Third Quarter 2016 Investment Themes from the CIO office

Content

Debt Opportunities ...... Page 1 Nigel Burton Director, Real Estate Investment

EURUSD: Downside bias to accentuate after Brexit shock...... Page 3 Raman Trehan Head of FX, Commodities Advisory & Strategy

India: Consumer spending power on the rise ………………………………... Page 5 Anita Gupta Head of Equity Strategy

A secular investment theme: Asia …………………………………………….... Page 8 Kanishk Bishnoi Equity Analyst

Invest in the future : Autonomous Driving Page 10 Robots replacing the workforce ………………………………………………… Kanishk Bishnoi Equity Analyst

Dividend paying companies to outperform in a low yield world ………….. Page 12 Anita Gupta Head of Equity Strategy

Hybrid Instruments: Understanding the basics ……………………………... Page 14 Yahya Sultan Fixed Income Strategist

DEBT OPPORTUNITIES – SHADOW BANKING In the years prior to the Global Financial Crisis, US, UK and European banks experienced an extraordinary period of growth, both in terms of their assets and the complexity of their businesses. Underwriting standards were lax and many financial models were unable to cope with a prolonged downturn in underlying collateral values. The collapse of Lehman Brothers in September 2008 had profound implications for the Global banking system and the Global economy with subsequent bankruptcies, bail-outs, mergers and a series of economic crises.

Chart 1: Financial Sector as a percent of U.S. GDP: 1850-2009

Source: Philippon, 2008, Kaufmann Foundation, 2011

In order to avoid another potential collapse of the global banking system, European and US financial regulators have imposed tough new regulations, principally under rules known as Basel III in Europe and the Dodd Frank Act in the US. Amongst other things, these regulations have drastically altered a bank’s capital requirements requiring them to significantly increase the ratio of bank reserves against risk-weighted loans. The result is that more capital has to be set aside for riskier loans, both current and future. Persistent concerns from investors about the long-term health of the banking sector has led to limited enthusiasm for further bank recapitalisations (at any price) which leaves banks little option but to significantly reduce or dispose of high risk and non-core loans and limit further activity in this space in order to comply. What activity there is now comes with much stricter underwriting standards than in the past. In addition, many banks have been recapitalised by taxpayer funded bail-outs leading to intense public and political pressure to focus current and future lending activities on core markets and domestic businesses in order to support the national economy, usually through increased lending to individual consumers and small and medium sized enterprises (“SMEs”).

This limited credit environment has disproportionately affected certain sectors, mainly property (being a principle culprit in the financial crisis in the first place) as well as other capital intensive sectors such as infrastructure, shipping and aircraft. Of the estimated EUR 2.3trn1 of non-core loans being disposed of by European banks at present, almost half is secured against either commercial or residential real estate. It has also disproportionately affected private borrowers who, unlike public entities, rely almost solely on banks because they do not have access to other forms of financing such as the public bond market.

However, the current turmoil does create some compelling opportunities for new lenders and those that can capitalise on the distress. New Europe-wide legislation for insurance companies, known as “Solvency II”, is having the opposite effect to Basel III by making secured lending a more attractive proposition. There has also been a significant rise in dedicated loan origination funds who are not bound by the same regulation. These funds present investors with the opportunity to capitalise on the current distress banking system and seek superior, ‘equity like’ returns (i.e. returns from being an equity participant in the capital structure) by making new secured loans at attractive margins in the relative absence of traditional competition. Participating lower down the capital structure also provides greater security against any potential decline in asset values, as any equity in the transaction would be in the ‘first loss’ position.

1 Source: PwC, 2016

Table 1: Types of current debt opportunities

Traditional Bank Activity Opportunity

Peer-2-Peer Lending Consumer and SME Finance Bridge Loan Origination

Aircraft and Shipping Loans Origination Asset-Based Finance Invoice Factoring

Project Finance Infrastructure Loans Origination

Secured Real Estate Lending Secured Real Estate Loan Origination

Mezzanine Loans and Quasi-Equity Instruments Investment Banking Distressed Debt Investments Real Estate Bond Investments

Another debt opportunity presented by current bank de-leveraging is the bulk acquisition of secured loans, both public and private, at a deep discount to original or ‘par’ value. Investors receive discount-adjusted coupons (i.e. interest on the loan) and holding to maturity or foreclosing on the borrower can lead to a potential capital value ‘uplift’. However, this is a complex strategy requiring specific expertise, large pools of capital and high-level relationships within banks or government agencies (for the so-called ‘bad banks’) to execute effectively. There has been exceptional activity in this space with a record EUR 141bn of loan sales (of which EUR 86bn was real estate related) across the UK and Europe in 20152. This momentum has carried over into 2016, with EUR 89bn already transacted or in the process of completion3 so far this year.

