Sentiment & Positioning January 28, 2014

A widely expected move higher in bond yields has yet to materialize in 2014, and those expectations actually may help explain why yields have declined. Financial markets occasionally “zig” just when a growing majority expects a “zag.” Bonds are no exception, and many investors have been caught off guard by early 2014 bond strength. Although profit taking hit bonds on Monday, January 27, 2014, the Barclays Aggregate Bond Index is still up over 1% year to date. After dropping as low as 2.71% last Friday, the 10-year Treasury yield closed Monday, January 27, 2014 at 2.76%, still 0.27% lower in just over three weeks of trading this year — a significant move.

Lopsided sentiment can often drive contrarian moves by financial markets, especially in the bond market. One indicator that captured the overwhelmingly negative sentiment on bonds was the Commitments of Traders report, which is issued weekly by the U.S. Commodity Futures Trading Commission (CFTC). The CFTC Commitments of Traders report includes the net positioning of speculative investors across a variety of futures contracts. Observing whether speculative investors are net long (betting on higher prices) or net short (betting on lower prices) can reveal positioning of institutional speculative investors.

In late 2013, the CFTC report showed one of the largest net short positions on record in 10-year Treasury futures, indicating that the market was expecting rates to rise. The near 200,000 net short position was a level witnessed only rarely over the past 10 years [Figure 1]. These extremes have

often coincided with contrarian rallies as evidenced by the shaded areas. As prices rise and yields decline, speculative investors scramble to cover their short positions for fear of incurring losses. The rush to exit positions can be a powerful force and, here in early 2014, the subsequent buying has helped propel the bond market higher.

This contrarian indicator can help explain pullbacks as well. The buildup of long positions in early 2013 to some of the highest levels of the past few years coincided with the 2013 bond pullback and rise in yields.

At the same time, the indicator is not foolproof, and a significant net long position prior to the 2007 – 08 financial crisis coincided with a long decline in yields. In addition, the CFTC data are released with a slight lag meaning sentiment may have shifted, but it does help explain market moves. The CFTC report is just one tool to assess sentiment that may be offside and a lead to a contrarian move in the markets, but it needs to be evaluated in conjunction with other data.

Positioning

Positioning of short-term speculators is far from the only factor driving bond prices, and investor positioning appeared to corroborate the negative sentiment at the start of the year. The firm Stone & McCarthy Research Associates conducts a survey of bond investors to assess whether they are positioned short, neutral, or long relative to their broad benchmarks. A short or long bias would reveal investor expectations of rising or falling interest rates, respectively. In mid-January, Stone & McCarthy’s survey revealed investors on average were at 96.6% of their target interest rate sensitivity, or duration, the most defensive reading since the third quarter of 2008.

As bond prices rise and interest rates fall, defensively positioned investors may see their portfolios likely lag benchmark performance. Investors then would likely buy to get closer to their benchmark in order to limit underperformance to a benchmark. Bond buys to get portfolios closer to neutral may have aided bonds in early 2014.

When coupled with fundamental drivers, positioning and sentiment can be a potent combination. In early January 2014, a weaker-than-expected employment report sparked questions about the strength of the economy and bonds rallied, setting in motion a buying spree as wrong-footed investors reversed bets on lower bond prices. Pension investors also took advantage of yields near two-and-a-half-year highs and also gave bond prices a boost to start 2014 (please see blog post Why Own Bonds? 1/21/14 for more details).

Recent momentum was aided by a host of emerging market (EM) issues spurring buys of higher-quality assets like Treasuries. Weaker-than-expected economic growth from China, Turkey’s central bank’s attempt to stabilize its currency, political instability in the Ukraine, and Argentine currency devaluation all contributed to US Treasury demand.

EM currency fears appear contained for now, however, with no signs of disruption in domestic intra-bank lending markets. The TED spread, a key gauge of inter-bank lending pressures during the 2007 – 08 financial crisis and several times during the European debt fears of recent years, has served as an early warning signal but is near a post-recession low for now [Figure 2], indicating no global contagion from EM currency weakness.

Where Do We Go From Here?

Although EM concerns may support high-quality bonds during the current week, the offside positioning in the bond market has been largely reversed. Figure 1 illustrates that while speculators may still be net short, positioning is much closer to neutral and away from an extreme. The most recent J.P. Morgan investor duration survey shows fewer participants “short” and a greater number now “neutral.”

This suggests that the fuel for additional price gains will likely need to come from fundamental data. The preponderance of economic data suggests the U.S. economy continues to expand near our expected pace of 3% (as measured by real gross domestic product) and that the weak employment report may have been an outlier, suggesting further bond gains may be limited. Bond investors may refocus on economic data now that positioning and sentiment appear more balanced.

Furthermore, this week’s auctions of new two-, five-, and seven-year Treasury securities may give investors pause after the recent run-up in prices. Add a Federal Reserve (Fed) meeting, and a bond market breather is likely until new information is digested. The Fed is also widely expected to announce a further $10 billion reduction in bond purchases at the conclusion of Wednesday’s Fed meeting. Both factors augur for higher yield probability over the course of the year.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Why Own Bonds? January 21, 2014

Strong equity market performance in 2013 and still-low yields may cause investors to overlook the fact that bonds can still serve as an effective diversification tool. Following a year in which stocks returned 30% and bonds posted their worst return since 1994*, investor sentiment for stocks remains positive while bond sentiment is poor. The divergence in sentiment is evident in actual investment dollars. Inflows into stock mutual funds totaled $168 billion in 2013 versus a rare outflow for bonds, which totaled $82 billion. Our 2014 forecast calls for 10% to 15% returns for stocks and another challenging year for bonds with returns roughly flat^{^.}

The case for stock investing is strong but pullbacks can arrive without warning. As mentioned in our

Outlook 2014, we expect more volatility this year. In 2013, the stock market experienced only one brief pullback of just over 5%. Historically such calm is rare. Looking beyond 2014 the case for stocks over bonds is compelling, but for investors with shorter-term horizons protection against an equity market sell-off is prudent. After all, the average annual peak-to-trough decline in the S&P 500 from 1960 to 2013 has been 16%, and pullbacks can arrive without warning. Investors need to be prepared and bonds can help provide a buffer.

