Inve

stor

s’ In

sight

V

onto

bel A

sset

Man

agem

ent

Higher yields with a manageable risk

Summary 3

1. Future challenges for bond investors 4

1.1 Interest rates set to remain low

1.2 Public debt: negative trend in industrialised nations

1.3 Corporate deleveraging

2. Options available to bond investors 6

2.1 Alternatives within the bond segment

2.2 So what makes high-yield bonds attractive as a substitute for equities?

3. Why invest in high-yield bonds? 7

3.1 Large market, broad spectrum

3.2 High-yield corporates with increasing refinancing requirement

3.3 Attractive yields and low volatility compared with equities

3.4 Default rates still modest

3.5 Diversification boosts returns

3.6 Risks associated with high-yield bonds

Conclusion 8

Annex – Glossary 9

Contents

3

According to the old stock market adage “Stocks help you eat well, but bonds let you sleep well”, government bonds are tantamount to a safe investment. But nothing seems further away from the truth given the ongoing turmoil in the European Monetary Union (EMU). This raises the question of what euro investors should do with the supposedly safe part of their portfolio.

“Nowadays any investor seeking higher

returns and a more evenly balanced

portfolio has no option but to consider

high-yield bonds.”

Fixed-income bonds typically form the lion’s share of portfolios held by both institutional and private investors. But nowadays any investor seeking higher returns and a more evenly balanced portfolio has no option but to consider high-yield bonds.

What are the key features of these investments? High-yield bonds are issued by companies with a relatively low credit rating

In concrete terms this means that the credit rating of such companies is “below investment grade”, which is equivalent to “Baa3” for the credit rating agency Moody’s or “BBB-” for Standard & Poor’s (Figure 1.1).

The yield produced by this type of corporate bond for the investor is generally higher than that provided by a government bond with the same maturity. This extra yield is known as the spread or risk premium. This premium makes up for the extra risks the investor is exposed to when buying a riskier corporate bond.

Compared with the situation back in 2008, the balance sheets of many corporations look very healthy today. Their financial situation has improved and their level of

Summary

Oliver Russbuelt, Senior Investment Strategist

June 2012

debt has been reduced. The risk of default is therefore limited as well. Despite the adverse market conditions since 2008, high-yield bonds have subsequently become a much more attractive asset class for investors.

It should be noted that some top companies, like the strongest economies, enjoy the highest possible triple-A credit rating, but they tend to be few and far between. Current examples include Microsoft, Exxon and Johnson & Johnson.

Figure 1.1: Overview of different rating levels at bonds

Source: Moody’s, S & P

Ratings Interpretation

Moody’s S & P

Long-term

Short-term

Long-term

Short-term

Inve

stm

ent

Gra

de

Aaa

Prime-1

AAA A-1+ Prime bonds

Aa1 AA+

A-1High-grade bonds, risk only marginally greater than AAA/Aaa paper

Aa2 AA

Aa3 AA-

A1

Prime-2

A+

A-2

Upper-medium grade, strong capacity to make scheduled principal and interest payments

A2 A

A3 A-

Baa1

Prime-3

BBB+

A-3

Lower-medium grade, issuer still has adequate capacity to make scheduled principal and interest payments

Baa2 BBB

Baa3 BBB-

Spec

ulat

ive

Gra

de

Ba1

Not Prime

BB+

B

Contains speculative elements, uncertain capacity to meet financial commitments

Ba2 BB

Ba3 BB-

B1 B+Very low ability to meet financial commitments

B2 B

B3 B-

Caa1 CCC+

C

Low quality bonds, issuer may already have defaulted on a payment

Caa2 CCC

Caa3 CCC-

Ca CC Junk quality bonds, extremely speculativeC

Def

ault C

Not Prime

D

D Issuer in default

Christophe Bernard, Chief Strategist Vontobel Group

4

1. Future challenges for bond investors

Investor confidence has been badly shaken since financial turmoil and the debt crisis first broke back in 2008. The uncertainty has cast a deep shadow not only across equity markets, but bond markets as well. The traditional bene-fits of government bonds – risk-free investments guaran-teeing regular and lucrative interest payments – either no longer exist, or only apply to a limited extent.

