SPOTLIGHT USD CORPORATE BONDS LOOKING FOR YIELD CAPITALISING ON THE DEPTH OF THE USD CORPORATES MARKET

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1 MARKETING MATERIAL FOR PROFESSIONAL INVESTORS ONLY (as defined in MiFID Directive 2004/39/EC Annex II). For Qualified Investors (Art. 10 Para. 3 of the Swiss Federal Collective Investment Schemes Act (CISA)). For institutional investors only. Further distribution of this material is strictly prohibited. Deutsche Asset Management, Mainzer Landstrasse 11-17, Frankfurt am Main, Germany Authors: Olivier Souliac olivier.souliac@db.com, Timur Shaymardanov timur.shaymardanov@db.com, Shuchang Sun shuchang-a.sun@db.com Date: September 2017 PASSIVE INSIGHTS SPOTLIGHT USD CORPORATE BONDS LOOKING FOR YIELD CAPITALISING ON THE DEPTH OF THE USD CORPORATES MARKET L homme est incapable de choix et agit toujours cédant à la tentation la plus forte. People are incapable of making choices and always act giving in to the greatest temptation. André Gide INTRODUCTION This document summarizes the results of our analysis of a Yield Seeking investor in the USD corporate bonds sector, similarly to the paper published in 2015 on EUR corporates1 (our previous paper ). Most results are similar to those of our previous paper, where we showed that yield seeking investors face numerous biases but overall should hold tight to downgraded bonds. The specificities of the USD corporate bond market make the search for yield even more interesting in this asset class: We find that due to the depth and the maturity of the USD corporate markets, concentrating towards higher yielding (riskier) bonds causes lower diversification biases and therefore lower impacts in terms of risks historically than for EUR bonds as per our previous paper Our historical price analysis shows that, as an alternative to (often complex and less diversified) relative-value based bond picking, a systematic, broad and diversified spreaddriven bond selection combined with a reasonable relaxation of rating restrictions can help deliver the bulk of higher yielding returns available from bonds with higher spreads. Finally, we find that the well-documented supply-demand imbalances around downgrades of bonds below BBB are also present, although to a lesser extent, around downgrades below AA and below A. This contributes to justifying that an overall yield seeking approach does enable investors to benefit from relative value as well, albeit to a lesser extent. USD corporates: an interesting playground for yield seeking investors It pays to hold tight, not only to fallen angels Final Remarks References Risk Warning 1 See Looking for Yield in Corporate Bond indices? it pays to hold tight, Deutsche AM Passive Spotlight, November 2015 Page 2 Page 8 Page 13 Page 13 Page 13

2 USD CORPORATES: AN INTERESTING PLAYGROUND FOR YIELD SEEKING INVESTORS A very deep market For Professional Clients only (MiFID Directive 2004/39/EC Annex II), respectively Qualified Investors With more than 5000 bonds, 1400 issuers from more than 50 countries and a weight of around 60% in the global investment grade ( IG ) corporate indices2 the USD cor porate bonds market is by far the widest and deepest corporate bond market. Financials currently only make up 35% (compared with approx. 42% in EUR corporates) and bonds from US domi- ciled companies only 68%3 of the index. This illustrates that this market, known to be the oldest one, is the most mature. The USD Corporate bonds market is by far the deepest in terms of supply, the widest in terms of geography and the most mature in terms of sector diversification. Increasing the spread component is key Similarly to our findings in our previous paper, Figure 1 and Figure 2 show that increased duration can be expected to be a by-product of a yield oriented portfolio. This prompts the question for investors as to whether they should prefer focusing on spreads (where spread curve are generally expected to be flatter than yield curves) instead of yields. It is however important to mention that spread curves being currently steeper than during crisis times, focusing on spread will thus probably also (albeit to a lesser extent) cause higher duration. The spread component of USD corporates remains attractive from a risk/return contribution perspective $ corporates, bond yields and spreads as of 2009 Figure 1: Bond yields (in grey, in %, left hand scale) and spreads (in orange, in Bps, right hand scale) within different buckets of outstanding maturity Source IHS/ Markit iboxx USD Corporate Bonds index, 30/06/2009 $ corporates, bond yields and spreads as of 2017 Figure 2: Bond yields (in grey, in %, left hand scale) and spreads (in orange, in Bps, right hand scale) within different buckets of outstanding maturity Source IHS/ Markit iboxx USD Corporate Bonds index, 30/06/ Source Bloomberg Barclays Global Aggregate Corporates index, 30 June Source IHS/Markit iboxx USD Corporates index, 30 June 2017

