FREQUENTLY ASKED QUESTIONS GLOBAL SENIOR SECURED BONDS

GLOBAL SENIOR SECURED BONDS OFFER CAPITAL STRUCTURE SENIORITY

WHAT ARE SENIOR SECURED BONDS?

SENIOR DEFINITION OF “SENIOR” AND “SECURED”? A bond is a debt obligation sold to investors. If a corporation defaults on its obligations, it can be forced into bankruptcy liquidation, in which case its assets are sold off to repay its debts. Debts are repaid in a prescribed order of priority. “Senior” debt comes first, SENIOR SECURED ahead of junior, or subordinated, debt. If a bond is LOANS / BONDS classified as “secured”, it is backed by issuer collateral, or some form of assets. As such, in the event that a company defaults, a secured bond may have a higher recovery rate of the amount invested than an unsecured bond (see page 3 for details).

FOR SENIORITY, WHAT ARE “FIRST LIEN” AND “SECOND LIEN”? While both first lien and second lien bonds are forms of senior debt, second lien bonds are second in priority to HIGH YIELD first lien bonds when it comes to repayment in the case BONDS of bankruptcy or default.

ARE THESE BONDS USUALLY “SENIOR AND SECURED” OR “SENIOR OR SECURED”? The term senior secured means that a bond is both senior and secured in its structure. A bond can also be senior but unsecured, meaning there is no specific collateral guaranteeing the bond. EQUITY ARE THE ISSUERS OF SENIOR SECURED HIGH YIELD BONDS SMALLER AND UNKNOWN NAMES?  SUBORDINATE Not necessarily. Some of the most recognizable brands and leaders within their respective industries have senior secured bond facilities outstanding, such as Burger King, Hertz, Bausch Health Companies and FOR ILLUSTRATIVE PURPOSES ONLY. Travelex, for example. Senior secured bonds can be issued for a variety of reasons, such as refinancing existing debt, or as part of a finance package to complete a merger or acquisition. FAQ GLOBAL SENIOR SECURED BONDS

GLOBAL SENIOR SECURED BOND MARKET SIZE

$400B

$350B

$300B

$250B

$200B

$150B

$100B

$50B

$0B Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17 BB Single-B

SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF NOVEMBER 30, 2018.

HOW BIG IS THE GLOBAL SENIOR SECURED BOND MARKET? IS THIS A NEW ASSET CLASS? They are not a guarantee of credit quality, probability of default, or recommendation to buy or sell. Issuers rated below investment The senior secured bond market has experienced substantial grade are expected to have a greater risk of default, and therefore growth since the financial crisis, particularly in Europe. This is due typically pay a higher rate of interest to investors to compensate largely to the emergence of the asset class as a viable source of for that risk. funding for companies as other capital-raising avenues—including loans and unsecured bonds—faced limitations as banks pared WHY WOULD A CORPORATION ISSUE SENIOR SECURED lending during and after the financial crisis. Today, the value of the BONDS RATHER THAN MORE TRADITIONAL UNSECURED market is in excess of $310 billion.1 HIGH YIELD BONDS? DOES AN ISSUER HAVE WORSE FUNDAMENTALS IF A SENIOR SECURED HIGH YIELD BOND It is also worth noting that this is not a new asset class—senior IS IN ITS CAPITAL STRUCTURE? secured bonds have been in existence for years. Starting in 2009— following the financial crisis—many high yield companies* looked There can be a range of reasons for issuing a certain structure of to refinance senior secured bank loans into senior secured high bond, and the choice doesn’t necessarily indicate the quality of an yield bonds, rather than the more common unsecured bonds. issuer’s fundamentals. Companies will aim to match their balance As such, the proportion of secured bonds issued by high yield sheet with what is specifically required for their needs and what companies after the financial crisis increased markedly, especially is available in the market. If a company has assets it can pledge as in Europe. security, a secured bond—as opposed to a traditional high yield bond—may better suit its needs, and could be a cheaper method SENIOR SECURED BONDS ARE RATED BELOW of financing. Additionally, lenders may want to invest on a secured INVESTMENT GRADE. WHAT DOES THIS MEAN FOR basis if a company has a limited operating history, while they may INVESTORS? be more comfortable investing in traditional high yield bonds from more established firms. Credit ratings indicate the relative ability of an entity to repay its debt, based on its history of borrowing, repayment and Traditional high yield bonds are typically unsecured, meaning they other factors. Ratings reflect a current assessment of an issuer’s rank behind secured assets; often, these bonds offer investors a higher creditworthiness and do not guarantee performance now or in the return to compensate for this perceived additional risk. Senior secured future. Sub-investment grade, or high yield bonds have a credit bonds, on the other hand, pledge security on assets (physical or rating below investment grade (Baa3/BBB-), as determined by the intangible), typically with a limit on the proportion of assets and cash bond ratings assigned by one of the three major rating agencies: flow derived from the assets covered. This in itself will partially define Moody’s Investors Service (Moody’s), Standard & Poor’s and Fitch. the security of the bond, as it typically gives bondholders the ability to The ratings are the opinion of the agency. drive a restructuring should a downside scenario occur.

