Category: High Yield Quarterly

In the first quarter of 2020, the Bloomberg Barclays US Corporate High Yield  Index  (“Index”) return was ‐12.68%, and the CAM High Yield Composite gross total return was ‐10.03%. The S&P 500 stock index return was ‐19.60% (including dividends reinvested) for Q1. The 10 year US  Treasury rate  (“10  year”)  generally drifted lower throughout the quarter finishing at 0.67%, down 1.25% from the beginning of the quarter.

The 10 year did make a record low of 0.54% in early March. That is just one of the many records to take place across markets in 2020. During the quarter, the Index option adjusted spread (“OAS”) widened 544 basis points moving from 336 basis points to 880 basis points. During the first quarter, each quality segment of the High  Yield Market participated in the spread widening as BB rated securities widened  472 basis points, B rated securities widened 532 basis points, and CCC rated securities, widened 836 basis  points.   Take  a  look  at  the  chart  below  from  Bloomberg  to  see  the  eye‐popping  visual  of  the  enormous spread move in the Index. The chart displays data for the past five years. Notice the previous ramp in the Index OAS spread from 2015. That ramp took seven months before reaching the peak and topped out around 850 basis points. The ramp‐up this time around happened inside of five weeks and topped out at 1100 basis points. “It sure was a long year this past month,” is a saying that seems to capture the feelings of many across Wall Street as the first quarter closed.

The  Utility,  Technology,  and  Insurance  sectors  were  the  best  performers  during  the  quarter,  posting  returns of ‐5.06%, ‐5.31%, and ‐5.95%, respectively. On the other hand, Energy, Transportation, and REITs  were  the  worst performing  sectors,  posting  returns  of ‐38.94%, ‐20.90%,  and ‐16.87%, respectively. At the industry level, wireless, supermarkets, pharma, and food/beverage all posted the best  returns.   The  wireless  industry  (‐1.04%)  posted  the  highest  return.   The  lowest  performing  industries during the quarter were oil field services, e&p energy, retail REITs, and leisure. The oil field services industry (‐49.18%) posted the lowest return.

During  the  first  quarter,  the  high  yield primary market posted $81.8 billion  in  issuance.   That  is  the  total issuance including a market that was essentially closed for the month of  March.   Issuance within  Financials was the strongest with almost 23% of the total during the quarter.  The  last  few  days  of  March did see the high yield market begin to open up just a bit for issuance. That was a very encouraging sign to see. We expect that  when  the  issuance  door  opens  some  more,  there  will  likely  be  a  flood  of  companies  coming to  market to fortify their balance sheets.

The  Federal  Reserve  was  very  busy  during  the  quarter.   They  pulled  out  all  the  stops  by  not  only  dropping the Target Rate to an upper bound of 0.25%, but they passed numerous programs (PMCCF, SMCCF, TALF, MMLF, CPFF, etc.) in order to keep the credit markets functioning. While they may run out  of  acronyms  at  some  point,  they  truly  are  injecting  unprecedented  amounts  of  support  in  the  markets. Additionally, after some political wrangling, Congress passed a massive $2 trillion rescue package. The package is very wide reaching and a critical piece of legislation that will go a long way to help support businesses and citizens during such a troubling time.

While Target Rate moves tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries decreased 125 basis points over the quarter, as the 10‐year Treasury yield  was  at  1.92%  on  December  31st,  and  0.67%  at  the  end  of  the  quarter.   The  5‐year  Treasury  decreased 131 basis points over the quarter, moving from 1.69% on December 31st, to 0.38% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. There is no doubt that  economic  reports  are  going  to  be  quite  noisy  over  the  balance  of  2020.   However,  the  revised  fourth quarter GDP print was 2.1% (quarter over quarter annualized rate), and the current consensus view of economists suggests a GDP for 2020 around ‐1.3% with inflation expectations around 1.3%.

The global pandemic and crumbling oil prices were the main themes in the quarter leading to markets falling at the fastest pace everi. The energy sector was hit especially hard as crude fell from $60 to $20 a barrel.   The  price  drop  was  due  not  only  to  demand  destruction  caused  by  the  COVID‐19  economic  fallout but also a supply side dispute between Russia and Saudi Arabia. An OPEC meeting broke down when Russia wouldn’t agree to production cuts. In a follow‐up move, Saudi Arabia decided that they would not only increase production but slash their selling price as well. The energy market has been reeling  ever  sinceii.   Within  high  yield,  the  downgrades  have  been  plentiful  and  the  bankruptcies  are  beginning to trickle in.

Being  a  more  conservative  asset  manager,  Cincinnati  Asset Management is structurally underweight CCC and lower rated securities. This positioning has served our  clients  well  so  far  in  2020.   As  noted  above,  our  High Yield Composite gross total return has outperformed  the  Index  over  the  first  quarter  measurement period. With the market so weak during the first quarter, our cash position was a main driver of our  overall performance.  Further,  our  structural  underweight  of  CCC  rated  securities  was  a  benefit.   Additionally, our underweight positioning in the communications sector was a drag on our performance. While  our  overweight  positioning  in  energy  hurt  performance,  our  credit  selections  within  the  midstream industry performed much better than the sector. Unfortunately, our credit selections within the  consumer  cyclical  services,  leisure,  and  auto  industries  hurt  performance.  However,  our  underweight in the transportation sector and our overweight in the consumer non‐cyclical sector were bright spots. Further, our credit selections within the media and healthcare industries were a benefit to performance.

