not TBA or REMIC eligible, and sponsorship may primarily come from money managers and REITs; thus, our fair value estimate on 125+LTV 30-year 4s is between ½ point and 1 point over TBA

• Be neutral overall, but shorten spread duration

Views

• Remain underweight super-premiums (5.5s and above)

• Own lower payup seasoned 5s; be cautious of call protection stories such as LLBs in a sell-off, where investors may not be assigning long enough durations

• Continue to be underweight Ginnies versus conventionals owing to fundamental richness and the potential for event risk around the LCR

Despite the rally that brought interest rates back towards their recent range, mortgages moved sideways this past week relative to swaps and Treasuries. Fundamental

value on most coupons is fair, with Libor OAS levels in the 5-15bp range across the stack, close to historical averages. As we discussed in our latest publication, hedge-adjusted carry has deteriorated for most coupons, having currently fallen to several ticks per month, down 3-5 ticks from levels witnessed at the start of the year. We believe that these valuations do not justify a significant overweight position in light of several considerations. First, from a technical perspective, many investors are already overweight the sector, so there is assumedly limited room for significant further purchases from private investors; we discuss later the outlook for REITs in particular. Second, event risk looms over the mortgage market, both in terms of QE3 uncertainty and policy changes with respect to refinancings.

Technicals overall remain solid, driven by roughly negative $50bn of net issuance this year; but, it is questionable how much money managers will add to existing positions. As shown in Exhibit 1, money managers are still significantly overweight the mortgage basis, dollar-weighted (near the highs since we began the survey). In aggregate, it is conceivable another $50bn or so this year in purchases, but a repeat of a surge as seen in 2010 is unlikely, as money managers jumped in to take advantage of new rounds of QE. We estimate that these purchases in aggregate were as large as $300-500bn.

The possibility of QE3 has also helped attract sponsorship to the mortgage market. Investors have recently asked what probability of QE3 is priced into the market. In Exhibit 2, we highlight one estimate, based on the amount of spread directionality observed in mortgage

Exhibit 1: Mortgage overweights remain high Results of the J.P. Morgan investor survey in March, dollar-weighted

Source: J.P. Morgan

0%10%20%30%40%50%60%70%80%90%

100%

Jul-0

9Se

p-09

Oct-0

9De

c-09

Feb-

10M

ar-1

0M

ay-…

Jun-

10Au

g-10

Oct-1

0No

v-10

Jan -

11Fe

b-11

Mar

-11

Apr-1

1Ju

n-11

Jul-1

1Au

g-11

Sep-

11No

v-11

Dec-

11Ja

n-12

Feb-

12M

ar-1

2

Underweight: 11%

Overweight:62%

Neutral: 26%



31

performance compared to the directionality witnessed around the announcement of Operation Twist. In theory, as investors expect a greater chance of QE3 happening, rates should rally and mortgages tighten, as the expectation is that mortgages would be a central instrument used by the Fed. During Operation Twist, every 10bp decline in rates corresponded to a 4-5 tick outperformance of mortgages, net of hedges. A month ago, each 10bp translated into as much as 2-3 ticks of excess return, equivalent to a 60-70% chance of QE3 being priced into the market. But recently, the probability implied by mortgage prices has fallen to around 20%, in line with our own estimates (admittedly there is a lag in our calculation because it is done on 1-week changes observed over a trailing 1-month window). We believe QE3 would be difficult to transmit efficiently into primary mortgage rates owing to the widening in primary / secondary spreads. Nevertheless, the uncertainty around QE3 makes a large basis trade difficult to justify.

Policy unknowns continue to plague the sector. Along those lines, we asked investors what they thought the next “shoe to drop” would be. Responses were evenly split across ideas such as increasing cross-servicer refis, clarifying rep / warrant risk, or even no announcement (Exhibit 3). We believe that we are almost certain to get more policy announcements / clarifications over the months ahead, as policymakers struggle to improve the efficiency of refinancings in a historically low interest rate environment. HARP 2.0 is primarily a same-servicer policy; it is possible that, in order to refinance BoA’s servicing book, the administration could push for more cross-servicer refis. This way the efficiencies of the fastest servicers (e.g., Chase, Wells) could be extended to the slower ones. Achieving this efficiency is not as easy, however, owing to information asymmetry and rep / warrant concerns about refinancing other servicers’ books (despite existing assurances from the GSEs). Consequently, it is possible that some combination of (cross-servicer with rep/warrant clarification) could occur, although the impact on speeds should be marginal.

We made an “other” category available in our survey for write-ins. While few investors dared to dig into their imagination, the administration did bring up the issue of principal forgiveness for GSE loans this past week. From a mortgage investor’s perspective, we do not think this is a major consideration: if forgiveness were done on only seriously delinquent loans, then the impact would be zero, since these loans would have already been bought

out of MBS pools. If done on current loans that were severely underwater, the impact overall would still be low, given that only 2-3% of GSE loans are above 125 LTV (we discuss valuation of this sector later), although higher coupons such as 6s have more exposure (10-15%).

Outlook for REITs: Price / Book ratio will drive equity issuance and MBS buying With the decline of the GSE portfolios in the past several years, REITs have emerged as one of the main sources of levered mortgage buying in the market. REITs bought $101 billion of MBS last year, based on $14.7 billion of equity raises. Assuming leverage of 6x, future equity

Exhibit 3: Gauging event risk: investors are split over the next “shoe to drop” in refi policy Results of the J.P. Morgan investor survey for March: percentage of investors who expect each of the following changes to refi policy in the months ahead

Source: J.P. Morgan

Exhibit 2: Mortgage investors’ expectations of QE3 are falling Ratio of directionality of mortgage performance vs. weekly 5-year Treasury moves, relative to the directionality observed around Operation Twist

Source: J.P. Morgan

31%34% 34%

1%0%

5%

10%

15%

20%

25%

30%

35%

40%

No Announcement

Cross-servicer refi

Rep/warrant risk Other

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Jan 12 Feb 12 Mar 12



32

raises will be key to predict REITs’ buying. In the analysis below we find that REIT equity issuance is mainly confined to periods when REITs’ price / book ratio is over one. Based on our estimate of changes in price / book ratios of selected REITs, we expect roughly $3-5bn in equity raises this coming quarter, translating into as much as $15-30bn of MBS purchases. If rates were to sell-off, we do not expect REITs to sell MBS; indeed, REITs have weathered many sell-off scenarios in the past, while assets continued to rise. The biggest threat to REITs’ MBS holdings is most likely their repo funding, which appears to be solidly intact. Equity raises have been highly correlated to REIT MBS purchases historically; thus, predicting the volume of REIT equity issuance is a good methodology to predict REIT MBS buying. Exhibit 4 shows the dollar amount of quarterly mortgage REIT equity raises versus their price / book ratio covering 2001–2011. REITs have typically performed equity raises when the price / book ratio is over 100%, and have issued very little when their equity was trading at a discount to book. Note that we have used equity issuance during the same quarter versus their price / book ratio; the exact timing of their decision to issue equity is uncertain given the nature of quarterly data. (While the size of the market has changed over the past decade, this same pattern holds when viewed as a percentage of REITs who issued equity versus their price / book ratio.)

What does this imply about REITs’ willingness to issue equity in the upcoming quarter? To address this, we began with year-end price / book ratios for major REITs (the latest data available), then estimated the current ratios based on changes in equity prices (dividend-adjusted) and in the mortgage / Treasury spread. Specifically, we estimate that mortgages have tightened about 9bp versus Treasuries over the past quarter. Assuming a spread duration of three years and 6x

Exhibit 4: REITs have typically issued equity when the price / book ratio is over par Amount of equity raised over 2001-2011 by mortgage REITs as a function of the price / book ratio at the time

Source: J.P. Morgan, SNL

Exhibit 5: Estimating current price / book ratios for major mortgage REITs Actual price / book ratios for 4Q11 (dotted) and estimated current ratio (solid) for selected mortgage REITs, based on 3-month changes in equity price and mortgage spreads; circles scaled to the size of MBS holdings by REIT

Source: J.P. Morgan

0123456789

10

60-70 70-80 80-90 90-100 100-110110-120120-130 130+

Amt E

quity

Rais

ed ($

bn)

Price/Book

85 87 89 91 93 95 97 99 101 103 105 107 109 111Price/Book

American Capital

Annaly

Anworth

ARMOUR

CYS

Capstead

Hatteras

InvescoMFA

Two Harbors



33

leverage on average, this implies that book values have increased by about $1.50 (9bp * 3 years = 27cents, or $1.50 given 6x leverage). Current coupon yields have been fairly steady on net over the quarter.2

Combining numerator and denominator movements, Exhibit 5 shows the change in price / book ratio for selected REITs, where the bubble size is scaled to the size of the agency MBS portfolio. Certain REITs have increased significantly in price / book ratio (such as Invesco) owing to a rally in their equity price. Others have become more discounted. To estimate what this means for future equity issuance, we calculated that roughly 22% more REITs (asset-weighted) were above par on a price / book ratio basis relative to 4Q11. Given that REITs issued $4bn in the fourth quarter, we expect roughly $5bn in issuance for the upcoming quarter, which could translate into as much as $30bn of mortgage purchases potentially. Finally, while there has been concern about REIT selling of MBS in the event of a sell-off, we find that unlikely. As shown in Exhibit 6, REITs’ assets have grown monotonically over the past couple of decades, despite sharp sell-off scenarios (e.g., 1994, 1998, 2003 and 2008). We would instead expect REITs to adjust their dividend to reflect market pressures. The one scenario where we would expect REITs to sell would be if their repo funding were eliminated. However, even in the crisis of 2008, REITs still managed to grow assets (at least in agency MBS), so we do not find this to be a major threat for the sector. Estimating the fair value of 125+ high LTV HARP collateral The roll-out of HARP 2.0 was essentially complete two weeks ago after the GSEs implemented DU/LP updates. The final milestone is June 1, when 125+LTV HARP loans can be pooled and sold to MBS investors. Fannie will begin pooling 30-year 125+LTV loans under the CR prefix (U9 for Freddie). Until then, the GSEs are providing whole loan cash execution. Fannie is pricing them flat to TBA and Freddie is at ½ point back. As we

2 Note that this methodology holds mainly for agency MBS REITs; the analysis could be expanded for Non-Agency REITs based on the movements in Non-Agency prices, even though we estimate that it would produce similar results in 1Q, assuming Non-Agencies appreciated around 6% with around 2x leverage.

Exhibit 7: HARP pools offer nearly unrivaled near-term call protection Prepay speeds (3-month) observed on high LTV 100% refi (HARP) and LLB (85,000 max loan size) 2010 vintage FNMA 4.5% pools, observed since January 2011

Source: J.P. Morgan Exhibit 8: Extrapolating from recent prepay data, model intrinsic values for high LTV MHA/HARP collateral are points above TBA Select valuation metrics for high LTV 4% FNMA 30-year HARP pools in the base case, up 100bp and up 200bp scenarios

Source: J.P. Morgan

Exhibit 6: REITs’ assets have continued to grow, even through sharp sell-offs Total REIT holdings of agency securities ($bn), 1990-present

Source: J.P. Morgan, SNL

0

1

2

3

4

5

6

7

8

9

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12

3mo

CPR

LLB80-90 LTV90-95 LTV95-100 LTV105-125 LTV

FN 4.0 LTV Price OAD Cvx OAS 3yr CPR LT CPR ZV Sprd OptCostTBA 105.0 3.2 -2.7 10 23.9 22.7 90 8190 108.2 5.9 -0.5 10 3.4 12.7 68 58

115 109.4 6.6 0.1 10 3.5 10.8 54 45150 110.2 6.7 0.2 10 4.4 9.7 44 34TBA 100.4 5.4 -1.4 10 6.4 8.0 57 4790 101.4 6.8 -0.3 10 2.6 6.2 43 33

115 102.0 7.0 0.1 10 3.0 6.2 37 27150 102.7 7.0 0.3 10 4.0 6.6 31 21TBA 94.5 6.6 -0.3 10 4.8 5.6 30 2090 94.3 7.3 0.1 10 2.3 4.8 24 15

115 94.8 7.3 0.3 10 2.7 5.0 22 13150 95.5 7.1 0.5 10 3.9 5.6 20 10

Up 100

Up 200

Base

-

50

100

150

200

250

300

1990 1993 1996 1999 2002 2005 2008 2011

Agy M

BS H

olding

s ($b

n)



34

head into the typical 2-month cycle of rate lock, closing and pooling, originators have begun contemplating secondary execution. We discuss the dynamics around their pricing.

High LTV (80+) HARP collateral exhibits exceptional call protection and unrivaled near-term stability in prepay convexity (Exhibit 7). HARP (a.k.a. MHA) pools have been created with various LTV tiers since early 2010. Based on the 2010 vintage 4.5 coupon, they have paid almost uniformly slower than even the LLBs (85,000 max loan size), and are of course substantially slower than generic collateral. Given the paucity of empirical data, we are naturally somewhat cautious about the collateral’s long-term prepay characteristics. Nonetheless, it is reasonable to note the following trends: 1) the higher the LTV, lower the voluntary speeds; 2) the higher the LTV, higher the involuntary prepayments; 3) beyond 90%, there should be little difference in refi speeds by LTV tiering over the medium term; and, 4) long-term prepay convexity should depend on the path and the pace of home price recovery.

We have modeled the cashflows of 100% refi, high LTV (MHA/HARP) collateral based on the aforementioned characteristics. With equal OAS pricing to TBA, the full theoretical value of a 4% coupon 125+LTV pool come to about 5 points above TBA. In the same framework, 105-125LTV (CQ/U6 prefix) pools come in at over 4 points payup to TBA and 90LTVs are worth 3.5 points over TBA. Even though there is little near-term base case speed differentials between 90+LTV and 125+ LTV pools, long-term differences should emerge due to both voluntary and involuntary speeds differentials. Generally, 125+LTV collateral should pay relatively faster, because of deep discounts due to higher delinquencies. Plus, the higher LTVs provide better long-term call protection over a wide variety of interest rate and home price scenarios. Thus, the higher the LTV, the lower the option cost; this is reflected in their model payups (Exhibit 8).

Notwithstanding the greater uncertainties associated with their long-term intrinsic value, unique demand dynamics will dictate pricing. The 125+LTV CR collateral will face substantial demand headwinds because they are neither TBA nor REMIC (i.e., CMO) eligible. In contrast, 80-105LTV HARP collateral are both TBA and REMIC eligible. The 105-125 Fannie CQ pools are not TBA eligible, but are REMIC eligible. The IRS mandate

dictates that REMIC (i.e., CMO) eligibility begins at a maximum of 125% LTV.

The lack of REMIC eligibility is a major drawback. For instance, despite not being TBA eligible, payups on 105-125LTV CQ pools have matched or exceeded those of TBA eligible 90+LTV HARP pools, largely thanks to CMO demand. Almost 80% of all CQ collateral went

Exhibit 10: The Fed has bought $157bn MBS so far… Fed MBS net purchases from October 3, 2011 to March 28, 2012 ($mn)

Source: Federal Reserve

Exhibit 9: 125+ LTV HARP pools should trade at substantial payups to TBA An estimation of payups on 125+LTV 4% 30-year HARP pools versus TBA

Source: J.P. Morgan

Exhibit 11: …and $7bn MBS this past week. Fed MBS purchases from March 22, 2012, to March 28, 2012

Source: Federal Reserve

Cumulativ e Net Purchases ($MM)Maturity Coupon FHLMC FNMA GNMA GNMA2 Total30 Year 3.0 1000 1000

3.5 25,150 44,150 5,250 11,950 86,500 4.0 17,250 29,100 1,850 5,500 53,700

42,400 74,250 7,100 17,450 141,200 15 Year 2.5 1250 1,250

3.0 4,700 6,150 10,850 3.5 1,700 2,350 4,050

6,400 9,750 16,150 48,800 84,000 7,100 17,450 157,350

Estimation of 125+ LTV HARP Pool Payups vs TBAModel intrinsic payup to TBA (points) 5.2105-125 CQ pool actual/model ratio 31%125+ CR payup if CMO eligible (1/32) 51Deduction for lack of CMO demand (1/32) 16 - 32Imputed fair value payup (1/32) 19 - 35

Week ending 3-28-2012 ($MM)Maturity Coupon Settlement FHLMC FNMA GNMA GNMA2 Total30 Year 3.0 May 100 100

3.5 Apr 1,100 2,050 3,150 3.5 May 350 950 1,300 4.0 Apr 650 1,200 1,850

Gross 30yr 1,750 3,350 350 950 6,400 15 Year 2.5 May 50 250

3.0 May 200 350 350 Gross 15yr 200 400 600

Net Total 1,950 3,750 350 950 7,000



35

into CMO deals. This compares to about 20% for 80-105LTV TBA eligible collateral.

Given their superior prepay profiles, REITs may become sponsors of 125+LTV pools. Contrary to popular belief, over 125LTV collateral can be purchased by mortgage REITs. Qualifying for the REIT tax status involves several asset tests. The most well known is the 55% whole pool or whole loan test. Less well known is the 75% qualifying income test, i.e., 75% of REIT income has to derive from qualifying real estate assets. MBS are generally qualifying assets. However, in the case when LTV exceeds 100%, only the pro-rata share of the income up to 100% LTV is deemed to qualify. For example, out of a $100 income from a 150LTV MBS, only $100x100/150=$66.7 is qualifying. The 75% ratio is an all-or-none threshold. In other words, once satisfied, all income qualifies for tax-free distribution. For instance, once a REIT generates 75% of its income from < 100%LTV mortgages, the other 25% can come from assets regardless of LTV. Practically, with the vast majority of income derived from loans and securities having <100 LTV, REITs should be able to purchase 100+LTV MBS.

We expect 125+LTV FNMA CR pools to trade at a substantial discount to intrinsic value, owing to several factors: 1) specific pools typically trade at a fraction of intrinsic value; 2) non-deliverability sets back fair value due to liquidity and sponsorship concessions; 3) lacking REMIC status, 125+LTV pools are further disadvantaged from a demand perspective. To estimate “fair value”, different from intrinsic value, we start with CQ (105-125 LTV) paper. FNMA 4% CQ pools are not TBA eligible, but they benefit from strong CMO sponsorship. They are currently priced at 44 ticks payup or about one-third of intrinsic value. Applying the same discount, CR pool could fetch 50 ticks payup if CMO eligible. In our view, the lack of CMO sponsorship should set back their pricing by ½ to 1 point, leading to fair value payups ranging between ½ to 1 point (Exhibit 9). Given the uncertainties around demand/supply and sponsorship, 125+LTV pools may well start at further concessions to the imputed fair value.

Week in review • The Fed net purchased $7bn of agency MBS from

March 15 through March 21. $1.95bn were in Freddies (+$150w/w), $3.75bn were in Fannies (-

$150mn) and $1.30bn were in Ginnies (unchanged). Since the program’s inception (October 3, 2011), the Fed has purchased $48.8bn in Freddies, $84.0bn in Fannies and $24.6bn in Ginnies.

• MBA Weekly Survey: For the week ending March 23, 2012, the purchase application index increased 3.3% to 190.6 and the refinance index decreased 4.6% to 3,438.6 (seasonally adjusted).

• Freddie Mac’s portfolio declined $14.7bn (2.3%) to $627.8bn in February. Holdings of Freddie Mac MBS declined $6.2bn (2.9%) to $206.1bn, holdings of non-Freddie Mac MBS declined $1.3bn (4.0%) to $31.0bn, holdings of Non-Agency MBS declined $1.6bn (1.2%) to $139.8bn, and mortgage loan holdings declined 5.5bn (2.1%) to $250.9bn.

• Freddie Primary Survey: For the Monday-Wednesday period prior to March 29, 2012, 30-year conventional conforming fixed-rate mortgages averaged 3.99% (average of 0.7 fees & points for the week), down 9bp from the previous week.

• Primary dealer MBS positions decreased $5.12bn (w/w) to $67.2bn for the week ending March 21, 2012.

• Fixed-rate agency gross and net issuances were $107bn and -$8bn, respectively, in February. Gross issuance MTD in March has been $133.0bn, including jumbos, 40-years and IOs.

• Fails charges totaled $199.1bn for the week ending March 21, 2012, a $12.3bn increase week-over-week.


John SimAC (1-212) 834-3124 Abhishek Mistry (1-212) 834-4662 Asif Sheikh (1-212) 834-5338 Kaustub Samant (1-212) 834-5444 J.P. Morgan Securities LLC

36

Non-agency RMBS and Home Price Commentary

• The non-agency market is likely to continue to grind tighter according to nearly 70% of surveyed investors

• We generally agree, but we expect any tightening from current levels to be gradual. While assets are shifting into stronger, real-money hands from fast-money accounts, many investors are using this period of strength to lock in gains and prune portfolios. Moreover, it has become increasingly difficult to find double digit loss-adjusted yields

• Option ARMs outperformed other non-agency asset classes. However, at this point we think pricing has improved to a point where longer-term distressed money investors may be less interested. Roughly, POA loss-adjusted yields are in the 7-8% context

• Price return is less likely to be a driver of returns going forward, hence we are not fans of locked-out cashflows. Stick to cashflowing bonds as our bias for fixed-rate paper holds

• Roughly 70% of investors think principal reductions related to the AG settlement will be skewed towards bank portfolio loans

• Our new servicer reports highlight the variation in advancing and resolution of delinquent loans

Market Commentary Market activity remains vibrant with solid price performance in the first quarter. Investors believe that the non-agency market is more likely to continue to grind tighter rather than widen (Exhibit 1). We can certainly buy into gradual spread tightening (less than 50bp) from current levels. One of our traders put it best, “Whereas fast money demand was prevalent from 2009-2011, we’ve seen the re-emergence of the real money bid at the end of 2011 and into 2012”. This is largely viewed as permanently removing float from the market. We’ve been talking about the asset shift from fast money to real money accounts for some time now. Real money generally has a lower yield hurdle than fast money. Also,

it was pointed out to us that FINRA trace data shows that customer buys outpaced sells in March, whereas customer sells marginally outpaced buys in January and February. Regardless, pricing should trend sideways to gradually tighter from here as many investors are using this period of strength to lock-in gains and prune their portfolios. It has become increasing difficult to find double digit loss-adjusted yields in the non-agency space.

Option ARMs have performed the best, year-to-date (Exhibit 2). As our readers may recall, this was the sector that we felt would benefit the most as an overall recovery trade. However, at this point we think pricing has improved to a point where longer-term distressed money investors may be less interested. Roughly, loss-adjusted yields are in the 7-8% context. We would rather own 5-7% fixed-rate paper for a few reasons. The buyer base is stronger, providing a buffer against any downside retracement. Additionally, there is greater cashflow stability given that such a large portion of the expected return comes from P&I. Price return is less likely to be a driver of returns going forward unless fundamental assumptions improve. Consequently, we are not fans of locked-out cashflows (e.g. last cashflow subprime paper).

Home prices hit new lows in January, but declines moderated

The Case/Shiller 20-city composite was down 0.8% (non-seasonally adjusted), compared to 1.1% in December. The January print is a new index low and is 3.8% lower than January 2011. Negative monthly growth was reported in 16 of the 20 major metros.

Exhibit 1: Bulls on Parade? Non-agency investor sentiment is strong Survey: Where do you think non-agency yields will be in six months?

Source: J.P. Morgan

3%

67%

30%

0%0%

10%

20%

30%

40%

50%

60%

70%

>100bps tigher 0-100bps tigher 0-100bps wider >100bps wider



37

Nationally, the Case/Shiller index was down 1.5% in January, compared to 1.4% in the month prior. We generally think that we are at or are very near the bottom in home prices at a national level. The risk to this view is if existing home sales decline even more from their already depressed levels. We are less concerned about immediate supply pressures as several government initiatives continue to chip away at the shadow inventory (see our publication from 3/9/2012).

New servicer reports highlight the variation in advancing and resolution of delinquent loans

This month we introduce a set of new servicer reports in our MBS Credit Monthly publication, breaking out advancing, modification policies, short sales, timelines, and lender rolls. Exhibits 4 and 5 show a snapshot breakout for subprime and option ARMs from February remits.

In each report we are showing the largest servicers sorted by the delinquent balance they are servicing. We grouped servicers that have merged or sold servicing; however, we caution that these are still based on original servicer and do not take into account servicing transfers such as J.P. Morgan’s sale of third party originated subprime servicing to Ocwen. This information is hard to track down.

As we have noted before, advancing percentages vary dramatically by servicer. Chase and Wells had the most subprime advancing, with more than 75% of delinquent loans being advanced on, while Ocwen advanced on fewer than 40%.

In resolving delinquent loans, Bank of America has done the fewest modifications (25% of outstanding subprime balance modified), while American Home has done the most (52% of outstanding balance). Very few of these have been principal reductions, although Ocwen reduced balance on at least 4% of outstanding loans, with an average forgiveness amount of $57,000.

Chase has been particularly active in short sales, with short sales making up 82% of last month’s liquidations, and had the fastest timeline of liquidations last month, averaging 21 months delinquent at the time of liquidation. Bank of America was particularly slow, with 29 months of delinquency at liquidation. Looking forward, Chase loans in REO and in foreclosure have been 34 and 28 months delinquent on average,

respectively, which implies considerable timeline extension that will eventually be realized, even with a high share of short sales (i.e. expect severities to rise despite stabilizing home prices).

Option ARMs saw far more principal forbearance/reduction activity, especially relative to rate reductions. Bank of America and Chase forgave or forbore principal on 5-7% of securitized option ARMs, roughly half of their modifications on these deals. The average reduction was over $100,000.

We expect to roll out further breakouts of modification and liquidation activity, including trends and recent activity, in our monthly publication next week.

