MACQUARIE PRIVATE PORTFOLIO MANAGEMENT

Transcription

1 MACQUARIE PRIVATE PORTFOLIO MANAGEMENT

2 Macquarie Private Portfolio Management Limited Diversified Fixed Interest Strategy Discussion Paper January 2013 Executive Summary Purpose The purpose of this discussion document is to summarise MPPM s Diversified Fixed Interest strategy s characteristics, performance, recent drivers of the Australian bond market and trends in the listed interest rate securities market. Background MPPM has been operating discretionary investment portfolios focused on fixed interest and listed interest rate securities (IRS) since its inception in We offer clients a blended exposure to fixed interest with IRS, high credit quality fixed rate bond exposure via managed funds (mainly Government debt) and cash, to provide clients with a holistic income producing exposure. Fixed interest and the IRS universe have been attracting increased investor interest during recent months as a result of: the positive returns achieved over short and long term time horizons from this sub-sector, the large amount of new issuance in the listed IRS universe during the last twelve months (~$12bn in 2012), relative capital stability compared to equity markets, and high tax effective yields available in a falling cash rate environment. We expand on these points in the following pages. As a result of these developments we have seen renewed interest in this asset class from both investors with a high allocation to growth assets, looking to reduce volatility in their long term investment portfolios and also investors looking to reallocate a portion of their cash investment to enhance returns (exploring options to earn a higher yield, following the recent Reserve Bank of Australia RBA cash rate reductions). The following paper provides details and insights into our Diversified Fixed Interest Strategy, recent events in the Australian bond market and IRS universe, and briefly describes our investment process. Macquarie Private Portfolio Management 1

3 Table of Contents MPPM DIVERISIFIED FIXED INTEREST STRATEGY... 3 Strategy Overview... 3 Objective... 3 General Portfolio Characteristics... 3 Current Portfolio Characteristics... 4 Strategy Returns... 4 AUSTRALIAN BOND MARKET... 5 Why bond market exposure... 5 Current characteristics of the Australian bond market... 5 Recent performance of the Australian bond market... 5 Movements in Australian government bond yields... 6 Australian Fixed Interest fund exposure... 7 LISTED INTEREST RATE SECURITIES... 7 Why listed interest rate securities... 7 What is the listed interest rate securities market... 8 Listed Interest Rate Securities vs. Equities... 9 Drivers of Recent Issuance Universe Concentration Liquidity Current Valuation MPPM S INVESTMENT APPROACH MPPM s Investment Approach Risk Management Recent Strategy Performance & Volatility Charts SUMMARY Macquarie Private Portfolio Management 2

4 MPPM DIVERSIFIED FIXED INTEREST STRATEGY Strategy Overview MPPM s Diversified Fixed Interest strategy blends exposure of: High quality listed interest rate securities, Domestic unlisted fixed rate bond markets, and Cash. We actively manage a portfolio of directly held listed interest rate securities and wholesale domestic fixed interest managed funds. For full strategy details please refer to the detailed MPPM Diversified Fixed Interest strategy description document available on the resources page of our website. Objective The strategy has two key objectives: Primary Objective to provide a tax effective yield at a premium to the cash rate with moderate levels of capital volatility, via investment predominantly in ASX listed interest rate securities, diversified fixed interest exposure and cash. Secondary Objective: to outperform the UBS Australian Composite Bond Accumulation index by one per cent after fees and costs, in a tax efficient manner, over three to five years. Expected Return Outcome The portfolio is expected to provide the following return outcomes: Provide a reliable tax effective yield, at a premium to cash rates, Portfolio has higher potential volatility than pure bond market exposure, As a mainly credit focussed strategy the portfolio: - is expected to perform well during times of benign and improving credit markets, - will perform below long run expectations during periods of credit market instability, - diversification helps smooth overall portfolio volatility, Portfolio turnover is expected to be moderate (15 to 25 per cent) per annum. General portfolio characteristics MPPM select investments on an after taxation basis and runs a number of variations of the strategy for clients with different taxation status. Most clients are seeking a strategy which benefits from imputation credits and this is a focus of this paper. The following table shows the characteristics of the portfolio as at January 2013: Macquarie Private Portfolio Management 3

