Got income? The hunt for yield continues
In an attempt to spur economic growth in 2020, the U.S. Federal Reserve’s commitment to historically low rates and easy monetary policy has produced an increasingly challenging investment environment for liability driven investors.
The resounding theme in this issue of Insurance Quarterly remains finding income to meet asset and liability matching needs. With opportunities across the asset class spectrum—from taxable munis to private equity real estate—our strategists and portfolio managers offer a variety of alternatives worth your consideration.
- $14.1 billion in insurance company assets under management1
- Nearly three decades of insurance investment experience externally and five decades managing the general account for Principal Life
- 48 insurance company clients place their trust in our investment expertise
- An established global investment manager with $507.3 billion in AUM for more than 900 institutional clients worldwide1
Investing through the pandemic
Contributor: Seema Shah, Chief Strategist, Principal Global Investors
The third quarter saw the global economic recovery continue to progress faster than many expected, while a rapid market rebound erased the financial market havoc inflicted by the pandemic earlier in the year.
However, economic activity data remained below pre-pandemic levels, and markets pulled back a bit in September, amid fears of a new COVID-19 wave in Europe; fading monetary policy impulse; reduced fiscal support; and uncertainty surrounding the U.S. presidential election. And with the equity market advance propelled by just a handful of companies—the tech giants—investor discomfort has escalated, rendering markets increasingly vulnerable to a correction.
Extraordinary market performance extended through much of the third quarter.
- Fueled by central bank liquidity and tech sector dominance, the S&P 500 reached new historic highs in mid-August, marking the best consecutive two-quarter performance for the index since 2009.
- Asset price gains continued to mount even in the face of record decreases in earnings growth and a concerning rise in U.S. coronavirus cases, cultivating an air of market complacency against a backdrop of overbought conditions.
- Still, the dislocation between financial market performance and the economic impact of the COVID-19 crisis continued, and as a loss of economic momentum increasingly came into focus in September, market dynamics took a negative turn. The S&P 500 finished the quarter with a four-week decline, though still ended up 8.5%, significantly higher than where it started the period. The NASDAQ rose 11.0% in the quarter, even after a 5% drop in September.
Global economic activity has bounced back but hasn’t fully returned to pre-COVID levels.
- Sequential indicators, such as global PMIs, have enjoyed a sharp rebound, returning to the high-50 levels they had attained prior to the pandemic, accompanied by stronger consumer confidence and improved business activity.
- Investors shouldn’t necessarily interpret this data as evidence that global economic activity has come full circle. In fact, after a disastrous April in which global activity essentially came to a halt, positive monthly growth numbers were almost inevitable.
- The global economy still has some way to go before it gets back to early 2020-levels. Assuming continued monetary support from central banks and no significant COVID surprises, we expect earnings should catch up to their 2019 year-end numbers by the end of 2021.
To high yield or not to high yield…. That is the question
Contributor: Jack Bishop, Portfolio Manager, General Account, Principal Financial Group
Based upon information gathered from December 31, 2019 statutory filings, it appears that large public U.S. life insurance portfolios are becoming less excited about public high yield allocations as the median allocation for the industry has fallen nearly 0.5% year-over-year. This balance sheet reduction might be explained by excellent market timing through increase in quality rotational selling by insurance companies, or perhaps through elevated bank loan repricing/flexing, or perhaps a result of a foundational rotation away from large-cap public high yield to smaller cap-private high yield. Whatever the reason the reduction is real. The macro picture for high quality investments is becoming more challenged as the Fed and European Central Bank (ECB) have created a massive demand for income. This demand is coming from multiple channels including insurers, pensions, and retirees and will likely continue to increase over the foreseeable future providing a tremendous backstop for liquidity in these markets. Perhaps the primary question in 2020 for insurance portfolio strategy is the pacing of high yield investing. To be clear, our portfolio allocation has been consistent with the industry, but we do believe opportunities exist and are worth pursuing if the appropriate framework can be implemented.
