2013 Leveraged Credit Outlook

INVESTMENT PROFESSIONALS

B. SCOTT MINERD

Chief Investment Officer

ANTHONY D. MINELLA, CFA

Co-Head of Corporate Credit

MICHAEL P. DAMASO

Co-Head of Corporate Credit

JEFFREY B. ABRAMS

Senior Managing Director, Portfolio Manager

KEVIN H. GUNDERSEN, CFA

Managing Director, Portfolio Manager

KELECHI OGBUNAMIRI

Associate, Investment Research

JANUARY 2013

High Yield and Bank Loan Outlook

As we kick off 2013, there is a noticeably cautious tenor surrounding the leveraged credit market. Although 2012 saw impressive returns in the high yield bond and leveraged loan markets of 14.7 and 9.4 percent, respectively, few are expecting a repeat of this performance. Since December 2008, the high yield bond and leveraged loan markets have recorded annualized average returns of 22 and 14 percent, respectively, but record high prices, historically low yields, and gradually deteriorating fundamentals have tempered forward expectations with forecasts calling for single digit returns.

Muted optimism aside, the leveraged credit market remains the primary destination of choice for investors seeking yield in the fixed income market. Despite leverage stealthily ticking up towards post-recession highs and the return of increasingly aggressive deal structures, investors are seemingly willing to trade covenant protection for higher yields. While the demand for yield and accommodative monetary policy provide strong, technical undercurrents, generating above-market returns will require an even greater emphasis on fundamental credit analysis to unearth undervalued opportunities. We believe bank loans, particularly upper middle-market financings, offer attractive relative value going forward.

REPORT HIGHLIGHTS:

• Rebounding from a 1.8 percent return in 2011, bank loans gained 9.4 percent in2012. High yield bonds returned 14.7 percent in 2012, compared to 5.5 percentin 2011.

• Nominally low yields throughout the fixed income universe drove capitalinto the leveraged credit sector, with issuers responding with record level supply.2012 high yield bond issuance totaled $346 billion, the most ever, while the loanmarket enjoyed its highest level of issuance since 2007.

• Since 1992, the Credit Suisse Leveraged Loan Index, on average, has yielded 130basis points less than the Credit Suisse High Yield Index. With bond yields finishingthe year at 6.25 percent, the lowest level on record, this differential has narrowed to30 basis points, increasing the relative value of bank loans.

• As default rates have stabilized below historical averages, investors havebeen willing to tolerate increased credit risk in exchange for incremental yield.During 2012, covenant-lite loans represented 33 percent of total bank loan issuance,three times the average of the previous four years.

INSTITUTIONAL INVESTOR COMMENTARY IG • HY • ABS • CMBS • RMBS

HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

CREDIT SUISSE HIGH YIELD INDEX RETURNS CREDIT SUISSE LEVERAGED LOAN INDEX RETURNS

SOURCE: CREDIT SUISSE. DATA AS OF DECEMBER 31, 2012.

■ Q3 2012 ■ Q4 2012 ■ Q3 2012 ■ Q4 2012

SOURCE: CREDIT SUISSE. EXCLUDES SPLIT B HIGH YIELD BONDS AND BANK LOANS. *DISCOUNT MARGIN TO MATURITY ASSUMES THREE-YEAR AVERAGE LIFE.

