Bond Market Town Hall Meeting

Bond Market Town Hall Meeting August 12, 2011

What is the impact of the S&P downgrade?

Vs. The downgrade was more a political statement than an economic analysis The US economy still looks very strong relative to many AAA rated countries The sheer size of the US economy dwarfs most of the remaining AAA countries like Liechtenstein

Do Nothing or Do Something? Take little action as they have in Greece…Or Enact austerity measures in the face of a downgrade like they have in England

Neither approach has received a warm reception from the public

Two Major Events Actually, there were two major events over the week of August 5-12, 2011: S&P Downgrade of US Treasuries http://www.standardandpoors.com/home/en/us 2. Fed policy statement that it intends to keep interest rates low until mid-2013 http://www.federalreserve.gov/newsevents/press/monetary/20110809a.htm

What S&P Did Long-term US notes and bonds downgraded to AA+ for the first time in history Short-term bills maintained top A-1 rating Moody’s and Fitch maintained the AAA rating but kept the US on negative watch

What S&P Said “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.”

“More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges”

“…we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.”

The S&P Downgrade S&P is saying that they believe what is going on in Washington is not business as usual – There is a greater degree of partisanship Two views of how America ought to be governed are in direct conflict to a greater degree than normal with no clear path to resolution – Infighting between Republicans and Democrats poses a greater barrier to solving the debt problem

Where does that put the US? The sovereign debt of 126 countries are rated by S&P 18 have AAA rating (was 19) 3 have AA+ rating (was 2): Belgium New Zealand USA

First and Second Tier Countries

Comparing the AA+ Countries Belgium Tied the record for a democratic country without a government in place in 2010 Economy is ranked 20th or would be 8th as a State behind Ohio New Zealand Recovering from one of the largest natural disasters in history Economy is ranked 52nd or would be 31st as a State behind Kansas

Are Government bonds still safe? What about municipal and corporate bonds?

US Government Historical Defaults Has never happened, so no data available Yields on Treasuries went down after S&P announcement, ,[object Object]

S&P credibility may be hurt; several corporate bonds remain AAA rated in spite of S&P’s policy of not rating companies above their country’s rating,[object Object]

AgenciesWe select whichever asset class offers the highest yield for any particular year, which creates opportunities to swap when conditions change

Municipal Debt Defaults Municipal debt defaults are very rare for investment grade bonds. Investment grade mean AAA, AA, A, BBB rating Asset Dedication uses only AAA or AA bonds for retirement portfolios “A” rated bonds occasionally used if nothing higher is available for a particular year when the portfolio is implemented BBB or lower are never used

[1] Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970-2009 [2] Moody’s Corporate Default and Recovery Rates, 1920-2009 [1]Standard and Poors U.S. Municipal Rating Transitions and Defaults, 1986-2009 [1] Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970-2009 Data source: Standard and Poor’s

Corporate Debt Defaults Corporate debt defaults are also rare for investment grade bonds but more frequent than municipal bonds (see next slide) As before, Asset Dedication uses only AAA or AA bonds for retirement portfolios “A” rated bonds occasionally used if nothing higher is available for a particular year when the portfolio is implemented; BBB or lower are never used Only four corporations currently rated AAA: Microsoft, Exxon, Johnson & Johnson, Automatic Data Processing

[1] Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970-2009 [2] Moody’s Corporate Default and Recovery Rates, 1920-2009 [1]Standard and Poors U.S. Municipal Rating Transitions and Defaults, 1986-2009 [1]Moody’s Investor Services, Corporate Bond Defaults and Recoveries, 1920-2009 Data source: Moody’s

[1] Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970-2009 [2] Moody’s Corporate Default and Recovery Rates, 1920-2009 Data source: Moody’s

[1] Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970-2009 [2] Moody’s Corporate Default and Recovery Rates, 1920-2009 [1]Standard and Poors U.S. Municipal Rating Transitions and Defaults, 1986-2009 Data source: Hempel

Are individual bonds better than bond funds?What will happen when rates rise?

Flat Rates or Rising Rates Given that there is little room for rates to move down farther, we would expect rates to either stay low or rise There is historical precedent for rates staying low and flat as we have seen in the US following severe economic crises and as Japan has experienced since 1985 In prior periods of rising rates, bond funds have lagged individual bonds, particularly when clients take withdrawals

Historical Interest Rates Average Yield 1800-2010 Long Depression Great Depression Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962.

