By investing only in very short-term, high-quality fixed income securities, MMFs sought to maintain the value of their shares at a stable $1 per share. The stable value of these funds makes them attractive to investors – individuals, businesses and governmental entities – who want to avoid risk and manage their cash investments without principal variation. At the same time, MMFs have also provided a cost-effective credit option for businesses, financial institutions and governmental entities in need of short-term funding. The fact that MMFs held approximately 40% of outstanding commercial paper, 67% of short-term state and local government debt and significant portions of outstanding short-term Treasury and federal agency securities in late 2010 highlights the vital funding role MMFs play in the United States economy. 1

When the Reserve Fund “broke the buck”, an extremely rare event, investors withdrew their funds at a dramatic pace while issuers struggled to refinance their short-term debt. With investors cashing out, the nation’s short-term credit markets virtually froze, threatening businesses and government entities. Some argue, without urgent stabilizing actions by the Federal Reserve and Treasury, the negative consequences to the economy and capital markets would have been far worse.

The Securities and Exchange Commission (SEC) adopted new rules in January 2010 to enhance MMFs’ stability and resiliency, and to ultimately stave off future stress in MMFs. The changes included raising credit quality, shortening maturity, increasing liquidity and enhancing transparency of MMFs.

Continuing Area of Disagreement
Since the financial crisis, the SEC has grappled with whether to permit MMFs to maintain their net asset value (NAV) at a stable price without valuing their holdings using current market prices. The SEC believes stable value MMFs leave investors with a false sense of confidence, and that eliminating this feature would lead to more informed investors who would be less likely to panic the next time a MMF is unable to maintain a stable NAV.

Although MMFs seek to maintain price stability, there has never been a guarantee. Fluctuations in NAV have always been possible, but rare. MMFs typically do not value the securities in the fund at the current market value when calculating the NAV. Rather, they use the amortized cost method for valuing securities (securities are valued at cost, plus or minus any accreted discount or amortized premium). The rationale for maintaining stable NAVs is that a portfolio of high credit quality and short maturities of securities, limits significant volatility in the NAV. Nonetheless, MMFs continue to “shadow price” their portfolios, whereby the amortized cost is compared to mark-to-market values. If the difference between the methods is more than one half of one percent, MMFs must reprice shares at less than one dollar. Historically, sponsors of MMFs have supported the funds if the value of the fund has fallen below $1. There is no obligation to do so, however, and in the case of the Reserve Fund, the sponsor did not have the financial resources needed to provide such support.
Many investors along with the mutual fund industry are opposed to a floating net asset value. In general, investors in MMFs are conservative and use MMFs for cash management purposes. They also argue the accounting and tax issues involved with purchases and sales of shares of fluctuating value MMFs would unreasonably burden cash managers and treasurers. Further, many state and municipal government investors are required by statute to use MMFs as an investment tool for cash management because of their stable net asset value feature. If a floating net asset value is imposed upon MMFs, then government entities may be forced out of these funds or incur unneeded expenses related to legislative changes.

An alternative perspective postulates that since MMFs are not guaranteed, changing to a floating NAV is merely an accounting convention and would not alter the underlying investments held by MMFs. By reflecting the current market value, fluctuating NAV MMFs would provide investors with more transparent disclosure of their holdings.

Next Phases
The SEC has continued to evaluate various ways to strengthen MMFs while making them less susceptible to irrational investor behavior in times of crisis and less of a source of systemic risk to the capital markets and economy. The SEC is expected to submit proposals for public comment in the Spring of 2012. While the final form is not yet fully known, there are various options being considered to strengthen MMFs.

Under one alternative, MMFs could continue to use the stable NAV accounting convention if the MMF builds up a capital buffer and imposes “redemption restrictions”, both intended to diminish large redemptions. There are costs associated with each change. A capital buffer could squeeze MMF yields. Any negative effect on yield would be exacerbated by the current low yield environment. The size and scope of such a cushion is not known. A challenge to this approach is how to establish a capital buffer that offers meaningful protection without unnecessarily interfering with the efficiency of the market. The proposed redemption restrictions, a freeze on 3% to 5% of an account’s assets for 30 days after each redemption, would bar investors from making full use of their assets, limiting liquidity.

Under an alternative option, MMFs could simply abandon the stable NAV accounting convention. The change would drive home the point to investors that money funds are not federally insured, nor is their share price guaranteed. This explicit acknowledgement might discourage panic if a fund’s share price fell below $1. The change could make every money fund transaction into a taxable event, forcing investors to calculate even small gains and losses in share prices.

