Corporate Credit View

October 30, 2019 by

Market summary

The Investment Grade (IG) Corporate bond market (per Bloomberg Barclays Index) struggled in the third quarter, as spreads widened. Excess returns over Treasuries were slightly negative at -0.2%, but with the Treasury yield rally, total return was 3.1%. The IG market outperformed the S&P Index, which returned 0.9% and High Yield market (per Bloomberg Barclays Index) at 1.1%.

The risk asset rally in the first half of the year started to stall in the third quarter, as investors became more concerned with the economy. As the probability for recession has increased, so have risk premiums for weaker credits. This was exemplified in the third quarter by weakness in the IPO market (Renaissance IPO Index -10.1%), small caps (Russell 2000 Index -2.6%), and CCCs (Bloomberg Barclays CCC -1.8 %). The leveraged loan market has struggled of late as well. While credit remains available as reflected by the strong demand in September for new issue IG credit and weekly data from banks, the weakness in these higher risk segments of the markets coupled with projected GDP growth are not constructive for spreads in the near term.

IG corporate credit spreads have been supported by very strong technicals, and we expect this to continue in the near term. Demand for USD bonds as measured by ETF and foreign buying has increased this year, and net debt issuance (i.e., supply) is at a post-crisis low. M&A activity has slowed despite very compelling financing costs for companies, which reflects uncertainty in the C-Suite regarding global growth and domestic policies, a situation that is unlikely to abate as we enter an election year. This makes it more likely that issuance remains low in 2020 and debt leverage for companies stable/improving, in addition to keeping fixed investment (capital spending) depressed.

Market outlook

For the fourth quarter of 2019, we expect central banks to remain dovish, but the trajectory of economic growth remains concerning. The risks to the downside for U.S. GDP growth have increased with: (1) disappointing ISM reports and leading indicators that point to further downside (2) softening business confidence which suggests investment growth could slow further, and (3) slowing job creation and hours worked with top line pressures increasing cost cutting rhetoric. However, positive data points include the stabilization in China manufacturing PMI and a rebound in the U.S. housing market. A more constructive tone towards trade is helpful, but we remain skeptical that this issue will be resolved before the election.

In summary, due to very strong technicals, current spreads reflect stronger fundamentals than those that exist today or that we anticipate in the near term. The heightened level of uncertainty and the expansion and resulting debt created post financial crisis alongside challenging demographics diminish growth potential. Low rates have worked to fuel investment and capacity, and as expectations are revised and lower growth rates are accepted, we would expect to see that start to rebalance and impact demand. This means we would expect risk to reprice in this next phase of the cycle and defaults to creep higher. While we would expect spreads to widen before fundamentals improve, as the cycle plays out, we recognize timing of this is difficult.

We entered October with a neutral opinion on the IG Corporate bond sector given our view that technicals would remain supportive and we would avoid a recession in the near term. As spreads have rallied this month in reaction to the potential trade agreement with China, we are selling BBB rated credits that have outperformed. We are recommending a defensively positioned Corporate portfolio given the increased economic risks and lack of appropriate risk premiums (industry, credit quality, and maturity). We are in a position to add risk when spreads become more attractive and continue to take advantage of attractively priced opportunities.

Figure 1

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August 6, 2019 by

Market summary and outlook

The Investment Grade (IG) Corporate bond market (per Bloomberg Barclays Index) continued its strong performance in the second quarter, delivering a 5% total return given the Treasury rally, with spreads tightening only 4 basis points (bps). The IG market outperformed the S&P Index, which returned 3% and High Yield (per Bloomberg Barclays Index) 2%.

Risk assets have rallied this year around investor expectations for more accommodative central banks and benign outcomes related to trade agreements and geopolitical issues. Over the past couple weeks, more hawkish Fed commentary, increased risks of a hard Brexit and a prolonged trade war with China have caused spreads to widen and market volatility to increase. The Treasury curve continues to signal a recession is likely in the near term, although credit remains widely available. That was reiterated in the Senior Loan Officer Survey released this week as well as by the bank CEOs in second quarter earnings calls. The availability of capital keeps the credit cycle alive.

IG corporate credit spreads are tight on a historic basis, reflecting very strong demand for USD bonds, as yields dropped in the first half, especially overseas. The supply of USD corporate bonds has been less than expected, as lower growth and heightened uncertainty has resulted in less capital spending and reduced appetite for increased debt leverage. While companies continue to repurchase shares and pursue acquisitions, it has been largely with free cash flow and within boundaries set by the rating agencies. We expect that behavior to continue, although the risk of bad behavior (i.e., debt funded share repurchase and/or M&A activity) increases as debt yields fall. We note an increasing number of IG companies have dividend yields that materially exceed their cost of debt.

For the second half of 2019, we expect central banks to remain dovish and economic growth to remain positive in the U.S. That is supportive for IG credit. The risks to the downside are largely growth related, factors that would increase the probability of a recession in 2020. Credit risk premiums for low quality and/or cyclical credits would likely widen more significantly, and more liquid sectors would see spreads widen as investors move into safe haven securities.

With lackluster valuations today and the expectation for late cycle spread volatility to continue, we are taking advantage of opportunities to optimize portfolios. The duration of the Corporate IG market has extended; therefore, with low credit spreads and volatility expected to remain elevated, there is little room for error in total return portfolios and with Treasury yields and spreads this low, fewer compelling income opportunities for yield buyers. Security selection and the ability to execute on investment ideas are critical in this late cycle environment.

Performance summary – 2Q2019 reflected investor unease

Volatility picked up in the second quarter with trade related concerns. Spreads tightened In June after the market was comforted by dovish messages from the ECB and the Fed along with a fairly benign G20 summit. Economic data also came in weaker than expected in the second quarter, which once again, was interpreted as good news to the market.

