FIRM OVERVIEW

The Babson Capital Staff Letter

Babson Capital Management LLC manages more
than $100 billion in assets for a broad range of
institutional investors in the U.S. and abroad
and is the lead investment advisor to our parent,
the Massachusetts Mutual Life Insurance Co.
(MassMutual). Our goal is to build long-term
relationships, based on transparency and trust,
that provide value to our clients. Through
proprietary research and analysis and a focus
on investment fundamentals, we develop
products and investment strategies that leverage
our broad array of expertise in fixed income,
equities, alternatives, structured product, and
debt financing for corporations and commercial
real estate.
Second Quarter 2009
The Economic Backdrop
The corporate credit markets saw the best quarterly returns in history this
past quarter (see Figure 1), followed by a slight pull back near the quarter’s
end. Investors also pulled back, reminding themselves of the true state of the
fundamentals of the economy despite the much-talked-about “green shoots.”
HIGHLIGHTS
■ The second quarter saw very strong returns, especially in the corporate
credit markets, albeit with some market correction near the end
■ Inflation has been a concern in the markets in the environment of low
interest rates, quantitative easing, and the projected $1.85 trillion
budget deficit

TOTAL ASSETS MANAGED: $108.3 BILLION* ■ With the beta trade behind us, opportunities lie in specific sector picks
and individual security selection

Equity
$1.2B Investment Grade
CDO/CLO Corporate
$2.5B $25.3B
Residentials
Government intervention continued full force with much pump-priming,
$2.9B
Bank Loans
including Fed- and Treasury-related programs such as the TARP, TALF and
CMBS
$4.0B
$21.7B PPIP, with varying degrees of success. The quarter witnessed TARP funds
Mezzanine/
Private Equity being paid back by 32 banks, indicating some healing of financial firms.
$4.9B
Treasuries/
The TALF program has also been credited with the resuscitation of the ABS
RMBS/ABS
$5.0B
Agencies
$12.3B
markets. However, PPIP has yet to revive the legacy-debt market.
CMO
$5.8B Noteworthy events this quarter include the bankruptcies of Chrysler and
Money Market GM, oil rising to $70, mortgage rates failing to fall to the much desired
$5.7B High Yield Commercial
Corporates Mortgage Loans 4% level and unemployment hitting 9.5% for June (see Figure 2). China’s
$6.2B $10.7B
recovery continued with many watching for its potential inflationary impact
on commodity prices.
TABLE OF CONTENTS
Inflation has been a concern in the current environment of low interest rates
Macro Overview . . . . . . . . . . . . . . . . . . . . . 1 and quantitative easing. Inflation hawks focus on the Fed’s aggressive use of
monetary policy to support the economy and financial markets and argue
Investment Grade . . . . . . . . . . . . . . . . . . . . 3

High Yield . . . . . . . . . . . . . . . . . . . . . . . . . 4 FIGURE 1: BENCHMARK RETURNS

Bank Loans . . . . . . . . . . . . . . . . . . . . . . . . 5
European Bank Loan . . . . . . . . . . . . . . . . . . 7
Structured Credit . . . . . . . . . . . . . . . . . . . . 8
Mortgage and Asset Backed Securities . . . . . 9
Real Estate . . . . . . . . . . . . . . . . . . . . . . . 10
RETURNS 1Q09 (%) RETURNS 2Q09 (%) OAS (%) YTW (%)
U.S. Treasury -1.32 -3.02 -0.01 2.37
U.S. Corporate Investment Grade -1.93 10.45 3.06 5.98
U.S. Corporate High Yield 5.98 23.07 9.45 12.28
U.S. Bank Loans* 7.17 18.60 NA 10.28 **
European Bank Loans* 2.80 18.96 NA 12.77 **
Distressed Debt*** -7.98 -52.66 NA NA
U.S. Mortgage Backed Securities 2.20 0.70 0.36 4.34
U.S. Consumer ABS 8.14 7.64 3.44 5.20
Investment Grade CMBS -1.43 12.04 8.11 10.45

* Assets include Babson Capital Management LLC and
its subsidiary Babson Capital Europe Limited as of
June 30, 2009
* All returns are Barclays Index returns except for U.S., European Bank Loans, and Distressed Debt which are
Credit Suisse returns.
** 3 Year DM Yield
*** Distressed Debt returns are the Distressed / Defaulted return components of the Credit Suisse High Yield Index

