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A WHITE PAPER FROM
PRUDENTIAL Fixed Income
The Case for Short-Maturity,
Higher Quality, High Yield Bonds
The institutional asset managers behind Prudential Investments’ mutual funds do more
than manage money. Many are also thought leaders and publish frequently in their areas
of expertise. This white paper offers you a manager’s current thinking on an important
industry issue. We hope this information is helpful in providing guidance for the financial
challenges facing you.
Perspectives
January 2012
The Case for Short-Maturity,
Higher Quality High Yield Bonds
Despite the economic, political, and market turmoil of the past several years, the high
Paul Appleby, CFA
Managing Director and Head of
Leveraged Finance Group
Prudential Fixed Income
yield bond asset class provided long-term investors with competitive risk-adjusted
returns. However, in today’s low interest rate environment, investors are seeking
additional yield or income with more modest levels of volatility and downside risk. We
believe that a well-researched, diversified portfolio of short-maturity, higher quality
high yield bonds can be an attractive investment opportunity within a broader asset
allocation strategy. In this paper, we evaluate the benefits of this niche sector and
explore the favorable fundamental and technical characteristics that lead to its
attractive value proposition.
Michael Collins, CFA
Senior Investment Officer and
Credit Strategist
Prudential Fixed Income
An Often Overlooked Segment of the High Yield Bond Market
Short-maturity, higher quality high yield bonds are often an overlooked segment of
the high yield bond market. A key reason is that
the yields offered by this segment do not rival
those of lower-quality or longer-term high yield
Short-Maturity, Higher Quality
debt. However, the structural reasons behind their
High Yield Bonds provide an
lower yields—shorter maturities and better
opportunity to diversify across
fundamental quality—have led the segment to
issuers, industries, and
offer the most attractive risk/return profile in the
maturities:1
high yield bond market over the long term.
Market Value²:
$248 Bil
We define short-maturity high yield bonds as
seasoned bonds that are slated to mature within
the next five years or are highly likely to be
tendered or called by the issuer within that time.
Within this universe, we have found that higher
quality credits—mostly BB and B rated bonds—
offer the most attractive opportunities.
# Issues:
499
# Issuers:
340
Industries:
38
Avg. Yield-to-Worst:
7.27%
Avg. Duration:
2.32 yrs
Avg. Maturity:
3.54 yrs
Avg Quality:
Ba3/B1
Avg. Option Adj Spread: 654 bps
1 Data
is for the Barclays Capital US High Yield
Ba/B 1-5 Year 1% Issuer Constrained Index
as of Dec. 31, 2011.
2 Market value is approximately 1/4 the size of
the total high yield universe.
To make our case, we first look at how higher
quality high yield bonds and short-maturity bonds
exhibit more favorable fundamentals and lower
volatility than lower-quality, longer-dated credits.
We then explain how market segmentation enables both higher quality bonds and
short-maturity bonds to be attractively valued, particularly in today’s low interest rate
environment. Finally, we look at the roles these securities can play in dedicated and
broader fixed income portfolios, as well as the risk considerations for this niche
sector.
Prudential Fixed Income
Perspectives January 2012
Page 2
Lower Credit Risk Allows Investors to Keep More Income
The stronger fundamental position, or credit quality, of BB and B rated bonds can best be illustrated by
first reviewing the default history of the high yield market as a whole, then the default history of each
quality segment of the market.
Over time, the high yield bond market averages approximately a 5% annual default rate. It ranges from
roughly 2% in good years when the economy and corporate fundamentals are strong, to more than 10%
in a bad year. This is typically when the economy undergoes a severe slowdown and/or liquidity comes to
a sudden halt, as it did during the financial crisis of 2008. As illustrated below, the most recent 12-month
U.S. corporate default rate is less than 2%, well below the historical average.
15
High Yield Bond
Default Rate by
Number of Issuers:
Mean Default Rate is
5.0% Historically
Defaults (%)
Average Default Rate
10
5
1.82%
Jan 1, 1989 to
Dec. 31, 2011
0
Source: Moody’s. Represents annual default rates. Past performance is not a guarantee or a reliable indicator of future results.