Exhibit 1: OAS Volatility Increased in 2Q2019

*Source: Bloomberg Barclays, AAM as of 6/28/2019*

In the second quarter, merger and acquisition activity picked up and a number of weaker IG credits reported disappointing results, causing idiosyncratic risk to rise vs. the basis rally in the first quarter. Energy, Technology and Utilities underperformed in the second quarter vs. more domestically focused sectors with more stable cash flows such as Communications and Consumer Non-cyclicals. The relative value of BBB rated corporate bonds was little changed in the second quarter, and we took advantage of spread widening especially in new issues and secondary offerings in credits we expect will improve fundamentally.

Exhibit 2: Excess Returns 2Q2019 (%)

*Source: Bloomberg Barclays as of 6/28/2019, AAM Data*

Fundamentals become challenged in a low growth environment

Unlike the period in 2011-2013 when U.S. economic growth and interest rates were low, fueling a rebound in 2014-2015, the domestic economy is more mature and China appears less willing to stimulate its economy. Stimulus thus far has been very targeted since it has much to balance, chiefly its debt as well as its currency in the midst of trade negotiations. This week is an example of sensitivities around not only the actions taken but the uncertainties and unintended consequences regarding those actions.

It is clear that companies exposed to Europe and China are facing greater revenue pressure and continued weakness is driving forward estimates lower. From a tariff and cost perspective, while mid-to-large U.S. companies have been able to navigate this headwind by moving production out of China and/or eliminating jobs in these soft economic regions, small companies have had more difficulties. Until the uncertainty related to trade falls, revenue and capital spending outlooks should remain pressured especially for small companies. We note loan demand from small companies has weakened since the second half of 2018 despite accommodative lending standards. Moreover, sectors like Materials and Technology have been more volatile given their exposure to China and Europe. From a credit perspective, after the 2016 downturn in commodity prices, Materials companies improved their balance sheets and are in the process of being upgraded by the rating agencies. Conversely, since 2016, BBB rated Technology companies have done less especially given the cash flow volatility in a recession, making them more vulnerable.

While not as strong as last year, domestic oriented companies have largely reported good results in the second quarter, as the consumer continues to spend and service related firms remain relatively healthy. According to Bloomberg and AAM data, revenue growth for North American firms geared towards the consumer or commercial sectors is estimated to be 5-7% for 2019 and 2020, with EBITDA growth rates expected to be higher as margins are forecasted to expand. Industrial related firms are expected to grow a little less at 3-5%. The weakness for North American firms is reflected in capital spending, which is expected to grow modestly this year (except for industrial firms) but turn negative in 2020.

Take advantage of spread volatility

We are reminded that IG spreads have widened post the financial crisis for mainly one reason, increased recession risk (e.g., 2010-2012, 2015-2016, 2018). We believe the best case scenario for the IG market in the second half is for domestic growth to remain around 2%, allowing the Fed to remain dovish. That environment should allow spreads to remain range bound in the 100-150 bps range. We believe the downside risks are mainly (1) slower than expected growth or (2) an unexpected macro shock. We note our signals for economic concern remain “yellow” with the Treasury curve flashing “red” while lending conditions remain “green.” Importantly, management commentary about the economy and forecasts for the second half while softer have not been overly bearish. That has been helpful in predicting recessions in the past.

If rates were to surprise to the upside due to stronger growth prospects (including a resolution to the China trade conflict), which at this point appears unlikely in the second half, spreads should be supported by yield sensitive investors especially since yields overseas are very low. According to Bank of America, the US currently pays 89% of all global investment grade yield despite accounting for roughly half of the $55T global IG bond market. In addition to strong foreign investor demand this year, fund flows have been strong year-to-date with the prospect of low rates, only second over the last ten years to the very strong inflows in 2017. Mutual funds and foreign investors have been the primary drivers of demand for IG corporate credit over the years, absorbing the increased supply.

Spreads have fallen below our expected range for this year even with the spread widening over the last week. We are not forecasting a recession in the near term; therefore, we continue to invest in corporate credit. However, valuation is lackluster so security selection remains important. We continue to advocate taking advantage of the volatility in spreads, adding credits we favor fundamentally on spread widening and reducing risk when spreads tighten, especially for credits that exhibit a higher level of spread volatility. As shown below, since the beginning of 2018, we have seen spreads widen 50-100 bps in periods of volatility.

Exhibit 3: Current Spreads at Mid/Low End of a Volatile Range

*Source: AAM, Bloomberg Barclays Index (Current: 7/9/2019; Range 1/1/2018-7/9/2019)*

June 14, 2019 by

Summary

The upcoming G20 summit beginning June 28^th is a critical date for the investment community. What will happen if there is no trade agreement between the United States and China? Will the Fed lower rates in anticipation of that outcome or if disappointing, in reaction to it? As written in our last quarterly Corporate Credit Review, the bond market seems to have taken a much more negative stance than the equity market on the economy. And, unlike the start of the year when most Wall Street firms had fairly similar outlooks for the year, now they differ on what the Federal Reserve will do and the outcome regarding tariffs on Chinese goods. This type of market provides opportunities. AAM believes the probability of reaching a deal has increased modestly after the quick resolution with Mexico, but that probability is more remote than is a hardened stance. That expectation leads us to take a more defensive position in risk assets, preferring less cyclical sectors and higher quality credits.

What happened to the deal the markets expected in April?

