Corporate Credit View

Is It Really That Bad?

Earnings season is almost over and while the data was positive overall, management commentary coupled with weaker than expected economic data disappointed the markets, sending equities and Treasury yields lower.  Corporate spreads were mixed with intermediate-to-longer duration bond spreads widening while short duration spreads tightened.  Similarly, cyclical and other economically sensitive sectors generally underperformed.  The Corporate market, as measured using Barclays Corporate Index, posted -66 basis points (bps) of excess return for the month, pulling down the excess return year-to-date to -48 bps.  We expect this volatility to continue in the second half of the year.  Since 1989 when the U.S. GDP growth rate was between 0% to 2%,  the Investment Grade Credit market posted positive excess returns.  We expect the same in 2010, although sector and credit selection is critical, as the credit market should continue to differentiate and assign greater risk premiums to sectors and credits that face challenging growth prospects either due to the economy or idiosyncratic issues.

Since last month’s Corporate Credit View was dedicated to Financials, this month’s will focus on Industrials and Utilities.  Despite a quarter of better than expected results (Table 1), analysts were busily revising their estimates down for Industrials and Utilities for 2010 (See Exhibits 1 and 2).  Even Western Europe surprised on the upside both for the second quarter and the forecast for the second half of the year.

 

We attribute these negative revisions to the worse than expected economic data that continued through August, notably imports, jobless claims, and home sales.  Economists revised GDP forecasts down for the second quarter and the second half of 2010 and increased the probability of a double-dip recession, now approximately 25%.

CEOs from bellwether companies, Cisco and WPP PLC, voiced their concerns about the uncertain state of the economy and how that may affect their businesses, as customers make changes to their purchasing decisions.  They were not alone, as the number of companies sounding a more cautious tone increased.  Most have been cautious but not pessimistic and the lack of job creation, capital spending, and inventory re-stocking reflect this outlook.  For example, retailers in general have tempered their full year guidance. Most of the companies who are reporting better than expected earnings have done so because of improvements with expenses rather than sales, as same-store sales have slowed in the second quarter versus the first quarter.  Inventories have increased, which could lead to heavier promotion and potentially lower margins in the third quarter.   Our cautious outlook for the economy and the consumer in particular leads us to invest only in category leaders, which includes high quality discounters such as Walmart and Target.

Despite a slowing Manufacturing sector, we saw continued improvement in the Rail sector.  Every rail company beat estimates in the second quarter of 2010 and management commentary was constructive.  Pricing and productivity enhancements are driving margins, and volumes are supporting the improvement in sales versus last year. We heard from most management teams that the economic recovery is in place even though it would probably be best described as only modestly growing. If volumes remain on the current trajectory, we could see an uplift to earnings estimates for the second half of 2010, accompanied with more aggressive share repurchase activity.  This would be notable since rail loadings reflect customer decisions made six to nine months in the past, or in the case of third quarter 2010 results, the period of time when Europe garnered significant attention.  Despite the Rail sector’s exposure to the broad economy, we consider the more diversified rail operators (i.e., Union Pacific (UNP), Burlington (BRK), Norfolk Southern (NSC)) viable investment alternatives in a low growth environment given strong competitive advantages versus other shipping modes and steady cash flow generation.  We believe Rail spreads are attractive versus cyclical sectors, as they are about flat to each other and Rail spreads are less volatile (Exhibit 3).

In the Energy sector, second quarter results were a mixed bag, and we expect them to remain murky in the second half of 2010.  Generally speaking, the independent and integrated companies produced strong second quarter 2010 results due to increased production as well as higher commodity prices.  The contract drillers and service companies, however had weak quarters due to the moratorium in the Gulf of Mexico and reduced demand from Latin American countries.  In the second half of the year, we expect cash flows to be flat to slightly weaker for most of the Energy sector.  Particularly vulnerable are those companies that are levered to natural gas, which has suffered due to abundant supply and weaker industrial demand.  Absent a hurricane in the third quarter, natural gas prices are unlikely to rise meaningfully in the second half of the year.  Contract drillers and service companies are likely to suffer weaker results due to uncertainty in the Gulf of Mexico, excess capacity created by the moratorium, and weaker natural gas prices.  In terms of economic barometers, the following data points in Table 2 reflect positive, albeit slowing, demand domestically and continued strong demand from China, which is supportive for the Energy sector in the near-to-intermediate term and suggests a continuation of slow growth at a macro level:

