The Case for Short-Maturity, Higher Quality, High Yield Bonds

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1 PRUDENTIAL INVESTMENTS» MUTUAL FUNDS A WHITE PAPer FROM PrudenTial Fixed Income The Case for Short-Maturity, Higher Quality, High Yield Bonds The institutional asset managers behind Prudential Investments mutual funds do more than manage money. Many are also thought leaders and publish frequently in their areas of expertise. This white paper offers you a manager s current thinking on an important industry issue. We hope this information is helpful in providing guidance for the financial challenges facing you.

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3 Perspectives January 2012 The Case for Short-Maturity, Higher Quality High Yield Bonds Paul Appleby, CFA Managing Director and Head of Leveraged Finance Group Prudential Fixed Income Despite the economic, political, and market turmoil of the past several years, the high yield bond asset class provided long-term investors with competitive risk-adjusted returns. However, in today s low interest rate environment, investors are seeking additional yield or income with more modest levels of volatility and downside risk. We believe that a well-researched, diversified portfolio of short-maturity, higher quality high yield bonds can be an attractive investment opportunity within a broader asset allocation strategy. In this paper, we evaluate the benefits of this niche sector and explore the favorable fundamental and technical characteristics that lead to its attractive value proposition. Michael Collins, CFA Senior Investment Officer and Credit Strategist Prudential Fixed Income An Often Overlooked Segment of the High Yield Bond Market Short-maturity, higher quality high yield bonds are often an overlooked segment of the high yield bond market. A key reason is that the yields offered by this segment do not rival those of lower-quality or longer-term high yield debt. However, the structural reasons behind their lower yields shorter maturities and better fundamental quality have led the segment to offer the most attractive risk/return profile in the high yield bond market over the long term. We define short-maturity high yield bonds as seasoned bonds that are slated to mature within the next five years or are highly likely to be tendered or called by the issuer within that time. Within this universe, we have found that higher quality credits mostly BB and B rated bonds offer the most attractive opportunities. To make our case, we first look at how higher quality high yield bonds and short-maturity bonds exhibit more favorable fundamentals and lower volatility than lower-quality, longer-dated credits. Short-Maturity, Higher Quality High Yield Bonds provide an opportunity to diversify across issuers, industries, and maturities: 1 Market Value²: $248 Bil # Issues: 499 # Issuers: 340 Industries: 38 Avg. Yield-to-Worst: 7.27% Avg. Duration: 2.32 yrs Avg. Maturity: 3.54 yrs Avg Quality: Ba3/B1 Avg. Option Adj Spread: 654 bps 1 Data is for the Barclays Capital US High Yield Ba/B 1-5 Year 1% Issuer Constrained Index as of Dec. 31, Market value is approximately 1/4 the size of the total high yield universe. We then explain how market segmentation enables both higher quality bonds and short-maturity bonds to be attractively valued, particularly in today s low interest rate environment. Finally, we look at the roles these securities can play in dedicated and broader fixed income portfolios, as well as the risk considerations for this niche sector.

4 Prudential Fixed Income Perspectives January 2012 Page 2 Lower Credit Risk Allows Investors to Keep More Income The stronger fundamental position, or credit quality, of BB and B rated bonds can best be illustrated by first reviewing the default history of the high yield market as a whole, then the default history of each quality segment of the market. Over time, the high yield bond market averages approximately a 5% annual default rate. It ranges from roughly 2% in good years when the economy and corporate fundamentals are strong, to more than 10% in a bad year. This is typically when the economy undergoes a severe slowdown and/or liquidity comes to a sudden halt, as it did during the financial crisis of As illustrated below, the most recent 12-month U.S. corporate default rate is less than 2%, well below the historical average. 15 Average Default Rate High Yield Bond Default Rate by Number of Issuers: Mean Default Rate is 5.0% Historically Jan 1, 1989 to Dec. 31, 2011 Defaults (%) % Source: Moody s. Represents annual default rates. Past performance is not a guarantee or a reliable indicator of future results. Not surprisingly, most defaults naturally occur in the lower-quality tiers of the high yield bond market. As you can see below, the historical average annual default rate for BB rated issuers is only 2% compared to 5.2% for B rated issuers and almost 11% for CCC rated bonds. Given that the credit fundamentals of higher quality high yield bonds are stronger to start with, they are less dependent on a robust economic environment and have less refinancing risk than lower-quality high yield bonds. High Yield Bond Defaults by Quality: BB Rated Bond Defaults are 2% Historically Represents Average 5-Year Cumulative Defaults by Quality (Annualized) Jan. 1, 1970 to Dec. 31, 2010 Defaults (%) % 5.2% 2.1% BB B CCC Quality Source: Prudential Fixed Income, based on data from Moody's 2010 Annual Corporate Bond Default Survey. (Moody s 2011 Annual Corporate Bond Default Survey is expected to be released in late Feb ) Defaults are measured on an issuerweighted basis. Data was generated by averaging the five-year default rates of cohorts formed at monthly intervals, reported on an annualized basis. Past performance is not a guarantee or a reliable indicator of future results.

