how to earn the credit risk premium across the business...

11 May 2011 Cross Asset Research

The Smart ETF Investor

UniCredit Research page 1 See last pages for disclaimer.

How to earn the credit risk premium across the business cycle with ETFs

The performance of corporate high-yield bonds is strongly influenced by the business cycle. Based on this simple observation we present a quantitative allocation scheme that involves a rebalancing between German government bonds and high-yield bonds. The rebalancing is triggered by the following simple signals:

■ Buy signal: Shift the capital into high-yield bonds if the business expectations component of the Ifo Business Climate Index has increased for at least three consecutive months. The transaction is executed on the day the Ifo Business Climate Index is published.

■ Sell signal: The drawdown of the high-yield investment is monitored on a daily basis. The capital is shifted to low-risk German government bonds as soon as:

– the drawdown of the high-yield investment exceeds 6%.

– or the business expectations component of the Ifo Business Climate Index has decreased for at least three consecutive months.

PERFORMANCE OF THE INVESTMENT STRATEGY

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exposure to German government bonds

Markit iBoxx Euro Liquid High Yield (strategy)Markit iBoxx Euro Liquid High Yield 30 (strategy)

Source: UniCredit Research

The proposed investment strategy can be fully implemented with ETFs. Focusing on the two liquid euro-denominated high-yield bond indices, the

■ Markit iBoxx EUR Liquid High Yield Index and the

■ Markit iBoxx EUR Liquid High Yield 30 Index,

we discuss the pros and cons of using ETFs, tracking them as the basis for our strategy.

Contents Introduction ________________________________ 2High yield benchmark indices___________________ 3Investment strategy __________________________ 6Implementing the strategy with ETFs _____________ 9Conclusion ________________________________ 11Literature and references _____________________ 12 ETF Sales & Advisory Chris Hofmann Head of ETF Sales & Advisory +49 89 378-12934 [email protected]

Oliver Kilian [email protected]

Florian Lenhart [email protected]

Sushil Krishan [email protected]

Oliver Weidenmüller oliver.weidenmü[email protected]

Franco Rossetti +39 02 8862-0660 [email protected]

Andrea Manciocco [email protected]

Paolo Giulianini Head of ETF Trading +44 207 826-6921 [email protected] ETF Trading Lines Milan +39 02 8862-0660 Munich +49 89 378-17585 London +44 20 782-66789

Quantitative Cross Asset Strategy Thorsten Weinelt, CFA (UniCredit Bank) +49 89 378-15110 [email protected]

Dr. Stefan Schulz (UniCredit Bank) +49 89 378-12765 [email protected] Bloomberg UCGR Internet www.research.unicreditgroup.eu




Introduction Historical origins Speculative or non-investment grade bonds became ubiquitous in the 1970s and 1980s as a

then largely new financing mechanism in mergers and acquisitions and leveraged buyouts. The money-raising abilities of such controversial financiers like Michael Milken [1], nicknamed the "Junk Bond King", largely helped to ignite the 1980s leveraged buyout boom. Since then,high-yield bonds have become a well-established asset class for risk-loving investors. In the current low-yield environment, many investors are considering building up exposure to high-yield bonds to enhance their returns. Not long ago, building up exposure to the high-yield bond segment was only possible either by buying individual bonds or through an investment in actively managed funds. With the launch of two ETFs tracking euro-denominated liquid high-yield indices last year, investors now have two more exchange-traded products forbuilding up exposure to this asset class. In this work, we present a relatively simple, rule-based, and transparent investment strategy based on these high-yield ETFs.

Volatile outperformance The performance of high-yield bonds displayed in the left chart of Figure 1 may suggest that a buy-and-hold strategy delivers an attractive outperformance over Treasuries. However, such a strategy would probably exceed the risk capital of most institutional investors. Furthermore,a passive high-yield investment is so volatile that the cumulated outperformance generated over many years may vanish in a matter of weeks.

Business cycle and spreads For obvious reasons, the performance of corporate high-yield bonds is strongly influenced by the business cycle. The right chart of Figure 1 impressively underscores the impact a recession has on the average high-yield credit spread. In light of the current discussion about historically low credit spread levels, it is interesting to note that while spread tightening has lead to low corporate yields in absolute terms, the credit spread to the average Treasury yield is still not at the all-time lows observed in October 1997 or June 2007. However, that is no reason to ignore the substantial spread tightening since the Lehman bankruptcy in September 2008. The unprecedented 26-month bull market that started in March 2009 is likely to end in a backlash with a sudden increase in credit spreads if the economic outlook dims. Therefore, any significant exposure to high-yield bonds should be accompanied by risk management in the form of a stop-loss rule. Because of the strong link between business cycle and creditspreads, it is worth striving to find an economic indicator to identify the turning points of the economy, thus connecting the stop-loss rule with a consistent start-gain policy.

