Energizing High Yield Bond Investors: Finding Opportunities Amid Shifting Market Conditions

Energizing High Yield Bond Investors: Finding Opportunities Amid Shifting Market Conditions

Energizing High Yield Bond Investors: Finding Opportunities Amid Shifting Market Conditions Contents Executive summary 2 2 3 4 4 6 Energy: The big story From volatility to opportunity A history of rewarding patience Economy is favorable to high yield bonds Back to fundamentals Conclusion The story in high yield bonds for the past six months is one of energy. As oil prices have tumbled, investors have scrambled to re-evaluate their holdings to help ensure they are positioned to weather a downturn in the oil markets and any additional effects outside the sector. The Barclays U.S. Corporate High Yield Index, which has a 13% allocation to energy, dropped 12.9% during the second part of 2014 as oil prices were cut in half. 1 Investors who have been enjoying tightening spreads due to the financial crisis began to move capital elsewhere. Declining oil prices weighed heaviest on the market and caused high yield bonds to fall from their post-crisis highs. Oil and energy are the story in high yield, said James FitzPatrick, Managing Director and Portfolio Manager of the Seix High Yield Bond Strategies. However, experienced investors are not shying away from high yield bonds because there are potential opportunities to be found, especially in the current environment. Many of these lie in the energy sector, where some companies appear to be positioned to weather the downturn in prices. In addition, there is the chance to find high quality issues at attractive prices, thanks to lower investor demand. Other factors, such as a stable U.S. economy, continued low default rates and more responsible leverage also continue to make high yield bonds an attractive asset class for investors. Key takeaways: Oil prices are affecting the market as a whole, but overall, defaults are expected to remain below historical averages. Spreads have stabilized; spread tightening is likely. There are opportunities to invest in quality credits, particularly in the energy sector. A strengthening economy, solid fundamentals and other factors can also make high yield bonds attractive to investors. Low interest rates helped many companies lock in favorable financing and shore up balance sheets; corporate profits will offset higher borrowing costs from higher rates. 1 Barclays Live, 2014 Energizing High Yield Bond Investors 1

Energy: The big story Oil is the key focus and investors in all asset classes are watching where the price per barrel will stabilize. In the interim, the price readjustment has caused many to worry about defaults across asset classes. Oil exploration and production companies that benefited from low interest rates and higher oil prices are now feeling a squeeze to service their debt. Oil prices around $60 2 a barrel mean it is harder for companies to pay high levels of debt, particularly smaller, more speculative credits, which may increase the number of defaults. Spreads of high yield bonds widened by more than 100 basis points, ending the year at 504 basis points over Treasuries with comparable maturities. 3 EXHIBIT 1: COMPOSITION OF BARCLAYS U.S. Corporate High Yield Index (2004 & 2014) Market Value % As of 12/31/2004 Financial Institutions Energy 2.5% 4.3% Utility 16.0% Industrial 77.1% Financial Institutions 11.2% Energy 13.3% Note: Numbers may not equal 100% due to rounding. Source: Barclays Live, 2014 Market Value % As of 12/31/2014 Utility 3.5% Industrial 72.1% The weakness was not confined to the energy sector, but bled into the entire high yield market because energy has grown in size relative to other sectors. In December 2004, energy made up just 4.3% of the Barclays U.S. Corporate High Yield Index, but that climbed to 13.3% by the end of 2014. 4 (See Exhibit 1) From volatility to opportunity Despite the volatility in high yield bonds, savvy investors should have plenty of opportunities. The most significant potential opportunities lie in energy, said FitzPatrick. Energy services as well as oil exploration and production companies bear watching with caution because the decline in oil prices could trigger higher levels of defaults. Some oil exploration and production companies have done a better job of hedging the price of oil than others. Investors should look for credits that have hedges in place to protect against a decline in oil prices and the subsequent likelihood of default, cautioned FitzPatrick. The midstream pipelines have the least commodity exposure and they are like the toll collectors of the energy market, further explained FitzPatrick. And refiners benefit to some degree from the decline in oil prices because oil is their biggest input. While energy services and oil exploration and production companies are most directly affected by low oil prices, we are seeking potential opportunities in all five energy sub-sectors. While energy is proving to be challenging to high yield holdings, this decline in prices may have run its course, FitzPatrick said. Oil prices have somewhat stabilized and, though they may move lower in the short term, many high yield bonds have been repriced in anticipation of this move. This move should not be as dramatic as it was in the last half of 2014. However, the sell-off repriced other bonds within the high yield market, many of which are independent of oil. Defaults to stay low. Despite the turmoil in the energy sector, few have predicted widespread defaults. We expect default rates to stay steady, said Michael Kirkpatrick, Managing Director and Senior Portfolio Manager of the Seix High Yield Strategies. We do think it will increase from where it has been, but still be below historical averages. 2 As of 4/30/2015 3 Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/series/bamlh0a0hym2 4 Barclays Live, 2014 Energizing High Yield Bond Investors 2

