WELCOME TO CABOT’S25TH ANNUAL INVESTMENT & WEALTH MANAGEMENT CONFERENCE

Your interests and goals always come first.

Safe Income in a Dangerous Bond Market

Understanding the Risks of Fixed-Income Investing

WILLIAM LARKIN, JR.

PORTFOLIO MANAGER

CABOT WEALTH MANAGEMENT

10-year bonds a/o 9/2/2014

Does This Make Any Sense?

Germany = 0.9%

France = 1.3%

Ireland = 1.8%

Spain = 2.3%

United Kingdom = 2.4%

Bulgaria = 3.1%

Poland = 3.1%

Portugal = 3.2%

Why Has Demand for Zero Interest Rates Skyrocketed?

In Behavioral Finance there’s a term called Risk Intolerance, which is defined as market conditions when investors refuse to take risk to earn a return. An abrupt shift in risk tolerance is similar to containers on a ship that all shift to one side at the same time. Things obviously become unstable.

Favorable Backdrop

Investor Balance

Fear – The Return of Your Money vs. Return on Your Money

Greed – Many High Return Investments are Facing Stretched Valuations

Is The Market is Out of Balance?

Have Central Banks Temporarily HaltedThe Law of Physics When it Comes to Fair Lending Rates?

Investors Borrowers

Quantitative Easing Has Two Fundamental Parts

Spending

Employment

Interest Rates

Investment

Risk Reward

Save

Invest

The Fed’s Focus

What’s the Impact? THE EXTREME COST OF SAFETY HAS

REDUCED THE EARNING POWER OF BONDS

High Yield Bond = $5,750Corporate Bond = $3,030Mortgage Backed Security = $1,380US Government Agency = $1,400US Treas. Security = $1,580US T-Bill = $30Money Market = $10

Yield Calculated from ML Index Data Base a/o Sept 2014

$100K

The Natural Reaction Is For Investors To Reach For YieldOver Time To Keep Both Their Wealth and Income Stable

Declining Benefit Curve

How is This Done? The Government Has Eliminated Many Investment Options

Gov

’t B

onds

Corporate B

onds

Mon

ey M

arke

ts

Muni B

ondsM

ortg

age

Sec

uriti

es

Pre

ferr

ed

Hig

h Y

ield

Bon

dsF

loating Rate

What’s The Logic Behind This Strategy?It Facilitates the Three Pillars of Fed Policy

#1 Generate Wealth

#2 Foster Productive Lending

#3 Create Stable Employment

Cheap Loans& Refinancing

Forces RiskTaking

Capital SeeksMore ProductiveOpportunities

Wealth Pump Raises Consumer Spending

Wealth Effect2 Primary Sources

15%

Wealth Generation85% Earned

Income

Source: Alan Greenspan

ATM Cash Machine

EmploymentIncome

InvestmentReturns

Housing Appreciation

$

Supports The Three Pillars of HousingWhite Line - Housing AffordabilityYellow Line - 30-year Mortgage Lending RateOrange Line - US Median Income

The Winds of Change Are In The Air

#1 Adapt

#2 Resist

#3 Create An Advantage

The Lens Approach

A Critical Business Perspective

The Fed Needs to Begin Raising Interest Rates in the Next 12 MonthsAnd Highly Leveraged Markets and Economies Will Not React Well

The Seeds of Inflation Have Been Planted

The Market is Telling Us it Expects ChangesSoon

3-year US Treasury Bond

Is the Market Prepared for the Coming Change?

Abrupt Shift

Slow Transit

ion

No ChangeRates

Fall

Rates Across the Globe are at Historic Lows. Are we Facing a Day of Reckoning ?

Starting Gun ProblemEveryone’s Getting Ready, so when It actually happens

be careful not to get Run over

Increases Liquidity Risks

The Fed’s Primary Strategy is Based On their Ability to Maintain Credibility

The Fed will maintain their accommodative policies,

facilitate job creation, and keep prices stable

Over-Confidence Trap

What Happens If The Fed Fails?

The Central Bank Can Print Money

By 1887, George Parker had hired his first employee and rented a store in Salem for $12.50 a month (where the Hawthorne Hotel now stands). He realized he was good at selling and developing games. He was not so good at production and finance, though his older brother Charles was. George in 1888 invited Charles to join him as a partner and Parker Brothers was born.

Creating Your Own Demand

S c r u t i n i z e C o l l a t e r a l

Regulations

Control

Supply

We Haven’t Been Here Before

Expansion

Boom

Recession

Depression

Recovery

Economic Cycles – Impact the Value Of Fixed-Income Securities

Price Variability

Bond Risk – Option #1 Duration/Time

1-3 Year Till Maturity

3-7 Years Till Maturity

7-10 Years Till Maturity

Return Curve

Short-Term

Intermediate Term

Long Term

1.86%

ML 1-3 Year Corp & Gov’t Index B1A0 ML 5-7 Year Corp & Gov’t Index B310

2.19%

Time Till Maturity

High Grade 3.14%

High Yield 3.9% 4.14% 5.55%

ML 7-10 Year Corp. & Gov’t B4A0

1921 1929 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 2012

We Should Understand Interest Rates Could Stay Low

2%

4%

6%

8%

10%

12%

14%

16%

Source: FactSet; Robert Shiller – Yale University

28 Years

Corporate Balance Sheets Are Strong

Default Rates Should Remain Low

0%

1%

2%

3%

4%

5%

6%

7%

2.6% 2.5%2.8% 3.6%

4.5%5.2%

10%

AAA AA A BBB BB B CCC (In Poor Standings)

Credit Ratings

Yield (%)Compensation For Credit Risk

AAA = C0A1 AA = C0A2

5.8% 5.8%

A = C0A3

6.1%

Blue = 6/30/06

BBB = C0A4

6.4%

BB = H0A4

8.1%7%

CCC = H0A3

11.6%

Summary To Bond Investing

1st – The Fed is trying to end their 6-year monetary experiment, it’s a good time to be cautious. Policy mistakes could occur Changes could happen more abruptly than currently anticipated

3rd – Remain flexible and do not overreact to false market assumptions Inflation should remain subdued because pricing is now global Global factors could create unforeseen effects

2nd – This is an excellent environment to deploy a bar bell strategy Short-term opportunity offer low yields, but lots of future flexibility Long-term opportunities are expensive so exploit less known market segments

4th – Interest rate changes move in long cycles based on expected inflation rates Employment – wage growth and unemployment trends Housing – price stability Speculation – appetite for risk Wealth – confidence and spending Corporate Earnings Growth – healthy business environment

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