Documeent title on one or two. high-yield bonds. Executive summary. W Price (per $100 par) W. The diversification merits of high-yield bonds

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1 April 01 TIAA-CREF Asset Management Documeent title on one or two The lines enduring Gustan case Book for pt high-yield bonds TIAA-CREF High-Yield Strategy Kevin Lorenz, CFA Managing Director Co-portfolio manager TIAA-CREF High-Yield Strategy Jean Lin, CFA Managing Director Co-portfolio manager TIAA-CREF High-Yield Strategy James Tsang, CFA Director Global Derivatives and Quantitative Portfolio Management Executive summary Market conditions are causing investors to question whether investments in U.S. high-yield bonds are worth the additional risk. Demand has reduced yields to record lows and bid up prices to levels that limit further appreciation. Meanwhile, the prospect of rising interest rates carries the potential for price declines. Yet our research shows that high-yield bonds can still play a beneficial role in diversifying portfolios, helping reduce volatility and enhancing returns. We also find that the income component of high-yield bonds tends to drive long-term returns, outweighing price fluctuations caused by short-term changes in market demand and interest rates. A strategic, long-term allocation to high yield can offer important benefits: (i) diversification by virtue of low correlations to higher-grade fixed-income securities and to equities; (ii) lower sensitivity to rising interest rates than Treasuries and high-grade bonds; and (iii) opportunities for attractive risk-adjusted returns. To address the higher risks of high-yield bonds, we suggest limiting exposure to securities with higher default risks in order to preserve principal and allow income to drive returns. The diversification merits of high-yield bonds The influx of capital into the U.S. high-yield bond market has raised prices and reduced yields to record lows, as investors have pursued higher fixed-income returns amid historically low interest rates (Exhibit 1). Exhibit 1: High-yield bond yields have declined alongside an increase in price W Price (per $100 par) W Yield to worst Yield to worst (%)* Yield has dipped below 6% in 01 for the first time on record (5.71% as of /1/01) Par-weighted price ($) 0.0 Dec-0 Dec-0 Dec-0 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-1 Feb-1 Mar-1 50 Yields and prices of the BofA Merrill Lynch US Index (December 1, 00 March 1, 01) * Yield to worst is the lowest yield a buyer can expect among reasonable alternatives, such as yieldto-maturity or yield-to-first-call-date. It assumes the borrower s ability to repay, but it also makes worst-case scenario assumptions by calculating the returns received if the borrower exercised certain provisions (such as a call or prepayment) prior to the stated maturity date.

2 Additionally, the progressive 0-year decline in interest rates is limiting the potential for bond-price increases, while increasing the prospect of higher rates and potential bond-price declines in the future. These developments have led investors to rethink their fixed-income portfolios and question whether high-yield bonds adequately compensate them for their higher default risk, compared with high-grade corporate bonds and Treasuries. Yet our research demonstrates that, despite current low yields and the prospect of rising interest rates, a long-term, strategic allocation to high-yield bonds offers significant diversification benefits. For example, over the past 0 years (199 01), 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 (0.6), as shown in Exhibit. High-yield bonds have exhibited negative or low correlations to Treasuries, high-grade corporate bonds and equities over the past 0 years. Exhibit : High-yield bonds have exhibited low correlations to other bonds and to equities* High-yield 1 High-yield 1.00 Leverage loans Mortgage backed Ten-year treasuries Threemonth treasuries 5 High-grade corporates 6 Large stocks 7 Small stocks 8 Leverage loans Mortgagebacked Ten-year treasuries Three-month treasuries High-grade corporates Large stocks Small stocks * January 1, 199 February 8, 01 1 BofA Merrill Lynch US Cash Pay Index S&P/LSTA Leveraged Loans Index BofA Merrill Lynch US Mortgage Backed Securities Index BofA Merrill Lynch 10-year US Treasury Index 5 BofA Merrill Lynch US -month Treasury Bill Index 6 BofA Merrill Lynch US Corporate Index 7 S&P 500 Index 8 Russell 000 Index