Chart 2: Value of transactions by country Chart 3: Value of transactions by loan type

Source: PwC analysis

2 Source: PwC, Cushman & Wakefield, 2016 3 Source: PwC, 2016

EURUSD : DOWNSIDE BIAS TO ACCENTUATE AFTER BREXIT SHOCK

 EU political risk far from over  BREXIT adds to European economic uncertainty  Inflation outlook remains dismal  Monetary policy divergence to weigh on Euro

The shock outcome of the UK referendum triggered a violent risk-off reaction across the financial markets. The biggest currency impact was seen in the British pound, which plunged from $1.5000 to $1.3225 at one point. Most investors are paying close attention to BREXIT’s likely negative impact on UK economic growth to understand what might be a new equilibrium price for GBP. We believe that in the medium to long term, this development could well turn out to be equally negative for the European economy and EUR if not more. Simply put, it adds to the long list of issues facing the Eurozone and ECB.

Political and Economic Uncertainty: Many European countries have domestic euro-sceptical movements of their own. A successful British leave vote emboldens them and increases the risk of "contagion exit" in these countries. The fact that in the immediate aftermath of the "leave" vote, the stock markets in Italy and Spain were down almost twice as much as in the UK substantiates the view that BREXIT paves the way for greater political uncertainty within EU. It is therefore not completely impossible that sentiment turns even sourer from here, bringing the possibility of a eurozone break-up to the fore again. Should this scenario play out and peripheral spreads come under renewed pressure, ECB would be forced to act, accentuating the downside bias on the euro currency.

The European economic recovery remains fragile amidst weak investment. Quantifying the negative economic impact of BREXIT is anything but easy. As per a recent OECD analysis, it's not just Britain that would pay an economic price in the event of a vote to exit. By 2020, growth in the rest of the European Union would be 1% lower than it would otherwise have been - not lower than it is now, but it would grow less. That is a significant impact if it's right.

Chart 1: Near-term effects of Brexit on real GDP in the UK and the EU

Source: OECD Calculations

We, therefore, believe that concerns about the growing political and economic uncertainty could further dampen the outlook and would continue to weigh on the euro currency in the medium to long term.

Monetary Policy Divergence: The global central banks’ policy response to the BREXIT development would likely be dependent on size and persistence of the financial market shock. In all likelihood, this increases the chance of US Federal Reserve taking a more cautious approach to leave interest rates unchanged until at least the extreme volatility in financial markets is behind us.

Monetary stimulus has a greater role to play in the euro area as the inflation outlook remains dismal and the region continues its struggle to reflate. Despite this, the European Central Bank has faced considerable opposition to aggressive easing within its governing council during recent months. However, the pro-easing camp could now get the upper hand as a result of negative shock from BREXIT, leading to more aggressive stimulus regarding either size or length of stimulus.

Chart 2: Overall HICP Inflation rate (May 2016)

Source: Eurostat

We expect the monetary policy divergence to continue with the market presuming the Federal Reserve will delay policy normalisation while the ECB continues with/ increases its QE program at full speed setting the stage for a resumption of the Euro downtrend.

EURUSD Technical Perspective: EUR/USD dropped as low as 1.0909 post BREXIT news, down from a peak of 1.1432 posting a bearish outside day in the process. Despite the BREXIT volatility, the pair continues to trade within 2016 yearly trading range of 1.0825-1.1500. 1.0800-1.0825 has held strongly so far this year. However, the trading pattern has strong resemblance to the one charted in the first half of 2015 (refer EURUSD daily chart). We wouldn’t be surprised to see a similar pattern playing out for rest of 2016 and expect 1.08-10825 support to give way for a move towards 1.0520-1.630.

Chart 3: EURUSD Daily Chart

Source: Emirates NBD, Reuters (as at 26th June 2016)

INDIA: CONSUMER SPENDING POWER ON THE RISE

 Dairy and packaged food, personal care products, automobiles, smart phones and branded jewellery are the growth areas, with spending power following a rise in personal incomes  India has a working urban population of 129 million with a skew towards youth, 440 million millennials providing the base for an exponential rise in demand for branded goods  Increased mobile connectivity and ecommerce provides the channels to boost growth  In Q4 (March 2016) the consumer discretionary sector had amongst the highest year on year revenue (+15%) and earnings (+ 50%) growth  Indications of consumption picking up are personal loan growing +18.9% in March (year on year)

Low penetration provides potential: India has a long way to catch up with other emerging and developed countries.

Chart 1: Passenger Cars (per 1,000 people) Chart 2: Internet users (per 100 people)

Source: Data.gov.in Source: World Bank - World Development Indicators

Chart 3: Mobile subscribers (per 100 people) Chart 4: Electric Power Consumption (Kwh per capita)

Source: World Bank - World Development Indicators Source: World Bank - World Development Indicators

Improving margins: The fall in oil prices has reduced distribution and input costs helping margin expansion. The introduction of the Goods & Services Tax will create a uniform playing field across states and improve efficiencies in the supply chain.

Increasing spending power: Saturation of urban markets will push consumer companies to rural markets. However, the growth is still coming from the urban areas. Even a normal monsoon will boost rural expenditure. Through the Make in India campaign, the government targets creating 100 million jobs doubling the population earning $2,500+.The recent pay commission hikes ($24 billion over two years) provide increased spending power to government employees.

