Xavier Student Bond Investment Fund
Fund Managers
Radhi Alzayer
Mike Knapke
Sunil Kumar
John Mulligan
Steve Stull
Fund Professor
Dr. Stafford Johnson, Professor
Department of Finance
XSBIF Committee Members
Tami Hendrickson
Vice President, Treasurer
Federal Home Loan Bank
Doug Gerstle
Assistant Treasurer
Procter and Gamble
Bill Effler
Former Senior Vice President
American Money Management
Brian Gilmartin
Portfolio Manager
Trinity Asset Management
John Horan
Vice President
Merrill Lynch
Kim Renners
Investment Manager
OJM Group
Bill Hogan
Senior Vice President
American Money
Management
Becky Wood
Managing Principal
Fund Evaluation Group
Fort Washington Investment Advisors, Inc.
Paul Tomich, CFA
Roger Lanham, CFA
Dan Carter, CFA
Tim Policinski, CFA
1
Table of Contents
Investment Policy Statement………………………………………………………………..
3
Executive Summary…………………………………………………………………………
4
August 2012 Holdings and Characteristics…………………………………………………
5
Position and Performance—August-November, 2012……………………………………...
8
Analysis of Current Investment and Economic Climate……………………………………
12
Portfolio Trades. ……………………………………………………………………………
24
November 2012 Holdings & Characteristics………………………………………………..
28
Horizon Analysis……………………………………………………………………………
30
Position and Recommendations…………………………………………………………….
32
Appendix ……………………………………………………………………………………
33
2
Investment Policy Statement
The Xavier Student Bond Investment Fund (XSBIF) manages a portion of the Xavier University
Endowment as a fixed-income fund. The Fund seeks total return benchmarked against the BAC
Merrill Lynch U.S. Corporate & Government Master Index (B0A0). The primary investments of
the fund are investment grade corporate credits, U.S. Treasuries and agencies. The secondary
investments are Treasury Inflation Protected Securities (TIPS), taxable municipals, dollardenominated sovereign credits, agency pass-throughs, floating rate notes, preferred stock and the
Fort Washington High Yield Fund, LLC. The primary objective of the Fund is to provide
preservation of capital with an emphasis on long-term growth of capital without undue exposure
to risk.
Guidelines:
1. Duration of the portfolio will be set based on current and expected market conditions that
will yield optimal performance given investment objectives and risk profiles.
2. Exposure to the high yield market may be accomplished through investments in the Fort
Washington High Yield Fund, LLC. No More than 10% of the market value of the
portfolio may be allocated to this high yield fund.
3. All positions must be denominated in U.S. dollars.
4. With the exception of the U.S. Treasuries, no more than 5% of the portfolio market value
may be invested in a single issue or corporate entity.
5. With the exception of the high yield exposure, each debt instrument must be investment
grade prior to inclusion in the portfolio.
6. Preferred stock must be trust preferred stocks that are investment grade.
7. No more than 10% of the market value of the portfolio may be invested in preferred
stock.
8. The portfolio will be rebalanced at least annually to maintain target allocations.
9. Debt issues with split ratings from Standard & Poor’s, Moody’s, and Fitch rating services
will be governed by the lowest rating.
10. The fund managers will make management decisions in accordance with the Xavier
University Endowment Fund Investment Policy Statement and the Investment Objectives.
3
Executive Summary
The Xavier Student Bond Investment Fund commenced the semester holding a portfolio
of assets with an over-allocation to intermediate-term and corporate bonds with lower duration
and convexity than that of the benchmark BAC Merrill Lynch Index (B0A0). With these
characteristics and a declining interest rate environment, the fund outperformed the index by
37bp over the period of August 20 – November 9, 2012.
Over the past semester, the fund faced an economic climate full of uncertainty and slow
growth in spite of the extraordinary expansionary fiscal and monetary actions taken by the U.S.
since the financial collapse in 2008. Increasing debt and deficits, political gridlock, rising
commodity prices, and concerns over global economic health have contributed to the slow
growth in the U.S. and continues to present businesses and investors with uncertainty. Looking
forward, the fund expects to see slow economic growth in the U.S. and global economy in the
mid- to long-term horizon. There is also growing concern over the potential economic impact of
global austerity measures as we see governments around the world attempting to deal with outof-control budgets.
Given the outcome of the U.S. presidential and congressional election, anxiety over
global economic health, and potential impacts of fiscal tightening, the fund managers decided to
prepare for an environment with widening credit spreads and a possible flight to safety that could
put additional downward pressure on Treasury yields. The managers voted to decrease the fund’s
corporate allocation and increase its Treasury exposure and portfolio duration distribution to the
positively-sloped intermediate segment of the yield curve. In performing a one-year horizon
analysis on the portfolio, the managers found the portfolio positioned to outperform the
benchmark B0A0 Index in the event of stable to declining interest rates. As the economic growth
story unfolds, future considerations for the fund have included increased exposure to
intermediate Treasuries or Mortgage-Backed Securities.
4
August 2012 Holdings and
Characteristics
Exhibit 1 lists the holdings of the fund and the fund’s characteristics compared to the
index as of August 15, 2012. As shown, the portfolio consisted of 43 credits, with a market
value of $1.273 million. Relative to the index, the fund was underweight in Treasuries and
Federal Agencies (32% compared to 59%), while overweight in corporate bonds (67% compared
to 33%). The fund had a cash position of 2%. The YTW of the fund was 2.359%, lower than the
benchmark YTW of 1.638%. With respect to quality distributions relative to the index, the fund
had a smaller allocation to AAA-rated bonds and approximately the same allocation to A-rated
bonds, and greater allocations to BBB-rated credits. The fund also had 10% invested in Fort
Washington High Yield Fund, which consists of bonds with an average quality rating of B. The
overall portfolio quality rating of the fund was A+, lower than the Benchmark’s AA rating. The
modified duration of the fund was 5.821, lower than the index’s duration of 6.046, and the
convexity of the fund was .738, similar to the index’s convexity of .772. The fund was
overweight in bonds with a modified duration values between 0-1 and 3-5 years.
