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  • 1. Q1 2 0 0 9 Investment Report U.S. High Yield Market Review The Barclay’s 2% Issuer Constrained High Yield Index Return dispersion by sector was elevated in the quarter. returned 6.61% in the first quarter of 2009. This was Industrials returned 7.17% while utilities and financials the Index’s best quarterly return since 2Q03. The option- returned 2.73% and -2.20%, respectively. Of the 15 sub- adjusted spread (OAS) of the Index narrowed 156 basis sectors, 14 generated positive absolute returns. The top points (bps) over the period and ended at +1,502 bps. (It performing subsectors included communications (11.43%) was two years ago in March 2007 when the Index OAS and energy (11.27%). Communications benefited from the hit its cyclical low of +275 bps.) The Index generated 702 general increased level of risk taking which took root in bps of excess return versus similar duration U.S. Treasur- the period. Large and well capitalized companies within ies during the quarter. The Index yield-to-worst (YTW) the subsector (i.e. Sprint, which returned 12.00%) were declined from 19.41% at the end of 4Q08 to 18.01% by the some of the first to catch a bid and rally. Most energy end of 1Q09. Despite the 141 basis point drop in YTW, the issuers performed well as oil rebounded over 40% from its current quarter-end yield is the second highest on record intra-period low and closed at $49.66. Sandridge Energy, since Lehman began aggregating the data in 1993. one of the largest high-yield oil and gas exploration and production companies, returned 31.58%. The worst The quarter began with high-yield generating its fifth best performing subsectors were financials (-2.20%) and monthly return on record in January. What made the perfor- technology (0.31%). GMAC, the largest financial company mance all the more remarkable was that it took place despite in the Index, returned -21.01% for the period. GMAC a weakening economic backdrop and rising default rates. continues to support of troubled mortgage lender and By most measures, the economy continued its downward subsidiary, Residential Capital. spiral. The most recent February economic data contin- ued to show significant weakness. Rising jobless claims, Not surprisingly, the high-yield default rate moved higher declining home prices, plummeting consumer confidence, during the quarter. The trailing 12-month issuer-weighted reduced manufacturing activity and further loan quality default rate for U.S. speculative-grade credits rose to 7.45% deterioration were all in evidence during February. News by the end of the quarter from 4.53% at the end of 2008 was also negative as 4Q08 earnings reports were weaker and 1.81% in the year earlier period. This was the highest than expected on balance, and usually accompanied by default reading since November 2002. New issue activity reduced company forecasts going forward. March was a remained muted for the asset class with only $11.2 billion solid month for high-yield and helped the asset class end the coming to market. Fallen angel volumes have surged with period on a good note. Economic news remained generally the downgrade to below investment grade of many subor- negative but a rising appreciation that high-yield valuations dinated issues of banks and insurance companies. Fallen had overshot reasonable expectations gave investors reason angels have added more than $25 billion to the high-yield to be optimistic regarding the opportunity of attractive market so far this year, including certain issuance of AIG, relative total return prospects for high-yield versus other Bank of America, Lloyds, MBIA and others. High-yield asset classes. Assuming a below average recovery rate on mutual fund flows continued to remain positive, and gained defaulted securities of 30% of par valuations, current $3.02 billion in contributions during the quarter. valuations imply a five year cumulative default rate of 68%, or nearly 7 out of every 10 issuers in the Index. Cumulative Composite Review five year high-yield default rates have topped 30% three The U.S. High Yield Composite returned 2.36% in 1Q09, separate times since 1924; the highest period was from underperforming its primary benchmark, the Barclays 1931-1935 at 46%. © Western Asset Management Company 2009. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients and their investment consultants. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.