The  Bloomberg  Barclays  US  Corporate  High  Yield  Index  ended  the  first quarter  with  a  yield  of  9.44%.   This yield is an average that is barbelled by the CCC‐rated cohort yielding 17.54% and a BB rated slice yielding 7.24%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), had the proverbial moonshot moving from 14 to a high of 83. For context, the average was 15 over the course of 2019. The first quarter had four issuers default  on  their  debt,  and  the  trailing  twelve  month  default rate was 3.35%ⁱⁱⁱ. Default rates are on the rise and the strategists on Wall Street are already bumping up  their  forecasts.  Fundamentals  of  high  yield  companies have been mostly good and will no doubt be tested as we move through 2020. From a technical perspective, supply is still tracking higher than last year at this time even including the March shutdown of  the  primary  market.   High  yield  has  certainly  had  trouble  this  year;  however  there  are  now  many  more opportunities present in the market than existed just three months ago. For clients that have an investment horizon over a complete market cycle, high yield deserves to be considered in the portfolio allocation.

With the High Yield Market trading at the current elevated spread level, it is important that we exercise discipline and selectivity in our credit choices moving forward. We are very much on the lookout for any pitfalls as well as opportunities for our clients. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis.  It  is  important  to  focus  on  credit  research  and  buy  bonds  of  corporations  that  can  withstand  economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations. Finally, we are very grateful for the trust placed in our team to manage your capital through such an  unprecedented 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.

i Wall Street Journal March 24, 2020: “Markets Melt Down at Fastest Pace Ever”

ii Wall Street Journal April 1, 2020: “Price War Batters OPEC’s Weak”

iii JP Morgan April 1, 2020: “Default Monitor”

In the fourth quarter of 2019, the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was 2.62% bringing the year to date (“YTD”) return to 14.32%. The CAM High Yield Composite gross total return for the fourth quarter was 2.37% bringing the YTD return to 16.31%. The S&P 500 stock index return was 9.06% (including dividends reinvested) for Q4, and the YTD return stands at 31.48%. The 10 year US Treasury rate (“10 year”) drifted higher throughout the quarter finishing at 1.92%, up 0.26% from the beginning of the quarter. During the quarter, the Index option adjusted spread (“OAS”) tightened 37 basis points moving from 373 basis points to 336 basis points. During the fourth quarter, each quality segment of the High Yield Market participated in the spread tightening as BB rated securities tightened 33 basis points, B rated securities tightened 46 basis points, and CCC rated securities, tightened 22 basis points. 

The Banking, Finance, and Basic Industry sectors were the best performers during the quarter, posting returns of 3.56%, 3.54%, and 3.25%, respectively. On the other hand, REITs, Communications, and Other Financial were the worst performing sectors, posting returns of 1.30%, 1.74%, and 2.00%, respectively. At the industry level, autos, wirelines, pharma, and oil field services all posted the best returns. The automotive industry (4.97%) posted the highest return. The lowest performing industries during the quarter were tobacco, retail REITs, leisure, and cable. The tobacco industry (-3.08%) posted the lowest return. 

During the fourth quarter, the high yield primary market posted $81.4 billion in issuance. Issuance within Consumer Discretionary was the strongest with 18% of the total during the quarter. The 2019 fourth quarter level of issuance was much more than the $16.9 billion posted during the fourth quarter of 2018. Wall Street strategists are calling for slightly less overall issuance in 2020. However, the issuance is likely to remain focused on refinancing. 

The Federal Reserve held two meetings during Q4 2019, and the Federal Funds Target Rate was reduced 0.25% at October meeting and held steady at the December meeting. The rate reduction marked the third move lower of the Target Rate in 2019. While the past four Fed meetings had dissenting members, the vote to hold steady was unanimous among the voting members. Chairman Powell commented, “our economic outlook remains a favorable one despite global developments and ongoing risks. As long as incoming information about the economy remains broadly consistent with this outlook, the current stance of monetary policy likely will remain appropriate.” Although Chair Powell’s comments point to the Fed continuing to hold rates flat; as of this writing, investors are pricing in a 54% probability of a cut by the FOMC during 2020.i While we are interest rate agnostic and do not attempt to time interest rate movements, we are very aware of the impact Fed policy has on the markets. Therefore, we will continue to monitor this very important theme throughout 2020. 

While the Target Rate moves tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries increased 26 basis points over the quarter, as the 10-year Treasury yield was at 1.66% on September 30th, and 1.92% at the end of the quarter. The 5-year Treasury increased 15 basis points over the quarter, moving from 1.54% on September 30th, to 1.69% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Inflation as measured by core CPI has been testing the upper bound of the last several years. The most recent print was 2.3% as of the December 11th report. The revised third quarter GDP print was 2.1% (quarter over quarter annualized rate). The consensus view of economists suggests a GDP for 2019 around 1.8% with inflation expectations around 2.1%. 

The chart above shows that two year to ten year Treasury spread has reached the highest level in over a year. It seems like ages since a main theme was yield curve inversion. The dip in the ratio through August was “driven by deepening pessimism over the global outlook amid rising trade tensions and a string of weak manufacturing data.”ii Since that time, China and the U.S. have reached agreement on Phase 1 of a trade deal, the Fed has begun lowering rates for the first time in over a decade, and investor sentiment has improved.

President Trump was impeached by the House of Representatives in December. The market shrugged off the news fully expecting the Senate to provide an acquittal. Meanwhile, the agreed upon Phase 1 trade deal “will see lower U.S. tariffs on Chinese goods and higher Chinese purchases of U.S. farm, energy and manufactured goods.”iii Additionally, intellectual property protections are to be increased by the Chinese. Across the Atlantic, Brexit is looking more and more likely. Britain’s exit from the European Union still has some hurdles to jump, but U.K. Prime Minister Boris Johnson is pressing to deliver by the January 31, 2020 cutoff.

Being a more conservative asset manager, Cincinnati Asset Management is structurally underweight CCC and lower rated securities. This positioning has served our clients well in 2019. As noted above, our High Yield Composite gross total return has outperformed the Index over the YTD measurement period. With the market remaining robust during the fourth quarter, our cash position remained the largest drag on our overall performance. Further, our structurally underweight of CCC rated securities was a headwind as that group saw a pop in Q4 after lagging in Q2 and Q3. Additionally, our underweight positioning in the energy exploration & production and oil field services industries were a drag on our performance. Further, our credit selections within the consumer non-cyclical sector and wireline industry hurt performance. However, our underweight in the cable industry and our overweight in the consumer cyclical sector were bright spots. Further, our credit selections within the midstream and automotive industries were a benefit to performance. 

