SIPCO Corporate Bond Strategy

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1 . SIPCO Corporate Bond Strategy The principles of SIPCO believe that bond investors are best served by primarily investing in corporate bonds. We are of the opinion that corporate bonds offer the best methodology for investors to meet their investment return goals, especially in an environment of low historical yields. Here are six key facts about investing in corporate bonds; 1. History has demonstrated that the majority of investment return from bonds has come from coupon (over 90%). Thus by focusing investment dollars on higher coupon corporate bonds, an investor ultimately will be rewarded over an extended period of time. 2. Corporate bonds historically have provided returns above that of government bonds. The promised yield on the top ranked U.S. corporate bonds rated by S&P as AAA (the highest quality bonds issued only by blue chip companies) has been 0.7% higher. BBB bonds, the lowest grade bonds deemed by S&P still to be considered investment grade, have a historical yield spread of 1.9% above Treasuries. 3. Credit risk is not the determining factor in the pricing of corporate bonds. 4. Actual credit defaults are very low and the credit rating agencies have historically overestimated the default rates, especially for non-investment grade bonds. 5. Corporate bonds are generally less sensitive to a rise in interest rates. 6. BBB & BB rated bonds have historically demonstrated the best risk/return matrix of any corporate bond category. AVERAGE INCOME COMPONENT OF RETURNS FOR 5, 10, 20 YEAR ROLLING DATA Table 1.1 Source: Brandes Investments based upon data from Ibbotson, 12/31/2011

2 Returns from bonds come from two sources: interest payments, paid out as income, and changes in price. Over time, interest payments typically contribute far more to returns than changes in price. History has demonstrated than more than 90% of the total return generated from a broadly balanced portfolio of bonds has come from interest payments as opposed to change in price. Based on a review (table 1.1 above) of 86 years of U.S. and U.K. investment returns fixed income by Brandes Investments, the importance of income s contribution in bonds to total returns is long-established. Corporate bonds have demonstrated a stronger tie to the income component than government securities. As measured by Morningstar (table 1.2), the income component for total corporate bond returns has averaged over 96%. Fixed income returns were dominated by the income component for all time horizons longer than five years. COUPON IS A MAJORITY COMPONENT OF CORPORATE BOND RETURNS Table 1.2 Period ending 12/31/2012 Income Price Government Bonds 91.7% 8.3% Corporate Bonds 96.6% 3.4% Source: Morningstar. Total return includes compounded income and capital appreciation over the 20-year period ended 12/31/12. Government bonds are represented by the Barclays U.S. Government Index and corporate bonds are represented by the Barclays U.S. Credit Index. The downside of this analysis for investors in both government and corporate bonds is that at the current low levels of interest that these bonds generate, it makes it extremely difficult for bond investors to generate attractive returns. In a low yield environment such as 2013, clipping the coupons on traditional government bonds will generate most of a modest return of 2-3%. An investor can look beyond the typical government bonds and consider higher yielding corporate securities. Credit Suisse Company publishes a yearbook that examines the long term returns of various asset classes, including corporate bonds. As the U.S. has consistent corporate bond data going back to 1900, the return subset is quite large. Credit Suisse has found that the long term return of corporate bonds over 111 years, from 1900 to 2010, was 2.52% per year. This was 0.68% per year more than on U.S. Treasuries. Published academic research in the past decade years also reports the advantage of favoring corporate bonds over treasuries. Alexander Kozhemiakin (2007)1 demonstrated in his study published in The Journal of Portfolio Management that the excess return of corporate bonds over treasuries is consistent over time. Furthermore, he found that as investors move to lower quality corporate bonds, the return differentials become more pronounced. This is especially true in the BB category, where the excess returns is the highest of any grade. The lower tier of the investment-grade spectrum (A/BBB) accounts for two thirds 1 Kozhemiakin, A. (2007). The Risk Premium of Corporate Bonds. The Journal of Portfolio Management,

3 of the investment-grade market capitalization. The returns from corporate bonds for all the major ratings categories is listed in table 1.3; CORPORATE BOND HISTORICAL RETURNS AND RISK January 1985 to December 2005 Table 1.3 Return Risk Return Risk AAA/AA Rating 8.9% 1.9% A Rating 9.2% 2.2% BBB Rating 9.3% 3.3% BB Rating 11.0% 6.5% B Rating 9.7% 9.0% CCC Rating 2.8% 15.2% Source: Kozhemiakin, A. (2007). The Risk Premium of Corporate Bonds. The Journal of Portfolio Management, Risk measured by Standard Deviation. PERFORMANCE FOR BB RATED BONDS VS. BOND INDEX Table 1.4 January 1985 to December Year 10 Years 20 Years BB Rated Bonds 9.29% 8.78% 11.03% Barclays Aggregate Bond Index 6.52% 5.74% 7.80% Barclays Govt. Bond Index 5.62% 4.87% 6.76% Source: Kozhemiakin, A. (2007). The Risk Premium of Corporate Bonds. The Journal of Portfolio Management, An investor should expect corporate bonds to trade at higher yields than Treasury bonds over extended periods of time. The primary differentiation between the two yields has been historically related to the credit spread. Other key factors previously examined include tax treatment, illiquidity, and the unique provisions that are included in the contracts of corporate bonds. These are all characteristics that government bonds do not share. Although most investors will look at the excess returns as coming

