1. Sage Update...Your Insurance Investment Management Resource
Sage Insurance Monitor
Second Quarter 2015
As interest rates continued to fall, investment
managers, economists, and analysts talked about
a reversion to the “norm.” The problem with that
notion is that the “norm” is different for everybody
depending on their age and economic perspective.
Somebody who obtained their first mortgage in 1970
at a rate of 7.5% is most likely going to associate
that with normal, while others who obtained their
first mortgage in the early 1980’s at 18% may
have an entirely different view. Over the last few
years, 30-year fixed mortgage rates have teetered
between 3-4%, and have become the "norm" for
many homeowners. With interest rates having
declined over the past
thirty years, are low
rates the new normal?
We know inflation plays
a big role in determining
market interest rates.
The relationship between
30-year mortgage rates
and inflation are highly
correlated. In 1970, the
inflation rate was 5.7%,
and in 1980 it was 13.5%. The average inflation
rate for the past three years has been only 1.7%.
According to the U.S. Bureau of Labor Statistics, the
inflation rate for the United States (CPI-U) was 0%
through the 12 months ending in May 2015. Inflation
has been negatively impacted by falling oil prices
and the energy sector. Fed Chair, Janet Yellen, has
already stated that a path towards a 2% medium-
term inflation rate would be a condition of a rate
increase.
Generally, labor costs are a huge driver of inflation
butwithunemploymenthavingbeensohigh,workers
had little leverage and wages have been fairly flat
since 2008. Compensation costs for civilian workers
increased 2.6% over this past year, an improvement
over the prior year rate of 1.8%. The previous five
year period wages increased at an average annual
rate of just 1.3%. However, after adjusting for
inflation, wages actually decreased at an average
annual rate of 0.24%. The unemployment rate has
dropped from 10% in October of 2009 to almost half
of that as of June 2015 at 5.3%. We expect to see
wage rates continue to build on the gains over the
past couple of years, creating inflationary pressures
as unemployment rates approach the threshold for
full employment.
To help gain perspective, at the beginning of 2008
the Fed Funds rate was 3.5% and the 10-year
treasury was at 3.74%. Today the Fed Funds rate is
near zero and the 10-year treasury rate is 2.45%. Of
course, the Fed doesn’t control long-term rates, but
its policy with regard to short-term rates sets the
basis for yields on government bonds with longer
maturities. However, the central bank did impact
longer-term rates through its quantitative easing
program, which was in place from 2008 through
2014, where the Fed purchased over $3 trillion in
treasuries and mortgages.
Throughout history, economists have been trying to
determine the “natural rate of
interest.” Swedish economist,
Knut Wicksell, first put forth
the theory in 1898 that “there
is a rate of interest on loans
which is neutral in respect
to commodity prices and
tends neither to raise nor to
lower them.” The “natural”
rate of interest is not a law
of nature nor observable, so
it must be estimated. Monetary policy makers are
interested in estimating the natural rate of interest
because real rates above or below it would tend to
depress or stimulate economic growth, which is why
in recent years the Fed has sought to keep interest
rates as low as possible. While this has stimulated
the economy, it has not yet created the economic
tailwinds sufficient to fuel the necessary levels of
inflation.
Creating a fertile interest rate environment is
a daunting task and can be full of unintended
consequences. While the Fed’s actions to keep
interest rates artificially low to stimulate the
economy have reduced unemployment substantially,
it has also had negative consequences on other
segments of society. Retirees who place a
great reliance on fixed income to supplement
their retirement have seen their earnings fall
precipitously. For example, the average yield on
a five year certificate of deposit in 2007 was 4%;
today the average yield is 1.19%. That is a 70% drop
in earnings and an even bigger drop in earnings for
retirees banking on the continuance of 5-year CD
yields in 1990 at 8%. Life insurers’ have also been
hit hard as current market yields have fallen below
the guaranteed interest rate levels on some life
THE NATURAL RATE OF INTEREST
Continued on page 4
OUR SERVICES
Sage Advisory provides comprehensive
portfolio management and services that
integrate the operational aspects of
the insurer with appropriate investment
solutions. Our customized strategies address:
Liability Assessment and Analysis
• Dynamic cash flow modeling
• Interest rate & inflation risk sensitivity analysis
• Customized liability benchmark creation
• Gap analysis & risk budget creation
• Financial statement projections
• Tax efficiency analysis
Investment Management
• Liability targeted investments
• Core Fixed Income Investment Strategies
• Tactical ETF Investment Strategies
• Tax sensitive and income oriented portfolio
management
Reporting and Administration
• Daily online investment reports
• Investment compliance and oversight reports
• Customized quarterly performance evaluations
• Statutory Schedule D reporting
Contact Us
Jeffrey L. Sims, CPA
Executive Vice President, Director of
Insurance Investment Management
p: 512.327.5530 c: 512.202.9244
jsims@sageadvisory.com
Joshua A. Magden
Vice President, Consultant Relations
p: 512.327.5530 f:512.327.5702
jmagden@sageadvisory.com
Please visit our website for more information.
