Absolute Return Fixed Income

Pension Fund Service December 2017

Aon Hewitt Surrey Pension Fund GAM PGIM UBP Allianz

Stamford Associates NN Investment Partners CQS Lombard Odier Neuflize OBC Investissements Contact: [email protected]

Chris Southworth – Chief Executive Officer No.1 Booths Park, Chelford Road, Knutsford. WA16 8GS Tel: 0044 1565 648205 Aon Hewitt Retirement and Investment

The Form and Function of Absolute Return Bond Strategies

Fixed Income investors are increasingly searching for portions of their portfolios to provide both a unique source of alpha and an uncorrelated complement to their traditional interest rate sensitive fixed income allocations. Absolute Return Bond Strategies (ARBS) may provide an opportunity to capitalize on the unique skillset of select fixed income managers in order to drive positive and uncorrelated alpha within an investor’s portfolio. We believe ARBS have the form and function to potentially meet the disparate needs of fixed income investors in the current market environment.

Let’s start with form ARBS strategies are available in different forms and Sectors utilized in ARBS: while sectors will vary by structures and are provided by a number of fixed strategy due to manager preference and expertise, income managers. Over time, the listed universe of ARBS many managers utilize a broad array of fixed income available in research databases has increased to meet sectors to invest in. These include global and emerging the growing demand by investors. Although there are market sovereigns, investment grade and high a number of strategies that may be labelled or classified yield corporate bonds, broadly syndicated loans, as ARBS, we feel that the quantity that fit our select mortgage-backed securities, other asset backed criteria is fewer in number. Simply stated, many managers securities, and currencies. Liquidity is a key metric classified as ARBS are not absolute return focused. We for ARBS and therefore fixed income sectors tend to also draw a clear delineation between those strategies be those that can be more easily transacted in. ARBS that maintain a long only bias and those that are able vehicles typically offer daily or weekly liquidity. to adjust long and short bias over time. We maintain that strategies that are able to shift their directional positioning are the preferred approach for ARBS.

Traditional Active Fixed Income ARBS Benchmark Physical bonds 3-month LIBOR Return Target 0.5 – 2% over benchmark 1 – 6% over benchmark Drivers of returns 80% market / 20% skill 20% market / 80% skill Volatility TE of 1 – 4% Vol of 3 – 6% Duration 4 to 8 years -4 to 4 years Credit Beta 0.8 to1.2 -0.6 to 0.6 Investable Universe Fixed-income instruments, Fixed-income instruments, derivatives and currencies derivatives and currencies

Source: Aon

Performance (what is expected of ARBS?) Unlike the majority of traditional bond strategies in the sectors, ARBS are expected to employ high conviction marketplace, ARBS tend to be measured against cash purposeful trades that result in a diversified and often benchmarks such as the London Interbank Offered complex portfolio structure. Therefore, the approaches Rate (LIBOR). Utilizing a cash like benchmark aligns lend themselves to matching respective return and manager returns with manager alpha targets. While volatility targets rather than focusing on outperformance benchmarks may be used internally for certain invested versus traditional fixed income benchmarks.

1 One of the hallmarks of ARBS strategies is the goal Fund A Fund B Fund C Fund D Fund E Fund F ICE ML US High Yield Index to provide positive returns over time irrespective 250 of performance of the market. This factor drives 200 greater scrutiny on the consistency of performance given the pure alpha targets that are common in 150 the absolute return space. Performance targets can range on the lower end from Libor + 1 – 2% to 100 higher levels of Libor +4 – 6%. Higher return targets may be achieved through different approaches such 50 as constructing a strategy with larger positions, or ealth Inde Setember adding economic leverage to the overall portfolio. 0 Sep 17 Sep 11 Sep 13 Sep 12 Sep 15 Sep 14 Sep 16 Sep 07 Sep 10 Sep 09 The following chart shows the gross performance of a Sep 08 representative peer group of USD based ARBS managers Source: eVestment, Aon, ICE-Merrill Lynch. Data correct as of September 2017 that Aon monitors, broken down by quartile ranking. Past performance does not guarantee future results. ARBS generally focus on shorter term opportunities in 16% order to harvest return, but some do combine longer 14% term focused positions alongside a shorter term trading 12% program to boost expected returns, limit risk and 10% increase diversification. For example, a manager may 8% combine individual bottom up credit selection in an 6% 4% out of favour sector (longer term view) with a short

ross Return 2% position in an index focused credit default position 0% (short term sector view). The result is a strategy and -2% portfolio that seeks to add incremental return over -4% both the short and long term on a consistent basis. 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Coinciding with various performance targets within Source: eVestment, Aon. Data correct as of September 2017 Past performance does not guarantee future results. the absolute return product universe, are stated levels of volatility that the strategies expect to incur. A deep Performance drivers can vary by strategy, but are understanding of observed (ex-post) and targeted typically globally diversified. This factor is a key (ex-ante) risk is imperative to portfolio construction element in the ability of strategies to have multiple of ARBS. From a research perspective, we expect a sources of return in the portfolio, not solely focused solid absolute return manager to deliver a Sharpe ratio on the traditional fixed income sources of return such approaching 0.5 over the medium to long term. as credit, carry, and duration positioning. However, there are some specialist ARBS which focus on a Use of derivatives and risk management single sub-category of the fixed income universe, A key feature of ARBS is the risk management processes, e.g. credit or developed government bonds. which include the techniques and resources that managers employ to ensure a detailed understanding Alongside yield curve positioning and sector and security of the overall risks of the portfolio. Risk measures and selection, ARBS also draw upon additional strategies in analytics utilized in ARBS commonly draw from those order to generate alpha. For example, many ARBS utilize factors most often employed in both the traditional long-short credit, relative value and other quantitatively fixed income and the alternative or hedge fund space. oriented strategies in order to generate returns that are This suite includes stress testing, scenario analysis, less correlated or uncorrelated with traditional fixed and portfolio measures such as Value at Risk (VaR) income return streams. The following chart shows the and drawdown. Additionally, an understanding of gross performance of ARBS with a 10-year track record risks external to the portfolio must be analysed and versus the return of US High Yield. This displays that understood. Technical factors, political risks, equity while high yield may play a part in ARBS returns other market dynamics and other drivers of the broader global drivers and diversifiers of performance are evident. macro environment are key inputs to the understanding

2 of absolute return portfolio managers and can guide Lastly, we advocate for using ARBS within Liability overall level of risk taking within the portfolio. The Driven Investment (LDI) strategies where appropriate. overarching purpose of risk management is to measure Fixed income is at the center of liability hedging pools and analyse the intended and unintentional investment within LDI frameworks. Historically these collateral pools risks within ARBS so they are clear and quantifiable and consisted of government securities or cash to provide then addressed appropriately by portfolio managers. the liquidity needed to support liability hedging. With persistent low levels of yields in the current market, ARBS Once risks are identified, ARBS then refer to a risk can provide an opportunity to generate increased return management tool-kit, in order to maintain liquidity over cash and government securities while maintaining and hedge unwanted risk, while investing globally. the level of liquidity needed for potential cash calls from Portfolio construction and diversification help to alleviate the hedging portfolio. unwanted risks in absolute return portfolios. However, given their opportunistic approach ARBS tend to utilize Risks derivatives as an additional tool in risk management. ARBS do not invest without risk and their goal to provide consistent positive returns is not guaranteed to be met. Derivatives can assist in smoothing out the performance As discussed, ARBS do tend to be complex in structure profile by protecting the portfolio from extreme and investment approach and therefore require a detailed drawdowns in performance and to buffer the portfolio understanding of the process, people, and investment from sharp increases in volatility. Instruments used philosophy involved. Additionally, the absolute return often include options, interest rate swaps, forwards, label can carry different meanings to investors given the futures and credit default swaps among others. Rather diversity of strategies and managers available to invest than being used to purely generate leverage and with. A summary of potential risks is listed below: adding to risk, derivatives are utilized in optimizing and balancing risk in the portfolio and allow the targeting • LIBOR ≠ Risk Free: Investments in ARBS carry risk of specific risks that managers want to take on while of capital loss. In addition, there are trading costs avoiding those that are unwanted. Also, strategies may associated with these strategies meaning they should use derivatives to access areas of the market on a more not be treated as cash vehicles. efficient basis rather than requiring cash- bond positions. • Manager alpha capabilities: Assessing alpha Function — what’s the use? generating capabilities and on-going monitoring requires specialist knowledge and research. ARBS derive their characteristics from both traditional fixed income investments and hedge fund approaches, • Diversification and liquidity: The sturcture of ARBS thus leaving many investors with the dilemma of where does not impose any fixed allocation to any given sector ARBS fit into a broader portfolio. ARBS are utilized in of fixed income asset class but instead encorages a a number of ways by institutional investors such as construction of portfolios based on best ideas. providing a relatively stable return stream, as a diversifying • Counterparty risk: ARBS managers make greater asset, or as a portable alpha opportunity. We advise that use of derivatives than their traditonal fixed income ARBS are appropriate for these purposes given client’s counterparts, therefore clear policies realting to individualized and customized needs and preferences. counterparty management must be in place. • Reporting : ARBS require more detailed and Given the current low level of nominal yields in the major sophisiticated reporting. The manager needs systems bond markets, we feel that ARBS offer an attractive risk/ that support the process and allow for identification of return balance compared to government, cash, and sources of risk taken and mitigation of unintended risk. investment grade corporate bonds. Also, given the low Ability to attribute performance to the risk taken in the or negative duration profile of many ARBS, they may offer portfolio is crucial. protection in a rising interest rate environment. Many ARBS carry the ability to include directional trades as well • Fees: Fees tend to be higher than those charged for as non-directional or short positions within their portfolios traditional fixed income. and as discussed in the “form” section above, this helps We advise investors to conduct rigorous and detailed to lower correlation with traditional long only fixed and manager research and operational due diligence, to equity mandates. As a result, ARBS can be utilized as a address the complexity and potential risks of investing diversifying asset within a portfolio construct. in ARBS.

