Horizon 1 - Bond Portfolio Annual Review September 2009 Investment Management Level 12, 105 153 Miller Street North Sydney NSW 2060 review for the year ending 30 September 2009 Page 1 of 11
Important information This information has been provided by Limited (ABN 90 000 000 402) a member of the National Group, 105-153 Miller Street, North Sydney 2060. This material was prepared for advisers only. Any advice in this communication has been prepared without taking account of individual objectives, financial situation or needs. Because of this you should, before acting on any information in this communication, consider whether it is appropriate to your objectives, financial situation and needs. You should obtain a Product Disclosure Statement or other disclosure document relating to any financial product issued by Investments Limited (ABN 30 002 641 661) and Nominees Pty Ltd (ABN 93 002 814 959) as trustee of The Universal Super Scheme (ABN 44 928 361 101), and consider it before making any decision about whether to acquire or continue to hold the product. A copy of the Product Disclosure Statement or other disclosure document is available upon request by phoning the call centre on 132 652 or on our website at mlc.com.au. An investment in any product offered by a member company of the National group does not represent a deposit with or a liability of the National Australia Bank Limited ABN 12 004 044 937 or other member company of the National Australia Bank group of companies and is subject to investment risk including possible delays in repayment and loss or income and capital invested. None of the National Australia Bank Limited, Limited, Investments Limited or other member company in the National Australia Bank group of companies guarantees the capital value, payment of income or performance of any financial product referred to in this publication. Past performance is not indicative of future performance. The value of an investment may rise or fall with the changes in the market. Please note that all return figures reported are before management fees and taxes, and for the period up to 30 September 2009, unless otherwise stated. The specialist investment management companies are current as at 30 September 2009. Funds under management figures are as at 30 September 2009, unless otherwise stated. Investment managers are regularly reviewed and may be appointed or removed at any time without prior notice to you. review for the year ending 30 September 2009 Page 2 of 11
Horizon 1 Bond Portfolio About your Portfolio Your Horizon 1 Bond Portfolio is designed to be a complete portfolio solution. It is well diversified within asset classes, across asset classes and across investment managers, who invest in many companies and securities around the world. We are focussed on growing your wealth for a low to moderate level of volatility. We won t chase risky returns when markets are very strong, which may temporarily result in a lower return than comparable funds that do. At other times, and particularly when markets are weak, we expect your Portfolio to have higher returns than comparable funds. Your Horizon 1 - Bond Portfolio is invested almost entirely in defensive assets and has a priority of preserving your capital. How we design investment solutions How we design investment solutions to grow and protect your wealth We design solutions based on investors fundamental needs to grow wealth over the long-term. We manage the risk in your portfolio by building thoroughly diversified portfolios at every level asset class, country, currency, industry, company and manager. You access exceptional investment managers in the world who carefully invest your money in the right businesses and assets. We keep your investment goals on track because we actively manage your portfolio to stay true to its original intent. Recent Example of this in action Although your portfolio is focussed on capital preservation, we have maintained some exposure to credit risk. Credit risk is highest in your investments in global high yield and bank loans (for super and pension). Although it was not enough to drag your returns down when credit markets were at their weakest, it is expected to provide a return premium over the long term. In the last six months, this credit exposure has been paying rewards. You have a small exposure to emerging market bonds to boost the long-term return we expect from your portfolio. Emerging market bonds offer a higher yield (interest rate) than more traditional developed country government bonds because they have greater credit and currency risk due to their political and economic instability. And they can behave differently to the developed world which is why they are used to diversify your debt portfolio s returns. While the Horizon 1 portfolio only has a small exposure to emerging market bonds, by including them in the strategy your returns have been boosted in recent months. Despite the extreme conditions over the past year, at 31 March 2009 PIMCO had 12% of their global nominal bonds strategy invested in emerging markets bonds. After capturing strong returns from the recovery in emerging markets, by 30 September they had sold down most of their exposure. Refer to the Investing in emerging markets debt at the end of this section. has been reviewing your portfolio over recent months; details are provided in Investment Management Team Recent Activity. In light of the past year the review has been focused on the way we manage risk. In the June quarter we replaced cash with a higher return seeking cash strategy to boost returns. The next step has been the removal of Australian inflation-linked bonds to reduce interest rate risk. More changes will be announced over the next few months. An outcome of the review is your portfolio should provide greater capital preservation in future credit crunches. review for the year ending 30 September 2009 Page 3 of 11