Not surprisingly, most defaults naturally occur in the lower-quality tiers of the high yield bond market. As
you can see below, the historical average annual default rate for BB rated issuers is only 2% compared to
5.2% for B rated issuers and almost 11% for CCC rated bonds. Given that the credit fundamentals of
higher quality high yield bonds are stronger to start with, they are less dependent on a robust economic
environment and have less refinancing risk than lower-quality high yield bonds.
12
Represents Average
5-Year Cumulative
Defaults by Quality
(Annualized)
Jan. 1, 1970 to
Dec. 31, 2010
10.8%
10
Defaults (%)
High Yield Bond
Defaults by Quality:
BB Rated Bond
Defaults are 2%
Historically
8
5.2%
6
4
2
0
2.1%
BB
B
CCC
Quality
Source: Prudential Fixed Income, based on data from Moody's 2010 Annual Corporate Bond Default Survey. (Moody’s 2011
Annual Corporate Bond Default Survey is expected to be released in late Feb. 2012.) Defaults are measured on an issuerweighted basis. Data was generated by averaging the five-year default rates of cohorts formed at monthly intervals, reported on an
annualized basis. Past performance is not a guarantee or a reliable indicator of future results.
Prudential Fixed Income
Perspectives January 2012
Page 3
The lower incidence of defaults in BB and B rated debt is largely responsible for the long-established
structural appeal of higher quality high yield bonds. As illustrated below, over the past 15 and 25 years
BB rated bonds delivered higher average annual returns and lower volatility than both B and CCC rated
credits. In fact, the volatility of BB rated bonds was half that of CCC rated issues. These results are
attributed to the fact that higher quality high yield bonds have re-paid their principal more often than
lower-quality bonds to well overcome their lower yields. Therefore, investors are not being
commensurately rewarded for the increased risk of going “down in quality.”
Higher Quality High
Yield is “Sweet Spot”
Over the Long Term
As of Dec. 31, 2011
Annualized Return (%)
10
BB
9
8
B
CCC
7
6
5
4
6
7
8
9
10
11
12
13
14
15
16
17
18
Annualized Volatility (%)
● 15 Years
 25 Years
Source: Barclays Capital. Data is for Barclays Capital US High Yield Ba Index, Barclays Capital US High Yield B Index, and Barclays
Capital US High Yield Caa Index. Volatility represents the annualized standard deviation of monthly returns. Past performance is not
a guarantee or a reliable indicator of future results. An investment cannot be made directly in an index.
Seasoned high yield bonds with a short remaining life also exhibit lower default characteristics. Most high
yield bond defaults occur in the early stages of a bond’s life cycle—within the first few years after being
issued. In other words, if a high yield company “survives” its first few years, it is much more likely to
survive long enough to repay its bonds at (or prior to) maturity. As a result, bonds that are due to mature
within the next few years tend to have the lowest default rates, as shown below.
7
Seasoned bonds have
lower historical
default rates
Seasoned (ShortMaturity) High Yield
Bonds Demonstrate
More Favorable
Default Statistics
Jan. 1, 1970 to
Dec. 31, 2010
Default Rate (%)
6
5
4
3
2
B
1
0
BB
10
9
8
7
6
5
4
3
2
1
Years Remaining to Maturity
Source: Prudential Fixed Income, based on data from Moody’s 2010 Annual Corporate Default Survey. (Moody’s 2011 Annual
Corporate Bond Default Survey is expected to be released in late Feb. 2012.) Past performance is not a guarantee or a reliable
indicator of future results
In summary, we believe the best way to reduce credit losses, and achieve strong, long-term risk-adjusted
performance, is to combine the two segments of the market with the most favorable fundamentals and,
therefore, the least amount of defaults: higher quality high yield bonds with a shorter maturity.
Prudential Fixed Income
Perspectives January 2012
Page 4
Attractive Valuation Supported By Market Segmentation
Short-maturity, higher quality high yield bonds are also supported by the effect of market segmentation,
which results in these bonds being overlooked by many high yield bond and investment grade corporate
bond investors. Market segmentation is an investment theory that attributes pricing anomalies in certain
markets to different preferences or tendencies by investors in those markets. Often, this results in certain
securities being undervalued relative to other segments of the market.
