Insight – Page 58 – Cincinnati Asset Management

20 Jan 2017

Investment Grade Weekly, Weekly Insights CAM Bond Funds 0 comment

CAM Investment Grade Weekly Insights

Fund Flows & Issuance: According to Lipper, for the week ended January 18th, investment grade funds posted a net inflow of $1.893bn. The total year-to-date net inflow into investment grade funds ended the week at $8.108bn. Per Bloomberg, investment grade corporate issuance through Thursday was ~$29bn. Thus far, $121.8bn of investment grade corporate bonds have been issued in January, besting consensus estimates of $112bn.

(Press Release) IBM Reports 2016 Fourth-Quarter and Full-Year Results

Highlights
- Diluted EPS from continuing operations: GAAP of $4.73; Operating (non-GAAP) of $5.01
- Revenue from continuing operations of $21.8 billion
- Strategic imperatives revenue for full-year 2016 of $32.8 billion up 13 percent (up 14 percent adjusting for currency) represents 41 percent of IBM revenue
- Cloud revenue of $13.7 billion for full-year 2016, up 35 percent
  - Cloud as-a-service annual exit run rate of $8.6 billion at year end, up 61 percent year to year (up 63 percent adjusting for currency)
- 2017 EPS Expectations: GAAP of at least $11.95; Operating (non-GAAP) of at least $13.80
“In 2016, our strategic imperatives grew to represent more than 40 percent of our total revenue and we have established ourselves as the industry’s leading cognitive solutions and cloud platform company,” said Ginni Rometty, IBM chairman, president and chief executive officer. “IBM Watson is the world’s leading AI platform for business, and emerging solutions such as IBM Blockchain are enabling new levels of trust in transactions of every kind. More and more clients are choosing the IBM Cloud because of its differentiated capabilities, which are helping to transform industries, such as financial services, airlines and retail.”

(NYT) Morgan Stanley Nearly Doubled Profit From Year Earlier Fourth Quarter

Morgan Stanley roared in the fourth quarter, but it also exposed the limits of animal spirits. The bank led by James Gorman almost doubled its profit in the period from a year earlier to $1.7 billion. As at rivals, though, return on equity remains subpar.
Some banking businesses do not fare well when too much hangs in the balance, as occurred with an OPEC meeting, an Italian constitutional referendum and the American election late last year. Fees from new stock sales, for example, fell 5 percent from the third quarter at Morgan Stanley, 19 percent at JPMorgan Chase and 34 percent at Bank of America.
Trading desks ought to have been reaping the benefit from market mood swings. They certainly performed better in last year’s final quarter than during the same span in 2015. Morgan Stanley’s fixed-income, currency and commodities dealers raked in, at $1.5 billion, nearly three times as much revenue.
Profitability also remains subdued. With annualized return on equity of 8.7 percent in the fourth quarter, Mr. Gorman is inching toward his 2017 goal of 9 percent to 11 percent. For now, Morgan Stanley keeps failing to cover its cost of capital, generally assumed to be 10 percent for large banks.
Business may pick up in time, but that story has been told for years. What could power earnings is largely beyond Wall Street’s control: more and faster interest-rate increases from the Federal Reserve and financial rule changes from Washington.
Morgan Stanley is well placed to benefit from both. It is growing its lending business and its mostly domestic wealth-management unit accounts for an increasing share of the company’s profit. With a capital ratio of 16.8 percent, the bank holds more excess than rivals and thus has plenty to return to shareholders if regulators allow.

(Bloomberg) Key Republicans at Tom Price Hearing Still Wary on Health Law Repeal

A hearing on President-elect Donald Trump’s choice for health secretary became an arena Wednesday for key Republicans to stress their opposition to overturning the current health law without a clear replacement.
The panel was considering the selection of Rep. Tom Price (R., Ga.), but much of the session focused on GOP plans for undoing the health law. Sens. Lamar Alexander (R., Tenn.) and Susan Collins (R., Me.) pointedly told Mr. Price their concerns about an initial Republican strategy of repealing the law without an agreed alternative in hand.
Mr. Alexander, who chairs the Senate Health, Education, Labor and Pensions Committee, warned that the fragile insurance market in his state means he cannot support anything that would trigger further disruption. He finished on a similar note, telling Mr. Price he was confident he had secured his agreement.
“What I heard from you, I believe I’m correct about this, is that while we intend to repair the damage of Obamacare and that will eventually mean repealing parts of it—major parts of it—that won’t become effective until there are practical, concrete alternatives in place to give Americans access to health care,” he said.
The GOP-controlled Senate and House have taken their first procedural steps toward repealing the ACA, passing a budget that directs lawmakers to start drafting legislation to dismantle much of the law. But Republicans’ 52-48 Senate majority offers little room for defections as they move ahead.

