January 2011

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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

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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.

December 2010

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Fixed Income Market Recap

Despite ongoing open-market Government bond purchases by the Federal Reserve, investment grade bond prices declined in December. The most intense selling pressure occurring in the first half of the month, as the market continued to be buffeted by the selling pressure that commenced in November. The principal driver was a much better than expected holiday selling season and the positive spillover effect that surprise had on the broader economy. As was the case last month, the sharp selloff in the overall bond market was the overriding negative contributor to performance. The rise in interest rates was offset marginally by a slight tightening in credit spreads and an exceptionally strong performance in the High Yield bond market. Despite the sharp rise in interest rates associated with longer maturity bonds, interest rates for securities of less than one-year actually fell for the month.

Economic Overview
The unexpected improvement in domestic economic activity that materialized in November continued to drive rates higher. Coincident with the mid-term election, consumers began to appear more confident and willing to consume. Additional contribution to the acceleration in economic activity came from the manufacturing sector, which has recovered to pre-recession levels, and the stock market which finished the year less than a basis point from the two-year high. The irony is that interest rates hit a bottom just as the Fed outlined the details of its planned buyback of public securities. When viewed from the intramonth low yield in November to the intramonth high yield in December, interest rates on 5-, 10-, and 30- Treasury securities were all approximately 100 basis points higher.
However, the improvement in economic activity did little to calm either the troubled European government bond market or the domestic municipal bond market. On December 31st, the yield-to-maturity on 10-year government bonds of Greece, Ireland, Spain and Italy were all at, or near multi-year highs, as investors continue to believe that some form of default or restructuring is inevitable. Similarly, investors in the municipal bond market continued to reduce their exposure to the sector, resulting in a 194 basis point loss in the Barclays Municipal bond index. With municipal bonds now yielding more than 100% of U.S. Treasury notes, we believe municipal bonds offer an attractive value play and will be selectively be buying them for our taxable and tax-exempt clients.

Outlook
Looking forward, we expect volatility to be heightened and, with that, the opportunity to add value to the portfolio through active trading. Moreover, we believe that as the economy continues to expand, rhetoric from the Federal Reserve will begin to refocus from monetary stimulus to how they intend to sop up the massive amount of liquidity they’ve added in the last two years. Expecting that it will prove more problematic than they’ve acknowledged, we will continue to significantly underweight the government sector, overweight corporate notes, maintain a weighted average duration well below benchmark, and employ interest rate hedges.

November 2010

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Fixed Income Market Recap
November could be characterized as a month in which old news, thought to be resolved and impotent, reemerged to the detriment of the capital markets. With attention focused on the Federal Reserve and its well broadcast plan to reduce rates through a second round of quantitative easing (QE2), investors had positioned their portfolios for a continued fall in rates. When the anticipated rate decline failed to materialize, traders were quick to shed holdings of Treasury notes, pushing interest rates more than 40 basis points higher mid-month trough-to-peak. Exacerbating the rate rise was an unexpected, but welcome improvement in domestic economic activity. Just as the Fed’s public handwringing spooked investors into pushing the 5-year treasury yield down to nearly 1% during the month, improvement in employment, retail sales, and manufacturing served to reverse that trend, launching the 5-year note yield 50 basis points higher on an intra-month basis.

Economic Overview
While investors were caught off guard by the unexpected volatility in Treasury notes, even greater volatility was evident in the Municipal bond market. A reemergence of state and local debtor solvency concerns gained steam throughout the month, culminating during the week of the 14th, during which investors staged a stampede out of the sector. Over the course of that week, $4.2 billion redeemed from municipal mutual funds; the single heaviest week of redemptions ever. Several high-profile, long maturity municipal bond funds were down between five and ten percent for the month.

Concurrent with heightened fears in the Muni market, investors again began to worry that the weaker peripheral countries of the Euro were at risk of default. Investors were cheered earlier this year with the bailout of Greece and what appeared to be a “more-than-sufficient” stabilization fund. However, as economic activity remained depressed throughout Europe, investors began to again worry that the weaker, peripheral countries were at risk of default. Such worry spiraled into reality with Ireland, as borrowers became unwilling to lend to the sovereign, ultimately forcing an EU bailout similar to what was extended to Greece. As was the case with the Greek bailout, a relief rally ensued and at the time of this writing, the as-yet-unrescued nations of Portugal, Spain, and Italy are enjoying a reprieve from default concerns. However, just as Ireland required a Greek-style bailout, we wouldn’t rule out a requirement of similar support for the three remaining peripherals.

Outlook
As we head in to the final month of 2010, we continue to believe that the economy will continue to improve, and that fixed income investors have overpriced government and government-related debt. As such, we will continue to significantly underweight the government sector, overweight corporate notes, maintain a weighted average duration well below benchmark, and employ interest rate hedges.

October 2010

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Fixed Income Market Recap
Dominating attention through the month was the Federal Reserve with the Fed and Wall Street trading-desks attempting to out-game each other. Clearly, the Fed has not handled the idea and implementation of QE2 very well. When the concept was first floated, interest rates fell as the Fed had certainly hoped. Then, concluding that the easing was fully “priced-in”, traders sold bonds and pushed rates back up to the pre-announcement level. The Fed countered by hinting that QE2 would be bigger than first suggested. Rates tumbled and the cycle repeated itself. In our opinion, QE2 is a flawed strategy. The back and forth on interest rates and the public debate among Fed governors and presidents only serve to confuse and alarm consumers. Nonetheless, the Fed has committed and it’s their move. In 2001, the yield on the 30-year bond fell 40 basis points in two days on the news of the elimination of the security as a funding vehicle. With the interest rate spread between the 10-year and 30-year Treasury’s close to a record wide, a strategy of focusing purchases on the very long end of the yield curve could have a similar effect and force the entire term-structure lower. At least temporarily. Back in 2001, the 30-year rate rose back to the pre-announcement level one month later.

Economic Overview
Buried amidst the monetary policy rhetoric, recent economic activity has showed some sign of improvement. Specifically, Retail Sales grew at a faster rate than was expected. Similarly, recent news on housing sales and new home inventory hinted that the worst may be behind us. However, the employment picture has yet to signal that job creation is imminent. While employment is a lagging indicator, the naggingly high unemployment rate is likely to continue to be an impediment to acceleration in economic growth. With the holiday selling season rapidly approaching, it will be telling to see if consumer spending will hold up. If it does, the possibility exists that it could be enough to ignite a virtuous circle with enough momentum to make a meaningful dent in the unemployment rate. If such an outcome were to materialize, talk would quickly shift from quantitative easing to the mountain of excess reserves sitting in the banking system.

Outlook
Anticipating continued heightened volatility and mindful of the potential for extreme moves in the capital markets, we continue to maintain a defensive posture in the portfolio and have implemented long option positions to mitigate the impact of an extreme outcome.