JP Turner & Company, LLC

Thanks to recent reductions in short-term rates by the Federal Reserve – which we suggested would occur at some point in 2007 way back in January and reiterated our forecast in the spring when many of our peers were calling for the Fed to tighten credit, yield trends in the Treasury sector are changing. But as we saw earlier this year, don’t expect the consensus about what happens in the coming quarters in the bond market to be correct. With endless talk of recession and need for additional Fed rate cuts now dominating the media coverage, it’s easy to understand why conventional wisdom believes the multi-year rally in the Treasury sector will continue. However, a closer look at the unique reason for the Fed rate cuts, recent economic data and host of real-time market in-dicators and its apparent longer term rates could be bottoming now and poised to increase once the economy regains momentum. If our analysis is correct, bonds most sensitive to volatile longer term governments – higher quality, longer term, fixed-rate agencies, corporates and municipals – are going to underperform and potentially significantly in 2008.

Why Aren’t Long-Term Treasury Rates Declining As Fast As Short-Term Rates?

To help keep the problems in the mortgage and housing sectors contained and insure the credit markets don’t freeze up (allowing companies to refinance maturing loans), Fed policymakers have reduced short-term lending rates 75 basis points to 4.50% in the last two months. But it’s critical to recognize this easing was more about avoiding a full-blown credit crunch than responding to an economy headed for protracted subpar growth. In fact, comments made by policymakers following their latest meeting (October 31st) suggest a reluctance to reduce short-term rates any further and recent data seems to reinforce this cautiously-optimistic macro view. Third quarter GDP registered a healthy annualized rate of 3.9% and job creation is regaining some traction (166,000 new jobs in October). While most economists expect growth to downtrend in the fourth quarter to about 2% annualized, key indicators in the financial markets continue to point to a “soft landing” rather than a recession. Economically-sensitive equity and high yield corporate bond prices have rallied since their August correction, industrial commodity and energy prices are approaching record territory and the Treasury yield curve is steepening (short term rates falling more than long term rates), creating a more favorable lending environment for banks. The fact longer term Treasury rates have fallen less than 25 basis points during a period when the Fed has reduced short-term rates 75 basis points (and expected to ease further) is a huge red flag in our opinion. History says if the bond market believed a recession was imminent, investors would be rushing to purchase the securities that perform the best in such a scenario – longer term, higher quality bonds. So far, this hasn’t been the case. Actually, just the opposite is occurring as bond investors have quietly begun to increase their credit exposure in the last several months. When the precise turning point on when the economy and credit markets stabilize will occur is impossible to predict. How-ever, we do know the bond market almost always leads the Federal Reserve in correctly anticipating future changes in the economy and monetary policy (policymakers have to wait for confirmation of economic trends). So let’s keep a close eye on investor-determined, long term Treasury rates. If these yields, which currently trade close to the same levels as when the Fed first started reducing short-term rates in September push lower, it would signal the Fed has more easing work to do with slower growth a bigger potential problem than inflation. Conversely, if longer term market rates don’t decline and/or start moving higher as we expect - especially if the Fed eases further, watch out. The stage will be quietly setting for a significant “flight from safety” reversal in the bond market that will gain momentum as it becomes more apparent the worst is over for the economy. Look for longer term rates to reverse higher first followed by changes in Fed policy next year (first a switch to neutrality and then tightening later) to try and keep inflation in check. Again, the market almost always leads the Fed. Given all the money that’s understandably sought refuge in creditworthy governments this year, a reversal in sentiment could carry significant implications for bond investors. If forced to make a prediction, we wouldn’t be surprised if long term Treasury yields were 100 basis points higher at this time next year. For holders of ultra-volatile 30-year Treasuries, such a rate spike would translate to a paper loss of almost 15 points ($1,500 on $10,000 maturity value) or a whopping three years’ worth of interest payments. As a rule, the longer the maturity and higher the credit quality, the greater a bond’s price sensitivity to changes in rates.

