The Evolution of High-Yield Bonds into a Vital Asset Class

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1 Allianz Global Investors White Paper Series The Evolution of High-Yield Bonds into a Vital Asset Class 07/2016 Executive Summary With high-quality bond yields near all-time lows, investors have looked to high-yield bonds to enhance the return profile of their overall portfolio. Although this has fueled concerns about an overheated high-yield market, Allianz Global Investors believes investors would be better served by thinking of high-yield bonds as more of a strategic allocation for the long term than a tactical allocation for today. High-yield bonds have turned into a legitimate asset class that is larger, bet-ter established and less risky than in years past, providing evergreen benefits that make them a sound addition to most diversified portfolios. In addition, the current environment is still attrac-tive for highyield bonds as a whole and active managers with rigorous credit research pro-cesses can help investors best maximize the risk/return potential of this important asset class. Table of Contents Page 2 What Are High-Yield Bonds? Page 3 High-Yield Bonds, Past and Present Pages 4 5 Benefits of High-Yield Investing Pages 6 7 How High-Yield Bonds Fit into an Asset Allocation Strategy High-yield bonds offer attractive income potential in a low-yield environment where short-term interest rates are expected to remain low for the foreseeable future. Consider: With today s over 7% yield and over 600 basis points spread over Treasuries, high-yield bonds appear to be attractive. High-yield bonds can potentially be one of the few sources of upper-range single-digit returns. We believe that just because an asset class is attractive and doing well doesn t mean it s overvalued. For example, as we will show later in this paper, high-yield companies generally have quality earnings and exhibit historically low default rates; these qualities may be worth a premium to some investors.

2 In comparison to other asset classes, yields of high-yield bonds make them attractive to today s investors. Upgrade candidates are those high-yield issuers whose creditworthiness is likely to improve, often leading to an increase in value. So what role should high-yield bonds play in a diversified portfolio? For those answers, it may help to begin with an overview and history of high-yield bonds, and an exploration of how they ve evolved. What Are High-Yield Bonds? High-yield bonds and investment-grade bonds are the two segments of bond debt, known collectively as corporate bonds, that are issued by public and private companies to access credit markets and raise capital. Investment-grade bonds are issued by the most creditworthy issuers. They have ratings of between AAA and BBB (or the equivalent) and their interest rates are slightly higher than those of government bonds. High-yield bonds are issued by less-creditworthy companies, as determined by the widely accepted evaluations of several major ratings agencies. They have ratings of less than BBB (or the equivalent) and their interest rates are considerably higher than those of government bonds to make them more attractive to potential investors. The creditworthiness of a corporate bond issuer is rated by ratings agencies such as Standard & Poor s, Moody s and Fitch (see Exhibit 1). Their ratings are designed to precisely reflect levels of credit risk the risk that an issuer may default on payments. Ratings are reviewed at least once a year and can be maintained, upgraded, downgraded or placed under review with positive or negative implications, pending completion of an additional study. The spread of high-yield bonds the yield differential between high-yield bonds and government bonds is primarily dependent on the creditworthiness of the issuer. Experienced high-yield bond investors look for securities whose creditworthiness is likely to improve i.e., upgrade candidates. An improvement in an issuer s creditworthiness warrants a lower spread, which tends to result in a lower overall interest rate and Exhibit 1: A full spectrum of corporate bond choices An overview of ratings issued by the primary ratings agencies, showing varying levels of creditworthiness in the corporate-debt market. Investment Grade Speculative Grade/High Yield Moody s S&P Fitch Long Term Short Term Long Term Short Term Long Term Short Term Aaa Prime-1 AAA AAA F1+ Aa1 Prime-1 AA+ AA+ F1+ A-1 Aa2 Prime-1 AA AA F1+ Aa3 Prime-1 AA- AA- F1+ A1 Prime-1 A+ A+ F1+ or F1 A-1 A2 Prime-1 or Prime-2 A A F1 A3 Prime-1 or Prime-2 A- A- F1 or F2 A-2 Baa1 Prime-2 BBB+ BBB+ F2 Baa2 Prime-2 or Prime-3 BBB BBB F2 or F3 A-3 Baa3 Prime-3 BBB- BBB- F3 Ba1 BB+ BB+ B Ba2 BB BB B Ba3 BB- BB- B B B1 B+ B+ B B2 B B B B3 Not Prime B- B- B Caa1 CCC+ CCC C Caa2 CCC CC C Caa3 CCC- C C C Ca CC RD/D RD/D C C Sources : S&P, Moody s and Fitch. Long-term ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. Short-term ratings are opinions of the ability of issuers to honor short-term financial obligations (those within the next 13 months) and reflect the inherent importance of liquidity and near-term concerns within the assessment of the longer-term credit profile. 2

