GSAM’s High Yield Team Discusses the Outlook for 2011

Strategy InsightsFebruary 2011

GSAM’s High Yield Team Discusses the Outlook for 2011The high yield corporate bond market has been among the strongest performing sectors

of the global fixed income market in the last two years. In this Q&A, High Yield

co-heads Rachel Golder, Michael Goldstein and Rob Cignarella at Goldman Sachs Asset

Management (GSAM) discuss the potential for further gains in 2011, as more investment

opportunities arise across this fixed income sector.

Since the market rebounded in 2009, high yield has set records for returns and issuance. Based on your macroeconomic and corporate sector outlooks, are conditions still favorable for the high yield market in 2011?

Golder: We’ve just had two years of exceptionally strong high yield performance, and the environment remains very positive.

The difference now is an improving economic outlook, and gross domestic product (GDP) is probably the single best determinant of high yield performance. Growth signals have strengthened significantly over the past year, particularly in the US. Jobs gains are slower than most would like, but we’re moving in the right direction. We’ve seen promising sales gains in many sectors of the economy, and improving consumer confidence levels, which recently reached the highest levels since the onset of recession.

Among high yield corporate issuers, balance sheets in our view are now arguably stronger than ever before. Overall, companies are enjoying a great deal of flexibility in managing their businesses and are much more able to control their destiny at this point in the credit cycle. In the down-cycle of 2007-2009, the corporate sector focused on balance sheet repair and cost cutting, building cash reserves and extending the maturity of their debt. We’ve just seen the fourth consecutive quarter of earnings expansion.

With the improvement in economic growth and balance sheet fundamentals, the high yield sector has experienced a very swift decline in defaults. The high yield default rate peaked above 11% on an annualized basis in November 2009, and recently we’ve seen it reach close to 3% (on a trailing 12-month basis). We anticipate the default rate will approach 2% as we progress through 2011, roughly half the average over the past 20 years.1

Rachel GolderCo-Head of Global High Yield and Bank Loans and Head of Global Credit Research

Fixed Income

Michael GoldsteinCo-Head of Global High Yield and Bank Loans

Rob CignarellaCo-Head of Global High Yield and Bank Loans

1 All calculations based on Bloomberg, Barclays Capital and Standard & Poor’s data.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. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document.

Strategy and Outlook Strategy Insights

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Supply and demand factors are also supportive for high yield. Investor demand remains strong, and is making greater use of the asset class’s diversity. More investors are finding value in the thriving market for bank loans, and exploring yield opportunities in bonds from first-time issuers. In an environment of generally low global interest rates, we believe high yield credit continues to offer among the most attractive yields in fixed income.

Spreads have already come down considerably over the past two years. Can the high yield market deliver more for investors this year?

Goldstein: In our view, we’re in the midst of a virtuous cycle for credit, whereby strong demand is helping issuers reduce their borrowing costs and refinance debt, which is in turn helping to boost their credit quality. Moreover, the combination of macroeconomic and corporate factors that Rachel described makes this probably the most benign credit market environment I have seen in my career.

It’s true that the market has staged an extraordinary rebound from the crisis, which can prompt concerns that valuations are overstated. Recently risk premiums on high yield indexes declined below the market’s averages over the past couple of decades of around 550 basis points (bps). But given that risk premiums, or spreads, aim to compensate for risk of default, the current market levels still imply defaults around the rate of 4% to 5% over the next 12 months2. That is roughly double the consensus expectation for defaults. If defaults turn out to be closer to 2% in 2011, which is what we expect, we see room for risk premiums to decline further this year, taking levels on the benchmark global indexes3 closer to 425 bps over US Treasuries.

Moreover, cycles in the high yield market historically tend to last a long time, not weeks or quarters but years. For much of the last decade, and the decade before that, spreads were below average for stretches of four to five years, reaching the all-time tight level of 250 bps in May 2007. Considering this history, we think high yield spreads may be sustainable for an extended period at levels below their averages over the past 20 years.

What are the potential risks to this positive market outlook?

Cignarella: For most investors, concerns about rising interest rates are front and center. While we believe that low central bank policy rates in the US and Europe should keep benchmark government yields relatively well anchored at the front end of the curve this year, we do expect longer-dated yields to rise in line with strengthening growth. That trend is already in place, as government yield curves in the US and Eurozone have been steepening for months. Yet high yield bonds seems to have continued to outperform government bonds over that period.4

High yield historically has a relatively low correlation to rates markets. That’s because high yield is less exposed to rising interest rates, due to the additional income cushion implied by higher risk premiums and the generally shorter maturities on high yield debt. New high yield issues rarely carry maturities beyond 10 years, whereas maturities out

2 Calculations based on Bloomberg, Barclays Capital and Standard & Poor’s data. data. As of January 31, 2011.3 Global indexes include Merrill lynch US high Yield Master II Constrained Index, Barclays Capital US high Yield 2% Issuer Constrained Bond Index.4 Source: Bloomberg, as of February 23, 2011.

