A Case for Investing in Fixed Income

A Case for Investing in Fixed Income Fixed income is considered a defensive asset class and is designed to achieve stable returns in the form of income, often with little or no capital growth. This is in contrast to other asset classes such as equities, or growth assets, which aim to increase in value over time, generating strong returns in the form of capital growth. For investors, understanding this risk-return balancing act between the performance of growth and defensive asset classes is fundamental to achieving a well diversified portfolio. THE AUSTRALIAN FIXED INCOME MARKET As much of the focus has traditionally been given to equity markets, it is not generally well known that global debt markets are actually larger than combined equity markets, offering a wide variety of investment opportunities. 1 The United States and Japan have historically been the largest and most liquid bond markets, compared with Australia, whose bond market size is around the average for developed nations. The structure of the Australian bond market can be divided into two main classes of issuers: 1. GOVERNMENTS Commonwealth government State government Government agencies / Supranationals / government backed securities 2. NON-GOVERNMENTS Financial institutions Large corporations Asset backed issuance Non-resident bonds (Foreign companies issuing Australian Dollar denominated bonds, sometimes referred to as Kangaroo bonds) FIGURE 1: AUSTRALIAN BONDS OUTSTANDING 1400.0 1200.0 1000.0 800.0 600.0 400.0 200.0 As can be seen from Figures 1 and 2, the private debt market (i.e. non-government) has surpassed government issuance since the late 1990s, and within this market, financial institutions have historically been the largest issuer. Traditionally, retail investors have not been large participants in the Australian bond market as minimum investment sizes (usually $500,000) and the requirement to trade in the over-the-counter market have limited their ease of access. This, combined with strong equity market returns observed in the five year period up to 2007, has resulted in the equities asset class typically forming a majority portion of investment portfolios. However, the Global Financial Crisis (GFC) changed all this. The GFC highlighted the need for investors to review their portfolios and assess how different asset classes perform under various market conditions. What may have performed well in high growth markets could perform poorly in environments where volatility and uncertainty dominate investor thinking. Risk management and capital preservation became front and centre for investment management, and it was the defensive asset classes such as cash and fixed income that investors looked at to achieve this. FIGURE 2: NON-GOVERNMENT AUSTRALIAN BONDS OUTSTANDING 1000.0 900.0 800.0 700.0 600.0 500.0 400.0 300.0 200.0 100.0 0.0 Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar 1992 1994 1995 1997 1998 2000 2001 2003 2004 2006 2007 2009 2010 2012 FINANCIALS CORPORATES ASSET-BACKED NON-RESIDENTS Source: Reserve Bank of Australia. 0.0 Sep Mar Sep Mar Sep Mar Sep Mar Sep 1992 1994 1995 1997 1998 2000 2001 2003 2004 NON-GOVERNMENT GOVERNMENT Source: Reserve Bank of Australia. Mar Sep 2006 2007 Mar 2009 Sep 2010 Mar 2012 1

FIGURE 3: GROWTH OF $100 JANUARY 2005 JUNE 2012 190 180 170 160 150 140 130 120 110 100 90 1/3/05 1/3/06 1/3/07 1/3/08 1/3/09 1/3/10 1/3/11 1/3/12 S&P/ASX Australian Fixed Interest Index S&P/ASX Government Bond Index S&P/ASX 200 Accumulation Index Source: SSgA, S&P and FactSet. Performance represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. FIGURE 4: ROLLING ONE YEAR RETURNS JANUARY 2006 JUNE 2012 45% 35% 25% 15% 5% -5% -15% -25% -35% -45% 1/3/06 1/3/07 1/3/08 1/3/09 1/3/10 1/3/11 1/3/12 S&P/ASX Australian Fixed Interest Index S&P/ASX Government Bond Index Source: SSgA, S&P and FactSet. S&P/ASX 200 Accumulation Index Australia s bond market proved fairly resilient during the financial crisis, as can be seen in the graphs above. Figure 3 depicts the growth of $100 over the last seven years when invested in both S&P /ASX equity and fixed income benchmarks. While an equity investment could have grown to as high as $185 in late 2007, all of these gains vanished during the sharp downturn experienced in financial markets. Interestingly, while a $100 bond investment did not see the highs and lows of its equity counterpart, it has, in fact, grown more than an equity investment over the same investment horizon. $100 invested in a fixed income benchmark in 2005 would be now be approximately $167 versus $138 for an equity benchmark. Similarly, Figure 4 shows yearly investment returns for the same period. As expected, equity investment returns have been as high as 45% p.a., but also as low as 45% p.a. Fixed income on the other hand, maintains a fairly steady and positive return stream, showing significant outperformance relative to equities between early 2008 and late 2009. So, what does this mean for investors? An allocation to fixed income can have a