By May, the markets were pricing in a high likelihood of a deal with China in regards to tariffs. There are a multitude of reasons as to why progress was halted, including the possibility that the U.S. administration was employing a “hard-bargaining” negotiation strategy which meant the likelihood of an agreement was always lower than the market grew to believe. This may have been the strategy with Mexico, although that outcome was much easier to predict given the extreme downside risks.

We do not believe China can yield to the demands the U.S. is making as it would be politically unpalatable. The breakdown of talks occurred due in part to the U.S. administration’s insistence that Chinese curb subsidies to its state-owned enterprises in strategic sectors, like technology. China finds this unacceptable given its ‘Made in China 2025’ strategy. For China’s economy to continue to grow, its manufacturing has to evolve to higher value added products and services and manufacturing capabilities. The insistence by the U.S. administration that enforcement of the deal would come in the form of changes in China’s laws and oversight mechanisms not just through regulatory changes represented a direct challenge to China’s state control model laid out in the 2025 strategy. And, existing tariffs would not be lifted until enforcement of the trade deal was verified. Political stakes are high, and both leaders feel the need to remain strong in these negotiations.

Now what?

We look at possible outcomes through a three outcome framework:

*Source: AAM Corporate Credit team with OAS referring to Bloomberg Barclays Corporate Index*.

1. The status quo remains for the duration of the year and most likely, until the next U.S. presidential election.

2. Tensions increase with both countries increasing tariffs and imposing other restrictive measures. The temporary general license issued by the U.S. government suspending the ban against selling equipment and software to Huawei is not extended.

3. Significant progress is made during the G20 summit followed by a trade deal that works to ends hostilities between the two countries and starts to lift at least some of the tariffs.

While direct costs seem to be relatively easy to calculate for the current level of tariffs and are relatively modest (e.g., less than 0.3 percentage points off U.S. and China’s growth respectively), the more difficult calculation is related to the uncertainty and loss of confidence by businesses and consumers. If the global economy is in fact oversupplied and is relying on credit growth to absorb this excess supply, a loss of confidence that impacts investment and spending would be particularly threatening to global and U.S. GDP. Therefore, despite tariffs being viewed as inflationary, the impact would over the longer term, be in fact deflationary. An escalation of the “trade war” would be very costly in the form of economic growth and financial costs, resulting in falling Treasury yields and equity markets. We would expect spreads to widen materially as the risk of recession increases. In particular, underperformance is expected from long duration, low BBB credits as well as cyclical and liquid sectors.

AAM believes the status quo is the most likely outcome in 2019, as the costs related to tariffs are less than the political fallout that would likely occur for US President Trump and China President Xi Jinping if either concedes. Our expectation for a trade deal at the G20 summit getting done or foreshadowed is quite low since getting tough on China is one of few bipartisan issues in the U.S., making it difficult for the current administration to soften its stance unless the risk of recession increases more materially. Moreover, given this stance, we believe it is more likely that threats escalate as China’s President Xi, who faces no term limits, is unable to bend to US demands without facing significant pressure from the Chinese Communist party. Therefore, we are assigning a material probability to that outcome.

The G20 summit at the end of the month may change these probabilities materially. The candlestick chart shows the IG corporate credit spread volatility that has occurred over just the last two years. Current spreads largely in the mid-points of their trading ranges reflect the uncertainty that exists in the various trade outcomes we have outlined with the potential for near term volatility being quite high. With relatively little dispersion (~40 bps), we prefer more defensive sectors with stable cash flows and exposure to the U.S. economy. In regards to the more cyclical and liquid sectors, we have a more defensive position from a duration and/or credit risk perspective. The Banking sector in particular has been more resilient than we would have expected given falling rates and growth expectations. We view sectors such as Communications as providing less value today given the trajectory of growth, required investments (capital and operating) and lack of financial flexibility.

Current OAS vs. Min/Max Range

Source: AAM, Bloomberg Barclays data from 10/06/2017-6/7/2019; Sector OAS derived using the average of A-/higher and BBB ratings and 10 year maturities; Horizontal bar denotes value as of 6/7/2019 with top and bottom of vertical bar representing max and min values respectively.

April 18, 2019 by

Market summary and outlook

The Investment Grade (IG) Corporate bond market (per Bloomberg Barclays Index) returned to positive territory in the first quarter, delivering a 5% total return, with spreads tightening 34 basis points (bps). The IG market underperformed the S&P Index, which returned 14% and High Yield (per Bloomberg Barclays Index) 7%. Worldwide equity markets are very optimistic, while the Treasury market continues to reflect caution. Which market will prove to be correct?

Risk premiums have fallen this year in the equity and credit markets. Investors expect: (1) the Fed to be more apt to cut rates, (2) a China trade agreement and resumption of growth, driving a second half 2019 earnings recovery and (3) the avoidance of a hard Brexit and/or European recession. The Treasury curve reflects the expectation for lower growth, predicting a 27% probability of a recession next year per the NY Fed (see Exhibit 1).

Corporate spreads have tightened more than we expected for the year. We remain comfortable investing in the sector given improved financial conditions and our outlook for 2%+ GDP growth. However, lackluster valuation and our expectation for heightened volatility and margin pressure causes us to build liquidity and flexibility to add at more attractive levels.

Exhibit 1: Probability of US Recession Predicted by Treasury Spread* – Twelve Months Ahead (month averages)

*Parameters estimated using data from January 1959 to December 2009, recession probabilities predicted using data through March 2019. The parameter estimates are α=0.5333, β=-0.6330.
*Source: Bloomberg as of 4/2/2019*

Performance summary

The year started with more attractive valuations and a heightened level of concern regarding economic growth (China in particular). Since that time, Chinese economic data has surprised to the upside and trade related tensions have eased. Importantly, the Fed has pivoted to a more dovish position, and US economic data seems to support that view. An outlook for lower yields and economic growth around 2% increased the demand for fixed income. As shown in Exhibit 2, shorter maturities have benefited, and credit curves have steepened.

