CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO MAY 2013

CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO MAY 2013

Context Currently developed market sovereign bonds are not appealing from an investment perspective. They offer negative or low real returns and are exposed to the risk of central bank policy reversal. In addition, nominal bonds are exposed to the risk of rising inflation expectations if unconventional policy continues. Sovereign bonds continue to have a role to play in controlling assetliability risk for some investors. Inflation-linked bonds may continue to have some appeal given their inflation protection characteristics. Over the last few years many investors have built allocations to non-government fixed income, as a means of broadening out their growth asset exposure. Such investors have generally focused on investment grade credit and some parts of the securitised markets (such as mortgage securities). Others have also invested in newer opportunities such as government debt issued by developing countries (emerging market debt) The fixed income opportunity set continues to evolve and grow. Investors are getting more comfortable with exposures to noninvestment grade multi-asset credit. This paper focuses on the role of fixed income to generate wealth (as opposed to preserve wealth or to hedge liabilities). As such the rest of the paper does not focus on developed market sovereign bonds, nor on investment grade credit (as they are deemed to be part of an investor s liability hedging portfolio or defensive portfolio). We note that this paper is written primarily from the perspective of an investor based in the developed world. The opportunity set The growth fixed income opportunity consists of the following (sub) asset classes: Emerging market debt: Investing in the sovereign debt of emerging markets. This can be debt issued in local currency or (typically) in US dollars. The risk premium available to investors is the compensation for being exposed to credit and currency (for debt denominated in local currency) risks. Local currency debt also has realistic prospects of currency appreciation (many of these countries are expected to have capital inflows related to their growth which should result in their currencies appreciating over time) and also some structural real yield advantage ( positive carry in the jargon). High yield bonds: Investing in debt issued by companies which are below investment grade (i.e., have a credit rating that is lower than BBB- or equivalent). The risk premium available is compensation for credit and liquidity risk as these companies have a higher chance of failing and the bonds are therefore subject to more default risk, the risk premium available is higher than for investment grade corporate bonds. The bonds are publicly traded but are likely to be less liquid than investment grade corporate bonds. Bank loans (also known as secured or leveraged loans): Investing in loans to non-investment grade corporate borrowers. These loans are typically arranged by investment banks. The loans are normally issued by mid to large sized companies to, for example, finance business expansion. They are senior in the capital structure and are typically secured by the borrower s assets and will tend to have priority rights. Senior loans are floating rate in nature with a coupon return comprised of a nominal spread over LIBOR, for example a coupon of LIBOR + 4%. One of the most important features of senior loans is that they are privately rather than publicly traded. The liquidity is significantly less than investment grade bonds or even high yield bonds. Bank loans secured by underlying assets will tend to have stronger defensive qualities than high yield bonds. Historic recovery values following defaults, which have been higher than for high yield bonds, provide some evidence of this. Private debt (or private credit): The ability of banks to lend directly has diminished since the financial crisis and this has reduced the supply of private debt in a number of areas. As a result, institutional investors have the opportunity to provide debt capital to borrowers involved in infrastructure projects, real estate and private equity financing (amongst others). The debt can be secured (by the underlying assets) or can have a mix of equity and debt-like characteristics (e.g., mezzanine). The risk premium available to investors is the underlying credit risk and in this case the investment will also be very illiquid so the investor should get compensation for the lack of liquidity. 1 CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO

Absolute return bond strategies: Each of the ideas so far can be considered an asset class with an associated risk premium. Absolute return bond approaches are more about accessing a basket of alpha opportunities. The actual characteristics will be very product-specific, but the products are designed to deliver a positive return in all market environments. Investment managers will take advantage of numerous alpha opportunities within the fixed income universe and many of the products will be long and short with limited (if any) directionality. The better approaches should seek to be uncorrelated with growth assets when the latter are doing badly but will have a higher degree of correlation when equities are rising. This is because managers will generally seek to take advantage of the additional spread available in credit markets in positive market environments but look to hold little or no spread assets at times of heightened volatility. On the whole we would expect absolute return bond products to have low sensitivity to the direction of interest rates and credit (they will tend to have low to zero interest and credit duration). This is about accessing manager skill as there is no inherent risk premium available. There is no clear definitional distinction between absolute return bond strategies and fixed income hedge funds. Some absolute return bond strategies that are run at moderate to high risk levels are also marketed as hedge funds, and are sometimes held within hedge fund portfolios. Multi-asset credit strategies: One way to think about these funds is that they are the credit only equivalent of balanced funds. They seek to invest in a basket of multi-asset credit opportunities (many set out above) with a view to rotating between the different opportunities. As such they provide access to a wide variety of credit exposures whilst providing some active management of beta exposures (e.g. loans versus high yield). Many also will have the flexibility to move part of the allocation to cash, government bonds or investment grade credit as a way of managing the overall credit exposure (of the investor). The variety of underlying exposures and the level of liquidity will vary by product. The risk premia available are expected to be dominated by those available via investing in the underlying asset classes, as set out above. There may also be smaller contributions to return stemming from active management of the mix between these asset classes and from security selection within these asset classes. Unconstrained bond strategies: Unconstrained bonds strategies can best be described as an unconstrained approach to traditional fixed income investing. The underlying investment is likely to be developed market sovereign bonds, investment grade credit, and securitised debt (e.g., asset-backed securities). Some products may also stray into high yield and emerging market debt. The risk premium available is compensation for duration and credit risk plus some alpha via beta management between the sectors, interest rate management, security selection and currency positioning. The strategies will tend to have inherent interest rate and credit exposure although the extent of the exposures is expected to vary. Further details and the characteristics of each of the strategies above are set out in Appendix 1. Discussion Investors decisions on which fixed income opportunities to access will depend largely on the following considerations: Strategic rationale what do investors want to achieve from the allocation to growth fixed income and how does this fit in with their existing allocations to the other elements of their growth portfolios? Is the focus on reducing exposure to credit and interest rate exposure (favouring loans or absolute return approaches) or is the focus primarily on return (favouring, say, private debt)? Governance do investors want to add specific strategies (e.g., high yield) to the portfolio once they have an understanding of the opportunity or do they prefer to have access to a basket of opportunities? What capacity do investors have for additional managers and for the additional monitoring burden and complexity which may come from this? View on active management how comfortable is the investor giving their manager(s) wider discretion to manage the beta allocation across a number of opportunities? And what are the additional costs of active management? Liquidity some of the opportunities are less liquid (though not necessarily illiquid); an investor will need to be comfortable with this. It is worth noting that, in our view, some of the more compelling return opportunities are illiquid. The portfolios we have set out below reflect our current views on the growth fixed income opportunities set. We see opportunities in emerging market debt and private debt as structural opportunities which have a strategic place in investor portfolios. Both of these also add additional drivers of return into a typical investor s portfolio and therefore provide additional diversification. Some of the other opportunities, such as securitised credit (which, for example, may include investment in mortgaged-backed securities) and bank loans look attractive but are likely to be more cyclical in nature. Also, high yield has performed well recently and has attracted a lot of investor capital, including retail flows, so the asset class is now less appealing. We are also entering into a macro environment characterised by GDP dispersion the notion that some countries will emerge from the crisis more quickly and stronger than others. This will increase the opportunities for fixed income managers with a strong global perspective. As such we believe that investors should be considering exposure to a basket of credits and selecting a strategy where the manager is allocating to their best ideas across the fixed income spectrum and also has some flexibility to rotate between the different opportunities. May 2013 2

