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Phil Galdi +1 212 449 5545

Research Analyst, MLPF&S

phil_galdi@ml.com

Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 34-35.

Global Bond Indices & Analytics

Closing the gaps in fixed income performance measurement

10631849

5 October 2007

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The missing performance factorsThe missing performance factors

Policy DecisionFactors

BenchmarkSelection Factor

MarketFactors

Income CurveShift

CurveReshape

Volatility SectorSelection

BondSelection

PortfolioPerformance

IndexReturn

PortfolioReturn

Investment decisions

3

Policy choices affect results…Policy choices affect results…

Investment Universe

PolicyUniverse C

PolicyUniverse B

PolicyUniverse A

Investment universe return

─ Policy universe return

Policy selection factor

4

……as do benchmark choices within as do benchmark choices within those policy decisionsthose policy decisions

Investment Universe

Policy Universe

Index C

Index BIndex A

Policy universe return

─ Index return

Index selection factor

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Watch out for non-compliant indices!Watch out for non-compliant indices!

Investment Universe

Policy Universe

Index A

Common causes of non-compliant indices:

Inclusion of ineligible securities

Sector/issuer concentrations exceed limits

Duration out of range

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Decomposing non-compliant index Decomposing non-compliant index performanceperformance

Policy performance factor

TRRinvestment universe – TRR(policy universe U index)

Portfolio performance factors:

1) Uncontrollable portfolio performance factor

[ TRRportfolio – (TRR[ index – (policy universe ∩ index) ] ) ]X uninvestible index weight

2) Controllable portfolio performance factors

[ TRRportfolio – TRR(policy universe ∩ index) ]X investible index weight

where TRR = total rate of return

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Decomposing non-compliant index Decomposing non-compliant index performance (duration adjusted)performance (duration adjusted)

Policy performance factorTRRinvestment universe – TRR(policy universe U index)

Portfolio performance factors:

1) Uncontrollable portfolio performance factor

[ ERportfolio – (ER[ index – (policy universe ∩ index) ] ) ]X uninvestible index weight

2) Controllable portfolio performance factors

[ TRRportfolio – ERportfolio ) ─ (TRRindex – ERindex ) ] + [ ( ERportfolio – ER(policy universe ∩ index) ) X investible index weight ]

where TRR = total rate of return; ER = excess return over risk matched Treasuries

(Note: the above formulation assumes that the portfolio is able to match index interest rate and yield curve risks)

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Index customization can reduce or Index customization can reduce or eliminate policy varianceseliminate policy variances

Investment Universe

Policy Universe

Index A1

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Liability-based portfolios pose Liability-based portfolios pose particular problemsparticular problems

Insurers– Complexities include:

Liability and policy requirements Accounting treatment (historical amortized cost) Taxation “Buy-and-hold” tendencies Recognized gain/loss limits, or directives

– External managers: most use standard market-cap indices

– In-house managers: most use homegrown proxies, or nothing at all Pensions

– Most use standard market-cap indices

– Liability durations are typically much longer than the benchmarks

– Funding status of many plans has eroded…

…while many PMs happily report “outperformance”!

– New trend toward liability-driven investment (LDI) strategies

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Building relevant book income Building relevant book income performance measuresperformance measures

Index rules aligned with policy guidelines– Duration requirements

– Targeted asset allocations

– Concentration limits

– Etc. Purchase lot accounting for index constituents Index receives funding concurrent with the portfolio Index meets portfolio gain/loss constraints or directives Results include book income AND total return metrics

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Performance indices should be Performance indices should be aligned with policy guidelinesaligned with policy guidelines

com

plia

nce

revi

ewInvestment/ Compliance Depts.

Portfolio Performance

Performance Measurement Dept.