A look back at prior stock market pullbacks illustrates how bonds have historically provided good diversification benefits. Figure 1 shows all equity market pullbacks of 5% or more lasting three weeks or more over the past 10 years and the corresponding return for stocks and high-quality bonds. Figure 1 also illustrates the hypothetical return of a balanced 60% stock/40% bond portfolio and the dampening impact bonds can have on stock weakness. During stock market pullbacks in excess of 5%, bonds outperformed stocks on average by a double digit margin, a significant difference. Excluding the historic mid-2008 to early-2009 sell-off, the performance differential narrows but is still notable at a 9.6% advantage in favor of high-quality bonds.

In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions. In 2008, high-quality bonds provided a buffer but not without volatility, as investment-grade corporate bonds declined for the year and even high-quality mortgage-backed securities (MBS) suffered brief declines. While not all segments of the bond market perform similarly every time, an allocation to high-quality bonds has proven effective at offsetting stock market weakness.

Not About Yield

Today’s low-yield environment does not negate the diversification potential of bonds. During 2012, the stock market suffered two pullbacks greater than 5%, and bonds rose more than 1% over each period. The 10-year Treasury yield varied between 1.4% and 1.9% during the 2012 equity market sell-offs, much lower than today’s level.

In fact, during each stock market pullback in Figure 1 bond market performance is fairly consistent, averaging 1%, despite varied levels of interest rates. Two of the bond market’s strongest gains during stock market sell-offs occurred in 2010 and 2011, a post-recession period in which yields had already declined sharply.

Over short-term periods, price movement, not interest income, is the primary driver of bond performance. Interest income accrues slowly and although the primary driver of long-term bond returns, price changes, up or down, often overwhelm the impact of interest income over short periods of time. Therefore, a low-yield environment does not preclude bonds acting as a diversification tool.

Pension Buyers

Pension plans represent another investor group that can use bonds to address a specific objective. Pension investors, who have a very long time horizon and are therefore less sensitive to interest rate movements, use bonds to offset their long-term liabilities. Robust equity market gains in 2013 improved pension funding ratios broadly and reduced the need to take on additional risk to achieve investment goals. Following a year in which equities gained 30%, pension buyers took advantage of long-term Treasury yields near 4% and long-term corporate bond yields above 5% to better balance the risk-reward profile of their investment portfolios [Figure 2]. Pension buying, which has been a steady source of demand so far in 2014 and one reason why bonds are off to a good start, illustrates another way in which bonds can address specific investor objectives.

Conclusion

Low yields will likely translate into lower long-term bond returns, and therefore the hurdle for stock investors to beat bond performance over the long term is lower. However, for investors with shorter horizons or those simply unwilling to endure stock market swings, bonds can play a diversification role even in today’s low-yield environment. In conjunction with sectors that historically hold up better against rising rates, such as high-yield bonds and bank loans, an allocation to core bonds makes sense to help protect against potential stock market weakness.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Stock and mutual fund investing involves risk including loss of principal.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

Mortgage-backed securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

2014 Fixed Income Outlook December 3, 2013

In 2014, interest rates are likely to continue to move higher and bond prices lower in response to improving economic growth, reduced Federal Reserve (Fed) bond purchases, and the likelihood of an interest rate hike in 2015. Even though a Fed rate hike is a 2015 event, bond prices are likely to decline and yields increase as valuations remain expensive to historical averages and forward-looking markets prepare for a rate hike. We view the start of interest rate hikes as more important than the pace of tapering, but tapering will mark the first step in bond prices and yields returning to historical norms. We see a defensive investment posture focused on less interest rate sensitive sectors as the most prudent way to invest in 2014.

Yielding to Growth

Longer-term bond yields have historically tended to track the change in gross domestic product (GDP) growth absent the influence of Fed actions. Our expectation for a 1% acceleration in U.S. GDP over the pace of 2013 suggests a similar move for the bond market. This would prompt a rise in the yield on the 10-year Treasury from around 2.75% as of mid-November 2013 to about 3.25% to 3.75% in 2014.

On the Horizon

While investors may see the Fed end direct involvement in the bond market in 2014 as the bond-buying program comes to a close, the Fed may make its presence felt again in 2015 with a series of rate hikes. The expectation for rate hikes in 2015 may also lead to rising pressure on bond yields in 2014. Each period of Fed interest rate hikes is different, but by evaluating key metrics such as short-term Treasury yields, the shape of the yield curve, and inflation-adjusted yields prevalent at the start of prior Fed rate hikes, we can approximate the trajectory of yields in 2014 as the market braces for a potential interest rate hike in 2015.

Given the Fed’s current guidance for a mid-2015 start to interest rate hikes, supported by our outlook for stronger GDP and job growth in 2014, we may expect at least an 18-month path of reduced Fed involvement in the bond market from around the start of 2014 to mid-2015. This reinforces the fundamental case for the 10-year Treasury yield rising by 0.5% to 1.0% as yields rise to more “normal” valuation levels that would translate to a 10-year Treasury yield at the end of 2014 of 3.25% to 3.75%. Total returns may be roughly flat under that scenario  [Figure 1].

It is possible that yields could increase by 1.0% to 3.75% should inflation-adjusted yields return to more normal levels. Under that scenario, high-quality bond total returns would be negative, as indicated by Figure 1.  However, we see a move of this magnitude as less likely unless the markets expect an earlier start to Fed rate hikes. Instead, we think it is more likely the Fed may wait longer than mid-2015 to raise interest rates, which supports a more modest rise in the 10-year of 0.50% to 0.75%.

A number of factors indicate yields may rise less than our forecasts, and this is the primary risk to our bond outlook.

• Low Inflation. Inflation is an enemy of bondholders since it makes fixed payments worth less over time. While inflation is likely to pick up modestly in 2014, fortunately, it is likely to remain historically low. Bond valuations may therefore remain historically expensive. The lower the pace of inflation, the less bond yields will need to rise in response.
• Disappointing growth.  Slower-than-expected growth may reinforce the low inflation environment and delay the timing of eventual Fed rate hikes — both of which are positives for bond prices. Should the economy grow at a slower pace than anticipated in 2014, bond prices may similarly prove more resilient.
• Fed delays.  Our interest rate forecast is based upon the Fed gradually tapering bond purchases in 2014 and market participants’ expectation for a potential interest rate hike in June 2015. If these are pushed back, yields may rise less than our base forecast and bond prices may prove more resilient. Low single-digit returns may result if it becomes clear the Fed may wait longer than mid-2015 to raise interest rates.

