Fixed-income opportunity: Short duration high yield

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1 March 2014 Insights from: An income solution for a low or rising interest-rate environment Generating income is a key objective for many investors, and one that is increasingly difficult to achieve in today s low interestrate environment. At MacKay Shields, we currently see an opportunity in higher-quality, short duration high-yield bonds. We believe these bonds have the potential to generate attractive risk-adjusted returns and income, with less interest-rate sensitivity versus investment-grade alternatives. We view this as an ideal time for investors to diversify their fixed-income exposure through short duration high yield. This outlook is based on several factors in today s fixed-income market: Short duration bonds have proven resilient during periods of rising rates. Higher-quality, short duration high-yield bonds offer higher spreads than investment-grade alternatives with less interest-rate sensitivity. Valuations in the higher-quality segment of the high-yield market remain attractive. Many higher-quality, short duration high-yield bonds have unusually resilient credit profiles. Higher-quality, short duration bonds are an attractive complement to leveraged loans. Following is a discussion of the current market environment as well as the opportunity in higher-quality, short duration high-yield bonds. Short Duration High Yield Has Proven Resilient During Periods of Rising Rates During the four most recent periods of rising interest rates, short duration high-yield bonds have generated competitive returns against investment-grade bonds. Exhibit 1: Short Duration High Yield Historically Offered Competitive Returns Versus Investment Grade Annualized Return, % (10/31/98-1/31/00) (6/30/03-5/31/06) (12/31/08-4/30/10) (7/31/12-9/30/13) Periods of Rising Rates BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index Barclays U.S. Aggregate Bond Index Sources: Bloomberg, Bank of America, and Barclays, as of 12/31/13. The periods of rising rates shown above are based on periods of rising 10-year treasury yields. Short duration high yield bonds are represented by BofA Merrill Lynch 1-5 Year BB- B Cash Pay High Yield Index and investment grade bonds are represented by Barclays U.S. Aggregate Bond Index. Performance of the indices does not represent the performance of MainStay Short Duration High Yield Fund. For the most current month-end performance of the Fund, please visit 1

2 Short Duration High Yield Compares Favorably to Investment Grade There are two main risks in investment-grade bonds today. First, their spreads are near historically low levels. Second, their duration is elevated, making them vulnerable if interest rates rise. Interest rates have remained extremely low due to a combination of aggressive Federal Reserve policy and low investor fear of inflation. However, recently, interest rates have started to move, and investment-grade bonds have underperformed. We believe investors should consider diversifying their fixed-income portfolios with shorter duration fixed-income assets to help mitigate this risk. Exhibit 2: Investment-Grade Bonds Low Spreads, High Duration Spread Duration Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 US Duration (Mod. Adj.) Average Spread Source: Barclays, as of 12/31/13. We believe higher-quality, short duration high-yield bonds compare favorably to investment-grade alternatives, offering a higher yield with less interest-rate risk. It is important to remember, however, that higher yields come with a trade-off of lower-quality credits, which may carry higher credit risk. Exhibit 3: Spreads and Duration: Higher-Quality, Short Duration High-Yield Bonds vs. Investment-Grade Bonds Spreads Short Duration High-Yield Bonds BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index 286 bps (Spread to worst) Investment-Grade Bonds Barclays U.S. Aggregate Bond Index 62 bps (Average spread) Duration 2.05 years 5.55 years Sources: MacKay Shields and Barclays, as of 12/31/13. Bps = Basis points. Past performance is no guarantee of future results. Index performance is not representative of Fund performance, and this illustration is not intended to predict or project the performance of any fund. You cannot invest directly in an index. Higher-Quality, High-Yield Bonds Remain Attractively Valued We believe the U.S. high-yield market continues to be an attractive investment opportunity for disciplined investors. We often refer to the high-yield market as a tale of two markets. The larger market segment is comprised of higher-quality bonds with strong credit profiles. Valuations here remain attractive spreads for bonds rated BB and B are near their long-term historical average. In addition, credit profiles for many of these bonds have never been more resilient than they are today. This means near-term default risk is relatively low. On the other hand, as investors have reached for yield in the low rate environment, bonds in the riskier segments of the market have become overvalued. The additional spread that weaker CCC bonds offer, compared to B bonds, is also historically low. Credit profiles for these bonds are generally weak, and we anticipate that future defaults will be heavily concentrated in this segment of the market. 2

