Credit brochure

4 The liquidity pitfall of passive investing

6 Stricter rules, new solutions

8 A smarter way to harvest factor premiums

14 ESG integration, in particular for corporate bonds

WE CRASH TEST THE WORLD FOR THE BENEFIT OF OUR CLIENTS CHALLENGING TRENDS AND OPPORTUNITIES IN CORPORATE BONDS

Contents The Robeco approach for credits

2

Challenging trends and opportunities in corporate bonds

3

The liquidity pitfall of passive investing

4

Stricter rules, new solutions

6

A smarter way to harvest factor premiums

8

More diversification with emerging economies

10

Flexible strategies to benefit from relative value trade-offs

12

ESG integration, in particular for corporate bonds

14

Further information E contact@robeco.com W www.robeco.com/credits

The Robeco approach for credits Robeco’s credit team has an investment style that focuses on thorough research, on which every investment is based. We believe that the management of a corporate bond portfolio is not about selecting a few of the best bonds, it is about avoiding the losers in a well-diversified portfolio. This generates alpha.

The team follows its own research, not public opinion or the general consensus. “We always aim to act contrarily in our portfolios,” says Sander Bus, head of the credit team.

Macro approach for beta positioning Global trends are an important element in the investment approach.

These are analyzed every quarter, as external specialists such as brokers and strategists discuss specific market themes together with our analysts and portfolio managers in order to assess the risks and opportunities in the credit market. This top-down macro approach forms the input for the desired beta positioning of the portfolios. Victor Verberk, co-head of the credit team: “Understanding the global macro economic environment is essential to understanding our investment category.”

Sector focus for knowledge advantage The Robeco credit team consists of 27 portfolio managers, credit analysts, researchers and traders. The team invests globally and applies an integrated approach for investment grade, high yield and emerging credits strategies. This approach is unique. Analysts have a sector responsibility irrespective of grade or country of origin. After all, sector developments are global and therefore should be monitored and analyzed

2 | Challenging trends and opportunities in corporate bonds

from a global perspective. This approach gives the analysts a knowledge advantage and gives the team the possibility to capitalize on the inefficiencies that occur as a result of existing market segmentations. The credit analysts in the team are all very experienced in their sector. They are offered the possibility to advance their careers within their disciplines and to rise above their international peers with their expertise and seniority.

Sustainability research, integral part of issuer selection Each analysis is carried out according to a predefined framework. Issuers are analyzed based on five components, i.e. company strategy, company position, financial profile, company structure and sustainability criteria.

With regard to sustainability, the analyst analyzes the downside risk resulting from poor scores on Environmental, Social and Governance factors. The sustainability analysis is thus an integrated part of our credit research.

The Robeco credit team manages approximately EUR 21 billion in various funds and mandates as of the end of April 2014. Assets under management have increased by approximately 25% a year since 2008.

Challenging trends and opportunities in corporate bonds Corporate bond markets are in a constant state of flux and continue to present new challenges to us as asset managers. In addition to the usual market cycles for investment categories, the bond market is also subject to structural changes. Not only asset managers and their clients are being confronted with this, it is also relevant for institutional investors with their obligations to pensioners and policy holders.

In this magazine we identify a number of market trends, which we believe are relevant for our clients. We will specifically discuss the challenges that these trends pose, and more importantly, how we think our clients can capitalize on these trends.

Changing market conditions can limit the effectiveness of passive investing Stricter risk regulations for liquidity providers (banks and brokers) have structurally changed market conditions. We argue why active managers are better equipped to capitalize on market liquidity than passive fund managers.

Stricter rules, new solutions

led to the successful introduction of a new type of investment products based on factor investing. Our ‘conservative’ strategies are based on what is known as the ‘low-risk’ anomaly. This approach is already known from equity investments; however, our research has shown that this anomaly also exists in credits.

More sustainability information results in better investment decisions Another important issue for companies and investors is how to deal with sustainability. Increasingly companies in which we invest are focusing on sustainability and reporting on this. Investors who are able to interpret this information correctly and translate this into risks and opportunities have an information advantage. In this publication, we discuss how to incorporate sustainable investing and how Robeco integrates this in the investment process, and we also correct a number of misconceptions regarding sustainable investing.

I hope you will enjoy reading this publication and I would like to invite you to enter into a dialog with us about the challenges that we face as investors in corporate bonds.

