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Michael Walton: This is Michael Walton. Thanks for joining us as we review first quarter performance commentary and attribution. I'm joined remotely by my good friends Dustin Finley and Thomas Serrano. So first of all, we hope this finds everyone who's listening in safe and healthy. Our thoughts are with everyone.

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Before we jump into the discussion, you know, things are changing so fast that I think it's important to timestamp the conversation. So it's around noon in Austin on what would normally be tax day, April 15th. So we know every one of you are getting overwhelmed with commentary from managers, our hope that this recording offers a different perspective. So the idea is to provide specific portfolio level commentary and deliver the information in a way that helps you have really good conversations with our mutual clients during what is inevitably going to be a challenging quarterly review season. So we actually thought the best and most interesting way to structure the discussion is to address the most commonly asked questions we're getting asked in reviews with consultants and clients. So with that, Dustin, you want to kick us off?

Dustin Finley: Yeah, absolutely. And I think, you know, in talking with consultants so far, and we've had numerous conversations over the last three weeks, as you can imagine, and maybe I'll point this question to Thomas. And, you know, the one of the big questions is what happened to my fixed income portfolio? And I think it's coming from two different directions. One is, it's been so long, since investors have seen relative underperformance from their actively managed bond portfolios, like we saw in the latter parts of March. And I think the second part of that in having a conversation last night with a consultant was you know, my biggest issues this being the consultant are not really in beating the broad benchmarks because of my equity portfolios being down 30%, it's because the broad bond indices like the aggregate were up over 3%. And my bond managers really had a hard time keeping up. So I think that kind of brings us back full circle to know what happened to the steady Eddy core fixed income that we all have come to know and love.

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Thomas Urano: Right, so thanks, Dustin. That's a great question. I mean, first quarter of 2020 certainly was a challenging one. Everything was running along smoothly until, you know, mid-March, at which point the COVID/virus situation and really a global economic shutdown occurred. And given that there were some couple key responses to the global economic shutdown that really drove returns across fixed income markets. Number one, as a normal flight to quality you saw Treasury yields fall and that generated some pretty strong returns across the Treasury market. Capital appreciation and price gains augmented the income in the first quarter and the overall Treasury index returned almost 8%. That was largely driven by 30-year Treasuries. So to the extent that investors had 30-year Treasuries involved in a portfolio, you saw substantial performance. The long Treasury index returned 20% in the first quarter. So the Treasury market did fine, did well as expected.

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The real trouble occurred in everything else outside of Treasuries in the bond market. You look at the investment grade corporate bond market where you would normally expect it to move along with Treasuries, maybe lag a little bit, you actually saw negative returns. So we got into this highly unusual environment where corporate yields rose while Treasury yields fell, so the corporate return investment or corporate return in the first quarter was negative 3.6%.

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And even worse than that, if you were involved in the high-yield market, the high-yield return in the first quarter was negative 12.6%. So large negative returns in an environment where you would have expected positive returns. What drove that? That's really a significant question. Why did the corporate bond market have negative returns? I think a lot of it was liquidity driven. We look back at flows. And over the last 52 weeks, the bond market had about $580 billion worth of inflows into it over the course of a year.

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In the second half of March, the bond market experienced $260 billion of outflows, right, so that's about a half a year. Over half a year's worth of flows were withdrawn from the market in a two-week window in the second half of March. And the way that happened was a large number of investors were forced sellers. You had to liquidate everything. You had to liquidate corporates, you had to liquidate mortgage securities, you had to liquidate structured products. So forced liquidation, everybody was trying to sell everything in order to raise cash and build the liquidity in response to a global economic shutdown. Companies needed cash, needed liquidity, how do I pay payroll, pay bills, pay rents and so forth. And so there was this rush for liquidity and that real significant forced selling or I guess, fund flows out of fixed income, forced everybody to the same side of the boat – and that's the selling side. So everybody lined up to sell assets. And the only thing that could offset that pressure was price. And so we saw pretty significant price dislocations across everything but Treasuries in the bond market.

Michael Walton: Hey, quick follow up question. It was kind of an unusual environment as well in that we saw spreads widen more with shorter-term corporate paper than we did with intermediate and long-term corporate bonds, and that obviously had an impact on short and ultra-short strategies with, you know, many posting sort of negative returns. While intermediate core portfolios maybe leveled out or were slightly positive for the quarter. But can you speak to that it's, you know, again, a very highly unusual environment, but kind of what drove that?

Thomas Urano: Yeah, good question. We did see this very unusual inversion between short-term investment grade corporate bonds and longer-term investment grade corporate bonds. And I think a lot of that was what I mentioned earlier, this rush to sell assets and raise cash. You know, the first and most natural thing to sell would be short duration cash equivalent assets. How do I sell my short duration assets, and I convert them to cash? That happened in money market funds, that happened in short duration bond funds. It was, “Let's sell front-end assets and raise cash.” The problem was everybody tried to sell those assets at the same time, and that created this large downward pricing pressure on short-term investment grade fixed income assets. The problem with it was that those particular bonds did not have a lot of Treasury duration to offset that. In the longer assets and more core and longer duration portfolios, you saw price gains as a function of the duration and Treasury exposure, offsetting those large withdrawal requests and that pressure in the corporate space. So, you know, I think at the end of the day, that the yield that you have, at this point on a go forward basis, in short duration fixed income will resolve itself. It'll just take a little bit more time for the performance to recoup in those short duration bond funds.

