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INSTITUTIONAL INVESTOR COMMENTARY

IG HY

ABS

CMBS

RMBS

JANUARY 2013

High Yield and Bank Loan 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

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 in 2012. High yield bonds returned 14.7 percent in 2012, compared to 5.5 percent in 2011. Nominally low yields throughout the fixed income universe drove capital into the leveraged credit sector, with issuers responding with record level supply. 2012 high yield bond issuance totaled $346 billion, the most ever, while the loan market enjoyed its highest level of issuance since 2007. Since 1992, the Credit Suisse Leveraged Loan Index, on average, has yielded 130 basis points less than the Credit Suisse High Yield Index. With bond yields finishing the year at 6.25 percent, the lowest level on record, this differential has narrowed to 30 basis points, increasing the relative value of bank loans. As default rates have stabilized below historical averages, investors have been 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.

Leveraged Credit Scorecard


AS OF MONTH END
HIGH YIELD BONDS Dec-11 Spread Credit Suisse High Yield Index Split BBB BB Split BB B CCC / Split CCC 728 402 511 597 740 1,384 Yield 8.23% 5.17% 6.04% 6.85% 8.23% 14.94% Spread 581 309 390 481 594 1,030 Oct-12 Yield 6.54% 4.19% 4.72% 5.47% 6.60% 10.96% Spread 583 314 398 470 591 1,013 Nov-12 Yield 6.49% 4.16% 4.74% 5.27% 6.49% 10.68% Spread 554 302 376 442 566 958 Dec-12 Yield 6.25% 4.16% 4.58% 5.03% 6.27% 10.21%

BANK LOANS Dec-11 DMM* Credit Suisse Leveraged Loan Index Split BBB BB Split BB B CCC / Split CCC 656 325 444 542 726 1,615 Price 92.19 99.30 97.74 96.91 92.89 71.23 DMM* 557 302 393 483 582 1,415 Oct-12 Price 96.23 100.11 99.98 100.02 98.28 77.29 DMM* 561 300 391 485 584 1,420 Nov-12 Price 96.28 100.22 100.05 100.12 98.35 77.65 DMM* 555 296 385 486 584 1,359 Dec-12 Price 96.60 100.30 100.22 100.26 98.58 79.39

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

Q3 2012 Q4 2012
6%

Q3 2012 Q4 2012
6% 5.7%

5% 4.3% 4% 4.2% 4.1% 4.1%

4.5%

4.6% 3.7%

5%

4% 3.4% 3.1% 3% 2.2% 2% 1.5% 1.6% 1.1% 1.5% 1.7% 1.5% 2.6%

3.5% 3% 2% 3.1% 2.1% 3.1% 2.6%

1%

1%

0% Index Split BBB BB Split BB B CCC / Split CCC

0% Index Split BBB BB Split BB B

-0.3% CCC / Split CCC

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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

Macroeconomic Overview
U.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 Years 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 assetbacked securities.

The 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 postrecession, opportunities exist, but have become harder to come by at current valuations.

HIGH YIELD BOND SPREADS FOLLOWING END OF RECESSION


1,200bps
Credit Suisse High Yield Bond Spreads

1,100bps 1000bps 900bps 800bps 700bps 600bps 500bps 400bps 300bps 200bps 0 10 20 30 40 50 60 70 80 Number of Months Following End of Recession 90 100 Dec. 2012

R2 = 0.605

110

120

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

2012 Leveraged Credit Recap


BENIGN 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 years 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.

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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?

CREDIT SUISSE HIGH YIELD INDEX HISTORICAL SNAPSHOT

Yield (LHS) Spread (RHS)


25% HIGH LOW LAST YIELD 20.5% 6.2% 6.2% SPREAD 1,816 271 554 2,000bps

20%

1,600bps

15%

1,200bps

10% AVERAGE: 591bps 5%

AVERAGE: 11.1%

800bps

400bps

0% 1986

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

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

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 Beware
CALLABILITY 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 bonds 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.

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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.

BONDS PIERCE THROUGH HISTORICAL YIELD FLOOR


22% 20% 18% 16% 14% 12% 10% 8% HISTORICAL FLOOR = 7% 6% 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Aug.12 7%

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

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

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
40% 35% % of Index Market Value 30% 25% 20% 15% 10% 5% 0% 9% 6% 3% <80 2% 1% 80<--->85 5% 2% 85<--->90 6% 3% 90<--->95 95<--->100 Price 100<--->105 105<--->110 110+ 6% 18% 86% of Index Trading at Par or Better vs. 62% at End of 2011 37% 31% 27% 22% 23%

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

New Issue Market Trends


DEMAND 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.

