new tool rising rate environment

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1 M&G Retail Fixed Interest High yield floating rate bonds a for a Retail bond investors in search of a new tool to not only mitigate higher interest rates, but also take advantage of the next phase of the monetary policy cycle should consider high yield floating rate bonds, argues Fund Manager James Tomlins. The instruments offer a unique combination of characteristics for fixed income investors, namely exposure to credit spreads alongside materially lower interest rate risk. We are entering a new era for interest rates in the developed world. The extended period of ever looser monetary policy is starting to draw to a close. In the wake of the tapering of quantitative easing (QE) from the Federal Reserve (Fed), investors are now bracing themselves for the first interest rate rises in many years, initially in the US, and subsequently in the UK (see figure 1). The principal focus of the debate is over the questions of when? and how fast? interest rates should rise, not if? For bond investors in particular, this transition has thrown up a lot of difficult questions. Having benefited greatly from falling yields and tightening credit spreads, the move to a more hawkish cycle will create many more headwinds and challenges when it comes to delivering returns for many fixed income asset classes. Consequently, any product or instrument that can help investors navigate this environment has rightly been receiving a lot of interest and attention. Here, we focus on one such instrument, the high yield floating rate bond. In recent years, this instrument has gained popularity with many issuers and the market has grown in size to more than US$40 billion. 1 A high yield floating rate note (FRN) has the following defining features: floating rate coupon automatically adjusted in line with changes in interest rates; relatively high credit spread that reflects the additional credit risk of a noninvestment grade issuer; interest rate duration close to zero. It is the combination of these three features which not only enables investors to receive an attractive income stream now, but also allows them to benefit from higher coupons should interest rates increase with no associated loss to capital. This last element, the lack of a hit to capital in a rising interest rate environment, is the key difference to the traditional universe of fixed coupon bonds, which suffer from price declines as yields move up. August 20 new tool rising rate environment I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalising monetary policy. Federal Reserve Chair Janet Yellen, Cleveland, 10 July 20 Fig 1. Historical and expected central bank base rates Central bank base rates (%) US UK Europe Future expectations -1 Jan 07 Nov Jul 09 May Jan 12 Nov 12 Jul May 16 Jan 17 Nov Jul 19 May Source: M&G, Bloomberg, May 20 (expectations based on synthetic forward rates in US, UK and Germany).

2 So what are the characteristics and makeup of the high yield floating rate bond market? What key drivers of returns do we need to consider? What are the risks and how can these be managed? High yield floating rate bonds The key characteristics of high yield floating rate bonds can be summarised as follows: It is a bond issued by a company that has a below-investment grade credit rating The coupon, usually paid quarterly, is made up of: 1) a variable component, which is adjusted in line with a money market reference rate, typically every three months (throughout this note, we will refer to this measure as 3-month Libor ) 2) a credit spread, which is fixed for the life of the bond and reflects the additional credit risk of lending to a company The bond has a fixed maturity (typically 5-7 years at the time of issue) The bond is a publicly traded instrument that can be bought and sold like any other corporate or high yield bond As an example, suppose that a 5-year bond is issued with a coupon of 3-month Libor basis points (bps). For the first year, 3-month Libor is 50 bps, so the coupon is 500 bps (or 5%) over that period. In the second year, 3-month Libor rises to 75 bps, so the coupon increases to = 525 bps, or 5.25%, during that period. ket characteristics Table 1 below highlights some of the characteristics of the high yield floating rate market and compares it with the more traditional government, corporate and high yield fixed coupon bond markets using data from Bank of America Merrill Lynch s fixed income indices. In terms of credit risk (measured by the composite rating) and credit spread (the yield premium above government bonds that compensates investors for the higher risk of default), the high yield floating rate market is very similar to the traditional high yield market. This is to be expected as there is a great deal of commonality between the two, in terms of underlying issuers. However, there is a big difference when we look at the effective duration of the two asset classes. Effective duration measures the sensitivity of bond prices to changes in yields. A duration of 4.3 years means that for every 1% increase in yields, there will be an approximately 4.3% loss of capital. The effective duration of the high yield floating rate index is very close to zero (due to the regular re-setting of coupons, cashflows are only fixed for a very short time). This means that if, all other things being equal, there is a broader sell-off in the government bond markets and all fixed income yields need to adjust upwards, the capital loss would be close to zero. This limited exposure to moves in the broader yields means that the high yield floating rate market tends to be much less sensitive to any wider interest rate-inspired " The point at which interest rates may begin to rise is moving closer. Bank of England Governor k Carney, London, July 20 Table 1: High yield floating rate market compared with other fixed coupon bond markets Index High Yield Floating Rate High Yield Government Bond Corporate Average maturity (years) Effective duration (years) Spread duration (years) Face value (US$ billion) 42 2,172 21,784 8,074 Yield to maturity (%) Spread (vs government bonds, bps) Composite rating BB3 B1 AA2 A3 Source: M&G, BofA Merrill Lynch 30 June 20. 2