Deadlock?
Opposition to additional regulation of MMFs from various directions appears to have made it difficult for the SEC to reach a defined course of action. If the SEC is unable to reach an agreement, the Financial Stability Oversight Council established by the 2010 Dodd-Frank Act to monitor large risks to the economy may decide to officially designate money funds as “systemically important.” Such a move would increase pressure on the SEC to overcome disagreements to the new rules.

We believe it is likely that many MMFs would continue to maintain their stable value, by investing in a conservative portfolio of securities, making it less likely that the fund’s share price would fall below $1. These new rules may lead to a stratification of money market funds, with those more likely to have fluctuating net asset values offering higher yields, while those geared toward the most conservative investors with higher quality, shorter maturity funds offering lower yields.

Any of the approaches currently being considered would meaningfully affect MMFs. Investors in MMFs should stay current with information from the SEC and consider how the eventual changes will affect their liquidity.

Sofia Anastopoulos, CFA
VP, Client Service

Labor Markets
The April employment report showed the economy added 115,000 jobs. The report was disappointing though the unemployment rate declined slightly to 8.1%. Although the unemployment rate remains elevated, current economic data suggests that the labor market is improving at a slow but steady pace.

Retail Sales
In March, Retail Sales rose 6.8% on a year-over-year basis. Consumer spending rebounded from the depths of the recession and recent activity has been healthy. Nevertheless, elevated unemployment levels continue to restrain consumer spending to some degree.

Housing Starts
Single-family housing starts edged down slightly in March to 462,000, compared to 463,000 in February. The housing market remains under pressure, but seems to have stabilized following several years of sharp declines.

Though some recent domestic economic data has been weaker than expected, we continue to believe the data is consistent with a slow growth environment. The labor market continues to improve (albeit at a slow pace), consumer spending trends have been healthy and the manufacturing sector remains strong. First quarter corporate earnings have also been generally better than expected. While it seems the pace of the domestic economic recovery has recently moderated, we believe the overall trajectory remains positive. Meanwhile, political turmoil related to the sovereign debt crisis in Europe, along with growing concerns about slowing economic growth in China, continues to create volatility in the global financial markets.

In April, The Federal Reserve Open Market Committee kept policy rates unchanged, with the fed funds target rate remaining in the range of 0.0-0.25%. The FOMC statement was virtually unchanged from March. There was no change to the Fed’s assurance that the fed funds rate will remain exceptionally low through late 2014. Overall, the Fed continues to see the economy as “expanding moderately.” However, comments about the labor market were somewhat cautionary. The Fed held off announcing any additional forms of quantitative easing, and we expect that the Fed will remain on hold for at least the next few months. The next FOMC meeting is scheduled for June 19th and 20th.

At Chandler we feel many of the issues that led to market volatility in 2011 remain mostly unresolved as we look forward into 2012. We consider the largest, but by no means only, lingering concern for market participants remains Europe sovereign debt risk and the impact on US markets. The European Central Bank (ECB) recently engaged in a form of quantitative easing via two Long Term Refinancing Operations (LTROs) to inject liquidity into the European banking system. The three year term on the loans offered by the ECB limits the time frame for the ECB’s balance sheet to expand. European sovereign bond yields recovered after implementation of the LTROs, and no additional such operations are expected.. In our view, the ECB continually does just enough to calm markets in the short term, but fails to provide a definitive long term solution. Finding the right balance of policies to promote fiscal austerity and simultaneously stimulate economic growth, so that even more austerity is not required down the road, will prove challenging for the Eurozone.

The recovery in the United States remains lackluster by historical standards. The soft recovery has contributed to the unemployment rate remaining elevated and less revenue for Federal, State, and Local governments. The inability of political leaders at the Federal level to find common ground on long-term deficit reduction is poised to impact markets in 2013. The rules put in place prior to the formation of the bipartisan “Super Committee” in 2011 require significant spending cuts across the Federal Budget in 2013, including expiration of the Bush tax cuts. Consensus estimates average a negative 2.5% – 3.5% impact to GDP in 2013. We question whether the markets are strong enough to absorb a contraction in government spending coinciding with a less accommodative Federal Reserve. When taking into account the totality of the economic backdrop, including the impact of a slowing Europe and the coming fiscal contraction in the United States, fears of accelerating inflation are not supported in our view.

