gs $ investment grade index™ gs $ investop™ index · the gs $ investment grade indexes –...

Global Credit Strategy

Fernando Cunha [email protected] New York: 1-212-357-9674

Dana Letendre, CFA [email protected] New York: 1-212-902-3067

Paul K. Feldman [email protected] New York: 1-212-902-7323

Global Credit Strategy Credit Indexes

GS $ Investment Grade Index™ GS $ InvesTop™ Index Rules & Methodology

December 2002

Table of contents 1 The Index Policy Committee

1 GS $ Investment Grade Index™

2 GS $ InvesTop™ Index

5 Monthly rebalancing

5 Calculation methodology

"GS $ InvesTopTM", "GS $ Investment Grade IndexTM" and "Goldman Sachs�" are trademarks of Goldman, Sachs & Co. The methodology of the GS $ InvesTopTM

Index is owned by Goldman, Sachs & Co. and may be covered by one or more patents or pending patent applications.

United States Global Credit Strategy

The GS $ Investment Grade Indexes – Rules & Methodology

The Index Policy Committee The rules of the Goldman Sachs US $ Investment Grade Indexes are governed by the Index Policy Committee. The committee is composed of at least 50% non-Goldman Sachs external members. The committee’s decisions are binding, and decisions are made with unanimity.

The policy committee meets at least once a year to review the rules and composition of the indexes in the light of changing market structure, though it also strives for continuity. If there are exceptional circumstances that affect the entire market or a particular bond, any member can call a meeting to request a ruling from the committee.

GS $ Investment Grade Index™

General selection criteria The Goldman Sachs US $ Investment Grade Index is composed of US dollar-denominated bonds issued by corporate issuers and rated by either (or both) Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Rating Services, a division of The McGraw-Hill Companies, Inc. (“S&P”). The index composition is eligible for rebalancing once a month, after the close of business on the last business day of the month (“the rebalancing date”).

For a bond to be included and remain in the index, it must meet the criteria described below at month-end:

Candidates

�� Denomination and Market. Must be denominated in US dollars and publicly registered in the US with the Securities and Exchange Commission; must also clear and settle through DTC. Globals and Yankees may be included, but Eurobonds are excluded.

�� Corporate Credit. Must be corporate credit, i.e., debt instruments backed by corporate issuers that are not secured by specific assets. Debt of governments, sovereigns, quasi-sovereigns, and government-backed or guaranteed entities is excluded.

�� Geographic Scope. The issuer, or in the case of a finance subsidiary, the issuer’s guarantor, must be domiciled or have most of its operations in the US, Canada, Western Europe (Andorra, Austria, Belgium, Denmark, Faeroe Islands, Finland, France, Germany, Gibraltar, Greece, Iceland, Ireland, Italy, Liechtenstein, Luxembourg, Malta, Monaco, The Netherlands, Norway, Portugal, San Marino, Spain, Sweden, Switzerland, the United Kingdom, and Vatican City State), or Japan.

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Global Credit Strategy United States

�� Agency Ratings. Bonds must be rated at least BBB- by S&P or Baa3 by Moody’s to qualify. Split-rated (e.g., Baa3/BB+ or Ba1/BBB) issues are excluded from the index. After a bond has migrated into investment grade from junk status, it must retain that status for three months before it can be included in the index.

�� Size. The outstanding face value of a candidate bond must be greater than or equal to $500 million. Size changes caused by partial buybacks or add-ons are reflected on the following rebalancing date.

�� Age. New issues must have first settlement dates on or before a rebalancing date to be included in the index for the next period. As of any rebalancing date, bonds must be less than five years old and have at least three years remaining to maturity.

�� Bond Type. Fixed coupon bonds, step-ups with schedules known at issuance (or as functions of the issuer’s rating), sinkables, and zeros are candidates for inclusion. Effective January 1, 2003, medium-term notes (“MTNs”) will also become candidates for inclusion. Preferreds, convertibles, bonds with equity features attached (e.g., warrants), perpetuals, and floating rate notes may not enter the index. All putables are excluded. Make-whole callables are included, but all other callables are excluded.

