The recent volatility of high-yield bonds: Spreads widen though fundamentals stay strong

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1 Investment Insights The recent volatility of high-yield bonds: Spreads widen though fundamentals stay strong Kevin Lorenz, CFA, Managing Director, Lead Portfolio Manager of TIAA-CREF's High-Yield Fund Jean Lin, CFA, Managing Director, Co-Portfolio Manager of TIAA- CREF's High-Yield Fund Article Highlights After recording solid gains over the last few years, the high-yield bond market experienced a broad sell-off and increased volatility in May and June as investors reacted to rising interest rates across the fixed-income landscape. Because the increase in rates was so sudden, high-yield bonds responded more negatively than has been the case in previous periods of rising rates. High-yield corporate bond fundamentals remain strong, however, and the recent drop in prices and increased interest rates has made valuations more attractive. A strategic allocation to high yield continues to offer compelling long-term benefits. After producing double-digit gains in 2012 and solid returns through the first four months of 2013, high-yield bonds suddenly reversed course in May and into June. In the wake of sharply rising yields for U.S. Treasuries that began in early May, high-yield spreads, the difference between yields on higher-yielding, non-treasury securities and the 10-year Treasury note, reverted back to levels not seen since the end of The increase in spreads was dramatic over the last two months. Between May 9 and June 25, for example, the option-adjusted spread (OAS) on the BofA Merrill Lynch US Cash Pay High Yield Index widened by 109 basis points (from 417 to 526) even as the 10-year Treasury yield soared. 1 Widening spreads usually indicate increased risk for bond investors, though with improving economic fundamentals, we believe the recent increase in spreads has to do with investor jitters over the Treasury rate increase, not a changing outlook for corporations. The recent spread-widening in high yield did not indicate underperformance versus Treasuries, however. For the two-month period from May through June, high-yield returns (-2.37%, as measured by the BofA Merrill Lynch US Cash Pay High Yield Index) were ahead of both Treasuries (-2.79% for the Barclays U.S. Treasury Index) and investment-grade corporate bonds (-5.04% for the Barclays

2 Capital U.S. Corporate Investment Grade Bond Index) while lagging equities (+0.96% for the Standard & Poor s 500 Index). 2 The spike in volatility occurred over such a short timeframe that it created broadbased investor risk aversion, causing sharp fund outflows and price declines across many major asset classes in May and June. Markets have settled to some degree, but have not yet completely stabilized. Figure 1: High-yield spreads jumped in May and June Fast-rising Treasury yields concerned investors We do not believe the May-June selloff in high yield to have been a response to deteriorating credit fundamentals or rising default expectations. In fact, since the financial crisis, corporate balance sheets have strengthened, debt levels have declined and existing corporate debt has been extended and refinanced at lower rates. The U.S. economy has also perked up in recent months, particularly in the private sector, which has shown many signs of improvement. Employment, housing and consumer confidence have risen in Investors have been more focused in recent months on the statements coming from the U.S. Federal Reserve, rather than on an improving economy. The Fed has purchased $85 billion of bonds each month in an attempt to stimulate economic growth through its quantitative easing (QE) program, which is aimed at keeping interest rates very low in an effort to stimulate the economy. Investors have long feared that when the Fed stops purchasing bonds that prices would fall as interest rates increase. Fed comments in recent months have suggested that it would taper or reduce QE purchases sometime this year, which prompted investors to sell before it happens.

