Josh Adams – Portfolio Manager – Page 15 – Cincinnati Asset Management

06 Apr 2020

Insight, Investment Grade Quarterly Josh Adams - Portfolio Manager 0 comment

2020 Q1 Investment Grade Commentary

Investment grade credit just endured one of the most volatile quarters in the history of its existence. Most market participants would agree that only the 2007-2008 global financial crisis can compare to what we have experienced the past month. Spreads were humming along for the first two months of the year before they spiked to levels that had only been seen once since the 1988 inception of the Bloomberg Barclays US Corporate Index.

At its nadir on March 20, the index was down -10.58% year-to-date. For investment grade, in our view, this violent sell off was much less about credit than it was about liquidity and fund flows. Investors pulled a record amount of funds from bond markets over a two week period and the unbridled panic selling coupled with the proliferation of the liquidation of exchange traded funds led to a liquidity vacuumi. As a result there was very little in the way of orderly price discovery. It was perhaps, in our estimation, one of the worst times to sell in the history of the investment grade credit market and this was reflected in the prices of bonds that did sell during this time periodii. The tone in the market shifted substantially on Monday, March 23 as it seemed investors came to terms with the fact that yes, the challenges in front of us are enormous, and the economic data could be quite bad for some time, but humanity will persevere and the world will not end. The shift in tone led to a reversal in risk appetite and the Bloomberg Barclays US Corporate Index finished the quarter with a total return -3.63% while the S&P500 finished with a total return of -19.60%. This compares to CAM’s gross total return of -3.09%. We believe that policy actions by the Federal Reserve, and to a lesser extent, the passage of stimulus by lawmakers did much to restore confidence within the credit markets.

While we are not satisfied that the value of our portfolio declined during the quarter we feel that we are well positioned to weather an economic downturn. The portfolio has a significant structural underweight in BAA-rated credit and it is also underweight the energy sector and zero weight the leisure, gaming, lodging and restaurant industries, which have been particularly hard hit by the cessation of economic activity.

Overwhelming Supply and Outsize Compensation

We frequently speak of new issuance in our commentaries because it is the lifeblood of the corporate credit markets and one of the fundamental ways that fixed income investors acquire new investment opportunities. At CAM, during the invest-up process we will typically populate a new account with 20-30% new issuance as long as concessions from borrowers are attractive and we will also use these opportunities to add exposure for fully invested accounts that have cash available for reinvestment. There are companies constantly borrowing in the corporate bond market to fund capital allocation plans such as property, plant and equipment, liquidity or even shareholder returns. The month of March was one of the most interesting time periods for issuance that we have ever seen in our market and it was really a dichotomy of two halves. In first half of the month the primary market battled volatile treasury rates and record outflows from investment grade funds. According to data compiled by Bloomberg, through Friday, March 13, issuance stood at $37 billion. This was modestly lighter than street expectations to that point as volatility in both spreads and rates had kept issuers at bay. This all changed on March 17, as a myriad of high quality companies elected to take advantage of historically low Treasury rates and push through with issuance even despite historically high credit spreads. The new issue concessions offered during the two week period that would follow were the most attractive that the market has seen in over a decade with many concessions approaching 50-100bps relative to secondary offerings. As a colleague put it, the primary market was being dominated by borrowers who don’t need credit. What we saw were dozens of companies with extremely strong balance sheets borrowing to bolster liquidity in the face of economic uncertainty and they were willing to pay up to do so, but even if spreads where high, the borrowing costs that they were paying were still quite low when viewed through a historical lens. By the time the month had ended, March had rocketed to the top of the leaderboard for the busiest month in the history of the primary market with $259.2 billion in new supply. This was 46% higher than the previous record of $177.7 billionⁱⁱⁱ. Below you will find a table of all of the primary deals that CAM purchased for client accounts during the month of March.

As we turn the page to April we are still finding attractive concessions, but they are not what they were two weeks ago. We expect that volatility in credit spreads will come and go as the world battles through the current crisis but it is entirely possible that we may go a decade or more before we see primary market opportunities like the ones we saw the third and fourth week of March. This is why we constantly preach the need to have a long term strategic view for this asset class. A permanent allocation of capital is ideal in order to take advantage of opportunities like these when they do arise.