Michael Walton: So, kind of moving on to attribution. Dustin, you handle most of the attribution for our clients that work with Sage. Can you share some insights on what you're seeing on that front?

Dustin Finley: Yeah, and there was a little bit of a dichotomy between strategies that's a little bit unusual, just given the nature of what you guys just discussed with regards to short-term versus core portfolios. But I think when you look at the overall attribution for really high level, you know, there were a couple drivers and I think Thomas hit on in the opening. But the obvious ones were any allocation to spread product and that manifests primarily within the corporate bond portfolios. So, your number one attractor was how much corporate exposure did you have? And then if you dig a little bit under the hood there, you can look at the different subsectors within corporate credit. And I think I'd like to ask Thomas this question kind of as a follow up but you know, when I started doing the attribution early on in the quarter, yeah, I think it was it was pretty obvious that you know, the layoffs were going to be energy. Anything related to the price of oil was going to get hit. Now the airlines obviously with a shutdown there, anything related to hotels, hospitality. But I think there were a couple surprises when you when you kind of lifted the hood and started looking at attribution at least from my perspective. And, you know, in hindsight, these are pretty obvious. But at first glance, you know, I didn't realize the impact that the shutdown would have on banking, your finance companies, on the real estate market with regards to rates. And then I think some of the more consumer-related securitized parts of the market, like asset backed

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mortgages and commercial mortgages.

Thomas Urano: And I think the reason behind that was an economy wide shut down, right, these segments of the market really live off of exchanging of cash flows and auto receivables is dependent on people paying their auto payment, pay their monthly payments, credit card receivables, same thing mortgages, people depending on people paying their mortgage payments in the commercial space, depending on people paying their rents. And so that disruption in the short run caused a lot of concern and uncertainty on how these securities perform in an

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environment where there'll be a one, two or three-month delay in a variety of these types of payment streams.

Michael Walton: Alright, so Thomas moving on. So can you speak to kind of the stabilization that we saw towards the last week of March, and the recovery really from those March lows and sort of what you think are the main catalysts behind that stabilization of recovery?

Thomas Urano: Right, so the market was experiencing some significant downward pressure. And then I think was the week of March 23. The Fed came in and began providing assistance to the market, right, they began saying we're going to start buying Treasuries, and then immediately provided liquidity back into the Treasury market that provided some support into the agency mortgage market. Then the fiscal stimulus package was put out that provided some more support, and then ultimately, the Fed followed up again, with a with an even larger scope to basically printing QE and provide support to the bond market across a variety of different segments. All of that had a pretty significant impact and put a halt to really the downward pressure that we saw in that last week of March and caused the market to reverse course. So I would say if you look at the segments overall, you know, the Treasury market recovered its liquidity immediately.

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The mortgage market recovered in price rather significantly. Agency mortgages, you know, prior to the Fed stepping in, were probably down about 3%. They turned around and got all that back and then ended up generating some additional price gains into the end of the end of the quarter. So the Fed salvaged the Treasury market, the agency mortgage market first, and then coming out and saying we're going to provide support to the corporate market via two different programs. And then ultimately, after that came out and said, we're going to provide support to the asset backed market and more recently, we're going to provide support to the commercial mortgage backed market and the high-yield market as well. All of these programs have caused a significant turnaround in valuations. We've probably recovered, I'm going to say 50% to 60% of the drawdown we have so far. And I think the market will continue to mend.

Michael Walton: Can you provide perspective on the magnitude of policy that's being put in place today versus what we saw during the financial crisis of 2009?

Thomas Urano: Yeah, the magnitude is amazing. The Fed's balance sheet prior to the situation in February was about $4.2 trillion.

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It's grown to about $5.6, $5.7 trillion. So it's grown by, you know, a trillion and a half in a matter of two or three weeks. And then recently, the Fed announced another $2.3 trillion of stimulus or quantitative easing support that they're going to provide to the market. So that puts you somewhere in the neighborhood of $3.5-ish trillion dollars of, of purchases, the Fed is going to add to the market. That's a substantial amount of capital. It's hard to fathom just how big three-odd trillion dollars is. But put this into perspective, the balance sheet was only $4.2 trillion prior to all of this taking place. So the Fed has grown its balance sheet by north of 75%, in a matter of, you know, call it 60 days – that’s tremendous support. And the magnitude is it's really hard to comprehend, but it provides a significant amount of support to the market.

Dustin Finely: So with that said, Thomas, you know, looking at what happened in March, and I, you know, we haven’t really touched on it, but it's obvious that there were a systematic sell-off in corporate bonds. There's obviously going to be some opportunities that arise from that as it pertains to companies that still have some relative strength to them. That you know, have seen some significant price movement downward.