Digitization and the increased use of data: India has 1 billion mobile users of which only 120 million have internet connectivity. There is significant unrealized potential for growth in the use of data. Bharti Infratel is a beneficiary of data growth when users make heavier use of mobile devices for internet use

E-commerce will help the sale of branded goods. Today, it has a very modest share of India’s market-place.

Chart 5. Expected growth in Retail Penetration from 2015 to 2019

8% 13%

Organized Retail Organized Retail Penetration Penetration Unorganized Retail Unorganized Retail Penetration Penetration 92% 87%

Source: IBEF, Retail Jan 2016

Key growth areas: Dairy and packag ed food: India’s branded market in food and beverage is $100 billion compared to China at $800 billion. Dairy constitutes only 11% of the packaged market in India and edible oils 8%. Dairy and oil command the largest share of the principally vegetarian food basket in India, and this gap provides significant potential for the growth of packaged goods as consumers look for variety and convenience. 27 million babies are born in India every year adding to the demand for infant formula. The top 3 players in edible oil Marico, Adani and Ruchi, have 28% market share. However, we prefer ITC Ltd, which is slowly gaining in market share and with strong pricing power. Biscuits are a large and growing share of the packaged food industry (today's value $ 2.8 billion), and the market leaders are Britannia, Parle and ITC.

Chart 6: Food and Personal Care Revenue (Sept’15) Chart 7 Retail sales in India ($ million)

Skin Care Digestives 4.0% 6.0% Hair Care Home Care 23.0% 7.0%

OTC & Ethicals 10.0%

Food 18.0% Oral Care 16.0% Health Supplements 16.0% Source: IBEF, FMCG Jan 2016 Source: 2015-16 Outlook for the Retail and Consumer Products Sector in Asia (PwC)

Personal care products: We expect the $ 14 billion market expect Hair oil and skincare to continue growing. Per capita spending on skincare is $1 compared to $ 49 in the US. Godrej Consumer Products is the leader with increasing market share.

Automobile sector: India has tremendous potential to increase sales of motor vehicles. India has among the lowest penetration rates for ownership of motor vehicles with 25 million passenger cars and 120 million 2 wheelers in a population of 1.3 billion. Last five years CAGR for cars is 3% and for two-wheelers 7%. The latter is driven by the increased spending power of farmers whose incomes are poised to double. GST could lead to a 3-4% reduction in ex- showroom prices. The government is bringing in policies to curb pollution where trucks that are older than ten years will have to be replaced.

Maruti Suzuki (firm margins and new launches) and Mahindra & Mahindra (Tractor pick up in rural areas) are well positioned to capture this opportunity. Market leader Honda has a 26% share of the scooter market, and we expect it to continue increasing market share.

A SECULAR INVESTMENT THEME: ASIA

 Asia a secular investment theme as the balance of incremental demand dollars shifts eastward  Asia Pacific tourism growth exceeds the global averages significantly  Asian airlines, airports and hospitality groups should benefit from this growth  Asian REIT’s offer high dividend yield and currency diversification

Asia emerges as an even more imp ortant secular source of global gro wth in a post-Brexit. We highlight five themes in Asia with long-term return potential.

1. Outsized growth in Asia Pacific tourism: Rising incomes and a growing middle class are fuelling demand in Asia where growth in tourism in the last five years (6.1%) has far outpaced the global average (4.5%). Tourists visiting Asia are spending 30% above the global average as measured by receipts per capita c. $ 1,400 versus a global average of $ 1,100. The sectors positioned to benefit from this broader trend are airlines (added benefit of lower fuel costs), airports, hotel operators and hospitality real estate investment trusts. Standout names to play this theme are: Asia Aviation, AirAsia, Bangkok Airways, Cebu Air, Airports of Thailand and Erawan Group (DBS Group Research)

Chart 1: World Tourism Growth 2010- 2015 Chart 2: Receipts ($ per capita)

Source: UNTWO, DBS Bank

2. The rise of online gaming in Asia: The Asian gaming industry, in particular, the mobile segment, has been outpacing its western counterparts, and the high double-digit growth path continues unabated. Moreover, the passion of gamers in Asia and their willingness to pay is second to none. The largest firm in the global gaming arena is Tencent Holdings, a Chinese company that has 16% market share (versus. 11% for nearest rival Microsoft) and reported $16 billion in 2015 revenue (+30% year-on-year growth).

Chart 3: Share of global gaming revenue Chart 4: Tencent’s online gaming revenue ($ billion)

Source : Bloomberg

3. Cutting edge optical component manufacturing with cost advantages: The degree of sophistication of Asian component manufacturing now rivals Western counterparts while labour cost arbitrage persists, especially in China. This is the core of our argument to gain exposure to niche components manufacturing. In this context, a standout company is China’s Accelink, an optical component manufacturer that will continue to benefit from the growth in mobile data consumption, telecom network upgrades and growing fibre broadband penetration.