TOTAL RETURN AND OUTPERFORMANCE YIELDS, SPREADS AND RECESSIONS

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Figure 1: Performance comparison between the Bank of America Merrill Lynch Treasury Master Index and the Bank of America Merrill Lynch U.S. High Yield Master II Index (left chart). Historical spreads between the redemption yield of the Bank of America Merrill Lynch Treasury Master Index and the Bank of America Merrill Lynch U.S. High Yield Master II Index (right chart). The gray-shaded areas indicate U.S. recessions as defined by the National Bureau of Economic Research. Sources: Thomson Reuters Datastream, National Bureau of Economic Research




GLOBAL CORPORATE DEFAULTS GLOBAL CORPORATE DEFAULT RATES

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Figure 2: Global corporate defaults both in terms of absolute numbers (left chart) and in terms of rates (right chart). The default rates that appear in the left chart are calculated based on the number of issuers rather than the nominal amounts affected by defaults. Source: Standard & Poor's

Corporate default rates The risk that issuers of high-yield bonds might not be able to meet their interest and principalobligations to bondholders is substantial, particularly when measured relative to investment-grade bonds. As displayed in Figure 2 (left chart), the count of defaulting companies hit an all-time high in 2009 [2]. When the default rate is calculated based on the number of issuersrather than on the nominal amounts affected by the defaults, a value of 9% is easily achieved during an economic downturn. Because of their lower credit ratings and higher risk of default,high-yield bonds must compensate investors adequately for the risk they take. Ideally, for awell-diversified high-yield portfolio, the earned risk premium is high enough to compensate for potential defaults through the downturns of many economic cycles.

High yield benchmark indices Liquid indices In this section we want to focus on two euro-denominated high-yield bond indices that are

tracked by recently issued ETFs, namely the

■ Markit iBoxx EUR Liquid High Yield index, and the

■ Markit iBoxx EUR Liquid High Yield 30 index.

Both of the above indices are members of the iBoxx EUR High Yield index family launched on 1 January 2007 by Markit Indices Limited [3]. They comprise the most liquid bonds from the Markit iBoxx EUR High Yield core cum crossover index (Bloomberg: EHYTCQRQ). The cum crossover indices, in contrast to the ex-crossover indices include split-rated bonds. While we believe that both of the above liquid high-yield indices provide a balanced exposure to the high-yield bond segment in terms of risk-return profile, Table 1 reveals a number ofdifferences regarding their construction and diversification level.

Idiosyncratic risks Perhaps the most striking difference between both indices is the degree of diversification. Investor exposure to idiosyncratic (firm-specific) risk is thus roughly (194/30)1/2 2.5≈ times higher for the more concentrated Markit iBoxx EUR Liquid High Yield 30 index. However, investors should not jump the gun and shy away from this idiosyncratic risk. Note that the index rules restrict the weight of an issuer to 5% of the market value of the index, thus ensuring a level of issuer diversification comparable or even superior to many blue-chip equity indices such as the German DAX or Swiss SMI.




INDEX FACTS

Markit iBoxx EUR Liquid High Yield Index Markit iBoxx EUR Liquid High Yield 30 Index Number of index constituents 194 30ISIN GB00B57G6H43 GB00B6728P13Market Value in EUR 113,818,273,737 28,037,005,957Yield (annual) 6.64% 6.13%Modified Duration (annual) 3.30 3.24Convexity (annual) 17.48 16.10Bloomberg Code IBOXXMJA IBOXLH3TRIC .IBOXXMJA .IBOXLH3TIssuer type Corporate non-financial and financial debt Only corporate non-financial debt Issuer domicile EUR-denominated debt issued by both eurozone and non-

eurozone issuers is eligible for inclusion. EUR-denominated debt issued by both eurozone and non-eurozone issuers is eligible for inclusion. Issuers selected for the index need to be based in a country with an investment-grade debt rating.

Bond Type The following bond types are eligible for the index Fixed-coupon bonds Floating-rate notes Callable bonds Callable fixed-to-floaters Rating-sensitive bonds Bonds with poison put options Bonds with make-whole call or tax changes call provisions Event-driven bonds Step-up bonds with known schedules The following bond types are not eligible for the index Perpetuals Zero-coupon bonds Payment-In-Kinds Putables (other than poison puts) Sinking funds Convertibles Preferred shares Private placements Index-linked notes

The following bond types are eligible for the index Fixed-coupon bonds Floating-rate notes Callable bonds Callable fixed-to-floaters Rating-sensitive bonds Bonds with poison put options Bonds with make-whole call or tax changes call provisions Registration-sensitive bonds Step-up bonds with known schedules The following bond types are not eligible for the index Perpetuals Zero-coupon bonds Payment-In-Kinds Putables (other than poison puts) Sinking funds Convertibles Preferred shares Private placements Index-linked notes

Minimum amount outstanding EUR 250 million per bond EUR 500 million per bond Weight restrictions The weight of an issuer in the index is capped at 5% of the

market value of the index at the rebalancing date. The size of individual bonds from an issuer is capped in relation to their market value.

The weight of an issuer in the Index is capped at 5% of the market value of the Index at the rebalancing date.

Minimum time to maturity 2 years for new bonds. No restriction for bonds already in the index

2 years for new bonds. 1.25 years at each quarterly rebalancing for bonds already in the index

Maximum original time to maturity

10.5 years to maturity as of the first settlement date of the bond to the maturity date

10.5 years to maturity as of the first settlement date of the bond to the maturity date

Rating To be eligible a bond must be rated sub-investment grade. The average of the ratings from Fitch, Moody’s and S&P is used to determine if a bond is investment grade or high yield. The highest rating from the three agencies is used for bonds where all three ratings from the agencies are below investment grade. If any of the agencies rates a bond as CC or lower, such bond is removed from the index at the next rebalancing.

