#MICEU #ValueInvesting #FixedIncome @BlackRock Michael Krautzberger Head of European Fixed Income, BlackRock
New Age of Fixed Income Investing Michael Krautzberger, Head of Euro Fixed Income March 2016
Current challenges faced by investors
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Challenge 1: Yields are diminishing in anything perceived half way safe Yield seeking behavior has driven risk appetite 2015 was a record year for issuance, with debt-financed M&A and share repurchases as main catalysts Fixed Income Indices Yielding Over 4% US IG issuance vs M&A activity 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% US Treasury US Municipal Global Credit Global High Yield US Agencies Emerging Market US MBS US CMBS Source: BlackRock, GCM, Goldman Sachs, Dealogic, Bloomberg, Citi as at November 2015 4
Standard Deviation (%) Standard Deviation (%) Challenge 2: Volatility is increasing A combination of fears around a slowdown in China s economy, several negative idiosyncratic stories, and raising concerns over a weakening in Emerging Market economies has led to a poor sentiment on the markets There has also been a quick turnaround in sentiment for the FOMC in March, from a rate hike to rate cut speculations As a result, volatility has been increasing since the beginning of the year Volatility is picking up again in bonds As well as in equities 3.0 2.5 2.0 80 60 1.5 1.0 0.5 0.0 2008 2009 2010 2011 2012 2013 2014 2015 2016 Euro Treasury Euro Corporate Euro Financials 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 US Equities European Equities * Volatility for bonds is computed as the historical standard deviation in % of the Indices MTD Total Returns. Volatility for equities is measured as the standard deviation of daily returns over a 30-day window on an annualised basis. Source: BlackRock, Barclays as at February 2016 40 20 5
Challenge 3: Traditional buyers are turning to sellers Foreign official investors are net sellers of Treasuries Helping them fund large fiscal deficits Private investors have taken up some of the slack in demand But foreign official & private investors combined are adding no new demand for treasuries on a net basis Source: BlackRock as at November 2015 6
Challenge 4: The speed at which the market is jumping from one economic scenario to the next is stunning Feb 16 Mar 16 Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17 Dec 17 Mar 18 Jun 18 Sep 18 Dec 18 Mar 19 Jun 19 Feb 16 Mar 16 Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17 Dec 17 Mar 18 Jun 18 Sep 18 Dec 18 Mar 19 Jun 19 After the Fed s rate hike in December 2015 and given the close ties in their economies, markets were expecting the UK to follow with a rate hike in March 2016 Early 2016 however, a combination of weaker UK economic data, a high deficit and fears around a Brexit have shifted the sentiment on the market 160 120 which is now pricing a rate cute for the country in 2016 Path of Market-Implied Rate Changes as at 31 st December 2015 160 120 Path of Market-Implied Rate Changes as at 25 th February 2016 80 80 40 0-40 40 0-40 UK US EUR Source: BlackRock, Bloomberg as at February 2016 UK US EUR 7
Challenge 5: The correlation between risk assets is increasingly high Correlation of weekly performance from Feb-14 through Feb-16 Euro Government Euro Corporate Euro Industrials Euro Financials European High Yield S&P500 Euro Government 1.00 0.71 0.71 0.63 0.41 0.15 0.29 Euro Corporate 0.71 1.00 0.94 0.96 0.64 0.21 0.26 Euro Industrials 0.71 0.94 1.00 0.81 0.43 0.10 0.15 Euro Financials 0.63 0.96 0.81 1.00 0.75 0.28 0.31 European High Yield 0.41 0.64 0.43 0.75 1.00 0.50 0.59 S&P500 0.15 0.21 0.10 0.28 0.50 1.00 0.76 SXXE 0.29 0.26 0.15 0.31 0.59 0.76 1.00 SXXE Energy and Equities correlation 0.8 0.6 0.4 0.2 0-0.2 2006 2008 2010 2012 2014 2016 Industrial Metals and Equities correlation 0.8 0.6 0.4 0.2 0 2006 2008 2010 2012 2014 2016 Source: Bloomberg, Barclays, BlackRock as at February 2016. Correlations of weekly price % change. Past performance is not a guide to future performance. 8
Challenge 6: Market depth and liquidity are disappearing 800 600 400 200 0 3,500 3,100 2,700 2,300 Fixed income futures on EUREX (in bn) 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Traded contracts (EUR bn) Contracts per trade (RHS) Size of the European government bond market (in bn) 50 40 30 20 10 0 1,900 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: EUREX, Bloomberg as of November 2015 9
Challenge 7: Political risks are plentiful 1 2 3 4 5 6 7 8 Brexit Referendum Isis and Terrorism Syria Tensions between Saudi Arabia and Iran Uncertainty around Spain s coalition government Unstable government in Brazil Presidential elections in the United States Political crisis in Ukraine Source: BlackRock as at February 2016 10
How do we navigate these markets?
