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MACQUARIE PRIVATE PORTFOLIO MANAGEMENT
Macquarie Private Portfolio Management 1
Macquarie Private Portfolio Management Limited
Diversified Fixed Interest Strategy Discussion Paper
January 2013
Executive Summary
Purpose
The purpose of this discussion document is to summarise MPPM’s Diversified Fixed Interest strategy’s
characteristics, performance, recent drivers of the Australian bond market and trends in the listed interest
rate securities market.
Background
MPPM has been operating discretionary investment portfolios focused on fixed interest and listed interest
rate securities (IRS) since its inception in 2000. We offer clients a blended exposure to fixed interest with
IRS, high credit quality fixed rate bond exposure via managed funds (mainly Government debt) and cash,
to provide clients with a holistic income producing exposure.
Fixed interest and the IRS universe have been attracting increased investor interest during recent months
as a result of:
• the positive returns achieved over short and long term time horizons from this sub-sector,
• the large amount of new issuance in the listed IRS universe during the last twelve months (~$12bn
in 2012),
• relative capital stability compared to equity markets, and
• high tax effective yields available in a falling cash rate environment.
• We expand on these points in the following pages.
As a result of these developments we have seen renewed interest in this asset class from both investors
with a high allocation to growth assets, looking to reduce volatility in their long term investment portfolios
and also investors looking to reallocate a portion of their cash investment to enhance returns (exploring
options to earn a higher yield, following the recent Reserve Bank of Australia ‘RBA’ cash rate reductions).
The following paper provides details and insights into our Diversified Fixed Interest Strategy, recent events
in the Australian bond market and IRS universe, and briefly describes our investment process.
Macquarie Private Portfolio Management 2
Table of Contents
MPPM DIVERISIFIED FIXED INTEREST STRATEGY ................................................................ 3
Strategy Overview .................................................................................................................................................. 3
Objective ................................................................................................................................................................ 3
General Portfolio Characteristics............................................................................................................................ 3
Current Portfolio Characteristics ............................................................................................................................ 4
Strategy Returns .................................................................................................................................................... 4
AUSTRALIAN BOND MARKET ................................................................................................... 5
Why bond market exposure ................................................................................................................................... 5
Current characteristics of the Australian bond market ............................................................................................ 5
Recent performance of the Australian bond market ............................................................................................... 5
Movements in Australian government bond yields ................................................................................................. 6
Australian Fixed Interest fund exposure ................................................................................................................. 7
LISTED INTEREST RATE SECURITIES ..................................................................................... 7
Why listed interest rate securities ........................................................................................................................... 7
What is the listed interest rate securities market .................................................................................................... 8
Listed Interest Rate Securities vs. Equities ............................................................................................................ 9
Drivers of Recent Issuance .................................................................................................................................. 10
Universe Concentration ....................................................................................................................................... 11
Liquidity ............................................................................................................................................................... 12
Current Valuation ................................................................................................................................................. 13
MPPM’S INVESTMENT APPROACH ........................................................................................ 14
MPPM’s Investment Approach ............................................................................................................................ 14
Risk Management ............................................................................................................................................... 15
Recent Strategy Performance & Volatility Charts ................................................................................................ 16
SUMMARY…………………………………………………………………………………….…….…. 17
Macquarie Private Portfolio Management 3
MPPM DIVERSIFIED FIXED INTEREST STRATEGY
Strategy Overview
MPPM’s Diversified Fixed Interest strategy blends exposure of:
• High quality listed interest rate securities,
• Domestic unlisted fixed rate bond markets, and
• Cash.
We actively manage a portfolio of directly held listed interest rate securities and wholesale domestic fixed
interest managed funds. For full strategy details please refer to the detailed MPPM Diversified Fixed
Interest strategy description document available on the resources page of our website.
Objective
The strategy has two key objectives:
• Primary Objective – to provide a tax effective yield at a premium to the cash rate with moderate
levels of capital volatility, via investment predominantly in ASX listed interest rate securities,
diversified fixed interest exposure and cash.
• Secondary Objective: to outperform the UBS Australian Composite Bond Accumulation index by
one per cent after fees and costs, in a tax efficient manner, over three to five years.
Expected Return Outcome The portfolio is expected to provide the following return outcomes:
• Provide a reliable tax effective yield, at a premium to cash rates,
• Portfolio has higher potential volatility than pure bond market exposure,
• As a mainly credit focussed strategy the portfolio:
- is expected to perform well during times of benign and improving credit markets,
- will perform below long run expectations during periods of credit market instability,
- diversification helps smooth overall portfolio volatility,
• Portfolio turnover is expected to be moderate (15 to 25 per cent) per annum.