The Utility sector posted modestly improved second quarter 2010 results behind strong weather-related demand in the northeastern part of the U.S.  The results were partially offset by weaker pricing, which is the by-product of lower natural gas prices.  Companies seem to be preparing for an improving environment, as their allowance for doubtful accounts have been trending lower.  Most utilities expect demand to be up very modestly in the second half, as industrial demand remains tepid.  Weak natural gas prices should also lead to lower prices, which will hurt the margins of the unregulated power producers.  More than demand or pricing however, the biggest concerns identified by the sector were regulatory uncertainty regarding the now abandoned cap and trade regulation and the potential for increased taxes on dividends.  We believe these concerns could lead to potentially lower capital spending and greater share repurchases.  Regulatory and tax uncertainty were also cited as concerns by telecom companies, among others. We believe these are the main reasons why companies have been hesitant to spend or invest. Until this uncertainty is resolved, we expect these companies to remain hesitant to reduce cash or reinvest earnings. The approaching November elections only add to the difficulty of predicting the upcoming regulatory environment.

We like the backdrop the cash build (Exhibits 4 and 5) provides for the economy, and believe cash at the investor level has provided positive technical support for the Corporate bond market this year, especially for high quality Industrial and Utility credits.  Unless the probability of a recession increases another 10+ percentage points, we expect this positive technical support to continue.

We remain constructive on the Corporate market, but as spreads for Utility and Industrial credits have generally marched tighter and Treasury yields have fallen, all-in yields for these two sectors are historically very low (Table 3).  If spreads provide compensation for default risk adjusted for recoveries, the high dollar prices (which affects recovery rate) coupled with the uncertain economic outlook (which affects default rate) make spreads for these sectors particularly vulnerable to widening.  We have reduced our exposure to more economically sensitive Industrial sectors (e.g., Media/Entertainment), redeploying the funds in non-Corporate sectors.

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This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.

Can We Still “Bank” on Economic Growth in the Second Half of 2010?

After a volatile three months, Corporate spreads tightened in July. Spreads ended the month 20 basis points (bps) tighter, generating 134 bps of excess returns per the Barclays Corporate Index. The Energy sector recovered some of the widening year-to-date, posting 259 bps of excess returns in the month. The Corporate Index is back in positive territory, generating 23 bps of excess returns year-to-date. Finance is outperforming with 41 bps of excess return vs. Utilities (+15 bps) and Industrials (+13 bps). Of the Industrial sub-sectors, those that are less cyclical are outperforming (Exhibit 1). This is what we had expected, consistent with a slow, fragile recovery.

Exhibit 1: Industrial Sub-Sector Performance
Source: Barclays

As the near term lift from the stimulus wanes, investors are combing through earnings reports to help forecast near term economic activity. Consumers need to keep spending and businesses need to hire more people. It sounds very simple. As of late afternoon on Friday July 30, approximately one third of companies had reported results. Of this set, sales growth was evident in most sectors relative to 2009 (Exhibit 2). We explained earlier this year that credit selection and investing in growth would be keys to outperformance (versus a down-in-credit quality strategy). Except for Energy, which is an idiosyncratic issue, there does appear to be a nice correlation between growing and/or defensive industries with excess returns.

Exhibit 2: Second Quarter 2010 Earnings Review (as of 7/30/10)

Source: Bloomberg

We began our earnings review with the banking sector. That sector is the first to report and the most efficient, as virtually all the large banks report in the first few weeks, including many of the European banks. We will concentrate on this sector in this month’s AAM Corporate Credit View, addressing Industrials and Utilities next month. That said, there is a common thread among all sectors, and that is the importance of top line growth to job growth. Therefore, while it’s nice to see earnings and sales growth in the second quarter, we are more sensitive to future periods and thus far, management guidance and commentary have been supportive of a continued slow, but growing economy.

The US banking sector generated stronger than expected second quarter 2010 operating results due to materially improved credit costs. However, the improvement in asset quality was somewhat overshadowed by questions about revenue sustainability as a result of shrinking balance sheets and the yet-to-be-quantified costs of the Dodd-Frank bill (financial regulatory reform).