The Bloomberg Barclays US Corporate High Yield Index ended the fourth quarter with a yield of 5.19%. This yield is an average that is barbelled by the CCC-rated cohort yielding 10.43% and a BB rated slice yielding 3.63%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), remained fairly muted ending the quarter just under 14 down about 2 points. The fourth quarter had seven issuers default on their debt. The twelve month default rate was 2.63% and has been driven by default volume in the energy and metals & mining sectors. Excluding those two sectors from the data, the default rate would fall to only 1.26%.iv Additionally, fundamentals of high yield companies continue to be mostly good. From a technical perspective, supply has increased from the low levels posted in 2018, and flows have been positive relative to the negative flows of 2018. Due to the historically below average default rates, the higher yields available relative to other spread product, and the diversification benefit in the High Yield Market, it is very much an area of select opportunity that deserves to be represented in many client portfolio allocations. 

With the High Yield Market remaining very firm in terms of performance, it is important that we exercise discipline and selectivity in our credit choices moving forward. With the market seemingly tight on a yield and spread basis relative to the last couple of decades, we are on the lookout for pitfalls as well as opportunities for our clients. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations. 

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 January 2, 2020, 4:00 PM EDT: World Interest Rate Probability (WIRP)
ii Bloomberg December 19, 2019: “Yield Curve Hits Steepest Since 2018 as Inflation Risks Eyed”
iii Reuters December 19, 2019: “China says in touch with U.S. on signing of Phase 1 trade deal”
iv JP Morgan January 2, 2020: “Default Monitor”

In the third quarter of 2019, the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was 1.33% bringing the year to date (“YTD”) return to 11.41%. The CAM High Yield Composite gross total return for the third quarter was 2.30% bringing the YTD return to 13.61%. The S&P 500 stock index return was 1.70% (including dividends reinvested) for Q3, and the YTD return stands at 20.55%. The 10 year US Treasury rate (“10 year”) spent most of quarter in rally mode save for a 40 basis points backup during the first half of September. The 10 year finished the quarter at 1.66%, down 0.35% from the beginning of the quarter. During the quarter, the Index option adjusted spread (“OAS”) tightened 4 basis points moving from 377 basis points to 373 basis points. There was a massive 210 basis points of widening that took place in Q4 2018 and since that time, the OAS has tightened 153 basis points. During the third quarter, the higher quality segments of the High Yield Market participated in the spread tightening as BB rated securities tightened 12 basis points and B rated securities tightened 15 basis points. The lowest quality segment, CCC rated securities, widened 78 basis points.

The Banking, Insurance, and Brokerage sectors were the best performers during the quarter, posting returns of 3.72%, 3.51%, and 3.10%, respectively. On the other hand, Energy, Basic Industry, and Other Industrial were the worst performing sectors, posting returns of -4.38%, 1.25%, and 1.69%, respectively. At the industry level, life insurance, P&C insurance, wireless, and banking all posted the best returns. The life insurance industry (8.06%) posted the highest return. The lowest performing industries during the quarter were oil field services, independent energy, pharma, and wirelines. The oil field services industry (-10.72%) posted the lowest return.

the high yield primary market posted $76.8 billion in issuance. Issuance within Communications was the strongest with 25% of the total during the quarter. The 2019 third quarter level of issuance was much more than the $50.8 billion posted during the third quarter of 2018. Through the first nine months of 2019, issuance has already surpassed the $186.9 posted during all of 2018.

The Federal Reserve held two meetings during Q3 2019, and the Federal Funds Target Rate was reduced 0.25% at both meetings. These were the first reductions to the Target Rate in over a decade. Chairman Powell pointed to “the implications of global developments for the economic outlook as well as muted inflation pressures” as reasoning to begin lowering the Target Rate. Following the second interest rate cut, Chairman Powell noted that “weakness in global growth and trade policy have weighed on the economy.” There were three dissenting votes at the September 18th meeting.

That was the highest number of dissents since 2016. However, it is important to note that one of the dissenting votes was in favor of a 0.50% cut rather than 0.25%, and the remaining two dissenting votes were in favor of no change to the Target Rate. As can be seen in the chart above, the Fed dot plot is currently suggesting that rates won’t change through 2020. As of this writing, investors are pricing in a 62.5% probability of a cut at the FOMC October meeting.i  Also shown in the chart is the rate that the market is pricing in through Fed Fund Futures for the next couple of years. Clearly, the Fed is still out of step from what the market is expecting. While we are interest rate agnostic and do not attempt to time interest rate movements, we are very aware of the impact Fed policy has on the markets. Therefore, we will continue to monitor this very important theme throughout the rest of this year and into 2020.

While the Target Rate moves tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries decreased 35 basis points over the quarter, as the 10-year Treasury yield was at 2.01% on June 30th, and 1.66% at the end of the quarter. The 5-year Treasury decreased 23 basis points over the quarter, moving from 1.77% on June 30th, to 1.54% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Inflation as measured by core CPI was trending lower since the 2.4% print in mid-2018. However, the rate has ticked higher on each of the last three reports. The most recent print was 2.4% as of the September 12th report. The revised second quarter GDP print was 2.0% (quarter over quarter annualized rate). The consensus view of economists suggests a GDP for 2019 around 2.3% with inflation expectations around 1.8%.

