UBS Diversified Credit Fund Quarterly investment report to 31-Mar-14
Summary as at 31-Mar-14 Performance Before fees and expenses, the portfolio rose by 2.34% over the quarter, outperforming the UBS Australia Bank Bill Index, which rose by 0.64%. % Return (Gross) Fund 1 Benchmark* Difference 3 months 2.34 0.64 1.70 1 year 6.12 2.77 3.35 3 years 7.98 3.74 4.24 5 years 12.85 3.92 8.93 Calendar Year to Date 2.34 0.64 1.70 Since inception (04/02) 6.45 5.07 1.38 1 Performance figures are gross of ongoing fees and expenses. After fees and expenses, the portfolio rose by 2.16% over the quarter, outperforming the UBS Australia Bank Bill Index, which rose by 0.64%. % Return (Net) Fund 2 Benchmark* Difference 3 months 2.16 0.64 1.52 1 year 5.38 2.77 2.61 3 years 7.23 3.74 3.49 5 years 12.06 3.92 8.14 Calendar Year to Date 2.16 0.64 1.52 Since inception (04/02) 5.73 5.07 0.66 2 Performance figures are net of ongoing fees and expenses. * UBS Australia Bank Bill Index Performance can be volatile and future returns can vary from past returns. The benchmark does not incur these costs. The performance figures quoted are historical, calculated using end of month redemption prices and do not allow for the effects of income tax or inflation. The calculations also assume that all income distributions have been reinvested. Performance has been prepared in accordance with 2012 GIPS standards. Quarterly Performance review Credit spreads continued to tighten during the March quarter with Australian corporate cash spreads tightening by 13 bps, outperforming the Australian itraxx which widened 3 bps over the quarter. Moving towards the end of last year we decided to hedge 80% of our US high yield exposure. We took the opportunity with the widening of high yield spreads in January following concerns over emerging markets to reduce a portion of this hedge. Our view was that we would remove more of the hedge on any further widening in US high yield spreads which never occurred. Spreads continued to tighten finishing 24 bps tighter over the quarter. The March quarter experienced the lowest volume of primary corporate bond issuance since 2008 which resulted in all new deals being well over subscribed and performing strongly in the secondary market. We participated in the new Bendigo and Adelaide T2 deal as well as the Barclays and Perth Airports deals, in particular the Perth Airports bond contracted by 20 bps the day after the deal closed with strong follow on buying out of Asia. The pipeline for Australian corporate issuers still remains quite thin so we are expecting technicals to remain strong which should remain a supportive factor for credit spreads. Australian corporate fundamentals should remain stable during 2014 supported by low interest rates, moderate growth and strong company balance sheets. We expect a moderate contraction in credit spreads during 2014 though the advent of tapering by the Fed, any associated rise in US interest rates and concern about China or emerging markets may cause temporary bouts of volatility. Overall the fundamental and technical backdrop should remain supportive for credit spreads. UBS Global Asset Management 2
Portfolio positioning as at 31-Mar-14 The following charts sets out the asset allocation as at quarter end. The following charts sets out the credit allocation as at quarter end. 3 UBS Global Asset Management
Market review as at 31-Mar-14 Economic The key global developments driving markets during Q1 2014 can be broadly broken down as follows: Emerging market jitters: As the year started, Inflation pressures and generalised currency weakness in the face of the US Federal Reserve's ongoing tapering of quantitative easing put significant pressure on some emerging market countries (particularly capital outflow risks). Notably, central banks in India, Turkey and South Africa were forced to raise interest rates, and in Argentina, to devalue their currency. Data out of China was generally a little softer, and fears of defaults in the Chinese shadow banking sector also caused concern for markets. Geopolitical: Russian troops entering and annexing Ukraine's Crimean region and then Russia calling a local referendum resulted in US and European politicians threatening, and then following through on, economic and political sanctions. Russia threatened to retaliate against the sanctions by potentially turning off gas pipelines that provide Western (and Eastern) Europe with a high proportion of their energy needs. Given the major economic risk to Ukraine, the IMF stepped in to provide a support package. Markets focused not only on the risk of this confrontation flaring up into something much worse, but also on the near-term implications for Europe's still-weak economic growth. By quarter-end, Putin had ordered a partial troop withdrawal and it looked increasingly like a diplomatic solution might be reached. Central Bank-speak: As widely anticipated, the US Federal Reserve continued to slowly withdraw QE through the tapering of Treasury and MBS purchases during Q1. Also, a change in Fed guidance from a 6.5% unemployment rate threshold to using more qualitative guidance was not a major surprise. However, an off-the-cuff response during a Q&A session from the new Fed Chair's Yellen that implied that the Fed Funds rate was likely to start being raised at an earlier date than the market had previously expected caused a swift market reaction. In Australia, the RBA also changed its rhetoric somewhat during the quarter initially the RBA attempted to try to talk down the high $A (a difficult task to do on a sustained basis) in order to aid growth in the non-mining sectors of the economy, but during March they were flagging concerns about the sharp rises in property prices and the potential risks to price stability. Growth concerns: US economic data was generally on the somewhat softer side however given the extreme weather-related