INSTITUTIONAL INVESTOR COMMENTARY

IG HY

ABS

CMBS

RMBS

JULY 2013

High Yield and Bank Loan Outlook

INVESTMENT PROFESSIONALS B. SCOTT MINERD Global 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 Senior Managing Director, Portfolio Manager KELECHI C. OGBUNAMIRI Senior Associate, Investment Research

Despite the parallels being drawn between current credit conditions and those of 2007, the chances of experiencing a sudden spike in near-term defaults, similar to what ensued following the end of the previous credit cycle, remain remote given the robust capital markets activity. While rapidly deteriorating credit quality and excessive market leverage were the chief culprits behind the abrupt end to the previous credit rally, neither factor is currently a significant concern in the leveraged credit market. Interest-rate risk, specifically the markets uncertainty regarding future monetary policy, precipitated the recent market sell-off and will likely continue to shape the performance of high yield bonds and bank loans in the near term. Amid increased interest-rate volatility and a gradual softening in underwriting standards, investors should seek to safeguard portfolios by shortening interest-rate duration and improving credit quality. While we continue to view bank loans as the preferred investment vehicle to achieve these dual objectives, the backup in bond yields has created an attractive re-entry point to selectively increase allocations to high yield bonds.
REPORT HIGHLIGHTS:

The Federal Reserves (Fed) announcement of possible tapering as early as the end of 2013 has caused investors to re-price risk. With yields on the 10-year Treasury note 82 basis points higher since May, current market conditions necessitate a greater focus on optimal positioning on the yield curve. Investors preference for bank loans over high yield bonds is likely to persist until interest-rate volatility subsides. During the second quarter, high yield bonds lost 1.4 percent while bank loans returned 0.3 percent. Credit conditions remain relatively benign compared to the experiences of 2006 and 2007. Analyzing market leverage and the financing terms of leveraged buyouts (LBOs) from the respective periods helps illustrate this contrast.

Leveraged Credit Scorecard

AS OF MONTH END
HIGH YIELD BONDS Dec-12 Spread Credit Suisse High Yield Index Split BBB BB Split BB B CCC / Split CCC 554 302 376 442 566 958 Yield 6.25% 4.16% 4.58% 5.03% 6.27% 10.21% Spread 473 252 339 387 480 789 Apr-13 Yield 5.34% 3.52% 4.17% 4.39% 5.28% 8.41% Spread 489 276 339 400 504 807 May-13 Yield 5.80% 4.01% 4.54% 4.86% 5.79% 8.83% Spread 541 310 380 453 564 865 Jun-13 Yield 6.74% 4.65% 5.38% 5.81% 6.80% 9.87%

BANK LOANS Dec-12 DMM* Credit Suisse Leveraged Loan Index Split BBB BB Split BB B CCC / Split CCC 498 324 403 489 560 939 Price 99.86 100.53 100.38 100.26 99.38 99.73 DMM* 453 298 363 427 494 853 Apr-13 Price 100.63 100.79 100.90 100.88 100.42 101.45 DMM* 459 304 364 426 499 769 May-13 Price 100.23 100.36 100.57 100.58 100.07 98.71 DMM* 491 321 385 453 527 885 Jun-13 Price 99.44 99.84 99.79 99.49 99.41 97.59

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

CREDIT SUISSE HIGH YIELD INDEX RETURNS

CREDIT SUISSE LEVERAGED LOAN INDEX RETURNS

Q1 2013 Q2 2013
6% 5% 4% 3% 2% 1% 0% -1% -1.4% -2% Index -2.1% Split BBB -2.0% BB -1.8% Split BB B CCC / Split CCC -1.2% -0.5% 1.0% 2.9% 2.1% 3.2% 5.5%

Q1 2013 Q2 2013
4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.6% 1.5% 1.0% 0.5% 0.0% Index Split BBB BB Split BB B CCC / Split CCC 0.3% 0.2% 0.4% 0.1% 1.3% 0.8% 0.1% 2.2% 3.9%

2.7% 2.1%

1.7%

SOURCE: CREDIT SUISSE. DATA AS OF 06/30/2013.

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HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2013

Revised first quarter GDP data showed that the contribution from housing-related activities made up 69 percent of the economys 1.8 percent growth. With interest rates rising, however, home affordability is plummeting from its recent historic high. Even a flattening of housing activity would cause economic growth to slow materially. This decreases the likelihood that the Fed tapers its asset purchases in 2013. Scott Minerd, Global CIO

