Colin A. Robertson Managing Director Fixed Income

1. Fixed Income Update Colin A. Robertson Managing Director Fixed Income

2. Fixed Income - Agenda • Review – 2008 Fall FOCUS • Environment • Outlook • Update – Fixed Income Markets • Environment • Outlook

3. Fixed Income Update 2008 Environment and Outlook

4. Fixed Income Update Environment - 2008 Fall FOCUS • Globally, authorities grasped the scale of threats relatively quickly and have taken drastic actions • Fed moves have been aggressive in both traditional and unorthodox channels • Reduced funds rate from 5.25% to 1.5% in short time frame • Created new borrowing facilities (PSCF, TSLF) • Backstopped money market mutual funds • Took Bear Stearns and AIG assets onto Fed’s balance sheet • Purchased high quality commercial paper from corporate entities • ECB and BOE actions have been equally aggressive and creative • Highly complex, globally integrated, fast-moving global financial system has complicated efforts at repair • Authorities have limited understanding of aggregated risks created by inter-connections between assets, especially derivatives and securitizations • Pattern of financial institution rescues/failures (especially Lehman) has confused investors which has severely damaged confidence • Primary focus of banks and investors is on deleveragingonly

5. Fixed Income Review Outlook - 2008 Fall FOCUS • Turmoil will have lasting impacts for macro economy • High growth/low inflation environment not likely to return for years • Expect prolonged period of weak growth as de-levering process follows a decentralized, case-by-case path • Set back for a globalization and integrated financial system • Governments will have bigger fiscal deficits and greater financing needs • Growth will be slower • Need to absorb costs of rescuing banks, additional stimulus programs • Consequences longer term will be higher taxes • Companies will seek stronger balance sheets, have lower need for day-to-day financing

6. Fixed Income Review Outlook – 2008 Fall FOCUS • Turmoil will have lasting impacts for credit creation • Duration of de-levering will depend on severity of US recession and impacts on bank balance sheets • Tightening credit conditions will slow future growth • Slow growth will cause defaults to rise • Rising defaults will cause banks’ non-performing assets to rise, undermining capital raising efforts • Thus, outlook for restarting credit creation is not good, absent launch of special government programs • Current de-levering process has damaged functioning of cash, collateral and counterparty risk management frameworks – these will need to be repaired, revamped or rebuilt • Process will be slow, arduous and highly political • Essential for return of risk appetites and restarting of innovation efforts • Institutional investors will end up with fewer, larger and more regulated counterparties

7. Fixed Income Review Outlook – 2008 Fall FOCUS • Turmoil will have lasting impacts for issuers • Issuance preferences and risk premiums will change across instruments and capital markets. • Shift back to simplicity and away from complexity in credit instruments • More equity • Less structured, floating rate and wrapped debt • More long term debt, issued at higher yields • Growing portion of debt will be supported by government • Credit premia to be permanently elevated for any/all complex securities • Fed to become central counterparty and biggest player in repo market • Fed to start paying interest on reserve balances • Enables it to have a credit policy that’s independent of monetary policy • Puts a floor under the traded overnight rate (so can provide liquidity in times of stress without affecting overnight rate) • Eventually (3+ years), expect credit conditions to normalize around pre-bubble levels

8. Fixed Income Review Outlook – 2008 Fall FOCUS • Turmoil will have lasting impacts for investors • Investors will be in risk avoidance mode for next several years • Investment guidelines will be overhauled • Transparency will be emphasized • All types of oversight will be increased • Focus will return to traditional instruments/practices • Experience will matter more than innovation • Liquidity and marketability will be stressed • Leverage will be avoided

9. Fixed Income Review Outlook – 2008 Fall FOCUS • Turmoil will have lasting impacts on investment strategies used by short term funds • Investment guidelines will be made more restrictive • Will be structured for liquidity/safety and not for yield • Instruments:Only very high quality securities, including repo, time deposits, CD's, commercial paper, corporates and Government Agencies • Interest Rates:Focus will be on rate and curve positioning, waiting for revamp and rebuild of short credit and funding markets • Credit:Not a focus. Will be de-emphasized indefinitely, at least until de-levering process is complete and next generation investment instruments and portfolio guidelines are developed and fully vetted

10. Fixed Income Review Outlook – 2008 Fall FOCUS • Turmoil will have lasting impacts on investment strategies used by core and high yield bond funds • Investment guidelines may be made more restrictive • Will revert to more traditional investment instruments and strategies • Rate and curve positioning/bets • Traditional, independent credit analysis (No reliance on NRSROs) • Use of CDS for signaling and trading strategies will change • Shift from OTC to exchange • Regulation to increase • Trading spreads will increase • Trading volume / flow will gradually build • Number of dealers will increase • Capital commitments by dealers will decrease