3 Key characteristics and qualities we focus on for rating ARBS • Strategies that are not benchmarked against • A focus on adding value through both directional a traditional index but tend to be based off of and relative value strategies and not just by taking LIBOR + a rate of return on additional market risk • Strategies that use derivatives to a greater extent for • Ability to attribute performance to the risk taken liquidity and for hedging risks in the portfolio • Strategies that tend to have lower return targets than • Risk management framework that ensures the similar focused hedge funds alongside lower fees and positions are sized appropriately for the risk each greater transparency brings to the portfolio • Track record of key investment professionals in • Systems that support the process and allow managing investments in the absolute return framework for identification of sources of risk taken along with • Structure of the product that doesn’t adhere to a risk mitigation strategic allocation to any given sector or fixed income • Ability to achieve best execution in terms of pricing asset class, but rather encourages a construction of and volume portfolios based on best ideas • Technology infrastructure that facilitates real-time • Ability to generate alpha consistently while effectively position monitoring and market pricing managing downside volatility • Rigorous pre- and post-trade compliance procedures • Clear process for sourcing ideas from a wide range that ensure dealing and settlement quality of alpha sources and combining them into a diversified portfolio

Contact: Paul Whelan Elijah Reese Fixed Income Manager Researcher US Head of Fixed Income Research Aon Global Investment Practice Aon Global Investment Practice +44 (0)20 7086 9256 +1 312 381 9961 [email protected] [email protected]

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4 Phil Triggs, finance manager, Surrey County Council Pension Fund

How do the underlying portfolios of absolute return fixed income strategies differ from more traditional fixed income portfolios and how do these strategies differ from equity-based, or multi-asset absolute return vehicles? We regard bond strategies as having four potential sources of return: duration; curve (timing of duration exposures); credit spread; and illiquidity. For a long-only strategy, the mix will be heavily influenced by the choice of benchmark. A duration of a gilt fund will be over ten years, which will dominate everything else.

The duration component falls and the other components rise as you move from gilts to global sovereigns (duration 8 years), to global aggregate (duration 7 years), to investment grade credit (duration 6 years), to high yield (duration 5 years) to private debt (duration 3 years), to loans (duration less than 1 year).

Total return and absolute return bond strategies in effect take away a lot of duration to let the other return sources matter more. A total return bond fund will usually have a duration in the range 0 - 5 years, with a ‘neutral’ position of 2.5 years. They have positive duration all of the time. Absolute return bond funds look to have a neutral duration of 0 with a range +/- 2 years around that. If they get that right, they can generate positive returns in a rising rate environment, whereas a total return bond fund would find that harder.

These strategies are therefore not comparable with other types of absolute return strategy based on equities or multi-asset, although they may appear to be seeking the same outcome. The key question when selecting any absolute return fund is always, ‘do you have confidence that the manager is good at...?’ - be that bond market timing/credit selection, equity selection or tactical asset allocation depending on the fund type. The second issue is then to invest in a range of different ones to gain manager diversification.

5 GAM INVESTMENTS – ABSOLUTE RETURN FIXED INCOME

The current environment presents investors with a number of challenges; questionable valuations within the equity market, tight credit spreads and rising central banks rates. The latter is particularly troublesome for fixed income investors and has led some to forecast an end to the 40-year bull market for bonds.

Introduction to absolute return fixed income Why should pension funds invest in absolute return fixed Absolute return fixed income strategies offer a solution, income now? with their typically broad investment parameters creating Looking forward there are a number of reasons why the potential for positive returns even when asset prices are pension funds should consider absolute return strategies falling. However, the term “absolute return” is wide-ranging as an alternative to traditional fixed income portfolios. The and many of the biases present within more traditional long- most obvious is the return of inflation to developed market only strategies can be found within the absolute return sector. economies and the potential for that to drive bond yields As such, understanding the strengths and weaknesses of a higher (and bond prices lower) as US and European central particular absolute return product or fund manager is arguably banks begin the process of policy normalisation via interest more important than with more conventional fund investments. rate hikes and a tapering of QE programmes.

So what is absolute return? Inflation is rising Absolute return strategies seek to deliver a positive return in all market environments, typically targeting a return above 6% cash. To achieve this goal the fund managers at the helm 5% of such products are given a great deal of flexibility with regard to asset allocation and security selection. At GAM, 4% we believe this flexibility is the key to successful absolute 3% return investing, with our absolute return bond strategies investing across the full spectrum of the global fixed income 2% market and utilising the widest possible range of tools and 1% techniques to deliver on our performance objective and protect investor capital. 0%

-1% Pension funds with assets allocated to benchmark-orientated fixed income strategies, or buy and maintain credit portfolios -2% 2001 2003 2005 2007 2008 2010 2012 2014 2015 2017 have realised strong gains as interest rates have fallen and spreads have compressed to pre-crisis levels. However, with United States much of the return now squeezed out of these markets and Eurozone increased risk of capital losses, the rationale for shifting from Britain a beta-orientated investment to an alpha-orientated absolute Source: Bloomberg, Oct 2017. return approach is increasingly apparent for both return YoY CPI, Non-seasonally adjusted where available generation and downside risk management.

6 In the UK, a simple return to the long-term average yield would absolute return strategies to exploit changes in yield curve result in a loss of more than 25% from the 10-year Gilt - an shape via flattening and steepening trades, which are typically equity style loss from an asset that many would consider to be less volatile than simple directional views and a common a safe haven investment. feature within the absolute return bond strategies at GAM.

Under such market conditions the GAM Absolute Return Bond A steepener trade is designed to profit from a widening in strategies, have the potential to shield investors from such the spread between longer and shorter dated bond yields, losses via short positions in the government bond market whereas a flattener trade profits from a reduction in this (executed via derivatives such as government bond futures or spread as the slope of the yield curve flattens. At present, interest rate swaps), or by allocating to assets in economies GAM’s absolute return bond strategies are positioned for a where inflation is either falling or has stabilised. The emerging steepening of yield curves in the UK, Canada and Australia, world offers a number of opportunities in this respect. while flatteners are in play in Norway and the eurozone.

We consider this a preferable strategy to buying inflation- Cross-market strategies are another way to overcome some linked securities, which already reflect heightened inflationary of the challenges associated with the current fixed income expectations and where real yields are too low or negative. environment and while there is ongoing debate over the likely This is certainly the case in the UK, where at the time of pace of economic growth, there can be no doubt that investors writing, the 10-year inflation-linked gilt offered investors a yield are facing increasingly divergent central bank polices and this in of negative 1.8% and the equivalent breakeven rate exceeded itself creates opportunities for absolute return bond strategies. 3%. By comparison, the 10-year nominal government bond yield in the UK is below 1.3%. An example of one such trade is a curve steepener in Canada which is held against a flattener in Norway. While inflation in Extensive bond buying programs and low (sometimes Canada has recently eased, we believe this is the result of negative) interest rates have led to an extreme flattening of transitory factors and strong economic growth has seen the yield curves in the developed world, with pension funds well output gap narrow. Conversely, inflation in Norway is weaker aware of the challenge this creates for liability management. It than expected and has the potential to drift lower. Furthermore, also removes the upside available to investors willing to take concerns regarding a bubble in the housing market are longer-term risks and has created a dearth of opportunities unlikely to see the Norwegian central bank cut interest rates towards the front of the curve as both government and sufficiently to hit its inflation target (2.5%) and this is expected corporate issuers seek to lock in cheap long term financing. to weigh on economic growth in the coming years.

Absolute return managers, with the ability (and skill) to Absolute return bond strategies also have the potential to anticipate the flattening and steepening of yield curves, extract value from credit markets at a time where spreads are at can overcome this challenge by actively allocating capital multi-year lows. The chart below demonstrates the compression to jurisdictions where the downside risk is minimal. More in spreads to pre-crisis levels. Traditional credit investments importantly, the use of modern investment techniques enables offer limited upside and downside risks have risen.

BofA Merrill Lynch A-BBB US corporate bond index (excl. REITS & Financials) Option-adjusted Spread (OAS) vs UST

31 May 2007 29 February 2016 30 September 2017 1,200 1,200 1200 1,100 1,100 1100 1,000 1,000 1000 900 900 900 800 800 800 700 700 700 600 600 600 500 500 500 400 400 400 300 300 300 200 200 200 100 100 100 0 0 0 0 2468101214 02468101214 - 2 4 6 8 10 12 14 Years’ maturity Years’ maturity Years’ maturity

Source: BAML via Bloomberg, September 2017

7 In fact, here at GAM we believe the secret to adding value in the fully hedge the interest rate and FX risk associated with their current environment is to marry old-school accounting based positions, our government bond team do not take credit risk and credit research with more modern investment techniques. we actively hedge tail risk through the use of options. This is More specifically, we believe that after many years of almost particularly important within our convertible bond book. universally strong performance, the ability to differentiate between good and bad companies - shorting the weaker Our absolute return objective is also universal, which means that issuers either outright or against stronger names via relative every member of our investment team has the same absolute value positions - will add value as interest rates begin to rise and return objective as an investor in any one of our absolute greater attention is given to issuer specific risks. return strategies. We do not challenge or remunerate our fund managers and analysts to beat sector specific benchmarks; Perhaps most importantly, the flexibility to allocate across a we challenge and remunerate based on delivery of consistent wide selection of the fixed income universe, while employing positive returns within their area of expertise or specialist sector. both conventional and more modern investment techniques means that solutions such as the GAM Absolute Return Bond This approach is also evident in our asset allocation process strategies typically have a very low correlation with traditional whereby our lead portfolio managers will ask the opinion of bond and equity portfolios, making them a good diversifier of the relevant sector specialists before allocating capital to any investment risk for pension funds. market segment. If that specialist does not believe his or her sector offers sufficient upside potential, then capital will be withheld and if that proves to be the right investment decision How does GAM construct an absolute return bond portfolio? then that specialist will be rewarded. Quite simply, GAM does Our absolute return bond strategies focus on capturing the not compensate its investors to take risk; instead, GAM inherent inefficiencies which exist in global fixed income compensates for the management of risk. markets. We believe that while financial markets are ultimately driven by economic fundamentals, prolonged periods of When constructing portfolios, our lead portfolio managers mis-pricing can occur when other drivers dominate. In such seek a diverse set of ideas which capture more upside than instances we need to be flexible in our approach to the market downside. Key investment themes are discussed and debated and the tools we use to extract value. at the team level, and sector allocations are based on the attractiveness of each from both an absolute and a relative risk/ In fact, this philosophy fostered the addition of systematic return perspective. The most appropriate instruments are then strategies to our fundamentally valued based process at the end chosen for each trade. of 2014 and more recently a tactical allocation away from high yield bonds in favour of convertible debt. Ultimately, however, The GAM Absolute Return Bond strategies have assets under our objective is to deliver our investors consistent positive management of approximately GBP 10 billion and are available returns from the fixed income market and limit their exposure via a UCITS vehicle offering daily liquidity. It can be accessed to downside risk, so in practice our process is very simple, buy through various levels of volatility and with target returns ranging bonds, buy protection. from cash plus 1-2% to cash plus 2-4% and cash plus 3-5%. A more focused version combining the team’s best discretionary Here at GAM, this protection is at the heart of portfolio rates and FX trades with model-based investments, targets a construction, as is the notion of ‘sector specialists for each return of cash plus 8-10%. specialist sector’ which means, each experienced member of our investment team provides expertise in managing risk in The chart below depicts the risk versus return profile for the their particular investment field. Consequently, our credit team GAM Absolute Return Bond strategies.

