Commentary

High Yield and Enhanced Fixed-Income Market Overview 

Our enhanced fixed income strategy aims to supplement an investor's allocation to traditional fixed-income: we believe that the debt securities favored by the portfolio tend to outperform during periods of economic growth, which is the time when more typical bonds suffer from concerns over inflation or rising interest rates. By incorporating an enhanced fixed income allocation of more growth-oriented bonds (such as high yield and convertible securities) into an overall portfolio, we can provide investors with the potential to earn total returns that may offset losses or weaker performance by other more interest-rate-sensitive bonds, which tend to suffer when interest rates rise.

Our current economic outlook suggests that this strategy will prove particularly valuable for the foreseeable future, as we believe that we are in the mid-phase of the growth cycle, which can last for years. During such periods, the growth orientation of the portfolio can benefit from the equity market's upside potential, and, in our opinion, should outperform traditional, higher quality bonds. With that said, it's important to note that the portfolio still retains the potential downside protection that bonds can provide, even though it offers some equity participation.

While the first quarter of 2006 was an excellent example of the merits of the portfolio's growth orientation, the second quarter demonstrated the merits of its downside protection: For example, during the first quarter of 2006, interest rates rose and the investment grade market, as measured by the Lehman Brothers Aggregate Bond Index,¹ was down -0.65%, whereas our enhanced strategies returned more than 4%, thanks to its greater equity sensitivity. In the second quarter, equities suffered and equity-oriented securities declined, but the portfolio's bond qualities provided downside protection almost equivalent to the broad bond market, declining only slightly more than the Lehman Brothers Aggregate Bond Index return of -0.08%. Thus, the combination of the benefits of equity upside during the first quarter and the downside protection during the second quarter has resulted in significant outperformance of our enhanced fixed income portfolio relative the to broad bond market for the year-to-date.

Looking ahead, we continue to position the portfolio for a growth economy, where we believe larger, growth-oriented companies and those with stronger balance sheets will outperform. Our portfolio reflects this bias, as we tend to hold bonds among the higher-quality tiers of the below-investment-grade realm, and avoid the lowest quality, more speculative securities. To date, these lower quality (CCC-rated) bonds have actually outperformed, but we do not believe that this rally is sustainable, nor are investors currently adequately compensated for the risks associated with such lower rated companies. We are instead focusing on issuers that should benefit from the mid-phase of the growth cycle, and favoring convertible securities over straight corporate bonds. As we have stated in the past, we continue to focus on companies with bonds that may benefit from M&A activity, equity issuance or other corporate events that may improve the company's standing.