To be eligible a bond must be rated sub-investment grade. The average of the ratings from Fitch, Moody’s and S&P is used to determine if a bond is investment grade or high yield. The highest rating from the three agencies is used for bonds where all three ratings from the agencies are below investment grade. If any of the agencies rates a bond as CC or lower, such bond is removed from the index at the next rebalancing.

Rebalancing Monthly in accordance with rules available on indices.markit.com. The membership list and weightings remain constant during the month until the next rebalancing.

Quarterly on the last calendar day of February, May, August and November.

Pricing New bonds enter the index at their ask price. For all other bonds, the bid price is used. For the calculation of the index level, the bid price is used.

New bonds enter the index at their ask price. For all other bonds, the bid price is used. For the calculation of the index level, the bid price is used.

History Available daily back to 2 January 2006 Available daily back to 30 November 2006

Table 1: Index facts as of 6 May 2011 Source: Markit iBoxx




PERFORMANCE COMPARISON RELATIVE PERFORMANCE

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Figure 3: Performance comparison between high-yield indices and a short-term German government bond index (left chart). Performance relative to the Markit iBoxx EUR Liquid High Yield core cum crossover index (right chart). Data from 30 November 2006 to 3 May 2011. Sources: Markit, Bloomberg, UniCredit Research

The left chart of Figure 3 compares the performance of the following high-yield bond indicesto short-term German government debt:

■ Markit iBoxx EUR High Yield core cum crossover index

■ Markit iBoxx EUR Liquid High Yield 30 index

■ Markit iBoxx EUR Liquid High Yield index.

The right chart of Figure 3 displays the cumulative performance of the Markit iBoxx EURLiquid High Yield 30 index and the Markit iBoxx EUR Liquid High Yield index relative to the Markit iBoxx EUR High Yield core cum crossover benchmark index.

Tracking error analysis Until the end of April 2009, the returns of the liquid indices relative to the core cum crossoverindex appear to fluctuate rather randomly, fully in line with their ex-post tracking errors. From November 2006 to April 2009, the values of the annualized tracking error of the Markit iBoxx EUR Liquid High Yield index and Markit iBoxx EUR Liquid High Yield 30 index were 1.36% and 3.44%, respectively. However, since rebalancing on the last calendar day of April 2009, the Markit iBoxx EUR Liquid High Yield index started to significantly deviate from the Markit Euro High Yield core cum crossover index. This is even more surprising as the ex-post tracking error of the Markit iBoxx EUR Liquid High Yield index increased only slightly for the period between May 2009 and April 2011 from 1.36% to 1.44%. During the same period the tracking error of the more concentrated Liquid High Yield 30 index narrowed by more than 80 basis points from 3.44% to 2.61%. Despite these countervailing tracking-error shifts, the broader Markit iBoxx EUR Liquid High Yield index still has a smaller tracking error to the core cum crossover index.

The above analysis of the tracking error hints at the coincidental nature of the outperformance achieved by the Markit iBoxx EUR Liquid High Yield 30 index since April 2009. Of course, the outperformance can be fully explained in terms of a performance attribution analysis at the level of the individual index constituents. However, this ex-post analysis reveals that the observed outperformance is mainly due to a combination of rather singular events, such as an increase in the share of subordinated financials due to weakening ratings of banks and other financials during the peak of the recent financial crisis [4]. Rather than inferring a sustained superiority of one of the liquid indices over the other, investors should not overstate the above outperformance, carefully analyze the current index constituents and choose the index that best conforms with their sector or even name-specific views on future spreads.




SECTOR ALLOCATION

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Financials

Consumer Goods

Consumer Services

Oil & Gas

Basic Materials

Construction & Materials

Health Care

Industrials

Media

Technology

Telecommunications iBoxx EUR High Yield core cum crossover LCMarkit iBoxx EUR Liquid High YieldMarkit iBoxx EUR Liquid High Yield 30

Figure 4: Sector allocations as of 13 April 2011. Because of liquidity selection criteria, the Markit iBoxx EUR Liquid High Yield 30 index may not provide exposure to all sectors at all times. Source: Markit

Investment strategy The prolonged drawdowns observed during past credit bear markets have often prevented

buy-and-hold investors from earning a long-term risk premium adequately compensating themfor the risk taken. As evidenced from Figure 3, a passive high-yield investment is often so volatile that the cumulated outperformance generated over many years may vanish in amatter of weeks. Therefore, our goal is to devise a quantitative, transparent, and economicallyintuitive investment strategy that seeks to

■ profit from the long-term risk premium,

■ while limiting the probability of suffering extended losses.

Since the performance of high-yield bonds is strongly influenced by the business cycle, our investment strategy will be based on identifying the turning points of the economy by using a leading indicator. Thus, we first need to identify an appropriate economic indicator for deriving investment timing decisions that can be applied to the liquid high-yield indices introduced in the previous section. To confine the economic indicator to a geographic region, we analyzethe allocation of the two liquid indices by issuer domicile. Table 2 displays the corresponding index weights of all European-domiciled issuers. Even if some of the domiciles chosen by the issuers may not coincide with the countries where the operational units actually run theirbusiness activities, the allocation profile in terms of issuer domicile is still a very good approximation to the exposure to a country's economy.

Since the issuers eligible for the Markit iBoxx EUR Liquid High Yield 30 index need to be based in a country with an investment-grade debt rating, a potential downgrade of any issuer country to a speculative rating would strongly affect the composition of the index. In light of the European debt crisis, such a rating action cannot be completely ruled out.