Exhibit 1: August 2012 Holdings and Characteristics – Portfolio vs. B0A0 Index
Indicator
Bloomberg Composite Rating
Coupon
Maturity (Years from Today)
Market Value
Yield to Worst
Modified Duration
Option Adjusted Duration
Convexity
Portfolio
A+
4.881
8.984
$1,273,270
2.359
5.821
5.886
0.738
Benchmark
AA
3.521
8.229
NR
1.638
6.046
6.123
0.772
+/1.360
0.755
NR
0.721
-0.225
-0.237
-0.034
5
August 2012 Holdings and
Characteristics
Issuer
BB Comp
XSBIF 8/1/2012
A+
› Cash
› Corporate Debt
ALLY FINANCIAL INC
B+
BANK OF AMERICA CORP
ACITIGROUP INC
ACENTERPOINT ENERGY INC BBBCANADIAN NATL RESOURCES BBB+
CAPITAL ONE FINANCIAL CO BBB+
CONOCOPHILLIPS
A
CVS CAREMARK CORP
BBB
DOMINION RESOURCES INC BBB+
E.I. DU PONT DE NEMOURS
A
DUKE ENERGY CAROLINAS
AGENERAL ELECTRIC CO
AA
GENERAL MILLS INC
BBB+
GOLDMAN SACHS GROUP INC AINTL PAPER CO
BBBJC PENNEY CORP INC
B+
MONDELEZ INTERNATIONAL BBBNEW YORK LIFE GLOBAL FDG AA+
PETROBRAS INTL FIN CO
BBB
AT&T INC
ATEVA PHARMACEUT FIN BV AUS BANK NA
A+
VERIZON COMMUNICATIONS A› Government Debt
FEDERAL HOME LOAN BANK AAA
FREDDIE MAC
AAA
FREDDIE MAC
AAA
FREDDIE MAC
AAA
FANNIE MAE
AAA
US TREASURY N/B
AAA
US TREASURY N/B
AAA
US TREASURY N/B
AAA
US TREASURY N/B
AAA
US TREASURY N/B
AAA
› Securitized Debt
FN AH0524
AAA
FN AH2711
AAA
Cpn Mty (Yrs) Px Close Mkt Val
Wgt YTW Mod Dur
4.88
8.99
$ 1,272,735 100.00 2.37
5.83
0.00
0.00
$ 25,000
1.96 0.00
0.00
OAD
Cvxty
5.90
0.74
0.00
0.00
6.25
5.00
5.50
5.95
6.25
7.38
5.90
5.75
5.95
5.00
5.63
5.00
3.15
7.50
7.40
7.95
6.13
5.38
5.38
5.63
2.40
6.30
4.90
5.06
8.50
1.93
4.23
25.34
1.53
19.93
4.56
22.59
0.68
0.05
0.23
9.10
6.26
1.59
4.39
5.23
0.85
8.21
3.59
4.00
1.23
2.84
108.50
107.35
106.57
114.33
131.28
110.27
130.76
119.16
129.63
104.32
101.61
102.18
104.24
117.57
110.57
96.13
121.37
105.30
111.73
117.11
104.64
108.20
112.19
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
77,775
21,687
27,047
28,582
33,411
44,666
33,125
18,018
26,078
26,136
20,513
15,327
41,856
36,308
22,304
74,081
36,411
26,832
27,947
17,674
52,590
22,260
22,808
6.11
1.70
2.13
2.25
2.63
3.51
2.60
1.42
2.05
2.05
1.61
1.20
3.29
2.85
1.75
5.82
2.86
2.11
2.20
1.39
4.13
1.75
1.79
4.44
4.00
2.40
2.55
4.24
1.56
3.72
1.60
3.97
0.40
0.52
0.50
2.62
4.38
1.60
8.98
1.99
0.57
3.75
1.09
1.28
0.77
0.91
4.51
7.07
2.06
4.00
14.11
1.70
12.73
4.27
13.69
0.94
0.33
0.50
7.89
5.13
1.76
3.70
4.79
1.08
6.89
3.52
4.05
1.42
2.89
4.53
7.19
2.06
4.02
14.50
1.70
13.05
4.29
14.06
0.94
0.33
0.50
8.23
5.18
1.76
3.72
4.82
1.08
7.00
3.53
4.06
1.42
2.89
0.25
0.60
0.05
0.19
2.85
0.04
2.18
0.22
2.57
0.01
0.00
0.00
0.72
0.33
0.04
0.17
0.27
0.02
0.57
0.15
0.19
0.03
0.10
4.00
3.00
3.75
6.25
5.00
1.25
2.75
3.13
4.38
9.13
0.82
1.71
6.37
19.68
2.43
6.47
6.26
8.51
28.51
5.51
104.07
105.32
116.16
151.63
112.40
101.84
111.61
114.94
137.92
147.31
$
$
$
$
$
$
$
$
$
$
21,137
52,671
23,491
22,786
17,081
51,080
73,371
40,460
90,252
29,849
1.66
4.14
1.85
1.79
1.34
4.01
5.76
3.18
7.09
2.35
0.27
0.32
1.21
2.84
0.38
0.97
0.92
1.32
2.52
0.75
1.07
1.95
5.91
13.09
2.54
6.44
5.97
7.74
18.18
4.78
1.07
1.94
5.97
13.43
2.54
6.52
6.04
7.90
19.15
4.80
0.02
0.05
0.41
2.24
0.08
0.46
0.41
0.69
4.39
0.28
4.00
4.00
28.08
28.16
107.24 $
107.24 $
36,783
35,340
2.89 1.72
2.78 1.74
3.27
3.29
2.38
1.65
0.21
0.22
6
August 2012 Holdings and
Characteristics
7
Position and Performance
August 20 – November 9, 2012
With the portfolio’s duration distribution weighted slightly more in intermediate-term
bonds and with the overall duration less than the index, the portfolio was positioned in August to
outperform the index under a stable or increasing interest rate scenario with some small gains
coming from trading down the yield curve if the curve remained steep in the intermediate
segment. In addition, with a greater proportion of the fund invested in corporate credits and less
allocated to Treasury and agency bonds, the fund was positioned to outperform the index if there
was narrowing of credit spreads.
