Thought Leadership

High Grade Core Intermediate 2nd Quarter 2012

July 30, 2012

Fixed income performance in the second quarter was a study in conflicts.

  • Intermediate Treasuries rallied and produced a return for the quarter of 1.56%. A slowing economy, a volatile and falling stock market, combined with continued overseas concerns, drove quality bond prices higher and the yield curve flatter.
  • Yet, concerns about quality appeared to have no bearing on the performance of the corporate bond market. If worries about the financial health of the world made investors move their capital back into Treasuries, Corporate bond investors did not get the memo. The Intermediate Corporate Index produced a Treasury-like return of 1.58% for the period. In fact, lower quality corporates outperformed higher quality ones. High yield bonds did even better, generating a return of 1.85% for the period.

During this tug of war between risk on and risk off, we have stayed focused on a middle path driven by our intermediate to longer term value oriented methodologies and our high quality focus. As a result, and as the yearto date performance data shows, we modestly underperformed the Barclays Intermediate Aggregate for the period, but we continue to keep pace, on a gross of fee basis, with the index excluding the types of lower quality, or structured sectors we do not purchase (asset backed securities, CMBS, BBB rated corporates). There are several notable aspects of our portfolio structure that have helped us to maintain our performance, despite our bias toward higher quality and our underweight to Treasuries:

  • We anticipated in late 2011 and early 2012 that the economy was in better shape than many investors believed and we brought our exposure to investment grade corporates to its highest level in years. We maintained this overweight through the second quarter. Our decision to be overweight the best performing sector during the period was an important contributor to performance.
  • Just as our valuation methodology led us to be overweight corporates for some time, we have been reducing that exposure in recent weeks as we believe that valuations have moved from undervalued to overvalued for this stage of the economic cycle.

Yet, a shift in our thinking has occurred with regard to the role high quality corporates should play in balanced, conservatively managed portfolios, particularly in light of our concerns about the Treasury market. Our overweight to spread sectors (including corporates) has allowed us to maintain the yield and income of our portfolios at levels comparable to a lower quality benchmark. This overweight, however, was built with an emphasis on sectors with less volatility and better Sharpe ratios, as shown in the table to the right.

When attention is focused more closely on the volatility structure of the market, particularly the differing spread volatility of corporates and sovereigns in general, we believe you can see a major transition in how risk is priced and what the markets consider safe and less safe. Just as we have previously written about the evolution of new currency safe havens, we believe new safe havens are appearing in high quality fixed income markets. Using our definition of a safe haven – a sector that is comparatively stable, high quality, and offers liquidity – corporate bonds, particularly industrials, continue to rise on our scale of safety. The chart to the right, comparing the risk characteristics of industrials and financials (a chart reader of prior commentaries will recognize) underscores this point.

Looking deeper into this issue, we offer the charts below, which show the standard deviation of spread volatility for corporates, industrials, and financials as well as U.S. dollar denominated sovereigns. Importantly, the corporate spread standard deviation has dropped, while the standard deviation of spreads for sovereigns has not only risen over the years, but risen above corporates. This trend becomes particularly evident when the 5-year, 3-year, and 1-year trailing averages for spread volatility of these sectors are compared. The 5-year trailing average for investment grade corporate spread volatility was 135% of that of investment grade sovereigns, while for the 1 year trailing average this relationship dropped to 94%. The decline is apparent in both financials and industrials.

It must be acknowledged that these data-driven observations about spreads rest on an important fundamental proposition: corporate strength has improved in recent years, sovereign strength has weakened. While sovereigns have experienced more downgrades than upgrades in recent quarters, the ratio of upgrades to downgrades in corporates has been trending upward.

Samson’s approach to corporates has always rested on certain values: a preference for transparent, analyzable balance sheets and income statements, stability of earnings, and large liquid issuers that are dominant market share leaders with strong brands – in short, strong companies. Our research efforts are focusing on additional barometers of corporate strength to inform our investment process. For example, what else makes a company strong? The treatment of its employees, the quality of its products, and its concern for best business practices and shareholder rights, are all factors we are considering. We look forward to reporting back in our next commentary on our research in these areas.

