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 December 31, 2014 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 SUMMARY: Portfolio returns closely resembled those of their benchmarks in the quarter. Our yield curve, duration positioning, investment grade credit and Mortgage-backed security selection provided alpha for clients. Our asset allocation overweight to high-yield risk assets was a detriment to performance as riskier credit faltered in the face of rising geopolitical risks, liquidity concerns and slower global economic growth. As we enter the first quarter of 2015, we believe inflation and inflation expectations remain well anchored, supporting our current overall duration positioning of neutral to long to our benchmarks. The group continues to prefer securities maturing 10 years and longer due to a lack of high quality, liquid assets, low global yields, and lack of inflation pressure. The Federal Reserve (the Fed) continues to communicate its desire to raise the Fed Funds rate in While this has understandably garnered attention from investors, we believe it s more important to think about how much and how fast short rates will rise in the next few years. We continue to believe rate increases will occur at a slow and measured pace. Our sector allocation continues to emphasize a preference for credit risk assets. While credit spreads widened in the last six months, fundamentals remain strong and default risk is low. We continue to prefer financial to industrial issuers and prefer lower-quality issuers trading at wider spreads that are less sensitive to interest rate risk. FOURTH QUARTER PORTFOLIO ATTRIBUTION ANALYSIS Northern s Active Long Duration Fixed Income Group manages portfolios with the goal of outperforming specific benchmarks. Our philosophy is a conservative one. We believe our clients desire to use fixed income allocations in their portfolio for things such as protection of principal, generation of current income, and providing liquidity in case of need. As such, we continuously guard against downside risks. Our investment process is designed with this conservative philosophy in mind and seeks to construct high quality, well diversified, liquid investment portfolios. We are a traditional bond manager, attempting to generate alpha through our yield curve and duration positioning, asset allocation and security selection. The group endeavours to exploit inefficiencies in the market, reacting to changing conditions and positioning portfolios in an effort to obtain superior returns. Our decisions are a reflection of views on the economy, fiscal and monetary policy, political developments, credit fundamentals and relative bond valuations. northerntrust.com Active Fixed Income Quarterly Update 1 of 10

2 ECONOMIC AND MARKET BACKDROP Preliminary fourth quarter economic data indicate global growth was slow and inflation remained subdued. Major central banks kept monetary policy accommodative. The United States was one of the best performing major economies, with employment gains on track for their best year since Eurozone economic growth continued to disappoint investors. Unemployment remained high and inflation fell sharply. The European Central Bank, concerned by the drop in inflation, announced its exploring additional measures to stimulate the economy. Growth in Japan, the world s third largest economy, continued to disappoint investors. Growth has contracted in three of the last four quarters and is continuing to track at weak levels. Growth continued its slowing trend in other large, emerging economies such as Brazil, Russia and China; driven by lower commodity prices, weaker exports and political uncertainty. The Fed continues to provide an accommodative monetary policy for the U.S. economy, in spite of the end of their asset purchase program. To support continued progress toward their goals, the Fed reaffirmed its view in their December statement that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Fed will assess progress both realized and expected toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of economic information. Fixed income markets had strong and consistent inflows of new money during the year, providing managers with money to put to work. Inventories of bonds held by broker/dealers remained near record lows in 2014, making the new issue markets the best place to source blocks of bonds. While new issuance of investment grade corporate bonds set another record in 2014, issuance across a wide variety of other fixed income asset classes was disappointing. The consistent inflows, coupled with a disappointing supply of new bonds, provided a positive technical backdrop to the fixed income market all year. EXHIBIT 1: IG CORPORATE NEW ISSUANCE 1,200 IG Corporate New Issuance 1, $ (Billions) Source: Thomson Reuters northerntrust.com Active Fixed Income Quarterly Update 2 of 10

