September 15, 2013 Rising rates on risk free assets have turned a frantic search for yield into

an even more frantic dash for a shrinking exit. Conventional wisdom today is that interest rates are moving higher and investors are voting with their feet, running away from risk interest-sensitive sectors of the market. But the consensus track record is spotty at best and following the herd has historically been an expensive habit, albeit one that is psychologically difficult to break. The Bond Bogeyman For years, we have argued that interest rates are likely to stay lower for longer than most market participants were able to envision, given the powerful deflationary forces created by balance sheet deleveraging in the aftermath of crisis. With private sector balance sheets in much better shape today and unconventional monetary policy quickly becoming conventional, we are approaching the conclusion of this extended deleveraging process. As a result, interest rates should naturally move higher over time as domestic growth improves and economic imbalances continue to adjust. But this process remains far from complete. Short term fluctuations in the bond market may be driven by a number of factors but long term levels of interest are ultimately a function of inflation. When viewed in this perspective, the outlook for treasury yields looks quite favorable, as the inflation bogeyman has yet to come out of the bottle and inflation expectations continue to fall despite the rise in nominal rates. According to the good folks at Hoisington Investment Management, the Treasury bond yield and the inflation rate have moved in the same direction 80% of the time since 1954. Accordingly, this years performance is quite unusual, considering that one of the Feds favorite inflation indicators (the core personal consumption expenditures deflator) stands at a record low for the entire five plus decades of its history.

Source: Hoisington Investment Management

Over the past year, interest rates have risen as nominal growth has continued to slow. In fact, GDP growth is the slowest of any expansion on record since 1948 and below the level that marked the entry point of every economic contraction over this period. Despite consensus hopes that the economic recovery will soon accelerate (such dreams typically begin in the back half of each year), the data clearly demonstrate chronic long term economic underperformance.

Source: Hoisington Investment Management

Central Bank To The World The Feds assessment of the economy, which has triggered panic in the bond markets, is far too optimistic in our opinion. In fact, such chatter has begun consistently in the first half of each of the past three years in response to the perception of improving data and rising asset prices. In each instance, the Fed has acted too soon in removing the punch bowl from financial markets. We dont think this year is any different, particularly given the devastating impact of rising rates on liquidity-dependent emerging markets. Even still, it is prudent to consider the alternative. What if the consensus is right? What if the US economy is normalizing, taking interest rates higher with improving growth prospects? Simply put, we believe that a continued rise in rates would be very negative for the global economy and for corporate profits given the extraordinary high leverage in the system. The Federal Reserve is the central bank to the world, explains Jim Grant. If, by reducing the gait of its money printing, the Fed plunges the BRICs into further crisis, the American economy will shortly feel Brazils and Russias and Indias and Chinas pain. This, of course, would be the historical precedent, and perhaps todays catalyst for another leg down in rates. Five years after the crisis, it is increasingly difficult to recall how close to the edge the economy hung at the time. Investors applauded central bankers for rescuing capital markets, but in order to fix the patient, our heroes engineered a more dangerous addiction to credit. As weve discussed in the past, the resulting leverage in the system means that even minor rises in rates can create major headaches, as the choking point has become lower and lower over time.

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In 1989, when rates rose to 9.5%, they popped the commercial real estate bubble and caused the S&L crisis. In 1999, the tech bubble burst as rates approached 6.5%. And in June of 2006, interest rates at 5.25% triggered a collapse of the residential property market and brought about the Great Recession. In early 2010, we suggested that the next choking point for the economy would be significantly lower than the previous ones and submitted that 10 Year Treasury Bonds yielding 4% offered investors an attractive hedge against deflation, in light of growing macroeconomic risks on the horizon. Europes sovereign debt crisis arrived right on cue , ultimately taking yields below 2% and generating a 50% return for the long bond over the ensuing eighteen months. To be clear, we are not making the case that 2013 is 2010, as there are greater upside risks to treasury yields today (i.e. mortgage convexity and Fed succession). Yet, there are downside risks on the horizon as well (i.e. Syria and the debt ceiling) and the intensifying balance of payments problem in various emerging markets suggests that the choking point for the system has moved lower still. Massive debt levels have been tolerable until now only because interest rates are at generational lows. But with leverage so high, we believe it is highly unlikely rates will wholly normalize. Consequently, the ten year bond is beginning to look more interesting with a three-handle, so we are once again buyers of treasuries, but not quite with the same enthusiasm we demonstrated a few years ago. That enthusiasm is reserved for another segment of the bond market today.

