The Case for International Fixed Income

The Case for International Fixed Income June 215 Introduction Investing in fixed-income securities outside of the United States is often perceived as a riskier strategy than deploying those assets domestically, especially with the introduction of currency risk. While the perception of risk may have merit when viewed as a stand-alone investment, when examined in the context of a global multi-strategy portfolio similar to what most institutions manage today, increasing allocations to international fixed income becomes a compelling proposition. Apart from the larger and often better value opportunity set, there are benefits to diversification from not being reliant on one political situation, one central bank, and one inflation outlook. In the present global economic environment of extraordinary monetary policy and central bank intervention into financial markets, a more globally diversified approach has never been more important. A neglected asset class When examining current institutional allocations to international fixed income in relation to the aggregate size of the global fixed-income market, the long standing perceptions surrounding risk within the asset class do seem to be contributing to under allocation within the asset class by institutional investors. Greater exposure to international fixed income does not necessarily have to be in addition to existing domestic fixed-income allocations. When looking within the context of the overall size of global fixed-income markets, decreasing domestic in favor of international exposure may be a logical approach. It used to be that bond portfolios restricted from investing outside the still had the majority of the s fixed income to choose from. As can be seen from the chart at the bottom of the page, this no longer remains true as non- fixed income is now 56% of the total global opportunity set. By excluding or neglecting international fixed-income investors are missing more than half of the total fixed-income investment opportunities available to them. The chart shows that the average allocation to international fixed income by institutions is below 5% of the total portfolio fixed-income allocation; which is in stark contrast to the asset class s 56% share of the total fixed-income universe. In fact many investors have no exposure to the asset class which is an amazing statistic given the breadth and depth of international fixed-income markets. Over the last 3 years the international fixed-income markets have changed dramatically and during the same time period, investors approach to the asset class has not kept pace leading many institutional portfolios to be under allocated to a significant and varied asset class. Global fixed income A growth story Sovereign bond market The sovereign bond market has seen substantial growth in terms of both size and issuers over the last 3 years and international markets now make up the largest portion of the global bond market. The total size of the global fixed-income debt markets as of December 214 is $56,477 billion and is as diverse in issuance as the markets. Global Debt Markets (all sectors) Public 96% United States 4 Taft- Hartley 98% 56% Corporate Foundation Endowment 98% 96% Source: Callan Market Plus 4Q214 and author calculations/bloomberg

Global Debt Markets (all sectors) Size of total market $56,477 billion as at 31 December 214 Quasi Sovereign, Supranational, Regional & Provincial Govts. 1% Collateralised 13% Corporate Debt % Corporate Debt High Yield Corporate Debt (Investment Grade) 15% Sovereign (External Debt) 1% Sovereign Potential (China & India) 3% Sovereign Debt (Investment Grade) 4 Tradeable Sovereign (Local Market) 6% Global Inflation Protected Sovereign Debt However, the remains less than one third the size of the total tradable sovereign bond market in the despite this latest growth trend. Furthermore, the recent growth in the Treasury market is not likely to continue long into the future because the quantitative easing programs in the are winding down while recently the European Central Bank (ECB) has begun a large scale quantitative easing program of their own. The dramatic growth of the international sovereign bond market can be attributed to the addition of 37 issuing countries across 38 currencies into the market over the last 3 years. The addition of so many new issuers has had the important effect of broadening diversification within the global fixed-income market and reducing the importance of the sovereign market. Percentage market value of Global Sovereign Bond market 1985 215 Prior to 28, as the global fixed-income markets grew, the share of the market continued to shrink, even during times of dollar strength. However, since 28, this trend has reversed as government debt has grown with Federal Reserve accommodation and quantitative easing being used to sustain the economy. 55% 45% 3 68% Size of tradable Global Sovereign Bond markets (USD Billions) USD Billions 3, 2, 1, 1,574 2,51 5,345 6,639 1,717 18,733 28,38 1985 199 1995 2 25 21 215 Percentage market value of Global Sovereign Bond markets comprised Treasuries 6% 55% 53% % 38% 31% 2 2 3 1985 199 1995 2 25 21 215 1985 1995 25 215 Number of markets 16 2 22 38 Number of issuing countries 16 2 37 53 Global credit markets Outside of sovereign debt markets, credit markets have grown at a similar pace and with similar diversification. The credit markets have almost doubled in total size since 25 and have maintained a consistent growth rate since 1995. Size of tradable Global Investment-Grade Corporate Debt markets (USD Billions) USD Billions 1, 8, 6, 4, 2, 1,283 2,274 4,318 6,852 8,612 1995 2 25 21 215 WELLS CAPITAL MANAGEMENT 2