Exhibit 2: Q1 results are in: option ARMs outperform other non-agency asset classes 2007 originations

Source: J.P. Morgan

Exhibit 3: Roughly 70% of investors think principal reductions related to the AG settlement will be skewed towards bank portfolio loans Survey: To fulfill AG settlement obligations, servicers will forgive principal…

Source: J.P. Morgan

Sector 2010 Return 2011 Return 2012 Return YTDPrime Fixed 29% 1% 3%Prime Hybrid 21% -3% 6%Alt-A Fixed 34% 1% 5%

Alt-A Hybrid PT 15% -1% 5%Alt-A Hybrid Floater 27% -4% 7%

Option ARM 20% -2% 10%Subprime LCF 23% -19% 7%

22%

48%

21%

8%

0%5%

10%15%20%25%30%35%40%45%50%

Only in portfolio Mostly in portfolio

Mostly in securitizations

Only in securitizations



38

Exhibit 4: Subprime servicing report

Exhibit 5: Option ARM servicing report

Note: Advancing on option ARMs based on post-recast borrowers Source: J.P. Morgan, Loan Performance

DLQ Loans Modifications % Short 60+ Loans in FC Loans in REO Recent Liquidations Lender Rolls CDR SevServicer Bal ($bn) % Adv % of Bal % Rate Rate Drop % Prin Prin Red Sale Mos DQ Mos DQ in FC Mos DQ in FC in REO Mos DQ in FC in REO 90->FC FC->REO 1M 1M

1 BoA (BoA/Countrywide/HLS/Greenpoint) 40.2 45% 25% 18% 3.42 2% 49,128 49% 14.9 32.2 12.6 35.6 11.8 6.0 29.2 11.8 7.5 6.5% 4.2% 13.3 82.9

2 Chase (Chase/WaMu/EMC) 19.3 75% 42% 36% 3.80 2% 53,704 82% 8.0 27.6 14.1 34.0 10.2 9.4 21.2 12.9 10.5 9.1% 1.6% 8.2 80.4

3 Ocwen (Ocwen/Saxon/HomeEq/Novastar) 16.0 36% 47% 39% 4.14 4% 57,709 23% 6.6 22.2 11.5 30.5 8.6 10.0 23.5 9.9 9.8 7.8% 2.6% 7.8 77.8

4 American Home/Option One 12.7 48% 52% 39% 4.20 1% 72,811 44% 6.0 22.6 13.2 28.8 9.6 8.3 22.5 11.2 9.4 9.6% 2.5% 7.8 72.8

5 Goldman (Litton/Fremont/Avelo) 10.4 16% 47% 41% 3.80 5% 56,202 46% 10.7 25.2 9.6 33.3 9.4 10.6 23.0 12.7 11.8 13.5% 2.0% 6.8 78.1

6 Wells Fargo 9.4 76% 42% 37% 3.11 0% 49,617 36% 7.5 24.4 12.8 30.8 9.6 7.8 24.2 10.3 9.1 8.0% 3.4% 6.8 77.9

7 Wilshire 5.7 16% 26% 22% 3.81 4% 49,931 62% 14.2 32.9 15.6 35.1 14.4 5.8 23.9 13.7 7.7 3.4% 5.1% 13.8 72.8

8 Ameriquest 5.5 44% 39% 33% 4.38 1% 62,574 37% 5.5 22.6 13.4 29.6 11.7 7.7 25.7 12.0 8.0 10.9% 2.6% 7.2 79.7

9 PNC (National City) 4.6 51% 41% 36% 3.40 2% 49,998 52% 8.9 24.2 11.0 28.8 10.0 6.3 21.8 9.1 9.0 8.3% 4.2% 9.5 70.2

10 New Century 3.2 34% 62% 55% 2.47 1% 51,802 37% 7.3 24.3 12.3 30.5 9.9 8.6 27.8 10.8 11.4 10.4% 2.7% 10.9 71.4

11 Nationstar/Aurora 2.8 43% 53% 36% 3.95 1% 59,591 39% 6.3 23.0 12.4 27.5 9.2 8.1 17.0 8.9 9.2 6.5% 2.8% 7.8 78.8

12 HomeComings 1.6 64% 48% 42% 3.03 0% 53,904 60% 4.4 23.1 16.2 26.8 12.4 6.2 16.6 12.3 7.2 8.6% 2.1% 8.7 76.5

13 Select Portfolio 1.5 62% 47% 39% 3.27 11% 52,996 53% 5.6 20.7 9.1 25.9 7.5 5.4 16.9 10.1 5.3 9.4% 4.1% 11.7 83.8

14 Equity One 1.2 9% 27% 24% 4.10 7% 46,013 50% 8.5 23.9 8.7 35.7 9.4 11.9 23.8 12.2 12.3 14.3% 2.4% 4.9 80.1

15 OneWest (IndyMac) 1.0 66% 32% 21% 3.73 2% 67,486 58% 5.6 29.2 20.4 33.8 13.0 9.9 14.8 13.9 7.7 7.7% 1.4% 10.6 85.1

16 MLN 0.9 97% 34% 30% 2.72 0% 24,246 32% 5.7 29.7 25.3 35.6 19.6 6.5 24.4 20.2 4.9 5.3% 2.2% 11.4 83.7

17 Long Beach 0.7 73% 37% 32% 3.66 1% 59,053 86% 8.9 25.4 10.9 31.2 6.5 10.9 21.3 9.1 9.7 10.5% 1.3% 6.3 69.0

18 Ally (GMAC ResCap) 0.7 41% 51% 47% 3.06 2% 27,584 68% 6.4 23.9 11.2 30.3 8.4 8.7 12.0 10.4 9.8 3.9% 2.1% 11.3 90.8

19 Americas Servicing Company 0.7 75% 37% 30% 3.07 1% 34,958 34% 6.8 26.2 13.8 31.2 9.2 8.0 23.9 11.6 8.2 8.8% 3.2% 5.9 75.5

20 Accredited 0.6 61% 34% 33% 3.07 4% 49,856 44% 5.8 20.4 9.8 26.0 9.3 4.9 19.6 9.3 6.5 8.7% 3.8% 6.1 73.1

21 Centex 0.6 19% 55% 32% 4.10 0% 27,704 29% 4.1 19.3 11.6 25.0 10.0 6.4 19.9 13.1 6.1 5.0% 3.5% 4.6 78.0

22 Fieldstone 0.4 13% 52% 45% 3.49 2% 54,495 38% 9.2 20.5 6.1 31.3 7.2 8.7 23.8 10.0 5.5 15.0% 3.3% 7.6 73.7

23 People's Choice 0.4 14% 36% 32% 4.13 4% 46,375 45% 15.0 30.4 12.6 40.1 8.8 15.8 26.2 16.8 9.3 13.1% 2.4% 8.6 81.0

24 Popular 0.3 10% 35% 31% 4.48 9% 57,322 51% 9.8 21.9 6.9 33.1 9.6 8.6 23.0 9.2 7.0 12.9% 2.0% 4.5 83.3

25 Chec 0.3 0% 64% 26% 4.24 0% 0 9% 4.3 19.9 12.7 23.7 10.7 5.7 20.7 8.7 6.9 7.0% 3.2% 8.2 84.5

26 Provident 0.2 15% 26% 22% 3.65 2% 28,599 57% 6.9 20.2 5.9 31.8 5.8 10.7 19.9 8.7 11.3 15.3% 1.8% 3.1 79.9

27 Aames 0.2 38% 49% 46% 3.42 0% 55,471 58% 8.8 25.9 13.1 32.7 6.9 10.9 20.0 10.6 15.1 10.2% 3.5% 9.1 76.0

28 Fairbanks 0.2 57% 32% 24% 3.35 10% 47,401 44% 5.1 19.7 9.2 26.1 5.5 7.2 19.7 11.9 5.8 6.6% 5.0% 5.8 88.3

29 WMC 0.1 71% 52% 46% 3.89 2% 46,054 76% 7.9 29.0 12.1 37.2 12.4 10.6 18.6 4.7 9.5 7.9% 1.7% 9.1 69.0

30 Aegis 0.1 11% 62% 50% 3.77 2% 24,266 1% 5.2 14.6 6.5 31.7 9.3 8.8 21.6 5.9 10.3 7.5% 2.9% 8.8 83.7

DLQ Loans Modifications % Short 60+ Loans in FC Loans in REO Recent Liquidations Lender Rolls CDR SevServicer Bal ($bn) % Adv % of Bal % Rate Rate Drop % Prin Prin Red Sale Mos DQ Mos DQ in FC Mos DQ in FC in REO Mos DQ in FC in REO 90->FC FC->REO 1M 1M

1 BoA (BoA/Countrywide/HLS/Greenpoint) 29.6 81% 12% 10% 1.57 7% 101,765 46% 19.2 31.4 13.2 35.6 11.8 6.1 30.8 10.9 7.0 9.1% 4.5% 17.8 67.1

2 Chase (Chase/WaMu/EMC) 15.0 73% 15% 13% 2.46 5% 107,050 71% 11.5 25.9 13.6 30.9 10.0 8.0 22.8 10.4 7.3 13.6% 2.2% 12.5 57.8

3 American Home/Option One 4.5 55% 19% 16% 2.32 6% 71,674 45% 6.5 23.9 15.4 27.0 10.8 7.3 23.1 10.6 8.5 11.3% 2.9% 13.4 64.1

4 OneWest (IndyMac) 3.9 87% 16% 14% 1.98 22% 109,643 47% 6.9 26.6 17.4 29.7 9.1 9.6 22.5 10.3 7.4 11.6% 1.5% 9.3 62.7

5 Ally (GMAC ResCap) 2.1 71% 33% 28% 3.01 8% 113,431 54% 8.0 22.9 13.7 25.9 8.6 7.3 18.8 8.9 6.5 16.6% 2.6% 9.8 61.9

6 HomeComings 1.2 70% 12% 8% 1.01 0% 8,459 55% 10.8 22.4 11.9 27.9 5.9 8.5 21.7 7.8 4.8 12.2% 1.2% 5.8 62.2

7 Nationstar/Aurora 0.9 83% 16% 13% 3.46 23% 95,503 62% 10.9 22.9 11.4 27.0 6.4 9.0 21.6 9.6 11.4 13.3% 2.3% 9.5 62.3

8 Downey 0.7 58% 32% 27% 2.49 15% 133,156 27% 7.2 15.0 8.0 23.7 7.6 7.6 22.5 7.5 10.7 12.0% 6.7% 14.0 57.8

9 Goldman (Litton/Fremont/Avelo) 0.3 16% 15% 14% 3.97 39% 132,560 76% 11.7 20.0 6.2 24.6 6.7 6.8 16.2 6.6 9.3 15.2% 2.0% 14.8 32.5

10 Central Mortgage 0.2 71% 19% 17% 4.14 0% 130,016 59% 5.7 16.9 10.8 23.3 10.0 5.8 18.3 8.9 8.1 11.5% 4.5% 17.8 55.9

11 Wilshire 0.1 15% 24% 23% 4.29 4% 116,823 69% 5.7 15.5 8.6 23.2 8.3 5.7 18.0 7.0 6.5 13.6% 6.1% 10.6 43.3

12 Ocwen (Ocwen/Saxon/HomeEq/Novastar) 0.1 39% 22% 20% 1.78 14% 102,150 43% 10.2 24.2 12.9 32.1 7.4 11.9 26.9 9.9 8.3 3.8% 0.8% 19.4 63.7

13 Cenlar 0.1 96% 12% 10% 1.38 0% 0 100% 9.4 24.6 16.1 30.8 10.3 7.9 34.0 30.0 0.0 9.5% 4.1% 2.6 71.2

14 Alliance 0.1 94% 41% 33% 1.98 15% 89,324 100% 11.1 25.8 15.4 33.7 11.3 6.4 15.0 6.0 0.0 6.3% 0.0% 3.7 36.0

15 Mortgage It 0.0 73% 30% 27% 1.81 0% 0 100% 7.3 23.0 11.4 24.8 5.7 8.5 11.5 8.0 0.0 11.8% 3.8% 6.0 61.5


Edward J. ReardonAC (1-212) 270-0317 Meghan C. Kelleher (1-212) 270-2017 Joshua D. Younger (1-212) 270-1323 J.P. Morgan Securities LLC

39

CMBS

• Flows were light going into quarter-end; CMBS ended the week unchanged to modestly wider across the capital structure, with benchmark A4s at S+215; 5-year new issue super-seniors outperformed the 10-year class

• 1Q supply was the lightest since mid-2010; we look for issuance to accelerate to $9bn in 2Q following the rally in primary market spreads; we are on track to meet our forecast of $35bn in gross supply for the year

• Even though new issue has rallied, the credit curve remains quite steep; super-seniors and the AS class are trading rich to legacy; add single-As and select BBBs, which should rally 50-75bp

• Agency CMBS constitutes roughly 70% of recent issuance; our top picks for yield are GNR IOs and Freddie K-Program Cs

• Synthetics have largely decoupled from cash bonds and other risky assets; add long-risk positions in CMBX.3 and 4 AJs with duration-matched shorts in CDX.HY; select REIT CDS are still cheap to CMBX.1.AAAs

• This week, Best Buy announced their plans to close 50 big-box stores; due to typical co-tenancy agreements, properties co-anchored by a Bed, Bath & Beyond with Best Buy leases expiring this year are more at risk; the impact on securitized loans should be minimal

• Over the past couple of years, the balance of performing and non-performing matured loans has increased significantly; we examine the characteristics of these loans, and identify deals with the heaviest exposure

Markets were soft through mid-Thursday on heightened macro risk, but rallied into the end of the week on better-than-expected domestic consumer data (spending and confidence) as well as greater clarity out of Europe. CMBS widened marginally at the top of the capital structure in sympathy with other risky assets, but ended the week with spreads roughly unchanged to modestly wider, with benchmark legacy A4s at S+215. In new

Exhibit 2: Issuance should accelerate following the slowest pace of quarterly supply since mid-2010 Gross supply of domestic private-label CMBS ($bn); grey indicates forecast

Note: Forecast from J.P. Morgan CMBS Research Source: J.P. Morgan, Commercial Mortgage Alert

Exhibit 1: CMBS Spread Summary

Source: J.P. Morgan, PricingDirect

$0

$2

$4

$6

$8

$10

12Q2F11Q411Q210Q410Q209Q409Q208Q408Q2

1 WK 1 MTH YTD

5yr TW AAA 195 0 -5 -507yr AAA A-SB 220 0 0 -3010yr 30% AAA 215 0 -15 -6010yr Mezz AAA 485 10 10 -7010yr Junior AAA 1575 0 -25 -225

AA 41 0 0 0A 30 0 0 0BBB 9 0 0 0BBB- 9 0 0 0

New Issue CMBS (Swap):5yr Super-Senior AAA 80 -10 -25 -4010yr Super-Senior AAA 95 0 -10 -30AA 225 0 -125 -175A 350 10 -50 -150BBB 495 10 -80 -120

Agency CMBS:Freddie K A1 46 -1 -12 -17Freddie K A2 72 0 -2 -13Freddie K B 260 -6 -105 -215FNMA DUS 10/9.5 75 0 0 -22GNMA Project Loan (3.5yr) 60 0 -15 -20*Freddie K spread data as of Thursday COB

ThisWeek

Change

Legacy (to Swaps):

Price-Based:



40

issue, 5-year super-seniors outperformed, tightening 10bp to S+80 while the 10-year class traded flat at S+95; credit bonds were unchanged to modestly wider with AAs, single-As, and BBBs closing Friday at S+225 (unchanged), S+350 (+10bp), and S+485 (+10bp), respectively.

Private label issuance was relatively quiet this week, with only one small private-label deal in the market. This brings total 1Q supply to $5.3bn, the vast majority of which priced in March (the lightest quarterly supply since mid-2010; Exhibit 2). Although the year is off to a relatively slow start, the rally in new issue spreads has led to a surge in origination; in fact, we have heard anecdotally that, rather than being something of a lender of last resort, conduits have started to drive loan pricing in some markets. As a result, we expect issuance to accelerate to $9bn in 2Q, with as much as $5bn hitting the market in April alone. This puts us roughly on track for our $35bn 2012 issuance forecast. Though spreads are tighter across the capital structure, it is important to note that the new issue credit curve is nearly as steep as it was last fall (Exhibit 3). The AS class in particular is now trading around S+150, which is more than 100bp tighter than where they began the year—an opportunity we admittedly missed when these bonds were pricing at S+320 last summer. At current levels, however, new issue AAAs—particularly the AS class—look rich to legacy on a risk-adjusted basis (Exhibit 4), and thus have limited upside. As a result, the most likely way forward is a flattening of the credit curve; add single-As and select BBBs, which should rally by an additional 50-75bp over the next couple of months. We also continue to see opportunities in new issue agency CMBS. While this segment of the market is sometimes overlooked by investors, it constitutes roughly 60% of post-crisis (i.e., 2009 onwards) issuance (Exhibit 5). In fact, the $12bn of structured agency CMBS deals that have priced since January account for 70% of total 1Q supply. With the recent surge in issuance, this sector is outpacing our full-year forecast of $35bn—roughly 50% of total expected CMBS issuance. Our top picks for mid-single digit yield opportunities within agency CMBS are GNR IOs as well as Freddie K-Program Cs; meanwhile, wrapped Freddie A1s and A2s offer roughly 40bp of spread pick-up to comparable-duration agency

Exhibit 4: Junior AAAs off of new issue are trading rich to legacy on a risk-adjusted basis Spread to swaps (bp)

Note: Assumes 5% losses for new issue Source: J.P. Morgan, Markit Partners

Exhibit 3: Though spreads have rallied, the new issue credit curve remains nearly as steep as it was last fall Spread to swaps (bp)

Source: J.P. Morgan

Exhibit 5: The GSEs account more than half of all post-crisis CMBS supply % of face value at issuance ($bn)

Note: Agency excludes individual DUS pools and MEGAs Source: J.P. Morgan, Commercial Mortgage Alert

50

100

150

200

250

300

10% 15% 20% 25% 30% 35% 40%

2005

2006

2007

Loss-Adjusted Credit Support (Base Case)

New Issue AS

New Issue A4

0

100

200

300

400

500

600

700

800

AS AA A BBB

2011 Tights (May 2011)Current (March 2012)2011 Wides (Oct 2011)

0%10%20%30%40%50%60%70%80%90%

100%

00 01 02 03 04 05 06 07 08 09 10 11 YTD

Agency Private Label



41

debentures with strong call protection (lockout followed by defeasance). In legacy space, synthetics remain largely decoupled from both cash bonds and other risky assets. In fact, the degree of correlation between at-the-money tranches of the CMBX and equities has collapsed since January, and is now at multi-year lows (even negative by some measures; Exhibit 6). We believe recent price action is primarily due to two factors:

1) Synthetics, particularly down in credit and the later series, outperformed last fall as liquidity in the cash space deteriorated. Thus, with the index already trading rather rich to start the year, prices had limited upside as credit and equity markets rallied.

2) As trading in seasoned credit has picked up, many investors have preferred this sector for expressing a macro view due to the relative simplicity of analysis (deep credit dives are more feasible for individual deals than the index), as well as better carry.

As a result, synthetics have lagged both cash and other risky assets over the past couple of months. The question then becomes when (and how) this trend reverses. We can think of two (non-mutually exclusive) catalysts: either cash prices catch up to synthetics, or secondary supply of seasoned credit bonds dries up. While we do not anticipate this will occur over the near term, in the meantime investors should position themselves to profit from a realignment of the CMBX and broader credit markets. In particular, CMBX.3 and 4 AJs have underperformed high yield since January, and at this point the basis between the two has retraced virtually the entire rally from late last year (Exhibit 7). Add long-risk positions in CMBX.3 or 4 AJs at a mid-clean price of $65.47 and $63.90 (as of Thursday’s close, and an implied par spread 1,073bp and 982bp), respectively, with duration-matched shorts in 5-year CDX.HY at a par spread of 577bp. This position has cheapened 200-250bp since last December, and while we do not expect a full retracement to levels seen last March, we believe it can rally 300bp in a “risk-on” trade. Further up the capital structure, synthetic AAAs are trading more in line with other risky assets. However, we do see relative value opportunities in particular sectors of

Exhibit 7: CMBX.AJs have underperformed synthetic high-yield credit since the beginning of the year Difference in implied par CDS spread (bp)

Note: CDX.HY is 5-year Risk n’ Roll index from JPM Credit Research Source: J.P. Morgan, Markit Partners Exhibit 8: Select REIT CDS are still cheap to AAA1s Difference in implied par CDS spread (bp)

Note: CDX.IG is 5-year Risk n’ Roll index from JPM Credit Research Source: J.P. Morgan, Markit Partners

Exhibit 6: Synthetics have largely decoupled from other risky assets Two-month correlation coefficient of two-week percent price changes

Source: J.P. Morgan, Markit Partners

-200

0

200

400

600

800

Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12

CMBX.3.AJ - CDX.HYCMBX.4.AJ - CDX.HY

-100

-50

0

50

100

150

200

Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12

CDX.IG 5yr - CMBX.1.AAAWDC.AU - CMBX.1.AAAPLD - CMBX.1.AAA

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12

CMBX.4.AJ vs S&P500CMBX.2.AA vs S&P500



42

corporate credit. In particular, we would maintain long-risk positions in select retail and industrial REIT CDS (e.g., WDC.AU and PLD at par spreads of 199bp and 175bp when we first recommended the trade on February 10) paired with duration-matched, short-risk exposure to CMBX.1.AAAs (at a spread of 120 as of February 10; Exhibit 8). Going forward, our REIT credit analysts expect the sector more broadly, and these names in particular, to outperform (see Mark Streeter’s REIT commentary in the most recent “High Grade Sector Snapshot,” March 26, 2012); at the same time, even though the CMBX.1.AAA is trading cheap to its cash constituents, we expect them to trade sideways due to a combination of high dollar price (which makes it an appealing hedge) and a wide bid/ask (which discourages long-risk investors). This position has returned roughly 20bp of profit since we first recommended it in early February, and we anticipate approximately 20-25bp of additional upside, which translates in to a 20% total return including three months of carry at 165bp, and assuming 0.75 points of bid/ask, 3 points up-front on the CMBX.1.AAAs, and 6 points of combined initial margin on the position. On the collateral performance front, Best Buy announced this week their intention to close 50 big-box stores this year (or roughly 4.5% of the total) in an attempt to cut $800mn in costs. We see this as part of a larger trend in which national retail changes are seeking to cut costs by reducing floor space and moving to smaller format stores. Best Buy specifically is the seventh largest tenant in conduit transactions, with a floor space-weighted exposure of approximately $1.3bn (comparable to Macy’s, Walmart, and Home Depot; Exhibit 9). It also tends to be an important tenant: of the roughly 250 outstanding conduit loans for which the company is a top-3 lessee, Best Buy occupies a median of roughly 25% of the available floor space (inter-quartile range 13-100%), including 70 loans for which it is the sole tenant. Although a list has not been disclosed, we believe Best Buy will focus on underperforming stores in less populated areas. At the same time, since the company has not declared bankruptcy, and thus barring some specific termination option will be responsible for all outstanding leases, we also expect that they may also prefer to close those with upcoming lease expiries in an attempt to achieve their target through roll-off (which is achievable considering the relatively small number of closings).

