Market Perspectives and Strategies: Core Fixed Income Richard Merriam, CFA

1. Market Perspectives and Strategies:Core Fixed Income Richard Merriam, CFA Managing Partner and Founder Galliard Capital Management, Inc. Experience. Performance. Consistency.

2. Elements of Effective Fixed IncomeInvestment Policy Objectives • Return: Seek to maximize return while meeting claims and support underwriting process • Risk: Designed to be conservative; stable performance and predictability in cash flows Constraints • Legal/Statutory: Comply with state statutes for quality and weightings of holdings • Liquidity: Work to maintain sufficient liquidity for claims; no excess • Tax: Tax exempt (usually) • Time Horizon: Dependent on liabilities • Unique Needs: Dependent on organization 1

3. Policy Implications for Insurance Reserves: Objectives • Return Objectives • Work to maximize return with a preference for yield over capital gains • Seek to produce steady and consistent income to complement premiums collected in the underwriting process • Goal to meet or exceed a benchmark return where the benchmark is a common index, or immunize the portfolio against a liability stream determined by an actuary 2

4. Policy Implications for Insurance Reserves: Objectives • Risk Objectives • Maintain well-diversified portfolio across issuers, sectors, and maturities designed for conservative investors • Work to limit volatility of cash flows • Seek to preserve principal and limit volatility in capital gains and losses • Focus on compliance with state statutes 3

5. Policy Implications for Insurance Reserves: Constraints • Legal and Statutory • Rules vary by governing entities, but often include strict limitations around: • Security Type – eg. U.S. Treasuries only • Security Rating – eg. Not below A+ • Duration – eg. 80% to 120% of benchmark duration • Tax • Most entities are tax exempt; consequently, it makes sense to avoid tax-favored assets such as tax-free municipals or preferred stock 4

6. Policy Implications for Insurance Reserves: Constraints • Liquidity Goals: • Portfolio income can be balanced with proceeds from underwriting to meet claims • Do not “pay for liquidity” • Liquidity needs are somewhat predictable and depend on the organization’s expected claims Time Horizon • The nature of liabilities: determine the portfolio’s investment time horizon 5

7. Policy Implications for Insurance Reserves: Constraints Accounting Rules • GAAP compliance creates the need to: • Report portfolio income on the income statement • Mark assets to market values • The need to project and budget annual plans requires overall portfolio strategy to complement the organization’s operations Unique Needs • Some organizations have self-imposed restrictions such as Socially Responsible Investing guidelines • Added scrutiny of being in the “public eye” 6

8. Characteristics of Fixed Income Assets to Invest in: • Superior Yield – Income enhancers • High Quality (Investment Grade) – Minimal or no credit risk preferred • Predictable Cash Flows – Stable cash flows line up with the liability stream or benchmark • Liquidity – Markets for the asset are deep and efficient, but yield is not sacrificed • Multiple Asset Categories – Correlation < 1 between these assets provides diversification benefits 7

9. Characteristics of Fixed Income Assets to Avoid • Derivatives – When relied on speculatively, payoffs can be too volatile to produce stable predictable cash flows; derivatives also create accounting issues • Foreign Currency – Introduces currency risk; portfolio generates foreign currency income, but organizational expenses are likely paid in U.S. Dollars • Embedded Options – Create potentially adverse investment circumstances which work against the portfolio’s yield advantage and create asset/liability mismatch • Assets Which Cannot be Held to Maturity – Speculation on short-term pricing inefficiencies introduces undue dependency on price volatility 8

10. Sample Portfolio • Broadly Diversified • Superior Yield • Credit ~ 30% • Cash Flow Variability ~ 20% - 40% 9

11. Sample Portfolio: Treasury Assets 10

12. Sample Portfolio: Credit Assets 11

13. Sample Portfolio: Structured Assets 12

14. Summary of Sample Portfolio • The model portfolio seeks to generate 50-70 basis points of excess return over a government benchmark annually by emphasizing assets with superior yield • Cash flow risk and volatility are minimized by purchasing assets with limited optionality and more predictable payments • Credit Risk is minimized by allocating only 30% of the portfolio to investment grade credit and diversifying across sub-sectors • The portfolio is broadly diversified to capitalize on low correlation benefits 13

15. The information contained herein reflects the views of Galliard Capital Management, Inc. and sources believed to be reliable by Galliard as of the date of publication. No representation or warranty is made concerning the accuracy of any data and there is no guarantee that any projection, opinion, or forecast herein will be realized. The views expressed may change at any time subsequent to the date of publication. This publication is for information purposes only; it is not investment advice or a recommendation for a particular security strategy or investment product. Graphs and tables are for illustrative purposes only. 14