Corporate Credit View

Political Risk is Rising

What an ugly month! The Barclays Corporate Index posted -333 basis points (bps) of excess return in August, wiping out the positive return that had been generated through July, leaving -241 bps of excess return year-to-date. Spreads widened in all sectors with Cyclical Industrials and Financials underperforming more defensive sectors. The shedding of risk assets was also evident in the widening of the differential between A and BBB rated credits (see Exhibit 1). The spread widening was concurrent with falling Treasury yields (62 bps for the 10-year in August) after the downgrade of the US Treasury’s AAA rating by Standard & Poor’s and the sharp fall and subsequent volatility of the equity market. After many weaker than expected economic reports and a slower recovery of the consumer after such a sharp contraction of net worth, economists revised their GDP estimates lower. Equally important was the increasing uncertainty of the resolution of the debt crisis in Europe, resulting in losses for bank equities and widening bond spreads as investors feared a repeat of 2008.

Exhibit 1

Source: Credit Suisse LUCI Index, 7-10 year maturities

We are more concerned about the near term political risk surrounding Europe than we are a U.S. recession, but both are troublesome for credit investors. A lower-than-expected growth outlook has caused the Federal Reserve to extend its timeline for very low rates to 2013, and the resulting flatness of the curve (LIBOR to 2-year Treasury) is weighing on bank profitability. Analysts have been busily revising down their expectations for earnings in 2012, but not to the degree the equity market is expecting. That said, even though corporate fundamentals are very strong today, a recession (especially one that is mired in another banking crisis) would be problematic for lower quality credits and those relying on capital markets or bank (mainly European) funding. The spread widening in high yield (160 bps in August vs. 55 bps of widening for Investment Grade) reflects this risk.

The warning signs raised over the last two months have tempered our optimism for excess returns this year. Although we had cited weak economic growth and sovereign risk as two of four main headwinds for 2011, the Beaufort Wind Force Scale is registering more of a strong gale than breeze. At current spread levels, we believe there are opportunities to both add and reduce various credits and sectors, but overall, believe spreads fairly reflect near term risk. New issue concessions were attractive once again during August, reflecting a secondary market that was illiquid and uncertain. This opportunity is likely to return in September given the expectation for heavy new issuance and headlines from Europe. An area we believe will continue to be highly volatile and vulnerable to downside risk is the European credit sector, namely Banks, Telecoms, and Utilities. Despite the spread widening in that sector (see Exhibit 2), we continue to avoid credits in the European Union (EU) periphery and have been reducing our exposure to financials in Europe outside of the periphery due to the increased systemic risk.

Exhibit 2

Source: Credit Suisse LUCI Index, 7-10 year maturities

The health of the European bank sector is inextricably linked to the health of the Euro area sovereigns. In contrast to the United States, the European banking sector is far more concentrated amongst a handful of large national champions, and the transmission of credit from investors to borrowers takes place more so through bank lending than through corporate and government bond markets. Because the European banking system is so integral to the funding of persistent deficits of Euro area sovereigns, questions about the solvency and liquidity of peripheral Euro area sovereigns (i.e., Greece, Portugal, Ireland, Spain, Italy) must lead to similar questions about the banks.

The origin of the sovereign crisis engulfing the Euro area has its roots in the 1992 Maastricht Treaty on European Union, and subsequent monetary union in 1999. While the union created a common monetary system and policy (set and implemented by the European Central Bank/ECB), fiscal policies were still set at the national level. Although the potential for (and likelihood of) divergent fiscal and debt profiles of the Euro area nations was clearly evident from the outset, sovereign debt investors made little distinction between the various sovereign issuers over the first decade of the monetary union’s existence (despite the obvious differences in fiscal health and relative debt burdens between stronger and weaker members of the union). This was partly a function of investors belief that no individual member would be allowed to fail (despite a “no bail-outs” clause in the Treaty). As well, European banks had a strong regulatory incentive to purchase sovereign debt (see Exhibit 3) as Basel capital rules assigned a much lower risk weighting to sovereign debt than to other credit exposures (and this classification is maintained under the Basel III regime that will go into effect in 2013).

Exhibit 3

Source: European Central Bank

Beginning in late 2009, the market increasingly perceived the deterioration of the fiscal positions of various sovereigns in the Euro area as unsustainable, and began to make distinctions between the weaker peripheral sovereigns and the rest of the Euro area members. The process began with Greece which ultimately lost access to funding markets and was saved from default/restructuring through an aid package provided jointly by the EU and the International Monetary Fund (IMF) in May 2010. While it was hoped that this sign of commitment on the part of the EU to avoid a disorderly restructuring would serve to restore market confidence in the broader Euro sovereign market, the market successively forced Ireland and Portugal to seek similar bail-outs from the EU over the course of 2010 and the first half of 2011, culminating in a second request for aid from Greece in June 2011. A second, comprehensive aid package, a Greek debt restructuring, and flexible EU-wide liquidity facility were agreed to by the Euro area finance ministers in July 2011. However, sovereign debt markets immediately reflected their disappointment with the new liquidity facility (European Financial Stability Facility/EFSF) by forcing up the yields on Spanish and Italian sovereign debt, thereby forcing those nations to resort to the ECB to support their sovereign debt markets through secondary bond market purchases.

The inability of the EU to restore the confidence of the markets results from the failure to address the underlying imbalances between the seventeen national economies (rather than just addressing liquidity issues). While all of the peripheral Euro area sovereigns have instituted structural reform programs to address inefficiencies in their economies (particularly with regard to labor markets, taxation and ease of doing business) as well as fiscal austerity programs to eliminate budget deficits and reduce overall debt loads, the Euro area as a whole suffers from a shortage of credibility. In the absence of a credible enforcement mechanism for austerity measures, sovereign investors reasonably question why nations that have never shown fiscal rectitude in the past will suddenly reform themselves. However, the imposition of oversight by the EU would likely lead to domestic political opposition on the grounds that such oversight represents a forfeit of sovereignty (and the imposition of painful austerity measures lends such populist appeals all the more weight).

In the face of such intractable debt overhangs, the question of why struggling indebted sovereigns don’t just restructure their debt naturally arises. However, because of the European bank sector’s regulatory preference over the past decade for sovereign debt, the EU banks suddenly faced the prospect of write-downs on their substantial sovereign holdings that had previously been treated (and reserved for) as risk free assets (see Exhibit 4). The European bank sector’s credit issues are further exacerbated by the rapid expansion in cross-border banking within the EU in the decade following monetary union (examples include German Landesbank commercial real estate lending in Ireland, French bank acquisitions in Italy and Greece and United Kingdom (UK) residential mortgage lending in Spain). As a result, a restructuring of any one sovereign (i.e., Greece) would immediately render that nation’s bank sector insolvent and result in large write-downs for banks from other countries. As the sovereign debt crisis has moved from the smaller to the larger peripheral sovereigns, the implications for the entire European banking sector become more serious.

Exhibit 4

Source: European Central Bank

Faced with the prospect of having to bail out the entire European banking sector (with total assets of €41 trillion, well in excess of Euro area GDP of €11 trillion), or providing a liquidity life line to struggling peripheral sovereigns in return for promises of fiscal reform, the EU has opted to take the latter approach. Calls for issuance of a common “Eurobond” jointly and severally guaranteed by all Euro area members have been rejected by both Germany and France on the grounds that such a program in the absence of greater fiscal integration and reform would merely export the fiscal weakness of the periphery to the core of the Euro area. As a result, the Euro area is faced with the prospect of several years of painful fiscal adjustment on the periphery, and a likely continued need for substantial purchases of Italian and Spanish bond purchases by the ECB (as these two sovereigns’ refinancing needs are too large to be met by the EFSF). In the face of such a prospect, sovereign investors are justifiably unsettled by the potential for growing political resistance within the periphery to painful fiscal adjustments, and the potential for increasing inflation expectations with regard to the Euro as a result of the substantial volume of bond purchases that the ECB could be forced to undertake from Italy and Spain.