The pandemic and response from the Fed through policy intervention during the first half of the year elevated the need for additional company level cashflow and ratings forecast analysis. The credit team was asked to implement a “survivor framework” that classified companies into three distinct buckets: improving, static, or deteriorating; and the severity within each of those categories. We combined these metrics with existing sizing targets to produce a framework that enabled the team to move quickly and react to market opportunities to buy and sell. At the same time, the portfolio construction team improved the framework incorporating additional metrics at a sector and industry level providing more macro level analysis. Specifically, the team augmented existing stochastic and deterministic drift data with new econometric modeling using key forecastable metrics to provide additional insights on potential capital impacts from ratings drift. The team combined the bottom-up and top-down analysis within a newly implemented execution management system to better inform decision makers about the opportunity set. These frameworks didn’t always reach the same conclusion, but did improve the team’s ability to strategically make real-time decisions and focus on improving portfolio outcomes centered around earnings and ratings outlooks across the entire capital stack, including high yield.
Spotlight on Portfolio Allocation Strategies
Emerging market debt—a slow and uneven recovery
Contributor: Damien Buchet, CIO-Total Return Strategy, Finisterre Capital
At $17 trillion and 16% of global securities outstanding, the emerging market debt (EMD) universe has now become too significant a source of income and differentiation for global portfolios to ignore. Yet, with three sub-asset classes—including more than 70 countries, 30 currencies and 1,000 corporate entities —investors often struggle to make sense of this diversity. They grapple with market timing, volatility management and the occasional liquidity crunches. Insurance investors, in particular, are interested in the income and return opportunities available across the EMD universe. They seek sustainable, risk-managed exposure to the asset class as a core allocation for their portfolios.
A structural case for long-term investing
While the short term may be uncertain, the structural case for long-term investing remains as solid as ever. Technology and domestic consumption themes are helping to reduce emerging market (EM) cyclicality. At the same time, recognizing that these unique markets cannot be treated as homogenous will demand more sophisticated asset allocation strategies. Investors will need to adapt to a new global economic cycle in a post-pandemic world that will require adjusting one’s lens to a new definition of opportunity.
Following the unprecedented support provided to developing market (DM) assets by global central banks, we believe the bulk of the asset price dislocation opportunity has evaporated. While the quest for yield by insurance companies continues, zero to negative rates on government bonds, and rising credit risks in a recessionary environment make traditional income less attractive. Emerging markets are not immune to recent macro and credit hardship. Although we will likely see more sovereign defaults/restructurings in coming months, they generally retain much more attractive risk premia compared to both DM equivalent assets and their own historical ranges. Unlike the U.S. or EU high yield sectors, many EM potential defaults are concentrated among smaller, already identified frontier countries.
For the largest and systemically important EM countries, years of domestic financing and a drastic reduction in external sovereign funding dependency, have essentially precluded a broad based systemic crisis a la Asia ‘97 or Russia ‘98. Finally, when it comes to local currency EM assets, beyond multi-year currency cheapness in real effective terms versus the USD, the growing perception of a weaker greenback going forward could provide an attractive entry point for EMFX. We will nonetheless have to wait for more convincing EM growth signals for a longer lasting performance.
Beyond the yield and valuation opportunities currently exhibited by EMD assets, a key feature of the asset class over the past few years also has been a constant increase in return dispersion across countries, credit sectors and currencies.
The varied impacts and responses to the ongoing COVID-19 crisis have only deepened this disparity across EM situations, from resilient and mature A/AA rated countries to default/ restructuring candidates.
What helped the EMD asset class
Gains came from China local rates and FX positioning supported EMD. China continues its V-shaped recovery after posting year-over-year growth in second quarter of approximately 3% and is expected to post larger gains in third quarter. Other strong performers include Romania sovereign credit, Egypt local rates and our short TRY versus USD position.