5 Prudential Fixed Income Perspectives January 2012 Page 3 The lower incidence of defaults in BB and B rated debt is largely responsible for the long-established structural appeal of higher quality high yield bonds. As illustrated below, over the past 15 and 25 years BB rated bonds delivered higher average annual returns and lower volatility than both B and CCC rated credits. In fact, the volatility of BB rated bonds was half that of CCC rated issues. These results are attributed to the fact that higher quality high yield bonds have re-paid their principal more often than lower-quality bonds to well overcome their lower yields. Therefore, investors are not being commensurately rewarded for the increased risk of going down in quality. 10 Higher Quality High Yield is Sweet Spot Over the Long Term As of Dec. 31, 2011 Annualized Return (%) BB B CCC Annualized Volatility (%) 25 Years 15 Years Source: Barclays Capital. Data is for Barclays Capital US High Yield Ba Index, Barclays Capital US High Yield B Index, and Barclays Capital US High Yield Caa Index. Volatility represents the annualized standard deviation of monthly returns. Past performance is not a guarantee or a reliable indicator of future results. An investment cannot be made directly in an index. Seasoned high yield bonds with a short remaining life also exhibit lower default characteristics. Most high yield bond defaults occur in the early stages of a bond s life cycle within the first few years after being issued. In other words, if a high yield company survives its first few years, it is much more likely to survive long enough to repay its bonds at (or prior to) maturity. As a result, bonds that are due to mature within the next few years tend to have the lowest default rates, as shown below. 7 Seasoned (Short- Maturity) High Yield Bonds Demonstrate More Favorable Default Statistics Jan. 1, 1970 to Dec. 31, 2010 Default Rate (%) B BB Seasoned bonds have lower historical default rates Years Remaining to Maturity Source: Prudential Fixed Income, based on data from Moody s 2010 Annual Corporate Default Survey. (Moody s 2011 Annual Corporate Bond Default Survey is expected to be released in late Feb ) Past performance is not a guarantee or a reliable indicator of future results In summary, we believe the best way to reduce credit losses, and achieve strong, long-term risk-adjusted performance, is to combine the two segments of the market with the most favorable fundamentals and, therefore, the least amount of defaults: higher quality high yield bonds with a shorter maturity.