Abs return 0% - 30% Credit oportunities 20% - 30% Local currency EMD 20% - 40% Private debt 20% - 40% Portfolio Construction The paper acknowledges that investors have different needs and preferences. As such, we set out below an aspirational portfolio for investors with a focus on growing their assets and who do not have any constraints. We than present some other possible portfolios. Portfolio 1 This is our preferred portfolio. The focus is on generating return from multiple sources. Portfolio allocations Best of Mercer Portfolio ABS return 11% - 30% Credit oportunities 20% - 40% Local currency EMD 20% - 40% Private debt 20% - 40% Strategic rationale: The portfolio focus is on return via investing in opportunities which are primarily structural in nature. This is combined with strategies which seek to invest across the credit spectrum and seek to add value via beta management of different multi-asset credit opportunities. The portfolio has a high degree of credit exposure but is a portfolio where the returns are less reliant on the developed markets macro environment. Should the investor wish to add some defensiveness, this can be done by adding absolute return bonds into the mix. Governance: Challenging, as it could involve appointing many managers and including illiquid opportunities. Reliance on active management: A mix of beta allocation by the investor and accessing the beta and alpha management capabilities of managers. Risk/Return: We have modelled the returns of this and other portfolios under three economic scenarios (see appendix 2 for details). This portfolio is expected to have a return of about 8.2% p.a. in a muddle through scenario but the return could be higher at closer to 11% p.a. in a trend growth scenario but only just above zero at about 1.6% p.a. in a weak growth scenario. Liquidity: Liquidity is expected to be moderate. Part of the portfolio will be illiquid, but the intention is for this portfolio not to be totally illiquid. Appropriate for what type of investor: It is designed for investors for whom growth fixed income allocations are a significant part of the overall allocation and who therefore are willing to access broad a basket of return sources. 3 CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO

High level Investment Guidelines: Asset Class Emerging Market Debt - Local Currency Strategic Considerations Allocation 20-40% Permit ability to invest off-benchmark to, for example, EMD corporates allocation to EMD will depend on whether the multi-asset credit strategy includes EMD as one of its components. Multi-asset credit 20-40% A basket of multi-asset credit but avoiding strategies which are EMD heavy Private debt 20-40% Sizing depends on allocation within Private Equity to Debt/Credit opportunities Absolute Return 0-30% Higher allocation if the focus is on capital preservation and a investor does not have a dedicated allocation to hedge funds. Consistent with our guidance on building hedge fund portfolios, we would advocate prudence in sizing allocations to any individual strategies within this category that are run at risk levels high enough to allow them to be classified as hedge funds, with no more than 10% being allocated to any such strategy. Total 100.0% The portfolio above only makes sense if the allocation to growth fixed income is focused on return and where the investor is tolerant of complexity and illiquidity. We propose a number of simpler portfolios below they can be seen as starter portfolios which can be built on over time or portfolios which capture investor constraints e.g. a lack of tolerance to illiquidity. Our preferred portfolio is shown, for comparison purposes. Asset class Portfolio 1 Aspirational (Best of Mercer) Emerging market debt (local) Portfolio 2 Aspirational simplified Portfolio 3 Simple and liquid Portfolio 4 Lower risk 20%-40% 40%-60% 30%-60% 30%-40% High yield 30%-60% Bank loans 30%-40% Private debt 20%-40% Absolute return bonds 0%-30% 30%-40% Multi-asset credit 20-40% 40%-60% Unconstrained bonds 0%-30% Total 100% 100% 100% 100% Some observations: Portfolio 2: This portfolio is designed to capture a basket of betas whilst maintaining simplicity. The portfolio also reflects the fact that credit markets have done well over the last few years and therefore is an approach which has flexibility to rotate between different betas and critically to reduce overall credit exposure when credit markets are too rich and therefore risky. The exposure to a multi-asset credit strategy provides diversified access to multi-asset credit with some management of overall credit exposure (this will depend on the individual strategy) and beta management of the sub-strategies (high yield versus loans). By adding some floating rate exposure the approach will reduce interest rate sensitivity. For those with existing exposure to emerging market debt, this is simple in that this portfolio requires adding one manager to access a basket of opportunities. This portfolio is expected to have a return of about 7.3% in a muddle through scenario but the return could be higher at about 8.3% in a trend growth scenario but only about 2.5% in a weak growth scenario. The portfolio is less volatile than Portfolio 1. May 2013 4