We increasingly see that supervisory bodies are tightening the rules on the financial markets. Examples are Basel III for banks and Solvency II for insurance companies. As a result, all market players are being confronted with new questions, but equally important, certainly also with interesting new investment opportunities.

Flexible strategies benefit from relative value trade-offs Flexible integrated credit strategies are emerging. These strategies can benefit from making relative value trade-offs to switch between credit segments. Traditionally, institutional investors tend to select specific managers for each segment, which can be a disadvantage in today’s markets. We explain the rationale and the drivers behind the benefits of flexible integrated strategies.

More diversification with emerging economies Investors’ horizons will expand further in the coming years. On the one hand, information analysis will become more complex due to the convergence of developed and emerging economies; on the other hand, this development offers new diversification possibilities for investors.

We believe that an increasing strategic portfolio allocation to ‘new economies’ will be an important theme in the coming years. We will discuss our expectations regarding the growing importance of emerging credits.

Factor investing within credits Within Robeco, research has been the basis for every investment since we first began in 1929. Quantitative research based on market anomalies has

Edith Siermann Chief Investment Officer Fixed Income

Challenging trends and opportunities in corporate bonds | 3

The liquidity pitfall of passive investing Investing in ETFs can be very risky, especially during periods of limited liquidity.

Patrick Houweling and Victor Verberk explain why and how active management and the use of derivatives can provide both a solution and an investment opportunity.

Decreasing liquidity is changing the market In recent years, investors in corporate bonds have been confronted with decreasing market liquidity. This is mainly attributable to the changed attitude of investment banks. Banks have become more cautious due to the financial crisis and have therefore reduced their corporate bond trading activities. In addition, banks are maintaining higher capital ratios because of stricter regulations. They trade less often for their own account and focus mainly on bringing buyers and sellers together.

Uncertainty about Greece brought the price of the high yield tracker below the net asset value

Patrick Houweling, senior quantitative researcher and fund manager of the Robeco Quant High Yield Fund, concludes that the reduced liquidity could cause problems for investors in passive funds. “The credit market has grown significantly in recent years, also because of the increased popularity of ETFs. In normal market conditions, ETFs can be traded quite easily. However, when markets turn and corporate bonds go out of favor, investors can be unpleasantly surprised. Passive funds typically mirror their underlying index. As a consequence the fund managers must sell and buy certain bonds regardless of market conditions. When adverse market conditions prevail and a large number of investors wish to sell bonds without finding enough buyers to match supply, this may cause the investments in the ETFS that are based on full replication to be sold considerably below their net asset value. This applies mainly in turbulent markets.”

100

‘In turbulent markets, ETFs are sometimes sold far below their net asset value’ Houweling illustrates this with an example: “Corporate bonds were under pressure in May 2012 due to the uncertainty about Greece. The market price of a corporate bond fund normally lies above its net asset value.

However during that period, the market price of the iShares-tracker in European high-yield bonds was up to 89 basis points lower than its net asset value. The reverse is true as well as this could also work the other way around when passive fund managers need to buy in buoyant markets conditions. In that case, they will pay too much for the bonds they need to replicate their index. This occurred in July 2012.”

4 | Challenging trends and opportunities in corporate bonds

104

2.0%

103 1.0% 102 101

0.0% -1.0%

99

Premium/discount

Market Price

15-07-12

08-07-12

01-07-12

24-06-12

17-06-12

10-06-12

03-06-12

27-05-12

20-05-12

13-05-12

06-05-12

29-04-12

-2.0% 22-04-12

15-04-12

98

Net Asset Value

Source: Robeco, Bloomberg

Active management avoids crowding at the exit Victor Verberk, co-head of the credit team, says that when investors opt for active management they will no longer have to worry about executing orders in unfavorable market conditions and avoid crowding at the exit.

“Managers of actively managed funds have various buttons that they can press. First of all, as a fund manager you can seek to profit from market movements. It is often unwise to sell during periods of market stress.

Markets often overreact. This is mainly due to parties such as ETFs that are obliged to replicate their benchmark. Active management allows you to capitalize on this situation. If you would like to reduce the size of your portfolio, you can use that moment to sell less attractive bonds and – vice versa – if you are enlarging your portfolio you can buy additional expected outperformers. You must have the courage to trade contrarily. As an active investor, you can thus profit from forced buying and selling by passive funds. In fact, you can collect the premium that they need to pay.”

