August 2010 SeaCap Update

SeaCap’s Mission:

To provide our clients with high quality, moderate maturity portfolios, delivering a predictable income stream and principal stability during times of credit stress, changing interest rates, and volatile equity markets.

Updated August 18, 2010

Protecting client asset value through tumultuous markets is a primary focus of SeaCap Investment Advisors

SeaCap’srigorous approach to credit analysis,dedicated trading resources, wide range of dealer relationships, and proactive approach to participation in new taxable and municipal issues are all intended to optimize our trading on behalf of our clients as we navigate the challenges ahead.

We look forward to hearing from you! Please contact Laurie Nichols if you would like to have a client portfolio analyzed or you need marketing and client service support. She can be reached at 206-654-0484 or lnichols@seacapinvests.com

Please see below the full text of our Investment Team’s market and strategy commentary.

                                               *******************************************************************************

                                                                 ********************************************************

The US bond market continued to extend year to date gains in July as rates fell with the exception of thirty year Treasuries. Investors reached out the curve for additional yield from very short maturities which caused the five year Treasury yield to fall the most. US Treasury yields fell to a record low 0.55% for the two year maturity. Yields were 2.91% for the ten year, and 3.99% for the thirty year.

Investors reacted to disappointing economic data, especially weak employment numbers. Revised economic data shows that the recession was even deeper than previously estimated. There was an increased concern about the potential for a double dip recession. Fiscal policy stimulus is winding down, while inventory building appears to have about run its course and will now be dependent on the pace of sales. There was also increased talk of the possibility of deflation.

Expectations that short rates would remain exceptionally low were extended out further. August 10^th, the FOMC announced that they will keep the value of their portfolio constant at $2.05 billion by reinvesting agency maturities and mortgage principal payments into 2-10 year Treasuries. This action results in maintaining the current amount of financial market support, instead of passively tightening. Bond yields dropped further with the news the Fed left open the potential for future quantitative easing.

Taxable Bonds by Jerry Wiesner, CFA and Manager

Corporate bond yield spreads versus treasuries narrowed sharply last month as 1-10 year corporates returned 1.85% and the financial sector 2.32% while 1-10 year treasuries returned 0.78%. The broad financial sector performed the best as the Dodd/Frank financial regulation bill became law. The regulation was less stringent than many feared and removed some of the uncertainty surrounding the sector. The European bank stress tests showed that fewer than expected banks failed which increased confidence in the banking sector. The energy sector rebounded as well as the Gulf oil spill was contained and BP was able to sell assets.

We remain positive on the high grade corporate sector and are over weighted in client portfolios. Our expectation is that corporate sector returns will benefit from the higher yield than the Government sector while further spread narrowing is less likely. Corporate balance sheets are strong as evidenced in July by the lowest monthly level of downgrades in seven years. High grade corporate supply increased as borrowers took advantage of the strong investor demand, low interest rates, and narrow spreads. Corporate issuance of $85.7 billion was the busiest July for on record. IBM recently issued a three year bond with a 1% coupon while McDonalds issued a ten year bond with a 3.50% coupon. These bonds were issued at narrow spreads to Treasuries.

SeaCap taxable bond strategy currently favors the industrial sector and is under weight the broad financial sector. We target selective regional banks and Canadian banks in the financial sector. Our Agency emphasis continues to favor the non-mortgage agencies Federal Home Loan Bank (FHLB), and Federal Farm Credit Bank (FFCB). Portfolio durations are slightly short to about neutral to the target index duration.

Municipal Bonds by John Simms, CFA and Chief Investment Officer

Several factors aligned to fuel additional strength in the municipal market. The decline in US Treasury yields, an attractive municipal-to-Treasury yield ratio, a limited supply of new issuance, and easing credit anxiety all contributed to the popularity and price gains of municipal bonds. Tack on discussions of higher income taxes for wealthy investors in the future and conditions were nearly ideal.

Mid year data, released in July, reflected a continuing trend of fewer tax exempt municipal issues and more taxable municipal issuers. QII total municipal supply (taxable and tax exempt) was down 24% from 2009 at $111 billion and the year to date supply of tax exempt issuance is down 20% from the fist half of 2009. Strong demand and limited supply leads to firmer prices.

Investors also found the municipal/Treasury ratio attractive in July. At year end, ten year AAA municipal bonds yielded 77.5% of ten year Treasury yields. At mid year, the ratio had improved to 94.9%. Ratios of this magnitude imply that municipal bonds will likely make sense for investors in nearly every tax bracket.

Anxiety over municipal credit quality also appeared to subside during the month.

Concerns over the impact of the oil spill on Gulf Coast issuers generally proved unfounded and several high profile issuers, including the State of California, appeared to move closer to budget compromises. Even the nation’s capital proved friendly to the municipal market in July. Treasury Secretary Geithner joined the call for higher tax rates in 2011 and new legislation was introduced to extend the Build America Bonds program beyond 2010.

While lower yields may be a mixed blessing for municipal investors – higher prices but lower yields on new investments – the decline was entirely welcomed by municipal issuers. Lower yields often allow issuers to refund existing debt with lower cost debt. Such refunding activity is up 23% year to date reflecting the appeal of lowering borrowing costs.

