The heightened volatility in the fixed income market that first developed in mid-July continued into August, as investor continued to grapple with mixed economic signals and nervousness out of the Federal Reserve. The 30-year Treasury bond began the month with a yield-to-maturity of 2.54%, which rose to 2.95% mid-month before falling back to 2.67% at month end. That equates to a more than six percent price loss and a subsequent recovery of nearly five percent. The broad market, as measured by the Barclays Aggregate Bond Index, experienced similar volatility, with the index losing as much as 1.08% mid-month before closing the period with a gain of 7 basis points.

The Federal Reserve, at the conclusion of the September Federal Open Market Committee (FOMC) meeting, announced that they will begin a third round of quantitative easing. Specifically, they plan to buy $40 billion of mortgage backed securities in the secondary market every month. That’s in addition to the $40 billion of long maturity Treasury notes they are already buying in their operation twist program. Unlike earlier rounds of QE, the Fed did not offer an end point for the money printing exercise. That point was amplified by the statement that “the committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable length of time after the economic recovery strengthens.” As if the implications of open ended quantitative easing weren’t clear enough, Bernanke, in the press conference that followed, stated that the bond buying would continue until the economy improved “substantially.” The capital markets reacted to the message with a sharp drop in bond prices and an equally sharp rally in equity prices. In the twenty four hours after the announcement, the S&P 500 was approximately 2% higher and the 30-year Treasury bond approximately 2% lower in price. Historically, the Fed begins to reduce accommodation as economic growth accelerates and inflationary forces increase. The quick and dirty interpretation of Bernanke’s statement is that the monetary accommodation will continue even as inflation exceeds the stated target. With that acceptance of higher inflation, the already negative real rate of return on 10-year notes will become even more negative, resulting in reduced purchasing power when those notes mature. Conversely, tolerance of rising inflation means that nominal profit forecasts should be raised, which effectively lowers forward price/earnings expectations, hence the rally in the stock market. However, equity investors should take care, in that price/earnings multiples typically fall in a rising inflation environment.

We caution that tolerance for a “little more” inflation runs the risk of a rising inflation expectations spiral. Such a spiral works as follows. Consumers react to prices rising faster than expected by demanding a wage increase that is at least in line with the greater than expected price rise. As prices continue to rise at a faster rate than consumers expect, they continue to demand a wage that will keep them in line with rising prices, but will also demand an increment above that rate for assuming the risk that inflation will again register more than their last wage adjustment. In saying that monetary policy will remain accommodative as inflation rises implies that the Fed can break such a feedback loop. With such an enormous amount of liquidity already in the system and an enormous amount on the way, we’re concerned that the Fed will not be able to normalize policy without damaging the economy.

However, inflation is unlikely to spiral out of control or anything close to such an outcome in the near future. Our expectation is that the recent selloff will bottom as the Fed rolls the printing presses and buys paper in the open market. Also, economic uncertainty caused by the looming fiscal cliff is likely to keep a lid on economic activity. If anything, campaign “mud-slinging” may suppress consumer confidence and with it, fourth quarter retail sales. Despite that fear, we continue to remain defensive and seek to minimize our sensitivity to interest rates.

June was a month of relative reprieve from the ongoing European fiscal drama. Favorable outcome in the Greek election combined with the agreement among Eurozone members to move toward an FDIC-like bank support model went a long way to soothing the nervousness that griped the capital markets at the beginning of June.

Of note during the month was SEC Chairwoman Mary Schapiro’s comments before Congress in which she advocated for the changes in the structure of money market funds, as recommended by the Volker rule. Specifically, she’s in favor of daily mark-to-market valuation of the Net Asset Value of the funds. As it currently stands, money market funds maintain straight line amortization/accrual of their bond holdings, thereby always maintaining a stable NAV of $1.00. The problem is that when the valuation of one or more of the fund holdings falls sharply, the fund is forced to abandon its steady NAV and mark the portfolio to market, an occurrence known as “breaking the buck.” “Breaking the buck” is usually a precursor to a run on the fund. A glaring example of such a run occurred in 2008 when The Reserve Fund was forced to suspend redemptions following the Lehman Brothers bankruptcy. In moving to a daily mark-to-market valuation, or floating rate NAV, the money market funds would experience daily performance variation and the “breaking the buck” issue would go away.

