Thought Leadership

High Grade Core Intermediate 2nd Quarter 2013

July 26, 2013

During the second quarter of 2013, we continued to build positions in undervalued, high quality sectors of the market. We took advantage of higher yields and wider credit spreads, and invested accordingly as dictated by our fundamental, risk managed approach. Though the Treasury sell-off during the period captured all of the headlines, ironically, intermediate treasuries performed better than most sectors on a relative basis. Our significant underweight to treasuries, a sector we have viewed as very overvalued, and our over allocation to what we view as undervalued spread sectors created some performance drag in the near term. As we will see in our discussion of the second quarter, we believe our repositioning will serve our portfolios well as the year progresses.

The second quarter was truly all about the Fed. The Federal Reserve has become a large market force not only through their purchase of Treasury and Agency mortgage-backed securities, but also through forward guidance. On May 22nd, Chairman Bernanke addressed Congress and explained: “If we see continued improvement, and we have confidence that that is going to be sustained, in the next few meetings we could take a step down in our pace of purchases.” And so the concept of “tapering”, a decline in the Fed’s monthly purchase program, entered the lexicon of both retail and institution bond investors. An unlikely catchphrase, “Fed Tapering,” quickly made the rounds of trading desks, parties, neighborhood picnics, and financial news shows.

The idea of tapering caught the market by surprise and accelerated investors’ timeline for when easy money would end. If there was ever any doubt that expectations for Fed policy drive major turns in the direction of rates, let alone bond market returns, the second quarter of 2013 certainly has put that doubt to rest with an exclamation point.

Since the beginning of quantitative easing (QE), bond market investors have been lulled into complacency. The financial crisis had severely rattled their nerves, and like a good doctor, the Federal Reserve dispensed a tranquilizer to the market– a prescription called quantitative easing– and the medicine worked. The patient swallowed the pill, easing fears of interest rate volatility, spread movement, and sharp changes in yield curve slope.

The vital signs of the bond market showed great improvement as measured by the bond market’s EKG, also known as the Merrill Lynch Move Index (MOVE). MOVE is the lesser known cousin of the equity market’s VIX Index. Just as VIX has become known as the fear index of the stock market, defining fear as a jump in the level of volatility implied by the options market, so too has MOVE become known as the fear index of the bond market. As the chart to the right shows, bond market volatility steadily fell from 2008, albeit with fits and start, until the second quarter of 2013. That is when the Federal Reserve, doctor to the bond market, hinted that its prescription might be changed, that quantitative easing and the Fed’s bond purchase program might be reduced– and that is when the spike in volatility began.

Various bond market indicators broke out of their well-defined trading ranges in reaction to both fears that the Fed would stop buying longer-maturity bonds and concerns that the economy would actually slump if the Fed began tightening. These fears unleashed waves of selling that roiled the markets. Suddenly, investment decisions that had been predicated on easy money seemed less secure. As a result, the yield curve steepened, corporate spreads widened, municipal bond funds saw huge outflows, and mortgage backed securities were hit by the possibility of less central bank sponsorship. These were all headwinds for our strategy.

As a value oriented manager, we relied on our longer term fundamental research and statistical valuation models to identify opportunities for clients during this period. While the market spent most of the quarter worrying about the end of QE, we focused on the fundamentals outlined in the FOMC minutes and Chairman Bernanke’s public statements. As we noted in our firm commentary in late June, we do not believe there will be a material tapering, tightening, or end of QE in any real fashion until the level of unemployment falls to the Fed’s target and the level of inflation rises to the Fed’s target.

As value oriented investors, we do not pick market tops and bottoms, but instead seek to build positions over the longer term. Our strategy was positioned for a steeper yield curve at the start of the year, and as the yield curve steepened to levels inconsistent with our outlook, we moved from a bullet structure to a key rate duration neutral posture. This chart below shows that we reduced our allocations to the 3-5 year part of the curve, and increased our exposure to the longer maturity buckets as the curve steepened. This change reflected our view that the curve had steepened too far. These purchases brought our strategy in line with the maturity structure of the benchmark.

With regard to sectors, we began the quarter with an overweight to undervalued municipals, and we added selectively to our holdings as the market cheapened further. Municipal bonds were under pressure due to a variety of factors. The greatest factor was the decision of retail mutual fund investors to redeem their holdings and reallocate to other sectors. Municipal mutual fund redemptions were significant, forcing funds to sell bonds at very cheap levels. We believe the high quality holdings we own are fundamentally undervalued and will likely enhance returns over the longer term. During the quarter, municipal bond exposure did not materially impact the overall performance of the strategy relative the benchmark.

