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Search for yield and crisis fatigue?
Themes for fixed income investors in 2013
For investment professionals only
David Oliphant- Head of Investment Grade Credit
January 2013
What keeps us up at night?
1.
2012 is going to be a difficult year to follow from a return perspective.
2.
Complacency around riskier assets is high
3.
Geo-political risks have not been eliminated
1.
The Eurozone – what happens if OMT does not work?
2.
USA - Going over the fiscal cliff, or a resolution that still leads to near recessionary growth in the US
3.
The lack of credit growth fuelling yet another growth scare in H1 2013
4.
Japan responds inappropriately to deflationary pressures
5.
A relapse in Chinese growth
4.
Corporate behaviour could become increasingly bond holder unfriendly
5.
Vulnerability in the government bond market and negative real yields
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Crisis Fatigue

Eurozone progress in 2013 has been impressive. Problem solved or more trouble ahead ?

Slow growth is assured but the issue for markets has been more about the stability of the monetary union

A checklist for a Eurozone solution
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Open-ended commitments to buy troubled debt
P
Move current accounts back to surplus
P
Credible plan to restore primary account surpluses
P
Get rates in Italy and Spain to non-stressed levels
P
Retreat from misguided view of severe austerity as the solution
P
Restructure Greece without inducing contagion
P
Reduce levels of fiscal drag by 2013
P
Cohesive policy view and support from Germany
P
Structural reforms / competitiveness
No, but Ireland shows it can be done
Banking / fiscal union
No
Conditions for OMT bond purchases met and agreed to
No
Finish deleveraging the banking system
No, but will peak in 2012/2013
2
Euro area: fiscal policy tightening in all regions
Fiscal tightening, % GDP
Lending growth, % year
2012
2013
35
Austria
0.0
-0.9
30
Belgium
-1.7
-0.8
25
France
-1.1
-1.7
20
Finland
-0.4
-0.5
Germany
-0.1
-0.2
Greece
-3.6
-2.5
Ireland
-4.4
-0.4
5
Italy
-2.9
-1.7
0
Netherlands
-1.1
-1.9
-5
Slovenia
-3.7
-1.3
Portugal
-1.2
-1.6
Spain
-4.1
-2.8
% year
% GDP
15
10
-10
04
05
06
07
08
09
10
Spanish households
Spanish corporates
Italian households
Italian corporates

Fiscal multiplier in normal times assumed at 0.5

Deposit outflows exacerbate this trend

But Greek experience suggests downside risk

Greek/Irish experiences worsened from here

Austerity will continue to drag into 2013
Source: Threadneedle, ECB, OECD, May 2012.
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11
12
Fiscal drag will hinder growth in 2013
The impact however has peaked
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Fiscal Cliff -2013
The dynamics of the negotiations of the cliff
Fiscal Cliff offers
The deal so far is small –
to avert a rating
downgrade and explosive
debt dynamic, the large
deal is yet to come
11/29/12
12/3/12
12/12/12
12/15/12
12/17/12
12/18/12
1/1/13
Not over ‘til its over
Source: Washington Post January 2013
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Current and primary accounts moving back into surplus!
A collapse in imports has been part of the story
Greece
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Italy
Ireland
6
Portugal
Spain
Emerging market growth has become more sustainable
Slow growth should not dent emerging market debt outperformance
Gross debt as % of GDP – spot the pattern
2012 growth estimates
8
120%
110.2%
7
100.6%
6
100%
5
80%
4
77.5%
73.8%
3
60%
2
49.6%
41.1%
1
40%
38.7%
33.2%
Emerging
Europe
Latin
America
CIS
Middle East
Asia
Emerging
markets
Euro area
Japan
UK
US
-1
Advanced
economies
0
20%
0%
2000
2005
Developed

2010
2012E
Emerging
Better growth, better fundamentals in emerging market bonds
A play on the structural
shift in the global economy
Source: IMF, September 2012
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China – Slower growth but bottoming in 2013

