Corporate Credit View

July 24, 2017 by

By Elizabeth Henderson, CFA
Director of Corporate Credit

Market summary and outlook

The Investment Grade (IG) Corporate bond market delivered a 3% total return in the second quarter 2017, with spreads tightening 9 basis points (bps). Risk assets performed similarly, as the S&P Index returned 3% in the second quarter, high yield 2%, and Emerging Markets 2% as well. Corporate bonds with maturities greater than 10 years outperformed shorter dated securities, contributing more than two-thirds of the total return performance of the IG Index per Bloomberg Barclays. Similarly, BBB rated securities outperformed and drove more than 50% of the performance.

We continue to see strong demand from bond funds for investment grade securities, and foreign buying of USD IG debt remains a source of demand despite the less attractive yield advantage (net of hedging costs). New issue supply normalized in the second quarter, and the relatively light new issuance in longer dated maturities was one contributor to the outperformance of long corporate bonds. The unwind of QE may be a headwind for spreads in the intermediate term, but the market has digested the information constructively thus far.

We expect returns to be generated largely from income over the near term, as the potential for spread tightening remains limited unless growth surprises to the upside and/or companies begin to meaningfully reduce debt. Despite lackluster valuations, we have a neutral opinion on the IG corporate sector, expecting technicals to remain supportive and fundamentals relatively stable over the near term given policy related uncertainty, improving overseas growth, and favorable lending conditions. Margin pressures such as rising labor costs and/or disappointing growth remain a risk given the elevated level of debt leverage and size of the credit market, BBB rated securities specifically. Tactically, we are maintaining flexibility to add on spread widening related to the unwind of central bank quantitative easing (QE).

Source: Bloomberg Barclays, AAM

Performance summary year-to-date

Spreads continued to tighten in the second quarter, with OAS 14 bps tighter year-to-date. Energy spreads underperformed in the second quarter due to the heightened volatility of oil prices. Year-to-date, every corporate sector has generated positive returns, with the Basic Materials and Finance sectors outperforming.

Rating actions have been positive with more than two times the number of “rising stars” (bonds moving from High Yield to Investment Grade) vs. “fallen angels” (from IG to HY). Improving fundamentals was the driver of 78% of the upgrades, with M&A being a smaller contributor. The same held true for the downgrades. M&A activity has remained active this year for larger deals. M&A related leverage loan volumes were down in the first half. LBO related activity has stalled due to high valuations and the limitation on leverage by the Federal government, although more leverage is being used to fund deals this year vs. prior years. Net demand for leveraged loans has been strong, resulting in weak covenant protection. We continue to monitor loan market fundamentals for signs of stress.

Source: Bloomberg Barclays Index (as of 6/30/2017), AAM

Credit fundamentals

Credit metrics remained fairly stable in the first quarter of 2017. We expect continued revenue and EBITDA growth in the second quarter, although it’s likely to moderate vs. the first quarter. Sectors expected to drive growth include Technology, Materials, and Energy with Telecom expected to be a drag. While it is early in the financial reporting season, we are pleased at the rate of loan growth for large, diversified banks given the weakness witnessed in the first quarter. Moreover, small business lending conditions as reported in the Credit Managers Index have improved, and the high yield and leverage loan markets remain accommodative. That said, we are not seeing signs of a break-out in growth that would cause U.S. GDP forecasts to be revised materially higher.

Policy uncertainty remains high, with tax reform unlikely in 2017. Sectors that were expected to benefit from firms repatriating cash from overseas have continued to access the debt market to fund acquisitions and debt maturities. A survey by Bank of America (Shin, John; “2017 Risk Management Survey” 7/10/2017) asked companies how they plan to use repatriated earnings, and of those that expect to benefit, 65% would use earnings to reduce debt as well as other uses such as share repurchases (46%), M&A (42%) and capital expenditures (35%).

Interestingly, the companies that have been the most aggressive buyers of their common stock have seen their stocks lag in performance relative to the broad market (S&P 500). Since the financial crisis, this has not occurred on an annual basis except in 2014. We view that constructively from a credit perspective since firms have been using debt to fund share repurchase programs.

Margins remain historically high for many sectors, with management increasingly communicating labor cost related pressures. This remains a concern of ours especially as we saw the JOLTS Quits rate for the private sector increase to a level not seen since 2006. This has been a reliable indicator in the past for predicting increasing labor costs. Sectors like Consumer Discretionary and Healthcare are particularly exposed to rising labor costs. We have been very selective within these sectors, monitoring ROE and projected revenue growth. Sectors that are more immune to rising wages include Energy, Technology, and Insurance.

