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Look No Further: Global Credit Exposure Through Actively Managed USD-Denominated Investment Grade Credit

Dr. Vladimir Karlov Managing Director, Chairman, PineBridge Investment Solutions Committee PineBridge Investments, New York Robert Vanden Assem, CFA Managing Director, Head of US Investment Grade Fixed Income PineBridge Investments, New York

Introduction
Investment grade fixed income has always been a key component in well diversified investment portfolios. Over the last several years, the asset class has gained even more traction, as the increased volatility witnessed during the global financial crisis has driven investors to seek more stable portfolio returns. In addition to offering attractive valuations versus government bonds, investment grade credit represents one of the largest and highest quality investment opportunity sets and has, consequently, been a beneficiary of increased investor appetite. The need for investors to diversify their credit exposures has generated interest in global investment grade credit solutions. However, this has introduced a number of complexities and unintended risks into portfolios, such as exposure to foreign exchange rates and sensitivity to global interest rate curves. If not managed or hedged properly, these risks could negate the perceived diversification benefits of adding global investment grade credit. As an alternative, we believe that it is possible, and even preferable for investors to capture global credit exposure in US dollar-denominated global credits through an actively managed investment grade strategy. While some investors actively seek exposure to a wide variety of currencies and international yield curves in their fixed income allocations, we believe that the volatility and risks associated with such an approach will likely dampen the value of a higher quality and stable target return for an investment grade allocation.

The Opportunity Set and Alpha Generation in Global Investment Grade Credit
Proponents of global investment grade credit list, among their reasons for considering the asset class, its breadth of opportunities versus what is available in individual country credit allocations. Their argument is that there should be a resulting increase in alpha and information ratios, given the broader credit universe, currencies and interest rate curves. Grinolds fundamental law of active management stipulates that information ratio (IR) is equal to information coefficient (IC) multiplied by the square root of breadth (N). IR=IC*SQRT(N) Looking at this formula, it is clear why one would expect the IR for global investment grade managers, on average, to be higher than for US investment grade managers, as the opportunity set, or breadth, is larger. Further, in theory, the forecasting ability of the manager, measured by IC, should not differ much whether a manager is running a global or a country specific portfolio. To test this hypothesis, we analyzed the IRs of all managers in the eVestment Alliance Global and US Investment Grade Universes. Contrary to the hypothesis, the data shows that, on average, the information ratio for the US credit universe was higher than that of the global universe for the 3- and 5-year periods shown in Figure 1.

This material must be read in conjunction with the disclosure statement.

FIGURE 1

Universe Characteristics: Active Global vs. Active US


US Credit 3 Year Global Credit 3 Year 2.56 1.48 1.03 0.58 0.18 -0.44 -1.25 US Credit 5 Year 1.35 1.22 0.73 0.39 -0.16 -0.36 -0.45 Global Credit 5 Year 0.86 0.75 0.36 0.10 -0.12 -0.73 -0.79

High 5th Percentile 25th Percentile Median 75th Percentile 95th Percentile Low

2.85 2.35 1.79 1.00 0.21 -0.80 -1.67

As can be seen, while the Global and US Credit universes are different in the number of issues, the gap between the liquid USD universe and the global liquid universe is minimized in notional terms. In addition, as reflected in Figure 3, the most liquid international names tend to issue bonds in the USD market. Thus, by focusing on the liquid subsets of the universes, the breadth appears to be quite similar. FIGURE 3 Liquid Issuers in the Global and USD Credit Markets
Liquid Global Issuers US Europe Japan UK Australia Rest of World 58.01% 64.60% 63.40% 39.98% 12.46% 52.68% Liquid USD Credit 54.93% 86.38% 77.40% 87.94% 92.07% 85.53%