Q3 2012 was the seventh consecutive quarter of decelerating growth and a post-crisis low

The economy appears to be close to a cyclical bottom

Industrial profits have been very weak but have started to rebound in recent months

Leadership transition is almost complete, current policies likely to continue

However, external risks remain a concern
Real GDP growth (%)
Profits of larger industrial firms by ownership (YoY %)
20
30
18
25
State control
Collective
Foreign & HMT
Share Holding
Private
20
16
15
14
10
12
5
10
0
8
(5)
(10)
6
(15)
YoY
QoQ saar
4
(20)
(25)
2
2007
2008
2009
2010
2011
2012
2012E
Jan 12
Source: Threadneedle as at September 2012
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Feb 12
Mar12
Apr12
May12
Jun12
Jul12
Aug12
Sep12
The Debt - Equity cycle
Corporate Leverage is low but has stopped improving
It’s about 3:00 o’clock, but it’s not clear this is a classic cycle
Corporate Leverage falling
REPAIR
RECOVERY
2H08 onwards
2H 2009 - ?
Balance sheet repair, rights issues to pay back debt,
focus on cash generation and survival!
Credit better than equity
1
The
DebtEquity
Clock
Lower Economic growth
DOWNTURN
2H07, 1H08
2
4
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EXPANSION
2006-07
Margins peak, leverage rising, FCF falling, volatility
rising, M&A/LBOs more speculative. Credit bear
market starts, equities still in bull market
Both Equity and Credit Down
Source: Morgan Stanley, October 2011
Both equity and credit up
Higher Economic growth
3
Recession. Attempts to delever foiled by falling asset
prices. Continued bear market for credit. Equities enter
bear market
Restructuring efforts boost cashflow.
Margins rising, FCF growing, leverage falling
Equity better than Credit
Corporate Leverage rising
9
Government bond yields and credit spreads
Spreads are attractive; core government bond yields are not
Government Bond Yields
Credit Spreads
(UK, US and German 10 year bond yields)
(investment grade, high yield & emerging market bonds
relative to government yields)
12
25
10
20
Spread (pct)
Yield (pct)
8
6
15
10
4
5
2
0
0
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
UK
US
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
IG Spreads
Germany
Source: Bloomberg, October 2012
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HY Spreads
EMD Spreads
Where to find yield today
Investors of all types are demanding income with relative safety
Current asset class yields (%) vs. volatility
8%
7%
US HY
6%
EU HY
5%
Yield
EM Soverign
4%
Eurostoxx
FTSE 100
3%
US IG
S&P 500
2%
EU IG
UK Gilts
CMBS
1%
Treasuries
Bunds
US T Bills
0%
0%
2%
4%
6%
8%
10%
12%
Trailing 24 m onth volatility
Low yields and higher volatility requires
an evolving investment framework
Source: Merrill Lynch 31st December 2012
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Where are the opportunities in bond markets?
Corporate credit is still attractive despite a powerful rally
High Yield spreads are wide relative to defaults
16%
Global High Yield YTM
2,000
14%
1,800
13.1%
1,600
11.9%
12%
10.3%
1,400
1,200
7.5%
8%
1,000
7.2%
Defaults (2013e)
2.3%
Loss Given
Default
60%
Default
Assumptions
8.6%
10%
6.6%
6.9%
800
6%
600
4%
Total Expected Default Losses
1.3%
Excess Premium Over Default
Losses
5.3%
400
2%
200
0
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
0%
Default Rate (LHS)
US Spread (RHS)
Europe Spread (RHS)
Corporate credit quality is still improving
relative to sovereign quality
Source (left hand chart) Merrill Lynch, JPMorgan as at September 2012. European Spread used is the HPS2 Index. US Spread is H0A0 Index; (right hand table):
Merrill Lynch and Threadneedle as at January 2013.
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Can bonds deliver respectable total returns?
It’s not as bad as you might think
Total return projections for various market environments (12-month horizon)
12%
7.5%
8%
4.3%
4%
8.9%
7.1%
4.4%
3.1%
2.0%
0.3%
0%
-4%
-0.8%
-0.3%
-0.9%
-8%
-7.7%
-12%
Double dip
Bunds
Slow growth
EU Corp
EU High Yield
Recovery
USD Emerging Market Sovereign