Although the data on lease terms are incomplete, we estimate that relatively few Best Buy leases supporting securitized loans will expire this year, with all but a handful scheduled to roll in 2014-18. Those properties that are most at risk are those which are co-anchored by a Bed, Bed & Beyond, which more commonly had co-tenancy agreements that allowed other tenants to terminate their lease early if one or both of these anchors left or went dark. It is, however, important to note that of those securitized loans with both retailers among the three largest tenants, none have a Best Buy lease expiring before 2013 and thus are unlikely to be targeted for closure. That said, lease-level data is often incomplete and/or stale, and investors should seek more updated

Exhibit 9: Best Buy is the seventh largest overall tenant in conduit CMBS Floor space-weighted exposure in fixed-rate conduit deals ($bn)

*The T.J. Maxx companies, which also include Marshall’s and HomeGoods. Source: J.P. Morgan, Trepp

Exhibit 10: Recent economic and CRE data most impact our bullish scenario Index level (1Q05 = 100)

Source: J.P. Morgan

$0

$1

$2

$3

$4

Wall

-gr

eens

JC P

enny

Sear

s

TJX*

Kohls

Mac

y's

Best

Buy

WalM

art

Hom

e De

pot

K-M

art

60

70

80

90

100

110

120

05 06 07 08 09 10 11 12 13 14 15 16 17

BullishBaseBearishVery bearish



43

information if their bonds have significant exposure, particularly if Bed, Bath & Beyond is a co-anchor. Revising our model forecasts This week, we introduce revised model forecasts and loss estimates for conduit CMBS, which incorporate the most recent commercial property data, as well as updated remits and minor revisions to our loss severity model. Our base case expectation for property prices are qualitatively unchanged (Exhibit 10): we look for a cyclical bottom in valuations this year, with minimal nominal gains through 2014. Our bullish case, on the other hand, has improved considerably on better-than-expected economic data, while our bearish and very bearish scenarios show quicker price declines in the event of a double-dip recession. The net impact on losses is relatively modest, but we do see some compression of the vintage curve in the base case, with average deal-level 2007-vintage losses declining roughly 1% to 11.2% by securitized balance as the 2006 vintage rises a little over 30bp to 8.0% (Exhibit 11). Characteristics of performing matured and non-performing matured loans As loans have struggled to refinance in a tight credit environment, the balance of loans transitioning into performing and non-performing matured status has increased significantly. Loans are labeled as performing or non-performing matured when they are unable to make their balloon payments at maturity, and either continue to make monthly payments (performing matured) or stop making monthly payments (non-performing matured). Since performing and non-performing matured loans are past their scheduled maturity dates, they create a level of uncertainty in bond cash flows, given the timing of ultimate payment and method of resolution (full payment, liquidation, or even modification) becomes unclear. Front pay AAA bonds, which almost exclusively trade at a premium, can be particularly affected by heavy concentrations of these loans. Failure to pay off at maturity gives bondholders a free extension option, although looming payments in any given month can affect total return, especially if extension assumptions have already been incorporated into investment decisions. This week, we discuss characteristics of

performing and non-performing matured loans, and identify deals with heaviest exposure. Historically, more than 3,400 loans with a total securitized balance of $35.1bn have been performing or non-performing matured. The universe of these loans started to grow substantially in 2009, as the first wave of 5-year loans from 2004 reached their scheduled maturity dates and could not refinance amidst frozen lending markets; through 2009, the balance of performing and non-performing matured loans increased by nearly five times, from $677mn to $3.2bn (Exhibit 12). As the

Exhibit 12: The balance of performing and non-performing matured loans continues to increase Balance of performing matured and non-performing matured loans (LHS, $bn) and the 6-month trailing average of new additions to performing matured and non-performing matured (RHS, $bn)

Source: J.P. Morgan, Trepp

Exhibit 11: Our loss expectations are lower for the 2007 vintage, but higher for more seasoned deals Average pool-level cumulative loss (% of securitized balance) by deal vintage


$0.0

$0.5

$1.0

$1.5

$2.0

$-

$2

$4

$6

$8

$10

Jun-

08Se

p-08

Dec-

08M

ar-0

9Ju

n-09

Sep-

09De

c-09

Mar

-10

Jun-

10Se

p-10

Dec-

10M

ar-1

1Ju

n -11

Sep-

11De

c-11

Mar

-12

Non-Performing Matured (LHS)Performing Matured (LHS)6-month Trailing Avg. New Additions (RHS)

3.6%2.3%

2.8%

4.7%

8.0%

11.2%

0%

2%

4%

6%

8%

10%

12%

14%

2002 2003 2004 2005 2006 2007

Updated

As of 2/12



44

balance of maturing 5-year loans picked up substantially since 2010, the size of the performing and non-performing matured universe has more than doubled, and currently totals $7.2bn as of the March remittance period. Though a recovery in the commercial real estate market has slowly taken hold, new additions to the performing and non-performing matured universe continue to increase. In fact, 2H11 saw the steepest pace of increase in the balance of these loans, a statistic that reflects the combination of aggressively underwritten, 2006-vintage 5-year loans coming due amidst a challenging macroeconomic environment that once again substantially slowed conduit lending operations. In 2012, the peak of the 5-year loan “refi wall,” we expect the balance of performing and non-performing matured loans to continue to increase, given the impending maturity schedule of 2007-vintage 5-year loans. That said, steadily improving market conditions, bolstered by a recovery in the domestic economy, should help to both slow new additions and move existing loans through the pipeline. As we have alluded, 5-year loans have historically comprised an outsized portion of this universe; 57% by balance of performing and non-performing matured loans have been 5-year loans, far outpacing their 12% share of total issuance volume. This reflects both the total volume of peak of the market originations and the aggressively underwritten nature of 5-year loans originated at this time. No real trend exists by property type however, as the property type distribution of these loans is roughly proportional to that of total conduit issuance volume. Currently, 537 loans with a total current balance of $7.2bn are performing or non-performing matured. Consistent with the historical trend, non-performing matured loans comprise the majority of this balance at $6.1bn, or 85%. Nearly 40% of these loans are from the 2006 vintage given recent 5-year loan maturity dates in 2011, even though the volume of loans from the 2007-vintage is growing as they begin to come due in 2012; since January, the balance of performing and non-performing matured loans originated in 2007 has increased from $283mn to $1.5bn. About 70% of loans that are currently performing matured or non-performing matured have reported full-year cash flows as of December 2010 or later. Among these loans, most still report DSCRs above 1.0x (Exhibit

13), at 76% and 85% of non-performing matured loans and performing matured loans, respectively. We caution, however, that these cash flow data may still be stale, as most of these loans first became performing or non-performing matured within the past six months. The data, however, support the fact that most loans transition into performing and non-performing matured from a “Current” delinquency status (Exhibit 14). Of loans that have historically been performing matured or non-performing matured, $17.6bn, or 50%, have been

Exhibit 14: Performing loans most often transition into performing matured and non-performing matured Distribution of prior delinquency status for all transitions into performing matured and non-performing matured status, % by balance

*Note: Loan can be represented more than once Source: J.P. Morgan, Trepp

Exhibit 13: Most performing matured and non-performing matured loans still report DSCRs above 1.0x Distribution of DSCR NCF for the current universe of performing matured and non-performing matured loans reporting FY cash flows as of at least December 2010, % by balance


0%10%20%30%40%50%60%70%80%90%

100%

C 30 60 90+ FC/REO

Non-Performing MaturedPerforming Matured

0%

5%

10%

15%

20%

25%

30%

35%

40%

<0.5x 0.5-0.74x 0.75-0.99x 1.0-1.24x 1.25-1.49x >=1.5x

Non-Performing MaturedPerforming Matured



45

retired or liquidated. More than 70% of this total were retired or liquidated from performing or non-performing matured status (i.e., the loan did not transition to another status before repayment). Overall, loans resolved from non-performing matured status are slightly more likely to be liquidated (54% liquidated versus 46% retired), while performing matured loans are considerably more likely to be retired (77% retired versus 23% liquidated). Somewhat surprising to us was the short lag to resolution for these loans; loans retired from performing or non-performing matured status were outstanding for an average of just three months after their scheduled maturity dates, while liquidated loans were outstanding for just six to seven months. Since performing and non-performing matured loans are a source of uncertainty in bond cash flows, we identified deals with the heaviest concentration (at least 5% of total deal balance) of these loans and the current pay bond in each deal (Exhibit 15). GSMS 2006-GG6 currently has the largest concentration of these loans at 11.5%, stemming from six non-performing loans. Across most deals, the average length of time loans have been performing or non-performing matured is relatively short, between one and five months. However, a handful of deals have exposure to highly seasoned performing and non-performing matured loans, including GSMS 2006-GG6, GECMC 2005-C4, and LBUBS 2005-C7.

Current pay bonds are most sensitive to these loans, as yield to maturity can hinge on when these loans pay off. Particularly important for deals with high concentrations of performing matured and non-performing matured loans is the treatment of these loans when running price/yield tables in third party cash flow engines. Since these loans are past their scheduled maturity dates, baseline assumptions have the loans pay off in the next reporting period (essentially 100 CPY). Therefore, if the balance of matured loans is close to or exceeds the balance of the front pay bond (as is the case for several deals in Exhibit 15), the bond WAL will be reported as zero if the bond can be repaid in the following month. Though 100 CPY may be somewhat unrealistic given the underlying situation of each loan and thus the variability in the timing of repayment, it is nevertheless the most conservative way to value these front pay bonds.

Exhibit 15: Several deals contain high exposure to performing matured and non-performing matured loans List of deals with at least 5% exposure to performing matured and non-performing matured loans

Note: Weighted average P/NP seasoning calculated from most recent transition into performing matured or non-performing matured Source: J.P. Morgan, Trepp, Bloomberg

Deal Name Perf./Non-Perf.

Matured Balance Deal Current

Balance % P/NPWtd. Avg. P/NP

Seasoning (Mos.)Current Pay

Bond Bond

Balance Factor Orig. WALCurrent

WALP/NP Bal. / Current

Pay Bal.GSMS 2006-GG6 356.79$ 3,105.09$ 11.5% 14.2 A2 516.34$ 0.49 4.72 2.18 69%

MSC 2005-IQ9 109.91$ 1,213.77$ 9.1% 4.0 A3 133.68$ 0.69 6.81 1.22 82%MLCFC 2007-6 166.71$ 1,948.32$ 8.6% 1.5 A2 88.40$ 0.52 4.85 0.00 100%

GECMC 2005-C4 170.72$ 2,014.01$ 8.5% 15.9 A2 54.51$ 0.24 4.90 0.00 100%LBUBS 2005-C7 153.88$ 1,938.46$ 7.9% 18.8 A2 166.15$ 0.48 4.90 0.06 93%

BSCMS 2005-T20 137.45$ 1,805.66$ 7.6% 7.9 A2 101.66$ 0.54 4.79 0.00 100%BSCMS 2005-PWR7 57.86$ 860.34$ 6.7% 3.9 A2 61.20$ 0.33 6.76 0.00 95%

MSC 2007-IQ13 90.00$ 1,378.05$ 6.5% 1.0 A2 114.68$ 1.00 4.83 0.00 78%MSC 2007-HQ11 133.00$ 2,109.69$ 6.3% 3.0 A2 138.05$ 0.70 4.84 1.06 96%

GCCFC 2007-GG9 373.31$ 5,941.75$ 6.3% 4.1 A2 884.49$ 0.75 4.92 0.26 42%COMM 2007-C9 170.00$ 2,818.89$ 6.0% 1.6 A2 140.22$ 0.87 4.60 0.95 100%

JPMCC 2007-LDPX 270.44$ 4,808.27$ 5.6% 2.3 A2S 563.04$ 0.82 4.82 1.30 48%COMM 2006-C8 171.88$ 3,104.62$ 5.5% 5.4 A2B 197.77$ 0.54 4.86 0.52 87%


Ed ReardonAC (1-212) 270-0317 Kaustub Samant (1-212) 834-5444 J.P. Morgan Securities LLC

46

Asset-Backed Securities

• The ABS market traded sideways this week, with spreads mostly staying in equilibrium

• FFELP ABS, an asset class that is cheap compared to historical levels, has seen more active trading in recent weeks

• We recommend investors to go down in credit in cards and autos, and look at sectors such as UK RMBS for spread pickup

• We explore the risks of rental car ABS, and highlight the recent spread trends in new issue

• Residual value risk in the sector is low, as the used car market is healthy, and rental car companies have been largely successful in selling non-program vehicles for a premium

• Although investors need to be cognizant of car manufacturer and sponsor risk, these entities are currently in a stable financial condition

• Considering the risk factors, we think spreads in rental car ABS are attractive

Market views The ABS market was mostly flat this week. Although there was active trading in the secondary market, spreads were generally unchanged. Short cards and autos, which were flying off the shelves in the first two months of the year, have seen less investor interest in recent weeks. This is not surprising considering the supply we have seen in this sector. So far in 2012, approximately $3.1bn of money market prime auto tranches have priced in the new issue market. In comparison, at around the same time in 2011, $2bn of short prime auto bonds had priced in the market. However, all in yields for short prime auto tranches are still higher than ABCP. Based on our indicative spreads, prime auto AAA tranches offer yields of 0.37%, while 90-day ABCP rates are closer to 0.26%.

FFELP student loans, on the other hand, have been more actively traded in recent weeks. This sector is cheap compared to historical levels, when it traded on top of prime autos (Exhibit 1). However, ratings volatility and the negative headlines about the growing student debt load caused 3-year AAA FFELP spreads to widen to

almost 60bp in August 2011 versus prime auto spreads at 33bp. Since then FFELP spreads have rallied to 35bp. However, we remain neutral the sector, as we await more clarity around Moody’s downgrades due to the change in their criteria.

We still think that investors should go down in credit in ABS. Three-year single-A-rated prime auto and credit card subs continue to offer value at 90bp and 75bp, respectively. Spread levels in dollar-denominated UK RMBS are also attractive at 160bp, especially given the strong seller servicer support that they receive. This week, for investors who want to add exposure to other esoteric ABS, we highlight rental car ABS.

Rental Car ABS Since the start of 2012, spreads in most traditional ABS sectors have tightened across the curve. Three-year AAA prime auto ABS spreads have tightened by 5bp to 25bp from 30bp, and 3-year single-A tranches are trading 25bp

Exhibit 2: Rental Car ABS has three major issuers

Source: J.P. Morgan, Bloomberg, Intex, Remit Reports

Exhibit 1: FFELP spreads are still cheap compared to prime autos (bp)

Source: J.P. Morgan

AESOP HERTZ RCFC

Holding Co.Avis Budget

GroupHertz Global

HoldingsDollar Thrifty

Automative GroupRating (M/S/F) B1 / B+ / B+* NA / B+ / NA B2* / B+ / NA

Notes Outstanding ($mn) 4,695 2,732 917Master Trust ($mn) 6,517 5,292 1,679

2010-11 Issuance ($mn) 3,580 1,348 500* positive outlook

0

10

20

30

40

50

60

70

Nov-10 Mar-11 Jul-11 Nov-11

Prime Auto FFELP



47

tighter. Investors looking for any spread pickup in ABS, have to look outside of prime auto loans and bank cards. One sector that deserves consideration is rental car ABS.

There is currently a little over $8bn outstanding of rental car ABS, with Avis Budget serving as the largest and most consistent sponsor in the market (Exhibit 2). Hertz and Dollar Thrifty also participate in the market, but their trusts are less frequent issuers. The transactions utilize a master trust structure, with a revolving pool of assets that support multiple series of predominantly fixed-rate notes. The master trust is backed by leases on rental vehicles to the rental car companies. The resulting lease payments cover the bond interest payments and other costs of the transactions, while the sale of the vehicles generates principal for bond paydowns (or purchase of new assets if the transaction is in its revolving period).

Investors in the sector are exposed to three risk factors:

1. Residual value risk from the vehicle sales;

2. Bankruptcy of the car manufacturers that are part of the trusts’ program vehicles; and,

3. Bankruptcy of the sponsor/rental car company.

In the following discussion, we argue that these three risks have declined considerably in the past year, making rental car ABS an attractive investment. We explore each of these risk factors below.

Residual value risk

To reflect the revolving vehicle fleet and the master trust’s exposure to the program versus non-program vehicles, the rating agencies’ required credit enhancement is dynamic. To illustrate this, in Exhibit 3, we work through Moody’s calculation of the required credit enhancement in AESOP 2011-5 as of February 2012. At the inception of the transaction, Moody’s specifies a credit enhancement percentage that varies based on whether the car is part of a manufacturer’s program, and the credit rating of the manufacturer. In the example, Moody’s specified the same credit enhancement percentage for all-non program vehicles: 35.3%. In rental fleet ABS transactions, credit

: Since vehicle sales have a significant impact on repayments, the residual value of the vehicles in the collateral pool is an important determinant of the performance of the transaction. The vehicles in the trusts are either program or non-program vehicles. Program vehicles are part of manufacturer agreements, which bind the manufacturer to repurchase the vehicles back at a guaranteed price. Since program vehicles are sold back to manufacturers, these vehicles are not exposed to residual value risk (unless the manufacturer is bankrupt and unable to fulfill its repurchase obligation). On the other hand, non-program vehicles are not part of such repurchase agreements, and their liquidation values can vary based on the condition of the used car market. Both the concentration of the car manufacturers and the breakdown between program and non-program vehicles (Exhibit 3) change in the master trust over time. Since car rental companies are offered similar incentives for their program vehicles, the mix of program versus non-

program can move in tandem across master trusts, as reflected in Exhibit 3.

Exhibit 3: Non-program vehicles make up a large percentage of master trusts

Source: J.P. Morgan, Remit Reports

Exhibit 4: The mix of program type and car manufacturer is reflected in the dynamic credit enhancement calculated by the rating agencies

Source: J.P. Morgan, Remit Reports

30%35%40%45%50%55%60%65%70%75%

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12

Avis Non-program VehiclesHertz Non-program Vehicles

Program Type Pool Moody's Moody'sManufacturer Pct. Allocation CE (%) CE ($)

Program VehiclesGM 20% 128,238,580 32.5% 41,677,538

Ford 11% 72,459,291 32.5% 23,549,270Chrysler 8% 50,217,292 32.5% 16,320,620

Kia 3% 21,016,707 25% 5,254,177Hyundai 2% 11,536,325 25% 2,884,081

Toyota 1% 5,460,976 25% 1,365,244Non-Program Vehicles

All Manufacturers 56% 361,070,828 35.3% 127,277,467Aggregate 100% 650,000,000 33.6% 218,328,397



48

enhancement is mostly from overcollateralization. That is, the book value of the vehicles exceeds the bond principal outstanding. The credit enhancement for non-program vehicles does not depend on the manufacturer, as the vehicles are not part of a repurchase agreement. On the other hand, the credit enhancement percentages for program vehicles do vary based on manufacturer. Since GM, Ford, and Chrysler have lower corporate ratings than Kia, Hyundai, and Toyota, their credit enhancement percentages are higher at 32.5%. This higher credit enhancement reflects the higher credit risk for lower rated manufacturers. These individual manufacturer credit enhancement requirements are then multiplied by each manufacturer’s pro-rata share of the vehicles’ book value in the master trust to calculate a required credit enhancement level for all classes of bonds. In some transactions, the actual credit enhancement falling below the required credit enhancement levels is an early amortization trigger.

Residual value risk is more prominent in non-program vehicles as these are not part of repurchase agreements and, therefore, they need to be sold in the used car market, which has performed well in recent years. The Manheim Used Car index, which is often a barometer for pricing in the sector, increased to 125 in February 2012 from its post crisis low of 98. The improved health of the used car market helps residual values. Additionally, rental car companies have a history of consistently selling non-program vehicles for valuations that are higher than their book value, which is determined based on a set depreciation schedule (Exhibit 5).

Any shortfall of sale price versus book value would otherwise raise the deal’s required credit enhancement. In Exhibit 4, using AESOP as an example, we show the excess of sale proceeds over the non-program vehicles' book values. As is clear, Avis Budget has regularly sold vehicles at premiums to the book value. During the crisis (late 2008 – early January 2009), when used car prices bottomed, sale proceeds fell short of the non-program vehicles’ book values in only one of the months.

Manufacturer bankruptcy:

Exhibit 6: The three major issuers are financially stable as reflected by their stock prices

The second risk is the bankruptcy of a car manufacturer with program vehicles in the trust. In such case, the program vehicles could be converted to non-program vehicles, exposing the program vehicles to residual value risk. Currently, Chrysler, Ford and GM constitute 87% of AESOP’s program vehicles, and 76% of Hertz’s program vehicles.

Source: J.P. Morgan, Bloomberg

Exhibit 5: In recent years, Avis has consistently sold non-program vehicles for a premium over book value

Source: J.P. Morgan, Bloomberg, Remit Reports

Exhibit 7: Recent AESOP AAA pricing in new issue market

Source: J.P. Morgan

100110120130140150160170180190200

10/3/2011 11/3/2011 12/3/2011 1/3/2012 2/3/2012 3/3/2012

CAR DTG HTZ

95

100

105

110

115

120

125

130

-5%

0%

5%

10%

15%

20%

25%

30%

Aug-08 May-09 Feb-10 Nov-10 Aug-11

% Sale PremiumManheim Used Car Index (Right)

0

50

100

150

200

250

Mar-10 Sep-10 Mar-11 Sep-11 Mar-12

3 year 5 year



49

Subsequent to the 2008 crisis, the outlook of these three car manufacturers has improved. Naturally, this improvement is driven by the successful restructuring of both GM and Chrysler, which has reduced the bankruptcy risk of both domestic car manufacturers. This improvement in the outlook for domestic car manufacturers is a positive for rental car ABS.

Sponsor bankruptcy

To highlight spread trends in rental car ABS, we use new issue pricing spreads for AESOP, which is one of the more regular issuers in the space (Exhibit 6). As in other esoteric ABS, spreads in rental car widened in the last quarter of 2011, due to concerns around domestic and international sovereign risk. In August 2011, AESOP’s 5-year tranche priced at 202bp over swaps, which was more than 85bp wider than the prior deal. As sovereign default risks receded, spreads across consumer ABS tightened, and AESOP’s most recent 5-year tranche that priced this March was 50bp tighter at 150bp over swaps. This is still 35bp wider than the deal that priced a year ago. Despite the recent tightening, spreads in the rental car sector are still attractive relative to other consumer ABS asset classes. Given the healthy residual values, improvement in the performance of the domestic car manufacturers, and stable rating outlook of the sponsors we recommend that investors looking for spread pickup consider investing in rental car ABS.

: In addition to the health of the car manufacturers, bondholders are also exposed to sponsor default risk. If the sponsor defaults, the transaction can go into early amortization, possibly resulting in a forced liquidation of the fleet. Currently, all three major sponsors are rated single-B (Exhibit 2), with a stable or positive outlook. Avis Budget, Hertz, and Dollar Thrifty’s stocks have performed well over the last six months (Exhibit 6), and have recovered sharply since the crisis. While investors should be cognizant of the sponsor risk, currently, the financial health of the three major issuers in the sector appears to be stable.

Week in review Spreads in the ABS market were generally unchanged. Three-year AAA credit card floaters widened by 1bp. Three- to ten-year FFELP ABS spreads tightened by 5bp to 10bp. There was no issuance in the ABS market.

This week, S&P raised ratings on 28 classes affirmed its ratings on 214 classes of ABS backed by US bank card

receivables. The ratings actions were a result of a recent review of each of the credit card ABS transactions that S&P rates from six of the largest originators/issuers of U.S. bank credit card ABS.

As part of the review, S&P updated its base-case assumptions and stresses to key performance variables. S&P noted that it has seen a 59% decline in loss/charge-off rate over the last two years, from a peak of 10.5% in February 2010. Furthermore, payment rates have also increased—a phenomenon that S&P attributes to the rising deleveraging by US consumers.



50

Exhibit 8: ABS spread performance Spread to benchmark (bp)

Note: Tier 1 names represented by above. Source: J.P. Morgan Exhibit 9: AAA cross sector spreads (3-year) (bp)

Source: J.P. Morgan

Exhibit 10: Cross-sector yields (%) 5-year AAA Card ABS and Treasury, JULI Financials, FNMA Current Coupon 30-year

Source: J.P. Morgan

Current 1-wk Current 1-wkBenchmark 03/29/12 Change Avg Min Max Benchmark 03/29/12 Change Avg Min Max

Credit Card - Fixed Rate Student Loans (FFELP)2-yr Swaps 8 0 7 6 8 3-yr Libor 30 -5 42 30 503-yr Swaps 12 0 12 12 14 7-yr Libor 70 -10 87 70 1005-yr Swaps 25 0 25 25 25 Private Credit Student Loan10-yr Swaps 45 0 45 45 45 AAA 3-yr Libor 175 0 196 175 235B-Piece (5-yr) Swaps 80 0 84 80 90 Global RMBS (UK Bullet) C-Piece (5-yr) Swaps 120 0 120 120 120 3-yr AAA Libor 155 0 159 155 160Credit Card - Floating Rate 5-yr AAA Libor 165 0 169 165 1702-yr Libor 10 0 8 6 103-yr Libor 13 1 13 12 15 Stranded Assets5-yr Libor 25 0 25 25 25 2-yr Swaps 8 0 8 8 1010-yr Libor 38 0 38 38 38 3-yr Swaps 13 0 13 13 15B-Piece (5-yr) Libor 85 0 85 85 85 5-yr Swaps 28 0 28 28 30C-Piece (5-yr) Libor 120 0 120 120 120 10-yr Swaps 60 0 60 60 60Auto - Prime Auto - Subprime1-yr EDSF 6 0 6 6 7 1-yr EDSF 40 0 41 40 452-yr Swaps 15 0 16 15 17 2-yr Swaps 60 0 64 60 703-yr Swaps 25 0 26 25 28 3-yr AA Swaps 100 0 109 100 150B-Piece Swaps 90 0 92 90 100 3-yr A Swaps 170 0 185 170 240

10-week 10-week

0

100

200

300

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Credit Card ABSPrime Auto Loan ABSFFELP Student Loan ABSJULI AA Bank (1-3 year)CMBS

Current132730

106135

0

2

4

6

8

10

Jul-07 Apr-08 Jan-09 Oct-09 Jul-10 Apr-11 Jan-12

TreasuryAAA Card ABSAgency MBSFinancials

Current1.01.53.03.9



51

Exhibit 14: 3-year floating-rate AAA ABS spread to Libor (bp)

Exhibit 15: 5-year fixed-rate AAA ABS spread to Treasuries (bp)

Exhibit 16: 3-year floating-rate AAA ABS spreads to Libor (bp)

Exhibit 11: 2-year fixed-rate AAA ABS spread to swaps (bp)

Exhibit 12: 5-year fixed-rate AAA ABS spread to swaps (bp)

Exhibit 13: 3-year single-A fixed-rate ABS spread to swaps (bp)

0

20

40

60

80


Credit CardPrime AutoStudent Loan

Current1327

30

20

40

60

80


Credit Card

Stranded Asset

Current48

51

050

100150200250300350400450


US$ UK RMBSPrivate Credit Student Loans

01020304050607080

05

101520253035404550


Prime AutoCredit CardSubprime Auto (Right)

152025303540455055


Credit Card

Stranded Asset

Current2528

050100150200250300350

406080

100120140160180


Credit cardPrime AutoSubprime Auto (Right)

High Grade Strategy and Credit Derivatives Research US Fixed Income Markets Weekly March 30, 2012

Eric BeinsteinAC (1-212) 834-4211 Dominique D. Toublan (1-212) 834-2370 Miroslav Skovajsa (1-212) 834-5154 Anna Cherepanova (1-212) 834-3220 J.P. Morgan Securities LLC

52

Corporates

• As 1Q ends, there are reasons to be more cautious: spreads have tightened meaningfully on the quarter, J.P. Morgan expects Europe to fall into recession in 2Q and 3Q, China’s expected growth acceleration remains to be confirmed, US corporate earnings are expected to see their lowest quarterly growth in nine quarters, Moody’s downgrades hang over the banks, UST yields have retraced more than half of their rise, and trading activity usually declines after 1Q.

• On the positive side, we expect bond supply to moderate, US growth to accelerate over the quarter with solid labor market trends, banks to report strong earnings, and the broader dynamic of insufficient spread product supply versus demand to remain in place.

• Overall we expect modest spread tightening over time, but with more volatility in 2Q than 1Q.

As 1Q ends, there are reasons to be more cautious on spreads. J.P. Morgan expects US growth to accelerate to 2.5%q/q in 2Q from 1.5% this quarter, but elsewhere in the world to slow. In Europe, we see recession in 2Q and 3Q after a flat 1Q. In the UK, we view negative growth this quarter and, in Japan, we anticipate slowing from a strong 1Q. In China, the official forecasts calls for stronger growth in 2Q (8.4%) than in 1Q (7.2%) and for even stronger growth in 2H12, but this depends on strong March data and fiscal and monetary policy support, which are not yet in place. It is difficult to square this forecast with the European recession and still-subdued US growth, but Chinese growth patterns have been disassociated with them at other times as well. We also expect a weak 1Q US corporate earnings season with equity analysts calling for EPS growth over the year of just 3%—the slowest growth since 3Q09. Moody’s should follow up in 2Q with downgrades of large Financials, in our view. Finally, markets have performed well in 1Q with spreads 47bp tighter at 189bp, which makes valuation less compelling and will cause some to reduce risk, as trading volumes usually decline after 1Q. All these factors are negative for spreads.

Exhibit 1: Life Insurance companies invested assets

Source: J.P. Morgan

Exhibit 2: P&C Insurance companies invested assets

Source: J.P. Morgan.

Exhibit 3: J.P. Morgan expects 2Q to be the weakest quarter for global growth this year, with the US being the outperfomer

4Q11 1Q12 2Q12 3Q12 4Q12 US 3.0 1.5 2.5 3.0 2.0 Euro -1.3 0.0 -1.5 -0.3 0.3 Germany -0.7 1.0 0.0 1.0 1.0

Spain -1.2 -0.5 -2.5 -2.0 -1.5 Italy -2.9 -2.0 -2.5 -1.5 -1.0

China 9.2 7.2 7.8 9.5 10.0

UK -0.8 2.0 -1.0 2.5 1.5

Japan -0.7 2.2 1.6 1.2 1.0 Source: J.P. Morgan.