The economic picture globally is continuing to dim. The Organization for Economic Cooperation and Development (“OECD”) recently cut the global growth outlook while citing concern over trade tensions. The OECD commented that global growth is now at its lowest level in over a decade.ii Additionally, Moody’s has lowered their outlook on global manufacturing to negative noting that most industries are softening.iii However, as the Federal Reserve is easing monetary policy, other central banks are responding as well. The European Central Bank is stepping up stimulus with a rate cut and a restart of a monthly bond buying program.iv Further, the Bank of Japan is more likely to add additional stimulus at their October meeting after Governor Kuroda commented, “We don’t have any preset idea on whether to act next month. But we’re more keen to ease than before since overseas risks are heightening.”v

One matter of particular interest was the funding market dislocation of mid-September that raised concern of the Fed possibly losing control over short-term interest rates.vi  The term “chaos” was used to describe the repo market which saw Treasury general collateral spike 625 basis points overnight to a high print. To put that spike in context, the repo market has more typical fluctuations in the 10 basis points range. The suggested cause of the dislocation was quarterly tax payments which drew down cash reserves at the same time that Treasury supply was increasing for coupon auction settlements.vii The Federal Reserve Bank of New York (“FRBNY”) stepped in to deliver the first sizable ad hoc repo operation since the global financial crisis. This action and subsequent actions taken by the FRBNY leading into quarter-end helped to bring rates back inline. However, it is a situation to be observed over the balance of 2019. “Just to get through this year end, the Fed will have to inject significantly more reserves, and they will need to do it in a manner that doesn’t cause any other dislocations,” said a repo trader at a large Wall Street bank.

Being a more conservative asset manager, Cincinnati Asset Management is structurally underweight CCC and lower rated securities. This positioning has served our clients well so far in 2019. As noted above, our High Yield Composite gross total return has outperformed the Index over the third quarter and YTD measurement periods. With the market remaining robust during the third quarter, our cash position remained the largest drag on our overall performance. Additionally, our underweight positioning in the communications, banking, and finance sectors were a drag on our performance. Further, our credit selections within the consumer cyclical services, wireless, and healthcare industries hurt performance. However, our underweight in the energy, and pharma sectors were bright spots. Further, our credit selections within the midstream, aerospace/defense, technology, and utility industries were a benefit to performance.

The Bloomberg Barclays US Corporate High Yield Index ended the second quarter with a yield of 5.65%. This yield is an average that is barbelled by the CCC rated cohort yielding 10.73% and a BB rated slice yielding 4.05%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), jumped over 10 points to 25 at the end of July and beginning of August on escalating trade tensions with China. The VIX worked its way lower for the balance of the quarter finishing at 16. The third quarter had six issuers default on their debt. The twelve month default rate was 2.52% and has been driven by default volume in the energy sector. Excluding the energy sector, the default rate would fall to only 1.21%.viii Additionally, fundamentals of high yield companies continue to be mostly good. From a technical perspective, supply has increased from the low levels posted in 2018, and flows have been positive relative to the negative flows of 2018. Due to the historically below average default rates, the higher yields available relative to other spread product, and the diversification benefit in the High Yield Market, it is very much an area of select opportunity that deserves to be represented in many client portfolio allocations.

With the High Yield Market remaining very firm in terms of performance, it is important that we exercise discipline and selectivity in our credit choices moving forward. While the first quarter displayed similar returns across the quality buckets, the second quarter began to show investors differentiating a bit on the lower quality spectrum as the CCC bucket under-performed the broader market. This theme has continued through the third quarter. As more differentiating continues to creep into the higher quality buckets, it is expected that opportunities for our clients will be presented. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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 October 1, 2019, 4:00 PM EDT: World Interest Rate Probability (WIRP)
ii Reuters September 19, 2019: “OECD Cuts Growth Outlook to Post-Crisis Low”
iii Moody’s September 17, 2019: “Outlook revised to negative on lower earnings forecast”
iv The Guardian September 12, 2019: “ECB announces fresh stimulus”
v Reuters September 24, 2019: “BOJ’s Kuroda says any easing will target short-, medium-term rates”
vi Bloomberg September 16, 2019: “Repo Market Chaos Signals Fed May Be Losing Control of Rates”
vii Wells Fargo September 17, 2019: “Repo Running Wild”

viii JP Morgan October 1, 2019: “Default Monitor”

In the second quarter of 2019, the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was 2.50% bringing the year to date (“YTD”) return to 9.94%. The CAM High Yield Composite gross total return for the second quarter was 3.59% bringing the YTD return to 11.07%. The S&P 500 stock index return was 4.30% (including dividends reinvested) for Q2, and the YTD return stands at 18.54%. The 10 year US Treasury rate (“10 year”) spent most of quarter in rally mode finishing at 2.01% and down 0.40% from the beginning of the quarter. During the quarter, the Index option adjusted spread (“OAS”) tightened 14 basis points moving from 391 basis points to 377 basis points. There was a massive 210 basis points of widening that took place in Q4 2018 and since that time, the OAS has tightened 149 basis points. During the second quarter, the higher quality segments of the High Yield Market participated in the spread tightening as BB rated securities tightened 8 basis points and B rated securities tightened 2 basis points. The lowest quality segment, CCC rated securities, widened 10 basis points.

The Banking, Finance, and Insurance sectors were the best performers during the quarter, posting returns of 4.64%, 4.11%, and 3.87%, respectively. On the other hand, Energy, Other Financial, and Basic Industry were the worst performing sectors, posting returns of -0.92%, 1.01%, and 1.66%, respectively. At the industry level, supermarkets, environmental, p&c insurance, and life insurance all posted the best returns. The supermarkets industry (5.35%) posted the highest return. The lowest performing industries during the quarter were oil field services, independent energy, retail REITs, and chemicals. The oil field services industry (-4.37%) posted the lowest return.

During the second quarter, the high yield primary market posted $81.4 billion in issuance. Issuance within Consumer Discretionary was the strongest with 22% of the total during the quarter. The 2019 second quarter level of issuance was much more than the $52.8 billion posted during the second quarter of 2018. When 2019 is complete, there is little doubt that the final issuance for the year will surpass the $186.9 posted during all of 2018.

