Corporate Credit View

First Quarter – 2013

• Corporate Market Generates Modest Excess Returns vs. Treasuries
• Financial Sector Outperforms Industrials and Utilities; BBBs Outperform As
• Company Fundamentals Remain Sound But Idiosyncratic Risk Has Increased with Two Leveraged Buyouts Announced
• Headlines in Europe and Sequestration in the US Resulted in Minimal Spread Volatility
• AAM Expects Similar Performance from Corporate Bonds in the Second Quarter

Investment Grade Corporate Bond Spreads Tighten Modestly

The Investment Grade Corporate market started the year well, as spreads tightened 8 basis points (bps) in response to fiscal cliff resolution and better than expected economic data. After the first week, the enthusiasm waned with increased event risk (e.g., Dell leveraged buyout (LBO)) and investor concern with the technical support of the fixed income market if rates moved sharply higher. Spreads have been stable despite the government spending reductions, Italian election uncertainty, and the Cyprus bail-out (Exhibit 1). New issuance in all markets remains healthy, and new issue demand has been very strong with deals remaining well oversubscribed.

Exhibit 1

Source: Barclays Capital, AAM

The Investment Grade Corporate market earned 0.28% over Treasuries in the first quarter 2013 per Barclays. The Finance sector continued to outperform as did BBB rated securities (Exhibit 2). Investors looked to Finance and Utilities as safe haven sectors as opposed to the more event risk prone Industrial sectors like Energy, Telecommunications, Technology, and Consumer NonCyclicals. Industrial bonds with long maturities performed particularly poorly (-101 bps), as investors recognized the lack of spread protection in the face of increased volatility.

Exhibit 2

Source: Barclays Capital, AAM
Exhibit 3

Exhibit 3 shows the difference in industry excess returns vs. the Corporate market overall for the first quarter of 2013 and our expectation for the entire year. It is clear that Finance has exceeded our expectations thus far. Not only has Insurance performed strongly, but Banks and REITs as well. In Industrials and Utilities, we are taking advantage of current market levels, and believe the following are particularly:

Unattractive

• Telecom, Media (Networks), Technology – We believe softening credit fundamentals, heightened event risk, and the prospect for new issuance are not reflected in relatively tight spread levels.

• Electric Utilities – We anticipate fundamentals to remain relatively stable in 2013 given our modest domestic growth expectations.  However, we anticipate the sector’s excess returns to be among the weakest due to limited spread compression opportunities and its OAS, which trades well inside of its one year average.

• Food & Beverage – Event risk is very high in this sector due to LBO risk (e.g., Heinz) and pressure to generate satisfying returns for shareholders including spin-offs and mergers and acquisitions. Fundamentally, we like the large, global participants with strong brand equity and balance sheets, but they offer little value from a spread perspective.

 Attractive

• Energy – We believe that most of the Energy space is fairly valued.  However threats of increased investor activism at Hess, Transocean and Nabors in January 2013 combined with good fundamentals has provided opportunities in the Oil Service subsector, which we now value attractively (To read more, please see our recent white paper, “[download id=”11″]”

• Metals & Mining – New issuance has re-priced this sector, and we have taken advantage of that opportunity. We expect that commodity prices will be volatile but should be supported by better demand from China. We expect mergers and acquisitions will pick up this year, resulting in attractive new issuance opportunities.

• Pipelines – We have a favorable relative value opinion of the Pipeline sector due to positive growth characteristics, improved credit profiles and comparatively cheap valuations.

Industry Highlights – Banking and Energy

As part of our investment process, analysts internally present industry specific topics that are relevant to fixed income investing. Two of these presentations in the first quarter included Banks – Orderly Liquidation Authority (OLA) and Energy – Transformational Times in North America.

We highlighted OLA in our “[download id=”10″]” and since that time, Moody’s reiterated its Negative Outlook on the systemically important U.S. Banks. This Outlook reflects its concern that regulatory support is weakening given the prospect of a credible resolution regime (enshrined in OLA). Concurrent with the expectation for a formal OLA proposal later this year, Moody’s expects to update its bank holding company rating support assumptions by year-end. Worst case, if Moody’s removed its notching for systemic support, Bank of America and Citigroup could see their bank holding company ratings lowered to Ba1. Our expectation is for Moody’s to remove a notch of rating support, resulting in one-notch downgrades across the board. Given our fundamental outlook and the spread tightening to date, we do not expect material spread tightening for the large domestic banks in the near term. To read more about the risks on the horizon for the banking sector, see “[download id=”9″]”

In Energy, we presented the potential for liquefied natural gas (LNG) exports from the U.S, in the intermediate term with the expectation of a domestic oil production surge and ultimate approval and construction of the Keystone XL pipeline. We expect the energy revolution to be a driver of economic activity in the U.S. in addition to the housing recovery and a deleveraging consumer. Specifically, we are taking advantage of transportation companies such as relevant pipelines and railroads. Railroads will benefit from the production regardless of the construction of the Keystone XL pipeline, as they currently transport crude oil from the burgeoning Bakken Shale in the Great Plains to the refineries located in the Gulf Coast, mid-Continent and Rust Belt. If the Keystone XL pipeline was built, they would remain critical in the transportation of materials such as the chemicals used to transport the oil to the refineries through the pipeline. Moreover, the low natural gas prices in the near to intermediate term is beneficial to US manufacturers, potentially allowing them to reclaim manufacturing activities lost in the 2000s from emerging market countries.[1]

Fourth Quarter Earnings Season Exceeded Lowered Expectations

Earnings and sales growth were better than expected in the fourth quarter of 2012, with the companies in the S&P 500 reporting sales growth of 3.7% and earnings growth of 9.2% versus the fourth quarter of 2011. All sectors but Energy reported positive sales growth in the fourth quarter. The Finance sector posted the strongest performance with sales growth of 22%. The aggregate EBITDA margin fell modestly in the fourth quarter, continuing its downward path since the peak in 2011. Management commentary was marginally positive in particular about China.

