Fixed Income Market Commentary

First Principles Capital Management August 2012 Liquid rates markets Fixed Income Market Commentary Continued optimism around ECB President Mario Draghi s pledge to do whatever it takes to save the euro fueled a sell-off in the rates market at the beginning of August. The sell-off reversed course mid-month, however, when the FOMC s minutes indicated the Fed was willing and ready to commit to additional easing measures if the pace of economic recovery does not accelerate. The rally continued into the Jackson Hole meeting where Bernanke defended the Fed s easing actions to-date. For the month, Treasury yields were up 6 basis points on average, LIBOR swap rates increased 5 basis points, and TIPS real yields fell 5 basis points. MTD change (bps) 1 1 8 13 How much can inflation help with write down of U.S. public debt? Inflation, in theory, is supposed to be beneficial to countries with high debt. The theory being that these countries have benefitted in the past by borrowing at yields lower than where they can borrow today, and the longer the maturity of their past borrowings, the better. Given that U.S. public debt has increased precipitously since the onset of the great recession, the hope is that if the Fed s efforts to drive up inflation are successful, public debt would be a beneficiary. U.S. public debt can be separated into two components: 0.2 Treasury Yields 8/31/2012 0.59% 1.55% 2.67% 2Y 5y 10Y 30Y Debt held by the public, or marketable debt, including Treasury securities held by investors outside the federal government, as well as that held by individuals, corporations, the Federal Reserve System, and foreign, state and local governments. - - Debt held by government accounts or intragovernmental debt including non-marketable Treasury securities held in accounts administered by the Federal Government that are owed to program beneficiaries, such as the Social Security Trust Fund. 1.4-1.18% TIPS/Breakeven Yields 8/31/2012 1.99% -1.4 2.26% 2.29% -0.7 Yields 0.39% MTD Real Yields change (bps) -17-13 1 9 Let s take a look at the approximate debt breakdown by ownership as of August month-end: public ($11.3 trillion), intragovernmental holdings ($4.8 trillion) and total public debt outstanding ($16.0 trillion or around 10 of GDP). Since intragovernmental debt appears as both an asset and liability on the federal government s balance sheet, they effectively negate each other, so we we ll exclude this non-marketable debt from this discussion. According to the Department of Treasury web site, as of May 2012, the weighted average maturity of marketable U.S. Treasury securities outstanding was 63.9 months; an increase from 48.5 months in October 2008. Now, consider par securities with 63.9 months to maturity. If interest rates increase by 100 basis points from current rate of 0.8% to 1.8%, then the present value of savings for the issuer is roughly 5.. So, for $11.3 trillion of marketable public debt, an increase in interest rate of 100 basis points theoretically would save the government $576 billion ($11.3 trillion X 5.). BE Page 1

The Fed, however, has been actively buying Treasury securities, agency debt and MBS in its quantitative easing programs. Since the end of 2007, the Fed has purchased an additional $1.8 trillion of these securities, bringing total holdings to $2.6 trillion. To fund these additional purchases, the Fed issues currency or pays over-night interest on excess reserves to the banks. The currency in circulation has increased by around $0.3 trillion to $1.1 trillion since the end of 2007. Unless the Fed plans to bring this currency amount down to 2007 levels, for all practical purposes, $0.3 trillion of federal debt has been monetized. Currency, of course, is the cheapest form of funding for the Fed as it has no expiration date and carries no interest. However, printing money to buy securities can be done only on a limited scale before the capital markets confidence in the currency is eroded. The $0.3 trillion funded through currency issuance aside, the other $1.5 trillion of additional securities purchased by the Fed since 2007 has been funded through excess reserves with the banks. On these excess reserves, the Fed pays the banks an overnight rate of 0.25% or the targeted fed funds rate. Looking at the balance sheet of the Treasury and Fed as a whole, since 2007, $0.3 trillion of debt issued by the Treasury has been paid by issuing currency, and $1.5 trillion of debt issued by the