The Federal Reserve held two meetings during Q2 2019, and the Federal Funds Target Rate was held steady at both meetings. While the Target Rate didn’t move, the real story was the continued shift in messaging by the Fed. The January FOMC statement showed that the Fed was at least thinking about the end of rate increases. i The March FOMC statement moved further in that direction with officials acknowledging weaker economic reports and downgrading their GDP estimates.ii At a conference in early June, Chairman Powell pushed forward the idea of possible rate cuts.iii The market has taken notice and, as of this writing, investors are pricing in a 100% probability of a cut at the FOMC July meeting.iv As can be seen in the chart at the left, the Fed is still currently out of step from what the market is expecting. While we are interest rate agnostic and do not attempt to time interest rate movements, we are very aware of the impact Fed policy has on the markets. Therefore, we will continue to monitor this very important theme throughout the rest of this year and into 2020.

While the Target Rate moves tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries decreased 40 basis points over the quarter, as the 10-year Treasury yield was at 2.41% on March 31st, and 2.01% at the end of the quarter. The 5-year Treasury decreased 46 basis points over the quarter, moving from 2.23% on March 31st, to 1.77% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Inflation as measured by core CPI has been trending lower since the 2.4% print in mid-2018. The most recent print was 2.0% as of the June 12th report. The revised first quarter GDP print was 3.1% (quarter over quarter annualized rate). The consensus view of economists suggests a GDP for 2019 around 2.5% with inflation expectations around 1.9%.

Besides the Fed’s more dovish messaging, the rising trade tensions between the US and China was another major theme over the course of Q2. Throughout the quarter, both countries were increasingly posturing in order to bolster their negotiating position. However, the market was well aware of the G20 meeting taking place in Japan at the end of June. It was likely that new information would come out of a meeting between President Trump and China’s leader Xi Jinping. Now that the G20 has taken place, regarding the trade talks, Trump said “we’re right back on track.”v It has been universally reported that the meeting between the two leaders was very productive on many of the contested issues. However, at this point, it is very probable that the topic of global trade will remain at the forefront of investors’ minds for quite some time.

Being a more conservative asset manager, Cincinnati Asset Management is structurally underweight CCC and lower rated securities. This positioning has served our clients well so far in 2019. As noted above, our High Yield Composite gross total return has outperformed the Index over the second quarter and YTD measurement periods. With the market remaining robust during the second quarter, our cash position remained the largest drag on our overall performance. Additionally, our underweight positioning in the communications, banking, and finance sectors were a drag on our performance. Further, our credit selections within the communications sector and automotive industry hurt performance. However, our underweight in the energy sector and overweight in the consumer noncyclical sector were bright spots. Further, our credit selections within the midstream, consumer services, and healthcare industries were a benefit to performance.

The Bloomberg Barclays US Corporate High Yield Index ended the second quarter with a yield of 5.87%. This yield is an average that is barbelled by the CCC rated cohort yielding 10.14% and a BB rated slice yielding 4.36%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), oscillated a bit throughout the quarter but finished about where it started with a reading of 15. High Yield default volume remained low during the second quarter with only six issuers defaulting. The twelve month default rate was 1.46%. vi Additionally, fundamentals of high yield companies continue to be mostly good. From a technical perspective, supply has increased from the low levels posted in 2018, and flows have been positive relative to the negative flows of 2018. Due to the historically below average default rates, the higher yields available relative to other spread product, and the diversification benefit in the High Yield Market, it is very much an area of select opportunity that deserves to be represented in many client portfolio allocations.

With the High Yield Market remaining very firm in terms of performance, it is important that we exercise discipline and selectivity in our credit choices moving forward. While the first quarter displayed similar returns acrossthe quality buckets, the second quarter began to show investors differentiating a bit on the lower quality spectrum as the CCC bucket underperformed the broader market. As more differentiating creeps into the high quality buckets, it is expected that opportunities for our clients will be presented. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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 January 30,2019: “Fed Folds as Message Shifts to Peak from Pause”

ii Bloomberg March 20, 2019: “Powell’s FOMC Turns Pessimistic and Passive”

iii Bloomberg June 4, 2019: “Powell Signals Openness to Fed Cut”

iv Bloomberg July 1, 2019, 4:00 PM EDT: World Interest Rate Probability (WIRP)

v The New York Times June 29, 2019: “5 Takeaways From the G20 Summit” vi JP Morgan July 1, 2019: “Default Monitor”

In the first quarter of 2019, the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was 7.26%, and the CAM High Yield Composite gross total return was 7.22%. The S&P 500 stock index return was 13.65% (including dividends reinvested) for Q1. The 10 year US Treasury rate (“10 year”) spent most of quarter between a range of 2.79% and 2.60%. However, over the last week and a half of the quarter, treasuries rallied and the 10 year yield dropped the range and finished at 2.41%. The 2.41% yield was down 0.28% from the end of the 2018. During the quarter, the Index option adjusted spread (“OAS”) tightened 135 basis points moving from 526 basis points to 391 basis points. This tightening in Q1 was after the massive 210 basis points of widening that took place in Q4 2018. During the first quarter, every quality grouping of the High Yield Market participated in the spread tightening as BB rated securities tightened 119 basis points, B rated securities tightened 144 basis points, and CCC rated securities tightened 187 basis points.

The Finance Companies, Energy, and Utilities sectors were the best performers during the quarter, posting returns of 9.00%, 8.27%, and 7.81%, respectively. On the other hand, Other Financial, Insurance, and Transportation were the worst performing sectors, posting returns of 5.12%, 6.33%, and 6.34%, respectively. At the industry level, refining, oil field services, pharma, and supermarkets all posted the best returns. The refining industry (12.20%) posted the highest return. The lowest performing industries during the quarter were retail REITs, office REITs, airlines, and life insurance. The retail REIT industry (2.86%) posted the lowest return.

