Bank Loan Portfolio Manager’s Jason Rosiak, JP Leasure, and Michael Marzouk discuss the recent performance, relative value considerations, and the outlook for the asset class

Start at the top, discuss the macro environmentRosiak: As we enter the last quarter of 2013, Washington D.C. is dominating the macro landscape. Given the uncertainty around Fed tapering, the extent of the government shutdown, and increasing fear surrounding the debt ceiling, investors seem to be a bit in “wait and see” mode around monetary and fiscal policy. Until further clarity is provided, the near-term outlook on interest rates, economic growth, and corporate guidance will be more uncertain.

Explain the themes that have driven the strong relative perfor-mance of bank loans in 2013Marzouk: The first theme has been the limited-to-no duration risk of the sector due to floating rate coupons. Since April, we have seen a normalization of Treasury yields to more fair value levels given a shift in Fed policy and stabilizing economics. The sharp move higher in yields and subsequent rate volatility negatively affected all fixed income sectors, save bank loans (Table 1). Only high yield and bank loans have positive total returns year-to-date, highlighting the out-performance of credit risk versus interest rate sensitive sectors.

Table 1: Bank loans outperform in a volatile rate environment

Index September 3-Month Year-to-dateBank Loans 0.29 1.40 4.25High Yield 0.99 2.28 3.73Agency MBS 1.41 1.03 -1.00Treasury 0.70 0.10 -2.01Corporate 0.69 0.82 -2.62Municipal 2.15 -0.19 -2.87EMD 2.26 1.38 -5.24TIPS 1.45 0.70 -6.74

Source: Barclays, Credit Suisse as of 09/30/2013

Bank loans in an asset allocation

With limited duration and low correlation to most asset classes, bank loans provide portfolio diversification, an interest rate hedge, and the ability to increase yields through credit risk.

Bank loans have the highest yield per unit of duration

Source: Barclays, Credit Suisse, as of 9/30/2013

Limited correlation provides diversification across portfolios

Source: Credit Suisse, as of 9/30/2013

september 2013

THE INVESTOR

NAVIGATING THE CREDIT MARKETS

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The second theme has been the strong technical backdrop, which has essentially put a floor under prices. While gross issuance in 2013 is at record levels, the primary use of proceeds has been for refinancing, leading to lower net issuance (Chart 1). At the same time net issuance is constrained, demand for the asset class through floating rate mutual funds and CLO issuance has been strong, leading to a balanced supply/demand environment (Chart 2). This has resulted in limited volatility relative to other fixed rate asset classes, which in many cases saw record setting outflows during the summer.

Chart 1: While gross issuance is at record highs, the focus re-mains on refinancing, reducing net supply

Source: JP Morgan, as of 9/28/2013

Chart 2: Strong demand has led to a balanced technical picture, mitigating the volatility seen relative to other fixed income

Source: JP Morgan, as of 9/28/2013

With strong demand and open capital markets, do you have concerns regarding valuations in the asset class?Leasure: Corporate health in non-investment grade credit remains favorable as liquidity, operating trends, free cash flow, and maturi-ty profiles are indicative of below average default risk over the next several years. While leverage is increasing across industries and sectors, credit fundamentals remain favorable overall. The muted economic outlook continues to constrain corporate behavior rela-tive to previous cycles, which in our view is leading to an extended cycle of below average default rates.

Rosiak: It is appropriate to evaluate what the catalysts are driving the demand, and whether those could shift abruptly. We believe the demand is driven by investors seeking to mitigate duration risk, di-versify traditional fixed income, and increase portfolio yields. The growth and development of the floating rate mutual fund market means that short term volatility may occur due to fund flows, as we see frequently with high yield bonds. However, with concerns towards duration only heightened following the recent rate vola-tility, we believe these demand catalysts are likely to continue as investors strategically allocate to the asset class.

With CLO issuance an important part of demand, how does possible legislation affect the technicals?Rosiak: CLO issuance has been strong in 2013 and an important part of the balanced technical picture. However, as proposed by Dodd-Frank, CLO managers would be required to hold a portion of issuance, potentially 5%, as part of risk retention guidelines. While this potential legislation is not due to take effect until 2015, a recent survey by the LSTA (Loan Syndications and Trading As-sociation) reported that 57% of CLO managers would not be able to obtain funding needed to comply with the regulation. With CLO’s accounting for around 50% of demand year-to-date, it is important to monitor this pending regulation and its potential impact.

While fundamentals remain favorable towards a low default rate, we have seen an increase in aggressive issuance in 2013Leasure: Aggressive issuance is picking up, however it remains far below cyclical peaks (Chart 3). Companies have begun engaging in more opportunistic transactions, such as covenant-lite structures, dividend deals, and second liens. Taken in isolation these measures may be of concern. However, taken in aggregate and relative to credit fundamentals, it is a natural feature of an evolving credit cycle. Of particular importance for loan investors has been the re-cord amount of refinancings year-to-date, which is an inherently deleveraging transaction, thus resulting in more downward pres-sure on default rates (Chart 4).