Leveraged Credit Scorecard AS OF MONTH END

HIGH YIELD BONDS

Dec-11 Oct-12 Nov-12 Dec-12Spread Yield Spread Yield Spread Yield Spread Yield

Credit Suisse High Yield Index 728 8.23% 581 6.54% 583 6.49% 554 6.25%

Split BBB 402 5.17% 309 4.19% 314 4.16% 302 4.16%

BB 511 6.04% 390 4.72% 398 4.74% 376 4.58%

Split BB 597 6.85% 481 5.47% 470 5.27% 442 5.03%

B 740 8.23% 594 6.60% 591 6.49% 566 6.27%

CCC / Split CCC 1,384 14.94% 1,030 10.96% 1,013 10.68% 958 10.21%

BANK LOANS

Dec-11 Oct-12 Nov-12 Dec-12DMM* Price DMM* Price DMM* Price DMM* Price

Credit Suisse Leveraged Loan Index 656 92.19 557 96.23 561 96.28 555 96.60

Split BBB 325 99.30 302 100.11 300 100.22 296 100.30

BB 444 97.74 393 99.98 391 100.05 385 100.22

Split BB 542 96.91 483 100.02 485 100.12 486 100.26

B 726 92.89 582 98.28 584 98.35 584 98.58

CCC / Split CCC 1,615 71.23 1,415 77.29 1,420 77.65 1,359 79.39

4.3%

1%

0%

2%

3%

4%

5%

6%

Index Split BBB BB B

Split BB

CCC / Split CCC

3.1%

2.1%

3.1%

2.6%

3.5%

4.2% 4.1% 4.1%

4.5% 4.6%

3.7%

1%

0%

2%

3%

4%

5%

6%

Index Split BBB BB B

Split BB

CCC / Split CCC

1.5% 1.7%

1.5%

3.1%

1.6%

2.2% 2.6%

3.4%

5.7%

1.1%

1.5%

-0.3%


Macroeconomic OverviewU.S. ECONOMIC EXPANSION REMAINS RESILIENT AMID MACRO HEADWINDS

Although Europe remains in a recession, more importantly, the political process towards fiscal

unity appears to be underway with the initial steps taken towards the creation of a banking

union. This has, for the time being, eliminated the ‘worst case scenario’ – an unwinding of the

European Union. With a centralized regulator in Europe, it will be much easier for the European

Central Bank to manage the individual financial crises within each country. As the structural

outlook in Europe improves, albeit at a glacial pace, tail risk is significantly mitigated.

Amid this slow, but encouraging progress in Europe, the markets have now begun focusing

on the U.S. debt ceiling debate, following Congress’ New Year’s reprieve on the Fiscal Cliff.

Despite the uncertainty created by political bipartisanship in Washington, the strength of

recent U.S. economic data demonstrates the resilience of the current U.S. economic expansion:

Industrial Production advanced 1.1 percent month-over-month in November, the most since

December 2010; initial jobless claims four-week moving average has fallen to a level last seen

in April 2008; and revised third quarter GDP surpassed expectations. Future GDP growth

should be buttressed by the continued recovery in the housing market. In its most recent

reading, the National Association of Home Builders (NAHB) Index surged to the highest level

since April 2006, as national home prices have risen 4.3 percent year-over-year. Continued

growth in U.S. household formation, which increased by 1.2 million in 2012, compared to an

annual average of 670,000 during the prior four years, should help absorb the current excess

housing inventory by 2015.

On the monetary front, the Federal Reserve is likely to continue with its asset purchase

program throughout 2013 in its effort to combat long-term structural unemployment.

A continuation of quantitative easing (QE), coupled with the acceleration in home price

appreciation, serve as significant tailwinds for long-term growth prospects. While this is

a longer-term forecast, it is not too early for investors to start positioning their portfolios

for an age of greater prosperity in the United States. In the fixed income domain, abundant

liquidity and the continuation of open-ended QE suggest a benign credit environment with

low default rates, which is constructive for select below-investment grade credit and asset-

backed securities.

“A greater portion of investment activity in the high yield market is now based on investors simply wanting to own the asset class. As a result, it has become harder to find the same level of value previously experienced in the below-investment grade market. While there is still a fair amount of room for spreads to tighten further, investors should be aware of the shift in the environment and adjust investment decisions accordingly.”

– Scott Minerd, Chief Investment Officer


HIGH YIELD BOND SPREADS FOLLOWING END OF RECESSIONThe typical credit cycle, following a recession, has historically lasted anywhere from 60 to 80 months before spreads began to widen. With January 2013 representing only the 43rd month post-recession, opportunities exist, but have become harder to come by at current valuations.

200bps

400bps

600bps

1000bps

800bps

300bps

500bps

700bps

1,100bps

900bps

1,200bps

0 10 20 30 40 50 60 70 80 90 100 110 120

R2 = 0.605

Number of Months Following End of Recession

Cred

it Su

isse

Hig

h Yi

eld

Bond

Spr

eads

Dec. 2012


2012 Leveraged Credit RecapBENIGN CREDIT CONDITIONS DRIVE STRONG PERFORMANCE

The Credit Suisse High Yield and Leveraged Loan Index posted gains of 3.1 and 1.5 percent,

respectively, in the fourth quarter, capping off a stellar year in the leveraged credit market.