During the first quarter, the high yield primary market posted $74.4 billion in issuance. Issuance within Financials was the strongest with almost 18% of the total during the quarter. The 2019 first quarter level of issuance was a bit more than the $66.4 billion posted during the first quarter of 2018. When 2019 is complete, it is likely that the final issuance for the year will be higher than the $186.9 posted during all of 2018. The Federal Reserve held two meetings during Q1 2019, and the Federal Funds Target Rate was held steady at both meetings. While the Target Rate didn’t move, the real story was the shift in messaging by the Fed. The January FOMC statement showed that the Fed was at least thinking about the end of rate increases.i The March FOMC statement moved further in that direction with officials acknowledging weaker economic reports and downgrading their GDP estimates.ii Additionally, the Fed dot plot was signaling zero rate hikes in 2019 as of the March statement. This was down from a projected three hikes in 2019 from just three months ago. The Fed is still currently out of step from what the market is expecting. Even with no hikes projected in 2019, they are projecting one hike in 2020. However, market participants are currently pricing in a better than fifty percent probability that the Fed cuts rates in 2019.

While the Target Rate moves tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries decreased 28 basis points over the quarter, as the 10-year Treasury yield was at 2.69% on December 31st, and 2.41% at the end of the quarter. The 5-year Treasury decreased 28 basis points over the quarter, moving from 2.51% on December 31st, to 2.23% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Inflation as measured by core CPI has been trending lower since the 2.4% print in mid-2018. The most recent print was 2.1% as of the March 12th report. The revised fourth quarter GDP print was 2.2% (quarter over quarter annualized rate). The consensus view of most economists suggests a GDP for 2019 around 2.4% with inflation expectations around 1.9%.

Over the course of Q1, more headlines had been made about certain parts of the yield curve inverting. Importantly, the much watched 2year/10year has yet to invert and at quarter end maintained a spread of 15 basis points. Additionally, some market participants are not as concerned that the yield curve inverts, but they are focused on the magnitude of inversion. There has been work done suggesting that the central bank is compressing the 10 year by around 65 basis points.iii Further, there are other forces at play that have the ability to move rates meaningfully for a period of time. Recently, a wave of traders hedging their positions in the swaps market helped explain the downward move in treasury rates.iv The prolonged government shutdown was a major news item during the quarter. The shutdown lasted 35 days making it the longest shutdown in US history. Ultimately, the shutdown ended with a short term funding package to provide Congress time to negotiate a deal on immigration and border security. As the short term package approached its deadline, legislation was signed to fund the government through September of 2019. Across the pond, the withdrawal of the United Kingdom from the European Union, known as Brexit, continued to dominate the headlines. Many votes have been held in Parliament to decide the Brexit outcome. However, the debate continues and the eventual ripples around the globe are still far from clear. Finally, the trade negotiations between the US and China are ongoing. The very latest reports suggest that representatives are going line by line over the proposed agreement and the end is likely near.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly underweight CCC and lower rated securities. For the first quarter, each quality cohort posted very similar performance. As noted above, our High Yield Composite gross total return was also very similar to the return of the Index. With the market so strong to start the year, our cash position was the largest drag on our overall performance. Additionally, our underweight in the energy sector and overweight in the consumer cyclical services industry were a drag on our performance. Further, our credit selections within the consumer cyclical services industry hurt performance. However, our overweight in the capital goods sector and midstream industry were bright spots. Further, our credit selections within the midstream, other industrial, and building materials industries were a benefit to performance.

The Bloomberg Barclays US Corporate High Yield Index ended the first quarter with a yield of 6.43%. This yield is an average that is barbelled by the CCC rated cohort yielding 10.52% and a BB rated slice yielding 4.85%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), declined throughout the first quarter moving from a reading of 25 down to 14. High Yield default volume stayed low during the first quarter with only nine issuers defaulting. The twelve month default rate was 0.94% and is the lowest default rate since 2014. v Additionally, fundamentals of high yield companies continue to be mostly good. From a technical perspective, supply remains generally low and flows have been positive during the first three months of the year. Due to the historically below average default rates, the higher yields available relative to other spread product, and the diversification benefit in the High Yield Market, it is very much an area of select opportunity that deserves to be represented in many client portfolio allocations.

With the High Yield Market starting 2019 firing on all cylinders in terms of performance, it is important that we exercise discipline and selectivity in our credit choices moving forward. The first quarter displayed similar returns across the quality buckets, and that is unlikely to remain the case over the balance of the year. As the returns start to diverge, it is expected that more opportunities will present themselves. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also See Accompanying Endnotes enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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 January 30,2019: “Fed Folds as Message Shifts to Peak from Pause”

ii Bloomberg March 20, 2019: “Powell’s FOMC Turns Pessimistic and Passive”

iii Bloomberg December 19, 2018: “For Some, Curve Inversion Isn’t If or When, But How Deep”

iv Bloomberg March 26, 2019: “Here’s Why Bond Yields Plunged So Much Over the Past Week”

v JP Morgan April 1, 2019: “Default Monitor”

In the fourth quarter of 2018, the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was -4.53%, and the CAM High Yield Composite gross total return was -3.41%. For the year, the Index returned -2.08%, and the CAM Composite returned -3.39%. The S&P 500 stock index return was -4.39% (including dividends reinvested) for 2018. The 10 year US Treasury rate (“10 year”) spent most of quarter going lower. It finished at 2.69% which was down 0.37% from the end of the third quarter. While generally range bound between 2.80% and 3.10% for the majority of the year, the 10 year popped both the top and bottom of the range during the fourth quarter as volatility made a comeback. During the quarter, the Index option adjusted spread (“OAS”) widened a massive 210 basis points moving from 316 basis points to 526 basis points. For context, the Index hasn’t posted an OAS north of 500 basis points in over two years. During the fourth quarter, every quality grouping of the High Yield Market participated in the spread widening as BB rated securities widened 148 basis points, B rated securities widened 219 basis points, and CCC rated securities widened 405 basis points.

