Quarterly Newsletter: March 2006

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1^st Quarter Returns
Investors enjoyed a vigorous bounce in the equity markets in the first quarter with the alternative classes leading the way. Standout performers were Real Estate (+14.7%), US Small Cap Equities (+13.9%), Emerging Markets (+12.1%) and International (+9.5%). Though it pales in comparison, US Large Cap Equities delivered a still enviable 4.5% gain. Fixed income posted a modest loss of 0.6% due to the continued headwinds of rising interest rates. Market pundits continue to actively debate when the Fed may pause in its rate hike campaign.

Asset Class Update: Floating Rate Securities
New chairman, same result—on March 28th, Chairman Ben Bernanke presided over his first FOMC meeting and announced their unanimous vote to increase rates another 25 basis points, bringing the target Fed Funds rate to 4.75%. Needless to say, it has been a steady march upward from 1.00% when former Chairman Alan Greenspan declared the first rate hike in June 2004.

During this time, client portfolios have benefited from holding "floating rate securities" since the yield on these investments has increased in lockstep. Unlike most bond investors, an investor in floating rate securities roots for rates to rise rather than fall. However, with Fed Funds futures calling for a peak rate of 5% and the threat of inflation seemingly low, it is a good time to ask what continuing role this investment should have in client portfolios.

Let's begin with a refresher on this asset class. Sure, the yield floats higher when the Fed hikes rates, but what are you buying? The investment vehicle we have been using is what is generically referred to as a floating rate fund. Specifically, this is a well-diversified portfolio of bank loans made to non-investment grade corporate borrowers. In the industry, these loans are referred to as leveraged loans since these corporations tend to borrow more (i.e., have greater financial leverage) than their investment grade counterparts.

The interest rate these borrowers pay consists of a base rate that floats with short term market rates (e.g., LIBOR) plus a spread that provides additional compensation for the credit risk (the riskier the loan, the larger the credit spread). As a general rule, these loans do not increase or decrease in value with changes in market rates since they are issued on a floating rate basis, hence the attraction in an environment of increasing short term rates. Importantly, these loans are senior (first in line to be repaid if the company defaults on its debts) and secured (collateralized by assets of the corporation).

Let's review the asset class in terms of three key metrics – return, risk and correlation.

Return

• The expected return on the portfolio of loans is the expected yield (interest income) minus the expected loss (any principal that is not repaid) when any borrowers default. For instance, with LIBOR at approximately 4.75% and supposing the borrower pays a credit spread of 2.25%, the expected yield is 7.00%. Historically, these loans have a default rate of 3% and an 89% recovery rate upon default. As such, the expected loss is only 0.33% (3% default rate times an 11% loss realization). So, in total, the expected return is 6.67%, a reasonable expectation for leveraged loan index returns in today's market.
• Importantly, the default and recovery data are averages. With corporate credit quality at cyclical highs, it is reasonable to expect deterioration in the default and recovery rates from current levels. However, at cyclical lows (for instance in the recent recession in 2002) the numbers are still compelling with an expected loss of only 1.50% (7.5% default rate, 20% loss realization).
• As with other investments, the daily value of these loans tends to fluctuate with changes in market sentiment. In times of stronger (weaker) investor confidence, the required credit spreads decrease (increase) which results in an increase (decrease) in the interim value of the loan. This price behavior is no different than strong investor confidence driving P/E ratios and thereby equity returns higher. Over the long haul, however, the mathematics described above tend to prevail. As you can see in the chart on the next page, the leveraged loan index has delivered handsome returns with no loss years (1992 was the first year of index data).

Risk

• The words leveraged loan and non-investment grade tend to connote "high risk". However, one of the most compelling attributes of the asset class is its low volatility. The annualized risk (as measured by the standard deviation of returns) for 1992 through 2005 was only 2.2%, the lowest of all asset classes other than cash. For comparison, each of the major equity asset classes (large cap U.S., small cap U.S., international, emerging markets and real estate) posted double digit annualized risk percentages while the Lehman Brothers Aggregate Bond Index had annualized risk of 4%.



• The asset class is especially attractive when you consider its risk adjusted return. We can gauge the efficiency of an asset class in producing return by dividing its annualized return by its annualized risk (how much return did the investor receive per unit risk). Leveraged loans have delivered the highest ratio of all asset classes at greater than 3:1. For perspective, the Lehman Brothers Aggregate Bond Index was less than 2:1 while the S&P 500 was less than 1:1.

Correlation

• An asset brings significant diversification benefits to a portfolio when it has a low correlation with the other holdings. It is even more helpful when the correlation is negative. As investors, we want some assets to "zig" while others "zag" in order to dampen volatility in the total portfolio. For leveraged loans, the highest correlation with any asset class is only 0.26 (small cap U.S. equities). Its correlation with TIPS, intermediate term bonds and short term bonds is negative. Due to its low correlation with equities and negative correlation with bonds, leveraged loans bring significant diversification benefits to most any portfolio.

Conclusions
Investors made a good tactical decision to invest in floating rate securities in June 2004 and "ride rates higher". After fifteen consecutive rate increases, yields have reached more reasonable levels and should enable solid total returns going forward. Over the long run, it is reasonable to continue to expect leveraged loans to have low volatility and a low correlation with other asset classes. As such, this asset class is a compelling long term holding in most portfolios. Naturally, it is most tax-efficient to hold the asset in a qualified account, since we can expect most of the return to be taxed as ordinary income. Though an inevitable weakening in corporate credit quality will dampen returns on an interim basis, it is advantageous to include the asset class in well diversified portfolios.

Sources for data within the text include CSFB, Standard & Poors, Lehman Brothers and Zephyr Associates, Inc.

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