The impressive performance in 2012 stands in stark contrast to the turbulent market conditions

of 2011, which were marred by geopolitical concerns such as the European sovereign debt

crisis and U.S. debt ceiling debate. Rebounding from a 1.8 percent return in 2011, bank loans

gained 9.4 percent, the sixth best annual performance on record. Meanwhile, high yield bonds

returned 14.7 percent, the third largest annual gain over the past fifteen years, compared to

5.5 percent in 2011. In 2012, the high yield bond market experienced only one negative month,

a 1.3 percent loss in May. This compares favorably to the highly volatile markets during 2011,

where four of the last seven months of the year saw negative performance, including a 3.7

percent loss in August.

The unprecedented global monetary accommodation, which resulted in low default rates and

ample liquidity, coupled with the search for yield, created a conducive environment for high

yield bonds and bank loans. With yields on Treasuries remaining largely range-bound and the

Barclays U.S. Corporate Investment Grade Index yielding 2.71 percent, just off the all-time

lows, the leveraged credit sector continued to benefit from the dearth of viable fixed income

alternatives. The following are key themes and trends that highlighted the market in 2012:

• Aggregate leveraged credit issuance totaled $640 billion in 2012, the most ever. Fifty-two

percent of new issue proceeds were used to refinance existing debt. Replacing expensive

capital structures with lower cost funding lifted the median interest coverage ratio to 3.8x,

compared to 3.1x at the end of 2009.

• The strong demand for yield created a positive technical bid for the leveraged credit market.

During 2012, bond spreads tightened by 175 basis points, as yields fell to a historical low

of 6.25 percent.

• Bank loans benefitted from the resurgence of the collateralized loan obligation (CLO) market.

CLO issuance totaled $55 billion in 2012, four times the previous year’s total. In the latter

half of the year, the relative value of bank loans attracted strong retail flows. Loan funds

experienced 18 consecutive weeks of positive flows to end the year.

• Robust demand has led to a surge in opportunistic issuance. For the year, covenant-lite loans

represented 33 percent of total bank loan issuance, three times the average of the previous

four years. In the bond market, aggressive payment-in-kind (PIK) toggle notes reappeared.

Nineteen PIK toggle deals priced, raising total proceeds of $6.7 billion, exceeding the

aggregate proceeds of the previous three years.


2,000bps

1,600bps

1,200bps

800bps

400bps

0bps

25%

20%

15%

5%

10%

0%1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

AVERAGE: 591bps

AVERAGE: 11.1%

In 2012, a benign credit environment and the need for yield propelled the leveraged credit

sector higher. While both of these factors are still in play, rich valuations and increasingly

aggressive trends in the new issue market may impede further appreciation in high yield bonds

and bank loans.

Buyer BewareCALLABILITY LIMITS UPSIDE IN SECONDARY MARKET

While equity investors enjoy the theoretical luxury of unlimited upside, valuations in the

leveraged credit sector have traditionally been constrained by yields. Historically, there has

been an assumed yield floor – or minimum acceptable yield investors required to own highly

leveraged credit securities – of around 7 percent. Prior to 2012, the Credit Suisse High Yield

Index had closed below 7 percent on a monthly basis just six times, and in each instance, yields

quickly retraced off this level in subsequent months. Firmly dispelling the notion of a yield floor,

Index yields have now closed below 7 percent for five consecutive months, ending 2012 at 6.25

percent. With all-in yields no longer a reliable gauge for valuation, evaluating prices may be

more constructive in determining the potential for further appreciation.

With the Credit Suisse High Yield Index ending the year at $104.61, just shy of the all-time high,

and the Credit Suisse Leveraged Loan Index finishing at a five-year high of $96.60, callability

may largely dictate the potential for further price appreciation. High yield bonds typically

include call protection for a period equal to half of the bond’s stated maturity. After that period,

the issuer has the right to redeem the bonds at a pre-determined premium to par. Bank loans,

on the other hand, have historically not offered any call protection.

