Market Commentary – Cincinnati Asset Management

30 Jan 2018

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q4 2017 High Yield Commentary

During the fourth quarter of 2017, albeit at a slower pace, the High Yield Market continued the positive return trend of the first three quarters. The Bloomberg Barclays US Corporate High Yield Index return was 0.47% for the fourth quarter. For the year, the Index returned 7.50% which leads many asset classes in the fixed income world. The lowest quality cohort, CCC rated securities and lower, once again outperformed their higher quality counterparts. The widely observed reach for yield continues unabated with highest risk, Ca‐D, followed by Caa‐rated bonds returning 13.76% and 10.38%, respectively, the highest returns of all high yield rating categories1 . It is important to note that during 2008 and 2015, the lowest quality cohort of CCC rated securities recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC rated cohort may not be appropriate for many clients’ risk profile and tolerance levels.

While the 10 year US Treasury finished the quarter and year essentially where it started, the 5 year US Treasury was noticeably higher on the quarter and year. The 5 and 10 year US Treasury ended 2016 at 1.928% and 2.447%, ended 3Q17 at 1.920% and 2.327% and finished 2017 at 2.210% and 2.411%, respectively. Offsetting the 29 basis point higher 5 year US Treasury during the fourth quarter was 3 basis points of tightening of spreads in the high yield index, suggesting much of the return was attributed to coupons. For the year however, the 28 basis point rise in the 5yr US Treasury was more than offset with 66 basis points of tightening in spread. While high yield spreads (343 basis points at year end) continue to grind tighter toward the multi‐year low of 323 basis points reached in 2014, it is still a ways off from the 233 basis points reached in 20071,2. Each quality cohort behaved in a similar fashion.

For the year, the U.S. High Yield Index generated a total return of 7.50% leading many other fixed income markets. This compares to a 10‐year U.S. Treasury return of 2.14%. Also, the Investment Grade Corporate Bond Index return was 6.42% with spreads tightening 30 bps over the year 1.

To consider the high yield performance in a broader context, a comparison to the total returns of other major asset classes is in this chart. (The returns may differ slightly due to the publisher’s selection of indices.) Equities delivered spectacular returns. Riskier classes outperformed, while the least risky asset classes lagged. Omitted is the frequently overlooked performance of gold, which rallied 14% in 20174. Intensifying geopolitical risks may be the catalyst. North Korea’s unbridled nuclear ambitions and Iran’s similar pursuits, as recently exemplified in its test launches of medium range ballistic missiles, are grave concerns. Both paths are troubling: forcing a change in behavior may be achieved only through armed conflict and the development of nuclear arsenals by these two rogue regimes and how they might eventually be deployed in light of their rhetoric is unimaginable. Considering the importance to the proper functioning of the global economy of oil exports from the Middle East, the threat of political instability and armed conflict is a major factor driving investment behavior.

Industry sector analysis reveals the top three 2017 performers in descending order were utilities, chemicals and gaming/leisure. The worst performer was retail followed by telecommunications and then consumer products (source: JP Morgan 1/2/18).

Moody’s reports that 18% of rated debt of retailers is rated Caa and lower, exceeding that during the “great recession” of 2007 – 2009. They estimate the speculative grade default rate of retailers to peak at 10.5% in March 2018, up from 8.9% at year‐end 2017 5. High profile retailers, Toys‐R‐Us filed in October and Sears Canada filed in December. Very weak retailers include luxury retailer Neiman Marcus, Sears Holdings and JC Penny. The seminal shift to online retailing will continue to cause disruptions across the “brick and mortar” retailing industry and related real estate industry.

High yield issuance (excluding emerging markets) continued to be fairly robust at $282.4 billion across 525 deals, versus $226.8 billion across 359 deals in 2016. For the third quarter, issuance by broad rating category was essentially divvied up in line by market size of each broad rating category. Issuance from emerging markets based entities added $81.7 billion and 147 more deals. This was up significantly from 2016’s emerging markets’ $46.2 billion across 75 deals. The largest deals included $3.25 billion by Valeant Pharmaceuticals, $1.5 billion by Hilton Worldwide Holdings, $2.2 billion by Community Health Systems and $1.25 billion by Equinix 6. Most dealers interviewed by Prospect News expect high yield issuance to increase in 2018.

Even with the Federal Reserve’s third 0.25% rate increase in the Federal Funds Target Rate on December 13, yields on intermediate Treasuries are slightly changed with the 10‐year Treasury at 2.41% at the end of 2017, roughly flat from 2.44% at the beginning of the year 7. The 10 year Treasury was the “pivot point” as the yield curve flattened as the FED raised the Fed Funds Target Rate with the 30‐year bond yield falling from 3.07% to 2.74%, while the 2‐year note yield climbed from 1.19% to 1.88% and the 5‐year note rose from 1.93% to 2.21% 8.

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. Although the revised third quarter GDP print was 3.2% following the second quarter’s 3.1%, the consensus view of economists reported in The Wall Street Journal, forecasts a GDP of 2.7% for 2018 up from 2% at the end of September ( with Wall Street Journal’s consensus estimate of economists 12/1/2017 inflation expectations at 2.2% for 2018). It is easy to understand that the “search for yield” that we have witnessed continues and that the high yield market is benefitting from that search.

Top of mind for bond investors is the tax bill recently signed into law. S&P’s analysis concludes, “the details of the proposal suggest the legislation will be a positive for overall credit quality, although less so for highly

leveraged speculative‐grade issuers”9.
The recently signed tax bill has significant changes that affect corporate earnings. The major elements impacting the majority of high yield issuers are: 1. The decline in the income tax rate from 35% to 21%, 2. The interest expense deductibility limit of 30% of adjusted taxable income (defined as EBITDA through 2021 and EBIT thereafter) and 3. The full expensing of qualifying capital expenditures. The chart to the left by S&P estimates that the new tax bill will have at most just slightly negative impact on companies with lower interest coverage ratios (those with more debt), “as the negative effect of lower interest deductibility would offset the positive effect of lower tax rates and the full expensing of capital expenditures” 10.