Fallen Angels and the Growth of BAA-rated Credit

One of the favorite topics of the financial press is back at the forefront, and for good reason, as it is a legitimate concern that could have a significant impact on the credit markets. In our discussions with investors we tend to find that there is fear surrounding fallen angels as it relates to the investment grade credit market but this is really a high yield problem, and it comes down to the size, depth and liquidity of the high yield universe relative to the investment grade universe. The face value of the investment grade universe is $6.7 trillion while the high yield universe is just over $1.2 trillion. The investment grade BAA-rated universe is over $3.4 trillion, almost three times the size of the
entire high yield universe^iv. According to research by J.P. Morgan, they expect a record $215 billion in high grade debt could fall to high yield in 2020, driven predominantly by the energy and automotive sectors^v. This is not a problem for investment grade in general as these bonds are simply leaving the investment grade universe. It could be a problem for the bondholders of those companies who are downgraded and for high yield investors who are beholden to an index and must purchase the downgraded bonds of investment grade companies whether they like them or not.

As far as CAM’s positioning, we limit our exposure to BAA-rated credit at 30%, while the investment grade universe is more than 50%. Although we are significantly underweight BAA-rated credit we do allow the portfolio to hold split rated credits. Most often this is because it is a credit with just one or two investment grade ratings that is on its way to becoming fully investment grade but sometimes it is a fallen angel that we will continue to hold. There are two reasons we would continue to hold a fallen angel, it could be that we expect a full recovery to investment grade or we could be positioning for a more opportunistic sale. It is important, in our view, to never put the portfolio in a
position where it is a forced seller of a bond as a forced sale usually amounts to an ill-timed sale. We did have one credit in our portfolio get downgraded to fallen angel status during the month of March and we have elected to hold it for the time being as our research indicates that the pricing of the bonds is significantly below the fair market value. We expect more volatility in the BAA-rated portion of investment grade as we navigate economic uncertainty and
we expect our underweight will serve us well from a relative performance perspective.

Fed to the Rescue

The actions of the Federal Reserve have been extremely beneficial to the restoration of confidence in the bond markets. On Monday, March 23 the Fed announced a primary market and a secondary market corporate credit
facility. These actions were in response to turmoil within the commercial paper market and lack of liquidity for bond ETF redemptions. The timing could not have been better as the market ended the previous week with an extremely heavy tone so it was a moment of much needed confidence and the Fed stepped up and delivered exactly what was needed.

Tomorrow and Beyond

Tomorrow brings uncertainty; of that much we are certain. We expect continued volatility, particularly in the energy sector and in lower quality BAA rated credit. We are also optimistic and hopeful. We believe that we will come together, not just as a country, but as a civilization, to defeat the global pandemic. We take comfort in the fact that thousands of the smartest people in the world are currently working on solutions. We do not expect it to be easy and it may even take longer than expected but we know that we will eventually prevail. We believe now that a recession is inevitable so our credit selection is even more discerning than it usually is though we always look to position the portfolio in a manner to ensure it can perform through a full market cycle. A big question on investors’ minds is what will the recovery look like? Our view is that it will probably be less of a “V” and more of a “U” making credit selection paramount as it is important that companies within the portfolio have the balance sheet wherewithal to navigate an extended recovery.

We are sanguine on the current valuation of credit spreads. After closing at a high of 373 on March 23, the OAS on the corporate index ended the quarter at 272. This compares to the 5yr average of 128, the 10yr average of 140 and the average since 1988 inception of 135. Clearly credit has been repriced for the challenges that lie ahead and it has become a “credit pickers” market where a skilled active manager can make a difference.

As always please do not hesitate to call or write us with questions or concerns. We hope that you and your loved ones remain in good health during this difficult time.

This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.

The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

i The Financial Times, March 19, 2020 “Asset manager rocked by record bond outflows”

ii Institutional Investor, March 19, 2020 “The corporate bond market is “basically broken” Bank of America says”

iii Bloomberg, April 1, 2020 “IG ANALYSIS US: Record setting March ends with $13 billion bang”

iv ICE BAML Index Data, April 1, 2020

v J.P. Morgan, March 23, 2020 “Fallen angel risk in this crisis”

03 Apr 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

The investment grade credit markets experienced another week that was largely positive in nature, although spreads are still wide to historical averages. Bright spots included tighter spreads and higher commodity prices. The spread on the Bloomberg Barclays US Corporate Index closed Thursday at 279, 16 basis points tighter from the end of the week prior. The tone is mixed as we go to print on Friday morning amid a brutally high unemployment report.

