High Grade Core Intermediate 4th Quarter 2012
We believe the Samson High Grade Core Intermediate strategy held its own during the “risk on” rally in 2012. Our strategy returned 2.96% gross of fees and expenses and 2.60% net, in line with the benchmark excluding the types of assets we avoid like BBB corporates, asset backed bonds, and commercial mortgages. The benchmark’s holdings in lower-rated corporate bonds and securitized issues were the best performing asset classes this year. This market backdrop created headwinds for value-oriented investors, but we believe that we found ways to navigate without sacrificing our risk-managed discipline.
Federal Reserve Chairman Ben Bernanke has been clear that he wants to keep interest rates low and financial conditions accommodative, all in the interest of helping the wheels of commerce turn faster. While he does not explicitly say that he wants investors to move out of cash in order to take greater risks, we believe this to be Bernanke’s intent—in essence, Central Bank CPR intended to get the economy completely off life support and back to a full, healthy recovery. The powerful combination of a zero-rate Fed Funds policy and quantitative easing have indeed motivated yield-starved savers into unexpected places during this period of continued economic uncertainty.
The reach for yield presents unique challenges and opportunities for value investors. It is rare when quality bond investors can enjoy a higher yield than a riskier benchmark, but our sector rotation away from Treasuries towards cheaply valued tax-exempt municipals has helped us achieve this result. As seen in the portfolio’s sector breakdown relative to the index, our yield advantage comes from sector rotation, not from buying longer maturities or overweighting lower-quality, high volatility sectors. We’ve found value away from segments experiencing historically rich valuations like Treasuries, and instead, we have maintained overweights in attractively valued municipals and high quality mortgage backed securities (MBS). Treasuries comprise 36% of the index, but we have never bought a sector simply because it is in the index.
Tighter corporate spreads are in part the result of investors’ search for income. It has been our conclusion for some time that Treasuries are overvalued, and indeed, we have maintained an underweight to the sector throughout the year. Initially, when corporates were undervalued, we maintained an overweight to the sector. As valuations shifted, however, we rotated defensively away from corporates towards deeply undervalued municipals. As corporate spreads tightened, municipal /treasury ratios remained very attractive and at times, cheapened. Our movement into municipals, at yields well above Treasuries, allowed us to maintain both yield and quality.
While we maintain an overweight to MBS, our risk management approach leads us to a bias towards owning GNMAs. Although the majority of the MBS in our benchmark are FNMA and FHLMC issues, the majority of the mortgages in our portfolios are GNMAs. As we await news of how conservatorship will end for FNMA and FHLMC, not to mention something resembling a plan for the future, we would prefer to insulate our portfolios from the unknown political risks surrounding these yet to be made decisions.
We are heartened by the steps consumers have taken to pay down debt, encouraging corporate earnings, and improvement in the housing market, but our expectation is for continued modest growth and low inflation. The exact shape and size of both tax increases and spending cuts is unknown, but these actions will be headwinds for an economy already experiencing low growth. While we are not political analysts, the upcoming decisions regarding sequestration and the debt ceiling may prove acrimonious and possibly disruptive to capital markets. Our focus on investing in the more liquid issues in the market means we are well positioned to respond to changing market circumstances and opportunities.
Much has been made of the Fed’s large-scale purchases of Treasuries and Agency MBS—and for good reason. The balance sheet, as seen below, has grown from $1 trillion before the financial crisis to $3 trillion today, and recent pronouncements promise continued action until either employment meets their target or inflation increases. But Fed policy alone is not the only reason yields remain low, though it is a major reason. Underlying growth remains on a moderately positive path, and though we have witnessed years of central bank money printing, we have yet to see a genuine surge (long expected by pure monetarists) in inflation. Higher inflation is unlikely to rear its ugly head as long as growth is moderate and credit creation is flat.
Though our base case is a muddle-along economy with rates stubbornly low for longer than many expect, our conclusion is that the risks to our scenario are on the upside – a healthier economy, higher interest rates, and a steeper yield curve. We are concerned that as growth accelerates (timing unknown), the Fed’s historic easing reverses course, and market forces begin to get the upper hand over central bank central planning, the yield curve will steepen significantly.
As an end to Operation Twist inevitably approaches, we believe we must prepare our portfolios for the possibility that longer maturities may experience a meaningful rise in yields as bond market vigilantes, last seen playing a meaningful role in the Treasury markets in the 1980’s and 1990’s, may make a comeback. In the meantime, we continue to hold our current positions, which yield more than the benchmark, are bulleted from a yield curve perspective, and are shorter in duration when we adjust for the traditional beta between municipals and Treasuries.
This approach, defensive and value oriented, helped us to generate 2012 performance comparable to the benchmark excluding those sectors we do not purchase. The overweight to municipals positively contributed to performance, as the sector outpaced Treasury returns this year. Improved tax receipts and structural reforms have placed municipalities in solid fiscal shape. We adjusted the size of our overweight through the year, but expect this allocation to be a core holding until the relationship between taxables and tax-exempt bonds normalizes. As seen above, municipals yield more than Treasuries, and past history indicates that municipals are likely to outperform Treasuries in a rising rate environment. Municipals will be exempt from the new Affordable Care Act surtax of 3.8% applied to high income earners in 2013, enhancing their value. We are monitoring events to see whether policymakers change the full exemption of municipal income, but we believe the present level of dysfunction in Washington makes large-scale changes to the tax code unlikely.
Our corporate allocation was unchanged for the past quarter. We entered the year overweight and drew back to neutral in the summer. Spreads versus Treasuries are fairly valued and there are multiple scenarios we can envision that could contribute towards a general widening environment ranging from upcoming budget talks in Washington, to a general asset allocation away from overvalued fixed income sectors, or weaker economic data. We continue to focus on identifying issuers that meet our requirements of transparency of analysis, strong balance sheets, clear business models, and strong market positions in their particular industries.
Our style bias (which leads us to tilt towards industrials over financials) can lead to sector underperformance relative to the benchmark in risk-on environments, as was the case in 2012. Yet, our approach also means we can readily rebalance portfolios as the types of credits that meet our criteria also tend to be among the more liquid names in the market. As corporate bond inventories held by Wall Street banks dwindled this year, this liquidity focus has been especially important.
While we believe the economy is in the midst of a genuine recovery, we also believe it remains vulnerable to the after-shocks of the financial crisis. As a result, capital preservation oriented investors must take great care to navigate these cross-currents successfully.
Chief Investment Officer
January 29, 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 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.