Corporates, 45%

Mortgages, 11%

Structured Securities,

21%

Treasuries and

Agencies, 8%

Sovereigns, 4%

Cash and Others, 11%

Equity, 21%

Treasuries and

Agencies, 21% Corporates,

18%

Structured Securities,

12%

Munis, 11%

Sovereigns, 3%

Cash and Others, 14%



53

There are offsetting positives as well, causing us to remain with an overweight recommendation but with a modest tightening expected, as spreads are at 189bp versus our 175bp target. On the positive side, we expect supply pressures to lessen after 1Q as usual but, this year, the decrease could more than usual, given the strong supply in 1Q and our expectation that UST yields will rise. Demand metrics, including inflows into mutual funds and discussions with investors, suggest that there is still an excess of demand for HG credit. We expect corporate credit metrics to remain solid, but probably deteriorate to some extent with slower revenue and EBITDA growth expected in the first part of this year. We also believe that UST yields should rise into mid-year with a 2.5% 10-year forecast. We expect no change in the Fed’s interest rate strategy, which has contributed to demand for short-dated corporates as an alternative to cash. These factors favor tighter spreads, but clearly there is less of an upside now than at the beginning of the year.

Corporate holdings declining in relative terms

Insurance company general account holdings for year-end 2011 have recently become available, revealing several interesting trends. We will be looking further into this information over the next several weeks.

Life insurers in our survey (the 20 largest with combined insurance assets under management of $2.2tn) added $70bn to their corporate bond holdings in 2011. Over the past six years, this category enlarged by $112bn, so 63% of the growth since 2005 occurred last year. For comparison, HG bond market net issuance was about $350bn last year and HY was about $75bn; therefore, these 20 insurers absorbed about 16% of the net supply. It is likely that they absorbed a greater share of the HG bond market and smaller share of the HY issuance, but the HG/HY split of their holdings is not available. However, as depicted in Exhibit 1, while assets under management for Life Insurance companies increased by 9% and 21% over the past one year and six years, respectively, corporates holdings increased by 8% and 13% only. Therefore, the percentage of assets invested in corporates has decreased relative to total assets.

Also interesting is the large rise on holdings of Sovereigns positions last year, including both EM and

DM bonds, excluding US Treasuries and Agencies. This category is only 4% of the total portfolio but it has more than doubled in the past six years compared with a 21% increase in the overall portfolio size. However, we note that most of this growth is only due to two insurance companies. Structured securities (includes CMBS, ABS and RMBS) also significantly grew last year.

P&C insurers present similar data. The total assets under management of the 20 P&C insurers in our study grew by only $2bn on an $840bn base, i.e., almost no growth. There were not major shifts in positions on the year, but holdings in US Treasuries and Munis declined while Equity, Sovereigns and Structured Securities increased.

Economic risks outside the US increase as we enter 2Q, while we expect US growth to accelerate

In Europe, we forecast a recession in the 2Q and 3Q, following a flat 1Q. Moreover, we expect the weakest

Exhibit 4: In 2012 companies responded to the weaker outlook over the year by reducing share buybacks, and new buyback announcements in 1Q12 have been muted


Exhibit 5: Cash declined modestly in 4Q for the S&P universe of companies, but it remains very high, giving companies the capacity to return more to shareholders


0

100

200

1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12

Share Buybacks $bn

0

2

4

1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11

Balance Sheet Cash for S&P 500 companies

$tn



54

quarter of the year in the UK and slowing quarter-over-quarter growth in Japan. Ongoing fiscal austerity and a pullback in credit availability contribute to these trends in Europe. Entering 2012, we had already expected negative growth in 1Q, but a surprisingly strong growth in core Europe to offset negative growth in the periphery. Now heading into 2Q, we see peripheral Europe’s slowdown intensifying, bringing the average European growth rate down to negative. The LTRO program is still yielding benefits with solid demand for peripheral European bonds in the recent auctions and modest credit contraction, as measured by the bank lending surveys, although Spanish and Italian yields have been moderately rising and the market is again focused on these trends. We are also watching the budget deficit trends with a focus today on Spain, and we believe official fiscal deficit targets are optimistic everywhere in peripheral Europe. Ongoing austerity will likely increase social unrest heading into the summer and elections in some regions, which will turn market focus on the challenges of structural reform and a return to growth.

On the upside, there has been progress towards increasing the size of European rescue funds, with Europe working towards a larger program that should persuade the IMF to increase the size of its resources. If and when these goals are achieved, it should keep European concerns somewhat muted at least through 2012, as markets will be more comfortable with official sources filling in for the gaps in the public sector’s willingness to fund these deficits.

Discussions on the European firewall progressed. As initially designed, the ESM was set to permanently succeed the EFSF in July 2013, with a €500bn limit on its lending operations, including the EFSF’s outstanding commitments. In December 2011, it was decided to bring forward the ESM’s start date to July 2012, such that the two programs will overlap for a year. Germany has been under enormous pressure to allow the overall support ceiling to rise, not least as a precondition for the provision of additional contingent support from non-Euro countries via the IMF.

Our expectation has been that Germany would ultimately allow the full-lending capacity of both the ESM and EFSF to run side by side for a period—meaning a €940bn limit to the total loan capacity. The EFSF has already committed €200bn of its €440bn, leaving €740bn

still available. Nevertheless, it was always likely that Germany would just allow a temporary expansion, seeking to limit the scale of the ESM in the longer term.

A Bloomberg story yesterday on a draft of the Summit statement suggests that our base view looks broadly correct, but with a few wrinkles. Based on that draft, the €940bn of total lending capacity across the EFSF and ESM will remain available for use over the next 12 months. But the €240bn of uncommitted EFSF capacity will be available only for “exceptional circumstances,” if the €500bn capacity of the ESM appears insufficient, and it will be subject to a unanimous vote among Euro area heads of state. After mid 2013, as the EFSF is wound down, the uncommitted capacity of the facility will not be available, but the ceiling on ESM operations would be €700bn. Whether the Summit draft will prove a reliable guide to tomorrow’s outcome remains to be seen. To the extent that one can judge what the Euro area needs to do to entice more money from the IMF, the draft delivers the minimum that is required. See Malcom Barr’s note from March 29 (Report).

In China, we expect growth to accelerate in 2Q versus 1Q and then to accelerate further in 2H12, but there are downside risks. There has been a lot of concern about Chinese growth, given the decline in housing prices—which is underway—and other economic indicators such as power, steel and cement demand showing weak trends. Also, the contraction in Europe is expected to weigh on Chinese exports, but a pickup in US growth should at least be partially offsetting. The current challenge is that the weak 1Q data is obfuscated, in part, by the timing of the Lunar New Year, as it distorts annual trends. In addition, it is expected that declining inflation will soon lead to some policy responses both on the fiscal and monetary fronts. March data will, therefore, be important, as it should not reflect holiday timing and, if it disappoints, it will likely call for downward revisions to the strong growth rebound currently priced in our forecasts. Particularly, retail sales data (due April 13) will be pivotal, as the figures were very weak in January and February. If this comes in below expectation, markets will likely take it poorly.

We expect US growth to accelerate thanks to solid trends in employment growth, less negative impact from energy prices as they stop rising, and the benefits of rising financial markets on consumer

https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-818218-0.html�



55

sentiment. Employment growth has been a key positive development. In a recent research note, our economists forecast a 200,000 gain in employment per month through 2012, thus implying that the unemployment rate should fall to 8.0% at year-end 2012 and 7.7% at year-end 2013, even as the participation rate is forecasted to rise 0.4%-pt. Rising employment and supportive financial markets have been somewhat offset by rising energy prices, but these have stabilized, and even if they stay at current levels, the lack of additional rises will mean they have a decreasing effect on consumer spending over time. The US will be impacted by slower growth globally and ongoing fiscal restraint at home, but we expect growth to reach 3.0%q/q in 3Q before moderating to 2.0% in 4Q as the election and fiscal challenges into the New Year become more evident.

Cash back to shareholders: Limited so far, but likely to increase

Encouragingly for creditors, companies have recently been modest about returning cash to shareholders, despite the better economic environment so far, but this is likely to change to some extent. Rising economic data and strong stock markets encourage companies to return more cash to shareholders via higher dividends and more share buybacks. Managements are more comfortable paying out cash when they see their operating environments strong, such that they are steadily generating cash, and also when they see supportive funding conditions in capital markets for their loans and bonds. These conditions have been in place for the past few quarters, yet the pace of cash being returned to shareholders has been muted.

Combined share-buybacks and dividends total $196bn for the S&P universe in 1Q11, when economic confidence was high, but it fell to $163bn in 4Q11. Companies reduced their share buybacks late in the year, when economic risks rose due to events in Europe and financial markets were unsupportive. For full-year 2010, S&P companies paid out $725bn in dividends plus buybacks versus the $811bn paid in 2007, the peak year, even though earnings were stronger last year than back in 2007. J.P. Morgan’s Equity Strategist Tom Lee points to the potential and likelihood of greater share buybacks and dividends as one of the bullish arguments for stock

markets over the year—companies have the cash and the history of being more aggressive in this area.

We will not know about 1Q12 buybacks until companies report earnings for the quarter, but we indeed track buyback announcements. QTD they total $67bn versus $115bn in 1Q11 and $103bn in 1Q09—well below the prior trend (buyback announcements tend to be cyclically concentrated in 1Q of each year). Despite this low total, we still may learn that companies were aggressive in share-buybacks this quarter under the existing programs, but it is interesting that the equity market rally YTD has not yet led to a jump in these announcements.

There is a strong correlation between stock market prices and share buybacks. Companies tend to be the most aggressive in buying back their shares at the peak. In 2009, when the stock market was at its lows, total S&P buybacks and dividends were just $339bn, less than half their level in 2007, when stocks were at their peak. This pattern suggests that actual buybacks and dividends will rise this year as equity markets have been strong, even though the YTD announcements has not reflected that yet. One final point is that dividends paid in 4Q11 were a record of $68bn, compared with about $55-60/quarter paid in 2007, prior to the crisis. Share buybacks last year were significantly lower than in 2007, however.

Investors disagree with our view that off-the run high dollar-priced bonds offer value

One of the interesting results of our investor survey last week was that not one investor believed that there was value in high dollar-priced bonds versus low dollar-priced bonds, despite the recent widening of their spread gap. The majority (60%) felt that differences in liquidity justified a wide spread difference, some cited M&A concerns as a reason to avoid high dollar-priced bonds and the rest mostly cited other issues, such as accounting treatment, which limits their interest in these bonds.

This is a different perspective than ours, as we have looked at the return performance of high dollar-priced bonds versus low dollar-priced bonds; and, the results show that, over time, bonds with higher yields outperform ones with lower yields no matter the bond’s price at entry. Even in periods of market sell-offs, we did



56

not find that high dollar-priced bonds underperformed. When spreads are tight and narrowing, one would expect investors to pursue higher spreads/yields where they can be found, but clearly liquidity concerns now remain high.

The continued aversion to high dollar-priced bonds is likely explained by several factors. First, there has been a lot of supply YTD, so there have been on-the-runs par-priced bonds available. The $241bn issued YTD averages $4bn/day, which compares to the $13.4bn/day average trading volume in secondary markets YTD. Second, investors turned less bullish in this survey versus last month, as valuation is tighter and the economic data trends have turned more mixed. Liquidity matters more when one is concerned about weaker markets. Third, the back up in UST yields is raising some concerns about a further rise in yields and potentially less demand for fixed-income products. This is not visible in the data yet, but the uncertainty about this creates an environment where liquidity is more highly valued. Mathematically this is counter-intuitive as higher UST yields reduce the price of all bonds and should lessen the high dollar-price discount, but so far this has not been evident, probably because yields have not backed up that much. Fourth, the uncertainty around implementation of the Volcker Rule and Dodd-Frank among investors is high, based on the amount of focus on this issue from investors in our conversations. There is uncertainty about how it may impact dealer positioning and the ability/willingness to hold and trade bonds once implemented.

Some of these issues are likely to fade as the year progresses. Supply should lessen, UST yields should rise (lowering the price of bonds further), and there should be more clarity on the implementation of Dodd-Frank and its impact by mid-year (at this point, the impact on how we trade HG bonds should be minor). Overall, we continue to believe that bonds with higher yields will outperform lower yielding/lower priced bonds in an environment of solid corporate fundamentals such as today. Therefore, we expect the spread gap between high dollar-priced versus low dollar-priced bonds to narrow.

Monthly JULI rebalance

On April 1, 133 newly issued bonds will join our HG index (JULI); 37 will exit. At the end of each month we rebalance our HG index (JULI). Recently, large volume of new HG issuance leads JULI growing in size. The

amount of bonds leaving the index is consistent month-to-month outside of rating downgrades, which have been rare. As a result, a pickup in issuance leads to the index increasing in size. In March, 133 new bonds will enter the index, while 37 bonds will exit. There are no fallen angels (bonds downgraded out of the HG space). All 37 bonds were removed either because they fell below the 13-month minimum maturity limit or the $300 million minimum issue size limit due to tenders. There are 21 rising stars this month (bonds upgraded from HY into HG) accounting for $14.5bn. Overall, JULI will be 96 bonds and $68bn (2.2%) larger in April versus March.

The effect of the rebalance on JULI spreads, prices, and yields will be small. Bonds dropped this month’s trade significantly tighter than the overall index, as most of them are short. As a result, the index will be 0.7bp wider due to rebalance. Index Price and Yield will be unchanged.

Within JULI, March was a busy month for rating changes. The most significant were Moody’s rating changes related to the Exelon and Constellation merger. Baltimore Gas & Electric, Commonwealth Edison, and Constellation Energy were upgraded ($7bn in the index; 0.2%), while Exelon Generation and Exelon Corp were downgraded ($5bn; 0.2%). Moody’s also upgraded Plains All American Pipeline ($3.5bn; 0.1%) and downgraded Bank of New York Mellon one notch to Aa3 ($11bn; 0.4%), Macquarie one notch to A3 ($5.5bn; 0.2%), and Nomura one notch to Baa3 ($4bn; 0.1%). S&P upgraded Williams Partners one notch to BBB ($5.6bn; 0.2%) and downgraded Enel one notch to BBB+ ($7bn; 0.2%).

Four companies were upgraded from HY to HG and thus entering the index. S&P upgraded Williams Companies to BBB- (3 bonds; $1bn) and Moody’s upgraded Anadarko to Baa3 (11 bonds; $11bn), Life Tech (4 bonds; $2bn), and Starwood Hotels to Baa3 (3 bonds; $1.3bn).

North America High Yield Research US Fixed Income Markets Weekly March 30, 2012

Peter AcciavattiAC (1-212) 270-9633 Tony Linares (1-212) 270-3285 Nelson R. Jantzen, CFA (1-212) 270-1169 Alisa Meyers (1-212) 834-9151 J.P. Morgan Securities LLC.

57

High Yield

• With many of the same themes weighing on the tape, namely uncertainty around China’s economic slowdown and Europe, this week was a continuation of last week’s weakness once you strip out Monday’s rally in stocks. High-yield bond yields increased 5bp week-over-week to 7.49%, whereas the yield to maturity for our recently-launched J.P. Morgan Leveraged Loan Index decreased 10bp to 6.68%

• There seems to be some developing concern that this spring is shaping up to be a carbon copy of 2011’s and 2010’s, an idea arguably gaining credence as prices for risky assets move higher, along with burgeoning risks such as China, the Middle East, higher gasoline prices, and an always developing situation in Europe. The S&P 500 has already gained 12% YTD and is on track to be the best 1Q since 1998. As momentum ebbs and expectations realign, the setup into 2Q is not nearly as benign. But, we do not see the latest growth scares changing our views as low rates and low defaults remain supportive of high yield, but they make the short-term risk/reward less asymmetrically favorable

• Retail demand for high yield is still a positive theme. This week, $457mn moved into high-yield funds, bringing the 17-week total inflow to $24bn (or 10% of AUM). At the same time, loan fund flows totaled $216mn this week, after a $219mn inflow last week

• This week 16 bonds priced for $8.0bn, doubling last week’s volume. February’s and March’s $40.4bn and $39.7bn of issuance are the third and fourth highest on record, respectively, and brings 1Q12 issuance to a new quarterly record, $106bn. A focus on refinancing continues to keep supply within the confines of demand while also serving to anchor medium-term default expectations. For institutional loans, new-issuance has been relatively consistent over the past four weeks (around $5.3bn per week), which compares to the average weekly volume of $1.7bn in the year’s first 10 weeks

• We are raising our 2012 high-yield bond issuance forecast by $75bn to $300bn, in-line with 2010’s record volume. Despite a $420bn annualized run-rate in 1Q, we temper our expectations for 2Q-4Q due to seasonal factors and the likelihood of extremely conducive macro conditions to slip

Credit strategy update With many of the same themes weighing on the tape, namely uncertainty around China’s economic slowdown and Europe, this week was a continuation of last week’s weakness once you strip out Monday’s rally in stocks. A glance at any economic index will reveal that data has not been as good as it was in January and February, but this also merely reflects the fact that consensus expectations have caught up with better data. The US labor market is still heading in the right direction (359,000 claims new recovery low), and even housing indicators are better on the margin. Sovereign fears are flaring mildly (Spain’s budget, Portugal), but nothing like it was during periods of 2011. But there seems to be some concern developing that 2012’s spring is shaping up to be a carbon copy of 2011’s and 2010’s, an idea arguably gaining credence as prices for risky assets move higher, along with burgeoning risks such as China, the Middle East, higher gasoline prices, and an always developing situation in Europe. For context, the S&P 500 has already gained 12% YTD and is on track to be the best 1Q since 1998. With momentum ebbing and expectations realigned, the setup heading into 2Q is not nearly as benign. But for high yield, we do not see the latest growth scares as changing our views as low rates and low defaults remain supportive of these yields, but they do make the short-term risk/reward less asymmetrically favorable. Year-to-date, high-yield bonds returns (+5.9%) and loan returns (+3.9%) continue to outperform the majority of other options within fixed income. Certainly, the potential for a hard landing in China is the most talked about growth scare at the moment, supported by a number of contracting data points such as passenger vehicle sales (-1.6%), steel production (-3.5%), residential sales (-13.5%), and power demand (down over the month).

Exhibit 1: Performance by asset class and rating

Sources: J.P Morgan; Bloomberg

Assets 2007 2008 2009 2010 2011 Jan-12 Feb-12 MTD YTDHigh-Yield Bonds 2.88% -26.83% 58.90% 15.05% 5.73% 3.12% 2.55% 0.09% 5.85%Lev eraged Loans 2.08% -29.10% 53.14% 9.91% 1.61% 2.23% 0.74% 0.89% 3.89%Inv estment Grade Bonds 5.98% 0.53% 18.48% 9.33% 8.67% 2.08% 0.81% -0.50% 2.41%Emerging Market Bonds 5.86% -10.91% 28.18% 12.04% 8.47% 1.76% 2.95% 0.04% 4.81%10-Year Treasury 9.76% 15.31% -8.76% 8.27% 16.96% 0.79% -1.07% -1.45% -1.73%Dow Jones Industrials 8.88% -31.93% 22.68% 14.06% 8.38% 3.55% 2.89% 1.64% 8.29%S&P 500 5.49% -37.00% 26.46% 15.06% 2.11% 4.48% 4.32% 2.91% 12.17%Russell 2000 -1.56% -33.79% 27.18% 26.86% -4.17% 7.06% 2.39% 2.80% 12.69%By Rating BB-rated bonds 3.08% -15.63% 40.98% 14.08% 6.56% 2.49% 2.52% -0.42% 4.64%B-rated bonds 4.54% -29.11% 45.37% 14.27% 6.12% 3.31% 2.38% 0.14% 5.92%CCC-rated bonds -0.14% -47.02% 110.58% 20.19% 0.26% 5.31% 3.85% 1.25% 10.74%BB-rated loans 2.41% -29.10% 33.68% 7.74% 2.41% 1.56% 0.65% 0.44% 2.66%B-rated loans 1.16% -34.89% 64.87% 11.19% -0.14% 2.84% 0.53% 0.93% 4.35%Split B/CCC-rated loans -1.69% -45.81% 87.17% 18.60% -8.86% 6.91% 2.94% 0.84% 10.98%



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Our economists all along have highlighted that Chinese GDP growth was likely to slow in 1H12 (bottoming at 7.2% in 1Q), but Chinese policy is expected to remain growth supportive, helping to set the stage for a rebound around mid-year, making this a short-term phenomenon (this is also consensus’s opinion, albeit outliers). The next RRR cut is likely to happen in a few weeks, and the government is already deploying structural tax cuts and targeted expenditure programs that will gradually boost growth. Certainly, the second short-term headwind is higher gasoline, which at $3.93 is 20% above where prices began the year. However, offsetting this to a degree has been the restoration of household purchasing power, rising confidence and wealth, and solid underlying gains in labor income. And ultimately, our economists see labor markets as driving spending growth, and here the signs remain supportive. For us, we ascribe to the idea that US growth in 2012 will remain unspectacular (closer to 2% rather than 3%), inflation low, and demand for higher yielding fixed income product high. This will likely encompass periodic resumptions of market volatility behind no short list of risks, if not more benign than last year, given the sounder US economic underpinning. In terms of performance for the week, the S&P 500 rose +0.8%w/w bringing its YTD return to +12.2%, while high-yield bonds and loans posted modest returns of +0.02% and +0.25%, respectively, bringing their YTD returns to 5.9% and 3.9%. High-yield bond yields increased 5bp week-over-week to 7.49%, whereas the yield to maturity for our recently-launched J.P. Morgan Leveraged Loan Index decreased 10bp to 6.68%. As for other asset classes this week, 10-year Treasuries, emerging markets, and high-grade bonds returned +1.1%, -0.2%, and +0.6%, respectively. And for spreads, high-yield finished 12bp lower at T+635bp and loan spreads (to maturity) finished 1bp wider at L+558bp. The CDX.HY, LCDX, and CDX.IG widened 28bp, 3bp, and 2bp to 577bp, 288bp and 93bp. Meanwhile, retail demand for high yield continues to be a positive theme. This week $457mn moved into high-yield funds, bringing the 17-week total inflow to $24bn (or 10% of AUM). At the same time, loan funds are bringing in weekly inflows of more than $200mn for the first time since July 2011. For context, the past two week’s inflows of $216mn and $219mn are equal to approximately 1.3% of AUM. And after slowing last week in response to weaker stocks, primary market activity managed to make a final push into quarter-end. This week, 16 bonds priced for $8.0bn, doubling last week’s volume. With one final day to go, March’s new-issue volume totals $39.7bn, the fourth

most active month on record behind only February’s $40.4bn, March 2010’s $40.5bn, and May 2011’s $45.7bn. And including five weeks when volumes exceeded $10bn, year-to-date totals $105.8bn, the largest quarterly volume on record, exceeding $92.4bn in 2Q11. For context, the current pace of activity is consistent with annualized volume of $420bn, but we attribute some transitory factors (seasonal boost, very low volatility, lower need to refinance) and do not expect this pace to sustain over the balance of the year. But the more important takeaway from all of this supply is the continued focus on refinancing bond and loan facilities, which continues to keep net supply within the confines of demand while also serving to anchor medium-term default expectations. For institutional loans, new-issuance has been relatively consistent over the past four weeks, around $5.3bn per week, which compares to the average weekly volume of $1.7bn in the year’s first 10 weeks. Specifically, 12 loans priced this week for $5.1bn, bringing March’s total volume to $21.4bn. Thus, March’s activity is now the highest monthly volume since May 2011. Even so, YTD volumes remain fairly modest at $46.5bn, versus $101.4bn which priced over the comparable time period last year. Raising our 2012 high-yield new-issue forecast

• We are raising our 2012 high-yield bond issuance forecast by $75bn to $300bn, in-line with 2010’s record volume

• February’s and March’s $40.4bn and $39.7bn of issuance are the third and fourth highest on record, respectively, and brings 1Q12’s issuance to a new quarterly record, $106bn

• A focus on refinancing continues to keep supply within the confines of demand while also serving to anchor medium-term default expectations

• Despite a $420bn annualized run-rate in 1Q, we temper our expectations for 2Q-4Q due to seasonal factors and the likelihood extremely conducive macro conditions slip

Coming into 2012, we expected new-issue conditions to remain robust, but choppy. For perspective, after pricing $182bn between January and June last year, volumes dropped 65% in 2H11 to $64bn, as fear around Europe and the potential for a US economic recession led to higher yields, pushing investors and issuers to the sidelines. With uncertainty high entering the year but investor demand strong and issuer appetite expected to remain intact, we forecasted high-yield bond issuance of $225bn in 2012. Since then economic sentiment has improved, market



59

volatility has receded, inflows into HY bond funds are running at record levels (5 of 10 largest weekly inflows occurred this year), and yields for high-yield bonds have fallen all the way back to where they stood nine months ago. In response, new issue volumes have soared, with February and March topping the record stretch during April and May last year. After pricing $25.7bn in January and $40.4bn in February, $39.7bn has priced in March. This brings 2012’s issuance to a new quarterly record, $106bn, surpassing 2Q12’s $92bn, and represents a more than 50% increase versus all of 2H11’s activity. Clearly, new-issuance is tracking well ahead of our full-year estimate of $225bn from December. But the more important takeaway is the continued focus on refinancing bond and loan facilities, which continues to keep supply within the confines of demand while also serving to anchor medium-term default expectations. Given what we have already seen YTD and the dramatic change in the way investors view the world, we are raising our 2012 high-yield bond issuance forecast by $75bn to $300bn, which compares to $246bn last year and the annual record for HY issuance, $302bn in 2010. This forecast is well short of the $420bn annualized run-rate for the first quarter, driven by a couple of tempering factors. For one, seasonal factors have provided a boost to volumes in 1Q and will fade during the summer months (July-August) and December. Secondly, the heavy focus on refinancing in the quarter after a brief reprieve in 2H has reduced the dependence on capital markets for issuers in the immediate term (2014 maturities will remain a focus). And finally, 1Q has been accompanied by falling market volatility and unusually conducive macro conditions for issuers. As the past couple of years have taught us, there is certainly a chance something emerges—be it from Europe, Washington, oil, geopolitics and so on—that will disrupt markets for at least a period of time. And finally, robust market conditions and Treasury yields near their all-time lows has led to record low coupon rates for high-yield borrowers. The average high-yield new-issue coupon rate is now down to 7.3% in 2012, an all-time low, compared to 7.8% last year, 8.4% in 2010, 9.3% in 2009, and above 8% between 2005 and 2008. This has brought the average coupon on our high-yield index down to 8.34%, also an all-time low. Some observations regarding high yield bond yields and spreads

The first observation from the following table, high-yield bond yields today are only 75bp above their all-time low

Exhibit 2: 1Q12’s high-yield bond issuance sets new quarterly record

Source: J.P. Morgan Exhibit 3: Raising our 2012 high-yield new-issue forecast

Source: J.P. Morgan Exhibit 4: Record low new issue coupons for HY issuers

Note: New issue coupons are calculated using a weighted-average Source: J.P. Morgan

$31 $39

$22

$57 $44

$61

$12

$31

$8

$36

$7 $1

$13

$55 $52

$60

$77

$48

$86 $91 $90

$92

$25 $38

$106

$0

$20

$40

$60

$80

$100

$120

1Q06

3Q06

1Q07

3Q07

1Q08

3Q08

1Q09

3Q09

1Q10

3Q10

1Q11

3Q11

1Q12

Quar

terly

HY ne

w iss

ue vo

lume (

$bn)

126 151

100

47

95 68

152 158

106

149 148

53

181

302

180

300

28 57 60 44 34

58 90

154 184

325

388

72 38

155

170 175

0

50

100

150

200

250

300

350

400

450 19

97

1998

19

99

2000

20

01

2002

20

03

2004

20

05

2006

20

07

2008

20

09

2010

20

11

20…

New-

issue

volum

e ($b

n)

High-yield new-issue volume

Institutional leveraged loan new-issue volume

8.5%

7.9% 8.1%

8.6% 8.8%

10.0%

9.3%

8.4%

7.8%

7.3%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

2003 2004 2005 2006 2007 2008 2009 2010 2011 YTD

Average new-issue coupon



60

6.75%, reached last year on May 11. This is interesting as high-grade bond yields at 4.12% are 14bp off their record low reached March 2 this year, and 47bp below where they stood last year on May 11. Of course historically low Treasury yields are providing support to lower yielding, higher quality bonds. For example, both 5- and 10-year Treasury yields are nearly 100bp below where they were last May. Low Treasury yields have led to inflated spreads relative to history. For example, BB-rated bonds reached their all-time low yield earlier this month (5.56%), meanwhile BB spreads are 300bp above their record low. Conversely, today’s 7.74% yield for single-B rated credits is well above the all-time low, 6.71%, on January 4, 2005. The same holds true for CCC-rated bonds, which have a 11.91% yield today, compared to an all-time low of 9.66% on May 3, 2011. The sharp swing in macroeconomic sentiment and greater rate versus credit risk at these yields supports our underweight rating on BB-rated bonds.

