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Kjerstin Hatch, portfolio<br />
manager at distressed-debt<br />
investor Madison Capital<br />
Management in New York.<br />
Junk<br />
bonds take<br />
centre stage<br />
The US corporate bond market experienced its<br />
most dramatic day since the Enron and Worldcom<br />
scandals on May 5 when Standard & Poor’s (S&P’s)<br />
cut its credit ratings on General Motors (GM) and<br />
the Ford Motor Company to junk status. The<br />
removal of these two American household names<br />
from the investment-grade ranks turned<br />
US$290bn of senior unsecured debt into junk<br />
bonds – the largest such transformation ever seen<br />
in a single day – and will influence the direction<br />
of the US bond markets for months to come.<br />
Andrew Cavenagh reports.<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
THE IMPACT OF S&P's ratings action, which lowered<br />
the long-term ratings GM and Ford from BBB- to BB<br />
and BB+ respectively, on the quoted debt of both<br />
companies, was immediate and savage. The following day,<br />
GM’s 2033 long-dated bond dropped more than four points<br />
to 74.5 cents on the dollar (bumping its yield up from the<br />
8.375% coupon to 11.42%). In the meantime the shorterterm<br />
2013 instrument issued by Ford Motor Credit, the auto<br />
maker’s finance arm, lost more than three points to close the<br />
week at 87 cents on the dollar.The extent of the reaction led<br />
one banker to comment: “If you look at the spreads on the<br />
short-dated bonds now, they look quite attractive.”<br />
It did not take long for the knock-on effect to catch up<br />
with the US automotive supply industry. On May 18, S&P<br />
lowered its rating on Delphi from BB to B, having previously<br />
downgraded it on April 21 and also cut Collins & Aikman’s<br />
(C&A’s) further from CCC+ to CCC-. Within hours, C&A<br />
DEBT REPORT: US BOND ISSUES<br />
51
DEBT REPORT: US BOND ISSUES<br />
52<br />
applied for court protection<br />
from its creditors under the<br />
US Chapter 11 bankruptcy<br />
code of practice.<br />
Dramatic as the investor<br />
reaction was, there is little<br />
risk that GM or Ford will<br />
have to contemplate this<br />
course – at least in the near<br />
to medium term. While<br />
most analysts believe that<br />
further downgrades are<br />
eminently possible (S&P<br />
has put both companies'<br />
ratings on negative watch)<br />
they still have large cash positions and substantial undrawn<br />
bank facilities.“The companies have a lot of liquidity and that<br />
is a source of hope,” maintains Scott Sprinzen, the S&P<br />
analyst in New York who covers the industry. “In the auto<br />
sector there have been examples of dramatic turnarounds.”<br />
Sprinzen adds that the big cash holdings combined with<br />
relatively light profiles of maturing debt make it unlikely that<br />
either company could seek Chapter 11 protection in the next<br />
two years.“You have to be able to demonstrate that you’re<br />
insolvent, and that’s hard to do when you are sitting on a lot<br />
of cash,”he points out.<br />
While the senior unsecured bond markets are probably<br />
closed to both companies for the foreseeable future, they<br />
can still raise further liquidity if required by selling more<br />
asset-backed securities. Almost all their main asset types<br />
(retail loans, wholesale loans, retail leases) are securitisable.<br />
Alternately, they can unload loan portfolios to third parties<br />
in the whole-loan markets. Nevertheless, the loss of<br />
investment grade status for two motor titans will have<br />
widespread ramifications for the corporate – and other –<br />
bond markets. It has already led to the downgrading of<br />
several collateralised debt obligations (CDOs) in which<br />
Ford and/or GM bonds formed part of the collateral.<br />
Following a review of 561 European synthetic CDOs, S&P<br />
said 19 of the 745 classes required downgrading and a<br />
further 25 needed to be placed on negative watch.<br />
While much of the reaction to date has focused on the<br />
CDO market – much of it down to hedge funds that<br />
misread arbitrage opportunities in the derivatives of the<br />
equity and mezzanine tranches covering positions –<br />
investment grade portfolio managers may well have to<br />
offload tens of billions of dollars' worth of the auto makers'<br />
bonds in the coming weeks.<br />
The picture is clouded, however, by the impending<br />
change in Lehman Brothers' US Aggregate Bond <strong>Index</strong>, the<br />
most widely used US measure for tracking investment<br />
grade credits. From July 1, the index will use the middle<br />
rating from the top three agencies (S&P, Moody’s and<br />
Fitch) rather than the lower of S&P's or Moody's as it does<br />
at present. Provided Moody’s and Fitch do not downgrade<br />
the companies to sub-investment grade in the meantime,<br />
their bonds could become eligible holdings again in a few<br />
US Auto Sector measures impact of new junk bond status<br />
120<br />
110<br />
100<br />
90<br />
80<br />
70<br />
31-Dec-03<br />
31-Jan-04<br />
29-Feb-04<br />
31-Mar-04<br />
30-Apr-04<br />
31-May-04<br />
30-Jun-04<br />
31-Jul-04<br />
31-Aug-04<br />
30-Sep-04<br />
31-Oct-04<br />
30-Nov-04<br />
Ford Mtr Cr Co Cont Offer Bd Mtnf 7.100 09/20/13<br />
31-Dec-04<br />
31-Jan-05<br />
29-Feb-05<br />
31-Mar-05<br />
30-Apr-05<br />
31-May-05<br />
General Mtrs Corp Deb 8.375 07/15/33<br />
Data as at June 05. Source: <strong>FTSE</strong> Group.<br />
weeks. A lot of investors<br />
holding GM and Ford<br />
bonds are consequently<br />
expected to sit tight.“That<br />
means the process of<br />
shifting Ford and GM<br />
[stock] is not going to<br />
happen in one go,”says the<br />
deputy head of credit<br />
strategy at one of the<br />
leading Continental<br />
European banks in<br />
London. “Personally, I<br />
think it is going to be<br />
relatively protracted.”<br />
He adds that the sell-off could have a bigger impact on the<br />
high-yield bond markets in Europe than in the US, given<br />
that the downgraded debt of GM and Ford would account<br />
for a much higher percentage – about a third – of the market<br />
on this side of the Atlantic.“I think over time the effect you<br />
see will be more pronounced in Europe,”says the banker.<br />
There is also a risk that the Ford/GM situation will blight<br />
wider corporate issuance in the US. The latest figures from<br />
the data provider Dealogic revealed a dramatic drop in new<br />
issues from speculative-grade companies in the second<br />
quarter so far – 69% down on the comparable period of<br />
2004 – and a 7% decline in the volume from investmentgrade<br />
companies.This followed the pattern seen in the first<br />
three months of 2005, where junk bond issuance dropped<br />
64% and investment-grade 18% on last year, but in part<br />
reflects stronger cash positions after seven quarters of<br />
continuous profits growth.<br />
There was also evidence that investor confidence in the<br />
senior unsecured sector was starting to ebb before S&P<br />
announced the Ford and GM downgrades. Spreads had<br />
certainly started to widen in March, after GM had warned<br />
that its profits for 2005 were likely to be 80% lower than<br />
previous forecasts. The month also saw the inflow of foreign<br />
capital into US corporate bonds dive from about US$80bn in<br />
February to US$48bn, a development that aroused the<br />
interest of foreign-exchange analysts and dealers who<br />
believe the subsequent Ford and GM downgrades can only<br />
accelerate this move. “I would have thought that that [the<br />
downgrades] is ultimately going to put pressure on those<br />
credit markets going forward,” says Richard Franulovich,<br />
senior currency strategist at Westpac Banking Corp in New<br />
York, “the next big adjustment is a further widening of<br />
spreads.” Franulovich adds that Ford and GM’s loss of<br />
investment grade status was also affecting the market for US<br />
Treasuries, with the yields on short term bills dropping as<br />
low as 3%.“It is generating a flight to quality,”he explains.<br />
The rating agencies are not forecasting a general decline<br />
in corporate access to unsecured capital market debt at this<br />
stage.“We have not really seen it show up yet,”says David<br />
Hamilton, head of default research at Moody’s Investor<br />
Services in New York.“The damage seems to be fairly well<br />
contained to pockets of distress at this point.” In its latest<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
monthly default report, Moody’s<br />
for risk over the coming months.<br />
also points out that while it expects<br />
“The resilience of the market has<br />
(12-month ahead) default rates to<br />
not really been tested so far [in<br />
rise from the current 2% to 3.3% by<br />
this crisis].” He adds that buyers<br />
April 2006, this figure will still be<br />
are likely to become more<br />
below the 20-year average annual<br />
selective. “I guess they are going<br />
rate of 4.9%.<br />
to become very much more<br />
Standard & Poor’s (S&P) also<br />
discriminating towards credit, and<br />
published a positive credit outlook<br />
there will be a lot more<br />
for US corporate bonds in mid-<br />
differentiation between sectors.”<br />
April. The agency’s analysis<br />
Hatch at Madison believes that<br />
revealed that in the first quarter of<br />
the distressed debt market for<br />
2005 the ratio of downgrades to<br />
corporate debt is consequently set<br />
total rating actions fell to 53% -<br />
for spectacular growth over the<br />
dropping well below the 18-year<br />
next three years in the aftermath of<br />
average of 62%. It attributed the<br />
the high-profile cases such as<br />
improvement to the expanding<br />
Enron, Worldcom and K-Mart, as<br />
economy (US GDP rose 4.4% in<br />
external factors and a change in<br />
2004) which had seen the profits of<br />
corporate approach will produce a<br />
speculative-grade companies rise Diane Vazza, director of <strong>Global</strong> Fixed Income further wave of bankruptcy filings<br />
more rapidly than those of<br />
Research at Standard and Poor’s.<br />
from middle-tier companies. On<br />
investment grade ones. The S&P<br />
top of the pressures of rising<br />
outlook did caution, however, while most industries interest rates, commodity prices and increased competition<br />
seemed to be “extremely solid”a few still had problems and from foreign competitors, Hatch maintains that Chapter 11<br />
highlighted airlines, petrochemical companies, retail and no longer carries the stigma it did a decade ago and that<br />
restaurant businesses as those most at risk. It said more some companies increasingly view it as a strategic tool to<br />
than 30% of the companies in these sectors had negative get rid of unwanted financial burdens, such as pension<br />
outlooks. Diane Vazza, managing director in global fixed- obligations, healthcare costs and expensive leases.<br />
income research at S&P in New York, adds that defaults The most recent example was United Airlines’successful<br />
among high-yield issuers will start to “tick up”as the credit court petition on May 10 to transfer US$10bn of pension<br />
quality of issuers deteriorates in what is an ageing bull liabilities from its four schemes to the Federal pension<br />
market. She points out that 50% of speculative-grade protection plan. Hatch believes the senior unsecured bonds<br />
issues this year have been rated B- or lower, with triple-C of companies that use the bankruptcy regime for these<br />
bonds carrying a 29% chance of default in their first year. purposes should offer better recovery rates. She points to<br />
“Gains from here are going to be limited,”she concludes. the experience of the “slew” of companies that entered<br />
In the high-yield market, Moody’s estimates there are Chapter 11 over the past four years to seek protection from<br />
US$56bn of high-yield corporate bonds due to mature, and asbestos claims. “The recovery rates for those bonds are<br />
which need refinancing, over the next three years. The higher than for those [companies] with an honest to<br />
figure includes US$20bn of maturing debt in the goodness reason for going into Chapter 11.”<br />
telecommunications, technology and media sector, which At the same time she cautions that overall recovery rates<br />
was the primary source of corporate defaults in 2004. in the distressed debt market are likely to plummet as<br />
Investors in US corporates also expect to see some sectors higher interest rates, fuel costs and commodity prices make<br />
to suffer more than others. Kjerstin Hatch, portfolio manager the economic environment – and refinancing – more<br />
at distressed-debt investor Madison Capital Management in difficult. “It is not going to be as easy to rely on the next<br />
New York, says those that will come under the most stress churn.” In many cases, she says companies that enter<br />
over the next three years are automotive suppliers, airlines, bankruptcy proceedings will no longer have any<br />
textile manufacturers, and some of the traditional worthwhile assets to restructure and holders – or buyers –<br />
supermarket groups. They will struggle to compete on cost of their paper will need to revise their expectations<br />
with the low-wage Wall-mart model suggests Hatch.“Your accordingly. She expects recovery rates – as a percentage of<br />
old-time supermarket stores are still operating under a bonds’par values - to drop from the current 50-70% range<br />
unionised system,”Hatch explains.“And I think we are going into the “teens and low 20s”. She believes the trend will<br />
to see more pain in the airline sector – probably Delta.” work in the favour of the more established distressed-debt<br />
Meanwhile, Matein Khalid, the capital markets specialists, as these lower returns will drive many of the<br />
strategist and chief dealer at Union National Bank in Abu relative newcomers out of the market and reduce the<br />
Dhabi who previously managed global bond portfolios at demand for such debt.“I think as money flows out, you will<br />
Chase Manhattan and First Chicago in New York, says get the over-reaction and that will give opportunities to the<br />
the difficulties in these sectors will test investor appetite experienced investors.”<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
53
DEBT REPORT: JUMBO PFANDBRIEFE<br />
54<br />
Jumbo<br />
How the<br />
took flight<br />
It is ten years since the birth of Jumbo Pfandbriefe propelled the antiquated covered-bond market<br />
from the relative calm of the backwaters of German finance onto the world stage. In that time the<br />
Jumbo covered bond market has grown from a gleam in a banker’s eye to more than €400bn today.<br />
Meanwhile new issuance of covered bonds for 2005 alone is forecast to top €130bn. The number<br />
of issuing countries has grown from one (Germany) to seven and at the same time the share of non-<br />
German investors in the Jumbo Pfandbriefe market has risen from as little as 5% to almost 30%.<br />
Where can the market go next? By Paul Whitfield<br />
THE SUCCESS OF today’s covered bond business<br />
seems a long way from the withering market into<br />
which a handful of German banking pioneers sought<br />
to pump life with the launch of the first Jumbo Pfandbriefe<br />
back in 1995. Then, a combination of small issuance size<br />
(typically less than DM60m; the equivalent of €30.6m) and<br />
an insignificant secondary market had squeezed liquidity<br />
out of the Pfandbriefe market driving spreads to<br />
insupportable levels. “Investors had to pay about 100bp<br />
over Libor,” says Claudia Vortmueller a covered-bond<br />
analyst at Commerzbank Corporates & Markets.<br />
The extent of the market’s liquidity problem became<br />
painfully evident in the two years prior to the birth of the<br />
Jumbo market. In 1993, a Pfandbriefe bull market had attracted<br />
large amounts of both investors and issuers into covered<br />
bonds. However, when the market turned in 1994 investors<br />
found themselves trapped by the paucity of willing buyers.<br />
The experience spooked investors. Foreign investment<br />
banks in particular were rattled and all but abandoned the<br />
market. By 1995 it was estimated that non-Germans held a<br />
meagre 5% share of the of Pfandbriefe market. Even in its<br />
homeland Pfandbriefe began to lose its appeal. From<br />
accounting for about half of the German bond market in<br />
1990, Pfandbriefe had shrunk to nearly a third by 1995.<br />
There is disagreement over what constituted the first Jumbo<br />
Pfandbriefe. Most agree that the first major step toward the<br />
new market, if not the birth of the Jumbo itself, came in May<br />
1995, with the DM500 million Frankfurter Hypothekenbank<br />
deal, a 5.875% June 1999 public sector Pfandbriefe.<br />
The deal was the first truly large Pfandbriefe but it lacked<br />
many of the essential features that have been enshrined in<br />
today’s Jumbo market. Crucially the market maker was also<br />
the issuer – Frankfurter Hypothekenbank (now Eurohypo<br />
AG) – an arrangement which while necessary, given the<br />
lack of other options, meant the market lacked the<br />
transparency of today’s Jumbos.<br />
The first Jumbo to incorporate most of the key features<br />
that sit at the core of today’s vehicles was an August 2005<br />
issue by Depfa. The bond was far larger than the<br />
Frankfurter issue, at DM2bn, and, crucially, it had three<br />
lead managers who also pledge to create a secondary<br />
market and maintain tight spreads.<br />
Since 1995 the Jumbo market has grown quickly. By mid<br />
1996 the amount of outstanding paper topped €50bn. Within<br />
another two years it had tripled in size to €150m and by 2000<br />
was approaching the €350m mark. Today’s outstanding<br />
volume of about €400 million makes the Jumbo Pfandbriefe<br />
market Europe’s fourth-largest bond market, behind the<br />
government bonds of Italy, Germany and France.<br />
Yet, however spectacular the growth of Jumbo<br />
Pfandbriefe has been in Germany, the most interesting<br />
aspect of its success has been the spread of Jumbo’s beyond<br />
German borders.“It is wrong to think of this as a German<br />
product anymore, covered-bonds are now a European<br />
market and we will see the percentage share of the<br />
German market continue to decrease over time as<br />
European issuance grows,”says Vortmueller.<br />
In 2000 about 90% of all new Jumbo issues originated in<br />
Germany, that percentage had fallen to 50% by 2003 and by<br />
the end of 2004 it had fallen to almost 30%. Investing in<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
Jumbos is also no longer an exclusively German practice – a<br />
10-year €1bn Jumbo covered bond issued in February by<br />
Austria’s Kommunalkredit was bought by investors in France,<br />
Spain, the Benelux countries, Scandinavia, China and South<br />
Korea, as well as Austria and Germany.<br />
The attraction of Jumbo covered-bonds to foreign banks is<br />
easy to understand. On the supply side the bonds are popular<br />
with banks because they allow issuers with AA or A credit<br />
ratings to create instruments that typically enjoy ratings of<br />
AAA – making raising funds cheaper. On the buy side, the<br />
bonds have both the liquidity and size that are necessary to<br />
attract large investors. They also have the key advantage for<br />
banks of requiring only half the capital coverage of a bond<br />
issued directly by banks that issue mortgages. The reason for<br />
this, say regulators, is because the bonds are secured against<br />
stable long-term loans, making them particularly safe –<br />
though critics suggest that the narrow asset base means the<br />
bonds are not as safe as many think.<br />
The financial advantages of Pfandbriefe, coupled with<br />
the new found success of the Jumbo format, led, in 1999, to<br />
the first non-German issuance of covered-bonds when<br />
Spain launched its cédulas hipotecarias and France issued<br />
obligations foncières. More recently they have been joined<br />
by Austria, the UK (which in 2003 became the first country<br />
The Pfandbrief<br />
In 2005 the Jumbo Pfandbrief marks its 10th anniversary.<br />
For a decade, the Jumbo Pfandbrief has been setting the standard in the international fixed income market. From a<br />
standing start, the Jumbo Pfandbrief has grown to a market of 400 billion euros and an average issue size in excess<br />
of 1.7 billion euros. The groundbreaking Jumbo segment has spurred the development of the pan-European Jumbo<br />
covered bond market worth nearly 600 billion euros.<br />
The Jumbo Pfandbrief: quality, liquidity and a yield pick-up.<br />
Find out what investors should know about the Pfandbrief � � � www.pfandbrief.org<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
to issue a covered-bond without specific legislative<br />
backing), Ireland, and in March 2005, Italy’s first Jumbo<br />
covered-bond – albeit one sponsored by the state rather<br />
than a private bank.<br />
The ranks of Jumbo covered-bonds are expected to be<br />
further swelled by issues from Sweden, Norway and perhaps<br />
Portugal, all which could make their debut later this year, and,<br />
at a later date, Finland, Poland and Hungary.“The coveredbond<br />
markets have expanded into almost all the European<br />
countries, but although legislation has been implemented,<br />
covered-bonds have not actually been issued in all areas,”<br />
says Christof Juetten, executive director, responsible for<br />
covered-bond Origination at Goldman Sachs International.<br />
For the time being the big three markets of Germany,<br />
Spain and France, collectively account for about 90% of all<br />
Jumbo covered-bond issuance. That high-rollers club may<br />
have to expand in the coming years, says Juetten.“We expect<br />
to see most growth from Italy. It is the last, large European<br />
economy which has yet to introduce covered-bonds on a<br />
significant scale.” Doomsayers had predicted that<br />
European-wide issuance of Jumbos would lead to thinner<br />
demand. In fact the opposite has occurred. Investors in new<br />
issuing countries have more than met their own domestic<br />
demand and begun to search in other markets.<br />
MEMBER INSTITUTIONS<br />
OF THE ASSOCIATION OF<br />
GERMAN MORTGAGE BANKS<br />
AHBR<br />
Berlin Hyp<br />
Deutsche Hypo<br />
Deutsche Schiffsbank<br />
Dexia Hypothekenbank<br />
DG HYP<br />
Düsseldorfer Hypothekenbank<br />
Essen Hyp<br />
Eurohypo<br />
HSH Nordbank Hypo<br />
Hypo Real Estate Bank<br />
Hypo Real Estate Holding<br />
HypoVereinsbank<br />
Karstadt Hypothekenbank<br />
MünchenerHyp<br />
SEB Hyp<br />
Warburg Hyp<br />
WL-BANK<br />
Württemberger Hypo<br />
Wüstenrot Hypothekenbank<br />
55
DEBT REPORT: JUMBO PFANDBRIEFE<br />
56<br />
It seems increasingly<br />
likely that issuance of 160<br />
covered Jumbos will soon 150<br />
spill out of Europe. A 140<br />
number of other countries, 130<br />
notably from central and<br />
120<br />
South America, have been<br />
110<br />
investigating the possibility<br />
100<br />
of issuing covered-bonds,<br />
90<br />
while delegates from US<br />
have also started to take an<br />
interest in the mechanics<br />
of constructing coveredbonds.<br />
“It will get very<br />
interesting if non-<br />
European countries come into the market, such as Mexico or<br />
a South American country. And of course if the US enters the<br />
mix then everything will change,”says Vortmueller.<br />
The growth of a larger market in covered-bonds has<br />
added length and depth to the covered-bond yield curve –<br />
in particular the Spanish cédulas have added mass and<br />
liquidity to the long end of the yield curve. Yet the market<br />
has also remained largely homogenous as a result of the<br />
adoption of similar legislation across the issuing countries.<br />
That is not expected to change.<br />
Juetten says: “The economic principles that drive the<br />
development of the product are the same and therefore a<br />
convergence of covered-bond legislation has taken place.”<br />
The exception to this has been Britain and Italy, both of<br />
which have issued covered bonds without the backing of<br />
legal infrastructure – though in the case of Italy that looks<br />
like a one off with new laws expected to be enacted soon.<br />