‘As an active portfolio manager, you have more buttons that you can press’

‘With CDS indexes, you can profit from market trends at lower costs’ “A second advantage of active management is that you can maintain a somewhat larger cash position. A lack of liquidity in the market is not a problem if you do not necessarily have to sell or buy immediately. The cash position makes this possible. Furthermore, you can reinvest the cash in bonds that are liquid at any moment.”

According to Verberk, the third button which the fund manager can press is the composition of the portfolio. “Actively managed funds can deviate from the chosen benchmark. Not only does this provide flexibility, it can also lead to an advantage in stressful markets. In June 2013, when there was unrest in connection with the Fed policy, we were able to sell triple-A asset backed securities relatively easily.

Finally, you can also make use of credit derivatives in the portfolios. These are generally more liquid than bonds issued by the same company.”

Making use of liquid credit derivatives Houweling has recently been appointed manager of a fund that predominantly invests in credit derivatives. “The Robeco Quant High Yield Fund is a very liquid solution to invest in credits. The portfolio consists of credit default swap (CDS) indexes, which are much more liquid than individual corporate bonds. This is very appealing from a risk perspective.

Due to the absence of an illiquidity premium, CDS indexes suffer much less in bear markets. Another advantage is that CDS have a ‘bullet structure’. This means that, unlike many high yield bonds, they cannot be redeemed in advance. This is a positive feature for the return potential of CDS.” “Because of the high liquidity of the CDS indexes, you can actively and cheaply position the portfolio to profit from market trends. The fund uses a proven quantitative model, which we have used now for many years, to vary the beta of the fund between 0.5 and 1.5. Such a quantitative investment style offers diversification for investors in addition to fundamentally managed funds. Moreover, the fund is interesting for investors with a tactical investment view. For these investors, who would like to implement their investment view actively, the large degree of liquidity and the low costs are very favorable.”

Houweling concludes that liquidity in the corporate bond market does not have to be a problem. “Active management and the use of derivatives offer both a solution and an investment opportunity.”

Challenging trends and opportunities in corporate bonds | 5

Stricter rules, new solutions Increased regulation for banks and insurers, implemented in the wake of the financial crisis, is changing the landscape for pension funds and other professional investors. But Basel III and Solvency II also present opportunities in fixed income, particularly in the shape of new hybrid bonds and low-volatility credits.

Basel III Basel III, which came into force on 1 January 2014, obliges banks to have higher levels of core capital, specifically Common Equity ‘Tier-1’.

The expectation is that banks’ capital buffers will increase further in the coming five years.

The stress test for EU banks has raised the bar significantly. The European Banking Authority on April 29, 2014 said banks will need to show they have enough capital to be able to survive a worst-case scenario. This entails: a 7% drop in GDP, a 14% fall in house prices and a 19% decline in equity prices. These are far more stringent criteria than those of the 2011 stress test, which only allowed for a 0.5% fall in GDP. The real economic contraction in the recession that followed was higher than that.

“The stress test seems to be fairly harsh, but we do not expect that there will be many banks with capital shortfalls. We think that most banks which had potential problems have issued equity already,” says Jan Willem

6 | Challenging trends and opportunities in corporate bonds

de Moor, portfolio manager of the Robeco Financial Institutions Bonds fund. “So we expect that the confidence in the banking sector will further increase because of the stress test.”

Basel III forms part of a wider banking union and the introduction of the Single Supervisory Mechanism, where the European Central Bank will take over bank supervision from November 2014 onwards. The banking union envisages a common EU policy, a single pan-European supervisory mechanism, a deposit guarantee scheme and a resolution mechanism that would recapitalize or liquidate failing banks in a structured way.

Basel III is providing interesting investment opportunities related to financial sector credits. In future, existing ‘old style’ Tier 1 bonds will no longer comply with the Basel III regulations. These will therefore be replaced by a new type of bond (additional Tier 1) which offers a bank more safety options if they get into trouble. Several hundreds of billions of euros in new bonds are expected to be issued in the coming years. This

will replace existing Tier 1 bonds once they reach their call date. Banks are also expected to continue issuing subordinated Tier 2 paper for general funding. This will offer huge investment opportunities.

In the early stage of bank refinancing, capital was created in the form of ‘contingent convertibles’, or CoCos. The CoCo element can be added to Tier 2 bonds or even senior bonds. CoCos have a trigger mechanism for emergency measures dependent on the bank’s core capital level falling beyond a specific level. Banks may then skip coupon payments to save money – which means investors run the risk of losing interest income – or convert the bonds into equity. The bond could also be wholly or partially written off. As these bonds are riskier and more complex than traditional bonds, a higher level of investment expertise is necessary.