The chart below on the left shows the percentage of investment grade and high yield issuers impacted to any degree by the new law’s limit on interest expense deductibility. Logically, a larger proportion of high yield companies are impacted, however, the impact in most cases is entirely manageable, as the chart above illustrates. Also, the percentage of high yield companies adversely impacted increases after 2021 with the change in the definition from EBITDA to EBIT, as shown in the chart below on the left. Furthermore, the chart below on the right shows the percentage of rated companies impacted by leverage ratio. The higher the leverage ratio, the greater the number of companies impacted.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly concentrated in less leveraged high yield companies. We limit our purchases to those companies rated single‐B or better, so we are underweight CCC and lower rated securities. So the changes in the tax law will have less of an impact on our portfolios than those of the broader high yield market, in which approximately 15% are rated CCC and lower11. This underweight contributed to our High Yield Composite performance lagging the return of the Bloomberg Barclays US Corporate High Yield Index (6.86% gross versus 7.50%) in 2017. Over the year, we continued to be cautious in our investment strategy, maintaining higher cash balances as we become more selective in our security purchases. Given the positive market performance, these cash balances served as a drag on our performance.

The Bloomberg Barclays US Corporate High Yield Index ended 2017 with a yield of 5.72%. This yield is an average that is barbelled by the CCC and lower rated cohort yielding about 8.5% and a BB rated cohort yielding about 4.4% 12. These yields are being earned in an environment that is fairly attractive. S&P forecasts that the trailing 12‐month default rate of 3.0% as of 12/31/17 will fall to 2.7% by September 2018, significantly below the 36‐year historical average of 4.1%. S&P also observed that “nearly all market‐based measures of future default pressure are now at benign levels” 13. Due to the higher income available in the High Yield market, it is still an area of select opportunity relative to other fixed income products.

The continued tightening of credit spreads needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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

1.Bloomberg, Bloomberg Barclays Indices

2.Wall Street Journal historical US Treasury rates

3.Credit Sights 1/1/2018

4.Wall Street Journal 1/2/2018

5. Moody’s Investor Service, U. S. Retail, Apparel, Restaurants:2018 Outlook 12/14/2017

6.The Prospect News, High Yield Daily 1/2/2018 Bloomberg Barclay’s Indices Statistics

7.ibid

8.S&P Global Ratings, U.S. Tax Reform: An Overall (But Uneven) Benefit For U.S. Corporate Credit Quality

9. S&P Global Ratings, U.S. Tax Reform: An Overall (But Uneven) Benefit for U.S. Corporate Credit Quality 12/18/2018

10. ibid
11. Bloomberg Barclays
12. ibid
13. S&P Global Ratings 11/14/2017

30 Jan 2018

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

Q4 2017 Investment Grade Commentary

As the fourth quarter of 2017 came to a close, investment grade corporate bond spreads narrowed to the tightest levels of the year, and the lowest since 2007i. The Bloomberg Barclays US IG Corporate Bond Index OAS started the year at 1.22% and finished at 0.93%, which means that, on balance, credit spreads for the index tightened 29 basis points throughout 2017. During 2017, BBB credit spreads tightened more than single‐A spreads by 8 basis points. BBB spreads tightened 36 basis points in 2017, after starting the year at 1.60% and finishing at 1.24%, while A‐rated spreads tightened 28 basis points after starting the year at 1.01% and finishing at 0.73%.

At CAM, our market reconnaissance, observance and experience told us that the insatiable demand for yield and income by both foreign and domestic investors drove the 2017 outperformance of lower quality investment grade credit relative to higher quality investment grade credit. Additionally, the composition of the investment grade universe has changed since the financial crisis ‐‐ in 2007, less than 35% of the Bloomberg Barclays US Corporate Index was BBB‐rated, while today nearly 50% of said index is BBB‐rated.

Source: Barclays Bank PLC

At CAM, we believe that now, more than ever, it is prudent for us to populate our portfolios with credits that we believe have the durability and financial strength to make it through a downturn in the credit markets. We continue to limit our exposure to BBB‐rated credits at 30%, a significant underweight relative to an IG universe where nearly 50% of credits are BBB‐rated. We are focusing on sectors that we believe will behave more defensively if the credit cycle turns, or if spreads go wider. For example, we would rather forego a modest amount of yield and purchase a single‐A rated regulated utility operating company as opposed to a single‐A industrial with cyclical end markets. We continue to take appropriate risks within the BBB‐rated portion of our portfolios, but only if the individual credit is trading at a level that provides appropriate compensation for the risks. We intend to maintain a significant relative overweight to EETC airline bonds, which are highly rated bonds that are fully secured and offer excess compensation relative to what we are finding elsewhere in the market. As always, we are diligent in screening for and avoiding credits that are at risk for shareholder activism, as we attempt to steer clear of situations where shareholders are rewarded at the expense of bondholders. Simply put, we are loath to change our conservative philosophy against the backdrop of exuberant credit markets. The principal decision makers on our investment grade team measure their experience in decades, not years, so we have seen the cycles come and go. Thus, we believe skepticism and caution are the prudent courses of action, and our portfolios will be positioned accordingly. We believe our core differentiator is our credit research and bottom up process that allows us to populate our portfolios with individual credits with a goal of achieving superior risk adjusted returns over the longer term.