Exhibit 2: IG Cumulative Flows Across Tenors

*Source: EPFR, Goldman Sachs Global Investment Research*

The Energy, Communications and Banking sectors outperformed, which we would expect in a high beta rally given the liquidity in these sectors. BBB rated securities also outperformed. The basis between BBB and A-/higher rated non-Financial credits has narrowed modestly but remains around its historic average which is fair. Debt issuance has tracked last year’s pace.

Exhibit 3: Contributors to IG Corporate Excess Returns 1Q2019

Credit market fundamentals

We anxiously enter the first quarter reporting season, expecting weak first quarter results to be outweighed by optimistic outlooks. Sectors that were impacted by China trade tensions and/or economic deceleration are expected to rebound sharply in the second half (Materials, Technology). Consumer sectors are also expected to benefit as confidence improves. However, the trajectory of growth has shifted lower and wage pressures are rising. That earnings pressure coupled with low interest rates increases event risk. Companies that have pursued this have been rewarded by equity holders. We expect increased event risk to place more pressure on spreads in the upcoming quarters.

In regards to the expectation for an earnings recession in the first half of 2019, a number of factors are driving this. First, revenue declines are anticipated in sectors like Technology and Energy that are more closely tied to global growth and China in particular. Foreign exchange is a headwind for companies on a revenue and/or cost basis. Lastly, higher wages and labor costs are becoming more problematic. The unemployment gap (difference between actual unemployment rate and long-run natural rate) has been negative since 2017, placing pressure on wage growth. An increasing number of industries are experiencing above-trend wage growth (Morgan Stanley, “Wage Pressures: Risks from Labor Costs Rising,” 04/15,19) and citing labor as their most important problem (NFIB survey). This is an issue as top line growth slows. For fixed income investors, this is especially problematic given the degree of debt leverage at corporations. Despite this, we do not expect material deleveraging this year, and with this margin pressure, leverage may rise. Only those companies that are forced to reduce debt because of their very large capital structures will do so. The cost of debt is simply too low for the majority of companies.

Exhibit 4: Earnings Transcript Mentions of Labor Cost – 4Q2018 Breakdown

*Source: Alphasense, Morgan Stanley Research as of 3/31/2019*

Liquidity has fallen, with companies maintaining the lowest cash balance relative to debt since 2008. Repatriation was one driver of this, but the trend was not isolated to those companies. This may reflect the confidence companies have in the markets, or the pressure management teams face from activist investors. Debt leverage remained broadly stable in 2018 vs. 2017, as additional debt incurred due to M&A and share repurchases offset the reduction in debt driven by changes in the tax law or industry pressures. In regards to capital spending, we expect very modest growth this year and next. We expect this to largely track economic growth expectations.

January 24, 2019 by

Economic Outlook

Following two strong quarters of economic activity, U.S. real GDP growth for Q4 2018 and for all of 2019 appears to be slowing towards the economy’s long-term trend rate. On a year-over-year basis (q4/q4), real GDP growth is forecasted to slow from a 3.1% pace for 2018 to 2.2% for 2019. Reduced impact from the tax cuts and fiscal stimulus are reasons for the forecasted slowdown. Consumer spending, which increased around 2.8% in 2018, is projected to moderate to 2.4% for 2019. A strong labor market and rising wages should continue to support spending. Also driving the slower growth projection for 2019 is weaker business spending/investment. Recent declines in business sentiment suggest manufacturers and service-sector businesses are becoming less confident with the economic outlook. Additional downside risks to growth include a Fed policy mistake, slowing global growth, trade tensions, and geopolitical risks. We are calling for below-consensus GDP growth in 2019 as we view the risks to growth as skewed to the downside. We do not expect the U.S. economy to fall into a recession in 2019.

The Federal Reserve seems to have become more dovish as downside risks to economic growth have increased. Recent comments from Fed officials suggest they will be more “patient” with future rate hikes, with Fed policy becoming more data dependent. We believe the Fed will be closely monitoring incoming data for signs of increasing inflation (CPI, core PCE), strengthening labor markets (unemployment rate, wages), increases in market based inflation expectations (forward breakeven rates), and increases in survey based measures of inflation (ISM prices paid, consumer inflation expectations). With economic growth slowing and inflation expected to remain near the Fed’s target of 2%, we expect them to increase the Fed Funds target range one time this year, or 25 basis points.

Treasury yields, according to consensus forecasts, are expected to move modestly higher from current levels. The benchmark 10-year Treasury yield is forecasted to end 2019 at 3.15% based on the median forecast among economists. The yield spread between the 10 year and 2 year Treasury notes is expected to remain in a tight range of 20bps. We are calling for the 10 year Treasury yield to end the year modestly higher but below 3%. Exhibit 1 lists our risks to U.S. GDP Growth, Inflation, and Treasury Yields.

Exhibit 1: GDP Growth, Inflation, and Treasury Yield Risks

Fixed Income

2018 – Going into 2018 we anticipated the Fed to raise the Funds rate, causing the economy to slow and the yield curve to flatten. The Fed raised the Funds rate by 1.0% with the final nail in the coffin coming in December. We saw the economy slowing in Q4 which, when coupled with apparent Fed indifference to the current state of the economy and the market’s gyrations, caused a significant selloff. In December, equities fell, credit spreads widened, and we finished the year with losses and uncertainty across a number of sectors.

