Author: Josh Adams - Portfolio Manager

As the fourth quarter of 2017 came to a close, investment grade corporate bond spreads narrowed to the tightest levels of the year, and the lowest since 2007i. The Bloomberg Barclays US IG Corporate Bond Index OAS started the year at 1.22% and finished at 0.93%, which means that, on balance, credit spreads for the index tightened 29 basis points throughout 2017. During 2017, BBB credit spreads tightened more than single‐A spreads by 8 basis points. BBB spreads tightened 36 basis points in 2017, after starting the year at 1.60% and finishing at 1.24%, while A‐rated spreads tightened 28 basis points after starting the year at 1.01% and finishing at 0.73%.

At CAM, our market reconnaissance, observance and experience told us that the insatiable demand for yield and income by both foreign and domestic investors drove the 2017 outperformance of lower quality investment grade credit relative to higher quality investment grade credit. Additionally, the composition of the investment grade universe has changed since the financial crisis ‐‐ in 2007, less than 35% of the Bloomberg Barclays US Corporate Index was BBB‐rated, while today nearly 50% of said index is BBB‐rated.

Source: Barclays Bank PLC

At CAM, we believe that now, more than ever, it is prudent for us to populate our portfolios with credits that we believe have the durability and financial strength to make it through a downturn in the credit markets. We continue to limit our exposure to BBB‐rated credits at 30%, a significant underweight relative to an IG universe where nearly 50% of credits are BBB‐rated. We are focusing on sectors that we believe will behave more defensively if the credit cycle turns, or if spreads go wider. For example, we would rather forego a modest amount of yield and purchase a single‐A rated regulated utility operating company as opposed to a single‐A industrial with cyclical end markets. We continue to take appropriate risks within the BBB‐rated portion of our portfolios, but only if the individual credit is trading at a level that provides appropriate compensation for the risks. We intend to maintain a significant relative overweight to EETC airline bonds, which are highly rated bonds that are fully secured and offer excess compensation relative to what we are finding elsewhere in the market. As always, we are diligent in screening for and avoiding credits that are at risk for shareholder activism, as we attempt to steer clear of situations where shareholders are rewarded at the expense of bondholders. Simply put, we are loath to change our conservative philosophy against the backdrop of exuberant credit markets. The principal decision makers on our investment grade team measure their experience in decades, not years, so we have seen the cycles come and go. Thus, we believe skepticism and caution are the prudent courses of action, and our portfolios will be positioned accordingly. We believe our core differentiator is our credit research and bottom up process that allows us to populate our portfolios with individual credits with a goal of achieving superior risk adjusted returns over the longer term.

The passage of a sweeping tax bill has generated some inquiry from our clients who would like to know what impact tax reform may have on the credit markets in 2018 and beyond. For investment grade corporate credit, we believe the impact will be relatively muted. There are two issues that could affect credit markets, interest deductibility and repatriation. Interest paid on debt is tax deductible, so as the corporate tax rate is lowered from 35% to 21% it makes debt issuance somewhat less attractive due to a lower overall tax burden. As far as repatriation is concerned, the repatriation tax rate on liquid assets held offshore will fall from 35% to 15.5%, so it is likely that some companies will bring some offshore cash back to the U.S. but we expect only a modest impact on investment grade credit. Of the $1.4 trillion that is held offshore by non‐financial U.S. companies, over 42% of that cash is controlled by just 5 large technology companiesii. While some companies will repatriate cash to pay down debt or to avoid taking on more debt, there will be others that repatriate cash for shareholder rewards and for M&A. Overall, we believe that tax reform will have a very modest impact on investment grade credit and that effect is most likely to be felt in 2018 investment grade new issuance. 2017 was a robust year for corporate bond issuance, with $1.327 trillion in gross issuance, 1% less than the amount of issuance that came to market in 2016iii. Even if tax reform does incent some companies to issue fewer bonds, the M&A pipeline remains robust with pending deals and potential deals, so we at CAM are expecting an issuance figure similar to the last two calendar years.

2018 should be another interesting year at the Federal Reserve. Jerome Powell will be the next Chair of the Federal Reserve, pending a confirmation vote by the full Senate. There is some belief that the Fed may turn more hawkish in 2018, as inflation is slowly creeping back into the picture and the labor market is showing signs of tightening, though wage growth remains relatively subduediv. The Fed continues to target three rate hikes in 2018, but what does this mean for the corporate bond market?v Though the first Fed rate hike of the current cycle occurred in December of 2015, the impact on the 10yr treasury has been relatively muted compared to the front end of the yield curve.