3 YIELD CURVE POSITIONING This year s decline in long-term U.S. Treasury yields has received considerable attention, but the decline in yields hasn t occurred across the U.S. Treasury curve. Treasury notes with two and three year maturities have seen yields rise as investors assess the Fed s communications regarding when the Federal Funds rate will begin to increase. We believe the evolution of data on economic growth and inflation over the next year will be what ultimately determines the timing of an increase in the Federal Funds rate. The Fed noted after its December meeting the underutilization of labor resources in the economy is diminishing. They also noted inflation has been continuing to run below their longer-run two percent objective. As such, we re monitoring a wide variety of employment and inflation data in order to gauge progress in the economy toward the Fed s goals of full employment and price stability. Currently, the Fed Funds Futures market shows investors believe the Federal Funds rate will begin to rise sometime in the middle of next year. While investors are very focused on the timing of the first increase in the Funds rate, in our opinion it is more important to focus on how much and how fast rates will rise in the next few years. While the Fed s members believe the Funds rate will be around 1.125% at the end of 2015 and 2.50% at the end of 2016, at the current time we believe these estimates present a view of the economy that is too optimistic. That said, the rise in short-term yields this year suggests investors are looking closely at the Fed s communications for clues on when the Federal Funds rate may increase. Our current positioning across the curve relative to the Barclays U.S. Aggregate benchmark is as follows: Overweight one- to three-year maturities Neutral five- to 10-years Neutral to overweight 10+ years Our yield curve strategy provided a positive contribution to our returns relative to our benchmarks in the quarter. EXHIBIT 2: U.S. TREASURY YIELD CURVE /31/13 12/31/ UST Yield (%) Mo 3 Mo 6 Mo 1Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr Source: U.S. Department of the Treasury northerntrust.com Active Fixed Income Quarterly Update 3 of 10

4 DURATION POSITIONING The team feels U.S. Treasuries represent good value relative to where long-term interest rates trade globally. The fixed income market is a global one and investors have the ability to invest in debt of many highly-rated, liquid, developed economies. Central banks in the Eurozone and Japan have been trying to stimulate their economies using unconventional policies. This has helped bring long-term yields in these economies to their lowest in history. Furthermore, it has intensified investors search for yield and caused many investors outside the U.S. to purchase U.S. dollar denominated debt throughout We believe this trend may continue in 2015 and help to suppress yields on long-term debt. EXHIBIT 3: GLOBAL SOVEREIGN 10YR YIELD SPREADS TO U.S. TREASURIES AT 12/31/ Switzerland Denmark Japan Sweden Germany Austria Finland Netherlands France Belgium Ireland Norway Spain UK Canada Italy Australia New Zealand As of 12/31/2014. Source: Bloomberg Inflation expectations in the U.S. moved lower in the quarter, with Treasury Inflation Protected Securities (TIPS) showing investors expect less inflation over the next five- to ten-years. This move coincided with continued appreciation in the U.S. dollar versus the Euro and the Japanese Yen and a sharp decline in the price of crude oil. In our view, the appreciation in the U.S. dollar will help to restrain U.S. economic growth and assist in keeping inflation in check in The Fed noted after their December meeting that inflation continues to run below their longer-run objective of two percent. They re watching inflation and inflation expectations closely as they ve kept the Federal Funds rate near zero for six years now. Our view of well anchored inflation and inflation expectations led our portfolios to be positioned neutral to long duration relative to our benchmarks throughout the quarter. This was a positive contributor to our overall performance. northerntrust.com Active Fixed Income Quarterly Update 4 of 10

5 EXHIBIT 4: 10 YEAR TIPS BREAK EVEN 2.00 Last Price /30/ /31/ /30/ /31/2014 Source: Bloomberg SECTOR ALLOCATION Portfolios remained overweight credit risk assets such as corporate bonds and commercial mortgage-backed securities in the quarter. While our overweight to non-investment grade corporate bonds resulted in a negative contribution to our performance, we believe the fundamental reasons behind why we own these investments remains intact. We attribute the poor performance of credit risk assets to heightened geopolitical risk, liquidity concerns around outflows, and slower global growth. Demand for corporate debt continues to be strong, driven by large inflows into fixed income, low default rates, an accommodative Fed and low yields in other fixed income asset classes. The team remains positive on corporate debt and continues to prefer debt of U.S. financial institutions over industrial issuers. As we look at credit spreads across the ratings curve, we continue to think AAA to A spreads are tight, and better value can be found in BBB to B rated companies. In the lower rated companies we are focusing on issuers that could be potential credit upgrades and/ or merger and acquisition targets. As always, our research analysts and traders are also looking for misunderstood situations where the market isn t pricing risk appropriately. northerntrust.com Active Fixed Income Quarterly Update 5 of 10

