STEVEN KACZMAREKGENE D. BALAS, CFA631 574 2474Info@EastEndWealthManagement.comwww.EastEndWealthManagement.com

Why We Like Fixed income

There are plenty of market commentators who will advise you against high quality corporate and

government bonds. They argue that today’s relatively low yields will soon become a thing of the past, sending bond prices lower as interest rates rise. There is reason to think their advice may be misplaced.

The simple fact is that when a view is so easy to understand and widely shared, it is likely already priced into the market. As such, the bearish sentiment is now reflected in yields, which have already risen from their recent lows in the course of this year. A seemingly contrarian point of view, then, is to take the opposite side of the trade, with a perspective that yields are currently fairly valued and may even represent some compelling opportunities.

Bonds can be an important part of many investors’ portfolios, given that they can help smooth volatility, as some bonds can benefit from any turmoil in riskier parts of the market. They offer diversification and a potential hedge against some types of risk. They provide income, and that cash flow can also help even out some of the market gyrations along the way. Also, they may offer upside, if the economy disappoints and interest rates fall, which would send bond prices higher.

Now, we are not saying that longer term interest rates are going to zero and bonds will have another decades-long bull market like we had beginning in the early 1980s. However, we don’t think interest rates would increase by

much, either. Simply because rates are low by historical standards is not enough reason for interest rates to rise. Interest rates can remain low for quite some time, as we have seen with rock-bottom yields in Japan for over two decades. We cite several factors why interest rates are unlikely to rise substantially in the near term (which also are factors that may hold back equities, by the way), including:

» The economy is not growing robustly, corporate profit growth is slowing, and we believe equities are fully and fairly valued with less upside here than in earlier parts of the recovery. An asset allocation trade away from stocks and into bonds can occur with any event, foreseen or not, that triggers investors’ fear of volatility. This can easily happen in the very near term with the budget battles now brewing in Washington. A flight to quality trade can benefit fixed income securities – including Treasuries, even if those securities are the very ones at the center of potential default risks – as well as corporate bonds.

» The political brinkmanship being played on Capitol Hill, full of disaster scenarios if “the other side” gets its way and the budget is cut – or not cut – impacts consumer confidence. In fact, confidence already has fallen. As the public becomes more fearful and loathing of Washington surges, they may feel that both sides are proposing

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losing propositions. Consumers’ natural response may be to cut spending and increase savings. More savings can mean more fund flows to fixed income securities.

» As consumer spending is curtailed, the economy slows. Remember that consumers’ incomes have been barely growing after inflation. In fact, the average worker has seen his or her hourly pay advance by just 0.7% after inflation over the past year. It isn’t as though each individual household has the wherewithal to increase spending, even if they wanted to. Given that the savings rate is already a low 4.6%, it is half of what it was in decades prior. And that was when more workers were covered by traditional defined benefit plans and further away from retirement. Now, Baby Boomers are nearing retirement and their savings are woefully unprepared for their Golden Years. Consumers will likely look to any excuse to save instead of spend.

» Businesses’ response to a slowing economy – or fear about fiscal policy – may be to reduce their inputs of both capital and labor. They may curtail investment in property, plants and equipment, given uncertainty about federal taxation and spending policies. That signals a limit in their ability and willingness to grow, expand and hire. Another drag on the economy is that companies will hold the line on labor costs by reducing hiring and limiting pay raises, as they strive to bolster their profit margins. As we have a service economy (manufacturing is only 12% of our economic output), labor costs far outweigh other expenses a typical business has.

All of these forces conspire to reduce inflation, depress economic growth and limit the attractiveness of riskier assets, especially stocks. Mark Zandi, chief economist at Moody’s Analytics Inc., has estimated that a three-to-four week government shutdown would cut growth by 1.4 percentage points. He projects a 2.5% annualized pace of fourth-quarter growth without a shutdown. The natural beneficiary of these conditions would be high quality bonds, both those issued by the U.S. government and by corporations enjoying better credit ratings.

We believe corporate bonds are more attractive than government securities in the current environment. Corporations have, by and large, been steady stewards of the funds investors have placed with them. They tend to maintain judicious spending restraint, and their

motive is a profit and providing returns to shareholders. Governments have no such objective of generating a profit for their investors, and may continue to borrow with impunity.