The primary market continues its record breaking pace. Not only was March the busiest month for new issuance on record with $259.2 billion in volume, but this week also set the record for weekly supply with $110.9 billion through Thursday; and it is not yet over with several deals in the market on Friday morning. Last week has now fallen to the #2 spot in the record books as this was the second week in a row of record breaking supply. Issuance this week was led by Oracle who printed $20bln on Monday and T-Mobile with a $19bln print on Thursday that boasted an order book of $74bln. The majority of issuers to this point are still comprised of companies that would be considered high quality borrowers. These companies are simply acting in a prudent and reasonable manner, shoring up their balance sheets amid an environment of uncertainty.

Investment grade credit was hit outflows again but a substantially smaller amount than in prior weeks. According to data compiled by Wells Fargo, outflows for the week of March 26-April 1 were -$4.6bln which brings the year-to-date total to -$32.5bln. As we have alluded to in previous commentaries, flows can do a lot to help stabilize the market and if they turn positive then the path of least resistance is tighter credit spreads.

27 Mar 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

What a difference a few days makes. The investment grade credit market, like equities, went out with a whimper last week. On Monday, with the stimulus package in limbo, a deluge of supply pushed spreads out to their widest levels of the year, and the Bloomberg Barclays Corporate Index closed at 373. The next few days saw a much improved tone, and even in the face of a historically large primary calendar, spreads ratcheted in 71 basis points to close Thursday at 302. To put this 71 basis point move into context, it was larger than the yearly range of the corporate index for each of the preceding three years, and it took only three days; truly a stunning reversal. Even with the improved tone, through Thursday, the index was down -5.96% year-to-date while the S&P 500 was down -18.21%.

The primary market continues to bustle with activity and through Thursday it easily smashed the record for its busiest week in history. $98.9 billion had priced through Thursday eclipsing the previous weekly record of $74.8 billion, according to data compiled by Bloomberg. There are several deals in the market as we go to print on Friday morning which will push the final weekly total north of $100 billion. The bulk of the issuance this week was from highly rated issuers with “A” credit ratings but we started to see some BAA-rated issuers get into the mix as the week wore on. There is one lower quality BAA issuer in the market on Friday morning which is really the first of its kind in recent weeks so we will get an idea about how the market feels about lending to more challenged credit stories.

Investment grade credit was hit with major outflows for the fourth consecutive week. Flows for the week of March 19-25 were -$43.3bln according to data compiled by Wells Fargo. The four week total was nearly -$100bln. Year-to-date flows are now negative to the tune of -$28bln. We would like to think that with an improved tone that many of the panic sellers and leveraged fast money has exited a space that is more suited for strategic permanent capital. Improving flows can only help to further strengthen the tone in the credit markets.

23 Mar 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

We hope this commentary finds you all safe and healthy. We wish we would be able to provide you more frequent commentary however things have been changing so rapidly that any update we could provide would have been deemed irrelevant by the time the ink dried on the page. We will seek to provide you with commentary weekly or as is relevant.

The investment grade credit market has just capped off one of the most volatile two week periods in the history of its existence. The impact of a global pandemic as well as the Saudi-Russia oil standoff has weighed heavily on risk assets of all stripes, and although high quality investment grade typically behaves as a safe haven, even it has not been able to escape the grasp of panicked sellers. Through the week ended March 20, the YTD gross total return on the Bloomberg Barclays US Corporate Index was -10.58%. For context, the S&P 500 was down -28.33% over the same time period. CAM does not provide intra-monthly performance for our portfolios but we are generally more conservatively positioned relative to the corporate index. Recall that CAM has a significant structural underweight on BAA-rated credit by capping our exposure at 30% while the index has a BAA concentration of nearly 50%. CAM also targets a minimum rating of A3 for its portfolio. In a risk off panic, such as the one we have experienced as of late, it is BAA-rated debt that typically underperforms relative to A-rated debt and that has been consistent with what the market has experienced so far in 2020. Year-to-date, A-rated credit has outperformed BAA-rated credit as spreads on the A-rated portion of the index have widened 270 basis points while BAA-rated credit has underperformed to the tune of 46 basis points, having widened 316 basis points thus far in 2020. The AAA/AA portion of the corporate index has held up even better, having outperformed the BAA-rated portion of the index by 126 basis points year to date on a spread basis. To be sure, a pandemic driven global recession is not bullish for investment grade credit, however, it is important to remember that we are talking about high quality investment grade rated companies. This portion of a portfolio is designed to be the ballast that, over time, will reduce volatility and correlations with other asset classes in the context of a well-diversified portfolio. A recession is not good for any asset class and there will be some investment grade companies that are more affected than others. By and large the majority of these companies will see themselves through to the other side and the vast majority of companies will continue to pay interest and debts owed to bondholders. It is also important to remember that, in the framework of a capital structure, bondholders are ahead of equity holders as it is the bondholders that have first claim on the assets of a company. We are already seeing numerous companies change their behavior by suspending share buybacks and cutting dividends in order to protect their balance sheets so that they can continue to make good on their financial obligations that are not negotiable – payments to bondholders.

