The Long-Term Benefits of High Yield

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1 The Long-Term Benefits of Q Newsletter Introduction As shown below, the average discount rate for U.S. definedbenefit pension plans exceeds the yield-to-maturity offered by investment grade bond indices by a considerable margin. This puts plan sponsors in a conundrum when attempting to maintain/improve the funded status of their respective plans. They can either increase regular contributions to the plan (which impedes company earnings) or pursue asset classes offering higher return potential (which increases plan risk). Most seem to prefer the latter of these two imperfect options but have been put off by the excessive volatility exhibited by equities over the past few years. Average Pension Plan Discount Rate = 5.4% 1 Government Bond yield-to-maturity = 1.2% 2 Core Bond Index yield-to-maturity = 3 Index yield-to-maturity = 7.1% 4 Unlike pension fund managers, endowments, foundations, individuals, and most other investors are not burdened with formally-regulated liability requirements. Nevertheless, these investors face the same rudimentary challenge to improve upon the paltry yields offered by investment grade bonds without assuming undue risk. At current yields, an investment in high grade bonds appears condemned to generate negative real returns which would erode investors purchasing power. This is counter to the basic tenet of all investors: to increase or maintain purchasing power. The high yield bond asset class is a worthy consideration to most investment portfolios. As shown in Chart 1, high yield has generated higher returns than investment grade bonds and has exhibited lower volatility than equities. It also has limited correlation with other major asset classes. The remainder of this newsletter will expand on these factors and outline the case for including an allocation to high yield in an investment portfolio Risk/Return (9/86-3/12) Core Bonds Improved Portfolio Efficiency Equities Index narrative and performance can be found after conclusion of commentary. Chart 2 depicts an efficient frontier for a simple portfolio composed of two asset classes: core bonds (investment grade) and high yield. The data cover more than 26 years, beginning in 1986 which was the inception of the high yield index. Unsurprisingly, a portfolio composed of 10 high yield bonds would have generated a higher return and greater volatility than a portfolio composed of 10 core bonds. Because the two asset classes are not highly correlated, adding a small high yield allocation to a core bond portfolio would have increased the portfolio s return and decreased its volatility (or maintained the same level of volatility). Identifying multiple asset classes that combined, create an improved risk/return profile is the primary objective of modern portfolio theory a combination of core bonds and high yield appears to do just that % 7.5% 2. Core Fixed Income + (9/86-3/12) Portolio with Highest Sharpe Ratio (3 HY) Core Bonds Hypothetical illustration based on actual historical returns. Past performance is no guarantee of future results. 1 Source: P&I (top 100 plans, most recent available) 2 BofAML US Treasury & Agency Index (3/31/12) 3 BofAML US Corporate, Government & Mortgage Index (3/31/12) 4 BofAML US Master II Index (3/31/12)

2 Similar to Chart 2, the light green line on Chart 3 is the efficient frontier of a portfolio composed of two asset classes. Rather than combining core bonds with high yield, however, the light green line combines core bonds with equities. The lower-left-most point on this line represents 10 core bonds and the upper-rightmost point represents 10 equities. The dark green line on Chart 3 highlights the effect of adding a high yield allocation to the core bond/equity mix. Every point on the dark green line includes a high yield allocation with the core bond/equity mix pro-rated. For example, the midpoint on the light green line represents 50/50 core bonds/equities while the midpoint on the dark green line represents 40/40/20 core bonds/equities/high yield. The important point is that adding high yield to a typical portfolio made up of core bonds and stocks can improve the portfolio s risk/return profile. 9.5% % 7.5% Hypothetical illustration based on actual historical returns. Past performance is no guarantee of future results. Correlation 3. Core Fixed Income + Equities (9/86-3/12) No There are two primary reasons why adding high yield to a typical portfolio can improve its risk/return profile: 1) high yield itself offers a compelling risk/return profile, and 2) high yield has had a low-to-moderate correlation with other major asset classes. Table A: Correlation (1/1/88 3/31/12) High Yield BofAML US Treasury & Agency Index BofAML Corporate Master Index 0.53 BofAML Mortgage Master Index 0.15 S&P 500 Index 0.60 Russell Index 0.63 MSCI EAFE Index 0.54 MSCI Emerging Markets Index 0.56 As shown in Table A, high yield is more closely correlated with equities than with fixed income. Even so, its correlation with equities is modest at around 0.6, which can still produce a considerable diversification benefit. Attractive Carry (income) The sizable income generated by high yield bonds is often the most appealing attribute to potential investors. Chart 4 compares income-generating characteristics for various asset classes. For fixed income, we show the current yield (annual coupon payments/market price). For equities, we show the dividend yield (annual dividend payments/market price) HY 4.9% 4.4% Corp Mtg Gov't Bonds: Current Yield 4. Income Yield (3/31/12) 3.9% 3.1% 2.1% 1.6% Int'l Emg Mkts US Lg Cap US Sm Cap Equities: Dividend Yield Income is only one of the two sources of return, of course, with capital appreciation being the other. While capital appreciation can often overshadow income, particularly for equities, coupon and dividend payments has been the more stable of the two return sources. Chart 5 highlights the coupon income generated by the high yield market each year since. Coupon income averaged per year over this period, ranging from 8.1% to 12.8%. Not only can this provide a stabilizing feature, it can provide investors with the flexibility to fund ongoing obligations, rebalance the total portfolio, or simply reinvest. Investors would have been able to reinvest in the high yield market at a current yield no less than 8% at any point over this period a compelling observation Market Return Decomposition (BofA ML Master II Index) Total Return (annual) Return from Coupon Income (annual) Range: 8.1% % H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 5