4 from pure credit risk, academic research has concluded otherwise. Credit risk is in fact not the primary factor in explaining excess corporate bond returns. Jing-zhi Huang of Penn State University and Ming Huang of Stanford found that within the investment grade bond arena, less than one-third of the excess return was associated with default risk2. Additional studies confirm these findings. Professors Gordon Delianedis and Robert Geske of The Anderson School at UCLA found that for AAA rated firms, only a small fraction (5%) could be attributed to actual default risk. For BBB rated firms, which are those rated just above junk, only 22% of the credit spread can be attributed to default risk. The team further concluded that credit risk and credit spreads above government bonds are not primarily explained by default, leverage, or a firm s specific risk - but are primarily attributable to liquidity, market risk, and other factors3. One primary theory for why the wide yield spread for corporate bonds persists is the typical illiquidity of these bonds. The foundation for excess returns is that the illiquidity of corporate bonds has a larger than customary effect. While corporate bonds are traded widely on market such as the New York Stock Exchange, the volume of transactions is far less than for government bonds. Since increased liquidity is an attractive quality of any investment, investors will thus demand extra remuneration for holding securities that are less liquid and thus more expensive to sell. For corporate bonds, this illiquidity premium shows up in higher interest rate spreads over otherwise comparable government securities. That is the theory of several prominent researchers. Patrick Houweling, Albert Mentink, and Ton Vorst (2005) analyzed the effect of liquidity risk on corporate bond credit spreads based on a sample of 999 investment-grade corporate bonds4. In their paper, they controlled two common factors 1) the excess return from the stock market and 2) the excess return of long-term corporate bonds over long-term Treasury bonds in addition to the rating and maturity of each bond. They found that liquidity risk is priced into credit spreads and does explain a significant portion of observed credit risk spreads. In addition to liquidity risk, corporate bonds also have a substantial amount of volatility risk. While relatively protected for most economic periods, corporate bonds become a far riskier asset class in severe recessions. This has been demonstrated emphatically in the deep recession of 2008/2009. Corporate bonds returned a negative 21.3% in 2008, while the Barclays U.S Year Treasury Index returned a positive 16.7%. Thus, the volatility risk associated with owing corporate bonds during recessions adds to the spread over traditional government bonds. Liquidity and volatility risk are now perceived to be even more vital in explaining corporate bond spreads. This is especially true given the historical data on actual default rates for corporate bonds. It is actually much lower than expected, and gives credence to the argument that spreads are based more upon liquidity/volatility than default. According to the aforementioned Credit Suisse yearbook, default rates for all rated corporate bond issuers since 1900 has averaged only 1.2% per year. Of course over certain chaotic economic periods the default rate has reached much higher extremes. Default rates were at the highest levels following the Great Depression, at 8.4% in 1933 for corporate bonds. The default rate for all corporate bonds reached 3.7% in the recession of The second worst episode for default rates followed the recent credit crisis and, in 2009, the default rate on all rated bonds was 5.4%. Highyielding bonds with lower ratings had default rates just over 13%. However, most of the defaults during these crisis times were in the lowest investment categories (B- to CCC). Many academics have confirmed the historical default rates are much less than anticipated. Stephen Kealhofer, Sherry Kwok, Wenlong Weng found that true default rates for AAA bonds were only 0.13%, while even the riskier BB rating category only showed a default rate of 1.42%5. As measured by S&P (table 1.5), the default rates 2 Huang, Jing-zhi, Huang, Ming. How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk? (October 2002). NYU Working Paper No. FIN Geske, Robert L. and Delianedis, Gordon, The Components of Corporate Credit Spreads: Default, Recovery, Taxes, Jumps, Liquidity, and Market Factors (December 2001). UCLA Anderson Working Paper NO Houweling, Patrick, Albert Mentink, and Ton Vorst "Comparing Possible Proxies of Corporate Bond Liquidity." Journal of Banking and Finance 29, pp. 1,331-1, Uses and Abuses of Bond Default Rates. Stephen Kealhofer, Sherry Kwok, Wenlong Weng.. Document Number:

5 are even lower than the Kealhofer, Kwof, and Weng study. S&P default rates are lower than 1% for non-investment grade rated bonds BB+ and BB. BB- rated bonds had a default rate slightly above 1%. This indicates is that the default rates of BBB and BB rated bonds is not only lower than expected, but is very thin between the two specific categories. U.S. CORPORATE DEFAULT RATES Table 1.5 Bonds rated BB- to BBB+ Year BBB+ BBB BBB- BB+ BB BB