As shown in Chart 1, the on-the-run/off-the-run Treasury yield decreased slightly from
August to November, while maintaining a positive slope in the intermediate segment. With the
lower duration, this downward shift increased the Fund’s total return on governments less than
the Benchmark’s return. However, the yields on lower quality bonds also decreased during this
period, with the yield curve shifting down as well (Chart 1). With the fund’s greater allocation to
corporate credits, the corporate yield curve shift led to a greater increase in the fund’s total return
on corporates than the benchmark’s return, with this effect dominating the smaller duration
effect. As a result, from August to November, the fund outperformed the Benchmark (see
Exhibit 2). As for individual corporate credits, the fund had a greater allocation in financials.
Based on total return, the best perofmers for year to date were Bank of America (20.05%) and
Goldman Sachs (20.06%).
8
Position and Performance
August 20 – November 9, 2012
Chart 1: Historical Yield Curve, August to November
Treasury On-the-Run-Off-the-Run and Industrial B-Rated Yield Curves
Treasury Yield Curves—August and November
B-Industrials Yield Curve—August and November
9
Position and Performance
August 20 – November 9, 2012
Exhibit 2: Total Return - XSBIF and B0A0 Index
August 20, 2012-Novermber 9, 2012
10
Position and Performance
August 20 – November 9, 2012
Name
XSBIF
› Cash
› Corporate Debt
ALLY 6 ¼ 12/01/17
BAC 5 05/13/21
C 5 ½ 10/15/14
CNP 5.95 02/01/17
CNQCN 6 ¼ 03/15/38
COF 7 ⅜ 05/23/14
COP 5.9 10/15/32
CVS 5 ¾ 06/01/17
D 5.95 06/15/35
DD 5 07/15/13
DOLE 8 10/01/16
DUK 5 ⅝ 11/30/12
GE 5 02/01/13
GIS 3.15 12/15/21
GS 7 ½ 02/15/19
HCP 3 ¾ 02/01/19
IP 7.4 06/15/14
JCP 7.95 04/01/17
MDLZ 6 ⅛ 02/01/18
NYL 5 ⅜ 09/15/13
PETBRA 5 ⅜ 01/27/21
T 5 ⅝ 06/15/16
TEVA 2.4 11/10/16
USB 6.3 02/04/14
VZ 4.9 09/15/15
› Government Debt
FHLB 4 09/06/13
FHLMC 3 07/28/14
FHLMC 3 ¾ 03/27/19
FHLMC 6 ¼ 07/15/32
FNMA 5 04/15/15
T 0 ¼ 02/15/15
T 1 ¼ 04/30/19
T 1 ⅝ 08/15/22
T 2 ¾ 02/15/19
T 3 ⅛ 02/15/42
T 3 ⅛ 05/15/21
T 4 ⅜ 05/15/41
T 9 ⅛ 05/15/18
› Securitized Debt
FN AH0524
FN AH2711
% End Wgt
100.00
1.82
55.78
5.84
1.68
1.97
2.15
2.43
3.29
2.41
1.34
1.92
1.90
1.49
1.12
3.13
2.77
1.63
5.68
2.71
1.91
2.06
1.29
3.87
1.58
1.63
37.69
1.51
3.84
1.70
1.68
1.22
0.73
3.71
4.04
5.30
2.38
2.96
6.46
2.18
4.70
2.42
2.28
% Tot Rtn 1M
0.75
0.00
0.56
0.90
0.97
0.41
0.85
1.95
-0.07
1.10
0.04
3.18
-0.09
0.08
-0.01
-0.01
2.19
0.94
0.60
0.25
-0.57
0.52
0.05
-1.45
-0.50
0.16
0.02
-0.29
1.23
0.00
0.04
0.51
2.48
-0.03
-0.05
0.55
0.61
0.45
1.70
1.00
3.45
0.25
-0.18
-0.15
-0.21
% Tot Rtn 1Y
7.26
0.00
9.06
21.16
31.18
6.39
8.17
9.10
4.64
10.88
8.27
10.72
0.96
0.33
1.22
1.25
9.74
19.63
0.60
6.13
2.73
9.03
1.87
10.69
5.61
8.05
2.75
3.91
5.66
0.52
1.08
6.10
11.28
1.72
0.40
3.21
-0.99
4.77
8.96
6.50
9.81
3.35
4.35
2.96
4.27
11
XSBIF Analysis of the Current
Investment & Economic Climate
Since the recession ended in mid-2009, U.S. GDP has grown at an annualized rate of just
2.2%. This growth—albeit modest—is primarily attributed to the expansionary monetary and
fiscal policy actions undertaken since the 2008 financial collapse. Since 2009, the Federal
Reserve has continued to maintain its policy of quantitative easing, keeping short-term rates near
zero, and continuing to inject cash into the financial system. These actions combined with the
Fed’s earlier actions of moving the bad loans of commercial banks and financial institutions to
its balance sheets, implementing (with the Treasury) Bank Stress tests that forced banks to raise
more funds privately or via TARP, and continuing “Operation Twist” policies of selling shortterm securities and purchasing long-term securities all served to stabilized the banking industry
and lower intermediate rates.1 Currently, bank capital ratios exceed pre-crisis levels and most
TARP loans have been repaid. In September, the Federal Open Market Committee voted to adopt
a third round of quantitative easing, “QE3,” as a means to support the fragile housing market and
spur new hiring by businesses. The Fed announced it would establish a policy of purchasing
approximately $40 billion per month of agency mortgage-backed bonds. This is the first time
that the Fed has specified a specific volume per month of asset purchases. The Fed also took the
unusual step of leaving open the horizon for these purchases. In leaving open the time frame for
these purchases the Fed signaled that it would take whatever monetary steps are available to it as
a means of spurring the economy and reducing unemployment.
Similarly, the Obama Administration’s fiscal policy stimulants also served to pull the
economy out of the recession and possibly avert a second one. The Administration’s fiscal policy
actions were on a scale similar to FDR’s policies of the 1930s; they included: government
spending increases as part of the $800 billion American Recovery and Reinvestment Act,
increases in direct transfers (food stamps, unemployment insurance, and subsidies to state and
local government for Medicaid), and a $600 billion fiscal stimulant that included a two-year
payroll-tax reduction. The Obama Administration’s fiscal actions, though, significantly increased
the deficit from $459 billion in 2008 to $1.8 trillion in 2009, to $1.258 trillion in 2010, and to
$1.2 trillion in 2011, pushing the U.S. debt from 70% of GDP in 2008 to 98%. These high debt
levels, in turn, have led to a credit downgrade, brought into question by the U.S. government’s
ability to continue incurring debt, and raised the possibility of a potentially deeper fiscal crisis in
which the U.S. would have to implement more robust austerity programs.
