Third Quarter 2009
Forward Long/Short Credit Analysis Fund
Managed by Cedar Ridge Partners, LLC
Performance as of September 30, 2009 3Q09 YTD 1 Year Inception* Expenses
Forward Long/Short Credit Analysis Fund—Institutional Class 21.10% 48.53% 33.56% 16.56% 6.08%/5.17%
Barclays Capital U.S. Municipal Bond Index 7.12% 14.00% 14.85% 7.36%
Barclays Capital U.S. Corporate High-Yield Bond Index 14.22% 48.98% 22.34% 6.10%
Returns for periods greater than one year are annualized.
The Fund’s investment advisor has contractually agreed to waive a portion of its fees and reimburse other expenses until April 30, 2010, in
amounts necessary to limit the Fund’s operating expenses (exclusive of brokerage costs, interest, taxes, dividends and extraordinary expenses) for
Institutional Class shares to an annual rate (as a percentage of the Fund’s average daily net assets) of 1.60%.
The performance quoted represents past performance and does not guarantee future results. Current performance may
be lower or higher than the performance quoted. The investment return and principal value of an investment will fluctuate
so that shares, when redeemed, may be worth more or less than their original cost. Performance current to the most
recent month-end may be obtained at www.forwardfunds.com or by calling (800) 999-6809. Investment performance
reflects fee waivers in effect. In the absence of fee waivers, total return would be lower. Total return is based on NAV,
assuming the reinvestment of all distributions. Performance does not reflect the deduction of taxes that a shareholder
would pay on fund distributions or the redemption of fund shares.
At September 30, the year’s inflows into municipal bond funds hit a record $65.5 billion; the previous full-year record was $42.9
billion in 1993. Municipal issuers sold $25.24 billion of bonds in September, up from about $20.19 billion in September 2008.
However, about $7.18 billion (or 28.5%) of the month’s new issuance was in the form of taxable municipal bonds. Municipal
bond performance remains greatly influenced by classic “supply/ demand” metrics, and as a result, Municipal Market Data
(MMD) reported that the yield on 10-year “AAA” rated municipal bonds plunged almost 40 basis points in September.
Regarding the year’s projected supply of new issues, some observers now project annual issuance of about $373 billion, with
about $55 billion in the form of taxable “Build America Bonds” (“BABS”), a new fixed income asset class. If these numbers hold
up, projected issuance of tax-exempt municipal bonds will fall almost 19% versus $391 billion in 2008 (and fall about 35% over
2007’s record issuance of $430 billion). It is possible that BABS could conceivably represent a seminal event for the municipal
market as significant issuance of BABS by municipal issuers could lead to tens of billions in reduced new issue supply of
traditional tax-exempt municipal bonds. When one also considers the coming reduction of outstanding tax-exempt issues resulting
from the pay-down of “pre-refunded” municipal bonds that is scheduled to occur over the next several years, we believe
municipal market technical factors will continue be quite favorable on the supply side and set the tone for generating total returns
from the asset class.
The economics behind the issuance of BABS remains compelling for both issuers and investors. Enacted through the American
Recovery and Reinvestment Act in February 2009, the program provides municipal issuers with a 35% subsidy from the Federal
Government on interest costs if issuers forego the issuance of tax-exempt debt. For example, the State of California returned to
the capital markets during the week of October 5, selling tax-exempt, taxable and BABS bonds. The State sold $1.75 billion of
BABS due in 2039 @ 7.232% (30Y Treasury + 325 basis points). Allowing for the 35% federal interest rate subsidy, the State
incurred an interest cost of 4.70%, while the State’s long dated tax-exempt debt exceeded 5%. Investors that have historically
never bought municipal bonds because they did not need tax-exempt income are attracted to investing in BABS as they are able to
buy high-quality fixed income securities that trade at a higher yield than other taxable market alternatives. As an example of
“relative value” investing, California’s BABS were sold at 30Y Treasury plus 325 basis points in a market where the Republic of
Colombia sold debt at 30Y Treasury plus 200 basis points. We should note that Colombia is rated Ba1/ BBB-/BB+ while
California, the world’s eighth largest economy, is rated Baa1/A/BBB. We continue to actively trade in the BABS market as a
relative value opportunity.
The question we are asked most often typically concerns “missing” the recent rally in municipal bonds and our views on the
market going forward. Readers should note that we remain convinced that market valuations will continue to be restored over
time in our focus sectors and we firmly intend to take full advantage of these market opportunities on behalf of ourselves and our
investing clients. That said, we still think that municipal bonds are by far the cheapest of our asset classes, notwithstanding the
recovery in valuations that has already occurred. This view is centered on the premise that a number of technical measures
conspire to raise the overall demand for owning municipal bonds, including 1) historically high Municipal/U.S. Treasury ratios;
2) increasing marginal tax rates at both the federal and state levels; 3) increasing demand for municipals, referenced by increasing
amounts of investor dollars flowing to the sector; and 4) continuing reduction in near-term net new issuance of long-term bonds.
Since municipal bonds enjoy tax-exempt status, historically the Municipal/ U.S. Treasury ratio in 30 years has averaged about
87%. At the close on October 21, the 30-year Municipals/ U.S. Treasury ratio had fallen to about 97% (from a high in December
2008 of 217%). While part of the story behind these historically wide ratios may be explained by investors bidding up the price
for long-term Treasuries, we expect municipals to out-perform Treasuries going forward. We do not use ratios as a signal to buy
or sell; we simply use them as a data point and as one consideration in our assessment of value. In the current market, we suggest
absolute rate levels must not be lost within some greater “ratio analysis” or “investing model.” The truth remains that municipal
bonds at 5% remain a compelling investment alternative, particularly when one considers the absolute level of other investment
alternatives and the impact of taxes. Federal funds remain at 0-0.25%; money market returns approach 0.25%; 10Y U.S. Treasury
rates are at 3.42%; and the return on a 5% municipal bond equates to a 10% pretax return at a 50% tax rate. Recently, market
commentary has noted that “municipals have lost their attraction, as rates fell too far to justify investing.” While we acknowledge
that 10-year MMD index data recently hit decades lows, we note that this level has already quickly corrected itself as a sell-off in
short duration municipals has taken place since October 5. The 10-year index corrected by about 60 basis points over a week. We
also note that long-dated municipal bonds did not suffer to the same extent, as the 30Y MMD index was off about 27 basis points
during the same period. Notwithstanding this move, the municipal yield curve remains quite steep, as the 2-30 year spread is
about 371 basis points; the steepness of the same duration U.S. Treasury curve is at 324 basis points. After the noted recovery in
valuations, a retracing was bound to occur; we view the market as consolidating at current levels and expect to use this as an
incremental buying opportunity.
We note that Barron’s cover story for the week of October 26 calls for the Federal Reserve to commence a tightening cycle by
raising the federal funds rate to 2% from the current range of 0-0.25%. By our reading, the tightening argument is centered on a
perceived “all clear” emanating from the credit and equity markets, higher year-to-date commodity prices for crude oil and gold,
and a continuing slide in the value of the dollar versus other world currencies. In addition, market observers continue to warn of
impending inflationary pressures caused by the more than doubling of the Federal Reserve’s balance sheet to over $2.01 trillion as
a result of its programs to unfreeze the credit markets and support the financial system, and presuming that the Fed will be unable
and/or unwilling (due to political constraints) to remove its significant monetary easing on a timely basis once economic recovery
Our view is that the credit and equity markets performance since the dark days of March 2009 are a direct result of unprecedented
Federal Government intervention in the economy and support to the capital markets through qualitative easing. While we support
a strong dollar policy, we note that the value of the currency is not much different than the value a year ago. The Dollar Spot
Index closed at 75.112 on October 21, about unchanged from early August 2008. We suggest most of the notable strength in the
dollar late last year and earlier this year, represented a “flight to quality” into the U.S. dollar as the world economy was on the
verge of falling into a “depression.” Interestingly, and somewhat ironically, in the heat of the crisis it was the dollar and U.S.
Treasuries that everyone wanted to own. While coordinated Government and Central Bank policies prevented the crisis from
spiraling into an economic depression, we see scant evidence that a recovery in consumer confidence, job creation and housing
valuations is underway. Consumer spending and housing are too important to the U.S. and global economies to assume any
sustainable recovery can happen until they improve, and current data simply do not support meaningful signs of improvement.
Until a discernable positive trend is observed in these metrics, we expect to retain a fair amount of caution about the markets and
the economy in general.
Specifically regarding housing, while we acknowledge that home sales are up, such numbers are likely directly related to the
increase in foreclosure sales and subsidized by the $8,000 first-time-buyer tax break. In addition, home lending by private lenders
is almost non-existent; the home mortgage market is basically controlled by Fannie-Mae, Freddie-Mac and FHA, and supported
by outright purchases by the Federal Reserve. Without these programs, housing activity would likely be much worse. Until we see
an end of the subsidies and a return of private lending in the housing market we don’t think one could argue that the housing
market has stabilized. Unfortunately, many current policy trends in Washington are making the housing market more dependent
on public financing support, and thus continue to crowd out the return of private lenders. Moreover, we think that an early
tightening of policy by the Federal Reserve could have a material adverse impact by raising mortgage rates at a time when
nurturing any form of a housing recovery is warranted.