4. Niche play in device connectors: Another specialised segment with potential is connectors (components to connect devices externally) given the fragmented industry structure and easy sourcing of raw materials in Asia. Shenzhen Luxshare Precision Industries is the largest connector manufacturer in China, but with less than 2% global market share. The firm has experienced consistently high revenues and profit growth and is expected to enhance its market share given demand from Apple and Chinese smartphones.

Chart 5: Increasing demand for optical components Chart 6: Growth wave in device connectors

Source: Bloomberg

5. High dividends and diversification benefits of Asia REIT’s. The Asian economic growth story with China’s ascent and tourism spend has helped Real Estate Investment Trusts (REIT’s) in Asia. MapleTree Industrial Trust, CapitaLand Mall Trust and Frasers Hospitality Trust combine high dividend yield, and their long weighted average lease expiry gives cash flow visibility. They also provided a stable price performance in the turmoil post-Brexit.

Table 1: Asia Basket: Tourism, Gaming, Niche Technology and REIT’s Target Price One year P/E EPS Growth Dividend Company Industry Country Upside performance Beta 2016E 2016E Yield 2016E

Tourism Asia Aviation PCL Industrials Thailand 11% 42% 0.6 14.5 94.2% 2.5% AirAsia BHD Industrials Malaysia 14% 69% 1.2 6.7 99.0% 2.8% Bangkok Airways Co Ltd Industrials Thailand 30% 4% - 17.7 51.5% 3.7% Cebu Air Inc Industrials Philippines 16% 17% 0.7 6.6 105.6% 2.2% Airports Of Thailand PCL Industrials Thailand 9% 29% 1.0 29.2 2.0% 1.5% Erawan Group PCL/The Cons. Disc Thailand 24% 6% 0.8 33.5 69.4% 1.2%

Technology Accelink Technologies Co - A Technology China 18% 34% 1.1 40.9 35.4% 1.1% Luxshare Precision Industr - A Industrials China 13% (13%) 0.4 25.1 36.7% 0.4% Tencent Holdings Ltd Technology China 13% 14% 1.1 33.7 44.7% 0.3%

REIT's Frasers Hospitality Trust Financials Singapore 7% (10%) 0.4 15.1 - 7.8% Mapletree Industrial Trust Financials Singapore (3%) 10% 0.3 15.5 (49.1%) 6.5% Capitaland Mall Trust Financials Singapore 2% (1%) 0.6 18.5 (30.9%) 5.4% Average 12.8% 16.6% 0.7 21.4 41.7% 2.9% MSCI AC ASIA PACIFIC 18.2% (12.7%) Source: Bloomberg & DBS Research

INVEST IN THE FUTURE: AUTONOMOUS DRIVING

 Leading engineering bodies estimate more than half of the world’s cars to be driverless by 2040.  Mega investments are creating an ecosystem connecting driverless cars, mobile applications and ride hailing companies.

A long run way for gro wth. More than half of the world’s cars may be driverless by 2040 as estimated by IEEE, a leading engineering body. The current $2 billion market of partially autonomous cars is expected to grow to $77 billion by 2035, a 21% CAGR over two decades. The software segment is likely to drive growth. Alphabet, the parent company of Google, is the leader given its expertise in machine learning and artificial intelligence. On the communication infrastructure side, Cisco is fast adapting its business model to serve this market segment with its cloud platform already used by eleven major cars companies.

Large technology firms are inv esting in the future of transportation. While Alphabet has a lead in patents and almost a hundred self-driving prototypes on the roads, Apple is working on CarPlay a dashboard system allowing drivers to control their cars information and entertainment systems via an iPhone. There is unconfirmed news that Apple is operating in stealth mode to produce an electric car. Apple, Toyota, GM and VW have done deals with Didi, Uber, Lyft and Gett respectively (car-hailing services) and can be seen a signal of their interest in driverless cars.

Ecosystem disruption i s already underway. To make cars autonomous and safer, high-end semiconductor chips and data processing are required to facilitate car-to-car communication, along with driver assist systems, safety sensors, night vision cameras and smart seat belts. The industry’s need for high-end semi-conductor chips gives a competitive edge for Nvidia and STMicroelectronics Autoliv (safety systems), American Towers (wireless transmission sites) and Continental AG (auto parts for advanced driver assist systems).

Chart 1: Driverless car market estimated at $77B Chart 2: Software leading the growth by 2035

Source: Morningstar Estimates

Near-term c atalysts. Google is at the forefront with its Self-Driving Car Project Google’s Self Driving Car logging 1.5 million miles in California and Texas. The testing fleet consists of Prototype modified Lexus SUV’s and its prototypes. In Europe, Volvo is testing autonomous cars in Sweden with test cars expected on British roads by 2018. Germany’s transport ministry has begun laying out guidelines for the use of driverless cars on the autobahn. BMW has set 2021 as a goal for producing a driverless car ‘iNext” in partnership with chip maker Intel and Tesla could launch by 2020