11. Fixed Income Update 2009 Environment and Outlook

12. Fixed Income Update Environment • Change in paradigm for consumers and corporate profitability • Changes in securitization market • Limitations of global fiscal stimulus to produce sustained economic recovery • Changes to regulatory frameworks • Shortcomings/revisions to globalization thesis • Rise of non G8 countries as drivers of global growth, especially China

13. Fixed Income Update Environment • Post-Lehman bankruptcy • Continued slowdown in bank lending across industrialized economies • Unprecedented monetary liquidity in global financial system • Governments acted to promote credit creation via capital markets • Amid banking crisis, capital markets have become the main channel of monetary transmission in the economy • Allows borrowers to bypass bank lenders and raise funds directly from capital markets • Economic benefits of this development are unevenly distributed • Can the 2009 capital markets rally end the credit shortage in the real economy?

14. Fixed Income Update Environment • Aggressive/expansive government policies are heavily influencing all bond markets (types, maturities and regions) • Monetary • Fiscal • Emergency support policies/programs are motivated by political as well as economic considerations • Investment outlooks must incorporate analysis of traditional and novel drivers • Traditional • Economic • Credit • Technical • Novel • Government Programs (timeline, permanence, unwind)

15. Fixed Income Update Outlook – Money markets, Treasuries and TIPS • Fed to maintain record low interest rates for extended time period • Real cash rate to stay close to zero • Key catalyst for US growth to strengthen • Persistent sub-par growth and low inflation likely to outstrip concerns about US deficits and heavy Treasury (UST) supply • Foreign buying of USTs to continue unabated • Additional demand for growing volume of USTs expected to come from increasing US savings rate, former buyers of securitized products • Benign inflation backdrop likely to favor coupon Treasuries over TIPS of comparable maturity

16. Fixed Income Update Outlook – Investment Grade Credit • Using BarCap Credit Index as proxy • Expanded reliance/use of government guarantees will increase weighting of AAA issuers • AA and A rated issuer weightings to decline for same reason • Significant churn likely among BBB credits, with some falling to junk • Non-corporate sector to grow at expense of others (industrial, utility, financial), as result of Build America Bonds and similar programs • Financial and non-corporate OAS levels likely to tighten, based on increased presence of government guarantees • Investment Grade credit generally positioned to do well in post-crisis credit/funding environment • Banks - reduced ability and willingness to lend • Investors - ongoing distaste for innovative, complex, opaque credit structures • Investors – strong demand for traditional, transparent, plain vanilla debt

17. Fixed Income Update Outlook – High Yield • Era of tight junk spreads, easy credit terms now over • End of voluntary shift by “A” rated companies toward below investment grade credit ratings and balance sheets • Accelerating slide of investment grade companies to below investment grade ratings, due to business and/or financial difficulties • Junk bond market to adjust to changed economic and risk environments • High yield market to refocus on basic (not alternative) credit structures and meeting needs of traditional high yield investors • High yield spreads will not return to compressed levels of recent years • Instead, will trend sideways around historical median level • Cooling of trend toward globally integrated high yield market • Performance bifurcation by sector likely to sharpen • Some to implode amid creative destruction • Other to sail along relatively untouched

18. Fixed Income Update Outlook – Municipals • Fallout from credit markets crisis and subsequent economic developments • Exit of monoline bond insurers from municipal new-issue market • New municipally-focused programs included in federal stimulus package • Build America Bonds (BAB) initiative • Waiver of Alternative Minimum Tax on tax-exempt issues sold to finance private activity bonds • Increase in size of municipal issuers purchased by banks that qualify for tax exemption • Programs have helped to repair municipal market and rally prices • Constrained volume and type of tax-exempt municipal issuance • Increased demand from existing and new sources • Changed composition of buyers of municipal debt • Overall result, richened municipal valuations relative to Treasury yields

19. Fixed Income Update Outlook – Municipals - 2 • Fallout from credit markets crisis and subsequent economic developments • Expect smaller/simpler short-term municipal market • Short-structured debt issuance to shift to intermediate maturity range • Downward trend of fundamental municipal credit quality • No regional safe-harbors, negative trend is nationwide • Do not expect federal government to provide direct guarantees of municipal debt • Using BarCap Municipal Index as proxy • Downgrades to monoline insurers have decreased weighting of AAA rated new issues • AA and A rated issuer weightings to increase for same reason • From a sector perspective (general obligation, revenue, insured, pre-refunded), the market’s composition is expected to gradually rebalance • Reduced weighting for insured sector • Increased weighting for general obligations and revenue sectors

20. Thank you. Colin A. Robertson Managing Director Fixed Income