Lazard Insights. Frustrated by Fixed Income? Solutions for a Rising Rate Environment. The Impact of Rising Interest Rates. Summary

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1 Lazard Insights Frustrated by Fixed Income? Solutions for a Rising Rate Environment Jeffrey Clarke, CFA, Senior Vice President, Research Analyst Adam Mitchell, Senior Vice President, Portfolio Manager/Analyst Summary A variety of fixed-income investments underperformed in the wake of the US Federal Reserve s announcement of reduced bond purchases. Investors today fear rising interest rates and are logically looking for favorable investments to battle the reversal in interest-rate trends. We believe high-yield bonds and convertible securities are potential solutions for diversifying interest-rate risk. The unique characteristics and return drivers of the two proposed solutions appear attractive in the face of a new interest-rate setting. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author on 29 April 21. The original recording can be accessed via The Impact of Rising Interest Rates Fixed-income markets reached an inflection point in the spring of 213 when the US Federal Reserve (the Fed) signaled the winding down of its bond purchase programs. Interest rates are expected to trend higher toward normalized levels commensurate with underlying economic conditions. The thirty-year downward trend in the 1-year US Treasury yield evidences a multi-decade bull market in interest rates that benefited fixed-income assets (Exhibit 1). However, bond investors today are rationally seeking solutions to combat the potential trend reversal as quantitative easing fades and interest rates move higher. In the pages that follow, we will discuss two solutions for the new interest-rate paradigm in the fixed-income space: high-yield bonds and convertible securities. As interest rates rose from generational lows in 213, asset classes where interest rates are the predominant driver of returns suffered. Returns at year-end 213 were negative (in some cases significantly) for US Treasuries, the broad US bond market, investment-grade corporates, and even emerging-market local currency debt. In addition, those bond proxies which are more interest-rate sensitive also posted negative performance. In contrast, high-yield and convertible bonds (fixed-income assets which have alternative drivers of return) performed well through 213 (Exhibit 2). We believe it is instructive to analyze additional episodes of rising interest rates. Specifically, we evaluated periods since the early 199s where the 1-year US Treasury yield rose over basis points (bps).

2 2 Exhibit 1 Interest-Rate Normalization 1-Year US Treasury Yield (%) Tapering Announced, May Dec 21 Jun 211 Dec 211 Jun 212 Dec 212 Jun 213 Dec 213 As of 31 December 213 Source: Haver Analytics Exhibit 2 The Effect of Rising Rates in 213 Fixed-Income Investments Returns in 213 (%) Long-Term Treasuries Broad US Bond Market -2. IG Corporate Bonds -2. EM Local Currency Bonds -.3 High-Yield Bonds. Convertible Bonds 2.9 Bond Proxies US Preferred Stocks -.2 REITs 1.3 Global Consumer Staples 2. US Utilities.1 As of 31 December 213 All data in US dollars. Long-Term Treasuries = Barclays Capital US Aggregate Government Treasury (2+ Y) Index; IG Corporate Bonds = ishares iboxx USD Liquid Investment Grade Index; High-Yield Bonds = Barclays Capital High Yield Very Liquid Index; Broad US Bond Market = Barclays Capital US Aggregate Bond Index; EM Local Currency Bonds = J.P. Morgan GBI-EMG Core Index; US Convertibles = Bank of America Merrill Lynch All US Convertibles Index; Preferred Stocks = S&P US Preferred Stock Index; REITs = MSCI US REIT Index; US Utilities = MSCI US Investable Market Utilities 25/5 Index; Global Consumer Staples = S&P Global 12/ Consumer Staples Index. Source: FactSet, Bloomberg Exhibit 3 How Does Credit Perform in a Rising-Rate Environment? Oct 1993 to 7 Nov 9 1 Jan 199 to 12 Jun 9 2 Jul 212 to 27 Dec 13 Yield Increase in 27 1-Year US Treasury (bps) Returns Long-Term Treasuries (%) a Broad US Bond Market (%) US Convertibles (%) High Yield Bonds (%) As of 1 April 21 a Based on monthly data for the October 1993 to November 199 period using month start and end dates. Long-Term Treasuries = Barclays Capital US Aggregate Government Treasury (2+ Y) Index); Broad US Bond Market = Barclays Capital US Aggregate Bond Index Total Return; Convertibles = Bank of America Merrill Lynch All US Convertibles Index; High Yield Bonds = High Yield Master II Index. Source: Bloomberg, Bank of America Merrill Lynch, Barclays These periods comprise two instances in the 199s and one in In all instances, the broad US bond market had negative returns and long-term Treasuries exhibited double-digit negative returns. As such, this eye-opening negative performance reinforces the fears of rising rates. However, not all fixed-income investments are built equally, as some are able to more favorably withstand interest-rate increases. For example, high-yield bonds had positive returns for all periods studied, and convertibles outperformed the broad US bond market each time (Exhibit 3).

