2011 Investment OutlOOk
ALTERNATIVEINVESTMENTS
LISTEd EquITIES
FIXEd INCOME
PineBridge Investments manages assets for
institutional and individual clients across an
extensive platform of listed equity, fixed income,
private equity and hedge funds of funds capabilities.
With decades of experience in investing, we
thoroughly understand our clients’ interests and
are solidly positioned to deliver comprehensive
investment solutions to meet their needs. With more
than 800 employees in 32 countries and jurisdictions,
PineBridge Investments’ strong global network
captures local market knowledge and identifies
potential opportunities for the benefit of investors
around the world.
2011 Investment OutlOOk
ALTERNATIVEINVESTMENTS
LISTEd EquITIES
FIXEd INCOME
Economic Overview 2
Capital Markets Overview 6
Alternative Investments Overview 12
Hedge Funds of Funds 14
developed Markets direct Investments 16
Emerging Markets Private Equity 17
Private Market Fund Investments 19
Private Equity Secondaries 22
Developed Markets Equities Overview 26
European Equities 28
Japanese Equities 30
uS Equities 32
Emerging Markets Equities Overview 34
African Equities 36
Asian (ex-Japan) Equities 38
Latin American Equities 40
Developed Markets Fixed Income Overview 44
Emerging Markets Fixed Income Overview 46
Leveraged Finance Overview 49
Leveraged Loans 50
uS High Yield Bonds 52
US Investment Grade Fixed Income Overview 54
uS Investment Grade Credit 56
uS Securitized Products 57
disclosures 60
2
2011 Investment OulOOk
government action
Emphasizing the bipolarity of the new world economic order,
the recovery was triggered by roughly equal-sized fiscal stimu-
lus packages in the uS and China, each worth about 6% of their
respective GdPs. The resulting pickup in economic growth
had a strong impact on export-oriented economies, such as
Germany and Sweden, Asia’s newly industrialized economies
and, initially, even Japan. Looking ahead, the critical issue will
be the handover from public- to private-sector-driven growth,
mainly through stronger domestic employment growth. This
is where the uS recovery still falls short of expectations, with
barely 15% of the jobs lost during the recession recaptured.
The global economy is on track to grow at a 5% rate in 2010, on
par with the record pace it was on just before the 2008 crisis
hit. However, we still spent most of 2010 making the case for
growth and arguing against “double dip recession” concerns.
We will not have the same problem in 2011. The recovery is
now well underway and has spread to every corner of the
world. At the end of 2010, the OECd’s Leading Economic Indica-
tor was getting very close to the 28-year high reached in July
2007, which represented the peak of the last expansion. Look-
ing ahead, overall global economic growth is likely to moderate
somewhat in the next two years, but should remain between
4.75% and 5%, just about matching the record 5% average in
the years between 2004 and 2007.
economic overview
Markus Schomer, CFA, Chief Economist
LEADING INDICATOR AMPLITUDE ADJUSTED - OECD TOTAL RECESSION PERIODS - UNITED STATES
90
92
94
96
98
100
102
104
106
108
‘65 ‘70 ‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘10
FIGuRE 1 GLObAL - OECd LEAdING INdICATOR
Source: FactSet Research Systems as of 20 December 2010
(Index)
3
Another risk on the horizon centers on the impact of further
diverging monetary policy around the world. In the uS, the
Fed remains preoccupied with the deflation tailrisk, as small
as it may be. Meanwhile, the extremely accommodative uS
monetary policy, coupled with improving global growth, is
stoking commodity prices and, with that, inflation in many EM
economies. The challenge for central banks around the world
is to find the right balance between raising policy rates and
allowing currencies to appreciate in order not to stifle export
and domestic demand growth.
Financial markets swooned every time China raised rates
last year and inflation-watching has become a key part of an
economist’s job. The eventual normalization in uS monetary
policy will take the pressure off of faster growing emerging
markets, but, in the meantime, diverging inflation trends and
the resulting currency imbalances constitute another source
of risk to the global recovery. We expect the policy debate in
the uS will shift toward reducing the monetary stimulus in the
second half of 2011. However, an actual rate increase seems
unlikely, at least until 2012.
United states
The key driver of uS domestic demand in 2011 should be faster
employment growth. Last year, private-sector job growth
averaged about 110,000 per month, which mainly represented
businesses rehiring some of the workers laidoff during the
recession when everybody was predicting a rerun of the Great
depression. In 2011, corporate profits will start boosting the
pace of job creation. uS companies have been able to pre-
serve productivity and with that, profit margins through the
downturn, and are now in great shape to benefit from expand-
ing top-line growth. Historically, the uS corporate profit and
employment cycles have been highly correlated. Employment
Contrast that with Canada, where payrolls fell 2.3% during the
downturn, but have increased 2.6% since then; or Germany,
where employment declined less than 0.5%, but has since
increased by more than 1%.
With unemployment still close to 10%, the uS unveiled two
additional stimulus programs at the end of 2010, despite the
backlash against government activism in last November’s mid-
term elections. First, the uS Federal Reserve (Fed) announced
a second asset purchase program, worth about uS $700
billion, designed to increase uS money supply growth (qEII).
Then, Congress agreed to another set of new tax measures,
worth an additional uS $160 billion in 2011, as part of a package
that included an extension of all of the expiring 2001/2003 tax
cuts. This additional stimulus is coinciding with accelerating
private demand, which should push uS economic growth above
3% over the next two years.
fiscal policy
Fiscal policy issues pose the greatest near-term threat to the
global outlook. This is most glaring in Europe, where soaring
budget deficits triggered a liquidity crisis in 2010. This neces-
sitated the creation of a support fund from which Eu member
states can draw. The risk of a sovereign default is still substan-
tial, judging from the extreme dispersion of credit default swap
spreads, but the support facilities drawn up by Eu member
states should prove sufficient to prevent a broader contagion.
The risk in the uS centers on the budget shortfalls in state and
local governments. Rising tax revenues may ease the problem
in 2011, yet public spending cuts could be a drag on uS growth
in the next few years. The fiscal problems in the developed
world contrast dramatically with emerging markets (EM)
where the cyclical recovery in tax revenues will be sufficient to
restore balanced budgets.
TABLE 1
2010 2011 2012
Global Economy 5.0 4.8 4.7
united States 2.9 3.4 3.3
Eurozone 1.8 2.3 2.3
Japan 4.2 1.0 1.4
Emerging Economies 7.6 7.0 6.8
PINEbRIdGE INVESTMENTS GLObAL GdP GROwTh FORECASTS
4
2011 Investment OulOOk | economic overview
benefits of strong demand for European exports. Tax rev-
enues are already rebounding at a faster pace than expected
in Germany and a broader recovery in the core will have the
same impact on France, Italy and other countries tied in to the
German business cycle. Stronger growth will go a long way
toward taking the sting out of the planned fiscal retrenchment.
That may not be enough to help Greece, Portugal and Ireland.
Yet, even if a debt restructuring was eventually necessary, it is
much easier to accomplish during a strong recovery in the rest
of the world, as opposed to a forced consolidation in the midst
of a deep global recession. The eurozone should manage about
2.3% growth in the next two years, still led by Germany in 2011,
but with narrowing dispersion thereafter.
Japan
Rounding out the G3 outlook, our view on Japan for the next
few years is well below consensus. The Japanese economy
is facing enormous structural headwinds from an ageing and
tends to follow profits with a lag of about nine months, which
is consistent with a pickup in payroll growth in early 2011.
Consequently, we expect the unemployment rate to decline to
about 8% at the end of 2011 and 7% at the end of 2012.
eUrope
While financial markets will remain focused on the evolving
sovereign debt crisis in the eurozone’s periphery, at least in the
early part of 2011, they run the risk of overlooking the strong
growth performance in the heart of Europe. Germany has been
a major beneficiary of the debt-crisis-induced weakness of the
euro. Strong exports triggered a manufacturing boom that is
now creating jobs and raising household incomes.
In 2011, we are likely to see stronger consumer spending
emerge as a second pillar of the recovery. Stronger German
wage growth will allow other eurozone economies to improve
their competitiveness and grab a bigger share of the economic
(% 2YR ANN) NONFARM PAYROLL GROWTH, 8 QTR. % (AR) (Right) (LEAD 3Q , % 2YR ANN) OPERATING PROFITS, 8 QTR. % (AR), 2 QTR. LEAD (Left)
-20
-10
0
10
20
30
‘60 ‘65 ‘70 ‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘10-4
-3
-2
-1
0
1
2
3
4
5
FIGuRE 2 uS - CORPORATE PROFITS ANd EMPLOyMENT
Source: FactSet Research Systems as of 20 December 2010
(Profits, 2-year change in %) (Nonfarm payrolls, 2-year change in %)
5
However, behind the early-cycle volatility are powerful drivers
that will continue to allow emerging economies to outper-
form the developed world. One is favorable demographics,
which will allow emerging economies to benefit from falling
dependency ratios for another decade or so. The second driver
is strong infrastructure spending, which not only creates
employment and income now, but also raises the potential
growth rate these economies can achieve in the future. In both
cases, the developed world has fallen dangerously behind. EM
accounted for about 72% of global growth in 2010. That share is
likely to fall below 70% by 2012, yet growth in these parts of the
world should remain close to 7%, compared to about 2.75% in
the developed world economies during the same time period.
2011 oUtlook
In conclusion, 2011 should see a further broadening of the
global recovery momentum. Some of the extremely strong
2010 growth rates, especially in EM, will give way to a more
moderate, but sustainable, expansion, which may help ease
some of the inflation pressures visible in many emerging
economies. The developed world is still grappling with the fis-
cal fall out from the last recession, but stronger growth should
help ease some of the most extreme fears of debt contagion.
Some of the positive surprises next year may come from the
realization that the euro will not collapse. uS job growth may
also surprise forecasters and the uS dollar is likely to stage a
rebound in the second half of the year.
The key risks to this fairly bullish outlook are policy errors in
Europe, which is still facing the risk of a liquidity crisis, and
from the uS, which has so far shown no willingness to follow
through on the tough talk of the last election campaign with
actual tough measures. A credible uS fiscal exit strategy would
be the best way to solidify investor confidence and refocus the
debate away from debt and back to growth.
shrinking population and a government debt burden that is
threatening the solvency of Japan’s entire financial system,
given that about 60% of outstanding government bonds are
held by domestic banks and insurance companies. What is
buffering economic activity is the strength of export demand,
especially from Asia. However, the yen’s almost 10% apprecia-
tion again the uS dollar and near 19% gain vis-à-vis the euro in
2010 will have a negative impact on Japan’s export competitive-
ness in the near term. Add to that efforts by China and other
developing nations to cool economic growth through tighter
monetary policy and you have a recipe for a significant slow-
down in Japanese export growth, which accounted for almost
three-quarters of Japan’s GdP rebound in the first three quar-
ters of 2010. Japan’s situation will only change once the yen can
depreciate more seriously. That requires a widening in interest
rate differentials, which will not happen until the Fed and the
European Central Bank start raising rates. In the meantime, it
is only a matter of time before debt-shy investors start homing
in on the country with the biggest debt burden, which is Japan.
Monetary policy will remain extremely accommodative;
outright debt monetization by the Bank of Japan is already one
of the main funding sources for the government. Fiscal policy
will only be able to address the debt burden once the currency
has depreciated sufficiently to stimulate nominal GdP growth
and possibly through international/foreign investors, who are
extremely underweight Japanese assets. GdP growth should
remain at between 1% and 1.5% in the next two years.
emerging markets
2010 brought a very strong growth rebound in EM. Singapore
is on track to post a 14% growth rate; Chinese growth is likely
to exceed 10%; and India’s economy is running at a rate close
to 9%. Not surprisingly, many of the fast-growing economies
are facing a growing inflation problem, which has triggered
monetary policy tightening in many parts of the emerging
world. We are not changing our structurally bullish outlook on
EM, but growth will be less spectacular in 2011 and 2012.
6
2011 Investment OulOOk
for the foreseeable future. This had many economists fretting
back in June that once policy stimulus wore off, a double dip
recession would ensue. Instead, the economic growth baton
was gracefully passed on to the private sector. despite numer-
ous known headwinds, a sustainable business-led recovery is
now unfolding, and employment and investment are following
the profit cycle with their normal nine-month lag. Economists
are rushing to upgrade their 2011 forecasts.
Global investors are finding themselves underexposed to uS
stocks and the uS dollar, while overexposed to “risk free”
government yield curves. Even without a meaningful uS
contribution, global GdP paced at 5% in 2010 and in our view,
is poised to repeat this impressive performance in 2011. Yet,
with memories of the financial crisis of 2008 still top-of-mind,
capital markets are pricing in a slow-growing risk-prone world
judging from the shape of our capital markets line (CML).
United states
The unexpected cyclical strength in the uS is occurring while
disinflationary pressures continue to impress many market
observers. Taxes on capital flows by Brazil and China’s harsh
warnings (and higher inflation and interest rates) are work-
ing to chase away foreign investors at the same time that an
improved uS investment backdrop is encouraging capital
to remain in the uS. Judging by the now rising dollar, qEII is
staying in the uS. This paves the way for the Fed to complete
its program and raises the odds of qEII’s impact being concen-
trated on uS markets. We have also always acknowledged that
After a “two speed” year, where most emerging economies
were growing too fast while most developed economies were
growing too slowly, the two leading economies – the uS and
China – are now both strengthening as we enter 2011. In Chi-
na’s case, this is not surprising, as its recovery is well behind it
and its expansion phase is the order of the day. Investors have
been unanimously upbeat on growth prospects, as they have
for most emerging markets (EM). However, an unwelcome sur-
prise on the landscape has been China’s sudden burst of infla-
tion. While this inflation was caused by a spike in food prices,
China’s monetary policy will now play it extra safe. China has
experienced very rapid growth in its money supply since 2008.
On top of this, it views quantitative easing (qEII) as more excess
liquidity that could spill over into China. A political leadership
transition in sight for 2012 also argues for more aggressive
monetary policy moves in 2011 to clear the inflation decks.
Most emerging markets are now raising interest rates, with
Brazil and China playing catch-up. Prior to this, economic
improvement in EM was still being nurtured by policy. This
combination (economic strengthening plus policy accom-
modation) is the sweet spot for stock markets. With this new
inflation focus, EM’s new economic backdrop/policy mix is
more neutral for markets. despite overall outperformance
since 2000, periods marked by rising interest rates and a
rising uS dollar often witnessed EM transitioning into market
performers. This is where we see most EM as we enter 2011,
a state likely to continue through most of the first half of 2011,
before reasserting leadership again in the second half, driven
by secular fundamental improvement.
While most were not expecting strength in the uS economy
for years to come, we exit 2010 with surprising and notable
strength. What is truly different this cycle is the housing
overhang, which now serves as a speed limit on this economy
capital markets overview
Michael Kelly, CFA, Global Head of Asset Allocation and Structured Equities
Jose Aragon, Portfolio Manager, Asset Allocation Strategies
7
The peripheral countries — the ones with today’s balance sheet
problems — also unfortunately have income statements that
have priced themselves into uncompetitive situations. Labor
rates in Italy, Spain, Greece and Ireland have risen rapidly since
the euro came into existence. In effect, they are income state-
ment as well as balance sheet workouts – very difficult to fix. In
a market environment where one needs to be able to demon-
strate one’s ability to grow out of an overleveraged situation,
these peripheral countries have had austerity measures forced
upon them. While these austerity commitments received
extensive press earlier in the year, for the most part, they are
only now beginning to be implemented. Their economic drags
will build throughout 2011, potentially making their leverage
situation even worse. With a newly resurgent uS dollar, the
euro is now free to reflect Europe’s impaired status.
Japan
Japan has been a tougher call for us. A strong yen throughout
2010 should have led to export weakness. Yet, as its trade
with its strengthening Asian neighbors surpasses its trade
with the uS and Europe, this has not happened. This is a new
favorable offset to their growth drag caused by their ongoing
demographic shock. Without growth, liquidity cycles have
been the dominant driver of Japan’s markets over the last two
decades. It is not clear whether the Bank of Japan (BOJ) will
now grow its balance sheet more aggressively. The subpar
growth of the BOJ’s balance sheet since the financial crisis
began has resulted in a stubbornly strong yen. We remain
neutral on Japan, without great conviction in how its trends
will play out in 2011.
qEII could not stimulate through the mortgage markets. We
have believed that higher stock prices would boost business
and consumer confidence, encouraging these two sectors to
spend more confidently. This seems to be happening.