Portfolio 3: A portfolio which is liquid and simple. For those who already have exposure to emerging market debt, strategically the next opportunity which they should consider is high yield. High yield has a strategic role in investor portfolios but currently the asset class is less appealing so investors may need to be on the lookout for better entry points. They may consider ware-housing this allocation to absolute return bond strategies or an unconstrained bond strategy whilst waiting for a more opportune entry point. Governance is simple apart from the challenge of managing the entry point. This portfolio is expected to have a return of about 6.3% in a muddle through scenario but the return could be higher at just over 7% in a trend growth scenario but only about 2.4% in a weak growth scenario. The expected returns are lower than Portfolios 1 and 2 but the portfolio is less risky. Portfolio 4: A portfolio which is less sensitive to credit and interest rate risk and holds up reasonably well in a rising rate or a rising credit spread environment. The portfolio will be more defensive in nature. The portfolio is likely to be more challenging from a governance perspective as it requires appointing a number of fixed income managers. Also, the absolute return strategies should be adequately diversified this adds an additional governance challenge. This portfolio is expected to have a return of about 5.3% in a muddle through scenario with the return only marginally higher at about 5.8% in a trend growth scenario but will hold up more in a weak growth scenario with an expected return of about 3.0%. The return expectations from this portfolio are expected to be the lowest but this is also likely to be the most stable portfolio. Summary of risk and returns The table below sets out the expected returns for the four portfolios in three different scenarios. This dispersion of returns is a better indicator of the risks of the portfolios than the historic risk. The scenarios are described in more detail in Appendix 2. It should be noted that the three scenarios in this table do not encompass the full range of potential outcomes, and that it is possible to construct scenarios in which the returns for all four model portfolios would have been meaningfully negative (as was the case in 2008). Portfolio 1 Aspirational (Best of Mercer) (%) Portfolio 2 Portfolio 3 Aspirational Simplified Simple and liquid (%) (%) Muddle through 8.2 7.3 6.3 5.3 Weak growth 1.6 2.5 2.4 3.0 Trend growth 11.0 8.3 7.3 5.8 Expected return 7.3 1 6.5 5.6 4.9 Risk (historic) 6.3 7.6 10.0 6.1 Sharpe ratio 1.2 2 0.9 0.6 0.8 Portfolio 4 Lower risk (%) 1 We have estimated the return assuming that the muddle through scenario is given a 65% weight, the prolonged recession a 20% weight and the trend growth 15% weight. 2 Assuming a risk free return of 0%. 5 CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO

Concluding remarks Lower-rated credit will likely play a greater role in client portfolios there are more interesting opportunities available to investors partly as a result of the reduced role of some of the traditional players in the provision of credit as well as secular changes in the emerging markets. Investor comfort and understanding of the opportunities in credit is still evolving also parts of the credit market tend to be more clearly cyclical than, say, equities. Also some of the emerging opportunities are illiquid in nature. We anticipate that investors will approach the opportunity set based on a number of considerations; this includes governance as well as beliefs in e.g. active management. We have put forward four possible portfolios these ranges from Mercer s preferred portfolio assuming that the client does not have any major constraints (say on liquidity needs) to more simple portfolios for clients seeking to take a step-by-step approach. The portfolios have differing characteristics some have more growth potential, others are more defensive in nature. Conflicts of Interest For Mercer s conflict of interest disclosures, contact your Mercer representative or see www.mercer.com/conflictsofinterest. Risk warnings The value of Gilts, bonds, and other fixed income investments including unit trusts can go down as well as up and you may not get back the amount you have invested. Investments denominated in a foreign currency will fluctuate with the value of the currency. Certain investments, such as illiquid, leveraged or high-yield instruments or funds and securities issued by small capitalization and emerging market issuers, carry additional risks that should be considered before choosing an investment manager or making an investment decision. For higher volatility investments, losses on realisation may be high because their value may fall suddenly and substantially. Where investments are not domiciled and regulated locally, the nature and extent of investor protection will be different to that available in respect of investments domiciled and regulated locally. In particular, the regulatory regimes in some domiciles are considerably lighter than others, and offer substantially less investor protection. Where an investor is considering whether to make a commitment in respect of an investment which is not domiciled and regulated locally, we recommend that legal advice is sought prior to the commitment being made. Universe notes Mercer s universes are intended to provide collective samples of strategies that best allow for robust peer group comparisons over a chosen timeframe. Mercer does not assert that the peer groups are wholly representative of and applicable to all strategies available to investors. May 2013 6