1.1 Interest rates set to remain lowIn the past investors have usually done well by purchas -ing government bonds and “leaving them in the bottom drawer”. But this approach is becoming increasingly inef-fective, due to the historically low level of nominal yields on government bonds (Figure 1.2). Yields on sovereign bonds have been in permanent decline since the 1980s. By way of illustration: Swiss 10-year government bonds have yielded less than 1% since the fourth quarter of 2011, to give just one example. This compares with a yield of 3.5 % in mid-2008.

German Bunds denominated in euros currently even offer negative yields in real terms (adjusted for inflation), which means that investors’ purchasing power is actually diminishing. There is no sign of any improvement, as the European Central Bank is likely to maintain its policy of low interest rates for quite a while yet in the face of the smouldering bank crisis, anaemic economic data, rising unemployment and soaring government debt.

It is very unlikely that yields on (European) government bonds will quickly rebound over the coming decades to the sort of level they stood at 10, 20 or even 30 years ago – despite the fact that interest rates have probably bottomed out already.

The same is true of the USA. Here too, key interest rates stand at historical lows. The Chairman of the US Fed, Ben Bernanke, cautioned in February 2012 that he would be prepared to hold down interest rates until well into 2014 if necessary.

1.2 Public debt: negative trend in industrialised nations But it is not just low interest rates – especially in the euro zone and the US dollar region – that tend to make investments in sovereign bonds unattractive. Another argument against purchasing government bonds is the declining quality of issuers of sovereign debt. As the financial and debt crisis has deepened, the credit ratings of most euro zone countries have been downgraded. The question facing bond investors is therefore how – and where – they should invest the part of their port fo lio which they had previously assumed to be secure.

The situation is made worse by the fact that the debt mountains of euro zone countries will continue to soar in the years ahead due to unfavourable demographic trends (Figure 1.3). The keyword here is implicit state debt. This refers to the government’s future payment obliga -tions such as future welfare benefits and pensions, as well as public health and care for the elderly.

Adding these future implicit liabilities on to the existing (explicit) deficit makes it clear that the current level of public debt looks quite modest compared with what can be expected in future.

12

10

8

6

4

2

01960 20101990 200019801970

German 10Y Govt. Bond Yield Swiss 10Y Govt. Bond Yield

Figure 1.2: Government bond yields in decline

Source: Thomson Datastream

120

110

100

90

80

70

601991 1994 1997 2000 2003 2006 2009 2012

Source: Thomson Datastream

Figure 1.3: Government debt as a percentage of GDP

in industrialised countries

5

Unless countermeasures are taken, the demographic bur-den will force up euro zone debt from the current average of 80 % of gross domestic product (GDP) to more than 430 % (!) by 2060. This last figure includes implicit state debt. Although the expected increase in Switzerland will be far lower, from around 40 % at present to roughly 120 % of GDP by 2050, the final level will still be very high.

1.3 Corporate deleveragingIn contrast to individual states, the financial situation of most companies has improved significantly since the technology bubble burst in 2001. The comparison of US government debt as a percentage of GDP and corpo - rate debt as a percentage of US GDP shows that America’s (non-financial) corporations have made great strides in strengthening their balance sheets over the past 11 years (Figure 1.4).

120

100

90

80

70

60

502000 2002 2004 2006 2008 2010

US government dept to GDP ratio as a %

US non-financial corporate dept to GDP ratio as a %

Source: Datastream

Figure 1.4: Company balance sheets: Quality continuously

improving

25%

20%

15%

10%

5%

0%90 94 96 98 00 02 04 06 0892 10 12

US corporate high-yield spread

Default rate US speculative

Default rate baseline forecast

Default rate optimistic forecast

Default rate pessimistic forecast

Source: Thomson Datastream, Moody’s

Figure 1.5: : US corporate high-yield spread and

default rates in %

Issuers of high-yield bonds have also been fairly active. Their main focus in the years following the financial crisis of 2008/2009 has been to reduce their debt levels, extend the terms of their liabilities and build up cash reserves. Today the balance sheets of these debtors are healthier than they have been for most of the past 15 years, especially as far as the relationship between debt and profit is concerned. The default rate for high-yield bonds is therefore likely to remain very modest (Figure 1.5).