Bond weighting Bonds are weighted according to their outstanding market capitalization amount.

Subindexes The bonds composing the subindexes are a subset of the bonds in the composite indexes and therefore have to pass the same eligibility tests. Bonds are assigned to specific issuer entities and industry sectors by Goldman Sachs.

Base date The base date for the index is December 31, 1998. Some of the subindexes, however, came into existence after that date.

GS $ InvesTop™ Index The GS $ InvesTop is a basket of 100 bonds,1 rebalanced monthly on the rebalancing date, designed to provide balanced representation of the US dollar investment grade corporate market through some of the most liquid corporate bonds available. All 100 bonds in the basket are equally par-weighted.

General selection criteria 1. Qualified Entrants. Bonds must satisfy all the conditions for inclusion in the GS $

Investment Grade Index.

2. Disqualification. Bonds are automatically disqualified from the InvesTop

1 The number of bonds in the InvesTop Index changed from 30 to 100 on July 1, 2002.

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candidacy for any of the following reasons:

�� Security Type and Issuer. Yankees and all debt issued by Goldman Sachs are excluded.

�� Agency Ratings. Bonds not rated by either Moody’s or S&P are excluded.

�� Chronic Poor Bidding Performance. If a bond’s spread to the government benchmark is 250 bp over the average spread for the GS $ Investment Grade Index for six or more business days during the prior two months, the bond is disqualified from the InvesTop Index candidacy for a period of six months. An incumbent InvesTop Index bond that tests positive will be removed from the index at the next rebalancing date.

�� Spread Volatility. The three-month par asset swap spread histories of all bonds in the GS $ Investment Grade Index are scanned. From each bond’s spread history, the natural logarithm of the standard deviation of the daily changes is computed and recorded into a vector. From the vector of such values, a mean (�) and a standard deviation (�) are computed. Any bond whose value falls outside the range of � ± 2.576� (corresponding to a 1% proportion of the bonds under a normal distribution assumption) is disqualified from the InvesTop Index candidacy for a period of six months. An incumbent bond that tests positive for excessive spread volatility on the rebalancing date will be removed from the InvesTop. A bond with fewer than three months of spread history in the index will automatically test negative.

�� Lockout Period. A bond that drops out of the InvesTop Index at rebalancing faces a three-month lockout period before it can reenter the InvesTop Index. In addition, if the bond has dropped out for testing positive to a disqualification rule and is ineligible for a term beyond three months, that longer ineligibility term will take precedence.

�� Minimum Potential Run. Any bond that enters the InvesTop Index must have a minimum potential run in the index of at least six months. Thus, there must be at least three years and six months remaining to maturity.

3. Liquidity Score. Every bond is assigned a liquidity score that approximates its ease of transaction execution. The liquidity score is an additive composite of three factors:

miumPreIncumbencymiumPreIssuerScoreRawScoreLiquidity ��

�� Raw Score. The Raw Score is a function of the age and size of the bond, with parameters constructed by studying actual trader inputs. The formula reflects the fact that larger issues are more liquid but become less liquid with age.

)3.0exp()15)ln(3( ageavgsizeScoreRaw ��

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where size is the face amount outstanding for the bond in millions, and avg age is the face-weighted average age in years of all add-ons plus the original


principal that are part of the total bond. For example, if a $1 billion face bond that is one year old had a $1 billion add-on six months ago, avg age would be 0.75 year.

�� Issuer Premium. Issuer Premium gives the biggest issuers in the market a higher overall Liquidity Score. The aggregate age-adjusted debt of every issuer (∑ size � exp(-0.3 � avg age)) is calculated, and the largest one identified (MAX).