Our principles Valuation Driven Approach Medium to long term time horizon Preference for Relative Value Implementation of tail hedges Emphasis on diversification Mindful of consensus Bottom-up portfolio construction in a holistic way Liquidity as a portfolio level concept Empowerment of our investment Teams No over-reliance on macro economic forecasts Source: BlackRock as at February 2016 12
Diversification limits the impact of idiosyncratic events Barclays Euro Aggregate Corporate Index OAS (bps) 150 130 110 Subordinated debt bail-in 90 BES has reported a bigger-than-expected loss of 3.6bn for H1 2014 CEO quits on the back of corruption scandal Merger talks Pollution emissions scandal Merger agreement Renault under investigation Threats of credit rating downgrade to junk 70 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Firm announces that its profits have been Source: Barclays, BlackRock as at January 2016. Reference to the names of each company overstated by 263m mentioned in this communications is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Merger agreement Concerns over commodity prices Warnings of 6bn losses Senior bondholders forced to fund a banking bailout 13
Diversification: The foundation of our investment approach Capital Preservation - Diversification usually helps to reduce the overall portfolio risk Stability A diversified portfolio can help smooth returns over time and will generally outperform a concentrated portfolio over the long run Liquidity Small positions can be easier to liquidate, especially in a turbulent market environment Undiversified Portfolio Diversified Portfolio : Idiosyncratic event Euro Bond Fund: an example of diversification Source: BlackRock as at January 2016 282 issuers, 5 currencies, 15 corporate industries, 607 securities, Rating range from AAA to CCC, 30 year maturity range, 15 security types, : 33 countries 14
The importance of Relative Value A relative value strategy refers to the identification of mispricing among securities that share similar economic and financial characteristics 2.5% While both markets sell off 50 The spread tightens 2.0% 40 1.5% 30 20 1.0% 10 0.5% Feb-15 May-15 Aug-15 Spain 10Y Yield Nov-15 Italy 10Y Yield Feb-16 0 Feb-15 May-15 Aug-15 Nov-15 Spain 10Y vs. Italy 10Y Spread (bps) Feb-16 Relative Value trades help to reduce fund directionality Source: Bloomberg as at February 2016 15
Emphasis on Relative Value BlackRock focuses on exploiting relative value strategies Diversified exposures are designed to deliver consistent outperformance BlackRock uses traditional strategies in measured ways Traditional Strategies Relative Value Strategies Duration Sector/Country Rotation Capital Structure Credit Beta/ Quality VALUE ADDED Security/Instrument Selection Spread & Yield Curve Source: BlackRock as at January 2016 Currency Execution 16
Relative Value and the availability of alpha Lower yields in Europe mean directional opportunities are less rewarding on a risk-adjusted basis However, cross-asset class dispersion within European fixed income is on the rise since mid-2013, especially as a proportion of overall yields healthy volatility is a pre-requisite for alpha generation For example, the difference in performance between the best performing and worst performing sector in January 2016 was 2.5 times the annual yield for the Euro Aggregate Index 6.0% 5.0% 4.0% 3.0% 2.0% As yields continue to fall 300% 250% 200% 150% 100% alpha opportunities become more important 1.0% 0.0% 2010 2011 2012 2013 2014 2015 2016 Euro Aggregate Euro Government Euro Corporate Source: Barclays as at January 2016 50% 0% 2010 2011 2012 2013 2014 2015 2016 Best performing sector minus worst performing sector monthly total returns as a proportion of Euro Aggregate Index annual yield Sectors: Government Bonds, Government Guaranteed, Industrials, Utilities, Financials and Securitised 17
