INVESTING IN THE US FIXED INCOME MARKET. Curt Burns, US Fixed Income Portfolio Manager

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1 INVESTING IN THE US FIXED INCOME MARKET Curt Burns, US Fixed Income Portfolio Manager October 2012

2 INVESTING IN THE US FIXED INCOME MARKET Summary...3 Bonds are no longer boring... 4 Largest and most liquid bond market... 5 The US corporate bond market...6 Investment grades and high yields offer good value Slow growth is not bad for bonds

3 THOUGHT LEADERSHIP SERIES INVESTING IN THE US FIXED INCOME MARKET Although other global bond markets have been growing in recent years, the US market remains the largest and most liquid bond market in the world. It is also one of the safest, most efficient and transparent markets. While these attributes are often discounted during periods of economic and political calm, they become increasingly important in periods of downturn and instability. Market turmoil and volatility over the past several years have forced many institutional and retail investors alike to rethink the existing investment paradigm. The adage that equities offer greater long-term returns than bonds in exchange for greater risk has been challenged by the ten and fifteen year returns of many global fixed income and equity asset classes. The underperformance of equities has left a bad taste with many investors, who have reacted by transitioning away from stocks towards bonds. Given the magnitude of uncertainty that the global economy faces today, the lower risk/lower return profile of US debt investments continues to look favorable. Due to the highly uncertain global-macro backdrop, current market expectations range from doom and gloom to bullish. The truth, as usual, is likely somewhere in the middle. Indeed, consensus forecasts call for sloweryet-positive global growth and slow-to-moderate US growth. Contrary to equities, which feed off of top-line revenue growth, bonds have historically performed well in slower growth environments. 3

4 BONDS ARE NO LONGER BORING Prior to 2008, bonds seemed boring. True, downside was somewhat limited by bondholders position above stockholders and by the nature of the investment: economic and capital market conditions typically need only be such that bond issuers can pay back their debts. But upside was also limited. At best, bondholders could expect coupon and repayment of par at maturity and any capital appreciation from buying at a discount. However, in the aftermath of the financial crisis, at which point many global equity asset classes ten year returns had turned negative, regular income and greater downside protection no longer seemed so unattractive. Even with equity valuations having recovered since 2008, ten year global stock returns remain behind those of US bonds, as a myriad of global imbalances have weighed heavily on investors expectations for future returns on investment. The attractiveness of fixed income investing for any given investor will, of course, depend on that investor s goals. Generally speaking, however, investment goals typically include the ability to meet some type of future liability or spending need. For example, many institutions invest in order to meet future pension obligations or other liabilities and many individuals invest in order to pay for future college expenses or retirement spending. Investors therefore have often needed to carefully weigh reaching for higher returns against securing more modest returns with greater probability. Since the financial crisis, investors have been weighing the latter more heavily as reflected in Chart 2. Chart 2: US fixed income and equity flows (August 2009 May 2012) Chart 1: 10-year global asset class returns $1,000 $ billions % US HY Corporate Bonds US IG Corporate Bonds US Bonds US Equities Global Equities Developed International Equities $800 $600 $400 $200 $0 -$200 Fixed Income Equity 10 Year Return (as of 3/31/2009) 10 Year Return (as of 5/31/2012) 4

5 LARGEST AND MOST LIQUID BOND MARKET IN THE WORLD To an investor, a larger investment universe is typically preferable, because it offers diversification and a greater opportunity set, and in turn, the potential for superior results. To a fixed income investor, the ability and incentives of borrowers to repay their debts is also of utmost importance. It is in light of these primary concerns for market breadth and security that the compelling value of the US fixed income market can be fully recognized. Constituting nearly 40% of the overall global bond market and 45% of the global corporate bond market, the US bond market is the largest and most liquid bond market in the world. Chart 3: Outstanding global debt breakdown by countries as at Dec 2011 Chart 4: Outstanding corporate debt breakdown by countries 100% 80% 60% 40% 20% 0% Dec 09 Dec 10 Dec 11 United States Japan France China Germany Others At this size, the breadth of opportunities available in the US surpasses any other bond market. Additionally, US fixed income investments are supported by strong corporate governance, low levels of corruption, and an ease of doing business. 40% These factors either directly or indirectly impact the 35% 30% 25% credit worthiness of issuing entities and an investor s ability to assess the risks associated with their investment choices. 20% 15% 10% 5% 0% United States Pan Euro Asia Pacific Others Furthermore, the US market benefits from a dynamic financial system, as illustrated by its top ranking for access to capital, which measures such factors as the macroeconomic and institutional environment, the involvement of financial and banking institutions in financing businesses, and the level of alternative sources of capital and international funding. 5