2019 – We expect that the Fed will have significantly less impact on the markets in 2019. Recently, they have indicated more of a “wait and see” approach while the market is pricing in zero rate hikes for 2019. Just as investors could only see bad news after the December 19th Fed meeting, it seems that there is nothing but roses since the new year.

Our expectation for interest rates is that the yield curve will not invert, and 10 year Treasury yields will stay below 3.0%. There are number of risks to this benign forecast that include but are not limited to: failed Chinese tariff negotiations, stalling economic growth in Europe, a hard Brexit, or a spike in wage driven inflation.

AAM expects that 2019 will be a positive environment for spread product and equities. However, given the potential impediments to growth, risk assets are NOT attractive enough to aggressively overweight. We recommend that risk allocations be maintained at a conservative level in order to allow flexibility to add should the markets stumble. Once again, we anticipate individual security selection and a focus on risk will prove to be the right call in 2019.

Exhibit 2: 2018 Returns by Asset Class

Source: Bloomberg Barclays Index Series, S&P 500, Barclays Global High Yield Index, VOA0 (Merrill Lynch Convertibles Ex-Mandatory)

Corporate Credit

2018 was a disappointing year for the markets despite record revenue and profit growth. After a period of credit creation in 2016-2017, the unwind of QE programs and higher rates caused a sharp slowdown in credit creation from both the private sector and central banks in 2018. The Investment Grade (IG) market also suffered from idiosyncratic events related to GE, Goldman Sachs, Comcast, PCG and the tobacco companies. The spread to Treasuries for the IG market (OAS) closed the year 60 basis points wider with BBBs and longer maturities underperforming.

Exhibit 3: Global central bank securities purchases, rolling 12 months ($T)

Source: National Central Banks, Citi Research

We expect revenue and EBITDA growth rates to decelerate in 2019 to approximately 5% and 8% respectively on average. Capital spending is also expected to decelerate to 2-3%. Debt leverage for IG companies on aggregate changed very little in 2018, but given the focus on debt by the equity community and rating agencies today, we expect companies with over-leveraged balance sheets to work more proactively to reduce debt leverage in 2019. However we do not expect this to be widespread since: (1) lower growth rates make it more difficult to reduce leverage organically, as the equity market has become accustomed to companies using the majority of their excess cash to repurchase stock, and (2) historically, the C-suite does not get more aggressive with credit improvement unless the cost of debt approaches the cost of equity, which has not yet occurred. Therefore, we believe material fundamental credit improvement will be challenging in 2019, with companies facing uncertain growth outlooks and higher costs (labor, transport, interest, trade).

From a technical or supply/demand perspective, we expect net supply of IG bonds to be down materially in 2019 due to the high level of debt maturing, and gross debt supply to be down modestly. This environment of uncertainty/volatility does not support increased M&A activity, and despite improved economics from year-end 2017 (i.e., the spread between earnings yield and the after tax cost of debt), we would not expect an acceleration of debt financed share repurchase activity. Therefore, net supply should be related to refinancing upcoming maturities and tendering others. We believe the demand for IG debt could be lackluster again in 2019 due to higher short term rates and the shape of the Treasury curve. Therefore, we expect another year of less supportive technicals.

Valuations have improved with the IG OAS widening to a point at year end 2018 that reflects an approximate 25% probability of a recession, and the spread premium for BBBs vs. A/higher rated securities widening towards its historic average of 88 bps. Our credit cycle signals related to the shape of the Treasury curve and access to funding have weakened but do not flag the end of the credit cycle. However, given our economic outlook which has risks skewed to the downside, we do not consider current spreads to be “attractive.” Therefore, we would recommend maintaining a neutral position vs. a benchmark in the IG credit sector, investing cautiously in the asset class, preferring shorter duration bonds, sectors with stable cash flows through the economic cycle, and credits we consider to be higher quality from a balance sheet perspective. We have a constructive view on the following sectors: Banks, Pharmaceuticals, Midstream, Capital Goods, Food/Beverage, and Insurance. On the contrary, we are concerned with the fundamental performance of: Chemicals, Cable, Autos, Tobacco, Consumer Products, and lower quality Media credits. It is important to stress that security selection is critical at this late stage of the credit cycle.

Our market and sector outlooks are supported by expectations of: (1) positive albeit lackluster economic growth in the US and EU (2) geopolitical events (i.e., trade talks with China, a hard Brexit, and Italy leaving the EU) remaining at a simmer point (3) Federal Reserve pausing its rate hike cycle. If growth disappoints, the biggest upside surprise for all markets would be a reversal in the unwind of various QE programs to support and stimulate growth. We are not assigning a material probability to that in the US in 2019, since the labor market is far tighter than it was three years ago with unemployment below the natural rate.

Structured Products

With the exception of shorter duration Asset Backed Securities (ABS), structured products performed relatively poorly in 2018. The prospect of slowing domestic growth and dislocations in global trade caused risk assets to underperform less risky Agency and Treasury securities. We’re cautiously optimistic that structured securities will perform better in 2019, although we do anticipate a fair amount of volatility over the course of the year. We expect non-agency mortgage backed securities, Commercial Mortgage Backed Securities (CMBS), and consumer backed ABS securities to outperform lower risk assets.

Agency Residential Mortgage Backed Securities (RMBS) experienced their worst yearly performance relative to Treasuries since 2011 as spreads widened 25bps. Unlike in prior years when Federal Reserve asset purchases materially reduced the available supply of RMBS, balance sheet normalization which began in the second half of 2018, will provide an incremental $170b to $180B of supply which the market will struggle to absorb. Traditionally, domestic banks have been big purchasers of agency RMBS, but with the relaxation of liquidity rules for small and mid-sized banks and since money managers have generally been avoiding the sector, we don’t see the market being able to absorb the supply without some spread concession. In the most recent release of the FOMC minutes there was some discussion of selling securities from the mortgage portfolio, but we do not believe the Fed will follow through with any sales. Given the poor technical environment, we favor allocating investments elsewhere within structured products and to other spread sectors.