1
BCL4077_09/332
 FIGURE 2: UNEMPLOYMENT FIGURE 4: U.S. DEBT TO GDP
%
%
12 400

11
350
10

9 300
8

7 250

6
200
5

4 150
3
Sep-78 Jul-82 May-86 Mar-90 Jan-94 Nov-97 Sep-01 Jul-05 May-09 100
1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
Source: Bloomberg as of June 30, 2009 Source: Moody’s Economy.com as of December 31, 2008

that the surge in money-supply growth will translate consumer spending, both of which have been falling
into higher inflation in the near future. precipitously of late. Weak housing, construction, and
commercial real estate sectors add to the argument for
Those who think inflation is not a concern argue that, slack in the economy.
though money supply in the form of M2 did grow
more than 15% (seasonally adjusted annualized rate) Concerns have also been raised about the projected
in both the fourth quarter of 2008 and the first quarter $1.85 trillion budget deficit crowding out private
of 2009 (JP Morgan May 7th 2009, “Bouncing Towards investment in productive capital. However, during the
Malaise”), the huge slack in the economy is preventing worst of the credit crunch the private debt markets
any inflationary pressures from developing. The had ground to a halt and non-government lending, in
ongoing deleveraging means that much of the “excess” the form of commercial bank lending is still anemic
liquidity now in the system is being absorbed in the form notwithstanding some resumption of issuance in
of reserves, rather than being lent — i.e. the supply certain parts of the credit market. Government debt
of money is up, but the velocity of money is still became a necessary stop-gap to help the economy
very low. Also, those favoring lower rates note that 10- continue to function, leading to the shift of debt from
year U.S. Treasuries are still well below 4% (see Figure the private to the public sector. As a result, it is going
3), whereas economies experiencing inflationary to be exceptionally difficult to reduce the debt-GDP
pressures due to liquidity injections would typically ratio (see Figure 4).
see higher longer-term yields.
OUTLOOK
FIGURE 3: TWO YEAR AND TEN YEAR TREASURY YIELDS As the financial markets move toward stability,
6
economic fundamentals are starting to improve, with
5
improving earnings, better than expected jobless
4 claims, and a modest move up in existing home
sales. During the remainder of 2009, we expect to see
Yields (%)

a continued series of rallies and sell-offs until there

2
is greater evidence that the end of the recession is
1
in sight.
0
Jul-04 May-05 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09
We believe that the beta trade is largely behind us
GT02 Govt GT10 Govt
as spreads across the board have come in, and that
Source: Bloomberg as of July 9, 2009
opportunities now lie in specific sector picks and
individual security selection. We expect mortgage rates
Unusually high levels of slack in the economy typically to decline and equity volatility to rise and remain high.
translate into a deceleration of business costs and Finally, we expect corporate credit spreads to tighten
prices. Very high unemployment rates also tend to further toward spread levels seen during the recession
put downward pressure on labor costs and on nominal of 2002.

2 The Babson Capital Staff Letter Second Quarter 2009

Investment Grade Corporates
With excess returns of 1,187 bps for the investment Viewed from a ratings perspective, BBB and A-rated
grade asset class, the second quarter of 2009 was by far paper performed significantly better than higher
the best quarter in investment grade history as measured rated paper, with
by Barclays. Spreads excess returns of
for the U.S. Credit INVESTMENT GRADE HIGHLIGHTS 1,605 bps and 1,234
Index tightened ■ With excess returns of 1,187 bps and a total return of 10.5%, the bps, respectively.
sharply from 483 second quarter of 2009 was the best quarter in investment grade BBB Industrials
bps to 275 bps history, led by the Financials, in a turnaround in sentiment of
and Utilities and
(see Figure 5) this “nationalization” fears of the first quarter
single-A Financials,
quarter. Financials ■ Even though spreads are still historically very wide, we are concerned having started the
led the way with that the market may actually have priced in a more significant recovery
quarter with wider
excess returns of than what may materialize
spreads, were in
1,717 bps (see Figure ■ We believe investors should be neutral the intermediate and long end of demand.
6). This represented the credit curve so that returns are not penalized if spreads do continue
a rebound from the to tighten, and on the front end of the curve we suggest investors take Issuance of $262
“nationalization” advantage of the wider spreads still available and over-weight lower
billion for the
fears that gripped quality issues
quarter was robust,
the markets in and during the first
February and March two months, deals
and pushed long-dated Bank of America subordinate were routinely over-subscribed and did well in the
paper into the $50s. Spreads for financial paper averaged secondary market. As the quarter drew to a close,
close to 800 bps during the peak of the crisis and have
spreads tightened quite a bit and pricing was much less
almost been cut almost in half.
compelling, with new issues seeing less demand and
being bid at issuance price in the secondary market.
FIGURE 5: INVESTMENT GRADE CREDIT OAS
%
6.00
OUTLOOK
We believe investors should be wary of “one-way”
5.00
markets with rapidly and steadily falling rates. They
4.00 can turn on a dime and liquidity can dry up with
3.00 buyers turning into sellers very quickly.
2.00
That said, we believe investment grade spreads at 275
1.00 bps are still historically very wide (a long-term average
0.00
is closer to 150 bps). Even though we might look back
Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09
at these levels in two years and wish we had bought
Source: LehmanLive as of June 30, 2009 whatever we could, we ought to have a shorter-term
tactical outlook and be cautious. We have come in very
FIGURE 6: INVESTMENT GRADE CORPORATES OAS far, very fast, and pricing is not nearly as compelling
%
8.8 as it was earlier in the year. We are concerned that the
7.8
market may actually have priced in a more significant
6.8
recovery than what may materialize.
5.8