With regard to our other sector decisions –

  • Though mortgages underperformed Treasuries for the period (as one would expect when Treasury yields fall sharply), our allocation to the sector modestly outperformed the benchmark due to our conservative approach, particularly our emphasis on GNMAs in building positions over the past year. GNMAs outperformed FNMA and FHLMC bonds for the quarter and this contributed to our stable performance profile both for the last 3 months and year-to-date. Mortgages have cheapened on a relative value basis considerably in recent weeks as they underperformed Treasuries and we have not only added to our positions, but are likely to continue to expand this sector at the expense of those corporate holdings in our portfolios that are becoming overvalued. Whenever we can transition from an overvalued security to an undervalued one while simultaneously going up in quality, liquidity, and yield, we find this an opportunity worth taking.
  • Our allocation to high quality municipals also generated healthy positive returns, though they underperformed Treasuries. We will likely be increasing our exposure to this sector in the weeks ahead, both because our valuation measures highlight an attractive opportunity, and as a matter of defense. Though we believe the economy has decelerated, we do not believe we are slumping into a recession. As a result, our expected return analysis suggests the treasury curve is overvalued and municipals are likely to hold their value better on a total return basis in rising rate scenarios. While there are concerns about municipal credit quality, all issues we purchase must be approved by our own credit team using a fundamental approach to credit analysis that emphasizes capital preservation.
  • Though we were underweight Treasuries for the quarter, we view high quality multilateral institutions (like the World Bank), Canadian Provincials (like the Province of Ontario), and other high quality supranational issues as Treasury substitutes, and these allocations performed their role well while offering what we believe to be favorable yield and liquidity characteristics.

Looking forward, we share many investors’ concerns about the economy however we do not feel it is prudent to extend duration and add interest rate risk at this time. Though we want to maintain a fully invested posture to reduce reinvestment risk and we prefer undervalued sectors to overvalued ones, we do not believe duration is an appropriate tool to add value for conservative investors at current interest rate levels. While many investors have extended duration and been rewarded with a flattening yield curve, our view is that the forces driving the long-end of the yield curve are a combination of politics and desperation, a potent potion that is one part Operation Twist, one part Eurozone Crisis, and one part investor quest for yield. Predicting the behavior of policy makers and politicians (whether they reside in Treasury, the Fed, and Congress or outside the U.S.) is a tough proposition at best. While it is true the Eurozone crisis will not be resolved any time soon, reflationary central bank policies around the world continue to raise the risks for currency debasement and inflation. Though inflation fears are not showing up in the implied rates forecast by the U.S. Treasury Inflation Protected Securities (TIPS) markets, commodity prices (despite their volatility) tell a different story as investors seek real wealth preservation through gold.

So, where does that leave us? We question the prudence of purchasing volatile long maturity bonds to get an extra percent or so of yield over intermediate bonds, or a couple percent over money markets. For example, the return on a 30 year maturity US Treasury could be -15% or more in half a year if rates go up just 100 basis points. The risk/return outlook for a 10 year Treasury is better, but in the same way that getting in a one-car accident is better than a two-car accident. If rates rise 100 basis points over the next six months, the total return on that instrument is in the -7% range.

Our response to this phenomenon is, as you might expect, value oriented and driven by our conservative bias. As the curve has flattened, we have moved increasingly towards a bulleted yield curve posture, and there we will wait for a steeper curve to reward us with a risk premium more appropriate for these times. Our goal, as always, will be to generate returns consistent with high quality fixed income markets, but with an emphasis on risk management, and preservation of capital.

 

Jonathan Lewis

Managing Principal

Chief Investment Officer

 

July 30, 2012

 

No representation or assurance is made that Samson High Grade Core Intermediate Strategy will or is likely to achieve its objectives, or will make a profit or will not sustain losses. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Samson does not provide tax, accounting or regulatory advice. ANY TAX STATEMENT CONTAINED HEREIN IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY PERSON, FOR THE PURPOSE OF AVOIDING TAX PENALTIES.

Past performance is not indicative of future results. Performance reflects the reinvestment of income and other earnings. Any benchmarks or indices shown are for illustrative purposes only, are unmanaged, assume reinvestment of income, and have limitations when used for comparison or other purposes because they may have volatility, credit or other material characteristics (such as number and types of securities) that are different from (HGCI). Certain information is based on third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed. This information is confidential, is intended only for intended recipients and their authorized agents and may not be distributed to any other person without our prior written consent.

 

High Grade Core Intermediate Composite

Schedule of Investment Performance for the Period 12/31/04–12/31/11

Primary Benchmark: Barclays Capital Intermediate Aggregate

 N.A. – Information is not statistically meaningful due to an insufficient number of portfolios in the composite for the entire year or lack of a full year or full three years of performance.

1) Definition of Firm: Samson Capital Advisors LLC (the “Firm”), founded in June 2004, is an SEC registered investment adviser as of May 2004. Samson provides investment management services.

