A World of Change: Less Efficient Markets, More Opportunity

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1 Fixed Income October 213 A World of Change: Less Efficient Markets, More Opportunity Executive Summary In the post-28 world following the financial crisis, we believe two major changes in global fixed income and currency markets create opportunities. First, stricter regulation has led large broker/dealer firms to reduce their risk-taking and market-making activities in fixed income markets relative to the pre-28 period. Second, central bank intervention in fixed income and currency markets has increased significantly. As a result, a larger proportion of market activity is driven by central bank policy objectives rather than profit-seeking investors. We believe these changes reduce the efficiency of global fixed income and currency markets and create a diverse, global opportunity set for generating attractive returns through arbitrage and relative value strategies. This opportunity set is particularly relevant today because it provides the potential to generate returns from fixed income alpha, without relying on falling interest rates or other traditional beta exposures. We believe global fixed income alternative and unconstrained investment strategies are best positioned to capture this opportunity set, as these strategies can employ many of the same global, alpha-driven trading approaches that dealers have historically employed. The World Has Changed From an investment perspective, the world has changed since the financial crisis of 28. Two of the largest players in the market central banks and the broker/dealer community have fundamentally changed their role and the way they interact with the financial markets. Central banks have become far more interventionist, while dealers have retreated from both risk-taking and market-making. We think the result is a tangible shift in the balance between market activity driven by pure profit-seeking and market activity driven by macroeconomic policy objectives. EXHIBIT 1: THE FED AND PRIMARY DEALERS HAVE CHANGED THEIR ROLE IN THE MARKETS US primary dealer net holdings of corporate bonds versus Federal Reserve direct holdings of securities $, billions Primary Dealer Credit Inventory (left axis) Fed Securities Holdings (right axis) Source: Bloomberg, New York Fed, GSAM. As of July 213. Credit inventory includes corporate and mortgage credit $, trillions Fixed Income Goldman Sachs Asset Management 1

2 We believe this shift makes markets less efficient and creates more potential to generate returns from strategies focused on relative value and idiosyncratic risk. These strategies can be used either to enhance the total return potential of a portfolio employing traditional market-directional strategies based on rates and credit spreads or as the main driver of portfolio return potential when directional strategies are unattractive. Change #1: Broker/Dealers Are Taking Less Risk In an efficient market, similar bonds should trade at similar prices and yield curves should be relatively smooth. However, in reality, investor flows can cause the price of an individual bond to deviate from where fundamentals or historical or mathematical relationships suggest that it should trade relative to other bonds. Historically, the Wall Street broker/dealer community has helped to limit these inefficiencies in the fixed income market in two ways: First, dealer proprietary trading desks policed markets for pricing inefficiencies, seeking the potential to profit from betting that the relationship would revert to its historical norm. Second, dealers would use their own capital to make markets, taking the other side of customer trades and holding bonds on their own balance sheets as inventory rather than simply matching buyers and sellers at whatever price allows the trade to be completed. Since the 28 financial crisis, dealers have reduced their risk taking and altered their approach to market making, primarily due to a stricter regulatory environment. New regulations such as Basel III and Dodd-Frank (which includes the Volcker Rule prohibition on proprietary trading) have placed greater restrictions on what dealers can do and increased the cost of maintaining riskier bonds in inventory. As a result, dealer market-making activity has shifted towards connecting buyers and sellers, and dealers are much less willing to take on risk when they cannot find a matching buyer/seller on specific securities. Change #2: Central Banks Are More Interventionist The other major change in financial markets is a massive increase in central bank intervention. While the US Federal Reserve ( Fed ) has been particularly aggressive by directly purchasing more than $2 trillion in Treasuries and mortgage-backed securities, the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) have all engaged in large-scale market interventions. In our view, central bank intervention has two main implications for financial markets: First, central banks are focused on achieving policy objectives, not on earning a profit. As a result, the single biggest player in each of the world s four largest markets is essentially insensitive to prices and fundamentals when purchasing securities. Second, central bank intervention and easing have been a one-way, global trend, but the policy outlook now appears increasingly uncertain and dependent on local factors rather than a global cycle. For example, the Fed has introduced more uncertainty about its policy by indicating that it might taper the pace of its asset purchases, and then surprising the market by choosing not to taper at the September 213 meeting. Meanwhile, the BoJ only recently began a massive increase in its asset purchases, and the ECB and BoE could move in either direction, depending on the progress of recent growth improvements in the Eurozone and UK. Implications: Less Efficient Markets, More Relative Value and Idiosyncratic Opportunities We believe these changes have led to a tangible decline in market efficiency and a corresponding increase in the opportunity set for trades focused on relative value and idiosyncratic, security-specific risk. Market Efficiency Central banks try to limit their effect on markets to the policy objective, but the magnitude of central bank intervention has been so large that market distortions are difficult to completely avoid. One example is the Fed s effect on the US mortgage-backed securities (MBS) market (Exhibit 2). The Fed s goal is to reduce borrowing costs and stimulate the US economy, not distort the MBS market. However, the Fed is buying Fixed Income Goldman Sachs Asset Management 2

