Finding Value in US High Yield Fixed Income

Investment Research Finding Value in US High Yield Fixed Income Jeffrey Clarke, Senior Vice President, Research Analyst, CFA Thomas M. Dzwil, Director, Portfolio Manager/Analyst Michael Zaremsky, Director, Client Portfolio Manager Over the past several years, central banks have tried to repair the damage from the global financial crisis by cutting interest rates to historic lows. In response, investors have sought income by reaching for higher yield. Many of these investors, however, may not have fully recognized that higher yields represent higher risk as well as higher returns. As yields remain under pressure in the face of this demand, the challenge of finding attractive yield that is fairly priced has intensified. We believe a potential solution is non-distressed US corporate bonds rated BB and B. In the current market environment, we believe higher quality US high yield fixed income has reached newly attractive valuations. Falling commodity prices and fears associated with the US Federal Reserve rate hike have brought down high yield security prices regardless of quality and underlying fundamentals. However, there is a meaningful difference between the marginal credits that will likely face impairment and the healthy credits that should continue to meet all of their financial obligations and weather the current market conditions. Therefore, in our view, these depressed prices could represent an attractive entry point for high yield US corporate bonds with better quality characteristics.

2 High Time for High Yield One of the main reasons we believe that US high yield bonds represent value in today s market is our view that the US economy will continue to grow, and that interest rate increases will reflect that strength. The period of ultra-low interest rates since the global financial crisis has been extraordinary and virtually unprecedented. The last time interest rates were at current levels for a sustained period was in the 193s during the Great Depression. At that time, the US economy was contracting, deflation had set in, and unemployment was 19% (Exhibit 1). In contrast, the US economy today marked by economic growth, low but steady inflation, and low unemployment is no longer in crisis. Interest rates will eventually adjust and rise as the Fed begins to unwind its crisis-driven policy. We view such policy normalization as appropriate and necessary given the strength of current economic conditions. Rising interest rates are traditionally challenging for fixed income because of interest rate risk. As rates rise, the value of most bonds declines. The longer the duration of the security, the more value it is expected to lose. For companies issuing high yield bonds, however, rising rates can be generally beneficial if they reflect a positive business environment. Default rates have typically declined in past economic expansions as companies have been better able to meet their financial obligations and avoid bankruptcy. 1 High yield bonds have outperformed most other fixed income assets in past rising rate environments (Exhibit 2). The outperformance of high yield bonds over long-term US Treasuries has been especially significant. This reflects the fact that companies issuing high yield bonds have greater exposure to economic growth, and that the driver of high yield returns is not primarily interest rates or duration, but the underlying strength of the individual issuer. While the asset class is not entirely immune to interest rate risk, it does have lower sensitivity to this variable than other fixed income assets (with approximately half the sensitivity of similar-duration Treasuries). In many cases, the beneficial effect from spread tightening can more than offset the detrimental impact of an interest rate rise. Investor sentiment for US high yield fixed income is being supported by a number of other factors as well. US markets in high yield bond assets are mature and, unlike in many other countries, bankruptcy laws and recovery are well established. The US dollar is relatively strong, and the United States continues to be seen as a safe haven in global markets. We believe US high yield also has favorable maturity dynamics, is at an attractive point in the credit cycle, and has a more stable risk/return profile than is currently priced by the market. US companies have been able to refinance their debt and issue securities at longer maturities, which has lowered short-term pressure to pay their obligations. Prior to the financial crisis in 28 29, there was a maturity wall (or a particularly high percentage of debt securities maturing) between 2 and 21. Companies took advantage of the very low rates available in the wake of the crisis, as well as easy access to financing, to reissue debt. As a result, the percentage of outstanding issues due to mature through 2 and 217 is significantly smaller than after 218 (Exhibit 3). Exhibit 1 The Economy Appears Normal but Interest Rate Policy Does Not US Treasury 3-Month T-Bill Yields: 1931 Present (%) 8 1931 193 1955 1967 1979 1991 23 215 Recession 3M T-Bill 193 1938 Cumulative (%) Annualized (%) Nominal GDP Growth -.9-2. Inflation -18.6-2.3 28 21 Nominal GDP Growth 21.9 3.5 Inflation 1.5 1.7 Unemployment Rates (%) 1938 19. September 215 5.1 Source: Bloomberg, Federal Reserve Bank Exhibit 2 High Yield Bonds Have Outperformed Treasuries and the Broad Bond Market during Past Rate Increases Total Return Impact in a Rising Yield Environment, 199 215 a US Convertibles US High Yield EMD Hard Currency EMD Local Currency Asian Bonds US Corporates IG US Broad Bond Market US 1-Year Treasury - -3-2 -1 1 2 3 5 (%) For the period January 199 to November 215 (unless otherwise noted) a Average over rolling 3-month periods with more than 25 bps rise in 1-year Treasury All data in US dollars. 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. Data shown for periods of rising rates defined as rolling 3-month periods when the US 1-year yield increased more than 25 bps since 199, data permitting. Broad US Bond Market = Barclays Capital US Aggregate Bond Index; IG Corporate = Barclays Capital US Investment Grade Credit Index; US 1-year Treasury = Barclays Capital US Treasury (1-year) Bellwethers Index; EMD (Local) = J.P. Morgan GBI-EM Broad Composite Index; EMD (USD) = J.P. Morgan EMBI Global Index; Asian Bonds (USD) = J.P. Morgan Asia Credit Index (data since 1999); US High Yield Bonds = Barclays Capital US Corporate High Yield Index (data since 22); Convertible Bonds = Bank of America Merrill Lynch US Convertibles Index. Source: Bloomberg, J.P. Morgan Asset Management