Credit quality within bank loan books improved broadly, continuing a trend which began to manifest itself in the fourth quarter of 2009. In general, the large money center banks are about a quarter ahead of the regional bank sectors in the asset quality improvement cycle, primarily reflecting the differing make-up of their respective loan books. Commercial & Industrial and credit card portfolios led the way in terms of asset quality improvement, while commercial real estate and construction loans continued to deteriorate and home equity loan asset quality appears to have stabilized for the moment, but at an elevated level of credit costs. In a number of instances, operating performance benefited from reserve releases (somewhat surprising given still high non-performing asset levels), with such releases being most notable for the three large credit card issuers (JPMorgan/Bank of America/Citi). Although provisions, net charge-offs, non-performing assets and early stage delinquencies all fell materially for the sector, bank management teams have cautioned that credit costs are not likely to show the same rate of improvement in the second half of 2010 if the economy cools and unemployment remains high.

Offsetting the positive credit quality developments, there is growing concern over revenue sustainability as a result of loan book contraction, narrowing interest spreads and the potential impacts of financial regulatory reform. Banks are experiencing shrinking loan balances and muted credit demand as consumers de-lever and corporations conserve cash in the face of economic uncertainty. In addition, many banks continue to run-off portions of their loan books (e.g., subprime), which removes interest earning assets even as it removes asset quality issues. Interest income is also being squeezed by the extended period of low interest rates, particularly as higher yielding assets re-price. While this has been offset to some extent by a run-off of more expensive Certificates of Deposit sourced during the funding crunch, the absolute level of net interest income is likely to contract given the low absolute level of interest rates and narrowing interest spreads (this situation is mirrored in available-for-sale portfolios as well).

Finally, the impact of the Dodd-Frank bill, while impossible to quantify on a system-wide basis before required rule writing and implementation, is likely to negatively impact non-interest revenue in several areas. Within retail banking, lucrative overdraft fees and credit and debit card interchange revenue will be impacted, although, only JPMorgan and Bank of America have attempted to quantify the impact to date. In money center bank space, the impact of the Volcker Rule and derivative regulations were blunted somewhat in the conference process. The likely end result of financial regulatory reform on bank performance was best summed up by Jamie Dimon of JPMorgan, who noted that while specific revenue streams will no doubt be impacted, “mitigation” efforts to spread costs and recoup loss fee revenue through new charges/products will likely offset the impact of the bill on bank results over time.

Overall, we would characterize the quarter as guardedly positive, particularly as we saw a continuation of the credit quality improvement trend that has been key to our overweight allocation to the banking sector. While questions about balance sheet, revenue and profit growth appear to be looming in investors’ minds, we would characterize this (for the moment) as more of an equity concern, given the still strong liquidity and capital positions of the sector as a whole. Going forward, the biggest challenge appears to be macroeconomic, as a slower rate of GDP growth in the second half of 2010 may cause credit improvement to stall (or even reverse). Since we are forecasting a slow, muted recovery, we are comfortable with the credit profiles of the money center banks, highest quality regional banks, and select international banks. We are investing defensively in this sector(i.e., high quality banks), believing the spread differential between banks and industrials is too wide (Exhibit 3). We realize that spreads will remain volatile until we get confirmation that credit trends will not reverse as a result of a double-dip recession or protracted slow economic growth.

Exhibit 3: Bank Spreads Remain Wide vs. Industrials

Source: Barclays

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.

June was another volatile month for Corporate credit (Exhibit 1). Spreads ended the month modestly wider, generating -9 basis points (bps) of excess returns for the Barclays Corporate Index driven mainly by the underperformance of the Energy sector (-249 bps excess return).

June failed to produce sufficient positive signs to allay concerns regarding the sustainability or strength of the domestic economic recovery. Early indicators are pointing to a slowdown in growth in the second half of the year. The question is how slow? We had believed growth would be modest this year, less than 3%, and vulnerable to a public to private sector handoff as stimulus spending waned (Exhibit 2). Since May, manufacturing has continued to expand, albeit at a slower pace, and private sector employment has disappointed, as private employers turn more cautious. We believe we may be at a point where inventory restocking has stalled and employers are willing to replace but not build (Exhibit 3). Small business owners, as reflected by the National Federation of Independent Business (NFIB) survey, and large business CEOs, as reflected by the Business Roundtable survey, are concerned with the overall global economy, legislative policy, and new regulations and rules. Managers do not feel comfortable hiring new workers or spending capital when they are uncertain of the return on investment. Therefore, jobs remain very difficult to source. We have been expecting jobless claims to fall below 400,000, a level that typically coincides with the end to payroll employment losses, and are still waiting. The jobs report released on July 2, 2010 was very weak, considering household employment declined sharply and both the workweek and average hourly earnings declined.