The Absolute Return Bond Strategy launched in 2004

Absolute Return obective* LIBOR +1-2%pa LIBOR +2-4%pa LIBOR +3-5%pa LIBOR +8-10%pa Return Macro (UCITS) Typical volatility <2% pa <3% pa <5% pa <10% pa Typical VaR <1% monthly <2% monthly <2% monthly <2% monthly ARBF Plus (UCITS) Source: GAM, As at 30 Sep 2017. * Net of institutional fees over rolling three year periods in normal market conditions ARBF (UCITS) ARBF Risk (Offshore)

ARBF Defender (UCITS)

Return

8 Outlook and positioning We see value in the emerging world where yields remain Fixed income investors have faced a wide variety of challenges attractive versus their converged and developed market this year, with heightened political tensions supporting a move equivalents. Emerging market bonds should also benefit from into defensive assets, while the potential for rising interest strong investor demand as rising interest rates in the developed rates suggested such a transition could prove costly. While it is world drive institutional investors back to this segment of certainly true that an environment of policy normalisation could the market. Furthermore, inflation in the emerging world is prove tricky for many fixed income investors, we do not share subsiding, enabling central banks to start easing (or stop the negative outlook that has been so prevalent in the financial tightening) monetary policy rates at a surprisingly rapid pace, press. In fact, the divergence we are beginning to see between which of course benefits fixed income investors. Mexico is an central banks in both the developed and the emerging world excellent example of such an economy. creates a plethora of opportunities for absolute return fixed income strategies. Spreads within the corporate bond market have continued to grind lower on the back of central bank buying and persistent At the portfolio level this is reflected by a negative duration investor demand. In some instances this has taken spreads bias in the developed world and a long position in emerging to multi-year lows, offering little protection against any rise in markets such as Mexico, South Africa and Brazil. Furthermore, government bond yields or interest rates. This is also evident divergent growth stories within the developed world have in the credit default swap market, where the cost of protecting created opportunities for cross market trades that are against a default in either Europe or the US has fallen to a 10- particularly well suited to our investment style and approach. year low. Examples include the before mentioned curve trades in Norway and Canada, as well as a long position in Swedish However, the outlook for this segment of the market is not interest rates against a short in the US. entirely negative and we believe the marriage of traditional credit research with more modern investment techniques, including The US Federal Reserve appears determined to press relative value strategies and outright shorts has the potential ahead with a December 2017 rate hike and while we remain to deliver a good level of performance. Bank and financial positioned for a rise in mid-term yields, the impact of these names should benefit from a steepening of yield curves in the shorts on duration has been offset by our holding of longer- developed world and we continue to see value in the energy and dated US Treasury bonds. The latter reflects our view that any resource sectors. normalisation of US monetary policy is likely to be extremely slow and have limited impact on the long end of the yield curve Alternative forms of credit, such as short-dated trade finance in the near term. It also reflects our view that demand for longer- securities, offer an alternative to negative yielding government dated Treasury bonds will be supported by their safe haven debt in Europe and when combined with a third party status and attractive relative yield. At the time of writing, the US insurance or government guarantee, provide excellent risk- 30-year US Treasury bond yielded 2.8% against an equivalent adjusted returns. yield of 1.3% in Germany and 0.8% in Japan. Convertible debt has historically outperformed other riskier The UK remains our favourite developed market short with the forms of credit in rising interest rate environments and we see Bank of England lifting its benchmark interest rate in November no reason why this will not be the case again. However, high 2017 on the back of rising labour costs and currency weakness equity valuations and questions over market breadth suggest that has driven inflation to a multi-year high. Brexit negotiations a degree of caution is essential and we have built significant are progressing slower than many had anticipated and the downside protection into this segment of the portfolio – threat of a hard exit persists. While the government is said utilising both equity index and credit options. The technology to be preparing for this possibility, proposed investments in sector remains one of our favourite hunting grounds within the technology and infrastructure (fiscal stimulus) have the potential convertible bond market as it circumvents many of the existing to drive bond yields higher directly via an increase in supply, or political concerns, but value can also be found in the industrial indirectly via rating agency downgrades. and consumer sectors, and we are positive on the outlook for commodity prices. The UK is closely followed by a short bias in Europe, where improvements in the economic outlook and a tapering of the Finally, currencies are and will prove to be a most useful tool ECB’s bond buying program can be expected to push yields to reflect tactical changes and news events. Bouts of US dollar higher. Politics in the Eurozone requires careful monitoring strength will make emerging market assets struggle and if with the current degree of stability buoyed by the optimism fundamentals can overcome politics, then the British pound surrounding President Emmanuel Macron’s ambitious reforms and the emerging world should prosper. in France. However, populist movements remain a risk factor to watch with Italian elections in spring 2018. In Spain, Catalonia’s nationalism has the potential to buoy demand for higher quality European markets, including the Nordic economies where the portfolio would profit from any fall in yields/rise in bond prices.

9 Conclusion GAM’s approach to absolute return fixed income investing is ideally suited to today’s economic backdrop. We invest across the full spectrum of the global fixed income market, utilising the widest possible range of tools and techniques to deliver on our performance objective and protect investor capital.

Unlike many absolute return bond managers, our fixed income business was built on the concept of absolute return investing. It is the cornerstone of our fixed income offering and represents the bulk of our assets under management and is at the core of everything we do. Our strategies have a low correlation with traditional bond and equity investments and perhaps most importantly, we have a proven ability to add value in periods where bond markets have fallen and traditional fixed income strategies have faltered.

Delivering performance in all markets from 30 Apr 2004 (inception) to 31 Oct 2017

80 %

60 %

40 %

20 %

0 % 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

GAM Absolute Return Bond Composite - GBP Citigroup WGBI (GAM hedged) in GBP 3 Month Libor in GBP

Past performance is not indicative of future performance. Performance is provided gross of fees. Source: GAM, Thomson Reuters

For pension schemes, the diversification of risk away from traditional long interest rate risks which can dominate their balance sheets is the key benefit of investing in an absolute return bond strategy. Pension schemes are typically mandated to have a significant exposure to fixed income, and they can feel confident in outsourcing sector and tactical asset allocation to professional investors at GAM who have the expertise to use absolute return strategies to protect their portfolio.

10 Contact details

Ben Edwards, CFA Emmet Naughton Head of Institutional (UK & Ireland) Client Manager T +44 (0) 20 7917 2459 T +44 (0) 20 7917 8808 [email protected] [email protected]

For more information, please visit www.gam.com Important legal information

Source: GAM, unless otherwise stated. (Where applicable and, unless otherwise noted, performance is shown net of fees, on a NAV to NAV basis). GAM has not independently verified the information from other sources and no assurance can be given as to whether such information is accurate, true or complete and GAM makes no warranty, expressed or implied, regarding such information. Every effort has been made to ensure the accuracy of the information provided, but GAM cannot be held responsible for any errors or omissions. While every effort has been made to ensure the accuracy of the financial information herein, you should note that some of the information may be based on unaudited or otherwise unverified information. This material is confidential and intended solely for the use of the person, persons or entities with nationality of or respectively with their residence, domicile or registered office in a State or Country in which such distribution, publication, making available or use is not contrary to laws or other regulations, and may not be reproduced, copied or given, in whole or in part, to any other person. It is aimed at sophisticated, professional, eligible, institutional and/or qualified investors/ intermediaries appointed by GAM who have the knowledge and financial sophistication to understand and bear the risks associated with the investments described. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be solely relied on in making an investment or other decision. This document qualifies as marketing material. The views expressed herein are those of the manager at the time and are subject to change. The price of shares may go down as well as up and the price will depend on fluctuations in financial markets outside GAM’s control. As a result an investor may not get back the amount invested. Past performance is not indicative of future performance and reference to a security is not a recommendation to buy or sell that security. Holdings and allocations are subject to change. Prices quoted refer to accumulation shares, unless otherwise stated. Historic data may be subject to restatement from time to time. This is not an invitation to invest in any GAM product or strategy. Investments should only be made after a thorough reading of the current prospectus, offering memorandum, the Key Investor Information Document “KIID”, the articles of association and the current annual and semi-annual reports (the “legal documents”), as well as after consulting an independent finance and tax specialist. The legal documents can be obtained in hard copy and free of charge from the addresses indicated below. Some of the sub-funds may not be registered for sale in all jurisdictions. Therefore, no active marketing must be carried out for them. Subscriptions will only be received and shares or units issued on the basis of the current fund prospectus. Shares of the fund have not been registered under the US Securities Act of 1933, as amended (the “Securities Act”) and the fund is not registered under the US Investment Company Act of 1940, as amended (the “Company Act”). Accordingly, unless an exemption is available, such shares may not be offered, sold or distributed in the United States or to US persons. However, pursuant to an exemption from registration under the Securities Act and the Company Act, the shares may be sold or resold in the United States or to certain qualified US investors in transactions that do not constitute a public offering. In addition, certain GAM products are closed to all US investors. This material/presentation may mention GAM Funds domiciled in Luxembourg, registered office at 25, Grand-Rue, L-1661 Luxembourg, each an umbrella investment company with variable capital and segregated liability between the sub-funds, incorporated under the laws of Luxembourg and authorised by the CSSF as a UCITS Fund in accordance with the Directive 2009/65/EC. Management Company is GAM (Luxembourg) S.A., 25, Grand-Rue, L-1661 Luxembourg. UNITED KINGDOM: As far as UCITS described herein are recognised schemes under section 264 of the Financial Services and Markets Act 2000: Copies of the legal documents can be obtained in English, free of charge, from the Facilities Agent GAM Sterling Management Limited, 20 King Street, London SW1Y 6QY (authorised and regulated by the FCA) or on the internet at www.funds.gam.com. Investments in the funds are not protected by the Financial Services Compensation Scheme. Within the UK, this material has been issued and approved by GAM London Ltd, 20 King Street, London SW1Y 6QY, authorised and regulated by the Financial Conduct Authority. November 2017

11 PGIM FIXED INCOME Perspectives August 2017

The Return of Absolute Return Fixed Income

Although the three-decade developed country government bond rally is likely behind us, we believe fixed income can still provide plenty of alpha opportunities. In the current Michael Collins, CFA environment, some fixed income investors may be looking for strategies that can provide Managing Director, Senior Portfolio Manager higher yields than cash and also guard against a rise in interest rates. One alternative, an PGIM Fixed Income ‘absolute return’ fixed income strategy, may meet both objectives.

