Category: Investment Grade Quarterly

30 Jul 2016

Q2 2016 Investment Grade Commentary

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

The second quarter of 2016 initially saw an increase in Treasury yields; however, by late April, yields began to plummet to the lows of the year. Credit spreads began the quarter with a continuation of their persistent tightening since the mid‐February widest levels of the year, but they ended the quarter only slightly tighter across the credit curve as spreads began to soften a bit. Specifically, the 10 Year Treasury began the quarter at 1.77% and ended at 1.47% (1.91% on 4/25/16), the A Rated Corporate credit spread tightened from 1.26% to 1.24% (1.13% on 4/26/16), and the BBB Rated Corporate credit spread tightened from 2.19% to 2.05% (1.96% on 5/2/16). As of today, July 26, the 10‐Year Treasury is trading at 1.57%, and spreads are at 1.12% and 1.86%, respectively. Interest rates this month (July) have hit an all‐time low for the 10 Year Treasury and credit spreads are at the tightest levels of the year.

There are a number of “forces” at work in the robust performance of the investment grade corporate bond market. Global interest rates have fallen to the extent that approximately 60% of sovereign debt ($13 trillion) is trading at negative yields. So US Treasury 10‐year Notes trading at 1.56% represent a significant premium to what is available in many parts of the globe. In addition, the European Central Bank commenced a QE program that involves the monthly purchase of $89 billion of euro‐denominated corporate debt. This has encouraged US Corporations to issue debt outside the US (negatively impacting potential supply in the US) and has also encouraged European investors to buy US securities (increasing demand). So these forces, along with our own Fed “easy money” policies have led to the performance results experienced in the first half of 2016. We should also point out that investment grade corporate bonds continue to offer good relative value when compared to other investment grade fixed income categories. Over reasonable investment cycles (2‐4) years, corporate bonds outperform other taxable fixed income categories (Credit Suisse and Lipper Data). So not only do they represent good relative value at this time, but they do so with expected greater total return than their investment grade fixed income counterparts as well. Moreover, corporate bonds have shown lower volatility than non‐fixed income categories. Their longer term volatility (measured by standard deviation) is approximately 30% of that of the S&P 500 (Credit Suisse Strategy Monthly, December 2015). So corporate bonds can provide a stabilizing force in a total portfolio that includes equity exposure.

With strong performance and happy (hopefully) investors, this might be a good time to consider what could alter the landscape and produce a more challenging return environment. We will do this in a general way, as all portfolios will react differently to different circumstances. One scenario we can look at is by using the duration calculationi of our Investment Grade composite, which was 6.8 at the end of Q2 2016, and apply different rate outcomes to approximate the potential, temporary impact on the market price of portfolios. For example, if the US 10 Year Treasury, which was at 1.47% on 6/30/16, were to go back to the level it started the year at 2.27%, the 0.80% increase in yield would have an impact of an approximate decline of 5.44%ii on the value of the overall portfolio, assuming corporate

yields were to increase by the same amount (spreads remained constant). While this price decline is a temporary impairment of the portfolio, as bonds discounted to par do recover lost value as they approach maturity, it would be volatility felt by corporate bond investors that may not be anticipated nor expected…but should be. A move wider in credit spreads for A rated corporate bonds, which were 0.49% wider in mid‐February than they are today, would have an impact of an approximate decline of 3.33%iii on the value of the portfolio. In the unlikely, but possible, scenario of both US Treasury yields increasing to the highs of the year and credit spreads widening to mid‐February levels at the same time, the impact would be an approximate decline of 8.77%iv. While we are not projecting nor predicting either of these events to occur in insolation or together, we are simply trying to illustrate potential portfolio volatility based on the current portfolio duration and various movements of interest rates and credit spreads in the markets. No matter what type of portfolio volatility there may be, any decline would always be offset by the cash flow generated by the bonds.

As we described in the introduction to this commentary, the level of interest rates and credit spreads are risks that we as portfolio managers are unable to control. What we are able to control is the assessment of credit risk in our portfolios and ensure we own securities that do not permanently impair our clients. While there are very few instances of corporate bonds defaulting while they are rated investment grade, there is the risk of being downgraded from investment grade to non‐investment grade or high yield. Quite often during this downgrade process, investors are forced to sell these “Fallen Angels” as they are prohibited from holding non‐investment grade debt in their respective accounts and strategies. This forced selling can create an impairment for investors who choose to follow their lead and exit these positions at the same time. While Cincinnati Asset Management is not mandated to be a forced seller in this situation for our Investment Grade strategy, it is a situation we try to avoid as to not experience unwanted volatility in the portfolio. We believe utilizing a corporate bond manager with an extensive history of credit research such as Cincinnati Asset Management can help investors navigate that potential mine field of potential deteriorating credits and ensure investors hold securities with a stable or an improving credit profile.

As the second half of the year gets underway, we remind investors that overall yields are starting from an extremely low level. With cash flow being a primary driver of returns, this level of yields should tell investors future return expectations may be lower than returns from the recent past. Additionally, the yield curve as measured by the 2 Year to 10 Year Treasury yield differential is below its 20 year average, thus removing some benefit we have had the past several years of rolling down a steep yield curve. As is written on most investment materials: Past performance should not be taken as an indication of future results…it would be wise to manage future return expectations for Investment Grade corporate bonds appropriately.

