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High Yield and Bank Loan Outlook

October 16, 2012

The value proposition in bank loans is quite compelling: comparable risk profiles, higher yields, seniority in the capital structure and no sensitivity to interest rates. While the key components needed to sustain the rally are still firmly in place (an accommodative monetary policy and strong sector inflows), we believe the easy opportunities are behind us.
-Scott Minerd, CIO, Guggenheim Partners

The leveraged credit market turned in an impressive Q3 with high yield bonds and bank loans returning 4.3 and 3.1 percent, respectively. Unprecedented accommodation from central bankers across the globe has alleviated much of the macroeconomic tail risk that we highlighted in last quarter’s publication. Presented with a seemingly insatiable demand for new issue bonds, issuers returned to the torrid pace of issuance that characterized the start of 2012 by raising a record $99 billion during the third quarter.

Assessing the leveraged credit landscape from a relative value perspective, we see a bifurcated market with BB rated high yield bonds at one extreme and bank loans at the other. Historically low yields and increased sensitivity to rates underpin our underweight stance on BB rated bonds. The value proposition in bank loans is quite compelling: comparable risk profiles, higher yields, seniority in the capital structure and no sensitivity to interest rates. While the key components needed to sustain the rally are still firmly in place (an accommodative monetary policy and strong sector inflows), we believe the easy opportunities are behind us.

REPORT HIGHLIGHTS:

• The strong sector return was balanced across the credit spectrum with higher rated bonds outperforming during the first half of the quarter and lower rated names picking up in the latter half. BBs returned 4.1 percent for the quarter, while CCCs returned 4.6 percent.

• The resurgence of Collateralized Loan Obligations (CLO) has been a positive for the bank loan market. 2012YTD CLO issuance has totaled $32.3 billion compared to $13.6 billion in all of 2011.

• Historically low yields on BBs have led to widening spreads relative to CCCs. The current spread of 460 basis points is markedly higher than the average spread of 350 basis points during the previous expansion from 2004-2007.

• The trailing 12-month bank loan default rate ended the quarter at 1.22 percent compared to 1.20 percent at the end of Q2. The trailing 12-month high yield bond default rate decreased from 2.17 percent to 1.90 percent over the same period. The ample liquidity in the financial system decreases the likelihood of a sustained long-term rise in defaults.

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