September 2011

Financial anxiety remained elevated during September as evident in the hyper-volatility of the stock market, acute widening in credit spreads, sharp rally in the U.S. Dollar, and the continued flight to U.S. Government debt. Our opinion is that with stability returning to the stock market and bank rumors subsiding, the price of corporate bonds will swing from loss to profit.

A byproduct of the worry was the dramatic, broad-based market downturn in commodity prices, including oil and gold. The logic behind the commodity swoon was, if economic expansion slows, less discretionary income will be available for energy consumption and a corresponding fall-off of inflation would reduce demand for gold. Less apparent during the month was the significant widening in financial credit spreads. On the back of liquidity-related rumors, the yield-to-maturity for high profile names such as Bank of America, Morgan Stanley, and Goldman Sachs rose to more than 5% for maturities of three years and longer. The paradox is that those three names have been specifically identified by the Federal Reserve as entities that are systematically important. Deemed “too big to fail,” those entities are subject to heightened scrutiny from the regulators with the intention of ensuring that failure is not possible. Nevertheless, in reaction to rumors, investors ignored balance sheet fundamentals and, instead, invoked the “sell first, ask questions later” tactic. Exacerbating the price weakness was the lack of secondary demand from Wall Street. A central tenant of Wall Street reform, known as the Volker Rule, is the abolishment of bank-related proprietary trading desks. In theory, the absence of a trading desk reduces the risk to the financial health of the bank due to swings in the market value of the instruments traded. The unintended consequence of closing those desks is heightened volatility. Historically, trading desks have provided liquidity during periods of market stress and, arguably, lessened volatility. Their absence, as witnessed in August and September, directly contributed to the weakness in corporate bond prices. From a trading perspective, we at Halyard view the market inefficiency that tends to result from heightened volatility as an opportunity over the long-term.

A perplexing characteristic of the current state of the economy is continued expansion in Gross Domestic Product despite the naggingly high rate of unemployment. Without a doubt, overall unemployment remains too-high by any standard. A disaggregation of the unemployment statistics yields a surprising outcome. This recession and subsequent expansion has been especially harsh on the lowest income earners and not nearly so for college educated adults. According to the Bureau of Labor statistics, the unemployment rate for adults that dropped out of high school and those with a high school diploma but no college is 14.0% and 9.7%, respectively. Those high school graduates with some college education are unemployed at an 8.4% rate, while the rate for adults with a college education is only 4.2%. At 4.2%, the rate of unemployment among college educated adults, the largest of four categories, has steadily fallen and is now the lowest it’s been in 2 ½ years. Moreover, the category of college educated individuals has grown by 10 million in the last decade, while the category of those not graduating from high school has declined by nearly one million. Because college educated individuals earn significantly more than their less educated counterparts, they have been the driver of economic growth during what has come to be called the jobless recovery. But that’s no solace for the approximately 50 million Americans with no college education, and especially the 5.2 million individuals in that category that are unemployed.

Looking forward, we are cautiously optimistic that the coming holiday selling season will be supportive of job growth and economic expansion. With that view, we have maintained our current position of overweight credit, minimal interest rate sensitivity, and hedged with options on short-term interest rates.

August 2011

Echoes of October 2008 were evident in the capital markets through much of August, as investors reacted harshly to ongoing deficit bickering in Washington and the downgrade of U.S. Government debt by Standard and Poor’s. While volatility was not near the level witnessed in the fall of 2008, the performance of the capital markets certainly felt similar in many ways.

The aggressive price-insensitive buying of Treasury notes continued and volatility in the equity market as represented by the VIX index averaged 32% for the month. While the temporary resolution of the debt ceiling issue offered a brief reprieve from the fear of U.S. default, that return to normalcy was short lived as Fed Chairman Bernanke confused the market with his speech at the Central Bank retreat at Jackson Hole Wyoming. In advance of the speech, consensus opinion was that Chairman Bernanke would announce some form of additional stimulus. Instead, he disclosed that the September FOMC meeting would be lengthened to two days giving the Fed time to discuss the need for additional stimulus and the manner in which such incremental stimulus would be implemented. However, since then, additional comments from members of the Federal Reserve Board indicate that it’s highly likely that the Fed will pursue some manner of additional quantitative easing. The most widely discussed tool is yield curve manipulation euphemistically named “operation twist.” The objective of operation twist is to artificially depress long-term interest rates through the direct purchase of U.S Treasury notes with maturities of more than 10 years. Still to be clarified is whether the Fed will purchase the long-dated notes with income from their existing portfolio of securities or will they sell shorter maturity securities out right to fund the purchase. As we’ve discussed in previous letters, we are not in favor of such manipulation of interest rates and are wary of the unintended consequences.

