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Risks and Rewards in High Yield Bonds
Navy Yard Corporate Center, Three Crescent Drive, Suite 400, Philadelphia, PA 19112 www.penncapital.com
Peter R. Duffy, CFA, Partner, Senior Portfolio Manager
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• Bonds rated below the top 4 rating tiers by rating agencies (S&P, Moody's, Fitch)
• Also referred to as “non-investment grade”, “speculative grade” or “junk bonds”
• Familiar High Yield Issuers*
What is a High Yield Bond?
Sprint Nextel
Chrysler
Liberty Mutual
Sears
Rite Aid
Sirius XM Radio
Goodyear
Toys R Us
E*Trade
Bank of America
Hertz
Burger King
* Company names are for illustrative purposes only. Their inclusion is not meant to be an endorsement of any company, bond issue or security.
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High Yield Market Overview
• Over $1 trillion market
• New issuance of $913 billion since 2009
• Inflows of over $26.2 billion into the market YTD in 2012
Source: Credit Suisse; J.P. Morgan
0
200
400
600
800
1,000
1,200
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Market Size (in Billions)
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Two Components of High Yield Return: Principal and Coupon
Source: Credit Suisse, BofA Merrill Lynch
Coupon: • Drives the return
• Cushions the downside
• Generates cash
9.55%
0.54%
10.11%
0%
2%
4%
6%
8%
10%
12%
Ave
rage
Ret
urn
Credit Suisse High Yield Index Return Breakdown 1986 - 2011
Coupon Principal Total Return
Principal: • Capital gains generated by purchasing
bonds at a discount
• Active management is key to avoidance of defaults and principal loss
Total Return meets/exceeds actuarial assumptions!
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High Yield Correlations Between Various Assets: 1980 - 2011
• Low correlation to other fixed income asset classes
• High yield has a higher correlation to equity, though experiences significantly less volatility
January 1980 to December 2011
US 30 Day TBill
US Inter Gov.
US Long Term Gov
ML Mortg
ML Corp.
Barclay Agg. Bond
S&P 500
Russell 2000
MSCI EAFE
Gold
High Yield Bonds -0.02 0.25 0.22 0.42 0.61 0.45 0.55 0.57 0.50 0.08
Source: Credit Suisse
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Risk vs. Reward
• Since 1980, High Yield has outperformed the Russell 2000 while slightly underperforming
the S&P 500 with half the volatility
• High yield bonds have produced a negative calendar year return only four times since 1980!
BofA ML BB/B Non Distressed HY Index
Barclays Capital Aggregate Index
Russell 2000 Index
S&P 500 Index
BofA ML US High Yield Index
2%
4%
6%
8%
10%
12%
1% 4% 7% 10% 13% 16% 19% 22% 25%
10
Ye
ar A
nn
ual
ize
d R
etu
rns
10 Year Standard Deviation of Returns
10 Year Risk vs. Reward
Source: PSN Enterprises
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The Optimal Portfolio Allocation: Investment Grade and High Yield
• With low default expectations through 2013, we see a distinct benefit of adding high yield to an
investment grade portfolio
• Based on a 25 year analysis, the volatility of a portfolio declines until a mix of 15% high yield
and 85% investment grade securities is reached
Source: JP Morgan
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• High yield has historically performed well in rising rate environments
• These two periods were mid-cycle, during an improving economy
1.27%
-4.36%
0.01%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
1/31/94 to 2/28/95
Rat
e o
f R
etu
rn
Performance Returns During Fed Rate Hike Period
ML US HY Index
ML US 10 year Treasury Index
Barclays Aggregate Index
7.62%
4.61%
2.93%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
6/30/04 to 6/30/06
Rat
e o
f R
etu
rn
Performance Returns During Fed Rate Hike Period
ML US HY Index
ML US 10 year Treasury Index
Barclays Aggregate Index
Source: Bloomberg; Merrill Lynch; Barclays
High Yield in a Rising Rate Environment
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• Despite tepid GDP growth, credit metrics for high yield issuers have steadily improved
- Leverage/debt outstanding has decreased
- Cash on hand and interest coverage ratios have improved
- Maturities have been pushed out lowering default risk
• Upside catalysts remain as corporate deleveraging/refinancing continues and strategic
M&A increases
High Yield Fundamentals: U.S. Corporate Fundamentals Remain Solid
Source: JP Morgan
3.5
3.7
3.9
4.1
4.3
4.5
4.7
4.9
5.1
5.3
1Q
08
2Q
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3Q
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4Q
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1Q
