Category: Investment Grade Quarterly

Investment grade corporate credit experienced positive performance during the quarter with a one-two punch of lower Treasury rates and tighter credit spreads. As a result, investors were able to claw back some of the losses that were incurred during the first quarter of 2021. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index compressed 11 basis points during the quarter, opening at 91 and closing at 80.

Lower Treasury rates benefited returns during the quarter as the 10yr Treasury opened at 1.74%, drifting lower throughout the stanza before finishing at 1.47%. Recall that the 10yr moved 83 basis points higher during the first quarter which was the primary driver of negative performance during that period. The Corporate Index posted a total return of +3.55% during the second quarter. This compares to CAM’s gross quarterly total return of +2.78%. Through the first six months of 2021, the Corporate Index total return was -1.27%, while CAM’s gross year-to-date total return was -0.81%.

Portfolio Management & Positioning

We often find ourselves fielding questions from investors regarding the difference between our portfolio and the investment grade universe so we will walk through and refresh some of the ways that we differentiate. We build our investors highly customized separately managed accounts. Unlike a mutual fund or ETF, our clients know what they own within their portfolios down to the exact issuer and quantity. This is important for the individual investor because of the complete transparency it provides. Each individual account will be built with 20-25 positions. The invest-up period will occur over what we like to refer to as an abbreviated economic cycle, generally a period of 8-10 weeks that allows us to invest over a myriad of rate and spread environments.

Relative to the Bloomberg Barclays Corporate Index, we would best be described as “index aware” rather than looking to track or hug the benchmark. At the end of the day, we aim to provide our investors with a return that is as good or better than the Corporate Index but we would like to get there by taking less credit risk and less interest rate risk while incurring limited volatility along the way.

We manage credit risk through our bottom up research process. We thoroughly study each holding within the portfolio, evaluating individual credit metrics, looking to populate our investor portfolios with stable to improving credits that provide an opportunity to benefit from credit spread compression. Our composite consists of 100 issuers and 340 individual bond issues. The Corporate Index had 6,817 individual issues at the end of the second quarter, 4,290 of which would be classified as intermediate maturities, where we primarily invest. Simply put, we are highly selective while populating our investor portfolios and our research process dismisses a large percentage of the investable universe. We also have some hard and fast rules on the quality of our portfolio, the biggest of which is our 30% limitation to BAA-rated credit. BAA-rated bonds represent the riskier portion of the investment grade universe and the corporate index was 51.4% BAA-rated at the end of the second quarter, leaving CAM with a material underweight in lower quality credit relative to the index. Our up-in-quality bias allows us to target a solid A3 rating for each individual separately managed account.

As far as interest rate risk is concerned, we limit ourselves to intermediate maturities. During the invest-up period, we will populate new portfolios with maturities that range from 8 to 10 years. Then we will take advantage of the steepness of the 5/10 Treasury curve as well as the slope of the intermediate corporate credit curve, allowing those bonds to season, rolling down to the 5 year mark, at which point they will be ripe for sale and opportunistic redeployment of proceeds back into the 8-10 year range. This is one of the reasons we advise our investors to look at our portfolios with a 3-5 year time horizon, at a minimum, if they would like to get the most out of the strategy. As a result of our intermediate positioning, our composite modified duration at the end of the second quarter was 6.4 while the Corporate Index had a modified duration of 8.7.ⁱ We wrote at length on curves in our 1st quarter 2021 commentary and would encourage you to revisit if you would like to learn more.

As always, although we are attempting to maximize total return, the primary focus of our strategy is preservation of capital. We are not infallible but rarely will you see us pick up pennies in front of the proverbial steam roller to eke out a few extra basis points of return. Our decision process always comes down to risk and reward and although we will certainly take risks for the right reasons, our investors must be appropriately compensated.

Current Market Conditions

2020 will be a year that was remembered for liquidity runway, something that is not often associated with investment grade rated borrowers. Due to the uncertainty surrounding the depth and severity of the pandemic, we saw issuers rush to the new issue market in 2020 in an effort to bolster their balance sheets. In many cases, these were extremely high quality issuers who did not necessarily need to borrow, but at that time the mentality had become “borrow when you can, not when you have to”. Records for new issuance volume were shattered in 2020 as a result of this borrowing binge and the Corporate Index (excluding Financials) net leverage ratio rose from 2.5x at the end of Q1 2020 to 3.6x at the end of Q4 2020.ⁱⁱ There is evidence that the peak has passed as net leverage has since ticked down to 3.5x at the end of Q1 2021.ⁱⁱⁱ It stands to reason that now, as North American economies are largely re-opened or getting more open by the day, we will continue to see an increase in earnings by those sectors most affected by the pandemic. There is reason to be optimistic about credit conditions as earnings rebound, borrowing abates and debt pay down follows suit. That said there are several risks that continue to loom through 2021 and beyond: lingering worries regarding inflation, Federal Reserve tapering and tight spread valuations amid a backdrop of eager lenders.

The first two risks really go hand in hand –mounting inflationary pressures and the associated FOMC response. It is likely that each of our readers has experienced price increases in one way or another but the Fed insists that much of these will be “transitory” in nature. We tend to agree with the Fed on this one and we revert to the official definition of inflation which is an unrelenting broad-based and sustainable increase in prices across the board. We, like the Fed, would argue that just because the cost of some goods have increased due to things like inventory and production shortages or a disruption of the semiconductor supply chain, it does not mean the table is set for runaway inflation. We believe that as inventory levels are right-sized and household balance sheets deploy excess capital, supply and demand will find equilibrium over time. Additionally, there are still millions of Americans that are unemployed and as federal unemployment assistance reverts to more normalized historical levels it will result in easing price pressures as workers rejoin the labor force. As far as the FOMC response is concerned, the results from the June meeting showed that the median projection is for an unchanged Fed funds rate in 2021 and 2022 with two rate hikes in 2023. While rate hikes are important for the front end of the yield curve, it is tapering that is the more immediate concern, in our view. We argue that technically the Fed has already begun tapering with its exit from the corporate bond market and the sale of its holdings which began in June of this year.^iv Its corporate bond holdings, however, were miniscule in the grand scheme of things, at less than $14 billion total. Much larger pieces to this puzzle are its monthly purchases of Treasury securities at $80 billion and mortgage-backed securities at $40 billion. The Fed has yet to supply a timeline of when it will start to normalize its policy, perhaps dialing back on these purchases, but the market is now expecting a possible announcement on tapering at the end of August during the Fed’s Jackson Hole policy symposium. We think that the Fed will continue to be deliberate and cautious in its messaging and that it will be able to avoid a taper-tantrum like event, but we do acknowledge the risks associated with this view.