The success of the British bond has paved the way for more<br />
like it and importantly it has shown a way forward for banks<br />
in other countries, without specific covered bond legislation.<br />
“In (Britain and Italy) issuers have had to substitute the<br />
legislative framework with private law. Because they are<br />
effectively using structuring techniques and every issuer<br />
has a slightly different documentation more caution is<br />
needed when comparing one covered-bond with another,”<br />
says Karlo Fuchs, associate director Financial Institutions<br />
Ratings at Standard & Poor’s Frankfurt. The growth of<br />
covered-bonds outside Germany has given rise to another<br />
notable trend, namely the growth of the mortgage sector in<br />
the market. This too is expected to continue.<br />
Throughout the 1990s, the covered-bond market was<br />
dominated by German public-sector lending collateralised<br />
bonds. While the laws in the new issuing countries allow for<br />
the issuance of both mortgage and public sector based<br />
covered-bonds it is already evident that it is the former that<br />
will dominate. This development could have a negative<br />
impact on the market as it is attracting the interest of financial<br />
regulators, who are concerned that savings banks are issuing<br />
debt that ranks higher than the deposits of customers.<br />
The UK regulator has already issued guidelines that no<br />
more than 4% of total assets can be repackaged as debt.<br />
This has put the brakes on UK issuance of covered bonds<br />
“The high-rollers club” – Germany, Spain and France<br />
Dec-99<br />
Jun-00<br />
Dec-00<br />
Jun-01<br />
Dec-01<br />
Jun-02<br />
as a number of building<br />
societies are already<br />
pressing up against this<br />
limit. If an upcoming<br />
liberalisation of the laws<br />
governing issuers of<br />
Pfandbriefe in Germany<br />
leads to an increase in<br />
German savings bank<br />
issuance then the German<br />
regulator is expected to<br />
review its regulations.<br />
The actions of<br />
Data as at June 05. Source: <strong>FTSE</strong> Group. regulators and legislators<br />
will become increasingly<br />
important as the covered-bond market becomes ever more<br />
international and thus competitive. In such a market the<br />
impositions and protection afforded by regulators will go a<br />
long way to determine the availability and popularity of the<br />
different nation’s bonds. Thankfully, the biggest regulatory<br />
change facing the industry is likely to have a positive<br />
impact on the covered bonds market. The introduction of<br />
the Basel II accord, tipped for 2008, will more closely align<br />
banks’ capital requirements with the economic risk of<br />
holding different financial products.<br />
That will deliver a boost to fixed-income products in general.<br />
More specifically it is good news for covered bonds because it<br />
will allow a lower risk rating for mortgages – make the issuing<br />
of covered bonds more attractive and further securing the<br />
Jumbo market’s success for the next ten years and beyond.<br />
Dec-02<br />
<strong>FTSE</strong> France Pfandbrief <strong>Index</strong> <strong>FTSE</strong> German Pfandbrief <strong>Index</strong> <strong>FTSE</strong> Spain Pfandbrief <strong>Index</strong><br />
Jun-03<br />
Dec-03<br />
Jun-04<br />
Dec-04<br />
JUMBO PFANDBRIEFE BASICS<br />
FIRST ISSUED IN Germany over 230 years ago<br />
Pfandbriefe (more or less pronounced fund brief) are<br />
covered-bonds collateralised by long-term debt – either<br />
mortgages or loans to the public sector. Despite an<br />
increasing geographical diversity of issuers the principles<br />
created in 1995 – with the launch of the Jumbo<br />
Pfandbriefe market - have been widely adopted as the<br />
governing tenet of all of Europe’s Jumbo markets.<br />
The minimum standards for Jumbo Pfandbriefe were<br />
officially adopted by German mortgage banks in 1997<br />
and updated again in 2004. They include: A minimum<br />
issue size of €1 billion, with a minimum initial issue size<br />
of at least €750 million. The average size tops the<br />
€1.5 billion mark.<br />
The use of only straight bond formats to create<br />
Jumbo paper – i.e. fixed coupon payable annually in<br />
arrears with bullet redemption. A minimum of three<br />
market-makers who are pledged to quote bid/ask (twoway)<br />
prices simultaneously for lots of up to €15 million.<br />
Market makers should also have agreed to maintain a<br />
standard and pre-determined bid offer spread based on<br />
the residual life of an issue – for example the maximum<br />
bid/offer spread for an 8 to 15 year maturity is 10bp.<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
Agence France Trésor (AFT), the French public debt<br />
and treasury management agency, has never been<br />
one to take a back seat. In 2001 it issued the firstever<br />
government deal linked to Eurozone inflation<br />
and just four months ago – with the launch of its<br />
50 year note – it brought the longest ever G7<br />
government bond to the market. And it seems the<br />
issuer, which had to scale back €19.5bn of investor<br />
demand to price its €6bn 2055 deal, has started<br />
something of a trend. Chris Newlands reports.<br />
SINCE AFT LAUNCHED its 50 year note back in late<br />
February of this year, just 16 days after appointing<br />
Barclays Capital, BNP Paribas, CDC Ixis, Credit Suisse<br />
First Boston (CSFB), Deutsche, HSBC, CCF and JP Morgan<br />
to gauge the potential market demand for such a bond, both<br />
Telecom Italia and the UK’s Debt Management Office<br />
(DMO) have brought ultra long notes to the market – and<br />
the investment community believes there will be many more<br />
deals to follow.“We expect to see a lot more issuance of very<br />
long-term debt,”says Mary John Miller, director and head of<br />
fixed income at T. Rowe Price.“Historically low interest rates<br />
make this beneficial for issuers and the increasing demand<br />
for long duration investments among certain investors<br />
makes 50 year notes appealing. Rising long-term rates<br />
might dampen investor demand but the focus on pension<br />
plan reform and asset and liability matching should keep<br />
certain parts of the market very interested.”<br />
Wayne Bowers, head of global fixed income at Northern<br />
Trust <strong>Global</strong> Investments (NTGI), agrees: “We will see more<br />
governments following France's lead with Italy, Spain and<br />
others all likely to issue long maturity government debt,<br />
although perhaps not at the 50 year level. Expected and actual<br />
changes in pension legislation are driving investors’ demand<br />
for ultra long deals and, while these changes can take many<br />
months to filter through to trustee investment meetings, it<br />
should ensure that demand is maintained. Consequently,<br />
government borrowers will be encouraged to pursue an<br />
issuance programme that includes longer-dated notes.”<br />
Indeed, in addition to the UK’s 26 May nominal deal, the<br />
DMO is also making plans to bring the world’s first inflationlinked<br />
50 year bond to the market in either July or September.<br />
Meanwhile the German government is to decide when and if<br />
it will issue 50 year deals before the end of this year. At the<br />
same time, AFT expects to increase its existing €6bn issue to<br />
somewhere between €10bn and €15bn and (after a four year<br />
absence from the benchmark) the US treasury is looking at<br />
the prospect of launching a 30 year note.<br />
“We will examine if we have the flexibility to issue 30 year<br />
bonds while maintaining deep and liquid markets in our<br />
other securities,” said Timothy Bitsberger, the United States’<br />
assistant treasury secretary for financial markets, in a<br />
statement.“We need to determine if nominal bond issuance is<br />
cost effective.”After taking public comments, the department<br />
will decide whether to issue the bond on 3 August. If the<br />
answer is yes (and the overwhelming expectation is that it will<br />
be) then the first auction will take place in February 2006.<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Wayne Bowers, head of global<br />
fixed income at Northern Trust<br />
<strong>Global</strong> Investments<br />
LONG<br />
BONDS<br />
GAIN<br />
FAVOUR<br />
DEBT REPORT: EUROPEAN LONG BONDS<br />
57
DEBT REPORT: EUROPEAN LONG BONDS<br />
58<br />
But continued demand from the European pension fund<br />
community and its appointed managers is crucial to the<br />
success of any future ultra long issuance. Analysis of AFT’s 50<br />
year February deal shows that pension and asset managers<br />
made up more than 50% of the €19.5bn order book, while<br />
hedge fund investors, insurance buyers and banks made up<br />
just 18%, 14% and 13% of total demand respectively.<br />
Philip Read, director of the €2.05bn pension scheme for<br />
Metal Box, the UK manufacturer, says: “It is very positive<br />
that any government wants to issue very long dated indexlinked<br />
bonds but there needs to be a lot more of it. There is<br />
no magic in a 50 year note, however. We have liabilities that<br />
go out 80 years and so having a 50 year note helps with that<br />
but it is not the be all and end all. What we need is a range<br />
of index-linked deals that stretch out as far as is necessary.”<br />
The pension fund community in the Netherlands<br />
endorses this. Forthcoming changes to Dutch pension<br />
solvency requirements, entitled FTK, that are scheduled to<br />
come into effect at the beginning of next year, will force<br />
pension fund investors to mark their liabilities to market<br />
ahead of fixed rate usage. This shift to fair value accounting<br />
will sharply increase the volatility of their liabilities and it is<br />
widely expected that investors will beef up their exposure to<br />
very long-dated paper and become forced sellers of equities<br />
and shorter-dated deals in order to reduce volatility.<br />
“The 30 year state-swap spread, which is already at<br />
historically tights, could narrow even further as a result of<br />
the new supervisory framework for pension funds and<br />
insurers that will be introduced in 2006,” says Bert<br />
Heemskerk, chairman of the executive board at Rabobank<br />
Nederland.“The rationale being that we expect the FTK to<br />
lead to a massive interest in receiving fixed ultra long swap<br />
Arnaud Mares, Head of Portfolio Strategy, at the UK’s Debt<br />
Management Office<br />
rates, which will push in spreads versus ultra long bonds.”<br />
Indeed, Harvinder Sian, an analyst at ABN Amro, believes<br />
that more than €120bn worth of Dutch pension and<br />
insurance assets will flow into long-bonds as a result of the<br />
new requirements and investors’ need to match liabilities.<br />
“Dutch pension funds should be big buyers of duration this<br />
year on regulatory factors,”he says.“Pension funds will want<br />
to hedge the risk in their long-term liabilities to avoid the<br />
most onerous regulation elements and we expect around<br />
€bn120-€150bn in [long-dated] buying.”<br />
But even though investors in the Netherlands are<br />
expected to be large consumers of very long-dated debt –<br />
and interestingly, demand from the Benelux region made<br />
up seven per cent of AFT’s €19.5bn order book – the<br />
Dutch government is unlikely to issue a 50 year bond any<br />
time soon. The borrower did, however, issue its first 30<br />
year bond in seven years at the end of April after<br />
instructing ABN Amro, Fortis and CSFB to investigate the<br />
potential market demand for the note. The Dutch State<br />
Treasury Agency had intended to issue a 10 year deal but<br />
found enough interest to price a €5.2bn 2037 deal that<br />
paid four basis points over German bunds and was 40%<br />
sold to pension and asset managers.<br />
Erik Wilders, head of the Dutch State Treasury Agency,<br />
says: “There is obviously demand in the market for very<br />
long-dated bonds and the research from ABN Amro, Fortis<br />
and CSFB found that there was indeed room for us to come<br />
to the market with a 30 year deal. But issuing a 50 year<br />
bond is simply not an option for us right now,” he adds.<br />
“You need a huge amount of outstanding debt to<br />
successfully launch such a deal and, at the moment, we do<br />
not have that. Our goal is to issue debt as cheaply as<br />
possible at a given level of risk.”<br />
But it is precisely this attitude that makes many buyers<br />
worry that 50 year bonds are a much better bet for issuers<br />
than investors.“While moves to increase the availability of<br />
very long-dated assets are to be welcomed, we expect these<br />
deals to be a sideshow for most investors,”says Jeremy Toner,<br />
fixed income portfolio manager at Investec Asset<br />
Management. “Although governments are showing an<br />
astute understanding of timing by issuing very long-dated<br />
instruments when inflation and interest rates are particularly<br />
low, investors face the risk of capital losses unless the bonds<br />
are priced with the potential for higher future inflation.<br />
Previous experience with very long dated bonds has been<br />
unhappy for investors. For example, the undated UK war<br />
bonds issued prior to WW1 and reissued at 3.5% in 1932<br />
(another period of very low inflation and interest rates) have<br />
experienced significant capital losses to date.”<br />
Denis Gould, head of UK fixed income at AXA<br />
Investment Managers, agrees: “There is clearly demand for<br />
ultra long maturities, especially from liability driven<br />
investors but we think the current craze for 50 years may<br />
wane. In government bonds, 50 year issues have the benefit<br />
of higher convexity, which is worth something, but<br />
investors receive next to no extra yield for moving out to a<br />
rather isolated point on the curve where liquidity could be<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
poor. Worse, if many other countries follow France’s lead,<br />
demand could quite quickly become exhausted.”<br />
Jon Little, chief executive officer at Mellon <strong>Global</strong><br />
Investments is equally as critical. “There was definitely a<br />
herd mentality going on with the French deal and I would<br />
not be surprised if after few years some of those investors<br />
that bought into the bond begin to wonder what they got<br />
themselves into. The pricing left a lot to be desired.”<br />
But this does not worry Benoit Coeuré, deputy chief<br />
executive officer at AFT. The borrower’s February deal<br />
attracted demand from at least 10 different countries<br />
including Italy, Germany, the UK, Japan, the US, Sweden<br />
and France, while its eventual size beat expectations by<br />
around 100 per cent. Indeed, the issuer plans to increase<br />
the size of that deal to somewhere between €10bn and<br />
€15bn and then has ambitions to launch an inflationlinked<br />
50 year note once this has been achieved.<br />
“We were definitely surprised by the amount of investor<br />
demand there was for our deal,”says Coeuré.“We expected<br />
and were committed to issuing a deal of somewhere<br />
between €3bn and €4bn but eventually brought a deal to<br />
market that was twice as big as we thought. What we learnt<br />
is that demand is very deep and that there is more than<br />
enough room for other issuers to come to the market. In fact<br />
the more that come the better and that does not just mean<br />
sovereigns. We would also like to see more non-sovereign<br />
issuers, such as utilities, bringing 50 year deals as this will<br />
add more depth and liquidity to the sector.”<br />
Arnaud Mares, head of portfolio strategy at the UK’s DMO,<br />
also rubbishes Gould’s suggestion that the appearance of too<br />
many government 50 year bonds will dilute and ultimately<br />
extinguish investor demand. He believes that there is more<br />
than enough space for other ultra long issues and is<br />
unconcerned by the fact that there has been a spate of 50 year<br />
deals in a relatively short space of time.<br />
“It was never an issue for us what the other governments<br />
were doing and whether or not we were the first into the<br />
market,”says Mares.“It is not a race. We know that there is<br />
significant demand out there from the pension fund<br />
community but demand is not restricted just to pension<br />
funds. ultra long bonds have a high convexity and this<br />
makes them appealing to other sections of the market,<br />
such as hedge funds and the trading desks of banks.”<br />
But whether or not the demand for 50 year deals dries<br />
up over the next couple of years, right now investor<br />
interest in such bonds remains strong. Continued moves<br />
from the various European regulators to increase<br />
protection for pensioners and reduce their exposure to<br />
market risk is increasing the need for fixed income<br />
products – particularly long-dated instruments as<br />
countries move to fair-value liability accounting.<br />
At the same time, national treasury agencies throughout<br />
Europe have been eyeing the opportunity to issue very<br />
long-term debt at a time when both interest rates and<br />
inflation are at relative lows. This demand and supply<br />
match-up looks set to mark the arrival of many more ultra<br />
long bonds over the next 12 months, despite investors’fear<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Benoit Coeuré, deputy chief executive officer at AFT<br />
of rising interest and inflation rates.<br />
“Nominal 50 year deals are not as attractive as<br />
inflation-linked bonds but you can be sure that investors<br />
will jump into any deal if other investors are doing so,”<br />
says Read at Metal Box.“People do not like to be left on<br />
the sidelines and European sovereigns will not have a<br />
problem finding demand.”<br />
“Interest in these deals will not wane,”adds Emeric Challier,<br />
global CIO for European fixed income at Fortis Investments<br />
“If governments become too active in issuing 50 year bonds<br />
we may see a fall in demand but this will only happen over the<br />
longer-term. Right now we are just at the beginning.”<br />
Emeric Challier, global CIO for European fixed income at Fortis<br />
Investments<br />
59
DEBT REPORT: UK GILTS<br />
60<br />
The Debt Management Office<br />
(DMO), the UK Government’s bond<br />
issuance office, an executive<br />
agency of the UK Treasury, is<br />
determined to build liquidity in 50year<br />
gilts following the first of its<br />
ultra long bonds being auctioned<br />
to investors in late May. Francesca<br />
Carnevale talked to Robert<br />
Stheeman, the DMO’s chief<br />
executive, about the market<br />
response to the auction and the<br />
agency’s issuance calendar for the<br />
remainder of the 2005-6 fiscal year.<br />
SMOOTHING THE WAY FOR<br />
ULTRA<br />
AS MAY SLOWLY ground to a close the DMO sold<br />
via auction an inaugural 50-year plain vanilla bond<br />
which marked the longest dated bond the UK<br />
Treasury has brought to the market in more than four<br />
decades. At present, the longest issues out in the market<br />
LONG<br />
with a finite maturity are for around 30 years (please refer to<br />
Table 1) – there are however some outstanding bonds (£3bn<br />
of ‘undated’ bonds, in fact) some stretching as far back as<br />
the nineteenth century.<br />
The new ultra long offering comprised £2.5bn of 2055-<br />
BONDS<br />
dated paper, carrying a coupon of 4.25% and issued at a<br />
yield of 4.21% (at the time of issuance, by comparison, the<br />
30-year benchmark bond offered a yield of 4.33%). The<br />
bond was in large part deemed attractive by market<br />
commentators, given a healthy backdrop of investor<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
demand and the expectation that UK interest rates will<br />
begin to fall in the autumn. The bond also marks only the<br />
first stage in the UK’s issuance of ultra long-dated bonds,<br />
according to Robert Stheeman, the chief executive of the<br />
DMO, who expects its success to be followed by at least<br />
one further issue later this year and another early next. It<br />
could, he acknowledged be extended from the second<br />
quarter of the 2005/2006 financial year to include an indexlinked<br />
offering.<br />
The UK’s return to the long term gilt market has<br />
highlighted efforts by leading European sovereign issuers<br />
to lock-in low interest rates at a time when pension funds<br />
and insurers are clamouring for long-term assets. When<br />
France’s Agence France Trésor (AFT), for instance, issued a<br />
similar a €6bn 50-year bond through a syndicated offering<br />
it was more than three times oversubscribed, raising<br />
€19bn-worth of investor interest following a formal bookbuilding<br />
process.<br />
While Stheeman smilingly acknowledges that demand<br />
for the UK ultra long bond might have been stronger (the<br />
auction was covered 1.6 times), he is sanguine enough to<br />
state that the issue was “very normal for a long dated<br />
auction. We are always pleased with our issues and this is<br />
no exception. We spent a long time building up to it. The<br />
French government has issued something of comparable<br />
length, but not by auction. I have to say that it [the auction]<br />
very much met our expectations.”A second intention was<br />
to ensure a well-run auction process. “I would stress that<br />
for us it was very important to run an open, transparent<br />
process”, adds Stheeman.<br />
The DMO has long preferred the auction process over<br />
syndications. “It is a transparent and predictable way of<br />
issuing debt,” says Steve Whiting, the DMO’s policy<br />
advisor, continuing “while maintaining a level playing field<br />
for primary dealers and at the same time delivering value<br />
for money for the government.”<br />
“An auction suited our purpose well in that case”<br />
explains Arnaud Mares, who is head of portfolio strategy at<br />
the DMO. “There are very good arguments for using<br />
syndication [sic], but it also raises issues” he adds.<br />
<strong>FTSE</strong> All-Share <strong>Index</strong> vs. <strong>FTSE</strong> UK Gilts<br />
150<br />
140<br />
130<br />
120<br />
110<br />
100<br />
90<br />
80<br />
70<br />
60<br />
50<br />
May-00<br />
Nov-00<br />
May-01<br />
Nov-01<br />
May-02<br />
Nov-02<br />
May-03<br />
Nov-03<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
May-04<br />
Nov-04<br />
May-05<br />
<strong>FTSE</strong> All-Share <strong>Index</strong> <strong>FTSE</strong> British Government Stocks over 15 years <strong>Index</strong><br />
<strong>FTSE</strong> British Government <strong>Index</strong>-linked over 15 years <strong>Index</strong><br />
Data as at June 05. Source: <strong>FTSE</strong> Group.<br />
United Kingdom: Structure of the assets of pension<br />
funds and insurance companies (as % of total assets)<br />
90<br />
80<br />
70<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
Securities other than equities: short-term<br />
Medium-term bonds<br />
Long-term bonds<br />
Listed equities<br />
Non-listed equities<br />
Foreign equities<br />
0<br />
96 97 98 99 00 01 02 03 04 05<br />
Source: Ixis CIB<br />
Stheeman picks up the theme.“We would have to choose<br />
only a few lead managers for instance, so it could suggest<br />
we were favouring or giving status to a small group of<br />
banks. We try to treat all the gilt edged market makers<br />
(GEMMs) in an equal and transparent fashion. It is very<br />
important to us,”he says.<br />
But while the DMO is happy with the take up of the<br />
issue, Stheeman admits he was after rather bigger fish. The<br />
DMO was keen not just to sell down one or more ultra long<br />
bonds in the year, it was also keen to develop a long term<br />
viable market for ultra long dated gilts. "Liquidity is<br />
important, and it is something we have focused on very<br />
carefully. We had to be sure that whatever we introduced<br />
was sustainable," he says. That requirement comes into<br />
focus strongly as Stheeman outlines the UK’s medium<br />
term borrowing requirements.“For the next four years we<br />
will average over £50bn – more than last year,” says<br />
Stheeman, while Arnaud Mares stresses that the DMO<br />
“has no particular concerns on the ability of the capital<br />
markets to absorb this requirement. The market itself has<br />