Percentage market value of Global Investment-Grade Corporate Debt market 36% 1996 6 214 6% The maintains a relatively large share of the total global credit universe; however, compared to 16 years ago, the international credit markets now show true depth and variety which will likely be the source of tremendous opportunity for investors going forward. International fixed income Significant investment opportunities International fixed income as an asset class presents numerous opportunities for well-positioned investors. Non-dollar bond exposure can help portfolios generate improved risk-adjusted returns through increased diversification and historically low correlations with other asset classes as well as improved returns from opportunities for price appreciation and higher yields. Currently, many institutional portfolio allocations do not adequately reflect the size and importance of the international debt markets and therefore risk forgoing the positive benefits which can be derived from investing in them. When looking at opportunities within sovereign debt, global fixed-income benchmarks are dominated by older more developed economies which skew the benchmarks toward the most indebted countries. Significantly, it is in the newly developed economies where debt positions are much healthier, growth is more sustainable, and consumers have both the ability and the desire to acquire consumables that offer better value. Growth in global credit sectors - 12/31/1998-12/31/214 6, 4, 2, Debt 547,821 171,7 1998 214 2,5, 2,, 1,5, 1,, 5, Global High Yield 2,82,95 235,733 1998 214 1, Credit 91,746 Global Quasi Sovereign & Soverdiegn 1,. Guaranteed debt 5, 32,511 1998 214 5,.. 5,366 1,34 1998 214 4, Global Inflation Protected Sovereign Debt Markets 2,5 1,. Global Securitized Debt Markets 7,287 2, 27 1998 214 5,.. 2,482 1998 214 WELLS CAPITAL MANAGEMENT 3

GDP weighted total sovereign debt as percent GDP (median forecast) 14.% 119.6 12.% 15.% 1.% 8.% 6.% 4.% 2.%.% USA Developed World (Ex-USA) 42.89% World GDP weighted nominal 1-year sovereign yields 7.% 6.% 5.% 4.% 3.% 2.% 1.%.% 1.98% USA.9% Developed World (Ex-USA) 6.7% World The charts to the left illustrate the relatively large level of leverage relative to gross domestic product (GDP) within developed markets versus emerging markets. Developed markets debt is about 1 of GDP compared to a more modest 43% within the emerging markets. Despite the more sustainable fundamentals of the emerging and developing debt markets investors are often rewarded with both higher real and nominal yields presenting tremendous value and yield opportunities for investors. In addition to the attractive value opportunities and fundamentals of international sovereign markets, expanding the opportunity set to include international credit provides similar opportunities. The developing debt markets provide prospects for enhanced returns when investing away from global fixed-income benchmark weightings. It is often argued that the available excess returns in global bonds over the equivalent are derived from the foreign exchange exposure, particularly the depreciation of the dollar. However, even if the currency is hedged (hedging will be explored later in greater detail), the risk-adjusted returns from international bonds, due to its lower volatility, can be a solid source of alpha. When looking at individual markets rather than global indices, there are always markets that have provided superior returns to the market. In fact, when looking at local currency market returns, the has only been in the top five in terms of returns two years out of the past 16 years and only the top returning market once as shown in the chart on the next page. Nominal 1-year sovereign yields As at 28 February 215 14.% 12.% 1.% 8.% 6.% 4.% 2.%.% USA Australia Austria Belgium Czech Republic Finland France germany Ireland Italy Netherlands Portugal Slovenia Slovak Rep Spain Denmark Japan New Zealand Norway Sweden Switzerland UK Canada Brazil Chile China Colombia Hungary India Indonesia Malaysia Mexico Peru Philippines Poland Romania Russia South Africa South Korea Taiwan Thailand Turkey WELLS CAPITAL MANAGEMENT 4