As far as the credit market goes, we do have some concerns about current valuations in some portions of the market but we also believe spreads can go tighter from here, especially in more non-discretionary sectors. The areas of uneasiness are largely corners of the market that are highly levered to reopening such as automotive, unsecured airlines, leisure, gaming, lodging and restaurants. The bonds of many of these companies are priced to perfection and some of the companies have borrowed to fund their way through the pandemic. It will take time to repair these balance sheets and unless the rosiest of reopening scenarios come to fruition these companies will not be able to remain investment grade rated entities. We are taking little to no exposure for our portfolio in these areas and ironically they have been some of the best performing portions of the bond market year to date. This illustrates our point about lenders and investors that are perhaps too eager to lend to such entities and what we would classify as classic “reach” in the search for yield. We may sacrifice some near term performance by not participating in these riskier areas of the market but we manage the portfolio with an eye on the long term and will continue to do so. While there is a risk that we could be wrong and these sectors will in fact live up to the most optimistic predictions, we remain skeptical.

Halfway Home

We have a sense of guarded optimism as we enter the second half of the year but risks remain. Unfortunately, the pandemic is not over and continues to rage on in some portions of the world. Thankfully, vaccination progress has the potential to achieve global normalization over the course of the next year, but variants and vaccine-resistant strains could threaten this timeline. The FOMC will remain in the spotlight as it attempts to manage investor expectations and craft its moves carefully. We at CAM plan to stick to the script. We will not be making wholesale changes to our strategy and we will likely be taking less risk than usual in the coming months given the current risk reward backdrop we are seeing in our market. Please reach out to us with any questions or concerns. We thank you for your continued interest and for placing your trust and confidence in us to manage your money.

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 A representative sample of a newly invested individual separately managed account had a modified duration of 8.4 at 06/30/2021
ii Barclays, June 23 2021 “US Investment Grade Credit Metrics Q1 21 Update”
iii Barclays, June 23 2021 “US Investment Grade Credit Metrics Q1 21 Update”
iv Reuters, June 2 2021 “NY Fed says it will begin to sell corporate bond ETFs on June 7”

It was a challenging first quarter for corporate bonds as rising interest rates were a headwind for performance across the fixed income universe. Investment grade credit spreads were a bright spot, having shown resiliency during the quarter, but tighter spreads could not overcome volatile interest rates. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index compressed 5 basis points during the quarter, opening at 96 and closing at 91. It was only a little more than a year ago when the global pandemic had roiled markets, sending the spread on the index all the way out to 373. The tone has improved substantially since last March and spreads are now tighter than their narrowest levels of last year when the index opened 2020 at an OAS of 93.

Higher Treasuries were the negative driver of performance for credit during the quarter. The 10yr Treasury opened 2021 at 0.91% and was volatile along the way before closing the quarter at 1.74%. This 83 basis point move in the 10yr over such a short time period was too much to overcome for coupon income and spread compression. The Corporate Index posted a total return of -4.65% during the first quarter. This compares to CAM’s gross quarterly total return of -3.50%.

First Quarter Recap

Excess return presents a picture of the performance of credit spread and coupon income, excluding the impact of Treasuries. The sector that posted the best excess returns to start the year was Energy. This should come as no surprise as oil prices were up over 20% during the quarter and Energy was the worst performing sector for the full year 2020. It was ripe for a rally. Packaging was the lone major industry to post a negative excess return during the quarter of just -0.05%. This is in line with the larger theme in the market currently that has made more cyclical sectors in vogue as the pandemic recovery trade was in full force. This has left some more stable and defensive industries as out of favor at the moment. The recovery trade theme has also led to outperformance for riskier BBB-rated credit versus higher quality A-rated credit. BBB-rated credit outperformed A-rated during the quarter to the tune of 85 basis points on a gross total return basis – a significant number to be sure. We will see, as the year plays out, if this reach for yield can sustain its outperformance over a longer time horizon. We believe that some of the move in cyclicals has been overdone and as a result the portfolio is positioned with a more defensive posture than the index.

Investing in a High Rate World

After the corporate index posted a cumulative gain of almost 25% over the previous two years through the end of 2020, most of it on the back of tighter spreads and lower rates, it is fair to expect a pull-back at some point. The current quarter’s performance can almost entirely be defined by Treasuries reclaiming some of the ground that they gave up during the pandemic. Recall that the 10yr Treasury closed as high as 1.88% in the early months of 2020 before falling as low as 0.51% in August of last year and now closing the first quarter of 2021 at 1.74%. But there is more to the story than a higher 10yr Treasury and a closer look at the Treasury curve reveals some more interesting details, particularly the spread between the 5yr and 10yr Treasury. As you can see from the below chart, the 5/10 Treasury curve has steepened substantially over the course of the past year.

CAM consistently positions the portfolio in maturities generally ranging from 5-10 years and there are several reasons that we have structured our investment grade program around this intermediate positioning. First, our customers will know precisely what they are going to get from us in that they can see the exact quantity of each individual company bond that they own and they can count on us to be positioned within a certain maturity band. This allows the client to more effectively manage other portions of their asset allocation accordingly without worrying that we might engage in interest rate speculation or a wholesale change in strategy. The second reason we have settled on this maturity positioning is that it exposes clients to less interest rate risk than the benchmark and far less interest rate risk than if we went further out the curve by purchasing 30yr bonds. We are good at credit work; building customized portfolios, populating them with individual credits based on our analysis of their credit worthiness and reaping those rewards over a 3-5 year time horizon. Our intermediate positioning allows our returns to be driven by credit spread compression and not by our ability to accurately time interest rates. The third and perhaps most important reason that we settled on this intermediate positioning as part of our core strategy has to do with the steepness of both the Treasury curve and the corporate credit curve from 5 to 10 years. Over long time periods this tends to be the steepest portion of both of those curves relative to the curve as a whole.ⁱ To provide some context, at quarter end, the 10/30 Treasury curve was 67 basis points; that is, the compensation afforded for selling a 10yr Treasury and buying a 30 year Treasury was an additional 67 basis points in yield, or 3.35bps of yield per year for each year of the 20 year maturity extension. If we compare this to the 5/10 curve at quarter end when that particular curve was 80 basis points, or 16 basis points of extra yield for each of the 5 years between 5 and 10yrs, you can see that the 5/10 curve is significantly more steep than the 10/30 curve. You are extracting much more compensation from selling a 5yr bond and extending to 10yrs than you would get from selling a 10yr bond and moving all the way out to 30 years. Not only is an investor being much better compensated for each additional year from 5/10 but they are taking substantially less interest rate risk by limiting their extension to just 10 years in lieu of 30 years. As you can see from the above chart, the 5/10 curve flattened all the way down to 7 basis points during the worst of the pandemic-related market dislocation but it has since steadily risen, and is now at its highest level since the 3rd quarter of 2014.

To say we are excited about this newfound steepness in the Treasury curve would be an understatement –we are ecstatic, as it allows us to do two things. First, it allows seasoned accounts (those who have been with us at least 3-5 years) to extract attractive compensation by selling their 5yr corporate bonds and using those proceeds to purchase bonds that mature in 8 to 10 years. For those accounts that have been with us for less time or for new accounts it provides an attractive entry point for new money that can take advantage of the roll-down afforded by the steep yield curve. The roll-down to which we refer is the aforementioned 16 basis points per year that a bond was receiving at quarter end for each year that it declined in maturity.
But the bond math doesn’t stop there. On top of the Treasury curve is another curve, the corporate credit curve. Since corporate bonds trade with spread on top of Treasuries they also have their own curve that varies with steepness over time. The shape of the corporate credit curve is more consistently upward sloping than the Treasury curve. Treasury curves, at times, can flatten or even invert. The corporate credit curve on the other hand is almost always upward sloping.ⁱⁱ It only rarely flattens or inverts on a temporary basis during times of extreme market stress or dislocation, and we are happy to take advantage of those fleeting opportunities when they do appear.