expanded, turnover has increased and liquidity has<br />
improved. We do not sense the market has a problem with<br />
the increased level of issuance.”<br />
Stheeman’s ambitions for the ultra long dated bonds<br />
find a receptive audience among pension fund advisers<br />
who have warned that issuance of ultra long dated bonds<br />
must be substantial to avoid the problem of retirement<br />
funds locking away a limited supply of long dated paper<br />
and creating an illiquid market. In the late 1990s, for<br />
instance, when public finances were in surplus, trading in<br />
30-year gilts became illiquid for a time, producing in turn<br />
wide price swings. The US, for another, even suspended<br />
issuance of 30-year bonds back in 2001 when its budget<br />
was in surplus. The US Government has, however,<br />
recently launched a consultation on the resuming issuance<br />
of 30-year bonds.<br />
Ultra long dated bonds have a particular appeal to the<br />
investment community, for various reasons. Pension<br />
funds, for one, have largely been in favour of them.<br />
61
DEBT REPORT: UK GILTS<br />
62<br />
Interest in them by defined-benefit pension schemes, in<br />
particular, is being driven by ageing maturity profiles and<br />
legislation which encourages them to match their assets<br />
against their liabilities. Consequently as of the beginning of<br />
this year demand for long-dated bonds strongly<br />
outweighed supply, thereby creating a good climate for the<br />
UK via the DMO to return to the ultra long dated market.<br />
“It is fair to say that the vast majority of this issue has gone<br />
THE APPEAL OF THE ULTRA LONG BOND<br />
to the domestic market,”explains Stheeman, although this<br />
assessment is based on anecdotal evidence. It will be some<br />
time before the DMO gets a clear picture of the<br />
composition of buyers of the paper. “In a syndicated<br />
offering you get a better breakdown,”he acknowledges.<br />
Historically, UK pension funds and insurance companies<br />
have been by far the largest buyers of gilts – in particular<br />
index-linked gilts. This trend is likely to continue especially<br />
THE IDEA OF a very long-term bond is not brand new, but it has become very popular in recent months. In some<br />
part this is because pension funds are undergoing rising regulatory pressure to match long-term liabilities and<br />
assets. As well, governments have also acknowledged that current financial conditions make long-term bonds a<br />
cheap way to grow funds.<br />
The launch of the longest dated British Government securities ever issued – aside from undated gilts, which have<br />
no fixed redemption date – came in the aftermath of World War I. In June 1919 the Government launched two<br />
inaugural ultra long gilts on the same day: 4% Victory Bonds, which raised £287m and a further 4% Funding Loan<br />
dated 1960-1990 £288m. In today’s terms, the issues constituted a considerable operation for the time –<br />
equivalent to around £14bn in current money, according to Steve Whiting, a DMO policy advisor.<br />
Issuing authority for the bonds was obtained from the House of Commons by the then Chancellor of the Exchequer<br />
Austen Chamberlain on 2 June. “There then followed several days of speculation in the press over the terms and<br />
conditions of the bonds prior to their official launch in the Guildhall by the Chancellor and the Lord Mayor, on the<br />
evening of 12 June 1919,” he explains. Although the Prime Minister, Lloyd George could not be in attendance, he<br />
telephoned a message of support, stating that in buying the bonds you “get the premier security of the world”. His<br />
comments were received with cheers by the audience when they were read out by the Chancellor. As part of the<br />
launch of the new bonds, a floral fête was also held in Trafalgar Square in celebration. “In addition, at the Prime<br />
Minister's request, over 120 MPs agreed to speak as advocates of the new bonds in their constituencies,” says Mark<br />
Deacon, senior quantitative analyst at the DMO.<br />
Investors could purchase the bonds for cash or by exchanging Treasury bills or other short-dated gilts, “the latter<br />
being part of a government drive to reduce the proportion of the government's debt that was in either floating rate or<br />
short-dated form,” says Whiting. When it was issued, 4% Funding Loan 1960-1990 had a 71-year maturity.<br />
However, in practice it was redeemed early in November 1972, making it a 53-year bond. 4% Victory Bonds were<br />
redeemed in 1976, giving them a near 57-year maturity.<br />
Other ultra long double-dated gilts were issued after 1919. For instance, in 1954 the government issued 3.5%<br />
Funding Stock 1999-2004. This was created as a result of a conversion out of another gilt issue. The yield at issue<br />
was 3.62% and so this was consistent with the 3.5% coupon. The highest price for this bond in 1954 was £99 3/16<br />
and the lowest – at the end of the same year – was £95 1/16. Although this gilt was technically a 50-year gilt as its<br />
final maturity date was in 2004, it was actually redeemed early in 2003, making it a 49-year bond. Of the gilts<br />
currently in existence, the longest dated at issue is 5<br />
1/2% Treasury Stock 2008-2012 which was issued in<br />
October 1960, making it a 48-52 year depending on<br />
its precise redemption date. “At the time, there was<br />
Mark Deacon, senior<br />
rather a lot of speculation in the press when this<br />
quantitative analyst<br />
particular bond was launched that one of the<br />
objectives of the sale was to absorb demand, which<br />
was reported as being large and showing signs of<br />
increasing,” explains Whiting. “The last double-dated<br />
gilt was launched in 1980 and nowadays the policy of<br />
the UK government is to concentrate issuance on<br />
large benchmark bonds with a vanilla bullet structure,<br />
in line with the products available in other leading<br />
international bond markets,” adds Deacon. The<br />
demand for bonds is set to continue, thinks Deacon,<br />
and to increase as European institutional investors<br />
still have a large mismatch between their need for<br />
bonds and what they actually have in their books.<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
as more schemes try to address their matching<br />
shortfalls. However, many schemes have<br />
liabilities with maturities longer than that of<br />
the longest-dated gilts. <strong>Index</strong>-linked gilts, for<br />
example, extend to 2035, with only nine issues<br />
available (and, reportedly, most of the UK’s<br />
pension schemes have liabilities that extend<br />
well beyond that date). Further, the<br />
implementation of international accounting<br />
standards (IAS) as well as more constraining<br />
regulations is forcing life insurance companies<br />
and pension funds to better match their<br />
liabilities. By marking-to-market larger parts<br />
of their balance sheets, these institutions are<br />
motivated to reduce their duration<br />
mismatches if they want to reduce the risk of<br />
high volatility in their financial results.The UK<br />
market is a powerful indicator of the potential<br />
impact this trend towards longer dated<br />
investments can have on the bond market. In<br />
the UK, the changes in regulation forcing<br />
pension funds to better match the duration of<br />
their liabilities has resulted in a strong<br />
increase of the bond portfolio weight in the<br />
asset allocation to the detriment of equities.<br />
The share of equities has fallen from 68% in<br />
1998 to 52% in 2004 and the share of bonds<br />
has risen from 25% to 39%.<br />
Since 2001, the UK institutional investors<br />
have been net sellers of equities and net<br />
buyers of bonds. The impact of the regulation change has<br />
been strong performance of long dated gilts and<br />
ultimately an inversion of the yield curve. As of the end of<br />
January 30-year gilts traded at a yield of 4.5% compared<br />
to 4.6% in the 10-year sector. At the peak of the inversion<br />
in January 2000, 30-year gilts yielded more than 1% less<br />
than the 10 year maturities.<br />
In the period before the DMO kick-started the ultra long<br />
dated bond issuance process, a shortage of long-dated<br />
sterling bonds had, in the meantime, encouraged banks<br />
and other financial institutions to offer products such as<br />
inflation swaps to help retirement funds hedge exposure to<br />
future liabilities. But it is/was nowhere near enough to help.<br />
No surprise then that the DMO ultra long inaugural bond<br />
was snapped up by the local market.<br />
Finally, it was becoming obvious that UK sovereign<br />
issuance was on the rise as the shortfall between<br />
government spending and tax revenue has widened<br />
considerably in recent years. Chancellor Gordon Brown<br />
signalled his intent to issue 50-year gilts in his March 2005<br />
Budget speech to the British Parliament, in a move that<br />
would “lock in low borrowing costs and simultaneously<br />
benefit taxpayers and investors”.<br />
Even though it was well aware of this confluence of<br />
trends, the DMO had undertaken a lengthy market<br />
consultation process well in advance of the March budget<br />
to test the appetite of the larger investment community<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Steve Whiting, Policy Advisor & Press Officer.<br />
towards longer dated issues. “It is becoming a typical<br />
process for us and others are now taking our lead,”explains<br />
Stheeman. The consultation was spearheaded by Arnaud<br />
Marés, and Steve Whiting.“Arnaud and Steve kicked it off<br />
in an informal way last summer,” explains Stheeman.“We<br />
needed to understand the structural needs of the market<br />
and our own investor base. The formal consultation began<br />
in earnest in December of last year.”<br />
Most of the dealers involved in the wide-ranging<br />
consultation process (taking in investment advisors,<br />
actuaries, pension trustees and market traders) gave<br />
preference to a 50-year issue, but some asked for a 40-year<br />
bond. Dealers also called for the DMO to re-open<br />
conventional bonds maturing in 2032 and 2038, and<br />
evinced an interest in launching a 2040 gilt, according to<br />
national press reports at the time.<br />
The DMO is likely to come to market with a further ultra<br />
long dated bond later this year. Take up on the next gilt<br />
issue will be a bellwether of the success of the DMO’s effort<br />
to stoke up liquidity. A further milestone will also be<br />
achieved, if the DMO manages to meet demand for an<br />
ultra long dated index-linked bond.“It is fundamentally a<br />
different animal,” concedes Stheeman, “and so that may<br />
take longer to achieve. We will have to take the measure of<br />
the market and demand and the technical issues in<br />
structuring an index-linked facility over such a long tenor.”<br />
Knowing the DMO, it will leave nothing to chance.<br />
63
SECTOR REPORT: DISTILLERS<br />
64<br />
Blithe Spirits IN A<br />
The spirit of capitalism is up and roaring – at least<br />
among the world’s distillers. The few remaining<br />
liquor giants today squint avariciously at each<br />
other’s brands, with a view to takeovers and<br />
amalgamations. Allied Domecq, the British-based<br />
company that is the world’s second largest liquor<br />
seller, having scarcely digested its spoils from the<br />
Seagram’s carve up of four years ago, is now itself<br />
on the slab awaiting the brand-hoarders’ hatchets.<br />
Its shareholders are not complaining. Like a prize<br />
bull fatted for market, the carved up company is<br />
worth far more than on the hoof. Ian Williams<br />
considers the outlook for the industry.<br />
Philip Bowman,<br />
chief executive, Allied Domecq<br />
= bull<br />
run
TODAY’S SPIRITUOUS FRENZY is a return of an<br />
older cycle of trade. In the seventeenth and<br />
eighteenth centuries, the distillation of brandy and<br />
rum helped turn the engines of world commerce, leading<br />
to the development of the modern Atlantic economy. New<br />
Englanders traded their cod for molasses from the<br />
Caribbean, which they made into rum. Apart from<br />
drinking lots of it themselves, it was a major article of trade<br />
for the slavers.<br />
Alcohol was also a major source of early trade wars since<br />
the French and Spanish tried to protect their domestic<br />
brandy producers from colonial competition by banning<br />
the rum trade, and distillers worldwide used their<br />
domestic clout to ensure that foreign rivals were taxed at a<br />
much higher rate.<br />
People have always thought that tipple from across the<br />
sea was more exotic and chic than anything produced in<br />
their hometown distilleries. Colonial Americans, for<br />
example, oft times paid a premium for Jamaica Rum over<br />
their local New England variety, while their contemporary<br />
British paid more for sometimes-smuggled French brandy<br />
rather than locally produced gin or whisky.<br />
Eventually, that led to the development of global brands<br />
recognised across the drinking world. In more recent times,<br />
World Trade Organisation rulings and free trade<br />
agreements have now cut back on the previous tariff<br />
barriers that penalised foreign spirits, creating a real world<br />
market. Countries may tax drinking heavily, but they can<br />
no longer favour local distilleries.<br />
In the last ten years, as a result of these developments,<br />
the industry has steadily grown from a relatively high<br />
population of small family-owned enterprises to a much<br />
smaller group of massive international companies. And,<br />
just as in the buccaneering Rum era, French, British and<br />
American giants are now playing a modern form of poker<br />
across the Atlantic table.<br />
So far advanced is the process of consolidation that to<br />
stay one step ahead of the regulators, recent takeovers have<br />
involved shuffling brands between rivals so that each can<br />
maintain a balanced portfolio of products without<br />
developing a monopoly in any one sector. Because this is a<br />
global business, companies<br />
have to comply with Fizz and pop in the spirit world<br />
European and US anti- 500<br />
monopoly regulations, and 450<br />
400<br />
each merger and<br />
350<br />
acquisition results in a 300<br />
judicious reshuffle of 250<br />
brands as the companies 200<br />
150<br />
try to assemble the hands<br />
100<br />
they want to deal in each 50<br />
of the big markets.<br />
0<br />
Driving the present barroom<br />
brawl is the growing<br />
popularity, and even faster<br />
Allied Domecq Pernod–Ricard<br />
growing profitability, of<br />
Diageo Fortune Brands<br />
premium branded spirits.<br />
Apr-00<br />
Oct-00<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Apr-01<br />
Oct-01<br />
Apr-02<br />
Oct-02<br />
Constellation Brands A<br />
<strong>FTSE</strong> Beverages <strong>Index</strong><br />
Data as at June 05. Source: <strong>FTSE</strong> Group/FactSet Limited (Price <strong>Index</strong> values in US Dollars)<br />
Once a heavily taxed luxury, rising affluence and declining<br />
relative prices have caused spirit consumption to soar –<br />
especially in the branded varieties where the wiles of<br />
marketers can persuade drinkers that there is enough<br />
virtue in a branded variety of pure ethanol and water to be<br />
worth five times the price of a generic equivalent. Young<br />
people in their twenties in particular are downing spirits.<br />
Sales in the US for example are rising by 4.1% a year, while<br />
beer drinking, at 0.5% annual growth, these days can<br />
hardly raise its froth above the glass.<br />
Marketers have successfully persuaded significant<br />
numbers of the bright twenties age group that only much<br />
more expensive super-premium brands have the necessary<br />
cachet. Furthermore, these days it is peer-group social<br />
death to be seen drinking lesser brands without the lore. As<br />
a result Impact Databank, the alcohol sellers’ bible,<br />
assessed the value of the world's top 100 spirits brands as<br />
rising 5% to $56bn last year.<br />
That price and worth are not necessarily identical is<br />
suggested by American Sidney Frank’s sale of the “Grey<br />
Goose”vodka brand to Bacardi for $2bn last September. It is<br />
perhaps symptomatic that Frank began his career making<br />
alcohol-based jet fuel. His “invention” of Grey Goose was<br />
based on sound economic principles. As he has explained,“A<br />
bottle of Absolut sells for $20 a bottle.Vodka is just water and<br />
alcohol, so if I sold a bottle for $30, the $10 difference is<br />
almost all profit.”He knew that there is nothing as easy as<br />
parting a snob from his money, and made Grey Goose in<br />
France, to tickle American consumers’sense of chic.<br />
There is indeed room for a little boy to do the emperor’s<br />
new clothes routine on drinks such as premium vodka.<br />
Dimitry Mendeleyev took time off from laying the Periodic<br />
table of Elements to draw up the specifications for vodka<br />
for the Tsar in 1894. It comprised 60% water and 40%<br />
ethanol. So the major difference in premium drinks is the<br />
label on the bottle – and the price. Since most of the<br />
drinkers add mixers or drink the vodka as part of a cocktail,<br />
any homeopathic differences between brands would need<br />
a gas chromatograph to identify. One envisages a world full<br />
of unscrupulous bar-owners decanting basic vodka into<br />
expensive bottles every evening.<br />
Apr-03<br />
Oct-03<br />
Apr-04<br />
Oct-04<br />
Apr-05<br />
But with the mysterious<br />
alchemy of branding, Grey<br />
Goose has left former<br />
premium brands behind,<br />
as mere cooking vodkas<br />
for the undiscerning. It has<br />
also triggered a chain<br />
reaction as other firms<br />
have sought to put alcohol<br />
and water in pretty bottles<br />
that attracted superpremium<br />
prices.<br />
Its very simplicity is<br />
what makes vodka perfect<br />
for this form of comodification.<br />
However,<br />
65
SECTOR REPORT: DISTILLERS<br />
66<br />
global companies need a full<br />
range of spirits, single malts<br />
and aged rums and brandies<br />
even before you get to the<br />
modern liquid candy<br />
confections striving for<br />
market share. Bacardi’s<br />
purchase of Grey Goose and<br />
other brands such as<br />
Bombay Sapphire and<br />
Dewars shows that it realises<br />
that the fairly generic white<br />
rum that it is usually<br />
associated with does not pull<br />
in the growth and dollars it<br />
wants. Bacardi, itself one of<br />
the world’s most recognisable brands, has also grown<br />
apace, but not perhaps as fast as its rivals, or indeed as fast<br />
as the family. There are constant hints that its 600-plus<br />
(and increasingly extended) family shareholders may want<br />
to go public so they can take a quick shot from the stock<br />
markets. Bacardi executives meanwhile are looking<br />
askance at their declining market share as the major, stockmarket-funded<br />
giants merge and acquire.<br />
And of course, to add a little spritz to the mix, Bacardi has<br />
been fighting its own grudge fight against Pernod-Ricard<br />
over the American rights to Havana Club. Pernod-Ricard<br />
has the worldwide rights, except in the USA, where the<br />
courts and Congress share the Bacardi family’s antipathy to<br />
Fidel Castro.<br />
Some cynics also suggest that Havana Club’s distinctive<br />
nose shows up the blandness of Bacardi – which might<br />
explain how, without selling a single bottle legally in the<br />
world’s biggest marketplace (i.e. the USA) Havana Club<br />
sales have been steadily rising until it is now 44th in the<br />
world’s top hundred spirits list.<br />
Among the quoted spirit companies meanwhile, the<br />
present reshuffle began when Edgar Bronfman Jr decided to<br />
pull out of the family’s Seagram’s spirits empire, whose<br />
success had been built on the proximity of Canadian<br />
distilleries to Prohibition-era America. Diageo and Pernod-<br />
Net turnover by business area %<br />
Year end figures, August 2004.<br />
Total £2,611m<br />
Spirits & Wine £m %<br />
1. North America 632 28<br />
2. Europe 734 28<br />
3. Latin America 268 10<br />
4. Asia Pacific 226 9<br />
5. Premium Wine 475 18<br />
6. Other 50 2<br />
7. Quick Service Restaurants 226 9<br />
Total 2,611<br />
“If Pernod-Ricard can pull off the<br />
Allied Domecq takeover, it will be selling<br />
77m cases of spirits a year, and own 20<br />
of the top 100 brands, even after<br />
divesting some of the Allied Domecq’s<br />
brand portfolio to Fortune brands. It<br />
would also double Pernod-Ricard’s share<br />
of the American market to over a<br />
quarter and make it the second biggest<br />
spirits company in the world.”<br />
Source: Allied Domecq’s Press Pack 2005.<br />
Ricard worked together to<br />
pick over Seagram in a $8.7bn<br />
vivisection that gave each of<br />
them the brands they wanted<br />
and they thought that the<br />
regulators would let them get<br />
away with.The effect has been<br />
to shuffle the pack of the top<br />
brands, and more cards are<br />
now about to change hands.<br />
Pernod-Ricard – eagerly<br />
building up its portfolio since<br />
it decided that its eponymous<br />
anise flavoured drink alone<br />
was not going to conquer the<br />
world – added Seagram’s gin,<br />
Chivas Regal and Martell Brandy to its cabinet to give it 12<br />
of the world’s 100 biggest spirits brands.<br />
In the end, while Bronfman would undoubtedly have<br />
been better off sticking with booze than chasing a dot.com<br />
dream with Vivendi, there is a distinct hint of bubble<br />
economy about the spirits fad. The Super Premium brands,<br />
creations of astute marketing as they are, require heavy<br />
investment in brand maintenance, especially as others try<br />
to recreate their success. No less than 130 new brands of<br />
vodka were launched last year, each of them hoping to<br />
knock Grey Goose off its precarious perch.<br />
However, high maintenance costs raise the entry<br />
premium for new brands, and in the modern world global<br />
brands tend to dominate. Size does matter in the booze<br />
business. Smaller brands wilt. The giant multinational<br />
drinks businesses often do not even make their own<br />
drinks, but market and distribute other companies’<br />
productions, assembling brands to make up a balanced<br />
global liquor cabinet.<br />
That is the background to current takeover battles<br />
when, in April, Pernod-Ricard and Fortune Brands bid<br />
$14bn for the hearts and spirits of Allied Domecq,<br />
Diageo’s British rival.<br />
If Pernod-Ricard can pull off the Allied Domecq takeover,<br />
it will be selling 77m cases of spirits a year, and own 20 of<br />
Trading profit by business area %<br />
Year end figures, August 2004.<br />
Total £657m<br />
Spirits & Wine £m* %<br />
1. North America 183 29<br />
2. Europe 139 22<br />
3. Latin America 44 7<br />
4. Asia Pacific 68 11<br />
5. Premium Wine 98 15<br />
6. Other 16 2<br />
7. Quick Service Restaurants 86 14<br />
Total 634<br />
*Excludes £23m of Britannia Source: Allied Domecq’s Press Pack 2005.<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
the top 100 brands, even after divesting some of the Allied<br />
Domecq brand portfolio to Fortune brands. It will also<br />
double Pernod-Ricard’s share of the American market to<br />
over a quarter and make it the second biggest spirits<br />
company in the world.<br />
Fortune will also double its US market share, and it is<br />
widely felt that the deal is its last chance to get within stalking<br />
distance of Diageo, the British company whose size haunts<br />
the spirit world in the US as well globally. It would make<br />
Fortune (whose flagship hooch at the moment is Jim Beam<br />
bourbon) the fourth largest spirits company in the world.<br />
However, the perception that Allied Domecq’s takeover<br />
and dismemberment will lock up market share for a long<br />
time to come has now prompted a counter-offer from<br />
American company Constellation Brands backed by<br />
Brown Forman.<br />
Constellation Brands lacks any major international<br />
spirits brands to balance its stronger beer and wine<br />
portfolio, while Brown Forman has been building up from<br />
its flagship Jack Daniels bourbon with Appleton’s rum and<br />
