UNDERSTANDING INVESTING High Yield Bonds

High yield bonds – defined as corporate WHAT MAKES A HIGH YIELD? bonds rated below BBB − or Baa3 by Credit rating agencies evaluate bond issuers and assign ratings. Issuers are established credit rating agencies – can rated on their ability to pay and principal as scheduled. Those issuers considered to have a greater risk of defaulting on interest or principal play an important role in many portfolios. repayments are rated below investment grade (see Chart 1). These issuers They typically offer higher coupons than must therefore pay higher coupons to attract investors to buy their bonds. government bonds or high grade corporate * † bonds (or, corporates) and have the Moody’s Standard & Poor’s Fitch potential for price appreciation in the event Investment Grade of an improvement in the economy, or Highest quality Aaa AAA AAA performance of the issuing company (of High quality (very strong) Aa AA AA course, if these conditions worsen, then Upper medium grade (strong) A A A prices can also go down). Because the high Medium grade Baa. BBB BBB yield sector generally has a low correlation to other sectors of the market Below Investment Grade Lower medium grade along with less sensitivity to Ba BB BB (somewhat speculative) risk, an allocation to high yield bonds may provide portfolio diversification benefits. In Low grade (speculative) B B B addition, high yield bond investments have Poor quality (may default) Caa CCC CCC historically offered similar returns to equity Most speculative Ca CC CC No interest being paid or bankruptcy markets, but with lower volatility. C C C petition filed In default C D D

Source: Moody’s, Standard & Poor’s, Fitch

*The ratings from Aa to Ca by Moodys may be modified by the addition of a 1, 2 or 3 to show relative standing within the category, e.g., Baa2. †The ratings from AA to CC by Standard & Poor’s and Fitch may be modified by the addition of plus (+) or minus (-) sign to show relative standing within the category, e.g., A-.

While agency credit ratings define the high yield market, and many investors rely on these ratings in their portfolio guidelines, investors may also conduct independent credit analysis of company fundamentals and other factors to form their own conclusions about a security’s risk of default. 2 Understanding High Yield Bonds

WHO ISSUES HIGH YIELD BONDS? WHY INVEST IN HIGH YIELD BONDS?

Until the 1980s, high yield bonds were simply the High yield bonds may offer investors a number of potential outstanding bonds of “fallen angels” – former investment benefits, coupled with specific risks. Investors can endeavor to grade companies that had been downgraded below investment manage the risks in high yield bonds by diversifying their grade. Investment , led by Drexel Burnham Lambert, holdings across issuers, industries and regions, and by carefully launched the modern high yield market in the 1980s by selling monitoring each issuer’s financial health. new bonds from companies with below-investment grade • Diversification– High yield bonds typically have a low ratings, mainly to finance mergers and acquisitions or correlation to investment grade fixed income sectors, such leveraged buyouts. as Treasuries and highly rated corporate debt, which The high yield market has since evolved, and today, much high means that adding high yield securities to a broad fixed yield debt is used for general corporate purposes, such as income portfolio may enhance portfolio diversification. financing capital needs or consolidating and paying down Diversification does not insure against loss, but it can help lines of credit. Mainly focused in the U.S. through the decrease overall portfolio risk and improve the consistency 1980s and 1990s, the high yield sector has since grown of returns. significantly around the globe in terms of issuance, outstanding securities and investor interest. • Enhanced current income – To encourage investment, high yield bonds usually offer significantly greater yields than government bonds and many investment grade corporate GROWTH OF HIGH YIELD bonds. Average yields in the sector vary depending on the economic climate, generally rising during downturns when 2,500 default risk also rises (high yield companies may be more negatively affected by adverse market conditions than 2,000 investment grade companies). For example, for much of the 1,500 1980s and 1990s, U.S. high yield bonds typically offered 300 to 500 basis points of additional yield relative to U.S. 1,000 Treasury securities of comparable maturity, according to the Market Value ($bn) Value Market Securities Industry and Financial Markets Association. But 500 following the credit crisis in 2007–2008, the spread between high yield and government bonds was much greater 0 97’ 98’ 99’ 00’01’ 02’ 03’04’ 05’ 06’ 07’ 08’ 09’ 10’ 11’ 12’ 13’ 14’ 15’ 16’ reaching highs of close to 2,000 basis points. • Capital appreciation – An economic upturn or improved Source: Bank of America Merrill Lynch as of 31 December 2016 performance at the issuing company can have a significant impact on the price of a high yield bond. This capital New high yield issuance can vary greatly from year to year appreciation is an important component of a total return depending on economic and market conditions, typically investment approach. Events that can push up the price of a expanding along with economic growth, when investors’ bond include ratings upgrades, improved earnings reports, appetite for risk often increases, and waning in recessions or mergers or acquisitions, management changes, positive market environments, when investors are more cautious. product developments or market-related events. Of course, The high yield sector includes both originally-issued high yield if an issuer’s financial health deteriorates, rating agencies bonds and the outstanding bonds of fallen angels, which can may downgrade the bonds, which can reduce their value. have a significant impact on the overall size of the market if • Equity-like, long-term return potential – High yield bonds large or numerous companies are downgraded to high yield and equities tend to respond in a similar way to the overall status. Conversely, the sector can shrink when companies are market environment, which can lead to similar return upgraded out of the speculative grade market into the profiles over a full market cycle. However, returns on high investment grade sector. yield bonds tend to be less volatile because the income component of the return is typically larger, providing an added measure of stability. In addition, the combination of enhanced yield and the potential for capital appreciation (though less than for equities) means that high yield bonds Understanding High Yield Bonds 3