As you can see from the chart above, the yield curve for investment grade corporates shares some of the current qualities of the Treasury curve with a pronounced steepness in the belly of the curve and a much flatter slope beyond 10 years. The beauty of these curves is that, even in the unlikely event that Treasuries and credit spreads stay static over the next 5 years we can still generate a positive total return from coupon income and capital appreciation through the roll-down of bonds currently held. Additionally, the steepness afforded by curves currently offers us some protection from rising rates and/or wider credit spreads.

Our proven strategy seeks to provide clients with a transparent separately managed account that provides a return that is good as or better than the Bloomberg Barclays U.S. Corporate Index. We also want to get them there with less volatility through diminished interest rate risk and credit risk along the way. One of the reasons we outperformed the index by 115 basis points during the first quarter was by virtue of our intermediate positioning. Our portfolio ended the quarter with duration of 6.30 while the index had duration of 8.48.

Looking Ahead

Preservation of capital is at the forefront of our strategy so we hate to post a quarter with a negative total return and we know that our investors feel the same way. Thankfully, given the way that bond math works, and especially for investment grade rated credit, such impairments are typically temporary in nature. Take for example a bond that is trading at a discount to par –as time passes and it gets closer to its maturity date, its price gets closer to par, all else being equal. Discount bonds eventually recapture their value as time goes by – it is just a function of the way that the math works. As regular readers know, even in good times after we post a great quarter, we are loath to focus on such short term performance. Investment grade rated corporate credit is at its best when it is treated as a strategic long term allocation that is part of a well-diversified portfolio. In fact, one of the reasons to own this asset class is to aid in that goal of achieving diversification due to its low correlation with other asset classes and its often negative correlation with equities. Bottom line, if an investor is looking for income, diversification and capital preservation as well as a chance to keep up with and/or beat inflation, then investment grade credit is among the ideal asset classes for helping to achieve those goals. After a volatile first quarter we have a guarded optimism and believe there is an attractive opportunity set for our investment philosophy going forward. We thank you for your continued interest and for placing your trust and confidence in us to manage your money.

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 Federal Reserve Board, June 2006 “The U.S. Treasury Yield Curve: 1961 to the Present”
ii Robert C. Merton, May 1974 “On The Pricing of Corporate Debt: The Risk Structure of Interest Rates

Investment grade corporate bonds rode a roller coaster in 2020 so it should be no surprise that, after peaks and valleys, spreads finished the year nearly right where they started. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index opened the year at 93, but soon thereafter, pandemic induced uncertainty gave way to panic stricken selling, sending the OAS on the index all the way out to 373 by the third week of March– its widest level since 2009, during the depths of The Great Recession. On March 23, the Federal Reserve announced extensive measures to support the economy and liquidity within the bond market and spreads reacted in kind, grinding tighter. There were pockets of volatility along the way, but absent a few hiccups it has been a one-way trade of tighter spreads since the end of March, with the OAS on the index finishing 2020 at 96; a mere 3 basis points wider on the year.

Lower Treasuries were the biggest driver of performance for credit during the year. The 10yr Treasury opened 2020 at 1.92% and closed as low as 0.51% at the beginning of August before finishing the year at 0.91%. The Corporate Index posted a total return of +3.05% during the fourth quarter and a full year total return of +9.89% for 2020. This compares to CAM’s gross quarterly total return of +1.86% and full year gross return of +8.73% for 2020.

2020 Investment Grade Returns – What Worked & What Didn’t?

The big winner in 2020 was duration, with lower rates leading to higher prices for bonds, all else being equal. Although the Corporate Index was up almost 10% for the year, excess returns, which measure the performance of corporate credit excluding the benefit of lower Treasury rates, were modest. The sectors that posted the best excess returns in 2020 were Basic Industry, Technology and Financials. At the sector level, Energy was the worst performer with an excess return of -5.97%, with particular underperformance for Independent Energy, which as an industry posted a 2020 excess return of -11.27%. Also at the industry level, Airlines predictably underperformed, with a 2020 excess return of -8.91%.

What to Expect in 2021?

With equity indices at all-time highs and yields on corporate bonds at all-time lows, where do we go from here? In our opinion, the theme for 2021 should be one of guarded optimism. Vaccinations have been approved and are being administered and there are more in the pipeline. Healthcare providers have become more adept at managing care and therapeutic treatments are more readily available. The policy response from the Federal Reserve has been strong and the Fed stands ready and willing to lend more support if it is needed.

As far as investment grade bonds are concerned, we expect a transition to occur as we enter 2021 and that the script will flip from 2020’s broad based risk rally to more of a credit pickers environment in 2021, where bottom up fundamentals become more important and investment managers must carefully evaluate the risks and potential rewards for each individual position within a portfolio. Credit spreads and Treasuries are beginning the year at levels that do not set-up well for the type of returns we experienced in 2019 and 2020, when the corporate index tallied gains of +14.54% and +9.89%, respectively. But outsize returns over short time horizons are not the best case for owning investment grade corporate bonds. Advisors and clients that we talk to favor investment grade corporate bonds for their low volatility, the diversification benefit they provide to an overall portfolio or their ability to generate income in a safer manner than relatively more risky asset classes. These traits are magnified over longer time horizons and thus the asset class lends itself to being more strategic in nature as an allocation within a portfolio.

As we turn the page to the New Year we see several factors that could lend support to credit spreads in 2021.

• Lower New Issue Supply in 2021 – Investment grade borrowers issued nearly $1.75 trillion of new debt in 2020 which shattered the previous record by 58%ⁱ. Bond dealers are expecting as much as $1.3 trillion of issuance in 2021, but most estimates are falling around $1.1 trillion. Even at the high end of the estimated range, the expectation is for substantially less supply. Demand overwhelmed supply the last several months of 2020 as evident by oversubscribed order books and narrow new issue concessions (the extra compensation/yield that issuers use to compensate investors in order to entice them to buy their new bonds versus their existing bonds). An environment with excess investor demand is supportive of spreads in the secondary market.
• It’s Just Math: Global Edition – Even though US nominal yields are low, they are still meaningfully higher than foreign investors can find elsewhere. There was $17.8 trillion in negative yielding debt around the globe at the end of 2020ⁱⁱ. The following developed countries had negative 10yr sovereign bonds at conclusion of the year: France, Germany, Netherlands, and Switzerland. Sweden had a 10yr yield at year end of 0.009% and Japan was at 0.013%. Simply put, foreign investors have very few options, and many, such as pensions and insurance companies, must generate a return by investing in high quality assets. The U.S. investment grade credit market is the largest, deepest and most liquid bond market in the world by an order of magnitude. There is some nuance at play here in that these investors must account for hedging costs and that can cause demand to ebb and flow at times but they will remain an important fixture in our market for the foreseeable future and their demand is a technical tailwind for spreads.
• Improving Economy – We expect that the economy will see solid improvement in 2021 but that it will be highly industry/company specific. Some industries are still significantly impaired, and some will be impaired permanently. There will be some opportunities in industries that are facing temporary headwinds. As earnings recover it will be important for an investment manager to differentiate among those companies who will use the earnings recovery for balance sheet repair versus those who may choose to engage in M&A, shareholder rewards or adopt a more aggressive financial policy by operating with higher leverage.
• Yields are Low, but Curves are Steep – Of particular importance to an intermediate manager like CAM, is the steepening that we have seen in the 5/10 Treasury curve. If you are a repeat reader, you know that we are interest rate agnostic and that we typically buy 8-10yr bonds and allow those bonds to roll down the curve to 4-5yrs before we sell and redeploy the proceeds back out the curve. The 5/10 curve ended the year at 55 basis points which was near its highest levels of the year, after averaging less than 35 basis points during 2020. For context, the 5/10 curve closed above 30 on only one day for the entire two year period from the beginning of 2018 to the end of 2019. A steeper curve allows for more attractive extension trades and offers better roll-down potential for current holdings. It is a mechanism that allows a manager to generate a positive total return despite a low rate environment.

