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High yield corporate bonds Preference: overweight Spread USD HY (24 Oct): 540bps (last month: 573bps) UBS View USD HY spread target (6-month): 475bps ¢ We reiterate our spread target of 475bps based on still robust corporate fundamentals, a favorable technical backdrop and the commitment of major central banks to provide strong monetary support. In particular, the Fed's buying of mortgage-backed securities (MBS) is likely to provide further support for the credit universe. ¢ Thus, US high yield (HY) bonds continue to offer attractive value although spreads tightened considerably in Q3. We think the recent rally has been justified in light of the favorable default outlook and central bank action. The ongoing slow recovery of the US economy, healthy company balance sheets, robust earnings, and strong investor appetite for yield assets continue to push spreads lower. US HY thus remains our preferred asset class. ¢ Despite the recent uptick in defaults, in the absence of a renewed US recession, we expect the default rate to remain stable at 3.5% until the end of the year. A heavy load of new issuance so far this year means that HY companies will be faced with a lower risk of failed refinancing going forward (e.g. in case of an unexpected economic slump). 4 Positive scenario USD HY spread target (6-month): 400bps e Even in the positive economic scenario, spreads are unlikely to tighten to pre-crisis lows of below 300bps due to lower liquidity and a generally higher risk premium after the financial crisis. Benchmark yields would rise, limiting HY returns to around 7%. European HY outperforms the US. & Negative scenario USD HY spread target (6-month): 1,000bps ¢ A global recession is the major risk for high yield bonds. Based on the robust state of the corporate sector, we would not expect spreads to surpass "usual" recession levels around 1,000bps. Although short- term spikes are possible due to liquidity suddenly drying up, we expect a quick normalization. Note: Scenarios refer to global economic scenarios (see slide 7) What we're watching Why it matters Credit quality/ default cycle US earnings were roughly flat in 2Q compared to 1Q. A modest pickup is expected in 2H. Balance sheets are backed by high cash levels and low debt ratios. Against this backdrop the default rate will likely remain below its long-term average. New issuance For now, favorable conditions in the primary market have mainly been used for refinancing. More aggressive issuance activities should be monitored. Bank lending standards 2 UBS Bank lending provides an important source of funding. US banks relaxed standards further in early 3Q. Key dates: late October, US Fed Senior Loan Officer Survey For further information please contact CIO's asset class specialist Philipp Schdttler, philipp.schoettler@ubs.com Recommendations Tactical (6 months) e US high yield corporate bonds offer an attractive return outlook and should be overweighted. We prefer US over European issuers given the increasing proportion of peripheral and financial issuers in the European HY universe and the poorer economic outlook in Europe. Inflows into HY mutual funds have been strong so far in 2012. New issuance was strong in Q3. Strategic (1 to 2 years) e We expect US defaults to remain at below- average levels for longer. Significant re- leveraging is unlikely in the medium term. e We believe US high yield corporate bonds will provide good returns both relative to other fixed income and for absolute return-oriented investors. Yield spreads 2,500 bps 2,000 4,500 4,000 500 0 2005 2006 2007 2008 2009 2010 2011 2012 —EUR High Yield —USD High Yield Source: Bloomberg, UBS, as of 16 Oct 2012 Note: Past performance is not an indication of future returns. 27 Please see important disclaimer and disclosures at the end of the document. HOUSE_OVERSIGHT_025274