As earnings growth slows and debt balances grow, gross debt leverage continues to creep higher, but it remains lower than its peaks in 2003 and 2009, especially on a net debt basis (Exhibit 4).

Debt leverage has increased for Metals & Mining companies due more to falling cash flows, as the global economy (mainly China) has cooled, bringing commodity prices down. Whereas, acquisitions have resulted in increased debt balances for sectors such as Consumer and Healthcare. The level of cash on balance sheets continued to grow throughout the year.

Exhibit 4
Notes: Gross leverage is Total Debt/ LTM EBITDA. Net leverage is (Total Debt Less Cash/EBITDA.
Source: Morgan Stanley Research, Bloomberg, Yieldbook

Capital spending remained quite strong in the fourth quarter, increasing 13% year-over-year or 4% vs. the third quarter. We continue to believe that the low cost of funds and the lower level of systemic risk (given the central bank support) will incentivize management teams to invest in their businesses. That said, we expect the rate of growth to continue to decline in 2013, driven primarily by the lower level of spending from Metals/Mining and Energy companies, which comprise a dominant share of the overall level of capital spending (Exhibits 5A and 5B).

Source: AAM, CapitalIQ (analysis based on 280 Industrial companies)
Lastly, the very low cost of debt and reduced systemic risk (given worldwide central bank support) are resulting in an increased appetite for leverage. We are witnessing this as credits such as CenturyLink, AT&T, ADT and Safeway increase debt to reward shareholders, resulting in modest rating downgrades. Extreme examples are the leveraged buyouts for Dell and Heinz, and Verizon’s publically stated goal of buying Vodafone’s 45% stake in Verizon Wireless, which would cost more than $100 billion and likely result in its low-A ratings to fall to mid/high BBB.

AAM Expects Similar Performance from Corporate Bonds in the Second Quarter

First quarter earnings season has started and we expect companies to continue their trend of surprising to the upside, as expectations have been set fairly conservatively. The second quarter is expected to be the softest from an economic perspective in the U.S. due to the fiscal tightening. Since the second quarter is expected to be soft, we expect spreads to remain relatively stable. The catalyst for change is likely to occur later in the quarter when investors should have a more informed opinion of the trajectory of growth in the second half. We would not expect that to occur earlier based on management outlooks or commentary in earnings calls, but it is a possibility.

We continue to expect the Corporate market to generate positive excess returns vs. Treasuries in 2013 driven primarily by yield (vs. spread tightening). The level of excess return year to date has been underwhelming due to two main reasons: (1) the underperformance of high quality Industrials and (2) the underperformance of long end maturities. We would not expect either to reverse in the second quarter unless the trajectory of growth expected for the second half of 2012 is modified lower.

Written by:
Elizabeth Henderson, CFA
Director of Corporate Credit

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.

[1] Manoj Pradhan, “Market Insights: EMs must respond to US industrial revival,” Financial Times. April 10, 2013, accessed April 10, 2013

Strong Performance from Investment Grade Corporates

• QE3 has Increased Demand for Investment Grade Corporates

• Company Earnings and Outlooks have been Weaker than Expected

• Spreads are Fully Valued but Technicals Remain Supportive

• Rating Migration to BBB is Expected to Continue within Investment Grade Industrials

• A/AA Rated Industrial Credit Spreads Do Not Reflect Increased Credit Risk

Investment Grade Corporate Bond Spreads Reacted Positively to QE3

The Investment Grade Corporate market rallied, propelled by more quantitative easing (QE) than expected, benign European headlines (including Moody’s affirmation of Spain), and better than expected economic data. While the equity, high yield and credit default swap (CDS) markets reacted negatively to weak earnings reports, investment grade spreads remain largely unchanged (Exhibit 1). We believe spreads are benefitting from the increased demand due to QE3, as the supply of mortgage backed securities has contracted. This is likely to become more pronounced when/if the European Central Bank (ECB) starts its Outright Monetary Transactions (OMT) program. European investors returned to the Corporate market in August, and we expect this continued in September (Exhibit 2).

The Investment Grade Corporate market earned 1.17% over Treasuries in September and 1.47% in October, increasing the year-to-date excess return to 7.63% per Barclays. The Finance sector continued to outperform as did BBB rated securities and long maturities. From an industry perspective, those more levered to the economy outperformed the more defensive, higher quality sectors. New issuance in all markets remains healthy and new issue concessions nonexistent except for the lower yielding, higher quality deals. Since September, credit curves have flattened more than expected with the short and long ends benefitting from the increased demand due to QE3. We expect this technical support to continue over the next twelve months, softening the volatility that we expect  from macroeconomic headlines (including fiscal cliff related discussions), weaker company level results and increased shareholder friendly actions.

Exhibit 1

Source: Barclays Capital, AAM

Third Quarter Earnings Have Been Lackluster

This earnings season has been fairly negative, not only from a reporting standpoint for the third calendar quarter, but also from an outlook perspective (Exhibit 3). On earnings calls, management teams have talked about the uncertainties in the marketplace due to upcoming fiscal decisions in the U.S., China and Europe, causing companies to invest more cautiously. This is the second quarter we have seen sales and earnings growth plateau, reflecting the low growth rate of the domestic economy and slowing growth outside the U.S. The only sector that has positively surprised with higher than expected Sales is Finance.

Exhibit 2

Exhibit 3

Source: Bloomberg, AAM (S&P 500 constituents)

We had expected spreads to widen in the second half of 2012 due to our expectation of softening fundamentals, not to mention the potential economic and European related event risk. Historically, there has been a strong relationship between earnings estimates and spreads. As shown in Exhibit 4, since May 2012, this relationship reversed. We believe this reflects the increased demand for Corporate credit, as investors look to earn a higher risk adjusted return over risk free rates in a more uncertain environment.

Exhibit 4

Source: Bloomberg, AAM

How Has AAM Been Investing in Corporates?

