High Yield from another angle

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High yield has been fair to overvalued for some time now and until recently continued its lofty ascent with few serious downdrafts. The I-Shares HYG ETF that represents a large portion of the high yield market began to crack in late June and then recovered into mid August where it began a serious decline as it is down 2.58% over the last month.

At times it is informative to look at other related markets to gauge overall health in a particular risk asset class. In this piece we will review Business Development Companies and how their performance may be indicative of risk appetite and the forward risk reward in credit.

To begin, we highlight the major characteristics this asset class possesses with a little history.

” In 1980, the U.S. Congress created a class of corporation called a business development company (BDC) to encourage the flow of public equity capital to private businesses. ” They likely did this in order to help facilitate the development of companies that were overlooked by larger lenders.

To qualify as a “regulated investment company,” a BDC must invest at least 70% of its assets in private or thinly traded, public U.S. corporations, and must distribute at least 90% of its taxable income to shareholders in the form of dividends.

BDCs must also make available significant managerial assistance to their client companies and make mostly short-term, unsecured loans in the $2 million to $50 million range. Also, they frequently take ownership positions (equity interest) in their client companies. Since they must pay out most of their profits to shareholders, BDCs must raise cash to fund expansion by selling more shares or via borrowing.
BDCs went through hard times in 2008 and early 2009 when the economy tumbled. Now, most have recovered, are financially strong, and well positioned to prosper if the economy continues to strengthen. ” Source-“Dividend detective”

As outlined above, BDCs invest in a very risky part of the capital markets that have the characteristics of high yield and private equity. These are both risky asset classes and a robust flow of credit is essential to both strategies.

The appeal for high yield and for BDCs is mainly the yield and the Fed induced reach for yield has many investors out on a risky limb. Let’s take a look at an I-Share representation of this asset class. The UBS ETRACS linked to the Wells Fargo Business Development Company Index(BDCS) represents finance companies that hold as their portfolio the debt and at times equity of the target companies. This is a solid business model in a growing economy where the BDCs can lend at low rates and earn the spread on the debt they own. If this relationship is threatened, losses can be immense as they were in 2008 when BDCs generally did much worse than the S&P500.

Over the last 3 months, this instrument has generated a return of negative 7% which is also about the timing of the slide in high yield debt. There are many factors at work in a complex system but we would like to provide some thoughts to help guide your next investment discussion on risk.

It is important to determine if we are entering a credit slowdown or a sharp deterioration in credit conditions. If those conditions are true, then both high yield and BDCs will likely do poorly. Also, if borrowing costs rise in the face of a faltering economy, it could be even worse.

We recommend that investors look past the 4.74% yield on the I-Share HYG and the 7% plus yield on the BDCS ETN and look to see if this is merely a risk off pull back or a sign from two markets that credit is going to become even more expensive.

Sincerely,

Tom Koehler-CIO

Interest rates. Long or short? Review and repost

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The post below is taken from our Sept 14, 2014 interest rate and Fed Funds rate increase historical perspective piece.  Given the current debate on the timing of a rate increase, we believe it would be helpful to take a look again at some historical evidence.

At this point, we view rate volatility to remain the risk as opposed to a major regime change where rates find a new much higher equilibrium. Over the next few months, we advise that your firm take advantage of volatility to add to high quality duration. Below is the past article.

Rate fears, rate reality and some history.   There is a lot of concern with regard to interest rates and the inevitable higher levels in most investors minds. We feel it is worthwhile to examine history with regard to interest rate increases and the effect on the overall yield curve or long rates specifically.   Short term and long term rates react differently to market dynamics and the “rates will rise” concern, while very legitimate needs to be dissected and assessed in a historical context. This will help advisors and investment committees sort through and adjust their portfolios given some potential scenarios.   According to a June 2014 Economics report by Credit Suisse, there have been four Federal Reserve tightening “cycles” of various sizes and durations over the past two decades.   (First Rate hike)                      Full Cycle

Starting Fed Funds Target Date Size basis pts Length in months Size in basis points Number of rate hikes Terminal Fund rate
3 Feb 94 25 13 300 7 6
5.25 March 97 25 1 25 1 5.5
4.75 June 99 25 12 175 6 6.5
1 June 04 25 25 425 17 5.25

