The Core Conundrum: Dealing with Fixed-Income Market Realities

PORTFOLIO STRATEGY RESEARCH | FEBRUARY 2013

THE CORE CONUNDRUM As U.S. monetary policy continues to artificially depress yields on government-related securities, traditional core fixed-income strategies have proven less effective in achieving total return objectives. Compounding this issue is the flagship fixed-income benchmark, which has become heavily concentrated in government and agency debt. As benchmark yields languish around 1.9 percent, the chasm between investors’ return targets and current market realities deepens.

Bridging this gap, without assuming undue credit or duration risk, requires a shift away from the traditional view of core fixed-income management in favor of a more diversified, multi-sector approach. An increased tolerance for tracking error provides the flexibility to increase allocations to undervalued yet high-quality credits across sectors. We believe this approach offers a more sustainable way to improve total risk-adjusted returns in today’s low-rate environment.

1 | PORTFOLIO STRATEGY RESEARCH

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OVERVIEW

Report Highlights

• The combined impact of U.S. monetary and fiscal policy has created the core conundrum: How can core fixed-income investors meet their yield objectives while maintaining low tracking error to the Index, which has become approximately 75 percent concentrated in low-yielding government-related debt?

• The benign credit environment is encouraging investors to take investment shortcuts, such as increasing credit and duration risk, to generate yield.

History has shown that the market has a tendency to underestimate these risks, particularly during periods of monetary policy accommodation.

• In the current environment, we believe the surest path to underperformance is to remain anchored to the past. Investors must develop a new, sustainable, long-term strategy to generate yield without assuming excessive credit or duration risk.

• Accessing short-duration, investment-grade quality securities with considerable yield pickup relative to government and corporate bonds may be the investment blueprint needed to navigate the current low-rate environment and hedge against interest rate risk.

CONTENTS

SEC TION 1 The Core Conundrum

INVES TMENT PROFESSIONAL S

3

SEC TION 2 7 Coping with New Market Realities SEC TION 3 Future Investment Blueprint

10

2 | PORTFOLIO STRATEGY RESEARCH

B. SCOT T MINERD Chief Investment Officer ERIC S. SILVERGOLD Senior Managing Director, Portfolio Manager

ANNE B. WALSH, CFA Assistant Chief Investment Officer, Fixed Income JAMES W. MICHAL Director, Portfolio Manager

KELECHI C. OGBUNAMIRI Associate, Investment Research

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SEC TION 1

The Core Conundrum

In an environment where the benchmark index is heavily concentrated in low-yielding government and agency securities, maintaining low tracking error and pursuing total return targets have seemingly become contradictory objectives. In the following section, we will discuss how recent monetary and fiscal policy has created this conundrum for core fixed-income investors.

Monetary Policy Distorting

Artificially low yields have long been the case with

Government and Agency Markets

Treasuries, and this distortion is increasingly true

Having reached the limits of conventional monetary

for agency mortgage-backed securities (MBS),

policy, quantitative easing (QE) has become the

which have been purchased at the rate of $40 billion

preferred tool for U.S. central bankers to keep interest

per month since the start of QE3 in September

rates artificially low in hopes of stimulating the

2012. With the start of an additional $45 billion per

economy. Over the past five years, the total aggre-

month Treasury purchase program beginning in

gate assets on the Federal Reserve’s balance sheet

January 2013, and the Fed’s statement that highly

increased by a staggering 225 percent (compared

accommodative monetary policy will continue

to 22 percent over the previous five-year period).

at least until specific unemployment or inflation

Recognizing that the Fed’s asset purchases are

targets are reached, Treasury and agency MBS

entirely policy-driven and contrary to natural

markets are likely to remain distorted throughout

market dynamics, investors should pause to fully

the next several years. Today, these overbought

appreciate the attendant implications. Whenever

asset classes currently represent nearly 75 percent

there is an uneconomic buyer making large-scale

of the Barclays U.S. Aggregate Bond Index.

investment decisions irrespective of price, market distortions are inevitable.

