1. 1 Does a longer time period reveal a different return-risk relationship? Historically, there has been no pay-off from duration extension –Intermediate Treasuries have had returns similar to long Treasuries There has also been no pay-off to investing in credit –Long corporates have had returns similar to intermediate and long Treasuries One Month Treasury Bill Intermediate Treasury Long Treasury Long Corporate S&P 500 Source: Ibbotson Associates ……………………… No duration pay-off No credit pay-off ……. Historic Return and Risk December 1959 to December 2002

2. 2 Fixed Income Investment Choices December 1988 to December 2002 For some investors cash is the “safe” asset A look at historical return and risk suggests two fixed income conclusions –Investment grade bond returns have been essentially the same, and –Fixed income investors have only had one choice to make How much return volatility to take Treasury Bill Lehman MBS Lehman Aggregate Lehman Government Lehman Credit Note: Lehman duration data begin Dec. 1988.

3. 3 Is Yield the Best Predictor of Future Return? Average Credit Ratings And Yield December 1988 to December 2002 AAA AAABBBBBBC Credit C Credit B Credit BB Credit BBB Credit A Credit AA Credit AAA US Government MBS Many investors believe that, in the long-run, higher yield should translate into higher return Typically, higher yield is associated with higher credit risk Credit losses, though, may diminish a yield advantage Have higher yields translated into higher return? Source: Merrill Indices, Bloomberg

4. 4 AAA AAABBBBBBC Credit C Credit B Credit BB Credit BBB Credit A Credit AA Credit AAA US Government MBS Is Yield the Best Predictor of Future Return? Average Credit Ratings And Yield December 1988 to December 2002 Historically, investors have had a hard time forecasting credit losses As a result, higher yield has not been a source of higher return –Rather it has been a source of opportunity cost Source: Merrill Indices, Bloomberg

5. 5 Historical Pay-Off to Sector Diversification December 1988 to December 2002 For many investors, the government sector is the “safe” fixed income sector Historically, the credit sector has had the same return as 5-7 years Government bonds Historically, the mortgage sector has had: –Return volatility similar to three year governments, and –Outperformed comparable duration governments by about 50 basis points per annum Three Month Treasury Bill Lehman US MBS Lehman Aggregate US Government US Credit US Government 1-3 Years US Government 3-5 Years US Government 5-7 Years US Government 7-10 Years US Government 10+ Years US High Yield

6. 6 Historic Return And Risk December 1925 to March 2003 lkjlkjljlj One Month Treasury Bill Intermediate Treasury Long Treasury Long Corporate S&P 500 ……………………… No duration pay-off No credit pay-off ……. Inflation

7. 7 Does a longer time period reveal a different return-risk relationship? Historically, there has been no pay-off from duration extension –Intermediate Treasuries have had returns similar to long Treasuries There has also been no pay-off to investing in credit –Long corporates have had returns similar to intermediate and long Treasuries One Month Treasury Bill Intermediate Treasury Long Treasury Long Corporate S&P 500 Source: Ibbotson Associates ……………………… No duration pay-off No credit pay-off ……. Inflation Historic Return And Risk December 1959 to March 2003

8. 8 Historical Return And Risk December 1925 to March 2003 One Month Treasury Bill Intermediate Treasury Long Corporate Long Treasury S&P 500 Note: Data source Ibbotson Associates. Methodology: create two vectors of real returns conditional on the contemporaneous real return of the S&P 500. One vector represents asset returns when the stock market real return is above average, the other represents returns when equity real returns are below average.

9. 9 Historical Return And Risk December 1925 to March 2003 One Month Treasury Bill Intermediate Treasury Long Corporate Long Treasury Note: Data source Ibbotson Associates. Methodology: create two vectors of real returns conditional on the contemporaneous real return of the S&P 500. One vector represents asset returns when the stock market real return is above average, the other represents returns when equity real returns are below average.

10. 10 Historical Return And Risk December 1925 to March 2003 One Month Treasury Bill Intermediate Treasury Long Corporate Long Treasury S&P 500 Note: Data source Ibbotson Associates. Methodology: create two vectors of real returns conditional on the contemporaneous real return of the S&P 500. One vector represents asset returns when the stock market real return is above average, the other represents returns when equity real returns are below average.

11. 11 Historical Treasury Returns When Treasury Index Rates Rise Or Fall Contemporaneous, December 1988 to April 2003

12. 12 Historical Treasury Returns After Treasury Index Rates Rise Or Fall One Month Lag, December 1988 to April 2003

13. 13 Historical Returns After Treasury Index Rates Rise One Month Lag, December 1988 to April 2003

14. 14 Historical Returns After Treasury Index Rates Rise One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

15. 15 Historical Returns NBER Expansion/Recession Contemporaneous, December 1988 to April 2003 Return In Excess Of T-Bill

16. 16 Historical Yields December 1988 to April 2003

17. 17 Historical Returns Positive Yield Curve One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

18. 18 Historical Returns Yield Curve Above In Sample Average One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

19. 19 Historical Returns Yield Curve Above Trailing Twelve Month Average One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

20. 20 Historical Returns Five Year CMT Rates Rise One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

21. 21 Historical Returns Three Month CMT Rates Rise One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

22. 22 Historical Returns Three Month CMT Above One Year Average One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

23. 23 Historical Returns S&P 500 Returns Positive One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

24. 24 Historical Returns S&P 500 PE Above One Year Average One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

25. 25 Historical Returns BAA-AAA Spread Above One Year Average One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

26. 26 Historical Returns BAA-AAA Increase One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

27. 27 Historical Returns Growth Outperforms Value One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill

28. 28 Fixed Income Indices

29. 29 Claude, I would like to concentrate on the graphs on pages 1, 2, 4, and 5. Basically, we will cut the data into two buckets, A and B and graph the curves for these (on the same graph, i.e. there will be two curves, sample A and sample B). 1. A=NBER recessions (Peak to Trough), B=NBER expansions (Trough to Peak) http://www.nber.org All of the next graphs are predicitve. We observe a state and then take a position the next month. 2. Term structure inversions (5yr-3mo Treasury yield). A=Inversion (sample the month *after* inversion, i.e. if term structure inverts in Feb, March goes into A, if it returns to positive slope in September, A will include March-September, October will go to B. This way, we are operating on an ex ante basis. 3. Past changes in interest rate yields. A=month after US 5-yr increases, B=month after US 5yr decreases. 4. Same except use 90 day T-bill yield 5. The 90-day T-bill minus the 12month moving average of the Tbill yield. Positive is A, negative is B. 6. Last month's S&P 500 return, negative is A, positive is B. 7. S&P 500 P/E minus 12-month average P/E negative is A, positive is B. 8. Change in Moody's Baa-Aaa (on Federal reserve of St. Louis Website), negative is A, positive is B 9. Baa-Aaa minus 12-month moving average. Positive is A, negative is B. 10??? Value minus growth performance??? in previous month? Add whatever your favorite indicator is. -Camhttp://www.nber.org

30. 30 Historical Treasury Returns After Treasury Index Rates Rise Or Fall One Month Lag, December 1988 to April 2003