It will take time for th e industry to b ecome profitable. However once scale kicks These cars have sensors in and as driverless cars become mainstream, the current investments will provide designed to detect objects as far as two football fields away in all significant additions to cash flows and earnings. The high cost of investing in this directions, including pedestrians, technology provides barriers to entry, and the early pioneers will benefit. cyclists and vehicles. The software processes all the Imagining the future. The nexus of ride-hailing companies, autonomous cars and information to help the car safely mobile technology will dominate transportation. The CEO of Uber expects the firm’s navigate the road. fleet to be driverless by 2030. Hailing driverless cars through mobile apps is seen as the biggest game changer this decade. Source: Company Website

ROBOTS REPLACING THE WORKFORCE  Robots are getting smarter, more dexterous and skilled as they begin to replace humans in the workplace.  Applications for robotics are emerging in defence, prosthetics, drones and intelligent home

The smar t Robot ha s arrived: In the workplace, robots are expanding their skills, increasing productivity and replacing humans at jobs. A multitasking bot, from Momentum Machines, can make a gourmet hamburger in 10 secs and could soon replace an entire McDonald’s crew. A McDonald’s in Phoenix is manned entirely by Robots and if the store is successful the firm plans to open 25,000 Robot run restaurants within the next three years. The transition towards a n automa ted workforce is being dri ven b y the need for higher e fficiency, lo wer costs and significantly lower management supervision.

McDonald’s delivery counter in Phoenix, Arizona

The new robot McDonald’s is located at 7th St & McDowell Rd in downtown Phoenix. The new automated “employees” are expected to be fifty times faster than the average human, with no chance of error. Add to that cost efficiencies and this may just be the beginning of a trend in fast food automation.

Source: Company Website

Leaders are emerging in a packed field: iRobot Corp has received a $30 million U.S. Army defence contract for PACKBOT 510, a battle-field proven robot. Such a contract is an early sign that there could be a multibillion-dollar defence spending allocation to robotic armies given the possibility to save human lives, greater efficiency and lower costs for governments. iRobot has made robots with the dexterity to open doors and sweep floors, opening up possibilities in the hotel industry and homes. Alphabet (not surprisingly) is another leader in the field with its acquisition of Boston Dynamics, maker of the walking, jumping and running robots. Add to that the firm’s recent purchase of smart appliance maker Nest, and it is clear that Alphabet is targeting the intelligent homes space. Notable others include Touch Bionics (intelligent prosthetics), Northrop Grumman (drones) and Bosch (automated mowing).

Chart 3: iRobot’s revenue growth reflects sector Chart 4: Growing EPS at iRobot potential

Source: Bloomberg

Clear growth path with healthy profitability: Adoption of robots for commercial use has risen significantly, and both revenue and profitability for market leading firms is on the rise. iRobot the leader in defence robotics has as a result of the R&D cycle maturing and product adoption increased its revenue fivefold in the past decade with double-digit year- over-year growth in eight out of the last ten years. Earnings growth too is in the double digits over the past five years.

DIVIDEND PAYING COMPANIES TO OUTPERFORM IN A LOW YIELD WORLD  In a low growth world, we expect dividend income to remain an important part of returns.  Several countries have negative sovereign yields making the high dividend trade attractive.

Equity div idends o ffer a n importan t source of in comes for i nvestors at a time when other as sets such as bonds have low or negative yields. The US 10 year Treasury yield is at 1.38% while the German Bund yield has fallen below zero. By contrast the S&P 500 Index composite yield is at 2.2%, and the EuroStoxx is at 3.8%.

Equities c arry a risk premium compared to sovereign or inv estment g rade d ebt. Hence the importance of screening for those companies with future dividend growth, have not cut dividends in the last five years and have adequate cash to cover payouts. We also look for consistent, and high earnings growth as that leads to higher dividend growth.

U.S. companies pay out a large majority of their earnings as dividends. From 1871 to 2015, the average dividend yield was 4.4%, however, this has fallen to 2.1% over the last ten years. The average dividend payout ratio remains constant at c. 60%. (Dividend payouts are being complemented by historically high share buybacks as companies return capital to shareholders, rather than invest in a low growth world). The payout ratio is rising for some sectors i.e. energy which has lower earnings. However, it remains constant in the consumer staple sector.

In recen t years, div idends are generating mor e retur n th an price per formance. In an environment of dovish Central banks, globally low and falling bond yields, slowing growth, elevated equity multiples, the high dividend trade continues to represent good value. Global EPS has dropped 11% in the last 15 months however dividends per share “DPS” is up 5%

Chart 1: S&P 500 yield greater than 10 Year UST Chart 2: Dividend paying stocks outperform in the US

Source: Bloomberg Globally the telecom, en ergy and utilit y sectors generate th e highest yields. They have outpaced the market in 2016 returning 10%, 16% and 12% respectively. Table 1: Globally the telecom and energy sectors have the highest yield