3 3 A further investigation into rising rates episodes over the last twenty years leads to similar results. Analyzing the total return impact over three-month rolling periods that experienced more than a 25 bps rise in the 1-year US Treasury revealed a familiar pattern. Once again, asset classes where the main return driver is interest rates had negative returns. By contrast, US high-yield bonds and convertible bonds outpaced the broad US bond market by 32 and 9 bps respectively.¹ A High-Yield Solution Many investors preconceived notions for the return pattern of US high-yield bonds can be summarized as steep valleys and tall mountains. While this statement is repeated often, it is a misperception. The left chart in Exhibit shows the distribution of annual returns from 195 to 213. We observe that the high-yield market annual return has been below negative 2% only three times since 195, and 1% of the time returns have been between negative 2% and positive %. Exhibit High-Yield Return Perceptions versus Reality, Distribution of Historical US High Yield Market Annual Returns Frequency 1 2 <-2% -2% to 5% 5% to % % to 2% As of December 213 Source: Bank of America Merrill Lynch 2%+ Frequency <-2% -2% to 2% >2% Relative to Beginning-of-the-Year Coupon Another common belief is that high-yield investors typically clip the coupon. That is, investors can expect the total return to mirror the coupon measured at the start of the year. We believe this is also a fallacy, since over the last twenty-eight years the market s return has not closely matched the beginning of the year s coupon. The right chart in Exhibit illustrates this point. The majority of yearly returns have fallen outside the range of plus or minus 2% of the coupon. This dynamic underscores the importance of price movements for the US high-yield market price movements are stronger drivers of returns. As we take a closer look at the fundamentals of the high-yield market we first focus on new issuance activity and the subsequent use of proceeds. It is imperative to understand the implications of how issuance proceeds are deployed, as this has key implications for companies balance sheets and the overall credit cycle. When companies rely on issuance proceeds to refinance debt, it is assumed they have been able to extend the maturity as well as lower the interest rate. This is analogous to individuals who refinance a fixed-rate home mortgage when interest rates decline leading to lower monthly payments. In the last several years, refinancing has been the dominant use of proceeds in the high-yield market (Exhibit 5). This signals the credit cycle is healthy because companies repair their balance sheets with cheaper and longer-dated debt, thus creating added operational flexibility for the business. Conversely, if new issuance proceeds are destined for activities such as acquisitions, leveraged buyouts (LBOs), or dividends it indicates companies are putting their balance sheets under greater stress. As new issuance activity shifts from refinancing into these categories the credit cycle could be coming to an end. In the period 2 2 this trend was evident leading to the most recent end of the credit cycle in 2. Importantly, a direct consequence of refinancing activity has been that the maturity wall for high-yield bonds has been extended. This is markedly different from the scene in 29 when investors were concerned about the looming maturities due in The recent refinancing volume has generated a favorable maturity schedule, which Exhibit 5 Refinancing Validates a Strong Credit Market Proportion of Total (%) Refinancings Capex General Corporate Purposes Acquisitions, LBOs, Dividends As of 31 March 21 Source: Bank of America Merrill Lynch