(Bloomberg Intelligence) Dakota Access Still Has Path to Completion Despite Corps’ Review

The Dakota Access Pipeline project may be delayed by a new Army Corps environmental review, but that isn’t likely to stop the project from being completed.
The pipeline lost a court bid to block the Army Corps from preparing an environmental impact statement on the lake crossing, opening up the project to a period of public comment and review ending Feb. 20.
While publication of the EIS notice somewhat hems in the incoming Trump administration, the new president’s appointees may still withdraw it or reverse course.
In the interim, the federal district court in Washington could also agree with Dakota Access that the easement was actually granted in July, negating the EIS process completely.
If the EIS process is allowed to go to completion, that process may last as long as six months.

13 Jan 2017

High Yield Weekly CAM Bond Funds 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to Wells Fargo, flows week to date were $0.3 billion and year to date flows stand at $1.1 billion. New issuance for the week was $1.2 billion and year to date HY is at $1.4 billion.

(Business Wire) Williams and Williams Partners Announce Financial Repositioning for Long-Term, Sustainable Growth

Williams and Williams Partners L.P. announced an agreement to permanently waive payment obligations under the incentive distribution rights held by Williams and convert Williams’ economic general partner interest into a non-economic interest for 289 million newly issued Williams Partners common units
The estimated transaction value is approximately $11.4 billion. Following the IDR Waiver, Williams will hold approximately 660 million Williams Partners common units, representing approximately 72% of the common units outstanding
Williams also announced that it expects to purchase newly issued common units of Williams Partners at a price of $36.08586 per unit. Williams expects to fund the unit purchase with equity. With respect to units issued to Williams in the private placement, Williams Partners will not be required to pay distributions for the quarter ended December 31, 2016 and the prorated portion of the first quarter of 2017 up to closing of the private placement
As a result of the measures announced today, Williams expects that Williams Partners will not be required to access the public equity markets for the next several years. In addition, the Transactions result in debt reduction at Williams Partners and a meaningful increase in its cash coverage ratio to approximately 1.2x in 2017 and maintenance of strong coverage in excess of 1.1x thereafter
Strengthening Williams Partners’ coverage and credit profile through the Transactions will benefit stakeholders in Williams Partners, including Williams. In addition, maintaining Williams Partners as a strong, separate entity provides on-going strategic and financial flexibility to Williams, enabling it to capitalize on future opportunities to grow both organically and inorganically

(Business Wire) Parsley Energy Buys Permian Properties for $607 Million

Parsley Energy Inc. is buying oil and gas properties in America’s hottest shale play for $607 million as it seeks to boost production by almost 60 percent this year
The acquisition comprises 23,000 net acres of land adjacent to the company’s existing operations in the Midland and Southern Delaware portions of the Permian Basin
The Permian shale formation straddling West Texas and New Mexico has been a hot spot for deals and the center of a revival in U.S. oil drilling as producers have managed to make a profit in the region even during the worst price crash in a generation

Sabine Pass Liquefaction was recently upgraded to BBB- by Fitch. This makes the Sabine bonds rated investment grade by two of the three major rating agencies.

(Bloomberg) Valeant Sells $2.1 Billion in Assets to Ease Debt Burden

Valeant Pharmaceuticals agreed to sell about $2.1 billion in assets in two deals, an important first step in the struggling drugmaker’s endeavor to get cash and begin easing its debt burden
L’Oreal SA, the Paris-based cosmetic giant, will pay Valeant $1.3 billion for three skin-care brands. Valeant will also sell its Dendreon Pharmaceuticals unit to closely held Chinese conglomerate Sanpower Group Co. for about $820 million. Valeant’s shares and bonds jumped after the news
The agreements mark Valeant’s biggest divestitures in almost three years, and a start to its efforts to pay down about $30 billion in debt. It’s a significant break for Chief Executive Officer Joe Papa, who took over in May to help turn around a company that had been embroiled in scandals about high prices and accounting that led to legal and regulatory investigations
Proceeds from both sales will be used to permanently repay term-loan debt under Valeant’s senior credit facility, according to the company. The Sanpower transaction is expected to close in the first half of this year, while the sale to L’Oreal should close in the first quarter

