Compass Financial - Market Update - Oct 27, 2008

LP L FINANCIAL R E S E AR C H

Market Update Adam Norman Research Analyst, Fixed Income Strategy, LPL Financial

October 24, 2008

High Yield Update: Financial market turmoil and fears of a prolonged recession have caused the high yield bond asset class to experience its worst selloff in history, sending yield spreads to their widest levels ever. Valuations of high yield bonds appear to reflect a deep recession for the U.S. economy, in which default rates would soar well beyond record levels. While we expect the high yield market to remain challenged in the near term due to a lack of support from leveraged players as well as a tightening of lending standards for high yield issuers, we recommend an investor with a longer time horizon take advantage of current pricing.

1

High Yield Spreads and the Default Rate Default Rate (left hand scale) 1200

10.0%

1000

8.0%

800

6.0%

600

4.0%

400

2.0%

200

0.0%

0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

12.0%

Basis Points

Default Rate

Yield Spread (right hand scale)

Source: Moody’s, Lehman, LPL Financial

During past credit market downturns, yield spreads gradually gapped out wider as the default rate increased. The worst credit cycles occurred when spreads eclipsed the 1000 basis points level during the 1990 savings and loan crisis, and the 2002 corporate fraud scandals. In each case, it took about five or six months for spreads to widen by 400 basis points to their peak levels. The current selloff is unprecedented both in magnitude and speed as spreads gapped out by 400 basis points in just ten days. The average high yield bond yields nearly 18.5% and the spread to Treasuries closed Monday October 20, at 1554 bps, well above its record high, set in October 2002. High yield bonds have priced in deteriorating economic conditions and a rapid increase in default rates well in advance of actual data. The following chart shows quarterly data, going back to 1982 and therefore excludes the current month. Remarkably, spreads have widened out almost 500 basis points in the month of October, marking the current environment as the worst high yield market ever. The trailing 12-month default rate for U.S. speculative grade issuers has increased steadily since December 2007, when it was just 0.9%, its lowest level since 1981. Moody’s most recent calculation estimates a default rate of 3.4% as of the end of September, still below its historical average of around 5%. Yet the average price of a high yield bond has declined to 65 cents on the dollar, only slightly exceeding its record low. Using an average recovery rate on a defaulted bond of 30 cents on the dollar (which is below the longterm average of 40 cents on the dollar) and factoring in the more than 18% yield, implies a default rate of greater than 20%. While we agree that default

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rates will continue to increase, we do not expect them to reach the levels implied by current pricing. In the last 30 years, the default rate reached more than 10% just twice, peaking at 13% in June 1990. S&P forecasts that the default rate will increase to 7.6% over the next 12 months, while Moody’s forecasts a default rate of 7.9% a year from now. In our opinion, investors are being more than compensated for the risk that defaults will increase to their record levels. The average price of a corporate bond has simply fallen off a cliff over the last month, as evidenced by the following chart. 2

Lehman Corporate High Yield Average Price

4/15/2008

10/15/2008

4/15/2007

10/15/2007

4/15/2006

10/15/2006

4/15/2005

10/15/2005

4/15/2004

10/15/2004

4/15/2003

10/15/2003

4/15/2002

10/15/2002

4/15/2001

10/15/2001

4/15/2000

10/15/2000

10/15/1999

110 105 100 95 90 85 80 75 70 65 60

Source: Lehman, LPL Financial

High yield bonds have historically demonstrated exceptional performance following periods of extraordinary yields. Since 1987 (the earliest time for which Lehman data is available), a 14% yield threshold has been breached only four times, other than the current period. Each coincided with a financial crisis and includes: October 1987, February 1989, November 2000 and October 2002. Starting with the following month, the 12-month total returns of the Lehman U.S. High Yield Index were: +17.31%, -5.25%, +8.09%, and +33.77%. During the 1989-1990 timeframe, yields were still on the rise, and ultimately peaked at 20.94% in December 1990. Over the following 12 months, the Index returned +46.19%. Picking the peak in yields will prove nearly impossible, but when yields eventually decline, the benefit to the asset class is evident. Do to significant issuer risk, we do not suggest purchasing individual high yield bonds. Rather, we recommend an open-end mutual fund, due to the importance of credit research and diversification. While we find current valuations on high yield bonds compelling, we caution that we do not expect yield spreads to compress to the same degree and speed in which they sold off. Financial conditions will improve over time, but investors’ risk appetite may remain subdued for several months. If default and recovery rates ultimately remain at manageable levels, high yield investors with a long-term time horizon ought to be handsomely rewarded. Since 1983, the high yield bond market has posted negative total returns only four times. The year-to-date returns through October 21, 2008, already exceed the total of those four years combined. Credit markets tend to move in cycles and we expect spreads to eventually tighten. Even if spreads fail to revert to their mean, and stay rooted at current levels, the current coupon income provides an attractive return.

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IMPORTANT DISCLOSURES Municipal Bonds are subject to availability and change in price. They are also subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to alternative minimum tax. Federally tax-free but other state and local taxes may apply. High yield/ junk bonds are not investment grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors. Investing in mutual funds involves risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus. 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 referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

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This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC. 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

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