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This is an example of high yield mutual funds. This document is useful for conducting high yield mutual funds.
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 1 JP Morgan 2003 High Yield Annual Review January 2004 2 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. 3 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. appetite. 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 800 stimulate economic expansion. On the other hand, both Spread 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 200 value as profits fall. As the economy begins to emerge from a recession, high yield bonds (and stocks) tend to 0 12/31/97 12/31/98 12/31/99 12/31/00 12/31/01 12/31/02 12/31/03 3/31/98 6/30/98 9/30/98 3/31/99 6/30/99 9/30/99 3/31/00 6/30/00 9/30/00 3/31/01 6/30/01 9/30/01 3/31/02 6/30/02 9/30/02 3/31/03 6/30/03 9/30/03 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 Diversification 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. This material contains general information only on investment matters; it should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information it contains does not take account of any investor's investment objectives, particular needs or financial situation. This material is given in good faith and has been derived from sources believed to be accurate as at March 2004. Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions herein. The contents of this material have been approved solely for the purposes of S.21 of the Financial Services and Markets Act 2000 by Principal Global Investors (Europe) Limited, which is authorised and regulated by the Financial Services Authority. In the United Kingdom this document is directed exclusively at persons who are market counterparties or intermediate customers (as defined by the rules of the Financial Services Authority). In all other jurisdictions, this document is directed exclusively at professional or other sophisticated institutional investors. No persons should rely on the contents of the material. Products upon which composite results contained in this material, if any, are based may not themselves be available in the United Kingdom and certain other jurisdictions; however, the underlying investment management capability can be made available to institutional investors subject to all applicable local regulations and restrictions. In connection with its management of client portfolios, Principal Global Investors (Europe) Limited may delegate management authority to affiliates that are not authorised and regulated by the Financial Services Authority. In any such case, the client may not benefit from all protections afforded by rules and regulations enacted under the Financial Services and Markets Act 2000. This presentation is issued in Singapore by Principal Global Investors (Singapore) Limited, which is regulated by the Monetary Authority of Singapore. Issued in Hong Kong by Principal Global Investors (Asia) Limited, which is regulated by the Securities and Futures Commission. Issued in Australia by Principal Global Investors (Australia) Limited (Licence number 225385), which is regulated by the Australian Securities and Investments Commission. All figures shown are U.S. dollars unless otherwise noted. For U.S. registered representative use only. In the United States, this is not for distribution to the general public. The information included in this document has been prepared for use in private presentations to select investors. 801 Grand Avenue • Des Moines, Iowa 50392-0490 800-533-1390 • www.principalglobal.com Principal Global Investors is a member of the Principal Financial Group® FF 5714
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