High yield bonds. US senior loans update. begin on page 4.

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1 Chief Investment Office WM 20 March 2014 High yield bonds US senior loans update Barry McAlinden, CFA, strategist, UBS FS Loan performance can best be characterized as slow and steady over the past nine months, but loans performed best on a relative basis during periods when interest rates rose. Solid corporate fundamentals, reasonable valuations, and strong demand continue to support our recommendation for senior loans. With prices of most loans trading at or near par, additional appreciation is limited. Loans can therefore best be described as a "carry" investment that should provide steady coupon income. Loan prices should be more resilient than traditional fixed income segments in a rising rate environment. Loans slow and steady... When measured since the inception of our US senior loan investment theme in July 2013, loans have produced a total return of 4%, which falls short of the performance of investment grade (IG) corporate bonds at 4.6% and US high yield (HY) bonds at 8%. The main reason why loans underperformed during this period is that loans tend to perform best relative to traditional fixed income segments when interest rates are rising. While rates have moved modestly higher since mid-2013, this has occurred in a range bound and choppy fashion, which contrasts to the May to July 2013 period when rates moved abruptly higher. Further benefiting IG and HY bonds was the sharp contraction in credit spreads that occurred during 4Q13 as the economic backdrop exhibited strength into yearend and the Fed engineered a market-friendly start to tapering. This backdrop supported traditional credit segments as the spread tightening allowed prices to appreciate, even as benchmark rates edged higher....but shined when rates rose Loans outperformed most other fixed income segments during recent periods when rates were rising, which includes the aforementioned "taper tantrum" from May to July 2013 (+bps rise in the 10yr UST yield) and also November through December 2013 (+50bps rise in the 10yr UST yield). Looking back further, Fig. 3 shows the performance of various asset classes during periods of rising interest rates since Loans achieved a very attractive return of 8% annualized during these periods and outperformed most other fixed income segments, with the exception of high yield bonds. Fig. 1: Performance mid-2013 to present Total return since 1 July 2013, in % Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 HY bonds IG bonds S&P/LSTA loans Treasuries Source: Bloomberg, UBS CIO WMR, as of 14 March 2014 Fig. 2: Loans outperformed during 2013 taper scare Total return May to August May-13 1-Jun-13 1-Jul-13 1-Aug-13 HY bonds IG bonds S&P/LSTA loans Treasuries Source: Bloomberg, UBS CIO WMR, as of 1 August 2013 This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 4.

2 Demand likely to remain a tailwind Steady inflows was one of the reasons why loans outperformed nearly all other fixed income segments during the spring of 2013, including HY bonds. Investors pulled money from traditional bond funds as rates rose rapidly and redeployed into short duration alternatives, such as senior loans. However, so far in 2014, flows into traditional fixed income segments have been positive on account of the benign rate environment. Should this momentum shift as rates rise, we believe investor preferences would again move in favor of the senior loan asset class. Furthermore, demand from institutional investors remains solid. Institutional investors and collateralized loan obligations (CLOs) comprise the lion's share of the senior loan ownership structure. Certain risk retention rules have yet to be finalized and could result in reduced CLO activity due to more punitive holding requirements. However, these regulations are still in their development stages and we believe final rules will likely take into account the significance that the CLOs represent to a well-functioning leveraged finance market when fully implemented. Fundamentals still supportive Many of the same positive underlying trends that are evident in the US HY bond market are also supportive of senior loans. Among the larger issuers, about two thirds of the speculative companies currently have both loans and bonds outstanding, so there is a high degree of issuer overlap. While leverage ratios have edged higher from their post crisis lows reached in , they are still strong from a historical basis. Receptive market conditions have enabled issuers to refinance debt and lengthen debt maturities. The low funding rate environment has also resulted in very strong interest coverage ratios, which is a measure of a company's ability to service its debt. Furthermore, US lending conditions remain favorable as banks continue to ease lending standards. These factors, along with an more self-sustained growth path for the US economy, should prolong the credit cycle and prevent the leveraged finance markets from transitioning to a downturn phase over the medium term. Aggressive issuance trends likely to continue As the loan market recuperated from the financial crisis, there's been an increase in aggressive types of issuance in the form of covenant-lite (cov-lite) deals, dividend deals, and non-cash coupons. The proportion of cov-lite issuance is historically high at 60% of all loan issuance last year and about 50% so far this year. Despite these warning signals, the overall trend is that cov-lite deals tend to be issued by the stronger and more liquid companies, many of which are well-researched by the institutional investment community. Moreover, cov-lite deals are not completely void of all covenants. While they often lack maintenance covenants, most of them do contain protection from additional debt incurrence. When looking back at the performance of past covlite loans, a Moody's study concluded that cov-lites actually defaulted less during the pre-crisis years relative to those with full covenant protection. As a result, we're not alarmed by the degree of cov-lite issuance. More generally, we view these trends as representative of a highly accessible market environment within the middle stages of the credit cycle, rather than signaling an overheating market. Fig. 3: Performance during rising rate periods since 1996 Total return, in % 20% 15% 10% 5% 0% -5% 16% 16% 14% interest rates fall Treasuries High yield corporate bonds 6% 9% -2% -4% interest rates rise Investment grade corporate bonds Senior loans Source: Bloomberg, UBS CIO WMR, as of 31 Jan Note: average annualized returns; the interest rate regime refers to the change of the 5-year Treasury yield Fig. 4: HY bond and loan prices Index price level, left, 5yr Treasury yield, right, in % S&P/LSTA loan index HY bonds 5yr Treasury yield (right) Source: Bloomberg, UBS CIO WMR, as of 28 February 2014 Fig. 5: Issuers have termed out debt maturities Maturities, in USD bn Maturities ($bn) % Bonds Source: Bloomberg, UBS CIO WMR, as of 10 March 2014 Loans UBS CIO WM 20 March