The Federal Reserve’s balance sheet expanded from $929 billion at the end of 2007 to $2.291 trillion in December
2008 and $2.029 trillion in January 2009.
1
12
XSBIF Analysis of the Current
Investment & Economic Climate
Deficits
Debt
Deficits/GDP
Debt/GDP
Slow Economic Recovery Rate
The 2.2% growth rate in the U.S. economy, since 2009, represents one of the slowest
economic recoveries on record—an economic recovery rate that has not been able to bring about
job growth. The unemployment and underemployment rates still remain high, with
unemployment at 7.9% and underemployment at 14% as of October 31, 2012. Certain economic
factors, such as the type of fiscal policy stimulant, energy prices, the European debt crisis, and
declining economic growth rates in China, India, and other emerging market countries, have
13
XSBIF Analysis of the Current
Investment & Economic Climate
served to slow the U.S. economic recovery and curtail the positive impacts of the fiscal policy
stimulant, low interest rates, and a stable banking system.
Some economists point out that while the size of the fiscal stimulant has been large, many
of the government expenditures were direct transfer payments that typically have GDP multiplier
effects that are smaller and of shorter durations than the multiplier effects resulting from capital
expenditure increases. In addition, given the slow growth in electric car sale, the competition
from China in solar panels, and the growth in natural gas from shale rock, the impact from
government investments and support of green technologies, electric car batteries, and high speed
rail may have been small if not negative.
Real GDP (2005 Dollars)
Unemployment
Economic recovery has also been slowed by the rise in oil prices. With the upheavals in
the Middle-East, crude oil prices have averaged $96 per barrel over the past year (NYMEX WTI
crude oil index), with a range between $79.47 and $109.8. Other commodity and agriculture
prices such as corn, aluminum, lumber, and copper have also remained at relatively high levels
(see Exhibit 3: Commodity Price Table).
14
XSBIF Analysis of the Current
Investment & Economic Climate
Exhibit 3: Commodity Price Table
Crude Oil Prices
Corn
Gasoline Prices
Lumber
15
XSBIF Analysis of the Current
Investment & Economic Climate
Copper
Aluminum
The economic growth rate in China, as well as other emerging market countries, has also
been slow. China grew at a rate of 8.9% in 2011 and is projected to grow at a slightly slower rate
of 8.4% in 2012, with a projected inflation rate of 3.5%. This contrasts with an average growth
rate of 11.5% in 2007. There are also growing concerns about China’s investment expenditures
and export growth occurring at the expense of consumption, its growing wealth gap, and its
excessive mis-investments. To redress the slower growth, China did reverse its earlier tight
monetary policy by lowering reserve requirements and benchmark rates. In addition to China, the
IMF recently reported that the growth rates of emerging market countries has slowed and that
world economic indicators show a slowing global economy (see Exhibit 4 for an analysis of the
China’s economic challenges).
China Annual GDP Rate 2003-2012
16
XSBIF Analysis of the Current
Investment & Economic Climate
Exhibit 4: China’s Economic Challenges
Throughout the U.S. economic recovery and the financial crisis in Europe, China has
continued its robust growth pattern, with GDP exceeding 8% annual growth each of the past five
years. The primary driver of this strong growth has been China’s continued high levels of
investment in fixed assets such as infrastructure, machinery, and housing. As a proportion of
GDP, China’s fixed investment amounts to 48% of the country’s total output—a proportion that
exceeds the peak levels experienced by Japan and South Korea during their own economic
modernization periods during the 1960’s and 1990’s, respectively. However, China’s private
consumption as a proportion of GDP is currently only 33%—a share that has declined steadily
since its own economic expansion and modernization began in the early 1980’s. The challenge
for the Chinese economy over the next several decades will be how it transitions to a more
consumption-based economy rather than a fixed investment-based economy.
Although China’s capital intensity, or amount of fixed capital assets per person, is low
relative to Japan, the U.S., and South Korea, there is concern among some economists that much
of China’s output and employment is concentrated in investment-supporting industries such as
steel and construction. It may therefore be difficult for the Chinese economy to transition to more
of a service- and consumption-based economy. As a result of the difficulties in making this
transition, the impact on US-based corporations such as P&G, Caterpillar, and General Motors
remains to be seen. Maintaining and growing the incomes of the Chinese middle class and
reducing the stratification of incomes is a high priority for the Chinese communist party
leadership. However, to accomplish this, it is widely believed that China must begin to consume
the output of its large industrial sector domestically rather than through exports.
Although its trade surplus remains substantial (approximately $201 billion, or 2.8% of
GDP), China’s net exports have softened in recent years as a result of deteriorating economic
conditions in the U.S. and Europe (China’s primary outlets for its export activity). In addition,
with the slower flow of inexpensive, low-skilled labor to the Chinese coastal cities from the rural
western parts of China and with the workforce becoming more skilled, there has been an increase
in Chinese labor costs. Thus, while China is still a relatively inexpensive source of labor, this
labor cost advantage over more developed economies is decreasing. Moreover, some economists
argue that in order to maintain full employment, the propensity of Chinese consumers to save
rather than consume must be reduced.
17
XSBIF Analysis of the Current
Investment & Economic Climate
China Real GDP 2007-2012 (Annual YoY %)
In the Euro Zone, the fiscal crisis that began in Greece, Ireland, and Portugal and then
extended to Spain and Italy still threatens to lead to sovereign debt defaults and the collapse of
the euro. The crisis was temporarily averted by European Central Bank purchases of sovereign
debt.2 In March 2012, the European Financial Stability Facility, with its €700 billion lending
capacity and authority to issue bonds, began recapitalizing banks in Spain and providing loan
assistance.3 In Greece, the implementation by the ECB and the EU of “Collective Action
Clauses” (CAC) led to Greek creditors exchanging their debt for new bonds with reduced interest
and principal in return for the Greek government’s agreement to reduce its deficit-to-GDP ratio.4
Greece’s government, in turn, was able to successfully pass several unpopular austerity measures
2
The European Central Bank (ECB) administers the monetary policy of the 17 EU member states. During the period
the ECB held rates constant at 1%. On February 29, 2012 the ECB held a 36 month auction, referred to as
“LTRO2,” to provide 800 euro zone banks with €530 billion in 1% loans.
