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1 This summary reflects our views as of 12/15/08. Merrill Lynch High Yield Master Index effective yield at 23%. Asset Class Review: High-Yield Bonds Executive Summary High-yield bonds have had a terrible year in 2008, with the Merrill Lynch High-Yield Master Index losing almost 33% as of 12/15/08. Defaults over the last 12 months have been about average, but are forecasted to go significantly higher going higher, possibly reaching 20% in the next year or two. Both absolute yields and spreads versus Treasuries and investment-grade bonds are far above prior peaks. A near-worstcase scenario is currently priced into the market. Potential average returns over the next five years are likely to be in the mid-teens. Valuation Rating 2 1 is extremely undervalued, 5 is extremely overvalued However, economic and high-yield-specific risks are not to be ignored, and if they materialize, we could see more short-term volatility, although losses over a 12-month time period seem very remote. The high-yield asset class is attractively valued and we have a tactical overweighting in our model portfolios. We believe this position makes sense even on an after-tax basis, but because much of high yield s return comes from income, it is best to own the asset class in tax-deferred accounts if possible. Recent Equity Market Performance Performance Survey as of 11/30/08 Merrill Lynch High Yield Master YTD -31.4% 3 Month -29.7% 1 Year -31.2% 3 Year -7.6% 5 Year -1.8% 10 Year 1.5%

2 RELATED CHART High Yield Returns-Trailing 3 and 12 Months Key Factors The Economy: Because many companies with high-yield debt are less financially stable than their peers, they are also more sensitive to changes in the economy, and clearly the economy is not strong right now. We are now starting to feel the impact of the economic "imbalances" that were not resolved in the last recession; consumers are retrenching, the current-account deficit is still huge, and savings rates are low. Added to that is normalization in home prices, which for several years had soared beyond rational levels, creating a wealth effect that is now being reversed. Finally, the credit crunch makes debt financing (and refinancing) harder to come by. With these conditions, companies with less creditworthy debt are more likely to default on their interest or principal payments, which hurts the highyield asset class both directly (through reduced interest payments) and indirectly (a loss of confidence in these bonds results in a higher risk premium and lower prices). Default Rate: Default rates are an important component in assessing the total-return potential of high-yield bonds. Yields and price changes represent the most easily observed variables, but a high default rate reduces total return and therefore must be factored into the analysis. Trailing 12-month defaults are still quite low, and are expected to be a little over 4% for Moody s is forecasting defaults of 10.4% in 2009, but current yield levels imply defaults higher than that (a market-based model used by Chris Garman of Leverage World suggests a forward default rate of almost 22%, although it is based on the distress ratio the percentage of junk bonds with spreads of more than 1,000 basis points over Treasuries a metric which is currently extremely distorted by exceptionally low Treasury yields). Defaults have reached low double-digits during prior periods of unusual stress, and we have heard other analysts suggest that, based on the current composition of the high yield universe, defaults could even reach mid-teens levels in a 1990s-style recession.

