Case for High Yield Sep 10

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This material is provided or educational purposes only and should not be construed as investment advice or an oer or

solicitation to buy or sell securities. This inormation discusses general market activity, industry or sector trends, or other

broad-based economic, market or political conditions and should not be construed as research or investment advice.

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FOR PROFESSIONAL INVESTORS USE ONLY – NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.

High-yield bonds led global nancial markets in a powerul rebound rom

the credit crisis, delivering investors at this riskier end o the corporate bond

market record returns in 2009. The rally has given way to more tentative

gains in 2010 across all asset classes, each o which aces new challenges as

the global economy recovers. The high-yield market has responded to those

challenges so ar with robust returns and healthy new issuance.

We believe the key point or investors contemplating new or continued allocations to

high yield is that the current subdued outlook or the global economy is better suited

to the asset class than many appreciate. While equities fourish in periods o strong

growth, and government debt ares best in a severe downturn, corporate bonds tend to

outperorm other asset classes in periods o moderate economic activity.

Furthermore, the very actors that sustain that modest growth outlook are also

supportive o the high yield market. Historically low interest rates – which are likely to

persist as the major economies recover – encourage demand or high yielding assets, as

investors aim or better returns. And solid signs o improvement in the corporate sector,

including stronger balance sheets and generally robust earnings reports, add to the

attraction o corporate debt.

In our view, the current ragile economic conditions present a potential sweet spot

or high-yield investment, and it’s worth getting to know the asset class better, to

understand the value it continues to oer.

The high-yield market consists o debt issued by companies with low credit ratings, or

purposes such as mergers or buyouts (known as leveraged buyouts or “LBOs”), or to

meet expanding capital needs. The two years since the credit crisis has seen a massive

shit towards renancing existing debt, though, as companies have taken advantage o

a lower interest rate environment, and resurgent investor appetite or yield, to lock incomparatively cheap unding.

Indeed, having virtually shut down at the height o the crisis in 2008, the high-yield

market has reopened with a vengeance. By mid-September, this year’s issuance

had already surpassed the 2009 all-time record, reaching US$208.3 bn, according to

Bloomberg data. In total, the Securities Industry and Financial Markets Association

estimates the volume o high yield bonds outstanding globally in excess o US$1.2 tn in

ace value as o this year. Though the bulk o the market is in the US, where high yield

has been trading since the late 1970s, the younger European markets have seen very

strong growth.

Goldman Sachs Asset Management

Case for High Yield

September 2010

In our view, the current ragile

economic conditions present

a potential sweet spot or high-

yield investment, and it’s worth

getting to know the asset class

better, to understand the valueit continues to oer.

What is high yield?








Technically, the high-yield asset class comprises the roughly 20% o the global corporate

bond market that is rated below investment grade by the leading ratings agencies (in the

BB category or lower or Standard & Poor’s; Ba category or lower or Moody’s Investors

Service). To compensate or their lower credit quality, high yield bonds pay investors

larger coupons than both high-quality corporate bonds and government debt. The size

o the coupon depends largely on the perceived risk o deault on the bonds. Ratings

agencies base their ranking on actors such as the corporate borrower’s business risk, the

amount o debt on its balance sheet, and where the bonds sit in the company’s capital

structure, which determines the priority o principal repayment.

Not all high-yield debt started out that way, however. About a th o the market consists

o “allen angels” – debt o companies that lost their investment-grade ratings as a result

o a merger or LBO, or deteriorating perormance.

The appeal o high yield or investors boils down to three main actors. The rst, and most

obvious, is the higher potential income or investors. Secondly, high yield’s comparatively

low correlation with other asset classes means this debt can help add diversity in a

portolio. And thirdly, the tendency o high-yield debt towards shorter maturities, and its

close relationship to the corporate borrower’s perormance, makes these bonds generally

less sensitive to interest-rate cycles (duration risk) than most other xed-income

instruments.

The income potential in high yield owes to the higher coupons they oer relative to

most other debt, and to their considerable scope or price appreciation. High-yield bonds

currently pay roughly 4.81% more than investment grade bonds, to compensate or the

higher perceived risk o deault. But assuming the borrower keeps up with payments

on the company’s debt, high-yield bonds also have ample opportunity to gain in value.

Positive news or the corporate borrower, such as a ratings upgrade, a better-than-

expected earnings report or promising new products or management changes, are all

potential drivers o price appreciation. Furthermore, at the level o the market, high

yield debt overall may benet rom improvements in investors’ general appetite or risk,

whether it’s spurred by greater condence in the economy, or increased demand or

higher-yielding assets in a low interest-rate environment.

Total returns annually, refecting coupon and price contribution

Source: Merrill Lynch.

