Bond Market Insights October 10, 2014

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1 Bond Market Insights October 10, 2014 by John Simms, CFA and Jerry Wiesner, CFA General Bond Market Treasury yields rose in September as prices fell. Yields in the belly of the curve (5- to 7-year maturities) rose the most, about 0.15%. During the third quarter, the Treasury yield curve flattened; 3-year yields rose 0.17% and 5-year yields rose 0.13%, while 10-year yields fell 0.04%. As interest income offset price declines, most investment grade bond indices showed slightly negative to slightly positive returns for the quarter. At the September meeting of the Federal Open Market Committee (FOMC), the quantitative easing program was tapered by another $10 billion to $15 billion ($10 billion Treasuries and $5 billion MBS) in monthly bond purchases. The FOMC expects to conclude its asset purchases in October with a $15 billion reduction. FOMC forecasts show most participants expecting to begin rate tightening in 2015, with a Fed Funds rate projection of 1.375% at year-end 2015, and rising to 3.75% by year-end The long-run neutral Fed Funds rate projection was lowered slightly to 3.75%. Economic growth was generally moderate in the third quarter. The latest jobs data released in early October showed monthly average job creation in 2014 of 227,000. The jobless rate fell to 5.9%, the lowest since July 2008; however, the labor force participation rate fell to a threedecade low of 62.7%. Inflation continued to trend below the Fed s 2% target, with August s year-over-year CPI at 1.7%. The Fed s preferred inflationary measure, core PCE, has averaged 1.5% over the last year. Economic growth slowed in Europe and Japan during the third quarter; additionally, inflation slowed further to near zero in Europe, leading to some concern of deflation. The monetary policy of both the European Central Bank and the Bank of Japan continued to be highly accommodative, with further easing likely. The FOMC will likely continue to reinvest maturities and pay downs once tapering is complete, thus keeping their balance sheet size constant.

2 The beginning of the Fed s tightening process will be data-dependent. Fed projections suggest there are two camps in the FOMC; the hawks expect to raise rates more rapidly, while the doves expect to raise rates in a gradual and measured pace. Currently, the doves likely dominate the FOMC. The Fed will now publish the Labor Markets Condition Index that includes 19 labor market indicators on a monthly basis. The FOMC will use this broader measure to evaluate labor market conditions, as opposed to relying primarily on the unemployment rate. While the employment picture has improved, there still appears to be considerable employment slack, with low labor force participation. Wage growth has been subdued primarily due to the increase in employment in lower-paying jobs; we expect gradual upward wage pressure over time. SeaCap expects the Fed to wait for further employment improvement, and to be patient before they begin to raise rates. Many on the FOMC would prefer to be slow to react, rather than raise rates prematurely. Bond investors are not pricing in for yields to rise soon or rapidly. The 2-year Treasury yield is currently 0.50%, below the recent peak of 0.58%. U.S. 2-year Treasury yields are attractive compared to 2-year Government yields in Japan and Europe, with several countries showing negative yields. Recent U.S. dollar strength has also benefitted foreign investors holding U.S. assets. Municipal Bond Market September reflected flat returns for the municipal market, as price weakness related to higher yields was mostly offset by coupon income. The Barclay s Intermediate Muni 1-10 year Blend (1-12) returned -0.06% for the month and 0.84% for the third quarter, a more sustainable pace of return at current market yields. Municipal yields rose across all maturities, but the rise was most pronounced around 5 to 10 years. The AAA MMD 10-year yield rose from 2.07% to 2.17%, the largest monthly increase in yields this year. Of note was the resilience of the municipal market relative to comparable taxable bond indices. Continuing lackluster issuance and strong demand are providing support to market values. Yearto-date supply is off 12% from the prior year, reflecting a relatively large percentage of refunding issues, which simply replace existing issues (39% in Sept.). Net new issuance is still expected to be negative for the year, the fourth year running, which will leave investors with a shrinking universe of bonds. Strong demand was once again reflected in mutual fund flows, with net inflows of $1.6 billion during the month.

