Exploring the opportunities and challenges in fixed income investing

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Exploring the Opportunities and Challenges in Fixed Income Investing

Mark Mitchell - Director & Portfolio Manager Justin Tyler – Director & Portfolio Manager

DISCLAIMER Issued by: The Investment Manager, Daintree Capital ABN: 45 160 989 912 ASFL No: 487489.

Responsible Entity: Perennial Investment Management Limited ABN 13 108 747 637, AFSL: 275101.

Whilst every effort has been made to ensure that the information in this presentation is accurate; its accuracy, reliability or completeness is not guaranteed. Daintree Capital expressly advises that it shall not be liable in any way whatsoever for any loss or damage which may be suffered by any person relying upon such information or any opinion, analysis, recommendation or conclusion contained in this presentation or otherwise arising in connection with the content of, or any omission from, this presentation.

The fact that particular securities may have been mentioned should not be interpreted as a recommendation to either buy, sell or hold those securities.

The contents of this presentation were prepared for information purposes only. Accordingly, reliance should not be placed on this presentation as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation.

Past performance is not a reliable indicator of future performance. Gross performance does not include any applicable management fees or expenses.

Net performance is based on redemption price for the period and assumes that all distributions are reinvested. Fees indicated reflect the maximum applicable.

Contractual arrangements, including any applicable management fee, may be negotiated with certain large investors. Investments in the Trusts must be accompanied by an application form. The current relevant product disclosure statements, reference guides and application forms can be found on Daintree Capital’s website www.daintreecapital.com.au

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AGENDA Key Concepts in Fixed Income Common Pitfalls in Fixed Income Investing Overview of Products Available

Market Outlook Brief Overview of Daintree Products

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KEY CONCEPT: DURATION A measurement of a bond’s sensitivity to interest rate movements Measured in years “Long” duration means a higher sensitivity to interest rate and higher risk

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KEY CONCEPT: YIELD CURVE

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Generally the longer you invest the higher the expected return Australian Government Bond Curve

2 1.8 1.6 1.4

Yield

1.2 1 0.8 0.6 0.4 0.2 0 3M

1Y

2Y

3Y

4Y

5Y

6Y

7Y

Maturity Source: Bloomberg

8Y

9Y

10Y

12Y

15Y

20Y

30Y

KEY CONCEPT: CREDIT RISK What are the chances this company goes out of business and doesn’t give me my money back?

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KEY CONCEPT: CREDIT SPREADS

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When you take credit risk you should expect to get paid for it Credit Spreads 5 4.5 4 3.5

Yield

3 2.5 2 1.5

1 0.5 0 3M

6M

1Y

2Y

3Y

4Y

5Y

6Y

7Y

8Y

Maturity Gov't Source: Bloomberg

Corp

9Y

10Y

12Y

15Y

20Y

25Y

30Y

COMMON PITFALLS

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Dangers: •

Passive investing in fixed income

•

Chasing performance in long duration fixed income

•

Reaching for yield without considering risk

•

Direct bond investing

•

Investing with an Australian only fund

COMMON PITFALLS

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Chasing Performance/Passive Investing: Long duration strategies have performed well, but now there is substantial duration risk in the indices and yields are down close to 1%. Need negative yields for this to continue Fund

Duration

Blackrock iShares US Agg Bond

5.9 years

Blackrock iShares Core US Agg Bond

6.0 years

Vanguard Total Bond Market Index Fund

6.5 years

Vanguard International Bond Fund

8.4 years

iShares Core Composite Bond (Aus)

5.8 years

Vanguard Australian Fixed Interest (Aus)

5.8 years

Source: Fund Fact Sheets Source: Bloomberg

COMMON PITFALLS Chasing yield without considering risk: The lower rated end of the high yield market really suffers during recessions‌

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...yields decreasing while overall credit quality deteriorating.

Tim e series: Proport ion of issu ers t o defau lt , by rat in g: All rat in gs 45%

40% 35% 30% 25% 20% 15% 10% 5% 0% 1983

1987

1991 Aaa

Source: Citigroup

1995 Aa

A

1999 Baa

2003 Ba

B

2007

2011

2015

Caa or lower Source: Wall Street Journal

COMMON PITFALLS

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Direct Investing in Bonds:

• Be very careful about running concentrated fixed income portfolios.

Unforeseen things happen all the time.

• Bonds have an asymmetrical payoff profile. Very little upside with lots of downside.