3 The second point supporting spreads versus yields for yield seeking investors is risk contribution. A quantitative risk contribution analysis of the USD corporates market using Bloomberg4 shows that currently, out of a global risk (as measured by ex-ante portfolio volatility) of 3.9% within the market, the main risk contributor is the interest rates curve (especially long term rates) for 4.3% of risk (with therefore more than 100% of risk contribution) and the second is credit spreads with -1.6%, contributing negatively to risk. This indicates that in a normal market regime (i) interest rates are by far the leading risk factors in the asset class and (ii) spreads can even, at times, contribute to reducing risks within this benchmark. It is worth noting that the picture can look substantially different in crisis scenarios, where credit spread risks would be a material (and positive) risk contributor to the overall investment grade benchmark, we will review such type of situation over the course of this paper. Lastly, on average, corporate credit spreads made up more than 40% of the yields of the USD Corporate bond benchmarks5, which is substantially more than the amount of their risk contribution. The case for yield seeking investors to concentrate on credit spreads instead of yields is therefore quite compelling. Considering spreads instead of yields reduces the duration bias for yield seeking investors Yield dispersion: US corporates are an attractive playground for bond selectors We now consider cross sectional dispersion of benchmark spreads as a proxy of the number of opportunities for yield seeking investors to enhance spreads versus benchmarks. Figure 3 shows that during the crisis, spread dispersion was higher in Europe than in the US, while in 2005 as well as currently, dispersions were higher in the USD benchmark. It is worth noting that financial companies (and especially subordinated bonds) made up more than 45% (respectively 14%) in EUR Corporates versus 39% (respectively 11%) in USD corporate bonds during the crisis (30/06/2009). Given the very high dispersion in these segments, it may have been an explanation for the higher dispersion in Europe. Currently however, at comparable levels of spreads between EUR and USD bond benchmarks, the dispersion of USD corporate bond spreads can be considered more attractive by yield seeking investors. A possible fundamental explanation for this higher dispersion during non-stressed market regimes can lie in the fact that USD corporate default rates per rating cohort have been greater historically than that of EUR corporates, as shown on Figure 3. Higher default rates could be expected to create more market tensions around distressed (subject to negative news flows) investment grade names, contributing to higher spread differences versus market average in USD bonds and therefore higher dispersion. Spread dispersion is higher in USD corporates than EUR corporates, making the USD Corporates asset class an interesting playground for yield-seeking investors Benchmark spread dispersions Figure 3: Benchmark spread dispersion in bps within EUR and USD corporate benchmarks Jun Jun Jun Jun USD Corps EUR Corps Source IHS/ Markit iboxx EUR/USD Corporate Bonds indices, Source Bloomberg PORT applied on the Bloomberg Barclays US Aggregate Corporates index, as of 30 June Retrospective analyses were made as of 31/12/2015 at the peak of the energy crisis, showing around 9% positive risk contribution for spreads and as of 31/12/2010 showing 4%. 5 Source IHS/Markit iboxx USD Corporates index, 30 June

