MLC Diversified Debt Commentary
MLC Annual Review
September 2009
MLC Investment Management
Level 12, 105 –153 Miller Street
North Sydney NSW 2060
Important information
This information has been provided by MLC Limited (ABN 90 000 000 402) a member of the National Group, 105-153 Miller Street, North Sydney 2060. This material was prepared for advisers only.Any advice in this communication has been prepared without taking account of individual objectives, financial situation or needs. Because of this you should, before acting on any information in this communication, consider whether it is appropriate to your objectives, financial situation and needs. You should obtain a Product Disclosure Statement or other disclosure document relating to any financial product issued by MLC Investments Limited (ABN 30 002 641 661) and MLC Nominees Pty Ltd (ABN 93 002 814 959) as trustee of The Universal Super Scheme (ABN 44 928 361 101), and consider it before making any decision about whether to acquire or continue to hold the product. A copy of the Product Disclosure Statement or other disclosure document is available upon request by phoning the MLC call centre on 132 652 or on our website at mlc.com.au.
An investment in any product offered by a member company of the National group does not represent a deposit with or a liability of the National Australia Bank Limited ABN 12 004 044 937 or other member company of the National Australia Bank group of companies and is subject to investment risk including possible delays in repayment and loss or income and capital invested. None of the National Australia Bank Limited, MLC Limited, MLC Investments Limited or other member company in the National Australia Bank group of companies guarantees the capital value, payment of income or performance of any financial product referred to in this publication.
Past performance is not indicative of future performance. The value of an investment may rise or fall with the changes in the market. Please note that all return figures reported are before management fees and taxes, and for the period up to 30 September 2009, unless otherwise stated.
The specialist investment management companies are current as at 30 September 2009. Funds under management figures are as at 30 September 2009, unless otherwise stated. Investment managers are regularly reviewed and may be appointed or removed at any time without prior notice to you.
MLC Diversified Debt Commentary
Benefits and risks of debt securities
/ When investing in debt securities, you are effectively lending money to businesses or governments.Things to consider:
Returns typically comprise interest and changes in the market value of the security.
· There are different types of debt securities and these will have different returns and volatility. Cash is usually the least volatile type of debt.
· The market value of a debt security may fall due to factors such as an increase to interest rates or concern about defaults on loans. This may result in a loss on your investment. Securities with a longer time until they mature tend to fall further than those with a shorter maturity.
· Investing outside of Australia exposes your investment to movements in the exchange rate between the Australian dollar and foreign currencies. These movements can largely be removed by “hedging” the currency exposure back to Australian dollars.
· Debt securities are usually included in a portfolio for their defensive and income characteristics.
Investment objective
/ The Fund is designed to be a complete portfolio for the debt asset class, and aims to deliver growth by using investment managers who invest and diversify across many companies and securities within the debt asset class.How you can assess performance
/ You can assess the performance of the Fund against its market benchmark over a full market cycle. When making this assessment, be aware the market benchmark doesn’t take into account fees and taxes that may apply to your account.The MLC Diversified Debt Fund is expected to outperform a blended benchmark (50% UBS Composite Bond Index (All Maturities) and 50% Barclays Capital Global Aggregate Bond Index AUD hedged) over rolling 4 year periods. When making this assessment, be aware that the benchmark doesn’t take into account fees and taxes that may apply to your account.
Where MLC invests your money
/ The Fund is diversified across different types of debt securities in Australia and around the world that typically have a reasonably long time to maturity. As a measure of maturity, the Fund’s duration is currently 4.5 years.Other assets such as commodities and hybrid securities may be used to hedge against inflation or provide additional diversification. Foreign currency exposures will generally be substantially hedged to the Australian dollar.
As a result of capital restructures of debt issuers, the Fund may have an incidental exposure to shares from time to time.