In addition to floating the NAV, Chairwoman Schapiro is a strong advocate of having the money market mutual funds hold back 3% of every fund liquidation for 30 days. The intention of the rule is to lessen the impact to the fund should a material percentage of fund investors decide to liquidate. From our perspective, the idea is badly flawed. Should a material percentage of investors decide to sell the fund at once, it’s likely a fundamental problem is at the root of the redemption and a 3% holdback would do little to resolve the problem. In the money market space a sudden drop in assets under management begets a run on the fund. A 30 day hold back would only exacerbate the run given that the first to redeem would be the first to get their remaining 3%.

During the testimony, Chairwoman Schapiro disclosed the rather surprising news that since 1970 there have been more than 300 occasions in which a mutual fund management company injected cash into their money market fund to avoid “breaking the buck.” Moreover, she characterized the $2.5 trillion dollar industry as having grown so large that the potential exists for a money market panic to destabilize the global financial system. From her comments, it’s clear to us that the money market mutual fund industry is not the riskless “mattress” that it has come to be viewed, but instead a threat that requires immediate attention. With regard to the two proposals, we’re in favor of the mark-to-market concept, but not the holdback. In moving toward marking-to-market, investors will come to understand that there is risk in their holdings and will be able to compare the riskiness of competing funds much as they do when comparing any other mutual fund. However, we think that the holdback idea is not a good one and simply attempts to protect poor portfolio management. Investors, both retail and institutional, consider their money market fund to be cash and are not going to be happy to learn that it’s only 97% cash.

While the effort has been in the works for some time, it now seems that the likelihood of implementation is growing. Despite the radical changes being discussed, it doesn’t appear that the investing public realizes that changes are afoot. It should be interesting to observe investor response. At the very least, we expect institutional investors to shift assets out of money market funds and into separately managed accounts.

Also of note during the month, the Bureau of Labor Statistics released the third and final version of first quarter GDP. While the report reconfirmed that economic growth for the period was 1.9%, it revised quarter-to-quarter aggregate corporate profit to a slight decline; the first decline in 12 quarters. Digging deeper, the report showed that the profit shortfall was driven, not surprisingly, by the problems in Europe. Domestically, corporate profits grew at a healthy 2.66% quarter-on-quarter, with all industry segments improving. However, profits generated from the rest of the world fell a worrying 11.7%, quarter-to-quarter. The question going forward is will that profit contraction prove transitory, and if not, how will it impact the equity market? Anecdotal evidence of economic weakness and the 5% appreciation of the dollar versus the Euro during the quarter don’t offer much hope for a bounce in European profitability in the second quarter. As we commence earnings season, we’ll be watching closely for clues.

As we conclude another robust earnings season, media attention has fixated on select weaker economic data, while ignoring economic strength. In the previous two years, global economic activity has slowed as spring arrived in the northern hemisphere. Anticipating a third consecutive year of second quarter weakness, investors over the last six weeks have reacted by selling stocks and buying Treasury notes. Again this year, the insidious phrase “sell in May and go away” is freely offered as a sensible investment strategy. Given that backdrop, the month was characterized by a flight to U.S. Treasury notes, with the Yield-to-maturity of the 10-year note falling 30 basis points, closing out the month at 1.91%.

Indeed, the list of potential stock rally-ending events is worrying. The ongoing fiscal and growth issues in Europe are first and foremost. From the continent, fears include of the willingness and ability of Spain and Italy to close their yawning budget deficits without sending the European south into a deep recession. Also of concern is the willingness of Francois Hollande, the newly elected President of France, to follow the path of economic unity established by former President Sarkozy and German Chancellor Merkel. Yet another worry, though to a much lesser extent, is the ongoing problems in Greece. With the country lacking leadership, the risk of an exit from the Euro is rising, although the damage would be minimal compared to the risk that existed last year. Offsetting those concerns, the risk that the European banking sector posed last year has been mitigated by the Long Term Repo Operation funding implemented by the European Central bank.

