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October 2015 Monthly Performance Report Smarter Money Higher Income (SMHI) Strategy

• Smarter Money Higher Income’s (SMHI) total returns after fees rose in the month of October (+0.2%) while its net weighted-average interest rate (ie, running yield) across SMHI’s 44 deposits and investment-grade floating-rate notes (FRNs) remained a robust +3.5% pa after all fund fees as at 31 October (subject to the unit class). This running yield is in line with SMHI’s official benchmark of the RBA cash rate (currently 2%) + 1.5% pa. The chart below shows the running yields available from different asset-classes, including the leading 1, 3, 6, 9 and 12 month term deposit rates, SMHI, Smarter Money Active Cash, and the Australian equities market (note different investments carry different risks and past performance is not a guide to future returns). SMHI, which offers daily application/redemption rights on a t+3 basis, is designed to carry very low interest rate duration (historically always less than 3 months) and credit (historically in the "A" band) risk that should outperform conventional “duration-rich” fixed-income strategies when long-term interest rates start to normalise. With the US Federal Reserve expected to hike rates in December, duration exposed products are now being punished by higher yields (see more below).

• Despite extreme financial market turbulence in June, August and September (Australian equities, ASX hybrids, government bonds, and corporate debt were subject to several “two standard deviation” shocks as highlighted in the table below) SMHI has delivered a year-on-year gross (net) return over the 12 months to 31 October of 3.7% (2.7%), which was superior to the AusBond Bank Bill Index (+2.4%) and in line with the performance of the AusBond Floating Rate Note Index (+2.7%) over the same period notwithstanding the fact that SMHI has a portfolio weight to cash whereas the FRN index is fully invested in bonds.

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• As at 31 October SMHI had 95.1% of its portfolio invested across 33 different (mainly bank-issued) Australian FRNs with the remaining 4.9% allocated across 2 deposits. This is the largest number of FRNs SMHI has held, which is a function of the increase in its portfolio size. The weighted-average credit rating across SMHI’s deposits and FRNs was “A-” in October consistent with its mandated target of staying in the “A” band. Accounting for both its holdings of deposits and FRNs, SMHI’s portfolio is diversified across 11 APRA-regulated Authorised Deposit-Taking Institutions (ADIs).

• Technical research question: how should bank deposits be rated? Deposits in Australia benefit from unconditional priority ranking over all other unsecured debts, including senior bonds, through the “depositor preference” elements of the Banking Act (see this RBA paper on the subject). This means that

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in insolvency a bank deposit with or without a government guarantee is protected by a range of subordinated securities, including all senior bonds, subordinated bonds, additional tier one hybrids, and common equity tier one capital. In the case of the four major banks this legislated subordination is equivalent to about 40 per cent of bank assets and implies that deposits should receive higher credit ratings than senior bonds and other junior-ranking securities. While S&P does not rate deposits per se, Moody’s does and recently released a new global bank rating methodology that explicitly recognises the capital structure priority of deposits protected by legislated preference in an event of default. Moody’s has started implementing the new method in other countries like the US that has resulted in rating upgrades for deposits of typically 3 notches above senior bonds. We expect Moody’s to eventually apply this same approach in Australia once it acknowledges APRA’s expansive bank resolution and bail-in powers under the Banking Act. We believe that applying senior bond ratings to deposits categorically results in rating underestimates (arguably errors) given the presence of legislated depositor preference in Australia.

• We have long forecast a major re-rating of interest rate risks across bond markets (see this AFR column last weekend) on the back of stronger-than-expected jobs growth in the US (refer also to our detailed analysis of this issue last month here). It should not therefore be surprising that the biggest news in financial markets right now is the jump in interest rate duration risks driven by the US Federal Reserve signalling a December “lift-off” off from the current 0% to 0.25% lower-bound in the fed funds rate. This was amplified by stunningly strong US payrolls numbers on Friday (viz., 271,000 new jobs in October versus the ~180,000 consensus estimate), which bested every single forecaster, and a further decline in the US jobless rate to 5.0% (cf. Australia’s jobless rate at 6.2%). This makes a 16 December Fed hike all but certain barring a global calamity and has forced a sharp re-rating of Australian interest rate risk. Specifically, the 3 year (10 year) Aussie government bond yield has jumped from ~1.75% (2.58%) in October to ~2.07% (2.93%) in November. The RBA’s Glenn Stevens keeps in close contact with the Fed’s chair Janet Yellen and he may have had insights on the latter’s December meeting that helps explain the RBA’s own decision to pause in November. As the Fed is the most important marginal influence on global interest rates, any hike has significant ramifications for Australian monetary policy. The RBA is hoping that “lift-off” will put downward pressure on the Aussie dollar, which has started to occur via the jump in government bond yields over the last week or two. During this time the Aussie dollar has fallen from ~US72c to ~US70c.

