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Corporate bond investing in an inflationary environment

Ben Lord, Fund Manager October 2013

Five years of sticky cost-push inflation

(2007-2012)

RPI Target

UK RPI

UK CPI

CPI Target

Source: Bloomberg, M&G, 30 September 2013

UK RPI and CPI

UK inflation has been above target 54 out of 60 months

over the past 5 years

Sterling has lost around 20% since 2007

GBP/USD

GBP/EUR

Source: Bloomberg, 30 September 2013

Sterling depreciation

A weaker pound has driven up import costs

UK electricity and gas prices

Five years of sticky cost-push inflation Higher energy bills and fuel costs

Source: Bloomberg, 31 December 2012

Energy and gas prices have risen over 35% since 2007

Rising food prices

And UK food bills shot up by 3.8% in the past year

UN Food and Agriculture World Food Price Index

2007 2008 2009 2010 2011 2012 2013

UK real wage growth has been negative

Negative real wage growth

Putting household budgets under pressure

Time for demand-pull inflation?

UK all-sector PMI

PMI data hits record highs

All sectors moving in the right direction

Recent data points to further acceleration in growth

FFL scheme

LSL Acadametrics Nationwide HBOS

UK house price indices

UK housing market showing signs of life

Source: Bloomberg, 31 July 2013. Rebased to 100 at 28 February 2002

Surprise Index

Data above

expectations

Data below

expectations

Citi Economic Surprise Index

Economic recovery appears to be taking place

What does this hold for inflation?

Recent economic data has been surprising on the upside

Months from start of recession

6 12 18 24 30 36 42 48 54 60 66

1990/93

1973/76

1930/34

1920/24

1979/83

2008/?

Change in real GDP

-15% 0

UK economic slump is worse than Great Depression

Source: ONS, NIESR, September 2013

UK economic growth compared with previous recessions

The UK is no safe haven

UK employment is well above previous recession levels

Source: Bank of England Inflation Report, May 2013

Level of whole-economy employment compared with previous recessions

Quarters from pre-recession peak in GDP

20 18 16 14 12 10 8 6 4 2 0 2 4 6 8

2008/09

1980/81

1990/91

ices: p

10,000,000,000,000

1,000,000,000,000

100,000,000,000

10,000,000,000

1,000,000,000

100,000,000

10,000,000

1,000,000

100,000

10,000

Germany

France

Switzerland

1971 1913

Global inflation series

Source: Deutsche Bank, GFD , 12 September 2011

Re-based to 1 as at December 1899 on a log scale

What lessons does this hold for 21st century investors?

trillion

Central banks have printed almost $10 trn since 2007

Source: DB Research, February 2013

Sum of major central bank balance sheets

…larger than the combined GDP of the UK, Germany and

France

US, UK, ECB, Japan, China and Switzerland

BoE’s Carney offers some forward guidance

Source: Bank of England, Quarterly Bulletin-Q2, June 2013

BoE Inflation report – August 2013

Mervyn King focused on quantity of money. Carney is

now focusing on velocity of money

“We are introducing forward guidance as part of a mixed strategy which includes

bank rate at historic lows, asset purchases and the funding for lending scheme”

Forward guidance Focus on money

velocity

Repair transmission

mechanism (FFL scheme)

Return confidence to

business and households

Inflation and credit views

Inflation expectations

Valuations support inflation protection

Inflation protection looks cheap

UK (RPI) US Germany

Five-year breakeven rates for the UK, US and Germany

Oil shocks analysis

Source: Fathom Consulting , Bloomberg, 30 September 2013

Effect on inflation measures of an oil price increase

Oil price ($/barrel) Oil Price

$/Barrel UK RPI

EA CPI

ex-tobacco US CPI

40 -1 -1.2 -3

50 -0.8 -0.9 -2.4

60 -0.6 -0.7 -1.8

70 -0.4 -0.5 -1.2

80 -0.2 -0.2 -0.6

90 0 0 0

100 0.2 0.2 0.6

120 0.4 0.5 1.2

130 0.6 0.7 1.8

140 0.8 0.9 2.4

150 1 1.2 3

160 1.2 1.4 3.6

170 1.4 1.6 4.2

180 1.6 1.9 4.9

1% 0.4% 1%

IG Non-Fin AA A BBB

Actual Average Actual Worst Implied Defaults

Five-year implied default rates, UK non-financials

Source: Implied defaults calculated using 40% recovery rate. Deutsche Bank and Merril Lynch Indices, 30 September 2013. * Bps