6 Prudential Fixed Income Perspectives January 2012 Page 4 Attractive Valuation Supported By Market Segmentation Short-maturity, higher quality high yield bonds are also supported by the effect of market segmentation, which results in these bonds being overlooked by many high yield bond and investment grade corporate bond investors. Market segmentation is an investment theory that attributes pricing anomalies in certain markets to different preferences or tendencies by investors in those markets. Often, this results in certain securities being undervalued relative to other segments of the market. In the short-maturity, higher quality high yield space, market segmentation is evident for two reasons: 1) limited demand for the BB rating category, and 2) trading convention differences (spread vs. yield). 1) Limited Demand for BB Rating Category The investment objectives and risk tolerances of traditional investment grade corporate bond and high yield investors do not tend to favor higher quality high yield bonds. Investors in investment grade corporate bonds are often explicitly restricted from buying non-investment grade, or high yield, bonds. Conversely, many high yield investors deliberately underweight the highest quality/lowest yielding bonds within the high yield market because of their lower yields relative to lower-quality bonds. This lack of natural buyers generates a tendency for higher quality high yield bonds to be undervalued, leading to a favorable risk/return profile over the long term. 2) Trading Convention Differences (Spread vs. Yield) Investment grade corporate bond investors pay close attention to the level of U.S. Treasury yields, as the market trades based on the yield spread between an investment grade corporate bond and a U.S. Treasury bond. In today s market, many investors consider a high quality investment grade corporate bond that provides +100 to +200 bps in spread over U.S. Treasuries to be attractive. Because U.S. Treasury yields are at historic lows, investment grade corporate bonds with two-to-five years to maturity can find willing buyers even at yields of 2%. High yield bond investors, on the other hand, are more focused on the absolute yield of a high yield bond. For this reason, most high yield bonds are traded on a dollar price or an absolute yield basis instead of on a spread basis. In terms of absolute yields, many high yield investors find it unattractive to buy a high yield bond with a yield to maturity of less than, say, 5% in today s market, especially one with little room for price appreciation because of its short maturity. As a result, in today s extraordinarily low U.S. Treasury yield environment, short-maturity, higher quality high yield bonds trade at very high spread levels relative to similar duration U.S. Treasuries and investment grade corporate bonds.

7 Prudential Fixed Income Perspectives January 2012 Page 5 Key Favorable Risk/Return Characteristics in the High Yield Universe The combination of relatively attractive spreads and lower historical default rates vs. traditional high yield bonds has led to very attractive risk-adjusted returns for short-maturity, higher quality high yield bonds. As shown below, the historical annualized returns of short-maturity, higher quality high yield debt have been just slightly below the returns of the broad high yield market, but with considerably less volatility, resulting in a superior Sharpe ratio. 8.5 Short-Maturity, Higher Quality High Yield Bonds (Short HQHY): Comparable Returns with Lower Volatility Jan. 1, 1997 to Dec. 31, 2011 Annualized Returns (%) Short HQHY BB/B 1-5 Yr HQHY BB/B Annualized Volatility (%) HY Barclays Ba/B 1-5 Yr Index Barclays Ba/B Index Barclays HY Index Annualized Return 6.84% 6.83% 6.99% Annualized Volatility 6.75% 8.53% 9.73% Sharpe Ratio 0.56% 0.44% 0.40% Data source: Barclays Capital. Calculation source: Prudential Fixed Income. Data is for following indices: Short HQHY: Barclays Capital US High Yield Ba/B 1-5 Year 1% Issuer Constrained Index; HQHY: Barclays Capital US High Yield Ba/B 1% Issuer Constrained Index; HY: Barclays Capital US High Yield 1% Issuer Constrained Index. Jan. 1, 1997 is the inception date of the Barclays Capital US High Yield Ba/B 1-5 Year 1% Constrained Index. Past performance is not a guarantee or a reliable indicator of future results. Attractive Yields and Spreads Today If an investor wants good relative value and lower volatility, the yields of short-maturity, higher quality high yield bonds are quite attractive, especially today. In fact, the current yield-to-worst of a representative index was 7.3% as of Dec. 31, 2011 (as measured by the Barclays Capital U.S. High Yield Ba/B 1-to-5 Year 1% Issuer Constrained Index.) Yields in the index ranged from approximately 5.0% for one-year issues to 8.5% for 5-year maturities. Short-Maturity HQHY: Current Yield-to- Worst is About 7.3% As of Dec. 31, 2011 Yield-to-Worst (%) Short HQHY BB/B 1-5 Yr 5-Yr US Treasuries 3-Yr 8.54% 1-Yr 6.66% 4.93% 0.10% 0.39% 0.88% Weighted Average Life (Years) Data source: Barclays Capital. Calculation source: Prudential Fixed Income. Data for Short HQHY is the weighted average yield-toworst of 1, 3, and 5-year issues in the Barclays Capital US High Yield Ba/B 1-5 Year 1% Constrained Index. Past performance is not a guarantee or a reliable indicator of future results.

