Defensive Short Duration High Yield Bonds An Overlooked and Underutilized Source of Durable Alpha

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1 Specialists in Complete Capital Structure Analysis Peter Duffy, CFA Senior Portfolio Manager, Senior Partner Matthew Bogdan Quantitative Research Analyst Defensive Short Duration High Yield Bonds An Overlooked and Underutilized Source of Durable Alpha Executive Summary This paper examines the superior risk and return characteristics of Defensive Short Duration High Yield bonds. Most investors tend to use investment grade bonds as a risk diversifier, especially during volatile or uncertain periods, when in fact BB-B rated short duration high yield bonds have historically provided more stability with a higher yield. In this paper, we will examine the underlying factors of this performance anomaly, and why they are overlooked and underutilized within the industry. Topics Addressed Characteristics, outperformance, and risk statistics Industry and asset class factors contributing to underutilization Minimal need for market timing per historical spread and recession analysis Fit within a portfolio allocation and resulting effects The Consistency of Short Duration High Yield Performance YTD (8/31) 3Y 5Y 1Y FOR ILLUSTRATIVE PURPOSES ONLY. The index information and data contained herein was obtained from BofA ML, BBgBarc, and S&P/LSTA. ualized data as of August 31, Intrepid Avenue, Suite, Philadelphia, PA Penn Capital. All rights reserved.

2 Defensive Short Duration High Yield Bonds ( Defensive SD ) consist of BB-B rated corporate bonds with a maturity under 3 years. They account for a small portion of the high yield market and have historically exhibited unique characteristics. Defensive SD has demonstrated a return profile more consistent than investment grade and high yield bond markets while outperforming both (Exhibit 1). Its durability stems from macro factor insensitivity, such as interest rate and high yield spread conditions, relative to similar asset classes. With a duration of 1.7 compared to 7. and 3.9 for investment grade and high yield bonds, the asset class is less impacted by changes to interest rates. $5 $ $35 $3 $5 $ Asset Class Sortino Omega Down % Up % High Yield Invest Grade Exhibit 1 Year Performance and Growth of $1 $15 $1 $ Bonds Investment Grade Defensive Short Duration High Yield High Yield An Overlooked and Underutilized Outperformer. Defensive SD makes up $116 billion of the $1.3 trillion high yield bond market (Exhibit ). Lacking potential for economy of scale and requiring significant research coverage, large active managers tend to avoid the space. Passive managers have likewise been unsuccessful but for different reasons, given the difficulty to track and emulate, with top ETF s delivering significantly lower returns and higher volatility relative to short term high yield indices. Additionally, databases generally understate or don t recognize the asset class, such as Morningstar which does not have a high yield short duration category. These factors, paired with the fact that Defensive SD has never been the top performing asset class in any calendar year, has not been a primary beneficiary of 3 years of interest rate decline, and is capacity constrained, have kept the asset class under the radar of many investors. Exhibit Relative Size Market Value ($Mil) Duration Rolling 5Y Outperform % Y Last Years US Treasury $9,56, urn vs IG 89% Invest Grade $6,31,36 7. vs IG 65% High Yield $1,3, urn vs 6% Y $115, vs 93% Def SD Invest Allocation Effect Grade High Yield Private Credit Lower Duration Lower Volatility Lower Defaults X Incr Diversification Incr Yield X X Incr Liquidity X Incr Ratio As of August 31, 17. Source: Morningstar Direct, BofA ML Index Data. Indices: Equity:, High Yield: BofA ML US Master, High Yield Year: BofA ML US Year, Invest Grade: BofA ML US Corp Master, Loan: S&P/LSTA, regate: BBgBarc US Bond, Treasury: BofA ML US Treas Master

3 Recessions, Spreads, and Timing the Market, these are three things that keep investors awake at night. Market conditions, as measured by high yield spreads, can significantly impact return potential. This leads many down the notoriously hard path of timing the market, which can be difficult. For example 81% of CCC, 6% of, and % of high yield year returns were derived from the top 1 months of their respective performance. If an investors timing was slightly off, their performance was impacted. That figure is reduced to % for 1-3 year BB s, the same as investment grades and % lower than treasuries. Timing has shown to be a significant factor for most asset classes, but less so for Defensive SD. This is further exemplified when viewing performance over various points in the credit cycle, market recessions, bubbles, and events. Over the last two recessionary periods, Defensive SD outperformed the more volatile and high yield indices as expected, but also outperformed higher quality investment grade bonds (Exhibit 3). Exhibit Recession: March 1 to November BB 1-3Y IG Recession: December 7 to June BB 1-3Y IG High Yield Spread Durability throughout the market cycle. Over the last years, Defensive SD s rolling 5 year performance was not affected by the high yield spread level at the date of entry (Exhibit ). Its relative indifference to market timing has historically made it ideal as a long term portfolio fixture or for periods of uncertainty. Linear Avg 5 Year Forward urn (%) Starting High Yield Spread and 5Y Forward urn 5 Year Rolling Window, 1 Month Shift, 1997 to 17 High Yield BB 1-3Y Invest Grade regate Starting High Yield Spread Exhibit As of August 31, 17. Source: Morningstar Direct, BofA ML Index Data. Indices: Equity:, High Yield: BofA ML US Master, High Yield BB 1-3 Year: BofA ML US BB 1-3 Year, Invest Grade: BofA ML US Corp Master, Loan: S&P/LSTA, regate: BBgBarc US Bond 3

4 Where Credit Quality and Maturity Reach Optimization. To help illustrate the rationale behind each component of Defensive SD, Exhibit 5 breaks down performance by credit quality, maturity, and both. BB s exhibited the top risk-adjusted performance relative to other credit qualities. High yield bonds within the 1-3 year maturity range, though returning less than other maturities, exhibited considerably less volatility which resulted in superior risk-adjusted returns. These factors translated into strong 1-3 year BB-B performance. Exhibit 5 Quality Maturity Short Dur CCC All B BB BBB..9 IG Treas All CCC B BB BBB IG Treas Summary and Conclusion. Defensive SD has demonstrated suitability for a variety of functions. These include improving credit quality of high yield portfolios, enhancing liquidity of direct lending or distressed portfolios, shortening duration of investment grade portfolios, and optimizing portfolio returns while protecting against uncertainty. Defensive SD s durable returns and low correlations to investment grade, aggregate, and treasury bonds 5 year.5,., and.1 correlations, respectively make it an ideal and complementary diversifier within an optimal portfolio. While difficult to passively emulate and unable to massively scale, the asset class has historically realized its potential with focused, disciplined, and fundamentally driven active management. Penn Capital Defensive Short Duration High Yield has consistently produced alpha and superior Ratios vs the BofA ML Year Index since inception on a 3 year rolling basis (Exhibit 6) Year Trailing Ratio Rolling Basis Since Inception Exhibit 6 3Y Ratio Penn Capital Def Short Duration Y Investment Grade High Yield Short Term ETF - SJNK 5 year trailing performance as of August 31, 17. Source: Morningstar Direct, BofA ML Index Data. Indices: High Yield, Invest Grade, and Treasury of all Maturities: BofA ML US Indices, Equity:, Loan: S&P/LSTA, regate: BBgBarc US Bond

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