Another casualty of the investor nervousness was the high yield bond and bank debt market. The sectors were down 4.0% and 4.7% for the month, respectively, which was comparable to the nearly 6.0% loss incurred by the S&P 500. The high yield market, while technically categorized as fixed income, has a high correlation to the equity market during times of market stress. The rationale for the correlation is that weakness in stocks portends economic weakness which would likely result in heightened default risk to lesser-quality borrowers. The fund had no exposure to either sector as the month began, but we did make a 1% allocation to bank debt in the final days of the month. While it’s possible that it could experience additional price depreciation, we think current levels represent an attractive entry point.

July 2011

The fragile and uneven economic growth witnessed so far this year was put at risk by the childish bickering of our elected officials in July. The posturing and gamesmanship that went into negotiating the debt ceiling was far worse than anyone had expected. To be certain, damage was done to investor and consumer confidence, as evident by the wholesale dumping of equities and the price-insensitive buying of Treasury notes. The situation was worsened by the blow-by-blow attention the media devoted to the dual specter of a ratings downgrade and the once unthinkable possibility of a default on United States debt. Despite Congress having finally reached agreement, investor fears continued unabated with the loss in the S&P 500 index wiping out the entire gain of 2011 and the yield on 30-year Treasury bonds falling below 4.00%.

The circumstances surrounding the debt ceiling were, in effect, the fifth “one-in-one-hundred year flood” of the year. Economic activity was disrupted to some degree following the Japanese catastrophe, the mid-west tornadoes, the flooding of the Mississippi river, the European Sovereign debt crisis, and the recent U.S. default risk crisis. In addition to the five natural and man-made disasters, it was reported during the month that second quarter GDP was significantly lower than expected and economic activity in the first quarter was lowered to a mere 0.4% growth rate. Well below the original pace and a level suggesting the economy is teetering very close to recession. What’s perplexing is that revision doesn’t jibe with the positive monthly data released during the period. During the first quarter, monthly employment growth averaged 165,000, retail sales grew an average of 1% a month, and durable goods orders grew an average of 2.5% a month. Given those metrics, we’re suspicious that the benchmark revisions that were included in the release may have had the effect of downwardly distorting the growth rate.

The true casualty of the debt crisis was the second quarter earnings season. Corporate American again surprised investors with terrific results. Earnings grew for the sixth consecutive quarter, and with approximately 70% of companies reporting through month-end, 76% of those companies reported better than expected earnings and 72% reported better than expected revenue, according to Factset. Rising revenue is especially important in that it demonstrates improved overall activity. Better revenue can come in the form of improved sales and/or improved pricing power, both positive signs for corporations. Especially encouraging is the breadth of the positive results. Two notable standouts were Harley Davidson and Polaris Industries. The former manufactures high-end motorcycles, while the latter produces all terrain vehicles and snow mobiles. Both companies are strongly influenced by the state of the economy, as their products are discretionary items with large price tags. Similarly, transportation had an excellent quarter as evident in the results of FedEx and the railroads. Of the seven major rail companies, only Kansas City Southern reported below consensus earnings. Comparatively, CSX and Norfolk Southern exceeded expectations by 5.0% and 7.3%, respectively.

We have not changed the thesis upon which we’ve constructed our portfolio, however, given the damage done to the economy by Congress, we have refocused our timeline for accelerating growth and rising interest rates and have pushed out our expectation for a rise in short term interest rates until late next year. With that said the most recent move in the market has reduced the cost of hedging and we’ve used that move as an opportunity to extend our hedge further out in time. Moreover, we’ve further reduced the sensitivity of the portfolio to interest rate moves.

