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FOR INVESTMENT PROFESSIONALS ONLY - NOT FOR USE BY RETAIL INVESTORS

Understanding Fixed Income
November 2012

While many investors are familiar with the main concepts of fixed income investing, some of the finer details may need explaining. This primer covers topics such as returns, price and duration, reasons for investing and the relationship of fixed income to equities. What is fixed income?
Fixed income describes a variety of debt instruments, although it most commonly refers to bonds. Typically, a borrower such as a government or a company may issue a bond, which is a contract outlining the conditions of a loan, to a bond holder (lender). This involves an exchange of principal at inception and at maturity, and periodic interest payments, known as coupons, from the issuer to the holder.

The components of a bond’s return
Payment 150 100 50 0 -50 -100 -150 1 2 3 4 Fixed coupon payments

Does fixed income mean a fixed return?
It is a frequent misconception that the return of a bond is fixed. True, the income component, equal to the bond’s coupons and set when the bond is first issued, is a fixed sum. Likewise, if an investor were to purchase a bond at issue (for the full principal amount, known as par) and hold it to maturity, without the issuer defaulting, then the return would be fixed because the principal would be repaid. The preservation of capital in this instance is one of the attractions of owning bonds. But a bond’s price fluctuates throughout its lifetime and the investor can hope to make capital gains when prices rise. Why do bond prices change? As with any tradable financial asset, prices reflect the balance of buyers and sellers, whose demand can be affected by changes in interest rates or economic sentiment. The expected income return from coupons is known as the running yield. But the most reliable measure for estimating the annual percentage return of a bond held to maturity is yield (short for yield-to-maturity) which takes into account the total return i.e. coupon payments and any changes in value as the principal reverts to par, coupons and the full principal amount.

5 6 7 Time (years)

8

9

10

11

Price

A B

Par (100)

Issue date

Maturity date

A  During the life of the bond, the price may rise above par. The bond holder can sell the bond at a profit. B  At maturity, the price of the bond reverts to par as the bond holder receives the entire principal amount from the bond issuer.

Why do bonds go up in price if yields go down?
Or, for that matter, why do bonds go down in value when yields go up? Coupon Yield Bond price There is an inverse relationship between bond prices and movements in yield. If interest rates go up, the price has to fall in order for the yield to remain competitive, and vice versa. Existing investors who have locked in yields look for prices to rise; new investors look for prices to fall in order to capture a higher yield. This can be confusing as sometimes investors think that a bond pays interest and thus will benefit from rising interest rates. This is incorrect as the interest earned by holding a bond is instead always fixed, as set by the coupon rate.

How much do bonds fluctuate in price and what is duration?
In order to estimate the change in price of a bond, it is important to understand the concept of duration. Duration measures the sensitivity of a bond’s price to a change in interest rates and is commonly expressed as number of years. This will depend on two main factors: • outstanding life of the bond – shorter the maturity, the shorter the duration • size of the coupons – bigger the payments, the shorter the duration There is a formula to calculate duration but that is beyond the scope of this article.

Duration explained
The amount by which a bond changes in price is roughly proportional to its duration multiplied by the size of any interest rate change. % Change in bond’s price = Duration x % Change in yield In this simplified example, assume that we have two bonds, one with duration of 4 years and the other with duration of 9 years. What happens when interest rates fall by 1%? Duration 4 years 9 years % Change in interest rates -1% -1% = -4 years x -1% = -9 years x -1% Change in bond’s price = 4% = 9%

Given a 1% fall in interest rates, the price of the long-duration bond rises by 9%, compared with a 4% gain in the short-duration bond. As such, if an investor expects interest rates to fall, it is more profitable for him to hold long-duration bonds. Likewise, if he expects interest rates to rise, he should pursue a short-duration strategy. Clearly, the calculation of a portfolio’s duration is essential to determining the return from a change in interest rates.

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Understanding Fixed Income – November 2012

Why invest in fixed income?
Fixed income investments offers various benefits, depending on investor needs: • Diversification: for investors who are exposed to a wide range of risky assets, the defensive nature of fixed income through diversification is most crucial. Traditional fixed income is negatively correlated with other asset classes such as equities and is also typically less volatile. However, it should not just be thought of as a substitute for cash as bonds have duration that typically rise in value when equities fall. Therefore, a balanced portfolio with a reasonable fixed income allocation should perform well under a variety of economic scenarios and ultimately reduce volatility of returns. • Capital preservation: while shorter-duration products are usually held for capital preservation, longer-duration bonds held to maturity (which does not default) will also return all of its initial capital. Although a fixed interest portfolio may not always hold bonds to maturity (often in order to capitalise on fluctuations in bond valuations through active management), the portfolios themselves will still benefit in the long run from this defensive dynamic - a security sold at a loss will typically be used to purchase a cheaper one. • Regular income stream: as the name suggests, investing in fixed income offers income. Many investors, particularly retirees, benefit from a regular income stream. Additional credit risk may give yield enhancement, which is more consistent and, on average, higher than interest earned on cash and term deposits.

