Asset Class Review. Bank Loans: Helping to Provide Protection Against Rising Interest Rates. November 30, 2012 LPL FINANCIAL RESEARCH

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1 LPL FINANCIAL RESEARCH Asset Class Review November 30, 2012 Bank Loans: Helping to Provide Protection Against Rising Interest Rates 1 Example of a Capital Structure Priority of Repayment: Senior Secured Debt Source: LPL Financial 09/30/12 Senior Unsecured Debt Subordinated Debt Equity Please see the 11/27/2012 issue of Bond Market Perspectives for a current market view on bank loans. Floating rate bank loans are loans issued by below investmentgrade companies for short term funding purposes with higher yield than short-term debt and involve risk. A continuing search for yield accompanied by an increasing concern over a potential rise in interest rates has led many investors to consider the bank loan asset class. In this Asset Class Review, we discuss the characteristics of bank loans, review the bank loan mutual fund universe, and provide an overview of the bank loan funds on the LPL Financial Research Mutual Fund Recommended List. Characteristics of Bank Loans Bank loans are syndicated debt instruments that companies use to borrow money for a variety of reasons. Bank loans differ from traditional bonds in a number of ways, but some of the key differentiators between the two are coupon payments, credit quality, seniority, and collateralization. Bank loans tend to be senior debt instruments, and as such are higher in the capital structure than equity and other types of unsecured debt. This means that if a company were to liquidate, bank loan investors would be among the first stakeholders to be repaid. Any assets that exist after these holders get paid, then trickle down to unsecured debt holders and finally equity holders [Figure 1]. Bank loans also tend to be secured with tangible assets specified as collateral. In the event of a bankruptcy, secured debtholders are entitled to the value of this collateral, and as a result, the recovery rate of these securities in the event of bankruptcy tends to be higher than for unsecured obligations. Bank loans are typically floating rate instruments, meaning that the interest rate payable on these obligations is generally specified in terms of a spread over a reference rate, such as LIBOR. Since the interest payments of floating rate securities will adjust upward in a rising rate environment, they are more insulated from interest rate risk. The most common measure of interest rate sensitivity is duration, which measures the percentage change in a bond s value given a change in interest rates. The higher the duration of a bond, typically the worse it will perform in a rising interest rate environment. The floating rate nature of bank loans tends to translate into a lower duration than that of comparable fixed rate obligations. Current durations imply a loss of almost 5% for the Member FINRA/SIPC Page 1 of 7

2 2 Duration Comparison Historical Drawdowns 0% -5% -10% -15% -20% -25% -30% Duration, Years Morningstar Intermediate Bond Category Average Morningstar Bank Loan Category Average Recommended Bank Loans* Source: Morningstar, LPL Financial 09/30/12 * Average of the bank loans on the Mutual Fund Recommended List. -35% Source: Zephyr, LPL Financial 09/30/ Please see the Important Disclosures page for Morningstar Category definitions. Morningstar Bank Loan Category Average S&P/LSTA U.S. Leveraged Loan Index S&P/LSTA U.S. Leveraged Loan TR is unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. Please see the Important Disclosures page for Morningstar Category definitions. average intermediate-term bond fund in the event that rates rise by 1%, while the implied loss for the average bank loan fund in the same type of environment is less than 1% [Figure 2]. Although bank loans have several advantages, they also have a number of risks, the most important of which is credit risk. Bank loans are typically funding means sought by lower credit quality companies, and they are generally not investment-grade obligations. These companies have a higher likelihood of defaulting on their obligations than do higher quality companies that are able to achieve investment-grade ratings and have better access to capital markets. As such, despite of their low duration, bank loans should not be considered to be a cash alternative. Unlike traditional fixed-income bonds, the market for floating rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, when in fact the underlying loans held in the funds are subject to significant credit, valuation, and liquidity risk. It is also important to note that bank loans are not immune to market risk. Even if a company is in a good position to meet the obligations of a bank loan, or the value of the collateral posted for the loan is sufficient to repay creditors in the event of bankruptcy liquidation, this may not necessarily prevent panic selling from driving the price of the security down [Figure 3]. This is yet another reason that investors should not consider bank loans to be a cash alternative. Bank Loan Mutual Fund Universe Although the bank loan mutual fund universe has been growing rapidly, including a 40% increase in number of funds in 2011, the category is still very small at around 40 funds total in the Morningstar bank loan mutual fund category as of September 30, Funds in the category differentiate themselves in a number of ways, the key factors being: Varying degrees of credit risk; Use of leverage; Allocation to securities other than bank loans (i.e. high-yield bonds, convertible bonds); Allocation to internationally originated loans; and Daily liquidity. Funds that invest in floating rate loans may be appealing products to investors seeking greater returns because, in order to compensate lenders for taking on additional credit risk, the loans yields tend to be higher than investment-grade bonds. Funds that invest in floating rate loans may be attractive in a low or rising interest rate environment because, in addition to having higher yields, the floating rate feature allows the fund s interest rate to increase when rates rise. This is because the underlying interest rate on most floating rate loans reset after a relatively short period of time, like 30, 60, or 90 days. LPL Financial Member FINRA/SIPC Page 2 of 7