3 | THE CORE CONUNDRUM

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The Impact of the Financial Crisis Rise in U.S. Treasury Debt Outstanding since the Financial Crisis $20Tn

2001 – 2006 46%

projected 68%

2007 – 2012 162%

$15Tn

$10Tn

$5Tn

$0Tn 1980

1984

1988

1992

1996

2000

2004

2008

2012

2016

2020

2022

As the U.S. government’s fiscal deficit soared from 1.3 percent of GDP in 2007 to 10.4 percent of GDP by 2009, the resulting impact was a significant rise in Treasury issuance. Treasury debt outstanding grew from $4.5 trillion in 2007 to $11.3 trillion by the end of 2012. The Congressional Budget Office (CBO) projects an additional 68 percent increase to $18.9 trillion over the next ten years.

Source: SIFMA, Congressional Budget Office. Data as of 12/31/2012.

The Evolution of the Core Fixed-Income Universe Reweighting of the Universe toward Risk-Free Assets

19.0%

2007

Treasuries

Agency MBS

Agency Bonds Investment-Grade Bonds

Non-Agency MBS

Taxable Municipals

ABS

34.5%

2012

The massive increase in Treasury debt has reshaped the core fixed-income universe. Since bottoming in 2007 at 19 percent of core bonds outstanding, Treasuries nearly doubled to 35 percent of the universe by 2012. Combined with agency debt, U.S. government assets now comprise almost two-thirds of the core fixed-income universe, and nearly 75 percent of the Barclays Agg. Source: SIFMA, Credit Suisse. Data as of 12/31/2012.

4 | THE CORE CONUNDRUM

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Assessing the Relative Value of the Barclays Agg Historical Yield per Unit of Duration 4%

3%

0.3 %

12/31/2012

2%

1%

0% 1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

Currently, the Barclays Agg is the least attractive it has ever been as measured by yield per unit of duration. Given the Fed’s recent pledge to keep rates low at least until specific unemployment or inflation targets are reached, the Index’s unattractiveness from an investment standpoint is likely to continue in the near term. Source: Barclays. Data as of 12/31/2012.

Fiscal Policy Reconfiguring

the universe of fixed-income assets. However,

Composition of Barclays Agg

the fixed-income universe has evolved over the

Since its creation in 1986, the Barclays U.S.

past twenty years with the growth of sectors

Aggregate Bond Index (the “Index” or the “Agg”)

such as asset-backed securities and municipals.

has become the most widely used proxy for the U.S.

Over the past five years, the composition of the

bond market with over $2 trillion in fixed-income

Barclays Agg has been altered by the massive

assets managed to it. Inclusion in the Agg requires

volume of Treasuries issued in response to the

that securities be U.S. dollar-denominated,

U.S. financial crisis.

investment-grade rated, fixed-rate, taxable, and meet minimum par amounts outstanding. In 1986,

The sheer glut of Treasuries and their increasingly

the fixed-income landscape primarily consisted of

dominant representation in the Index is a trend

U.S. Treasuries, agency bonds, agency MBS, and

unlikely to reverse anytime soon. The need

corporate bonds – all of which met these inclusion

to fund government shortfalls – present and

criteria. Therefore the Agg was a useful proxy for

future – is astonishing. The U.S. Treasury debt

5 | THE CORE CONUNDRUM

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balance totaled $4.5 trillion in 2007. By the end

Anchored to a benchmark heavily allocated to

of 2012, it had skyrocketed to $11.3 trillion. Yet,

sectors yielding negative real rates of return

it is projected to go even higher – hitting $18.9

has forced investors to reassess the traditional,

trillion by 2022, according to estimates from the

benchmark-driven approach to core fixed-income

Congressional Budget Office. As Treasuries climbed

management. While historically, core strategies

from 19 percent of the core fixed-income universe

have had negligible exposure to leveraged credit,

to 35 percent over the last five years, the market-

emerging-market debt, and non-agency structured

capitalization weighted Agg has followed suit.

credit – all of which are typically higher yielding

Treasuries currently comprise 37 percent of the

and commensurately, higher risk segments of the

Agg, and combined with agency debt, total U.S.

fixed-income universe – this aversion to riskier

government-related debt comprises nearly 75

assets appears to be waning given the need for

percent of the Index with a weighted-average yield

yield. In the next section, we will analyze the

of 1.6 percent, as of January 31, 2013.

strategies being employed to generate yield, as investors adjust to new market realities.

