October2012 HY Sector Outlook Report

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

OCTOBER 2012

High Yield and Bank Loan Outlook

The leveraged credit market turned in an impressive Q3 with high yield bonds and bank loans returning 4.3 and 3.1 percent, respectively. Unprecedented accommodation from central bankers across the globe has alleviated much of the macroeconomic tail risk that we highlighted in last quarter’s publication. Presented with a seemingly insatiable demand for new issue bonds, issuers returned to the torrid pace of issuance that characterized the start of 2012 by raising a record $99 billion during the third quarter.

Assessing the leveraged credit landscape from a relative value perspective, we see a bifurcated market with BB rated high yield bonds at one extreme and bank loans at the other. Historically low yields and increased sensitivity to rates underpin our underweight stance on BB rated bonds. The value proposition in bank loans is quite compelling: comparable risk profiles, higher yields, seniority in the capital structure and no sensitivity to interest rates. While the key components needed to sustain the rally are still firmly in place (an accommodative monetary policy and strong sector inflows), we believe the easy opportunities are behind us.

REPORT HIGHLIGHTS:

• The strong sector return was balanced across the credit spectrum with higher rated bonds outperforming during the first half of the quarter and lower rated names picking up in the latter half. BBs returned 4.1 percent for the quarter, while CCCs returned 4.6 percent.

• The resurgence of Collateralized Loan Obligations (CLO) has been a positive for the bank loan market. 2012YTD CLO issuance has totaled $32.3 billion compared to $13.6 billion in all of 2011.

• Historically low yields on BBs have led to widening spreads relative to CCCs. The current spread of 460 basis points is markedly higher than the average spread of 350 basis points during the previous expansion from 2004-2007.

• The trailing 12-month bank loan default rate ended the quarter at 1.22 percent compared to 1.20 percent at the end of Q2. The trailing 12-month high yield bond default rate decreased from 2.17 percent to 1.90 percent over the same period. The ample liquidity in the financial system decreases the likelihood of a sustained long-term rise in defaults.

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

PAGE 2 HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2012

HIGH YIELD BOND RETURNS BANK LOAN RETURNS

SOURCE: CREDIT SUISSE, DATA AS OF SEPTEMBER 28, 2012.

■ 2Q 2012 ■ 3Q 2012 ■ 2Q 2012 ■ 3Q 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 Jul-12 Aug-12 Sep-12Spread Yield Spread Yield Spread Yield Spread Yield

Credit Suisse High Yield Index 728 8.23% 640 7.05% 614 6.76% 592 6.57%

Split BBB 402 5.17% 347 4.38% 338 4.33% 322 4.22%

BB 511 6.04% 450 5.17% 435 5.05% 412 4.86%

Split BB 597 6.85% 528 5.82% 504 5.58% 495 5.53%

B 740 8.23% 653 7.09% 626 6.82% 604 6.61%

CCC / Split CCC 1,384 14.94% 1,138 11.93% 1,085 11.39% 1,022 10.79%

BANK LOANS

Dec-11 Jul-12 Aug-12 Sep-12DMM* Price DMM* Price DMM* Price DMM* Price

Credit Suisse Leveraged Loan Index 656 92.19 594 94.80 578 95.46 555 96.29

Split BBB 325 99.30 303 99.73 303 99.82 296 100.07

BB 444 97.74 419 99.15 416 99.38 403 99.76

Split BB 542 96.91 513 98.87 510 99.06 490 99.66

B 726 92.89 628 96.63 609 97.41 580 98.40

CCC / Split CCC 1,615 71.23 1,269 79.89 1,464 75.55 1,332 78.96

4.3%

1%

0%

2%

3%

4%

5%

6%

Index Split BBB BB B

Split BB

CCC / Split CCC

1.6%

2.7%

2.0%

1.5% 1.6%

0.4%

4.2% 4.1% 4.1%

4.5% 4.6%

1%

0%

2%

3%

4%

5%

6%

Index Split BBB BB B

Split BB

CCC / Split CCC

1.0% 0.7%

1.0%

3.1%

1.6%

2.2% 2.6%

3.4%

5.7%

0.8% 0.8% 0.8%


Macroeconomic OverviewUNORTHODOX MONETARY POLICY SUPPORTIVE OF ECONOMIC GROWTH

BUT MAY HAVE FUTURE INFLATIONARY REPERCUSSIONS

The macroeconomic landscape has been dominated by monetary easing by global central

banks. The ECB’s program and the program recently announced by the FOMC are both

unlimited in terms of scale. This type of open-ended policy action is unprecedented. The ECB’s

program will see the unlimited purchase of assets that have a maturity of three years or less.

