Goldman Sachs Asset Management

Case for High Yield

September 2010

In our view, the current fragile economic conditions present a potential sweet spot for highyield investment, and its worth getting to know the asset class better, to understand the value it continues to offer.

High-yield bonds led global financial markets in a powerful rebound from the credit crisis, delivering investors at this riskier end of the corporate bond market record returns in 2009. The rally has given way to more tentative gains in 2010 across all asset classes, each of which faces new challenges as the global economy recovers. The high-yield market has responded to those challenges so far with robust returns and healthy new issuance.
We believe the key point for investors contemplating new or continued allocations to high yield is that the current subdued outlook for the global economy is better suited to the asset class than many appreciate. While equities flourish in periods of strong growth, and government debt fares best in a severe downturn, corporate bonds tend to outperform other asset classes in periods of moderate economic activity. Furthermore, the very factors that sustain that modest growth outlook are also supportive of the high yield market. Historically low interest rates which are likely to persist as the major economies recover encourage demand for high yielding assets, as investors aim for better returns. And solid signs of improvement in the corporate sector, including stronger balance sheets and generally robust earnings reports, add to the attraction of corporate debt. In our view, the current fragile economic conditions present a potential sweet spot for high-yield investment, and its worth getting to know the asset class better, to understand the value it continues to offer.

What is high yield?

The high-yield market consists of debt issued by companies with low credit ratings, for 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 shift towards refinancing existing debt, though, as companies have taken advantage of a lower interest rate environment, and resurgent investor appetite for yield, to lock in comparatively cheap funding. Indeed, having virtually shut down at the height of the crisis in 2008, the high-yield market has reopened with a vengeance. By mid-September, this years 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 of high yield bonds outstanding globally in excess of US$1.2 tn in face value as of this year. Though the bulk of 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.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information 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. Please see additional disclosures. FOR PROFESSIONAL INVESTORS USE ONLY NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.

The appeal of high yield for investors boils down to three main factors. The first, and most obvious, is the higher potential income for investors.

Technically, the high-yield asset class comprises the roughly 20% of the global corporate bond market that is rated below investment grade by the leading ratings agencies (in the BB category or lower for Standard & Poors; Ba category or lower for Moodys Investors Service). To compensate for their lower credit quality, high yield bonds pay investors larger coupons than both high-quality corporate bonds and government debt. The size of the coupon depends largely on the perceived risk of default on the bonds. Ratings agencies base their ranking on factors such as the corporate borrowers business risk, the amount of debt on its balance sheet, and where the bonds sit in the companys capital structure, which determines the priority of principal repayment. Not all high-yield debt started out that way, however. About a fifth of the market consists of fallen angels debt of companies that lost their investment-grade ratings as a result of a merger or LBO, or deteriorating performance.

Appeals of high yield

The appeal of high yield for investors boils down to three main factors. The first, and most obvious, is the higher potential income for investors. Secondly, high yields comparatively low correlation with other asset classes means this debt can help add diversity in a portfolio. And thirdly, the tendency of high-yield debt towards shorter maturities, and its close relationship to the corporate borrowers performance, makes these bonds generally less sensitive to interest-rate cycles (duration risk) than most other fixed-income instruments. The income potential in high yield owes to the higher coupons they offer relative to most other debt, and to their considerable scope for price appreciation. High-yield bonds currently pay roughly 4.81% more than investment grade bonds, to compensate for the higher perceived risk of default. But assuming the borrower keeps up with payments on the companys debt, high-yield bonds also have ample opportunity to gain in value. Positive news for the corporate borrower, such as a ratings upgrade, a better-thanexpected earnings report or promising new products or management changes, are all potential drivers of price appreciation. Furthermore, at the level of the market, high yield debt overall may benefit from improvements in investors general appetite for risk, whether its spurred by greater confidence in the economy, or increased demand for higher-yielding assets in a low interest-rate environment. Total returns annually, reflecting coupon and price contribution
70% 50% 30% 10% -10% -5.20% -30% -26.11% -50% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 YTD 4.48% Coupon return % Price return % 27 .97% 10.87% 2.78% 10.76% 2.53% 8.48% 58.10%

-0.53%

Source: Merrill Lynch. This graph breaks down the components of return on high-yield investments. The coupon on high-yield bonds provides a source of income annually, regardless of the direction of the market. Meanwhile, bond price fluctuations which may be specific to the individual bond, or driven by general market movements can add or subtract from that income. Last years returns were a highly favourable combination of the two components.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information 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. Please see additional disclosures. FOR PROFESSIONAL INVESTORS USE ONLY NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.

In terms of ratings, high-yield credits are covered by 11 classifications, from the cusp of investment grade, down to the distressed levels closest to default.

