Sage Update...YoUr InSUrance InveStment management reSoUrce

Sage Insurance Monitor Second Quarter 2015

As interest rates continued to fall, investment managers, economists, and analysts talked about a reversion to the “norm.” The problem with that notion is that the “norm” is different for everybody depending on their age and economic perspective. Somebody who obtained their first mortgage in 1970 at a rate of 7.5% is most likely going to associate that with normal, while others who obtained their first mortgage in the early 1980’s at 18% may have an entirely different view. Over the last few years, 30-year fixed mortgage rates have teetered between 3-4%, and have become the "norm" for many homeowners. With interest rates having declined over the past thirty years, are low rates the new normal?

We know inflation plays a big role in determining market interest rates. The relationship between 30-year mortgage rates and inflation are highly correlated. In 1970, the inflation rate was 5.7%, and in 1980 it was 13.5%. The average inflation rate for the past three years has been only 1.7%. According to the U.S. Bureau of Labor Statistics, the inflation rate for the United States (CPI-U) was 0% through the 12 months ending in May 2015. Inflation has been negatively impacted by falling oil prices and the energy sector. Fed Chair, Janet Yellen, has already stated that a path towards a 2% medium-term inflation rate would be a condition of a rate increase.

Generally, labor costs are a huge driver of inflation but with unemployment having been so high, workers had little leverage and wages have been fairly flat since 2008. Compensation costs for civilian workers increased 2.6% over this past year, an improvement over the prior year rate of 1.8%. The previous five year period wages increased at an average annual rate of just 1.3%. However, after adjusting for inflation, wages actually decreased at an average annual rate of 0.24%. The unemployment rate has dropped from 10% in October of 2009 to almost half of that as of June 2015 at 5.3%. We expect to see wage rates continue to build on the gains over the past couple of years, creating inflationary pressures as unemployment rates approach the threshold for full employment.

To help gain perspective, at the beginning of 2008 the Fed Funds rate was 3.5% and the 10-year treasury was at 3.74%. Today the Fed Funds rate is near zero and the 10-year treasury rate is 2.45%. Of course, the Fed doesn’t control long-term rates, but its policy with regard to short-term rates sets the basis for yields on government bonds with longer maturities. However, the central bank did impact longer-term rates through its quantitative easing program, which was in place from 2008 through 2014, where the Fed purchased over $3 trillion in treasuries and mortgages.

Throughout history, economists have been trying to determine the “natural rate of interest.” Swedish economist, Knut Wicksell, first put forth the theory in 1898 that “there is a rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor to lower them.” The “natural” rate of interest is not a law of nature nor observable, so

it must be estimated. Monetary policy makers are interested in estimating the natural rate of interest because real rates above or below it would tend to depress or stimulate economic growth, which is why in recent years the Fed has sought to keep interest rates as low as possible. While this has stimulated the economy, it has not yet created the economic tailwinds sufficient to fuel the necessary levels of inflation.

Creating a fertile interest rate environment is a daunting task and can be full of unintended consequences. While the Fed’s actions to keep interest rates artificially low to stimulate the economy have reduced unemployment substantially, it has also had negative consequences on other segments of society. Retirees who place a great reliance on fixed income to supplement their retirement have seen their earnings fall precipitously. For example, the average yield on a five year certificate of deposit in 2007 was 4%; today the average yield is 1.19%. That is a 70% drop in earnings and an even bigger drop in earnings for retirees banking on the continuance of 5-year CD yields in 1990 at 8%. Life insurers’ have also been hit hard as current market yields have fallen below the guaranteed interest rate levels on some life

THE NATURAL RATE OF INTEREST

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OUR SERVICES Sage Advisory provides comprehensive portfolio management and services that integrate the operational aspects of the insurer with appropriate investment solutions. Our customized strategies address:

Liability Assessment and Analysis

• Dynamic cash flow modeling

• Interest rate & inflation risk sensitivity analysis

• Customized liability benchmark creation

• Gap analysis & risk budget creation

• Financial statement projections

• Tax efficiency analysis

Investment Management

• Liability targeted investments

• Core Fixed Income Investment Strategies

• Tactical ETF Investment Strategies

• Tax sensitive and income oriented portfolio management

Reporting and Administration

• Daily online investment reports

• Investment compliance and oversight reports

• Customized quarterly performance evaluations

• Statutory Schedule D reporting

Contact Us Jeffrey L. Sims, CPAExecutive Vice President, Director of Insurance Investment Managementp: 512.327.5530 c: 512.202.9244jsims@sageadvisory.com

Joshua A. MagdenVice President, Consultant Relationsp: 512.327.5530 f:512.327.5702jmagden@sageadvisory.com

Please visit our website for more information.www.sageadvisory.com

Quarter In Review

For municipal bond investors, the backdrop was challenging as rates moved higher for much of the quarter and spreads leaked wider. While total return oriented investors saw this as a negative, insurers with a book yield orientation saw this as a great opportunity.The Barclays Municipal Index experienced a negative total return of 0.89%. With liquidity concerns on the rise, lower quality credits modestly underperformed. The Barclays Muni BBB Index had a negative 1.04% quarterly return, versus the AAA Index return of negative 0.74%. Municipal bonds generally outperformed equivalent taxable fixed income, as the Barclays Aggregate Bond Index returned negative 1.68% for the quarter, the worst quarter for US core fixed income in two years.

Within risk assets, most equity markets were close to flat for the second quarter, with international equities outperforming, but generating less than 1% returns. REITs underperformed, as rising rates weighed the sector down, while commodities outperformed, bolstered by a weaker dollar and better second half growth outlook. For fixed investors, the backdrop was particularly challenging as long rates moved higher for most of the quarter and spreads leaked wider. 10 year Treasury yields stabilized into quarter-end on equity market turmoil but finished 40 basis points higher. The net result was the worst quarter for US core fixed income in two years, with the Barclays Aggregate index returning -1.68%.

See disclosures for indices used in asset class returns.*Returns are not annualized.

See disclosures for indices used in asset class returns.*Returns are not annualized.

See disclosures for indices used in asset class returns.*Returns are not annualized.

Equities/Alternatives Returns 3 MO* 12 MO

Diversified Commodities 5.45% -32.28%

Emerging Markets 0.81% -4.81%

Developed International 0.80% -3.59%

U.S. Large Caps 0.28% 7.42%

U.S. Small Caps 0.19% 6.70%

U.S. REITS -10.44% 3.95%

For insurers' fixed income portfolios, the backdrop was particularly challenging as long rates moved higher for most of the quarter and spreads leaked wider. 10 year Treasury yields stabilized into quarter-end on equity market turmoil, but finished 40 basis points higher, while investment grade credit spreads widened 13 basis points. The net result was the worst quarter for US core fixed income in two years, with the Barclays Aggregate index returning -1.68%. All major sectors experienced negative absolute returns, while on a relative basis, Agency MBS outperformed and credit lagged. Outside core fixed markets, returns were mixed with high yield and emerging market debt outperforming, while preferred stocks and non-dollar fixed income underperformed.