For Conservative Income Investors, It’s Time To Go On Defense

Conservative bond investors (i.e., income is secondary to principal preservation) who agree with our bearish rate outlook – we’re reversing our longstanding bullishness on Treasuries – need to reduce their interest rate exposure. Because returns on most fixed rate, investment grade municipal, corporate and government agencies are closely-indexed to Treasuries, increases in long-term Treasuries will result in price declines on these higher quality bonds and preferreds as well. The dilemma for safety-conscious bond investors interested in investing more defensively right now is returns on short-term instruments such as money markets, CDs and T-bills are falling because the Federal Reserve is lowering short-term rates. For investors living on fixed incomes, a strategy of keeping your entire savings in higher paying, riskless short-term instruments is becoming less attractive with every reduction in short-term rates by the Fed. A common strategy used by professional portfolio managers when long term rates are expected to rise is laddering. Very simply, laddering involves building a portfolio of bonds maturing sequentially over a certain time frame. Any combination of corporate, municipal, government agency or Treasury debt and/or certificates of deposit will work. The ladder is maintained as proceeds from maturing bonds or CDs are reinvested within the context of the existing ladder. As long term rates (and then short-term rates) move higher, the income stream in a laddered portfolio gradually trends higher. Ladders outperform other bond strategies when rates are rising because investors are one, able to reduce overall portfolio volatility (by avoiding longer term bonds), two, establish clearly defined maturity or call dates, three, not forced to try and guess where the optimum maturity point might be in the Treasury yield curve and four, stay more current with changing market conditions by replacing lower-yielding, maturing issues with higher-paying, longer term maturities. When it appears long term Treasury rates are peaking, portfolio managers will begin easing out of laddered positions and extend maturities to increase their exposure to more rate-sensitive, longer term maturities in an attempt to reposition for a new bull Treasury market.

No Two Bond Ladders Alike

Listed below are two sample $100,000 laddered portfolios, one is conservative, the other more aggressive. We use the qual-ifier “sample” because every investor’s financial situation is unique and it would be imprudent to suggest a universal strategy without first determining an individual’s needs, goals, risk tolerance, tax bracket and amount of savings. In this exercise, we’re simply trying to provide specific risk/return scenarios based on current market conditions. Because FDIC-insured CDs offer more yield than Treasuries and there is very little yield advantage now in owning higher quality corpor-ates and mortgages, our conservative ladder consists entirely of CDs. This portfolio mix will change once longer term Treasury rates move higher and laddering will allow us to diversify out of maturing CDs. In addition to being more current with the market, the 4.73% yield to maturity on our conservative portfolio is 125 basis points more than paid on 18-month Treasuries. In our more aggressive ladder, we’ve selected five different lower rated corporate bonds. Involved in this sector on a daily basis, we’re confident each highlighted company below has the ability to service its debt in a moderating economy. While we’re comfortable with the credit risk, it’s important to understand this is the reason the yields on this laddered portfolio is twice the rate currently being paid on comparable Treasuries. It is still a fact high yield bonds present a greater risk of default on principal and interest payments than investment grade bonds. Investors should bear this in mind before purchasing high yield bonds.

Conservative Ladder

Security Type	Rating	Qty	Issuer	Coupon	Maturity	Price	Initial Call	Call Price	YTM	YTW*
Bank CD	FDIC-insured	20K	Community Savings	4.60%	5/15/08	100	N/C	N/C	4.70%	4.70%
Bank CD	FDIC-insured	20K	Independent Bank	4.65%	11/15/08	100	N/C	N/C	4.65%	4.65%
Bank CD	FDIC-insured	20K	First Bank	4.70%	5/18/09	100	N/C	N/C	4.70%	4.70%
Bank CD	FDIC-insured	20K	City Bank	4.80%	11/16/09	100	N/C	N/C	4.80%	4.80%
Bank CD	FDIC-insured	20K	Nara Bank	4.90%	11/23/10	100	N/C	N/C	4.90%	4.90%

Maturity Value: $100,000	Estimated Annual Income: $4,730	Yield To Maturity: 4.73%
Cost: $100,000	Average Maturity: 1.6 years	Yield to Worst: 4.73%

More Aggressive Ladder

Security Type	Rating	Qty	Issuer	Coupon	Maturity	Price	Initial Call	Call Price	YTM	YTW*
Corporate	B1/B	20K	Ford Motor Credit	6.375%	11/5/08	100	N/C	N/C	6.375%	6.375%
Corporate	Caa3/CCC	21K	Level 3	6.00%	9/15/09	95	N/C	N/C	9.02%	9.02%
Corporate	B2/B+	20K	Unisys	6.875%	3/15/10	98.50	N/C	N/C	7.58%	7.58%
Corporate	Caa1/B-	20K	Dole Foods	8.875%	3/15/11	98	12/3/07	$104.44	9.58%	9.58%
Corporate	A2/BB	22K	Alltel	7.00%	7/1/12	91.50	N/C	N/C	9.30%	9.30%

Maturity Value: $103,000	Estimated Annual Income: $7,225	Yield To Maturity: 8.37%
Cost: $99,280	Average Maturity: 2.66 years	Yield to Worst: 8.37%