3 High-yield bonds have changed significantly since the 1980s. Today, domestic highyield bonds represent a robust, diversified and mature asset class. an increase in the value of the securities. Conversely, it is important to avoid bonds whose creditworthiness will deteriorate: A drop in creditworthiness warrants an increase in the spread, which tends to result in a higher overall interest rate and an automatic decline in the value of the securities. High-Yield Bonds, Past and Present While high-yield bonds are portfolio staples for many investors, they can also be underutilized or ignored by others. This may be at least in part due to some commonly held misperceptions about an asset class that has changed significantly in recent decades. Yesterday: An immature market. A brief boom. Before 1977, almost all high-yield bonds (known as junk bonds ) were fallen angels bonds issued by firms that originally had investment-grade ratings but had since been downgraded, which indicated a heightened possibility of default. In 1977, however, new-issue high-yield bonds were introduced to the marketplace, and the asset class soon began to boom. The new market was in large part created by investment bank Drexel Burnham Lambert and its star trader, Michael Milken, who offered a new way for many The Evolution of High-Yield Bonds into a Vital Asset Class firms considered bad investments and starved of capital by banks to gain access to credit. In the 1980s, Drexel s legal difficulties and other scandals severely tarnished the reputation of high-yield bonds, and the high-yield market dried up in the face of rising interest rates, rising defaults and a new regulatory environment. Today: A mature market for a new environment In the last few decades, the environment for high-yield bonds has changed dramatically. US high-yield bond gross issuance was only $150 billion in 1990 but by 2015, it was more than $1.5 trillion. The US makes up the largest portion of the global high-yield corporate bond market (see Exhibit 2). Domestic high-yield issues represent a well-diversified universe (see Exhibit 3). Unlike in previous years when high-yield bonds were concentrated in certain sectors, no single industry dominates the high-yield universe today. Companies today rarely use proceeds for takeovers or new investments relative to history; instead, they re Exhibit 2: The US high-yield bond market is the largest The US has $1,335 billion of the $1,970 billion global high-yield bond market, providing the widest opportunity set for investors. Exhibit 3: The high-yield bond universe is well diversified The wide range of sectors in the US high-yield bond market helps investors diversify their bond allocations. Emerging Markets High Yield 15% US High Yield 68% Euro High Yield 18% Utility 3% Leisure 3.8% Financial Services 3.9% Banking 4.1% Services 4.4% Retail 5% Technology Electronics 5.5% Capital Goods 5.6% Consumer Goods 2.9% Automotive 2.1% Transportation 1.1% Insurance 0.8% Real Estate 0.8% Energy 14.1% Basic Industry 12.6% Media 11% Telecommunications 9.7% Healthcare 9.6% Source: BofA Merrill Lynch as of 30/6/2016. US high yield is represented by the BofA Merrill Lynch High Yield Master II Index, euro high yield by the BofA Merrill Lynch Euro High Yield Index and emerging markets high yield by the BofA Merrill Lynch Global Emerging Market Credit Index. Past performance is no guarantee of future results. Sources: BofA Merrill Lynch, Bloomberg and Allianz Global Investors. Data as of 30/6/2016. Based on the BofA Merrill Lynch High Yield Master II Index, industry percent market value. Diversification does not assure a profit or protect against loss. 3