The passage of a sweeping tax bill has generated some inquiry from our clients who would like to know what impact tax reform may have on the credit markets in 2018 and beyond. For investment grade corporate credit, we believe the impact will be relatively muted. There are two issues that could affect credit markets, interest deductibility and repatriation. Interest paid on debt is tax deductible, so as the corporate tax rate is lowered from 35% to 21% it makes debt issuance somewhat less attractive due to a lower overall tax burden. As far as repatriation is concerned, the repatriation tax rate on liquid assets held offshore will fall from 35% to 15.5%, so it is likely that some companies will bring some offshore cash back to the U.S. but we expect only a modest impact on investment grade credit. Of the $1.4 trillion that is held offshore by non‐financial U.S. companies, over 42% of that cash is controlled by just 5 large technology companiesii. While some companies will repatriate cash to pay down debt or to avoid taking on more debt, there will be others that repatriate cash for shareholder rewards and for M&A. Overall, we believe that tax reform will have a very modest impact on investment grade credit and that effect is most likely to be felt in 2018 investment grade new issuance. 2017 was a robust year for corporate bond issuance, with $1.327 trillion in gross issuance, 1% less than the amount of issuance that came to market in 2016iii. Even if tax reform does incent some companies to issue fewer bonds, the M&A pipeline remains robust with pending deals and potential deals, so we at CAM are expecting an issuance figure similar to the last two calendar years.

2018 should be another interesting year at the Federal Reserve. Jerome Powell will be the next Chair of the Federal Reserve, pending a confirmation vote by the full Senate. There is some belief that the Fed may turn more hawkish in 2018, as inflation is slowly creeping back into the picture and the labor market is showing signs of tightening, though wage growth remains relatively subduediv. The Fed continues to target three rate hikes in 2018, but what does this mean for the corporate bond market?v Though the first Fed rate hike of the current cycle occurred in December of 2015, the impact on the 10yr treasury has been relatively muted compared to the front end of the yield curve.

In 2017 we experienced a flattening of the treasury curve. The 5/10 treasury curve started the year at a spread of 51 basis points and ended 2017 at 20 basis points. It is important to note that, even if the treasury curve were to flatten completely, or even invert, there would still be a corporate credit curve that would afford extra compensation to investors for owning 10yr corporate bonds in lieu of 5yr corporate bonds. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. 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 (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 29 years.

prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.

i Bloomberg December 27, 2017 “Surging Demand Sends Investment‐Grade Bond Spread to 2007 Levels”
ii Moody’s Investor Service November 20, 2017 “Corporate cash to rise 5% in 2017; top five cash holders remain tech companies”
iii Bloomberg December 14, 2017 “Investment Grade Issuance Total for December 14, 2017”
iv Federal Reserve Bank of Atlanta December 26, 2017 “Wage Growth Tracker”
v Bloomberg Markets December 13, 2017 “Fed Raises Rates, Eyes Three 2018 Hikes as Yellen Era Nears End”

30 Oct 2017

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q3 2017 High Yield Commentary

During the third quarter of 2017, albeit at a slower pace, the High Yield Market continued the positive return trend of the first and second quarters. The Bloomberg Barclays US Corporate High Yield Index return was 1.98% for the third quarter. Positive returns of 2.70% and 2.17% were posted for the first and second quarters of 2017, respectively. Year to date the Index has returned 7.00% which leads many asset classes in the fixed income world. As seen in the first quarter of 2017, the lowest quality cohort of CCC rated securities once again outperformed their higher quality counterparts. The widely discussed reach for yield was once again on display. It is important to note that during 2008 and 2015, the lowest quality cohort of CCC rated securities recorded negative returns of 49.53% and 12.11%, respectively.
We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC rated cohort may not be appropriate for many clients’ risk profile and tolerance levels. While the 10 year US Treasury finished the quarter essentially where it started, the Index spread tightened 17 basis points moving from 364 basis points to 347 basis points over Treasuries. While the Index spread continues to grind tighter toward the multi‐year low of 323 basis points reached in 2014, it is still a ways off from the 233 basis points reached in 2007. Each quality cohort participated in the spread tightening as BB rated securities tightened 21 basis points, B rated securities tightened 21 basis points, and CCC rated securities tightened 33 basis points.

The Energy Sector was back to its winning ways of 2016 during the third quarter of 2017. The Independent Energy and Oil Field Services Industries provided the tailwind that the Energy Sector needed after the negative returns posted in the second quarter. The Transportation, Utility, and Industrial Sectors were other top performers. The Communications Sector had a bit of tough time during the quarter as the Wireline Industry was the major drag on performance. Finally, the Consumer Non‐Cyclical Sector was one of the bottom performers as Amazon’s takeover of Whole Foods injected much uncertainty into the future landscape of the Supermarket Industry. Additionally, the Healthcare Industry saw more credit specific weakness in some of the hospital operators.

During the third quarter, high yield issuance continued to be fairly robust at $79.8 billion versus $98.7 billion and $77.2 billion during the first and second quarters, respectively. For the third quarter, issuance by broad rating category was essentially divvied up in line by market size of each broad rating category. Year to date issuance stood at $255.6 billion. This pace is very likely to exceed 2016’s total issuance of $286.2 billion.

Even as the Federal Reserve has increased the Federal Funds Target Rate twice this year, yields on intermediate Treasuries have declined with the 10‐year Treasury at 2.33% at September 30, roughly flat from 2.31% at the beginning of the quarter and down from 2.45% at the beginning of the year.

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. Although the revised second quarter GDP print was 3.1%, the consensus view of most economists suggests a GDP in the 2% range with inflation expectations at or below 2%. It is easy to understand that the “search for yield” that we have witnessed continues and that the high yield market is benefitting from that search.

The most recent FOMC meeting was on September 20th 2017. While the Committee voted to maintain the current Fed Funds Target Rate, they did note that they will initiate a balance sheet normalization program in October i. We expect the program to be a very long and slow process as to best mitigate the risk of riling the markets. The Fed’s current “dot plot” is projecting one hike in December and three additional hikes in 2018. While not all of the projected hikes might come to fruition, the Fed continues to move in the direction of easing up on the accelerator. This is unique relative to the other major central banks. The ECB, BOE, and BOJ have all continued to increase their balance sheets since 2015.

