NORTHERN TRUST ACTIVE FIXED INCOME QUARTERLY UPDATE. Core/Core Plus Investment Strategy

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1 NORTHERN TRUST ACTIVE FIXED INCOME QUARTERLY UPDATE Core/Core Plus Investment Strategy SUMMARY: The Northern Fixed Income Fund (NOFIX)*and Northern Core Bond Fund (NOCBX)** both received four-star overall ratings from Morningstar. There are 945 bond funds in the Morningstar Intermediate-Term Bond category and the rating was derived from a weighted average of the fund s 3-, 5-, and 10-year risk-adjusted returns as of 9/30/15. September 30, 2015 Northern Trust Asset Management 50 South La Salle Street Chicago, Illinois northerntrust.com Fred Azar Director of Business Management fa11@ntrs.com Scott Warner Head of Fixed Income Product Management sw13@ntrs.com Ian Birtch Product Specialist ib21@ntrs.com Global economic data continued to be mixed during the quarter confirming our view of slower and lower growth and inflation. The highly anticipated Federal Open Market Committee (FOMC) meeting came and went without a change to the benchmark federal funds rate. Portfolios underperformed relative to their benchmarks during the quarter, mainly driven by security selection and sector allocation. Duration and curve management provided mostly neutral returns relative to their benchmarks. We increased our exposure to corporate bonds, believing supply technicals have pushed credit spreads wider and attractive relative value exists in this sector. ECONOMIC AND MARKET BACKDROP Global economic demand remains challenged by high aggregate debt levels, unsupportive demographics, and transitioning emerging market economies. Consequently, over 30 central banks around the world have eased monetary policy this year in an attempt to stimulate their economies. Additionally, oversupply and weak demand for commodities has led to a significant correction in the price of various raw materials over the past year further impacting the strength of developing economies and global inflation expectations. While all eyes were on the Federal Reserve (Fed) during their September FOMC meeting, most investors came away disappointed by the Fed s decision to keep the benchmark federal funds rate unchanged at a range of 0 to 25 basis points. Global growth concerns as well as tighter financial conditions were stated as the primary reasons for not electing to tighten in September. The emphasis on global risk markets caused many investors to question if the Fed is adding a third mandate to their list of responsibilities. Regardless, the decision to leave monetary policy unchanged resulted in the largest drop in the 2-year Treasury bond since northerntrust.com Active Fixed Income Quarterly Update 1 of 8

2 EXHIBIT 1: U.S. TREASURY YIELDS PRE & POST FOMC MEETING Yield (%) /16/15 9/30/15 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr Source: U.S. Department of the Treasury, NT Fixed Income The Fed s concern regarding growth headwinds was largely attributed to events in China. As the world s largest user of energy, grains, and metals, China has been a main driver for the downward trajectory of commodities prices, as their economy continues to transition. We believe the reduction in commodities demand, coupled with the People s Bank of China weakening the yuan, may meaningfully contribute to global inflation remaining low. Additionally, many investors suspect the actual growth in China is well below the published 7% GDP, leading to a reassessment of inflation expectations going forward. EXHIBIT 2: CHINA GDP GROWTH VS. INFLATION GDP Growth CPI Year Over Year % Jun 2005 Dec 2005 Jun 2006 Dec 2006 Jun 2007 Dec 2007 Jun 2008 Dec 2008 Jun 2009 Dec 2009 Jun 2010 Dec 2010 Jun 2011 Dec 2011 Jun 2012 Dec 2012 Jun 2013 Dec 2013 Jun 2014 Dec 2014 Jun 2015 Sources: Bloomberg, IMF, NT Fixed Income northerntrust.com Active Fixed Income Quarterly Update 2 of 8

3 YIELD CURVE AND DURATION POSITIONING The highly anticipated FOMC meeting came and went without providing investors a clear picture of the Fed s strategy. Investors were left to ponder how a stronger U.S. dollar, lower commodity prices, as well as the state of emerging market economies will impact future Fed decisions. Investor expectations of at least one rate increase this year began to waiver in August when international markets were hit with a bout of volatility. The decision to leave monetary policy unchanged further reduced expectations of any tightening happening this year. Market participants read the Fed s inaction, as well as the dovish tone of their comments as an indication of larger concerns over the prospects for continued economic growth. Subsequent speeches by members of the Fed have attempted to posture for an increase before the end of the year, but many investors remain skeptical. EXHIBIT 3: PROBABILITY OF FOMC RAISING RATES AT LEAST ONCE IN % 80% 70% 60% 50% 40% 30% 6/1/2015 6/9/2015 6/23/2015 7/8/2015 7/22/2015 8/5/2015 8/19/2015 9/2/2015 9/16/2015 9/30/2015 Source: Bloomberg, NT Fixed Income Uncertainty around monetary policy has added volatility across the yield curve. We expect this to continue until the first rate hike. We believe the markets focus should be on the pace of hikes and the terminal federal funds rate rather than the initial move. As such, we expect rates to be lower than the market anticipates, inflation expectations will remain well anchored, and stable rates will persist. Our current positioning across the curve relative to the Barclays U.S. Aggregate benchmark is as follows: Neutral one- to three-year maturities Neutral three- to 10-years Neutral 10+ years northerntrust.com Active Fixed Income Quarterly Update 3 of 8