Corporations, meanwhile, must deliver strong enough financial results to attract investors’ capital, making them what we believe to be a better investment, especially since corporate bonds yield more than government securities. While it would be unprecedented, it is possible for corporate bonds to yield less than government securities, if the federal government risks default in the event the debt ceiling is not increased in time. A different way of saying this is that corporate bond yields may be less likely to increase than those of government bonds if a default seems likely. Bonds may be more attractive than stocks if these risks materialize.

Stocks, meanwhile, have already seen an impressive run-up based on expanding multiples; less so from improving corporate profits. According to FactSet, profits at S&P 500 companies increased 3.6% in the first quarter and 2.1% in the second quarter, and are expected to show a rise of 3.1% for the third quarter. These are soft readings by historical standards.

And don’t forget that some of the profit growth per share we’ve seen in recent periods has been due to companies buying back their shares – particularly with borrowed money. And some profit growth has been derived from cost-cutting. Both forces are unlikely to continue to the same extent now that many companies have already done so. Longer term financing in the bond market is now more expensive while further cost cutting activities will be limited, in our opinion, to companies holding the line of pay increases, slowing the economy even as payrolls may increase.

Overall, though, commonly used valuation metrics are stretched compared to history. The S&P 500 is trading at 14.3 times the next 12 months’ worth of earnings, above the average of 12.9 for the past five years and 14.0 for the past 10 years, according to FactSet. A year ago, the S&P’s P/E was 12.9. This means that with higher-than-average valuations combined with unimpressive profit gains going forward, stock market appreciation may be limited. That makes bonds a relatively more attractive investment.

While some of these forces that reduce the attractiveness of riskier assets are on vivid display right now, particularly the drama in Washington, an investment in investment grade fixed income isn’t necessarily just a short term trade. The economy doesn’t turn on a dime, and neither

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will the political discord abate soon, at least until (maybe) the next election.

In the meantime, the enmity and divisions in the political arena we have now isn’t based on numbers in the budget; it is based on ideology, the existential aspect of the role of government in society. As long as our citizenry are so divided as to what we expect governments to do – or to refrain from doing – there is going to be continued impasses in Washington.

The Affordable Care Act, or Obamacare, is perhaps a tipping point, the last straw with which one faction of the population cannot abide. That faction is in total disagreement with those who propose more government intrusion (or involvement, depending on your point of view) in the private sector. The government has already shown a willingness to engage in surveillance activities, whether it is the IRS or the NSA, and plenty of folks want to curb the increase in government power.

This sets up the stage for a revolt of sorts of more conservatively-minded voters to demand that lawmakers halt government intrusion in private affairs. One way of doing that is by cutting spending on many government programs, and the shutdown, though certainly not ideal, is one way of finding out which programs the population misses, and which ones they do not. Those deemed not essential can therefore be cut.

So, what would be, in “ordinary” times be considered a budget impasse, where either or both sides can agree to perhaps cut spending here or maybe raise taxes there, is in fact now something entirely different. The issues are ideologies, not numbers, and mindset trumps mathematics. Changing one’s point of view is much more difficult to do than changing numbers in the budget. As such, the logjam will continue, even to the point of default, with each side blaming the other while the country traverses a perilous journey whose outcome is as yet unknown. Even if the current situation is resolved without disaster, the fault lines that can create future tremors are well established, setting the stage for continued battles.

This level of uncertainty plays out in corporate executives’ minds. They are worried about fiscal issues, what the government spends and what it takes in the form of taxes. Businesses want to make sure their own operations can continue with minimal damage. As a result, they may commit to fewer new investments and hires, and hold the line on expenses.

This leads us to another theme. With companies likely focusing on cost control, low labor cost increases will cause scant inflation at the same time that corporate profits – and stock prices – may be restrained. This is despite, and indeed, because of companies’ efforts to the contrary. This would tend to be an environment conducive to bond investing.

So, despite all of the efforts of the Federal Reserve’s bond buying programs, the Fed simply cannot bring about more inflation by decree, as there are no ways to force companies to pay their workers more. While we are not necessarily forecasting actual deflation, we still see inflation as a far-off and frail animal, not a creature that inhabits the current economic landscape. Without higher inflation or greater appetite for riskier assets, we find it hard to make a strong bearish case for bonds. The primary reason for bearish views is simply that yields are relatively low. We find this argument far from compelling because we see no catalysts to cause yields to rise.