events, interpretation of the data was difficult. In contrast, Chinese growth was unambiguously a bit softer, even after noting the timing of the Lunar New Year holidays may have impacted the data. The manufacturing PMI and industrial production numbers, and retail sales data were all weaker than expectations. The PBoC (China's central bank) widened the CNY currency bands, and the market awaited any announcement from the government of a mini stimulus program that might be enlisted in order to meet their stated 7.5% growth target. Australian economic data continues to paint a mixed picture - the capital expenditure survey was weak, and business surveys were on the softer side. However retail sales and building approvals have been on an improving trend both clearly benefiting from lower official cash rates. Australian inflation for Q4'13 was much stronger than market expectations the headline CPI rose 0.8% quarter-on-quarter/2.7% year-on-year. UBS Global Asset Management 4
% Market review Bond Markets Early in the quarter the shocks to global emerging market economies caused by the start of the Fed's QE tapering was a key driver in bond (and equity) market volatility. These concerns about emerging markets, along with some weatherrelated softness evident in US economic data, hit growth assets hard and lent a safe haven bid to US Treasuries. Australian bond yields broadly followed the US and rallied strongly. Post the stronger-than-expected CPI release, residual market expectations for a potential further rate cut by the Reserve Bank of Australia were wound back. During the middle of Q1, the bond market benefited from a flightto-safety rally following tensions between Russia and the Ukraine, weaker data out of the US, and poor Australian business investment data. Market Yields Cash % 3 year % 10 year % Australia 2.50 (-) 2.99 (+4bps) 4.08 (-16bps) US 0.25 (-) 0.87 (+10bps) 2.72 (-31bps) (x)= change on the quarter Australia Index Returns Mar 2014 % Dec 2013 % UBS Composite 1.45 0.37 UBS Treasury (CGL) 1.23 (0.22) UBS Credit 1.52 0.84 The biggest driver of global bond yields towards the end of the quarter was changing commentary coming for the US Federal Reserve, and its ramifications for when the next US tightening cycle is likely to begin. Given longer-dated bonds had already risen over the past year, it was the short-to-middle part of the yield curve that took the brunt of market repricing during March. Partially offsetting this, heightened geopolitical risk out of Ukraine along with concerns about the softer growth outlook for China provided support for bond yields. In Australia too, changes in central bank messaging had an impact on market pricing. The RBA appeared a little less keen to jawbone the $A lower, and was clearly becoming more concerned about trends in property prices. This put pressure to the front end of the Australian yield curve. 2.5 2.0 1.5 1.0 1.23 Sector Returns 1 st Quarter 2014 1.65 1.52 1.45 Physical corporate bonds generally remained supported during the quarter, with the higher-yielding BBB rated issues performing particularly well. In contrast, the main credit derivatives (itraxx) index lagged, as some market participants used the contract to hedge their credit positions. 0.5 0.0 Treasury Semi-Govt Credit UBS Composite Bond Index 5 UBS Global Asset Management
Outlook and strategy We have structured the interest rate risk in our fixed income portfolios around three themes: short-term rates are vulnerable to stronger data and changed Central Bank communication; long-term bonds are less vulnerable as they have priced in higher rates; and the entire yield curve will rise somewhat as the year progresses. To date, the first two views are playing out but yields overall are within their recent ranges. The incremental changes in Central Bank commentary in the US, Australia and the UK have made the markets much less certain about the path of short-term interest rates. Should the data continue to improve as we expect then it is likely that the market will build in a premium for earlier rate increases and yields generally should rise. The Australian market is particularly vulnerable as little is priced in this year. A run of higher-than-expected housing, employment and inflation data in the coming months would see this pricing shift. Housing will remain strong and our analysis suggests that the latest strong labour market number merely corrected unusually weak data in prior months. This has led us to be short duration and underweight the three year part of the curve, against both the long-end and the very short-end. We see this as a core strategy for the time being but are conscious of the myriad non-economic risks around at the moment, hence our desire to take profits along the way. We do not expect a significant rise in yields. Given the market already discounts an increase in yields over the next few years, it would take a large upside surprise to growth or inflation to cause a dramatic sell-off. We estimate that fair value for the Australian 10 year bond is around 4 ½ to 4 ¾ %, and yields are currently around 4.1% - so we are not that far from fair value. We expect a moderate contraction in credit spreads during 2014. However, with the advent of tapering by the Fed and any associated rise in US interest rates, and possible renewed concerns surrounding a slowdown in Chinese growth or adverse emerging markets developments may cause temporary bouts of volatility. Yields in Australia are about where they were at the start of the year while global yields are lower, especially in Europe. As noted, a few central banks, including the RBA, have shifted from the very dovish postures they have had for a few years. Also, the US is recovering from a harsh winter so we should see better news on the economy there and perhaps also in China. UBS Global Asset Management 6
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