While investors grappled with fear that economic growth in Europe would spillover to the United States, the Federal Reserve expressed a less accommodative tone and suggested that the possibility of a third round of quantitative easing was less likely. At the conclusion of the April 25th Federal Open Market Committee meeting, Chairman Bernanke described monetary policy “as being approximately in the right place at this point.” Moreover, the committee was quoted as seeing “some signs of Improvement” in the housing sector with the expectation that housing activity would “pick up gradually.” In addition to less accommodative language, the forecasts presented by the Federal Reserve members reflected an upgraded expectation for economic growth. Their forecast for the unemployment rate at year-end 2012 is now 7.8% to 8.0%, a significant reduction from the 8.2% to 8.5% forecast that was presented in January. Even more surprising was the change in their Fed Funds forecast. The Chairman continues to guide investor perception to a 0.25% Fed Funds rate until late 2014. However of the 17 forecasts, only 4 members now expect Fed Funds to remain at 0.25% through 2014 and only 7 members forecast a rate below 1.0% at that time.

Also commanding attention has been a marginal slowdown in economic activity that began in March and continued through April. It now appears that the mild winter pulled activity forward at the expense of second quarter growth. The most glaring example is the slowing rate of job creation. After adding an average of 250,000 jobs in December, January, and February, job growth over the last two months has been 166,000 and 130,000 respectively. We believe that the slowdown in job creation will be temporary and are already seeing evidence of improvement in the weekly unemployment insurance claims rate. After spiking briefly in April, initial claims have again drifted lower, seemingly indicating that job growth is again gaining steam. Another measure of the job market is the Jobs Openings and Labor Turnover Survey, known as JOLTS. The JOLTS survey presents the total number of jobs currently available but not yet filled. In March that figure climbed to 3.737 million jobs, the highest level since July 2008. Digging deeper into the report every category, save government, saw an increase in help wanted.

As we commence this month, we think to sell in May, or to buy into the Treasury rally, would be a mistake. Economic activity continues to improve with the housing market showing signs of bottoming, gas prices have eased, and U.S. manufacturing continues to enjoy a renaissance. Moreover, as the Federal Reserve’s manipulation of Treasury note prices concludes at the end of June, a very large marginal buyer will exit the market. We wouldn’t be surprised to see investors sell Treasury securities in advance of the end of that program. Certainly, investors will continue to be subject to heightened volatility caused by “tape bombs,” as market moving bad news is known on Wall Street. However, we don’t expect that to derail the accelerating recovery in the United States.

Despite the price weakness observed during the month, we continue to believe that U.S. Treasury interest rates remain artificially low and that corporate and municipal debt offers an attractive investment opportunity. To detail that thesis, we’ve prepared the following valuation discussion.

In its simplest form, valuation is the expected purchasing power (also known as the real rate of return) of a dollar invested in a bond at the end of a holding period, given the current interest rate and anticipated rate of inflation. The starting point for this exercise is the U.S. Treasury note, also known as the “risk-free” rate. Note that “risk-free” refers to credit-worthiness, not interest rate sensitivity. As Figure 1 illustrates, the risk-free Treasury rate can be described as a combination of the inflation rate and the real rate. In 2005, a 7-year Treasury note yielded 4.43%, but 3.40% of that yield was compensation for expected inflation, as measured by the Consumer Price Index. From that, the investor expected to be rewarded with 1.03% more buying power at the end of the one year holding period. The “rule of thumb” among bond investors is that a real rate of 1.0% is approximately fair value. At the end of 2005, one could conclude that the 7-year note in question was fairly valued. The circumstances today are much less favorable. With the 7-year note yielding 1.38% and inflation registering 3.0%, an investor holding the note for one year would realize 1.62% less buying power at the end the holding period. Using the 1% real return “rule of thumb,” the current 7-year note would need to rise to 4.0% to be considered fairly valued. Inputting that interest rate differential into a bond calculator delivers the astonishing conclusion that the price of the 7-year note is 15% overvalued.

