THE CASE FOR U.S. HIGH-GRADEAND HIGH YIELD CORPORATEDEBT IN 2001

We believe that high-grade and high yield corporate debt

securities will outperform most other fixed income sectors in 2001.

In a nutshell, here’s why:

� The liquidity environment is supportive.

� Risk-adjusted valuations are historically cheap

by several measures.

� Corporate capital spending is declining.

� Investor psychology has gotten used to the idea

of decelerating macroeconomic growth and is

better-prepared for bad news.

� Rising defaults in the high yield market suggest that

the timing for investment in high yield is favorable.

� Tolerance for risky assets is much greater than previously.

The CSAM U.S. Core Fixed Income Management Team

New York, March 30, 2001

T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 12

2 0 0 0 : T H E PA S T A S P R O L O G U E

Before we look forward, it’s instructive to briefly look back on

2000 to see how today’s market conditions took shape.

2000 was a year of historically unprecedented distress in U.S.

credit markets. [Note: by “distress,” we specifically mean

instances in which bond prices fell at least 15% in a short period

of time.] Selling activity was harsh, as investors fled credit sectors

in response to rising interest rates, extraordinary volatility in the

equity market, and anxiety about slowing macroeconomic growth

and its negative implications for borrowing costs and corporate

earnings. It was not uncommon for bond prices to plunge 40

points or so very quickly, based on even a hint of bad news. In

the high-grade universe, the bonds of numerous prominent

companies suffered such pain.

It’s safe to say that most large investors in high-grade debt

during 2000 were hit by “credit bombs” ( i.e., sudden shocks to

creditworthiness in the form of things like unexpected earnings

shortfalls and ratings downgrades) from these companies or

others. The result was selling whose snowballing impact on the

marketplace took on a life of its own: fear of credit bombs

turned into falling risk tolerance, which prompted further selling

to reduce overall risk

exposure, which created

a dramatic imbalance of

market liquidity in which

sellers rushed headlong

for the exits while buyers

nearly disappeared.

Year-end valuations

reflected the extreme

pessimism that pervaded investor sentiment. Option-adjusted yield

spreads for high-grade corporates versus U.S. Treasuries, for

example, were 190 basis points (bp) according to Lehman

Brothers, up from 111 bp at the end of 1999. Aggregate high

yield paper, in the form of the Credit Suisse First Boston

Domestic+ High Yield Index, traded at 950 bp over Treasuries,

compared to 554 bp a year earlier.

High-Grade and High Yield Spreads vs. Treasuries(in basis points, 1990-2000)

Y E A R - E N D 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0

High-grade * 151 107 88 84 78 60 53 64 118 111 190

High yield ** 1096 729 548 481 388 484 355 386 657 554 950

* Lehman Bros. option-adjusted spreads for aggregate high-grade ratings sectors ** CSFB Global HY Index for 1990-1998; CSFB Domestic+ HY Index for 1999-2000 Sources: Lehman Brothers, Credit Suisse First Boston

A year ofhistoricallyunprecedenteddistress in U.S.credit markets.

T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 1 3

2 0 0 1 : R E A D Y F O R TA K E - O F F

As we write late in the first quarter, we’re happy to say that the

marketplace has changed in ways that, in our opinion, bode very

favorably for the performance of U.S. high-grade and high yield

corporate debt. Essentially, the gloom and doom of 2000 sowed

seeds of appreciation that are already starting to bear fruit.

THE LIQUIDITY ENVIRONMENT IS SUPPORTIVE. Perhaps

the single most bullish development for the credit markets thus

far in 2001 has been the

Federal Reserve’s

aggressiveness in

promoting monetary

liquidity. The Fed

unexpectedly cut short-

term U.S. interest rates

by a half-point on January

3, and chopped additional half-points at its regularly scheduled

FOMC meetings on January 31 and March 20.

The positive significance of the Fed’s accommodative stance for

corporate debt is multi-faceted:

� Dealers’ short-term financing costs for positions in corporate

bonds have become attractively lower, which helps to facilitate

trading activity.

� The yield curve has steepened, which serves to nudge

investors to buy longer-dated and higher-yielding debt.

� Borrowing costs have fallen, which reduces debt-service

obligations and means that funding is more readily available for

borrowers all along the credit spectrum.

� Prospects for U.S. macroeconomic growth in the second

quarter have improved, which should ultimately raise corporate

creditworthiness in general.

� Big buyers of corporate debt like insurance companies and

banks have more cash around to invest in bonds.

We agree with the consensus view that the Fed will probably cut

short-term rates again during the second quarter by a total of

100 bp. Our research indicates that corporates tend to

handsomely outperform in the periods surrounding Fed rate-cuts.

RISK-ADJUSTED VALUATIONS ARE HISTORICALLY CHEAP

BY SEVERAL MEASURES. Several metrics we utilize to

measure risk-adjusted

valuations for high-grade

and high yield corporates

unanimously indicate that

investors may currently be

much better-compensated

than usual for buying

bonds in these sectors. In

other words, corporates

are historically cheap. This

remains the case even after bonds have rallied so far in 2001.