2008 2012

LEVERAGED LOAN
$350Bn $300Bn $250Bn $200Bn $150Bn $100Bn $50Bn $0Bn 9 2013 2014 2015 51 67 38 19 2016 1 2017 2018 224 290 $180Bn $160Bn $140Bn 204 156 115 $120Bn $100Bn $80Bn $60Bn $40Bn $20Bn $0Bn 23 90

HIGH YIELD BOND


165 141 119 104 82 88 85 65 36

2013

2014

2015

2016

2017

2018

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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.

LBO FINANCING TRENDS

Equity Contribution (LHS) Purchase Price Multiple (RHS)


50% 45% 40% 35% 30% 25% 7.8 7.1 6.7 6.0 7.1 6.6 7.3 9.7 9.1 8.4 7.6 8.4 7.7 8.5 8.8 10x 9x 8x 7x 6x 5x

8.7

1997

1998

1999

2000

2001 2002

2003

2004

2005

2006 2007

2008 2009

2010

2011

2012

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

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
CLO Mercer Field CLO Madison Park Funding X OHA Credit Partners VII Venture XII CLO CIFC Funding 2012-II ALM VII Ares XXIV OHA Credit Partners VI Octagon Investment Partners XIV Northwoods Capital IX Manager Guggenheim Partners Investment Management Credit Suisse Asset Management OakHill Advisors MJX Asset Management CIFC Asset Management/Greensledge Apollo Credit Management Ares CLO Management XXIV Oak Hill Advisors Octagon Credit Investors Angelo, Gordon & Co. Size ($mm) 1,054 802 770 750 748 722 719 674 626 626 Date Dec-12 Nov-12 Oct-12 Dec-12 Oct-12 Oct-12 Aug-12 Apr-12 Nov-12 Nov-12 Cov-Lite Loans 60% 40% 50% 40% 40% 70% 30% 50% 50% 50%

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

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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


5x 4x 3x 2x 1997 5x 4x 3x 2x 1997 Coverage Leverage

1999

2001

2003

2005

2007

2009

2011

1999

2001

2003

2005

2007

2009

2011

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

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
2007 Refinancings as % of Total Issuance M&A and LBO Financings as % of Total Issuance Covenant-Lite as % of Total Loan Issuance PIK Toggle as % of Total Bond Issuance Equity Contribution as % of Total LBO Financing LBO Purchase Price Multiples
SOURCE: S&P LCD. DATA AS OF DECEMBER 31, 2012.

2012 52% 27% 33% 2% 38% 8.5x

21% 62% 30% 14% 31% 9.7x

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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 middlemarket financings, which generally consist of deals from smaller companies, first-time issuers or growing businesses in newer, yet fundamentally sound industries. We define upper middlemarket as high yield bond and bank loan tranches between $300 and $750 million. While these segments are typically assumed to be less liquid, they actually represent fairly sizable portions of the leveraged credit market, over 40 percent of the high yield market and nearly a third of bank loans. An increased level of dialogue and communication can enable underwriters to price deals more appropriately, while sponsors get long-term partners in their deals. Generally more prevalent on the bank loan side, our feedback on structuring transactions has resulted in greater protections for investors such as limited restricted payments, tighter financial covenants, and greater call protection.
BARCLAYS CORPORATE HIGH YIELD INDEX
Size ($mm) <300 300 400 400 500 500 750 750 1000 >=1000 Market Weight 12.3% 11.3% 10.7% 21.8% 12.5% 31.5% Yield to Worst 7.6% 6.4% 5.9% 5.4% 5.3% 5.5%

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.

CREDIT SUISSE LEVERAGED LOAN INDEX


Size ($mm) <300 300 400 400 500 500 750 750 1000 >=1000 Market Weight 15.8% 9.2% 6.3% 16.5% 10.2% 42.0% Discount Margin to Maturity 763 628 575 526 523 536

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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
16% 12% 8% Nominal Total Return 4% -150 -100 -50 0% -4% -8% -12% -16% Change in Interest Rates (Basis Points)
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.

A 75 basis point rise in rates fully offsets interest income

50

150

200

250

300

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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 Implications
THE 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 middlemarket 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

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.

Credit Suisse High Yield Index Spreads (LHS) Recession


2,000bps 1,800bps 1,600bps 1,400bps 1,200bps 1,000bps 800bps 600bps 400bps 200bps 0bps 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Historical Regression

2006

2008

2010

2012

2014

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

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HIGH YIELD AND BANK LOAN OUTLOOK | Q1 2013

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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 capabilities built on a proven commitment 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 authors 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.
2 The 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.