Convertible Specific Comments

The Merrill Lynch Convertible Index rose for the three-month period. Similar to the second quarter, the improvement in the prices of corporate bonds continued to be the primary driver of convertible returns, given the low delta and high average premium of the market.

Speculative grade issuers led performance again in the quarter and smaller- capitalized companies continued their outperformance. As discussed in the last commentary, even though equity markets are higher, credit has been the primary driver of convertible returns. As the capital markets opened up and access to capital improved, credit spreads tightened dramatically, driving all corporate bond prices higher.

All industries contributed to the index return, with many adding double-digit percentage gains. Leading industries included Airlines, Materials and Energy. Again, the broad market attribution was notable. Nearly all of the bond-like or busted convertibles rose in price, regardless of the companies’ operating fundamentals. Many of those issues rarely trade; thereby, even if an issue was identified as a good candidate for purchase, the liquidity was not there to build a position.

While few in number, weaker-performing industries included Utilities, Healthcare and Consumer Staples.

New issuance was below expectations in the quarter, with new issuers raising just $8.3 billion. Many companies accessed the corporate debt markets instead of the convertible markets in order to avoid shareholder dilution at depressed stock prices.

High Yield Specific Comments

The high yield market seems to be back. The combination of performance, new issuance and demand has returned the market to full functionality. The Merrill Lynch Master II Index returned double digits for the three-month period. By way of comparison, the high yield market outperformed the ten-year Treasury return.

The highest risk issuers led performance again this quarter. Additionally, the most striking new element to market conditions was the surge in lower quality new issuance. The trend now is to refinance old subordinated notes of generally lower quality issuers with senior secured first lien notes. These notes are pari passu (of equal seniority) with the banks if any bank debt exists. This type of transaction immediately reduces the credit risk of the issuer. By eliminating near-term maturities, the issuer benefits and the buyer has a better claim on assets by moving to a senior part of the capital structure. Credit risk in the market has been reduced across the board, due to high yield issuers having access to capital.

Leading industries included Publishing, Insurance and Broadcasting. The notable link connecting these industries is the generally poor operating performance among many of the issuers. Again, the broad market attribution was notable. Much like last quarter, the contribution to return was tangible across several hundred issues. As with the convertible market, many of those high yield issues rarely trade; therefore, even if an issue was identified as a good candidate for purchase, there was no liquidity to build a position.

New issuance was robust in the quarter. One hundred twenty-one deals priced, raising $52 billion in proceeds for issuers. Year-to-date, 265 issues have been priced, raising more than $120 billion. Looking at the 2009 use of proceeds, 78.6% has been for refinancing.

The ratio of upgrades to downgrades increased to 1.1:1, with 72 upgrades and 71 downgrades. The default rate continues to decline, ending the quarter at approximately 8.8% on a par-weighted basis. Distressed debt, as measured by price (below 50% of par), has dropped to 2.2% of total high yield debt outstanding and only 8.2% now trades below 70% of par.

Domestic Equity & Option-Specific Comments

Continuing a theme set in the second quarter, the broad equity markets were up double digits in the third quarter. The S&P 500, the Russell 1000 Growth , and NASDAQ were all up over the same period.

The equity rally was broad based and most industries yielded positive returns. Technology, Consumer Discretionary and Staples were the standout industries that drove the Russell 1000 Growth index higher. Smaller- capitalized companies outperformed the larger-capitalized companies as investors shifted to riskier assets.

The Chicago Board Options Exchange Volatility Index® (VIX®) continued its downward trend through the quarter as the equity markets marched higher and investor confidence grew. The index averaged mid twenties volatility over the time period compared to previous quarters’ mid-thirties volatility.

Convertible Specific Comments

Positions in the Financials, Energy and Technology industries helped performance in the quarter. Financial companies benefited from completing capital raises and net charge- offs coming in lower than expected. Energy companies were positive in the quarter, as earnings and margins came in ahead of expectations. Technology issuers in the semiconductor space moved higher as second quarter earnings exceeded expectations and earnings guidance was positive.

Our positions in the Defense and Telecommunication industries hurt performance. A defense company was down on the potential uncertainty of defense spending cuts. A wireless telecommunications service company reported disappointing net additions for the quarter and was sold.

The conversion premium at quarter end was 35% versus 72% for the convertible market. As the equity markets improved, the portfolio’s conversion premium returned to a more balanced, asymmetric risk return level.

High Yield Specific Comments

The lowest priced issues were again the greatest contributors to benchmark performance. Even though the portfolio participated in the majority of the rally, the portfolio’s relative underweight in the lowest priced/distressed issuers dragged on performance.

Several industries in the portfolio generated positive performance in the quarter. Three of the best were Technology, Paper and Energy.

There were only two negative performers of note. A truck part manufacturer did not benefit from the broad rally in the industry as order trends lagged the auto rebound. Also, a company that provides capital for small businesses was not successful in addressing near-term amortization of its debt. The position was sold.

Domestic Equity & Option-Specific Comments

Most industries in the portfolio helped, but the positions in Technology, Healthcare and Energy were the best performers. Technology companies that exhibited stabilization and an acceleration in end market demand performed well. In addition, healthcare drug distributors and pharmacy benefit management services reported much higher revenues than expected. Energy companies rose on higher commodity prices and exploration & production was more robust than originally forecast.

Telecommunications was a detractor during the quarter as investors rotated to higher beta companies.

Despite the declining market volatilities, attractive call option premiums were available, and the portfolio was able to capture premiums during the quarter on an index and a single-stock basis. Due to dramatic upward moves of the underlying index, some index option premiums were not realized at July’s expiry. This was only true for a single month, and the fund was able to recognize all the index option premiums for the balance of the quarter.

The outlook for the equity and credit markets remains positive. The markets were oversold, and the rally that ensued was abrupt, but not unfounded. Third quarter corporate earnings will likely be down from last year, but should continue to show signs of improvement from the second quarter. In addition, economic statistics, both globally and domestically, have improved.

While sentiment and economic data have improved, more evidence needs to be seen for a sustainable equity and convertible market recovery. Year to date, improving credit conditions have played the most significant role in the recovery of the convertible market. While credit will likely continue to play an important role in returns, the equity component of the convertible bond may become a bigger driver of returns going forward.

The high yield asset class continues to offer a compelling total return opportunity. Spreads, which have narrowed to 800 basis points, are now inside of prior market-cycle highs. The default rate has either peaked, or is very close to peaking. We have argued that the default rate is unlikely to surpass past-cycle highs for several reasons. The industry concentration in the last down cycle was far greater, with 42% in Telecom, Media and Technology. Few industries have benchmark weights greater than 10% today; therefore, no one industry or group should have a broad market impact. In addition, among many issuers there is more tangible asset value than seen in the business-plan-heavy market weight in the past cycle. Refinancing over the past several years has created lower interest expense obligations and extended maturities.

Our disciplined approach of focusing on companies that are exceeding expectations and improving their credit statistics should be rewarded as those companies differentiate themselves from their peer group. In this environment, we believe companies that have reasonable earnings visibility should command premium valuations relative to other companies.