• Optimal diversification for an investment grade portfolio somewhere around 100-150 issuers

• Mackay Sugar: Bond investors got 50c on the dollar

• Virgin Australia: Bond investors got back 10-13c on the dollar

COMMON PITFALLS

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Investing only in Australia: Australia is a good credit market but there are times when offshore can look compelling‌

..and if you are only looking at Australia you are severely limiting your choices Global Bond Market

A$ Source: Westpac

Source: Bloomberg

ROW

FIXED INCOME ASSET CLASS

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Why do you have fixed income in your portfolio?

Provide a regular income

Help protect my risky assets when things go bad

Limited duration

Greater duration

Greater credit risk

Less Credit Risk

Higher Yield

Lower Yield

Limited protection against equity sell off

Some protection against equity sell off

“Ideally you would have a fund that offers elements of both�

INCOME INVESTMENT OPTIONS Objective

Risk Tolerance

Timeframe

High

5yrs +

Equity Income Funds Property Funds

Strong Income Focus

Med to High

3-5yrs+

High Yield Bond Funds Leverage Loan Funds Listed Hybrid Funds

Balance Income and Capital Preservation

Low to Med

1-3yrs

Investment Grade Credit Defensive Alternatives

Low

<1yr

Gov’t Gtd Term Deposits Short Duration Gov’t Bonds

Maximise Income

Pure Capital Preservation

Suggestions

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INCOME INVESTMENT OPTIONS

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No surprise that higher returns normally come with higher risk Asset Class

Return

Volatility

Min Return

Max Return

Term Deposits

3.4%

0.9%

2%

5%

AU 10yr Govt Bonds

4.4%

1.6%

1%

7%

Equity Income Funds

5.9%

14.2%

-28%

26%

Lev. Loans Funds

5.9%

11.1%

-14%

22%

Listed Hybrids Index

6.5%

7.5%

-24%

21%

ASX 200 Index

8.7%

16.7%

-38%

37%

High Yield Funds

9.8%

17.2%

-27%

61%

Source: Bloomberg, Indicative returns over the last 20 years.

EXCHANGE TRADED OPTIONS Category

Examples

Potential Positives

Potential Negatives

Long Duration

VAF, VGB, CRED

Some equity protection Low cost options available

Absolute yields very low Significant interest rate risk

Simple Credit Beta

AAA, QPON, FLOT

Low cost Simple to understand

Not well diversified Low returns

Active BM Unaware

ECOR, EMAX, XKAP, PAYS

High returns Active market makers Assets marked to market

Greater credit risk Redemption risk

LITs

KKC, PGG, PCI, NBI, MXT

High income levels Access to offshore managers Access to other asset classes

Material credit risk High fees More likely to deviate from NAV Poor trading liquidity

Hybrids

CBAPD, NABPF, WBCPE

High levels of income Highly rated bank issuers

Significant equity risk Little diversification benefit

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SUMMARY • Be clear on what you are trying to achieve with your income-oriented investments.

• Generating income is not the same thing as being defensive • Be clear on the timeframe for your investments. Make sure its long enough to handle the corrections that inevitably come for all asset classes

• Be aware of the common pitfalls of fixed income investing • Really understand the risks of all your investments (credit risk, duration risk, equity risk)

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OUTLOOK

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CAPITAL GROWTH IS EASY TO FIND Interest rates have been driven by inflation being bought under control, and staying under control 18

16

16

14

14

12

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This has increased debt levels, but also wealth (and wealth disparities) around the world

10

12

8

10

6

8

4

6

2

4

0

2

-2

0

-4

79

82

85

88

91

94

97

00

US 10yr bond yields Source: Bloomberg, Daintree

03

06

09

12

15

18

US CPI Source: Sufi, A: “The Saving Glut of the Rich and the Rise in Household Debt”, 2019

YIELD IS HARD TO FIND Bond yields are now extremely low…

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… and real yields (i.e. adjusted for inflation) are negative across the developed world

Source: Bianco Research

YIELD WILL REMAIN HARD TO FIND The RBA has said cash rates will remain low for years for good reason Australian unemployment rate (seasonally adjusted %) 8.0

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Bond markets should remain unconcerned about inflation. Therefore low rates will remain 3.50 3.25

7.5 7.0 6.5 6.0

3.00 2.75 2.50

5.5 5.0 4.5 4.0

2.25 2.00 1.75

3.5

1.50 3.0

05

06

07

08

09

10

11

12

13

14

15

US Forward Inflation Expectations

Source: ABS

Source: Bloomberg

16

17

18

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PROTECTING GAINS: JAPAN Pre 2010: equities down 37%; bonds up 3.7% Post 2010: equities down 24%; bonds up only 0.5%

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Bonds can’t provide protection if interest rates (and hence bond prices) don’t move

