High Yield Bonds: Income Potential in a World Starved for Yield

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1 High Yield Bonds: Income Potential in a World Starved for Yield Q&A with the Portfolio Managers Class A: CPHYX Class C: CCHIX Class I: PHYTX Class P: PYHPX Mark Denkinger and Darrin Smith, Principal High Yield Fund Portfolio Managers, discuss the high yield landscape and where they see opportunities. The 10-member high yield team averages over 15 years investment experience and manages more than $6 billion in high yield assets. The team has managed the Fund for three years and aims to offer income and total return potential by effectively identifying and adapting to market risk. Mark Denkinger, CFA, Portfolio Manager 21 years investment experience Mark joined the firm in 1990 and assumed his current role in 2004, having previously served as a Portfolio Manager and Senior Research Analyst. Darrin Smith, Portfolio Manager 20 years investment experience Darrin joined the firm in 2007 and has over 10 years experience as a High Yield Portfolio Manager Why do you believe now is a good time to invest in high yield? MARK: If low interest rates have you looking for income, then we think high yield should be on your radar. High yield offers a potentially higher income than government bonds and investment-grade credit due to the additional risk associated with investing in high yield bonds. The real attractiveness comes from a backdrop of very strong fundamentals. Corporate earnings remain very good; default rates are at or near record lows. And the yield advantage continues to be very attractive, with strong diversification benefits. 15% 12% 9% 6% 3% 0% Figure 1: Capture the Gap between Default Levels and Spreads January March 2012 High Yield 12-Month Trailing Default Rate Barclays High Yield Index Spread Over Treasuries Default Rates vs. High Yield Spreads { 600 Capture 400 the Gap Source: Barclays POINT. Yield spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. Moody s 12-Month trailing default rate is based upon the number of high yield bond issuers that have defaulted in the last year. Default risk is when companies or individuals will be unable to make the required payments on their debt obligations. See glossary for definition of the index. Index performance information reflects no deduction for fees, expenses, or taxes. Indices are unmanaged and individuals cannot invest directly in an index. Past performance is no guarantee of future results. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Lower-rated securities are subject to additional credit and default risks. Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company s preferred securities are senior to common stock but subordinated to all other types of corporate debt. International investing involves increased risks due to currency fluctuations, political or social instability, and differences in accounting standards. These risks are magnified in emerging markets. REIT securities are subject to risk factors associated with the real estate industry and tax factors of REIT registration. Asset allocation/diversification does not guarantee a profit or protect against a loss.

2 What are the benefits of high yield to an investor s portfolio? MARK: If your portfolio s fixed-income allocation is currently limited to government bonds and investment-grade credit, then high yield can offer the potential for higher income. Similarly, high yield is a potential source of diversification for fixedincome portfolios. (See Figure 2 below.) The income component of high yield total returns also offers investors a potential cushion to price volatility, which has the capability to stabilize a portfolio s overall total return. With historically low correlations to government debt, equities, investmentgrade corporate credit, and emerging market debt, high yield can be a source of diversification that could help reduce overall portfolio volatility. Because bondholders have priority over preferred and common stockholders, high yield puts investors above equity in the firm s capital structure. This preferred treatment could help prove valuable in potentially managing downside losses and thereby improving long-term performance. Figure 2: Low Correlation of High Yield Offers Diversification Benefits Barclays U.S. Treasury Bond 7-10 Years Barclays Muni Bonds U.S. Corporate Investment Grade Index 10-Year Correlations to High Yield Bonds S&P 500 Source: Zephyr StyleADVISOR. Past performance is no guarantee of future results. An investor cannot invest directly into an index. Index performance does not reflect performance of any Principal Fund. This illustration does not reflect past, current, or future performance of this or any investment product. Correlation measures the relationship between two investments. A correlation of 1.0 means both investments respond identically to changes in the market, a correlation of 0 means there s no relationship between how the investments respond to changes in the market, and a correlation of -1.0 means the investments respond completely opposite to changes in the market. Asset allocation/diversification does not guarantee a profit or protect against a loss. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. See glossary for index definitions. What are your current themes for managing the High Yield Fund? DARRIN: We feel that the U.S. high yield market offers some attractive opportunities for investors. Our analysis points to several sectors where we find good fundamental stories given the current macroeconomic background. We are currently pursuing overweighted positions in wireless communications, gaming, natural gas pipelines, and certain environmental companies. As many European 1 companies issue bonds denominated in U.S. dollars, we also find attractiveness in European cable and entertainment companies. While we believe that Europe continues to offer some attractive opportunities, we maintain that issuer selection will be critical because of the ongoing Eurozone 2 crisis, which means that liquidity in Europe could be fragile at times. On the other hand, there are certain sectors where our research has given us some relative pause. We currently find that companies in the textile, building materials, automotive, and home construction industries offer a sub-optimal mix of fundamental, technical, and valuation factors. Overall, we keep our focus on the high yield universe s more liquid issuers; we find that this provides us the needed ability to show discipline and execute our investment process, regardless of the risk-on or risk-off mindset of the market. 1 International investing involves increased risks due to currency fluctuations, political or social instability, and differences in accounting standards. 2 A geographic and economic region that consists of all the European Union countries that have fully incorporated the euro as their national currency. 2