What hurt the EMD asset class
The post-March recovery in risk assets has taken the vast majority of names along with it, as even some of the riskier swathes of the EM credit market rallied for much of third quarter. As U.S. rates on the long end moved up sharply in August, some of the low-beta names saw performance clipped as spreads had rallied so far.
And while EM high yield performed well during the quarter, some of the riskier segments of the market saw a reality check from fundamentals that haven’t recovered as much as their bonds have. Turkey came under increasing pressure as President Erdogan/ Central Bank Republic of Turkey’s flawed “monetary” policy saw reserves fall to dangerously low levels. The Lira was one of the worst performing currencies as the efforts to stabilize the currency failed.
Risks we are modelling
- Brazil experienced consistent volatility relating to risks of the government breaching the spending cap and Finance Minister Guedes losing control of the agenda. We believe the government will present a social welfare proposal that meets the spending cap and likely includes automatic stabilizers, improving its sustainability over the next three years.
- After completing its external bond restructuring, Argentina surprised investors by imposing stringent capital controls to stop the rush of USD out of the country. We increased our exposure with the belief that while policy remains muddled, limited external payment pressures and a new International Monetary Fund (IMF) program will be beneficial to the space.
- In Sri Lanka, investors were disappointed by the new government’s ambivalence towards the IMF and their ‘trust us’ approach to the formidable financing needs in upcoming years. Investor discomfort was magnified by Moody’s downgrade to Caa1.
- Zambia put out a consent solicitation in late September asking investors to delay coupon payments through April 2021. Investors are unwilling to support the solicitation as presented since Zambia has been unwilling to provide investors with proper transparency on its outstanding debt for some time.
Markets experienced a setback in September due to concerns of increasing COVID-19 cases in Europe, risk of a chaotic Brexit, uncertainty over a fiscal deal before the U.S. election, the Fed and ECB largely being out of bullets and the possibility of a contested U.S. election. After a strong V-shaped recovery, DM growth showed signs of stalling while conversely, we believe most large EMs will continue to recover at a slow but steady pace as the trade-off between public health concerns and the economy clearly tilts towards the latter. While a contested U.S. election is still a concern, we believe a clear outcome, no matter the result, should reinstate focus on fundamentals (continued consistent recovery in EM versus DM) and be supportive for the EM asset class. Finally, a breakthrough in a vaccine still remains in the pipeline into year-end and should benefit large EM sovereigns with high caseloads (e.g. India, Brazil). Indeed, we view the recent bout of volatility as a potential buying opportunity as both valuations (cheaper recently and still very attractive versus DM) and technicals (somewhat lighter positioning) have improved.
Asset Class Perspectives
Total return strategies to bridge the income gap
Contributor: John N. Urban, Managing Director, Portfolio Manager, Principal Real Estate Investors
As real estate capital markets thaw out after the shock of COVID-19 and the search for yield continues unabated, numerous strategy options in private market equity real estate are worth exploring. Core real estate investing can be an attractive strategy, but for insurance companies contending with risk-based capital (RBC) requirements and GAAP depreciation (for direct investments) reducing above-the-line income yields, this may not be the right fit, even with the help of leverage. Fortunately, there are other options to consider. Following is a summary of several total return solutions that potentially can produce economic returns in the 8-20+% range on a pre-fee basis, assuming customary leverage at the project level for 55- 60% of project cost. Principal has been an active investor in all of these strategies for our clients.
Value-add investing is focused on buying assets that need some attention, typically some combination of improving a property due to age, functionality or cosmetic issues; leasing a property up to a higher level; or bringing capital to the table to rescue distressed ownership situations. Principal Real Estate Investors expects more distressed real estate situations to become available during the remainder of 2020 and into 2021.
Build-to-core development is a way to “manufacture” high quality core properties for longer-term holding periods and to do so at a lower cost basis than buying a core property on the open market. Principal has been investing through this strategy for its own General Account for almost 50 years.