Japanese Interest Rates Since 1985

Impact of Interest Rates on Total Return

Bond Funds and Rising Rates When bond yields rise, prices fall The period from 1950 to the peak in 1981 saw bond fund total return lag individual bonds by more that 3% compounded* Turnover forces bond funds to recognize losses, which cannot be overcome, especially when the investor is taking withdrawals *The 10-year Treasury index (2.2%) is used as a proxy for bond funds compared to the 10-year Treasury bond (5.6%)

Rising Rates 1950-1981 Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average

Rising Rates 1950-1981Individual Bond Average Yield = 5.6%

Rising Rates 1950-1981Volatility of Bond Fund Returns and Unexpected Losses

Rising Rates 1950-1981Volatility of Bond Fund Returns Leads to Total Return of 2.2%

Bond Funds Funding Shortfall Volatility of bond fund returns and lower total return when rates rise cause funding shortfalls for investors taking withdrawals When compared to an income-matching portfolio of individual bonds, a bond fund will generally experience shortfall when rates rise* Essentially, rising rates for a bond fund that needs to generate income creates the worst case reverse dollar-cost-averaging scenario *The 10-year Treasury index (bond fund proxy) compared to a series of 8-year income-matching portfolios. Income-matching portfolios are built using bond prices for the starting year and are spend down. The funding target was $100,000 per year increasing at 3% inflation. An equivalent amount is set aside in a bond fund for each starting year and systematic withdrawals are taken out to cover the target.

Bond Fund Shortfall with Withdrawals Worst Case Reverse Dollar-Cost-Averaging Caused by Volatility Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. CRSP 10-year Treasury Index total return

Is now a good time to buy bonds with rates so low?

Evaluating the Tradeoff of Waiting Although rates are low, there is an opportunity cost of waiting for rates to rise Waiting is cash is the best place to wait even though money market rates extremely low (less than 10 bps) Bond funds will likely lose money if rates rise, erasing any advantage of waiting At current rates, for an investor with a 10 year horizon, rates would have to rise 75 bps just to break even The probability of breaking even is less than 10%

10-Year Treasury Yield 12 Month Rate Change Distribution 1881-2011 Rate Change > 0.75% 9.1% of the time Data source US Treasury, and Robert Shiller

The Living Yield Curve Show Clients How Rates Have Changed http://www.smartmoney.com/investing/bonds/the-living-yield-curve-7923/

Treasury Yields Yields do not seem to reflect concern about the safety of Treasuries, even in light of the downgrade Over the last year, rates have come down slightly YTD, rates have seen a greater change because rates rose through the early part of 2011 The last month has seen a steady decline

Yield Curve Comparison8/11/10 – 8/11/2011 Data source: US Treasury

10-Yr. US Treasury – Past 12 Mos. Data source: BondDesk Group

10-Yr. US Treasury – Past Month Data source: BondDesk Group

Daily and Historical Data on Yields Daily data on yields is available from a variety of sources. www.bonddesk.com provides comprehensive data on the retail bond market

What has been the impact on investment grade municipal and corporate bonds?

Evaluating the Yield Matrix CDs are delivering relative value out further than we have seen in the last 12 months Municipal bonds seem to be tracking treasury yields closely For taxable accounts, municipal bonds still deliver superior after-tax yields relative to other asset classes (and are safer than similarly rated corporate bonds) Corporate bonds are starting to see spreads increase

Yesterday’s Yields on Munis (For more details on municipal bonds, click here)

Yesterday’s Yields on Corporates (For more details on corporate bonds, click here)

More details on Corporates The spread between corporate bonds and Treasuries has increased slightly Corporate bonds have not seen yields slip as much as Treasuries Unfortunately for investors, there is little diversification among industries in investment grade bonds Not only do financial firms dominate the volume of issues, but they also deliver higher yield at similar credit ratings

Corporate Spreads Data source: BondDesk Group

Corporate Bond Sector Concentration Data source: BondDesk Group

Corporate Bond Yield Matrix Data source: BondDesk Group

The Fed’s Guidance Indicates That Rates Will Stay Low for the Foreseeable Future “The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” FMOC press release 8/9/2011

Forecasters are notoriously bad at guessing the direction of interest rates, let alone the actual value

“Indeed, the trend towards far higher rates is already beginning” “Here Come Higher Interest Rates” by Shawn Tully, editor-at-large of Fortune Magazine, on 6/19/2009.

The Federal Funds Target Rate has remained unchanged since… December 16th, 2008 Board of Governors of the Federal Reserve System, 2010

Yield Curve Comparison6/19/09 – 8/11/2011 Data source: US Treasury

3 Types of Interest Rate Forecasters Those that don’t know where rates are going Those that don’t know they don’t know Those that know they don’t know but get paid lots of money to pretend they do. Larry Swedroe: The Value of Interest Rate Forecasts, moneywatch.com

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