June 2011

Investors grappled with the fear of “what if,” as the European debt crisis continued to drag on through much of June. Commencing with the first trading day of the month, risky assets swooned in favor of the relative safety of U.S. Treasury debt. Driving the fear was a concern that the Greek legislature would fail to approve austerity measures mandated by the International Money Fund before additional aid was released. Assuming that the messy and sometimes violent protests in the streets of Athens would convince the parliament to vote against austerity, investors deduced that Greece was certain to default. The financial media worsened the fears by outlining a worst case scenario in which the sovereign crisis caused a repeat of the Lehman Brothers failure. It was suggested that a default by Greece would render many European banks insolvent, resulting in worldwide financial collapse. As the month wore on, the worries deepened. At one point the yield-to-maturity on the 10-year Treasury note had fallen to a 2011 low of 2.86% and the S&P was more than 7.3% lower than the 2011 high. Similarly, High Yield bonds and Commercial Mortgage-Backed securities sold off sharply. Just as investors seemed to conclude that the worst would come to pass, the Greek Parliament, on June 27th, voted in favor of the austerity terms. Investors were not positioned for that constructive turn and, over the last four trading days of the month, markets staged a sharp reversal. Moreover, the reversal was intensified in that it came amid light pre-holiday trading and in advance of the quarter-end. Over the course of the last four days the S&P 500 rallied 4.1% and the price of the 10-year Treasury note fell -2.47%.

A troubling bit of information surfaced amidst the market gyrations and the European debt turmoil. Specifically, that U.S. regulated 2A-7 Money Market funds, those meant to be the safest, held significant overweight exposure to European financial institutions. Moreover, their holdings extended beyond the large, closely regulated European Money-Center banks, to include smaller regional banks in the most fiscally stressed regions of the continent. Rule 2A-7 permits Money Market funds to maintain a steady Net Asset Value of $1.00 by pricing their underlying securities based on straight line accrual accounting, instead of marking the securities to market. However, during the 2008 panic a number of funds experienced large redemptions that could only be met by selling the securities at a price below the accrued value. In doing so, they were forced to realize a loss which resulted in the value of the portfolio falling below the $1.00 NAV. In industry parlance, such an outcome is known as “breaking the buck,” and a very unfavorable occurrence for a money fund. On numerous instances in 2008, money market fund managers injected capital into their money market fund to maintain liquidity and avoid marking the portfolio to market. In the worst case, a very large money market fund suspended redemptions, which proved disastrous for the fund and its investors. Understanding that a collapse of confidence in Money Market funds had the potential to be systematically destabilizing, the Federal Reserve and the regulators were quick to aid the industry with a line of credit and a temporary principal guarantee from the government. In addition, the government vowed to review and correct any unforeseen risk so as to avoid a future panic. With that in mind, investors were shocked to learn that some of the biggest and most recognized money market funds had more than 50% of their portfolio in securities issued by European Financial Institutions. A Wall Street Journal article titled “Money-Market Mayhem,” published on June 27, 2011 was especially critical of the oversight.

As we commence the second half of 2011, we believe there are a number of indicators that have changed from negative to positive. Namely, retail sales and manufacturing both improved meaningfully in June, as reported by the U.S. Census. Similarly, auto sales by U.S. manufacturers posted very impressive gains which should continue throughout the year, as the annual selling rate for automobiles reverts to a mean that is more than 2,000,000 units higher than the monthly selling rate for the last 10 years, as calculated by the U.S. Commerce Department. Moreover, there are signs that the downward pressure on home prices has subsided, as witnessed by the Case-Shiller home price index and FHFA House price index. While we don’t expect a meaningful improvement in prices anytime soon, we believe that a simple stabilization in home prices would go long way to boosting confidence of the American consumer.

May 2011

As 2010 came to a close, consensus opinion was that Gross Domestic Product would expand at a 3% to 4% annualized rate for the first six months of 2011. Now, as we enter the final month of the first half, economic growth is certain to fall short of that goal. With that outcome, we’ve been asked what happened, and if a forecast of accelerating growth continues to drive our portfolio construction. The question is especially relevant given the pronounced deceleration witnessed over the last six weeks. A recent CNBC segment asked the question “what happened in May” to slow the economy? The answer, as was the case in the first quarter, has been Mother Nature. Recall that blizzard after blizzard brought economic activity to a standstill in the Northeast United States in February. Later in the quarter, manufacturing output slowed as the global supply chain was disrupted by the Japanese catastrophe.

Arguably, the havoc wreaked by nature was far more disruptive to economic activity in the second quarter than in the first. NOAA reports that through May, the rate of tornado activity is more that 100 percent above average. Of particular note this year were Saint Louis, which sustained serious damage in late April and the town of Joplin, Missouri where 142 people perished in the May 22nd twister. Even Springfield, Massachusetts was impacted by the aberrant weather.