Index Provisioning

Investment Policy

Guidelines

Portfolio Manager Security Selection

PortfolioHoldings/

Performance

Index Holdings/ Performance

Index Rules

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Index and portfolio accounting Index and portfolio accounting should be consistentshould be consistent

Bond valuations:– The index purchases securities at current market yields

– Thereafter securities are carried in the index at their book yields/prices (the market yield at which they entered the Index)

– Securities exit the index at market yields/prices Ordinary book income is calculated monthly on a scientific yield basis

(change in book price + change in accrued + coupons received) Capital gains/(losses) are calculated when bonds exit the index

(market price – book price)

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The index should get funding at the The index should get funding at the same time as the portfolio…same time as the portfolio…

Source: Merrill Lynch Global Indices

ML Treasury Index Book Yields Assuming Varying Start DatesML Treasury Index Book Yields Assuming Varying Start Dates

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Book performance is dependent on Book performance is dependent on the timing of cash flows the timing of cash flows

Source: Merrill Lynch Global Indices

Change in Book Yield

Market Yield

Portfolio A (funded 12/96)

Portfolio B (funded 12/98)

Portfolio C (funded 12/00)

Portfolio D (funded 12/02)

Portfolio D vs.

Portfolio A

Last year 0.54 -0.14 -0.02 -0.03 0.28 0.42 Last 2 years 0.77 -0.73 -0.48 -0.48 0.47 1.20

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Book income index constructionBook income index constructionstep 1: define the index rulesstep 1: define the index rules

Select the eligible assets and weighting scheme: Determine the preferred benchmark characteristics (e.g., duration,

asset allocation targets, issuer caps, etc.)– Distinguish between “hard” and “soft” characteristic targets

Hard targets: policy requirements that must be met Soft targets: achieved with new cash flows, but do not trigger sales

Develop a program of custom “index rules” that takes account of the targeted characteristics

Custom index rules are modified over time to reflect changes in policy

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Duration targets are usually defined Duration targets are usually defined as a range, not a pointas a range, not a point

Upper duration boundary

Lower duration boundary

Duration-neutral position

Index duration

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Policy changes are rarely Policy changes are rarely implemented overnightimplemented overnight

The portfolio typically migrates to the new targets– Through investment of cash flow

– Through gradual re-allocations of existing holdings The index should also converge on the new targets over time

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Book income index constructionBook income index constructionstep 2: inception date holdingsstep 2: inception date holdings

Assemble the inception date index holdings: Current investment staff and policies in place for a while:

– Match the target index characteristics, and

– Portfolio distribution across purchase dates

– Quantifies cumulative performance

AND/OR

Recent change in investment staff or policy or goal is to measure impact of current period decisions:– Match actual portfolio characteristics, and

– Portfolio distribution across purchase dates

– Quantifies current period performance

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Book income index constructionBook income index constructionstep 3: ongoing rebalancingstep 3: ongoing rebalancing

Match target index characteristics/reinvestment rules– Can use buy and hold investment style subject to policy conditions

Invest or withdraw cash from:– Index endogenous cash flows (i.e., coupons and redemptions)

– Portfolio exogenous inflows and outflows (i.e., new deposits or withdrawals Meet portfolio gain/loss constraints

– Directive to realize a cap gain/loss target requires additional sales, the proceeds of which must be reinvested at current market yields

– Restrictions on gain/loss recognition may impact the ability to match the risk structure of the target index

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Key investment performance metricsKey investment performance metrics

Performance statistics can include:– Book yield– Book return

Ordinary income Realized capital gains/losses

– Unrealized gains/losses– Total return

Book AND total return results compiled on a:– Pre-tax basis– After-tax basis

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Total Return

OrdinaryIncome

Realized CapGain/Loss

Change inUnrealized Cap

Gain/Loss

Acc

ount

ing

Ret

urn

Attr

ibut

ion

Fac

tors

Market Return Attribution Factors

Income CurveShift

CurveReshape

Volatility SectorSelection

BondSelection

Book income and total return are not Book income and total return are not mutually exclusivemutually exclusive

Sector Decisions

Bond Decisions

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Measuring the person vs. the policyMeasuring the person vs. the policy

Measure the investment managers versus a benchmark that reflects existing policy

Measure the current policy benchmark versus an alternative that reflects possible changes in:– Eligible asset classes

– Asset allocation targets

– Duration targets

– Concentration limits

– Gain/loss constraints

– Etc. It is best to independently measure the impact of each possible

change in policy

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Unbundling investment performanceUnbundling investment performance