significant impact both on the risk and return characteristics of a portfolio, particularly during times of market stress and volatility. WHY INCLUDE FIXED INCOME IN A PORTFOLIO? THE ROLE OF ASSET ALLOCATION As previously mentioned, asset allocation can be an important step in achieving investment objectives. But what is it exactly? Asset allocation involves spreading your investments across a variety of asset classes (e.g. shares, bonds, commodities, cash etc) depending on overall asset allocation strategy. This could depend on a number of factors: Your stage in life - have you just started working and need to accumulate wealth over the next 40 years, or are you about to retire and will need to draw on this wealth to fund your retirement? Your risk appetite how comfortable are you with taking on investment risks? Your current financial situation For example, if you are a long way from retirement, a higher allocation to growth assets could be more appropriate, whereas if you were nearing retirement, protecting your wealth would be a higher priority and defensive assets may be more suitable. 2

FIGURE 5: THREE SCENARIOS SCENARIO 1: 100% EQUITIES 1 YEAR 3 YEAR (PA) 5 YEAR (PA) 7 YEARS (PA) RETURN -6.71% 5.65% -4.00% 3.82% VOLATILITY 14.70% 13.88% 16.46% 15.01% GROWTH OF $100 (JAN-05 - JUN-12) $138.3 SCENARIO 2: 50% EQUITIES, 50% FIXED INCOME 1 YEAR 3 YEAR (PA) 5 YEAR (PA) 7 YEARS (PA) RETURN 3.13% 7.61% 2.53% 5.77% VOLATILITY 5.95% 6.02% 7.42% 6.81% GROWTH OF $100 (JAN-05 - JUN-12) $155.4 SCENARIO 3: 100% FIXED INCOME 1 YEAR 3 YEAR (PA) 5 YEAR (PA) 7 YEARS (PA) RETURN 13.08% 8.91% 8.51% 6.97% VOLATILITY 4.05% 3.32% 3.70% 3.39% GROWTH OF $100 (JAN-05 - JUN-12) $165.6 Source: SSgA, S&P and Factset. BENEFITS OF FIXED INCOME DIVERSIFICATION By including fixed income in a portfolio, you are including an asset class which has different risk/return characteristics to other asset classes such as equities. This strategy is designed so that when one asset class falls in value (eg equities), the other asset class (eg fixed income) could offset against these losses and will, ideally, increase in value over the same period. Let s take the $100 investment example again. In Scenario 1, we have assumed a 100% allocation to equities (S&P/ASX 200 Accumulation Index) over the period 2005-2012. In Scenario 2, we have assumed a 50% allocation to equities (S&P/ASX 200 Accumulation Index) and 50% allocation to fixed income (S&P/ASX Australian Fixed Interest Index). In Scenario 3, we have assumed a 100% allocation to fixed income (S&P/ASX Australian Fixed Interest Index). Figure 5 and Figure 6 show the returns results of each of the portfolios. Over this time period, an exposure to fixed income has safeguarded the portfolio value by protecting against large downward movements in equity markets (the 1- and 5-year return figures for Scenario 1 are negative; -6.71% and -4.00% respectively), whereas the same returns under Scenario 2 are positive (3.13% and 2.53%). These returns have also been achieved with lower risk, with the volatility metrics in Scenario 2 lower across all periods than Scenario 1. To complete the picture, a 100% exposure to fixed income over the same time period significantly outperformed on one and five year numbers (13.08% and 8.51% respectively). volatile markets can reduce portfolio value significantly. This of course, can also apply to fixed income markets. Rising interest rates can indicate strong economic conditions, with higher rates assisting in the control of inflation. However, in these markets, defensive assets such as bonds tend to fall in value, particularly those bonds that are sensitive to changes in interest rates (as indicated by their duration ). In this example, Scenario 2 highlights how diversification can impact portfolio value under a variety of market conditions. In the strong equity market period from January 2005-2008, the 50% exposure to equities increased portfolio value in a period where fixed income returns were relatively flat. Similarly, between January 2011-June 2012, where equity returns were negative, the 50% allocation to fixed income helped buffer portfolio value, preventing it from falling as far as equity markets. FIGURE 6: GROWTH OF $100 (THREE SCENARIOS) JANUARY 2005 JUNE 2012 Source: SSgA, S&P and FactSet. 190 180 170 160 150 140 130 While it is important to remember that these performance numbers can change depending on the time period used for assessment, this scenario analysis demonstrates the benefits of diversification. While a 100% exposure to equities has the potential to perform extremely well in stable, growth markets such as 2002-2008, without a crystal ball and the ability of investors to time the market perfectly (i.e. pick the tops and bottoms of cycles), 100% equities exposure in tumbling or 120 110 100 90 31/1/05 31/1/06 31/1/07 31/1/08 30/1/09 30/1/10 30/1/11 30/1/12 Scenario 1: 100% Equities Scenario 2: 50% Equities, 50% Fixed Income Scenario 3: 100% Fixed Income Performance represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. 3

