THE FIXED INCOME DILEMMA: Rethinking Fixed Income with a Global Perspective AN NEI REPORT UPDATED AS AT JUNE 30, 2015

THE FIXED INCOME DILEMMA: Rethinking Fixed Income with a Global Perspective AN NEI REPORT UPDATED AS AT JUNE 30, 2015

THE FIXED INCOME DILEMMA: Rethinking Fixed Income with a Global Perspective UPDATE: This report was originally written in the Summer of 2014 and updated as at June 30, 2015. While much has happened over the past year, many of the same issues remain. Fixed income continues to be an integral risk management component of most investors portfolios, however continued low interest rates force Canadians to look outside the box for alternative sources of yield. In this report we discuss some of these challenges and why, in our opinion, Canadians should consider global fixed income markets. We also explain why we believe that passive indexing is not an advisable approach for global fixed income investors and describe the many ways active management can add value for investors in a global context. SECTION 1 Why Go Global with Your Fixed Income...3 SECTION 2 Five Key Considerations for Global Fixed Income Managers...8 SECTION 3 Conclusions and Implications...12 SECTION 4 Glossary...13 this document is provided for informational purposes only and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters. nei investments endeavors to ensure that the contents have been compiled or derived from sources that we believe are reliable and contain information that is accurate and complete. however, nei investments makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions contained herein views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any funds managed by nei investments. commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. please read the prospectus before investing. mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. nei investments, ethical funds, northwest funds, make money. make a difference. and aiming for better returns with less risk are registered marks and trademarks owned by northwest and ethical investments l.p.

SECTION 1 SECTION 2 SECTION 3 SECTION 4 WHY GLOBAL FIXED INCOME: Canadian Fixed Income The End of a Spectacular Run To gain perspective on issues that Canadian fixed income investors now face, let us first examine historical returns of this asset class. Looking back, there is no doubt that Canadian fixed income has certainly exhibited a strong performance. Over the last 26 years, Canadian fixed income 1 has delivered an annualized return of 8.01%. In comparison, Canadian equities 2 only slightly outperformed with an annualized return of 8.29% over the same period. It is commonly understood and expected that over the long run, investors bearing higher risk should be compensated with higher returns. How then did lower-risk Canadian bonds achieve levels of return similar to that of Canadian equities? To answer this question, we turn to Figure 1, which depicts the yield on Government of Canada 10-Year Bonds superimposed with cumulative returns of the FTSE TMX Canada Universe. FIGURE 1: Historical Bond Yields and Bond Returns in Canada 12% 10% 8% 6% 4% 2% FTSE TMX Canada Universe Cumulative Return (Right Axis) Government of Canada 10-Year Bond Yield (Left Axis) 600% 500% 400% 300% 200% 100% 0 0% 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Strong Canadian bond returns were largely fueled by declining yields, now near their all-time lows. Source: Bloomberg and FTSE TMX Global Debt Capital Markets, monthly data from July 31, 1989 to June 30, 2015. As shown in the chart, until about the early 1990 s, Government of Canada bond yields had stood at relatively much higher levels. Since that time, however, bond yields have steadily declined, reaching an all-time low of 1.24% in February 2015 and standing at 1.68% as of the end of June 2015. Over the last 26 years, Canadian bond investors have certainly benefited from declining bond yields and corresponding bond price gains. Bond yields Canadian bond investors have certainly benefited from declining bond yields and corresponding bond price gains. 1 Represented by the FTSE TMX Canada Universe Bond Index 2 Represented by the S&P/TSX Composite Total Return Index 3

