Insight – Page 17 – Cincinnati Asset Management

10 Nov 2022

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

CAM Investment Grade Weekly Insights

Investment grade credit spreads were unchanged on the week until the CPI print sent spreads tighter on Thursday morning. If this “risk-on” trade has legs, then spreads will finish the week in solidly positive territory. The credit market is closed this Friday in observance of Veteran’s Day but equities will remain open. The Bloomberg US Corporate Bond Index closed at 152 on Wednesday November 9 after having closed the week prior at 152. Treasury yields are sharply lower on the week with the bulk of that move occurring after CPI at 8:30am this morning. The 10yr Treasury closed last Friday evening at 4.16% and it is trading at 3.92% as we go to print. Through Wednesday the Corporate Index had a YTD total return of -19.5% while the YTD S&P500 Index return was -20.3% and the Nasdaq Composite Index return was -33.4%.

It was a lighter week for economic data relative to the last few weeks due in part to the fact that there were only 4 trading days. The big news of the week was CPI on Thursday, which was weak across the board. Recall that the last couple of CPI prints came in hotter than expectations. This is only one data point, so it cannot be called a trend, but it is a welcome relief to bond investors to see this number move in a favorable direction for a change. The next CPI release is on December 13 and the next FOMC decision is on December 14. There is also an employment report on December 2 as well as other economic data that will help guide the Fed. It will be interesting to see if the data allows the Fed to take its foot off the gas and back off from 75bps to 50bps at its December meeting.

The primary market was extremely active this week as 28 companies issued over $45bln of new debt across just three trading days. It is worth noting that the high yield primary market has thawed as well and it posted its busiest week since June. There are no new investment grade deals pending as we go to print on Thursday morning. The 2022 issuance tally stands at $1,125bln in volume which trails 2021’s pace by ~12%.

04 Nov 2022

High Yield Weekly, Insight Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were $4.7 billion and year to date flows stand at -$55.1 billion. New issuance for the week was $1.5 billion and year to date issuance is at $93.5 billion.

(Bloomberg) High Yield Market Highlights

U.S. junk bonds are set for the biggest weekly loss in six, snapping a two-week gaining streak as yields surge to 9.22% as recession fear spurred a selloff in equities and an extreme inversion in a key portion of the Treasury yield curve. The low-grade market erased most recent gains across ratings. CCCs, the riskiest of junk bonds, posted a loss of 1.04% Thursday, the biggest one-day fall in more than four months. That’s put the notes on track to end a two-week gaining stretch, with a week-to-date drop of 1.08%.
The October rally fueled and lured investors into junk bond market as US high-yield funds reported a cash intake of $4.7b for the week, the third biggest weekly inflow this year.
The cash haul came in at the time of acute shortage of new supply, bolstering secondary market prices as investors looked for new paper. The primary market was mostly quiet until this week.
The rally brought some relief to bankers who have long waited to clear all pending deals to fund leveraged buyout. Apollo’s Tenneco was the first to get out of the gate earlier this week. Nielsen Holdings, a US TV rating business firm, kicked off a bond sale Wednesday to fund its buyout by Elliott Investment Management and Brookfield Asset Management.
Satellite TV company Dish Network also jumped into the market Wednesday to start marketing 5-year notes to fund the build-out of wireless infrastructure, among other purposes.
The rally was sapped after the Federal Reserve signaled a higher terminal rate against a backdrop of slowing growth.
Despite continued near-term pressures Morgan Stanley expects a “significant deceleration in the inflation path” to take hold by mid-2023, Morgan Stanley’s Srikanth Sankaran wrote last week.

(Bloomberg) Powell Sees Higher Peak for Rates, Path to Slow Tempo of Hikes

Federal Reserve Chair Jerome Powell opened a new phase in his campaign to regain control of inflation, saying US interest rates will go higher than earlier projected, but the path may soon involve smaller hikes.
Addressing reporters Wednesday after the Fed raised rates by 75 basis points for the fourth time in a row, Powell said “incoming data since our last meeting suggests that ultimate level of interest rates will be higher than previously expected.”
Powell said it would be appropriate to slow the pace of increases “as soon as the next meeting or the one after that. No decision has been made,” he said, while stressing that “we still have some ways” before rates were tight enough.
“It is very premature to be thinking about pausing,” he said.
The Federal Open Market Committee said that “ongoing increases” will still likely be needed to bring rates to a level that are “sufficiently restrictive to return inflation to 2% over time,” in fresh language added to their statement after a two-day meeting in Washington.
The Fed’s unanimous decision lifted the target for the benchmark federal funds rate to a range of 3.75% to 4%, its highest level since 2008.
“Slower for longer,” declared JP Morgan Chase & Co, chief US economist Michael Feroli in a note to clients. “The Fed opened the door to dialing down the size of the next hike but did so without easing up financial conditions.”
Officials, as expected, said they will continue to reduce their holdings of Treasuries and mortgage-backed securities as planned.
The higher rates go, the harder the Fed’s job becomes. Having been criticized for missing the stubbornness of the inflation surge, officials know that monetary policy works with a lag and that the tighter it becomes the more it not only slows inflation, but economic growth and hiring too.
Still, Powell stressed that they would not blink in their efforts to get inflation back down to their 2% target.
“The historical record cautions strongly against prematurely loosening policy,” he said. “We will stay the course, until the job is done.”
Fed forecasts in September implied a 50 basis points move in December, according to the median projection. Those projections showed rates reaching 4.4% this year and 4.6% next year, before cuts in 2024. Powell’s remarks made clear that the peak signaled in that projection would be higher if it came at this meeting.
No fresh estimates were released at this meeting and they won’t be updated again until officials gather Dec. 13-14, when they will have two more months of data on employment and consumer inflation in hand.