Macroeconomic Overview
CONCERNS OVER IMMINENT FED TAPERING LIKELY OVERBLOWN

Amid a rapid ascent in long-term interest rates beginning in May, high yield bonds dropped 3.2 percent to end the second quarter, the largest two-month decline since September 2011. The severe dislocation in credit markets is the result of investors surprise over the faster-thanexpected pace at which the Fed indicated plans to taper and eventually end quantitative easing (QE). Instead of waiting for the Fed to act, the markets have preemptively begun to re-price risk. This market reaction is analogous to the experiences of the bond market crash of 1994, when then-U.S. Fed Chairman Alan Greenspan unexpectedly increased the federal funds rate by 25 basis points in February of that year, the first rate increase in five years. In the subsequent bond-market rout the worst since the Great Depression investors immediately began re-pricing bonds to where they assumed rates would be at the end of the tightening cycle. Based on the Feds economic projections, which will be used to determine if conditions warrant a change in monetary accommodation, the hysteria regarding imminent tapering may be largely overblown. The Feds outlook on the unemployment rate by year end suggests a belief that economic activity will accelerate as we head into the summer. However, we are already beginning to see pressure on housing and the broader economy from higher interest rates. We believe there is a strong possibility that the Fed will shift the tone of its guidance from QE tapering back to QE expansion or extension before the end of 2013. Given the likelihood of sustained interest-rate volatility, investors should look to reduce interest-rate duration through bank loans. Additionally, improved bond market valuations have created opportunities to increase spread duration through select, lower-rated high yield bonds.
MEASURING THE IMPACT OF THE HOUSING RECOVERY ON GDP
5% 4%
REAL GDP GROWTH
HOUSING-RELATED ACTIVITIES*

Housing-related activities have positively contributed to real GDP growth for five consecutive quarters. In the first quarter of 2013, housing-related activities contributed more than two-thirds of the growth in real GDP.

OTHER SECTORS

3% 2% 1% 0% -1% -2% Mar-11 Sep-11 Mar-12 Sep-12 Mar-13

SOURCE: HAVER ANALYTICS, GUGGENHEIM INVESTMENTS ESTIMATES. DATA AS OF Q1 2013. * HOUSING-RELATED ACTIVITIES DEFINED AS PRIVATE RESIDENTIAL INVESTMENT, PERSONAL EXPENDITURES ON HOUSEHOLD DURABLE GOODS AND UTILITIES, AS WELL AS CONSUMPTION WEALTH EFFECT FROM HOME PRICE APPRECIATION.

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HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2013

This Time is Different

SIGNIFICANT DIFFERENCES BETWEEN CURRENT AND PREVIOUS CREDIT CYCLES

It has often been said that the past is the best predictor of the future. Based on this notion, there have been numerous attempts to draw comparisons between the current credit cycle and the previous one in an effort to extrapolate what potentially lies ahead for high yield bonds and bank loans. However, after analyzing the credit conditions of the respective periods, it is apparent that current conditions remain far from the levels of excess that ultimately culminated in the credit crisis. The following table includes a comparison of credit metrics during 20062007 vs. 2012-2013. While current credit conditions appear materially more benign across virtually every measure, one metric that notably stands out is market leverage.
SUMMARY OF KEY CREDIT CYCLE DRIVERS
KEY CREDIT CYCLE DRIVERS
Leveraged Buyout (LBO) Volume Purchase Price Multiple Equity Contribution Leverage Bridge Loan Value CLO Leverage Total Return Swap Line Volume Total Return Swap Line Leverage Issuance Covenant-Lite as % of Total Loan Issuance M&A / LBO as % of Total Issuance Refinancings as % of Total Issuance 20% 60% 22% 45% 22% 60% $330 Billion 10-12x $250 Billion 8-10x $50 Billion 7-12x <$100 Billion 3-4x $667 Billion 9.2x 31% $164 Billion 8.6x 37%

Investors should be hesitant to draw parallels between the current credit cycle and that of 2006-2007, which was characterized by a surge in mergers and acquisitions (M&A) and LBO financings and excessive market leverage.

2006 2007

2012 2013

SOURCE: FITCH RATINGS, JP MORGAN, S&P LCD. DATA AS OF 06/30/2013.

While fundamental factors, such as weak operating performance and heavy debt burdens, were the primary catalysts that set off the credit crisis in 2007, the velocity and magnitude of the descent was exacerbated by the excessive leverage in the credit markets. After peaking at $100.11 in February 2007, the Credit Suisse Leveraged Loan Index went into a freefall, declining nearly 40 percent by the end of 2008. In the years preceding this collapse, bank loan investors had grown increasingly more aggressive in seeking ways to augment their returns. Seemingly calm credit conditions encouraged investors to utilize leverage as a means to enhance bank loan returns. Similar to buying on margin, total return swaps (TRS) enabled institutional investors to participate in the ongoing credit rally on a leveraged basis, typically