Like any investment process, there are risks to our view as well.

1. Inflation – We think that 2021 will be a year that is rife with inflation scares and that it could lead to volatility in Treasuries and corporate bond valuations. In fact, the first trading day of 2021 generated a headline as the 10yr breakeven rate surpassed 2% for the first time in over 2 yearsⁱⁱⁱ. The breakeven rate implies what market participants expect inflation to be in the next 10 years, on average^iv. We do think that we will see inflation in 2021 but that it will be isolated pockets of higher prices confined to specific sets of circumstances. We have already seen this happen for some goods, such as lumber and building materials and we expect to see the same when demand increases for items like airline travel and indoor dining. The official definition of inflation, however, is a broad based and sustainable increase in prices. The U.S. consumer has been resilient, but consumer spending has been biased toward upper middle class and high income households who have been less affected financially by the pandemic. The overall unemployment rate remains high at 6.7% and it is significantly worse for those workers with lower educational attainment. The unemployment rate for those 25 years and over with less than a high school diploma is 9% and those with a high school diploma and no college is 7.7% while those with a bachelor’s degree or higher have a 4.2% unemployment rate^v. In our view, without a more complete recovery across the entirety of the labor market, it is unlikely that the economy will experience significant inflation.
2. Slower Economic Recovery – Risk assets are at all-time highs and it appears that good news surrounding vaccines and economic recovery is fully priced as far as valuations are concerned. This leaves little room for error if expected outcomes do not meet lofty expectations. Domestically, the initial vaccine rollout fell short of its goal, having administered only 4.2 million doses by year end versus a target of 20 million^vi. The scientific community is also concerned with new variants of Covid-19, with the UK strain having recently been identified in the U.S.^vii and some epidemiologists’ are questioning vaccine efficacy on a newly identified strain found in South Africa^viii. We are also concerned about the lingering economic impact that the pandemic may have on small business. While small business optimism has rebounded smartly from the depths of the crisis, many of these firms do not have the financial wherewithal to survive a more prolonged recovery^ix.

CAM’s Portfolio Positioning

Our investment strategy has remained consistent in its approach, with a focus on bottom-up fundamentals. It was a challenging year that required constant adaptation to market conditions and the investable opportunity-set at any given point in time. In March and April, we were extremely involved in the new issue market, as concessions rose and high quality borrowers tapped the market to shore up their balance sheets. We were also able to invest in shorter maturities as forced selling caused dislocation across corporate credit curves creating opportunities to buy shorter bonds at yields that were equal or greater to longer maturities. As market conditions normalized throughout the second half the year, we took a more balanced approach between the new issue market and the secondary market. Our focus remained biased toward higher quality credit and sectors of the market that were less levered to the re-opening of the economy and those industries that benefited from more work and leisure time spent at home. As we head into the first quarter of 2021 we continue to favor companies with strong balance sheets and stable credit metrics as the entire market has continued to rally into the New Year. As spreads and yields compress, the incremental compensation afforded from taking additional credit risk has skewed risk-reward to the downside. The “buy the dip” trade has played out in our view and we are scrutinizing the capital allocation strategies of each of the companies in our portfolio. 2021 could be the year were there is a more clear bifurcation between those companies who will exit the pandemic stronger and those who will languish because the business is saddled with too much leverage and unable to effectively compete in the marketplace. As always, preservation of capital will continue to be at the forefront of our decision process.

We wish you a happy, healthy and prosperous New Year. Thank you for your business and continued interest.

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 15, 2020 “Freeze to Frenzy, Corporate Bonds Bounce Back”
ii Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value USD
iii Bloomberg News, January 4, 2021”Treasuries Inflation Gauge Exceeds 2% for First Time Since 2018”
iv Federal Reserve Bank of St. Louis (T10YIE)
v U.S. Bureau of Labor Statistics, December 4, 2020 “Employment status of the civilian population 25 years and over by educational attainment”
vi The Hill, January 4, 2021, “Operation Warp Speed chief adviser admits to ‘lag’ in vaccinations”
vii The Wall Street Journal, January 4, 2021, “Highly Contagious Covid-19 Strain Has Been Found in New York State, Gov. Cuomo Says”
viii Bloomberg, January 4, 2021, “South African Covid Strain Raises Growing Alarm in the U.K.”
ix NFIB, December 8, 2020, “NFIB Small Business Economic Trends – November”

Corporate credit turned in a solid performance during the third quarter. Spreads were tighter, with the option adjusted spread on the Bloomberg Barclays U.S. Corporate Index opening the quarter at 150 and closing the quarter at 136. Treasuries were almost unchanged on the quarter with the 10yr Treasury opening at 0.66% and closing at 0.68%, but that does not tell the whole story of the volatility that was experienced throughout the period. The 10yr closed as low as 0.51% on August 4th and as high as 0.75% on August 27th with the average coming in at 0.64%. The Corporate Index posted a total return of +1.54% during the quarter with a year-to-date tally of +6.64%. This compares to CAM’s gross quarterly total return of +1.76% and year-to-date gross return of +6.74%.

Investment Grade Bonds – Where is The Value?
We have been at this a long time and the lightning quick risk reversal we have experienced in 2020 is the type of thing that only comes around once every decade or so. Going back to March 20, the Corporate Index closed that day with a year-to-date total return of -10.58%, but quickly rebounded over +17.2% through the end of the third quarter, a period of just over 6 months from the low. In March, the risk reward for corporate credit was very attractive, especially for extremely high quality A-rated credit. The spread on the Corporate Index traded north of 370 during the spring malaise, a level not seen since the financial crisis in early 2009, which is the last time we saw such a tremendous spread rally.