As we have discussed previously, high yield spreads continue to tighten at the same time the restrictive covenant protections contained in the indentures became more relaxed. The weakening of covenant protections has made its way to the loan market as large companies are increasingly able to finance their business with covenant‐lite terms ii. Additionally, weakened covenants are not simply a US phenomenon. International debt deals are increasingly covenant‐lite as well iii. This type of activity is not without consequences. J.Crew Group took advantage of covenants in their indenture to remove collateral value from some creditors. This type of activity is not happening across the board. Some creditors are successful in pushing back against companies while other creditors are not as lucky iv. More and more, a professional manager is needed to select bonds of quality – bonds that compensate the investor for the risks he undertakes in a high yield portfolio.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly underweight CCC and lower rated securities. This underweight contributed to our High Yield Composite performance lagging the return of the Bloomberg Barclays US Corporate High Yield Index (1.66% versus 1.98%) during the third quarter. Over the quarter, we continued to be cautious in our investment strategy, maintaining higher cash balances as we become more selective in our security purchases. Given the positive market performance, these cash balances served as a drag on our performance. We were also underweight the Energy Sector which was the best performing sector for the third quarter. On the other hand, some top contributors of our performance were our credit selections across the Capital Goods Sector as well as the Technology Sector.

The Bloomberg Barclays US Corporate High Yield Index ended the third quarter with a yield of 5.45%. This yield is an average that is barbelled by the CCC rated cohort yielding about 8.5% and a BB rated cohort yielding about 4%. These yields are being earned in an environment that is fairly attractive. There has been a significant amount of central bank stimulus. High Yield has displayed a fundamental backdrop that is stable to improving. The default rate of 1.27% is significantly below the historical average and expected to remain low over the next year. Additionally, the default volume during the third quarter was the lowest amount since the fourth quarter of 2013v. Due to the higher income available in the High Yield market, it is still an area of select opportunity relative to other fixed income products.

Over the near term, we plan to be rather selective. Changes to the Affordable Care Act are on the back burner at best, but tax reform is now front and center. Tax reform does have the ability to be a positive factor for the High Yield Market. That said, the continued tightening of credit spreads needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

i FOMC Statement September 20, 2017
ii Bloomberg September 26, 2017: “That Junk Loan is Now Basically a Junk Bond”
iii Bloomberg September 29,2017: “High Yield Investors Sweat for Return in Europe Sellers Market”
iv Wall Street Journal September 21, 2017: “Deal to Save J.Crew from Bankruptcy Angers High Yield Debt Investors”
v J.P. Morgan October 2, 2017: “Default Monitor”

30 Oct 2017

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

Q3 2017 Investment Grade Commentary

The third quarter of 2017 was a reprise of what we experienced in the first two quarters of the year investment grade corporate bond yields were lower and credit spreads were tighter. As far as fundamentals are concerned, the majority of investment grade corporate issuers are displaying earnings growth and balance sheets are generally in good health. Demand for investment grade bonds has been robust in 2017, and issuers have responded in kind by issuing $1.06 trillion in new investment grade corporate bonds, though this pace of issuance trailed 2016 by 5%. During the quarter, the A Rated corporate credit spread tightened from 0.88% to 0.80% (down 8bps), the BBB rated corporate credit spread tightened from 1.41% to 1.31% (down 10bps) and the Bloomberg Barclays US Investment Grade Corporate Index credit spread tightened from 1.09% to 1.01% (down 8bps)ii. To provide some context, the all‐time tight for the Bloomberg Barclays US IG Corporate Index is 0.54%, last seen in March of 1997, while the all‐ time wide is 5.55%, last seen in December of 2008.

As you can see from the chart above, credit spreads are near multi‐year lows. During times like these, when spreads have continued to move tighter, our experience shows that our client portfolios are best served by investing in high quality companies with durable earnings and free cash flow. In other words, we would rather forgo the extra compensation afforded from a lower quality credit and instead focus on investing in a stable to improving credit. Preservation of capital is a key tenet of our strategy, and we do not feel that the current level of credit spreads is providing adequate compensation for the riskier portions of the investment grade corporate bond market. At CAM, we focus on bottom up research through the fundamental analysis of individual companies and we do continue to see pockets of value in the investment grade market, particularly in the higher quality portions of the market.

While credit spreads tightened during the quarter, the movement in Treasury yields was modestly higher as the 10 Year Treasury yield began the quarter at 2.31% and ended it at 2.33% (up 2bps). The 10 Year Treasury started the year at a yield of 2.45%, so while short term rates have increased as the Fed has implemented two rate increases so far in 2017 (i.e. the 2 Year Treasury ended the quarter 27 basis points higher from where it started the year), intermediate Treasury yields remain lower on the year. When short term rates increase and intermediate/long term rates stay stable or decrease, we refer to this as a flattening of the yield curve. This continuation of lower intermediate Treasury yields and tighter credit spreads resulted in lower corporate bond yields at the end of the quarter, relative to where yields started the year. The Bloomberg Barclays US Investment Grade Corporate Index returned +1.34% for the quarter, outperforming the Bloomberg Barclays US Treasury 5‐10 year index return of +0.46%iii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +1.23% for the quarter which slightly underperformed the Investment Grade Corporate index but outperformed the US Treasury index.

See Accompanying Footnotes

New issuance in the quarter saw issuers price nearly $350 billion in new investment grade corporate bonds, bringing the YTD total to $1.06 trillioniv. We have now eclipsed the $1 trillion mark for the sixth straight year, which speaks to the persistent, global demand from investors searching for yield and income for their portfolios. With low‐ to‐negative yields in global fixed income securities, the US Investment Grade corporate bond market still provides a good alternative for global investors (see chart)v.