4 Historical default rates, S&P Figure 4: Expected default rates in %, 5 years to maturity AAA AA A BBB EUR Corporates USD Corporates Source S&P, Yield seeking investor in USD corporate bonds: definition and expected impacts First we define a theoretical (and unsophisticated!) yield plus investor, similarly to that of our previous paper, as an investor selecting the top 33% bonds from the benchmark exhibiting the highest spread. Every month, such yield seeking investor would re-iterate the same selection process, thereby ignoring transaction costs. In light of the inherent diversity and depth of the market, the 33% instead of 50% in our previous paper seems justified. The additional concentration also caters for the expected duration adjustment that investors may consider making so as to keep a duration profile in line with the overall benchmark, and which will be expected to have a cost in terms of yields. We analyse the expected biases in terms of rating, sector and duration versus historical impact in terms of yields. In terms of duration, we find that looking for yield indeed leads to a noticeable increase in duration. Nevertheless, our decision to focus on spread instead of yield mitigated that increase: the average corporate bond market duration from 31 December 2015 to 31 December 2016 was 6.5 and selecting the top 33% higher yielding bonds on the basis of spreads would already have increased it by 2.2 to 8.7. However, doing so on the basis of yields instead of spreads would have increased it by a staggering 4.5 to 11 years. Not surprisingly, we find that during the crisis, the Financial sector would have been materially overweight (cf. Figure 7), suggesting the necessity for yield seeking investors to cap their sector exposure. We also find that, in line with our previous paper, attractive bonds can be found in every rating category, although predominantly in the lower, BBB category especially in the context of slowly depreciating ratings in the asset class (cf. Figure 5 and Figure 6). We propose a couple of potential explanations for this in the next section. Also in line is our finding that a (unsophisticated) yield seeking investor would have endured more than 300 bps additional spread widening during the year 2008, causing material (but temporary) underperformance versus the benchmark (see Figure 9). This underperformance, albeit lower than that found in our previous paper, would have been partly caused by the financials overweight and would have reverted during 2009 (cf. Figure 7 and Figure 8). Also during the 2015 energy sector crisis, the Oil & Gas sector overweight built up during the period (marked by a depreciation of oil prices) would have caused around 60 bps spread widening over Most of such widening reverted during 2016 (see Figure 10 regarding the Glencore bonds6) but we found in our historical study that more than 100 bonds from this sector were downgraded below investment grade during , making up approx. 20% of the number of bonds in this sector and approx. 30% of the number of higher yielding bonds in this sector. This clearly prompts yield seeking investors as to what to do in the case of market corrections and especially downgrades: Last, Figure 11 illustrates the impact that a yield seeking strategy can have on liquidity: Concentrating on yield may lead to bps additional bid-offer costs on average for yield seeking investors. It is also important to see that in phases of stress such as in 2008, such bid-offer cost can almost double, even if such periods are only temporary7. On the one hand, the spread widening and liquidity arguments again stress the importance for such yield seeking investors to stay invested, to the extent possible, during times of crisis8. On the other hand, the USD corporate bond market has matured since the 2008 crisis, with increased diversification both in terms of number of bonds (from approx years ago to 5000 now) and in terms of sector diversification (Herfindahl index9 of the sector distribution was years ago in the benchmark, it is 0.18 now), which suggests that a crisis scenario from the past may have a milder impact now. 4 6 Such bonds suffered heavy price corrections on the back of a lack in transparency of fundamentals and fears of downgrade which eventually did not materialise 7 This of course raises the question as to whether additional liquidity constrains are needed for such yield seeking investors. 8 Trying to sell such yield seeking portfolio at times of stress results at least in losses both from a mark-to-market perspective and from a transaction cost perspective, and such losses may in all likelihood exceed the additional yield pickup harvested beforehand. 9 Defined as the sum of the square of each sector market value weight in the index, source: IHS / Markit iboxx

5 Figure 5: Historical rating distribution of a yield seeking investor s bond portfolio. 100% 80% 60% 40% 20% 0% Jan Jan Jan Jan Jan Jan AAA AA A BBB Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 Figure 6: Historical rating overweights/underweights of a yield seeking 40% 20% 0% -20% -40% Jan Jan Jan Jan Jan Jan AAA AA A BBB We focus on the top 1/3 bonds from the broad USD Corporates benchmark when simulating the behaviour of a yield seeking investor. Rating, sector, duration and liquidity biases arise for yield seeking investors and such biases need to be addressed. Reminder: our theoretical (and unsophisticated!) yield plus investor is defined as an investor selecting the top 33% bonds from the benchmark exhibiting the highest spread. 5

