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									                                             The Case for
                                             HIGH YIELD
    2002 to 2003—Year in Review

Sentiment Went from Fear to Greed                                declined from 7.32% at year-end 2002 to 2.92% at year-end
What a difference a year can make! While 2002 may have           20032. This marks the second consecutive annual decline
been characterized by a year of “fear” (increasing default       in the default rate following four consecutive yearly
rates, headline accounting fraud, a plethora of fallen angels,   increases: from 1.43% in 1997 to 8.33% in 2001. Only 57
disappointing performance for almost all asset classes), 2003    high yield issuers defaulted in 2003—the fewest since
saw a reversal of fortune. Declining default risk, higher        1998—compared to 87 issuers in 2002. Despite the decline
yields compared to other fixed-income alternatives, and an       in defaults, the average size of 2003’s defaulted issuers
improving economy, were the major themes in 2003 that            remained high at $427.1 million, the second-highest average
helped high yield mutual funds, as well as institutional         behind 2002’s $639.0 million.
investors, attract record-breaking inflows. The surge of new
cash boosted high yield performance to the best level since      The total amount of distressed debt (defined as bonds
1991. The Lehman Brothers U.S. High Yield Corporate              trading at or below 50% of par or accreted value), a good
Index returned 29.0%, its first double-digit annual return       indicator for future defaults, declined 90% in 2003 to $6
since 1997. Investors’ appetite for risk and constant search     billion from $59 billion in 2002. This represents a
for yield helped high yield outperform nearly all other fixed-   substantial decline of distressed debt from 12.3% to 1.0% of
income alternatives. By comparison, the 10-year Treasury         the high yield market during 2003. The year-over-year
returned 1.73%, while investment grade corporate bonds           decline is attributable to the year’s record-breaking demand
returned 8.31%. High yield only slightly underperformed          and improved economic environment.
equities, as the S&P 500 Index returned 28.69%.
                                                                 Credit conditions improved in 2003, as the ratio of
Due to the improved overall environment for high yield and       upgraded issues to downgraded issues increased for the first
investors’ increasingly more aggressive strategies,              time in five years, and the total volume of fallen angels
throughout the year lower tier bonds (CCC) was the highest       decreased 72%. Although downgrades still outnumbered
performing category returning 60.2%. Middle category (B)         upgrades, 862 compared with 379, the upgrade-to-
and upper-tier bonds (BB) achieved a 26.6% and 17.7%             downgrade ratio rose to the highest level since the 12
return, respectively.                                            months ended Sept. 30, 2001.

Yield Spreads Narrowed1                                          New Issuance and Capital Inflows
The average spread vs. U.S. Treasuries on the high yield         A total of 504 new issues valued at approximately $149
market decreased 4.74% to 4.84% in 2003, the lowest level        billion entered the market in 2003. This was more than
since July 1998 when the spread was 3.9%. The average            double the 260 new issues in 2002, which totaled about $70
yield to maturity of the high yield market has decreased to a    billion. Total new issuance in 2003 was the second highest,
record-low of 7.68%. The decline in spreads was relatively       trailing by a slim margin behind 1998’s record year of
consistent throughout the year, declining in 10 of 12            $150.8 billion.
months after starting the year at about 9.58% on Jan. 1,
2003.                                                            Demand for high yield was strong in 2003, as high yield
                                                                 mutual funds welcomed a new record with a $30.2 billion
Improving Credits and Declining Default Rates                    inflow, compared with $14.2 billion in 2002, and the
One of the biggest themes in 2003 was an improving default       previous high of $22.0 billion in 1997.
environment, as the annual domestic, high yield default rate

 JP Morgan 2003 High Yield Annual Review January 2004
 JP Morgan 2003 Annual Review January 2004
2004—Why High Yield Now and in the Future?
2004—Expect “Coupon” Returns                                     In either case, it would not be unreasonable to expect high
While credit spreads have narrowed considerably, there is        yield to, at a minimum, “clip its coupon” and provide
still a distinct possibility that spreads could narrow even      investors with an 8% to 9% annual return in 2004.
further over the next 12 to 24 months. Lower default rates
and the quest for higher returns should again be the two         High yield bonds are an asset class that should be
dominant factors driving investors in 2004. With this in         incorporated into all long-term investment programs. High
mind, high yield could be poised to be one of the best-          yield offers a higher expected return than other fixed
performing asset classes within the spectrum of fixed            income investments, can be used as a lower-risk substitute
income.                                                          for equities, and offers diversification benefits when coupled
                                                                 with almost all asset classes. The current environment
The forecast for 2004 calls for default rates to decline to 2%   presents an excellent tactical opportunity for investors.
and the market’s average spread to decline to approximately      Current yield levels and positive trends in several of the
4.5%3. This would be a little bit below the median but still     factors that influence high yield bond returns suggest that
higher than the tightest spread environment that was             the asset class continues to provide attractive opportunities
experienced in 1997 when the spread was 3.0%.                    relative to traditional bonds and equities.