4 The risk/reward profile of the high-yield sector has historically been more favorable than that of traditional asset classes. High-yield bonds are an effective diversification tool in an investor s overall portfolio. refinancing balance sheets and reducing borrowing costs, which reduces the risk of default. Benefits of High-Yield Investing The evolution of the high-yield debt market makes it a legitimate asset class for diversified portfolios, and cements the role of high-yield bonds as an important strategic allocation. We believe there are three primary benefits of high-yield investing: income potential, risk diversification and positioning against inflation and rising rates. High current yields fill a need for income With historically low interest rates, high-yield spreads are currently approximately 621 basis points over Treasuries. 1 This gives high-yield bonds a yield advantage over Treasuries, which are currently so low-yielding that their real returns may actually fail to keep up with inflation. Of course, Treasuries are the only investments guaranteed by the US government as to timely repayment of interest and principal, but investors are finding attractive income opportunities with highyield bonds. High-yield bonds provide portfolio risk diversification In addition to a high and steady stream of potential income, high-yield bonds can provide other benefits to a portfolio. Exhibit 4 shows that high-yield bonds have a favorable risk/reward profile when compared to more traditional asset classes including large-cap US stocks, small-cap US stocks and international stocks providing equitylike returns with much less volatility. High-yield bonds are generally less volatile because they provide a steady stream of income that provides a cushion in periods of market weakness. Exhibit 4: High-yield bonds boast a favorable risk/reward profile High-yield bonds have a favorable risk/reward profile relative to other asset classes, providing equity-like returns with less volatility. 12 Return (% Annualized) BofA Merrill Lynch US High Yield Master II Index S&P 500 Index Russell 2000 Index MSCI EAFE Index Risk (% Annualized) Sources: BofA Merrill Lynch, FactSet and Allianz Global Investors. Data from 31/1/88 30/6/16. Past performance is no guarantee of future results. The performance of the indexes are not indicative of the past or future performance of any Allianz Global Investors product. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index. 4

5 When interest rates rise, high-yield bonds, which are negatively correlated with Treasuries, provide solid positioning. Like stocks, high-yield bond returns are closely correlated to the fundamentals of their issuing companies. High-yield bonds help investors combat inflation and rising rates Should interest rates rise from today s historic lows as they inevitably will an allocation to high-yield issues would be an obvious choice. High-yield bonds have shown a tendency to hold up better than other types of bonds, particularly Treasuries. However, it s important to keep in mind that bond prices will normally decline as interest rates rise and the impact may be greater with longer-duration bonds. High-yield bonds exhibit a correlation to interest-rate-sensitive 10-year Treasuries, providing solid positioning for rising-rate environments. 2 Conversely, high-yield bonds are more strongly correlated with stocks. As of 30/6/16, they exhibited a 0.62 correlation with US small-cap stocks, a 0.62 correlation with US large-cap stocks and a 0.56 correlation with international stocks. 3 Exhibit 5 shows that, on average, high-yield bonds have outperformed Treasuries by over three percentage points during rising-rate cycles. We believe the reason for high-yield bonds ability to perform more like stocks during rising-rate cycles may be that, much like stocks, high-yield bond returns are closely correlated to the business successes and fundamentals of their issuing companies. This closer link to business fundamentals means that when interest rates rise, high-yield bonds tend to outperform investment-grade bonds, since interest rates tend to rise when business conditions are robust. Exhibit 5: High-yield bonds have outperformed in three of four rising-rate cycles During the four periods of rising rates since 1988, high-yield bonds outperformed high-quality bonds by an average of 1.59 percentage points, and outperformed Treasuries by an average of 3.02 percentage points. Rising-Rate Cycle 1: 29/03/1988 to 24/02/1989 Rising-Rate Cycle 2: 04/02/1994 to 01/02/1995 Rising-Rate Cycle 3: 30/06/1999 to 16/05/2000 Rising-Rate Cycle 4: 30/06/2004 to 29/06/2006 Core Bonds 3.41% -2.04% 2.02% 2.99% 10-Year Treasuries 2.82% -6.07% 1.64% 2.29% High-Yield Bonds 8.95% -1.77% -1.84% 7.41% Cycle Total Rate Hike Fed Funds Rate at Beginning of Cycle Fed Funds Rate at End of Cycle % Change % 6.50% 9.75% % % 3.00% 6.00% % % 4.75% 6.50% % % 1.00% 5.25% % Source: Morningstar Direct. Core bonds are represented by the Barclays US Aggregate Index and high-yield bonds by the BofA Merrill Lynch US High Yield Master II Index. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index. Past performance is no guarantee of future results. 5

