Manager Research Newsletter: October 2017

Portfolio Construction: Considering Moving from High Yield into Investment Grade? Read This First.

After eight years of economic expansion, many investors are beginning to question how much longer the bull market can continue. As a result, institutional investors are deciding on ways to better position their portfolios moving forward. One particular area of interest has been in fixed income, where investors are concerned about tight credit spreads and the Fed signaling that rates are poised to continue to rise. While many take this as a sign to trim the credit risk of their fixed income portfolio, they may be underestimating another important factor, which is the added interest rate risk that comes with the transition from high yield bonds to investment-grade bonds.

Reducing Credit Risk May Increase Interest Rate Risk

Coinciding with the current bull market from March 9, 2009 to August 31, 2017, high yield bond investors have been rewarded with a total return of 191.93%, or 13.46% annualized (based on BofA Merrill Lynch "High Yield" Master II Constrained Index). As the United States enters the later stages of the economic cycle, investors may be considering their options as they manage risk in their portfolio. With respect to fixed income, it is important to focus on positioning the portfolio to better align with the expectation of rising rates.

Given that we believe the economy is expected to continue to grow, albeit at a slower pace, investors may be focusing on the wrong risk. With regards to fixed income, a typical reaction for many investors is to reduce their high yield exposure and shift to investment-grade credit. While this move is seemingly logical, for investors looking to reduce their credit risk, they may be ignoring the increased interest rate risk as the move from high yield to investment-grade corporate has historically increased the effective duration. As rates continue to slowly climb and the economy continues to stabilize, interest rate risk will arguably be more problematic. Additionally, the potential for give-up in yield when going from high yield to investment grade may be a significant headwind for both income-centric and total return investors.

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Against this backdrop, a short duration high yield strategy could be compelling. The BofA Merrill Lynch 1-5 Year BB-B Cash Pay High Yield Index ("Short Duration High Yield") is a subset of the BofA Merrill Lynch US Cash Pay High Yield Index, and it includes all securities that have a remaining term to final maturity of less than five years, and is rated BB1 through B3. In this article, we discuss some important characteristics across these indices, as well as the BofA Merrill Lynch US Corporate Master Index ("Investment Grade").

As the name suggests, the short duration high yield index includes high yield bonds with shorter maturities than the high yield index. It has an effective duration of 2.19 years, which is markedly less than the broad high yield index’s effective duration of 3.94 years. Despite the lower duration, short duration high yield is able to deliver approximately 75% of the yield at 4.16%, compared to 5.62% for high yield.(Source: Bloomberg, as of 8/31/17). Furthermore, the credit quality of the bonds in the short duration high yield index is higher than those in the high yield index. Not only does this lower the duration, but it also may improve the credit quality of the portfolio – an important point many investors miss.

Volatility across the Fixed Income Quality Spectrum

Short duration high yield and investment-grade corporate bonds have exhibited similar risk profiles, as measured by standard deviation. For the period ended August 31, 2017, the short duration high yield index has exhibited a lower standard deviation than the investment-grade corporate bond index over the most recent five-year period (3.66% vs. 3.89%), while only being slightly higher over the last three years (4.24% vs. 3.86%). For the last 10 years, which includes the Financial Crisis of 2007-2008 and the Great Recession, short duration had a standard deviation of 8.05%, compared to 5.88% for investment grade and 10.51% for high yield corporate.



More importantly, the downside risk (semi-standard deviation) for short duration high yield is also attractive. As seen in the chart below, it has a lower downside deviation, compared to both investment-grade corporate and high yield bonds across the three- and five-year time periods, while falling between the two on the longer 10-year time horizon.



Consider the Yield vs. Duration

Since the merits of volatility as a risk measure for fixed income can be debated, it is very important to consider both the credit risk and the interest rate risk across these three indices as well.

With regards to interest rate risk, the move from high yield to investment-grade corporate has historically increased the effective duration, making it more susceptible to rising rates. Short duration high yield, however, would potentially lower the effective duration to 2.19 years and retain the yield component, better positioning the portfolio in a spread widening or risk-off environment.

Another important metric that shows the value of short duration high yield as an asset class is the yield per unit of duration, which is calculated by dividing the yield to worst by the effective duration. This measure can help us understand the expected return per unit of interest rate risk for the index.

As the exhibit and chart above demonstrate, a small increase in interest rates may have significantly cut into the expected return of investment-grade corporate bonds. By this measure, short duration high yield may be best positioned for a rising rate environment.

While the lower duration is certainly beneficial in a rising rate environment, high yield as an asset class tends to be more sensitive to its credit quality than to its interest rate risk. Inherently, investment-grade bonds will have a higher credit rating than high yield bonds. However, the short duration high yield subset falls in between those two asset classes, as seen in Exhibit 3:

Interestingly, moving from high yield corporate to short duration high yield has historically eliminated or reduced the exposure to bonds rated CCC and below, and increases the allocation to BB- and B- rated bonds; both of which significantly improve the credit quality of the portfolio. The current default rate on CCC-C bonds is more than double that of B- rated bonds at 55.84% vs. 27.46%.1


Correlation to the 10-Year Treasury

With the Fed poised to continue to raise short-term interest rates, the yield on the 10-Year Treasury is likely to rise, meaning the price of Treasurys may fall. In this scenario, we believe it may be beneficial to own an asset class that has historically had a low or negative correlation with Treasury bonds.