In the short-maturity, higher quality high yield space, market segmentation is evident for two reasons:
1) limited demand for the BB rating category, and 2) trading convention differences (spread vs. yield).
1) Limited Demand for BB Rating Category
The investment objectives and risk tolerances of traditional investment grade corporate bond and high
yield investors do not tend to favor higher quality high yield bonds. Investors in investment grade
corporate bonds are often explicitly restricted from buying non-investment grade, or high yield, bonds.
Conversely, many high yield investors deliberately underweight the highest quality/lowest yielding bonds
within the high yield market because of their lower yields relative to lower-quality bonds. This lack of
natural buyers generates a tendency for higher quality high yield bonds to be undervalued, leading to a
favorable risk/return profile over the long term.
2) Trading Convention Differences (Spread vs. Yield)
Investment grade corporate bond investors pay close attention to the level of U.S. Treasury yields, as the
market trades based on the yield “spread” between an investment grade corporate bond and a U.S.
Treasury bond. In today’s market, many investors consider a high quality investment grade corporate
bond that provides +100 to +200 bps in spread over U.S. Treasuries to be attractive. Because U.S.
Treasury yields are at historic lows, investment grade corporate bonds with two-to-five years to maturity
can find willing buyers even at yields of 2%.
High yield bond investors, on the other hand, are more focused on the absolute yield of a high yield bond.
For this reason, most high yield bonds are traded on a dollar price or an absolute yield basis instead of on
a spread basis. In terms of absolute yields, many high yield investors find it unattractive to buy a high
yield bond with a yield to maturity of less than, say, 5% in today’s market, especially one with little room
for price appreciation because of its short maturity. As a result, in today’s extraordinarily low U.S.
Treasury yield environment, short-maturity, higher quality high yield bonds trade at very high spread
levels relative to similar duration U.S. Treasuries and investment grade corporate bonds.
Prudential Fixed Income
Perspectives January 2012
Page 5
Key Favorable Risk/Return Characteristics in the High Yield Universe
The combination of relatively attractive spreads and lower historical default rates vs. traditional high yield
bonds has led to very attractive risk-adjusted returns for short-maturity, higher quality high yield bonds. As
shown below, the historical annualized returns of short-maturity, higher quality high yield debt have been
just slightly below the returns of the broad high yield market, but with considerably less volatility, resulting
in a superior Sharpe ratio.
Short-Maturity, Higher
Quality High Yield
Bonds (Short HQHY):
Comparable Returns
with Lower Volatility
Jan. 1, 1997 to
Dec. 31, 2011
Annualized Returns (%)
8.5
8.0
7.5
Short HQHY
BB/B 1-5 Yr
7.0
HQHY
BB/B
HY
6.5
6.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
10.0
Annualized Volatility (%)
Barclays Ba/B
1-5 Yr Index
Barclays Ba/B
Index
Barclays HY
Index
Annualized Return
6.84%
6.83%
6.99%
Annualized Volatility
6.75%
8.53%
9.73%
Sharpe Ratio
0.56%
0.44%
0.40%
Data source: Barclays Capital. Calculation source: Prudential Fixed Income. Data is for following indices: Short HQHY: Barclays
Capital US High Yield Ba/B 1-5 Year 1% Issuer Constrained Index; HQHY: Barclays Capital US High Yield Ba/B 1% Issuer
Constrained Index; HY: Barclays Capital US High Yield 1% Issuer Constrained Index. Jan. 1, 1997 is the inception date of the
Barclays Capital US High Yield Ba/B 1-5 Year 1% Constrained Index. Past performance is not a guarantee or a reliable indicator of
future results.
Attractive Yields and Spreads Today
Short-Maturity HQHY:
Current Yield-toWorst is About 7.3%
As of Dec. 31, 2011
Yield-to-Worst (%)
If an investor wants good relative value and lower volatility, the yields of short-maturity, higher quality high
yield bonds are quite attractive, especially today. In fact, the current yield-to-worst of a representative
index was 7.3% as of Dec. 31, 2011 (as measured by the Barclays Capital U.S. High Yield Ba/B 1-to-5
Year 1% Issuer Constrained Index.) Yields in the index ranged from approximately 5.0% for one-year
issues to 8.5% for 5-year maturities.