5 Table 1: Current Portfolio Characteristics Portfolio sub-sector exposure With Imputation Australian Bond Market Exposure 29.0% Cash 3.1% Listed Interest Rate Securities 67.9% Portfolio 100.0% Portfolio Characteristics With Imputation Expected Gross Internal Rate of Return 5.75% Current Gross Running Yield 5.81% Average Issuer Credit Quality AA to AA- Minimum Issuer Credit Quality BBB- Modified Duration (years) 1.25 Fixed Rate exposure 29.0% Australian bond market exposure characteristics With Imputation Assumed Yield to Maturity (Long Term Assumption) 5.5% Modified Duration (years) 3.8 Number of funds held (Macquarie Enhanced Australian Fixed Interest fund) 100.0% Number of securities within index 250+ Average underlying index constituents credit quality AAA to AA+ Fixed Rate exposure 100.0% Listed Interest Rate Securities (IRS) characteristics With Imputation Expected Gross Internal Rate of Return 5.98% Current Gross Running Yield 6.08% Trading margin above swap rates 3.04% Number of listed IRS held 14 % of listed IRS exposure paying franked distributions 58.8% Fixed Rate exposure 0.0% Source: MPPM, Feb 2013 Strategy Returns The following table shows the Diversified Fixed Interest Strategy recent and longer term returns 1, including imputation credits. Table 2: Diversified Fixed Interest Strategy Returns Source: MPPM, Iress. Jan 2013 N =Returns shown are prior to MPPM Management fees. The gross return shows the assumed after taxation return for a 0% taxpayer entitled to rebate imputation credits. Past performance is not indicative of future performance= Macquarie Private Portfolio Management 4

6 AUSTRALIAN BOND MARKET Why bond market exposure? MPPM believes that in the longer term, a diversified approach to portfolio construction is likely to result in lower portfolio volatility and greater likelihood of meeting the strategy s return objective. Within the Diversified Fixed Interest Strategy, MPPM currently invests in the Macquarie Wholesale Enhanced Australian Fixed Interest Fund to provide clients with exposure to Australian bond markets. This fund is managed by Macquarie Investment Management Limited (MIML) a separate entity to Macquarie Private Portfolio Management. Specifically the following are the key benefits of exposure to the Australian bond market: High credit quality, fixed rate exposure to Australian unlisted bonds (mainly Australian Government debt), Quarterly income stream, Potential for positive returns in the event that the domestic and global economic outlook deteriorates, Materially increases overall portfolio diversification benefits and credit quality, and Performs well in a falling interest rate environment. Current characteristics of the Australian Bond market The following table charts highlights the key characteristics of the UBS Composite All Maturities Bond Index, referred to as the Australian bond market for the purposes of this discussion. Source: MIML, MPPM, Jan 2013 Recent performance of the Australian Bond Market The performance of the Australian bond market has been above average over the last12 months and the five years since Strong returns have been driven by: a moderation in the outlook for domestic growth, reductions in the domestic cash rate to 3% 2, a global flight to safety (increased risk aversion) and significant buying of domestic government bonds from offshore investors. These four drivers have resulted in bond yields falling (driving capital prices of bonds higher). Table 3: Australian Bond Market and the Macquarie Enhanced Australian FI fund returns O =pçìêåéw=o_^=eoéëéêîé=_~åâ=çñ=^ìëíê~äá~i=g~å=omnpf= Macquarie Private Portfolio Management 5

7 Source: MPPM, MIML, Iress. Jan 2013 Movements in Australian Government Bond Yields During 2012, Australian bond markets rallied materially, mainly in the June quarter 2012 due to increased risk aversion, increased buying of domestic bonds by offshore participants and action by the RBA to lower the domestic cash rate. This is illustrated in the following chart which shows that during financial year 2012 the yield on the Australian 10 year government bond fell from 3.7% to 3.3%, and during the June quarter yields hit an all time low of 2.7%. Chart 1: Australian Government Bond Yields (2012 year) 5.00% Australian Commonwealth Government 10 Year Bond Rate % 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 2/01/ /01/ /01/ /02/ /02/ /03/ /03/2012 9/04/ /04/2012 7/05/ /05/2012 4/06/ /06/2012 2/07/ /07/ /07/ /08/ /08/ /09/ /09/2012 8/10/ /10/2012 5/11/ /11/2012 3/12/ /12/ /12/2012 Source: MPPM, Iress. Jan 2013 Given the current valuation of domestic bonds, we expect more muted returns from bond markets in the near future, although remain attracted to their potential to deliver positive returns should the global macroeconomic outlook deteriorate. Macquarie Private Portfolio Management 6