Nonetheless, as valuations normalize to levels consistent with the high quality and preferential tax treatment of the municipal sector, we believe these holdings will add significant value. In the meantime, at the current ratios and yield relationships seen below, our municipal holdings are making a significant contribution to the superior yield our strategy generates relative to the benchmark. As an up-in-quality, value oriented manager, we will likely continue to add to those positions as we expect relationships to normalize.

While undervalued municipals modestly enhanced performance, this was not true of our other sector overweights. During the second quarter, we initiated a position in the Treasury Inflation Protected Securities market. We have long believed that the Fed’s experimental policy of QE, which has flooded the economy with liquidity, would lead to an increased level of inflation. Our confidence on this point has grown as we have seen a recovery in the housing sector and the broader economy. We believed that the TIPS market was slightly undervalued, given our expectations that inflation would rise over 2% in the years to come, and as a result we initiated positions during the quarter. Yet, at that same time, many investors concluded that if the Fed tightened policy, inflation would fall. As value oriented investors, we added to positions as inflation expectations fell and we continued to look through market fears to policy fundamentals. As outlined in our recent commentary, we avoid TIPS that are held by large buyers such as the Federal Reserve and mutual funds. As it is difficult to predict when the Fed will unwind its bond buying program, or when particular mutual funds will be forced to sell their holdings to meet redemptions, we will continue to avoid those TIPS largely owned by the Fed, and the mutual fund oligopoly. Nonetheless, our TIPS exposure detracted from performance this quarter as well.

We added to corporate exposure during the second quarter. With regard to our corporate exposures, it is important to note our view that the economy will continue to grow at a modest pace and avoid recession. Spread widening during the period was more related to talk about tapering than fundamentals, and we took the opportunity to add to high quality names at cheap levels. We remain focused on the most liquid issuers in our approved list to make sure we can transact in times of market dislocation. Historically, spread products have outperformed in rising rate environments. This concept is rooted in economic fundamentals– if interest rates are rising because of improving fundamentals, then we believe corporates (linked to the improving performance of the economy) should outperform Treasuries.

The conservatism in our approach to mortgage-backed securities also contributed to underperformance. We have written for some time about our longer-term concerns about FNMA and FHLMC securities. As we have noted in the past, until a clear pathway out of conservatorship for these agencies has been announced, we prefer to deemphasize these holdings in favor of full-faith and credit GNMA mortgages. The characteristics associated with more conservative GNMA securities, including the prepayment characteristics of the underlying mortgage holders, contributed to underperformance relative to FNMA and FHLMC securities. Despite this short term underperformance, the conservative rationale that has led us to overweight these securities remains in place and we will continue to emphasize them in our holdings.

Ironically, perhaps the greatest contributor to our underperformance was our significant underweight to US Treasuries. While the sector generated a negative return for the period too, it outperformed its peers. Treasuries, the transmission vehicle for the wave of volatility unleashed by changing expectations of the Fed’s policy, in the end proved to be the best performer. Our thesis for remaining underweight Treasuries is long term, as readers of our commentaries are familiar with, and we will maintain that posture for the foreseeable future.

Looking Forward

Some investors think this is the beginning of the end of the bull market in bonds and a sneak peek at how the largest monetary stimulus in history will end. We are fundamental investors looking at the long term. In our view, the ingredients for a bear market in bonds aren’t there: inflation is low, fiscal policy remains contractionary, and the consumer is still struggling with stagnant wages. More importantly, as the Fed has taken great pains to repeat, there is no preset course to reducing quantitative easing, and any action taken by the Fed will remain data-dependent. We will continue to emphasize fundamental data analysis and credit analysis in our portfolio construction, and allocate to undervalued sectors accordingly.

 

Jonathan Lewis

Managing Principal

Chief Investment Officer

 

Brian Meaney

Portfolio Manager

 

July 26, 2013

 

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.

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 of performance. 3 Year Standard Deviation data is not available because 36 months of returns does not exist for the time period indicated.

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 claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Samson has been independently verified for the period June 1, 2004 through December 31, 2008 by Ashland Partners & Company LLP and from January 1, 2009 through December 31, 2012 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 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.


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 cash 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.