Stay in the Middle

Among high-quality bonds we prefer intermediate-term bonds, which possess far less interest rate risk compared with long-term bonds [Figure 2].  The yield curve remains relatively steep today. A positive factor for intermediate-term bonds is that they include the steepest portion of the yield curve. A yield curve is a chart of bond yields from the shortest-maturity issues to the longest-maturity ones. The steepest point is that which offers the biggest increase in yield per additional increase in term.

While short-term bonds offer the least interest rate risk, their low yields make them less attractive. We believe intermediate-term bonds possess a better combination of interest rate risk mitigation and reward in the form of yield under a range of outcomes.

Intermediate-term bonds have the ability to generate modestly positive returns despite a fair rise in interest rates. Importantly, given their position on the yield curve, intermediate-term bonds can also provide some defensive properties to a portfolio [Figure 3].  Immediate-term, high-quality bond returns turn negative with a 1.0% rise in interest rates — just above the high end of the most likely range we expect for intermediate-term bonds in 2014. However, they can produce mid-single-digit gains if interest rates are unchanged or even decline slightly — driven by disappointing economic growth or a negative event causing investors to take a temporary defensive stance. In that event, intermediate-term bonds may provide a gain offsetting losses in the event of a stock market pullback — a key reason for holding bonds in a portfolio.

Harvesting Yield

A rising interest rate environment presents a challenge to bond market investors. Investors must seek to minimize interest rate driven losses and at the same time focus opportunistically on sectors that have traditionally produced gains during rising rate environments.

High-yield bonds and bank loans are two sectors that have historically proven resilient and often produced gains during periods of rising interest rates. In 2013, both sectors were among the leaders of bond sector performance during a year of higher interest rates.

High-yield bonds and bank loans are attractive bond sectors for 2014. Deteriorating credit quality and rising defaults are the key risks to investors in these lower-rated bonds, but we believe these risks will be manageable in 2014 as growth picks up. The global speculative default rate was a low 2.8% at the end of October 2013 — well below the historical average of 4.5%. Moody’s forecasts a low default environment to persist through 2014, a forecast we agree with given the limited number of maturing bonds in 2014. In addition to a low default environment, both high-yield bonds and bank loans remain supported by good fundamentals. Company leverage has increased over recent quarters, but the cost to service that debt remains quite manageable with interest coverage near post-recession highs.

High-yield bonds and bank loans are likely to produce low- to mid-single-digit returns in 2014. High-yield bond valuations are more expensive heading into [Figure 4]. As 2014 progresses, yield spreads may increase as investors begin to demand greater compensation for a potential  increase in defaults in 2015. Bank loans may also be impacted by investors bracing for higher defaults, but less than high-yield bonds due to their shorter-term nature and higher  seniority.

Among high-quality bonds we favor investment-grade corporate and municipal bonds. Investment-grade corporate bonds are likely to be impacted by rising interest rates, but still yield, on average, 1.3% more than comparable Treasuries. In a rising rate environment, interest income can be a buffer against price declines associated with rising interest rates. The higher yield potential of investment-grade corporate bonds, which remain supported by good credit quality fundamentals, may therefore be able to provide better protection than Treasuries.

Corporate bond sectors, both investment-grade and high-yield, have historically provided better protection against rising interest rates [Figure 5].  During periods of rising Treasury yields, corporate yields tend to rise less and corporate bond prices have been more resilient.  Figure 5 illustrates how the yield differential, or spread, between Treasuries and  investment-grade corporate bonds and high-yield bonds has generally narrowed when Treasury yields rose. Since 2000, investment-grade corporate bond yield spreads have narrowed in all but two periods of rising Treasury yields and all but one for high-yield bonds.

Among high-quality bonds, we also find municipal bonds attractive, favoring intermediate-term rather than traditional long-term municipal bonds.

International Debt

Emerging market debt (EMD) is another way to add higher income generating potential to portfolios. In general, EMD issuers have lower debt burdens and stronger economic growth than their developed market peers. In addition, valuations are attractive as 2013 winds down with an average yield spread of 3.6% to comparable Treasuries, near the upper end of a four-year range. Better valuations set the foundation for a better 2014, following a difficult 2013. However, not all EMD issuers are alike. In the face of relatively sluggish global demand in recent years, some emerging market countries have relied on extraordinary liquidity provided by the world’s central banks to grow their economies at the cost of running current account deficits as they increasingly borrow to import more than they export. As global credit conditions tighten and developed market bond yields rise, some EMD issuers have suffered as investors find more attractive yields in more financially secure markets. As these EMD issuers adjust to the lessened liquidity provided by central banks, they become increasingly attractive. Emerging market debt is increasingly attractive in 2014, but we remain cautious on developed foreign bond markets given weak growth and unattractive valuations.

Opportunities in a Less Liquid Market

Like 2013, 2014 may also provide investors with opportunities created by volatility. In 2013, the 10-year Treasury yield fell as low as 1.6% and also rose as high as 3.0% — a remarkably wide range given the steady and sluggish pace of economic growth and lack of abrupt changes by the Fed. Although these movements may seem dramatic in a historical context, they may become the norm as recent financial regulations discourage traditional market-making firms from participating in the bond market. As a result, these less liquid markets can experience sharp swings up or down and temporarily take prices and yields beyond levels warranted by fundamentals. Tactical investors may harvest opportunities that could arise in a low-return, volatile market. This may be experienced more dramatically in less liquid markets, such as emerging market debt and municipal bonds among others.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Preferred stock investing involves risk, which may include loss of principal.

High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Preferred stock investing involves risk, which may include loss of principal.