  • 2. U.S. High Yield Investment Report Capital U.S. High-Yield 2% Issuer Capped Bond Index, by 425 bps. For instance, we are encouraged by the pace of new issu- ance in the investment-grade market. Investment-grade The following portfolio positioning impacted relative credits issued over $250 billion in fixed-rate bonds in 1Q09. performance for the period: We are beginning to see evidence that the enthusiasm for • Issue selection had a negative impact on relative investment-grade issuance is migrating to the high-yield performance due in part to 6 of the top 10 overweights market. Currently, new issue transactions are running underperforming and in part to underweights in 9 of 10% ahead of last year’s pace, albeit primarily in high B the top 10 performing issuers. My best guess here is and BB rated credits. With respect to the aforementioned “6 of the top 10 underweights outperforming”. proactive bond exchanges, it’s important to note that while the agencies may officially account for such transactions • Subsector allocation had a negative impact on relative as defaults, recent market experience suggests that the performance. The benefit of the fund’s overweight price action resulting from successful exchanges is quite to energy (11.27%) and an underweight to finan- different than what we have observed with more traditional cial institutions (-0.46%) was more than offset by defaults. The simple reason for such market reception is that underweights to media cable (16.65%) and consumer these transactions are designed to fix the issuers’ balance non-cyclicals (11.02%), as well as an overweight to sheets while avoiding cumbersome and costly bankruptcy transportation (3.04%). processes. The market often values the lesser amount of • Credit quality allocation had a decidedly negative exchanged bonds at a significant premium to the aggregate impact on relative performance. The fund maintained value of unexchanged bonds. In many instances the new an overweight to CCCs (4.78%) and an underweight securities gain collateral, increased coupon and structural to BB rated issues (9.02%). guarantees as the result of a negotiated process, which further enhances the new security’s market value. Our over- • There were four issuers held in the Composite that all view on the high yield market is predicated on our belief defaulted during the period; Charter Communications, that the economy will stabilize toward the end of 2Q09. Idearc, Verasun Energy and Station Casinos. The net impact of the defaults on relative return was neutral Positioning within our portfolio remains aggressive when to positive as we were marginally overweight Charter judged on a ratings basis although we are positioned con- (+20% in 1Q09) and roughly equal weight on Idearc, servatively when viewed on a sector basis. Unfortunately, Verasun Energy and Station Casinos. our ratings bias has detracted from recent performance Outlook as the highest quality bonds have performed the best. Despite a solid +5.98% return year-to-date, we maintain our Through March 2009, the BB portion of the Barclays 2% belief that the high-yield market currently presents investors Issuer Constrained Index returned 9.01% year-to-date with a compelling risk-adjusted opportunity. With a yield while the CCC portion has returned 5.54%. Although of 18.01% and a spread of 1,502 bps, high-yield valuations our rating positioning has not been beneficial, we remain remain considerably cheaper than historical averages and confident that this strategy will ultimately prevail as the close to the record levels we witnessed during 4Q08. We economy stabilizes. We will therefore continue to exploit recognize that the pace of defaults is accelerating and that the yield pick-up anomaly by overweighting select CCCs recoveries are expected to be far lower than previous cycles. and underweighting BBs. As the year progresses, we Our expectation is that defaults will breach 10% this year expect investors’ risk aversion to decline and the market and could even reach as high as 15%, driven in large part to improve, and expect lower-rated issues to significantly by proactive bond exchanges that could get rolled up into outperform. official default measures depending on the specifics of the transaction. However, the combination of extreme valua- As mentioned above, while our ratings profile tends to tions as well as improving technical trends in the market be on the more aggressive side, our industry positioning should lead to longer-term positive performance. is designed to be somewhat defensive and provide a bit Western Asset 2 1st Quarter 2009