6 Investors who have added just a 10% allocation of high-yield bonds to their traditional 60/40 portfolio of stocks and bonds have historically found increased returns, less risk and a superior Sharpe ratio. How High-Yield Bonds Fit into an Asset Allocation Strategy With the establishment of high-yield bonds as a legitimate asset class that is larger, better established and less risky than in years past, we believe there are compelling reasons why investors should consider a long-term allocation to a portfolio of actively managed high-yield issues. High-yield bonds are an attractive addition to almost any portfolio allocation As we have shown, high-yield bonds have historically provided high current income potential, improved risk/reward profiles and solid positioning against rising rates. Yet to the detriment of long-term investors, many basic asset allocation models are unallocated, underallocated or misallocated to high-yield bonds. Traditionally, investors have relied heavily on fixed income to generate an income stream in their portfolios. But as interest rates have tapered off in recent years, so have the yields that investors earn on conventional bonds. As Exhibit 6 shows, adding high-yield bonds to an investor fixed income allocation expands the efficient frontier, reducing risk and increasing returns over the long term. Using an asset allocation strategy does not assure a profit or protect against loss. You should consider your investment time frame, risk tolerance level and investments. Allianz Global Investors does not make suitability determinations. Exhibit 6: High-yield bonds can improve the efficient frontier Adding high-yield bonds to a fixed-income allocation can help reduce risk and increase potential returns. Annualized Average Total Return (%) % High-Yield Bonds 100% 5- and 10-Year Treasuries Annualized Standard Deviation (%) 100% High-Yield Bonds Sources: BofA Merrill Lynch and Allianz Global Investors. Data from Jan 93 Jun 16. High yield is based on the BofA Merrill Lynch US High Yield 100 Index and 5- and 10-year Treasuries are based on the BofA Merrill Lynch US Treasury Current 5-Year Index and the BofA Merrill Lynch US Treasury Current 10-Year Index, respectively. Past performance is no guarantee of future results. It is not possible to invest directly in an index. 6

7 Passive high-yield ETFs may have significant disadvantages to actively traded highyield portfolios. Active managers seek to directly improve outcomes for shareholders through fundamental analysis, diversification and constant risk assessment. Passively managed high-yield ETFs vs. actively managed high-yield portfolios While exchange-traded funds (ETFs) are gaining acceptance as efficient ways to access many asset classes, they are not always the optimal investment vehicle for highyield investing. Because of the high-yield marketplace s unique characteristics, passively managed high-yield ETFs may actually have significant disadvantages compared with actively traded high-yield portfolios. For example, ETFs are meant to closely track indexes, but, unlike equity ETFs, which usually own all of the stocks in a benchmark, fixed-income ETFs hold significantly fewer issues than the indexes they re tracking, which often contain thousands of individual securities. Case in point: One major high-yield index, the BofA Merrill Lynch High Yield Master II Index, represents more than 2,000 high-yield holdings. To mirror the general characteristics of the index without holding all of the 2,000+ securities, a high-yield ETF would likely hold the largest, most liquid and most recent new issuers. Like ETFs, actively managed portfolios may not fully represent an index or may be over- or underweight certain securities. However, unlike ETFs, many active managers look for issuers they believe to have upgrade potential or the best perceived creditworthiness. In addition, when high-yield markets are stressed, trading can become an issue for ETFs if secondary trading volume fails. That s because ETFs must make good on cash deliveries