NORTHERN TRUST HIGH YIELD FIXED INCOME QUARTERLY UPDATE. Highlighting attribution, economic and market analysis

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1 NORTHERN TRUST HIGH YIELD FIXED INCOME QUARTERLY UPDATE Highlighting attribution, economic and market analysis March 31, 215 Northern Trust Asset Management 5 South La Salle Street Chicago, Illinois 663 northerntrust.com Fred Azar Director of Business Management fa11@ntrs.com Scott Warner Head of Fixed Income Product Management sw13@ntrs.com SUMMARY: Northern High Yield Fixed Income Fund* was recently awarded a four-star overall rating by Morningstar. There are 595 high yield funds in Morningstar High Yield Bond category and the rating was derived from a weighted average of the fund s 3-, 5- and 1-year risk-adjusted returns as of 3/31/15. The Fund posted positive performance in the first quarter as sector selection contributed to performance, while security selection was a slight detractor. The quarter was characterized by its volatility as the Federal Reserve (Fed) and interest rates were the primary focus of financial markets. However, oil and commodity prices caused significant volatility as well. The market began the quarter focused on higher-quality securities, but strong inflows into the market caused investors to expand their purchases to lower quality securities. Commodity price volatility negatively impacted energy and raw material sectors in the quarter, but the market stabilized and ended with a positive tone. Interest rate volatility, commodity prices and geopolitical events should continue to be the greatest potential sources of market volatility in the second quarter of 215. However, we believe the high yield market remains relatively attractive and continues to be broadly supported by stable credit fundamentals and a low default rate. Security selection and the avoidance of credit issues should remain a key to performance this year. PHILOSOPHY Northern Trust s Active High Yield Fixed Income Group manages portfolios in an effort to generate returns consistent with the high yield market. We use a total return approach to help generate alpha through fundamental credit analysis, security selection and sector allocation. We do not employ equities, leverage or derivatives in portfolio construction. Our investment process is designed to preserve capital and seeks to limit risk by constructing well diversified investment portfolios that are a reflection of the economic backdrop, fiscal and monetary policy and market valuations. ECONOMIC AND MARKET BACKDROP First quarter economic data indicate global economic growth was slow and inflation remained subdued, while the U.S. dollar continued to appreciate against other currencies. The European Central Bank (ECB) began its Quantitative Easing program in March, purchasing bonds throughout eurozone countries and driving interest rates throughout the region to their lowest levels on record. U.S. interest rates were volatile as the Federal Reserve (Fed) postured for a rate increase, a clear divergence from foreign central banks. The Fed s March meeting proved to be a pivotal event in the quarter. Although commodity prices were still a focus, interest rates became the main driver of volatility. The main message was one of assurance that the Fed doesn t plan to raise interest rates as a result of a continued reduction in the unemployment rate. They would, however, like to see continued improvement in the labor market and be reasonably confident inflation will move back to its 2% objective prior to hiking the federal funds rate. In the accompanying projections, the Federal Open Market Committee cut its estimate of long-term sustainable unemployment to 5%. Importantly, they also lowered the projected future path of the federal funds rate. Interest rates rallied across the U.S. Treasury curve, with yields ending the quarter significantly lower than at the start. northerntrust.com High Yield Fixed Income Quarterly Update 1 of 8