6

Faced with these challenges, investors can consider alter-native bond segments or equities. From both perspectives high-yield bonds are attractive.

2.1 Alternatives within the bond segmentThere are basically two ways for investors to gain expo-sure to bonds: firstly, they can diversify geographically by buying bonds from emerging-market countries. Secon d- ly, investors can also boost potential returns by investing in debt paper with lower credit ratings, such as high-yield bonds. In this study we will concentrate on this second option. We already published a study back in March 2011 on emerging market bonds, entitled “Opportunities created by the global power shift: in vesting in the next decade”.

2.2 So what makes high-yield bonds attractive as a substitute for equities?With equity investments, the attraction for investors is the prospect of sharing in future profits. Nevertheless, cor-porate profit margins are currently very high, and this pre-sents a problem: Since margins have a tendency to revert to the mean, they are likely to come under pressure in the short to mid-term, which will in turn have a negative im-pact on share prices. Other factors likely to unsettle equi-ty markets include weaker-than-average economic growth and the growing debt mountains of western industrialised nations. The need to make savings in many Western coun-tries will inevitably lead to higher taxes in the mid-term, which will have a negative impact on companies and ulti-mately also on their shareholders as providers of risk capital.

In such a climate, we expect equity markets to continue their volatile sideways trend, as they have done since 2000. At the same time the individual cycles are likely to be rather short. Timing will therefore be critical when investing in equities.

High-yield bonds are also exposed to these short cycles, although their value tends to fluctuate much less than share prices. High-yield bonds have another important advantage: a (lucrative) coupon.

2. Options available to bond investors

7

3.1 Large market, broad spectrumThe corporate bond market offers a broad spectrum of is-suers, sectors and rating categories. The USA continues to have the biggest selection of high-yield bonds. Accord-ing to the US rating agency Moody’s, the performance of Europe’s high-yield bond market was significantly dif-ferent in the first and second half of 2011. In the first six months of 2011, investors had a much bigger risk appetite for high-yield bonds, with frantic issuance activity reach-ing a total volume of 70 billion US dollars, even beating the prior record of 65 billion US dollars worth of new issues set in 2010. If the European debt crisis drags on, however, Moody’s reckons that the volume of issues in the European high-yield segment will fall short of more recent records.

3.2 High-yield corporates with increasing refinancing requirement The market for high-yield bonds should continue to grow: Companies will increasingly look for other sources of financing, because banks in both the USA and Europe are becoming more reluctant to lend money (Figure 3.1).

In the Global Financial Stability Report published by the International Monetary Fund in April 2012, the IMF em-phasises that European banks must significantly trim their balance sheets by the end of 2013 (Figure 3.2). For their part, European financial institutions have announced that they intend to reduce their assets by some 2 trillion US dollars in the mid-term. And if banks lend less money in future, institutional and private investors will step in to fill the gap.

3.3 Attractive yields and low volatility compared with equitiesThere is a common view that equities should be favoured over bond investments. For the past decade at least, that’s certainly not true. During this period US high-yield bonds performed much better than US equities – and with much less volatility. We therefore believe there is a strong possibility that the positive price trend of high- yield bonds will continue in the years ahead and will allow investors to enjoy significantly higher returns.

3.4 Default rates still modestAs far as default rates are concerned, the most important thing for investors is to screen issuers of high-yield bonds very thoroughly. Bank Vontobel reckons that the market is currently pricing in a default rate of 8 – 9 % for European companies – a figure that seems far too high. At the end of January 2012 the default rate stood virtually at a record

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

Sales of equities and reduction of interbank loans

Reduction in borrowing, rest of the world

Reduction in borrowing, euro zone

Trill

ion

US

dolla

rs

Negative scenarioNo policy changeReform scenario

1.7

0.4

0.1

2.0

0.4

0.2

2.5

0.9

0.4

Source: IWF, NZZ

Figure 3.2: Europe’s banks need to trim their balance sheets

3. Why invest in high-yield bonds?

Source: Moody’s

Figure 3.1: Companies increasingly financing themselves through bonds as the proportion of bank loans declines

150

120

90

60

30

0

80%

70%

60%

50%

40%

30%

20%

10%

0%

Bonds Bank Total Bank quota in %

2011

16

46

62

23

60

83

25

63

89

3645

81

2012 2013 2014

Trill

ion

US

dolla

rs

8

low of 2.2 %. The historical average for default rates is between 3 % and 4 %. Even if there is a slide back into recession, we do not expect default rates to climb above 6 % in the next 12 to 18 months.

