Download Why Diversified Debt?

MLC Diversified Debt Teleconference
July 2008
General advice warning and
disclaimer
This document was prepared by MLC Investments Limited (ABN 30 002 641 661), and MLC Limited
(ABN 90 000 000 402), members of the National group of companies, as an information service
without assuming a duty of care. Accordingly, reliance should not be placed by anyone on this
document as the basis for making any investment, financial or other decision. While the information
included is believed to be accurate, no member of the MLC Investments Limited or any member
company of the National Group of companies accepts responsibility for any inaccuracy or for
investment decisions or any other actions taken by any person on the basis of the material included.
An investment with MLC does not represent a deposit with or a liability of National Australia Bank
Limited, MLC Investments Limited, MLC Limited, or other member company of the National Group of
companies and is subject to investment risk including possible delays in repayment and loss of income
and capital invested.
None of National Australia Bank Limited (ABN 12 004 044 937), MLC Investments Limited, MLC
Limited, other member companies in the National Group of companies, the underlying fund managers
of the investments, any trustees or their respective officers guarantee the repayment of capital
invested, the payment of income, the performance of the specific investments selected by investors or
the performance of any MLC products except where specified on the current disclosure document.
2
Agenda
• Economic and Investment Market update
• Building a diversified debt strategy
3
Agenda
• Economic and Investment Market update
• Building a diversified debt strategy
4
The state of play
• Too much liquidity
• Too much leverage
• Too much complacency
• Voracious risk appetites
• A benign macroeconomic environment
Have led to….
• Risk being way underpriced – too little reward on offer for risks that have not been
properly understood
• In short, returns have been too high, and volatility has been too low, and this
situation is now normalising
The problem was (and still is) much larger than just US sub-prime
mortgages!
5
When too much debt just isn’t
enough Total US debt as % of GDP
“In the end, the root of the problem is unavoidable. At some point US
consumption will have to come into line with US incomes, and US growth will
need to be built without constantly growing debt levels. This adjustment will be
painful. The pain can be spread across time and across people, but it cannot be
avoided.”
- Bridgewater 24 March 2008
6
US housing: the state of play
..helping to create a huge overhang of
unsold homes
Home sales have plummetted..
8500
'000 annualised
12
7500
10
6500
8
5500
Unsold single-family homes to total sales ratio
6
4500
Total home sales (new + existing)
3500
2500
Jan-93
4
2
Jan-96
Jan-99
Jan-02
Jan-05
Jan-08
Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06
..but more forced sales are likely as
delinquency rates have soared.
Housing starts have fallen in response
to sharply weaker demand..
2500
3.5
Delinquency rate % of loans outstanding
3.0
2000
2.5
1500
2.0
1000
1.5
Housing starts (lhs)
1.0
500
Jan-93
7
Jan-96
Jan-99
Jan-02
Jan-05
Source: Thomson Financial Datastream
Jan-08
Q2 1990
Q2 1993
Q2 1996
Q2 1999
Q2 2002
Q2 2005
The US economy is probably in
recession already
Consumer confidence is already at recession
levels
GDP growth is OK, but the leading indicators
look lousy
Annual change %
10
135
Conference Board leading index
Real GDP
125
Expected
conditions
115
Current
conditions
8
6
US University of Michigan consumer sentiment indices
105
95
4
85
2
75
65
0
55
-2
45
-4
Q1 1988 Q1 1991 Q1 1994 Q1 1997 Q1 2000 Q1 2003 Q1 2006
8
Source: Thomson Financial Datastream
35
Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06
No, it’s not just a US problem
..and G3 consumer sentiment is
also falling
EU, Japanese manufacturing
confidence is following US lower..
Std deviations away from 5yr average
3
US
3
Std deviations away from 3yr average
EU-15 and Japan
US
2
2
1
1
0
0
-1
-1
-2
-2
-3
Q1 1990
-3
Q1 1990
9
Q1 1995
Q1 2000
Q1 2005
Source: Thomson Financial Datastream, MLC Investment Management
Q1 1995
EU-15 and Japan
Q1 2000
Q1 2005
Some of the major central banks
have started the rescue operation…
9
Official interest rates %
9
Official interest rates %
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
May-04 Feb-05 Nov-05 Aug-06 May-07 Feb-08
0
May-04 Feb-05 Nov-05 Aug-06 May-07 Feb-08
US
Canada
Euro-area
UK
Japan
Australia
New Zealand
China
Source: Thomson Financial Datastream. US rate is target rate for Federal Funds. For Europe, short-term repo rate.