2) Compliance Statement: Samson Capital Advisors claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Samson Capital Advisors has been verified for the periods June 1, 2004 through December 31, 2008 by Ashland Partners & Company LLP and from January 1, 2009 through December 31, 2011 by The Spaulding Group.Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation. The High Grade Core Intermediate Composite has been examined for the periods December 31, 2004 through December 31, 2008. The verification and performance examination reports are available upon request.

3) Policies: Additional information regarding the Firm’s policies and procedures for calculating performance, valuing portfolios, and preparing compliant presentations is available upon request.

4) Composite Description: The High Grade Core Intermediate Composite was created September 30, 2005. The Composite consists of all fully discretionary, fee paying separately managed accounts in the High Grade Core Intermediate style. The High Grade Core Intermediate strategy is a relative return focused mandate appropriate for investors with an indefinite investment horizon, seeking to maximize return with a lower degree of principal volatility than typical aggregate market strategies. The minimum account size for this composite is $2.5 million.

5) Benchmark: For comparison purposes, the composite is measured against the Barclays Capital Intermediate Aggregate Index.The Barclays Capital U.S. Intermediate Aggregate Index is an unmanaged index that represents the U.S. domestic investment-grade bond market. It is comprised of the Barclays Capital Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, including securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million. Please note that indices do not take into account any fees and expenses of investing in the individual securities that they track and that individuals cannot invest directly in any index. Data about the performance of these indices are prepared or obtained by NBM and include reinvestment of all dividends and capital gain distributions.

6) Reporting Currency: Composite returns are expressed in U.S. dollars.

7) Fees: Gross-of-fees returns are presented before management fees, but net of all trading expenses, and withholding taxes. Actual returns will be reduced by investment advisory fees and other expenses that may be incurred in the management of the account. The collection of fees produces a compounding effect on the total rate of return net of management fees. As an example, the effect of investment management fees on the total value of a client’s portfolio assuming (a) quarterly fee assessment, (b) $1,000,000 investment, (c) portfolio return of 8% a year, and (d) 1.00% annual investment advisory fee would be $10,416 in the first year, and cumulative effects of $59,816 over five years and $143,430 over ten years. Additional information regarding the policies for calculating and reporting returns is available upon request. The management fee schedule is as follows: 0.40% on the first $10 million, 0.30% on the next $10 million, and 0.25% thereafter. Actual investment advisory fees incurred by clients may vary. Net-of-fee performance is show net of model management fees (the highest charged to an account in the composite), all trading expenses, custodial fees, and withholding taxes.

8) Significant Flows: The composite policy requires the temporary removal of any portfolio incurring a client initiated significant cash inflow or outflow of at least 15% of portfolio assets. The temporary removal of such an account occurs at the beginning of the month in which the significant cash flow occurs and the account re-enters the composite at the beginning of the month, after full investment.

9) Internal Dispersion: The measure of dispersion used in this presentation is the asset-weighted standard deviation of annual gross-of-fees returns of those portfolios that were included in the composite for the entire year. This calculation measures the fluctuation of the rates of return of portfolios with the Composite in relation to the average return. Dispersion is not shown for composites with 5 or fewer portfolios for a full year.

10) List of the Firm’s Composites: In addition to the Composite, the Firm provides investment management services utilizing different strategies. A complete list of composite descriptions is available upon request.

11) Additional Disclosures: As of 7/1/09 portfolios are revalued for cash flows of 10% or more. Prior to 7/1/09 portfolios were not revalued for large flows.Benchmarks are shown for illustrative purposes only, may not be available for direct investment, are unmanaged, assume reinvestment of income, and have limitations when used for comparison or other purposes because they may have volatility, credit, or other material characteristics (such as number and types of securities) that are different from the Strategy. Information is as of the date hereof unless otherwise indicated. Certain information is based on data provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed. This information is confidential, is intended only for intended recipients and their authorized agents and may not be distributed to any other person without the Manager’s prior written consent. Notwithstanding and foregoing, the recipient and their authorized agents may disclose to any and all persons, without limitation of any kind, the structure and tax aspects of the transactions described herein and all materials of any kind that are provided by Samson to the recipient related to such structure and tax aspects.Beginning January 1, 2008, the composite definition was expanded to include accounts with mandates that allow for investment in securities which do not fall within the High Grade Core Intermediate style. For example, the mandate may allow for allocations to alternative sectors or an extension in duration outside the acceptable boundaries of the High Grade Core Intermediate style. At their time of inclusion, these portfolios had no allocation to these securities. Should these portfolios become invested in these securities, they will be removed from the composite.