Finlandia vodka and could doubtless complement that<br />
cocktail with a few more international brands.<br />
To add to the tension, Diageo, Pernod-Ricard’s former<br />
partner in dismembering Seagrams, could not make an<br />
offer for Allied Domecq without bringing monopoly<br />
regulators crashing down on it. But it is hovering around<br />
offering spare cash to whichever bidder will allow it to<br />
cherry pick further brands from Allied Domecq’s cabinet.<br />
That would help it blunt the threat from the Pernod-<br />
Ricard/Allied Domecq merger which would bring the<br />
resulting company closer to Diageo’s hitherto unassailable<br />
position as the world’s number one barkeeper.<br />
And just to complicate the issue further, Bacardi, clearly<br />
trying to expand from its rum base was also rumored to be<br />
interested, whether in concert with the others, or even a<br />
direct bid of its own that would fulfill the desire of some of<br />
the family shareholders to get a stock market listing by<br />
inheriting Allied Domecq’s position in London.<br />
Of the interest in Allied Domecq’s overall portfolio, the<br />
keenest is perhaps in Allied Domecq’s premium brands.<br />
Although, they only make up a third of Allied Domecq’s<br />
sales, the premium brands contribute to half of its profits<br />
and have built the company up to its present size – thereby<br />
making it such a desirable prize.<br />
There may well be more mileage in the long run in the<br />
merely premium aged spirits but for now the attractions of<br />
a quickly made product selling at very high multiple of its<br />
production costs will certainly maintain attention on the<br />
white spirits, in particular vodka. It is a lot easier to add a<br />
fruit flavour to alcohol fresh from the still than to nurture<br />
a malt whisky or cognac for quarter of a century in<br />
expensive oak casks.<br />
While the “brown” spirits are steady earners, for the<br />
foreseeable future, the high spirits of the twenty something<br />
generation are going to be the effervescent force in the<br />
global liquor stakes. There are many more hands to be<br />
played, and brands to be reshuffled.<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Patrick Ricard, chairman and CEO of Pernod Ricard.<br />
SPIRITED PLAYERS<br />
AND THEIR HANDS<br />
When Allied Domecq folds, its hand includes<br />
Ballantine’s, Beefeater, Kahlua, Malibu,<br />
Stolichnaya, Centenario, Teachers, Tia Maria, single<br />
malt brands including Laphroaig, Glendronach, Scapa<br />
and Tormore and “fun” brands such as Midori, Caribe,<br />
which would go to Pernod-Ricard while Canadian<br />
Club, Courvoisier, Maker’s Mark,Teachers and Sauza<br />
would go to Fortune Brands.<br />
Fortune Brands already owns Jim Beam and Knob<br />
Creek bourbons, DeKuyper cordials, Starbucks<br />
Coffee Liqueur, The Dalmore single malt Scotch, and<br />
Vox vodka<br />
Pernod-Ricard already has Wild Turkey Bourbon and<br />
Seagram’s Gin and distributes Chivas Regal, Jameson<br />
Irish whiskey, Havana Club, Martell Cognac, Wódka<br />
Wyborowa, Viuda de Romero tequila, as well as its<br />
original Pernod and Ricard anises.<br />
Diageo’s hand currently includes, Smirnoff, Gilbey’s,<br />
Gordon’s Tanqueray gin and vodka, White Horse,<br />
J&B rare, Pinch (Dimple), Crown Royal, Seagram’s,<br />
Buchanan’s, Cardhu, Bailey’s, Myers, Captain<br />
Morgans, Hennessy, Romana Sambucca, José<br />
Cuervo, Don Julio, and an array of Classic Malts.<br />
Bacardi, apart from its own array of rums, has<br />
Bombay Sapphire gin and Martini & Rossi vermouth,<br />
Dewar's Scotch whisky, DiSaronno Amaretto and now<br />
of course, Grey Goose as well.<br />
67
DERIVATIVES REPORT: CME<br />
68<br />
CME<br />
Craig S. Donohue,<br />
CME CEO<br />
at the new<br />
frontier<br />
As market boundaries flounder in the wake of globalisation, stock and derivatives exchanges have<br />
oft-times struggled to redescribe their role in the new financial order. Not so the Chicago<br />
Mercantile Exchange (CME) which, since demutualisation back in 2001, has swelled in confidence,<br />
strength and reach. Armed with a $700m war chest, big could get bigger as the CME scouts for<br />
strategic acquisitions, joint ventures and growth. Chief executive officer (CEO) Craig S. Donohue<br />
talks to Francesca Carnevale, about the seemingly unstoppable force that is now the CME.<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
NO SURPRISE THAT in Illinois, which now boasts<br />
an economy greater than that of Russia,<br />
testosterone-charged numbers are de rigueur at the<br />
Executives’ Club of Chicago’s early-bird monthly breakfast<br />
meetings. The sometimes biting elite of Chicagoan<br />
corporate society has gathered this day to hear Craig S.<br />
Donohue, the CME’s urbane CEO, explain why “The<br />
Future is in Futures”. In the sometimes catty table talk<br />
before his speech, more than one person pointedly remarks<br />
that the CME, which has a market capitalisation of some<br />
$7bn, is but only one of the top 25 companies in Chicago.<br />
Yet even this number-jaded clique, looks up in conceded<br />
surprise when Donohue eventually lobs his own fat<br />
statistics into the mix.<br />
Last year more than 800m contracts were traded on the<br />
exchange, with a gross value of $463trn. That is over 10<br />
times the current annual gross domestic product (GDP) of<br />
the United States (US). Put another way, in the first two<br />
weeks of January, the CME traded more in notional value<br />
terms than the New York Stock Exchange handles in a full<br />
year. It is an indication of just how far futures and options<br />
markets have come. Today it is a global growth industry<br />
which boasts “compounded annual growth of 38% during<br />
the last three years, compared with the relatively flat<br />
growth for the world’s stock exchanges,” according to<br />
Donohue. His well-practised delivery bears fruit, even<br />
among Chicago’s uber-moneyed city fliers. “He seems to<br />
know what he is talking about,” says one of the<br />
breakfasters, if a tad grudgingly. It is a back-handed<br />
compliment that Donohue would laughingly appreciate,<br />
with the sort of gracious ease that masks years of driving<br />
hard work and a sometimes ruthless strategic focus.<br />
A 17-year veteran of the CME, he does indeed know the<br />
business very well. Still barely in his forties Donohue took<br />
over as CEO of CME Holding and the CME itself only in<br />
January 2004, but to many market watchers, he was a<br />
natural choice for the job. He succeeded James J. McNulty<br />
who stepped down after steering the CME through<br />
demutualisation, an initial public offering (IPO) and the<br />
early rise of electronic<br />
trading via the CME Globex<br />
platform. Donohue<br />
entered as a general<br />
counsel back in 1989, with<br />
a list of academic and legal<br />
qualifications almost as<br />
long as this article. He<br />
joined from the local law<br />
firm of McBride Baker &<br />
Coles where he had<br />
specialised in corporate<br />
and securities law. Steadily<br />
working through one<br />
senior management<br />
position after another, in<br />
each role Donohue played<br />
an important part in<br />
400<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
Dec-03<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
“Increasing Market Share at the Expense of the<br />
European Exchanges” – Chicago Mercantile Exchange<br />
vs. Deutsche Bourse and Euronext<br />
Mar-04<br />
Jun-04<br />
Chicago Mercantile Exchange Deutsche Bourse AG Euronext<br />
CME MONTHLY AVERAGE DAILY VOLUME (In Thousands)<br />
May 2005 May 2004 Percent<br />
Change<br />
CME PRODUCT LINE<br />
Interest Rates 2,385 1,878 27%<br />
E-Minis 1,205 1,238 -3%<br />
<strong>Equity</strong> Standard 102 95 7%<br />
Foreign Exchange 296 163 82%<br />
Commodities 53 45 16%<br />
Sub Total 4,041 3,420 16%<br />
trakrs 22 86 -74%<br />
Total<br />
VENUE<br />
4,063 3,506 18%<br />
Open Outcry 1,054 1,516 -30%<br />
CME Globex (Ex trakrs) 2,942 1,868 57%<br />
Privately Negotiated 45 36 25%<br />
Source: CME June 1st 2005<br />
setting the organisation’s vision and developing growth<br />
strategies to expand the exchange’s core business and<br />
global distribution.<br />
It is a particularly good time to be CEO at the CME. Over<br />
the last five years, it has morphed into the largest futures<br />
exchange in the US and the world’s largest clearing house<br />
for futures and futures options contracts. The exchange’s<br />
products have sounded a particular resonance to<br />
contemporary investors, providing as they do a means for<br />
hedging, speculation and asset allocation relating to the<br />
risks associated with interest-rate movements, equity<br />
ownership, and fluctuations in foreign currency (FX) values<br />
and the prices of commodities – including cattle, hogs and<br />
dairy. The CME launched the first of its stock index futures<br />
contracts based on the S&P 500, back in 1982. Today, it<br />
trades Eurodollar contracts and futures and futures options<br />
on an ever-widening variety of indices, including the<br />
NASDAQ-100, S&P/BARRA Growth and Value <strong>Index</strong>es,<br />
Sep-04<br />
Dec-04<br />
Mar-05<br />
Data as at June 05. Source: <strong>FTSE</strong> Group/FactSet Limited, US Dollar price indices.<br />
and the Nikkei 225, as well<br />
as its electronically traded<br />
E-mini S&P 500 and Emini<br />
NASDAQ-100<br />
contracts, that are among<br />
the fastest growing<br />
products in the industry’s<br />
history.<br />
Most recently the CME<br />
added futures contracts on<br />
three of the largest and<br />
most popular exchange<br />
traded funds (ETFs –<br />
baskets of securities<br />
designed to track an<br />
index). The move is<br />
significant. The fast<br />
growing US ETF market is<br />
69
DERIVATIVES REPORT: CME<br />
70<br />
reported to have combined<br />
ETF assets under custody<br />
of some $226bn (as of the<br />
end of last year), with the<br />
S&P 500, NASDAQ-100<br />
and Russell 2000 ETFs<br />
accounting for about one<br />
third of that amount.<br />
New CME ETF futures<br />
contracts that are based on<br />
those indices began<br />
trading on the CME Globex<br />
electronic trading platform<br />
in June. Futures on the<br />
S&P 500 and NASDAQ-<br />
100 indices continue to<br />
trade exclusively at<br />
CME. “<strong>Equity</strong> market<br />
CME Outperforming Peers<br />
participants want access to a broad array of products and<br />
markets, and the growth of our CME E-mini S&P 500,<br />
CME E-mini NASDAQ-100 and CME E-mini Russell 2000<br />
contracts makes the ETF products a natural addition,”says<br />
Donohue. The move also portends a broader long term<br />
marketing initiative by the exchange. The addition of the<br />
ETF futures means, “we will be able to attract more new<br />
customers, particularly sophisticated retail equity<br />
investors,”he adds.<br />
Aggressive accretion of market share, wherever it might<br />
be, has been a priority for the exchange since at least the<br />
turn of this century. Between then and now the CME has<br />
assumed a more uncompromising character. It is a<br />
transformation kick-started by demutualisation in<br />
November of 2000 and a subsequent successful IPO in<br />
December 2002 with shares priced at $35 (these days the<br />
exchange’s shares trade in a high low range of $181 to<br />
$235). Contiguous developments include virtually<br />
continual product and technology innovation, expanding<br />
global distribution and the establishment of strategic<br />
partnerships in Europe and Asia.<br />
The results are impressive. 2003 and 2004 were banner<br />
years. The exchange’s net revenues rose 37% last year to<br />
reach $733bn, with net income up 80% to $219m based<br />
on an operating margin in the year of 50.1%, compared<br />
with 38.5% in 2003. But 2005 threatens to outclass even<br />
that performance. The trend, for the moment is but one<br />
way. Donohue explains that record volumes across all<br />
major product groups were and are “spurred by the<br />
phenomenal growth of electronic trading.” In particular,<br />
the exchange’s performance reflected the additional<br />
revenues generated from clearing Chicago Board of Trade<br />
(CBOT) transactions (of which more later).“Not bad for a<br />
company that began modestly in 1874 with the<br />
establishment of a private association in Chicago to help<br />
butter and egg dealers,”he smiles.<br />
The CME also currently manages more than twice as<br />
many futures and options on futures contracts than any<br />
other futures clearing organisation in the world, and over<br />
Average Daily Volume (round turns, in millions)<br />
5<br />
4<br />
3<br />
2<br />
1<br />
0<br />
1Q<br />
03<br />
2Q<br />
03<br />
3Q<br />
03<br />
4Q<br />
03<br />
1Q<br />
04<br />
2Q<br />
04<br />
3Q<br />
04<br />
4Q<br />
04<br />
1Q<br />
05<br />
4.5 – CME<br />
3.5 – Eurex<br />
3.0 – CBOT<br />
2.0 – Euronext.<br />
liffe<br />
2Q<br />
05<br />
through<br />
May<br />
NOTE: Based on futures and options on futures. Excludes individual equity options.<br />
© Chicago Mercantile Exchange Inc. All rights reserved.<br />
90% of all US futures<br />
contracts. “Our electronic<br />
trading business<br />
continues to grow rapidly<br />
due to our focus on<br />
expanding functionality,<br />
capacity, distribution and<br />
access to our CME Globex<br />
trading system,” says<br />
Donohue. “As new<br />
electronic trading groups<br />
and individual electronic<br />
traders continue to emerge<br />
in markets globally, CME<br />
is competing to attract<br />
their business.”<br />
The CME has also<br />
ridden a flow tide of<br />
business. According to the most recent Futures Industry<br />
Association report, the volume of global futures and<br />
options trading grew 8.9% to total 8.89bn contracts in<br />
2004, with even more growth expected this year. Futuresonly<br />
volume, for example, topped 3.5bn contracts, up<br />
16.3% on the year. Options trading grew more slowly<br />
however, rising 4.6% to 5.4bn contracts, mainly due to<br />
lower levels of trading in Korea’s Kospi 200 index option.<br />
Although volume rose in all sectors, trading in FX grew<br />
the most, surging 35.4% to 105.4m contracts worldwide.<br />
The largest volume in this category was, in fact, the Bolsa<br />
de Mercadorias & Futuros’US Dollar futures contract (up<br />
42.7% to 23.9m contracts for the year). In context,<br />
volume on the CME’s Euro FX futures product almost<br />
doubled over the same period, rising 82.7% to 20.5m<br />
contracts in the year.<br />
Interest rate products apparently maintained their lead<br />
as the world’s most active futures contracts. And while the<br />
CME’s 3-month Eurodollar future gained an additional<br />
42.5% to 297.6m contracts to remain the world’s largest<br />
futures contract, in a countertrend, Eurex’s Euro-Bund<br />
declined slightly, down 1.9% to 239.8m contracts.<br />
Meanwhile, in the dynamic top ten derivatives exchange<br />
league tables, the CME moved past Euronext.liffe in<br />
December last year to become the world’s third-largest<br />
global derivatives exchange.<br />
Performance records aside, in the sedate setting of the<br />
CME’s South Wacker Drive’s offices, Donohue muses over<br />
the emerging view of the CME as a latter-day Galactico<br />
among global exchanges.“Conversion from a membership<br />
organisation to a publicly traded company fundamentally<br />
transformed us,” declares Donohue, though he concedes,<br />
the going has not been easy and back in 2001, nothing was<br />
certain. Though bullish on “the future of our industry,” he<br />
stresses “it was not always so.” “Everyone says,‘well, it was<br />
easy, or that it was well timed.’I tell you, it was not obvious<br />
to us. The risk of failure was real enough. It was out there.”<br />
Challenges were becoming apparent even as the century<br />
opened and the global financial markets began to assume<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
a more sombre cast (well before 9/11 in fact). The<br />
competitive game in which the CME was playing was in<br />
flux. Competition between futures exchanges intensified<br />
and the stage became global, rather than national or<br />
regional. Although liberalising legislation via the<br />
Commodity Futures Modernization Act of 2000 (CFMA),<br />
had given the CME added impetus with which to face the<br />
future, advances in technology and a more favourable<br />
regulatory environment simultaneously encouraged<br />
European exchanges – namely Euronext.liffe and Eurex – to<br />
mount a competitive charge on the benchmark products of<br />
the US futures market.<br />
The CME found that it faced a clear and present<br />
danger, perhaps for the first time. The specialist<br />
derivatives media added to the pressure. Chicago’s<br />
exchanges were simply not up to growing competition<br />
from abroad, they said and CME would be forced to cut<br />
trading fees to non-economic rates to encourage more<br />
volume, or that its mix of users would change and alter<br />
its profitability. Ironically, all that did happen, but not<br />
quite in the way the doubters expected.<br />
The CME realised it needed to overhaul not only its<br />
business structure and strategy, but also its international<br />
ambitions. Its response was rapid, accelerating changes<br />
that were already in motion, such as migration to<br />
electronic trading and a reduction in trading costs. “We<br />
always thought about competition in terms of three major<br />
industry trends: deregulation, rapid advances in<br />
technology, and globalisation of intermediaries and<br />
customers,” explains Donohue. “We built the financial<br />
strength and critical mass necessary for executing our<br />
long-range strategy of expanding our core business,<br />
broadening our product range, providing third-party<br />
transaction services and exploring new business<br />
opportunities and that process continues.”<br />
Investment in technology was intensified, as a priority.<br />
”We spend more on technology today than was our entire<br />
operating budget five years ago,”says Donohue.“In the last<br />
8 years we have invested over $1bn in technology and gone<br />
from having 125 or so technology specialists five years ago<br />
to employing around 450 today … the processing<br />
capabilities that we have, the global distribution network,<br />
even the backup and disaster recovery facilities point to us<br />
being more attuned to technology than ever before.”<br />
“Today, we have marketing offices, telecommunications<br />
hubs and customer support capabilities in major financial<br />
centres, including London, Milan, Amsterdam, Frankfurt,<br />
Gibraltar, Paris, Dublin and Singapore,” expands<br />
Donohue. In preparation for that, over the last decade,<br />
CME has developed, enhanced and refined, its electronic<br />
trading platform. “Our order Return Delivery Time is 25<br />
milliseconds, among the fastest in the industry. CME<br />
Globex is also accessible virtually 24 hours a day, longer<br />
than any other electronic platform.” CME had launched<br />
the industry’s first electronic trading platform (or system),<br />
back in 1992. CME Globex revolutionised derivatives<br />
trading by delivering much faster trade execution and<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
trading anonymity. It also eliminated CME membership<br />
requirements for traders. Originally based on a DEC<br />
platform developed by Reuters, CME upgraded to its<br />
present multiplatform environment in 1998 – the service<br />
is built on top of a heterogeneous environment of IBM<br />
and Tandem mainframes, Solaris and Linux systems.<br />
Investment in enhancing transaction rates means more<br />
than just faster processing.The company makes money by<br />
charging for executing trades and then charging to settle<br />
those trades. Therefore, the faster its systems are, the<br />
more trades it can handle, and the more profitable the<br />
CME becomes.<br />
Migration to electronic trading has also spurred<br />
efficiency. Late last year the CME estimated that the<br />
average rate per trade (an important profitability measure)<br />
is around 77 cents for CME Globex products, compared with<br />
52 cents for products traded via open outcry.The CME then<br />
simply earned 60% more revenue when a contract is traded<br />
on electronically than on the floor. Electronic trading is<br />
therefore elemental to earnings growth and simultaneously<br />
provides the CME with more room to compete with other<br />
exchanges on fees. As a consequence a number of fee<br />
cutting initiatives have been underway, particularly aimed<br />
at European customers, Asian banks and hedge funds.<br />
There are also other related initiatives. For instance, “we<br />
have expanded the market maker program to nonmembers,<br />
and non-member firms, so that an electronic<br />
proprietary trading group or electronic trading arcade that<br />
would like to meet our market making requirements can<br />
do so at very reduced fees,” acknowledges Donohue.<br />
Recent press reports would have it that around 80% of the<br />
market by transaction volume is trading electronically in<br />
CME Globex Eurodollars for between 14 cents and 18 cents,<br />
compared with prices anywhere between 50 cents and 80<br />
cents on the open outcry floor, because of brokerage costs<br />
and the scale of the trade. Donohue concedes that few, if<br />
any, exchanges can compete at its lower price levels.<br />
Outrageous fortune has not come without its slings and<br />
arrows. Eurex US which to date has not succeeded in<br />
setting up a strong foothold in the North American market<br />
filed a second amended antitrust complaint with an Illinois<br />
District Court against the CBOT and CME in March this<br />
year. Eurex US had also filed an antitrust action against the<br />
two exchanges back in October 2003 for alleged anticompetitive<br />
behaviour. The complaint included allegations<br />
that the CBOT and the CME have violated the Sherman<br />
Act by lowering transaction fees to predatory levels and<br />
allegedly attempting to keep Eurex from obtaining clearing<br />
services. The CME dismisses the charges.<br />
The move nonetheless illustrates Eurex’s frustration over<br />
the difficulties in breaking into the US market, particularly<br />
as it was the first foreign exchange to establish a US<br />
subsidiary and enter into direct head-on competition with<br />
the incumbent exchanges. Eurex has however succeeded in<br />
establishing partnerships with important local institutions.<br />
In its home market, Eurex has been a champion of vertical<br />
integration, but in the US it has railed against the vertical<br />
71
DERIVATIVES REPORT: CME<br />
72<br />
silo created at the CME. However Eurex did not take the<br />
measure of the ruthless drive of the US exchanges to<br />
undercut any market solutions that Eurex was touting. The<br />
CME and the CBOT clearly understood their own turf and<br />
what they could and could not do to withstand any assault<br />
on their market. But, stresses Donohue, the picture is<br />
greyer than market watchers often paint it. Developments<br />
in the market have been utilised to cooperate with other<br />
exchanges as well as compete with them. Recognising, for<br />
instance, that demands for greater efficiency have a wider<br />
application that the CME can also leverage to mutual<br />
advantage, Donohue claims that the exchange has led the<br />
trend toward standardisation and consolidation. “For<br />
example, Euronext.liffe uses CME’s Clearing 21 System to<br />
clear and process the majority of their securities and<br />
derivatives products. In the area of risk management CME<br />
literally created the industry standards when it developed<br />
its proprietary SPAN Margining System,” he recounts.<br />
SPAN, which allows exchanges to monitor risk exposure,<br />
has now been licensed to some 47 exchanges and clearing<br />
houses, including the Shanghai Futures Exchange. It is,<br />
says Donohue “an important step for China in the process<br />
of moving toward global industry standards.”Not least, he<br />
points to the “historic clearing processing agreement with<br />
CBOT,” as an “example of our willingness to seek<br />
standardisation and consolidation benefits that have<br />
