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 June 30, 2015 Northern Trust Asset Management 50 South La Salle Street Chicago, Illinois northerntrust.com Fred Azar Director of Business Management Scott Warner Head of Fixed Income Product Management Marie Winters, CFA, CAIA Senior Research Analyst Eric Williams Portfolio Manager SUMMARY: The high-yield market remains relatively attractive and continues to be broadly supported by stable credit fundamentals and a low default rate. Security selection will remain a key to performance over the remainder of the year. Interest rate volatility, geopolitical events, commodity prices and slow global growth should continue to be the greatest potential sources of market instability in the coming months. Northern High Yield Fixed Income Fund* maintained a four-star overall rated fund by Morningstar. There are 611 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 10-year risk-adjusted returns as of 6/30/2015. 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 limit risk by constructing well diversified investment portfolios that are a reflection of our views on the economy, fiscal and monetary policy, and market valuations. ECONOMIC AND MARKET BACKDROP Preliminary economic data showed global growth continued to disappoint investor expectations in the second quarter, causing the International Monetary Fund and the World Bank to lower their global growth forecasts for this year. The one major economic block that has exceeded investor s expectations this year has been the eurozone, where the European Central Bank s much anticipated plan to lower long-term interest rates through purchases of sovereign debt began in March. Interest rates around the globe rose in the quarter on a confluence of factors. Long-term interest rates began to rise in April, driven by increasing inflation expectations on the back of the first increase in oil prices since last summer. The sharp rise in interest rates and the volatile trading was exacerbated by a lack of bond market liquidity. Regulatory changes to financial institutions continue to impact the amount of capital trading desks can employ. While these regulatory changes are designed to bolster the financial system, an unintended consequence for broker-dealers is an inability to hold as many securities in their inventory, leaving them less capable of fulfilling their traditional role as market makers. Ultimately, this creates a less liquid market, which can increase price volatility. The Federal Reserve (Fed) continued to prepare the market for an increase in the benchmark federal funds rate for the first time since This stance represents a divergence from foreign central banks that have steadily eased policy since the start of the year. The timing and trajectory of the rate increase has also been a source of volatility in markets. northerntrust.com High Yield Fixed Income Quarterly Update 1 of 7

2 PERFORMANCE High-yield bonds, while not immune to the volatility in markets this year, are the best-performing asset class year-todate compared to the S&P 500, 10-year U.S. Treasury, investment grade corporate bonds, and emerging market debt. The Yield-to-Worst (YTW) on the high-yield market ended the quarter at 6.57%. On a rating basis, the YTW on BB s was 5.08%, B s was 6.62% and CCC s was 10.07%. High-yield issuers have benefited from the ongoing slow-growth U.S. economic backdrop. Unlike previous economic cycles, the extended slow-growth environment has caused corporations to maintain conservative spending policies. In our view, this has contributed to companies having manageable leverage metrics, high-interest coverage, and few near-term maturities. Accordingly, the default rate on high-yield bonds remains below-average, ending the second quarter at 2.0% according to Moody s, compared with a 15-year average of 5%. The default rate peaked at nearly 15% in November EXHIBIT 1: HIGH YIELD DEFAULT RATE AND YIELD-TO-WORST 24 Yield-to-Worst Default Rates Yield (%) Source: Bloomberg High-yield companies continue to issue debt to fund general corporate purposes and to refinance outstanding issues. Although refinancing activity is down compared to last year, there has been a significant increase in proceeds tied to merger and acquisition (M&A) activity. While new issuance is lower than it was in 2014, this could change in the third quarter as several companies prepare to finance recently announced acquisitions. The most notable transaction in the quarter surrounded Charter Communications planned acquisition of Time Warner Cable for approximately $55 billion. northerntrust.com High Yield Fixed Income Quarterly Update 2 of 7

3 Technical factors, such as fund flows, particularly Exchange Traded Fund (ETF) flows, continued to be a source of volatility in the market. ETFs saw significant outflows in the quarter, unwinding nearly all of the inflows in the first quarter as macroeconomic factors and interest rate volatility weighed on retail investors. This volatility has put strain on the larger, more liquid bond structures that ETF s own. The performance of individual issuers was primarily dependent on rating category, with lower-quality issuers performing best, narrowly outperforming single-b issuers. Overweight positions in B and CCC rated securities, along with an underweight in BB securities benefitted the Fund s performance. On a sector basis, underweight positions in the metals/mining and wireless telecommunication sectors, along with overweight positions in the oil refining sector contributed to performance. Overweight positions in traditional wireline telecommunication providers and underweight positions in oil field services and pharmaceutical companies detracted from performance. The fund will continue to be positioned in the mid-range of the credit quality spectrum. The highest quality securities carry a material amount of interest rate risk and the lowest rated securities carry credit and general market volatility risk. Although the high yield market remains relatively attractive and supported by fundamentals, management of credit and interest rate risk is critical for performance. In addition, by keeping ample cash in the portfolio, the fund is able to reduce its reliance on market liquidity in periods of increased volatility. The energy market remained volatile as the price of West Texas Intermediate crude oil increased from $47 to nearly $60 during the quarter. While the energy sector outperformed the broader High Yield Index by 2% during the period, in June it underperformed as expectations for further gains moderated. The fund continues to position conservatively within the broader energy sector and remains cautious when evaluating investments as significant risks remain. SPOTLIGHT SECTOR CABLE INDUSTRY The Cable and Satellite sector comprises nearly 6% of the Barclay s 2% Capped HY Index and consists of a mix of large and small U.S. and foreign cable and satellite companies. These firms by nature are capital intensive and have largely funded network upgrades and expansion programs with debt. A relatively high predictability of future cash flows has enabled these companies to use greater amounts of leverage than many of their high yield industrial peers. One of the biggest concerns investors have raised for the Cable TV industry in recent years relates to the decline of video subscribers and penetration of pay-tv households. Video products have long served as Cable s bread and butter business. Since the mid-2000s, the Cable video business has sagged under the combined forces of a saturated pay-tv market, competition from telecom satellite TV providers, and the relatively more recent proliferation of over-the-top ( OTT, internet streamed TV) video services from providers such as Netflix, Amazon, and Hulu. Currently, the Cable sector holds just under 50% of pay-tv video subscribers, down from 54% as recently as At the same time, the percentage of households subscribing to video service in the U.S. has also declined for pay-tv overall from a peak of 86% to approximately 80% at the end of 2014 as some consumers cut the cord and pursued other OTT options. northerntrust.com High Yield Fixed Income Quarterly Update 3 of 7

