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Practical steps for implementing fixed income

into portfolios

Fixed Income

Ross Bolton, Senior Portfolio Manager Fixed Income

June 2014

Overview

• The role of fixed income

• How can fixed income enhance portfolio performance

• Not all fixed income is the same

• Fixed income versus cash

• Current market themes

• Scenario analysis

• Questions?

p. 2

The role of fixed income

• Advisers should be VERY clear on the role fixed income plays in their overall asset

allocation

• Fixed income is an investment and at times will be viewed as over or under valued

based on market fundamentals

• However, return is just one of a number of criteria investors should focus on when

considering the merits of a fixed income investment

p. 3

Source of regular, fixed income streams

• In Australia, regular six monthly coupon payments

Fixed income investment also offers a number of invaluable defensive attributes:

Capital stability

• Repayment of capital at maturity

Liquidity

• Post GFC liquidity is key due to regulation changes

• Government securities most liquid

Portfolio diversification

• Low correlation to other asset classes, especially equities

• Counterbalance to equities and property

• Even out portfolio returns in times of high volatility

• Preserve capital value

• Lessen volatility of portfolio returns

p. 4

Fixed Income Assets offer investors more than just a return

A little more on protection

Portfolio Return Risk

Equities 8.37% 19.4%

Bonds 6.54% 4.6%

75% Equities 25% Bonds 8.49% 13.6%

-50

-40

-30

-20

-10

0

10

20

30

40

50

Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13

% R

etu

rn

Fixed Income versus Equities

Domestic Bonds ASX 200 Accumulation

GFC/US Financial Crisis

Internet Bubble

European Sovereign Debt

Dubai Property

SSgA believes Fixed Income Investments should act to protect portfolio value

during periods of financial market volatility

p. 5

Source: SSgA, Bloomberg. As at December 2013.

Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.

Past performance is not a guarantee of future results. The information contained above is for illustrative purposes only.

How defensive is your fixed income exposure?

Not all fixed income securities have the same defensive capabilities

Issuer Safe Haven Value Why ?

Commonwealth Very High • Guaranteed by Commonwealth Govt

• Able to be funded by Commonwealth taxes

• RBA Repoable

• Sought for Banks Liquidty Books

Semi Government High • Guaranteed by State Governments

• Able to be funded by State taxes/GST

• Sought by Bank Liquidity Books

Supranational Good but issuer specific • Issuer structures are different

• Some issuers explicit foreign govt guarantee

• Not all issuers are repo eligible

Corporate Sporadic/Volatile/Low • Guaranteed by Issuer

• Credit quality decreases with volatility

• Not repo eligible

• Counterparties want to de-risk balance sheet

Mortgage Backed Very Low • Small amount of fixed Issuance

• Mortgage backed bonds sought after in good times

High Yield Very, Very Low • Thin Domestic market

• Global more liquid

• Market Volatility leads to credit spread widening

Hybrid Securities Extremely Low • Not repo eligible

• Not sought after for bank liquidity books

• Equity characteristics will be a negative during times of volatility

• Lack of secondary pricing

p. 6

Source: SSgA.

The information contained above is for illustrative purposes only.

Summing up

• All securities have a role to play

However…

• Some securities have better defensive capabilities than others

• If yield is your only goal you will have to endure high volatility in times of market turmoil

• In todays market, liquidity has to be paid for, and the investor is the payer

p. 7

Defensive assets: Cash versus Fixed Income

Superannuation Funds still hold a high allocation to cash

June 2012 June 2013

Australian Shares 27% 26%

Global Shares 23% 25%

Listed Property 2% 2%

Unlisted property 8% 7%

Australian Fixed Income 9% 9%

Global Fixed Income 5% 6%

Cash 9% 8%

Other Assets 16% 16%

Source: APRA: Annual Super Bulletin Average AA of default strategy

For a defensive play…could fixed income play a better role ?

p. 8

Cash versus fixed income

Both cash and fixed income have a role to play. However, they do have different

characteristics to their structure:

• If you want your defensive assets to offset the drag of growth assets in a period of

volatility it is most likely fixed income investments will provide that protection

• This due to the potential for capital appreciation and the negative correlation with equity

markets

Cash Fixed income

High capital stability Capital repaid at Maturity

Receive RBA cash rate or less Coupon generally above cash rate

No capital appreciation Potential for capital appreciation

High liquidity Liquidity dependent on security

Risk of negative real return Inflation premium built in to yield

p. 9

Yields on cash versus fixed income

• The expectation that the RBA is on hold for the medium term highlights the reinvestment

risk for cash

• Bond Index Running Yield above Term Deposit rates

• Market Weighted coupon divided by capital price

• Indication of the Income component of a fixed income investment

• Running yield of the S&P/ASX Australian Fixed Interest index at end May 2014 was

4.93%

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14

%

Date

S&P Running Yield - RBA Cash - Average Special TD >$10K

S&P Running Yield RBA Cash Term Deposits

p. 10 Source: RBA, S&P. As at May 2014.

