August 25th, 2010 Letter to Shareholders

August 25, 2010

Dear Shareholder:

In the March 31^st shareholder letter I briefly outlined the Federal Reserve Bank’s exit strategy and concluded that we would have to wait and see how and when it was rolled out. The wait-and-see game continues. At its meeting on August 10^th, nearly a full year into the economic recovery, the Fed downgraded its forecast of near-term economic growth and reiterated its commitment to “exceptionally low levels of the federal funds rate for an extended period”. In a slight change of policy, the Fed also decided to roll over maturing bonds carried on its balance sheet into longer-term Treasury securities.

In taking these steps, the Fed cited a slowed pace of recovery in output and employment, constrained household spending, lower housing wealth and tight credit conditions. Recent economic data and revisions to previously released data demonstrate that the recession was more severe than anyone thought. The Commerce Department’s latest GDP figures show economic growth slowing to a 2.4 % annual pace in the second quarter, down from a rate of 3.7 % in the first quarter. The data revisions are even more revealing as they confirm that the recession has been the worst in the post-war period. Economic activity now appears to have declined by 4.1 % from peak to trough, compared with a 3.7 % decline in 1957-58 and roughly a 3.0 % decline in 1981-82.

In the meantime, the deceleration in growth has raised the question of whether economic growth is at or approaching “stall speed” to borrow a term from aviation. The possibility of a dreaded double dip recession is even being mentioned in the public press these days and talk has shifted away from worries about inflation to new worries about potential deflation. We’ve previously addressed the inflation issue, so I’ll shift gears and, at the risk of oversimplifying, tell you a little about deflation and how that might affect our bond portfolios should it come to pass.

Deflation is a general decline in the prices of goods and services. At first blush, you might think falling prices is a good thing--it’s not always. Here’s the rub. The problem is that as the buying power of a dollar increases, consumers typically defer purchases because they get the notion in their heads that goods can be bought cheaper at a later date as prices continue to fall. This “psyche” almost always results in a collapse in aggregate demand which leads to a decline in output and to higher unemployment levels. A loss of jobs leads to a further decline in consumption and the cycle repeats itself. Once deflation takes hold it is not easy to deal with. Just ask the Japanese who have been mired in a deflationary cycle for close to two decades now.

It is highly unlikely that the U.S. economy will experience this Japanese-style deflation. However, ongoing deleveraging by individuals and businesses, a soft housing market, and weak consumer demand and bank lending suggest that economic growth will continue to be below trend for some time. This raises the risk that we will experience some mild deflation. The good news is that in a slow-growth mild-deflation environment, intermediate and longer-dated high quality bonds typically perform well because, as prices fall, a steady, high quality fixed income stream becomes more valuable. Treasuries, government bonds, and municipal bonds all typically perform well in a deflationary environment.

The municipal bond market has seen yields drop to new lows (prices up) recently as retail and institutional investors have continued to snap up tax-exempt bonds at a furious pace. The Municipal Market Data triple-A scale for a 10-year bond set a new low on August 18^th at 2.32% and the yield on a 20-year bond was 3.44%. The tepid economic recovery, a very tight supply of tax-exempt bonds, and expectations that the Bush tax cuts will expire have all resulted in a very firm municipal bond market.

States and municipalities are still struggling with balancing their budgets and will continue to do so for the next couple of years. Federal assistance has helped states balance their budgets. Congress recently approved a $26.1 billion funding bill for states which includes $16 billion in Medicaid funds to help states cover their Medicaid payments for the first six months of 2011, as well as $10 billion in education funding. Despite ongoing fiscal strains, there are some early signs that state tax revenues are beginning to recover. Kentucky’s General Fund receipts for July (the first month of Fiscal Year 2011) increased by 4.6% compared to July 2009 receipts.

States are also dealing with unfunded pension obligations. Historically, pension funding ratios have fluctuated over time with funding levels ranging from as low as 50% in the 1970s, 80% in the 1980s, and as high as 100% in the mid-1990s. Experts have generally set an 80% pension funding ratio as the benchmark to meet. According to a report recently issued by the Pew Center on the States, the average state pension funding was at 84% in 2008 which is above the benchmark. That’s not to suggest that the unfunded pension liability issue is not a problem. However, it’s important to remember that this issue has been around for a long time, and it has never posed an immediate threat to the solvency of state and local governments.

A copy of our Annual Report is enclosed with this letter. I encourage each of you to read it, as it contains important information about our funds.

Sincerely,

Allen E. Grimes, III

Executive Vice President

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