8 Australian Fixed Interest fund exposure The MPPM Diversified Fixed Interest Strategy currently gains exposure to bond markets through the Macquarie Enhanced Australian Fixed Interest fund. This wholesale fund (managed by MIML) has the following characteristics: Low tracking error approach to portfolio construction, with the Fund Manager looking to add value via security selection, sector rotation and yield curve positioning, The strong historical track record relative to the bond index, and also comparable managers. A physical portfolio of fixed interest securities is held, The portfolio only invests in securities issued by investment grade borrowers and cash, All derivative exposure is fully cash backed (bond futures are often used for interest rate risk management), A very competitive Management Expense Ratio (0.19%), and MPPM clients are currently eligible for a partial rebate of this fee (as at January 2013). The key portfolio characteristics of the fund as at 31 st December are as follows: Source: MIML, MPPM, Jan 2013 LISTED INTEREST RATE SECURITIES Why listed interest rate securities? MPPM currently blends its bond market exposure with a range of directly held listed interest rate securities (IRS) that undergo our rigorous portfolio construction requirements. Following are the key benefits/characteristics of the Australian listed IRS market: IRS pay a regular, tax efficient income stream (generally floating rate) at a premium to cash and bond market interest rates, We access a wide range of structures with two common characteristics being: - higher in the capital structure than equity, - a fixed face value (generally $100 per security), MPPM focuses on providing high quality, low beta exposure to this sub-sector, Macquarie Private Portfolio Management 7

9 Exposure to Australian credit markets, which MPPM believes are currently undervalued when compared with long term valuations, Are expected to perform well during times of benign and improving credit markets, Are likely to underperform (relative to Government bonds) during periods of credit market instability, and Are likely to perform well in a rising rate environment (unlike fixed rate bonds). The Listed Interest Rate Securities market? The listed interest rate securities market is a broad collection of income producing investments in a range of fixed interest (or fixed interest like) structures. It has a current market capitalisation of approximately $34.2bn across 74 separate issues 3. As shown in Chart 2, the IRS market has grown steadily in recent years. The predominant issuers have been large, domestic companies with investment grade credit ratings. Investment Grade means the issuer has an independent credit rating from Standards and Poor s, Moody s or Fitch Ratings that is, above the cut off point for the general definition of Investment Grade. The minimum Investment Grade credit rating is BBB- for S&P or Baa3 from Moody s. Securities issued are typically subordinated debt securities or preference equity (they no longer have independent security level credit ratings in the retail/listed market due to regulatory changes in 2010). Chart 2: Historical Market Capitalisation Historical Market Capitalisation : ASX listed interest rate securities $30,000,000,000 $25,000,000,000 $20,000,000,000 $15,000,000,000 $10,000,000,000 $5,000,000,000 $0 Mar-01 May-01 Jul-01 Sep-01 Source: ASX, MPPM, June 2012 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Floating Rate Notes Corporate Bonds Convertible Notes Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 In general, the IRS market provides floating rate credit exposure to investors. Investors benefit from relative capital stability, historically high credit margins, tax effective regular income streams and priority to ordinary equity. P =Source: ASX Dec 2012 Listed Interest Rate Securities market update= Macquarie Private Portfolio Management 8 Hybrids