Source: eVestment Alliance

Not only did the average US manager perform better, but so too did the universe as a whole. This analysis shows that expanding the opportunity set may actually detract from alpha generation and that the IC decreases between two and four times faster than the square root of the breadth. Clearly, there must be an explanation for this phenomenon. To try to unlock the mystery, we first look to see if the opportunity sets of the two universes are really that much different. Figure 2 shows the geographic breakdown (by number of issues, market value and currency exposure) of the Barclays Capital Global Credit and US Credit indices and the Liquid USD Universe. FIGURE 2 Universe Characteristics: Global and US Including Liquid Subsets
Global Credit Issues Notional % US 3,653 34.8% Europe 1,949 28.3% Japan 731 8.0% UK 229 2.5% Australia 415 4.2% Rest of World 1,597 22.0% 3.9% 1.3% 6.6% 3.6% 24.1% Global Credit Currency Exposure 60.5% US Credit Issues Liquid USD Credit Issues Liquid Global Credit Issues

Source: Barclays Capital. Data as of March 30, 2012. The liquid universes are segmented out of the broader credit indices by average bid-ask spread as of reference quarter-end.

Notional % Notional % Notional % 3,815 67.9% 230 14.3% 94 4.8% 42 1.8% 30 1.4% 575 27.3% 1,454 57.7% 173 12.4% 66 3.7% 35 1.6% 28 1.3% 393 23.3% 1,643 35.6% 1,154 32.3% 432 9.0% 78 1.8% 40 0.9% 522 20.4%

Another measure that can be used to estimate the difference in breadth of the two universes is the dispersion of spreads. Shown in Figure 4, this measurement is a good proxy for alpha generation capacity from credit selection and we see that the numbers for the two universes are fairly similar. In fact, Europe, Japan and the Rest of the World have more spread and alpha potential in the USD liquid universe than in the global universe. Hence, the fewer issues in the USD universe versus the Rest of the World shouldnt present a problem from an alpha generation perspective. Given the similar breadth in liquid credit opportunities between two universes, we can see why the global universe does not actually achieve the hypothesized increase in IR. Nevertheless, this does not explain why the IR for global managers is actually lower. This is likely explained by the fact that the only additional opportunity sets available to global managers are currency and duration. As managers take uncompensated currency and duration bets, they detract from their credit decisions. Therefore, on a risk-adjusted basis, it is generally a lot more difficult to consistently make successful currency and duration bets. Since most US credit managers take very little of these risks, they are in a better position to be rewarded for their decisions. Non-US investors who prefer a credit strategy that is denominated in a currency other than the US dollar can easily tailor the strategy to fit their needs. This can be achieved by bringing the USD credit component to the right

Source: Barclays Capital. Data as of March 31, 2012. The liquid universes are segmented out of the broader credit indices by average bid-ask spread as of reference quarter-end.

FIGURE 4

Universe Characteristics: Dispersion


US Credit Global Credit Liquid USD Credit 171 +/- 5 Liquid Global Credit

US

174 +/- 6

263 +/- 6

188 +/- 4

Europe

158 +/-12

241 +/-15

213 +/- 12

185 +/- 11

has been bolstered by the low rate environment that has pushed investors to the relative attractiveness of corporate debt and driven strong demand for the asset class. A significant increase in cash balances has been generated, given the ability of companies to access the debt markets and overall reductions in capital expenditures. Corporate balance sheet discipline has also included a trend toward lower leverage, as companies seek to maintain strong credit metrics. The European sovereign debt crisis belies a more global trend among developed nations to increase debt. In the US, debt-to-GDP levels have increased substantially as the government has sought to stimulate the economy weakened by the financial crisis and a prolonged housing slump. Specifically, high debt levels are not only evident at the federal level, but also across the nation in states and municipalities, that are facing rating downgrades and fiscal difficulties in the foreseeable future. Going forward, corporate fiscal discipline will remain a key focus, especially given the uncertain economic environment. Therefore, a strategy that employs investments in an asset class that exhibits stable to improving fundamentals, with a focus on selection at the security level, is one that makes good sense.

