Fixed Income Asset Allocation

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F ^ixed i ^ncome A ^sset A ^llocAtion

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JANNEY MONTGOMERY SCOTT www.janney.com

INTRODUCTION CURRENT OUTLOOK

RECOMMENDED ALLOCATIONS INFORMATION & DISCLAIMERS

See page 5 for important information regarding certifications, our ratings system as well as other disclaimers.

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Chief Fixed Income Strategist 215 665 6034

[email protected]

Our 1Q three-pronged approach to 2015 portfolio construction has run its course, with value today found in securitized products and preferreds.

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ntroductIon

• It’s been a volatile start to 2015 for fixed income, with the best month in a quarter century (Jan) followed by the worst (Feb) and then a decent finish (Mar) to generate solid net returns.

• Janney’s Moderate Fixed Income Asset Allocation posted a quarterly +1.7% return, beating out the Barclays Agg benchmark by 40 basis points, and returning to our trend of outperformance.

• The three pronged approach proposed in our Outlook 2015 for unconstrained investors—short term high yield, intermediate term municipals, and the thirty year Treasury bond—posted a more significant +2.7% return.

• Yields have descended to roughly match our forecasts, which leaves us less willing to make aggressive duration bets, though the bias is still slightly towards lower rather than higher yields.

• Reflecting the toughness of duration bets, our 2Q Moderate FI Allocation includes a higher portion of spread assets, notably RMBS/ABS/CMBS and preferred securities.

-0.40%

-0.20%

0.00%

0.20%

0.40%

0.60%

0.80%

Treasuries Agencies Mortgages IG Credit HY Credit ABS/CMBS Preferreds Munis Bars indicate sources of

over/underperformance of Moderate Allocation relative to the Aggregate bond markets

Moderate Allocation Outperformed Benchmark in 1Q and for Last Twelve Months

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

3Q 2010 4Q

2010 1Q 2011 2Q

2011 3Q 2011 4Q

2011 1Q 2012 2Q

2012 3Q 2012 4Q

2012 1Q 2013 2Q

2013 3Q 2013 4Q

2013 1Q 2014 2Q

2014 3Q 2014 4Q

2014 1Q 2015 Janney Moderate FI Allocation

Barclays Agg Benchmark

Janney FISR Moderate Fixed Income Allocation Outperformed Barclays Aggregate by Cumulative 1.0% LTM

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FI ASSET ALLOCATION • PAGE 2 CONTENTS

The value of the three- pronged portfolio has faded now that long term yields have more reasonably priced in the course of Fed policy.

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Heading into 2015, we made a few core arguments. Number one, we commented that refreshed consensus calls for 3%-plus economic growth were just as bunk for 2015 as they were for 2014.

Number two, the long end of the US yield curve wasn’t accurately pricing in the potential for a lower

“peak” fed funds rate when the Fed finishes its tightening cycle in 2018 or so. Number three, foreign central bank policy easing would inevitably flow through into the US markets over time.

So far, we’re three for three on those arguments. First quarter growth forecasts are being revised lower as this note is published, with the Atlanta Fed’s suddenly in-vogue GDP now tracker projecting as low as a +0.2% result. It’ll be nearly impossible to get to 3% with that sort of start. Yields on the long end have descended about 25 basis points to more reasonably reflect a peak in overnight interest rates around 2%. And the Euro marked its worst quarter in history versus the dollar, drop- ping a little more than 11% in three short months. With that sort of record, it’s clearly time to take a few bets off the table. The bets we’re talking about in this context was the third component of our three-pronged portfolio approach (short term high yield, intermediate term munis, and the thirty year Treasury). At this point, the opportunities for further outsized returns on the long bond are more limited, as it’s trading close to our fair value.

Rather than requiring the market pricing coming around to the economic reality—which was the implicit backing of our long end bet—further rallies on the long end of the US yield curve now re- quire either, one, an expectation of slowing economic growth, or two, an expectation of accelerated declined in the Euro relative to the dollar. The former would introduce risk of recession and turn what is a bear flattening yield curve (front end yields rise, long end unchanged) into a bull flattening yield curve (front end rises slightly, long end yields fall). The latter would compress longer term real yields as supply of global longer term assets gets sopped up by the €60 billion per month ECB bond buying. The bias is still towards lower, not higher, rates on the long end of the US yield curve, but the path is no longer as certain.