4.8 We believe we should still “be cautious” and we believe

3.8 investors should be neutral the intermediate and long
2.8
end of the credit curve so that returns are not penalized
1.8
if spreads do continue to tighten. On the front end of
0.8
Jul-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 the curve, we suggest investors take advantage of the
Finance Utility Industry wider spreads still available and overweight lower
Source: LehmanLive as of June 30, 2009 quality issues.

Babson Capital Management LLC 3

 High Yield Corporates
The high yield market as measured by the Barclays their second-half 2009 and full-year 2010 forecasts,
Capital U.S. High Yield Index returned 23.1% during after many had raised their forecasts during the first
the second quarter and 30.4% year-to-date, capping quarter. The much-anticipated bankruptcy filing of
the best quarter and General Motors on
six-month period in HIGH YIELD HIGHLIGHTS June 1st is the year’s
the 26-year history largest so far. The
■ With a total return of 23.1%, the high yield sector had the best quarter
of the index. Risk in history, driven by demand for low-priced and low-quality securities,
Moody’s U.S. bond
appetite has clearly indicating that risk appetite has returned speculative-grade
re t u r n e d t o t h e (issuer-weighted)
■ We believe that a further rally in high yield is unlikely to follow the same
market as a majority path as the first half of 2009. We are analyzing whether current pricing
default rate stands
of the rally has been levels can indeed support what might be the new norm of contracted at 12.3%, on par
driven by demand top-line revenues and anemic growth prospects over the next few years with peak default
for low-priced and ■ We continue to focus our attention on companies with strong free-
rates in 1990-91 and
even low-quality cash flows and an ability to manage their capital structure, and 2001 (see Figure 8).
securities. Bond Communications is such a sector that has shown good performance While the forecast
spreads are now year-to-date. is for a continued
inside 1,000 bps, a rise in the default
level not seen since rate, potentially
late September 2008 (see Figure 7). peaking in mid-2010, the easing of credit conditions
has certainly helped a number of issuers stave off
FIGURE 7: BARCLAYS U.S. HIGH YIELD INDEX OAS bankruptcy fears.
%

20

18

16
FIGURE 8: SPECULATIVE GRADE DEFAULT RATES
14 %
14
12
12
10
10
8
8
6

6
4

4
2
Jun-07 Dec-07 Jun-08 Dec-08 Jun-09
2

Source: LehmanLive as of June 30, 2009

0
Jan-00 May-01 Sep-02 Jan-04 May-05 Sep-06 Jan-08 May-09

Par- weighted default rate Issuer-weighted default rate

The new-issue calendar surged in the second quarter
with a total of $55 billion in issuance, the most active
quarter since the fourth quarter of 2007. While new
issuance through April was predominantly focused on
higher quality companies, the significant drop in yields
during the second quarter has allowed a number of
larger, more distressed issuers to come to market with
deals. AMG mutual fund flows show over $12 billion of
inflows into high yield so far this year, creating a strong
technical bid for new issues as well as providing some
secondary market support. The last time the high yield
asset class saw such large inflows was in 2002, when the
market went on to return more than 25% for the year.
The pace of defaults decelerated in the latter half of
the quarter, leading some market analysts to lower
Source: Moody’s as of June 30, 2009
OUTLOOK
The pace at which this market rally ensued was truly
remarkable and unprecedented. The year-to-date
return chart shows the almost uninterrupted rise in
returns over the last three months. As one of the best
performing asset classes in 2009, high yield has almost
recaptured all of its losses from 2008 (see Figure 9).
With the sharp market rise also comes renewed focus
on credit fundamentals. We are analyzing whether
current pricing levels can support what might be the
new norm of contracted top-line revenues and anemic
growth prospects over the next few years.