3 Why is the macroeconomic perspective a beneficial approach over the next 12 to 18 months? DARRIN: We have a fundamental, bottom-up style that embraces a macroeconomic perspective. This allows us to view the Fund in a context and direction that a strictly bottom-up manager would miss. We invest in the larger, more liquid issuers in the high yield universe; combined with a top-down viewpoint, this allows the Fund to be repositioned quickly. Our philosophy and process are designed to provide high yield returns with lower volatility. We use a stable, repeatable, and unemotional investment approach that seeks to provide strong and consistent performance. We believe it s an approach that can be relied upon in up and down markets. We have used this disciplined approach to help us avoid defaults in the past. 12% Figure 3: Better Returns with Lower Volatility vs. the Index 10-year period ending March 2012 We use a stable, repeatable, and unemotional investment approach that seeks to provide strong and consistent performance. Return 10% 8% Principal High Yield A 1 Market Benchmark: Barclays U.S. Corporate High Yield 6% 6% 8% 10% 12% Risk 2 1 Return shown excludes sales charge. 2 As measured by standard deviation, see glossary for definition. Source: Zephyr StyleADVISOR. Past performance is no guarantee of future results. An investor cannot invest directly into an index. Index performance does not reflect performance of any Principal Fund. This illustration does not reflect past, current, or future performance of this or any investment product. If sales charges were reflected, performance illustrated would be lower. What differentiates your approach? MARK: One of the best opportunities with a fund like ours is the ability to access a wide spectrum of high yield. We think that we possess an informational advantage through the internal touch points that we have in gaining access to market knowledge. Not only do we have a very experienced and capable high yield team, but we can also tap into the insights of our broader fixed-income credit teams. In fact, our high yield team sits alongside our investment-grade credit and emerging market debt teams. We re also able to tap into the unique on-the-ground perspective of our global colleagues based in Chile, Hong Kong, Singapore, and Australia. With this interaction, our team can better understand the local nuances and our research can better identify good investment opportunities. DARRIN: We generate our own internal credit ratings; this provides an independent viewpoint to assist in anticipating market recovery rates and capturing high-quality issuers with lower beta; Principal Global Investors, sub-advisor of the Principal High Yield Fund, has been doing this since 1965, and we strongly believe that this type of proprietary research is crucial for effective security selection. We also have explicit exit strategies designed to help the Fund avoid defaults, with clearly defined limits linked to market volatility. These are designed to limit risk when needed and increase risk when warranted. The aim is to avoid or manage the impact of defaults but give us sufficient diversification for growth. Asset allocation/diversification does not guarantee a profit or protect against a loss. 3