Solvency II capital requirements have been calibrated on historical volatilities, which implies that a Conservative Credits portfolio not only delivers superior returns per unit of risk, but also per unit of Solvency II capital.

“Solvency II looks as if it could have been designed for Conservative Credits. Insurers can use it to invest in a strategy with low risk and less Solvency II capital, while generally being able to earn the needed returns for their clients,” says portfolio manager Patrick Houweling.

“The strategy is perfectly situated between AAA-rated government bonds, which are very safe but offer low yields, and general credits, with higher yields but also substantially higher risks.”

“We buy CoCos if we think that the capital reserves are sufficient and if there is only a very, very small chance that the bank’s core capital will reach the trigger level. The risk of conversion is then considered a tail risk,” says De Moor. “We look at the quality of the banks as well as the bond’s specific characteristics, including the trigger for potential writedowns or coupon deferral. In addition we consider the bank’s business profile, to see how volatile their earnings are likely to be.”

Solvency II When Solvency II comes into effect, insurers will also need to have higher capital buffers against the risks they run. The slow legislative process in finalizing the framework’s details has led to its implementation date being postponed until at least January 2016, but most insurers have already taken the necessary steps in anticipation of these changes.

Insurers will be obliged by Solvency II to hold enough capital to cover the risk of their investments, while they also try to raise returns for policyholders. The Catch-22 problem here is that yields on safe sovereign bonds are at historical lows, requiring investors to look at higher-yielding products such as credits. This raises the risk profile of their holdings requiring more capital to act as a buffer.

Robeco’s Conservative Credits strategy is based on the ‘low-risk anomaly’: over the long term lower-risk bonds have consistently performed better than bonds with higher risks. This means that the Sharpe ratios of low-risk bonds have been consistently higher.

Challenging trends and opportunities in corporate bonds | 7

A smarter way to harvest factor premiums Factor investing is often only associated with equities. Scientific research shows that focusing on the characteristics (‘factors’) of equities results in an improvement of the risk-adjusted return. However it is less well known that factor investing also works for credit portfolios. Our research in credit markets shows that investing based on factors results in a better Sharpe ratio than investing in the market index.

Scientific research1 in equity markets shows that investing based on factors results in an improvement of the Sharpe ratio of portfolios in the long term. Well-known factors are Low-risk (low-volatility stocks), Value (stocks with a low price/book ratio), Momentum (stocks with a high return over the past twelve months) and Size (small companies). These factors are also referred to as anomalies because their returns cannot be explained with traditional investment theories. Research carried out at the request of the Norwegian Government Pension Fund showed that the largest part of the active return of this fund could retrospectively be attributed to the exposures to these factors.

is specific for credits and not to just ‘simply’ copy the equities definition.

“For example, the objective for Value is to determine whether a company’s credit spread is too high or too low and not whether the shares are expensive or cheap. For ‘credits Value’, the trade-off is generally between the market estimate of the risk - the credit spread - and the objective risk as for example estimated by a rating agency. Another example: for the low-risk factor for equities historical volatility is often used. For credits, the maturity and the rating are generally regarded as generic risk measures: the longer the maturity and the lower the rating, the riskier the bond.

Better Sharpe Ratio

Smarter definitions

Basing its approach on factor investing in equities, Robeco carried out research into the construction of corporate bond portfolios using the following factors: Value, Momentum, Size and Low-risk. Martin Martens, Head Quantitative Fixed Income Research at Robeco: “Our research shows that investing based on factors results in a better Sharpe ratio than investing in the whole market index. This applies to both investment grade and high yield. So factor investing indeed works for credits.” This is illustrated in the figure below.

In addition to a generic definition of each factor, Robeco also uses a ‘smarter definition’. Robeco examined whether the Sharpe ratio of the general definition could be improved by estimating risks more precisely or avoiding unnecessary risks. Martens: “For Value, instead of looking at ratings, you can look at theoretical credit risk models that combine a company’s balance sheet information, such as leverage, and a company’s equity information, such as its volatility, in a smart way.” Houweling: “You can construct a low-risk portfolio by avoiding the longest maturities and the worst ratings. This already results in a better Sharpe ratio than the market. However, we have found smarter risk measures than ratings. Our study shows that a better Sharpe ratio can be achieved for each factor than with the generic definition.”

