Ahyfx q12011 Letter

8/7/2019 Ahyfx q12011 Letter

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Dear Aegis Investors:

The Aegis High Yield Fund delivered another quarter of solid performance during the first three months of 2011 ashigh yield bonds continued to strengthen. The Aegis High Yield Fund increased 4.84 percent, nicely exceeding the3.88 percent return of our primary benchmark, the Barclays Capital High Yield Index. The Fund also outperformedthe Credit Suisse High Yield Index, which returned 3.77 percent. Fund performance continued to be bolstered bystrong returns in coal, oil & gas exploration and production, and refining issues. Past performance data for theAegis High Yield Fund and its primary Barclays benchmark is presented in Table 1 below:

Performance data quoted represents past performance and does not guarantee future results. Current perfor-mance may be lower or higher than the performance data quoted. The investment return and principal valuewill fluctuate so that upon redemption, an investors shares may be worth more or less than their original cost.For performance data current to the most recent month end, please call us at 800-528-3780 or visit

www.aegisfunds.com. The fund has an annualized expense ratio of 1.20%.

The high yield market maintained its upward trend during the quarter as the economy continued on its now famil-iar path of economic recovery. High yield securities are strongly benefitting from increased appetite for marketrisk, as investors react to the unprecedented injections of liquidity by the United States Federal Reserve. Cur-rently, the Federal Reserve is in the process of completing a renewed $600 billion program of debt monetizationthrough money printing, known as QE2, which has now resulted in a near tripling of the monetary base since early2009. The enormous surge in liquidity from this questionable economic policy has forced short-term interest ratesto extraordinarily low levels, driving all manners of investors into risk assets to avoid the painful, slow erosion ofpurchasing power when holding cash or treasury bills with yields under the rate of inflation. In this low-rate envi-ronment, high yield bonds have certainly proven to be a popular asset class with investors. The first quarter of2011 was no exception, with Credit Suisse estimating high yield fund flows of $5.4 billion.

Increased high yield investor inflows have resulted in continued strength in the pace of new high yield issuance,with Credit Suisse estimating that 182 issuers raised $79.4 billion during the quarter. Default rates have remainedextraordinarily low, with only 6 domestic issuers defaulting on a paltry $3.5 billion of debt in the quarter. Overthe last 12 months, 23 issuers have now defaulted on an aggregate $18.3 billion of debt, according to CreditSuisse. With current recovery rates on defaulted securities estimated at nearly 60 percent, the performance dragon the $1.1 trillion high yield market from defaults over the last year is estimated to be about 0.8 percent.

The Aegis High Yield Fund experienced a technical default shortly after quarter-end on our investment in Pfleider-er (variable rate perpetual bonds) after the companys secured creditors decided that a financial restructuring ofthe company was necessary. As was mentioned in last quarters letter, industry overcapacity and raw materialprice increases were straining building product margins at the company. While the full details of the restructuringhave yet to be disclosed, it is likely that the our holdings of Pfleiderer bonds will be converted into a minorityequity position in the company. While returns on our Pfleiderer bonds adversely impacted quarterly returns byapproximately 0.2 percent over the quarter, there is a good probability we will achieve material recovery of valueas the company works through its debt restructuring process and industry dynamics begin to improve. As of today,our holdings of Pfleiderer debt represent 0.25 percent of the Funds portfolio.

High Yield Fund

Portfolio Managers Letter

Quarter Ended March 31, 2011

April 15, 2011

Table 1: Performance of the Aegis High Yield Fund

Aegis High Yield Fund

Barclays Capital High Yield Index

4.84%

3.88%

Three

Month

Annualized

4.84%

3.88%

Year-

to-Date

13.90%

14.31%

One

Year

15.06%

12.94%

Three

Year

10.50%

9.12%

Five

Year

NA

8.63%

Ten

Year

9.09%

8.59%

Since

Inception
http://www.aegisfunds.com/http://www.aegisfunds.com/


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Nearly $1.4 trillion of todays massive $2.4 trillion monetary base now consists of excess reserves held at the Fedby shell-shocked financial institutions. Many of these banks are now conservatively positioning their assets afterbeing subjected in recent years to often arbitrary and highly subjective regulatory evaluation. However, as regu-latory and economic sentiment improves, banks may eventually choose once again to lend out these high-poweredexcess reserves, resulting in an inflationary money supply surge as these funds are loaned out time and againthrough our fractional banking system.

Excessive Federal Government deficit spending is being facilitated by the Federal Reserves multiple programs ofmoney printing, allowing politicians to avoid addressing the bloated federal budget. While the Federal Govern-ment continues on track to spend more than $1.5 trillion more than it receives this year, politicians recently de-clared a shutdown-averting victory with a $38 billion compromise cut in the $3.8 trillion federal budget. Whilethe Washington Post hailed the Biggest Cuts in U.S. History, anyone with basic math proficiency can understandthe intellectual incoherence of touting a one percent cut in a federal budget in this fashion, particularly giventhat the federal budget has increased by an incredible 40 percent since 2007. The current level of governmentspending is clearly unsustainable.