In the face of uncertainty about the ultimate resolution of the Euro area sovereign crisis, liquidity in the bank wholesale funding markets has begun to tighten. This is most notable in widening spreads in the secondary market for unsecured European bank bonds and a near complete halt in new issue market for European bank debt since July 2011. At the same time, Euribor (a measure of the cost of short term bank borrowing) has begun to rise (see Exhibit 5), signaling challenges in raising funding in the interbank and money markets. While liquidity conditions are not nearly as bad as they were in the wake of the collapse of Lehman Brothers in September 2008, the trend is worrying, as European banks are much more dependent on wholesale funding than the more deposit rich US banks. However, there are a number of factors that leave the sector as a whole in a better position to weather the funding disruptions than in 2008. Most notably, the sector has considerably reduced leverage and has substantially extended the duration of outstanding wholesale funding over the past three years. Additionally, European banks hold substantially larger amounts of liquid assets than they did heading into fall of 2008. As a result, there is much less of an immediate need to replace maturing funding, as the banks can either run down their balance sheets liquidity pools to redeem debt, or replace maturing unsecured debt with secured funding using the same liquid assets as collateral.

Exhibit 5

Source: Bloomberg

Finally, the ECB has increasingly asserted itself as the lender of last resort to the European bank sector; a role that it was previously hesitant to embrace. The ECB has been utilizing its standard monetary policy operations (Main Refinancing Operation/short-term repo and the Marginal Lending Facility/ECB equivalent of the discount window) as well as non-standard monetary tools established in response to the 2007/2008 financial crisis (long-term repos, outright securities purchases and foreign currency swap lines) to provide liquidity support to stressed parts of the European banking sector (see Exhibit 6). Beginning in mid-2010, the ECB progressively began to provide unlimited funding to the Greek, Irish and Spanish savings bank sectors, as well as engaging in purchases of those countries sovereign debt. The ECB has also shown considerable flexibility in the collateral it deems acceptable, thus further increasing the liquidity available to stressed bank sectors. As the sole authority for monetary creation and policy implementation, the ECB has unlimited capacity to provide liquidity to both individual banks and sovereigns, although capacity for the same would ultimately be constrained by inflationary pressures that would ultimately arise from such actions (and which has engendered considerable resistance from various members of the EU; most notably Germany).

Exhibit 6

Source: European Central Bank

The combination of stronger liquidity profiles and lower leverage within the broad European bank sector heading into the sovereign crisis, as well as the increasing support provided by the ECB gives comfort that the sector is not in danger of an imminent liquidity crisis. Within that context, the strongest banks domiciled within the strongest and most supportive core EU nations remain fundamentally sound from a credit perspective. However, until the underlying questions about the Euro area’s ability to achieve greater fiscal integration are answered and the creditworthiness of its weaker peripheral members is resolved, the investment performance of the European banking sector will be plagued by wider overall trading levels and episodic bouts of volatility. In the near-term, the parliamentary approval process for the new Greek bail-out (unanimous approval required) and the recapitalization of the Spanish savings bank sector are possible political triggers to further volatility. In the intermediate-term, the national elections in France and Germany in 2012, as well as the ability to the peripheral sovereigns to maintain their austerity programs and achieve targeted economic growth levels will be key trends to follow. The challenges the EU faces in achieving a consensus on the future form of the Union (both political and economic), and the protracted time line of the EU’s current approach, argue for a very cautious stance with regard to ongoing investments in the sector.

Written by:

Elizabeth G. Henderson, CFA
Director of Corporate Credit

Sebastian Bacchus, CFA
Vice President, 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.

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Leadership

The Corporate credit market turned up in July, posting 33 basis points (bps) of excess return per the Barclays Corporate Index. The sovereign issues abroad and at home affected sentiment and performance. Negatively, Financials widened, as investors were concerned about capital adequacy due to European peripheral exposure and the prospect for ratings downgrades, including U.S. Treasuries. Conversely, they looked to highly rated, defensive Industrials and Utilities as substitutes (Exhibit 1). Regarding the supply side of the market, new issue volume was low, and dealer inventories continued to decline.

Exhibit 1: High Quality Credit Outperformed in July

	Total	AAA	AA	A	BBB
Corporate	33	97	21	25	45
Industrial	71	114	108	69	62
Utility	83		178	98	69
Finance	-39	81	-27	-48	-34

Source: Barclays (July month-to-date excess returns in basis points)

August is not starting off well, as markets are concerned about the recent slowdown in economic activity, both here and abroad. The Corporate market per Barclays moved from being up 108 bps of excess return year-to-date as of July 29 to down 16 bps as of August 8 due mainly to spread widening in Banks, Finance, Life Insurance, and deep cyclical Industrials. A question we face in the near term is how the consumer will react to the steep drop in the equity market over the last week. Last year, we witnessed consumers (regardless of income level) pulling back after similar questions were raised. Falling oil prices will provide a stimulus for the second half, but that may be insufficient if the velocity of consumer spending slows.

Our outlook for the economy continues to one of cautious optimism (i.e., very low GDP growth), notwithstanding the increasing concerns of a recession. The deleveraging of the consumer takes time. Unemployment will remain high and the economy will be vulnerable to external shocks until the housing market rebounds and the private sector is confident about growth prospects. We continue to be concerned about structural credit problems in Europe and their impact on the global financial markets. Given our economic outlook, we have been prioritizing growth in our corporate bond recommendations, looking to companies that benefit from: dominant market positions, emerging market exposure, higher income earners, productivity enhancements, flexible balance sheets, new product innovation, and strong management. In the Finance sector, we look to companies with high quality assets, liquid balance sheets, strong capital positions, astute management, and exposure to strengthening economies and customers (commercial, industrial, or consumer). Security selection is imperative in this environment. Before making changes to our investment thesis, we await more information in the very near term about the following: (1) consumer sentiment and spending, (2) earnings for 2011-2012, and (3) the Eurozone. We are particularly wary of lower rated credits that have outperformed, but are poised to move meaningfully wider if there is confirmation of a slow down (Exhibit 2).

Exhibit 2

	Excess Returns (bps)
Sector	Month-to-date	Year-to-date
Corporate	(120)	(16)
Industrial	(96)	28
Utility	(30)	153
Finance	(182)	(132)
	Option Adjusted Spread (bps)
Sector — Rating	8/8/11	Maximum since 2010	Difference
Industrial — A	107	121	14
Industrial — BBB	189	216	27
Utility — A	109	134	25
Utility — BBB	170	211	41
Finance — A	246	275	29
Finance — BBB	299	409	110

Source: Barclays (as of August 8, 2011)

For the approximate 61% of U.S. companies that have reported as of August 9, earnings have been better than expected. Second quarter earnings reports have surprised the market with EPS and Sales growth of 19.5% and 13.1%, respectively. This is quite an achievement given the negative economic data releases and stock market moves this quarter and the wrangling that has gone on in Washington and Europe. On earnings calls, management teams are highlighting the many headwinds they are facing: weak consumers, debt ceiling uncertainty, Japan related disruptions, commodity inflation, rising food and fuel costs, and strained government spending both in Europe and the U.S.. Companies are largely benefiting from the strength of emerging markets, cost cuts due to productivity enhancements and/or market share growth. After the last month, we can’t help but draw a distinction between management in the public vs. private sector.

