Blyth Fund: Fixed Income Currencies & Commodities Coverage Group May 27, 2014

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1 Blyth Fund: Fixed Income Currencies & Commodities Coverage Group May 27, 2014 VP: Miraj Rahematpura Associate: John Cherian Analysts: Reinier Eenkema van Dijk, Michael Limandibhratha, Ian Naccarella, David Schmitt, Luke Thompson, Gary Thung Investment Thesis Currently the Blyth Fund has 45% of its assets in Money Market Funds. This is a poor investment choice, because these Money Market Funds are highly liquid, return less than 1% a year, and lose value due to inflation. As an alternative, we believe that Blyth should allocate some of its investments into US corporate debt. How the bond market has historically performed 1994, 2003, 2013 Bond Market routs 1994: short notice to fixed-income markets of interest rate hike. Rapid selloff of bonds to avoid losses. 2003: investors sold in anticipation of rising interest rates as the economy rebounded and the stock market rallied Similar event in 2013: tapering of QE created beliefs that interest rates would rise to counteract inflation, prompting a selloff Financial Crisis Low federal funds rate leading up to 2007 spawned many risky mortgages; federal funds rate rose quickly in about 2 years from Defaulting on subprime mortgages ruined subprime lenders and financial institutions which held mortgage backed securities (whose value fell sharply) o Defaults due to drop in home prices and rising interest rates; people could not afford to pay anymore or did not want to pay for underwater mortgages Institutions dumped assets to pay loans taken out to finance other transactions o No one wants to buy these assets even at relatively low prices US Treasuries favored over riskier assets because of decrease in investor confidence, especially of financial institutions. Resulted in bond price increase from the increase in demand, and from yield on 10-year Treasuries fell from 4.75% to 2.25%

2 Quantitative Easing During QE: markets interpret QE as inflationary, and higher inflation expectations increase nominal bond yields, therefore decreasing bond prices Tapering and ending QE: can lead to interest rates increase to lower inflation, which would drive bond prices down Ending QE has led to yields on Treasuries declining (related to decreasing inflationary expectations) and prices increasing Current macro trends and how they affect the bond market Currently, the Fed is buying a large proportion of newly created government bonds. The private sector wants these bonds for lower risk investments and diversification and thus is willing to accept lower yields. This is increasing demand for U.S. treasuries, which is driving down their yield. However, the Fed is tapering bond purchasing by $10 billion per month, which might make treasuries more attractive. However, Chairman Yellen, Chair of the Board of Governors of the Federal Reserve System since February 3, 2014, is known for historically being more dovish (keeping interest rates lower longer than expected) than hawkish (raising interest rates faster than expected). Cons of European Debt In Europe, buyers wants U.S. treasuries because they see the Euro as overvalued. Furthermore, Corporate debt in the PIGS is uncertain, because their growing economies are still volatile. Furthermore, Europe is behind the U.S. in its recession cycle, so investors are leaning towards government debt, driving the yield down of PIGS government debt. Cons of Chinese Debt In China, Shanghai Chaori Solar Energy Science & Technology Co. recently defaulted on it s debt. This default was not a huge financial burden, but it has large implications because of how heavily regulated the Chinese market is. This default was followed by the Chinese junk bond market's first default. The Chinese premier also made a statement saying China will start tightening its credit and not provide low interest loans to every company in need, allowing poorly run companies to default. This makes Chinese corporate bonds much more risky, as they no longer have their government safety net. Cons of U.S. Government Debt A large number of U.S. treasuries were sold recently. The main culprits for this are China and Russia. It is expected that China may have sold a large number of U.S. treasuries in order to get cash to shore up its credit markets and help it deal with the recent defaults. In Russia, it is believed that the U.S. debt may have been sold in expectation of potential U.S. sanctions over Russia's role in

3 the Ukraine crisis. In either case, these issues for Russia and China have not been resolved, and we believe that they may continue selling large numbers of U.S. treasuries. Investment Pitch Why investment grade bonds Bonds get a bond credit rating from AAA to C/D (depending on the rating agency). To be an investment-grade bond it needs to have a rating of at least BBB-, which means that the lender is low-medium risk. This will bring down the Blyth Fund s risk. ITR-SPDR Barclays Capital Intermediate Term Credit Bond ETF Current Price: $34.30 Fees: 0.15% Yield: 2.71 Sectors o Corporate Industrial: 53.41% o Corporate Finance: 36.90% o Corporate Utility: 8.20% 1 Year Return: 2.00% SCPB-SPDR Barclays Short Term Corporate Bond ETF Price: $ Year Return: 1.50% Both of these investments have low fees and a diversity of holdings. We chose to focus on both short term and intermediate bonds because they are not subject to long term interest rates. Additionally, we believe the current state of the market reflects a good entry point for both of these positions. Interest rates are low and the market is at an all time high. If the market is due for a correction, these types of assets will reduce our risk. Inversely correlated with the stock market, the bond market is at a low, indicating a good entry point. If we wait too long to buy these assets, they may be back in upswing or there may be a change in Fed sentiment.

4 Risks Risk Risk Level Reason Inflation Risk Low The Fed isn t indicating a tightening of monetary policy Interest Rate Risk Low Chairman Yellen s policy tendencies Default Risk Low ETF s have low default risk Downgrade Risk Low ETF s have low downgrade risk Liquidity Risk Low/Medium The ETF has difficulty switching the bonds it owns, but it s easy for the Fund to sell this asset Exit Strategy We expect to hold this position for 12 months. However, if there is a change in the expected interest rates, we would consider reevaluating this position. Currently, interest rates are expected to be low; however if that changes, it may be a good idea to sell off. Another reason that may signal reasons for exiting includes a large sell-off by China, Russia, or Europe. This can be triggered by a significant drop in the Euro value, developments in the Crimea Crisis, or if Chinese corporate bonds sell off.

5 Other bonds explored by the coverage group: BYLD: ishares Yield Optimized Bond ETF Analyst Coverage: Luke Thompson Exposure to the bond market An ETF of bond ETF s in order to create diversification in one trade This ETF attempts to offer a solution to the issue of extremely low yields in the bond market by investing in some of the riskier bonds without increasing the risk profile too much Non investment grade bonds make up less than 20% of the ETF s holdings HYHG: ProShares High Yield Interest Rate Hedged Analyst Coverage: Reinier Eenkema van Dijk An ETF that trades in a diversified portfolio of high yield bonds hedged against the rising interest rates through shorting treasury bonds. o The hedged factor makes it a good option while the Fed reduces QE 0.50% expense ratio Targets a duration of zero o This is a measure of the sensitivity to interest rate changes o Lower than short term bonds TIP: ishares Barclays Treasury Inflation Protected Securities Fund Analyst Coverage: Gary Thung Exposure to US TIPS whose face value increases with inflation o Janet Yellen, new Chairperson of Fed, typically a dove : more focus on o unemployment than inflation Yellen views deflation as bad because: Deflation is correlated to interest rates increases. This deters businesses from capital formation, which increases output and jobs Low risk, good long term investment and provide a guaranteed real rate of return from US government Adds diversity to overall portfolio by protecting against inflation that exceeds market expectation ANGL: Market Vectors Fallen Angel High Yield Bond ETF Analyst Coverage: Ian Naccarella Tracks high-yield, junk bonds that were originally issued with an investmentgrade rating 73.2% allocation to BB-rated debt, 16.4% in B-rated debt and 6.0% in CCC-rated debt Exposure to high yield bonds from companies that were originally investment grade, but were downgraded due to unfavorable market conditions Not investing in super high-yield bonds, so less likely to be in a bubble