Multi-Asset Credit (MAC): 7th Anniversary Edition

Western Asset’s Multi-Asset Credit (MAC) strategy is currently celebrating its seven-year anniversary. We sat down with Lead Portfolio Manager and Deputy Chief Investment Officer Michael Buchanan to discuss MAC’s key fea- tures and how the portfolio’s current position seeks to take advantage of today’s market environment.

What do investors find appealing about MAC? In today’s low-interest-rate world, finding an attractive source of income remains a global challenge for individual investors, funds and institutions. The challenge is exacerbated by the complexities involved in asset alloca- tion, market timing and risk management. MAC is our answer to this challenge.

MAC is a strategy that seeks to capture the income, return potential and diversification benefits offered by credit MICHAEL C. BUCHANAN 27 Years Experience markets worldwide. These markets include corporate credit within the traditional high-yield and investment-grade Western Asset Management spaces and a host of other sectors that offer compelling income and risk-adjusted returns, such as agency and Company non-, residential and commercial mortgage-backed securities (MBS), debt (EMD), Deputy Chief Investment Officer, 2005– loans, and USD and non-USD global sovereign credit. Unlike other multi-sector products that may have a bias Credit Suisse Asset Management toward a particular sector, geography or credit quality, our MAC strategy has none. Managing Director, Head of U.S. Credit Products, 2003–2005 Some of the big worries most investors involve concerns such as the potential loss of capital (drawdown Janus Capital Management Executive Vice President, Portfolio risk), see-sawing returns (volatility) and the ability to quickly redeem funds when needed (liquidity risk). History has Manager, 2003 shown that these concerns are warranted. Market-jolting events may always lurk beyond the next bend. If we look BlackRock Financial at just the past couple of years, global financial markets have been roiled by Brexit, fears of a slowdown, oil Management Managing Director, Portfolio market volatility and US Federal Reserve rate hikes. Manager, 1998–2003 Conseco Capital Management To help mitigate the downside associated with unforeseen negative events, our MAC strategy allocates an annual risk Vice President, Portfolio Manager, 1990–1998 budget of 40–50 basis points (bps) for tail-risk hedges. These hedges may be relatively simple in form, such as taking Brown University, B.A. long-duration positions in government bonds, or they may be a bit more complex, such as utilizing derivatives on

Chartered Financial Analyst credit indices or equity indices to reduce or remove credit risk. Sometimes the approach may involve implementing strategies designed to hedge against potential negative events. More recently, we’ve preferred put option strategies and put spread option strategies on the S&P 500 Index given their meaningful correlation to the US high- yield market during market turbulence; high-yield constitutes a large portion of our portfolio’s credit exposure.

What has contributed to MAC’s success over the past seven years? I think the key to MAC’s success is its ability to fully leverage Western Asset’s global investment capabilities. The Firm has over 40 years of fixed-income experience with a platform that spans seven investment offices across five continents. We have specialized sector teams including Global Investment-Grade Credit, High-Yield Credit and Bank Loans, Structured Products and Emerging Market Debt. Each team comprises battle-tested portfolio manag- ers and traders, in addition to more than 100 research analysts with an average of 20+ years of experience covering their specific companies, industries and regions. Our expertise in the “macro” side of the equation has been the foundation for the success of our global credit teams and also stands on its own as an important alpha driver. Hav- ing a strong understanding of the drivers of yields, the forces shaping inflation and the trends influencing economic

© Western Asset Management Company 2017. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission. Western Asset 1 Q & A November 2017 Multi-Asset Credit (MAC): 7th Anniversary Edition

growth and currencies is of paramount importance for a true global fixed-income manager such as Western Asset. The views of our macro team not only impact credit allocation decisions, but also directly influence our duration and positioning across markets. This depth of global fixed-income coverage and resources across the credit space in “macro” enables us to feel confident that we can find appropriate investment opportunities and help our clients with their asset allocation decision across global fixed-income.

Another key factor contributing to MAC’s success has been the way risk management complements the manage- ment of the strategy. On a daily basis, we use models produced by the risk team to ensure the risks that we are actually taking in the portfolio are the ones we indeed intend to be taking. If a mismatch arises, then we can quickly make an adjustment. We run scenario analyses on both anticipated market events (e.g., Brexit, French elections) and historic events (e.g., a severe spread widening such as the Great Financial Crisis, or the taper tantrum) to get a picture of the possible impact on our holdings. While our risk team does not function as the “portfolio police” or anything like that, they help us elevate our game by keeping us quite aware of the “what-ifs” and making sure we are keeping our focus where it should be. Our high Sharpe ratio, which we discuss a bit more later, is a testament to the success of our partnership with the risk team.

Exhibits 1 and 2 show our MAC strategy’s strong annualized performance over various time periods and highlights its compelling risk and return profile relative to single-name asset classes.