4 The Babson Capital Staff Letter Second Quarter 2009

While a vast majority of new issues through May FIGURE 9: BARCLAYS U.S. HIGH YIELD YTD TOTAL RETURN
experienced strong performance after the initial 850

pricing, we saw our first signs of instability in June, 800

with close to 20% of 2009 new issues now trading 750

Total Return Since Inception

below their issue price. We believe that the market is 700

likely at an inflection point, where investors are re- 650

evaluating their positions and are potentially adjusting 600

their portfolios for the road ahead. 550

While the distressed ratio (percentage of the index 500

trading with spreads over 1,000 bps) has clearly 450

Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jun-09
declined from its peak in late 2008, current levels
Source: LehmanLive as of June 30, 2009
(around 40%) are now on par with the peak levels
seen during the last credit cycle in 2001-02 (see Figure
10). This leads us to believe that a further rally in high FIGURE 10: DISTRESSED RATIO CHART
90 18
yield is unlikely to follow the same path as the first
80 16
half of 2009, where distressed securities clearly drove 70 14

performance.

HY Distress Ratio
60 12

IG Distress Ratio
50 10
We continue to focus our attention on companies with
40 8
strong free cash flow and an ability to successfully 30 6
manage their capital structure. Second-quarter earnings 20 4

season is just getting underway and will be a good 10 2

indication of overall earnings stability and whether 0

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
0

companies have been able to manage their cost USD USD IG

structures given the deterioration in top line revenues. Source: LehmanLive as of June 30, 2009
Communications is an area we like with strong free
cash flow metrics and good performance year-to-date.

Bank Loans
Bank loans had the best performance in history, In addition to strong cash inflow, high-yield takeouts
returning 18.6% for the quarter and 27.1% year-to-date fueled the loan market’s strong performance in the
(see Figure 11). The average price of loans rose steadily second quarter, as 10 issuers printed a total of $5.6
to $76, back up to billion of bonds that
early October 2008 BANK LOAN HIGHLIGHTS
took out institutional
levels (see Figure ■ Bank loans have had the best performance in history, returning 18.6% l o a n s . M o re o v e r,
12). The driving for the quarter, driven mainly by overwhelmingly positive fund flows and there are currently
force behind the high yield take-outs
another 13 bond-
rally has largely ■ Prices in the second half of 2009 should be range-bound as we do for-loan takeouts in
been technical not expect this rally to remain as strong and fevered, but risk-appetite- the offing, totaling
as loan-fund dependent opportunities still exist $4.7 billion (S&P
flows have been ■ We believe bank loans can be an inflation hedge as the total return rises LCD News, July 6th
overwhelmingly with interest rates. 2009).
positive this past
Amend-to-Extend
quarter. Inflows
was also a prevalent theme this past quarter. Since
were recorded in 24 of the first 26 weeks of 2009 with
April, 12 such deals were reported by S&P LCD News
net inflow of $2.12 billion - $1.5 billion in the second
totaling $8.2 billion, bringing the year-to-date tally to
quarter alone — versus the $2.49 billion outflow
14 deals totaling $11.5 billion. This has pushed back
through the first 26 weeks of 2008.
maturities of 3% of performing loans so far this year.

Babson Capital Management LLC 5

 Sectors that pushed for all amendments, including
FIGURE 13: REQUESTED AMENDMENTS BY SECTOR
amend-to-extend types, were the ones most affected
1H 2009
by the recession. Retail produced the most, hurt INDUSTRY AMEND REQUESTS
by contracting consumer spending, and chemical Retailing 18
companies, plagued by higher input prices and softer Chemicals 15
demand, came in second (see Figure 13). Oil & gas 14
Media 13
OUTLOOK Automotive 12
We do not expect the rally to continue with the strength Gaming and hotels 12
and fervor of the past quarter, but expect prices to be Printing & publishing 12
range-bound for the coming quarter and the next six Forest products 11
months. In terms of new issue, we expect that to be Computers & electronics 11
a slow grind well into 2010, with only performing Machinery 8
companies being able to seek refinancing options.
Source: S & P LCD News as of July 1, 2009

Defaults have reached an all-time high of 9.15% for

lows probably took place a little earlier than expected.
the end of June 2009 (S&P LCD, see Figure 14), and
We believe risk-appetite-dependent opportunities still
we expect this 12 month moving average to climb to
exist in the loan market in three main categories. The
the low teens. We believe that the rating agencies have
most conservative is in stable companies that still offer
been accurate in terms of default expectations, and
a compelling yield relative to historical yields with
in particular we like the S&P LCD Shadow Default
ample protection at spreads of L+400 to 600. For the
Rates for an indication of where near-term default
investor looking for double-digit returns of 12-16%,
rates are headed.
there are opportunities in companies that are not able
In terms of our view of investment opportunities, the to service the entire capital structure, where certain
beta trade is done, and the rally from the undervalued layers of debt are exchanged for equity. Risk-takers
who are after 20%-plus returns may be interested in
FIGURE 11: CREDIT SUISSE LEVERAGED LOAN INDEX distressed companies which will undergo restructuring
280 where not all debt will be reinstated and other types
of instruments may be used in the exchange process.
260

We believe bank loans can be a hedge to inflation. As

Index Value (12/31/1991=100)

