Fixed Income Investing in the Current Economic Environment. Agenda. About YieldQuest. FPA Retreat Jay K. Chitnis, CFA.
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1 FPA Retreat 2006 Fixed Income Investing in the Current Economic Environment Jay K. Chitnis, CFA Portfolio Manager and Chief Investment Officer May, 6th 2006 Agenda I. A Quick Word on YieldQuest s Background II. The Economic Environment & Bond Market Outlook III. Opportunities Created by the Markets in the Fixed Income World. a. Yields & Yield Curve Opportunities b. Sector Opportunities c. Inefficiently Priced Instruments 2 About YieldQuest We are an investment boutique working solely with fee-only and fee-based investment managers and financial planners all across the country. Our focus and mandate is to provide our clients with ideas and products that may add value to fixed-income & equity portfolios over and above what may be achieved by simply using typical open-end mutual funds or basic individual bond strategies. In doing so, we provide our clients with a very high level of service and expertise, and the tools they need to effectively communicate our unique strategies and performance to their clients. 3
2 The Economic Environment and Bond Market Outlook 4 Over the past month, the 10-year Treasury has approached its multi-year highs at 5.15%. Although we believe that rates could move higher over the short-term, we believe this may create an excellent buying opportunity. We still maintain that globalization and muted inflationary pressures could restrict the 10-year form trading substantially above to 5.25% for an extended period of time. 10-Year U.S. Treasury Yield Source: Bloomberg L.P. 5 Fed expectations have also moved higher, indicating a peak of the Fed Funds rate of 5.25% sometime during the fall of With the first meeting from the new chairman under out belts, we believe the Fed Funds Rate can move higher than we previously forecast, with a peak now anticipated at 5.25% by early summertime. Federal Funds Futures Source: YieldQuest Securities LLC / Bloomberg L.P. Fed Funds Futures Expectations Current Fed Funds Futures Fed Funds Futures 1 M onth Ago 5.50% 5.25% 5.00% 4.75% Expected Rate 4.50% 4.25% 4.00% 3.75% 3.50% 3.25% 3.00% M ay-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Date 6
3 In previous tightening cycles, the 10-Year Treasury has peaked sometime between three and four months before the Fed finished its tightening. If the Fed is expected to raise two more times, we could be seeing the peak in the 10-Year Treasury in the coming weeks. Federal Funds Rate and the 10-Yr Treasury Source: YieldQuest Securities LLC / Bloomberg L.P. 7 The recent trend towards a flattening of the yield curve has changed in the past two months the 10-Year less 2-Year Treasury spread has widened by 30 basis points. In previous tightening cycles, the yield curve started to steepen as the Fed reached its peak in rates. 10-Yr Less 2-Yr Treasury Spread Source: YieldQuest Securities LLC / Bloomberg L.P Year - 2 Year Treasury Spread Spread (Basis Points) (0.25) (0.50) 12/26/2003 2/26/2004 4/26/2004 6/26/2004 8/26/ /26/ /26/2004 2/26/2005 4/26/2005 6/26/2005 8/26/ /26/ /26/2005 2/26/2006 4/26/2006 Date 8 There are already signs that the housing market is weakening. We believe that the path of monetary policy will determine if the correction in housing becomes more problematic for the broad economy. Weakness in Housing Source: Bank Credit Analyst April, 2006 Page 4 9
4 One of the main reasons that we believe that the Fed will not go too far and raise rates above 5.5% is the impact any such move could have on the housing market. The U.K. housing market has provided insight into the U.S. market in the past. The U.K. market experienced a drop in house prices, that was followed by a plunge in retail sales. We do not believe the Fed wants to cause such a move in the U.S. economy, but rather a moderation or slight correction in housing prices. House Prices and Retail Sales in the U.K. Source: Wachovia Economic Commentary, March 23, 2006 Page 2 10 In addition to the effect higher rates would have on housing affordability and thereby home prices, higher rates would also considerably slow home equity withdrawals, which have been a substantial driver of consumer spending. These type of withdrawals added almost 8% to the level of disposable income during Equity Withdrawals and Disposable Income. Source: Wachovia Economic Commentary March 23, 2006 Page 5 11 Finally, it appears that as interest rates moved higher, so have interest payments paid out by banks to individuals. The chart below shows that the annual interest paid out has surged over the last two years and nearly caught up with the increase in the amount of mortgage interest paid. Annual Changes in Personal Interest Income and Mortgage Interest Paid Source: Citigroup Portfolio Strategist, March 9, 2006 Page 16 12