Scarcity of Yield across Fixed-Income Landscape Historically Low Yields across Traditional Core Sectors 18% 15% 12% 9% 6%

5.0%

5.5%

0% Sector Weight

1.9%

Barclays Agg 100.0%

4.5% 1.8%

1.0% ABS 0.4%

Historical High

6.6%

5.5%

3.3% 3%

7.9%

8.0%

7.3%

Municipals 1.4% Historical Low

CMBS 1.8% Current

2.8%

2.5% 1.1%

0.9% Corporates 21.6%

Treasuries 36.6%

Agency MBS 29.4%

Agency Bonds 8.9%

Historical Average

With the average yield of the Barclays Agg at 1.9 percent, and 75 percent of the Index allocated to Treasuries, agency MBS, and agency bonds, investors with minimum yield targets have nowhere to hide within the Index and benchmark-driven strategies may continue to fall short of the yield requirements for most institutional investors. Source: Barclays. Data as of 01/31/2013.

6 | THE CORE CONUNDRUM

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SEC TION 2

Coping with New Market Realities As institutional investors evaluate their need to generate yield, a softening stance toward tracking error appears to be emerging, industry-wide.

Traditional yield enhancement techniques, such as increasing duration and lowering credit quality, may boost total returns in the near term, but at what cost? Currently, benign credit conditions may be overshadowing the potentially deleterious, long-term effects of higher credit and interest rate risk.

Prioritizing Yield Targets

low-rate environment. Despite historically low yields,

For investors who service their cash liabilities

materially lowering investment return targets is

through the income stream generated from their

simply not a viable option for particular investor

bond portfolios, relative performance to an Index,

classes. As portfolio return targets remain unhinged

that finished 2012 with a total return of 4.2 percent

from current market yields, many investors have

and a yield of 1.7 percent, is of secondary impor-

begun assuming increased investment risks.

tance, and in some cases, inconsequential. For

Demand for yield has precipitated a relaxation

institutional investors, such as insurance companies,

in underwriting standards and eased the avail-

pension funds, and endowments, absolute yields

ability of credit. For example, during 2012, the

and returns are preeminently important. While

investment-grade and high-yield bond markets

several prominent pension funds recently lowered

set records for issuance. Particularly in the high-

portfolio return estimates by 25 to 50 basis points,

yield market, there was a significant increase in

these diminutive cuts appear largely symbolic

deals lacking covenant protection; volume from

in nature as they fail to address the investment

lower-rated, first-time issuers; and aggressive deal

shortfall concerns emanating from this persistent,

structures. The negative, long-term impact of

7 | COPING WITH NEW MARKET REALITIES

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these worsening trends in new issuance is currently

Asymmetric Risk in Treasuries

being obscured by the benign credit environment,

During the 1940s, the Fed, acting in concert with

a by-product of the Fed’s unprecedented monetary

the Treasury Department, fixed interest rates on

accommodation. As the Fed begins the fifth year of

short-term Treasury bills while committing to buy

its zero-bound monetary policy, continued expec-

long-term Treasury bonds in order to ensure cheap,

tations for low rates would appear to mitigate the

adequate financing for World War II and the

risk of extending duration in pursuit of incremental

attendant recovery. The end of this practice, under

yield. However, using historical precedent as our

the Treasury Accord of 1951, led to a tumultuous

guide, the market sometimes fails to effectively

sell-off in longer-duration bonds as the market

discount the potential for sudden monetary

failed to anticipate the shift in monetary policy.

policy shifts.

Once the Fed inevitably begins removing excess

Historically, the End of Fed Intervention is Bad News for Bonds U.S. 10-Year Treasury Yields since 1800 15% 13%

1

2

Rate Stability

Bear Market in Bonds

10-Year Treasury Yield

11% 9% 7% 5% 3% 1% 1800

Treasury Accord 1815

1830

1845

1860

1875

1890

1905

1920

1935

1950

1965

1980

1995

2010

The removal of Fed support of bond prices at the long end of the curve in 1951 set off a bear market in bonds that lasted thirty years. Could history repeat itself once the current period of low rates ends?