The unprecedented Fed liquidity injections may already be fanning inflationary flames. Since the beginning of2010, oil prices are up nearly 30 percent, and gasoline prices are now exceeding $4 per gallon in some states. TheGoldman Sachs Agricultural Index is up more than 45 percent with corn prices rising more than 60 percent.

Wholesale US food prices jumped in February by the largest amount since 1974. Cotton prices in recent monthsreached the highest price since the New York Cotton Exchange opened in 1870. Alarmingly, commodity price in-flation is now working its way through to consumer prices. Wal-Mart CEO Bill Simon recently told USA Today thatcost increases were starting to come through at a pretty rapid rate, and that inflation was going to be seri-ous.

Ironically, Bernanke and other senior Federal Reserve staff appear as of yet unmoved by the potential inflationarythreat, with Atlanta Fed President Dennis Lockhart even suggesting, incredibly, that another round of moneyprinting may be necessary should oil prices continued to climb. With the Fed seemingly on a continuing path ofcurrency debasement, it is difficult to see inflationary pressures subsiding anytime soon. Government inflationstatistics themselves are also suspect, having been subject over the years to changes in calculation methodology,which now include modifications such as hedonic adjustments and substitution effects, all of which appear tomoderate the reported rate of inflation. Reported inflation would have hit an annual rate of 9.6 percent in Feb-ruary, had the reporting methodologies remained consistent with those in place prior to 1980, according to theShadow Government Statistics newsletter.

Given our unease with inflation, and our concern over the impact of inflation on interest rates, we continue tokeep the adjusted duration of Aegis High Yield Fund bonds at a short 2.7 years, well beneath the approximately4.6 year adjusted duration of the Barclays HY Very Liquid Index. By keeping our duration short, we hope to avoidthe carnage that is likely to occur as rates move higher to incorporate increased inflationary expectations. We arealso taking other measures to combat rising inflation and interest rates. At quarter-end, we held nearly 7 percentof the portfolio in two variable rate bonds and a REIT that holds primarily variable rate hotel loans, 11 percent inforeign corporate bonds denominated in the currencies of foreign commodity exporting countries, and 6 percent inconvertible securities that should directly benefit from a higher inflation and interest rate environment.

In recent months, inflationary fears have begun to push long rates higher, which is remarkable because it is occur-ring despite Federal Reserve purchasing pressure, which acts to drive prices up and yields lower. Yields on 10-year treasuries increased from 3.30 percent to 3.47 percent during the quarter, and are up nearly 100 basis pointsover the last 6 months. As can be seen in Figure 1, high yield credit spreads over treasuries continued to compress

during the quarter, with the Barclays Capital High Yield Very Liquid Index interest rate premium over treasuriesdeclining another 57 basis points, to a spread of only 4.01 percent, significantly beneath the 16-year averagespread of 5.42 percent.

When credit spreads are low and the yield curve steep with short term rates near zero, fixed income funds haveincreased incentive to borrow money at ultra-low short rates to finance longer-duration bond purchases toenhance yield. In this context, it is somewhat disconcerting to note that reported margin debt has now in-creased to $310 billion in February, up a significant 7.2 percent from January and well up from its $200 billionpost-crash low in early 2009. Borrowing in this manner to boost yield is risky behavior that can end badly, as 2008can attest. Rest assured that we do not borrow money to enhance yield, as we want to be in a position of fullcontrol over our investments should the markets experience volatility.


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The largest Fund purchase during the quarter was Reddy Ice First Lien Senior Secured Bonds (11.25% due March2015), which we bought to yield approximately 9.8 percent to maturity. Reddy Ice is the largest domestic distrib-utor of ice, with a strong market presence in the Southeast. The company experienced a downturn in its ice busi-ness as the economy declined in 2008. Particularly damaging for ice demand was a dramatic drop-off of home-building and outdoor construction in core Reddy Ice markets. Investor sentiment was further depressed as thegovernment initiated an anti-trust investigation into the ice distribution industry, which was recently concludedwithout further action against Reddy Ice. Currently the highly levered company is finally beginning to see stabili-zation in end-use ice demand, but is still challenged by its high cost of capital and increased market competition.Given our debts senior position, the stabilization of company EBITDA and additional corporate cost-cutting ef-forts, we believe the value of our bonds is well protected. Currently, the first lien debt has a manageable netdebt to projected 2011 EBITDA multiple of 4.25 times. It is possible that private equity players with access tolower cost capital may have an interest in large, ice industry players, which could ultimately lead to a company

recap.