Looking at spreads, things change dramatically. Whereas yields are near record lows, spreads are not. High-yield bond spreads today are 647bp, nowhere close to the 263bp low of June 2007. Even April 2011’s recent low of 498bp is more than 200bp above the all-time low. And noteworthy, high-yield bond spreads have routinely traded between 300bp and 500bp during economic expansions. And finally as it pertains to prices, the $103 average has recovered $8.5 since early October, but remains $3 below where it stood last May and its record high set in March 2005. For us, we continue to see modest price appreciation for high-yield bonds between now and year-end and maintain a 7% YTW year-end target. This translates into a year-end dollar price for the Global HY index just shy of $105, an 8% total return left between now and year-end, with 6.25% of the return coming from current income.

Exhibit 5: Average new issue coupons by rating

Note: New issue coupons are calculated using a weighted-average Source: J.P Morgan

Exhibit 6: All-time low yields and spreads for high-yield bonds

Source: J.P Morgan Exhibit 7: Current prices for high-yield bonds relative to their all-time high

Source: J.P Morgan

Wght Avg Cpn 2003 2004 2005 2006 2007 2008 2009 2010 2011 YTDSplit BBB 6.9% 5.8% 6.6% 6.7% 6.8% 8.0% 7.4% 6.4% 5.9% 5.9%BB 7.4% 6.7% 6.7% 7.6% 7.3% 8.5% 8.9% 7.5% 6.8% 6.2%Split BB 8.7% 7.4% 7.3% 8.5% 7.5% 8.9% 9.1% 8.1% 7.2% 6.8%B 9.0% 8.4% 8.4% 8.8% 8.7% 10.5% 9.7% 8.8% 8.2% 7.9%Split B 8.3% 9.7% 10.1% 9.8% 10.3% 11.5% 12.4% 9.3% 9.0% 10.7%CCC 10.0% 9.7% 10.4% 9.4% 9.9% 11.4% 8.9% 10.1% 9.4% 9.6%NR 9.1% 12.3% 9.8% 10.7% 12.2% 13.3% 9.9% 8.7% 8.5% 6.7%

YTW STW YTW STW YTW STWHY 7.49% 647 6.75% 263 5/11/2011 6/5/07BB 5.81% 468 5.56% 173 3/2/2012 3/9/05B 7.74% 684 6.71% 251 1/4/2005 6/5/07CCC 11.91% 1106 9.66% 466 5/3/2011 6/5/07

All-time low DateCurrent

Current Price All-time high DateHY 103.06 106.40 3/7/05BB 105.10 110.95 1/23/04B 103.46 109.25 1/23/04CCC 94.32 100.51 2/18/11



61

High-yield bond and loan flows High-yield bond funds reported inflows totaling +$457mn this week (53% ETFs), down from +$978mn the prior week. It was also a 17th consecutive inflow for the asset class (last outflow in November), a period which has seen a record $24bn move into the asset class (10% of AUM). The prior eleven weeks inflows were +$978mn, +$487mn, +$957mn, +$565mn, +$837mn, +$1.77bn, +$1.79bn, +$1.60bn, +$1.88bn, +$1.35bn and +$1.79bn. The breakdown for this week’s number is an inflow of +$244mn for the HY ETFs (53%) and +$213mn for actively managed funds, versus +$146mn (15%) and +$832mn last week. The HY ETFs now account for $6.2bn, or 33% of the $18.8bn moving into HY in 2012. The $6.2bn for the ETFs exceed inflows for full-2011, whereas $12.6bn of inflows YTD for actively managed funds also exceeds the $9.9bn for all of last year. Meanwhile, inflows into loan funds continue to track at a level not seen since July 2011. Leveraged loan funds had inflows of $219mn this week, the largest in the past 42 weeks and comparable to last week’s $216mn inflow. This week’s inflow was also the ninth in the year’s first 13 weeks, after seeing outflows in almost every week between August and December. After taking in $16mn last week, bank loan ETFs took in $34mn over the past five days. And despite outflows totaling 10.7bn since July, the $61bn asset base for retail loan funds still stands 80% higher than where it stood at the beginning of 4Q10. Year-to-date, inflows into high-yield bond funds are +$18.8bn, versus $15.6bn for all of 2011, while outflows from leveraged loan funds are +$127mn versus +$13.9bn of inflows for full-2011. High-yield bond and loan new-issuance After a pause last week, high-yield new issue activity picked up its pace again this week as 16 bonds priced for $8.0bn, doubling last week’s volume. With a few $12bn plus weeks through mid-March, MTD new issue volume grew to $39.7bn, making it the fourth highest month on record, following February 2012 ($40.4bn), March 2010 ($40.5bn), and May 2011 ($45.7bn). Thus, this quarter’s issuance now stands at $105.8bn, making it the best new issue calendar quarter for the high yield market, exceeding $92.4bn priced in 2Q11. For context, the current pace of activity is consistent with an annualized volume of over $420bn and compares to $246bn in 2011 and a record $302bn in 2010. In the details, refinancing continues to dominate activity with just 5 out of 15 bonds for $2.8bn priced this week for non-refinancing purposes. The non-refinancing issuance was split between $1.8bn of proceeds for general corporate purposes and $1.0bn for acquisitions. Lawson Software’s $1.0bn Senior Notes (part of a dual-tranche deal including

€250mn Senior Notes) were upsized almost $200mn and made up the bulk of acquisitions related volume. Other highlights included $1.063bn Senior Notes for OGX Austria GmbH and the dual-tranche LyondellBasell deal with $2.0bn and $1.0bn tranches maturing in ’19 and ’24, respectively. LyondellBasell’s $3bn offering was the second largest deal of 2012, trailing only the $3.25bn dual-tranche deal for CIT Group in early February. Proceeds from the deal will go towards financing tender offers for its €103.9mn 8% Senior Notes due 2017, its $618.9mn 8% Senior Notes due 2017, and its $1.922bn 11% Senior Notes due 2018 as the company looks to clear out a handful of medium-term maturities. The 7-year tranche was the seventh to clear the market at 5% just in the last month alone while the12-year issue is the first with tenor exceeding 10 years so far this year. For OGX Austria GmbH, this week’s issue was a return to the market 10 months after its $2.563bn debut offering with the proceeds aimed at funding Capex for several complexes. For institutional leveraged loans, primary market activity has been stable over the past four weeks, around $5.3bn per week, which compares to the average weekly volume of $1.7bn in the year’s first 10 weeks. Specifically, 12 loans priced for $5.1bn this week, bringing March’s volume to $21.4bn. March’s activity already exceeds the $19.1bn that priced last month and is now the highest volume to price in a calendar month since May 2011. Nevertheless, volumes remain modest as $46.5bn priced YTD, versus $101.4bn which priced over the comparable time period last year. Thus with the pickup in loan paydowns ($17bn this month or about half of all paydowns YTD), resurgence in CLO new issuance, and retail flows, which turned modestly positive YTD, net institutional loan supply YTD is tracking in the negative territory. By far the largest transaction this week was for Telesat Canada. Due to strong demand, the deal was flexed to include a Canadian carve out. The transaction finalized as a $1.725 TLB at L+325 / 1% / 99.5, with a Canadian $175mn carve out priced at BA+375 / 1.25% / 99. The original $1.9bn TLB was talked at L+350 / 1.25% / 99. The deal will fund a $705mn distribution to shareholders. Similarly to activity in the primary market for bonds, refinancing dominates leveraged loan volumes placed, with only 4 out of 12 loans this week for non-refinancing purposes. Thus, looking at YTD figures, refinancing makes up 59% of all the volumes placed versus 22% for acquisition financing. For refinancing activity, this year’s 59% is in line with last year’s contribution, however, for acquisition financing, 22% is about 10% below the 32% contribution last year. Looking



62

ahead volumes seem to be ramping up with an additional 16 institutional deals launched this week for $7.3bn. The launched in-market institutional calendar now stands at 31 institutional deals totaling $15.6bn while the forward calendar of launched and announced deals currently stands at 46 loans for $18.5bn.


Alex Roever CFAAC (1-212) 834-3316 Teresa Ho (1-212) 834-5087 Chong Sin (1-212) 834-2611 J.P. Morgan Securities LLC

63

Short-Term Fixed Income

• It was a solid first quarter for the money markets, but large overhangs remain in the near term, such as the conclusion of Moody’s review, the decline in Treasury bill supply, and money fund reform

• While the near-term bias is for Libor to move lower from current levels, the aforementioned risks could ultimately lead Libor higher by the end of the second quarter. We revise our 3-month Libor forecast to 50bp from 45bp at end-June

• We discuss various cash investment alternatives available to current money fund shareholders, should the SEC adopt some of the proposals

• Based on Morningstar and iMoneyNet data, there is a strong relationship between retail money fund short-term bond fund balances. However, the relationship is less compelling for institutional money as institutional investors participate in the short duration space directly or via separately managed accounts

Solid first quarter but large overhangs remain It was a solid first quarter for the money markets. Thanks to ECB’s €1tn of 3-year loans, risk appetite among liquidity investors gradually returned. During the first two months of the year, prime money market funds increased their total Eurozone bank exposures by nearly $60bn, a complete reversal from their behavior last year (Exhibit 1). This risk-on mentality has not languished, despite Moody’s announcement to place 17 GCMIs and various European banks on review for downgrade. In fact, we suspect when we receive next month’s money fund holdings report, holdings of Eurozone banks will increase again, for the third consecutive month. From a rates perspective, increased bill supply has helped buoy front-end rates higher this quarter. Every year the Treasury increases their net bill issuances between February and April to fund the upcoming tax season. This year the stock of outstanding bills rose by approximately $155bn. This added bill supply, combined with the risk-on characteristics of investors (best reflected in the $80bn of government money fund outflows YTD), have been the most significant factors contributing to the rise in yields of bills, discos, GC repo, and Fed funds effective (Exhibit 2).

With that said, looking ahead into second quarter, there are reasons to be more cautious on the liquidity markets: • The end of tax season: Treasury tax receipts are

expected to increase significantly next month, which should lower Treasury’s short-term funding needs going forward. Our Treasury strategists predict that over the next eight weeks, bill outstandings will fall by approximately $100bn (Exhibit 3), withdrawing two-thirds of the additional supply seen this year.

Exhibit 1: In contrast to last year, prime money funds have increased Eurozone bank exposures by nearly $60bn in the first two months of the year Monthly change in prime MMF exposures to Eurozone bank credit*; ($bn)

Source: J.P. Morgan estimates, fund holdings reports *Includes unsecured CP, CD, ABCP, repo, time deposits, floaters, fixed notes, and other short-term notes.

Exhibit 2: Increased seasonal T-bill supply and risk-on mentality of investors were the major factors pushing some money market yields higher this year T-bill outstanding ($bn) versus 3-day moving average of overnight GC repo, Fed funds effective, 1-month disco, and 1-month T-bill yields (%)

Source: J.P. Morgan

-100

-50

0

50

100

Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12

1400

1450

1500

1550

1600

1650

1700

0.00

0.05

0.10

0.15

0.20

0.25

29 Dec 12 Jan 26 Jan 09 Feb 23 Feb 08 Mar 22 Mar

T-bills outstanding

O/N GC repo

1m T-bills1m discos

Fed fundseffective



64

• Concluding Moody’s reviews: Over the course of April and May, Moody’s will finalize its bank rating reviews. Our expectation is that Moody’s will follow through and downgrade the banks it had put on negative watch on February 15. Some banks may, as a result of the downgrade, end up with a short-term rating of P-2 versus P-1, limiting some money market investors from making certain types of investments. Notably, Moody’s-rated funds may be precluded from purchasing unsecured debt (CP/CD) and some kinds of secured debt (ABCP, non-traditional repo) from issuers rated P-2. Furthermore, 2a-7 funds may be limited to investments in issuers that carry split ratings, such as P-2/A-1, which is most prevalent among ABCP conduits. While the banks on review have probably begun to prepare for the downgrades, overall it is still a negative for market liquidity. We could see investors shift away from selected bank credits that have been downgraded and move into safe-haven assets like Treasuries, Agencies, and Non-Financial CP. For more on the implications of a Moody’s downgrade, see our prior published pieces.3

• Money Market Reform: This is probably the largest overhang in the liquidity markets. A proposal from the SEC has still yet to be published, despite the Wall Street Journal article in mid-February citing that it should be coming out very soon. We still think a proposal will come out and discuss our expectation of timing below. When it does, it is likely going to initiate large outflows out of prime money funds.

Beyond that, investigations by authorities into Libor continue to take place. Most recently, the British Banker’s Association, the group responsible for the calculation of Libor, announced they will conduct a review on the financial instruments used in defining the benchmark, among other things.4

3 A. Roever, T. Ho. C. Sin, “Short-Term Fixed Income Research Note: Moody’s GCMI ratings review and the money markets,” February 17, 2012; “Short-Term Strategy and Outlook,” February 27, 2012; “Short-Term Fixed Income Research Note: Moody’s ratings review spells trouble for short-duration municipal debt,” March 2, 2012

While the review itself is unlikely to have any large impact on Libor, the optics of it may keep Libor from declining much further, as the postings have barely moved in March. Combined with the pressures that some banks may be facing in the coming weeks, either from Moody’s and/or money fund reform, Libor could begin to set higher towards the end of the second quarter, although the near-term bias maybe to move slightly lower

4 http://www.bbalibor.com/news-releases/libor-update

from its current levels. As such, we are revising our June 30 forecast for 3-month Libor to 50bp from 45bp. Money funds: waiting on the world to change First quarter 2012 has come and gone, and the SEC has yet to release a draft of its proposed overhaul of money market mutual funds. While our expectations on the pace of regulatory reform have once again proven overly aggressive, we doubt our “disappointment” will survive 2Q12. Even at its glacial pace, we think the SEC reform proposal will appear before the end of June, to be followed by a public comment period, and then reconsideration by the SEC and maybe a final proposal by year-end. Maybe. The world has not been standing still waiting on the SEC. Money market funds have had an interesting start to 2012. Taxable funds’ assets under management are down about 3.5% YTD. But unlike the experience during the European debt crisis last year, the outflows are coming out of funds invested in Treasuries and other government securities (down $80bn YTD), as investors continue to take cash out of safe havens in search of higher returns. Meanwhile, prime fund assets are almost flat (down only $3.5bn YTD) and portfolio holdings show funds continue to grow more comfortable with higher quality European banks. We will get a closer look at portfolio trends late next week when the funds release their monthly holdings reports. Considering the alternatives Whenever the topic of MMF reform comes up, it is often followed by a discussion of where assets currently invested in money funds might move to if the new

Exhibit 3: We expect T-bill supply to drop by about $100bn over the next eight weeks Net T-bill issuance forecast ($bn)

Source: J.P. Morgan

-60

-50

-40

-30

-20

-10

0

05 Apr 12 Apr 19 Apr 26 Apr 03 May 10 May 17 May

$40bn CM bill maturing



65

regulations prove untenable for fund shareholders. While we happen to think there is a viable market for variable NAV (VNAV) money funds, we suspect it is small relative to the market for constant NAV (CNAV) MMF. If VNAV money appealed to holders of cash, then it would already be a much more developed and available product. It is possible VNAV funds do not yet thrive because they live in the long shadow of the CNAVs, which offer shareholders a better combination of principal stability, liquidity and yield. If reform takes away this combination from money fund shareholders, these shareholders will likely consider their alternatives in addition to settling for a VNAV money fund. As we see it, aside from VNAV, there are basically three places shareholders might take their money. In no particular order, the options are: • Find another CNAV product. If reform forces only

prime money funds to shift to a VNAV format—leaving government and/or Muni funds as-is—prime fund shareholders may find CNAV funds invested in Treasuries and Agencies preferable to VNAV prime funds. In the current low interest rate environment (as it is likely to persist for the next two years or so), the yield differential between prime and government funds is de minimis, and the price protection from the CNAV is comforting and has little cost in yield terms.

• Shift funds into bank deposits. At the core of the money fund reform debate is how to make bank funding safer for society. This is likely why most of the discussion focuses on prime funds, which predominantly invest in bank credit. The status quo, pro-CNAV faction believes a regulated investment company owning a well diversified portfolio of bank obligations (deposits, senior and secured debt) is capable of providing shareholders daily liquidity and some yield while maintaining a stable share price. The anti-CNAV bloc believes only bank depositors should be privy to principal stability, although yield and liquidity are options that are not necessarily available as a package. As we noted in a recent report on bank deposit growth (see Short Term Markets Outlook and Strategy, 3/5/12), the repeal of Reg Q has not resulted in massive growth of interest bearing deposits at the expense of money funds. Rather, most deposit growth has come in non-interest bearing accounts, which we believe have been boosted by the presence of temporarily unlimited deposit insurance (expiring on 12/31/12). When and if this round of money fund reform takes effect, the bank environment for the types of entities that currently own institutional

money fund shares (about 70% of taxable MMF AUM) will likely be less welcoming than it is now. The Basel III LCR will require a substantial portion of these deposits to be backstopped with liquid assets, making these types of deposits more costly for banks. Also, the likely sunset of unlimited transaction account deposit insurance may leave many large, institutional depositors facing considerable credit exposure to their depositories. Of course, depositors could try to spread money across more banks to diversify this risk and/or game the deposit insurance system, but that sort of deposit management can get complicated and costly.

• Invest in a market based alternative. One of the challenges faced by VNAV money funds is that they lack specialness. By this, we mean there is very little practical difference between a money market mutual fund with a floating NAV and an open-end mutual fund invested in short duration securities. SEC Chairman Mary Shapiro stated as much in a November speech at the SIFMA annual meeting. While it is possible money fund sponsors might try to add features to VNAV money funds to create specialness (perhaps multiple settlements during the day or other liquidity-focused features), the distance between money funds and the various types of short-term bond funds will be quite small. If there is nothing special to keep MMF shareholders attracted to VNAV funds, we expect hundreds of billions of cash currently invested in MMF will ultimately seek out alternatives in the short-duration fixed-income markets. Indeed, quite a bit of cash already has.

Data from Morningstar show there is growing interest in short duration bond funds, and there is some evidence of an inverse relationship with money fund outstandings, particularly at the retail level. The taxable short duration bond fund universe can generally be divided into three strategies: ultrashort bond, short-term government and short-term bond funds (Exhibit 4). Collectively, they had AUM totaled $286bn at 2/29/12 with the short-term bond product accounting for 72% of the total. As with every other asset class on earth, there is also a growing ETF market mirroring each of these strategies, although it currently totals only about $37bn.

In the retail investor space, there is a strong relationship between MMF and short-term bond fund outstandings (Exhibit 5). Over the past three years, every $100bn of retail prime MMF AUM decline was associated with about a $50bn increase in short-term bond fund outstandings.



66

However, the relationship is less apparent for institutional MMFs, which are where the big money resides in the MMF world. We think there is a good explanation for this lack of a relationship on the institutional side: institutions do not usually buy open-end bond funds.

While there is good anecdotal evidence that many institutional MMF shareholders already participate in the short-term fixed income markets, there is no particularly good data on the scale of this participation. This is in large part because these investors participate via other channels, including direct investment or separately managed accounts, with many of the latter managed by the same firms that manage the bond funds, using strategies similar to those employed in the bond funds. For institutional cash holders, these fund alternatives can offer advantages such as lower cost or better risk management. Even so, although short-term bond fund data do not capture the scale of institutional participation in these various strategies, they do provide a reasonable proxy for returns earned using the various strategies (Exhibit 6).

Relative to other market based alternatives, VNAV money funds may have some factors working in their favor over the next couple of years. Although it is not clear Rule 2a-7 will have any meaning in a post-CNAV world, most of the institutional money currently invested in MMF is there to provide liquidity and shareholders’ preference would prefer it invested in a manner similar to how CNAV funds are currently. Maybe this is the role VNAV MMFs are

destined to fill. As long as rates are low and securities are scarce it will be easier for VNAV funds to play that role, since low returns mean less incentive to take risk. The return gap between ultrashort bond funds and prime funds is relatively small now. But as was the case almost a decade ago, expectations of higher returns though rising interest rates or new investment options will create an incentive to chase returns. As was the case then, the money will likely follow (Exhibit 7).

Exhibit 4: The short duration mutual fund universe generally consists of three strategies (ultrashort, short-term bond, and short-term government) with short-term bond funds accounting for 72% of the total in terms of AUM Short duration open-end mutual fund and exchange traded fund types, AUM and fund sizes as of 2/29/2012

Source: Morningstar

Exhibit 5: Over the past three years, every $100bn decline in retail prime MMF AUM coincided with about a $50bn increase in short-term bond mutual fund AUM Retail prime MMF AUM versus open-end short-term bond mutual fund AUM ($bn)

Source: Morningstar, iMoneyNet, J.P. Morgan

Morningstar Category Description AUM Top funds by size AUM Top funds by size

Vanguard Short-Term Inv estment-Grade Inv ($38bn) iShares Barclay s 1-3 Year Credit Bond ($9bn)

Vanguard Short-Term Bond Index Inv ($24bn) SPDR Barclay s Capital Short Term Corp Bd ($1bn)

PIMCO Low Duration Instl ($21bn) Guggenheim BulletShares 2013 Corp Bond ($0.1bn)

Vanguard Short-Term Treasury Inv ($6bn) iShares Barclay s 1-3 Year Treasury Bond ($11bn)

Vanguard Short-Term Federal Inv ($6bn) iShares Barclay s Short Treasury Bond ($2bn)

Sentinel Short Maturity Gov t A ($3bn) Vanguard Short-Term Gov t Bd Idx ETF ($0.2bn)

PIMCO Short-Term Instl ($11bn) PIMCO Enhanced Short Maturity Strgy ETF ($1bn)

DFA One-Year Fix ed-Income I ($7bn) SPDR Barclay s Capital 1-3 Month T-Bill ($1bn)

Prudential Core Short-Term Bond ($4bn) Guggenheim Enhanced Short Dur Bond ETF ($0.1bn)

Short-Term Bond $206bn

Short gov ernment funds hav e at least 90% of their holdings in US Treasuries or agency debt and ty pically hav e durations of 1 to 3.5 y ears.

Short Gov ernment

Ultrashort bond funds primarly inv est in high grade US fix ed income securities w ith durations less than one y ear.

Ultrashort Bond $37bn

$42bn

$3bn

Short-term bond funds are ty pically blends of high grade credit, mortgage- and asset-backed securities, US Treasuries, and non-US gov ernment and agency bonds. Durations ty pically range from 1 to 3.5 y ears.

Open-end mutual funds Exchange traded funds

$20bn

$14bn

y = -0.5308x + 474.15R² = 0.9772

60

80

100

120

140

160

180

200

220

500 550 600 650 700 750 800Retail prime MMF AUM

ST B

ond M

F AU

M



67

Coming attractions • The next employment report is scheduled to be

released on 4/6. J.P. Morgan is expecting a change in nonfarm payrolls of 200,000, slightly lower than current market consensus of 210,000.

• First quarter earning season will kick off with JPM and WFC first reporting among the financials on Friday 4/13. They are followed by C on 4/16, GS on 4/17, BAC on 4/19, and MS on 4/20.

• On March 15, Moody’s published its expected

timetables for conclusion of bank rating reviews. Over the course of April and May, Moody’s will conclude its bank rating reviews with some notable conclusions as follows: Italian banks, week of April 16; Spanish banks, week of April 23; German, Dutch, and Swedish banks, week of May 7; firms with global capital markets operations, French, and UK banks, week of May 14.

Trading Themes

We favor staying with high-quality assets and look for directional moves or relative value within sectors, as the current risk-reward tradeoffs present minimal value in today’s low interest rate environment. • Overweight MBS repo versus bills

While both products satisfy money fund requirements, the spread between MBS repo and 3-month bills has steadily widened since the beginning of the year. Currently, the pick-up over 3-month bills is approximately 15bp versus 3-5bp in 1H11.