Rolling 30 day volatility of 5yr duration JGBs 0.7%

0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 0.0% 91 Source: Bloomberg, Daintree

93

95

97

99

Source: Bloomberg, Daintree

01

03

05

07

09

11

13

15

17

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FUND MANAGER SKILL

...unfortunately, opportunities to add value are going to be much more limited

Interest Rate Volatility

Source: Bloomberg, Daintree

100 99.5 99

98.5 98 97.5

97

Source: Bloomberg, Daintree

06-2020

02-2020 04-2020

12-2019

10-2019

08-2019

06-2019

02-2019 04-2019

12-2018

10-2018

08-2018

02-2018 04-2018

12-2017

10-2017

96.5

08-2017

225 205 185 165 145 125 105 85 65 45 25 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019

Australian 10 Year

06-2018

“But my manager is good at timing bond markets…”

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OTHER PROTECTIVE STRATEGIES

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What are some other things you can consider besides simple long duration strategies?

Strategy Implementation Pros/Cons More Dynamic Asset Allocation

Dial down equity exposures when worried

Pro: very clear risk reduction Con: requires good timing to really add value

Safe Havens: Gold, Yen, Swiss Franc

Allocate to assets that tend to do well in risk off environments

Pro: relatively low-cost hedge Con: effectiveness can vary and requires reasonable timing

Option/Volatility structures

Array of option strategies: long puts, put collarsâ&#x20AC;Ś

Pro: high level of confidence in the amount of protection for the cost Con: can be very expensive

Short equity positions

Either a static or dynamic allocation to short equity index/futures

Pro: very clear risk reduction Con: will be a performance drag unless can effectively time

OUTLOOK

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• Monetary policy support is close to its limits • Fiscal policies are helping but more may be needed. Watch for extensions.

• Hard to see government bond yields going too much lower • Expect to see a spike in HY and leverage loan defaults in 2021 • Significant share buybacks and dividend payments may be less sustainable going forward • Market expects a vaccine and the sheer number at the trialling stage raises the bar for market disappointment • Be very careful with long duration strategies • Big dislocation between markets and fundamentals as liquidity, TINA and FOMO dominate

SUMMARY CONCLUSION

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TO DO

Duration likely to be much less effective as Re-evaluate if cost and risk of using long an equity hedge in the future. duration as an equity hedge are still worthwhile. Might need to start closely considering other alternatives.

Going to be much harder for active duration managers to add value in a low rate low volatility world.

If you continue to stay in long duration products, you need to develop some confidence that a manager can somehow generate alpha in a low volatility world

The argument for passive investing in long Possibly consider moving to lower duration duration fixed income is much less passive strategies or consider other compelling in this environment alternatives Passive management in credit makes less sense as active management can clearly add value

Look for well diversified, actively managed credit strategies

INVESTMENT PHILOSOPHY

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Fixed income markets are fundamentally changing. The days of buying fixed rate bonds and generating a good return by benefitting from interest rates moving lower are coming to an end. The approach for the next decade will need to be much more sophisticated and focus on the following: Absolute Return - funds should have the ability to generate positive returns with interest rates and credit spreads going up or down.

Benchmark Unaware - Fixed income benchmarks are limited and arbitrary. We believe they should largely be ignored to construct optimal portfolios.

Active Management – Given that benchmarks are so limited and often poorly diversified, we believe passive management makes little sense in fixed income management.

Capital Preservation - Fixed income is there to play defense in your portfolio. Funds should have an obsession with capital preservation and downside protection.

Global Focus – Australia is less than 2% of the global bond market. If you don’t look offshore you are severely limiting your investment opportunity set.

DAINTREE PRODUCT SUITE Criteria

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Core Income (ECOR)

High Income (EMAX)

RBA Cash +150-200bps

RBA Cash +300-400bps

Cash/Enhanced Cash Alternative

Equity/Hybrid Alternative

0-100%

0-100%

90-100%, 0-10%

50-100%, 0-50%

Average Credit Quality

A+/A

BBB/BBB-

Minimum Security Rating

BB-

N/A

0-40%

0-100%

Range -1 to +3

Range -2 to +4

90% - 110%

80% - 120%

Securities

100-150

200-400

Distribution Frequency

Monthly

Monthly

Daily

Daily

Recommended Minimum Timeframe

3 years

3 â&#x20AC;&#x201C; 5 years

PDS Fee

50bps

75bps

Return Target (net) Application Cash Range Investment Grade, High Yield

Foreign Country Risk Duration AUD exposure

Liquidity

PRODUCT BENEFITS Features Liquidity

Ease of administration Better return than cash Monthly income Downside protection strategies Government guaranteed Low interest rate risk Diversification Multiple sources of return Low volatility