Japan

117 +/-3

65 +/-3

159 +/- 5

85 +/- 6

UK

183 +/-10

273 +/-11

175 +/- 10

228 +/- 10

Australia

119 +/-2

185 +/-8

119 +/- 2

155 +/- 8

Rest of World

105 +/-11

194 +/-12

155 +/- 3

94 +/- 12

Source: Barclays Capital. Data as of March 30, 2012. The liquid universes are segmented out of the broader credit indices by average bid-ask spread as of reference quarter-end. Note: Spread dispersion is defined as average option-adjusted spread (OAS) +/- monthly volatility.

duration on the curve in the investors currency of choice. For example, Australian investors could (1) hold USDdenominated investment grade credit, (2) execute swaps that change the duration of the portfolio from fixed to floating, and (3) hedge USD into Australian Dollars (AUD). This would have resulted in a spread of approximately 170 bps over AUD cash as of the end of April 2012. The investor could then either move the spread to their desired position on the curve or simply keep the 170 bps in credit without taking any interest rate risk. Such exposure to USD-sourced global investment grade credit presents an attractive, active opportunity from a risk-return perspective and could result in high marginal return on economic capital.

Conclusion
In summary, direct exposure to the global credit universe introduces foreign exchange and duration exposure in other currencies that, if not managed or hedged properly, may negate all of the perceived diversification benefits of a global credit portfolio and result in a low information ratio. Since the opportunity set available to global credit managers is actually similar in breadth to what is available to US credit managers, global credit strategies have experienced deteriorating information ratios as currency and duration bets have detracted value. Thus, investors who are looking to capture exposure to global investment grade credit may consider achieving that exposure through an actively managed strategy that invests in US dollardenominated global investment grade credit and then hedge the dollar exposure back to their home currency. Finally, the US investment grade credit markets current favorable outlook is an additional reason to consider the asset class. n

Why Investment Grade Credit in the Current Macroeconomic Environment


In addition to the benefits of using US dollar denominated investment grade credit instead of global credit as described above, the US credit market also has a bright outlook in the current macroeconomic environment. The optionadjusted spread (OAS) of the Barclays Capital U.S. Credit Index was trading at more than 170 basis points at the end of April 2012, a level that indicated that the investment grade market was already partially pricing in the chance of a double dip recession. We believe that this makes the asset class attractive from both a fundamental and valuation perspective. As governments in the developed world have sought to spend their way back to economic growth, private companies have focused on improving their liquidity profiles and cost structures. The focus on balance sheet discipline

BIOGRAPHIES
Dr. Vladimir Karlov, Chairman, PineBridge Investment Solutions Committee PineBridge Investments, New York Mr. Karlov joined the firm in 2000 and is responsible for managing preferred equity portfolios. As the Chair of the firms Investment Solutions Committee, he is involved in establishing House Views with regard to investment opportunities and risks. He is also engaged in asset allocation decisions, asset-liability management, liability driven investments, execution of structured and derivatives transactions. Previously, Mr. Karlov was responsible for managing capital structure arbitrage and convertible portfolios. Prior to joining the firm, he was a Consultant in the Financial Risk Management Group at PricewaterhouseCoopers LLP in New York. At PwC, Mr. Karlov worked with banks, investment management companies, mortgage companies and government agencies on a wide variety of risk management projects. He received a BS and an MS (Honors) in Applied Mathematics and Cybernetics at Moscow State University in Russia, and a Doctor of Science in Operations Research from George Washington University.

Robert Vanden Assem, CFA Managing Director, Head of Investment Grade Fixed Income PineBridge Investments, New York Mr. Vanden Assem joined the firms predecessor company in 2001. He is currently the head of the Investment Grade Fixed Income group and responsible for the management of high grade institutional and retail fixed income portfolios. Previously, Mr. Vanden Assem worked at Morgan Stanley Dean Witter Advisors as a Portfolio Manager for the MSDW Strategist and Variable Strategist mutual funds, in addition to other institutional and individual fixed income assets. He also managed institutional and individual monies exclusively, at Dean Witter InterCapital, the precursor to MSDW Advisors. He received a BS in Accounting from Fairleigh Dickinson University and an MBA in Finance from New York University. Mr. Vanden Assem is a CFA charterholder.

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