While we do not think this is imminently possible, future policy change is increasingly a concern.

Source: Bloomberg. Data as of 12/31/2012.

8 | COPING WITH NEW MARKET REALITIES

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Era of “Return-Free Risk” U.S. 10-Year Treasury One-Year Holding Period Returns 15% A 20 basis point move in rates wipes away the total return in 10-year Treasuries

Nominal Total Return

10% 5% 0% -150

-100

-50

0

100

150

200

-5% -10% -15% -20% Change in Interest Rates (Basis Points)

U.S. 10-Year Treasury One-Year Holding Period Total Returns

Purchasing 10-year Treasuries at current yields comes with considerable duration risk. Today’s low coupon rates mean a 20 basis point rise in rates would lead to a negative total return over a one-year holding period. With the risk in Treasuries heavily skewed to the downside, we believe Treasuries have gone from offering “risk-free returns” to now effectively becoming “return-free risk.” Source: Bloomberg.

Data as 12/31/2012. The total return scenario is calculated based on the coupon rate of 1.625% and an effective duration of 9.1.

liquidity from the financial system, could a repeat

The dearth of yield within traditional core fixed-

of the 1950s occur? While we do not envision any

income sectors has resulted in an uptick in tracking

sudden monetary policy shifts or a meaningful

error as investors increase allocations to riskier

rise in rates in the near term, given where rates

investments, such as emerging-market bonds and

are today and how grossly overvalued Treasury

high-yield debt. According to eVestment Alliance,

securities have become, the risk to rates is clearly

the average tracking error for core fixed-income

to the upside. At current coupon rates, a 20 basis

strategies rose to 1.09 percent over the past three

point rise in rates would result in a negative total

years ending December 2012, compared to 0.66

return on 10-year Treasuries over a one-year holding

percent in the three-year period from 2005 to 2007.

period. Based on the asymmetrical risk-return

Given investors’ increased willingness to venture

profile, we believe Treasuries have gone from

outside the traditional confines of core fixed-income,

offering “risk-free returns” to now effectively

in the following section, we propose a more optimal

becoming “return-free risk.”

method to generate attractive yields without sacrificing credit quality or extending duration.

9 | COPING WITH NEW MARKET REALITIES

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SEC TION 3

Future Investment Blueprint

While it may seem that increased credit and duration risk have become prerequisites to generate yield, there is a more sustainable, long-term strategy that relies on the ability to uncover quality, investment-grade opportunities outside of the traditional benchmark-driven framework.

Short-Duration Strategy

yields to longer-dated corporate bonds with signific-

Predicated on our view that the risk to interest rates

antly less interest rate risk. While traditional

is to the upside, we would advise investors to

securitizations of credit card receivables, student

shorten portfolio duration and look for innovative

loans, and auto loans represent the majority of the

ways to approach core fixed-income investing.

ABS market, the sector has diversified into more

Shortening duration offers a buffer against rising

specialized, niche segments of securities backed

rates, but this generally comes at the expense

by various types of collateral, such as aircraft

of yield, particularly in corporate credit securities.

and shipping container leases, timeshare vacation

The presumed positive correlation between yield

ownership interests, and franchise fees. Largely

and duration in the investment-grade universe has

owing to its association with the subprime crisis,

driven demand down the credit spectrum into

these types of lesser-known, “orphan” credits suffer

lower-rated, high-yield bonds. A broader investment

from a lingering negative connotation. The illiquidity

focus beyond the traditional core fixed-income

and complexity of these non-traditional, “off-the-

framework demonstrates that lowering duration

run” sectors provide opportunities to generate yield

and producing attractive portfolio yields do

in excess of comparably rated corporate credits.

not necessarily have to be mutually exclusive

While corporate bond investors are exposed to the

investment objectives.