According to Patrick Houweling, Quantitative Credits portfolio manager and researcher, the challenge is to use a definition for each factor that Sharpe ratio factors

Low-risk credits

0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00

Market Value Momentum Size Low Risk Market Value Momentum Size Investment Grade High Yield

Generic definitions

Smart definitions

Low Risk

Analogously to low-risk equity investing, Robeco developed a strategy two and a half years ago for low-risk corporate bond portfolios. Houweling: “Our empirical research shows that, in a full investment cycle, low-risk corporate bonds have the same return as ordinary corporate bonds, but with a 50% lower volatility. This results in a better Sharpe ratio.

The key is that you implement the low-risk factor by investing in lowrisk bonds of low-risk companies.” Martens lists three rules of thumb for the implementation: avoid unnecessary risks, do not go against other anomalies and avoid unnecessary turnover. Martens: “Avoiding losers is more important than selecting winners. In addition, you can decrease risks by constructing a diversified portfolio. Do not select

Source: Robeco

1

See also: Fama & French (1992), “The Cross-Section of Expected Stock Returns,” The Journal of Finance; Jegadeesh & Titman (1993), “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” The Journal of Finance; en Blitz & Van Vliet (2007), “The Volatility Effect: Lower Risk without Lower Return,” The Journal of Portfolio Management.

8 | Challenging trends and opportunities in corporate bonds

companies only based on Low-risk characteristics, but also make use of Value and Momentum. And finally, opt for a buy and hold strategy to avoid unnecessary turnover and high transaction costs, and to earn the illiquidity premium.

Fundamental check In addition to quantitative analysis, fundamental analysis by the Credit Team is also important in order to monitor non-quantifiable risks that are difficult to capture in a model. What does the structure of the company look like? Has the parent company issued a guarantee for the entity that issued the bond? Did the management announce a planned acquisition that will result in higher leverage? How does a company score on ESG criteria, such as sustainability, labor conditions and the quality of the management? Houweling: “These types of risks are not reflected in the existing balance sheet data. Our analysts identify the non-quantifiable risks timely and thus help further reduce the risk of the portfolio.�

Robeco Conservative Credits Within Robeco Conservative Credits, the low-risk factor is implemented by investing in a disciplined manner in low-risk bonds of low-risk companies. Conservative Credits is being applied in various mandates with a total size of EUR 2.6 billion as at the end of April 2014. Robeco is currently carrying out research into the implementation of other factors in disciplined strategies.

For more information visit www.Robeco.com/conservative-credits

THE MORE WE KNOW THE MORE WE CAN DISCOVER

Challenging trends and opportunities in corporate bonds | 9

More diversification with emerging economies The beginning of the 21st century was characterized by a strong increase in global trade, relocation of production from developed to emerging countries and an unprecedented demand for natural resources.

This resulted in a period of more than ten years of uninterrupted economic growth in emerging countries.

Increasing financing requirement Due to a significant increase in prosperity and more social security in emerging markets, households have started to consume more and make use of credit. This often concerns short-term loans, for example, to purchase household goods or a car. However, a market for mortgages and long-term loans is also starting to arise. In order to ensure that the supply increases in line with the demand for goods and services, companies have been investing in production capacity, infrastructure and real estate.

Consequently, a structural increase has also occurred in the demand for loans among companies in recent years.

This rapid growth of corporate loans and consumer loans has caused the total debt of emerging countries to be more evenly spread between the private and public sector as the debt of the public sector has grown a lot less rapidly. These economic developments have stimulated the development of capital markets.

Capital markets for emerging markets are rapidly maturing Prior to 2000, the governments of emerging countries could practically only borrow in hard currencies such as the dollar or the euro. As a result of the increased stability in the past years, investors are now more often willing to lend to governments in local currencies.

The emergence of a market for corporate bonds is the next step. The market for corporate bonds from emerging countries is developing extremely fast. The market has grown in the past five years from USD 340 billion to more than USD 1.4 trillion today . This investment category is thus already bigger than, for example, the US high yield market.

The credit market was initially dominated by large state-owned companies in specific sectors such as oil and gas or banks. However, more diversification has occurred in recent years with companies for the consumer sectors such as IT or retail. The trend in creditworthiness has also been positive. In 2014, approximately 70 percent of the issuing companies has an investment grade rating.