INCOME GENERATION In the same way that shares pay dividends, bond investors can also receive a regular income stream in the form of coupon payments. In fact, bonds could be considered more reliable as an income generating asset, as bond issuers are legally required to pay coupons either quarterly or semi-annually, whereas companies have discretion over whether they pay a dividend or not. This regular, predictable nature of coupon payments can be particularly helpful to investors when it comes to managing cash flows. Figure 7 depicts the yields on the same benchmarks as mentioned above. Given the S&P/ASX Australian Fixed Interest Index includes corporate issuers such as Financial and Industrial companies, it is expected that the yield would be higher than the S&P/ASX Government Bond Index, as these issuers are considered riskier than the Commonwealth or State governments. This is due to the way the instruments are structured, that is, investors should expect to receive the face value of the bond back at maturity. Equities, on the other end, can rise or fall in value depending on market movements, and investors have no prior claim over any assets at any particular price. Of course, bonds are not risk free either. Issuers (governments or corporates) can still default on their debt obligations, with the prospect of investors receiving nothing, or a minimal amount of their initial investment. This has been a real risk during the European Debt Crisis, where doubts over the ability of the Greek Government to repay their debts plagued market activity and investor sentiment. Similarly, bonds are exposed to price movements throughout their life, and if investors choose to sell their bond on market, before maturity, capital reservation may not be possible (i.e., if the bond is trading lower than the price at which it was purchased). FIGURE 7: BENCHMARK YIELDS 8.00% 7.00% 6.00% AVERAGE YIELDS (per annum): S&P/ASX Australian Fixed Interest: 5.8% S&P/ASX Government Bond: 5.4% S&P/ASX 200: 4.6% In the event of a default however, bond investments may provide a higher level of investor protection than equity investments in the same company. This is referred to as the capital structure and represents the way a company finances its assets through a combination of securities (equity, debt or a mixture of both). Figure 8 depicts a company s typical capital structure. 5.00% FIGURE 8: TYPICAL CAPITAL STRUCTURE 4.00% 3.00% 31/1/05 31/1/06 31/1/07 31/1/08 30/1/09 30/1/10 30/1/11 30/1/12 S&P/ASX Australian Fixed Interest Index S&P/ASX 200 Accumulation Index S&P/ASX Government Bond Index Source: S&P, FactSet The sharp decline in fixed income yields between January 2008 and January 2009 was reflective of the interest rate easing cycle, where the Reserve Bank of Australia aggressively cut interest rates in a bid to prop up the economy amid volatile financial markets. The average yield for the S&P/ASX Australian Fixed Interest, Government Bond and 200 indices over this time period was 5.7%, 5.4% and 4.7% respectively. Despite a higher observed volatility in bond yields compared to equity yields (this is expected given their close relationship with prevailing interest rates), these average yields indicate that bond investments can play an important role in generating income for investors. CAPITAL PRESERVATION AND SECURITY Compared with other asset classes such as equities, fixed income can offer a higher level of protection over the value of an investment portfolio, assuming the bond is held to maturity. SENIORITY INVESTMENT TYPE RISK HIGH LOW DEBT EQUITY SENIOR SECURED DEBT (E.G. BANK LOANS) SENIOR DEBT (E.G. BONDS) SUBORDINATED DEBT (E.G. CONVERTIBLE NOTES) PREFERRED EQUITY (E.G. HYBRIDS) COMMON EQUITY (E.G. SHARES) RIGHTS / WARRANTS The figure indicates that bonds rank higher in a company s capital structure than equity stemming from the fact that bondholders have a prior claim over a company s assets than shareholders in the event of bankruptcy. LOW HIGH FIXED INCOME RISKS As with any investments, fixed income securities are subject to a number of risks. These can include: CREDIT RISK The issuer of a security or the counterparty may be unable to make coupon payments and will be forced to default on their debt obligations. 4

INTEREST RATE RISK The value of a bond may change over time in response to changing market interest rates. Declines in interest rates tend to increase the price of bonds as newer bonds will generally pay coupons off the lower rate, and therefore be less appealing to investors from an income perspective (and vice versa). LIQUIDITY RISK Fixed income as an asset class is less liquid than equities owing to the lack of an official exchange market like the ASX. Transactions mostly occur in the OTC market, and these are often executed via a broker-dealer. If there aren t enough buyers and sellers in the market, it may be difficult to execute transactions within the preferred timeframe. There are also liquidity risks within the asset class. Government bonds are very liquid, and generally easily bought and