High Yield Bonds A Primer

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1 High Yield Bonds A Primer With our extensive history in the Canadian credit market dating back to the Income Trust period, our portfolio managers believe that there is considerable merit in including select Canadian high yield investments within a wellconstructed portfolio. Our investment thesis is based on a number of factors, including the following: Because of its infancy, the Canadian high yield market displays significant pricing inefficiencies due to the limited credit history of issuers; Credit rating agencies have a short history of assessing credit risk on Canadian corporations and this is reflected in the relatively lower credit ratings that they apply to new issuers; Strong covenants in the Canadian high yield market may provide significant protection to investors against deterioration in serviceability and potential default; With their high position within the corporate capital structure, i.e., high yield bonds sit ahead of converts, preferreds and common equity holders, if you are willing to hold an equity position, why not hold the high yield debt? In the current market environment, high yield debt still appears fairly priced relative to investment grade and sovereign debt; Finally, the Canadian high yield market has matured significantly since the late 2000s with increased issuance and institutional investment appetite, resulting in a deeper secondary market, which satisfies our test of liquidity and complies with our disciplined selling strategies. Until 2009, corporate and investor experience in the high yield space was generally restricted to the USA where a deep and liquid market had developed for non-investment grade securities. In Canada, there was little demand for

2 corporate high yield paper as government securities continued to carry relatively attractive yields and there were other yielding assets that satisfied demand. But two events changed the Canadian landscape the removal of favoured tax status for Canadian Income Trusts in 2006 and the collapse of Lehman Brothers Inc. ( Lehman ) in While legislative changes for Income Trusts created an investor void of high yield, the collapse of Lehman precipitated a credit crisis which resulted in reduced corporate lending from the banks and forced corporations to look elsewhere for reliable credit sources. Today the market in Canada has grown with a total issuance of over $13 billion across 44 different corporations and 58 individual issues. In addition to growing Source: TD Bank supply, demand drivers have also matured with over 200 institutional investors running high yield strategies that have all but absorbed new supply. Flow data supports the case for high yield investing with data showing a steady liquidation of equity and money market investments, in favour of balanced, fixed income and high yield mandates. Source: Scotia Capital Source: Scotia Capital

3 Features of High Yield Bonds In general, high yield bonds are defined in Canada as corporate issues which carry a credit rating below BBB (Moody s) or do not carry a rating at all. But while the credit rating may determine its relative risk profile compared to other fixed income instruments, it is important from an investment perspective to understand where these types of instruments fit within the corporate structure. Canadian high yield bonds reside at the top of the corporate capital structure and usually have a senior unsecured or secondary lien claim on assets. Source: Bank of Montreal Source: Scotiabank

4 Unlike equity investments, high yield bonds carry relatively restrictive covenants that help protect holders in the event of bankruptcy providing priority over assets to pay bondholders in advance of certain other stakeholders. And interestingly, covenant protection generally gets tighter the lower the credit rating. Finally, according to Moody s, covenants with Canadian issuers are generally considered to be stronger than those in the USA. 1 From a pricing perspective, the relative infancy of the Canadian high yield market has also resulted in some mispricing of credits relative to similar issues in the U.S. market. This has in general resulted in higher coupons and tighter covenants than might otherwise be the case. Given the limited credit experience that issuers in Canada have experienced, credit agencies are reluctant to provide higher credit ratings until such time as a credit history has been established. As a result, Canadian issuers find themselves with generally lower credit ratings for their first issue with the expectation that credit ratings will improve as credit history develops. Due to these structural issues, Canadian investors may capture materially higher coupons relative to the credit risk assumed. As the market develops, greater pricing efficiency is expected to result in lower spreads and higher credit ratings among experienced issuers. Canadian High Yield Spreads vs. US High Yield Spreads As of November 20 th, 2012 Source: Bloomberg Finance L.P. 1 Canadian High Yield Bonds Offer More Investor Protection Than US Bonds, Moody s Investor Service. September 10 th, 2012

5 Secondary Market Characteristics In addition to their high coupon, high yield bonds also exhibit other characteristics which make them a compelling investment within a well diversified portfolio. Because of the higher coupons associated with high yield bonds, they carry lower interest rate risk compared to sovereign and investment grade issues with the same maturities. 2 Consequently, high yield investments may have better risk/return characteristics as prices are less volatile relative to returns. Source Scotiabank And where fixed income portfolios may underperform in a rising interest rate environment, high yield bonds will generally outperform. Why? Because higher interest rates generally mean improving economic conditions, this translates into better operating environments for corporate issuers. If company profitability is 2 Duration is the common metric used to measure a bond s price sensitivity to interest rate risk. Simply put, the higher the coupon, the lower the duration of a bond and therefore the lower it s correlation to changes in interest rates.

6 improving, then credit spreads will tighten and high yield bond prices will rise. Thus making high yield investments a compelling fixed-income investment in an environment where interest rates will eventually start to rise. Barometer Security Selection For Barometer, we look at the high yield bond market as essentially being divided into three camps: i) bond issuers who were once investment grade and have fallen into the high yield camp as a result of deterioration in their balance sheet and overall credit quality; ii), issuers who are new to the market and start as high yield issuers with expectations that they will evolve into investment grade credits over time; and iii) issues which are fairly priced and which will likely remain noninvestment grade. In keeping with the Barometer investment approach, we focus on the second camp of strong corporate issuers who have constructive balance sheets and strong cash-flow projections. In addition to a number of these and several other quantitative factors, our portfolio managers spend considerable time understanding qualitative issues like the quality of assets (and their subsequent ability to generate cash flow), management expertise, the cyclicality of the business and barriers to entry. High yield bonds constitute only a portion of our overall asset allocation today, and because we are a tactical manager, we pick and choose only those issues which we feel would be constructive to our portfolios. When conditions are no longer supportive for a particular issue or the asset class in general, we seek to invest elsewhere. Dedicated high yield managers however, are forced to be fully invested in the asset class, which places the onus on the investor to make the decision to remove the exposure from their portfolio.