3 $4 billion of MBS every month, mostly focused in new, current coupon issues. Price action clearly suggests Fed buying has been a key driver of volatility in the MBS market. In our view, that volatility has periodically created pricing distortions, which probably would have been smaller in a market where the dealer community was more active in taking risk and policing the markets for inefficiencies. EXHIBIT 2: FED POLICY HAS BEEN A KEY DRIVER OF VALUATIONS IN THE MBS MARKET Fannie Mae 3-year Current Coupon MBS Option-Adjusted Spread versus Treasuries Basis points Fed announces QE1 Source: Barclays. As of August 2, 213. Fed signals QE2 Current Coupon MBS Spread -5 Sep-8 Sep-9 Sep-1 Sep-11 Sep-12 Fed announces QE3 The Japanese government bond (JGB) market is another example where we believe central bank activity and reduced risk intermediation by the dealer community have resulted in market distortions. Exhibit 3 shows the JGB yield curve before and after the BoJ announced a massive expansion of its bond purchases in early April. As the chart shows, the JGB curve was relatively smooth before the BoJ announcement, but over time the curve developed a kink around the seven-year maturity. EXHIBIT 3: BANK OF JAPAN BOND-BUYING CONTRIBUTED TO A KINK IN THE JGB CURVE Japanese government bond yield curve before and after the April announcement of additional bond buying July 8, 213 (Post-BOJ) Yield (%) 1..5 Post-BoJ "Kink" April 1, 213 (Pre-BOJ). Source: Bloomberg, GSAM. 2Y 5Y 7Y 1Y 15Y 2Y Maturity (Years) We believe this kink in the JGB curve was caused by flows rather than fundamentals, considering the supply/demand factors at play: The BoJ s announcement caused JGB volatility to spike; Japanese banks were long JGBs and wanted to reduce risk given the spike in volatility; Fixed Income Goldman Sachs Asset Management 3

4 Banks did not want to sell their JGBs at a loss, so they sold JGB futures as a hedge; For technical reasons, seven-year bonds are the cheapest to deliver against a 1-year JGB futures contract; However, BoJ purchases excluded seven-year bonds, because they were the cheapest-to-deliver against futures; As a result, bank selling was focused in the one part of the curve excluded from BoJ purchases. The JGB yield curve and the US mortgage market are both relatively large distortions tied to major policy shifts. However, fixed income markets are prone to inefficiencies due to the fact that large market participants use fixed income instruments for hedging or other non-profit-seeking purposes. (This also applies to currencies and commodities and is one of the reasons dealers have historically grouped Fixed Income, Currencies and Commodities together into FICC trading divisions). As a result, most of the inefficiencies we see in the fixed income market arise from more commonplace situations where the supply of a specific bond is out of synch with the demand, and dealers are not using their own capital to intermediate that risk in pursuit of profits. We think the municipal bond market illustrates this dynamic. Exhibit 4 shows the 3-year AAA municipal bond yield as a ratio of 3-year Treasury yields. A yield ratio of more than 1% indicates municipal yields are higher than Treasury yields. Historically, municipal bonds have almost always been lower than Treasury yields due to the tax advantages. If municipal yields moved above Treasury yields, the dealer community would often buy municipals and sell Treasuries with the expectation that the relationship would normalize. Today, the relationship is much more volatile, with municipal yields periodically spiking well above Treasury yields before normalizing. Although other factors have contributed to municipal market volatility, we believe the spikes seen since 28 would probably be smaller in a market where dealers were more actively intermediating risk. EXHIBIT 4: US MUNI MARKET IS MORE PRONE TO TEMPORARY DISLOCATIONS VERSUS TREASURIES Yield ratio on AAA-rated 3-year municipal bonds versus 3-year Treasury yields 225% 2% Ratio 175% 15% 125% 1% 75% From 1998 to 28, the relationship between municipal bonds and Treasuries was very stable 5% Source: JP Morgan. As of August 23, 213. A Larger and More Global Opportunity Set for Relative Value and Idiosyncratic Risk While inefficiencies have always existed in the fixed income markets, we believe the evolving role of the dealer community has fundamentally changed the pricing function in these markets. Essentially, prices are more likely to gap to the level at which buyers or sellers emerge rather than move in a series of steps from one price level to another. We think this increases the opportunity set for relative value and idiosyncratic risk in three key ways: First, price distortions seem to develop more frequently from relatively smaller flow imbalances. In the past, we think larger flows were generally required to create inefficiencies. Second, we think price distortions can sometimes be larger today than they would have been previously, but may be shorter-lived. Fixed Income Goldman Sachs Asset Management 4