6 EXHIBIT 5: OPTION ADJUSTED SPREADS INVESTMENT GRADE AND HIGH YIELD Investment Grade Option Adjusted Spread 140 High High Yield Yield Option Adjusted Spread /1/2014 3/31/2014 As of 12/31/2014. Source: Barclays Live 6/30/2014 9/30/ /31/ /31/2012 1/1/2014 3/31/2013 3/31/2014 6/30/2013 As of 12/31/2014. Source: Barclays Live 6/30/2014 9/30/ /31/2013 9/30/ /31/2014 Commercial Mortgage-backed Securities (CMBS) offer investors value in the current environment as well. Our portfolios own AAA rates securities with weighted average lives between one- and three-years. These securities offer significant yield in comparison to cash or U.S. Treasuries and look attractive relative to lower rated corporate bonds. The lack of new issuance in 2014 provided a positive technical aspect supporting this asset class as well. As the economy improves we expect continued broad-based improvement in commercial real estate fundamentals. The sector continues to recover with several years of improving delinquency rates and loan resolutions providing support for our fundamental case. There has been little new construction during the current economic expansion, allowing owners pricing power as the economy expands and empty space is absorbed. The long lead cycle needed to bring new commercial construction into the market leads us to believe pricing will remain favorable for landlords in the next few years. The current low interest rate environment we ve been in since 2008 has also made borrowing rates attractive for owners when loans come up for renewal. In our opinion, the search for yield will create growing demand for CMBS as the year goes on and this will be favorable for Option Adjusted Spreads on our short-term, high-quality holdings. northerntrust.com Active Fixed Income Quarterly Update 6 of 10

7 EXHIBIT 6: CMBS OPTION ADJUSTED SPREAD (OAS): YEAR 130 CMBS ERISA Eligible: Year OAS /30/ /31/ /31/ /30/2014 As of 12/31/2014. Source: Barclays Live SECURITY SELECTION Portfolios continue to be overweight corporate debt, specifically debt of U.S. Financial companies. The fundamentals of U.S. Financial companies continue to look more attractive than those of industrial firms. Our research shows financial firms have more than replaced the capital they lost during the credit crisis and are now in a strong financial position. These firms now have shorter, higher quality, and more liquid balance sheets than in the past. They are subject to significantly more regulation now than they were prior to the credit crisis, and this regulation keeps them from participating in riskier businesses. The loan losses suffered in the credit crisis, coupled with the increased regulation, have led to tighter lending standards, higher-quality loans, and a significant reduction in loan losses. It s our belief that these factors have created firms with more stable earnings and cash flows that still aren t fully appreciated by the market. Individual security selection has been a great source of alpha in the past few years and was once again a positive contributor to performance in the quarter. Our fixed income research team utilizes a fundamental approach, seeking to identify attractive fundamental attributes in companies and industries that can add value in client portfolios. Our analysts are experienced, career professionals, having an average of 16 years of experience in the industry. Analysts spend a significant amount of time analyzing company financial statements, spending time with management teams, rating agencies, and industry experts to assess the regulatory, political and competitive landscape firms operate in. This fundamental analysis, coupled with the relative pricing between financial and industrial firms, has led our portfolio managers to overweight many U.S. financial institutions in our portfolios. northerntrust.com Active Fixed Income Quarterly Update 7 of 10

8 EXHIBIT 7: INDUSTRIALS VS FINANCIALS Investment Grade: Industrial OAS Investment Grade: Finance OAS /1/2014 3/31/2014 6/30/2014 9/30/ /31/2014 As of 12/31/2014. Source: Barclays Live northerntrust.com Active Fixed Income Quarterly Update 8 of 10

9 EXHIBIT 8: PERFORMANCE AS OF DECEMBER 31, 2014 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 Northern Core Bond Fund % 3.49% 4.98% 4.95% 5.09% 0.57% 0.42% 3/29/01 Benchmark: Barclays U.S. Aggregate Bond Index 5.97% 2.66% 4.45% 4.71% Northern Fixed Income Fund % 3.88% 4.98% 4.58% 5.50% 0.48% 0.46% 4/1/94 Benchmark: Barclays U.S. Aggregate Bond Index 5.97% 2.66% 4.45% 4.71% Northern Short Bond Fund 0.59% 1.41% 2.03% 2.92% 4.30% 0.45% 0.41% 1/11/93 Benchmark: Barclays 1 3 Year U.S. Government/Credit Index 0.77% 0.89% 1.41% 2.85% Northern Short-Intermediate U.S. Government Bond Fund 1,2 0.94% 0.32% 1.40% 2.54% 3.36% 0.49% 0.43% 10/1/99 Benchmark: Barclays 1 5 Year U.S. Government Index 1.18% 0.68% 1.75% 3.12% Northern U.S. Government Fund 1,2 2.32% 0.55% 2.36% 3.18% 4.43% 0.72% 0.44% 4/1/94 Benchmark: Barclays Intermediate U.S. Government Index 2.52% 0.99% 2.78% 3.76% 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 9 of 10

10 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. 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 10 of 10 Q (1/15)