4 EXHIBIT 2: MULTICHANNEL NET SUBSCRIBER ADDITIONS FOR CABLE, DBS* AND TELCO TV** Cable DBS Telco 2,500 2,000 1,500 Thousands of Subscribers 1, ,000-1,500-2,000-2, Source: BofA Merrill Lynch Global Research estimates and Company reports, Battle for the Bundle, 5/14/15 *Direct-broadcast satellite ** (Fiber-enabled TV Service) We believe the decline in video customers is very manageable for the Cable sector. This is because one of the Cable sector s true competitive advantages, in our view, lies in its broadband product. Most Cable companies have upgraded their networks, leading to a superior broadband offering (based on supported download and upload speeds and reliability) relative to most of their competition. Since the mid-2000s, cable companies have increasingly taken broadband share in an expanding market from its Telecom competitors as shown in the following chart. EXHIBIT 3: CABLE VERSUS TELECOM BROADBAND SHARE OF NET SUBSCRIBER ADDITIONS Cable Telco 140% 120% 100% 80% Percent 60% 40% 20% 0% 20% 40% 4/2014 5/2014 6/2014 7/2014 8/2014 9/ / / /2014 1/2015 2/2015 3/2015 Source: BofA Merrill Lynch Global Research estimates and company reports, Battle for the Bundle, 5/14/15 northerntrust.com High Yield Fixed Income Quarterly Update 4 of 7

5 The Cable sector underwent a significant change in 2014 as broadband became the lead product, as measured by the number of broadband versus video TV subscribers. Noting this development, The National Cable & Telecommunications Association, the Cable industry s principal trade association since 1952, changed the name of its annual convention from The Cable Show to The Internet & Television Expo. EXHIBIT 4: CABLE SUBSCRIBERS BY SERVICE (U.S.) TV Broadband Millions Q Q Q Q Q Q Q Q Note: Select major cable providers. Source: Leichtman Research Group, Business Insider, 4/3/15 The four largest streaming video providers comprise over 50% of Residential Peak Period Downstream Internet traffic in the U.S., according to Sandvine s Global Internet Phenomena Report. The following chart shows that not only do the four largest streaming video providers account for a relatively constant 53% share of usage, but that the market is also growing quite rapidly as measured by median monthly consumption. These trends are expected to continue and other options are expected to develop and grow. HBO Go, while not included in the totals below, currently accounts for approximately 1% of consumption and bears watching. New streaming video launches from Sony, Apple, and HBO (HBO Now for non-pay-tv video subscribers) are expected to augment Cable broadband growth prospects even further. Fixed Access Usage 2H H H 2014 Netflix 33.0% 31.6% 34.9% YouTube 14.8% 18.7% 14.0% Amazon Instant Video 1.8% 1.6% 2.6% Hulu 1.4% 1.3% 1.4% Total 52.3% 53.2% 52.9% Median consumption* Source: Sandvine, Global Internet Phenomena Report (2H 2012, 2H 2013, 2H 2014) *Median monthly downstream consumption in GBs for all fixed access uses northerntrust.com High Yield Fixed Income Quarterly Update 5 of 7

6 We think the cable sector is uniquely well-positioned to benefit from these trends as well as the growth of online usage volumes in general. This is because customers desiring to stream video need a robust high-speed internet connection. Broadband is also a significantly higher margin business for cable companies than video due to high programming costs for video services. Gross margins for broadband usually exceed 80%, or even 90% in some instances. This compares to less than 50%, and sometimes below 30%, gross margins for video. Over the coming quarters we expect broadband penetration to continue to rise. When you layer in the cable sector s opportunity to grow its share in broadband in the underpenetrated commercial space, as well as in the residential space, it is apparent that cable s broadband offering is a strategic advantage and suggests an attractive future for cable companies. This is one of the reasons why we continue to find value in a number of cable TV issuers. northerntrust.com High Yield Fixed Income Quarterly Update 6 of 7

7 * High Yield Fixed Income received 4 stars for the 3-year rating among 611 high yield bond funds, 4 stars for the 5-year rating among 516 funds and 3 stars for the 10-year rating among 362 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 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. 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 0.01%, or one one-hundredth of a percent of yield and 100 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 2015 northerntrust.com High Yield Fixed Income Quarterly Update 7 of 7 (7/15)