now, however, are near their all-time lows, and are expected to remain low for some time. The Bank of Canada Overnight Lending Rate, which largely influences short term bond yields, is currently sitting at 0.5% following five years of accommodative monetary policy. In response to a plunge in oil prices, the Bank of Canada cut interest rates twice in 2015 in an attempt to offset slower than expected economic growth. With much uncertainty around the Canadian economy, it is quite likely that the return to normal in terms of interest rates is still a ways off. Furthermore, when rates and yields do eventually begin to climb, bond prices would be expected to fall and negatively impact returns. All factors combined, we believe that it is unlikely to see the same past conditions repeated in the future, nor is it likely that to see the same level of returns from Canadian fixed income. A Global Perspective With some context on the outlook for Canadian bonds, let us now take a broader perspective and examine fixed income on a global scale. A breakdown of the most popular global fixed income benchmark, the Barclays Global Aggregate Bond Index, is illustrated in Figure 2. At 16,860 issues across 70 countries and having a total market value of $53.3 trillion (CAD) 3, it is a broad-based measure of the global investment grade fixed income market. FIGURE 2: Barclays Global Aggregate Bond Index Regional Breakdown by Market Value Source: Barclays, as of June 30, 2015. United States (40.80%) Pan-Euro (32.79%) Asian-Pac (18.87%) Eurodollar (1.01%) Private Placements (2.92%) Canadian (2.68%) Euro-Yen (0.02%) Other Currencies (0.92%) With only 748 out of the total 16,860 issues in the index, Canada represents less than 3% market value of the global fixed income market. When we look at the average Canadian investor s fixed income portfolio as shown in Figure 3, however, we quickly see a disconnect. While Canada represents only 2.7% of the global fixed income market, Canadian investors have over 70% of their total fixed income investments allocated to Canadian fixed income mutual funds. By contrast, on the equity side, Canadians average a near 50/50 split between Canadian and global equity mutual funds, where again, at 3.3% 4, Canada accounts for a small portion of the global market. While Canada represents only 2.7% of the global fixed income market, Canadian investors have over 70% of their total fixed income investments allocated to Canadian fixed income mutual funds. 3 Source: Barclays, as of June 30, 2015. 4 Based on Canada s weight in the MSCI World Index as of June 30, 2015. 4

FIGURE 3: Asset Allocation of Canadian Investors 100% 75% 50% 25% 0% Equity Fixed Income Source: CIFSC/Investor Economics, as of June 30, 2015. Foreign Domestic UPDATE Over the last year, Canadians have moved 5% of their domestic fixed income mutual fund investments to global fixed income. Using June 30, 2015 figures, 5% equates to about $8.5 billion. Though it is common for investors to exhibit some degree of home country bias, a disproportionately high allocation to Canadian bonds may have investors missing out on significant opportunities elsewhere. Figure 4, for instance, compares yields on 10-year government bonds across developed countries. As you can see, Canadian yields are in the middle of the pack. Admittedly, a comparison of yields alone fails to take into consideration differences in regional economic conditions, credit risk ratings, and other important factors, but the table does nonetheless illustrate the breadth of yields available on government bonds of other developed economies. In addition, corporate bonds generally yield even higher than the government bonds of their country of domicile in order to compensate investors for their lower credit worthiness. As corporations increasingly expand their global footprints, investors may be able to take advantage of additional global yield opportunities without necessarily assuming higher risk. A disproportionately high allocation to Canadian bonds may have investors missing out on significant opportunities elsewhere. FIGURE 4: Sovereign Bond Yields COUNTRY YIELD ON 10-YEAR GOVERNMENT BOND Australia 3.01 % Italy 2.35 % United Kingdom 2.33 % Spain 2.30 % United States 2.02 % Canada 1.68 % France 1.20 % Germany 0.76 % Japan 0.47 % Attractive yield opportunities abound outside of Canada. Source: Bloomberg, as of June 30, 2015. 5

Taking an even broader look, Figure 5 shows the performance of Canadian fixed income 5 relative to other global fixed income sectors. Most investment professionals are familiar with the quilt graphic that compares the performance of different equity sectors over time and highlights the importance of diversification. The same observation and message also holds equally true with fixed income. Figure 5 illustrates that while Canadian fixed income has performed well in the past, relative to other fixed income categories returns have varied substantially from year to year, suggesting Canadian fixed income investors may have been better served by having a more diversified set of holdings. While Canadian fixed income has performed well in the past, relative to other fixed income categories returns have varied substantially from year to year. FIGURE 5: Opportunities Exist Around the World 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 12.2 11.9 12.2 7.8 8.3 57.7 15.1 9.7 19.2 6.5 11.1 12.0 6.5 9.1 7.1 7.2 34.7 12.3 7.8 17.9 2.2 8.8 7.4 5.6 5.5 7.0 6.4 8.8 6.7 6.0 11.2 2.2 7.6 7.2 4.8 5.3 5.3 6.4 6.9 6.5 5.4 7.1 1.7 5.9 4.9 4.3 5.2 4.2 6.2 5.9 6.1 4.3 5.7 1.2 5.0 4.3 4.1 4.3 3.7 5.6 5.4 4.6 3.6 4.2-0.1 4.8 3.1 3.8 4.1 3.7 5.2 5.1 3.0 3.2 4.1-1.2 4.5 2.7 3.5 3.6 2.0-5.5 3.1 2.8 2.7 3.6-2.0 4.5 1.8 2.4 0.0 1.4-14.7 1.6 2.2 2.3 2.3-2.5 2.6-25.2 1.5 1.7-0.9 2.2-3.2 0.7 Global Aggregate (Hedged, USD) Global High Yield (Hedged, USD) Euro-Aggregate (Hedged, USD) Asian Pacific Japanese Yen (Hedged, USD) Asian Pacific Aggregate (Hedged, USD) EM Local Currency Government (Hedged, USD) EM Hard Currency Aggregate (Hedged, USD) U.S. Aggregate (Base Currency, USD) U.S. Floating Rate Notes (Base Currency, USD) FTSE TMX Canada Universe (Base Currency, CAD) Canadian fixed income performance has been mixed relative to other global fixed income categories. Source: Barclays and FTSE TMX Global Debt Capital Markets, annual returns from 2004 to 2014. 5 Represented by the FTSE TMX Canada Universe 6