Now that the market has rallied so far so fast, clients are asking about the valuation of IG credit. Some clients are even wondering if it is worth owning IG bonds at all. For most investors, it is important to remember that IG credit is but one part of a well-diversified portfolio. Most of our clients own IG credit as a way to generate income, diversify away from equities or dampen overall portfolio volatility. We think that IG credit is still attractive for a few reasons and that the asset class still has a key part to play in an investor’s overall asset allocation.

Spreads still present opportunity in our view, particularly when looking at the percentage of yield that is comprised of credit spread. Remember that there are two components of yield as a corporate bond investor: the yield of the underlying Treasury at the time of purchase and the corporate credit spread on top of that Treasury yield. For example if the purchase of a security occurred while the 10yr Treasury was 0.70% and the corporate credit spread of the security was trading at 200 basis points then the yield to maturity for that particular bond purchase would be 2.70%. In this case we would calculate the spread component of our overall yield by dividing 200/270bps arriving at a figure of 0.74%, which is very high by historical standards.

As you can see from the above charts, as the yield on the index has fallen, the percentage of yield that is comprised of credit spread has risen. This gives us two items that make us feel reasonably optimistic about the current level of spreads. If the economy is slow to recover from the pandemic, and Treasury rates remain near historical lows for an extended period, then spreads could well grind tighter, to a ratio that is more in line with the historical level of compensation relative to interest rates. On the other hand, if the economy recovers more quickly than the market currently anticipates, then we would expect a gradual increase in interest rates toward pre-pandemic levels. In the “quicker recovery” scenario, because the economy would be improving, then the path of least resistance would be tighter credit spreads which would help to offset rising interest rates. Recall that the spread on the index opened the year at 93 versus 136 at the end of the third quarter, so it is not hard to imagine tighter credit spreads from current levels amid an environment of more robust economic growth.

We are also monitoring several technical tailwinds that could be supportive of credit spreads for the remainder of 2020 and beyond. First, investor demand for corporate credit has been robust in 2020, with over $203 billion in net inflows into high grade funds through the end of the third quarterⁱ. Second, there has been a resurgence in the foreign bid for $USD credit. The Bloomberg Barclays Global Aggregate Negative Yielding Debt Index closed September at -$15.5 trillion, not terribly far from its all-time high of -$17 trillion in August of 2019. Asia is one of the largest buyers of $USD IG credit and overnight Asian buying has been substantially positive every month for the past year and Asian demand was especially large in March, April and May of this yearⁱⁱ. Third and finally, we are looking for supply to slow substantially going forward. 2020 has seen a tidal wave of new issue supply as companies have been keen to meet the aforementioned investor demand with new corporate bond issuance. Through the end of the third quarter, companies had issued a record breaking $1.542 trillion in new debt, +67% ahead of 2019’s paceⁱⁱⁱ. The level of issuance has been so robust that it is unlikely to keep pace going forward as companies have largely completed their liquidity boosting and refinancing endeavors. We expect that companies in certain sectors that are more exposed to the economic slowdown will continue to tap the market for liquidity, but we do not anticipate nearly as much supply from those in less affected sectors. Not only that, but M&A activity is typically a large driver of supply, and it has dwindled to a standstill amid pandemic-related uncertainly. Of 200 IG deals in the 3rd quarter, fewer than 10 were tied to acquisitions bringing the year-to-date total to 20 acquisition-related deals versus 31 over the same time period in 2019^iv. Less new issue supply often creates an environment that is supportive of credit spreads as investors must put their money to work in existing bonds.

Understanding the Risks
Opportunities are not without risk. Some risks loom large, like presidential and congressional elections that are just around the corner that will determine the direction of the country for the next several years. Risks related to the elections are less about the market as a whole and more about individual securities and how they may be impacted by things like tightening or loosening of restrictions related to climate change, financial regulation or changes at the Federal Reserve which could ultimately affect monetary policy. This is where bottom up credit research comes in. Our thorough research process and relatively concentrated portfolio means we are well aware of how current and potential investments might be impacted and we eschew those investments that are exposed to adverse outcomes. As far as the Federal Reserve is concerned, there is little worry about near term changes in policy as Chairman Jerome Powell’s term does not expire until February 2022 and the prevailing thought is that he would be nominated for an additional 4-year term by either presidential candidate.

An emerging risk for passive fixed income investors that has received little attention in our opinion is the increasing duration of the investment grade corporate bond universe. In the past decade, the Bloomberg Barclays Corporate Index has seen its modified duration increase from 6.7 to 8.7 years. Revisiting the concept of duration, all else being equal, if the duration is 8.7 years, then a 100 basis point linear increase in interest rates would yield an 8.7% loss of value for a portfolio invested in the index. Investors in passively managed index portfolios probably do not realize that they are exposed to almost 30% more interest rate risk than they were incurring for the same investment just 10 years ago.

CAM’s modified duration change over the past 10 years was unchanged at 6.2 years and CAM’s duration was 2.5 years shorter than the index at the end of the third quarter. Now, CAM’s duration did exhibit slight fluctuations over the most recent 10 years, but the average during that period was 6.4 years and the range of change over the preceding 10 years was just 0.9, less than half the index range of 2.2 years. The duration gap has clearly grown between CAM’s IG composite and the Index, especially over the past 2 years, as the Index has gradually seen its duration creep higher.

Why has the Corporate Index duration increased? Low interest rates have helped, but much of the change is driven by what we call reverse inquiry. That is, demand from long term institutional investors in the corporate bond space such as pensions, insurance companies and endowments who are extremely thirsty for yield. Company Treasury departments recognized this demand and happily obliged by issuing a higher percentage of longer term debt at rates that were attractive to the company and with enough yield to satiate the institutional investors. Debt maturing in 10 years or more now makes up one-third of the overall IG Index while debt maturing in 20 years or more has grown to 22.4%^v.

Why has CAM’s duration exhibited such little change by comparison? As we have discussed many times before in these commentaries, you know exactly what you are going to get when it comes to our portfolio: intermediate maturities positioned in the 5-10 year portion of the yield curve. Rather than try and “guess” the direction of interest rates we will always position the portfolio in intermediate maturities as it has historically been the best place to be from a risk reward standpoint. For example, the 5/10 Treasury curve at the end of the third quarter was 41 basis points, or about 8.2 basis points of compensation or “roll down” per year earned from holding a 10 year security until the 5 year mark. The 10/30 Treasury curve was 77 basis points, or about 3.8 basis points of compensation per year from the 30 year to the 10 year mark. Thus the 5/10 curve was significantly steeper than the 10/30 curve, and this steepness is one of the reasons CAM favors intermediate maturities. The compensation afforded for the duration risk incurred by extending beyond 10 years does not offer good risk reward in our view. Additionally, there are corporate credit curves that trade on top of these Treasury curves and these corporate curves tell a similar story. At the end of the third quarter the average A2 rated industrial bond traded at a credit spread of +45 to the 5yr, +89 to the 10yr and +125 to the 30yr. Thus the A2 industrial 5/10 curve was 44 basis points while the 10/30 curve was 36 basis points^vi. This illustrates that an investor was being better compensated by moving from a 5yr corporate bond to a 10yr corporate bond than they were by moving from a 10yr corporate bond to a 30yr corporate bond. The major take away from this exercise is that Cincinnati Asset Management will not speculate on interest rates. Instead, we will continue to focus on the intermediate portion of the yield curve where we can add value through our robust bottom up research process and opportunistic credit selection.