Source: Factset, AAM as of 3/31/2017 (Data excludes Energy, Metals/Mining, Financials, Utilities)

QE unwind

This Fall, the market expects the ECB to announce plans to taper its bond buying program and the Fed to announce that it has begun to shrink its balance sheet. If bond buying is reduced by half, what will happen to the demand for IG fixed income? While there has been a correlation between central bank purchases and the direction of US IG credit spreads, the cause of this relationship is less certain.

Since the financial crisis, there has been less net spread product issued due mainly to the contraction in the Structured Product and Muni markets. If we see MBS spread widening related to the unwind, it could put pressure on the Corporate market. However, we believe spread widening risk is higher for MBS since the net supply related to the unwind would be material as a percentage of the total MBS net supply expected in 2017 (>50%) vs. a much larger net supply of IG Corporates (<20%)** (footnote JPM Eric Beinstein June 2017; US High Grade Credit Market Trends and Outlook)

We acknowledge this technical risk, and given lackluster valuations, maintain flexibility to add on spread widening.

Source: National central banks, Citi Research, EMFX reserve changes are FX-adjusted

Written by:

Elizabeth Henderson, CFA

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was 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 representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. 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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

April 20, 2017 by

By Elizabeth Henderson, CFA
Director of Corporate Credit

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Market Summary and Outlook

The Investment Grade (IG) Corporate bond market delivered a 1% total return in the first quarter 2017, with spreads tightening 5 basis points (bps) since year-end 2016. Risk assets outperformed, as the S&P Index increased close to 6% in the first quarter, high yield returned approximately 3%, and Emerging Markets also returned approximately 3%. After outperforming in the fourth quarter 2016, corporate bonds with maturities greater than ten years underperformed in the first quarter.

We continued to see strong demand from bond funds for investment grade securities despite volatility in high yield fund flows. Foreign buying of IG debt has fallen from the very strong levels in 2015-2016, but we continue to expect it to remain a source of demand given the yield advantage (net of hedging costs) of U.S. IG bonds. New issue supply was higher than expected to start the year, with companies accessing the market in anticipation of higher rates, a modest headwind for spreads.

The Option-Adjusted Spread (OAS) is approaching our target for the year; therefore, we expect returns to be generated largely from income over the near term. Our base case expects stable to improving commodity prices, approximately 2% domestic economic growth, containment of risks overseas, regulatory relief in the U.S., and some tax relief. If risks to our base case increase to the downside, we would expect spreads to widen as Treasury yields fall. However, we believe the risk of material spread widening due to an increase in default risk is low given the availability of credit and low probability of a recession. Uncertainty should keep event (and ratings) risk more subdued as well.

Source: Bloomberg Barclays, AAM

Performance Summary and Year-to-Date

The driver of returns for Investment Grade Corporates in the first quarter 2017 was primarily coupon income with spreads starting the year at relatively low levels. Performance has been driven primarily by the higher yielding sectors, Energy and Basic Materials, as well as Financials that tightened due to the prospect of higher interest rates and regulatory relief. For Metals and Mining, metals prices stabilized due to supply disruptions caused by weather and political issues and solid Chinese economic data. This coupled with credit rating upgrades drove tighter spreads for Metals and Mining issuers. The risk of debt funded acquisitions caused the Telecom/Media/Technology sector to underperform even though it is one of the wider spread sectors.

Source: Bloomberg Barclays Index (as of 3/31/2017), AAM

Credit Fundamentals Expected to Improve From Cyclically Weak Levels

Credit metrics continued to weaken in 2016, as EBITDA growth did not keep up with rising debt levels, resulting in debt leverage to increase once again. That said, companies became more parsimonious with debt leverage in the second half of 2016 in response to the capital markets closing and spreads widening meaningfully with a rising probability of a recession earlier in 2016.

We project improving revenue and EBITDA growth in 2017 driven mainly by:
Higher commodity prices, benefitting energy and basic material issuers
Higher interest rates relative to 2016 and modest loan growth, benefitting banks
Improving emerging market economies, consumer demand for PCs and smartphones (iPhone 8, new features), and investment in cloud infrastructure, benefitting technology issuers.