7 Barometer Disciplined Approach Disciplined selling is a key part of the Barometer investment philosophy and although high yield investments present unique challenges in this respect, we still employ a strict strategy focused on managing small losses so that they do not translate into big losses. Similar in philosophy to our equity sell strategy, following is out approach to high yield: Upon investing in a high yield issue, we construct our own cash-flow and interest coverage models to ensure that the company has the capacity to pay its obligations; Once established, we set exit levels on the basis of both absolute and relative developments in these metrics, and should coverage or cash-flow metrics commence a downward trend, we will exit the position; If we own the equity of an issuer, then we monitor the equity position with an eye on the potential impact on the corresponding bond issue; should we elect to liquidate the equity, we will reassess our view on the underlying credit;

8 From a yield perspective, if any issue that we own starts to trade through a predetermined yield level, we will liquidate; and, Most importantly, because Barometer does not manage its high yield portfolio against a high yield benchmark, any material deterioration in this market will see Barometer exit the space altogether and seek leadership elsewhere. Current Performance In broad market terms, we believe the high yield sector currently remains fairly priced and in our opinion is well positioned for a rebound should economic conditions start to improve. Yield spreads over investment grade bonds continue Source: Bank of Canada, Bloomberg Finance L.P. to remain attractive, and present considerable scope for price appreciation while also generating attractive income. With respect to our current holdings, overall we have experienced positive movement in yields over the course of our holding period.

9 As of November 16 th, 2012 Source: Bloomberg Finance L.P. Key Risks No investment strategy is without its hazards, and although we feel that our portfolio of high yield investments provides attractive risk adjusted returns, it is important to point out some of the unique risks associated with high yield corporate bonds. As with all corporate fixed-income investments, one of the greatest risks to a bond portfolio is an expansion in credit spreads, which would come as a result of an overall deterioration in perceived credit quality for underlying issuers. This deterioration in credit quality could come as a result of a significant market event (i.e., the failure of Lehman, which had adverse implications for all corporate borrowers), deterioration in the broader economy, which would impact corporate profitability, or finally as a result of a specific corporate event, which would be more issue specific. In each case, a widening of the spread over government securities would likely result in a price decline in the portfolio and would negatively impact returns.

10 While we cannot completely eliminate the risks associated with unforeseen market disruptions like we experienced in 2008, as a tactical manger we can react to market signals that point to deterioration in an asset class and choose to liquidate our exposures. As mentioned previously, unlike style specific funds (i.e., High Yield Corporate Bond Funds) we are not mandated to be in the asset class and can chose to move out of it should the risk/reward metrics show deterioration. However, there is always a risk that unforeseen market events could materially impact liquidity in the secondary market preventing our ability to liquidate positions. But given that our thesis is to own issues with constructive valuations and coverage metrics, and by observing concentration limits across asset classes and single securities, we position our portfolios such that we can best manage through forced liquidation in distressed markets. From the perspective of individual issuers, we monitor our cash-flow models and coverage ratios to ensure that issuers have the capacity to pay and that there are sufficient unencumbered assets on the balance sheet to satisfy claims in the event of default. In the event that these models point to significant deterioration, we may liquidate the position and redeploy capital elsewhere. A move higher in interest rates would also have a detrimental impact on bond prices (as interest rates and bond prices are inversely related). But as noted earlier in this paper, high yield bonds have a much weaker correlation with broader bond yields, as higher interest rates are generally associated with a stronger economy, which is positive for corporate issuers. While we construct and monitor our high yield portfolio in the basis of relative spreads, the average duration for our high income portfolio is just under 4 years suggesting that there is significantly lower interest rate risk in the portfolio then a mid- to long-term investment grade or sovereign bond portfolio. Finally, bankruptcy is the most extreme risk facing an investor in the corporate structure be it as a common shareholder or a bondholder. While there can be no guarantee that either will recover all or part of their investment in the event

11 that a company becomes insolvent, by owning the bond an investor will rank in priority on claims on the corporate assets over the common equity holders. Conclusion While on the path to maturity, we continue to see opportunities in the Canadian high yield market, which presents attractive risk/reward opportunities. With our experience in the Canadian credit landscape through the last decade, we have the tools to confidently access discrete credit risk in this space. And, we believe that there are pricing discrepancies which present compelling reasons to include quality high yield issues within our investment portfolios. High yield bonds provide attractive income streams but at the same time are natural hedges against higher interest rates which, we see as inevitable over the next few years. These greater correlations to broader economic conditions, as opposed to central bank actions, help provide efficiency within a well-constructed portfolio. Disclaimer: The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. This report is for informational purposes only and is not an offer or solicitation with respect to the purchase or sale of any investment fund, security or other product. Particular investment or trading strategies should be evaluated relative to each individual s objectives. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. This document does not provide individual financial legal, investment or tax advice. Please consult your own legal, investment and tax advisor. All opinions and other information in this document are subject to change without notice. Barometer is not liable for any errors or omissions in the information or for any loss or damage suffered.

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