3
The European Financial Stability Facility (EFSF) was created in response to the European sovereign debt crisis.
The facility has €700 billion in lending capacity and has the authority to issue bonds or other debt instruments to
raise necessary capital. On March 16, 2012, the EFSF committed €109.1 billion over four years to the second Greek
bailout after covering the costs of the Greek debt swap. Overall, the EFSF has committed €192 billion in the three
bailouts of Ireland, Portugal, and Greece.
4
The invocation of the CAC caused The International Swaps and Derivatives Association to declare the triggering
$3.2 billion of credit default swaps (sellers to pay $2.4 billion). Had Greece defaulted in 2010, banks would have
lost approximately $51 billion at a 25% recovery rate. Due to the delay, the majority of losses were shifted to
European taxpayers. Upcoming elections add political risk, potentially jeopardizing the austerity policies demanded
by bailout funds.
18
XSBIF Analysis of the Current
Investment & Economic Climate
that included sharp cuts to pensions, salaries and social services, as well as tax increases. In
Spain, the ECB and EFSF loan assistance and recapitalization programs similarly required that
Spain implement austerity programs to reduce its deficit-to-GDP from 9.2% to 6%.5 With
Spain’s debt-to-GDP now at 145% and Greece’s ratio approaching 190% and with
unemployment in Spain at 25.8%, there continues to be a realistic fear that these targets will not
be reached.
Slow Economic Recovery from the Financial Crisis
The slow recovery rate from the collapse of the real estate market in the U.S. is consistent
with recovery rates from previous financial crises. Normally, recoveries from financial crises
such as Japan’s asset bubble, the 1980’s emerging market crisis, or the 1930’s stock market crash
take longer than “V-shaped” recoveries following cyclical recessions. The U.S. continues to
experience a slow process of deleveraging. Since 2009, the growth in the residential real estate
market has remained sluggish, and the construction of new residential homes still remains at
depressed levels. With the collapse of the housing market contributing to a delinquency rate of
9% on residential mortgages (worth $900 billion), the Obama Administration, in an effort to
redress this, implemented a policy of encouraging banks to write down or modify loans.
However, the policy resulted in only 2.3 million mortgage modifications or refinances—the
target was eight million. There is some hope that the Fed’s latest quantitative easing policy with
its focus on MBS purchases and the recent growth in the rental market will lead to future growth
in the housing market. Even with this, some economists project that with a 2.3% to 3% growth
rate it would take seven to ten years for the U.S. economy to recover from the real estate crisis
and to return to a steady-state, full-employment level.
GDP, $trn (2005 dollars)
15
15
Potential GDP
13
13
11
11
9
Actual GDP
7
1990
9
7
1993
1996
1999
2002
2005
2008
2011
5
Moodys is on the verge of downgrading the Spanish government debt from the current Baa3 to below investment
grade.
19
XSBIF Analysis of the Current
Investment & Economic Climate
Exhibit 5: Housing Sector Indicators
U.S. Housing Starts
Case-Shiller Housing Price Index
Mortgage Delinquencies
Inventory of Houses for Sale
20
XSBIF Analysis of the Current
Investment & Economic Climate
Vacant Housing Units
Corporate Earnings and Cash Positions
During this slow economic recovery period, corporate earnings have been positive until
the last quarter of 2012. Positive corporate earnings can be attributed to work force reductions
and to lower interest rates that has reduced corporate borrowing costs. During this period, firms
have also decreased their investment expenditures. This decrease, coupled with their earnings
increases, has resulted in significant increases in corporate cash positions. U.S. companies have
become net suppliers of funds instead of net users. As of June 2012, S&P 500 firms had
approximately $900 billion of cash, 40% higher than their holdings in 2008. The Economist
reports that GE expects to have $100 billion in cash holdings over the next few years, which GE,
in turn, estimates will be sufficient to finance their new investments, acquisitions, and share
buybacks. Similar phenomena are also occurring in other countries, such as Japan, Britain, and
Canada, where corporate liquidity holdings have increased.
The large corporate cash positions reflect an economic environment of uncertainty,
leading, in turn, to lower levels of corporate investments. While liquid wealth represents the
potential for future investments, large cash positions also reflect current low levels of corporate
investments—dead money. Moreover, this decrease in corporate investment is another factor
contributing to the slow economic recovery, and portends for slower future corporate earnings
growth. In fact, in the third quarter of 2012, earning per share for the S&P 500 declined (see
Exhibit 6).
21
XSBIF Analysis of the Current
Investment & Economic Climate
Exhibit 6: S&P 500 Financials
Cash Per Share
Profit Margins
EPS
Return on Equity
Economic Outlook
The consensus long-term forecast for the U.S. economy and the global economy is for the
continuation of a slow economic recovery. There is also a fear that in the short-run there could
be another recession depending on how the following well-known challenges are resolved: the
Euro-zone crisis, the U.S.’s fiscal cliff, slow economic growth in China, and upheavals in the
Middle East.
There is also a growing concern about the economic impact changes in government
economic policies, from stimulus to austerity, may have on the current recovery. Specifically, the
Euro-zone crisis, and to some extent America’s fiscal cliff, point to how sovereign solvency
22
XSBIF Analysis of the Current
Investment & Economic Climate
concerns are moving policy makers from stimulus to austerity measures. In a classic study by
Reinhart and Rogoff (This Time is Different); the authors found that public debt above 90% can
reduce average growth rates by more than 1%. However, in assessing the impact of austerity
programs, there is a growing concern that the multiplier effects of cutting deficits may be greater
than in normal economic times. Just recently, the IMF revised its multiplier estimates from .5%
to 1.5%, indicating a 1% reduction in the deficit resulting from a government spending cut or a
tax increase could reduce GDP by 1.5%. Similarly, a study by Christiano, Eichenbaum, and
Robelo argued that in normal economic times the multiplier is approximately one, but in periods
when interest rates are low, the multiplier could be as high as three. Thus, these studies suggest
that austerity measures undertaken now in Europe and the U.S. could have a more negative effect
than if undertaken at some other economic time.