Similarly, the central United States suffered as the Mississippi river crested at 48 feet in Memphis, Tennessee on May 10th, only to surpass that mark a week later, cresting at 65 feet in Greenville. In essence, normal economic activity in large regions of the United States ceased in May as people feared for their lives and their homes. With that, it’s no surprise that the economy added fewer jobs than expected for the month. In fact, one could argue that economic growth during the quarter is testament to the resiliency of the American spirit.

On or about June 9th, the Federal Reserve’s current round of quantitative easing, known as QE2, will come to an end. As described previously, we have not been proponents of the program and believe that it will ultimately come to be viewed as a mistake. In the near-term, however, there is much concern as to how the market will perform once the Fed ceases the daily purchase of approximately $6 billion of U.S. Treasury notes. In the near term, we think that rates could rise marginally even if economic data continues to register on the lower end of expectations. However, should growth reignite, the adjustment to higher rates could be sharp and swift. As we’ve discussed previously, QE2 has created a short-squeeze in the Treasury note market and many investors, traders and hedge funds have been forced to buy at higher and higher prices. Should market momentum reverse, those same buyers would likely seek to cut losses by selling. In such a situation, there is a risk that we could reverse the entire rally of the last seven weeks.

Considering the fundamental and technical impact of the adverse weather and the effects of QE2, we have not changed our thesis that economic growth is set to reaccelerate and that interest rates remain at artificially low levels. With that we continue to maintain a defensive posture in the Halyard Fixed Income Fund and have added to our hedge against a rise in short term interest rates.

April 2011

Fixed Income Market Recap
Economic data released during the month of April were solidly representative of a self-sustaining economic expansion. Of the major indicators, retails sales were surprisingly strong, consumer confidence improved smartly, and even the housing market showed some life, with housing starts and building permits both registering better than expected monthly results. However, interest rates defied convention and fell on the better than expected news.



Economic Overview
A source of minor debate during the month was the initial claims for unemployment insurance statistics, which are released every Thursday. As the name implies, the measure represents the number of people making their first filing for unemployment compensation. Since peaking above 650,000 in 2009, the number has steadily fallen, with the measure ticking as low as 385,000 on the first Thursday of the month. Investors became concerned as subsequent weekly readings steadily rose, with the latest measure rising to 474,000. While such a rise in newly unemployed would force us to reconsider our accelerating economy thesis, the underlying data do not support such a concern. As is the case with much of the economic data reported by the government, the initial claims measure is adjusted by a seasonal factor designed to smooth out seasonal variations in economic activity. One such example is the auto industry. Once a year, typically in July, the auto manufactures cease operations for two weeks to retool the assembly plant for design changes to be implemented in the new model year. For that two week period, 100,000 auto workers join the ranks of the unemployed and are entitled to unemployment insurance. To avoid reporting that annual unemployment “blip,” the Bureau of Labor Statistics simply subtracts 100,000 from the total initial unemployment claimants, and then adds them back at the end of the period. Such was the case with the weekly releases throughout April. Looking past the seasonal adjustment to the actual change, the relatively steady trend in unemployment continued. Understanding that select few market participants look past the headline number, we consider the uptick to be noise and not meaningful data, and certainly not meaningful enough to change our opinion on growth.

As scheduled, Federal Reserve Chairman Bernanke hosted a press conference following the conclusion of the April 27th FOMC meeting. As stated, the goal was to clarify the collective thinking of the FOMC, including thoughts and concerns surrounding monetary policy, unemployment, and inflation. Surprisingly, the press was rather kind to the Chairman, limiting their questions, for the most part, to broad macro themes. While Chairman Bernanke looked ill at ease at times, he was fairly forth-coming with his answers. As expected, he did not give a date as to when monetary policy would be reversed, he denied that the Federal Reserve was intentionally pursuing a policy of dollar weakness, and he thought that the recent uptick in inflation would be transitory and not problematic. In all, the press release was a repeat of his recent speeches. Anecdotally, on the day following the Chairman’s press conference, the Commerce Department announced that U.S. GDP in the first Quarter topped an annualized $15 trillion for the first time in history and marking the seventh consecutive quarter of growth.

1st Quarter 2011 Municipal Bond Highlights

1st Quarter 2011 Municipal Bond Highlights

• Short maturity yields are low
• Long end yields have corrected
• Yield curve is historically steep
• Credit spreads are attractive

Municipal bonds suffered a decline in price after an apocalyptic prognostication from layman during the 4th quarter of 2010. Suggestions that the municipal market faced defaults in excess of $100 billion resulted in a wholesale exodus from the sector. As we mentioned in our last municipal market piece in January, this flight from the sector resulted in a good buying opportunity. As the headlines subsided during 2011, municipal bonds managed to outperform US Treasuries for the 1st quarter.