6 Sep-86 Jun-87 Mar-88 Dec-88 Sep-89 Jun-90 Mar-91 Dec-91 Sep-92 Jun-93 Mar-94 Dec-94 Sep-95 Jun-96 Mar-97 Dec-97 Sep-98 Jun-99 Mar-00 Dec-00 Sep-01 Jun-02 Mar-03 Dec-03 Sep-04 Jun-05 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11 Mar-12 US CORPORATE BOND MARKET US Treasuries constitute the bulk of the debt market followed by mortgage related debt and corporate issues. As the US government continues to issue debt to finance its deficit, the size of the US Treasury market will continue to be a significant portion of the US bond market. US corporate bonds also constitute a large percentage of the overall debt market. Since the 2008 financial crisis, the number of issuers in the Barclays US Aggregate Bond Index has grown over 20% as foreign companies have looked to diversify their funding. Chart 5 : US Debt Market Breakdown as at Q ,000 $ billions 10,000 Growth within the investment grade corporate bond market specifically can be attributed to this shift as well as an increase in the size of issues that have come to market, which has largely been a function of strong demand in recent years. Chart 6 : US Corporate Bond Market Growth 5,000 $ billions 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, ,000 6,000 4,000 US High Yield US Investment Grade 2,000 0 Chart 7 : US Corporate Bond Market Breakdown as at 31 March ,000 $ billions 3,500 3,000 The US bond market has remained attractive to foreign issuers given its depth and transparency as well as its relatively safe haven status. As funding within Europe has become less attractive, more issuers have come to the US market. 2,500 2,000 1,500 1, US High Yield US Investment Grade 6

7 INVESTMENT GRADES AND HIGH YIELDS OFFER GOOD VALUE US Investment Grade Corporate Bonds US High Yield Corporate Bonds One trend that will be a positive driver for investment grade credit over the next 1-3 years is the strong demand for high quality, non-treasury bonds. This trend has recently helped support tighter credit spreads and is likely to persist for three main reasons High yield companies also rest relatively well positioned in the current market environment due to the significant level of re-financing that has been accomplished since the financial crisis, which has left only approximately $86 billion in bonds and loans maturing through year-end First, a high level of uncertainty in the marketplace, which should keep investors more conservatively positioned/allocated. These low near-term maturities allow for good liquidity in the market and are big factors influencing the low expected default rate through the end of Second, high quality fixed income is becoming scarcer, and in turn, leading to greater demand for those high quality bonds that are still available. With a yield of over 6% and an expected default rate of less than 3%, high yield continues to offer good relative value. Third, record-low treasury yields will probably continue to push traditional treasury investors down the risk spectrum into non-treasury investment grade bonds. Investment grade bonds should continue to benefit from strong demand for high quality, non-treasury bonds in the highly uncertain macro backdrop. Given the declining supply of high quality fixed income and paltry US treasury yields that persist, US IG bonds remain attractive in the current market environment. While the macro backdrop is highly uncertain, we remain constructive on the high yield asset class. Although slow growth can be challenging for equities, high yield offers greater downside protection since the majority of total return comes from regular coupon payments. Quote from fund manager, Curt Burns Quote from fund manager, Mark Redfearn 7

8 SLOW GROWTH IS NOT BAD FOR BONDS While slow-to-moderate growth might not be something to cheer otherwise, it is not necessarily a bad thing for US fixed income investors. In fact, slow-to-moderate US growth has historically produced comparatively attractive US corporate bond returns, being low enough to prevent materially higher interest rates and high enough to prevent significant corporate balance sheet deterioration Chart 8 : Quarterly US high yield and investment grade performance vs. % change in following quarter GDP % Contraction (GDP < 0%) Low (GDP 0%<-->2%) US Investment Grade Medium (GDP 2%<-->4%) US High Yield High (GDP > 4%) The latter point is particularly true today, as US corporate balance sheets remain healthy. Companies have generally cut costs and behaved conservatively as a reaction to the financial crisis and as a hedge against future uncertainty. Industrial companies credit metrics remain solid, and even financial companies rest relatively well positioned in terms of their ability to pay back bondholders, as illustrated by rising capital levels and falling non-performing assets 2. In conclusion, it is not surprising that many investors have transitioned away from stocks towards fixed income in the wake of the financial crisis, which erased 10 years worth of equity returns. The erratic investment environment of the past several years serves to remind investors of the attractive features of fixed income that become discounted in periods when everything is going well. While these features may not include unlimited upside potential, they do include regular income, lower volatility, and in turn, better principal preservation. Given the highly uncertain global-macro backdrop and expectations for slower growth ahead, these features continue to look attractive. From a global perspective, the US offers one of the most robust fixed income markets from which to seek these benefits. Steady Income Benefits of bond investing amid a highly uncertain global macro backdrop Volatility Dampening Principal Preservation Unlike equity returns, the large majority of US fixed income long-term returns is derived from coupon rather than the much more volatile price movements that drive equities returns. Over the past 15 years, US high yield and investment grade corporate bonds have performed with approximately 40% and 65% less volatility than equities, respectively, providing a crucial counterbalance to equity volatility within diversified portfolios 3 US fixed income peak-to-trough losses have historically been significantly lower than those of equities, translating into significantly greater safety of principal at any given time 4 8