  • 3. U.S. High Yield Investment Report of a hedge in the portfolios. Electric utilities remain our remain overweight in aggregate exposure yet defensive single largest sector bet as it currently affords a great with our positioning within the capital structures. There- opportunity to buy a historically defensive sector at fore we remain underweight the OEMs and suppliers yet attractive valuations. We also remain overweight to other overweight the auto finance companies. Finally, we are defensive sectors including aerospace/defense, wireless intrigued by opportunities with both the fallen angel space and media-cable. Our significant sector underweights (mainly financials) and commodity sensitive sectors, and have remained constant as we are concerned about the will look to add exposure as is warranted by investment cyclical and consumer dominated industries. For this opportunities. reason we remain underweight in the retail, media non- cable and technology sectors. Within the auto space we For more information on Western Asset visit our website at www.westernasset.com. Past investment results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management Company and its affiliates (“Western Asset”). Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. This material may not be used or reproduced in any form without express written permission. © 2009 Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319). Western Asset 3 1st Quarter 2009
  • 4. Performance Disclosure (as of September 30, 2008) US High Yield Composite Composite Inception Date: 2/1/94 Composite Creation Date: 2/1/94 No. of Mkt. Value Net Total Gross Total Lehman US HY % Firm Disper- Firm Assets Accts (US$mil.) Return Return 2% Issuer Cap Assets sion (US$mil.) 1998 1 $95 11.96% 12.40% 1.87% 0.19% -na- $49,701 1999 3 $224 14.62% 15.07% 2.39% 0.38% -na- $59,435 2000 7 $1,060 -5.73% -5.36% -5.86% 1.39% -na- $76,504 2001 6 $619 5.09% 5.51% 5.28% 0.66% -na- $94,186 2002 7 $601 -2.16% -1.77% -1.41% 0.54% -na- $112,087 2003 4 $457 23.99% 24.47% 28.97% 0.31% -na- $148,333 2004 2 $533 11.01% 11.45% 11.13% 0.27% -na- $197,837 2005 5 $1,152 3.18% 3.59% 2.75% 0.46% -na- $249,233 2006 16 $7,627 12.71% 13.16% 10.76% 1.49% -na- $510,172 2007 14 $7,425 1.37% 1.77% 2.26% 1.19% 0.64% $621,493 2Q 2008 16 $6,952 -1.58% -1.39% -1.08% 1.14% 0.31% $610,802 Description: Western Asset’s US High Yield composite includes portfolios that employ an actively managed approach that is risk controlled and assimilates the Firm’s top-down macro-economic views with credit analysts’ fundamental and relative value views regarding industry and issuer opportunities in an effort to build and maintain a portfolio that generates superior risk-adjusted returns. Objective: Exceed the benchmark return by 150 basis points annually over a 3- to 7-year period while approximating benchmark risk. Fee Schedule: 40 of 1% on first US$100 million, .20 of 1% on amounts over US$100 million. The minimum separate account size for a US High Yield portfolio is US$25 million. Base Currency: USD Composite Minimum: US$20 million Western Asset has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®). 1. For GIPS® purposes, the firm is defined as Western Asset, a fixed-income investment manager comprised of Western Asset Management Company, Western Asset Management Company Limited, Western Asset Management Company Pte. Ltd., Western Asset Management Company Ltd and Western Asset Management Company Pty Ltd, with offices in Pasadena, New York, London, Singapore, Tokyo and Melbourne. Each Western Asset company is a wholly owned subsidiary of Legg Mason, Inc. (“Legg Mason”), but operates autonomously and Western Asset, as a firm, is held out to the public as a separate entity. Western Asset Management Company was founded in 1971. In February 1996, Legg Mason, Inc. acquired Lehman Brothers Global Asset Management, Ltd. and renamed the acquired entity Western Asset Management Company Limited, at which time it was incorporated into the definition of Western Asset. In September 2000, Western Asset established Western Asset Management Company (Asia) Pte. Ltd. in Singapore. The Singapore office expanded in December 2003 when Legg Mason acquired Rothschild Asset Management (Singapore) Limited, thereby forming Western Asset Management Company (Asia), a division of Legg Mason Asset Management (Asia) Pte Ltd (“LMAMA”). In October 2006, Legg Mason reorganized its Singapore operations, and LMAMA was renamed Western Asset Management Company Pte. Ltd. (“Western Singapore”). In December 2005, Legg Mason, Inc. acquired a substantial part of Citigroup’s worldwide asset management business. Citigroup’s North American fixed-income asset management business was integrated into the legal entity Western Asset Management Company, and the fixed-income asset management business of Citigroup Asset Management Limited (“CAM Ltd”), located in London, was integrated into Western Asset Management Company Limited. As part of the Citigroup acquisition, Western Asset opened Western Asset Management Company Pty Ltd (“Western Australia”) located in Melbourne, Australia. The fixed-income asset management business of Citigroup Asset Management Australia Limited was integrated into Western Australia. Similarly, the fixed-income asset management business of Citicorp Investment Bank (Singapore) Limited, and its affiliates in Singapore, were integrated into Western Singapore. In 2006, the accounts from these Citigroup offices transitioned to Western Asset and were incorporated into the definition of the Firm. Consequently, the historical composite performance records of accounts previously managed by Citigroup Asset Management meet the portability requirements set forth by GIPS®. Western Asset’s retail separately managed account business was integrated into the Firm in January 2006. From