Yield Yield Relative value opportunities in government bonds Despite very low yields, the European Fixed Income space remains rich with relative value opportunities For instance, we prefer Ireland over France as the former has stronger growth, lower unemployment and has been more successful in implementing fiscal measures than the latter Similarly, Spain shows stronger growth prospects and a better fiscal backdrop than Italy and offers attractive levels 5Y Ireland vs. 5Y France spread (bps) 5Y Spain vs. 5Y Italy spread (bps) 12% 1,200 10% 1,000 8% 800 6% 4% 600 2% 400 0% 200-2% 0 2006 2008 2010 2012 2014 2016 Spread (RHS) Ireland France Spread 8% 200 6% 100 4% 0 0% -200 2006 2008 2010 2012 2014 2016 Spread (RHS) Spain Italy * Those figures are estimates. Source: Bloomberg, BlackRock, European Commission as at February 2016 18 2% -100 Spread
Relative value opportunities in credit With Q4 earning weaker than expected and an increasingly worrying exposure to Emerging Markets, Santander seems to be going through a rough path Intesa announced a dividend distribution of 2.4bn, above the 2.3bn consensus, and we have seen continued capital build in the bank in 2015 We therefore prefer Intesa to Santander and are overweight Intesa cash and underweight Santander CDS Intesa 2022 vs. Santander CDS Sub 5Y 420 320 220 120 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Santander Sub 5Y CDS Price Source: Bloomberg as at February 2016 Intesa 2026 Cash Bond Z-Spread 19
A wide universe and a great variety of instruments is crucial Engie s 5Y CDS has been taken wider during the recent market sell-off in January-February 2016 We have therefore taken advantage of this opportunity to enter a long Engie 5Y CDS versus Engie 5Y Cash Bond position 120 Engie 5Y CDS vs. Engie 5Y Cash Bond 100 80 60 40 20 0 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Source: Bloomberg as at February 2016 Engie 5Y Senior CDS Price Engie 2021 Cash Bond Z-Spread 20
Crowded positions Amidst a volatile start to the year, investors have piled into perceived safe havens such as Japanese yen and US rates Notable crowded positions as of 19 th February include long JPY, short EM equities, European credit, Canadian dollar and industrial metals Crowded Long Positions 3 2 Overall Crowded Position Scores Crowded long positions: JPY 1 0-1 Crowded Short Positions -2-3 EM Equities European Credit JPY CAD Industrial Metals Crowded short positions: EM Equites; European Credit; CAD; Industrial Metals A crowded position is one that has attracted an unusually large number of participants. Characteristics of crowdedness include extreme moves in portfolio flows, positioning and price momentum. Source: BlackRock as at February 2016 21
Tail hedges with profit potential even in normal times Opportunities can arise from the mispricing between inflation-linked bonds and inflation swaps By buying a Spanish inflation-linked bond and hedging it with an inflation swap, we remove our exposure to inflation and only keep the exposure to the country risk With the below trade, we are therefore taking advantage of a dislocation in the inflation market without having exposure to inflation Spanish inflation-linked bond vs. Spanish nominal bond spread (bps) 1.40% 0.30% 1.00% 0.10% 0.60% -0.10% 0.20% -0.30% Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Spread (RHS) Inflation-Linked Bond Yield + Inflation Swap Yield Spanish Nominal Bond Yield For illustrative purposes only. Source: Bloomberg as at February 2016 22