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INDEX DESCRIPTIONS

The Barclays Capital Aggregate Bond Index is an unmanaged market capitalization-weighted index of most intermediate-term U.S. traded investment-grade, fixed rate, non-convertible and taxable bond market securities including government agency, corporate, mortgage-backed, and some foreign bonds.

The Barclays Capital High Yield Index covers the universe of publicly issued debt obligations rated below investment-grade. Bonds must be rated below investment-grade or high-yield (Ba1/BB+ or lower), by at least two of the following ratings agencies: Moody’s, S&P, Fitch. Bonds must also have at least one year to maturity, have at least $150 million in par value outstanding, and must be US dollar denominated and nonconvertible. Bonds issued by countries designated as emerging markets are excluded.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Navigating the Markets November 26, 2013

Compass Changes

• No Changes

Investment Takeaways

• We expect the S&P 500 Index to grind higher through year-end, supported by durable U.S. economic growth, accommodative Federal Reserve (Fed) policy, and earnings gains.

• Our positive small cap view reflects our U.S. focus and potential to capture further stock market gains.

• We continue to favor the more U.S.-focused, consumer-oriented sectors over the global, export-focused sectors.

• We find bond valuations roughly fair and expect yields to remain largely range-bound through year-end.

• Higher-yielding, fundamentally sound segments of the bond market such as high-yield bonds, bank loans, and preferred securities remain among the more attractive fixed income options.

• Among high-quality bonds, we favor investment-grade corporate bonds due to the potential for higher yields and good fundamentals.

• We find high-yield municipal bonds attractive, but high-quality municipal bonds possess more attractive valuations and compelling taxable-equivalent yields.

• From a technical perspective, the S&P 500 Index price continues to make new all-time highs, establishing a new bullish price objective at 1845.

Broad Asset Class Views

LPL Financial Research’s views on stocks, bonds, cash, and alternatives are illustrated below. The positions of negative, neutral, or positive are indicated by the solid black compass needle, while an outlined needle shows a previous view.

Equity & Alternative Asset Classes

Favor Small Caps for U.S. Focus Potential for Further Stock Market Gains

• We expect the S&P 500 Index to continue to grind higher over the balance of the year, supported by durable U.S. economic growth, accommodative Fed policy, and earnings gains.

• We favor small caps for their potential to capture further stock market gains.

• We favor U.S. stocks relative to emerging markets (EM) and developed foreign, as Europe struggles to grow, and the growth trajectory in several key EM countries has been uneven. The recent pickup in China’s growth is encouraging.

• We maintain a preference for growth over value due to growth’s tendency to outperform in slow-growth environments and our positive consumer discretionary view.

• We believe further downside to crude oil (WTI) may be limited in the near term from a technical perspective, though the latest inventory data and relative calm in the Middle East are bearish.

• The potential for the Fed not to taper its bond purchases until after the New Year may provide near-term support for gold.

Equity Sectors

Maintain Preference for U.S. and Consumer-Focused Cyclical Sectors

• We continue to favor the more U.S.- focused, consumer-oriented sectors over the global, export-focused sectors.

• Our consumer discretionary view remains positive as spending continues to increase, albeit modestly, and the housing recovery continues despite higher mortgage rates.

• Our financials view is neutral. We see the U.S. focus, earnings gains, and valuations as positives, although mortgage activity, fixed income trading, and regulation remain concerns.

• Our modestly positive health care view reflects our U.S. focus, robust pace of product innovation, and demand uptick from the Affordable Care Act (ACA).

• The materials sector is one to watch for a potentially more positive view due to positive technicals and evidence of a pickup in growth in China.

• We expect a potential pickup in business spending and improving growth in China to help industrials sector performance.

• We remain cautious on telecom and utilities due to their interest rate sensitivity, though telecom valuations have become more reasonable in recent months.

• Our recent downgrade in our consumer staples view was driven by above-average valuations and weakening technicals, but lower oil prices help the outlook.

Fixed Income

A New Yield Range

• We find bond valuations roughly fair and expect bond prices and yields to continue to be largely range-bound between now and year-end 2013.

• We believe intermediate maturity bonds provide a better risk/return trade-off compared to short-term bonds.

• We find high-yield municipal bonds attractive, but high-quality municipal bonds possess more attractive valuations and compelling taxable-equivalent yields.

• A modest rise in yields to start November shows the bond market remains sensitive to tapering fears, but clarity from economic data, Washington, and the Fed may take months to become evident.

• Higher-yielding, fundamentally sound segments of the bond market such as high-yield bonds, bank loans, and preferred securities remain among the more attractive fixed income options.

• Among high-quality bonds, we favor investment-grade corporate bonds due to the potential for higher yields and good fundamentals.

All performance referenced herein is as of November 19, 2013, unless otherwise noted.

Global macro strategies risk include but are not limited to imperfect knowledge of macro events, divergent movement from macro events, loss of principal, and related geopolitical risks.

Real estate/REITs may result in potential illiquidity and there is no assurance the objectives of the program will be attained. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International and emerging markets involve special risks such as currency fluctuation and political instability. The price of small and mid-cap stocks are generally more volatile than large cap stocks. Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. Precious metal investing is subject to substantial fluctuation and potential for loss. These securities may not be suitable for all investors. Alternative strategies may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses. Stock investing may involve risk including loss of principal.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

For the purposes of this publication, intermediate-term bonds have maturities between three and 10 years, and short-term bonds are those with maturities of less than three years.

All bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availably and change in price. High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors. Municipal interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply. Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.

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DEFINITIONS:

EQUITY AND ALTERNATIVES ASSET CLASSES

Large Growth: Stocks in the top 70% of the capitalization of the U.S. equity market are defined as Large Cap. Growth is defined based on fast growth (high growth rates for earnings,

sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).

Large Value: Stocks in the top 70% of the capitalization of the U.S. equity market are defined as Large Cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

Mid Growth: The U.S. mid-cap range for market capitalization typically falls between $1 billion and $8 billion and represents 20% of the total capitalization of the U.S. equity market. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).

Mid Value: The U.S. Mid Cap range for market capitalization typically falls between $1 billion and $8 billion and represents 20% of the total capitalization of the U.S. equity market. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

Small Growth: Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as Small Cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).

Small Value: Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as Small Cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).