In most of the over leveraged developed economies, a key
question has been whether their growth would be fast enough
to enable them to grow their way out of their highly leveraged
situation. While another round of fiscal stimulus had been
written off as politically impossible, a stealth and surprisingly
broad uS $800+ billion stimulus recently took place under
the cover of extending the 2001/2003 tax cuts. The sudden
business-led recovery, amplified by additional monetary and
fiscal accommodation, has ensured that growth would be
adequate to de-lever and de-risk the uS economy. This has
created a new sweet spot in the world’s largest risk markets
at a time where most risk premiums have been very wide.
The uS stock market is now rising rapidly to price in this new
reality, and pulling the uS dollar and Treasury yields up with it.
We see the uS leadership as likely to persist well into the first
half of 2011, as midyear seems to be the earliest point by which
China’s inflation fears could begin to subside.
eUrope
While common in its currency, Europe remains deeply divided
by current prospects and policy approaches of individual mem-
ber states. On their own, their individual damaged economies
are not large enough weights in the equity indices to drag down
the region as a whole. Yet their troubles cannot be brushed
aside, since they continue as a source of potential contagion
through Europe’s intertwined banking systems.
8
2011 Investment OulOOk | capital markets overview
currencies to appreciate further. We continue to like local cur-
rency denominated EM debt over the course of 2011 as a way to
benefit from such currency realignment.
traditional investments
In fixed income, qEII is bringing about a similar pattern in the
yield curve as did qEI. during that earlier episode, in a much
weaker economy, quantitative easing produced a 10-year uS
Treasury bond yield that backed up over 100 basis points within
four months, to 4%. This has begun to repeat, with today’s
backup becoming self-fulfilling as the massive inflows that
had been flooding into bond funds turned negative for the past
several weeks.
despite recent whiplash, our capital market line suggests
that risk-free assets still appear overpriced and vulnerable to
rotation. With markets having moved beyond double dip and
deflation fears, and the Fed determined to ensure a margin of
safety from further disinflation, the secular trend toward disin-
emerging markets
We still believe in secular EM currency strengthening. Outside
of the Chinese renminbi (RMB), this did occur in 2010. In fact,
Brazil even felt it necessary to tax capital flows to discourage
further appreciation. From here, broad-based EM currency
strength probably needs to await more movement on the RMB.
While China is incentivized to continue signaling a very moder-
ate pace of RMB appreciation (so as not to encourage capital
inflows), its focus has shifted toward controlling inflation. At
some point, we anticipate China will come to the realization
that reserve-requirement increases alone are not enough to
contain inflation and that more meaningful interest rate and
currency increases are also necessary.
Overall, currency realignments remain the great healers,
which are in everyone’s current interest. As such, we remain
cautiously optimistic that, in fits and starts, we will evolve
toward a more flexible RMB, clearing the decks for other EM
EXPECTED RISK (%)
EX
PE
CTE
D R
ETU
RN
(%)
US CoreBond
Europe Equity
Japan US Equity
EM Sovereign
3MonthT-Bill
TIPS
Inter Corp
Bank Loans
Fund of Hedge Fund
EM Local
EM Latam
Private Equity
EM Asia
EM EMEA
Taxable Muni
JGBBund
Commodity(DJUBS)
Unlevered Real Estate
US High Yield
ISC
Long Credit
US Treasury (5-7)
EM Corp
Emerging Markets
The size of the dot corresponds to the average correlation of the asset with the other asset classes, larger is higher correlation. The color corresponds to the liquidity of the asset class as indicated in the key below.
0 5 10 15 20 25
0
2
4
6
8
10
12
14
16
18
20
22
Liquid
Asset May Experience Impaired Liquidity
Illiquid
FIGuRE 1 CAPITAL MARkETS LINE (as of 17 December 2010 )
See disclosure for asset class definitions
9
energy outlook in 2011. The indices could have a stronger year,
even while most commodities rest with a stronger dollar.
Hedge funds spent the first part of the year de-levering and
the second part of the year being whipsawed by stop and go
markets. We suspect that, with more sustainable economic
fundamentals in 2011, market trends will themselves be longer
lasting and easier for most hedge strategies to exploit.
Toward year end, our interest began growing in private equity
for the first time in many years. dry powder continues to hold
back the asset class at large. Yet, the unwillingness of most
to invest in this space is allowing this risk premium to reprice,
just as some improvements are beginning to occur in the
underlying portfolio cash flows and the ability to exit. While
this divergent asset class at large is still a bit below our CML,
pockets always exist. Today’s dry powder is disproportionately
represented among the bigger players and larger deals. The
mid-market is the pocket that is beginning to appeal to us. This
segment has not been able to benefit from high yield issuance
and continues to be ignored by the regional banks that never
rebuilt their equity and continue to suffer from commercial
real estate fears. Mid-market lenders have shrunk in numbers
over the past several years from approximately 100 special-
ists in the uS to 30 occasional dabblers today. Such neglect,
combined with improving fundamentals, offers value. Finally,
growth-orientated private equity, centered on Asia, also still
has great appeal.
flation is likely coming to an end. If so, this would also mark the
end to the historically unprecedented 30-year bull market in
government bonds. during this period they not only provided a
powerful tailwind to most other forms of fixed income, but also
outperformed many equities.
Credit spreads were at fair value going into this risk-free
backup, not wide enough to offset the upward shift in the
risk-free curve. A challenge entering 2011 is that companies
are changing their priorities away from bond-friendly uses of
cash (debt pay down), toward equity-friendly actions (higher
dividends, acquisition, investment spending). This backdrop
leads us to favor equities in general over fixed income. Of
course, opportunities will still exist within fixed income, simply
in different types of fixed income. As short-term interest rates
eventually rise to preempt inflation, this will begin to favor
floating rate instruments, such as bank loans. Higher yielding
asset classes, such as non-investment grade corporate and
EM bonds, still offer some spread narrowing potential which
could offset part of the back-up in the risk-free curve.
alternative investments
In alternatives, our preference has been for the more liquid
commodities and hedge fund spaces. Most commodities had
an extremely good year, even though the major indices were
more sluggish, weighted down by large energy weightings.
Energy was the only major commodity that did not have a very
strong year. Yet, supply and demand argues for a stronger
ALTERNATIVE INVESTMENTS
Alternative Investments Overview 12Hedge Funds of Funds 14developed Markets direct Investments 16Emerging Markets Private Equity 17Private Market Fund Investments 19Private Equity Secondaries 22
12
2011 Investment OulOOk
2011 oUtlook
Looking ahead, we believe a variety of direct and indirect
consequences of the past few years’ tumult will have a last-
ing impact on the alternative investment landscape. These
changes will help to define areas of investment opportunity, as
well as the competitive landscape itself.
Over the near term, we believe the market dislocations, which
have defined much of the past few years, will continue to
present opportunities. For example, we believe the overuse of
leverage in many areas of the buyout world and near elimina-
tion of entire sectors of credit providers will present continued
opportunities for providers of flexible and more innovative
financing solutions. In addition, the considerable effort spent
by general partners on protecting and improving their port-
folio companies through recent periods has helped to refine
and improve investment practices, which will hopefully pay
dividends within and beyond current portfolios.
Meanwhile, institutional investors are implementing more
sophisticated and dynamic risk-based approaches to asset
allocation decisions. These changes will present opportunities
to market participants who wish to rebalance their portfolios
to reflect these new paradigms and investment approaches.
Certainly, all of this change will present challenges for inves-
tors. Whether making allocation decisions between existing or
newly defined asset classes or navigating the attractive, but
diverse, opportunities across emerging markets, investors will
be well served to align with partners who can enhance their
own capabilities.
2010 recap
While far from a straight line recovery, the broad trends
across alternative investments were positive when reviewing
2010 as a whole. As expanded upon in the coming alternative
investment subsections, the year certainly included a fair
amount of volatility and the economic climate had a diverse
impact across subsectors and individual market participants.
However, with investment realizations picking up and signs of
increased movement among investors in deploying capital, the
tide does seem to be shifting, if not reversing entirely, from the
challenges of the past few years.
For example, private equity buyout-backed exits rebounded in
2010, with a 62% increase in the number of exits, and a 245%
increase from 2009 in aggregate exit value.1 Globally there
has also been a 29% increase, year-to-date, in the number of
private equity deals announced, compared to 2009, with an
aggregate deal value coming in at 220% over 2009’s total deal
value. Emerging markets’, particularly Asia’s, proportion of
the deal activity is growing rapidly. As can be expected, the
fundraising environment is still volatile, but recent data shows
emerging-markets-focused funds have already matched
2009’s total fundraising, while funds focused on North America
or Europe are capturing less attention and assets.
alternative investments overview
Robert Thompson, Head of Alternative Investments
1. Source: Preqin, data as of December 13, 2010
13
of this evolution of the alternative investment landscape will
materialize in various ways, such as the need for newer and/or
smaller managers to more quickly reach scale. Such pres-
sures will likely play out through consolidation activity as well
as through growth in seeding programs across the alterna-
tives spectrum.
From a competitive standpoint, we believe the landscape
across alternative investments will continue to evolve in
meaningful ways. We believe we will continue to see a grow-
ing polarization between highly focused investment managers
and those seeking to leverage or gain the scale necessary to
capture opportunities across multiple asset classes. Both of
these poles will see their fair share of consolidation and shifts
in strategic focus.
Hedge fund managers will also have to consider a variety of
factors that range from the macroeconomic to the political.
Western economies are allowing interest rates to remain low
and are pursuing further quantitative easing to stimulate lack-
luster growth. Corporate balance sheets are strong and could
be deployed toward acquisitions. World demand for commodi-
ties will also continue to pick up. All of these factors will create
opportunities that can be exploited by savvy managers.
A meaningful change is underway in the relationship dynamic
between investors and asset managers. This includes specific
developments like the issuance and significant adoption of the
Institutional Limited Partners Association guidelines, which
will further align the general partner-limited partner relation-
ship with transparency. It also involves a notable shift toward
investors seeking more substantive strategic partnerships,
bridging the historical “investor-manager” divide. The impact
14
2011 Investment OulOOk | alternative investments
the prospect of quantitative easing pulled the uS dollar lower.
Commodity markets were very erratic at times in 2010. On bal-
ance, gains were made from long commodity exposure. Long
exposure to fixed income was generally profitable throughout
the year during both risk-aversion and risk-seeking periods.
As more time passes from the 2008 financial crisis and we
look toward 2011, the markets are focusing more on individual
country fundamentals and divergent growth expectations.
Macro managers see opportunities as monetary policies
diverge between countries and regions. With this, they have
increased their activity in the fixed income markets globally.
In Western economies, managers see opportunities to play
the ramifications of interest rates remaining low and further
quantitative easing. In commodity-oriented and emerging
economies, they see opportunities to speculate on the tim-
ing of interest rate hikes. With the expectation of continued
recovery in emerging Asian economies and lackluster growth
in the West, managers are biased toward long positions in
emerging market-currencies versus short ones in Western
market currencies.
In commodities, managers believe world demand will continue
to pick up and they remain constructive on commodities over
the longer term, as many markets are trading at or below
cost of production. Managers maintain exposure in industrial
metals and energy as a result. In agricultural commodities,
weather and reduced supply are the driving factors. Managers
continue to hold corn, soybeans and cotton.
Equity Long/Short
2010 was, in many respects, a rollercoaster ride for equity
markets, with large movements – up and down – from one
month to the next. One driving factor was the economic data
from the united States, which was seemingly bearish one
month, only to turn more positive the following month. despite
formidable macro headwinds at times, strong corporate
earnings gave equity markets a boost. On several occasions
in 2010, we commented on the compelling valuations many of
our hedge fund managers saw. However, the uncertainty of the
macro backdrop, coupled with the elevated correlation levels
witnessed in the first half of 2010, held many back from fully
putting on risk.
2010 recap: “see-saw”-like markets
The last year has witnessed tremendous monthly swings in
financial markets, which have impacted both hedge fund and
traditional managers alike. By the end of the first quarter, it
seemed like 2010 might be a continuation of the broad-based
rallies witnessed in 2009. However, back and forth risk-seek-
ing behavior, followed by risk-averse behavior, led to a “see-
saw”-like phenomenon in 2010.
A number of issues created macro and political headwinds in
2010, including the ongoing eurozone debt crisis, the 6 May
2010 “flash crash,” high global unemployment, a worsening uS
housing market, China’s monetary tightening, the largest oil
spill in uS history, and the passage of uS financial and health
care reforms and the resulting uncertainty in those sectors.
Combined, these have sparked fears of a global slowdown.
We commented one year ago that the quantitative easing and
zero-interest-rate environment would need to be unwound.
One year later though, the uS Federal Reserve is poised to
start a fresh round of quantitative easing. ultimately, fiscal
stimulus will likely be paid for through future tax increases,
which, in combination with demographics, will restrain devel-
oped market consumers in the cycle ahead. Across strategies,
managers are contemplating the potential impact of these
factors on both an absolute and relative basis across markets.
The managers in our hedge funds-of-funds are staying liquid
and flexible across strategies, concentrating on individual
fundamental ideas, and avoiding momentum-driven beta
plays. Within the major strategies employed by the hedge fund
managers in our portfolios, we see the following trends and
opportunities as we look ahead in 2011.
2011 oUtlook: staying liqUid and flexible
Global Macro/CTA
Risk on/risk off sentiment drove the markets throughout 2010.
Gains were made in short euro positioning in the first half of
the year and short uS dollar positioning in the second half, as
HEdGE FuNdS OF FuNdS
Robert Discolo, CFA, Head of Hedge Fund Solutions Group
15
Looking forward to 2011, our managers expect merger deal
activity to remain robust. The current economic conditions,
which include strong corporate balance sheets, low organic
growth rates and low interest rates, are favorable for sus-
taining deal activity. In addition, equity markets appear to
favor acquirers who are involved in accretive strategic deals.
Industrial companies in the S&P 500 Index continue to hold
lofty levels of cash. The latest figure available shows a cash
level of uS $843 billion, up from uS $773 billion a year earlier.
This equates to 11.6% of its market capitalization, which is a
record high according to S&P. It is expected that corporations
will start deploying some of that cash toward acquisitions.
In credit markets, the looming wall of maturities is still
expected to provide distressed opportunities. According to JP
Morgan High Yield Research, approximately uS $815 billion of
high yield bonds and leveraged loans are set to mature through
2014, as of 30 September 2010. As a result of the significant
refinancing over this past year, the maturity pool has been
reduced by 20%. However, our managers believe that there will
be a large divergence between higher-yielding companies that
can access the capital markets and those that will not have
the ability to do so. Most companies that recently refinanced
were higher-quality companies and, thus, less likely to become
distressed. Lower-rated credits still make up a large portion
of the market and will likely be significant contributors to the
supply of distressed debt.
As we look ahead to 2011, net exposure is still limited (rela-
tive to historic levels), and the recent run-up in the markets
has tempered the excitement level of some, as valuations in
various areas have grown substantially. Financial and health
care stocks still remain under the cloud of political uncertainty
in the uS, and many stocks in these areas, along with certain
global leaders in their respective industries, sell at potentially
appealing levels.
Manager portfolios are fairly full from a gross exposure stand-
point, and many of our managers are finally deploying normal
amounts of capital to top long and short names, similar to lev-
els in 2006 and 2007. Although some managers are concerned
about valuations, the majority of our funds still see enough
opportunity to build a robust long portfolio. On the short side,
some managers shifted exposure back to index/custom ETF
baskets during the late third-quarter rally. However, a stabili-
zation in equity indices would, most likely, allow these manag-
ers to shift back to their individual short ideas.
Event/Multi-Strategy
Risk arbitrage spreads tightened considerably over the course
of 2010. Plain vanilla deals generally traded at unattractive,
single-digit, annualized spreads, but situations involving
hostile transactions and unique scenarios provided profitable
opportunities. The complexity of these transactions allowed
our managers to utilize their expertise and deep understanding
of the space to dynamically trade around positions properly,
using both equities and options.
The increase in hostile bidding situations resulted in record
levels of deals trading with negative spreads. According to
Barclays Risk Arbitrage Research, on average, 26% of deal
value was associated with negative spreads in 2010. These
complex situations provided our managers with an opportunity
to creatively structure risk arbitrage trades with stocks and
options for favorable risk/reward profiles.
In credit markets, the rally that started in 2009 extended
through 2010, despite fears of sovereign and municipality
risks. during risk-seeking periods, profits were earned across
the credit spectrum. Restructuring opportunities and post
reorganized equities were accretive.
16
2011 Investment OulOOk | alternative investments
Extending and optimizing supply chains to source inputs and •
procure finished goods at the lowest possible cost.