reduced performance bond requirements for market users<br />
by more than $2bn and has saved our joint clearing<br />
member firms more than $200m in capital”.<br />
Utilising CME’s own clearing house, it was officially<br />
launched at 7:00 p.m. on Sunday, November 23, 2003 when<br />
CME began providing clearing and settlement services for<br />
a number of CBOT products, including agricultural, Federal<br />
Reserve funds, swap, municipal and Dow futures and<br />
options on futures contracts. The CME clearing house is<br />
now the world’s largest derivatives clearing organisation.<br />
“The funds we hold in custody dwarf anything held by any<br />
of our nearest competitors by a wide margin,” claims<br />
Donohue.“We hold about $40bn in collateral, and we move<br />
about $1.5bn to $6bn of collateral each day. I am confident<br />
that the $2bn savings that we provide dwarfs what can be<br />
offered by our competitors.”<br />
It was an imperative for the CME to achieve vertical<br />
integration, for four elemental reasons: It creates value,<br />
maintains Donohue, “and the ability to manage every<br />
aspect of how we deliver value to our customers. The CME<br />
can now manage all elements without being dependent on<br />
third party partners or service providers,” he explains.<br />
Equally, he expands, “I do not want to see us outsource<br />
critical functions because we would deprive ourselves of<br />
the opportunity to create and leverage our intellectual<br />
capital and lose our innovator’s advantage.” Three,<br />
Donohue is content that the Clearing House means that<br />
“we now have every major financial futures and options<br />
product cleared in a single clearing facility.” Last but not<br />
least, it was an effective nuclear deterrent. Two exchanges<br />
that would rather cheerfully run over each other suddenly<br />
began talking and acting like long lost friends. Had they<br />
been to Damascus? Or had they realised either by luck or<br />
by judgement that the initiative was a highly effective<br />
counterpunch to Eurex’s planned product launch at the<br />
beginning of 2004? Donohue answers indirectly,“both the<br />
CBOT and the CME have increased market share at the<br />
expense of the European exchanges. There has been a sea<br />
change. We are now seen as setting the pace of growth.”<br />
Perhaps the clearest indication of the direction of the<br />
CME’s near term strategy came in mid-April of this year<br />
when it announced that it was enhancing its strategic<br />
planning and corporate development capabilities and<br />
appointing Ann Shuman and Kendal Vroman as co-heads<br />
of corporate development. The appointment of two heads,<br />
rather than one to replace the work of outgoing managing<br />
director Scott Robinson indicated that the CME was<br />
bringing strategy into greater focus.<br />
Both Shuman and Vroman played key roles in the<br />
clearing agreement with the CBOT and the distribution<br />
partnership to provide CME FX on Reuters, Donohue<br />
explained at the time. The announcement was given<br />
additional piquancy when the same release mentioned the<br />
appointment of Johannes Zhou, as director of Asian<br />
business development. Zhou previously served in high<br />
executive positions in the Hong Kong Futures Exchange.<br />
Undoubtedly his experience of the operation of Chinese<br />
markets and his contact book will come in very handy for<br />
the CME.<br />
Just how handy became clear last year as the CME began<br />
to establish a bridgehead in the all-important China<br />
market. A Memorandum of Understanding (MOU) was<br />
signed in June last year with China Foreign Exchange<br />
Trading System and National Interbank Funding Centre<br />
(CFETS), a subsidiary of the People’s Bank of China, the<br />
central bank. It was a canny move. Regulated by China’s<br />
State Administration of Foreign Exchange, CFETS already<br />
provides an electronic bidding system for matching spot<br />
trading of the Renminbi (RMB) against the world’s main<br />
currencies and also operates markets for RMB interbank<br />
lending and RMB bond trading.<br />
Under the MOU, CFETS provides CME with local<br />
market intelligence and in turn the CME helps CFETS<br />
become “more familiar with the international FX<br />
derivatives markets practices”, products and regulations,<br />
according to the CME’s press blurb. “Expanding global<br />
distribution of our products and adding new customers in<br />
Asia is part of CME’s long-term growth strategy,”explains<br />
Donohue. Another similar MOU, this time with the<br />
Shanghai Stock Exchange (SSE) followed in March this<br />
year. “China’s exchanges can gain enormous growth and<br />
acceleration benefits by collaborating with global<br />
exchanges like CME to utilise its extensive infrastructure,<br />
trading and clearing platforms, and industry standardised<br />
business practices,”says Donohue, acknowledging that the<br />
CME’s long-term growth strategy is to expand global<br />
distribution of its products and to add new customers<br />
throughout Asia. He adds “We had introduced an Asian<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
Incentive Plan to make our products more attractive to new<br />
customers from the Pacific Rim. We also launched a<br />
telecommunications hub in Singapore designed to make<br />
our markets more cost-effective and accessible.”<br />
To unseasoned observers, these appear small steps to<br />
cross huge chasms. But the significance of the relationships<br />
has not been lost in the region itself, which has been awash<br />
with a growing network of strategic alliances including not<br />
only exchanges but also regulators and governments. It<br />
indicates that the CME is playing for big stakes in a<br />
politically very savvy regional league. Just a few examples of<br />
extant market-to-market arrangements are the MOU<br />
between the Online Commodity Exchange of India and<br />
Malaysia Derivatives Exchange, the strategic partnering<br />
arrangements between Singapore Exchange and Bursa<br />
Malaysia, and the understanding between Sydney Futures<br />
Exchange and Hong Kong Exchanges and Clearing Ltd.<br />
Each relationship sees itself as a major power hub with<br />
much broader regional pretensions.<br />
One of the forces driving this interest in regional<br />
agreements has been structural change in the exchanges.<br />
More and more institutions in the region have taken the<br />
demutualisation route and, at the same time, derivatives<br />
and securities businesses have been rationalised. Everyone<br />
in the Asia Pacific region, it seems, is learning to play the<br />
CME’s game. In Singapore, Hong Kong and Korea, for<br />
example, the separate exchanges have been combined into<br />
a single market operator. A similar example is the<br />
Australian Stock Exchange, which recently announced<br />
plans to move its futures, options and stocks products onto<br />
a single technology platform by 2006. This trend has<br />
encouraged these consolidated, for-profit entities to focus<br />
on the opportunity to grow their share of regional and<br />
indeed world trading.<br />
For the time being, in Asia, the CME is playing the role<br />
of learned benefactor. In a speech earlier in the year to the<br />
SSE, for example, Donohue had stated that the CME’s<br />
purpose “is not to threaten or overtake the internal<br />
development of China’s emerging futures markets.”Just so.<br />
It is an unusually benign statement from a highly<br />
competitive operator and most people agree that<br />
competition made the CME. The exchange’s ability to<br />
successfully respond to the challenge from its European<br />
competitors; its willingness to ruthlessly cut costs so that<br />
it could equally ruthlessly cut prices; and its single<br />
minded focus on global expansion, has forged the<br />
successful entity that it is today. A number of questions<br />
however, still hang over the exchange. Will it merge with<br />
the CBOT? Will it acquire in Europe or Asia, and if it does<br />
acquire, will it buy another derivative exchange?<br />
Donohue is not drawn on specifics and instead<br />
emphasises that the CME’s merger and acquisition<br />
strategy is not limited to exchanges, securities or<br />
otherwise.“We have a well thought out strategy and if we<br />
were to do something it would be to create shareholder<br />
value, not because of someone’s idea of what we should<br />
be.”That’s telling us.<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Looking South on Madison, Chicago<br />
73
DERIVATIVES REPORT: CDOS<br />
74<br />
Bill May, a managing director<br />
in Moody’s derivatives group<br />
CDOs GIVE<br />
HEDGE<br />
FUNDS A<br />
HEADACHE<br />
In 10 short years collateralised debt obligations<br />
(CDOs) have transformed the credit markets,<br />
allowing lenders and investors to manage their<br />
credit exposure as never before. But these<br />
complex securities, which reallocate cash flows<br />
from debt instruments in tranches exposed to<br />
different degrees of default risk, contain traps<br />
for the unwary – including sophisticated<br />
investors such as hedge funds. Neil A. O’Hara<br />
reports from Boston.<br />
HEDGE FUNDS TRADING the synthetic CDO<br />
market suffered a rude awakening in May when<br />
Standard & Poor’s dropped its rating on the debt<br />
of General Motors and Ford below investment grade. The<br />
so-called “correlation trade”– long the equity tranche of a<br />
CDO and short the mezzanine tranche – was supposed to<br />
be a sure bet. If defaults stayed low the return on the equity<br />
tranche would outstrip losses on the mezzanine, while if<br />
defaults ticked up gains on the short mezzanine position<br />
would more than offset equity losses.“The premise for the<br />
trade – that the two tranches will always be correlated in<br />
your favour – is particularly puzzling,” says Jeffrey<br />
Gundlach, president of TCW Asset Management Company<br />
and head of the firm’s fixed income operations,“It is flawed<br />
logic. There are outcomes where the equity goes to zero<br />
and the mezzanine does not.”<br />
CDOs are pools of debt instruments, often rated below<br />
investment grade, divided into senior, mezzanine and<br />
equity tranches entitled to cash flows from the pool that<br />
bear increasing exposure to the risk of default. The senior<br />
tranche can qualify for an Aaa rating because defaults must<br />
wipe out both the mezzanine and the equity before<br />
investors suffer any loss. The mezzanine layer, which has<br />
only the equity shield against losses, often carries a Baa<br />
rating while the unrated equity bears first dollar loss risk.<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
CDOs trace their origins to the late 1980s but the market<br />
really took off in 1996; (see, for example, data for CDOs<br />
rated by Moody’s in Figure 1: CDOs: Dramatic Growth to<br />
Record Levels in 2004).The early transactions were cash flow<br />
CDOs that allowed financial institutions to lay off credit<br />
risk through repackaged high-yield bonds but the structure<br />
soon spread to other asset classes. In today’s market, the<br />
assets most commonly securitised are high yield corporate<br />
loans and asset backed securities, but collateral extends<br />
from investment grade bonds to bank and insurance<br />
company preferred stocks and real estate.<br />
Cash flow CDO transactions dominated the market in<br />
the United States until the past couple of years, according<br />
to Drew Dickey, managing director and head of the<br />
structured credit team at Babson Capital Management,<br />
LLC. The absence of actively traded cash collateral bred a<br />
synthetic market in Europe, where credit risk was<br />
concentrated in banks rather than bonds. A synthetic CDO<br />
holds high quality near cash collateral and adds credit<br />
exposure through a portfolio of credit default swaps, which<br />
are effectively put options on default risk.<br />
CDOs challenge the efficient market hypothesis: why will<br />
investors pay more when the overall risk in a CDO equals<br />
the sum of the risks in its collateral portfolio? The structure<br />
adds value by facilitating the transfer of credit risk. Bill May,<br />
a managing director in Moody’s derivatives group, cites<br />
CDOs based on middle market bank loans as an example.<br />
The individual loans are relatively small and unrated; an<br />
institutional investor cannot afford to monitor enough<br />
companies to build a diversified portfolio. The lenders, who<br />
do track the companies, repackage the loans into CDOs,<br />
although they retain some exposure to each loan so<br />
investors know the sponsor has some skin in the game if a<br />
loan goes bad. In effect, CDO investors outsource the credit<br />
research and monitoring.“It gives investors an opportunity<br />
to invest in an asset class that they could never do on their<br />
own,”says May,“And it gives these small companies access<br />
to capital they could otherwise never get.”<br />
Artificial restrictions that require many investors to hold<br />
only rated instruments contribute to the repackaging<br />
arbitrage. “These portfolios are fairly diverse,” says Sivan<br />
Mahadevan, executive director and head of structured<br />
credit research at Morgan Stanley,“You can get investment<br />
grade ratings for a lot of the tranches that have even a little<br />
bit of subordination.” Rated CDO tranches command a<br />
premium because they appeal to a broader market.<br />
Senior CDO tranches find a home among pension funds,<br />
insurance companies, banks, and conduits set up by banks<br />
that use the high-quality assets as collateral to support<br />
commercial paper issued to money market mutual funds<br />
and other cash market investors. The mezzanine notes go<br />
to insurance companies, banks, mutual funds and hedge<br />
funds. <strong>Equity</strong> tranches appeal to banks and insurance<br />
companies looking for assets that offer leveraged returns<br />
relative to their regulatory capital requirement. Other<br />
investors willing to accept the risk (including hedge funds)<br />
buy equity for the high potential return.<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Drew Dickey, managing director and head of the structured credit<br />
team at Babson Capital Management<br />
CDOs challenge the efficient market<br />
hypothesis: why will investors pay more<br />
when the overall risk in a CDO equals<br />
the sum of the risks in its collateral<br />
portfolio?<br />
The allocation of losses in a CDO pool turns the equity<br />
and mezzanine tranches into leveraged plays on default<br />
risk – with price volatility to match. Hedge funds<br />
compounded that volatility by trading on margin. When<br />
the expected correlation between the equity and<br />
mezzanine tranches broke down, margin calls loomed as<br />
funds faced mark-to-market losses on both sides. “If you<br />
buy something on mark-to-market leverage you tend to<br />
give up the freedom to have your own view of the world,”<br />
Babson Capital Management’s Dickey says, “You can<br />
think that pricing is completely absurd. It might be absurd.<br />
But that doesn’t really matter when you have to put up<br />
more collateral.”<br />
In theory, correlation refers to the probability that if one<br />
credit in a CDO pool defaults other credits will also default.<br />
In practice, correlation is not a measurable input to the<br />
pricing model, according to Dickey. Companies don’t<br />
default often enough to generate reliable data on credit<br />
75
DERIVATIVES REPORT: CDOS<br />
76<br />
correlation, and even if<br />
synthetic CDO typically<br />
they did the theoretical<br />
includes more than 100<br />
price would not match the<br />
reference entities so one or<br />
market price. “Correlation<br />
two downgrades have little<br />
is an observed plug<br />
impact on the CDO’s<br />
number that expresses<br />
overall credit risk.“GM and<br />
what's implicit in the<br />
Ford have not defaulted.<br />
model,”he says.<br />
There are no credit events<br />
Powell Thurston, vice<br />
associated with them,” he<br />
president and CDO<br />
says, “Investors have not<br />
product manager at<br />
lost a dime as long as they<br />
PIMCO, likens the role of<br />
don’t sell.” His attitude<br />
correlation in CDO pricing<br />
reflects Moody’s focus on<br />
to implied volatility in<br />
default probability and<br />
options pricing. Just as<br />
recovery after default, a<br />
options traders use<br />
service aimed at investors<br />
implied volatility to<br />
who buy and hold to<br />
account for the<br />
maturity rather than<br />
unexplained difference<br />
traders worried about daily<br />
between the theoretical<br />
mark-to-market value.<br />
price of an option and its<br />
For senior tranches, the<br />
market price, CDO traders<br />
default risk depends<br />
rely on correlation to express the residual value. mostly on the performance of the asset class represented<br />
“Correlation does not drive the market,”he says,“It is the in the underlying collateral; likewise the mezzanine and<br />
other way around: the market drives correlation.”<br />
equity tranches in a static CDO, for which the collateral<br />
The correlation trade encapsulates the view that credit pool is fixed at the outset. Dynamic CDOs have actively<br />
spreads will widen – causing the mezzanine price to drop – managed collateral, which introduces an additional risk,<br />
but not cause any defaults that would diminish the equity according to TCW Asset Management Company’s<br />
value, Thurston explains. “The hedge funds thought they Gundlach – manager performance. While some CDO<br />
could handle the mark-to-market risk,”he says,“In reality sponsors do their own collateral management, others farm<br />
they could not. They simply unwound their positions.” it out to third party managers such as Babson, PIMCO and<br />
A stampede to the exit drove prices to extremes. TCW.“The equity tranche holders are really exposed to the<br />
Desperate hedge funds not only dumped equity tranches manager,” he says, “If there is negative alpha they are<br />
but also chased up the price of credit default swaps that going to have a very bad outcome even if the premise of<br />
would hedge the affected credits. Meanwhile, the the asset class works.”<br />
“correlated” mezzanine price rose on short covering.“The Gundlach claims the rapid growth in CDOs is<br />
movements were largely driven by supply and demand and attracting collateral managers who lack experience. He is<br />
not by fundamentals,”says Thurston.<br />
not just talking his own book.TCW manages some CDOs<br />
The turmoil in synthetic CDOs highlighted the that include tranches from other CDOs in their collateral<br />
difference between cash flow CDOs and synthetics. The pool, so poor third party manager performance could<br />
secondary market in cash flow CDOs is much less active adversely affect TCW's own collateral.“We try to create a<br />
and prices didn't budge.“It is not a derivative market. It is diversified pool where we hope we can select managers<br />
a cash market where typically all parts of the deal are sold with high standards,” he says, “It is not that easy. The<br />
so there is no residual risk left,”explains Morgan Stanley’s CDO market has a lot of inexperienced, under-funded,<br />
Mahadevan,“It is fully distributed.”<br />
understaffed participants.”<br />
Notwithstanding the dramatic impact on some hedge Cross-ownership among CDOs reached a new level in<br />
funds, Standard & Poor's' move had minimal effect on so-called CDO-squared (CDO<br />
CDO ratings despite the widespread use of GM and Ford<br />
as reference credits in synthetic CDOs. While the agency<br />
had rated 561 synthetic CDOs in Europe covering 745<br />
tranches that referenced at least one of the affected credits,<br />
it downgraded just 10 tranches (1.3%) as a result, in each<br />
case by a single rating notch. It placed another 27 tranches<br />
(3.6%) on CreditWatch with negative implications, though<br />
it suggested they were likely to recover within three<br />
months in the absence of other negative credit experience.<br />
That came as no surprise to May. He points out that a<br />
2 Powell Thurston, vice president and CDO product manager at PIMCO<br />
) structures, in which<br />
existing CDO tranches represent the entire collateral for a<br />
new CDO. The underlying collateral pool is more<br />
diversified; if each synthetic CDO contains 100+ credits a<br />
synthetic CDO2 pool references indirectly thousands of<br />
credits.To compensate for compounded structural leverage,<br />
the rating agencies demand a larger cushion beneath the<br />
Aaa rated senior tranche and more equity under the rated<br />
mezzanine tranches. “We look at what tranches they are<br />
buying and how correlated those tranches are to others,”<br />
says Gary Witt, another Moody’s managing director, “Do<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
they have a lot of overlap?<br />
Do they have the same<br />
credits in them or not?”<br />
100<br />
Senior Aaa and Aa<br />
90<br />
CDO2 tranches appeal to<br />
80<br />
insurance companies,<br />
conduits and banks in<br />
Europe and Asia,<br />
according to Dickey.“They<br />
are rating sensitive<br />
investors looking for<br />
things they believe have<br />
low credit risk but offer<br />
more spread,”he says. The<br />
extra structural leverage in<br />
70<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
CDO2 equity and<br />
mezzanine reduces the number of potential outcomes for<br />
those tranches: they become closer to all or nothing bets.<br />
Gundlach believes cross-ownership among CDOs<br />
creates a contagion risk.“The CDO market could fall victim<br />
to mad cow disease,”he says,“A lot of CDOs own equity or<br />
mezzanine in other CDOs. They are feeding on each other,<br />
so if a few go bad you’ll find it poisons a bunch of others.”<br />
Even though CDOs that permit cross-ownership often<br />
limit other CDO tranches to 10% of their collateral<br />
portfolio the problem could spread quickly if defaults<br />
increase across the board.<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Figure 1: Dramatic Growth to Record Levels in 2004<br />
$ Billions<br />
Others disagree. Witt<br />
sees more risk in the<br />
250<br />
collateral behind each<br />
200<br />
segment of the market.<br />
He focuses on CDOs that<br />
150<br />
hold asset backed<br />
securities, some of which<br />
100<br />
have<br />
concentrated<br />
become<br />
in<br />
50<br />
residential mortgage<br />
backed securities. “If<br />
0<br />
house prices go down<br />
those deals are not going<br />
to do very well,” he says,<br />
“But not because they<br />
bought other CDOs. It is<br />
going to be because their underlying risk is home loans.”<br />
Mahadevan at Morgan Stanley suggests investors have<br />
learned from the last downturn in the credit cycle from<br />
2000 to 2002, when they discovered more overlapping<br />
credit exposure among CDOs than expected; it turned out<br />
to be a key risk factor. Morgan Stanley believes default risk<br />
today is low among investment grade credits because<br />
corporations have healthy balance sheets and relatively low<br />
leverage. Spreads have widened across the credit markets<br />
in recent months, but until that translates into defaults<br />
Gundlach’s mad cow hypothesis will remain untested.<br />
1988 1989 1990 1991 1992 1993 1994 19951996 1997 1998 1999200012001 2002 2003 2004<br />
Rated volume (Left Axis) Number of Transactions (Right Axis)<br />
Source: Moody’s Investor Services, June 2005<br />
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77
BANK PROFILE: COMMERCE BANCORP<br />
78<br />
Vernon W. Hill II,<br />
the chairman and<br />
president of the company<br />
Executives with Citibank and Chase Manhattan<br />
Bank – heavyweights in the financial business<br />
worldwide – could be forgiven if they paid<br />
scant attention to a modest-sized New Jersey<br />
bank when it said, five years back, that it<br />
would open branches in their backyard, in<br />
New York City. They are probably paying<br />
attention now. Commerce is setting a new<br />
standard in customer care – can the big<br />
banks keep pace? Do they want to?<br />
Bill Stoneman reports.<br />
Bending the<br />
Benchmark of<br />
customer care<br />
