2016 - Quarter 2

Safe haven assets performed well across the board in the second quarter after the fed lowered future rate expectations and Britain voted to leave the European Union.

Fixed Income Return Summary

Long fixed income outperformed the short end as the yield curve continued to flatten.

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Global Rates

Rates in the U.S. are best viewed in a global context. Much has been said in the media about how the Fed is going to take rates higher and there has been an incredible amount of air time devoted to when these increases will occur and how many times they will raise rates. The bond market has been telling us to ignore this “noise” and instead of rates rising they have fallen. One reason our rates are so low is that rates in other developed countries are even lower. The chart below shows a comparison of our rates to France, Germany, Spain, Italy, and Japan. Our rates are higher than any of these other major countries for all maturities out to 10 years. Many of the countries even have negative rates. The shaded areas highlight which countries have negative rates for various maturities. We are the only country that does not have negative rates.

World Bond Rates

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Sluggish Growth

Growth targets are being reduced both in the U.S. and by the IMF for the rest of the world. Unusually high levels of debt for developed countries create a strong headwind for growth. Unfortunately, the monetary authorities encouraged borrowing before the financial crisis in 2008 as a way to stimulate economic growth. Logic would dictate that if the problem is too much debt, the solution would be to go through a period of debt liquidation to reduce that debt. Instead, monetary policies worldwide have been designed to stop the debt liquidation process or “deleveraging” in an attempt to grow their way out of the problem. This has not worked because we are in a classic liquidity trap and these policies are simply “pushing on a string.” Japan is now suffering two lost decades due to these failed policies.

The other problem contributing to sluggish growth is negative demographic trends caused by declining birth rates and aging populations. This is reducing the size of the labor force. A reduced labor force has led to declining productivity gains. This is important because without increasing productivity the nation’s wealth suffers and workers find themselves without sufficient wage gains.

The Rise of Populism

Worker dissatisfaction with anemic wage gains and failed government policies has led to the rise in populist movements sweeping the globe. Working class people are becoming more vocal and are revolting against those in power. This has led to the rise of populist political figures like Bernie Sanders and Donald Trump. The recent vote for Brexit in England is another example of this trend. We expect this trend to continue as taxpayers express their frustration with those in power. This movement is leading to a reversal of the trend toward globalization and free trade, and will likely be a drag on economic growth in the future.

Finding Yield In A Low Yield Environment

We have believed we are in a low rate environment for a long period of time. We have implemented an intermediate barbell strategy which has some bonds in the 10‐15 year part of the curve and some bonds due in about 1 year. This strategy has performed well and we believe it will continue to do well going forward. It has taken advantage of the higher yields available in longer intermediate bonds as the yield curve has flattened. We expect this trend to continue as low Treasury yields lead investors to search for more yield.

TFS has also found value in investment grade credits which we like. These credits have performed well as credit spreads have tightened. We expect this trend to continue in the future. We have increased exposure to bonds backed by financials. Many of these are tax‐free gas pre pays where public utilities are able to lock in their cost of gas for a long period of time. These loans are typically guaranteed by banks. We have become more comfortable with this sector due to increased regulation of the banking industry. Reduced leverage for banks has led to a reduction of risk in the financial sector. We believe banks are in much better shape today than they have been in the past.

We also find value in some charter school bonds. The rating agencies have historically punished this sector because of charter school renewal risk. We use extensive due diligence in our credit work to find schools that have a strong track record of academic success, large wait lists, and good governance. The key to investing in this sector is to concentrate on schools with a long history of providing students with a great education. This leads to increased demand from parents, which creates wait lists to get their children into the school, and mitigates the risk of charter renewal in the future. TFS also reduces risk by investing in states that have favorable charter school legislation. Arizona has some of the most favorable legislation in the country. Typically, these schools receive per pupil payments from the state which go directly to the bond trustee to pay debt service on the bonds. The excess funds then flow through to the school. This has been a good example of an inefficiency in the bond market. Rating agencies have been slowly coming around to recognize some schools in this sector are not as risky as they once thought.

We also find value in the affordable housing sector. Many of these deals are for rentals to the elderly. One of the key metrics for us in this sector is to find deals which have HUD subsidies for rental payments. These subsidies make these bonds attractive because the risk of occupancy rates declining during an economic downturn is mitigated. In fact, if we went into a recession there would be increased demand for cheap rents subsidized by the government. It can be difficult for renters to get into these units because of the strong demand. Many of these bonds are A rated and come at yields which offer exceptional value for the quality.

Declining oil and commodity prices combined with the strong dollar created an excellent opportunity in Emerging Market (EM) debt funds and High Yield as investors fled these markets in the period from November to February. Many of these funds traded at discounts to net asset value (NAV) of over 15% and offered yields of 8%‐12%. Some of these funds were trading at discounts that were 3 standard deviations away from how they normally trade. This type of opportunity usually only occurs during panic selling at major market turning points. Many of these funds have recovered nicely, but are still relatively cheap from a longer term perspective. Going forward, we expect these funds to do well compared to bonds for developed countries. Many of the EM countries have much lower debt ratios and more favorable demographics.

For investors which are income oriented, we have also used some taxable closed end funds (CEF’s).