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Limitations of current pension Limitations of current pension benchmarking practicesbenchmarking practices

Traditional bond market indices do not offer sufficient duration– Broad bond indices have a third of the interest rate exposure of most plans

– Even long indices (e.g., 10+ year) are well short of liability durations LDI managers typically create their own custom indices comprised of

a blended basket of several published indices– Match custom index basket interest rate sensitivity to the liabilities

(duration, key rate duration, etc.)─ OR ─

– Use an asset allocation model to find an efficient blend of assets (indices) that will outperform the liabilities while minimizing risk of underperformance

Blended indices may solve the duration problem, but…– Fail to measure the impact of asset allocation decisions implicit in the

design of the blended index

– Not an arms length measurement process The solution: benchmark plan asset performance to liability returns

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US Pension Indices are based on US Pension Indices are based on “typical” US pension liabilities“typical” US pension liabilities

0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69

Retiree Plan Mature Plan Av erage Plan Young Plan

Source: Mercer

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Liability returns are derived directly Liability returns are derived directly from the pension cash flowsfrom the pension cash flows

Discount projected liability cash flows at spot curve rates Liability return = % change in the NPV of the liabilities

– Discount cash flows at beginning of month spot curve (NPV1)

– Roll cash flows down the curve and discount at end of month spot curve (NPV2)

– Return = NPV2 / NPV1 - 1

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US Pension Indices are compiled US Pension Indices are compiled using four alternate discount curvesusing four alternate discount curves

US Treasury off-the-run spot curve Par swap spot curve AAA-A corporate spot curve

– Fit the spread curve from observed AAA-A index constituent spreads

– Add the spread curve to the par coupon Treasury curve to produce a par coupon AAA-A par yield curve

– Bootstrap the par corporate curve to produce the spot curve 3-tier AAA-A corporate spot curve with 24-month historical smoothing

– Simple average of spot rates across three maturity buckets: 0.5-5.0 year 5.5-20.0 year 20.5-30.0 year

– Moving average of current day rates and rates on the 23 preceding month-end dates

30-year spot rate held constant to discount liabilities beyond 30 years

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Comparative spot discount curvesComparative spot discount curves(as of 8/31/07)(as of 8/31/07)

3

3.5

4

4.5

5

5.5

6

6.5

7

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Treasury Sw ap AAA-A Corporate 3-Tier AAA-A Corporate

Source: Merrill Lynch Global Bond Indices

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Constructing an investible liability Constructing an investible liability indexindex

A discounted set of pension cash flows is not an investible index A tradeable swap index comprised of a single long-duration zero

swap is not a liability index An investible liability benchmark is:

– Interest rate neutral to the liability returns Rate risk Curve risk

– Comprised of actual securities that can be traded, e.g.: Combinations of Treasury Notes, Bonds and/or STRIPs Par coupon and/or zero swaps

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Assembling Tradeable US Pension Assembling Tradeable US Pension IndicesIndices

Calculate the key rate durations of the projected plan liabilities for each of the four typical plans

Structure blended baskets of funded par swaps that are KRD-matched to the liabilities

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The tradeable indices do a very good The tradeable indices do a very good job of tracking the liabilitiesjob of tracking the liabilities

Source: Merrill Lynch Global Bond Indices

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Mechanics of the Tradeable US Mechanics of the Tradeable US Pension IndicesPension Indices

Each index is comprised of a 3-month Libid cash asset and five par coupon swaps (2-, 5-, 10-, 20- and 30-year)– Cash position equals the NPV of the corresponding liability index

– Par swap notional values set so as to match liability KRDs Daily valuations:

– Par swaps are priced using the mid-market par swap curve as of 3pm Rates sourced from ML trading desks

– The cash Libid asset is priced off BBA 11am Libor fixing rates minus 12.5 bps

Rebalancing takes place on the last business day of the month– All positions are rolled to constant maturities

Regular settlement for all valuations (T+2)

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Comparison of alternative US Comparison of alternative US Pension IndicesPension Indices

Date

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Important Disclosures

The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill Lynch, including profits derived from investment banking revenues.

Date

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