In the following Q&A, Michael Collins, Managing Director and Senior Portfolio Manager, PGIM Fixed Income, discusses different types of absolute return fixed income portfolios and how a well-diversified, duration-constrained portfolio can take advantage of alpha-

generating opportunities while avoiding systematic exposure to rising interest rates.

Q) What is an absolute return fixed income strategy?

Absolute return fixed income strategies go by a number of different names: absolute return, unconstrained, real return, strategic alpha, opportunistic, strategic income, non- traditional, and even ‘go-anywhere’ or ‘GA’ fixed income.

Regardless of the name, these strategies generally share two common traits:

1) They strive to deliver positive absolute returns over a specified period regardless of the direction of interest rates, and

2) Unlike traditional fixed income strategies, they are not typically managed against a market-capitalization weighted bond index. Rather, they are often managed against a cash-based benchmark such as 3-month LIBOR or any country’s money market (‘risk-free’) rate.

The defining feature of these types of strategies is that they are opportunistic. In most cases, they can select from a broad array of security types and ‘go-anywhere’ within the fixed income market in search of attractive returns.

Traditional Fixed Income Absolute Return Fixed Income • Seeks to maximize risk-adjusted excess • Seeks to maximize risk-adjusted absolute OBJECT IV E returns over a market index returns over a cash-based benchmark BENCHM ARK • Market-based • Cas h-based • Maximize information ratio • Maximize Sharpe ratio PERFORM ANCE GOAL (excess return over benchmark/tracking error) (excess return over cash/volatility)

L EV ERAGE • None • Modest leverage may be utilized • Must have capability and can be multiples • None to extensive DERIV AT IV ES of the portfolio

Source: PGIM Fixed Income.

Professional Investors Only

www.PGIMFIXEDINCOME.com

12 PGIM FIXED INCOME Perspectives—August 2017

Beyond these two traits, absolute return strategies can vary widely in terms of eligible sectors and security types, alpha objectives, risk parameters, and manager styles. Asset managers, in large part, each have their own concept of ‘absolute return’. Some may limit exposure to non-investment grade securities or to the credit and ‘spread’ sectors, some may aggressively adjust duration or use modest leverage, and others may invest heavily in privately-issued (vs. publicly-issued) securities. There are global multi-sector absolute return portfolios, single-sector absolute return portfolios, and even regionally-based portfolios.

In addition, while traditional long-only fixed income strategies have the luxury of underweighting positions versus their benchmarks, many absolute return fixed income strategies need to tactically ‘short’ specific bonds or sectors of the market—often through the use of derivatives—to implement a negative view. Accordingly, these strategies can at times have a negative duration (e.g., go ‘short’ interest rates) which can directly benefit investors when interest rates rise.

A key point to note is that absolute return fixed income strategies are not typically hedge funds. These strategies may be levered as a result of their interest rate hedging techniques, but they are not always economically levered. In addition, the vehicle and fee structures for most absolute return strategies are similar to other institutional and retail fixed income portfolios. For example, there are typically no lock-up periods or gates.

Q) How would you categorize the different types of absolute return fixed income strategies?

Broadly speaking, we view absolute return fixed income strategies as falling into three categories:

1) A macro-based approach that expresses Variety of Styles and Approaches top-down views on interest rate, currency, country, and sector exposures. Alpha Target 100 bps  500 bps Expected Volatility 1% 10% 2) A concentrated approach, investing either  across the broad fixed income market or Benchmark Cash-based  Market-based specializing in a single sector or region. US Global These portfolios tend to hold larger Region  positions in a fewer number of issues, Style To p -down  Bottom-up sectors, currencies, and/or countries. Duration -5  8 3) A blended macro and micro approach Currency -100 100 that uses both top-down and bottom-up  investment styles. These portfolios are Sector Single  Multi generally well diversified and invest in the # of Issuers 10 300 full spectrum of global fixed income sectors,  rate markets, and currencies. Position Size 1%  20% In our view, a blended approach that actively Credit Leverage 0  1-2x manages duration within a modest, Gross Notional Exposure 1x 5x specified band represents the best approach  to keeping the alpha associated with fixed Source: PGIM Fixed Income. For illustrative purposes only. income security selection while limiting the structural interest rate beta.

Actively managing this type of a diversified portfolio across the fixed income and currency markets in both developed and emerging countries provides the strongest base to consistently generate alpha, respond to changing market conditions, limit idiosyncratic risk, and manage overall portfolio risk.

Low Correlation to Traditional Fixed Income

Another benefit of absolute return fixed income portfolios is they tend to have a low correlation to traditional fixed income, as is illustrated in the chart below. In fact, during periods of rising government bond yields, an absolute return portfolio with a near zero duration has the potential to post positive returns as the interest rate hedge—created via interest rate futures or swaps—may generate a positive return on a mark-to-market basis. Page 2

13 PGIM FIXED INCOME Perspectives—August 2017

However, absolute return strategies may be strongly correlated to risk assets, such as high yield bonds and equities. In other words, a balanced portfolio of stocks and bonds, with a large portion of the bonds invested in absolute return strategies, may be suboptimal. That’s because during ‘risk-off’ periods both the stocks and absolute return portions of the total portfolio may decline in value.

5-Year Correlation to Market Index ABSOLUTE RETURN Absolute Return Fixed Income HAS LOWER Bloomberg Barclays U.S. Treasury 0.02 CORRELATION TO GLOBAL FIXED Bloomberg Barclays Global Aggregate Index (USD Hedged) 0.23 INCOME BUT HIGH Bloomberg Barclays Global Aggregate Index (Unhedged) 0.37 CORRELATION TO S&P 500 Index 0.59 RISK ASSETS MSCI World Index (Unhedged) 0.72

As of 30 June 2017. Source: Historical correlations of Morningstar Non-Traditional Bond Category average versus market indices. Source: Calculated by PGIM Investments using data presented in Morningstar software products. All rights reserved. Correlations are based on monthly returns for the trailing 5-year period. See Appendix for index descriptions. You cannot invest directly in an index.

Q) In a time when managers are seeking incremental flexibility, why does a duration-constrained approach make sense?

The duration constraint, achieved by limiting interest rate risk relative to a near zero duration cash benchmark (e.g., +/- 2 years), not only reduces interest rate risk, but focuses a portfolio’s risk allocations on those areas that can provide the greatest value per unit of risk: country, sector, industry, and issue selection. Portfolios constructed in such a manner are likely to offer higher information ratios and more consistent returns. By comparison, portfolios with wider duration bands (e.g., +/- 5-8 years) can present challenges that may result in a portfolio that is not consistent with an investor’s objectives.

Most apparent among these challenges is potential style drift. For example, an investor seeking low interest rate risk may find that the portfolio manager has extended the portfolio’s duration to an intermediate or long duration ‘style box’. Such a drift could heighten interest rate sensitivity precisely at a time when the investor is looking to reduce exposure. Furthermore, strategies with significant negative duration can lead to subpar returns in many scenarios.

Finally, an absolute return strategy with some duration constraints may complement an investor’s overall asset allocation expectations given that interest rate moves are not a primary driver of returns. Conversely, ultra-flexible strategies with wider duration bands can make it difficult to anticipate, or model, how the strategy might contribute—or detract from—an investor’s overall portfolio.

Q) What is an appropriate alpha target and expected volatility for an absolute return fixed income strategy?

Depending on an investor’s risk appetite, we believe an alpha target in the range of +100 bps to +500 bps over 3-month LIBOR or a government cash-equivalent rate is reasonable over a full market cycle, assuming the portfolio focuses largely on fixed income securities. The appropriate alpha target is a function of a client’s return objective and risk constraints, with a key driver being the extent to which they are willing to invest in the ‘plus’ sectors of the fixed income market (below investment grade securities, emerging markets debt, and foreign currencies) and to utilize leverage. A universe that is limited to high-quality bonds and allows for only limited FX and interest rate risk would naturally have a lower alpha objective, while those with the greatest flexibility have the potential to achieve a higher alpha target.

Volatility expectations, or bands, are a defining feature that differentiate the variety of styles employed by asset managers in this space. Naturally, lower return seeking portfolios should experience lower volatility, say in the 1-3% range. More aggressive versions with return expectations of 4-6% above cash may exhibit volatility of 6-10%.

We would expect a Sharpe ratio generally between 0.5 and 1.0, given the expected Sharpe ratios and correlations of the underlying alpha-generating activities. For example, a portfolio with an alpha target of +300 bps over LIBOR and an expected Sharpe ratio of 0.67 (or 2/3) would have an expected volatility of 450 bps. The expansion of the investment

14 PGIM FIXED INCOME Perspectives—August 2017

opportunity set as alpha targets increase may allow the portfolio’s Sharpe ratio to remain consistent, or decline only modestly, even as the risk budget expands.

Alpha Target Over Cash Benchmark Volatility (Annualized Over Full Market Cycle) Expectations Investment Criteria

• Investment grade quality with only +100 bps 1-3% SAMPLE modest allocation to ‘plus’ sectors ABSOLUTE RETURN FIXED INCOME • Broadly diversified with up to 50% in + 300 bps 4-6% PORTFOLIOS ‘plus’ sectors

• Significant (as much as 100%) +500 bps 6-10% exposure to ‘plus’ sectors and/or modest leverage

There is no guarantee these objectives will be achieved.

Q) How is the alpha generated in an absolute return fixed income strategy?

Alpha is generated primarily by identifying fundamentally undervalued fixed income sectors and securities across the global markets, and by capitalizing on temporary mispricings and relative value trading. Portfolios should be actively managed with both strategic and tactical allocations.

Global credit sectors: Both investment grade and non-investment grade credit can offer significant long-term value, especially given the current low level of default risk and the asynchronous nature of the credit cycle whereby different industries are moving through the cycle at different paces.

Government rates and yield curves: Evaluating the economic cycles across countries helps to identify mispricings— whether interest rates truly reflect the fundamentals of a specific country or if they are unduly influenced by technical factors.

Currencies: There will always be currencies that are appreciating and others that are depreciating. As such, currencies can provide a range of opportunities at any given time. Capitalizing on those changes can create macro trading opportunities where alpha can be added in a risk-controlled manner.

Structured product: The broad variety of asset-backed securities—CMBS, CLOs, RMBS, securitized consumer loans, etc. —and the flexibility to invest across the “capital stack” (e.g., senior, subordinated, mezzanine) can provide diversified sources of alpha.