ALLOCATION BY ISSUER COUNTRY

Issuer country Country rating / outlook Markit iBoxx EUR Liquid High Yield Index Markit iBoxx EUR Liquid High Yield Index 30 Austria AAA /stable 0.61%Belgium AA+ / negative 0.89%Denmark AAA / stable 0.57%Finland AAA / stable 2.20%France AAA / stable 16.61% 12.36%Germany AAA / stable 16.31% 19.05%Ireland BBB+ / stable 4.29% 7.70%Italy A+ / stable 0.98%Jersey 0.41%Luxembourg AAA / stable 15.82% 12.10%Netherlands AAA / stable 15.28% 20.24%Norway AAA / stable 0.41%Spain AA / negative 2.57% 4.37%Sweden AAA / stable 0.26%United Kingdom AAA / stable 7.88% 8.05%Sum 85.09% 83.87%

Table 2: Index weights of European-domiciled issuers. Data as of 13 April 2011. Sources: Markit, Standard & Poor's, UniCredit Research

Ifo Business Climate Index Since over 80% of all issuers in the index are domiciled in Europe, a natural choice for a leading indicator is the expectations component of the Ifo Business Climate Index. The Ifo Business Climate Index is the most widely observed indicator for the German economy. The index is based on around 7,000 monthly survey responses of firms in manufacturing,construction, wholesaling and retailing. As displayed in the left chart of Figure 5, Germany's heavy reliance on exports [5], in particular to western European countries, should provide a somewhat secure basis to use the expectations component of the Ifo Business Climate Index as a leading indicator for the European economy.

Ifo business expectations: A reliable leading indicator

The analysis of historical data confirms good leading properties of the forward-looking business expectations component for turning points in the German economy. Although thepredictive power in respect to the magnitude of business cycles varied substantially, the Ifo expectations component has been able to track almost all important peaks and troughs of economic activity. These leading properties suggest using changes in the Ifo business expectations index as allocation signals for a quantitative investment scheme.

GERMANY'S SHARE OF EUROPEAN TRADE IFO BUSINESS EXPECTATIONS

China6.4%

Austria5.0%

Belgium4.8%

Switzerland4.3%

Spain3.4%

31.1%

France9.2%

Netherlands7.4%

US6.4%

Italy6.0%

United Kingdom5.8%

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Figure 5: Germany's external trade partners by trading volume (exports + imports) in 2009 (left chart). Comparison between the Ifo business expectations and the Ifo Business Climate Index (right chart). Sources: German Federal Statistical Office (www.destatis.de), Bloomberg




Strategy definition In this section we will substantiate the above ideas by presenting a quantitative allocation scheme that is digital in the sense that at any time all of the capital is either fully allocated to an ETF tracking a high-yield bond index or to an ETF tracking a German government bond index. The timing strategy between German government bonds and high-yield bonds involvesa rebalancing between these two asset classes, triggered by the following simple signals:

■ Buy signal: Shift the capital into high-yield bonds if the business expectations component of the Ifo Business Climate Index has increased for at least three consecutive months. The transaction is executed on the day the Ifo Business Climate Index is published.

■ Sell signal: The drawdown of the high-yield investment is monitored on a daily basis. The capital is shifted to low-risk German government bonds as soon as:

– the drawdown of the high-yield investment exceeds 6%.

– or the business expectations component of the Ifo Business Climate Index has decreased for at least three consecutive months.

The particular choice of the drawdown limit is somewhat arbitrary. However, choosing adrawdown limit somewhere between 5% and 7% should provide enough leeway to account for the natural price volatility of high-yield bonds. Another possible economic rationale for a trailing stop-loss in this range could be the desire of the investor to limit potential losses to athreshold not exceeding the average coupon of the index. In general, the above rules connect two key success factors for high-yield investments:

■ The trailing stop-loss limit provides consistent and forceful risk management.

■ The business expectations component of the Ifo Business Climate Index delivers an economic rationale for timing the high-yield investment.

PERFORMANCE OF THE INVESTMENT STRATEGY

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Markit iBoxx EUR Liquid High Yield 30 (strategy)

Markit iBoxx EUR Liquid High Yield (buy-and-hold)

Markit iBoxx EUR Liquid High Yield 30 (buy-and-hold)

Figure 6: Performance and allocation profile. Data from 30 November 2006 to 8 April 2011. Transaction costs are included according to the model specified in the next section. Sources: Bloomberg, UniCredit Research




In Figure 6 we backtest our strategy using both the Markit iBoxx EUR Liquid High Yield Index and the Markit iBoxx EUR Liquid High Yield 30 index. The backtest of the strategy starts on 30 November 2006, the first date for which there is historical data available for the MarkitiBoxx EUR Liquid High Yield 30 index. The strategy starts with the capital fully invested in short-term German government bonds. The exposure to German government bonds is modeled using the eb.rexx Government Germany 1.5 – 2.5 index.

LIST OF TRANSACTIONS

Date Transaction Comment

30 November 2006 Start the strategy with buying the eb.rexx Government Germany 1.5 - 2.5

The strategy starts with exposure to government bonds because on 26 September 2006 the Ifo business expectations had decreased for 3 consecutive months, signaling a deteriorating economic environment.

19 December 2006 Shift the capital into the high-yield bond index On 19 December 2006 the Ifo business expectations had increased for 3 consecutive months.