How to Approach Global Fixed Income: Active or Passive? Having made the case for investors to consider global bonds, we now turn our attention to how they can incorporate them into a portfolio. As mentioned previously, the Barclays Global Aggregate Bond Index is the most widely used benchmark for global fixed income. Investors can choose to either invest passively by replicating this index, or invest in an actively managed fund that is benchmarked to this index. One may argue that passive indexing is sufficient to obtain exposure to the global bond market, and that this approach may be justified by the lower management fees typically charged by index funds. Exchange Traded Funds (ETFs) are widely available that seek to track most major indices by replicating their underlying constituents, and are a low-cost solution for those who wish to invest passively. However, few global fixed income ETFs are available, as attempting to efficiently invest in over 16,000 securities across multiple bond markets can be problematic due to complexity, cost, and liquidity issues. In our view, there is also a fundamental challenge unique to global bonds that makes taking the passive route a potentially riskier and much less optimal option. The challenge lies in the very nature of the approach, in that bond indices are usually constructed using weightings based on bond market values (outstanding debt), similar to the way equity indices are constructed with weightings based on market capitalization. For equities, one can make the argument that an increased allocation to large companies is acceptable, and perhaps for some even desirable, as larger companies may be seen as safer investments. However, our concern in doing so for global bonds is that weightings will be skewed towards the corporations and governments that are taking on the greatest amount of debt. By passively investing in an index, an investor may be unwillingly allocating more dollars to the most indebted issuers, who oftentimes offer neither the safest nor the best opportunities. As a case in point, as of end of June 2015 approximately 14% of the Barclays Global Aggregate Bond Index was allocated to Japanese government debt 6. Although Japan has reached a debt/gdp ratio of approximately 232% 7, which would normally mean higher yields in order to compensate investors for the higher risk, the Bank of Japan s massive quantitative easing program has pushed yields to dismally low levels. The Japanese 10-year government bond, for example, only yields 0.47% 7, likely not a very attractive place for investors to park their money. In our view, not only does passive global fixed income indexing provide for sub-optimal bond allocations, it is actually rather difficult to implement and potentially ineffective. By leveraging five critical factors, we believe that an active approach allows the investor to be unconstrained and go beyond the limited opportunities offered by passive indexing. With passive indexing, attempting to efficiently invest in over 16,000 securities across multiple bond markets can be problematic due to complexity, cost, and liquidity issues. By passively investing in an index, an investor may be unwillingly allocating more dollars to the most indebted issuers, who oftentimes offer neither the safest nor the best opportunities. 6 Source: Barclays, as of June 30, 2015. 7 Source: Bloomberg, as of June 30, 2015. 7

SECTION 1 SECTION 2 SECTION 3 SECTION 4 FIVE KEY CONSIDERATIONS FOR GLOBAL FIXED INCOME MANAGERS What, then, are some of the key considerations that should be taken into account when making global fixed income investments? The following section of the report discusses five crucial factors we believe active managers should address in order to successfully invest in fixed income beyond Canadian borders. The first two factors are exclusive to global fixed income investing. The last three are factors in any fixed income investment, but they become significantly more complex to manage when operating globally. 1. Country Selection At the country level, bonds can often exhibit investment profiles that are heavily influenced by regional economic considerations and investment trends. Because of this, it is common to find bonds in some regions that represent better value over similar bonds available from other regions. Figure 6 shows sovereign yield curves as of June 30, 2015. FIGURE 6: Sovereign Yield Curves Bonds can often exhibit investment profiles that are heavily influenced by regional economic considerations and investment trends. 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% Canada Germany Australia France United Kingdom United States 1M 1Y 4Y 7Y 10Y --- 15Y 20Y 25Y 30Y 40Y 50Y Source: Bloomberg, as of June 30, 2015. For example, Australia and Canada have identical credit ratings and broadly similar economies as both countries are highly concentrated in the financial and natural resource sectors. Yet Australian local interest rates, sovereign bond yields, and inflation rates are much higher than in Canada due largely to stronger economic growth and a tighter labour market. As of June 30, 2015, Australian 10-year government bonds yield about 133 basis points more than similar Government of Canada bonds, an interesting opportunity if Australian yields and exchange rate remain stable. 8