9
8
7
6
5
4
3
2
1
0
Short HQHY BB/B 1-5 Yr
US Treasuries
1-Yr
5-Yr
3-Yr
8.54%
6.66%
4.93%
0.10%
0.39%
1
3
0.88%
5
Weighted Average Life (Years)
Data source: Barclays Capital. Calculation source: Prudential Fixed Income. Data for Short HQHY is the weighted average yield-toworst of 1, 3, and 5-year issues in the Barclays Capital US High Yield Ba/B 1-5 Year 1% Constrained Index. Past performance is not
a guarantee or a reliable indicator of future results.
Prudential Fixed Income
Perspectives January 2012
Page 6
From a spread perspective—the yield spread of short-maturity, higher quality high yield bonds over U.S.
Treasuries—the sector also looks attractive. Current spreads are 654 bps over equivalent-duration U.S.
Treasuries. Historically, spreads average roughly 500 bps.
1,800
Short-Maturity HQHY:
Current Above-Average
Spread Over US
Treasuries of 654 Bps
Jan. 1, 1997 to
Dec. 31, 2011
Spread (Bps)
1,600
1,400
Short HQHY BB/B 1-5 Yr
Average Spread
1,200
1,000
800
600
654
400
200
0
Source: Barclays Capital. Data is for the Barclays Capital US High Yield Ba/B 1-5 Year 1% Issuer Constrained Index. The inception
date of the index is Jan. 1, 1997. Past performance is not a guarantee or a reliable indicator of future results.
Using Short-Term High Yield Bonds to Enhance an Overall Fixed Income Portfolio
In addition to investing in a dedicated portfolio of short-maturity, higher quality high yield bonds, there are
a number of roles these securities can play in broader fixed income portfolios today.
Short Duration Credit Portfolios: With money market rates near zero, short duration portfolios that offer
even modest levels of yields have garnered much attention. A diversified short duration credit portfolio
may be comprised of short duration corporate bonds, select structured securities, senior secured loans,
and short-maturity, higher quality high yield bonds.
High Yield Bond Portfolios: The higher quality and short maturities of these bonds can help offset some
of the risk of lower-quality bonds in a broad market high yield portfolio. The lower volatility and lower
interest rate sensitivity of short-maturity, higher quality high yield bonds can also improve the overall risk
profile of these portfolios.
Core Plus Portfolios: Holding short-maturity, higher quality high yield bonds vs. the many short duration
government bonds and agency mortgages in the Barclays Capital U.S. Aggregate Bond Index appears to
be a great relative value trade at the current time.
Absolute Return Portfolios: Absolute return portfolios typically seek competitive risk-adjusted returns
relative to LIBOR. The absolute risk/return characteristics of short-maturity, higher quality high yield
bonds, and their significant current spreads vs. LIBOR, make them attractive today for these types of
opportunistic portfolios.
Risk and Analytical Considerations
There are three primary risks to short-maturity, higher quality high yield securities: credit risk, refinancing
risk, and market risk.
 Credit Risk: The most significant risk is credit risk. Naturally, it is imperative to carefully scrutinize each
individual issuer prior to purchase and while held in a portfolio to minimize default risk. Although default
risk may be mitigated because of the short maturities of the issuers, it is still a risk that must be closely
analyzed and monitored. In fact, analysts typically have much better visibility and insight into the
trajectory of a company’s credit profile over a short time horizon. Accordingly, analysts can more easily
Prudential Fixed Income
Perspectives January 2012
Page 7
identify those short-maturity high yield bonds that are likely to avoid default through maturity. We would
also note that, at the time of this writing in January 2012, credit quality is healthy and defaults are
expected to remain below average over the next several years.
 Refinancing Risk: The second risk is refinancing risk. Quite simply, the success of a strategy employing
short-maturity, higher quality high yield bonds hinges on the ability of the issuers to pay off their shortmaturity debt when it comes due. During times of extreme market stress, such as that seen in 2008, even
creditworthy companies can have temporary trouble accessing the markets to refinance their outstanding
debt, potentially leading to an inability to pay off existing bondholders. To properly assess this risk,
analysts must carefully review the issuer’s cash balances, its access to cash via a credit facility, its ability
to generate free cash flow by operations or asset sales, and its access to the capital markets. In today’s
market, many corporations have sufficiently strong cash balances and place a high value on liquidity,
given the turmoil in the financial markets in 2008. We believe these companies are in a good position to
pay off their outstanding short-term debt as it comes due.