Muni Diaries The long case for treasuries was a difficult sell at 4% three years ago. It is a tougher sell today. There is nothing exciting about a 3% pre-tax return on capital. Todays low-rate environment is a nightmare for those saving for the future. Thankfully, there are better alternatives today, as panicked liquidations from bond funds have created compelling opportunities for patient investors. Consider that the yield on investment-grade tax-free bonds reached 5% in recent weeks. Consider that this tax-free bond has a taxable equivalent yield as high as 10% depending on the marginal tax bracket and residency of the investor. Now consider your alternatives. Where else can you find a liquid, high-quality investment that is likely to generate a 10% return today? While double-digit returns from stocks were once considered the norm, from current levels, domestic markets would be lucky to deliver half of their historical average return. Granted, there are individual securities priced to deliver attractive returns in every market, but we struggle to find an asset class priced as attractively as municipal bonds at present. Against the backdrop of falling inflation and sluggish nominal growth, a tax-free return of 5% is a terrific bargain. Once again, we find ourselves bullish bonds. But this time, we are buying municipal bonds. Jitter Bug This years decline in the muni market has been driven by credit jitters following Detroit's bankruptcy, aggravated by rising rates, and accelerated by persistent fund outflows. Lets review each of these factors in turn to analyze the present situation and determine the extent of the opportunity at hand.

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The municipal market is comprised of almost 100,000 issuers and totals $3.7 trillion in assets today. The majority of the market is made up of high-quality credits, with only a small percentage of this universe rated below investment grade. According to Moody's, the one-year default rate averaged 0.03% for rated municipal issuers over the last five years. We would note that this period is inclusive of the worst recession experienced in the past century. In other words, Motor Cities are extremely rare. Detroit's bankruptcy filing did not happen overnight. Municipal filings are pretty predictable for analysts that actually do the credit work, as these entities are usually in trouble for some time. Detroits credit first fell below investment grade in 1992. This was not exactly new news. The bankruptcy was expected and discounted by market participants. More recently, investor attention has turned from the Midwest to the Caribbean, as Barrons and Forbes have brought troubles in Puerto Rico to the front page of the financial press. While related credits have sold off as much as twenty points, we struggle to understand how so many investors were caught with their bathing suits down. Even limiting your due diligence to Wikipedia would have telegraphed the islands difficulties. Puerto Rico is poorer than the poorest state of the United States. At the macroeconomic level Puerto Rico has been experiencing a recession for 7 consecutive years, starting in 2006 after a series of negative cash flows. Academically, most of Puerto Rico's economic woes stem from federal regulations that expired, have been repealed, or no longer apply to Puerto Rico; its inability to become self-sufficient and self-sustainable throughout history; its highly politicized public policy which tends to change whenever a political party gains power; as well as its highly inefficient local government which has accrued a public debt equal to 66% of its gross domestic product throughout time.

Source: Source: The Nelson A. Rockefeller Institute of Government It appears investors in Puerto Rican bonds may have spent more time on the beach than modeling cash flow. Nonetheless, outside of a minority of mismanaged and poorly run municipalities, state tax revenue growth remains broadly positive (chart above), despite the pessimistic forecasts made by a few market pundits. Tax-Free Margin of Safety Rational investors should logically demand a higher yield for a fully taxable bond than a tax-free equivalent. In the past, this has been the case, and we believe it will again be the case in the future. However, investors are not behaving rationally today. This should not come as a surprise to students of market history who have watched greedy buyers bid prices higher, only to be followed by fearful sellers pushing prices lower. Municipal bond prices reflect such a pessimistic extreme today. Investors, for the time being, are thinking with whats in their pants (their wallets) rather than their heads. Consequently, we are using our heads to capitalize on the bargain they have provided us.

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Lets take a step back for a minute and again consider the existing opportunity. This is not rocket science: Taxfree bonds yield more than taxable bonds, period. The only way this even begins to make sense is if we assume a major difference in credit quality. But these bonds come from a sector where the history of defaults is approximately zero in the last century. Treasury obligations are technically a superior credit, but not by much! And even relative to corporates, municipals have lower cumulative default rates than equivalently rated bonds (chart below). From our perspective, munis look good relative to treasuries, corporates, and junk bonds on a risk-adjusted basis. More importantly, we think muni yields look attractive in absolute terms today.

