Opportunities in credit higher quality high-yield bonds

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1 Highlights > > Default rates below the long-term average > > Valuations wide of historical average in BB and B rated credit > > Despite sluggish economy, high yield can still perform well > > High yield versus equity history 85% of the return, half the volatility > > Less interest rate risk historically than investment-grade fixed income > > Considering higher quality high yield One of the more compelling opportunities across today s fixed-income landscape is within the higher quality segment of the high-yield market bonds rated BB and B. Strong underlying fundamentals driven by a wave of refinancing and solid operating performance have greatly diminished credit risk among these issuers, as demonstrated by exceptionally low current and expected default rates. Despite this, spreads, or yield premiums relative to Treasuries, are generally higher than long-term averages. For investors searching for incremental yield in today s interest rate environment who want to dampen price volatility associated with both the equity market and the lowest quality segments of the high-yield market (bonds rated below B), this unique segment of the market may offer an attractive risk-adjusted return opportunity. Default rates below the long-term average The financial health of leveraged corporations has come a long way since the financial crisis of Many companies have taken aggressive action to shore up their balance sheets, with the result being lean cost structures, strong profit margins and historically high cash balances. The charts on the next page illustrate the resulting improvement in leverage and interest coverage, as ratios are now near pre-crisis levels and compare favorably to historical averages. 1

2 Select credit metrics: net leverage and interest coverage Fourth quarter net leverage of 3.3x remains well below 3.6x long-term average Net Leverage (Net Debt/LTM EBITDA, x) Select credit metrics: net leverage and interest coverage Fourth quarter interest coverage of 3.6x remains well above 3.2x long-term average Coverage (LTM EBITDA/Net LTM Interest Expense), x Net leverage measures a company s ability to repay debt obligations from cash earnings. A lower ratio suggests that cash earnings are sufficient to meet financial obligations when they come due Leverage ratio Coverage ratio Average leverage (3.6x) Source: Bank of America Merrill Lynch Global Average coverage (3.2x) Source: Bank of America Merrill Lynch Global Interest coverage measures the ability of a corporation to satisfy its interest payments. A ratio above one indicates that earnings sufficiently cover current interest obligations on outstanding debt. Default rates below the long-term average Additionally, the shock of being unable to access credit markets in 2008 has led many high-yield issuers to capitalize on record-low interest rates and refinance outstanding debt obligations. Since 2009, 67% of the record high-yield new issuance volume has been used for refinancing activities. Because corporate financial health and near-term amortizations directly influence default rates, an extended maturity schedule together with strong financial performance should keep default rates among high-yield issuers below the long-term average of 4.2% in each of the next two years. In fact, Moody s and JP Morgan have published default expectations for 2012 of 3.0% and 1.5%, respectively, for the broad high-yield market. Valuations wide of historical average in BB and B rated credit Given the low default expectations, we believe valuations have mispriced credit risk in the BB and B rated sectors of the high-yield market. High-yield bonds carry a higher interest rate to compensate investors for potential credit losses that may be incurred in the event of default. However, as the table on the next page shows, credit losses between the lowest quality tier of investment grade (BBB) and the highest quality tier of high-yield (BB) bonds have historically been minimal. Current spread differentials, which exceed both recent and average credit losses, suggest that investors are being sufficiently compensated for moving down in credit quality. Given the low default expectations, we believe valuations have mispriced credit risk in the BB and B rated sectors of the high-yield market. 2