Treasury has been converted into over-night debt in the form of excess reserves. For the purpose of discussion, disregard the currency and assume the average maturity of the Fed s purchases is equivalent to the average maturity of the Treasury s liabilities. Now, if we replace $1.5 trillion of marketable public Treasury securities with over-night bonds, the weighted average maturity of all marketable debt would be reduced from 63.9 months to 55.4 months. Applying a calculation similar to that above, a 100 basis points rise in interest rate will now save the government only $497 billion in present value term, a decrease in savings of $79 billion. By extension, If the Fed continues to expand its securities purchase program, the less the savings for the Federal Government when interest rates rise. Liquid rates markets outlook On September 13, the FOMC announced that it would expand the MBS purchase program by $40 billion a month with no expiration date. Immediately following the announcement, Treasuries significantly underperformed LIBOR swaps and agency MBS since Treasuries were not included in the latest QE program. The unlimited MBS purchase program didn t seem to satisfy the market. Some investors were disappointed that the additional monthly purchase is only $40 billion, while others in the marketplace are already advocating for additional easing by buying unlimited amounts of Treasuries. If the chorus is loud enough, the trigger-happy Fed will willingly oblige. Once Treasuries are included in the all-you-can-eat buffet, however, what else can be brought to the table to satiate the market s appetite? Securitized markets YTW Modified Duration Spread Duration Auto ABS 0.77% 1.95 1.95 Credit Card ABS 1.0 4.13 4.13 AGY Fixed Rate MBS 2.2 2.94 3.92 AGY Hybrid Arm 0.47% 0.61 2.16 CMBS 2.29% 3.19 3.19 Source: Barclays Capital Agency MBS moved roughly in line with the Treasury and LIBOR swap market in August. When the Fed announced its QE3 program on September 13, however, agency MBS took off, leaving other liquid nominal rates markets in the dust. From the beginning of August to the September 14 close, Treasury yields were up by 28 basis points on average, LIBOR swap rates increased by 22 basis, and FNMA 30-year, fixed-rate, current coupon mortgage rate dropped 2 basis points; that s a significant outperformance of 30 and 24 basis points versus Treasury yields and LIBOR swap rates, respectively. How much is a leveraged agency MBS portfolio expected to earn? How much can an investor in a leveraged MBS portfolio reasonably expect to earn from that portfolio, especially after QE3? This question is particularly important to banks, as it concerns their net interest and to REITs, as they recently raised fresh equity to put to work in the current agency MBS market. The answer will depend on two factors: 1) the method of hedging, if at all, and 2) the amount of leverage (assuming funding cost is 3-month LIBOR ( 3ML ) which is around 0.4). We ll look at the generic FNMA 3. coupon as the agency MBS of choice since that should be the most highly produced coupon in the near term. The average life and yield expectation on FNMA 3.0s vary greatly from dealer to dealer, and the long-term constant prepayment rate ( CPR ) assumptions by dealer models are around 18 CPR. For FNMA 3.0s, 18 CPR implies an average life of 4.5 years, with a yield of Page 2

1.77% (using dollar price of $105). The LIBOR option-adjustedspread ( LOAS ) for FNMA 3.0s, using these assumptions, is roughly -20 basis points. If a portfolio owns FNMA 3.0s unhedged and leveraged about 7 times (buy 1 unit of FNMA 3.0s using equity outright and buy 6 units of FNCL 3.0s funded at 3ML), the expected return on equity, using the above assumptions, would be 1.77% + (1.77% - 0.4) * 6 = 10.. Suppose the portfolio owns FNMA 3.0s hedged in duration to average life with interest rate swaps only (i.e., no convexity hedge) and leveraged about 10 times. The fixed rate on an interest rate swap with 4.5 years average life is around 0.7. The floating rate on an interest rate swap is just 3ML, which again, is 0.4. The expected return on equity for this portfolio is now 1.77% + (1.77% - 0.4) * 9 (0.7-0.4) * 10 = 11.. Now, suppose the portfolio owns FNMA 3.0s hedged both for duration and convexity, and again, is leveraged 10 times. When the duration and convexity of a position are hedged using LIBOR interest rate swaps and swaptions, what are we left with? Just the LOAS, which is -20 basis points (-0.2) in