(Bloomberg) Sprint Debt Upgraded by Moody’s on Better Performance, Liquidity

“Despite the heavy promotional activity, profitability has remained stable due to Sprint’s cost-reduction initiatives,” Moody’s said, adding that annual savings could top $2 billion. The more solid footing “has reduced Sprint’s refinance risk and its dependence upon the often-volatile high-yield bond market,” Moody’s said. Sprint also benefits from implicit support of its parent, SoftBank Group Corp., the report said.
Sprint has struggled to improve its finances under Chief Executive OfficerMarcelo Claure. The unprofitable carrier, based in Overland Park, Kansas, has had to borrow money using assets including airwave licenses as collateral to help finance the business. Through promotions such as half-off pricing, it has curbed subscriber defections and turned in its first annual increase in seven years.

(New York Times) Senate Takes Major Step Toward Repealing Health Care Law

In a 51 to 48 vote, the Senate took their first major step toward repealing the Affordable Care Act, approving a budget blueprint that would allow the health care law to be gutted without the threat of a filibuster.

13 Jan 2017

Investment Grade Weekly CAM Bond Funds 0 comment

CAM Investment Grade Weekly Insights

Fund Flows & Issuance: According to Lipper, for the week ended January 11th, investment grade funds posted a net inflow of $4.029bn. The total year-to-date net inflow into investment grade funds ended the week at $6.215bn. Per Bloomberg, investment grade corporate issuance through Thursday was $38.8bn. Thus far, $92.8bn of investment grade corporate bonds have been issued in January, while consensus estimates call for $112bn for the full first month of the year.

(Bloomberg) Teflon Chemical Cases Face Uncertain Fate If Dow, DuPont Merge

Uncertainty cloaks DuPont Co.’s liability for 3,500 toxic tort lawsuits over a Teflon-related chemical as the company proceeds toward a merger with Dow Chemical Co.
PFOA has been found in drinking water in West Virginia and Ohio, near the Parkersburg plant. In the first three of those 3,500-plus cases, DuPont lost to residents of that area who claimed DuPont’s PFOA was responsible for their cancer.
DuPont’s spinoff, Chemours Co., will defend the PFOA cases although DuPont has been the named defendant.
Tom Claps, litigation analyst at Susquehanna Financial Group LLLP, said his company estimates DuPont will be liable for about $550 million for settlement of the current 3,500-plus PFOA cases. Chemours is required to reimburse DuPont for that amount, as the companies agreed in 2015.
“However, DuPont must write the initial PFOA checks to plaintiffs in these cases, and will then go after Chemours for reimbursement,” Claps said.
According to the Environmental Protection Agency, PFOA was found in blood serum in 99 percent of the U.S. general population between 1999 and 2012, but that percentage has been decreasing as domestic companies phase out production of the chemical.
The agency issued a health advisory in 2016 limiting PFOA exposure to 0.07 parts per billion after studies in test animals showed the chemical has adverse health effects, including cancers and impacts on development and the immune system.

(Moody’s, CAM notes) Constellation Brands Raised to Investment Grade by Moody’s

The rating upgrade reflects Constellation’s strong brand portfolio and favorable category trends, and its commitment to manage its net debt/EBITDA leverage to around 3.5x compared to a historical targeted range of 3x to 4x.
Moody’s expects that Constellation will maintain strong liquidity, characterized by over $1.4 billion in annual operating cash flow and $1.15 billion in revolving credit facilities with substantial borrowing availability.
With this Moody’s upgrade, Constellation is now rated investment grade by all three rating agencies.

(Bloomberg) ‘End of Covenants’ Sparks Revolt Over Erosion of Bond Safeguards

The first time Adam Cohen’s Covenant Review sounded the alarm in October about a new passage creeping into bond offerings, it described the junk-rated deal from Rackspace Hosting Inc. as “outrageous” and “unprecedented.” Investors bought it anyway.
To Cohen, it seemed no one was paying attention to the fine print. So he blasted out a report titled “The End of Covenants,” ultimately fingering 18 deals with the disputed passage.
“I had to do something dire,” said Cohen, founder and chief executive officer of his New York-based firm. “By sending out something with the ridiculous title of ‘The End of Covenants,’ people figured out, ‘Wait, something’s going on here.’”
Bonds typically come with a lengthy array of standard covenants that protect bondholders by requiring company managers to maintain certain financial ratios, limit asset sales and meet certain deadlines. If they don’t, it can be deemed a voluntary default that entitles bondholders to penalty payments. The “no premium on default” passage casts doubt on those payments, according to Cohen’s firm.
Such language may be less jarring to junk-bond owners, who accept more risk and allow corporate managers more leeway in return for higher yields. Mainstream investors weren’t so forgiving.
Chatter about the covenants spread through buy-side e-mail chains and chatrooms Monday and Tuesday, with some investors urging others to contact banks to oppose the language.
The firestorm that erupted by the middle of this week pushed issuers including Marsh & McLennan, GM and Broadcom Ltd. to drop the idea. The report had struck a nerve with buyers of high-grade bonds, who already have fewer protections and aren’t eager to go down the path that led to five years of eroding protection for junk-bond covenants, as tracked by Moody’s Investors Service.