1. Source: Bank of America Merrill Lynch. As of November 30, 2018. *Companies that issue high yield or below-investment grade corporate bonds.

2 FAQ GLOBAL SENIOR SECURED BONDS

PLEASE COMPARE THE INVESTOR RISK- ANNUALIZED RETURNS VERSUS RISK-ADJUSTED RETURN PROFILE OF SENIOR SECURED RETURNS (DECEMBER 2003—NOVEMBER 2018) HIGH YIELD BONDS VERSUS THAT OF

TRADITIONAL HIGH YIELD BONDS. 12% 1.0

11% Senior secured bond returns have been 0.9 compelling on a historical basis—over the last 10% 0.8 15 years, global senior secured bonds have 9% delivered average returns of approximately 8% 0.7 7.0% per annum (graph at right). While that 7% return is slightly lower than the average return 0.6 generated by U.S., European and global high 6% 0.5 yield bonds, it is worth noting that traditional 5% high yield bonds have meaningful portions 4% 0.4 of unsecured credit. In other words, senior U.S. Loans European Global Senior U.S. Corporate Global European Currency secured bonds offer investors greater claim Loans Secured Bonds High Yield High Yield High Yield to principal protection versus unsecured Annualized Returns (LHS) Risk-Adjusted Returns (RHS) high yield bonds. The bottom line is that for SOURCES: BARCLAYS, BANK OF AMERICA MERRILL LYNCH AND CREDIT SUISSE. AS OF NOVEMBER 30, 2018. investors willing to give up a minor amount RISK-ADJUSTED RESTURNS CALCULATED AS ANNUALIZED RETURNS/STANDARD DEVIATION. of spread* or yield, senior secured bonds can offer the benefit of added protection in the event of a default. SENIOR SECURED BONDS HAVE HISTORICALLY OFFERED HIGHER RECOVERY RATES WHAT DOES “SENIOR SECURED”

COLLATERAL MEAN? 80%

Many different assets can be used as collateral, 62.3 including real estate, equipment, vehicles 60% and intangible items such as software or 47.9 trademarks. Lenders can be offered different 40% security packages by buying into a specific 28.0 claim or lien over the collateral. Secured lenders are in effect the most preferred creditors in a 20% company’s capital structure, having first call on a particular pool of assets ahead of even the most senior unsecured lenders. 0% Senior Secured Bonds Senior Unsecured Bonds Subordinated Bonds 1987—2017 WHAT ARE RECOVERY RATES AND WHY ARE THEY IMPORTANT FOR SOURCE: MOODY’S CORPORATE DEFAULT & RECOVERY RATES. AS OF DECEMBER 2018. SENIOR SECURED HIGH YIELD BONDS?