This graph breaks down the components o return on high-yield investments. The coupon on high-yield bonds provides

a source o income annually, regardless o the direction o the market. Meanwhile, bond price fuctuations – which may

be specic to the individual bond, or driven by general market movements – can add or subtract rom that income. Last

year’s returns were a highly avourable combination o the two components.

Appeals o high yield

-50%

-30%

-10%

10%

30%

50%

70%

2010 YTD2009200820072006200520042003200220012000

-5.20%

4.48%

-0.53%

27.97%

10.87%2.78%

10.76%2.53%

-26.11%

58.10%

8.48%

Coupon return %

Price return %

The appeal o high yield or

investors boils down to three

main actors. The rst, and most

obvious, is the higher potential

income or investors.

2








High yield is also useul or investors as a way o diversiying risk in their portolios. High

yield bonds have low correlation with both government bonds and equities, meaning their

perormance isn’t closely tied to either asset class. Though the correlation between high-

yield debt and equities does increase rom time to time, high yield is less sensitive to

economic news. The main drivers o high yield perormance are idiosyncratic, such as the

state o the issuer’s balance sheet, or the extent o active trade in their bonds.

Well-balanced portolios also take advantage o the opportunities to diversiy within the

asset class, by ratings, and across corporate sectors. These sectors range rom the more

deensive, such as utilities, to those more exposed to economic cycles, such as retail.

In terms o ratings, high-yield credits are covered by 11 classications, rom the cusp o

investment grade, down to the distressed levels closest to deault. Distinctions also exist

between high-yield credits according to their seasoning, that is, where they are in their

lie cycle. The average high-yield bond has a lie span o just 4-5 years. In the rst couple

o years ater their launch ollowing a company’s initial public oering or reorganisation,

their credit quality is potentially at its shakiest, since the issuer is generally highly levered.

The next phase, 3-4 years into the bond’s term, is when the majority o high-yield

deaults occur. From this point on, though, the bond has the most potential to appreciate

substantially since, i the company survives, it will have executed its capital plan and

be on to the next phase. By the time they are our years or more into their tenor, these

bonds are likely to be oering a generous spread or the amount o risk involved. Prudent

managers aim or a healthy mix o these three so-called cohorts o high-yield.

The third key attraction in high yield, particularly or dedicated xed-income investors,

is their lower duration risk, or lower vulnerability to rising interest rates, relative to

other xed-income assets. Their shorter lie span means high-yield bonds tend to

be less exposed to the interest-rate cycle than longer-dated investment-grade or

government debt. In addition, the premium high yield oers over other xed-income

instruments provides a cushion or investors against potential losses in a rising interest-

rate environment. Furthermore, since interest-rate hikes are generally a sign o a

strengthening economy, any corresponding improvement in corporate sector prots may

well help high-yield debt outperorm other xed-income assets.

O course none o these benets can be guaranteed, and the extra yield in high-yield

bonds is oered as compensation or a higher risk o deault. Anyone looking or an

illustration o the key pitalls in high yield investing need look no urther than the recent

crisis. At the end o 2009, that record year or both returns and issuance, high yield

deaults hit a peak o 13.48%, according to Moody’s.

The shakier credits were the rst market casualties o the crisis, as low-rated companies

that had borrowed heavily in the preceding years o razor-thin interest rates and heavy

investor demand ound themselves unable to access capital markets at all. Periods o

turmoil in nancial markets oten take a greater toll on risk assets, as investors tend

to ofoad these rst, in avour o more conservative assets oering better principal

protection and more stable returns; usually government bonds. The exodus rom high

yield in mid-2007 to early-2009 drove bond prices sharply lower and issuers’ borrowing

costs to record highs, and eectively roze the market.

Though these exceptional events aected capital markets across all sectors, the crisis

was a heavy-handed reminder that high yield can be more prone than other asset classes

to protracted periods o ill iquidity, or poor trading conditions. To minimise that liquidity risk,

our proessionals target securities that will perorm over a two- to three-year investment

horizon. An added benet o this “buy and hold” strategy is that it limits the transaction

costs associated with trading in and out o positions on a more regular basis. Another way

to limit liquidity risk is to maintain globally diverse portolios.

Risks o high yield

In terms o ratings, high-yield

credits are covered by 11

classications, rom the cusp

o investment grade, down to

the distressed levels closest

to deault.

3








This sort o diversication is as important as ever, as nancial markets respond to the

latest threats to global growth: unsustainable debt burdens and scal distress among the

governments o the developed world, and uncertainty over how impending regulatory

reorms will impact nancial institutions in still-ragile markets. Against this backdrop the

corporate sector has a particular appeal, as many companies, particularly in the US, can

boast strong cash reserves and much improved earnings.

The normalisation o credit markets since the credit crisis has seen a dramatic

compression in risk premiums, and despite recent market upheaval, that compression

is likely to proceed.