04 Nov 2022

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

CAM Investment Grade Weekly Insights

Investment grade credit spreads look as though they will finish the week slightly tighter. The Bloomberg US Corporate Bond Index closed at 155 on Thursday November 3 after having closed the week prior at 158. Treasury yields moved higher during the week. The 10yr Treasury closed last Friday evening at 4.01% and it is trading at 4.17% as we go to print this Friday afternoon. Through Thursday the Corporate Index had a YTD total return of -19.7% while the YTD S&P500 Index return was -20.9% and the Nasdaq Composite Index return was -33.5%.

It was an active week for central bankers and there was plenty of economic data to parse. The FOMC raised the policy rate by 75bps for the fourth consecutive meeting, moving the benchmark to a target range of 3.75% to 4%. This move was largely expected by markets but some investors may not have been sufficiently prepared for Powell’s comments which were perceived as hawkish in nature. In our view this should not have come as a surprise as Fed officials have been consistently hawkish in recent weeks. Powell did indicate that the committee may look to slow the pace of Fed Funds rate increases but that they are committed to seeing this through to the end in order to tame inflation. We think that this level of commitment increases the probability that the economy will start to slow significantly in the months ahead. Not to be outdone by the FOMC, the Bank of England was on the tape Thursday with a 75bps hike but its rhetoric was much more dovish than the U.S. central bank. The BOE warned investors that market expectations for its terminal rate have overshot, and that while additional rate hikes may be required, the bank will be careful to limit the associated impact on economic growth. The BOE expects that GDP for the UK will contract for eight consecutive quarters until mid-2024. The final major piece of data came on Friday morning when the October jobs report showed that the U.S. labor market was still quite healthy. Although the unemployment rate did tick higher from 3.5% to 3.7%, it is clear that the labor market was still too tight relative to FOMC expectations. Futures contracts are pricing in a 50-basis point hike at the Fed’s December 14 meeting, but if the data over the next month does not paint a picture of slowing inflation then 75bps could be on the table once again.

Primary market activity in corporate credit was muted during the week. Borrowers brought just over $12bln in new debt to market relative to expectations that were looking for $15bln on the low-end. 2022 has seen over $1,080bln in new issue volume which trails 2021’s pace by ~12%.

Investment grade funds reported a modest outflow for the week. Per data compiled by Wells Fargo, inflows for the week of October 27–November 2 were -$0.4bln which brings the year-to-date total to -$147bln.

28 Oct 2022

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

CAM Investment Grade Weekly Insights

Investment grade credit spreads will likely finish the week tighter. The Bloomberg US Corporate Bond Index closed at 161 on Thursday October 27 after having closed the week prior at 164. Treasury yields drifted lower throughout the week. The 10yr Treasury closed last Friday evening at 4.22% and it is trading at 3.99% as we go to print this morning. Through Thursday the Corporate Index had a negative YTD total return of -19.1% while the YTD S&P500 Index return was -19.1% and the Nasdaq Composite Index return was -30.4%.

It was an extremely active week for economic data and rate decisions by global central banks. We cannot cover it all in this brief note but we will do our best to hit the highlights. Early in the week, data releases showed housing prices that slowed more than expected and a consumer confidence number that was underwhelming relative to expectations. US 30-year mortgage rates topped 7% for the first time since 2001 and mortgage applications continued to slow. On the bright side, new home sales were a slight beat relative to expectations and the third quarter US GDP report showed that growth rebounded into positive territory after two consecutive quarters of contraction. On the central bank front, The Bank of Canada surprised investors with a half-percentage point increase in its policy rate from 3.25% to 3.75%. Investors were expecting the BOC to increase by 75 basis points. The BOC also made comments that indicate that, while it is not done with rate increases, it is getting closer to the end of its hiking cycle. Lastly, the European Central Bank raised its policy rate by 75 basis points to 1.5%, its highest level in more than a decade. ECB President Lagarde said further rate hikes are on the horizon but her tone was cautious given the deteriorating outlook for the Eurozone economy as the region barrels toward a recession. Overall, the news flow continues to paint a mixed picture and there were pieces of data that both hawks and doves could cling to.

It was an active week in the primary market as 13 borrowers priced more than $34bln in new debt through Thursday. There is one deal pending on Friday morning that will push that total further as Honeywell is looking to tap the market for up to $2bln spread across several tranches. Next week will likely bring more muted issuance volumes with the FOMC meeting on Wednesday –market prognosticators are calling for $15-$20bln of issuance weighted toward the front end of the week. 2022 has seen over $1,066bln in new issue volume which trails 2021’s pace by about 13%.

Investment grade funds reported their first inflow in 9 weeks. Per data compiled by Wells Fargo, inflows for the week of October 20–26 were +$1.6bln which brings the year-to-date total to -$146.6bln.

28 Oct 2022

High Yield Weekly, Insight Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were $3.7 billion and year to date flows stand at -$59.9 billion. New issuance for the week was nil and year to date issuance is at $92.0 billion.

(Bloomberg) High Yield Market Highlights

U.S. junk bonds are headed for their biggest weekly gain in more than three months after a four-session rally as investors flooded the market with cash looking for new paper. A gauge of the debt rose 0.57% Thursday, the biggest one-day gain in more than three weeks. It was headed for the best week since June, up 1.93% so far this week. The rally was partly fueled by investors returning to the asset class as US high-yield funds reported a cash influx of $3.7b for the week.
The cash haul came at a time when the junk bond primary market faced an acute shortage of new supply, helping to bolster secondary-market prices.
October supply is down by more than 85% from 2021; The year-to-date supply is the lowest since 2008 at $92b, versus more than $415b for the same period last year.
The recent rally in junk bonds suggests the high-yield market is slowly coming around to the view that inflation’s pace is slowing and may begin to decline in the middle 2023.
Despite continued near-term pressure, Morgan Stanley expects a “significant deceleration in the inflation path” to take hold by mid-2023, Srikanth Sankaran wrote on Monday.
A potential window of respite from rates volatility and a more dispersed period of earnings risk should help to provide tactical support for credit markets, Sankaran wrote.
Amid this issuance-starved market, a group of banks led by Citigroup may sell as soon as next month part of a leveraged loan that’s financing Apollo’s buyout of Tenneco, according to people with knowledge of the matter.
The rally extended across all high yield ratings. Yields tumbled to a five-week low of 9.12% after falling for five sessions in a row, the longest declining streak in almost three months. Yields fell 56bps in the last four sessions.
Single B and BB rated bond yields also fell to a five-week low of 9.35% and 7.33%, respectively.
CCCs, the riskiest of junk bonds are up 1.52% this week as of Thursday, set for the biggest weekly advance in almost three months. CCC yields dropped 38bps this week to close at 15.44%, a more than two-week low.