credit risk of a specific issuer or entity, idiosyncratic risks are mitigated in CLOs and ABS through large,

Within the investment-grade universe, floating-rate

diversified collateral pools. Additionally, these

collateralized loan obligations (CLO) and short-

securities offer significant downside structural

duration asset-backed securities (ABS) offer similar

protection during stressed economic environments

10 | FUTURE INVESTMENT BLUEPRINT

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through overcollateralization, excess spread,

These traditional sectors, which represent the

reserve accounts, and triggers that cut off cash

lion’s share of the ABS exposure in the Barclays

flows to subordinated tranches. Lastly, the

Agg, have a weighted-average yield of 1.0 percent.

amortizing structures of many asset-backed

Yields on credit card ABS are currently below

securities reduce credit exposure over time,

1 percent, while yields on auto loans are between

while risks remain constant in corporate bonds

1 and 2 percent. Although student loans offer

due to their bullet maturities.

slightly higher yields of 2 to 4 percent, the regulatory risk coupled with our belief that loan

Monetizing Complexity

prepayments will be low, which would extend

Despite the generally positive credit fundamentals

the average life of the securities to 10 to 15 years,

in traditional ABS sectors, low nominal yields

significantly reduce their relative attractiveness.

decrease the attractiveness of these segments.

Relative Value of ABS and CLOs vs. Corporate Bonds Spread Comparison between BBB-AA-rated ABS, A-rated CLOs, and BBB-A-rated Corporates 2,100bps 1,800bps

1,500bps

1,200bps

900bps CLO 600bps ABS 300bps Corporate 0bps 2002

2004

2006

Largely owing to their association with the subprime crisis, CLOs and ABS frequently offer excess yield over corporate bonds given their increased complexity and illiquidity.

Source: JP Morgan, Bank of America Merrill Lynch. Data as of 12/31/2012.

11 | FUTURE INVESTMENT BLUEPRINT

2008

2010

2012

Spread

High:

Low:

Avg:

Last:

CLO

2,070

68

460

315

ABS

1,983

104

431

200

87

199

163

Corporate 710

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Discovering Yield in the Investment-Grade Universe New Issue, Esoteric ABS Provide Yield without Increased Credit and Rate Risk 8%

Barclays B Corporate Index

Yield to Worst

6%

(A S&P / A Fitch) Barclays BB Corporate Index (A S&P / A Fitch)

4%

Barclays BBB Corporate Index

BofA ML ABS Master BBB-AA Index

Barclays A Corporate Index

2% Barclays U.S. Aggregate Bond Index (AA)

Barclays AA Corporate Index

0% 2

3

4

5 Duration

6

7

8

In the investment-grade complex, ABS is one sector offering leveraged credit-type yields without the commensurate credit risk. Additionally, the shorter duration of ABS securities relative to comparably rated corporate bonds offers greater protection against rising rates.

Source: Bloomberg, Bank of America Merrill Lynch, Barclays. Data as of 12/31/2012. Willis Lease is a U.S. public company and a major lessor of spare aircraft engines. BCP is a leading commercial bank in Peru.

We believe CLOs and ABS backed by aircraft leases

have shorter durations, and offer yields in excess

are the two sectors currently offering the most

of 6 percent on senior BBB tranches – a premium

attractive relative value. CLOs are benefitting from

of almost 300 basis points over corporate bonds.

low bank loan default rates, healthier corporate

Due to the immense diversity and complexity

balance sheets, and robust new loan issuance

of CLOs and ABS, however, ascertaining relative

(nearly $300 billion in 2012). In the aircraft ABS

value requires in-depth analysis of both deal

space, the recent wave of restructurings and

structure and the underlying collateral.

recapitalizations of U.S. airlines have resulted in improved profitability and lower fixed costs.

