Simplifying Unconstrained Fixed Income Investing

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1 Investment Management Fixed Income Team, July 204 Simplifying Unconstrained Fixed Income Investing Introduction Financial markets fluctuations in recent years and central banks attempts to sustain the global recovery have left investors stranded in a low yielding and highly uncertain environment. Fixed income investors in particular have benefited from widespread monetary actions which have driven government yields to historically low levels and depressed credit and liquidity premia. The financial crisis of made some investors more aware of the deficiencies in traditional bond indices (such as sector concentration or deteriorating credit quality). These conditions have severely tested traditional, benchmarkdriven approaches but have proven to be a fertile ground for a resurgence of benchmark-agnostic, unconstrained strategies. By setting an investment manager s reference point as and by determining a return target commensurate with a given risk budget, we believe that skillful managers can add value by building a truly diversified portfolio. In fact, the defining feature of unconstrained strategies is flexibility in their approach to asset allocation and security selection within the global fixed income universe, which can offer better returns and much more downside protection. An unconstrained approach reduces the starting point for interest rate risk and/ or credit risk to zero and allows for a more diverse set of global opportunities to drive returns. Defining The Universe There is little market consensus on defining unconstrained fixed income strategies. Terminology varies across managers and geographies, which can be confusing. In order to clarify this mixed marketing, we have identified three main types of unconstrained fixed income strategies prevalent within the market place. These are: - Multi-Asset Credit (MAC) - Total Return Bond Strategies (TRBS) - Absolute Return Bond Strategies (ARBS) The diagram on the right-hand side illustrates some of the labels managers use and how we, through our research process, classify them. KEY TAKE AWAYS. Absolute return Total return We consider the absolute return and total return approaches to be distinct. Looking at the name of the strategy and/ or its reference benchmark (being ) is not enough. 2. Risk free is not risk free and neither are strategies which target + returns. Risk of loss of capital can be comparable with benchmark driven credit strategies. 3. Unconstrained = Diversification We do believe that all forms of unconstrained investing, when implemented by a skillful manager, can provide diversification to existing asset mix and away from traditional sources of fixed income risk. 4. Manager selection is key Unconstrained fixed income strategies are highly sophisticated investments that require thorough due diligence. Absolute Return High Alpha Total Return Diversified Income Dynamic Bonds Unconstr ained Strategic Income Due Diligence Multi- Sector Plus

2 Investment Management Fixed Income Team, July 204 Key Characteristics Compared to traditional benchmark driven fixed income strategies, unconstrained approaches have several distinguishing features: ) Are benchmark agnostic e.g. go anywhere approach 2) Have a broad opportunity set 3) Exhibit less reliance on the market betas 4) Operate with reduced levels of absolute volatility (but higher tracking error) against credit 5) Greater potential use of derivatives which can protect and generate return streams In the table below, we compare each of the MAC, TRBS and ARBS to a Traditional Active Investment Grade (IG) Credit Strategies across a range of key characteristics. The arrow indicates the degree of flexibility allowed to the manager compared to index-driven strategy. Traditional Active IG Credit Strategies Benchmark Physical bonds Physical bonds or Physical bonds or Return target (gross of fees, p.a.) -3% over benchmark 2-4% over benchmark or 6-0% absolute 2-4% over benchmark or 6-8% absolute 2-5% over benchmark Return composition 90% Beta/ 0% Alpha 80% Beta/ 20% Alpha 60% Beta/ 40% Alpha 20% Beta/ 80% Alpha Absolute volatility Similar to underlying index Higher Similar Lower Absolute duration 4 to 8 years 0 to 6 years -2 to 8 years -6 to 6 years IG credit beta 0.8 to to to to 0.6 Orientation Long-only Long-only Long and short Long and short Average quality A Lowest Lower Similar Investment horizon 3 to 5 years Similar Shorter Shortest Correlation to equities and high yield 0.5 to 0.7 Higher Similar Low to negative Fees 20 to 40bps Higher, might include performance fee Higher, might include performance fee Higher, tend to include performance fee Subscriptions/ redemptions Daily Daily to quarterly Daily to bi-weekly Daily to bi-weekly 2