As credit analysts, we understand that management is a key factor in determining whether a credit will outperform or underperform its peers. Shareholder activism has increased (e.g., McGraw Hill, Clorox) as well as mergers and acquisitions, asset divestitures, and spin-offs (e.g., Kraft, Conoco Philips). Restructurings and re-capitalizations to increase shareholder returns are bound to increase when economic growth is anemic. Therefore, when assigning our fundamental risk scores to credits, we rate the quality of management and its track record (operational achievements), including its attitude towards bondholders (capital management). The following are samples of credits that rank high or low in this regard:

AAM Management Team Rating: HIGH

Barclays plc

The tandem of CEO Bob Diamond and his now retired predecessor, John Varley, along with CFO Chris Lucas and Investment Bank co-heads, Jerry Del Missier and Rich Ricci, have been one of the more effective (and unheralded) management teams in the global money center space over the past five years.  In contrast to UK peers (RBS, Lloyds, Northern Rock), the bank was early to raise capital (including large amounts of common equity) in advance of the worst of the financial crisis.  In addition, then-President Diamond moved aggressively to reduce risky balance sheet exposures to both structured finance and leveraged loans beginning in the second half of 2007.  As a result, Barclays was the only UK bank that did not require government capital investments and liquidity support during the second half of 2008.  Furthermore, the bank’s foresight in raising capital, and the excellent cooperation between then CEO Varley and then President Diamond, left the bank ideally positioned to acquire the U.S. assets of bankrupt Lehman Brothers Holdings at a fire sale price in late 2008.

Since that time, the bank has built upon its Lehman acquisition to grow market share in U.S. banking and capital markets businesses, while maintaining its strong position in Europe.  The bank’s foresight in cleaning up its UK retail credit exposures (particularly in BarclaysCard) in 2006 has also aided in the faster than its peers recovery in asset quality in the UK retail loan portfolio.

Chubb Corporation

Chubb Corporation is one of the best managed companies in the property/casualty sector. The company is highly disciplined in its underwriting and investment exposures. It is consistently profitable and regularly outperforms its industry peers. The company has produced a five-year average total return on capital in excess of 13%. Chubb’s consistency and strength in earnings largely reflects the company’s success in integrating underwriting, actuarial and claims functions, which has in turn enabled it to maintain underwriting and pricing discipline and to adapt to changing market conditions.

Apache

We believe Apache Corp. is a uniquely strong credit in the energy sector due to the strength of its long serving management team consisting of Steve Farris, Rod Eichler, Roger Plank (son of founder, Raymond Plank) and Tom Chambers. Collectively, this group has served Apache for more than 80 years. Unlike nearly all of its peers, Apache consistently delivers positive free cash flow regardless of the commodity environment due to its focus on rate of return and its firm grasp on costs. Apache has been free cash flow positive in nine of the last ten years as its EBITDA margins have remained near 70% every year. Apache management further distinguishes itself through its ability to grow organically and to successfully integrate large acquisitions, while maintaining a strong and remarkably stable credit profile (debt/cap of 20%-30%, debt/EBITDA of 0.5x-1.0x and debt/BOE of $2.60-$4.50 for the past decade). These factors have contributed to Apache’s shareholder returns exceeding their peers by 40% and 300% in the last 5 and 10 years, respectively. Additionally, Apache’s strong credit profile and shareholder returns allow for easy access to the capital markets.

The ability of Apache to quickly tap the capital markets, combined with the respect for Farris and his colleagues by their peers, along with the group’s reputation for being willing and able to close a transaction quickly, provide Apache access to lucrative deals others don’t get to see (i.e., the Forties transaction in 2001, the Permian, Egypt and Western Canada transactions in 2010). As a result, management’s strategy of delivering top rates of return, while maintaining financial discipline becomes circuitous.

DirecTV

DirecTV (DTV) is a good example of the connection between strong management and investor results. DTV differentiates itself from its competitors based on technological leadership, a strategy that has been the soul of the company since it was founded in 1994 by Hughes Communications. It has gone through close to a decade of management distractions relating to ownership. The latest positive development was mid-year 2010 when Dr. John Malone (Liberty Media) reduced his voting interest from 24.3% to 3% and resigned as Chairman of the Board along with the other Board members from Liberty Media after the FCC imposed restrictions on Liberty Global and its ownership of two of three pay TV providers in Puerto Rico. Malone pressured Rupert Murdoch to sell him NewsCorp’s stake in DTV through a greenmail type tactic, a stake which Murdoch purchased from GM in 2003 after DTV’s merger with EchoStar fell through.

Murdoch’s team was responsible for taking DTV to the next level, as the technology oriented company lacked operational focus. Their marketing strategy in particular has been a success, targeting the upper end of the market (particularly men with families) with superior sports packages, premium content (HD, 3D) and user interface. The current management team is essentially the same as when Chase Carey of NewsCorp took over, except for Chase Carey himself, who went back to NewsCorp after Peter Chernin left in 2009. The new CEO, Mike White, came from Pepsi, a company that is no stranger to the consumer. Not only is this ownership clarity important from a management/operational perspective, it is important from a financial policy perspective, a particular concern for bondholders (including ourselves) given Malone’s history of taking investment grade companies to high yield. The rating agencies appreciated this too, with Moody’s upgrading to Baa2 from Baa3 after Malone reduced his stake. The improvement in credit spreads and the equity price is a good indication of management’s performance (Exhibit 3).

Exhibit 3

Source: AAM, Bloomberg, Barclays

Dow Chemical

We upgraded Dow’s management score in 2010, after witnessing management’s actions both strategic and financial. After almost losing its investment grade ratings in 2008, we believe management understands the importance of a strong balance sheet and low cost of funding. The transformation to a less cyclical chemical giant took shape with the acquisition of Rohm & Haas and subsequent non-core, commodity based asset sales including Morton Salt and Styron. In the near term, we believe that additional debt reduction would most likely come by additional asset sales and/or through a settlement with Kuwait over the failed joint venture transaction (expected by the end of 2011). We continue to believe that ratings, in the intermediate to long term, can return to single-A due to steps management has taken. Management continues to maintain that higher ratings will provide strategic advantages to the company, namely lower cost of capital and opportunity to grow through acquisitions. Aside from balance sheet restoration, Dow has exceeded its own operational goals and should continue to improve as a premier, global chemical producer with emphasis on less volatile specialty chemical products.

CEO Andrew Liveris (Second Quarter 2011 earnings call):

“You can count on us being a strong, aggressive balance-sheet manager to aggressively release and have more flexibility on the balance sheet. That’s been our single focus, and with $35 billion of cash coming from operations in the next several years, you can count on us to be a liberator and lower debt.”

 

AAM Management Team Rating: WEAK

Suntrust Banks Inc.

CEO James Wells has continued a tradition of underperformance and weaker than peer credit metrics over a protracted period.  The bank’s strong competitive position in its core market (Georgia) has allowed it to avoid improving operating efficiency which has resulted in below-peer return on assets and profitability.  The ill-timed expansion into Florida retail banking through mergers and acquisitions has saddled the bank with a still material portfolio of high LTV mortgages and home equity loans.  While credit costs are moderating, we note that the bank continues to maintain a loan loss reserve-to-non-performing assets ratio well below 1:1.  While it can be pointed out that reserves were sufficient to meet the losses experienced in 2009, we note that it has run a reserve-to-NPA (Non-Performing Assets) ratio well below its peers, leaving the bank considerably exposed in the event that housing prices continue to fall, and less well positioned than its peers should the economy fall back into recession.  We believe that the bank will face increasing competition from stronger, larger and better run competitors encroaching on surrounding markets, and believe that the bank may ultimately find itself pressured to sell.  However, management has traditionally resisted such considerations and appears to still view itself as an acquirer.

Allstate Corp.

Illustrating its market standing, Allstate Corp. fell to the 9th most admired Property & Casualty company in 2011 from 5th in 2010 (Fortune Magazine) and could be ranked lower after a series of disappointing financial results and questionable management decisions. The company is facing increasing competitive pressure in its personal lines business, losing market share in both its auto insurance and home insurance businesses, and experiencing rising combined ratios. The company responded by acquiring auto insurer, Esurance, and the insurance agency, Answer Financial, for $1 billion. On July 18, 2011, the president of Allstate’s main businesses stepped down following one and a half years of what the Allstate CEO referred to as “inadequate results”.

Allstate has reported earnings that missed Wall Street analyst consensus estimates in 12 of the past 14 quarters. Since the Allstate CEO was hired in January 2007, Allstate shares have declined approximately 55% (compared to a gain of 8% in Travelers Companies stock over the same time). Earlier this year, Allstate announced its decision to exit both the bank and broker/dealer distribution channels, de-emphasize spread based businesses and focus on Allstate career agency distribution and mortality and morbidity products. The company reported a $21 million loss on the dissolution of Allstate Bank when the agreement to sell it to Discover Bank was terminated.

Encana

For some time the market provided a premium to Encana bonds due to the perceived quality of its management. However, after a series of questionable strategic decisions, delays and disappointments, we believe that premium is no longer justified. Recall that in May 2008, management approved a proposal to split Encana into two highly focused energy companies – one a natural gas company with North American natural gas assets and the other a fully integrated oil company with oil sands properties and refineries. Less than six months later, this company-altering strategy was postponed. Less than twelve months later, the company proceeded with plans to complete the spin-off of the oil related assets, which would be known as Cenovus. Cenovus has generated returns of 67% since then compared with Encana’s 7%.

In February 2011, management announced that PetroChina would pay $5.4 billion (in Canadian dollars) to acquire a 50 percent interest in Encana’s Cutbank Ridge business assets in British Columbia and Alberta, with the intention of using the proceeds to meet a substantial free cash flow shortfall in 2011. However, not six months later, Encana announced that negotiations ended with PetroChina pertaining to the Cutbank Ridge joint venture. Equally concerning, is management’s efforts to increase capital expenditures (resulting in the free cash flow shortfall in 2011) to become more “oily” less than three years after spinning off Cenovus. This lack of strategy and forethought combined with volatile cash flows and limited capital discipline make us question Encana’s management. Given Encana’s share performance relative to its peers (-50%, -22% and -25% in the last 1-year, 3-year and 5-year’s, respectively) some type of shareholder friendly (bondholder unfriendly) activity is likely soon.

Dell

After relinquishing the CEO role in 2004, Michael Dell returned in 2007. Since that time, the company has cut costs and built out an indirect distribution channel, focusing more on the non-PC enterprise side of the market (servers, storage, software and services) and minimizing PC related overhead. Specifically, management has set a target of doubling the enterprise business by 2014. Management entered the PC retail distribution market as it was slowing, was late to enter the enterprise market, and late to expand into Asia. While Dell’s initial vision proved successful, the company has struggled to differentiate itself competitively. Its global market share has fallen to #3 in PCs, and it lacks leading market positions in its other product categories as well. In terms of managing expectations, the company has missed its revenue guidance seven of the last twelve quarters. Its assumptions underlying its revenue guidance this year are among the most optimistic in the technology sector since it has been expecting a strong increase in public sector spending (approximately 25% of revenues) and back-to-school sales. Not only are both not likely, Dell is late with its tablet offering, has a presence in the mid-tier server market which is being squeezed by the low and high end, and is likely to see the commercial PC refresh cycle slow (normalize).

We believe management will be forced to pursue sizeable mergers and acquisitions to meet its goals. Unfortunately, 60-70% of its cash resides overseas and since its stock trades below its peers based on virtually all valuation metrics (Exhibit 4), it will likely need to raise debt to fund this activity. Exemplifying management’s lack of foresight, in June of last year, Michael Dell acknowledged he had contemplated taking the company private, an option discussed further by the CFO in November. This caused spreads to widen close to 100 bps, tightening over the course of this year as the company has worked to dismiss such an option. At current spreads, we do not believe bondholders are being compensated for this credit and event risk.

Exhibit 4: Dell Does not Stack Up Well vs. Its Peers

	Dell Inc.			Bloomberg Peers		S&P 500
	Current	1 Yr. Ago	5 Yr. Avg.	Current	Pctl	Current	Pctl
Price/T12M EPS	9.44	13.51	15.44	12.17	27%	13.98	10%
PEG Ratio	0.12	n/a	0.88	0.27	20%	0.63	8%
Price/T12M Sales	0.51	0.44	0.65	0.64	38%	1.27	10%
Price/T12M Cashflow	7.49	7.07	12.11	8.15	39%	8.89	29%
EV/T12M EBITDA	4.69	5.66	8.34	6.48	29%	n/a	7%

Source: Bloomberg, as of 8/1/2011 (Pctl = percentile)

Clorox

Clorox management has been put in a very difficult position post the $80 per share offer from Carl Icahn announced on July 19 ,2011. Ultimately, we believe bondholders will suffer. The chance of a “white knight” riding in to buy the company for a significant premium to the current offer seems unlikely. Over the last year, Clorox has lowered its 2011 guidance twice in addition to offering disappointing 2012 guidance. The company has limited exposure to emerging markets, is in low growth categories (high exposure to private label), and is more exposed than most of its consumer product competitors to Wal-Mart (customer base at that retailer is hurting), which accounts for 27% of sales. Market share trends have not been encouraging. Even lower average pricing did not improve share in 2010. In a slow growing economic environment Clorox’s product categories will have a difficult time expanding.

We believe management’s poor strategic decisions and operational performance has resulted in this action from Icahn. It can be debated whether or not Carl Icahn is really interested in buying the company or rather starting a process to restructure and revalue the company. Regardless, Clorox management will need to do something to placate investors. This could include stock repurchases, a large one-time dividend, or perhaps a strategic acquisition. All of those options would most likely result in additional debt and lower ratings. Moreover, management may be forced to sell to Icahn at a higher price or to another private equity firm. A highly leveraged deal would result in much lower ratings, perhaps in the single-B category, as suggested by Standard & Poor’s.

Summary

While bottom up analysis is critical, performance – operationally and financially – will also be affected by macroeconomic and political/regulatory factors. It is critical to analyze both to measure risk appropriately. We have to question whether management in the public sector understands this connection, particularly as we approach an election year. Uncertainties delay decisions, negatively affecting all parties. This uncertainty needs to diminish for management in the private sector to feel confident and add jobs. Our investment thesis is not predicated on this happening in the near term. In Corporates, we are investing in companies with strong management teams that can identify market opportunities, positioning them for growth in the intermediate to longer term. We expect our portfolios to benefit from our more selective credit and sector positioning.

Written by:
Elizabeth G. Henderson, CFA
Director of Corporate Credit
and the AAM Credit Research Team

 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.

