Bentham High Yield Fund Quarterly Commentary June 2010 Responsible entity Challenger Investment Services Limited ABN 44 119 605 376 AFSL 320505
Performance The Bentham High Yield Fund (the Fund ) returned +2.55 percent (before fees) in the June quarter, outperforming the Merrill Lynch High Yield Cash Pay Constrained Index (AUD) by +1.93 percent. The Fund underperformed the UBSA Composite Bond Index Constrained Index (AUD) by 1.05 percent over the quarter. As at 30 June 2010, the Fund had a yield to maturity of 13.7 percent and an option adjusted spread of 778 basis points. Chart 1. High Yield Fund annual returns relative to benchmark 70 60 50 40 30 20 10 0-10 -20-30 -40 5.2 6.4 3.3 2.8 2001 2002 28.1 30.6 2003 16.5 15.1 High Yield Fund Gross Return (before fees) 2004 11.3 11.4 4.35.2 4.7 3.5 Merrill Lynch High Yield Cash Pay Constrained Index (AUD) 2005 2006 2007 2008 58.7 59.4 2009 8.5 6.4-27.0-27.1 As at 30 June 2010 2010 Source: Challenger, Bloomberg The information in chart 1 is presented on a before fees basis. Gross returns are calculated by using pre-distribution month end withdrawal prices and assumes income is reinvested in additional units with Management Costs deducted added back. Returns after fees are included in the information presented in tables 1 and 2 on page 4. Returns may be volatile and may vary from year to year. Past performance is not a reliable indicator of future performance. Chart 2. High yield index yield spreads and the rolling 12 month default are both falling 17% CS HY Index Spreads (RHS) Moody's Global HY Default Rate by # is currently 6.1% 17% Market commentary Most sectors underperformed government bonds in the June quarter. The Credit Suisse High Yield index had a cumulative total return of -0.21 percent compared with the US 10 year treasury return of 8.54 percent for the quarter. The S&P 500 and Dow Jones equity indexes returned 11.43 percent and 9.36 percent respectively for the quarter. The quarter was dominated by headlines associated with European sovereign debt. Market participants are concerned about the negative market and economic consequences of the high levels of public high debt levels in European countries such as Greece, Spain and Portugal. The market is concerned that European problems will begin to impede the recovery of the US economy despite arguments that any problems will be contained. According to Credit Suisse, outperforming high yield sectors included healthcare, chemicals and gaming/leisure returning 1.91 percent, 1.75 percent and 1.74 percent respectively. Underperforming sectors were energy, forest product and services returning 0.87 percent, 1.42 percent and 1.92 percent respectively. Fund activity During the quarter aggregate risk in the Fund s investment profile was increased, with a reduction in exposure to the overlay protection (HY CDX*) and cash holdings. On an industry level, exposure to the oil and gas and broadcasting and entertainment segments were increased. Themes Defaults fell 14% 11% 8% 5% 14% 11% 8% 5% JP Morgan reported that the high yield default rate by issuer fell from 4.04 percent to 2.71 percent over the quarter. Only three defaults occurred for the quarter totalling less than US $500 million. The Fund was not exposed to defaults during the quarter. 2% -1% February-89 February-90 February-91 February-92 February-93 February-94 February-95 February-96 February-97 February-98 February-99 February-00 February-01 February-02 February-03 February-04 February-05 February-06 February-07 February-08 February-09 February-10 2% -1% Source: Credit Suisse & Moody s 31-1-1989 to 30-6-2010 Not withstanding the fall in defaults over the quarter, the market is pricing in a higher default rate than forecast by the rating agencies. As shown below in chart 3 the market is currently pricing in a constant default rate of 5.8 percent for the next three years, despite Moody s rating agency forecast of less than 2 percent. *Markit CDX North America High Yield Index. Bentham High Yield Fund Page 1 of 5
Chart 3. Current bond price does not reflect rating agency default forecasts 25% HY Spread Implied Constant Default Rate to Maturity Moody's Global HY Rolling 12 mth Default Rate Moodys Global Default Forecast 25% 15% 15% 10% 10% 5% 5% 0% 0% -5% Jan 86 Jan 88 Jan 90 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12-5% The Moody's Senior Unsecured Bond historical issuer weighted recovery rate for 1982-2008 is 36.4% Assumptions: Implied Default Rate = (Spread - Requried Risk Premium ) Loss Given Default High Yield market: Risk Premium of 300 bp Recovery Rate 30% Loss Given Default 70% Source: Bentham Asset Management Pty Limited and Moody s. Updated to 30 June 2010 High yield supply at a record breaking pace Although issuance began to slow towards the end of the second quarter, it was the highest quarter for issuance since the third quarter of 