Fixed Income Monthly. September 2015

September

2015

Contents

Strategy Summary

1

Macro and Rates Overview

2

Inflation Linked Bonds

3

Investment Grade Credit

4

High Yield

5

Strategy Summary

The FIXED INCOME MONTHLY provides a forward-looking summary of the medium-term views

from the Fidelity Fixed Income team. Our investment approach is multi-strategy, with portfolio

managers given clear accountability and fiduciary responsibility for all investment decisions in a

portfolio. Given this portfolio manager discretion, there may at times be differences between

strategies applied within a fund and the views shared below. We believe in managing portfolios

with a mix of active investment strategies, including top-down and bottom-up, such that no single

strategy dominates risk in a fund.

Rates – – – = + ++

Duration 

UST Rates 

EUR Rates - Core 

EUR Rates - Periphery 

GBP Rates  Inflation – – – = + ++ Overall Breakevens*  IL – US  IL – EUR  IL – GBP  IL – JPY  EM IL  Credit – – – = + ++ Credit Beta  USD IG  EUR IG  GBP IG  Asian IG (USD)  High Yield – – – = + ++ US HY  European HY  Asian HY  EM – – – = + ++

EM Hard Currency Sovereign 

EM Local Currency Debt 

EM Hard Currency Corporates 

Real Yields % Redemption Yields %

Inflation Linked Government Bonds Investment Grade

Corporate Bonds High Yield Emerging Market Bonds

48

Source: Fidelity Worldwide Investment, 2 March 2015. Redemption yields based off JPM and BofA ML indices, shows yield to worst for high yield indices. *Inflation linked bonds show real yields. Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of fluctuations.

0.59 _0.26 -0.76 1.55 0.58 1.49 1.80 3.49 1.46 3.47 3.52 7.30 5.64 9.21 6.45 6.27 6.98 6.24 3.28 U S D E U R G B P U S D E U R C o re E U R P e ri p h G B P U S D E U R G B P A si a US E u ro p e a n A si a H Y H C S o ve re ig n H C C o rp o ra te L o ca l C u rr e n cy C h in a R M B L C I n fl a ti o n L in ke d

Inflation Linked* Government Bonds Investment Grade

Corporate Bonds High Yield Emerging Market Bonds

Source: Fidelity Worldwide Investment, 31 August 2015. Redemption yields based off JPM (EMBI Global, CEMBI Composite, GBI EM GD) and BofA Merrill Lynch bond indices (US Treasury Master G0Q0, FR+GE+NL Gov NVC0, GR+IE+IT+PT+ES Gov EGLR, UK Gilts G0L0, US Corp Master C0A0, Euro Corp ER00, Sterling Corp Collateral UC00, Asia Dollar Bond IG Corp ACIG, US HY Master II H0A0, Global HY European Issuers Constrained HQ0C, ACCY 20% Lvl4 Cap 3% Constr Q490, Dim Sum Broad Market CNHJ), shows yield to worst for high yield indices. *Inflation linked bonds show real yields. Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of fluctuations.

Summary of returns as at 31 August 2015 (%)

Government 1M 3M 6M YTD 1Y 3Y (Ann.)

USD (Treasuries) 0.1 0.0 -0.2 0.9 2.5 1.1 EUR (Bunds) -0.9 -1.6 -2.5 -0.5 2.1 2.5 GBP (Gilts) 0.3 0.1 0.3 0.5 6.5 2.9 Inflation Linked USD -0.8 -1.6 -1.9 0.4 -2.5 -1.4 EUR -2.1 -2.4 -3.6 0.7 0.2 4.3 GBP -0.6 -1.0 -0.2 -1.6 1.5 2.1

Investment Grade Corporate

USD -0.7 -1.8 -2.4 -0.6 -0.4 2.5 EUR -0.8 -1.5 -2.4 -1.0 0.6 4.3 GBP -0.9 -2.0 -2.3 -0.2 3.6 5.6 Asian Dollar -0.6 -1.2 -0.2 1.4 2.4 3.7 High Yield US -1.8 -3.9 -2.9 0.1 -3.1 4.9 European -0.9 -1.3 0.8 4.3 2.4 8.8 Asia -3.1 -3.5 -1.3 1.0 -2.4 5.1 Emerging Markets EM USD Sovereigns -1.1 -2.4 -0.5 1.1 -3.0 1.5 EM USD Corporates -1.7 -2.9 0.5 2.1 -1.1 2.9 EM Local Currency (USD unhedged) -5.4 -8.9 -11.4 -12.3 -21.5 -7.0

China RMB -2.1 -1.6 1.0 0.6 1.1 3.3

Source: Fidelity Worldwide Investment, Datastream 31 August 2015. Total Returns based off JPM (JCBBCOMP Index, JGENVUUG Index and JPEGCOMP Index ) and BofA Merrill Lynch bond indices (G0Q0, G0D0, G0L0, GWQI, EZJI, GWLI, C0A0, ER00, UC00, ACIG, CNHJ, H0A0, HQ0C, Q490).