can offer equity-like total returns over the long term. WHAT ARE THE RISKS? Also, bondholders have priority over stockholders in a company’s capital structure in the event of bankruptcy or Compared to investment grade corporate and sovereign liquidation; high yield bond investors therefore have a greater bonds, high yield bonds are more volatile with higher default chance of recovering their investment than equity investors. risk among underlying issuers. In times of economic stress, defaults may spike, making the asset class more sensitive to the HISTORICAL RISK AND RETURN OF U.S. HIGH economic outlook than other sectors of the bond market. High YIELD BONDS AND U.S. EQUITIES yield bonds share attributes of both fixed income and equities, and can be used as part of a diversified portfolio allocation. Annualized Annualized Return/ Return (%) Volatility(%) Volatility 3 Year GLOSSARY : The interest payments a bondholder receives until the High Yield 4.48 6.03 0.74 bond matures. Equities 9.61 10.21 0.94 : Debt instrument issued by a private corporation, as distinct from one issued by a government or government agency. 5 Year Credit/default risk: The risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a or otherwise High Yield 6.92 5.25 1.32 meet a contractual obligation. Equities 14.64 9.48 1.54 Credit spread: The yield differential between a corporate bond and an equivalent maturity sovereign bond. For example, if the 10-year Treasury 10 Year note is trading at a yield of 3% and a 10-year corporate bond is trading at a yield of 4%, the credit spread is 1% or 100bps. High Yield 7.54 10.60 0.71 Fallen angel: : An investment-grade company that has subsequently had Equities 7.18 15.14 0.47 its debt downgraded to speculative grade. 15 Year High yield bond: Corporate bonds rated below BBB- or Baa3 by established rating agencies. High Yield 8.92 9.28 0.96 Interest rate risk: When interest rates rise, the market value of fixed- income securities (such as bonds) declines. Similarly, when interest rates Equities 8.34 14.04 0.59 decline, the market value of fixed-income securities increases. 20 Year Maturity: The number of years left until a bond repays its principal to investors. High Yield 6.92 9.05 0.76 Yield: The income return or interest received from a bond. Equities 7.15 15.07 0.47

Source: BofA Merrill Lynch, Bloomberg, PIMCO as of 30 June 2017 High Yield represented by the BofA Merrill Lynch U.S. High Yield Index; Equities represented by the S&P 500 Index

• Relatively low duration – One reason high yield bonds often have relatively low duration is that they tend to have shorter maturities; they are typically issued with terms of 10 years or less and are often callable after four or five years. Generally, high yield bond prices are much more sensitive to the economic outlook and corporate earnings than to day-to-day fluctuations in interest rates. In a rising rate environment, as would be expected in the recovery phase of the economic cycle, high yield bonds would be expected to outperform many other fixed income classes. That said, the high yield sector does not demand great economic times; most issuers may function very well and continue to reliably service their debt in a low growth environment. IMPORTANT DISCLOSURES Newport Beach Headquarters Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and 650 Newport Center Drive may lose value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in Newport Beach, CA 92660 them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in the bond market is +1 949.720.6000 subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity Hong Kong and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. 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