Both the high yield corporate and short duration high yield indices have exhibited a lower correlation with the 10-Year Treasury than the investment-grade corporate index over the last three-, five-, and 10-year time periods. Short duration high yield, in particular, has the lowest correlation to the 10-Year Treasury, with a -0.10 correlation for the past three years, 0.00 for five years, and -0.24 for the last 10-year period.


Performance in Rising Rate Periods

Lastly, by looking at several periods of stress over the past couple decades, we can evaluate how the different fixed income asset classes performed during various macroeconomic environments. The following chart illustrates the performance of the high yield corporate, short duration high yield, and investment-grade corporate indices during the two most recent periods of Fed tightening, which are the two instances since the short duration high yield index’s inception on December 31, 1996.

The short duration high yield index outperformed the investment-grade index by an average of 8.1% in both of the periods above. In other periods of rising interest rates, short duration high yield has exhibited a similar relationship, as seen below:

The two periods above represent the US economy emerging from the Great Recession, during which the 10-Year Treasury’s yield increased by 141 basis points, and the Taper Tantrum in 2012-2013, during which the yield on the 10-Year Treasury increased 113 basis points. Once again, short duration high yield outperformed the investment-grade corporate index by a substantial margin, averaging an additional 17.7% in cumulative total return.


Conclusion

When deciding how to be best-positioned for the upcoming macroeconomic environment, the short duration high yield subset of the high yield corporate index appears to be an attractive alternative, compared to making the switch from high yield to investment-grade corporate in many regards. In addition to significantly shortening the duration to only 2.19 years, the index maintains an attractive yield-to-worst of 4.16%, while also finding a compromise between the two in terms of credit quality. Beyond those metrics, the asset class has delivered extremely attractive returns during periods of Fed tightening and while Treasury yields were rising.


Percentages are based on fixed-income securities held in the Fund's investment portfolio and exclude any equity or convertible securities and cash or cash equivalents. Ratings apply to the underlying portfolio of debt securities held by the Fund and are rated by an independent rating agency, such as Standard and Poor's or Moody's. If ratings are provided by the rating agencies, but differ, the lower rating will be utilized.If only one rating is provided, the available rating will be utilized. Securities that are unrated by the rating agencies are reflected as such in the breakdown. Unrated securities do not necessarily indicate low quality. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade.

Returns represent past performance which is no guarantee of future results. Current performance may be lower or higher. Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Performance reflects a contractual fee waiver and/or expense limitation agreement in effect through 2/28/18, without which total returns may have been lower. This agreement renews automatically for one-year terms unless written notice is provided prior to the start of the next term or upon approval of the Board. Visit mainstayinvestments.com for the most recent month-end performance.

Average annual total returns include the change in share price and reinvestment of dividends and capital gain distributions. Class I shares are generally only available to corporate and institutional investors. Class R shares are available only through corporate-sponsored retirement plans.

SEC 30-Day Yield is based on net investment income for the 30-day period ended 9/30/17 divided by the offering price per share on that date. Yields for other share classes will vary.

Unsubsidized 30-Day Yield reflects what the yield would have been without the effect of waivers and/or reimbursements. Please note that there was no reimbursement for this time period.
MainStay Short Duration High Yield Fund

Intensive Credit Research
A time-tested, value-oriented selection process that seeks to identify undervalued credit of companies with stable, positive cash flow and strong balance sheets.

Short Maturity
The Fund seeks to minimize interest rate risk by keeping a duration under three years.

Credit Specialists
MacKay Shields has over 40 years’ experience with a focus on income investing.

Before considering any investment, you should understand that you could lose money.

1 S&P—US Corporate Average Cumulative Default Rates, 1981-2015 (10-year average cumulative default rates) Credit Ratings: S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Past performance is no guarantee of future results.

The MainStay Short Duration High Yield Fund is not a money market fund and does not attempt to maintain a stable net asset value. The Fund's net asset value per share will fluctuate. Investing in below investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets.

Floating rate loans are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. The Fund may invest in derivatives, which may increase the volatility of the Fund's net asset value and may result in a loss to the Fund. Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer's ability to make such payments may cause the price of that bond to decline.

The information provided represents the opinion of the Portfolio Manager and is not intended to be a forecast of future events, a guarantee of future results, or investment advice.

*Standard Deviation measures how widely dispersed a fund's returns have been over a specified period of time. Semi-standard deviation is a statistical tool derived from the square root of a semi variance. Semideviation represents the standard deviation of the returns that are lower than the mean return. A high standard deviation indicates that the range is wide, implying greater potential for volatility. Beta is a measure of historical volatility relative to an appropriate index (benchmark) based on its investment objective. A beta greater than 1.00 indicates volatility greater than the benchmark's. R-Squared measures the percentage of a fund's movements that result from movements in the index. The Sharpe Ratio shown is calculated for the past 36-month period by dividing annualized excess returns by annualized standard deviation.

Effective Maturity is the average time to maturity of debt securities held in the portfolio, taking into consideration the possibility that the issuer may call the bond before its maturity date. Modified Duration is inversely related to the approximate percentage change in price for a given change in yield.The Annual Turnover Rate is as of the most recent annual shareholder report.

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.

FOR INSTITUTIONAL USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC.

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