Mid-Year Review and Outlook

Investment grade corporate bond spreads widened again last month, producing     -35 basis points (bps) of excess return, as the OAS of the Barclays Corporate Index widened 7 bps. Performance year-to-date as of June 30 remained strongly positive (73 bps of excess return), albeit lower than the high of 152 bps on May 6. The Barclays High Yield Index widened 32 bps. For comparison, Barclays European Investment Grade Corporate Index widened 20 bps and the European High Yield Index widened 54 bps. This reflects the market’s primary concern, the potential for systemic risk emanating from Europe. Excluding credits that were involved in leveraging Mergers & Acquisitions (M&A), negative pre-announcements, ratings downgrades, etc., the credits that underperformed last month were largely European banks and telecommunication companies as well as domestic banks and insurance companies. The spread differential between Industrial BBB and A rated credits widened as well as the differential between Finance and Industrials (Exhibits 1A and 1B). Generally, the Finance, Energy, Utility and Satellite/Cable sectors have outperformed.

Exhibit 1A:     Risk Premiums Revert to January LevelsSource: Barclays, AAM

Exhibit 1B: Risk Premiums Revert to January Levels Source: Barclays, AAM

A reflection of the uncertainty and spread volatility, corporate bond new issue volume dropped significantly last month, to $30.4 billion gross or -$600 million net from $79.3 and $58.7 billion respectively in May. Commensurate with the decline in new issue volume, dealers were able to reduce inventories as investors sought purchases in the secondary market. For those deals that were issued, we saw strong demand. Therefore, buyers are present but more selective.

Entering 2011, we expected compression between BBB and A rated credits and Finance and commodity based sectors to outperform, leading to positive excess returns for Corporate bonds relative to Treasuries. Our main concerns were: higher input costs, sovereign related risks, increased event risk, and weaker than expected economic growth. Over the last two months, three of these risks have come to the fore, causing a re-pricing of risk assets. We have not changed our outlook, believing the US economy in the second half of 2011 will be more robust after auto production normalizes, and the downside stemming from a sovereign default in Europe will keep parties incentivized to work towards a managed solution. Moreover, our commodity price outlook remains consistent with GDP growth in the US of slightly less than 3%.

Industrials

We continue to expect commodity based sectors to outperform in the second half of the year, preferring Metals & Mining and Energy – Oil Field Service companies. We also see attractive risk-adjusted income opportunities in the Cable/Satellite sector. Conversely, we consider the following sectors as currently unattractive due to spreads that are not adequately reflecting various risks: Food/Beverage, Pharmaceuticals, Retail, Consumer Products, Paper, Technology and Media Noncable (namely newspapers and other “old line” media businesses). In greater detail:

Metals & Mining

Commodity prices have been volatile this year, mainly trending meaningfully upward, and China’s growth and demand remain a key factor.  The Japanese natural disaster disrupted the market, impacting both coal and steel.  We expect prices to remain strong and event risk to be high.  That said, we believe the large, diversified metals companies have the financial flexibility to make acquisitions within their ratings profiles due to their very large cash coffers (50% Cash/Total Debt at 3/31/11 for the industry vs. a trough of 19% on 6/30/08).  We remain skeptical of the pure play metals companies, as most gravitate towards low-triple-B and tend to focus on the very cyclical steel industry. We like the large, diversified mining companies that own long life assets and have ratings upgrade and spread tightening potential.  Surprisingly, the industry has not ramped capital spending relative to revenues (11.7% at 3/31/11 vs. 11.2% at 3/31/07).  We believe companies are more apt to increase their capital spending, but given the natural supply constraints, we are not worried about the magnitude relative to free cash flow generation.

Energy – Oil Field Services

A higher oil price and the expectation for an increase in exploration should lead to higher demand for oil field services. Going into 2011, management teams had used an oil price of $70-80/per barrel (bbl) to determine their capital spending plans. With oil currently slightly less than $100/bbl, we expect teams to revise their plans upward, which has positive ramifications for the drillers and service companies. Spreads have recovered from their peak after the Gulf spill, but continue to offer value versus other Energy and Industrial credits. As shown in Exhibits 2A and 2B, they offer considerable tightening potential relative to their levels prior to the financial crisis; a period of high oil prices. The main risks in this sector are higher capital spending without the corresponding increase in revenues due to economic contraction and/or leveraging M&A.

Exhibits 2A and 2B:

Source: Credit Suisse (LUCI Index; Current is 7/6/11; data since 1/1/05; benchmark spreads to curve), AAM

Note: Pre-Crisis is minimum spread prior to financial crisis as of 1/1/05

Media

We continue to remain comfortable with the fundamentals in the Cable/Satellite sector and with select companies in the Entertainment sector. The questions in 2010 about whether consumers would look to bypass their cable operators via Netflix and other similar services (“over-the-top”) have diminished as the cable companies innovate and media companies have re-priced content on these platforms. Consumers continue to prefer faster broadband speeds, giving the cable companies an edge versus the DSL providers. The Small and Mid-Sized Enterprises (SME) market should be a source of growth, mitigating the downside risks of lost revenues due to voice substitution(wireless, VoIP) and/or pricing pressure. Positively, these companies are largely domestic with no European exposure. That said, the housing market affects them and if it remains weak, will continue to pressure subscriber growth.

In the Entertainment sector, we prefer companies with original/produced content, a mix of mature and growing networks, domestic and international exposure, and strong brands. Cable and internet advertising continue to take share from the more traditional platforms (e.g., publishing, broadcast). In this more uncertain economy, we believe management teams may be more inclined to make investments with faster payback periods, which bodes well for advertising since it’s flexible and more predictable relative to investing in research and development, which provides returns over years not months. The risk in the near term for this sector is that the economy is much weaker than expected, causing advertisers to pull back to manage earnings. Longer term, the sector must manage the technological changes that increase risks of piracy and/or disrupt their business model (e.g., over-the-top, ad skipping).

Lastly, in the midst of the News Corp scandal, it goes without saying that a key variable for credit analysts is management, and for media companies, it is even more important given the nature of the assets.

Pharmaceuticals

This sector is stepping up to a significant patent expiration cliff whose lost revenues will not be replaced given the insufficient pipeline of new drugs. Companies have been preparing for this by rationalizing their cost structures, making acquisitions, diversifying both horizontally and vertically, and increasing their payouts to shareholders. These actions will come at a cost to bondholders. This is a sector that used to have several credits with triple-A ratings (Merck, Pfizer, Eli Lilly, Abbott). In the intermediate term, we believe ratings for this sector head towards single-A. Having said all that, we expect pharmaceutical companies to benefit from secular growth including the aging population in the U.S. and improving standards of healthcare and faster economic growth in emerging markets. We revised our relative value opinion to “unattractive” for the sector in the beginning of this year, as very tight spreads did not reflect our concern that credit quality will migrate south until growth prospects become more favorable.  Year-to-date, this sector has been one of few to generate negative excess returns.

Food, Retail, Household and Personal Products

Commodity price “takers” or companies in these sectors will face headwinds of rising raw material costs at a time when the consumer is deleveraging and unemployment is high.  We prefer sectors with more inelastic products, as shown in Exhibit 3.  The consumer is not used to inflation and is more accustomed to deflation (apparel, toys, household products).  The Commodity Research Bureau’s index of commodity prices has been up at least 20% this year, resulting in a rising Producer Price Index (PPI) while the Consumer Price Index (CPI) has only risen modestly, outpacing PPI by 200 basis points for over a year.  Companies have been absorbing this difference due to the fragility of the consumer, protecting margins via productivity improvements and innovation.  The companies that have disproportionately benefitted are those more exposed to higher income consumers, who are less sensitive to prices of goods and gasoline.