Another way to view the market developments over the first three months of the year is that the potential risk of placing duration bets has increased materially. For the purposes of our asset allocation calculus, lower confidence in duration bets generally means higher confidence in bets on spread asset classes, such as credit and municipals. Value in the investment grade corporate markets might be best described as “good, not great,” with spreads, even excluding energy companies, well wider than 2014’s midyear tights. Value in the high yield corporate markets is similarly good, as the high yield ETFs were forced to sell the baby (non-energy names) with the bathwater (energy) when investors requested redemptions in late-2014. Value in the municipal sector, meanwhile, remains a province of the tax-exemption benefit, which is just as strong today as it’s been at any point in the last thirty years. Those three opinions—IG, HY, and muni value—are similar to the ones we ad- dressed in our initial 2015 allocation note.

Two additional areas of focus for 2Q are the RMBS/ABS/CMBS and the preferred sectors. RMBS/

ABS/CMBS, or securitized products, are generally accessible only for institutions or for individuals in packaged form, such as mutual funds or ETFs. Spreads are not especially wide in the sector by historical standards, but in comparison to other asset classes, there’s decent value in securitized products. Preferred meanwhile have a few advantages in a low income environment: wide spread, pricing off of a longer point on the curve, and tax advantages for QDI-eligible securities. Given our benign view of long term yields and the near-universal need for income, preferreds have always been one approach, but our like for the sector goes a little deeper. As Jody Lurie pointed out in her recent note, Stress Testing the American Way, regulatory requirements and market shifts have enhanced the soundness of the US banking system. In essence, the utility-ification of banking helps protect the financial industry against future systemic downturns. Our Moderate and Aggressive portfolios below include greater allocations to both securitized products and preferreds.

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Higher allocations to the preferred sector reflect the wide spreads and greater income combined with a more stable financial sector credit picture.

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Moderate (our core allocation; includes access to all fixed income asset classes with limitations on weightings reflective of an average risk tolerance)

Aggressive (Expands limitations on asset class weightings, permitting more access to higher risk/higher return asset classes reflective of an above-average risk tolerance)

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FI ASSET ALLOCATION • PAGE 4 CONTENTS

Our recommended allocation sets up well against a period of Fed rate hikes, even though those hikes are al- ready priced in.

Conservative (Excludes access to below-investment grade and other higher risk/

higher return asset classes reflective of a below-average risk tolerance)

We believe in the power of backtesting investment strategies not as a tool to build them, but rather as a secondary confirmation that the strategy we’ve built would have performed well in the environment for which it was designed. As noted in the “Worldview” section on page two, we’re looking at a relatively stable, if historically low, interest rate environment on the long end of the curve, and rising short term rates. Couple that with a reasonably constructive credit environment, and the argu- ably best historical corollary is the 2004 – 2005 portion of the last Fed rate hike cycle, in which long rates were stable, and the credit boom was getting going. Backtesting our fixed income allocation across a range of historical scenarios indicates that the portfolio performs as anticipated. With the greater allocation to illiquid assets than the benchmark, the allocation expectedly underperforms the broader bond markets in periods of liquidity stress, as denoted by the 2007 mini-credit crunch and the 2008 full blown Global Financial Crisis. Similarly—and more importantly—back testing the portfolio against the Fed rate hikes in 2006 indicates that the portfolio outperformed the Aggregate in periods of tightening monetary policy.

Backtested Moderate Allocation Total Returns

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2.00%

4.00%

6.00%

8.00%

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Liquidity Crisis Moderate Credit Detioration Easy Credit Days Fed Rate Hikes Moderate Allocation Returns

Aggregate (Benchmark)

Source: Janney Fixed Income Strategy; Barclays

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Analyst Certification

I, Guy LeBas, the Primarily Responsible Analyst for this report, hereby certifies that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Definition of Outlooks

Positive: Janney FIS believes there are apparent factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades

Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades.

Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades.

Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades.

Definition of Ratings

Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return

Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return

Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return

Benchmarks

Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the “Barclay’s U.S. Aggregate Bond Market Index” as a benchmark.

Treasuries: Janney FIS ratings employ the “Barclay’s U.S. Treasury Index” as a benchmark.

Agencies: Janney FIS ratings employ the “Barclay’s U.S. Agency Index” as a benchmark.

Mortgages: Janney FIS ratings employ the “Barclay’s U.S. MBS Index” as a benchmark.

Investment Grade Credit: Janney FIS ratings employ the “Barclay’s U.S. Credit Index” as a benchmark.

High Yield Credit: Janney FIS ratings for employ “Barclay’s U.S. Corporate High Yield Index” as a benchmark.

Municipals: Janney FIS ratings employ the “Barclay’s Municipal Bond Index” as a benchmark.

Disclaimer

Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication.

Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS).

This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney’s express prior written consent.

This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change.

Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor.

Fixed Income Asset Allocation