Optimism remains elevated post the election, and analyst estimates for EBITDA and capital spending for the majority of sectors remains higher as well. Entering 2017, our outlook for credit fundamentals was generally positive except for a handful of sectors where we expected growth to disappoint (e.g., Autos, Retail, Cable). Growth disappointments related to secular challenges or cyclical slowdowns keep event risk (and thus, ratings risk) elevated. For example, after a disappointing fourth quarter and forecast, S&P downgraded Under Armour from investment grade to high yield.

Default Risk Falls

We expect the default rate to fall in 2017 due to higher commmodity prices and a much improved credit market. Bank standards have loosened, yields have fallen (high yield, investment grade and emerging markets), and the leveraged loan market is wide open after being closed for a period of time in 2015-2016. Demand is especially strong for leveraged loans, causing spreads to tighten in CLOs and bank loans. This has resulted in loan refinancings and investor willingness to accept looser covenants (“covenant lite”). Lastly, the Credit Manager Index continues to reflect a favborable environment for non-bank lenders.

The credit cycle, which had appeared to have peaked in late 2015, has been rejuvenated. Until we see evidence of credit contraction, we expect spreads to remain range bound (OAS between 110 – 140 bps).

Rating Stability Expected

The credit rating of the IG Corporate market has fallen over the last ten years as the percentage of BBB rated securities has increased due primarily to: (1) rating downgrades as companies take advantage of lower rates to increase shareholder returns (share repurchase, M&A), (2) changes in rating methodologies in the Finance sector post the financial crisis, and (3) an increase in the number of non-Financial issuers, which tend to be capitalized with more debt.

Source: Bloomberg Barclays (based on market values); AAM

Tax policy is uncertain, and the changes being discussed have varying consequences to IG issuers. While we have an understanding of how this may affect firms in various industries, we (and management teams) are at a standstil until there is more clarity on what is likely to pass. At this point, we do not expect meaningful changes to the tax code with a modest reduction in the corporate tax rate most likely. Except for industries that face structural issues such as Retail, we expect ratings to remain largely stable in this period of uncertainty despite a historically flat WACC curve by credit rating.

Market supply and demand technicals remain supportive

Insurance and Pension Funds, traditional holders of corporate bonds, increased purchases in 2016, on the prospect of increased rates and because competing asset classes were less attractive. Comparatively, money market funds sold corporate bonds due to money market reform. But, the real story was the increase in demand from foreign investors. Foreign ownership of corporate bonds has been rising over the past twenty years with an acceleration over the past couple years given very low (or negative) interest rates in overseas markets. Buying was especially strong from European investors, as the ECB included corporate bonds in its bond buying program, causing yields and supply to fall.

Source: Morgan Stanley

What do we expect this year from foreign buyers? We believe the political and geopolitical uncertainty in Europe will support an accomodative ECB and keep rates low over the near term. The risk is that the ECB becomes more hawkish due to higher than expected economic growth or inflation. We do not believe that risk is incorrectly priced today.

The other technical benefit to IG corporate bonds today is the relative attractiveness to fixed income asset classes such as Structured Products and Municipals, which have experienced spread tightening year-to-date. Moreover, with equity valuations rising and credit spreads tightening in risk sectors such as high yield and emerging markets, it increases the relative attractiveness of IG corporate bonds.

One risk over the near-to-intermediate term is related to balance sheet management by the Fed. Mutual Funds reduced their holdings of MBS after 2008 (per Fed Flow of Funds data), increasing their allocation to credit. If a Federal Reserve unwind of its QE program makes Treasuries and/or Mortgage Backed Securities (MBS) more attractive then a subsequent rotation out of credit and into MBS by fund managers would likely put pressure on corporate spreads.

Written by:

Elizabeth Henderson, CFA

October 17, 2016 by

Remain Disciplined

By Elizabeth Henderson, CFA
Director of Corporate Credit

We are in the late stage of the credit cycle and anticipate an increase in credit rating downgrades to put pressure on spreads for investment grade issuers. These negative fundamentals are partially offset by strong market technicals. We advocate remaining defensive and selective while maintaining the flexibility to take advantage of opportunities that we expect will arise over the near-to-intermediate term.