Global Fixed Income Returns 3 MO* 12 MO

Asset-Backed Securities 0.17% 1.64%

High Yield 0.00% -0.40%

Agencies -0.59% 1.46%

Emerging Markets -0.71% -0.38%

Mortgage-Backed Securities -0.74% 2.28%

Commercial Mortgage-Backed Secutities -1.06% 1.91%

Treasury Inflation Protected Securities (TIPS) -1.06% -1.73%

Aggregate Bond -1.68% 1.86%

U.S. Treasuries (7-10 yr.) -2.43% 3.65%

Investment Grade Credit -2.88% 0.93%

Municipal Returns 3 MO* 12 MO

Municipal Bond Index -0.89% 3.00%

Municipal 1-10 Yr Index -0.51% 1.74%

Municipal 3 Yr Index -0.02% 0.57%

Taxable Bond Returns

Aggregate Bond -1.68% 1.86%

Investment Grade Credit -2.88% 0.93%

U.S. Treasuries (7-10 yr.) -2.43% 3.65%

Equities/Commodities Returns

U.S. Large Caps 0.28% 7.42%

Developed International 0.80% -3.59%

Diversified Commodities 5.45% -32.28%

Fourth Quarter 2013

Outlook & Positioning

After suffering the worst quarter since the summer “taper tantrum” of 2013, we head into the third quarter more optimistic toward core fixed income returns. Given our view that the Fed will remain cautious, data is likely to disappoint consensus rebound expectations, we are less worried about a sustained rate correction, but have grown more defensively minded toward the credit sector. We expect long rates to remain stable with 10 year Treasury yields in the 2-2.5% range.

Given our outlook, we increased duration exposure where possible subject to insurers' constraints, to intermediate and long rates in the second quarter. We maintain an underweight toward short rate exposure, however, we expect curve flattening with rising short rates and stable long term rates. From a sector perspective, we have turned more cautious toward credit and have pared back our corporate allocation to an underweight position, while increasing exposure to agency backed MBS. Credit appears vulnerable to further spread volatility, while we are more constructive on MBS given positive real estate fundamentals and diminished prepayment risk.

The macro backdrop appears constructive for equities, but with global valuations at cycle highs and policy uncertainty in the US, it also suggests higher volatility and increased vulnerability to a correction. We, however, expect global QE-driven liquidity, a bounce in US data, and continued Eurozone recovery to keep the “buy on dip” mentality alive over the coming quarter for equity markets. We continue to view developed market equities as most attractive among risk assets given ECB and BOJ policy support and the pick-up in economic momentum in Europe. Currently, we see limited opportunity outside of core developed market equities as commodities and emerging markets continue to face growth and currency headwinds.

See disclosures for indices used in asset class returns.Returns are not annualized.

Sage Allocations

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

-40%

-35%

-30%

S&P 500 EAFE EM Equity COMMODITIES

See disclosures for indices used in asset class returns.Returns are not annualized.

12 Month Risk Asset Returns

0 5%

1.0%

1.5%

2.0%

0.0%

0.5%

MBS CMBS ABS IG Credit

U.S. Fixed Income Sector Spreads

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0.0%

0.5%

1.0%

0 5 10 15 20 25 30

3 MO Ago Current 12 MO Ago

U.S. Treasury Yield Curve

See disclosures for source.

This publication contains the current opinions of the manager and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This publication is distributed for education purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Forecasts are based on proprietary research and should not be interpreted as an offer or solicitation, nor the purchase or sale of any financial instrument. No part of this publication may be reproduced in any form, or referred to in any other publication, without the express written permission of Sage Advisory Services, Ltd. Co. Past performance is not a guarantee of future results.

Source: Bloomberg. SNL Financial. Fixed Income asset classes represented by the following indices: Municipal Bond by Barclays Municipal Bond Index, Municipal 1-10 Year by Barclays 1-10 Year Municipal Bond Index, Municipal 3 Year by Barclays 3 Year Municipal Bond Index, Aggregate Bond by Barclays Aggregate Bond Index, Investment Grade Credit by Barclays U.S. Investment Grade Credit Index, U.S. Treasuries by Barclays 7-10 Year Treasury Index. Equity asset classes represented by the following indices: US Large Cap by S&P 500 Index, Developed International by MSCI EAFE Index, Diversified Commodities by Deutsche Bank Liquid Commodity Index.

and annuity policies creating a negative spread between crediting rates and market yields.

At this juncture, it appears we may be closer to the new norm, at least for a while. Any Fed funds rate increases are projected to be minor. The end of Quantitative Easing almost a year ago has not resulted in much of a rise in long-term rates and inflation. The necessary catalyst for rising interest rates is at zero. The good news is that the U.S. Economy is growing stronger every day and so is the dollar. Eventually, this will lead to inflationary pressures and we will begin to see rates rise modestly. In the near term, our view is the yield curve will continue to flatten as short-term rates rise and longer-term rates hold steady.