Source: U.S. Municipal Bond Defaults and Recoveries, 1970-2011, Moodys Investors Service, March 2012

The present market pricing is irrational. When a tax-free bond has a higher yield than a taxable bond with a similar probability of default, it is not priced according to credit risk. It is being priced by emotional investors. The bond managers at Cumberland Advisors explain, The AAA-rated tax-free municipal bond has a zero default rate one year after issuance, five years after issuance, and ten years after issuance. Historically, AAA bonds have experienced zero defaults. There is no evidence that any true AAA-rated tax-free municipal bond has ever triggered a default in the state and local government debt sector in the US.

On some measures, it appears that municipals have already discounted higher treasury yields, given the extent of the losses in the sector this year. This suggests that investors have a margin of safety in municipals that is not available in taxable bonds today. As we see it, market technicals are the only explanation for tax-free yields above taxable securities. The bond market sell-off rattled nerves and the healing process will take time. While mom and pop are licking their wounds, we are scooping up very cheap municipal bonds, with a comfortable margin of safety.

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Public Services & Capital Preservation Individual investors hold a large share of the municipal market, and as a result the investor base tends to be more conservative. Mom and pop looks to municipal bonds for capital preservation, tax-exempt income, and as a portfolio stabilizer and diversifier. Over time, the sector has achieved these goals. The municipal market is a great diversifier. Correlations to municipal bonds across various asset classes are quite low, given the essential public services they support.

Source: Zephyr In the long term, municipal bonds have been extremely resilient throughout challenging market environments. Losses of the magnitude experienced this year have been few and far between. More importantly, cyclical downswings have historically been followed by powerful rallies as experienced in the 2008-2009 time period.

Source: Barclays Despite the sectors long-term benefits, headline risks can impact liquidity and pricing as performance can be dominated by retail flows in the short-term. Unfortunately, these characteristics can also make the market prone to extreme bouts of short-term volatility. Because of the thinner market liquidity and the tendency for retail investors to herd in one direction, individuals can create imbalances in the market by overreacting to headlines, causing prices to overshoot fair value. Consequently, this behavior creates opportunities for savvy investors who can patiently wait for discounts to fair value, as we are seeing in the market today.

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Buying At A Discount To Intrinsic Value While municipal bond funds have been hit harder than other segments of the fixed income universe, losses have been even worse for closed-end municipal funds, which are at the bottom of the pack among the universe of closed-end funds. Performance has continued to languish since June, leaving some down as much as 20% this year. Wide spreads, embedded leverage and growing discounts to net asset value have magnified losses for the average retail investor sheepishly holding high-yielding, closed-end funds.

Source: Morningstar Those investors who stretched for yield earlier in the year and purchased closed-end funds at a premium to net asset value are suffering the consequences today. But those with the discipline and patience to hold zeroyielding cash now have the opportunity to purchase the same funds at 5% - 10% discounts to their underlying assets. This gap has continued to widen since the end of the second quarter.