www.sageadvisory.com

2. Quarter In Review
For municipal bond investors, the backdrop was
challenging as rates moved higher for much of the
quarter and spreads leaked wider. While total return
oriented investors saw this as a negative, insurers with
a book yield orientation saw this as a great opportunity.
The Barclays Municipal Index experienced a negative
total return of 0.89%. With liquidity concerns on the
rise, lower quality credits modestly underperformed. The
Barclays Muni BBB Index had a negative 1.04% quarterly
return, versus the AAA Index return of negative 0.74%.
Municipal bonds generally outperformed equivalent
taxable fixed income, as the Barclays Aggregate Bond
Index returned negative 1.68% for the quarter, the
worst quarter for US core fixed income in two years.
Within risk assets, most equity markets were close
to flat for the second quarter, with international
equities outperforming, but generating less than 1%
returns. REITs underperformed, as rising rates weighed
the sector down, while commodities outperformed,
bolstered by a weaker dollar and better second half
growth outlook. For fixed investors, the backdrop was
particularly challenging as long rates moved higher for
most of the quarter and spreads leaked wider. 10 year
Treasury yields stabilized into quarter-end on equity
market turmoil but finished 40 basis points higher.
The net result was the worst quarter for US core fixed
income in two years, with the Barclays Aggregate index
returning -1.68%.
See disclosures for indices used in asset class returns.
*Returns are not annualized.
See disclosures for indices used in asset class returns.
*Returns are not annualized.
See disclosures for indices used in asset class returns.
*Returns are not annualized.
Equities/Alternatives Returns 3 MO* 12 MO
Diversified Commodities 5.45% -32.28%
Emerging Markets 0.81% -4.81%
Developed International 0.80% -3.59%
U.S. Large Caps 0.28% 7.42%
U.S. Small Caps 0.19% 6.70%
U.S. REITS -10.44% 3.95%
For insurers' fixed income portfolios, the backdrop
was particularly challenging as long rates moved
higher for most of the quarter and spreads leaked
wider. 10 year Treasury yields stabilized into quarter-
end on equity market turmoil, but finished 40 basis
points higher, while investment grade credit spreads
widened 13 basis points. The net result was the worst
quarter for US core fixed income in two years, with
the Barclays Aggregate index returning -1.68%. All
major sectors experienced negative absolute returns,
while on a relative basis, Agency MBS outperformed
and credit lagged. Outside core fixed markets, returns
were mixed with high yield and emerging market debt
outperforming, while preferred stocks and non-dollar
fixed income underperformed.
Global Fixed Income Returns 3 MO* 12 MO
Asset-Backed Securities 0.17% 1.64%
High Yield 0.00% -0.40%
Agencies -0.59% 1.46%
Emerging Markets -0.71% -0.38%
Mortgage-Backed Securities -0.74% 2.28%
Commercial Mortgage-Backed Secutities -1.06% 1.91%
Treasury Inflation Protected Securities (TIPS) -1.06% -1.73%
Aggregate Bond -1.68% 1.86%
U.S. Treasuries (7-10 yr.) -2.43% 3.65%
Investment Grade Credit -2.88% 0.93%
Municipal Returns 3 MO* 12 MO
Municipal Bond Index -0.89% 3.00%
Municipal 1-10 Yr Index -0.51% 1.74%
Municipal 3 Yr Index -0.02% 0.57%
Taxable Bond Returns
Aggregate Bond -1.68% 1.86%
Investment Grade Credit -2.88% 0.93%
U.S. Treasuries (7-10 yr.) -2.43% 3.65%
Equities/Commodities Returns
U.S. Large Caps 0.28% 7.42%
Developed International 0.80% -3.59%
Diversified Commodities 5.45% -32.28%

3. Fourth Quarter 2013
Outlook & Positioning
After suffering the worst quarter since the summer
“taper tantrum” of 2013, we head into the third quarter
more optimistic toward core fixed income returns.