4 With most of the world still lowering interest rates or applying unconventional policies such as quantitative easing, the U.S. was in a unique position in contemplating raising interest rates this past quarter. Consequently, the anticipation and reaction to the Fed s decision caused volatility to spike during September. While the Fed s decision to keep rates unchanged was met with market disappointment, we do not feel that the timing of a 25 basis point move in the federal funds target rate has significant implications for long-term investors. We believe investors should focus on the projected future path of increases when considering investment decisions. We believe interest rate moves will follow a shallow path, as inflation and inflation expectations remain well anchored. We derive comfort in this view as the Fed has been moving toward this line of thinking, lowering their projected path of the federal funds rate at each of their quarterly meetings this year. These views led our portfolios to be positioned neutral to long duration relative to our benchmarks throughout the quarter and resulted in little contribution or detraction to performance over the quarter. EXHIBIT 4: CHANGE IN FOMC FORECASTS VS FEDERAL FUNDS FUTURES 4.0% Fed Funds Futures Rates as of September 2015 Dec FOMC Forecast September 2015 FOMC Forecast 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Dec Dec Dec Source: Federal Reserve; CME Group; NT Fixed Income SECTOR ALLOCATION The past 15 months have seen investment-grade credit spreads widened 70 basis points. Investors have demanded additional compensation to buy bonds as new issuance and merger and acquisition (M&A) activity has soared. The team began to increase corporate bond exposure during the third quarter as wider credit spreads made the market attractive from a relative value perspective. Additionally, we believe the relationship between the yield-to-worst (YTW) for credit and the current levels of option-adjusted spreads (OAS) shows that credit is providing investors with higher relative compensation for the level of risk taken. As Exhibit 5 illustrates, by moving from Treasuries into high grade credit, an investor has been rewarded with double the yield. northerntrust.com Active Fixed Income Quarterly Update 4 of 8

5 EXHIBIT 5: U.S. CREDIT INDEX: CONTRIBUTION TO YTW FROM OAS AND TREASURY YIELD Credit YTW Credit OAS OAS as a % of YTW (%) (%) Source: Barclays, NT Fixed Income Spreads on non-investment grade debt have widened significantly during the quarter. Our overweight to non-investment grade corporate bonds resulted in a negative contribution to performance. The fundamental reasons we own these investments remains intact. Widening spreads in high-yield bonds are largely due to the problems energy and mining companies have experienced, in which the prices of their products have significantly declined over past year. Outside of these two sectors, high-yield issuers are in good financial position and wider credit spreads represent an attractive opportunity for investors in the low interest rate environment. As we enter the fourth quarter, we expect corporate issuance to become more manageable as M&A slows on a relative basis, providing a positive technical. Additionally, as some large institutional buyers appear to be re-entering the market, spreads should begin to tighten. We will continue to tactically add to the sector when opportunities arise. SECURITY SELECTION Security selection was a detractor to our performance in the quarter. Our overweight to financials and bias towards higher-quality securities benefited our performance, but this was overshadowed by our exposure to the basic material and energy sectors, where significant spread widening occurred along with the broad based decline in commodity prices. Overall, our portfolios continue to be overweight credit risk assets such as corporate bonds and commercial mortgage back securities. northerntrust.com Active Fixed Income Quarterly Update 5 of 8

6 EXHIBIT 6: EXCESS RETURNS BY SECTOR PAST 3 MONTHS Finance Companies Other Financial Banking Insurance Other Industrials REITS Brokerage Consumer Noncyclical Technology Capital Goods Electric Consumer Cyclical Natural Gas Transportation Communications CREDIT Energy Basic Industry Source: Barclays Live, NT Fixed Income The Fixed Income Research team continues to find the fundamentals of financial companies more attractive than those of industrial firms. Many global banks exhibit stronger capital ratios, shorter and more liquid balance sheets, and tighter underwriting standards for new loans. Regulation of the industry has increased dramatically in the aftermath of the credit crisis, keeping these institutions from participating in many of the riskier businesses that led to problems and losses of capital. In our view, the stand-alone financial strength of these firms has improved dramatically. We also see a lower probability of M&A in the banking sector than in the industrial sector, providing what we believe to be a favorable environment for investing. northerntrust.com Active Fixed Income Quarterly Update 6 of 8