3 Subdued Negative Performance High yield credits are defined as such because the major rating agencies view the bond and/or the issuing company as having greater credit risk than investment grade alternatives, and have rated the bond accordingly. The rating agencies track record of distinguishing low risk bonds from high risk bonds is questionable at best, but in aggregate, high yield bonds have experienced negative credit events more frequently than investment grade bonds. To compensate for greater credit risk, high yield investors demand a greater yield. In the end, you have an asset class that has generated better total returns than investment grade bonds but has also generated greater volatility (as shown in previous charts). We thought it would be interesting to isolate the negative volatility to better gauge how bad the worst high yield environments really were (we have yet to meet an investor that is troubled by positive volatility ). Chart 6 highlights the calendar year returns of the high yield market going back to the inception of the broad market index, the BofA Merrill Lynch Master II Index Market Calendar Year Returns -4.4% % -1.9% -26.4% /2012 Index performance can be found after conclusion of commentary. Clients have told us they are surprised that only 5 of the 25 calendar year periods were negative and that the worst year prior to was -5.1%. The market has never experienced two negative years consecutively. Also, each negative year except was followed by a strong recovery the subsequent year (>). The green line in Chart 7 shows the high yield market s rolling 10-year return. There has never been a 10-year period in the history of the high yield market where an investor would have earned a negative return this is a claim that equities cannot make. 15% 5% -5% Year Rolling Returns (annualized) Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Rising Rate Environments Chart 8 depicts the yield on the 10-year Treasury bond since the mid-1980s (the inception of the high yield index). Interest rates have declined throughout this 25 year period, which has provided a tailwind to Treasuries and other interest-rate sensitive instruments Rising Rate Periods While interest rates could subsist near the record-low levels of today, or even establish a new low, a reversion upward seems the more likely risk. Increasing rates would reverse Treasuries tailwind into a headwind. High yield bonds, however, have performed well in rising rate environments. This is because high yield bond performance is more dependent on the credit environment than the interest rate environment. In Chart 8, we boxed five periods when interest rates, as defined by the 10- year Treasury yield, rose by more than 150 basis points. Table B displays the average annualized performance of high yield, core bonds (investment grade), and the 10-Year Treasury during these rising rate periods. It also displays the average annualized performance for falling rate periods, which are the non-boxed periods. Table B: Average s During Rising and Falling Rate Environments (9/1/86 3/31/12) High Yield Equities (S&P 500) Year Treasury Yield Since 9/86 Core Bonds (Master II) Mar-86 Mar-88 Mar-90 Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar Year Treasury Rising Rates 12.8% 1.7% -3.4% Falling Rates 6.5% 9.8% 11.7% H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 5

4 An Established Market A final misconception that we would like to dispel is the idea that the high yield market is underdeveloped, undersized, and untested. We believe, to the contrary, that the market is established, extensive, and enduring. As shown in Chart 9, the high yield market was in its infancy in the early 1980s until it proliferated during the Milken-era of the mid-1980s. The asset class was embraced by S&Ls, mutual funds, and insurance companies. The market withstood the S&L crisis in the late 1980s/early 1990s, the tech/telecom bubble burst a decade later, and the financial crisis of. Today, the market is as large and as liquid as it has ever been. Its investors are broad: mutual funds, institutional investors, sovereign funds, specialty funds, and even retail investors. The market has been tested with liquidity shocks, corporate fraud, asset bubbles, and excessive leverage. It has endured, and we are confident that it is here to stay. Conclusion We believe high yield bonds can represent a happy medium for investors seeking higher return potential than investment grade bonds but lower volatility than equities. Adding high yield s compelling risk/return profile and its low correlation with other asset classes can improve a traditional portfolio s efficiency. It generates higher income than other major asset classes and has exhibited resiliency in down markets. The high yield market has proliferated extensively over the past several decades, transforming into a critical funding source for many US companies. For these reasons, we believe a strategic allocation to high yield would benefit most investors. Mark Hudoff, Portfolio Manager Ray Kennedy, Portfolio Manager Patrick Meegan, Portfolio Manager Ryan Thomes, Portfolio Analyst $ billions 1,200 1, Size of Market $1.11 Trillion /2012 Past performance is not a guarantee or reliable indicator of future results. Index performance is not indicative of fund performance. An investment cannot be made directly in an index. To obtain fund performance please visit You should consider the Fund s investment objectives, risks, and charges and expenses carefully before you invest. This and other important information is contained in the Fund s summary prospectus and prospectus, which can be obtained by calling or visiting our website at Read carefully before you invest. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 5