6 Investor s bond portfolio versus benchmark Figure 7: Historical sector distribution of a yield seeking investor s bond portfolio. 100% For Professional Clients only (MiFID Directive 2004/39/EC Annex II), respectively Qualified Investors 50% 0% Jan Jan Jan Jan Jan Jan Financials Consumer Services Telecommunications Health Care Basic Materials Consumer Goods Utilities Oil & Gas Industrials Technology Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 Figure 8: Historical sector overweights/underweights of a yield seeking investor s bond portfolio versus benchmark 30% 10% -10% -30% Jan Jan Jan Jan Jan Jan Financials Consumer Services Telecommunications Health Care Basic Materials Consumer Goods Utilities Oil & Gas Industrials Technology Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 Figure 9: Historical benchmark spreads in bps of both benchmark and yield seeking investors portfolios Jan Jan Jan Jan Jan Jan Mkt cap weighted spreads - Yield seeking investor Delta versus Benchmark 6 Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16

7 Yield seeking investors increase their carry, at the price of higher spread/price volatility and downgrade probability. Figure 10: Xstrata Finance Ltd (USC98874AN76, part of Glencore group), clean BID price evolution before and after the bond becomes part of the yield seeking investor s portfolio. 103 Inclusion in the yield seeking portfolio Apr Aug Dez Apr Aug Dez Apr Aug Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/04/14-31/09/16 Figure 11: Historical Bid/Ask spreads of both benchmark and yield seeking investors portfolios. 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Jan Jan Jan Jan Jan Jan Mkt cap weighted Bid/Ask spreads - yield seeking investor Delta versus Benchmark Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 7

8 IT PAYS TO HOLD TIGHT, NOT ONLY TO FALLEN ANGELS Downgrade risks increase for yield seeking investors For Professional Clients only (MiFID Directive 2004/39/EC Annex II), respectively Qualified Investors As seen in the previous section, with higher yields, investors also increase the riskiness of their portfolio. At the same time holding tight (to the extent possible) to higher yield portfolios seem to be a compelling case. In this section at first we take a look at the historical P&L arising from different strategies. In addition, we analyze fundamental risks and removal rules in investment grade indices. We first take a look at the historical default numbers in order to get a better picture of risk and reward associated with the yield seeking strategy: in our data sample (Dec 2006 to Dec 2016) we find that 1.8% of all available bonds defaulted in the analysed ten-year period. For the yield seeking investor that figure more than doubles to 3.8% of bonds. The defaults in the USD corporate bond space were thus much more frequent than in EUR corporate bond space analysed in our previous paper. We can verify these findings by taking a look at the historical default rates for corporate bonds from S&P 10. As an example, BBB rated US bond with 7 years to maturity had historically a default probability of 3.1% but for the similar bond in Europe the default probability was almost three times less at 1.1%. Our findings show that yield seeking investors 11 are widely overcompensated for the additional risks taken, especially when they are not subject to rating constraints. The following P&L figures from Table 1 are consistent with the numbers from our previous paper, however due to the higher concentration (33% instead of 50%), yield seeking bond investors could realise higher average P&L in comparison to the benchmark with the USD corporates. Rating-unconstrained buy-&-hold investors seeking yield would have generated additional returns versus IG constrained investors. Investors selling bond after the downgrade below BBB are losing more on average as the investors in the EUR corporates. Besides that, pushing the removal rules further by one rating letter (selling upon downgrade to B instead of upon downgrade to BB) may be an interesting approach for yield seeking investors who are not necessarily constrained by IG rules. Default and downgrade risks are higher for USD corporates than their EUR counterparts, which explains the higher spreads available in USD corporates. Yield seeking investors are widely overcompensated for the additional risks taken, especially when they are subject to relaxed rating constraints. Table 1: Empirical USD Corporate Bonds Study for benchmark bond investor. Investor Type BENCHMARK BOND INVESTOR Bond universe IG benchmark (4600 bonds historically) Investment constraint No constraint, buy and hold only Sell upon downgrade below BBB** % bonds sold because of constraint % Average P&L upon sale for downgraded bonds % Average P&L buy-&-hold (subject to constrained selling) for all bonds in universe* 12.3% 10.7% Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 (*) defined as the latest available monthly price from IHS Markit prior to such event occurring (typically 13 months prior to maturity), still active bonds were excluded (**) Markit iboxx Average Rating. 10 Source: S&P, Average Cumulative Default Rates For Corporates By Region, US and Europe ( ) 11 See footnote 12 8