Given our view that the Fed will remain cautious, data
is likely to disappoint consensus rebound expectations,
we are less worried about a sustained rate correction,
but have grown more defensively minded toward the
credit sector. We expect long rates to remain stable
with 10 year Treasury yields in the 2-2.5% range.
Given our outlook, we increased duration exposure
where possible subject to insurers' constraints, to
intermediate and long rates in the second quarter.
We maintain an underweight toward short rate
exposure, however, we expect curve flattening with
rising short rates and stable long term rates. From
a sector perspective, we have turned more cautious
toward credit and have pared back our corporate
allocation to an underweight position, while increasing
exposure to agency backed MBS. Credit appears
vulnerable to further spread volatility, while we are
more constructive on MBS given positive real estate
fundamentals and diminished prepayment risk.
The macro backdrop appears constructive for equities,
but with global valuations at cycle highs and policy
uncertainty in the US, it also suggests higher volatility
and increased vulnerability to a correction. We,
however, expect global QE-driven liquidity, a bounce
in US data, and continued Eurozone recovery to keep
the “buy on dip” mentality alive over the coming
quarter for equity markets. We continue to view
developed market equities as most attractive among
risk assets given ECB and BOJ policy support and the
pick-up in economic momentum in Europe. Currently,
we see limited opportunity outside of core developed
market equities as commodities and emerging markets
continue to face growth and currency headwinds.
See disclosures for indices used in asset class returns.
Returns are not annualized.
Sage Allocations
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
-40%
-35%
-30%
S&P 500 EAFE EM Equity COMMODITIES
See disclosures for indices used in asset class returns.
Returns are not annualized.
12 Month Risk Asset Returns
0 5%
1.0%
1.5%
2.0%
0.0%
0.5%
MBS CMBS ABS IG Credit
U.S. Fixed Income Sector Spreads
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
0.0%
0.5%
1.0%
0 5 10 15 20 25 30
3 MO Ago Current 12 MO Ago
U.S. Treasury Yield Curve
See disclosures for source.

4. This publication contains the current opinions of the manager and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Such opinions are subject to change
without notice. This publication is distributed for education purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Forecasts are based on proprietary research
and should not be interpreted as an offer or solicitation, nor the purchase or sale of any financial instrument. No part of this publication may be reproduced in any form, or referred to in any other publication, without the express
written permission of Sage Advisory Services, Ltd. Co. Past performance is not a guarantee of future results.
Source: Bloomberg. SNL Financial. Fixed Income asset classes represented by the following indices: Municipal Bond by Barclays Municipal Bond Index, Municipal 1-10 Year by Barclays 1-10 Year Municipal Bond Index, Municipal
3 Year by Barclays 3 Year Municipal Bond Index, Aggregate Bond by Barclays Aggregate Bond Index, Investment Grade Credit by Barclays U.S. Investment Grade Credit Index, U.S. Treasuries by Barclays 7-10 Year Treasury Index.
Equity asset classes represented by the following indices: US Large Cap by S&P 500 Index, Developed International by MSCI EAFE Index, Diversified Commodities by Deutsche Bank Liquid Commodity Index.
and annuity policies creating a negative spread
between crediting rates and market yields.
At this juncture, it appears we may be closer to
the new norm, at least for a while. Any Fed funds
rate increases are projected to be minor. The end
of Quantitative Easing almost a year ago has not
resulted in much of a rise in long-term rates and
inflation. The necessary catalyst for rising interest
rates is at zero. The good news is that the U.S.
Economy is growing stronger every day and so is
the dollar. Eventually, this will lead to inflationary
pressures and we will begin to see rates rise
modestly. In the near term, our view is the yield
curve will continue to flatten as short-term rates
rise and longer-term rates hold steady.
