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.