Equities The new best friend for income hunters?

Brian Gallagher Portfolio Manager of the UBS UK Equity Income Fund

March 2009

This document is for Professional Clients only. It is not to be distributed to or relied upon by Retail Clients under any circumstances.

2

Agenda

Life is tough – all exits appear to be blocked

Market outlook

How can UK equities provide income?

3

Life is tough

The Economist6 – 12 December 2008

Financial Times31 December 2008

FT Weekend3 – 4 January 2009

4

All exits blocked – deposit rates

UK clearing banks base rate – middle rate

0

2

4

6

8

10

12

14

16

18

1950 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Source: DataStream from 31 January 1950 to 30 January 2009

Jan 1950 – Jan 2009

All time low

5

All exits blocked – gilts May 1986 – Jan 2009

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

May-86 Nov-88 May-91 Nov-93 May-96 Nov-98 May-01 Nov-03 May-06 Nov-08

UK 10 year gilt yield - FTSE 100 dividend yield (%)

US 10 year treasury yield - S&P 500 dividend yield (%)

Source: DataStream from 15 May 1986 to 9 January 2009

6

0

2

4

6

8

10

12

14

16

18

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Year

Def

ault

Rat

e (%

)

Actual Default Rate Matterhorn Ayers Rock

All exits blocked – corporate bonds

The implication of an expected peak default rate of 12 – 17% over the course of the next 18 months under the “Matterhorn” default scenario implies almost a default a day

Source: Bank of America Securities–Merrill Lynch

7

50

60

70

80

90

100

110

120

130

140

150

1983 1988 1993 1998 2003 2008

(%)

Top 10 historic dividend yield

All exits blocked - high yield equity strategy not working

Source: MF Global Securities as at 31 December 2008

Cumulative average annual relative return

8

All exits blocked - strike 4 for dividend income

Source: UBS Global Asset Management. YTD is to 31 January 2009.

£674m

£923m

£1.5bn£1.5bn

£1.7bn

2004 2005 2006 2007 2008 YTD

Cut in

div

iden

ds (£

)

£10.5bn

Abbey NationalSafeway

RMC GroupCountrywide

Assured Group TBI

PLC

O2Exel

Peninsular and Oriental Steam

NavigationPilkington

RACSomerfield

Geest

BAABOC Group

Gallaher Group

Alliance Boots

Brambles IndustriesAlliance UniChem

Corus GroupViridian GroupAWG

Wilson BowdenStanley leisure

De Vere Group

John Laing

Scottish Power

HansonNorthern Rock

Imperial Chemical Industries

Kelda GroupEMI GroupEmap Int

GCAP MediaAlfred

McAlpineAbbot Group

HBOSLloyds TSB

A&LB&B

WoolworthsEnodis

JJBRentokil

Topps TilesAGA RBS

WolseleyKingfisher

ITVF&C

PersimmonDSGIPunch

Trinity Mirror

Dividend cuts

AngloAmerican

Wetherspoon

Cookson

Travis Perkins

British Airways

Xstrata

Market outlook

10

Note: Past performance is no guarantee of future resultsSource: Stifel Nicholas. For 1826 through 1925: Combined individual stock prices for NYSE stocks. Goetzmann, William N., Ibbotson, Roger G. and Peng , Liang, A New

Historical Database for the NYSE 1815 To 1925: Performance and Predictability (July 14, 2000). Yale ICF Working Paper No. 00-13; Yale SOM Working Paper No. ICF - 00-13. Available at SSRN: http://ssrn.com/abstract=236982. For 1926 to 1958, Ibbotson Large Capitalization US stock market total return and in subsequently, the S&P 500 total return.

1 Returns based on calendar years; calendar year 2008 data updated through 31 December 2008.

2008: The worst 10-year return period since 1938

-5

0

5

10

15

20

25

1835 1860 1885 1910 1935 1960 1985

Annualised rolling 10-year nominal returns

(%)

Y/Y %, 10-yr annualised Average

2008

10-year moving annualised nominal returns1835-20081

11

0

5

10

15

20

25

30

1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

UK

Tra

ilin

g P

/E (

%)

Equities are cheap…

Source: DataStream to 31 December 2008

…but not quite at historical lows yet

1212

Rich pickings for forward looking investorsSubsequent returns from recessionary troughs

Source: National Bureau of Economic Research (NBER), UBS Global Asset Management Returns based on S&P 500.