Jobless Claims
Exhibit 7: Leading Economic Indicators—Components
New Orders Consumer
New Orders Capital
Building Permits
23
Post-Election Trades
Given concern about slow economic growth, austerity measures in the U.S. and Europe,
decline in corporate profits and investments, and slower economic growth in China, the XSBIF
fund managers took the position that credit spreads are likely to widen in the future and that a
flight to safety could possibly put downward pressure on Treasury yields. Accordingly, the
XSBIF fund managers decided to:
1. Decrease the fund’s corporate allocation and increase its Treasury allocation
2. Increase the allocation of the portfolio’s duration distribution to the positively-sloped
intermediate segment of the yield curve
Following the election, the fund managers, in turn, voted to sell two of its corporate credits Teva Pharmaceutical and Petrobras International. The proceeds from that sale, and some the
fund’s cash position, were used to purchase intermediate Treasuries (See Exhibit Boxes 8 and 9
for descriptions of Teva and Petrobras).
XSBIF Trade Summary
Date
Action
11/8/2012
Sell
Sell
Buy
Buy
Issuer
Issue
# Held
Teva Pharmaceuticals
Petrobras International
U.S. Treasury
U.S. Treasury
TEVA 2.4 11/10/2016
PETBRA 5.375 1/27/2021
T 1.25 10/31/2019
T 1.625 8/15/2022
50
25
75
25
Sale Price
$
$
$
$
105.232
113.074
101.086
99.797
24
Post-Election Trades
Exhibit 8: Teva Pharmaceutical


Teva Pharmaceutical Industries Ltd (Teva) is a global pharmaceutical and drug company. It
develops, produces and markets generic drugs in all treatment categories.
Principal products include Copaxone and Azilect.
Bases for Selling Teva:

On October 11, 2011, TEVA borrowed approximately $6.5 billion under the June and
September credit facilities to finance the acquisition of Cephalon.

The leverage ratio of TEVA increased from approximately 24% on December 31, 2010 to
approximately 39% at December 31, 2011.

TEVA’s principal and interest payment obligations have increased substantially and may
increase further.

TEVA has a history of making large acquisitions; the company acquired SICOR Inc for $3
Billion in 2003, IVAX Corp for $7.5 Billion in 2005, Barr Pharmaceuticals for $8.83 Billion
in 2008, Ratiopharm for $4.9 Billion in 2010, and Cephalon Inc for $6.15 Billion in 2011. To
purchase these companies, the company issued long-term and short-term debt. Due to this, it
now has relatively high debt/equity ratio, higher than the industry average.
25
Post-Election Trades
Exhibit 8: Teva Pharmaceutical

In November 2012, the credit spread of the company’s bond widened.

There has been a decrease in Teva’ cash position.
Exhibit 9: Petrobras International

Petrobras International Finance Company is a special purpose entity. The company raises
capital for general corporate purposes and to lend money to Petrobras.

Parent Company - Petroleo Brasileiro S.A. (Petrobras) – (PBR): Petrobras explores for and
produces oil and natural gas. The company refines, markets, and supplies oil products.
Petrobras operates oil tankers, distribution pipelines, marine, river, and lake terminals,
thermal power plants, fertilizer plants, and petrochemical units. The company operates in
South America and elsewhere around the world.
26
Post-Election Trades
Exhibit 9: Petrobras International
Bases for Selling Petrobras:

Declining Operating Margins: From 28.9% at 12/31/2006 to 17.95% at 12/31/2011
o Reasons: Costs rising quicker than sales
o Increasing labor and equipment costs

Increasing total Debt-to-EBIT ratio: From 1.04 in 2006 to 3.5 in 2011.

Net loss in the 2nd quarter of 2012 of $685m USD.
o A 7.2% appreciation of the USD against the BRL contributed to the loss.
27
November 2012 Fund Characteristics
Current Portfolio
Exhibit 10 lists the fund’s holdings and characteristics compared to the benchmark as of
November 9, 2012. As a result of the November 7th trades, the fund’s allocation to nongovernment bonds increased from 33% to 45% and its allocation to corporate credits decreased
from 59% to 50%. The YTW on the fund decreased from 2.359% to 2.044% (compared to the
benchmark YTW of 1.545%). With respect to the quality distribution, the fund has a smaller
allocation to AAA-rated bonds and larger allocation to A-rated and BBB-rated credits. Finally,
the modified duration of the portfolio increased from 5.821 to 6.309, closely matching the
benchmark’s duration of 6.042, with the fund’s duration distribution concentrated even more in
the intermediate range. The portfolio is positioned to do better in the event of widening credit
spreads and if the yield curve remains positive in the intermediate segment.
