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Analysis & Trends:

High-yield

corporate bonds

Higher bond yields with

reasonable credit risk

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Decisive Insights

for

forward-looking investment

strategies

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Analysis & Trends

Content

4

High-yield corporate bonds

4

Corporate credit

5

Corporate credit value drivers

6

Managing high-yield bonds

7

Recent developments in the high-yield

bond market offer buy opportunities

12

Decisive Insights

Imprint

Allianz Global Investors Europe GmbH

Mainzer Landstraße 11–13 60329 Frankfurt am Main Capital Market Analysis Hans-Jörg Naumer (hjn) Dennis Nacken (dn) Stefan Scheurer (st) Olivier Gasquet (og) Richard Wolf (rw) Jochen Dobler (jd)

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High-yield corporate bonds

High-yield corporate bonds have suffered from a lack of

liquidity and from investor risk aversion. The higher yields

these bonds offer are linked to the issuers’ creditworthiness.

High-yield corporate bonds

1. High-yield bonds and investment-grade bonds constitute the two segments of bond debt issued by private companies, known as corporate bonds.

• Investment-grade bonds are issued by the most creditworthy issuers. • High-yield bonds are issued by less

creditworthy issuers.

2. In view of the additional risk, corporate bonds have a higher interest rate than government bonds. This difference is called the “spread”: the less creditworthy the issuer, the higher the spread. The spread of high-yield bonds is therefore higher than that of investment-grade bonds.

3. During an economic and stock market cycle, when the economic situation and credit risk improve, corporate credit becomes a real investment opportunity. When the economic situation and credit risk worsens, corporate credit has the greatest risk exposure of the different types of bonds. High-yield bonds are the most volatile and most risky of the two types of corporate bonds.

I Corporate credit

Here, we will discuss only listed issues of bonds.

Corporate credit, or corporate bonds, refers to bond debt issued by private companies. There are two types of corporate bonds.

• Investment-grade bonds, known as senior bonds, are issued by the most creditworthy issuers. They have ratings of between “AAA” and “BBB-”. Their interest rates are a little higher than those of government bonds. • High-yield bonds are those issued by less

creditworthy companies. They have ratings of less than “BBB-” and their interest rates are considerably higher than those of gov-ernment bonds.

The creditworthiness of an issuer is rated by specialised rating agencies, such as Standard & Poor’s, Moody’s and Fitch Ratings. Their ratings are designed to precisely reflect levels of credit risk: i. e. the risk that an issuer may default on payments.

Ratings are reviewed at least once a year. They can be maintained, upgraded or downgraded, or placed “under review” with “positive” or “negative” implications, pending completion of an additional study.

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II Corporate credit value drivers

1. Corporate bonds and changes in interest rates

Like any government bond, corporate bonds are affected by changes in long-term interest rates. Their prices thus depend on the level of economic activity, inflation and key interest rates.

When interest rates on government bonds increase, at constant spread, the interest rates of corporate bonds with the same maturity also increase. As is the case with all bonds, their market value will then go down. The more sensitive (the longer the maturity and / or the lower the interest rate) the bond, the greater the drop in price. Conversely, if the interest rate on government bonds falls, the rate on corporate bonds will decrease and their market value will increase. The more sensitive the bond, the greater the increase in its market price.

Due to their higher interest rates, high-yield bonds are less affected by changes in long-term rates than government bonds. There is, however, another determining factor.

2. Corporate bonds and creditworthiness

The “spread” and thus the interest rate of a high-yield bond is primarily dependent on the creditworthiness of the issuer, i. e. its credit quality.

It is therefore important to hold securities whose creditworthiness will improve. An improvement in an issuer’s creditworthiness warrants a lower spread, which tends to result in a lower overall interest rate and an increase in the value of the securities. Conversely, it is important to avoid bonds whose creditworthi-ness will deteriorate: a fall in creditworthicreditworthi-ness warrants an increase in the spread, which tends to result in a higher overall interest rate and an automatic drop in the value of the securities.

3. Study of risk

A thorough analysis of a company is needed to assess its credit quality.

A company’s equity (shares) and medium- and long-term debt (bonds) are what com-prise its long-term resources, i.e. an essential part of the company’s liabilities. An analysis of the issuer’s sector, market positioning, strat-egy, balance sheets and financial statements must verify that the company’s day-to-day operations will allow it to service its liabilities adequately over the long term.

A company’s equity analysis and debt analysis comprise these same steps. Equity analysis determines the value of the company’s shares, which represent ownership of a por-tion of the company. Debt analysis deter-mines the value of the company’s bonds, which represent ownership of a portion of the company’s debt.