U.S. Stocks: Stock of companies domiciled in the U.S.

Large Foreign: Large-cap foreign stocks have market capitalizations greater than $5 billion. The majority of the holdings in the large foreign category are in the MSCI EAFE Index.

Small Foreign: Small-cap foreign stocks typically have market capitalizations of $250M to $1B. The majority of the holdings in the small foreign category are in the MSCI Small Cap EAFE Index.

Emerging Markets: Stocks of a single developing country or a grouping of developing countries. For the most part, these countries are in Eastern Europe, Africa, the Middle East, Latin America, the Far East and Asia.

REITs: REITs are companies that develop and manage real-estate properties. There are several different types of REITs, including apartment, factory-outlet, health-care, hotel, industrial, mortgage, office, and shopping center REITs. This would also include real-estate operating companies.

Commodities – Industrial Metals: Stocks in companies that mine base metals such as copper, aluminum and iron ore. Also included are the actual metals themselves. Industrial metals companies are typically based in North America, Australia, or South Africa.

Commodities – Precious Metals: Stocks of companies that do gold- silver-, platinum-, and base-metal-mining. Precious-metals companies are typically based in North America, Australia, or South Africa.

Commodities – Energy: Stocks of companies that focus on integrated energy, oil & gas services, oil & gas exploration and equipment. Public energy companies are typically based in North

America, Europe, the UK, and Latin America.

Merger Arbitrage is a hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. A merger arbitrageur looks at the risk that the merger deal will not close on time, or at all. Because of this slight uncertainty, the target company’s stock will typically sell at a discount to the price that the combined company will have when the merger is closed. This discrepancy is the arbitrageur’s profit.

Long/Short is an investment strategy generally associated with hedge funds. It involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value.

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EQUITY SECTORS

Materials: Companies that engage in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel.

Energy: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection or the exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.

Industrials: Companies whose businesses: Manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery; provide commercial services and supplies, including printing, employment, environmental and office services; provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.

Consumer Discretionary: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services.

Technology: Companies that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services. Technology hardware & equipment include manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.

Financials: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs.

Utilities: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.

Health Care: Companies in two main industry groups: Healthcare equipment and supplies or companies that provide healthcare-related services, including distributors of healthcare products, providers of basic healthcare services, and owners and operators of healthcare facilities and organizations or companies primarily involved in the research, development, production and marketing of pharmaceuticals and biotechnology products.

Consumer Staples: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of nondurable household goods and personal products. It also includes food and drug retailing companies.

Telecommunications: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network.

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FIXED INCOME

Credit Quality: An individual bond’s credit rating is determined by private independent rating agencies such as Standard & Poor’s, Moody’s and Fitch. Their credit quality designations range from high (‘AAA’ to ‘AA’) to medium (‘A’ to ‘BBB’) to low (‘BB’, ‘B’, ‘CCC’, ‘CC’ to ‘C’).

Duration: A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The bigger the duration number, the greater the interest-rate risk or reward for bond prices.

Munis – Short-term: Bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. These bonds generally have maturities of less than three years.

Munis – Intermediate: Bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. These bonds generally have maturities of between 3 and 10 years.

Munis – Long-term: Bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. These bonds generally have maturities of more than 10 years.

Munis – High-yield: Bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. These bonds generally offer higher yields than other types of bonds, but they are also more vulnerable to economic and credit risk. These bonds are rated BB+ and below.

Treasuries: A marketable, fixed-interest U.S. government debt security. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level.

TIPS (Treasury Inflation Protected Securities): A special type of Treasury note or bond that offers protection from inflation. Like other Treasuries, an inflation-indexed security pays interest every six months and pays the principal when the security matures. The difference is that the underlying principal is automatically adjusted for inflation as measured by the consumer price index (CPI).

Mortgage-Backed Securities: A type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.

Investment-Grade Corporates: Securities issued by corporations with a credit ratning of BBB- or higher. Bond rating firms, such as Standard & Poor’s, use different designations consisting of upper- and lower-case letters ‘A’ and ‘B’ to identify a bond’s investment-grade credit quality rating. ‘AAA’ and ‘AA’ (high credit quality) and ‘A’ and ‘BBB’ (medium credit quality) are considered investment-grade.

Preferred Stocks: A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

High-Yield Corporates: Securities issued by corporations with a credit rating of BB+ and below. These bonds generally offer higher yields than investment-grade bonds, but they are also more vulnerable to economic and credit risk.

Bank Loans: In exchange for their credit risk, these floating-rate bank loans offer interest payments that typically float above a common short-term benchmark such as the London interbank offered rate, or LIBOR.

Foreign Bonds – Hedged: Non-U.S. fixed income securities generally from investment-grade issuers in developed countries, with hedged currency exposure.

Foreign Bonds – Unhedged: Non-U.S. fixed income securities normally denominated in major foreign currencies.

Emerging Market Debt: The debt of sovereigns, agencies, local issues, and corporations of emerging markets countries and subject to currency risk.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

Past performance is no guarantee of future results.

Stock investing involves risk including loss of principal.

Preferred stock investing involves risk, which may include loss of principal.

Distressed investing involves significant risks, including a total loss of capital. The risks associated with distressed investing arise from several factors including: limited diversification, the use of leverage, limited liquidity, and the possibility that investors may be required to accept cash or securities with a value less than their original investment and/or may be required to accept payment over an extended period of time.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Summer of Love August 6, 2013

Summer of Love

It has been a summer of love for the stock market. As the temperatures heated up, so did the stock market. From June 24 to August 2, 2013, the S&P 500 Index rose 9%, pushing stocks up about 20% for the year. The last time we saw stocks perform the way they have this year in both pattern  and magnitude was 1967 [Figure 1]

During 1967’s Summer of Love, the Haight-Ashbury neighborhood of San Francisco became the center of a cultural movement known as the Hippie Revolution, but there was a lot more going on economically and socially that offer parallels to today that could explain the stock market similarity:

• Bond yields rose over the course of 1967, but most notably from April to August when the 10-year Treasury note rose about one percentage point — similar to this year’s move over the same time period.

• Gross domestic project (GDP) averaged a lackluster 2% in the first half of 1967, not too far from the 1.4% growth seen in 2013’s first half.