3 4 Recommended Bank Loan Managers vs. Benchmark and Peer Group, Annualized Performance (Net) Name Ticker Inception Date Our recommended managers overall provide pure, unleveraged exposure to bank loans. Expense Ratio SEC Yield Std. Dev. 3-Yr Recommended Bank Loan Managers Similar to measuring the skills of managers in other asset classes, performance data reflecting risk and returns are the primary focus in reviewing managers in this asset class. We have chosen three managers that we believe best represent varying risk exposure to the asset class. In performing our analysis, we found that these managers offer what we believe to be among the best risk/return characteristics, management teams, and investment processes. Below are the recommended bank loan managers classified according to three different risk classifications: conservative, moderate, and aggressive. Conservative funds tend to exhibit lower volatility, tend to outperform peers during periods of broad market declines, and/or have a more conservative approach in general, investing in the securities of higher quality and more stable companies. Aggressive funds tend to exhibit higher volatility, tend to underperform peers during periods of broad market declines and may invest in more speculative or cyclical companies. Moderate funds tend to be neither as aggressive as funds classified as aggressive, nor as conservative as funds classified as conservative. RidgeWorth Seix Floating Rate High Income (SAMBX) Conservative option, Analyst Top Pick Eaton Vance Floating Rate (EIBLX) Moderate option Oppenheimer Senior Floating Rate (OOSYX) Aggressive option Our recommended managers overall provide pure, unleveraged exposure to bank loans as well as in-line-to-higher yields relative to the peer group, less risk than the benchmark and peer group as measured by standard deviation, and competitive returns [Figure 4]. Next, we lay out the team s and processes behind the strategies. LPL Financial Member FINRA/SIPC Page 3 of 7 YTD 1-Yr 3-Yr 5-Yr 10-Yr Web Address RidgeWorth Seix Floating Rate High Inc I SAMBX 3/1/ N/A Eaton Vance Floating Rate I EIBLX 1/30/ Oppenheimer Senior Floating Rate Y OOSYX 11/28/ N/A Morningstar Bank Loan Category Average 8/1/ N/A S&P/LSTA U.S. Leveraged Loan TR 11/29/1996 N/A N/A Source: Morningstar, LPL Financial 09/30/12 The fund s 30-day yield is based on yield to maturity of a fund s investments over a 30-day period and not on the dividends paid by the fund, which may differ. The gross expense ratio is the fund s total annual operating expense ratio. It is gross of any fee waivers or expense reimbursements. The performance data quoted represents past performance. Past performance is not an indicator of future results. Investment return and principal value will fluctuate so that an investor s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance information quoted. To obtain current month-end performance information, please refer to the manager s websites displayed in the table above. The performance data quoted reflects the reinvestment of dividends and capital gains, is net of expenses. The Volatility of the benchmark used to compare performance is materially different from that of the portfolio. Standard deviation is a historical measure of the variability of returns. If a portfolio has a high standard deviation, its returns have been volatile; a low standard deviation indicated returns have been less volatile. Floating rate bank loans are loans issued by below investment-grade companies for short term funding purposes with higher yield than short-term debt and involve risk. Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus.