sold in the market. Bonds from small issuances or those with less well known issuers can be more illiquid, and therefore more difficult to trade. CALL/PREPAYMENT RISK A bond or other security may be called, or repaid, before its final maturity date. REINVESTMENT RISK As bonds reach maturity, investors may not be able to invest their funds into a new fixed income investment yielding a similar interest rate. INFLATION RISK Inflation is often an unanticipated risk of fixed income investments. When inflation outpaces market gains, it can erode portfolio value. Investors who rely heavily on lower-return investments may risk falling short of their financial goals and experiencing diminished spending power. However, some bonds, including Government Inflation-Protected Securities and funds that invest in those securities, do offer principal adjustments for inflation. It is important to note that the risks may vary depending on the type of fixed income investment that is undertaken. HOW TO ACCESS THE FIXED INCOME MARKET As previously mentioned, debt markets have typically been a challenging asset class for retail investors to gain exposure to. Minimum investment parcels of $500,000 have made diversification efforts difficult. Eligibility criteria to participate in the over-the-counter market has often prevented most retail investors from transacting. Because of these limitations, investors have often looked to fixed income managed funds or other securities such as hybrids, which have both debt and equity like characteristics, to gain fixed income exposure. In the case of hybrids, whilst these instruments provide a regular income stream in the form of coupon payments, their correlation with equities became apparent at the height of the GFC. During this period, price movements in these securities indicated they behaved more like equities, and the true fixed income diversification effect was reduced. The introduction of fixed income ETFs in the Australian market is a turning point for retail investors. There is now an efficient, liquid and transparent way for individual investors to gain direct exposure to the fixed income market. BENEFITS OF FIXED INCOME ETFS TRADABILITY Bond ETFs eliminate previous trading challenges in the fixed income asset class. Unlike fixed income managed funds, investors will have the ability to transact intraday (rather than at end of day unit prices). This can provide investors with more flexibility, allowing them to determine when they want to transact and affording greater price transparency. DIVERSIFICATION Bond ETFs can facilitate easier diversification than a direct investment. In one trade, the ETF will invest in a variety of securities with varying issuers, maturities and interest rates. LOWER COST ETFs are designed to be cost-efficient. As an index investment, they can have the advantage of being less expensive to operate than actively managed funds, and therefore typically have lower management costs. This is particularly important in a bond ETF, where regular income is often an important investment objective, as any additional fees reduce the income distributed to investors. TRANSPARENCY Index investments are designed to inherently replicate the performance of the underlying index. For equity ETFs, securities are generally purchased in accordance with their index weighting. A different approach is used fixed income ETFs owing to the lack of exchange and liquidity concerns in the underlying securities. This is referred to as Stratified Sampling and is discussed in further detail below. In both cases, ETF underlying holdings data is available daily. This is in contrast to fixed income managed funds, where investors may often have to wait for quarterly reports to know what securities they have exposure to. SPDR FIXED INCOME ETFS SPDR S&P/ASX AUSTRALIAN BOND FUND AND SPDR S&P/ASX AUSTRALIAN GOVERNMENT BOND FUND S&P and ASX have a long history in servicing both debt and equity markets, domestically and globally. Seeking to create an investable Australian fixed income index, accessible to all investor types including retail, S&P/ASX have created the S&P/ASX Australian Fixed Interest Index ( AFI Index ) and the S&P/ASX Government Bond Index ( AGB Index ). The 5

SPDR S&P/ASX Australian Bond Fund and the SPDR S&P/ ASX Australian Government Bond Fund seeks to track these indices, respectively. The AFI Index is the flagship bond index, representing broad exposure to the Australian fixed income market. Key investment criteria includes minimum 1 year to maturity, investment grade and AUD denominated securities only, with minimum sized issues of $250m for government issues and $100m for non-government issues. In addition, the security type is restricted to fixed rate bonds with a bullet maturity only. Asset backed securities and bonds with embedded optionally (callable, extendable, step up, etc.) are not permitted in the index. The AGB Index is a subset of the AFI Index, where the issuer criterion is restricted to government and semi-government issues only. STRATIFIED SAMPLING