The Federal Reserve has become a more transparent institution under Chairman Bernanke’s leadership. The committee remains steadfast in its official communication regarding its commitment to accommodative monetary policy, driven primarily by low rates of resource utilization and a subdued outlook for inflation over an intermediate time horizon. Since the onset of the financial crisis the Fed’s balance sheet expanded dramatically, increasing in size by over 3x. The composition of the underlying assets on the balance sheet has also changed, with the Mortgage Backed Securities component now being larger than the size of the overall balance sheet pre crisis. However we are now well past the most aggressive expansion of the Federal Reserve’s balance sheet via the first two rounds of Quantitative Easing (QE). Operation Twist (OT), set to expire in June 2012, is the latest iteration of unorthodox Fed policy. OT has not altered the size of the Fed’s balance sheet, just the maturity of the underlying holdings of the Treasury component. It is not only the actual level of interest rates or the size of the Fed’s balance sheet that influence prices in the capital markets – the rate of change in each of these metrics is also an important element. Post expiration of OT in June 2012, the potential risk is the rate of change will turn negative as the Fed’s balance sheet will start to contract and the average maturity of the underlying assets will shorten, potentially putting upward pressure on interest rates.

We believe any move materially higher in interest rates will be self-correcting. Real yields (interest earned less inflation) are so low, investors feel compelled to consider a more material allocation to higher risk assets for the potential to earn a real rate of return commensurate with historical norms. If equity markets and other higher risk assets deteriorate in a higher rate environment, we believe consumer balance sheets will deteriorate, and the already weak recovery will take a few steps backward.

Arguably one of the most significant legacies of Chairman Bernanke is his willingness to be creative with unorthodox tools available to the Federal Reserve to promote full employment and economic growth. Policymakers need to continue this trend of being creative with the Federal Reserve’s balance sheet to achieve its dual mandate of maximum employment and stable prices. If you can accept the hypothesis that historically low rates are a foregone conclusion over an intermediate time horizon, the Fed should avoid disrupting the recovery by lessening its support of the higher risk assets via low fixed income rates. A significant move lower in equity market valuations could potentially derail some of the positive aspects of the recovery experienced to date. We welcome the day when monetary policy can normalize. Normalization in our view is consistent with a Fed Funds rate of approximately 2.0%, Ten year yields of approximately 4.0%, and a contracting Fed balance sheet; however that day is not yet upon us.

William Dennehy II
VP, Portfolio Manager

Labor Markets
In February, Retail Sales rose 6.5% on a year-over-year basis. Consumer spending rebounded from the depths of the recession and recent activity was moderate; however, high unemployment continues to restrain consumer spending. High gas prices may also pose a headwind to future consumer spending.

Retail Sales
The March employment report showed the economy added 120,000 jobs. The report was moderately disappointing, even though the unemployment rate declined 0.1% to 8.2%. Although the unemployment rate remains elevated, current economic data suggests the labor market is improving at a slow but steady pace.

Housing Starts
Single-family housing starts declined 9.9% in February to 457,000, compared to 507,000 in January. However, there was strength in multi-family starts which rose 21.1% for the month. The housing market remains under pressure, but seems to have stabilized following several years of sharp declines. Some housing data has recently surprised to the upside.

We believe domestic economic data remains indicative of a slow growth environment. The labor market continues to improve and the manufacturing sector remains healthy. In March, the unemployment rate fell to 8.2% from 8.3% in February, and non-farm payrolls grew by an average of approximately 212,000 per month throughout the first quarter. Consumer confidence also continues to show strength, despite the near 20% rise in gas prices since the beginning of the year. Though political and economic turmoil in Europe continues to create volatility in global financial markets, European leaders have made progress in addressing the regions debt crisis.

In March, the Federal Reserve announced it would retain the policy rate range of 0.0-0.25%. The Fed provided a generally upbeat assessment of the economy, and held off on announcing any new forms of quantitative easing, despite market speculation to the contrary. There was no change to the Fed’s assurance the fed funds rate will remain exceptionally low through late 2014. Recent increases in gas prices were acknowledged, but the Fed expects the impact on overall inflation will be temporary. The Fed noted that while strains on global financial markets have eased, they continue to pose a significant downside risk to the economic outlook. The next FOMC meeting is scheduled for April 24th and 25th.