Current Dividend Dividend Payout MSCI WorldSector Dividend Yield FY1 YTD Pe rform ance Yield Ratio Telecom 4.1% 4.3% 80.4% 9.5% Energy 3.8% 3.7% 211.0% 15.6% Finance 3.7% 4.0% 47.6% (8.8%) Utilities 3.6% 3.8% 121.3% 11.8% Material 2.8% 2.6% 319.5% 7.4% Cons. Staple 2.5% 2.8% 63.0% 6.8% Industrials 2.5% 2.8% 49.8% 2.8% Cons. Disc. 2.2% 2.4% 40.7% (4.9%) Healthcare 2.0% 2.2% 56.4% (2.2%) Infotech 1.7% 1.8% 41.5% (2.3%)

MSCI World 2.7% 2.9% 59.6% 0.4% Source: Bloomberg

If interest rates stay low, stocks with above-average dividend yields should continue to outperform. However, if the FOMC decides to raise the Fed funds rate, then dividend growth-oriented strategies will outperform. In a rising interest rate environment, stocks with growing dividends should outperform bond-like high dividend yield equities. During the past ten years, high dividend growth stocks had outperformed the S&P 500 when bond yields were rising. Almost two-thirds of the Eurostoxx companies offer a higher current Dividend Yield than the corporate bond market. However, the current payout ratio is stretched at 40-year highs due to oil and a few other sectors retaining their dividend in the face of weak earnings. Companies are returning cash and have lowered capital investment with a focus on immediate shareholder return. The large integrated oil players have maintained dividends in spite of falling oil prices and are UK’s most important dividend payers. BP and Shell consistently feature in the FTSE 100’s top income stocks. Shell has not cut its dividend since the Second World War. BP’s record is not as long, but until the Gulf of Mexico disaster in 2010, delivered uninterrupted dividends. With a 7% dividend yield, more than twice the market average Shell accounts for over a tenth of the total dividends paid by UK companies. In the US Chevron has maintained dividends albeit at a higher payout ratio. If the oil price remains unchanged, will dividends be sustainable? The oil majors’ dividends are currently not covered by cash flow, and hence the companies are paying the dividends out of increased borrowings and asset disposals. The situation is unlikely to change unless the oil price rises. However, companies such as Shell are managing costs due to synergies on account of the merger with BG. Shell management continues to guide positively and plans to “thrive in a ‘lower forever’ oil price environment”. Below is a selection of companies with the dividend yield greater than 3%, no dividend cuts in the last five years, consistent dividend payout and adequate dividend cover. As yield should not be at the cost of capital loss companies with growing earnings and valuations in line with their peer group, have been chosen. These stocks outperformed the MSCI world by five percent in the five days post-Brexit, providing both absolute and relative return in volatile markets.

Table 2: Ten dividend yielding stocks with consistent and growing dividends

Target Perform ance Cash Dividend Price 5 days post NET De bt/ Dividend Divide nd Company Country yield 2016E Ups ide Br e xit YTD Be ta Eq u it y Cover payout ratio

Cons Staple Procter & Gamble US 3.2% 1.0% 0.4% 6% 0.6 29.7% 1.2 85.1 Coca Cola US 3.1% 6.9% (0.9%) 3% 0.6 94.4% 1.3 78.1 Unilever GB 3.1% 3.5% 1.9% 3% 1.0 72.1% 1.4 69.3 Nestle SZ 3.1% 0.8% 3.4% 0% 0.8 24.1% 1.3 77.2

Healthcare Pfizer US 3.4% 10.4% 1.6% 8.5% 0.7 24.1% 1.0 102.8 Astrazeneca GB 4.8% 9.0% 10.6% (6.8%) 0.8 41.8% 0.8 125.2 Roche SZ 3.3% 19.3% 3.1% (8.1%) 0.9 60.4% 1.3 79.0

Telecom Cisco US 3.3% 9.5% (1.6%) 4% 1.3 (58.7%) 2.2 45.5

En e r g y Chevron US 4.2% 4.0% 1.1% 15% 1.3 17.7% 0.6 174.2 Shell NE 6.9% 3.3% 1.7% 16% 1.1 16.2% 0.2 621.5

Average 3.8% 6.8% 2.1% 4.1% 0.9 MSCI World 2.8% 13.4% (3.2%) (1.2%)

Source: Bloomberg 30th June 2016; Price target = Bloomberg Consensus analyst target

HYBRID INSTRUMENTS – UNDERSTANDING THE BASICS  Concerns on global banking groups profitability impact hybrid instruments  We prefer old style debt with proximate call dates for yield enhancements

Basel committee’s continuous effort in strengthening the regulatory capital framework for the banking system with the aim of shoring up capital base, consistency as well as transparency of how capital is being treated within the banking capital structure have laid a solid platform for the various defined structures within banking debt securities.

Introducing a framework to promote the conservation of capital and the build-up of adequate buffers above the minimum that can be drawn down in periods of stress along with loss absorbing mechanics and capital triggers and limitations to avoid making large payouts as dividends, share buy backs, superfluous compensation during financial stress and deteriorating economic conditions have all been transformed to a more rigid banking system.