Merchant build development aims to build and lease high quality properties and then sell them once stabilized. This approach delivers the highest holding period returns of the strategies highlighted.
Participating construction loans use a hybrid debt/equity structure to earn high single-digit to low double-digit returns with a lower required capital charge than the other options and above-the-line income from day one.
Real Estate Private Debt
Meeting the challenges of a (still) low yield environment
Contributor: Christopher Duey, Senior Managing Director, Portfolio Manager, Principal Real Estate Investors
Insurance companies and institutional investors continue to use private real estate debt as a means to generate higher returns and to complement their fixed income allocations. For many, private real estate debt, and specifically commercial mortgages, serve as a foundational asset class to support their asset and liability matching needs, while providing excess yields relative to corporate bonds.
Depending on an insurance company’s risk/return objectives, several private real estate debt strategies are worth exploring. For most insurance companies, core commercial mortgages are the primary asset class.
These fixed-rate mortgages are secured by the four main commercial property types (office space, industrial, multi-family rentals, and retail) typically located in the top primary U.S. markets. Although overall yields have been compressed since the COVID-19 pandemic, commercial mortgages continue to provide 100-125+ basis points (bps) of excess spread over comparable corporate bonds, depending on credit quality and tenor.
As insurance companies move further out on the risk spectrum in search of higher-yielding investments, there are several other private real estate debt strategies that can be implemented. At Principal, we are active investors in all of these strategies and have a long track record of lending across the risk spectrum.
Bridge lending is similar to value-add investing in the private real estate equity space. In this case, the insurance company is lending against a property that is going through some sort of transition with a borrower that has a business plan to invest capital into the property to increase cash flow and ultimately the value of the property. These are typically floating rate mortgages with shorter loan terms. Currently they can offer an additional 25-50+ bps in spread relative to core mortgages.
Construction lending is another strategy utilized by to core mortgages. They offer strong relative value as compared to corporate bonds.
Lastly, investment grade subordinate debt can provide strong relative select insurance companies as a means to increase yields. Construction loans can be floating or fixed rate, with most opportunities today focused on the multifamily and industrial property sectors. These loans tend to be focused on the top primary markets with the most favorable market fundamentals. Currently construction loans provide an additional 50+ bps in spread relative value and an attractive risk/return profile. While the flow of investment grade subordinate debt is not nearly as prominent as the other three strategies, it tends to pick up in times of volatility or distress in the marketplace. These opportunities can be floating or fixed rate, and typically provide for 75 -100+ bps of excess spread relative to core mortgages.
CMBS: Underwriting and structure helps cushion COVID stress
Contributor: Marc Peterson, CFA, Chief Investment Officer-CMBS, Principal Global Fixed Income
Stability and spread tightening returned to the CMBS market in third quarter after the initial market reaction to the economic disruption from the COVID-19 crisis drove volatility and spreads to levels not seen since the Great Recession. Investment-grade CMBS bonds rated A- and higher have especially benefited from an increase in demand from insurance companies and other institutional investors. These investors have come back to the CMBS market due to attractive yields and because the market is implying that the level of credit enhancement and relatively conservative loan underwriting will protect most of those classes from higher expected loan losses and rating agency downgrades post-COVID.
The higher required debt service coverage ratios and lower loan-to-value is expected to cushion defaults as occupancies and rents across different property types are expected to be under pressure until the economy fully recovers. Hotel and retail properties have been the exception, however, with delinquencies spiking to 25% and 15%, respectively, the prospect of a recovery and borrower’s equity that remains with a property may keep more loans out of foreclosure and help mitigate the risk of loss.
Higher credit enhancement from the rating agencies may protect higher-rated CMBS bonds issued after 2010 (CMBS 2.0) from the downgrade and loss experience from the Great Financial Crisis (Legacy CMBS).