Exhibit 10: Fund Characteristics—November 9, 2012
Indicator
Bloomberg Composite Rating
Coupon
Maturity (Years from Today)
Market Value
Yield to Worst
Modified Duration
Option Adjusted Duration
Convexity
Portfolio
A+
4.541
9.548
$1,376,120
2.044
6.309
6.359
0.839
Benchmark
AA
3.445
8.483
NR
1.545
6.042
6.130
0.772
+/1.096
1.065
NR
0.498
0.267
0.229
0.068
28
Exhibit 11: November 2012 Holdings
Name
XSBIF 11/8/2012
› Cash
› Corporate Debt
ALLY 6 ¼ 12/01/17
BAC 5 05/13/21
C 5 ½ 10/15/14
CNP 5.95 02/01/17
CNQCN 6 ¼ 03/15/38
COF 7 ⅜ 05/23/14
COP 5.9 10/15/32
CVS 5 ¾ 06/01/17
D 5.95 06/15/35
DD 5 07/15/13
DUK 5 ⅝ 11/30/12
GE 5 02/01/13
GIS 3.15 12/15/21
GS 7 ½ 02/15/19
IP 7.4 06/15/14
JCP 7.95 04/01/17
MDLZ 6 ⅛ 02/01/18
NYL 5 ⅜ 09/15/13
T 5 ⅝ 06/15/16
USB 6.3 02/04/14
VZ 4.9 09/15/15
› Government Debt
FHLB 4 09/06/13
FHLMC 3 07/28/14
FHLMC 3 ¾ 03/27/19
FHLMC 6 ¼ 07/15/32
FNMA 5 04/15/15
T 0 ¼ 02/15/15
T 1 ¼ 04/30/19
T 1 ¼ 10/31/19
T 1 ⅝ 08/15/22
T 2 ¾ 02/15/19
T 3 ⅛ 02/15/42
T 3 ⅛ 05/15/21
T 4 ⅜ 05/15/41
T 9 ⅛ 05/15/18
› Securitized Debt
FN AH0524
FN AH2711
BB Comp
A+
Cpn
Mty (In Years) Px Close
Mkt Val
4.54
9.55
$ 1,375,826
0.00
0.00
$
5,885
Wgt YTW Mod Dur OAD Cvxty
100 2.04
6.31 6.36 0.84
0.43 0.00
0.00 0.00 0.00
B+
AABBBBBB+
BBB+
A
BBB
BBB+
A
AAA
BBB+
ABBBB+
BBBAA+
AA+
A-
6.25
5.00
5.50
5.95
6.25
7.38
5.90
5.75
5.95
5.00
5.63
5.00
3.15
7.50
7.40
7.95
6.13
5.38
5.63
6.30
4.90
5.06
8.50
1.93
4.23
25.34
1.53
19.93
4.56
22.59
0.68
0.05
0.23
9.10
6.26
1.59
4.39
5.23
0.85
3.59
1.23
2.84
110.25
112.99
107.87
116.63
133.30
109.61
132.33
120.28
129.77
103.05
100.23
100.98
106.48
125.26
109.25
103.13
122.54
104.18
116.17
106.82
111.63
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
80,213
23,085
27,055
29,558
33,555
45,195
33,177
18,418
26,428
26,154
20,541
15,348
43,091
38,098
22,437
78,996
37,256
26,242
17,761
21,693
22,471
5.83
1.68
1.97
2.15
2.44
3.28
2.41
1.34
1.92
1.90
1.49
1.12
3.13
2.77
1.63
5.74
2.71
1.91
1.29
1.58
1.63
3.99
3.24
1.33
1.83
4.12
1.01
3.61
1.16
3.95
0.44
0.35
0.43
2.33
3.03
1.48
7.10
1.60
0.37
1.02
0.69
0.75
4.26
6.88
1.85
3.75
14.27
1.44
12.81
4.02
13.44
0.67
0.06
0.23
7.65
5.11
1.49
3.65
4.53
0.84
3.26
1.19
2.68
4.28
6.99
1.84
3.76
14.57
1.43
13.15
4.03
13.76
0.67
0.06
0.23
7.95
5.15
1.49
3.65
4.56
0.84
3.26
1.19
2.67
0.22
0.57
0.04
0.17
2.87
0.03
2.17
0.20
2.50
0.01
0.00
0.00
0.68
0.32
0.03
0.16
0.25
0.01
0.13
0.02
0.09
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
AAA
4.00
3.00
3.75
6.25
5.00
0.25
1.25
1.25
1.63
2.75
3.13
3.13
4.38
9.13
0.82
1.71
6.37
19.68
2.43
2.26
6.47
6.97
9.76
6.26
29.26
8.51
28.51
5.51
103.09
104.64
116.46
152.31
111.26
99.91
102.02
101.48
100.46
111.41
108.16
114.64
134.43
145.51
$
$
$
$
$
$
$
$
$
$
$
$
$
$
20,757
52,736
23,377
23,141
16,737
9,996
51,022
75,119
80,669
72,832
32,666
40,649
88,750
29,980
1.51
3.83
1.70
1.68
1.22
0.73
3.71
5.46
5.86
5.29
2.37
2.95
6.45
2.18
0.24
0.29
1.08
2.78
0.35
0.29
0.93
1.03
1.57
0.87
2.72
1.30
2.65
0.70
0.82
1.68
5.74
12.86
2.32
2.26
6.22
6.67
8.97
5.77
19.42
7.48
17.77
4.51
0.82
1.67
5.79
13.21
2.31
2.26
6.28
6.76
9.20
5.83
20.10
7.61
18.31
4.53
0.01
0.04
0.38
2.17
0.07
0.06
0.43
0.49
0.89
0.38
4.90
0.64
4.25
0.25
AAA
AAA
4.00
4.00
28.08
28.16
107.24 $
107.24 $
33,354
31,389
2.42 1.75
2.28 1.45
3.36 2.03
3.00 1.32
0.28
0.24
29
Horizon Analysis
With the portfolio’s modified duration close to the benchmark, the duration distribution
weighted more in intermediate-term bonds and less in the short- and long-term credits, and the
increased allocation to Treasuries, the fund is currently positioned to outperform the benchmark
under a decreasing interest rate scenario in which there is a parallel shift in the yield curve. This
can be seen by examining the results of a portfolio simulation conducted by the managers that
are summarized in Exhibit 12. The results reflect a shift of the yield curve by -100, -50, 0, 50,
and 100 basis points with a one-year time horizon.
Exhibit 12: Portfolio Simulation
Horizon Analysis of Portfolio (November 2012 - November 2013)
Principal
(M)
Accrued
Interest (M)
Horizon
Value (M)
Duration
Convexity
BPV
YTW
% Return
Initial Portfolio
Values
1359.33
15.5
1374.84
6.29
0.76
854.87
2.15
--
-100bp
1296.14
14.04
1483.16
5.98
0.57
852.06
1.31
7.88
-50bp
1262.08
14.04
1449.2
5.8
0.72
805.39
1.55
5.41
No Change
1222.27
14.04
1409.81
5.61
0.67
755.03
1.99
2.54
+50bp
1184.71
14.04
1372.61
5.43
0.61
708.68
2.44
-0.16
+100bp
1149.47
14.04
1337.81
5.26
0.55
666.83
2.89
-2.69
The results indicate that the fund would underperform given a 50 or 100 basis points
increase in rates over one year. However, in the case of stable to decreasing rates, returns would
continue to outperform with rates of 7.68% and 5.41% in a 100 and 50bp decrease respectively,
compared to the benchmark returns of 6.52% and 4.88% for the same shift.