Exhibit 1 Exhibit 2 Multi-Asset Credit Performance Comparative Risk-Reward Profiles

01 Oct 10 to 31 Oct 17 (since inception) Multi-Asset Credit Composite (Gross) Multi-Asset Credit Composite (Net) 8 9 8.1 Western Asset US High Yield 8 7.4 7 Multi-Asset Credit Composite¹ 7 6.3 6.3 6 5.7 5.8 6 5 4.8 4.9 USD Emerging 4.2 4.3 5 Markets 4

Total Return (%) US Investment-Grade 3 4 Credit 2 ReturnReward (Annualized %) 3 1 0 2 1 Year 3 Years 5 Years 7 Years Since Inception 2 3 4 5 6 7 8 9 10 01 Oct 10 Risk (Standard Deviation %) Source: Western Asset. As of 31 Oct 17 Source: Bloomberg Barclays, JPMorgan, Merrill Lynch, S&P/LSTA, Western Asset. As of 31 Oct 17 Returns for periods greater than one year are annualized. Performance shown is gross of fees. Returns for periods greater than one year are annualized. Please see the Please see the performance disclosure for more information. Performance Disclosure for more information. ¹Previously referenced as the Diversi ed High Income Composite, incepted 01 Oct 10. US Investment Grade Credit is represented by Bloomberg Barclays U.S. Credit Corporate Index. US High Yield is represented by Bloomberg Barclays U.S. High Yield Index. USD Emerging Markets is represented by JPM Emerging Markets Index Plus (EMBI+).

Mike, why do you think this strategy is relevant in today’s environment and going forward? Given the absolute low levels of interest rates globally, there’s going to be a greater reliance on income to drive re- turn. For our MAC strategy, a main component of this will be the dynamic use of credit sectors. Exhibits 3 and 4 de- pict MAC’s historical allocation since inception and the historical ranges by sector since inception. We think global credit is going to be an important part of an investor portfolio in the years ahead, and active rotation across these sectors will remain vital. Bear in mind that credit sectors don’t necessarily move in tandem; they have different cycles, and they do well in different markets. The ability to tactically add emphasis to one sector and de-emphasize another to find value and drive alpha in a diversified portfolio is important.

Western Asset 2 Q & A November 2017 Multi-Asset Credit (MAC): 7th Anniversary Edition

Exhibit 3 Exhibit 4 MAC Sector Allocation Since Inception Historical Ranges by Sector Since Inception

Monthly Holdings by Sector Holdings by Sector (High/Low) 100 60 In ation- Global Governments 31 Oct 17 90 Linked Cash/Cash Equivalents Asset-Backed Securities 50 80 40 70 Mortgage-Backed Securities 30 60 Bank Loans 50 20

Investment-Grade Credit Market Value (%) 40 High-Yield Credit 10 30

Percent of Portfolio (Market Value) 0 20 Emerging Markets Corporates USD Emerging Markets 10 -10 Local Emerging Markets HY Emerging Mortgage- IG Bank Asset- Cash & Govt Inflation- 0 Credit Markets Backed Credit Loans Backed Other Linked Oct 10 Jun 11 Feb 12 Oct 12 Jun 13 Feb 14 Oct 14 Jun 15 Feb 16 Oct 16 Jun 17 Securities Securities Securities Source: Western Asset. As of 31 Oct 17 Source: Western Asset. As of 31 Oct 17 All percentages are relative to market value. The information provided is supplemental to the Multi-Asset Credit Composite. Please see the Performance Disclosure for more information. A negative cash position may be reported, which is primarily due to the portfolio’s unsettled trade activity.

Also, not being benchmarked or tethered to the low levels of benchmark rates will be important going forward. I say that because strategies that look to beat a benchmark inherently have to be conscious of tracking error and, as a result, managers may own sectors that they have to live with rather than those for which they have a strong conviction. By measuring the performance of MAC through a Sharpe ratio, we’re able to manage the portfolio to express our highest-conviction ideas while still giving a clear sense of how we’re performing on a risk-adjusted basis. MAC’s Sharpe ratio of 2.45 over the past year and 1.52 since the strategy’s inception demonstrate our ability to generate strong risk-adjusted returns. We see MAC as an unconstrained strategy that can help investors navigate through different market environments.

What have been the key return drivers of MAC over the last year? Our MAC composite has returned +8% over the one-year period ending October 30, 2017. At the beginning of the period, MAC portfolios held a 27% allocation to high-yield corporate bonds and a 16% allocation to investment- grade corporate bonds with most of the exposure in US-domiciled corporates. The portfolio benefited from the strong spread compression we observed in both sectors over the period. As high-yield valuations became less attractive coming into 2017, we migrated some of that exposure into bank loans, which are higher in the capital structure and generally less risky (i.e., exhibit less price volatility) than high-yield bonds. We currently hold about 10% of this type of exposure in our MAC portfolios.