*Source Credit Suisse from the Federal Reserve   “Fed tightening cycles were initiated at different times of various business cycles, against different economic and financial backdrops. But there are a few overarching themes common to all these episodes. 1. In general, the FOMC recognized the importance of fighting inflation before inflation was a problem. A long-term chart of inflation overlaid with initial Fed rate hikes suggests that the Fed had success in this endeavor. The challenge then, as now, was to balance the benefits of pre-emption with the costs of potentially tightening prematurely. 2. Each of the past four rate hike cycles began with a small, 25bp rate hike. Many of these cycles began after years without a tightening, and the FOMC assumed that the first rate hike after a long hiatus would have an over exaggerated effect. 3. In tightening cycles over the past 20 years, the FOMC took seriously its obligation to explain to the public why rate hikes were necessary, and the Committee took various steps to prepare the markets for tighter credit conditions.” *Source credit Suisse   It may be helpful to note that 10 yr rates rose prior to the initial tightening in 2004 and subsequently declined after the tightening. This may help as the thought that rates will “explode” upward at all points on the yield curve may be slightly misguided if history parallels. In part the decline is or may be due to the perception that the Fed has inflation under control. It may be once again that the market on the long end of the curve moves higher in yield in order to encourage the Fed to begin to raise rates to stave off potential inflation and to begin to drain the massive amount of excess liquidity from the system.   Charles Schwab’s Fixed Income Team recently compiled a piece with regard to this issue and feels that given Fed statements with regard to timing, we are looking at mid 2015 as the first of the Fed Funds Rate Hikes. Here are a couple key points.

    • Improving economic data hasn’t changed our estimate that the first Federal Reserve interest rate hike of this business cycle will occur in mid-2015.
    • As the Fed raises rates, we think the yield curve will flatten as yields increase on the short end of the curve.

That implies that investors should not completely abandon all duration as they seem to believe that longer term rates are reasonably anchored. We at Zenith also believe that longer rates may rise but not substantially and though there may be a bond bubble, it is not imminently going to burst. They cite some important statistics. “The economic data have not been consistently strong and inflation is holding near 2%. For example, much of the increase in the Q2 GDP estimate was due to a rise in inventories, which may suggest slower production as those inventories are drawn down. Also, housing activity has slowed substantially this year. Moreover, the majority of Fed officials are focused on unemployment. One measure they’re watching is the high level of “underemployment,” which includes those who are working part-time because they can’t find a full-time job, as well as those who are marginally attached to the workforce. Additionally, the number of people unemployed for over six months remains above 30%—high by historical standards.” They cite the important short-term/long-term rate dynamic similar to the work Credit Suisse provided on the subject. “We expect the yield curve to flatten as the first Fed rate increase of the cycle approaches, meaning that short-term yields will rise more than long-term yields. This was the pattern in the past three Fed rate hike cycles–in 1993-94, 1998-2000 and 2003-06. In each case, more than half of the increase in 10-year Treasury yields from the cycle trough to peak occurred before the first Fed rate hike, and then yields on the short end of the curve began to follow suit. It seems likely to us that if the Fed begins to raise short-term rates next year as indicated, a similar pattern will unfold, for three reasons. First, short-term interest rates are still near zero, where they have been for nearly five years. Meanwhile, long-term rates have already risen by nearly 100 basis points from the lows of last year. A basis point is one-hundredth of a percentage point. And with inflation at 2%, short-term rates are negative in real terms, while real long-term rates are at least positive. It appears to us that the process of “normalizing” interest rates has already begun for longer-term rates but not for short-term rates. Second, inflation and inflation expectations are relatively stable. While short-term interest rates are heavily influenced by Fed policy, long-term rates are influenced to a great extent by inflation expectations. Currently the indicators for inflation expectations that we follow, such as the implied inflation expectations in the TIPS market, suggest that expectations remain steady near 2%. Third, the yield curve is already quite steep by historical standards. Although the yield curve has flattened since the start of the year as long-term rates have fallen while short-to-intermediate term rates for two-year to five-year bonds have risen, the difference is still wide compared to the long-term average. Over the past ten years, the average difference has been 95 basis points. It currently stands at over 200 basis points.” We at Zenith understand the immense challenges for any fixed income investor and stand by ready to help you analyze and determine your current risk profile as a whole and by product. As mentioned in our previous segments to this series, there are overvaluations in the US and globally. We also believe that there are managers who are able to potentially mitigate some of this risk and also who may be able to uncover value. We hope you enjoyed this short piece on the rising rate question and welcome your thoughts, concerns or observations you have with regard to this issue. We will be back next week with some manager selection and insight for your consideration. Sincerely, Tom Koehler-CIO

Bond Market Uncertainty

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Bond Market Assessment-Domestic Part #1

In our last piece we identified a few major concerns with regard to the fixed income market. The major issues include low global real interest rates, inflation uncertainty and overall potential overvaluation.