30
Horizon Analysis
Horizon Analysis of Benchmark (November 2012 - November 2013)
Principal
(M)
Accrued
Interest
(M)
Horizon Value (M)
Duration
Convexity
BPV
YTW
%
Return
Initial
Portfolio
Values
1375007.18
17788.39
1392795.57
5.31
0.58
731383.3
2.22
--
-100bp
1318142.85
17356.96
1483541.82
5.09
-0.88
712244.8
1.68
6.52
-50bp
1295371.09
17356.96
1460783.63
4.9
0.43
673596.5
1.83
4.88
No Change
1261591.98
17356.96
1427266.21
4.76
0.47
636327.7
2.27
2.47
+50bp
1229513.09
17356.96
1395419.9
4.58
0.48
597114
2.73
0.19
+100bp
1199462.98
17356.96
1365665.06
4.42
0.44
560961.8
3.18
-1.95
31
Position and Recommendations
Position
As a result of the trades, the fund managers believe that the current portfolio reflects a
successful implementation of the strategy of dealing with the expectation of a widening of credit
spreads and a continuation of low interest rates. Specifically, from the trades executed, the
managers were able to achieve the following:
 Increase the fund’s Treasury allocation with investments in a 1.25% Treasury, maturing in
2019 and a 1.625% Treasury maturing in 2022.
 Decrease the fund’s allocation to corporate credits by selling Teva and Petrobras.
 Increase the fund’s allocation to the intermediate segment of the yield curve.
 Reduce the cash position of the fund.
 Position the fund to gain in the event of credit spread widening.
 Position the fund to gain against the benchmark if the yield curve shifts down and remains
steep in the intermediate portion of the yield curve.
Recommendations
The 2012 XSBIF fund managers believe that the current portfolio is positioned to outperform the
previous portfolio as well as the benchmark in stable to decreasing interest rate scenarios. To
match or meet the benchmark’s performance in the future, the XSBIF managers recommend
investing the proceeds from two maturing bonds in intermediate Treasuries or MBSs.
32
Appendix: Fund Analytics
Default Risk
Issuer
Average
AT&T Inc
Bank of America Corp
Canadian Natural Resources Ltd
Capital One Financial Corp
CenterPoint Energy Inc
Citigroup Inc
ConocoPhillips
CVS Caremark Corp
Dominion Resources Inc/VA
EI du Pont de Nemours & Co
General Electric Co
General Mills Inc
Goldman Sachs Group Inc/The
International Paper Co
JC Penney Co Inc
Mondelez International Inc
Verizon Communications Inc
Default Likelihood (%) Model CDS (bp) Market CDS (bp) Hist Model CDS (bp)Hist Market CDS (bp)
0.114
125
137
137
158
0.007
58
78
56
79
0.083
156
161
213
235
0.074
108
117
127
142
0.006
86
107
98
108
0.041
89
102
137
124
0.096
160
156
232
231
0.016
106
52
116
57
0.015
59
47
71
49
0.007
64
46
78
41
0.091
111
52
118
52
0.066
68
102
88
117
0.002
47
38
51
38
0.148
177
186
206
259
0.100
114
121
158
139
1.166
592
876
461
914
0.021
71
40
61
46
0.008
60
53
56
54
33
Appendix: Fund Analytics
Events
Company Name
Bank of America Corp
Goldman Sachs Group Inc/The
Canadian Natural Resources Ltd
Canadian Natural Resources Ltd
CVS Caremark Corp
Capital One Financial Corp
CVS Caremark Corp
Dominion Resources Inc/VA
Citigroup Inc
Goldman Sachs Group Inc/The
Bank of America Corp
AT&T Inc
General Mills Inc
Citigroup Inc
Federal National Mortgage Association
Verizon Communications Inc
Verizon Communications Inc
EI du Pont de Nemours & Co
Citigroup Inc
Citigroup Inc
Capital One Financial Corp
Multiple Companies
Citigroup Inc
Citigroup Inc
Multiple Companies
Bank of America Corp
Bank of America Corp
Canadian Natural Resources Ltd
Bank of America Corp
Verizon Communications Inc
Citigroup Inc
Goldman Sachs Group Inc/The
EI du Pont de Nemours & Co
Date
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/13/2012
11/14/2012
11/14/2012
11/14/2012
11/14/2012
11/14/2012
11/14/2012
11/15/2012
11/15/2012
11/20/2012
11/27/2012
11/29/2012
11/29/2012
11/29/2012
11/29/2012
12/3/2012
12/4/2012
12/4/2012
12/4/2012
12/4/2012
12/5/2012
12/12/2012
12/12/2012
Event Description
Bank of America Merrill Lynch Equity Conference
Bank of America Merrill Lynch Banking & Financial Services Conference
Bank of America Merrill Lynch Global Energy Conference
Bank of America Merrill Lynch Global Energy Conference
Lazard Capital Markets Healthcare Conference
Bank of America Merrill Lynch Banking & Financial Services Conference
Wall Street Journal CEO Council
EEI Financial Conference
National Association of Real Estate Investment Trusts (NAREIT) Convention
National Association of Real Estate Investment Trusts (NAREIT) Convention
National Association of Real Estate Investment Trusts (NAREIT) Convention
Morgan Stanley Technology, Media & Telecoms Conference
Morgan Stanley Global Consumer & Retail Conference
Forex Magnates Summit 2012
Big Data Business Forum
Big Data Business Forum
Morgan Stanley Technology, Media & Telecom Conference
Morgan Stanley TMT Conference
Profit & Loss Forex Network Canada 2012
European Money Fund Summit
FBR Capital Markets Fall Investor Conference
Capital Link Investor Forum
Total Energy USA Conference
Total Energy USA Conference
Capital Link Investor Form - Panel
Bank of America Merrill Lynch Leveraged Finance Conference
Bank of America Merrill Lynch Leveraged Finance Conference
Business Update Call
Bank of America Merrill Lynch Leveraged Finance Conference
UBS Global Media and Communications Conference
Bloomberg Hedge Funds Summit
New York Times DealBook Conference
Investor Meeting Day 1
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