• Earnings per share growth for S&P 500 companies was pretty flat on a year-over-year basis then and now.

• Protest politics took place around the world in 1967; this year, Egypt and Brazil are two of the hot spots for protest-driven societal change.

• Recent events still bring forth faint echoes of the race and gender equality struggles of 1967.

• Detroit’s bankruptcy was almost 46 years to the day that the Detroit riots of 1967 broke out and are considered to be the seminal event that started the erosion of the tax base that left the city to declare bankruptcy in 2013.

• President Obama’s Affordable Care Act and other programs have drawn comparisons to President Johnson’s Great Society programs passed in the mid-1960s, which included Medicare, the extension of welfare, and environmental activism, and were seen as part of a host of large government spending programs that would speed economic growth as they came into effect in 1967 and beyond.

• The National Security Agency’s (NSA) Project MINARET began in 1967, intercepting electronic communications of U.S. citizens without warrants or judicial oversight. This controversial program can be compared with the revelations in 2013 regarding NSA spying on U.S. citizens.

It can be dangerous to look back selectively. Of course, there are lots of differences between now and 46 years ago, and there is no assurance that stocks will continue to follow the 1967 pattern. Nevertheless, if the pattern in the stock market mirroring 1967 that has unfolded so far this year holds in the second half, we may see a volatile market with a slower pace of gains — but more record highs ahead. That historical flashback happens to be consistent with our market forecast for the second half of the year.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
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INDEX DESCRIPTIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

S&P 500 Indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Bond Market Perspectives June 25, 2013

When Will the Selling Stop?

The past week brought about the summer solstice, the official start of summer, but for bond investors it feels more like the dead of winter. Bond weakness continued in response to a Federal Reserve (Fed) that remains fixated on slowing, or tapering, bond purchases following last week’s policy meeting.

A review of several bond metrics may help answer the question at the forefront of bond investors’ minds: “when will the selling stop?” Although we believe bond market weakness is overdone, we have to respect market action and evaluate how high yields may rise. A look at economic growth, Fed rate hike expectations, and the slope of the yield curve may help investors determine how high bond yields may rise in a more adverse scenario. The measures discussed below are simplistic guides but can still help triangulate how high yields may rise.

Economic growth and Treasury yields – The pace of economic growth has historically been one of the primary drivers of Treasury yields. The yield on the 10-year Treasury note has been roughly similar to annualized economic growth, as measured by nominal gross domestic product (GDP), over long periods of time [Figure 1]. The relationship has changed over the years as market confidence in a persistent low inflation-environment has grown, which has caused the 10-year Treasury to frequently yield less than annualized GDP growth over the past 10 years, but the two remain correlated.

Over the past 10 years, annualized nominal GDP growth has averaged 0.43% more than the 10-year Treasury yield. Assuming this relationship holds, subtracting 0.43% from annualized nominal GDP growth of 3.40% produces a 10-year Treasury yield of 2.97%. However, the Fed has been applying extraordinary stimulus for just under five years. Over the past five years, the 10-year Treasury yield has averaged 0.57% less than annualized nominal GDP growth, which implies a 2.83% 10-year Treasury yield, based upon the metric above. Since the Fed will remain active with bond purchases and remains committed to refrain from raising interest rates, this latter reading may be more appropriate. However, if the bond market is transitioning to a more “normal” state, free of Fed influence, then the2.97% 10-year Treasury yield provides a guide according to the GDP growth-Treasury yield relationship.

Rate hike expectations – The bond market continues to confuse “taper” with “rate hike.” Therefore, assessing market expectations for a first interest rate hike can may help determine how much more weakness is in store. According to fed fund futures, one of the better gauges of assessing market expectations of Fed interest rate changes, the first 0.25% interest rate hike is fully priced in by February 2015. This is a dramatic increase from just a few weeks ago, when fed fund futures indicated a late 2015/early 2016 as the mostly likely timing of a first rate hike.

Should the market move to fully price in a first rate hike by the fourth quarter of 2014, we believe bond selling pressure may subside. Last week, Fed Chairman Ben Bernanke outlined a broad plan to remove stimulus that begins with tapering bond purchases “later this year,” then ending bond purchases completely by mid-2014 (assuming the unemployment rate drops to 7.0% by then), followed by raising interest rate hikes by mid-2015 (assuming a further decline in the unemployment rate to 6.5%). By moving to price in a late-2014 first rate hike, bond market pricing would be more aggressive compared to the Fed’s game plan, while also providing a buffer should the Fed not stay true to its word or the labor market improve more quickly than currently anticipated. Furthermore, a fourth quarter 2014 rate hike would be a relatively short turnaround from the time of ending bond purchases. The Fed has stated in the past that a substantial period of time would elapse between the time bond purchases end and the time when interest rates will be increased.

To determine whether a fourth quarter 2014 rate hike is fully priced in, we can observe the fed fund futures contract expiring on December 2014. As of June 24, 2013, the December 2014 contract was priced to reflect a 0.40% fed funds rate, meaning that a 0.25% rate increase to 0.50% was not fully priced in. From Wednesday through Friday of last week (June 19, 2013 through June 21, 2013) the 10-year Treasury yield rose by 0.34% to 2.53% compared to a 0.12% rise in the implied yield of the December 2014 contract, a ratio of roughly three-to-one. Therefore, if the implied yield of the December 2014 fed fund futures increases by another 0.1%, to reflect a 0.5% fed funds rate, it would translate to an approximate 0.3% increase to the 10-year Treasury yield, taking it to 2.83%.

The yield curve – Over the past five years, the yield differential between the 2-year and 10-year Treasuries has peaked twice at 2.9% [Figure 2]. A greater differential is indicative of a “steep” yield curve, and a low differential represents a “flat” yield curve. At a current yield differential of 2.15%, the 10-year Treasury yield would have to increase by an additional 0.65% to reach the prior yield curve peak of 2.9%, as measured between 2- and 10-year Treasury yields. A 0.65% increase in the 10-year Treasury yield would imply a further increase to a 3.19% 10-year Treasury yield (approximately) based upon Monday’s close of 2.54%. Should the 2-year Treasury yield rise as well, then the 10-year Treasury yield may rise further. Nonetheless, the yield curve relationship indicates a 10-year Treasury yield in the low 3% range.