Banks with strong and adequate capital base have also faced difficulties on their liquidity management during financial crisis which raised concerns for the overall proper functioning of the financial markets and the banking sector. The main reason for the attribution was the basic principles of liquidity risk management. The liquidity coverage ratio was developed to address the aforementioned difficulties of liquidity management.

Basel 3, guidelines and framework addresses how capital is treated along with debt instruments with various loss absorbing features. Several forms of loss absorbing features have been introduced on capital boosting bonds via the PONV (Point of Non Viability) as stated upon the issuance of the bond and should be treated with importance from a bond holder perspective.

Banks such as UBS, Société Générale, Credit Suisse, Deutsche Bank and Royal Bank of Scotland have issued about €91 billion ($102 billion) of additional tier-1 capital from April 2013 until early 2016.

In the GCC space, total outstanding issuance of sub debt(Tier 1 and Tier 2) totals $11.1B of which UAE banks accounts for nearly 72.5% followed by some of the Oman, Kuwait, Qatar and Bahrain banks.

Understanding terminologies on hybrid debt instruments

Additional Tier 1 (AT1) Contingent convertible capital instruments (CoCos) are hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level. In this article, we go over the structure of CoCos, trace the evolution of their issuance, and examine their pricing in primary and secondary markets. CoCo issuance is primarily driven by their potential to satisfy regulatory capital requirements. The bulk of the demand for CoCos has come from small investors, while institutional investors have been relatively restrained so far. The spreads of CoCos over other subordinated debt greatly depend on their two main design characteristics – the trigger level and the loss absorption mechanism. CoCo spreads are more correlated with the spreads of other subordinated debt than with CDS spreads and equity price

Tier 2 Capital One of two categories by which a bank's capital is divided. Tier 2 capital is supplementary bank capital that includes items such as revaluation reserves, undisclosed reserves, hybrid instruments and subordinated term debt. A bank's reserve requirements include its Tier 2 capital in its calculation, but it is considered less reliable than its Tier 1 capital. Components of Tier 2 Capital can be split into two levels: upper and lower. Upper Tier 2 maintains characteristics of being perpetual, senior to preferred capital and equity; having deferrable and cumulative coupons; and its interest and principal can be written down. Lower Tier 2 is relatively cheap for banks to issue; has coupons not deferrable without triggering default; and has subordinated debt with a maturity of a minimum of 10 years.

Tier 3 The terms of the bonds allow for their permanent partial or full write-down or conversion to a subordinated instrument by the resolution authority. Such an event would not constitute a default event. The bonds rank below senior unsecured bonds but above subordinated Tier 2 bonds (and by extension AT1s and equity), hence the Tier 3 designation

Total Loss – Absorbing Capacity (TLAC) A Federal Reserve Board rule that requires domestic and foreign banks that operate in the United States to meet a long-term debt requirement, through the issuance of senior, unsecured bonds, relative to a measure of assets and debt, in order to withstand financial stress without imposing losses on taxpayers

What we advocate Given the vast types of hybrid securities at the market place, we highlight a few points for investors,

 Understand the type of bond structure – Old style instruments versus Basel 3 compliant securities / bonds

 Probability of risk of conversion / triggers and final losses to bond holders in the event of conversion from debt to equity

 Risk of Coupon restrictions / cancellation – these are at the sole discretion of the issuer. There could be mandatory restrictions if banks fail to comply or fall short on combined buffer requirements (CBR) / insufficient ADI (Available distributable items.

 Grandfathering rules on old style bonds – whereby old rule continues to apply to some securities / bonds while a new rule to all future new issuance of bonds.

 We prefer old style hybrid securities with near call date optionality (securities that are vulnerable to be redeemed / “Called” by the issuer)

Chart 1 – Bank capital structure simplified

Lowest risk Senior secured debt

Term Deposits Application liquidation

in

Senior unsecured debt

of payment

Subordinated debt (Tier 2) losses

Hybrids (Tier 1, AT1, COCO) Priority of Highest risk Shares

Table 1 – Non eligible Tier-1 and Tier-2 sub debt (GCC)