Appendix 1 - The building blocks Investment Asset Class Role Strategic Rationale Key Drivers of Return Key Risks / threats to opportunity Local currency Emerging Market debt Growth Exposure to higher yields on improving sovereign credits Positive relative growth dynamics should provide currency appreciation over time Coupon + potential capital appreciation + currency appreciation Inflation leading to rising rates Global deep recession Currency volatility High Yield Growth Diversification of corporate credit risk Yield pick-up more than offsets realised defaults over time Coupon + spread contraction underlying sovereign movements Global recession leading to large increase in defaults Reduction in banks balance sheets leading to refinancing problems Senior Loans Growth Floating rate so income rises in line with interest rates Seniority in capital structure, negative covenants and lack of spread duration provides downside protection Coupon + LIBOR Reduction in banks balance sheets leading to refinancing problems Private debt Growth Offers long term yield premium for give up in liquidity Coupon + Potential equity kicker Banking crisis deepens hitting primary and secondary markets Ensuring exposure is adequately diversified. Absolute return Core Uncorrelated sources of alpha Strong diversification benefits due to emphasis on downside protection Pure alpha from rates, currency and credit decisions Limited asset allocation Should be independent of beta Subject to market opportunities and manager skill Liquidity Risk Assessment Governance challenge Medium Medium/ High Medium Low/Medium Medium/ High Medium Low Medium Medium Very low (3-5 years lock-up similar to private equity) High High Good Low Low/Medium 7 CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO

Investment Asset Class Role Strategic Rationale Key Drivers of Return Investment Grade Corporate Credit Core High grade credit exposure with low probability of defaults Coupon + spread contraction - underlying sovereign rate movements Multi-asset credit Growth Dynamic (not tactical) beta management across less liquid and non-traditional multi-asset credit such as loans, convertibles etc but very product-dependent as some will have an allocation to investment grade credit and others also to distressed credit. Alpha from beta rotation and security selection. Lack of liquidity also a return driver Unconstrained Bonds Core Dynamic beta management across traditional sovereign, corporate credit and structured credit. Also security selection and currency alpha. Provides opportunity to capture best performing asset classes through the cycle Alpha from beta rotation Elements of running yield Key Risks / threats to opportunity Default rates pick up Sovereign yields increase significantly. Benchmark concentration in financials but can be avoided using buy and maintain approach Illiquidity risk Requires competence across credit spectrum Subject to credit events Limited downside protection Liquidity Risk Assessment Governance challenge Good Low Low Low/Medium (3 months to 1 year lock-ins, possibly longer) Medium to High (very strategydependent) High Medium Medium Low/Medium May 2013 8