CREDIT SUISSE HIGH YIELD INDEX HISTORICAL SNAPSHOT


■ Yield (LHS) ■ Spread (RHS)

YIELD SPREADHIGH 20.5% 1,816LOW 6.2% 271LAST 6.2% 554

The lack of yield in fixed income alternatives continues to steer capital into the high yield sector. After closing 2012 with a yield of 6.25 percent, could the Credit Suisse High Yield Index break 6 percent in 2013?


A relatively recent advent in new issue bank loans has been the inclusion of “101 soft call

protection” in refinancings, which forces issuers to pay a one percent premium to reprice loans

in the first year. After that initial year of soft protection, loans become freely callable at par.

At current levels, broadly investing in the secondary market may result in simply clipping

interest coupons and thus increases the relative value of new issue bank loans, which tend to

price at discounts to par, and new issue high yield bonds that may offer greater call protection.

As investors flock to the new issue market, this has shifted the balance of power from investors

to issuers.

LIMITED POTENTIAL FOR PRICE APPRECIATION IN SECONDARY MARKET BONDS

SOURCE: BOFA MERRILL LYNCH. DATA AS OF DECEMBER 31, 2012.

Over the past year, the percent of high yield bonds trading at par or better has increased from 62 percent to 86 percent. The upside in these secondary market credits is limited given their callability. New issue bonds offer considerably more potential for price appreciation.

■ 2011 ■ 2012

15%

10%

5%

0%

20%

25%

30%

35%

40%

<80 80<--->85 85<--->90 90<--->95 95<--->100 100<--->105 105<--->110 110+

% o

f Ind

ex M

arke

t Val

ue

Price

86% of Index Trading at Par or Better

6%

1% 2%

6%

22%

27%

37%

2% 5% 6%

23%

31%

vs. 62% at End of 2011

18%

3%

9%

3%

12%

10%

8%

6%

14%

16%

18%

20%

22%

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

HISTORICAL FLOOR = 7%

Aug.12

7%

BONDS PIERCE THROUGH HISTORICAL YIELD FLOOR


Index yields crossed the formerly sacrosanct 7 percent threshold in August 2012 and have not looked back. Going forward, valuation in the high yield bond market should be discussed in the context of prices, and specifically, call ceilings.


New Issue Market TrendsDEMAND FOR YIELD OBSCURING RISING SECTOR RISKS

The recovery of the new issue market over the past four years has been truly remarkable.

At the end of 2008, the prospects for the leveraged credit sector appeared extremely bleak.

The ‘04-‘07 vintage leveraged buyout (LBO) financings, issued at the peak of the credit

cycle, were set to mature over the next several years. However, waning risk appetite among

investors and investment banks created a massive supply / demand imbalance. After high

yield borrowers had amassed $880 billion of debt maturing between 2012 and 2014, the capital

markets froze. Leveraged credit issuance in 2008 totaled $141 billion, a precipitous decline

from the $426 billion annual average of the preceding three-year period. With insufficient

demand to refinance near-term debt, leveraged credit default rates spiked to 14 percent by

the end of 2009.

An entirely different dynamic exists today in the new issue market, where demand is outpacing

supply. Of the $1.5 trillion of leveraged credit debt issued over the past three years, more than

half has been used for refinancings, easing concerns over the debt maturity wall that existed

at the end of 2008. This high level of refinancing activity has limited the net new supply of

leveraged credit securities at a time of growing demand for high yield bonds and bank loans.

Despite bond yields falling to historical lows, sustained demand drove 2012 high yield bond

issuance to $346 billion, the most ever, while the loan market enjoyed its highest level of

issuance since 2007. Looking ahead, with only $298 billion of debt set to mature over the next

three years, refinancing supply alone is likely inadequate to satisfy the demand of yield-starved

investors. To fill this void, issuers have turned to increased opportunistic issuance.

COMPARISON OF DEBT MATURITY WALL AT END OF 2008 VS. 2012


The wave of refinancings has greatly diminished the amount of near-term debt maturities. Based on the 2012 average of $30 billion in monthly refinancings, the $298 billion in leverage debt maturing over the next three years could be refinanced as quickly as October 2013.