In 2017 we experienced a flattening of the treasury curve. The 5/10 treasury curve started the year at a spread of 51 basis points and ended 2017 at 20 basis points. It is important to note that, even if the treasury curve were to flatten completely, or even invert, there would still be a corporate credit curve that would afford extra compensation to investors for owning 10yr corporate bonds in lieu of 5yr corporate bonds. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. In our experience, investors spend a large portion of their time focusing on the risk they can’t control ‐ interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long‐term is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 29 years.

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.

i Bloomberg December 27, 2017 “Surging Demand Sends Investment‐Grade Bond Spread to 2007 Levels”
ii Moody’s Investor Service November 20, 2017 “Corporate cash to rise 5% in 2017; top five cash holders remain tech companies”
iii Bloomberg December 14, 2017 “Investment Grade Issuance Total for December 14, 2017”
iv Federal Reserve Bank of Atlanta December 26, 2017 “Wage Growth Tracker”
v Bloomberg Markets December 13, 2017 “Fed Raises Rates, Eyes Three 2018 Hikes as Yellen Era Nears End”

New issuance in the quarter saw issuers price nearly $350 billion in new investment grade corporate bonds, bringing the YTD total to $1.06 trillioniv. We have now eclipsed the $1 trillion mark for the sixth straight year, which speaks to the persistent, global demand from investors searching for yield and income for their portfolios. With low‐ to‐negative yields in global fixed income securities, the US Investment Grade corporate bond market still provides a good alternative for global investors (see chart)v.

The Federal Open Market Committee (FOMC) opted not to raise rates at its September meeting, with the market focused squarely on the December meeting. During its September meeting, the FOMC did provide the long awaited details on its program to gradually reduce the size of its balance sheet. The FED is merely reducing the reinvestment of principal payments from the Federal Reserve’s securities; it is not actively selling its holdings. The FOMC has provided a roadmap of its policy normalization efforts along with a schedule of how it plans to gradually reduce its balance sheet over time (see chart)vi. Like most policy actions, the FOMC has showing a willingness to be flexible, pending new information and economic data, so time will tell if the securities reduction schedule is actually implemented as planned.

While the FOMC has begun a gradual effort to tighten monetary policy, the ECB too has discussed scaling back its monetary easing as soon as January 2018, but the plan is vague at this point and the world will be watching closely for more details when they meet again near the end of October. Meanwhile, the BOJ recently pushed back the window for achieving its 2% inflation target for the sixth time; to around fiscal year 2019, meaning the bank will not embark on policy tightening in the near termvii. Bottom line, we are only in the very early innings of a more concerted effort to tighten monetary policy by global central bankers.

A recurring theme for us in our quarterly notes this year has been the lack of market volatility thus far in 2017, and the third quarter of the year was no different from the previous two in that volatility remained low (previous commentaries can be found at www.cambonds.com). Volatility is a fact of life in the capital markets and we know at some point it will return to the forefront. We feel that the best way we can position client portfolios is to focus on the risks that are within our control –namely the quality of the companies in which we invest. While volatility in See Accompanying Footnotes

credit spreads or interest rates is difficult, if not impossible to predict, it is important to understand the impact that higher yields would have on the corporate bond market especially as it relates to a corporation’s balance sheet, cash flows and credit quality. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. In our experience, investors spend a large portion of their time focusing on the risk they can’t control ‐ interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long‐term is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 28 years.

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.

i Bloomberg September 28, 2017 “Investment‐Grade Issuance Total”
ii Barclay’s Credit Research: Daily Credit Call
iii Bloomberg Barclay’s Indices
iv Bloomberg September 29, 2017 “Robust High‐Grade Bonds Sales of September Likely to Fade” v Federal Reserve Flow of Funds
vi Federal Reserve Bank of New York September 20, 2017 “Statement Regarding Reinvestment in treasury Securities and Agency Mortgage Backed Securities”
vii Japan Times July 20, 2017 “BOJ delays window for achieving 2% inflation target”