The MLC Diversified Debt Fund is a carve-out of MLC Horizon 5 – Growth Portfolio’s debt strategy. MLC tailors its debt strategies across the MLC Horizon portfolios for interest rate risk, inflation risk, credit risk, currency risks, and the level of domestic assets. The debt strategy for MLC Horizon 5 – Growth Portfolio is focused on real capital preservation and has higher return-seeking strategies. The debt strategy for MLC Horizon 1 – Bond Portfolio is focused on nominal capital preservation, with a low volatility risk return outcome. Its performance commentary is provided in a separate section with the other MLC Horizon Portfolios. The debt strategies for the rest of the MLC Horizon portfolios are a graduated mix of these two “book-ends”.
Target asset allocation
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Executive summary
/ · The Fund is now on the path towards the more “normal” returns we expect from your debt strategy.· The sharp rise in yields (interest rates) on securities with credit risk that weighed so heavily on your returns after Lehman Brothers collapsed in September 2008, have now mostly been offset by the strong returns in the second half of the year.
· With interest rates in Australia starting to rise, being diversified across global nominal bonds has helped you capture stronger returns from bonds issued overseas.
· Although your exposure to high yield is just under 8%, it was the strongest performing debt sector this past year and therefore made a meaningful contribution to your return. The real return strategy was also very strong.
· The Fund’s performance relative to the market benchmark has improved.
· All but one manager exceeded their respective benchmark’s returns over the quarter. In most cases the positions that were hurting their returns in the first six months, such as higher credit exposure, have been helping their returns in the last six months.
· MLC has been reviewing the debt strategy over recent months. Details on the removal of Australian inflation-linked bonds are provided in ‘MLC Investment Management Team Recent Activity’. An outcome of the review is the debt strategy should provide greater diversification relative to shares in future credit crunches.
MLC review for the year ending 30 September 2009 Page 1 of 11
The table outlines performance
/ Performance to 30-Sept-09 / Product / 5 Years % pa / 3 Years % pa / 1 Year % / 3 Months %MLC Diversified Debt Fund
(takes into account fees) / MLC Wholesale / - / - / 2.8 / 3.7
MLC Diversified Debt Fund
(takes into account fees and tax) / MLC MasterKey Super Fundamentals / - / - / 1.5 / 3.1
MLC Diversified Debt Fund
(before taking into account fees and tax) / MLC Wholesale / MasterKey Super / 5.8 / 4.9 / 4.2 / 3.9
50% UBS Composite Bond Index (All Maturities) and 50% Barclays Capital Global Aggregate Bond Index (hedged) / 6.6 / 7.1 / 9.5 / 2.8
Absolute returns
/ The disappointing returns MLC’s debt strategy produced earlier this year have effectively reversed. Your returns are now on the path towards the more “normal” returns we expect from your debt strategy. The sharp rise in yields that weighed so heavily on returns after Lehman Brothers collapsed in September 2008, have now mostly been offset by the strong returns since March 2009. The turnaround has been surprisingly quick and you’ve already started to earn the rewards of staying invested over this extremely difficult period. While we don’t expect the extremes of 2008 to be repeated sometime soon, you should always expect volatility when investing.When Lehman’s collapsed, yields on securities with any credit risk rose sharply as the market anticipated a massive rise in defaults. In an environment where fear drives decisions, businesses borrowing money are forced to pay higher interest rates to compensate investors for taking on, presumably, higher credit risk. Your greatest credit risk is in the real return strategy and global high yield sector. Remember that when yields are rising, the prices of the securities are falling which is why your overall return had been so weak.
As the economy has shown signs of strengthening over the second half of the year and confidence is returning to the market, yields on these “higher credit risk” securities have been steadily falling, and their values rising. That’s why the returns from these sectors were so strong and mostly offset the losses suffered in the first half of the year.
