ETFs 302: Understanding Fixed Income ETFs --- Facts & Fantasies. Sponsored by:

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1 ETFs 302: Understanding Fixed Income ETFs --- Facts & Fantasies Sponsored by:

2 SPEAKERS MODERATOR SPEAKER SPEAKER Matt Hougan Chief Executive Officer Inside ETFs Bill Ahmuty Head of SPDR ETF Fixed Income Group State Street Global Advisors David Mazza Head of ETF and Mutual Fund Research State Street Global Advisors

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6 ETFs 302: Understanding Fixed Income ETFs: Facts & Fantasies July 2016 FOR INVESTMENT PROFESSIONAL USE ONLY. Not for use with the public. IBG-20107

7 Table of Contents 1. Stock & Bond Market Structure Overview 2. Fixed Income ETF Landscape and Liquidity 3. What to Do? Appendix A: Important Disclosures All the information contained in this presentation is as of date Indicated unless otherwise noted. IBG

8 Stock & Bond Market Structure Overview Where and how Stocks and Bonds Trade Source: State Street Global Advisors as of March 31, IBG

9 Differences between equity and fixed income market structure Equity Markets Well defined trading hours Ability to handle large program trades Fixed Income Markets Prevalence of electronic trading OTC (dealer-based model) Market on close Efficient reporting of trades Publicly displayed, clear, transparent order book Transparent fees Direct retail participation Exchange-based model Prevalence of electronic trading IBG

10 Trades by appointment only How often do these bonds even trade? According to a recent report by analysts at Deutsche Bank, Roughly 1/4th of HY and 1/3rd IG bonds rarely ever trade and could go for months without a single real print on the tape After new issue, between days one and five, average volume drops by 80% in HY, and by 65% in IG One-year-old bonds represent around 20% of both IG and HY benchmarks, but 35% of trading activity. Generally, bonds turn from liquidity magnets to liquidity drains when they turn between 2-3 years old. Net Result: Indexes tracking thousands of ISINs on a daily basis are routinely guessing values for 25% 40% of their constituents Volume Decay in new issues by days since placement HY cumulative share of volumes by age Source: Deutsche Bank, as of May 6, Source: Deutsche Bank, As of May 6, IBG

11 Changes in the Structure of Primary Dealer Balance Sheets Regulation and policy changes stemming from the financial crisis have led to higher capital charges and restrictions on proprietary trading leading to a reduction in dealer balance sheet The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law July 2010, which includes the Volcker Rule Basel III is the third installment of the Basel Accords, which are global, voluntary regulatory frameworks on bank capital adequacy, stress testing, and market liquidity $300B $250B $200B $150B $100B $50B $0B Notional Value of Fixed Income (RMBS, ABS, CP, Corp) Dealer Inventories* Source: NY FED Dealer Balances; ICI.* IBG

12 Principal Model Buy-Side A/C Dealer IBG

13 Agency Model Who Asset Manager Buy-Side A/C Wants Hedge Fund To Buy Dealer This? Other Inst. Clients IBG

14 Fixed Income ETF Landscape and Liquidity Liquidity and Trading Qualities Source: State Street Global Advisors as of March 31, IBG

15 Liquidity Spectrum SMA Mutual Fund ETF What is an ETF? A basket of securities that tracks the performance of a broad or specific market segment Like stocks, and unlike mutual funds, shares of ETFs are bought and sold on the exchange throughout the day In many cases, ETFs may offer investors lower expenses, greater transparency and improved tax efficiency relative to mutual funds that track the same market segments You can buy ETFs in nearly every possible asset class Liquidity Spectrum SMA MF ETF Description Privately held portfolio Exchange listed Exchange Listed Intra day pricing Price Transparency Customized per Investment management agreement (IMA) No intra day price Liquidity/Accessibility No intra day trading Dependent on IMA Guidelines End of day NAV Intra day pricing Primary market Primary and secondary market Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. IBG

16 US Exchange Listed ETFs by Asset Class US Exchange Listed ETFs by Asset Class ($mm) 2,500,000 2,000,000 1,500,000 1,000, , /29/ /31/ /31/ /31/ /31/ /30/ /29/ /31/ /31/ /31/ /31/ /30/ /31/ /31/ /31/ /31/2015 6/30/2016 Specialty Mixed Allocation Fixed Income Equity Commodity Alternative US focused fixed income ETF assets climbed to ~$423 Billion, as of June 30 th, 2016 Source: Bloomberg Finance, L.P. as of June 30, IBG

17 Fixed Income ETF Market Profile Market Size Data: SIFMA (Q1 2016), Barclays (June 6th, 2016), The Loan Syndications & Trading Association (LSTA) (June 30th, 2016). ETF AUM: Bloomberg Finance, L.P. as of (June 30th, 2016). Average Daily Volume (3M ADV) Bond Trading: Bloomberg Finance, L.P. as of June 30th, 2016, EMTA (Q1 2016). Average Daily Volume (3M ADV) ETF Trading: Bloomberg Finance, L.P. as of (June 30th, 2016). IBG

18 Fixed Income Markets and Liquidity High Yield ETFs have become a valuable trading tool. During periods of high volatility we see increased secondary market activity. Yet concerns over High Yield ETF liquidity remain. Source: SPDR ETF Capital Markets Group, Bloomberg Finance, L.P. IBG