Enabling technologies that will allow them to deepen their •
ties to customers, suppliers and other business partners.
Of course, capital in its various forms (i.e., financial, tangible,
knowledge-based or human) will be required to fund these
advances. unfortunately, many mid-sized companies continue
to be constrained by relatively high levels of leverage on their
balance sheets and, unlike their large-cap brethren, remain
unable to secure all of the debt needed to finance growth.
This supply-demand imbalance favors private capital
providers, as middle-market firms typically cannot access
the public bond markets. In addition, many of their traditional
lenders, such as regional banks and collateralized loan
obligations (CLO), have reduced their new issue volume or
curtailed their lending altogether. While these institutions
will either eventually become more active or be replaced by
new entrants, we do not anticipate a return to the excesses of
recent years, when capital was abundant and cheap.
As an established investor in middle-market companies,
we believe there will be a surfeit of attractive opportunities
over the coming years to support leading firms that require
capital for growth. Going forward, we will remain focused on
identifying companies that possess a strong, fundamentally
sound core business model and that simultaneously offer
the prospect of incremental gains (i.e., returns) through the
successful exploitation of expansion opportunities. In addition,
we will continue to seek transaction structures that optimize
the risk-reward equation by combining contractual returns
with exposure to equity upside, and that allow us to provide the
capital that will help the world’s top middle-market companies
to augment their businesses and enhance their leading status.
2010 recap: the strong sUrvive and prosper
In contrast to 2009’s volatility, the last 12 months have been
characterized by a slow, but steady, recovery in developed
markets private equity. Transaction volume was up over the
prior year’s levels, as strategic and financial buyers returned
to the marketplace. In addition, financial performance across
many sectors improved, though these gains were largely
concentrated among market leaders.
We believe that these firms succeeded because they pos-
sessed the strength in their brands, product portfolios, market
share and management, to remain relevant throughout the
downturn and emerge well-positioned to leverage their
prominence once the recovery began. As a result, in 2010 many
of these leading companies experienced an uptick in demand,
which also tended to translate into strong earnings growth as
a result of efficiencies that were realized in the wake of last
year’s focus on cost reduction and productivity gains.
These signs of progress are obviously encouraging, but we
remain realistic in our outlook and anticipate an environ-
ment that will be characterized by further tepid growth in
North America. Accordingly, we will continue to work with our
management teams and financial partners to identify invest-
ment opportunities that will facilitate growth and make each
company’s business model more compelling – even if the
economy remains somewhat lackluster.
2011 oUtlook: time to capitalize on growth opportUnities
Over the next 12 months we expect many firms to enhance
shareholder value by:
Establishing a presence in, or further expanding into, new •
markets, with a particular focus on faster growing regions,
such as Asia and Latin America.
Enhancing customer utility by developing new products and •
improving existing ones.
dEVELOPEd MARkETS dIRECT INVESTMENTS
Scott Gallin, Managing Director, Vantage Partners
17
Asia
Asia’s strong fundamentals and diversified growth drivers
make this an interesting region for private equity investing.
While a large amount of private equity capital has flowed into
the region, we believe there are still many opportunities to
achieve healthy returns.
In Asia, much of the focus is on India and China. The consoli-
dation of their economic strengths and their extension into
new domains create many opportunities. Skilled labor and a
well-educated workforce, combined with comparative advan-
tages in terms of labor costs and productivity, provide further
opportunities. Sectors benefiting from the domestic consump-
tion boom, enterprises moving up the value chain, sustainable
development and infrastructure are some of the areas with
tremendous promise for private equity investors.
The exponential growth in India and China has instilled
confidence among private equity investors and there has been
a sharp increase in country-specific funds in addition to pan-
Asian regional funds. Given the size of these countries’ econo-
mies, we believe that they are better suited for such funds, and
this is further supported by the socioeconomic conditions.
South korea and countries in Southeast Asia, while currently
in the shadows of India and China, also continue to present
worthy opportunities and flows.
CEE
Prospects in Central and Eastern European (CEE) countries
are currently not as favorable as some of the other emerg-
ing markets, but have continued to show economic recovery,
supported by healthy external demand and an improving
domestic demand environment. However, sharp differences
in the speed of the economic recovery remain, with Poland,
the Czech Republic and Slovakia moving faster than Bulgaria,
Romania and Hungary. The major challenge for the CEE
economies is to balance this pace of growth with the urgent
need for further fiscal consolidation. Poland, for example, has
proved to be Europe’s most determined economy, being the
only one avoiding a recession. Having its own currency and
being outside of the eurozone has been a positive for Poland’s
2010 recap: resilience and recovery
Emerging markets economies have proved to be resilient
against the financial crisis, and growth during 2010 has been
robust. Therefore, it is of no surprise that there is also a strong
recovery underway in emerging markets private equity, which
has led to the investment pace picking up significantly post-
crisis. The primary forces driving the pace of private equity
investing in emerging markets are superior GdP growth driven
by growing domestic consumption; resilience against the cur-
rent financial crisis; improving socioeconomic environments;
and improved governance and standards.
To date, private equity investments in the emerging markets
have been led by continued strong activity levels in China and
India and an investment surge in Latin America.
2011 oUtlook: robUst growth and less risk
The relative attractiveness of private equity investing is
shifting to emerging markets, and investors have started to
embrace emerging markets private equity, increasing their
allocations to these geographies. This has led to a number of
private equity firms rushing to participate in and capitalize on
the anticipated capital flows from investors.
One question that naturally arises is “Which model will work
and in which markets?” For the general partners tradition-
ally pursuing the developed markets buyout model, there will
be many hurdles to overcome for success. The International
Finance Corporation, a long-term investor in emerging
markets private equity, has found that in emerging markets,
minority investments have produced considerably higher
returns than majority stake investments and that funds with a
solid local presence and experience are advantaged.1
EMERGING MARkETS PRIVATE EquITY
Kristina Matthews, Managing Director, Emerging Markets Private Equity
1. BCG and IESE (2010). New Markets, New Rules: Will Emerging Markets Reshape
Private Equity?
18
2011 Investment OulOOk | alternative investments
low production costs gives Brazil advantages in global trade,
with exports helping propel growth and providing substantial
trade surpluses. Brazil is seeing a very high level of interest
from both investors and private equity firms. New entrants are
looking to participate in the private equity market, and global
private equity firms are seeking to expand their reach and reap
the potential benefits from investing in Brazil. As with other
emerging markets, the diversified consumer base and growth
in domestic consumption represent the key drivers for sectors
where there will be exceptional growth and solid opportuni-
ties for meaningful private equity returns. The upcoming 2014
FIFA World Cup and 2016 Olympic Games in Brazil also provide
optimistic backdrops.
Conclusion
With PineBridge’s long history in emerging markets, local
teams and preference for growth equity investing, we are very
encouraged by the numerous opportunities presented by the
robust growth seen in most emerging markets countries.
For investors, there is a powerful argument in favor of emerg-
ing markets not just in the year ahead but for years to come.
economy. Poland’s floating currency has acted as a buffer and
has helped keep Polish products competitive in world markets
as a whole, not just within Europe.
Gateway Region
We believe the “Gateway” region, which we consider as Turkey,
the Middle East/North Africa, Sub-Saharan Africa and Russia/
Former Soviet union, is the fourth emerging market (after
Asia, Latin America and emerging Europe).
From an investment standpoint, this region is quite excit-
ing. It is the predominant natural resource basin of the
world, with rich endowments of numerous critical natural
resources, including approximately 80% of the world’s oil
and gas reserves, as well as a number of important minerals
and extensive agricultural production. The Gateway region
presents substantial broad-based growth prospects at levels
projected to greatly exceed developed markets, underpinned
by not only natural resources, but also convincing demograph-
ics, increasing cross-border M&A activity, direct investment
and trade.
Brazil
In Latin America, Brazil presents a compelling investment
story, with promising long-term GdP growth rates and a
strong and diverse consumer base stemming from rising
disposable income. The abundance of natural resources and
19
Liquidity and valuations improved in most private equity
portfolios. However, the importance of manager selection,
diversification and a forward-looking investment strategy
continued to be paramount in generating excess returns.
Further, concentration on managers who adopt/take on an
intense operating model served investors well, as some funds
and companies were better positioned than others to transition
into offense from defense.
Many investors expected the recession would create abundant
opportunities to buy companies “cheaply.” This did not quite
happen. The rebound and bottoming process occurred quickly
enough that many investors did not even realize it had hap-
pened. However, the improving capital markets, the increase
in availability of debt and increased confidence on behalf of
buyers and sellers helped to drive transactions in 2010.
Although prices paid could not generally be characterized
as cheap, valuations were based on lower levels of EBITdA,
with less leverage and more in line with historical averages.
distortions remain at the margin of the risk/reward continuum,
but many transactions remain attractive and should position
investors to generate returns well in excess of public market
equivalents. The return per unit of risk is even more attractive
in private credit markets and the opportunity set remains large
and fragmented.
Finally, fund investors were reminded of the importance of
being diligent in their portfolio monitoring and staying on top
of developments at the general partner level, as well as the
underlying portfolio company level. For example, maintaining
advisory board seats on funds enables investors to provide
advice and better shape their exposure to a particular fund,
and also provides critical market intelligence and perspective
that helps optimize decisions for other parts of their portfolio.
Our intense focus in this area helped us avoid certain pitfalls
faced by other investors.
2010 recap: divergent paths in recovery
Although 2010 can be generally summarized as a year of
recovery, upon deeper probing a path of divergent recoveries
becomes evident. The contrast is seen in the growth rates of
developed versus emerging economies, financial performance
and flexibility of large versus small companies, investment
performance of investment grade versus high yield bonds,
actual and/or perceived benefits of stimulus versus austerity,
and the list goes on.
The cost-cutting initiatives that were first implemented in 2008
continued to bear fruit in 2010 with earnings and cash flow
benefiting from cost structure resets and scaled back capital
expenditure programs. Many companies have a high degree
of operating leverage and are positioned well for recovery, but
revenue stability and gains are elusive, depending on sector,
size, geography and so on.
Capital markets in 2010 continued to show depth and resil-
ience. Private equity portfolios have benefited from robust
capital market activity, whether through investor interest in
junk bonds or initial public offerings (IPO). The debt markets
continued to support the “amend and extend” phenomenon and
even showed appetite for dividend recaps. This balance sheet
activity has allowed companies to lower their costs of capi-
tal, extend maturities, and help to return capital and protect
internal rates of return, as investment holding periods have
been extended.
Further, IPO demand has not only provided an exit alternative
for healthy growth companies, it has also provided a lifeline
and currency to companies that, up until recently, seemed to
have few options. While this is all good news for private equity
investors, it is important to note that this activity has almost
solely benefited large-capitalization companies. There have
been some knock-on effects, but small-capitalization compa-
nies continue to lack access to the liquid public markets, and
the number of private market lenders has dwindled to a small
fraction of its 2007 highs/levels.
PRIVATE MARkET FuNd INVESTMENTS
Steven Costabile, CFA, Head of Private Funds Group
20
2011 Investment OulOOk | alternative investments
Further, with public equity and debt markets not as deep as
those in the developed economies, private equity is gaining
acceptance as an alternative and viable funding source for
growth and expansion investments.
Our primary focus for capital commitments in 2011 will be
toward debt strategies, with a secondary focus on the resump-
tion of our next global growth and small- and middle-market
initiatives.
Our analysis indicates that the highest risk-adjusted returns
will be generated by a portfolio of funds positioned primarily
for rescue capital and new issuance of senior and junior debt,
as well as opportunistic distressed investments and secondary
purchases of debt. We believe a portfolio of funds in this space
can generate 18-20% IRRs with the majority of return coming
from current cash yield. The new issue market for rescue and
other similar financings has attractive loan-to-value (LTV) and
is based on trough multiples and cash flows. Further, these
investments have meaningful call protection, better covenants
and improved documentation.
There is no shortage of credit funds raising capital, nor a
shortage of deal flow, but investors need to be very careful
in conducting due diligence on managers’ credit selection,
because they will likely not be rewarded for “buying the mar-
ket.” We plan to invest in smaller funds (i.e. fund sizes below
uS $750 million) because, in our view, the real opportunity
is with managers targeting smaller companies that cannot
access the traditional liquid credit markets. Investments in this
space should generate returns in excess of 1,000 basis points
over the public high yield market.
The secular and cyclical deleveraging cycle will also pres-
ent opportunistic windows of distress and special situations,
where inventory will require granular, complex credit analysis
for opportunities that can generate unlevered mid-to-high
2011 oUtlook: generating excess retUrn by playing offense
The headwinds that adversely affected markets in 2010 will
continue to challenge them in 2011, but the key will be pick-
ing regions, sectors and funds that will help to ensure excess
returns, regardless of the macroeconomic environment.
The private credit markets in the uS and Western Europe will
continue to provide opportunity throughout 2011. The secu-
lar void of traditional financing, muted growth environment
and impending leveraged loan and high yield maturities will
continue to create opportunities. Opportunities will be espe-
cially acute within the middle market (defined as companies
with less than uS $100 million of EBITdA) where companies
lack capital structure flexibility, asset optionality and depth of
resources. Secondary debt markets will be active, but “buying
the market” will be much less rewarding, and return prospects
for senior debt will likely revert to historical averages.
In the private equity markets of the uS and the uk, France
and other parts of Northern Europe, a focus on managers and
funds who invest in small- and middle-market enterprise valu-
ation companies should generate disproportionate returns.
Specifically, a focus on managers who have strong operat-
ing and buy-and-build expertise will help drive growth and
returns. In addition, debt-to-equity conversion strategies and
operational turnarounds will also become more prevalent and
generators of good risk-adjusted returns.
Although investments in the regions do not come without
considerable risk, the developing economies of Asia and Latin
America will be a bright spot for investments. These regions
continue to demonstrate the best prospects for continued
and sustainable economic growth, based on strong underly-
ing economic fundamentals; large population bases with
favorable demographics; rapid urbanization and the rising
affluence of a middle income class; as well as a shift from
export-dependent to domestic consumption economies.
21
teens returns. The sellers will generally be uS, Western
European and Japanese financial institutions, sovereign enti-
ties and structured vehicles seeking liquidity. Here, again, the
opportunity set is large and diverse, but manager selection
will be key.
Within credit, we are more focused on the uS fund opportunity
set, but we will pursue some developed Europe opportunities
as well. However, in Europe our required rates of return are
higher, due to less mature credit teams and the vast diversity
in jurisdictional corporate and bankruptcy laws.
In addition, our team has had a long-term focus on global
small- and middle-market equity investing for over 10 years,
and we continue to believe that the best risk-adjusted returns
in control and significant minority investments will be at this
end of the market. In the uS and Europe, we will be somewhat
sector-agnostic and focus largely on existing control-oriented
managers seeking to raise less than uS $1.25 billion.
The highest returns in Asia and Latin America will generally be
driven by newer teams/firms, and having entrenched relation-
ships on the ground is critical in these regions. In Asia, we will
invest in GPs pursuing minority and growth equity investments
in China and India, and in Latin America, we will focus on man-
agers investing in Brazil and the Andean Region (Peru, Chile
and Colombia). The number of market players in this area of
the market can be overwhelming, and due diligence and man-
ager selection will continue to be paramount. To complicate
matters, the nuances change according to geography.
Although the investment landscape continues to become
more complex, the reset in the marketplace and the continued
deleveraging has us extremely excited about 2011 vintage
funds. We expect that returns generated by this vintage, on a
risk-adjusted basis, will be extremely attractive and capable of
generating significant premiums over the comparable public
opportunity set.
22
2011 Investment OulOOk | alternative investments
with many investors now more focused on reallocating their
portfolios across strategies, geographies and managers that
are best aligned with their investment objectives.
The recovery of debt markets from their darkest days in late
2008 and 2009 is one factor driving the liquidity many private
equity investors are experiencing in their portfolios. Much of
the portfolio company debt due in the next several years has
either been refinanced or is in the process of being refinanced.
In addition, private equity sponsors have been able to access
high yield markets to induce liquidity events in their portfolios
as evidenced by the recently announced debt offering by kkR
and Bain Capital for hospital operator HCA, which funded a
uS $2 billion dividend to limited partners. To a lesser extent,
an improvement in middle-market lending has also increased
liquidity for middle-market sponsors. Finally, financial sponsor
acquisitions have picked up and the IPO market has improved,
both of which are expected to be active drivers of liquidity in
the private equity market in 2011.