General portfolio characteristics MPPM select investments on an after taxation basis and runs a number of variations of the strategy for
clients with different taxation status. Most clients are seeking a strategy which benefits from imputation
credits and this is a focus of this paper. The following table shows the characteristics of the portfolio as at
January 2013:
Macquarie Private Portfolio Management 4
Table 1: Current Portfolio Characteristics
Portfolio sub-sector exposure With ImputationAustralian Bond Market Exposure 29.0%Cash 3.1%Listed Interest Rate Securities 67.9%Portfolio 100.0%
Portfolio Characteristics With ImputationExpected Gross Internal Rate of Return 5.75%Current Gross Running Yield 5.81%Average Issuer Credit Quality AA to AA-Minimum Issuer Credit Quality BBB-Modified Duration (years) 1.25Fixed Rate exposure 29.0%
Australian bond market exposure characteristics With ImputationAssumed Yield to Maturity (Long Term Assumption) 5.5%Modified Duration (years) 3.8Number of funds held (Macquarie Enhanced Australian Fixed Interest fund) 100.0%Number of securities within index 250+Average underlying index constituents credit quality AAA to AA+Fixed Rate exposure 100.0%
Listed Interest Rate Securities (IRS) characteristics With ImputationExpected Gross Internal Rate of Return 5.98%Current Gross Running Yield 6.08%Trading margin above swap rates 3.04%Number of listed IRS held 14% of listed IRS exposure paying franked distributions 58.8%Fixed Rate exposure 0.0%
Source: MPPM, Feb 2013
Strategy Returns
The following table shows the Diversified Fixed Interest Strategy recent and longer term returns1, including
imputation credits.
Table 2: Diversified Fixed Interest Strategy Returns
Source: MPPM, Iress. Jan 2013
N=Returns shown are prior to MPPM Management fees. The gross return shows the assumed after taxation return for a 0% taxpayer entitled to rebate imputation credits. Past performance is not indicative of future performance=
Macquarie Private Portfolio Management 5
AUSTRALIAN BOND MARKET
Why bond market exposure?
MPPM believes that in the longer term, a diversified approach to portfolio construction is likely to result in
lower portfolio volatility and greater likelihood of meeting the strategy’s return objective. Within the
Diversified Fixed Interest Strategy, MPPM currently invests in the Macquarie Wholesale Enhanced
Australian Fixed Interest Fund to provide clients with exposure to Australian bond markets. This fund is
managed by Macquarie Investment Management Limited (MIML) – a separate entity to Macquarie Private
Portfolio Management. Specifically the following are the key benefits of exposure to the Australian bond
market:
• High credit quality, fixed rate exposure to Australian unlisted bonds (mainly Australian Government
debt), • Quarterly income stream, • Potential for positive returns in the event that the domestic and global economic outlook
deteriorates, • Materially increases overall portfolio diversification benefits and credit quality, and • Performs well in a falling interest rate environment.
Current characteristics of the Australian Bond market
The following table charts highlights the key characteristics of the UBS Composite All Maturities Bond
Index, referred to as ‘the Australian bond market’ for the purposes of this discussion.
Source: MIML, MPPM, Jan 2013 Recent performance of the Australian Bond Market
The performance of the Australian bond market has been above average over the last12 months and the
five years since 2007. Strong returns have been driven by: a moderation in the outlook for domestic
growth, reductions in the domestic cash rate to 3%2, a global flight to safety (increased risk aversion) and
significant buying of domestic government bonds from offshore investors. These four drivers have resulted
in bond yields falling (driving capital prices of bonds higher). Table 3: Australian Bond Market and the
Macquarie Enhanced Australian FI fund returns
O=pçìêÅÉW=o_^=EoÉëÉêîÉ=_~åâ=çÑ=^ìëíê~äá~I=g~å=OMNPF=
Macquarie Private Portfolio Management 6
Source: MPPM, MIML, Iress. Jan 2013
Movements in Australian Government Bond Yields During 2012, Australian bond markets rallied materially, mainly in the June quarter 2012 due to increased
risk aversion, increased buying of domestic bonds by offshore participants and action by the RBA to lower
the domestic cash rate. This is illustrated in the following chart which shows that during financial year 2012
the yield on the Australian 10 year government bond fell from 3.7% to 3.3%, and during the June quarter
yields hit an all time low of 2.7%.