Canadian rate is Bank of Canada policy rate. Australian rate is the RBA cash rate target. Chinese rate is the
1yr benchmark lending rate. NZ rate is RBNZ cash rate target.
10
..but how much more debt can be rammed down the
throats of consumers in the English speaking world?..
Australian household debt
%
180
160
as % of GDP
140
as % of disposable income
120
100
80
60
40
20
0
Q1 1980 Q1 1985 Q1 1990 Q1 1995 Q1 2000 Q1 2005
UK household debt
%
180
160
as % of GDP
140
as % of disposable income
120
100
80
60
40
20
0
Q1 1980 Q1 1985 Q1 1990 Q1 1995 Q1 2000 Q1 2005
11
Source: Thomson Financial Datastream
US household debt
180 %
160
as % of GDP
140
as % of disposable income
120
100
80
60
40
20
0
Q1 1980 Q1 1985 Q1 1990 Q1 1995 Q1 2000 Q1 2005
House prices in the English speaking (!?)
economies
300
Real (inflation adjusted) house prices. March quarter 1988 equals 100
US
250
UK
Aust
200
150
100
Sources: Datastream, RBA, MLC Investment Management
50
Q1 1988
12
Q1 1991
Q1 1994
Q1 1997
Q1 2000
Q1 2003
Q1 2006
“.. there are known unknowns; that is
to say we know there are some
things we do not know. But there are
also unknown unknowns -- the ones
we don't know we don't know."
…”
• What we don’t know…(and may not know, that we don’t know)
? How far US house prices will fall
? How much damage will be done to household balance sheets
? The full impact on US financial institutions’ balance sheets (and
hence their ability to create credit)
? The full impact on household spending and hence the economy
? The full impact on corporate earnings
13
Previous US house price booms…
14
Previous US house price booms…and
the subsequent busts
15
Australian economic prospects
• Australian economic growth to slow significantly (either the economy slows ‘by
itself’ or RBA will make it slow!)
• (Patriotism has paid handsomely over past five years, but this will not
last!)
Australia's economy accelerated while the G4 was slowing
6
Annual growth in real GDP %
5
4
3
2
1
0
Q1 2000
16
Q1 2002
Q1 2004
Q1 2006
Q1 2008
An already tight labour market became
even tighter over the last year…
25
7
Annual CPI inflation (%) - average of RBA's preferred measures
%
%
12
6
20
10
Trend
unemployment rate (rhs)
5
8
15 4
10
6
3
Cash rate (lhs)
2
5
1
00
Jan-83
2
Source: RBA, MLC
Q2 1989
17
4
0
Jan-87
Q2 1992
Jan-91
Q2 1995
Jan-95
Q2 1998
Jan-99
Jan-03
Q2 2001
Jan-07
Q2 2004
Q2 2007
..helping to keep inflation above the
RBA’s
target range
Annual CPI inflation (%) - average of RBA's preferred measures
7
Consumer prices y/y% - average of RBA's preferred measures
7.0
6
6.0
5
5.0
The RBA's worst target 'miss' of the low-inflation era?
4
4.0
3
3.0
2.0
1.0
2
1
Source: RBA, MLC
0.0 0
Q2 1989 Q2 1991 Q2 1993 Q2 1995 Q2 1997 Q2 1999 Q2 2001 Q2 2003 Q2 2005 Q2 2007
Q2 1989
18
Q2 1992
Q2 1995
Q2 1998
Q2 2001
Q2 2004
Q2 2007
Has RBA done enough? (Are borrowing costs
too high?)
..but higher inflation has kept
real borrrowing costs lower
Nominal interest rates the
highest since (at least) 1996..
14
%
10
%
Source: RBA
9
Source: RBA, MLC Investment Management
12
8
10
7
6
8
5
6
4
4
Cash rate
Bank std. variable
2
Mortgage managers standard
Mortgage managers basic
3
Cash rate
2
Bank std. variable
1
Mortgage managers standard
Mortgage managers basic
Bank small/med. business rate
0
Jan-95
19
Jan-98
Jan-01
Jan-04
Jan-07
0
Jan-95
Bank small/med. business rate
Jan-98
Jan-01
Jan-04
Jan-07
Lending approvals are still falling
25000
$Am
20000
Total ex-refinancing
Owner-occupiers (ex-refinancing)
Investors
15000
10000
5000
0
Jun-99
20
Source: Thomson Financial Datastream
Jun-01
Jun-03
Jun-05
Jun-07
Retail sales, confidence figures suggest
rate are starting to have an effect
…and consumer sentiment
has plummeted
Retail sales are slowing..