2 Although inconsistent, market illiquidity did not materially change in the first quarter. Regulatory changes to financial institutions continue to impact the amount of capital trading desks can employ. As a result of these changes, they are no longer able to hold as many securities in their inventory, which leaves them less capable of fulfilling their role as a market maker. High yield companies continue to issue debt to fund general corporate purposes and to refinance outstanding issues, and an increase in merger and acquisition (M&A) activity this year has boosted new issue volumes. M&A was particularly strong in the healthcare sector as companies are searching for next generation drugs to grow and diversify their product offerings. One of the most notable transactions occurred when Valeant Pharmaceutical issued approximately $1 billion in debt to fund its acquisition of Salix in the largest high yield offering of the year. The high yield energy sector has experienced tremendous growth over the past several years as low financing rates, the high price of oil and improved technologies made many projects economically viable. A divergence between the supply and demand of oil has caused a material impact on the high yield market and on June 2th 214, oil peaked with the high yield market reaching its low point in spread the next day. At that time, the independent energy and oil field services sectors were 13 basis points (bps) (.13%) and 54bps (.54%) wider than the Barclays high yield index, respectively. As oil declined throughout the second half of the year, option-adjusted spreads (OAS) on the high yield market widened as the energy and commodity sectors sold off. As of March 31, 215, the oil & gas exploration and production and oil field services sectors were 336bps (3.36%) and 63bps (6.3%) wider than the Barclays high yield index, respectively. These two sectors represent approximately 1% of the market, and smaller commodity-exposed sectors, such as metals and mining, have also suffered material declines. EXHIBIT 1: OIL PRICES RELATIVE TO HIGH YIELD OPTION ADJUSTED SPREADS WTI Crude HY Corporate Independent Energy Oil Field Services 1,4 12 1,2 1, 1 8 Yield (%) Date 8/214 9/214 1/214 11/214 12/214 1/215 2/215 3/215 Source: Barclays Live and the Department of Energy northerntrust.com High Yield Fixed Income Quarterly Update 2 of 8

3 While companies exposed to deteriorating commodity prices continue to face a difficult operating environment, credit fundamentals across the high yield market have been relatively stable. The asset class had roughly $9 billion of inflows in the first quarter as the low interest rate environment continues to attract non-traditional investors, such as ETF s and cross-over investment grade accounts, to high yield. Generally speaking, companies have manageable leverage metrics and high interest coverage this provides a constructive backdrop for the high yield market. EXHIBIT 2: HIGH YIELD DEFAULT RATES VS YIELDS % Yield Default Rates Yield (%) Source: Bloomberg PERFORMANCE Sector selection was a greater driver of performance than rating category in the first quarter with 28 of 44 sectors exceeding the return of the market. Higher-quality securities performed best, but there was little differentiation by rating. An overweight position in B rated securities in the Fund benefitted performance, while an underweight in BB securities detracted from performance. Underweight positions in independent energy and metals, along with overweight positions in refining and environmental contributed to performance. Detractors included an overweight in media cable and underweight positions in wireless and building materials. As investors search for yield in a world with seemingly ever lower interest rates, the high yield market continued to attract money during the first quarter. Managers put their cash to work and new issuance was roughly 15% greater than the first quarter of last year. Investors showed a distinct preference for higher-quality debt in a quarter. Spreads on CCC rated bonds widened relative to BBs, with all in yields for CCC issuers rising to over 1%. This was driven by the energy sector. The yield-to-worst on the high yield market ended the quarter at 6.18%. northerntrust.com High Yield Fixed Income Quarterly Update 3 of 8

4 EXHIBIT 3: CORPORATE OPTION ADJUSTED SPREADS BB CCC 1, Basis Points (BPS) /214 5/214 6/214 7/214 8/214 9/214 1/214 11/214 12/214 1/215 2/215 3/215 Source: Barclays Individual security selection has been a great source of alpha in the past few years but was a small detractor to performance in the quarter. Security selection will become even more important in 215. If the first quarter is any indication, investors have become more risk averse, and when combined with liquidity constraints in the market, preserving capital is crucial for generating alpha. As such, our focus on fundamental credit analysis remains a core principle and allows us to manage our level of risk. 214 marked the 9th consecutive year the Northern High Yield Fixed Income Fund did not own a defaulted security. Our analysts and portfolio managers remain focused on preservation of principal and downside risk avoidance. northerntrust.com High Yield Fixed Income Quarterly Update 4 of 8