The high level of unemployed workers is being reflected in lower consumer confidence. The June Conference Board Index (Exhibit 4) reading disappointed (52.9 vs. a revised 62.7 in May) with a 16% drop in the expectations part of the index, a source of concern given the reliance on the consumer to solidify the recovery. As reflected in the present situation portion of the index, consumers recognize the obstacles they and their government face.

Firm and industry level data has been encouraging, albeit reflecting decisions that may have been made earlier in the year or quarter. For instance, data points such as rail carloads, intermodal traffic, rig count, energy consumption (Exhibit 5), advertising, retail sales on the Industrial side and return on assets, net interest margin and asset quality on the Banking side have all shown improvement from 2009 levels. Acknowledging the time lag that exists from when a decision is made at the consumer and/or business level to when the information is made available to the public via a statistic or index figure, we will continue to analyze this data and incorporate management commentary and forecasts to make changes to our base case. That said, recent economic data suggests the risk of growth coming in below consensus forecasts has increased.

Our investment mantra earlier this year of “investing in growth” instead of “reaching for yield” reflected our view that investors could benefit from investing in high quality companies in defensive industries. We believed and continue to believe that a “slow growth” environment should result in merger and acquisition activity, innovation to differentiate, and industry participant bifurcation where industries are cleansed of weak operators that benefitted from the earlier days of
easy money. We are early in this process, but are seeing signs of potential catalysts for the latter (i.e., widening divergence of balance sheets and access to capital for strong vs. weak firms).

At this point, we believe fundamental improvement has taken place in many facets of the economy, including investment grade company balance sheets (Exhibit 6), and a recovery, even one that is lackluster, is still on track. However, the recent jobs report shows that the labor market has yet to reach the point where it is self sustaining, making our base case forecasts at the credit level vulnerable to downward revisions. The degree of these revisions could affect our opinion on the Corporate credit market, but at this point we continue to expect positive excess returns for those credits that are higher quality and more defensive (e.g., food, beverage, pharmaceutical, aerospace/defense, rails), in addition to high quality banks and believe there are opportunities in the energy sector.

 

 

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

 This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.

Out Like a Lion

May brought a steep reversal of the spread tightening over the previous few months. After 44 basis points of spread widening in May, excess returns turned negative for the year (-99 basis points excess return year-to-date and -260 basis points in May for the Barclays Corporate Index). The widening occurred in all three sectors, Industrials, Utilities, and Finance although defensive sectors generally outperformed, as shown in Table 1 (e.g., Aerospace/Defense, Railroads, Consumer Noncyclical sectors).

In addition to widening credit spreads, Treasury yields rallied among other signs of increased risk, reflecting three primary concerns:

Economic uncertainty in Europe – The market seems to be taking a “prove it” stance towards the Eurozone periphery countries, also known as PIIGS (Portugal, Italy, Ireland, Greece, Spain), and other European countries, as government liquidity and austerity measures are not resulting in positive market reaction. Fears of a public to private transition for GDP growth worldwide and the uncertainties relating to fiscal deficits and debt burdens are high, and the Eurozone periphery countries represent proof and consequence. In addition, there continue to be questions surrounding the stability of the banking sector in Europe. The contagion to the domestic economy is a concern if this weakness continues. While U.S.

exports are a small component of GDP growth, there are many indirect economic consequences if this region deteriorates economically. For instance, a weaker Euro would likely cause the Chinese export market to weaken, resulting in slower Chinese and emerging market growth, which would negatively affect U.S. growth. The indicators that we will be watching closely include: confidence, manufacturing, auto and retail sales, railcar loads, and various European GDP and banking related reports. The economic fragility coupled with limited monetary and fiscal alternatives remain our primary concerns, if the U.S. does enter another recession.

Stock market correction – In addition to many other consequences, a continued decline in the stock market has the potential to weaken consumer and business confidence, which is essential for our economy to continue to grow. As the government stimulus is withdrawn and the early drivers of GDP growth wane (e.g., inventory reduction), U.S. GDP growth will become increasingly more reliant on traditional sources of growth – fixed investment and the consumer. So far in 2010, the consumer has been stronger than expected as reflected in the latest confidence report. Consumer confidence has increased largely due to the expectations factor, highlighting the vulnerability of the consumer in light of high unemployment and a weak housing market. If expectations from the consumer and business leaders deteriorate, it puts the progress in these areas at risk. There are many other direct and indirect effects that would negatively impact not only GDP but individual company results (e.g., annuity writers).