After the strong rally, the corporate market is at the tight end of our fair value range. The spread compression between Finance and Industrials is largely over after strong performance from Financial credits this year, but the basis between A and BBB rated Industrials remains too wide (Exhibit 5). We expect continued performance from BBB rated securities, and generally believe A/better rated Industrials are rich.

Exhibit 5

Source: Barclays Capital, AAM

Tactically, we remain defensively positioned in regard to Europe, avoiding European financial and infrastructure credits and hold fewer low quality credits, which we believe are more likely to fall to high yield. We are replacing that yield with a greater percentage of higher quality BBB rated credits and less liquid securities (e.g., private placements) while preserving overall portfolio yield and liquidity. Our security analysis has proven that in Investment Grade, the spread for “reaching for yield” is inadequate to compensate insurance companies for the increase default risk and risk based capital (RBC) charges associated with the credit rating downgrades.

The risk of increased leverage is rising, as the forecast for low rates lengthens and volatility has subsided due to increased support from the Federal Reserve and the ECB. We expect ratings migration to continue from the A to the BBB category.

In a recently published S&P report titled, “The Credit Overhang – 101 Lost ‘As’ – A Dozen Years of Decline for U.S. Industrial Ratings,” the authors detail the migration, including the rationale (Exhibit 6). The authors end the report by stating that “S&P believes that the number of ‘A’ companies will continue to decline. The low cost of debt (especially for investment-grade issuers), the tax advantages of issuing debt, and the pressure to return money to shareholders suggest that other considerations can outweigh the benefit of having an ‘A’ category rating. Under such conditions, S&P believes that companies will be more inclined to take on increased financial risk, even if it means carrying lower credit ratings.”

Exhibit 6

Source: Standard & Poor’s

We generally agree with S&P, which is why we believe it is imperative that one measures credit risk on a forward looking basis, assigning internal credit ratings. We measure returns based on these internal risk assessments, and look to maximize risk adjusted income. An example in the Media sector is in Exhibit 7, showing the differences of our risk assessment vs. the agencies. Spreads for A/AA rated Industrials are historically very tight; therefore, we generally believe investors are not being compensated appropriately for the expectation of increased credit risk.

Exhibit 7

Source AAM, Capital IQ, Bloomberg, broker runs.

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

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.

Back to Work

• Corporate Bond Markets Outperformed Treasuries in August
• European Headlines Will be Plentiful, Leading to Higher Volatility
• Stimulus in China is Likely by Year-End
• Companies are Cautious, But Consumers are Still Spending

Investment Grade Corporate Bond Spreads Continue to Tighten in August

Investment grade corporate bond performance in August was strong with Finance outperforming Industrials. The Investment Grade Corporate OAS tightened six basis points (bps) per Barclays. The market earned 0.42% over Treasuries in August, increasing the year-to-date excess return to 4.80% per Barclays (Exhibit 1). “BBB” rated securities have earned 4.87% over Treasuries and 5.09% over “A” rated securities year-to-date (0.54% and 0.38%, respectively, in August). From an industry perspective, Life Insurance outperformed in August (2.03% excess return) and Metals & Mining underperformed -0.99%). The domestic high yield market also performed well, earning 1.15% over Treasuries in August. In Europe, the Corporate market had a good month as well, earning 1.20% of excess return in August according to Barclays.

Exhibit 1

Source: Barclays Capital, AAM

New issuance in all markets was healthy, and for most deals in the domestic investment grade market, new issue concessions were nonexistent. We expect September to be an active month for new issuance with over $80 billion of supply expected. The market continues to be in our Fair value range, but the risk is skewed to the downside. We would not be surprised if spreads widened this month due to heightened volatility and new issue supply.

How Has AAM Been Investing in Corporates?

We believe the market has largely priced in: (1) the policy actions expected from the Federal Reserve, European Central Bank, and People’s Bank of China, (2) positive headlines from Europe (i.e., a supportive German Constitutional Court, Greece remaining in the Euro, Spain receiving support from the Troika), and (3) an avoidance of the fiscal cliff in the United States. If the market is right, business and consumer confidence is likely to rise, supporting and possibly propelling GDP growth. While our base case reflects market sentiment, we believe the risk and uncertainty surrounding these events is high and will lead to increased volatility. Current spread levels are not compensating investors for heightened volatility. We are defensively positioned for our clients, owning more Corporates versus our benchmarks while avoiding Europe and more cyclical and/or fundamentally weak credits. From a rating perspective, we prefer higher quality BBB rated Industrials/Utilities and domestic Financials versus A rated Industrial/Utilities due to the historically wide spread differential and the importance of income in this environment. We believe it remains prudent to avoid Europe until real fundamental solutions are presented and are not investing in more volatile, weak BBB rated credits due to the lack of value for their deteriorating fundamentals.

European Headlines Will Be Active – Status Quo Most Likely, But Tail Risk Remains

September is a critical month with the Federal Reserve and European Central Bank expected to announce programs to help stimulate their respective economies.  Mario Draghi, President of the European Central Bank, pleased the markets this morning with his announcement that the Securities Market Program (SMP) will be used to purchase government bonds with maturities of one to three years. The amount will be unlimited, but the countries that participate must enter into the rescue fund and comply with such conditions. The ECB has used this program very little in the past due to the objections by the Germans. They objected to this plan as well, and were the sole objectors of the 23 member Governing Council.

Liquidity may be further increased via the European Stability Mechanism (ESM), assuming the German Constitutional Court rules that Germany’s participation in the European Stability Mechanism (ESM) is legal. This announcement is expected on September 12.  We are also waiting for ratification of the ESM by other countries, which are likely post September 12.  Finland has been most resistant to further bail-outs and to the ESM.  A unanimous vote is needed by the European Union countries to move forward.  Importantly, the Dutch election is also September 12 and one such outcome could return a coalition against aggressive austerity and in favor of a Greek exit.