Given this view, we believe that a fixed income component makes sense for many investors, depending on one’s time horizon, risk tolerance and tax considerations. We focus on investing in investment grade fixed income securities. We use our trading prowess – based on East End Wealth Management founder Steve Kaczmarek’s decades of experience – to spot and exploit inefficiencies in individual securities, applying credit analysis as appropriate. These market dislocations have provided substantial opportunities for our Enhanced Income Strategy to deliver return advantages to our benchmarks, though of course, past performance doesn’t indicate how the strategy will perform in the future. For more information about our performance, please refer to our results here and here.

We also have significant experience in economic analysis to determine the likely direction of interest rates, inflation and other macro forces that lead us to determine optimal length of maturities in our portfolios and the credit quality profile. Colleague Gene Balas, with decades of experience as an economist and strategist, incorporates macro views in portfolio positioning, especially pertaining to risk management for the asset class as a whole.

All investments do carry some risk. Of course, a mitigating factor to price changes is coupon payments. Unless there is a default, the issuer repays the principal value at maturity, lessening some of the risk between now and then. Because you own the bonds in your own account in our Enhanced Income Strategy, not shares of a mutual fund that invests in bonds, you will receive

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This information is intended to describe a general investment strategy and is not a recommendation to buy or sell any specific securities. The strategy discussed does not and should not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. Any investment carries risk, including the loss of principal. Any investment strategy discussed here or available through East End Wealth Management is not an obligation of a bank and is not guaranteed by the FDIC and may lose money. Some investments are not suitable for all investors. Past performance is not indicative of future results. We cannot guarantee that this information is accurate or complete. As with any investment strategy, you should thoroughly discuss your particular investment situation and with your financial representative and understand any investment recommendation that might be made before investing any money.

East End Wealth Management is registered as an investment advisor with the States of New York, Florida and California. East End Wealth Management only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements.

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For more information on East End Wealth Management, including our performance results, please visit our website: www.eastendwealthmanagement.com

that principal value at maturity, unlike a mutual fund investor, who receives no such payment at maturity. That can help mitigate the risk of interest rate movements in a separate account. (See our paper, “Why Invest in Bonds in a Separate Account.”)

Overall, we do believe that bonds belong in those investors’ portfolios whose risk tolerance, tax considerations and time horizon make them suitable. We do recognize that there are those who are bearish on the sector, but we first need to see compelling evidence on why interest rates are likely to rise; the catalyst for doing so is missing, in our opinion.

Even though interest rates may be low by some standards, the potential return from an already-richly valued stock market, incumbent with its own number of identifiable risks, may be even lower than in fixed income markets. In this paper, we’ve pointed to a number of risks that the equity market faces, which correspondingly make fixed income more attractive. And even though yields on benchmarks may be low, we continue to find more attractive opportunities in individual bonds, belying index averages.

We look forward to discussing with you how we can benefit you and how bonds can benefit your portfolio.

Biographies

STEVEN KACZMAREK

gENE d. bAlAS, CfA

Steve is the President of East End Wealth Management. He has over 30 years of experience in trading and risk management in a wide range of markets. Most recently, Steve held the position of Managing Director at Legend Merchant Group. His background also includes the positions of Partner at Schonfeld Securities; a proprietary trading firm, NYMEX floor trader and Lieutenant, United States Army Reserve. Steve graduated New York University with a degree in Economics.

As an active member of the investing, planning and trading community, Steve is a member of NAIFA and the Financial Planning Association. Locally, he is the Chairman of the Southampton Youth Board, focused on youth issues on the East End of Long Island.

Balas has over twenty years’ experience in investment management. He currently writes economic commentary for TheStreet.com’s RealMoney site. Previously, he was Director of Investments at Genworth Financial Asset Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of thematic drivers to develop investment strategy, He also headed the firm’s manager due diligence efforts. Prior to GFAM, Gene was Director, Investment Management & Guidance at Merrill Lynch & Co. In that role, he advised pension funds, endowments and foundations as to appropriate asset allocation strategy. In previous roles, he advised both institutional and individual investors on asset allocation and manager selection decisions, beginning his career in 1989. He has an MBA from Columbia Business School and a BBA in Finance from the University of Houston, where he attended on a full National Merit scholarship. He is a Chartered Financial Analyst.

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