this case, if the funding rate equals 3ML, which is our assumption. With both 10 times leverage and equity, which saves one unit of financing (0.4), the expected return on equity is -0.2 * 10 + 0.4 = -1.6%. Following is a summary of results so far: Hedging method Leverage Expected return on equity Unhedged 7 10. Duration hedged to average life 10 11. Duration & convexity hedged 10-1.6% These expected returns on equity figures do not include management fees, and some REITs charge fees based on amount of assets. This means the higher the leverage, the higher the management fees for investors. The full duration and convexity hedged portfolio is a non-starter given its negative expected return on equity. Of the other two portfolios, the unhedged portfolio carries the larger duration risk per unit of bonds. Even though this portfolio has fewer units of bonds due to its lower leverage, the total duration risk, which is duration risk per unit of bonds times the amount of leverage it employs, is still higher than the duration hedged to average life portfolio. The advantage of the lower leverage of the unhedged portfolio is its reduced exposure to sudden increases in funding cost relative to 3ML. While the portfolio with duration hedged to average life provides some protection against higher interest rates, its higher leverage means if funding cost rises significantly relative to 3ML, it will be more negatively impacted than lower-leveraged portfolios. Even though this portfolio is duration hedged, if interest rates move sharply one way or the other, the expected return will still decrease since it is not convexity hedged. The eventual return of each portfolio will depend on both the realized prepayment experience and the particular interest rate path. Before investing in a portfolio, however, an investor should have some expectation of the return on equity and associated risks depending on the hedging strategy and the amount of leverage, as discussed in the examples above. Securitized markets outlook QE3 is the ultimate shock and awe in the agency MBS market. With the Fed taking out 5 to 6 of the gross supply of fixedrate agency MBS every month for the foreseeable future, technical strength in MBS is undeniable and makes it difficult to be short. However, it is also hard to imagine the impetus driving another round of significant MBS tightening. While we anticipate these fundamental and technical tectonic forces of MBS to grind against each other in the medium term, and to drive MBS volatility to virtually zero, eventually something has to give. Technicals might be the initial winner, but sooner or later fundamental forces will overcome, and the ensuing earthquake will be felt far and wide. Municipal bonds 4% 0.3 AAA GO Muni Yields 8/31/2012 0.77% 1.96% 3.35% MTD change (bps) 1 4 12 8 Page 3

In August 2012, the municipal bond market fairly closely tracked the decline and rise of other nominal liquid rates markets. For the month, Bloomberg AAA G.O. yields increased 6 basis points on average. In comparison, for the month, Treasury yields went up by 6 basis points and LIBOR swap rates rose 5 basis points. Municipal credit default swaps ( MCDS ) stabilize after standardization On April 3 of this year, the International Swaps and Derivatives Association, Inc. ( ISDA ) called in to effect the 2012 US Municipal Reference Entity Credit Default Swap ( CDS ) Protocol. The Protocol s purpose was to implement changes to the Municipal CDS ( MCDS ) transactions similar to those made to corporate and sovereign CDS by the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol ( Big Bang Protocol). The Protocol aligned the MCDS market with the corporate and sovereign CDS markets and incorporated the following changes: Added the concept of auction settlement as a method that eliminates the need for physical settlement of MCDS transactions. Incorporated the resolutions of the ISDA Credit Derivatives Determinations Committee for the Americas ( DC ) into the terms of the standard MCDS contracts. Added the credit event and succession event look back provisions (or backstop dates), which institute a common standard effective date for MCDS transactions. In concert with ISDA, the derivatives industry agreed to standardize trading conventions for MCDS similar to those for corporate CDS according to the Standard North American Corporate ( SNAC ) CDS Contract Specification. Specifically, following are some of the new standardized contract terms for MCDS: Scheduled