Macro and Rates Overview

Monthly Review Strategy – – – = + ++

 Headlines from China resulted in heightened volatility which weighed on fixed income markets globally.

 Increased uncertainty over a Fed rate hike in September further dampened sentiment.

 Core government bonds benefitted from flight to quality demand, with the exception of German Bunds, which underperformed other sovereign bonds.

 The correlation between government bonds and higher beta asset classes has become somewhat less negative of late, potentially due to fx reserve repatriation flows.

Duration 

UST 

Core Euro Rates  Periphery Rates 

UK Rates 

Outlook

Policy gyrations in Asia and uncertainty about the possible rates path in the U.S. kept investors busy in August, during what is usually a quiet period of the year for markets.

The PBOC’s decision to change the renminbi fixing methodology, making it more market driven, reinvigorated fears of competitive devaluations and of the deflationary implications that these may have. Furthermore, uncertainty as to whether we will see “lift-off” in US rates was an added source of volatility and risk aversion.

Over the month, these developments led to negative returns across most asset classes. As August comes to an end, we observe that 30 of the world’s stock indices have lost 20% from the recent peaks, credit spreads have widened further, with global high yield (HW00 BofA Merrill Lynch Index) OAS spread now at levels last seen in 2010, and volatility as measured by the VIX has more than tripled in the space of a few days.

Looking ahead, the tightening in financial conditions and the sharp repricing in inflation expectations that we have seen will keep central bankers cautious and increase the likelihood of further action. Lower rates where possible, further asset purchases and weaker currencies are all likely measures, against a backdrop of low growth and low inflation ahead.

This outlook continues to be supportive for fixed income assets. With government bonds already pricing in a very gradual increase in yields, we expect flat returns from the asset class over the next 12months.

European government bonds will outperform Treasuries, in our view. The recent increase in real yields and the appreciation in the trade weighed EUR are factors that the ECB is watching closely. HICP inflation is unlikely to reach the 2% target by the end of next year. Following the recent downward revisions to the ECB’s growth and inflation forecasts, there is scope for an extension of the ECB asset purchase programme beyond September 2016.

Technicals will be a headwind for Treasuries, on the other hand. With the Federal Reserve no longer buying assets, and global central banks repatriating foreign holdings in order to replenish reserves and compensate for the outflows in their capital account, further rallies will likely be met by stronger selling pressures than in recent past.

10 Year Government Bond Yields Probability of Fed Hiking Rates in September

0% 1% 2% 3% 4% 5% 6% 04 06 08 10 12 14 16 18 20 22 24

10yr Bund 10yr Gilt 10yr Treasury Implied 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00%

Mar 2015 May 2015 Jul 2015

Inflation Linked Bonds

Monthly Review Strategy – – – = + ++

 Inflation-linked bonds posted negative returns in August and underperformed nominal government bonds.

 Continued weakness in energy and commodities prompted investors to revise lower their inflation forecasts. As a result, inflation breakevens narrowed across all major regions.

 US TIPS outperformed European linkers over the month. Retail sales picked up in the US as steady employment gains and an uptick in wage growth translated into higher consumer spending, providing some support to inflation expectations. Overall Breakevens  IL – US  IL – EUR  IL – GBP  IL – JPY  EM IL 

The selloff in commodities that we have seen since the beginning of the year continues to weigh on inflation expectations. The recent moves in EM currencies, following the renminbi devaluation, did not give the asset class much respite, and brought back worries of competitive devaluations, which would further increase deflationary pressures.

At current levels, in Europe, breakevens price in an average inflation rate of only 40bp in Germany and 70bp in Italy over the next 5 years. The recent selloff in the asset class will be a worry for the ECB, which explicitly wants to avoid an excessive rise in real yields. Moreover, recent data releases point to a gradually improving growth outlook, with accelerating domestic demand and easier lending conditions, which make the case for an overweight position compelling in our view.

In the US, TIPS underperformed nominals in August, despite alleged selling pressures in the latter by global reserve managers. Valuations are attractive at current levels, but commodities will continue to be the main driver of performance. We will need to see some stability in the oil price and headline inflation for this to get reflected in the asset class.

