GROWTH FIXED INCOME APRIL 2013

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1 GROWTH FIXED INCOME APRIL 2013 BACKGROUND Most investors view fixed income investments as providing a liability-matching or defensive aspect to their total portfolio. The types of investments considered for these purposes typically include federal bonds, provincial bonds and investment grade credit issues. However, there are a variety of fixed income investments which should be considered for their role in an investor s growth portfolio where the focus is more on generating wealth, as opposed to preserving wealth or hedging liabilities. The return drivers of most portfolios are heavily concentrated in the equity risk premium. We believe that most investors should diversify their growth portfolio beyond public equities into: Real assets (primarily real estate and infrastructure), Private equity, Hedge funds, and Growth fixed income. These alternative asset classes can enhance growth portfolios by offering good return potential along with providing significant diversification and inflation-protection benefits. Various investor-specific circumstances and constraints (e.g., need for liquidity, desire for inflation protection, tolerance for complexity, governance resources, etc.) will impact the exact composition of a growth portfolio, but we generally believe that an allocation of up to 20% of the growth portfolio should be considered. This paper provides a summary of our views on the various opportunities within the growth fixed income category and general guidance regarding growth fixed income portfolio construction. Many of these growth fixed income strategies would be expected to outperform traditional fixed income mandates in a rising interest rate environment. While rising interest rates are not a certainty, there is widespread belief that this will happen eventually. Consequently, these growth fixed income opportunities should be of interest to many investors. We do not address government bonds or investment grade credit (which most investors regard as being part of their defensive portfolio or liability-hedging portfolio). We would be pleased to share our more detailed materials on this subject with you, and would be happy to discuss growth fixed income opportunities further.

2 THE GROWTH FIXED INCOME OPPORTUNITY SET The fixed income opportunity set continues to evolve and grow. Table 1 provides a high level description of the key components of the growth fixed income opportunity set and the underlying investment rationale for their use. Table 1: The growth fixed income opportunity set INVESTMENT DESCRIPTION INVESTMENT RATIONALE Emerging market debt High yield bonds Bank loans (also known as secured or leveraged loans) Private debt (or private credit) Absolute return bond strategies Multi-asset credit strategies Unconstrained bond strategies Investing in the sovereign debt of emerging markets. This can be debt issued in local currency or in hard currency (i.e., USD). Investing in the debt issued by companies which are below investment grade (i.e., have a credit rating that is lower than BBB- or equivalent). Investing in loans to non-investment grade, mid to large-sized, corporate borrowers. Bank loans are senior in the capital structure and are typically secured by the borrower s assets and will tend to have priority rights. They are floating rate in nature with a coupon return comprised of a nominal spread over LIBOR, for example a coupon of LIBOR + 4%. Typically, private debt relates to capital provided to borrowers involved in infrastructure projects, real estate and private equity financing (amongst others). These approaches are more about accessing a basket of alpha opportunities. They are generally designed to deliver a positive return in all market environments by using long and short positions with limited (if any) directionality. The better approaches should be uncorrelated with growth assets when the latter are doing badly, but will have a higher degree of correlation when equities are rising. These strategies seek to invest in a wide variety of credit exposures (many set out above) with a view to providing active management of beta exposures (e.g., loans versus high yield) by rotating between the different opportunities. Many of these strategies will also 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. These 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 securitized debt (e.g., asset-backed securities). Some products may also stray into high yield and emerging market debt. Exposure to higher yields on improving sovereign credits. Positive relative growth dynamics should also provide currency appreciation over time. Diversification of corporate credit risk. The yield pick-up should more than offset realized defaults over time. Floating rate, so income rises in line with interest rates. Seniority in capital structure, negative covenants and lack of spread duration provide downside protection. Offers long term yield premium as compensation for illiquidity. Uncorrelated sources of alpha. Strong diversification benefits due to emphasis on downside protection. Dynamic beta management across less liquid and non-traditional multi-asset credit exposures, but very productdependent as some will have an allocation to investment grade credit and others also to distressed credit. Dynamic beta management across traditional fixed income categories. Provides exposure to security selection and currency alpha. 2

3 PORTFOLIO CONSTRUCTION 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 further diversification. Some of the other opportunities, such as bank loans and high yield bonds may be attractive at times, but are likely to be more cyclical in nature. For example, high yield bonds have performed well recently and have attracted significant investor capital, including retail flows, so this opportunity is currently less attractive. We believe 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 considering exposure to multi-asset credit strategies where a manager is allocating to their best ideas across the fixed income spectrum and has some flexibility to rotate between the different opportunities. As with the overall growth portfolio, investors decisions on which fixed income opportunities to access will depend on a number of considerations including: Strategic rationale what do investors want to achieve from the allocation? Governance what investment structures are feasible for the investor? Liquidity how do these investments impact the investor s illiquidity budget? View on active management how much discretion should be provided to a manager? Putting investor-specific considerations aside, we set out in Table 2 an Aspirational portfolio for investors who are unconstrained and have a focus on growing their assets and generating returns from multiple sources. This portfolio currently represents our best (generic) advice for growth fixed income portfolio construction (i.e., our Best of Mercer view). We also present some additional, simpler portfolios in Table 2 that may be better suited to certain investors. Table 2: Suggested growth fixed income portfolio construction INVESTMENT PORTFOLIO 1 ASPIRATIONAL (BEST OF MERCER) PORTFOLIO 2 ASPIRATIONAL SIMPLIFIED PORTFOLIO 3 SIMPLE AND LIQUID PORTFOLIO 4 LOWER RISK Emerging market debt (local) 20% - 40% 40% - 60% 30% - 60% 30% - 40% High yield bonds % - 60% Bank loans % - 40% Private debt 20% - 40% - - Absolute return bonds 0% - 30% % - 40% Multi-asset credit strategies 20% - 40% 40% - 60% - - Unconstrained bonds - - 0% - 30% - Total 100% 100% 100% 100% 3

