Bond Market Perspectives June 2, 2010

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1. LPL FINANCIAL R E S E A R C H Bond Market Perspectives June 2, 2010 Fundamentally Attractive We view recent weakness in High-Yield Bonds as presenting an attractive Anthony Valeri, CFA opportunity for investors. The month of May was difficult for high-yield Market Strategist LPL Financial investors, as the sector posted its worst monthly performance since February 2009, as measured by the Barclays U.S. High Yield index. Was it justified? The sell-off is primarily attributable to European sovereign Highlightsdebt fears rather than deterioration in underlying fundamental financial High-Yield Bond performance in May wasperformance of high-yield corporate bond issuers. However, further updates the weakest since February 2009.on first quarter earnings reports along with updated gross domestic product (GDP) data show that financial performance of corporate bond issuers Several factors contributed to the sell-continues to improve. While we expect markets to remain volatile over off but none were related to underlying the near-term and recovery may take more than a few weeks, cheaper fundamentals, which continue to improve.valuations mean investors are paid to wait. We believe good fundamentals andThe 3.6% decline in the High-Yield Bond market in May was driven by attractive valuations should outweigh several factors, but none were related to the underlying fundamental fallout from European debt problems and performance of high-yield corporate issuers. view current weakness as an attractive Record issuance in March and April. The high-yield market witnessed a opportunity in High-Yield Bonds. record month of issuance in March with $40 billion in new bonds coming to market and April offered little let up with an additional $33 billion in new issuance. Two weeks during this period saw more issuance than is average for an entire month. When issuance is elevated, it requires steady demand from investors. Any let up, and High-Yield Bond prices will fall until 1Corporate Profits Surged Again During the Firstsupply and demand find equilibrium. Unfortunately, European sovereignQuarter Providing a Favorable Fundamentaldebt fears caused investors to reconsider lower rated bonds and sparkedBackdrop for Corporate Issuers.an exodus at a time when the market was saturated with new bonds.Corporate Profits with Inventory Valuation and News headlines of excesses in the high-yield market. HeadlinesCapital Consumption Adjustmentsthat new high-yield issues were incorporating some of the hallmarks of% Change Year-to-Year Seasonally Adjusted Annual Rate, Bil.$ poorly structured debt that led to the financial crisis added to High-Yield40 Bond weakness. The issuance of a payment-in-kind (PIK) bond, where an issuer has the option to forego interest payments in return for increasing an20 investors quantity of bonds, Leveraged Buyout (LBO) financed transactions, and lowest tier, CCC-rated, bonds did occur over the March-April period but 0 were a far cry from pre-financial crisis levels (see table on page 2). Heavy mutual fund outflows. Related to the first point, mutual fund -20 outflows totaled a negative $3.6 billion in May according to Lipper data, -40 one of the worst four-week stretches on record. Such a massive outflow at 99 00 01 02 03 04 05 06 0708 09 10a time of increased issuance creates a powerful one-two combination that Source: BEA, Haver, 6/01/10 can lead to sharp swings in bond prices. Shaded areas represent recession. Member FINRA/SIPC Page 1 of 3 2. BOND MARKET PER S P E C T I V E S2A Higher Interest Coverage Ratio Also Highlights FEARS OVER A SURGE IN SPECULATIVE NEW BOND ISSUES HAVE BEEN OVERBLOWN. Improving Corporate Fundamentals. Interest Coverage Ratio Issuance as Percentage of all High-Yield Bond Issuance 10.009.00 Issuance by Type (%)2006 2007 2008YTD 20108.00 Bottom tier CCC-rated 9.014.0 15.96.77.006.00 LBO/Acquisition 44.4 51.5 46.312.8 Coverage5.00 Related4.00 PIK 4.81.82.6 0.43.002.00 Source: JP Morgan, Bloomberg, LPL Financial 5/28/101.000.00At the same time, the fundamental picture for corporate bond issuers,Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar00 01 02 03 04 05 06 07 08 09 10both investment-grade and high-yield, continued to improve. In last weeksrevision to first quarter economic growth (as measured by GDP), theSource: Factset, LPL Financial as of May 28, 2010Bureau of Economic Analysis revealed that economy-wide corporate profitscontinued to surge, up 30% on a year-over-year basis roughly matching thepace of the fourth quarter of 