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The Investment Grade Corporate bond market delivered a 1% total return in the third quarter, tightening 18 basis points (bps), as defined by the Bloomberg Barclays index. Risk assets outperformed, as the S&P Index increased close to 4% in the third quarter, and high yield returned approximately 5%. Investors largely shrugged off oil price volatility, heavy new debt issuance, weaker than expected economic data, and a lackluster earnings season. China’s stimulus, dovish monetary policy and resilient economic growth have likely supported risk assets and commodity prices. Energy and Basic Materials have been significant outperformers this year due to higher commodity prices.

Exhibit 1: U.S. Corporate Investment Grade Option-Adjusted Spread (OAS)

Source: Bloomberg Barclays, AAM

For spreads to tighten meaningfully next year, fundamentals need to improve and market volatility needs to remain low. The cost of equity continues to surpass the cost of debt, incentivizing companies to reduce their equity base to drive growth. We expect this to continue until the cost of debt reprices, which will not likely come unless the probability of a recession increases and the market grows more concerned about future growth prospects. We recognize that in general, favorable market technicals, not broad credit fundamentals, have been the primary driver of tighter spreads. Thus, we remain disciplined as we build corporate bond portfolios.

Performance Summary Year-to-Date

Performance has been fairly widespread among the non-financial corporate bond sectors year-to-date. Energy and Basic Materials rebounded strongly and would have driven returns even higher if $33 billion of debt had not been downgraded to high yield in January and February of this year. Longer maturity corporate bonds have outperformed year-to-date given overall spread tightening and the demand from yield focused accounts, especially in Asia. Financials have lagged because of the prospect of lower rates for longer and the rally in commodity based sectors. Lastly, shorter maturity corporate bonds have underperformed in recent months in part due to money market reform in the US. The imposition of a floating NAV for institutional Prime Money Market Funds (MMF) has resulted in an outflow from these funds. As a result, issuers that had previously relied on CP issuance to Prime MMFs to fund working capital needs have instead tapped the corporate bond market in the 2-3 year space, thus pressuring this part of the corporate curve.

Exhibit 2: U.S. Contributors to IG Corporate Excess Returns YTD 2016

Source: Bloomberg Barclays Index (as of 9/30/2016), AAM

Credit Fundamentals Remain Lackluster

Credit metrics did not improve in the second quarter. Revenue growth (for non financials, excluding commodity related firms) was flat while EBITDA grew a modest 2%. This is not expected to change much in the third quarter, as reflected by analyst estimates. Debt growth at 7% continued to outpace EBITDA growth, as share buybacks accelerated. Shareholders continue to reward firms for using their balance sheets to buyback shares. Other credit metrics deteriorated as well, including cash interest coverage and cash as a percentage of debt.

Option-Adjusted Spread (OAS) per unit of debt leverage is nearing a historically low point. To approach the median (77), OAS needs to widen 55 bps which is about 60% of a one standard deviation move. Otherwise, fundamentals would need to meaningfully improve. This theme is consistent in U.S. high yield as well as European credit. Unless the cost of debt rises (or the cost of equity falls), we do not expect companies to change their behavior radically as it is in the best interest of shareholders to continue to de-equitize unless growth prospects improve.

Exhibit 3: Median OAS/Debt Leverage

Source: Bloomberg Barclays, CapIQ using median figures for IG non-Financials as of 6/30/2016, AAM

Regarding growth prospects, economists are not expecting global growth to accelerate much next year, with global GDP expected to increase from 2.9% in 2016 to 3.1% per Bloomberg estimates.

GDP Estimates	2016 (%)	2017 (%)
United States	1.5	2.2
European Union	1.8	1.4
China	6.6	6.3
Japan	0.6	0.8
Latin America	-1.7	1.7
United Kingdom	1.8	0.7

Source: Bloomberg (Economist estimates) as of 10/12/2016

M&A Still Preferred Over Capital Investment

Companies continue to use debt and cash to fund acquisitions versus increasing capital expenditures despite increased resistance from regulators and the U.S. Treasury. Reduced investment spending as a percentage of GDP has been driving productivity lower.

Exhibit 4: (1) North America M&A Volume and (2) Business Investment

Source: St Louis Fed, Bloomberg, AAM

When analyzing 2017 capital spending estimates for the universe of investment grade companies, we expect spending next year to be approximately flat vs. 2016 on the aggregate with less than ten industries growing at a rate faster than (1) they did in 2016 and (2) the economy overall (2% assumed). While acquisitions have slowed since the peak in 2015, share repurchases have only accelerated. Given the relative performance of companies that have pursued this strategy, per Bank of America’s study, we would expect this behavior to continue.