28 August 2007 Shift the capital into the eb.rexx Government Germany 1.5 - 2.5 index

On 28 August 2007 the Ifo business expectations had decreased for 3 consecutive months, signaling a deteriorating economic environment. The drawdown limit of 6% had not yet been reached on 28 August 2007

25 March 2009 Shift the capital into the high-yield bond index On 25 March 2009 the Ifo business expectations had increased for 3 consecutive months, signaling economic recovery.

Table 3: Rule-based allocation decisions of the strategy during the backtesting period. Source: UniCredit Research

The transactions triggered by our investment rules are summarized in detail in Table 3. Duringthe backtesting period, the stop-loss rule limiting the drawdown to a maximum loss of 6% never took effect, since the Ifo business expectations component deteriorated before this drawdown limit was reached. Particularly the last allocation signal for shifting the capital back to high-yield bonds on 25 March 2009 underscores the good leading properties of the ifobusiness expectations to identify turning points in the economy. Since the allocation signalsare linked to the business cycle, the strategy will most likely only trigger a small number of transactions in the long term. However, due to the digital allocation rule, each transactionincurs a turnover of 200%. In the next section we will focus on the practical implementation ofthe investment strategy covering topics such as index tracking quality and transaction costs.

Implementing the strategy with ETFs The implementation of the investment strategy outlined above is straightforward. Some facts

about two ETFs tracking the indices discussed in this paper are compiled in Table 4. Apart from the fact that the high-yield indices tracked by the two ETFs differ slightly in their constituent selection process, the two ETFs also differ in technical features such as the use of income and replication method [6].

ETF FACTS

ETF iShares Markit iBoxx Euro High Yield Bond Lyxor ETF iBoxx EUR Liquid High Yield 30ISIN DE000A1C8QT0 FR0010975771Issuer iShares (www.ishares.com) Lyxor (www.lxyoretf.com)Benchmark Markit iBoxx EUR Liquid High Yield Index Markit iBoxx EUR Liquid High Yield 30 IndexAuM in EUR 735,859,000 60,260,000Fund inception 3 September 2010 9 December 2010Listing on Xetra 26 November 2010 8 March 2011Fund domicile Ireland FranceUse of Income Distributing (semi annually) AccumulatingTER 0.50% 0.45%Replication method physical (sampling) swap-based

Table 4: Data as of 11 May 2011. Sources: iShares, Lyxor




Index tracking quality In order to assess the index-tracking quality of the two high-yield ETFs from iShares and Lyxor we compare the cumulative performance of the total return benchmark index with theactual performance of the fund. Note that in the case of the iShares ETF, displayed in the left chart of Figure 7, we have assumed a full reinvestment of the distributed income. Judging from the historical data available so far, both ETFs track their respective benchmarks convincingly. The different replication methods used by the ETF issuers and the liquidity oftheir underlying indices translate into different tracking errors. While the optimized physical sampling used by iShares leads to a larger tracking error than the swap-based replication, so far this increased tracking error has not been detrimental to the performance. On the contrary,the tracking error of the iShares ETF is accompanied by a small outperformence relative tothe tracked index, whereas the Lyxor ETF slightly underperforms its benchmark with a verysmall tracking error.

ISHARES MARKIT IBOXX EURO HIGH YIELD BOND LYXOR ETF IBOXX EUR LIQUID HIGH YIELD 30

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Lyxor ETF iBoxx EUR Liquid High Yield 30

Markit iBoxx EUR Liquid High Yield 30 Index

Figure 7: Index-tracking quality of the iShares Markit iBoxx Euro High Yield Bond (left chart) and the Lyxor ETF iBoxx EUR Liquid High Yield 30 (right chart). Sources: iShares, Lyxor

Transaction costs Since the allocation signals are linked to the business cycle, the strategy will most likely only trigger a small number of transactions in the long term. In terms of assessing transactioncosts, it is important to remember that the calculation of the benchmark index level is basedon bid prices. Therefore, shifting the capital from high-yield bonds to short-term German government bonds is generally a cheaper transaction than vice versa. Under normal market conditions we assume the following fees in terms of transaction volume V :

■ for selling high-yield bond ETFs: =HYsellα 0.80%

■ for buying high-yield bond ETFs: =HYbuyα 0.20%

■ for selling German government bond ETFs: =Govsellα 0.05%

■ for buying German government bond ETFs: =Govbuyα 0.05%

While there are a number of sophisticated transaction models, for the sake of simplicity wewill assume that the investor pays a transaction-volume independent fixed fraction VV /Δ of the traded volume as transaction costs:

(1) ≈−⋅−−=Δ )1()1(1/ Govbuy

HYsell ααVV 0.8496%

(2) ≈−⋅−−=Δ )1()1(1/ HYbuy

Govsell ααVV 0.2499%




Conclusion We have presented a simple, transparent, and rule-based investment strategy that aims at

maximizing the credit risk premium that can be earned with a diversified euro-denominated high-yield bond portfolio. Our strategy is based on timing the business cycle, which shouldimprove the performance in terms of total return, particularly when compared to a simple buy-and-hold strategy. The proposed investment strategy can be fully implemented with ETFs.Focusing on the two liquid euro-denominated high-yield bond indices, the

■ Markit iBoxx EUR Liquid High Yield index and the

■ Markit iBoxx EUR Liquid High Yield 30 index,

we discussed the pros and cons of using the ETFs, tracking them as the basis for our strategy. In summary, even if the more concentrated Markit iBoxx EUR Liquid High Yield 30index has outperformed the broader Markit iBoxx EUR Liquid High Yield index by over 15%since April 2009, we have found no evidence that this outperformance is due to a systematically superior index concept. With the Markit iBoxx EUR Liquid High Yield 30 indexoutperforming the Markit iBoxx EUR Liquid High Yield index by only 0.37% this year, thespread tightening potential of the more concentrated Markit iBoxx EUR Liquid High Yield 30 index seems to be exhausted.