While the ECB’s actions are a near term positive solution for liquidity, we do not view this unconstrained monetization as a long-term solution.  Fiscal unification is required as well as structural reform and growth initiatives for countries in the periphery.  Without growth, deficit and debt reduction cannot be achieved without debt repudiation, a very painful process.  Lastly, unification of European Union (EU) bank regulation is also being discussed, although it is unlikely that it will be in place this year.  The European Commissioner for Economic and Monetary Affairs and the Euro, Olli Rehn, favors giving the EU supervisory power for all euro area banks as this framework is the only one that would allow the euro area to recapitalize banks directly.  It is expected that once this is in place, the ESM will be able to recapitalize the banks similar to what the U.S. Federal Reserve did with T.A.R.P.

In addition, we expect to learn more about Spain’s banking system and how much capital is needed of the €100 billion of aid pledged.  Four of its regions have approached the sovereign for emergency liquidity support and bank deposits (for the country) continue to drain.  Prime Minister Rajoy has not officially asked for a bailout from the Troika, but this is expected over the near term.  The terms are important, since Spain has been diligent with its austerity and in the minds of the Spaniards, is not able to implement further austerity.  Germany has been slowing economically and cannot afford to have a break-up of the Euro.  Therefore, we believe the Germans will capitulate, allowing Spain to enter the program without materially harsher measures.

And, don’t forget Greece!  Prime Minister Samaras has asked key euro policy makers to discuss relaxing its conditions of the last bail out agreement to give Greece another two years to meet its commitments.  This month, the Troika will be examining Greece’s fiscal and economic progress and releasing its report by the end of October.  Although the report is expected to disappoint, it is not a foregone conclusion that Greece will leave the Eurozone with a 30% probability (per Intrade) being assigned to its departure this year.

From a ratings perspective, Moody’s left Spain’s rating on review, waiting for more details from the German court and Spain’s funding requirements.  It also placed the EU’s triple-A rating on negative outlook, reminding investors of the correlation between the four largest member states’ (Germany, France, Netherlands, UK) ratings and the EU’s rating.

China – Expect More Policy Action Over the Near Term

We continue to see evidence of a slowing economy, exemplified by the latest manufacturing report. Policy action so far has not gotten sufficient traction; therefore, more is expected to maintain growth. Specifically, the market expects China to cut its reserve ratio by 150 basis bps by year-end. Inflation concerns should be tempered by recent reports, although policy action may be delayed due to the transition in leadership in November. While growth has come down and the overall contribution to world GDP is quite large, companies are revising their spending plans in the country, a near term consequence. For instance, Metals and Mining companies are extending their capital spending plans because of lower commodity prices and higher costs and Media companies are cutting their revenue forecasts due to a lower growth rate for advertising. In addition, large, global conglomerates such as Caterpillar (CAT) have suffered. CAT is cutting production in China and will export to other parts of the world to get inventory in that region to a more comfortable position.

In summary, we believe the government will remain supportive with policy action later this year, but are more cautious and concerned with the secondary affects on the Corporate sector since China has been a significant contributor to many companies’ financial results.

Sector Fundamental Reviews

We thought it would be worthwhile to revisit our fundamental sector views due to the slowing economic growth worldwide. Second quarter results highlighted managements’ uncertainty and caution with few increasing 2012 estimates. Pricing was more difficult, higher input costs and a stronger dollar affected margins, and emerging market growth was weaker than expected. We are seeing an increase in share repurchase activity, a logical step given the cash on the balance sheet and political and economic uncertainty, suppressing organic investment and acquisition activity.

Finance – Fundamentals Remain on Track, But Spreads Have Compressed

Banks – Improving Asset Quality and Loan Growth, But Revenue Growth is Anemic and Event Risk is Rising

Finance bonds have performed very well this year, compressing with Industrials (Exhibit 2), due to continued fundamental improvement and technical support as net supply is expected to be meaningfully down this year.  Domestic banks largely met expectations in the second quarter. Bank fundamentals have been on a steady improving trend for twelve quarters driven by improving asset quality, as the banks have steadily repaired their balance sheets.  Falling credit costs have been the key driver of profitability, which has in turn driven balance sheet repair in the form of growing capital and continued run-off of non-core loan portfolios (commercial real estate, home equity). Modest loan growth has continued with banks expecting commercial and industrial lending growth of 2%, rolling out more credit card and installment lending to consumers, and being more active in auto and student lending. Banks are taking advantage of the deleveraging required by European banks, as well as becoming more aggressive with leveraged buyout and syndicated lending. We continue to believe it’s not banks’ willingness to lend, but companies’ unwillingness to add debt that has held back loan growth.

Exhibit 2

Source: Barclays Capital, AAM

However, we are beginning to see a counter-trend of top-line revenue pressure due to the protracted low interest rate environment. While modest loan growth has somewhat offset compressing interest margins, net interest income has fallen in seven of the last nine quarters. Additionally, the money center banks’ non-interest income has been pressured by weak capital markets revenues over the past two years as the Eurozone crisis has driven down volumes and Basel III has led to the exit of select capital market businesses. The result has been deteriorating efficiency ratios (non-interest expense/net revenues) despite continued expense reduction initiatives and pressure on the absolute level of bank profitability despite improving pre-tax margins.

While the improving asset quality and capital growth trends have been fundamentally positive for bank creditworthiness, the sector has struggled to generate adequate returns for shareholders. The combination of higher capital requirements under Basel III, low interest rates and weak economic growth are causing banks to struggle to achieve adequate return on equity and return on assets. As a result, the credit positive of steady balance sheet improvement is offset by our concerns that event risk may be rising as management faces pressure from equity holders (not to mention the specter of macro-political risk in the forms of the Eurozone crisis and the U.S. fiscal cliff).

REITs – Fundamentals Continue to Improve and Management Remains Prudent

The industry remains fundamentally healthy with management remaining disciplined towards acquisitions and development despite very strong liquidity. Broadly, occupancy and rental rates are increasing in Retail and Multi-family while Office remains challenged. Financial metrics have improved post financial crisis especially liquidity.