3 Investment Management Fixed Income Team, July 204 Whilst sharing some features, we consider the three unconstrained approaches distinct and fulfilling different roles in clients portfolios. Multi-Asset Credit (MAC) MAC is a type of TRBS that focuses solely on deriving value from either sector rotation or bottom up credit ideas or a combination of both in credit markets. Most MAC strategies are long-only in nature but they can use derivatives to adjust duration and credit exposures. MAC strategies tend not to take currency risk. Total Return Bond Strategies (TRBS) TRBS are investment strategies that seek to generate returns from rotating between fixed income asset classes. TRBS are typically not bound by an index but rather by an absolute risk budget. However, TRBS are typically skewed to the long side in line with their systematic bias to be long spread sectors and/ or duration. TRBS have a similar investable universe to ARBS. However, the style in which money is deployed differs as does the balance between strategic and tactical views. TRBS tend to have larger core credit allocations, typically of lower credit quality (and shorter maturity), which have limited use in ARBS. Strategies are implemented through physical bonds and derivatives and can be long and short, with the latter largely being market hedges. Absolute Return Bond Strategies (ARBS) We define ARBS as strategies whose returns are independent of traditional market betas. They seek consistently positive results by deploying techniques that are able to profit from both the ups and downs in markets and security prices. ARBS have usefully typically low correlations to traditional fixed income and other assets classes. These strategies are typically only constrained by the overall risk budget and redemption terms. Symmetrical discretion to be long or short credit, interest rate duration or currencies (mainly through use of derivatives) allows skillful managers to generate returns from a wide array of long and short positions. We consider the ability to manage short positions to be just as important as managing long exposures, especially in the current market environment. On average, ARBS have shorter term investment horizons than other unconstrained strategies and, as a result, higher credit quality with more market liquidity resulting from the higher use of derivatives in only the most liquid markets. ARBS share many similarities with fixed income and macro hedge funds, but focus on the lower end of return spectrum, offer full transparency into underlying holdings and more generous liquidity terms. As a result, ARBS might be appropriate for clients averse to hedge funds but looking for diversification and plus returns. 3

4 Investment Management Fixed Income Team, July 204 Historical Backdrop The large dispersion of returns between a sample of managers and fixed income market indices shown below highlights the importance of manager due diligence. In the opening paragraph, we mentioned the resurgence of unconstrained strategies. These strategies, often labelled as absolute return and quoting capital preservation as their key objective, first gained popularity in early 2000s. The credit crisis of exposed their weaknesses - the markets recognised that these strategies were nothing more than long-only credit or broad total return investments. 90.0% Cumulative Returns 70.0% 50.0% High Yield MAC TRBS 30.0% EMD IG Credit 0.0% ARBS Equities 90.0% 70.0% Govt. Bonds 3M 50.0% Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-0 Jun-0 Sep-0 Dec-0 Mar- Jun- Sep- Dec- Mar-2 Jun-2 Sep-2 Dec-2 Mar-3 Jun-3 Sep-3 Dec-3 Mar-4 Source: evestment, MLX, Barclays, JPM Indices. Data in USD. Period: April 2008 to March 204. The analysis below shows several of the key differences in behaviour of MAC, TRBS and ARBS compared to each other and to the broader, more traditional bond and equity benchmarks. Of particular interest is the extent of drawdowns and overall performance over the most recent market cycle since April 2008 (the height of the financial crisis). Representative strategies Indices IG Credit Rates EMD High Yield Equity Return (p.a.) 9.0% 8.6% 5.2% 6.% 3.8% 7.9%.3% 4.9% Risk (p.a.) 8.2% 6.% 2.7% 5.4% 3.0% 0.7% 2.9% 20.0% Max. Drawdown -6.7% -8.9% -2.2% -.2% -3.% -2.8% -3.6% -50.8% Correlation to equities Source: evestment, MLX, Barclays, JPM Indices. Data in USD. Period: April 2008 to March 204 4

5 Investment Management Fixed Income Team, July 204 Why Manager Selection Is Crucial Whilst most unconstrained fixed income managers benefited in recent years from the rally in rates and credit, a quick look at performance at the turn in the market in 2008 separates managers solely relying on beta from those adding value. The peer group of 7 unconstrained strategies presented below indicates lack of risk controls in an average manager. Manager due diligence and manager selection is therefore crucial. 40.0% Annual Returns 30.0% 20.0% 0.0% 0.0% Top quartile Upper quartile Lower quartile Bottom quartile -0.0% -20.0% Source: evestment. Data in USD To further improve experience, clients deciding to allocate to unconstrained strategies might like to consider blending the MAC, TRBS and/ or ARBS approaches. We believe these three types of unconstrained strategies can be highly complementary both qualitatively and quantitatively. Whilst we recognise correlations are dynamic and tend to move to one in stressed markets, below we show correlation analysis over the last six years, which supports our fundamental view and points to potential advantages of having more than just one style of unconstrained strategy. Representativ e strategies Correlation Representative strategies IG Credit Rates Indices EMD High Yield Equity MAC TRBS ARBS IG Credit Indices Rates EMD High Yield Equity.00 Source: evestment, MLX, Barclays, JPM Indices. Period: April 2008 to March 204 5

6 Investment Management Fixed Income Team, July 204 Disclaimer This document has been produced by the Investment Management Team of Aon plc. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. Aon plc 8 Devonshire Square London EC2M 4PL Copyright 204 Aon plc 6