Portfolio manager William Larkin Jr., of Cabot Wealth Management, discusses understanding the risks of fixed-income investing.

1. WELCOME TO CABOT’S
25TH ANNUAL INVESTMENT & WEALTH MANAGEMENT CONFERENCE
Your interests and goals always come first.

2. Safe Income in a
Dangerous Bond Market
Understanding the Risks of Fixed-Income Investing
WILLIAM LARKIN, JR.
PORTFOLIO MANAGER
CABOT WEALTH MANAGEMENT

3. Does This Make Any Sense?
10-year bonds a/o 9/2/2014
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%

4. Why Has
Demand for
Zero Interest
Rates
Skyrocketed?
Favorable Backdrop
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.

5. 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?

6. Investors Borrowers
Have Central Banks Temporarily Halted
The Law of Physics When it Comes to Fair
Lending Rates?

7. Quantitative Easing Has Two Fundamental Parts

8. Spending
Employment
Interest Rates
Investment
Risk Reward
Invest
Save
The Fed’s Focus

9. What’s the Impact?
THE EXTREME COST OF SAFETY HAS
REDUCED THE EARNING POWER OF BONDS
High Yield Bond = $5,750
Corporate Bond = $3,030
Mortgage Backed Security = $1,380
US Government Agency = $1,400
US Treas. Security = $1,580
US T-Bill = $30
Money Market = $10
Yield Calculated from ML Index Data Base a/o Sept 2014
$100K

10. The Natural Reaction Is For Investors To Reach For Yield
Over Time To Keep Both Their Wealth and Income Stable
Declining Benefit Curve

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

13. What’s The Logic Behind This Strategy?
It Facilitates the Three Pillars of Fed Policy
Cheap Loans
& Refinancing
#1 Generate Wealth
Forces Risk
Taking
#3 Create Stable Employment
#2 Foster Productive Lending
Capital Seeks
More Productive
Opportunities

14. Wealth Pump Raises Consumer Spending
Wealth Effect
2 Primary Sources
Housing
Appreciation
15%
Wealth Generation
85% Earned
Income
ATM Cash Machine
Source: Alan Greenspan
Employment
Income
Investment
Returns
$

15. Supports The Three Pillars of Housing
White Line - Housing Affordability
Yellow Line - 30-year Mortgage Lending Rate
Orange Line - US Median Income

16. The Winds of Change Are In The Air
#1 Adapt
#2 Resist
#3 Create An Advantage

17. The Lens Approach
A Critical Business Perspective

18. The Fed Needs to Begin Raising Interest Rates in the Next 12 Months
And Highly Leveraged Markets and Economies Will Not React Well
The Seeds of Inflation Have Been
Planted
3-year US Treasury Bond
The Market is Telling Us it Expects Changes
Soon

19. Is the Market Prepared for the Coming Change?

20. Starting Gun Problem
Everyone’s Getting Ready, so when It actually happens
be careful not to get Run over
Increases Liquidity Risks

21. 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

22. What Happens If The Fed Fails?

23. 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.

24. Creating Your Own Demand
S c r u t i n i z e C o l l a t e r a l
R
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25. We Haven’t Been Here Before

26. Economic Cycles
– Impact the Value Of Fixed-Income Securities
Expansion
Boom
Recession
Depression
Recovery

27. 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%
2.19%
ML 1-3 Year Corp & Gov’t Index B1A0 ML 5-7 Year Corp & Gov’t Index B310
Time Till Maturity
High Grade  3.14%
High Yield  3.9% 4.14% 5.55%
ML 7-10 Year Corp. & Gov’t B4A0

28. We Should Understand Interest Rates Could Stay Low
16%
14%
12%
10%
28 Years
1921 1929 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 2012
8%
6%
4%
2%
Source: FactSet; Robert Shiller – Yale University

29. Corporate Balance Sheets Are Strong
Default Rates Should Remain Low

30. 7%
6%
5%
4%
3%
2%
1%
0%
5.8% 5.8%
2.6% 2.5%
6.1%
6.4%
2.8% 3.6%
7%
4.5%
8.1%
5.2%
11.6%
10%
AAA AA A BBB BB B CCC (In Poor Standings)
Credit Ratings
Yield (%)
Compensation For Credit Risk
AAA = C0A1 AA = C0A2
A = C0A3
Blue = 6/30/06
BBB = C0A4
BB = H0A4
CCC = H0A3

31. 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
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
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
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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