Fixed income Old lessons re-learned for income investors Michael Korber Head of Credit August 2009
Role of fixed income in a portfolio The role of fixed income in a portfolio a fixed or floating rate of interest (coupon) a fixed maturity date a return of capital (at par) upon maturity tradeable on the secondary market These characteristics assist investors in three main ways: they make fixed interest a less volatile asset class than equities the provide a regular income stream preservation of capital 1
Fixed income lessons investors forgot Some fixed income funds performed like equities Investor sentiment was opportunistic, risk seemed a historical concept Product development primarily completed at historical low credit margins Credit ratings used benign, historical default rates and inadequate methodology A lack of understanding by investors (and arguably other parties) fuelled this Illiquidity was not properly factored in 2
Credit markets are cyclical Credit market cycles Investment grade credit spreads 1990-2009 Sub-prime 700 600 500 Junk bonds 400 Emerging markets High grade corporate 300 200 100 0 Source: Bloomberg, Perpetual July 2009 3
Is it time to re-think risk management in fixed income? Not necessarily, in fact one could argue it s back to basics focus on downside risk (default) investing in quality assets that are transparent and understandable properly valuing liquidity achieving appropriate diversification (not just issuer, but also sector and type) actively manage credit spreads and interest rate duration These are not new lessons, in fact they ve always been key principles of Perpetual s approach to fixed income. However in periods of sustained bull markets, across practically all investment types and asset classes, it is easy to forget the fundamentals. 4
Evaluating risk credit risk 15 year cumulative average default rates (%) Standard - & Poor s survey of rated corporate obligations (1981 2008) 60 50 40 Investment grade High liquidity and low running yield Sub- investment grade Low liquidity and high running yield 30 20 10 0 AAA AA A BBB BB B CCC Source: Standard & Poors Apr 2009 Perpetual risk score: 0.1 0.35 0.80 1.80 3.80 5.00 5.00 S&P 7 20 50 250 1,000 4,000 8,000 5
Evaluating risk security related risks Maturity Seniority Credit rating Position size Industry / sector 6
Evaluating risk example of security decision New issuance April 2009 Tabcorp Retail ASX listed bond 5yr senior bond BBB+ rated Credit spread of 425bps Perpetual risk score was 1.84 Preferred secondary market offer Tabcorp bond Oct 2010 Maturity 2.5yr senior bond BBB+ rated Credit spread of 385bps Perpetual risk score was 0.53 7
Evaluating risk duration risk Australian treasury yield curve 8.00 7.00 6.00 Yield (%) 5.00 4.00 3.00 2.00 1.00 - as at 30 Jun 08 as at 31 Mar 09 as at 31 Jul 09 1 yr 2 yr 3 yr 4 yr 6 yr 7 yr 10 yr 15 yr Term (yrs) Source: Bloomberg, RBA Aug 2009 8
Key building blocks for defensive portfolios CLIENT NEEDS Client needs DURATION Duration Client Portfolio Credit CREDIT risk RISK Market outlook 9
What does a good defensive portfolio look like? Establish specific criteria - What are the client s immediate liquidity needs? - What is the client s investment horizon? - What is the client s appetite for volatility? Consider the alternative sources of return and evaluate risks - Cash - Bonds fixed rate (carry interest rate risk and credit risk) - Credit floating rate (carry credit risk but not sensitive to interest rates) - Global vs domestic and more volatile alternatives like hybrids and syndicated loans 10
Understanding your defensive portfolio Increasing sensitivity to movements in interest rates Fixed rate Duration Floating rate Credit risk 11
What do you have to know about fixed income? Debt securities can be issued as fixed or floating interest rate securities Fixed rate securities are typically issued by govt, semi-govt and corporates Tend to be benchmarked to UBSA Composite Bond Index (duration of > 3yrs) Sensitive to both interest rate movements and credit risk Floating rate securities are typically issued by corporates, asset backed Tend to be benchmarked to UBSA Bank Bill Index (Duration of > 0.1yrs) Sensitive to credit risk but little sensitivity to interest rates The term (or maturity) of a security will impact the sensitiveness of a debt security to changes in interest rates/credit spreads. The longer the term, the greater the impact. 12
Understanding your defensive portfolio Increasing sensitivity to movements in Interest Rates Duration Sov vereign Investm ment-grade credit Hig gh yield Credit risk Increasing default risk Increasing correlation to equities Decreasing liquidity Increasing exposure to credit spreads 13
The return for taking on credit risk is unusually high 12.0% Average A rated corporate credit spreads (Aug 05 Jun 09) 10.0% CBA Spectrum 3 yr A credit plus bills 90 bank bill rate 8.0% Return 6.0% 4.0% 2.0% 0.0% Source: Commonwealth Bank Research, Perpetual Aug 2009 14
Summary main points to remember Risk management is critical in fixed income. The keys to success are: to select high quality securities and use caution for riskier assets properly valuing default risk and liquidity portfolio diversification active management Fixed income returns are highly predictable remember the pull to par concept. Invest with three main goals in mind: capital preservation producing a consistent income stream maintaining liquidity High quality, diversified portfolios should deliver strong predictable returns 15
Perpetual s Wholesale Diversified Income Fund Broad investment strategy and active approach Floating rate portfolio = Little interest rate sensitivity (0.1 years duration) Focus on investment grade securities, and the top of the capital structure High levels of diversification High liquidity = remained open throughout credit crisis Experienced, disciplined and risk aware team 16
Quality and diversification Portfolio characteristics as at 30 June 2009 BBB 17.02% B 0.48% Credit rating NR 5.48% BB 2.79% Cash 18.65% MORTGAGES 3.78% WRAPPED 1.64% CASH 18.65% Sector ABS 2.53% STRUCTURED* 1.79% BANK 12.92% CMBS 6.23% AAA 21.74% UTILITIES 0.47% RMBS NC 11.63% CORPORATE 5.04% FINANCE 4.68% A 22.21% AA 11.12% 45% 40% 40.05% Maturity RMBS 13.75% PROPERTY 5.91% OS BANK 10.97% 35% 30% 25% 20% 25.00% 18.50% 15% 10% 8.53% 7.29% 5% 0% 0.62% 0-1 yrs 1-2 yrs 2-3 yrs 3-4 yrs 4-5 yrs 5+ yrs * Prior to Aug-07 Structured recorded as part of ABS Source: Perpetual July 2009 17
Historical running yield At 30 June the portfolio running yield was 8.35% and the average margin to bills was 5.15% Portfolio weighted average maturity = 2.2 years 13 12 11 10 9 Effective yield (% %) 8 7 6 5 4 3 2 Source: Perpetual July 2009 Bank bills Margin 18
19 This presentation has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for Portfolio Construction only. It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The product disclosure statement (PDS) for Perpetual s Wholesale Diversified Income Fund, issued by PIML, should be considered before deciding whether to acquire or hold units in it. The PDS can be obtained by phoning 1800 062 725 or visiting www.perpetual.com.au. No company in the Perpetual Group guarantees the performance of any fund or the return of an investor s capital (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries). Past performance is not indicative of future performance.