• In good news for depositors and fixed-income investors, the major banks reported in October and November that they have boosted their equity capital by a stunning $33 billion over the last year and are now all reporting common equity tier one (CET1) capital ratios that are comfortably in the top 25% of peer banks globally (see NAB charts below). We have been forecasting the need for this recapitalisation process since 2013, which will undoubtedly continue for years yet. On a related note, on Monday evening the Financial Stability Board announced its final "total loss absorbing capacity"

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(TLAC) rules, which will affect most global banks one way or another. The key take-aways are as follows:

• TLAC of 16% in 2019 is much lower than first FSB proposal in November 2014 of 18% with corresponding reductions in the FSB’s expected short-fall to as little as EUR42bn for developed GSIBs (assuming all existing debt is refinanced over time in accordance with TLAC rules)

• Introduction of statutory bail-in regimes for all bank-issued debt securities (including senior bonds) in the US, UK, Europe, Canada, and NZ means all future senior issuance by resolution entities can be used to satisfy any TLAC short-falls at lower cost

• TLAC should be a non-issue for Australia's four major banks because: it does not formally apply to them given they are not globally systematically important banks (GSIBs), although APRA will eventually introduce its own customised TLAC regime; their globally top quartile common equity tier one (CET1) and total capital (similar to TLAC) ratios of ~13% and ~18% respectively should meant they are well positioned to meet APRA's version of the TLAC rules; they are continuing to march their CET1 ratios higher, which will further lift their TLAC ratios; APRA’s very sensible desire to “hasten slowly” in the unproven and risky domain that is TLAC and its ability to customise the rules to ensure the majors are not in any way disadvantaged vis-a-vis peers; and APRA's “flick-of-the-switch” ability to make all major bank senior debt in principle TLAC eligible through its existing statutory bail-in powers under the Banking Act, which means they should theoretically have among the highest TLAC ratios in the world today (rating agencies have evidently yet to figure this out)

• Now that most overseas banks are issuing TLAC-eligible senior bonds combined with the lower 16% TLAC target---the FSB found the average GSIB is comfortably TLAC compliant if they roll their existing senior debts into TLAC eligible securities---means there should be no TLAC-driven tsunami of higher cost CET1, AT1 or T2

• One of the most interesting and little-understood insights to come out of this exercise is the recognition that ARPA already has the capacity to bail-in senior ranking bonds in a crisis, which it formally acknowledged in its response to the Financial System Inquiry: “APRA does have compulsory transfer of business powers, which, in certain circumstances, could be used to achieve a similar economic effect to a bail-in. Subject to certain triggers and safeguards, this power could be used to transfer a failing ADI’s assets to another entity, leaving behind capital instruments and certain unsecured liabilities to absorb losses,” APRA wrote. Deloitte's regulatory guru Kevin Nixon agrees, commenting, "APRA has far-reaching powers under the Banking Act in respect of winding up a failed institution, giving it powers to do anything it deems appropriate, which means we have de-facto bail-in powers already".

• To their credit, Australian regulators have been belatedly manning-up on the banks across the board. Last week the RBA's "concerned" and "surprised" Phil Lowe revealed that regulatory investigations discovered that 10 banks, including two majors, had conveniently misclassified $50 billion of investor loans as (arguably lower risk) owner-occupied products. This resulted in the speculative share of the mortgage market jumping from 35% to a record high 40%. (A company one of our portfolio managers founded spent years enhancing the RBA's house price data, which Lowe said "helped improve the general understanding of housing market developments".)

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• The RBA is also to be congratulated for adopting a sophisticated "Merton model" for assessing corporate credit risk, which is an upgrade to its real-time risk monitoring. We use Merton's option pricing methods to quantify the probability of default and loss on our bonds and the RBA says "the model's ability to identify risks stemming from the real estate sector in 2008, and the deterioration in financial health in the resource sector more recently, indicates the value it adds". More specifically, SMHI’s team of two portfolio managers and seven analysts, which now includes 3x PhDs, use an array of sophisticated quantitative models (including several Merton derivations) to estimate the true “fair value” of an FRN from independent top-down and bottom-up perspectives (more information on these methods is available on request). Every day the analysts revalue hundreds of FRNs based on the security’s features (eg, maturity, credit rating, liquidity, industry sector and capital structure position), the issuer's financial characteristics (eg, assets, liabilities, leverage, volatility, etc), the probability of the issuer defaulting on the FRN, the expected losses in this event, and, where appropriate, objective market pricing for similar securities. The chart below shows the "fair value" credit spreads produced by SMI’s multi-factor top-down model for almost 200 different FRNs minus the market's traded credit spread (or actual price) for those FRNs. Red dots above (below) the horizontal x-axis are cheap (expensive) according to SMI’s models. If you would like to access our valuation insights on specific securities we are happy to share them with you.