High yield is also useful for investors as a way of diversifying risk in their portfolios. High yield bonds have low correlation with both government bonds and equities, meaning their performance isnt closely tied to either asset class. Though the correlation between highyield debt and equities does increase from time to time, high yield is less sensitive to economic news. The main drivers of high yield performance are idiosyncratic, such as the state of the issuers balance sheet, or the extent of active trade in their bonds. Well-balanced portfolios also take advantage of the opportunities to diversify within the asset class, by ratings, and across corporate sectors. These sectors range from the more defensive, such as utilities, to those more exposed to economic cycles, such as retail. In terms of ratings, high-yield credits are covered by 11 classifications, from the cusp of investment grade, down to the distressed levels closest to default. Distinctions also exist between high-yield credits according to their seasoning, that is, where they are in their life cycle. The average high-yield bond has a life span of just 4-5 years. In the first couple of years after their launch following a companys initial public offering 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 bonds term, is when the majority of high-yield defaults occur. From this point on, though, the bond has the most potential to appreciate substantially since, if the company survives, it will have executed its capital plan and be on to the next phase. By the time they are four years or more into their tenor, these bonds are likely to be offering a generous spread for the amount of risk involved. Prudent managers aim for a healthy mix of these three so-called cohorts of high-yield. The third key attraction in high yield, particularly for dedicated fixed-income investors, is their lower duration risk, or lower vulnerability to rising interest rates, relative to other fixed-income assets. Their shorter life 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 offers over other fixed-income instruments provides a cushion for investors against potential losses in a rising interestrate environment. Furthermore, since interest-rate hikes are generally a sign of a strengthening economy, any corresponding improvement in corporate sector profits may well help high-yield debt outperform other fixed-income assets.

Risks of high yield

Of course none of these benefits can be guaranteed, and the extra yield in high-yield bonds is offered as compensation for a higher risk of default. Anyone looking for an illustration of the key pitfalls in high yield investing need look no further than the recent crisis. At the end of 2009, that record year for both returns and issuance, high yield defaults hit a peak of 13.48%, according to Moodys. The shakier credits were the first market casualties of the crisis, as low-rated companies that had borrowed heavily in the preceding years of razor-thin interest rates and heavy investor demand found themselves unable to access capital markets at all. Periods of turmoil in financial markets often take a greater toll on risk assets, as investors tend to offload these first, in favour of more conservative assets offering better principal protection and more stable returns; usually government bonds. The exodus from high yield in mid-2007 to early-2009 drove bond prices sharply lower and issuers borrowing costs to record highs, and effectively froze the market. Though these exceptional events affected 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 of illiquidity, or poor trading conditions. To minimise that liquidity risk, our professionals target securities that will perform over a two- to three-year investment horizon. An added benefit of this buy and hold strategy is that it limits the transaction costs associated with trading in and out of positions on a more regular basis. Another way to limit liquidity risk is to maintain globally diverse portfolios.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information 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. Please see additional disclosures. FOR PROFESSIONAL INVESTORS USE ONLY NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.

The normalisation of 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.

This sort of diversification is as important as ever, as financial markets respond to the latest threats to global growth: unsustainable debt burdens and fiscal distress among the governments of the developed world, and uncertainty over how impending regulatory reforms will impact financial institutions in still-fragile 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.

Why high yield now?

The normalisation of 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 years subdued economic environment is likely to favour high yield. We believe the most conducive environment for corporate credit is economic growth in the order of 0%-2%. Any slower, and the contraction harms the corporate sector; while faster 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 confident will favour 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 of declining default rates, which has been a key support for high yield over the past year. The spike in risk premiums during the crisis significantly overstated the likelihood of defaults on high-yield debt, with estimates at the beginning of 2009 running well above historic levels in excess of 20%, far more than was justified by the fundamentals underlying the corporate sector. In its most recent defaults report, released in August, Moodys projected the high yield default rate would fall to 1.8% in the first half of next year. Continued improvements in corporate earnings and balance sheets, which have in turn facilitated record high-yield issuance over the past year, should keep such promising default projections on track. Furthermore, the success high yield issuers have had accessing markets since the crisis augers well for the asset class in the coming years. Among the biggest threats to the health of the market was the mountain of debt corporate borrowers had to refinance. Despite the strong trend of deleveraging since the crisis struck, high-yield borrowers face massive funding requirements over the next five 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.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information 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. Please see additional disclosures. FOR PROFESSIONAL INVESTORS USE ONLY NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.

The markets boom may be over for now, but in this uncertain investment environment, high yield has more to offer.

Use of annual high-yield proceeds 2005-2010

HY Issuance (US$bn) 200 Renancing LBO 160 M&A Recap Gerneral Purp. Other

120

80

40

2005

2006

2007

2008

2009

2010 YTD

Source: Standard & Poors, LCD. As of 30 September 2010. Historically, companies have used most of the proceeds of their high-yield borrowing to finance mergers and leveraged buyouts. This balance has shifted dramatically the most popular use for the record volume of high-yield issuance since the credit crisis has been debt refinancing.

Of course, this fundraising would not have been possible without very resilient investor demand. That demand, inspired initially by the need to build profits following a devastating year in financial markets, remains supported by a shortage of yield opportunities elsewhere. Yields on more conservative fixed-income instruments, such as Treasuries and some investment grade bonds, remain anchored by historically low interest rates in the worlds leading economies. And those exceptionally low levels are likely to persist for the foreseeable future. With the sharpest moves of the credit markets rebound behind us, investors are struggling to adjust to what could be a prolonged period of halting economic recovery. But the prevailing environment of modest growth and historically low interest rates, combined with strengthening corporate earnings, make high-yield attractive for investors with the capacity to research their choices in this hugely diverse asset class. The markets boom may be over for now, but in this uncertain investment environment, high yield has more to offer.

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information 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. Please see additional disclosures. FOR PROFESSIONAL INVESTORS USE ONLY NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.

If you would like more information please contact your Goldman Sachs Asset Management Relationship Manager

Additional information
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAMs prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient. High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities. This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research (GIR) Department. The views and opinions expressed may differ from those of the GIR Department or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of 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 financial promotion and has been approved solely for the purposes of Section 21 of 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

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This information 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. Please see additional disclosures. FOR PROFESSIONAL INVESTORS USE ONLY NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC.