February 20, 2017

Howard is a co-founder of Convoy Investments

Dealing with overvalued markets

Convoy Investments LLC | www.convoyinvestments.com | (302) 319–3659

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When markets feel overvalued

One of the toughest decisions investors

face is between staying invested in

what feels like expensive markets and

going to the safety of cash. This is a particularly tricky

question today because we are in a world of low returns and

high uncertainty. From historically low bond yields to reco

rd stock and real estate prices, virtually everything looks

ugly and overvalued. Many investors feel

the need to wait out the storm in the

safety of cash. In

this commentary I

provide my framework for thinking about

the tradeoff between sitting in cash an

d being invested. I’ll use bonds as an

illustration because bonds prices are mathematical

ly derived so we have more transparency.

Below I show the price to earnings (i.e. yield) multiple on bo

nds since 1953. At a multiple

of 66X, bonds prices are at

their highest ever.

Source: St. Louis Fed and Convoy analysis

The increase in price came as bond yi

elds steadily fell over the last 35 year

s from a peak of 15%+ in 1981 to under

2% today. Most bond investors fear that there will be an

inevitable reversal of yields

in the coming decades and

believe that the logical rout

e is to sit out of bonds.

Source: St. Louis Fed

To illustrate how I approach this question, I first replicat

e an interesting Bank of America analysis I recently saw.

Let’s say that many investors’ nightm

are does come true and the secular tailwind of dropping yields becomes a

headwind of rising yields. Below I show a hypothetical path

of bond yields where the next 35 years exactly replicates

Price/Yield Ratio of US 10 Year Treasuries

10%

12%

14%

16%

18%

US 10 Year Treasury Yields

MONTHLY

COMMENTARY

CONVOY

February 20, 2017

Convoy Investments LLC | www.convoyinvestments.com | (302) 319–3659

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the past 35 years but in reverse such that yields went from under 2% today to a peak of 15%+ in 2051. How would

bond investors fare under this scenario that many fear?

Source: St. Louis Fed and Convoy analysis

Because bond prices are determined by yields, bond re

turns can be precisely calculated: bond returns = coupon

returns + price change from yield changes.

To illustrate how this works, below I

looked at the historical bond yields

to calculate the historical bond return

s. Not surprisingly, from bond yields you can very closely replicate both the

level and pattern of actual bond returns.

Rolling 3 Year Annualized Returns

Source: St. Louis Fed and Convoy analysis

Below I use this same methodology on the hypothetical case

of rising future yields to

back out bond performance

should yields revert back to 15%+ over the next 35 years.

10%

12%

14%

16%

18%

1970

1982

1994

2006

2018

2030

2042

Historical US 10 Year Treasury Yields

Hypothetical Future Path

10%

15%

20%

25%

Simulated 10 Year Treasuries

Actual 10 Year Treasuries

Since 1970

Simulated 10

Year Treasuries

Real 10 Year

Treasuries

Annualized Total Return

7.7%

7.5%

Annualized Risk

5.5%

5.6%

Convoy Investments LLC | www.convoyinvestments.com | (302) 319–3659

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Cumulative Total Returns

Source: St. Louis Fed and Convoy analysis

While bond returns will clearl

y be lower in a prolonged period of yield ri

se than bond returns in a period of yield

drop, people may find it counter intuitiv

e that bonds will actually generate substantially positive total returns in this

unfavorable scenario and sitting in cash would be a losi

ng proposition. Below I disc

uss the reason behind this

phenomenon and its implications on choosing betw

een cash and a potentially overvalued asset.

In the short run, investments are dominated by price,

in the long run, investments are dominated by income.

While rising yields are clearly unfavorable for the price of an

asset, higher yields are gr

eat for the income of assets.

Therefore, if yields rise over a long

enough time horizon for income accrual to

become a major factor, rising yields

are not all gloom and doom. Below, I break out the impact of

collecting coupon income vs. the impact of price change

from yield swings over the two periods we discussed above.

What we find is that while dropping yields have clearly

been a boon for bond returns, the ma

jority of the 8% we got from bonds since 1981 came from coupon income

rather than price change.

Source: St. Louis Fed and Convoy analysis

More broadly, over shorter time frames

, investment income tends to not matte

r enough to overcome price changes.

But over longer time frames, income

becomes the dominant factor. Below I br

eak down how much income and price

explained bond returns over various time horizons since 1970.

-50%

50%

100%

150%

200%

250%

300%

350%

2016

2026

2036

2046

Simulated 10 Year Treasuries

Actual Treasuries

1981-2016

Simulated Treasuries

2017-2061

Starting Yield

15.3%

1.6%

Ending Yield

1.6%

15.3%

Annualized Total Return

8.4%

4.1%

Worst Year

2013: -4%

2047: -10%

Best Year

1982: 27%

2049: 24%

Actual Treasuries

1981-2016

Simulated Treasuries

2017-2061

Annualized Price Change

2.0%

-2.1%

Annualized Coupon Income

6.3%

Total Return

8.4%

4.1%

Convoy Investments LLC | www.convoyinvestments.com | (302) 319–3659

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Percent of Bond Returns Explained over Various Time Periods

Source: St. Louis Fed and Convoy analysis

On a month to month basis, the vast majority of bond retu

rns are driven by price changes. But after 3 years or so,

bonds collect enough coupons that the income becomes the mo

re important driver of returns. While this is more

precise and transparent in bonds, most

other investments follow a similar pattern

. For example, real estate collects

rent and stocks receive dividends that

become more important than the pric

e swings over longer time frames.

When predicting the future, people typi

cally focus on the direction of their prediction. For example, it seems that at

historical lows, yields have nowhere to go but up, so it appe

ars to be a no brainer that we

should avoid bonds. Yet, as

we see in the presented case study, the timeframe of the pr

ediction is just as important because if your prediction

plays out over multiple years, coup

on income becomes a major driver.

So when markets feel expensive and we want to go to cash

, the main question boils down

to how tightly can we call

the top? Do we loosely think bonds will fare poorly in the ne

xt decade or do we think that yields will turn sharply in

the next year or two? If we have confid

ence in our ability to forecast in the

right direction and in a tight time frame

(less than 3 years), then we can sit out of the markets an

d wait for the price to adjust knowing that the income

accrual won’t have much time to work against us. If we ha

ve less confidence in our ability and our forecast is on a

loose time frame, the price swing we predict may eventually

come but we’ve missed out on so much income accrual

during the wait that the tradeoff might

not be worthwhile. Or worse, there is always a chance that the predicted

price adjustment may never actually come or even go ag

ainst us, exacerbating the opportunity cost of our missed

income.

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

01234567891011121314

Years

Coupon Income

Price Fluctuation

Coupon Income Price Fluctuation

1 Month

13%

87%

6 Months

24%

76%

1 Year

31%

69%

3 Years

47%

53%

10 Years

60%

40%

15 Years

69%

31%

Convoy Investments LLC | www.convoyinvestments.com | (302) 319–3659

CONFIDENTIAL: DO NOT DISTRIBUTE

Disclosures:

Please read the following disclosures as

they provide important information an

d context. Additional information is

available upon request except where the proprietary na

ture of the information precludes its dissemination.

Client returns reported here are net of fees total retu

rns. The returns reported are based on market prices and

intended for informational pu

rposes only. Final redemption

value may be impacted by transaction costs and liquidity

considerations. Any net of fees returns are estimates and

are not finalized until the end of the year. From time to

time the Fund’s advisor may waive or

lower fees, without which performance wo

uld have been lower. This document

is confidential and for informational purposes only and s

hould not be relied upon as a prediction of future market

performance or Convoy management perfor

mance. It is not an offer to sell or

the solicitation of an offer to buy the

securities or other instruments mentio

ned. Portfolio allocations shown are for illustrative purposes only and may

not reflect the actual or current implementation of our

strategy. Historical performance is not an indication or

assurance of future results. There is no assurance that th

e fund will necessarily achieve its investment objective or

that it will or is likely to achieve results comparable to t

hose shown in this document, or

will make any profit, or will

be able to avoid incurring losses. No representation is being made that any account will or is likely to achieve returns

similar to those shown. Past performance is not necessarily

indicative of fu

ture results. Performance as of the

current month is estimated and subject to change. The hist

orical performance information herein has been prepared

by Convoy and has not been independently audited or ve

rified, except for certain

year-end data. Historical

performance is calculated using geometrically linked

time-weighted re

turn methodology and reflects the

reinvestment of dividends.

Net returns experienced by an individual in

vestor will vary depending on their month of

investment.

This document is not intended to be legally binding. For

the full legal contract, each investor should carefully review

the Private Placement Memorandum, the Limited Partnership Agreement, and the Subscription Agreement. The

views expressed here are solely that of Convoy Inve

stments LLC and are subject to change without notice.

Reasonable people may disagree. You should assume that

Convoy Investments LLC has a

financial interest in the

views discussed. The research presented is for informationa

l and educational purposes only

and is not an offer to sell

or the solicitation of an offer to buy the investments ment

ioned. It does not constitute

a personal recommendation

or take into account the particular inve

stment objectives, financial situations

, or needs of individual investors.

Investors should consider whether any ad

vice or recommendation in this resear

ch is suitable for their particular

circumstances and, where appropriate, seek professional

advice, including tax advice.

Investment decisions should

not be based solely on simulated, hypothet

ical or illustrative information. Past

performance is not a guide to future

performance, future returns are not guaranteed, and a lo

ss of original capital may occur. Certain transactions,

including those involving futures, options,

and other derivatives, give

rise to substantial risk and are not suitable for

all investors. Fluctuations in exchange rates could have

adverse effects on the value or price of, or income derived

from, certain investments. No part of this material may

be copied, photocopied or duplicated in any form by any

means or redistributed without the prior wr

itten consent of Convoy Investments LLC.

Historical market information shown here

in is included to illustrate Convoy’s

investment theses and/or to support

an argument, hypothesis or statement made in the mont

hly commentary and not as a standard of comparison.

Market index information was compiled from sources that

Convoy believes to be reli

able; however, Convoy does

not make any representations or guaran

tees hereby with respect to the accu

racy or completeness of such data.

Return and risk expectations shown here are based on C

onvoy analysis and reasonable people may disagree with

the assumptions used and expectations developed there from

and there is no guarantee the expectations shown can

be achieved. The expectations are considered hypothetical and are subject to inherent limitations.

Howard Wang, Convoy Investments, LLC

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