The Federal Open Market Committee (FOMC) opted not to raise rates at its September meeting, with the market focused squarely on the December meeting. During its September meeting, the FOMC did provide the long awaited details on its program to gradually reduce the size of its balance sheet. The FED is merely reducing the reinvestment of principal payments from the Federal Reserve’s securities; it is not actively selling its holdings. The FOMC has provided a roadmap of its policy normalization efforts along with a schedule of how it plans to gradually reduce its balance sheet over time (see chart)vi. Like most policy actions, the FOMC has showing a willingness to be flexible, pending new information and economic data, so time will tell if the securities reduction schedule is actually implemented as planned.

While the FOMC has begun a gradual effort to tighten monetary policy, the ECB too has discussed scaling back its monetary easing as soon as January 2018, but the plan is vague at this point and the world will be watching closely for more details when they meet again near the end of October. Meanwhile, the BOJ recently pushed back the window for achieving its 2% inflation target for the sixth time; to around fiscal year 2019, meaning the bank will not embark on policy tightening in the near termvii. Bottom line, we are only in the very early innings of a more concerted effort to tighten monetary policy by global central bankers.

A recurring theme for us in our quarterly notes this year has been the lack of market volatility thus far in 2017, and the third quarter of the year was no different from the previous two in that volatility remained low (previous commentaries can be found at www.cambonds.com). Volatility is a fact of life in the capital markets and we know at some point it will return to the forefront. We feel that the best way we can position client portfolios is to focus on the risks that are within our control –namely the quality of the companies in which we invest. While volatility in See Accompanying Footnotes

credit spreads or interest rates is difficult, if not impossible to predict, it is important to understand the impact that higher yields would have on the corporate bond market especially as it relates to a corporation’s balance sheet, cash flows and credit quality. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. 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 (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 28 years.

i Bloomberg September 28, 2017 “Investment‐Grade Issuance Total”
ii Barclay’s Credit Research: Daily Credit Call
iii Bloomberg Barclay’s Indices
iv Bloomberg September 29, 2017 “Robust High‐Grade Bonds Sales of September Likely to Fade” v Federal Reserve Flow of Funds
vi Federal Reserve Bank of New York September 20, 2017 “Statement Regarding Reinvestment in treasury Securities and Agency Mortgage Backed Securities”
vii Japan Times July 20, 2017 “BOJ delays window for achieving 2% inflation target”

30 Jul 2017

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q2 2017 High Yield Commentary

The Bloomberg Barclays High Yield Index returned 2.17% during the second quarter of 2017 and 4.93% for the first half of the year, continuing, although at a slower pace, the robust 2016 performance (+17.13%) which was the best since the 2009 recovery performance of 58.21%. Unlike Q1 and all of 2016, the highest rated credit sector (BB rated) outperformed the weaker sectors (i.e., BB rated bonds outperformed B and CCC rated bonds). While the highest rated credits within the universe outperformed the lower quality credits, the entire market was characterized by continued spread tightening – the Index spread tightened from 383 to 364, or 21 basis points over Treasuries and BB rated credits tightened from 252 to 227 or 25 basis points over Treasuries. Spreads are now near their tightest in almost a decade, and while performance during Q2 was positive across all credit subsectors, it is important to note that during 2008 and 2015, the lowest rated credit subsector (CCC) recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC credit subsector may not be appropriate for many clients’ risk profile and tolerance levels.

Unlike calendar 2016’s performance that was, in great measure, attributable to the robust recovery of the Energy Sector, Q2 witnessed positive performance by almost all Sectors, led by the Financial Institutions Sector, which was up 3.67%. That Sector accounts for over 9% of the Index, so its performance had a positive impact on the Index performance, but clearly not the significant impact that Energy played during 2016. In fact, Energy posted negative returns of 1.16% for Q2 as oil traded below $50 in the area of $45 per barrel for most of the quarter.

Even as the FED has increased the Federal Funds Target Rate twice this year, yields on intermediate Treasuries have declined with the 10‐year Treasury at 2.31% at June 30, down from 2.39% at the beginning of the quarter and from 2.45% at the beginning of the year. Intermediate term yields more often reflect GDP and expectations for future economic growth rather than actions taken by the FOMC to adjust the Target Rate. The consensus view of most economists suggests a sluggish GDP in the 2% range with inflation expectations at or below 2%. It is easy to understand that the “search for yield” that we have witnessed for several years continues and that the high yield market is benefitting from that search. This search for yield has also been observed in the investment grade universe where the lowest credit rated debt has outperformed the investment grade index as a whole. During Q2, high yield issuance continued to be fairly robust at $76.7BB versus $98.7BB during Q1. Year to date issuance stood at $175.3BB. This pace could see us easily exceeding 2016’s total issuance of $286BB.

Discussed at length during the year by many high yield observers was the fact that, while spreads were tightening, the restrictive covenants contained in the indentures under which the bonds were being issued were becoming more and more “relaxed”. In other words, while investors were searching for yield, issuers were able to negotiate with investors to remove covenants that previously were provided as standard protection for the investor: namely leverage constraints, disposition of assets, etc. More and more, a professional manager is needed to select bonds of quality – bonds that compensate the investor for the risks he undertakes in a high yield portfolio.

Cincinnati Asset Management buys only B3/B‐ and higher rated securities, and, given that the CCC sector underperformed the Index as a whole, it is easily understood that our performance exceeded the Index for the 2nd Quarter (2.24% gross total return vs. 2.17%). During this period, we remained cautious in our investment strategy, maintaining higher than normal cash balances as we become more selective (higher credit quality) in our security purchases. Given the market performance, these cash balances served as a drag on our performance as well.