This has major implications for fixed income investors and especially for financial professionals who are in a difficult position as they need to allocate to an arguably expensive asset class.

As an example, a firm that has as part of its internal investment policy statement, a certain percentage allocated to fixed income is faced with a dilemma when a new client brings in new money.

Assume for a moment that a client arrives with $1,000,000 and they are deemed to be a conservative investor. For the hypothetical firm in question, that could mean that a conservative investor is allocated 50% to fixed income. This is for illustrative purposes and of course that can depend on each firm’s definition of conservative and the amount of alternative strategies within the portfolio that may reduce to some degree the fixed income allocation. For a million dollar portfolio, $500,000 needs to find a home in a tough asset class.

We will examine various US bond indexes mainly through ETFs that represent them to frame the issue more thoroughly.

I-Shares Barclays Aggregate (AGG)
Barclays US Aggregate Index

This fund possesses a 1.96% yield with a duration of 5.19 and an overall investment grade credit quality.

This product has produced approximately a 5.30% one year return in part due to the strong bid in the treasury market along with reasonable returns from Mortgage Backed bonds. Our concern is that there is major duration risk in this product. The investment grade rating does provide some comfort with regard to credit risk although it also limits the opportunity set.

Treasury Notes comprise 37% of the portfolio and have the potential to rally even from these low levels if deflation becomes a concern or if geopolitical issues do not resolve themselves. The real yield is not positive along a significant portion of the treasury yield curve and this means there is little value in this area. The negative real yields, though unappealing are still higher than their European counterparts as those yields have been driven even lower due in part to deflation concerns.

While there are always two sides to the valuation debate on any asset class, it might be worth noting an observation by Pimco’s Bill Gross in a recent article.

“Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century’s time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.”

Mortgage Backed Securities(MBS) comprise 28.5% of this fund and this asset class has benefited from the QE program as well as its favorable credit and interest rate profile. It has returned about 5% over the last year. While it has been feared that MBS rates would rise in conjunction with Fed Tapering, the coincidental reduction in supply of new mortgages has placed at least for now a floor under MBS debt. They also possess a superior risk to reward to Treasuries at least in the Agency space. An investor simply has a better interest rate to duration ratio. The I-Shares MBB that represents the agency mortgage backed market has a yield of 2.02% with a duration of 4. This is slightly better than Treasuries but not necessarily a powerfully positive risk to reward.

Prepayment Speeds have been a major factor in the decrease in mortgage backed supply according to Double Line headed by Jeffrey Gundlach. They go on to state, “We believe that these slower prepayment speeds are emblematic of an economy where the consumer is over levered and unable to behave in a fashion that would create greater economic strength. Whereas a decrease in mortgage rates should bring about an increase in prepayments, this increase should be less than what would normally be expected due to conditions that exist in the mortgage market today. It would take a major adjustment in underwriting standards and/or an improvement in nationwide incomes for this situation to change and we do not expect any major changes anytime in the near future.”

Prudential seems to share this view that the current environment may not posses the fuel needed to change significantly at least in the near term. While many are waiting for an inevitable rise in interest rates, Prudential believes that there will be continued moderate growth along with moderate inflation and that the “natural” state of the 10-yr Treasury Note is around 3%. This has been a level associated with a lot of institutional buying. Also, an anchor to US yields are even lower Japanese and Bund yields.

While Mr. Gross may be correct in his assessment that yields on Treasury products are over valued, Prudential is counting on more of the same. They state; “Against this backdrop of modest growth, moderate inflation, and low money market rates we believe that the ongoing search for yield will remain the overarching theme in the bond market.
We see this search not only keeping long term rates low, but also pushing credit spreads narrower, and thereby fueling outperformance by the non-government fixed income sectors, such as long term investment grade corporates, high yield corporates, structured products, and emerging markets debt. While returns will generally be lower in the years ahead than they’ve been in the decades past, over the long term, we believe most fixed income sectors are still likely to post positive returns, with the highest returns likely to be recorded by the aforementioned higher yielding sectors.”

