P A R A G O N CAPITAL MANAGEMENT

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1 Bond Market Overview July 2013 Bonds declined in value last quarter as interest rates rose by the most in over two years. The increase was a function of economic surprises, Federal Reserve policy confusion, and investor selling. The dramatic increase in rates provides more attractive yields relative to inflation and our economic outlook, and rapid increases like this one have usually been followed by rate declines. However, from a longer term perspective, interest rates have not normalized, bonds are over owned by investors, and expected returns are well below average. Interest rates rose the most since % Yield Comparison 5.0% 4.0% 3.0% 2.0% AAA Corp AAA Muni 10 Yr Tst 1.0% 0.0% Jan 10 Jun 10 Nov 10 Apr 11 Sep 11 Feb 12 Jul 12 Dec 12 May 13

2 The increase in interest rates pushed prices down, reversing the gains of the last 18 months. Long term bonds had larger interest rate increases Interest Rates 5.00% 4.00% 3.00% 2.00% 1.00% AAA Municipal Yield Curves 0.00% Maturity 4/30/2013 6/28/2013 Long term bonds are more interest rate sensitive and had larger losses.

3 Price Change from 4/30 to 6/28 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% AAA Municipal Price Changes (for different maturities) Price Change 0.0% 0.5% 1.4% 2.6% 3.6% 5.8% 8.9% Why did Rates Rise so much? Crowded Trades Hedge funds using debt trading strategies have expanded at a record pace, attracting $100 billion over the last three years. Since these strategies used borrowed money to leverage returns, losses are magnified. As volatility increased, risk management techniques dictated portfolio selling. Thus, exchange traded funds, which is a preferred hedge fund vehicle, saw many times the selling/fund withdrawals of traditional open end mutual funds.

4 Hedge Fund Selling Hedge funds drove much of the bond fund selling. Similar to 2007, selling in one part of a complex global portfolio leads to selling in another part of the portfolio that is then aggravated by crowded trades (i.e., many investors/lots of dollars invested in the same trade with the result of limited liquidity/ability to get out at the same time). In addition, Federal Reserve and regulatory actions have resulted in less flexible markets; for example, banks are less willing to accommodate customers, and Federal Reserve bond buying has led to collateral shortages.

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6 Federal Reserve Communications P A R A G O N Apparently oblivious to the strained market conditions and the over crowded hedge fund trades from years of exceptionally low interest rates, Federal Reserve Chairman Bernanke suggested that the Federal Reserve s asset purchases might decline later this year and end next year. These unsupportive remarks sent the markets into a tail spin.

7 Liquidity Mutual funds, especially exchange traded funds that can be traded throughout the day like a stock, give the appearance of liquidity, but, frequently, as in the case with high yield bonds and municipal bonds, the assets in the portfolio are not very liquid. While hedge funds are trading these securities like a liquid vehicle, significant selling can result in poor execution because of the inherent illiquidity of the underlying market. The effect is that the selling pressure on exchange traded funds shows up as a discount to the value of the fund portfolio, so the price to trade has dropped more than the portfolio value. The price loss begets more selling. Thus, lack of liquidity results in large price declines that are immediately transmitted to the market. The two lines in the graph below are the price of the bond fund and the actual (net asset) value of the bond portfolio per share; the red in the lower panel is the discount of price to net asset value (NAV). The discount was widest after Bernanke s comments. Junk bond exchange traded fund

8 Short term Outlook In the short term, liquidity, policy, economic fundamentals, and technical factors are supportive of lower rates. As can be seen on the previous chart, liquidity conditions quickly returned to normal (red went to green). Federal Reserve officials have tried to calm the market and reiterated that they will maintain an accommodative monetary policy. Despite an expectation of somewhat stronger economic growth later this year, robust sets of data indicate that domestic and global economic growth is tepid and more at risk of stalling than accelerating. Along with very low inflation, the economic fundamentals are supportive of low interest rates. Finally, bond markets moved to extreme oversold levels and are likely to recoup some of the losses. Rates are more likely to roll over than go higher in light of economic expectations

9 Inflation expectations are supportive of lower interest rates.

10 Oversold markets usually recover relatively quickly.

11 Long term Outlook While interest rates are low and have declined for 30 years, it is impossible to identify when, why, and how rates will move higher. However, as illustrated below, rates tend to move higher periodically in a cyclical pattern where investors and the economy move to extremes and then reverse, correcting the excesses. The aggressive bond buying that has characterized the last couple of years may have ended for this cycle, and, judging by the Federal Reserve committee voting, at least half of the members believe that the costs of the Fed s buying program may outweigh the benefits. We also note that past cycles frequently have a break before a more significant bear market develops. Such a break is a warning that risk levels are high. As we have seen with commodities, it can take time before there is a more general realization that an asset class is in a state of decline. The recognition that a more generalized decline is in place can be obscured by noisy assets; for example, in commodities where energy may be up and copper down. In bonds, where losses may be less painful, investor reactions may be delayed. In conclusion, bonds are over valued and offer unattractive prospective returns. With a potential change in policy and investor sentiment, a more defensive approach could be in order.

12 Tax exempt Bonds Are Attractive P A R A G O N State governments finances continue to improve.

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