2007. At this pace, it is likely that 2010 will be a record year for high yield bond issuance. According to JP Morgan, flows into high yield mutual funds have been variable. June had inflows of US $1 billion compared with outflows of US $5.7 billion in May, YTD a net of US $281 million has left high yield mutual funds. In comparison, leveraged loan mutual funds received a net of US $4.7 billion over the quarter. Chart 4. High yield issuance is expected to break last year s record 200 180 160 140 120 100 80 60 40 20 0 31.1 29.3 10 1.4 46 69.1 43 47 73.4 126 150.8 99.8 47.3 94.7 67.9 151.6 158.2 106.1 149.1 147.9 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 YTD Source: JP Morgan High Yield Issuance 52.9 180.7 125 Bentham High Yield Fund Page 2 of 5
Positive ratings trends Signs are emerging that credit market fundamentals have improved in the US for sub-investment grade borrowers. For the first time since 2000, the high yield bond sector received credit rating upgrades from Standard & Poor s that have outpaced downgrades for the first half of the year. Upgrades to downgrades were at a ratio of 1.19:1 and 1.52:1 for the first and second quarters of 2010 respectively. In contrast, credit rating downgrades in investment grade outpaced upgrades. Upgrades to downgrades were at a ratio of 0.32:1 and 0.42:1 for the first and second quarters of 2010 respectively. The return of investment grade bonds can be more sensitive to downgrades than high yield bonds, especially if the company falls out of the investment grade category. This is because investment grade credit portfolios have less flexibility to hold sub-investment grade securities. There are two types of sub-investment grade bonds included in high yield indices. Bonds that were issued with sub-investment grade ratings, and bonds that were downgraded from investment grade (fallen angels). Fallen angels typically have weaker credit protections such as security, covenants, reporting requirements and dividend restrictions. Chart 5. S&P upgrades to down grades US Sub investment grade credit quality has improved 2000 S&P Upgrades to Downgrades United States Sub Investment Grade 2001 2002 2003 2004 2005 2006 Source: Standard & Poor s, Bloomberg 2007 2008 2009 2010 (YTD) 60% 40% 0% - -40% -60% -80% -100% US Sub Inv Grade S&P Credit Upgrades/ Downgrades Market valuations and outlook Chart 6. Peak high yield spread has been followed by a sustained period of excess return over the last credit 2 cycles. 31-8-1989 to 30-6-2010 Source: Barclay s Capital and Bentham Asset Management Pty Limited. While peak excess returns of 62 percent better than bonds arrive on time November 2009 or 12 months after the peak in spreads in November 2008. Yield spreads are still well above average and remain a source value given the falling default rate. High levels of supply make fundamental analysis on individual names important. Market technicals are positive with defaults forecast to fall by the rating agencies. Rating upgrades also reflect the improving balance sheet of the high yield sector in general. This positive outlook for the high yield sector is tempered against some concerns over the strength of US economic recovery. Although US unemployment fell from 9.7 percent to 9.5 percent over the quarter, a majority of the fall was a result of people leaving the labour market rather than the creation of new jobs. Bentham High Yield Fund Page 3 of 5
Table 1. Bentham High Yield Fund returns Merrill Lynch US High Yield Cash Pay Constrained Index Bentham High Yield Fund returns UBSA Composite Bond Index As at 30 June 2010 Total Return (after fees) % Gross Return (before fees) % Benchmark* % Excess Return % 1 Month 1.22 1.28 1.67-0.38 3 Months 2.35 2.55 0.62 1.93 6 Months 8.10 8.52 6.37 2.15 Std Dev 1 Year 27.25 28.26 30.23-1.97 4.94-0.40 3.97-0.50 2 Year (p.a.) 9.54 10.40 10.70-0.30 18.84-0.02 7.60-0.04 3 Years (p.a.) 7.28 8.09 7.32 0.77 15.77 0.05 6.37 0.12 5 Years (p.a.) 8.01 8.74 7.93 0.81 12.35 0.07 5.02 0.16 10 Years (p.a.) 8.42 9.10 9.08 0.03 10.09 0.00 3.95 0.01 Positive months (%) 100 93 Negative Months 40 47 Positive months (%) 71 66 Worst month (%) -18.28-19.54 Best month (%) 10.00 10.71 Average month (%) 0.70 0.71 Fund Size AUD $29.3M Months since inception 140 *Benchmark is the ML High Yield Cash Pay Constrained Index, return is hedged into AUD. The inception date of the fund is 15th Oct 1998. Total Returns are calculated (after fees) using pre-distribution month end withdrawal unit prices and assume all income is reinvested in additional units. Gross Returns are calculated by adding back the Management Costs deducted. Past performance is not necessarily indicative of future performance. Returns may be volatile and may vary from year to year. Source: Bloomberg, State Street Sharpe Ratio Track Error Info Ratio Table 2. Bentham High Yield Fund returns UBSA Composite Bond Index