3 volatility in the market. Indeed, during the so-called taper tantrum of 20, when former Fed Chairman Ben Bernanke first introduced the idea that QE would begin to be phased out, the high yield floating rate market was much more resilient in terms of price impact than the other major bond markets as investors adjusted to the concept of tighter monetary policy. The high yield floating rate note market demonstrated similar resilience during the sudden upturn in yields during the second quarter of 20 as investors adjusted to the prospect that US interest rate rises are looming (see figure 2). We can also see how this has recently played out at an individual bond level. In April 20, mobile telco Salt formerly Orange s Swiss unit, rebranded following its acquisition by French entrepreneur Xavier Niel in early 20 issued both an FRN, paying Euribor bps maturing in 2022, and a fixed rate 3.875% bond also maturing in Both bonds are equal-ranking senior secured liabilities that are issued by the same company. In other words, the credit risk in both instruments is effectively identical. However, the interest rate risk exposure differs significantly. While the FRN contains virtually no interest rate risk, the fixed rate bond has an effective duration of just under 6 years. With government bond yields rising sharply in recent months, these different duration profiles have resulted in a significant divergence in the performance of the two bonds since they were issued (see figure 3). Upon issue on April, both bonds were priced at 100% of par. Shortly after the issue date, government bonds started to sell off sharply. Bunds, in particular, suffered a dramatic reversal as a pick-up in eurozone inflation and an improved economic outlook sent yields surging. Between April and 30 June, the fixed rate bond suffered a capital loss of around 4.7% as a result of the rise in government bond yields. However, with virtually zero levels of interest rate duration and with credit spreads little changed the FRN delivered a small positive return of 0.6% Figure 2: Fixed income total returns HY FRN HY IG US high yield sell-off as oil prices plunge Total returns (rebased to 100) Volatility caused by taper tantrum Government bond sell-off in Q Dec 12 Jun Dec Jun Dec Jun Source: M&G, Bloomberg, BofA Merrill Lynch indices, 30 June 20. Rebased to 100 at 31 December Figure 3: Salt floating rate vs fixed rate bond prices since issue Price (EUR) % Euribor +375bps floating rate note bond* 3.875% fixed rate bond ** 95 Apr 22 Apr 29 Apr 06 May May 20 May 27 May 03 Jun 10 Jun 24 Jun 30 Jun Source: M&G, Bloomberg, 30 June 20. *MATTER (Salt) Float **MATTER (Salt) 3.875%