Chart 1: Australian Government Bond Yields (2012 year)
Australian Commonwealth Government 10 Year Bond Rate - 2012
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
2/01
/201
2
16/0
1/20
12
30/0
1/20
12
13/0
2/20
12
27/0
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12/0
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26/0
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9/04
/201
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/201
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21/0
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/201
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18/0
6/20
12
2/07
/201
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16/0
7/20
12
30/0
7/20
12
13/0
8/20
12
27/0
8/20
12
10/0
9/20
12
24/0
9/20
12
8/10
/201
2
22/1
0/20
12
5/11
/201
2
19/1
1/20
12
3/12
/201
2
17/1
2/20
12
31/1
2/20
12
Source: MPPM, Iress. Jan 2013
Given the current valuation of domestic bonds, we expect more muted returns from bond markets in the
near future, although remain attracted to their potential to deliver positive returns should the global
macroeconomic outlook deteriorate.
Macquarie Private Portfolio Management 7
Australian Fixed Interest fund exposure
The MPPM Diversified Fixed Interest Strategy currently gains exposure to bond markets through the
Macquarie Enhanced Australian Fixed Interest fund. This wholesale fund (managed by MIML) has the
following characteristics:
• Low tracking error approach to portfolio construction, with the Fund Manager looking to add
value via security selection, sector rotation and yield curve positioning,
• The strong historical track record relative to the bond index, and also comparable managers.
• A physical portfolio of fixed interest securities is held,
• The portfolio only invests in securities issued by investment grade borrowers and cash,
• All derivative exposure is fully cash backed (bond futures are often used for interest rate risk
management),
• A very competitive Management Expense Ratio (0.19%), and MPPM clients are currently
eligible for a partial rebate of this fee (as at January 2013).
The key portfolio characteristics of the fund as at 31st December are as follows:
Source: MIML, MPPM, Jan 2013
LISTED INTEREST RATE SECURITIES
Why listed interest rate securities? MPPM currently blends its bond market exposure with a range of directly held listed interest rate securities
(IRS) that undergo our rigorous portfolio construction requirements. Following are the key
benefits/characteristics of the Australian listed IRS market:
• IRS pay a regular, tax efficient income stream (generally floating rate) at a premium to cash and
bond market interest rates,
• We access a wide range of structures with two common characteristics being:
- higher in the capital structure than equity,
- a fixed face value (generally $100 per security),
• MPPM focuses on providing high quality, low beta exposure to this sub-sector,
Macquarie Private Portfolio Management 8
• Exposure to Australian credit markets, which MPPM believes are currently undervalued when
compared with long term valuations,
• Are expected to perform well during times of benign and improving credit markets,
• Are likely to underperform (relative to Government bonds) during periods of credit market
instability, and
• Are likely to perform well in a rising rate environment (unlike fixed rate bonds).
The Listed Interest Rate Securities market? The listed interest rate securities market is a broad collection of income producing investments in a range
of fixed interest (or fixed interest like) structures. It has a current market capitalisation of approximately
$34.2bn across 74 separate issues3. As shown in Chart 2, the IRS market has grown steadily in recent
years. The predominant issuers have been large, domestic companies with investment grade credit ratings.
Investment Grade means the issuer has an independent credit rating from Standards and Poor’s, Moody’s
or Fitch Ratings that is, above the cut off point for the general definition of Investment Grade. The
minimum Investment Grade credit rating is BBB- for S&P or Baa3 from Moody’s.
Securities issued are typically subordinated debt securities or preference equity (they no longer have
independent security level credit ratings in the retail/listed market due to regulatory changes in 2010).
Chart 2: Historical Market Capitalisation
Historical Market Capitalisation : ASX listed interest rate securities
$0
$5,000,000,000
$10,000,000,000
$15,000,000,000
$20,000,000,000
$25,000,000,000
$30,000,000,000
Mar
-01
May
-01
Jul-0
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Sep-1
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Nov-1
1
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12
Mar
-12
May
-12
Floating Rate Notes
Corporate Bonds
Convertible Notes
Hybrids
Source: ASX, MPPM, June 2012
In general, the IRS market provides floating rate credit exposure to investors. Investors benefit from relative capital stability, historically high credit margins, tax effective regular income streams and priority to ordinary equity.
P=Source: ASX Dec 2012 Listed Interest Rate Securities market update=
Macquarie Private Portfolio Management 9
The key structures include:
• Senior Bonds,
• Subordinated Debt,
• Subordinated Floating Rate Notes, Preference Securities and Capital Notes (often referred to as
‘Hybrids’, however they generally have no embedded equity price risk).