5 EXHIBIT 4: HIGH YIELD DEFAULT RATE AND YIELD CHART Year Defaults Held by Fund % of Fund at Time of Default Moody s Default Rate Notable Defaults NOT Held by Fund 1999 No Defaults.% 5.7% Integrated Health Systems 2 No Defaults.% 5.7% Owens Corning Tjiwi Kima.35% Republic Technologies.1% IT Group.7% Adelphia Communications.1% 1.5% Argentina, Enron, USG, Bethlehem Steel 8.4% WorldCom, Kmart, United Airlines 23 Healthsouth.69% 5.3% Mirant, Parmalat 24 No Defaults.% 2.3% RCN Cable, ATA Airlines 25 Tower Automotive.31% 1.8% AAipharma, Colins & Aikman, Delphi, Calpine 26 No Defaults.% 1.7% Dana Corp, Dura Automotive 27 No Defaults.% 1.1% N/A 28 No Defaults.% 4.4% Tribune, VeraSun, Abitibi, SemGroup, Linens N Things, Quebecor World 29 No Defaults.% 13.9% GM, CIT, Lyondell, Charter, Idearc, Capmark 21 No Defaults.% 3.3% Blockbuster, The Great Atlantic & Pacific Tea Co. 211 No Defaults.% 1.8% AMR Corp., Dynegy, MF Global 212 No Defaults.% 3.5% Patriot Coal, ATP Oil & Gas, Eastman Kodak, Edison Mission Energy 213 No Defaults.% 2.2% Reader s Digest, Gengage Learning, Exide Technologies, FriendFinder 214 No Defaults.% 1.9% Sorenson Communications, Mmodal, Energy Future Holdings, James River Coal, Momentive, Essar Steel SPOTLIGHT SECTOR FINANCIALS Financial services represent a large and important sector for high yield strategies that has grown since the financial crisis in Many new companies were formed in the aftermath of the crisis as large institutions abandoned riskier businesses. While the high yield financials space includes subsectors such as aircraft leasing, consumer finance, and business development companies, one rapidly developing area is capital securities issued by global banks. In particular, European Additional Tier 1 (AT1) instruments. This is a relatively new form of subordinated bank debt that we believe represents an attractive opportunity for high yield investors. northerntrust.com High Yield Fixed Income Quarterly Update 5 of 8

6 The European AT1 instruments market debuted approximately two years ago, driven by new global, regional and local regulatory requirements. The goal of this debt is to elevate minimum capitalization ratios and cap leverage in the aftermath of the financial crisis, while also offering banks a cheaper, non-dilutive alternative to equity capital. Given the large additional capital requirements for European banks under the new regulatory rules, the market has developed rapidly, growing to its current size of about 6 billion euros, of which, half has been issued in U.S. dollars. The following chart summarizes the current market size by country of origin: EXHIBIT 5: AGGREGATE BANK DEBT ISSUANCE BY COUNTRY 25 UK Spain France Switzerland Billions Germany Sweden Italy Denmark Netherlands Belgium Country As of 3/31/215. Source: JPMorgan Current expectations anticipate up to 1 billion euros of incremental issuance over the next three years, providing an important source of new supply. As the following chart illustrates, these securities carry ratings that firmly entrench this developing market into the high yield universe; however, the parent issuers are investment grade. northerntrust.com High Yield Fixed Income Quarterly Update 6 of 8

7 EXHIBIT 6: AT1 CREDIT QUALITY BREAKDOWN Number of Issuers AAA AA+ AA AA A+ A A BBB+ BBB BBB BB+ BB BB B+ B B CCC+ CCC CCC CC C D NR S&P Ratings As of 3/31/15. Source: Bloomberg Note: Grouped by S&P rating, where not available Moody or Fitch. Coupon levels have come down from the levels seen in the initial phase of the market as market intelligence regarding this new asset class has improved. That said, these securities offer yields that significantly exceed those offered by similarly rated corporate transactions in addition to providing increased liquidity. Since the primary issuers in this market are the largest global banks, the inherent level of regulatory and political scrutiny adds an important layer of oversight that is not available in typical high yield corporate transactions, further increasing the appeal of these structures. Challenges do remain for European banks though. Conduct charges, geopolitical risks, and the economic outlook blur the macro background for large European banks in general and junior capital tranches in particular. We expect improvement in underlying fundamentals for European banks moving forward. The European Central Bank is their new primary regulator and is pressuring institutions to clean up non-performing loans and raise capital buffers. We also believe technical considerations, such as real money investors increasing participation, and the size and liquidity benefits of this asset class over typically smaller corporate issuance are positives. Moreover, issuer and investor incentives are well aligned as dividend payments are typically conditioned by timely and full payment of AT1 coupons, which in turn depends on minimum earnings levels. northerntrust.com High Yield Fixed Income Quarterly Update 7 of 8