The unemployment rate is now approaching 10%, as the economy has shed about 7.2 million jobs since December 2007,
including a 263,000 drop in September payrolls. Federal Reserve staff project that the unemployment rate may be moving down
to about 9.25% by the end of 2010. While unemployment is typically a lagging economic indicator and we expect that
unemployment rates will continue to rise even after a “bottoming” in the economy takes place, we believe employment and
consumer confidence are directly linked. While we concur that depression-like conditions in the U.S. economy are no longer
likely, and certain economic indicators show signs of promise, we believe a continued drawn-out period of recession, followed by
tepid growth remains most likely. Finally, we believe the Federal Reserve will have ample time to fight off inflation as the
powerful combination of reduced spending, paying down of debt and diminished asset valuations remain a “deflationary” drag on
Against the backdrop of “continued normal” recessionary concerns, it remains to be seen how the market will perceive and
ultimately react to the plethora of impending “changes” proposed out of Washington. New health-care programs, energy
programs (including “cap and trade”), new financial market regulations and the impact of continued ownership of corporate
America by the U.S. Government all reflect uncharted waters. This legislative agenda remains immense to say the least, and
speculation about its success and ultimate consequences only adds to the overall uncertainty facing the markets and the economy.
While the recovery that has taken place in municipal bond valuations is notable, we expect the recovery in valuations to continue
over some months. We believe valuations in our core investing sectors, particularly high-quality and high-yield municipal bonds,
remain extremely attractive. The interest rate environment remains favorable, and the Federal Reserve appears ready to maintain
the federal funds rate at the current low levels for an extended period to support recovery. While economic recovery will come,
the timing and extent of the recovery remains uncertain. We note that without a recovery in consumer confidence, job creation
and housing valuations, we retain a fair amount of caution about the markets and the economy generally. As a reminder, current
or future portfolio holdings are subject to risk.
—Alan Hart, Portfolio Manager
—Guy Benstead, Co-Portfolio Manager
The Barclays Capital U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate,
taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is
Ba1/BB+/BB+ or below, respectively. The Barclays Capital U.S. Municipal Bond Index covers the USD-denominated long-term,
tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds
and pre-refunded bonds. The index figures do not reflect any deduction for fees, expenses or taxes. It is not possible to invest
directly in an index.
Municipal bonds are a debt security issued by a state, municipality or county to finance its capital expenditures that usually have a
set maturity. Municipal bonds are exempt from federal taxes and from most state and local taxes, especially if you live in the state
in which the bond is issued.
Municipal Market Data (MMD) is a provider of benchmark data—they provide a broad range of technical and fundamental analysis
of the municipal cash, futures, and U.S. Treasury markets updated throughout the day.
Credit ratings are a measure of an entity's ability and willingness to repay debt. The rating system was designed to help investors
determine the risk associated with investing in a specific company, investing instrument or market. For example, the Standard and
Poor’s credit rating of AAA indicates the lowest risk, while a rating of BB indicates high risk.
A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is
commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.
Build America Bonds (BABs), created under the American Recovery and Reinvestment Act, are taxable municipal bonds that carry
special tax credits and federal subsidies for either the bond issuer or the bondholder. The purpose of BABs is to reduce the cost of
borrowing for state and local government issuers and governmental agencies.
The American Recovery and Reinvestment Act of 2009 is an economic stimulus package enacted in February 2009 intended to
provide a stimulus to the U.S. economy in the wake of the economic downturn.
Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.
The Fund will invest in lower-rated debt securities and may utilize derivatives for hedging purposes. The Fund’s use of
short selling involves additional risks and transaction costs, and creates leverage, which can increase the volatility of the
Fund. The Fund may invest a larger percentage of its assets in the securities of a smaller number of issuers, since it is a
“non-diversified” mutual fund.
High-yield bonds involve a greater risk of default and price volatility than U.S. Government and other high quality bonds.
High-yield/high-risk bonds will experience sudden and sharp price swings, which will affect net asset value. The Fund’s
prospectus allows for investment in non-investment grade securities.
Please consider the investment objectives, risks, charges and expenses carefully before investing in the Fund. A
prospectus with this and other information about the Fund may be obtained by calling (888) 312-4100 or by
downloading one from www.forwardfunds.com. Please read it carefully before making a final investment decision.
The opinions and estimates noted herein are accurate as of September 30, 2009, and are subject to change at any time. Past
performance does not guarantee future results.
Forward Funds are distributed by ALPS Distributors, Inc.