3 The role of high-yield bonds in a diversified portfolio With the recent volatility, some investors may question whether high-yield bonds belong in their portfolios. Regardless of where we are in the economic or market cycle, high-yield fixed income plays an important role in generating potentially attractive risk-adjusted returns and providing potential diversification for investors. High yield should be regarded as a core, long-term holding in most portfolios. High-yield bonds generate returns through a higher yield (coupon) than can be found in other fixed-income instruments; the higher yields compensate for potential price volatility and elevated default risk. From , high-yield securities outperformed broad indices of stocks and bonds, generating returns superior to those of investment-grade fixed income and comparable to equities with less volatility (see below). High yield (Bank of America Merrill Lynch High Yield Master Index) High-grade corporate bonds (Bank of America Merrill Lynch High Grade Corporate Index) Big stocks (Standard & Poor s Index of 500 Common Stocks) Small stocks (Russell 2000 Index) Average Annual Return (%) Standard Deviation High yield therefore can be said to occupy a middle ground, as the asset class exhibits risk and return characteristics that lie somewhere between those of stocks and investment-grade bonds, while maintaining several unique characteristics, including: Diversification High-yield bonds have a low correlation with other varieties of fixed income. Importantly, they are negatively correlated with U.S. Treasuries. And because of their low correlation with equities, they could also potentially reduce volatility in stock portfolios. 3 Low duration High-yield bonds, because they have higher coupons and tend to have maturities of 10 years or less, display relatively low sensitivity to interest rates. Like other bonds, high yield has experienced short-term volatility during the extraordinary fluctuations of interest rates over the past 15 years, but the effects of such fluctuations tend to smooth out over time. The spread of high-yield bonds over investment-grade or Treasuries can narrow when rates rise without necessarily

4 eroding prices; today s elevated spread, given the historically low default rates currently prevailing, may provide a wider margin of protection. Coupon income High-yield bonds have experienced extraordinary demand in recent years as investors reached for yield amid the unprecedented low interest rate environment. This has driven up prices, limiting their potential for price appreciation. But short-term price fluctuations tend to cancel each other out; in the long run, the income component of high yield comes to dominate total returns and account for its historical out-performance. What happens when interest rates rise? After several years of post-crisis interest rates hovering around record lows, many market participants are anticipating an eventual rise in interest rates. Interest rates generally climb amid economic recovery, growth and inflation. In these kinds of markets, investor risk appetite rises, which may cause investors to favor high-yield bonds over other types of bonds. For their part, issuers experiencing improved profitability and cash-flow generation exhibit reduced credit and default risk, improving the risk characteristics of their highyield debt. In a rising interest rate environment, elevated risk appetite and improving credit characteristics have driven high-yield debt to outperform other fixed income securities. Although high-yield spreads have recently defied conventional wisdom by widening rather than narrowing, over longer periods during which rates increased more gradually, high yield has generally performed as expected. For example, between July 24, 2012, and June 19, 2013, a period of 330 days, the 10-year Treasury yield rose 91 basis points. At the same time, high-yield spreads narrowed by 152 basis points (from 630 to 478 bps). A long-term focus provides more insight into how highyield is likely to behave when markets are not subject to unusual pressures and anomalies, such as the potential slowdown or end of the Fed s monthly bond buying program. High-yield fundamentals remain strong The economic strengthening that has fueled speculation about Fed tapering and sent markets tumbling is the same economic strengthening that provides a favorable backdrop for high-yield investing over the long term. We believe the high-yield market will continue to improve on a fundamental basis. With fundamentals on solid footing, the widening of spreads has created clear buying opportunities. High-yield valuations are more favorable now than they were a month ago.

5 High-yield investors should avoid the temptation to get caught up in short-term price and spread volatility and focus instead on long-term fundamentals such as economic growth and default risks. A strategic allocation to high yield continues to offer compelling benefits for diversified, long-term investors. For more information on TIAA-CREF s views on high-yield investing, read our white paper, "The enduring case for high-yield bonds." 1 Option-adjusted spreads measure the relative value of fixed-income securities that contain an embedded option (such as a call provision in a corporate bond); they are quoted as a spread, or differential, over a benchmark security in this case, the 10-year U.S. Treasury yield. The wider the option-adjusted spread, the higher the implied return and risk of the bond, compared with the benchmark. 2 It is not possible to invest in an index. Performance for indices does not reflect investment fees or transaction costs. 3 For example, from 1993 to 2012, high-yield bond returns have exhibited negative correlation to Treasuries (-0.10), low correlation to high-grade corporate bonds (0.56), and relatively low correlation to equities (0.62). High-yield bonds are subject to interest rate and inflation risks, and have significantly higher credit risk than investment-grade bonds. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance does not guarantee future results. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc., is a registered investment adviser and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). TIAA, TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and FINANCIAL SERVICES FOR THE GREATER GOOD are registered trademarks of Teachers Insurance and Annuity Association Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY C11461