8 * High Yield Fixed Income received 4 stars for the 3-year rating among 595 high yield bond funds, 4 stars for the 5-year rating among 51 funds and 3 stars for the 1-year rating among 35 funds. Past performance is no guarantee of future results. Ratings reflect fee waivers in effect; in their absence, ratings may have been lower. Star ratings are based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund s monthly performance (including the effects of sales charges and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The overall rating is a weighted average of the 3-, 5-, and 1-year (if applicable) returns. 5 stars = top 1% of funds in an asset category; 4 stars = next 22.5% of funds; 3 stars = next 35%; 2 stars = next 22.5% and 1 star = next 1%. A fund must be in existence three years to be rated. Ratings are subject to change monthly. 215 Morningstar, Inc. All Rights Reserved. Morningstar and/or its content providers are the proprietors of this information; do not permit its unauthorized copying or distribution; do not warrant it to be accurate, complete or timely; and are not responsible for damages or losses arising from its use. Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates. High-Yield Risk: Although a high-yield fund s yield may be higher than that of fixed-income funds that purchase higher-rated securities, the potentially higher yield is a function of the greater risk that a high-yield fund s share price will decline. Quality Distribution: Credit quality ratings are based on the conservative average of Moody s, Standard & Poor s and Fitch ratings. If ratings from all three rating agencies disagree, the model assigns the middle rating to the security. If two of the three agree, the model assigns the rating from those two to the security. If none of these three rating agencies has assigned a rating, the Fund will assign a rating of not rated. The ratings, expressed in Standard & Poor s nomenclature, range from AAA (extremely strong capacity to meet its financial commitment) to D (in default). Short-term ratings, expressed in Standard & Poor s nomenclature, range from A-1 (obligor s capacity to meet its financial commitment on the obligation is strong) to A-3 (exhibits adequate protection parameters). The ratings represent the rating agencies opinions of the quality of the securities they rate. Ratings are relative and subjective and are not absolute standards of quality. We define investment grade securities with an S&P rating of BBB or higher; those securities with ratings below BBB are considered high yield. Alpha: Measures a fund s risk-adjusted performance and represents the difference between a fund s actual performance and its expected performance, given its level of risk. Basis Points (bps): Unit of measure used in quoting yields, changes in yields or differences between yields. One basis point is equal to.1%, or one one-hundredth of a percent of yield and 1 basis points equals 1%. Option-adjusted spread (OAS) is the difference in yield between two fixed income securities (generally between a fixed income security with credit risk and a comparable treasury bond), adjusted for differences in duration and embedded options. Yield-to-worst: The lowest potential bond yield received without the issuer defaulting, it assumes the worst-case scenario, or earliest redemption possible under terms of the bond. Barclays U.S. Corporate High Yield 2% Issuer Capped Index is an unmanaged index that measures the market of U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bonds. It is a version of the Barclays High Yield Corporate Bond Index except it limits its exposure of each issuer to 2% of the total market value and redistributes any excess market value index-wide on a pro-rata basis. It is not possible to invest directly in an index. Please carefully read the prospectus and summary prospectus and consider the investment objectives, risks, charges and expenses of Northern Funds before investing. Call to obtain a prospectus and summary prospectus, which contains this and other information about the funds. Northern Funds are distributed by Northern Funds Distributors, LLC, not affiliated with Northern Trust. northern trust 215 northerntrust.com High Yield Fixed Income Quarterly Update 8 of 8 (4/15)