                                                                                          JP Morgan 2003 Annual Review January 2004

High Yield 101                                                   Warner, Chrysler and Revlon. In some cases, the timely
                                                                 issuance of high yield bonds helped build entire cities such
Investors know that to achieve superior returns, you             as Las Vegas, where nearly all of the businesses were
typically have to assume investment risks. But just how          financed through this asset class.
much risk could be more perception than reality. Consider        High yield bonds have two return components—income
high yield bonds. Make no mistake: these securities do           and price appreciation. Of the two components, the income
carry greater risks than most other types of bonds. But, all     return is more predictable and smooth. The income return
investments have some level of risk. And, as we have seen        is closely linked to the general state of interest rates
in recent years with the stunning announcement of alleged        (coupon/yield).
accounting irregularities by many large, well-known
companies, even investment grade bonds carry a high              Price, on the other hand, is more volatile and produces
degree of credit risk despite a historically smaller chance of   more sporadic returns than the income component. Price
default.                                                         appreciation is often the driver of outsized returns. It is
                                                                 determined by the economic fundamentals of the
High yield bonds are corporate bonds whose credit is rated       underlying companies issuing high yield debt as well as the
below investment grade, based on the risk of default. High       market’s appetite for risk. Any number of factors can affect
yield bonds are rated below Baa3 by Moody’s Investor             the price return, from corporate governance and industry
Services (Moody’s) and below BBB- by Standard and Poor’s         competition to economic variables and investor sentiment.
(S&P). High yield bonds are either original issues or fallen
angels (those bonds previously rated investment grade but
subsequently downgraded to non-investment grade). The
                                                                 Yield Advantage
                                                                 High yield bonds provide an attractive investment
credit ratings assigned by S&P and Moody’s represent an
                                                                 opportunity from both an absolute and relative perspective.
assessment of the bond issuer’s creditworthiness, that is, the
                                                                 One way to measure the opportunity in high yield bonds is
company’s ability to make interest and principal payments
                                                                 by comparing the yield spread relative to U.S. Treasury
to bondholders. Since the financial condition of a non-
                                                                 bonds. Yield spreads over U.S. Treasuries increased
investment grade company is not as strong as an investment
                                                                 dramatically between 1998 and 2002, as illustrated in Chart
grade company, non-investment grade companies are
                                                                 1. Late 2002 was the start of a narrowing trend that has
compelled to pay higher interest rates on their bonds than
                                                                 contributed to strong relative performance. As the market
higher-rated borrowers. The higher the credit rating, the
                                                                 returns to more normalized conditions, the stage is set for
lower the interest rate; the lower the credit rating, the
                                                                 credit analysis to resume its traditional place as the primary
higher the interest rate.
                                                                 determining factor of performance.
The amount of high yield debt outstanding has increased
                                                                 There are two opportunities for price appreciation as
from $10 billion in 1974 to almost $1 trillion as of 2004.
                                                                 company earnings improve. First, as economic conditions
There are currently thousands of high yield issues, ranging
                                                                 improve in the months ahead we would expect to see
from regional companies (with hundreds of millions of
                                                                 spreads decrease. Second, investors may benefit from price
dollars of debt) to multinational companies (with billions of
                                                                 appreciation as issuers are upgraded by the rating agencies.
dollars of debt). As high yield bonds have evolved over the
                                                                 According to many of the experts, it is anticipated that, on a
past 20 years, they have been used to finance entire
                                                                 relative basis, high yield is positioned to continue to
industries such as cable television and cellular telephones,
                                                                 outperform as an asset class.
as well as some well-known companies including Time
Investment Strategies
Post Advisory Group (Post) manages assets for our clients         The objective is to achieve 200 to 300 basis points above the
under separate accounts and commingled funds via both             high yield benchmark over a three-to-five year market cycle.
onshore and offshore entities. The right investment strategy      The five-year volatility is about 20% less than the typical
is dependent upon the client's investment objective and risk      high yield benchmark.
                                                                  High Yield Plus
Traditional High Yield                                            The high yield plus strategy has been employed by Post
Post has managed its traditional high yield strategy since        since 1992. It is a tactical combination of high quality,
1993. Typically, “traditional” high yield securities are          medium quality, and lower quality high yield issues with an
considered the “safest” in the high yield universe with the       overall “average” quality rating of B to B-. Volatility has
lowest credit risk and a typical average credit rating of BB-     been reduced through diversification, intensive credit
to B+. Investments include liquid, U.S. dollar-denominated        research and a relatively short average life (about five years).
securities of at least $100 million in size. Post's traditional   The objective is to produce returns approximately 400 to
high yield composite is highly diversified, with internal 20%     600 basis points above the high yield benchmark over a
per industry (average below 15%) and 5% per issuer limits.        three-to-five year market cycle.
Over 95% of the traditional high yield composite is
comprised of bonds that are rated B- or higher.