3 In our opinion, the US high yield market is at an attractive point in its cycle, which appears to be lengthening (Exhibit ). Historically, these cycles have lasted about seven years, and rising acquisition, leveraged buyout (LBO), and dividend activity (spiking in the 5% 6% range) often signaled the cycle was near its end. However, six years into the current cycle such activity remains below the peak levels of prior credit cycles, and defaults the cycle tends to be near an end when they reach elevated levels are near historic lows. If either of these indicators had moved materially higher it would warrant caution, but the data suggest that the current cycle will likely persist longer than those in recent history. Exhibit 3 High Yield s Maturity Wall Has Been Pushed Out to 218 US High Yield Maturity Profile Outstanding Issues due to Mature (%) 18 6 Finally, the US high yield market is more stable than many perceive. High yield bonds have historically generated attractive performance over the long term (Exhibit 5), especially in risk-adjusted terms. Dispersion has also appeared among rating segments, with higherquality credits providing stronger annualized returns. The BB 215 2 217 218 219 22 221 222 This schedule is based on both bonds and loans maturities. Source: Bank of America Merrill Lynch 223 22 225+ The Impact of Rising Interest Rates on Income-Generating Assets Can Vary Income-generating assets tend to come under pressure when interest rates rise, but their performance may depend on other factors as well. When rates were rising and investors were nervous about growth (e.g., as occurred in the second quarter of 213 and September 21), US high yield fell alongside other assets. However, when investors were solely concerned about interest rate risk (e.g., as occurred in the first half of 215), high yield has tended to perform well, particularly against other yield proxies. This clearly demonstrates the benefits of a growing economy for US high yield credit. Returns for Income Assets 3 January 215 September 21 May 213 1 June 215 (%) 21 (%) 2 June 213 (%) Change in 1.6 2.38 2.3 2.9 1.93 2.5 1-Year UST Yield Bank Loans 1.27-1.86-1.91 High Yield Bonds 2.1-2.57-6.6 EM Local Currency Bonds -.62 -. -.58 Global Consumer Staples 1.5-1.96-6.58 REITs -9.89-6.92-15.15 US Utilities -1.1-2.53-7.96 EM Local Currency Bonds = Market Vectors Emerging Markets Local Currency Bond ETF; Bank Loans = PowerShares Senior Loan Portfolio; REITs = Vanguard REIT ETF; Global Consumer Staples = ishares Global Consumer Staples ETF; US Utilities = Vanguard Utilities ETF; High Yield Bonds = SPDR Barclays High Yield Bond ETF. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: Bloomberg Exhibit The Current High Yield Cycle Appears to Have Lengthened US High Yield Issuer Default Rates and Use of Proceeds Default Rate (%) Use of Proceeds (%) 8 21 23 25 27 29 211 213 3Q 215 Defaults, Proportion of Market Value [LHS] Acquisitions, LBOs, Dividends; Proportion of Total Use of Proceeds [RHS] Opinions and estimates are as of October 215 and are subject to change. Source: Bank of America Merrill Lynch, Bloomberg, Moody s Exhibit 5 High Yield Performance Has Been Relatively Strong Annualized January 1989 September 215 Return (%) Sharpe Ratio BofA Merrill Lynch US High Yield Cash Pay Index 8.25.6 BB 8.9.77 B 7.81.53 CCC 7.56.31 Barclays US Aggregate Index 6.6.87 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. Not intended to represent any product or strategy managed by Lazard. Source: Bank of America Merrill Lynch, Barclays Capital, Bloomberg, Lazard 6 5 3 15

