An LPL Financial Research

Market Update
February 12, 2008

Anthony Valeri, CFA
Senior Vice President, Fixed Income Strategist LPL Financial

Bank Loan Market Update
• The bank loan (a.k.a floating rate) market has surprised investors as one of the worst performing Fixed Income asset classes. January marked the second worst monthly performance on record and weakness has continued into February, with the market down nearly 3%. As of February 8, the average bank loan price declined to 88.2 according to Lehman data, nearly 3 points below the record low price of 92 set in 2002. Particularly noteworthy, bank loans, despite being a more conservative and less volatile asset class, have underperformed both high yield bonds and equities since mid-January.

...the average bank loan price declined to 88.2 according to Lehman data, nearly 3 points below the record low price of 92 set in 2002.

• Heightened investor risk aversion, an increase in defaults, a sharp drop in the London Interbank Offered Rate (LIbOR), and massive supply demand imbalance have all factored into dismal recent performance. • Although we do not expect a rebound in coming months we would encourage existing investors to hold bank loan investments and not sell at overly depressed prices. Current bank loan prices imply a double-digit default rate, which would exceed the prior default peak of 8% witnessed in early 2001. In fact, we would argue that the asset class is attractive for long-term investors who can withstand near-term turbulence. bank loans pay off at par (100) and have historically averaged 3 years to do so. The current yield of LIbOR + 6.0%, 1.5% above the prior peak in yield spreads, coupled with substantial discounts to par value presents an attractive risk/return opportunity. Current market January marked the second worst monthly performance on record (July 2007 being the worst) as weakness has continued into February, with the Lehman brothers US High Yield Loan Index down 2.7% in just one week. Particularly noteworthy is that bank loans, despite being a more conservative and less volatile asset class, have underperformed both high yield bonds and equities since mid-January. bank loans also have first claim on company assets ahead of high yield bond debt holders which in turn rank ahead of equity holders. This suggests other factors are at work which we discuss further below. Poor performance dating back to July has come even though fundamentals remain relatively healthy. Defaults did increase in January to 1.4% but remain below the 2.8% historical average. At an average price of 88, the bank loan market is pricing in a double-digit default rate. A price of 88 means that an investor should expect to lose 12% of par value (100) or 12 cents of every dollar invested. In the event of default, bank loan recovery rates have historically averaged 70% of par, but dropped to a low of 57% in 2002. Assuming a recession-like 55% recovery rate, this implies the market is expecting a default rate of 26% (26% x 45% loss = 88 dollar price). by means of reference, the historical peak for defaults occurred in 2001 reaching 8%. S&P stated it conservatively estimates the current “risk premium” in the market at 10%. So while investors debate whether a recession is coming or underway, the bank loan market has more than priced it in.
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Current bank loan prices imply a double-digit default rate, which would exceed the prior default peak of 8% witnessed in early 2001.