The Utilities, Banks, and REIT sectors were the best performers during the quarter, posting returns of -1.39%, -2.10%, and -2.57%, respectively. On the other hand, Energy, Finance, and Basic Industry were the worst performing sectors, posting returns of -10.04%, -5.45%, and -5.13%, respectively. At the industry level, airlines, office reits, and supermarkets all posted the best returns. The airline industry (-0.23%) posted the highest return. The lowest performing industries during the quarter were e&p, refiners, and oil field services. The oil field services industry (-16.12%) posted the lowest return.

During the fourth quarter, the high yield primary market posted only $16.9 billion in issuance. Issuance within Energy was the strongest with just over 20% of the total during the quarter. The 2018 fourth quarter level of issuance was significantly less than the $86.2 billion posted during the fourth quarter of 2017. While the 2017 issuance of $330.1 billion was the strongest year of issuance since 2014, the low issuance for 2018 was less than 40% of the 2017 total.

The Federal Reserve held two meetings during Q4 2018. The Federal Funds Target Rate was raised at the December 19th meeting. Reviewing the dot plot from Bloomberg that shows the implied future target rate, the Fed is expected to increase two more times in 2019. This is down from the three additional raises projected at the end of last quarter. However, based off certain market trading levels, traders are actually projecting a Fed cut as early as 2020. i While the Fed continued raising rates, the market has begun contemplating slowing growth and certain parts of the yield curve have started to invert. Since inversion, more research has been published on the meaning an implication. Importantly, the much watched 2year/10year has yet to invert and at quarter end maintained a spread of 19 basis points. Additionally, some market participants are not as concerned that the yield curve inverts, but they are focused on the magnitude of inversion. There has been work done suggesting that the central bank is compressing the 10 year by around 65 basis points.ii While the Target Rate increases tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries decreased 38 basis points over the quarter, as the 10-year Treasury yield was at 3.06% on September 30th, and 2.68% at the end of the quarter. The 5-year Treasury decreased 44 basis points over the quarter, moving from 2.95% on September 30th, to 2.51% at the end of the quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Inflation as measured by core CPI has been moving steadily higher during 2018 from 1.8% to 2.4% and has settled at 2.2% as of the December 12th report. The revised third quarter GDP print was 3.4% (QoQ annualized rate). The consensus view of most economists suggests a GDP for 2019 around 2.6% with inflation expectations around 2.2%.

The midterm elections came and went during the quarter. Much as the market expected, Congress is now divided with the Republican Party maintaining control of the Senate and the Democratic Party controlling the House of Representatives. The oil market maintained a persistent downtrend throughout the quarter on a combination of supply concerns and declining economic growth outlooks. It was a brutal three months as WTI moved from $75 per barrel to $45 per barrel. Another theme during the quarter was the ongoing trade and tariff negotiation between the United States and China. Currently, the two countries are in talks to try and reach an agreement by March 1st. At which time, a trade truce expires and tariffs on $200 billion of Chinese goods will hike to 25%. The resolution of this trade war will undoubtedly be a major focus in 2019 as the implications are vast. As of this writing, Apple has announced a revenue guidance cut from $91 billion to $84 billion citing among other things a slowdown in China.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly underweight CCC and lower rated securities. For the fourth quarter, the focus on higher quality credits did finally bear fruit. As noted above, our High Yield Composite gross total return outperformed the return of the Index by 1.12%. Our underweights in the banking sector and gaming industry were a drag on our performance. Additionally, our credit selections with the other industrial and automotive industries hurt performance. However, our overweight in the consumer non-cyclical sector and underweight in energy were bright spots. Additionally, our credit selections within utilities and healthcare were a benefit to performance.

The Bloomberg Barclays US Corporate High Yield Index ended the fourth quarter with a yield of 7.95%. This yield is an average that is barbelled by the CCC rated cohort yielding 12.55% and a BB rated slice yielding 6.24%. While the yield of 7.95% is up 1.71% from the 6.24% of last quarter, seeing near an 8% yield hasn’t happened in well over two years. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), came out of its shell during the fourth quarter. The VIX ended the third quarter around 12 however; the level elevated in October and November before the big spike above 35 in the second half of December. High Yield default volume stayed low during the fourth quarter with only seven issuers defaulting. The twelve month default rate was 1.08% when iHeart Communications is excluded from the total and remains well below the historical average. iii Additionally, fundamentals of high yield companies continue to be generally solid. From a technical perspective, supply remains very low and could possibly provide some support as investors begin bargain hunting after the higher move in yields. As can be seen in the correlation triangle, high yield also has a diversification benefit relative to equities and investment grade credit. Due to the historically below average default rates, the higher yields available, and the diversification benefit in the High Yield market, it is very much an area of select opportunity that deserves to be represented in many client portfolio allocations.

Over the near term, we plan to remain rather selective. As the riskiest end of the High Yield market showed cracks in the quarter, our clients began to accrue the benefit of our positioning in the higher quality segments of the market. However, one quarter does not make a credit cycle, and we believe that it is over a complete cycle where our clients will gain the most benefit. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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 19, 2018: “Prospect of Fed Cut in 2020 Firms”

ii Bloomberg December 19, 2018: “For Some, Curve Inversion Isn’t If or When, But How Deep”

iii JP Morgan January 2, 2019: “Default Monitor”

In the second quarter of 2018, the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was 1.03%.  For the year, the Index return was 0.16%.  While Treasury rates have generally increased throughout 2018, High Yield is one of the best performing asset classes within fixed income.  As seen last year and also during Q1, the lowest quality portion of high yield, CCC rated securities, outperformed its higher quality counterparts.  As we have stated many times previously, it is important to note that during 2008 and 2015, CCC rated securities recorded negative returns of 44.35% and 12.11%, respectively.  We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC rated cohort may not be appropriate for many clients’ risk profile and tolerance levels.  During the quarter, the Index option adjusted spread widened 9 basis points moving from 354 basis points to 363 basis points.  As a reminder, the Index spread broke the multi-year low of 323 basis points set in 2014 by reaching 311 basis points in late January.  The longer term low of 233 basis points was reached in 2007.  Mid April 2018 had a low spread of 314 basis points essentially retesting the 311 spread of late January.  Every quality grouping of the High Yield Market except CCC rated securities participated in the spread widening as BB rated securities widened 16 basis points, B rated securities widened 9 basis points, and CCC rated securities tightened 45 basis points.