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Chart 3: Aggressive issuance is increasing, albeit far below previous credit cycle peaks

Source: ML/BoA as of 8/30/2013

Chart 4: New issuance continues to be driven by refinancing, which is inherently a deleveraging transaction, and thus good for corporate fundamentalsBank loan new issuance use-of-proceeds

Source: BoA/ML as of 8/30/2013

One type of new issuance that has exceeded previous cyclical peaks is covenant-lite loans, is that a concern?Marzouk: We believe there is a misconception of what “cov-lite” loans are. Your seniority and security are generally not affected by full covenant versus covenant-lite structures. The major differ-ence is what happens when a company breaches a covenant, gen-erally the financial maintenance tests (Debt/EBITDA or Interest Coverage Ratio for example) that exist within full covenant loans but generally do not exist in covenant-lite loans. When a company breaches a maintenance test in a full covenant loan, lenders have the ability to call the loan or demand additional compensation. In covenant-lite structures, lenders do not have the ability to call the loan or demand additional compensation. Covenant-lite structures give borrowers a greater degree of financial flexibility should

earnings drop or revenues fall short, impacting financial ratios.

Leasure: Covenant-lite loan structures have also become more prevalent in the larger issuers, which we believe is a structural change as the asset class evolves into a capital market instrument. As of September, 35% of the Credit Suisse Leveraged Loan Index now consists of covenant-lite loans, and more than 45% of all new issuance year-to-date has been covenant-lite. However, if you break down the issuance by size, you notice that the majority of covenant-lite loans have been issued by the largest borrowers. Full covenant loans are now more likely to be issued by smaller issuers with less diversified revenues, fewer divisible assets, limited subordinated capital, and greater revenue volatility, thus having greater degrees of credit risk. From our perspective, it is far more advantageous to invest in a solid company with a covenant-lite structure than a weaker company with full covenants.

How would you state the relative value proposition today for an allocation to bank loans?Rosiak: We believe the relative value continues to be the ability to mitigate interest rate risk and increase portfolio yields through credit risk in the senior secured part of a company’s capital struc-ture. Over the past few years, one of our favorite sayings about bank loans has been that even if rates do not move higher, inves-tors were getting paid to wait. Bank loans have not only delivered on that, but have shown over the past few months to be a great tool in mitigating interest rate risk in an overall asset allocation.

What provides Pacific Asset Management an advantage in managing loan strategies in today’s environment?Marzouk: Our selectivity and size gives us an advantage. We be-lieve security selection ultimately drives performance in bank loans. Our selective process is further enhanced as a function of our size. Given the current liquidity in fixed income, as assets grow, most managers are forced to incorporate larger numbers of issu-ers into the portfolio. This leads to security selection having less impact on performance. With our current asset base and structure, we are able to obtain meaningful exposure to our favorite bank loans, invest in a diversified portfolio, yet remain selective around our highest conviction names, focusing on maintaining 120-140 is-suers.

Leasure: The credit cycle remains favorable for investors to al-locate to non-investment grade credit. However, as cycles mature, aggressive issuance and deteriorating credit fundamentals sow the seeds for potential credit losses in the future. Our focus on the larger, rated issuers in conjunction with our ability to be highly selective relative to our peers provides us the framework to miti-

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ABOUT PACIFIC ASSET MANAGEMENTFounded in 2007, Pacific Asset Management specializes in credit oriented fixed income strategies. Pacific Asset Management is a division of Pacific Life Fund Advisors LLC, an SEC registered investment adviser and a wholly owned subsidiary of Pacific Life Insurance Company (Pacific Life). As of June 30, 2013 Pacific Asset Management managed approximately $3.7bn. Assets man-aged by Pacific Asset Management includes assets managed at Pacific Life by the investment professionals of Pacific Asset Management.

IMPORTANT NOTES AND DISCLOSURESFor Institutional Investor use only. The opinions expressed are not intended as an offer or solicitation with respect to the purchase or sale of any security. The information presented in this material has been developed internally and/or obtained from sources believed to be reliable; however Pacific Asset Management does not guarantee the accuracy, adequacy, or the complete-ness of such information. This material has been distributed for informational purposes only without regard to any particular user’s investment objectives, financial situation, or means, and Pacific Asset Management is not soliciting any action based upon such information, and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term. The information provided herein should not be construed as providing any assur-ance or guarantee as to returns that may be realized in the future from investments in any asset or asset class described herein. Bank loan, corporate securities, and high yield bonds involve risk of default on interest and principal payments or price changes due to changes in credit quality of the borrower. This material contains forward-looking statements that speak only as of the date they are made, Pacific Asset Management assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous as-sumptions, risks, and uncertainties, which change over time. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. FOR MORE INFORMATIONPacific Asset Management • 700 Newport Center Drive • Newport Beach, CA 92660 • www.pam.pacificlife.com • ContactPAM@PacificLife.com

gate many of the downside risks to credit through this long, extended credit cycle.

SummaryBank loan performance year-to-date has been driven by a lack of du-ration risk, a positive credit backdrop, and a strong technical envi-ronment. Going forward, while return forecasts are mostly coupon-like, we believe the value of mitigating interest rate risk in an overall asset allocation is attractive. An extended credit cycle continues, and while we are seeing signs of releveraging, corporate health points to below average default risk over the next several years. By taking on the incremental increase in credit risk through bank loans relative to investment grade strategies, investors can receive attractive levels of income, while hedging the uncertainty of higher rates down the road.

Pacific Asset ManagementSeptember 2013