Bentham High Yield Fund returns UBSA Composite Bond Index As at 30 June 2010 Total Return (after fees) % Gross Return (before fees) % Benchmark* % Excess Return % Std Dev Sharpe Ratio Track Error Info Ratio 1 Month 1.22 1.28 1.67-0.38 3 Months 2.35 2.55 0.62 1.93 6 Months 8.10 8.52 6.37 2.15 1 Year 27.25 28.26 30.23-1.97 4.94-0.40 3.97-0.50 2 Year (p.a.) 9.54 10.40 10.70-0.30 18.84-0.02 7.60-0.04 3 Years (p.a.) 7.28 8.09 7.32 0.77 15.77 0.05 6.37 0.12 5 Years (p.a.) 8.01 8.74 7.93 0.81 12.35 0.07 5.02 0.16 10 Years (p.a.) 8.42 9.10 9.08 0.03 10.09 0.00 3.95 0.01 Positive months (%) 100 93 Negative Months 40 47 Positive months (%) 71 66 Worst month (%) -18.28-19.54 Best month (%) 10.00 10.71 Average month (%) 0.70 0.71 Fund Size AUD $29.3M Months since inception 140 *Benchmark is the UBSA Composite Bond Index Sharpe Ratio is the Excess Return divided by the Annualised Standard Deviation. Tracking Error is the Standard Deviation of the Excess Return Information Ratio is the Excess Return divided by the Tracking Error. The inception of the fund was 15-Oct-1998. Total Returns are calculated after fees using pre-distribution month end withdrawal unit prices, and assumes all income is reinvested in additional units. Gross returns are calculated by adding back the Management Costs deducted. Past performance is not necessarily indicative of future performance. Returns may be volatile and may vary from year to year. Source: Challenger, State Street. Bentham High Yield Fund Page 4 of 5
Table 3. Fund portfolio breakdown as at 30 June 2010 Top 10 company exposures Issuer General Motors Acceptance Corp. 1.4% Comstock Resources, Inc. 1.3% Tesoro Corp 1.1% Deluxe Entertainment Services Group Inc. 1.1% Chart Industries Inc 1.1% Wallace Theater Corp. II 1.1% CF Industries, Inc. 1.0% Brocade Communications Systems, Inc. 1.0% Omega Healthcare Investors 1.0% UPC Germany GmbH 1.0% Exposure by split rating Split Ratings AA 5.2% A -4.9% Split BBB 4.5% BB 12.9% Split BB 17.4% B 45.4% Split B 9.2% NR 3.2% CCC/Split CCC 5.9% Distressed/Default 1.1% Exposure by debt seniority Cash 5.5% Derivative -5.2% Senior secured 28.3% Senior subordinate 10.3% Senior unsecured 59.0% Subordinated 0.8% Equity 1.3% Top 10 industry exposures Issuer Oil and gas^ 13.2% Broadcasting and entertainment 9.0% Telecommunications 7.8% Automobile 5.9% Mining, steel, iron and non-precious metals 5.3% Chemicals, plastics and rubber 5.2% Beverage, food and tobacco 5.0% Hotels, motels, inns, and gaming 4.5% Aerospace and defense 4.4% Healthcare, education and childcare 4.3% Maturity profile Split Ratings 0 to 1 years 4.2% 1 to 3 years 16.1% 3 to 5 years 31.5% 5 to 7 years 24.9% 7 to 10 years 22.4% > 10 years 1.0% Regional exposures Americas 94.8% Australia & NZ 5.5% Europe -0.3% Portfolio summary stats Yield to maturity 13.70% Running yield 12.58% Option adj spread 778 Credit duration 3.73 IR duration 3.35 Number of securities 217 Number of issuers 171 ^ Oil and gas sector is greater than 12% and is a passive breach that has been corrected in early July 2010. Bentham High Yield Fund Page 5 of 5
The information in this document is current as at 30 June 2010 unless otherwise specified and is provided by Challenger Investment Services Limited ABN 44 119 605 373, AFSL 320505 the issuer of interests in the Bentham Wholesale High Yield Fund ASRN 088 907 224 (the Fund). It is intended as general information and not as financial product advice and has been prepared without taking into account any person s objectives, financial situation or needs. Because of that each person should, before acting on any such information, consider its appropriateness, having regard to their objectives, financial situation and needs. Each person should obtain a copy of the Fund s Product Disclosure Statement (PDS) and consider the information in the PDS before making any investment decisions. A copy of the PDS can be obtained from your financial planner, our Investor Services team on 13 35 66, or on our website: www.challenger.com.au <http://www.challenger.com.au/>. If you acquire or hold an investment in the Fund we will receive the fees and other benefits disclosed in the PDS for the Fund. We and our employees do not receive any specific remuneration for any advice provided to you. However, financial advisers (including Challenger Group companies) may receive fees or commissions if they provide advice to you or arrange for you to invest in the Fund. Some or all of the Challenger Group companies and their directors may benefit from fees, commissions and other benefits received by another Challenger Group company. Past performance is no indication of future performance. Any opinions expressed in this commentary (including as to future matters) may change. This is because outcomes may be affected by known or unknown risks and uncertainties that are not able to be presently identified. 10636/0710