Income or Outcome The Evolution of Bond Strategies Through The Lens of International Pension Funds

Income or Outcome The Evolution of Bond Strategies Through The Lens of International Pension Funds Andy Howse, Head of Institutional Fixed Income, Product and Analytics Fidelity Worldwide Investment

Agenda 1. A turning point for the bond markets? 2. Traditional benchmarks versus smart beta 3. Advice structures: a) Separation of alpha and beta b) Matching and growth portfolios 4. Total return bonds 5. Absolute return bonds 6. Summary

A long-run bull market for fixed income Protracted period of falling inflation, falling yields has led to strong total returns from bonds The rising tide has lifted all boats Government Bond yields 1980 2015 20% 15% 10% 10 yr Gilt Yield 10 yr US Treasury Yield 10 yr German Bund Yield 10 yr Japanese Govt. Bond Yield 10 yr Canadian Government Bond All maturity government bond index total returns 120% 115% 110% 105% Germany Japan US Treasury UK Canada 5% 0% Jan 80 May 88 Sep 96 Jan 05 May 13 100% 95% Nov 85 Jan 90 Mar 94 May 98 Jul 02 Sep 06 Nov 10 Jan 15 Beta has bailed out bond investors Source: Bloomberg, Citibank, Fidelity Worldwide Investment, 31 March 2015. RHS chart= 12 month rolling cumulative returns in local currency rebased to100 at 30 November1985.

Polling Question #1 Canadian government bonds have produced an annualised total return of over 5% over the past 10 years. Over the next 10 years, will the return be: 1. Higher 2. Similar 3. Lower?

Bond markets unlikely to be so compliant in the future As economic recovery continues, inflation should trend upwards and CBs should begin to normalise rates This should result in an increase bond yields Total returns will vary but should be generally lower which will put pressure on managers fees Market analysis for a UK pension fund on impact of rising bond yields (pessimistic case) 5.0 4.0 Yield % Spread % UK Base Rate (LHS) 10 yr Gilt Yield (LHS) BBB Corporate Spread (RHS) 2.0 1.9 Maturity (Years) Govt Total Returns AAA Total Returns AA Total Returns A Total Returns BBB Total Returns 0 0.0% 0.2% 0.1% 0.4% 0.8% 3.0 1-1.0% -0.8% -0.8% -0.5% 0.1% 2.0 1.0 1.8 1.7 5-3.7% -3.4% -3.2% -2.8% -2.2% 10-7.6% -7.3% -6.8% -6.3% -5.8% 15-11.2% -10.8% -10.0% -9.4% -8.8% 0.0 0 1 2 3 Years 1.6 20-14.4% -13.9% -12.9% -11.9% -11.2% Source: Fidelity Worldwide Investment, Proprietary Quantitative Analysis, 25 March 2015. Total returns are annualised over a 3 year period. For illustrative purposes only.

Evolving active fixed income strategies Relative Return Total Return Absolute Return Performance objective relative to a benchmark Performance objective expressed as a total return Performance objective relative to a cash return Typically market cap. weighted benchmark Market beta exposure heavily influenced by the benchmark Strategy typically constrained by a tracking error limit Unconstrained from benchmark Positive market exposure (beta) Returns determined by beta management and relative value No benchmark Broadly market neutral - limited drawdown tolerance Returns determined by relative value Source: Fidelity Worldwide Investment, 31 March 2015.

Fixed income benchmarking, blurring alpha and beta Security characteristics (e.g. subordination) Credit Trajectory Currency Stock of Debt Maturity Correlation Key rate Volatility Credit premium Fiscal Stability Credit Quality Financial Ratios GDP Source: Fidelity Worldwide Investment, March 2015

Traditional market cap benchmarking Traditional market cap benchmarks emphasise the most indebted issuers This can introduce considerable asset type and currency biases Barclays Global Aggregate Bond Index split BoA ML Global High Yield Index split 100% 18% 15% 13% 54% Treasury Government-Related Corporate Securitized 80% 60% 40% 20% 0% '97 '99 '01 '03 '05 '07 '09 '11 '13 US LATAM CEEMEA Asia UK EU Smaller pension funds that are unable to implement complex strategies are looking at better bond benchmarking Source: Bloomberg, Fidelity Worldwide Investment, 31 March 2015. Snapshot of asset class components of Barclays Global Aggregate Index as at 24 April 2015. BoA Merrill Lynch Global High Yield Index 01 January 1998 to 13 July 2014

