High yield bonds. Fig. 1: Performance in 2015 (USD) Total return since 31 December 2014, in % Fig. 2: US loan prices considerably below 100 in USD

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1 US loans Attractive floating yield 1 August 215 CIO WM Research Barry McAlinden, CFA, strategist, barry.mcalinden@ubs.com; Philipp Schöttler, strategist We think US senior loans, offering a yield of 5.3%, are an attractive addition to other fixed income assets for investors able to tolerate lower liquidity. Slow primary market issuance and strong demand from CLOs have provided a supportive backdrop for US loans this year. We believe this favorable backdrop will persist in the near term. US regulatory factors such as leveraged lending guidance and risk retention rules pose potential risks but do not alter our constructive view on US loans at this time. US loans have delivered decent total returns of 2.6% since the beginning of the year, outperforming high quality fixed income segments, and by and large meeting our expectations. The yearto-date performance of US loans stems from their income return, as loan prices have weakened again to their beginning-of-the-year value of USD The average US loan spread (when measured at a 3-year call date and which includes the benefits of LIBOR floors) tightened from a peak level of LIBOR plus 56 basis points (bps) at year-end 214, to LIBOR plus 493bps in April. Since then, spreads have widened again to LIBOR plus 535bps as general market sentiment worsened. In particular, the weakness in lowerrated energy sector issuers weighed on US credit segments. But at only 5%, the sector has a relatively small weight within the US loans index when compared to 14% within US high yield. Thus, the underperformance of the energy sector in recent months explains the outperformance of loans over US high yield, which has achieved total returns of 1% year-to-date. Supportive technical backdrop The supply-demand backdrop has been favorable for senior loans. New issue markets are open but deal flow is running nearly 4% below last year's record pace. The majority of new-issue proceeds this year has been used for acquisition purposes; however, the terms of these deals have been less aggressive, with a focus on strategic mergers and acquisitions (M&A) over private leveraged buyouts. Another reason for the supply slowdown has to do with originators adhering to more strict compliance with the Federal Reserve's leveraged lending guidance. The criteria include the borrower's ability to repay over a reasonable period (e.g., 5 7 years for senior unsecured debt) and deal leverage being below 6 times. There has been stricter enforcement of this criteria by regulators, which have cut down on "non-pass" deals. In addition, while M&A activity has been steady, it is down from 214 peak levels, contributing to the reduction in loan supply. Source: UBS database Fig. 1: Performance in 215 (USD) Total return since 31 December 214, in % Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 US HY US IG Loans IG 1-5 year Treasuries Source: Bloomberg, UBS, as of 7 August 215 Fig. 2: US loan prices considerably below 1 in USD US HY Index price US loan Index price Source: BoA, S&P LCD, UBS, as of 7 August 215 This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

2 Against a modest supply backdrop, the institutional source of loan demand has been consistently present. The buyer base of collateral loan obligations (CLOs) includes banks, pension funds, insurance companies, and asset managers. CLOs continue to be an appealing investment choice for these entities as each risk tranche, from AAA to equity, has attractive risk-reward properties for their respective buyer base. New CLO issuance declined in July but is expected to remain strong and exceed USD 1bn through year-end. Flows from retail investors have been inconsistent, but we expect inflows to be more prevalent as the Fed should soon begin its first monetary tightening cycle in nine years. Floating-rate assets, such as loans, are therefore expected to gain in popularity again among retail investors. However, we continue to expect CLOs, and not funds, to remain the primary outlet for new loans that come to market. Leveraged loans in the credit cycle In the context of a four-stage credit cycle, we believe that we are in the third, or the re-leveraging phase, which may persist for some time. Fig. 5 shows the annual year-over-year returns for both US leveraged loans and high yield bonds going back to For the decade leading up to the financial crisis, loans had a lower total return beta compared to high yield bonds. This beta rose close to one during the crisis as deleveraging among market participants exacerbated the losses in both asset classes. Since then, the correlation of loans and high yield bonds has remained fairly high; that said, loans did not correct by the same magnitude as high yield bonds during both the 213 taper tantrum ( 1% loans versus 5% high yield) and the 214 energy-related corrections ( 2% loans versus 5% high yield). This is not surprising since loans have lesser exposure to the causes of each downturn, with lower sensitivity to interest rates and a smaller weighting to energy companies (5% loans versus 15% high yield). As a floating-rate asset class, loans usually perform well when interest rates are on the rise. Fig. 6 shows that US loans and high yield bonds on average showed positive and superior total returns over other fixed income asset classes in past periods, when Treasury yields were rising. One caveat to that is today's prevalence of LIBOR floors in the US loan market, where 9% of outstanding US loans have a LIBOR floor. The average floor value of 1bps means that coupon rates will only start adjusting upwards once that threshold has been passed. LIBOR floors also add a small fixed duration element to the asset class. Nevertheless, we believe that demand for loans in a rising rate environment will pick up as investors position themselves, leading to attractive returns this time as well. The average total return of 8% should not be expected this time when rates rise because the overall yield level is still close to record lows. However, we think that loans will significantly outperform fixed income assets with a higher interest rate sensitivity. Fig. 3: Leveraged loan issuance volume in USD bn Institutional Pro Rata Source: S&P LCD, UBS, as of 7 August 215 Fig. 4: CLO issuance remains robust in USD bn (5) (1) (15) Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 CLO issuance Prime fund flows Source:,S&P LCD, UBS, as of 3 June 215 Fig. 5: Leveraged loans are highly credit sensitive Year-over-year returns (left), in %, and spread (right), in bps (2) (4) , 1,5 1, 5 Leveraged loans yoy returns HY bonds yoy returns HY OAS (right) Source: S&P LCD, UBS, as of 3 April 215 Fig. 6: Loans usually perform well when rates rise Average annualized returns of US assets in month when 1-year Treasury rates fell/rose since % 15% 1% 5% 15% 16% 13% 5% 8% 8% % -5% -2% interest rates fall -4% interest rates rise Treasuries Investment grade corporate bonds High yield corporate bonds Senior loans Source: Bloomberg, S&P LCD, UBS, as of 31 July 215 CIO WM Research 1 August 215 2