Going forward we plan to stick to our script, as disciplined investors of your hard earned capital. We thank you for your interest and support. As always, please do not hesitate to contact us with any questions.

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 Wells Fargo Securities, October 1 2020, “Credit Flows: Supply & Demand: September 24-September 30”
ii Credit Suisse, October 2 2020, “CS Credit Strategy Daily Comment (IG September Recap)”
iii Bloomberg, September 30 2020, “IG ANALYSIS US: Mondelez Brings 5th Deal, Month Cracks Top Seven”
iv The Wall Street Journal, October 3 2020, “Credit Markets: Corporate Bond Sales Reach Record”
v Deutsche Bank Research, August 18 2020, “Is Duration Risk The New Credit Risk In IG?”
vi Raymond James, October 2 2020, “Fixed Income Spreads”

What a difference a quarter makes. The investment grade credit market has experienced a reversal of fortune since the dark days of late March, with both spreads and returns rebounding smartly from the levels seen earlier this year.

The resumption of risk appetite led to a sharp tightening in spreads for the Bloomberg Barclays Corporate Index which closed the quarter 122 basis points tighter, moving to an OAS of 150 at the end of June versus 272 at the end of March. Spreads are still well off the lows that we saw in the first quarter of the year when the Corporate Index closed at 93 for several days in a row back in late January. Recall that tighter spreads lead to higher valuations for corporate bonds. Investment grade corporate bonds have also been a beneficiary of the increasing value of Treasuries as lower interest rates have provided a tailwind that has led to higher total returns for investment grade credit. The 10yr Treasury closed 2019 at 1.92%, 0.67% on March 31 and it saw little change in the second quarter, closing at 0.66% on June 30.

The reversal in returns is really something to behold, most especially the speed with which the move has occurred. The total return for the Bloomberg Barclays Corporate Index was as low as -10.58% on March 23, and since that time it has rallied all the way back, and then some, closing the second quarter at a year-to-date total return of +5.02%. This compares to CAM’s year-to-date gross total return of +4.89% for the Investment Grade Strategy. For context, the S&P 500 closed the second quarter with a year-to-date total return of -3.09%. CAM’s gross performance was 54 basis points better than the Corporate Index at the end of the first quarter but now trails the index by 13 basis points year-to-date. CAM’s modest under-performance year-to-date is largely a result of conservative positioning and our structural underweight to the lower rated BAA-portion of the investment grade universe. As is normally the case when markets snap back, the lower quality portion of the Corporate Index tends to outperform, so this caused CAM to give up some ground versus the benchmark.

Portfolio Construction in a Recession
The U.S. officially entered a recession in February according to the National Bureau of Economic Research.i So what does this mean for the way that we manage the portfolio? You may be surprised to find that our behavior has really only changed at the margins. Unlike an ETF or broad market mutual fund, we are looking to construct well diversified portfolios of individual bonds for our clients. Because we build separately managed accounts, our clients will know exactly what they own, in what quantity and its current valuation. No matter where we are in the economic cycle, we will always look to invest in companies that have the ability to manage through a downturn because past experience has taught us that there will always be a recession at some point, and usually when it is least expected. Cyclical sectors and industries tend to get hit the hardest in a recessionary environment and although we have some of this risk in the portfolio we are significantly underweight relative to the Corporate Index. And of course we always operate with a structural underweight on the lower echelon of riskier BAA-rated credit. If anything has changed with our behavior and thinking it is that we are cautious on businesses that have significant exposure to China as we believe that there is risk to U.S.-China trade that could manifest itself at any time.

What’s the Fed been up to?
The Federal Reserve has been quite active in its support of the corporate bond market. The Fed made its first foray into the market by dipping its toe into investment grade credit ETFs in mid-May and by mid-June the Fed had moved on to outright purchases of the individual bonds of 794 companies.ⁱⁱ What may prove to be interesting is where the Fed goes from here. When the original plans were announced on March 23, it was a bleak time for the capital markets. The credit markets were not functioning in a healthy manner and the fixed income ETF model had broken the very first time it faced stress. Since the Fed has made its announcement however, things have improved markedly and the market is back to behaving in a highly efficient manner.

The terms of the Fed’s current program allow it to purchase up to $250 billion of corporate debt on the secondary market. Per the most recent Fed release, it has just over $10bln in corporate bonds on its balance sheet, but the program expires on September 30, at which time the Fed will either hold the bonds it bought, allowing them to mature or it will sell them on the open market. At the current run rate of its purchases, the Fed will get nowhere close to $250 billion as the current rate implies less than $70bln in purchases per year. There are only 63 trading days between July 1 and the expiration date of the current program and it seems unlikely that the Fed’s pace of purchasing will accelerate to the point that it will be able to use almost $240bln of dry powder in just 63 trading days. So one of two things will happen: 1.) The Fed will continue to purchase bonds at its current run rate of less than $300 million per day which would put its balance sheet at approximately $29bln by September 30, less than 12% of its total $250bln capacity or 2.) The Fed will extend the expiration date of the program beyond September 30. We think that the second scenario seems the most likely and that the Fed may in fact not come anywhere close to approaching its $250bln capacity if it does not need to. If there is a spike in volatility then certainly the Fed can buy more but if things remain relatively calm, as they are now, then we believe that the Fed will continue to purchase bonds at or near the current run rate and it will reserve the right to purchase more beyond that only if it needs to do so in order to subdue fear within the markets. The market seems to be operating under the assumption that it is a foregone conclusion that the Fed will use the full amount of its facilities no matter what, but we simply disagree.

Keep on Rollin’
The new issue market has been highly topical this year as 2020 will assuredly smash the all-time issuance record which was $1.3 trillion in 2017. At quarter end, 2020 supply was running 98% ahead of 2019’s pace with $1,176.9bln in new corporate debt having been priced in the first half of the yearⁱⁱⁱ. So you may be wondering why are borrowers, in many cases extremely high quality ones with plenty of liquidity, rushing to borrow more debt? The answer really comes down to uncertainty. If the pandemic gets worse, if we don’t get a vaccine, if growth does not rebound as quickly as expected, these are all the types of questions that companies must ask themselves as they plan for the future. If a large global multinational can afford to borrow today at rates that are reasonably attractive relative to historical standards in order to shore up liquidity amid uncertainty then it is prudent to do so. As for opportunities in the new issue market, they still exist and we are still finding what we consider good value but the times of extraordinary opportunity that we saw in March and April are no longer with us for the time being. It could well be that those opportunities are, as we suspected at the time, the type that only come along once every decade or so.

Second Half Outlook
We believe valuations have recovered to the extent that pockets of volatility in the credit markets may now start to occur with more frequency. Immense demand has largely kept volatility at bay since the end of March, so that is really the wildcard. Individual credits will continue to trade choppy surrounding news on vaccines, virus case counts and the various failures and successes of “re-openings.” From a spread perspective, although spreads are significantly tighter from the widest levels, valuations are reasonably compelling. The spread on the index closed the quarter at an OAS of 150. This compares to the 5yr average of 131, the 10yr average of 141 and the average since 1988 inception of 134. We continue to find compelling opportunities in individual bonds through our bottom up research process.