APPROACH The SPDR S&P/ASX Australian Bond and the SPDR S&P/ ASX Australian Government Bond ETFs utilise a stratified sampling approach to track the performance of its underlying index. Stratified sampling is based on stratifying or dividing an index into manageable risk elements (also called buckets). The multiple dimensions of risk within an Australian bond portfolio are commonly defined as follows: yield curve, duration, sector, credit, issuer and liquidity. Portfolios using stratified sampling follow tolerance guidelines to ensure broad representation of the index on multiple levels and to deliver performance within a tight level of tracking error. SSgA has pioneered stratified sampling methods to match a benchmark s defining characteristics, even in the most volatile of environments. In our experience, stratified sampling is the most efficient income index management technique for constructing broad index portfolios when full replication is not an option. This investment process relies on two steps: CONCLUSION The GFC and subsequent market events, such as Bear Sterns sale, Lehman Brothers collapse, European Debt Crisis to name a few, sent shockwaves throughout global financial markets, with Australia being no exception. Australian investors loveaffair with domestic equities, which had arguably served them well in the preceding 15 years, was put under the microscope. Questions were asked by the investment community about the appropriateness of an aggressive, equity-focused strategy in the new, post-gfc era. Will what worked for us in the past, work for us in the future too? The sustained volatility in financial markets suggests otherwise, with a new paradigm of Australian investing forming. Capital protection and stable income generation have become primary investment objectives amongst market volatility, and diversification into defensive asset classes such as fixed income was highlighted as a way to achieve this. SPDR Fixed Income ETFs provide an efficient and cost effective way to access the Australian fixed income market, once the domain of institutional investors, and ultimately, help safeguard portfolio value under a variety of market conditions. INVEST IN FIXED INCOME WITH ETFS Today, Australian investors can gain direct exposure to the local fixed income market with ease and transparency through fixed income ETFs SPDR S&P/ASX Australian Bond Fund [Ticker: BOND] SPDR S&P/ASX Australian Government Bond Fund [Ticker: GOVT] LEARN MORE AT SPDRS.COM.AU 1. Screening the universe using a broad set of analytics 2. Building a portfolio to reflect the index as closely as possible across multiple dimensions with a focus on minimising transaction costs and maintaining pools of liquidity. Using a stratified sampling approach, tracking error can be minimised with disciplined exposure guidelines based on the risk elements defined above. This implies that while individual security weightings may not match the index (as per a full replication strategy), yield curve, duration, sector, issuer and liquidity elements are designed to track that of the index. 6

ABOUT SPDR ETFS Offered by State Street Global Advisors, SPDR ETFs are a family of ETFs that provide investors with the flexibility to select investments that are precisely aligned to their investment strategy. Recognised as an industry pioneer, State Street Global Advisors created the first ever ETF in 1993 the SPDR S&P 500, which is currently the world s largest ETF. 2 In 2001, SSgA introduced ETFs in Australia when it launched the SPDR S&P/ASX 200 Fund and the SPDR S&P/ASX 50 Fund. Currently, State Street Global Advisors manages approximately US$300 billion of ETF assets worldwide. 3 For more information about our ETFs or how to invest, please call +612 9240 7600 or email info@spdrs.com.au. STATE STREET GLOBAL ADVISORS, AUSTRALIA, LIMITED Level 17, 420 George Street Sydney, NSW 2000 +612 9240 7600 www.spdrs.com.au 1 Bank of International Settlements, SSgA and Factset. 2 Bloomberg, as of 30 June 2012. 3 As of 30 June 2012. This AUM includes the assets of the SPDR Gold Trust (approx. US$66 billion as of 30 June 2012), for which State Street Global Markets, LLC, an affiliate of State Street Global Advisors serves as the marketing agent. FOR PUBLIC USE. IMPORTANT RISK INFORMATION This material has been issued by State Street Global Advisors, Australia Services Limited ( SSgA, ASL)(ABN 16 108 671 441) (Australian Financial Services Licence AFSL 274900), the Responsible Entity for SPDR ETFs, in conjunction with State Street Global Advisors, Australia, Limited ( SSgA ) (ABN 42 003 914 225) (AFSL Number 238276) the Investment Manager of SPDR ETFs. The issuer of units in SPDR S&P/ASX Australian Bond Fund (ARSN 159 002 623) and the S&P/ASX Australian Government Bond Fund (ARSN 159 002 801) is SSgA, ASL. A Product Disclosure Statement ( PDS ) for units in the Fund is available at www.spdrs.com.au. Investors should consider the PDS in deciding whether to acquire, or continue to hold, units in an ETF. 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