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HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2013

obtaining 8-10x leverage on their equity. However, as bank loan prices reversed course and began to fall precipitously, TRS investors received margin calls. Forced to either post additional equity or sell bank loan holdings to raise cash, most investors chose the latter option, resulting in further price degradation. In addition to highly leveraged institutional investors, investment banks also became forced sellers in the bank loan market. During the LBO boom years of 2006 and 2007, investment banks routinely committed capital in the form of bridge loans to help secure lucrative underwriting mandates. Bridge loans are short-term bank loans that provide interim financing until more permanent funding is secured. During normal market conditions, these bridge loans are quickly repaid through syndicated financings from institutional investors. According to JP Morgan estimates, banks total committed capital exceeded $330 billion at its peak. As investor demand for risk assets began to sour in late 2007, banks were unable to raise long-term financing to take out these bridge loans, the majority of which had been issued to highly leveraged companies. With risk exposures ballooning, banks acquiesced to mounting regulatory concerns and began selling these loans at significant discounts. This placed excess supply on the market at a time of shrinking demand, compounding the volatility and downward price spiral in the bank loan market. Comparing the deal metrics of H.J. Heinz and TXU, the largest LBOs of their respective periods, highlights the difference between current credit conditions and those of 2007.
LEVERAGED BUYOUT DEAL COMPARISON
TXU Corp.
(Currently Energy Future Holdings)

Emblematic of the excesses of the leveraged credit market at the time, equity contribution represented a relatively small percentage of the total financing used to fund the buyout of TXU in 2007. Investment banks committed over $11 billion in bridge loans for this landmark transaction.

H.J. Heinz Co.

February 2013 $28 Billion 58% 42% 8.5x $2.1 Billion Second Lien Bridge Loan 8%

Transaction Date Deal Size Equity Contribution, % of Deal Debt Financing, % of Deal Post-LBO Total Leverage Bridge Commitment Bridge Commitment, % of Deal
SOURCE: FITCH RATINGS, DATA AS OF 06/30/2013.

October 2007 $44 Billion 19% 81% 9.6x $11.25 Billion Senior Unsecured Bridge Loan 26%

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HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2013

Optimal Portfolio Positioning

BANK LOANS REMAIN OUR PREFERRED INVESTMENT VEHICLE

While far from the excesses of 2006-2007 from a credit underwriting and market leverage perspective, investors, nonetheless, need to be cognizant of the current dynamics that are likely to impact performance. While we are monitoring the slight deterioration in underwriting standards, we believe this is a secondary, longer-term concern. In the near term, defaults should remain muted, given the preponderance of refinancing activity over the last three years. We anticipate monetary policy, and its attendant implications on interest rates, will continue to be the primary driver of credit markets over the next several years. Our preferred investment vehicle to mitigate interest-rate risk continues to be bank loans. The floating-rate coupons of bank loans provide greater protection against movements in interest rates. Due to their seniority in the capital structure, maintenance covenants, and secured status, we consider single B-rated bank loans to be of comparable credit risk to BB-rated bonds. Since rates began moving higher in early May, interest-rate sensitive BB-rated bonds have declined 3.9 percent, while single B-rated bank loans were essentially flat.
COMPARATIVE PERFORMANCE DURING RATE BACKUP

The rate backup over the past two months has helped demonstrate the value of bank loans. While higher duration BB-rated bonds fell nearly 4 percent, the floating-rate coupons of bank loans left them fairly insulated from the interest-rate volatility.

BB Bonds CS High Yield Index B Bonds CCC Bonds CCC Loans B Loans CS Leveraged Loan Index BB Loans -4.5%

-3.94% -3.16% -2.87% -2.69% -0.57% -0.30% -0.29% -0.28% -4.0% -3.5% -3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0%

SOURCE: CREDIT SUISSE. DATA AS OF 06/30/2013.

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HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2013

Despite covenant-lite loans representing 53 percent of 2013 year-to-date total loan issuance, we believe concerns over this apparent relaxation in underwriting are largely overstated. This trend is likely more symptomatic of shifting capital market dynamics and investor demand than worsening credit quality. Based on their default and recovery characteristics, covenant-lite bank loans are very similar to senior secured bonds. The strong retail demand for floating-rate assets and robust collateralized loan obligation (CLO) creation have incentivized issuers to raise debt financing through the bank loan market over the bond market. Bank loan issuance, currently totaling $395 billion year-to-date, is on track to exceed bond issuance for the first time since the financial crisis. The shorter call protection periods and smaller call premiums of bank loans have also influenced greater loan issuance. Our long-standing belief that the unprecedented monetary accommodation from global central banks would eventually give rise to increased market volatility has come to fruition. Now that volatility has finally arrived, this will likely increase the demand for bank loans. Our portfolios remain positioned accordingly, with an overweight bias in bank loans. While largely staying the course, we remain poised to take advantage of market pullbacks to selectively add exposure to fundamentally strong credits. The recent 140 basis point backup in bond yields over the past two months has helped create more favorable valuations, particularly in single B-rated bonds. As the market struggles to determine the appropriate risk premium during this period of interest-rate uncertainty, our focus remains on optimal investment allocation across the credit quality and yield curve.

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HIGH YIELD AND BANK LOAN OUTLOOK | Q3 2013

Our Firm
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