Exhibit 5: Cumulative Stock Performance of Companies Repurchasing Shares Relative to the Market

Market Supply and Demand Technicals Remain Supportive

Unlike fundamentals, it is difficult to predict a change in technical related behavior. We note that while valuations look expensive relative to fundamentals, we believe it will take a major shock to increase credit spreads meaningfully in an environment where central banks are buying fixed income securities, reducing available supply. Demand continues to come from yield hungry foreign investors.

Exhibit 6: Foreign Ownership of USD Corporate Bonds

Investing in the Late Stage of the Credit Cycle

Defaults have increased this year largely due to commodity related issuers. We continue to monitor the contagion effects of weak economic growth and tighter credit standards. We expect the default cycle will be longer and recoveries lower than they have been historically given the (1) amount of debt outstanding is relatively high, (2) low level of interest rates, making it more difficult to lower the cost of debt via monetary policy, and (3) structural changes in the market post financial crisis affecting liquidity (and the ability to access the market for refinancing). That said, defaults are expected to decline over the near term with the improvement in commodity prices. Moody’s expects the U.S. default rate to be 5.9%, declining to 4.1% by third quarter 2017. But as its forecast indicates, the pessimistic rate rivals the rate in 2009.

Exhibit 7: Moody’s US Speculative-Grade Default Rates (Actual and Forecast)

Source: Moody’s “September Default Report” 10/10/2016

We are in the late stage of the credit cycle and anticipate an increase in credit rating downgrades to put pressure on spreads for investment grade issuers. These negative fundamentals are partially offset by strong market technicals. We advocate remaining defensive and selective with opportunities in intermediate maturity domestic banks, high quality short insurance and autos, electric utilities, M&A related new issuance (e.g., pharma), and select telecom/tower and energy credits. We want the flexibility to take advantage of opportunities that we expect will arise over the near-to-intermediate term, while investing in credits with more predictable cash flows that offer a yield advantage. We recognize the importance of earning sufficient income to not only satisfy the needs of our clients but to cushion the spread volatility that is likely to increase from a very low level over the last six months.

Written by:
Elizabeth Henderson, CFA

Elizabeth Henderson is a Principal and the Director of Corporate Credit at AAM with 19 years of investment experience. She joined the firm in 2002. Elizabeth graduated with Honors and Distinction from Indiana University with a BS in Finance and earned an MBA in Finance, Analytical Consulting and Marketing from Northwestern University’s Kellogg School of Management.

For more information about AAM or any of the information in the Corporate Credit View, please contact:

Colin T. Dowdall, CFA, Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John J. Olvany, Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer, Vice President of Business Development
neelm.hameer@aamcompany.com

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was 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 representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

March 7, 2016 by

The start of the year ushered in a heightened level of spread volatility. Markets reacted to lower commodity prices and an increased risk of a global recession. The Investment Grade Corporate market experienced spread widening of 50 basis points at the wide point in mid-February. Defensive industries have outperformed, with non commodity sectors contributing more to the market widening this year.

Is It Over?

As of early March, the market has recovered about half of that widening due to the bounce in commodities and more favorable economic data. The economic data points we follow have signaled a slight improvement from the deterioration we have seen since September 2015. Market anxiety remains in regards to China, “Brexit,” and the trajectory of commodity prices. AAM entered the year expecting volatility to be higher and economic growth to be lower than expected but not negative. We have been communicating that we believe we have been in the late stage of the credit cycle since mid-2014. After reviewing fourth quarter results and listening to earnings calls during which management teams provides their guidance for the year and discuss capital allocation, we do not believe the cycle has turned, and thus, do not expect Investment Grade credit spreads to meaningfully tighten.

Fundamentally, credit risk is elevated. At a market or median level and excluding commodity related sectors, revenue and EBITDA growth rates remain abysmal. There are certainly exceptions at an industry level. We highlight sectors such as Pharmaceuticals that are expected to grow nicely this year. That sector is one we expect will continue to be active with mergers and acquisitions, and we anticipate attractively priced new debt issues to be the result.

During earnings calls, we did not hear management teams become more balance sheet focused unless they were in the midst of deleveraging from a prior transaction or in a stressed sector like Energy. We heard much of the same – cash flow and capital allocated to share repurchase programs, increased dividends, and the pursuit of M&A opportunities. With the cost of debt still well below the cost of equity, we don’t anticipate a change. Until markets reprice risk, we expect to remain in this trading range, more likely resetting higher as economic risk increases given the tightening of financial conditions.