ADIB CAPITAL DIB TIER 1 SUKUK EMIRATES NBD TIER EMIRATES NBD 2014 ADCB FINANCE ADCB FINANCE Issuer CBQ FINANCE LTD EMIRATES NBD PJSC INVEST 1 LT LTD 1 TIER 1 CAYMAN LTD CAYMAN LTD ISIN XS0851081660 XS0902330769 XS0935833292 XS1111114135 XS0466365383 XS0897453493 XS0937539921 XS0910935021 XS0851081660 Corp XS0902330769 Corp XS0935833292 Corp XS1111114135 Corp XS0466365383 Corp XS0897453493 Corp XS0937539921 Corp XS0910935021 Corp ISIN ISIN ISIN ISIN ISIN ISIN ISIN ISIN Type Tier 1 Tier 1 Tier 1 Tier 1 Tier 2 Tier 2 Tier 2 Tier 2 Rank Jr Subordinated Jr Subordinated Jr Subordinated Jr Subordinated Subordinated Subordinated Subordinated Subordinated BASEL 3 NO NO NO NO NO NO NO NO Shariah Compliant YES YES NO NO NO NO NO NO Currency USDUSDUSDUSDUSDUSDUSDUSD Issue Size 1,000,000,000.00 1,000,000,000.00 1,000,000,000.00 500,000,000.00 600,000,000.00 750,000,000.00 300,000,000.00 750,000,000.00 Coupon 6.375 6.25 5.75 6.375 7.5 4.5 3.125 4.875 Issue date 11/19/2012 3/20/2013 5/30/2013 9/17/2014 11/18/2009 3/6/2013 5/28/2013 3/28/2013 Maturity PERP/CALL PERP/CALL PERP/CALL PERP/CALL AT MATURITY AT MATURITY CALLABLE CALLABLE Next Call Date 10/16/2018 3/20/2019 5/30/2019 9/17/2020 N/A N/A 5/28/2018 3/28/2018 Issue Spread / Next Call spread 539.3 495.4 451.3 423.7 400.0 265.0 220.0 389.8 over Mid Swaps (Bps) Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Coupon Deferral N/AN/AN/AN/A cumulative cumulative cumulative cumulative Dividend Stopper YES YES YES YES N/A N/A N/A N/A Write-down / N/A N/A N/A N/A N/A N/A N/A N/A Conversion trigger Event N/A N/A N/A N/A N/A N/A N/A N/A Capital Event Partial derecognition Partial derecognition Partial derecognition Full derecognition N/A Full derecognition Full derecognition Full derecognition

Tax / Regulatory At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par call Minimum 200,000 200,000 200,000 200,000 100,000 200,000 200,000 200,000 Investment Table 2 – Basel 3 compliant Tier 1 debt (GCC)

BURGAN TIER 1 BOUBYAN TIER 1 NATIONAL BANK OF AHB TIER 1 SUKUK DIB TIER 1 SUKUK 2 NATIONAL BK OF NOOR TIER 1 SUKUK Issuer AHLI UNITED BANK NBK TIER 1 FNC LTD BANK DHOFAR SAOG FINANCING CAPITAL OMAN LTD LTD ABU DHABI LTD

ISIN XS1133289832 XS1106874198 XS1407089926 XS1206972348 XS1233710380 XS1321921899 XS1073217561 XS1167284436 XS1243334668 XS1413609576 Type Tier 1 Tier 1 Tier 1 Tier 1 Tier 1 Tier 1 Tier 1 Tier 1 Tier 1 Tier 1 Rank Jr Subordinated Jr Subordinated Subordinated Jr Subordinated Jr Subordinated Jr Subordinated Jr Subordinated Jr Subordinated Jr Subordinated Subordinated BASEL 3 YES YES YES YES YES YES YES YES YES YES Shariah Compliant NO NO YES NO NO NO YES YES NO YES Currency USD USD USD USD USD USD USD USD USD USD Issue Size 400,000,000.00 500,000,000.00 250,000,000.00 700,000,000.00 300,000,000.00 300,000,000.00 500,000,000.00 1,000,000,000.00 750,000,000.00 500,000,000.00 Coupon 6.875 7.25 6.75 5.75 6.85 7.875 5.5 6.75 5.25 6.25 Issue date 4/29/2015 9/30/2014 5/16/2016 4/9/2015 5/27/2015 11/18/2015 6/30/2014 1/20/2015 6/17/2015 6/1/2016 Maturity PERP/CALL PERP/CALL PERP/CALL PERP/CALL PERP/CALL PERP/CALL PERP/CALL PERP/CALL PERP/CALL PERP/CALL Next Call Date 4/29/2020 9/30/2019 5/16/2021 4/9/2021 5/27/2020 11/18/2020 6/30/2019 1/20/2021 6/17/2020 6/1/2021 Issue Spread / Next Call spread #N/A Field Not 538.7 532.5 558.8 411.9 512.8 619.3 373.0 512.6 335.0 over Mid Swaps Applicable (Bps) Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Discretionary, Non Coupon Deferral cumulative cumulative cumulative cumulative cumulative cumulative cumulative cumulative cumulative cumulative Dividend Stopper YES YES YES YES YES YES YES YES YES YES Write-down / Discretionary Discretionary Discretionary Discretionary Discretionary Discretionary Discretionary Discretionary Discretionary Discretionary Conversion trigger Permanent write- Permanent write- Permanent write- Permanent write- Permanent write- Permanent write- Permanent write- Permanent write- Permanent write- Permanent write- Event down in part/whole down in part/whole down in part/whole down in part/whole down in part/whole down in part/whole down in whole down in whole down in whole down in whole Capital Event Partial derecognition Partial derecognition Partial derecognition Partial derecognition Full derecognition Full derecognition Partial derecognition Partial derecognition Partial derecognition Partial derecognition Tax / Regulatory At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par / at 101% At Par At Par / at 101% At Par / at 101% call Minimum 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000 200,000 Investment The above table is for illustrative purposes and is not part of any investment recommendation on any of the stated securities.

Source: Bloomberg

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