4 Figure 4: Principal Global Investors Disciplined Five-Step Process We also find that a big part of making good security calls is not only knowing when to invest, but also when to exit a position. Macro & Risk Perspective Sector Allocation & FTV Framework Security Selection & FTV Framework Portfolio Construction & Monitoring What have been the key drivers to performance? Performance Analysis DARRIN: We generate returns from security and sector selection. This means that historically, we have thrived in environments where a manager can truly distinguish between credits and find relative-value opportunities, as opposed to those where headlines and market movements are the main drivers behind returns. What really drove performance in 2011 was our security selection. Our process focuses on identifying three sets of factors as the basis for our best investment ideas: fundamental, technical, and valuation. In 2011, that pointed us toward overweighted positions in some tech and communications companies that benefited from merger announcements and positive debt refinancings. We also find that a big part of making good security calls is not only knowing when to invest, but also when to exit a position. So our process puts a strong emphasis on exit strategies. This helps our team to understand when an investment is no longer living up to our original thesis, or when another option offers more relative value. What is your outlook for high yield for the remainder of 2012? MARK: High yield is once again off to a strong start, as the search for yield and income remains a key driver of investors into riskier assets. We believe high yield is well positioned to capture these investor flows, given the long-term performance of the asset class. While volatility remained subdued during the first quarter of 2012, it is expected that times of increased volatility will exist during the year. We expect that default rates will creep higher throughout the year. Given current outlooks, we expect the global default rate to end 2012 somewhere around 3.5% well below the long-term historical average of around 4.5%. We re expecting slow, but positive, Gross Domestic Product (GDP) growth, which should continue to benefit the high yield asset class. At this point, corporate issuers have done as good a job as they can on improving gross profit margins, so revenue growth (and hence profitability) will really depend on how strong the global economies can grow. If the economy really starts to pick up steam, interest rates will likely rise. We believe this will still favor high yield over other fixed-income asset classes. High yield s shorter duration and higher coupons should be sufficient to help it weather the higher Treasury rates. Typically, a little bit of inflation is good for high yield, and that s what we re expecting for In the United States, if the Federal Reserve begins a third round of quantitative easing, we might see an increased risk for higher inflation, which could hurt fixed-income returns. 4

5 Figure 5: Historical Performance of High Yield Bonds as Rates Increased 8% 6% 4% Barclays U.S. Treasury Index Barclays U.S. Aggregate Bond Index Barclays U.S. Corporate High Yield Index % 0% -2% % -6% Oct Dec 1994 Oct Jan 2000 Mar May 2006 Source: Zephyr StyleADVISOR. Past performance is no guarantee of future results. An investor cannot invest directly into an index. Index performance does not reflect performance of any Principal Fund. This illustration does not reflect past, current, or future performance of this or any investment product. See glossary for index definitions. For European high yield companies that issue in U.S. dollars, we see some attractive opportunities for both higher yields and wider spreads. This was reflected during the first quarter of 2012, where European high yield bonds significantly outperformed those issued in the United States. However, being selective in Europe is critical as the European high yield market is more volatile and less liquid, therefore magnifying credit mistakes. Figure 6: Europe Offers Attractive Opportunities for Yield BofA Merrill European High Yield Index Barclays High Yield 2% Capped Index Barclays Aggregate Bond Index Barclays U.S. Government Index /31/07 12/31/08 12/31/09 12/31/10 12/31/11 3/31/12 Source: Factset. Past performance is no guarantee of future results. An investor cannot invest directly into an index. Index performance does not reflect performance of any Principal Fund. This illustration does not reflect past, current, or future performance of this or any investment product. 5

6 We like to summarize our position by saying, spreads are cheap, but all-in yields are not. But in a world starved for yield, we believe high yield will continue to see support. Summary High yield can potentially offer higher income than government bonds and investment-grade corporate bonds for investors willing to accept more risk. We believe defaults should remain low, given the current prudent stance of corporate management. Interest rates are likely to rise; however, this should still favor high yield over other fixed-income asset classes. We find that U.S. dollar-denominated European high yield can offer some relative-value potential. Principal High Yield Fund Class A & Class I Yields As Of 3/31/2012 Average Annual Total Returns* Performance (as of 3/31/2012) 30-DAY SEC YIELD NON- SUBSIDIZED (GROSS) 30-DAY SEC YIELD SUBSIDIZED (NET) 30-DAY DISTRIBUTION YIELD YEAR-TO- DATE 1-YEAR 5-YEAR SINCE INCEPTION Class A (Excluding Sales Charge) 5.96% 5.96% 6.82% 5.00% 5.06% 7.24% 7.91% Class A (Including Sales Charge) 5.73% 5.73% 6.56% 1.04% 1.07% 6.44% 7.62% Class I 6.32% 6.32% 7.17% 5.26% 5.46% 7.63% 8.27% Class P and I shares are available only to certain investors. See the prospectus for more information. Investment results shown represent historical performance and do not guarantee future results. Your investment s returns and principal values will fluctuate with changes in interest rates and other market conditions so the value, when redeemed, may be worth more or less than original costs. Current performance may be lower or higher than the performance shown. For more information, including the most recent month-end performance, visit principalfunds.com, call your financial professional, or call A maximum up-front sales charge of 3.75% may apply. See the prospectus for details. Performance listed with sales charge reflects the maximum sales charge. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Performance assumes reinvestment of all dividends and capital gains. Gross investment expense ratio: Class A shares: 0.92%; Class I shares: 0.57%. * Class I shares were first sold July 28, Returns for Class I shares prior to July 28, 1998, are based on performance of Class A shares adjusted to reflect the fees and expenses of Class I shares. Class A shares were first sold April 8, The 30-day distribution yield is calculated based on the actual distribution paid as of the last month-end, expressed as an annual percentage rate. 6