ETF VS INDEX-PERFORMANCE

ETF / Index absolute performance performance relative to benchmarkiShares Markit iBoxx Euro High Yield Bond ETF 2.19% +0.18%Lyxor ETF iBoxx EUR Liquid High Yield 30 1.98% -0.13%Markit iBoxx Euro Liquid High Yield 2.02%Markit iBoxx Euro Liquid High Yield 30 Index 2.11%

Table 5: Performance figures for the period from January 24, 2011 to May 4, 2011. Sources: Bloomberg, Lyxor, iShares, UniCredit Research

So far, the iShares Markit iBoxx Euro High Yield Bond ETF has attracted much more assets than the Lyxor iBoxx EUR Liquid High Yield 30 ETF. A performance comparison between these ETFs is only possible for a relatively short period starting on 20 January 2011, the launch date of the Lyxor iBoxx EUR Liquid High Yield 30 ETF. As of 4 May 2011, the iShares Markit iBoxx Euro High Yield Bond ETF has outperformed the Lyxor iBoxx EUR Liquid HighYield 30 ETF by +21 basis points, whereas the relative performance of their underlying indices for the same period amounts to -9 basis points. However, keep in mind that the performance figures in Table 5 should not be over-interpreted as they only represent a snapshot.

Stefan Schulz +49 89 378-12765 [email protected]




Literature and references [1] http://en.wikipedia.org/wiki/Michael_Milken

[2] Default, Transition, and Recovery: 2010 Annual Global Corporate Default Study andRating Transitions, Standard & Poor's, 30 March 2011

[3] www.markit.com

[4] High Yield Pacenotes, UniCredit Research, 1 April 2011

[5] Aussenhandel. Rangfolge der Handelspartner im Aussenhandel der Bundesrepublik Deutschland [Ranking of trade partners in foreign trade of the Federal Republic ofGermany] 2009, German Federal Statistical Office, 16 December 2010

[6] Delta One Navigator – ETF/ETC Manual, UniCredit Corporate & Investment Banking,1st Quarter 2011