Further addressing the issue of performance by credit sub-sector, the following table highlights the impact of the performance of the several credit sub‐sectors in the high yield universe on the aggregate high yield performance:

An additional observation: The Index yield for the High Yield Market is 5.62%. Default rates have been low since the Energy sector “crisis” of 2015/16; however, there will always be defaults in the high yield universe. Historically, those defaults have come principally from the CCC and lower subsectors. So pricing needs to reflect that eventuality. With respect to 2017, we continue to be cautious. Many potentially positive factors could favorably impact corporations in the high yield space (changes in the tax code, relaxed and fewer regulations, etc.); however, the impact of changes in trade agreements and the health of the global economy need to be carefully monitored. Defaults, excluding Energy, have remained lower than the long‐term average default rate – a positive sign with respect to the current health of the asset category. On the other hand, the “shrinking” spreads (i.e., implied premium to Treasury bonds) is of concern given that the “search for yield” may have resulted in an overvalued market. The tightening of spreads implies the expectation of a robust recovery in corporate performance.

In this uncertain environment, it is important to focus on credit research and to attempt to buy bonds of corporations that we believe can withstand economic headwinds and can enjoy improved credit metrics in a stable to improving economy.

30 Jul 2017

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

Q2 2017 Investment Grade Commentary

The second quarter of 2017 saw a continuation of the prevailing trend of tighter credit spreads across the US corporate bond market. This trend of tighter spreads, which has been unabated for nearly 16 months, has been a significant contributing factor to the overall positive performance of the Investment Grade corporate bond market during that time frame. Specifically, during the quarter the A Rated Corporate credit spread tightened from 0.97% to 0.88% (down 9bps), the BBB Rated Corporate credit spread tightened from 1.51% to 1.41% (down 10bps) and the Bloomberg Barclays US Investment Grade Corporate Index credit spread tightened from 1.18% to 1.09% (down 9bps)i. Along with this credit spread tightening the movement in Treasury yields were generally lower as the as the 10 Year Treasury yield began the quarter at 2.39% and ended it at 2.31% (down 8bps). This continuation of lower treasury yields and tighter credit spreads have seen the overall yields of corporate bonds end the first half of the year lower than where they started the year. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with lower yields, thus both achieving positive performance, Investment Grade corporate bonds outperformed Treasuries due to the tightening of credit spreads and higher coupon income collected. The Bloomberg Barclays US Investment Grade Corporate Index returned +2.54% for the quarter, outperforming the Bloomberg Barclays US Treasury 5‐10 year index return of +1.24%ii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +2.08% which slightly underperformed the Investment Grade index but outperformed the US Treasury index.

New issuance in the quarter was a robust $344 billion in new Investment Grade corporate bonds, yet slowing down from the record pace in the first quarter, bringing the YTD total to $760 billion iii. We are well on our way to the sixth straight year of over $1 trillion in new issuance, which speaks to the persistent, global demand from investors searching for yield and income for their portfolios. This demand is partially driven by the fact there still exists $6.5 trillion of negative yielding securities in the Bloomberg Barclays Global benchmark index, a sum that has shrunk from a peak of $12 trillion in June 2016 (see chart)iv. With low‐to‐negative yields in global fixed income securities, the US Investment Grade corporate bond market still provides a good alternative for global investors.

The Federal Open Market Committee (FOMC) acted again during the quarter by boosting the target range for the Federal Funds rate by another 25bps at their June 14th meeting v. At the time of the FOMC action the 10yr US Treasury yield was 2.17% and the move up in short term rates influenced by the policy move has flattened the yield curve even further, something we discussed extensively in our Q1 2017 commentary. (A copy of that and all of our previous commentaries can be found on our website at www.cambonds.com.) Central Banks around the world have been hinting at ending their ultra‐ loose monetary policy and begin to wind down their active quantitative easing (QE) programs vi. While the FOMC has not been actively adding to its balance sheet via QE, it has been maintaining it around $4.5 trillion by reinvesting proceeds from maturing bonds in its portfolio. Members of the Federal Reserve board, including Janet Yellen, have openly discussed starting to unwind its $4.5 trillion balance sheet sometime this fall by letting some of its maturing securities run off and not be reinvested. However, as of yet, no set timetable has been established vii. As with most FOMC policy shifts, investors are best served to watch what the FOMC does and not what they say as they make these changes. The unwinding of trillions of dollars of securities will be difficult to execute, and will be closely watched by investors around the world. While the FOMC is looking to reduce the size of its balance sheet, the European Central Bank and Bank of Japan have been significantly adding to theirs over the past several years with both recently surpassing the size of the balance sheet of the Federal Reserve (see graph)viii. While neither of the two have definitive plans to end QE it would seem that halting open market purchases would be the first step in the direction of policy normalization.

With potentially significant central bank policy shifts on the horizon US Investment Grade corporate bond markets have exhibited a strange sense of calm in the first half of 2017. This could be attributable to the lack of volatility exhibited across nearly all asset classes along with the prevailing market perception that nearly any disruption in credit markets would be met with a large dose of liquidity from the Federal Reserve. While the Fed is close to meeting its unemployment mandate, it is failing to meet its desired inflation mandate. This is giving the market the sense that the Fed will feel that it has the flexibility to deliver more liquidity into the market if deemed necessary. With the persistent tightening of credit spreads and decline in overall interest rates, performance has been stable, consistent and fairly robust. With yields and credit spreads below their long term averages investors should not grow too complacent to think these trends will continue in perpetuity. A change in QE policy by global central banks or deterioration in credit conditions due to the onset of recession may alter the path of both interest rates and credit spreads rather quickly. While we are not predicting the imminent commencement of either of these events, investors should be prepared for potential volatility in corporate bonds that a reversion to the long term mean in rates and credit spreads would bring about. This volatility may not come for some time, but it is something to consider when thinking about expectations for the asset class. While this may, or may not, occur during the timeframe of anyone’s investment horizon, when it does, it will be imperative to understand the impact higher yields will have on the corporate bond market especially as it relates to a corporation’s balance sheet, cash flows and credit quality. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. 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 (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 28 years.