� By the most standard metric, yield spreads, Lehman’s

Corporate Bond Index is trading at an average of nearly

200 bp higher than comparable Treasuries.

� Option-adjusted high-grade spreads (i.e., from Lehman) and

high yield spreads (i.e., via the Salomon Smith Barney

High-Yield Market Index) are at around 1.6 and 2.8 standard

deviations from their respective historical means.

� The break-even default rates for high-grade and high yield

(i.e., the average annual rates at which defaults would have

to compound in order for these sectors to underperform

Easier Fedmonetary policy is especially bullish.

High-grade and high yieldcorporates arehistoricallycheap.

T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 14

Treasuries over the next 10 years) are unprecedentedly high.

This suggests that the relative risk of owning high-grade and

high yield—that is, the likelihood of their underperforming

Treasuries—in the foreseeable future is low.

CORPORATE CAPITAL SPENDING IS DECLINING. A major

contributor to anxiety in the credit markets last year was the

massive levels of debt raised by companies to fund huge capital

projects, notably for telecommunications and technology

infrastructure. Telecom

and tech companies

themselves, moreover,

were forced to raise

capital (often via debt

issuance) to pay for the

high costs of new-

generation wireless

licenses and their corresponding equipment requirements.

Ratings on bonds of big-name and smaller companies alike were

slashed accordingly by ratings agencies.

The fallout from this situation was most acute in the high yield

market, in which fixed-line telecom companies returned –25.8%

(i.e., in the Credit Suisse First Boston Domestic+ High Yield

Index). This was not only the year’s worst performance among

high yield industry sectors, but also represented the most

negative change in return among high yield industry sectors

compared to 1999. The increase in spread-to-worst (i.e., the

spread between the lowest yield an investor can receive among

those corresponding to a bond’s potential maturities and that of a

comparable-maturity Treasury issue) versus 1999 for fixed-line

telecom companies, in addition, was the biggest such increase in

the high yield market.

Fortunately, we can say that “That was then, this is now,” and

now is starting to look a lot better than then. The simple

explanation is that so much was spent on infrastructure that,

broadly speaking, less is needed. This should be a boost to

creditworthiness both for telecom/tech issuers and the corporate

market as a whole. 2001 should prove to be the next phase—

i.e., one of healthy self-correction—in this boom-and-bust cycle.

INVESTOR PSYCHOLOGY HAS GOTTEN USED TO THE

IDEA OF DECELERATING MACROECONOMIC GROWTH AND

IS BETTER-PREPARED FOR BAD NEWS. Much of the activity

across asset classes and regions in 2000 was driven by a

gnawing uncertainty about the extent to which macroeconomic

growth, both in the U.S. and globally, was slowing down. The

pendulum of investor psychology swung 180 degrees from the

boundless euphoria of late 1999 to a deepening pessimism about

interest rates, corporate earnings, energy prices and inflation.

At this point, our sense is that psychology is far more in synch

with the potential for bad

macroeconomic news

than it was last year.

Movement in the equity

market is already

demonstrating that some

investors are willing to

stomach the weak data projected for the next couple of quarters

or so and, instead, look ahead to what they hope will be a

resurgence in growth a bit further down the road. Given the low

level to which corporate-bond valuations have fallen, this suggests

that the upside potential from this kind of psychological adjustment

could be substantial.

Lower capitalspending is good for creditworthiness.

Investors are more tolerant of bad news.

T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 1 5

RISING DEFAULTS IN THE HIGH YIELD MARKET SUGGEST

THAT THE TIMING FOR INVESTMENT IN HIGH YIELD IS

FAVORABLE. According to Moody’s Investors Service, the

default rate for issuers of U.S. speculative-grade debt securities

in 2000 was 6.82%, up

from 5.75% in 1999 and

the highest such rate

since the all-time high

of 10.57% in 1991.

[To put this in historical

perspective, 1991 was

the apex of the meltdown

that struck the high yield market due to a singularly painful

coincidence of macroeconomic recession, the demise of Drexel

Burnham Lambert and the Gulf War.]

Moody’s currently forecasts that this rate will rise sharply in 2001

and reach a new all-time high of nearly 11.00%. While this does

not sound like something to cheer about, we note that yield

spreads in the high yield market—and, therefore, investor

pessimism—tend to peak (and then start to narrow) months ahead

of a peak in actual default rates. If this historical pattern continues

to hold true, as we think it will, it means that the present could

turn out to be an unusually opportune time to be in high yield.

TOLERANCE FOR RISKY ASSETS IS MUCH GREATER THAN

PREVIOUSLY. The sum of the preceding factors we’ve cited in

this section is that investors are much more comfortable with

risky assets now than they were even a couple of months ago.

This has an impact on overall market sentiment that is impossible

to quantify, yet materially beneficial.