The different objectives of fixed income
Interest Rate Risk (Duration)

Defense against equities Yield enhancement Short term capital reservation

Credit Risk (Rating)

Case study: Performance of fixed income throughout the global financial crisis
The global financial crisis highlighted the defensive nature of traditional fixed income and the downside of too much credit risk. In a slowing economic environment in 2008, Asia ex Japan equities dropped in value by 51.63%. In the second half of the year, regional central banks loosened monetary policy to encourage lending and lift growth. China, for example, cut rates for the first time in six years. As interest rates fell, the HSBC Asian Local Bond Index returned 0.98% for the year as investors sought value in higher fixed interest payments relative to the new level of low interest rates. Asian bonds denominated in US dollars, measured by the JACI Composite Index, posted a loss of 9.82%. The index includes exposure to government issuers and Asian companies in which investors saw less value due to an increased concern of default. Less “traditional” fixed income indices containing lower quality companies such as the JACI Non-Investment Grade Index returned -17.72% amid extreme levels of concern about default. Clearly, fixed income products with duration were effective in diversifying a balanced portfolio whereas fixed income with lower quality credit (hence higher credit risk) behaved more like equities and thus was a poor diversifier.

03

Understanding Fixed Income – November 2012

Why are bonds negatively correlated with equities?
The returns of traditional fixed income and equities are typically negatively correlated. In other words, when equities outperform, bonds tend to underperform and vice versa. When investors become risk averse, bonds are typically seen as a “safe-haven” asset class as they are less volatile by nature. Thus if investors begin to panic when equity markets are falling, they may sell shares and buy bonds. This additional demand for bonds will push prices higher as equities fall further. Longer term the relationship between equities and bonds is driven by the level of interest rates over the economic cycle. In periods of high economic growth, companies are more profitable hence equities tend to outperform. To avoid inflation, the central bank will usually constrain growth by raising interest rates. Bonds underperform when interest rates increase. However, in times of low growth, equities perform more poorly as corporate earnings dip. The central bank will typically stimulate the economy by lowering the cash rate which will be positive for bond holders.

Returns of equities and fixed income over last 10 years
80 60 40 20 0 -20 -40 -60 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Asian credit (JACI composite index) Asian equities (MSCI Asia Pacific ex Japan index) Asian local currency government bonds (HSBC Asian local bonds index)
Source: Bloomberg, November 2012

How does fixed income risk-return compare to equities?
For any investment, it is important to examine potential returns in the context of risk (volatility). Fixed income typically returns less than equities albeit with less risk and a more favourable risk-return ratio. Reasons for less risk compared to equities include: Fixed Income Fixed interest payments (coupons) Defined maturity with known capital redemption value In case of default/bankruptcy, bond holders are paid back first on any recovery value (higher up the capital structure) Traditional fixed income includes exposures to high quality issuers including governments Equities Uncertain income (dividends) Perpetual security In case of default/bankruptcy, equity holders are paid back last (bottom of the capital structure) Higher exposure to companies and higher concentration risk

The chart above illustrates the importance of diversification. Over the last 10 years, Asian local currency government bonds have posted annual returns of 1%-19%. Equities, on the other hand, have experienced much higher gains, with the market rising by more than 70% in 2009 alone. However, equities also registered three negative years, whereas government bonds were positive in the same periods. Meanwhile, the credit market was also less volatile than equities.

Return vs risk of equities and fixed income over 10 years
Total return, Year-over-Year p.a. 25% 20% 15% 10% 5% 0% 0% 5% 10% 15% 20% Risk Volatility 25% 30% 35%

Asian fixed income (HSBC Asian local bond index) Asian equities (MSCI Asia Pacific ex Japan index)
Source: Bloomberg, November 2012

The chart above highlights the significantly lower historical volatility of fixed income relative to equities, albeit with a marginally lower return.

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Understanding Fixed Income – November 2012

FOR MORE INFORMATION Client Services Team Kristina Najjar (Nordics) +46 8412 8069 Rik Brouwer (Benelux) +31 20 6870510 Frédéric Lejeune (France / Monaco) +33 1 7309 0303 Hartmut Leser (Germany / Austria) +49 69 76807 2310 Krisztina Kozma (Hungary) +36 1 413 2951 Matteo Bosco (Italy) +39 0288210821 Marina Poletto (Spain / Portugal) +44 20 7463 6260 Anton Commissaris (Switzerland) +41 44 208 3849 Chrissy Shuttleworth (UK) +44 20 7463 6328 Investor Services +352 46 40 10 820 [email protected]

Important information FOR INVESTMENT PROFESSIONALS ONLY - NOT FOR USE BY RETAIL INVESTORS Past performance is not a guide to future performance. The value of securities may go down as well as up and may be impacted by exchange rate movements. An investor may not get back the amount invested. Investments in EMs may involve a higher element of risk and volatility due to political and economic instability and underdeveloped markets and systems. The views expressed herein should not be relied upon when making investment decisions. The above is strictly for information purposes only and should not be considered as an offer, or solicitation, to deal in any of the investments mentioned herein. Aberdeen Asset Managers Limited (“the Manager”) does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document an expressly disclaims liability for errors or omissions in such information and materials. Any research or analysis used in the preparation of this document has been procured by the Manager for its own use and may have been acted on for its own purpose. The results thus obtained are made available only coincidentally and the information is not guaranteed as to its accuracy. Some of the information in this document may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies. These statements are only predictions and actual events or results may differ materially. Readers must take their own assessment of the relevance, accuracy and adequacy of the information contained in this document and make such independent investigations, as they may consider necessary or appropriate for the purpose of such assessment. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither the Manager nor any of its agents have given any consideration to nor have they or any of them made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document. The manager reserves the right to make changes and corrections to its opinions expressed in this document at any time, without notice. Issued by Aberdeen Asset Managers Limited which is authorised and regulated in the United Kingdom by the Financial Services Authority.

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