6 BBB+ BBB BBB- BB+ BB BB- Average Stand Minimum Dev Maximum Source: Standard & Poor's Global Fixed Income Research and Standard & Poor's Credit Pro. Given the above default rates as measured by S&P, it is especially rewarding if investors concentrate their corporate bond holdings within the BBB and BB ratings universe. These bonds typically will reward a bond investor with a sizeable annualized premium over the same duration government bond. For BB rated bonds, a 3% plus premium seems downright generous, especially given the fact that the annual default rate for these bonds was nominal even in the economic collapse of DECOMPOSITION OF HIGH YIELD RETURNS 1996 to 2011 Table 1.6

7 Sources: TIAA-CREF, Bank of America Merrill Lynch, and Bloomberg With interest rates at historic lows, any long-term investor should consider the potential total coupon. Since the ultimate return for an investor will be the income, examining higher income alternatives is paramount. Many managers argue that the one comparative disadvantage of higher yielding corporate bonds is the heightened sensitivity to marketsus fluctuations. During 1996 to 2012, higher yielding bonds have indeed traded at a wide range of prices. In table 1.6 below, the coupon (or yield) has been displayed versus the price change. In some years such as 2008, the price drop in high yield bonds was substantial versus the income collected. The reverse was true for However, the total return graph over time indicates that despite the price moves over time, the overall return for higher yielding bonds was primarily from the coupon. The average annualized coupon over this time period was 9%, nearly equivalent to the average total return. Thus, despite the enhanced volatility, total return will ultimately be primarily determined by coupon. One advantage of higher yielding bonds over traditional government securities is the susceptibility to interest rates. Higher yielding corporate bonds have proven to tolerate higher interest rates better than other categories within fixed income. This is largely due to two reasons. First, when interest rates rise, the economy is generally doing fine. In a strong economic environment, high yield bond defaults have historically dropped. Lower default rates make higher yielding bonds a more attractive investment selection. Second, a higher coupon will offset price loss as interest rates rise. Ultimately, a higher yielding corporate bond portfolio will maintain more stability in a rising rate environment. This is demonstrated in table 1.7 below, where high yield bonds have historically maintained positive returns in 11 of 13 periods of increasing interest rates since HIGH YIELD BONDS SENSITIVITY TO HIGHER INTEREST RATES Table 1.7 High-yield bonds have exhibited lower sensitivity to increases in the 10-year Treasury rate in 13 different periods during ; 10 Year 10 Year Treasury Treasury High Yield yield- change Bonds total Period range start 1 in yield return 3 09/30/ % % 1/31/ /31/ % % 12/31/ /28/ % % 3/31/ /30/ % % 11/30/ /31/ % % 8/31/ /31/ % % 6/30/2004

8 08/31/ % % 10/31/ /31/ % % 6/30/ /31/ % % 6/30/ /31/ % % 2/28/2009 3/31/ % % 6/30/ /30/ % % 12/31/ /31/ % % 3/31/2011 AVERAGE 3.60% % Sources: TIAA-CREF, Bank of America Merrill Lynch, and Bloomberg Higher yielding bonds in the BBB and BB field are the most attractive investment selection. As yield provides over 90% of total investment return over a ten year period, the higher yielding corporate bond will nearly always provide a return above that of government securities. In examining the data for the last twenty years, both categories have provided a high total return with a minimal default rate. 20 Year Data: Return SD Default Rate BBB Rating 9.3% 3.3% 0.23% BB Rating 11.0% 6.5% 0.88% Source: Kozhemiakin, A. (2007). The Risk Premium of Corporate Bonds. The Journal of Portfolio Management,

9 SIPCO s strategy focuses on what we feel is the best reward ratio within the corporate bond market. In the past five years, our portfolios have maintained an average exposure in the BBB and BB categories of nearly 80%. Credit Quality (% of SIPCO Bond Holdings) - 5 Year Average AAA 1% AA- 2% A+ 2% A 3% A- 5% BBB+ 10% BBB 16% BBB- 24% BB+ 10% BB 10% BB- 8% B+ 3% B 3% B- 3% In addition to our concentration in the BBB & BB credit spectrum, our principles also utilize interest rates hedges to moderate the price decline risk that occurs when interest rates rise. As our goal is to produce a stable rate of investment return in each calendar year, interest rate hedges can mitigate the substantial bond price movements that occur when interest rates rapidly rise. Our principals are confident that our SIPCO U.S. Bond Portfolio is a compelling investment vehicle over the ensuing decade. This is especially critical in 2013, as we feel the next decade will most likely offer government bond investors scant single digit returns. SIPCO Investment Committee

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