3.5 Diversification boosts returnsBecause of their generous returns, high-yield bonds act as a hedge against inflation and are an effective instru-ment for diversification. Research has shown that adding high-yield instruments to a bond portfolio can not only reduce risk, but boost returns.

At the same time it would be a mistake to cast high- yield and government bonds in the same mould. In a well-balanced portfolio, the role of high-yield bonds is to enhance returns. The purpose of sovereign bonds is to act as a cushion for risk.

«High-yield corporate bonds

are an attractive addition

to portfolios in our view.»

ConclusionHigh-yield corporate bonds are an attractive addition to portfolios in our view, even though they can be riskier than government bonds. By investing in these securities, it is possible in the long run to achieve superior returns to those provided by investment-grade corporate bonds. Sometimes it is even possible to achieve yields that are similar to equities, but without the same level of risk and with much lower volatility.

3.6 Risks associated with high-yield bondsThe extra yield provided by high-yield bonds is mainly compensation for the credit risk: the possibility of the issuer defaulting. Apart from compensation for the gener-al systemic risks, the spreads can also reflect risks asso-ciated with liquidity, future events and (if the bond can be repaid before the maturity date) early redemption.

Economic performance can also be problematic for in-vestors in high-yield bonds. A deep recession and an esca-lation of the European debt crisis could trigger phases of increased volatility in high-yield bonds. Political uncer-tainty and social unrest could also depress demand for this type of debt paper.

9

Implicit state debts refer to the government’s future legal payment obligations, such as welfare or pension benefits, or public health and care for the elderly.

The default risk is the risk of a company that has issued bonds falling behind with payments or going bankrupt.

Long-term debt paper classed as investment grade by rating agencies is considered to be the highest quality. With the US rating agency Moody’s, for example, the ratings Aaa, Aa, A and Baa qualify as investment grade. Credit ratings of Ba or lower are classed as “below investment grade”, i.e. more speculative.

There are essentially two types of high-yield bonds. On the one hand, corporate bonds issued by companies with poor credit ratings (“below investment grade”), and on the other, emerging-market bonds. Because of the higher risk (of default), issuers of high-yield bonds pay a higher coupon, or interest rate.

Spread or risk premium: premium to compensate inves-tors for the risks associated with the purchase of riskier corporate bonds.

Volatility: fluctuations in share prices and interest rates on stock markets.

Annex – Glossary

06/1

2 EN

Bank Vontobel AGGotthardstrasse 43CH-8022 ZurichTelephone +41 (0)58 283 71 11Telefax +41 (0)58 283 76 50www.vontobel.com

Important legal notice: This document is for information purposes only and nothing contained in this document should constitute a solicitation, or offer, or recommen-dation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal act of any kind whatsoever. This document has been produced by Bank Vontobel AG. It is explicitly not the result of a financial analysis and therefore the “Directives on the Independence of Financial Research” of the Swiss Bankers Association is not applicable. The Vontobel Group and/or its board of directors, executive management and employees may have or have had interests or positions in, or traded or acted as market maker in relevant securities. Furthermore, such entities or persons may have or have had a relationship with or may provide or have provided corporate finance or other services to or serve or have served as directors of relevant companies. Although Vontobel Group believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this report.

Neither this document nor any copy hereof may be distributed in any jurisdiction where its distribution may be restricted by law. Persons who receive this report should make themselves aware of and adhere to any such restrictions. In particular this report must not be distributed or handed over to US Persons and must not be distributed in the USA. Any use, in particular the total or partial reproduction of this document or disclosure to third parties is only permitted with the prior written consent of Bank Vontobel AG.