As far as our portfolio positioning is concerned, we are not infallible and we have some credits that have been impacted by the economic consequences of the pandemic. We are closely monitoring these situations as we always do. We are fortunate in that we have zero exposure to gaming, lodging, leisure or restaurants, as these have been particularly hard hit by the pandemic. We have some exposure to the energy sector but we are materially underweight relative to the corporate index. We have some exposure to airlines but no exposure to unsecured bonds – our only exposure to airlines is through bonds that are secured by the aircraft themselves. Our high quality bias and our bottom up research process leaves us feeling positive about the positioning of our portfolio relative to the index and we are constantly monitoring the portfolio for opportunities to better position, which for us usually means to more conservatively position.

Market Recap

Remarkably, the investment grade primary market remains alive and well as the week of March 16-20 ended up as the third busiest of all time with 23 borrowers bringing over $62bln in new debt. This flurry of issuance was important for the psyche of the market in our view as it once again proved that the investment grade market is never closed to high quality issuers. This was true during the depths of the financial crisis and it is true now. So why, may you ask, would issuers choose to print deals amid such volatility? First, it is really just the prudent thing to do if a company has access – faced with an uncertain near term economic outlook; it makes sense to bolster the balance sheet. Second, due to the drop in Treasuries, debt remains cheap. Take Coca-Cola for example, which was able to issue 10yr debt with a coupon of 3.45% on Friday. That is a very reasonable interest rate when viewed through a historical context. It is also reasonable compensation for investors who are faced with declining yields throughout the world.

Flows have not been the friend for credit investors with long time horizons these past two weeks and the flows themselves have been an even bigger driver of performance than the pandemic in our view. Outflows from IG credit for the week of March 12-18 were an eye-watering -42.7bln according to data compiled by Wells Fargo. This represents the largest outflow on record and is nearly 5x larger than the previous record for a weekly outflow. Investment grade credit is liquid, especially compared to the majority of other fixed income products, such as municipals, but it is not liquid enough to withstand an outflow of this magnitude without serious dislocation, and that is exactly what occurred over the past week. Liquidity for investment grade was easily as bad as it has been since the financial crisis and quite possibly worse based on the opinion of our team at CAM. To be clear, yes the pandemic will weigh on credit metrics for many IG companies, but the underperformance of the IG market over the past week was much more about flows than concerns about creditworthiness. This was panic selling plain and simple. If the market gets to a point where flows are positive or even neutral then the path of least resistance is tighter spreads. The dislocation has created opportunity for committed investment grade buyers especially at the front end of the curve as you can now purchase the 5-6-7 year bonds of some issuers at yields that are greater than their bonds that mature at 10yrs and beyond.

The Federal Reserve continues to act aggressively and decisively as it announced support for numerous market segments on Monday morning. Of particular interest to us is that the Fed will now be buying investment grade rated corporate bonds. The Fed will operate a Primary Market Corporate Credit Facility and a Secondary Market Corporate Support Facility. Through the Primary Facility the Fed will purchase IG rated corporate bonds with maturities of 4 years or less. Through the Secondary Facility, the Fed will purchase IG rated corporate bonds maturing in 5 years or less and it will also be providing liquidity for fixed income ETFs which should go a long way to correcting some of the price discovery problems we saw in the IG market last week. This package by the Fed had the immediate effect of driving IG credit spreads significantly tighter, but more importantly than that it gave the market some much needed confidence. The next step to instilling some semblance of calm into the capital markets would be the passage of a substantial relief package by the Senate. They failed to come to an agreement Sunday evening and for the second time Monday afternoon but we are hopeful that they will come to terms by the end of this week.

As we continue to navigate these turbulent times we wish the best for the health of you and your families. Thank you for your continued interest.

