James Barrow's BHMS 3Q BHMS Fixed Income Commentary

3Q13 MARKET REVIEW: After the Federal Reserve 'balked' in its September 17th decision NOT to reduce quantitative easing (QE), the fixed income market enjoyed a reprieve from negative returns sparked by the 'Taper Tantrum' of May, June, and July. Armed with new evidence of stilltepid growth in both jobs and GDP, the Fed elected to maintain the current pace of its $85B per month U.S. Treasury and Agency MBS purchase program. The announcement ignited a strong bond market rally. The 10yr Treasury yield, having reached a year-to-date high of 3.00% on September 5, quickly declined and finished 3Q13 at 2.64%. Despite the late quarter rally, the 10yr yield remained 101 basis points (bps) above its 1.63% YTD low set on May 1, and 12 bps higher than the 2.52% of June 30. The 30yr Treasury also rose 19bps to close 3Q13 at 3.68%, resulting in a steeper yield curve. The other sectors of the U.S. fixed income market participated in the rally as well, with spreads narrowing across all sectors in the last two weeks of September.

The Barclays Aggregate Index rose by 0.57% in 3Q13, having stood at a loss of -0.36% the day before the FOMC's declaration to not slow QE. Despite the bounce, the Index remains in negative territory YTD and for the trailing 12-months at -1.77% and -1.68%, respectively. In stark contrast to 2Q13, Investment Grade (IG) corporate spreads tightened 10bps during 3Q13, producing a positive nominal return of 0.82% and an excess return of 0.92%. The respective YTD total returns in IG remain a disappointing -2.62%, but excess returns are still positive at 0.61% YTD. The 1-Yr results for IG Credit now fall to a nominal -1.58%, but 1.79% in excess of Treasuries.

The Financial sector was the best performer in the Barclays Aggregate Index during 3Q13, generating nominal and excess returns of 1.54% and 1.40%, respectively. Spreads in High Yield (HY) issues tightened substantially, propelling Ba/B credits to a 2.07% nominal and 1.74% excess return. Mortgage Backed Securities (MBS) also reacted ! positively to the Fed decision, as Agency MBS outperformed comparable duration Treasuries with a 1.03% nominal and 0.95% excess return. Commercial Mortgage Backed Securities (CMBS) were resilient as well, finishing 1.02% higher in nominal terms and 0.66% excess in 3Q13. Non-Corporate Credit issues fared positively in 3Q13, but with a relatively weaker 0.37% nominal and 0.41% excess return.

In the absence of a dramatic rally in 4Q13, the Barclays Aggregate Index is on pace for the worst calendar year for U.S. fixed income assets in 40-plus years. In stark contrast to the 20% YTD return of the S&P 500, bonds look set to suffer their first negative annual return since 1999, and only the second negative year since 1994. In both of those years, the Federal Reserve tightened monetary policy. Consequently, investors may soon wonder whether an inevitable transition toward higher interest rates will not only end the 30-year bull market in bonds, but also the 4-year bull market in stocks. Higher yields may make fixed income strategies more competitive on a risk-adjusted basis.

"Weak growth and higher bond yields are not a great cocktail for stocks." -- Barclays

'Unless things get better, we taper later.' –Ethan Harris, Bank of America

THE ECONOMY, INTEREST RATES & THE FED: The September Surprise! To the surprise of all but a minority of investors, the Federal Reserve 'whiffed' on the opportunity to launch the much anticipated transition toward 'normalizing' interest rates at the September 17-18 FOMC meeting. The foregone conclusion of 'tapering' in the $85B monthly security purchase program ($45B in U.S. Treasuries and $40B in agency MBS) was not only postponed, but Chairman Bernanke's post-committee commentary hinted at an even more 'dovish' tone about the prospects for future rate action. Though the Fed has attempted to calm markets with reassurances that tapering would not indicate 'tightening', Bernanke went even further in muting fears of higher interest rates, redefining the thres! holds for! the end of ultra-accommodation. The Fed's new guidance targeted no tightening until unemployment is "considerably below" the 6.5% benchmark, or as long as inflation "remains below 2% for some time".

While the foregone conclusion had favored at least a modest reduction of the Fed's purchase program, many had also come to believe that tapering was justified to ensure better alignment of supply and demand in the Treasury and MBS markets. New issue Treasury auction supply in 2014 is expected to diminish (20% by some estimates) with the sharp narrowing in the budget deficit. The smaller deficit stems from the ~$150B in incremental annual receipts from this year's tax increases and an improving economy, coupled with the $85B sequestration spending cuts. Otherwise, the current pace of Fed purchases will rise from ~90% of net Treasury duration to above 100%. A small amount of Fed 'tapering' was seen as necessary to simply prevent an INCREASE in Fed accommodation.

3Q13 BHMS BOND COMMENTARY

There were also concerns that the Agency MBS market has become too dependent upon Fed purchases. Higher interest rates and the modest growth environment have already negatively impacted new MBS originations. The sharp rate rise since May's initial 'taper- talk' virtually halted mortgage refinance volumes, and new originations were suppressed by the slow growth in jobs and new household formation. As a result, a possible 100% Fed ownership of net new MBS supply favored at least some reduction in MBS purchases. The extent of a pullback was uncertain, as many deemed the underlying strength of the housing market still insufficient to be self-sustaining.

BOTTOM LINE: The Fed's unexpected "U-turn" decision created a sense of confusion and uncertainty, but possibly also reveals their concern about the underlying strength of the economy, and perhaps even the validity of their own metrics. The inaction may have acknowledged that the official U-3 measure of labor strength is both artificial and inappropriate, an! d current! conditions reflect structural, as much as cyclical, headwinds. In fact, the Fed's decision to postpone tapering was confirmed by their downgraded assessment of second-half 2013 growth. The latest Fed forecast of 2013 GDP growth was revised to 2.0-2.3%, from June's 2.3-2.6%. The 2014 forecast was lowered to 2.9-3.1% ,from 3.0-3.5%. The Bloomberg composite survey projects 2013 GDP growth at a mere 1.6%. The bipartisan Congressional Budget Office estimates growth in U.S. GDP will remain below potential until 2017 (WSJ 9/9/13). Bernanke's post-meeting comments suggest the Fed's forward guidance now projects a more benign path for rates. Removing the unprecedented accommodation, much less tightening, is becoming more difficult as the economy remains stuck in stall-speed. While the inevitable long-term path for interest rates is still upward, the horizon over which the rise will occur is likely extended.

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