8 Prudential Fixed Income Perspectives January 2012 Page 6 From a spread perspective the yield spread of short-maturity, higher quality high yield bonds over U.S. Treasuries the sector also looks attractive. Current spreads are 654 bps over equivalent-duration U.S. Treasuries. Historically, spreads average roughly 500 bps. Short-Maturity HQHY: Current Above-Average Spread Over US Treasuries of 654 Bps Jan. 1, 1997 to Dec. 31, 2011 Spread (Bps) 1,800 1,600 1,400 1,200 1, Short HQHY BB/B 1-5 Yr Average Spread 654 Source: Barclays Capital. Data is for the Barclays Capital US High Yield Ba/B 1-5 Year 1% Issuer Constrained Index. The inception date of the index is Jan. 1, Past performance is not a guarantee or a reliable indicator of future results. Using Short-Term High Yield Bonds to Enhance an Overall Fixed Income Portfolio In addition to investing in a dedicated portfolio of short-maturity, higher quality high yield bonds, there are a number of roles these securities can play in broader fixed income portfolios today. Short Duration Credit Portfolios: With money market rates near zero, short duration portfolios that offer even modest levels of yields have garnered much attention. A diversified short duration credit portfolio may be comprised of short duration corporate bonds, select structured securities, senior secured loans, and short-maturity, higher quality high yield bonds. High Yield Bond Portfolios: The higher quality and short maturities of these bonds can help offset some of the risk of lower-quality bonds in a broad market high yield portfolio. The lower volatility and lower interest rate sensitivity of short-maturity, higher quality high yield bonds can also improve the overall risk profile of these portfolios. Core Plus Portfolios: Holding short-maturity, higher quality high yield bonds vs. the many short duration government bonds and agency mortgages in the Barclays Capital U.S. Aggregate Bond Index appears to be a great relative value trade at the current time. Absolute Return Portfolios: Absolute return portfolios typically seek competitive risk-adjusted returns relative to LIBOR. The absolute risk/return characteristics of short-maturity, higher quality high yield bonds, and their significant current spreads vs. LIBOR, make them attractive today for these types of opportunistic portfolios. Risk and Analytical Considerations There are three primary risks to short-maturity, higher quality high yield securities: credit risk, refinancing risk, and market risk. Credit Risk: The most significant risk is credit risk. Naturally, it is imperative to carefully scrutinize each individual issuer prior to purchase and while held in a portfolio to minimize default risk. Although default risk may be mitigated because of the short maturities of the issuers, it is still a risk that must be closely analyzed and monitored. In fact, analysts typically have much better visibility and insight into the trajectory of a company s credit profile over a short time horizon. Accordingly, analysts can more easily

9 Prudential Fixed Income Perspectives January 2012 Page 7 identify those short-maturity high yield bonds that are likely to avoid default through maturity. We would also note that, at the time of this writing in January 2012, credit quality is healthy and defaults are expected to remain below average over the next several years. Refinancing Risk: The second risk is refinancing risk. Quite simply, the success of a strategy employing short-maturity, higher quality high yield bonds hinges on the ability of the issuers to pay off their shortmaturity debt when it comes due. During times of extreme market stress, such as that seen in 2008, even creditworthy companies can have temporary trouble accessing the markets to refinance their outstanding debt, potentially leading to an inability to pay off existing bondholders. To properly assess this risk, analysts must carefully review the issuer s cash balances, its access to cash via a credit facility, its ability to generate free cash flow by operations or asset sales, and its access to the capital markets. In today s market, many corporations have sufficiently strong cash balances and place a high value on liquidity, given the turmoil in the financial markets in We believe these companies are in a good position to pay off their outstanding short-term debt as it comes due. Market Risk: Periods of extreme market stress can lead to disruptive price volatility, even in short-maturity bonds. In late 2008, systematic redemptions from high yield bond mutual funds and the widespread portfolio deleveraging by investors, financial institutions, and hedge funds that impacted many fixed income securities led to massive forced selling of many bonds. In an unplanned liquidation situation like this, many high yield portfolio managers will sell the lowest-yielding, most cash-like bonds they own. This may result in heavier-than-normal selling of short-maturity, higher quality high yield bonds. In addition, bonds that are expected to be called near term may extend to a longer-term call date or maturity, which could cause the bond s price to drop further. In Summary A diversified portfolio of short-maturity, higher quality high yield bonds can offer an attractive risk/return profile in a dedicated portfolio or in conjunction with a broader asset allocation strategy. Short-maturity, higher quality high yield bonds exhibit more favorable fundamentals and lower defaults, lower volatility, and more competitive long-term performance than lower-quality and longer-maturity high yield bonds. Market segmentation allows this niche sector to be attractively valued over time and especially in today s low U.S. Treasury rate environment. Key risks can be mitigated through careful research, analysis, and portfolio management. We believe today s market environment provides an attractive entry point into this niche sector of the fixed income market.