Insurance – Companies are Navigating Well in this Environment

Earnings were stronger than expected for Life companies with interest rate swaps and less liquid, higher yielding assets (e.g., commercial real estate, private placements) helping to mitigate the effects of falling interest rates. Property and Casualty company results were as expected. The sector that disappointed was Health due to higher medical expenses. Although, we see this as a short term phenomenon, as the companies will work again to increase rates to offset this cost. We expect associated headlines in 2013.

Cyclical Industrials – Consumers are Still Spending While Businesses are Being Affected by Deleveraging in Europe and Slowing Growth in Asia

Energy – International Oil Remains the Bright Spot While Uncertainty is an Overhang for the Services Sector

Oil prices have increased with the markets and the quantitative easing sentiment. Based on fundamentals and a slowing world economy, we project a twelve month price of $85 per barrel. We expect demand to increase by 500,000 barrels per day, supply to increase by 850,000 per day and the market to shift its focus on slower growth from China and declining demand from the U.S. and Europe. Supply is more of the unknown variable due to the political unrest in the Middle East and will keep oil prices higher than fundamentals support.

Similarly, natural gas prices remain low with the supply glut domestically. Strong productivity of 105 million cubic feet per day per rig is nearly 50% greater than 2011 and at the highest level in more than a decade. However, the natural gas rig count has declined by 46%, which will eventually impact supply. The potential for increased demand for natural gas in the next three years as coal burning electric plants are retired and replaced by natural gas burning electric plants should not be meaningful until 2014 at the earliest. Moreover, given the significant coal to natural gas switching that has already taken place in 2012, we believe the influence of coal closures will be less than previously expected. Our forecast remains $3 per MMBtu (million British thermal units) over the next twelve months.

As it relates to companies, those with international oil exposure are outperforming their domestically focused peers. Weak natural gas prices and escalating service costs in the first half of 2012 have resulted in a decline in North America spending plans. We are examining whether those reduced capital expenditure plans for North America will spill over to the international market, putting pressure on contract drillers.

Media – Advertising Growth Remains Solid, But Signs of a Weak Economy are Emerging

Away from commodities and moving on to advertising, growth estimates have been revised down for advertising especially in Europe (Exhibit 3). Europe’s growth was revised down from 2.3% to 0.8% by MagnaGlobal.  Most of the revision was due to sharp revisions in ad spending in Greece, Spain (12% lower), Portugal and Italy (5% lower).  Carat was the latest to make revisions, taking Europe from 1.5% to 0.2% and Asia from 8.7% to 6.8%. This will affect companies differently, depending on their geographic exposure.  As evidence, after affirming guidance on June 14, WPP recently revised its revenue projection for 2012 down from over 4% to 3.5% due slower growth in Southern Europe and North America. WPP’s Chairman has been very vocal regarding his concerns for the economy in 2013 and thus, advertising due to the political uncertainties. It is worthwhile to note that in the U.S., advertising is expected to be about flat with 2011 levels if one were to strip out political and Olympic advertising. Therefore, the expectations are certainly not high in terms of a base for growth in 2013.

Exhibit 3: Global Advertising Growth Projected for 2012

Research Unit	New 2012 Projection	Old 2012 Projection	Date of Revision
Zenith Optimedia	4.3%	4.8%	6/18/2012
MagnaGlobal	4.8%	5.0%	6/18/2012
GroupM	5.1%	6.4%	6/19/2012
Carat	5.0%	6.0%	8/23/2012
Average	4.8%	5.4%

Source: Bloomberg

Another sign of a weak economy was the increase in direct response advertising. Direct response advertising grew 8% year-over-year in the second quarter, the fastest growth since first quarter 2008. This type of advertising is emblematic of a weak economy because these advertisers are buying excess inventory on short-notice at a sizeable discount to standard rates. Apart from this, advertising was solid in the second quarter especially given the weakness in cable network ratings. Auto spending has contributed nicely this year, and should be maintained through the second half unless the consumer turns more cautious.

Retail – The Consumer is Still Spending

The two bright spots in the quarter were the resiliency of the consumer and the continued strengthening of the housing market. Back-to-school sale estimates were raised and overall retail results were better than expected, foreshadowing a strong holiday season. Retailers benefited from promotional activity and higher overall volume despite softer pricing, as consumers are still in the hunt for good deals. Even more positive was that the results were strong across the spectrum of retailers with both discount and luxury performing well. Inventories are in a comfortable position as retailers still remain somewhat defensive in this environment. In addition, retailers have improved they way they manage their inventory resulting in better turnarounds and more efficient demand feedback.

Rails – Growth is Tepid, But Pricing is Firm

The recovery in the housing market is benefitting not only the retailers but the Rails as well with volume increases in lumber and other building related products. Besides housing products, the Rails are taking advantage of the changing utility landscape, moving crude oil and other petroleum products and fracking materials across the U.S. That said, growth is slowing somewhat with rail car loadings about flat to 2011 levels over the last couple of months. Rails have benefited more from price, given the economic advantage they offer their customers over other modes of transport. Volume should generally follow the relative strength of the economy.

Utilities – Fundamentals Reflect Economic Conditions in the U.S.

Electric Utilities – Regulatory News was the Highlight

It was a quiet quarter fundamentally. Domestic electricity consumption was modest, much like economic growth. Utilities benefited from the hot summer as residents used more energy while being hurt from the slowing manufacturing sector, as commercial and industry energy consumption slowed.