21 Feb 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

Corporate credit spreads were wider across the board this week but lower Treasury rates were the bigger story and more than offset the move wider in spreads. After closing the week prior at a spread of 96, the Bloomberg Barclays Corporate Index closed Thursday evening at a spread of 97, but spreads are weak and drifting wider as we go to print on Friday morning. Global risk markets are skittish among renewed fears that coronavirus may not be adequately contained. Frankly, we are a bit mystified at how easily markets dismissed virus fears to this point. It is not so much the virus itself but the fact that the second largest economy in the world has been closed for business for the better part of a month. This has serious consequences for growth across the globe due to the interconnected nature of the global economy. Treasuries were volatile over the course of the past week. The 10yr closed at 1.58% last Friday and it is wrapped around 1.45% as we go to print, coincident with its lowest levels of 2019. Meanwhile, the 30yr Treasury fell as much as 7 basis points on Friday morning to an all-time low of 1.89%.

The primary market had a very solid week especially considering it was shortened by one day due to a market holiday on Monday. Weekly issuance topped $35bln pushing the month-to-date total north of $86bln. Year-to-date issuance is now closing in on $220bln which is ahead of 2019’s pace by more than +23% according to data compiled by Bloomberg. Issuance is off to a strong start in 2020 but we would expect this pace to slow in the second half of the year as the presidential election approaches.

According to Wells Fargo, IG fund flows during the week of February 13-19 were +$7.4bln. This marks one of the strongest starts to a year on record. Year-to-date IG fund flows have now eclipsed $71bln.

07 Feb 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

Spreads for corporate credit were generally tighter on the week. After closing the week prior at a spread of 102, the Bloomberg Barclays Corporate Index closed Thursday evening at a spread of 96. The tone at mid-day Friday is mixed as risk markets continue to weigh the impact of coronavirus. Treasuries were volatile over the course of the past week. The 10yr closed at 1.51% last Friday which was its lowest level of the year. The benchmark rate then closed as high as 1.65% this Wednesday and is now fluttering around 1.58% on Friday afternoon.

The primary market had a fair week as corporate borrowers issued over $21bln in new debt. 2020 issuance has eclipsed $154bln according to data compiled by Bloomberg.

According to Wells Fargo, IG fund flows during the week of January 30-February 5 were +$9.0bln making it the largest 5-week total for fund flows on record. This brings year-to-date IG fund flows to over $36bln. Both domestic and global investors continue to favor U.S. credit markets as one of the last bastions for reasonably safe yield.

24 Jan 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

Spreads drifted 2 basis points wider on the week with the OAS on the corporate index moving from 93 to 95. Fears of a global health crisis drove Treasuries to 2020 lows and the 10yr is currently trading at 1.698% as we go to print, its lowest level of 2020.

It was another solid week for the primary market as over $25bln in new debt was priced. January issuance has now topped $123bln which is up 46% relative to 2019’s pace according to data compiled by Bloomberg. New deals of all stripes have been well oversubscribed and while there were still new issue concessions available they were quite slim, typically just a few basis points.

According to Wells Fargo, IG fund flows during the week of January 16-22 were +$4.8bln. This brings year-to-date IG fund flows to over $20bln. This is the third consecutive week of strong inflows into the IG credit market.

(Bloomberg) Delayed Disclosure of Biggest Corporate Bond Trades Stalls

S. regulators have halted a plan to test whether delayed disclosure of corporate bond trades would boost market liquidity after a powerful group of investors, including Vanguard Group Inc., Citadel and AQR Capital Management, slammed the proposal.
A Wall Street trade group informed its members late last year that the Financial Industry Regulatory Authority’s controversial plan had been put on hold, said two people familiar with the matter. The brokerage watchdog could still make changes and go forward after consulting with the Securities and Exchange Commission, another person said.
Finra’s plan was to review the impact of giving traders two full days before having to reveal so-called block trades — the largest transactions. Some of the biggest money managers, such as Pacific Investment Management Co. and BlackRock Inc., have argued that a requirement that block trades be reported within 15 minutes has made it harder for banks to profit from facilitating buying and selling. That has prompted Wall Street securities firms to retrench, making it harder for buy-side participants to execute trades.
Finra first proposed its study in April 2019 and gave the public until June 11 of last year to provide feedback. The regulator has said little about the test in the seven months since the comment period expired.
Corporate bond trades are revealed through Finra’s Trade Reporting and Compliance Engine, better known as Trace. The regulator introduced the system in 2002 with the goal of increasing transparency, as most transactions have historically taken place over the phone between buyers and sellers.
A common refrain among Wall Street banks is that rules passed in the wake of the 2008 financial crisis made it harder and more expensive for them to hold large inventories of corporate bonds. That has prompted banks to function mostly as intermediaries that link up buyers and sellers, rather than purchasing big blocks of bonds from investors and then unloading the debt over time for a profit.
Vanguard disputes those claims. In its letter, the asset-management giant said there’s no proof that prompt disclosure of trades is hurting liquidity. But it is clear, according to Vanguard, that increased transparency lowers transaction costs. It called the proposed study “a harmful solution to an unsubstantiated problem.”

