Brandywine Global Investment Management, LLC

Topical Insight | March 31, 2012

1Q 2012

Global High Yield Perspectives

An exit by a euro-zone (EZ) member that would force recognition of potential losses associated with EZ member central bank imbalances is currently an underappreciated event. An EZ federalization of these imbalances will not occur and is not a viable solution for most EZ political democracies. The three-year Long-Term Refinancing Operation (LTRO) has reduced funding stress in EZ economies. Low quality credit assets and junk-rated financial asset prices have risen dramatically this quarter. Current dollar prices of low quality credit assets reflect excessive optimism on the stresses in Europe and economic growth in the U.S. and Asia.

Gerhardt (Gary) Herbert, CFA Portfolio Manager

Joined the Firm in 2010, and has 19 years of investment experience Columbia University, M.B.A., Finance, with Honors Villanova University, B.S.

Brian L. Kloss, JD, CPA Portfolio Manager

We cant go on together with suspicious minds And we cant build our dreams on suspicious minds. Elvis Presley Were caught in a trap. Hans Werner-Sinn, President of the Ifo Institute for Economic Research

Joined the Firm in 2009, and has 13 years of investment experience Villanova School of Law, J.D., summa cum laude University of Scranton, B.S., Accounting

Regina G. Borromeo* Portfolio Manager

Joined Brandywine Global Investment Management (Europe) Limited in 2010, and has 11 years of investment experience University of Pennyslvania, B.A., Communications

Most of us remember these lyrics from Elvis Presleys crooning of Suspicious Mindsor in the case of the more contemporary investor, from Fine Young Cannibals; however, to hear these words from the dour Hans Werner-Sinn should cause concern. The trap, that Werner-Sinn has highlighted, is the imbalances in the payment claims between EZ central banks (see Figure 1 on next page). To simplify, these claims develop and accumulate when cross-border bank transfers occur within the EZ; when certain member countries import more goods and services than they export, these countries are dependent on capital inflows to balance the difference. Yet the banks in many of these stressed sovereigns were unable to raise capital through deposit inflows or reasonably priced borrowings, and instead turned to their central banks to make up the capital shortfall. These central banks simply printed euro to fill the capital gap for their banks, which then became a claim on the other EZ central banks via the European Central Bank (ECB).

* Employee Brandywine Global Investment Management (Europe) Limited. In rendering portfolio management services, Brandywine Global Investment Management, LLC may use the portfolio management services, research and other resources of its affiliates. For Institutional Investors Only

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These imbalances have continued to grow (see Figure 2); the German response has been to demand austerity to reduce the financing gap potentially tumbling the already overleveraged, stressed EZ economies into a multi-year severe recession. The ultimate issue will be whether these recessions, if severe enough, cause a member country to exit the EZ. If, for instance, Greece were to leave the EZ and return to the drachma, these imbalances would be crystallized as real losses and the likelihood of the Greek central bank defaulting on the claims due to the Bundesbank would become a moot point. While economic stress in the EZ has been reduced by the three-year LTRO, a return to synchronized economic growth will now determine if EZ economies can escape the monetary trap created by a common currency. A national debt, if it is not excessive, will be to us a national blessing. It will be powerful cement of our union. Alexander Hamilton, Letter to Robert Morris, April 30, 1781

Figure 1 Current TARGET2 Balances of Euro-Zone Central Banks Billions of Euros*

-100
-180.1 -175.0

-119.7

-108.2

-200 Germany Italy Spain Ireland Greece Portugal

*Germany, Italy as of Jan 2012; Ireland, Greece, Portugal as of Nov 2011; Spain as of Dec 2011. Source: Ifo

Many observers of the EZ difficulties have called for a United States of Europe as a solution to the financing problems of the stressed EZ sovereigns (see Figure 3 on next page). The difficulty with this concept is that they neither accept the history of Europe nor understand Hamiltons response to early economic circumstances of the United States as the first Secretary of the Treasury. In this case, Germany would be required to assume excessive liabilities without any taxing authority. The hardships Germans faced to combine into a unified Germany reduced growth and transferred investment throughout the 1990s. Today, there is no compelling political willingness to assume the debts of stressed Southern European sovereigns by Northern European sovereigns, nor is there a willingness to allow Northern European sovereigns to impose broad-based taxing authority and oversight on Southern European sovereigns. As a general marches at the head of his troops, so should they march at the head of affairs, insomuch that they ought not wait until the event to know what measures to take, but the measures they have taken ought to produce the event. Alexander Hamilton, Papers of Alexander Hamilton

Figure 2 Rescue Activities Over Time A Breakdown of the Bail-Out Funds; Billions of Euros
2500
Italy becomes a Target debtor 2036*

2000
Target liabilities plus government bond purchases and rescue packages*** June 2010 Approval of temporary rescue package

1500

1000

500

May 2010 Approval of 1st rescue plan for Greece ECB government bond purchases begin Target liabilities GIPS countries

Government bond purchases plus rescue packages

0 2008 2009 2010

IMF rescue package parallel EFSM and EFSF 250bn EFSM 60bn IMF** 30bn EU**** 53bn EU** 80bn

2011

2012

*Total bail-out funds; data as of figure 1. **First rescue package for Greece (granted by euro countries and IMF) ***Calculated using month-end figures **** Credits disbursed by the end of 2011, unused resources to be released by EFSF Greece, Italy, Portugal, Spain (GIPS); European Financial Stabilization Facility (EFSF); European Financial Stabilization Mechanism (EFSM) Source: Ifo

ECB President Mario Draghis three-year LTRO has had the desired impact on risk premiums in Europe. Spreads on the riskiest segments of the credit markets have been dramatically reduced. European banks and lower quality credits have regained access to the capital markets.