Non-agency RMBS still represents an attractive investment option. Credit fundamentals in the sector still look very good and since underwriting continues to be very conservative, we anticipate the sector outperforming agency RMBS and to a lesser extent Treasuries this year. Housing price appreciation should slow to roughly 3.5% as compared to levels of 5% and 6% in prior years; however, we don’t anticipate that it will negatively impact the market. With the consumer being in such excellent financial shape due to low unemployment of 3.9% and wage growth of 3.2%, delinquency and default rates should remain at very low levels.

Commercial real estate fundamentals remain in relatively good shape following multiple years of property price appreciation and domestic economic strength. Conduit CMBS supply is estimated to be $70B this year which should prove to be very manageable including only $7.5B of maturing conduit loans in need of refinancing. Ordinarily this type of environment would lead us to conclude that CMBS spreads should tighten in 2019, however, we see more risk to the CMBS market from global economic risks and trade dislocations rather than technical and fundamental factors. Spreads of senior conduit CMBS securities tend to track single A rated corporate bonds fairly closely and we’re anticipating heightened volatility within the corporate sector this year. We expect spread levels to closely track corporate bond spreads but with slightly less volatility which should allow them to modestly outperform Treasuries and single A corporate bonds. Our investment of choice within the sector continues to be conservatively underwritten single asset transactions with low leverage. As in prior years we remain concerned about the retail sector, particularly regional malls in less populated areas, which must be carefully analyzed in any conduit securitization.

ABS was the only structured products sector to outperform Treasuries last year, and we believe they will outperform again in 2019. Healthy consumer balance sheets due to strong job growth and healthy wage gains will support credit performance. We’ll continue to maintain significant portfolio weightings in the asset class particularly in structures backed by consumer receivables. High credit quality and stable cash flows make ABS an attractive alternative to short Corporate Credit, Taxable municipals and Treasuries. Our favorite sub-sectors continue to be prime and some select subprime auto, credit card, and equipment transactions.

Municipal Market

We are maintaining a constructive bias for the tax-exempt sector. During the tumultuous level of volatility that stressed the capital markets during the latter half of 2018, the municipal sector held its ground and performed very well due to very favorable technical conditions. As we enter 2019, we remain constructive on the sector due to similar themes that are expected to see municipal relative valuations continue to improve, especially in the near term.

Tax-reform will once again play a large role in providing a solid technical environment for the tax-exempt sector. The Tax Cut and Jobs Act (TCJA) that passed late in 2017, eliminated the use of tax-exempt advanced refundings, which is a process that allowed issuers to effectively refinance their debt more than 90 days before the actual call date. Its absence resulted in a year-over-year decline in issuance of approximately $100 Billion during 2018 to $339 Billion and, in 2019, its repealed status will continue to suppress supply conditions. We expect to see only a 10% increase in new issuance to $375 Billion, and that level would be 14% below the average annual issuance produced in the three years before tax reform was implemented.

On the demand side, reinvestment flows of coupons/calls/maturities are expected to remain sizable during the year and provide ample support. The record level of refundings that were executed from 2015 to 2017 is expected to result in a large number of maturities during the year that will lead to net supply levels of negative $69 Billion. Although that’s not as extreme as the negative $121 Billion in net supply during 2018, it should remain as a major underpinning to the sector’s solid relative performance during the year.

In looking at the different market segments of demand, we expect that the muted investment behavior from institutional investors (primarily banks and insurance companies) in 2018 will continue to be in play during 2019. Municipal tax-adjusted yield levels at the new 21% corporate rate remain below that of Treasuries inside of 10 years and are well below that of taxable spread product across the yield curve. The Federal Reserve’s Flow of Funds data reported that banks reduced their exposure to municipals by approximately $40 Billion during the first three quarters of 2018, and we expect to see more right-sizing of institutional portfolios during the course of 2019.

However, we are also expecting the retail segment to remain fully engaged in the market. These investors will be flush with cash from reinvestment flows, and tax-adjusted yield levels for investors in the highest tax bracket of 40.8% (37% plus 3.8% Medicare surtax) look very compelling versus taxable alternatives. At the start of the year, grossed-up yields of tax-exempts were 116 basis points north of Treasuries in the 10 year maturity and were at comparable levels to corporates in maturities 10 years and shorter.

Additionally, we do not expect any headline risk to create selling pressure in the space, as we expect credit fundamentals to remain solid during the year. Individual and corporate tax revenues have been growing at a robust rate during 2018 and are expected to continue going forward. That should bode well for solid fiscal performance for state and local governments.

For our insurance portfolios, we believe that tax-adjusted yield levels remain unattractive versus taxable alternatives. However, the relative slope of the municipal curve remains steep from 2 to 20 years and we view the 11 to 20 year relative curve steepness as attractive. We will continue to look at underweighting the sector into any relative outperformance in favor of taxable alternatives that provide a better after-tax yield profile.

The risks to the upside include:

Stronger than consensus economic growth that would lead to even stronger tax revenue growth.

The risks to the downside include:

A continued downward move in oil prices could pressure the fiscal performance of the heavy oil-producing states.
Sharply higher Treasury rates could lead to heavy mutual fund outflows.
Potential passage of federally-sponsored infrastructure spending that leads to higher-than-expected new issuance.