Smart beta benchmarking using a global high yield example Under an Equal Risk Contribution (ERC) umbrella, emerging markets in global high yield carry more weight ERC has delivered superior results 2.1 Total Return 31/12/97 = 100 1.6 1.1 5% 5%4% 13% 20% 6% Market 15% ERC Cap Weighted Weighted 56% 17% 24% 17% 18% US EU LATAM UK CEEMEA Asia Source: Bloomberg, Fidelity Worldwide Investment, Bloomberg, BofA Merrill Lynch 13 July 14. 0.6 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 ERC HY ERC HY Global HYGlobal HY US HY US HY since 1999 Historical Ret 4.3% 3.2% 3.0% Volatility 12.1% 11.0% 10.8% IR 0.36 0.29 0.28 Max DD 42% 42% 44% from 2004 Historical Ret 6.6% 4.9% 4.5% Volatility 12.8% 11.4% 11.1% IR 0.52 0.43 0.40 from 2010 Historical Ret 8.2% 7.0% 6.7% Volatility 8.6% 7.6% 6.9% IR 0.95 0.93 0.97

Change in governance models by European pension funds Improving Current Governance Increased use of independent trustees Increase in investment subcommittees More use of professional advisors and outsourcing to Investment managers 48% of respondents to a 2013 survey now use either an independent trustee company or independent trustees, or both Adoption of new Governance models Glide path strategies Disciplined risk management A distinct shift towards managing funding levels and minimising risks versus liabilities Source: Bloomberg, Fidelity Worldwide Investment, 31 March 2015. Source: survey conducted by Mercer, 30 November 2013

The glide path strategy Taking off In flight Preparing for landing Touching down Glide Path Adoption Sponsor formalises risk management program Relatively low funded status Hedging objective is to obtain duration which offers high bang-forthe-buck Relatively high allocation to return seeking assets Focus is on strategic positioning as opposed to tactical precision Source: FMR Pyramis, 4 March 2015. Glide Path Execution Sponsor has adopted a glide path which leads to dynamic de-risking as the plan s funded ratio improves Typically the longest stage of the journey As the plan becomes better funded (closer to end stage), the program shifts towards less return seeking assets and hedging assets Hedging precision become more important as the plan s financial health improves Migration from Glide Path to Landing Pattern Plan is well funded, approaching end-stage, which requires the derisking program to be more precise and specific. Program needs to be nimble in order to act swiftly once the plan has reached the end-goal funded status Focus is on preparing for endstage execution rather than on upside gains End-Goal Execution Concrete steps are taken to implement final solution End goal is sponsor-specific and may have many forms Retention/immunization Risk transfer such as lump sums and annuitisation Mix of retention and risk transfer

Governance Allocation? Advice structures have shifted To meet this glide path, trend is for clear separation of beta (market risk) and alpha (manager skill) Manifests itself in the creation of matching (risk management) and growth (return delivery) portfolios Emphasis on global rather than local investing: improved opportunity set, diversification and liquidity Disciplined triggers for de-risking activity Growth Portfolio Matching Portfolio Funding monitoring and rebalancing Equities Total Return Fixed Income Absolute Return Fixed Income Government, Corporates & Credit Fixed / Inflation Leverage Global Opportunity Set Derivative overlay Managers need to adapt their approach to fit this structure Source: Bloomberg, Fidelity Worldwide Investment, 31 March 2015.

Polling Question #2 For the pension funds in the audience, as part of your investment structure, do you currently use: 1. Total Return bond fund(s) 2. Absolute Return bond fund(s) 3. Both 4. Neither?

Evolving active fixed income strategies Relative Return Total Return Absolute Return Performance objective relative to a benchmark Performance objective expressed as a total return Performance objective relative to a cash return Typically market cap. weighted benchmark Market beta exposure heavily influenced by the benchmark Strategy typically constrained by a tracking error limit Unconstrained from benchmark Positive market exposure (beta) Returns determined by beta management and relative value No benchmark Broadly market neutral - limited drawdown tolerance Returns determined by relative value Source: Fidelity Worldwide Investment, 31 March 2015.