3 Exhibit 4: Historical High-Yield Quality Market Spread BB B CCC CCC B 31 December 2013 (bp) Year Median (bp) , through 1991 (recessionary period) Median (bp) ,041 1,348 Current CCC-B Spread Well Below 20-Year Median Peak (bp) 540 1,026 3,568 2, through 2002 (recessionary period) Median (bp) ,172 1,378 Peak (bp) 670 1,025 2,741 1, through 2006 (period of growth) Median (bp) Peak (bp) , Source: J.P.Morgan, as of 12/31/13. A Snapshot of High Yield Bonds A Tale of Two Markets Profile Valuations Credit profiles Future defaults/volatility Higher-Quality High Yield Larger segment of the market, typically rated BB and B Attractive spreads are near their long-term average Generally more resilient most of these companies have ample liquidity and stronger balance sheets We believe default rates are likely to be significantly lower compared to the lower-quality segment of the high-yield market Lower-Quality High Yield Smaller segment of the market, with weaker CCC-like credit metrics Unattractive the excess spread investors are getting paid for credit risk has never been lower Generally weak many companies are over levered We believe most future defaults will occur in this segment Resilient Credit Profiles in Many Quality Short Duration High-Yield Bonds We believe that many short duration high-yield bonds today have resilient credit profiles. These companies generally have significant liquidity, modest leverage, and limited near-term debt maturities. The following table highlights some examples of these bonds and their credit attributes. Exhibit 5: Sample Company Profiles (Stats based on profiles of actual companies; names are fictitious) Company Rating Characteristics Theater Co., 5%, due 2018 Manufacturing, 8.125%, due 2018 Animal Health, 9.25%, due 2018 Utility, 7.875%, due 2017 BB BB B B Secured by first lien on stocks of a global mass media company and U.S. leading television network Secured second lien on theater business Very low leverage Employee owned Substantial asset coverage; high multiple business Strategic assets First maturity; non-callable Solid asset coverage Cable Company, 8.375%, due 2018 B+ Source: MacKay Shields, as of 12/31/13. Carries over 20% of global internet traffic Secured by first lien 3

4 A Complement to Leveraged Loans Expectations for rising rates have led many investors to focus on floating rate loans another asset class that has the potential to perform well in a rising interest-rate environment. Both high-yield bonds and leveraged loans are below investment-grade credits, but there are key distinctions. Loans pay a floating coupon based on a spread over a pre-determined reference rate generally, the U.S. Dollar London Interbank Offered Rate (LIBOR), whereas coupons on bonds are generally fixed. However, loans can generally be redeemed at par at any time by the issuer. High-yield bonds, on the other hand, have upside potential in the event of a tender or early redemption. Higher-quality, short duration high-yield bonds have historically had higher risk-adjusted returns than the leveraged loan index as a whole, making them an attractive complement in a fixed-income portfolio. Past performance is no guarantee of future results. Exhibit 6: Quality Short Duration High Yield Alpha and Beta vs. Credit Suisse Leveraged Loan Index Alpha Beta BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index Source: Morningstar Direct (1/1/98 to 12/31/13) Calculation benchmark: Credit Suisse Leveraged Loan Index. MainStay Short Duration High Yield Fund (MDHAX) MainStay Short Duration High Yield Fund primarily invests in higher-quality, shorter duration high-yield corporate bonds. The Fund s higher credit profile, compared to the broad high-yield market, offers investors high-yield exposure with significantly less credit risk 1. The shorter duration seeks to manage the negative effects of rising interest rates. This combination of lower interestrate risk, compared with longer duration assets and competitive yield over investment-grade bonds, offers investors the opportunity to earn attractive risk-adjusted income. The MacKay Shields High Yield Investment Team manages the Fund through the same bottom-up, fundamental investment process as all of their products. Their strategy involves: Higher-quality high-yield bonds The Fund primarily invests in credits rated BB/B that the team believes have strong credit profiles: substantial asset coverage, conservative debt maturities, and robust liquidity. Corporate debt focus The Fund s focus is non-investment grade corporate debt. Other short duration funds may invest across other asset classes (mortgages, sovereign debt, etc.) which may impact the overall quality of the portfolio. No leverage The Fund does not use leverage, which can increase risk. To learn more about MacKay Shields' views and opportunities in MainStay Short Duration High Yield Fund, visit us at mainstayinvestments.com. MacKay Shields A Leader in Income-Oriented Investing: Experience and Quality - With over 40 years of experience, we are committed to partnering with our clients to deliver: Tailored, income-oriented investment solutions based on their goals and objectives. The highest levels of client service and consistent investment performance. Our People A firm comprised of nearly 140 dedicated employees, including 46 investment professionals. Our Approach Investment teams recognize and integrate the importance of capital preservation into all of their investment philosophies. Long-Term Commitment Similar to our investment approach, we take a long-term perspective toward our clients, their portfolios, and our business. 1. Source: Morningstar Direct, 1/1/98 12/31/13. Based on standard deviation. The BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index (representing short duration high yield) had a standard deviation of 7.21 versus a standard deviation of 8.94 for the Credit Suisse High Yield Index (representing the broad high-yield corporate bond market) since the inception of the BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index on 1/1/98. 4