High Yield

After credit spreads fell to a post financial crisis low in early October, the high yield market re-priced significantly in Q4 2018 with spreads widening 223 basis points (bps). This resulted in returns of -2.08% for that year. To put that in perspective, 2018 marks only the 7th time in 35 calendar years of index data the high yield asset class experienced negative total returns. Broad market yields ended the year at 7.95% with credit spreads at +526 bps, both metrics exceeding their 5 year average. Valuations for the sector have become more attractive given the underlying fundamentals as 2019 default rates are expected to remain below the long-term average.

Exhibit 4: High Yield Market Credit Spreads

Source: Bloomberg Barclays US Corporate High Yield Index

Unlike the investment grade market, high yield issuers have generally deleveraged their balance sheets since 2015, as evidenced by a continued positive upgrade/downgrade ratio and the percentage of CCC rated issuers in the market, which has declined to a decade low at 13% of the index. Further, interest coverage ratios remain high, and the level of future debt maturities to be refinanced is manageable.

Exhibit 5: Default Rates

Note: 2018 data is through November 30.
Source: J.P. Morgan

Technicals for the asset class are supportive as the high yield market debt outstanding has been shrinking since 2016. New issue supply for High Yield was $187 billion or -43% year-over-year which was the lowest volume since 2009. In contrast, the loan market has been a funding alternative for high yield corporates, as issuance of $697 billion ranked as the second highest annual total on record despite a 28% drop from 2017. It bears watching that acquisition-related issuance has drifted higher to 21% of volume, but that level remains below the long-term average of 24% which is well below the highs of over 50% in 2007. Additional headwinds for the sector will likely persist if macroeconomic declines exceed expectations. Increased hedging costs have weighed on foreign demand as US monetary policy has diverged from global central banks, and further rate hikes would likely extend this trend. A recession could also impact valuations as BBB issuers are downgraded to high yield, increasing supply. However, higher yields and spreads overall improve break-evens and provide more downside protection around interest rate risks and potential credit concerns. We continue to believe credit risk is best managed with an active approach that emphasizes credit quality and diversification to reduce risk in portfolios. Long-term investors with the ability to act as liquidity providers to the market during periods of volatility are likely to be rewarded.

Convertibles

While convertibles outperformed most asset classes in 2018, the year is best viewed as two distinct periods – the first nine months of the year, and the last three months of the year.

First quarter 2018 through the third quarter saw a continuation of the longest equity bull market on record, and many convertibles moved further “up the curve” becoming ever more equity-like. However, the market capitulation in the fourth quarter highlighted the lack of downside protection afforded by equity-like convertibles. As some individual stocks dropped by a magnitude of 50% or more, equity-like convertibles linked to those shares fell virtually in lockstep with the underlying stock price.

Balanced convertible portfolios, on the other hand, offered downside protection during the fourth quarter as bond floors held up and provided support.

In the aggregate, balanced convertibles did their job in 2018, providing upside participation as equities climbed during the first three quarters, and delivering downside protection as markets fell in the fourth quarter. Over a complete market cycle – which we have not seen in nearly ten years – we expect the “ratchet” effect provided by balanced convertibles will result in equity-like returns with less volatility.

U.S. primary market activity was strong with convertible issuance of $53 billion during 2018. That made 2018 the biggest year for convertible issuance since 2008 (when issuance was $59 billion). The Technology and Healthcare sectors represented 60% of new issuance at 43% and 17%, respectively.

Convertible issuance combined with the fourth quarter equity market decline allowed us to counteract two fundamental issues associated with the convertible market today: technology sector concentration and equity sensitivity.

The sector breakdowns below highlight the Technology concentration in the broader market (using the V0A0 index as a proxy) versus a balanced convertible composite (using the Zazove Associates Blend Strategy Composite as a proxy).

Exhibit 6: V0A0 Sector Breakdown as of 12/31/18

Source: ICE BofAML Convertible Index Data

Exhibit 7: Zazove Associates Blend Composite Sector Breakdown as of 12/31/18

Further, the weighted average investment premium (a measure of downside risk exposure) of the V0A0 Convertible Index is 49.4% versus 20.5% for the Zazove Blend Composite. For investors in convertibles, active management of portfolio investment premium mitigates downside risk and leads to superior risk-adjusted returns over market cycles.

To the extent interest rates continue to increase in 2019, the low duration of convertibles (~2 years or less) will insulate our portfolios from the headwinds typically associated with a rising interest rate environment.

Further, if the fourth quarter of 2018 portends renewed 2019 market volatility that would be a positive development for investors in AAM/Zazove balanced convertible strategies. As an active manager of balanced convertible portfolios, volatility provides abundant trading opportunities and allows us to rebalance, take advantage of attractive valuations, and continue to optimize portfolios. As an aside, volatility increases the value of the embedded option of convertibles.

The opportunity set and trading environment for convertibles is as strong as it has been in years, and we are excited about the prospects for 2019.

Contributions by:
Greg Bell, CFA, CPA | Director of Municipal Bonds
Marco Bravo, CFA | Senior Portfolio Manager
Scott Edwards, CFA, CPA | Director of Structured Products
Elizabeth Henderson, CFA | Director of Corporate Credit
Reed Nuttall, CFA | Chief Investment Officer
Scott Skowronski, CFA | Senior Portfolio Manager
Stephen Bard, CFA | Chief Operating Officer, Zazove Associates
Gene Pretti | Chief Executive Officer, Zazove Associates

December 5, 2018 by

Frosty the Snowman’s Summary

The holiday season continues to be a critical time of year for retailers as they earn up to 40% of their annual revenues during this time period. Based on adjusted figures from the U.S. Census Bureau, retail sales (excluding auto and gas) for the 2017 holiday season were up 6.1% which was the best growth in over ten years. That number will be difficult to beat this year. Despite the high hurdle, we think holiday sales will be up around 6.0% on an adjusted basis. Our bias is constrained given the tough comparison to last year and limited extraordinary spending trends. The following report explores some of the key components of our analysis.