THE EFFECT OF POPULATION
AND DEMOGRAPHIC SHIFTS
ON INTEREST RATES
It is also interesting to note the effect population
growth and demographics have on interest rates.
Typically young people are net borrowers and
older people are net savers. The relative number of
savers and borrowers has a determinable impact
on the market for loanable funds. For countries
with growing populations, young people comprise
the largest group, and therefore borrowers
dominate the market. With so many borrowers
and so few savers, supply and demand will dictate
that interest rise to meet the scarcity. However, if
population growth begins to stall or decline, as we
have seen in Japan and Germany, then the balance
shifts and savers dominate the market. With less
people borrowing, there are fewer opportunities
for savers to deploy their savings. Therefore,
interest rates have to fall to encourage borrowing
and discourage saving.
In the fastest growing countries where borrowers
predominate such as Brazil, India, Argentina, and
Indonesia the 10-year bond rate is above 7% (over
11% for Brazil). Conversely, the 10-year bond rate
countries where savers dominate, such as aging
Japan and Germany is only 0.27% and 0.46%
respectively. The interest rates reflecting these
changing demographics are similar to the theory
behind the natural rate of interest in that, it is
above or below that point of equilibrium between
savers and borrowers that borrowing/investing is
either stimulated or discouraged.
THE PLAYBOOK
With the Fed signaling a year-end rate hike,
it’s natural to speculate about the effect a rate
increase will have on the yield curve. It's harder
to gauge whether modifying a portfolio's duration
is merited based on future spreads and your own
tax rate even given the probability that such a rate
hike will be small (25-50 bps) and has been well-
telegraphed.
Moreover, volatility abounds as dealer inventory
shrinks in the aftermath of Dodd-Frank. The thesis
and timing of the trade are important, as is the
capacity to navigate the trade. While he may not
have said it with an economist’s eye, Napoleon’s
quote to the right margin of this column is a fitting
depiction of what continues to move markets –
whether the “interest” he was referencing implied
rates or not!
Making an interest rate or inflation call on a
fixed income segment, as straightforward as US
Treasuries, can prove deceptively challenging. Low
rates and spread compression leave little room
for error. No asset owner or investment manager
will get every market call or the precise timing of
every call right. Nor is doing so the purpose when
it comes to an insurer’s risk-bearing capital. The
key is to get the decision and the timing mostly
right. Like attempting to budget for the family’s
healthcare expenditures for HSA/FLEX plan
deductions in the coming year, the downside risk
of setting aside a little bit less than ultimately
needed for doctor visits versus far more than the
family uses is fairly small.
Just so, expressing an interest rate or inflation
view within the portfolio is less problematic when
done incrementally and with more navigable
instruments. For an admitted carrier, an SVO-rated
ETF such as Vanguard’s Long-Term Government
Bond ETF (VGLT) is NAIC-1 and could be purchased
up to the position size limit outlined in state
statutes – commonly 3-5% in many state insurance
codes. It had an average duration of 16.8 years as
of 6/30/15.
Similarly, Vanguard’s Extended Duration Treasury
ETF (EDV) is also NAIC-1 and with a focus on
long-duration Treasury STRIPS allows an insurer
to place an overlay on their portfolio vis-à-vis
inflation expectations.
The “natural” interest rate in the decade ahead
is likely to be driven by different geopolitical and
economic forces than 120 years ago. Perhaps we
should pay heed to a philosopher regarded no
less than Le Petit Caporal, closer to us in time
and geography (particularly here in Austin), King
George (Strait): “Sun shines, clouds rain, train
whistles blow and guitars play, preachers preach,
farmers plow, wishes go up and the world goes
round… It just comes natural.” Whatever the
determinants of the natural interest rate in years
to come, we have strategic tools to adapt.
A MOMENT OF ZEN
“There are two levers for moving men – interest
and fear.”
-- Napoleon Bonaparte
"In times of change, learners inherit the earth;
while the learned find themselves beautifully
equipped to deal with a world that no longer
exists."
--Eric Hoffer, American social writer
“Be not afraid of going slowly, be afraid only of
standing still."
--Chinese proverb
Continued from page 1
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