Long-Duration Strategy

Leasing rates have been supported through the

For investors who need to maintain longer asset

increased demand from airlines that have chosen

duration in order to match their liabilities, floating-

to lease rather than buy aircraft. In addition to

rate CLOs or short-duration ABS can be combined

our favorable view on the underlying collateral,

with longer-duration, fixed-rate securities as part

aircraft ABS securities tend to be amortizing,

of a barbell strategy. (“Barbell” means to structure

12 | FUTURE INVESTMENT BLUEPRINT

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Barbell means to structure a portfolio with both short- and long-duration securities in order to achieve a desired duration target. With a barbell strategy, the negative impact of rising rates on the longer-duration, fixed-rate assets is partially offset by the positive benefit of higher interest coupons on floatingrate securities.

a portfolio with both short- and long-duration

momentum of the housing sector. Home price

securities in order to achieve a desired duration

appreciation will eventually translate into higher

target.) Utilizing this approach provides investors

property tax assessments realized by local govern-

with yield advantages while still meeting portfolio

ments over the next several years.

duration objectives. With a barbell strategy, the negative impact of rising rates on the longer-

Aside from these improving fundamental factors,

duration, fixed-rate assets is partially offset by

the municipal sector may also benefit from technical

the positive benefit of higher interest coupons

catalysts. Building upon the record $50 billion in

on floating-rate CLOs. In the case of ABS, shorter

mutual fund inflows in 2012, continued demand

maturities and principal amortizations allow

for municipals will likely be aided by the expected

investors to reinvest proceeds at higher yields

growth of the U.S. economy throughout 2013.

if rates were to rise over an extended period.

Increased Federal revenues may lead to a decline in Treasury bond issuance, forcing investors into

To complement the short duration of ABS in the

other government-related alternatives such as

barbell strategy, we prefer select, longer-dated,

municipals and military housing. Our focus remains

taxable municipal bonds that offer yield premium

on A-rated revenue bonds maturing within 20 years

to Treasuries and agency debt. The political

that finance essential services, public universities

uncertainty over the past several years, namely

and transportation.

the debt ceiling debate and the Fiscal Cliff, has created attractive valuations in the municipal

Active Management in Practice

market. As investors begin focusing on the real

With nominal coupons across the fixed-income

economy and not the political economy, we believe

universe near historical lows, the opportunity cost

municipals are primed to benefit. According to

from employing a benchmark-driven, passively

the Rockefeller Institute, state tax revenues have

managed strategy has increased dramatically. An

grown for 10 consecutive quarters as employment

actively managed strategy provides the opportunity

at the state and local government level has stabilized.

to generate returns through targeted weightings

California, once the poster child for fiscal ineptitude,

to attractively valued sectors. The volatility of sector

is projecting an $850 million budget surplus for

performance over the past few years, quantified

full year 2014. A longer-term tailwind for municipal

in the following table, underscores the importance

credit fundamentals will be the continued

of active management.

13 | FUTURE INVESTMENT BLUEPRINT

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The Future of Core Fixed-Income

the demand for absolute yield, antiquating investors’

The traditional view of core fixed-income did not

historical focus on relative performance.

include active duration management, increased tolerance for tracking error, or significant allocations

In pursuing yield targets, investors must not allow

to non-indexed sectors such as floating-rate CLOs

short-term pursuits to derail long-term investment

and “off-the-run” ABS. As the chasm between

objectives. We believe the global easing cycle will

investors’ return targets and current market yields

continue to support a benign credit environment

deepens, it is apparent that the traditional view of

over the next two to three years; however, the current

core fixed-income management requires innovation.

accommodative conditions are likely masking a

The historically low-rate environment has intensified

comprehensive appreciation of investment risks.

Asset Allocation Matters, Particularly in Today’s Low Yield Environment Historical Annual Fixed-Income Sector Returns 2006