240
interest rates rise in an inflationary economy, there
220
can be a downward pressure on many fixed income
products. Loans, on the other hand, have fixed spreads
200 to LIBOR, so that when interest rates rise, investors can
actually benefit. Thus leveraged loans offer an extra
180
Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 advantage, in terms of rising returns rather than falling,
Credit Suisse Leveraged Loan Index Value if we do expect inflation in the near future.
Source: Credit Suisse as of June 30, 2009

FIGURE 14: LCD LOAN DEFAULTS RATES

FIGURE 12: CREDIT SUISSE LEVERAGED LOAN AVG PRICE %
10

100 9
Index Value (12/31/1991=100)

8
95
7
LTM Default Rate

90
6
85 5

80 4

3
75
2
70
1
65 0
Dec-98 Sep-00 Jun-02 Mar-04 Dec-05 Sep-07 Jun-09
60
Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 LTM Default Rate by Par Value LTM Default Rate by No. of Issuers

Source: Credit Suisse as of June 30, 2009

Source: Standard & Poor’s LCD as of June 30, 2009

6 The Babson Capital Staff Letter Second Quarter 2009

European Bank Loans
The second quarter of the year saw record gains in in an attempt to diversify their funding with proceeds
European leveraged loans, with the Credit Suisse being used to repay existing bank debt. Both concepts
Western European Leveraged Loan Index up 18.8% have been positively received by the market with
(denominated in lenders showing
Euros). CCC and EUROPEAN BANK LOAN HIGHLIGHTS strong appetite for
cyclical credits led ■ The second quarter of the year saw record gains in European leveraged both proposals.
the way, returning loans with the asset class up 18.8%, led by CCC’s and cyclical credits S e c o n d a r y
39.8% and 28.3% ■ Despite the wider market rally we remain nervous regarding the prices trading prices
respectively; both of loans that look certain to have to go through a restructuring event in have generally
of these had heavily the next 18 months, and with default rates on speculative grade credit risen after the
underperformed the expected to peak towards the end of the year, we see potential downside announcements.
index in the previous for many of those credits that have rallied hardest over the last quarter

year. For the first ■ We continue to believe an opportunity still exists on the defensive end The annualized
time, significant of the market, with double-digit yields to expected average life of the default rate by
interest has been seen loans in this category still looking attractive principal amount
in the asset class by hit a recent high
unleveraged new of 10.2% at the end
money accounts and this has been a primary driver of June with S&P reporting 76 companies having
of the rally. As the forced sellers in the market seen defaulted in the past 12 months. A combination of
last year have largely evaporated, and trading desks, covenant breaches and weak cash flows has driven
not willing to hold much risk, are keeping inventories the default rate higher, and the market concerns that
at historical lows. Despite the rally, the index is still the rate will peak in the high teens within the next
down 12.3% from a year ago (see Figure 15), primarily nine months.
caused by the significant falls seen in the fourth quarter
of 2008 and the accelerating default rate. OUTLOOK
Despite the wider market rally we remain concerned
FIGURE 15: CREDIT SUISSE EUROPEAN INDEX regarding the prices of loans that look certain to have
170 to go through a restructuring event in the next 18
months. Forecasts remain uncertain and, while there
Index Value (12/31/97=100)

160

are signs that the global economy is stabilizing, the

150
trading results of many companies continue to show
140
the pressures of the recession and bank funding
130 remains tight. With default rates on speculative-grade
credit expected to peak towards the end of the year, we
120
see potential downside for many of those credits that
110
Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 have rallied hardest over the last quarter.
Credit Suisse West Euro Leveraged Loan Index Value

Source: Credit Suisse as of June 30, 2009 We continue to believe an opportunity still exists in
defensive sectors, with double-digit yields to expected
Many companies have seen the better market average life of the loans in this category still looking
conditions as an opportunity to address near—term attractive.
refinancing concerns. Several large, liquid borrowers
have offered lenders an increased margin and/or
fee if they allow the maturity of existing debt to be
extended. Others have opted to issue high yield bonds