2013 2014 2015 2016 2017 2018 2013 2014 2015 2016 2017 2018

$100Bn

$150Bn

$0Bn

$50Bn

$200Bn

$250Bn

$300Bn

$350Bn

$60Bn

$80Bn

$0Bn

$40Bn

$20Bn

$100Bn

$120Bn

$140Bn

$160Bn

$180Bn

224

9

51 67

3819

115

1

204

90

23

104

36

119

82 88 85

65

141

156

290165

■ 2008 ■ 2012

LEVERAGED LOAN HIGH YIELD BOND


Shareholder dividends financed through the leveraged loan market represented

14 percent of total issuance compared to an average of 8 percent over the last five years.

Dividend recapitalizations represent another method private equity firms can use to monetize

their investments as sponsor-IPO volumes remain tepid. Additionally, many corporations

sought to preempt any potentially adverse tax changes that may have occurred as a result

of the Fiscal Cliff. While sponsors were taking capital out of existing deals, they were also

contributing less in new deals. In 2009, equity capital constituted 46 percent of total LBO

financing, but that number has since fallen to 38 percent by the end of 2012.

Incremental yield in the loan market has been generated at the expense of investor protections.

Covenant-lite issuance, as a percent of total issuance, totaled 33 percent, the most ever.

Underscoring the fact that this is likely not a fleeting trend, the structure of CLOs, the largest

buyers of bank loans, has begun to evolve accordingly. Recent CLOs have increased the

maximum allowance for covenant-lite loans from 30 percent to as much as 70 percent.

TEN LARGEST CLOs OF 2012

SOURCE: S&P LCD. DATA AS OF DECEMBER 31, 2012. INCLUDES BROADLY SYNDICATED CLOs.

The CLO market thrived in 2012 with $55 billion raised, including Guggenheim’s $1.05 billion CLO, the largest market-cash flow fund on record. Signaling that the market expects covenant-lite issuance to remain robust, recent CLOs have allowed for up to 70 percent allocations to covenant-lite loans.

CLO Manager Size ($mm) Date Cov-Lite Loans

Mercer Field CLO Guggenheim Partners Investment Management 1,054 Dec-12 60%

Madison Park Funding X Credit Suisse Asset Management 802 Nov-12 40%

OHA Credit Partners VII OakHill Advisors 770 Oct-12 50%

Venture XII CLO MJX Asset Management 750 Dec-12 40%

CIFC Funding 2012-II CIFC Asset Management/Greensledge 748 Oct-12 40%

ALM VII Apollo Credit Management 722 Oct-12 70%

Ares XXIV Ares CLO Management XXIV 719 Aug-12 30%

OHA Credit Partners VI Oak Hill Advisors 674 Apr-12 50%

Octagon Investment Partners XIV Octagon Credit Investors 626 Nov-12 50%

Northwoods Capital IX Angelo, Gordon & Co. 626 Nov-12 50%

LBO FINANCING TRENDS

SOURCE: S&P LCD. DATA AS OF DECEMBER 31, 2012. EQUITY CONTRIBUTION EXCLUDES ROLLOVER EQUITY. PURCHASE PRICE MULTIPLE INCLUDES FEES AND EXPENSES.

Since bottoming in 2009, LBO purchase price multiples have begun trending up. With access to cheap financing, sponsors’ equity contribution has dropped to 38 percent, not far off from pre-crisis levels.

■ Equity Contribution (LHS) ■ Purchase Price Multiple (RHS)

5x

6x

7x

9x

8x

10x

25%

30%

35%

45%

40%

50%

7.6

7.1

6.0

6.6

7.1 7.3

8.4 8.4

9.7

9.1

7.7

8.5 8.7

7.8

1997 2000 2003 2006 2009 20121998 2001 2004 2007 20101999 2002 2005 2008 2011

8.8

6.7


Amid a loan pipeline swelling with covenant-lite issuance, and the increased frequency of PIK

toggle structures, there is a natural tendency to draw parallels to the previous credit cycle.

While debt burdens have increased slightly, recent refinancings have extended near-term

debt maturities. Additionally, with coverage ratios at the highest levels in three years and

an improving U.S. economy, near-term event risk has been greatly diminished.

