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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