Secondary asset pricing has increased since the trough of the
financial crisis, as buyers have accounted for better funda-
mental portfolio company growth expectations, less macro
uncertainty and shorter durations. Likewise, sellers have
adjusted their expectations upward as well. Given that there
still remains some market uncertainty, pricing has not yet
returned to levels seen in the pre-crisis period, and we believe
pricing will be unlikely to return to prior peaks over the course
of 2011. Our expectations are that discounts to NAV on average
will hover somewhere in the 0% to 20% range throughout 2011,
depending on the type and quality of assets and the size of the
transaction. We also expect that the bid-ask spread will be
small enough to enable buyers and sellers to transact.
While a continuation of significant transaction volume should
be welcome news to secondary market investors, success in
today’s secondary market is contingent upon an opportunistic
investment approach. It will be critical for buyers to maintain
2010 recap: strong deal volUme
This time last year, when we took a moment to reflect on
trends facing the private equity secondaries market, buy-
ers had substantial capital, sellers were still challenged by
liquidity issues, and the bid-ask spread between the two was
converging. We suggested that all signs pointed to 2010 being
a significant year for secondary transactions – an outlook that,
over the course of the year, proved to be true. 2010 second-
ary deal volume is estimated to reach uS $20.0 billion.1 This
amount of activity is well beyond 2008 and 2009 volumes of uS
$16.4 billion and uS $8.8 billion respectively, making 2010 a
record year for the industry.
2011 oUtlook: another strong year for deal volUme
As we look forward, market trends suggest that strong deal
volume will continue into 2011. Perhaps the most telling indica-
tor – the demand and supply dynamics seen in 2010, are likely
to carry over into the next year.
On the demand side, secondary buyers began to put to work
the war chests of capital they amassed over the prior few
years, driving record-high transaction volume in 2010. As we
look forward to 2011, buyers are no longer as flush with dry
powder, but they still have adequate capital on hand for deal-
making and are likely to remain very active in 2011.
On the supply side, while seller motivations have shifted with
the financial market recovery, sellers continue to utilize the
secondary market to serve their portfolio needs. Most private
equity investors have seen a rise in the net asset value of their
total portfolio and more cash-generating liquidity events. Both
of these have steered sellers away from distressed transac-
tions. In the absence of distressed sales, rebalancing has
emerged as a catalyst for transactions after the financial crisis,
PRIVATE EquITY SECONdARIES
Harvey Lambert, Head of Private Equity Secondary Investments
1. Dow Jones Guide To The Secondary Market Buyers 2010, Probitas Partners.
23
flexibility in sourcing and underwriting the transactions they
believe will provide the best risk-adjusted returns. Buyers
will need appropriate motivation to carry out small transac-
tions, as well as the resources to conduct large portfolio
deals. They will need the capabilities and experience to
underwrite transactions across strategies, geographies,
funds and direct investments. And finally, buyers will need the
network and ability to source transactions outside of broadly
offered portfolio auctions.
The ability to be flexible while maintaining investment disci-
pline will continue to set leading secondary investors apart
from the pack and will remain all the more important in the
active market expected in 2011.
24
2011 Investment OulOOk
LISTEd EquITIES
Developed Markets Equities Overview 26European Equities 28Japanese Equities 30uS Equities 32Emerging Markets Equities Overview 34African Equities 36Asian (ex-Japan) Equities 38Latin America Equities 40
25
26
2011 Investment OulOOk
tries. As of 6 december, Germany was up almost 17% year-
to-date in local currency terms, while Spain (the S in the PIGS
acronym), was down 17% in euros. Germany has experienced
fantastic export growth and is one of the countries benefit-
ing the most from the continued growth in China. Peripheral
Europe has, over the years, lost its competitiveness and it
will now be a painful process adjusting back to what will be
sustainable over the longer term. We do find plenty of Euro-
pean companies that look attractive through our investment
process, however, and our global portfolios have a noticeable
exposure to truly world class European companies.
The Japanese market, measured in local currency terms, is
again a laggard among world equity markets. We do note the
historically low valuation levels with, for example, Japanese
companies’ dividend yields being higher than their 10-year
bond yields on average. This is a situation that typically does
not last for very long, and this very underowned market is,
toward the end of 2010, looking more attractive to us than in a
long while. We have closed our underweight position to Japan.
developed Asia is the region we overweight the most in our
global funds. We believe that the combination of access to fast-
growing China (and the rest of Asia) and the very low interest
rates will generate pockets of very significant performance for
certain Asian stocks.
What a year. There was a lot of talk about the “new normal”
during 2010, but we would certainly hope that what we expe-
rienced during the year is not actually the new norm, as the
markets were extremely volatile and the rollercoaster was
hard to follow. The market, as exemplified by the main uS
stock market index, the S&P 500, correcting 7% or more as
many as five times during the year, with the longest of those
corrections taking three weeks. There were plenty of less-
than-comfortable moments in a market with rapid sell-offs,
but in between we also had some stellar runs, with the S&P
500 recording a solid 10% year-to-date gain as of 6 december.
This was more than supported by a steadily improving earnings
outlook, as companies, on aggregate, kept on beating analysts’
earnings expectations for each of the reporting seasons.
Given continued, quite cautious, guidance from company
managements, despite better-than-expected earnings each
quarter, the ever-increasing estimates supported the mar-
ket, even in times of an uncertain macro backdrop. Earnings
estimates for 2010 rose 12% on average through the year. We
believe that uS companies can continue to generate strong
results, in excess of what market participants are currently
discounting, and favor uS as our preferred developed market
in our asset allocation accounts.
It was once again confirmed that Europe is not a homogenous
region, as the difference in actual economic development and
stock market appreciation was widespread between the coun-
developed markets equities overview
Robin Thorn, Head of Global Equities
27
While we cannot guarantee that the markets will be less vola-
tile in 2011 than they were in 2010, one certainty is that skillful
stock-picking will likely be in vogue again. The high correla-
tions between stocks experienced through most of 2010 will
most likely not be seen again for quite some time, and lower
correlations are good news for a truly active stock-picker.
For our fundamentally-driven active equity products, we strive
to have a very high active share – a measurement of active
management that shows the percentage of a portfolio that is
not in the index – with a goal of reaching 90% or above. diverg-
ing from the index, in our opinion, is how alpha can be added.
Good stock-picking ability in combination with prudent risk
management is how consistent returns can be generated. Let
us all look forward to a better-than-average stock market year
with many alpha opportunities, but without the rollercoaster
ride that markets took us on in 2010
28
2011 Investment OulOOk | listed eqUities
2011 oUtlook: balance sheet cash is ready to deploy
Corporate balance sheets are in good health and so the outlook
for 2011 appears to offer the potential for more spending. This
will likely come in the form of higher cash returns to share-
holders, M&A activity and increased capital expenditures. The
distribution of this investment will impact the degree of sales
growth we see over the coming years, but simply releasing the
cash in any form should help to drive demand.
Given the still high levels of uncertainty facing the global
recovery and the sovereign funding issues in Europe, it appears
likely that management of European companies will remain
prudent. The strong recovery in equity prices over the past two
years has led to sellers demanding high prices, which has, thus
far, limited the number of acquisitions seen, despite very low
funding costs.
The M&A activity will be a particularly important theme
for small-cap equity markets in 2011. In fact, we began to
experience a rebound in such activity in the second and third
quarters of 2010, despite summer doldrums. Many of the bids
have been by companies making strategic in-fill acquisitions,
as opposed to private equity buyers bidding up multiples,
supporting our thesis of attractive valuations. In an environ-
ment where top-line growth has been scarce, an accretive
acquisition is one way to achieve this goal. Many recent targets
have been small-cap companies that can be easily bolted on to
larger businesses.
Capital expenditure has already started to improve and
companies in industries ranging from mining and energy to
telecoms are planning to invest more for growth in 2011. This
“capex” remains a good deal below levels seen in 2007 and
2008, but should show a marked improvement in 2010. Eco-
nomic data in “Core Europe” is supportive of this, and markets
like Germany and Sweden continue to be buoyant for both
corporates and consumers.
2010 recap: cost cUtting and agility drove sUccess
The past year has seen a dramatic improvement in the cash
returns and profit margins of many listed companies in
Europe. This has been achieved despite relatively lackluster
growth in sales. Companies were quick to adjust their cost
bases during the recession and have been shy about adding
cost or capacity in the upswing. This has led to significant
improvements in productivity. The relatively high levels of
unemployment in Europe have allowed firms to achieve this
without pushing up wages. Whether this situation persists will
depend on top-line growth.
Over the last 12 months, smaller companies in Europe and
globally have defied the laws of gravity, outperforming large
caps on a relative basis and increasing in value absolutely.
This was not unexpected, as small-cap stocks have historically
come out of recession faster, due to their size and nimbleness.
do the valuation multiples look stretched? Over the last
12 months, despite strong performance, they are trading
broadly in-line with historic levels, but with potential earn-
ings upgrades continuing to flow through, current valuation
multiples may even be cheap. In addition, the divergence of
small-cap returns between the local markets is very apparent,
with the indebted peripheral countries declining significantly:
Greece -50%; Ireland, Italy, Spain and Portugal -20%, each.
EuROPEAN EquITIES
Graeme Bencke, Vice President, Head of European Large Cap Equities
Chantal Brennan, Managing Director, Head of Global Small and Mid Cap Equities
29
In our European portfolios, we will be looking to take advan-
tage of these trends and invest where the earnings outlook is
improving. The fundamental picture in Europe remains some-
what clouded by the risks associated with the high sovereign
debt position in many European countries. The coordinated
response of the European union members, the International
Monetary Fund and the European Central Bank during 2010
has limited the damage to some extent, but investors remain
concerned about the ultimate outcome.
Although we have been underweight the indebted peripheral
markets over the last 12 months, we are well aware of poten-
tial opportunities at attractive multiples once fears of sover-
eign default have passed. In these markets, the increase in the
cost of equity has been driven by a higher risk premium, rather
than the risk-free rate, which is lower now than it was pre-
credit crunch. Thus, fear in the bond market has pushed down
shares prices, despite the underlying fundamentals of many
companies being positive.
The extent to which the perception of how these risks are
played out will be an important consideration in deciding
where to invest to avoid being buffeted by factors beyond the
control of corporate management teams. We view the coming
year with enthusiasm and see numerous areas of growth upon
which to capitalize.
30
2011 Investment OulOOk | listed eqUities
2011 oUtlook: attracting foreign investors is key
Limited downside risk and increasing upside potential will pro-
vide good buying opportunities in Japanese stocks. We expect
that the recovery in the global economy will force investors to
pay attention to Japanese equities because of their high beta
nature compared to global cyclical stocks.
The risk of further large-scale declines in stock price is likely
limited, with sound balance sheets throughout the market,
particularly in global exporters. dividend yields have exceeded
the 10-year Japanese government bond yield. Looking back,
the last time this was true, it was followed by a strong stock
market turnaround.
Foreign investors, who are key to the supply-demand bal-
ance in Japanese equities, currently view Japanese stocks as
unattractive against the backdrop of a slowing global economy.
Thus, most global funds have significantly underweighted
Japan. When the market sees the global economy bottoming,
there will likely be significant potential for Japanese stocks to
outperform other markets.
We expect Japanese company profits to expand through 2011,
driven by a combination of aggressive cost cutting, stronger
export growth and the possible reversal of the yen. In the
first half of 2011, year-over-year profit growth is likely to
be flat-to-negative, due to the reversal of strong results of
2010. However, in the second half we expect them to recover,
driven by exporters, with the negative impact from the strong
appreciation of currency disappearing. Importantly, despite the
yen’s rise, several major exporters have raised their earnings
guidance, implying that they can thrive largely as a result of
aggressive cost cutting.
The typical top Japanese company has the necessary operat-
ing leverage for the global economy, particularly in emerging
Asian regions. With superior environmental–related technolo-
gies, these exporters have the strong potential for EPS growth
with expansion both in consumer expenditures and infrastruc-
ture investments in developing countries.
2010 recap: mixed signals from Japanese eqUities
Japanese stocks started the year strongly, as robust over-
seas economic indicators raised hopes for a global recovery.
Although there were concerns about monetary tightening in
China, tougher financial regulations proposed by the uS and
new fears concerning Greece’s financial status, the market
rallied sharply on reports of the European union and Inter-
national Monetary Fund’s joint emergency-support package
for Greece and speculation of further monetary easing by the
Bank of Japan.
Thereafter, the market started to decline. Concerns about a
“double dip” global recession emerged, due to the expanding
eurozone debt crisis and the increasing uncertainties of the
uS economic recovery. A stronger yen was also a drag on the
Japanese equity market. Stocks were bought with favorable
expected earnings when profit reporting began, but then the
market fluctuated, reflecting expectations for an economic
recovery countered by worries that the European debt crisis
might threaten the region’s financial system. With ongoing
yen appreciation and the G20’s pledge to cut deficits fueling
concerns about a negative impact on the economy, the market
declined, hitting a new low for the year at the end of August.
In November, Japanese stocks, which had lagged other
markets, attracted interest on the back of yen depreciation.
After the TOPIX Index renewed a year-to-date low, the mar-
ket started to rebound sharply, as the uS Federal Reserve
announced an additional monetary easing plan.
The Japanese small-cap market performed in line with the
large-cap market despite the significant liquidity dry out since
the downturn, which was offset by lower export sensitivity.
JAPANESE EquITIES
Shuhei Gotoh, Head of Investment Management Japan
31
On the fiscal front, the key issue to watch out for in 2011 will
be the much anticipated corporate tax reforms. The initial
proposal was to implement a 5% reduction in Japan’s effec-
tive corporate income tax rate from 40% to 35%. At present,
there is still no consensus on the exact size of the reduction,
but some magnitude of a cut is still likely, which should help
improve the relative competitiveness of Japanese companies,
given high tax rates relative to other countries.
As for small-cap equity, we believe that the downside of the
market is limited and the market will react more to positive
news than to negative news. As in 2010, we expect more mixed
signals from macro statistics, sales and earnings. However,
considering the current very pessimistic market sentiment
toward small caps among both individuals and institutional
investors and the attractive market valuations, there does not
appear to be much room for negative surprises in the market.
Price-to-book ratios stand higher than they were at the time of
the Lehman collapse and higher than the previous lows in 1998
(collapse of Hokkaido Takushoku Bank and Yamaichi Securi-
ties) and 2002 (nationalization of Resona Bank), based on the
Russell/Nomura Small Index. Current levels seem equivalent
to those seen in past credit crises, levels that do not typically
last for long.
On the small-cap earnings side, the current consensus for
2011 expects 4% revenue growth and 14% operating profit
growth for the MSCI Japan Small Cap Index’s constituent
companies, excluding financials. depending on the timing of
the macroeconomic recovery and currency conditions, these
forecasts seem to have some negative revision risks. However,
the current market valuation seems to have already discounted
such negative factors, as analysts usually forecast lags when
macro conditions change quickly. At the individual stock level,
we believe there are plenty of hidden gems to be found and
attractive companies are trading far below their fundamentals.
On top of the overall market recovery, we will seek to add
alpha by identifying such mispricing opportunities through our
bottom-up stock-picking process.
32
2011 Investment OulOOk | listed eqUities
The resiliency of improving corporate earnings only fully
became appreciated toward the end of the third quarter. Equity
market valuations rallied with improving economic data and
positive earnings revisions for uS companies. The uS Federal
Reserve (Fed), in the late fall, enacted a new quantitative
easing program (qEII) that would inject substantial liquidity
into the uS economy. Early cyclical companies led the move
upward and materials, industrials and technology stocks all
have outperformed the market at large.
For small caps, despite what was a summer of hedge fund
“de-risking” during seasonally low volumes, risk appetites
returned late in the year, and they outperformed their larger
peers for the year. As the Russell 2000 Index has just con-
cluded a 30% move since August and approaches its prior
high-water mark reached in 2007, we acknowledge that a
pullback or consolidation in the market may be due and, in
fact, encouraged as the market sets up for its next move.
ultimately, we do believe the market is headed higher for small
company stocks overall.
2011 oUtlook: recovery and monetary policy make Us eqUities attractive
We remain optimistic about uS equity markets as we head into
the new year. The Fed’s efforts to introduce excess liquidity to
spur economic activity should continue into 2011. While we do
not necessarily see greater quantitative easing, Fed Chairman
Ben Bernanke has stated that he would support it if needed,
so it is hard to imagine interest rates having a meaningful
increase in 2011. With uS Treasury yields in the 3 to 4.5%
range, equities look fairly attractive.