This is interesting from two view points. The first is the explicit outlook that Treasuries will underperform spread sectors and the implicit outlook that Treasuries themselves are not vastly overvalued. That is in a stable environment as a return to 3% is about a 25% move which is significant. Geopolitical concerns are aiding in the restraint on the part of Treasuries to move back to that level.

This reasonably benign scenario is based in larger part on an expanding economy with low inflation. A disruption in the credit markets would likely cause spreads to widen and depending on the severity of the issue, could cause a significant loss of principal.

Investment Grade Corporate bonds with an Industrial emphasis comprise 22.7% of AGG. The investment grade sector as represented by the I-Share LQD has produced a one year return of 10% and has a yield of 3.03% with a duration of 7. Improving fundamentals and spreads above treasuries that have compressed have helped propel this return as well as its duration measure.

The Credit Report by Morgan Stanley dated July 23rd, 2014 holds some insight with regard to the credit markets and specifically investment grade debt.

“Investment grade (IG) credit has been remarkably stable over the last month and we expect this range bound pattern will persist, barring a sudden rise in interest rates. However, at current spread levels investors have little cushion to offset the negative effect of rising rates which will eat into total returns.”

According to Loomis Sayles, Option-adjusted spreads on all three investment grade indices continued to make multi-year lows throughout the quarter. Taking credit risk was rewarded as lower-rated BBB corporate debt outperformed higher-quality bonds in the US, Europe and UK. With declining global yields, longer-duration US and European bonds produced the strongest returns. In the US, corporate bonds rated BBB had the highest duration and posted the highest total return.

This is important as they are basically saying that while credit fundamentals remain in place, spreads have tightened to levels that leave little room for error. They have benefited from a long duration profile and a move up in quality from high yield. It will be difficult to repeat this strong of a performance in the future.

At this juncture, we would like to review the three major debt class that are part of the Barclays US Aggregate and its ETF(AGG). Treasuries, mortgage backed debt and investment grade corporate bonds. As mentioned above, they have all performed well and hold various potential in the future.

Spreads

While spreads on US corporate debt, AA and BBB are at or near their 52 week low according to the Wall St Journal on line. Current annual inflation is 2% leaving investment grade credit a relatively attractive debt class v Treasuries in some maturity segments. The Bloomberg US Corporate Bond Index effectively yields 2.87% or only .87% on a real inflation adjusted basis. The 10yr Treasury yields 2.42% or .42% on a real or inflation adjusted basis.

The margin for gain is very slim indeed. So slim that an otherwise overvalued high yield sector continues to garner attention as the Bloomberg Aggregate High Yield Index yields 5.65% or 3.65% on a real inflation adjusted basis.

Mortgage Backed Option adjusted Spreads are tight as well while not as tight as investment grade debt and on aggregate possesses a similar yield to the IG index with less duration risk.

This is a very difficult time for advisors who are attempting to build a fixed income allocation while real yields domestically are very low in many areas and so it is worthwhile to take a look at corporate fundamentals.

Back in June, RBS weighed in on the state of the corporate debt market with this commentary. While not calling for an implosion, they are decidedly against duration risk and concludes gains may be muted in spite of the reach for yield technical phenomenon.
“The need for “reliable” risk-adjusted yield will remain a dominant theme for credit investors in the second half of 2014, reflecting the realities of the current economic, valuations and monetary policy environment. We believe the IG and HY asset classes are now fully valued to their fundamental metrics, but the strength of technical conditions could push spreads tighter still. Year-to-date, corporate credit’s total return performance has far exceeded our original forecasts, due in large part to a hefty contribution from the rally in Treasuries; in the second half of 2014, we believe the pace of total return accumulation will slow and possibly reverse as spreads struggle for traction amid compressed risk-free rates and as Treasury yields gradually back up.
We expect the Fed to conclude its asset purchase program by October and to ratchet up its efforts to prepare the financial markets for the eventual tightening, most likely in the second or third quarters of 2015. The policy normalization phase could be bumpy, as the eventual hike in base rates shakes market participants of their collective low volatility stupor. In the meantime, we believe High Yield will continue to provide a better risk-reward trade-off than Investment Grade, courtesy of its lower duration, higher carry and muted default risk.” Source Barrons June 27th 2014

Northern Trust in March of this year within their fixed income outlook stated, “we believe that fundamentals remain in tact, It’s also worth noting that U.S. corporations are in excellent condition, having used the low interest rate environment of the past few years to refinance their balance sheets cheaply. They’ve been reluctant to invest in their businesses, despite access to cheap money and willing investors in the capital markets. The lack of desire to invest is perhaps most clearly seen in the record amount of cash sitting on their balance sheets. All of these factors, combined, lead Northern Trust’s fixed income team to believe investors will continue to find corporate bonds attractive.”