The Federal Open Market Committee (FOMC) acted again during the quarter by boosting the target range for the Federal Funds rate by another 25bps at their June 14th meeting v. At the time of the FOMC action the 10yr US Treasury yield was 2.17% and the move up in short term rates influenced by the policy move has flattened the yield curve even further, something we discussed extensively in our Q1 2017 commentary. (A copy of that and all of our previous commentaries can be found on our website at www.cambonds.com.) Central Banks around the world have been hinting at ending their ultra‐ loose monetary policy and begin to wind down their active quantitative easing (QE) programs vi. While the FOMC has not been actively adding to its balance sheet via QE, it has been maintaining it around $4.5 trillion by reinvesting proceeds from maturing bonds in its portfolio. Members of the Federal Reserve board, including Janet Yellen, have openly discussed starting to unwind its $4.5 trillion balance sheet sometime this fall by letting some of its maturing securities run off and not be reinvested. However, as of yet, no set timetable has been established vii. As with most FOMC policy shifts, investors are best served to watch what the FOMC does and not what they say as they make these changes. The unwinding of trillions of dollars of securities will be difficult to execute, and will be closely watched by investors around the world. While the FOMC is looking to reduce the size of its balance sheet, the European Central Bank and Bank of Japan have been significantly adding to theirs over the past several years with both recently surpassing the size of the balance sheet of the Federal Reserve (see graph)viii. While neither of the two have definitive plans to end QE it would seem that halting open market purchases would be the first step in the direction of policy normalization.

After a very volatile end to the year in 2016, the first quarter of 2017 saw a much more benign movement in interest rates and corporate bond yields as most fixed income markets stabilized after a difficult fourth quarter. During the first quarter of 2017, Treasury yields traded within a fairly narrow, 24 bps range. The movements in Treasury yields were generally lower as the 10 Year Treasury yield began the quarter at 2.45% and ended it at 2.39%. Accompanying the lower yields in Treasuries, corporate credit spreads continued their persistent grind tighter that began in mid‐ February of 2016 and ended the quarter near the tightest levels of the past 13 months. Specifically, the A Rated Corporate credit spread tightened from 1.01% to 0.97% (down 4 basis points (bps)) and the BBB Rated Corporate credit spread tightened from 1.60% to 1.51% (down 9bps)i. When looking at the movement of interest rates and credit spreads together, the decline in Treasury yields and slightly tighter corporate credit spreads helped Investment Grade corporate bond yields end the quarter slightly lower than where they started. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with lower yields, thus both achieving positive performance, Investment Grade corporate bonds outperformed Treasuries due to the tightening of credit spreads and higher coupon income collected. The Barclays US Investment Grade Corporate Index returned +1.22% for the quarter, outperforming the Barclays US Treasury 5‐10 year index return of +0.89%ii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +1.37% which outperformed both of the above mentioned indices.

The beginning of the year saw robust demand for US Investment Grade corporate bonds which allowed for a record setting new issuance in the quarter. During the quarter there was $413B of new issuance across 565 issues which represented a 14% increase from Q1 2016iii. A large portion of the new issuance were bonds with 5 and 10 year maturities ‐ an area of interest for CAM. As an institutional investor who participates in the primary (new issuance) marketplace, we were able to be fairly active in Q1, which has benefits to our clients. According to CreditSights, the average yield pickup in the new issue market for 10yr Investment Grade Corporate Bonds in the first quarter was 10bps, or 0.10% in additional yield, versus comparable bonds of the same issuer in the secondary marketiv. We will continue to participate in the primary market when there are attractive opportunities in credits we like.

The first quarter was also marked by policy action by the Federal Open Market Committee (FOMC) at their March meeting. While CAM has always considered itself interest rate agnostic in its investment process, we think it makes sense to clarify what the FOMC has been doing and its effects on the yield curve as it relates to our portfolios. The FOMC sets interest rate policy for very short‐term interest rates by influencing the Federal Funds rate, the overnight lending rate between banks. One way this is done is through adjusting the reserve requirements of member banks with The Federal Reserve. The FOMC sets a target rate that is, effectively, what most think of when one hears that the Fed “raised rates” or “lowered rates”. This in no way directly affects interest rates for other, longer dated maturity bonds. Those interest rates are determined by investors’ inflation forecasts, which can be impacted by FOMC activities. So, interest rate policy indirectly affects yields on longer dated fixed income securities. It may be surprising what this impact has been since the FOMC has been hiking the target Federal Funds rate in this cycle. As an investor in the intermediate portion of the yield curve (5 – 10 year maturities), we will examine the 10 year part of the Treasury curve to analyze those interest rate movements around the recent FOMC policy actions.

The FOMC began their recent increase in monetary policy on December 16, 2015 by hiking the Federal Funds target rate by 25 bps or 0.25%v. This was their first “rate hike” in over a decade. The day they made this policy announcement the yield on the 10yr US Treasury was 2.30% (see graph)vi. The immediate effect on this yield was opposite of what most market commentators and investors thought as it began a sharp decline all the way to a low of 1.37% on July 5, 2016.