Babson Capital Management LLC 7

 Structured Credit
THE CLO MARKET
Rising loan prices finally propelled CLO liabilities
higher, reversing the downward spiral that had pushed
CLO prices down every month since mid-summer 2008.
AAA CLO spreads are
tighter by 100 bps, STRUCTURED CREDIT HIGHLIGHTS
but the spectacular ■ Rising loan prices finally propelled CLO liabilities higher, reversing the
moves were seen in downward spiral that had pushed CLO prices down every month since
mezzanine paper. mid-summer 2008
Original AA-rated
■ Nearly all original A-rated CLOs and a good number of original BBB
bonds surged from
should ultimately receive payment in full, and we remain bullish on
the $25 area to the CLO debt
$50 area, while
original single-A- ■ For investors with appetite for corporate credit risk and with limited
liquidity needs, we believe opportunities still exist in A-rated (original opportunities can be
rated paper jumped
rating) to AAA-rated CLO debt
from near $10 to
approximately $25.
Support was also found at the BBB level and BB level
though trading was muted for these risk categories. Of
course, precise trading levels are deal-dependent and
are driven by such factors as collateral quality, event-
of-default language, and structural enhancement.
The turning point came late in May, as investors
snapped up nearly $300 million of senior CLO
paper (close to $1 billion including middle-market
and balance-sheet deals) from the Whistlejacket
SIV liquidation. Though the bidding process was
unorthodox (indicative bids were followed by firm
bids two days later), it laid bare the depth of interest
in senior CLO paper, which in turn prompted accounts
and dealers to bid aggressively as new secondary paper
hit the market.
It is curious to note that much of the CLO rally
occurred in the face of significant downgrade activity.
In the first quarter, Moody’s downgraded more than
2,000 tranches from more than 600 CLOs. First-pay
(generally rated AAA) bonds were spared for the most
part, but mezzanine CLO tranches were generally
downgraded more than four notches. Beginning April
4 (in a process Moody’s calls “Stage II”), Moody’s began
downgrading AAA-rated tranches, often by two to
three notches. While Standard & Poor’s has not yet
moved to downgrade CLO tranches en masse, it is
clear that downgrades are coming.
The primary CLO
market remains dead
though secondary
activity is robust. Like
the first quarter, most
trading activity was
centered on originally
rated AA to AAA
bonds. Occasionally,
found on dealer offer
sheets but activity
seems to be centered
on BWIC lists, of which we see three to four a week,
and direct offerings, which often come from regional
dealers (as opposed to the large investment banks).
In some cases, there are observable two-way markets
which bring considerable clarity to the market for
many investors.
OUTLOOK
We still expect that ultimately nearly all original
A-rated CLOs will receive payment in full. Further,
we believe that a good number of original BBB CLO
tranches should receive full payment, albeit delayed in
some cases. Consequently, we believe that CLO prices
continue to reflect exceptionally high levels of loan
losses. Default rates will undoubtedly continue to rise,
but we do not believe currently that those rates will
exceed levels which are manageable by many originally
rated BBB CLO tranches. Therefore, we remain bullish
on CLO debt at current levels.
For investors with appetite for corporate credit
risk and with limited liquidity needs, we believe
opportunities still exist in A-rated (original rating) to
AAA-rated CLO debt.

FIGURE 16: TRADING LEVELS FOR TYPICAL CLOS

AAA AA A BBB BB EQUITY
CURR ∆ CURR ∆ CURR ∆ CURR ∆ CURR ∆ CURR ∆
CLOs 550 100 bps 50 +25 25 +15 14 +8 6 +2 <1 pmt -

Source: Babson Capital Management as of June 30, 2009

8 The Babson Capital Staff Letter Second Quarter 2009

MBS/ABS
Trends toward tighter spreads continued throughout market participants took advantage of spreads having
the quarter for non-mortgage ABS. By the final week of returned to levels not seen since before the Lehman
the quarter, TALF-eligible ABS (new issue car loans and bankruptcy.
credit cards) were Overall, the MBS/
trading at spreads so MBS/ABS HIGHLIGHTS ABS market enjoyed
tight (see Figure 17) ■ The MBS/ABS market enjoyed a solid quarter as the extraordinary a solid quarter as
that implied equity efforts of the Fed and Treasury actually seemed to work to pull the the extraordinary
returns for users of world’s financial system back from the brink of collapse. efforts of the Fed
TALF funding had ■ Distressed assets in the mortgage market will continue to be and Treasury seemed
declined to single aggressively pursued, resulting in substantial decreases in the risk to work to pull the
digits. Non-TALF ABS premia paid world’s financial
spreads narrowed as ■ We believe subprime MBS that are currently paying down with 1.5 year system back from
well, even for bonds or lower average lives offer attractive yields around 8%, even with a the brink of collapse.
rated below AAA. continued housing meltdown “baked in” the assumptions used to project
Residential mortgage- cash flows OUTLOOK
backed securities We believe distressed
(RMBS) experienced spread tightening along with their assets in the mortgage
ABS counterparts, seemingly driven by developments market will continue to be aggressively pursued,
in the stock market rather than fundamentals of credit resulting in substantial decreases in the risk premia
performance. On days that news was positive (e.g. paid. Buying should come from disparate sources,
homebuilders announcing smaller losses or house including purpose-built “opportunity” funds, macro
price gains in some regional markets), non-agency hedge funds, and even some banks that were previously
MBS responded with tightening spreads. As the stock expected to be sellers. Bonds that can be reasonably
market consolidated and pulled back a bit in June, projected to average lives of 1.5 years or less now
the non-agency RMBS market also gave back some trade at mid- to high- single digit yields, down from
of its gains. twice that level earlier this year. Even longer duration
RMBS now trade at mid-teen yields as opposed to
the mid-20 yields they sported a few months ago,
FIGURE 17: AAA CONSUMER ABS SPREADS in spite of their inherently unpredictable cash flows
1000
900
when projecting five to 10 years into the future. Our
800 optimism about the sector has to be tempered with
700 the realization that almost every fundamental credit
600
measure continues to deteriorate, so individual asset
bps