The yield to maturity on AAA rated bonds in 5 years was essentially unchanged, while the yield to maturity on both 2 year and 30 year AAA municipal bonds fell during the quarter. In contrast to the investment grade corporate market, municipal credit spreads did move wider during the period with AA rated 10 year spreads reaching 27bps from 20bps and 20 year BBB rated spreads pushing out to 170bps from 150bps. The widening in spreads reflected continued selling of lower rated credits as mutual fund liquidations persisted throughout the period.

Overall, the Barclay’s Municipal Bond index (average maturity of 13.5 years) returned 0.51% for the quarter compared to 0.42% for the Aggregate Bond index. The five- and ten-year Municipal index (more comparable to the Aggregate Index) returned 0.61% and 0.76%, respectively.

The selling pressure, a result of heightened headline risk and fear of rising interest rates, coincided with a sharp decline in municipal new issue supply. Borrowers, who issued a lot of bonds in the fourth quarter of 2010 (ahead of expiring BAB program), stayed on the sidelines during the first quarter of 2011. Fiscal deficits, curtailed infrastructure programs and unease in the market place forced issuers to delay or postpone bond offerings. As the quarter progressed, the decline in new supply helped to support bond prices, despite an improving economy and a divided Federal Reserve.


With fears of higher long term rates, market participants appear to be focusing buying in the 1 to 5 year maturity range, in an effort to earn a small amount of income without taking too much interest rate risk. The buying is focused on AA and AAA rated paper, leaving little liquidity for longer dated, lower rated credits.

We view this as an opportunity to make further enhancements to an intermediate municipal portfolio. Given our views on a strengthening economy and an overly aggressive monetary policy stance, we view interest rates, particularly on the short end, to be too low. State and local revenues continued to increase during the fourth quarter of 2010 as reported by the US Census Bureau.

Revenues have been estimated to have increased further during the 1st quarter of 2011, helping to repair the damaged caused by the recession. The over exaggerated spike in municipal defaults, pontificated by non-market participants in 2010 has yet to materialize.

With this in mind we have been adding to lower rated investment grade municipal bonds, in an effort to increase income as an improving economy helps rebuild municipal budgets from the revenue side. The progress, although with still much further to go, on the expenditure side is also encouraging.

Given our views that short term interest rates are too low, we have been incrementally implementing a barbell maturity structure, buying 20 year maturities and floating rate notes, while selling short and intermediate maturities. We continue to maintain a shorter duration position than the 5 year Barclay’s Municipal Index.

March 2011

Fixed Income Market Recap
Given the ongoing positive fundamentals evident throughout the first quarter, we continue to believe that bond market valuations are out of equilibrium given this stage of the economic cycle, and we continue to position the portfolio accordingly.

While we expected that the Federal Reserve would have been more proactive in normalizing interest rates, from a performance perspective we’ve been able to keep pace with the Barclays Aggregate Bond Index by actively trading and positioning the portfolio.

Economic Outlook
In positioning the Fund for the next stage of the interest rate cycle, we’ve anticipated that sequencing would play a big role in how Chairman Bernanke would move from stabilizing the U.S. economy to draining the massive amounts of excess liquidity from the banking system. Frustrating many, the Chairman has been glacial in effecting that change. As we expected, Q1 economic growth continued to demonstrate surprising strength, with the most pleasant surprise being the fall of the unemployment rate a full 1.0% in the last five months. Moreover, monthly job growth has continued to accelerate with monthly job gains registering approximately 200,000 in the last two months. That job growth paired with a rising stock market, a sharp rally in commodity prices, a renewed weakening in the trade-weighted dollar, and what’s arguably become a self-sustaining economy, have investors questioning why the Federal Reserve continues to aggressively ease monetary policy.