COMMERCE BANCORP INC., which had just $7bn<br />
in assets when it announced its foray into New York<br />
in August 2000, now tops $32bn, placing it among<br />
the 40 largest banks in the United States (US). Although it<br />
is still a relative minnow when compared with the size of<br />
Citi’s parent, Citigroup (with $1.5trn in assets), or Chase’s<br />
parent, JP Morgan Chase & Co. (with $1.2trn), Commerce’s<br />
easy entry into New York, where it quickly picked up $16bn<br />
in deposits, is contributing big time to an extraordinary<br />
record of growth.<br />
Not only has the bank quadrupled in size over the last<br />
five years, net income has risen at an annual rate of 34%<br />
between 1999 and 2004, while earnings per share rose on<br />
average 24% over the same period. And so when Vernon W.<br />
Hill II, the chairman and president of the company, says (as<br />
he does regularly) that he intends to surpass $100bn in<br />
assets by 2009, he is hard to ignore. But perhaps the biggest<br />
reason to pay attention to Hill is that Commerce has<br />
achieved all of its growth in the slow-growing Northeast of<br />
the US and all that without an acquisition in years or ever<br />
a large one. In other words, Commerce gets pretty much all<br />
of its business by taking it from someone else. While other<br />
financial institutions talk about winning market share,<br />
constant mergers and acquisition make it difficult to tell<br />
which, if any, really do.<br />
Commerce, it appears, takes market share by following<br />
Hill’s retailing instincts and by rejecting big chunks of<br />
banking industry conventional wisdom. Not only does Hill<br />
shun mergers and acquisitions, Commerce does not even<br />
talk all that much about its lending business. Attractive<br />
rates on deposit accounts are not part of its value<br />
proposition. It does not endlessly try to “cross sell”<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
customers additional accounts. On top of that, its expenses<br />
are well above industry standards.<br />
Instead what Commerce does is focus on attracting<br />
consumer depositors with an array of conveniences,<br />
gimmicks and services that other banks do not offer [or, at<br />
least do not make a big<br />
deal about]. Most visibly,<br />
Commerce keeps longer<br />
hours, including opening<br />
on Sunday, than virtually<br />
all of its competitors. It<br />
lures people into its<br />
branches with free coin<br />
counting machines.<br />
Branches are stocked with<br />
dog biscuits for customers<br />
who bring their pets in.<br />
And the bank will take care<br />
of all the rote work<br />
associated with moving<br />
online banking and bill<br />
payment from a<br />
competitor’s account. The<br />
many touches – or<br />
“extreme culture” and<br />
“fanatical execution,” in Hill’s words – seem to add up in<br />
the minds of consumers.<br />
“Commerce has differentiated itself from the other<br />
players,” says Charles B. Wendel, a banking industry<br />
consultant in New York. And that is something few other<br />
banks have done, he adds. While banks endlessly proclaim<br />
that they care about their customers or that they are their<br />
customers’ friend, Commerce is unusual in backing its<br />
words up with delivery of a distinctly different level of<br />
service, he explains.<br />
And that is exactly the idea.“The customer cares about<br />
the retail experience, rather than the highest rate,”Hill said<br />
recently, during a visit to a mid-town Manhattan branch<br />
that sits not much more than 100 metres from offices<br />
owned by the four largest US banking companies, Citi,<br />
Chase, Bank of America Corp. and Wachovia Corp. Indeed,<br />
seemingly illustrating the point, the branch, on Avenue of<br />
the Americas at 55th Street, has booked $267m in deposits<br />
since it opened in September 2001 – a large number for a<br />
mature office, let alone one less than four years old. In fact,<br />
beyond the results of one particular branch, Hill appears to<br />
be building a business around the premise that if a bank<br />
willingly, maybe even eagerly, pays for all the pieces of an<br />
attractive retail experience, then customers will not mind<br />
that the bank does not pay especially competitive interest<br />
on deposit accounts. With low-cost deposits flooding into<br />
new branches and flowing at a more measured pace into<br />
mature branches, Commerce is able to maintain relatively<br />
good interest-rate margins. Then, as long as overall deposit<br />
levels grow rapidly, earnings grow at a fast clip as well.<br />
US consumers, Hill asserts, are nearly universal in their<br />
dislike for their banks, making it rather easy to peel them<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
The quest for growth – turning an “amazing customer<br />
experience” into an “amazing investor experience” –<br />
Commerce Bancorp vs. US Banks<br />
50<br />
0<br />
away. Even commercial business is drawn in by Commercestyle<br />
retailing, Hill says, explaining that owners of small and<br />
mid-sized businesses are not going to stay with banks<br />
where their spouses or children have bad experiences.<br />
Hill, 59, launched the bank in 1973 when he was only 27<br />
Apr-00<br />
Oct-00<br />
Apr-01<br />
Oct-01<br />
Apr-02<br />
Oct-02<br />
Apr-03<br />
Oct-03<br />
Apr-04<br />
Oct-04<br />
Apr-05<br />
Commerce Bancorp NJ Citigroup JPMorgan Chase & Co<br />
Bank of America <strong>FTSE</strong> US Banks <strong>Index</strong><br />
Data as at June 05. Source: <strong>FTSE</strong> Group/FactSet Limited.<br />
years old, after running a<br />
site development business<br />
for a few years for retail<br />
chains such as<br />
McDonald’s Corp. In<br />
addition to his 4.46%<br />
stake in Commerce, he is a<br />
partner in a group that owns<br />
47 Burger King restaurants<br />
in the Philadelphia area.<br />
He says that he thought<br />
from the beginning that a<br />
government charter,<br />
effectively a license to<br />
accept deposits, nearly<br />
guaranteed that he would<br />
make money. He did not<br />
always expect that his<br />
bank would grow so large.<br />
But now he is so confident<br />
that he is practically daring competitors to stop him.<br />
With a base in the suburbs of Philadelphia, and now 178<br />
branches in the New York City area, Hill expects to open 10<br />
to 15 branches in and around Washington this year and 200<br />
over the next few years. He has said that either the Boston<br />
area or Florida will be next; analysts expect him to<br />
announce which it will be this summer. One of the big<br />
reasons that he can march into new markets, he says<br />
brashly, is that so many competitors do more to annoy their<br />
customers than please them with their constant mergers<br />
and acquisitions. “My competitors are in the cost-cutting<br />
business,”Hill says.“I’m in the top-line growth business.”<br />
Whether the characterisations are fair or not, Commerce<br />
has performed quite well. It has produced an annual<br />
average return to shareholders of 31% over both five and<br />
10 years through the end of March. That compared to<br />
compound annual average decline of 3% for the Standard<br />
& Poor’s 500 over the past five years and an 11% annual<br />
gain for the S&P 500 over a 10-year period.<br />
The big question for investors, however, is whether<br />
Commerce can keep up the pace – of apparently successful<br />
new branch openings, of entry into new markets and of<br />
continued growth in its longer-standing markets – or<br />
whether competitors learn to do a better job of holding<br />
onto their customers. At $28 in mid-May, the company’s<br />
stock traded on the New York Stock Exchange for about 16<br />
times the trailing 12 months’ earnings, suggesting healthy,<br />
but unspectacular, expectations of investors.<br />
A common view among analysts who follow Commerce<br />
is that the company has at least several good years of<br />
industry-leading growth ahead. “They are very good at<br />
taking market share,” said Claire M. Percarpio, an analyst<br />
79
BANK PROFILE: COMMERCE BANCORP<br />
80<br />
with Janney Montgomery Scott Inc. in Philadelphia, adding<br />
that unlike most banks, Commerce doesn’t depend on its<br />
own share price to fuel acquisitions and therefore growth.<br />
The bank attracts business, analysts said, because it<br />
stands apart from others in its hiring, its training and<br />
follow-through. Legend has it that job candidates are<br />
deemed unsuitable if they do not smile with the first 30<br />
seconds of an interview. At the other end of the process,<br />
“mystery shoppers” visit Commerce branches 100,000<br />
times a year, meaning that someone is sizing up each of<br />
more than 300 branches and writing a report about each<br />
one of them nearly every day.<br />
Not everyone, however, is convinced that the growth and<br />
market share gains are sustainable. For example, Thomas<br />
Monaco, an analyst with Moors & Cabot, a Boston-based<br />
brokerage firm, says that consumer deposit growth comes<br />
mostly from opening costly new branches. Once they are<br />
open a year or two, he said, consumer deposit growth trails<br />
off. That has been masked, he said, by a growing<br />
government deposit business. And the government<br />
business may have trouble ahead, he adds.<br />
Two Commerce executives were convicted in May of<br />
conspiracy charges in a municipal corruption case in<br />
Philadelphia. The executives were charged with helping a<br />
city official get personal loans on favorable terms in<br />
exchange for his steering city business to the bank.<br />
Whether Commerce backs off from pursuit of government<br />
business or local governments shy away from Commerce,<br />
the impact could be big, Monaco expands. Other analysts<br />
say they fear that additional improprieties in soliciting<br />
government business could surface, tarring the company<br />
directly next time around.<br />
In addition, analysts have expressed concern that a<br />
relatively unusual balance sheet could cause trouble if<br />
interest rates rise sharply. With loans on Commerce’s books<br />
totaling just 35% of deposits, the bank has a large portfolio<br />
of fixed-rate securities. The value of these securities could<br />
plummet if rates rise.That would deplete the equity that the<br />
bank needs to continue opening branches, Monaco adds.<br />
The biggest reasons for concern might be the possibility<br />
that the industry giants are getting their retail act together.<br />
NEW DEPOSIT ACCOUNTS – January 2005<br />
Wachovia<br />
12%<br />
Sovereign<br />
3%<br />
Sun Bank<br />
1%<br />
Commerce<br />
32%<br />
Metro Philadelphia<br />
Wilmington<br />
Trust<br />
2%<br />
Repeat<br />
Sales<br />
Credit U<br />
3%<br />
41,705 Accounts<br />
Fleet/BOA<br />
6%<br />
Citizens<br />
4%<br />
PNC<br />
9%<br />
Other<br />
28%<br />
Bank of NY<br />
2%<br />
North Fork WAMU<br />
2%<br />
3%<br />
HSBC<br />
3%<br />
Chase<br />
10%<br />
Citi<br />
7%<br />
Wachovia<br />
4%<br />
Metro New York<br />
Commerce<br />
31%<br />
87,450 Total Accounts<br />
Repeat<br />
Sales<br />
Fleet/BOA<br />
8% AFSB<br />
2% PNC<br />
2%<br />
45,745 Accounts<br />
Other<br />
26%<br />
DEPOSITS<br />
Billions<br />
$ 33<br />
30<br />
27<br />
24<br />
21<br />
18<br />
15<br />
12<br />
9<br />
6<br />
3<br />
0<br />
$5.6<br />
120<br />
39%<br />
A<br />
verage<br />
Deposit<br />
Growth<br />
$7.4<br />
150<br />
$10.2<br />
184<br />
2.38%* 2.84%* 2.25%*<br />
1999 2000 2001 2002 2003 2004<br />
# of Branches * Deposit Cost of Funds<br />
Analysts and consultants also say that banks that grew<br />
large through acquisitions have vastly improved their<br />
customer service in the last few years, partly in response to<br />
Commerce and other smaller banks taking business from<br />
them. Big New York banks just did not believe that<br />
Commerce’s approach to retailing would resonate with<br />
consumers, says Wendel, the industry consultant.<br />
Now, Washington-area banks appear to be gearing up<br />
for Commerce’s arrival. For example, PNC Financial<br />
Services Group Inc. of Pittsburgh, which just moved into<br />
Washington with an acquisition, said in April that it would<br />
extend its weekday hours and add Sunday hours in the<br />
nation’s capital. To be sure, just about everything that<br />
Commerce does to attract customers can be copied. In<br />
addition to keeping longer hours, a few other banks have<br />
installed coin-counting machines in their branches.<br />
Working in Commerce’s favour, however, is the strong<br />
possibility that creating a retail experience and a brand<br />
identity that complements that experience by imitating an<br />
original thinker is not so easy and that competitors are not<br />
really committed to it anyway.“Most of the banks that have<br />
tried to do this have implemented one, two, three or four of<br />
the kinds of things that Commerce does,” says Mark T.<br />
Fitzgibbon, co-director of equity research for Sandler<br />
O’Neill & Partners LP, a New York-based investment bank<br />
BRANCH PROFITABILITY ANALYSIS – Results in millions<br />
Fully allocated support costs approximate 1.50% of total deposits<br />
$14.5<br />
Average<br />
Average First Two<br />
Suburban Manhattan<br />
Branch Branches<br />
(annualized)<br />
Total Deposits $100.0 $250.0<br />
Total Income 5.2 12.4<br />
Total Branch Operating Expenses (1.3) (3.7)<br />
Net Pre-Tax Income $3.9 $8.7<br />
224<br />
1.34%*<br />
$20.7<br />
270<br />
42%<br />
.82%*<br />
$27.7<br />
319<br />
34%<br />
.84%*<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
that specialises in financial companies.“But they have not<br />
implemented the other 65.”<br />
So, even when competitors borrow an idea, they do not<br />
necessarily pull it off with the same élan. It is one thing,<br />
for example, to install machines in branches that quickly<br />
count huge quantities of unsorted coins. Commerce’s<br />
machines look like arcade games, with sounds and<br />
flashing lights. And just to make it amusing, Commerce<br />
invites visitors to try to guess how much all their coins<br />
are worth. If they are close, the bank gives them token<br />
prizes, such as a plastic piggy-bank “C” in Commerce’s<br />
trademark red.<br />
But that is not all. Wendel discovered when he took his<br />
young son and a huge jar full of coins to a Commerce<br />
branch, intending to have some fun counting the money.<br />
The coin counting machine was broken the day they<br />
visited, but the branch manager was not about to let the<br />
youngster go home disappointed, Wendel said. Without<br />
missing a beat, the manager called another branch, to<br />
make sure its machine was in working order, and then gave<br />
Wendel money to cover a taxi ride to the other office.“That<br />
was an amazing customer experience,”Wendel says.<br />
Competitors might dispute Hill’s assertion that he is the<br />
only one pursuing revenue growth. They would be hard<br />
pressed to argue, however, that Commerce does not spend<br />
generously, on items large and small, in that pursuit. For<br />
example, Commerce only takes the best locations when it<br />
opens new branches, says Jacqueline Reeves, a bank stock<br />
analyst with Ryan, Beck & Co., a New Jersey-based<br />
brokerage firm, even though it invariably pays more for<br />
them than other sites around town. One such site gives Hill<br />
a chance to chuckle occasionally at Chase’s expense. A<br />
photograph in Commerce’s standard analyst presentation<br />
shows a building at the corner of Fifth Avenue and 14th<br />
Street in New York. Commerce signs adorn the windows on<br />
the first floor, immediately below Chase signs. Chase, Hill<br />
explained, gave up its lease on the first floor, presumably to<br />
cut its sky-high Manhattan occupancy costs, and held onto<br />
space it had on the second floor. Commerce moved into the<br />
first-floor space, which is more accessible to customers and<br />
prospective customers walking by. The Commerce branch<br />
ASSET QUALITY<br />
Non- Performing<br />
Assets<br />
Charge-offs<br />
Loan Loss Reserve<br />
12/01 12/02 12/03<br />
.17% .11% .11% .11%<br />
.19% .18% .16% .19%<br />
1.46% 1.56% 1.51% 1.43%<br />
Non-Performing<br />
Loan Coverage 398% 640% 515% 413%<br />
Credit Rating: A-2/P-1<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
12/04<br />
Top 60<br />
Banks<br />
0.60%<br />
0.537%<br />
1.52%<br />
278%<br />
has $59m in deposits, more than thousands of bank<br />
branches around the US that have been open for many<br />
years longer than Commerce has been in New York.<br />
At the more modest end of the spectrum, where other<br />
banks tether a pen to a counter for customers to prepare<br />
routine forms, Commerce fills boxes with dozens and<br />
dozens of writing implements. Hill says the bank gives<br />
away 1m pens a month and would be happy to push that<br />
figure to 2m.“The average bank would say,‘How do we get<br />
our pen costs down,’”he says. Only time will tell how long<br />
Commerce’s high-cost approach to business can generate<br />
outsized earnings growth. Unless the model falters badly,<br />
however, it is unlikely that big banks will take Commerce<br />
for granted again.<br />
The Citis and Chases and Banks of America of this world<br />
regularly boast that their vast branch systems and even<br />
vaster networks of automated teller machines give<br />
unparalleled access to their customers’ accounts. But<br />
Commerce, which calls itself “America’s Most Convenient<br />
Bank”, appears to have neutralised that big-bank<br />
advantage and given clear meaning to what could easily be<br />
an empty slogan with a new costly program recently. The<br />
bank announced in March a wide-scale program to rebate<br />
automated teller machine fees that machine owners and<br />
other financial institutions charge its customers. It said it<br />
would cover the cost of using all machines, worldwide, for<br />
customers who have $2,500 in their checking accounts.<br />
Clever slogans are not necessarily hard to come by. But<br />
it certainly difficult for competitors to argue that cost-free<br />
access to customer accounts around the world is not<br />
pretty convenient.<br />
2004 SUMMARY<br />
Total Assets<br />
Total Deposits<br />
Total (Net) Loans<br />
Total Revenues<br />
Total Expenses<br />
Net Income<br />
Net Income Per Share<br />
$30.5B<br />
27.7B<br />
9.3B<br />
+34%<br />
+34%<br />
+27%<br />
$1,392.9M +28%<br />
938.8M +23%<br />
273.4M +41%<br />
$1.63 +26%<br />
81
INDEX REVIEW: CORPORATE GOVERNANCE<br />
82<br />
THE<br />
Building Blocks<br />
OF<br />
CORPORATE<br />
GOVERNANCE<br />
IN COLLABORATION <strong>FTSE</strong> and Institutional Shareholder<br />
Services (ISS) have created <strong>FTSE</strong> ISS CGI, the first global<br />
corporate governance indices. The series comprises two<br />
separate elements – a set of rankings, supplied by ISS, in<br />
which each company in the universe is scrutinised against five<br />
corporate governance themes, and a set of six equity indices,<br />
based on these rankings, covering developed markets. The<br />
ratings allow investors to understand corporate governance<br />
risk on a specific company, country and sector basis, while the<br />
overall index allows investors to see how corporate<br />
governance practice impacts their overall portfolios.The index<br />
series is the culmination of a full-fledged process that has<br />
harnessed <strong>FTSE</strong>’s expertise in index formulation with ISS’s<br />
specialist knowledge of the salient elements in corporate<br />
governance that have most relevance for today’s market.<br />
The index series is designed to raise awareness of<br />
corporate governance as an investment risk; encourage the<br />
collection and dissemination of accurate, high quality data<br />
on individual company corporate governance practices and<br />
highlight those companies working to high standards of<br />
corporate governance.<br />
Market research conducted by both firms throughout the<br />
whole of last year confirms a growing interest in the<br />
management of corporate governance risk. The majority of<br />
respondents (88%) from the various sections of the<br />
investment community expected interest in corporate<br />
governance to increase over the next two years. And it is<br />
the specific feedback from this consultation that has guided<br />
the construction and methodology of the new index series.<br />
These days corporate governance is an essential<br />
feature of the investment management process.<br />
A key business discipline contributing to the<br />
financial stability and growth of corporations, if<br />
ignored it can lead to the downfall of<br />
corporations both large and small. Carl Beckley,<br />
director, <strong>FTSE</strong> Group, examines the design,<br />
construction and performance of the <strong>FTSE</strong> ISS<br />
Corporate Governance <strong>Index</strong> (CGI) <strong>Series</strong>, and<br />
shows how it can be used by investors as an<br />
effective risk management tool.<br />
Designing the <strong>FTSE</strong> ISS CGI <strong>Series</strong><br />
Six indices (please refer to Table 1: <strong>FTSE</strong> ISS Corporate<br />
Governance <strong>Index</strong>es vs. Their Respective Benchmarks) have<br />
been developed in this initial phase, with the objective of<br />
closely tracking the structure and pattern of the <strong>FTSE</strong><br />
Developed <strong>Index</strong> and the <strong>FTSE</strong> All-Share <strong>Index</strong>. The first<br />
step was to decide the universe of stocks which would form<br />
the <strong>FTSE</strong> ISS Corporate Governance <strong>Index</strong> <strong>Series</strong>. To<br />
ensure global coverage, the CGI family covers large and<br />
mid-cap stocks in developed markets. This universe<br />
currently contains over 2,000 companies. The <strong>FTSE</strong> All-<br />
Share <strong>Index</strong> (which contains large, mid and small cap<br />
stocks) was used as the starting universe in the <strong>FTSE</strong> ISS<br />
UK CGI. The <strong>FTSE</strong> All-Share index is the main benchmark<br />
for UK institutional investors and was a natural choice as<br />
the basis of this particular index.<br />
For each of the six indices ISS collates all of the raw<br />
corporate governance scores for each constituent. <strong>FTSE</strong>, in<br />
turn, use ISS’s raw data to produce a cumulative score for<br />
each constituent. In order to make the scores more accessible<br />
the cumulative scores are normalised so that all scores fall<br />
between 0 and 100. A score of 0 represents the lowest<br />
corporate governance rating, while 100 is the highest score<br />
that can be attained.This is referred to as the CGI Final Score.<br />
In each index universe every constituent is classified into<br />
one of the 18 Industry Classification Benchmark (ICB)<br />
Supersectors and within each Supersector each constituent<br />
is ranked by its CGI Final Score. Constituents representing<br />
only the top 80% by investable market capitalisation in<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
each Supersector are eligible for inclusion in the index. Any<br />
remaining constituents in the lowest 20% by investable<br />
market capitalisation are excluded. This process is repeated<br />
for each of the Supersectors. Finally, Supersectors are<br />
combined to form the Regional or Country <strong>FTSE</strong> ISS<br />
Corporate Governance <strong>Index</strong>.<br />
This review procedure inevitably narrows the number of<br />
constituents in the <strong>FTSE</strong> ISS Developed CGI universe to<br />
1,350 constituents, down from the original 2,089<br />
constituents. In comparison, the <strong>FTSE</strong> ISS UK CG <strong>Index</strong> is<br />
focused on some 315 constituents (compared with the 578<br />
in the <strong>FTSE</strong> All-Share <strong>Index</strong> universe).<br />
During the market consultation exercise <strong>FTSE</strong> assessed<br />
various different methods of producing an appropriate<br />
index series that accurately reflected the corporate<br />
governance performance of the world’s listed companies.<br />
Three choices of methodology were available to the index<br />
design team. They could adopt an exclusion policy or they<br />
could retain all the traditional index constituents, but<br />