Whereas QE1 and QE2 were asset purchase programs with pre-set limits, under QE3, the Fed

will purchase $40 billion of agency mortgage-backed securities every month until the labor

market improves. By not setting a size on the bond purchase program, the Fed maintains the

flexibility to be more responsive to market conditions and not be hand-tied by policy if market

conditions warrant a modification in the size or pace of the program.

This unprecedented territory of monetary policy that we have entered is good news for

credit markets in the near-term. The abundant liquidity being pumped into the financial

system should enable leveraged credit issuers to continue to refinance near-term maturities.

Additionally, the Fed extending its intention to keep rates low from late 2014 to mid-2015 may

drive further flows into the high yield market as fixed income investors seek yield. The tenor

in the market has changed dramatically over the course of the year. At the start of 2012,

talk focused on how cheap risk assets were and how the market was discounting for worst

case scenarios. Today, the conversation has shifted to a potential bubble in the high yield

market and how the market has begun discounting a lot of good news. The swift improvement

in sentiment indicates that we should be alert to the possibility of a key inflection point.

Historically, increased consumer sentiment has been strongly correlated with rising interest

rates. As the economy improves, we could see a situation where rising rates overwhelm

spread tightening.

“Given how much cash and liquidity there is in the system and the search for yield, I do not see anything that is going to interrupt the market in the near term…But I think the extreme value that high yield has had over the last two years is slowly dissipating as spreads on below investment grade credit come in. The CCC and split B credit look relatively attractive and I think they should continue to perform but the upper end of the high yield market has become rich.”

– Scott Minerd, Chief Investment Officer September 2012

REBOUND IN CONSUMER CONFIDENCE SUGGESTS REAL TREASURY YIELDS SHOULD RISE

SOURCE: BLOOMBERG, GUGGENHEIM INVESTMENTS. DATA AS OF SEPTEMBER 28, 2012. *NOTE: THE REAL 10-YEAR TREASURY YIELD IS CALCULATED BY SUBTRACTING THE CORE PCE DEFLATOR RATE FROM THE NOMINAL 10-YEAR YIELD.

With the recent rebound in consumer sentiment and its historical relationship with real Treasury yields, we would expect nominal yields to increase to around 3 to 4 percent.

70

60

50

80

90

100

110

120

1%

0%

-1%

2%

3%

4%

5%

6%

2000 2001 2004 2005 2006 2007 2008 2009 2010 2011 20122002 2003

University of MichiganConsumer Confidence (LHS)

Real 10-Year Treasury Yield (RHS)


Leveraged Credit Third Quarter 2012 RecapREACH FOR YIELD CONTINUES TO DRIVE MARKETS HIGHER

At the onset of the third quarter, we believed the macroeconomic environment remained

constructive for the leveraged credit market. Markets awash with liquidity are supportive of

refinancings and result in low default rates. This thesis played out as new issue high yield

bond proceeds totaled $99 billion for the quarter with $46 billion raised in September alone.

September 2012 recorded the highest level of monthly issuance ever. As 68 percent of total

issuance was used to redeem existing bond and bank debt, defaults remained range-bound

during the quarter. In the third quarter, the leveraged credit market, benefitting from the reach

for yield, performed strongly relative to other major fixed income asset classes, with high yield

bonds and bank loans returning 4.3 and 3.1 percent, respectively, compared to returns of 3.8

percent on investment grade bonds and 0.9 percent on Treasuries.

Headline risk, which underscored our underweight European credit view, has diminished with

ongoing progress towards a fiscal union in Europe. While issues such as the U.S. fiscal cliff

still remain unresolved, the market’s view of the global macroeconomic picture has clearly

improved over the past three months.

• Q3 high yield bond issuance totaled $99 billion, eclipsing the previous quarterly record of

$97 billion set during the first quarter of this year.

• The search for yield has supported strong inflows into the sector. During the quarter, high

yield bond funds recorded $13.5 billion of inflows while bank loan funds received $3.1 billion.

• Decreased headline risk from Europe contributed to lower volatility in the sector.

Q3 annualized volatility in the high yield bond market was 1.1 percent compared to 5.2

percent through the first half of the year.

CREDIT SUISSE HIGH YIELD INDEX HISTORICAL SNAPSHOT


■ Yield (LHS) ■ Spread (RHS)

2,000 bp

1,600 bp

1,200 bp

800 bp

400 bp

0 bp

25%

20%

15%

5%

10%

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

AVERAGE: 591 bps

AVERAGE: 11.1%

YIELD SPREADHIGH 20.5% 1,816LOW 6.6% 271LAST 6.6% 592

Yields continued on their downward descent during the third quarter, closing at 6.57 percent. While Index yields are at the lowest levels on record, spreads are at historical averages and more than 300 basis points wide of the all-time tights set in May 2007.