Is There Value in the Investment Grade Market Today?

Yes. We entered the year, expecting the corporate OAS to trade within a range of 145-215 basis points (“The Future Ain’t What It Used to Be” – AAM 2016 Investment Outlook), and we remain on the wider end of that range. We highlight the following opportunities:

1. New debt issuance from:

a. issuers funding M&A transactions that we project will add value to the enterprise

i.Examples include credits in the Beverage and Pharmaceutical industries (Anheuser-Busch InBev N.V. (ABIBB), Molson Coors Brewing Company (TAP), Teva Pharmaceutical Industries Limited (TEVA), Pfizer, Inc. (PFE), Mylan N.V. (MYL))

b. high quality companies financing share repurchase programs

i. Examples include companies with stable cash flows and a sensitivity to credit quality because of their need to fund working capital (Lowe’s Companies, Inc. (LOW), Wal-Mart Stores, Inc. (WMT), 3M Company (MMM), Walt Disney Company (DIS))

c. high quality credits in sectors that have cheapened with the increasing risk of recession and “lower for longer” interest rates

i. Examples include Autos, Retail, Insurance Brokers, Banks (subordinated)

2. Secondary opportunities in credits with the financial flexibility to maintain investment grade ratings in a downside scenario. We also note the improvement in value on the short end of the corporate curve (1-5 years) relative to the last five years (Exhibit 1).

Exhibit 1:

Source: Barclays and AAM

We do not see value everywhere; however, and are largely avoiding sectors and credits we believe are most vulnerable in a low growth environment. The Technology sector is one that has raised a lot of debt and now faces lower return prospects. We are avoiding credits rated BBB in that sector. Another is Healthcare REITs, a sector we have avoided because of concerns about rapid consolidation and competition amongst the largest operators, and given our view that not all of the operators will thrive once the sector stabilizes. We are also cautious about the aggressive push into operating businesses under RIDEA (REIT Investment Diversification and Empowerment Act) by the largest Healthcare REITs. Lastly, the Food and Consumer Products sectors are filled with household names that have failed to execute and are vulnerable to shareholder activist pressure or debt financed M&A to increase shareholder returns. Looking at various spreads in these sectors (Exhibit 2), we fail to find value in the single-A rated credits vs. Industrial peers. For BBB Tech and Healthcare REITs, we believe the rationalization that needs to occur will push spreads wider, towards BB levels.

Exhibit 2:

Source: Barclays (as of 2/29/16), AAM [Note: Total = Barclays Industrial sector]

For more information, contact:

Colin T. Dowdall, CFA
Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John Olvany
Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer
Vice President of Business Development
neelm.hameer@aamcompany.com

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was 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 representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

October 12, 2015 by

The End of the Credit Cycle?

By Elizabeth Henderson, CFA
Director of Corporate Credit

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Volatility remained high in all markets with investment grade credit spreads widening 23 basis points (bps) versus Treasuries in the third quarter. The main driver of this widening was falling commodity prices in response to continued weak data from China and global growth concerns.

Repricing Risk

The Federal Reserve’s decision and communication led to investor consternation in the latter half of September. The prospect of higher rates concurrent with the increased risk of slower global growth resulted in a repricing of risk.

This was most evident in the high yield market with spreads widening 153 bps in the third quarter. Investors pushed back in the new issue market, demanding much higher yields (e.g., Frontier Communications, Altice, Olin). In investment grade, we witnessed issuers pulling deals from the market after poor investor response as well, a dynamic we have not experienced in some time. The CLO (Collateralized Loan Obligation) market has also suffered with credit quality erosion and market volatility impacting pricing and originations. Appreciating the importance of credit availability and creation to the health of the credit market and economy, we are concerned with these events.

We cited the increased risk of fallen angels in last month’s Corporate Credit View (“Fallen Angels Expected to Increase”). The market recognized this risk in the third quarter, repricing many BBB rated credits, with $211 billion of debt across 56 investment grade issuers trading like high yield credits[note]Stephen Antczak, CFA, “Fallen Angels: How many, how to cope,” Citi Research, October 2, 2015[/note].

Market Vulnerabilities

The first signs of credit contraction cause us to increase the top end of our range for spreads. We had entered 2015 with an expected range of 120-175 bps (Exhibit 1). Considering the change in quality and duration of the Barclays Corporate Index since prior points in the cycle, as well as corporate fundamentals today, we have modeled downside risk to be 225 bps.