MAXDebtAdjustedAgeAggregateIssueremiumPrIssuer -

�� 12

The bond with highest Raw Score (of an issuer) is awarded the full Issuer Premium, and every other bond (of the same issuer) is awarded a fraction of the full premium proportionate to the ratio of its Raw Score to the highest Raw Score of the issuer.

�� Incumbency Premium. Bonds that were members of the InvesTop Index in at least the prior month are assigned an Incumbency Premium to their liquidity score to reflect the notion that a new entry candidate would have to outscore an incumbent by a reasonable margin of additional liquidity in order to justify the expense of the trade. Also, incumbent bonds may become naturally more liquid since they will be traded with the InvesTop Index. All bonds from incumbent issuers are granted the following Incumbency Premium:

��

��

��

bondincumbentnonageavgbondincumbentageavg

emiumPrIncumbency-),3.0exp(4.2

),3.0exp(0.6

The non-incumbent bonds from an incumbent issuer are granted a reduced premium to facilitate a potential move to a new issue from the same issuer at the next rebalancing date.

4. Market Profile. To ensure that the InvesTop Index reflects the composition of the broad investment grade market, the GS $ Investment Grade Index is profiled annually every November 1. The date was chosen because it is roughly equivalent to the end of the underwriting season. The broad market is segmented into index cells. The percentage par amounts outstanding of the GS $ Investment Grade Index in each cell determine the bond allocation for the $InvesTop Index during the following 12 months.

The broad market is profiled across industry sector and maturity dimensions by segmenting the bonds into a 4�3 matrix. The four rows represent the industry sectors: Consumer, Finance, Telecommunication & Technology, and Industrials & Utilities. The three columns represent the maturity ranges: three- to seven-years (5yr), seven- to 15-years (10yr), and greater than 15-years (30yr). The current profile is displayed in Exhibit 1.

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Exhibit 1: November 1, 2002, market profile

5 Yr 10 Yr 30 YrConsumer 14 13 6Financial 14 12 2Telecom & Tech. 5 8 6Industrial & Utility 6 10 4

5. Selection Process. While the Market Profile is constant for a whole year, the bonds constituting the InvesTop Index are chosen at the end of every month to “fill the matrix” according to their liquidity scores. The qualified entrants in each cell are ranked based on their liquidity scores and chosen in descending order of liquidity subject to one-issue per issuer per cell. In case there aren’t enough qualified entrants to fill the predetermined number of bonds in any cell, the InvesTop Index is rebalanced with fewer than 100 bonds.

Bond weighting Bonds are equally par-weighted.

Base date The base date for the index is December 31, 1998.

Monthly rebalancing The composition of the indexes is held constant for any given calendar month to ensure continuity during the month and to avoid jumps unrelated to the price movements of the bonds.

�� The inclusion and exclusion criteria above are applied at month-end, after the close of business. If a bond conforms to all criteria listed above at month-end, it will be included in the calculations of the indexes for the next month. Bonds that were in the indexes, but that no longer satisfy all the criteria at month-end, will be removed from the indexes.

�� If a bond becomes eligible in the middle of the month, it will still need to pass the test at the end of the month and can only be included upon rebalancing at month-end.

�� When a bond is called, it remains in the index until the end of the month, after which it is removed.

�� Changes in issue size that take place during the month are taken into consideration only at the next rebalancing date.

Calculation methodology

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The GS $ Investment Grade Index is treated as a portfolio, where each bond’s weight is equal to its market capitalization. The GS $ InvesTop Index attributes the same par weight to each individual bond.


Calculations are made on a daily basis, using mid2 prices provided by Goldman, Sachs & Co. at approximately 3 p.m. Eastern Time, with reference to the market conditions prevailing at that moment.

Total return The components of the total return are price changes, accrued interest, coupon payments, and reinvestment income on cash flows received in the middle of the period.