Highest Returning sovereign bond markets (local currency) within G12 Top 5 Highest Returning sovereign bond markets (local currency) from all tradeable markets 1999 Japan 1999 South Africa Hungary Czech Republic Poland Norway 2 Australia 2 South Africa Australia New Zealand Hungary 21 Canada 21 Poland South Africa Czech Republic Hungary Hong Kong 22 22 South Africa Poland Romania Mexico Ireland 23 Canada 23 South Africa Mexico Norway New Zealand South Korea 24 Sweden 24 South Africa Hungary South Korea Poland Ireland 25 UK 25 Turkey Mexico China South Africa Hungary 26 Canada 26 Indonesia Brazil Mexico Russia South Korea 27 27 Turkey Brazil Indonesia Thailand 28 Australia 28 Australia Turkey Thailand South Africa New Zealand 29 Italy 29 Turkey Indonesia Russia Hungary Brazil 21 UK 21 Indonesia South Africa Turkey Brazil Russia 211 UK 211 Indonesia UK Brazil Australia Sweden 212 Italy 212 Portugal Ireland Hungary Italy Turkey 213 Spain 213 Ireland Spain Hungary Portugal Chile 214 Spain 214 Portugal Turkey Spain Italy UK Source: BofAML Index series The same case for international fixed income can be made when looking at fixed-income markets in aggregate. The chart below shows that the market and its large share of global indices has historically pulled down returns and increased Excess annual returns 31 December 1996 to 31 December 214 Total Returns % 1% 5% % -5% the volatility of returns. The charts below demonstrate the potential to generate superior risk/return characteristics within a tightly controlled currency risk management framework by including allocations to international fixed income. Global Aggretate (returns in USD) less US Aggregate Index (Ex USA) Annual returns Global Aggregate (Hedged to USD) less US Aggregate Index (Ex USA) Annual Returns Hedged to US$ -1% 1997 1998 1999 2 21 22 23 24 25 26 27 28 29 21 211 212 213 214 annual returns Volatility of annual returns 31 December 1996 to 31 December 214 31 December 1996 to 31 December 214 Total Returns % 6% 5% 3% 1% 5.27% 5.76% 5.8 Volatility % 6% 5% 3% 1% 5.65% 2.95% 3.6 % % Global Aggregate (returns in USD) Index (ex USA) Annual Returns Global Aggregate (Hedged to USD) Index (ex USA) Annual Returns Hedged to US$ Aggregate WELLS CAPITAL MANAGEMENT 5

Strong US$ 1996-22 Weak US$ 23-29 Strong US$ 21-214 Source: BofAML Index series Global Government Bonds (Returns in USD) Global Government Bonds (Hedged to USD) Treasuries annual return 4.27% 8.7% 7.36% Volatility of annual returns 1.55% 3.15% 5.13% annual return 7.39% 4.45% 4.61% Volatility of annual returns 8.19% 2.69% 5.19% annual return 2.1 4.15% 4.1% Volatility of annual returns 3.85% 2.8 4.4 Managing currency risk To hedge or not to hedge? One of the more difficult questions investors face in managing international fixed income is how to manage currency risk. The simple answer is it depends on the goals and risk budget parameters that exist for each unique portfolio. When simply looking to increase the allocation of international fixed income relative to domestic fixed income, empirical evidence suggests that hedging back to the dollar may provide higher returns with less volatility. When looking at historical returns in volatility data in the table at the top of the page, fully hedging to the dollar appears to be successful in more closely fitting and improving the risk profile of a portfolio dominated by domestic fixed-income exposure. Regardless of the amount of currency risk taken on within an international fixed-income portfolio, the historical analysis presented above highlights the need to actively manage the currency risk and exposure against a client s chosen benchmark, whether the benchmark is hedged or unhedged. Conclusion In the context of a globally diversified portfolio, international fixed income should likely make up a larger portion of the average institutional portfolio than it does today. International fixed income currently includes more than 5% of all global fixed-income opportunities making it a large and important part of the global opportunity set of investable assets. A global multi-strategy portfolio will likely benefit from larger allocations to international fixed income through stronger risk-adjusted returns, increased diversification, and a new source of alpha within the portfolio. Opportunistic and benchmark agnostic global bond management including active currency management within a strong risk controlled framework is the best strategy to access the asset class and increase the likelihood of maximizing portfolio benefits. Arguably, the most efficient method to delivering the latter global debt strategy is to create a de facto global fixed-income portfolio by employing an international manager in additional to domestic fixed-income managers. This approach to global fixed-income investing gives the portfolio the opportunity to benefit from specialization within the diverse fixed-income markets and provides the greatest structure for managing independent market and currency risks. WELLS CAPITAL MANAGEMENT 6

Tony Norris Managing Director and Senior Portfolio Manager, First International Advisors Tony Norris is a managing director and senior portfolio manager with the First International Advisors team at Wells Capital Management. Tony is one of five senior members of the investment team that forms the Senior Strategy Team. His responsibilities include developing investment strategies, macro-portfolio allocation, portfolio positioning, and risk management. He joined WellsCap from Evergreen Investments, where he served in a similar role since 199. Previously, he spent several years in banking, with particular emphasis on foreign exchange. Tony served in senior executive positions at Reserve Asset Managers and Gillett Brothers Fund Management. He began his investment industry career in 1966 at Wallace Brothers Bank. He is a member of the Society of Technical Analysts and is an associate of the International Federation of Technical Analysts. This paper significantly benefited from extensive research and development by Dan Irvine, product manager at Wells Capital Management. First International Advisors, LLC (FIA), a company formed in the State of Delaware with limited liability is a subsidiary of Wells Fargo & Company. FIA is a registered Investment advisor in the USA, and is authorised and regulated by the Financial Conduct Authority (FCA) in the UK. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8. WELLS CAPITAL MANAGEMENT is a registered service mark of Wells Capital Management, Inc. WELLS CAPITAL MANAGEMENT 7