500
400 selection and underlying collateral credit analysis are
300 more important than ever.
200
100 Consumer ABS securities behave as if there is a negative
0 net supply, given the success of the TALF deals and
Apr-08 Jul-08 Oct-08 Jan-09
continued “grinding in” of spreads in the secondary
Auto Fixed AAA 3Yr Credit Card Fixed AAA 3Yr Student Loans AAA 3Yr
market. Strong demand for this paper should continue
Source: LehmanLive as of June 30, 2009
until the end of the year with further spread tightening
Agency MBS enjoyed robust demand from the Fed’s a distinct possibility.
quantitative easing program, with a steady $4 billion to The only positive fundamental performance we saw
$5 billion per day purchase rate more than absorbing last quarter was an increase in voluntary prepayments
new MBS production. Existing and new mortgage in prime non-agency MBS. This tracked historical
REITs that specialize in holding agency MBS also seasonality, suggesting that the best borrowers are
managed to raise several billion in equity capital, and moving or refinancing in concert with the school
put it to work at six to eight times leverage. Selling year. This was a welcome bright spot in an otherwise
picked up among traditional long term MBS-holders dismal fundamental picture for mortgages. If this trend
(insurance companies and pension funds) as those continues through the summer and into the fall as

Babson Capital Management LLC 9

 usual, prime MBS will be able to improve their prices
simply by trading to shorter durations, apart from any
spread tightening they may experience.
For cash alternatives, we think consumer ABS with
less than one year average life offer acceptable yield
premiums to commercial paper or other short-term
options. We believe subprime MBS that are currently
paying down with 1.5 year or lower average lives offer
attractive yields around 8%, even with a continued
housing meltdown “baked in” the assumptions used
to project cash flows. In longer maturities, selectivity is
the key, with a few seasoned alt-A and subprime bonds
offering good value and equity-like returns in the mid-
teens. More conservative longer duration investors
may choose prime non-agency MBS on the thesis that
the summer prepayment surge will continue. However,
we caution that prime mortgage borrowers seem to be
suffering the brunt of increased unemployment in the
downturn, and the overall margin for safety (credit
enhancement) in prime MBS is much “thinner” than
it is for lower quality pools of loans, and hence prime
non-agency MBS may not be as attractive as they
might seem.

Real Estate
There were high hopes in the commercial real estate billion from 2001 through 2007. We are clearly in
markets that 2009 would witness a narrowing of the the midst of dramatic change in the commercial real
great divide between buyer and seller expectations, estate markets.
sparking some
P r o p e r t y
transaction activity. REAL ESTATE HIGHLIGHTS
fundamentals in all
Unfortunately, the ■ Property fundamentals in all sectors deteriorated further in the second
sectors deteriorated
fundamentals remain quarter, with changes most evident in the office and hotel sectors in
further in the second
under great stress, response to further job losses and reductions in corporate spending
quarter, with changes
keeping buyers and ■ We expect the vast majority of financing mandates to struggle to
most evident in the
sellers far apart find sufficient capital to refinance existing debt and will require an office and hotel
on pricing. Only additional equity injection to retire maturing debt
sectors in response
those sellers facing ■ There is reasonable value in pre-2005 vintage CMBS, although offerings
to further job losses
impending loan of these bonds are currently somewhat limited and reductions in
maturities and/or
corporate spending.
loan defaults must
Office vacancies rose
face the realities of
80 bps to 15.5%, a level last seen in the second half of
declining rents, negative absorption, and increasing
2004. In the lodging sector, it is widely anticipated that
vacancies and price properties where opportunistic
RevPAR (revenue per available room), an often-cited
buyers are willing to consider an acquisition. Real
metric of hotel performance, will reach its cyclical low in
Capital Analytics reports institutional property
the third quarter of this year. PKF Hospitality Research
sales averaged $2.9 billion per month during the
and Smith Travel Research project RevPAR losses will
first 5 months of 2009 (see Figure 19); this is down
account for 17.5% and 17.1%, respectively, in 2009.
significantly from a monthly average of nearly $19.8
Predictions for 2010 show improvement as RevPAR
FIGURE 18: TRANSACTIONS SALES VOLUME declines of only 3.5% to 3.7% are projected. Waning
550 corporate and consumer demand has also taken its toll
500 on the industrial sector, increasing industrial vacancy
450
400
to 13% in the second quarter, the highest level recorded
350 by Torto Wheaton Research since it began tracking it 20
Billions