2007

2008

2009

High Yield

Treasuries

Treasuries

11.8

%

Leveraged Loans

7.3

%

9.0

%

Municipals

7.6

%

13.7

%

Municipals

7.0

%

2010

2011

2012

High Yield

High Yield

Municipals

High Yield

%

%

%

58.2

Leveraged Loans

44.9

%

ABS

IG Corporates

IG Corporates

-4.9%

24.7%

IG Corporates

ABS

ABS

IG Corporates

4.7% 4.3

%

Municipals

3.2

%

Treasuries

3.1%

4.6 % 2.2

%

Leveraged Loans

1.9

%

High Yield

1.9%

-12.7

%

High Yield

-26.2

%

Leveraged Loans

-28.8%

ABS

18.7

%

Municipals

0.7

%

Treasuries

-3.6 %

15.1

Leveraged Loans

10.0

%

18.1

15.8% IG Corporates

Treasuries

9.8

9.8%

%

IG Corporates

IG Corporates

Municipals

Municipals

ABS

Leveraged Loans

9.0 % 7.2

%

Treasuries

5.9

%

ABS

5.9%

8.1% 5.1

9.4%

%

High Yield

5.0

ABS

3.7%

%

Leveraged Loans

1.8%

9.6 %

Treasuries

2.0 %

With nominal yields near historical lows, price performance is likely to become a larger component of total returns in the near term. Active asset allocation provides the opportunity for a portfolio to generate returns through increased weightings to attractively valued sectors and decreased weightings to overvalued asset classes. Source: Barclays, Credit Suisse. Data as of 12/31/2012.

14 | FUTURE INVESTMENT BLUEPRINT

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The Changing of the Guard The Future of Core Fixed-Income Management Traditional View: Barclays Agg YIELD

WEIGHT

U.S. Treasuries Agency MBS

Agency Bonds

1.3%

Corporates

Corporates

2.7%

RMBS n/a

RMBS

CMBS

74.7%

CMBS

1.7%

Taxable Municipals

gov.-related debt

Taxable Municipals

3.2%

ABS

ABS

0.9% 1.7%

Weighted-Average Yield 0%

1%

Weighted-Average Yield

2%

3%

4%

5%

0%

Future View: Guggenheim Core Fixed-Income U.S. Treasuries WEIGHT

U.S. YIELD Treasuries

0.9%

Agency MBS Agency Bonds U.S. Treasuries

0.9%1.3%

2.7% 2.2% gov.-related debt

RMBS n/a Agency Bonds

1.3%

CMBS Corporates

1.7%

RMBS Agency Bonds

2.3%

1.7% 2%

3.2% 3%

4%

5%

1.7%

Weighted-Average Yield 1%

0%

2%

4.2% 5.0%

CMBS Corporates 3.2%

1% 0.9%

2.3% 2.3%

4.2% 4.7%

Taxable Municipals RMBS

5.0% 4.8%

ABS CMBS

4.7%4.9%

0.9% 1.7%

Weighted-Average Yield Taxable Municipals ABS 0%

2.3% 1.0%

Corporates Agency MBS

2.7%

Taxable Municipals RMBS n/a ABS CMBS

Agency Bonds U.S. Treasuries

16.6%

Corporates Agency MBS

1.0%

Agency MBS

2.2%

Weighted-Average Yield Taxable Municipals ABS 0%

1%

2%

3%

4%

5%

4.2% 4.8% 5% 4.9%

4%

Weighted-Average Yield 3%

4.2%

0%

1%

2%

3%

4%

5%

With the traditional view of core fixed-income management quickly becoming antiquated in today’s U.S. Treasuries 1.0% low-yield environment, investors must begin looking forward towards the future of core fixed-income Agency MBS 2.3% management. Source: Barclays, Guggenheim Investments. Data as of 12/31/2012. Sector allocations are based on the representative

2.2%

Agency Bonds

2.3%

account of the Guggenheim Core Fixed-Income Strategy and excludes cash.

Corporates

2.7%

4.2%

RMBS

5.0%

CMBS

4.7%

Taxable Municipals

3.2%

4.8%

ABS

Given the overwhelming emphasis on total return, Weighted-Average Yield

7% 3%

4%

5%investors

must be vigilant in identifying the 1% 2% 3% risks 4% 0%

4.9%

4.2%

involved in reaching for incremental yield, since “not all yield is created equal.” Employing investment

By remaining tightly aligned to the Barclays Agg, which 5%

is currently bloated with low-yielding

government-related debt, investors are giving up the flexibility to take advantage of undervalued

shortcuts, such as increased credit or interest

sectors and underweight unattractive ones. In

rate risk, solely to generate yield may come at the

a market coping with unprecedented monetary

expense of future performance. Achieving yield

conditions, we believe the surest path to underper-

targets without assuming undue risk has proven

formance is to remain anchored to outdated core

extremely difficult under the traditional framework.

fixed-income conventions of the past.