2009 [chart 1]. Additionally, as earnings reportscontinue to trickle in we now have a more complete picture of specific 3 The Current Yield Spread to Treasuries is Attractive corporate bond credit metrics. In particular, the average companys ability and Compensates for Expected Defaults in Our View. to meet debt service obligations continued to improve as measured by theHigh-Yield Bond Spreadinterest coverage ratio, which measures the income available to pay interest13expenses. The higher the ratio, the greater the ability to meet regularly12 Yield Spread to Treasuries (%)scheduled bond interest payments and vice versa [chart 2].1110The sell-off has improved valuations on High-Yield Bonds with the average 9yield advantage, or spread, to comparable Treasuries, now 7.3% [chart 3]. 8We believe this yield advantage more than compensates for expected 7defaults. Moodys forecasts its 12-month trailing speculative-grade default 6rate to decline to 2.7% by year-end 2010. We would not be surprised to 5 4see a slight increase in their default forecast in coming weeks due toMayJul SepNov Jan MarMayMays market activity, but we expect any increase to be slight. It is worth 09 0909 0910 1010noting that defaults so far in 2010 have been running at a 1.5% annualizedrate according to Moodys data, suggesting their forecast may be too Source: Barclays, Bloomberg, LPL Financial as of May 28, 2010conservative to begin with. The last time the average High-Yield Bondspread to Treasuries exceeded 7% (November of last year) defaults wereexpected to be 4-6% according to Moodys and S&P forecasts at the time.The 7 .3% yield spread to Treasuries translates to an absolute yield of 9.3%Given the now higher yield, we believefor the average High-Yield Bond. We believe markets will remain volatile overinvestors are adequately paid to wait.the near-term as investor sentiment remains fragile and very sensitive todevelopments from Europe. We therefore believe a recovery from the recentsell off may take more than a few weeks as investors assess the healthof new issue markets and domestic economic data before aggressivelycommitting more money to high-yield. New issuance remains constrainedand liquidity is reduced as market participation remains weak. This willtake more time to heal. However, given the now higher yield, we believeinvestors are adequately paid to wait for the healing process to occur.LPL Financial Member FINRA/SIPCPage 2 of 3 3. BOND MARKET PER S P E C T I V E S We are watching developments in We are watching developments in Europe closely, but continue to believe Europe closely, but continue to believe that the High-Yield Bond market, which is primarily concentrated in the United States, may benefit from improving profit growth domestically, that the High-Yield Bond market will attractive yields, and favorable valuations. As high-yield valuations have benefit from improving profit growthimproved, Treasury valuations have become only more expensive making domestically, attractive yields, an High-Yield Bonds more compelling. Ultimately, we believe U.S. corporate favorable valuations. profitability, along with high-yield valuations, will have a greater impact on high-yield bond performance rather than European economic growth, which was expected to be low. IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate. High-yield/junk bonds are not investment grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. The Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moodys, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes Emerging Markets debt. The index was created in 1986, with index history backfilled to January 1, 1983. The U.S. Corporate High Yield Index is part of the U.S. Universal and Global High Yield Indices. Increase in interest rates will cause the price of corporate bonds to decline. Corporate bonds are not secured by collateral and are subject to credit risk and default risk. The return that an asset achieves over a certain period of time; it considers appreciation or depreciation (expressed as a percentage) of the asset, which is usually a stock or a mutual fund. Absolute return differs from relative return because it looks only at an assets return; it does not compare returns to any other measure or benchmark. CCC- rated bonds are measured by the S&P 500.This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC.To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and make no representation with respect to such entity. Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit Member FINRA/SIPCPage 3 of 3RES 2319 0610Tracking #641483 (Exp. 06/11)