segment of high yield, when compared to the Barclays US Aggregate Bond Index, has generated 185 basis points (bps) of annualized outperformance at a similar Sharpe ratio. In addition, higher-quality US high yield bonds (concentrated in BB and B credits, as represented by the ) have historically outperformed the broader US high yield market with lower volatility (Exhibit 6). High Yield: Caveat Emptor High yield bond issuers are a varied group, with a range of prospects. These differences were apparent to us in the summer and fall of 215, when bond market volatility rose as the phase of the economic and interest rate cycle pressured LBO financing and commodity debt. This sparked investor concern over the US high yield asset class in general, with spreads widening for most high yield securities, regardless of their underlying fundamentals. The degree of the movement appeared unwarranted given that forecasted default rates remain subdued (Exhibit 7). We believe the negative market sentiment has driven spreads approximately 2 bps wider than they should be, with investors under the impression that the recently challenged areas of the market indicate the poor health of the asset class overall. We view this disconnect as a potential opportunity for excess return as the market normalizes and spreads compress. In reality, much of the turmoil was limited to only a few sectors namely lower-quality high yield issuers (CCC) and companies with exposure to oil and commodities. This was to be expected given the downward pressure on prices in those sectors. Thus, US high yield markets have diverged. The broad spread widening conceals this divergence between the weaker parts of the market, which are more likely to default, and the healthy portions of the market, which are less likely to face any significant impairment. Higher-quality credits have been resilient and continue to outperform their lower-quality peers. As credit tightens in the future due to higher rates, we expect to see greater disparity between winners and losers. We believe this environment will offer ample opportunities for bottom-up security selection. Careful research can help identify fundamentally strong issuers and credits while avoiding those that exhibit imprudent risk. Exhibit 7 When High Yield Spreads Widened in the Past, Defaults Rose Spreads and Defaults Have Historically Had Strong Correlations Option-Adjusted Spreads (bps) (%) 1,1 9 13 Exhibit 6 Higher Quality High Yield Bonds Have Historically Outperformed with Lower Volatility 7 5 3 1 7 1-Year 3-Years (Annualized) 5-Years (Annualized) Performance (Return %) Volatility (Standard Deviation %) Risk Compensation (Sharpe Ratio).17 6.8 -.1 2.1 5.52.3-2.2 5.73 -..3 5.19.3.7.9.77.69.6.95 5.98 5.98.95 6.35 5.29 1.1 As of 31 October 215 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. Not intended to represent any product or strategy managed by Lazard. Source: Bank of America Merrill Lynch, Lazard 1 Market 1998 2 22 2 26 28 21 2 21 2 Non-Distressed High Yield [LHS] Moody s US Speculative Grade Default Rate [RHS] US Baseline Default Forecast [RHS] Return (%) US High Yield Master.5 Non-Distressed 1.92 BB 2.29 B -.3 CCC and Lower -5.92 Distressed -2.62 Sector Weight (%) a Return (%) Energy.9-9.65 Metals and Mining 3. -15.87 Paper 1.7-9.68 Steel.6-7.85 a Represents sector weights within the US High Yield Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. 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. Not intended to represent any product or strategy managed by Lazard. Source: Bloomberg 1

5 A Question of Liquidity Many investors today question whether high yield bond managers have enough liquidity to cope with extreme market volatility. They point out that some investment strategies, such as mutual funds and ETFs, must offer investors daily or intra-day access to capital while the underlying assets may be thinly traded or relatively illiquid. In a well-publicized case in 215, a high yield mutual fund was forced to bar further redemptions and was closed for an orderly distribution. We believe this does not accurately reflect the underlying conditions in the BB/B US corporate bond market but instead depicts it in similar terms as lower-rated credit. The areas of the market most sensitive to challenging liquidity conditions tend to be the marginal credits, issuance with small deal size, or CCC bonds. We believe that higher quality US corporate bonds will continue to have a reasonable level of sponsorship. Conclusion We believe that US high yield bonds, specifically the higher-quality elements of the market, are one of the strongest opportunity sets in the current economic environment. As growth continues, we believe mid-sized US-oriented borrowers (the companies typically issuing high yield debt) will benefit via improved revenue growth, potentially making their bonds more attractive. As a result, we expect that high yield credit spreads will tighten even as interest rates rise. Past patterns of high yield performance have shown that higher quality high yield is resilient in rising rate environments, particularly when growth fears are absent. In today s yield-starved world, we believe this can be a compelling opportunity for investors seeking income with adequate compensation for risk. This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 High yield default rates rose sharply during the 21 22 and 28 29 recession and declined or held steady during periods of economic growth (22 27 and 21 215). Important Information Published on 3 December 215. 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. All opinions expressed herein are as of the published date and are subject to change. 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. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) and sources believed to be reliable as of the publication date. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. 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