However, risk is skewed to the downside due to the difference in liquidity conditions (“The Perfect Storm? Fixed Income Portfolio Management in a Reduced Liquidity Environment”). In the Royal Bank of Scotland’s (RBS) September Survey 79% of investors believed that we are moving to a structural phase of high asset price volatility. As the survey results show, this was the second biggest fear among investors (first being China). RBS states that “declining liquidity and an increase in herding may exacerbate volatility during times of stress, with the IMF (International Monetary Fund) highlighting an increase in correlation among major asset classes and between fund positions, since the crisis.”[note]Alberto Gallo, “The Silver Bullet|Credit nearing breaking point: Stay Short,” Royal Bank of Scotland, September 30, 2015.[/note] Regardless of fundamentals, we believe the market needs to reprice for this level of volatility, hampering a return to 120 bps.

Exhibit 1: U.S. Corporate Investment Grade OAS

Source: Barclays, AAM as of 9/30/2015

We believe BBB rated credits away from the Energy and Basic Material industries are particularly vulnerable, if the credit cycle has ended and spreads widen. The spread differential (i.e., basis) of A and BBB rated Industrial credits has increased due to commodity related sectors, as the risk premium for other BBBs (excluding Energy and Basics) has not widened (Exhibit 2).

Exhibit 2: BBB-A Industrial Rating Basis, excluding Energy and Basics

Source: Barclays, AAM as of 9/30/2015

Additionally, cyclical sectors away from commodities have performed in line with more defensive sectors. We believe the risk premium for economically sensitive sectors could also widen with sectors within Consumer Cyclicals particularly vulnerable.

Exhibit 3: Spread Changes for Sub Sectors YTD

Source: Barclays, AAM as of 9/30/2015

We would expect widening in Financials as well. They have outperformed year-to-date, but would be impacted in a credit correction, as increased credit defaults would be a drag on earnings and capital levels. We are watching bank lending standards and credit loan growth closely for additional signs of credit contraction. We note the third quarter loan growth was less than half the rate realized in the second quarter due to a slow down in commercial and industrial (C&I) lending.

Exhibit 4: Finance – Industrials Spread Difference

Source: Barclays, AAM as of 9/30/2015

The banks continue to operate in an opaque regulatory environment. A draft form for TLAC (Total Loss Absorbing Capital) is expected to be released by the Global Financial Stability Board before the G20 finance meeting in November. However, the Fed and OCC (Office of the Comptroller of the Currency) are expected to tweak it for the U.S. system, which is expected to take longer. Therefore, debt issuance requirements (needed to increase capital levels) may become clear later this year with a four to six year implementation period. We believe the long implementation timeframe is manageable, thus we do not believe this will be a systemic issue or stress on the system.

Summary

We are in the late stage of the credit cycle, and signs are emerging that we may have reached the end. If that proves true, we would expect spreads to widen and rating actions to become more punitive. Companies have increased leverage at a time of slowing earnings growth to increase shareholder returns. Regardless of whether we are at the end of the cycle, we expect this credit deterioration to continue to be a headwind for spreads and an impetus for rating downgrades. In the past, economic cycles have lagged credit cycles by approximately 12 to 24 months. Therefore, we would not expect management behavior to become creditor friendly until the risk of a recession increases. Although spreads have widened, this is a time to remain defensive and selective. As growth forecasts are revised lower and credit appears to be contracting, we are growing increasingly more cautious.

For more information about AAM or any of the information in the Corporate Credit View, please contact:

Colin Dowdall, CFA, Director of Marketing and Business Development

colin.dowdall@aamcompany.com

John Olvany, Vice President of Business Development

john.olvany@aamcompany.com

Neelm Hameer, Vice President of Business Development

neelm.hameer@aamcompany.com

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was 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 representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

July 22, 2015 by

Volatility increased this quarter with investment grade credit spreads widening 16 basis points versus Treasuries in the second quarter. The main drivers of this widening included Greece, China, and increased merger and acquisition (M&A) activity. M&A activity in the second quarter was the highest in twelve years. We highlighted all of these issues in last quarter’s newsletter (The Top Five Issues That Will Affect Corporate Credit Spreads Today).

This quarter, we discuss the deterioration in investment grade credit fundamentals and what that means for investors when growth contracts and default risk increases. We believe this will become a critical issue over the near-to-medium term.