2.0
m/m%
Seasonally adjusted
Trend
140
Index
130
1.5
120
110
1.0
100
0.5
90
80
0.0
70
-0.5
Jan-06
Jul-06
Jan-07
Source: NAB Survey
21
Jul-07
Jan-08
60
Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07
NAB business survey points to
weaker growth
25
20
15
Net balance (%)
10
5
0
-5
Actual business
conditions
Confidence
-10
-15
-20
Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07
22
Source: NAB Survey
23
-40%
A
EI
Ts
H
ed
ge
d
A
us
tR
-U
nh
ed
ge
d
ed
ge
d
Sh
ar
es
-H
R
EI
Ts
es
Sh
ar
lo
ba
l
G
G
lo
ba
l
us
t.
Sh
ar
es
A
-5%
-20%
-35%
Source: MLC Investment Management
U
S
H
ig
h
Yi
el
d
D
eb
t-
C
as
h
H
ed
ge
d
A
us
t.
us
tN
lo
om
ba
in
lI
al
nv
D
G
eb
ra
t
de
D
eb
tH
ed
A
ge
us
d
t.
C
PI
lin
ke
d
de
bt
G
-10%
lo
ba
l
G
Annualised Returns (%pa)
Asset Class Returns to June 2008
15%
10%
5%
0%
-15%
*
-25%
-30%
3-Months
1 Year
3 Year
Global economic and investment
prospects
• Global economy slowing down (the US is in recession now)
• ..but the Chinese economy is well-placed to weather the storm
(good news for some parts of the Australian economy)
• The US Federal Reserve now understands the magnitude of the
problem, and is responding..
• ..and the economy and financial markets will eventually recover..
• ..but we are most unlikely to see a repeat of the kind of
investment returns seen in recent years.
24
Agenda
• Economic and Investment Market update
• Building a diversified debt strategy
25
Why Diversified Debt?
Roles of Debt within a portfolio:
• Reduce risk (dampen volatility)
• Protect capital
• Provide steady income
• Enhance returns
• Diversification in economic environments where other asset
classes may perform poorly
Question: Is the same debt portfolio suitable for
all investors regardless of risk profile?
26
A tailored diversified debt strategy can
diversify across….
Different risks:
• Interest Rate Risk
• Inflation Risk
• Credit Risk
• Currency Risk
• Domestic & Global exposures
Different types of assets:
• Sovereign
• Corporate
• High yield
• Emerging markets
• Inflation-linked
May also include commodities, hybrids,
equity securities from capital
restructures
Result is a strategy focussed on real capital preservation,
with higher long-term return seeking strategies
27
Typical debt sector funds provide
limited market exposure
Debt sub-sector allocations
Australian Nominal Debt
(All Maturity)
50%
50%
Global Investment Grade
Nominal Debt Hedged
(All Maturity)
Source: MLC Investment Management
28
Philosophy on Diversified Debt
1. Start with a wide definition of opportunity set;
2. Understand investor demands from debt assets;
3. Tailor strategy risk profiles to client needs;
4. Build robust strategies via environmental diversification;
5. Be flexible with manager and mandate strategy;
6. Continually innovate & evolve strategy
Outcomes:
• Avoid segmentation effects
• Understand risks you are taking (& being compensated for)
• Robust portfolio construction: across sectors & managers
29
Start with a broad opportunity set
Domicile
Domestic
Global
Inflation Exposure
Nominal
ILBs
Capital Structure
Secured
Unsecured
& Sub Debt
Issuer
Govt
Corporate
/ Securitised
Implementation
Physical
Derivative
Funding Source
Bank
Debt
Bonds
Credit Rating
Inv Grade
Sub-IG
Maturity
$-Market
Bond
Market
Raising
Public
Issue
Private
Placement
Fluidity in strategy creates opportunities, reduces costs & avoids
segmentation effects
30
Understand investor demands from
debt differ
Based on:
• Investment Objectives;
• Risk Profiles;
• Investment Time Horizon
Asset Allocation
Risk Profile
Investment Horizon
Nominal / Real capital
preservation focus
31
0/100
30/70
50/50
70/30
85/15
Conservative
Growth
Shorter
Longer
Predominantly
Nominal
Predominantly
Real
Tailor investment strategy
accordingly
Asset Allocation
Interest rate risk
Inflation risk
Credit risk
Currency risk
Domestic v
Resulting
Global
strategy
Nominal capital
Protection via
0/100
preservation,
100%
cash, short
lower volatility
Low = 1.8 years
maturity nominal
Small allocation
strategically
Predominantly
risk/return
duration
debt and ILBs
to HY and EMD
hedged
domestic
outcome
30/70
50/50
70/30
Small unhedged
Protection via
Greater exposure
exposure for
ILBs, real return
to high yield,