However, prior peaks in the yield curve occurred before the Fed’s commitment to refrain from raising interest rates, and therefore, a return to the prior peak level is unlikely. The Fed’s commitment to refrain from raising interest rates, in conjunction with Fed bond purchases, helped “flatten” the yield curve as investors extended maturity into higher-yielding investments, putting downward pressure on longer-term bond yields. As the Fed removes stimulus it is natural that the yield curve would steepen, but since the Fed’s commitment to refrain from raising interest rate remains intact, a return to prior peaks of yield curve slope remain unlikely. Furthermore, early 2010 and early 2011, the last two times the slope of the yield curve was at this maximum steepness, turned out to be very good buying opportunities for bond investors. High-quality bonds returned 4.7% and 7.4%, respectively, over the remainder of 2010 and 2011, as measured by the Barclays Aggregate Bond Index, from March of each year through the remainder of the calendar year. We doubt the bond market will provide such an easy opportunity for investors, and therefore, the rise in yields is likely to fall short of the target implied by the slope of the yield curve.

Conclusion: Cautious Until Signs of Stability Emerge

These three approaches may provide a guide as to a realistic high end of the range for bond yields. Collectively, they suggest the 10-year Treasury yield could find support between 2.75% and 3.00%, should the rise in bond yields continue.

Our belief is that Treasury yields may begin to stabilize near current yield levels. Bond price declines have been exacerbated by very illiquid trading conditions that, in some cases, pushed bond prices lower than justified by intrinsic value. Two of the more illiquid segments of the bond market, emerging market debt and municipal bonds, have therefore borne the brunt of recent weakness, but no sector has been immune. As a result, more evidence is needed to confirm yields have stabilized. Ultimately, we believe the rise in Treasury yields will likely stop short of the 2.75-3.00% range, since economic growth remains sluggish and inflation remains very low.

Some opportunities are emerging in fixed income markets due to the highest yields in over two years, but illiquid trading conditions, the approach of quarter-end this week which may foster risk aversion, and new issuance in Treasury and municipal bond markets may weigh on the bond market this week. We take a cautious view on the fixed income markets until additional signs of stability emerge.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Bonds given an investment grade rating indicate a relatively low risk of default.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Emerging market debt portfolios invest primarily in sovereigns, agencies, local issues, and corporate debt of emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

Futures and forward trading is speculative, includes a high degree of risk, and may not be suitable for all investors.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Bond Market Perspectives February 5, 2013

The Fed’s Bond Diet 

Bond investors may revisit an early catalyst to bond market weakness in 2013, when Federal Reserve (Fed) policymakers reconvene this week. The official statement following the conclusion of this Wednesday’s Fed meeting will be scrutinized for clues about whether the Fed’s bond appetite may be satiated. Minutes of the December 2012 Fed meeting, released during the first week of January, sparked selling among high-quality bonds, as investors feared the Fed would end or curtail bond purchases earlier than expected. Minutes also revealed that…”Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.” As we commented in early January, we believe bond market reaction to the Fed meeting minutes was overdone (please see the January 8, 2013, Bond Market Perspectives: Sour Start to New Year for more details), but scrutiny over the Fed’s bond holdings will continue.

With the Fed’s balance sheet surpassing $3 trillion [Figure 1], investors’ attention may once again be drawn to the Fed’s bond buying. The Fed is widely expected to maintain its current bond-buying diet of $45 billion in long-term Treasuries and $40 billion of government-agency mortgage-backed securities (MBS) as Fed policymakers reconvene this week.

However, in 2013, the Fed is no longer offsetting Treasury purchases with Treasury sales. The Fed will be buying a total of approximately $115 billion of government bonds per month after including reinvestment flows, which have averaged slightly more than $30 billion per month over the last six months. At that rate, the Fed’s balance sheet will be steadily  progressing toward $4 trillion, and bond investors are assessing the potential impact.

Fed Buying and Bond Valuations

Fed bond purchases, and subsequent expansion of the balance sheet, are one of the main drivers of expensive bond valuations. As the Fed’s balance sheet has grown with bond holdings, the yield on Treasury Inflation Protected Securities (TIPS) fell and, until recently, declined further into negative territory [Figure 2]. Fed bond purchases, in addition to their commitment to refrain from raising interest rates for an extended period have both contributed to making Treasury bonds expensive.

Aside from the impact on valuations, the interest rate sensitivity of the Fed’s bond portfolio will continue to increase. Bond investors will monitor interest rate sensitivity, since it may influence the Fed’s decision on whether to continue buying bonds and at what pace. And so will Fed officials, as this week’s Weekly Economic Commentary notes: “…both the efficacy and the costs would need to be carefully monitored and taken into account in determining the size pace and composition of asset purchases” according to the Fed.

Our analysis of Fed bond holdings reveals an average coupon rate of 3.9% and average duration (a measure of interest rate sensitivity) of 6.5 years. As a rough rule of thumb, duration reveals the percentage change in a portfolio for a given change in interest rates. For example, if interest rates rise by 1%, the Fed’s portfolio would suffer a 6.5% loss in price. However, duration does not factor in time horizon. Should the 1% rise in interest rates occur over one year, the 6.5% loss would be offset by 3.9% of interest income for a net loss of 2.6%. Nonetheless, a 2.6% loss on the Fed’s $2.8 trillion market value of bond holdings produces a $74 billion loss.

According to Fed data, the Fed has an unrealized gain of $249 billion from its bond holdings. The unrealized gain suggests the Fed’s bond portfolio could, simplistically, sustain a 2% rise in interest rates (~$150 billion loss) before the Fed may come under political pressure to stop bond purchases. Over time, the Fed’s portfolio will change and market sensitivity will increase, making it hard to pinpoint how large an interest increase the Fed would be willing to suffer through. Adding more bonds in the coming months will add interest rate risk and increase the potential for loss in a rising rate environment.