i Barclay’s Credit Research: Daily Credit Call
ii Bloomberg Barclay’s Indices: Global Family of Indices June 2017
iii CreditSights: US IG Credit Monitor Q2 2017
iv Bloomberg Markets July 11, 2017: “Pool of Negative‐Yield Debt Shrinks Rapidly as Bond Market Turns” v FOMC statement dated 6/14/2017
vi Bloomberg Markets June 28, 2017: “Central Bankers Tell the World Borrowing Costs Are Going Up”
vii Janet Yellen semiannual Humphrey‐Hawkins testimony to US House Financial Services committee 7/12/2017
viii Yardeni Research, Inc. 7/7/2017: “Global Economic Briefing: Central Bank Balance Sheets”

30 May 2017

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

Q1 2017 Investment Grade Commentary

After a very volatile end to the year in 2016, the first quarter of 2017 saw a much more benign movement in interest rates and corporate bond yields as most fixed income markets stabilized after a difficult fourth quarter. During the first quarter of 2017, Treasury yields traded within a fairly narrow, 24 bps range. The movements in Treasury yields were generally lower as the 10 Year Treasury yield began the quarter at 2.45% and ended it at 2.39%. Accompanying the lower yields in Treasuries, corporate credit spreads continued their persistent grind tighter that began in mid‐ February of 2016 and ended the quarter near the tightest levels of the past 13 months. Specifically, the A Rated Corporate credit spread tightened from 1.01% to 0.97% (down 4 basis points (bps)) and the BBB Rated Corporate credit spread tightened from 1.60% to 1.51% (down 9bps)i. When looking at the movement of interest rates and credit spreads together, the decline in Treasury yields and slightly tighter corporate credit spreads helped Investment Grade corporate bond yields end the quarter slightly lower than where they started. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with lower yields, thus both achieving positive performance, Investment Grade corporate bonds outperformed Treasuries due to the tightening of credit spreads and higher coupon income collected. The Barclays US Investment Grade Corporate Index returned +1.22% for the quarter, outperforming the Barclays US Treasury 5‐10 year index return of +0.89%ii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +1.37% which outperformed both of the above mentioned indices.

The beginning of the year saw robust demand for US Investment Grade corporate bonds which allowed for a record setting new issuance in the quarter. During the quarter there was $413B of new issuance across 565 issues which represented a 14% increase from Q1 2016iii. A large portion of the new issuance were bonds with 5 and 10 year maturities ‐ an area of interest for CAM. As an institutional investor who participates in the primary (new issuance) marketplace, we were able to be fairly active in Q1, which has benefits to our clients. According to CreditSights, the average yield pickup in the new issue market for 10yr Investment Grade Corporate Bonds in the first quarter was 10bps, or 0.10% in additional yield, versus comparable bonds of the same issuer in the secondary marketiv. We will continue to participate in the primary market when there are attractive opportunities in credits we like.

The first quarter was also marked by policy action by the Federal Open Market Committee (FOMC) at their March meeting. While CAM has always considered itself interest rate agnostic in its investment process, we think it makes sense to clarify what the FOMC has been doing and its effects on the yield curve as it relates to our portfolios. The FOMC sets interest rate policy for very short‐term interest rates by influencing the Federal Funds rate, the overnight lending rate between banks. One way this is done is through adjusting the reserve requirements of member banks with The Federal Reserve. The FOMC sets a target rate that is, effectively, what most think of when one hears that the Fed “raised rates” or “lowered rates”. This in no way directly affects interest rates for other, longer dated maturity bonds. Those interest rates are determined by investors’ inflation forecasts, which can be impacted by FOMC activities. So, interest rate policy indirectly affects yields on longer dated fixed income securities. It may be surprising what this impact has been since the FOMC has been hiking the target Federal Funds rate in this cycle. As an investor in the intermediate portion of the yield curve (5 – 10 year maturities), we will examine the 10 year part of the Treasury curve to analyze those interest rate movements around the recent FOMC policy actions.

The FOMC began their recent increase in monetary policy on December 16, 2015 by hiking the Federal Funds target rate by 25 bps or 0.25%v. This was their first “rate hike” in over a decade. The day they made this policy announcement the yield on the 10yr US Treasury was 2.30% (see graph)vi. The immediate effect on this yield was opposite of what most market commentators and investors thought as it began a sharp decline all the way to a low of 1.37% on July 5, 2016.

The next FOMC policy action came a year later on 12/14/16 when they announced a hike in the target rate by another 25bpsvii. At the time of this announcement the yield on the 10yr US Treasury was back up to 2.54%. The reaction to this policy move was again a decline in yield to a low on 2/24/17 of 2.31%. The FOMC’s most recent move, their third “rate hike” of 25bps saw the 10yr US Treasury yield at 2.51% which has since declined to 2.18% (as of 4/18/17)viii. In summary, since the FOMC began moving up their target range on the Federal Funds rate in December 2015 by a total of 75bps or 0.75%, the yield on the 10yr US Treasury has moved down from 2.30% to 2.18% with more downside volatility in between. We are not suggesting that this pattern will continue or that it is indicative of any future direction of interest rates. In fact if the FOMC were to begin unwinding their $4.5trillion balance sheet, as has been recently discussed by Janet Yellenix, they may directly affect this part of the yield curve by selling treasury and mortgage securities in the open market. Prior unconventional FOMC actions of quantitative easing (QE) directly affected longer term interest rates by lowering them through open market purchases of treasuries and mortgages. If any future unconventional FOMC policies were to unfold we will address those issues in future quarterly commentary or white papers available at www.cambonds.com. The point is that while investors are sometimes focused on the short term noise of the FOMC policy actions, the long term outcome can be different from what one expects. In addition to this decline in yields on 10yr US Treasuries, credit spreads have tightened considerably during this time, giving a boost to the performance of US Investment Grade Corporate Bonds. During this period of FOMC policy action of “rate hikes” the total return of US Investment Grade Corporate Bonds as measured by the Barclays IG Corporate Bond index has been in excess of +7.0%x. Clearly this type of return was not expected by many when the FOMC embarked on this “rate hike” cycle, and should not be expected to continue in the future, but has rewarded those investors who stayed the course and were not led to exit corporate bonds because the FOMC was “raising rates”.