Within these classifications there is a large variety of security characteristics and terms that make each
issue unique.
Key security characteristics include: regular income stream, priority to ordinary equity, issued by investment
grade ASX 200 companies, fixed face value of $100 per security (potential to convert to equity or redeem
at face value), 5-7 years expected time to redemption4.
The key risks can be summarised as: credit and market risk, credit spread duration (short term impacts
from movements in credit spreads), bank bill swap rate risk (re-investment risk), maturity extension risk
(many securities are perpetual securities) and specific terms of issue.
Listed Interest Rate Securities versus Equities
A key benefit of a listed interest rate security is its priority ranking within the issuer’s capital structure. In
the event that companies issue further equity, listed interest rate securities remain in priority rather than
being diluted as equities would be. The following table outlines the relative ranking of a company’s capital
structure. As noted, the IRS component of client portfolios MPPM invest includes Senior Bonds,
Subordinated Bonds, Subordinated Notes and Preferred Equity.
Table 4: Capital Structure
The income stream of IRS is more reliable as it is set by the terms of issue, rather than management
discretion and is paid in priority to ordinary equity. Most issues have capital restriction clauses which limit
the issuer’s ability to pay equity dividends or return capital to equity holders unless listed IRS distributions
are paid first. Many securities have cumulative interest payments, whilst bank Convertible Preference
Q= In many structures redemption at the first call date is not certain, and subject to management discretion or minimum share price requirements in certain circumstancesK=
Macquarie Private Portfolio Management 10
Shares ‘CPS’ securities distributions are non-cumulative they are paid in priority to equity dividends and
have a set level of required catch up of IRS distributions before equity distributions can resume.
Many of the newer structures in particular have maturity dates and material incentives to redeem at the first
call date (generally five years). Some of the converting preference shares may be perpetual in nature,
however, are likely to redeem earlier unless the issuer suffers financial distress. This is due to the
mandatory conversion clauses, potential loss of APRA capital benefits and reputational risks for the
issuers.
Another key difference between equities and fixed interest is the asymmetric risk profile. Listed interest rate
securities have a fixed face value (generally $100 per security) and over time converge to their face value
as maturity/redemption approaches. This fixed face value also leads to greater capital stability, when
compared to equities. However, listed IRS (and other debt securities) can generally be worth no more than
their face value, but can be worth materially less in the event that the issuer defaults. To mitigate the
potential for default, MPPM only invests in the higher quality issuers and structures and undertakes a
detailed research process at both the issuer and security level.
Drivers of Recent Issuance Since November 2011, approximately $19bn has been raised by Australian companies5. These issues
have been dominated by Industrial Companies and Banks/Insurance companies.
Key drivers of the increased issuance have been the elevated cost of funding in wholesale markets and
strong investor demand for high yielding securities. Other drivers of issuance have been changes to credit
rating agencies rating methodologies, the resulting impact on structures and the upcoming introduction of
Basel III.
Industrial companies have sourced funds from the market by issuing ‘subordinated notes’ which meet the
credit rating agency requirements for ‘equity classification’, for a period of time. Generally at the end of
year five, the rating agency classification of the security moves from equity to debt, acting as an incentive
for the issuer to redeem or replace the security. Recent issuers to take advantage of this structure include:
Woolworths, Origin Energy, Colonial Group, Tabcorp, and AGL Energy. Smaller, unlisted or unrated
companies have also used senior bond structures to access funding from the market (in light of higher
wholesale funding costs). These include Tatts Group and Heritage Bank.
During 2012, banks and insurance companies issued two Basel III compliant structures. Westpac and
Insurance Australia Group ‘IAG’ issued CPS structures that meet the new requirements for Tier 1 Capital6.
These Basel III compliant mandatory converting preference securities have important structural differences
to the previous structure of bank converting preference securities, due mainly to a contingent capital
clause. ANZ Banking Corporation, Westpac Bank and National Australia Bank ‘NAB’ issued high quality
subordinated bond securities meeting the Basel III Tier 2 capital requirement. The attractive terms resulted
in strong investor demand and both issuers were able to raise more than $1bn from listed investors with
pricing similar to the current wholesale market (above 275bps).
5 Source: MPPM, Iress, ASX Jan 2013 Market Update=S=Tier 1& 2 capital are forms of capital banks are required to hold under APRA and BASEL regulations. T1 is generally more flexible capital than T2.
