Despite continued headlines surrounding the U.S. fiscal cliff, Euro-pean debt, and instability in the Middle East, the European Central Bank (ECB) and our Federal Reserve have been able to offset much of the tail-risk plaguing the capital markets over the past 12 months. Most risk assets, including credit markets, have ridden a tremendous tailwind. In particular, credit spreads have compressed significantly, with investment grade and high yield spreads leading the charge.

The 3rd quarter saw a continuation of the Bernanke and Draghi “put”, as credit markets outperformed on the announcements of aggressive monetary stimulus. In near unison, the Federal Reserve and ECB pro-vided open ended, potentially unlimited asset purchases. On Septem-ber 6th, the ECB announced the third liquidity program since Mario Draghi took presidency of the ECB, the Outright Monetary Transac-tions (OMT) program. This liquidity program followed the words of the ECB President on July 26th that the ECB would do whatever it takes to save the Euro. On September 13th, the Federal Reserve fol-lowed the ECB action with a very dovish statement and the announce-ment of QE3, an open-ended, quantitative easing program.

Chart 1: Credit outperforms, Government related weakens

Total returns (%) October 3Q12 2012Treasury -0.17 0.57 1.91Agency MBS -0.17 1.13 2.63CMBS 0.55 3.83 8.94ABS -0.01 1.23 3.42Corporate 1.29 3.83 10.06High Yield 0.88 4.53 13.08Bank Loans 0.37 3.14 8.20

Source: Barclays, Credit Suisse

Yield Convergence

Given the rally in corporate credit and the degree of spread com-pression, we believe bank loans offer relative value. With high yield bond and bank loan yields roughly equivalent, the ability to move up the capital structure without sacrificing yield is at-tractive.

High yield bond and bank loan yields converge

Source: Barclays, Credit Suisse

Yield differential favors moving up in the capital structure

Source: Barclays, Credit Suisse

october 2012

THE INVESTOR

NAVIGATING THE CREDIT MARKETS

COMPRESSION

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Following the strong rally in high yield, bond and loan yields have converged

Chart 2: The Federal Reserve is squeezing investors out of Gov-ernment related assets. Corporate bonds look likely to benefit.

Source: Barclays

CompressedWith the Federal Reserve engaged in QE, credit sectors have bene-fited indirectly. By focusing QE3 on the Agency MBS market, inves-tors may be moved out of Government related assets and into the next area of yield and liquidity in investment grade securities, cor-porate bonds (Chart 2). We believe the market reaction of sizeable spread compression in September following the Fed announce-ment was warranted given the direct effects the removal of MBS supply will have on corporate bonds.

Over the past 12 months, returns in credit have far outpaced government instruments such as Treasuries, Agencies, and MBS (Chart 1). With the treasury curve relatively flat since Q3 2011, incremental returns have been propelled by spread compression. Investment Grade corporate spreads have decreased by 65bps, led largely by debt of financial institutions, whose spreads are down 123bps. The Barclays Corporate Index yield-to-maturity (YTM) ended the quarter at 2.80%, from 3.63% last year.

High yield bonds seemed to have indirectly benefited the most from Fed and ECB policy (Chart 3). High yield spreads have decreased by 124bps in the past year, with all credit qualities performing well. The combination of yield starved investors, lower systemic risk, and strong corporate fundamentals have led to market partici-pants continuing to invest record inflows into high yield bond mu-tual funds. Year-to-date, high yield mutual funds have recorded an inflow of more than $37bn. The Barclays High Yield Index finished with a yield of 6.49%, down more than 2% over the past 12 months.

Credit fundamentals warrant riskWith economic data weakening on the margin and some macro events moving closer to deadlines, the key word in the title of this section is “credit” fundamentals. Corporate behavior is generally remaining debt holder friendly and capital markets have been wide open for corporations to refinance or address maturities.

Corporate health continued to keep default rates low amidst an un-certain macro and fiscal environment. The Moody’s 12 month trail-ing global default rate ended the third quarter at 3.0%, up from 2.9% the previous quarter, but well below the historical average of 4.8% since 1983. The strength in corporate fundamentals can also be seen with bank loans, which exhibited a very low default rate. The Moody’s 12-month trailing default rate for bank loans finished unchanged on the quarter, remaining at 1.6% versus a historical average of 3.9%. As mentioned earlier, with accessible capital mar-kets and the ability to refinance have led to limited upcoming ma-turities, which is likely to keep default rates low for the next sev-eral quarters.

Chart 3: Lower risk premiums supported high yield bonds

Source: Barclays, CBOE

Relative value and macro concerns warrant cautionOver the past year, Central Bankers engaged in aggressive mone-tary policy to offset weak global growth and fiscal uncertainty. The effect of the policy announcements have led to strong performance in risk assets, with equities and credit sectors reaching post crisis highs.

Despite aggressive policy action, fiscal clouds remain on the hori-zon, which may likely constrain market rallies. The ECB action of September provides a potential backstop to sovereign debt mar-kets but does not address the lack of progress towards greater fis-cal integration, consolidation, and structural adjustments. Within the U.S., as the rush of monetary stimulus fades, the focus will re-turn to the domestic fundamentals and the fiscal cliff.

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compressionoctober 2012

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Indirectly, high yield bonds have benefited significantly from Fed policy announcements

QE3 Announcement

With economic data weakening, and some high frequency data points pointing to increased probability of recession, economic growth may not be able to provide the escape velocity needed to offset any contraction from fiscal stimulus in 2013. Uncertainty will continue to constrain capital, and capital market strength or weakness looks to be firmly in Washington’s ability to provide clar-ity. Given the rally in credit and the degree of spread compression, relative value favors risk mitigation over return maximization.

Pacific Asset ManagementOctober 2012

compressionoctober 2012

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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). Investment professionals at Pacific Asset Management also have investment responsibilities at Pacific Life. As of September 2012, Pacific Asset Management managed approximately $3bn. Assets managed by Pacific Asset Management includes assets managed at Pacific Life by the investment professionals of Pacific Asset Management and assets managed within Pacific Asset Management.

IMPORTANT NOTES AND DISCLOSURESThe 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 inter-nally and/or obtained from sources believed to be reliable; however Pacific Asset Management does not guarantee the accuracy, adequacy, or the completeness 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. State-ments concerning financial market trends are based on current market conditions, which will fluctuate. High Yield and Bank Loan Securities involve risk, including the risk of default or loss of principal. 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 informa-tion provided herein should not be construed as providing any assurance or guarantee as to returns that may be realized in the future from investments in any asset or asset class described herein. Corporate securities 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 state-ments are subject to numerous assumptions, 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