Emerging markets debt: The idiosyncratic fundamental and political trends across more than 65 emerging market countries can create numerous opportunities. Many emerging market sovereign bonds offer higher yields than developed country sovereigns, and the stronger economic growth in emerging countries and accompanying rise in productivity should make their currencies appreciate over time. In addition, emerging market contagion has declined in recent years and the quasi-sovereign and corporate bond markets in emerging countries are growing rapidly, providing both strategic and tactical opportunities.

Q) How have absolute return fixed income strategies mitigated interest rate risk?

A primary attraction of absolute return fixed income strategies is their ability to limit downside risk in a rising interest rate environment. As is illustrated in the accompanying chart, during periods of rising rates (as measured from December 2008 to June 2017), absolute return strategies have, on average, posted positive total returns and consistently generated positive excess returns relative to the aggregate bond indices.

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15 PGIM FIXED INCOME Perspectives—August 2017

Outperformance of Absolute Return Bloomberg vs. Bloomberg Change in US Barclays U.S. Barclays Treasury Yield Absolute Return Aggregate Bond U.S. Aggregate Period (bps) Category Avg1 (%) Index (%) Bond Index (%)

Dec 18, 2008 – Feb 27, 2009 +97 2.0 -1.2 +3.2

Mar 18, 2009 – Jun 10, 2009 +141 8.0 -0.2 +8.2 Oct 7, 2009 – Dec 28, 2009 +67 1.9 -0.5 +2.4 ABSOLUTE RETURN Feb 5, 2010 – Apr 5, 2010 +44 1.5 -0.7 +2.2 STRATEGIES CAN OUTPERFORM Oct 8, 2010 – Dec 15, 2010 +114 0.3 -3.1 +3.4 DURING PERIODS OF Sep 22, 2011 – Oct 27, 2011 +67 0.3 -1.7 +2.0 RISING RATES Jan 31, 2012 – Mar 19, 2012 +58 1.5 -1.2 +2.7 December 2008 to June 2017 Jul 24, 2012 – Sep 14, 2012 +47 1.6 -0.7 +2.3

Nov 16, 2012 – Jan 30, 2013 +44 1.8 -1.0 +2.8 May 2, 2013 – Sep 5, 2013 +135 -2.7 -4.9 +2.2

Oct 23, 2013 – Dec 31, 2013 +55 0.5 -1.1 +1.6

Jan 30, 2015 – Mar 6, 2015 +57 1.0 -1.9 +2.9 Apr 17, 2015 – Jun 10, 2015 +63 -0.1 -2.8 +2.7

Jul 5, 2016 – Mar 13, 2017 +125 3.8 -3.7 +7.5

Source: Morningstar, Bloomberg, Barclays, and PGIM Fixed Income. Past performance is not a guarantee or a reliable indicator of future results. 1Represents the average return of the Morningstar Non-Traditional Bond Category. The table illustrates the Morningstar Non-Traditional Bond Category average and Bloomberg Barclays US Aggregate Bond Index performance during periods where interest rates rose by 40+ bps from 18/12/2008 through 31/3/2017. Rising interest rate periods as measured by the daily business day movements of the 10-year Treasury bond yield, which is a commonly used reference point for the purposes of tracking the general movement of interest rates for the US fixed income market. The decision to use 40+ bps threshold was done so that an investor could see multiple instances of rate rising periods over the last 5+ years to better assess how Non-Traditional Bond Investments have performed during these types of periods.

Q) What are the downside risks and how are they managed?

As in traditional fixed income strategies, the key risks in an absolute return fixed income portfolio are interest rate risk, credit risk, and currency risk. And just like traditional fixed income strategies, each of these risks must be actively monitored and managed.

At the portfolio level, risk budgets with thresholds on systematic risk (yield curve, currency, sector, quality) and tail risk (country, industry, issuer, liquidity) can provide a framework for determining risk allocations and proactive monitoring. In addition, individual issuer exposure must be actively monitored to identify improving and deteriorating credits, especially in portfolios with exposure to investment grade corporate bonds, high yield bonds, emerging markets debt, sovereign debt, and asset-backed securities.

Active risk and sector allocation, including tactical shifts along the credit spread curves, selling bonds and going to cash, and moving up and down an issuer’s capital structure, are other ways an asset manager can tactically increase or decrease overall credit risk. Finally, tail-risk hedging/mitigation strategies that utilize interest rates, currencies, and credit derivatives can allow asset managers to quickly reduce overall portfolio systematic risk.

No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

Q) How is interest rate risk hedged and what is the ‘cost’ of hedging?

The interest rate hedging process uses a combination of U.S., German, Japanese, and/or other global interest rate futures contracts and interest rate swaps to hedge the interest rate risk of the underlying bonds in a portfolio. Futures and swaps can also be used to implement active duration and yield curve positions within specified bands and to capitalize on relative value opportunities across the rate markets.

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16 PGIM FIXED INCOME Perspectives—August 2017

The ‘cost’ of the hedge in yield terms—assuming static interest rates—is essentially the difference between the yields on the hedging instrument and cash. For example, to hedge the duration of a 5-year corporate bond using U.S. interest rate swaps, the cost is the yield of the 5-year swap minus 3-month LIBOR. In mid-2017, the cost of this hedge would have been 0.68% (1.88% yield on 5-year U.S. interest rate swap less 1.20% for 3-month LIBOR). * In practice, however, interest rate risk is hedged at the portfolio level, rather than on a bond-by-bond basis. This overall portfolio interest rate hedge decreases portfolio yield when the yield curve is positively sloped.

Investing in a portfolio with essentially a zero-target duration is also subject to potential opportunity costs relative to longer duration portfolios. For example, when interest rates fall dramatically, absolute return portfolios may lag longer duration portfolios on a total return basis.

* Data as of May 25, 2017. Source of data: Bloomberg.

Conclusion

Although the three-decade bull market in government bonds is likely behind us, we believe fixed income still provides plenty of alpha opportunities. An absolute return fixed income strategy managed against a cash-based benchmark is one option for investors seeking to reduce interest rate exposure and generate higher returns than cash. Among the array of absolute return strategies available, we believe a diversified, blended approach that utilizes both top-down and bottom-up investment strategies while constraining duration within a modest, specified band is the best strategy to generate a consistent alpha stream and limit structural interest rate exposure.

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17 PGIM FIXED INCOME Perspectives—August 2017

Appendix Bloomberg Barclays US Treasury Index: Measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting. The US Treasury Index is a component of the US Aggregate, US Universal, Global Aggregate and Global Treasury Indices. The US Treasury Index was launched on January 1, 1973.

Bloomberg Barclays Global Aggregate Index: Provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities. Securities included in the index must have at least 1 year until final maturity and be rated investment-grade (Baa3/ BBB-/BBB) or better using the middle rating of Moody’s, S&P, and Fitch.

The S&P 500® Index is a commonly recognized, market capitalization weighted index of 500 widely-held equity securities, designed to measure broad U.S. equity performance. A benchmark index is not professionally managed, does not have a defined investment objective, and does not incur fees or expenses. Index performance includes the reinvestment of all dividends. You cannot invest directly in this index. S&P 500 is a registered trademark and service mark of the McGraw-Hill Companies.

The MSCI World Index is a broad global developed markets equity benchmark designed to support: Asset allocation: Consistent, broad representation of the performance of developed equity markets worldwide, without home bias. The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries

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18 PGIM FIXED INCOME Perspectives—August 2017

NOTICE: IMPORTANT INFORMATION Source(s) of data (unless otherwise noted): PGIM Fixed Income as of August 23, 2017.

PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; and (iii) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore. Prudential Financial, Inc. of the United States is not affiliated with Prudential plc, which is headquartered in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.

These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary as defined by the Department of Labor.

These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.

Conflicts of Interest: PGIM Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. PGIM Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. PGIM Fixed Income and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PGIM Fixed Income’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PGIM Fixed Income’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PGIM Fixed Income’s Form ADV.

In the United Kingdom, information is presented by PGIM Limited, an indirect subsidiary of PGIM, Inc. PGIM Limited is authorised and regulated by the Financial Conduct Authority of the United Kingdom (registration number 193418) and duly passported in various jurisdictions in the European Economic Area. These materials are issued by PGIM Limited to persons who are professional clients or eligible counterparties for the purposes of the Financial Conduct Authority’s Conduct of Business Sourcebook. In certain countries in Asia, information is presented by PGIM Singapore, a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan, registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is presented by representatives of PGIM (Hong Kong) Limited, a regulated entity with the Securities and Futures Commission in Hong Kong to professional investors as defined in Part 1 of Schedule 1 of the Securities and Futures Ordinance. © 2017 PFI and its related entities.

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UBP Asset Management

Absolute Return Fixed Income On the back of a multi-decade interest rate rally and one of the longest US expansion phase on record since World War II, some investors are getting concerned about rising interest rates and/or about widening credit spreads and potential losses on their fixed income portfolios. Against this backdrop, Absolute Return strategies are enabling for a flexible allocation to global fixed income markets that would be suitable for all types of macroeconomic environments.

Absolute Return strategies: Why are they different? Absolute Return strategies drastically differ from traditional actively managed fixed income strategies. The later aims to deliver an excess return over its respective benchmark within a certain deviation range (tracking error). This means that by construction the returns of actively managed benchmarked strategies are first and foremost driven by the returns of the underlying asset class. The same applies for so-called Total Return or Income strategies with a reference to a benchmark. The difference is that those strategies allowed more deviation from their benchmarks. At the end of the day, they are all beta-driven strategies: with low-tracking error for traditional benchmarked strategies and higher tracking-error for total return/income strategies. They would suffer the same drawdown as their asset class and exhibit the same volatility.

The aim of absolute return strategies is different. They are genuine flexible bond strategies: their aim is to deliver returns without any reference to a benchmark whatever the market backdrop. Unlike traditional bond funds, these strategies are not managed against a benchmark so give their managers the flexibility to invest wherever the best opportunities lie in the fixed income markets and deliver returns in line with fixed income markets in the past. A summary table of the different fixed income strategies is presented in Figure 1 below and detailed what to expect and how to measure the quality of those strategies.