SeaCap municipal strategy continues to target a range of short to intermediate maturity bonds, often in a barbell structure emphasizing ten year maturity bonds. This portfolio structure was rewarded during the month as the ten year maturity sector was the top performing sector within the broad municipal index. We continue to target portfolio average effective maturity (duration) at five years and limit credit quality to bonds rated AAA to A. Our targeted average portfolio quality remains at AA.

www.seacapinvests.com

For more information contact Laurie Nichols, Managing Partner at 206-654-0484 or lnichols@seacapinvests.com

The US bond market extended year to date gains in June as demand for less risky assets overwhelmed concerns about higher interest rates. The resulting lower yields were most pronounced in the taxable bond market. As appealing as June bond returns appear, this pace of return is not sustainable. June’s total return for the Barclay’s Intermediate Government/ Credit Index of 1.36% was comprised of 0.29% of coupon income, the most predictable source of return, and 1.07% of price appreciation, a more volatile source of return. As such, our expectations for the pace of future returns more closely resemble the income component of June’s results.

The popularity of high grade US fixed income assets in June related mostly to continued anxiety about sovereign deficits and debt burdens, disappointing global economic news and price volatility in other asset classes. Benign inflation data further encouraged investors as did the FOMC June statement noting financial conditions that were less supportive of growth and reinforced the expectation that the fed funds rate will likely stay unchanged for the foreseeable future.

Taxable Bonds  Demand for additional yield continued to draw investors toward the corporate bond market. The Barclay’s Intermediate US Credit Index returned 1.45% for the month, including 0.42% of coupon income. Even with this strong recent performance, we remain positive on the high grade corporate sector and over weighted in client portfolios. Our positive outlook is premised by healthier corporate balance sheets, declining default risk, and a shortage of new issuance from high grade companies. At mid year, companies had issued the fewest bonds since 2004.

SeaCap taxable strategy continues to evaluate the credit curve, or yield spread above US Treasury securities for various maturities, to determine portfolio maturity structure. A relatively flat credit curve is prompting our emphasis on short to intermediate maturity corporate securities. Alternatively, the steep yield curvecontinues to support a portfolio duration approaching the market index duration. Importantly, a steep yield curve provides some protection from the price impact of higher interest rates, particularly if the market response to an eventual tighter Fed monetary policy resembles the response of mid 2004 to mid 2006. Longer maturities generate higher income and will typically experience a more modest price impact as the yield curve flattens.

Municipal Bonds   The municipal market also extended year to date gains although, for nearly all sectors of this market, positive performance arose entirely from income. Absent the flight-to-safety trade that fueled strength in the taxable bond market, municipal investors reflected caution in accepting current low yields amidst concerns about municipal credit quality. A continued shortage of tax exempt municipal supply and reinvestment demand from heavy mid year cash flows likely prevented a more pronounced decline in prices.

Headlines on municipal credit risk have grown from a trickle to a flood, as an increasing number of financially troubled issuers, at the state and local levels, continue to surface. Whether well intentioned pleas for federal support or attempts to stimulate constructive budget negotiations, the desperation of many official statements is taking a toll on investor confidence. At a minimum, this flood of media attention has resulted in more informed investors and a wider recognition that the municipal market is a heterogeneous market requiring robust and adaptive analysis.

In fact, adaptive analysis is becoming increasingly important as traditional municipal credit risks morph into political-financial risks. The financial strains brought about by a prolonged economic downturn have reinforced the necessity of careful credit evaluation. Part of that evaluation has traditionally included an understanding of possible remedies to budget shortfalls, such as cost containment or revenue increases.    Unfortunately, most remedies are unpopular, including public sector layoffs or salary and benefit cuts, and some shortfalls seem nearly insurmountable, such as accumulating pension obligations. Attempts to implement such remedies have not been easy to accomplish, and, increasingly, face understandable resistance from public sector unions. 

This is the point at which municipal risks reflect a more political nature. Public sector unions are perceived as politically empowered and investors increasingly express a fear that bond holders may be sacrificed for jobs, payroll, and benefit protection. Since political risks are potentially systemic, individual issuer credit analysis, alone, may no longer suffice. This is perhaps one of the underlying points of Warren Buffet’s early June prediction of a terrible problemfor municipal bonds in the coming years, particularly since he invoked a comparison to the General Motors government bailout.  

SeaCap strategy response has been to avoid any temptation to grasp for yield in financially weak issuers, regardless of traditional bond holder protection.   Portfolio diversification remains critical, and diversification must be useful and not simply expand the number of portfolio holdings. This is particularly important for systemic risk mitigation. We understand the painful nature of addressing budget shortfalls but believe that fears of a systemic, widespread sacrifice of municipal bondholders will prove unwarranted. 

SeaCap municipal strategy continues to target a range of short to intermediate maturity bonds, often in a barbell structure. The steep municipal yield curve still provides reasonable yield incentive for including intermediate maturity exposure. We continue to target portfolio average effective maturity (duration) at five years.

As has been the experience in the corporate and mortgage backed securities sectors, tax exempt municipal issuance remains well below the levels of the past several years. This lack of supply combined with an expanding appreciation for the desirability of strong underlying credit quality is resulting in shortages in some types of issues. This scarcity may require longer lead times to fully invest cash flows and new portfolios and also slow the turnover of existing portfolio holdings.

www.seacapinvests.com

For more information contact Laurie Nichols, Managing Partner at 206-654-0484 or lnichols@seacapinvests.com