Slightly more cautious is the credit driven investment house Loomis Sayles. Their overall assessment is as follows; “The US is in the late expansion phase of the credit cycle,
which could continue for some time as fundamental and technical factors provide support to the credit markets. At current levels, credit valuations are stretched. As a result, we have modestly reduced risk and raised reserves as we wait for buying opportunities. As always, we remain focused on issue selection”

At Zenith, we have examined a number of themes with regard to the domestic credit markets and would like to summarize the current state.

A. Treasury securities have rallied significantly this year driving returns in the over all broad market as they and most any duration asset has done well. This has been in part due to the geopolitical risks, reasonable inflation and a yield advantage over the European and Japanese Bond markets.

B. Mortgage Backed Debt similar to Treasuries have rallied in spite of the imminent end of QE in October as high quality assets with duration have done well. At this point, we feel that these have a relative risk to reward advantage over Treasuries.

C. Investment Grade Bonds which are also a significant portion of the Barclays Aggregate Index have rallied especially those with a longer duration. Spreads have tightened significantly and leave little room for error in either a credit or duration shock.

D. High Yield Debt which is not a part of the Barclays US Aggregate Index have rallied as well and have very low option adjusted spreads. Since they have a lower duration than the IG universe, it has gained mostly on stable fundamentals, low default rates and a continued search for yield.

In sum, if rates and spreads remain stable, fixed income investors will continue to earn the “carry” until that time when fundamentals, inflation or both deteriorate. Before we recommend a few manager solutions to help navigate this new world for you, we will examine the global debt market-ex US to help shape the discussion for potential placements.

Sincerely,

Tom Koehler-CIO

Bond Market Issues and potential solutions

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Bond market issues and potential solutions

 

There are many worries with regard to the bond market and some of the investments that are held by many investment firms. In spite of all the concern, bonds generally have performed well since the sell-off a little over a year ago and year to date are performing nicely with the 10-yr note down to approximately 2.40%.

 

Bond, ETFs and mutual funds with longer durations have performed better than those with low or zero duration generally speaking as yields have come down significantly.

 

That solid performance has led many to deem the current conditions as a bubble or at least possessing stretched valuations. This places many firms in a conundrum since many investment policies mandate that there must be some allocation to fixed income. There may be many questions and concerns at this time in the cycle.

 

Given our reading and market observance we have compiled a short list of issues that may resonate in part or fully with your firm as you contemplate your fixed income asset allocation.

 

  1. Interest rates are low and anticipated to rise. Many products’ durations are high and a rise in interest rates would likely lead to a loss in principal.

 

  1. Low to negative real yields persist globally. Where are there pockets of value if any across the global debt markets? Many ETFs do not possess the nimbleness to be able to take advantage of the few that may remain. Would it be prudent to seek an active manager to replace some ETF exposure?

 

  1. Uncertainty with regard to inflation rates and the effect on bond market performance is a real concern. Is it time to shift some money allocated to traditional bonds and move it to inflation indexed notes?

 

  1. Spreads over Treasuries are tight by historical standards in many bond classes. It has become more difficult to find value. Spreads in some areas may remain tight but could tighten further or if conditions deteriorate, they may widen. It is important to have a flexible manager who is able to navigate these spread sectors.

 

We suggest that your firm dedicate an entire series of investment committee meetings to address these difficult issues to determine if a change is warranted.

 

In that effort, Zenith is happy to extend its assistance in a few ways. First, we are able take the time to discuss the various markets across the global bond landscape to share our insight as it relates to valuation, risk, potential rewards and outlook.

 

We are also ready to take an objective look at your current holdings and let you know our unbiased thoughts. This would provide you with an outside view to help facilitate a robust discussion that would either lead to a renewed conviction in your holdings or it could begin a healthy process that uncovers additional managers or ETFs that better suit your firm’s risk tolerance.