3 Municipal credit spreads contracted modestly during the month as investors moved down in quality to increase yields. Credit concerns during the month were mostly related to distressed issuers like Detroit, but ratings downgrades for New Jersey and Pennsylvania served as reminders that the persistent and unresolved challenges of pension liabilities are still burdening many municipalities and states. Low yields and expensive ratios of municipal-to-taxable yields limit the likelihood of material price gains from current levels. Our strategy is focusing on issuer-specific opportunities and on callable security structures to enhance income without forfeiting some protection from higher rates. Portfolios reflect modestly defensive maturity structures with targeted durations at 3.5 to 4.5 years. We continue to utilize premium coupon, callable securities within portfolios for further yield enhancement. Positive fund flows year-to-date could reverse as rates rise. This reversal could lead to the higher yields we would seek to capture in portfolios. This could be accomplished through the sale of short maturity bonds to fund purchases of intermediate maturity bonds. We expect the trend of higher yields will likely be gradual, and perhaps muted, as bond investors continue to reflect bearish market attitudes and defensive portfolio positioning, thus limiting motivated selling as rates rise. At this time, municipal investors are more likely to be surprised by lower rates than they are by a long anticipated rise in market yields. Although investors in low investment grade debt have been rewarded in 2014, credit spreads are narrow and the value in lower investment grade securities is less compelling. We continue to target portfolio average quality at AA and require single A issuer credit quality at a minimum. This quality bias seems to be catching on in more media and marketing pieces, perhaps due to narrow credit spreads and the recent experience of bond investors in Puerto Rico, Detroit, and other stressed issuers. Taxable Bond Market The Treasury yield curve continued to flatten in the third quarter, and flattened significantly year-to-date. The pivot point this year has been the 5-year maturity, where the yield remains relatively unchanged; in contrast, the 3-year yield rose 0.27% and the 30-year yield fell 0.77% year-to-date. The Fed Funds rate remains near zero, which helps to anchor yields less than one year.

4 Support for the Treasury bond market has come from a number of sources: foreign investors seeking attractive U.S. Treasury yields compared to bond yields in Europe and Japan; continued Fed bond buying (especially of longer term bonds); commercial bank buying due to regulatory need for high quality liquid assets, coupled with strong deposit growth and slow loan growth; and pension demand for longer term bonds. Highly rated corporate issuers sold about $913 billion year-to-date through September 30 th, up over $50 billion from the same period last year according to Dealogic. Many corporate treasurers have taken advantage of this year s low yields and strong investor demand to increase and extend their debt. Mutual fund inflows diverged between investment grade bond mutual funds that continued to receive inflows and high yield bond mutual funds, which experienced heavy outflows during late July. Some investors, including a few Fed officials, cautioned that high yield bonds had rallied too sharply and were unattractive at such low yields. SeaCap does not invest in high yield bonds, but we follow the spread relationships compared to investment grade corporates to help determine value and to watch for potential early warning signs of market changes. Credit spreads widened in September and for the quarter, which resulted in underperformance versus Treasuries. Quarterly performance for corporate sectors was -0.16%, 0.13%, and -0.14% for intermediate industrials, utilities, and financials respectively compared to 0.02% for intermediate Treasury returns according to Barclays index data. SeaCap is positioning intermediate taxable portfolio durations (effective maturity) defensively at the low end of our 3.5- to 4-year target range. Some portfolios drifted shorter than 3.5 years, but we extended many of these portfolios back to the target range during September. We maintain the long-term view that interest rates should rise as the economy continues to slowly improve, inflation gradually moves higher and the Fed finishes tapering. However, yield levels may not rise as much as expected, given the many bond investors positioned defensively at present. Given this outlook, we will seek to extend portfolios to at least the midpoint of our target range on any significant rise in yields. SeaCap s yield curve strategy currently emphasizes the 3- to 5-year sector, which is a relatively steep section of the Treasury yield curve. The 7- to 8- year sector also provides good value; as such, we selectively participated in some 7-year new issue corporate deals and purchased 8-year Treasury bonds. SeaCap continues to significantly overweight the corporate sector. Although corporate spreads widened a bit last quarter, we did not increase our overweight position and generally do not plan to add to the corporate sector. Holdings emphasize the industrial corporate sector in the A and high-bbb rating categories.

5 Key Bond Market Indices Sep-14 YTD Index Total return Total Return Barclays U.S. Aggregate Barclays U.S. Gov/Credit Barclays U.S. Intermediate Gov/Credit Merrill 1-10 Yr Corp/Gov ( A or better Corporate) Merrill 1-5 Yr Corp/Gov Merrill 1-3 Yr Corp Gov Barclays Intermediate U.S. Treasuries Barclays Intermediate Agency Barclays Intermediate A Rated Corporate Barclays Intermediate BAA Rated Corporate Barclays Mortgage Barclays TIPS 1-10 Year Barclays 1-10 Year Municipal Barclays Municipal Bond For more information, contact SeaCap at or

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