7 EXHIBIT 7: PERFORMANCE AS OF SEPTEMBER 30, 2015 Northern Funds 1-Year Return 3-Year Avg. Annual Return 5-Year Avg. Annual Return 10-Year Avg. Annual Return Avg. Annual Since Inception Gross Expense Ratio Net Expense Ratio Inception Date Northern Core Bond Fund % 1.76% 3.55% 4.87% 4.88% 0.51% 0.44% 3/29/01 Benchmark: Barclays U.S. Aggregate Bond Index 2.94% 1.71% 3.10% 4.64% 4.97% Northern Fixed Income Fund % 1.89% 3.54% 4.48% 5.32% 0.49% 0.47% 4/1/94 Benchmark: Barclays U.S. Aggregate Bond Index 2.94% 1.71% 3.10% 4.64% 5.81% Northern Short Bond Fund 0.48% 0.65% 1.37% 2.91% 4.18% 0.44% 0.41% 1/11/93 Benchmark: Barclays 1 3 Year U.S. Government/Credit Index 1.19% 0.86% 1.04% 2.85% 4.18% Northern Short-Intermediate U.S. Government Bond Fund 1,2 1.75% 0.16% 0.89% 2.67% 3.30% 0.48% 0.41% 10/1/99 Benchmark: Barclays 1 5 Year U.S. Government Index 2.05% 0.90% 1.24% 3.19% 3.86% Northern U.S. Government Fund 1,2 2.93% 0.34% 1.51% 3.34% 4.37% 0.82% 0.45% 4/1/94 Benchmark: Barclays Intermediate U.S. Government Index 3.00% 1.10% 1.88% 3.85% 4.97% Performance quoted represents past performance and does not guarantee future results. Investment return and principal value will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than that shown here. Performance data current to the most recent month end is available at northernfunds.com. The Advisor has agreed to reimburse certain expenses of the Fund. The contractual reimbursement arrangement is expected to continue until at least July 31, After this date, the contractual arrangements may be terminated if it is determined to be in the best interest of the Fund and its shareholders. In the absence of fee waivers, yield, total return, growth since inception and dividends would have been reduced. Total return is based on net change in NAV assuming reinvestment of distributions. Annualized for periods greater than one year. 1 Mortgage-Backed Securities Risk: Mortgage-backed investments involve risk of loss due to prepayments and, like any bond, due to default. Because of the sensitivity of mortgage-related securities to changes in interest rates, the Fund s performance may be more volatile than if it did not hold these securities. 2 U.S. Government Guarantee: U.S. government guarantees apply only to the underlying securities of a Fund s portfolio and not the Fund s shares. northerntrust.com Active Fixed Income Quarterly Update 7 of 8

8 * Fixed Income received 4 stars for the 3-year rating among 945 intermediate-term bond funds, 4 stars for the 5-year rating among 831 funds and 3 stars for the 10-year rating among 589 funds as of 9/30/15. ** Core Bond received 3 stars for the 3-year rating among 945 intermediate-term bond funds, 4 stars for the 5-year rating among 831 funds and 4 stars for the 10-year rating among 589 funds as of 9/30/15. 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 10-year (if applicable) returns. 5 stars = top 10% 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 10%. A fund must be in existence three years to be rated. Ratings are subject to change monthly 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. 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. Barclays 1 3 Year U.S. Government/Credit Index is an unmanaged index of securities issued by the U.S. government and corporate bonds with maturities of one to three years. It is not possible to invest directly in an index. Barclays 1 5 Year U.S. Government Index is an unmanaged index of securities issued by the U.S. government with maturities of one to five years. It is not possible to invest directly in an index. Barclays Intermediate U.S. Government Index is an unmanaged index including all public obligations of the U.S. Treasury and all publicly issued debt of U.S. government agencies with maturities of up to 10 years. It is not possible to invest directly in an index. Barclays U.S. Aggregate Bond Index is an unmanaged index of prices of U.S. dollar-denominated investment-grade fixed income securities with remaining maturities of one year and longer. It is not possible to invest directly in an index. Basis Points (bps): Unit of measure used in quoting yields, changes in yields or differences between yields. One basis point is equal to 0.01%, or one one-hundredth of a percent of yield and 100 basis points equals 1%. Beta: Beta represents the systematic risk of a portfolio and measures its sensitivity to a benchmark. 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. ERISA: Employee Retirement Income Security Act of 1974 (ERISA) enacted rules for U.S. qualified plans to help protect the retirement assets. 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 (YTW) is the lowest potential yield that can be received on a bond assuming options available to the issuer are exercised. 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 2015 northerntrust.com Active Fixed Income Quarterly Update 8 of 8 NTFI WPR CORE (10/15)