Emerging markets (EMs) were the other large contributor to performance, where we currently hold about 25%. We added to EM local markets in countries such as , , and during the early part of 2016 and have been the beneficiary of the solid rebound in EMs over the past year. An improved global backdrop, receding concerns over a China slowdown, and a stabilization in oil prices precipitated a broad-based rally across EM local debt and currency markets, which we expect to continue.

Exposure to structured credit was another large contributor to performance over the period. We reduced our expo- sure slightly to legacy non-agency bonds as valuations improved and increased our exposure to the growth areas within non-agency residential mortgage-backed securities (NARMBS), such as the agency credit-risk transfer (CRT)

Western Asset 3 Q & A November 2017 Multi-Asset Credit (MAC): 7th Anniversary Edition

bonds, which Fannie Mae and Freddie Mac use to reduce the mortgage risk on their balance sheets. This has been a growing segment of the market and returns have been strong. We currently hold roughly 8% in NARMBS and about 14% in commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS).

Both duration and curve positioning contributed positively to performance year-to-date. Is that normal in a credit-oriented strategy such as MAC? This is an important element that needs to be explained regarding the MAC strategy. Traditionally, duration and yield-curve positioning are intended to serve as “ballast” against spread sector exposures, and this is something that we employ in the MAC strategy. With that said, there were opportunities during the year that—because of our fundamental assessment of growth prospects and inflation versus what was priced into the market—we added to the duration of our portfolio. First was US President Donald Trump’s reflation trade, which took US rates materially higher in the latter part of 2016. We felt that the market was too optimistic regarding the Trump agenda and used this period of euphoria as an opportunity to add duration. Rates moved lower throughout 2017 and we benefitted. We also benefitted from our position in German bonds and long position in French bonds prior to the French elections. Throw in some opportunistic yield curve trades, which worked well, and we ended up with a large contribution from duration and curve. Being able to employ these macro-relative trades using duration and curve positioning can be a welcome source of return.

What keeps you awake at night on this strategy? Like all portfolio managers, many things keep me awake. I constantly ask myself big “what if” questions and envision potential vulnerabilities in our portfolio positioning. One of the things that’s key to our unconstrained strategies, which includes MAC, is the relationship between duration and risk. At Western Asset, we tend to use developed market government duration as an offset to our spread product, as touched on earlier. Over time, this relationship has worked. However, there have been brief periods when it hasn’t (e.g., during the taper tantrum in 2013).

I also focus quite a bit on our tail-risk hedges. We recognize these tail hedges have to work in a hard “risk-off” envi- ronment; it’s one of the key features of our MAC strategy. However, we run the risk that there might be a breakdown in correlations that causes our tail hedge to underperform when needed. This might occur when we have most of our hedges in S&P puts or put spreads and equities are holding up, but the higher-beta segments of the fixed- income markets are selling off. It’s an unlikely scenario and we are continually examining those correlations, but this is the type of risk that we think about late at night.

How do you see MAC over the next seven years? We believe MAC is a strategy with staying power. MAC’s emphasis on “making fixed-income work harder” makes it highly adaptable to evolving global credit markets. This brings us back to the importance of being properly re- sourced. Given the complexity of global credit and the numerous pitfalls associated with investing and managing risk in this market, we believe Western Asset has the global scale and resources to exploit the growing opportuni- ties in credit markets for the benefit of our clients.

Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and members of JIAA (membership number 011-01319) and JITA. Western Asset Management Company Limited (“WAMCL”) is authorized and regulated by the Financial Conduct Authority (“FCA”). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FCA Handbook and has been approved by WAMCL.

Western Asset 4 Q & A November 2017 Performance Disclosure December 31, 2016

Multi-Asset Credit Composite Composite Inception Date: 10/01/2010 | Composite Creation Date: 07/17/2013 No. of Gross Total Net Total Benchmark Gross Total Benchmark Total Internal Mkt. Value Percentage of Firm Assets Accts Return Return Total Return 3-Yr St Dev 3-Yr St Dev Dispersion (US$mil) Firm Assets (US$mil) 2007 -na- -na- -na- -na- -na- -na- -na- -na- -na- $621,493 2008 -na- -na- -na- -na- -na- -na- -na- -na- -na- $505,660 2009 -na- -na- -na- -na- -na- -na- -na- -na- -na- $482,218 2010 1 1 0.23% 0.13% -na- -na- -na- -na- $472 0.10% $453,909 2011 1 8.29% 7.86% -na- -na- -na- -na- $464 0.10% $443,140 2012 1 13.93% 13.48% -na- -na- -na- -na- $478 0.10% $461,891 2013 1 2.36% 1.95% -na- 4.27% -na- -na- $393 0.09% $451,632 2014 3 5.21% 4.69% -na- 3.99% -na- -na- $515 0.11% $466,036 2015 4 -2.35% -2.93% -na- 4.23% -na- -na- $615 0.14% $433,747 2016 6 9.56% 8.91% -na- 4.18% -na- -na- $879 0.21% $419,207