overweight companies with good corporate governance<br />
performance and underweight the poorer performers.<br />
Alternately, they could produce best and worst in class<br />
indices with a limited number of stocks.<br />
Before a decision was taken, each of the options was<br />
thoroughly investigated. Difficulties became obvious very<br />
quickly. The overweight versus underweight methodology, for<br />
instance, did not give major differences to the exclusion policy.<br />
The reason was simple. Removing a proportion of stocks is<br />
just another way of radically underweighting them, which<br />
then will automatically overweight the remainder. Any<br />
resulting performance would therefore be more reliant upon<br />
the particular mix of stocks that are included (or excluded)<br />
from the index. This mix relates to both relative market<br />
capitalisation sizes and then individual stock performance.<br />
The other issue on exclusion is that of turnover. The more<br />
constituents that are excluded from the index the higher the<br />
turnover can potentially be. This has an influence on<br />
deciding what level of market capitalisation could be<br />
excluded from the index. Removing a large amount of<br />
market capitalisation may have more influence on<br />
performance but would theoretically lead to higher turnover.<br />
Removing less than 20% would not have had a sufficiently<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
useful effect, but removing more would begin to have<br />
implications for turnover. Having looked at this issue it was<br />
clear that an 80/20 split gave the right balance between<br />
inclusion and exclusion.<br />
Indeed it is this last point that ensured that at least in<br />
these early stages our third option of producing the “best”<br />
and worst”indexes could potentially lead to high turnover.<br />
In the end, the team opted for an exclusion<br />
methodology. The majority of participants in the market<br />
consultations process had suggested that for the first<br />
phase of the Corporate Governance Indices, investors<br />
were most interested in an index where constituents<br />
that tended towards poor corporate governance practices<br />
were excluded.<br />
Exclusion Performance<br />
The <strong>FTSE</strong> ISS CGI <strong>Series</strong> aims to track its underlying<br />
benchmark indices very closely. This is helped by its sector<br />
neutral approach and by removing only 20% of the<br />
underlying market capitalisation at review.<br />
As a result of using this methodology, we would expect<br />
similar historical correlations and performance as the<br />
underlying benchmarks. The main issue with looking at<br />
historical performance is determining constituent changes<br />
in corporate governance practices.<br />
<strong>FTSE</strong> used FactSet software to run a series of backcast<br />
index values to highlight any performance differences. The<br />
backcasts are based on a current set of constituents for each<br />
index and are calculated backwards for a period of five<br />
years. As this methodology does not take into account<br />
constituent changes throughout time the same<br />
methodology was applied to the relative underlying<br />
benchmarks to remove any calculation biases.<br />
The analysis is mixed as to whether corporate<br />
governance has an overriding effect on company<br />
performance. Equally, the evidence of a clear link between<br />
corporate governance standards and share price<br />
performance is mixed. The <strong>FTSE</strong> ISS UK CGI outperforms<br />
its equivalent <strong>FTSE</strong> index over one and three years, and the<br />
<strong>FTSE</strong> ISS Developed CGI, <strong>FTSE</strong> ISS Japan CGI, and <strong>FTSE</strong><br />
ISS US CGI outperforms over a five-year period. The <strong>FTSE</strong><br />
ISS Europe and Euro CGIs underperform their respective<br />
Table 1: <strong>FTSE</strong> ISS Corporate Governance Indices versus their respective benchmarks<br />
CG <strong>Index</strong> Stocks Net Market Net Market Benchmark <strong>Index</strong> Stocks Net Market Net Market<br />
Cap Cap (Local Cap Cap (Local<br />
(USD Bn) Curr. Bn) (USD Bn) Curr. Bn)<br />
<strong>FTSE</strong> ISS US CG <strong>Index</strong> 412 9,048 9,048 <strong>FTSE</strong> US <strong>Index</strong>* 743 12,216 12,216<br />
<strong>FTSE</strong> ISS UK CG <strong>Index</strong> 315 2,176 1,140 <strong>FTSE</strong> All-Share <strong>Index</strong>* 578 2,713 1,421<br />
<strong>FTSE</strong> ISS Japan CG <strong>Index</strong> 353 1,647 172,988 <strong>FTSE</strong> Japan <strong>Index</strong>* 479 2,077 218,217<br />
<strong>FTSE</strong> ISS Developed CG <strong>Index</strong> 1,350 17,600 17,600 <strong>FTSE</strong> Developed <strong>Index</strong>* 2,089 22,828 22,828<br />
<strong>FTSE</strong> ISS Europe CG <strong>Index</strong> 347 5,590 4,259 <strong>FTSE</strong> Developed Europe <strong>Index</strong>* 502 6,985 5,321<br />
<strong>FTSE</strong> ISS Euro CG <strong>Index</strong> 194 2,892 2,203 <strong>FTSE</strong> Eurozone <strong>Index</strong>* 277 3,516 2,678<br />
*Excludes Investment Companies Data as at 3rd March 2005<br />
83
INDEX REVIEW: CORPORATE GOVERNANCE<br />
84<br />
benchmark indexes although the underlying differences<br />
are marginal with high correlations. Each index is closely<br />
correlated to its underlying benchmark index. Over a fiveyear<br />
period the tracking errors are higher with the<br />
individual country indexes, while the regional indexes of<br />
<strong>FTSE</strong> ISS Developed, <strong>FTSE</strong> ISS Europe, and <strong>FTSE</strong> ISS Euro<br />
CGI show a five-year tracking error of 1.09%, 1.32%, and<br />
1.11% respectively.<br />
Although separate from the index methodology, analysis<br />
based around a sample portfolio containing the top 50 and<br />
bottom 50 constituents from each theme within the <strong>FTSE</strong><br />
US <strong>Index</strong> universe has shown that the bottom 50<br />
underperform the top 50 in four out of five themes over a<br />
five-year period. The analysis based on equally weighting<br />
the portfolios on a daily basis using FactSet Software,<br />
shows this out-performance when using the overall<br />
company CGI rating. Apart from the theme Board Structure<br />
each bottom 50 portfolio also under-performs an equally<br />
weighted <strong>FTSE</strong> US <strong>Index</strong>. The Compensation theme<br />
interestingly has a negative performance over the period of<br />
one year, with the highest volatility of all the themes over<br />
the five-year period.<br />
Given the level of specific information available at<br />
present, there is no definitive link between corporate<br />
governance and stock returns. The performance analysis<br />
on the US is only a starting point, and by no means<br />
conclusive over a five year period. But, over reasonable<br />
time periods it is likely that governance factors will show<br />
themselves in investment returns. There are a number of<br />
reasons put forward for this. One is that sufficient<br />
information to make detailed decisions by all investors has<br />
The <strong>FTSE</strong> ISS Corporate Governance <strong>Index</strong> <strong>Series</strong><br />
Review Universes<br />
Universe <strong>Index</strong><br />
<strong>FTSE</strong> All-Share <strong>Index</strong><br />
<strong>FTSE</strong> North America<br />
<strong>Index</strong><br />
<strong>FTSE</strong> Developed<br />
Europe ex UK <strong>Index</strong><br />
<strong>FTSE</strong> UK <strong>Index</strong><br />
<strong>FTSE</strong> Developed Asia<br />
Pacific ex Japan <strong>Index</strong><br />
<strong>FTSE</strong> Japan <strong>Index</strong><br />
<strong>FTSE</strong> ISS CGI<br />
<strong>FTSE</strong> ISS UK CGI<br />
<strong>FTSE</strong> ISS Developed<br />
CGI<br />
The design process aims to capture 80% of the market<br />
cap within each Supersector<br />
not been available. Analysis of corporate governance is a<br />
skilled affair and the general investment community<br />
encompassing asset owners and managers does not have<br />
the necessary skills or resources to carry out such<br />
investigations across all of their investments.<br />
Further, corporate governance is not a one-off due<br />
diligence exercise. It is a continuous process. Having carried<br />
out the initial work on a company, the corporate governance<br />
risk then takes on the mantle of a watching brief. As a<br />
consequence, there is a requirement for continual<br />
monitoring of corporate governance due diligence.<br />
Another consideration is that there have been some high<br />
profile investment firms that take corporate governance<br />
very seriously and have done so for some years and applied<br />
their views to their investments. In the main however many<br />
investors (and legislators) only really began to tackle these<br />
issues in the wake of scandals such as WorldCom and<br />
Enron. Any corporate governance effect would only have<br />
been noticeable at some stage after these events.<br />
In short, it can be argued even now, that any corporate<br />
governance implementation will at best be applied in a<br />
somewhat unstructured way particularly across a number<br />
of markets. This will help to dissipate any potential “return<br />
effects”. Differing legislation and codes of practice can<br />
affect the returns within a country. If all companies within<br />
a country fall into line then the issues that the rules are<br />
meant to rectify will in effect be removed from that market.<br />
As time goes by it is fair to assume that a more cohesive<br />
implementation by market practitioners around the world<br />
will come into play. When this occurs there may well begin<br />
to be noticeable return effects.<br />
The <strong>FTSE</strong> ISS Corporate Governance <strong>Index</strong> <strong>Series</strong><br />
Construction Methodology<br />
2<br />
3<br />
Oil & Gas<br />
Rank by Corporate<br />
Governance (CGI) Final Score<br />
Highest<br />
Lowest<br />
1<br />
Basic Resources<br />
<strong>FTSE</strong> Japan<br />
Oil & Gas Review Process<br />
<strong>FTSE</strong> ISS Japan<br />
CG <strong>Index</strong><br />
Chemicals<br />
5<br />
Oil & Gas Basic Resources Chemicals<br />
6<br />
4<br />
Cumulative<br />
Investable Mcap<br />
Construction<br />
& Materials<br />
80%<br />
20%<br />
Construction<br />
& Materials<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
<strong>FTSE</strong> <strong>Global</strong> Markets Company Directory<br />
Company Name Page Company Name Page Company Name Page Company Name Page<br />
ABN Amro<br />
ABN AMRO Mellon <strong>Global</strong><br />
32<br />
Securities Services 36<br />
Agence France Trésor 61<br />
Agence France Trésor 57<br />
AIG <strong>Global</strong> Investment Corp. 8<br />
AIM 24<br />
Allied Domecq 64<br />
American Century Investments 14<br />
American International Group Inc. 8<br />
Archipelago Exchange 14<br />
Athens Organising Committee 25<br />
Athens Stock Exchange 25<br />
Babson Capital Management 75<br />
BancWest Corporation 32<br />
BancWest Corporation 32<br />
Bank of America Corp. 79<br />
Bank of Athens 25<br />
Bank of the West 32<br />
Bankers Trust Company 25<br />
Banque Paribas 30<br />
Baoshan Iron & Steel Co Ltd 22<br />
Barclays Capital 57<br />
Barclays <strong>Global</strong> Investors 6<br />
BNP Paribas 57<br />
BNP Paribas 28<br />
BNP Paribas 32<br />
BNP Paribas Securities Services<br />
Brown Brothers Harriman<br />
41<br />
(BBH) Ltd 36<br />
Burger King 79<br />
Bursa Malaysia 73<br />
Caldwell Asset Management 16<br />
Caldwell Financial Ltd 16<br />
Caldwell Management Ltd 16<br />
Caldwell Securities, Ltd 16<br />
Calyon 32<br />
CCF 57<br />
CDC Ixis 57<br />
CDP Capital 23<br />
Cedel International 45<br />
Cedel International 46<br />
Charles Schwab & Co., Inc 19<br />
Chase Manhattan 53<br />
Chase Manhattan Bank 78<br />
Chicago Board of Trade 70<br />
Chicago Mercantile Exchange 68<br />
China Asset Management Co Ltd 6<br />
China Asset Management Company 20<br />
China Foreign Exchange<br />
Trading System 72<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
China Merchants Bank Co Ltd 22<br />
China Mobile<br />
China Petroleum & Chemical<br />
6<br />
Corp (Sinopec) 22<br />
Huaneng Power International Inc<br />
China Securities Regulatory<br />
22<br />
Commission 22<br />
China Telecom<br />
China’s State Administration of<br />
6<br />
Foreign Exchange 72<br />
Citibank 78<br />
CITIC 22<br />
Citigroup<br />
Citigroup <strong>Global</strong> Transaction<br />
78<br />
Services 42<br />
Clearstream 44<br />
Clearstream International 45<br />
CME Holding 69<br />
Cogent 31<br />
Commerce Bancorp Inc<br />
Commodity Futures<br />
78<br />
Modernization Act 71<br />
Commodity Research Bureau 10<br />
Community First Bankshares, Inc. 32<br />
Community First National Bank 32<br />
Conseil des Marchés Financiers 30<br />
Crédit Agricole<br />
Credit Agricole Indosuez<br />
32<br />
Securities Japan 32<br />
Crédit Suisse Asset Management 38<br />
Credit Suisse First Boston 57<br />
Debt Management Office 60<br />
Debt Management Office 57<br />
Delaware Investment<br />
Depository Trust & Clearing<br />
23<br />
Corporation 18<br />
Deutsche 57<br />
Deutsche Börse 25<br />
Deutsche Börse AG 46<br />
Deutsche Börse Clearing<br />
Dexia Banque Internationale à<br />
45<br />
Luxembourg 34<br />
Economist Corporate Network 8<br />
EFG Balkan Investments 25<br />
Eurex 71<br />
Euronext 25<br />
Euronext.liffe 71<br />
European Union 26<br />
Executives’ Club of Chicago 69<br />
First Chicago 53<br />
First Hawaiian Bank 32<br />
Ford 74<br />
Fortis<br />
Fortis Haitong Investment<br />
8<br />
Management Co. Ltd. 8<br />
<strong>FTSE</strong> Group 24<br />
General Motors 74<br />
<strong>Global</strong> Advisors 10<br />
Goldman Sachs<br />
Greece’s Capital Markets<br />
16<br />
Commission 25<br />
Haas School of Business 16<br />
Hellenic Postal Savings Banks<br />
Hong Kong Exchanges<br />
26<br />
and Clearing Ltd 73<br />
HSBC 57<br />
HSBC 32<br />
HSBC 38<br />
Illinois District Court 71<br />
ING Investment Management 8<br />
INSEAD University 25<br />
Instinet 14<br />
Janney Montgomery Scott Inc 80<br />
Japan’s UFJ Holdings 32<br />
JP Morgan<br />
JP Morgan Worldwide<br />
57<br />
Securities Services 36<br />
KPMG/CREATE 40<br />
Lehman Brothers 8<br />
London Stock Exchange 24<br />
Madison Capital Management 53<br />
Malaysia Derivatives Exchange 73<br />
Man Investments, Inc 18<br />
McBride Baker & Coles 69<br />
McDonald’s Corp 79<br />
McGill University<br />
Mellon’s Investment<br />
23<br />
Manager Solutions 41<br />
Mercer Oliver Wyman<br />
Ministry of National Economy<br />
45<br />
and Finance 25<br />
Moody’s Investor Services 77<br />
Moors & Cabot 80<br />
Morgan Stanley 75<br />
Morningstar 21<br />
Shanghai Securities News 21<br />
NASDAQ 14<br />
National Bank of Greece 25<br />
National Interbank Funding Centre 72<br />
New York Mercantile Exchange 10<br />
New York Mercantile Exchange 10<br />
New York Stock Exchange 14<br />
New York Stock Exchange 69<br />
Northern Trust 36<br />
Northern Trust 8<br />
Northern Trust <strong>Global</strong> Investments 57<br />
OMHX<br />
Online Commodity Exchange<br />
25<br />
of India 73<br />
OPEC 10<br />
People’s Bank of China 72<br />
PIMCO 76<br />
PNC Financial Services Group Inc 80<br />
PowerShares Capital Management 6<br />
RBC <strong>Global</strong> Services 42<br />
RBS 32<br />
Reuters 14<br />
Royal Bank of Canada 34<br />
Russian Standard Bank 30<br />
Russian Standard Group 30<br />
Ryan, Beck & Co 81<br />
Sandler O’Neill & Partners LP 80<br />
Schwab Institutional<br />
Securities and Exchange<br />
19<br />
Commission 14<br />
SEI Investments 23<br />
Shanghai Stock Exchange 72<br />
Shanghai Stock Exchange 22<br />
Sidney Frank 65<br />
Singapore Exchange 73<br />
Société Générale 30<br />
Société Générale 8<br />
Standard & Poor’s 74<br />
Standard Life Investments 23<br />
State Street <strong>Global</strong> Advisors 6<br />
State Street <strong>Global</strong> Advisors 22<br />
Sydney Futures Exchange 73<br />
T. Rowe Price 57<br />
TCW Asset Management Company 74<br />
TCW Asset Management Company 76<br />
Telecom Italia 57<br />
The Bank of New York 41<br />
TowerGroup 42<br />
Turk Economi Bankasi 32<br />
Union National Bank 53<br />
United California Bank 32<br />
United Safe Deposit Bank 32<br />
University of Athens 25<br />
University of California 16<br />
Wachovia Corp 79<br />
Wall-mart 53<br />
World Trade Organisation 23<br />
COMPANIES IN THIS ISSUE<br />
85
MARKET REPORTS BY <strong>FTSE</strong> RESEARCH<br />
86<br />
<strong>FTSE</strong> <strong>Global</strong> <strong>Equity</strong> <strong>Index</strong> <strong>Series</strong> – <strong>Global</strong>, Year to Date<br />
31st December 2004 - 31st May 2005<br />
<strong>FTSE</strong> Regional Indices Performance (USD)<br />
120<br />
115<br />
110<br />
105<br />
100<br />
95<br />
90<br />
<strong>FTSE</strong> Regional Indices Capital Returns (USD)<br />
%<br />
<strong>FTSE</strong> Developed Country Indices Capital Returns<br />
%<br />
31-Dec-04<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
-6<br />
-8<br />
<strong>FTSE</strong> <strong>Global</strong> AC<br />
<strong>FTSE</strong> All-World <strong>Index</strong><br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
<strong>FTSE</strong> Large Cap<br />
31-Jan-05<br />
<strong>FTSE</strong> Mid Cap<br />
<strong>FTSE</strong> Small Cap<br />
<strong>FTSE</strong> Developed AC<br />
28-Feb-05<br />
<strong>FTSE</strong> Adv Emerging AC<br />
<strong>FTSE</strong> Emerging AC<br />
<strong>FTSE</strong> All-Emerging AC<br />
31-Mar-05<br />
<strong>FTSE</strong> Latin America AC<br />
<strong>FTSE</strong> Middle East & Africa<br />
<strong>FTSE</strong> North America AC<br />
30-Apr-05<br />
<strong>FTSE</strong> Asia Pacific ex Japan AC<br />
<strong>FTSE</strong> Japan AC<br />
<strong>FTSE</strong> Dev Europe AC<br />
31-May-05<br />
<strong>FTSE</strong> Emerging Europe AC<br />
<strong>FTSE</strong> Australia AC<br />
<strong>FTSE</strong> Austria AC<br />
<strong>FTSE</strong> Belgium/Lux AC<br />
<strong>FTSE</strong> Canada AC<br />
<strong>FTSE</strong> Denmark AC<br />
<strong>FTSE</strong> Finland AC<br />
<strong>FTSE</strong> France AC<br />
<strong>FTSE</strong> Germany AC<br />
<strong>FTSE</strong> Greece AC<br />
<strong>FTSE</strong> Hong Kong China AC<br />
<strong>FTSE</strong> Ireland AC<br />
<strong>FTSE</strong> Italy AC<br />
<strong>FTSE</strong> Japan AC<br />
<strong>FTSE</strong> Netherlands AC<br />
<strong>FTSE</strong> New Zealand AC<br />
<strong>FTSE</strong> Norway AC<br />
<strong>FTSE</strong> Portugal AC<br />
<strong>FTSE</strong> Singapore AC<br />
<strong>FTSE</strong> Spain AC<br />
<strong>FTSE</strong> Sweden AC<br />
<strong>FTSE</strong> Swizerland AC<br />
<strong>FTSE</strong> United Kingdom AC<br />
<strong>FTSE</strong> USA AC<br />
<strong>FTSE</strong> <strong>Global</strong> AC<br />
<strong>FTSE</strong> Developed Europe AC<br />
<strong>FTSE</strong> Japan AC<br />
<strong>FTSE</strong> Asia Pacific AC ex Japan<br />
<strong>FTSE</strong> Middle East & Africa AC<br />
<strong>FTSE</strong> Emerging Europe AC<br />
<strong>FTSE</strong> Latin America AC<br />
<strong>FTSE</strong> North America AC<br />
Dollar Value<br />
Local Currency Value<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
<strong>FTSE</strong> All-Emerging Country Indices Capital Returns<br />
%<br />
70<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
-10<br />
-20<br />
<strong>FTSE</strong> <strong>Global</strong> All Cap Sector Indices Capital Returns (USD)<br />
%<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
-20<br />
Stock Performance<br />
Best Performing <strong>FTSE</strong> All-World <strong>Index</strong> Stocks (USD) Worst Performing <strong>FTSE</strong> All-World <strong>Index</strong> Stocks (USD)<br />
Orascom Telecom Holdings 115.5% Doral Financial -76.5%<br />
Orascom Construction 101.7% Elan Corporation -71.7%<br />
Dacom Corporation 101.4% LG Card -60.0%<br />
Mitac International 95.7% TD Banknorth -59.9%<br />
Thai Petrochemical Industry 88.7% Pacifica Group -53.9%<br />
Overall <strong>Index</strong> Return No. of Value 1 M 3 M YTD Actual<br />
Consts Div Yld<br />
<strong>FTSE</strong> <strong>Global</strong> AC 7,793 299.66 2.0% -3.2% -2.0% 2.12%<br />
<strong>FTSE</strong> <strong>Global</strong> LC 1,102 293.78 1.5% -3.1% -2.5% 2.27%<br />
<strong>FTSE</strong> <strong>Global</strong> MC 1,868 392.94 3.0% -2.4% -0.2% 1.79%<br />
<strong>FTSE</strong> <strong>Global</strong> SC 4,823 352.51 3.3% -3.8% -2.0% 1.73%<br />
<strong>FTSE</strong> All-World 2,970 179.40 1.8% -3.1% -2.0% 2.17%<br />
<strong>FTSE</strong> Asia Pacific AC ex Japan 1,870 345.26 1.5% -4.9% 0.3% 3.02%<br />
<strong>FTSE</strong> Latin America AC 173 486.64 6.8% -5.7% 3.5% 3.73%<br />
<strong>FTSE</strong> All Emerging Europe AC 84 429.89 1.7% -13.6% 0.7% 2.04%<br />
<strong>FTSE</strong> Developed Europe AC 1,512 315.63 -0.2% -6.0% -3.1% 2.91%<br />
<strong>FTSE</strong> Middle East & Africa AC 171 393.05 -1.5% -9.4% -7.1% 2.75%<br />
<strong>FTSE</strong> North Americas AC 2,656 283.44 3.6% -0.8% -1.3% 1.71%<br />
<strong>FTSE</strong> Japan AC 1,327 300.90 -1.1% -5.4% -4.9% 1.16%<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Dollar Value<br />
Local Currency Value<br />
Capital<br />
<strong>FTSE</strong> Argentina AC<br />
<strong>FTSE</strong> Brazil AC<br />
<strong>FTSE</strong> Chile AC<br />
<strong>FTSE</strong> China AC<br />
<strong>FTSE</strong> Columbia AC<br />
<strong>FTSE</strong> Czech Republic AC<br />
<strong>FTSE</strong> Egypt AC<br />
<strong>FTSE</strong> Hungary AC<br />
<strong>FTSE</strong> India AC<br />
<strong>FTSE</strong> Indonesia AC<br />
<strong>FTSE</strong> Israel AC<br />
<strong>FTSE</strong> Korea AC<br />
<strong>FTSE</strong> Malaysia AC<br />
<strong>FTSE</strong> Mexico AC<br />
<strong>FTSE</strong> Morocco AC<br />
Mining<br />
Oil & Gas<br />
<strong>FTSE</strong> Pakistan AC<br />
Chemicals<br />
<strong>FTSE</strong> Peru AC<br />
Construction & Building Materials<br />
<strong>FTSE</strong> Philippines AC<br />
Forestry & Paper<br />
Steel & Other Metals<br />
<strong>FTSE</strong> Poland AC<br />
Aerospace & Defence<br />
<strong>FTSE</strong> Russia AC<br />
Diversified Industrials<br />
Electronic & Electrical Equipment<br />
<strong>FTSE</strong> South Africa AC<br />
Engineering & Machinery<br />
<strong>FTSE</strong> Taiwan AC<br />
Automobiles & Parts<br />
Household Goods & Textiles<br />
<strong>FTSE</strong> Thailand AC<br />
Beverages<br />
<strong>FTSE</strong> Turkey AC<br />
Food Producers & Processors<br />
Health<br />
Personal Care & Household Products<br />
Pharmaceuticals & Biotechnology<br />
Tobacco<br />
General Retailers<br />
Leisure & Hotels<br />
Media & Entertainment<br />
Support Services<br />
Transport<br />
Food & Drug Retailers<br />
Telecommunication Services<br />
Electricity<br />
Utilities - Other<br />
Banks<br />
Insurance<br />
Life Assurance<br />
Investment Companies<br />
Real Estate<br />
Speciality & Other Finance<br />
Information Technology Hardware<br />
Software & Computer Services<br />
Total Return<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
87
MARKET REPORTS BY <strong>FTSE</strong> RESEARCH<br />
88<br />
<strong>FTSE</strong> <strong>Global</strong> <strong>Equity</strong> <strong>Index</strong> <strong>Series</strong> – Developed ex US,Year to Date<br />
31st December 2004 - 31st May 2005<br />
<strong>FTSE</strong> Developed Regional Indices Performance (USD)<br />
115<br />
110<br />
105<br />
100<br />
95<br />
90<br />
31-Dec-04<br />
%<br />
31-Jan-05<br />
28-Feb-05<br />
31-Mar-05<br />
30-Apr-05<br />
<strong>FTSE</strong> Developed Regional Indices Capital Returns (USD)<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
<strong>FTSE</strong> Developed<br />
%<br />
<strong>FTSE</strong> All-Emerging<br />
<strong>FTSE</strong> Developed ex US<br />
<strong>FTSE</strong> Developed Europe<br />
<strong>FTSE</strong> Developed Asia Pacific<br />
<strong>FTSE</strong> Developed Asia Pacific ex Japan<br />
<strong>FTSE</strong> Eurozone<br />
<strong>FTSE</strong> Developed ex US Indices Sector Capital Returns (USD)<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
-20<br />
<strong>FTSE</strong> US<br />
<strong>FTSE</strong> Developed AC ex US<br />
<strong>FTSE</strong> Developed LC ex US<br />
<strong>FTSE</strong> Developed MC ex US<br />
<strong>FTSE</strong> Developed SC ex US<br />