During the third quarter of 2012, high yield bond spreads tightened by 68 basis points,

while all-in yields fell by 82 basis points. The Credit Suisse High Yield Index ended September

2012 with a spread of 592 basis points to U.S. Treasuries and has returned 11.2 percent for

the year. The Credit Suisse Leveraged Loan Index ended the third quarter with the average

discount margin to maturity tightening by 47 basis points. The Index has returned 7.8 percent

for the year.

Sector ForecastKEY THEMES TO FOLLOW IN 4Q 2012

1. LIMITED VALUE IN THE HIGHER END OF THE CREDIT SPECTRUM:

CAPPED UPSIDE AND INCREASED DURATION RISK IN BBs

As yields on the Barclays U.S. Corporate Investment Grade Index have closed below 3 percent

for three consecutive months, non-traditional leveraged credit investors, particularly retail

investors, have gravitated to the safest and most liquid part of the high yield market. BB rated

bonds, the first frontier into the high yield market, have benefitted from this reach for yield.

With declining dealer inventories making it difficult to efficiently put sizeable capital to work in

the secondary market, the primary market has become the destination of choice. This strong

demand has led to new issues outperforming the broader market. Higher grade credits, BBs

and Bs, representing 82 percent of the 2012YTD new issue market, have benefitted from the

strength of the primary market.

Despite these near-term positive catalysts, we expect the relative performance of BB rated

bonds to suffer as the economy continues to improve. After bottoming towards the end of July

2012, yields on the 10-year Treasury note have slowly begun trending upwards. Since August,

returns on BB bonds have underperformed CCC bonds and single B bank loans by 158 and

48 basis points, respectively. During the two-month period ending in March 2012, returns on

BB bonds underperformed CCC bonds and single B bank loans by 300 and 46 basis points,

respectively, as yields on the 10-year Treasury note rose by 41 basis points. A continuation in

the uptrend of interest rates, amid a strengthening economy, may limit the upside in higher

duration BBs. With almost 90 percent of BBs currently trading at a premium, future price

appreciation will be constrained since bond prices exceed average call prices by over three

percent. Based on the risks of rising rates and call ceilings present in BBs, we see greater value

in other areas of the leveraged credit market.

GREATER POTENTIAL FOR PRICE APPRECIATION LOWER DOWN THE CREDIT SPECTRUM

SOURCE: BANK OF AMERICA MERRILL LYNCH. DATA AS OF SEPTEMBER 28, 2012.

BB Average Price: $107.30 ■ CCC Average Price: $98.02 With the average price of BB rated bonds currently at a significant premium to par, we would expect limited opportunity for further appreciation. As the risk-on trade gains momentum, select, high quality, discounted CCCs should be the primary beneficiaries.

15%

10%

5%

0%

20%

25%

30%

35%

40%

0.6%

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

% o

f Ind

ex M

arke

t Val

ue

Price

89% of BBs Currently Trading

6.0%

1.3% 0.4%

5.7%

18.9%

35.4% 35.0%

3.6%

9.1% 8.8%

23.3%

8.9%

27.6%

at Par or Better vs. 60% of CCCs

12.9%

2.7%


2. COMPELLING VALUE PROPOSITION IN BANK LOANS:

BANKS LOANS OFFER SUPERIOR RISK-ADJUSTED RETURNS

While BB rated bonds appear rich at current levels, we believe bank loans offer significant

value. BBs finished September 2012 yielding 4.86 percent, the lowest monthly close on record

and significantly below the historical average of 8.83 percent. This has created opportunities

to move up the capital structure and pick up incremental yield. The spreads on single

B secured bank loans are currently 168 basis points more than the spreads on BB rated

unsecured bonds, which we consider to have comparable risk.

Particularly beneficial in today’s environment, bank loans are zero-duration assets and exhibit

decreased volatility compared to high yield bonds. Although default rates are likely to remain

below historical averages in the near-term, typically default rates rise as we move further

along in the credit cycle. In a rising rate, rising default environment, investors could benefit

from the increased income, lower default rates and higher recovery rates of bank loans.

The resurgence of CLOs serves as a positive technical dynamic for bank loans. $32.3 billion in

CLOs have priced thus far in 2012 with estimates for an additional $13 billion before the end

of the year. CLO creation has resulted in increased demand not only for primary loan issuance,

but also the secondary market, as managers scramble to fully invest within the fund’s typical

three month ramp period. This dynamic is currently manifesting itself in the marketplace,

resulting in pressure on broadly syndicated loan original issue discounts, spreads to LIBOR,

LIBOR floors, and sadly, covenants. We are currently focused on driving value in the

off-the-run secondary market and the middle market segment of new issues. These areas

contain better covenants and offer greater yields than the broadly syndicated market.