5 Third, the bond market is more global, but the universe of opportunistic, global fixed income investors is probably smaller today than it was when the broker/dealer community was actively policing relative value relationships around the world, across borders and between market sectors. In our view, these trends provide the potential to construct a broad and diversified portfolio of investment strategies focused on relative value, where the manager seeks pricing relationships that have become skewed by flows and then implements trades intended to profit from those value relationships reverting to previous norms. Looking Ahead: Where Might Future Opportunities for Relative Value Arise? In our view, a broader opportunity set for relative value trades is particularly relevant today because of the potential to generate returns from fixed income markets without relying on falling interest rates, tightening credit spreads or other traditional drivers of fixed income returns that may offer less return potential relative to the past. If a portfolio can incorporate relative value and idiosyncratic risk, these strategies can be used to either drive returns when directional risks are unattractive or diversify the return sources in a portfolio when directional risks are attractive. Where might these opportunities come from in the future? We see two main themes. First, a divergence in central bank policy is likely to create more volatility in global fixed income and currency markets. Second, the growth of the global bond market has expanded the universe of pricing relationships, while the universe of global investors capable of policing those relationships for inefficiencies has contracted. Policy Divergence and Volatility Create Opportunity in Global Rate and Currency Markets In the last few years, all of the major central banks have been in easing mode and have made some form of commitment to keeping rates lower-for-longer through forward guidance. That convergence in monetary policy led investors to anticipate low short-term rates far into the future. The trend now appears to be reversing as stronger growth trends in the US and UK are leading investors to anticipate divergence in future short-term rates (Exhibit 5). EXHIBIT 5: EXPECTATIONS OF FUTURE SHORT-TERM RATES ARE BEGINNING TO DIVERGE Yield on 3-month interbank lending rate futures on a rolling, three-year forward basis 4.% 3.5% 3.% 2.5% Lower-for-longer 2.% 1.5% 1.%.5%.% UK US Eurozone Japan Source: Bloomberg. As of August 28, 213. The chart shows the yield on three-month Eurodollar, Sterling, Euroyen and Euribor futures contracts using the 12 th contract on a rolling basis. The lower-for-longer trend in monetary policy led investors to anticipate not only lower rates but also lower volatility in rates. This was particularly evident in the US, where interest rate volatility implied by options contracts fell to a record low (based on the Merrill Lynch MOVE index of implied interest rate volatility). Interest rate differentials are one of the main drivers of foreign exchange rates, so the convergence of rate expectations in major markets along with the decline in expected rate volatility led to a marked decline in currency market volatility. Now, with the Fed sending mixed signals about reducing its asset purchases, volatility has increased significantly in both the rate market and the global currency market (Exhibit 6). Fixed Income Goldman Sachs Asset Management 5

6 EXHIBIT 6: POLICY DIVERGENCE IS LEADING TO MORE VOLATILITY IN RATES AND CURRENCIES JP Morgan Global FX Volatility Index versus Merrill Lynch MOVE Index (indices rebased to January 211=1) US Rate Volatility Global Currency Market Volatility Lower-for- Longer Source: Bloomberg, JP Morgan, Merrill Lynch. As of September 23, 213. In our view, higher volatility in the global rate and currency markets creates more potential for temporary price distortions and relative value opportunities. For example, after the Fed hinted at future tapering of its asset purchases, rates rose not just in the US but across the developed world. In our view, this shift was caused by investors exiting interest rate risk and did not reflect the fundamentals of individual rate markets. Thus, a macro-oriented relative value trade might then be to position for US and French 1-year rates to diverge given the significant differences in economic conditions between the two countries (Exhibit 7). EXHIBIT 7: US AND FRENCH RATES HAVE CONVERGED DESPITE DIVERGING ECONOMIC FUNDAMENTALS US and French 1-year government bond yields and unemployment rates 5% 1-Year Yield 12% Unemployment Rate 4% 11% France 3% 2% 1% US France 1% 9% 8% 7% US % % Source: Bloomberg, Yield data as of August 213. Unemployment data as of July 213 for the US, June 213 for France. We think diverging investor views on emerging market fundamentals are also contributing to the increase in market volatility. In recent years, inflows into emerging market debt have been driven by two broad themes: 1) The pull of stronger EM growth and debt fundamentals, and 2) The push of low developed market rates. Fixed Income Goldman Sachs Asset Management 6