• Overweight ABCP versus bank unsecured CP/CD Despite Europe’s financial conditions, underlying US credit fundamentals remain solid. Our ABS strategists believe that even weak economic growth (1.8% GDP in 2012) will be sufficient to support decent ABS credit trends. As such, we favor ABCP conduits backed by traditional asset classes (autos, trade, equipment), all of which already have built in credit and liquidity enhancements. This pick-up over bank unsecured ranges from 15bp to 20bp.

• Overweight 1–3-year callables versus NC agencies

Given the Fed’s pre-commitment policy, front-end rates are likely to remain anchored at current low levels. As such, short-dated callables will continue to be called

and remain attractive relative to lockout- and duration-matched bullets. Our Agency strategists calculate that over 75% of Agency callables with call dates in the next two months are “in-the-money.”

• Overweight 1–3-year ABS versus agencies Both asset classes are rated AAA, but ABS trade much wider than Agencies. For example, AAA-rated 2-year auto ABS is offered at the equivalent of swaps +17bp versus 2-year agency at swaps-24bp. Consequently, ABS should provide a safe haven to investors looking for relatively higher-yielding cash surrogates.

Exhibit 7: In 2003, expectation of higher yields pushed money out of money funds into “enhanced cash” and other short duration strategies Taxable MMF AUM ($bn) versus Fed funds target and 3-month Libor 1y-year forward rates (bp)

Source: J.P. Morgan, iMoneyNet

Exhibit 6: Ultrashort bond funds have outperformed prime money funds with less volatility than other longer-term short duration strategies Monthly net total returns (bp)

Source: Morningstar, iMoneyNet, J.P. Morgan *Returns are through March 29, 2012.

1400

1900

2400

2900

3400

3900

0

1

2

3

4

5

6

Dec 02 Dec 04 Dec 06 Dec 08 Dec 10

TaxableMMF AUM

Fed fund Target

3m Libor 1y forward

-20

0

20

40

60

80

100

Jan 12 Feb 12 Mar 12*

ST Govt ST Bond Ultrashort Prime MMF



68

• Overweight 2-year non-financial and low beta

financial floaters We recommend overweighting non-financials and low beta financials in the 2-year FRN sector to capture the spread roll down. The spread pickup to extend from 1-year to 2-year for non-financial FRNs is about 50bp and 45-60bp for low beta financials.


Rishad AhluwaliaAC (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.P. Morgan Securities LLC

69

Collateralized Debt Obligations

• PineBridge priced a $413mn CLO bringing YTD supply to $5.4bn. The AAA at L+140bp is the tightest since August 2011. Reiterate L+125bp spread and $20bn supply targets for 2012

• March witnessed the most secondary BWIC activity since January 2009, but the $9.7bn tally comprises very large liquidations of ABS CDOs

• Concerns with China, oil prices, valuations, etc. spilled over into risky markets, which have had a mixed couple of weeks. While CLOs have largely traded sideways (except for super senior and AAA), we stay overweight. Value in AAA (in primary, 35bp wider than CMBS), BBB (in secondary, 225bp wider than loans), and equity (if 2012 matches 2011’s average 26.7% cashflow)

• We are pleased to release the results of our fifth CLO client survey. Responses were obtained from 79 clients; thanks to everyone who participated

• Regulatory reform and the arbitrage are the two main concerns. In terms of regulation, clients are most concerned with risk retention but if we add up Bank (SSFA, Basel III) and Insurance (Solvency II) risk capital, this is the highest

• Investor cash balances are a little lower than in December, but we cannot say for certain if there has been an actual decline as the respondent pool may be different in the current survey. At any rate, about one-third indicate cash of at least 10%

• More importantly, the investor buying/selling ratio at 8.50 is the highest since our inaugural survey in December 2009. This indicates continued very strong demand for CLO paper, even as spreads are tighter on the year

• Most respondents picked L+125bp as the most appropriate primary US AAA CLO spread, about 25bp tighter than the view taken in December. There is a tail extending tighter to about L+100bp

• The vast majority picked 12-15% as appropriate primary US CLO equity return. Interestingly, there does not appear to be a major difference in views between CLO managers and investors

Exhibit 1: Global CLO secondary spreads and recommendations

Spread to Libor or Euribor (bp) for originally-rated categories Source: J.P. Morgan. Note: 1. Between November 21, 2008 and December 9, 2010, AA to BB spreads are estimated using simplified duration and other assumptions; thereafter, indicative spread levels are used. 2. AAA is weighted average pass-through spreads. 3. Our series represents ‘mid-quality’ pricing in secondary trading. 4. WAL at issuance. Exhibit 2: US CLO 2.0 AAA prints (bp)

Source: J.P. Morgan, Bloomberg, S&P LCD, IFR. Exhibit 3: Global CDO BWIC volume ($mn)

Sector WAL* (years)

Current Spread

Change vs 03/22

Change YTD

Change 2011

Recommendation

US CLOSuper Senior 3-5 160 0 -30 20 Ov erw eightAAA 6-8 180 0 -40 -10 Ov erw eightAA 7-10 330 0 -120 100 Ov erw eightA 8-10 500 0 -115 165 Ov erw eightBBB 9-11 775 25 -75 200 Ov erw eightBB 9-11 1050 25 -125 225 Ov erw eightEuro CLOAAA 6-8 250 0 -30 25 Ov erw eightAA 7-10 575 0 -175 150 Ov erw eightA 8-10 800 0 -400 500 Ov erw eightBBB 9-11 1350 0 -200 500 NeutralBB 9-11 1900 0 -250 650 Neutral

100 110 120 130 140 150 160 170 180 190 200

Jan-

10M

ar-1

0M

ay-1

0Ju

n-10

Aug-

10Se

p-10

Nov-

10Ja

n-11

Feb-

11Ap

r-11

Jun-

11Ju

l-11

Sep-

11No

v-11

Dec-

11Fe

b-12

Apr-1

2

0

2,000

4,000

6,000

8,000

10,000

Jan-

09

Apr-0

9

Jul-0

9

Oct-0

9

Jan-

10

Apr-1

0

Jul-1

0

Oct-1

0

Jan-

11

Apr-1

1

Jul-1

1

Oct-1

1

Jan-

12

Monthly 3 Month Trailing



70

Primary & Secondary Flows

PineBridge priced a $413mn CLO bringing YTD supply to $5.4bn. The AAA at L+140bp is the tightest since August 2011 (Exhibit 2). We reiterate our L+125bp spread and $20bn supply targets for 2012. Turning to secondary, March 2012 witnessed the most CDO BWIC activity since January 2009 (Exhibit 3), but the $9.7bn tally comprises very large liquidations of ABS CDOs.

Relative Value

Concerns with China, oil prices, valuations and other factors spilled over into risky markets, which have had a mixed couple of weeks. CLOs have largely traded sideways (except for super senior and AAA), but we stay overweight. We point out value in senior (AAA primary 35bp wider than CMBS), mezzanine (BBB secondary 225bp wider than loans), and equity (if 2012 matches 2011’s average 26.7% cashflow). As a gauge to the second quarter, we explore investor views in our CLO survey.

2Q12 CLO Survey Results: Highest Buyer/Seller Ratio since December 2009

We are pleased to provide the results of our fifth CLO client survey. Responses were obtained from 79 external clients. Thanks again to everyone who participated.

Regulation looms large…but so does the arbitrage

Respondents have been concerned with regulatory reform, and this time is no different (Exhibit 4). The next question explores regulation, but the arbitrage placed a strong second, a result of concern with CLOs’ lag to loans: e.g., primary CLO BBB at L+600-625bp is not far off from L+700bp last year, whereas single-B loans are nearly 100bp tighter to L+536bp. The new category “CLO extension” is in the middle, suggesting concerns with lengthening risks. Finally, “Other” comprises tight spreads, market set-back, AAA appetite, FATCA, etc.

Risk retention most damaging to new issue, followed by Bank Risk Capital then Volcker

We pose a new question to gauge concerns with regulatory reform. Risk retention is seen as the most damaging to CLO new issue, a view taken by managers, investors, and others alike (Exhibit 5). While CRD122a is in place in Europe, the US is still waiting for guidance on risk retention set out in the Dodd-Frank bill. CLO market participants are also very focused on risk capital regimes. If we add up Bank and Insurance risk capital, this actually tops risk retention as a regulatory concern. The US banking industry commented on the SSFA proposal, but there are

Exhibit 4: What are your main concerns for the CLO market over the next 6 to 12 months?

Source: J.P. Morgan CLO Client Survey. Exhibit 5: Which regulatory changes pose the biggest hurdle to development of the CLO primary market?

Source: J.P. Morgan CLO Client Survey. Exhibit 6: How would you describe your current cash position?

Source: J.P. Morgan CLO Client Survey.

05

1015202530

Regu

lator

y ref

orm

Arbit

rage

in pr

imar

y

Colla

tera

l cre

dit

dete

riora

tion

CLO

exte

nsion

Liquid

ity in

Se

cond

ary

Scar

city o

f CLO

pa

per

BWIC

/Liqu

idatio

n

Othe

r con

cern

s

Manager Investor Both Other Respondent

01020304050

Risk

rete

ntion

Bank

risk c

apita

l

Volck

er ru

le

Insu

ranc

e risk

capit

al

Taxa

tion c

hang

es

Othe

r reg

ulatio

n


0%

10%

20%

30%

40%

50%

Low (0-5%) Moderate (5-10%)

High (10-15%) Very High (> 15%)

Q2 2012 Q1 2012



71

also broader concerns with Basel III. With respect to the strong showing of insurance risk capital in our survey, we think most of this is coming from Europe as the industry prepares for Solvency 2, which may adversely impact buying of CLOs and other products. Finally, the Volcker Rule is in third, indicating respondents felt there would be some impact. Please refer to our prior articles on regulatory reform.

Investor cash positions seem to have declined a bit, but still sizable proportion of “very high cash”

Investor cash balances are a little lower than in December, but we cannot say for certain if there has been an actual decline as the respondent pool may be different in the current survey. At any rate, about one-third of the current survey indicates a low cash balance, higher than in December 2011 (Exhibit 6). That said, the proportion of “very high cash” is unchanged, and, about one-third of the survey indicates a cash balance of at least 10%. It is hard to say, but the results may understate cash available to the CLO market, as our conversations with investors suggest many funds are still underinvested in the market.

Investor buy/sell intention ratio highest since Dec 2009

The most positive response has to do with anticipated positioning, and here the ratio of buying divided by selling intention is 8.50. Although we do not have a very long-term history, this ratio is the highest since our inaugural December 2009 client survey (Exhibit 7). About 63% of investor respondents plan to add, up from 50% in December 2011 (Exhibit 8). The proportion looking to hold or reduce dropped (though again, we cannot say for certain whether the pool of respondents has changed).

Targeted primary AAA spread has dropped by 25bp to about L+125bp

In December 2011, most respondents voted for a primary US CLO AAA spread of 150bp, in the aftermath of the selloff in risky markets, and as a few primary CLO AAAs printed as wide as L+170-175bp. The “new normal” in our survey points to about L+125bp, as per Exhibit 9. The adjustment represents an approximately 25bp move to the left of the chart, as respondents adjust to expectations of a tighter spread regime.

Interestingly, there is a tail tighter than L+125bp, with about 40% of the distribution at L+120bp or below (although this comprises more non-investor respondents). CMBS new issue spreads have tightened to about S+100bp, so there may be room for more spread tightening in CLOs if the overall trend continues.

Exhibit 7: CLO investor positioning in survey since 2009

Source: J.P. Morgan CLO Client Survey. Exhibit 8: How would you describe your anticipated CLO investment plans for the next six months?

Source: J.P. Morgan CLO Client Survey. Exhibit 9: What do you think is an appropriate primary US CLO AAA spread?


012345678910

0%10%20%30%40%50%60%70%

Dec-

09

Mar

-10

Jun-

10

Sep-

10

Dec-

10

Mar

-11

Jun-

11

Sep-

11

Dec-

11

Mar

-12

Add/Reduce ratio (rhs) AddHold Reduce

0%5%

10%15%20%25%30%35%40%45%

Add -

CLO

debt

an

d equ

ity

Add -

CLO

debt

on

ly

Add -

CLO

equit

y only

Main

tain/

hold

Redu

ce

Q2 2012 Q1 2012

0

5

10

15

20

< 100

bp10

0bp

105b

p11

0bp

115b

p12

0bp

125b

p13

0bp

135b

p14

0bp

145b

p15

0bp

155b

p16

0bp

165b

p17

0bp

175b

p> 1

75bp




72

12-15% most appropriate for primary equity return, with 15% garnering the most votes

Exhibit 10 illustrates the final question on appropriate primary US CLO equity return. As shown, the 15% return tranche garnered the most votes, similar to prior surveys, but there is a tail below this to slightly lower returns. Overall, the 12-15% return range makes up about 75% of the voting population in the survey. We find it interesting that there does not appear to be a major difference in views across respondent types, with a limited observable distinction between managers and investors. Perhaps the lack of equity or rising equity prices in secondary (along with the search for yield) has led to these results.

Exhibit 10: What do you think is an appropriate primary US CLO equity return?


0

5

10

15

20

25

< 10% 10

%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

> 20%

Manager

Investor

Both

Other Respondent



73

Credit Derivatives

• CDX.HY has outperformed IG this week after underperforming recently, but it remains too wide versus IG

• We recommend trading the HY/IG compression through options

• HY roll took place on March 27 and the S18/S17 roll spread has been very stable, but closer to fair value than we expected

• Bonds and their CDS have been trading about in line with each other and the CDS-bond basis is fairly priced in both HG and HY

• Credit underperformed versus equities

Softer markets

Both CDX.IG and CDX.HY widened this week, but are still tighter than a month ago and the beginning of the year. CDX.IG widened 2.5bp to 93bp. Meanwhile, CDX.HY is unchanged at 575bp ($96.88). CDX.HY has thus outperformed IG this week, as the usual trading pattern is for HY spreads to move about 6x more than IG spreads.

Nevertheless, HY is still significantly lagging IG in this year’s rally. In a 6-month perspective, HY is about 35bp/$1.4 too wide/cheap relative to IG (2 standard deviations away from a strong 96% R-square regression). HY has been too wide relative to IG for some time, in our opinion. This is likely due to technical factors such as the strong HY cash bond issuance YTD as we discussed recently in this publication. Cash investors use CDX.HY as a tactical instrument to put money at work while waiting to find cash bonds to buy in the primary or secondary markets. Generally, issuance is quite heavier in the first quarter, but demand is less seasonal. Therefore, we expect technical drivers to soften and HY to outperform IG going forward. However, defaults in the HY portfolio might limit CDX.HY’s outperformance. The single name CDS market is currently pricing a large default probability for some names in the HY index (such as ResCap and TXU) and this is partly responsible for HY’s relative underperformance.

Exhibit 1: CDX Indices (bp) Spread 1w change IG 90 3 HY 566 35 LCDX 278 0 Theoretical 1w change IG 95 3 HY 566 42 LCDX 382 -5 Basis 1w change IG -4 0 HY 0 -7 LCDX -104 5 Source: J.P. Morgan

Exhibit 2: CDX indices sold off this week, but CDX.HY is still lagging

Source: J.P. Morgan

Exhibit 3: A 6-month regression implies that HY is about 35bp ($1.4) too wide relative to IG

Source: J.P. Morgan

400

500

600

700

800

900

80

100

120

140

Mar 11 Jun 11 Sep 11 Dec 11 Mar 12

CDX.IG RnR, lhs (bp)

CDX.HY RnR, rhs (bp)

y = 5.24x + 53.66 R² = 0.96

350

550

750

75 95 115 135 155

CDX.

HY 5Y

Spr

eads

CDX.IG 5Y Spreads



74

Note that we use our Risk ‘n Roll CDX indices to “look through the roll” to assess their performance over time. This index indicates that CDX.HY is unchanged over the last month, but has tightened 129bp (+$5.0) YTD and widened 100bp (-$4.2) over the last year. This “through the roll” performance is not straightforward to determine, as names in the CDX portfolio change from one Series to the next and the index maturity is lengthened by 6-month (i.e., an increase of almost 11% for the 5-year contract at roll time). The Risk ‘n Roll index adjusts the history of the on-the-run CDX indices for both these factors and the entire history is recalculated every day. First, we adjust for the name changes (e.g., a +12bp impact in 17/18 roll). Second, we adjust for the time to maturity so that the historical index level has the same time to maturity as the current Series 18 index. We use the on-the-run curve to calculate the impact due to the maturity difference. We believe that the Risk ‘n Roll index allows for a better comparison of CDX.HY historical spread trends with other instruments both in credit and in equities. Also note that we also calculate Risk ‘n Roll indices for CDX.IG and LCDX. They are all available on Morgan Markets/DataQuery.

CDX options also indicate that investors have turned somewhat more cautious, more so in IG than in HY

Implied volatility increased this week, more in IG than in HY, as the indices were somewhat softer. On the week, IG implied volatility is up 5% at 53% and HY’s is up 2% at 48%. Such a large gap between IG and HY has not been seen since early January. This does not seem to be justified by the index levels or by their realized volatility. First, IG’s implied volatility is in line with its index in a 6-month perspective, while HY’s is about 5% too low. Second, IG’s realized volatility is 26% lower than HY’s which is at 33%. Therefore, we believe it is attractive to sell IG volatility and buy HY volatility.

We believe that the options market offers an interesting opportunity to position for relative outperformance of CDX.HY going forward. On Thursday, we recommended buying $50mn HY June call options struck at $100 at 62c and sell $250mn IG June call options struck at 80bp at 14c and thus receive $40,000 upfront. We like this trade because the HY index has been lagging IG’s but its implied volatility is lower. We size the trade this way as the long-term relationship between HY and IG is 6:1 for spread levels and thus 5:1

in a mark-to-market perspective (because of the difference in duration between the two indices). Therefore, the trade is sized 1:5 and the distance between the current level of the indices and the options strikes is about 1:6 in spreads terms (i.e., about 65bp for HY and 12bp for IG).

Exhibit 4: Implied volatility has increased this week, but more in IG than in HY, opening a gap not seen since early January

Source: J.P. Morgan

Exhibit 5: A 6-month regression implies that HY implied volatility is about 5% too low

Source: J.P. Morgan

Exhibit 6: CDX.IG trading volumes jumped on the roll day, as is usual

Trading volumes ($bn)

Change

3/27 3/28 $bn % CDX.HY S18 5y 6.9 7.9

1 14%

CDX.HY S17 5y 11.2 6.4 -4.8 -43% Source: J.P. Morgan, Markit

35%

55%

75%

Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12

CDX.HY 3m Implied Vol CDX.IG 3m Implied Vol

y = 0.0009x + 0.0265 R² = 0.699

40%

50%

60%

70%

80%

500 550 600 650 700 750 800



75

The trade should perform in a rally, especially if spreads go back to their levels about one year ago when IG was trading at 90bp and HY at 475bp (using our Risk ‘n Roll index to look through the rolls). The trade gain would stay at $40,000 if the markets sell off. One of the risks to the trade is for IG to tighten past 80bp and HY to stay wider than 500bp by June. However, note that IG has basically not traded below 80bp since early 2011 but that HY traded below 400bp then. We thus believe this to be limited. Another risk to the trade is defaults in the HY portfolio between now and June, which cannot be excluded given where some of the HY constituents single name CDS trade today (such as ResCap and TXU).

CDX.HY roll a little narrower than expected

The CDX.HY Series 18 index started trading on March 27. It started to trade in line with our expectations relative to Series 17, with the 17/18 roll opening at $1.50. However, the roll narrowed for most of the day and closed at $1.25 as there were marginally more long risk investors than short risk investors rolling from S17 to S18. The roll closed quite close to its $1.27 fair value. The Series 18 5-year index closed at $97.63 (527bp), $0.22 dearer than the fair value implied by its underlying CDS. Since then, the roll has been quite stable around $1.25 as shown in the Exhibits (see CMOS 03/30/2012).

The roll caused volumes to significantly increase in Series 17 and Series 18. For Series 17, the trading volume on the first day reached $11.2bn and $6.4bn on Wednesday. Series 18 traded $6.9bn on Tuesday and $7.9bn on Wednesday. This is much more than what the $4bn that the on-the-run index normally trades on average.

Credit underperformed equity this week

Over the week, while the S&P 500 gained 10pts, CDX.IG was 2.5bp wider. Therefore, equities outperformed credit as the last 6-month trading relationship is for the S&P and IG to move by about 4.3pts:1bp. However, this relative equity outperformance comes on the back of credit outperforming equities in the previous few weeks. Nevertheless, equity has generally outperformed in the recent rally if we compare the current levels to those of one year ago.

CDS and bonds trade in line in both HG and HY

CDS and bonds traded in line with each other last week, both in IG and HY. Over the last week the CDS bond basis is unchanged in both IG and in HY. In IG, bonds currently are trading 22bp wider than their CDS, on average. The basis in IG has been range bound between -10bp and -30bp in the last six months. The basis is currently closer to the wides of this range as IG bonds have underperformed their CDS by 9bp on average in March. In comparison, the basis in HY is still close the tights of its last 6-month range. On average HY bonds have traded very closely with their CDS in March with the current basis at -52bp. The basis in IG has been more volatile than in HY but the current CDS-bond basis levels in both IG and HY are fair in our opinion.

Exhibit 7: The 6-month regression is thus strong and CDX.IG and S&P 500 are currently trading in line with that trading pattern

Source: J.P. Morgan

y = -0.23x + 416.16 R² = 0.96

80 90

100 110 120 130 140 150

1050 1150 1250 1350 1450

CDX.IG

SP500


Peter DeGrootAC (1-212) 834-7293 Josh Rudolph (1-212) 834-5674 J.P. Morgan Securities LLC

76

Municipals

• Next week’s $8.5bn of yield oriented primary market issuance should be well received, with some potential for spread widening given the holiday shortened week

• Muni inflows rose to $430mn, after slowing in the week prior, with inflows reaching $16bn YTD

• New issue volume in 1Q12 was $78bn or 70% above the $48bn of supply in 1Q11

• We recommend an overweight in the higher education sector, with a balance of large highly-liquid top-tier universities and A rated private universities with valuable niche specializations

• Moody’s review of financial institutions would result in, at most, $20bn of VRDOs and $6bn of TOBs losing Tier 1 ratings if issuers did nothing to alter structures and all institutions under review were downgraded

Municipal market outperformance leads to resilient fund flows which are expected to buttress distribution amid a heavy calendar in the coming holiday-shortened week This week, against the backdrop of just $4.4bn supply, the market performed very well through Wednesday, with 10-year high-grade yields falling by 7bp and the Muni-Treasury ratio by 2%, from the close last week. By Friday however, trading activity had slowed and 10-year Municipal yields rose by 2bp in anticipation of next week’s calendar. Next week we expect up to $8.5bn in supply, over the holiday-shortened week, heavily weighted in yield oriented product (Exhibit 1). The largest three deals are rated below AA, led by $1.5-2.0bn A+/A+ Kaiser Permanente, $1.1bn Baa1/BBB+ New Jersey Economic Development (Cigarette Tax) bonds, $675mn Baa3/BBB- Virginia Small Business Financing bonds, $575 Aa3/AA- South Carolina Public Service, and $269mn Broward County Florida bonds. We anticipate strong demand, for the slate of yield-oriented bonds, with the possibility of some spread

widening given the large supply being placed over the shortened week. Any potential volume-related spread widening would likely be exacerbated should Treasury yields rise moving into quarter-end and the employment report on Friday. We believe that any meaningful spread widening in higher yielding bonds, particularly in the 1–10-year portion of the curve, should be viewed as a buying opportunity. Fund Flows Rebound Placement of new issue will be facilitated by sizable inflows for the year and the rebound in fund flows last week. Strong YTD market performance, as referenced by the 2.56% return on the S&P Municipal Bond IG Index,

Exhibit 1: Next week’s long-term issuance of approximately $8.5bn, exceeds the 2012 weekly average of $5.9bn Weekly Municipal bond issuance; ($bn)

* Holidays Source: Bloomberg

Exhibit 2: Fund flows bounce back as rates remain volatile

Source: Lipper FMI, J.P. Morgan

0

5

10

15Tax-exempt Taxable

20112010J J S O N D J F MA M J J A

*

*

* *

*

*

* * **

*

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N

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Fund flows Fund AssetsType of funds Actual 4-wk. avg. Actual 4-wk. avg.All term muni funds 430 1,039 537,363 536,297New York -22 16 34,026 34,002California 35 54 50,038 49,981National funds 416 923 369,457 368,636High Yield 98 197 52,822 52,589Intermediate 137 367 125,915 125,636Long Term 149 376 310,003 309,518Tax-exempt money market -2,439 -881 284,021 286,777Taxable money market -14,238 -12,283 2,292,311 2,313,253Taxable Fixed Income 4,403 8,934 3,210,206 3,199,846Equity -2,674 2,781 5,991,944 5,966,097



77

has resulted in $16bn of Municipal bond fund inflows thus far in 2012. For the week of 3/28/2012, funds saw inflows of $430mn (Exhibit 2) with most of the reported inflows coming from weekly-only funds. This week’s inflow is approximately one-third the average YTD inflow of $1.2bn, but shows renewed interest after last week’s marginal flows of $88mn. Investors spread the capital out relatively evenly with $149mn of inflows into long-term funds, $137mn in intermediate funds and $98mn of cash into high-yield funds. The vast majority of the flows for the period were from weekly filers as monthly reporters contributed just $127,000. ETF’s were marginally up at $27mn. We expect greater fluctuations in capital flows if yields continue their recent volatile path. Refunding volume drives issuance Issuance in the Municipal market has approximately been $78.2bn YTD versus $48bn last year and a 10-year average issuance of $86bn. The pace of new issuance continues to track near our full-year forecast of $350bn versus last year’s $297bn and trailing 10-year average annual issuance of $386bn. Much of this year’s volume has been the result of refunding volume given the exceedingly low rate milieu. The $78bn of total new issue volume in 1Q12 is comprised of $26bn (35%) in new money, $37bn (47%) refunding, and $15bn (19%) combined issuance. The heavy contribution of current refundings to total supply typically places additional emphasis on sustained low rates in order for supply to maintain the current pace. Given today’s extremely low yields in comparison to the debt that is available for refunding, longer dated yields could easily withstand a 100bp increase before meaningfully detracting from refunding volume. The high concentration of refunding has shifted issuance into the 10- to 20-year area of the curve at the expense of the 20- to 30-year sector. Year-to-date, 10- to 20-years have seen 7% greater proportional share of issuance relative to 1Q11. The changing issuance patterns explains the weaker and more volatile performance of intermediate term assets this year.