2010 recap: eUropean debt and environmental disaster balance economic strength
The past year can be defined by both abounding optimism and
unrestrained fear. The nascent months of 2010 witnessed the
emergence of a debt crisis in a minor member of the European
union, which threatened to cause a contagion across much
of the developed European markets. The Macondo oil spill
shocked equity markets, as they were attempting to recover
from the valuation degradation caused by the European debt
panic. As quickly as it seemed that global equity markets were
teetering on the precipice of destruction, improving economic
fundamentals emerged, which drove markets to close the year
at new highs.
Improving corporate earnings were overshadowed by a break-
down in the Greek debt markets. Investors turned on Greek
sovereign debt following disclosures that it had misstated
its existing leverage. As expected, markets began to reflect
speculation about a possible breakdown of the eurozone. A
dearth of liquidity in European fixed income markets was
followed by a global flight away from emerging markets. While
the uS was viewed as relatively safer, there was a lack of major
capital flows into uS equity markets.
The European Central Bank, finally, introduced liquidity
measures to stem worries about a debt crisis across Europe.
Equity markets reacted positively to the expectation that
major central banks would coordinate their efforts to curb any
obstacles to a global economic recovery. However, uS markets
were rattled when news broke in late April of the blowout at
BP’s deep Water Horizon rig in the Gulf of Mexico. The oil spill
was the largest environmental disaster in uS history and it
was predicted that the uS economy, particularly those states
dependent on the Gulf for commerce, would be irreparably
damaged. The summer doldrums never fully materialized, as
investors brooded over the potential economic fallout.
uS EquITIES
Dan Neuger, Head of US Active Equities
Jamie Cuellar, CFA, Portfolio Manager, US Small and Mid Cap Equities
33
uS $79 billion in withdrawals in 2010, on top of uS $40 billion
in withdrawals in 2009, according to the Investment Company
Institute. ETFs have offset some of these outflows, but the net
result is still money coming out of the market. This does not
paint the picture of a greed-driven, overbought market, and
provides the market with incremental buyers as retail inves-
tors eventually return after reducing household debt levels.
Small-cap valuations remain slightly above longer-term aver-
ages, according to Bank of America Merrill Lynch. Given where
we are in the economic cycle, with depressed revenues, mar-
gins and earnings, it should be expected that the market would
be valued higher than historical averages. Small-cap growth is
actually trading below long-term averages on most metrics. As
is usually the case, there are some areas of the small-cap uni-
verse where valuations seem a bit frothy. Currently, multiples
seem stretched in certain parts of technology where a healthy
M&A premium has made its way into networking, software and
storage industries where we have seen some consolidation.
Monetary policy and improving economic fundamentals will
continue to spur corporate revenue growth in 2011. Recent
revenue growth in an expanding economy can outpace operat-
ing expenses and input costs. The improving business environ-
ment, further stimulated by a more constructive uS tax policy,
will lead to a robust employment market. The biggest surprise
of the year, in our opinion, will be the greater-than-expected
drop in the unemployment rate.
An increasingly rosy economic outlook, coupled with vocational
training for parts of the labor force, will likely lead to a recov-
ery in the housing market. We anticipate that this will result in
greater workforce mobility.
As we expected, 2011 forecasts for uS markets fell during the
second half of 2010. We believe that they have become too neg-
ative, which should lead to positive earnings revisions in the
future. Throughout the year, high correlations between stocks
made it difficult to find individual positions that would distin-
guish themselves and also led to outperformance by lower
quality stocks, as measured by return-on-assets or return-on-
invested capital. This is not uncommon as the market comes
out of recessions and is generally short-lived. We believe this
phenomenon, which had already started to weaken at the end
of 2010, will continue to do so in 2011. In fact, higher quality has
led this fall’s rally, and we believe that active management and
true stock-pickers still likely outperform going forward.
We are confident on continued strong smaller-company
performance for a number of reasons. First, it is our opinion
that the incremental buyer and seller of small caps over the
past several years has been hedge funds dipping into lower-
cap stocks to generate alpha. As we have started to see a
return to normalcy in hedge fund flows and the fund-of-funds
market, liquidity in the small-cap market has improved, and
we believe this will continue. Second, despite seeing solid
returns from domestic stocks in the last two calendar years,
domestic-equity mutual fund flows have been negative, with
34
2011 Investment OulOOk | listed eqUities
worries plaguing EM. As 2010 drew to a close, those issues
were still on the plate and the European sovereign debt crisis
had intensified. In addition, there was the risk of heightened
tensions on the korean Peninsula, a situation which is particu-
larly sensitive to the change in leadership of the kim dynasty.
With those opportunities and risks in mind, we are in much the
same position at the outset of 2011 as we were in 2010.
The second round of quantitative easing (qEII) in the united
States, while not to everyone’s liking, certainly enhanced the
rosy scenario for many emerging markets. The commodity
producers will benefit from quantitative easing, although a
lower dollar translates into stronger local currencies. When
added to monetary policy, this increases the probability of addi-
tional capital controls. In 2010 we saw Brazil “double down”
on its capital controls, charging a hefty 4% on fixed income
transactions, twice that charged for equity transactions. While
higher commodity prices are good for some countries, they are
an important source of inflation for others.
Not all emerging countries have encouraging macroeconomic
scenarios. The economic recovery in Russia has been weaker
than expected and that country does not share the demo-
graphic strength story, as its population is ageing, which is a
potential risk. korea and South Africa also fit into this cat-
egory. However, both countries’ equity markets are relatively
attractive in valuation terms, making them a potential source
of alpha in 2011.
An important question facing the global economy is whether
continued robust growth in the major emerging economies can
offset the potentially anemic performance of the major devel-
oped economies. At the heart of this debate sits China, whose
share of world GdP has increased from 2% (purchasing power
parity basis) in 1998 to nearly 12% in 2008 and contribution to
global trade increased from a negligible 1% to more than 8%
over that same period.
Emerging markets (EM) can be divided into two major groups,
commodity-based and export-based. The former relies more
heavily on Chinese demand and the latter on global economic
recovery, which we have not yet witnessed. Another way to
cut the emerging pie is to separate those with a very positive
demographic underpinning (India, Turkey, Indonesia, Brazil and
Latin America) from those with either an ageing or a shrinking
population (Russia, China, Malaysia). There are also the main
economies, Brazil, Russia, India and China (BRICs), versus the
smaller more defensive ones (Chile, Colombia, Turkey, Indo-
nesia etc). Clearly there is some overlap, but there is no doubt
that the Chinese economy is a crucial variable to the success of
all economies, both emerging and developed.
As we enter 2011, the macroeconomic outlook for EM is still
rosier than the outlook for developed markets. Industrial
production, GdP growth and consumer confidence are coupled
with attractive demographics in many of these countries to
support a powerful secular investment story. Thinking back to
the beginning of 2010, overheating in China, food price infla-
tion and the European sovereign debt crisis were some of the
emerging markets equities overview
Stacy Steimel, Global Emerging Markets Portfolio Manager, Head of Latin America Equities
35
While the world has focused its attention on China, there are
other interesting Asian stories that bear comment. Taiwan is
the antithesis of China, as its market has underperformed, and
its fiscal expansion can continue as inflation is not a threat.
We have seen a large uptick in demand in the components
sector, which is Taiwan’s sweet spot, and the financial sector
is healthy, with no non-performing loan (NPL) threat on the
horizon. India, on the other hand, suffered from an inflation-
ary threat in 2010, which is still running high. It has corrected,
however, and the country’s valuations are not stretched, when
compared to previous market peaks in 2007.
Monetary policy will be on the early agenda in 2011, with
tightening expected to reign in runaway growth and infla-
tion in both Brazil and China. One can expect performance in
those markets to be constrained until the length and extent
of the tightening is clear. For the year as a whole, however,
there is no doubt that the better growth prospects and higher
earnings growth in EM as a whole will underpin a very solid
performance in 2011.
36
2011 Investment OulOOk | listed eqUities
regarded as the un-bankable majority of the population —
normally those with either too small an income or based in
a location where a physical brick and mortar branch did not
make economic sense. Consequently, across the continent,
demand for banking services is growing at high rates, which
is driving credit growth and demand for housing, mortgages,
cars and other consumer goods.
Positive demographics are also playing their part. Africa
currently accounts for approximately 2% of global GdP, yet it
has around one-sixth of the world’s population. Further, unlike
some emerging countries like China, Africa’s population is
expected to grow strongly, from 1 to 1.5 billion by 2050, with
the urbanized population increasing from 300 million to 1 bil-
lion over the same period. As GdP and, as importantly, income
per capita increases, so too will a visibly growing middle class
with ever-increasing consumption demands.
2011 investment oUtlook: the world is on notice
These positive economic trends have not gone unnoticed
outside of Africa, particularly in the developing world, includ-
ing India and China — the latter’s whose trade with Africa has
increased by 10 times over the last 10 years. Foreign direct
investment and remittances into Africa have also been rising,
as investors increasingly recognize the opportunities that
Africa offers.
Against this backdrop, we are very positive about the short-,
medium- and long-term economic prospects for the region.
Also, from an investment perspective, it is encouraging that
the number of countries with public equity markets and the
number of securities listed on their exchanges continue to rise.
However, in late 2008/early 2009, these markets fell sharply,
as international investors withdrew capital. Subsequently,
while there has been some recovery, Africa’s equity markets
are still lagging the rebound seen in emerging markets, and
yet, with the exception of the commodity-endowed countries,
corporate earnings have generally been resiliently positive
throughout the last two years. As a result, valuations are now
2010 recap: africa escapes economic woes
unlike previous global economic downturns, Africa as a whole
did not experience a collapse in economic growth in 2009.
Certainly, a number of resource or commodity-endowed
countries, such as Botswana (diamonds) and Angola (oil) saw a
significant pullback in growth of gross domestic product, but in
aggregate, the 46 countries in Sub-Saharan Africa grew their
economies by over 2% in 2009. This followed a strong growth
period between 2000 and 2008, when real GdP rose 4.9% per
year – more than twice its pace in the 1980s and ‘90s – and the
IMF currently predicts a return to similar growth rates over
the next five years.
This is a testament to much-improved macroeconomic
governance over the last decade or so, which has seen infla-
tion reined in, allowing interest rates to fall. At the same
time, institutions have been strengthened in many countries.
However, there are a number of other positive macro themes
at work across the continent.
First, there is a widespread misconception that Africa is debt
laden. In fact, public debt-to-GdP levels are typically in the
range of 20% to 45% in many countries, and GdP levels are
often understated, owing to the presence of large informal
sectors. Further, although banking regulations differ from
country to country, capital and liquidity requirements are
generally high and banks, by and large, stick to core banking
activities. As a result, Africa was not significantly impacted by
the 2008/2009 international debt crisis, and country and corpo-
rate balance sheets in general remain in good shape.
Notwithstanding the above, advances in information technol-
ogy and communications over the past decade have had a
positive impact across Africa. One example is kenya where,
10 years ago, there were less than 200,000 fixed telephone
lines serving a country that, at that time, had a population of
30 million. In 2010, this had increased to over 20 million active
mobile phone subscribers. More recently, newly laid undersea
fiber optic cables have allowed broadband access for many
countries. These types of developments have, in turn, allowed
the banking sector to start to penetrate what was previously
AFRICAN EquITIES
Jonathan Stichbury, Head of Sub-Saharan Equities and Fixed Income
37
attractive at one-half to two-thirds their 2008 levels and it is
still possible to build a public equity portfolio with a single digit
P/E ratio, a 4% to 5% dividend yield and with 25% plus long-
term earnings growth prospects.
Clearly investors have been risk averse in 2010 and admittedly
these are small, illiquid and not well understood markets.
Also, with 53 countries, it is inevitable that some bad news
about some part of Africa will make the international head-
lines, which can unfortunately mask the majority of countries
that are quietly making steady progress.
Nevertheless, given the growth prospects and increas-
ing interest in Africa, it is unlikely to be much longer before
mainstream investors are compelled to take a greater interest
in the region.
38
2011 Investment OulOOk | listed eqUities
August was a weak month, as disappointing economic num-
bers renewed fears of a double dip recession, but the senti-
ment rebounded strongly in September, when expectations of a
second round of quantitative easing by the uS Federal Reserve
brightened the outlook for the economy. Australia, Hong kong,
the Philippines and Thailand had strong returns in the third
quarter. Australia was driven by a strong performance in the
Australian dollar and commodities, while Thailand was also
helped by the weak uS dollar and a strong rebound in domestic
consumption after the political crisis earlier this year.
Chinese equities were relative underperformers, as the
A-share market remained weak, caused by the policy overhang
concerns over wage increases. The renminbi appreciation
issue continued to be a focal point during the third quarter,
while the weak uS dollar caused a surge in most commodities
and Asian currencies. The Indian equity market remained weak
until August when it witnessed a huge rise attributed mainly to
foreign investors bringing a huge amount of money into India.
2011 oUtlook: markets will continUe watching china
Asia enters 2011 with economic growth rates that are
expected to be at least twice as fast as those of the developed
economies. Given this, and against a backdrop of interest
rates remaining low globally, the region is likely to continue
to attract strong portfolio inflows, thereby extending the
policy challenges for the various monetary authorities. These
authorities must manage the inflows to prevent asset bubbles
from developing, without unilaterally engineering a competi-
tiveness-eroding rise in their underlying currencies.
Consequently, investors in Asian equities have shown concerns
over the imposition of capital controls. However, the evidence
thus far is of policy-makers taking measured, rather than
broad-brush, actions, given their recognition of the importance
of foreign investments to their economies.
2010 recap: markets driven by crisis in eUrope and policy in china
Emerging Asian equities started the year sluggishly, but began
to pick up toward the end of the first quarter. Investors started
taking profits when they became concerned with the tightening
or withdrawal of stimulus measures by governments all over
the world. This was particularly significant in the Hong kong/
China market, where the index fell to a trough just before Chi-
nese New Year on speculation of Chinese tightening. Indonesia
and Malaysia both performed well early in the year, driven by
better-than-expected earnings and Malaysia’s introduction
of more investor-friendly policies. Thailand also performed
well, despite the unrest in Bangkok, and korea was up, driven
by foreign investor interest in the tech sector. In India, the
year began on a positive note with foreigners continuing their
buying, but the first quarter saw more tightening of monetary
policy in light of inflation reaching nearly 10%.
The Asian market rally continued into the second quarter until
contagion from the European sovereign debt crisis brought
it to an end and markets struggled until May, when govern-
ments in Europe introduced measures to ensure the stability
of the European debt market. Meanwhile in China, the govern-
ment instituted measures to rein in the property market.
Indonesia, Malaysia, Philippines and Thailand continued their
positive runs through the second quarter. Indonesia was
driven by surprises in economic and corporate numbers and
Thailand returned to normality after the deadly clashes in
Bangkok in April. The rising tensions in the korean Peninsula
caused an underperformance in korean equities, and Taiwan
also underperformed significantly, as enthusiasm on cross-
strait relations faded. Meanwhile, in India, rising inflation
caused the Indian central bank to tighten the policy rates, and
foreign flows kept the market buoyant, but the market had a
negative quarter.
ASIAN (EX-JAPAN) EquITIES
Peter Soo, Head of Asia ex-Japan Equities
39
export proceeds on the back of a weakening uS dollar, all point
to the continuation of the current bullish outlook for Asian
equities. Hence, we remain relatively constructive toward equi-
ties in this region.
India remains a good long-term growth story. The favorable
demographics and the increasing infrastructure spending will
help sustain its secular growth phase. The short-term risk is
the inflation outlook, which we think may have peaked.
Recent strong increases in food-related commodity prices
have created additional complications for regional central
banks. Given the sensitivity to the former in the consumer
price index baskets of most countries, interest rate hikes may
be necessary to control inflationary pressures. However, with
the global economic environment remaining quite uncertain,
doing so runs the risk of crimping domestic demand, which has
been a supporting plank for growth.
As has been the case in the aftermath of the credit crunch
of 2008, attention will be focused on developments in China,
whose relatively swift recovery has arguably been the
engine of support for the economies of its neighbors. The
latest releases of monthly inflation data in the country have
prompted worries about a repeat of 2007, when an overheating
economy led to a series of interest rate hikes.
Nonetheless, comparisons on such indicators as industrial
production would appear to suggest that the Chinese economy
is not nearly as stretched as it was in 2007. In the meantime,
the government has been careful and selective in its moves to
contain price pressures, such as the administrative measures
introduced in the real estate sector, which were more lenient
than first envisaged. It has also imposed higher reserve
requirements on the banking sector, rather than resorting to
outright increases in interest rates. Outside of this near-term
situation of ensuring economic stability of the Chinese econ-
omy, the official focus will be on implementing the recently
announced five-year national development plans. Included in
these, as part of the process of refashioning the economy, will
be the continuing emphasis on developing domestic consump-
tion as a key contributor to growth. This is meant to encourage
further urbanization, promote higher value-added industries
and expand basic social services.