Recession – Bunds -40bps, IG spread +50bps, HY spread +175bps*, EM spread +100bps

Slow growth – Bunds +35bps, IG spread -50bps, HY spread -110bps**, EM spread -65bps

Recovery – Bunds +125bps, IG spread -70bps, HY spread -225bps***, EM spread -130bps
Source: Bloomberg, Threadneedle as at 31st December 2012.
* 4% defaults with a 40% assumed recovery rate
** 2% defaults with a 40% assumed recovery rate
*** 1% defaults with a 40% assumed recovery rate
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Fixed income – the path forward in 2013

The search for yield is not yet over, as policy rates will remain lower than inflation

Valuations in corporate and emerging market bonds are not stretched and these sectors are poised to outperform

Core government bonds represent poor value but a spike in yields is not imminent

The tug-of-war between reflationary policy and sluggish growth will continue to produce bouts of volatility
throughout the year

In the eurozone, receding default and break-up risk are the key drivers – expect a better year on that front but with
lower returns

There will be pockets of good return in fixed income, but adjust your sights lower!
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Conclusion

Macro economic background is very challenged and there are considerable downside risks

Interest rates will stay low for a very long time

Yielding assets remain attractive against this backdrop

Equity valuations continue to be undemanding

Our asset allocation stance reflects a more positive view on equities as tail risks begin to abate
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Current asset allocation model
Strongly Dislike
Dislike
Neutral
Favour
Government Bonds
Index Linked
Property
Commodities
Cash
Equities
Credit
Global Equity
Region
Europe ex UK
US
Japan
UK
EM
Pacific ex-Japan
Global Equity
Sector
Energy
Staples
Utilities
Telecoms
Financials
Materials
Industrials
Consumer Cyclicals
Healthcare
Japan
Germany
US
UK
Nordic
Australia
EM Local
Sterling Investment
Grade
EM Debt
European High Yield
Asset Allocation
Bond - FX Hdgd
Credit
Commodity
FX
JPY
AUD
Technology
Base Metals
Softs
Grains
Livestock
Precious Metals
Energy
Euro
GBP
Nordic
USD
Portfolio Risk
X
Source: Threadneedle, November 2012.
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Strongly Favour
16
Threadneedle Absolute Return Fixed Income Product Range
Benchmark
Performance
objective
Asset class focus
Launch date
Relative
performance since
inception
Global Opportunities Bond
Fund
Absolute Return Bond
Fund
Credit Opportunities Bond
Fund
Absolute Emerging
Markets Macro Fund
1M $ LIBOR
3M Libor
1M EURIBOR
3M $ LIBOR
BM +4.5% gross
BM +3.0% gross
BM +3.5% gross
7.5%–12.5% net
Diversified global
Macro, Developed
Governments, Rates, FX
Credit – Investment Grade
and High Yield
Emerging market sovereign,
local and international
currency and FX
August 2011
October 2005
May 2009
September 2010
+7.29%
+1.99% p.a.
+6.79% p.a.
+3.37% p.a.
Source: Threadneedle / FactSet as at 31 July 2012. Gross performance from 31 March 2010 onwards is based on daily cash flows and valuations, from 1 January 2008
to 31 March 2010 based on Global Close prices, and prior to January 2008 based on 12pm prices. Fund data is quoted on a bid to bid basis with gross income reinvested at bid. Fund returns calculated Gross of TER (and Tax) for comparison with index. The relative returns shown are calculated on a geometric basis and are
annualised.
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Threadneedle absolute return funds’ performance
UCITS absolute return funds
Launch
date
Ccy.
2012
2011
2010
2009
2008
2007
2006
2005
2004
Absolute Return Bond Fund
Oct 2005
GBP
0.48
0.59
-1.17
3.16
13.50
6.93
2.86
-
-
3.35
2.76
Target Return Fund
Apr 2008
EUR
-0.14
1.16
-1.26
3.33
11.28
4.92
-
-
-
2.80
2.82
Target Return Core Fund1
Jun 2008
EUR
-2.66
1.80
0.30
2.14
3.22
-
-
-
-
1.09
1.54
Target Return (USD) Fund
Aug 2009
USD
0.07
-1.77
-1.21
-
-
-
-
-
-
-1.07
2.59
Credit Opportunities Fund2
Apr 2009
EUR
6.78
0.27
7.43
7.43
-
-
-
-
-
5.64
3.11
Absolute Emerging Market Macro Fund
Sep 2010
USD
11.88
-0.76
-3.33
-
-
-
-
-
-
3.20
n/a
Global Opportunities Bond Fund
Aug 2011
USD
6.54
1.80
-
-
-
-
-
-
-
6.28
n/a
American Absolute Alpha Fund
Jun 2010
USD
4.52
3.61
1.70
-
-
-
-
-
-
3.93
n/a
UK Absolute Alpha Fund
Sep 2010
GBP
2.37
3.81
3.89
-
-
-
-
-
-
4.68
n/a
European Smaller Companies Absolute
Alpha Fund
Mar 2011
EUR
3.73
1.94
-
-
-
-
-
-
-
3.24
n/a
Source: Morningstar as at 31 December 2012. Performance stated net of fees. Net performance based on noon prices, unadjusted income reinvested. Volatility based
on annualised standard deviation.
1 Performance data for 2008 since launch of Threadneedle Target Return Core Fund in June 2008. 2012 performance data to 31 October 2012 due to fund closure.
2 Performance data for 2009 since launch of Threadneedle Credit Opportunities Fund in April 2009
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Since inc. Volatility
(p.a.)
( p.a.)
1
Appendix
Core Government bond yields
US 10 year note less core inflation
8
7