31 Dec 2016

Investment Grade Quarterly, Market Commentary Josh Adams - Portfolio Manager 0 comment

Q4 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 fourth quarter of 2016 saw a substantial increase in Treasury yields as they generally trended higher at the beginning of the quarter and moved sharply higher towards the end of the quarter. The movement higher in Treasury yields did not begin on November 8th (election day in the US) but accelerated at that point before peaking in mid ‐December. Offsetting the higher yields in Treasuries, corporate credit spreads continued their persistent tightening since the mid‐February widest levels of the year and ended near the tightest levels of the year. Specifically, the 10 Year Treasury began the quarter at 1.60%, peaked at 2.60% (up 100 bps) on December 15th and ended the quarter at 2.45% (up 85 bps). The A Rated Corporate credit spread tightened from 1.12% to 1.01% (down 11bps) and the BBB Rated Corporate credit spread tightened from 1.78% to 1.60% (down 18bps). When looking at movement of interest rates and credit spreads together, the sharp rise in Treasury yields was only partially offset by tighter credit spreads, thus yields for Investment Grade corporate bonds ended the quarter higher than where they started. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with higher yields, Investment Grade corporate bonds outperformed by a considerable margin.

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

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

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

For 2016 our Investment Grade Corporate Bond composite provided a gross total return of +4.03% vs the Barclays Investment Grade Corporate Index total return of +6.11%. Our limiting of bonds rated BBB to 30% of a portfolio vs approximately 53% for the benchmarkii, was a primary factor for the full year underperformance. The dispersion of performance in the benchmark across credit quality is highlighted below:

Since our portfolios tend to hold fewer BBB rated bonds and more A & AA rated bonds, one can see how this influenced our performance relative to the benchmark. This contrasts with our 2015 outperformance of the benchmark (+1.01% vs ‐0.68%) which can be partially attributed for the exact opposite reason of widening credit spreads and our long time policy of limiting BBB rated bonds.

As the year ended, we saw a continuation of many of the same themes we have written about in our previous commentaries. The continual tightening of credit spreads, which has provided better relative returns than US Treasuries, continued unabated since mid‐February. New corporate bond issuance set a new record in 2016 with nearly $1.3 Trillion of new Investment Grade issuance providing the supply to meet robust investor demand iii. Companies have been very eager and aggressive to issue bonds to lock in coupon rates near all‐ time historic lows (chart above).

As we enter 2017 a great deal of concern and speculation has centered on the future direction of interest rates due to potential new policy actions by a new administration in Washington DC. We as a firm do not utilize interest rate anticipation or forecasting in our investment process thus, we do not have an official firm view on the direction of rates. We do understand the concern investors have with the uncertainty of the direction of interest rates, but it is a risk we have no control over. What we do have control over is the composition of a portfolio as it relates to the credit quality it exhibits and assessing the risks associated with each company’s capacity to pay its future interest payments and ultimately return of principal to investors. As an investment manager solely focused on assessing this credit risk, this is where believe we have the ability to add value to a fixed income portfolio where an allocation to US corporate credit has been made. It is important to note that credit spreads are at levels that are tighter than their 30 year average. There is risk of potential corporate bond volatility due to these credit spreads mean reverting, which is something investors should be aware of as we move forward. If this credit spread widening were to unfold, we believe a portfolio with a corporate bond manager like CAM that underweights the riskiest credit quality of Investment Grade bonds and focuses on understanding the credit risks of the companies it owns, should help alleviate some of the potential volatility relative to other Investment Grade fixed income sectors. It is important to note that higher Treasury yields have historically provided a buffer to adverse interest rate movements ‐‐with absolute yields at the lower end of long‐term ranges, small rate changes can have a larger impact on bond values as there is less cushion to absorb adverse outcomes.