Financial regulatory reform – The primary risk facing bank credit investors is the possibility of rating downgrades associated with a reduced ability on the part of the government to provide extraordinary support in the future. For a handful of “systemically important” institutions, the ratings currently reflect a level of implicit and explicit support from the U.S. government. Should regulators be legislatively prohibited from providing extraordinary support to struggling financial institutions (as they did during the 2008 liquidity crisis), the rating agencies have signaled that they could potentially downgrade a number of large banks from the A category to BBB. While the rating agencies appear to be taking a measured approach to assessing the impact of financial regulatory reform, rating downgrades remain a possibility in the intermediate-term. From a bank Balance Sheet perspective, unlike three years ago, banks are very liquid and have deleveraged, leaving them better able to manage a downgrade to the BBB rating level. However, this is significant not only because it increases funding costs, but it also reduces the availability of funds (Commercial Paper, Repurchase Agreements). This has a negative impact at an economic level because it constricts lending and therefore, the velocity of funds, which is already low. At this point, we remain comfortable with the financial sector from a fundamental standpoint (improving asset quality/strong capital and liquidity), but raise the concern more at an economic level.

Entering 2010 vigilantly, we had advocated a defensive position in credit. We have been concerned about the economic fragility around the world and the limitations governments face due to the burdensome debt obligations and strained fiscal balances. Although we have witnessed improving company fundamentals, the possibility of an exogenous shock to the economic system puts the sector at risk of underperformance in the near term. Our cautious approach to the sector has reduced the volatility of our portfolios and puts us in good position to take advantage of spread widening in the high quality sectors over the next few quarters.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

 This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.

A Greek Tragedy?

The nearly $1 trillion aid package announced by the Eurozone policy makers on May 10, 2010 appears to be stabilizing investment grade bond markets in the US and Europe for the moment.  The need for extraordinary action was clear. In the past month, concern over the Greek fiscal condition had evolved into fears about that nation’s ability to refinance its sovereign debt maturities. The implications of a disorderly Greek debt restructuring (default) are two-fold.  Firstly, financial institutions holding Greek sovereign debt (banks/insurers/pensions) would be faced with large write-downs, possibly impacting solvency of some institutions.  Second, the evolution of fiscal concerns about Greece into funding concerns served to focus the market’s attention on other fiscally challenged sovereigns with large funding needs, including Portugal, Ireland and Spain.  The aid package provides a refinancing backstop for the sovereign issuers that were faced with spiking funding costs, if not outright roll-risk on upcoming refinancing of their debt issuances.  At the same time, the announcement of extraordinary measures by the European Central Bank, including purchase of public and private debt, as well as reinstating term lending facilities and U.S. Dollar swap lines with the Federal Reserve Bank, should counter rising pressures on European banks that had manifested themselves in the interbank funding markets in the two weeks prior to May 10^th.

However, the challenges facing the Eurozone remain daunting.  While near-term refinancing risks appear to be addressed via the aid package, the persistent fiscal imbalances underlying the recent market fears remain.  A number of the Eurozone economies continue to spend in excess of their ability to grow revenue resulting in growing indebtedness.  This issue is exacerbated by structural rigidity in certain economies that makes labor market and government spending adjustments challenging, thus further depressing economic growth (particularly in Greece and Spain).  While the Maastricht Treaty which formalized the European Monetary Union laid out budget deficit and debt-to-GDP limits, numerous members of the Eurozone have violated these criteria over the years, with several members doing so in an unsustainable manner.  Until Greece, Portugal and Spain (and potentially Italy) are able to get control of their persistent budget deficits and stabilize their debt levels, the markets will continue to be cautious of the sovereign debt and the issues of banks domiciled in those countries.

So what are the implications for global bank credit?  Given the impediments to successfully addressing the Greek fiscal imbalances, some form of restructuring of Greece’s sovereign debt seems likely, as it is hard to see how Greece can “grow into” its current and future projected debt load.  Furthermore, other members of the Eurozone may face similar choices if they are unable to overcome their persistent deficits and rising indebtedness.  Perhaps the least bad option, a managed restructuring of Greek obligations, might go a long way towards stabilizing the rest of the Euro area and giving countries such as Portugal, Ireland and Spain time to address their own fiscal imbalances.  While the likelihood of default appears low, given the support mechanisms put in place this past weekend, individual banks that are exposed to the sovereign debt of Greece would face write-downs in the event of a restructuring.  As such, we recommend avoiding banks in the affected countries (Greece, Portugal, Spain, Italy and Ireland) and confining Eurozone bank exposure to national champions in the fiscally stable and supportive Eurozone countries (i.e., France/BNP Paribas, Netherlands/Rabobank).  Despite the underlying strong fundamentals at banks such as BBVA and Banco Santander in Spain, the risk-adjusted returns on their bonds are not compelling, given the macro risk facing their sovereign hosts.