As discussed earlier, this year’s subdued economic environment is likely to avour high

yield. We believe the most conducive environment or corporate credit is economic

growth in the order o 0%-2%. Any slower, and the contraction harms the corporate

sector; while aster growth encourages more takeover activity, which drives companies to

take on more debt and spend more aggressively on dividends. Simply put, those investors

most bullish on the economy will be more inclined to equities, and the least condent will

avour investment-grade or government securities. Investors with a more moderate view

are best suited to higher-yielding corporate credits.

Modest growth in turn will likely preserve the recent trend o declining deault rates,

which has been a key support or high yield over the past year. The spike in risk premiums

during the crisis signicantly overstated the likelihood o deaults on high-yield debt, with

estimates at the beginning o 2009 running well above historic levels in excess o 20%,

ar more than was justied by the undamentals underlying the corporate sector. In its

most recent deaults report, released in August, Moody’s projected the high yield deault

rate would all to 1.8% in the rst hal o next year. Continued improvements in corporate

earnings and balance sheets, which have in turn acilitated record high-yield issuance over

the past year, should keep such promising deault projections on track.

Furthermore, the success high yield issuers have had accessing markets since the crisis

augers well or the asset class in the coming years. Among the biggest threats to the

health o the market was the mountain o debt corporate borrowers had to renance.

Despite the strong trend o deleveraging since the crisis struck, high-yield borrowers ace

massive unding requirements over the next ve years, peaking at US$500 bn in 2014.

Record issuance this year means borrowers have already made good headway to cover

those needs, and at comparatively reasonable rates.

Why high yield now?

The normalisation o credit

markets since the credit

crisis has seen a dramatic

compression in risk premiums,

and despite recent market

upheaval, that compression

is likely to proceed.

4








Use o annual high-yield proceeds 2005-2010

Source: Standard & Poor’s, LCD. As o 30 September 2010.

Historically, companies have used most o the proceeds o their high-yield borrowing to nance mergers and leveragedbuyouts. This balance has shited dramatically – the most popular use or the record volume o high-yield issuance since

the credit crisis has been debt renancing.

O course, this undraising would not have been possible without very resilient

investor demand. That demand, inspired initially by the need to build prots ollowing

a devastating year in nancial markets, remains supported by a shortage o yield

opportunities elsewhere. Yields on more conservative xed-income instruments, such

as Treasuries and some investment grade bonds, remain anchored by historically low

interest rates in the world’s leading economies. And those exceptionally low levels are

likely to persist or the oreseeable uture.

With the sharpest moves o the credit markets rebound behind us, investors are

struggling to adjust to what could be a prolonged period o halting economic recovery.

But the prevailing environment o modest growth and historically low interest rates,

combined with strengthening corporate earnings, make high-yield attractive or

investors with the capacity to research their choices in this hugely diverse asset class.

The markets boom may be over or now, but in this uncertain investment environment,

high yield has more to oer.

0

40

80

120

160

200

2010 YTD20092008200720062005

Refinancing

LBO

M&A

Recap

Gerneral Purp.

Other

HY Issuance (US$bn)

The markets boom may

be over or now, but in

this uncertain investment

environment, high yield has

more to oer.

5








This material is provided or educational purposes only and should not be construed as investment advice or an oer or solicitation to buy or sell securities.

Past perormance is not indicative o uture results, which may vary. The value o investments and the income derived rom investments can go down as well as up. Future

returns are not guaranteed, and a loss o principal may occur.

Opinions expressed are current opinions as o the date appearing in this material only. No part o this material may, without GSAM’s prior written consent, be (i) copied,

photocopied or duplicated in any orm, by any means, or (ii) distributed to any person that is not an employee, ocer, director, or authorised agent o the recipient.

High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated xed income securities.

This material has been prepared by GSAM and is not a product o the Goldman Sachs Global Investment Research (GIR) Department. The views and opinions expressed may

dier rom those o the GIR Department or other departments or divisions o Goldman Sachs and its aliates. Investors are urged to consult with their nancial advisors beore

buying or selling any securities. This inormation may not be current and GSAM has no obligation to provide any updates or changes.

Views and opinions expressed are or inormational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are

current as o the date o this presentation and may be subject to change, they should not be construed as investment advice.

IMPORTANT NOTICE: in the United Kingdom, this material is a nancial promotion and has been approved solely or the purposes o Section 21 o the Financial Services and

Markets Act 2000 by Goldman Sachs International, which is authorised and regulated in the United Kingdom by the Financial Services Authority.

Copyright © 2010 Goldman, Sachs & Co. All Rights Reserved. 41168.UCITS.TPD.TMPL

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Case for High Yield Sep 10