The Federal Reserve has injected confidence into the fixed income markets. While the actions of the Fed were drastic and unprecedented they were also much needed. Words can hardly describe the extreme malaise that was occurring within the markets over the course of the trading days from March 9 through March 20, up until March 23, the day when the Fed announced its initial plans. A side effect of the confidence that the Fed instilled is that it has created an atmosphere of exuberance and has encouraged more risk taking by market participants. We are at odds with this feeling of euphoria as we believe that this is a great time to take less risk, not more. There are plenty of opportunities to take smart calculated risks by purchasing bonds of companies with solid balance sheets that can navigate an extended downturn in the economy. We have positioned the portfolio accordingly. Not only are we underweight BAA-rated credit but we are also underweight the energy sector and zero weight the leisure, gaming, lodging and restaurant industries, which are becoming correspondingly riskier by the day as the economic uncertainty wears on. We will continue to manage your capital in a prudent manner and we thank you for your continued interest and partnership.

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 The Wall Street Journal, June 8, 2020 “Recession in U.S. Began in February, Official Arbiter Says”
ii The Wall Street Journal, June 28, 2020 “Automakers, Technology Firms Are Largest Components of Fed’s Corporate-Bond Purchases”
iii Bloomberg, June 30, 2020 “IG ANALYSIS US: June Ends in Top 6 With July Bringing $100B More”

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

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

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

Overwhelming Supply and Outsize Compensation

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

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

Fallen Angels and the Growth of BAA-rated Credit

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

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

Fed to the Rescue

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

Tomorrow and Beyond

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

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

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

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

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

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

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

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

iv ICE BAML Index Data, April 1, 2020

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

Investment  grade  credit  markets  have  continued  to  enjoy  strong  performance  in  2019,  although  spreads showed little movement during the third quarter. The Bloomberg Barclays US Corporate Index  closed  the  quarter  at  an  option  adjusted  spread  of  115,  which  is  exactly  where  it  opened.   Coupon income and lower Treasury yields were the driving forces of positive returns during the quarter  as  the  10yr  Treasury  finished  the  quarter  at  1.66%  after  having  opened  at  2.01%.   While  Treasuries finished lower, the path was not linear and there was volatility along the way: the 10yr closed at a low of 1.45% on September 3, before rocketing higher to close at 1.89% on September 13,  a  massive  move  of  44  basis  points  over  the course of just eight trading days. Corporate  bond  returns  are  off  to  the  best  start through the first three quarters of any calendar  year  dating  back  to  2009  when  the  US Corporate Index posted a total return of +17.11%. Through the first 9 months of 2019 the Bloomberg Barclays US Corporate Index had a total return of +13.20%. This compares to CAM’s gross total return of +11.69% for the Investment Grade Strategy.

The Primary Market is Back, Bigly

Lower Treasuries, retail fund flows and foreign buyers who were faced with increasingly negative yields  in  many  local  markets  combined  to  lead  a  resurgence  in  the  primary  market  during  the  quarter.

September was one for the record books as companies issued $158bln in debt, making it the 3rd largest volume month in the history of the corporate bond market. According to data compiled by Bloomberg, issuance through the end of the third quarter stood at $923.6bln, trailing 2018’s pace by 3.9%.

Portfolio Positioning

While we at CAM are pleased with the year‐to‐date performance of our investment grade strategy, we  would  like  to  remind  our  investors  that  this  performance  has  occurred  over  a  very  short  timeframe. We strategically position our clients’ portfolios with a longer term focus and an emphasis on providing a superior risk‐adjusted return over a full market cycle. Amid such a strong start  to  the  year  for  credit,  we  would  like  to  illustrate  to  our  investors  how  we  are  positioning  portfolios for the longer term. While we do not seek to replicate or manage to an index, we do use the Bloomberg Barclays US Corporate Index as a benchmark for the performance of our strategy so this discussion will refer to that index as a tool to compare our relative positioning.

Credit Quality

CAM  targets  a  30%  limitation  for  BBB  exposure,  the  riskiest  portion  of  the  investment  grade  universe. There is an additional target of maintaining an overall portfolio credit quality rating of at least A3/A‐. The US Corporate Index was 50.39% BBB‐rated at the end of the third quarter with an average rating of A3/Baa1. While this high‐quality bias can cause CAM’s portfolio to underperform during periods of excessive risk taking, it should tend to outperform during periods of market stress. One of the tenets of our strategy is preservation of capital and our BBB‐underweight is helpful in achieving this goal for our investors.

Interest Rate Sensitivity

CAM avoids the fool’s errand of attempting to make tactical bets on the direction of interest rates. Instead we manage interest rate risk by positioning the portfolio in intermediate bonds that range in maturity from 5‐10 years. CAM will occasionally hold a security that is shorter than 5 years or longer  than  10,  but  very  rarely  does  so.   By  always  investing  in  intermediate  maturities,  CAM’s  seasoned portfolio is more conservatively positioned than the corporate index with a shorter duration and fewer average years to maturity.

Liquidity

Liquidity is always on our minds at CAM. Maintaining an intermediate maturity profile requires that we sell bonds prior to maturity so we must be sure that we will be able to effectively exit positions. CAM  targets  SEC‐registered  securities  that  have $300  million  minimum  par  amount  outstanding.

Additionally CAM attempts to cap its ownership exposure to 5% of any particular issue. By investing in larger more liquid issues and by limiting exposure to any particular issue it makes it easier to achieve best  execution  when  it  comes  time  to  sell.   CAM’s  US Corporate average ownership exposure per issue held at the $869 million end of the third quarter was 0.7%.

Diversification & Industry Sector Limitations
CAM diversifies client accounts by populating individual separately managed accounts with 20‐25 positions.   Additionally  CAM  imposes  a  20%  exposure  limitation  at  the  “sector”  level  and  a  15%  limitation at the “industry” level. As an example, “Capital Goods” is at the sector level and beneath that  sector  there  are  individual  buckets  at  the  industry  level,  such  as  Building  Materials.

CAM invests in bonds that we believe will add value to the performance of the portfolio. Because CAM does not manage to, or attempt to, replicate an index it does not encounter the problem of over‐diversification or of owning the bonds of an issuer simply because the issuer represents a large weighting within an index.

The Fed Strikes Again, Now What?
The FOMC lowered its target for the Federal Funds Rate twice during the quarter, once at its July meeting and then again in September. The current implied probability of a cut at its meeting at the end of October is around 60% but closer to 75% for the December meeting, as market participants’ views remain mixed on the possibility of further cuts in 2019. We believe that the Fed will abide by its commitment to data dependency. Economic data showing strength or resiliency will result in no further cuts in 2019, but data showing a deteriorating economic picture could mean that more cuts are on the horizon.