3 Valuations wide of historical average in BB and B rated credit Current and median spread and credit loss differentials: Yield advantage of BB and B rated bonds pays for historical credit losses 2011 credit loss differential 20-year median credit loss differential 03/31/12 spread differential 20-year median spread differential BB-BBB B-BB CCC-B 0.00% -0.04%* 4.74% 0.29% 1.37% 4.99% 126 bps 189 bps 424 bps 101 bps 174 bps 508 bps Sources: Moody s Investors Service and JPMorgan * Negative credit loss differential indicates that credit losses were modestly higher within BB than B rated credits during Current spread differentials highlight that the risk premium relative to historical averages is most compelling in the BB and B quality segments of the high-yield market, while CCC rated credit appears less attractive. We expect defaults to remain low across all traunches of the high-yield market, but our relative value analysis suggests that BB and B rated credit may offer the best risk-adjusted returns. Despite sluggish economy, high yield can still perform well Despite recent improvements in several macroeconomic indicators, investors still face challenges stemming from modest growth expectations and historically low interest rates. Because the asset class is less dependent than equities on earnings to drive performance, high-yield bonds can still perform well through a sluggish economic environment. During the last 20 years, when annual gross domestic product has grown less than 2.5%, high-yield bonds returned an average of 6.67% during the same period. Additionally, high-yield bonds are less influenced by movements in interest rates than other fixed-income sectors. Given this dynamic, we believe a core allocation to higher quality high-yield bonds has the potential to generate attractive returns and enhance income despite the challenges from a low-growth, low-yield environment. During the last 20 years, when annual gross domestic product has grown less than 2.5%, high-yield bonds returned an average of 6.67% during the same period. High yield versus equity history 85% of the return, half the volatility In the wake of recent market volatility, there is a strong case for complementing a traditional equity-biased portfolio with an allocation to higher quality high yield. Over the past 25 years, the BofAML BB-B U.S. Cash Pay High Yield Index has consistently achieved a more attractive return per unit of risk than the S&P 500 Index by producing more than 85% of the total return with less than half the volatility.** 10-year rolling return per unit of risk Higher quality high-yield bonds deliver superior riskadjusted returns (%) 10-year risk/return BofAML US HY BB-B Const. Index S&P 500 December Source: Bank of America Merrill Lynch and Morningstar Return per unit of risk attempts to show the risk associated with generating returns. A ratio above one indicates that for every one percentage point of volatility, there has been one percentage point of return. This is especially relevant given the potential for ongoing volatility stemming from current macroeconomic uncertainties. In contrast, an extended period of slow-to-moderate GDP growth could weigh heavily on stock market performance. **Past performance does not guarantee future results 3

4 High yield vs. equity history 85% of the return, half the volatility Investments in higher quality high yield allow for upside participation through price appreciation as the economy recovers, and their coupon provides a current income stream that tempers downside volatility relative to equities. Higher quality high-yield bonds trade primarily on credit fundamentals and risk appetite and are therefore less sensitive to rate-driven price volatility. Less interest rate risk than investment-grade fixed-income Although interest rates are currently low, all signs point to them eventually moving higher when the Federal Reserve changes course and begins to implement a program of tightening monetary policy. Whereas rising interest rates pressure performance in most fixed-income sectors, higher quality high-yield bonds trade primarily on credit fundamentals and risk appetite, and they are therefore less sensitive to rate-driven price volatility. The past three Fed tightening cycles provide a useful example of how corporate credit across the ratings spectrum has responded to rising interest rates. In the 12 months prior to tightening, easy financial conditions provided a strong tailwind to the most credit-sensitive sectors, as indicated by the significant outperformance of CCC rated credit. Then, as monetary policy shifted and the Fed began to tighten, higher quality high-yield bonds outperformed. Average return by credit quality BB and B have performed better than higher rated credit both before and after Fed tightening (%) months before tightening 12-months after tightening 15.7 What about CCC rated bonds? While our preference is for the BB and B rated segment of the high-yield market, this does not discount the value in CCC rated issues. For investors who are able to tolerate incremental price volatility, CCC rated bonds present an attractive opportunity to generate additional investment income. It is important to remember that the volatility inherent in the lower quality cohort of the high-yield market derives from increased default risk, which has been mitigated by refinancing activity and strong underlying fundamentals. Default risk can be further mitigated by diversifying issuer-specific risks using a mutual fund manager who emphasizes fundamental credit research and actively controls downside tail risk.* Considering higher quality high yield We believe higher quality high-yield bonds offer investors an attractive solution to help navigate the challenges in today s market environment. Fundamental repair across leveraged borrowers has served to greatly reduce default risk and is a primary driver of the attractive risk-adjusted values we currently see in the high-yield marketplace. Current spread premiums appear out of step with underlying credit metrics and more than compensate investors for dipping below investment grade into BB and B rated credit. Additionally, higher quality high yield has historically generated equity-like returns without the commensurate volatility, an especially important characteristic given the uncertainty surrounding economic growth expectations. As a result, we believe that investors in higher quality high-yield bonds are likely to enjoy strong risk-adjusted returns relative to other asset classes AAA AA A BBB BB B -6.2 CCC Source: Barclays * Diversification does not assure a profit or protect against loss. 4