The high yield bond default rate for 2013 and 2014 stayed around 2%. Defaults could climb to around 3%, however, that is well below the historical long term average of 4.4%, according to Moody s Investors Service. 5 While depressed oil prices will cause some energy names to default, this is unlikely to be a widespread problem, said Kirkpatrick. There are a couple of reasons for this muted view on defaults. First, many energy companies have hedged their oil prices at about $80 a barrel, and those hedges are in place through 2015 and into 2016. After that, it s a different story, warns Kirkpatrick. The default rate could rise if oil prices do not rebound. Second, the combination of the low rate environment and the improving economy has spared U.S. balance sheets. With less money going to debt service, companies have more cash on hand to weather tougher economic climates. Spread levels are not a full reflection of that balance sheet strength. Spreads very much compensate investors for the current default environment and the default rate for the foreseeable future, said Kirkpatrick. A history of rewarding patience Despite the recent downturn, keeping some capital in high yield bonds can be a good idea in order to capture steady returns. On a risk-adjusted basis, the return on high yield bonds is greater than investment grade bonds and stocks over the long term. (See Exhibit 2) High yield bonds have delivered an equity-like 7.7% return for the 10-year period ended December 31, 2014, but their volatility has been significantly less than equities. 6 At the same time, high yield bond returns surpassed investment grade bonds. The Barclays U.S. Aggregate Bond Index returned just 4.7% during that time frame. (See Exhibit 2) There are two reasons for this risk-adjusted performance: first, the steady coupon income accounts for the biggest proportion of the asset class s returns, not capital appreciation. Second, high yield bonds are senior to equity in the capital structure, exhibiting less volatility than stocks. EXHIBIT 2: HIGH YIELD BONDS, INVESTMENT GRADE BONDS AND EQUITIES: TOTAL RETURN AND STANDARD DEVIATION (2005-2014) Index Total Returns Annualized Standard Deviation Barclays U.S. Corporate High Yield Index 7.7% 9.0% Barclays U.S. Aggregate Bond Index 4.7% 3.6% S&P 500 Index 7.7% 15.1% Source: FactSet, data pulled 02/26/15 5 Barron s, 10/23/14, http://blogs.barrons.com/incomeinvesting/2014/10/23/high-yield-default-rate-down-to-1-7-should-stay-low-moodys/ 6 FactSet as of 12/31/14 Energizing High Yield Bond Investors 3

Economy is favorable to high yield bonds The high yield bond market is especially sensitive to the health of the overall economy and the moderate growth of the economy has not disappointed the asset class. Gross domestic product (GDP) growth of 2.47% for the year ended March 31, 2014, and a further decline in the unemployment rate signal an improving financial system. 7 (See Exhibit 3) EXHIBIT 3: CORPORATE PROFITS AFTER TAX IN TRILLIONS OF DOLLARS (2010-2014) $1.895T $1.625T However, many investors remain wary of high yield investments as the U.S. Federal Reserve contemplates when it will raise interest rates. As much as low interest rates provided the support for the asset class s performance in recent years, higher rates don t signal the end. High rates may already be priced into the high yield bond market. $1.375T 2Q11 3Q12 Source: http://ycharts.com/indicators/corporate_profits, 02/26/15 3Q13 In fact, higher rates owing to a strong economy demonstrate corporate strength. Since stronger corporate profits put companies in a better fiscal position, they more than offset higher borrowing costs. Back to fundamentals Against this economic backdrop, high yield bond fundamentals look solid. Much of the new issuance during the lower rate environment was used to retire older, higher cost debt and push back maturities. The result: stronger corporate balance sheets. 8 (See Exhibit 4) EXHIBIT 4: Purpose of High Yield Bond Issuance First Half of 2014 ($180 billion in issuance) Project Financing 1% Recap/Divided 5% Recap/Other 3% LBO 4% Other 11% Refinancing/Bonds 28% M&A 22% Refinancing/Bank Debt 13% Source: S&P Capital IQ/LCD, 2014 Refinancing/General 13% 7 Bureau of Economic Analysis, Feb. 27, 2015, https://www.bea.gov/newsreleases/national/gdp/gdphighlights.pdf 8 S&P Capital IQ, http://www.highyieldbond.com/primer/#!lbos Energizing High Yield Bond Investors 4