Earnings momentum in Asia remains positive and valuations
remain reasonable. A confluence of events, such as negative
interest rates — when the inflation rate is higher than short-
term interest rates — and surging foreign exchange reserves/
40
2011 Investment OulOOk | listed eqUities
2011 oUtlook: brazil boUnceback and andean ascension
Looking to 2011, macroeconomic fundamentals should support
equity prices, as GdP growth expectations have been rising and
are above long-term trend. This has been supporting the earn-
ings revision cycle. Latin American earnings growth is forecast
to be 21%, versus 15% for developed markets. As a result of
these growth expectations and valuations of 11.9x P/E, 2011 is
not looking at all stretched.
While valuations are at the top end of Latin America’s 15-year
average, multiple expansion is likely in a scenario where the
flows to emerging markets could continue strongly and inter-
est rates are relatively low compared to historic rates. These
two factors reduce companies’ cost of equity.
With respect to interest rates, continued inflationary pressure,
particularly in Brazil, could threaten the positive environment.
In fact, the market is now expecting a 150 to 200 basis point
increase in Brazilian rates at the beginning of 2011. Of course,
that could put additional pressure on the currency.
The integration of Andean capital markets in 2011 is poten-
tially a transformational event. Not only will it focus investor
attention on the Andean countries, but it should dramatically
increase the number of listed companies, improve the liquidity
of the markets, and enhance the overall transparency of these
2010 recap: sUrprising stars emerge
during 2010, Latin American economies showed widespread
and strong economic growth, far exceeding the previous
decade and the rest of the world’s expectations. This drove
Latin American equities to outperform developed markets.
Nevertheless, the dispersion among the countries was
remarkable, with Brazilian stocks underperforming Mexico
and Andean markets (Chile, Colombia and Peru), due to a large
overhang caused by the Petrobras secondary offering and a
drawn-out presidential election process.
Expectations that Chinese authorities intended to cool their
economy also hit the Brazilian market, as it was interpreted as
reduced demand for commodities. This volatile environment
led the defensive Mexican equity market to outperform in spite
of its weak macroeconomic environment, security problems
and obvious links to the united States. The stars of 2010,
however, were the Andean markets, where economic growth
exceeded expectations.
LATIN AMERICAN EquITIES
Stacy Steimel, Global Emerging Markets Portfolio Manager, Head of Latin America Equities
41
capital markets. Looking back at the impact of capital market
reform on the Bovespa reveals that the total market cap of
these three countries could benefit over the long term. This
needs to be balanced against the higher valuations of the most
liquid names in these countries, due to their 2010 outperfor-
mance. This new, integrated market will be the second largest
in the region after Brazil, pushing Mexico into third place.
Consequently, we plan on favoring companies that focus
on the domestic markets, taking advantage of the Latin
American consumption and investment cycle. In terms of
countries, after 2010’s underperformance, Brazil presents
the best risk/return reward, although the interest rate cycle
presents an early challenge. The Andean region has room to
expand multiples with the integration process and is a perfect
complement to Brazil.
42
2011 Investment OulOOk
FIXEd INCOME
Developed Markets Fixed Income Overview 44Emerging Markets Fixed Income Overview 46Leveraged Finance Overview 49Leveraged Loans 50uS High Yield Bonds 52US Investment Grade Fixed Income Overview 54uS Investment Grade Credit 56uS Securitized Products 57
43
44
ated versus both the uS dollar and euro, as domestic inves-
tors repatriated investments from these areas when the yield
advantage versus Japanese assets significantly declined.
2010 proved to be a challenging year for eurozone peripheral
sovereign bond markets. Investors questioned the future
government financing of these countries. Access to the capital
markets was effectively closed off to Greece in May and, as we
ended the year, Ireland was similarly challenged. The result
in the case of Greece was its exclusion from the major bond
indices in July, following the sovereign credit rating downgrade
to speculative grade by both Moody’s and S&P. The German,
Finnish and dutch bond markets outperformed, with investors
judging their AAA ratings to be least at risk of downgrade.
2011 oUtlook: keeping the attention of foreign investors
The current developed market world recovery is far from nor-
mal. Epitomized by the housing and employment markets in
the uS, the emergence from recession over the past one to two
years has been cyclically atypical and this is having a knock-on
effect on policy rates and bond yields around the globe. The uS
FOMC has clearly signaled its unease with the economic out-
look by virtue of the additional stimulus measures announced
in November, which, if fully realized, would likely absorb all
future uS Treasury bond issuance through the second quarter
of next year.
In Europe, the effect of 2010’s announced budget austerity
programs are set to have a significant impact on headline
growth. The combined effect of public cutbacks and fiscal
tightening, further exacerbated by both personal and business
balance sheet repair, is likely to restrain growth, which needs
to record levels consistent with reducing the overall stock of
2011 Investment OulOOk | fixed income
2010 recap: monetary and fiscal policy drive the market
Major global government bond markets remained highly
correlated to the uS Treasury market through 2010. As the
year began, growing concerns over eurozone sovereign risk
prompted higher investor risk aversion, reflected in the dra-
matic widening of yield spreads. In the case of Greek govern-
ment bonds, spreads widened more than 1000 basis points
over Germany in May.
Weaker than expected uS economic indicators led investors
to question the uS recovery and reignited concerns about a
double dip recession risk. Such fears prompted strong support
for fixed income assets, especially AAA-rated government
bonds in their guise as safe haven assets. In response, the
Federal Open Market Committee (FOMC) signaled the pos-
sibility of another round of quantitative easing during the third
quarter, which not only prompted a powerful bond market rally
in August, but saw long maturity, 30-year bond yields severely
underperform – partly reflecting the expectation that such a
reflationary policy would ultimately be successful.
The interest rate environment in Europe was more benign.
Short-dated yields rose during the summer, as the European
Central Bank (ECB) began withdrawing liquidity from what was
made available to banks, as they shrank their balance sheets.
Meanwhile, in Japan, further stimulus in the form of govern-
ment asset purchases kept 10-year bond yields close to 1%.
With respect to foreign exchange, commodity-related curren-
cies performed well, prompted by prolonged accommodative
monetary policy implemented by the major central banks and
coupled with favorable domestic economic fundamentals in
countries such as Australia. Asian currencies such as the
Singapore dollar and Malaysian ringgit found strong support
from linkages to a buoyant China. The Japanese yen appreci-
developed markets fixed income overview
Anthony King, Managing Director, Investment Grade Fixed Income
45
economic recovery, thus allowing currency appreciation. In
line with our forecasts for interest rates moving into 2011, it
is likely to take the uS until the second half of the year before
it establishes such an advantage among the G3 countries. In
the broader G10 arena, we continue to expect terms of trade
improvements for commodity-linked currencies, such as the
Australian dollar and Malaysian ringgit, as well as appreciation
for currencies with advantageous budgetary positions, such as
the Swedish krona.
Our outlook for non-uS corporate credit spreads remains
constructive. Corporate balance sheet repair following the
2008 financial crisis has created a landscape of investment
grade companies with strong access to public debt and syndi-
cated loan capital markets, stable free cash flow generation
and stable-to-improving margins. Refinancing has been a key
theme of 2010, with access to historically low funding costs,
and we expect issuance in 2011 to closely match that of 2010,
which, for non-financials, has been approximately 60% less
than 2009.
debt present in select eurozone countries. In aggregate, the
policy response needs to be one of loose monetary, tight fiscal
– resulting in official policy rates in the uS, uk, Japan and the
eurozone that remain accommodative over the medium term.
The specter of inflation in these markets appears to be latent,
as recently highlighted by core uS inflation falling below 1%,
while Japan continues to struggle with a deflationary environ-
ment. With policy rates effectively anchored over the near
term, the outlook for bond yields is supported. Yield spreads
of 2-year over 10-year bonds in excess of 200 markets in the
uS and uk remain attractive to fixed income investors for
roll-down purposes – in line with the scenario of bond prices
moving toward par value as their maturity approaches. When
coupled with an ongoing bond purchase program in the uS,
this provides further resistance to rising bond yields.
Sovereign bond markets in the eurozone have captured the
attention of investors in 2010, and we do not expect an end to
this as we move into 2011. The austerity packages approved by
the likes of Spain, Portugal and Greece will be closely moni-
tored to identify any signs of slippage, while already optimistic
growth projections must also be brought to fruition so that
investors, who are largely non-domestic, continue to support
the peripheral sovereign bond markets. We continue to favor
the primary budget-surplus nations, such as Italy, but also
expect that 2011 will provide opportunities to exploit dispro-
portionately wide spreads on a tactical basis.
In foreign exchange, the uS dollar ends 2010 approaching
historic lows from a broad trade-weighted perspective, as it
did in 1979, 1995 and 2008. While our current macroeconomic
outlook does not call for the uS dollar to breach these previous
lows, expectations of a cyclical turnaround also do not appear
to be imminent. Ongoing stimuli via bond purchases in the uS
are broadly inconsistent with a rising policy rate/bond yields,
which is the signal investors are awaiting as confirmation of
46
In addition, banking sector indicators reveal solid numbers,
consistent with the pace of the recent recovery. Private credit
growth is at, or below, 10% in the majority of EM, and with the
exception of some Baltic and CIS countries, non-performing
loans are typically below 5%, according to the IMF Global
Financial Stability Report,October 2010. In the public sector,
overall fiscal balances are marginally negative in Asia and
Latin America, slightly higher in emerging Europe and strongly
positive in the Gulf Countries. Nevertheless, the aggregate
gross public debt in terms of GdP is much lower than the 60%
Maastricht threshold set for the European countries in 1992.
With these extraordinary fundamentals, it is no wonder that
this asset class has been receiving foreign inflows from inter-
national investors in search of attractive returns. In the first
nine months of 2010, EM debt has received almost uS $70 bil-
lion of foreign inflows, out of which around uS $40 billion went
into local currency denominated debt and the remainder into
hard currency debt. As a comparison, in the first nine months
of 2007, total inflows were only half of these levels, proving the
popularity of the asset class in the last three years.
despite these massive inflows, the participation of foreign
investors in the local debt of these markets is not excessively
high. Apart from Indonesia, the Philippines and Mexico, which
have around 30% foreign participation in local debt, the rest of
EM has 10% or less of its debt held by foreigners. As this wall
of money floods into EM, several of the monetary authorities of
these countries are imposing barriers to prevent their cur-
rencies from a fast and abrupt short-term appreciation, which
could jeopardize external accounts, given the strong domestic
demand and import growth. Although the impact of daily uS
dollar purchases in the foreign exchange (FX) markets or the
implementation of taxes on dollar inflows may not be negli-
gible, they are also not sufficient enough to stem the apprecia-
tion of these currencies against the dollar in the long term.
2010 recap: concern aboUt a potential bUbble in emerging markets?
undoubtedly, emerging markets (EM) were in the spotlight in
2010, given their economic and financial resilience during the
global financial turmoil of 2008 and the positive prospects for
the years ahead. Growth of EM has been outpacing that of the
developed markets on the back of strong domestic consump-
tion and the vast investment pipeline. Fiscal accounts show
that emerging markets are in much better shape than their
developed market counterparts: public debt-to-GdP ratios
stand at half of what they are in developed markets, and the
primary results are generally positive. Although no significant
steps were taken on the reform or regulation fronts, recent
elections have not been accompanied by the volatility seen in
previous electoral cycles, given the solid economic and institu-
tional environments built over the last decade.
Generally speaking, after a dramatic drop in 2008, industrial
production is back to pre-crisis levels, with Asia leading the
recovery for the last two years. However, the emerging Europe,
Middle East and Africa regions are still lagging. With the inven-
tory cycle and counter-cyclical fiscal policies out of the way,
we could now witness low levels of unemployment and the
recovery of credit growth, which would support consumption
in emerging countries, thanks to the larger, and still growing,
middle class in Brazil, China, India and Indonesia.
The recent trend clearly shows that a structural change is in
place. As working population centers shift from developed to
emerging markets in the next few decades, consumption will
be a natural driver for growth in those markets. In fact, recent
IMF data shows that emerging markets’ share of the world’s
private consumption is now equivalent to that of the uS, hover-
ing around 30%. Should this pace continue, we will likely see
much stronger GdP coming from the emerging countries.
2011 Investment OulOOk | fixed income
emerging markets fixed income overview
Rajeev Mittal, Head of Emerging Markets and International Fixed Income
47
2011 oUtlook: monetary and fiscal policies continUe to sUpport em strength
It is difficult to see the virtuous emerging markets story being
reversed next year. So long as the basis for sustainable growth
is in place – investments and consumption growing at an
equivalent pace – we should not be concerned about imbal-
ances in the short term. With strong growth, debt sustainability
is easily achieved and most EM countries face no imminent risk
of insolvency.
Although the outlook seems rosy, there are some risks that
could taint the picture along the way. The first is monetary
policy error. We expect output gaps to be closed by next year,
which will likely add inflationary pressures at the same time
that food prices start to rise in international markets. Supply
shocks do not necessarily need to be abated with tighter mon-
etary policy. depending on the pass-through of the exchange
rate to inflation, stronger FX can help the central banks reach
their inflation targets in an environment of higher commodity
prices. However, the central bank dilemma is that stronger FX
may result in a negative current account, hence the monetary
authorities’ recent efforts to prevent fast appreciation. On
the other hand, tighter monetary policy may lure short-term
capital, resulting in a more undesirable currency appreciation.
So how do the banks get out of this cycle?
The answer, in our view, is through fiscal policy. As the drop in
economic activity was severe at the end of 2008 and beginning
of 2009, most countries launched counter-cyclical fiscal poli-
cies in order to support GdP growth. More than one year has
passed, and this fiscal stimulus has been partly withdrawn.
For example, temporary tax exemptions have been removed
and expenditure growth has been reduced in the last couple
of months. However, given the economic strength of these
Moreover, though some central banks are considering a tax
on fixed income investments, the majority of inflows to EM are
driven by equity flows or foreign direct investments. On the
latter, there is a pipeline of inward investments to EM of about
uS $6 trillion over the next three years, which will surely have
some positive impact on the currencies and growth prospects
of these countries.
With the continuing strong sovereign and macro fundamen-
tals underpinning the investment case for EM, the corporate
sector has resumed its burgeoning growth in terms of issu-
ance. The CFOs and treasury departments of almost every EM
corporate entity could not help but be attracted to interna-
tional capital markets at some stage during the year, as uS
yields remain at historically low levels. A large proportion of
these entities actually “pulled the trigger,” and, with over uS
$200 billion of issuance spread across over 330 individual
issues in 2010 (as of 30 November), we have already seen
the highest ever issuance in a single year, according to Bond
Radar. However, it is important to note that this issuance has
not been used to leverage-up the sector. More than 70% of the
funds have been used for either refinance or corporate liquid-
ity purposes, approximately 25% for capital expenditures,
and just 1% for mergers and acquisitions. Overall, the growth
of the external debt corporate market has outstripped its
sovereign counterpart, which has seen approximately uS $82
billion in issuance, according to Bond Radar.
The aggressive issuance by the sector has placed pressure
on corporate spreads and, despite corporate fundamentals
and risk metrics continuing their upward trajectory, overall
spreads are more or less unchanged year-to-date, with the
JP Morgan CEMBI Broad diversified Index currently standing
at 342 bps as of 7 december With the collapse of uS Treasury
yields, our expectation of “high single-digit returns” for 2010
has been far exceeded, with the JP CEMBI Broad diversified
Index returning 12.95% year-to-date (as of 30 November).
48
2011 Investment OulOOk | fixed income
rates further. From the FX perspective, South Africa is the
only country with significant concerns about FX valuations, but
capital controls are unlikely in any of the four.
We continue to view the EM corporate sector as an attrac-
tive asset class with a relative value proposition versus its
developed markets peers fully intact, given that spreads
remain materially wide on the strong supply pipeline we have
evidenced this year. As issuance levels plateau during 2011 and
the risk metrics continue on their positive trajectory, we would
expect spread compression and, for the year, we are again
forecasting high single-digit returns. We anticipate that the
high yield component of the market will again be the standout
performer but, as spreads tighten, we are likely to see a return
of the “pushing the envelope” credits (highly speculative or
non-conventional trades) in this part of the market. Therefore,
we continue to advocate a selective approach, with compre-
hensive initial due diligence remaining a vital component of
successful investing in this asset class.