3 Loans are attractive We think US senior loans, offering a yield of 5.3%, are an attractive addition to other fixed income assets for investors able to tolerate lower liquidity. The current healthy state of US corporate balance sheets and our outlook for low default rates over the next 12 months provide a supportive fundamental backdrop for US loans. The supportive technical backdrop is also likely to persist, in our view, as strong demand for loans is matched against more modest, but healthy supply levels. In fact, we believe loans are well positioned to perform well in a scenario where rates remain lower for longer, or are gradually rising. In the former scenario, the 4 5% yield level that loans offer should remain appealing to investors. In a scenario where rates move higher on account of economic strength, we would expect loans to outperform other high quality fixed income segments that will be adversely affected by their duration exposure. A short introduction to senior loans Loans are usually issued by sub-investment-grade rated companies, which is why they are also sometimes referred to as leveraged loans. In that respect, the asset class shares some characteristics with the high yield bond market. There is some overlap in companies that have both loans and high yield bonds outstanding, although not all loan issuers also have bonds. With more than USD 83bn outstanding, the US loan market is sizable but still almost 4% smaller than the US high yield market. There are some crucial distinctions between loans and bonds to be aware of: 1. Duration: The coupon rate on senior loans is floating, which means that it is reset regularly based on the development of a short-term benchmark rate plus a stated coupon. In the case of US loans, the benchmark is usually the 3-month USD LIBOR and the reset is done every 45 to 6 days on average. As a consequence, the rate duration of senior loans is close to zero and the interest rate risk is thus very low, which is especially beneficial in times of rising rates. A recent development since the financial crisis has been the introduction of LIBOR floors, or minimum reset rates. Approximately 9% of the US leveraged loan index currently contains a LIBOR floor of 1bps on average. Thus, a majority of loans will only see their coupon rates increase once LIBOR rises above 1%. LIBOR floors also add a small fixed duration element to the asset class. 2. Credit risk: As implied by their name, senior loans have a higher ranking within a company's capital structure. That means, in case of a default, this part of the debt will be first in priority to obtain recovery values. Additionally, senior loans are typically secured by the borrower's asset giving the lender or investor additional security. Furthermore, loans usually involve protective covenants that provide the lender with forceful control over the borrower. These features lead to lower default rates as well as higher recovery values for loans than for high yield bonds. The average annual credit loss over the last 2 years is 1% on US loans and 2.6% on US high yield bonds, mainly due to a considerably higher recovery rate of 7% on average on US loans, compared to 4% on high CIO WM Research 1 August 215 3

4 yield bonds. In summary, the credit risk of senior loans is considerably lower than for high yield bonds. However, the leveraged nature of issuers does makes the loan asset class highly sensitive to credit cycle fluctuations. 3. Liquidity: Loans are traded "over the counter" (OTC) between different banks and mostly loan fund managers. the secondary market liquidity of loans is lower than that of most other credit asset classes. This relative illiquidity is part of the attractive risk premium offered by the asset class. Investors can get access to the market via such a loan fund which usually offers liquidity on a monthly, weekly, or even bi-weekly basis. Furthermore, to protect fund investors from the adverse effect of a forced selling of the underlying loans when prices are low, these funds can "gate" at times of market stress. This means that a liquidation of the investment might not be possible immediately in times of distressed markets, but may take time. While this feature is a useful protection for long-term investors, it has to be considered carefully before making an investment in loans, and makes loans mostly a "buy-and-hold" asset class. 4. Call risk: The majority of loans are immediately callable, although some have a USD 11 "soft call" where the issuer has to pay a USD 1 penalty to refinance at a lower rate for the first six months or one year following issuance. Many issuers have taken advantage of strong market conditions and "repriced" their loans to lower credit spreads by taking advantage of this continuous call feature. Similar to the high yield bond market, call features will constrain the price appreciation potential of loans during strong market conditions. Thus, we do not expect the average loan price to trade above USD 1 for a sustained period. However, the call feature is usually compensated for by higher coupon rates, and callable loans and bonds tend to outperform non-callable securities in times of rising interest rates. CIO WM Research 1 August 215 4

5 Appendix Chief Investment Office (CIO) Wealth Management (WM) Research is published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. CIO WM Research reports published outside the US are branded as Chief Investment Office WM. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Deutschland AG, UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd, UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of Puerto Rico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-us affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-us affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. Version as per July 215. UBS 215. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. CIO WM Research 1 August 215 5