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4Q
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1Q
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2Q
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3Q
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LTM
De
bt/
EBIT
DA
(m
ult
iple
s)
75
95
115
135
155
175
195
215
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%
Cash as a Percentage of Short Term Debt Leverage Continues to Decline
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High Yield Fundamentals: Default Rates Expected to Remain Near Record-Low Levels
• Default rates are well below historic averages and are expected to remain low due to
the lack of lower quality new issuance
• The primary risk of default rates rising stems from several large LBO’s with maturities in
2014 that appear unable to refinance
0
2
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6
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19
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E 2
01
2
E 2
01
3
Par
We
igh
ted
Def
ault
Rat
es
(%)
High Yield Bond and Loan Default Rates to Remain Low for the Next Two Years
HY Bond Default Rate Loan Default Rate
Long term average default rate: HY Bonds: 4.2%
Leveraged Loans: 3.9%
Source: JP Morgan
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0%
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8%
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14%
0
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c-8
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r-1
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Au
g-1
2
De
fau
lt R
ate
(%
)
Sp
re
ad
(b
ps)
Spread Moody's 12 Month Default Rate
Current Valuation
• Despite low yields relative to historic levels, the spread pickup versus treasuries
adequately compensates investors for default risk
Spread Source: CS First Boston High Yield Index Spread to Worst vs. 10yr. U.S. Treasury Bond Default Source: Moody’s 12 month Trailing Default Rate: Percent of Issuers Basis
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High Yield Technicals: New Issuance has been Very Healthy
• Low quality, non-refinance issuance has remained low
• 60% of issuance has been to refinance existing debt
• Speculative issuance for acquisitions and LBOs remains below the key 25% level
• We expect High Yield companies to be net beneficiaries of acquisition activity
1.8% 1.9%
2.7%
3.6%
0.9% 1.0%
0.1% 0.1% 0.5%
1.7% 1.3%
2.7%
5.0%
1.3%
0.5%
1.4% 1.4% 1.0%
0%
1%
2%
3%
4%
5%
6%
19
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11
YTD
…
Lower Rated New-Issue Volume, Excluding Refinancings*
* Source: JP Morgan Graph as of July 31, 2012 Lower rated new issuance includes bonds rated Split-B or lower
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• With yields across most other fixed income assets near all-time lows, the current yield to worst
of the high yield market of 6.8% is extremely attractive
• Inflows continue to be strong after a robust 2011
- YTD, inflows into high yield bond funds are $26.2 billion (compared to $15.6 billion for 2011)
• The need for yield combined with stable U.S. economic data, strong corporate balance sheets
and low default expectations will continue to fuel inflows
High Yield Technicals: Inflows
* Source: Credit Suisse
-$15
-$10
-$5
$0
$5
$10
$15
$20
$25
$30
$35
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YTD
20
12
Flo
ws
($ b
illio
ns)
High Yield Mutual Fund Flows*
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Outlook
Economy
• Moderate GDP growth
• Continued low interest rates and inflation remains in check
• Capital expenditure and employment improve, but unemployment remains elevated
High Yield Market
• Negative real interest rates and strong credit fundamentals fuel continued demand
• Default rate remains below long term average
• Upside catalyst from M&A as large, cash-rich companies spur growth through acquisitions
• Security selection will continue to drive returns and avoiding defaults is paramount
• Expect coupon type returns over the next 12-18 months
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Risks/Rewards in High Yield Bonds
Risks:
• US recession
• Macro fears fuel a flight to quality
• Decreased liquidity of secondary market
Rewards:
• Generates high levels of cash/income
• Low correlation to other fixed income asset
classes
• Increases diversification, lowers volatility
and improves risk adjusted returns
• Lower sensitivity to rising interest rates
• Equity like returns with half the volatility
• Meets/exceeds actuarial assumptions!