diversification,
Balance of
preservation,
Higher = 4.7
strategies and
emerging
more manager
domestic and
higher real return
years duration
commodities
markets
flexibility
global
seeking strategy
85/15
Four key investment risks
32
Real capital
Understand economic exposures of subsectors
Economic growth
Inflation
 Investment Grade Corporate Debt
High
 High Yield Corporate Debt
 Inflation Linked Government Debt
 Emerging Markets Debt
 Commodities
 Commodities
 Cash and Short Term Securities
 Cash and Short Term Securities
 Nominal Government Debt
Low
 Nominal Government Debt
 Investment Grade Corporate Debt
 Inflation Linked Government Debt
 High Yield Corporate Debt
 Emerging Markets Debt
Seek diversification so returns are not dependent upon specific
macro-economic scenarios
33
Australia
Cash and Short Term Securities
Investment Grade Nominal Debt
Inflation Protected Debt
UBS
BlackRock
Oaktree
WR Huff
PIMCO
Bridgewater
4
3
2
2
1
2
1



Investment Grade Nominal Debt
Global
Multiple sectors
per manager
Number of Mandate Types
NSIM
Create flexibility in manager and
mandate allocations

Emerging Markets Debt

Diversified Real Return Strategy
Multiple managers per sector
* NSIM, UBS, BlackRock and PIMCO manage both short maturity
34
and all maturity mandates






High Yield Debt
Inflation Protected Debt















Continually innovate & refine
strategy
35
1985
Multi-manager domestic strategy commenced
1991
Introduction of new debt classes & styles
· Global sovereign debt
· Index enhanced Australian fixed interest
· Australian inflation linked securities
1997
Introduction of:
· Short term high quality global credit & mortgages
2000
Treat debt as 1 global asset class
Introduction of new debt sub-sectors:
· Extended global credit & mortgages
· Global inflation linked bonds
· Global high yield debt
· Global emerging markets debt
2003
Introduction of:
· A tailored debt strategy for each diversified portfolio
· Unshackling managers from benchmarks
2005
Real Return strategies evolved
2007/8
Alternative debt
MLC Diversified Debt Fund
Exposures
MLC Diversified Debt Fund provides
exposure to a greater range of debt
sub-sectors Debt sub-sector allocations
Australian Nominal Debt (All Maturity)
Australian Inflation Protected Debt
24%
32%
Global Investment Grade Nominal Debt
Hedged (All Maturity)
Global Investment Grade Nominal Debt
Unhedged (All Maturity)
8%
1%
24%
11%
Global High Yield Debt Hedged
Global Diversified Real Return Strategy
Source: MLC Investment Management
37
With access to four non-standard
debt sub-sectors
Global Real Return Strategies
Flexible global mandates designed to achieve
inflation plus return outcomes
38
Global High Yield
Debt
Global Unhedged
Nominal Debt
Domestic Inflation
Protected Debt
Higher yielding
corporate debt
securities
Small allocation to
foreign currency for
diversification
Returns driven by real
yields plus actual
inflation
Investment Manager Allocations
NSIM
UBS GLOBAL ASSET
MANAGEMENT
4%
16%
28%
BLACKROCK
4%
PIMCO
16%
12%
20%
WR HUFF ASSET
MANAGEMENT
OAKTREE
Source: MLC Investments
Source: MLC Investment Management
39
BRIDGEWATER
ASSOCIATES
Diversification benefits versus growth
assets*
Ten worst calendar quarters for Australian Equities (1998- June 2008)
Calendar Quarter
AVERAGE
Australian
Equities
MLC Diversified
Debt Strategy
Domestic Cash
MLC DDS versus
Australian
Equities
MLC DDS
versus
Quarterly
Total Return
Quarterly Total
Return
Quarterly Total
Return
Mar-08
-14.61%
2.06%
1.82%
16.67%
0.24%
Sep-01
-11.80%
3.40%
1.30%
15.30%
2.10%
Sep-02
-6.50%
3.80%
1.30%
10.40%
2.60%
Jun-02
-5.10%
2.20%
1.10%
7.30%
1.00%
Mar-03
-2.80%
1.90%
1.20%
4.70%
0.70%
Dec-07
-2.70%
1.50%
1.70%
4.20%
-0.20%
Sep-98
-2.00%
4.30%
1.30%
6.30%
3.00%
Dec-00
-2.00%
4.00%
1.60%
6.00%
2.40%
Sep-99
-2.00%
1.30%
1.20%
3.20%
0.00%
Jun-98
-1.90%
2.90%
1.20%
4.80%
1.70%
-5.14%
2.74%
1.37%
7.89%
1.35%
Cash
The MLC Diversified Debt Strategy has preserved capital
and outperformed cash during past negative equity markets
40
* Based on the All Maturities Strategy of Horizon 5 (Superannuation) before investment fees and tax. Australian Equities returns
shown are for the ASX 300 Index, Domestic Cash returns shown are for the UBS Australia Bank Bill Index.