4 over the same period, along with very little volatility. Between April and the end of June, the FRN had outperformed the fixed rate bond by 5.4%. This example demonstrates the clear advantages of floating rate instruments over fixed rate equivalents in a rising interest rate environment. It is important to note, however, that as non-investment grade instruments, there is still exposure to movement in credit spreads within the high yield floating rate market. From table 1, we can see that spread duration for the high yield floating rate market is around 2.6 years. Accordingly, if spreads were to widen on average by 100 bps, there would be an associated capital loss of around 2.6%, and vice versa if spreads were to tighten. However, the spread duration is significantly lower than that of the more traditional high yield universe (4.2 years). This means that in times of risk aversion and widening credit spreads, the impact on prices for the high yield floating rate market should be comparatively lower. This was especially evident towards the end of 20, when conventional high yield bonds sold off sharply as spreads widened, while high yield FRNs held up reasonably well (see figure 2). On the other hand, if spreads were to tighten from current levels, we would expect the high yield floating rate market to see an associated capital gain smaller than the more traditional high yield universe, given lower spread duration and, on average, a smaller degree of call protection (provisions which are designed to protect bondholders by preventing the early redemption of a bond). A globally diversified market In terms of the underlying issuers, the global high yield floating rate market is well diversified across different regions and industries (see figure 4). At present, there is a bias towards the euro market, driven in part by the trend for European issuers to refinance bank debt in the bond market. By issuing FRNs, companies can retain a similar debt structure to bank loans, but access deeper and more diversified sources of debt capital. US banks are, on average, less capital-constrained than the European banking system, so the need to tap sources of new capital has been less pressing. Nevertheless, there has been a steady stream of issuance from both European and US issuers over recent months as we can see from table 2. The other major trend we can see is the steady growth of the non-financial sector as a proportion of the overall market. The financial sector has been shrinking in recent years as banks have increasingly turned to other sources of finance (such as hybrids) in order to meet regulatory requirements. Banks account for the majority of the unsecured issuance within the FRN market. However, with much of the new issuance now consisting of nonfinancial names, we would expect secured bonds to make up an increasingly large part of this market over time. Figure 4: Regional and sector breakdown of global FRN market By region (%) By sector (%) US Euro core 31.6 Euro periphery Emerging markets UK Banking (27) Energy (16.9) Basic Industry (12.5) Telecommunications (9.9) Retail (7.7) Healthcare (5.9) Services (5.9) Capital Goods (5.4) Financial Services (3) Consumer Goods (2) Utility (2) Leisure (1.8) Insurance (1.6) Media (1.5) Automotive (0.8) Source: M&G, Bloomberg, Bank of America Merrill Lynch indices, 30 June 20 (HFLT). 4

5 Table 2: Selection of recent new issues Issue date Name Sector Issue spread (bps) Maturity Currency Amount issued (m) Feb- Innovia Group Capital goods EUR 342 UK - Premier Foods Consumer non-cyclical GBP 175 UK Country - Kerneos Tech Basic industry EUR 0 France Apr- Eden Spring Consumer non-cyclical 550 Apr-19 EUR 210 Israel Apr- Monier Basic industry 500 Oct-20 EUR 3 France Apr- Stongate Pub Consumer cyclical 475 Apr-19 GBP 0 UK Apr- Quick Consumer cyclical 750 Oct-19 EUR 5 France Apr- Quick Consumer cyclical 475 Apr-19 EUR 440 France Apr- Chesapeake Energy 325 Apr-19 USD 1,500 USA May- Galapagos Capital goods 475 Jun-21 EUR 325 Germany May- AES Corp Utility 300 Jun-19 USD 775 USA May- Avis Service 275 Dec-17 USD 250 USA May- Novacap Basic industry 500 May-19 EUR 310 France Jun- Xefin Lux Basic industry 375 Jun-19 EUR 325 Germany Jun- Monitchem Basic industry 475 Jun-21 EUR 175 Germany Jun- Hema Bondco Consumer cyclical 525 Jun-19 EUR 250 Netherlands Jun- Dry Mix Solin Basic industry 425 Jun-21 EUR 550 France Jul- Ardagh Packaging Capital Goods 300 Dec-19 USD 1100 Ireland Jul- Novafives Services 400 Jun-20 EUR 200 France Jul- Wind Acquisition Telecommunications 400 Jul-20 EUR 575 Italy Jul- Care UK Healthcare 500 Jul-19 GBP 325 UK Jul- Care UK Healthcare 750 Jan-20 GBP 75 UK Jul- Stretford Consumer Cyclical 425 Jul-20 GBP 350 UK Jul- Iglo Foods Consumer Non-Cyclical 450 Jun-20 EUR 500 UK Jul- TES Finance Media 500 Jul-20 GBP 100 UK Jul- Twin Set-Simona Consumer Cyclical Jul-19 EUR 0 Italy Jul- American Energy Energy 650 Jan-19 USD 350 USA Aug- Lock Financial Services 550 Aug-20 EUR Norway Oct- Cons Energy Fin Basic Industry 350 Oct-19 USD 200 Trinidad & Tobago Nov- Arrow Fin Financial Services 525 Jan-21 EUR 225 UK Nov- Level 3 Fin Telecommunications 350 Jan-18 USD 300 USA Nov- Lock Financial Services 550 Aug-20 EUR 100 Norway Nov- Alize Finco Services 550 Jan-21 EUR 100 UK Jan- General Motors Automotive 6 Jan-20 USD 250 USA Feb- Picard Groupe Consumer staples 425 Jan-19 EUR 342 France - Wind Acquisition Telecommunications Jul-20 EUR 400 Italy Source: M&G, Bloomberg, ch 20. 5