14 Oct 2022

High Yield Weekly, Insight, Uncategorized Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were -$1.0 billion and year to date flows stand at -$61.7 billion. New issuance for the week was $1.2 billion and year to date issuance is at $89.6 billion.

(Bloomberg) High Yield Market Highlights

U.S. junk bonds shrugged off the equity rally as yields climbed toward 10%. CCC yields, the riskiest of junk bonds, jumped to a 30-month high of 15.79% after core US inflation rose by more than forecast, pressuring the Federal Reserve to keep raising interest rates again. Junk bonds are set to end the week with a decline, heading for a fourth weekly loss in five. The bonds were down 1.2% so far this week as yields rose to 9.70%.
The rise in core consumer price index only reinforced the Fed officials’ commitment to raise rates to a restrictive level in the near term and holding them there to curb inflation.
The heightened asset volatility, as the Fed is expected to hike another 75bp in November with core inflation at multi-decade highs, increases tail risks for the economy and markets, Barclays’s Brad Rogoff wrote on Friday.
The losses spanned across ratings in junk bond market, with CCCs posting losses of 1.44% week-to- date, the most in two weeks.
Macro volatility, steady losses and continuing concern that the Fed may disrupt growth rattled junk bond investors.
The high yield primary market volume has been low amid rising cost of debt.
Third quarter supply was a modest $19b, the lowest 3Q volume since 2008.
New bond sales in September totaled $9b, the slowest September since 2011.
Year-to- date volume was at $88b, the lowest since 2008 and down about 78% from 2021.

(Bloomberg) Core US Inflation Rises to 40-Year High, Securing Big Fed Hike

A closely watched measure of U.S. consumer prices rose by more than forecast to a 40-year high in September, pressuring the Federal Reserve to raise interest rates even more aggressively to stamp out persistent inflation.
The core consumer price index, which excludes food and energy, increased 6.6% from a year ago, the highest level since 1982, Labor Department data showed Thursday. From a month earlier, the core CPI climbed 0.6% for a second month.
The overall CPI increased 0.4% last month, and was up 8.2% from a year earlier.
The advance was broad based. Shelter, food and medical care indexes were the largest of “many contributors,” the report said. Prices for gasoline and used cars declined.
On the heels of a solid jobs report last week, the inflation data likely cement an additional 75-basis point interest rate hike at the Fed’s November policy meeting and spurred speculation for a fifth-straight increase of that size in December. Traders also priced in a higher peak Fed rate for next year.
Policy makers have responded with the most aggressive tightening campaign since the 1980s, but so far, the labor market and consumer demand have remained resilient. The unemployment rate returned to a five-decade low in September, and businesses continue to raise pay to attract and retain the employees needed to meet household demand.
The CPI report is the last one before next month’s U.S. midterm elections and poses fresh challenges to President Joe Biden and Democrats as they seek to retain thin congressional majorities. Already, the surge in inflation has posed a serious threat to those prospects.
Shelter costs — which are the biggest services’ component and make up about a third of the overall CPI index — rose 0.7% for a second month. Both rent of shelter and owners’ equivalent rent were up 6.7% on an annual basis, the most on record.
Economists see the housing components of the report as being elevated for quite some time, given the lag between real-time changes in rents and home prices and when those are reflected in Labor Department data. Bloomberg Economics doesn’t expect year-over-year rates for the major shelter components to peak until well into the second half of next year.
While the Fed bases its 2% target on a separate inflation measure from the Commerce Department — the personal consumption expenditures price index — the CPI is closely watched by policy makers, traders and the public.
Fed officials have repeatedly emphasized in recent weeks the need to get inflation under control, even if that means higher unemployment and a recession. In minutes from their September meeting released Wednesday, many policy makers emphasized “the cost of taking too little action to bring down inflation likely outweighed the cost of taking too much action.”

12 Oct 2022

High Yield Quarterly, Insight Rich Balestra - Portfolio Manager 0 comment

2022 Q3 High Yield Quarterly

In the third quarter of 2022, the Bloomberg US Corporate High Yield Index (“Index”) return was ‐0.65% bringing the year to date (“YTD”) return to ‐14.74%. The S&P 500 stock index return was ‐4.89% (including dividends reinvested) for Q3, and the YTD return stands at ‐23.88%.

The 10 year US Treasury rate (“10 year”) generally marched higher after a small dip in July as the rate finished at 3.83%, up 0.82% from the beginning of the quarter. Over the period, the Index option adjusted spread (“OAS”) tightened 17 basis points moving from 569 basis points to 552 basis points. The higher quality segments of the High Yield Market participated in the spread tightening as BB rated securities tightened 50 basis points, and B rated securities tightened 12 basis points. Meanwhile, CCC rated securities widened 61 basis points. The chart below from Bloomberg displays the spread moves in the Index over the past ten years with an average level of 430 basis points.