7 Glossary Definitions Standard Deviation: The dispersion of returns around the average annual return of an investment to measure the investment s volatility. Standard deviation is also known as the historical volatility and is used as a gauge of the amount of the expected volatility. Barclays U.S. Corporate High Yield Index: The U.S. Corporate Index is a broad-based benchmark that measures the investment-grade, fixed-rate, taxable, corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-u.s. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements. Barclays U.S. Aggregate Bond Index: represents securities that are domestic, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subadvisors into more specific indices that are calculated and reported on a regular basis. BofA Merrill European High Yield Index: The BofA Merrill Lynch Euro High Yield Index tracks the performance of EUR denominated below-investment-grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below-investment-grade rating (based on an average of Moody s, S&P, and Fitch). In addition, qualifying securities must have at least one year remaining term to maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 100 million. Original issue zero coupon bonds, global securities (debt issued simultaneously in the eurobond and euro domestic markets), 144a securities, and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Defaulted, warrant-bearing and euro legacy currency securities are excluded from the Index. Barclays U.S. Treasury Index 7-10 Yrs: The U.S. Treasury Index includes public obligations of the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded. STRIPS are excluded from the index because their inclusion would result in double-counting. Barclays U.S. Government Index: The U.S. Government Index is comprised of the U.S. Treasury and U.S. Agency Indices. The U.S. Government Index includes Treasuries (public obligations of the U.S. Treasury that have remaining maturities of more than one year) and U.S. agency debentures (publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government). Barclays Muni Bond Index: The U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds. Many of the subindices of the Municipal Index have historical data to January In addition, several sub-indices based on maturity and revenue source have been created, some with inception dates after January 1980 but no later than July 1, Barclays High Yield 2% Capped Index: The U.S. Corporate High-Yield 2% Issuer Capped Index is an issuerconstrained version of the U.S. Corporate High-Yield Index that measures the market of USD-denominated, noninvestment grade, fixed-rate, taxable corporate bonds. The index follows the same rules as the uncapped index but limits the exposure of each issuer to 2% of the total market value and redistributs any excess market value index-wide on a pro-rata basis. S&P 500: An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. 7

8 Our Capabilities Global Investment Management Asset Allocation Expertise Retirement Leadership As a leading provider of mutual fund solutions, Principal Funds brings special expertise in global investment management, asset allocation, and retirement leadership to financial professionals and investors. Principal Funds are managed by many leading sub-advisors, including the extensive asset management capabilities of Principal Global Investors. Our asset allocation solutions and retirement resources support financial professionals in helping investors meet their long-term financial goals. WE LL GIVE YOU AN EDGE principalfunds.com MM5773 l 06/2012 l t fe 2012 Principal Financial Services, Inc. This material is not authorized for distribution unless preceded or accompanied by a current prospectus that includes more information regarding the risk factors, expenses, policies, and objectives of the investment. Contact your financial professional or call to obtain another copy of the prospectus. Read the prospectus carefully before investing. A mutual fund s share price and investment return will vary with market conditions, and the principal value of an investment when you sell your shares may be more or less than the original cost. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc., member of the Principal Financial Group. Principal Funds Distributor, Principal Shareholder Services, Principal Management Corporation and its affiliates, and Principal Funds, Inc. are collectively referred to as Principal Funds.

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