THE EFFECT OF POPULATION AND DEMOGRAPHIC SHIFTS ON INTEREST RATESIt is also interesting to note the effect population growth and demographics have on interest rates. Typically young people are net borrowers and older people are net savers. The relative number of savers and borrowers has a determinable impact on the market for loanable funds. For countries with growing populations, young people comprise the largest group, and therefore borrowers dominate the market. With so many borrowers and so few savers, supply and demand will dictate that interest rise to meet the scarcity. However, if population growth begins to stall or decline, as we have seen in Japan and Germany, then the balance shifts and savers dominate the market. With less people borrowing, there are fewer opportunities for savers to deploy their savings. Therefore, interest rates have to fall to encourage borrowing and discourage saving.

In the fastest growing countries where borrowers predominate such as Brazil, India, Argentina, and Indonesia the 10-year bond rate is above 7% (over 11% for Brazil). Conversely, the 10-year bond rate countries where savers dominate, such as aging

Japan and Germany is only 0.27% and 0.46% respectively. The interest rates reflecting these changing demographics are similar to the theory behind the natural rate of interest in that, it is above or below that point of equilibrium between savers and borrowers that borrowing/investing is either stimulated or discouraged.

THE PLAYBOOKWith the Fed signaling a year-end rate hike, it’s natural to speculate about the effect a rate increase will have on the yield curve. It's harder to gauge whether modifying a portfolio's duration is merited based on future spreads and your own tax rate even given the probability that such a rate hike will be small (25-50 bps) and has been well-telegraphed.

Moreover, volatility abounds as dealer inventory shrinks in the aftermath of Dodd-Frank. The thesis and timing of the trade are important, as is the capacity to navigate the trade. While he may not have said it with an economist’s eye, Napoleon’s quote to the right margin of this column is a fitting depiction of what continues to move markets – whether the “interest” he was referencing implied rates or not!

Making an interest rate or inflation call on a fixed income segment, as straightforward as US Treasuries, can prove deceptively challenging. Low rates and spread compression leave little room for error. No asset owner or investment manager will get every market call or the precise timing of every call right. Nor is doing so the purpose when it comes to an insurer’s risk-bearing capital. The key is to get the decision and the timing mostly right. Like attempting to budget for the family’s healthcare expenditures for HSA/FLEX plan deductions in the coming year, the downside risk of setting aside a little bit less than ultimately needed for doctor visits versus far more than the family uses is fairly small.

Just so, expressing an interest rate or inflation

view within the portfolio is less problematic when done incrementally and with more navigable instruments. For an admitted carrier, an SVO-rated ETF such as Vanguard’s Long-Term Government Bond ETF (VGLT) is NAIC-1 and could be purchased up to the position size limit outlined in state statutes – commonly 3-5% in many state insurance codes. It had an average duration of 16.8 years as of 6/30/15.

Similarly, Vanguard’s Extended Duration Treasury ETF (EDV) is also NAIC-1 and with a focus on long-duration Treasury STRIPS allows an insurer to place an overlay on their portfolio vis-à-vis inflation expectations.

The “natural” interest rate in the decade ahead is likely to be driven by different geopolitical and economic forces than 120 years ago. Perhaps we should pay heed to a philosopher regarded no less than Le Petit Caporal, closer to us in time and geography (particularly here in Austin), King George (Strait): “Sun shines, clouds rain, train whistles blow and guitars play, preachers preach, farmers plow, wishes go up and the world goes round… It just comes natural.” Whatever the determinants of the natural interest rate in years to come, we have strategic tools to adapt.

A MOMENT OF ZEN“There are two levers for moving men – interest and fear.”

-- Napoleon Bonaparte

"In times of change, learners inherit the earth; while the learned find themselves beautifully equipped to deal with a world that no longer exists."

--Eric Hoffer, American social writer

“Be not afraid of going slowly, be afraid only of standing still."

--Chinese proverb

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