Turning to the corporate bond market we employ a similar relative valuation technique to determine fair value. In this exercise we use the Barclays Capital U.S. Credit Index as a proxy for the corporate bond market. The index has interest rate sensitivity similar to the 7-year Treasury note. To assess value, we subtract the yield-to-maturity of the 7-year Treasury note just discussed from the yield-to-maturity of the index. The difference is defined as the credit risk premium, or the incremental return the investor expects for assuming credit risk over and above the risk-free Treasury note. In 2005, subtracting the 4.43% risk-free rate from the 5.30% yield-to-maturity of the index indicated that the credit risk premium was 0.87%. Again, using rule of thumb, fixed income investors would consider a risk premium of 0.87% to be a close approximation of fair value. Refocusing on the yield-to-maturity of the index at the end of February 2012, the credit risk premium stood at a significantly more attractive 1.68%. Returning to the bond calculator, we find that an investor would enjoy approximately a 5.5% appreciation in the price of the portfolio if that spread were to narrow from the current 1.68% to 0.87%.

Considering the two measures of valuation, an investor could conclude that assuming the risk of a 15% loss to achieve a 5.5% gain doesn’t make a lot of sense. After all is said and done, the outcome would result in an 8.5% loss. However, to offset the interest rate risk, we have positioned short interest rate hedges through the futures and options market. In doing so, we are attempting to profit from the relatively attractively priced corporate and municipal markets while neutralizing the downside risk inherent in U.S. Treasury notes.

As we commence the New Year, our thesis has not changed from that which we held 12 months ago; namely, U.S. interest rates are artificially low and the U.S. economy is performing better than general consensus believes. To fully clarify where we find ourselves at this stage of the economic cycle, we’ll first examine the trading dynamics witnessed in the just concluded fourth quarter, followed by a discussion of our current positioning and expectations for the coming year.

Following a summer of frightening headlines foretelling the demise of the Euro, default by one or more sovereign nations, a credit rating downgrade of U.S. government debt, and a systemic collapse of the banking system, investors willingly ignored improving fundamentals and focused instead on the barrage of doomsday scenarios proffered by the print and broadcast media. As the year came to a close, the three biggest concerns were the “turn” effect, fear of a sovereign default-induced banking problem, and the misinterpretation of the success of “operation twist.”

The “turn” pertains to the concept that banks and financial institutions must be fully funded when they close the books for year-end, also known as the “turn” of the year. While I don’t recall a single instance when a bank or financial institution was unable to fund itself at year end it, nevertheless, is an annual folly that creates unnecessary nervousness in the short maturity bond market. However, with investors fearful of European bank-induced systemic risk, year-end funding concerns spread to the debt of the banking sector and weighed on bank bond prices into the final trading day of the year. So much so that money center bank paper with less than a year to maturity were readily trading with a yield-to-maturity in excess of 3.0%.

At the other end of the extreme, investors continued to demonstrate an insatiable appetite for U.S. Treasury notes. Particularly perplexing was the logic in buying Treasury notes with long dated maturities. Anecdotal evidence points to a misconception among investors that the current Federal Reserve open market operation, colloquially know as “operation twist,” is taking long maturity bond supply out of the market. In fact we believe that the exact opposite is the case. In January 2011, the supply of U.S. Treasury bonds with a maturity of 20 years or more totaled approximately $400 billion, according to Barclays Capital. Today, that number is now approximately $500 Billion, a 23% increase in supply. We commend the Fed on an excellent marketing job, but as the misconception is realized and supply continues to pile up in 2012, the Fed is not likely to be able to maintain a 30-year interest rate in line with or below the rate of inflation.

Looking forward, we find the international investment landscape to be similar to that which was in place in 2003. Then, as now, it seemed unlikely that Europe would be a principal driver of global economic growth. Aggressive investors were shunning the continent in favor of emerging markets, with particular focus on China. Investors were fascinated with the growth potential of the burgeoning middle class, and the corresponding profit opportunity that growth would offer. History has shown that a growing middle class is accompanied by an increased demand in everything from food and shelter, durable and non-durable goods, and luxury items. From that demand is born a virtuous cycle of economic growth and profit potential. Much of what was anticipated eight years ago has come to pass. According to Reuters, more than 13 million automobiles were sold in China last year, which is a 900% increase in sales compared to the 1.3 million units sold there in 2003. Growth of that magnitude can be found in broad aspects of the economy across the emerging markets. Certainly, the current challenge faced by the Chinese central planners to cool the property sector without stalling the economy is likely to prove a daunting challenge and one that has given investors pause. Perhaps even more damaging to investor confidence has been the numerous high profile accounting scandals that have surfaced in the last year. Holding aside the short-term policy tweaks of the Central Bank and the petty malfeaseance said to be inherint in small and medium sized business, the secular growth story that was expected to dominate the 21st century eight years ago is still very much alive and well. The only change is that in 2003 China enjoyed a foreign exchange reserve of $403 million. As of September 2011, reserves have ballooned to $3.2 trillion according to the State Administration of Foreign Exchange of the People’s Republic of China. With such a pool of reserves and a middle class growing by more than 10 million persons annually, one would expect China to drive economic growth for decades to come.