In  our  view,  the  biggest  factor  for  the  performance  of  risk  markets  through  year  end  hinges  on  trade. We believe that the markets are pricing in a China trade resolution over the medium term. If this does not come to fruition or if the U.S. and China become more antagonistic then a negative market reaction becomes more likely. Aside from being positioned more conservatively than the market  as  a  whole,  with  considerably  less  BBB  exposure  and  a  markedly  shorter  duration,  we  believe that we are furthermore better positioned regarding general economic sensitivity as well as, more specifically, Chinese trade exposure.

While the investment grade credit market has performed well, caution still rules the day. We will continue  to  position  portfolios  accordingly  with  an  eye  toward  the  longer  term.  Thank  you  for  entrusting us with the responsibility of helping you to achieve your financial goals.

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

The performance of investment grade credit during the opening quarter of the year was in stark contrast to the final quarter of 2018, as risk assets of all stripes performed well during the first quarter. The spread on the Bloomberg Barclays US Corporate Index finished the quarter 34 basis points tighter, after opening the year at a spread of 153 and closing the quarter at a spread of 119. The one-way spread performance of investment grade credit was so pronounced that at one point in the quarter there was a 22 trading day streak where the market failed to close wider from the previous day.i This was a remarkable feat considering that there were just 61 trading days during the quarter. The 10yr Treasury opened the year at 2.68% and closed as high as 2.79% on January 18th, but it finished the quarter substantially lower, at 2.41%. Tighter spreads and lower rates yielded strong performance for investment grade credit and the Bloomberg Barclays US Corporate Index posted a total return of +5.14%. This compares to CAM’s gross total return of +4.95% for the Investment Grade Strategy.

What a Difference Three Months Makes

When the Federal Reserve issued its December FOMC statement the consensus takeaway by the investor community was an expectation of two rate hikes in 2019 with one additional rate hike thereafter, in 2020 or 2021. In any case, the prevailing thought was that we were nearing the end of this tightening cycle with a conclusion to occur over the next two or three years. The Fed then took the market by surprise in late January, with language that was more conservative than expected as FOMC commentary signaled that they were less committed to raising the Federal Funds Rate in 2019. It was at this point that the market perception shifted – with most investors expecting just one rate hike in the latter half of 2019. The March FOMC statement was yet another eyeopener for Mr. Market, with language even more dovish than the decidedly dovish expectations. The consensus view is now murkier than ever. Some market prognosticators are pricing in rate cuts as soon as 2019; but the more conservative view is that barring a material pickup in global growth or domestic inflation we may not see another increase in the federal funds rate for 6-12 months, if at all in this cycle. It is entirely possible that the current tightening cycle has reached its conclusion and that lower rates could be here to stay.

In the days following the March 20th FOMC release, the 10yr Treasury rallied sharply and there were two days during the week of March 25th where the 90-day Treasury bill closed with a slightly higher yield than the 10yr Treasury. This was the first time that this portion of the yield curve has been inverted since August of 2007. Note that this inversion was very brief in nature and as we go to print at the end of the day on April 1st, the 3m/10yr spread is no longer inverted and is now positive sloping at +17 basis points. That is not to say that this portion of the curve will not invert again, because Treasury rates and curves are dynamic in nature and ever changing.

What Has Happened to Corporate Credit Curves?

This is a common question in the conversations we have had with our investors in recent weeks. Corporate markets are entirely different from Treasury markets and behave much more rationally. The defining characteristic of corporate credit curves is that they nearly always have a positive slope. History shows that corporate credit curves typically steepen as Treasury curves get flatter. There are fleeting moments from time to time where corporate credit curves become slightly inverted but these instances are brief in nature and are quickly erased as market participants are quick to take advantage of these opportunities. For example, there may be a motivated seller of Apple 2026 bonds at a level that offers slightly more yield than Apple 2027 bonds. This has nothing to do with dislocation in the Apple credit curve and everything to do with the fact that there is an extremely motivated seller of the bond that is slightly shorter in maturity. Once that seller moves their position, the curve will return to normalcy and you could once again expect to obtain more yield for the purchase of the 2027 bond than you would for the 2026 bond. The following graphic illustrates current 5/10yr corporate credit curves for two widely traded investment grade companies, one A-rated and one BBB-rated. As you can see, corporate credit curves are much steeper than the spread between the 5 and 10yr Treasury.

The Bottom Line

The takeaway from this exercise is that investors will always be afforded extra compensation by extending out the corporate credit curve. At Cincinnati Asset Management, one of the key tenets of our Investment Grade Strategy is that we believe that it is nearly impossible to accurately predict the direction of interest rates over long time horizons. However, throughout economic cycles, we have observed that the 5/10 portion of the curve is usually the sweet spot for investors. Consequently, the vast majority of our client portfolios are positioned from 5 to 10 years to maturity. We will occasionally hold some positions that are shorter than 5 years but we almost never purchase securities longer than 10 years. Further, while an investor can earn more compensation for credit risk by extending out to 30yrs, more often than not this strategy entails excessive duration risk relative to the compensation afforded at the 10yr portion of the curve. Our strategy allows us to mitigate interest rate risk through our intermediate positioning and allows us to focus on managing credit risk through close study and fundamental analysis of the individual companies that populate our portfolios.

Where in the World is the Yield?

The value of negative yielding global debt hit a multiyear low in October of 2018 but it has exploded since, topping $10 trillion as the sun set on the first quarter, the highest level since September 2017.ii

The growth in negative yielding debt has, in some cases prompted foreign investors to pile into the U.S. corporate debt market. A measure of overseas buying in 2019 has more than doubled from a year earlier according to Bank of America Corp.iii Japanese institutions are among the biggest of the foreign investors and the Japanese fiscal year started on April 1, which could lead to even more buying interest in U.S. corporates according to Bank of America. According to data compiled by the Federal Reserve as of the end of 2018, Non-U.S. investors held 28% of outstanding U.S. IG corporate bonds.iv What does this all mean for the U.S. corporate bond market? First, it is safe to assume that foreign demand certainly played a role in the spread tightening that the investment grade credit markets have experienced year to date. Second, although U.S. rates may seem low, when viewed through the lens of global markets, they are actually quite attractive on a relative basis. As long as these relationships exist then there will be continued foreign interest in the U.S. credit markets.

Although our Investment Grade Strategy trailed the index in the first quarter, we are pleased with the conservative positioning of our portfolio. The modest underperformance can largely be explained by our significant underweight in lower quality BBB-rated credit relative to the index. We do not have a crystal ball, but are reasonably confident that we are in the later stages of the credit cycle so we continue to place vigilance at the forefront when it comes to risk management. Please know that we take the responsibility of managing your money very seriously and we thank you for your continued interest and support.

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. See Accompanying Endnotes

i Bloomberg Barclays US Corporate Total Return Value rounded to the nearest hundredth from the close on January 3rd, to the close on February 7th

ii Bloomberg, March 25, 2019, “The $10 Trillion Pool of Negative Debt is Late-Cycle Reckoning”

iii Bloomberg, March 22, 2019, “U.S. Corporate Debt Is on Fire This Year Thanks to Japan”

iv CreditSights, March 8, 2019, “US IG Chart of the Day: Who’s Got the Bonds?”