5 On the inflation front, we believe that inflation is currently contained as unit labor costs and import price inflation have both turned significantly lower, limiting upward price pressure. Inflation is Under Control Source: Bank Credit Analyst, May 2006 Page 6 13 Additionally, the labor market continues to support real consumer spending. We believe that the correlation between these two variables can continue, and do not anticipate any near term weakness in the labor markets. Source: Citigroup Portfolio Strategist, February 23, 2006 Page 3 14 The Dollar has dropped over the past month as the Fed tailwind is coming to an end. We believe the dollar can continue to weaken over the longer term without further tightening of monetary policy and continued strength in the developed global economies. The U.S. Trade-Weighted Dollar Index Source: Bloomberg L.P. 15
6 Economic Summary: 1. We believe the forces of globalization and inflationary pressures that remain well contained can keep the 10-year Treasury from trading above the 5% % level for an extended period of time. 2. As the Fed approaches the end of its tightening campaign (whether at 5% or 5.25%), we are likely approaching the peak in the 10-year Treasury. 3. The housing market remains the key variable in gauging the health of the economy for the rest of the year. We expect a moderation in housing activity, and not a bursting of the national housing market. 4. We believe the dollar can weaken further as European economies gather momentum and the tailwind of Fed tightening disappears over the coming months. 16 Potential Inefficiencies in the Bond Market: Relative Spread Differentials Odd-lot vs. Round Lot Advantage Relative Value Plays on Shape of Yield Curve and Duration. 17 On a relative spread basis, vanilla agencies and junk remain expensive while corporate bonds and mortgages are at neutral valuation levels. We would look to add to our corporate bond exposure if spreads were to continue to widen over the coming months. Mortgages would need to move to cheap levels given the previous experience of prepayments as interest rates moved lower. Agencies, Mortgages, and Corporate Yield Spreads Source: Ned Davis Research 18
7 Over the past month, we have observed an increase in real yields that matches the rise in nominal yields. 10 Year R eal Yield 2.6 (10 Year TIPS Security) So urce: B lo o m berg Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Rate Mar-06 D a t e 10 Year N om inal Yield Source: Bloom berg Rate Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 D a t e 19 In the first quarter of the year, the TIPS asset class underperformed the broad bond market (as measured by the TIPS ETF vs. the Lehman Aggregate Bond Index ETF) by 134 basis points. We continue to believe that only the shortest TIPS securities offer value for an investor. Revisiting TIPS First Quarter Performance Source: Bloomberg L.P. Revisiting TIPS One-Year Performance Source: Bloomberg L.P. 20 For the first quarter, municipal bonds (as proxied by VWITX Vanguard Intermediate Term Muni Index), have outperformed the broad bond market index (proxied by VBMFX Vanguard Total Bond Market) by 86 basis points as the yield percentage has moved to a multi-year low. We would look to selectively lower our muni allocation. 10-Year AAA Muni Yields as a % of the 10-Yr Treasury Source: YieldQuest Securities / Bloomberg L.P. 10 Year AAA M uni Yields as a % of the 10 Yr US Treasury 100% 95% 90% Percentage 85% 80% 75% 70% 8/14/1998 2/14/1999 8/14/1999 2/14/2000 8/14/2000 2/14/2001 8/14/2001 2/14/2002 8/14/2002 2/14/2003 8/14/2003 2/14/2004 8/14/2004 2/14/2005 8/14/2005 2/14/2006 D a t e 21
8 With the relative performance of municipal bonds, short-term muni yields are now less than 70% at the short-end of the curve and appear expensive in our view. We would sell short-term municipal securities and move out the yield curve, where there is still a 52 basis point spread between the 10-year and 2-year AAA bond. Bloomberg Municipal Bond Yields Source: Bloomberg L.P. 22 We would not advocate a wholesale shift out of municipal bonds though. In our view, the fundamentals support further relative performance given declining supply forecasted for the rest of Municipal Bond Market Fundamentals Source: BCA Research U.S. Bond Strategy Weekly Bulletin, March 2006 Page One potential area of inefficiency in the muni market revolves around odd lot bonds. See the example below: 24
