Anticipation of impending central bank policy actions buoyed financial markets in August. The VIX index, which is the broadest measure of market volatility, dropped to its lowest level in five years.

With this collapse in market volatility, risk premiums contracted and risky assets performed very well.

In addition, a string of positive US macroeconomic data pointed to an improving US housing market and employment picture thus dispelling any notion of an economic slowdown in the current quarter.

Investors continue to outdo themselves in their love for fixed income. Investors poured $30 billion into taxable-bond funds (including ETFs) and another $5.6 billion into municipal-bond funds in August, according to Morningstar. Bond funds (taxable and non-taxable) have now collected, an amazing, over $1 trillion in assets since the end of 2008 when the Fed cut rates to zero, Morningstar also reported.

The financial markets remain very myopic and solely focused on the near-term liquidity injection by global central banks. We believe the liquidity-driven rally may not have legs beyond a few weeks and weak global macroeconomic fundamentals will begin to assert themselves.

The upcoming US political uncertainty and "fiscal cliff" could also derail the current risk rally. At current valuation (many asset classes at their best levels in five years), risk/reward profile of  investment-grade bonds is now more balanced and perhaps skewed somewhat to the downside.

We are reluctant to add more risk to the model at the current time and instead focusing our attention on asset allocation shifts. First, with the Fed clearly pursuing a “reflationary” monetary policy, longer-dated Treasury securities are very vulnerable. As a result, we have established a small "short" in Treasuries via “TBT.

Second, inflation-related investments like Treasury Inflation Protected Securities (TIPS), commodities and floating-rate bonds are likely to do well over the near-term. Our model is already positioned to take advantage of this trend with exposure to TIPS and other similar investments.

We also expect mortgage-backed securities to continue to perform well on new Fed buying. We have exposure to this asset class through the iShares Barclays MBS Bond Fund, but will add more on any weakness. Within emerging markets, debt looks less attractive than equity, especially if some of the new liquidity pumped by the Fed finds it way overseas and leads to inflation in emerging market, thus preventing countries like China and Brazil to halt policy easing.

Also, some investments discussed in this presentation are for illustrative purposes only and there is no assurance that the adviser will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any composite or client account. Further, the reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Certain investments discussed are held in client accounts as of September 21, 2012. These investments may or may not be currently held in client accounts.The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Covestor model: Diversified Target Yield Bond ETFs

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