Sources of return The table below summarises the different sources of return (from an investor s perspective) available from opportunities in fixed income we have shown how the building blocks above access the different opportunities. TRADITIONAL EMERGING Credit beta Sovereign beta Structured credit beta (e.g. mortgage backed) Management of traditional beta Traditional alpha (e.g. credit security selection) Currency alpha Emerging market sovereign credit (hard) Emerging market sovereign credit(local) Emerging market currency Emerging market corporate Distressed Loans High Yield Long & short alpha Convertibles Private debt Investment grade credit a (a) a Absolute return (a) (a) (a) (a) (a) (a) a Unconstrained bonds a a a a a a a (a) EMD local (a) a a (a) EMD hard a (a) High yield (a) a Mult-asset credit a a (a) (a) (a) a a (a) Private debt a a The table above makes a distinction between investing in traditional opportunities, opportunities with which the investors is likely to be familiar and emerging opportunities, i.e. areas in which investors are only just building their understanding and comfort. Appendix 2 Scenario Analysis The tables below summarise the returns for each of the sub-asset classes followed by the returns of each of the proposed portfolios: Summary Returns Table Investment Muddle Through (%) Weak Growth (%) Trend Growth (%) Emerging Market Debt Local Currency 7.5 3.5 8.5 High Yield 5.5 1.0 6.5 Senior Loans 5.0 2.0 5.5 Private debt 10.0 0.0 16.0 Absolute return 3.5 3.5 3.5 Multi-asset credit 7.0 1.5 8.0 Unconstrained Bonds 4.5 2.5 5.5 Below we describe the three possible scenarios with accompanying assumptions for credit spread changes, rates rises (government bond curve) and currency appreciation or depreciation. 9 CONSTRUCTING A GROWTH FIXED INCOME PORTFOLIO

Muddle-Through Scenario (65%) Our base case scenario assumes a "muddle through" economic environment. This scenario assumes there will not be another financial crisis nor will there be a disorganised default of any significant developed country. We assume modest rates rises with modest spread tightening in investment grade credit with greater contraction in high yield. We believe local currency emerging market debt will continue to benefit from positive growth dynamics relative to developed markets and this should see currency appreciation, albeit with a high level of volatility. It will also see rates fall slightly as inflation concerns become less of a problem. Weak growth (20%) We attach a small though not insignificant probability to this occurrence. Under this scenario, we assume moderate credit spread changes in investment grade credit with larger moves in high yield. We would expect absolute return strategies to achieve their objectives with unconstrained bonds strategies returning below target due to their utilisation of credit. We expect local currency EMD to suffer some currency depreciation and significant volatility. Trend Growth (15%) Though we regard this as unlikely, it may be possible. Under this scenario, we believe investment grade credit would actually perform more poorly than in a muddle-through scenario because the market would price in greater rates rises than would be offset by contracting spreads. This would not be true in high yield, which therefore should do marginally better. We expect that an unconstrained bonds strategy should do better in this environment, owing to its LIBOR floor + target combined with contracting spreads. Local currency EMD should also benefit from marginally higher currency appreciation. Appendix 3 - Some history Historic Risk and Returns The table below summarises what the risk and returns have been from the major fixed income sub-asset classes over the period 2003 to 2012: Asset Class Return (%) Risk (%) Return/Risk Index/Source Emerging market debt - local currency 12.3 11.9 1.0 JPM GBI-EM GD Index Global High Yield 11.0 11.4 1.0 BoA ML Global High Yield Index Senior Loans 6.1 7.0 0.9 Median Manager Return Mercer US Leveraged Loan Universe Private debt 10.1 5.9 1.7 Median Manager Return Mercer Distressed Debt (Net of fees) Universe Absolute Return 4.8 2.9 1.7 Median Manager Return Mercer International Fixed Absolute Return Universe Multi-asset credit 10.0 5.1 2.0 Median Manager Return Mercer Multi-asset credit (Net of fees) Universe Unconstrained Bonds 7.1 5.9 1.2 Median Manager Return Mercer International Fixed Unconstrained Bond Universe Global Credit 6.2 7.0 0.9 Barclays Capital Global Aggregate Credit Index May 2013 10

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