The Energy, Communications, and Electric Utilities sectors were the best performers during the quarter, posting returns of 2.52%, 1.93%, and 1.47%, respectively.  On the other hand, Banking, Consumer Cyclical, and Capital Goods were the worst performing sectors, posting returns of -1.58%, -0.23%, and -0.16%, respectively.  At the industry level, supermarkets, pharma, oil field services, and independent energy all posted strong returns.  The supermarket industry (5.48%) posted the highest return.  However, automotive, tobacco, lodging, and building materials had a rough go of it during the quarter.  The automotive industry (-3.00%) posted the lowest return.

During the second quarter, the high yield primary market posted $52.8 billion in issuance.  Issuance within Financials and Energy was quite strong during the quarter.  The 2018 second quarter level of issuance was significantly less than the $75.6 billion posted during the second quarter of 2017.  Year to date 2018 issuance has continued at a much slower pace than the strong issuance seen in 2017.  The full year issuance for 2017 was $330.1 billion, making 2017 the strongest year of issuance since 2014.  

The Federal Reserve held two meetings during Q2 2018.  The Federal Funds Target Rate was raised at the June 13th meeting.  Reviewing the dot plot that shows the implied future target rate, the Fed is expected to increase two more times in 2018 and three more times in 2019.  However, the Fed will be quite data dependent and likely show flexibility since Chair Powell plans to “strike a balance between the risk of an overheating economy and the need to keep growth on track.”^[1]  While the Target Rate increases tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries increased 12 basis points over the quarter, as the 10-year Treasury yield was at 2.74% on March 31st, and 2.86% at the end of the quarter.  The 5-year Treasury increased 18 basis points over the quarter, moving from 2.56% on March 31st, to 2.74% at the end of the quarter.  Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate.  Inflation as measured by core CPI has been moving steadily higher during 2018 from 1.8% to 2.2% as of the June 12th report.  The revised first quarter GDP print was 2.0%, and the consensus view of most economists suggests a GDP for 2018 in the upper 2% range with inflation expectations at or above 2%.  The chart on the left from Bloomberg shows the yield compression of the 2 year US Treasury versus the 10 year US Treasury over the past year.

While the Fed continues a less accommodative posture, other Central Banks aren’t necessarily following suit.  The Bank of Japan is still buying an annualized JPY45 trillion of Japanese Government Bonds (“JGB’s”) and targeting a JGB yield of 0%.^[2]  The Bank of England is maintaining bond purchases and keeping rates at 0.5%.^[3]  Additionally, the European Central Bank has plans to keep rates where they are for at least another year as Mario Draghi recently commented “at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path.”^[4]  This backdrop has no doubt been a factor in the US Dollar appreciation during the second quarter of 2018.  As can be seen in the charts below from Barclays, growth is increasingly driven by the US and policy is becoming more divergent.

Investors had high expectations for the G7 Summit in Quebec in early June due to the United States’ positioning on global trade.  However, the Summit left much to be desired.  President Trump decided to leave early and withdraw support from the joint statement.  Canada, France, and Germany all spoke out against the US President following the meeting.  IMF’s Christine Lagarde noted that there is a risk to global growth with the escalating threats of a trade war.^[5]  So while US growth has been improving, trade is a risk that needs to be monitored as the US continues to push for a shake up of the global status quo.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly underweight CCC and lower rated securities.  For the second quarter, the focus on higher quality credits was again a detriment as our High Yield Composite gross total return underperformed the return of the Bloomberg Barclays US Corporate High Yield Index (-0.20% versus 1.03%).  The higher quality credits that were a focus tended to react more negatively to the interest rate movements.  Our credit selections in the capital goods, communications, and healthcare were an additional drag on our performance.  However, our credit selections in the food & beverage and metals & mining industries were a bright spot.  Additionally, our underweight in the energy sector hurt performance.  Our credit selection within the midstream subsector was a benefit to performance. 

The Bloomberg Barclays US Corporate High Yield Index ended the second quarter with a yield of 6.49%.  This yield is an average that is barbelled by the CCC rated cohort yielding 8.84% and a BB rated slice yielding 5.40%.  The Index yield has become more and more attractive since the third quarter of 2017.  Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index, has trended down from the first quarter of this year but is still elevated relative to 2017.   High Yield default volume was very low during the second quarter, and the twelve month default rate decreased to 1.98%.^[6]   The current default rate remains significantly below the historical average.  Fundamentals of high yield companies continue to be generally solid.  Moody’s recently published results of a survey they conducted on the effects of the Tax Cut and Jobs Act.  The results showed that across the credit spectrum, the majority of companies expect to be better off and have improved cash flow.  Finally, from a technical perspective, while flows have continued to be negative in High Yield, demand (coupon + flows) is outstripping supply (issuance + redemptions).  This positive backdrop is likely to provide support for the market especially as sizeable coupon payment demand begins to kick in towards the end of the year.  Due to the historically below average default rates and the higher income available in the High Yield market, it is still an area of select opportunity relative to other fixed income products.  

Over the near term, we plan to remain rather selective.  When the riskiest end of the High Yield market begins to break down, our clients should realize the benefit of our positioning in the higher quality segments of the market.  The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis.  It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy.  As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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.