 Market Risk: Periods of extreme market stress can lead to disruptive price volatility, even in short-maturity
bonds. In late 2008, systematic redemptions from high yield bond mutual funds and the widespread
portfolio deleveraging by investors, financial institutions, and hedge funds that impacted many fixed
income securities led to massive forced selling of many bonds. In an “unplanned liquidation” situation like
this, many high yield portfolio managers will sell the lowest-yielding, most “cash-like” bonds they own.
This may result in heavier-than-normal selling of short-maturity, higher quality high yield bonds. In
addition, bonds that are expected to be called near term may “extend” to a longer-term call date or
maturity, which could cause the bond’s price to drop further.
In Summary
A diversified portfolio of short-maturity, higher quality high yield bonds can offer an attractive risk/return
profile in a dedicated portfolio or in conjunction with a broader asset allocation strategy.
Short-maturity, higher quality high yield bonds exhibit more favorable fundamentals and lower defaults,
lower volatility, and more competitive long-term performance than lower-quality and longer-maturity high
yield bonds.
•
Market segmentation allows this niche sector to be attractively valued over time and especially in
today’s low U.S. Treasury rate environment.
•
Key risks can be mitigated through careful research, analysis, and portfolio management.
We believe today’s market environment provides an attractive entry point into this niche sector of the
fixed income market.
Prudential Fixed Income
Perspectives January 2012
Page 8
Notice
© 2012, Prudential Investment Management, Inc. Unless otherwise indicated, Prudential holds the copyright to the
content of the article. Prudential Investment Management is the primary asset management business of Prudential
Financial, Inc. Prudential Fixed Income is Prudential Investment Management’s largest public fixed income asset
management unit, and operates through Prudential Investment Management, Inc. (PIM), a U.S. registered investment
adviser. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its
related entities, registered in many jurisdictions worldwide.
These materials represent the views, opinions and recommendations of the author(s) regarding the economic
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Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will
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needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular
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ADV.
2012-0123
Index Definitions
The indices are presented to provide you with an understanding of their historic long-term performance and are not presented to illustrate the
performance of any security. The indices defined below are unmanaged. Investors cannot invest directly in an index or average. Past performance
is not a guarantee of future results. Individual investor results will vary.
Average Yield to Worst is the lower bond yield of yield to maturity or yield to call.
Average Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates.
Duration is expressed as a number of years.
Average Maturity is the average time to maturity for a bond.
Average Option Adjusted Spread of a bond or bond indexes is the current spread over the benchmark minus that component of the spread that is
attributable to the cost of the embedded options.
Barclays Capital U.S. High Yield 1% Issuer Constrained Index is an unmanaged index that covers the universe of U.S. dollar-denominated,
non-convertible, fixed-rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final
maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba1 or lower.
Barclays Capital Ba/B 1% Issuer Constrained Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible,
fixed-rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final maturity, at
least $150 million par amount outstanding, and be publicly issued with a rating of Ba or B.
Barclays Capital Ba/B 1–5 year 1% Issuer Constrained Index is an unmanaged index that covers the universe of U.S. dollar-denominated,
non-convertible, fixed-rate, non-investment-grade debt. Issuers are capped at 1% of the Index. Index holdings must have at least one year to final
maturity, at least $150 million par amount outstanding, and be publicly issued with a rating of Ba or B and maturities from one to five years.
Barclays Capital U.S. High Yield Ba Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate,
non-investment-grade debt. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be
publicly issued with a rating of Ba.
Barclays Capital U.S. High Yield B Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixed-rate,
non-investment-grade debt. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and be
publicly issued with a rating of B.
Barclays Capital U.S. High Yield Caa Index is an unmanaged index that covers the universe of U.S. dollar-denominated, non-convertible, fixedrate, non-investment-grade debt. Index holdings must have at least one year to final maturity, at least $150 million par amount outstanding, and
be publicly issued with a rating of Caa.
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