However, we are not changing our overweight recommendation on global banks more broadly, despite the challenges facing the southern European banks.  We believe the U.S. and global economic recovery continues to take hold and that the fundamental improvement of the bank sector will follow as bank balance sheet quality improves.  Furthermore, the global banking system has taken concrete steps to recapitalize and strengthen liquidity over the past two years.  While sovereign concerns will continue to cause spread volatility, we believe the fundamentals for banks in the most developed countries justify continued overweight to this sector.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.

In Like a Lamb?

Spring is starting off on a good note with Corporate bond option adjusted spreads (OAS) 23 basis points (bps) tighter per the Barclays Corporate Index, generating 128 bps of excess returns for the month and returning year-to-date excess returns to positive territory (114 bps).  Finance outperformed Industrials and Utilities, generating 193 bps of excess returns in March (171 bps year-to-date) vs. 94 bps (80 bps YTD) and 81 bps (93 bps YTD) respectively.  This is consistent with our 2010 forecast for the three broad sectors.  Sub-sector performance is proving itself as well with Metals & Mining posting a strong 212 bps of return in March (99 bps YTD), Energy- Oil Field Services 78 bps (152 bps YTD), Banking 180 bps (112 bps YTD), and Life Insurance 431 bps (439 bps YTD).  Unlike 2009, in which all sectors gapped tighter, credit selection has been more important thus far, and we expect this to continue.  For example, in terms of investment opportunities over the course of 2010, the Kraft new 10-year issue has tightened more than 55 bps and the Telefonica 10-year 60 bps from purchase amidst the Greek fears.  We continue to believe there are attractive opportunities within the Corporate sector and that it will outperform Treasuries in 2010.

Events and news in March were largely positive.  First, Greece was able to issue debt and get a back-stop from certain EU countries and the International Monetary Fund (IMF), if it is unable to borrow from the markets.  The European Central Bank (ECB) also helped Greece by extending the acceptance of collateral rated at least BBB- instead of its plan to reinstate the former A- threshold in 2011.  Greece sovereign debt is rated A2/BBB+/BBB+.  Second, domestic economic news was better than expected especially relating to the consumer, which appears to be spending at a faster rate than many had anticipated.  If the consumer continues to show strength and the ISM non-manufacturing index extends its recovery, our unemployment forecast may prove too conservative.  Third, after taking a brief hiatus in February, liquidity in the market re-emerged despite the continued fall in primary dealer positions in Corporate bonds with maturities greater than 1 year.  Aside from money market funds, AMG Mutual fund flows were positive for both debt and equities.  High yield debt and bank loans were in great demand, new issues regardless of credit quality were very well received in both the investment grade and high yield markets, and finally the talk of LBOs had the Street and investors dusting off models used to determine feasibility.

Last, but not least, at the government level, the Administration was able to get its Healthcare bill passed under reconciliation rules.  It appears more likely that a Financial Reform bill will get passed as well with the Republicans in a difficult position given the broad voter angst against the banks and Wall Street.  The Fed kept its rate language unchanged, signaling to the market that low rates are here to stay for the near term.  Finally, the Treasury auctions received more tepid demand in March, bringing into the forefront the discussion and forecasting of Treasury yields and what that means from an investment standpoint– specifically, what markets will outperform in an inflationary environment.

As it relates to Corporate bonds, we look to Exhibit 1 to remind us that spreads are not highly correlated to rates, but to data that may or may not move Treasury rates.

Given that the industrial capacity utilization rate is only 72.7%, well below the historical average of 81%, we are not concerned with near term inflationary pressures.  That said, our industry and credit analysis takes into account the prospect of rising rates over the intermediate term in various economic environments.  While commodity based industries may perform well in not only the current environment but that environment as well, others are likely to underperform as higher rates stymie the rate of consumer borrowing and thus, spending for example.  Hence, we continue to prefer “investing in growth,” namely manufacturing and commodity based industries, those that are non-discretionary in the consumer space, and certain Finance sectors versus a blind grab for spread product/yield as many investors are advocating.

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¹ AAM Corporate Credit View, January 6, 2010

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This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.