7 Today, with growth and rate trends diverging, the investment themes are more complex. From a growth perspective, emerging Europe appears materially weaker than emerging Asia or Latin America (Exhibit 8), reflecting the different situations in the Eurozone, China and the US. The rate dynamic is also evolving as investors appear to be less focused on which countries offer the most attractive government bond yields and more focused on which countries might be at risk from a turn in the global liquidity cycle as the Fed moves toward reducing its accommodation. The result of these shifts so far has been a broad sell-off in emerging market debt, with particular pressure on emerging countries with large current account deficits that rely on foreign inflows. This, in turn, has prompted actions by local central banks including currency interventions and rate hikes. We believe this creates an ongoing opportunity for relative value positioning based on fundamental, country-level research. In other words, while the lower-forlonger theme favored emerging market debt broadly, divergence creates more volatility and new opportunity for relative value strategies in emerging market debt and currency markets based on individual country fundamentals. EXHIBIT 8: REGIONAL EMERGING MARKET GROWTH TRENDS ARE DIVERGING Annual GDP growth and IMF forecasts across major emerging market regions 1% 8% 6% 4% 2% % -2% -4% -6% Central and eastern Europe Developing Asia (ex China and India) Latin America and the Caribbean Middle East and North Africa Actual Forecasts Source: IMF April 213 World Economic Outlook. In sum, we think the broad themes that have driven investor flows and returns in fixed income and currency markets are giving way to investment themes that are more complex and differentiated, which is leading to higher volatility. We believe that creates opportunity, particularly in a fixed income market that is itself more complex and global. A More Global Market Over the last 1 years, the size and composition of the global bond market have become notoriously difficult to quantify due to the vast expansion in both the number and types of debt instruments. We think a fair estimate is that the market has at least doubled in size over that period, with a large proportion of that growth occurring in emerging markets. For example, the emerging market debt universe covered by JP Morgan indices has more than tripled, from about $4 billion in 22 to around $1.7 trillion as of July 213. As a result, the fixed income market today is much more global, with many more functioning rate and credit markets than in the past. Global interest rate and credit markets should all have some relationship to each other. A bond is simply a series of cash flows that are subject to various risks, and there should be fundamental reasons that explain why one cash flow is more or less valuable than another. This is why government bond rates along a maturity spectrum should form a relatively smooth curve and why BBB-rated bonds should yield more than AAA-rated bonds. We think the aforementioned examples clearly show that flows can cause temporary dislocations in the relationships between different bonds. We also think it naturally follows that the more of these relationships there are, the more likely it is that dislocations will develop. The economic and market forecasts presented herein are based on proprietary models for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation. Fixed Income Goldman Sachs Asset Management 7

8 As one example, Exhibit 9 shows a measure of steepness in the Mexican yield curve versus a measure of longduration issuance by the Mexican government. In an efficient market, Mexican issuance should not be a significant influence on the steepness of the Mexican curve, but in this case Mexico was issuing a substantial amount of longterm bonds to term out its debt. This created an imbalance in supply relative to demand, as foreign investors are a large part of the market for Mexican government bonds and foreigners generally appear to prefer intermediate bonds rather than long-term bonds. Thus, a manager focused on fundamentals could potentially buy long-term Mexican bonds versus intermediate bonds on the view that the relationship would revert to historical norms once Mexico finished terming out its debt. EXHIBIT 9: MEXICAN ISSUANCE TO TERM OUT DEBT CONTRIBUTED TO STEEPNESS IN THE CURVE Mexican five-year forward curve steepness versus duration supply ( DVO1 ) in the market Pesos, billions Duration supply (left axis) Curve steepness (right axis) Basis points Source: Bloomberg, GSAM, as of January 212. Curve steepness measured by the spread between five-year forward five-year rates and five-year forward 1-year rates. Duration supply measured by the dollar value of a one basis point move in rates (DV1). Implementation: Capturing the Opportunity Set The implementation options for investors seeking to capture the relative value opportunity set are generally limited to alternative and unconstrained fixed income investment strategies. Relative value strategies require the ability to go short one asset and long another. In the traditional, long-only space, relative value strategies can be implemented by underweighting and overweighting securities versus the benchmark weighting. However, the universe will be limited and the benchmark return sources will still tend to dominate the overall portfolio return. If the goal is to move away from interest rate risk, relative value can provide diversification but generally will not add enough alpha to overcome the interest rate beta of a fixed income benchmark. In our view, macro-oriented fixed income hedge funds are best positioned to assume the risk-intermediation role formerly played by the dealer community. Hedge funds can implement long/short positions and are not constrained by traditional boundaries between emerging and developed markets, investment-grade and non-investment grade sectors or other limitations on the types of instruments and strategies that can be employed. We believe investors considering such a strategy should look for several capabilities: Specialization: We believe a significant degree of specialization is required to distinguish between a market inefficiency and a fundamentally-driven change in a pricing relationship. Dealer proprietary trading desks specialized in specific markets, thereby developing a deep understanding of the price relationships in that market. We think fixed income hedge funds should employ a similar approach, allowing specialists to identify opportunities within each sector and then managing the aggregated portfolio of risks through hedging strategies. Fixed Income Goldman Sachs Asset Management 8