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.

i Duration is an approximate measure of the sensitivity of the price (the value of principal) of a fixed‐income investment to a change in interest rates.

ii This figure is calculated by multiplying the duration by the move in interest rates (6.8 x 0.80 = 5.44%) iii This figure is calculated by multiplying the duration by the move in spreads (6.8 x 0.49 = 3.33%)
iv This figure is calculated by adding the two above figures together (5.44% + 3.33% = 8.77%)

30 May 2016

Q1 2016 Investment Grade Commentary

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

The first quarter of 2016 was characterized by a decrease in Treasury yields and a nominal aggregate decrease of credit spreads after reaching intra‐quarter cycle highs on these spreads. Specifically, the 10 Year Treasury began the quarter at 2.27% and ended at 1.77%, the A Rated Corporate credit spread widened from 1.22% to 1.26% (1.61% on 2/12/16), and the BBB Rate Corporate credit spread decreased from 2.24% to 2.19% (2.88% on 2/11/16). As of today, April 29, the 10‐Year Treasury is trading at 1.82%, and spreads are at 1.18% and 1.96%, respectively. So although rates declined, there continues to be some volatility, as we would expect.

Since our primary investment focus is on individual companies and not macro issues, such as the path of interest rates, our commentary each quarter has focused on updates on companies that we own within our strategies. This quarter we digress from this to discuss some fundamental issues impacting the investment grade corporate bond market as a whole, which we feel is important and timely.

Unprecedented global monetary policy of the last decade has resulted in numerous market distortions, one of which has been the exponential growth of US Corporate Debt. Using the Barclay’s US Corporate Index as a proxy, the outstanding US Corporate Debt has increased fourfold in less than 10 years from $1.16T to $4.45T1. BBB rated securities, the bottom tier of the Barclays US Corporate Index, now account for more than 50% of investment grade corporate bonds, up from 39%. It is important to note that a significant portion of this increase is the result of many major bank holding companies slipping into this credit sub‐sector as their debt was downgraded post the 2008 financial crisis.

From a company level perspective, gross leverage2 has increased to an all‐time high of 2.70×3 and when accounting for “cash on the balance sheet” this multiple is still slightly above average at 2.16x. This increase in leverage has been a result of the growth in use of debt in the capital structure and overall decline in overall corporate revenue the last year. For the quarter ended 12/31/15, revenue for the S&P 500 declined by 3.9%, marking the fourth consecutive quarter of negative revenue growth which has not been observed since Q4 2008 – Q3 20094.

Arguments can be made that the increase in leverage is manageable as the cost to service the debt has declined significantly. The average coupon that investment grade corporations pay has decreased from approximately 6% in 2009 to 3.5% today5, however, interest coverage6 (the ability for companies to service debt through earnings) has been declining since Q2 2013 and currently stands at 11.10×7 ‐ approximately the level experienced in 2009. Debt to cash flow has risen from 1.5 times to 2.3 times since 2007. We would expect some continued deterioration of the ability to service debt if corporate revenue continues to decline, however, we have every reason to believe that management teams would curtail stock purchase programs and institute other strategies that would address leverage and fixed charge coverage issues.

Additionally, as more than half of the investment grade corporate bond market is currently rated BBB, there is a high likelihood for potential downgrades to high yield (Fallen Angels). During the first quarter of 2016, downgrades to Fallen Angel status have already exceeded those for all of 20158. It should be noted that a significant portion of the Fallen Angels are in the Energy Sector and have experienced severe difficulties in the face of rapidly decreasing commodity prices.

In this environment, issuer selection becomes even more important than usual.

As we remain cautious in our credit anlaysis, we are encouraged by market “technicals.” Almost $7 trillion of foreign Sovereign debt trades at negative yields, making US debt instruments attractive on a relative basis. The ECB has committed to buy $89 billion of non‐US corporate securities per month and the effect is one of “crowding out” many investors in that market place, forcing them to seek alternative markets with the US market benefitting from their consideration. In addition, coupon payments and 2016 bond maturities approximate $387 billion per month (Credit Sights, April 11, 2016), so, assuming that these payments are reinvested in corporate bonds, there should be ongoing demand for this asset category.

We are in the eighth year of “emergency” monetary policy from the Fed, thus anchoring interest rates not far from 0% (the FED maintained the Target Rate at 25 basis points at its April meeting) and most developed countries have negative interest rates for maturities less than 10 years. What does this mean for corporate bond investors? Post‐2008, declining interest rates resulted in total returns well in excess of the coupon rate (10‐year Treasury yield was 4.03% at January 1, 2008 and declined to 1.76% at December 31, 2012); expectations for a similar experience given today’s yields is seemingly unrealistic. As a credit manager, we don’t take positions on interest rates, but major moves in rates over the near term don’t appear to be on the horizon. So current returns that are currently above 3% seem to provide value for the strategic investor, especially relative to other investment grade fixed income alternatives, such as Treasury and Agency securities. Corporate bonds continue to provide sound relative value, but the management of credit risk should always be the primary concern for investors, and the expectations for above average total returns need to be placed in their proper perspective.

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.

1 Barclays Global Family of Indices, July 2006 – January 2016
2 Gross leverage is defined as EBITDA / Total Debt. EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization.
3 JP Morgan US Fixed Income Markets Weekly, February 26, 2016 pages 61‐62

4 Factset Earnings Insight, February 26, 2016

5 JP Morgan US High Grade Bond Trends & Outlook, February 2016 pg. 20
6 Interest Coverage is defined as EBIT/Interest Expense. EBIT = Earnings Before Interest & Taxes 7 JP Morgan US Fixed Income Markets Weekly, February 26, 2016 page 62
8 JP Morgan US Fixed Income Markets Weekly, February 26, 2016