A Manager’s knowledge of what & when to buy
and how much to pay is good value

One of the simplest major factors to explain in the decision to employ a manager for a fixed income portfolio is the industry’s acceptable bond price markups. The NASD will tolerate a 5% mark-up, which they consider to be “fair and reasonable” (Wall Street Journal 7/28/04).

That is a lot of money! Through professional management, if you can “save” 2 1/2% per trade that equals a 1% “savings” per year on a portfolio with a modest 20% turnover. We apply the following actions to improve prices:

1. Daily market analysis is the foundation of our historical knowledge of maturity,
   yield and credit rating relationships among bonds. This is key to the decision of
   what to buy and what not to buy, when to buy and what to pay.
2. Seek competitive pricing (bids and offers in competition) from multiple broker dealers.
3. Trade in large size for many clients provides all clients with institutional round-lot pricing,
   which is generally less than retail odd lot prices.

A second major factor impacting prices is the structure of the market

Most bonds are traded in an over-the-counter market, not through a registered, supervised exchange. As such, investors purchase and sell many bonds without a means of determining up-to-date quotations or knowledge of the price levels of recent trades. Historical pricing knowledge has value when considered in this context. Also, this OTC structure increases the importance of seeking competitive bids through multiple broker dealers.

The NASD has tried to improve pricing transparency
with the bond trade reporting system, Trace

Market Axess is another 3rd party vendor that downloads Trace data and acts as a venue for clients to trade directly with one another, avoiding broker/dealers. Brokers are required to report all trades to Trace within 45 minutes of a trade (however, many subscribers are subject to a 4-hour delay). The objective is to have “real-time” pricing available (however brokers have been know to manipulate the system by posting fake trades that are later canceled). But only the very large issuers bonds trade with any regularity and frequency (e.g. Citigroup, Ford Motor, Boeing (finance), Caterpillar (finance)). Nearly all these large issuers are finance companies.

So the same bond does not trade every day. Many industrial issues trade efficiently maybe only once or twice a month. That makes any comparison to or analysis of an offering or bid more difficult (differences in seniority, terms, maturity, coupon, call features in analyzing different issues and differences in Treasury yields and corporate news/industry events in analyzing the same issue on different days). Additionally, when a bond does trade multiple times in any given day, the price can vary significantly. It is not unusual to see dollar price differences among a day’s trades of 3%. It’s simple math; that is $ 15,000.00 on a $500,000 trade. This was noted on a randomly selected, very liquid $4 billion Citigroup issue we reviewed in January 2007.

The market’s size adds to its fragmented nature

The $3.0 trillion corporate bond market is “populated” by over 20,000 issues from over 2,200 companies. The market is so large that no broker/dealer has an inventory anywhere near even 1% ($30 billion) of the market. Inventories are exclusive or vary among brokers (much like the market for used cars!). So access to multiple brokers’ inventories provides access to many more bonds as well as the ability to seek competitive bids when more than one broker offers the bonds. More choices allow us to be more selective in the construction of a well diversified portfolio of securities we truly prefer.

Brokers can not efficiently access their competitors’ inventories. Brokers like to know the end buyer of their bonds so they can trade them again. They can seek bonds offered by other firms for their clients “in the street”. However, the prices on those bonds are usually inflated or uncompetitive.

The third factor impacting prices are the terms and liquidity of each bond

Each of the over 20,000 issues is a unique legal contract with specific terms (e.g. call dates and prices, seniority, securitization, make whole agreements, change of control provisions, anti-layering restrictions). So, two issues from the same company can be very different, even though the maturity and coupon are the same. Analysis of the bond indenture terms is integral to determining the fair price of a bond and how attractive that bond is to other buyers. For instance, GM issued many billions of “smart notes” largely to retail buyers. Most institutional buyers find the “smart notes” to have inferior terms and as such they are unattractive. This impacts the liquidity and prices of those issues (especially in the event of bad news from GM).

Last, but certainly not least of the reasons to employ a manager for a bond portfolio are the manager’s:

1. Consistent application of an investment strategy: CAM’s relative value approach.
2. Consistent application of a portfolio management discipline: diversification by company and industry group to increase the conservative nature of the holdings.
3. Continual credit analysis of companies to help identify developing opportunities and hazards.
4. Constant search for the best values (more yield and less risk).

Credit analysis is a major factor

Big, well known companies like GM, Ford and Kodak have serious financial problems of which many investors are unaware, choose to ignore and are unable to measure. The measurement is important to the task of valuing a held position for sale.

Today, credit concerns are very low, because of the good economic conditions. But there is the possibility of a rapid change driven by surprise events in the war, terrorist’s acts and economic events (like the declining housing market and China’s growing manufacturing power). For investment grade bond buyers another real and growing concern is leveraged buy outs by all the private equity funds, which have grown so much over the past few years. In this environment an Arated company can very quickly become a single-B rated company. Those who don’t want to hold investment grade issues would be forced to sell. It is important to screen credits for the potential of an LBO (which we do, regularly) and still if one is announced, determine the best time and price to sell. Notable LBOs and companies threatened in 2006 were Harrah’s, Kinder Morgan, ARAMARK, Home Depot, Equity Office (potentially bad for holders of CMOs and mortgage paper), Health Management, Clear Channel and Neiman Marcus.

For potential avoidance of price declines the numbers argue for employment of a manager. If you have a portfolio diversified across 30 issues and one issue falls 20% in price that equals 0.66% (66 basis points) loss to the portfolio. That is well above our annual Investment Grade, Broad Market, and Short Duration fees. Considering the price volatility of GM and Ford over the past few years and the legislative risk which hit Canadian Royalty Trusts late in 2006 even a 10% loss is well within the range of the possible. If we are able to avoid or minimize the impact of these events through regular, ongoing credit research, just that aspect of our efforts is well worth the fee. A simple brokerage relationship will not provide you with this service o2f6 credit research and proactive response.