Past performance is not a guarantee of future results.

What does this mean?

RBA rate cuts have made cash less attractive as a defensive investment

Fixed Income characteristics make for a valuable tool when looking to smooth

potential portfolio return volatility

• Capital repaid on maturity, fixed regular income

• Can provide insurance against potential growth asset capital loss within a portfolio

…BUT AREN’T AUSTRALIAN BONDS EXPENSIVE?

YES…

• Compared to their history; and

• if the market expects global growth to rebound strongly, inflationary pressures to

rise and the RBA to talk about raising rates

What does current market pricing suggest about the economic outlook and

future direction of interest rates?

p. 11

Domestic market themes

RBA waiting for past stimulus to translate into domestic demand

• Domestic economy continues to show resilience but issues remain

• Transition from mining sector to other sectors continues at a slow pace

• Exports and Housing construction has been the driver of recent growth

• Capital Expenditure is expected to decline significantly during 2nd half of 2014

• Tighter fiscal policy will also impact demand over rest of 2014

• Consumer and Business sentiment remains constrained

• Leading Indicators still subdued

RBA has moved to a neutral stance on Monetary policy

• RBA is confident there is enough stimulus in the system

• Some concern about the strength of the currency

• Raising rates pushes AUD up/Cutting rates stimulates housing

Inflationary pressures remain well contained

• Trimmed Mean: 0.5% Q1 2014, 2.6% Q1 2014 YOY

• Wage Cost: 0.7% Q1 2014, 2.6% Q1 2014 YOY

p. 12 Source: Bloomberg

Current market pricing

Cash market

• Interbank 30 day Cash Rate Future

• Represents the market’s expectation for 30 day bank funding at that time

• By Sep 2014 market expects a cash rate of 2.68%

Bond market

• Australian yield curve normalised upward sloping

• Current 3-10yr spread about 100bps historically steep

• Long end pricing in US yield increase but constrained by cash rate

• Not expecting an inflation surge why do rates rise?

Popular notion is that cash rates and bond yields should rise but this is not necessarily supported by current market pricing

IB Contract %

Sep 14 2.48

Dec 14 2.49

Mar 15 2.52

Jun 15 2.61

Sep 15 2.68 2

2.5

3

3.5

4

4.5

3M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 13Y 15Y 20Y

%

Maturity

ACGB Yield Curve

ACGB Yield

p. 13 Source: SSgA

12 month scenario analysis

Market

movement Cash

Rentenbank

2020

Rates unchanged 2.53% 3.82%

100 bps rally 2.53% 7.87%

33 bps sell off 2.53% 2.53%

100 bps sell off 2.53% -0.10%

Look at bonds with similar characteristics to current S&P All Australian Fixed Income

Index:

• Rentenbank

• 5.5% 9 March 2020

• Yield 3.85%

• Price 108.405

• ModDur 4.886

With these characteristics, the yield on this bond needs to rise 33bps to break even with

cash and 100bps before the bond return turns negative

If rates stay the same or rally the bond return will significantly outperform cash

p. 14 Source: SSgA.

This information should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security.

SSgA Model Asset Allocation

Current themes

• Economy is doing well but expect trend growth at best

• Corporate sector doing well

• RBA on hold for extended period

• Interest rates not expected to increase significantly

• Happy to hold fixed income with credit spread exposure rather than sovereigns

Growth 55%

15%

15%

10%

5%

Defensive 45%

Corporate Bonds

Cash

Composite Bond

Semi Government

Summary

• Even at current yield levels, fixed income still has a role to play in a diversified

investment portfolio

• Fixed income can play a big role in capital protection and lowering the volatility of

portfolio returns ie counterbalance to equities and property

• VALUATION versus history should NOT be the only measure used when determining

the VALUE of a FIXED INCOME investment

p. 16

p. 17

Questions?

Disclosure

FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.

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Although bonds generally present less short-term risk and volatility risk than stocks, bonds contain interest rate risks; the risk of issuer default; issuer credit risk; liquidity risk; and

inflation risk. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Past performance is no guarantee of future results.

The views expressed in this material are the views of SSgA Australia through the period ended May 2014 and are subject to change based on market and other conditions. This

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