As seen in the chart above, credit fundamentals, on an absolute basis, have slightly

deteriorated, despite the recovery in the U.S. economy. This has largely been driven by the

scarcity of yield in the credit markets, which has forced lenders to take on incremental financial

risk in the form of additional leverage, and fewer structural protections (covenants) over the

past two years. However, current conditions remain far from the frothy market conditions

observed at the peak of the credit cycle in 2007, as illustrated in the table below. 2013 will

continue to be a credit pickers’ market where investors will have to discern which market

segments offer attractive relative value. In the following sections, we highlight the value

proposition in bank loans, specifically upper middle-market financings.

While, admittedly, risks are rising in the leveraged credit sector, investors should be hesitant to draw parallels to 2007, which was punctuated by M&A and LBO financings, constituting 62 percent of all issuance and PIK toggle deals, representing 14 percent of high yield bond issuance.

A TALE OF TWO MARKETS

SOURCE: S&P LCD. DATA AS OF DECEMBER 31, 2012.

2007 2012

Refinancings as % of Total Issuance 21% 52%

M&A and LBO Financings as % of Total Issuance 62% 27%

Covenant-Lite as % of Total Loan Issuance 30% 33%

PIK Toggle as % of Total Bond Issuance 14% 2%

Equity Contribution as % of Total LBO Financing 31% 38%

LBO Purchase Price Multiples 9.7x 8.5x

2x

3x

4x

5x

2x

3x

4x

5x

1997 1999 2001 2003 2005 2007 2009 2011

1997 1999 2001 2003 2005 2007 2009 2011

Leverage

Coverage

As high yield issuers have spent the past three years locking in cheap, long-term financing, coverage ratios have improved, rising almost a full turn since 2009. With near-term debt obligations extended, issuers have now begun releveraging. Currently, high yield sector leverage stands at 4.1x EBITDA, the highest level in over two years.

RECENT CREDIT TRENDS IN THE HIGH YIELD SECTOR

SOURCE: MORGAN STANLEY. DATA AS OF SEPTEMBER 30, 2012.


Upper Middle-Market Opportunities IDENTIFYING MARKET SEGMENTS WHERE INVESTORS CAN CREATE VALUE

The robust demand for new issuance has clearly tilted the balance of power in favor of issuers.

Issuers have capitalized on this leverage to cut spreads, raise prices, and, in the case of bank

loans, drop covenants. Even after employing reverse flex to the initial terms, many of these

deals are still heavily oversubscribed, relegating investors to price takers fighting for allocations.

As a result of these current dynamics, in the context of financings from well-known, repeat

issuers, investors have limited opportunities to create value by working with underwriters and

sponsors in order to help structure transactions and provide feedback.

One area where investors still have the opportunity to drive outcomes is in upper middle-

market financings, which generally consist of deals from smaller companies, first-time issuers

or growing businesses in newer, yet fundamentally sound industries. We define upper middle-

market as high yield bond and bank loan tranches between $300 and $750 million. While these

segments are typically assumed to be less liquid, they actually represent fairly sizable portions

of the leveraged credit market, over 40 percent of the high yield market and nearly a third of

bank loans.

An increased level of dialogue and communication can enable underwriters to price deals more

appropriately, while sponsors get long-term partners in their deals. Generally more prevalent

on the bank loan side, our feedback on structuring transactions has resulted in greater

protections for investors such as limited restricted payments, tighter financial covenants,

and greater call protection.

Upper middle-market tranches offer yield pickup of approximately 30 basis points in high yield bonds and 60 basis points in bank loans over similarly-rated, larger debt tranches. In select transactions, investors have the ability to drive deal terms, an opportunity generally not available in larger debt tranche offerings.