9 Table 2: Empirical USD Corporate Bonds Study. Investor Type YIELD SEEKING INVESTOR 12 Bond universe Top 33% yielding bonds (1600 bonds historically) Investment constraint No constraint, buy and hold only Sell upon downgrade below BBB** Sell upon downgrade below BB*** % bonds sold because of constraint % 10.0% Average P&L upon sale for downgraded bonds % -25.1% Average P&L buy-&-hold (subject to constrained selling) for all bonds in universe* 19.0% 14.5% 18.8% Bonds in universe* Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 (*) defined as the latest available monthly price from IHS Markit prior to such event occurring (typically 13 months prior to maturity), still active bonds were excluded (***) Markit iboxx Average Rating. Relaxing investment restrictions from BBB to BB for downgraded bonds enables yield-seeking IG investors to harvest the bulk of higher yielding returns available from bonds with higher spreads. 12 Given how volatile yields are, similarly to our previous paper, we defined in this section, a yield seeking investor as buying bonds either occurring at least 12 months in the top 33% yielding bond ranking historically (ie with benefit of hindsight) or occurring there at least once but also having been downgraded below IG rating thereafter (as a way to compensate against the survivor bias caused by the 12 month rule). Yield is still measured by the spread between corporate bond yield and sovereign bond yield for the same maturity, as per the previous section. This yield seeking investor definition is biased towards bonds that consistently offered higher yields and therefore does not consider value bonds the price of which would have recovered more rapidly. 9

10 A systemic supply/demand imbalance around downgrades We apply the same approach as in our previous paper to see if the bond prices demonstrate similar price behaviour before and after a downgrade below investment grade. Due to sample size considerations and data availability we use historical prices for the timeframe spanning 8 months before and 6 months after the downgrade. We identified 646 bonds out of our historical sample which were downgraded below IG. In addition to the clean prices, we calculated the evolution of dirty prices as well, by adding the accrued coupons. Similarly to our previous paper and in line with academic research published in this area 13, we see that the bond prices for USD denominated corporates bonds also go down already months before the downgrade. Although the recovery of the clean prices is not as strong as for EUR denominated bonds, we can nevertheless see that the downgraded bonds on average recovered the better part of what they had lost prior to downgrade. If we consider the dirty prices (which is actually what investors receive), then investors recover their money fully on average 6 months after the downgrade. The conclusion from our previous paper holds, in that bond prices can reasonably be expected to rise after a downgrade below IG. Average Clean Prices / total returns (USD) Figure 12: evolution of the average clean and dirty (including coupon payments) BID prices before (8 months) and after (6 months) downgrade below investment grade (Markit iboxx Average Rating) for downgraded bonds t-8 t-7 t-6 t-5 t-4 t-3 t-2 t-1 t0 t1 t2 t3 t4 t5 t6 Dirty BID Prices Clean BID Prices Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 More generally, let us keep in mind that (unsophisticated) yield seeking investors will tend to buy bonds, the price of which recently fell relatively to the market 14. In addition to the chart above we examine the price behaviour before and after a downgrade within the investment grade universe as well. The findings are enlightening (Figure 13 and Figure 14 below) as we see the sizable price decline and recovery even for bonds downgraded from AA to A and from A to BBB. Most of those bonds would have been the part of the yield seeking investors portfolio (51% of AA and 68% of A rated and downgraded bonds). This illustrates that a yield seeking investor will not only benefit from higher carry but also from ad-hoc, temporary value opportunities like downgrade or near downgrade situations (i.e. where no - or only partial- downgrades occurred eventually, as illustrated Figure 15 in the case of Volkswagen). A reference to this finding can also be found in our recent paper on USD assets 15 where we show that yield seeking investors in the USD Corporates IG space may increase the relative value versus a benchmark USD corporate bond investment. Next to the pure carry factor arise interesting value opportunities for yield seeking investors around names suffering negative news-flows such as (but not limited to) a downgrade within IG. 13 See Falling Angels & Forced Selling. Citi Research, March It may be less true for yield seeking investors who will keep in mind the negative noise around the issuers of such bonds. 15 See USD Bonds: A Strategic Beta Toolkit, Deutsche AM Passive Insights, June

