Bank Loans vs. Global High Yield Caveat Emptor vs. Carpe Diem

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1 Topical Insight February 6, 13 Bank Loans vs. Global High Yield Caveat Emptor vs. Carpe Diem The significant decline in nominal yields and commensurate decline in risk premiums of U.S. high yield bonds have forced those with an allocation to the asset class to reconsider current positioning. While an allocation to the U.S. high yield asset class has generated equity-like returns with significantly lower volatility 1 since 6, we expect U.S. high yield bond market returns over the next several years to be lower with higher volatility than the 6-12 period, driven by several forces (see figure 1). Figure 1 Risk / Reward Characteristics of Various Assets December 6 - December 12 Gold Annualized Return 1 1 Barcap AAA Corp ML Mortgage US Inflation US 3 Day TBill US IT ML Gvt Corp ML ABS Master Barcap Agg Bd JPM Emerging Markets Credit Suisse Leveraged Loan Index 1 Credit Suisse High Yield Index US LT Gvt 1 Source: Credit Suisse, The Bloomberg Professional Service, Datastream Chief among the concerns are the potential for higher U.S. interest rates due either to stronger-thanexpected U.S. economic growth or a surprise burst of inflation. Either outcome will likely cause an increase in short-term rates in the U.S. and, perhaps, the removal of unorthodox monetary policies. Many asset allocators are therefore considering other credit asset classes for their respective credit allocations. Assets with yields that float with changes in U.S. interest rates are viewed as providing a degree of protection that fixed rate U.S. bonds simply can t provide. Asset allocators with an eye to U.S. credit markets view U.S. bank loans as a tidy solution to these concerns. U.S. bank loans are senior in the capital structure to high yield debt and offer floating rates. We believe conventional wisdom in this case is wrong! While the facts are true, an empirical analysis of long-term performance, recovery rates, and correlations with the U.S. high yield asset class highlight that investors are simply swapping one segment of the fairly to modestly overvalued credit sector for another. S&P MSCI EAFE Annualized Return Volatility Russell 1 See Toward a Better Approach: Managing High Yield Credit through the Business Cycle 2 3 FTSE NAREIT All REITs 3 Gerhardt (Gary) Herbert, CFA Joined the Firm in 1, and has years of investment experience Brian L. Kloss, JD, CPA Joined the Firm in 9, and has 17 years of investment experience Regina G. Borromeo* Joined Brandywine Global Investment Management (Europe) Limited in 1, and has 12 years of investment experience * Employee Brandywine Global Investment Management (Europe) Limited. In rendering portfolio management services, Brandywine Global Investment Management, LLC may use the portfolio management services, research, and other resources of its affiliates. For Institutional Investors Only

2 Bank Loans vs. Global High Yield p2 Topical Insight February 6, 13 A review of historical performance of the U.S. loan sector shows correlations with high yield bonds above 8% for much of the prior five years; Since the early 199s, the two asset classes respective yields have averaged a near 88% correlation (see figures 2 and 3). Figure 2 Month Rolling Return Correlation of Various Assets with Credit Suisse Leveraged Loan Index August August 12 Figure 3 Leveraged Loan Yield vs High Yield Bond Yield January December % 17 HY Yield-to-Worst CS Lev Loan Index Yield (Assumes 3-yr Refi) Correlation 4-3.% Yield Correlation = /31/12 6.2%.93% Treasury Avg = -2.81% Libor Avg = -2.2% Credit Suisse High Yield Index Avg = 1. Source: Credit Suisse, The Bloomberg Professional Service, LB Boston Associates Source: Credit Suisse More worryingly, past performance since the Great Recession highlights the inability of loans to keep pace with the performance offered by U.S. high yield bonds (see figure 4). Figure 4 Cumulative Returns of Bonds, Loans and Equities December 6 - December 12 7 Total Returns Since 12/31/ CS High Yield Index BarCap Agg Bond CS Leveraged Loan Index S&P Source: Credit Suisse, The Bloomberg Professional Service While U.S. loans have not kept pace with U.S. high yield bonds in terms of performance, the conventional wisdom that because U.S. loan rates float, they will provide protection in a rising rate environment is simply not true. A historical review of return correlations highlights surprisingly, relative to conventional wisdom, no relationship exists (see figure 2).