The real news for the sector was regulatory related. In a 2-1 decision, the Court of Appeals for the D.C. Circuit vacated the United States Environmental Protection Agency’s Cross-State Air Pollution Rule (“CSAPR” or the “Transport Rule”), the EPA’s attempt to “fix” the Clean Air Interstate Rule to regulate downwind state air pollution under the Clean Air Act. The court found that the EPA exceeded its statutory authority, the so-called “good neighbor” provisions of the Clean Air Act, by potentially requiring an upwind state to reduce emissions in excess of its contribution to a downwind states exceedance of air quality standards. Additionally, the Court of Appeals for the D.C. Circuit struck the EPA’s decision to require that each state comply with a federal implementation plan to implement the emission reductions mandated by the Transport Rule rather than allowing each state to determine how best to achieve the reductions within the state[note]Jane E. Montgomery, Kathleen C. Bassi, and David M. Loring, “D.C. Circuit Vacates CSAPR, Instructs USEPA to Continue Administering CAIR,” Environmental Update, August 22, 2012, accessed September 4, 2012, https://www.schiffhardin.com/File%20Library/Publications%20(File%20Based)/HTML/env_aug22_12index2.html[/note].

Very importantly, utilities are still on the hook for meeting the Maximum Achievable Control Technology or MACT standard, which is scheduled to become effective in 2015. On May 3, 2011, the EPA proposed national emission standards for hazardous air pollutants from both new and existing coal electric generating units. The proposed rule would create national standards that require all coal electric generating units to achieve the maximum degree of reductions in emissions of hazardous air pollutants.

Pipelines – Fundamentals Remain Positive While Technical Risk May Increase Over the Intermediate Term

We believe the fundamentals for the pipeline segment are positive.  Volumes of oil, refined products, natural gas and natural gas shipments are largely determined by domestic GDP.  Our forecast for domestic GDP is 1%-2% for 2012, so we think volume growth should increase slightly.  Notably, volumes of natural gas liquids should probably increase faster than GDP growth given the heightened demand from the chemical sector.  We believe another positive fundamental is the expanding number of resource basins, which will lead to greater size and cash flow generating capability.  The Eagle Ford basin in South Texas, the Bakken Shale in North Dakota and the Utica Shale in Ohio will provide many domestic growth opportunities.  Offsetting these positive fundamental drivers is the levered business model, which relies on external funding to refinance maturing debt and in periods of capital market uncertainty, causes spreads to be more volatile. Moreover, as companies begin to exploit these relatively new resource basins, we expect capital spending and debt issuance to increase.

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

Michael Ashley
Vice President

Sebastian Bacchus, CFA
Vice President

Bob Bennett, CFA
Vice President

Patrick McGeever
Vice President

Hugh McCaffrey, CFA
Vice President

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.

---

 

Keeping It Simple

• Corporate Bond Market Outperformed Treasuries in July
• Near Term Outlook Uncertain with Politics in the U.S. and Europe
• Cost Cuts are Likely in the Near Term as Gross Margins are Compressing
• Simple Business Models Look Attractive

Investment Grade Corporate Bond Spreads Continue to Tighten in July

Investment grade corporate bond performance in July was strong across all three broad sectors and rating categories. The market earned 1.62% over Treasuries in July, increasing the year-to-date excess return to 4.35% per Barclays Capital. “BBB” rated securities have earned 4.30% over Treasuries and “A” rated securities 4.69% year-to-date (1.63% and 1.68%, respectively, in July). From an industry perspective, Media-Cable outperformed in July (3.17% excess return) and Supermarkets underperformed (-1.56%). The domestic high yield market also performed well, earning 1.25% over Treasuries in July, bringing the yield for the B/BB market down to an all time historic low of less than 6%. In Europe, its Corporate market had a good month as well, earning 0.58% of excess return in July according to Barclays Capital. New issuance in all markets was fairly robust, and for most deals in the domestic investment grade market, new issue concessions remain lackluster.

Company Fundamentals are Strong but Weakening

Like the equity market, the corporate bond markets benefited from central bank statements in Europe and the United States that implied willingness for further quantitative easing and economic support. After an initial wave of negative reports, earning reports came in broadly as expected with revenue surprises in Finance and Energy offset by weakness in Materials and Utilities. All sectors but Materials posted better than expected earnings in the quarter. That said, management commentary was either fairly cautious or uncertain about the second half of the year, and with the dollar continuing to fall and growth slowing worldwide, we believe management teams will look to cut costs more aggressively over the next six months. Debt leverage increased this year for the first time since second quarter 2008, as measured by net debt to EBITDA for S&P 500 companies, from 2.26x at the end of the first quarter to 2.33x at the end of the second quarter. Moreover, for 200 high yield issuers that have reported results, EBITDA growth was marginally positive (0.6% year-over-year) and revenues were up 1.5%, but Cost of Goods Sold increased 2.2.[1] This has been the trend for the S&P 500 constituents since the fourth quarter of 2011. Accordingly, we expect companies to pull back on more discretionary spending and reduce headcount and/or capital spending.

Politics will be a Drag on the Economy

The potential deterioration in consumer confidence from an election that reminds voters of domestic fiscal and economic challenges not to mention the drag on the economy if Congress does not act to raise the debt ceiling and/or prevent the fiscal cliff ($600 billion of tax increases and spending cuts due January 1, 2013), is not conducive for business related expansion. Economists are beginning to assign probabilities, recognizing the difficulty of doing so as the election is very close. Goldman Sachs recently published their thoughts on the fiscal cliff, assigning a probability of 33%. Goldman’s base case is a slight drag from fiscal policy of 1.5% in 2013 due to the payroll tax expiration and slowing government spending.[2] That is better than the 4% contraction if Congress allows us to fall off the cliff, placing the economy in a recession.

How has AAM been Investing in Corporates?    

Economically, we expect growth to remain slightly positive in the U.S. for the second half and issues in Europe to resurface in early fall, expecting Spain to request assistance from the “Troika” (European Union (EU)/European Central Bank (ECB)/International Monetary Fund (IMF)), and China to continue to support its economy as growth slows. With this volatility, we expect Corporate spreads to widen, leading to a buying opportunity. Over the past month, we have been reducing our exposure to sectors and credits that are economically sensitive with spreads that are rich and vulnerable to underperformance (Exhibit 1). This includes Media related credits that have recently outperformed (Exhibit 2). We believe advertising spending could be less than the market expects as companies pull back to preserve margins and growth remains stagnant.