Size ($mm) Market Weight Yield to Worst

<300 12.3% 7.6%

300 – 400 11.3% 6.4%

400 – 500 10.7% 5.9%

500 – 750 21.8% 5.4%

750 – 1000 12.5% 5.3%

>=1000 31.5% 5.5%

BARCLAYS CORPORATE HIGH YIELD INDEX

CREDIT SUISSE LEVERAGED LOAN INDEX

Size ($mm) Market Weight Discount Margin to Maturity

<300 15.8% 763

300 – 400 9.2% 628

400 – 500 6.3% 575

500 – 750 16.5% 526

750 – 1000 10.2% 523

>=1000 42.0% 536

SOURCE: BARCLAYS, CREDIT SUISSE. DATA AS OF DECEMBER 31, 2012. BARCLAYS CORPORATE HIGH YIELD INDEX EXCLUDES BONDS TRADING AT A PRICE BELOW 80.


Relative Value of Bank Loans SHRINKING BOND YIELDS CREATING ATTRACTIVE CAPITAL STRUCTURE ARBITRAGE

While the excess liquidity injected into the financial system by the Fed has enabled

high yield issuers to refinance over $300 billion of debt in 2012 and has also kept default rates

stable, seemingly benign credit conditions may be casting a false sense of security among

leveraged credit investors. Historically, default rates have proven to be lagging indicators,

but more importantly, focusing solely on credit metrics fails to provide a complete picture

of the risks associated with investing in the sector.

In the years ahead, interest rate risk may supplant credit risk as the primary determinant

of long-term performance for high yield bonds. As monetary policy continues to artificially

depress interest rates, investors may not be accurately discounting and positioning portfolios

for the inevitable rise in rates. Underscoring the increased importance of interest rate risk,

a 75 basis point rise in rates can lead to negative total returns over a one-year holding period in

new issue BB high yield bonds. Bank loans, which have floating-rate coupons, allow investors

to remain exposed to the leveraged credit sector while protecting against rising rates.

Readers of our past publications will recall that we first began highlighting the compelling

investment thesis in bank loans (Relative Value of Bank Loan vs. High Yield Bonds) following

the first quarter of 2012. Historically, bank loans have been overshadowed by high yield bonds

in terms of investor interest. The recent increased coverage of bank loans, coupled with

strong inflows into the sector, suggests that investors are finally beginning to appreciate its

tremendous value proposition. When compared to unsecured high yield bonds, bank loans’

seniority in the capital structure, secured status, and financial maintenance covenants have

historically resulted in lower default rates, decreased volatility, and higher recovery rates.

QUANTIFYING RATE RISK IN NEW ISSUE BB HIGH YIELD BONDS

SOURCE: S&P LCD, BLOOMBERG. DATA AS OF DECEMBER 31, 2012. ANALYSIS BASED ON 5 PERCENT COUPON, EFFECTIVE DURATION OF 6.7 AND ASSUMES ONE-YEAR HOLDING PERIOD.

High yield investors may be ignoring interest rate risk at their own peril. Interest rate increases of 75 basis points or more lead to negative total returns over a one-year holding period for BB bonds.

Nom

inal

Tot

al R

etur

n

Change in Interest Rates (Basis Points)

-4%

-8%

-12%

-16%

0%

4%

8%

12%

16%

-150 -100 -50 0 50 150 200 250 300

A 75 basis point rise in rates fully offsets interest income

http://guggenheimpartners.com/GP2011/media/pdf/High_Yield_and_Bank_Loan_Outlook_-_April_2012.pdf


This complement of safeguards has historically come at the expense of lower yield.

Since 1992, the Credit Suisse Leveraged Loan Index, on average, has yielded 130 basis

points less than the Credit Suisse High Yield Index, but the current differential stands at 30

basis points. Given the increased protection of bank loans, we view B bank loans, with average

spreads of 580 basis points, as having similar credit risk profiles to BB high yield bonds, with

average spreads of 380 basis points. The ability to move up the capital structure while picking

up considerable spread has recently led to retail capital flowing out of bond funds and into

loan funds, which could support further price appreciation.

Investment ImplicationsTHE BEST OFFENSE IS A GOOD DEFENSE

“Investors should realize that it is no longer early in the credit market. We are coming into the

seventh inning stretch and it is getting tougher to find attractive opportunities.” These words

are even more applicable now than when we first stated them in our publication following the

first quarter of 2012 (Relative Value of Bank Loan vs. High Yield Bonds). If April 2012 marked

the seventh inning, we may be headed towards extra innings of the credit rally. However, the

macroeconomic tailwinds supporting the U.S. leveraged credit market have the potential to

extend the rally. A strengthening economy, an accommodative Fed, and a dearth of viable fixed

income alternatives should mitigate the impact of deteriorating fundamentals.