Macquarie Private Portfolio Management 11
MPPM has taken advantage of the large amount of new issuance as it provides our portfolios with strong
diversification benefits. We have invested in a number of the new securities but have rejected a number of
securities as they did not meet our quality filter. Access to deals at IPO means trading occurs off-market
and does not incur additional brokerage.
For full details of each specific issue please refer to the individual PDS. Table 5: Summary Characteristics of Recent Issues
IssuerSecurity
CodeStructure Margin
Amount Raised
($m)
Expected Term to redemption
/exchange
Final Maturity
Woolworths Limited WOWHC Subordinated Note - dated, unsecured, subordinated, cumulative note 325bps 700 5 years 25 years
Origin Limited ORGHA Subordinated Note - dated, unsecured, subordinated, cumulative note 400bps 900 5 years 60 years
Tabcorb Limited TAHHB Subordinated Note - dated, unsecured, subordinated, cumulative note 400bps 250 5 years 25 years
Colonial Group CNGHA Subordinated Note - dated, unsecured, subordinated, cumulative note 325bps 1,000 5 years 25 years
AGL Energy AGKHA Subordinated Note - dated, unsecured, subordinated, cumulative note 380bps 650 7 years 27 years
Tatts Group TTSHA Senior Bond 310bps 200 7 years 7 years
Heritige Bank HBSHB Senior Bond 310bps 227 5 years 5 years
Westpac Bank WBCPC Mandatory Converting Preference Share 325bps Gross 1,168 8 years Perpetual
Insurance Australia Group IAGPC Mandatory Converting Preference Share 400bps Gross 377 7 years Perpetual
ANZ Bank ANZHA Subordinated Debt 275bp 1,509 5.25 years 10.25 years
National Australia Bank NABHB Subordinated Debt 275bp 1,172 5 years 10 years Source: MPPM, Issue PDS, S&P Global Credit Portal July 2012.
Universe Concentration The market capitalisation of the sector is approximately $34bn across 74 individual securities7. When
excluding smaller and lower quality securities from the universe: approximately 50 securities are of
sufficient size and quality for MPPM to consider for portfolio inclusion. At the issuer level, we consider the
universe to be concentrated (as noted in Chart 3 & 4). The following two charts illustrate the composition of
the universe.
Chart 3: IRS Market Capitalisation of Major Banks
ASX Listed IRS Market Capitalisation - Major banks (~60% of universe)
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
ANZ Bank CBA Westpac NAB
Source: Iress, MPPM July 2012.
Chart 4: IRS Market Capitalisations – Ex Top 4 Banks
T=Source: MPPM, Iress, ASX Jan 2013 Market Update=
Macquarie Private Portfolio Management 12
ASX Listed IRS Market Capitalisation - Non Big 4 bank (~40% of universe)
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
Sunc
orp
Colon
ial G
roup
Insu
ranc
e Au
stralia
Group
Orig
in E
nergy
Woo
lworths
AGL En
ergy
Mac
quarie G
roup
Tabc
orp Group
Seve
n Med
ia
Multip
lex
Bend
igo Ba
nk
Mac
quarie B
ank
Goo
dman
Group
Pape
rlinx
Australand
Ram
say Hea
lthca
re
Nufarm
Tran
spac
ific Indu
strie
s
Australia
n Fo
unda
tion
AMP
Bank
of Q
ueen
slan
d
Prim
ary Hea
lthca
re
Elde
rs
Hea
lthsc
ope Ltd
ALE
Prop
erty
Australia
n Unity
Gun
ns
Broo
kfield
Peet &
Co.
Source: Iress, MPPM July 2012.
Like the Australian wholesale corporate debt market, the majority of issuance comes from high credit
quality banks and other financial issuers.
Key details of the universe include:
• 50 securities across 33 different issuers,
• 95.5% of the universe is floating rate, major domestic banks dominate the universe, with the four
major Australian banks comprising 60% by market capitalisation (ANZ 20.5%, CBA 18.5%, WBC
12.9%, and NAB with 8.7%) or 42% by the number of securities (14),
• The next 29 issuers account for 40% of the sector.
We consider the universe large enough to provide suitable diversification across each individual issuer
however; we acknowledge the portfolio is skewed to major domestic banks. At the portfolio level we
currently have a 10% maximum issuer exposure rule, but generally hold a position size of 4%-7%. This
results in a portfolio holding 10-15 individual securities from a range of issuers, as well as a diversified
bond fund exposure via the Macquarie Enhanced Index Fixed Interest Fund.