UniCredit Research page 13

Disclaimer Our recommendations are based on information obtained from, or are based upon public information sources that we consider to be reliable but for the completeness and accuracy of which we assume no liability. All estimates and opinions included in the report represent the independent judgment of the analysts as of the date of the issue. We reserve the right to modify the views expressed herein at any time without notice. Moreover, we reserve the right not to update this information or to discontinue it altogether without notice. This analysis is for information purposes only and (i) does not constitute or form part of any offer for sale or subscription of or solicitation of any offer to buy or subscribe for any financial, money market or investment instrument or any security, (ii) is neither intended as such an offer for sale or subscription of or solicitation of an offer to buy or subscribe for any financial, money market or investment instrument or any security nor (iii) as an advertisement thereof. The investment possibilities discussed in this report may not be suitable for certain investors depending on their specific investment objectives and time horizon or in the context of their overall financial situation. The investments discussed may fluctuate in price or value. Investors may get back less than they invested. Changes in rates of exchange may have an adverse effect on the value of investments. Furthermore, past performance is not necessarily indicative of future results. In particular, the risks associated with an investment in the financial, money market or investment instrument or security under discussion are not explained in their entirety. This information is given without any warranty on an "as is" basis and should not be regarded as a substitute for obtaining individual advice. Investors must make their own determination of the appropriateness of an investment in any instruments referred to herein based on the merits and risks involved, their own investment strategy and their legal, fiscal and financial position. As this document does not qualify as an investment recommendation or as a direct investment recommendation, neither this document nor any part of it shall form the basis of, or be relied on in connection with or act as an inducement to enter into, any contract or commitment whatsoever. Investors are urged to contact their bank's investment advisor for individual explanations and advice. Neither UniCredit Bank AG, UniCredit Bank AG London Branch, UniCredit CAIB AG, UniCredit Bank AG Milan Branch, UniCredit Securities, UniCredit Menkul Değerler A.Ş., UniCredit Bulbank, Zagrebačka banka, UniCredit Bank, Bank Pekao, Yapi Kredi, UniCredit Tiriac Bank, ATFBank nor any of their respective directors, officers or employees nor any other person accepts any liability whatsoever (in negligence or otherwise) for any loss howsoever arising from any use of this document or its contents or otherwise arising in connection therewith. This analysis is being distributed by electronic and ordinary mail to professional investors, who are expected to make their own investment decisions without undue reliance on this publication, and may not be redistributed, reproduced or published in whole or in part for any purpose. Responsibility for the content of this publication lies with: a) UniCredit Bank AG, Am Tucherpark 16, 80538 Munich, Germany, (also responsible for the distribution pursuant to §34b WpHG). The company belongs to UCI Group. Regulatory authority: “BaFin“ – Bundesanstalt für Finanzdienstleistungsaufsicht, Lurgiallee 12, 60439 Frankfurt, Germany. b) UniCredit Bank AG London Branch, Moor House, 120 London Wall, London EC2Y 5ET, United Kingdom. Regulatory authority: “BaFin“ – Bundesanstalt für Finanzdienstleistungsaufsicht, Lurgiallee 12, 60439 Frankfurt, Germany and subject to limited regulation by the Financial Services Authority (FSA), 25 The North Colonnade, Canary Wharf, London E14 5HS, United Kingdom. Details about the extent of our regulation by the Financial Services Authority are available from us on request. c) UniCredit Bank AG Milan Branch, Via Tommaso Grossi 10, 20121 Milan, Italy, duly authorized by the Bank of Italy to provide investment services. Regulatory authority: “Bank of Italy”, Via Nazionale 91, 00184 Roma, Italy and Bundesanstalt für Finanzdienstleistungsaufsicht, Lurgiallee 12, 60439 Frankfurt, Germany. d) UniCredit CAIB AG, Julius-Tandler-Platz 3, 1090 Vienna, Austria Regulatory authority: Finanzmarktaufsichtsbehörde (FMA), Praterstrasse 23, 1020 Vienna, Austria e) UniCredit Securities, Boulevard Ring Office Building, 17/1 Chistoprudni Boulevard, Moscow 101000, Russia Regulatory authority: Federal Service on Financial Markets, 9 Leninsky prospekt, Moscow 119991, Russia f) UniCredit Menkul Değerler A.Ş., Büyükdere Cad. No. 195, Büyükdere Plaza Kat. 5, 34394 Levent, Istanbul, Turkey Regulatory authority: Sermaye Piyasası Kurulu – Capital Markets Board of Turkey, Eskişehir Yolu 8.Km No:156, 06530 Ankara, Turkey g) UniCredit Bulbank, Sveta Nedelya Sq. 7, BG-1000 Sofia, Bulgaria Regulatory authority: Financial Supervision Commission (FSC), 33 Shar Planina str.,1303 Sofia, Bulgaria h) Zagrebačka banka, Paromlinska 2, HR-10000 Zagreb, Croatia Regulatory authority: Croatian Agency for Supervision of Financial Services, Miramarska 24B, 10000 Zagreb, Croatia i) UniCredit Bank, Na Príkope 858/20, CZ-11121 Prague, Czech Republic Regulatory authority: CNB Czech National Bank, Na Příkopě 28, 115 03 Praha 1, Czech Republic j) Bank Pekao, ul. Grzybowska 53/57, PL-00-950 Warsaw, Poland Regulatory authority: Polish Financial Supervision Authority, Plac Powstańców Warszawy 1, 00-950 Warsaw, Poland k) UniCredit Bank, Prechistenskaya emb. 9, RF-19034 Moscow, Russia Regulatory authority: Federal Service on Financial Markets, 9 Leninsky prospekt, Moscow 119991, Russia l) UniCredit Bank, Šancova 1/A, SK-813 33 Bratislava, Slovakia Regulatory authority: National Bank of Slovakia, Stefanikovo nam. 10/19, 967 01 Kremnica, Slovakia m) Yapi Kredi, Yapi Kredi Plaza D Blok, Levent, TR-80620 Istanbul, Turkey Regulatory authority: Sermaye Piyasası Kurulu – Capital Markets Board of Turkey, Eskişehir Yolu 8.Km No:156, 06530 Ankara, Turkey n) UniCredit Tiriac Bank, Ghetarilor Street 23-25, RO-014106 Bucharest 1,Romania Regulatory authority: CNVM, Romanian National Securities Commission, Foişorului street, no.2, sector 3, Bucharest, Romania o) ATFBank, 100 Furmanov Str., KZ-050000 Almaty, Kazakhstan Agency of the Republic of Kazakhstan on the state regulation and supervision of financial market and financial organisations, 050000, Almaty, 67 Aiteke Bi str., Kazakhstan POTENTIAL CONFLICTS OF INTEREST UniCredit Bank AG acts as a Specialist or Primary Dealer in government bonds issued by the Italian, Portuguese and Greek Treasury. Main tasks of the Specialist are to participate with continuity and efficiency to the governments' securities auctions, to contribute to the efficiency of the secondary market through market making activity and quoting requirements and to contribute to the management of public debt and to the debt issuance policy choices, also through advisory and research activities. ANALYST DECLARATION The author’s remuneration has not been, and will not be, geared to the recommendations or views expressed in this study, neither directly nor indirectly. ORGANIZATIONAL AND ADMINISTRATIVE ARRANGEMENTS TO AVOID AND PREVENT CONFLICTS OF INTEREST To prevent or remedy conflicts of interest, UniCredit Bank AG, UniCredit Bank AG London Branch, UniCredit CAIB AG, UniCredit Bank AG Milan Branch, UniCredit Securities, UniCredit Menkul Değerler A.Ş., UniCredit Bulbank, Zagrebačka banka, UniCredit Bank, Bank Pekao, Yapi Kredi, UniCredit Tiriac Bank, ATFBank have established the organizational arrangements required from a legal and supervisory aspect, adherence to which is monitored by its compliance department. Conflicts of interest arising are managed by legal and physical and non-physical barriers (collectively referred to as “Chinese Walls”) designed to restrict the flow of information between one area/department of UniCredit Bank AG, UniCredit Bank AG London Branch, UniCredit CAIB AG, UniCredit Bank AG Milan Branch, UniCredit Securities, UniCredit Menkul Değerler A.Ş., UniCredit Bulbank, Zagrebačka banka, UniCredit Bank, Bank Pekao, Yapi Kredi, UniCredit Tiriac Bank, ATFBank and another. In particular, Investment Banking units, including corporate finance, capital market activities, financial advisory and other capital raising activities, are segregated by physical and non-physical boundaries from Markets Units, as well as the research department. In the case of equities execution by UniCredit Bank AG Milan Branch, other than as a matter of client facilitation or delta hedging of OTC and listed derivative positions, there is no proprietary trading. Disclosure of publicly available conflicts of interest and other material interests is made in the research. Analysts are supervised and managed on a day-to-day basis by line managers who do not have responsibility for Investment Banking activities, including corporate finance activities, or other activities other than the sale of securities to clients.