300
250
years ago. The multifamily market has not escaped the
200 effects of the economic malaise with vacancies raising
150 40 bps in the second quarter to 7.6% — the highest rate
100
50
in 22 years. The retail sector also exhibited increased
0
2001 2002 2003 2004 2005 2006 2007 2008 Jan-
vacancies and now suffers the ripple effect from tenants
May seeking rent relief and lease terminations on the basis
2009
of co-tenancy clauses, the latter being a tenant’s right to
Source: Real Capital Analytics as of May 2009
vacate or reduce its rent if other specific tenants leave

10 The Babson Capital Staff Letter Second Quarter 2009

the property and are not replaced by similar tenants
within a specified period of time.
REAL ESTATE CAPITAL MARKETS
Many traditional lenders in the private debt market
(senior commercial loans) remain on the sidelines. The
American Council of Life Insurers reports significantly
diminished loan volume - $5.6 billion through the first
five months of 2009 compared with $15.4 billion and
$13.6 billion for the same periods in 2007 and 2008,
respectively (see Figure 19). Leverage generally does
not exceed 65% of a new, much more conservatively
underwritten value; loan terms reflect more cautious
(many say more realistic) underwriting. Financing is
available, but only on the best properties, in the best
locations and with the best borrowers.
The traditional commercial mortgage-backed securities
(CMBS) market (the “public” debt market) remains
FIGURE 19: ACLI ORIGINATIONS
45
40
35
30
$ Billions
25
20
15
10
5
0
2007 2008 Jan-May 2009
Source: JP Morgan as of March 27, 2009
closed, as it has since mid-2008. Participants lack the
ability to hedge or warehouse transactions — there is
simply no way to ensure that loans can be originated
and subsequently securitized profitably.
OUTLOOK
Equity Markets
Until the fundamentals begin to stabilize, it is unlikely
the gap between buyers’ and sellers’ expectations
will narrow enough to result in a meaningful level
of transaction activity. As a result, it will continue to
be difficult to ascertain values, though most believe
values have generally fallen 30%-40% since the peak.
Despite this level of decline, it is too soon to say that
the markets have bottomed out.
Capital Markets
The private debt markets are expected to remain very
selective for the remainder of 2009. While exceptional
opportunities will likely spur competition between
Babson Capital Management LLC
lenders and receive attractive financing offers, we
think the vast majority of financing mandates will
struggle to find sufficient capital to refinance existing
debt and will require an additional equity injection to
retire maturing debt.
The TALF program, which looked to breathe life into
the nascent public debt markets, has struggled to find
the right formula of term, properties and sponsors to
ignite the markets. It appears TALF may initially be
best suited for REITs seeking to finance a diversified
portfolio of their properties. The government will be
heavily involved in approving the properties to be
included in the collateral pool as well as the terms of
the loans. We think the uncertainty around the “rules
of the game” and the ultimate cost to the borrower is
slowing progress on the program.
The recent bankruptcy filing of General Growth
Properties (GGP) is causing lenders — both private
and those potential public debt originators — to
carefully consider many of the basic structural loan
safeguards that are now the subject of a fierce battle
between the lenders and the debtor in bankruptcy
court. The number of bankrupt borrowers is growing;
however, this case has the potential to create precedent.
“Patience” is the watchword in both the debt and
equity markets. As vacancies increase, rents decrease
and the economy continues to weaken, sellers
will ultimately have to capitulate and the patient
buyers will have an opportunity to acquire attractive
investments. Lenders will have the opportunity to
select from the best opportunities. For those investors
interested in acquiring distressed debt, there has been
little available as many lenders have chosen to extend
maturing loans rather than foreclose. This may change
as loan maturities increase significantly over the next
two years and lenders are forced to foreclose or sell
their distressed mortgages to opportunistic buyers who
will ultimately convert the debt position into equity
ownership through foreclosure.
The public capital markets will continue to be
impacted by technical factors outside of real estate. As
such, large scale restarting of the CMBS market is not
likely to occur for a few years. In the interim, there is
reasonable value in pre-2005 vintage CMBS, although
offerings of these bonds are currently somewhat
limited. Assuming control rights are better defined in
TALF, and hedging and warehouse vehicles become
available, an opportunity could exist to contribute
loans to a new issue CMBS under the TALF program
while retaining the higher yielding B piece.
11
DISCLOSURE CONTACT
The information and opinions in this Staff Letter were prepared by Babson Capital Sales
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the author(s) named on page one of this Staff Letter. Managing Director
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