Exhibit 3: Issuance has been mostly in 10–15-year maturity range as refundings have dominated Market share; (%)

Source: S&P, J.P. Morgan

Exhibit 4: Issuers take advantage of lower rate environment with issues concentrated in lower coupon range Market share; (%)

Source: S&P, J.P. Morgan

5%

10%

15%

20%

25%

30%

1-5 5-10 10-15 15-20 20-25 25-30Nominal maturities

2011

2012

0%

10%

20%

30%

40%

0

0-3

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25

4.25

-4.5

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5

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Nominal coupns

20112012



78

The value of higher education has more than kept pace with the rapidly increasing costs This quarter is seeing more higher education bond issuance as a portion of total issuance than any other quarter in recent Municipal bond history (Exhibit 5). This spate of issuance, as well as our turn towards pro-cyclical credit sectors, encouraged this research note on US higher education institutions. We recommend an overweight in the higher education sector, with a balance of large highly-liquid top-tier universities and A rated private universities, such as Connecticut College, RPI, WPI, RISD, and Rollins. Most of these institutions have been around for well over 100 years and have niche specializations in an era when the value of higher education is greater than ever before. (Exhibit 6). For these reasons, top-notch large universities with global reputations drawing students from across state and national borders, with large and liquid endowments and low leverage, trade as well as the best credits in the Municipal market. Smaller colleges with long-established reputations offer an attractive way for Municipal bond investors to pick up 75-100bp with limited credit risk. In between the two, are universities such as NYU and UT that have premium reputations and highly inelastic demand that significantly boost their credit quality. This research note will first introduce the sector by detailing the risks and supports of its credit profile, and will then briefly discuss some credit factors of nine universities and colleges.

Two long-term headwinds make our positive credit view of higher education a contrarian view

There are two popular credit concerns with the sustainability of the high-grade risk profile of the higher education industry. First, some worry that the heavy reliance on endowment returns at large universities make for volatile cash flows. However, investment returns account for a relatively small portion of most schools’ revenues (typically less than 30% for privates; less than 10% for publics). Many schools only have a few hundred million dollars of endowment (much of which is restricted). The real credit strength of these institutions comes not from their investment returns but from their demonstrated willingness and ability to raise fees and manage costs to meet budgetary challenges. However, those rising student costs are in fact the second

Exhibit 5: More higher ed issuance than any quarter in years Higher education issuance as % of total Municipal bond issuance

Source: Thomson SDC

Exhibit 6: Higher education credit analysis involves a wide array of credit metrics Selected higher education credits; ranked by credit spread; credit strengths are shaded green and weaknesses are shaded orange

1 US News rankings reflect "national universities." For schools without a national ranking, we show their niche ranking. Rollins is #1 among regional universities in the South. CT College is #37 nationally among liberal arts colleges. Source: US News, school websites and filings, J.P. Morgan

0%

2%

4%

6%

8%

10%

12%

14%

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

2009 2010 2011 '12

Basic info Operational metrics Financial metrics10yr spread to Underlying Public/ Example Year Student enrollmt. Avg. Admit. Matricu- US News Tuition Endowment Leverage

Issuer AAA MMD (bp) credit rating private CUSIP estab. total # 5y cagr SAT % lation % ranking1 $k 5y cagr $bn $k/student spend debt svc./exp. debt/endwnt. coverageHarvard Univ. (MA) 0 Aaa/AAA Private 57583R5Q4 1636 27,594 1% 1485 6% 76% #1 $39,851 3% $31.7 $1,150 3.8% 8% 20% 6.0xYale Univ. (CT) 0 Aaa/AAA Private 20774UTU9 1701 11,875 1% 1500 7% 64% #3 $42,300 4% $19.4 $1,631 6.2% 11% 21% 6.5xUniv. of Texas (TX) 20 Aaa/AAA Public 9151373F8 1883 167,197 2% n/a 65% 47% #45 $14,336 4% $17.1 $130 5.0% 3% 34% 3.7xNew York Univ. (NY) 50 Aa3/AA- Private 649903S44 1831 39,000 2% 1380 26% 34% #33 $43,640 6% $2.8 $73 5.0% 8% 20% 1.0xConnecticut College (CT) 75 A2/nr Private 20774U7E9 1911 1,888 0% 1321 34% 28% #37(1) $43,990 -1% $0.2 $106 5.0% 4% 35% 1.4xWorcester Polytech. (MA) 85 A1/A+ Private 57583RS48 1865 5,778 8% 1290 57% 25% #62 $40,030 3% $0.4 $62 5.4% 8% 56% 2.1xRI School of Design (RI) 85 A1/nr/A+ Private 762242Z65 1877 2,396 0% 1225 34% 51% unranked $39,777 4% $0.3 $117 5.0% 4% 61% 2.4xRensselaer Polytech. (NY) 100 A3/A- Private 897579AB4 1824 6,914 -1% 1366 40% 21% #50 $41,600 4% $0.6 $84 8.0% 10% 123% 1.8xRollins College (FL) 100 A1/nr/nr Private 34073TBU0 1855 3,043 -1% 1220 56% 31% #1(1) $38,400 3% $0.4 $117 4.5% 1% 29% 2.6x



79

long-term credit risk facing the higher education industry. If the rampant inflation in college tuition prices continues unabated for another generation, many families will be priced out of the higher education market. Already over the past generation, the cost of a college education has increased nearly five times faster than consumer price inflation (Exhibit 7). While we agree that this is an issue that must be tackled by US higher education institutions, we would also point out that the only thing that has risen faster than the cost of education in the past generation is the benefit of education. A college degree has become the inimitable ticket to labor mobility in recent decades, due to both the rapid advance of technology and the doubling of the global labor force after the fall of the Berlin Wall (from 1.5bn to 3bn, due to the opening up of the world’s largest economies). These two trends have contributed to a global premium on the value of higher education unlike any other time in modern history. The resulting inelasticity of demand has engendered significant pricing power, particularly among the top-notch institutions.

The best offense is a good defense

As we noted last week, the cyclical upturn in economic growth helps the credit profile of higher education institutions through growth in endowment balances, state revenues, and person incomes. But the strongest relative feature of higher education credit profiles might be what they avoid, rather than what they offer. Along with other revenue bond sectors we have highlighted, higher education issuers allow investors to generally side-step the four relatively new credit issues that are facing state and local governments in the US. These issues are unfunded pension liabilities, escalating healthcare costs (although some universities have notable healthcare exposure), linkages to the federal government, and willingness to pay under political strain. Particularly, the unquestioned willingness of colleges and universities to pay debt service is a credit strength that highlights the relative strength of the higher education industry. Colleges and universities are demonstrating their willingness and ability to raise new revenues. This demonstration provides a degree of confidence and reliability in the rate covenant. To our knowledge, there has never been a wave of higher education debt repudiation in the US. The only real credit risk is that something happens to the school that prevents students from attending. Thus, credit risk for higher

education has a lot to do with extreme tail risks (scandals, natural disasters, terrorism, etc.). For example, the College of William and Mary had to close during the Civil War. But more often than wars or natural disasters, smaller denominational or gendered specific colleges have had to merge with or have their assets purchased by another college. For example, in the 1970’s, with the growing acceptance of coeducation, two women’s colleges in NY (Briarcliff and Bennett) had to sell their assets and enter bankruptcy. But even these instances of higher education credit events are exceedingly rare. Exposure to fiscal transfers can be more pronounced for public university systems than for private colleges. Last year the FL legislature commandeered a portion of the reserves of the state’s eleven public universities in order to balance the state budget. The year before that, the University System of NH made a “voluntary” contribution of $25mn to the state in order to keep the system’s recurring funding, according to Moody’s.

Exhibit 7: College is five times more expensive than it was a generation ago, after adjusting for inflation Cumulative US price inflation since 1980

Source: US Bureau of Labor Statistics

0

2

4

6

8

10

12

1980's 2000's1990's

1.8x

9.3x

Tuition

CPI



80

Eleven examples from across credit spectrum

• Harvard University (Aaa/AAA): Combining arguably the strongest brand name in the world of higher education, as well as the largest endowment in the country (Exhibit 8), Harvard is one of the strongest credits in the Municipal bond market. The University’s total expendable resources are 7.5x operating expenses and 5x debt outstanding ($6.3bn). Moreover, beyond the sizable endowment and limited leverage, we view the value proposition of this top-tier institution will maintain the revenue stream for this institution for generations to come.

• Yale University (Aaa/AAA): Founded over 300 years ago, Yale is one of the most elite educational institutions in the world. The average SAT of incoming freshmen is 1500 (highest in Exhibit 6). The school’s top-notch brand name and sizeable endowment ensure its ability to perform in difficult economic environments. The credit also features favorable trends in its revenue diversity and reliance on investment income. Yale also has both the highest endowment per student and the highest debt service coverage among the 11 schools listed in Exhibit 6. In recent years, Yale has taken steps to decrease its reliance on investment income as a means to fund their operations. In FY2011, the school allocated 11% less in endowment resources to fund operating activities, as compared to FY2010. Yale has successfully worked to offset the reduction in endowment spending by controlling expense growth. Meanwhile, revenue growth has been broad-based, allowing tuition growth to be modest as well.

• University of Texas (“UT”) (Aaa/AAA):

Awarding more than one-third of the undergraduate degrees in the state, and one half of the doctoral degrees, UT has a near monopoly in Texas higher education. In addition, the University has very strong financial metrics. At $13.2 billion, UT’s FY 2011 operating revenue was the highest of all Moody’s Aaa rated public universities. The University maintains 177 days cash on hand and a debt service coverage ratio of 3.7x. The

University’s System Revenue Bonds are secured by a diverse funding base, of which state appropriations account for only 14%. However, the 38% of revenues generated from health care via five academic medical centers poses future downside risk. Several of the UT medical centers have large exposures to Medicare and Medicaid, which continue to reduce the level of reimbursements. Additionally, many of the changes directed by President Obama’s Healthcare reform are not scheduled to take place until at least 2015. This may lead to consequent revenue pressures, cost inflation and margin erosion.

• New York University (“NYU”) (Aa3/AA-): This

University is composed of its main Washington Square campus, NYU School of Medicine, and Polytechnic University of NYU in Brooklyn, NY. It also opened a degree-granting branch in Abu Dhabi and a campus in Shanghai is in the works. NYU is one of the highest priced institutions in US (growing faster than any other school in Exhibit 6), with the academic component accounting for most of the university’s financial resources. The university’s greatest asset is its $7bn of real estate, while its greatest liability is the exposure of its medical school and clinical facilities to the healthcare industry. While the Washington Square campus generates strong operating surpluses, the School of Medicine has produced deficits ever since 2008, when it sold the rights to the recurring revenues

Exhibit 8: 18 schools have endowments larger than $5bn Endowment balance; ($bn)

Source: National Association of College and University Business Officers

32

19 17 17 17

10 8 8 7 7 7 7 6 6 6 5 5 5

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81

associated with a major drug, in order to make investments in the medical school. The medical school hopes to achieve a breakeven point in 2017 with these investments. NYU has also had successful fundraising campaigns, surpassing the original goal of $2.5bn by raising $3.1bn in 2008. Donations also increased by 40% in 2011. NYU’s debt structure is conservative, with most of its long-term debt in a fixed-rate mode with no debt-related derivatives.

• Connecticut College (A2/NR): This is a

selective liberal arts college located in New London, CT. It has a strong market position, accepting only 34% of the applicants this past year, 28% of which actually attended. The College highly relies on student charges, with tuition and auxiliary revenue forming 78% of operating revenues. The college also sees a very high tuition per student at nearly $44,000 (highest in Exhibit 6), above the $19,000 median for similar small private colleges. However, growth in tuition per student has slowed in recent year. For this reason, management has focused on attracting students from the west and southwest, as well as students who might pay the full tuition and not need any aid as economic conditions improve. The college currently has a fundraising campaign for $200mn, expected to end in 2013. The college plans to borrow $12mn within the next 12-18 months. All of its debt is in fixed-rate mode and the College saw an investment return of 21% in 2011.

• Worcester Polytechnic Inst. (“WPI”) (A1/A+):

Located in Worcester, MA, WPI is the third oldest private technological university in the US. With about 5,500 total students, WPI has seen an increase in applications and enrollment as selectivity has improved. In 2005, WPI constructed a life sciences and bioengineering facility in Worcester and became the sole member of the project. This transaction has increased the institute’s assets as well as its long-term debt. Tuition has increased over the years and WPI has become more dependent on student charges to fund operations, with tuition being 65% of operating revenues, up from 55%. The new administration that took over in 2006 has improved WPI’s financial performance. Operating margins were strong and endowment

spending remains around 5.4%. WPI’s maximum debt service is high with a debt burden of 8% of its operating expenses. Its variable rate bonds are supported by letters of credit from the TD Bank, N.A., adding risk to its credit profile. Annual giving has been solid with the alumni participation rate up to 20% from 17%.

• RI School of Design (A1/NR/A+): One of the

leading art and design colleges in the world, RISD is located in Providence, RI with 2,396 full-time students. The school admits 34% of applicants and half of those admitted actually attend. The student body is geographically diverse, with only 43% from the Northeast and with a high net tuition per student of $33,626. RISD has healthy operating margins due to its conservative budgeting practices, although they are expected to decrease from the high 12% level seen last year. In 2008, RISD had suspended spending from its endowment in order to preserve its assets but is expected to return to its normal 5% draw in 2013. RISD recently finished a strategic planning process, which includes investments over the next five years for research initiatives, student support, technology and facility investments. In 2011, the school’s total gift revenue was the lowest of the past five years. RISD is not planning to issue new debt and wants to fund its projects with internal funds and private gifts.

• Rensselaer Polytechnic Inst. (“RPI”) (A3/A-):

Founded in 1824, RPI is one of the first technological universities in the US. The school’s main campus is in Troy, NY, with an additional campus for graduate students is in Hartford, CT. RPI offers 140 degree programs in nearly 60 fields leading to bachelor, master, and doctoral degrees. RPI has seen an increase in its freshman applications in the past few years, helping it to become more selective. In 2000, RPI adopted a new strategic plan, called “The Rensselaer Plan” that included upgrading its facilities to attract a greater diversity of research and students. Within this plan, RPI has constructed a new Bio-Tech Center and opened a new arts facility. RPI’s endowment has decreased in the past three years, which is an important risk given that the institute relies on supplemental draws from its endowment for



82

spending (highest in Exhibit 6). However, the endowment spending has reduced in the past year as expenses were reduced in part because of refunding savings. Tuition for undergraduate students has increased, accounting for 52% of the institute’s operating revenues. The Hartford campus continues to be a problem with fewer enrollments leading to a decline in tuition revenue. RPI completed its largest fundraising campaign in October 2008, raising $1.4bn.

• Rollins College (A1): This private residential

liberal arts college in Winter Park, FL, is the top-ranked regional university in the South, with over 3,000 full-time students. Rollins has experienced a decline in its enrollment in the past five years, some of which was intentional due to the effect of increasing tuition rates for its continuing education program. It will be important to see that this decline in enrollment levels off, given that 75% of the College’s revenue depends on student tuition and charges. In 2011, the college had a -5.6% operating margin, driven by the lower net tuition revenue and increase in operating expenses. In order to increase revenues and cash flow, the college is currently building a 112-room college inn and restaurant that will support the increased debt service responsibility. Rollins is already planning its next capital campaign, after the success of the previous one, raising over $160mn. Debt levels are low, and Rollins has a successful commercial real estate venture near the campus, valued at roughly $45mn.

Moody’s review of financials presents another near term hurdle for money market buyers On February 24 and March 2, J.P. Morgan’s Short-Term Fixed Income Strategy team discussed the potential impact of Moody’s ratings review of large financial institutions on the short-term Municipal debt market. Below is a brief outline of the potential impact of the Moody’s actions as defined by Alex Roever et al. The full reports can be found on ‘link1’ and ‘link2’. On February 15, the rating agency announced the review of 17 global capital markets intermediaries and a number of large international banks. On February 21, Moody’s also placed on review over 1,000 Municipal bonds

related to these credits. We expect the review period will follow the typical cycle with the outcome announced in around three months. We estimate up to $20bn VRDOs, of the approximately $200bn held in money market funds, could be downgraded to “Tier 2” status (Exhibit 9). We also identified as much as $6bn out of a total $65bn of TOBs could be downgraded to Tier 2 (Exhibit 10). These projections are based on a worst case scenario in which all of the banks under review by Moody’s get downgraded. Note that the analysis assumes that securities backstopped by a bank with short-term ratings downgraded to P2 by Moody’s will remain Tier 1 if still rated A-1/F1 by S&P and Fitch, respectively. We expect that the rate of the SIFMA index will rise over the review period and fall subsequent any downgrades as the downgraded names are dropped from the index. Generally speaking, we believe the risk of failed remarketing is limited in that the demand for Tier 2

Exhibit 9: Yields on AA rated, taxable Municipal bonds have been tightening since January 2012.

Source: J.P. Morgan estimates, Crane Data, Bloomberg, Moody's

Remains Tier 1

Becomes Tier 2

Citibank Y 10.8 1.0 0.0 1.0Bank of America Y 5.6 3.8 0.0 3.8Morgan Stanley Y 3.8 0.3 0.0 0.2Deutsche PostBank Y 0.8 0.7 0.0 0.6Total under review 21.0 5.8 0.0 5.7

JPMorgan Chase N 14.4 8.8 0.0 0.0Wells Fargo N 7.7 2.5 0.0 0.0Deutsche Bank N 5.0 0.5 0.0 0.0US Bank N 5.0 1.9 0.0 0.0Roy al Bank of Canada N 3.5 3.3 0.0 0.0State Street N 2.2 2.2 0.0 0.0Branch Banking & Trust N 2.1 1.2 0.0 0.0Freddie Mac N 1.4 0.0 0.0 0.0Federal Home Loan Bank N 1.0 0.0 0.0 0.0Barclay s N 0.8 0.1 0.0 0.0Societe Generale N 0.3 0.0 0.0 0.0Bank of New York N 0.2 0.2 0.0 0.0Rabobank N 0.2 0.1 0.0 0.0BNP Paribas N 0.0 0.0 0.0 0.0Bay erische Landesbank N 0.0 0.0 0.0 0.0HSBC N 0.0 0.0 0.0 0.0Total not under review 43.8 20.9 0.0 0.0Total 64.8 26.6 0.0 5.7

Bank providing support

ST Ratings Under

Review by Moody's

TOB exposure to banks

in all MMF

Moody's Rated in

MMF

If Moody's cuts ST rating…

https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-800494-0.pdf�

https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-735435-0.pdf�



83

bonds will likely be sufficient, given higher market clearing levels. Following any potential downgrades, two most obvious technical takeaways would be for tighter spreads in the remaining 2A-7 eligible universe and wider spreads for non-money market eligible short-term paper. The quality of the SIFMA index should richen relative to Libor. That said, ratios may ultimately rise if swap market liquidity stalls, as downgraded firms are required to post additional collateral against existing swaps transactions. Market impact will likely be mitigated by issuers taking steps to limit exposure to financial institutions on the cusp of Tier 2 by moving some portion of the existing debt to direct loans, changing liquidity providers, and extending into longer term financings. That said, regulatory factors such as Basel III and the Volcker rule could further limit remaining Tier 1 bank’s appetite for VRDO’s, LOC’s and TOB’s. The performance of 4% bonds would drop off considerably given an increase in yields of 25bp or more, at about a $96 price, as 4.25% and 4.5% coupons would become the discount coupon of choice. Given a total increase in yield of around 45bp, de minimis would significantly limit liquidity of the bonds with egregious performance implications.

Exhibit 10: Yields on AA rated, taxable Municipal bonds have been tightening since January 2012.

Source: J.P. Morgan estimates, Crane Data, Bloomberg, Moody's

Bank providing supportRemains

Tier 1Becomes

Tier 2Bank of America Y 24.4 16.4 4.6 11.4Citibank Y 6.9 5.9 1.1 4.6Lloy ds TSB Bank Y 2.1 1.5 0.3 1.1Landesbank Baden-Wuerttemberg Y 1.6 1.6 0.0 0.9Morgan Stanley Y 1.0 0.7 0.2 0.3KBC Y 0.9 0.8 0.0 0.6BBVA Y 0.6 0.4 0.1 0.1UBS Y 0.4 0.4 0.0 0.4Roy al Bank of Scotland Y 0.3 0.2 0.0 0.2Total under review 38.1 27.9 6.3 19.6

JPMorgan Chase N 23.6 18.3 0.0 0.0Fannie Mae N 13.4 6.8 0.0 0.0Wells Fargo N 13.0 9.4 0.0 0.0US Bank N 9.7 6.1 0.0 0.0Freddie Mac N 7.7 4.2 0.0 0.0Roy al Bank of Canada N 7.0 6.3 0.0 0.0PNC Bank N 6.9 4.9 0.0 0.0Federal Home Loan Bank N 6.0 4.3 0.0 0.0Landesbank Hessen-Thuringen N 5.6 4.9 0.0 0.0Toronto Dominion N 4.4 3.5 0.0 0.0Branch Banking & Trust N 3.8 3.1 0.0 0.0Barclay s N 3.5 3.4 0.0 0.0State Street N 3.2 2.9 0.0 0.0Mitsubishi UFJ Financial N 3.2 2.1 0.0 0.0Bank of Nov a Scotia N 2.7 2.1 0.0 0.0Bank of Montreal N 2.3 1.4 0.0 0.0Northern Trust N 2.2 1.6 0.0 0.0Bank of New York N 2.1 1.7 0.0 0.0M&T Bank N 1.8 0.4 0.0 0.0SunTrust Bank N 1.8 1.7 0.0 0.0Top 20 not under review 123.9 89.1 0.0 0.0Total* 182.4 129.8 6.3 19.6

ST Ratings Under

Review by Moody's

If Moody's cuts ST rating…Moody's

Rated in MMF

VRDO exposure to banks

in all MMF



84

Trading recommendations • Overweight school districts in Utah (state

guaranteed) and Texas (Permanent Fund) Spread to AAA MMD: +25bp (US Fixed Income Markets Weekly, 10/28/11).

• Overweight airports with limited competition,

manageable leverage, and robust liquidity in growing service areas Spread to AAA MMD: LAX (+90bp), Houston (+100bp), Atlanta (+110bp) (US Fixed Income Markets Weekly, 9/30/11).

• Investors who hold longer-dated BABs and pay

above a 14% marginal effective tax rate should consider selling BABs and purchasing similarly rated tax-exempt bonds for sizable gains in taxable equivalent yield (US Fixed Income Markets Weekly, 9/23/11).

• Overweight established toll roads with

manageable leverage, tight flows of funds, ample liquidity, strong demographics and independent toll-setting regimes Spread to AAA MMD: HCTRA (+70bp), NYSTA (+115bp), PTC (+125bp) (US Fixed Income Markets Weekly, 9/23/11).

• Investors should consider using conservative 1:1

leverage in the intermediate sector of the curve to generate higher returns than investing in 30-year high-grade bonds, with similar curve risk, far greater roll down and a more liquid exit strategy (US Fixed Income Markets Weekly, 8/19/11).

• Overweight electric utility bonds with lower debt

burdens and lean cost structures located in healthy economies Spread to AAA MMD: NYPA (+55bp) (US Fixed Income Markets Weekly, 8/26/11).

• Overweight water and sewer bonds with conservative structures, healthy financial metrics, growing and prosperous populations, autonomous and experienced management, and sound regulatory compliance Spreads to AAA MMD: MWRA (+35bp), CA DWR (+45bp) (US Fixed Income Markets Weekly, 8/19/11).

• Overweight special tax bonds with clean flow of funds, reliable rule of law, abundant coverage, and a broad-based revenue stream Spreads to AAA MMD: MBTA (+35bp), TFA (+40bp), Build Illinois (+120bp), MD DOT (+15bp) (US Fixed Income Markets Weekly, 8/12/11).

• Investors should consider paring typically hard to

trade structures and credits while the primary calendar is thin and high grade yields remain low, thereby locking in total return gains since 1Q11 (US Fixed Income Markets Weekly, 8/5/11).

• Overweight the 8–12-year sector of the tax-

exempt yield curve to capture curve roll offered by the steep yield curve The belly of the curve offers 163-216bp of curve roll, except for the 10-year point, which only offers 143bp (US Fixed Income Markets Weekly, 7/8/11).

• Overweight California taxables both corporates

and Treasuries CA taxables (7.3% 2039) offer 62bp over A-rated corporates and 290bp over Treasuries. We expect the spreads over Treasuries to tighten another 10-20bp (US Fixed Income Markets Weekly, 6/12/11).

• Overweight BBB spreads in both tax-exempts

and taxables We expect tax-exempt Muni bonds will outperform Treasuries, over time, in a rising yield environment and believe the spread of BBB tax-exempt bonds will compress relative to the high-grade scale (US Fixed Income Markets Weekly, 6/12/11).

• Investors who expect 30-year high-grade yields to reach 3.75% in the near term may consider selling high-grade longer dated 4s while these bonds are still highly marketable. This structure will begin to trade at a steep discount and become very difficult to trade given a 20-25bp increase in 30y-year high-grade yields. It may also be prudent reduce concentrations in some of the less liquid sub-investment credits while high-yield investment capital is still plentiful (03/16/2012).