Responsible borrowing. Issuers have not used the low rate environment of the last few years to engage in reckless corporate financing, said Kirkpatrick. For example, leveraged buyouts (LBO), and the debt that goes along with them, have dropped as a percentage of issuance. In 2014, LBO debt made up 16% of the total new issuance volume compared to 43% in 2008. 9 With stock markets continuing their advance, many companies prefer to access financing this way, issuing initial public offerings at rich price-to-earnings multiples, rather than tapping the debt markets for a cash infusion. This deleveraging is good news for the remaining high yield market as existing credits and many new issues continue to look solid. EXHIBIT 5: Leverage for High Yield Issuers Remains Low (2008-2014) 5.5x 5.0x 4.5x 4.0x 3.5x 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 Leverage Ratio Source: J.P. Morgan, 2014 Further spread tightening ahead. Though high yield bond spreads have already tightened dramatically from their wide levels in 2008, the move is not yet over, said Kirkpatrick. Spreads continue to tighten for an average of 80 months after the end of a recession. 10 As of December 2014, spreads had tightened for only 66 months, meaning there should be room for additional price appreciation. Technically speaking, high yield is attractive. Those looking to put capital to work in the asset class should look beyond current market trends and dive into bond structures themselves for areas that may be mispriced. The way to gain an advantage in this market is to look for a technical factor that is being played out, said FitzPatrick. He and Kirkpatrick have identified certain investing themes based on these technicals that have altered the prices at which some high yield issues are trading. Regulatory changes. Recent regulatory changes have led to a dearth of parties available to make bids. Since the financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act s Volcker Rule restricted banks from trading with their own money. At the peak in 2007, primary dealers held $233 billion of corporate debt with maturities of more than a year. As of December 31, 2014, they held $5.7 billion in below investment grade bonds and notes. With major liquidity suppliers staying away, the market favors investors with a ready supply of liquidity. 11 Dealers are not the liquidity absorber they were in the past, so investors want to take advantage of that, said FitzPatrick. 9 S&P Capital IQ, http://www.highyieldbond.com/primer/#!lbos, 02/26/15 10 J.P.Morgan, 2014 Leveraged Loan Annual Review. 11 Federal Reserve of New York, http://www.ny.frb.org/markets/gsds/search.html# Energizing High Yield Bond Investors 5

Rating category mispricing. Finally, there is an opportunity to take advantage of the prices for different rating categories. The ratio of B to BB is at a four-year high, said Kirkpatrick. Investors are compensated for the additional risk of moving into B rated bonds and we believe this is a sweet spot from a valuation perspective. (See Exhibit 6) EXHIBIT 6: Effective Yield of B and BB Issuance (1996-2014) 20 18 16 14 Yield (%) 12 10 8 6 4 2 B Issuance BB Issuance 0 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00 1/1/01 1/1/02 1/1/03 1/1/04 1/1/05 1/1/06 1/1/07 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 1/1/13 1/1/14 Source: Bank of America Merrill Lynch, 2014 Conclusion While lower energy prices have caused turmoil in the high yield market lately, investors looking to put capital to work can still find opportunities, particularly when they work with managers who have experience in the space. The high yield market is still fundamentally strong, with measured corporate debt issuance, strong balance sheets and a resurging U.S. economy. Opportunities exist to find quality and underpriced credits, particularly in the energy sector itself. Managers with expertise in high yield bonds may be poised to take advantage of market disruption created by reduced flows, ratings mispricing and regulatory changes, which have caused some to flee the asset class. Since conditions in the high yield market are constantly changing, working with an active manager can help identify opportunities to take advantage of market disruptions. Energizing High Yield Bond Investors 6

One Maynard Drive, Suite 3200 Park Ridge, New Jersey 07656 seixadvisors.com 201.391.0300 Investment Risks: Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer term bonds and a lower rate of return. Generally, a fund s fixed income securities will decrease in value if interest rates rise and vice versa. Although a fund s yield may be higher than that of fixed income funds that purchase higher rated securities, the potentially higher yield is a function of the greater risk of that fund s underlying securities. Equity securities (stocks) may be more volatile and carry more risk than other forms of investments, including investments in high grade fixed income securities. The assertions contained herein are based on Seix s opinion. This information is general and educational in nature and is not intended to be authoritative. All information contained herein is believed to be correct, but accuracy cannot be guaranteed. This information is based on information available at the time, and is subject to change. It is not intended to be, and should not be construed as, investment advice. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decisions. Credit Ratings noted herein are calculated based on S&P, Moody s and Fitch ratings. Generally, ratings range from AAA, the highest quality rating, to D, the lowest, with BBB and above being called investment grade securities. BB and below are considered below investment grade securities. If the ratings from all three agencies are available, securities will be assigned the median rating based on the numerical equivalents. If the ratings are available from only two of the agencies, the more conservative of the ratings will be assigned to the security. If the rating is available from only one agency, then that rating will be used. Ratings do not apply to a fund or to a fund s shares. Ratings are subject to change. Barclays U.S. Aggregate Bond Index is a widely recognized index of securities that are SEC registered, 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. Barclays U.S. Corporate High Yield Index measures the market of USDdenominated, noninvestment grade, fixed rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. S&P 500 Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. It 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. Investors cannot invest directly in an index. A basis point is equal to 0.01%. Coupon is the interest rate stated on a bond when it s issued. Gross Domestic Product (GDP) refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country s standard of living. Leveraged Buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Price-to-Earnings Ratio (P/E) is a valuation ratio of a company s current share price to its per-share earnings. The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. Spread is the difference between the bid and the asking price of a security or asset. Standard Deviation is a statistical measurement of dispersion about an average, which depicts how widely returns varied over a certain period of time. 2015 Seix Investment Advisors LLC is a registered investment adviser with the SEC and member of the RidgeWorth Capital Management LLC network of investment firms. SXWP-hy-0615