5 Before you invest The Fund is not a money market fund and does not attempt to maintain a stable net asset value. The Fund s net asset value per share will fluctuate. There can be no guarantee that the Fund will achieve or maintain any particular level of yield. High-yield securities (commonly referred to as junk bonds ) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility. Foreign securities can be subject to greater risks than U.S. investments, including currency fluctuations, less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in tax or currency laws or monetary policy. Floating rate loans are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer s ability to make such payments may cause the price of that bond to decline. Definitions Duration provides a measure of a fund s interest-rate sensitivity. The longer a fund s duration, the more sensitive the fund is to shifts in interest rates. Spread to worst is the difference in overall returns between two different classes of securities, or returns from the same class, but different representative securities. The spread to worst measures the difference from the worst performing security to the best, and can be seen as a measure of dispersion of returns within a given market or between markets. The spread to worst can vary significantly depending on different market and economic variables. Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. Beta is a measure of historical volatility relative to an appropriate index (benchmark) based on its investment objective. A beta greater than 1.00 indicates volatility greater than the benchmark. High-yield (HY) corporate bonds are represented by the Credit Suisse High Yield Index, which is a market-weighted index that includes publicly traded bonds rated below BBB by S&P and Baa by Moody s. Short duration high-yield (SD HY) bonds are represented by the BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index, which is a subset of the BofA Merrill Lynch U.S. Cash Pay High Yield Index, including all securities with a remaining term to final maturity of less than 5 years and rated BB1 through B3, inclusive. Investment-grade (IG) bonds are represented by the Barclays U.S. Aggregate Bond Index, which is a broad-based index often used to represent investment-grade bonds being traded in the United States. Floating rate loans are represented by the Credit Suisse Leveraged Loan Index. An investment cannot be made directly into an index. Leveraged loans are loans extended to companies or individuals that already have considerable amounts of debt. Lenders consider leveraged loans to carry a higher risk of default and, as a result, a leveraged loan is more costly to the borrower. Par value is the face value of a bond. Par value for a share refers to the stock value stated in the corporate charter. Par value is important for a bond or fixed-income instrument because it determines its maturity value as well as the dollar value of coupon payments. Par value for a bond is typically $1,000 or $100. Shares usually have no par value or very low par value, such as 1 cent per share. The market price of a bond may be above or below par, depending on factors such as the level of interest rates and the bond s credit status. In the case of equity, par value has very little relation to the shares' market price. London Interbank Offered Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year. The information and opinions herein are for general information use only. The opinions reflect those of MacKay Shields and not necessarily those of New York Life Investments. New York Life Investment Management LLC does not guarantee their accuracy or completeness, nor does New York Life Investment Management LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. For more information about MainStay Funds, call 800-MAINSTAY ( ) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing. MainStay Investments is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. New York Life Investments engages the services of MacKay Shields LLC, an affiliated, federally registered advisor, to subadvise several mutual funds. The MainStay Funds are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 169 Lackawanna Avenue, Parsippany, NJ 07054, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC. NYLIM MSMSDHY-03/14 5