We continue to be underweight UK inflation linked bonds, although the rationale is more of higher real yields than widening breakevens. UK growth continues to be on a firm footing, and the Bank of England is expected to raise rates in Q2 2016. Inflation, though, is still lacking. The changes to the minimum wage will begin to feed through into higher prices next year, but the negative outlook for commodities and GBP strength will continue to weigh on import prices and on headline inflation.

Emerging market inflation linked bonds have been in the crosshairs of late, due to the unwelcome combination of slowing global growth and falling commodity prices. Ultimately we believe that the asset class will benefit from inflationary pass through from weaker currencies and lower local currency yields as emerging market central banks reverse rate hikes and begin to ease policy to bolster growth. At the moment, though, the focus of EM central bankers is more on avoiding excessive capital outflows, and may prefer to hike rather than cut rates in the short run. Our preference is therefore to express real duration views either via outright positions in longer dated paper, or via real rate flatteners.

10 Year Breakevens Oil Prices Continue to Drive Inflation Expectations

0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5%

Jun-14 Oct-14 Feb-15 Jun-15

Germany France US UK 0 0.5 1 1.5 2 2.5 3 0 10 20 30 40 50 60 70 80 90 100

May 2013 Nov 2013 May 2014 Nov 2014 May 2015 WTI (LHS) EUR 5y5y Inflation US 5y5y Inflation

Investment Grade Credit

Monthly Review Strategy – – – = + ++

 Investment grade corporate bonds posted negative returns over the month as credit spreads widened across all major markets.

 US investment grade credit lost ground and underperformed Treasuries, driven by growing concerns over the China slowdown, as well as speculation of a rate hike in the September by the FOMC

 European investment grade also posted losses, although the spread widening was more modest than for US IG. Improving macro data and the approval of Greece’s Third MoU by the Bundestag supported the asset class.

Credit Beta  USD IG  EUR IG  GBP IG  Asian IG (USD) 

The jump in volatility and market uncertainty, particularly around the Fed’s monetary policy outlook, did not help investment grade (IG) credit, with US IG in particular suffering the most from deteriorating fundamentals and a large amount of supply coming to market.

Despite the now more appealing valuations, we are still cautious on US IG. US corporate supply is going to be a persistent theme for the rest of the year, and issuers will continue to come to market aiming to lock in still attractive funding levels. The recent selloff in equities has made the relative cost of debt versus equity even more attractive, and will act as a strong incentive for fur ther issuance to finance buybacks. With the fundamental picture deteriorating and a still uncertain Fed outlook there is scope, in our view, for further underperformance.

European IG, on the other hand, proved relatively resilient over the month despite the selloff in European equities. Stronger corporate fundamentals and a macro picture that continues to show signs of improvement provide a fertile backdrop to the asset class, which we believe will continue to outperform. The focus remains on high quality names and on high coupon paying bonds, with the coupon cashflow acting as a cushion against market volatility and helping protect total returns.

The China-led increase in volatility impacted all regional markets, and the negative sentiment did not help Asia IG, which widened by 12bp over the month (ACIG BofA Merrill Lynch Index), although still managed to outperform other IG markets. We maintain our neutral stance on Asia credit, in light of further volatility that we are likely to see in regional asset markets following the regime shift in China. We do acknowledge that value is being created and there are good quality names available at attractive levels, but we would wait for better entry levels yet, before increasing exposure to the asset class.

Spreads ND/EBITDA vs. OAS

80 100 120 140 160 180 200

Jan 2014 Jul 2014 Jan 2015 Jul 2015

US IG Corps Euro IG Corps Asia IG Corps Sterling IG Corps OAS (bps)

1.5 2.0 2.5 3.0

Jan 2014 Jul 2014 Jan 2015

US Europe (RHS)

Source: BofA Merrill Lynch, Bloomberg, 1 September 2015 Source: Fidelity Worldwide Investment Quantitative Research as at 1 September 2015. ND/EBITDA stands for Net Debt over earnings before interest, taxes, depreciation, and amortization and illustrates the amount of leverage at corporate balance sheet level. OAS stands for Option-Adjusted Spread and illustrates the additional risk premium of a corporate bond over a risk-free rate.

High Yield

Monthly review Strategy – – – = + ++

 High yield (HY) corporate bonds posted negative returns in August, with credit spreads widening across major markets.

 Subdued oil and commodity prices took a toll on US HY credit once again as the highly levered energy sector, which represents around 16% of the market, remained under pressure. The moves were exacerbated by broad risk aversion triggered off by the Yuan devaluation and subsequent China growth concerns.

 The European HY market followed a similar trend, losing ground in August, although it was not a market driver over the month. Single B rated credits were more vulnerable, with the seasonally lower liquidity weighing on spreads.