Source: Morningstar

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As discounts have grown, our interest in the space has increased, despite the monotony of analyzing over 200 closed-end municipal bond funds. We began pairing the universe back by first reviewing the leverage embedded in each fund, relative to the discount at hand and the historical trading range over multiple time periods. Investors must recognize that the primary objective of these vehicles is a stable distribution rate for their retail investor base. So if the portfolio is under-earning, there is the potential for a dividend cut, which would generate strong selling pressure. This is something we would like to avoid, so we review each funds earnings relative to the distribution. Finally, investors should consider call risk in the portfolio. As some portfolios may see up to 30% of assets at risk of being called away, funds reinvested at lower rates could represent a further hit to the distribution. Again, something we would like to avoid. So where does this leave us? Well, we are staying away from highly leveraged funds for the time being. We prefer more conservative investments in the space that are fully earning the distribution and are still selling at very attractive discounts to NAV when viewed from a long term perspective. As we see it, the asset class is cheap enough to make an allocation today. And should we see another leg down in the market and discounts widen further, we have plenty of room to get more aggressive with regard to both the size of our allocation and the leverage in the vehicles we select. On a 12-month basis, highly levered funds look cheaper and have been hit harder. From a longer term perspective, current discounts dont appear extreme, particularly when viewed in the context of the panic sparked by Lehman. But leverage works both ways. More aggressive managers experienced equity-like declines in 2008, but draw-downs were followed by 40% - 50% gains in 2009 for highly levered vehicles. Given this extreme volatility, we are more comfortable allocating at the more conservative end of the spectrum today and adding to our exposure if discounts reach extremes tomorrow. Lucky Seven Discounts on closed-end funds tend to oscillate around their respective averages over time. Market sentiment may drive funds below their average discount, above it, or even to a premium, as seen during the prior twelve months. Over time, shrewd investors can capitalize on these emotional swings by keeping a clear head and recognizing that the pendulum always swings back in the direction it came from. Buying closed-end funds at a discount to NAV is equivalent to buying a dollar for less than a dollar. Its really that simple. Buying funds at a discount increases the probability that our investment is profitable even if the value of the underlying portfolio does not increase. In other words, the discount provides us with a margin of safety, even if interest rates continue to rise. And with tax-exempt yields above taxable equivalents today, we have an additional buffer against rising treasury rates. So, outside of crisis, downside risk is minimal in our view. The upside, however, is quite attractive with multiple value drivers. First, if we assume that the consensus opinion is wrong (we do) and rates retrace much of their recent move over the next twelve months, then municipals should rally 7% or so given the average duration of the sector. Second, if we assume that the consensus will again feel starved for yield over the next twelve months (we do), then current discounts to asset value should also close, representing another 7% of upside, give or take. Last but not least, if we are wrong on both fronts, we are comfortable sitting tight and collecting the 7% average yield on these instruments at current prices. And if a few things move in our direction over the next year, we believe the upside (7% + 7% + 7%) looks much better than expected returns on most risk assets with minimal risk of capital impairment. Sincerely,

Christopher R. Pavese, CFA Chief Investment Officer Broyhill Asset Management

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Broyhill Asset Management, LLC

Broyhill Asset Management is a private investment management boutique. We believe that capital preservation coupled with consistent, compounded returns is the key to long term wealth generation. We are conservative investors for our partners and for ourselves. Our objective is quite simple - superior risk-adjusted performance. Since the sale of Broyhill Furniture in 1980, the Broyhill family wealth has been managed as a single family office. Today, we are privileged to be able to offer the same level of expertise developed and refined over a quarter century within the Broyhill Family Office, to additional families and investors. We have the highest respect for the trust our investment partners have awarded us, and pledge to always treat non-family investments as if they were our own. Our Services The philosophies and strategies we endorse for our investors are only those we have developed and deployed for ourselves. We currently offer investors three different investment strategies, each of which is fundamentally driven by the same objective income generation and capital preservation. Each is consistent with our own goals and leverages our expertise in asset allocation, in equity research and in credit analysis. The Broyhill Global Thematic Portfolio is a diversified, multi-asset class investment strategy. Macroeconomic fundamentals and long term investment themes drive the portfolio construction process which is routed in a strict valuation discipline. Embedded in our approach is a relentless focus on the preservation of capital and the belief that risk management begins with portfolio construction. The objective is simply maximum total return, commensurate with the given risk profile of global capital markets and best suited for investors with a long term time horizon. The Broyhill Opportunistic Fixed Income Portfolio is a separately-managed individual bond portfolio focused on short duration, high-yielding fixed income securities. The portfolio aims to combine a high probability of the safe return of principal with a current return superior to a portfolio of US Treasury securities. A rigorous research process drives the selection of only those securities that meet our requirements based upon an independent assessment of each issuers fundamental strength. The result is a cash-generating portfolio focused only on our highest conviction ideas. The Broyhill High Quality Dividend Portfolio is a concentrated equity strategy invested in a select group of exceptional businesses judged to be competitively entrenched market leaders, trading at reasonable prices. Our research seeks to identify outstanding companies with sustainable competitive advantages, rather than speculate on mediocre businesses with uncertain futures. The result is a portfolio of profitable businesses which offer the potential for full participation in up markets while mitigating the brunt of down markets, delivered to investors in the form of attractive dividends and consistent earnings growth. For more information on our services, please contact: info@broyhillasset.com To subscribe to our research, please click here:

Broyhill Asset Management, LLC Post Office Box 500 800 Golfview Park Lenoir, NC 28645 (828) 758-6100 www.broyhillasset.com www.viewfromtheblueridge.com

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