Corporate Credit View

Second quarter earnings season is coming to a close with over 90% of firms having reported results. Overall, the quarter was better than expected from an earnings standpoint while sales came in within expectations. As Table 1 reflects, Health Care, Financials and Technology reported better than expected sales and earnings growth while sales growth was slower than expected in other sectors that lag in a recession.

Table 1
Positive Surprise/ Negative Surprise (x)	Sales	Earnings
All Securities	1.0	2.0
Utilities	0.4	1.9
Materials	0.4	1.7
Industrials	0.4	1.9
Consumer Staples	0.6	3.2
Telecom Services	0.6	2.2
Energy	0.6	1.2
Consumer Discretionary	0.8	2.2
Health Care	1.4	2.3
Financials	1.9	1.7
Information Technology	1.9	2.9
Source: Bloomberg

We expect sales growth to improve next year, as the domestic economy benefits from the Federal stimulus, business investment, and overseas demand and growth (namely Asia and Brazil). Firms will benefit from the operating leverage when sales return, driving earnings growth. This is consistent with a more traditional recession and recovery (i.e., “business led” where inventories are found to be bloated and then worked down).   Based on the U.S. government’s actions thus far, we believe the transition to the consumer will be gradual but this certainly is a risk considering the mounting deficit.

As reflected in the charts on the following page, it is evident that growth stems from the improvement in the Financial sector and cyclical sectors, namely Energy and Metals. While AAM’s sales and earnings estimates are slightly lower than the equity analyst estimates aggregated on Bloomberg (especially for banks and REITs), we remain constructive on Investment Grade Corporate bonds because we understand that spreads will remain firm and/or tighten in an environment of low growth. The key for fixed income investors is measuring downside risk – rating risk and default risk at the extreme. Earlier this year, that was very difficult given the government and economic related uncertainties, causing many analysts to assume the worst. Today, after benefiting from government related programs and actions, we are in a position to dismiss the worst case (depression, bank nationalization) and look forward. We believe consolidation will be critical in all sectors, as consumer leverage will not return and drive the growth it once did. Therefore, we remain committed to investing in companies that are market leaders and sectors like Energy that will benefit from the resumption of global growth.

August was another positive month for excess returns (76 bps) with the Barclays Corporate Index OAS tightening 16 basis points. We do not expect issuance to be as strong in the second half of 2009, and new issue concessions have reverted to nominal amounts. For the remainder of the year, we expect excess returns to be driven by spread compression (e.g., Financials remain wide relative to Industrials) and carry more so than wholesale spread tightening. We remain constructive on the market and continue to believe that being overweight the benchmark Index, taking a very selective approach to credit and industry selection is the right strategy for outperformance.

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.

Given current earnings and economic news, it is now more difficult to argue that we have not hit bottom. We believe the recovery is in its early phase, and the technical support to the Corporate bond market is unabated. We have been advocating an overweight to Corporate Credit since late 2008, and continue to believe spreads will grind tighter. The excess returns over Treasuries for the Barclay’s Corporate Credit Index were 3.84% for July and 17.37% year-to-date.

In last month’s letter,  we cited three areas we would be watching in the near term, two of which were the trajectory and magnitude of losses at the banks relative to expectations. The majority of the large domestic banks have reported second quarter earnings. The main take-away from the quarter is that while results were very weak, they were not weaker than expected. In fact, the percentage of “earnings surprises” continues to creep higher since the low point in the 4Q’08 (Exhibit 1). Historically, asset quality deterioration at the banks tends to persist for two quarters after unemployment peaks. Consequently, we expect asset quality deterioration to continue well into 2010, and loan loss provisioning to remain at elevated levels into the foreseeable future. Earnings performance will be weak commensurate with reserve builds, and “noisy” quarters will be the norm rather than the exception going into the first half of 2010. Further regulatory interventions should not be surprising for small banks and even certain regional banks.

Exhibit 1

Importantly, as bad as this sounds, this is what the market (and AAM) is expecting. CIT was a recent test, as the deterioration has been contained, keeping the risk idiosyncratic instead of systemic. We expect this cleansing process to take place in all industries to various degrees. In Moody’s latest default report (7/8/09), the global speculative-grade default rate was at 10.1% at the end of June. In April, Moody’s had expected this to peak at 14.8% in the fourth quarter this year. This peak estimate has been revised down over the last two months and is now expected to be 12.8%. The twelve month forward estimate has also been reduced from over 10% to 6%.

As you see in Exhibit 2, since 1973, spreads typically peak a year prior to defaults peaking, and the relationship is statistically significant. This is intuitive since investors need to measure risk in order to assign return expectations. Despite soft fundamentals, we expect spreads to continue to tighten, as uncertainties moderate surrounding rating downgrades and ultimately defaults. We continue to favor high quality credits especially certain high quality Financial senior bonds (e.g., GE, Barclays), which are 50-100 bps wide of Industrial/Utility equivalents.

Exhibit 2

Source: AAM, Moody’s, Barclays

AAM refers to Asset Allocation & Management Company, LLC, an SEC registered investment advisor specializing in insurance investment management. 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.

AAM continues to be cautiously optimistic about Corporate bonds. Corporate credit spreads have tightened materially this year, generating 13.49% excess returns year to date as of July 10, 2009. The tightening has been broad based across industries, all benefiting from the improvement in confidence in the financial sector and economy. Except for financials and most deep cyclical industries, spreads have returned to their 3 year average in the intermediate to long end of the curve. New issue concessions have tightened over the year as demand for Corporate bonds, especially those that are higher quality, has increased. Therefore, unlike in 2007-2008 when the technical driver was an exodus from Corporates to safe-haven Treasuries, the technical driver has been positive this year.

Source: Moody’s Economy.com

We enter the earnings season with spreads over 200 basis points tighter and signs of stabilization from an economic standpoint. Our expectation for unemployment to peak between 10-11% in the first half of next year is consistent with the markets’ and should allow Industrial and Utility companies to maintain their second half forecasts for 2009. Financial firms are expected to report dismal earnings the remainder of the year due to the elevated provision costs as late stage loans such as commercial & industrial and commercial real estate become a bigger problem. We are watching three main areas in the bank sector over the near term: (1) the trajectory and magnitude of loan losses (2) foreclosure mitigation (3) rate of change in loan balances. As long as these track within expectations, bank spreads should remain range bound with technicals possibly placing pressure on them in the latter part of the year as the Fed’s Temporary Liquidity Guarantee Program (TLGP) expires and banks resume funding in the unsecured market.

Since late 2008, AAM has been buying Corporate bonds from issuers that will withstand a period of prolonged single-digit economic growth. We need more than “green shoots” and “stress tests” to get more bullish and invest in the broader financial and deep cyclical sectors. We remain cautiously optimistic as we enter this very important earnings season.

Source: AAM, FDIC, Federal Reserve
Note: 4Q’09 reflects SCAP stressed case assumptions

AAM refers to Asset Allocation & Management Company, LLC, an SEC registered investment advisor specializing in insurance investment management. This report does not constitute an offer to any person to provide investment management services in any jurisdiction where unlawful or unauthorized. AAM only provides products or services to qualified investors.