3 High-yield bonds can serve as powerful diversifiers in two important respects. First, the past two decades, which spanned several market cycles, show that adding high-yield bonds to a pure Treasury portfolio significantly increased risk adjusted returns. The efficient frontier in Exhibit provides a clear illustration: An allocation of 0% to high yield increased the annualized returns of a 100% Treasury portfolio by 7 basis points, while reducing annualized volatility by 1 basis points; a high-yield allocation of 65% added 157 basis points in annualized return to a 100% Treasury portfolio, with only a slight increase in risk. Exhibit : Adding high-yield bonds to a Treasury portfolio increased risk/adjusted returns* Annualized average returns (%) % High yield/70% Treasuries 65% High yield/5% Treasuries 100% Treasuries 100% High yield Annualized standard deviation * According to The BofA Merrill Lynch US Cash Pay Index, and BofA Merrill Lynch Current 5-year and 10-year US Treasury Index, as measured from January 1, 199, through February 8, 01. Based solely on historical returns and standard deviations. Second, high-yield bonds can help reduce the volatility of a stock portfolio, making the case for including them in a diversified portfolio over the long term. This is evident not only in their low correlations to equities (Exhibit ) but also in their lower volatility compared to equities: From 199 through 01, high-yield bonds (represented in the BofA Merrill Lynch US Index) had a standard deviation of returns of 8.6, versus for large caps (S&P 500) and for small caps (Russell 000). Mitigating interest-rate risk With interest rates at historic lows, any long-term strategy should consider the potential effect of interest-rate increases on bond prices. Here, too, high-yield bonds can play a role: Compared to fixed-income alternatives, high-yield bonds have been less sensitive to interest-rate fluctuations, as reflected in their negative correlation with Treasuries. In contrast, high-grade corporate bonds and mortgage-backed securities had much higher correlations with Treasuries, at 0.65 and 0.81, respectively (Exhibit ). Additionally, during 1998 to 01, there were 1 different periods of increase in the 10-year Treasury rate of 50 basis points or more. The effect of these increases on high-yield bonds was remarkably lower than on Treasuries and high-grade corporate bonds, based on a comparison of average returns. During these periods, an average increase of 86 basis points in the 10-year Treasury yield resulted in losses for high-grade corporate bonds (-0.59%), 10-year Treasuries (-5.8%) and mortgage-backed securities (-0.9%) whereas high-yield returns actually increased by.%, on average (Exhibit ).

4 The effect of interestrate increases on high-yield bonds has been lower than on Treasuries and high grade corporate bonds. Exhibit : High-yield bonds have exhibited lower sensitivity to increases in the 10-year Treasury rate in 1 different periods during Period range 09/0/98 01/1/00 10/1/01 1/1/01 0/8/0 0/1/0 09/0/0 11/0/0 05/1/0 08/1/0 0/1/0 06/0/0 08/1/05 10/1/05 1/1/05 06/0/06 0/1/08 06/0/08 1/1/08 0/8/09 0/1/09 06/0/09 11/0/09 1/1/09 08/1/10 0/1/11 10Y Treasury yield start 1 10Y Treasury change in yield (bps) 1 OAS (bps) start OAS (bps) end change in OAS (bps) return High Grade return Mortgage backed return 10Y Treasury return S&P 500 return.% % -1.7% 1.7% % 9.%.7% % -1.0% -1.% -.9% 8.61%.87% % -1.86% -1.07% -.71%.76%.61% % 0.09% 0.6% -.0% 15.1%.5% % -.6% -0.95% -7.0% 5.07%.8% % -.% -1.16% -.8% 1.7%.0% % -.59% -1.8% -.5% -0.87%.0% % -1.7% -0.1% -.87%.71%.% % -0.7% -0.56% -.5% -.7%.5% % -1.% 0.8% -5.87% %.69% % 10.8% 0.61% -6.19% 15.9%.0% % -1.00% -1.8% -.85% 1.9%.8% % -0.0% 0.51% -6.0% 7.78% Mean.60% % -0.59% -0.9% -5.8% 7.7% 1 BofA Merrill Lynch 10-year US Treasury Index BofA Merrill Lynch US Cash Pay Index BofA Merrill Lynch US Corporate Index BofA Merrill Lynch US Mortgage Backed Securities Index Sources: TIAA-CREF, Bank of America Merrill Lynch, and Bloomberg High-yield bonds have been less sensitive to interest-rate increases for two reasons. First, their incremental yield or spread over Treasury and high-grade corporate yields serves as a cushion: It can narrow when rates rise without necessarily causing high-yield bond prices to erode and serves as a buffer to mitigate the effect of rising rates on a fixed-income portfolio. Since today s high-yield spreads over Treasuries are relatively high when compared to historical periods with similarly low default rates, they have the capacity to provide a wider margin of protection against high-yield price declines in a rising-rate environment. The BofA Merrill Lynch US Index (representing high-yield corporate bonds) showed a spread of 98 basis points in February, while the Moody s US trailing 1-month speculative-grade default rate stood at.8%. In contrast, high-yield spreads averaged 18 basis points during , when the default rate averaged.5%, and 1 basis points during , when the default rate averaged.55%.