ADDITIONAL REQUIRED DISCLOSURES UNDER THE LAWS AND REGULATIONS OF JURISDICTIONS INDICATED Notice to Austrian investors This document does not constitute or form part of any offer for sale or subscription of or solicitation of any offer to buy or subscribe for any securities and neither this document nor any part of it shall form the basis of, or be relied on in connection with or act as an inducement to enter into, any contract or commitment whatsoever. This document is confidential and is being supplied to you solely for your information and may not be reproduced, redistributed or passed on to any other person or published, in whole or part, for any purpose. Notice to Czech investors This report is intended for clients of UniCredit Bank AG, UniCredit Bank AG London Branch, UniCredit CAIB AG, UniCredit Bank AG Milan Branch, UniCredit Securities, UniCredit Menkul Değerler A.Ş., UniCredit Bulbank, Zagrebačka banka, UniCredit Bank, Bank Pekao, Yapi Kredi, UniCredit Tiriac Bank, ATFBank in the Czech Republic and may not be used or relied upon by any other person for any purpose. Notice to Italian investors This document is not for distribution to retail clients as defined in article 26, paragraph 1(e) of Regulation n. 16190 approved by CONSOB on October 29, 2007. In the case of a short note, we invite the investors to read the related company report that can be found on UniCredit Research website www.research.unicreditgroup.eu. Notice to Russian investors As far as we are aware, not all of the financial instruments referred to in this analysis have been registered under the federal law of the Russian Federation “On the Securities Market” dated April 22, 1996, as amended, and are not being offered, sold, delivered or advertised in the Russian Federation. Notice to Turkish investors Investment information, comments and recommendations stated herein are not within the scope of investment advisory activities. Investment advisory services are provided in accordance with a contract of engagement on investment advisory services concluded with brokerage houses, portfolio management companies, non-deposit banks and the clients. Comments and recommendations stated herein rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not suit your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely on the information stated here may not result in consequences that meet your expectations. Notice to Investors in Japan This document does not constitute or form part of any offer for sale or subscription for or solicitation of any offer to buy or subscribe for any securities and neither this document nor any part of it shall form the basis of, or be relied on in connection with or act as an inducement to enter into, any contract or commitment whatsoever. Notice to UK investors This communication is directed only at clients of UniCredit Bank AG, UniCredit Bank AG London Branch, UniCredit CAIB AG, UniCredit Bank AG Milan Branch, UniCredit Securities, UniCredit Menkul Değerler A.Ş., UniCredit Bulbank, Zagrebačka banka, UniCredit Bank, Bank Pekao, Yapi Kredi, UniCredit Tiriac Bank, ATFBank in the Czech Republic who (i) have professional experience in matters relating to investments or (ii) are persons falling within Article 49(2)(a) to (d) (“high net worth companies, unincorporated associations, etc.”) of the United Kingdom Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 or (iii) to whom it may otherwise lawfully be communicated (all such persons together being referred to as “relevant persons”). This communication must not be acted on or relied on by persons who are not relevant persons. 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Such information is provided for informational purposes only and does not constitute a solicitation to buy or an offer to sell any securities under the Securities Act of 1933, as amended, or under any other U.S. federal or state securities laws, rules or regulations. The investment opportunities discussed in this report may be unsuitable for certain investors depending on their specific investment objectives, risk tolerance and financial position. In jurisdictions where UCI Capital Markets is not registered or licensed to trade in securities, commodities or other financial products, transactions may be executed only in accordance with applicable law and legislation, which may vary from jurisdiction to jurisdiction and which may require that a transaction be made in accordance with applicable exemptions from registration or licensing requirements. The information in this publication is based on carefully selected sources believed to be reliable, but UCI Capital Markets does not make any representation with respect to its completeness or accuracy. All opinions expressed herein reflect the author’s judgment at the original time of publication, without regard to the date on which you may receive such information, and are subject to change without notice. UCI Capital Markets may have issued other reports that are inconsistent with, and reach different conclusions from, the information presented in this report. These publications reflect the different assumptions, views and analytical methods of the analysts who prepared them. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is provided in relation to future performance. 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UniCredit Research* Thorsten Weinelt, CFA Global Head of Research & Chief Strategist +49 89 378-15110 [email protected]

Dr. Ingo Heimig Head of Research Operations +49 89 378-13952 [email protected]

Cross Asset Research

Economics & FI/FX Research

Economics & Commodity Research

Andreas Rees, Chief German Economist +49 89 378-12576 [email protected]

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