10 The key structures include: Senior Bonds, Subordinated Debt, Subordinated Floating Rate Notes, Preference Securities and Capital Notes (often referred to as Hybrids, however they generally have no embedded equity price risk). Within these classifications there is a large variety of security characteristics and terms that make each issue unique. Key security characteristics include: regular income stream, priority to ordinary equity, issued by investment grade ASX 200 companies, fixed face value of $100 per security (potential to convert to equity or redeem at face value), 5-7 years expected time to redemption 4. The key risks can be summarised as: credit and market risk, credit spread duration (short term impacts from movements in credit spreads), bank bill swap rate risk (re-investment risk), maturity extension risk (many securities are perpetual securities) and specific terms of issue. Listed Interest Rate Securities versus Equities A key benefit of a listed interest rate security is its priority ranking within the issuer s capital structure. In the event that companies issue further equity, listed interest rate securities remain in priority rather than being diluted as equities would be. The following table outlines the relative ranking of a company s capital structure. As noted, the IRS component of client portfolios MPPM invest includes Senior Bonds, Subordinated Bonds, Subordinated Notes and Preferred Equity. Table 4: Capital Structure The income stream of IRS is more reliable as it is set by the terms of issue, rather than management discretion and is paid in priority to ordinary equity. Most issues have capital restriction clauses which limit the issuer s ability to pay equity dividends or return capital to equity holders unless listed IRS distributions are paid first. Many securities have cumulative interest payments, whilst bank Convertible Preference Q =In many structures redemption at the first call date is not certain, and subject to management discretion or minimum share price requirements in certain circumstancesk= Macquarie Private Portfolio Management 9

11 Shares CPS securities distributions are non-cumulative they are paid in priority to equity dividends and have a set level of required catch up of IRS distributions before equity distributions can resume. Many of the newer structures in particular have maturity dates and material incentives to redeem at the first call date (generally five years). Some of the converting preference shares may be perpetual in nature, however, are likely to redeem earlier unless the issuer suffers financial distress. This is due to the mandatory conversion clauses, potential loss of APRA capital benefits and reputational risks for the issuers. Another key difference between equities and fixed interest is the asymmetric risk profile. Listed interest rate securities have a fixed face value (generally $100 per security) and over time converge to their face value as maturity/redemption approaches. This fixed face value also leads to greater capital stability, when compared to equities. However, listed IRS (and other debt securities) can generally be worth no more than their face value, but can be worth materially less in the event that the issuer defaults. To mitigate the potential for default, MPPM only invests in the higher quality issuers and structures and undertakes a detailed research process at both the issuer and security level. Drivers of Recent Issuance Since November 2011, approximately $19bn has been raised by Australian companies 5. These issues have been dominated by Industrial Companies and Banks/Insurance companies. Key drivers of the increased issuance have been the elevated cost of funding in wholesale markets and strong investor demand for high yielding securities. Other drivers of issuance have been changes to credit rating agencies rating methodologies, the resulting impact on structures and the upcoming introduction of Basel III. Industrial companies have sourced funds from the market by issuing subordinated notes which meet the credit rating agency requirements for equity classification, for a period of time. Generally at the end of year five, the rating agency classification of the security moves from equity to debt, acting as an incentive for the issuer to redeem or replace the security. Recent issuers to take advantage of this structure include: Woolworths, Origin Energy, Colonial Group, Tabcorp, and AGL Energy. Smaller, unlisted or unrated companies have also used senior bond structures to access funding from the market (in light of higher wholesale funding costs). These include Tatts Group and Heritage Bank. During 2012, banks and insurance companies issued two Basel III compliant structures. Westpac and Insurance Australia Group IAG issued CPS structures that meet the new requirements for Tier 1 Capital 6. These Basel III compliant mandatory converting preference securities have important structural differences to the previous structure of bank converting preference securities, due mainly to a contingent capital clause. ANZ Banking Corporation, Westpac Bank and National Australia Bank NAB issued high quality subordinated bond securities meeting the Basel III Tier 2 capital requirement. The attractive terms resulted in strong investor demand and both issuers were able to raise more than $1bn from listed investors with pricing similar to the current wholesale market (above 275bps). 5 Source: MPPM, Iress, ASX Jan 2013 Market Update= S =Tier 1& 2 capital are forms of capital banks are required to hold under APRA and BASEL regulations. T1 is generally more flexible capital than T2. Macquarie Private Portfolio Management 10