The Energy, Transportation, and Other Industrial sectors were the best performers during the quarter, posting returns of 1.28%, 1.20%, and 0.54%, respectively. On the other hand, Banking, Consumer Non‐Cyclical, and Brokerage were the worst performing sectors, posting returns of ‐3.91%, ‐2.82%, and ‐2.06%, respectively. At the industry level, aerospace and defense, refining, and gaming all posted the best returns. The aerospace and defense industry posted the highest return 3.49%. The lowest performing industries during the quarter were pharma, healthcare REIT, and retailers. The pharma industry posted the lowest return ‐9.57%. Crude oil has continued trending lower as can be seen on the chart at the left. OPEC+ members just met and agreed to cut oil production by two million barrels per day in a bid to help support the price of oil in the face of a weakening global economy. However, it is noted that the impact to supply is likely to be smaller than the headline number. “OPEC and its partners have been meeting online on a monthly basis and weren’t expected to arrange an inperson gathering until at least the end of this year. The slump in prices may have been what prompted the change of tack, requiring the first face‐to‐face talks since 2020.”ⁱ

The primary market remained very subdued during the third quarter. The weak market led to year‐to‐date issuance of $95.2 billion and $19.6 billion in the quarter. That is the lowest quarter of issuance in four years. Discretionary took 37% of the market share followed by Technology at a 28% share. Currently, there isn’t much concern for lack of capital access due to issuers being so proactive with refinancing in the past few years. In fact, only about $50 billion in high yield bonds are due to mature from now through the end of 2023.

After the Federal Reserve lifted the Target Rate by 0.75% at their June meeting, Fed Chair Jerome Powell acknowledged that the hike was “an unusually large one.” It may have been a large one, but apparently it was not enough as the Fed raised an additional 0.75% at both the July and September meetings. For those keeping score, that brings the Fed to 300 basis points of raises this year.

The dot plot chart shows how the Fed projections of the 2022 year‐end Target Rate have evolved over the past year. The Fed was clearly behind the curve and now believes stuffing the market with three consecutive “unusually large” hikes in a singular bid to break inflation is the appropriate move, notwithstanding all the other consequences. “We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging,” Powell said. “We have got to get
inflation behind us. I wish there were a painless way to do that. There isn’t.”ⁱⁱ Based on the Fed’s Summary of Economic Projections, they accept that the continuing rate hikes are going to lower growth and push up unemployment.

Intermediate Treasuries increased 82 basis points over the quarter, as the 10‐year Treasury yield was at 3.01% on June 30th, and 3.83% at the end of the third quarter. The 5‐year Treasury increased 105 basis points over the quarter, moving from 3.04% on June 30th, to 4.09% at the end of the third quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. The revised second quarter GDP print was ‐0.6% (quarter over quarter annualized rate). Looking forward, the current consensus view of economists suggests a GDP for 2022 around 1.6% with inflation expectations around 8.0%.ⁱⁱⁱ

Being a more conservative asset manager, Cincinnati Asset Management Inc. does not buy CCC and lower rated securities. Additionally, our interest rate agnostic philosophy keeps us generally positioned in the five to ten year maturity timeframe. Due to the continued rate moves, this positioning was a detractor of performance in the quarter as short‐end maturities outperformed. Further, our credit selections within communications and energy were a drag on performance. Benefiting our performance was our lack of exposure to pharma and our credit selections within healthcare. All totaled, the CAM High Yield Composite Q3 net of fees total return of ‐1.38% underperformed the Index. The Composite YTD net of fees total return of ‐17.06% also underperformed the Index.

The Bloomberg US Corporate High Yield Index ended the third quarter with a yield of 9.68%. Equity volatility, as measured by the Chicago Board Options Exchange Volatility Index (“VIX”), had an average of 25 over the quarter moving from a low of 20 in mid‐August to a high of 32 atthe end of September. For context, the average was 15 over the course of 2019, 29 for 2020, and 19 for 2021. The third quarter had two bond issuers default on their debt. The trailing twelve month default rate stands at 0.83%.iv The current default rate is relative to the 0.92%, 0.27%, 0.23%, 0.86% default rates from the previous four quarter end data points listed oldest to most recent. The fundamentals of high yield companies still look good considering the economic backdrop. From a technical view, fund flows were positive in July but negative in August and September. The 2022 year-to‐date outflow stands at $61.5 billion.^v Without question there has been a fair amount of damage in bond markets so far this year. It is important to remember that bonds are a contractual agreement with a defined maturity date. Thus, despite price volatility, without default, par will be paid at the stated maturity date. Currently, defaults are quite low and fundamentals are still providing a cushion. No doubt there are risks, but
we are of the belief that for clients that have an investment horizon over a complete market cycle, high yield deserves to be considered as part of the portfolio allocation.

As we move into the last quarter of 2022, fixed income markets remain pressured as the Fed continues raising the Target Rate. The US dollar has been moving higher all year. Over 80% of central banks around the world are now hiking, the highest percentage on record.vi Japan has taken to currency intervention. The Bank of England is hiking while the British government is pushing through their largest tax cut package since 1972. Citi’s London team commented that euro credit markets are disorderly. Subsequently, the Bank of England started buying gilts while some of the tax cut package was walked back. Back in the US with the message from the Fed steadfast, caution is warranted as uncertainty remains around the cycle’s terminal rate and the resulting depth of an intentional economic slowdown. Markets have been roughed up this year, but brighter days will eventually appear. As this cycle plays out, current uncertainty and volatility can create opportunities that lead back to positive returns. Our exercise of discipline and selectivity in credit selections is important as we continue to evaluate that the given compensation for the perceived level of risk remains appropriate. As always, we will continue our search for value and adjust positions as we uncover compelling situations. Finally, we are very grateful for the trust placed in our team to manage your capital.