The dynamics of emerging credits Due to an unprecedented availability of international capital and the growing demand for loans, more and more companies are seeing the advantages of establishing long-term relationships with investors.

Companies are increasingly willing to adapt their reporting standards and

1

Source: JP Morgan Emerging Markets Reference Presentation March 2014 10 | Challenging trends and opportunities in corporate bonds

governance to the wishes of western investors in order to obtain access to international capital.

As a result of the rapidly growing number of ‘new’ companies, the emerging credit market is under-researched. This provides many opportunities for investors. The fact that this segment is underresearched, also provides extra opportunities for active managers such as Robeco, to prove their added value by realizing outperformance.

However, there is also another side to the coin. Not all companies are fundamentally healthy and, in some cases, investors are insufficiently protected. This demands a new approach. Not only the company or the country itself must be carefully analyzed. The influence of a country on a company and the importance of a company for a country are particularly relevant criteria. On the one hand, for instance, government intervention, corruption or legislation can impact a company. On the other hand, there is the importance of a company as, for example, a country’s energy supplier. By comparing companies worldwide within a sector and taking the country risk into account in the analysis, the quality of each company can be placed in a clearer perspective.

Opportunities for institutional investors Corporate bonds from emerging countries offer the possibility to obtain direct access to themes such as ‘the emerging consumer’ without the volatility of equities or currencies. Moreover, this new market offers the possibility to increase the diversification in an investment portfolio.

Economic cycles in emerging countries often differ from the cycles in Europe and the United States. In addition, this market offers a large number of new companies to invest in. Therefore, it is not surprising that investors are becoming increasingly interested in this market. In 2011, Robeco decided to build up expertise in corporate bonds from emerging economies in addition to its emerging equities strategies.

Robeco Emerging Credits Robeco manages the Robeco Emerging Credits fund based on a total-return approach. This is a fund that focuses specifically on corporate bonds from emerging countries. Of course, we also offer institutional investors the possibility to participate in this rapidly developing investment category via a mandate structure.

Challenging trends and opportunities in corporate bonds | 11

Flexible strategies to benefit from relative value trade-offs New flexible credit strategies offer institutional investors market segmentation benefits through one integrated approach. This article explains the benefits and the rationale.

Benefits from a flexible, integrated approach Most institutional investors allocate capital to specific asset classes, segments, sub-categories and then specific managers. For credits this includes segments such as high yield or investment grade, or subsegments such as Asset Backed Securities (ABS) or covered bonds.

It has been a modus operandi for decades, but this kind of ‘box-ticking exercise’ remains an inflexible approach. Now a trend has emerged to use flexible strategies which can allocate more freely, and are more diversified and globalized. Essentially, such a fund-building exercise benefits from being able to access all available opportunities across various credit segments.

This is more flexible than a traditional approach where changing allocations may require a new manager selection process, extra red tape and transaction costs. At the same time, institutional investors should be mindful about the cost effectiveness of flexible integrated strategies as well, since excessive switching between credit segments will also be expensive.

12 | Challenging trends and opportunities in corporate bonds

When using this flexible integrated approach, it becomes possible to look for relative value trade-offs within the whole credit universe, for instance in using ABS instruments versus covered bonds, or high yield subordinate securities versus investment grade paper. The goal of making the right relative value trade-offs is to achieve higher returns via a broader set of opportunities.

What are the main drivers behind this trend? Victor Verberk, head of investment grade credits at Robeco, highlights three underlying rationales.

Rationale 1: Desynchronized cycles The flexibility of an integrated credit strategy is increasingly required as central bank policies continue to desynchronize and as different credit markets reprice securities as their economies and companies improve at different rates. Desynchronized cycles lead to dispersed monetary policies and different interest rate environments across the globe, making it increasingly important to avoid a local bias.

Desynchronization has led to opportunities to switch between the traditionally separated developed and emerging credit markets.

The current compressed difference between high yield and investment grade offers fewer opportunities.

“As we are now quite late in the credit cycle, bonds are becoming more expensive and sometimes more rate sensitive”, says Victor Verberk. ”It’s now ideal to be able to jump between segments and not be constrained by boundaries.”

“For example, in the last 12 months emerging credits have significantly underperformed developed markets because rate fears from the Fed have been prevalent since June 2013. And now, developed markets may start underperforming.”

