RHOCORE

Rhocore UpdateMarch 2016

An offering memorandum containing important information relating to any securities described in this document has or will be filed with the securities regulatory authorities in each of the jurisdictions where a distribution has occurred or will occur pursuant to the offering memorandum. A copy of the offering memorandum is required to be delivered to you at the same time or before you sign the agreement to purchase the securities described in this document pursuant to the offering memorandum. This document does not provide disclosure of all information required for an investor to make an informed investment decision. Investors should read the offering memorandum of Rhocore Income Trust (the “Fund”), especially the risk factors relating to the securities offered, before making an investment decision.

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A clear understanding of credit quality as it relates to default rates and yield spreads is critical in evaluating the wide variety of private debt offerings in the exempt space – offerings that range from industrial equipment leasing to MICs.

The purpose of this short comment is simply to raise some questions that should be considered when a private debt investment is being contemplated. In the same fashion that volatility and correlation were rarely discussed in the exempt space 5 years ago but are common analysis today, we expect the analysis of expected default rates and yield spreads to be an area that will see increased sophistication in the coming years.

It is not an infrequent occurrence in the alternative space to be told that investment X is yielding 11% for a 3-year term and investment Y is yielding 7% for a 3-year term so investment X must be better for clients without sufficient analysis of the underlying credit quality and default risk – even when the investments are in the same asset class and such comparisons are more straightforward.

CHART 1: CUMULATIVE HISTORIC DEFAULT RATES (% LEFT AXIS) WITH INDICATIVE CORPORATE YIELDS BY RATING (% ABOVE BARS)

In the simplest terms, as an investor you are evaluating 1) the risk that your private loan will be repaid in full and then 2) whether the yield you are being paid compensates you for the excess default risk as compared to a risk free investment of the same duration i.e. what is the risk of loss and what are you being paid to accept that risk.

The challenge in the alternative market is sometimes a lack of historical default data for the underlying investments as many exempt issuers are blind pools or have short operating histories. Fortunately, ratings agencies maintain large databases of default data broken down by credit quality, industry, sector, year etc. from which useful insights can be drawn.

One powerful observation from rating agency data is not that default rates increase as credit quality goes from high to low but more importantly that this change is non-linear – by this I mean that moving from high quality to low quality credits typically increases defaults at an ever increasing rate. In the chart below, moving from AAA to CCC increases the expected default rate over 100 times.

Private Debt – Some Thoughts on Credit Quality, Default Rates, Realised Losses and Yield Spreads

Default Rate

Sources: St Louis Federal Reserve, BofA Merrill, Moody’s, S&P

2.6%

60%

40%

20%

0%Aaa/AAA Aa/AA A/A Baa/BBB Ba/BB B/B Caa- C/CCC- C

Moody’s S&P

2.7% 3.1%4.3%

5.8%

8.5%

18.3%

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Rhocore Update (continued)

Of course this non-linearity does not present a problem in and of itself when properly priced and managed, but I would argue that while the range of credit quality in the underlying investment portfolios of exempt issuers is quite wide, the spread of yields may not properly reflective of this variance – i.e. the exempt market may not yet be properly pricing default risk in the form of additional yield or structural enhancements. Take for example two potential investments in two corporate loan portfolios (an asset class with large amounts of historical default data):

§Portfolio 1 - focused on “A” credits (borrowing rates of approximately 6% and lower)

§Portfolio 2 - focused on “C” credits (borrowing rates of approximately 15% and higher)

To put these two portfolios into perspective, according to historical data from Moody’s1 and S&P:

§ “AAA” loans typically default at approximately 0.6% with recovery rates around 70% = 0.2% loss rates on average

§ “CCC” loans typically default at approximately 70% with recovery rates around 60% = 40% loss rates on average

Given this loss data, which reflects the distinctly non-linear increase in defaults as credit quality decays, all other factors being equal, is an investor properly compensated for investing in the 7% 3-year security

versus the 11% 3-year security. Does 400 bps of additional yield compensate for the additional losses the “C” credit portfolio will experience?

Another important pricing consideration is how differing quality credit portfolios behave during a change in underlying market/economic conditions. During a recession an AAA portfolio might become an A portfolio which, due to the non-linear change in defaults rates, results in a modest change in aggregate write-offs while a BBB portfolio might become a CCC portfolio completely eroding the benefit of the additional original yield and perhaps raising the specter of significant capital loss.

I would also argue, given the larger probability of individual defaults, lower credit portfolios must be highly diversified to take advantage of the law of large numbers. Undiversified portfolios of lower credit quality investments may deviate significantly from historical defaults rates with possibly good or bad consequences but ultimately this merely represents increased volatility which is risk for which the investor must receive additional compensation over and above the already high yields that such portfolios should provide – i.e. with all other factors being equal, a less diversified portfolio of lower credits should attract even higher yields than a more diversified portfolio of the same credits.

Stephen JohnstonDirector – Rhocore Income Trust

1 Moody’s Investor Services – Credit Loss Rates on Similarly Rated Loans and Bonds – Dec 2004

#2210, 8561 8A Ave SWCalgary, T3H 0V5Tel: 587 887 1541www.rhocorefund.com

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The forward-looking statements contained in this document are expressly qualified by these cautionary statements. The forward-looking statements are given as of January 27, 2016 and the Trust, the trustees and the Administrator disclaim any intent or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or results or otherwise, other than as required by applicable securities laws.

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