As the dynamics of the new issue market force investors to accept fewer protections and more

leverage to garner incremental yield, the value of bank loans has become even more apparent.

Moving up the capital structure from unsecured bonds into secured, floating-rate coupon,

shorter-maturity loans with covenants only costs investors 30 basis points in yield.

For investors willing to perform the requisite due diligence and analysis, upper middle-

market financings offer the potential for both greater yield and increased investor safeguards.

In an environment where there remain few opportunities for continued price appreciation,

we believe bank loans are the most attractive area of investment in 2013.

WINNING IN EXTRA INNINGS

SOURCE: CREDIT SUISSE. DATA AS OF DECEMBER 31, 2012. HISTORICAL REGRESSION OF HIGH YIELD BOND SPREADS AGAINST MONTHS FOLLOWING A RECESSION.

Credit Suisse High Yield Index Spreads (LHS) ■ Recession Historical Regression

Analyzing the historical performance during previous post-recession periods suggests that, at current levels, bond spreads could continue to tighten in 2013. However, with 86 percent of the market currently trading at par or better, these opportunities primarily exist in underfollowed, off-the run securities. 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

400bps

800bps

1,600bps

1,200bps

200bps

0bps

600bps

1,000bps

1,800bps

1,400bps

2,000bps

http://guggenheimpartners.com/GP2011/media/pdf/High_Yield_and_Bank_Loan_Outlook_-_April_2012.pdf

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ABOUT GUGGENHEIM PARTNERS

Guggenheim Partners, LLC is a privately

held global financial services firm with

more than $160 billion1 in assets under

management. The firm provides asset

management, investment banking and capital

markets services, insurance, institutional

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to institutions, governments and agencies,

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ABOUT GUGGENHEIM INVESTMENTS

Guggenheim Investments represents the

investment management division of

Guggenheim Partners, which consist of

investment managers with approximately

$137 billion2 in combined total assets.

Collectively, Guggenheim Investments has

a long, distinguished history of serving

institutional investors, ultra-high-net-worth

individuals, family offices and financial

intermediaries. Guggenheim Investments

offer clients a wide range of differentiated

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to investment excellence.

IMPORTANT NOTICES AND DISCLOSURES Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy or, nor liability for, decisions based on such information.

This article is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product or as an offer of solicitation with respect to the purchase or sale of any investment. This article should not be considered research nor is the article intended to provide a sufficient basis on which to make an investment decision.

The article contains opinions of the author but not necessarily those of Guggenheim Partners, LLC its subsidiaries or its affiliates.

The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed as to accuracy.

This article may be provided to certain investors by FINRA licensed broker-dealers affiliated with Guggenheim Partners. Such broker-dealers may have positions in financial instruments mentioned in the article, may have acquired such positions at prices no longer available, and may make recommendations different from or adverse to the interests of the recipient. The value of any financial instruments or markets mentioned in the article can fall as well as rise. Securities mentioned are for illustrative purposes only and are neither a recommendation nor an endorsement.

Individuals and institutions outside of the United States are subject to securities and tax regulations within their applicable jurisdictions and should consult with their advisors as appropriate.

“1Guggenheim Partners’ assets under management figure is updated as of 09.30.2012 and includes consulting services for clients whose assets are valued at approximately $35 billion. 2The total asset figure is as of 09/30/2012 and includes $9.56B of leverage for Assets Under Management and $0.83B of leverage for Serviced Assets. Total assets include assets from Security Investors, LLC, Guggenheim Partners Investment Management, LLC (“GPIM”, formerly known as Guggenheim Partners Asset Management, LLC; GPIM assets also include all assets from Guggenheim Investment Management, LLC which were transferred as of 06.30.2012), Guggenheim Funds Investment Advisors and its affiliated entities, and some business units including Guggenheim Real Estate, LLC, Guggenheim Aviation, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, Transparent Value Advisors, LLC, and Guggenheim Partners India Management. Values from some funds are based upon prior periods.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. ©2013, Guggenheim Partners, LLC.

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