“So if you are flexible and not restricted by segmentation strategies you can switch from developed to emerging markets, where many corporate bonds are now repricing. Or, if you anticipate that the Fed will increase interest rates much sooner and more aggressively than the market expects, you can switch into government bonds or ABS, which can outperform unsecured credit.”

You can also benefit from desynchronization if you take a wider, more integrated view, he says. “For a few years investors were long Europe versus the US and that worked perfectly well at the time. Now, due to rate risks, the US credit market will become more volatile. Emerging markets have already repriced, and that makes global positioning more important.”

Robeco’s new Global Credits fund Robeco’s new Global Credits fund offers the flexibility of an integrated strategy. The fund invests in the best-of-class credits across all asset classes regardless of type or location, and does not follow a benchmark. Since the Robeco credit team has a composite record, there is a three-year track record available for a similar strategy as the one for the new fund.

To make such a global strategy work, a large and experienced team is required to be able to pool individual specialties and enable the fund manager to get the best of all worlds under one roof. “We have a big credit team now of more than twenty people including expertise in emerging credits, high yield, investment grade and secured finance within one integrated team. It is ideally equipped to come up with all the best ideas in all the market segmentations,” says Verberk who is the portfolio manager of this fund.

Verberk serves on many of Robeco’s 500 credit committees,

Rationale 2: Changing perceptions of risk Verberk says one problem with continuing the traditional allocation by institutional investors is that perceptions of risk have changed since the financial crisis of 2008-09, and some bonds that appear ‘safe’ have become much more expensive, making quality risk-adjusted returns harder to come by.

“If everything is over-compressed in certain areas, then it looks safe, but it is expensive and can be misleading,” he says. “A high yield bond with a spread of 1,000 basis points over a sovereign bond can be safer than something that is 300 basis points over. You need the expertise to know what is really worth owning.”

Many institutional investors still provide mandates that require a strict split between all these segments. What can make matters worse is that regulators sometimes press for even less flexibility within mandates. This ensures that flexible, integrated funds will retain their benefits for the years to come.

Rationale 3: Benchmark disadvantages Another problem with the traditional allocation towards specific segments in combination with very specific benchmarks is that there is a greater chance they will include high risk securities an investor may want to avoid, such as unhealthy banks. “The smaller your universe is, the more you become obliged to invest in anything that’s in the index, and your chance of having bad luck with exposure to a company with a very high default risk is bigger,” says Verberk. “With a global view it is easier to find the best ideas.”

getting the best possible overview of all segments and regions.

“It means I can go across the teams and see everyone’s ideas. If for example there is a credit that is BB and is about to cross over into investment grade, one of the team members can spot it and alert me. I do the same for coming fallen angels for the high yield specialists. It is a flexible approach for a flexible strategy,” he says.

This lack of bias is used to investors’ full advantage. “The biggest benefit of being global is the ability to have global ideas generation,” says Verberk. “The breadth of our ideas is bigger as the global market is almost endless and there is always a good risk/return out there.”

“We typically have a research driven investment process with a somewhat longer investment horizon. The overwhelming amount of ideas comes from our own research. This way trading costs are limited. We prefer old-fashioned bonds with a prospectus and no counterparty issues, to derivatives. However, for short positions or overlay strategies, derivatives are very efficient.”

Challenging trends and opportunities in corporate bonds | 13

ESG integration, in particular for corporate bonds Institutional investors are becoming increasingly aware of the fact that trends such as population growth, the scarcity of raw materials and globalization have an impact on a company’s risks and opportunities. Under the pressure of regulators and investors, such as participants in pension funds, sustainable investing is slowly but surely evolving from a ‘niche’ to a general trend.

As an illustration: there are simply no longer any Requests for Proposal without questions about ESG (environment, social and governance). And the assets that are managed by organizations that have signed the UN Principles for Responsible Investment (PRI) have risen from USD 4 trillion at the introduction in 2006 to USD 34 trillion in 2014. This represents 15% of global assets available for investment. In addition, the signatories of the PRI have to comply with increasingly strict requirements.

The many interpretations of sustainability There is general consensus now on the fact that sustainable investing is not simply a hype that is going to blow over. Although most institutional investors no longer regard this as a ‘green’ or ‘ethical’ strategy, there are still a large number of interpretations and implementations, varying from excluding weapons manufacturers to a way to manage long-term risks.

Robeco helps pension funds to develop their convictions, ambitions and policy in the field of sustainability. In addition, we implement this policy by integrating sustainable investing in the existing investment policy or by offering voting and engagement services. We can also screen portfolios on sustainability and provide a detailed report on this.