 

Finally, we are ready to present those managers who we believe are best equipped to handle the difficult road ahead in the debt markets. We not only look at their historical metrics but we also look acutely into their process. This is important as only those fund managers with a broad mandate will be able to add value in our opinion over the next few years.

 

Let us know if we can help your firm sort through some or all of these issues with regard to the ever evolving and challenging bond market.

 

Sincerely,

 

Tom Koehler, CIO

Bond market danger?

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We have been reading a lot about the inherent dangers in the bond market given the low rates and the potential for interest rates to rise. While rates are low given historical spreads for most sectors, and the potential for higher rates both at the short and long end remains real, we will focus this brief piece on another risk that may be percolating.

Liquidity risk is the risk that the price of a security will not be able to be sold in the market due to a lack of interested buyers close to the current price. In a serious liquidity crisis, even high quality securities can lose value quickly before equilibrium is restored.

According to Simon Ejembi in a Punch article dated April 22nd 2014, The research department of the International Organisation of Securties Commissions said that, “Bond investors now face higher liquidity risk due to new regulation and interbank controls in the wake of the financial crisis.”

“Combined with the introduction of more transparency, this has made dealer banks to step back from their market-making role, causing a reduction in phantom liquidity. Bond investors now face higher liquidity risk as a result.”

The traditional inventory practice that is part of market making has been curtailed significantly by banks as regulations that curtail risk assets has dried up corporate bond market liquidity to a potentially dangerous level.

Nasdaq.com listed an article provided by Seeking Alpha that delves into a couple major issues with regard to the bond market. Namely, the major source of liquidity has been driven by retail investors who have piled into bond ETFs and funds. A significant portion of these funds has been poured into big name products such as AGG(I-Shares Barclays Aggregate Index) and LQD(I-Shares Investment Grade Corporate Index).

However; as the article points out very importantly, the market’s structural liquidity condition has gone in the opposite direction. Dealer inventories of corporate bonds have plummeted by nearly 75% from pre-crash levels, meaning that the ratio of dealer inventories to bond fund assets has virtually been vaporized. In 2008 that ratio stood at 15%, but presently it is only 1.5%. Likewise, daily trading volumes have been cut in half since the crisis.

The abundant liquidity that the Fed provided caused a major mispricing of liquidity so that the liquidity premium generally ascribed to debt assets has been absent.

Basically this means that when the conditions change, the price for these bonds may be well below current levels. Considering many firms use these ETFs for their core strategic holdings, it is a very good time to examine them and to also talk to your mutual fund manager to discuss this issue.

We recommend choosing a manager who is able to price liquidity appropriately and to be able to build and manage a portfolio that holds proper nimbleness and liquidity.

Sincerely,

Tom Koehler-CIO

Barclays Aggregate Index-Where to go?

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In our last piece, we described the problems associated with exposure to products that passively track the Barclays US Aggregate Index such as the I-Shares product(AGG). There is simply not a reasonable risk to reward under most circumstances and therefore we heavily favor active management.

Given the heavy weight in government debt in this index and most of the ETFs that track them, we will introduce a couple managers that similarly use the Barclays US Aggregate Index and who are heavily weighted toward Treasuries or Mortgage Backed Debt.

One of the issues with regard to fund selection in this area is the often times confusing labels. We have similar funds named, “intermediate bond”, “total return”, “core”, “core plus” etc. Even within each of these categories, there is much variance in the strategies.

The mandate can vary at a few levels that include; security type, credit quality, duration management and regional focus. To put any relative comparison in perspective, a quick review might provide some perspective.

As we mentioned in past posts on core fixed income, it is important to dig into the details to determine if the fund is truly a substitute for representation by the Barclays Aggregate Index. We found TCW to posses excellent management skills mainly within the realm of mortgage backed securities. That fund could be potentially used a strategic holding as exposure to a value added manager within a specific bond asset class. It should not be used as a broad based exposure to multiple markets to replace the I-Shares AGG due to its focused mandate.

GW&K Enhanced Core Bond Fund accomplishes outperformance vs the Barclays Aggregate Index differently than the TCW Total Return Fund. They add in a more active high yield opportunistic approach to enhance risk-adjusted returns while they maintain a solid position in AAA rated Mortgage Backed Securities. They also weigh more heavily in those areas among the investment grade world that offer more relative value.