Liquidity Given the purpose of the investment is to source a regular income stream, investors in IRS often take a buy
and hold approach to investing. As a result, annualised turnover is moderate at approximately 20% per
annum8 (around 1/5 of the ASX 200 equity market which generally has turnover of greater than 100% per
annum). At times of market crisis or where credit concerns regarding a specific issuer arise, liquidity can
tighten and result in volatile price behaviour.
MPPM manages liquidity in a number of ways, including; blending investments between the bond fund,
cash and listed IRS, setting issuer risk limits, security and tenure diversification, high quality focus (issuer,
size and terms of issue) and taking a medium to long term investment horizon. Additionally, we deal with a
variety of institutional brokers who have dedicated dealing desks that focus on the IRS universe. We
U=Source: ASX May 2012 listed IRS market update.
Macquarie Private Portfolio Management 13
typically use off–market transactions such as IPO’s, buybacks and redemptions as our key source of
liquidity.
Current Valuation We currently consider the valuation of IRS to be attractive due to high credit margins available for
investors. Grossed up income streams are almost double the current cash rate (before management fees).
Individual security returns range from 200bps to 600+bps depending on both the issuer, structure and
security specific terms of issue, with an average of approximately 325 basis points (as at Dec 2012) based
on our modelling of the sector. Securities with more flexible terms of issue, uncertainty regarding near term
redemption events, long times to maturity or lower credit quality generally trade at higher margins.
Trading margins available for investment increased during 2012, as a result of an increase in risk premiums
and technical factors, such as new issuance in the market, however over the last few months the risk
premiums/margins have been reducing, driving capital values of securities higher. The following chart
shows the movement in the Australian Corporate Itraxx Index since January 2010. This chart highlights
credit spreads are currently elevated and that a material premium exists in the listed IRS market relative to
senior debt. We expect credit margins to remain elevated and somewhat volatile in the medium term.
(Note: Prior to 2007 average margins from the listed universe was ~1% with investors not pricing more
flexible structures as widely as they do now).
Investors buying into the portfolio can now lock in the 3% margin above the bank bill swap rate for the
medium term (3-5 years).
Chart 5: Corporate Itraxx Bond Index
Australian Domestic Itraxx Index (Corporate Credit Spreads): Jan 2010 - Dec 2012
0
50
100
150
200
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350
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Date
Bas
is P
oin
ts (10
0 = 1
.00%
)
Average Listed IRS Gross Credit Margin, Jan 2013
Source: Iress, MPPM, Bloomberg, Jan 2013.
Macquarie Private Portfolio Management 14
The other key driver of valuations is the movement in the bank bill swap rate (BBSR), as 95% of the
universe has a floating rate income stream. The BBSR is currently 2.95% (as at Jan 2013) effectively
pricing in a chance of another Reserve Bank of Australia (RBA) rate cut in the near term. Given the current
outlook for the domestic economy and the fact the RBA has already cut the domestic cash rate to 3.0%
(from 4.25% in April 2012) we expect the BBSR to stabilise around current levels, although may go slightly
lower later in the year ahead if the RBA lowers interest rates further. A material deterioration of European
sovereign debt outlook or China as our major trading partner could see the RBA cutting rates beyond our
base case (which is that only moderate further rate cuts are likely in the near term).
We consider the listed interest rate security universe currently offers an attractive income stream due to
high margins and tax effective imputation stream. The income stream and expected internal rate of return
available is almost 100% higher than the current cash rate (the portfolios current IRR is approximately
5.8% vs. the current cash rate at 3.0%) and lower than risk government bonds, this represents an
appropriate premium for structural subordination.
MPPM’s INVESTMENT PROCESS
1. MPPM’s Investment Approach
MPPM has a thorough investment process with more than ten years experience constructing Fixed Interest
mandates. We draw upon internal proprietary research as shown above that is supplemented and tested
against third party fixed interest, credit rating and listed IRS specific research (which is sourced through our
external broking arrangements).
Fixed Interest Funds - MPPM review fixed interest funds prior to investment, with focus on track record,
quality of underlying exposure, tracking error, risk, liquidity, style and fees.
The portfolio weighting to fixed interest funds depends upon MPPM’s outlook for domestic interest rates,
yield curve, risk environment and the relative opportunities available in listed interest rate securities and the
Macquarie Private Portfolio Management 15
various categories of unlisted wholesale debt including Commonwealth Government Bonds, Semi
Government Bonds, Corporate Bonds/FRN’s and asset backed instruments. Additionally, all underlying
exposure within any selected fund must have an independent credit rating that meets the traditional
definition of “Investment Grade” and geared funds are excluded from investment.