termination date will always match one of the four quarterly roll dates (March 20, June 20, September 20 or December 20) Fixed coupons of (100 basis points) for investment grade entities and 5% (500 basis points) for high yield entities Regardless of the effective date, accruals will begin on the roll date immediately preceding the effective date. All settlements will be full coupons and the initial payment will take into account any accruals occurring prior to the trade date Recovery assumption will be 75% Rolling look-backs of 60-days for credit events and 90-days for succession events Automatic trigger for restructuring credit events Prior to SNAC standardization, the MCDS market traded mostly on par CDS basis. For example, prior to standardization, if 10- year California par CDS was quoted at 215 basis points, then a California protection buyer would pay 215 basis points per annum to a protection seller until a credit event (payment includes accrued interest until the occurrence of event). Upon the credit event, the protection buyer would receive for each dollar MCDS notional, an amount of $1 minus the entity recovery rate, which was assumed to be 8. After SNAC standardization, new MCDS contracts now come with a fixed coupon of for investment grade entities and a recovery assumption of 75%. Suppose everything else remained unchanged. How did this change the quoted spread poststandardization from a pre-standardization par CDS spread of 215 basis points for California? For now, let s put the coupon aside. Let s also assume the MCDS curve was flat, and we are looking at a 1-year MCDS with a pre-standardization spread of 215 basis points (assume annual 30/360 coupon). Suppose the default, if there is one, happens at the end of the year and the discounting interest rate is. We then get the following equation: 215 basis points = (1 old recovery rate) * probability of default (pre-standardization) Since we assumed the recovery rate was 8 prestandardization, this implies the probability of default was 2.15% (equals 215 basis points) (1 recovery rate) = 2.15% (1 8) = 10.75%. Post-standardization, the new MCDS spread becomes New CDS spread = (1 new recovery rate) * probability of default (post-standardization) By plugging in the new recovery rate of 75% with 10.75% default probability, the new CDS spread is 269 basis points. So, the spread is wider with the lower recovery assumption poststandardization. The coupon on the new contracts would affect the upfront premium amount, and should not significantly impact the quoted spread. The example above is intended for qualitative discussion only, as we made a lot of simplifying assumptions. In reality, the term structure of CDS spreads as well as non-trivial discounting factors will come into play and impact the results. Poststandardization, 10-year MCDS for California widened to around 240 basis points from pre-standardization s 215 basis points, and has remained roughly there ever since. Page 4

Major positive muni rating actions in August 2012 Anchorage (Alaska) G.O. was upgraded to AA+ from AA by S&P due to the city s strong and improving financial position and policies. Major negative muni rating actions in August 2012 State of Illinois G.O. was downgraded to A from A+ by S&P. Outlook is negative. The downgrade reflects the state's weak pension funding levels, lack of action on reform measures, and continued financial weakness. Fresno (CA) issuer rating was downgraded to BBB from A by S&P due to persistent general fund imbalance despite workforce reductions and modest revenue improvement starting in fiscal 2011. Municipal bond market outlook Now that summer is officially over, the municipal supply calendar should start to build again. The market is slowly pricing in a concession; however, with the MBS market mostly taken out by the Fed, cross-over investors will be interested in buying municipal bonds where yields are still over 10 of Treasuries. Therefore, for the remainder of the year, on any supply-induced cheapening of munis, we believe it makes sense to add them to investors portfolios. Total returns for fixed income sectors YTD 1 8% 7.9% 6% 4% 3.6% 2.7% 2.8% 2.4% Muni (AAA) Agency Securitized Treasury Corporate Source: Barclays Capital David Ho, Managing Director dho@fpcmllc.com Rongfeng Becky Li, Vice-President, CFA bli@fpcmllc.com 2012 First Principles Capital Management, LLC 140 Broadway 21st Floor New York, NY Page 10005 5 Tel 212-380-2280 Fax 212-380-2290 www.fpcmllc.com