The graph shows the contribution to total portfolio return of the different types of debt
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Australian nominal bonds
/ The graph shows Australian nominal bonds gave your return the biggest boost over the last year. Our strategy invests in nominal bonds with longer terms to maturity to benefit from the higher interest rates that are usually paid for longer-dated securities. This bias didn’t pay off in the first few months of the year though, because the RBA made massive cuts to the official cash rate, from 6% to 3%. Although you benefited from a fall in yields on longer dated bonds, they didn’t fall as much as shorter dated bonds.However, in the later half of the year short-term yields rose on expectations that the RBA will increase the official cash rate by more than 1% over the next couple of years. At the same time, yields on longer dated government securities fell. In this environment, the strategy’s tilt to longer dated Australian government securities helped you capture additional returns.
Global nominal bonds
/ With interest rates in Australia starting to rise, being diversified across global nominal bonds has helped you capture stronger returns from bonds issued overseas. Government bond yields across all maturities fell in all major developed countries over the past year. You also picked up returns from the falling yields on corporate investment grade (higher credit risk) securities in the second half of the year. So while Australian bonds were weaker in the last quarter, your global nominal bonds have been quite strong.High yield debt
/ Although your exposure to high yield in the Diversified Debt strategy is just under 8%, it was the strongest performing debt sector this past year and therefore made a meaningful contribution to your return.In the months following the collapse of Lehman Brothers, high yield spreads peaked at almost 22% in December 2008 and have subsequently fallen to almost 8% by the end of September 2009. To put this into some perspective, leading up to the global financial crisis in 2007, the credit spread on high yield was only around 2-3%.
Spreads started falling from their peak as investors became confident that the global economy was not in “free fall”. Investors in the market had a renewed appetite for risk and it didn’t take long for the value of higher credit risk debt securities compared to low yielding cash and government bonds to be realised. As investors started buying up the higher yielding securities, their price rose, forcing yields down.
What is the credit spread?
/ The credit spread is the additional rate of interest investors receive for accepting the risk of a borrower defaulting. Higher interest is compensation for taking credit risk.Real return strategies
/ Your real return strategies, managed by PIMCO and Bridgewater, provided a reasonable return this year. These strategies invest in a range of debt securities and were successful in producing a return above inflation. Together with high yield debt, they gave your return a real lift in the last quarter of the year.Australian inflation-linked bonds
/ Your investment in Australian inflation-linked bonds was the only debt sector to produce a negative return this year. Yields on Australian inflation-linked bonds rose as the government has increased issuance (supply) of these securities, pushing prices down. The impact of rising yields was exacerbated by the longer duration of the Australian inflation-linked bond market (8 years) compared to the nominal bond market (3.5 years). Although they are weak in the current environment, inflation-linked bonds provide an excellent hedge when inflation rises.Returns relative to the market
/ Our debt strategy has been underperforming the market benchmark in recent times. As shown in the graph below, the last year was particularly difficult mostly due to the strategy’s higher exposure to credit risk. In prior years the higher exposure to credit risk was one of the main reasons why the strategy consistently produced returns above the benchmark, particularly over 3 and 5 year periods.The strategy also has a higher weighting to Australian inflation-linked bonds which have not performed as well as nominal bonds over the past year. They did, however, help returns in the earlier part of the Global Financial Crisis when low credit risk securities were highly sought after.
The exposure to credit risk has helped your returns more recently which is why the lines in the graph started to kink upwards. Additionally, you have more in global debt than the market benchmark and global has outperformed domestic bonds more recently.
The graph shows returns of your Diversified Debt Strategy compared to its market benchmark
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We are reviewing your debt strategy
/ MLC has been reviewing the debt strategy over recent months; details are provided in ‘MLC Investment Management Team Recent Activity’. In light of the past year the review has been focused on the way we manage risk. The first step along this path has been the removal of Australian inflation-linked bonds to reduce interest rate risk. More changes will be announced over the next few months. An outcome of the review is the debt strategy should provide greater diversification relative to shares in future credit crunches.Your managers