12 MPPM has taken advantage of the large amount of new issuance as it provides our portfolios with strong diversification benefits. We have invested in a number of the new securities but have rejected a number of securities as they did not meet our quality filter. Access to deals at IPO means trading occurs off-market and does not incur additional brokerage. For full details of each specific issue please refer to the individual PDS. Table 5: Summary Characteristics of Recent Issues Issuer Security Code Structure Margin Amount Raised ($m) Expected Term to redemption /exchange Final Maturity Woolworths Limited WOWHC Subordinated Note - dated, unsecured, subordinated, cumulative note 325bps years 25 years Origin Limited ORGHA Subordinated Note - dated, unsecured, subordinated, cumulative note 400bps years 60 years Tabcorb Limited TAHHB Subordinated Note - dated, unsecured, subordinated, cumulative note 400bps years 25 years Colonial Group CNGHA Subordinated Note - dated, unsecured, subordinated, cumulative note 325bps 1,000 5 years 25 years AGL Energy AGKHA Subordinated Note - dated, unsecured, subordinated, cumulative note 380bps years 27 years Tatts Group TTSHA Senior Bond 310bps years 7 years Heritige Bank HBSHB Senior Bond 310bps years 5 years Westpac Bank WBCPC Mandatory Converting Preference Share 325bps Gross 1,168 8 years Perpetual Insurance Australia Group IAGPC Mandatory Converting Preference Share 400bps Gross years Perpetual ANZ Bank ANZHA Subordinated Debt 275bp 1, years years National Australia Bank NABHB Subordinated Debt 275bp 1,172 5 years 10 years Source: MPPM, Issue PDS, S&P Global Credit Portal July Universe Concentration The market capitalisation of the sector is approximately $34bn across 74 individual securities 7. When excluding smaller and lower quality securities from the universe: approximately 50 securities are of sufficient size and quality for MPPM to consider for portfolio inclusion. At the issuer level, we consider the universe to be concentrated (as noted in Chart 3 & 4). The following two charts illustrate the composition of the universe. Chart 3: IRS Market Capitalisation of Major Banks ASX Listed IRS Market Capitalisation - Major banks (~60% of universe) 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% ANZ Bank CBA Westpac NAB Source: Iress, MPPM July Chart 4: IRS Market Capitalisations Ex Top 4 Banks T =Source: MPPM, Iress, ASX Jan 2013 Market Update= Macquarie Private Portfolio Management 11

13 ASX Listed IRS Market Capitalisation - Non Big 4 bank (~40% of universe) 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Suncorp Colonial Group Insurance Australia Group Origin Energy Woolworths AGL Energy Macquarie Group Tabcorp Group Seven Media Multiplex Bendigo Bank Macquarie Bank Goodman Group Paperlinx Australand Ramsay Healthcare Nufarm Transpacific Industries Australian Foundation AMP Bank of Queensland Primary Healthcare Elders Healthscope Ltd ALE Property Australian Unity Gunns Brookfield Peet & Co. Source: Iress, MPPM July Like the Australian wholesale corporate debt market, the majority of issuance comes from high credit quality banks and other financial issuers. Key details of the universe include: 50 securities across 33 different issuers, 95.5% of the universe is floating rate, major domestic banks dominate the universe, with the four major Australian banks comprising 60% by market capitalisation (ANZ 20.5%, CBA 18.5%, WBC 12.9%, and NAB with 8.7%) or 42% by the number of securities (14), The next 29 issuers account for 40% of the sector. We consider the universe large enough to provide suitable diversification across each individual issuer however; we acknowledge the portfolio is skewed to major domestic banks. At the portfolio level we currently have a 10% maximum issuer exposure rule, but generally hold a position size of 4%-7%. This results in a portfolio holding individual securities from a range of issuers, as well as a diversified bond fund exposure via the Macquarie Enhanced Index Fixed Interest Fund. Liquidity Given the purpose of the investment is to source a regular income stream, investors in IRS often take a buy and hold approach to investing. As a result, annualised turnover is moderate at approximately 20% per annum 8 (around 1/5 of the ASX 200 equity market which generally has turnover of greater than 100% per annum). At times of market crisis or where credit concerns regarding a specific issuer arise, liquidity can tighten and result in volatile price behaviour. MPPM manages liquidity in a number of ways, including; blending investments between the bond fund, cash and listed IRS, setting issuer risk limits, security and tenure diversification, high quality focus (issuer, size and terms of issue) and taking a medium to long term investment horizon. Additionally, we deal with a variety of institutional brokers who have dedicated dealing desks that focus on the IRS universe. We U =Source: ASX May 2012 listed IRS market update. Macquarie Private Portfolio Management 12

