ROYAL LONDON DURATION HEDGED CREDIT FUND

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1 ROYAL LONDON DURATION HEDGED CREDIT FUND For professional investors only, not suitable for retail investors

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3 A UNIQUE STRATEGY DESIGNED FOR A RISING RATE ENVIRONMENT After years of persistent low interest rates, following on from the financial crisis of 2008/9, we are now entering an expectant period of rising rates. In this environment fear abounds that an increase in interest rates could result in considerable losses for fixed income portfolios, as rising rates mute the performance of bonds. The most obvious impact is expected to be on government bonds, as they are priced purely in terms of interest rate expectations. When interest rates start to rise, existing bond yields will need to adjust higher, causing prices to fall. Corporate bonds generally pay higher interest than government bonds to compensate investors for the additional credit risk the so-called credit spread - resulting in higher long-term performance. Therefore, in addition to vulnerability to changes in interest rates, corporate bonds are also vulnerable to changes in the spread, which in itself can be affected by interest rate levels. At Royal London Asset Management (RLAM) we have developed our Duration Hedged Credit Fund to deliver attractive performance from corporate bonds, while using derivatives to protect against interest rate risk. We feel that the Fund is suited to pension schemes requiring relatively attractive returns, such as those from credit assets, and provides a simple starting point around which to build a more customised LDI strategy. FUND OVERVIEW The Royal London Duration Hedged Credit Fund aims to achieve a positive absolute return over the medium (five years) to long (seven years) term in all market conditions. The majority of its assets are allocated to investment grade corporate bonds across a range of maturities, although it may also invest in UK government and other debt securities. The Fund actively manages the duration of the portfolio, effectively removing the duration sensitivity, with a target duration of zero years. The performance objective is to achieve annualised returns of 2% per annum in excess of three month LIBOR, over the medium to longer term. This reflects the absolute return potential of credit bonds effectively locking into attractive yields without having to worry about the impact of changes in long-term interest rates. 3

4 WHY INVEST IN DURATION HEDGED CREDIT BONDS Current credit spreads offer the prospect of attractive long-term returns relative to risk free government bonds. The chart below shows the average credit spread (yield premium above gilts) on the iboxx Sterling Non-Gilt All Maturities Index over time. While credit spreads have narrowed since the Fund was launched in September 2012, they remain high relative to historic norms. They are also significantly higher than historic defaults would warrant. In particular, using Moody s data ( ) the historical analysis of defaults shows the following: For the universe of investment grade bonds, looking at a 20 year holding period, the probability of a security defaulting is 6.7%. This can be more crudely represented as implying that if a representative portfolio of 100 investment grade bonds was held for 20 years, the most likely outcome would be that 7 of those bonds would have defaulted by the end of the period. To assess what yield premium on credit bonds adequately compensates for the risk of default investors need to make assumptions about how much of their initial outlay they will recoup from the sale of the issuer s assets in the event of default. Historically, investors have received about 40% of principal (i.e. 40p in the pound). However, we can also factor in a lower recovery rate i.e. 20%. Assuming this level of recovery for all investment grade bonds, the required yield premium based upon historical defaults is less than 0.3%. Assuming zero recovery following default (clearly the worst possible outcome), the required yield premium over gilts, based upon historical defaults, is approximately 0.4% for investment grade debt. The above required spreads are significantly lower to that available in the market at the present time reflecting a combination of risk aversion, liquidity risk and additional risk premium required by market investors. Our analysis suggests that credit investors are being overcompensated for the risk they are taking - highlighting the attractiveness of investing in credit at the present time. There have to be several caveats to the above analysis. Using historical analysis may be useful but investors need to be aware of changes in economies and markets that may make historical data less useful (e.g. corporates are more leveraged, banks are bigger / riskier and the ability of governments to support key sectors may be more questionable). Average investment grade sterling credit spread Spread over gilts (bps) Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015 Dec 2016 Sept 2017 Source: RLAM as at 30 September

5 Market inefficiencies provide an opportunity for long-term investors to capitalise on attractive credit spreads in excess of government bonds, whilst maintaining an appropriate level of risk. Our credit philosophy capturing market inefficiencies Constraints Mispricings Rule-based index construction Weightings based on indebtedness Benchmarks Security Market is not structured to reflect security as an attribute We target analysis of structure and covenants to identify value Not comprehensive: focus on default, not recovery Increasing inflexibility Not universally applied Ratings Liquidity Investors generally over-value liquidity Long-term investors can exploit heightened illiquidity premium INVESTMENT APPROACH The investment approach fully reflects our unique investment philosophy of achieving an attractive combination of value and security, while additionally applying a derivative overlay in order to hedge the interest rate risk associated with regular bond portfolios. We believe that bond markets are inefficient and, as active fund managers, we can exploit valuation anomalies as they occur. In addition, by considering a wider investment universe than many of our competitors - including unrated and asset backed bonds and loans - we can uncover value in many areas that are often overlooked. We are value investors, which means in practice that we emphasise our own research and that we prefer companies with sound long-term business models and bonds which offer strong covenant protection and asset backing. We believe that credit ratings are a lagging indicator and that bond investment is about assessing the probability of default and the recovery rate; we firmly believe that the credit markets are inefficient because too little emphasis is placed on the latter. This philosophy is the basis for an investment process that has been built around a carefully structured team of experienced portfolio managers and credit researchers and is focussed on valuations and on achieving the greatest security of cashflows, and diversification to limit stock-specific risks. Alongside this, we use interest rate swaps to hedge the interest rate risk of the bonds in the portfolio, with a well- equipped team of derivative specialists implementing this element of the strategy. 5