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The Case for a Strategic Allocation to High Yield – The Three P’s
Protection:
• High yield bonds are senior in the capital structure
• Increases diversification and risk adjusted returns and lowers total portfolio volatility
• High coupon cushions downside during economic downturns
• Short duration nature offers protection from rising rates
Paid to Wait:
• High Yield is currently yielding 6.8% with an average coupon of 8.0%*
• Coupon has historically accounted for 94% of High Yield total returns**
Performance:
• Provides meaningful real returns due to high coupons
• Since 1980, high yield has produced equity-like returns with half the volatility
• Has historically outperformed other fixed income asset classes in rising rate environments
• Meets/exceeds actuarial assumptions
* Source: BofA Merrill Lynch
** Source: Credit Suisse
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This information should not be considered as a recommendation to purchase or sell a particular security.
Indices are unmanaged and are used to measure and report performance of various sectors of the market. Direct investment in indices is not available.
Past performance is not a guarantee of future results and diversification does not ensure against loss.
Third party content: From time to time PENN may provide information in this presentation that was supplied by third parties. Any opinions, advice, statements, services, offers, or other information expressed or made available by a third party, are those of such third party and not PENN. PENN does not independently verify the information provided by third parties, does not guarantee the accuracy, completeness, timeliness or correct sequencing of such information, and assumes no responsibility for errors made by the cited parties.
Performance Disclosure
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Appendix
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High Yield Correlations Between Various Assets: 1980 - 2011
January 1980 to December 2011
US 30 Day TBill
US Inter. Gov.
US Long Term Gov
ML Mortg
ML Corp.
Barc Agg. Bond
Barc AAA Corp.
S&P 500
Russell 2000
DJ Wilsh 5000
MSCI EAFE
Gold US
Inflat
FTSE NAREIT - All
US Inter. Term Gov. 0.07
US Long Term Gov -0.01 0.89
ML Mortgage 0.06 0.06 0.85 0.79
ML Corp. 0.02 0.81 0.81 0.85
Barclay Agg. Bond 0.07 0.93 0.90 0.94 0.94
Barclay AAA Corp. 0.03 0.88 0.89 0.88 0.94 0.96
S&P 500 0.03 0.06 0.09 0.17 0.31 0.20 0.21
Russell 2000 -0.01 -0.04 -0.01 0.08 0.21 0.10 0.11 0.83
DJ Wilshire 5000 0.02 0.04 0.07 0.15 0.30 0.18 0.19 0.99 0.90
MSCI EAFE -0.01 0.03 0.04 0.12 0.26 0.15 0.15 0.66 0.60 0.66
Gold -0.18 0.07 0.03 0.04 0.08 0.05 0.03 0.03 0.09 0.06 0.17
US Inflation 0.39 -0.13 -0.21 -0.10 -0.12 -0.12 -0.17 -0.04 -0.05 -0.04 -0.06 0.03
FTSE NAREIT - All -0.04 0.08 0.08 0.15 0.32 0.20 0.20 0.58 0.67 0.61 0.48 0.10 -0.02
High Yield Bonds -0.02 0.25 0.22 0.42 0.61 0.45 0.43 0.55 0.57 0.58 0.50 0.08 0.00 0.59
Source: Credit Suisse
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Risk/Reward versus Various Asset Classes
January 1980 to December 2011
Annualized Total Return
Annualized Standard Deviation