All of this is not lost on the Fed officials, of course, and a working paper reveals that the Fed has already begun more thorough analysis of potential market impacts to its bond holdings over a longer term horizon. The Fed analyzed potential impacts under two policy paths: continuing the current pace of bond purchase through June 2013, and continuing purchases through the end of 2013. The Fed then subjected each path to: 1) a base case gradual rise in interest rates; 2) interest rates rise by 1% more than expected in the base case; and 3) a 1% decline in interest rates from the base case. The Fed also modeled assumptions for the pace of bond sells, pace of economic growth, and shape of the yield curve — all of which would impact bond prices. Many variables could affect the ultimate outcome, but the analysis is instructive of potential costs and risks faced by the Fed.

In summary, the Fed analysis found:

•  ŸUnder the base case, the analysis revealed Fed losses would reach approximately $10 billion if purchases ended mid-year 2013, and $40 billion if purchases continued at the current pace through year-end 2013.

• Under the bear case where the interest rate increase is greater, the analysis revealed that losses peak at $60 billion if purchases ended mid-year 2013, and $125 billion if purchases continued at the current pace through year-end 2013.

The key takeaway is that there is a notable reduction in risk, according to the Fed’s analysis, if the Fed ends bond purchases before the end of 2013. Therefore, investors will continue to look for clues for an earlier-than-expected end to purchases.

Our view is that the end of bond purchases may not necessarily lead to a bond bear market. As stated in our January 8, 2013 Bond Market Perspectives, prior halts of Fed bond purchases have led to lower Treasury yields. Our concern relates to more economically sensitive, higher yielding segments of the bond market such as high-yield bonds that have benefited in part from increased demand from Fed bond purchases and policy that helped push high-quality bond yields extremely low. Given the strong start to the year by corporate bonds and other credit-sensitive sectors, a change in underlying market dynamics, such as Fed purchases, is that much more important. We are unlikely to get additional clarity from the Fed this week, which means investors may have to wait a few weeks before minutes are released and details on the latest Fed thoughts on bond purchases may become clearer. In the meantime, we continue to favor corporate bond sectors in fixed income portfolios and their greater yields as defense against rising interest rates. However, we remain watchful of a signal from the Fed that buying habits may change and warrant a reduction given now-higher valuations.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio, as the principal is adjusted semiannually for inflation based on the Consumer Price Index—while providing a real rate of return guaranteed by the U.S. government.

Mortgage Backed Securities are subject to credit, default, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, market and interest rate risk.

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Same Europe, Different Crisis January 22, 2013

Weekly Market Commentary from Garrett & Robinson

While fourth quarter 2012 earnings results will again garner attention this week, investors may also be looking overseas to gauge market direction, since this week holds the first meeting of the year for European finance ministers. It is worth remembering that each spring for the past three years, the S&P 500 has started a slide of about 10% during the second quarter, led by events in Europe.

However, this year may be different. In 2012, the European Union finally took two important steps to halt the financial aspect of its ongoing crisis.

• One of those steps was the creation of the European Stability Mechanism (ESM), a permanent rescue fund for countries in need of credit and unable to borrow in the market.
• Another important measure was the authorization of Outright Monetary Transactions (OMT), granting the European Central Bank (ECB) more power to intervene in the bond markets to assist countries in distress.

With these programs able to lend with few limits to banks and willing to buy bonds of any country that will accept the conditions, we do not expect market participants to fear a European financial crisis this spring and drive a 10% decline for U.S. stocks as they have in recent years. But Europe’s crisis is far from over, and market participants may drive stocks lower later this year.

Europe has traded a financial crisis for an economic one. The ECB is able and willing to only fight one crisis. The price Europe has paid to avoid a financial crisis is in the form of recession and unemployment rising above 10% — including France at 10.7%, Italy at 11.1%, Ireland at 14.7%, Portugal at 16.3%, and Spain at 26.2%. The Eurozone is mired in a recession that the ECB has little ability to mitigate. Inflation is still over the 2% target.

This is not just a shift in the crisis facing Europe’s southern countries. It has now started to infect the core. In 2012, the economies of northern Europe, such as Germany, France, and Finland, were less negatively affected with economic growth and lower levels of unemployment more similar to that of the United States than the countries of southern Europe, including Italy, Spain, and Portugal. However, in 2013, the two largest economies of the Eurozone, Germany and France, will face low growth or even stagnation and rising unemployment.

The slowdown in northern Europe can make conditions in southern Europe worse by returning some risk of financial crisis. The economic slowdown in northern Europe may make these countries more reluctant to approve the release of aid packages to the southern countries. This is noteworthy, since if the Italian elections in February 2013 fail to produce a government that achieves political stability and applies economic reforms, the increased market pressure on Italy will likely require financial aid. Germany, the de facto decision maker as a result of making up the lion’s share of any aid package, may already be averse to approve any more unpopular aid packages ahead of the German elections coming this fall. With the elections slowing the decision-making process in Germany, no fundamental changes in policy will likely be made before the elections that may avert the growing economic crisis.

In early 2012, the European fear gauge was the bond yield of southern European countries rising as the financial crisis worsened. But now that a financial crisis has been allayed, the decline in northern European bond yields is a sign of a worsening economic crisis. In a remarkable sign of how the European financial crisis has eased, Portugal’s 10-year bond yield fell from 16% last summer to 6% [Figure 2], and Italian bond yields fell from 7.5% to under 5%. But at the same time, Germany’s 10-year bond yield fell below 1.5% [Figure 3]. This is not a sign of crisis averted, but of a different one brewing. Economists’ estimates for Germany’s gross domestic product (GDP) in 2013 are still coming down. Europe’s 2012 auto sales fell -8.2% from the prior year, the biggest drop in 19 years.

The investment consequences are that the bond yields of southern European countries may once again begin to rise, fall elections highlight the challenges putting pressure on stocks, and recession continues and ensnares more of the core nations of Europe. We may again see a stock market slide related to Europe’s evolving crisis, but it may not be until the summer or fall that it appears this year rather than in the spring. After the powerful rise in European stocks since the financial crisis was averted last summer, investors may be increasingly better off focusing on U.S. and emerging market stocks as the year matures and the European economic crisis deepens.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk, including the risk of loss.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

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INDEX DEFINITIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.