Recovery rates are the proportion of debt that Senior secured bonds have historically offered higher recovery rates relative to is repaid or recovered after an issuer defaults unsecured bonds. In the period from 1987–2017, the average recovery rate for defaulted or debt is restructured. The rate of recovery senior secured bonds was 62.3%, compared to 47.9% for senior unsecured bonds and will depend on a number of factors, including 28.0% for subordinated debt (graph above). the nature of the asset, the current market for it and the legal and practical steps involved in In reality, when an issuer defaults and goes through a restructuring, it is very rare for a recouping the principal assets. The bottom lender to actually gain direct ownership of the company or the assets—rather, lenders, line for any debt investor is that secured in the event of a default, are in a position to drive the debt restructuring in a way that lenders will always have a seat at the table in allows the greatest amount of principal investment to be recovered. In other words, it negotiations regarding a restructuring and will is not always about taking ownership of the assets and selling them—more often, it is be treated as senior throughout the process. about gaining control of the process and repackaging the debt.

*Spread versus the risk free rate.

3 FAQ GLOBAL SENIOR SECURED BONDS

It is also worth mentioning that restructuring an issuer’s debt in a restructuring, the senior lenders may seize the collateral or order to achieve the best possible recovery rate requires deep renegotiate the terms of the original bond, and may sit on a resources and experienced investment teams. To that end, we creditor’s committee, which can result in significant control over believe it is important for senior secured bond investors to the company. A restructuring is less likely to have a positive impact partner with managers who have a long track record of handling for junior, unsecured or equity holders. these situations through the ups and downs of credit and economic cycles. Although each restructuring event is unique, the process may be a good thing if the company is over-leveraged with too much debt WHAT MIGHT HAPPEN TO SENIOR SECURED BONDS IN A and too big an interest burden. If a company starts to deteriorate RECESSION? and comes under stress, bondholders may never recover the original amount paid. However, principal may be recovered While senior secured bonds are not recession-proof, they are through a restructuring versus just having the company default higher in the capital structure than unsecured bonds, which means and go into liquidation. As mentioned earlier, the complexities they can offer investors greater protection from principal loss in the involved in restructuring an issuer’s debt underscore the need for event that market default rates spike. The asset class, like traditional a highly experienced investment team overseeing a portfolio of high yield bonds, is sensitive to the credit fundamentals of the senior secured bonds. issuing company, and economic slowdowns can put pressure on corporate cash flows and/or profitability. FROM THE VIEW OF SECTORS AND GEOGRAPHY, IS THERE ANY DIFFERENCE BETWEEN SENIOR SECURED BONDS Senior secured bonds, like traditional unsecured high yield AND TRADITIONAL HIGH YIELD BONDS? bonds, tend to be more highly leveraged than their investment- grade counterparts and, therefore, may be more vulnerable in a Senior secured bonds are more prevalent in Europe, where they recession. However, managers may seek to mitigate the credit account for roughly 28% of the market, than in the U.S., where they risk associated with below investment-grade debt by carefully represent roughly 18% of the market. From an issuance standpoint, analyzing the fundamentals of the issuer and assessing the senior secured bonds have accounted for more than 40% of new collateral attached to the bond. At Barings, we have more than bond sales in Europe since 2009 (graph below). That compares 70 high yield investment professionals across the U.S. and Europe, to nearly 20% in the U.S., which is still heavily dominated by the providing the resources and expertise required to thoroughly traditional unsecured high yield bonds. analyze the fundamentals of every credit we underwrite.2 In terms of sector distributions, the senior secured and traditional WHAT HAPPENS WHEN SENIOR SECURED BONDS ARE unsecured high yield markets look fairly similar. While the markets RESTRUCTURED? IS THAT A GOOD OR BAD THING? have similar exposure to sectors like automotives, capital goods, retail and utilities, the broader global high yield bond market has Restructuring is not necessarily a good or bad event for senior greater exposure to energy and telecommunications relative to the lenders. Depending on the details of the restructuring, the global senior secured bond market. The global senior secured high event may, in fact, be beneficial for senior debtholders. Under yield market has greater exposure to media and health care.