They have done a nice job over the last few years and could have served as a reasonable substitute for the -I-Shares AGG product as they were able to adjust duration, credit quality and sector weights successfully. Their current yield stands at around 2.5%.

Another fund that has done well over the last few years on a relative and absolute basis v the Barclays Aggregate Index is the Aston TCH Fixed Income Fund. While they hold a lot of Mortgage Backed Bonds, they have achieved their numbers in part through an overweight to corporate debt below AAA as they opportunistically look for value in the BBB area of the credit spectrum. The dilemma here is that corporate and mortgage backed debt may be arguably fully valued so gains from here may be difficult to come by. They have a slightly higher duration than the AGG product and a 74 basis points yield advantage.

Thus far we have found at least one manager who may be able to fill the role of a value added manager in the mortgage backed space and two managers who have in the past been successful at beating their main benchmark.

While we support active management, it is difficult to see how theses funds will achieve the same success in the future since many fixed income classes are fully to overvalued. While we have looked at these funds it may be helpful to speak generally about various strategies and the potential benefits they possess as well as the drawbacks.

It may be difficult to find one manager who is able to be a Barclays Aggregate representative for your fixed income allocation. One reason is that it is simply difficult to find value in many spaces domestically. A US investment grade portfolio has limitations with regard to the amount of yield and capital appreciation available and a manager that tracks this will likely find it difficult although not impossible to outperform.

It strikes us at Zenith that a more unique approach is warranted. One that potentially has a wider mandate with regard to geography, security type and credit rating as well as very nimble duration management.

Here are a few strategies to begin to consider as the opportunity set that tracks the Barclays Aggregate may be limited for a while.

• Flexible Income Funds-The mandate is typically more nimble and the scope is wider.

• Global Bond Funds-The mandates vary but these managers are able to attempt to secure value domestically and to be able to search around the globe. This can involve multiple currencies and emerging markets. Each introduces their own risks but allows for a larger opportunity set.

• Unconstrained-These funds are in most cases the most nimble with regard to security selection, geographic reach and duration management. Some actually hold a negative duration. That can certainly work against the investor if rates decline.

We are convinced that a methodical move away from a core mandate around the Barclays Aggregate is one that needs to be taken over a reasonable time frame. Now would be a great time to internally assess your firms risk objective and what areas of the global bond market you are willing to explore for a portion of the bond portion of your portfolio.

We can help you through this process by taking a look at you current manager in terms of their process and if that process if conducive to future results. The high risk adjusted numbers for these managers over the last few years will likely be very difficult to achieve in the future unless their mandate and process are appropriately nimble.

Again to aid in this process we can sort through the various bond fund labels and how each may work to help or hurt your portfolio.

Thanks again for your time.

Sincerely,

Tom Koehler-CIO

Bond Market Update

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The bond market for the most part has done reasonably well this year as the broad US market has provided a return of approximately 3.68%.

This is the return on the Barclay’s US Aggregate and one instrument that represents this large market is the I-Shares ETF (AGG). We have written in the past about using passive ETFs as a strategic holding. Generally we have viewed them with caution at best given the limitations that most possess.

A placement in this product provides you with exposure to an investment grade portfolio with most of the credit at the top end of this spectrum. This is due in large part to the heavy weight to Treasury Securities. They comprise 37% of the portfolio while Mortgage Backed Debt is about 27%. That is a large bet on steady to declining interest rates as the overall duration is 5.18 through June 30th.

As a review, this means that the fund can go down 5.18% for every 100 basis point move up in interest rates. 200 basis points and clients will wonder what happened to their “safe” money.

Even if rates remain absolutely steady, a yield of 2%, is hardly compensation for a fund with this amount of interest rate risk and the potential for a credit shock that would send the prices of even investment grade debt tumbling.

We feel at Zenith that it is difficult to paint a broad brush across the entire bond market for a strategic placement as their are a lot of sub-segments within this market.

Treasuries, mortgage-backed debt, municipal bonds and high yield are just a few in a very dynamic and diverse market. We recommend that firms build out their fixed income exposure with a group of managers with unique insight and management style.

While this will not come close to guaranteeing a full proof way to avoid losses in bonds, it will enable your firm to capture the value added provided by top managers in various categories.

Next week we will present a couple managers who we feel should be up for consideration given their management skills and risk control.

Sincerely,

Tom Koehler-CIO

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