Figure 1: A summary table of fixed income strategies from ETF to Absolute Return

Benchmarked Total return/Income Strategy ETF Absolute return Low tracking error High tracking error Management Passive Active Active Active

Allocation Static Static Dynamic Flexible

Beta risk High High High to Moderate Low Volatility and In line with bench- Close to benchmark’s Similar to benchmark’s Low drawdown mark’s Performance Tracking-error Excess return Excess return Sharpe ratios indicator

Thus, Absolute Return strategies are flexible fixed income allocation strategies in order to deliver attractive returns in all type of macroeconomic conditions: growth, inflationary, recessionary environments. They would exhibit lower volatility, lower drawdowns and higher sharpe ratios than equivalent ETF or benchmarked strategies. Those benefits are illustrated in Figure 2 below with Absolute return strategies managed by UBP’s Global & Absolute Return Fixed Income.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed20 Income | November 2017 1 | 8

Figure 2: UBAM - Unconstrained Bond and UBAM - Global Credit Opportunities vs. USD broad fixed income market net of fees in USD.

30.06.2016 = 100 108 UBAM - Global Credit Opportunities, in USD UBAM - Unconstrained Bond, in USD BofA US Broad Market Index, in USD 106

104

102

100

96 06.16 09.16 12.16 03.17 06.17 09.17

Source: UBP, Bloomberg Finance L.P., as of 31.10.2017. Performance net of fees in USD (I share class). Past performance is no t a guide to current or future results.

The DNA of Absolute Return strategies is top-down asset allocation

Allocation decisions are the main sources of added value for a diversified fixed income portfolio. Macroeconomic cycles and top-down themes - political, monetary, and sectoral - are the main drivers of over and underperformance between fixed income segments. Recent years have clearly illustrated this predominance of macroeconomics and top-down themes: credit crisis and recession in 2008, banking regulation, deleveraging and QE of the US Federal Reserve from 2009, Greek crisis euro zone crisis from 2010 to 2012, Taper Tantrum in 2013, US QE tapering in 2017, the election cycle in the US and Eu- rope from 2016 - still ongoing with the absence of coalition in Germany and the upcoming elections in Italy, the decline and stabilization of oil and commodities in 2015-2016, then the gradual normalization of monetary policies from 2016: reduction of the Fed's balance sheet and reduction with extension of the ECB’s QE.

In this context, the different fixed income segments in the interest rates markets and in the credit market show investment opportunities that evolve according to the macroeconomic, monetary and financial cycles and top-down themes as illustrated in the Figure 3 below. A flexible and pro-active allocation approach between those different segments is a source of long- term value creation for a fixed income portfolio through economic and financial cycles.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed21 Income | November 2017 2 | 8

Figure 3: Return of fixed income segments by calendar years since 2004, before fees in local currencies

2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 ECB QE, EM, oil, QE taper- Taper EUR Reces- BCE hike Growth Fed hike US elec- Fed QE II Greece Lehman Subprime Fed ing Tantrum crisis sion rate plateau rate tions +1.6% +2.5% -0.3% +1.9% +2.6% +2.4% +1.7% +2.2% -2.8% +2.7% +3.1% +3.5% +1.6%

17.5 1.6 13.2 10.1 27.2 9.8 15.2 74.9 14.0 9.1 11.8 11.2 14.6 9.6 1.1 8.3 7.4 17.1 8.2 14.3 57.5 9.1 6.5 11.1 6.0 11.3 9.1 1.1 7.2 2.4 15.7 5.1 12.4 39.1 -3.3 5.1 10.0 5.9 10.9 9.1 0.8 6.0 2.3 15.6 4.4 11.8 25.3 -6.8 3.3 6.1 5.4 9.1 4.8 0.8 5.5 0.1 13.0 4.1 8.7 19.7 -8.9 2.2 4.6 4.0 7.7 4.2 0.7 4.5 -0.9 11.2 3.3 5.9 14.9 -18.1 1.9 3.1 2.8 7.6 3.3 -0.4 3.6 -3.4 9.4 2.0 4.8 4.4 -26.4 0.2 0.6 2.7 4.2 1.1 -4.6 2.5 -6.0 2.2 -2.5 1.1 -3.7 -34.2 -2.3 -0.5 1.5 3.5

US high yield EUR IG Sources : UBP et indices Bofa Merrill Lynch . Euro Government Index: EUR souverain, Euro Cor-

EM credit USD IG porate Index : EUR IG, Euro High Yield Index : EUR high yield, Treasury Index : USD sovereign, 1-10 Year US Corporate Index : USD IG, US High Yield Index, US high yield :US Emerging Mar- EM sovereign EUR sovereign kets External Sovereign Index, EM sovereign USD : Emerging Markets Corporate Plus Index : EUR high yield USD Sovereign EM credit. Past performances are not an indication of future results

A liquidity focus is conditional to top-down asset allocation

Changes in macroeconomic conditions, political or geopolitical events or external shocks lead to a change in investment opportunities and can trigger changing and rebalancing within a fixed income portfolio. History tells us that these moments often occur in a context of lower liquidity conditions. Even if it is not possible to be more liquid than the market, it is possible to build an attractive allocation i) by avoiding pockets of illiquidity and ii) by selecting for each fixed income segment the most liquid instruments. A strong focus on the liquidity of the instruments used allows for efficient implementation of allocation decisions while minimising friction costs (i.e. trading costs: bid-offer spreads). This liquidity focus enables for the proactive management of a fixed income allocation and an Absolute Return portfolio that creates value-added for investors and reduces volatility and drawdown risks. UBP’s Global & Absolute Return Fixed Income team, is focused on selecting liquid segments or liquid instruments within each segment they invest in as illustrated below.

The investment universe of the team in the investment grade market is pre-screened based on the issuers’ liquidity profile and the issues’ liquidity profile. This liquidity filter identifies for example the issuers which are not or little covered by the sell- side research. This is a flag of investors' lack of interest in these names and therefore a sign of fragility in terms of the overall liquidity profile of this name. In other words, the team is not chasing illiquidity spread premium. In terms of issues, the team avoids for instance private placement that are offered at a limited number of investors or structured products.

In high yield, the team only invest via high yield CDS indices. These indices are standardized and cleared, i.e. without counterparty risk. The transaction/friction costs of trading the high-yield CDS indices are just a fraction of the transaction costs of traditional high yield bonds: just 5 to 15 cents for high yield CDS indices (CDX high yield index for the US and iTraxx Cross- over Europe index for Europe) Thus, the high yield CDS indices allow a flexible and proactive management of the credit and high yield exposure. In addition, this liquidity advantage, or rather the lack of liquidity of high-yield bonds, has led to the outperformance of CDS indices in times of high stress as illustrated in Figure 4 below.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed22 Income | November 2017 3 | 8

Figure 4: High yield CDS strategy vs. High Yield cash bond strategy, maximum drawdown: peak-to-valley return before fees

Sources: UBP, Bloomberg, JP Morgan, as of 30.04.2017 CDS: 67% US CDX HY + 33% Europe iTraxx Crossover + BofA ML US Treasury 3-5 Years: with historical duration of 3.7 years Cash: 67% US HY BofA ML + 33% EUR HY BofA ML USD hedged, with historical interest rate exposure of 3.9 years. Past performance is not an indicator of future results

Absolute Return: Flexible top-down allocation strategies

How to identify a genuine Absolute Return strategy? Being dynamic in its asset allocation is not sufficient. It has to be completely flexible. Dynamic allocation management is restricted by a benchmark or reference investment universe whether from the point of view of the interest rate allocation and risk and the credit allocation and risk. In other words, historically it tends to be structurally long interest rate or long credit as is the case for Total Return strategies or low-tracking error benchmarked strategies. These are intrinsically “carry” strategies. The current yield is a good proxy for the expected returns. However, those strategies would eventually experience the volatility and the drawdowns of its asset class.

A flexible Absolute Return strategy is completely agnostic in terms of its exposure to interest rates as well as its exposure to credit. It is nimble to the extent that it can drastically reduce the credit allocation and it can have no interest rate exposure or an outright short interest rate exposure. For Absolute return strategies, the current yield is not proxy for the expected returns since the strategy allocation change from de-risking (low yield) to re-risking (higher yield). This agility would allow the strategy to display high sharpe ratios, drawdowns and contained volatility.

The track-record of an Absolute Return strategy is the best way to gauge the effective implementation of a flexible asset allocation. At UBP, the Global & Absolute Return Fixed Income team manages UBAM - Unconstrained Bond, a sub-fund of a Luxembourg incorporated UCITS Sicav with daily liquidity, whose target return is cash + 2% and its target volatility is less than 2% over a market cycle. This strategy’s historical allocation is testimony of the agility of the investment team’s in terms of asset allocation, as illustrated in Figure 5 below.

The strategy is managed with a macroeconomic and top-down driven allocation process to the sub-segments of the global fixed income universe. The allocation process is implemented within a strong risk control framework. The allocation to credit and interest rates has been actively managed, e.g. i) the credit exposure has reduced from 3.7 years to 1.3 years since April 2015, i.e. a risk reduction of -65%, ii) the interest rate exposure ranged from -0.1 years +1.5 year since the launch of the fund.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed23 Income | November 2017 4 | 8

Figure 5: UBAM - Unconstrained Bond: Allocation to credit (left) and to interest rates (right)

4.0 2.0 Credit exposure in RASD Interest rate exposure in modified duration

3.5 1.5

3.0 1.0

2.5

0.5 2.0

0.0 1.5

1.0 -0.5 07.13 07.14 07.15 07.16 07.17 07.13 07.14 07.15 07.16 07.17 Sources: UBP with UBAM – Unconstrained Bond, from 17.07.2013, as of 31.10.2017. RASD is a measure of the credit risk of the portfolio. The Risk Adjusted Spread Duration is defined as the weighted spread duration multiplied by the spread divided by the average spread of the universe. Past performance is not a guide to current or future results.

Managing an Absolute Return strategy: Optimising risk-reward with risk modelling tools The investment process of UBP’s Global & Absolute Return Fixed Income team is top-down macroeconomic-driven and asset allocation across fixed income segments is its key value added. It works with proprietary macro indicators (with nearly 20-year track record). The team puts a strong focus on the liquidity of the instruments used, to allow for efficient implementation of its allocation decisions (i.e. investing and divesting a segment). The team believes in investment discipline to preserve returns and optimise risk-reward. It works with tailor-made pragmatic risk modelling tools, such as hands-on stress tests and real-time performance monitoring.