4 Exhibit Fundamentals Support a Longer High-Yield Cycle (%) (%) % Defaults; Proportion of Market Value [LHS] Acquisitions, LBOs, Dividends; Proportion of Total Use of Proceeds [RHS] Q 21 As of 31 March 21 Source: Bank of America Merrill Lynch, Moody s, Bloomberg further supports the current credit cycle. The first hurdle is in 21 when approximately 12% of the current market is due, but a significant proportion is due from 22 onward.² Default rates always seem to permeate discussions about high-yield bonds. Over the last four years default rates have been historically low. We believe that given the current market conditions with a favorable maturity schedule, low interest-rate expenses, and an improving GDP outlook, default rates should remain low. In our sample, defaults peaked in 29 coinciding with the significant prior rise of new issuance activity used for acquisitions, LBOs, and dividends (Exhibit ). As a general guideline, if acquisitions, LBOs, and dividends represent more than 35% of new issuance goals, it is not considered healthy for credit markets. On average, these categories represented 1% over the 2 2 period and the current levels are around 21% which is encouraging for the credit cycle. While historically credit cycles last for seven years, investors may worry about markets nearing the end of the seven-year mark by the end of 21. However, we argue that the strong fundamentals discussed thus far point to an extended cycle relative to history. Turning to our last topic related to the high-yield market, we would like to highlight that risk-adjusted performance for the asset class has been attractive in both short and long terms. For the period January 199 to March 21, US high yield posted an attractive Sharpe ratio, superior to that of the S&P 5 Index but lagging the broad US bond market (represented by the Barclays Capital US Aggregate Bond Index). However, in the shorter time frame since 211 the riskadjusted results of US high-yield fixed income materially outperformed the broad US bond market and was slightly above US equities.³ A Convertibles Approach Convertible securities are fixed-income instruments that give the holder the right to convert into equity at a fixed price and can be structured to have various rankings in the corporate capital structure. For example, convertibles can be issued equal in rank to other non-convertible bonds, whether the issue has an investment grade or Exhibit 7 Convertibles in the Corporate Capital Structure Fixed Income Convertibles Equity Bank Loans Investment-Grade Bonds High-Yield Bonds Preferred Stock Common Stock This information is for illustrative purposes only. Senior Junior non-investment grade rating, or be more junior, such as in the case of convertible preferred stock (Exhibit 7). In our view, the convertible asset class has attributes that make it unique and timely given investors interest-rate worries. It should be emphasized that the convertible can be viewed as owning a fixed-income instrument with an attached call option on the underlying stock. Consequently, fixed-income investors can participate in equity upside, which is not the case with traditional fixed-income products lacking this option. Importantly, convertibles have lower sensitivity to interest-rate fluctuations (i.e., lower duration) than most fixed-income investments. In fact, the current duration for the Bank of America Merrill Lynch All US Convertibles Index is 2.7 years, whereas the Barclays Capital US Aggregate Bond Index duration is 5. years. Moreover, similar to traditional fixed-income assets, convertibles offer principal protection given its fixed-income features, notably maturity at par and coupon payments. In a portfolio context, convertibles can enhance the efficient frontier of a stock bond allocation (Exhibit ). This is just another way to say

5 5 Exhibit Enhancing a Portfolio s Risk-Return Profile Annualized Return (%) Convertibles % and Bonds % Convertibles 1% Stocks % and Convertibles % Stocks % and Bonds % Stocks 1% Bonds 1% Annualized Volatility (%) For the period December 199 to December 213 This information is for illustrative purposes only. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices listed above are unmanaged and have no fees. It is not possible to invest in an index. Index performance does not represent the performance of any product managed by Lazard. Efficient Frontier based on returns for Convertibles = Bank of America Merrill Lynch All US Convertibles Index; Stocks = S&P 5 Index; and Bonds = Bank of America Merrill Lynch US Corporate/Government Master Index. Source: Bloomberg that convertibles allow for higher return for the same amount of risk, resulting in a higher Sharpe ratio. One reason to support this result is because the convertible asset class is overlooked by both potential investors and sell-side research staff likely generating price inefficiencies. Moreover, issuers who come to the convertible market are often looking to raise capital quickly. In aggregate, these technical factors often cause the convertible s embedded option and/or credit to be mispriced or issued cheaply. Currently the spread advantage (57 bps over LIBOR) provides the widest starting point for corporate credit exposure. 5 The spread represents attractive relative and absolute yields over traditional fixedincome products. The result of the aforementioned attributes is that convertible securities offer investors a low duration, corporate credit exposure with a call option on equity upside yet retaining the downside protection of bonds (i.e., receiving par at maturity and an income stream). All of which is especially timely in this low interest-rate world. Conclusion In our opinion, the year 213 marked the end of a 3-year interestrate tailwind for traditional fixed-income assets. As US interest rates progress to higher levels consistent with the underlying economic conditions many fixed-income investments will languish. In this setting, it is natural for bond investors to seek solutions to address the challenge of investing amid rising rates. We believe high-yield bonds and convertible securities can provide strong diversification for interest-rate risk. In addition, credit market fundamentals remain healthy, and thus supportive of these asset classes. In general, high-yield bonds and convertibles have navigated rising rates very well, thereby representing a compelling and timely approach. Notes 1 Source: J.P. Morgan Asset Management. For the period January 199 to December Source: Bank of America Merrill Lynch. As of 31 March 21 3 Source: Bank of America Merrill Lynch, Barclays Capital, Bloomberg, Lazard. As of 31 March 21 Source: Bank of America Merrill Lynch, Barclays Capital. As of 23 April 21 5 As of 2 February 21 Important Information Published on May 21. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as junk bonds ) inherently have a higher degree of market risk, default risk, and credit risk. An investment in a convertible bond is speculative, involves a high degree of risk, and may lose value. The securities mentioned are not necessarily held by Lazard for all client portfolios, and their mention should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. The Sharpe ratio is a risk-adjusted measure of performance calculated by dividing a portfolio s excess return (versus the risk-free rate) by the standard deviation of the portfolio s returns. It effectively measures reward per unit of risk; the higher the Sharpe ratio, the better a portfolio s historical risk-adjusted performance. This paper is for informational purposes only. 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