Total return bond investing Total return strategies that are global and unconstrained (often sits within growth portfolio) Bond-like risk (positive market exposure), diversification benefits versus equity Not bound by a traditional benchmark - full flexibility to invest in all bond asset classes Example: Global Strategic Bond Strategy 100 80 60 Maximum tactical allocation band Fund's current allocation Strategic framework allocation Barclays Global Agg Index 40 30 33 33 20 16 6 0 Nominal Gov Related & Cash* Inflation-Linked Bonds Investment Grade Corporates EM (local currency) High Yield Beta management drives returns Source: Bloomberg, Fidelity Worldwide Investment, 31 March 2015. Portfolio allocations include the effect of derivatives and so do not sum to 100%. For illustrative purposes only.

Total return credit strategies Dynamically rotating beta throughout the credit cycle 10% 10% 5% 10% 5% 20% 15% 15% 25% Gov t Bonds IG Credit ABS Loans High Yield EM Corps Convertibles IRTXX/CDX 45% 40% 19% 9% 20% 10% 10% For illustrative purposes only. 10% 10% 9% 43% 15% 10% 35% Beta management drives returns Source: Bloomberg, Fidelity Worldwide Investment, 31 March 2015. Chart depicts dynamically rotating credit beta strategy of a Global Multi Asset Credit strategy.

Evolving active fixed income strategies Relative Return Total Return Absolute Return Performance objective relative to a benchmark Performance objective expressed as a total return Performance objective relative to a cash return Typically market cap. weighted benchmark Market beta exposure heavily influenced by the benchmark Strategy typically constrained by a tracking error limit Unconstrained from benchmark Positive market exposure (beta) Returns determined by beta management and relative value No benchmark Broadly market neutral - limited drawdown tolerance Returns determined by relative value Source: Fidelity Worldwide Investment, 31 March 2015.

Alpha Absolute return bond investing Aim is to capture alpha and produce a positive return over and above cash Often held out to be broadly market neutral Beware: many different types of AR bond strategy with varying degrees of market neutrality Absolute Return bond funds: Alpha vs Beta 5.00 4.00 3.00 2.00 A R Fund 1 A R Fund 2 1.00 FIDA* 0.00-1.00 A R Fund 6 A R Fund 3-2.00 A R Fund 4-3.00-0.40-0.20 0.00 0.20 0.40 0.60 0.80 1.00 Beta Correlation to equities Barclays Euro Agg Sov TR Absolute Return Fund 11 Absolute Return Fund 10 Absolute Return Fund 9 Absolute Return Fund 8 Absolute Return Fund 7 Absolute Return Fund 6 Absolute Return Fund 5 Absolute Return Fund 4 Absolute Return Fund 3 Absolute Return Fund 2 Absolute Return Fund 1 FIDA* Absolute Fidelity Return FAST Strategy Fi Looking to capture alpha more effectively 1yr correlation 3yr correlation weekly basis -50% 0% 50% 100% Source: Bloomberg, Morningstar, Fidelity Worldwide Investment, 31 March 2015. Uses a selection of absolute return bond funds, for illustrative purposes only. Basis: total return, in EUR, after fees as at month end. Alpha vs. Beta calculations taken from a FIDA* (Fixed Income Diversified Alpha) absolute return strategy launch on 11 March 2013 until 31 March 2015. Correlation taken as at 31 March 2015. Equity index: MSCI World Eur hedged. For illustrative purposes only.

Comparing these strategies Traditional Benchmarking Total Return Absolute Return Market Beta exposure Susceptibility to moves in the underlying asset class. Often constrained by an index Reliance on alpha / manager s skill Requirement for due diligence to identify investments HIGH MEDIUM LOW MEDIUM MEDIUM HIGH Derivative capabilities Requirement to use derivatives to manage risk LOW MEDIUM HIGH Transparency Simplicity and clarity of investment strategy for the trustee/investment committee HIGH LOW LOW Source: Fidelity Worldwide Investment, 31 March 2015.

Conclusion Bond markets are unlikely to be as accommodating in return terms in the future as they have been in the past Pension funds are changing their focus towards funding levels and risk management Fixed income allocations are shifting from traditional benchmarked funds towards fixed income solutions Successful bond managers will need to broaden their thinking and skill set Flexible investment approach Deeper research capabilities Larger tool box including full derivative capabilities

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Income or Outcome The Evolution of Bond Strategies Through The Lens of International Pension Funds Andy Howse, Head of Institutional Fixed Income, Product and Analytics Fidelity Worldwide Investment