6 High yield floating rate notes vs leveraged loans Given the characteristics outlined above, it is no surprise that high yield FRNs share many of the same investment characteristics as leveraged loans (floating rate coupons, senior position in the capital structure, non-investment grade issuers) (see table 3). However, there are some small but important differences between the two asset classes. Most important of all for non-institutional European investors is the fact that high yield FRNs are eligible for inclusion in authorised open-ended funds (also known as UCITS eligible ), whereas leveraged loans are currently considered eligible only for institutional investors. To date, this has meant that non-institutional investors could only access this market through closed-ended vehicles, such as investment trusts. However, with the emergence of the high yield floating rate market, non-institutional investors across Europe can access this market using a traditional open-ended fund. Drivers of returns and key risks For investors in the high yield floating rate bond market, the key factors that will influence returns will be: Credit spreads Income, in the form of a credit spread over Libor, is likely to form a major component of total returns, particularly in an environment of historically low interest rates. As the issuers in this market are rated belowinvestment grade, the corresponding credit spread that investors receive is higher than in other fixed income markets to compensate them for this risk (currently around 469 bps). As mentioned previously, returns will also be governed by changes in credit spreads. At a time of tightening spreads, returns will be boosted by capital gains; at times of widening spreads, investors will see capital losses. Interest rates The path of short-term interest rates will also have an impact. If short-term interest rates fall, total returns will also fall as the coupon is automatically reduced, and vice versa should short-term rates rise. Default rates If high yield default rates increase, investor returns would be hit as individual bonds can suffer from writedowns of capital during a bankruptcy process. However, please note that the high yield FRN market benefits from a more than 50% exposure to bonds that are secured against real assets (such as buildings or machinery) compared with around 17% for the global fixed rate high yield market. In the event of a default, secured bondholders should be able to recover more of their debts (see table 4). The poorest returns, therefore, would be during a period of falling interest rates, widening credit spreads and rising defaults. The best returns would be experienced during a period of rising interest rates, stable or tightening credit spreads and low or falling default rates. Table 3: Differences between high yield FRNs and leveraged loans High yield FRNS Leveraged loans Coupon Libor + fixed margin Libor + fixed margin Credit rating Non-investment grade Non-investment grade Security Typically first lien / senior secured Typically first lien / senior secured Liquidity Daily trading T+3 settlement Less liquid, uncertain settlement Public/Private Public information only Public and private information UCITS eligible Yes can be included in open-ended funds sold to non-institutional investors No limited to institutional investors only. Non-institutional investors can only gain exposure through closed-ended funds 6