The investment process is articulated around on three steps. Step 1 defines the top-down macro scenario and allocation views based on: } Cyclical and structural economic trends, monetary policies

} Politics and overarching market themes

} Top-down relative value analysis (focus on segments)

Step 2 defines the concrete asset allocation and sizing of the different segments adapted to the constraints and risk limits of any given portfolio, as illustrated in Figure 6 below. It is based on: } Risk and correlation analysis of allocation views

} Volatility and correlation analysis

} Stress tests and drawdown scenario

Step 3 defines the bottom-up instrument selection combining fundamental bottom-up credit research to select issuer and bottom-up relative value analysis to select instruments. At that stage, the portfolio is stressed test again to ensure that the consistency of the risk profile of the portfolio vs. the top-down allocation: volatility, VaR and drawdown scenario are run again to detect any deviation from the top-down allocation decided on during step 2.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed24 Income | November 2017 5 | 8

Figure 6: Illustration of the allocation process (step 2) for UBAM - Unconstrained Bond

Sources: UBP as of 31.08.2017. Volatility: 12 months data and weekly data points. Spreads or yields shock, in bps: 5 years US Treasury: - 40 bps, IG cash: +50bps, HY CDS index: +300 bps

Absolute Return strategies: It’s all about the sharpe ratios and the drawdowns! Summarising client’s approach to Absolute Return strategies, they expect high sharpe ratios and limited drawdowns. As a result of this disciplined approach to preserve returns and optimize risk-reward, UBAM - Unconstrained Bond have been delivering top-notch sharpe ratios with limited drawdowns as illustrated in Figure 7 below. UBAM – Unconstrained exhibits the 2nd highest sharpe ratios. #1 in this peer group in terms of sharpe ratios is penalised by -6.6% maximum drawdown.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed25 Income | November 2017 6 | 8

Figure 7: Peer group of flexible funds scattered by sharpe ratios and drawdowns

4.0

3.5 UBAM - Unconstrained Bond 3.0

2.5

2.0

Sharpe ratio 1.5

1.0

0.5

0.0 0 -5 -10 -15 -20 -25 -30 -0.5 Drawdowns (inverted scale), in %

Source(s): UBP, Bloomberg Finance L.P. Data as of 31.10.2017, 137 mutual funds in USD, EUR, GBP since 19.06.2013

UBP Global & Absolute Return Fixed Income team manages USD 15 bn across global fixed income markets and currencies. The team has a top-down and macro-driven investment approach. Asset allocation – taking long and short views – across global fixed income segments is driving alpha generation. The team has a genuine absolute return DNA, with more than 10 years of consistent excess returns with low volatility and drawdown. Crucial to the team’s absolute return DNA is the focus on risk management at all stages of the investment process: via stress tests when deciding on the asset allocation and constructing the portfolios and via real-time P&L monitoring on a day-to-day basis.

Lydia Carroll UK Institutional Sales

Union Bancaire Privée, UBP SA 26 St James’ Square | London | SW1Y 4JH T +44 20 7663 1565

Disclaimer This document is a marketing document and reflects the opinion of Union Bancaire Privée, UBP SA,(therafter UBP) as of the date of issue. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it directed to any person or entity to which it would be unlawful to direct such a document. Reasonable efforts have been made to ensure that the content of this document is based on information and data obtained from reliable sources. However, UBP has not verified the information in this document and does not guarantee its accuracy or completeness. UBP accepts no liability whatsoever and makes no representation, warranty or undertaking, express or implied, for any information, projections or any of the opinions contained herein or for any errors, omissions or mistatements. The information contained herein is subject to change without prior notice. UBP gives no undertaking to update this document or to correct any inaccuracies it it which may become apparent. This document may refer to the past performance of investment interests. Past performance is not a guide to current or future results. The value of investment interests can fall as well as rise. Any capital invested may be at risk and you may not get back some or all of your original capital. In addition, any performance data included in this document does not take into account fees and expenses charged on issuance and redemption of securities nor any taxes that may be levied. Changes in exchange rates may cause increases or decreases in your return. All statements other than statements of historical fact in this document are “forward-looking statements”. Forward-looking statements are not guarantees of future performance. The financial projections included in this document do not represent forecasts or budgets, but are purely illustrative examples based on a series of current expectations and assumptions which may not eventuate. The actual performance, results, financial condition and prospects of an investment interest may differ materially from those expressed or implied by the forward- looking statements in this document as the projected or targeted returns are inherently subject to significant economic, market and other uncertainties that may adversely affect performance. UBP disclaims any obligation to update any forward-looking statement, as a result of new information, future events or otherwise. The tax treatment of any investment depends on your individual circumstances and may be subject to change in the future. This is a marketing document and is intended for informational and/or marketing purposes only. It should not be construed as advice or any form of recommendation to purchase or sell any security unless otherwise specifically stated. It does not replace a prospectus or any other legal documents that can be obtained free of charge from the registered office of a fund or from UBP. The opinions herein do not take into account individual investors’ circumstances, objectives, or needs. Each investor must make his/her own independent decision regarding any securities or financial instruments mentioned herein and should independently determine the merits or suitability of any investment. Investors are invited to read carefully the risk warnings and the regulations set out in the prospectus or other legal documents and are advised to seek professional advice from their financial, legal and tax advisors. UBP is authorised and regulated in Switzerland by the Swiss Financial Market Supervisory Authority and is authorised in the United Kingdom by the Prudential Regulation Authority. UBP is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority.

Union Bancaire Privée, UBP SA | Asset Management | Global Absolute Return Fixed26 Income | November 2017 7 | 8 For professional investors only Bond benchmarks Forare professional not your investors only BondfriendFor professional benchmarks investors only areBond not benchmarksyour friendare not your friend

In the years following the financial crisis, “absolute return” has been a buzzword around the investment industry, covering a wide spectrum of investment strategies. The one unifying feature of these products is a rejection of a benchmark index in favour of an In the years following the financial crisis, “absolute return” has been a buzzword around outcome-orientatedIn the years following approach. the financial Portfolios crisis, “absolute are therefore return” managed has been witha buzzword the aim around of the investment industry, covering a wide spectrum of investment strategies. The one deliveringthe investment positive industry, returns coveringthrough aa wide cycle, spectrum regardless of investment of the overall strategies. market The direction. one unifyingunifying feature feature of ofthese these products products is is a a rejectionrejection ofof a a benchmark benchmark index index in favourin favour of an of an outcome-orientatedoutcome-orientated approach. approach. Portfolios Portfolios are thereforetherefore managed managed with with the the aim aim of of deliveringn thisdelivering paper we positive will positive discuss returns the returns benefit through and through practicalities a a cycle, cycle, of an absolute regardless return approach of of the the foroverall overall pension market funds, market with direction. particular direction. focus on its I application to credit. Freed from the constraints of a benchmark, we believe a global, multi asset approach will help an investor find the best opportunities, wherever they may lie.

Whyn this consider npaper this paper we will weabsolute discusswill discuss the return the benefit benefit inand and credit? practicalities practicalities Benchmarks of of anan absolute are return return not approach approach your for friend. for pension pension funds, funds, with with particular particular focus focuson its on its applicationI application to credit. to credit. Freed Freed from from the the constraints constraints of of a a benchmark, benchmark, we believebelieve a aglobal, global, multi multi asset asset approach approach will helpwill helpan investor an investor find find I the best opportunities, wherever they may lie. theAbsolute best opportunities, return has seen wherever strong take they up may in thelie. fixed income arena for a few reasons. First, there is a fundamental contradiction embeddedWhy inconsider the major absolute bond indices, return as they in are credit? weighted Benchmarks according to are market not capitalisation. your friend. In equities, such an approach can make Whysense asconsider companies absolute grow their profitsreturn and in increase credit? in value. Benchmarks In fixed income are however, not your it means friend. that those issuers with the highest debt burdensAbsolute will receive return has the seen greatest strong representation take up in the fixed, and income as a company arena for aor few government reasons. First, issues there more is a fundamental bonds, their contradiction share grows. Also, in the Absolutemajorembedded indices, return there hasin the seenis major no strongadjustment bond take indices, upfor inas credit thethey fixed qualityare weighted income or maturity, accordingarena forsuch toa few marketthat reasons. a $1bn capitalisation. 30 First, year there BBB- In equities, is issue a fundamental willsuch carry an approach the contradiction same can weight make as a embedded$1bn sense1 year asin AAA companiesthe issue, major even bondgrow though theirindices, profits the as former theyand increase are carries weighted in muchvalue. according In higher fixed incomerisk to formarket however,investors. capitalisation. it means that In thoseequities, issuers such with an theapproach highest can debt make senseburdens as companies will receive grow the their greatest profits representation and increase in, and value. as a companyIn fixed income or government however, issues it means more bonds,that those their issuers share grows. with the Also, highest in the debt burdensFor example,major will indices, receivein the there early the is 2000s,greatest no adjustment many representation companies for credit quality in, and the oras telecom maturity,a company sector such or thatover-indebted government a $1bn 30 year issues themselves BBB- more issue bonds,and will carrysubsequently their the share same grows.experiencedweight as Also, a in the majordistress$1bn indices, or 1even year there failure.AAA is issue, no Likewise, adjustment even though in the for theyears credit former leading quality carries up or muchto maturity, the higher financial such risk crisis,forthat investors. a banks $1bn 30leveraged year BBB- themselves issue will carryup rapidly the same and grew weight to overas a $1bn50% of 1 yearthe index. AAA issue, even though the former carries much higher risk for investors. For example, in the early 2000s, many companies in the telecom sector over-indebted themselves and subsequently experienced For example,distress orin eventhe early failure. 2000s, Likewise, many in thecompanies years leading in the up telecom to the financial sector crisis, over-indebted banks leveraged themselves themselves and subsequentlyup rapidly and grew experienced to over 50% of the index. distress or even failure. Likewise, in the years leading up to the financial crisis, banks leveraged themselves up rapidly and grew to over 50% of the index.

27 Bond benchmarks are not your friend

Selected sector weightings in the Global Aggregate - Corporate Index

40 Financial crisis

% 30

10 TMT bubble

0 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 9 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

Financial Institutions Communications & Technologies

Source: Barclays POINT, to October 2017. Past performance is not a reliable indicator of future results.

Common sense would suggest a moderation in exposure to an increasingly leveraged sector, but a benchmark-driven investor would have been inclined to increase their allocations at exactly the wrong time.

Conversely, in the aftermath of the financial crisis, banks have been reducing their leverage and improving their balance sheets (the total amount of debt has remained stable overall). On a fundamental basis, this is an improving situation for bondholders, and Financials have indeed outperformed the wider universe. Again, a benchmark-driven investor would have followed precisely the wrong strategy, decreasing their exposure to the sector when holding on or increasing the weight would have been beneficial.

The second argument for an absolute return approach in credit relates to the embedded interest rate risk in many indices. As interest rates have been at extremely low levels for many years, companies have taken the opportunity to lock in attractive terms for longer periods. Thus, the average maturity in the global credit index has risen to nearly nine years, increasing the risk exposure for investors, even as the yield on offer has fallen.