10 Prudential Fixed Income Perspectives January 2012 Page 8 Notice 2012, Prudential Investment Management, Inc. Unless otherwise indicated, Prudential holds the copyright to the content of the article. Prudential Investment Management is the primary asset management business of Prudential Financial, Inc. Prudential Fixed Income is Prudential Investment Management s largest public fixed income asset management unit, and operates through Prudential Investment Management, Inc. (PIM), a U.S. registered investment adviser. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of Prudential Fixed Income is prohibited. Certain information contained herein has been obtained from sources that Prudential Fixed Income believes to be a reliable as of the date presented; however, Prudential Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Prudential Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. Past performance is not a guarantee or a reliable indicator of future results. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. Prudential Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of Prudential Fixed Income or its affiliates. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions. Conflicts of Interest: Prudential Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. Prudential Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. Prudential Fixed Income affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. Prudential Fixed Income personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to Prudential Fixed Income s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2 of PIM s Form ADV

11 Index Definitions The indices are presented to provide you with an understanding of their historic long-term performance and are not presented to illustrate the performance of any security. The indices defined below are unmanaged. Investors cannot invest directly in an index or average. Past performance is not a guarantee of future results. Individual investor results will vary. Average Yield to Worst is the lower bond yield of yield to maturity or yield to call. Average Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years. Average Maturity is the average time to maturity for a bond. Average Option Adjusted Spread of a bond or bond indexes is the current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options. Barclays Capital U.S. High Yield 1% Issuer Constrained Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba1 or lower. Barclays Capital Ba/B 1% Issuer Constrained Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba or B. Barclays Capital Ba/B 1 5 year 1% Issuer Constrained Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba or B and maturities from one to five years. Barclays Capital U.S. High Yield Ba Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate, non-investment-grade debt. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba. Barclays Capital U.S. High Yield B Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate, non-investment-grade debt. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of B. Barclays Capital U.S. High Yield Caa Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixedrate, non-investment-grade debt. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Caa.

12 ABouT PrudenTIAL INVesTMenTS Prudential Investments is part of Prudential Financial, which is recognized by millions for its heritage of helping people grow and protect their wealth for more than 135 years. Prudential Investments offers a broad spectrum of mutual funds that can be used to build diversified portfolios that help address a wide range of investor needs. The managers of our funds manage money for major corporations, foundations, and pension funds around the world. That means when you invest with us, you benefit from the same process, research, risk management, and competitive performance demanded by some of today s largest and most sophisticated investors. Mutual fund Investing involves risk. Some are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. High yield bonds, known as junk bonds, are subject to a high level of credit and market risk. Unlike other investment vehicles, U.S. government securities and U.S. Treasury bills are backed by the full faith and credit of the U.S. government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. FOR More INFORMATion VISIT OUR WEBsiTE AT PrudenTialfunds.COM Consider a fund s investment objectives, risks, charges, and expenses carefully before investing. The prospectus and the summary prospectus contain this and other information about the fund. Contact your financial professional for the prospectus and summary prospectus. Read them carefully before investing. Mutual funds are distributed by Prudential Investment Management Services LLC (PIMS), a Prudential Financial company and member SIPC. Prudential Fixed Income (PFI) is a business unit of Prudential Investment Management, Inc. (PIM). PIM and PIMS are Prudential Financial companies. Prudential Investments, Prudential, the Prudential logo, and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. Mutual Funds: Are not insured by the FDIC or any federal government agency May lose value Are not a deposit of or guaranteed by any bank or any bank affiliate PI3356 Ed. 02/01/2012