Where invests your money Target Asset Allocation Super Your Horizon 1 portfolio is a complete solution to meet your financial goals. It s diversified within asset classes, across asset classes and across investment managers who invest in many companies and securities around the world. The main asset classes are shown in the pie charts below. Designing a complete portfolio solution involves much more than simply combining a number of asset classes. Every aspect of our Portfolios is important; from the securities we include and the way in which we mandate investment managers, to the asset classes we use. This is not a set and forget approach; the Portfolio is continuously kept balanced using efficient processes. And the Portfolio evolves through time as we research new opportunities to increase returns or reduce risk. Target Asset Allocation MasterKey Super Fundamentals Horizon 1 Bond Portfolio Global Bank Loans, 1.0% Global High Yield Debt, 3.7% Global Nominal Bonds, 24.5% Cash, 30.0% Australian Nominal Bonds, 40.8% review for the year ending 30 September 2009 Page 4 of 11
Target Asset Allocation Wholesale Target Asset Allocation Wholesale Horizon 1 Bond Portfolio Global High Yield, 3.8% Global Nominal Bonds, 24.8% Cash, 30.0% Australian Nominal Bonds, 41.4% Executive summary The conservative strategy used in this portfolio ensured it remained well insulated from the global financial crisis and has continued to provide you a return on your capital over the past year. Being diversified across Australian and global nominal bonds with short terms until maturity provided you higher returns than you would have achieved from a cash portfolio this past year. The Reserve Bank of Australia has commenced the increasing phase of the interest rate cycle which should equate into higher long-term returns from your debt portfolio. An exposure to high yield bonds gave the portfolio a small boost as credit markets started to recover. Performance has lagged the median manager recently. Most competitors have strategies that don t invest as broadly in different types of debt securities as this portfolio. review for the year ending 30 September 2009 Page 5 of 11
The table outlines performance Performance to 30-Sept-09 Horizon 1 - Bond Portfolio (after taking into account fees) Median Manager Returns Consistency since December 2005 % of time rolling return above Median Horizon 1 - Bond Portfolio (before taking into account fees) Strategic Benchmark Fund / Survey Wholesale IDPS Diversified Fixed Income Wholesale Wholesale 5 Years % p.a. 3 Years % p.a. 1 Year % 3 Months % - 5.0 4.3 2.2 5.8 5.8 7.3 4.0-20.0 47.1 53.5 6.0 5.8 5.0 1.9 6.2 6.3 5.8 1.6 Horizon 1 - Bond Portfolio (after taking into account fees and tax) Horizon 1 - Bond Portfolio (before taking into account fees and tax) Strategic Benchmark MasterKey Super Fundamentals MasterKey Gold Star Super MasterKey Super / Gold Star - - 3.3 1.9 3.5 3.3 - - 6.1 6.0 5.5 2.4 6.1 6.3 5.8 1.7 Absolute returns Historical Absolute Performance MasterKey Super Gold Star Horizon 1 Bond Portfolio (after taking into account fees and tax) 14% 12% 5 Year Return % p.a. 10% 8% 6% 4% 2% 0% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 5 Years Ended 30 September Contributors to your return Your Horizon 1 portfolio has continued to deliver capital preservation and a return on your investment, despite the market gyrations over the past year. The downward trend of returns from debt securities is evident in the above graph. The graph has averaged the returns over 5 years to dilute some of the sharp rises and falls (volatility) we see in returns over short periods of time. Evidence of markets functioning normally and the Australian economy proving to be resilient has led the RBA to commence the increasing phase of the interest rate cycle. Longer-term returns from debt should therefore improve over time. review for the year ending 30 September 2009 Page 6 of 11
The chart shows contributors to your return Contribution to Total Return by Asset Class MasterKey Super Fundamentals Horizon 1 Bond Portfolio (before taking into account fees and tax) 7.0% Return Contribution % (annualised for periods greater than 1 year) 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% Cash Australian Nominal Bonds Australian Inflation Linked Bonds Global Nominal Bonds Global High Yield Debt Global Bank Loans Total 5 Years to Sep-09 3 years to Sep-09 1 Year to Sep-09 Quarter to Sep-09 Australian nominal bonds Global nominal bonds Cash Global high yield The above graph shows Australian nominal bonds gave your return the biggest boost over the last year. Our strategy invests in nominal bonds with shorter terms to maturity to protect your capital from sharp rises in interest rates. This bias paid off in the first few months of the year, because the RBA made massive cuts to the official cash rate, from 6% to 3%. However, in the later half of the year short-term yields (interest rates) rose on expectations that the RBA will increase the official cash rate by more than 1% over the next couple of years. This hurt your returns. With interest rates in Australia starting to rise, being diversified across global nominal bonds has helped you capture stronger