85

Supply forecast Monthly tax-exempt bond issuance; ($bn) Monthly tax-exempt net supply/(redemptions); ($bn)

Source: Bond Buyer, J.P. Morgan Source: Bond Buyer, IDC, J.P. Morgan

Interest rate forecast Yield; (%)

Source: J.P. Morgan Source: J.P. Morgan

0

10

20

30

40

50


5yr avg.20112012

Annual total:$410$290$350

-25-20-15-10-505

10152025


5yr avg.20112012*

Annual total:+$87-$68+$4

2Q12 3Q12 4Q12Treasury Current Forecast Forecast Forecast2yr 0.33 0.30 0.30 0.305yr 1.04 1.25 1.25 1.2510yr 2.22 2.50 2.50 2.5030yr 3.34 3.60 3.60 3.60

AAA tax-exempt2yr 0.36 0.48 0.48 0.485yr 0.98 1.20 1.20 1.2010yr 2.11 2.44 2.44 2.4430yr 3.39 3.90 3.90 3.90

AAA tax-exempt yield / Treasury yield (% )Min Max Mean St. Dev. 3mo 12mo

2yr 107.60 76.48 165.05 117.88 30.20 -0.34 -0.565yr 93.99 73.33 103.75 89.42 8.62 0.5 0.0

10yr 95.18 88.09 102.98 94.49 3.34 0.2 -0.330yr 101.38 99.43 123.07 105.73 6.03 -0.72 -0.93

AA corporate yield - AA tax-exempt yield (bp)Min Max Mean St. Dev. 3mo 12mo

3-5yr 65.27 62.87 101.70 83.68 9.48 -1.9 -2.15-7yr 98.51 89.68 150.03 114.20 15.62 -1.0 -1.8

7-10yr 117.30 105.81 174.45 141.12 21.86 -1.1 -1.125yr 98.47 72.15 121.60 104.36 9.53 -0.6 0.5Negativ e/green v alues indicate cheaper than ty pical; Positiv e/orange indicate richer

Z-score

Z-score

Emerging Markets Research US Fixed Income Markets Weekly March 30, 2012

Joyce ChangAC (1-212) 834-4203 Luis Oganes (1-212) 834-4326 J.P. Morgan Securities LLC

86

Emerging Markets

• We remain overweight both EMBIG and CEMBI, but reduce risk after the strong rally YTD

• Japanese flows into EM fixed income turned positive for the first time in eight weeks and offset declines in US/European inflows

• YTD inflows to EM fixed income reached $21.4bn, roughly half of 2011's full-year inflows and more than half of this year’s target

Market views We remain overweight both EMBIG and CEMBI spreads, but continue to reduce risk after the strong rally YTD. Despite dovish comments from Bernanke at the beginning of the week, J.P. Morgan economists (and it seems the market too) view the odds of more QE from the Fed as unlikely, which may moderate the appetite for risky assets, including EM. However, our recent conversations with multilateral officials suggest that the bar for another LTRO auction by the ECB may be low; specifically, if the EU/IMF firewall is not meaningfully increased, another LTRO is likely to follow. In our GBI-EM model portfolio, we are 5% underweight EM FX (our middle option), which has worked well as the dollar rallied. We moved to neutral duration last week; we are short duration in EM Asia versus small overweight in Latin America (Brazil) and EMEA EM (long Poland and South Africa, short Turkey). Also, we took partial profits on the EMBIG overweight last week, and we retain a modest (2.5%) overweight in our EMBIG model portfolio. We are also overweight EM Corporates, even though we have reduced risk to high yield names in recent weeks. Japanese flows into EM fixed income turned positive this week and offset declines in US/European inflows. Dedicated EM fixed income enjoyed $727mn of inflows this week, a pace comparable to the previous week as the small decline in US/European inflows were offset by the modest pick-up in Japanese inflows. We estimate YTD EM inflows at $21.4bn, roughly half of 2011’s full-year inflows. In the US/European retail space, inflows dropped to $522mn from $852mn last week, with local fund flows of $285mn surpassing hard currency fund flows (+$202mn) and blended fund flows ($35mn). Japanese investment trust flows turned positive for the first time in

eight weeks, driven by hard currency funds. Total inflows of $204mn were the result of local currency outflows of $160mn partially offsetting hard currency inflows of $365mn. A sizeable pipeline of new launches in the coming month should be positive for Japanese inflow momentum, should they materialize. In the past month, EM bond fund flows have been matching or outpacing other asset classes in terms of percent of AUM. While this trend continued this week, the magnitude of inflows has been in a downtrend for the second consecutive week. EM bond flows at 0.4% of AUM this week are down from 0.6% last week and 1.1% two weeks ago. Trade recommendations • Malaysia and Thailand: Enter into curve steepeners.

The three legs underpinning the bond investment thesis in EM Asia (more Asian growth, more FX appreciation, and more inflows) are beginning to weaken, particularly since our forecast for a meaningful rebound in Chinese activity in the coming quarters seem to have downside risks. Bond curves in Southeast Asia, in particular, are subject to steepening pressure if foreign buying slows, as these markets are (1) highly sensitive to changes in foreign holdings, (2) already historically flat on past inflows, (3) lacking strong domestic back-stops, and (4) facing higher supply and deficits. In Malaysia, we enter a 1-year forward 2s5s MYR IRS curve steepener at 40bp and underweight MGS in our GBI-EM model portfolio. In Thailand, we roll our existing 2s10s THB IRS steepener into a 3s10s steepener instead at 61bp and underweight THAIGB in our model portfolio. Elsewhere, we continue to hold a forward start 2s10s SGD IRS steepener, and maintain a neutral call on INDOGB versus underweight on IDR FX.

• Peru: Stay overweight Soberano Aug’20 bonds. The correlation of the Aug-20s SoT versus 10-year UST suggests the yield should remain range bound in the near term. PEN is a low vol currency; the steady trend of the USD/PEN appreciation made it the only currency in the region to gain in 2011. Indeed, the Soberano bond market proved to be resilient in 2H11 as inflows picked up as global markets sold off. Despite a high share of ownership by foreigners, the size of the market should keep risk of a capital flight sell-off low. Soberanos are trading 50bp cheap to Peru Republic external debt bonds, which have rallied along with risky assets. The low volatility of the FX along with stable YTM for the bond should continue to attract investors looking for higher yields.


Michael E. FeroliAC (1-212) 834-5523 Bruce Kasman (1-212) 834-5515 Robert Mellman (1-212) 834-5517 J.P. Morgan Chase Bank

87

Special Topic: Swing shift: Better news from US labor demand and supply5

• US labor market is set for both demand and supply to lift materially

• Expect 200,000 monthly job gains as firms shift to expansion mode and as labor become a low-cost input

• A large shadow pool of workers is ready to enter the labor market; we expect the participation rate to rise 0.4%-pt over 2012-13

• Productivity gains to remain low, driving the unemployment rate down to 7.7% by end-2013

• Most of underutilized labor is cyclical and will restrain wage pressures over 2012-13

The damage caused by the Great Recession and subsequent sluggish expansion is most evident in the US labor market performance. Employment declined precipitously during the downturn and job gains through the first two and a half years of the economic recovery have proved disappointing. As a result, total employment remains about 5.5mn below its prior cyclical peak. Taking population growth into account paints an even bleaker picture: the ratio of employment to the working-age population is substantially lower than it was when the recession ended.

The collapse of labor demand has been accompanied by a sharp and unprecedented decline in labor supply. From an average of 66% over 2003-2007, the labor force participation rate fell to 64% in 4Q11, its lowest level since early 1984. Net immigration has also fallen, slowing the growth rate of the working-age population, from average growth of 1.3% from 2003-2007 to an average of only 0.8% over the past four years. The net result is that labor force slowed from a previous trend growth of 1.2% per year to an average of only 0.1% per year—essentially no growth—in the four years from the onset of recession through the end of last year. 5 This is an abridged version of “Swing shift: better news from US labor demand and supply,” Michael Feroli, et al, 3/28/2012. Full publication is available on Morgan Markets.

The absence of labor force growth has pushed the unemployment rate lower, despite only modest job gains. From a peak 10%, the unemployment rate has fallen to 8.3%. However, labor bargaining power continues to erode. Over the past year, growth of hourly compensation, as measured by both the monthly establishment survey and the ECI, has slowed to about a 2% pace and as yet shows no signs of accelerating. When viewed against the relative stability of measures of medium-term inflation expectations in TIPS markets and household surveys, it appears that real hourly wage gains have decelerated sharply in recent years and are likely now contracting.

Poor US labor market performance has solidified perceptions about the nature of the current expansion. The weakness in job creation is generally viewed as a sign that the expansion is vulnerable to negative shocks. It has also promoted the view that the damage caused by the recession has been structural and that labor utilization will remain permanently depressed. Consistent with this view, there are many observers arguing that wage and price pressures will build more quickly than the Federal Reserve anticipates, requiring an early removal of accommodative policies.

Against this backdrop, it is important to recognize that significant change is taking place in US labor markets that should alter perceptions and reverberate broadly across the macroeconomic landscape over the coming year. In particular,

• Expect payroll gains to average 200,000 per month. The labor market is transitioning to strong job growth as business gradually shifts toward a stance of medium-term expansion that is more consistent with the current environment of elevated profit margins, strong corporate balance sheets, and relatively easy financing. Payroll employment is expected to increase about 200,000 per month over

Exhibit 1: Forecast for real GDP and labor market indicators (%ch, saar) except as noted; years are 4Q/4Q

2004-07 2008-09 2010 2011 2012f 2013fReal GDP 2.6 -1.9 3.1 1.6 2.2 2.3

Payroll employment ('000 per month, sa) 161 -352 65 147 200 175

Unemployment rate (% sa eop) 4.8 9.9 9.6 8.7 8.0 7.7

Labor productivity (nonfarm business) 1.5 2.0 2.3 0.3 0.7 1.3

Length of workweek 0.1 -1.0 1.2 0.5 0.3 0.1

Participation rate (% sa, eop) 65.9 64.9 64.4 64.0 64.2 64.4

Employment cost index 3.4 2.0 2.0 2.0 2.0 2.0



88

the course of this year, even as overall real GDP growth proceeds at a trend pace.

• The participation rate has bottomed. There have been tentative signs in the past few months that increased hiring is starting to bring labor force dropouts back into the labor force and that labor supply has started to accelerate. The forecast looks for the labor force participation rate to shift from a decline of 0.4% in 2011 (4Q/4Q) to a modest increase of 0.2% this year, an increase similar to that which occurred at a comparable point in the previous expansion. If we are right, labor supply is expected to increase 1.4% over the next year, more like the norms of prior expansions, as the positive effects on labor force growth of more reentrants to the labor force offset the negative effects of an aging population.

• Okun’s Law broken due to slow productivity gains. Although GDP growth is expected to proceed near trend and labor supply is expected to grow well above trend, we expect the unemployment rate to fall, reaching 7.7% by the end of 2013. This breakdown in Okun’s Law reflects our expectation that labor productivity will proceed at a below-trend pace. Sub-par productivity growth tends to boost employment growth and depress the jobless rate.

• No wage pressure on the horizon. Stronger growth of hours worked and employment will boost labor income. But hourly pay is not expected to accelerate, since utilization rates are still low and inflation expectations anchored. Weak labor bargaining is a negative for labor income and consumer spending but is allowing business to boost employment while maintaining elevated margins. It is also central to our view that the Federal Reserve will be able to keep its policy rate on hold until 2014.

As an improving job market delivers better balance in the growth of business and labor income, perceptions that expansion has become more durable should increase. Both households and business are likely to become more confident that the economy will, over time, return to normal utilization rates. More confident households and lenders could help even the major lagging sector in the economy—housing—to heal. Greater confidence that labor utilization rates can rise materially will also improve prospects for narrowing the cyclical part of the federal budget deficit. How the political landscape

Comparing labor markets in expansions Recent years have seen a severe recession—with deeper job cuts than in 1975 and 1982—alongside a recovery in which job gains have moved in line with the pattern of the past two shallow recessions, which experienced early cycle “jobless recoveries.” Two unusual features during this expansion have been the sharp fall in the participation rate and the large rebound in the average workweek from deep recession lows.

Exhibit 2: Non-farm payrolls (ex. Census)

Exhibit 3: Participation rate

Exhibit 4: Average workweek (private production workers)

98

100

102

104

106

108

110

112

-6 -3 0 3 6 9 12 15 18 21 24 27 30

1975 1982 19912001 2009

Months after trough

96

97

98

99

100

101

102

-6 -3 0 3 6 9 12 15 18 21 24 27 30

1975 1982 19912001 2009

Months after trough

99

100

101

102

103

-6 -3 0 3 6 9 12 15 18 21 24 27 30

1975 1982 19912001 2009

Months after trough



89

responds to this slow but clear-cut healing in US labor markets—facing a still unsustainably large structural fiscal deficit—remains a key uncertainty in the outlook.

Assessing the shift to stronger job growth After some false starts, job growth finally appears to have accelerated in recent months. Non-farm payroll employment increased by an average 245,000 in the last three months (December 2011-February 2012), up from an average of 145,000 per month over the previous year. Recent readings reflect the largest three-month gain (ex. Census workers) since 2006. And this improvement is confirmed by other labor market indicators. The more volatile household survey measure of employment is up an average 412,000 per month over the past three months (after the population control adjustment). And, at long last, the ratio of employment to the working-age population has started trending gradually higher for the first time in the expansion. Moreover, initial jobless claims have tumbled from an average 414,000 per week in 3Q11 to an average 355,000 per week over the past month, and are beginning to approach their very low readings (a little below 300,000) of the prior two expansions. The employment detail of most consumer and business surveys has also improved substantially.

There are two proximate sources of the increase in hiring. Until recently, increased demand for labor was met partly by extending the workweek of existing workers back toward pre-recession norms and partly by increased hiring. With the workweek now almost back to normal, increased business demand for labor input is being predominantly met by increased hiring. In addition, strong corporate finances and the healing power of time appear to be allowing business to shift from an extremely defensive stance in the early stages of the expansion toward taking on more workers now.

While there is a wide range of indicators suggesting that labor demand has picked up, two factors suggest the published job figures may be overstating the improvement in recent months.

• A mild winter. Job growth over the winter was likely helped by unusually mild weather across much of the country. Using the household survey data reporting the number of people not at work due to bad weather as a proxy for the severity of the weather, we estimate that the unusual weather this

season added about 50,000 or 60,000 to nonfarm payrolls between November and February, or an average of just under 15,000 jobs per month. This boost will unwind eventually, but abnormally warm temperatures have persisted into March, leaving the timing of this drag uncertain. This recent run of mild

Exhibit 5: Non-farm payroll employment Ex. temporary Census workers; (%ch, saar)

Exhibit 6: Employment/population ratio and its change (%ch) %, ratio

Exhibit 7: Initial jobless claims Monthly average; (000s, sawr)

0.5

1.0

1.5

2.0

2.5


Over 3 months

Over 6 months

58.0

58.5

59.0

59.5

60.0

60.5

61.0

-4

-3

-2

-1

0

1

2009 2010 2011 2012

Change from year ago

Employment/population ratio

200

300

400

500

600

700

90 95 00 05 10

Latest



90

temperatures probably also boosted the workweek during the winter this year. The magnitude of this impact is likely minimal on the overall workweek, but it could be substantial for certain industries that are more dependent on the weather than others (like construction).

• A seasonal-adjustment bias. While an unusually mild winter weather does not seem to explain much of the recent acceleration in job growth, another technical factor related to the seasonal-adjustment process does seem to account for some of the striking strength over the winter relative to prior months. The Lehman bankruptcy in September 2008 was followed by huge net job losses averaging 750,000 per month between the following November and April. These results feed into the estimation of seasonal-adjustment factors that now tend to lift reported job growth in these months and then depress reported job growth starting in May, relative to seasonal factors that are estimated on a history that omits the deep job losses in late 2008 and the first months of 2009.

A recent research note (“US: another springtime head fake?” March 9, 2012) analyzes these potential distortions. It concludes that the seasonal distortions exist, but they have not been a main driver of reported trends in job growth over the past two years nor the main explanation for the acceleration in job growth since early last summer. Seasonal-adjustment factors, estimated using a counter-factual path in which employment is assumed to have grown modestly through 2008-2009, looks a lot steadier over the past six months than the reported data. And, the underlying trend in job growth, adjusted for this factor and the mild winter weather, looks to be closer to 200,000 per month than the 245,000 reported over the past three months. Seasonal factors should continue to give some artificial boost to the reported payroll employment through April. Given this assessment of the underlying trend, the forecast looks for growth of payroll employment to moderate to an average of 200,000 per month over the next two quarters as this seasonal distortions fade.

Exhibit 8: Average weekly hours Private production and nonsupervisory workers; (sa)

Exhibit 9: Non-farm payroll employment, total and ex. construction Monthly average; (000s, samr)

Exhibit 10: Growth in private payrolls, alternative seasonal adjustment estimates (%m/m, sa)

33.0

33.3

33.6

33.9

2007 2008 2009 2010 2011 2012

Monthly

3-month avg

Dec10-Feb11 Sep-Nov11 Dec11-Feb12Total 150 157 245

Construction 0 7 11

Total ex construction 150 150 234

Item: Construction hours -2.2 -1.1 11.5 (%ch saar)

-0.1

0.0

0.1

0.2

0.3

0.4

2010 2011 2012

X-12 on nsa data, with intervention conducted

X-12 on nsa data


Srini RamaswamyAC (1-212) 834-4573 J.P. Morgan Securities LLC

91

Forecasts & Analytics

Interest Rate Forecast

Swap spread forecast*

Mar 30, 2012 Apr 30, 2012 Jun 30, 2012 Sep 30, 2012 Dec 31, 2012 Mar 31, 2013

1m ahead 2Q12 3Q12 4Q12 1Q13

Rates Forecast Forecast Forecast Forecast Forecast

Effective funds rate 0.13 0.10 0.10 0.10 0.10 0.10

3-month Libor 0.47 0.45 0.50 0.50 0.50 0.50

3-month T-bill (bey) 0.09 0.04 0.02 0.02 0.02 0.02

2-year T-note 0.33 0.29 0.30 0.30 0.30 0.30

3-year T-note 0.50 0.51 0.55 0.55 0.55 0.55

5-year T-note 1.04 1.15 1.25 1.25 1.25 1.25

7-year T-note 1.61 1.70 1.85 1.85 1.85 1.85

10-year T-note 2.22 2.30 2.50 2.50 2.50 2.50

30-year T-bond 3.34 3.40 3.60 3.60 3.60 3.60

Curves

3m T-bill/3m Libor 38 41 48 48 48 48

2s/5s 71 86 95 95 95 95

2s/10s 188 201 220 220 220 220

2s/30s 301 311 330 330 330 330

5s/10s 117 115 125 125 125 125

5s/30s 230 225 235 235 235 235

10s/30s 113 110 110 110 110 110

* Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation.

Mar 30, 2012 Apr 29, 2012 Jun 28, 2012 Sep 26, 20121 M 3 M 6 M

Forecast Forecast Forecast

2-year sw ap spread 2 24 24 24



30-year sw ap spread 23 -28 -27 -26

*Forecast uses matched maturity spreads



92

Economic forecast

Financial markets forecast

Gross fixed-rate product supply*

0

50

100

150

200

250

300

350

Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12

Agency Corporate MBS CMBS ABS

* amount in $ billions

Financial markets forecastCredit Spread Current Mid-year

2012 Current Mid-year

201210Y swap spread* 25 7 S&P* ($) 1403 1430FNCL 4 OAS** 6 10 Brent** ($/bbl) 122.4 112.010Y AAA 30% CMBS (2007 vintage)** -30 225 Gold** ($/oz) 1661 18253Y AAA Credit Cards fixed** 5 11 EUR/USD 1.33 1.34JULI portfolio spread* 215 175 USD/JPY 82 86High Yield Index* 12 600Emerging Market Index* 192 325 ** 2Q12 quarterly average forecast

Corporate Emerging Market Index (Broad)* 633 350

** spread to swaps

* spread to Treasuries

* S&P500 forecast is a year-end 2012 forecast

%ch q/q, saar, unless otherw ise noted11Q2 11Q3 11Q4 12Q1 12Q2 12Q3 12Q4 13Q1 2010* 2011* 2012*

Gross Domestic Product Real GDP 1.3 1.8 3.0 1.5 2.5 3.0 2.0 1.5 3.1 1.6 2.2Final Sales 1.6 3.2 1.1 1.3 2.7 2.9 2.1 1.5 2.4 1.5 2.2Domestic Final Sales 1.3 2.7 1.3 2.1 2.8 2.9 2.2 1.4 2.9 1.4 2.5Business Inv estment 10.3 15.7 5.2 4.1 8.1 8.1 6.5 4.5 11.1 8.2 6.7Net Trade (% contribution to GDP) 0.2 0.4 -0.3 -0.8 -0.1 0.1 -0.1 0.1 -0.5 0.1 -0.3Inv entories (% contribution to GDP) -0.3 -1.4 1.8 0.2 -0.2 0.1 -0.1 0.0 0.7 0.1 0.0Prices and Labor Cost Consumer Price Index 4.4 3.1 1.3 2.3 1.6 1.5 1.5 1.7 1.2 3.3 1.7 Core 2.4 2.5 1.9 1.9 1.5 1.5 1.5 1.5 0.6 2.2 1.6Producer Price Index 6.0 4.2 2.1 1.5 1.5 1.5 1.5 1.5 3.8 5.6 1.5 Core 3.1 4.0 1.2 3.3 1.2 1.2 1.2 1.3 1.4 2.9 1.7Employ ment Cost Index 2.8 1.0 1.7 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0Unemploy ment Rate (%, sa) 9.0 9.1 8.7 8.3 8.2 8.1 8.0 8.0 - - -* Q4/Q4 change



93

Client surveys

DurationLong Neutral Short Changes

Mar 26, 2012 19 66 15 17Mar 19, 2012 25 60 15 213-month average 21 65 14 18

CreditCorporate Bond

WeightingCash

PositionSpread

OutlookMar 20, 2012 1.32 0.95 1.13Feb 27, 2012 1.52 1.03 0.943-month average 1.44 0.94 1.27

*Corporate bond w eighting index is the ratio of the sum of ov erw eights and neutralpositions to the sum of underw eights and neutral positions; the cash position indexis the ratio of the sum of high and medium cash positions to the sum of low andmedium positions; the spread outlook index is the ratio of the sum of positiv e andneutral outlooks to the sum of negativ e and neutral outlooks.

6 7 83 4 5

MBSOverweight Flat Underweight

March 2012 69% 19% 11%February 2012 61% 28% 11%3-survey average 65% 23% 12%

Treasury Client Survey

Credit Client Survey

-30

-20

-10

0

10

20

Feb 11 Apr 11 Jul 11 Oct 11 Dec 11 Mar 12

Longs minus shorts

0.8

1.0

1.2

1.4

1.6

1.8

Nov 08 Jul 09 Mar 10 Nov 10 Jul 11 Mar 12

Corporate Bond Weighting

MBS Investor Survey

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

Sep 09 Feb 10 Jun 10 Nov 10 Mar 11 Jul 11 Nov 11 Feb 12

Overweight - Underweight

US Fixed Income Strategy US Fixed Income Markets Weekly New York, March 30, 2012

94

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. Conflict of Interest: This research contains the views, opinions and recommendations of J.P. Morgan research analysts. Research analysts routinely consult with J.P. Morgan trading desk personnel in formulating views, opinions and recommendations in preparing research. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of J.P. Morgan trading desks which may conflict with your interests. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, trading desk and firm revenues and competitive factors. As a general matter, J.P. Morgan and/or its affiliates normally make a market and trade as principal in fixed income securities discussed in research reports. Other Disclosures

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General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

“Other Disclosures” last revised January 6, 2012.

Copyright 2012 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.


Market Movers

2 Apr ISM manufacturing (10:00am) Mar Construction spending (10:00am)

52.5

Feb

0.6%

Cleveland Fed President Pianalto speaks in Ohio (12:35pm)

3 Apr Factory orders (10:00am) Feb Light vehicle sales

1.8%

Mar

14.4mn

FOMC minutes San Francisco Fed President Williams speaks on the economy in San Diego (4:05pm)

4 Apr ADP employment (8:15am) Mar ISM nonmanufacturing (10:00am) Mar

57.5

San Francisco Fed President Williams speaks in San Francisco (11:00am)

5 Apr Initial claims (8:30am) w/e prior Sat Chain store sales

360,000

Mar Announce 3-year note Announce 10-year note (r)

$32 bn

Announce 30-year bond (r) $21 bn

$13 bn

St. Louis Fed President Bullard speaks on the economy in St. Louis (9:10am)

6 Apr Employment (8:30am) Mar Unemployment rate

215,000

Average weekly hours 8.3%

Consumer credit (3:00pm) 34.5

Feb Good Friday Equity market closed

9 Apr Chairman Bernanke speaks at conference in Georgia (6:00pm)

10 Apr NFIB survey (7:30am) Mar Wholesale trade (10:00am) Feb JOLTS (10:00am) Feb Auction 3-year note

$32 bn

Atlanta Fed President Lockhart speaks at conference in Georgia (12:45pm) Minneapolis Fed President Kocherlakota speaks in Minnesota (2:30pm)

11 Apr Import prices (8:30am) Mar Federal budget (2:00pm) Mar Beige book (2:00pm) Auction 10-year note (r)

$21 bn

Atlanta Fed President Lockhart speaks at conference in Georgia (8:20am) Kansas City Fed President George speaks at conference in NY (9:30am) Boston Fed President Rosengren speaks at conference in Georgia (10:30am) St. Louis Fed President Bullard speaks in St. Louis (5:00pm)

12 Apr Initial claims (8:30am) w/e prior Sat PPI (8:30am) Mar International trade (8:30am) Feb Auction 30-year bond (r) Announce 5-year TIPS

$13 bn

$16 bn

Atlanta Fed President Lockhart speaks in Atlanta (9:00am) Minneapolis Fed President Kocherlakota speaks in Minnesota (1:00pm)

13 Apr CPI (8:30am) Mar Consumer sentiment (9:55am) Apr preliminary

16 Apr Retail sales (8:30am) Mar Empire State survey (8:30am) Apr TIC data (9:00am) Feb NAHB survey (10:00am) Apr Business inventories (10:00am) Feb St. Louis Fed President Bullard speaks on the economy in St. Louis (3:30pm)

17 Apr Housing starts (8:30am) Mar Industrial production (9:15am) Mar

18 Apr

19 Apr Initial claims (8:30am) w/e prior Sat Existing home sales (10:00am) Mar Philadelphia Fed survey (10:00am) Apr Leading indicators (10:00am) Mar Auction 5-year TIPS Announce 2-year note

$16 bn

Announce 5-year note $35 bn

Announce 7-year note $35 bn

20 Apr

$29 bn

“Unless otherwise expressly noted, all data and information for charts, tables and exhibits contained in this publication have been sourced via J.P. Morgan information sources.”

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Analyst Certification: The strategist(s) denoted by (AC) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed.

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0320 US Fixed Income Markets Weekly

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