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.

Investors continued to grapple with exogenous events as volatility in the capital markets remained elevated throughout October. For much of the month, greed ruled as investors moved to buy equities amid a growing perception that the European Union had reached consensus to support the fiscally challenged members of the common currency. Indeed, approval of fiscal restraint by the Greek parliament was the catalyst for the 3.25% rally in the S&P 500 on October 27th. Unfortunately, the entirety of that one day move was undone two business days later when Prime Minister Papandreou vowed to hold a public vote on the newly approved package. In the United States, improving economic fundamentals and investor concern about the very low absolute level of interest rates resulted in the yield-to-maturity on the 10-year U.S. Treasury note rising approximately 20 basis during the month.

The 2.47% decline in price of the S&P 500 on the final day of the month obfuscated what was a surprisingly positive month of economic data and corporate earnings. Arguably the most surprising piece of data, 3rd Quarter GDP, was completely ignored by the market. Consider that just eight weeks prior to the release, consensus opinion was that the U.S. was sliding back into recession. None other than “Economist-in-Chief” Ben Bernanke, in August, communicated that the economy faced “significant downside risk.” To mitigate those risks, the Fed implemented the so-called operation twist, in which they sold government debt with less than five years to maturity and used the proceeds to buy long-term debt. Despite Chairman Bernanke’s dire forecast, gross domestic product expanded by a better than expected 2.5% for the quarter. Digging into the components of the report, the news was even brighter. Exports grew faster than imports, real final sales rose 3.6%, and Gross Private Investment rose 4.1%, as reported by the Commerce Department. Inventories were nearly unchanged for the period, which is a positive indicator of future growth. All things equal, inventories typically expand in step with the economy. If not, supplies decline forcing producers to increase production to restore depleted stocks.

Equally encouraging was the employment growth in October. The non-farm payroll rose 80,000 for the month which, at first glance, was not particularly impressive. However, the Bureau of Labor Statistics revised the number of workers hired in August and September by a total of more than 150,000. Recall that the August jobs report initially indicated that no jobs were added in August. Year to date, the U.S. economy has added in excess of 1.2 million jobs.

Against that backdrop the widening in credit spreads that occurred in August and September has persisted. To put that valuation in perspective, the current spread of the Barclays credit index stands at 189 basis points. That’s just 35 basis points below the widest level reached during the Enron/Worldcom corporate malfeasance era in 2002. With that, we now believe that rising interest rates and tightening credit spreads will likely come to pass.

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.

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.

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.