Low equity correlation

DCIT

7 Cash

Govâ&#x20AC;&#x2122;t Bond Funds

Hybrids

ESG IN FIXED INCOME Stage 1: Screening

Exclusions Negative Screens Positive Screens “I’m not going there”

Stage 2: Risk Assessment Risk Evaluation

RV Considerations Possible Engagement “I’m getting paid for the risk I’m taking”

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Stage 3: Impact Investing

Investing for Good Funding projects with clear ESG benefits “I need to make a difference beyond just getting a good return on my capital”

ESG: EXCLUSIONS Sector

Comments

Weapons/Munitions

Includes cluster munitions, anti-personnel mines and nuclear weapons.

Tobacco

Includes growers, packagers and wholesale distributors.

Alcohol

Exclude companies with > 5% revenue from alcohol production.

Gambling

Exclude companies with > 5% revenue from gambling-related activities.

Pornography

Exclude companies with > 5% revenue from production of adult material.

Fossil Fuel

Exclude companies with > 5% revenue from exploration/production of fossil fuels.

Coal Fired Power

Exclude companies with > 5% revenue from coal fired power generation.

Uranium

Exclude companies with > 5% revenue from uranium production.

Whale Meat

In line with the global moratorium of the International Whaling Commission.

Cannabis

In line with international and UN drug control conventions.

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CORE INCOME RATINGS/PLATFORMS Ratings

Platforms BT Asgard, BT Panorama, HUB24, Macquarie, Mason Stevens, MLC Navigator, MLC Wrap, Netwealth, Praemium, uXchange, Xplore Wealth, FNZ, Aegis The Zenith Investment Partners (ABN 27 103 132 672, AFS Licence 226872) (“Zenith”) rating (assigned May 2020) referred to in this document is limited to “General Advice” (s766B Corporations Act 2001) for Wholesale clients only. This advice has been prepared without taking into account the objectives, financial situation or needs of any individual and is subject to change at any time without prior notice. It is not a specific recommendation to purchase, sell or hold the relevant product(s). Investors should seek independent financial advice before making an investment decision and should consider the appropriateness of this advice in light of their own objectives, financial situation and needs. Investors should obtain a copy of, and consider the PDS or offer document before making any decision and refer to the full Zenith Product Assessment available on the Zenith website. Past performance is not an indication of future performance. Zenith usually charges the product issuer, fund manager or related party to conduct Product Assessments.

Full details regarding Zenith’s methodology, ratings definitions and regulatory compliance are available on our Product Assessments and at http://www.zenithpartners.com.au/RegulatoryGuidelines The Lonsec Rating (assigned August 2019 presented in this document is published by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445. The Rating is limited to “General Advice” (as defined in the Corporations Act 2001 (Cth)) and based solely on consideration of the investment merits of the financial product(s). Past performance information is for illustrative purposes only and is not indicative of future performance. It is not a recommendation to purchase, sell or hold Daintree Capital product(s), and you should seek independent financial advice before investing in this product(s). The Rating is subject to change without notice and Lonsec assumes no obligation to update the relevant document(s) following publication. Lonsec receives a fee from the Fund Manager for researching the product(s) using comprehensive and objective criteria. For further information regarding Lonsec’s Ratings methodology, please refer to our website at: http://www.lonsecresearch.com.au/research-solutions/our-ratings. © 2019 FE Money Management. all rights reserved. The information, data, analyses, and opinions contained herein (1) include the proprietary information of FE Money Management and Lonsec (2) may not be copied or redistributed (3) do not constitute investment advice offered by FE Money Management or Lonsec (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security (5) are not warranted to be correct, complete, or accurate. FE Money Management and Lonsec shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses, or opinions or their use. FE Money Management and Lonsec does not guarantee that a fund will perform in line with its Fund Manager of the Year award as it reflects past performance only. Likewise, the Fund Manager of the Year award should not be any sort of guarantee or assessment of the creditworthiness of a fund or of its underlying securities and should not be used as the sole basis for making any investment decision.

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CONCLUSION • An experienced investment team with excellent track record • Strong alignment of interests through equity ownership • Flexible approach with diversified sources of return • Support by a strong successful organisation • Ability to generate steady return even in a rising rate environment • Better expected future returns than many defensive alternatives given low cash rates and government bond yields • Strong ESG focus

“Daintree is well placed to be the core defensive allocation for client portfolios”

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THANK YOU

Mark Mitchell Justin Tyler

mark.mitchell@daintreecapital.com.au justin.tyler@daintreecapital.com.au

0419 474 016 0477 813 777

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