14 typically use off market transactions such as IPO s, buybacks and redemptions as our key source of liquidity. Current Valuation We currently consider the valuation of IRS to be attractive due to high credit margins available for investors. Grossed up income streams are almost double the current cash rate (before management fees). Individual security returns range from 200bps to 600+bps depending on both the issuer, structure and security specific terms of issue, with an average of approximately 325 basis points (as at Dec 2012) based on our modelling of the sector. Securities with more flexible terms of issue, uncertainty regarding near term redemption events, long times to maturity or lower credit quality generally trade at higher margins. Trading margins available for investment increased during 2012, as a result of an increase in risk premiums and technical factors, such as new issuance in the market, however over the last few months the risk premiums/margins have been reducing, driving capital values of securities higher. The following chart shows the movement in the Australian Corporate Itraxx Index since January This chart highlights credit spreads are currently elevated and that a material premium exists in the listed IRS market relative to senior debt. We expect credit margins to remain elevated and somewhat volatile in the medium term. (Note: Prior to 2007 average margins from the listed universe was ~1% with investors not pricing more flexible structures as widely as they do now). Investors buying into the portfolio can now lock in the 3% margin above the bank bill swap rate for the medium term (3-5 years). Chart 5: Corporate Itraxx Bond Index Australian Domestic Itraxx Index (Corporate Credit Spreads): Jan Dec Basis Points (100 = 1.00%) Average Listed IRS Gross Credit Margin, Jan /01/2010 1/02/2010 1/03/2010 1/04/2010 1/05/2010 1/06/2010 1/07/2010 1/08/2010 1/09/2010 1/10/2010 1/11/2010 1/12/2010 1/01/2011 1/02/2011 1/03/2011 1/04/2011 1/05/2011 1/06/2011 1/07/2011 1/08/2011 1/09/2011 1/10/2011 1/11/2011 1/12/2011 1/01/2012 1/02/2012 1/03/2012 1/04/2012 1/05/2012 1/06/2012 1/07/2012 1/08/2012 1/09/2012 1/10/2012 1/11/2012 1/12/2012 1/01/2013 Date Source: Iress, MPPM, Bloomberg, Jan Macquarie Private Portfolio Management 13

15 The other key driver of valuations is the movement in the bank bill swap rate (BBSR), as 95% of the universe has a floating rate income stream. The BBSR is currently 2.95% (as at Jan 2013) effectively pricing in a chance of another Reserve Bank of Australia (RBA) rate cut in the near term. Given the current outlook for the domestic economy and the fact the RBA has already cut the domestic cash rate to 3.0% (from 4.25% in April 2012) we expect the BBSR to stabilise around current levels, although may go slightly lower later in the year ahead if the RBA lowers interest rates further. A material deterioration of European sovereign debt outlook or China as our major trading partner could see the RBA cutting rates beyond our base case (which is that only moderate further rate cuts are likely in the near term). We consider the listed interest rate security universe currently offers an attractive income stream due to high margins and tax effective imputation stream. The income stream and expected internal rate of return available is almost 100% higher than the current cash rate (the portfolios current IRR is approximately 5.8% vs. the current cash rate at 3.0%) and lower than risk government bonds, this represents an appropriate premium for structural subordination. MPPM s INVESTMENT PROCESS 1. MPPM s Investment Approach MPPM has a thorough investment process with more than ten years experience constructing Fixed Interest mandates. We draw upon internal proprietary research as shown above that is supplemented and tested against third party fixed interest, credit rating and listed IRS specific research (which is sourced through our external broking arrangements). Fixed Interest Funds - MPPM review fixed interest funds prior to investment, with focus on track record, quality of underlying exposure, tracking error, risk, liquidity, style and fees. The portfolio weighting to fixed interest funds depends upon MPPM s outlook for domestic interest rates, yield curve, risk environment and the relative opportunities available in listed interest rate securities and the Macquarie Private Portfolio Management 14

