SUMMER 2011
(Q2-2011 Data)
Volume 21, Number 3

ewgate’s Global Fixed Income Portfolio gained 4.4% in the second quarter and is up 6.1% year to date, compared to 2.2% and 3.7% for the Lipper Global Fixed Income Index, respectively.

Market Review. The global economic recovery continues, but at a slower pace than most economists had predicted. Employment growth in the United States has been disappointing. Washington has been unable to resolve the upcoming debt limit. The markets have assumed that the US will come up with a solution for the near term and avoid an immediate downgrade. However, there has been long term, and possibly irreparable harm done to the US dollar as a safe haven currency.

The Federal Reserve ended the current round of quantitative easing but shows little inclination to meaningfully reverse recent bond purchases or raise interest rates. As a result, Treasury bond yields have remained low and the yield curve flattened during the quarter. Longer maturity bonds have outperformed shorter dated paper. Mortgage and other real estate related assets have outperformed the broader bond market. Federal Reserve action has been particularly supportive of mortgages as it attempts to ameliorate the damage done to the housing and commercial property markets. Even with the recent outperformance, mortgage bonds are still attractive relative to Treasuries. Mortgages have a higher yield because they are subject to prepayment risk as borrowers refinance when rates drop. However, despite low interest rates, far fewer borrowers are seeking to refinance due to the additional scrutiny and lengthy process required. Mortgage investors have reaped the benefits of higher yields without suffering the loss of principal from prepayments.

In Europe, the never ending debt crisis continues. Greece, Portugal and Ireland had their debt downgraded to junk status. Spain and Italy are now being scrutinized. Spain’s debt to GDP ratio is a relatively low 65%; Italy’s is much higher at 120%. With bond yields rising in these countries, the problem can no longer be considered on the European periphery. Given the severity of the debt crisis, the Euro’s stability against the dollar and other major currencies remains unknown.

Portfolio Review. Portfolio returns have come from a combination of above average yields, narrowing discounts on closed end funds and increases in funds’ net asset values.

Despite very real concerns about the long term health of the US Dollar, we find the best value in dollar denominated securities. Market consensus is highly suspicious of the dollar, yet there are few other currencies that do not have a structural debt problem. Other currencies considered “safe” have appreciated sharply. Emerging market currencies are up 30% from their March 2009 lows. The Australian dollar is up almost 70% during this period. Dollar based assets appear more attractive as we look outside the US for opportunities. Investment grade funds, such as the Duff & Phelps Utility and Corporate Bond Trust (DUC) yielding 7.4%, are the largest allocation (over 16%) in the Portfolio. Total corporate (non-REIT) exposure comprises 50% of the Portfolio.

Deeply discounted mortgage focused funds, such as the American Strategic Income Portfolio II (BSP) yielding 11% with an 11% discount, represent approximately 10% of the Portfolio. We have taken profits in this area; Federal Reserve activity has been supportive of this sector, but cannot be relied on indefinitely. Treasury securities were reduced to less than 4% of the Portfolio, primarily by the sale of the Alliance Bernstein Income Fund (ACG).

Outlook. Investors have been forced by the Federal Reserve to seek income outside of Treasury securities. Closed-end funds represent an efficient way to gain access to mortgages, preferred shares, senior loans and similar aspects of the fixed income market. Funds offer much greater diversification, with lower trading costs, than is otherwise available to most investors.

In contrast to governments, corporate balance sheets entered the recent period of economic uncertainty in good shape and have only improved since then. Duration of the Portfolio has been reduced to less than 3 years. The current yield of 7.0% represents a premium over government bonds worldwide and provides a needed level of diversification given current economic uncertainty.