3 Bank Loans vs. Global High Yield p3 Topical Insight February 6, 13 While U.S. bank loans are senior in the capital structure, the downside economic sensitivity of the underlying assets that bank loans have claims on overwhelms the ability of the liabilities to re-price upwards negative convexity in bond market parlance especially given today s premium prices to par and weaker covenant quality (see figures and 6). Figure Most Loans Trade At or Above Par 2 Figure 6 Cov-Lite Issuance Near All-Time Highs % 4% 3% % % 28% % Broader Loan Universe Liquid Par Loans % % 19% % 4% % 11% % % $1B 3% $1B $8B $6B $4B $B $B Cov-Lite Volume (LS) % of All Institutional Loans (RS) % 2% % 1% % % Source: Morgan Stanley, Bloomberg Source: Morgan Stanley, S&P LCD Having established that the downside and upside of U.S. bank loans are in fact quite similar to U.S. high yield bonds, many U.S. bank loan managers assert higher recovery rates on loans. A careful review of the recent data reinforces the changing nature of the U.S. bank loan market. Smaller, less well-established enterprises are accessing the U.S. bank loan market with weaker covenants and at higher acquisition prices (see figures 6 and 7), which leads to recovery rates that are not significantly higher on loans than those on bonds (see figure 8). Figure 7 Leverage Metrics for Leveraged Loan Underwriting Total Debt to EBITDA Multiples, Avg. of Upper Quintile Q4 11 Q4 12 Source: S&P LCD Figure 8 Bank Loan Recovery Rates by Covenant and Lien cov-lite first lien full covenants first lien cov-lite second lien full covenants second lien overall Avg Source: Credit Suisse

4 Bank Loans vs. Global High Yield p4 Topical Insight February 6, 13 A better approach to capturing yields and total returns associated with the leveraged finance sector is to go global. Although risk premiums are declining globally, not all international credit markets have experienced the magnitude of the spread compression seen in the U.S. high yield markets (see figure 9). In fact, most international markets are developing their belowinvestment credit markets out of necessity (as the U.S. did in the early 199s). European financial institutions are shrinking their balance sheets, while Asian corporates are seeking diversified funding source (see figures 1 and 11). The trend toward disintermediating traditional banking channels in international markets will persist. The ability to capture these excess risk premiums outside U.S. credit markets will be dependent upon a manager that can identify value in an international high yield credit through traditional credit analysis, but also must be able to identify the value offered by the underlying country and currency fundamentals. These three factors determine returns in international high yield, and have been core competencies at Brandywine Global for two decades. Figure 9 European B-Rated Credits Trade Much Wider than US B-Rated Credits 1-12 (bp) Jan 1 USD EUR Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Source: Morgan Stanley, The Yield Book, iboxx Astute investors are eschewing the more fully valued high yield bond and bank loan markets in the U.S. for the cheaper and safer valuations offered in international high yield bond markets. Carpe diem! Figure 1 European Banks Still Deleveraging 14 Figure 11 Asian Disintermediation Continues: Estimated Breakdown of MSCI AJX Corporates Debt Funding 3-13E Loans / Deposits Peak Months After Peak Japan (Peak = 1993) US (Peak = Q3 7) W Europe (Peak = Q4 ) UK Source: Morgan Stanley Research, SNL Financials 1% 9% 8% 7% 6% % 4% 3% % % /9 represents low debt issuance volumes. 69% 29% 2% 39% 49% 12% 9 76% 16% 8% 1 82% 2% 11 *Estimate 66% 63% % 12 13E* Bonds (US) Bonds (Local ccy) Loans Source: Bloomberg, Morgan Stanley Research 2 The broader loan universe is based on a list of 3 leveraged loans (term loan tranches only) with pricing data, representing $34bn in par outstanding. Liquid par loans list based on a smaller set of liquid par (non-distressed) loans with $196bn outstanding. 3 The estimate is base on 1 corporates that make up about 67% of the total debt of the whole MSCI AXJ non-financial universe. The views expressed represent the opinions of or any of its affiliates and are not intended as a forecast or guarantee of future results.

5 Bank Loans vs. Global High Yield p Topical Insight February 6, 13 All information obtained from sources believed to be accurate and reliable. In rendering portfolio management services, may use the portfolio management services, research and other resources of Brandywine Global Investment (Europe) Limited, an affiliate. Fixed income securities are subject to credit risk and interest rate risk. High yield, lower-rated, fixed income securities involve greater risk than investment-grade fixed income securities. The Barclays U.S. Aggregate represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and assetbacked securities. Characteristics, holdings and sector weightings are subject to change and should not be considered as investment recommendations. Indices are unmanaged and not available for direct investment. Unless otherwise noted, performance returns and other data are current as of December 31, 12. Brandywine Global will not change the information at a later date. Past performance is no guarantee of future results. 13,. All rights reserved.