38%

58%

31%

-18%

60%

68%61%

38%44%

37%

-7%

14%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

1970 – 1971 1974 – 1975 1980 1981 – 1982 1990 – 1991 2001

Trough +12 months Trough + 24 months

13

Reasons for cautious optimismQuantitative easing has begun already, not after a decade

Growth in estimates of the monetary base, 3 months on 3-months one year earlier (%), years from peak

(10)

0

10

20

30

40

50

60

70

80

-3 -2 -1 +0 +1 +2 +3 +4 +5 +6 +7 +8 +9 +1

Years

Gro

wth

Japan (Aug 1990)US (Sep 2007)UK (Sep 2007)Eurozone (Sep 2007)

Note: UK data has a structural break in 2006-2007, so year-on-year data is excluded for those years.Source: IMF, Bank of England, Federal Reserve

14

Sometimes the darkest moment represents the greatest opportunityTwo year returns; starting from lowest level

Source: Datastream; Currency MSCI: local, Currency JPM EMBI+: USD. These figures refer to the past. Past performance is not a reliable indicator of future results

70

80

90

100

110

120

130

140

150

Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00

JPM EMBI+Asia (Total return)

1997 – 1998: Asian Financial Crisis

+59%

1998: Russian Financial Crisis

0

20

40

60

80

100

120

140

Apr-98 Oct-98 Apr-99 Oct-99 Apr-00

JPM EMBI+Russia (Total return)

+283%

50

60

70

80

90

100

110

Apr-00 Apr-01 Apr-02 Apr-03 Apr-04

MSCI World (RI)2000 – 2003: Dot-com bubble / US recession

+43%

1987: Crash

70

80

90

100

110

120

130

Oct-87 Apr-88 Oct-88 Apr-89 Oct-89

MSCI World (RI)

+55%

How can UK equities provide income?

16

The 6 D’s

1. Diversify

2. Dollar

3. Dependable

4. Dominant

5. Derivatives

6. Developments

Key themes equity income investing for 2009

17

0%

5%

10%

15%

20%

25%

30%

35%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

UK stocks 2005 Continental European stocks 2007

1. Diversify

Source: Dresdner Kleinwort

Ex-dividend schedule, % of total income

18

2. Dollar

GlaxoSmithKline

Royal Dutch Shell

BP

HSBC

AstraZeneca

Rio Tinto

BHP Billiton

Anglo American

SABMiller

Standard Chartered

Xstrata

ShireSource: Bloomberg1 Source for statement: Morgan Stanley Research

US dollars accounted for over 40% of market profits in 20071

19

90

95

100

105

110

115

120

125

Jan-08 Apr-08 Jul-08 Oct-08

Rela

tive p

erf

orm

an

ce

3. Dependable income

A basket based on our 12 ‘gold-plated’ dividend ideas would have outperformed by 20% this year

Source: DataStream, Morgan Stanley Research

AvivaBP

BATGlaxoSmithKline

Home Retail Group Land Securities Group

Marks & SpencerNational Grid

PearsonRoyal Dutch Shell B

Scottish & Southern EnergyVodafone

+20%

Secure yield not high yield

Admiral

20

0

2

4

6

8

10

12

14

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

(%)

UK Gilt Yields BP/HSBC/VOD/GSK DY Blend

4. Dominant

Source: Citigroup as at 31 December 2008

21

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07

5. Derivatives

Source: DataStream and UBS Global Asset Management

BS S

SS

S

B

B

B

B

Vodafone – covered calls enhance income and keep capital upside

22

6. Developments

Market

closedEquities

Debt

ConvertibleHigh Coupon paper with rights to

convert into equity at pre-agreed price at later date

Funding gap

Market

closed

Convertibles

23

A balanced approach

Yield

P/E

Barbell High Yield Barbell

Total

Return

Balanced Approach

Covered Calls

Remains appropriate

Randgold

Capita Astra ZenecaGlaxo

Scot & Southern

Nat Grid

BP

BGShell

BAE Systems

DeLaRueDominos Pizza

VodafoneCentrica Admiral

RSA

Aberdeen

BATS

Imp Tobacco

Morrison

Tesco

Pearson

Autonomy

24

Source: UBS Global Asset Management as at December 20081 Historic yield, based on ‘A’ income shares priced as at 31 December 2008. Represents yield generated from the portfolio, European stocks, income

opportunities and covered calls.

UBS UK Equity Income – core principles remain the same

Equity income 20 7.00 1.34

Typical % of Fund Yield (%) Yield calc

Megacaps 50 6.00 2.85 Mid/Small caps 10 4.00 0.35 Growth 10 4.00 0.35 Tactical 0 – 5 0.00 0.00 European 10 7.00 0.70

TOTAL 100 5.59

Covered calls 0 – 20

Overall yield 7.30 1

25

Conclusion

All investors face a challenging period

Secure income is especially difficult to find

Tactical use of covered calls works in rising and falling markets

Balanced, multi-dimensional approach necessary

26

UBS UK Equity Income Fund

Aims to provide a yield of 120% of the FTSE All-Share Index

Aims to deliver year-on-year dividend growth

A current yield of 7.3%*

S&P ‘AA’ Rating

Quarterly income distributions

Note: As the annual management fee of the Fund is charged to capital, the potential capital growth of the Fund will be reduced. Neither the index or sector out performance nor the yield target quoted are part of the Fund’s investment objective and are indicative only.