We have been selectively adding credits in the new issue market, private and public, which offer attractive yields to compensate for liquidity and size of the enterprise. In this period of market illiquidity and political complexity, we prefer investing in simple business models where one is getting paid for liquidity and business risk. As an example, National Retail Properties (NNN) issued a 10-year bond at 3.8%. It is a mid-BBB rated REIT with a $3.2 billion market capitalization. It was one of a select few that did not have to cut their dividend during the financial crisis given their prudent financial management. Their business is straightforward, managing triple-net leased retail properties. Under the triple net lease model, tenants are signed to long-term (typically 12 to 15 years) leases that include automatic rent increases and adjustments for capital improvements and taxes (all inflation/pricing risk retained by lessee). The company underwrites new acquisitions based on the attractiveness of the real estate first and foremost (ease of re-leasing, if the lessee fails), although it also carefully underwrites the lessees and typically does not enter into leases with businesses that have less than a 7 to 10 year track record. An issue size of $325 million and total public debt outstanding of $1.5 billion means this issuer is difficult to find in the secondary market.

Exhibit 1

Source: AAM, Barclays Capital as of 8/8/2012. DTV=DirecTV
Calculated as the breakeven spread (OAS/Duration) divided by Standard Deviation.

Exhibit 2

Source: AAM, Barclays Capital as of 8/9/2012

Written by:
Elizabeth Henderson, CFA
Director of Corporate Credit

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.

[1] Hans Mikkelsen, “Over the Hump,” Bank of America Merrill Lynch Global Research: A Credit Strategy Report (August 6, 2012): 1.

[2] Allison Nathan and Alec Phillips, “Staring Down the Fiscal Cliff,” Goldman Sachs Global Investment Research (August 8, 2012): 4-5.

Focus Will Be on the U.S. in the Second Half of 2012

• Volatility has Increased in the Corporate Bond Market But is Lower than 2011

• Expect a Lackluster Earnings Season

• Company Fundamentals Have Plateaued

• Performance for the Investment Grade Market in the Second Half of 2012 is Expected to be Subdued Relative to a Strong First Half

Investment Grade Corporate Bond Spreads Continue to React to Economic Concerns

Volatility has increased in the Corporate bond market, reacting to a more pessimistic worldwide economic outlook. European fears remain elevated, despite positive headlines around the last summit, and investors are questioning the growth trajectory of the U.S. for the second half of 2012. Company revenue and earnings estimates have been revised lower, and mergers and acquisition activity has slowed substantially. Positively, after a subdued May, investment grade and high yield companies, both domestically and internationally, issued new bonds. Concessions for these new issues became more attractive, reflecting the market uncertainty. Investors reduced their exposure to Corporates, and broker-dealer inventory remains very low relative to historic levels.

Exhibit 1

Sources: Barclays Capital, AAM

Since our last publication in mid May, Corporate spreads are relatively unchanged after widening in May and tightening in June. Investors earned 2.63% in addition to their return from Treasuries for Corporate bonds in the first half of 2012. The spread over Treasuries for the Corporate market is currently at its last twelve month average, trading in a 61 basis point (bp) range this year, less volatile than its 103 bps range over the last twelve months (Exhibit 1). The Financial sector has outperformed by a wide margin (582 bps of excess return over Treasuries per Barclays), followed by BBB Industrials (187 bps). Five to seven year securities have outperformed longer dated bonds (461 bps vs. 178 bps).[1]

Earnings Season Is Expected To Be Lackluster

The second quarter earnings season will be a good indication of how companies are dealing with the more challenging economic and political conditions. We note that company issued financial guidance for the second quarter is the most negative since fourth quarter 2008, and more analysts have cut guidance for 2012 earnings per share (EPS) than during the crisis last year (Exhibit 2). The strengthening of the dollar has resulted in downward revisions to estimates as well as lowered economic growth expectations.

Exhibit 2

Sources: Bloomberg, AAM

Revenue growth expecta-tions for the quarter are also the lowest since fourth quarter 2009. Margin compression is evident with revenue growth expected to exceed earnings growth after a period of margin expansion (Exhibit 3). Additionally, as shown in Exhibit 3, earnings expectations are quite high for the second half 2012 and for 2013, reflecting optimism regarding a resolution in Europe and worldwide growth. Lastly, we expect management to remain fairly guarded when communicating expectations for the second half of this year, which will not quell market fears of slower growth.

Exhibit 3

Sources: Bloomberg, AAM

At an industry level, companies are managing the expectation for slower growth differently depending on industry conditions. For instance, as we get closer to the election, analysts have been revising down capital spending estimates for Defense contractors for fear that proposed spending cuts will crimp growth in this sector. This slowdown continues into 2013 for the sector. On the other hand, the Railroad industry continues to show growth having managed through the major slowdown in coal usage that is such an important part of their business. Capital spending estimates continue to get revised higher even as GDP growth slows. This is a testament to the Rail industry and its secular advantages.

Fundamental Improvement Has Plateaued

From a bondholder perspective, the cycle of credit enhancement has ended (Exhibit 4).  The current environment of low interest rates and market volatility makes it less compelling for treasurers to continue to build cash, looking instead to increase their shareholder remuneration.  As growth continues to slow, we recognize the increased likelihood that leverage is used to generate returns for shareholders.  For most companies, we expect that to occur within their rating levels. That said, we have seen increased shareholder activism, pressuring management to be more aggressive with their balance sheets. To date, companies that have split or sold assets have generally done so without rating implications and material spread widening. We believe the market is becoming complacent by failing to recognize the deterioration of asset and cash flow protection for bondholders. We are taking a more cautious stance towards sectors that we expect will be challenged from a growth perspective, specifically Food, Defense, and Consumer Products.