The integration of sustainability in credit investments Robeco applies complete integration of ESG factors in all credit strategies.

Besides a company’s competitive position, strategy, financial position and structure, ESG is one of the five pillars of the credit analysis. We do this because we are convinced that ESG factors provide additional relevant information so that we are better able to analyze a company and to limit the downward risk of investment portfolios. The weight of the ESG pillar in the total analysis depends on how financially material this is. There are a large number of ESG indicators for each company and we only analyze the ESG aspects that are the most relevant for the company’s financial position and profitability.

‘There is general consensus now on the fact that sustainable investing is not simply a hype that is going to blow over’ 14 | Challenging trends and opportunities in corporate bonds

Focus on limiting risk The Corporate Sustainability Assessment (CSA), or the sustainability scores of RobecoSAM, Robeco’s sustainable investing subsidiary, is based on surveys held among approximately 2800 companies and plays an important role in the credit process. These scores are discussed by the credit team with the specialized RobecoSAM sustainability analysts. We mainly focus on negative elements such as weak spots in the corporate governance or in the environmental policy. In addition, we supplement our research with other sources that can expose even more risks. For example, we scan the media to see if the company is involved in legal proceedings or settlements. After all, the amounts involved in issues like this can have a substantial impact on the company’s financial position.

Is sustainable investing expensive?

At Robeco, we look at ESG from a financial perspective. Return is the most important issue for us. It is a myth that ESG integration is at the expense of return. Many questions in RobecoSAM’s CSA concern financially material issues such as governance, risk management, personnel policy and other factors that ultimately also affect a company’s profitability. ESG analysis enables us to take better informed decisions and to pick up risk signals in an early stage. This way, we are able to avoid the losers.

Unique: an active dialog with credit issuers And we go a step further than just analysis. A team of engagement specialists enters into an active dialog - engagement - with selected companies about financially important themes that are determined in consultation with portfolio managers, investment analysts and sustainability analysts. That this not only takes place for equities but also for credits is unique. We encourage companies to take concrete steps to improve their sustainability, as this also has a positive effect on their creditworthiness.

An example is our engagement with the Brazilian energy company Petrobras. Petrobras subsidizes gas prices by purchasing at the market price and selling under the market price. As a result, the company has a large influence on the inflation rate. The chairman of the board of Petrobras is also the Brazilian Minister of Finance and therefore the company’s independence is doubtful. Together with a number of institutional investors and in cooperation with our credit analysts, our engagement analysts proposed two independent members of the Board.

This proposal was approved by the shareholders, which has resulted in a considerable improvement in the company’s corporate governance.

‘A company that has an answer to today’s challenges in the field of the environment, people and good governance, is more attractive for credit investors’ Exclusion also excludes improvement It is exactly because we believe in a constructive dialog that we only exclude companies if there is no other option, for example, if they structurally violate the principles of the UN Global Compact or manufacture controversial weapons. The most important objection to exclusions – especially exclusions on the basis of conduct – is that as an investor you then deny yourself the opportunity to exert a positive influence on the operations of the company in question. We believe in long-term relationships with companies – a positive approach in which we try to convince a company that improvement is also in its own interest.

Moreover, we are convinced that a company that has an answer to today’s challenges in the field of the environment, society and good governance, offers better prospects and entails fewer risks and is therefore more attractive for credit investors.

‘It is a myth that ESG integration is at the expense of return’

THE MORE WE FEAR THE BRAVER WE BECOME

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Important information Robeco Institutional Asset Management B.V. (trade register number: 24123167) is licensed by the Netherlands Authority for the Financial Markets (AFM) in Amsterdam. The Spanish branch Robeco Institutional Asset Management B.V., Sucursal en España is licensed by the Spanish Authority for the Financial Markets (CNMV) under register number 24. All funds in this publication are UCITS and authorized for the commercialization in France by the AMF. Any investment is always subject to risk. For the risk factors of the funds in this publication, you need to read the prospectus, the (semi)annual reports and the Key Investor Information Document. All these documents can be obtained free of charge at www.robeco.com. This publication is for professional investors only.

In Germany This information is solely intended for professional investors or eligible counterparties in the meaning of the German Securities Trading Act.The information contained is only intended for the addressee and must not be forwarded without the prior consent of Robeco.

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© Robeco 2014

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