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Figure 3 Deficit and Debt as Percent of GDP by Country

Ireland

120% 100%
Decit as % of GDP Debt as % of GDP

20% 15% 10% 5% 0% -5% -10%

Portugal

140%

0% -5% -10% -15% -20% -25% -30% -35% 2000 2002 2004 2006 2008 2010 2012 (E)

120%
Debt as % of GDP

80% 60% 40% 20%

100%

80%

60%

-15% 0% -20% 2000 2002 2004 2006 2008 2010 2012 (E) 40%

6% 4%
Decit as % of GDP

Italy

125% 120% 115% 110%

4% 2% 0% -2% -4% -6% -8% -10% -12% 2000 Debt as % of GDP 2002 2004

Spain

70% 60% 50% 40% 30% 20% 10% 0%

2% 0%

105% -2% -4% -6% 2000 2002 2004 2006 2008 2010 2012 (E) 100% 95% 90%

2006

2008

2010

2012 (E)

Deficit as % of GDP

Source: Boenning & Scattergood

A portfolio heavily skewed to these segments of the credit markets has achieved sizeable returns in a very short period of time (see Figure 4). Yet, we are troubled (see Figure 5 on next page) by the absolute high dollar price investors are now paying for the opportunity to earn income in the most default-prone segment of the credit markets.
Figure 4 2012 YTD Total Return by Rating Category (%) March 2012 MTD Total Return by Rating Category (%)

IG AAA IG AA IG A IG BBB HY BB HY B HY CCC -4% -2% 0% 2% 4% 6% 8% 10% 12%

IG AAA IG AA IG A IG BBB HY BB March MTD Total Return HY B HY CCC -4% -3% -2% -1% 0% 1% 2%

Source: RBS Securities, The Yield Book

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While our global high yield credit portfolios were not positioned to capture the CCC or lower Tier-2 junk financial rally, the prices being paid today to take on this risk do notin our estimationaccount for 1) the likelihood of recession in the next several years in the United States; 2) the small, but devastating probability of one of the EZ members leaving the euro zone; or 3) the need of an additional bailout of another stressed EZ sovereign. We are now metaphorically buying puts against our performance risk proxies in a low volatility economic environment (see Figure 6) by structuring and maintaining a higher credit quality portfolio to withstand future business-cycle and funding stresses.
The views expressed represent the opinions of Brandywine Global Investment Management and are not intended as a forecast or guarantee of future results. All information obtained from sources believed to be accurate and reliable. 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. There may be additional risks associated with international investments. International securities may be subject to market/ currency fluctuations, investment risks, and other risks involving foreign economic, political, monetary, taxation, auditing and/or legal factors. International investing may not be suitable for everyone. 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. The Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (e.g., Argentina, Brazil, Venezuela, etc.) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included. This information should not be considered a solicitation or an offer to provide any Brandywine Global service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Past performance is no guarantee of future results. 2012, Brandywine Global Investment Management, LLC. All rights reserved.

Figure 5 Agencies Propose Revisions to Leveraged Finance Guidance March 26, 2012

The agencies observed tremendous growth in the volume of leveraged credit leading up to the crisis and in the participation of non-regulated investors. While there was a pull-back in leveraged lending during the crisis, volumes have since increased while prudent underwriting practices have deteriorated. As the market has grown, debt agreements have frequently included features that provide relatively limited lender protection, including the absence of meaningful maintenance covenants and the inclusion of other features that can affect lenders recourse in the event of weakened borrower performance. In addition, capital structures and repayment prospects for some transactions, whether originated to hold or to distribute, have been aggressive. Management information systems (MIS) at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis, and many institutions have found themselves holding large pipelines of higher-risk commitments at a time when buyer demand for risky assets diminished significantly. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation Office of the Comptroller of the Currency
Figure 6 Price Volatility Falling in Global Asset Classes May 2011 - Present
220 200 180 160 140 120 100 80 May 2011 July 2011 Sept 2011 Nov 2011 Jan 2012 Mar 2012 Equity Commodity FX Credit Rates

Volatility is calculated from three-month, at-the-money option prices. Equity includes S&P, EuroStoxx, Nikkei, Kospi, Bovespa, Hang Seng. Commodity includes gold, oil. FX includes EURUSD, JPYUSD, USDKRW, AUDUSD. Rates includes USD Libor, Euribor, JPY Libor 3m3m 10y vol. Credit includes CDX IG, iTraxx Main. Source: Bloomberg, Quantitative and Derivative Strategies, Morgan Stanley Research