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 Bloomberg October 4, 2022: OPEC+ Considers Output Limit Cut
ii Bloomberg September 22, 2022: Powell Signals Recession May Be the Price for Crushing Inflation
iii Bloomberg October 3, 2022: Economic Forecasts (ECFC)
iv JP Morgan October 3, 2022: “Default Monitor”
v Wells Fargo September 29, 2022: “Credit Flows”
vi Goldman Global Markets Insights September 23, 2022: Markets/Macro

12 Oct 2022

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

2022 Q3 Investment Grade Quarterly

Negative performance continued to plague the investment grade credit market during the third quarter and 2022 built on its record as the most difficult year of performance that the market has ever experienced. It was a hopeful start to the quarter, as investment grade bonds posted sharply positive returns for the month of July, but August and September were ugly, as Treasury yields climbed higher, creating a major headwind for performance. Credit spreads finished the quarter modestly wider but behaved reasonably well for most of the period and the spread performance of IG‐credit was relatively strong compared to other risk assets, but the magnitude of the sell‐off in Treasuries during the quarter and during the first 9 months of 2022 has led to historically poor performance across fixed income. The option adjusted spread (OAS) on the Bloomberg US Corporate Bond Index widened by 4 basis points during the quarter to 159 after having opened the quarter at an OAS of 155. The 10yr Treasury opened the quarter at 3.01% and finished 82 basis points higher, at 3.83%. The 5yr Treasury opened the quarter at 3.04% and finished 105 basis points higher, at 4.09%. The 2yr Treasury opened the quarter at 2.95% and finished 133 basis points higher, at 4.28%. The very front end of the yield curve has experienced the most dramatic movement year‐to‐date and the 2yr has now climbed 355 basis points during 2022 through the end of the third quarter.

The Corporate Index posted a third quarter total return of –5.06%. CAM’s Investment Grade portfolio net of fees total return for the third quarter was –4.12%.

The drawdown in credit has continued. We cannot predict when the tide will turn but we are confident that it will do so eventually, and it is only a matter of time. An increasing amount of hawkishness has been priced into the Treasury markets as the year has worn on. Eventually, the economic data on inflation will break, whether it is this year, in 2023, or even beyond that. The valuations and compensation afforded from high quality investment grade credit are as high as they have been in a very long time. The process of getting to these yields has been painful to endure but the market is now trading at levels that set up well for investors with longer time horizons. The market could cheapen further but higher Treasury rates and wider credit spreads have given investors a larger margin of safety and increased the likelihood of positive returns in the future.

Cash Alternatives Are Back, Finally

We are a bond manager and are not in the business of giving investment advice, but this is a topic that has started to come up frequently in our conversations so we thought it would be helpful to discuss. The rise in short term Treasury rates has given investors the option to generate higher levels of income without taking much duration risk for the first time in a long time. For example, the 2-year Treasury has not offered yields this high since 2007. This is a great cash alternative for many investors in our opinion. Some may prefer to park their short term funds while for others it may make sense to allocate a larger portion of their portfolio.

We have received questions asking why we have not changed our intermediate investment grade strategy, putting all of our investments into short duration assets or even short term Treasuries. What investors need to understand is that a portfolio that is entirely reliant on short duration securities introduces a risk for those that have medium or longer term time horizons: reinvestment risk. When the time comes to sell or, for example, when the 2-year Treasury matures, the landscape could look totally different. Credit spreads could have raced tighter or intermediate Treasury yields could have decreased – or both of these things could have occurred, meaning the investor missed out on larger returns and now they find themselves in a position where they need to redeploy capital into a market with richer valuations. So we would caution investors from making wholesale tactical changes to their fixed income portfolios. A Strategic approach may yield better results, because like all risk assets, fixed income benefits an overall portfolio by being diverse in its exposure. Having different maturities, credit exposures and asset classes within fixed income is in our opinion the best way to build a portfolio with a longer term view. We do offer a variety of short duration strategies at CAM, but for most investors with longer time horizons a combination of short and intermediate duration strategies will typically be the best fit.

What Now for Low Dollar Bonds?

We have officially exited the longstanding regime of ultralow interest rates. As rates have rapidly increased, some of our holdings have incurred significant price declines. This is particularly the case with bonds that we purchased in 2020-2021 that were newly issued at the time. This was a time period when interest rates were much lower and credit spreads were tighter than they are today. As a result, many of these bonds have coupons that are lower than Treasuries are today, thus they have seen significant price declines, with dollar prices in the high 70s or low 80s (price declines of more than 15-20% since issuance). In almost all of these cases, our ongoing analysis has shown that the company that issued the bonds is operating well from the standpoint of creditworthiness. In other words, the price declines have not stemmed from concerns over credit risk but rather the declines have been all about duration and higher interest rates. We have received questions from investors about our expectation for price recoveries in these bonds.

Ultimately, the prices of these bonds stand to benefit the most from the passage of time and a reversal of the currently inverted yield curve. There are two curves that we deal with as a bond manager: the corporate credit curve and the Treasury curve. The corporate credit curve represents the extra spread that an investor receives for purchasing a corporate bond instead of a Treasury –it is the spread on top of the underlying Treasury. The corporate credit curve remains steep at the moment, as it almost always is. For A-rated credit at the end of the third quarter it was not uncommon for us to observe a 5/10 curve of 50 basis points for many A-rated credits. That is, you could sell a 5yr bond of a company at a spread of 50 basis points over the 5yr Treasury and then use those proceeds to buy the 10 year bond of the same company at a spread of 100 basis points over the 10yr Treasury. The corporate credit curve is even steeper for BAA-rated credits because riskier credits require steeper curves as investors demand more compensation to own the bonds of a lower quality credit. The problem with doing an extension trade at the moment is that at the end of the quarter the 5/10 Treasury curve was inverted to the tune of -26 basis points, which takes a big bite out of the compensation afforded by an extension trade because we are selling off of a higher 5-year Treasury (4.09%) and purchasing a bond that trades off a lower 10-year Treasury (3.83%). We would still be increasing yield by doing this trade, because of the steepness of the corporate credit curve, it is just much less of a yield increase than we would get in a typical environment where we have an upward sloping Treasury curve and an upward sloping credit curve. Thus, in order for these deeply discounted bonds to recover value it requires Treasury yield curve normalization. Historically, yield curve inversions have been brief in nature. The longest period of inversion was 21 months, beginning August 1978 until April 1980 . We don’t know when the yield curve will normalize but we expect that it will over time.