16 various categories of unlisted wholesale debt including Commonwealth Government Bonds, Semi Government Bonds, Corporate Bonds/FRN s and asset backed instruments. Additionally, all underlying exposure within any selected fund must have an independent credit rating that meets the traditional definition of Investment Grade and geared funds are excluded from investment. Our research and investment process within the listed universe can be best described as quality at a reasonable after taxation value. We have a strong focus on quality at the issuer level (in terms of credit quality and equity outlook) and specific focus on quality at the structure level, which is particularly important given the diverse terms available at the security level. We undertake credit and equity research on the securities prior to investment to determine our own internal shadow credit ratings. In addition to issuer research the terms of issue must meet our requirements with regards to fixed interest characteristics and solid risk and return characteristics. In summary we focus on: Is it a good issuer? Is it a good structure? Does it offer value on a risk adjusted basis? Our portfolio construction approach screens out issuers who don t meet our credit quality requirements (that is, it must be an Investment Grade issuer) or minimum issue size and maximum delta (if any). Securities not meeting these criteria will not be considered for portfolio inclusion. Our portfolio construction approach generally takes a long term view, with the expectation that we will buy and hold securities until maturity, although we actively trade the portfolio where risk adjusted valuations move beyond our tolerance bands or to take advantage of mispriced securities. Risk Management MPPM has a robust risk management process in place. It starts with a set of risk constraints that form the investible universe and cascades through the process to how an investment is approved for inclusion in a portfolio. From there, we have daily client level controls in place that flow through mandate compliance and security and trade monitoring. Macquarie Private Portfolio Management 15

17 Strategy Performance & Volatility Charts The following two charts highlight the positive returns achieved, during volatile equity market conditions during recent years, with less volatility than the equity market. Chart 6: MPPM Diversified FI Strategy vs. the All Ordinaries Accumulation Index 32.5% 30.0% 27.5% 25.0% 22.5% 20.0% 17.5% 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% -2.5% -5.0% -7.5% -10.0% -12.5% -15.0% 3/01/10 3/02/10 3/03/10 MPPM Diversified Fixed Interest strategy gross return (with imputation) vs Domestic Equity market Period: Jan Dec 2012 MPPM Diversified FI Strategy Gross Return ASX 200 Equity Accumulation Index Return 3/04/10 3/05/10 3/06/10 3/07/10 3/08/10 3/09/10 3/10/10 3/11/10 3/12/10 3/01/11 3/02/11 3/03/11 3/04/11 3/05/11 3/06/11 3/07/11 3/08/11 3/09/11 3/10/11 3/11/11 3/12/11 3/01/12 3/02/12 3/03/12 3/04/12 3/05/12 3/06/12 3/07/12 3/08/12 3/09/12 3/10/12 3/11/12 3/12/12 Source: MPPM, Iress, Jan 2013, Prior to fees. Chart 7: Daily Volatility of MPPM Diversified FI Strategy vs. Australian Equity Market 5.0% Daily Volatility: MPPM Australian Diversified FI Strategy vs Equity Market Period: Jan Dec % 3.0% 2.0% 1.0% 0.0% 3/01/2012 3/12/2011 3/11/2011 3/10/2011 3/09/2011 3/08/2011 3/07/2011 3/06/2011 3/05/2011 3/04/2011 3/03/2011 3/02/2011 3/01/2011 3/12/2010 3/11/2010 3/10/2010 3/09/2010 3/08/2010 3/07/2010 3/06/2010 3/05/2010 3/04/2010 3/03/2010 3/02/2010 3/01/2010 3/12/2012 3/11/2012 3/10/2012 3/09/2012 3/08/2012 3/07/2012 3/06/2012 3/05/2012 3/04/2012 3/03/2012 3/02/ % -2.0% -3.0% -4.0% -5.0% MPPM Diversified FI Strategy ASX 200 Equity Accumulation Index Source: MPPM, Iress, Jan 2013 Macquarie Private Portfolio Management 16