(Bloomberg) Investors Just Keep Pumping Cash Into Corporate Bond Funds

Credit bond funds continue to rake in cash as investor appetite for risk remains voracious.
Buyers pushed $4.2 billion into high-grade funds for the week ended Jan. 22, according to Refinitiv Lipper. That’s on top of last week’s $6.6 billion influx and a record $8.2 billion inflow from the prior reporting period.
This month’s sum covering the first three weeks of the year — a whopping $19 billion — already exceeds last year’s full-month January inflow total by about $5 billion.
Seemingly insatiable demand has kept the high-grade primary market hot as some new bond deals come in as much as seven times oversubscribed and secondary spreads stand at the tightest level since February 2018.

23 Jan 2020

Insight, Investment Grade Quarterly Josh Adams - Portfolio Manager 0 comment

2019 Q4 Investment Grade Commentary

Investment grade credit ended 2019 on a high note with another quarter of positive total returns. The Bloomberg Barclays US Corporate Index closed the year at an option adjusted spread of 93, a whopping 22 basis points tighter on the quarter. Treasuries of all stripes sold off during the quarter which mitigated the impact of tighter spreads. The 10yr Treasury closed 2019 at 1.92% after opening the 4th quarter at 1.66%, an increase of 26 basis points. The dichotomy of returns between 2018 and 2019 was stark. While 2018 was a disappointing year with the worst returns for corporate credit in a decade, 2019 was a complete reversal with the best returns in over a decade. For the full year 2019 the Bloomberg Barclays US Corporate Index had a total return of +14.54%. This compares to CAM’s gross total return of +12.78% for the Investment Grade Strategy.

2020 Outlook

As long-time readers know, our specialty at CAM is bottom-up credit research. We seek to invest in the most attractive corporate credit opportunities for our clients at any given time with the goal of generating superior risk adjusted returns. Preservation of capital is always at the forefront of our decision making process, which is one of the reasons we are always structurally underweight the riskier BBB portion of the investment grade credit market. We are not in the businesses of making speculative market bets, such as wagering on the direction of interest rates, but we certainly do have a framework and house view that we use to aid in our decision making process. To that end, we thought it would be helpful to explore some of the themes that we believe could influence the direction of the market in 2020. We expect four distinct factors could impact the fortune of the investment grade corporate credit market in the coming year: issuance, fund flows, foreign demand and fundamentals.

Issuance is Key

Net issuance is a metric that we track to gauge the availability of new investment opportunities. Net issuance is simply the gross amount of new corporate bond issuance less the amount of debt that matures or that is redeemed through call options or tender offers. Both gross and net issuance have been falling since 2017.

The net issuance forecast for 2020 is substantially lower relative to 2019 and some predictions have 2020 net issuance coming in at or near 2012 levels A few of the major investment banks are particularly bearish in their forecasts: Morgan Stanley expects net issuance to be down 22%, Bank of America down 21% and J.P. Morgan down a staggering 36%. i The decline in net issuance could be meaningful for the support of credit spreads. If continued inflows into corporate credit meet substantially lower new issuance this could create a supply-demand imbalance. This imbalance would create an environment that lends support to tighter credit spreads.

Inflows & the Incremental Buyer

IG fund flows have been broadly positive dating back to the beginning of 2016. The only period of sustained outflows from investment grade in the past four years was during the fourth quarter of 2018 which was a time of peak BBB hysteria.ii iii Over $300bln of new money flowed into IG mutual funds, ETFs and total return funds in 2019, according to data compiled by Wells Fargo Securities. The biggest story of 2019 as it relates to flows is the reemergence of the foreign investor, who has become the most important incremental buyer of IG corporates.