Exhibit 3: Price Elasticity of Demand (1995 – 2011)

Source: Credit Suisse (U.S. Census Bureau and Wells Fargo Securities, LLC)

While less than one fifth of all U.S. consumers make more than $100,000 annually, this income group accounts for more than one third of all spending.  In Retail, spreads reflect this as luxury retailers are trading inside of discount peers, a relationship that is uncommon (See Exhibit 4; average is 30 bps wide of discounters over last 5 years).  For the discount and mid-tier retailers, we are concerned that the double digit price increases planned for the second half of the year to offset the 10-20% increase in Cost of Goods Sold (COGS) could prove difficult, as the consumer remains weak and sensitive to rising gasoline prices.  Promotional activity drove the better than expected same-store-sale figures released this week, pointing to the difficulty of retailers attempting to raise prices in this environment.

Exhibit 4: Specialty Retailers have Outperformed in this Recovery

Source: AAM, Credit Suisse (LUCI Index, A rated issuers)

Similarly for food companies, we are concerned that the price increases they have started to implement are becoming increasingly more difficult.  There is a lag between the time in which the companies absorb rising input costs and the pace at which they can increase prices to compensate, which is the reason companies hedge raw materials costs.  That said, Wells Fargo equity analysts estimate that after the impact of hedges, input cost inflation will average 7-9% in 2011 for these companies (13% without)[1], a level that will be very difficult to offset with higher prices and productivity improvements.  The same issue applies to household product companies.

In this environment especially given very tight spreads, we believe the sector is largely unattractive, preferring companies in these sectors that have strong brands, have significant emerging markets exposure, and are deleveraging post acquisition.  While we understand many of these companies are of high credit quality, we are concerned that the margin compression and revenue pressure will result in companies becoming more shareholder friendly and/or pursuing cash funded M&A. In addition, given the mature nature of the consumer sector event risk includes pressure from activist shareholders and Leveraged Buyout (LBO) rumor/activity, especially those with smaller market caps.

Telecommunications

This sector is rarely boring and this year has been no exception (See Exhibit 5). As wireless penetration in developed economies approaches or for many, exceeds 100%, companies are searching for ways to grow their top lines while protecting margins. Revenues for European carriers have been pressured either as a result of the weak economies and austerity measures or the price competition that has ensued (France being the latest example). Rating agencies like Standard & Poor’s have revised their methodology to tie ratings of credits that are “sensitive to country risk” to the sovereign ratings, affecting industries like telecommunications and utilities. Hence, the sovereign weakness has not only pressured these credits from a top line perspective but a funding cost perspective as well. We continue to avoid European telecommunications credits, expecting continued fundamental weakness and spread volatility.

In the U.S., the industry has benefitted from the proliferation of smart phones and other connected devices like tablets, with data revenue growth more than offsetting the decline in voice revenues. Recently, companies have effectively increased their prices for data, removing or raising prices for unlimited packages. Given the strain on the network for tablets, we expect marketing emphasis will be placed on smart phones in the near term. The price differential for voice/data packages between the nationwide carriers and the pre-paid or discount companies continues to be meaningful. Family plans and the preference for consumers to own the latest technology has protected this gap, but as smart phones become more affordable and networks are upgraded, this may begin to close at the expense of the larger carriers. For regional telecom companies, we believe their DSL revenues are vulnerable, as the nationwide carriers deploy 4G services. Spreads reflect some of the technological uncertainty in this sector, and we continue to invest cautiously in both credits and maturity.

Exhibit 5: Higher Quality Credits Have Outperformed
Source: Credit Suisse, AAM

Finance

Banks

Fundamentals continue to improve from a bondholder’s perspective, as charge-offs are improving and tangible common equity and liquidity builds (Exhibits 6 and 7). Despite banks’ desire to lend, loan growth remains stagnant even as Commercial & Industrial (C&I) credit standards ease. Generally, lending is available for businesses but less so for consumers, as home equity loans and construction loans are being run-off. Regulatory related costs – both direct and indirect – have hampered the industry and especially equity valuations. Equity investors question the Return on Equity (ROE) generating ability of the sector, and the latest degree of economic uncertainty only adds to the pressure. In Europe, banks face similar questions on ROE under the Basel III rules in addition to having more exposure to the weak European sovereigns. While we continue to believe the sector is attractively priced for the risks assumed as bondholders, we admit that the market related risk is not decreasing as quickly as we would like. We do not see this changing in the near term unless the debt crisis in Europe is resolved sooner than expected (doubtful) or domestic growth is kick started. We prefer the strong domestic over the European banks and remain cautious as it relates to investing in the capital structure (senior only) and maturity curve (short-to-intermediate).

Exhibit 6:

Source: SNL

Exhibit 7: Nonperforming Assets, 25-Bank Aggregate ($ billion)

Source: Barclays Capital, SNL

Insurance

Insurance companies are overcapitalized with excess liquidity, which bodes well for bondholders. Not only have most reduced their investment risk, but they have also de-risked on the product side. Spreads have widened over the past couple months, but the sector has performed well year-to-date. Property & Casualty and reinsurance companies have been faced with questions about claims and their municipal exposure, life companies face questions surrounding stock market uncertainty and interest rates, and health companies face uncertainties surrounding the new regulation and political pressure surrounding rates. We are investing in the sector, prioritizing management and companies with strong market positions. We are less concerned about the regulatory pressures facing the health insurers, appreciating the lower level of investment risk and competition. We are avoiding insurance brokers and reinsurers that have tight spreads relative to their risk profiles.

REITs

After looking into the abyss during the financial crisis, management teams continue to remain financially prudent, avoiding large scale M&A and development.   Leverage continues to be worked down, and liquidity is good. After a very strong rally earlier in the year, spreads have pulled back. Our preference remains the Multi-family and Central Business District office sector REITs where the supply and demand dynamics are more favorable, leading to rent improvement. REITs have been adding properties via individual asset purchases and continue to sell equity to de-lever and fund acquisitions. Aside from a weaker than expected economic environment, a risk for the sector is a resumption of more aggressive M&A and/or development. That said, we do not believe this is a risk in the near term as large commercial developers are currently understaffed, construction credit is unavailable, and leading indicators are not pointing in that direction (e.g., Architectural Billings Index).

Utilities

Utilities have done well in this pull-back, a sector that is viewed as largely defensive and domestic. We recently revised our Pipeline sector recommendation to Fair from Attractive, viewing spreads as fairly reflecting the fundamental risks (Exhibit 8). This sector is not immune to the economy or political rhetoric (e.g., elimination of the Master Limited Partner (MLP) tax structure). In regard to Electrics, we believe the carbon emissions related rules expected later this year are key variables for credit analysis in the near term, as companies have threatened plant closures and capital spending retrenchment.

Exhibit 8: Pipelines Have Outperformed Electrics Year-to-Date

Source: AAM, Credit Suisse – LUCI data for 7-10 year BBB rated Pipelines and Electric Utilities

Written by:
Elizabeth G. 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] Schumaker-Krieg, Diane, “Testing Consumer Spending Power: Every Penny Counts,” Wells Fargo Securities Integrated Research and Economics: TRACS, Vol. 9, (June 2011), pg. 10.

How Important Are The Autos?