Implied vs actual default experience

Default risk premiums are very high vs. experience since

Source: M&G as at January 2011

Conclusions

• Economic recovery and current policy responses may be laying the

foundations for higher future inflation

• Markets are pricing in a very low level of inflation

• A strategy of short duration, inflation protection and high quality credit

that delivers a positive real yield has to be a wise strategy

M&G UK Inflation Linked Corporate

Bond Fund

M&G UK Inflation Linked Corporate Bond Fund

Source: M&G, 30 September 2013

Fund facts

• Co-fund manager Ben Lord

• Co-fund manager Jim Leaviss

• Aim To protect the value of capital and income

from inflation by generating a return

consistent with or greater than UK CPI over

the medium to long term

• Launch date September 2010

• Size £775 million

24 Please note that guidelines are subject to change

• Minimum 80% Sterling (or hedged back to Sterling)

• Minimum 70% exposure to investment grade credit (including derivatives)

• VaR limits

– Upper limit: 10%

– Lower limit: 0.0%

• Restrictions by corporate issuer rating

– AAA - BBB 5%

– BB & below 3%

– Structured credit (inv grade) 2.5%

– Structured credit (high yield) 1.5%

Regulatory

Internal

Sector

Effect on capital value if

Why low duration matters

Less exposed to a rise in interest rates

Duration Yields +1% Yields +3 %

M&G UK Inflation Linked Corp Bond Fund 2.5yrs -2.5% -7.5%

Iboxx £ Corp Bond Index 8yrs -8% -24%

BofA ML UK Gilt Index 10yrs -10% -30%

Yield Inflation 3% Inflation 4%

5Y UK Gilt +1.5% (nom. yield) -1.5% -2.5%

5Y UK IL Gilt -1.7% (real yield) -1.7% -1.7%

5Y UK IL Gilt + Credit “UKIL”

-1.7% (real yield)

+ 1.0% (IG credit)

- 0.7% (real yield)

-0.7% -0.7%

Inflation expected to return

How might the fund perform in an inflationary environment?

Fund returns are explicitly linked to RPI, while the credit

component provides an additional level of yield

Fund positioning

Fund duration Fund credit spread duration

Fund positioning summary

Key portfolio themes Duration

Duration Low interest rate

duration: 2.5 years

Index-linked government

bonds 13.0%

Index-linked corporate

bonds 16.4%

Synthetic index-linked corporates

FRNs 8.6%

Short dated corporate

bonds 6.0%

Cash 6.1%

Key portfolio themes

duration: 2.5 years

allocation

The core of the

fund is invested in

index-linked credit

Asset allocation, %

CCC & Below

Key portfolio themes Credit rating breakdown, %

duration: 2.5 years

allocation

The core of the

fund is invested in

index-linked credit

Credit risk

We find the best

risk/reward profile

in BBB credit

US Credit US Banks US Insurance

Key portfolio themes Allocation to US credit over time

duration: 2.5 years

allocation

The core of the

fund is invested in

index-linked credit

Credit risk

We find the best

risk/reward profile

in BBB credit

Geographic

exposure

We are moving

back into EU

credit

Key portfolio themes

duration: 2.5 years

allocation

The core of the

fund is invested in

index-linked credit

Credit risk

We find the best

risk/reward profile

in BBB credit

Geographic

exposure

We are moving

back into EU

credit

Value at

The low VaR is the

result of high

quality credit

portfolio with little

interest rate risk

30 day VaR (99%)

Fund positioning

AAA- AA+ AA AA- A+ A BBB+

Credit risk

A- BBB

Sep 2010

Jan 2011

Jun 2012

Feb 2013

Sep 2013

Itraxx Europe 5y (LHS) Fund risk free cash level 5-day MA (RHS)