Despite the structural benefits, and even after CMBS spreads tightened during the third quarter, CMBS yields continue to trade with an above-average premium to similarly rated corporate bonds. This yield premium is what has been bringing buyers to the market as CMBS continues to look attractive relative to alternatives on a nominal and risk-adjusted basis.
Capitalizing on attractive spreads and tax treatment
Contributors: Matthew R. Byer, Executive Director, Chief Operating Officer and Steven Solmonson, Senior Vice President, Marketing, Spectrum Asset Management
Institutional fixed-income investors are actively searching for yield given that “low-for-longer” interest rates are likely to persist, considering central bank policy. Insurance companies are selectively adjusting their portfolios and increasing their allocations to high-quality preferred and capital securities. By doing so, they not only can benefit from attractive credit spreads, but also from favorable treatment under the National Associations of Insurance Commissioners (NAIC) prescribed risk-based capital requirements (i.e., NAIC designations 1 or 2). In addition, perpetual preferred securities (preferreds) issued by U.S. companies generally qualify for lower dividends received deduction (DRD) tax treatment.
Under statutory accounting principles, valuation methods can evolve and tend to vary by credit quality, ownership and structure. Of particular note, NAIC members recently adopted the revised statement of statutory accounting principles (SSAP) number 32R, which is expected to be effective January 1, 2021. In short, the revision standardizes the valuation methodology applicable to perpetual preferred stock.
Under these revisions “all perpetual preferred stock is to be valued at fair value (FV), not to exceed any currently effective call price.” We do not see these changes as having a material impact on the appeal of the asset class. For one, a market-consistent valuation approach has generally applied to investments in high-quality (NAIC 1-2) perpetual preferreds held by companies that do not carry an asset valuation reserve (AVR), notably P&C and health insurers.
Meanwhile, for companies that do maintain an AVR (e.g., life insurers), most already choose to value higher-quality (NAIC 1-3) perpetual preferreds at FV despite the prior SSAP indicating “cost” as the measurement. Furthermore, higher-rated redeemable (non-perpetual) preferreds continue to be valued at amortized cost and lower-rated redeemable preferreds at the lower of amortized cost or FV.
The esoteric asset class continues to reward investors
Contributors: Nick Pierce, CIPM, Managing Director-Product Specialist; Andrew Dion, Managing Director and Chief Operating Officer; Garrett Schmid, Product Specialist, Principal Global Fixed Income
The taxable municipal bond market has proven its value in a tumultuous 2020 and rewarded insurance investors that are active in the space. Issuance has been over $100 billion year-to-date (largest annual issuance since the Build America Bond era of 2009 and 2010), which has grown the size of the market to over $650 billion. This increased issuance has been met with even stronger demand, as issues are consistently over-subscribed, some by a factor of eight times or more. The increase in market size and primary issuance means improved liquidity, which ultimately aids spreads as well.
Taxable municipal bonds continue to show low correlation with credits of the same quality. Year-to-date, taxable munis have had a correlation to treasuries of 0.86; a 0.59 correlation to investment grade corporates; and a 0.11 correlation to tax-exempt municipal credits. The incredibly low correlation of taxable munis to their tax-exempt counterparts makes perfect sense when you look at the type of investor in each space. The tax-exempt space is dominated by smaller retail investors that have a tendency to act on emotion and react to short-term market swings creating forced selling events for asset managers. In contrast, the taxable space is dominated by large institutional investors. As a reminder, taxable munis, when compared to investment grade corporates, are a higher-rated asset class, have lower defaults and better recoveries, have comparable yields, and a longer duration profile.
The asset class has been bolstered by the CARES Act and monetary programs (Municipal Liquidity Facility) and could receive further support if Washington passes the phase 4 relief package. While no asset class is immune from the shock that COVID-19 has thrust upon the economy, taxable municipal bonds have shown they have greater insulation from business cycle risk than more traditional credits.