returns from bonds issued overseas. Government bond yields fell in all major developed countries over the past year as governments slashed cash rates in an attempt to stimulate their economies. Cash has served its purpose well - to preserve your capital in the worst financial crisis since the Great Depression. However, cash rates are now extremely low by historical standards and not providing you much of a return, particularly compared to growth assets. Moving your cash to a higher return-seeking cash strategy, as reported in the June quarter, has helped you earn a slightly higher return from your cash. Although your exposure to high yield is just under 4%, it was the strongest performing debt sector this past year and therefore gave the portfolio a small boost. In the months following the collapse of Lehman Brothers, high yield spreads peaked at almost 22% in December 2008 and have subsequently fallen to almost 8% by the end of September 2009. To put this into some perspective, leading up to the global financial crisis in 2007, the credit spread on high yield was only around 2-3%. Spreads started falling from their peak as investors became confident that the global economy was not in free fall. Investors in the market had a renewed appetite for risk and it didn t take long for the value of higher credit risk debt securities compared to low yielding cash and government bonds to be realised. As investors started buying up the higher yielding securities, their price rose, forcing yields down. review for the year ending 30 September 2009 Page 7 of 11
What is the credit spread? Global bank loans Australian inflation-linked bonds Returns relative to competitors The credit spread is the additional rate of interest investors receive for accepting the risk of a borrower defaulting. Higher interest is compensation for taking credit risk. Super and pension investors also received a small return from the global bank loans strategy which produced a positive return. In the last quarter Oaktree, the manager of your bank loans portfolio, outperformed on the back of a very strong recovery in the market. Approximately 37% of the initial investment in bank loans has already been returned in the form of income and capital. Australian inflation-linked bonds was the only debt sector to produce a negative return this year. Yields on Australian inflation-linked bonds rose as the government has increased issuance (supply) of these securities, pushing prices down. The impact of rising yields was exacerbated by the longer duration of the Australian inflation-linked bond market (8 years) compared to the nominal bond market (1 year). As outlined in the Investment Management Team Recent Activity, from mid September 2009, the portfolio no longer invested in Australian inflation-linked bonds. Performance has exceeded the median manager only 47% of the time over 1 year periods. Prior to the collapse of Lehman Brothers in September 2008, the portfolio was strongly outperforming competitors. Then in late 2008, performance started lagging as shown in the graph below. It s worth noting that the period of time available for analysis is not long enough to be meaningful. The Portfolio s inception was 2006 so 5 year returns are not available. And as you can see, the difference over 3 years is quite small as some of the extreme short-term outperformance and underperformance offsets. The graph shows returns of your Portfolio compared to competitors 3.0% Wholesale Horizon 1 Bond Portfolio Excess Return vs Median Manager in IDPS Diversified Fixed Income (after taking into account fees) Rolling Excess Return (% p.a.) 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Data source:, Retail Mercer MPA 1 Year Wholesale 3 Years Wholesale review for the year ending 30 September 2009 Page 8 of 11
The main drivers of your returns relative to competitors Contributors Detractors 5 Year Not applicable Not applicable 3 Years Outperformance of NSIM and UBS, your Australian nominal bond managers, boosted your returns. WR Huff and Oaktree, the two high yield debt managers, outperformed their market benchmarks. 1 Year Your exposure to credit risk in high yield and bank loans has helped your returns Global nominal bonds outperformed Australian markets and you have more in this sector than competitors. Also positive was the performance of PIMCO (global nominal bonds) NSIM (Australian nominal bonds), and UBS (Australian nominal bonds) who all managed to exceed their market benchmarks. They have done well in a very tough environment. 3 months More exposure to higher credit risk securities such as those in global bank loans and high yield debt gave returns a boost over the quarter. Moving your cash to a higher return-seeking cash strategy, as reported in the June quarter, has helped you earn a slightly higher return from your cash. PIMCO, one of the global nominal bond managers achieved an excellent result as they maintained most of their credit exposures which have bounced back strongly. Overweight exposure to higher credit risk securities such as those in global bank loans and high yield debt has weighed heavily on 3 year returns. Global nominal bonds and Australian inflation-linked bonds underperformed the Australian nominal market and you have more in both these sectors than competitors. PIMCO and BlackRock, the global nominal bonds managers, underperformed their market benchmarks. Relatively low exposure to safe sectors like cash and government nominal bonds. The strategy had a higher weighting to Australian inflation-linked bonds which have not performed as well as nominal bonds over the past year. BlackRock reduced their exposure to credit risk, in hindsight, too early in the recovery, preventing full participation in the recovery in credit markets. BlackRock reduced their exposure to credit risk, in hindsight, too early in the recovery, preventing full participation in the recovery in credit markets. The strategy had a higher weighting to Australian inflation-linked bonds which have not performed as well as nominal bonds. review for the year ending 30 September 2009 Page 9 of 11