3 Another concern vis-à-vis defaults is the large number of low-quality junk bonds that are due to mature in the next couple of years. Many of these issuers depend on their ability to refinance, and tighter credit conditions could make this difficult, resulting in higher defaults for these distressed firms. It is important to remember that defaults don't typically result in a total loss. Some defaults are later cured and most others result in some recovery. Historically, recoveries have averaged about 40%, but there is a meaningful range around that average; during periods of high defaults, recovery rates tend to be at the lower end of the range (around 25-30%). As an example, we might assume that if defaults were 10%, with a 40% recovery rate, the impact on total return would be -6%. Distress Ratio: The distress ratio (the percentage of bonds yielding 1,000 basis points above the 10-year Treasury) is considered by some as a leading indicator that foreshadows default rates. At roughly 84% as of November 30, the distress ratio has reached a level never before seen. Part of this move has come from a decline in Treasury yields, so it is not entirely a function of declining junk-bond prices, but the huge rise in junk bond yields is worth noting: at over 23%, these bonds are yielding 500 bps more than they were at the peak during the 1990 high-yield meltdown. Note: Distressed bonds have historically had a much higher default rate than non-distressed (historical median one-year default rates of 23.5% and 1.2%, respectively), implying that most of the broad index s default losses come from distressed bonds. Supply and Demand: New issuance for YTD 2008 is the lowest it s been since At $55 billion as of November month-end, new issuance is about 35% of what it was for the same period last year. Moreover, 85% of this year s issuance was placed during the first half of the year; it has subsequently come to a near dead-stop. A decrease in supply is usually a good thing for asset prices, however, since an average of about half of new issuance is directed towards refinancing existing debt, a decrease in new issuance could actually be a problem for many companies going forward (i.e., an inability to refinance could cause them serious problems). On the demand side, high-yield mutual funds have experienced net outflows. However, mutual funds are only one small piece of the high-yield market, and we do not have data on the purchase/sales activities of hedge funds or other big institutional investors. It is reasonable to assume, however, that hedge funds are a big player in this asset class, and if the size of the hedge fund universe stays permanently lower, there will be a corresponding decrease in demand for high yield bonds. Market timers and hot money tend to have a greater impact on high-yield than on other asset classes. It seems to be consistently more subject to sudden shifts in inflows and outflows. We suspect that this has been an issue during this bear market, exacerbated by hedge fund deleveraging. This variable is impossible to predict with any certainty or consistency, and as such we typically give it less weight in our analysis. Nonetheless, it is a risk that bears considering. Interest Rates: Like other types of bonds, the high-yield asset class is sensitive to changes in interest rates. As such, a rising-rate environment could still result in a decline in junk-bond prices. Conversely, declining interest rates are generally a sign of economic weakness, which can also be bad for high-yield bonds. (Note: Under normal conditions, high-yield bonds comparatively lower durations make them less sensitive to interest rate changes versus Treasuries or high-quality investment-grade bonds.) Valuations There are two primary frameworks we use when assessing the attractiveness of high-yield bonds: spread-based valuations and potential returns (absolute and relative to other asset classes). Spreads: The sell-off in high-yield over the past year along with the huge drop in Treasury yields has caused spreads to reach high highs. At around 2,000 bps, the current spread level is far above its long-term average, and indeed is far above spread levels seen in prior high-yield bear markets. However, given the risks that are present in the economy (as well as this sector, which has some unique risks) we believe that high spreads are certainly warranted. Spreads versus high-quality corporates tell a similar story. As a point of comparison, high-yield spreads exceeded 900 bps in 2002 and approached 1,300 bps in the early 1990s, which historically were the best times to

4 overweight this asset class. We also look at interest-rate differentials on a ratio basis (which adjusts for the absolute level of interest rates), and based on this measure, high yield still looks very attractive. Potential Returns: Four main factors impact returns for high-yield bonds: the yield, the default rate, the recovery rate, and price changes (capital gain/loss). At over 23%, yields are far above average (the average, however, is biased upwards by the higher absolute level of interest rates in the 1980s), and offer both a high going-forward return and a lot of protection against losses at the total return level. As noted above, there are differing opinions about what defaults will be going forward. In our bear scenario, we assume peak defaults of 20% (again, this is far higher than in any other cycle), and five-year cumulative defaults of more than 50%, which is worse than any prior in history, including the Great Depression (although it s worth noting that the junk bond data going back that far is of debatable comparative value). Because recovery rates are generally inversely related to the default rate, we also assume recovery rates will be very low over the next five years. Price change is harder to analyze. We believe that big price increases are unlikely in the near-term (given the economic outlook), but over a multi-year time horizon we could see modest price appreciation as yields come down. In prior junk bond bull markets, yields have gone below 9%, and in 2004 they even briefly dropped below 7%. These bonds were yielding 11% as recently as August. If Treasuries yields are back at anything close to normal levels five years from now, and spreads are even a little bit above average, we believe an 11% yield for the index at that point in time is quite reasonable, even in a bear scenario. Pulling all of the math together, in a bear-case scenario, we arrive at a pre-tax return for the high-yield asset class of better than 16% annualized over the next five years. There are other scenarios that result in higher returns, particularly if high yield rallies prior to the end of our five-year horizon. In terms of short-term downside, all of the high-yield managers we ve spoken to believe that a very bad bear-case scenario is already priced into the asset class (although there was not uniform agreement on the ideal time to go to a heavily over-weighted position). With yields as high as they are, it would be nearly impossible for this asset class to experience a loss over a 12-month time period, but it s hard to predict what could happen over shorter intervals. (The market can be completely irrational if the time horizon is short enough, and technical factors such as forced selling by hedge funds can be very powerful.) Combining our take on the fundamentals with valuation analysis and a return outlook that is attractive versus both stocks and bonds, we believe that this asset class offers an appealing tactical opportunity.

5 RELATED CHARTS High Yield Bond Spreads vs. Treasuries and High-Quality Corporates High Yield Bond Yield to Maturity Certain material in this work is proprietary to and copyrighted by Litman/Gregory Analytics and is used by Yukon Wealth Management with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.

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