4 5 Recommended Manager Credit Quality Exposure 80% RidgeWorth Seix (SAMBX) Eaton Vance (EIBLX) Oppenheimer (OOSYX) Morningstar Bank Loan Category Average S&P/LSTA U.S. Leveraged Loan 100 Index 60% 40% 20% 0% BBB % BB % B % Below B % Not Rated % Credit Quality Source: Morningstar, LPL Financial 09/30/12 Credit Quality is one of the principal criteria for judging the investment quality of a bond or bond mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio s credit worthiness, or risk of default. RidgeWorth Seix Floating Rate High Income (SAMBX) An obligation rated BBB exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. Seix Investment Advisors is a boutique fixed income-focused asset management firm that sub-advises the RidgeWorth Seix Floating Rate High Income Fund. Led by George Goudelias, the mutual fund was launched in March of Goudelias has 25 years of investment experience, and prior to coming to Seix to launch their bank loan platform, he was a senior analyst on the J.P. Morgan securities Senior High-Yield team. Under Goudelias there is a small, but focused team of analysts that perform bottom-up credit analysis. The team s process is focused on finding high-quality companies that offer attractive cash flow, liquidity resources, and competitive positioning. They then add layers into their analysis to review industry positioning and relative valuation analysis to ensure they are not overpaying for securities. The resulting portfolio is higher quality with greater BBB exposure relative to our other recommended managers and the broader peer group. Eaton Vance Floating Rate (EIBLX) Obligations rated BB, B, CCC, CC, and C are regarded as having significant speculative characteristics. BB indicates the least degree of speculation and C the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions. Scott Page and Craig Russ are the co-portfolio managers on the Eaton Vance Floating Rate strategy. They have one of the deepest analyst teams in the industry, providing them ample coverage of their highly diversified portfolio. The mutual fund has a track record of over 10 years employing the same consistent investment process under Page s leadership. With approximately $8 billion in assets, they are the second-largest mutual fund in the Morningstar Bank Loan mutual fund category. Their process revolves around performing bottom-up credit analysis and looking for relatively undervalued opportunities. They tend to be a well-diversified across sectors and securities with credit exposure primarily in BB rated securities. Oppenheimer Senior Floating Rate (OOSYX) The Oppenheimer Senior Floating Rate Fund dates back to September 1999 and has been managed by Joseph Welsh since inception. Welsh has a team of analysts that perform rigorous bottom-up fundamental credit-related LPL Financial Member FINRA/SIPC Page 4 of 7

5 An obligation rated B is more vulnerable to nonpayment than obligations rated BB, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor s capacity or willingness to meet its financial commitment on the obligation. research and focus on finding securities that will deliver higher yields relative to their peers. In their portfolio, they are willing take on greater credit risk relative to peers. As shown in Figure 5, they have greater exposure to single B rated credit securities than our other recommended managers and the peer group. When credit is rewarded by the markets, they tend to perform well and as a result they have had strong returns over the last several years. Benefits of Using Active vs. Passive Management for Bank Loan Exposure Principal risk: An investment in Exchange Traded Funds (ETFs), structured as a mutual fund or unit investment trust, involves the risk of losing money and should considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts, Index tracking error. There is a relatively new Exchange Traded Fund (ETF), which provides passive exposure to the bank loan asset class called the PowerShares Senior Loan Portfolio (BKLN). It can be an effective vehicle for shorter term tactical trades to gain exposure to the asset class as it offers a high level of liqudity as well as a lower level of expenses than most bank loan mutual funds, but it does have its drawbacks. One of the issues with investing in BKLN is that the index it follows is market cap weighted. This means the largest holdings in the Index are the largest bank loans outstanding, and the performance of the ETF will be driven mainly by those top holdings. In addition, passive investors are likely allocating capital to the companies that currently have more debt outstanding than other companies with bank loans available in the market. With an actively managed vehicle, the manager has the ability to differentiate themselves from the Index. Conclusion Investors that are concerned with the potential threat of rising interest rates and are willing to take on some credit risk in seeking attractive yields may think about looking to the bank loan asset class. In looking for a way to gain exposure to the asset class, we suggest that clients consider the mutual funds in the bank loan category of the LPL Financial Research Mutual Fund Recommended List. We believe active management makes sense with bank loans and that the Recommended List contains proven, high-quality managers that provide pure expsoure to the asset class and span the risk/ return spectrum. LPL Financial Member FINRA/SIPC Page 5 of 7