Running yield What is the running yield? Notes on calculation of the running yield: Investing in emerging markets debt The running yield on s Horizon 1 Bond Portfolio (for super and pension products) is 5.5% at 30 June 2009. This is an attractive yield when compared to that available on cash investments which have a yield similar to the official cash rate of just above 3%. Running yield is the income received from a bond, expressed as a percentage of the market value of the bond. It is similar to the dividend yield for a share. In the past, the running yield has provided an indication of the total return that was eventually earned. A bond is issued with a set coupon (interest) rate. As the security is revalued on a mark-to-market basis, if interest rates rise the capital value falls and the yield on the security rises. The running yield therefore is the original coupon plus any realised capital gains/losses spread over the remaining term until maturity. Even if the portfolio remains the same, as the securities are valued daily the yield can change as a result of capital gains/losses. Fees and taxes have not been deducted Yield to maturity in local currency Interest rate differentials on currency hedging Accrual of expected inflation Discount margin on bank loan assets Assumes bond yields and Libor rates remain unchanged Ignores potential losses from defaults Sourced from Investment Management and s investment managers. Developing economies around the world, known as emerging markets, are rapidly maturing into key players in the global economy and debt markets. Although they are generally higher risk than most developed countries, many emerging countries now run disciplined fiscal and monetary policies. These policies have produced a steady increase in the credit quality of emerging market bond issuers. Your Horizon 1 Bond Portfolio has been investing in emerging market bonds for almost 9 years, primarily as a return-seeking strategy. Emerging markets bonds offer a higher yield (interest rate) than more traditional developed country government bonds because they have greater credit and currency risk due to their political and economic instability. And they can behave differently to the developed world which is why they are used to diversify your debt portfolio s returns. Although it s convenient to lump emerging market debt into a single category, it s far from a group of the same bonds. Individual countries may have very different growth prospects and risk factors at any point in time. When one emerging country's bonds may be performing poorly another's may be doing relatively well. That s why your exposure is managed by a number of investment managers who have the extensive resources needed to analyse the potential risks and returns of individual emerging countries. PIMCO and BlackRock are the managers responsible for your emerging markets bonds investments. They invest a small percentage of their global nominal bond strategies in emerging markets. Despite the extreme conditions over the past year, at 31 March 2009, when the market was just starting to turn the corner, PIMCO had 12% of review for the year ending 30 September 2009 Page 10 of 11
their global nominal bonds strategy invested in emerging markets. After capturing strong returns from the recovery in emerging markets (as shown in the graph below), by 30 September they had sold down most of their exposure and had only 2% invested. They are maintaining this modest exposure in what they believe are high quality emerging markets such as Mexico and Brazil that don t have many loans maturing (and principal to be repaid) in the near future and a high level of reserves. The graph shows both the return premium emerging markets bonds have had over investment grade bonds and the risk. Clearly shown is the impact from Lehman Brothers collapse which swiftly spilt over into emerging markets. The graph compares emerging market and investment grade bond returns 30.0% 25.0% Emerging markets vs investment grade bonds Rolling 1 year index returns comparison Rolling 1 year return (% p.a.) 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% Dec-04 Feb-05 Apr-05 Jun-05 Aug-05 Oct-05 Dec-05 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Global emerging markets debt $A hedged Global investment grade bonds (all maturities) $A hedged Data source: Global emerging markets debt index: JP Morgan EMBI+ AUD Hedged; Global investment grade bonds index: Barclays Global Agg ex JPY 100% Hedged Emerging market policymakers followed the examples set in the developed world and aggressively eased interest rates and used other stimulus measures to mitigate the crisis. That s why returns from your emerging markets investments have steadily risen in recent months. Emerging market bonds don t make up a substantial portion of the debt portfolio because it s a defensive strategy. However, they have served to boost the long-term return we expect from your Horizon portfolio. review for the year ending 30 September 2009 Page 11 of 11