The month-to-date total return is first computed on a daily basis for each single bond i according to the formula:

)(

)1()()(

,0,0

,0,0,1,1

ii

iiiiii

i APddaysr

CAPAPTRMTD

�

�

��

�

Where:

P0 = Clean (flat) mid price on the rebalancing date. If new, P0 equals the clean (flat) offer-side price on the rebalancing date

P1 = Clean (flat) mid price on the calculation date. If the bond is leaving the index, P1 equals the clean (flat) bid-side price on the rebalancing date.

A0 = Accrued interest as of the rebalancing date

A1 = Accrued interest on the calculation date

C = Coupon payment received

r = US $ one-month LIBID rate as of the coupon payment date

d = Day-count convention for the reference LIBID instrument.

Then, a weighted average of the individual total returns is calculated using the beginning-of-the-period market value of each bond i as follows:

� ��

iBondii weightTRMTDTRIndexMTD

Where, for the GS $ Investment Grade Index

� ��

��

�

jBondjjj

iiii

APAmountFace

APAmountFaceweight

)(

)(

,0,0

,0,0

and for the GS $ InvesTop Index

� �

�

�

jBondjj

iii AP

APweight

)(

)(

,0,0

,0,0

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2 Mid prices are defined as the middle points between the bid- and the offer-side prices.


Index value All indexes were set at 100 at inception on December 30, 1998. The Index Level reflects the cumulative performance of the historically active bonds in the index since inception. It is calculated by

TRIndexMTDLevelIndexLevelIndex dategrebalancindatencalculatio ��

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Goldman, Sachs & Co. or an affiliate makes a market in fixed income securities of issuers discussed in this report and may deal as principal in these securities. Copyright © 2002 by Goldman, Sachs & Co. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based upon this material. This material is for the general information of clients of Goldman Sachs. It does not take into account the particular investment objectives, financial situation or needs of individual clients. Before acting on any advice or recommendation in this material, a client should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. Certain transactions, including those involving futures, options, and high yield securities, give rise to substantial risk and are not suitable for all investors. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Opinions expressed are our current opinions as of the date appearing on this material only. While we endeavor to update on a reasonable basis the information discussed in this material, there may be regulatory, compliance, or other reasons that prevent us from doing so. We and our affiliates, officers, directors, and employees, including persons involved in the preparation or issuance of this material may, from time to time, have long or short positions in, and buy or sell, the securities, or derivatives (including options) thereof, of companies mentioned herein. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without Goldman, Sachs & Co.'s prior written consent. This material has been issued by Goldman, Sachs & Co. and/or one of its affiliates and has been approved by Goldman Sachs International, which is regulated by the Financial Services Authority, in connection with its distribution in the United Kingdom and by Goldman Sachs Canada in connection with its distribution in Canada. This material is distributed in Hong Kong by Goldman Sachs (Asia) L.L.C., in Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch, in Japan by Goldman Sachs (Japan) Ltd., in Australia by Goldman Sachs Australia Pty Limited (ACN 092 589 770), and in Singapore through Goldman Sachs (Singapore) Pte. This material is not for distribution in the United Kingdom to private customers, as that term is defined under the rules of the Financial Services Authority; and any investments, including any convertible bonds or derivatives, mentioned in this material will not be made available by us to any such private customer. Goldman Sachs International and its non-US affiliates may, to the extent permitted under applicable law, have acted upon or used this research, to the extent it relates to non-US issuers, prior to or immediately following its publication. Foreign-currency-denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of, or income derived from, the investment. In addition, investors in securities such as ADRs, the values of which are influenced by foreign currencies, effectively assume currency risk. Further information on any of the securities mentioned in this material may be obtained upon request, and for this purpose persons in Italy should contact Goldman Sachs S.I.M. S.p.A. in Milan, or at its London branch office at 133 Fleet Street, persons in Hong Kong should contact Goldman Sachs (Asia) L.L.C. at 2 Queen's Road Central, and persons in Australia should contact Goldman Sachs Australia Pty Limited. Unless governing law permits otherwise, you must contact a Goldman Sachs entity in your home jurisdiction if you want to use our services in effecting a transaction in the securities mentioned in this material.

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