Corporate Bond investors are compensated for two risks; interest rate risk and credit risk. The first, interest rate risk, is approximated by US Treasury yields. The second, credit risk, is the remuneration for the business risk of the underlying company; this remuneration is expressed as the premium received in excess of the US Treasury yield. In our experience, investors spend a large portion of their time focusing on the risk they can’t control ‐ interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long‐term is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital.

The fourth quarter of 2016 saw a substantial increase in Treasury yields as they generally trended higher at the beginning of the quarter and moved sharply higher towards the end of the quarter. The movement higher in Treasury yields did not begin on November 8th (election day in the US) but accelerated at that point before peaking in mid ‐December. Offsetting the higher yields in Treasuries, corporate credit spreads continued their persistent tightening since the mid‐February widest levels of the year and ended near the tightest levels of the year. Specifically, the 10 Year Treasury began the quarter at 1.60%, peaked at 2.60% (up 100 bps) on December 15th and ended the quarter at 2.45% (up 85 bps). The A Rated Corporate credit spread tightened from 1.12% to 1.01% (down 11bps) and the BBB Rated Corporate credit spread tightened from 1.78% to 1.60% (down 18bps). When looking at movement of interest rates and credit spreads together, the sharp rise in Treasury yields was only partially offset by tighter credit spreads, thus yields for Investment Grade corporate bonds ended the quarter higher than where they started. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with higher yields, Investment Grade corporate bonds outperformed by a considerable margin.

During the quarter, Investment Grade corporate bonds provided some protection to investors as US Treasury yields rose. The Barclays US Investment Grade Corporate Index returned ‐2.83% vs ‐4.47% for the Barclays US Treasury 5‐10 year index i. When looking at the performance of US Investment Grade corporate bonds the two primary factors that led to their outperforming comparable US Treasuries during the quarter were:

• higher starting yields
• tightening of credit spreads across the corporate credit curve

Our Investment Grade Corporate Bond composite provided a gross total return of ‐3.62%, which trailed the Barclays US Investment Grade Corporate Index, but outperformed the comparable US Treasury index. For the quarter, our underperformance relative to the US Investment Grade corporate benchmark can be primarily attributed to our focus on the 5 – 10 year part of the credit curve, the much shorter end of the curve was less impacted by increasing rates, and our underweight to the BBB credit quality segment relative to the benchmark.

Corporate Bond investors are compensated for two risks; interest rate risk and credit risk. The first, interest rate risk, is approximated by US Treasury yields. The second, credit risk, is the remuneration for the business risk of the underlying company; this remuneration is expressed as the premium received in excess of the US Treasury yield. In our experience, investors spend a large portion of their time focusing on the risk they can’t control – interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long-term is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve – to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital.

The third quarter of 2016 saw a small increase in Treasury yields as they generally trended higher throughout the quarter. Offsetting the higher yields in Treasuries, credit spreads continued their persistent tightening since the mid-February widest levels of the year and ended near the tightest levels of the year. Specifically, the 10 Year Treasury began the quarter at 1.47% and ended at 1.60% (up 13 bps), the A Rated Corporate credit spread tightened from 1.24% to 1.12% (down 12bps), and the BBB Rated Corporate credit spread tightened from 2.05% to 1.78% (down 27bps). These two factors together have added up to stable or slightly lower yields for Investment Grade corporate bonds.

From a performance perspective, this relatively benign move higher in interest rates was more than offset by the tightening in credit spreads. This allowed our portfolios to collect coupon and benefit from the tightening of credit spreads. Our Investment Grade Corporate Bond composite provided a gross total return 0.99% as compared to the 1.41% move higher for the Barclays US Investment Grade Corporate Index. Since the source of excess returns this quarter was primarily due to credit spread tightening, we need to analyze how the credit quality of our strategy influenced the performance of our portfolios relative to the benchmark. The Barclays US Investment Grade Corporate Index is comprised of approximately 53% BBB rated bondsi while our strategy caps our exposure to BBB rated bonds at 30%. This cap causes our portfolios to have a higher average credit quality relative to the benchmark and this underweight to BBB bonds was the primary reason we lagged the index in performance for the quarter.

As the third quarter progressed, there were several prevailing trends in the corporate bond market that continued:

• tightening credit spreads provided buoyant returns
• investor interest in the asset class provided new capital to be put to work
• new corporate bond issuance has been robust providing the supply for investor demand