HIGH YIELD NEW ISSUANCE

Europe U.S. 100% 100%

80% 80% 54 54 55 53 55 54 54 59 58 56 63 73 72 60% 60% 75 76 81 80 82 78 80

40% 40%

46 46 45 47 46 20% 41 42 44 45 46 20% 37 27 28 25 24 19 20 18 22 20 0% 0% 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Unsecured Secured

SOURCE: S&P HIGH-YIELD WEEKLY REVIEW. AS OF DECEMBER 31, 2018.

2. Source: Barings. As of December 31, 2018.

4 FAQ GLOBAL SENIOR SECURED BONDS

From a geographic perspective, the U.S. and European markets also look similar, although there are some notable differences. Health care and energy, for example, account for larger proportions of total market value in the U.S. than in Europe. Automotives, on the other hand, account for a larger proportion of the European market.3

INDUSTRY BREAKDOWN

20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0%

Global Senior Secured Bonds Global High Yield Bonds

SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF NOVEMBER 30, 2018.

AS WE MOVE THROUGH THE LATE STAGES OF THE CURRENT CREDIT CYCLE, DO YOU EXPECT TO SEE AN INCREASE IN DEFAULTS? AGAINST THIS BACKDROP, HOW DO YOU APPROACH INVESTING IN HIGH YIELD BONDS?

While recent market volatility has been a concern from some investors, it does not appear to be transitioning into widespread defaults. As of December 31, defaults in both the U.S. and Europe remain below historical averages.

However, as we move through the late stages of the current credit cycle, an increase in defaults is a possibility. Against this backdrop, we believe a credit-intensive, global approach to high yield investing is key. Leveraging the expertise of our large team, we aim to select credits that can withstand headwinds and hold up through credit cycles. Whether a credit is secured or unsecured is a critical component of our underwriting process, and we tend to favor senior secured versus unsecured credit, all else being equal. We take an active approach to investing, which allows us to move away from credits that exhibit fundamental weakness in favor of healthier issuers. We also have the benefit of an experienced team of stressed/distressed professionals to help us navigate challenging credit situations.

HIGH YIELD BOND DEFAULT RATES REMAIN LOW

10% 9.4

8% 6.6 6% 5.5

4% 3.2 3.4 3.3 2.1 2.1 1.6 1.8 1.7 2% 1.6 1.3 1.1 1.0 0.9 1.0 0.9 1.0 0.7 0.8 0.5 0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 European High Yield Bonds U.S. High Yield Bonds

SOURCE: CREDIT SUISSE. AS OF DECEMBER 31, 2018.

3. Source: ICE BAML European Currency Non-Financial High Yield Constrained Index (HPID), ICE BAML U.S. Non-Financial High Yield Constrained Index (HCNF). As of November 30, 2018.