Overall, the investment case for EM in terms of fundamentals,
technicals and valuations remains a compelling one. The most
significant risks to the asset class are, in our view, exogenous
factors, so bottom-up selection remains our overriding
mantra, and we should not take anything for granted in this
dynamically developing asset class.
economies and the relatively dovish statements of the central
banks, who are fearful of the external backdrop, the onus is
on the governments to generate additional tightening of fiscal
policy. This could reestablish the equilibrium between supply
and demand, easing the pressure on the balance of payments
and therefore resuming the path of sustainable growth.
We see a couple of countries that are aware of this “central
bank dilemma” and some others that are not facing the same
issues. In general, Latin America stands out for its amazing
growth rate in 2010 and great prospects for 2011. However, if
governments do not tighten fiscal policy, then central banks
will likely need to step in and guarantee that inflation targets
are on track for the years ahead.
We continue to expect strong growth in Asia, led by China,
and a continuing shift to reliance on domestic demand as
external uncertainties remain. This will certainly cause a rise
in inflation expectations. However, we think that the majority
of Asian countries will still meet their inflation projections for
2011, with the exception of a few peripheral countries. Stronger
currencies should also help and we expect China to allow more
appreciation. Post-crisis fiscal consolidation is set to continue
in Asia, with most countries on an improving track and, thus,
less debt issuance in view.
In emerging Europe, the Middle East and Africa, the stories
will be rather divergent, but fiscal policies will generally be
tighter. Turkey will grow quickly, raising questions about the
financing of the ballooning current account deficit. The central
bank needs to tighten, but will use all the other tools at its
disposal first. Poland and South Africa are in the middle, with
growth recovering, but their central banks have more room to
maintain a low rate environment. Finally, growth in Hungary
will likely stay weak, and its central bank may be able to cut
49
With interest rates near all-time lows, even the lofty bond •
and loan prices of today provide healthy credit spreads.
defaults seem likely to stay relatively low, probably in the •
2% to 3% range. If recoveries stay near long-term averages,
then credit losses will be modest, and would mean that
today’s credit spreads are well above long-term averages.
A number of economic indicators are beginning to point in a •
positive direction, and a healthy economy is almost always
very positive for the leveraged finance sector.
The new issue loan market is picking up. This will provide •
more discipline to the market and slow down the normal
tendency for credit markets to recover and then move
quickly to excess, in the form of poor credit underwriting
and inadequate spreads and covenants.
As the record performance in 2009 ended and 2010 began,
expectations were modest. In addition to the feeling that mar-
kets needed to take a breather after their historic 2009 run-up,
there were also several other issues to contend with, including
fears of still-lofty defaults, a still-declining economy and the
looming maturity wall of 2013 to 2014.
However, as 2010 unfolded, there was quite a bit of good news
on all fronts.
First, the default rate for both loans and bonds plunged quickly
and dramatically. From a high of over 10% in 2009, the default
rate dropped quickly to 1.87% by the end of 2010, one of the
sharpest recoveries we have seen in this market. There were
a number of factors at play, including much better market
liquidity, stronger corporate cash flow, and a growing sense of
confidence that the economy had, at last, found a bottom.
Second, the economy began to show evidence that it was
beginning to grow again. While GdP growth was minuscule, it
was, at least, putting fears of a double dip to rest. Job growth
was slow, and the housing market continued to struggle, but
capital spending and inventory rebuilding all contributed to
move things forward.
Third, the maturity wall saw material progress. As investors
searched for yield, inflows to high yield bond funds soared. This
triggered a massive wave of high yield bond issuance, much
of which was used to refinance looming loan maturities. This
provided loan investors with significant new cash to reinvest,
as well as growing confidence that the maturity wall may be as
much an opportunity as it was earlier perceived to be a risk.
As we approach 2011, it is harder to be bullish than at any time
since 2008. However, even with bond and loan prices near
three-year peaks, we see several reasons for optimism:
leveraged finance overview
John Lapham, III, CFA, Co-Head of Leveraged Finance
Steven Oh, CFA, Co-Head of Leveraged Finance
50
2011 Investment OulOOk | fixed income
LEVERAGEd LOANS
John Lapham, III, CFA, Co-Head of Leveraged Finance
Steven Oh, CFA, Co-Head of Leveraged Finance
Increasing current yield: 2009’s dramatic run-up in loan •
prices clearly rewarded both patient investors and those
that entered the market during the early stages of its recov-
ery. As secondary spreads began to normalize, underwrit-
ers and agent banks introduced two key mechanisms that
served to stimulate investor demand and were used with
increasing frequency throughout the year. The first was the
maturity extension amendment, whereby lenders allowed
borrowers to issue new loans with identical features as
their existing loans except for a higher spread over LIBOR
(typically 100-200 basis points higher) and a longer maturity
(typically two to three years longer). In exchange, lenders
received a fee and the option to exchange holdings in the
existing loans for an equivalent amount of the new higher
coupon, extended maturity loan. These amendments raised
the average price and spread of the extended tranches and
increased the attractiveness of performing loans whose
issuers face a similar need to extend portions of upcom-
ing maturities. The second mechanism was the adoption
of “LIBOR floors,” which were initially inserted into some
loans that underwent covenant modification, and became an
underwriting standard in 2010. As the name suggests, the
base rate in a loan with a floor is the lesser a minimum fixed
rate, typically ranging from 1.5% to 2.5%, or LIBOR. This
added feature, combined with significantly wider spreads
and up-front fees, boosted the attractiveness of loans by
capturing the best of both worlds: a high coupon in a low
interest rate environment, along with the possibility of an
even higher coupon if LIBOR rises.
At the start of the year, the loan market was preoccupied with
what seemed to be the largest issue emerging from the rubble
of the financial crisis, the “Great Recession” and the record-
setting default rate of 2009: the “Maturity Wall,” so named in
reference to the concentration of seven-year loans that mature
in 2013-2014. This anomaly can be traced to the explosive
growth of collateralized loan obligations (CLOs) in 2006-2007,
which made relatively cheap financing available to non-invest-
ment grade borrowers, which in turn facilitated the huge spike
2010 recap: even better than we thoUght
The past year saw very strong performance in the leveraged
loan market, which produced a return of 8.9% through 3
december, according to S&P. This very strong performance
followed the record 51% return in 2009, which in turn followed
the very weak performance during the peak of the financial
crisis in 2008.
The loan market’s 2010 performance was driven by three
trends, which together strongly underpinned the market dur-
ing the year:
A much lower than expected default rate for the year: •
Following the spike in defaults in 2009 and in the context of
an economy still struggling to gain traction, 2010 defaults
had been widely forecast at between 4% and 8%. However,
the default rate will finish the year at a much lower than
expected 2-3%. We attribute this lower than expected
rate to better liquidity in the capital markets, better than
expected cost-cutting measures that kept corporate cash
flows above expectations, and the fact that so many vulner-
able companies had already defaulted in 2009.
Positive derivative effects from the surge in demand for •
high yield bonds: With interest rates near zero, investors
worldwide were desperate to capture yield, and the high
yield bond market was the logical beneficiary of this search.
The massive flows into high yield funds, and the allocation
by some institutional investors away from equities and into
credit, provided the demand side to the record new issuance
of high yield bonds. Many of these new issues were used
to refinance loans, both to stretch out maturities and to
escape troublesome covenants. Loan-to-bond refinancings
drove the loan prepayment rate well above its 2009 level,
providing loan investors, especially CLOs, with a surge in
cash available for reinvestment.
51
The technical environment for leveraged loans should •
remain favorable. We believe that CLO issuance could come
back to life in 2011 but, if it does, it will be at a far more
muted pace than at the peak of the market in 2006-2007.
In addition, over the next three to four years, an increasing
number of existing CLOs will reach the end of their respec-
tive reinvestment periods. CLO demand, which had been
the principal driver of loan market growth in 2006-2007,
should therefore remain muted by historical standards and
comprised largely of existing structures seeking to replace
assets. On the other side of the equation, loan supply should
remain fairly steady given recent resurgence in buyout
activity, as well as the very significant and ongoing refinanc-
ing activity that should continue throughout 2011. As such,
we believe that the current technical environment is likely
to remain favorable, and that loan issuance should there-
fore continue to carry strong pricing.
Loans still offer above-average value. After the strong run- •
up in prices in 2009 and 2010, the loan market is undergoing
a shift from returns driven primarily by price appreciation,
to returns primarily based on current yield. As issuers refi-
nance the remainder of the maturity wall, the percentage of
loans carrying higher current yield should increase, thanks
to the addition of LIBOR floors and higher spreads. Assum-
ing that default rates in 2011 average 3% and recovery rates
60%, both of which are worse than our 10-year average, the
resulting credit losses of 120 basis points are clearly out-
weighed by the average spread to maturity, which finished
2010 close to LIBOR +535 basis points.
in leveraged buyouts (LBOs) in 2006-2007. At the beginning of
2010, the maturity wall stood at a whopping uS $452 billion,
or approximately 85% of all outstanding loans , a daunting
number by any standard, but particularly in a market that had
seen less than uS $30 million of primary first lien issuance in
the preceding twelve months.
Along with the declining default rate and the gradual improve-
ment in the economy, perceptions of the maturity wall shifted
from risk to opportunity throughout the year. The need to
refinance upcoming maturities, together with the pronounced
improvement in financial market liquidity, induced healthy
companies to restructure their balance sheets in ways that are
profitable for loan investors. Throughout the year, a large por-
tion of the maturity wall was refinanced in the high yield mar-
ket or extended via loan amendments or refinancings that pay
investors up-front fees and higher coupons. As we approach
the end of 2010, the maturity wall has been reduced to uS $289
billion, or about 57% of outstanding leveraged loans. Refi-
nancing activity will remain a central theme in 2011, and loan
investors stand to reap the resulting benefits of higher average
spreads and prices in a low default environment.
2011: another good year?
We remain optimistic that the year ahead will likely see
continued good performance, albeit modestly subdued relative
to 2009 and 2010. Our optimism is based on three principal
factors:
The current economic scenario of 1% to 3% GdP growth •
is quite healthy for leveraged credit. Slow GdP growth
provides a favorable operating environment for loan issu-
ers, while not forcing them into growth that is so quick that
it strains their liquidity. defaults, therefore, should continue
to run at the low end of their long-term range.
52
2011 Investment OulOOk | fixed income
uS HIGH YIELd BONdS
John Yovanovic, CFA, Head of US High Yield
during the year, however, high yield suffered through three
bouts of volatility, due to European sovereign debt issues and
the contagion fears that followed. Low monthly returns this
year can be traced to Greece (February and May) and Ireland
(November) and, as 2010 drew to a close, we still had open
questions about Portugal and Spain in the marketplace. These
contagion fears had the unexpected effect of portraying uS
dollar assets as a safe haven. All spread credit, including high
yield, received a boost from the ensuing rally in uS rates, as
evidenced by the Barclays uS Treasury 7-10 Year Index return-
ing 13.09% through November 2010.
The net effect is that total returns for high yield have been
attractive at 13.35% through November 2010. However, while
the yield-to-worst of 7.8% is 120 basis points tighter than last
year, spreads are only 35 basis points tighter, and the current
yield is still over 8.25%. The combination of spread, attractive
current yield and continued low default rate lead us to view
high yield credit as an attractive asset class into 2011.
2010 recap: investors remain interested
2010 was another rewarding year for high yield investors. The
year picked up where 2009 left off, as investor demand for
spread product continued to drive yields tighter. Lipper/FMI
reported retail inflows of uS $10.6 billion for the asset class
through October 2010, and institutional inflows were strong
as well. The continued interest from investors is warranted, in
our view, due to improving fundamentals in the asset class and
stabilizing macroeconomic reports.
Corporate fundamentals continued to improve during the
year. This combined with strong asset inflows to make capital
markets access available to a wider range of issuers. 2010 set
a new record for capital market issuance with over uS $263
billion placed as of November 2010; over 60% was targeted
toward refinancing and the extension of maturities. Broader
access gave lower-rated companies capital that simply was
not available during 2009. The availability will lead to default
rates being well below expectations. According to JP Morgan,
the 2010 high yield bond default rate ended the year near 1%,
a record low.
‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10-30
-24
-18
-12
-6
0
6
12
18
24
30
36
42
48
54
60
US GDP
JPM HY
TABLE 1 ANNuAL uS hy RETuRNS
Source: Bloomberg as of 31 December 2010
53
uS Treasury yields have been steadily moving higher in late
2010. As we’ve already noted, high yield spreads should be
tighter than current levels, based purely on fundamentals
and default rates. The asset class appears to have a spread
cushion that would likely absorb much of any anticipated rise in
uS Treasury yields.
The net effect of all of these variables is that we believe the
range of return expectations for high yield bonds next year to
be 7% to 8%. We expect fundamentals to remain strong and
believe the current yield will remain attractive to investors,
providing continued asset inflows. default rates should remain
low, making current spread and yield levels appear inexpen-
sive; in our opinion, yields are high enough to withstand much
of the anticipated rise in uS rates. Macro fundamentals are in
the “sweet spot” for the asset class. While we believe next year
may see bouts of volatility much like 2010, we remain of the
opinion that patient investors will be rewarded with attractive
returns from high yield bonds in 2011.
2011 oUtlook: fUndamentals will prop Up the market
We believe that high current yield will allow the asset class to
post attractive returns across a variety of scenarios. Within
high yield, spreads are a function of default rate and recovery;
specifically, what rate should investors demand to compen-
sate for default losses? Recall that many problem companies
defaulted in 2009. Much of the maturity wall the market faced
last year has been refinanced beyond 2014. Combined with
improving fundamentals, this was the reason 2010 default
rates were so low, a trend we expect into 2011 and 2012. We
expect default rates to continue to be around 2% in 2011, still
well below historic norms. This, in turn, suggests that high
yield spreads are more than 100 basis points cheaper than
their fair value.
Fundamentals have improved across the high yield universe
since mid-to-late 2009. BB and B rated issuers have lead
this improvement. Recently, however, we have also observed
improvements to lower-rated and consumer-related company
results. This continued trend bodes well for credit rating
upgrades and continued capital markets access. Therefore, we
see few problems within high yield as an asset class.
On the macro front, there are multiple variables to consider.
Macroeconomic fundamentals appear favorable. High yield
investors prefer an economic environment that is “not too hot,
not too cold.” Consensus GdP forecasts appear to be in the
zone that has historically resulted in favorable returns for the
asset class.
The two main risks, in our opinion, are sovereign contagion
fears and uS Treasury rates. To date we have seen volatility
across capital markets, due to problems and ensuing bailout
packages for both Greece and Ireland. Portugal and Spain
appear to be the next news items along those lines. The high
yield market feels second derivative effects via equity market
volatility. Over the past 10 years, high yield has been about 55%
correlated with equities, according to Bloomberg. We would
expect any volatility around this issue to cause short-lived
volatility in high yield, as it did in May and November 2010.
54
2011 Investment OulOOk | fixed income
The uS Treasury market has enjoyed a strong rally, led by
shorter maturities, in response to the anemic performance of
the economy this year. Economic performance has certainly
not been typical of rebounds in the recent past, an indication of
the impact a massive correction in key asset prices can exert.
Weak inflationary readings and high unemployment have
proven the catalyst for additional Fed measures to support
their twin directives of price stability and full employment. The
Fed’s plan to purchase uS $1.75 trillion of mortgage-backed
securities, which was designed to support the housing market,
was wound down in the first half of 2010.
In an effort to provide additional support to the market
and keep rates low, the Fed announced the purchase of uS
Treasuries over time, with the principal pay downs from this
portfolio. This initial effort at quantitative easing (qEI) was fol-
lowed in early November with qEII, a uS $600 billion program
to directly purchase uS Treasury securities over the ensuing
eight months. Therefore, for the final two months of 2010 and
the first six months of 2011, approximately uS $900 billion
in uS Treasury securities are slated to be purchased by the
central bank, virtually matching the uS Treasury’s projected
issuance. Moreover, despite the recent volatility surrounding
these measures, the overall impact has been, and will likely
continue to be, to keep rates low and the yield curve steep.
As 2010 began, continued improvement in the credit markets
was expected, as the markets healed from the severe disrup-
tion of the financial crisis of 2008. The liquidity that was pro-
vided by central banks served as the catalyst for a historic rally
in 2009 and 2010. The outlook for 2010 was for follow through,
albeit with some volatility. The economy would continue its
sluggish rebound and provide a good environment for fixed
income markets. This scenario seems to have been realized,
for the most part, with the surprise being the tremendous rally
in uS Treasuries fueled by the sluggish economy and additional
liquidity measures from the uS Federal Reserve (Fed).