Being level dependent and a dynamic management of positions is more important than macroeconomic forecasts Alpha, bps We believe it is essential to be nimble and active in position management and never assume that all macro calls will be perfectly timed FISF Inflation Alpha vs. European Inflation 120 100 99 97 80 95 60 40 20 93 91 89 87 Index Level 0 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 85 Inflation Alpha FISF (in bps) Rebased 10Y Euro BE Index Source: BlackRock as at December 2015 23
Case Study 1: The Short Duration Dilemma
Negative Yielding Assets BGF Euro Short Duration Bond Fund Barclays Euro-Aggregate 500+ 1-3 Years Index 23.72% 33.63% 76.28% 66.37% Positive yielding assets Negative yielding assets Positive yielding assets Negative yielding assets Fund Benchmark Yield 0.52 Government Bonds Yield 0.44 Corporate Bonds Yield 1.06 Rating A- Yield -0.04 Government Bonds Yield -0.25 Corporate Bonds Yield 0.69 Rating A+ Source: BlackRock as at 31 January 2016 25
Yield (%) Relative value also works with negative yields While German 5Y yields have been negative for most of the past year, French 5Y yields first slid into negative territory in November 2015 and slid further down early 2016 for the second time A relative value approach is not affected by negative yields 0.3% France 5Y vs. Germany 5Y spread (bps) 0-5 0.% 0.0% -0.3% -10-15 -20 Spread (bps) -0.6% -25 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Spread (RHS) Source: Bloomberg as at February 2016 Germany France 26
A wide universe can help to create safe positive yields While 1Y Japanese Government Bonds were yielding about 1bp over the course of 2015, they still offered an interesting opportunity Indeed, hedging a 1Y Japanese Government Bond into EUR offered an extra 9bps to the additional 1bp yield 1Y Japanese Government Bond Yield 0.05% 0.00% -0.05% -0.10% -0.15% -0.20% -0.25% Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Source: Bloomberg as at February 2016 27
Case Study 2: The LDI Dilemma
Long term government bond yields have been consistently falling Our traditional LDI approach has delivered in line with expectations, greatly helped by falling long term government bonds yields Several challenges have presented themselves along the way: government bonds are not longer considered risk free assets and even in the AAA-AA universe, significant credit risks remain which are difficult to manage BlackRock s investment approach changed accordingly with emphasis on downside protection and greater diversification including other asset classes and non-euro hedging assets 8% 30Y German Government Bond yield (%) 6% 4% 2% 0% 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Bloomberg as at February 2016 29
30Y France versus Swaps The flip side of falling long term interest rate yields is that inflation protection strategies are attractively valued for long term investors 30Y France vs. 30Y Euro Swap spread (bps) 6.5% 0.6 6.0% 0.4 5.5% 0.2 5.0% 0 4.5% -0.2 4.0% -0.4 3.5% -0.6 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Spread (RHS) France 30Y yield Euro Swap 30Y Source: Bloomberg as at February 2016 30
BlackRock Euro Fixed Income Products
Investment Universe Investment Grade Corpor ate Govt. & Supras RV focused Euro Fixed Income product suite Fund Short Duration Euro Bond Euro Corporate FISF ESSF Average duration 1-3 years >5 years >4 years -3 to +3 yrs >4 years Equity High Yield Size 9.19 bn 4.81bn 937m 5.63bn 70m 5y Gross ann. return (Alpha) 1 Year Ranking 3 Year Ranking 5 Year Ranking +3.31% (92bps) +7.35% (126bps) +6.22% (106bps) +4.29% (abs) N/A 2 1 1 Source: BlackRock, Morningstar as at January 2016. Past performance is no indicator for current or future performance. Performance is shown in EUR on a NAV price basis with income reinvested 1 1 1 1 2 2 Quartiles 1 2 3 4 32
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