The Economy                                                         Chart 1
High yield bonds differ from other, higher-rated fixed
income securities in that their performance has a higher                                     Lehman Brothers High Yield Index
correlation with the strength of economic activity. Higher-                                     Yield Spread vs. Treasuries
quality bonds typically provide strong returns during
recessions as bond prices rise in the face of declining                           1200

interest rates; this is because the Federal Reserve usually                       1000
lowers interest rates during a recession in an attempt to
stimulate economic expansion. On the other hand, both

high yield bonds and stocks are more sensitive to corporate                        600

earnings than higher-quality bonds. Therefore, during                              400
recessions both high yield bonds and stocks may decline in
value as profits fall. As the economy begins to emerge from
a recession, high yield bonds (and stocks) tend to                                  0











outperform investment-grade bonds. The reason: issuers of
high yield bonds depend on cash flows to service their debt.
Thus, if a company is generating lots of cash, investors see                                                                        Month-End Date

this as a sign that the company’s bonds are valuable and bid                                          B           BB        Index         B to BB spread differentials
up the price. The behavior of high yield bonds differs from
stocks, however, in one key respect: overall returns for            Source: Lehman Brothers
bonds are less volatile than those of stocks because interest
income generated is substantially higher than dividends
paid. In addition, high yield bonds provide investors better        Chart 2
asset “protection” than stocks because bonds are a legal
contract and, in the event of bankruptcy, bondholders are
paid ahead of equity holders.
                                                                                     10-Year Correlation vs. High Yield Bonds

Adding asset classes such as high yield bonds to a portfolio                      -0.11 Real Estate
should either increase expected returns, reduce overall risk,
or both. High yield can be viewed as a hybrid between core                                                International Stocks                     0.4
fixed income and equity. High yield has a large income
stream similar to core fixed income and has equity-like                                                                                                                  0.61
                                                                                                          U.S. Stocks
characteristics in that high yield bond prices are largely
driven by the underlying companies issuing the high yield
credit. Due to their unique characteristics, high yield offers                           Treasuries       -0.16

diversification benefits when used in combination with
virtually all asset classes, as illustrated in Chart 2.                          Core Fixed Income        0.01

                                                                          -0.2             -0.1       0           0.1        0.2       0.3       0.4       0.5       0.6        0.7

                                                                     Source: Principal Global Investors
Manager Makes the Difference                                      marketplace with little downside protection, particularly if
                                                                  there is little to no appreciation for the relative risk and
                                                                  reward. Therefore, it is in these euphoric times, when
Post is well positioned to take advantage of this next high       caution appears to be thrown to the wind, that credit
yield market cycle. As a firm, our credit analysts focus          selection, covenant protection, asset valuations, and
attention on downside risk protection—both in difficult           bottom-up analysis becomes extremely important.
market environments as well as good ones. Therefore, in
the current euphoric market environment where technicals        • Upgrading credit quality and seniority in the capital structure.
drive performance and not fundamental credit analysis, it is      In the current market, we believe there are areas where
even more compelling to identify a manager that is bottom-        investors are not being properly compensated for taking
up and credit intensive in its approach to portfolio              the inherent risks. Contrary to “chasing” the CCC end of
management.                                                       the market, we believe the spread is not sustainable
                                                                  between BB and CCC credits, so depending upon our
In past similar cycles Post has outperformed its benchmark        analysis, we prefer to hold B or BB credits that may be
by between 2% and 3% (rolling three year performance              upgraded in the future. We believe that at some point the
compared to benchmark; see important disclosure attached).        market will return to a more rational position where the
The following are some of the steps we are taking to create       fundamental value will be reflected in the price of high
optimal portfolios that include avoiding risk, preserving         yield securities.
capital, and identifying opportunities in today’s high yield
marketplace:                                                    • Investing in short duration securities. There are many risk
                                                                  factors when investing in all fixed-income, especially high
• Credit selection will become imperative once again. At the      yield credits. One risk factor—interest rate risk—remains
  riskier end of the market, CCCs and below, have                 out of our control. With interest rates holding at all time
  outperformed the entire high yield market (and beat out         lows, as a defensive measure we are investing in shorter
  equities as well!) returning 60.2% for 2003. It would be        duration securities such as yield to call bonds, putable
  wise to beware of the unsophisticated investors simply          bonds, or shorter maturities (less than three years). We
  chasing the higher yields associated with CCC securities.       believe taking this defensive position will allow us to
  The risk is truly in front of this sector of the high yield     remain nimble if interest rates begin to rise.

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                                                                  at March 2004. Subject to any contrary provisions of applicable law, no company in the Principal
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