L E T ’ S N O T F O R G E TT H E R I S K S

Although our optimism about high-grade and high yield

corporates is great, we must not forget the meaningful sources of

risk out there that could push bond prices downward or, at the

very least, prevent them from rising much. We see the most

important sources of risk as the following:

THE MACROECONOMIC ENVIRONMENT DOESN’T

IMPROVE. The economy, of course, is the key to the outlook for

any asset class. If the state of the macroeconomic environment in

the next few months reaches any place along the range of

conditions that represent a lack of improvement (e.g.,

deceleration, stagflation, recession), then the critical mass of

Peak default rates have been good for high yield returns.

2000

1500

1000

500

0

-500

-1000

-1500

-2000

12

10

8

6

4

2

0

Default Rates Have Been Good For High Yield Returns

Source: Lehman Brothers, Moody’s

-775

1989

-515

1990

1660

1991

552

1992

671

1993

258

1994

57

1995

769

1996

343.6

1997

-775.6

1998

479

1999

-1825

2000

904

2001 Forecasts

Excess Return of High Yield (bps)

Moody’s HY Default Rate

2001

Exc

ess

Ret

urns

(bp

s)

Def

ault

Rat

e (%

)

T H E C A S E F O R U . S . H I G H - G R A D E A N D H I G H Y I E L D C O R P O R AT E D E B T I N 2 0 0 16

positives needed to drive upward appreciation simply won’t fall

into place. We’re most concerned in this context about the recent

plunge in consumer confidence, which tends to be an accurate

directional indicator of yield spreads.

EQUITIES CORRECT OR EXPERIENCE ADDITIONAL HARSH

VOLATILITY. Investors in corporate bonds pay close attention to

developments in the equity market, which are usually driven by

news about earnings or other events. Considering the battering

that equities absorbed in 2000, it’s thus hardly surprising that

high-grade issues underperformed and high yield was crushed.

Stocks have rallied and then fallen even more in 2001, as

investors have alternatingly celebrated the Fed’s aggressive

interest-rate cuts and then feared that it won’t feel compelled to

keep cutting as much as market participants would like. What this

tells us is that it’s not out of the question for equities to correct

some more, which could well be bad news for corporate bonds.

THE TELECOM SECTOR DOESN’T RECOVER. We’ve

described the big problems faced by the world’s leading telecom

operators, some of which (e.g., AT&T, British Telecom, Deutsche

Telekom) are among the largest issuers in the corporate debt

market. If these companies can’t make visible progress toward the

resolution of their problems fairly soon, it’s likely that their bonds

may be further downgraded, which would result in wider spreads.

The sheer size of AT&T and its colleagues in the market, then,

means that such widening would undoubtedly have a spillover

effect not only on bonds of other telecom-related companies, but

also the high-grade and high yield markets more generally.

THE LIGHTS GO OUT FOR CALIFORNIA UTILITIES.

Headlines have blared about the severe financial squeeze that

has gripped the major California electric utilities, Edison

International and PG&E Corp. (both of which are large debt

issuers), in the last few months. The situation is tense and may

well end up with either or both companies forced into bankruptcy.

If things get appreciably worse, it’s not unrealistic to project that it

could have harmful effects on the rest of the country in the form

of higher electricity prices, credit problems for related lenders and

deteriorating credit quality for affected municipal borrowers. Since

California accounts for around 13% of U.S. GDP, is the nation’s

largest state economy and the sixth-largest economy in the world,

a lights-out scenario there could spell plenty of trouble elsewhere.

HOW WE’RE POSITIONEDTO SUCCEED

We have positioned our Core Plus portfolios to benefit from the

outcome that we anticipate. Specifically:

� We are overweighting high-grade corporates vs. relevant

benchmarks and recently added to total high-grade exposure.

Our focus has been on buying the long-maturity debt of issuers

that underperformed the broad market in 2000 and have good

prospects for de-leveraging and steady operating performance.

� We are shifting high yield exposure down the credit continuum

to single-B names from BBs, in line with our belief that lower-

rated credits have the most upside potential because they’ve

taken the worst punishment.

� We are placing increased emphasis on diversification as a

means of reducing portfolio risk. This takes the form both of

more names within high-grade and high yield industry sectors,

and smaller position sizes per name.

In addition, we note that there is great dispersion among the

returns of individual issues. This indicates that security

selection—which has, historically, been among the primary

strengths of our management approach—should play a vital role

in manager performance.

The information presented is for informational purposes only. CSAM’s investment views may change at any time without notice. This report is not a

recommendation to buy or sell or a solicitation of an offer to buy or sell any securities or adopt any investment strategy. Readers are advised not to infer or

assume that any securities, companies, sectors or markets described will be profitable and past performance is no guarantee of future performance.

Companies, securities and/or markets listed herein are solely for illustrative purposes regarding economic trends and conditions or investment process and

may or may not be held by accounts managed by CSAM. Characteristics and performance of individual client accounts will vary. The information presented

has been prepared on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. No

assurances are provided regarding the reliability of such information. All opinions and views constitute judgments as of the date of writing, are subject to

change at any time without notice. Investing entails risks, including possible loss of principal. The use of tools does not guarantee investment performance.

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