The volatility witnessed at the beginning of the year was
focused primarily on European sovereign debt issues and
the unfolding of the new financial regulatory environment.
The second quarter of 2010 proved to be the most volatile
as these issues, along with concerns about measures taken
by China and other emerging economies to slow growth and
the oil spill in the Gulf of Mexico, soured investor sentiment.
Indeed, May saw the fourth worst month of performance in the
investment grade credit markets since 2006, quite a statement
given the period that it encompasses. Nevertheless, markets
rebounded smartly from this setback over the summer, as
investor concerns were addressed through various measures,
notably strong central bank support, which permitted money to
resume its robust flow into the sector.
Us investment grade fixed income overview
Robert Vanden Assem, CFA, Head of US Investment Grade Fixed Income
55
The dynamics of economic growth, inflation and stimulus will
continue to exert tremendous influence on markets. Notably,
volatility will continue in the currency markets, as tensions
among nations are likely to ebb and flow, guided by these con-
cerns. Specifically, commodity-rich and emerging nations will
act to temper growth and inflation, while the major economic
blocs will strive to bolster economic growth.
Markets have continued to improve in 2010, albeit at a much
more measured pace than 2009. Moreover, volatility has
impacted the markets more forcefully than during previ-
ous cycles, as highlighted by May’s setback. Sovereign debt
problems in Europe, emerging market growth and inflation,
and the fragility of the recovery in the uS will continue to influ-
ence market conditions and overall sentiment. Nevertheless,
improving fundamentals at the corporate level, coupled with
abundant liquidity, have proven to be strong catalysts for credit
markets. In short, slow, steady progress in spread-product
performance, buffeted by periods of volatility experienced
within a range-bound, low-interest-rate environment, is the
favored scenario for 2011.
56
2011 Investment OulOOk | fixed income
Indeed, the tremendous rebound in credit spreads over the
last two years has left many sectors within our market at full
value. Earnings comparisons are likely to get more difficult in
the new year, given the less-than-stellar growth potential in
many segments. Moreover, large cash positions and a lack of
opportunities for organic growth have increased the potential
for less bondholder-friendly activity. M&A activity and share
buybacks are likely to continue to be a common occurrence in
2011 and highlight the fact that security selection will play an
increasingly important role.
Relative value and the ability to exact returns from sector and
security selection are likely to be the focus of 2011. despite
the relative richness in some sectors, others have yet to fully
recover from the conditions of the recent past and selecting
securities still represents value as well. For example, finan-
cials are trading significantly wider than their historical levels.
This is the result of the sector still reflecting the nature of the
crisis experienced over the last several years. Nevertheless,
the regulatory environment is centered on enforcing higher
capital levels and more ratings visibility and stability. There-
fore, despite the implied withdrawal of government support,
these efforts are actually more of a concern for equity returns
and a longer-term positive for credit. In addition, at the secu-
rity level, specific names and issues still represent value. Ris-
ing stars, securities with structure, less liquid securities and
new entrants offer perhaps the best value within our markets.
Our investment strategy remains consistent as we focus on
combining a top-down economic, market and sector view
with a rigorous analytical approach that stresses bottom-up
security selection. On the economic front, the focus of the next
year is likely to be centered on the pace of the recovery and the
efforts of the Fed to maintain price stability and improve the
employment situation. Moreover, global dynamics surrounding
European sovereign debt issues and commodity-linked and
emerging efforts to calm growth and inflation will continue to
be in the news. despite the fact that these elements will add
volatility to the mix, the strong technical environment, improv-
ing fundamental backdrop and reasonable valuations in many
sectors will provide support for sustained performance.
2010 recap: retUrns with volatility
2010 followed a two year period that saw a tremendous sell-
off, preceding a dramatic rally that left investors wondering
what could be next. The first quarter was basically a continu-
ation of the strong market conditions experienced in the
latter half of 2009, as improving fundamentals, liquidity and a
renewed interest in the asset class persisted. Nevertheless,
harbingers of increased volatility were present, as mounting
news of Greek sovereign debt issues and efforts by China
to slow its growth rate hit the market. Thus, by April, these
issues coupled with a renewed focus on financial regulation
in Washington and the oil spill in the Gulf of Mexico to cre-
ate the conditions for a buyers’ strike in our markets. The
month of May saw spreads in investment grade credit move
40 basis points or 30% wider (based on the Barclays Capital
uS Investment Grade Credit Index), driven by these factors. A
liquidity backstop provided by the European Central Bank for
Greece, coupled with more clarity surrounding other con-
cerns, stabilized markets. Moreover, by the end of the second
quarter, investors had built rather large cash balances that
needed to be put to work. Hence, a strong rally ensued during
the summer months. By the fourth quarter, spreads had
retracted to where they had begun the year. Overall, 2010 was
a volatile year, yet one that produced positive excess returns
for investment grade credit.
2011 oUtlook: sector and secUrity selection
As we look to 2011, questions remain regarding the strength
of the domestic economy and, consequently, the extent of the
uS Federal Reserve (Fed) easing that remains, the degree of
additional measures needed to support and/or restructur-
ing needed for governments in Europe, and the amount of
additional tightening of credit conditions to be seen from
commodity-linked and emerging economies. These factors are
set to ensure that volatility will not completely subside and add
uncertainty to the return scenario. Nevertheless, abundant
liquidity and the relative stability of the asset class should
continue to support the sector.
uS INVESTMENT GRAdE CREdIT
Robert Vanden Assem, CFA, Head of US Investment Grade Fixed Income
57
market. Second, the actual prepayments that have occurred to
date as a result of low interest rates have been only a fraction
of the level of refinancing that have historically occurred dur-
ing normal economic cycles. We attribute this to tighter credit
standards, the underwater nature of many housing borrowers
and weak consumer confidence, stemming from an uncertain
employment outlook. Finally, the overall skepticism about the
potential effectiveness, scope and duration of qEII has resulted
in sharply higher interest rates since the election, which, in
turn, have improved the outlook for Agency MBS, due to lower
perceived prepayment risk.
CMBS had a banner year in 2010, with sector returns of
more than 20% through the first 10 months of the year. As
we predicted in last year’s Investment Outlook, CMBS bonds,
particularly the so-called “super-duper” 30% credit-enhanced,
AAA-rated bonds, were extremely cheap going into 2010. In
fact, during the first six months of 2010, these AAA bonds were
trading cheap to BB-rated (high yield) corporate bonds. As
a result, as cross over investors increased their knowledge
of these bonds and obtained a better understanding of the
potential credit losses on them, credit spreads corrected sig-
nificantly. This correction occurred despite ongoing high levels
of delinquencies and uncertainty with regard to the ability to
refinance maturing commercial term loans.
ABS also had a solid 2010, returning 7.62% through the first
10 months of 2010, with the Credit Cards sector (+8.85%), and
utility-rate-reduction bonds (+7.97%), outpacing Auto ABS
(+3.38%). Overall, ABS credit continued to improve during the
year as credit card industry defaults declined and the Manheim
used Car Index reached recent highs. Stronger used car prices
lessen potential credit losses.
2011 oUtlook: secUritized prodUcts sectors look positive
Entering the new year, we believe that securitized sectors are
again poised to produce excess returns for investors. This is
supported by the goal of qEII, which is to make credit or spread
products more attractive to investors relative to Treasur-
2010 recap: another solid performance year
The Barclays Securitized Index returned a solid 7.26% during
2010 (year-to-date through 31 October 2010), which lagged the
return of the Barclays Aggregate Bond Index of 8.33% over the
same time period. The returns of the three major components
of the Securitized Index were 6.14% for agency mortgage-
backed securities (Agency MBS), 20.59% for commercial
mortgage-backed securities (CMBS) and 7.26% for asset-
backed securities (ABS).
Agency MBS is on track to show positive returns for the third
consecutive calendar year following the credit crisis. The year
began with many market pundits predicting wider spreads,
on the assumption that the completion of the MBS purchase
program (qEI) by the uS Federal Reserve (Fed) would result
in reduced investor demand for mortgages and, consequently,
wider spreads. This assumption proved to be false as banks,
overseas investors and a strong collateralized mortgage
obligation (CMO) bid kept MBS spreads from any significant
widening. However, an unexpected market factor, the govern-
ment-sponsored entity buyout of delinquent loans caused by a
FASB accounting change, resulted in a surge in Fannie Mae and
Freddie Mac MBS prepayments during the period of March to
June. These unexpected prepayments, against a backdrop of
premium-priced pools, resulted in sluggish MBS investment
performance during the middle part of 2010.
Further, the overall continued weakness in the uS economy
during the second and third quarters, leading up to the mid-
term elections, led to the expectation that additional quantita-
tive easing (qE II) would be needed to add additional stimulus to
the economy. This perception led to record-low interest rates,
as the 10-year Treasury yield fell to 2.38% in October, which
caused MBS investors to begin to fear a refinancing wave.
However, against this backdrop the MBS market regained
its strength after the mid-term elections, due to three fac-
tors. First, the Republican victories that allowed the Grand
Old Party (GOP) to control the House of Representatives have
reduced concerns over a “universal mortgage rate,” which
would have resulted in a large-scale refinancing of the MBS
uS SECuRITIzEd PROduCTS
John Dunlevy, CFA, Head of US Securitized Products
58
2011 Investment OulOOk | fixed income
rated bonds, and the fact that subprime MBS is no longer
a part of the Barclays ABS Index, which is a subcomponent
of the Barclays Aggregate Index. Next, many of the macro-
hedge funds that entered the market during the credit crisis
have exited, citing a general lack of detailed product sector
knowledge and their inability to effectively hedge their credit
bets now that the single-name CdS market has disappeared
post credit crisis. Finally, we believe that political risk is
another contributor to the current cheapness of the sector.
That is, the government at the local, state and national levels
has influenced everything from loan modifications to new
home purchases through tax credits and home foreclosure
timelines. We therefore believe that investors that have the
product experience, modeling capabilities and infrastructure
to undertake the required complex analysis in these product
areas will be able to properly assess the credit and cash flow
timing risks and earn attractive returns in this sector.
In 2011, we also expect the CMBS sector to perform well.
However, we believe sector spreads will prove to be more
volatile than the other securitized products sectors. We
attribute this increased sector spread volatility to the afore-
mentioned change in the composition of the CMBS investor
market. Therefore, given that the market is now comprised of
more yield-oriented buyers, such as crossover high yield bond
investors, we would expect the CMBS market to become more
highly correlated to other fixed income markets.
Additionally, we would expect sector spread volatility to
continue to be correlated with any news about the overall
domestic economy and, therefore, continue to have a positive
correlation to broad equity indices, such as the S&P 500. Over-
all, however, we continue to believe that the CMBS sector still
offers compelling relative value opportunities versus other
fixed income sectors and should, therefore, continue to enjoy
spread tightening next year. We also believe that insurance
company accounts will step up their demand for CMBS product
ies. Further, we believe securitized products will be viewed
as appealing Treasury substitutes, which offer a compelling
combination of spread, credit quality and liquidity.
We believe that the Agency MBS sector is properly positioned
to enjoy strong performance in 2011. This is due to four key
factors. First, as previously mentioned, we believe prepay-
ment risk will remain muted during the coming year. Reduced
prepayment supports the MBS bid by increasing “carry” on the
mortgage pools. Second, given the outlook for a continued lax
monetary policy and the stated qEII purchase policy, we would
expect interest-rate volatility to remain low or fall further.
Again, this should support MBS prices by lowering the effective
option costs embedded in the securities. Third, given the Fed’s
current policy of continued low short-term interest rates and
light qEII Treasury purchasing on the longer part of the curve,
we expect the yield curve to remain steep. The continued
positive slope to the yield curve supports MBS by increasing
the bid from dealers purchasing collateral to support Agency
CMO activity. Finally, we expect the overall housing market to
continue to exhibit sluggishness during 2011, which, in turn,
should result in limited new MBS supply.
Entering 2011, we think the Non-Agency MBS market offers
among the most compelling relative value opportunities
within fixed income, albeit not without risk. Although spreads
in Non-Agency MBS have tightened during the past one to
two years, they have lagged the tightening that has occurred
in many other sectors. The reasons for this compelling
opportunity are several. First, many traditional Non-Agency
MBS buyers have exited the market due to the demise of new
collateralized debt obligation (CdO) transactions, major bond
downgrades that have curtailed interest in the sector due to
the inability of many accounts to buy below-investment-grade
59
Within the CMBS market we continue to see inefficiencies that
can be exploited by investors who undergo extensive credit
work on the overall market. Additionally we expect the 2006
to 2008 vintage transactions, which currently trade at large
concessions to seasoned (2005 and older), and newly issued
CMBS, will begin to converge as investor demand grows for the
problem vintage deals.
Finally, we think traditional ABS segments, such as the AAA-
rated credit card and prime-auto bonds now look attractive,
relative to lower-rated BBB classes, off of the same deals, as
subordinated spreads in these sectors have outperformed dur-
ing 2010. Further, we continue to look for opportunities within
non-traditional ABS sectors. These sectors should outperform
during the coming year.
in 2011, following the release of the lower-than-expected
National Association for Insurance Commissioners sanctioned
sector-loss model. This model will replace the rating agency-
based model for setting capital reserve requirements for
CMBS investments.
Within ABS, we expect credit card and prime auto ABS to
perform in line with the market during 2011. We would expect
the non-traditional or “off-the-run” segments of the ABS
market to outperform next year, due to two factors. First,
these sectors, which include private student loans, rental car
and timeshare ABS, offer investors an incremental spread
advantage over more traditional ABS. Second, the rating agen-
cies have become much more conservative with regard to their
credit enhancement levels in many of these sectors, which, in
turn, offer investors a compelling risk/reward opportunity to
invest in these slightly less liquid asset classes.
We favor the following sectors and subsectors for 2011: Within
the Agency MBS market, we continue to focus on slow-paying
specified pools, plan to move up in coupon and look for
opportunities to add “carry” to portfolios. Higher-coupon pools
should be either seasoned, burnt out or be issued post-Home
Affordable Refinance Program (HARP) (HARP eligibility ended
for loans originated after March 2009) in order to minimize
prepayment risk.
Within the Non-Agency MBS sector we favor an overweight in
subprime and an underweight in prime MBS, based on a poor
risk/return profile. A portfolio that can be self-hedging with
regard to potential government policy risks is beneficial. That
is, some bonds will benefit from timeline extensions and fore-
closure delays and other bonds will benefit from the resump-
tion of distressed property sales and home foreclosures.
60
disclosures
indices that the capital markets line forecasts pertain to
Equities
uS Equity: MSCI uSA Index•
Europe Equity: MSCI Europe Index•
Japan Equity: MSCI Japan Index•
ISC: MSCI All Country World ex-uSA Index•
EM Equity: MCSI Emerging Markets Index•
EM Asia Equity: MSCI Emerging Markets Asia Index•
EM EMEA Equity: MSCI Europe, Middle East and Africa •
Index
EM Latam: MSCI Latin America Index•
Fixed Income
3 Month Treasury: uS 3 month Treasury Bill•
5-7 year Treasuries: Barclays Capital u.S. Government 5-7 •
Year Bond Index
uS Core: Barclays Capital uS Aggregate Bond Index•
Inter Corp: Barclays Capital Intermediate Corporate Bond •
Index
uS High Yield: Barclays Capital uS Corporate High Yield •
Bond Index
Long Credit: Barclays Capital uS Long Credit Bond Index•
Muni: Barclays Capital 8-12 Year Municipal Bond Index•
TIPS: Barclays Capital uS Treasury: uS TIPS Index•
JGB: Barclays Capital Asian-Pacific Japan Treasury Index•
Bund: Barclays Capital Euro Aggregate Treasury Germany•
EM Corporate: JP Morgan Corporate Emerging Markets •
Bond Index (CEMBI) Broad diversified
EM Sovereign: JP Morgan Emerging Markets Bond Plus •
Index (EMBI+)
EM Local Currency: JP Morgan Government Bond Index - •
Emerging Markets diversified
Bank Loans: S&P/LSTA Leveraged Loan Index•
Alternatives
Fund of Hedge Funds: HFRI FOF Index•
Private Equity: Thompson Venture Economics - Pooled •
internal rate of return of all uS Private Equity funds that
report returns to Thompson Venture Economics.
Commodities: dJuBS Index•
Real Estate: National Council of Real Estate Investment •
Fiduciaries (NCREIF) Index
61
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