3 Valuations not stretched Senior loan coupons are issued at a nominal spread over LIBOR, which represents the risk premium that investors earn for investing in the loan. Even though loans have low interest rate duration risk, there is still spread duration risk as fluctuation in spread can cause volatility in loan prices. Fig. 6 shows the historical index spread over LIBOR, which is currently in the mid 400bps range, compared to a pre-crisis average of 330bps and a low in the low 200bps range. In conjunction with our view for HY bonds, we believe loan spreads have incremental tightening potential, which should keep re-pricing activity high as issuers take advantage of lower market rates. History shows that even after a fed tightening cycle commences, credit spreads tend to grind tighter before the onset of the next credit downturn eventually takes place. As we published in our CIO Year Ahead report, we believe US corporations are in the re-leveraging phase of the credit cycle, where spreads are still biased to compress. Coupon driven returns from here With the majority of loan prices currently at or near par, loans can only deliver a coupon driven return in the 4% to 5% range since the continuous call features prevent prices from rising much further. Barring any financial market shocks, loan prices should deliver these coupon returns with low price volatility as demand remains strong in a rising rate environment. Since about 80% of loans contain LIBOR floors, the coupon is fixed until the market LIBOR rate exceeds the floor level. This means that coupon income will not reset higher until the Fed tightening cycle progresses. Factors that will detract from realized income include the ability for issuers to re-price their loans at lower coupon rates and actual defaults. We believe the former will be more of an issue than the latter, as default rates remain historically low. Although total return is limited from current levels, we look for loan performance to outpace higher quality fixed income segments over the course of the next 6-12 months. Fig. 6: S&P/LSTA Loan index spread Spread to maturity over LIBOR, in bps L L L L L+0.00 L L L L L Spread-to-maturity Pre-crisis average Source: Bloomberg, UBS CIO WMR, as of 14 March 2014 Fig. 7: Projected six month returns Total return, in % (1) (2) (3) (4) HY bonds IG bonds Loans 5yr UST 10yr UST Source: Bloomberg, UBS CIO WMR, as of 14 March Note: Analysis uses CIO WMR's six month interest rate forecasts and spread targets for IG and HY bonds. Loan coupon is reduced for assumptions about issuer re-pricing and defaults. Conclusion In summary, we continue to view US senior loans as an attractive addition to the credit sensitive portion of an investor's fixed income portfolio. The low price sensitivity to rising rates should provide loans with an advantage over government and IG corporate bonds that exhibit higher duration. Given the speculative-grade nature of the issuers who borrow in the loan market, we recommend that senior loans be considered by investors with an adequate risk profile who would otherwise be comfortable investing in HY bonds. UBS CIO WM 20 March

4 Appendix Statement of Risk Bond market returns are difficult to forecast because of fluctuations in the economy, investor psychology, geopolitical conditions and other important variables. Corporate bonds are subject to a number of risks, including credit risk, interest rate risk, liquidity risk, and event risk. Though historical default rates are low on investment grade corporate bonds, perceived adverse changes in the credit quality of an issuer may negatively affect the market value of securities. As interest rates rise, the value of a fixed coupon security will likely decline. Bonds are subject to market value fluctuations, given changes in the level of risk-free interest rates. Not all bonds can be sold quickly or easily on the open market. Prospective investors should consult their tax advisors concerning the federal, state, local, and non-u.s. tax consequences of owning any securities referenced in this report. Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. UBS CIO WM 20 March

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