Exhibit 4

Sources: Bloomberg, AAM

Due to the strong liquidity and deleveraging that has taken place, default expectations remain very low and as such, very little spread over Treasuries is required to compensate one for default risk in the investment grade market (Exhibit 5). We do not expect that to change in the near term unless an unexpected event occurs in Europe or the probability of a recession increases for the U.S.

Exhibit 5

Source: Default risk measured by Deutsche Bank (“2012 Default Study” April 16, 2012) using data from 1920, 10 year default period with 20% recovery; Barclays Capital Corporate Index as of July 13, 2012 used for total OAS and market price; AAM calculated market price premium as 1.5bps per bond point.

Macro Factors Will Continue to Drive Credit Spreads Over the Near Term with Particular Focus on the U.S.

Performing a regression analysis using economic and credit fundamental variables since 2009 to predict the Option Adjusted Spread (OAS) of the Investment Grade Corporate Index shows that approximately 80% of the variance in OAS can be explained by macro economic related variables. Adding more micro level variables (e.g., earnings revision ratio) increases this to approximately 93%. While we appreciate this relationship and apply a top down view to our credit analysis, we understand that at some point, credit spread volatility will be driven more by idiosyncratic vs. systemic risks.

Unfortunately, for the near term, we expect political and fiscal debates in the U.S. as well as events in Europe to drive spreads, keeping the market largely range bound around 200 bps. Our investment thesis remains unchanged, maintaining a more defensive Corporate portfolio. We continue to believe that Corporate bonds can produce positive returns over Treasuries in 2012; however, we do not expect the second half of the year to generate the level of excess return experienced in the first half (2.6% for the Barclays Capital Corporate Index). We anticipate a buying opportunity later in the year, when the risk of a U.S. recession increases.

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

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.

[1] Barclays Capital data as of July 6, 2012.

A Negative Rating Forecast Adds to Pressure on Yield Starved Life Insurance Companies

Investment Grade Corporate Bond Spreads Increase

Spreads have widened to reflect the increased volatility and credit risk associated with the increased uncertainty in Europe and the implications of the JP Morgan trading loss. The corporate market underperformed Treasuries in April by 50 basis points (bps), as spreads widened 9 bps. Month-to-date as of May 21, the corporate market has underperformed Treasuries by 151 bps with spreads widening 22 bps. Importantly, we had a strong start to the year. Therefore, year-to-date as of May 21, the corporate market has outperformed Treasuries by 185 bps, generated mainly by Financials and BBB rated Industrials. This week, new deals are being priced with above average new issue concessions, a change from how the market has behaved since February.   Our expectation is for this volatility to continue, with spreads likely to widen in the near term.

Earnings season is drawing to a close and results are largely better than expected (earnings 6% and sales 2% better than expected). Management’s tone on conference calls in regard to results for the year was more cautious given the uncertainties regarding Europe and the fiscal and economic conditions in the U.S.

Rating Forecast Turns Negative

Standard & Poor’s (S&P) published its monthly Credit Trends report[1] on May 17, 2012 stating that the number of potential downgrades is at its highest since October 2010. Although as Exhibit 1 shows, this level remains below pre-recessionary periods and based largely on a methodology change in the bank sector. We have been anticipating rating downgrades for the bank sector, with S&P and Moody’s changing their methodologies. The new S&P methodology explicitly anchors bank ratings off of the sovereign and bank regulation score of that bank’s primary domicile. Similarly, Moody’s is changing its rating methodology to reflect its view that banks and brokerage firms are undergoing secular changes. Factors that Moody’s is considering for domestic banks include: a heavy reliance on wholesale funding, opacity of risk profiles and interconnectedness, and evolving regulation and business models. For European banks, the review is being driven by a difficult operating environment, weakening sovereign creditworthiness, and challenges from capital market activities. For both European and domestic banks, we expect rating downgrades to be one-to-three notches. Moody’s started by downgrading Italian banks last week, and we expect the actions to be completed by July 2012. S&P’s negative outlooks for the banks reflect the sovereign outlooks as well as counterparty risk if liquidity and funding stresses in Europe spread to the U.S.

Exhibit 1

Exhibit 2

Exhibit 2 shows that not only are Banks pressured from a ratings perspective but also Utilities and Media companies. Utility rating outlooks are negative due largely to the negative outlook/watch assigned to the respective sovereign (mainly in Europe and Japan) or low natural gas prices. The vast majority of the Media credits that are on Negative Watch/Outlook are below investment grade, and Media is a sector that suffers from a high degree of negative rating bias (Exhibit 3). Of the 32 sovereigns on the potential downgrade list, 75% are in Europe. Clearly, the ratings bias is more negative for Europe than the U.S. (Exhibit 4).

Implications for the Life Industry

The quality of the investment grade corporate bond market has fallen dramatically over the last decade (Exhibit 5). We would expect this trend to continue as long as funding costs remain so low. This places added pressure on life insurance companies that manage to an average credit quality while searching for more yield. S&P entered the year with the expectation that Treasury rates would rise (10-year Treasuries: 2.3% in 2012, 2.8% in 2013) partly driving the Stable Outlook for the industry^[2].

Exhibit 5

Source: Barclays Capital

According to S&P, the average statutory net investment yield declined to about 5.20% in 2010 from about 5.75% in 2007, and we would expect that to be lower in 2012. Low interest rates continue to hamper life insurers’ efforts to obtain attractive yields on new investments. Some companies continue to marginally lower their asset quality by stretching for yield and, on the margin, investing in more risky/less liquid assets (i.e., commercial mortgages, private placements and high yield bonds).

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

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.

[1] Vazza, Diane, “Bond Downgrade Potential in Emerging and Developed Markets, Including the U.S. and Europe: Stress in Europe Widens The Gap Between Potential Downgrades and Upgrades,” Standard & Poor’s Credit Trends,May 17, 2012

[2] Carroll, Matthew; “Solid Capital And Liquidity Support A Stable Outlook In The Face Of Macroeconomic Headwinds,” Standard & Poor’s U.S. Life Insurance 2012 Outlook,November 30, 2011