11 Average Clean Prices (USD) Figure 13: evolution of the average clean BID prices before (12 months) and after (12 months) downgrade from A to BBB rating (Markit iboxx Average Rating) for all available bonds. Sample size: 910 bonds Downgrade t-12 t-10 t-8 t-6 t-4 t-2 t0 t2 t4 t6 t8 t10 Months before and after the downgrade from A to BBB 120% 100% 80% 60% 40% 20% 0% Average clean BID Prices Sample size (RHS) Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 16 Average Clean Prices (USD) Figure 14: evolution of the average clean BID prices before (12 months) and after (12 months) downgrade from AA to A rating (Markit iboxx Average Rating) for all available bonds. Sample size: 597 bonds Downgrade t-12 t-10 t-8 t-6 t-4 t-2 t0 t2 t4 t6 t8 t10 Months before and after the downgrade from A to BBB 120% 100% 80% 60% 40% 20% 0% Average clean BID Prices Sample size (RHS) Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/12/06-31/12/16 17 Figure 15: Volkswagen Finance LLC (XS ), clean BID price evolution before and after the bond becomes part of the yield seeking investor s portfolio. Inclusion in a yield 102 seeking portfolio May 2014 Sep Jan May 2015 Sep Jan May 2016 Sep Source: Markit iboxx USD Corporate Bonds index, Deutsche AM calculations, 31/05/14-31/12/16 16 Separate analysis with exclusion of the bonds downgraded between 06/2007 and 06/2009 shows that the price decline and recovery before and after the downgrade from A to BBB was less pronounced (around 3.1% vs 7.9% for all bonds as seen on Figure 13) under normal market conditions. 17 Separate analysis with exclusion of the bonds downgraded between 06/2007 and 06/2009 shows that the price decline and recovery before and after the downgrade from AA to A was less pronounced (around 1.7% vs 5.5% for all bonds as seen on Figure 14) under normal market conditions. 11

12 Looking for yield? Carry investors should hold tight and for longer Following up on the bond price behaviour before and after the downgrade, we examine the behaviour of bond prices before and after they would have been purchased by a yield seeking investor. For that purpose, we considered the aforementioned (see section 3.1) approx bonds. After inclusion date, we have reasonable price coverage (at least 85%) for 3 years. However almost 50% of the higher yielding bonds are included into a yield-seeking portfolio within 2 months after being issued. Hence the price figures before inclusion are based on a very limited number of bonds. We run a separate analysis for only those bonds, which had more than 6 months history prior to being selected (and therefore saw their price go down during that period) and came to the very similar outcome as in the Figure 16, thus making the selection bias limited or not existent 18. Figure 16 shows that on average, clean prices are declining for almost two years following inclusion into yield seeking investor s portfolio, they fully recover only after three years. However dirty prices, thanks to sound coupons, are staying stable at first and then rise together with clean prices at the end. This shows that yield seeking investors can expect the bulk of their returns to be generated from carry. Average Clean Prices / total returns (USD) Figure 16: evolution of the average clean and dirty (including coupon payments) BID prices after (36 months) a bond becomes part of the yield seeking investor s portfolio % % 92% % 84% 92 t0 t2 t4 t6 t8 t10 t12 t14 t16 t18 t20 t22 t24 t26 t28 t30 t32 t34 t36 Months after inclusion into the yield seeking portfolio 80% Dirty BID Prices Clean BID Prices Sample size (RHS) Source: : Markit iboxx USD Corporate Bonds index, Bloomberg, Factset, Deutsche AM calculations, 31/12/06-31/12/16. Note that these averages are cross sectional and do not reflect the performance of a yield seeking portfolio across time Please note the selection and survival biases which arise during such historical analysis. Firstly, according to our methodology bonds are kept in the index for at least 12 months after their inclusion, thus we are using the hindsight in our initial selection and focusing on the bonds which had disproportionately lower prices historically. Secondly, witnessed sample size decline were not caused by exclusion of defaulted or distressed bonds but mostly because some bonds were included in the index only in 2015 and 2016 and do not have data for the whole three years yet.