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 Barclays Indices: Global Family of Indices December 2016

ii Bloomberg Barclays Indices: Global Family of Indices December 2016

iii http://www.sifma.org/research/statistics.aspx

30 Oct 2016

Investment Grade Quarterly, Market Commentary Josh Adams - Portfolio Manager 0 comment

Q3 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 third quarter of 2016 saw a small increase in Treasury yields as they generally trended higher throughout the quarter. Offsetting the higher yields in Treasuries, credit spreads continued their persistent tightening since the mid-February widest levels of the year and ended near the tightest levels of the year. Specifically, the 10 Year Treasury began the quarter at 1.47% and ended at 1.60% (up 13 bps), the A Rated Corporate credit spread tightened from 1.24% to 1.12% (down 12bps), and the BBB Rated Corporate credit spread tightened from 2.05% to 1.78% (down 27bps). These two factors together have added up to stable or slightly lower yields for Investment Grade corporate bonds.

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

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

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

Since we just discussed the impact of tightening credit spreads on the performance of our strategy and the Barclays Index, we will examine the other noted trends and how they may influence future returns in the asset class. There is no denying the insatiable desire of investors to search globally for an attractive, and positive, yield on their investments. Whether it is insurance companies from Europe, pension funds from Japan or individual investors from the US, the search for yield has never been stronger than we see today. Foreign-based institutional investors, which represent approximately 40% of the buyers in the marketplace todayii, have been forced to look at the US fixed income markets for positive yielding investments as negative yielding bonds dominate their local markets. It is not known how long this influx of foreign capital will continue to support the US corporate bond markets, but it may continue for a period of time. Monitoring the state of yields in their local markets may provide some insights as to when this flow of funds subsides. Since the Federal Reserve Bank made it their policy to suppress interest rates to, amongst other reasons, force investors to take more risks via the “portfolio balance channel theory”iii, individual investors have been forced to buy securities with higher risks than they may have desired to obtain yields they once received on “low” to “no-risk” investments. Investment Grade corporate bonds, which carry both duration and credit risk, have been a primary beneficiary of this shift in investor risk preferences and the buying by individual investors continues to this day. While the Fed maintains a low interest rate policy, it is not a stretch to believe these individual buyers will remain significant buyers of corporate bonds, especially retirees who are in the desperate need of interest income to meet living expenses.

These robust sources of demand have allowed companies to supply this demand and issue a great deal of debt in the US Investment Grade markets at very low coupon rates. The issuance for 2016 has already surpassed $1.07 trillion, which is the 5th consecutive year that issuance has surpassed $1.0 trillion iv. This issuance has more than doubled the size of the US Investment Grade corporate bond market since 2008 as figure 1 below highlights.

While these trends remain firmly in place for the time being, we remain cautious with respect to any complacency regarding the concept of a “new normal” as it pertains to the pricing of corporate credit. The dynamics of tightening credit spreads that are diverging from underlying credit metrics, such as elevated leverage ratios v, should not be assumed as a “given” that will continue in perpetuity. One of two things has to happen to alleviate strains in these metrics, either growth of corporate debt has to slow down or company fundamentals (revenues and earnings) have to improve to bring down these ratios.

As an investment manager solely focused on assessing credit risk of the individual companies we own, we monitor these risks on an ongoing basis for all of our clients’ portfolio holdings.
In this environment, where strong demand has tightened credit spreads fairly indiscriminately, credit quality and issuer selection becomes more important than usual – because when this indiscriminate demand abates, US corporate bonds will be valued based more on the merits of the company’s ability to pay its interest and principal and less on the insatiable global demand for yield.

i Bloomberg Barclays Indices: Global Family of Indices September 2016
ii Wells Fargo Securities: Corporate Credit Outlook Q4 2016
iii Jackson Hole speech by then Fed Chairman Ben Bernanke August 31, 2012; http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm
iv http://www.sifma.org/research/statistics.aspx
v Morgan Stanley Research, Bloomberg http://www.bloomberg.com/news/articles/2016-09-09/leverage- soars-to-new-heights-as-corporate-bond-deluge-rolls-on

30 Jul 2016

Investment Grade Quarterly, Market Commentary Josh Adams - Portfolio Manager 0 comment

Q2 2016 Investment Grade Commentary

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.

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

Investment Grade Quarterly, Market Commentary Josh Adams - Portfolio Manager 0 comment

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.

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

← Previous 1…5758