9 By trading odd lot premium bonds and adding in zero coupon bonds, we can up the expected yield while minimizing principal erosion over time. Synthetic Par Portfolio AMT ISSUE CPN MATURITY CALLS RATING YTM PRICE $ AMOUNT 100 IN ST WTR REV /15/2013 NC AAA $ 100,000 TOTAL $ AMOUNT $ 100,000 INCOME / YEAR $ 3,400 AMT ISSUE CPN MATURITY CALLS RATING YTM PRICE $ AMOUNT 50 CHICAGO IL GO 7 08/15/2013 NC AAA $ 61, TX ST GO 0 08/15/2013 NC AAA $ 36, TOTAL $ AMOUNT $ 98,307 INCOME / YEAR $ 3,500 **Yield Levels may not reflect the current market. This chart is for explanatory purposes only. Is not meant to reflect actual trading or to be taken as investment advice. 25 It is interesting to look at the risk-adjusted performance of long-term bonds (VUSTX), short-term bonds (VSGBX), and intermediate-term bonds (VBMFX) to determine their performance during periods when the yield curve is steeping and flattening. When looking at total returns as well as riskadjusted returns, the intermediate area has historically provided the best risk-adjusted returns, especially during steepening yield curves, which we would expect to take place over the next three years. -See next page: 26 Fixed Income Performance and the Yield Curve Source: YieldQuest Securities / Bloomberg L.P. 27
10 The Interest Rate Dilemma: Can incremental value be added by managing the changes in direction of interest rates? Year Treasury Yield with YieldQuest Portfolio / Duration Adjustments Source: Bloomberg L.P. / YieldQuest Securities LLC 29 Fixed Income Summary: 1. We believe that inefficiencies do exist in the fixed income markets 2. By taking advantage of yield spread differentials in corporates, taxable municipals, CD s TIPs, individual municipals, etc., it is possible to add substantial value to portfolios. 3. Odd lot bonds can offer more yield than similar round lot offerings. 4. Interest rate management, and slight incremental duration adjustments, can be value additive over time. 30
11 To Learn more about YieldQuest or to get an electronic copy of the presentation materials, please contact us at: YieldQuest Advisors 3575 Piedmont Road, Ste 1550 Atlanta, GA Phone: (866-YQFUNDS) Fax: YQTRX- YieldQuest Total Return Bond Fund YQTEX- YieldQuest Tax Exempt Bond Fund YQCEX- YieldQuest Core Equity Fund 31 Disclosures: YieldQuest Total Return Bond Fund - There are risks associated fixed income securities which include, but are not limited to the same interest rate, inflation and credit risks associated with the underlying bond in the portfolio. High-yield securities may subject to greater fluctuations in value and risk of loss of income and principal. The Fund may invest in the shares of other mutual and exchange traded funds. These underlying funds may be subject to their own operating fees and expenses. There are special risks associated with international and emerging investing, including currency fluctuations, economic conditions and different governmental and accounting standards. The Fund may utilize short sales or invest in options and futures which may subject the portfolio to higher risk and volatility. YieldQuest Tax Exempt Bond Fund - There are risks associated fixed income securities which include, but are not limited to the same interest rate, inflation and credit risks associated with the underlying bond in the portfolio. High-yield securities may subject to greater fluctuations in value and risk of loss of income and principal. The Fund may invest in the shares of other mutual and exchange traded funds. These underlying funds may be subject to their own operating fees and expenses. The Fund may utilize short sales or invest in options and futures which may subject the portfolio to higher risk and volatility. Investments may be subject to state or local income taxes. Certain other income, as well as capital gain distributions, may be taxable. YieldQuest Core Equity Fund- There are special risks associated with international and emerging investing, including currency fluctuations, economic conditions and different governmental and accounting standards. The Fund may invest in the shares of other mutual and exchange traded funds. These underlying funds may be subject to their own operating fees and expenses. The Fund may utilize short sales or invest in options and futures which may subject the portfolio to higher risk and volatility. 32 Disclosures: Investors should carefully consider the investment objectives, risks, charges and expenses of the YieldQuest Funds. This and other information about the YieldQuest Funds is contained in the prospectus and should be read carefully before investing. The Fund s prospectus can be obtained by calling The YieldQuest Funds are distributed by Aquarius Fund Distributors, LLC. Investors should note that mutual fund values may fluctuate and that the funds price or value may rise or fall. Accordingly, investors may receive back less than originally invested. 33
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