4 Portfolio 1: 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. Should the investor wish to add some defensiveness, this can be done by adding absolute return bonds into the mix. Governance could be challenging, as it will involve appointing a number of managers and will include illiquid opportunities. It is designed for investors who are tolerant of complexity and illiquidity and for whom growth fixed income allocations are a significant part of the overall allocation and therefore are willing to access broad a basket of return sources. Portfolio 2: This portfolio is designed to capture a basket of beta opportunities in a fairly simple manner. 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. Portfolio 3: This portfolio is designed to be liquid and simple. For investors who already have exposure to emerging market debt, the next opportunity which they should consider is high yield. However, high yield is currently less appealing 1, so we suggest that investors consider warehousing this allocation to absolute return bond strategies or an unconstrained bond strategy while waiting for a more opportune entry point. Governance should be straightforward apart from the challenge of managing the entry point. Portfolio 4: This portfolio is less sensitive to credit and interest rate risk and should hold up reasonably well in a rising rate or a rising credit spread environment. The portfolio is designed to be more defensive in nature. In our view, the absolute return bond strategies should be adequately diversified, which contributes to making this portfolio more challenging from a governance perspective as it requires appointing additional fixed income managers. The return expectations from this portfolio are expected to be the lowest, but this is also likely to be the most stable portfolio. ADDITIONAL IMPLEMENTATION CONSIDERATIONS Some investors (e.g., where smaller investment funds are involved, or in defined contribution pension plans) may find even the simplified sample portfolios described above challenging to implement. In those situations, we recommend that investors at least consider core plus fixed income mandates as an easy-to-implement option which can capture at least some of the growth fixed income opportunities presented here. There are a number of core plus fixed income mandates offered in pooled fund vehicles to Canadian investors, and some of these are beginning to appear on defined contribution recordkeeper platforms. These mandates often benchmarked to the DEX Universe Bond Index and sometimes available benchmarked to the DEX Long Bond Index make use of out-of-benchmark, mostly non- Canadian fixed income and derivative strategies (including foreign investment grade credit, high yield and emerging market debt exposure) in order to attempt to achieve more aggressive excess return targets. 1 The yields on US high yield bonds have fallen to record lows the yield on the BarCap High Yield Bond Index was only 6.1% as of December 31,

5 RISK AND RETURN Table 3 summarizes the returns and volatility experienced over the period 2003 to 2012 (in USD): Table 3: Historical returns and volatility from 2003 to 2012 (in USD) ASSET CLASS RETURN RISK INDEX/SOURCE Emerging market debt (local) 12.3% 11.9% JPM GBI-EM GD Index Global High Yield 11.0% 11.4% BoA ML Global High Yield Index Senior Loans 6.1% 7.0% Mercer Median US Leveraged Loan Universe Private debt 10.1% 5.9% Mercer Median Distressed Debt Universe (net of fees) Absolute Return 4.8% 2.9% Mercer Median Int l Fixed Absolute Return Universe Multi-asset credit 10.0% 5.1% Mercer Median Multi-asset Credit Universe (net of fees) Unconstrained Bonds 7.1% 5.9% Mercer Median Int l Unconstrained Bond Universe Global Credit 6.2% 7.0% Barclays Capital Global Aggregate Credit Index Future returns are generally expected to be lower than those indicated above given the reduction in bond yields experienced over the last 10 years. For the four portfolios described earlier, Table 4 provides some preliminary expectations for future returns, along with historic measures of volatility (based on experience from 2003 to 2012). Table 4: Historical volatility and preliminary estimates of future return PORTFOLIO 1 PORTFOLIO 2 PORTFOLIO 3 PORTFOLIO 4 Expected return 6.8% - 7.8% 6.0% - 7.0% 5.1% - 6.1% 4.4% - 5.4% Risk (historic) 6.3% 7.6% 10.0% 6.1% CONCLUDING REMARKS We believe that lower-rated credit will likely play a greater role in investors portfolios. There are attractive 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. Some parts of the credit market tend to be more cyclical than, say, equities, and also some of the emerging opportunities are illiquid in nature. We have put forward four possible portfolios. These range from Mercer s preferred portfolio assuming that an investor does not have any major constraints to simpler portfolios for investors seeking to take a step-by-step approach. In the end, investor-specific objectives and constraints should be taken into account to determine the most appropriate portfolio construction. For those investors who find even the simplified sample portfolios described above challenging to implement, we recommend that they at least consider core plus fixed income mandates as an easy-to-implement option which can capture at least some of the growth fixed income opportunities presented here. 5

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