The average bank loan yield spread, according to S&P, is currently LIbOR plus 6.0%. S&P bases this spread on an average pay off of three years. by means of comparison, the average historical yield spread to LIbOR is 3.1% and the peak during the 2001-2002 recession was 4.5%. Performance drivers Several factors have conspired to produce dismal performance. Heightened investor risk aversion, which has plagued credit markets in general since July, has grown particularly acute as recession fears increase. This is corroborated by Fed Fund futures now pricing in a small probability of a 1.75% Fed Funds by the September FOMC meeting and commercial mortgage-backed bonds falling to all-time lows for the week ending February 8. An increase in defaults spooked investors in January. Nine bank loan issues defaulted in January, versus two for all of 2007, taking the default rate to 1.4%, up from a historic low of 0.25%. Defaults had been expected to increase for some time but the fact additional defaults finally arrived seemed to unnerve investors. The Federal Reserve’s 1.25% worth of rate cuts in January played a role. Three month Libor, a lending rate upon which floating rate loan interest payments are based, has declined by 1.6% since the start of the year to 3.1% on January 31. The Federal Reserve’s 1.25% worth of rate cuts in January played a role. Three month LIbOR, a lending rate upon which floating rate loan interest payments are based, has declined by 1.6% since the start of the year to 3.1% on January 31. Over the coming 30 to 90 days bank loan interest payments will be reset lower and yield oriented investors opted to rotate into other Fixed Income sectors such as high yield bonds (average yield of approximately 10%). For an asset class that typically does not offer the potential for price appreciation, declines in interest rates are obviously negative. However, the biggest factor in driving performance is a massive supply-demand imbalance. The Leveraged buyout (LbO) fueled debt increase over the first half of 2007 included some $230 billion of new issuance. This supply overhang has been worked down to approximately $150 billion at the end of January. The pace has been very slow and still leaves a significant new issuance in the pipeline. At the same time, major investment banks with bank loans commitments on their books have refused to bring new issues to market after the average bank loan price dropped to the low 90s. This has brought trading activity to a virtual stand still with forced sellers moving a very illiquid market lower. However, the biggest factor in driving performance is a massive supply-demand imbalance. Some banks have responded by keeping some loans on the books viewing them as investments but their capacity is limited. Historically, bank loans new issues have usually ranged from $500 million to $2 billion, but some LbO related new issues in the pipeline call for loan deals on the order of $10-$30 billion. Weakness has been exacerbated by traders cognizant not only of a large supply pipeline but also the pressure capital constrained banks are under to get loan commitments off the books. Furthermore, collateralized loan obligations (CLOs), the dominant buyer of bank loans over the past two years (responsible for absorbing roughly 60% of new issuance) have all but vanished from the current trading environment. CLOs purchase loans and then repackage them into varying levels of risk. A small segment of the CLO incorporate leverage and some structured to liquidate in the event of margin call. Several margin calls have been triggered and, barring a restructuring of some kind, investors are worried this may dump more supply on a fragile market. The municipal bond insurers have also had an impact on CLOs. With their AAA ratings threatened, the insurers have been unable to guarantee higher quality CLO tranches. While AAA buyers have money to deploy the inability to deliver product while at the same creating doubt over existing insurer-backed CLO tranches has only added to the supply problem. In sum, a much smaller base of retail and relative value investors have been left to account for demand at a time of historic supply.
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What’s next The supply-demand imbalance is the reason we do not see a near-term rebound. Although additional weakness is certainly possible, we believe we are near the bottom and further weakness might bring about “distressed loan” and other relative value buyers. Over time, financial institutions will have put write downs behind them and re-enter the market as well. It is important to realize that current market is driven primarily by supply-demand dynamics, and not by an asset class that has become fundamentally weak. It is important to realize that current market is driven primarily by supply-demand dynamics, (much like the municipal bond market was in August and November of last year) and not by an asset class that has become fundamentally weak. Much has been made of “covenant-lite” loans and weak structures but this segment represents approximately 20% of the market. While still significant, we believe a high level of defaults implied by current pricing more than compensates for this. And new issuance is coming with very favorable terms for investors including discounts to par, minimum coupon rates, and strict bondholder covenants. In a world of 2%-3% treasury yields, an asset class trading at 12% discount to par and yielding LIbOR plus 6% represents good value. According to S&P, the average bank loan was repaid in 3 years so investors should take a long-term view. While improvement could come more quickly or take longer, timing markets is difficult and its best to take advantage of relative value when it presents itself.

In a world of 2%-3% treasury yields, an asset class trading at 12% discount to par and yielding Libor plus 6% represents good value.

Important Disclosure

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.

This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., IFMG Securities, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. Not FDIC/NCUA Insured Not Bank/Credit Union Guaranteed May Lose Value Not a Bank/Credit Union Deposit

Not Guaranteed by any Government Agency

Member FINRA/SIPC Market Update | February 12, 2008 | Page 3 of 3 Tracking #423212 (Exp. 12/08) | RES 0399 0208