We have been flexible and taken advantage of recent

market volatility

Rank Issuer %

1 United Kingdom Gilt Inflation Linked 62.2

2 Tesco Plc 3.2

3 Verizon Communications Inc 1.5

4 National Grid Electricity Transmission P 1.4

5 Scottish Power UK Plc 1.3

6 Granite Master Issuer Plc 1.2

7 National Grid Gas Plc 1.2

8 American International Group Inc 1.2

9 Toyota Motor Credit Corp 1.0

10 America Movil 1.0

Top 10 physical positions

Rank Issuer %

1 Itrx Europe 5Y Index 23.0

2 Cdx Na IG 5Y Index 6.0

3 Heathrow Funding Ltd 1.9

4 Electricite De France 1.9

5 Deutsche Telekom Int Fin 1.9

6 Comcast Corp 1.4

7 Ford Motor Co 1.4

8 Eon Intl Finance Bv 1.2

9 Dow Chemical Co 1.1

10 Lloyds Banking Group Plc 1.1

Top 10 CDS positions

Risk and performance analysis

Value at Risk

Source: M&G, 31 August 2013

Plenty of headroom to add risk

Daily monitoring of global exposure using VaR with

methodology 99% one month with an equally weighted

observation period (history) of 250 business days

VaR limits

30 day VaR @99% Upper Limit Lower Limit

Credit stress tests

-0.05%

-4.73%

5.31% 4.00%

-6.24% -8.19%

-0.08%

-7.21%

-9.17% -10.39%

12.61%

Benchmark

Interest rate stress tests

-0.02%

-1.02%

-2.03%

-0.73%

-0.08%

-3.72%

-7.21%

-5.41%

IR +1bp IR -1bp IR+50bp IR-50bp IR+100bp IR-100bp IR CurveFlatteners

IR CurveSteepeners

Benchmark

Performance since inception in September 2010

Source: Morningstar. Inc., UK database, 31 August 2013, sterling A class shares, net income reinvested, price to price. Rebased to 100, 17 September 2010

M&G UK Inflation Linked Corporate Bond Fund In

IMA UK Index Linked Gilts sector avg

CPI Indexed

M&G Global Corporate Bond Fund

M&G Global Corporate Bond Fund Fund at a glance

An active fixed income fund consisting primarily of investment grade

corporate bonds diversified across industries, issuers and regions

Designed for investors who want access to investment grade corporate

bonds and to benefit from global macroeconomic trends

The fund manager is empowered to take conviction views and aims to

maximise total returns for investors

Backed by a team with an excellent track record* in managing fixed income

portfolios

A blue-chip global investment grade bond fund that is designed

to capture relative value opportunities across markets

*Range of 10 fixed interest funds managed over past 5 years: 4 ranked first quartile, 4 ranked second quartile

(Source: Morningstar, Inc., UK database, 31 August 2013, sterling shares, net income reinvested, price to price, rankings in IMA sectors)

• Unconstrained investment approach allows a high degree of selectivity

• Global investment grade is not a new asset class for us

– London-based research team covers approx 1/3 of global index

– We manage significant US investment grade corporate bonds in existing

portfolios ($5.8bn across 142 names in USD bonds/$7bn across 69 names in

US-based corporates)

• Fund manager has experience as US financials analyst

• Deputy fund manager has experience as a US credit analyst

• Access to US-based credit research via PPM America, an affiliate of M&G

Source: M&G, October 2013

Designed to be a best relative value opportunities fund

Why we can run a global fund

• PPM America, Inc., an affiliate of M&G, is a well-resourced and

established fixed income manager based in Chicago

• Approximately $89 billion of fixed income assets under management

as of 31 March, 2013

• M&G fund managers have access to views and proprietary research

generated by 22 analysts “on-the-ground” in Chicago

• M&G fund managers visit Chicago up to 4 times a year to meet with

the PPM America, Inc., credit analysis team

Access to credit research in the United States

Source: M&G, 31 July 2013

M&G Corporate

M&G Strategic

Corporate Bond

M&G European

Corporate Bond

M&G Global

Corporate Bond

Sector £ Corporate Bond £ Corporate Bond EUR Corporate Bond Corporate Bond

Fund type Blue chip, investment

grade corporate bond

More focused

investment grade

corporate bond fund

European investment

Global investment

Typical currency

exposure 95-100% GBP 90-100% GBP 95-100% EUR 95-100% USD

Typical asset allocation

Investment grade

High yield

Government bonds

90-100%

80-100%

90-100%

80-100%

Typical duration 6-9 years 4.5-11 years 3-6 years 4-8 years

Source: M&G, 13 August 2013. The inclusion of this fund information is for illustrative purposes only. Please note that guidelines are subject to change

Corporate bond range at a glance

- Sub vs senior financials

- Long end USD telcos

- High coupon USD credit

- CDS single name +ve basis

- CDS broad IG indices

- Synthetic vs physical

in Europe

(+ve basis opportunities)

- Hybrids

- Bullish credit

- Euro cash bond

valuations very rich

- Financials vs HY

- US/UK vs EU

financials

- USD TMT

Portfolio themes

MACRO ASSET TYPE SECTOR INDIVIDUAL CREDIT

- Hedging duration via

GBP & USD futures

- Preference for $

FRNs over € & £

- Short duration (5.3y

vs 5.7y for index)

- Yield curve too steep

- EU rates poor rel val

- Euro macro tail risks

underpriced

- € corp hybrids (low

rate sens, high yields)

- Fix to float yield

- 20-30y USD credit

Top down Bottom up

• Maximising cross-currency swap adjusted z-spreads amongst top credit relative

value picks across $, £ and € to exploit:

– Home bias (names trading cheaper in foreign currency)