6 UNDERLYING PORTFOLIO CHARACTERISTICS Key positions with the Duration Hedged Credit Fund Utilities Telecommunications Supranationals & agencies Structured Social housing Real estate Investment trusts Covered Insurance Gilts General industrials Foreign sovereigns Consumer services Consumer goods Banks & financial services 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% RL Duration Hedged Credit Fund iboxx Sterling Non-Gilts All Maturities Index RLAM as at 30 September Excludes derivatives. This portfolio is significantly different from the iboxx Sterling Non-Gilt All Maturities Index (a common fixed income benchmark used for measuring the performance of credit portfolios). Key observations on our positioning are: 1. We have a strong focus on asset rich sectors with robust claims on cashflows and underlying security over specific assets for example, there is a relatively large bias towards covered bonds, asset backed bonds (structured sector) and social housing. Exposure to investment trusts (including some unrated bonds) is significant, demonstrating the relative attractiveness of this undervalued asset rich sector. 2. We have maintained an exposure to bank and insurance debt reflecting the relative attractiveness of yields within this segment. 3. Exposure to more cyclical companies, e.g. consumer goods, consumer services and general industrials has been maintained but at lower levels, with only our views on the best credits implemented. We believe that these sectors are generally expensive (in relative spread terms) and do not generally offer adequate value, given their cyclicality and the challenging economic outlook. 4. Almost no exposure to supranational bonds - reflecting our view that this sector provides inadequate yields relative to swap rates. 5. An exposure to gilts to provide liquidity and collateral for any movements in the interest rate swaps that are implemented please refer to the appendix for details on how we use interest rate swaps for hedging the portfolio and further risk related information. 6. The fund is highly diversified, with over 150 individual credit bonds - reflecting the low relative single name credit risk. 6

7 INTEREST RATE SWAPS The interest rate sensitivity of the credit bonds held in the portfolio is hedged via the use of pay fixed/receive floating interest rate swaps. The chart below shows an example hedge of a c 30m bond portfolio using swaps spread across various maturities this approach allows us to hedge not only the interest rate risk related to changes in bond values from upward shifts in yields, but also the risk related to uneven curve movements (i.e. shifts in the shape of the yield curve). The orange bars labelled benchmark represent the swaps sensitivities to changes in yields whilst the purple bars represent bond sensitivities. For example, it can be seen that 2035 cashflows from the bond portfolio have a sensitivity of close to 3,000 for a 1bp (basis point) change in 30 year yields i.e. if the 30 year swap yield rose from say 2.20% to 2.21%, there would be a c 3,000 loss due to changes in the present value of cashflows from bonds in Against this the 30 year swap has sensitivity of c 5,000 but in the opposite direction, i.e. if the 30 year yield rises by 1bp, the swap would gain over c 5,000 value, whilst the bonds would lose c 3,000. The overall sensitivity of all bond cashflows to changes in yield curve levels has therefore been hedged using a few swaps across the curve. The cashflow profile of the bond portfolio shows that the portfolio has a relative bias to bonds up to 15 years long reflecting the greater availability of better value credit bonds in this maturity area. The swap portfolio therefore consists of larger swaps until the 15 year maturity, and relatively smaller swaps at the longer end. The overall picture below therefore shows an effective hedge for both yield curve shifts as well as changes in the level of underlying swap yields on the bond portfolio. When determining the best value hedge, we use our risk system, UBS Delta, which allows us to optimise the hedges. We then overlay the suggested swap portfolio with our practical market knowledge in relation to liquidity and yield levels across the swap curve. 20,000 Bonds Swaps 15,000 10,000 Sensitivity ( ) 5,000 0 (5,000) (10,000) (15,000) Sep-18 Sep-20 Sep-22 Sep-24 Sep-26 Sep-28 Sep-30 Sep-32 Sep-34 Sep-36 Sep-38 Sep-40 Sep-42 Sep-44 Sep-46 Sep-48 Sep-50 Sep-52 Sep-54 Sep-56 Sep-58 Sep-60 Sep-62 Sep-64 Sep-66 Source: UBS Delta, UBS 7