6 IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risk including loss of principal. Floating rate bank loans are loans issued by below investment-grade companies for short term funding purposes with higher yield than short-term debt and involve risk. Asset allocation does not ensure a profit or protect against a loss. An Asset Class is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). High yield/junk bonds (grade BB or below) are not investment-grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The market value of convertible securities tends to decline as interest rates increase and may be affected by changes in the price of the underlying security. Investors should consider the investment objectives, risks, charges and expenses of the variable annuity contract and sub-accounts carefully before investing. The prospectus contains this and other important information about the variable annuity contract and sub-accounts. You can obtain contract and sub-account prospectuses from your financial representative. Read prospectuses carefully before investing. Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus. Morningstar Intermediate-Term Bond Category Average: A fund that focuses on corporate, government, foreign or other issues with an average duration of greater than or equal to 3.5 years but less than or equal to six years, or an average effective maturity of more than four years but less than 10 years. Morningstar Bank Loan Category Average: Funds that invest primarily in floating-rate bank loans instead of bonds. In exchange for their credit risk, they offer high interest payments that typically float above a common short-term benchmark. Analyst top picks may change at any time without notice. An obligation rated BBB exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. Non-rated bonds have not been issued a rating by bond rating agencies such as Standard and Poors and Moodys. Bonds that have not been rated by an agency are usually considered to be junk bonds or fall below investment-grade. RidgeWorth Seix Floating Rate High Income (SAMBX) The fund is subject to many considerations such as Below Investment-Grade Securities Risk which are securities rated below investment-grade which at times are referred to as Junk Bonds. Credit Risk, which is the risk that the borrower will not make timely payments of principal and interest. Derivatives Risk, which can include swaps, foreign currency forward contracts and futures. Senior Loan Risk, where economic and other market events may reduce the demand for certain senior loans held by the fund. Swap Risk, which may increase or decrease the fund s exposure to credit risk and could result in losses if the Subadviser does not correctly evaluate the creditworthiness of the entity on which the credit default swap is based. U.S. Government Risk, where the U.S. Treasury obligations may differ in the interest rates, maturities, tines of issuance and other characteristics. Please read the funds prospectus for other important information such as additional risks, and expenses, carefully before investing. LPL Financial Member FINRA/SIPC Page 6 of 7

7 Eaton Vance Floating Rate (EIBLX) The fund is subject to many considerations such a Interest Rate Risk which is when interest rates rise, the value of fixed income investments is likely to decline. Foreign Investment Risk, where the value of fund shares can be adversely affected by changes in currency exchange rates and political and economic developments abroad. Derivatives Risk, which can lead to losses because of adverse movements in the price or value of the asset, index, rate or instrument underlying a derivative, due to failure of a counterparty or due to tax or regulatory constraints. Active Management, as the fund is an actively managed portfolio and its success depends upon the investment skills and analytical abilities of the investment adviser to develop and effectively implement strategies to achieve the fund s investment objective. Oppenheimer Senior Floating Rate (OOSYX) The fund is subject to many considerations such as Fixed Income Market Risk, where the developments relating to subprime mortgages have adversely affected fixed-income securities markets in the United States, Europe and elsewhere. Lower Grade Securities, whether rated or unrated, have greater risk than investment-grade securities. Borrowing and Leverage as the fund can borrow up to one-third of the value of its total assets, including the amount borrowed from banks, as permitted by the Investment Company Act of Foreign Investing as foreign issuers are usually not subject to the same accounting and disclosure requirements that U.S. companies are subject to, which may make it difficult for the fund to evaluate a foreign company s operations or financial condition. Derivatives Risk, which may involve significant risk as some derivatives have the potential for unlimited loss, regardless of the size of the funds initial investment. Concentration Risk, as the fund cannot invest 25% or more of its total assets in an industry, except that it may invest 25% or more of its total assets in securities of the group of industries in the financial services sector. PowerShares Senior Loan Portfolio (BKLN) The fund is subject to many considerations such as Fixed Income Securities Risk, which are subject to interest rate and credit risk. Interest rate risk refers to fluctuations in the value of a fixed-income security resulting from changes in the general level of interest rates. Investing in Loans which are subject to interest rate risk and credit risk. Risk of Loan Assignment, as the purchaser of an assignment, the fund typically succeeds to all the rights and obligations of the assigning institution and becomes a lender under the credit agreement with respect to the debt obligation; however, the Fund may not be able to unilaterally enforce all rights and remedies under the loan and with regard to any associated collateral. Non Investment-Grade Securities Risk, where all or a portion of the loans in which the Fund will invest may be determined to be non-investment-grade loans that are considered speculative. Other risks include prepayment risk, reinvestment risk, liquidity risk and the risk of investing in a closed end fund. INDEX DEFINITIONS The S&P/LSTA U.S. Leveraged Loan Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads and interest payments. London Interbank Offered Rate (LIBOR): An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers Association. The LIBOR is derived from a filtered average of the world s most creditworthy banks interbank deposit rates for larger loans with maturities between overnight and one full year. This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Not FDIC/NCUA Insured Not Bank/Credit Union Guaranteed May Lose Value Not Guaranteed by any Government Agency Not a Bank/Credit Union Deposit Member FINRA/SIPC Page 7 of 7 RES Tracking # (Exp. 11/13)

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