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4. Default risk

All issuers have a default risk, i.e. the risk of being unable to fulfil the terms of issue of their bonds. The default may result from the delayed payment or non-payment of inter-est due, or non-payment of part or all of the capital. It can also arise from a change in the terms of issue to accommodate the issuer’s inability to meet its initial obligations. The default rate is the percentage of compa-nies having defaulted within a sample defined either by a given rating, or an economic sector, or level of debt seniority. It is not the rate of real capital loss, as it must be supple-mented by the recovery rate, i.e. the propor-tion of the capital affected by the default, but ultimately recovered by the creditor. The default rate and the recovery rate together determine the planned or actual loss on a portfolio of corporate bonds. Deduct-ing it from the spread gives investors the net spread, which is the effective remuneration supplement received compared with govern-ment bonds.

III Managing high-yield bonds

The management of a portfolio benefits from the specific assets it focuses on.

1. Dual nature of high-yield bonds

High-yield bonds have dual share-bond characteristics.

As a bond or debt, their value is closely linked to the issuer’s creditworthiness, i. e. its ability to honour its commitments and to perform. The market also assesses this capacity through price of shares in the issuer. High-yield bonds not only depend on bond markets, but also on company risk, reflected in stock markets.

High-yield bond investors must therefore: • Be alert to any event likely to affect the

issuer’s trading and creditworthiness.

• Verify that a bond’s spread matches the issuer’s creditworthiness. When they consider that the spread underestimates the creditworthiness, they subscribe to the issue. Conversely, when the spread is insufficient, they reduce holdings in the bond.

• Diversify their portfolios between sectors and companies, as is the practice of all share investors.

2. High-yield bonds and volatility

Another characteristic of high-yield bonds is their volatility.

High-yield bonds are more volatile than government bonds. At constant spread, high-yield bonds are less susceptible to rises in long-term interest rates than government bonds, due to their higher interest rates. But high-yield bonds are much more affected by the issuer’s creditworthiness, which is considerably more uncertain than that of a country. The impact of creditworthiness on high-yield bonds’ values and interest rates is in fact decisive.

Yet high-yield bonds are, in theory, less volatile than shares, as they are less risky. In the event of liquidation, creditors are in fact reimbursed before the shareholders, so corporate bonds can still be worth some-thing when shares are already worthless.

3. High-yield bonds and liquidity

Another characteristic of high-yield bonds is their lack of liquidity. A company’s listed debt often comprises several tranches exhibiting distinct characteristics, each with a much smaller capitalisation than that of equity. Dur-ing stock market turmoil, the lack of liquidity produces distortions between a bond’s spread and intrinsic risk. These distortions offer as many opportunities to buy as to sell. Generally speaking, the lack of liquidity amplifies the volatility of high-yield bonds.

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IV Recent developments in the

high-yield bond market offer buy

opportunities

Recently, the high-yield bond market has been characterised by three simultaneous rises (see Chart 1):

• the rise in the spread of eurozone govern-ment bonds, as shown by the Markit iTraxx SovX Index: a family of sovereign CDS indi-ces converting countries.

• the rise in the spread of high-yield bonds, as shown by the Crossover Index (Xover): a corporate credit index comprising a mixture of high yield and higher yielding investment grade names

• the rise in the volatility of shares, as shown by the Standard & Poor’s 500 Volatility Index (S&P 500 VIX): a popular measure of the implied volatility of S&P 500 index options. It is also known as the “fear index”.

03/12/2009 01/02/2010 02/04/2010 01/06/2010 31/07/2010 29/09/2010 28/11/2010 27/01/2011 28/03/2011 27/05/2011 26/07/2011 800 700 600 500 400 300 200 100 0 Xover Sovx 350 300 250 200 150 100 50 0

Xover generic SovX generic

in basis points in basis points

04/12/2009 04/02/2010 05/04/201 0 04/06/2010 03/08/2010 02/10/2010 01/12/2010 30/01/2011 31/03/2011 30/05/2011 29/07/2011 40 20 0

Chart 1: The strong rise in stock market volatility has impacted the debt markets (as in May 2010)

VIX

Past performance is no reliable indicator for future results

Source: Allianz Global Investors Investments Europe (AllianzGI IE) Global Market Analysis, Bloomberg, 29 / 08 / 2011

A correlation can be observed between high-yield bond markets (excluding those issued by financial companies) and the sovereign debt crisis, with stock market volatility increasing and risk becom-ing systemic.

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The worsening creditworthiness of govern-ments, whose issues had been deemed “risk-free”, is affecting the perception of risk related to listed companies and their bond issues. For several months, investors have been massively selling (see Chart 2). Today, high-yield bonds offer high spreads, slightly greater than the spreads seen when Lehman Brothers collapsed, more than three years ago. They are also characterised by particularly high volatility, despite the fact that the default rate remains particularly low, which is clearly inconsistent.