8 PENSION FUND INVESTORS: POTENTIAL USE OF LDI We believe this product is suitable for pension funds who wish to have attractive positions in credit, which deliver an attractive level of additional return over and above government bond yields, but do not wish to be forced to invest in a long dated credit fund (with the obvious benchmark considerations). Pension funds could look at using this fund as a LIBOR plus generator whilst holding segregated swaps/gilts to ensure that their overall duration objectives are met. Investor holds bond portfolio Investor holds RL Duration Hedged Credit Fund Fund manager implements interest rate swap overlay Combined Fund & swap LDI solution Bond returns Duration* Libor + Credit excess returns Zero duration Sw + = Duration** Credit excess returns with liability duration match * May not be a good match versus liabilities ** Matched versus liabilities 8

9 The Team Piers Hillier Chief Investment Officer Jonathan Platt Fixed Income Nick Woodward Investment Solutions Ewan McAlpine Asset Allocation & Product Management Azhar Hussain Global High Yield Martin Foden Credit Research Eric Holt Credit Paul Rayner Government Bonds Craig Inches Short Rates and Cash Alex Robertson Stephen Tapley Zilla Chan Paola Binns Craig Inches Tony Cole Scott Lewis Khuram Sharih Matt Franklin Shalin Shah Ben Nicholl David Sweet Sebastien Poulin Tom Elliott Gary Ewen Carleigh Young Richard Nelson Gareth Hill Rachid Semaoune Guy Cornelius Trevor Greetham Multi Asset John Dolder Portfolio Risk Mike Fox Sustainable Investing Darren Bustin Derivatives Team of 7 Team of 2 Team of 6 Team of 4 Shalin Shah Credit Fund Manager Shalin Shah joined the Fixed Income Team at RLAM in mid Over the last eight years he has been involved in a variety of areas, with a particular focus on actively managing credit portfolios and working closely with RLAM s Fixed Income (Jonathan Platt) and Credit Research (Martin Foden) on the development and management of RLAM s Buy & Maintain credit strategies. Prior to joining RLAM, Shalin worked at PricewaterhouseCoopers LLP, where he was involved in advising clients on a variety of investment solutions, including LDI and strategic asset allocation. Shalin holds a BSc in MORSE (Mathematics, Operational Research, Statistics and Economics) from the University of Warwick and is a qualified actuary. 9

10 Asset allocation Fund name Minimum % Maximum % Credit bonds (UK and global ex. High Yield) Credit bonds (High Yield) 0 20 Gilts 0 50 Global government bonds 0 50 Index-linked bonds (UK and global) 0 50 Currency 0 20 Derivatives (1) (mark to market) (1) Note that notional exposures could be significantly higher. Mark to market refers to value of derivatives if closed out (negative or positive). Fund details Launch date 24 September 2012 Benchmark Fund structure 3 month LIBOR UK authorised ICVC (UCITS IV fund) Number of holdings Typical duration Available share class Currency 0 years Z (institutional) GBP Initial charge 0.00% AMC 0.50% OCF 0.54% Minimum lump sum investment 1,000,000 Minimum subsequent investment 50,000 Type of units (Inc/Acc) Type of units (Gross/Net of tax) Distribution frequency Payment dates Accumulation Net Twice yearly 30 June & 31 December 10

11 WHY RLAM? RLAM s Fixed Interest Team has developed a reputation as one of the UK s leading managers of government and corporate bonds, with over 53 billion of fixed interest assets under management. Our approach to fixed interest investing is highly differentiated, established and repeatable. We feel that our success is based on truly understanding the investment objectives of our clients and using our in-depth market knowledge to exploit investment inefficiencies that help us meet these aims. It is the experience, skill and stability of our 30 strong Fixed Interest Team that sets us apart, giving us an edge in a highly competitive market. Quite simply, by using our experience and exploring parts of the market that others overlook, we are able to add value for our clients. Source: RLAM as at 30 September

12 Contact us For more information about any of our products and services, please contact us. Royal London Asset Management 55 Gracechurch Street London EC3V 0RL Tel: Fax: Website: For professional customers only. The views expressed are the author s own and do not constitute investment advice. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. For more information concerning the risks of investing, please refer to the Prospectus and Key Investor Information Document (KIID). Financial promotion issued by Royal London Asset Management November Information correct at that date unless otherwise stated. Royal London Asset Management Limited, registered in England and Wales number ; Royal London Unit Trust Managers Limited, registered in England and Wales number RLUM Limited, registered in England and Wales number All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between subfunds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number , and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. Registered office: 70 Sir John Rogerson s Quay, Dublin 2, Ireland. Ref: BR RLAM PD 0010