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. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document.




to 30 years are common in the investment-grade market. We believe that our High Yield Fund should be well well positioned to withstand pressure from rising rates, since their maturity profiles are shorter than those of the benchmark indexes. Moreover, in our view spreads compression in the high yield market this year should absorb most, if not all, of any potential impact from rates increases in 2011.

Golder: If interest rates rose sharply—for example, if a central bank saw the need to tighten earlier than anticipated—that could be a stiff headwind for high yield. But we do not anticipate central banks will hike rates in the US, Eurozone or UK this year. In the US, the Federal Reserve we believe is unlikely to hike rates until there’s evidence of increased inflation or jobs growth. In Europe and the UK, inflation risks are mounting, but we believe the main upward pressures are temporary. On balance, we think that aggressive fiscal cutbacks, combined with a weak banking sector and Eurozone sovereign risk concerns, will probably overwhelm the case for higher policy rates.

As we have discussed, even if markets start to price in higher rates in anticipation of future central bank tightening, we think high yield investors may be less impacted from the selloffs elsewhere in fixed income.

What about risks to your expectations for defaults?

Goldstein: In our view, typical drivers of defaults in high yield at this stage of the credit cycle would be debt refinancing problems, or companies pursuing overly speculative business models.

We don’t see refinancing problems scuttling the rally in high yield. As we have discussed, the corporate sector has historically high cash balances. Companies have termed out their debt and retired a lot of their bank debt in order to get ahead of pending covenant requirements. At the end of 2009 a key concern for investors was the so-called “wall of maturities,” as around $108 billion of debt was coming due in 2011-2012. Over the last two years, high yield issuers have succeeded in raising a massive $480 billion, and about two-thirds of that has been used to refinance existing debt.5

We also don’t see any compelling signs that speculative business models are becoming more popular. Companies are still putting the bulk of their funds to conservative use, that is, refinancing debt. We believe we are seeing a greater willingness on the part of companies to take on leverage, engage in mergers and acquisitions (M&A), leveraged buyouts (LBOs), dividends and share repurchases. But we are not seeing companies borrowing heavily for riskier ventures, such as to finance expansion around a housing or communications boom.

Cignarella: Leverage is still nowhere near the aggressive levels we saw in 2006-2007, and today’s LBOs are being financed with a greater proportion of equity. As a result, the modest re-leveraging we have seen since the crisis hasn’t materially moved the needle on credit quality. New issue credit quality is probably a little lower than it was last year, and last year’s was a little lower than the year before, but we believe it’s still very healthy.

5 Source: Barclays Capital






At these levels of activity, we anticipate high yield credits will benefit from M&A, which tends to involve a larger, higher rated entity buying a smaller one, and buying out existing bonds to pay down the highest-cost debt. The result is a sturdier credit profile for the merged company, and potential ratings upgrades. Even in the case of a credit-negative acquisition, the covenants on high-yield bonds tend to provide investors a measure of coverage.

Moreover, mergers activity is already bringing new issuers to the market, offering debt with attractive yields, which means new total return opportunities for portfolios.

On the topic of new opportunities in high yield, what do you see as the main growth areas for the asset class in 2011?

Golder: We are already seeing more investors moving into bank loans, and we believe this asset class will expand on last year’s remarkable growth.

We believe this increased demand comes partly as a result of investors’ concerns about rising interest rates. Bank loans have floating interest rates, so they have essentially zero duration risk. As a result, bank loans are in our view a natural alternative to lower-yielding fixed rate bonds at this stage of the credit cycle. To be sure though, loan obligations and loan participations can be subject to credit risk, or the non-payment of interest by the issuer.

Supply and demand technicals appear to be very strong for loans, as is the case across the high-yield market. Over December-January we saw around $4.5 billion flowing into bank loan mutual funds.6 When you see that level of intense interest in an asset class, you start to get concerned about a shortage of yield, but issuance is meeting demand. Last year brought close to $300 billion in new bank loans across the US and Europe, almost triple the previous year’s issuance.7

Goldstein: We also see strong potential for some previously unloved sectors to bounce back in 2011, in particular, those most exposed to the recovery in consumer confidence and spending. We are increasingly positive on gaming, where spreads are around 150 basis points (bps) in excess of market averages, and yields are around 8.45%.8 We also continue to favor some cyclical sectors that are levered to further improvements in growth in the US economy, such as chemicals and general industrial sectors.