– Market’s preference for funding in one currency over another

– Other inefficiencies

• High coupon, high priced $ bonds present an opportunity to earn substantially

higher z-spreads in those cases where we are comfortable with the credit

Opportunities across global bond markets

Cross currency relative value opportunities

Source: Bloomberg, 7 October 2013

DT 8.75 06/15/2030 USD

DT 7.125 06/15/2030 GBP

DT 4.5 10/28/2030 EUR

Exploiting spread differentials across markets

Deutsche Telekom Z spreads

50 Source: Bloomberg, M&G, 30 September 2013.

Barclays Capital Global Corporate Index, BofA Merrill Lynch Sterling Corporate & Collateralised Index, BofA Merrill Lynch Euro Corporate Index

Asset allocation

M&G Global Corporate Bond Fund Fund positioning

Country allocation

11.7% Index-linkedgovernmentbonds

Investment grade

High yield

Credit rating breakdown Currency allocation

Fund Benchmark

USD GBP EUR Total

Fund Benchmark

Slightly short duration

Duration positioning

Fund Barclays Global

ML £ Corps ML € Corps

YTM 3.8% 2.9% 4.0% 2.2%

Duration 5.3 years 5.7 years 8.0 years 4.4 years

Duration contributions

Telecommunications

Banking

Basic Industry

Sovereign

Asset Backed

Utility

Consumer Non-Cyclical

Insurance

Mortgage Backed

Energy

Consumer Cyclical

Commercial Mortgage Backed

Technology & Electronics

Capital Goods

Healthcare

Automotive

Financial Services

Sector exposure

www.bondvigilantes.com

www.twitter.com/bondvigilantes

Appendix

Population over 60 by region

More developed regions Less developed regions

810 million

2.4 billion

Elderly dependency ratio1

Global population

Demographics

Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2008

Revision; Elderly dependency ratio = ratio of population 65+ per 100 population 15-64 based on a medium fertility variant

Increasing elderly dependency ratio

With more people consuming goods and services, and

fewer people producing them, prices will tend to rise

Population over 60 by region

10% 25% 0%

2011 2050

22% 34%

2011 2050

15% 24% 0%

2011 2050

6% 10% 0%

2011 2050

11% 24%

2011 2050

19% 27%

2011 2050

Demographics: ageing population

Source: Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2008

Revision; http://esa.un.org/unpp. Assumes medium-fertility variant, 2010-2050

Not just a developed world phenomenon…

The number of old people worldwide is growing faster

than any other age group

% of population aged 60 years or older

Pure interest rate risk

(duration)

“Risk free” yield

= -0.2% pa (2024 gilt linker)

BT I/L 2025

Yield = 1.4%

+ inflation

Pure credit risk

= 1.6% pa

What am I buying when I purchase an inflation-linked

corporate bond?

An inflation-linked corporate bond is a combination of

duration risk and credit risk, plus inflation

Some issuers of UK inflation-linked corporate bonds

Source: M&G, June 2013

Synthetic France Telecom linker

Credit default swap

(Pure Credit Risk):

France Telecom 5y = 1.0%

Pure interest rate risk

(duration):

UKTI 2022 “Risk free” yield = -0.5%

Yield = -0.5% + RPI + CDS premium

Synthetic inflation-linked corporate bonds

How to create one

CDS + government index linked bond = synthetic inflation

linked corporate bond

Ben Lord

• Ben Lord joined M&G in 2007 and was appointed

fund manager of the M&G Global Corporate Bond

Fund from launch in September 2013. Since

launch in September 2010, he has also been the

co-manager of the M&G UK Inflation Linked

Corporate Bond Fund and the M&G European

Inflation Linked Corporate Bond Fund. Additionally,

Ben is deputy manager of the M&G Short Dated

Corporate Bond Fund

• Ben previously worked at Gordian Knot as a credit

analyst covering global financial institutions

• He obtained an MA (Hons) from the University of

Edinburgh and is a CFA charterholder

Biography

Jim Leaviss

• Jim Leaviss joined M&G in 1997 from the Bank of

England. He is Head of M&G Retail Fixed Interest

• Manager of the M&G Global Macro Bond Fund

since September 1999

• Manager of the M&G Gilt & Fixed Interest Income

Fund since April 1998

• Co-manager of the M&G UK Inflation Linked

Corporate Bond Fund and M&G European Inflation

Linked Corporate Bond Fund since September 2010

• Has 21 years of experience in fixed income markets

Biography

The value of stockmarket investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount

you invested. For financial advisers only. Not for onward distribution. No other persons should rely on any information contained within. This

Financial Promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK and provides

investment products. The registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776

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