And a strategy expected to preserve
capital during negative equity markets*
Negative growth asset scenarios
Australian
Equities
Total Return p.a.
Expected Excess Return per annum of
MLC Diversified Debt versus Cash
Global depression or stagnation (1930s)
-18.5%
Financial collapse Risk
-16.8%
Aust Deflation – destructive (Japan 1990s)
-13.4%
Recession
-7.7%
Aust economic crisis, world weak
-6.9%
Market bust, economy not okay (rise in correlations)
-4.9%
1.2%
Aust only bust (world economy not weak)
-3.6%
1.2%
Global conflict / war
-3.5%
Credit / monetary contraction
-2.9%
Bubble bursts (economy okay)
-1.6%
Global Catastrophe adverse economic environment
-1.5%
Stagflation
-0.6%
Investor Pessimism - rise in risk premiums
-0.3%
4.1%
0.7%
2.3%
2.0%
1.8%
0.6%
-0.9%
0.8%
2.4%
-0.7%
0.6%
Diversified Debt is expected to outperform Cash by an average of +1.2% p.a.
*
41 Based on MLC scenario analysis modelling over a 5 year time horizon. Returns are nominal returns, before tax but after investment
manager fees
Inflation erodes real purchasing
power over time
Value of $100,000 today
Value of $100,000 in 10 years time
with inflation of 3% p.a. is $74,000
Inflation
erodes
purchasing
power
56% of the MLC Diversified Debt Fund is invested in
inflation protected debt and real return strategies
42
What differentiates a diversified
approach to debt strategy?
• Consider debt as one allocation to minimise impact of market
segmentations
• Tailor approach to client requirements – across multiple
dimensions/risks
• Emphasise relevant diversification – look at economic
exposures
• Combine manager skill sets and tailor mandates
• Continuous refinement of investment strategy
Only possible via efficient implementation and scale
43
MLC provides a complete debt
sector solution
The MLC Diversified Debt Fund provides:
• Access to non-standard debt sub-sectors
• The ability to tailor a customised strategy
• A strategy focussed on generating real returns
• A strategy focussed on capital preservation when its
needed most
44
Performance of MLC’s debt
strategy components
Sector Strategy Returns
% pa
12%
Real return strategies have performed
strongly in the current environment
10%
8%
6%
4%
2%
0%
Australian
Australian
Australian
Global Nominal Global Nominal
Nominal Bonds Nominal Bonds Inflation Linked Bonds (short)
Bonds (all)
(short)
(all)
Securities
Global
Diversified Debt
Real Return
Strategies
Source: MLC Investment Management
45
Gross returns to 30 June 2008
Global High
Yield Debt
Manager 1 yr returns
Manager 3 yr returns
Cash
Realised risk/return outcomes
NOMINAL RETURNS - Rolling 1 Year Risk/Return since tailored debt strategy inception
Dec-03 to Jan-08
12%
10%
Nominal Return
8%
Cash
Diversified Debt
Strategy
6%
4%
2%
0%
0.0%
0.5%
1.0%
1.5%
Standard Deviation
Source: MLC Investment Management
46
2.0%
2.5%
3.0%
Product Overview
MLC Diversified Debt Fund
Objective
Aims to provide returns higher than cash, over the medium to
long-term, from a diverse range of mostly debt investments.
Investment Strategy
Primarily invests in a diversified range of Australian and global
debt assets and other assets, where the overall risk and return
characteristics are expected to be similar to debt. The Fund may
also have some exposure to growth and other assets such as
commodities, hybrid assets and shares. The Fund is currently
actively managed. The Fund’s foreign currency exposure is
predominantly hedged back to the Australian dollar.
Investment fees /
MER
0.43 - 0.75%
Based on chosen platform
Platforms Available
MasterKey and MasterKey Custom
Research Ratings
Lonsec – Investment Grade
48