Investment grade corporate bond spreads widened last month, producing -39 basis points (bps) of excess return, as the OAS of the Barclays Corporate Index widened 8 bps. Performance year-to-date as of May 31 remains strongly positive (109 bps of excess return). Despite the spread widening, prices moved higher as Treasury yields fell by a greater amount given the flight to quality. Companies took advantage of the falling Treasury yields, issuing $80 billion of investment grade debt in May for a year-to-date total of $333 billion. We had been expecting $565 billion to be issued this year, and while we may revise our estimate higher, we do not expect the current pace will continue. Positively, demand for new issues remains very high as exemplified by the over subscription of deals. The magnitude of spread widening was modest considering the heavy issuance (i.e., May 2010 was $23 billion), disappointing economic data releases around the world (mainly U.S. and China), and the European debt crisis. In the second half of 2011, we expect the economic data releases to improve as industrial production related to Japan returns and gas prices remain below $4/gallon. We continue to believe that spreads will be range bound and exit the year posting positive excess returns.

The impact of the Japanese earthquake and tsunami in March of this year on the U.S. manufacturing segment was evident in the most recent release of monthly auto sales. We believe this increased the downside risk for growth in the U.S. but only on a temporary basis. The auto industry is a meaningful contributor to GDP, accounting for 1.4 percentage points[1] of the first quarter GDP growth of 1.8%. After reviewing the May employment report that showed motor vehicle hours worked and regressing the data against motor vehicle production, Deutsche Bank revised an earlier estimate of the reduction in GDP growth for the second quarter related to the autos from 0.5 – 0.75 percentage points[2] to 1.5 – 2.0 percentage points[3]. They anticipate that auto production for the second quarter could be the largest drop on record, larger than the -23% in the first quarter of 2009, the peak of the recession.

Exhibit 1

Japanese vs. US Auto OEMs
	2010 Unit Sales	% Parts Manufactured in Japan	% Produced in U.S.	% Produced in Japan
Japanese
Honda	1,230,480		87%	13%
Nissan	908,570		68%	32%
Toyota	1,763,595		67%	33%
Other	574,753		34%	64%
TOTAL	4,477,398	20%	68%	31%
Detroit 3	5,227,410	5%

Source: AAM, Ward’s, Bank of America, Goldman Sachs

While it varies by manufacturer, a significant portion of Japanese cars sold in the U.S. are produced in Japan, and importantly, 20% of the parts are sourced from Japan vs. 5% for U.S. car manufacturers (Exhibit 1). A number of auto parts manufacturers in Japan slowed the production process in the U.S. because key auto components (especially electrical) were not available to complete the assembly of certain cars.

This disruption has resulted in a very low level of inventories. The days supply of inventory for the Japanese Original Equipment Manufacturers (OEMs) was 42 days down from 49 days in April and well below the five year average for May of 50 days. Key models were down to alarming levels, including 27 days for the Honda Civic and 30 days for the Toyota Corolla. This compares with 59 days supply in May for the “Detroit 3” (Ford, GM, Chrysler)[4]. To avoid running out of stock, manufacturers pulled back auto incentives (Exhibits 2 and 3). Accordingly, the

Exhibit 2: U.S. Auto Growth vs. Incentive Growth

Source: Autodata, Kantar Media, Goldman Sachs Research

Exhibit 3: Growth Year Over Year in Incentives Per Vehicle Sold

Source: Autodata, Goldman Sachs Research

market share for the Japanese OEMs, which includes Toyota, Honda, and Nissan, fell to the lowest level in over five years in May (Exhibit 4). The Detroit 3 have taken advantage of the current situation in hopes of regaining legacy share.

Exhibit 4

Source: Bloomberg

In addition to the lack of incentives, we believe high gas prices have also impacted car sales. There has been a clear change in the mix given the lower percentage of sales to large pickups and Sports Utility Vehicles (SUVs) vs. more fuel efficient vehicles. We witnessed this same trend when gas prices were at comparable levels in mid-2008. In the meantime, consumers are absorbing price increases related to rising commodity prices and reading that their home values continue to fall. Therefore, the one-two-punch of rising prices and falling home values, negatively affected consumer sentiment, delaying the purchase of new cars. The title of a news article from the Los Angeles Times best reflects this sentiment: “Best Option for Car Shoppers: Postpone Buying” (May 22, 2011).

At this point, for 2011, we are optimistic that auto sales will resume and reach 13 million Seasonally Adjusted Annual Rate (SAAR), which is still well below the long-term average, as problems in the second quarter seemed to have stemmed from a natural disaster as opposed to economic fundamentals. We would expect buyers to defer their auto purchases towards the latter part of 2011, as inventories begin to normalize, prices recede, and 2012 models are introduced. Toyota and Honda have both been working extremely hard to get their production back in-line with normal levels. Toyota recently announced that production in Japan will be at 90% of normal levels in June, that it would increase production at its thirteen North America plants to 70% of capacity from 30% previously, as parts shortages are less severe than first expected, and that it would move to 100% production in North America on eight models. Similarly, Honda announced that production in North America will be at 100% of original plan by August, with the exception of the 2012 Civic. This should cause an acceleration of manufacturing activity, and put the economy back on track.

If the economy continues to slow or gas prices spike once again, we would not expect auto sales to reach our goal of 13 million SAAR. That said, we do not expect gas prices to rise unless Middle East tension increases or economic growth is higher than expected (which should be a positive for auto sales). Rising gasoline prices sapped household spending power by approximately $100 billion over the last five months[5], but have been trending lower along with the price of oil (Exhibit 5). Our 2011 forecast for oil is for $90/barrel (bbl) West Texas Intermediate (WTI), currently $100.50/bbl, both of which should result in gas prices less than the $3.96/gallon averaged in May.

Exhibit 5

Source: Energy Information Administration

Written by:

Elizabeth G. Henderson, CFA
Director of Corporate Credit

Michael J. Ashley
Vice President, 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] Reuters, “Japan earthquake impact on US autos may dent US GDP” 5/19/2011
[2] Reuters, “Japan earthquake impact on US autos may dent US GDP” 5/19/2011
[3] LaVorgna, Joseph, Deutsche Bank “Quantifying the impact of autos on Q2 real GDP” 6/6/2011
[4] Kohei Takahashi, JP Morgan, page 5, “US Inventory & Incentive Flash (May)”, 6/3/11
[5] LaVorgna, Joseph, Deutsche Bank “US Daily Economic Notes” 06/01/2011

More Buyers than Sellers – Is it Really that Simple?

There was a strong bid for Corporate bonds last month, as evidenced by the 42 basis points (bps) of excess return for the Barclays Corporate index in April and 146 bps year-to-date. The Option Adjusted Spread (OAS) of the index is 18 bps tighter this year, driven by tightening in Financial and BBB rated credits (Exhibit 1). This type of rally is what we expected this year. With the economy continuing to improve, we expected risk appetite to increase.

Exhibit 1

Excess Returns, Year-to-Date (bps)
	AA	A	BBB
Industrial	12	68	171
Utility	19	54	175
Finance	96	220	368

Source: Barclays

We have been supportive of Corporate credit for some time, for both fundamental and technical reasons. The majority of our monthly thought leadership pieces have focused on the fundamentals, and rightly so given their importance. This month, we are focusing on marketplace technicals. With QE2 expiring next month, investors have been focusing on the technical side of the Treasury market and the potential spill-over the expiration may have on other markets. Accordingly, it is important to understand what has (and has not) changed in the Corporate market from a demand and supply perspective. With the economy on firmer ground today relative to this time last year and the Fed’s communicated support, we are not expecting markets to react negatively when QE2 expires. We believe unless the fundamental outlook materially deteriorates, the demand for Corporate credit and limited supply will keep the sector from underperforming Treasuries.