US HY 

Euro HY 

Asian HY 

Outlook

Deteriorating fundamentals, a worsening Chinese macro picture and poor commodities performance continue to be strong headwinds for US high yield (HY), due to the strong share of the market represented by energy-related names. Although an increase in default rates is to be expected, the market is now discounting a rather gloomy outlook for US credit. HY energy credits are now pricing in higher default rates than historical averages. We remain neutral on US HY in light of the lingering risk of an earlier than expected rate hike by the Federal Reserve, but we are becoming more constructive on the asset class.

European HY prices moved in tandem with the rest of the HY market, with the asset class negatively impacted by the increase in volatility that we have seen. Despite its low dependence on commodities, European HY will continue to follow the jitters that we may see in oil and US credit. The fundamental picture remains constructive and more positive than in the US, with low leverage, easy monetary policy and an improving macro outlook for the region.

The negative sentiment that impacted Asia IG did not spare Asia HY, which was the worst performing regional market over the month. Despite the not particularly encouraging headline result, we have seen increasing dispersion across sectors within the Asian HY universe, with idiosyncratic stories in play. Chinese property names, for example, posted a meaningful outperformance, as they continue to take advantage of the fast developing local debt market to reduce their overall funding costs. The recent drawdown did dent the year to date performance, but the high coupon that the asset class offers will continue to compensate for short term volatility, smoothing total returns.

Spreads Current Default Rates vs. Forecast

300 400 500 600 700 800

Jan 2014 Jul 2014 Jan 2015 Jul 2015

US High Yield European High Yield

Asia High Yield

OAS (bps) HY Default Rate, %

2.4 2.2 2.0 2.8 3.0 2.4 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 Global US Europe

End of June July 2016 Forecast

Source: BofA Merrill Lynch. 1 September 2015 Source: Fidelity Worldwide Investment, Moody’s Research. Data as of 31st July 2015, forecasts to July 2016.

Emerging Markets

Monthly review Strategy – – – = + ++

 Emerging Markets (EM) continue to be under pressure with both hard currency sovereigns and corporates posting negative returns during the last month.

 The fundamental backdrop has been unfavourable for some time now. This has been exacerbated by a number factors including China’s devaluation of the CNY, the likelihood of Fed tightening, falling world trade volume growth, a negative terms of trade shock from weak commodity prices and a slowdown in EM domestic demand.

 EM local currency bonds continue to lag the rest of the EM complex, with currency depreciation and high FX volatility providing persistent headwinds.

Hard Currency Sovereign  Local Currency Debt 

Hard Currency Corporates 

China RMB  

Outlook

Emerging markets and EM currencies have been considered the source of recent instability, with the RMB shift tipping risk sentiment over the hedge. Looking at data, we find that emerging markets demand has contracted, but developed markets have not fared much better overall. The slowdown in global demand that we are seeing is a major headwind for emerging markets, via the trade channel, given their heavier dependence on exports.

The race to the bottom in currencies is therefore far from over, as authorities try to compensate for the lack of demand by depreciating currencies in an effort to increase or at least keep their share in a shrinking global trade pie.

We do acknowledge that after three years of underperformance, considerable value has been created in local currencies, which now look undervalued on most metrics. Nevertheless, we would need to see signs of at least stabilization, if not of a turnaround, in global demand before reconsidering our underweight stance.

While local currencies and local currency debt have been in the eye of the storm, weaker exchange rates continue to provide a tailwind for hard currency debt, in particular for sovereigns with low external liabilities and for EM corporates with a local currency cost base and a hard currency revenue stream.

These themes are set to continue in our view and therefore remain overweight hard currency corporates, where high coupons support total returns and compensate for short term drawdowns. Sovereign credit looks fairly priced here and the deterioration in global PMIs make us wary of moving overweight just yet.

Lastly, we prefer to shift our allocation back to neutral on RMB-denominated debt. The structural break in policy that we have seen in China, and the subsequent spike in realized and expected volatility, warrant a more prudent approach. Is it worth noting that the market continues to develop at a very rapid pace, with liquidity abundant even in times of stress. With observers expecting further support from Chinese authorities, in the form of monetary and fiscal stimulus, we will closely monitor the market looking for the right opportunity to reengage.

EMBIG Spreads vs. EM PMI Yields Across EM Asset Classes

46 48 50 52 54 56 58 200 250 300 350 400 450

Aug 10 Aug 11 Aug 12 Aug 13 Aug 14 Aug 15 EMBIG Spreads EM PMI - rhs inverted axis

4% 5% 6% 7% 8%

Jan 2014 Jul 2014 Jan 2015 Jul 2015

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