January 2011

Fixed Income Market Recap and Performance Summary
Following the sharp selloff in Treasury bond prices witnessed in November and December, price action in January was relatively sanguine. Looking beyond headline performance, the most notable price action for the month was the (3.5%) loss in 30-year Treasury bonds, and the 2.10% gain in the Merrill Lynch High Yield Master II index. Those returns, paired with 2.25% gain on the S&P 500 for the month reflect the widening belief among investors that economic growth has now become self-sustaining and, in fact, may be accelerating. Recent economic data points to such a possibility. The first glimpse of fourth quarter GDP was significantly stronger than Wall Street economists had been forecasting. When adjusted for inventory growth, the economy expanded at more than a 7% annualized rate for the period. Even more encouraging, the weak growth in inventory for the quarter is likely to be a contributor to future growth as manufacturers restock items that were sold in the fourth quarter. Equally encouraging, the Federal Reserve’s latest lending survey revealed that banks have become more willing to lend, have eased terms, and that loan demand has increased; the most upbeat lending report since prior to the crisis.

Portfolio Positioning and Economic Outlook
Given the backdrop of positive growth and the relative value of the various fixed income sub-asset classes, we have positioned the portfolio to reflect an increasing likelihood of a rate rise, the increased rate sensitivity of the Barclay’s Aggregate Index, and the wholesale cheapening of the Municipal bond market. At month-end, the duration of the Aggregate index stood at 5.07 years, the most rate-sensitive the index has been in over 20 years. In simplistic terms, a duration of 5.07 years implies that a 100 basis increase in interest rates would result in a 5.07% loss in value. Rather than replicate that increasingly risky profile, we’ve taken steps to position the portfolio to profit as rates rise. To accomplish that, we’ve reduced duration to less than half of the index and have further mitigated risk sensitivity by positioning floating rate notes. As interest rates rise, the floating rate note coupon adjusts upward, making such a security a valuable tool at this stage of the economic cycle. Moreover, as we have discussed on previous occasions, the interest rate options market currently offers a cost effective opportunity to profit from a rise in short maturity interest rates. With that, we’ve increased our exposure during the month to approximately 40 basis points of total fund value.

We suspect that in the not too distant future, criticism over the ongoing easing of monetary policy by the Federal Reserve will intensify, and ultimately evolve into a discussion of how and when policy will be reversed. Moreover, given the extraordinary measures taken to reflate the economy, we expect that the Fed will not pursue Greenspan-style incrementalist policy as a tool to drain liquidity. Instead, we expect that extraordinary tactics will be necessary to undo the extraordinary reflation measures that have been put in place over the last two years. Finally, as recently discussed, we’ve been selectively positioning municipal bonds and preferred equity notes. While the “baby and the bathwater” selling witnessed in November and December has subsided, we continue to find compelling opportunities in which to invest.

Opportunity in Municipal Bonds

Investors continued their exit from municipal bond funds throughout December and the first two weeks of January. Concurrent with heightened credit fears in the Municipal market, higher long term US Treasury rates, and an expected supply shift from long term taxable municipal bond issuance to long term tax exempt issuance led to indiscriminate selling among traditional tax exempt investors. Mutual fund outflows averaged more than $2.0 billion per week from the middle of November to the middle of January and have now approached $30 billion for the period according to ICI. Over the past two weeks, the municipal market has stabilized as lower new issuance supply, January 1st coupon and principal repayments and mutual fund outflows appear to have reached equilibrium. We believe that the market has over-corrected and see this back-up in the yield to maturity as an opportunity to adjust the portfolio.

From a total return perspective, the broad municipal market index (Barclay’s Municipal Index) has under-performed the Barclay’s Aggregate index over the last 3 months, falling 5.6% compared to a 1.7% decline in the Aggregate index. The US Treasury component of the Aggregate Index fell 2.9% during the same 3 month period. It is worthwhile noting that the Barclay’s Municipal Index has an average maturity of 13 years, compared to 7 years for the Aggregate Index and 6.6 years for the US Treasury Component of the Aggregate Index. Table 1 details the returns of the Municipal Index by maturity and compares those returns to similar on-the-run US Treasury securities. When compared in this fashion, it is evident, that while the fixed income markets had a difficult 3 month period, the intermediate sector of the municipal bond market actually out-performed comparable US Treasury Notes. Long maturity municipal bonds under-performed the long end of the US Treasury market by approximately 0.50%.

In our November commentary, we highlighted four drivers of the weakness in the municipal market, as follows:

• Low absolute rates, in general, and the selloff in US Treasury Bonds following the Federal Reserve‘s announcement of further quantitative easing
• Uncertainty surrounding Income tax rates and subsidy extensions
• Contagion of sovereign credit fears and incomplete media coverage of municipal credit worthiness
• Mutual fund outflows forcing heavy selling into a period of large new issue supply

We recognized in November that this under-performance of the municipal bond sector was creating an opportunity to invest at seemingly attractively levels, however, we remained cautious and resisted the temptation to extend duration meaningfully in light of the still artificially low levels of interest rates. Instead, we focused investments on shorter maturity issues, with an overweight to A-rated securities issued by essential service providers.

The confluence of these factors continued to weigh on the market in December and January – widening credit spreads and steepening the municipal yield curve. The yield to maturity on AAA rated 20 year bonds increased an additional 75bps to reach a 4.68%, while the yield to maturity on 30 year AAA rated paper rose approximately 60bps further to 4.90%. Chart 1 depicts a long term view of the yield to maturity on AA rated State General Obligation Bonds maturing in 20 years. The AA yield to maturity has averaged 6.0% since 1962. Interest rates were considerably higher during the hyperinflation period of the early 1980’s. While we believe that inflation will pick up to more moderate levels, we do not yet believe we are in for a period of mid to high single digit inflation. We believe that this additional 60 to 75bps of yield in the long end now presents an opportunity to begin building a position of longer term municipal paper.

Municipal credit spreads, while tighter than 2008 crises levels, remain wide reflecting reduced appetite for lower rated credits and in many instances reflect an attractive entry point. See Chart 2. Similar to credit spreads the municipal yield curve has steepened to a very attractive level (See Chart 3). We measure the steepness of the yield curve as the difference between the yield to maturity on the 30 year and the 2 year AAA municipal bond. Chart 3 shows that the 2s-30 year curve is at its steepest point since 1993. The difference is nearly 4.10% – almost twice its historical average. Given these factors, we have been adding to longer maturity bonds rated between AA and BBB. Specifically, we are concentrating our purchases in bonds maturing in 20 years. Chart 4 shows the current AAA rated municipal yield curve, the current on-the-run US Treasury yield curve and the taxable equivalent municipal curve.

In selecting the maturity to invest, we are taking a pragmatic approach to positioning on the yield curve. The municipal yield curve historically offers only about 10 bps more yield for a 30 year bond than a 20 year bond. With that in mind, we have been targeting municipal bonds with maturities around 20 years, thus we earn about 95% of the 30 year yield but with 10 years less time to maturity.