Bloomber Barclays Global Credit Index – Risk and Reward

10 9 8 7 6 5 4 3 2 1 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Weighted Average Maturity (Years) Yield to Worst (%)

Source: Bloomberg, to October 2017. Past performance is not a reliable indicator of future results.

28 Bond benchmarks are not your friend

The third strike against fixed income benchmarks is that for investment grade indices, rating agency actions may trigger sales and purchases at the wrong times. If an issuer is downgraded below the threshold, the bonds are subsequently removed from the index. Conversely, an upgraded issuer will see their debt included in mainstream indices at the next rebalancing. The market price will usually have already adjusted well in advance however, so that a strict benchmark or passive approach sells at low points and buys at highs.

Active management can work to mitigate the three issues described above, however there will always be considerations of fidelity to the benchmark, or “tracking error”. At a time when the premium on offer is compressed relative to historic levels, we think the case for selectivity and maximum manager discretion away from a benchmark is strong, which points us towards absolute return.

In addition to adopting a flexible approach, we think there are three further principles to help achieve success through economic cycles.

Principle 1: Go global Different regions will be in different points of the economic or credit cycle at any given moment. Thus, a global approach can liberate investors from the movements of the domestic economy; the manager can move about to wherever opportunities are most attractive and business fundamentals are stable or improving.

Principle 2: Increase diversification Moving from a domestic focus to a global opportunity set brings with it the benefit of added diversification. Opening up the investment universe to a multi-asset credit approach, including high yield and securitised credit should improve this even further. We can see this illustrated in the charts and tables below:

Key:  Financials  Industrials Utilities Govt. Related

BofA ML Sterling Corporate BofA ML Global Corporate Barclays Multiverse Credit Number of issues 755 Number of issues 13,267 Number of issues 16,721 Amount outstanding £315bn Amount outstanding £7,283bn Amount outstanding £15,108bn Effective duration 8.6y Effective duration 6.7y Effective duration 6.2y Yield to worst 2.47% Yield to worst 2.50% Yield to worst 2.92%

Source: Bloomberg, to October 2017.

Looking at the BofA ML Sterling Corporate Bond Index, it has under 1,000 securities to select from and is heavily skewed to long-dated utilities. Moving to a global stage dramatically increases the breadth of choice, while at the same time reducing the duration risk for a similar yield. Finally, adding sub-investment grade and government-related as in the Multiverse Index gives managers over 16,000 issues to compare, while balancing the sectors and improving the risk/reward ratio further.

Principle 3: Be dynamic While opening up the investment universe brings benefits, an active approach by sector and region is paramount to outperformance. We can see in the table below that no sector consistently delivers the best or worst returns due to desynchronised cycles; furthermore there is a wide average annual dispersion of 14% between asset classes, which creates significant opportunity for active allocation.

29 Bond benchmarks are not your friend

Annual % returns 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Global Investment Grade 8.9 8.4 6.3 5.5 3.7 3.8 3.4 -4.8 16.3 7.4 5.0 10.8 0.0 7.7 -0.2 6.1 Corporate

Global High Yield 3.4 -2.2 28.1 11.3 3.3 12.0 1.7 -27.0 60.7 15.4 3.2 18.9 7.1 2.5 -2.0 16.2

EM High Yield 0.9 1.7 26.0 12.5 9.3 9.4 3.5 -30.6 65.3 17.9 0.1 23.6 0.6 -2.0 2.9 18.4

EM Investment Grade 7.0 9.4 14.5 8.9 5.7 6.6 4.4 -17.5 38.3 12.8 4.2 15.5 -1.3 3.7 1.3 9.8

Securitised 7.4 8.5 3.0 3.0 3.0 5.3 -0.9 -20.7 18.5 11.8 4.1 6.4 0.6 3.1 0.8 2.7

Spread (Best-Worst) 8.0 11.7 25.1 9.5 6.4 8.2 5.2 25.7 49.0 10.6 4.8 17.2 8.4 9.7 4.9 15.7

Source: Bloomberg. Total returns by calendar year in USD hedged terms.

Managing risk and return: no free lunches In the absence of a benchmark to track, investors must consider the level of risk they are willing to take and the corresponding opportunities for returns. There are three main categories of risk in credit: liquidity, market and idiosyncratic; each demands careful management:

• Liquidity: with banks having withdrawn substantially from fixed income market making, the ability to buy or sell in an orderly fash- ion is important. Thus, managers should observe limits on the share of each issuer and security held, and also take care with the long tail of small bond issues in the market. • Market risk: even in an absolute return framework, the portfolio may have some exposure to the overall direction of markets. In credit, our preferred metric is Weighted Duration Times Spread (WDTS). Each security will have a risk according to its maturity and creditworthiness, so multiplying the two together with the weight in the portfolio gives an indication of the expected volatility and market exposure. • Idiosyncratic risk: there is always the risk of a credit distress event or default, which must be assessed through rigorous qualitative and quantitative credit analysis. Additionally, positions should be sized according to the expected risk of the issue, such that an adverse outcome will not produce large drawdowns in the portfolio.

As alluded to above, there is a broad spectrum of funds in the absolute return, multi-asset credit space, but they can be grouped into four rough categories of return objective and asset class exposure:

Typical characteristics Defensive Balanced Balanced Plus Aggressive Return target (over cash) 2-3% 3-4% 5% >5% Duration >3y 4y Flexible Flexible Focus universe Investment grade Investment grade credit, High yield bonds, loans, Distressed credit, corporate & securitised high yield, emerging emerging markets, collateralised loan markets convertible bonds obligations, illiquid assets Performance drivers Credit beta and interest Asset allocation Credit beta exposure, Liquidity premium, rate risk management between sectors bottom-up selection bottom-up selection

Source: JLT Employee Benefits, Let’s Talk Multi-Asset Credit, August 2014.

One of the common pitfalls for investors in absolute return funds is to mistake yield or targets for expected performance. The two rarely coincide, particularly in the short term. In late stages of the credit cycle as corporate leverage increases and premiums thin, one should be more cautious with the more aggressive strategies, as they will exhibit high volatility and drawdowns if and when markets do sell off. Indeed, the more defensive portfolios with some interest rate risk exposure should outperform, as government yields tend to have a flat or inverse relationship with credit spreads, especially for sub-investment grade.

30 Bond benchmarks are not your friend

3.50 1000

3.00 800 2.50

2.00 600 %

1.50 400 1.00 200 0.50

0.00 0 2012 2013 2014 2015 2016 US 10y Treasury Yield (%, LHS) Global High Yield Spread (bps, RHS)

Source: Bloomberg, to October 2017. Past performance is not a reliable indicator of future results.

At the time of writing, some managers in the latter two categories are either revising down return expectations for investors, or being forced to reach into riskier and less liquid areas of credit.

From principles to practice: Allianz Global Multi Asset Credit The above considerations were central to the development of our Global Multi Asset Credit strategy for UK pension fund clients in 2014. The main goals were to earn stable returns from a diversified credit portfolio, without embedded interest rate risk or constraints from a benchmark. To reduce volatility, the fund hedges foreign currency risk and limits exposure to the default-prone CCC rating band. A focus on credit risk makes the strategy more straightforward and less dependent on alpha generation for performance than some other funds in the absolute return category.

In periods of anticipated or actual volatility, the fund can deploy a suite of protection strategies such as buying government bonds or taking offsetting positions in credit derivatives or equity index futures. The fund sits on the cusp of the “Defensive” and “Balanced” categories described above, with performance driven by management of credit exposure and asset allocation between investment grade credit, high yield, securitised assets and emerging market debt, as well as bottom-up security selection. It has made use of dynamic asset allocation and hedging strategies to preserve capital in down markets, while capturing opportunities in recovery.

Allianz Global Multi Asset Credit Allocations by Contribution to Risk

8 %

S T D

W 6

0 May 14 Nov 14 May 15 Nov 15 May 16 Nov 16 May 17 Financials Structured EM IG Industrials HY Industrials

Source: Allianz Global Investors, to October 2017. Past performance is not a reliable indicator of future results.

31 Bond benchmarks are not your friend

Over its three year track record, it has delivered the intended target of 3% over cash with less than 2% volatility and a maximum drawdown of 0.85%.

Allianz Global Multi Asset Credit Composite Performance

114

112 Performance Characteristics Portfolio Annualised (inception) 3.5% 110 Benchmark Annualised (inception) 0.5% 108 Portfolio Volatility (inception) 1.6%

106 Portfolio Return / volatility 2.2

104

102

100 2014 2015 2016 2017 Composite Benchmark

Source: Allianz Global Investors, to October 2017. Returns gross of fees in GBP terms. Benchmark: BofA ML GBP 3M LIBOR Constant Maturity. Past performance is not a reliable indicator of future results.

Summary Contact us • Absolute return funds reject a benchmark in favour of an outcome-orientated approach

• This may be particularly useful for fixed income where Margaret Frost there are inherent contradictions in benchmark-driven Head of UK Institutional investing Phone: +44 (0) 20 3246 7385 Email: [email protected] • Beyond freeing oneself from the constraints of a benchmark, following three additional principles will help achieve success: • Go global • Increase diversification Corinne Crawford Head of Consultant Relations UK • Be dynamic Phone: +44 (0) 20 3246 7474 • There is a broad spectrum of absolute return funds Email: [email protected] • It is critical to understand where each fund sits and what are the performance drivers • Yield rarely equals return in the short term; high yield or return target funds usually come with volatility Jason Allan and drawdowns when markets become turbulent Director, Institutional Business Dev. UK • The Allianz Global Multi Asset Credit strategy has used Phone: +44 (0) 20 3246 7847 Email: [email protected] these principals to deliver on its objectives, with a diversified, flexible and resilient approach

32 Bond benchmarks are not your friend

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested.

Investing in fixed income instruments may expose investors to various risks, including but not limited to creditworthiness, interest rate, liquidity and restricted flexibility risks. Changes to the economic environment and market conditions may affect these risks, resulting in an adverse effect to the value of the investment. During periods of rising nominal interest rates, the values of fixed income instruments (including short positions with respect to fixed income instruments) are generally expected to decline. Conversely, during periods of declining interest rates, the values of these instruments are generally expected to rise. Liquidity risk may possibly delay or prevent account withdrawals or redemptions.

Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail.

This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY, www.allianzglobalinvestors.co.uk, which is subject to limited regulation by the Financial Conduct Authority (www.fca.org. uk). Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted.

Allianz Global Investors GmbH, UK Branch 199 Bishopsgate London EC2M 3TY

Telephone: 020 3246 7000 www. allianzgi.co.uk 17-2299