• Since its public inception in October 2014 SMHI has displayed low annual return volatility (or variability) of 0.66% pa (measured daily). SMHI’s “Sharpe Ratio”, which measures risk-adjusted returns, has been approximately 1.1 times since inception (the specific calculation is SMHI’s net return less the RBA cash rate, which is then divided by the SMHI’s return volatility).

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• SMHI’s portfolio has been constructed such that it has little-to-no “interest rate duration” risk (or “modified duration”), which was just 1.2 months on 31 October 2015. It achieves this by not investing in fixed-rate (as opposed to floating-rate) bonds that lock in interest rates for multi-year periods and expose investors to capital losses when rates climb. The chart below highlights the inherently higher risk of fixed-rate bonds, which have had 5.4 times the volatility of a portfolio of Aussie FRNs over the last 15 years notwithstanding that both these markets have similar underlying credit ratings. This is almost exclusively an artefact of the uncertainty introduced by interest rate risk.

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• Another indication of SMHI’s low interest rate duration risk is the fact that its monthly returns have historically had a low correlation to Australian fixed-rate bonds, which implies that it could provide conventional fixed-income portfolios with diversification gains. With non-normally distributed returns, volatility is best measured using daily rather than monthly data, which can induce biases. On this basis, SMHI’s since inception correlation with fixed-rate bonds is -3.1% (ie, negatively correlated). This should prove increasingly relevant as long-term interest rates normalise and traditional fixed-rate debt portfolios suffer capital losses. In the first chart below SMHI’s analysts highlight the performance of the Australian floating-rate versus fixed-rate bond universes during a rising rate climate between 2002 and 2007 when the cash rate gradually lifted from 4.75% to 6.75%. Understanding where normalised interest rates lie is also important because convergence back to these levels could cause problems, as fixed-rate fund manager returns in both April and June showed (they suffered two standard deviation losses as noted in the table above). If the 3 year Australian government bond yield gravitates back to a more normal level equivalent to current real GDP growth of 2.0% plus 2.5% inflation (or 4.5% in total), or its average level of around 6% in the notably “low-inflation” period since 1990, it would inflict circa -7.4% to -11.2% losses on holders of these assets, which are often assumed to be "defensive" (see second chart below).

• SMHI’s portfolio management team expects reasonable global economic growth—driven by the US—to eventually feed-back into a “surprising” resurgence in wage inflation in the US. Given the very strong correlation between US long rates and global rates, this could trigger a steepening of the yield curve that pushes otherwise dear equity, bond and house prices back towards more credible

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equilibrium values. If this perspective proves accurate, asset-allocation should be biased towards market-neutral equities alpha, cash, and FRNs as other investments, like long-only equities, fixed-rate bonds, and residential property, realise capital losses as net present values are adjusted downwards (given higher risk-free rates). We note that conventional asset-allocation within domestic portfolios tends to favour correlated Australian and global equities (including private equity and property equity) and has only modest holdings of cash and floating-rate debt. The chart below shows that the typical Australian super fund has around 77% of its capital tied up in equities risk despite the rapid ageing of the domestic population. If one examines the long-term relationship between the ASX/S&P 200 and the S&P 500 indices, the correlations look low at around 18%. (While the monthly correlation is a much higher 54%, one should where possible use daily as opposed to monthly returns to minimise statistical biases associated with low-frequency sampling.) The problem is that during the Chinese equities crash in August the correlation between Aussie and US equities spiked three times higher than its long-run average. Theoretical diversification that was meant to protect you faded. Many investors learned this lesson in the global financial crisis, when supposedly uncorrelated assets like listed equities, infrastructure, hedge funds and private equity suffered simultaneous losses.

• As at 31 October SMHI’s cash-flow duration across all assets was 1,201 days (spread duration was 3.0 years). Under its mandate, SMHI is not permitted to use any leverage, not allowed to invest in related party securities, and has never used derivatives. A summary of prohibited investments include:

No leverage No foreign-issued bonds No fixed-rate bonds with maturities > 24 months No equities No convertible preference shares

• SMHI is available on the ASX’s new managed fund platform, called “mFund” (code: SMF02), which allows you to buy/sell units in SMHI via a stockbroker, or online broking account from the likes of Bell Direct or CMC, without dealing with new application forms. SMHI distributes interest quarterly, offers online account access and daily (t+3) investment and withdrawal rights, including BPAY and direct debit facilities. It is accessible on numerous platforms, which you can view here. You can apply to invest in SMHI online here and read the full PDS here.

Disclaimer: Past performance does not assure future returns. Returns are shown after all trust fees. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. To understand SMHI’s risks better, please refer to the detailed Product Disclosure Statement. A fund is not a bank deposit and your capital is not guaranteed. This information has been prepared by Smarter Money Investments Pty Ltd. It is general information only and is not intended to provide you with financial advice.