Foreign investors were largely quiet in 2018 but in 2019 they poured $114bln into the U.S. IG market through the end of the 3rd quarter.iv Two factors have led to resurgence in foreign demand: First, for those investors that hedge foreign currency, the three Fed rate cuts in 2019 have made hedging much more attractive, as hedging costs are closely tied to short-term rates. Second, and perhaps the larger factor, is the negative yields that foreign investors have faced in their domestic markets. Negative yielding debt reached its zenith in August of 2019 at over $17 trillion. Although it has come down substantially, it remained over $11 trillion at year-end relative to $8 trillion at the beginning of 2019.v

Obtaining precise information on foreign holdings is difficult due to the myriad of ways that this group can invest in the U.S. markets; but what was once a bit player in our market has now become the single largest class of investor, holding an estimated 30-40% of outstanding dollar denominated IG corporate bonds. To put that into perspective the next largest holder is life insurance companies at just over 20%.vi Simply put, inflows are important in order to provide technical support to the credit market, but the real bellwether for flows is the foreign buyer. If foreign money continues to flow into the $USD market, we would expect continued support for credit spreads. However, if foreign investor sentiment sours, it will create a headwind for spreads.

Best of Times & Worst of Times

Although corporate credit performed well in 2019, credit metrics for the index at large have deteriorated and leverage ratios are near all-time highs. We would typically be apt to view such a development through a bearish lens; but the reality is that much of the increase in leverage reflects conscious choices by firms rather than a weakening of business fundamentals. Incentivized by the minimal additional cost incurred for funding a BBB-rated balance sheet relative to an A-rated one, many firms have sacrificed their higher credit ratings to fund priorities such as acquisitions and share repurchases. Investor demand for credit and a prolonged period of historically low interest rates have reduced the financial penalty for moving down the credit spectrum.

Interestingly, a vast majority of BBB-rated debt has remained in the upper notches of that category. According to data compiled by S&P, just 16% of BBB- rated debt is in the lowest BBB minus category while 47% is mid-BBB and 36% is rated BBB+.vii There will surely be some losers in this bunch which makes the BBB story an idiosyncratic one; managers need to choose credits carefully in this space and focus on those which can weather a downturn without putting credit metrics in serious peril. The median GDP forecast for 2020 is 1.8%.viii If this comes to fruition then most IG-rated companies will be able to maintain stable to improving credit metrics for the year which would be another positive for credit spreads. If growth underwhelms, it would not surprise us to see spread widening in more cyclical sectors and in the lower tier of investment grade credit. This is where our individual credit selection factors in heavily.

Risky Business

At over a decade in length, we are in the midst of the longest credit cycle on record yet the current backdrop suggests that it may have more room to run. Investment grade as an asset class is still compelling as part of an overall asset allocation but even the most bullish investor cannot expect 2020 to be a repeat of 2019 as far as returns are concerned. The fact is that there is not much room for error and there are several risks that will continue to loom large on the horizon in 2020.

Private equity companies are starting the year with a record $1.5 trillion in unspent capital. This is not a new story and remarkably this same “record” headline could have been written at the start of each of the last four years!ix Private equity is not bad, per se, but when they become involved with investment grade rated companies it is usually to the detriment of bond investors. Understanding the intricacies of each business in the portfolio and the covenants within each bond indenture can help to avoid a bad outcome.
Policy risk remains high. The Federal Reserve has telegraphed a relatively neutral policy in 2020, which is typically the stance that is taken in an election year, but any deviation from this path could be a shock for markets. The events leading up to the November election and its results both have the ability to effect the direction of credit spreads and the risks are skewed to the downside at current valuations.
Trade disputes have serious potential to derail domestic and global economic growth. The reality is that until uncertainty is removed, the market is subject to volatility and headline risk associated with global trade. The implications at the sector level are particularly severe in some instances and we are positioning the portfolio to mitigate this risk accordingly.

As always please do not hesitate to call or write us with questions or concerns. We will continue to provide the best customer service possible and to prudently manage your portfolios to the best of our ability. Thank you for your partnership and continued interest. We wish you a happy and prosperous new year.

i Bloomberg News, December 30, 2019 “U.S. Corporate Bond Sales to Slow in 2020 With Speed Bumps Ahead”
ii The Wall Street Journal, September 20, 2019 “There Have Never Been So Many Bonds That Are Almost Junk”
iii Bloomberg, October 11, 2018 “A $1 Trillion Powder Keg Threatens the Corporate Bond Market”
iv Bloomberg News, December 26, 2019 “The Corporate Bond Market’s $100 Billion Buyer Is Here to Stay”
v Bloomberg Barclays Global Aggregate Negative Yielding Debt Index
vi Federal Reserve System
vii S&P Global Ratings, December 16, 2019 “U.S. Corporate Credit Outlook 2020 Balancing Act”
viii Bloomberg Terminal, January 2, 2020 “US GDP Economic Forecast”
ix Bloomberg News, January 2, 2020 “Private Equity Is Starting 2020 With More Cash Than Ever Before”