31-May-05<br />
Mining<br />
Oil & Gas<br />
Chemicals<br />
Construction & Building Materials<br />
Forestry & Paper<br />
Steel & Other Metals<br />
Aerospace & Defence<br />
Diversified Industrials<br />
Electronic & Electrical Equipment<br />
Engineering & Machinery<br />
Automobiles & Parts<br />
Household Goods & Textiles<br />
Beverages<br />
Food Producers & Processors<br />
Health<br />
Personal Care & Household Products<br />
Pharmaceuticals & Biotechnology<br />
Tobacco<br />
General Retailers<br />
Leisure & Hotels<br />
Media & Entertainment<br />
Support Services<br />
Transport<br />
Food & Drug Retailers<br />
Telecommunication Services<br />
Electricity<br />
Utilities - Other<br />
Banks<br />
Insurance<br />
Life Assurance<br />
Investment Companies<br />
Real Estate<br />
Speciality & Other Finance<br />
Information Technology Hardware<br />
Software & Computer Services<br />
<strong>FTSE</strong> Developed (LC/MC)<br />
<strong>FTSE</strong> Developed Europe (LC/MC)<br />
<strong>FTSE</strong> Developed Asia Pacific (LC/MC)<br />
<strong>FTSE</strong> All-Emerging (LC/MC)<br />
<strong>FTSE</strong> Developed ex US (LC/MC)<br />
<strong>FTSE</strong> US (LC/MC)<br />
<strong>FTSE</strong> Developed Asia Pacific<br />
ex Japan (LC/MC)<br />
Capital<br />
Total Return<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
Stock Performance<br />
Best Performing <strong>FTSE</strong> Developed ex US <strong>Index</strong> Stocks (USD) Worst Performing <strong>FTSE</strong> Developed ex US <strong>Index</strong> Stocks (USD)<br />
Chiyoda Corp 65.1% Elan Corporation -71.7%<br />
Sembcorp Marine 51.6% Pacifica Group -53.9%<br />
Daido Steel Co 44.6% Paperlinx -52.3%<br />
Kingboard Chemical Holdings 44.0% Henderson Group -51.1%<br />
Sembcorp Industries Limited 37.6% Privee Zurich Turnaround Group -49.6%<br />
Overall <strong>Index</strong> Return No. of Value 1 M 3 M YTD Actual<br />
Consts Div Yld<br />
<strong>FTSE</strong> Developed ex US (LC/MC) 1,362 189.68 -0.2% -5.5% -3.5% 2.59%<br />
<strong>FTSE</strong> USA (LC/MC) 740 490.22 3.3% -0.5% -1.0% 1.75%<br />
<strong>FTSE</strong> Developed (LC/MC) 2,102 176.26 1.7% -2.8% -2.2% 2.13%<br />
<strong>FTSE</strong> All-Emerging (LC/MC) 868 264.95 3.4% -6.6% 0.7% 2.80%<br />
<strong>FTSE</strong> Developed Europe (LC/MC) 512 190.43 -0.3% -5.9% -3.5% 2.97%<br />
<strong>FTSE</strong> Developed Asia Pacific (LC/MC) 776 175.58 -0.7% -5.2% -4.3% 1.90%<br />
<strong>FTSE</strong> Developed Asia Pacific ex Japan (LC/MC) 298 289.98 -0.2% -4.1% -0.8% 3.50%<br />
<strong>FTSE</strong> Developed AC ex US 3,710 318.45 -0.2% -5.5% -3.1% 2.54%<br />
<strong>FTSE</strong> Developed LC ex US 527 299.21 -0.3% -5.4% -4.0% 2.70%<br />
<strong>FTSE</strong> Developed MC ex US 1,868 364.79 0.3% -5.5% -1.3% 1.79%<br />
<strong>FTSE</strong> Developed SC ex US 4,823 394.70 0.1% -5.9% 0.1% 1.73%<br />
<strong>FTSE</strong> <strong>Global</strong> <strong>Equity</strong> <strong>Index</strong> <strong>Series</strong> – Asia Pacific, Year to Date<br />
31st December 2004 - 31st May 2005<br />
<strong>FTSE</strong> Asia Pacific Regional Indices Performance (USD)<br />
110<br />
105<br />
100<br />
95<br />
90<br />
31-Dec-04<br />
31-Jan-05<br />
28-Feb-05<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
31-Mar-05<br />
30-Apr-05<br />
31-May-05<br />
<strong>FTSE</strong> <strong>Global</strong> AC<br />
<strong>FTSE</strong> Developed<br />
Asia Pacific (LC/MC)<br />
<strong>FTSE</strong> Developed Asia Pacific<br />
ex Japan (LC/MC)<br />
<strong>FTSE</strong> Asia Pacific (LC/MC)<br />
<strong>FTSE</strong> All-Emerging<br />
Asia Pacific AC<br />
<strong>FTSE</strong> Japan (LC/MC)<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
89
MARKET REPORTS BY <strong>FTSE</strong> RESEARCH<br />
90<br />
<strong>FTSE</strong> Asia Pacific Regional Indices Capital Returns (USD)<br />
%<br />
<strong>FTSE</strong> Asia Pacific All Cap Sector Indices Capital Returns (USD)<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
2<br />
0<br />
-2<br />
-4<br />
-6<br />
<strong>FTSE</strong> Asia Pacific AC<br />
%<br />
<strong>FTSE</strong> <strong>Global</strong> AC<br />
Mining<br />
Oil & Gas<br />
Chemicals<br />
Construction & Building Materials<br />
Forestry & Paper<br />
Steel & Other Metals<br />
Aerospace & Defence<br />
Diversified Industrials<br />
Electronic & Electrical Equipment<br />
Engineering & Machinery<br />
Stock Performance<br />
Best Performing <strong>FTSE</strong> Asia Pacific <strong>Index</strong> Stocks (USD) Worst Performing <strong>FTSE</strong> Asia Pacific <strong>Index</strong> Stocks (USD)<br />
Dacom Corporation 101.4% LG Card -60.0%<br />
Mitac International 95.7% Pacifica Group -53.9%<br />
Thai Petrochemical Industry 88.7% Paperlinx -52.3%<br />
High Tech Computer 83.3% Privee Zurich Turnaround Group -49.6%<br />
Korea Investment Holdings 80.2% ReignCom -47.0%<br />
Overall <strong>Index</strong> Return<br />
<strong>FTSE</strong> Developed<br />
Asia Pacific (LC/MC)<br />
Developed Asia Pacific<br />
ex Japan (LC/MC)<br />
<strong>FTSE</strong> All-Emerging<br />
Asia Pacific AC<br />
<strong>FTSE</strong> Developed<br />
Asia Pacific AC<br />
<strong>FTSE</strong> Japan <strong>Index</strong> (LC/MC)<br />
<strong>FTSE</strong> Asia Pacific (LC/MC)<br />
<strong>FTSE</strong> Asia Pacific MC<br />
<strong>FTSE</strong> Asia Pacific SC<br />
<strong>FTSE</strong> Asia Pacific LC<br />
Automobiles & Parts<br />
Household Goods & Textiles<br />
Beverages<br />
Food Producers & Processors<br />
Health<br />
Personal Care & Household Products<br />
Pharmaceuticals & Biotechnology<br />
Tobacco<br />
General Retailers<br />
Leisure & Hotels<br />
Media & Entertainment<br />
Support Services<br />
Transport<br />
Food & Drug Retailers<br />
Telecommunication Services<br />
Electricity<br />
Utilities - Other<br />
Banks<br />
Insurance<br />
Life Assurance<br />
Investment Companies<br />
Real Estate<br />
Speciality & Other Finance<br />
Information Technology Hardware<br />
Software & Computer Services<br />
Capital<br />
Total Return<br />
No. of Value 1 M 3 M YTD Actual<br />
Consts Div Yld<br />
<strong>FTSE</strong> <strong>Global</strong> AC 7793 299.66 1.95% -3.15% -2.01% 2.12%<br />
<strong>FTSE</strong> Asia Pacific AC 3197 319.40 0.13% -5.15% -2.54% 2.03%<br />
<strong>FTSE</strong> Asia Pacific (LC/MC) 1335 180.93 0.26% -5.13% -2.94% 2.05%<br />
<strong>FTSE</strong> Asia Pacific LC 497 305.97 0.36% -5.18% -3.34% 2.11%<br />
<strong>FTSE</strong> Asia Pacific MC 838 352.57 -0.15% -4.96% -1.40% 1.82%<br />
<strong>FTSE</strong> Asia Pacific SC 1862 369.71 -0.91% -5.03% 1.63% 1.90%<br />
<strong>FTSE</strong> Developed Asia Pacific ex Japan (LC/MC) 298 289.98 -0.21% -4.05% -0.76% 3.50%<br />
<strong>FTSE</strong> Developed Asia Pacific <strong>Index</strong> (LC/MC) 776 175.58 -0.67% -5.15% -4.25% 1.90%<br />
<strong>FTSE</strong> All-Emerging Asia Pacific (LC/MC) 559 204.15 3.66% -5.13% 1.97% 2.59%<br />
<strong>FTSE</strong> Japan <strong>Index</strong> (LC/MC) 478 111.52 -0.88% -5.66% -5.78% 1.15%<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
%<br />
%<br />
<strong>FTSE</strong> <strong>Global</strong> <strong>Equity</strong> <strong>Index</strong> <strong>Series</strong> – Europe, Year to Date<br />
31st December 2004 - 31st May 2005<br />
<strong>FTSE</strong> European Regional Indices Performance (EUR)<br />
110<br />
105<br />
100<br />
95<br />
31-Dec-04<br />
31-Jan-05<br />
28-Feb-05<br />
<strong>FTSE</strong> European Regional Indices Capital Return (EUR)<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
<strong>FTSE</strong> <strong>Global</strong> AC<br />
<strong>FTSE</strong> Europe AC<br />
<strong>FTSE</strong> Europe LC<br />
<strong>FTSE</strong> Europe MC<br />
<strong>FTSE</strong> Europe SC<br />
<strong>FTSE</strong> Developed Europe AC<br />
<strong>FTSE</strong> All-Emerging Europe AC<br />
<strong>FTSE</strong> Developed Europe Sector Indices Capital Returns (EUR)<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
31-Mar-05<br />
<strong>FTSE</strong> Eurozone AC<br />
30-Apr-05<br />
<strong>FTSE</strong> Developed Europe<br />
ex UK AC<br />
<strong>FTSE</strong> Eurofirst 300<br />
<strong>FTSE</strong>urofirst 80<br />
<strong>FTSE</strong>urofirst 100<br />
31-May-05<br />
Mining<br />
Oil & Gas<br />
Chemicals<br />
Construction & Building Materials<br />
Forestry & Paper<br />
Steel & Other Metals<br />
Aerospace & Defence<br />
Diversified Industrials<br />
Electronic & Electrical Equipment<br />
Engineering & Machinery<br />
Automobiles & Parts<br />
Household Goods & Textiles<br />
Beverages<br />
Food Producers & Processors<br />
Health<br />
Personal Care & Household Products<br />
Pharmaceuticals & Biotechnology<br />
Tobacco<br />
General Retailers<br />
Leisure & Hotels<br />
Media & Entertainment<br />
Support Services<br />
Transport<br />
Food & Drug Retailers<br />
Telecommunication Services<br />
Electricity<br />
Utilities - Other<br />
Banks<br />
Insurance<br />
Life Assurance<br />
Investment Companies<br />
Real Estate<br />
Speciality & Other Finance<br />
Information Technology Hardware<br />
Software & Computer Services<br />
<strong>FTSE</strong> <strong>Global</strong> AC (EUR)<br />
<strong>FTSE</strong> Developed Europe<br />
ex UK LC/MC (EUR)<br />
<strong>FTSE</strong>urofirst 300 (EUR)<br />
<strong>FTSE</strong> Developed Europe AC (EUR)<br />
<strong>FTSE</strong>urofirst 100 (EUR)<br />
<strong>FTSE</strong> Eurozone LC/MC (EUR)<br />
<strong>FTSE</strong>urofirst 80 (EUR)<br />
Capital<br />
Total Return<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
91
MARKET REPORTS BY <strong>FTSE</strong> RESEARCH<br />
92<br />
Stock Performance<br />
Best Performing <strong>FTSE</strong> Developed Europe <strong>Index</strong> Stocks (EUR) Worst Performing <strong>FTSE</strong> Developed Europe <strong>Index</strong> Stocks (EUR)<br />
Vestas Wind Systems 44.4% Elan Corporation -68.9%<br />
Allied Domecq 41.2% Henderson Group -46.2%<br />
Metso Corporation 39.4% Benetton -24.3%<br />
RCS Mediagroup 35.5% Invensys -24.2%<br />
Deutsche Boerse 34.9% Alcatel -22.5%<br />
Overall <strong>Index</strong> Return (EUR)<br />
No. of Value 1 M 3 M YTD Actual<br />
Consts Div Yld<br />
<strong>FTSE</strong> <strong>Global</strong> AC 7793 299.66 1.95% -3.15% -2.01% 2.12%<br />
<strong>FTSE</strong> Europe AC 1596 295.57 4.41% 0.94% 6.73% 2.90%<br />
<strong>FTSE</strong> Europe LC 211 329.86 4.11% 1.17% 5.69% 3.05%<br />
<strong>FTSE</strong> Europe MC 358 358.10 5.06% 0.88% 8.68% 2.54%<br />
<strong>FTSE</strong> Europe SC 1027 372.33 5.25% 0.78% 10.43% 2.40%<br />
<strong>FTSE</strong> Developed Europe AC 1512 294.36 4.38% 1.08% 6.67% 2.91%<br />
<strong>FTSE</strong> All-Emerging Europe AC 84 400.92 6.29% -7.08% 10.83% 2.04%<br />
<strong>FTSE</strong> Eurobloc AC 745 303.77 4.84% 0.46% 5.51% 2.88%<br />
<strong>FTSE</strong> Developed Europe ex UK AC 1031 305.64 4.92% 0.97% 6.17% 2.73%<br />
<strong>FTSE</strong>urofirst 300 300 1105.55 4.25% 1.25% 6.12% 3.01%<br />
<strong>FTSE</strong>urofirst 80 80 3843.64 4.63% 0.01% 3.86% 3.17%<br />
<strong>FTSE</strong>urofirst 100 100 3679.79 4.06% 1.06% 5.70% 3.24%<br />
<strong>FTSE</strong> UK <strong>Index</strong> <strong>Series</strong> – Year to Date<br />
31st December 2004 - 31st May 2005<br />
<strong>FTSE</strong> UK <strong>Index</strong> <strong>Series</strong> Performance (GBP)<br />
120<br />
115<br />
110<br />
105<br />
100<br />
95<br />
90<br />
31-Dec-04<br />
31-Jan-05<br />
28-Feb-05<br />
31-Mar-05<br />
30-Apr-05<br />
<strong>FTSE</strong> All-Share Sector Indices Capital Returns (GBP)<br />
%<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
-20<br />
31-May-05<br />
Mining<br />
Oil & Gas<br />
Chemicals<br />
Construction & Building Materials<br />
Forestry & Paper<br />
Steel & Other Metals<br />
Aerospace & Defence<br />
Electronic & Electrical Equipment<br />
Engineering & Machinery<br />
Automobiles & Parts<br />
Household Goods & Textiles<br />
Beverages<br />
Food Producers & Processors<br />
Health<br />
Personal Care & Household Products<br />
Pharmaceuticals & Biotechnology<br />
Tobacco<br />
General Retailers<br />
Leisure & Hotels<br />
Media & Entertainment<br />
Support Services<br />
Transport<br />
Food & Drug Retailers<br />
Telecommunication Services<br />
Electricity<br />
Utilities - Other<br />
Banks<br />
Insurance<br />
Life Assurance<br />
Investment Companies<br />
Real Estate<br />
Speciality & Other Finance<br />
Information Technology Hardware<br />
Software & Computer Services<br />
<strong>FTSE</strong> 100<br />
<strong>FTSE</strong> 250<br />
<strong>FTSE</strong> 350<br />
<strong>FTSE</strong> SmallCap<br />
<strong>FTSE</strong> All-Share<br />
<strong>FTSE</strong> AIM<br />
<strong>FTSE</strong> techMARK<br />
Capital<br />
Total Return<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
<strong>FTSE</strong> UK <strong>Index</strong> <strong>Series</strong> - Capital Return YTD (GBP)<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
-6<br />
<strong>FTSE</strong> 100<br />
Stock Performance<br />
Best Performing <strong>FTSE</strong> All-Share <strong>Index</strong> Stocks (GBP) Worst Performing <strong>FTSE</strong> All-Share <strong>Index</strong> Stocks (GBP)<br />
Stanelco 388.4% AEA Technology -59.3%<br />
Oxford Biomedica 75.7% Homestyle Group -55.4%<br />
BTG 71.6% Danka Business Systems -54.7%<br />
Elementis 66.8% Games Workshop Group -53.6%<br />
Edinburgh Oil & Gas 57.8% Gresham Computing -52.7%<br />
Overall <strong>Index</strong> Return<br />
No. of Value 1 M 3 M YTD Actual Net P/E<br />
Consts Div Yld Cover Ratio<br />
<strong>FTSE</strong> 100 100 4963.97 3.4% -0.1% 3.1% 3.31% 2.11 14.33<br />
<strong>FTSE</strong> 250 250 7114.30 5.7% -1.9% 2.6% 2.82% 1.92 18.43<br />
<strong>FTSE</strong> 350 350 2528.33 3.7% -0.4% 3.0% 3.24% 2.08 14.79<br />
<strong>FTSE</strong> SmallCap 343 2827.00 0.9% -3.9% 2.5% 2.12% 1.50 31.41<br />
<strong>FTSE</strong> All-Share 693 2483.35 3.6% -0.5% 3.0% 3.21% 2.07 15.06<br />
<strong>FTSE</strong> Fledgling 323 3226.73 0.3% -6.2% 2.4% 2.27% -1.76 0<br />
<strong>FTSE</strong> AIM 673 957.57 -4.6% -16.4% -4.8% 0.53% 0.29 651.37<br />
<strong>FTSE</strong> techMARK 100 100 1159.80 7.2% -1.3% -3.1% 1.67% - -<br />
<strong>FTSE</strong> Xinhua <strong>Index</strong> <strong>Series</strong><br />
31st December 2004 - 31st May 2005<br />
<strong>FTSE</strong> Xinhua <strong>Index</strong> <strong>Series</strong> Performance (RMB/HKD) – Q1 2005<br />
135<br />
130<br />
125<br />
120<br />
115<br />
110<br />
105<br />
100<br />
95<br />
90<br />
85<br />
31-Dec-04<br />
<strong>FTSE</strong> 250<br />
31-Jan-05<br />
<strong>FTSE</strong> 350<br />
<strong>FTSE</strong> Xinhua <strong>Index</strong> <strong>Series</strong><br />
<strong>FTSE</strong> Small Cap<br />
28-Feb-05<br />
<strong>Index</strong> Name Consts Value 1 M 3 M YTD<br />
Actual<br />
Div Yld<br />
<strong>FTSE</strong>/Xinhua 25 (HK$) 25 8105.44 -1.5% -7.6% -2.28% 3.20%<br />
<strong>FTSE</strong>/Xinhua China 50 (RMB) 50 3692.61 -10.8% -16.2% -11.73% 2.34%<br />
<strong>FTSE</strong> Xinhua All-Share (RMB) 995 2023.97 -7.6% -19.8% -17.28% 1.82%<br />
<strong>FTSE</strong> Xinhua 600 (RMB) 600 2185.26 -8.5% -19.1% -16.34% 1.98%<br />
<strong>FTSE</strong> Xinhua Small Cap (RMB) 395 1441.61 -2.4% -23.8% -22.25% 0.90%<br />
<strong>FTSE</strong> Xinhua China Bond Total Return <strong>Index</strong> (RMB) 29 94.23 1.12% 4.31% 7.52% 3.54%<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
<strong>FTSE</strong> All-Share<br />
31-Mar-05<br />
<strong>FTSE</strong> Fledgling<br />
30-Apr-05<br />
<strong>FTSE</strong> AIM<br />
31-May-05<br />
<strong>FTSE</strong>/Xinhua China 25 (HK$)<br />
<strong>FTSE</strong> Xinhua All-Share (RMB)<br />
<strong>FTSE</strong> Xinhua Small Cap (RMB)<br />
<strong>FTSE</strong>/Xinhua China A50 (RMB)<br />
<strong>FTSE</strong> Xinhua 600 (RMB)<br />
<strong>FTSE</strong> Xinhua China Bond<br />
Total Return <strong>Index</strong> (RMB)<br />
MARKET REPORTS BY <strong>FTSE</strong> RESEARCH<br />
93
MARKET REPORTS BY <strong>FTSE</strong> RESEARCH<br />
94<br />
<strong>FTSE</strong> Hedge <strong>Index</strong> <strong>Series</strong><br />
<strong>FTSE</strong> Hedge Management Styles (USD) – 5-Year Performance<br />
160<br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
May-00<br />
Nov-00<br />
May-01<br />
Nov-01<br />
May-02<br />
Nov-02<br />
May-03<br />
Nov-03<br />
<strong>FTSE</strong> Hedge<br />
<strong>FTSE</strong> All-World<br />
Directional<br />
Event Driven<br />
Non-Directional<br />
<strong>FTSE</strong> Hedge – Management Styles & Strategies (NAV Terms)<br />
<strong>Index</strong> Ann Return Volatility<br />
Level* 1 mth 3 mth (5-Year) (3-Year)<br />
Directional 2973.83 0.9% -2.1% 7.9% 5.0%<br />
<strong>Equity</strong> Hedge 2041.82 -0.1% -1.8% 7.4% 4.3%<br />
Commodity Trading Association (CTA) / Managed Futures 1983.03 1.3% -2.6% 10.5% 15.8%<br />
<strong>Global</strong> Macro 1848.44 3.4% -2.6% 6.5% 6.9%<br />
Event Driven 3064.03 0.2% -1.2% 3.5% 4.6%<br />
Merger Arbitrage 2014.21 0.5% 0.7% 1.8% 1.8%<br />
Distressed & Opportunities 2067.18 0.0% -2.8% 4.9% 7.6%<br />
Non-directional 2957.64 -0.2% -0.5% 4.0% 1.7%<br />
Convertible Arbitrage 1905.84 -0.1% -3.3% 7.5% 5.2%<br />
<strong>Equity</strong> Arbitrage 1971.36 -0.5% 0.1% 4.6% 2.7%<br />
Fixed Income Relative Value 2000.14 0.1% 0.5% 1.9% 1.3%<br />
* Based upon indicative index values as at 31 May 2005<br />
<strong>FTSE</strong> EPRA/NAREIT <strong>Global</strong> Real Estate <strong>Index</strong> <strong>Series</strong><br />
<strong>FTSE</strong> EPRA/NAREIT <strong>Global</strong> Real Estate <strong>Index</strong> <strong>Series</strong> Performance (Total Return) – Year to Date<br />
120<br />
115<br />
110<br />
105<br />
100<br />
95<br />
90<br />
Dec-04<br />
Jan-05<br />
Feb-05<br />
Mar-05<br />
May-04<br />
Apr-05<br />
Nov-04<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
May-05<br />
May-05<br />
<strong>FTSE</strong> EPRA/NAREIT <strong>Global</strong><br />
Total Return <strong>Index</strong> ($)<br />
<strong>FTSE</strong> EPRA/NAREIT North America<br />
Total Return <strong>Index</strong> ($)<br />
<strong>FTSE</strong> EPRA/NAREIT Europe<br />
Total Return <strong>Index</strong> (€)<br />
<strong>FTSE</strong> EPRA/NAREIT Eurozone<br />
Total Return <strong>Index</strong> (€)<br />
<strong>FTSE</strong> EPRA/NAREIT Asia<br />
Total Return <strong>Index</strong> ($)<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
<strong>FTSE</strong> EPRA/NAREIT <strong>Global</strong> Real Estate Indices (Total Return)<br />
Actual<br />
<strong>Index</strong> Name Consts Value 1 M 3 M YTD Div Yld<br />
<strong>FTSE</strong> EPRA/NAREIT <strong>Global</strong> <strong>Index</strong> ($) 274 2186.29 1.9% 2.6% 0.04% 3.98%<br />
<strong>FTSE</strong> EPRA/NAREIT North America <strong>Index</strong> ($) 134 2720.17 3.4% 6.6% 1.16% 4.65%<br />
<strong>FTSE</strong> EPRA/NAREIT Europe <strong>Index</strong> (€) 78 2292.34 7.0% 8.3% 11.99% 3.15%<br />
<strong>FTSE</strong> EPRA/NAREIT Eurozone <strong>Index</strong> (€) 30 2442.75 7.7% 11.5% 17.19% 4.15%<br />
<strong>FTSE</strong> EPRA/NAREIT Asia <strong>Index</strong> ($) 62 1517.22 -1.2% -3.1% -3.17% 3.28%<br />
<strong>FTSE</strong> Bond Indices<br />
<strong>FTSE</strong> Bond Indices Performance (Total Return) – Year to Date<br />
104<br />
103<br />
102<br />
101<br />
100<br />
99 99<br />
98<br />
97<br />
Dec-04<br />
Jan-05<br />
Feb-05<br />
<strong>FTSE</strong> Bond Indices (Total Return)<br />
<strong>Index</strong> Name Consts Value 1 M 3 M YTD<br />
Actual<br />
Div Yld<br />
<strong>FTSE</strong> Eurozone Government Bond <strong>Index</strong> (€) 252 152.90 1.09% 3.12% 3.79% 3.29%<br />
<strong>FTSE</strong> Pfandbrief (€) 312 175.90 0.89% 2.69% 3.08% 3.00%<br />
<strong>FTSE</strong> Euro Emerging Markets Bond <strong>Index</strong> (€) 42 200.47 1.68% 1.52% 2.77% 4.54%<br />
<strong>FTSE</strong> Euro Corporate Bond <strong>Index</strong> (€) 334 142.28 1.06% 1.76% 2.68% 3.66%<br />
<strong>FTSE</strong> Gilts <strong>Index</strong> Linked All Stocks (£) 9 1883.11 0.87% 2.56% 1.99% 1.78%*<br />
<strong>FTSE</strong> Gilts Fixed All-Stocks (£) 29 1848.96 1.65% 3.59% 3.11% 4.31%<br />
<strong>FTSE</strong> US Government Bond <strong>Index</strong> ($) 116 146.59 0.94% 2.26% 2.59% 4.12%<br />
<strong>FTSE</strong> Japan Government Bond <strong>Index</strong> (¥)<br />
* Based on 0% inflation<br />
220 111.00 0.07% 1.26% 1.21% 0.96%<br />
<strong>FTSE</strong> GLOBAL MARKETS • JULY/AUGUST 2005<br />
Mar-05<br />
<strong>FTSE</strong> Research Team contact details<br />
Apr-05<br />
May-05<br />
<strong>FTSE</strong> Eurozone Government<br />
Bond <strong>Index</strong> (€)<br />
<strong>FTSE</strong> Euro Corporate<br />
Bond <strong>Index</strong> (€)<br />
<strong>FTSE</strong> US Goverment<br />
Bond <strong>Index</strong> ($)<br />
<strong>FTSE</strong> Pfandbrief <strong>Index</strong> (€)<br />
<strong>FTSE</strong> Gilts <strong>Index</strong> Linked<br />
All Stocks (£)<br />
<strong>FTSE</strong> Japan Government<br />
Bond <strong>Index</strong> (¥)<br />
<strong>FTSE</strong> Euro Emerging Markets<br />
Bond <strong>Index</strong> (€)<br />
<strong>FTSE</strong> Gilts Fixed All-Stocks (£)<br />
Carl Beckley Bin Wu Gareth Parker<br />
Director, Research Senior <strong>Index</strong> Design Executive Head of <strong>Index</strong> Design<br />
& Development bin.wu@ftse.com gareth.parker@ftse.com<br />
carl.beckley@ftse.com +44 20 7448 8986 +44 20 7448 1805<br />
+44 20 7448 1820<br />
Jamie Perrett Andreas Elia<br />
Senior <strong>Index</strong> Design Executive Research Analyst<br />
jamie.perrett@ftse.com andreas.elia@ftse.com<br />
+44 20 7448 1817 +44 20 7448 8013<br />
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap<br />
95
CALENDAR<br />
96<br />
<strong>Index</strong> Reviews July-Oct 2005<br />
Date <strong>Index</strong> <strong>Series</strong> Review Type Effective Data Cut-off<br />
(Close of business)<br />
1-Jul TOPIX New <strong>Index</strong> <strong>Series</strong> Semi-annual review 28-Jul 17-Jun<br />
7-Jul TSEC Taiwan 50 Quarterly & annual review 15-Jul 30-Jun<br />
25-Jul OMX H25 Quarterly review 29-Jul 30-Jun<br />
1-Aug CAC 40 Quarterly review 1-Sep End of Jun<br />
12-Aug Hang Seng Quarterly review 9-Sep 30-Jun<br />
17-Aug MSCI Quarterly review 31-Aug<br />
31-Aug <strong>FTSE</strong> All-World Annual Review / Japan 16-Sep 30-Jun<br />
Aug/Sep NZSX 10 Quarterly review Sep<br />
Early Sep ATX Quarterly review 30-Sep 31-Aug<br />
Early Sep S&P US Indices Phase 2 float adjustment 16-Sep<br />
1-Sep SMI <strong>Index</strong> Family Semi-annual review 30-Sep 31-Jul<br />
02-05-Sep S&P MIB Semi-annual constituent review 19-Sep<br />
5-Sep DAX Quarterly review / Ordinary adjustment 16-Sep 31-Aug<br />
7-Sep <strong>FTSE</strong>/Hang Seng Asiatop Semi-annual review 16-Sep 31-Aug<br />
7-Sep <strong>FTSE</strong> UK Quarterly review 16-Sep 6-Sep<br />
8-Sep <strong>FTSE</strong> All-World Annual review / Developed Europe 16-Sep 30-Jun<br />
9-Sep NASDAQ 100 Quarterly review / Shares adjustment 16-Sep<br />
9-Sep <strong>FTSE</strong> techMARK 100 Quarterly review 16-Sep 31-Aug<br />
9-Sep <strong>FTSE</strong>urofirst 300 Quarterly review 16-Sep 2-Sep<br />
9-Sep <strong>FTSE</strong> eTX Quarterly review 16-Sep 2-Sep<br />
9-Sep <strong>FTSE</strong> Multinational Annual review 16-Sep 30-Jun<br />
9-Sep <strong>FTSE</strong> TMT Annual review 16-Sep 6-Sep<br />
13-Sep S&P MIB Quarterly review - shares & IWF 19-Sep<br />
14-Sep STOXX Quarterly review 16-Sep 1-Sep<br />
14-Sep STOXX Blue Chips Annual review 16-Sep 1-Sep<br />
14-Sep DJ <strong>Global</strong> Titans 50 Quarterly review 16-Sep 14-Sep<br />
14-Sep S&P US Indices Quarterly review 16-Sep<br />
14-Sep S&P Europe 350 / S&P Euro Quarterly review 16-Sep<br />
14-Sep S&P 500 Quarterly review 16-Sep<br />
14-Sep S&P Midcap 400 Quarterly review 16-Sep<br />
14-Sep S&P / ASX 200 Quarterly review 16-Sep<br />
14-Sep S&P TSX Quarterly review 16-Sep 31-Aug<br />
15-Sep Russell US Indices Quarterly review 30-Sep 31-Aug<br />
Sep/Oct CAC 40 Quarterly review Oct/Nov<br />
Oct Nikkei 225 Annual review Oct<br />
Oct TOPIX New <strong>Index</strong> <strong>Series</strong> Introduction of free float factors (Phase 1) 28-Oct<br />
13-Oct TSEC Taiwan 50 Quarterly review 21-Oct 30-Sep<br />
Oct/Nov <strong>FTSE</strong>/ASE 20 Semi-annual review 30-Nov 30-Sep<br />
24-Oct OMX H25 Quarterly review 31-Oct 24-Oct<br />
Sources: Berlinguer, <strong>FTSE</strong>, JP Morgan, Standard & Poors, STOXX<br />
JULY/AUGUST 2005 • <strong>FTSE</strong> GLOBAL MARKETS
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