13 FINAL REMARKS This paper confirms the findings from our previous paper on EUR corporates. We show that the relationships between bond prices and their ratings evidenced for EUR corporates also hold true for USD denominated corporate debt. This provides valuable insight and goes beyond what we identified so far from current academic research in this important asset class. In addition, we find that relaxing the removal rules is expected to help avoid selling the bonds at most unfavourable time. In contrast to the EUR corporates market, the yield of USD Fallen Angels remain high for a longer period of time, meaning that keeping such bonds will contribute to higher carry over the longer term. For Professional Clients only (MiFID Directive 2004/39/EC Annex II), respectively Qualified Investors We estimate that carry is by far the greatest style bias achieved by yield seeking investors, especially if they relax their rating constraints. We however see value (buying bonds prior to their price recovery) as being a second potential performance driver, coming, among others, from the downgrade of highly (A or AA) rated bonds or expected downgrades which did not materialise. Finally, similarly to our previous paper it is important to stress that the results shown are averages across time and/or across a sample. This means that both on the level of single bond investment and depending on different market periods, the actual outcome of such strategy as listed above or any of its parts could differ significantly from these average scenarios. REFERENCES Terry L Benzschawel, Yong Su, (January 2014), Hedging the Credit Risk Premium; Citi Research Stephen Antczak, Jung Lee, (March 2015), Falling Angels & Forced Selling; Citi Research IHS Markit, (September 2016), Markit iboxx USD Index Guide Aye M. Soe, Hong Xie, (January 2016), Factor-Based Investing in Fixed Income: A Case Study of the U.S. Investment-Grade Corporate Bond Market; S&P Dow Jones Indices LLC Ronen Israel, Diogo Palhares, Scott Richardson, (June 2017), Common factors in corporate bond returns, AQR Capital Management LLC IHS Markit, (May 2017), Markit iboxx USD Liquid Investment Grade Index Guide Jim Reid, Nick burns, (Apr 2016), Annual Default Study 2016; DB Research RISK WARNING Investments are subject to investment risk, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time. Past performance is not indicative of future returns. No assurance can be given that investment objectives will be achieved. Forecasts are based on assumptions, estimates, opinions and hypothetical models or analysis which may prove to be incorrect. This information is intended for informational purposes only and does not constitute investment advice, a recommendation, an offer or solicitation. 13

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15 For investors in Australia: In Australia, issued by Deutsche Australia Limited (ABN ), holder of an Australian Financial Services License. This information is only available to persons who are professional, sophisticated, or wholesale investors as defined under section 761 G of the Corporations Act 2001 (Cth). The information provided is not to be construed as investment, legal or tax advice and any recipient should take their own investment, legal and tax advice before investing. An investment with Deutsche Asset & Wealth Management is not a deposit with or any other type of liability of Deutsche Bank AG ARBN , Deutsche Australia Limited or any other member of the Deutsche Bank AG Group. The capital value of and performance of an investment is not in any way guaranteed by Deutsche Bank AG, Deutsche Australia Limited or any other member of the Deutsche Bank Group.Any forecasts provided herein are based upon our opinion of the market as at this date and are subject to change, dependent on future changes in the market. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. Investments are subject to investment risk, including possible delays in repayment and loss of income and principal invested. Deutsche Australia Limited is not an Authorised Deposit-taking Institution under the Banking Act 1959 nor regulated by APRA. For Investors in Taiwan: The interests described in this document may be made available for investment outside Taiwan by investors residing in Taiwan, but may not be offered or sold in Taiwan. 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The CBB is not responsible for performance of the securities, derivatives or funds. 15

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