1 Historic yield based on ‘A’ income shares priced at 31/12/08

Appendix

28

This is not the Great DepressionCatastrophic fiscal and monetary policy errors prolonged and deepened the economic contraction of the 1930’s

Poor fiscal policies during the 1930’s stemming from balanced-budget political agendas hurt economic growth

Real interest rates exceeding 12% as a result of massive deflation during the 1930’s severely dampened investment

Unprecedented fiscal and monetary policy responses we believe stimulate growth going forwardSource: FDIC, Federal Reserve Bank of St. Louis, Consensus Economics, UBS Global Asset Management1 2009 forecast released by the Congressional Budget Office2 Consensus mean for 2009 annual contraction in US GDP provided by Consensus Economics3 Consensus mean for 2009 Consumer Price Index provided by Consensus Economics4 Money supply measured by the M2 money supply which includes currency in circulation, demand deposits, travellers cheques, savings deposits, time

deposits, and money market accounts

Indicator Current recession 1929 – 1933

Real GDP Contraction -1.3%2 -29.0%

Unemployment Rate 7.2% 25.0%

Consumer Prices 1.2%3 -25.0%

Money Supply4 7.2% -33.0%

Budget Deficit (% of GDP) 10.1%1 2.6%

Bank Failures 25 7,000+

29

Number of consecutive years

2 3 4 5 10 18

Probability of Equity outperformance of Cash

67% 70% 74% 74% 92% 99%

Probability of Equity outperformance of Gilts

69% 76% 77% 75% 81% 90%

Has the market already priced in the bad news for equities?

Source: Barclays Capital, Equity Gilt Study 2009. Data as at 31 December 2008

Equity performance probability

30

3

4

5

6

7

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

%

600

800

1000

1200

1400

1600

1800

US: Cash as % of stock mutual funds MSCI Europe (rhs, inv)

Waiting to be reinvested when visibility gets better

US mutual fund liquid assets as a % of US assets under management

Cash on the sidelines on the rise

Source: ICI, UBS, DataStream to December 2008

31

£10

£100

£1,000

£10,000

£100,000

45 53 61 69 77 85 93 01

UK Financial History – dividends grow not bond coupons

Note: Scales calculated on a logarithmic basisSource: Barclays Capital, DataStream, Scottish Widows

07

£131,639

£8,511£4,550£2,876£1,833

£49

Barclays Equity Index Dividends Reinvested

Barclays Equity Price Index Ex-Dividends

Barclays Gilt Index Income Reinvested

Retail Prices Index

UK Building Society Index Income Reinvested

Barclays Gilt Price Index Ex-Income

32

Derivatives – covered calls

A covered call is a transaction in which the seller of call options already owns the corresponding amount of the underlying shares but agrees to sell them at a pre agreed price at a date in the future

These owned shares provide the ‘cover’ as they can be handed over to the buyer of the options when he/she decides to exercise them

In return for agreeing to sell them the seller will generate income, in the form of the premium paid by the option buyer

UBS UK Equity Income Fund employs a disciplined approach to covered calls

4 golden rules

1. Only use traded options

2. Only sell calls when share price has performed strongly

3. Only 10% of fund exposed to calls in total - 2% per position

4. 10% stop loss on positions not working

Low risk income generation

33

Important informationThis document is for Professional Clients only. It is not to be distributed to or relied upon by Retail Clients under any circumstances.

Past performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and are not guaranteed. Investors may not get back the amount originally invested. Neither the sector performance nor the yield target quoted are part of the Fund’s investment objective and are indicative only. As the annual management fee of the Fund is charged to capital, the potential capital growth of the Fund will be reduced. The data contained in this document has been sourced by UBS and should be independently verified before further publication or use. The relative performance data is based on arithmetic methodology.

This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the FSA requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document should not be considered a recommendation to purchase or sell any particular security and the opinions expressed are those of UBS Global Asset Management and are subject to change without notice. Furthermore, there can be no assurance that any trends described in this document will continue or that forecasts will occur because economic and market conditions change frequently. Telephone calls may be recorded.

© UBS 2009. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. Issued in March 2009 by UBS Global Asset Management (UK) Ltd, a subsidiary of UBS AG, 21 Lombard Street, London EC3V 9AH. Authorised and regulated by the Financial Services Authority.

21 Lombard StreetLondonEC3V 9AH

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