Topical Insight | February 6, 2013

Bank Loans vs. Global High Yield

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 volatility1 since 2006, we expect U.S. high yield bond market returns over the next several years to be lower with higher volatility than the 2006-12 period, driven by several forces (see figure 1).

Chief among the concerns are the potential for higher U.S. interest rates due either to stronger-than-expected 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.

Caveat Emptor vs. Carpe Diem

Figure 1 Risk / Reward Characteristics of Various AssetsDecember 2006 - December 2012

Source: Credit Suisse, The Bloomberg Professional Service, Datastream

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ML ABS Master

Brandywine Global Investment Management (Europe) Limited

Gerhardt (Gary) Herbert, CFA* Portfolio Manager• Joined the Firm in 2010, and has 20

years of investment experience

Brian L. Kloss, JD, CPA* Portfolio Manager• Joined the Firm in 2009, and has 17

years of investment experience

Regina G. Borromeo Portfolio Manager• Joined Brandywine Global Investment

Management (Europe) Limited in 2010, and has 12 years of investment experience

*Employee Brandywine Global Investment Management, LLC. Investment management services provided by Brandywine Global Investment Management, LLC as a sub-advisor to Brandywine Global Investment Management (Europe) Limited.

Issued and approved by Brandywine Global Investment Management (Europe) Ltd. Registered office Level 17, Heron Tower, 110 Bishopsgate, London EC2N 4AY. Registered in England and Wales, No. 06324517. Authorized and regulated by Financial Services Authority (the “FSA”) (FRN: 472774)

For Institutional Investors Only1See “Toward a Better Approach: Managing High Yield Credit through the Business Cycle”

Topical Insight | February 6, 2013

A review of historical performance of the U.S. loan sector shows correlations with high yield bonds above 80% for much of the prior five years; Since the early 1990s, the two asset classes’ respective yields have averaged a near 88% correlation (see figures 2 and 3).

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).

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).

Bank Loans vs. Global High Yield | p2

Figure 2 20 Month Rolling Return Correlation of Various Assets with Credit Suisse Leveraged Loan IndexAugust 1993 - August 2012

Source: Credit Suisse, The Bloomberg Professional Service, LB Boston Associates

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Treasury Avg = -25.81% Libor Avg = -2.02% Credit Suisse High Yield Index Avg = 51.10%

81.45%

30.20%

-51.34

Figure 3 Leveraged Loan Yield vs High Yield Bond YieldJanuary 1992 - December 2012

Source: Credit Suisse

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12/31/126.25%5.93%

Figure 4 Cumulative Returns of Bonds, Loans and EquitiesDecember 2006 - December 2012

Source: Credit Suisse, The Bloomberg Professional Service

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6Brandywine Global Investment Management (Europe) Limited

Topical Insight | February 6, 2013

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 5 and 6).

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).

Bank Loans vs. Global High Yield | p3

Figure 5 Most Loans Trade At or Above Par2

Source: Morgan Stanley, Bloomberg

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102-108101-102100-10199-10098-990-98

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28%

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Figure 6 Cov-Lite Issuance Near All-Time Highs1997-2012

Source: Morgan Stanley, S&P LCD

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Figure 7 Leverage Metrics for Leveraged Loan Underwriting Total Debt to EBITDA Multiples, Avg. of Upper Quintile2003 - 2012

Source: S&P LCD

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FuLL CovenAnts seConD Lien

(%)oveRALL

(%)1995 94.001996 56.921997 78.001998 73.581999 51.172000 56.75 56.752001 57.09 57.092002 62.67 59.56 62.592003 65.96 100.25 66.972004 82.30 97.87 83.412005 90.13 74.27 86.092006 83.64 49.41 66.082007 94.52 72.91 88.632008 48.21 60.24 7.96 41.67 53.652009 40.79 51.93 10.03 20.76 43.182010 77.13 70.77 14.38 18.20 50.542011 68.41 23.38 55.442012 69.77 55.09 11.31 13.56 48.72Avg. 58.98 73.02 10.92 45.78 65.16

Figure 8 Bank Loan Recovery Rates by Covenant and Lien1995-2012

Source: Credit Suisse

Brandywine Global Investment Management (Europe) Limited

Topical Insight | February 6, 2013

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 below-investment credit markets out of necessity (as the U.S. did in the early 1990s). European financial institutions are shrinking their balance sheets, while Asian corporates are seeking diversified funding source (see figures 10 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.

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!

2 The broader loan universe is based on a list of 305 leveraged loans (term loan tranches only) with pricing data, representing $304bn 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 100 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 Brandywine Global Investment Management, LLC or any of its affiliates and are not intended as a forecast or guarantee of future results.

Bank Loans vs. Global High Yield | p4

Figure 9 European B-Rated Credits Trade Much Wider than US B-Rated Credits2010 - 2012

Source: Morgan Stanley, The Yield Book, iBoxx

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Figure 10 European Banks Still Deleveraging

Source: Morgan Stanley Research, SNL Financials

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Figure 11 Asian Disintermediation Continues: Estimated Breakdown of MSCI AJX Corporates’ Debt Funding3 2008-2013E

Source: Bloomberg, Morgan Stanley Research

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2008/09 represents low debt issuance volumes. *Estimate

Brandywine Global Investment Management (Europe) Limited

Topical Insight | February 6, 2013Bank Loans vs. Global High Yield | p5

All information obtained from sources believed to be accurate and reliable. In rendering portfolio management services, Brandywine Global Investment Management, LLC 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, 2012. Brandywine Global will not change the information at a later date. Past performance is no guarantee of future results.

©2013, Brandywine Global investment Management, LLC. All rights reserved.

Brandywine Global Investment Management (Europe) Limited