5 About the Columbia Management High Yield Team The Columbia Management High Yield Sector Team, led by Jennifer Ponce de Leon, includes six sector managers and two portfolio analysts responsible for investment strategy, asset allocation, portfolio construction, security selection and trading. The portfolio management team has significant depth and continuity, having worked together since 1997 and averaging more than 22 years of industry experience. The team has 10 dedicated credit research analysts with an average of 14 years of investment experience. Our analysts are critical to our investment approach and work in equal partnership with the sector managers through all stages of the investment-decision-making process. Investment philosophy We believe total return opportunities in the high-yield market are best captured through rigorous, in-house credit research and we use a proprietary risk and relative value rating system that helps position the fund based on the trade-off between risk and expected return at the security, industry and portfolio level. In addition, we combine bottomup fundamental credit research with a top-down strategic review to seek consistent, competitive risk-adjusted returns across varying market environments. Columbia Income Opportunities Fund > > A higher quality high-yield fund specifically targeting the B and BB rated credit traunches of the market that have produced historical returns that are above category averages with 20% less volatility (Source: Morningstar, 12/31/11). > > Managed by a deep and stable team of high-yield sector specialists who manage more than $13 billion for retail and institutional clients globally. > > Constant focus on downside risk. Class A AIOAX Class Z CIOZX About Columbia Management Columbia Management is committed to delivering insight on subjects of critical importance, including insight on financial markets, global and economic issues and investor needs and trends. Our investment team examines the issues from multiple perspectives and we re not afraid to take a strong stand or point out opportunities even when there is no clear consensus. By turning knowledge into insight, Columbia Management thought leadership can provide: > > A deeper understanding of investment themes, trends and opportunities. > > A framework for more informed financial decision-making. Access the insight, intellectual strength and practical wisdom of our experienced team. Find more white papers and commentaries in the market insights section of our website columbiamanagement.com/market-insights 5

6 Past performance is not indicative of future results. The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate. Information provided by third parties is deemed to be reliable but may be derived using methodologies or techniques that are proprietary or specific to the third-party source. The views expressed are as of the date provided and are subject to change without notice at any time based upon market and other factors. There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer term securities. Non-investment-grade securities, commonly called high-yield or junk bonds, generally have more volatile prices and carry more risk to principal and income than investment-grade securities. JPM High Yield is represented by the JPMorgan Global High Yield Bond Index, which is designed to mirror the investable universe of the US$ global high-yield corporate debt market, including domestic and international issues. JPM Investment Grade is represented by the JPMorgan U.S. Liquid High Grade Index, which is a cash pay USD denominated index that includes corporate bonds rated investment grade by both S&P and Moody s with a minimum rating of BBBand Baa3, respectively. The Standard & Poor s 500 Index is an unmanaged list of common stocks frequently used as a measure of market performance and is not necessarily similar to our institutional portfolios. The Bank of America Merrill Lynch High Yield Index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. To learn more about the support and services available to you, contact Columbia Management at Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. For a free prospectus, which contains this and other important information about the funds, visit columbiamanagement.com. The prospectus should be read carefully before investing. 225 Franklin Street Boston, MA columbiamanagement.com Columbia Management Investment Advisers, LLC is an SEC-registered investment adviser that offers investment products and services under the names Columbia Management Investments, Columbia Management Capital Advisers and Seligman Investments. Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. Columbia Funds are distributed by Columbia Management Investment Distributors, Inc., member FINRA, and managed by Columbia Management Investment Advisers, LLC Columbia Management Investment Advisers, LLC. All rights reserved. CM-TL/ A (04/12) 3190/135269

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