19 HY ETF Trading Behavior Premium & Discount As the market for HY ETFs has matured, we have seen less volatility of the ETF premium/discount around the NAV, and trading tighter to NAV on average In 2015, JNK traded at a discount to NAV only 20 days The largest discount recorded was 68 bps (12/11/2015), and eight of those sessions was less than 5 bps JNK Premium & Discount (%) Source: Bloomberg Finance, L.P., as of December 31, IBG

20 ETF Liquidity During High Yield Sell-Off (December 2015) JNK traded over $3.84B during the week of December 7 11, including two separate days near $1.2B each JNK saw $1.467B of redemptions during the week The secondary to primary volume ratio also maintained its stability, demonstrating that ETF liquidity continues to be additive to the market High Yield Sell-Off (December 2015) The fund maintained its close relationship to its NAV, continuing to trade within a narrow band JNK s price fell 2.01% on 12/11, closing at 68 bps discount to NAV Source: Bloomberg Finance, L.P. as of December 31, Past performance is no guarantee of future results. There can be no assurance that a liquid market will be maintained for ETF shares. IBG

21 Fixed Income ETFs Trading Fixed Income ETFs generally trade at a premium to net asset value under normal market conditions as fixed income ETF NAVs are typically priced on the bid side The premium or discount of the ETF market price to the Net Asset Value (NAV) of the underlying basket can be a catalyst for the create/redeem process As the ETF decreases in value relative to the portfolio, arbitrageurs are incented to buy the ETF, redeem units in the ETF and sell the bonds for a profit As the ETF increases in value relative to the portfolio, arbitrageurs are incented to aggregate bonds, create units in the ETF and sell the ETF for a profit Factors for FI ETF Pricing NAV calculation Creation Process In Kind or Cash Costs to transact in underlying market Borrow cost on ETF Creation Fees Investor Sentiment Underlying market volatility, headline news, default risk, sensitivity to rate movements The premium or discount of the ETF market price to the Net Asset Value (NAV) of the underlying basket can be a catalyst for the create/redeem process IBG

22 What to Do? Build Better Bonds and Go Beyond the Agg IBG

23 1) Re-Weighted Aggregate Bond Sectors to 50% Corp/50% Other By re-weighting the Agg by its sub-sector components, the portfolio becomes less skewed towards Treasuries. Duration has been lowered, but the portfolio still remains very dependent on interest rate sensitivity. Portfolio Weights versus the Barclays US Aggregate Bond Index Characteristics and Risk Decomposition Bond Sector Breakdown Risk Decomposition Source: State Street Global Advisors, as of March 31, * Barclays US Aggregate Bond Index. Past performance is not a guarantee of future results. It is not possible to invest directly in an index. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. All Risk measures are derived from Bloomberg Finance, L.P. Fixed Income Risk Model and are expected risk measures forecast over the next calendar year. Forward looking risk factors are generated by means of a mathematical formula using the Bloomberg Finance, L.P. Fixed Income Risk Model which includes historical volatilities, correlations and sensitivities to interest rates, credit spreads and risk factors and assumes a time horizon of 1 year. It does not reflect actual trading and does not reflect the impact that material economic and market factors may have on a Portfolio. IBG

24 2) Expand Beyond the Agg to Balance Interest and Credit Risk A blend of exposures can be used to expand beyond Aggregate Fixed Income sectors, to increase yield and lower duration of a fixed income allocation, while striking a balance between credit and interest rate risk Portfolio Weights versus the Barclays US Aggregate Bond Index Characteristics and Risk Decomposition Sector Weights (%) Risk Decomposition IBG

25 3) Go Active in the Core With uncertainty over macro policy remaining high and difficult for investors to predict, an actively managed core fixed income strategy may play a critical role in a portfolio by seeking to provide stability, diversification and income IBG

26 A Potential Solution? SPDR DoubleLine Total Return Tactical ETF TOTL With TOTL, investors may rely on DoubleLine Capital s experience to help navigate an uncertain macro environment by allocating across multiple bond subsectors and applying individual security selection to potentially provide income, stability, and diversification IBG

27 Standard Performance IBG

28 Appendix A: Important Disclosures 28 IBG-20107

29 Important Disclosures Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. The values of debt securities may decrease as a result of many factors, including, by way of example, general market fluctuations; increases in interest rates; actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments; illiquidity in debt securities markets; and prepayments of principal, which often must be reinvested in obligations paying interest at lower rates. Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable. Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment. Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmark. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment. Non-diversified funds that focus on a relatively small number of issuers tend to be more volatile than diversified funds and the market as a whole. Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. IBG

30 Important Disclosures (continued) The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The Fund may invest in US dollar-denominated securities of foreign issuers traded in the United States. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any particular fund. The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data. Standard & Poor s, S&P and SPDR are registered trademarks of Standard & Poor s Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street Corporation s financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index. State Street Global Markets, LLC is the distributor for all registered products on behalf of the advisor. SSGA Funds Management has retained DoubleLine Capital LP as the sub-advisor. DoubleLine is a registered trademark of DoubleLine Capital LP. DoubleLine Capital LP are not affiliated with State Street Global Markets, LLC. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call or visit Read it carefully State Street Corporation All Rights Reserved. Tracking Number: IBG Expiration Date: 10/31/2016 Not FDIC Insured No Bank Guarantee May Lose Value IBG

31 SPEAKERS MODERATOR SPEAKER SPEAKER Matt Hougan Chief Executive Officer Inside ETFs Bill Ahmuty Head of SPDR ETF Fixed Income Group State Street Global Advisors David Mazza Head of ETF and Mutual Fund Research State Street Global Advisors