7 Mitigating default risk We view default risk as the key risk to be managed through the cycle, as this is the one driver that can lead to a permanent loss of capital. How can this risk be managed? We think there are three key mitigants: 1) Diversification Ensuring that any investment in this market is diversified across geographies and industries helps protect investors against major idiosyncratic shocks that could precipitate defaults in any one industry or region. For example, given the relatively large representation of US energy companies in the high yield universe, overexposure to the energy sector would have had a negative effect on returns following the dramatic slide in energy prices during the second half of 20. 2) Credit analysis As non-investment grade companies, the business, financial and legal risks associated with each bond issued can be very complex. Consequently, having the expertise and capability to assess these risks on a case-by-case basis is crucial. 3) Investing in senior secured instruments Instruments that are senior secured or first lien have prior claim over an issuer s assets in the event of a bankruptcy. This means recovery rates are much higher on average than unsecured liabilities (see table 4). High yield FRNs are often senior secured instruments or sit alongside loans in the capital structure. Using the data below from the US as a proxy, we would expect recovery rates for this market to be between 60% and 80% over the long term. A new tool As we have argued, high yield floating rate bonds offer a unique combination of characteristics for fixed income investors, namely exposure to credit spreads alongside materially lower interest rate risk. Consequently, we believe the development of this market will give bond investors a new tool that not only mitigates the potential headwinds of higher interest rates, but also gives them something that actually benefits from the next phase of the monetary policy cycle. Table 4: Average North American non-financial corporate debt recovery rates measured by ultimate recoveries, Emergence year Default year Lien position Loans 73.3% 91.7% 80.3% 81.3% 77.2% 80.3% Senior secured bonds Senior unsecured bonds* Subordinated bonds** 67.5% 63.6% 63.5% n/a 71.2% 63.5% 4.5% 36.0% 48.1% n/a 39.3% 48.1% 0.0% 9.2% 28.2% n/a.5% 28.2% *20 s senior unsecured bond recovery rate is based on five observations. **Includes senior subordinated, subordinated, and junior subordinated bonds. 20 s subordinated recovery rate is based on observation. Source: Moody s, August Source: M&G, BofA Merrill Lynch 30 June 20. For Investment Professionals and Professional Investors only. Not for onward distribution. No other persons should rely on any information contained within. This information is not an offer or solicitation of an offer for the purchase of shares in any of M&G s funds. For Switzerland: Distribution of this document in or from Switzerland is not permissible with the exception of the distribution to Qualified Investors according to the Swiss Collective Investment Schemes Act, the Swiss Collective Investment Schemes Ordinance and the respective Circular issued by the Swiss supervisory authority ("Qualified Investors"). Supplied for the use by the initial recipient (provided it is a Qualified Investor) only. This financial promotion is issued by M&G Securities Limited (registered in England 90776) and M&G International Investments Ltd. Both are authorised and regulated by the Financial Conduct Authority in the UK and have their registered offices at Laurence Pountney Hill, London EC4R 0HH. M&G International Investments Ltd is registered in England, No It has a branch located in France, 6 rue Lamennais, Paris 75008, registered on the Trade Register of Paris, No and a branch in Spain, with corporate domicile at Plaza de Colón 2, Torre II Planta, 28046, Madrid, Spain, registered with the Commercial Registry of Madrid under Volume , sheet 30, page M , inscription 1, CIF W B and registered with the CNMV under the number 79. This financial promotion is further issued by M&G Investments (Hong Kong) Limited. Office: Unit 4628, Level 46, The Center, 99 Queen's Road, Central, Hong Kong. For Hong Kong only: If you have any questions about this financial promotion please contact M&G Investments (Hong Kong) Limited. For Switzerland, the financial promotion is published by M&G International Investments Switzerland AG, Bahnhofstrasse 100, 8001 Zurich, authorised and regulated by the Swiss Federal Financial ket Supervisory Authority. The Portuguese Securities ket Commission (Comissão do Mercado de Valores Mobiliários, the CMVM ) has received a passporting notification under Directive 2009/65/EC of the European Parliament and of the Council and the Commission Regulation (EU) 584/2010 enabling the fund to be distributed to the public in Portugal. M&G International Limited is duly passported into Portugal to provide certain investment services in such jurisdiction on a cross-border basis and is registered for such purposes with the CMVM and is therefore authorised to conduct the marketing (comercialização) of funds in Portugal. JUL / 65104

A new tool for a rising rate environment - M&G Global Floating Rate High Yield Fund James Tomlins, Fund Manager

A new tool for a rising rate environment - M&G Global Floating Rate High Yield Fund James Tomlins, Fund Manager October 2015 A solution for taking advantage of rising interest rates M&G Global Floating