5 The second reason why high-yield bonds are less sensitive to interest-rate increases is that rising rates typically correspond to an improving economic environment, rising corporate profits and stronger balance sheets all of which tend to reduce default rates. The attractiveness of high-yield spreads Despite the diversification merits of high-yield bonds and their lower interest-rate sensitivity, investors may be asking: With yields at record lows, are these bonds still attractive? Compared to higher-grade alternatives, the answer is yes. The yield of high-yield bonds stands at 5.71% 1, which is still about three times the 10-year U.S. Treasury yield of 1.85% a considerable spread in today s low-rate environment. And while high-yield bonds carry a greater risk of default, this risk has declined significantly since the financial crisis (Exhibit 5) and we believe it will remain subdued over the next couple of years, owing to the economic recovery and improved credit metrics of issuers. Exhibit 5: The default rates of high-yield bonds have declined markedly since the financial crisis of * 15 Issuer-weighted rate (%) Dec-0 Dec-0 Dec-0 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-1 * According to the Moody s US trailing 1-month speculative-grade default rate As of February 8, 01 Source: Moody s Further, default rates aren t evenly distributed across the high-yield market as a whole and there are noteworthy disparities in credit risk among categories of high-yield bonds that investors should consider in their long-term allocations. Addressing the credit risk of high-yield bonds Both short- and long-term comparisons of high-yield default rates show that higher-quality bonds carry disproportionately less risk. According to Moody s, over an average five-year period between 199 and 01, 7.% of Ba-rated bonds and 19.% of B-rated bonds defaulted, versus 1.8% of bonds rated C to Caa+. 1 Yield-to-worst figures of the BofA Merrill Lynch US Index, as of March 1, 01 Source: Bloomberg 5

6 As a result, higher-quality bonds in the high-yield market have experienced lower volatility and better risk-adjusted returns, as reflected in their higher Sharpe ratios (Exhibit 6). Most notably, over the last two decades, BB-rated bonds exhibited Sharpe ratios twice the levels of C-CCC-rated bonds and even higher risk-adjusted returns than high-grade corporate bonds and Treasuries. Exhibit 6: U.S. high-yield bonds of higher credit quality show attractive risk-adjusted returns over the last two decades* 0. W Sharpe ratio W Average annual return 16 Sharpe ratio Average annual return (%) 0.00 AAA AA A BBB BB B CCC 0 * From January 1, 199, through February 8, 01 While high-yield bonds with the lowest credit rating (C-CCC) have the potential for higher average annual returns, their higher default risk also produces higher principal losses over the long term. Their historically lower Sharpe ratio reflects these principal losses and indicates lower returns per unit of risk (Exhibit 6). Therefore, we recommend a high-yield strategy emphasizing bonds in the mid- to high-quality segments (such as those rated B and BB), rather than bonds with the lowest credit ratings. Income as the predominant component of high-yield returns Recent growth in demand for high yield and the exceptionally low interest-rate environment have limited the potential for appreciation through future bond-price increases. While price can be an influential component of returns for high-yield bonds in the short run, long-term data show that income not price fluctuations is the predominant source of their returns. Consider the past quarter century as a case in point when comparing annual to annualized returns. During the last 5 years ( ), the annual return of high-yield bonds has been within ± percentage points of income return in just one year, according to the BofA Merrill Lynch US Index (a proxy for high-yield corporate bonds). In contrast, on an annualized basis, over the entire period, the index delivered returns of 8.88% despite a price decline (or principal loss) of 0.7%. The index more than made up for this principal loss thanks to a coupon of 9.61%. Our conclusion is that, despite short-term price volatility, year-over-year price fluctuations tend to cancel each other out on a cumulative basis over the longer term, allowing the income component (i.e., the coupon) to drive returns. 6

7 Managing default risk to preserve principal The higher default risk of high-yield bonds can limit the ability to preserve principal the key to a long-term strategy for maximizing risk-adjusted returns. Principal preservation is important because risks in high-yield bonds can be asymmetrical in relation to returns: There is upside potential, but a default could trigger a significant loss in value and wipe out coupon gains. Hence, a successful high-yield strategy is as much about reducing exposure to potential defaults as it is about pursuing attractive income. To help achieve this outcome, we advocate using active management through proprietary credit research. To learn more about TIAA-CREF Asset Management, visit asset management or speak with your relationship manager. Conclusion Despite cyclical price and yield fluctuations, high-yield bonds especially those of mid- to high-credit quality have demonstrated their ability to diversify portfolios by providing the following long-term benefits: Attractive risk-adjusted returns Negative or low correlations to Treasuries, high-grade corporate bonds and equities Lower sensitivity to interest rates than Treasuries and high-grade bonds Significantly higher yields compared to high-grade corporate bonds and Treasuries A predominant income component that in the long run has outweighed short-term price fluctuations These characteristics represent an appealing risk/return profile and make an enduring case for diversifying portfolios through a strategic allocation to high-yield bonds. 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. 01 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 70 Third Avenue, New York, NY C _880 (0/1)