The best prospect for value recovery in a deeply discounted bond that still has good credit metrics is to trust the bond math and to embrace the passage of time as our friend. With each passing day, a bond gets shorter and closer to its maturity and the credit spread gets tighter, all else being equal. The passage of time will also allow the Treasury curve to normalize and give investors a chance to recover principal and to execute more favorable extension trades where both the value of selling and buying are maximized. Finally, as the bond is held, the investor receives coupon payments which serve to help offset the decline in price.

How Are We Responding?

We will always stay true to our mandate as a manager of intermediate maturities, but we will also adapt to market conditions and we have responded to 2022’s market volatility in a number of ways. The single biggest dislocation we have observed in our portion of the market is that bonds that mature in 7.5-8.5 years have consistently offered exceptional value relative to other portions of the yield curve. We are still buying 9-10 year maturities when it makes sense to do so but we have been able to consistently find value in shorter maturities which has allowed us to take less duration risk while increasing yield. For example, it has become commonplace for the ~8yr bond of a company to trade at a wider spread than the ~10yr bond of the same company, which is something that should not happen with a high degree of frequency. This type of dislocation is something that has always occasionally occurred in the market but it is typically idiosyncratic in nature and quickly arbitraged away by market participants. What we are observing in 2022 is that this has become widespread which has presented an opportunity for an investor like us because when we buy an 8-year maturity we have a 3 to 4 year time horizon before we are looking to sell. 10-year bonds are trading rich to 8-year bonds usually because of some type of market technical. We believe that it is most likely occurring because the 10-year bond is being bid-up by short term investors that are primarily concerned with short term liquidity. These investors believe that the 10-year bond is more liquid and could be easier to sell a week or a month from now if needed. We are longer term investors and we are not concerned about liquidity a week or a month from now, we care more about liquidity 3 or 4 years from now. When our 8-year bond rolls down the yield curve and becomes a 5-year bond we are highly confident that we will have plenty of liquidity when the time comes to sell our bonds. Thus we will happily take advantage of this dislocation for our client accounts.

Not only have we been able to buy shorter maturities, but we have also become more patient when evaluating the sale of existing holdings. Much of this patience is borne out of necessity as a result of the currently inverted yield curve but some of it is also related to fund flows and technical factors at play in the market. Traditionally, we would look to exit most securities right around the time that they have 5 years left to maturity. For extremely high quality A-rated paper you could see us sell with 5.5 years left to maturity while some lower quality BAA-rated paper may need to roll down to 4-4.5 years in order to maximize value. What we are seeing in the current environment is that there is simply too much “juice” left in many of our 5 year holdings so we are continuing to hold them beyond the typical 5-year time period. We are willing to wait; allowing that bond to roll down to 3 or 4 years to maturity–it is entirely about being opportunistic and maximizing value for our investors. As the Treasury yield curve normalizes, we would expect that the market will revert to an environment where it makes more sense to sell nearer the 5-year mark.

We have also been able to take even less credit risk than we typically would. To be clear, we already position our investment grade strategy as “up-in-quality” relative to its benchmark and that high quality bias comes from the fact that we cap our BAA-rated exposure at 30% while the Corporate Index was 48.93% BAA-rated at the end of the 3^rd quarter. Even though we have a meaningful underweight in BAA-rated credit, we maintain a focus of adding value for our investors through credit research and identification of those BAA-rated credits that are mispriced or that are poised to improve their credit metrics. Traditionally, we have not necessarily shied away from risk taking in lower quality credit so long as it was for the right reasons and that the compensation was appropriate for the risk incurred. We always intend to stick to our cap of a 30% weighting for this portion of the market but we have always been willing to take credit risk based on thorough research. What we are finding in the current environment, however, is that we simply do not need to take much risk in order to find compelling value. There are plenty of very solid BAA-rated credits that offer spreads that are quite attractive in our view. We are positioning the portfolio for a recessionary period and shying away from those credits that are most exposed and we are in a position where we are able to dial-back risk without giving up yield.

Fed Fait Accompli

The Federal Reserve has been active in 2022, to say the least. Six rate hikes in six months is unprecedented, and the market has never experienced so many hikes in such a short period of time. The Fed has been clear in its communication in recent weeks. It is fully committed and will not stop until inflation shows signs of slowing. Our only prediction about where the Fed goes from here is that we continue to expect tightening through further increases in Fed Funds until the data on inflation and labor shows signs of cooling. This data is entirely backward looking in nature. This could be problematic for the economy because rate hikes take time to work their way through the economy. With the Fed focused on backward looking data, it introduces a risk that financial conditions will tighten too much and the potential for overtightening diminishes the probability of a soft landing. At the very least, it appears likely that the economy will slow throughout 2023. Growth may even turn negative, thrusting the economy into recession. If there is any good news that investors can take from the Fed’s quick action to this point is that we are likely closer to the end of tightening conditions than we were just a short six months ago.

Slipping Into Darkness

The economy is still reasonably strong by many measures but cracks are starting to form in the foundation, and housing could be leading the way. Housing is an important sector for the economy and it makes up 15-18% of GDP on average. Recently released data showed that during July housing prices experienced their first monthly decline since January 2019. It should come as no surprise that housing has shown signs of slowing as mortgage rates have climbed throughout 2022 and this his had a severe impact on home affordability. According to the US NAR Homebuyer Affordabilty Index, the monthly payment on a median priced single family home ($410,600) went from $1,011 in January of 2021 to $1,933 at the end of June 2022. Mortage rates were up another 1% from June through September so this payment will be even higher when the August and September data is released, with the montly payment on a median home having more than doubled in less than two years. Builders have started to report increasing cancellations and inventory has risen . It is only a matter of time until this data starts to filter through to lower home prices and ultimately to lower GDP.