5 FAQ GLOBAL SENIOR SECURED BONDS

CAN SENIOR SECURED BONDS pick up additional yield relative to PROVIDE MORE PROTECTION the perceived incremental credit or DURING THE LATE STAGES OF THE “…in the event of a default risk. Relative to an equity-like CREDIT CYCLE? asset class, high yield bonds have the default, senior secured potential to offer comparable returns Senior secured bonds will not with less volatility. necessarily serve as a volatility high yield bondholders dampener or offer more protection from At Barings, we believe fundamentals downside risk. Rather, senior secured drive high yield returns over the long bonds, relative to non-senior high yield are positioned term. In the short term, however, instruments, are higher in the capital markets can be very inefficient. In the structure. This means that in the event higher in the capital last several years, there have been of a default, senior secured bondholders several instances in which—as a result are positioned higher in the capital of technical factors like issuance levels structure during the restructuring structure during the or mutual fund flows—prices and process. Said another way, investors in spreads in the high yield market have senior secured bonds have first priority restructuring process.” moved dramatically, but fundamentals in claiming a company’s underlying have arguably changed very little. It assets pledged as collateral during a can be very difficult to time investment restructuring, offering greater potential decisions around these short-term recovery. This priority standing can be movements. For example, during the attractive to investors who may be wary “taper tantrum” in 2013 and the Brexit CAN HIGH YIELD BONDS BE of investing in a sub-investment grade vote in 2016, the entry point came and asset class, particularly amid a maturing CORE ASSETS FROM AN ASSET went relatively quickly. In our view, this credit cycle. ALLOCATION VIEW? is one of the strongest arguments for a ‘core’ allocation to high yield bonds As we move through the late stages of We think it makes sense to consider at a strategic level and for investing the credit cycle, we believe manager high yield bonds a core asset class through the credit cycle. selection plays a key role in minimizing within a broader portfolio. In addition downside risk in high yield. At Barings, to delivering historically attractive Even in the event of broader market our consistent focus is rigorous, returns, high yield bonds offer weakness, a strategic, long-term bottom-up credit selection based on diversification benefits due to their low investment in high yield bonds— company fundamentals. We certainly correlations with other asset classes. particularly for investors willing to take macroeconomic and external withstand some short-term volatility— factors into consideration, but only to Relative to other fixed income asset can facilitate the timely capture of the extent that they impact company classes–such as loans and investment evolving relative value opportunities fundamentals, which comes down to grade bonds–high yield bonds have and position investors to capture the an issuer’s ability to repay debt. over time offered the opportunity to upside as the market recovers.

HIGH YIELD BONDS SPREADS VERSUS SENIOR SECURED BOND SPREADS

900bps

800bps

700bps

600bps

500bps

400bps

300bps

200bps Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Global High Yield Bonds Senior Secured High Yield Bonds

SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF DECEMBER 31, 2018.

6 FAQ GLOBAL SENIOR SECURED BONDS

WHAT IS YOUR DEFAULT OUTLOOK FOR 2019 U.S. HIGH YIELD BOND MARKET SIZE AND BEYOND?

$1800B Despite being in the later stages of an elongated cycle, $1600B 1554 with positive economic growth across most major 1437 1446 $1400B markets and generally-solid corporate fundamentals, 1214 we do not expect leverage levels to move into $1200B 1068 unreasonable territory anytime soon. Looking ahead $1000B 928 over the next 6–12 months, we may see isolated secular 853 848 882 risk in some areas—U.S. retail, for instance—that are $800B 668 experiencing increased stress. However, from a broad 580 $600B market perspective, and barring any significant fiscal 363 policy missteps, we do not expect to see widespread $400B 283 weakness or an increase in defaults in the near term. $200B

$0B It is worth noting again that as we move through

4 14 the late stages of the credit cycle, manager selection 1994 1996 1998 2000 2002 200 2006 2008 2010 2012 20 2016 2018 is critical. As we look ahead to diverging monetary SOURCE: CREDIT SUISSE. AS OF DECEMBER 31, 2018. policies, and with a number of potential volatility triggers on the horizon, we believe managers with large, global teams and the ability to constantly monitor EUROPEAN HIGH YIELD BOND MARKET SIZE the relative value of each issuer in the market are well positioned. Ultimately, the flexibility to invest in high- conviction ideas, based on the continuous monitoring €500B 494 472 of credit fundamentals and relative value, can €450B 418 potentially help protect against downside risk. €400B

€350B PLEASE PROVIDE YOUR OVERALL VIEW ON THE

€300B 283 U.S. AND EUROPEAN HIGH YIELD MARKETS.

€250B The overall growth and maturation of global high yield €200B 154 bond market have created an investible universe that €150B looks much different from the market of a decade €100B 89 81 81 81 ago. For instance, the U.S. bond market has expanded 61 €50B 27 by nearly 50%, from $1 trillion in 2009 to roughly $1.5 1.7 8.8 trillion today. In Europe, the bond market has grown €0B over 4.5 times to €494 billion (graph at left). Today,

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 the U.S. and European high yield markets exhibit different characteristics, and as such can offer investors SOURCE: CREDIT SUISSE. AS OF DECEMBER 31, 2018. access to a much wider and more diverse universe of credits than a U.S.-only or Europe-only strategy. For example, in recent years, secured issuance in the European high yield bond market has outpaced that in the U.S., resulting in the European market having a greater percentage of senior secured bonds, which are higher in the capital structure. Expanding the opportunity set to Europe can also provide investors with diversification, increased yield opportunities and lower duration.