These differences highlight the fact that not all regions present the same level of opportunity. Given that conditions and trends change over time, it is important to have an approach that pays careful attention to geopolitical and economic conditions on an ongoing basis in order to better distribute assets across regions and more fully realize the benefits of global investing. 2. Currency Management When investing globally, investors should always be wary of currency risk. Our analysis suggests that currencies are much more volatile than bonds. Figure 7 illustrates the effect of currency hedging on the volatility of global fixed income 8 over the last 10 years. FIGURE 7: Effect of Currency Hedging on Fixed Income Volatility Annualized Volatility (%) 12 10 8 6 4 2 0 9.6% 3.6% 2.7% 0 25 50 75 100 Hedging Ratio (%) Barclays Global Aggregate (CAD) FTSE TMX Canada Universe Historically, currency hedging has greatly reduced the volatility of global fixed income. Source: Barclays and FTSE TMX Global Debt Capital Markets, monthly data from July 31, 2005 to June 30, 2015. Interestingly, fully hedging the currency (100% hedging ratio) on global fixed income would have reduced its volatility by over 70% (from 9.6% to 2.7%), making it even lower than that of Canadian fixed income 9 which had an annualized volatility of 3.6% as represented by the dotted line. In other words, with an unhedged global fixed income portfolio, more than 70% of the investment volatility (and fluctuations) comes from exposure to currencies, not bonds. Removing the effects of currency movements leaves the investor with pure global fixed income exposure. By not hedging currency risk, the total volatility of a global bond portfolio would behave similarly to a basket of global currencies and investors could therefore lose some of the risk reduction benefits of fixed income instruments. In our view, a 100% currency hedge should be the starting point of global fixed income investing and any currency risk taken should be with the specific intention to add value. In other words, active currency management should be overlaid on top of a full currency hedged global bond portfolio only when opportunities arise. As shown in Figure 7, global bond investors can generally afford to take some active currency exposure while keeping the volatility broadly similar to Canadian Bonds. This active currency exposure could translate into an additional potential source of added value. Currency movements may be anticipated by analyzing With an unhedged global fixed income portfolio, more than 70% of the investment volatility (and fluctuations) comes from exposure to currencies, not bonds. A 100% currency hedge should be the starting point of global fixed income investing. 8 Represented by Barclays Global Aggregate (CAD) 9 Represented by FTSE TMX Canada Universe Index 9

macroeconomic factors such as interest rate differentials, purchasing power parity (PPP), long-term equilibrium levels, and sometimes even by understanding central bank policies. Active currency management has the potential to add value because some of the largest participants in the currency market are central banks, whose top priorities may be promoting exports and balancing capital flows rather than making a profit in the currency markets. Investors can take advantage of these perhaps willing losers by closely monitoring the intentions of central banks. 3. Bond Sector Allocation Analysis of business cycles, credit fundamentals, and market factors affecting bond valuations drive strategic allocation amongst bond sectors. The difference in yield between corporate and government bonds is called the credit spread, and credit spreads fluctuate depending on the overall risk sentiment of the bond market. Referring back to Figure 5, high yield bonds saw their worst performance in 2008 due to widening credit spreads as the economy took a downturn, but outperformed all other fixed income sectors in four out of the five subsequent years as credit spreads returned to normal levels. As the global economy began showing signs of recovery, investors would have benefited by increasing allocation to corporate bonds to take advantage of narrowing credit spreads. Active managers can formulate insights on an issuer that may not be reflected in its credit rating. 4. Credit Research Credit research involves analyzing a company s financial statements and industry trends in order to assess the company s financial health and its ability to repay its debt. Through rigorous fundamental analysis, active managers can formulate insights on an issuer that may not be reflected in its credit rating. Credit ratings are typically issued by rating agencies such as Standard & Poor s or Moody s, and they have a significant impact on how the issuer s bonds are priced. Credit ratings are also subject to frequent revisions and being able to identify mispriced bonds ahead of the market may allow active managers to benefit from price appreciation and to avoid losses. With over 3,000 issuers represented in the Barclays Global Aggregate Bond Index, we believe there is significant potential to add value by thoroughly understanding the risks and upside of each issuer. 10