9 Sources for Charts Chart 1: Morningstar Direct total returns for the given time periods. US IG Corporate Bonds as measured by the Barclays US IG Corporate Index, US HY Corporate Bonds as measured by the BofA Merrill Lynch US HY Master II Index, US Bonds as measured by the Barclays US Credit Index, US Equities, as measured by the S&P 500, Global Equities as measured by the FSTE All World Index, and Developed International Equities as measured by the Russell Developed Index. All returns are in USD. Past performance does not guarantee future results Chart 2: Morningstar Direct as of 31 May For illustrative purposes only. Fixed Income as measured by net inflows into Morningstar s Worldwide OE & MM ex FOF universe of funds falling under the broad category group of Fixed Income, and Equity as measured by net inflows into Morningstar s Worldwide OE & MM ex FOF universe of funds falling under the broad category group of Equity Chart 3: Estimates based on the breakdown of the Barclays Global Aggregate Index as of 31 December 2011 Chart 4: Quarterly securities statistics and syndicated loans data from the Bank for International Settlements as of 31 December 2011 Chart 5: The Securities Industry and Financial Markets Association (SIFMA) as of Q Treasuries represent interest bearing marketable public debt. Mortgage related included GNMA, FNMA and FHLMC MBS/CMOs; and private-label MBS/CMOs. Money markets include commercial paper, bankers acceptances, and large time deposits. Asset-Backed includes auto, credit card, home equity, manufacturing, student loans and other; CDOs of ABS are included. Federal agency securities contain agency debt of Fannie Mae, Freddie Mac, Farmer Mac, FHLB, the Farm Credit System, and the federal budget agencies (e.g. TVA). Municipal includes municipal securities restated from 2004 onward and revised upward by about $840 billion Chart 6: Bank of America Merrill Lynch. Quarterly data from 31 September March US High Yield as measured by the BofA Merrill Lynch US High Yield Master II Index. US Investment Grade as measured by the BofA Merrill Lynch US Corporate Master Chart 7: Bank of America Merrill Lynch as of 31 March US High Yield as measured by the BofA Merrill Lynch US High Yield Master II Index. US Investment Grade as measured by the BofA Merrill Lynch US Corporate Master Chart 8: US Bureau of Economic Analysis and Barclays Capital. Note: US Investment Grade as measured by the Barclays Capital US Credit Index. US High Yield as measured by the BofA Merrill Lynch US High Yield Master II Index. US investment grade and high yield quarterly returns from 31 March December GDP as measured by quarterly annualized real GDP growth from 30 June March Important note: Since the performance of the fixed income market is often considered to be a leading indicator of the economy, the quarterly total returns are paired with the GDP environment the occurred one quarter later (ex. 3-Month total return ending 31 March 1997 is paired with the 30 June 1997 GDP figure) Sources for Footnotes 1 JP Morgan, High-yield and Leveraged Loan Market Update, June 2012., 2 SNL Financial as of the close of 1Q12, 3 Morningstar Direct as of 31 May As measured by the 15 year annualized standard deviation of monthly returns of the BofA Merrill Lynch US HY Master II Index (high yield corporate bonds), the Barclays US IG Corporate Bond Index (investment grade corporate bonds), and the FSTE All World Index (equities), 4 As measured by the cumulative growth of assets for the 15- Year period ending 31 May US fixed income as measured by the BofA Merrill Lynch US HY Master II Index and the Barclays US IG Corporate Bond Index 9

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