Our research and investment process within the listed universe can be best described as “quality at a
reasonable ‘after taxation’ value”. We have a strong focus on quality at the issuer level (in terms of credit
quality and equity outlook) and specific focus on quality at the structure level, which is particularly important
given the diverse terms available at the security level. We undertake credit and equity research on the
securities prior to investment to determine our own internal ‘shadow’ credit ratings. In addition to issuer
research the terms of issue must meet our requirements with regards to fixed interest characteristics and
solid risk and return characteristics. In summary we focus on: Is it a good issuer? Is it a good structure?
Does it offer value on a risk adjusted basis?
Our portfolio construction approach screens out issuers who don’t meet our credit quality requirements
(that is, it must be an ‘Investment Grade’ issuer) or minimum issue size and maximum delta (if any).
Securities not meeting these criteria will not be considered for portfolio inclusion. Our portfolio construction
approach generally takes a long term view, with the expectation that we will buy and hold securities until
maturity, although we actively trade the portfolio where risk adjusted valuations move beyond our tolerance
bands or to take advantage of mispriced securities.
Risk Management
MPPM has a robust risk management process in place. It starts with a set of risk constraints that form the
investible universe and cascades through the process to how an investment is approved for inclusion in a
portfolio. From there, we have daily client level controls in place that flow through mandate compliance and
security and trade monitoring.
Macquarie Private Portfolio Management 16
Strategy Performance & Volatility Charts The following two charts highlight the positive returns achieved, during volatile equity market conditions
during recent years, with less volatility than the equity market.
Chart 6: MPPM Diversified FI Strategy vs. the All Ordinaries Accumulation Index
MPPM Diversified Fixed Interest strategy gross return (with imputation) vs Domestic Equity market Period: Jan 2010 - Dec 2012
-15.0%
-12.5%
-10.0%
-7.5%
-5.0%
-2.5%
0.0%
2.5%
5.0%
7.5%
10.0%
12.5%
15.0%
17.5%
20.0%
22.5%
25.0%
27.5%
30.0%
32.5%
3/01/103/02/103/03/103/04/103/05/103/06/103/07/103/08/103/09/103/10/103/11/103/12/103/01/113/02/113/03/113/04/113/05/113/06/113/07/113/08/113/09/113/10/113/11/113/12/113/01/123/02/123/03/123/04/123/05/123/06/123/07/123/08/123/09/123/10/123/11/123/12/12
MPPM Diversified FI Strategy Gross Return
ASX 200 Equity Accumulation Index Return
Source: MPPM, Iress, Jan 2013, Prior to fees.
Chart 7: Daily Volatility of MPPM Diversified FI Strategy vs. Australian Equity Market
Daily Volatility: MPPM Australian Diversified FI Strategy vs Equity MarketPeriod: Jan 2010 - Dec 2012
-5.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
3/01/20103/02/20103/03/20103/04/20103/05/20103/06/20103/07/20103/08/20103/09/20103/10/20103/11/20103/12/20103/01/20113/02/20113/03/20113/04/20113/05/20113/06/20113/07/20113/08/20113/09/20113/10/20113/11/20113/12/20113/01/20123/02/20123/03/20123/04/20123/05/20123/06/20123/07/20123/08/20123/09/20123/10/20123/11/20123/12/2012
MPPM Diversified FI Strategy
ASX 200 Equity Accumulation Index
Source: MPPM, Iress, Jan 2013
Macquarie Private Portfolio Management 17
The following chart highlight the positive returns achieved, compared to the domestic bond market
Chart 8: MPPM Diversified FI Strategy vs. the UBS All Maturities Composite Bond Accumulation Index
MPPM Diversified Fixed Interest Strategy Return vs. Domestic Bond Market ReturnPeriod: Jan 2010 - Dec 2012
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
3/01
/201
0
3/02
/201
0
3/03
/201
0
3/04
/201
0
3/05
/201
0
3/06
/201
0
3/07
/201
0
3/08
/201
0
3/09
/201
0
3/10
/201
0
3/11
/201
0
3/12
/201
0
3/01
/201
1
3/02
/201
1
3/03
/201
1
3/04
/201
1
3/05
/201
1
3/06
/201
1
3/07
/201
1
3/08
/201
1
3/09
/201
1
3/10
/201
1
3/11
/201
1
3/12
/201
1
3/01
/201
2
3/02
/201
2
3/03
/201
2
3/04
/201
2
3/05
/201
2
3/06
/201
2
3/07
/201
2
3/08
/201
2
3/09
/201
2
3/10
/201
2
3/11
/201
2
3/12
/201
2
Date
Ret
urn
MPPM Diversified FI Portfolio Cash ReturnDomestic Bond MarketMPPM Diversified FI Portfolio Gross Return (includes imputation credits)
Source: MPPM, Iress, Jan 2013, Prior to fees.