5. Duration Management and Yield Curve Positioning Think of duration as a bond s sensitivity to interest rate changes. Bond prices and interest rates have an inverse relationship: as interest rates rise, bond prices fall, and vice versa. Bonds of longer maturities generally have higher durations, as prevailing interest rates have a greater impact on bonds with a longer stream of cash flows. The intention behind actively managing duration is to proactively anticipate and respond to the behavior of interest rates. If rates were expected to fall, for instance, the portfolio s duration could be lengthened by replacing shorter maturity bonds with longer maturity bonds. The expected result would be for the portfolio to experience additional appreciation from the decline in interest rates. Conversely, if rates were expected to rise, the portfolio s duration can be reduced by replacing longer maturity bonds with shorter maturity bonds, consequently cushioning the negative impact of rising rates. Duration and yield are similar to the concept of risk and return (with respect to interest rates), and some bonds may have higher yield per unit of interest rate sensitivity than others, creating what we call intra-curve opportunities. Provided that these market opportunities are present, it is possible for active managers to reallocate the portfolio amongst bonds of different maturities, a strategy known as yield curve positioning, and increase the portfolio s overall yield without changing the duration. These more advanced active management techniques incorporate the ability to potentially enhance gains and/or minimize losses through the addition of a cushioning factor linked to a strategic combination of longer and shorter dated bonds, referred to as convexity. The intention behind actively managing duration is to proactively anticipate and respond to the behavior of interest rates. 11

SECTION 1 SECTION 2 SECTION 3 SECTION 4 CONCLUSIONS & IMPLICATIONS 1. Canadian bonds have performed well historically, but it is unlikely that we will see the same level of returns going forward. Bond yields are near their all-time lows and as the Canadian economy continues its path to recovery, interest rates will inevitably rise, leading to downward pressure on bond prices. 2. Canadian investors should consider diversifying their fixed income portfolios and look for opportunities globally. Canada represents but a small portion of the global fixed income market and there are potentially more attractive prospects elsewhere in the world. 3. Global bond indices are weighed according to the amount of debt outstanding. As such, the largest weights in indices are given to the most heavily indebted corporations and governments. Active management in global fixed income investing avoids the one-dimensional passive approach and takes multiple factors into consideration, improving the bond allocation process to achieve potentially greater returns. 4. Country level analysis and monitoring of regional economic conditions and investment trends can uncover opportunities for potentially better returns without necessarily taking more risk than Canadian fixed income. 5. When investing globally, investors must be mindful of currency risk, avoid passive currency exposures, and consider active currency management as a means of adding value. 6. Global bond sectors from Government to Corporate and High Yield bonds offer various opportunities for investors throughout the business cycle, especially if active managers can use credit research to identify good relative value and avoid defaults and downgrades. 7. In today s uncertain and low interest rate environment, an ongoing attention to duration and yield curve management is of critical importance in maneuvering portfolios with global fixed income exposure. Bonds are an integral component of a diversified portfolio and an appropriate allocation can enhance a portfolio s overall risk-adjusted return. In the event of an equity market downturn, bonds can act as a cushion and soften losses. But the decision to allocate to bonds is not as simple as buying only Canadian Bonds. In our view, the global opportunity set is clearly more favourable but simply replicating a global bond index may not be an optimal solution, and should be avoided, even if it may carry a lower cost. A true active unconstrained global bond manager has the tools and resources to fully exploit market inefficiencies and find value wherever it exists. A true active unconstrained global bond manager has the tools and resources to fully exploit market inefficiencies and find value wherever it exists. 12

SECTION 1 SECTION 2 SECTION 3 SECTION 4 GLOSSARY S&P/TSX Composite Index The S&P/Toronto Stock Exchange Composite Index is a capitalizationweighted index designed to measure market activity of stocks listed on the TSX. The S&P/TSX Composite is the headline index for the Canadian equity market. Source: Bloomberg, S&P Dow Jones Indices FTSE TMX Canada Universe Bond Index The FTSE TMX Canada Universe Bond Index is the broadest and most widely used measure of performance of marketable government and corporate bonds outstanding in the Canadian market. Source: PC-Bond MSCI World Index The MSCI World Index is a free-float weighted equity index. The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries. With 1,643 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. Source: Bloomberg, MSCI Barclays Global Aggregate Bond Index The Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities. Source: Barclays 13