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Dustin Finley: Have you seen enough from either the federal response or just stabilization within the marketplace to dip your toes back in the water and take advantage of some of those opportunities or is caution still kind of ruling the day?

Thomas Urano: Yeah, that's a great question. Listen, the market created substantial opportunities in certainly in the corporate space. And in even in certain areas of the structured product space over the last year, we'd spent the last 12 months or so, lowering portfolio volatility, we've been shifting the corporate exposure more into that security space. Again, our anticipation was that the securities market would provide some dampening and lower volatility exposure.

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But as this as this market unfolded here in the last latter half of March, as I mentioned earlier, the corporate market certainly experienced the worst of it. The securitized market had some drawdown nearly as bad but when I looked at the portfolio allocation we had, we had some some significant dry powder in the portfolio. The allocation to agency mortgages, it worked out well and provided some powder for us to use to acquire some credit exposure. Now, again in the market, babies were thrown out with the bathwater. There was plenty of opportunities here. There were some really strong companies with really great balance sheets that had to come issue paper, issued debt at extremely cheap valuations. And we were able to take advantage of some of that stuff, we were able to convert some of the securitized exposure and dry powder we had into credit exposure at extremely discounted valuations. And I think that pays dividends, certainly paid dividends already in the first two weeks of April, and will likely continue to do so as we get policy support, both fiscal and monetary. From my perspective, at least this seems awfully easy, right? We had a really, really rough patch there in late March and around the globe came in, threw a bunch of

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money on it. And now it's business as usual, almost.

Dustin Finley: Is there anything out there right now that kind of gives you pause and says, Okay, there could be another leg to this? There's another shoe to drop. What is the worst-case or the next case scenario look like, from your perspective? Is it just off to the races again? Or is this going to be a more of a slow, long slow recovery?

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Thomas Urano: Yeah, I mean, economically, there's gonna be long, slow recovery. And, what do you do? This isn't an off to the races, again, situation, certainly from an investment standpoint. I think, you know, the Fed gave us an opportunity here and provided a lot of support. What that means is the market overall is pricing itself more on a technical perspective. The Fed’s showing up with the amount of balance sheet it's showing up with, there's a race to acquire some assets before the Fed gobbles up of the vast majority of it. And that's led to some significant price recovery. Given this price recovery, now it's incumbent on us, what we're looking at doing is saying how do I comb through these positions? Some of the issues that have had recoveries already and evaluate, you know, what's the prospect for these companies, these businesses, these business models to be successful and profitable on a go-forward basis, right? Which ones will likely struggle. I mean, sectors that we’re more in favor of – tech, utilities, telecom. Retail space, not so much – but certain segments of the retail space, DIY segments. I mean, for example, you know, O'Reilly, AutoZone. You know, people will be repairing cars more likely instead of buying new cars. Home Depot, Lowe's, you know, supply stores, again, certain segments of the market, I think create an opportunity for you in in the credit space.

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Other areas, again, where you want to probably come through and use this rebound, this Fed-induced rebound to try and clean up some positions that may struggle on a go-forward basis. I mean, certainly in the energy space, you know, we saw this large price decline in oil, a little bit stability here. And then the Fed coming in and providing this support. Now, now we spend some time thinking about our exposures, and they're looking at companies and, you know, how do you survive in a world where oil is, you know, more like $20 to $25 a barrel rather than $40. So you'll spend some time evaluating that and cleaning up some exposures where, you know, the business models are going to struggle a little more in that point. Same thing in the Travel and Leisure space. In the airline space, we'll look through those -- the airline industry overall has gotten support from the Fed and fiscal support as part of the stimulus package. So using that as an opportunity to kind of go through and identify companies that may do fine and may struggle, and then clean up positions based on that situation.

And then finally, you know, the REIT space. The REIT market has been a tried and true sector of the market for a long time, years, and years, and years, that has done exceptionally well. It’s a sleepier corner of the market, people don’t pay too much attention to it. Essentially, you own real estate, you get your rent payments and you move on. It’s not volatile and not too many people put a lot of focus on it. But for us it’s been a space we like to play in. Covenants have generally been exceptionally strong in REITs. Cash is exceptionally strong, and it’s a lower volatility segment of the market. In an environment where consumers are on hold and cash flows are getting delayed, you have to go through those exposures and identify segments of that REIT market and identify anyone who’s going to struggle or have a hard time with receiving proper amounts of cash flow on the underlying properties that they have. We’ll spend some time cleaning up and going through those. Finally, I’ll add on the securitized market, we’ve gone through and stress tested consumer receivables and commercial receivables. Fortunately, we’ve identified few in our positions where that would be a problem, and the handful that we have come up with that are a problem, we’re actively looking to exit positions in that space.

Michael Walton:  Thank you, everyone, for joining us today. As you know, your team at Sage is here for you anytime you need us. Take care.

Sage Advisory Services is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. This podcast is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

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