17 Jan 2020

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

It was another busy week in the corporate credit markets; inflows remained robust, the new issue calendar continued to hum and the secondary market featured buyers grabbing for yield. Risk markets have been incredibly resilient as they have shrugged off geopolitical turmoil and they seem to have little interest in impeachment or the upcoming presidential primaries and election. The spread on the corporate index is one basis point tighter on the week, currently trading at 95. The range in spreads on the index thus far in 2020 has been tight at just three basis points.

The primary market was busy again with more than $35bln in new debt coming to market on the heels of $60bln+ the week prior. Demand was very strong as order books were well oversubscribed, even for companies with marginal credit metrics. It is early in the year but so far new issue supply is 32% higher relative to last year, according to data compiled by Bloomberg. Recall that CAM’s projection as well as the general consensus is calling for overall supply in 2020 to be down relative to 2019 especially on a net basis. We expect that issuers will look to be quite active in the first half of the year and that issuance will be more subdued in the second half due to the uncertainty that typically accompanies a presidential election. The consensus supply number for January is $120bln, according to data compiled by Bloomberg, so next week should be another solid week for issuance but will likely be somewhat lower than the previous two weeks due to earnings blackout periods.

According to Wells Fargo, IG fund flows during the week of January 9-15 were +$5.5bln. This brings year-to-date IG fund flows to over $15.5bln, a strong start to the year.

(Bloomberg) That $1 Trillion BBB Powder Keg Worries Credit Investors Again

Investors raised doubts about BBB debt in late 2018, when General Electric Co. was in crisis, its bonds tanked, and investors fretted about market turmoil from mass downgrades. Those fears proved misplaced last year, when investors stampeded into BBB notes and crushed risk premiums on the securities to around their lowest level since the financial crisis. Those narrow risk premiums are what worry at least some money managers.
Because BBBs make up more than half the $8.4 trillion investment-grade corporate markets in both the U.S. and Europe, there’s that much more debt at risk of possibly falling to speculative grade. In 1993, BBBs were more like a quarter of the market.
Signs of trouble for BBB companies have started brewing this year. Italian infrastructure company Atlantia SpA lost its last remaining investment-grade rating this week, and Boeing Co.’s biggest Max supplier, Spirit AeroSystems Holdings Inc., has also fallen into junk.
Some money managers are focusing on finding bargains among BBB notes. Many of the largest BBB constituents gorged on debt to fund M&A, bringing their total obligations in 2018 to around $1 trillion, according to a Bloomberg analysis. Some of those companies have put debt reduction at the forefront, selling assets and cutting dividends to free up cash. That helped make GE, AT&T and AB InBev among 2019’s best corporate bond investments.

20 Dec 2019

Investment Grade Weekly Josh Adams - Portfolio Manager 0 comment

CAM Investment Grade Weekly Insights

Another week has come and gone and corporate bonds continue to inch tighter into year end. The OAS on the Bloomberg Barclays Corporate Index opened the week at 99 and closed at 95 on Thursday. Spreads are now at their tightest levels of 2019 and the narrowest since February of 2018 when the OAS on the index closed as low as 85. Price action in rates was relatively muted during the week amid low volumes but Treasuries are set to finish the week a few basis points higher. The 10yr opened the week at 1.87% and is trading at 1.91% as we go to print.

As expected, the primary market during the week was as quiet as a church mouse. December supply stands at a paltry $18.9bln according to data compiled by Bloomberg. 2019 issuance stands at $1,110bln which trails 2018 by 4%. As we look ahead to 2020, we expect robust supply right of the gates in January but the street consensus for 2020 as a whole is that supply will be down 5% relative to 2019. Further, net supply, which accounts for issuance less the 2020 maturity of outstanding bonds, will be down substantially from prior years. If these forecasts come to fruition then the supply backdrop could lend technical support to credit spreads in 2020. Supply, however, is merely one piece of the puzzle.

According to Wells Fargo, IG fund flows during the week of December 12-18 were +$0.85bln. This brings YTD IG fund flows to +$295bln. 2019 flows are up over 11% relative to 2018.

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