18 The following chart highlight the positive returns achieved, compared to the domestic bond market Chart 8: MPPM Diversified FI Strategy vs. the UBS All Maturities Composite Bond Accumulation Index 30.0% MPPM Diversified Fixed Interest Strategy Return vs. Domestic Bond Market Return Period: Jan Dec % 20.0% 15.0% Return 10.0% 5.0% 0.0% -5.0% 3/01/2010 3/02/2010 3/03/2010 3/04/2010 3/05/2010 3/06/2010 3/07/2010 3/08/2010 3/09/2010 3/10/2010 3/11/2010 3/12/2010 3/01/2011 3/02/2011 3/03/2011 3/04/2011 3/05/2011 3/06/2011 3/07/2011 3/08/2011 3/09/2011 3/10/2011 3/11/2011 3/12/2011 3/01/2012 3/02/2012 3/03/2012 3/04/2012 3/05/2012 3/06/2012 3/07/2012 3/08/2012 3/09/2012 3/10/2012 3/11/2012 3/12/2012 Date MPPM Diversified FI Portfolio Cash Return Domestic Bond Market MPPM Diversified FI Portfolio Gross Return (includes imputation credits) Source: MPPM, Iress, Jan 2013, Prior to fees. SUMMARY We employ a rigorous research process with respect to the MPPM Diversified Fixed Interest strategy, and have been managing fixed interest portfolios since Our research and experience supports our current view that the IRS sector is offering attractive margins over bank bill swap rates, whilst bond markets can continue to offer a hedge should the economic outlook deteriorate. The IRS market provides a lower risk alternative to equity markets, with a tax effective regular income stream. Its structure and diversification provides investors with an option to source a reliable income stream at attractive margins. Should you have further questions about MPPM s Diversified Fixed Interest strategy or its suitability for inclusion in your portfolio, please contact your adviser for more information. Macquarie Private Portfolio Management 17

19 This document contains purely factual information and/or general advice and does not take into account your objectives, financial situation or needs and, before acting on this information, you should consider whether it is appropriate to your situation. Macquarie Equities Limited is a related body corporate of Macquarie Private Portfolio Management Limited and will receive brokerage in respect of transactions entered into on your behalf by Macquarie Private Portfolio Management Limited. This discussion paper and investment strategy is indicative only. The appropriateness of the investment strategy referred to in this document is general in nature only; it should not be construed as a general endorsement of the investment strategy as being appropriate for all investors. Potential investors are advised to seek professional legal, financial and taxation advice on the implications of investing with respect to their own particular circumstances. This paper has been prepared by Macquarie Private Portfolio Management Limited ABN ( MPPM ) Australian Financial Services license no and is current as at March Macquarie Enhanced Australian Fixed Interest Fund ARSN ( Fund ) is offered by Macquarie Investment Management Limited ABN , AFSL ( MIML ). Investments in the Fund are not deposits with or other liabilities of Macquarie Bank Limited ABN or any Macquarie Group company and are subject to investment risk, including possible delays in repayment and loss of income or principal invested. None of Macquarie Bank Limited, MIML or any other member company of the Macquarie Group in any way stands behind or guarantees the performance of the Funds or the repayment of capital from the Funds or any particular rate of return. This presentation contains factual information and/or general advice and does not take account of your objectives, financial situation or needs. Due care and attention has been used in the preparation of any forecast information, however actual results may vary from forecasts and any variation may be materially positive or negative. No members of the Macquarie Group give, nor does any member purport to give, any taxation advice. The taxation information in this document is based on laws current at the time of writing. The application of taxation laws to each investor depends on that investor s individual circumstances. Accordingly, investors should seek independent professional advice on taxation implications before making any investment decisions. This paper is based on information obtained from sources believed to be reliable but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. No member of the Macquarie Group accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this research and/or further communication in relation to this research. Past performance is not a reliable indicator of future performance. Any forecasts contained in this presentation, are predictive in character and therefore investors should not place undue reliance on the forecast information. The forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The actual results may differ substantially from the forecasts and some facts and opinions may change without notice. The Macquarie Group or its associates, officers or employees may have interests in the financial products referred to in this presentation by acting in various roles including as investment banker, underwriter or dealer, holder of principal positions, broker, lender, director or adviser. Further, they may act as market maker or buy or sell those securities as principal or agent and, as such, may effect transactions which are not consistent with the recommendations (if any) in this presentation. The Macquarie Group or its associates may receive fees, brokerage or commissions for acting in those capacities and the reader should assume that this is the case. References to S & P in this presentation are references to Standard & Poor s (Australia) Pty Ltd ABN Credit-related analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase, hold, or sell any securities or to make any investment decisions. Macquarie Private Portfolio Management 18