800 0 –800 –1,600 –2,400 –3,200 –4,000 02/06/2010 25/08/2010 17/11/2010 09/02/2011 04/05/2011 27/07/2011 W

eekly flows in millions of US

$

Source: EPFR, 30 / 08 / 2011

Chart 2: Strong capital outflows in June, and even stronger in August, from US and European high-yield bond markets

Net buying flows of US high-yield bonds by mutual funds

Moody’s and Standard & Poor’s (S&P) expected default rates over the next 12 months are very low, at 1.9 % and 1.6 % respectively. Having reached 12 % at the height of the last financial crisis at the end of 2009, default rates have levelled off at 1.4 % in the eurozone and 2.1 % in the United States. Standard & Poor’s specifies that its forecast of 1.6 % lies on a scale between a best case scenario of 1.2 % and a worst case scenario of 4 %. In any event, the default rate is expected to be less than the long-term average of 4.6 % (see Chart 4). 2,000 1,000 0 –1,000 –2,000 –3,000 Monthly Inflow (EUR millions)

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11

10% 5% 0% –5% –10% –15% Monthly Inflow (% of AUM)  mm

% of assets under management

Monthly European High Yield Fund Flows for last 12 months.

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Default rates forecast by rating agencies and banks

Moody‘s 1.9 % S&P 1.6 % (*) 16 14 12 10 8 6 4 2 0 1985

Actual default rate 1988

31 % 30 % 21 %

1991 1994 1997 2000 2003 2006 2009 2012

Bank of America forecast Accumulated default rates

Default rate on long-term issues (%)

Chart 3: Low default rate expected by rating agencies

Default rates expected in the Unites States (Bank of America (BofA) and Moody‘s)

Source: Allianz Global Investors, 2011 (*) 12-month default rate. Source: Moody’s Investors Service, 2011

14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 1982 Recession 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Default rates of US speculative-grade bonds

% Long-term-average 4.59 %

Forecast for June 2012 Pessimistic 4.0 % (62 defaults) Baseline 1.6 % (25 defaults) Optimistic 1.2 % (18 defaults)

Chart 4: Default rates expected by Standard & Poor’s, according to different scenarios

Default rates of US speculative-grade bonds and 12-month forecast

The areas shaded in light blue correspond to the periods of recession defined by the National Bureau of Economic Research (NBER).

Sources: Standard & Poor‘s Global Fixed Income Research and Standard & Poor‘s CreditPro©.

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In fact, the worst case scenario seems unlikely, as companies took advantage of the recovery in 2009 and 2010 to renegotiate their loans and the dates on which the loans were due. Of course, a recession could prevent them from respecting the ratios provided for in their loan agreements. But the banks are currently too concerned with their equity to not be flexible regarding disputes, to avoid claims and losses.

Nonetheless, market prices can anticipate an economic crisis. The most representative issuers of the high-yield sector have a “B” rating (see Chart 5). In Europe, between 1981 and 2010, this sample’s total default rate over 5 years was 17 %. At 800 basis points – taking the recovery rate to be the long-term average of 40 % – the current spread anticipates a total default rate of 47 %. The market seems thus substantially overestimating the default risk.

25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 10 AAA AA (Time in years)

A BBB BB B CCC/C (right hand scale)

% 60 50 40 30 20 10 0 %

Chart 5: Default rate accumulated over 5 years

Accumulated average default rate of European companies over a several year period, ranked by rating (1981 – 2010)

Implied probability of default accumulated over 5 years

Recovery rate

5-year spread on the Xover index 50 % 40 % 30 % 20 % 10 %

1200 68.2 % 61.5 % 55.9 % 51.1 % 41.7 % 1100 65.0 % 58.3 % 52.8 % 48.1 % 44.2 % 1000 61.5 % 54.9 % 49.4 % 44.9 % 41.2 % 900 57.7 % 51.1 % 45.9 % 41.6 % 38.0 % 800 53.4 % 47.1 % 42.1 % 38.0 % 34.6 % 700 48.8 % 42.7 % 38.0 % 34.2 % 31.0 % 600 43.6 % 38.0 % 33.6 % 30.1 % 27.3 % 500 38.0 % 32.8 % 28.9 % 25.8 % 23.3 % 400 31.8 % 27.3 % 23.9 % 21.2 % 19.1 % 300 24.9 % 21.2 % 18.5 % 16.4 % 14.7 %

Sources: Standard & Poor‘s Global Fixed Income Research and Standard & Poor‘s CreditPro©

© Standard & Poor‘s 2011 * A spread of 800 basis

points for high-yield bonds implies a default rate ac-cumulated over 5 years of 47 % whereas a long-term average of Standard & Poor‘s is of 17 %

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We have seen that under certain circum-stances, the high-yield corporate bond market lacks liquidity and experiences a rise in its volatility.