We have also begun to see earnings revisions in other cyclically sensitive portions of the economy with companies in the chemical and semiconductor industries pointing to slowing demand, especially out of Europe. Retailers like Nike have reported bloated inventories and aggressive promotions. Large stalwart companies like Walmart and Amazon are slowing or altogether pausing hiring. It is too early to tell for sure but the negative data points are piling up, and we do not view these as the signs of a soft landing. We do not necessarily believe a severe recession is the base case but it is becoming more likely that the economy will slip into a recession at some point in 2023 or 2024.

What’s Ahead for Credit?

The good news is that the vast majority of the investment grade universe has balance sheets that will hold up reasonably well in a scenario where the economy experiences a modest recession. Investment grade companies were busy in 2020 and 2021, issuing debt at record low interest rates, decreasing their interest expense burdens and pushing out maturity walls. Most companies do not need to issue new debt to fund capital budgeting projects or to refinance existing debt balances. Cash balances have declined from their 2021 peak but remain elevated by historical standards. Interest coverage ratios are near a 13-year high. We are seeing some deterioration: revenue and earnings are slowing and for some companies profit margins are deteriorating, but these are coming off of very high levels. Many investment grade companies have multiple levers to pull in the face of a slowing economy and they have shown a willingness to make conservative choices with regard to capital budgeting and share buybacks. Credit fundamentals remain strong and point to our aforementioned narrative that the selloff in credit during 2022 has been much more about interest rates than it has been about creditworthiness.

As far as spreads are concerned, the OAS on the index recently hit a year-to-date wide of 164 on September 29. If there is a modest recession then spreads could trade out to 200 and they could temporarily trade even wider in a severe recession or in the event that we get an exogenous shock to the markets but investors are being reasonably well compensated from a yield perspective. The yield on the Corporate Bond Index finished the quarter at 5.69%, which provides some cushion against the potential for wider spreads.

Keep on Trucking

The volatility in the market has presented a real opportunity for investors. Yields have risen and investors do not need to be nearly as creative in their quest to generate income. Investment grade credit is a straightforward, easily understood, asset class. Due diligence and credit research are required to identify the companies that have the best creditworthiness and from there a manager can determine opportunities in the market based on their own measure of risk and reward. We are no longer in an environment of ultralow interest rates and tight credit spreads where investors may feel compelled to consider increasingly complex asset classes or products in order to generate income. Investment grade companies, by and large, will not have difficulty navigating a recessionary environment. Spreads could go wider and Treasury yields could even retest the high end of their range but the market has cheapened so much in such a short period of time that it is hard to ignore the level of compensation that is offered by the asset class. We think that investors that stay the course will be rewarded over a longer time horizon.

We thank you for your business and your continued interest. We look forward to hearing from you to discuss the credit markets and to help with any questions you may have.

i St. Louis Fed, 2022, “10‐Year Treasury Constant Maturity Minus 2‐Year Treasury Constant Maturity”
ii National Association of Homebuilders, 2022, “Housing’s Contribution to Gross Domestic Product” https://www.nahb.org/newsand‐
economics/housing‐economics/housings‐economic‐impact/housings‐contribution‐to‐gross‐domestic‐product
iii The Wall Street Journal, September 27 2022, “Home Pries Suffer First Monthly Decline in Years”
iv Bloomberg, August 9 2022, “Builders Are Stuck With Too Many Houses as US Buyers Pull Back”
v The Wall Street Journal, September 29 2022, “Micron Issues Another Muted Outlook After Missing Expected Sales Results”
vi Barron’s, September 16 2022, “Huntsman Falls Sharply After Cutting Profit Forecast”
vii Charged Retail Tech News, October 4 2022, “Nike is Aggressively Offloading Inventory Before the Holiday Season”
viii The Wall Street Journal, September 22 2022, “Walmart to Slow Holiday Hiring”
ix The New York Times, October 4 2022, “Amazon Freezes Corporate Hiring in Its Retail Business”
x J.P. Morgan North America Corporate Research , September 8, 2022, “HG Credit Fundamentals: 2Q 2022 Review”

07 Oct 2022

High Yield Weekly, Insight, Uncategorized Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were $0.8 billion and year to date flows stand at -$60.7 billion. New issuance for the week was nil and year to date issuance is at $88.3 billion.

(Bloomberg) High Yield Market Highlights

U.S. junk bonds were headed for a weekly gain heading into the jobs report on Friday morning, as yields moved to 9.13% from 9.88%, the highest since April 2020.
The gains came amid weak US manufacturing data and a 14-month low in US job openings.
The junk-bond rally followed a broad risk-on move as equities rebounded from the worst monthly loss in more than two years in September.
Still, the gains may be short-lived as Fed officials warn that market expectations for a pivot are misplaced and that there’s a need to boost rates to “restrictive territory.”
Continuing macro uncertainty, rising oil prices and steadily rising yields have turned issuers away from the primary market.
The sudden rally in junk bonds after the September losses brought investors back to the asset class with a cash inflow of just under $1b this week.