Highest Annual Return
Lowest Annual Return
Annual Median Return
# of Positive Return Years
# of Negative Return Years
Sharpe Ratio
US 30 Day TBill 4.90 0.97 13.97 0.05 4.81 32 0 0.00
US Int. Gov. 8.73 6.44 29.10 -3.59 9.33 29 3 0.62
US Long-term Gov. 10.24 12.29 40.36 -13.26 9.65 26 6 0.49
ML Mortgage 8.82 7.24 40.15 -1.60 7.31 31 1 0.57
ML Corp. 9.12 7.73 35.53 -6.82 9.11 29 3 0.58
Barclay Agg. 8.69 6.16 32.62 -2.92 7.86 30 2 0.64
Barclay AAA Corp. 8.65 8.12 39.32 -3.64 8.01 28 4 0.50
S&P 500 11.06 17.49 37.43 -37.00 15.43 26 6 0.43
Russell 2000 10.36 22.57 47.25 -33.79 17.41 22 10 0.34
DJ Wilshire 5000 10.90 17.91 36.40 -37.33 15.99 25 7 0.41
MSCI EAFE 9.38 19.78 69.94 -43.06 11.59 23 9 0.31
Gold 3.48 19.11 31.92 -32.15 2.65 19 13 0.01
US Inflation 3.44 1.25 12.40 0.09 3.14 32 0 -1.17
FTSE NAREIT All REITs
10.66 19.14 38.47 -37.34 15.16 25 7 0.39
High Yield Bonds 10.60 9.66 54.22 -26.17 10.93 28 4 0.63
Source: Credit Suisse, The Bloomberg Professional service, Ibbotson Associates
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High Yield Technicals: Historical Spreads
Monthly Credit Suisse High Yield Index Spread to Worst (bps) Annual Performance
Returns End of Year
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Credit Suisse High
Yield Index Moody's
Default Rate Fed Fund Rate
1988 480 458 467 447 417 424 391 406 443 451 434 448 13.66 % 3.48% 8.75 %
1989 419 406 451 517 525 591 629 583 636 745 771 790 0.39% 6.06% 8.25%
1990 774 837 794 773 793 736 718 798 970 1060 1058 1096 -6.38% 9.85% 7.00%
1991 1058 909 802 772 784 743 723 746 754 724 686 729 43.76% 10.43% 4.00%
1992 589 538 490 500 499 521 544 555 563 583 532 548 16.65% 4.94% 3.00%
1993 534 534 502 506 502 508 487 524 546 531 494 481 18.91% 3.59% 3.00%
1994 471 422 442 389 387 390 423 414 376 384 382 388 -0.98% 1.91% 5.50%
1995 406 426 424 414 447 461 426 446 447 457 482 484 17.38% 3.26% 5.50%
1996 473 426 418 402 385 417 398 375 383 404 412 355 12.42% 1.64% 5.25%
1997 347 315 335 352 334 339 357 337 335 381 373 386 12.63% 2.01% 5.50%
1998 384 371 378 377 395 417 416 619 691 743 624 657 0.58% 3.41% 4.75%
1999 659 613 605 559 564 574 564 594 632 628 601 573 3.28% 5.56% 5.50%
2000 581 608 668 671 714 728 733 773 829 837 949 959 -5.21% 6.05% 6.50%
2001 832 822 852 819 787 809 831 824 1012 993 877 868 5.80% 10.51% 1.75%
2002 834 854 744 739 736 823 954 968 1064 1080 929 947 3.10% 8.35% 1.25%
2003 887 884 825 727 742 676 625 593 599 536 509 486 27.94% 5.19% 1.00% 2004 469 494 495 440 474 456 448 456 430 408 357 346 11.95% 2.16% 2.25%
2005 354 307 373 431 430 406 353 379 377 393 398 388 2.26% 1.93% 4.25%
2006 364 350 334 325 329 359 370 377 371 357 350 318 11.91% 1.70% 5.25%
2007 300 305 316 302 271 315 435 462 423 438 575 589 2.65% 0.85% 4.25%
2008 690 760 790 674 636 711 764 794 1000 1471 1816 1706 -26.17% 3.10% 0.25%
2009 1480 1538 1495 1214 1096 978 867 858 764 731 738 634 54.22% 12.50% 0.25%
2010 643 657 591 572 688 708 660 698 642 613 632 571 14.42% 3.10% 0.25%
2011 534 508 505 511 536 569 580 723 811 703 759 728 5.47% 1.70% 0.25%
2012 680 624 621 629 699 660 640 8.54% 2.70% 0.25%
Average Spread: 603
Source: Credit Suisse, 2012 performance return for the index is through 7/31/2012