We remind our clients that 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 as described above. 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, more commonly known as the credit spread. 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. Following this philosophy over time can help investors to ignore the short term noise of any FOMC policy actions and focus on what is truly important.

i Barclay’s Credit Research: Daily Credit Call
ii Bloomberg Barclay’s Indices: Global Family of Indices March 2017
iii Dealogic & CreditSights, Strategy Analysis April 2017: US IG Issuance: Concessions Still Exist
iv Dealogic & CreditSights, Strategy Analysis April 2017: US IG Issuance: Concessions Still Exist
v FOMC statement dated 12/16/15 https://www.federalreserve.gov/newsevents/pressreleases/monetary20151216a.htm
vi FRED database https://fred.stlouisfed.org/series/DGS10
vii FOMC statement dated 12/14/16
viii FOMC statement dated 3/15/17
ix Bloomberg News April 30, 2017: “Fed’s Cut in Bond Holdings May Be Messier Than Yellen Hopes” x Bloomberg Barclay’s Indices: Global Family of Indices March 2017

30 Mar 2017

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q1 2017 High Yield Commentary

The High Yield Market returned 2.70% during the first quarter of 2017, continuing, although at a slower pace, the robust 2016 performance (+17.13%) which was the best since the 2009 recovery performance of 58.21% (Bloomberg Barclays Indices). As was the case for all of 2016, Q1 performance was characterized by outsized performance of the weakest credit sectors within the Index, i.e., the CCC and lower rated credits, which currently account for approximately 15% of the high yield universe. These lowest rated credits returned slightly less than 5% during Q1 (they returned over 30% during 2016). In fact, if we were to exclude the CCC rated credit sub‐sector, the Index would have posted a 1.44% return, lower than our gross return performance of 2.00%. It is important to note that during 2008 and 2015, that lowest rated credit subsector recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of that credit subsector may not be appropriate for many clients’ risk profile and tolerance levels.

Unlike calendar 2016’s performance that was, in great measure, attributable to the robust recovery of the Energy Sector, Q1 witnessed positive performance by all Sectors, led by the Utility Sector, which was up 4.37%. That Sector accounts for less than 2.76% of the Index, so its performance had a positive impact on the Index performance, but clearly not the significant impact that Energy played during 2016 (The Energy Sector was up over 37% during 2016 and comprised approximately 15% of the Index at year end.) In fact, Energy’s 3.0% return approximated the overall Index as oil traded in a $50‐$55 range for most of the quarter, although it did drop to a low of $47.34 late in the quarter.

The performance of the least credit‐worthy within the high yield universe represented the continuing “search for yield” that we have witnessed for several years as interest rates on Treasury bonds, in general, fell to their lowest levels in a decade during July ‘16 and then increased to a level at year end (2.45%) that was only marginally higher than where it began the year. After the FOMC increased the Federal Funds Target Rate by 25bps in December, the 10‐year Treasury yield declined from 2.60% mid‐December ’16 to 2.39% at March 31. (This search for yield has also been observed in the investment grade universe where the lowest credit rated debt has outperformed the investment grade index as a whole.) The result of this “search” has been the tightening of spreads, i.e. the premium yield of bonds relative to the risk free Treasury rate. At year‐end 2015, the premium yield on BB, B, and CCC rated bonds was 417, 654, and 1,351 basis points, respectively. We ended 2016 with those premia at 270, 382, and 807, respectively; and by March 31, spreads had tightened even more – to 252, 375, and 692, respectively. So, while Treasury rates over the first 3 months of 2017 declined, the premium demanded by the investor for “risk compensation” continued to fall considerably. We make note of this only to inform the investor of the market dynamics surrounding both yield movement (up and down) and premia movement: both impact bond prices.

The demand for yield was met by $98.7BB in new issuance during Q1 2017; total 2016 issuance was $286BB. The Energy and Metal & Mining Sectors were the largest issuers, accounting for 13% and 10% of total volume, respectively. It is interesting to note that the several years prior to 2015, 17‐19% of new issuance came from the lowest rated credits, and that percentage declined dramatically during 2015‐2016, to just over 10% in 2016. However, Q1 2017 saw that percentage increase to almost 16%.

Given that Cincinnati Asset Management does not buy CCC rated securities, it is easily understood that our performance trailed that of the Index for 1st Quarter (2.00% gross total return vs. 2.70%). We have remained cautious in our investment strategy, maintaining higher than normal cash balances as we become more selective (higher credit quality) in our security purchases. Given the market performance, these cash balances served as a drag on our performance as well.

With respect to 2017, we continue to be cautious. Many potentially positive factors could favorably impact corporations in the high yield space (changes in the tax code, relaxed and fewer regulations, etc.); however, the impact of changes in trade agreements and the health of the global economy need to be carefully monitored. Defaults, excluding Energy, have remained lower than the long‐term average default rate – a positive sign with respect to the current health of the asset category. On the other hand, the “shrinking” spreads (i.e., premium to Treasury bonds) is of concern given that the “search for yield” may have resulted in an overvalued market. While CCC spreads have tightened considerably, BB and B spreads remain modestly tighter on the year, although they had tightened considerably during 2016. The tightening of spreads implies the expectation of a robust recovery in corporate performance. In this uncertain environment, it is important to focus on credit research and to attempt to buy bonds of corporations that we believe can withstand economic headwinds and can enjoy improved credit metrics in a stable to improving economy.

Cincinnati Asset Management’s High Yield Strategy remains conservatively positioned. The construction of the portfolio is driven by our bottom‐up analysis and our restriction from CCC‐rated securities adds an additional level of conservatism.

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.

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 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

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