We believe the overall credit cycle is favorable, driven by improving domestic economic activity.  During 4Q 2011, the U.S. GDP grew by 3.0%.  This year, the consensus GDP forecast calls for about 2.2% growth.  We are positive on the domestic economy and believe the ongoing recovery in consumer demand will continue to benefit corporate earnings and credit trends.  However, we anticipate that ongoing turmoil in Europe will lead to continued volatility in the financial markets.

Fourth Quarter Earnings Review
Fourth quarter earnings season was generally better than expected.  On average, companies in the S&P 500 reported nearly 5% quarterly earnings growth on a year-over-year basis.  Average EPS results were about 3% better than expected, with 320 companies in the S&P 500 posting upside earnings surprises.

In the consumer sector, higher-end retailers continued to outperform mid- and lower-tier retailers during the holiday season.  In the food and grocery sectors, price increases helped drive revenue growth in the fourth quarter, though earnings continued to be pressured by high input costs.  High energy and commodities prices were also a headwind to some industrial companies.  Meanwhile, several oil and gas companies reported strong revenue growth, driven by increased volume and higher pricing, though the higher prices were a hindrance to refining margins.  Earnings in the technology sector were mixed with results for hardware companies significantly outpacing results from semiconductor, software, and services companies, on average.

During the fourth quarter, the financial sector faced a challenging environment of low interest rates, slow economic growth, and new regulations.  Banks with exposure to investment banking and trading revenues were negatively impacted in the quarter by client risk reduction and lower trading volumes.  Meanwhile, banks with less international exposure and larger commercial lending activity performed better.  Some banks did see positive growth in the quarter, and credit quality trends continued to show modest improvement.  Overall, earnings results in the financial sector were mixed.  Expectations were generally low prior to the earnings season, helping some banks post better than expected results.  Looking ahead, several banks plan to reduce expenses through layoffs.  Increased regulation is another obstacle for bank earnings.  Yet, stricter capital requirements and increased oversight has generally been beneficial to credit quality.  In summary, the financial sector continues to look attractively priced relative to the overall corporate bond market.

Earnings Outlook
Few companies raised their earnings guidance for the year during fourth quarter earnings season.  We expect first quarter earnings to show year-over-year growth on average, and to be in-line or better than analysts’ consensus views.  Earnings results in the banking sector may be more favorable, as trading volumes seem to have improved during the first quarter vs. 4Q11.  Some companies may have also benefitted in the latest quarter from recent easing in non-energy commodities prices.  Notably, over the past few quarters, the magnitude of overall upside earnings surprises declined, and we expect this trend will continue in the first quarter. We anticipate companies with significant international exposure to remain cautious, in light of uncertainties about global growth (Europe and China in particular).  While companies with significant business will benefit from ongoing improvement in the U.S. economy.   We also expect in many cases, strategic deployment of capital (via share repurchases and acquisitions) will help drive earnings growth, as several companies have recently used cash to buy back shares.

Looking further ahead, global event risk, employment trends, and oil prices are likely to have an important impact on corporate credit throughout the remainder of the year.  These are just a few of the key data points we will be watching closely.

Global Event Risk.  The European economy remains under stress and market participants continue to be concerned about global growth trends. We anticipate ongoing turmoil in Europe will continue to create volatility in the global financial markets over the near- to intermediate-term.

Furthermore, exogenous shocks to the U.S. economy, such as an unexpected escalation of the fiscal crisis in Europe or heightened Iranian tensions, could have a meaningful impact on the financial markets and credit spreads.

Employment.  U.S. unemployment also continues to be one of the most closely watched economic data points.  The unemployment rate is currently 8.3%, which remains high but is down from the recent recession peak of 10.1% during the third quarter of 2009.  According to Bloomberg data, market participants expect a slow decline in the unemployment rate over the next year and are calling for a rate of 7.8% by the second quarter of 2013.  We expect an improving labor market will help drive slow and steady demand and corporate earnings growth, which will continue to support corporate credit quality.

Oil Prices.  Rising oil prices could be a hindrance to corporate earnings over the next year.  According to the Energy Information Administration’s Short-Term Energy Outlook as of March 6th, the price of regular-grade motor gasoline is expected to average $3.79 per gallon in 2012, compared with $3.53 cents per gallon last year.  The EIA recently raised its forecasted price of West Texas Intermediate (WTI) crude oil by $5 per barrel to an average of about $106 per barrel in 2012, $11 per barrel higher than the average price last year.  Supply disruptions in the Middle East and Africa contributed to a significant increase in world crude oil prices during February.  Although we are not forecasting a significant increase in the price of crude oil, we believe a rise in prices to the $130-$150 per barrel range would begin to put pressure on consumer spending levels and the overall domestic economy.