every day, even during market downturns. If an ETF shareholder redeems shares, the ETF must provide proceeds. But when markets are dropping, ETF traders can encounter unfavorable bid/ask spreads yet must still take the price available that day. Of course, unlike actively managed portfolios, which only allow for redemption at the end of the day regardless of market activity, ETFs offer the ability to redeem midday. Moreover, active managers who use bottom-up, fundamental research may be able to reduce their exposure to riskier bonds before markets become overly stressed in the first place. Managers of actively managed high-yield portfolios can take direct steps to seek to improve outcomes for their shareholders, although there is no guarantee these strategies will be successful. Unlike ETFs, active managers: Assess credit quality with thorough analysis. Examining an issuer s sector, market positioning, strategy, balance sheets and financial statements helps the manager determine if the company s day-to-day operations will allow it to service its liabilities adequately over the long term. Verify that spreads match creditworthiness. When they determine that the spread underestimates the creditworthiness, they may decide to invest more; if the spread is insufficient, they can reduce their holdings. Look for upgrade candidates. As we previously mentioned, it s important to hold securities whose creditworthiness is likely to improve. Any improvement in an issuer s credit rating tends to result in a lower overall interest rate and an increase in the value of the securities. Can diversify their portfolios between sectors and companies instead of seeking to replicate an index. Of course, diversification does not assure a profit or protect against loss. Passively Managed ETFs Passive Generally largest, most liquid issuers in index Must take the price available in the market throughout the day, even in illiquid markets Not a goal of ETFs, which seek to represent a passive index Not a goal of ETFs Not a goal of ETFs Generally lower than actively managed portfolios Management style Representative holdings Stressed markets Managing risk Can assess credit quality Can examine balance sheets of underlying issuers Costs Actively Managed Portfolios Active Depends on manager; can be a well-diversified representation of an index Typically not forced into intraday trading Risk can be actively managed Yes, depending on manager Yes, depending on manager Generally higher than ETFs 7

8 Endnotes: 1. BofA Merrill Lynch and Allianz Global Investors, as of 30/6/ Barclays, BofA Merrill Lynch, FactSet and Allianz Global Investors, as of 30/6/16. Based on the BofA Merrill Lynch High Yield Master II Index. 3. Barclays, BofA Merrill Lynch, FactSet and Allianz Global Investors, as of 30/6/16. Based on the BofA Merrill Lynch High Yield Master II Index. Small-cap stocks are represented by the Russell 2000 Index, large-cap stocks by the Russell 1000 Index and non-us stocks by the MSCI EAFE Index. As at 30 June Information herein is based on sources we believe to be accurate and reliable as at the date it was made. We reserve the right to revise any information herein at any time without notice. No offer or solicitation to buy or sell securities and no investment advice or recommendation is made herein. In making investment decisions, investors should not rely solely on this material but should seek independent professional advice. Investment involves risks, in particular, risks associated with investment in emerging and less developed markets. Past performance is not indicative of future performance. Investing in fixed income instruments (if applicable) may expose investors to various risks, including but not limited to creditworthiness, interest rate, liquidity and restricted flexibility risks. Changes to the economic environment and market conditions may affect these risks, resulting in an adverse effect to the value of the investment. During periods of rising nominal interest rates, the values of fixed income instruments (including short positions with respect to fixed income instruments) are generally expected to decline. Conversely, during periods of declining interest rates, the values are generally expected to rise. Liquidity risk may possibly delay or prevent account withdrawals or redemptions. This material has not been reviewed by any regulatory authorities. This material is being distributed by the following Allianz Global Investors companies: Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No Z].