Rudolph’s nose may be red, but the consumer is a “beast”

We believe the most important driver of retail sales is consumer confidence. The following table summarizes our analysis of nine factors that contribute to that level of confidence measured year over year.

Exhibit 1

We have been tracking these factors since 2011, and they have never been this strong. Last year was good and this year looks moderately better year over year. Wages, confidence, and unemployment are all showing strong trends going into the end of the year. High gas prices are less of a factor now given the ease of online shopping, and inflation seems to be under control for now.

Ralphie Parker hates ‘back to school’ bullies, but what about his Christmas list?

A review of data from the last twenty years as displayed in Exhibit 2 reveals a significant correlation (78%) between “Back to School” retail sales – as measured in August and September – and holiday sales – as measured in November and December. To model the trend, we used the U.S. Census Bureau’s adjusted monthly retail trade data which includes a variety of retail businesses (excluding motor vehicle sales and parts dealers and gasoline stations; sales in those segments have been more heavily impacted by factors outside the control of consumers).

Exhibit 2

Our regression model predicts adjusted holiday sales of 3.8% when using the 4.8% actual for “Back to School” sales in 2018. This is just above the 20 year average of 3.9%. Comparatively, 2017 “Back to School” sales of 4.7% led to actual holiday sales of 6.1%. Clearly, the model did not do a good job last year in predicting holiday sales.

Same number of elves in the workshop this year

Overall, holiday related hiring is projected to be up this year versus last year. In many cases lower hiring in brick and mortar establishments is being offset by a greater need to support e-commerce sales. One thing for sure, costs to hire new employees is going up especially in those areas involved directly with product distribution.

The following is a graph from the National Retail Federation (NRF) which shows the change in holiday hiring over the past 15 years. The NRF predicts hiring will be up 585,000-650,000 positions compared to last years 582,500.

Exhibit 3

Buddy the Elf loves Gimbels, but consumers love e-commerce

Online retail sales continue to gather momentum and help fuel total retail sales even as store traffic continues to decline. Most industry experts are expecting mid-to-high teen increases this year from e-commerce sales. According to the U.S. Census Bureau, e-commerce now accounts for 11.2% of total retail sales year-to-date. We believe that figure actually is closer to 19% if you take excluded segments that are not currently at significant risk of an internet presence such as auto, restaurant/bar, and gas station sales. Thru October growth for the online category was 10.3% which is almost twice the 5.3% growth of total retail sales year to date.

Mobile shopping continues to be the largest driver of e-commerce. According to Salesforce data for Black Friday, mobile accounted for 67% of online traffic and 49% of actual order share. Salesforce data also showed that mobile traffic from social channels was up 94% on Thanksgiving Day with the vast majority of that originating from Facebook and Instagram.

Several third party sources have posted positive results for the 5 day holiday sales weekend starting with the day before Thanksgiving. Adobe seems to provide the most comprehensive results for online sales indicating that online sales were up 24% this year. The following graph details each day of the holiday sales period with comparisons to previous years.

Exhibit 4

What are all of the Whos in Whoville saying?

According to a survey released by the National Retail Federation (NRF), shoppers will spend an average of $1,007 in 2018 for a total of approximately $717 billion and they plan to spend most of their time online and in department stores. For the 12th year in a row, the most popular present is expected to be gift cards, while sales and discounts remain the most important factors motivating sales at individual retailers. We thought it would be interesting to look at how accurate different retail trade groups have been with their holiday predictions over the past three years and we have included a summary in Exhibit 5. While each of them uses a different data set to support their expectations, it is still interesting to note the predicted growth year over year. Based on this data, we would not favor any one of these trade group’s prediction over the other because while all three expect sales to grow about the same as last year all three were considerably conservative in their expectations for 2017.

Exhibit 5

Wind chills and a white Christmas?

Weather and the shifting calendar are always important factors for holiday spending. According to Weather Trends International (WTI), this holiday season is expected to be somewhat more favorable with cooler temperatures offsetting the expectation of increased precipitation. The ideal weather for holiday shoppers is cold and dry. Retailers want shoppers to buy winter products but not be turned away by heavy snow.

Exhibit 6

**Source:** Weather Trends International, Morgan Stanley

The days between Thanksgiving and Christmas are key shopping days. This year, those days total 32 (26 is the minimum, 32 is the maximum) versus 31 last year. In addition, there are ten total weekend days to shop (maximum) which is the same as last year.

The way the cookie crumbles

Despite the previously noted favorable developments, there are some issues that could negatively impact sales this holiday season. These include inventory stock outs potentially arising from lower orders from China due to higher tariffs along with difficulty in seasonal hiring given the current low unemployment levels. Also, volatility in the stock market could have a “wealth effect” and could slow spending if investors feel like their net worth has been negatively impacted. Finally, strain on the transportation sector may impact availability of product for the holiday season and may slow holiday deliveries. At the end of the day, some of these potential “issues” probably are more of a concern for profitability versus top line sales for retailers.

So what do we expect under the tree this year?

Overall, we are optimistic about 2018 holiday spending. The typical consumer is in a stronger economic position this year versus last year and advancements in online and mobile retail makes it that much more pleasant to shop. However, beating last year’s impressive growth will be difficult given the lack of significantly positive ancillary factors this year.