According to Moody’s, the default rate of 2 % it anticipates would justify, with the volatility range seen in the last four months of between 18 % and 30 %, a spread of between 433 and 628 basis points (see Chart 6). The current spread is 790 basis points. For a default rate of 2 %, it corresponds to volatility of 40 %; or for the current volatility of 30 %, it corresponds to a default rate of 6.3 %, which is considerably higher than the worst case scenario of 4 % and long-term average of 4.6 %. We can again conclude that the market seems overestimat-ing the default risk.

Holding a portfolio of such bonds could pro-vide an attractive annual return. Of course, a market collapse similar to the one in 2008 / 2009 would trigger a fall in prices. But

investors that are able to wait for the market’s return to normal and disappearance of their capital losses would continue to receive a particularly attractive return.

Moreover, a return to equilibrium in public finances in the medium term, and a return to slow growth, should mean that the market price of high-yield bonds gradually aligns with their true fundamental value. A decrease in the spread from 790 to 628 basis points, simply justified by the market’s current volatility, would generate a capital gain of 16 %. An additional contraction in spreads towards levels consistent with current expected default rates would generate sub-stantial additional gains (see Chart 6).

Chart 6: Comparison between the default rate and VIX

(measure of implied volatility of Standard & Poor’s 500 index options)

Source: JP Morgan, Moody’s, 12 / 09 / 2011

The market’s volatility explains the difference between the implicit default rate and the accumulated historical default rate

Model of the spread of high-yield corporate bonds, basis points

VIX 18 % 20 % 25 % 30 % 35 % 40 % 45 % 50 % Default rate 1.0 % 392 424 506 587 668 749 830 911 2.0 % 433 465 546 628 709 790 871 952 3.0 % 474 506 587 669 750 831 912 993 4.0 % 515 547 628 709 791 872 953 1034 5.0 % 556 588 669 750 832 913 994 1075 6.0 % 597 629 710 791 872 954 1035 1116 7.0 % 637 670 751 832 913 995 1076 1157 8.0 % 678 711 792 873 954 1035 1117 1198 9.0 % 719 752 833 914 995 1076 1157 1239 10.0 % 760 793 874 955 1036 1117 1198 1280 Optimal area

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Decisive Insights

The high-yield bond market is currently suf-fering from the sovereign debt crisis, investor risk aversion and a lack of asset liquidity. Doubts concerning countries’ creditwor-thiness are undermining the valuing of risky assets. And the required control of public spending is casting a shadow on future growth and issuers’ future financial perfor-mance. 15 10 5 0 01/01/198801/01/198901/01/199001/01/199101/01/199201/01/199301/01/199401/01/199501/01/199601/01/199701/01/199801/01/199901/01/200001/01/200101/01/200201/01/200301/01/200401/01/200 5 01/01/200601/01/200 7 01/01/200 8 01/01/200901/01/201001/01/2011 Default rate of high-yield bonds (left-hand scale) Merrill US HY Master II Index

2500 2000 1500 1000 500 0

Chart 7: Low valuation

Default rate on European high-yield bonds should remain low in 2011 and 2012

Default rate on all high-yield bonds & Merrill US HY Master II index (spread compared with the OAS index in basis points)

However, companies are in good health and the default rate is particularly low. Provided that there is no worsening of the financial crisis, the high-yield bond market should gradually return to normal (see Chart 7). In the medium term, spreads are likely to con-tract towards levels that are more consistent with the observed volatility of the market and the expected default rate. In addition to high coupons, investors could then enjoy significant capital gains.

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Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested. Past performance is not indicative of future performance. No offer or solicitation to buy or sell securities, nor investment advice / strategy or recommendation is made herein. In making investment decisions, investors should not rely solely on this material but should seek independent professional advice.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and / or its affiliated companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or willful misconduct. The con-ditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This is a marketing communication. This material has not been reviewed by any regulatory authorities, and is published for information only, and where used in mainland China, only as supporting materials to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors US LLC, an investment adviser registered with the US Securities and Exchange Commission; Allianz Global Investors Europe GmbH, an investment company in Germany, subject to the supervision of the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) RCM (UK) Ltd., which is authorized and regulated by the Financial Services Authority in the UK; Allianz Global Inves-tors Hong Kong Ltd. and RCM Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator.

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