Credit Quality Deterioration

We have witnessed a marked decline in credit quality since mid-year 2014, as commodity prices have declined and debt has increased to fund shareholder returns and M&A. When measuring the debt/EBITDA leverage of about 400 nonfinancial, nonutility investment grade credits and isolating the bottom third each quarter (defined as those with the highest debt leverage), leverage is approaching 4x, which is quite high considering the economy is still expanding. As seen in Exhibit 1, leverage has increased when the economy contracts, resulting in increased downgrades to high yield. While the rating agencies claim to assign ratings that reflect performance through an economic cycle, this has not generally proven to be the case.

Exhibit 1: Rating Downgrades to High Yield Expected to Increase

Sources: Leverage – AAM (Includes over 400 nonutility and nonfinancial companies);
Downgrades – S&P 2014 “Annual Global Corporate Default Study and Rating Transitions,”
Diane Vazza, April 30, 2015

Ratings Risk and Defaults

Simply, leverage is increasing and we expect rating actions to follow. As one would expect, increased leverage has been positively correlated with the percentage of investment grade companies that have defaulted, as shown in Exhibit 2.

Exhibit 2: Investment Grade Defaults Increase as Ratings Migrate Lower

Source: Standard & Poor’s 2014 “Annual Global Corporate Default Study And Rating Transitions,” Diane Vazza, April 30, 2015

The first question to ask is “are investors getting paid for the risk?” Our answer is “no,” we do not believe investors in low investment grade rated securities are being appropriately compensated. As Exhibit 3 shows, a one notch downgrade into high yield should result in a one percentage point increase in spread versus Treasuries. That has a material impact on the pricing of that security, and the default risk increases as well.

Exhibit 3: Rating Risk is Not Reflected in BBB- Securities

Source: AAM using five year maturities for BBB and BBB- rated securities; Barclays OAS for Ba1 rated securities with a duration of 4.8.

Market Liquidity

The second question becomes “if investors are not getting paid for the risk, can they simply sell the security?” Our answer is “it depends.” In the equity market, if an investment analyst believes the stock will underperform, the stock can be sold into the marketplace. The corporate bond market is an over-the-counter market, which means dealers act as intermediaries, quoting where bonds can be sold or purchased. Regulators have made it more onerous for these intermediaries to hold positions due to increased capital requirements and tighter risk limits, resulting in a much smaller secondary debt market (Exhibit 4). The decline from $280 billion in 2007 to a low of approximately $20 billion in 2014 is remarkable.

Exhibit 4: Net Primary Dealer Positions in Corporates, Commercial Paper, and MBS ($B)

Source: Federal Reserve, Bloomberg, Barclays Research

While the secondary debt market has fallen in size, the amount of debt outstanding has increased, as interest rates have declined (Exhibit 5). Where dealers used to control 4-5% of the market, they control less than 0.5% today.

Exhibit 5: U.S. Investment Grade Corporate Debt Market ($MM)

Source: Barclays Corporate Index, AAM

The illiquidity of the corporate bond market has caught the attention of the Federal Reserve and has been the topic for many financial reporters. Although many investment managers have talked about developing electronic trading platforms, they have failed to penetrate the market. According to the Financial Times[note]Michael Mackenzie “Search for liquidity tests corporate bond market,” Financial Times, November 4, 2014, accessed July 20, 2015, https://www.ft.com/cms/s/0/9ee487fa-4e43-11e4-adfe-00144feab7de.html#axzz3gYs9Ufrj.[/note], Greenwich Associates, a consultancy, estimates that 16% of institutional trading of investment-grade bonds is done via electronic platforms. And, while electronic trading is gaining some traction, it has involved smaller sized trades (i.e., less than $1 million) versus $5 million and higher.

Summary

Therefore, the bond market’s illiquidity may present challenges to larger managers who want to execute on the ideas originated by their investment staff. At AAM, our size allows us to be nimble and gives our portfolio managers the opportunity to execute on the ideas our team originates. We believe as the cycle matures and rating downgrades increase, smaller managers have a greater ability to differentiate and to outperform their larger peers.

Elizabeth Henderson, CFA
Director of Corporate Credit

For more information about AAM or any of the information in the Corporate Credit View, please contact:

Colin T. Dowdall, CFA, Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John J. Olvany, Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer, Vice President of Business Development
neelm.hameer@aamcompany.com

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was 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 representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.