9 Global resources: In our view, one of the key benefits of the fixed income relative value opportunity set is its breadth. We believe strategies focused specifically on emerging markets, or US MBS markets, or any single sector, can find inefficiencies in those markets. However, we think a portfolio limited to those markets will have less ability to generate returns across different market environments and diversify risks. We also believe global resources provide more potential to identify opportunity. For example, we think analysis of emerging market debt requires more than just an understanding of individual country balance sheets. It requires an understanding of commodity markets, trends in developed market rates, investor flows, global currency markets and other factors. Access to financing: One of the reasons markets are less efficient is that hedge funds have not been able to fully step into the role formerly played by dealers because of limited access to financing. A hedge fund seeking to employ leverage and short positions requires access to dealer balance sheets through the repurchase agreement (repo) market. Stricter regulation is prompting dealers to significantly reduce their participation in the repo market, and trading activity has declined in tandem (Exhibit 1). As new regulations are enacted, we believe dealers will continue to assess their client relationships and will either ration the use of their balance sheet by price (i.e., hedge funds will have to pay more for financing) or by relationship (i.e., dealers will factor other elements of the customer relationship into the financing transactions). EXHIBIT 1: DEALER FINANCING AND MARKET TRADING VOLUME ARE CLOSELY LINKED Repo outstanding versus average daily trading volume in the US fixed income market 7 6 Dealer Repo Outstanding (left axis) Average daily trading volume (right axis) 1,2 1, $, trillions $, billions Source: SIFMA. Annual data through 212. Broadly speaking, we think these considerations suggest that manager size is important when it comes to alternative fixed income investment approaches. In the hedge fund industry, many mid-sized to smaller hedge funds focus on specific market sectors such as mortgages or municipal bonds. We think specialization is important for spotting market inefficiencies, but breadth is equally important. In our view, investment strategies need the capability to dynamically allocate to opportunities as they arise, whether that opportunity is due to a sell-off in the municipal bond market, a kink in the Japanese yield curve or a supply/demand imbalance in the long-end of the emerging market local yield curve. Finally, investors seeking access to relative value opportunities on an unleveraged basis may want to consider the relatively new universe of unconstrained fixed income strategies. While unconstrained strategies cannot implement all of the relative value strategies that a hedge fund might employ, they generally have much broader latitude to invest across different markets compared to more traditional long-only strategies and can employ duration hedging strategies to isolate specific risks. Fixed Income Goldman Sachs Asset Management 9

10 Conclusion The global financial markets have gone through an unprecedented period of change in the aftermath of the 28 financial crisis, but each challenge associated with this period of change has been accompanied by opportunity. We believe the current environment is no different. Rising interest rates in the US (and eventually in other global fixed income markets) create a significant challenge for traditional fixed income investment strategies. However, we believe the opportunity set for generating returns from fixed income and currency markets through alternative and unconstrained investment strategies is broad, durable and compelling. In our view, the combination of stricter regulation of the broker/dealer community and greater market intervention by central banks has made fixed income and currency markets less efficient. We think this creates opportunity for other market participants to intermediate risk, and potentially be compensated for taking on some elements of the role that dealers have historically played. At the same time, we believe the opportunity set for intermediating risk has grown due to the increasingly global nature of markets and the expanding complexity of investment themes in an environment of diverging growth and policy trends. At GSAM, we believe our fixed income investment strategies are well positioned to capture this opportunity set. Our size allows us to employ specialist teams in every major market sector and a coordinated global approach to risk management and portfolio construction with the breadth to pursue market opportunities wherever they might arise. We also believe our size and the broad nature of our relationships within the broker/dealer community provide important advantages in terms of access to financing. In sum, we think we are uniquely situated to capture today s opportunities across global fixed income and currency markets. Fixed Income Goldman Sachs Asset Management 1

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