The Principal Muni team focuses on revenue bonds more than general obligation (GO) bonds and continues to build a diversified portfolio with respect to credit and curve relative to the index. The index is more concentrated in traditional GO bonds, which our team believes are more vulnerable long-term to the COVID-19 crisis and also under pressure from the ever-growing pension funding crisis. While the team does believe downgrades in the asset class are likely, they continue to favor sectors that are more insulated from political pressures, political cycles, and business cycles, such as revenue bonds in transportation, water and sewer, and housing.
High Yield Debt
An open spigot for riskiest corporate borrowers
Contributors: Jeffrey Stroll, Chief Investment Officer, Post Advisory Group Board member; Hugh Costello, Managing Director, Marketing, Post Advisory Group
As mentioned above, high yield opportunities exist and are worth pursuing in the appropriate framework. In the midst of record-setting primary issuance and fund flows, strong equity market returns, positive COVID-19 developments, and an accommodative Fed, the high yield market carried the momentum gained in the latter half of second quarter into third quarter. The Bloomberg Barclays US Corporate High Yield Index generated gains of 4.60% during the quarter, bringing the total return for the year to 0.62%.
Primary issuance volumes accelerated during the quarter, establishing several weekly volume records. On a year-to-date basis, $350 billion of new high yield bonds have been issued, $121 billion net of refinancing. With one quarter to go, this is in sight of 2013 record volumes of $399 billion, gross and $175 billion, net. The primary market has been supported by very strong technicals as high yield bond funds have seen inflows in nine of the last 13 weeks. Since the end of March, they have taken in $55 billion, or 21% of AUM.
With Treasury yields ending the quarter about where they started, high yield returns were driven by spread tightening, which was a benefit to longer duration bonds. Spreads on the Bloomberg Barclays US Corporate High Yield Index tightened by 108 bps over the course of the quarter to 517 bps, with BB spreads tightening 74 bps to 382 bps, B spreads tightening 103 bps to 540 bps, and CCC spreads tightening 258 bps to 951 bps.
As a consequence, CCC-rated credits generated the strongest returns in the quarter:
Sectors that have been the most sensitive to COVID-19 related concerns, such as consumer cyclicals (notably retailers) and transportation, generated the strongest returns during the quarter, whereas ongoing volatility in oil prices caused the energy sector to continue to lag.
Some improvements in the COVID-19 outlook and smatterings of a revival of economic activity no doubt contributed to a more optimistic tone in markets in third quarter. Nonetheless, the full measure of the economy remains quite complex, with unemployment levels still quite high. The outlook is further clouded by the expiration of expanded unemployment benefits at the end of July (and no word yet on a renewal of that program), lack of an agreement on a government funding bill, and uncertainty of highly contentious November election day. Consequently, prudent credit selection remains paramount as does avoiding the temptation to chase risk despite the recent outperformance of lower quality credits.
Partnering with insurance investors is a key strength of Principal Global Investors. From our own insurance company heritage, Principal Global Investors has grown into a global investment manager with more than $507.3 billion in assets under management, and over 900 institutional clients globally (as of September 30, 2020). Forty-eight of those 900 clients are external insurance companies. They trust Principal Global Investors to manage more than $14.1 billion in assets, ranging from private real estate debt and equity, to specialized debt and equity strategies.
Contact your Principal representative for more information on these and other production solutions.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Equity markets are subject to many factors, including economic conditions, government regulations, market sentiment, local and international political events, and environmental and technological issues that may impact return and volatility. International and global investing involves greater risks such as currency fluctuations, political/ social instability and differing accounting standards. Risk is magnified in emerging markets, which may lack established legal, political, business, or social structures to support securities markets. Emerging market debt may be subject to heightened default and liquidity risk. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In a bankruptcy preferred security are senior to common stock but subordinate to other corporate debt. Potential investors should be aware of the risks inherent to owning and investing in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk.
1 As of September 30, 2020.
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. Information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided
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