7 FAQ GLOBAL SENIOR SECURED BONDS

As we look at the high yield markets today, we believe the European market has grown increasingly attractive relative to the U.S. market. In recent months, spreads on single-B European bonds and loans have widened—in some cases significantly—in response to headline risk and macroeconomic volatility in the region, most recently in Spain and Italy. This widening is in spite of the fact that European GDP growth is on solid footing, defaults remain low, issuer fundamentals appear healthy and companies continue to demonstrate robust sales and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) growth.

From the secured versus unsecured standpoint, investors in senior secured bonds are currently being compensated similarly to investors in the broader market, which is largely unsecured. As we move through the late stages of the credit cycle, demand for senior secured assets may increase as investors seek added protection. Historically, increased demand has driven prices higher and caused spreads to tighten.

SENIOR SECURED AND HIGH YIELD BONDS HISTORICAL SPREADS

2000bps

1600bps

1200bps

800bps

400bps

0bps 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 BAML Global High Yield — Secured Bond B-BB OAS BAML Non-Financial Developed Markets High Yield Constrained Index — OAS

SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF DECEMBER 31, 2018.

In this environment, sector and credit selection remain critical. At Barings, we employ a consistent, repeatable investment process that is built upon decades of experience conducting rigorous, fundamental analysis on every investment we consider. Our global teams are in constant communication, which we believe puts us in a good position to identify and capitalize on relative value opportunities as they arise across geographies. The bottom line is that while the global high yield market continues to grow and present opportunities, in order to efficiently and successfully evaluate and access all the asset classes, an integrated global team with the right level of resources and experience is critical.

8 FAQ GLOBAL SENIOR SECURED BONDS

HOW DO U.S. AND EUROPEAN HIGH YIELD MARKETS DIFFER IN TERMS OF THEIR SECTOR EXPOSURES, PARTICULARLY ENERGY AND RETAIL? WHAT IMPLICATIONS DOES THIS HAVE FOR INVESTORS?

The global high yield market, and Europe in particular, has deepened significantly in terms of industry and issuer diversification. While the two markets demonstrate similar characteristics, the sub components and sector exposures within each market tend to vary, which can drive relative value in each region.

For example, energy exposure is much greater in the U.S.—where the sector accounts for nearly 17% of the index—than in Europe, where energy makes up roughly 4% of the index.4 As a result, during the 2015 energy selloff, U.S. high yield market was broadly down whereas Europe was somewhat insulated. Today, many energy companies are in a much better position than they were prior to the selloff, as they had the ability, during that time, to restructure their balance sheets. While it is possible—or even likely—that we may continue to see small pockets of risk or increased volatility around oil prices, we believe the sector as a whole is on more stable footing.

Retail is another example, with the sector accounting for 10% of the European index and roughly 5% of the U.S. index.4 Today, due to differences in buyer base, mentality and other factors, European retail is somewhat insulated from some of the heavy headwinds U.S. retail is facing as a result of the Amazon effect. This ultimately translates into different opportunity sets.

4. Source: ICE BAML European Currency Non-Financial High Yield Constrained Index (HPID), ICE BAML U.S. Non-Financial High Yield Constrained Index (HCNF). As of November 30, 2018.

9 Barings is a $303+ billion* global financial services firm dedicated to meeting the evolving investment and capital needs of our clients and customers. Through active asset management and direct origination, we provide innovative solutions and access to differentiated opportunities across public and private capital markets. A subsidiary of MassMutual, Barings maintains a strong global presence with business and investment professionals located across North America, Europe and Asia Pacific.

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