After a broad sell-off in 2008, demand has resumed for Corporate bonds albeit not to the levels witnessed in 2006-2007. Insurance companies, mainly Life companies, and Mutual Funds have been the predominant buyers of Corporate bonds over the last couple years (Exhibit 2). A lot of attention is placed on the continual buying of Corporate credit by mutual funds and the belief, according to investor surveys conducted by Wall Street firms, that many institutional investors are overweight Corporate bonds relative to their respective indices. This creates the perception that the market is biased to underperform. As Exhibit 2 shows, there are other investors that buy Corporate bonds. The household, foreign, banking and government sectors are also important constituents, and could resume net buying once they complete their deleveraging. The Corporate/Foreign bond sector has not grown since the peak in 2007, when it was $11.4 trillion up from $6.2 trillion in 2002. That said, relative to the total, this sector has moved from 20% of total Credit Market Debt in 2002 to 22% at year-end 2010.

Exhibit 2

Source: Federal Reserve, AAM

Note: Funding vehicles is defined by the Fed as nonbank financial holding companies, custodial accounts for reinvested collateral of securities lending operations, Federal Reserve lending facilities, and funds associated with the Public-Private Investment Program (PPIP); Foreign debt is defined as amounts borrowed by foreign financial and nonfinancial entities in U.S. markets only

Importantly, the low interest rate environment and lack of supply in sectors outside of Corporate bonds supports the demand for the asset class (Exhibits 3 & 4).

Exhibit 3

Source: Bank of America Merrill Lynch Global Research

Note: For Leveraged Finance net supply, calls/tenders are subtracted from gross supply only for 2009-2011; Spread product defined as first five columns

Exhibit 4

Source: Goldman Sachs Credit Strategy, SIFMA, Bloomberg, S&P LCD

Note: This chart shows the size of all fixed income assets and the yields comparable to 10-year treasury, with exceptions of HY and leveraged loans.

Lastly, secondary market liquidity is lower than it was before the financial crisis, as evidenced by the inventories held by broker dealers (Exhibit 5). A number of factors have conspired to constrain dealer inventories over the past several years.  Most notable has been the dwindling field of dealers with balance sheet capacity (e.g., Bear Stearns, Lehman Brothers, Merrill Lynch).  While numerous boutiques have sprung up in their wake, these start-ups have limited capital and balance sheet capacity.  At the same time, the remaining large dealers were made painfully aware of their over-reliance on wholesale funding to finance large inventories in the run-up to 2008.  Subsequently, dealers have been engaged in a multi-year de-leveraging process which has reduced average gross leverage from a high of well over 30 times (x) to around 20x today.  Lastly, the pending debut of the Basel III capital regime beginning in 2013 will put pressure on dealers to run lower inventory in a number of ways.  First, the market risk associated with inventories will be more heavily weighted in capital calculations.  Additionally, Basel III moves away from a purely ratings based risk weighting, resulting in higher capital charges for a range of structured products (e.g., Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS), Collateralized Loan Obligations (CLO)).  Finally, European banks will be subject to a 3% minimum gross leverage ratio, which will meaningfully constrain the ability to grow their balance sheets (U.S. banks are already subject to a minimum leverage ratio).

Reduced supply, especially of spread product, in both the new issue and secondary market along with investor demand that is likely to grow at the margin as deleveraging slows, bodes well for the demand for Corporate bonds. This is supportive for Corporate spreads and firms that are nimble and can take advantage of all segments of the marketplace.

Exhibit 5
Source: Bloomberg

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.

Will Higher Commodity Prices Result in Wider Spreads?

Spreads widened in March, as we had expected, but have rebounded sharply to date in April. The Barclays Corporate Index generated -6 basis points (bps) of excess return in March, getting as low as -39 bps in mid-March. From that point, spreads have tightened and excess returns are 36 bps month-to-date as of April 7. Higher beta sectors underperformed, as highlighted in Exhibit 1. We were active buyers of credits that widened more than their risk profiles would indicate, taking advantage of a more active new issue market in March.

Our outlook remains unchanged for Corporate credit, expecting outperformance in 2011 relative to Treasuries. While today’s challenges such as rising commodity costs may increase volatility and a divergence of performance among credits and sectors, we do not believe they warrant a revaluation of Corporate credit. Commodity prices remain within our “base case” and unless labor costs begin to show signs of increasing, we are not concerned about inflation in the near term. Companies are showing signs that they are able to pass through modest price increases; therefore, our expectation is for margins to remain range bound and for consumers to spend less, resulting in modest downward pressure on GDP. That said, we continue to expect modest GDP growth (3%), acknowledging that the risks are to the downside, therefore, limiting the upside.

Exhibit 1: Excess Returns Year-to-Date 2011

Source: Barclays Capital

Incorporating the economic consequences of the fighting in the Middle East and the earthquake in Japan, economists revised their first quarter 2011 GDP estimate down 80 bps to 2.6%.[note]Bloomberg News – Economists surveyed from April 1, 2011 to April 7, 2011[/note]   In January, we cited higher input prices as a risk to our forecast for positive excess returns for Corporates in 2011. So far this year, while they have increased, they have remained within our forecasted range. Oil continues on its upward path (see AAM Corporate Credit View dated March 7, 2011) and we will be following the elections in oil rich Nigeria this month, which could adversely affect an already tight supply situation. While gold and oil have received a lot of attention, other commodity prices have also risen sharply, approaching or exceeding their 2007 levels (Exhibit 2). Reasons for this include loose liquidity conditions, negative real rates, improving global manufacturing activity which includes the beginning of China’s twelfth five-year plan. China continues to consume more than one third of many metals, as shown in Exhibit 3. The point is since the increase in commodity prices is fundamentally driven, prices are unlikely to change course in the near term without an unexpected downward revision to economic growth in China, the United States and/or emerging markets or ramp in currently constrained supply.

    Exhibit 2 Commodity Prices are Increasing

Source: Bloomberg

 

         Exhibit 3

Market Balance and Price Outlook	2009	2010	2011F
Aluminum
China as % of total consumption	41%	41%	42%
Surplus/(deficit) as % of total demand	10%	2%	2%
Refined Copper
China as % of total consumption	37%	39%	39%
Surplus/(deficit) as % of total demand	6%	1%	-3%
Primary Nickel
China as % of total consumption	36%	34%	36%
Surplus/(deficit) as % of total demand	3%	-3%	1%
Refined Zinc
China as % of total consumption	41%	41%	42%
Surplus/(deficit) as % of total demand	10%	5%	1%
Iron Ore
China’s share of global trade	67%	62%	62%
China’s iron ore import ratio	70%	64%	67%
Surplus/(deficit) as % of total demand	1%	4%	2%

Source: CRU International; Brook Hunt; GS&PA

Our concern regarding higher input prices was the pressure they could place on margins if companies are unable to pass through the costs to a recovering consumer. We will glean more information soon in earnings calls, but are hearing companies have been successful at passing through price increases in small, frequent steps. While this may be supportive for company margins, we wonder how resilient the consumer will be if paychecks are eroded by higher food and energy prices while housing remains weak and unemployment remains high. Recognizing that consumer spending is tied to wealth (Exhibit 4) and that higher income households generate a proportionately higher amount of consumer spending, we are not yet concerned that such pressure will result in a double dip since the stock market is in positive territory year-to-date and home prices are falling less rapidly. In addition, the slack in the labor market and the relationship between labor costs and CPI (Exhibit 5) make us less concerned about inflation in the near term. Of course, the economy is recovering and set-backs are still possible, including the uncertainty relating to the end of the Federal Reserve’s second Quantitative Easing (QE2) program in the middle of this year. This risk, in addition to the others highlighted in this paper, concern us. But, unless the probability of a double dip begins to increase, we believe Corporate credit will outperform Treasuries in 2011.

Exhibit 4

Exhibit 5

Source: Bloomberg

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

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