We believe it is achievable under a broadened investment framework.

15 | FUTURE INVESTMENT BLUEPRINT

1.0%

Agency MBS

2.2%

Agency Bonds

7%

%

U.S. Treasuries

0.9%

GUGGENHEIM PARTNERS

1%

About Guggenheim Partners Guggenheim Partners is a privately held financial services firm that provides asset management, investment banking, and insurance solutions. At Guggenheim Partners, we combine innovative thinking and experienced advice to sophisticated clients. Our primary businesses include: INVES TMENTS

SECURITIES

INSUR ANCE

Fixed Income Equities Alternatives Managed Account Platform Asset Allocation

Advisory Financing Sales and Trading Research

Life and Annuity Capital Solutions Wealth Protection

About Guggenheim Investments Guggenheim Investments represents the investment management division of Guggenheim Partners, which consist of investment managers with approximately $143 billion in combined total assets.1 Collectively, Guggenheim Investments has a long, distinguished history of serving institutional investors, ultra-high-networth individuals, family offices, and financial intermediaries. Guggenheim Investments offers clients a wide range of differentiated capabilities built on a proven commitment to investment excellence. Guggenheim Investments has offices in Chicago, New York City, and Santa Monica, along with a global network of offices throughout the United States, Europe, and Asia.

NEW YORK

CHIC AGO

SANTA MONIC A

LONDON

135 E 57th St | 10022 212 739 0700

227 W Monroe St | 60606 312 827 0100

100 Wilshire Blvd | 90401 310 576 1270

5 Wilton Road | SWIV 1AN +44 207 052-8272

Assets Under Management(AUM) is as of 12.31.2012 and includes $10.71B of leverage. AUM includes assets from Security Investors, Guggenheim Partners Investment Management, LLC (“GPIM”, formerly known as Guggenheim Partners Asset Management, LLC; GPIM assets also include all assets from Guggenheim Investment Management, LLC which were transferred as of 06.30.2012), Guggenheim Funds Investment Advisors and its affiliated entities, and some business units including Guggenheim Real Estate, Guggenheim Aviation, GS GAMMA Advisors, Guggenheim Partners Europe, Transparent Value Advisors, and Guggenheim Partners India Management. Values from some funds are based upon prior periods.

1

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC (“GP”): GS GAMMA Advisors, LLC, Guggenheim Aviation, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Partners Investment Management, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners India Management, Guggenheim Real Estate, LLC, Security Investors, LLC and Transparent Value Advisors, LLC. Guggenheim Partners Investment Management, LLC (GPIM) is a registered investment adviser and serves as the adviser to the Core Fixed Income Strategy. GPIM is included in the GIPS compliant firm, Guggenheim Investments Asset Management, and is also a part of Guggenheim Investments. This material is intended to inform you of services available through Guggenheim Investments’ affiliate businesses.

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. This article contains opinions of the author but not necessarily those of Guggenheim Partners or its subsidiaries. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy.

Past performance of indices of asset classes does not represent actual returns or volatility of actual accounts or investment managers, and should not be viewed as indicative of future results. The benchmarks used are for purposes of comparison and should not be understood to mean that there will necessarily be a correlation between the portrayed returns herein and these benchmarks.

Past performance is not indicative of comparable future results. Given the inherent volatility of the securities markets, it should not be assumed that investors will experience returns comparable to those shown here. Market and economic conditions may change in the future producing materially different results than those shown here. All investments have inherent risks.

No representation or warranty is made to the sufficiency, relevance, importance, appropriateness, completeness, or comprehensiveness of the market data, information or summaries contained herein for any specific purpose. © 2013 Guggenheim Partners LLC. All Rights Reserved. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of Guggenheim Partners LLC.

16 | PORTFOLIO STRATEGY RESEARCH

GUGGENHEIM PARTNERS