RELATIVE VALUE OF BANK LOANS VS. HIGH YIELD BONDS


Despite similar risk profiles, single B bank loans are currently offering an incremental 168 basis points in spread compared to BB bonds. Additionally, bank loans are senior in the capital structure and afford greater protection in a rising rate environment.

400 bp

200 bp

0 bp

-200 bp

-400 bp

600 bp

800 bp

1,000 bp

1,200 bp

1,400 bp

1994 1992 1996 2002 2004 2006 2008 2010 20121998 2000

SINGLE B BANK LOAN SPREAD MINUS BB BOND SPREAD

Yield Differential

Pre-Recession Average: -12 bpsLast: 168 bps


Investment ImplicationsTRACKING THE CREDIT CYCLE

Since December 2008, the high yield market has returned 23 percent on an annualized

basis compared to the historical average of 9 percent since 1986. On the back of this

exceptionally strong performance and historically low yields, recent discussion has centered

on whether a bubble is forming in the high yield market. Historically, the primary market

has served as a useful gauge for determining where we are in the credit cycle. Specifically,

significant increases in both opportunistic issuance and the percent of issuance from lower

quality issuers serve as early warning signs of a potentially overbought market.

From 2005 through 2008, leading up to the financial crisis, 45 percent of new issue proceeds

were used to fund leveraged buyouts and mergers and acquisitions, with only 39 percent being

used to refinance existing debt. Additionally, the percent of new issue from nonrated issuers

and those rated CCC or lower peaked at 29 percent in 2007 compared to the historical average

of 16 percent. This massive increase in net new supply, particularly from issuers with weaker

credit profiles, culminated in the elevated default activity observed from 2008 through 2010.

While there has been nearly $750 billion in bond issuance over the last three years,

60 percent has been used to refinance existing debt. Net new supply has been minimal with

the high yield market growing only 16 percent since 2010. Monitoring the volume and pricing

terms of issues that increase net new supply and put technical stress on the market, such as

deals funding dividends, stock buybacks, leveraged buyouts and mergers and acquisitions,

can provide indications on potential future weakness in the market.

HIGH YIELD DEBT ISSUANCE BY USE OF PROCEEDS

SOURCE: BARCLAYS. DATA AS OF SEPTEMBER 28, 2012.

Strong primary issue demand and low nominal rates have driven the high level of debt refinancings. Since 2010, over $450 billion of bank loans and high yield bonds have been refinanced.

0%

20%

40%

60%

80%

100%

2005 2006 2007 2008 2009 2010 2011 2012YTD

36%

44%

14%

6%

31%

56%

10%

4%

46%

41%

6%

7%

73%

9%

17%

2%

64%

19%

11%

5%

56%

25%

15%

4%

61%

18%

17%

5%

45%

38%

6%

11%

LBO/M&A Average: 45% Refinancing Average: 39%

LBO/M&A Average: 18% Refinancing Average: 63%

■ LBO & M&A ■ Refinancings ■ GCP/CapEx ■ Other


Based on our analysis of the primary market and the strong technical dynamics supporting

risk assets, we do not believe the high yield market is at risk of a material slowdown in the

near term. The Fed-induced liquidity in the financial system should keep defaults stable

over the next two to three years while the nominally low rate environment creates a strong

bid for higher yielding assets. Strong demand for new issue BB paper has pushed yields

below 5 percent for the first time ever, making it increasingly difficult to identify attractive

opportunities in this segment of the market. We currently see better value in the secondary

market investing in older, lower rated bonds.

The widening spreads between the upper end and lower end of the credit spectrum has

increased the relative attractiveness of secondary securities such as CCCs and single B rated

bonds. We aim to identify high quality, lower rated credits that we believe are misrated. In

select opportunities, we are able to play an active role in driving short-term catalysts such

as refinancings in securities trading at discounts to call prices. However, it is important to

remember that this segment of the market requires intensive, issuer-specific research.

With some of the best moves in the market likely behind us, caution is in order.

The unprecedented monetary stimulus that is currently lifting risk assets will not be easily

reversed. We believe we are in the early stages of seeing Treasury rates rise for a sustained

period of time. Against this backdrop, we believe bank loans offer the best way to participate

in the rally while remaining protected against a future rise in interest rates

and defaults.

CONTACT US

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CHICAGO

227 W Monroe St | 60606 312 827 0100

SANTA MONICA

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LONDON

1 Knightsbridge Green | SW1X 7NE 44 207 052 8272

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October2012 HY Sector Outlook Report

Documents

bank loans

split b high yield bonds

bank loan market

bank loan outlook q3

month bank loan default

higher rated bonds

month endhigh yield

average spread