Adjusted for inflation Government bond yields
have rarely been more expensive
5

This reflects risk aversion
4

The path to credit downgrade
3

But……….. little likelihood for a spike higher until
rates change direction
Real Yields %
6
2
1
0
-1
-2
75
78
81
84
87
90
93
96
99
02
05
08
11
Real Yield
Source: Bloomberg as at 31 December 2012.
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Heightened fear of corporate defaults

Implied investment grade defaults
Current iTraxx Main Index
103 bps

Assumed recovery rate
40%
20%

5-year assumed default rate
7.1%
The € CDS Credit Market is implying a high level
of Investment Grade defaults in the coming years

At current spread of around 133, European Credit
market is discounting 11.1% cumulative default
probability (on a 40% recovery assumption).

Itraxx Main Index is a basket of 100 Corporate and 25
Senior Financial issuers
Historic experience has been far less than this

Average 5-year default experience is 0.8%

Worst cohort exhibited 2.4% in last 40 years

‘Great Depression’ estimated at around 5%
But how to price the risk of redenomination of
the Euro?
5.4%
Market default expectations are still running high
Source: Bloomberg as at 7 January 2013
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Historical default experience is very different
5-year cumulative default rate history
2.00%
1.50%
1.00%
0.50%
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
0.00%
1970
Cumulative default rate
2.50%
Historically IG Corporate defaults are very low
Source: JPMorgan 2012
PL12/10/078
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Important notes
For institutional clients, distributors, intermediaries and consultants only (not to be passed on to any third party).
Past performance is not a guide to future performance.
The value of investments and any income from them can go down as well as up.
The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been
acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change
without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed.
The mention of any specific shares or bonds should not be taken as a recommendation to deal.
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It may not be reproduced in any form or passed on to any third party without the express written permission of Threadneedle Investments. This presentation is the
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This presentation is not investment, legal, tax, or accounting advice. Investors should consult with their own professional advisors for advice on any investment, legal,
tax, or accounting issues relating an investment with Threadneedle.
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Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle
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