5 All investments contain risk and may lose value. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investment by the fund in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities. The Fund may invest in derivative securities, which derive their performance from the performance of an underlying asset, index, interest rate or currency exchange rate. Derivatives can be volatile and involve various types and degrees of risks. Depending on the characteristics of the particular derivative, it could become illiquid. Investment in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. The Fund may invest in foreign as well as emerging markets which involve greater volatility and political, economic and currency risks and differences in accounting methods. Diversification does not assure a profit or protect against loss in a declining market. Credit cycles vary in both length and volatility. Past credit cycles will differ from current or future cycles. Sector allocations are subject to change and should not be considered a recommendation to buy or sell any security. Special recognition to Yoshie Phillips, CFA and Russell Investments for eliciting select concepts highlighted in the paper. All references to high yield (HY) based on BofAML US Master II Index; core bonds based on BofAML US Corporate, Government & Mortgage Index; and equities based on S&P 500 Index. Data source(s): Charts 1, 2, 3, 6, 7: Bloomberg; Chart 4: Bloomberg, MSCI, S&P, Russell; Chart 5: Bloomberg, JPMorgan (Concept: Yoshie Phillips, CFA and Russell Investments); Chart 8: Barclays; and Chart 9: Credit-Suisse. Table A: Bloomberg, MSCI, S&P, Russell and Table B: Bloomberg. Average Annual Returns as of December 31, 2012 Charts 1, 2, 3 & 7: 1 year 3 year 5 year 10 year 15 year S&P 500 (Equities) % 1.66% % BofAML Corp/Govt/Mtg (Core Bonds) BofAML HY Master II () Chart 4: IG Corp: BofAML US Corporate Master Index IG Mtg: BofAML US Mortgage Master Index IG Gov t: BofAML US Treasury & Agency Index Int l: MSCI EAFE Index Emg Mkts: MSCI Emerging Markets Index US Lg Cap: S&P 500 Index US Sm Cap: Russell Index BofA Merrill Lynch U.S. Master II Index tracks the performance of below investment grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody s and S&P. BofA Merrill Lynch U.S. Mortgage Master Index tracks the performance of U.S. dollar denominated fixed rate and hybrid residential mortgage pass-through securities publicly issued by U.S. agencies in the US domestic market. BofA Merrill Lynch U.S. Corporate Master Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. BofA Merrill Lynch U.S. Treasury & Agency Index tracks the performance of U.S. dollar denominated U.S. Treasury and non-subordinated U.S. agency debt issued in the U.S. domestic market. BofA Merrill Lynch U.S. Corporate, Government & Mortgage Index is a broad-based measure of the total rate of return performance of the US investment grade bond markets. Barclays Capital U.S. 10-Year Treasury Bellwether represents an investment in 10-Year, on-the-run Treasury bonds. S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. Russell Index is comprised of the 2,000 smallest companies in the Russell 3000 Index. MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of 21 emerging market country indices. The indices do not reflect the payment of transaction costs, fees and expenses associated with an investment in the Fund. It is not possible to invest directly in an index. The Fund s returns may not correlate with the returns of its benchmark indices Hotchkis & Wiley. All rights reserved. Any unauthorized use or disclosure is prohibited. This presentation is circulated for general information only, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may see this report. The research herein is for illustration purposes only. It is not intended to be, and should not be, relied on for investment advice. Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. The opinions expressed are subject to change and any forecasts made cannot be guaranteed. H&W has no obligation to provide revised opinions in the event of changed circumstances. Mutual fund investing involves risk. Principal loss is possible. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE The Hotchkis & Wiley Funds are distributed by Quasar Distributors, LLC Charts 5 & 6: BofAML HY Master II calendar year returns % 13.36% 2.31% -4.36% 39.17% 17.44% 16.69% -1.03% 20.46% Chart 8: Rising Rate Periods 9/86-9/87 9/93-11/94 9/98-1/00 5/03-5/06 12/08-12/09 10-Year Treasury -9.6% -9.4% -5.6% 2.8% -4.1% BofAML HY Master II Pension Plan Discount Rate: The rate that a company uses to calculate the present value of its future obligations to retirees (i.e. the projected benefit obligation or PBO). Correlation: Statistical measure of the degree to which the movements of two variables (stock/option/convertible prices or returns) are related. Credit Risk: Risk associated with corporate bonds possibility of default. Basis point: Unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument. Yield-to-Maturity: Yield that would be realized on a bond or other fixed income security if the bond was held until the maturity date. Sharpe Ratio: A simple measure of the risk-adjusted return of an asset or portfolio. H&W 725 South Figueroa Street, 39th Floor, Los Angeles, CA of 5 HWHY-News-2Q 2012