Conclusion
Overall, we believe the outlook for corporate credit remains favorable this year.  Given our expectation for volatility in the financial markets, we believe the investment grade corporate bond sector provides an attractive risk/reward profile.  Though the pace of earnings growth and corporate credit rating upgrades has slowed, in light of ongoing economic uncertainty and market volatility, we remain constructive on corporate earnings and expect the overall economy will continue to grow.

- Shelly Henbest

VP, Credit Analyst

Labor Markets
The February employment report showed the economy added 227,000 jobs, with the six-month average slightly higher than 200,000 jobs.  The unemployment rate remained unchanged at 8.3%.  This report was better than analysts’ expectations.  Although the unemployment rate remains elevated, current economic data suggests the labor market is improving at a slow but steady pace.

Retail Sales
In December, Retail Sales rose 6.5% on a year-over-year basis.  Consumer spending has rebounded from the depths of the recession and recent activity was moderate; however, high unemployment continues to restrain consumer spending.

Housing Starts
Single-family housing starts declined 1.0% in January to 508,000, compared to 513,000 in December. The housing market remains under pressure, but seems to have stabilized following several years of sharp declines, and some housing data has recently surprised to the upside.

Domestic economic news continues to support our view that the U.S. economy is growing at a modest pace.  In February, payroll jobs grew by 227,000, better than the 204,000 boost the market was expecting. The unemployment rate remained unchanged at 8.3%. Meanwhile the manufacturing sector continues to expand, and consumer spending was relatively strong in spite of rising gas prices.  Several banks reported signs of growing loan demand in their recent quarterly results and consumer credit expanded.  In addition, the Federal Reserve indicated it will remain accommodative, which could be a tailwind for further domestic economic growth. However, the European economy remains under stress and market participants continue to be concerned about global growth trends. We believe the European Central Bank is unlikely to be as accommodative as the Fed, since the ECB has a heightened focus on promoting fiscal austerity in Greece and other weak European economies.  And, unlike the Fed, which has a dual mandate to promote employment and control inflation, the ECB has only one mandate, price stability.  Looking ahead, we anticipate that ongoing turmoil in Europe will continue to create volatility in global financial markets over the near- to intermediate-term.

Last week, the Fed announced it would retain the policy rate range of 0.0-0.25%.  The Fed provided a generally upbeat assessment of the economy and held off announcing any new forms of quantitative easing, despite market speculation the Fed might announce a new form of monetary stimulus.  There was no change to the Fed’s assurance that the fed funds rate will remain exceptionally low through late 2014.  Recent increases in gas prices were acknowledged, but the Fed expects the impact on overall inflation will be temporary.  The Fed noted that while strains on global financial markets have eased, they continue to pose a significant downside risk to the economic outlook.

U.S. economic data over the last several weeks has been indicative of a slow-to-modest growth environment. The manufacturing sector continues to show strength and the labor market is improving. In January, payroll jobs grew by 243,000, much better than the 135,000 boost that the market was expecting. The unemployment rate dropped to 8.3% in January from 8.5% in December. After the employment report, comments from Federal Reserve Chairman Bernanke remained dovish; foreshadowing the Federal Reserve does not intend to alter its accommodative stance. Though recent economic indicators have improved, we remain cautious about the global economy, particularly in light of the ongoing turmoil in Europe and concerns about decelerating growth in China. A severe contraction in the European economy caused by its debt crisis could impair the U.S. economic recovery. Furthermore, though the overall domestic economy seems to be strengthening, the housing sector remains sluggish and consumer spending continues to be uneven.

In January, the Fed announced that it would retain the policy rate range of 0.0-0.25%. Notably, the Fed stated that it now expects the fed funds rate to remain exceptionally low through late 2014, versus its previous statement that rates would remain exceptionally low through mid-2013; otherwise, the statement was virtually unchanged from December. The Fed continues to believe that the economy is expanding moderately despite a slowing in global growth.

Use as Yield Curve Quote:

Title: TREASURY YIELDS MOSTLY LOWER IN JANUARY

Treasury yields moved modestly lower in January, with the exception of the long end of the curve which moved slightly higher.