January 2006 through March 2007, Western Asset portfolio managers managed these portfolios as dual employees of ClearBridge Advisors, LLC and ClearBridge Asset Management Inc. (each a Western Asset affiliate). The portfolio managers follow Western Asset’s investment process and have access to Western Asset’s investment resources, expertise and investment outlook. Previously, these portfolios were managed by an unaffiliated business that was acquired by Legg Mason in December 2005 and subsequently integrated into Western Asset. Effective April 2007, Western Asset manages these portfolios as sub-adviser to its affiliate, Legg Mason Private Portfolio Group, LLC. In March 2007 the fixed-income asset management business of Citigroup Advisors Co., Ltd. was integrated into Western Asset Management Company Ltd (“Western Japan”) located in Tokyo, Japan and subsequently became part of the Firm. 2. Western Asset Management Company, Western Asset Management Company Limited, Western Asset Management Company Pte. Ltd., and Western Asset Management Company Ltd are registered investment advisors and are regulated by the Securities and Exchange Commission (“SEC”). Western Asset Management Company Limited is authorized and regulated by the Financial Services Authority in the United Kingdom. Western Asset Management Company Pte. Ltd. is registered as an investment advisor in Singapore and regulated by the Monetary Authority of Singapore. Western Asset Management Company Pty Ltd is regulated by the Australian Securities & Investments Commission and is the holder of Australian Financial Services License 303160. Western Asset Management Company Ltd is a financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319). 3. The Firm has been verified for the period from January 1, 1993 to December 31, 2007. 4. Net investment results reflect the deduction of investment advisory fees, while the gross investment results do not. Actual returns will be reduced by advisory fees and any other expenses that may be incurred in the management of an investment account. For each strategy shown, net performance results have been reduced by the amount of the highest fee charged to any Western Asset client employing that particular strategy during the period under consideration. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolio size. Western Asset’s fees are available upon request and also may be found in Part II of Western’s Form ADV (only applicable to SEC registered entities). 5. Composite performance results are time-weighted net of trading commissions and other transaction costs including non-recoverable withholding taxes. 6. Investment fees have an effect on investment results. For example, assume that a client places $1,000,000 under Western’s management and the firm achieves a 10% compound annual return on a gross basis over ten years. If an advisory fee of 0.325% of average assets under management for the ten years was charged and deducted from the gross returns, the resulting compound return would be reduced from 10.0% per year to 9.6425% per year. The final dollar value of the account would be reduced from $2,593,742 to $2,510,668. 7. The portfolios in the composites are all actual, fee-paying and performance fee-paying, fully discretionary accounts managed by the Firm for at least one full month. Investment results shown are for taxable and tax-exempt accounts and include the reinvestment of all earnings. Any possible tax liabilities incurred by the taxable accounts have not been reflected in the net performance. 8. Additional information regarding policies for calculating and reporting returns is available upon request. 9. The dispersion of annual returns is measured by the standard deviation of the asset-weighted portfolio returns represented within the composite. For each annual period, accounts with less than 12 months of returns are not represented in the dispersion calculation. Periods with five or fewer accounts are not statistically representative and are not presented. 10. Futures and options may be used occasionally to hedge market exposure or in an effort to add incremental value to the portfolio. Generally, Western Asset does not use derivatives in a manner that would result in the portfolios being leveraged. Where portfolio guidelines permit, futures and options are used from time to time to implement new portfolio strategies with minimum cost to the portfolio. Multi-currency portfolios use forward foreign exchange transactions frequently to hedge currency risk. 11. For strategies starting mid-year, the return shown in the inception year is for the composite and index since inception. 12. All returns for strategies with inception prior to January 1, 1998 are available upon request. 13. All data shown is as of period-end. 14. Past investment results are not indicative of future investment results. 15. To receive a complete list and description of Western Asset’s composites and/or a presentation that complies with GIPS® standards, please contact Veronica A. Amici at 626•844•9535 or ramici@westernasset.com. This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission. For more information on Western Asset visit our website at www.westernasset.com. 4