Given the scenario described above, we expect that European fiscal and balance sheet issues will continue to “spook” investors, but will not destabilize growth. The United States will likely continue to experience accelerating economic growth and falling unemployment, while the driver of the Global economy for the foreseeable future will be China. With that view, we’ve structured the portfolio to reflect three driving biases; overweight credit, long U.S. dollar, and avoidance of interest rate sensitivity.

In positioning for our bullish credit outlook, we’ve built an overweight exposure to U.S. bank and brokerage paper. While we anticipate that the sector will continue to be subject to headline risk and price volatility, we’re of the opinion that current valuations ignore the business risk reduction that has taken place in the sector since the financial crisis. Similarly, we favor Australian and Canadian banks for their conservative management and spread stability relative to risk free interest rates. Conversely, except for a select few names, we continue to avoid European banks.

Further expanding upon our credit bullishness, we continue to find exceptional value in both taxable and tax-exempt municipal bonds. At year end, our exposure to the municipal market had risen to 10% from 3.25% at the beginning of last year. The irony is that while municipalities have made steady progress in closing budget deficits and correcting flawed fiscal policies, municipal bonds continue to suffer from the “baby and the bath water” syndrome that has plagued the market for more than a year.

While our bullish credit view extends to a number of non-U.S. issuers, we do not favor investment in non-U.S. dollar denominated investments. At the commencement of 2011, a popular investment theme among strategists was investment in local currency denominated emerging market debt. The rationale hinged on a belief that countries like Brazil and Russia were in better fiscal shape than the U.S. and, hence holding bonds in those local currencies would offer the added value of currency appreciation and incremental yield. Advocates of the strategy became much less vocal as the year progressed and losses in the strategy began to mount. For the year, the Indian Rupee, lost 18%, the Brazilian Real and Mexican Peso both lost more than 12%, and the Russian Ruble lost more than 5%. As we’ve articulated previously, investment in fixed income instruments denominated in local currency result in “equity-like” risk for “fixed income-like” return. Currently, we see no opportunities in which both yield-to-maturity and currency valuation would prompt us to buy local currency-denominated emerging market debt. Similarly, for reasons discussed above, we are avoiding Euro-denominated debt as well. For the time being, we are staunchly dollar focused.

The mortgage backed securities (MBS) market falls solidly between our bullish and bearish call. With the risk of a possible sharp rise in rates looming, we deem mortgage-backed securities as being at an even greater risk to price deterioration. Due to the structure of mortgage-backed securities and the mathematics involved in pricing the securities, the price of MBS fall faster than Treasury securities in a rising rate environment. However, offsetting the rate rise risk is the ongoing speculation that the Fed is poised to launch QE 3, with the exclusive mandate of buying mortgage-backed securities. With that, we’re maintaining our MBS position for now, but will keep a watchful eye on the market for deterioration in the fundamentals.

Finally, we continue to view the short term interest rate hedge position as very attractive from a reward/risk tradeoff perspective because it affords us the opportunity to hedge the portfolio for very little cost through a short position in Fed Fund futures and interest rate options on LIBOR interest rates. Both Fed Fund and LIBOR interest rates continue to remain at rates very close to zero and do not expect this to change given the Federal Reserve’s pledge to keep interest rate near zero until at least mid -2013.

To conclude, as we evaluate the investment landscape for the coming twelve months, we believe the Halyard Fixed Income Fund is well positioned to perform as economic growth continues to expand, Europe continues on a path of slow but steady resolution to their debt and budget concerns, and investors develop a heightened appetite for risky assets and a distaste for U.S. government debt.