(Bloomberg) US Jobs Rise While Unemployment Drops, Keeping Pressure on Fed

U.S. employers continued to hire at a solid pace last month and the jobless rate unexpectedly returned to a historic low, indicating a sturdy labor market that puts the inflation-focused Federal Reserve on course for another outsize interest-rate hike.
Nonfarm payrolls increased 263,000 in September after a 315,000 gain in August, a Labor Department report showed Friday. The unemployment rate unexpectedly dropped to 3.5%, matching a five-decade low. Average hourly earnings rose firmly.
The median estimates in a Bloomberg survey of economists called for a 255,000 advance in payrolls and for the unemployment rate to hold at 3.7%. Hiring was relatively broad based, led by gains in leisure and hospitality and health care.
The figures are the latest illustration of the perennial strength of the US job market. While there have been some indications of moderating labor demand — most notably a recent decline in job openings and an uptick in layoffs in some sectors — employers, many still short-staffed, continue to hire at a solid pace. That strength is not only underpinning consumer spending but also fueling wage growth as businesses compete for a limited pool of workers.
The Fed, meanwhile, is hoping to see a significant softening in labor market conditions, with the goal of cooling wage growth and ultimately inflation. While the payrolls advance was the smallest since April 2021, policy makers are watching to see if their rate hikes spur an increase in the unemployment rate.
This is the last jobs report Fed officials will have in hand before their November policy meeting as they consider a fourth-straight 75-basis point interest-rate hike. Fresh inflation data out next week will also play a fundamental role in their decision making. The report is projected to show the depth and breadth of the Fed’s inflation problem, with a key gauge of consumer prices potentially worsening.
The labor force participation rate — the share of the population that is working or looking for work — eased to 62.3%. Among those ages 25 to 54, it also dipped.
The jobs report showed average hourly earnings were up 0.3% from August and up 5% from a year earlier, a slight deceleration from the prior month but still historically elevated. The solid increase suggests the Fed will have to continue to raise interest rates as it aims to rein in rapid wage growth that has bolstered household spending.
Central bank officials have been clear recently about their commitment to taming inflation, even if that leads to higher unemployment and recession, because they say that failing to do so would be worse for Americans. Fed Chair Jerome Powell said last month that slower growth and a softer labor market are painful for the public, but that there isn’t a “painless” way to get inflation down.

16 Sep 2022

High Yield Weekly, Insight Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were $0.1 billion and year to date flows stand at -$54.8 billion. New issuance for the week was $3.0 billion and year to date issuance is at $82.3 billion.

(Bloomberg) High Yield Market Highlights

U.S. junk bonds are headed for a weekly loss to end the August rebound after a higher-than-expected inflation reading on Tuesday triggered a broad market selloff. Yields surged to a two-month high of 8.61% after steadily rising for three straight sessions, pushing the week-to-date loss to 1.5%.
The losses extended across ratings in the U.S. high yield market, with CCCs leading the pack with the worst week-to- date loss of 1.7%, after sliding for three consecutive sessions. Yields rose to a two-week high of 13.72% and spreads were approaching distressed levels.
The primary market was suddenly jolted after the CPI data earlier in the week fueled concerns that the Federal Reserve may need to raise benchmark interest rate by even 100bps to tame inflation and trigger a recession.
The primary market may pause after the Citrix debt sale was used to assess the risk appetite and clearing price levels for new debt amid rising rates and slowing economy. Nielsen Holdings and Tenneco are among the other leveraged buyouts in the queue to sell debt at some point.

(Bloomberg) Inflation Surprise Puts Onus on Fed to Hit Brakes Even Harder

The U.S. economy has shown surprising resilience in the face of the fastest inflation and interest-rate hikes in a generation. That means the Federal Reserve will have to stomp even harder on demand.
What started as a pandemic-driven supply shock has morphed into widespread inflation rooted just as much in resilient demand, underscored by unexpectedly high numbers that dashed hopes price gains were ebbing. While consumers are showing some signs of slowing, they’re still largely keeping up with persistent price pressures, powered by historic wage gains.
All told, the Fed has a much harder task on its hands than previously thought. If Americans won’t dial back spending further, odds favor the central bank becoming that much more aggressive to take more wind out of the economy’s sails with the goal of bringing inflation down.
“It tells you that it’s going to take a longer time, and will require higher rates — and in macro language, maybe even require more demand destruction,” as in higher unemployment and slower growth, said Torsten Slok, chief economist at Apollo Management. “It raises the probability of a recession.”
Consumer prices advanced by more than forecast in August, defying expectations for a monthly drop due to falling gasoline prices. Shelter, food and medical care were among the largest contributors to price growth, underscoring the breadth and severity of inflation with several categories posting record increases.
“My experience with inflation is that some of the components that were very strong in today’s report, they tend to be sticky and have a lot of inertia,” like rent, said Blerina Uruci, U.S. economist at T. Rowe Price Associates. “So I would expect those to remain pretty strong in the coming months.”
The Atlanta Fed’s so-called sticky CPI measure rose 6.1% in August from a year ago, the biggest gain in 40 years. Meantime, the Cleveland Fed’s median CPI, which excludes categories with the largest price changes, increased by the most in data back to 1983.
Excluding the volatile food and energy categories, the so-called core CPI climbed 0.6% from July, double the median estimate in a Bloomberg survey of economists. The core measure rose 6.3% from a year ago, the first acceleration in six months and near a four-decade high, the Labor Department’s report showed.
“The composition is even more troubling than the aggregate reading,” Stephen Stanley, chief economist at Amherst Pierpont Securities, said in a note. “Outside of falling gasoline prices, inflation appears to be just as hot as ever, which means that the Fed still has plenty of work to do.”
It also means that the Biden administration and fellow Democrats have plenty of work to do, as the latest data may threaten what had been growing optimism in the party that they would hold their congressional majorities in November.
Traders are now fully expecting the central bank to raise interest rates by another 75 basis points when policy makers meet next week, which would be the third-straight hike of that size. They’re also upping bets that officials will go bigger at their November gathering and see the tightening cycle peaking around 4.3% early next year — more than a quarter-point higher than what was projected before the CPI report.
Chair Jerome Powell has communicated a stronger resolve to stamp out inflation since the Fed’s summit in Jackson Hole last month, signaling that the central bank is likely to keep raising interest rates and leave them elevated for a while. He’s stuck to that hawkish view and several of his colleagues also support hiking rates to a point that more clearly restricts demand.

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