SUMMARY We employ a rigorous research process with respect to the MPPM Diversified Fixed Interest strategy, and
have been managing fixed interest portfolios since 2000. Our research and experience supports our current
view that the IRS sector is offering attractive margins over bank bill swap rates, whilst bond markets can
continue to offer a hedge should the economic outlook deteriorate.
The IRS market provides a lower risk alternative to equity markets, with a tax effective regular income
stream. Its structure and diversification provides investors with an option to source a reliable income
stream at attractive margins.
Should you have further questions about MPPM’s Diversified Fixed Interest strategy or its suitability for
inclusion in your portfolio, please contact your adviser for more information.
Macquarie Private Portfolio Management 18
This document contains purely factual information and/or general advice and does not take into account your objectives, financial
situation or needs and, before acting on this information, you should consider whether it is appropriate to your situation.
Macquarie Equities Limited is a related body corporate of Macquarie Private Portfolio Management Limited and will receive brokerage
in respect of transactions entered into on your behalf by Macquarie Private Portfolio Management Limited.
This discussion paper and investment strategy is indicative only. The appropriateness of the investment strategy referred to in this
document is general in nature only; it should not be construed as a general endorsement of the investment strategy as being
appropriate for all investors. Potential investors are advised to seek professional legal, financial and taxation advice on the
implications of investing with respect to their own particular circumstances.
This paper has been prepared by Macquarie Private Portfolio Management Limited ABN 26 089 987 388 (“MPPM”) Australian
Financial Services license no. 237506 and is current as at March 2013.
Macquarie Enhanced Australian Fixed Interest Fund ARSN 085 130 794 (“Fund”) is offered by Macquarie Investment Management
Limited ABN 66 002 867 003, AFSL 237492 (“MIML”). Investments in the Fund are not deposits with or other liabilities of Macquarie
Bank Limited ABN 46 008 583 542 or any Macquarie Group company and are subject to investment risk, including possible delays in
repayment and loss of income or principal invested.
None of Macquarie Bank Limited, MIML or any other member company of the Macquarie Group in any way stands behind or
guarantees the performance of the Funds or the repayment of capital from the Funds or any particular rate of return.
This presentation contains factual information and/or general advice and does not take account of your objectives, financial situation
or needs. Due care and attention has been used in the preparation of any forecast information, however actual results may vary from
forecasts and any variation may be materially positive or negative.
No members of the Macquarie Group give, nor does any member purport to give, any taxation advice. The taxation information in this
document is based on laws current at the time of writing. The application of taxation laws to each investor depends on that investor’s
individual circumstances. Accordingly, investors should seek independent professional advice on taxation implications before making
any investment decisions.
This paper is based on information obtained from sources believed to be reliable but we do not make any representation or warranty
that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions
expressed are subject to change without notice. No member of the Macquarie Group accepts any liability whatsoever for any direct,
indirect, consequential or other loss arising from any use of this research and/or further communication in relation to this research.
Past performance is not a reliable indicator of future performance. Any forecasts contained in this presentation, are predictive in
character and therefore investors should not place undue reliance on the forecast information. The forecasts may be affected by
incorrect assumptions or by known or unknown risks and uncertainties. The actual results may differ substantially from the forecasts
and some facts and opinions may change without notice.
The Macquarie Group or its associates, officers or employees may have interests in the financial products referred to in this
presentation by acting in various roles including as investment banker, underwriter or dealer, holder of principal positions, broker,
lender, director or adviser. Further, they may act as market maker or buy or sell those securities as principal or agent and, as such,
may effect transactions which are not consistent with the recommendations (if any) in this presentation. The Macquarie Group or its
associates may receive fees, brokerage or commissions for acting in those capacities and the reader should assume that this is the
case.
References to S & P in this presentation are references to Standard & Poor’s (Australia) Pty Ltd ABN 62 007 324 852
Credit-related analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed
and not statements of fact or recommendations to purchase, hold, or sell any securities or to make any investment decisions.