The Funds largest sale during the quarter was the liquidation of our position in Horizon Lines Unsecured Con-vertible Notes (4.25% due August 2012). Horizon Lines is a Jones Act shipping company with intra-US routes toAlaska, Hawaii and Puerto Rico, as well as a transpacific business to Guam and China. Over the last several years,Horizon had been plagued by an industry-wide anti-trust investigation. Investors were also concerned about thelooming capital replacement requirements, as many of their vessels were quite old. Nevertheless, at the time ofour purchase in July 2009, these Horizon bonds were trading at less than 70 cents on the dollar with an 18 percentyield to maturity. We felt the company risks were more than adequately reflected in the bond valuations, and thecompany had the potential to gain operating leverage and substantially increase cash flows as the economy recov-ered.

As Horizon bonds appreciated to in excess of 90 cents on the dollar, ironically, company fundamentals appeared tobe deteriorating. Horizon lost a very profitable contract with Maersk for transpacific shipping in 2010, the margin

dollar replacement for which was a potential issue. We also learned that stifling union contract agreements wereeroding profits and hindering operational flexibility, rendering certain of Horizons trade routes unprofitable. Wecompletely exited the position at approximately 92-93 after learning that certain customers, alleging damagesfrom Horizons bad anti-trust behavior, were backing out of a proposed $60 million civil anti-trust settlement withHorizon, presumably in order to seek higher damages. Fortunately, our decision to sell was on point, as the bondssubsequently dropped to 75 cents on the dollar on news of possible default after the company plead guilty to price-fixing charges and 3 of its former executives received jail time. While it is possible that the final outcome forbondholders may eventually be positive, particularly from current price levels, at the moment we are more com-fortable following developments from the sidelines.

Overall, the Fund continues to focus on smaller issues with capital structure seniority. Given the inflationary pres-sures, and the extraordinarily low yields available in the market today, we are keeping our maturities short. Wealso are continuing our focus on bonds of companies with substantial tangible assets that can provide additional

Figure 1: High Yield Credit Spreads

Average: 5.42%

0%

4%

8%

12%

16%

20%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

SpreadOver10-yrTreasuries

Average: 5.42%

4.01%


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security for our debt. At quarter-end, 71 percent of the Funds bonds were either senior secured issues or unse-cured issues without any outstanding secured debt (net of cash), compared with an estimated 29 percent of suchissues in the Barclays Capital High Yield ETF (which tracks the index). This metric is reflective of the substantialeffort we place on minimizing credit risk in our portfolio.

We are working hard to navigate carefully through this increasingly dangerous yield environment while seeking outgood smaller credits for our portfolio. The Fund remains at a size where we believe we have the flexibility tocontinue to deliver good results by focusing on special situations within an increasingly challenging overall envi-ronment. Employees and our families own in excess of 5 percent of the Funds outstanding shares, and we intendto keep monitoring portfolio risks carefully. As always, our shareholder representatives are available via 1-800-528-3780 for routine questions. Should you have any questions at all regarding our Funds investment perfor-mance or market approach, you are always welcome to call me personally at (571) 250-0051.

Sincerely,

Scott L. BarbeePortfolio ManagerAegis High Yield Fund


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Any recommendation made in this report may not be suitable for all investors. This presentation does not consti-tute a solicitation or offer to purchase or sell any securities. Its use in connection with any offering of fundshares is authorized only in the case of a concurrent or prior delivery of a prospectus.

The Aegis High Yield Fund is offered by prospectus only. Investors should consider the investment objectives,risks, charges and expenses of the fund. The prospectuses contain this and other information about the fund andshould be read carefully before investing. To obtain a copy of the funds prospectus please call 1- 800-528-3780

or visit our website www.aegisfunds.com, where an on-line prospectus is available.

Risks associated with investing in the Aegis High Yield Fund include: credit risk, interest rate risk, liquidity risk,high yield security risk, market risk, foreign investment risk, prepayment risk, defaulted or bankrupt securityrisk, convertible securities risk, equity investment risk, manager risk, political and international crisis risk.

Performance data quoted represents past performance and does not guarantee future results. Current perfor-mance may be lower or higher than the performance data quoted. The investment return and principal valuewill fluctuate so that upon redemption, an investors shares may be worth more or less than their original cost.For performance data current to the most recent month end, please call us at 800-528-3780 or visitwww.aegisfunds.com. The fund has an annualized expense ratio of 1.20%.

The Aegis High Yield Fund imposes a 2% redemption fee on shares held for less than 180 days. Performance datadoes not reflect the redemption fee, which would have reduced the total return.

The article refers to three bonds held by the Fund, Pfleiderer Finance variable rate perpetual bonds due Febru-ary 2049, Reddy Ice Corp. 11.25% due March 2015 and Horizon Lines Inc. 4.25% unsecured convertible notes dueAugust 2012. As of March 31, 2011, the bonds represent 0.4%, 3.5%, and 0.0% of total Fund assets respectively.

Date of first use: April 19, 2011 Fund Distributor: Rafferty Capital Markets, LLC
http://www.aegisfunds.com/http://www.aegisfunds.com/http://www.aegisfunds.com/http://www.aegisfunds.com/

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Ahyfx q12011 Letter