With the improvement in economic growth, an intensifying debate is taking place within the Federal Reserve itself. From the Board of Governors, Chairman Bernanke continues to lead the easy money charge, backed by easy money activist Janet Yellen, and the seemingly voiceless Governors Duke, Tarullo, and Raskin. Two of the seven governor seats remain vacant. In pragmatic terms, we question the viability of a board of two economists and three lawyers to effectively forecast and manage the U.S. economy. Lining up on the opposite side of the boardroom are the Twelve Federal Reserve Regional Bank presidents. Five of those Presidents are voting members on the Federal Open Market Committee, and quite vocal as to where they would like to see monetary policy. Of that group, one of the most vocal is Dr. James Bullard, President of the St. Louis Federal Reserve. A heavy-weight economist on equal stature with Chairman Bernanke and fully of the mind that the Fed’s continued monetary stimulus is a serious policy mistake. Equally vocal is Richard Fisher, former vice-Chairman of Kissinger McLarty Associates, and President of the Federal Reserve Bank of Dallas. Mr. Fisher has publicly stated that the Fed should neutralize their easy money policy immediately.

Our expectation has been that solid economic growth would spur debate about the sensibility of continued monetary stimulus. In turn, that debate would turn to open and aggressive criticism of the Fed, which is where the matter currently stands. However, we expect that the criticism will soon become louder and more aggressive, with the credibility of the Federal Reserve soon being called into question. Especially since the European Central Bank has just raised interest rates despite a significantly less balanced growth trajectory and significantly worse fiscal condition than the United States.

With that said, all eyes will be on Fed at the conclusion of the April 27th FOMC meeting. In late March, the Fed announced that the chairman would conclude four of the eight annual FOMC meetings with a press conference, complete with a Question and Answer session. The first press conference is scheduled for later this month. Given the recent ECB rate hike, speculation is rife that the Chairman will use this opportunity to articulate a change in policy. Certainly such a venue would allow him to clearly articulate what he intends to do once quantitative easing ends in June.

Despite all of the noise surrounding the Federal Reserve, we are of the opinion that the economy has already become self-sustaining and that, with the approach of warmer weather, may come even greater growth. Moreover, we expect that the second quarter surprise will be an uptick in home sales and home prices. With such a backdrop, a rise in the Fed Funds may come as soon as the third quarter.

February 2011

Fixed Income Market Recap
From a point to point perspective, February appeared to be a rather calm month in the bond market. Yield-to-maturity of the 10-year Treasury Note ended the month 5 basis points higher than where it started and the yield curve was essentially unchanged. However, the intra-month volatility was anything but calm. In the first six trading sessions of February, the yield-to-maturity rose 35 basis points, shaving nearly 3% from the price of the 10-year Treasury Note. Heightened inflation worries and a continued improvement in the broad economy was the catalyst for the selling. However, those worries quickly faded as civil unrest in the Middle East prompted another round of flight to quality buying.

Economic Outlook
The economic data for the month was decidedly strong and reflective of a self-sustaining, accelerating economy. Initially, the employment report signaled otherwise, though. The headline non-farm payroll showed a disappointing gain of only 36,000 jobs for January. However, digging through the details revealed that the severe weather that gripped the Northeast and mid-Western United States distorted the number substantially. The February jobs data confirmed that with a solid increase of 192,000 workers and a drop of the unemployment rate to 8.9%. Clearly, the job market has improved and at this stage of the economic cycle, monthly job growth should be in excess of 150,000 per month.
Less ambiguous results were evident in the inflation indices. The Labor department reported that both the Producer and Consumer Price Index showed greater than expected year-over-year rates of change. With the risk of deflation fading, focus is quickly shifting to inflation, and to what level it may rise. We believe there is a complex dynamic at work that will likely cause inflation to rise faster than investors and economists currently assume. Specifically, the rapid growth in emerging market economies is creating a demand-pull situation in which their consumption of goods is bidding up prices and increasing the cost of goods sold. While the main culprits, China and India, are attempting to cool their economies, their actions have not yet had the desired effect. The second driver of inflation is likely to be housing. Because of the difficulty in measuring housing inflation on a monthly basis, the Bureau of Labor Statistics uses a measure called imputed rent as a proxy. A byproduct of the elevated level of foreclosures is an increasing demand for rental space which, in turn, has put upward pressure on rents. As the housing market improves, that upward pressure is likely to continue, which will contribute to upward pressure on inflation. To put it in perspective, imputed rent represents approximately 1/3 of the overall Consumer Price Index.
To summarize, the unemployment rate is falling, inflation rising, manufacturing is operating at multi-decade highs, the Dollar is weak relative to our main trading partners, and the Federal Reserve is printing money. We expect that the muted discussion surrounding QE2 will soon grow louder, and the Fed will come to been seen as falling behind in the need to drain liquidity. Given this backdrop, we believe that the fund is well positioned to perform in such an environment.

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.