In the US we’re increasingly sanguine on the prospects for the US banking sector. We have been underweight in financials in the past, and we remain cautious on European issuers. But we are identifying opportunities in some of the subordinated instruments of issuers that may be at a ratings crossover level, where we think there’s momentum for a potential upgrade to investment grade.

6 Source: AMG/lipper7 Source: Standard & Poor’s lCd leveraged loan Review 4Q20108 Source: Merrill lynch US high Yield Gaming Index, as of Feb. 10, 2011






Though our outlook on financials has evolved over the past year, within that context we continue to monitor a variety of security-specific or situation-specific risks. This surveillance is enabled and enhanced by the close coordination between our high-yield and investment-grade credit teams. These teams comprise analysts across New York, London and Tokyo, who know the macro and regulatory environments for financials in detail, and whose insights into individual credits are constantly leveraged in our investment process.

Which are the sectors you are most cautious on and why?

Cignarella: We pride ourselves on being global, and most of our non-US exposure is in Europe. Given the volatility we’ve seen in peripheral Eurozone markets, we are careful to favor sectors and issuers that should benefit from the strong growth in Germany and the Nordic regions. We are generally more cautious about investing in issuers dependant on growth in Greece, Spain, Portugal and Ireland.

As for industry sectors where we see limited opportunity, we remain bearish on electrical utilities, and natural gas in particular. In our view, natural gas prices are likely toweaken on abundant supply, as a result of new extraction technologies. Given a lack of integration across providers, we see little scope for profits to increase in this sector.

We also continue to avoid homebuilders. Though we have seen some indication that the housing market will bottom out this year, we see little likelihood of a near-term recovery in profits for construction companies.

Rachel, Michael, Rob – thank you.






Rachel Golder is the co-head of the high yield and bank loan team at Goldman Sachs Asset Management (GSAM). She is also the head of global credit research team, overseeing the high yield and investment grade research efforts. Before joining GSAM in 1997, she spent six years at Saudi International Bank (an affiliate of J.P. Morgan) as a high yield credit analyst and portfolio manager. She received a BA in Music from Yale University in 1983.

Michael Goldstein is co-head of the high yield and bank loan team at GSAM. Before joining GSAM in December 2010, he was director of high yield at Lord Abbett, where his primary responsibility was to help direct and implement high-yield investment strategy for the firm’s institutional and retail products. Michael earned an MBA from New York University and a BA in economics and political science from the State University of New York. He received his Chartered Financial Analyst (CFA) designation in 2001.

Rob Cignarella is co-head of the high yield and bank loan team at GSAM. He joined GSAM in 1998 as a corporate bond credit analyst and became a portfolio manager in 2004. Before joining GSAM, he worked for two and a half years in investment banking at Salomon Brothers. He received a BS in Engineering from Cornell University in 1991 and an MBA from the University of Chicago Graduate School of Business in 1998. He received his Chartered Financial Analyst (CFA) designation in 2001.

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Risk Considerations:The High Yield Fund invests in high yield, fixed income securities that, at the time of purchase, are non-investment grade. high yield, lower rated securities involve greater price volatility and present greater risks than higher rated fixed income securities. The Fund may also invest in foreign issuers who are denominated in currencies other than the US dollar and in securities of issuers located in emerging countries denominated in any currency. The Fund’s foreign and emerging market investments may be more volatile and less liquid than its investment in US securities and will be subject to the risks of currency fluctuations and sudden economic or political developments. At times, the Fund may be unable to sell certain of its portfolio securities without a substantial drop in price, if at all. The Fund may also engage in foreign currency transactions for hedging purposes including cross hedging or for speculative purposes. The Fund may make substantial investments in derivative instruments, including options, financial futures, eurodollar futures contracts, swaps, options on swaps, structured securities and other derivative investments. derivative instruments may involve a high degree of financial risk. These risks include the risk that a small movement in the price of the underlying security or benchmark may result in a disproportionately large movement, unfavorable or favorable, in the price of the derivative instrument; risks of default by a counterparty, and the risks that transactions may not be liquid.

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economic and market forecasts presented herein reflect our judgment as of the date of this presentation and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.

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GSAM’s High Yield Team Discusses the Outlook for 2011