Description: Western Asset's Multi-Asset Credit Composite includes portfolios that employ an active, team-managed investment approach around a long-term, value-oriented investment philosophy. These portfolios seek to generate income from diversified investments in high yielding securities from all sectors of the global fixed-income market. The approach is to construct a diversified portfolio of global high income securities, including investment-grade credit, non-dollar, high yield, bank loan, emerging markets, and structured securities. We seek to add value through sector rotation, yield curve positioning, issue selection, duration management, country selection, and currency positioning. Objective: Maximize return consistent with the current market environment and outperform the broad market over the course of a market cycle. Benchmark Description: The Composite is not measured against a benchmark as accounts that may comprise the Composite are measured on an absolute return basis. There is no benchmark available that appropriately reflects the guidelines of all accounts within the Composite. Base Currency: USD | Composite Minimum: No minimum asset size requirement. Current Fee Schedule: .60 of 1% on the first $100 million, .40 of 1% on amounts over $100 million. Examination Period: The Composite has been examined for the period from January 1, 2013 to December 31, 2016. 1 Partial period return (October 1, 2010 to December 31, 2010). Western Asset claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Western Asset has been independently verified for the periods from January 1, 1993 to December 31, 2016. Verification assesses whether (1) the Firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the Firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. The verification and performance examination reports are available upon request. For GIPS® purposes, the Firm is defined as Western Asset, a primarily fixed-income investment manager comprised of Western Asset Management Company, Western Asset Management Company Limited, Western Asset Management Company Pte. Ltd., Western Asset Management Company Ltd, Western Asset Management Company Pty Ltd, and Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários (DTVM) Limitada, with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Dubai. Each Western Asset company is a wholly owned subsidiary of Legg Mason, Inc. ("Legg Mason") but operates autonomously, and Western Asset, as a Firm, is held out to the public as a separate entity. Western Asset Management Company was founded in 1971. The Firm is comprised of several entities as a result of various historical acquisitions made by Western Asset, and their respective performance has been integrated into the Firm in line with the portability requirements set forth by GIPS.

The Composite is valued monthly. The Composite returns are the asset-weighted average of the performance results of all the accounts in the Composite. Gross-of-fees returns are presented before management fees, but after all trading expenses. Net of fees results are calculated using a model approach whereby the current highest tier of the appropriate strategy's fee schedule is used. This model fee does not reflect the deduction of performance-based fees. The portfolios in the Composite are all actual, fee-paying and performance fee-paying, fully discretionary accounts managed by the Firm for at least one full month. Investment results shown are for taxable and tax-exempt accounts and include the reinvestment of all earnings. Any possible tax liabilities incurred by the taxable accounts have not been reflected in the net performance. Composite performance results are time-weighted net of trading commissions and other transaction costs including non-recoverable withholding taxes. Policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request.

The returns for the accounts in the Composite are calculated using a time-weighted rate of return adjusted for weighted cash flows. The returns for the commingled funds in the Composite are calculated daily using net asset values (NAV), adding back the funds' total expense ratio or equivalent. Trade date accounting is used since inception and market values include interest income accrued on securities held within the accounts.

Composite returns are measured against a benchmark. The benchmark is unmanaged and provided to represent the investment environment in existence during the time periods shown. For comparison purposes, its performance has been linked in the same manner as the Composite. The benchmark presented was obtained from third party sources deemed reliable but not guaranteed for accuracy or completeness. Benchmark returns and benchmark three-year annualized ex-post standard deviation are not covered by the report of independent verifiers.

Internal dispersion is calculated using the asset-weighted standard deviation of annual gross returns of those portfolios that were included in the Composite for the entire year. For each annual period, accounts with less than 12 months of returns are not represented in the dispersion calculation. Periods with five or fewer accounts are not statistically representative and are not presented. The three-year annualized ex-post standard deviation measures the variability of the composite and the benchmark returns over the preceding 36-month period. The three-year annualized ex-post standard deviation is not presented for periods where 36 monthly returns are not available for the composite or the benchmark. Any gross total three-year annualized ex-post standard deviation measures prior to 2011, included within the "Examination Period" identified above, are not covered by the report of independent verifiers.

Past investment results are not indicative of future investment results.

Western Asset's list of composite descriptions is available upon request. Please contact Jan Pieterse at 626-844-9977 or [email protected]. All returns for strategies with inception prior to January 1, 2007 are available upon request.

For more information on Western Asset visit our website at www.westernasset.com Western Asset