Corporate Credit View

Too Far Too Fast?

As equity markets sell off due to concerns about global growth, whether it be from the disaster in Japan, rising oil prices or political unrest, the Corporate market has been relatively resilient. The correlation between the two markets has been above average, breaking down over the last month. The Corporate market’s Option Adjusted Spread (OAS) as of March 14, 2011 as represented by the Barclays Capital Corporate Index, has widened 2 basis points (bps) from the minimum in mid-February. Year-to-date, the OAS is 15 bps tighter, producing 137 bps of excess returns (107 bps excess return for Industrials, 103 bps for Utilities, 193 bps for Finance). The lower rated credits are outperforming (177 bps of excess return for BBB rated credits vs. 129 bps for A rated credits). We had expected this type of performance for the year and have achieved a significant amount in the first two months. Spreads of higher quality Industrial credits are very close to their minimums reached in 2006. We would not be surprised to see spreads widen in March, as global growth estimates are revised lower and investors shun nuclear related credits.

Economic data has largely met or exceeded expectations, reflected in rising Gross Domestic Product (GDP) and Earnings Per Share (EPS) estimates. Earnings season has been largely positive as well with all nine of ten broad sectors (Utilities disappointed) surprising to the upside (sales and earnings per share). The National Federation of Independent Business (NFIB) small business survey, to which we pay particular attention, continues to show an improving trend. Consumer confidence is increasing despite stagnant wages and job creation. The unemployment rate is falling mainly due to the number of workers dropping out of the labor force, perplexing many economists.

Focus has moved from the backward looking data to the turmoil in the Middle East and Japan, causing investors and likely management teams to rescind and reflect on the fragility of the global economy. In fourth quarter earnings calls, management teams were largely cautiously optimistic for 2011, expecting modest GDP growth. The risks to their forecasts are not immaterial, as the uprising in the Middle East resulted in the price of oil moving 16% from $90.77/bbl to $105.25/bbl from the start of February to March 7, 2011 before the earthquake in Japan. Deutsche Bank economists estimate that if oil reaches $150/bbl over a sustained period of time, global GDP could contract 50-60% from the current estimate for 2011 of 4.3%. They are assigning a 10-15% probability to that scenario[note]Peter Hooper and Thomas Mayer, “Oil and the Global Economy: Measured Impact,”Global Economic Perspective, Deutsche Bank, March 3, 2011[/note]. Bank of America Merrill Lynch believes if oil goes above its historic peak of $150/bbl on a sustained basis, a global recession becomes a real risk and at $200/bbl, it is almost certain.[note]Ethan Harris and Alberto Ades, “An Oil Shock to the Global Economic Forecast,”Global Economics, Bank of America Merrill Lynch, March 8, 2011[/note]

Our forecasts assume oil remains in a $80-100/bbl range, which is manageable for the economy and particularly constructive for the Energy sector, to which we are favorably disposed (See Exhibit 1). With Libya off line, the oil utilization rate (demand/supply), increases from 92% to 93.5%. If unrest emerged in Saudi Arabia, oil would spike, as the utilization rate would exceed 100%. In this environment, we would expect Corporate credit spreads to widen materially due to the fear of a slowdown in world growth. Similarly, Credit Suisse’s economists are forecasting a 1 percentage point reduction in global GDP growth from the disaster in Japan in a worst case scenario (0.2% is their central case)[note]Garthwaite, Andre, “Further comments on the impact of Japan,”Credit Suisse, Global Equity Strategy, March 15, 2011[/note]. Whether it’s the unrest in the Middle East or the uncertainty in Japan, both highlight the vulnerability of GDP to events that are very difficult to predict.

Exhibit 1

Source: Bloomberg; 2010 adjusted for BP’s cash obligations related to the oil spill

Accordingly, until there is more clarity, analysts have been unable or perhaps unwilling to model the effect of higher input costs on margins due to the number of uncertainties – i.e., level and duration of input prices, price increases for final goods, cost reductions, end user demand (See Exhibit 2).

Exhibit 2

While companies claim they intend to raise prices frequently in small percentage increments and absorb the remainder via cost savings programs, we question firms’ abilities to meaningfully reduce costs from current levels and raise prices when consumers are still deleveraging. Positively, some firms do believe they will be able to raise prices, as noted in the NFIB March 2011 small business survey, with 21% of owners (net seasonally adjusted) planning to raise prices in the future.

The Corporate market has performed well year-to-date, and we would not be surprised to see spreads widen in March. The reverberations of the financial crisis are still being felt with GDP growth rates vulnerable to exogenous shocks. We believe 2011 will look much like 2010, as these shocks cause investors to question economic stability. Spreads have tightened and while we consider them to be largely fair but vulnerable to near term widening, we expect them to be range bound as the technical environment is very positive for spreads. In a time of uncertainty, Corporate credit is a good investment alternative, and when supply is relatively tight as it is today, it is difficult for many to invest in the sector.

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.

2011 Outlook

We believe the Corporate market faces less uncertainty relative to this time last year, and that is reflected in tighter spreads. The OAS of the Barclays Index was 150 basis points (bps) on January 31, 2011 vs. 171 bps at the end of January last year. Company balance sheets are strong and revenue growth has resumed, allowing profit margins to expand. Banks are loosening lending standards as their credit provisions slow. The consumer is spending again despite stubbornly high unemployment and a weak housing market. Sovereign related risks remain high in Europe and the Middle East, and China and other emerging markets are growing at record paces, two issues that are unchanged from last year. Importantly, domestic political and regulatory uncertainty should be lower this year after a busy legislative year in 2010 and Republicans reclaimed the House of Representatives. Overall, we are optimistic about the Corporate market and expect positive excess returns again in 2011. We expect spread tightening, as financial credits and BBB rated credits compress with A rated Industrial and Utility credits.

Besides Finance which is at its historic average, Utility and Industrial sector spreads are inside their historic averages, but well above their historic minimums (two to over three times). As shown in Exhibits 1 and 2, spreads are similarly distributed relative to the last economic recovery in 2003, albeit the Finance sector is today what the Industrial and Utility sectors were in the 2001/2002 recession (i.e., the catalyst). Similar to 2003, the U.S. economy and credit fundamentals are improving, and growth is expected to be strong from Asia and emerging markets. However, the consumer is weaker, the financial system is weaker and growth in Europe is expected to a fraction of what it was in 2003. Surprisingly, equity volatility as measured by the VIX (The Chicago Board Options Exchange Volatility Index) is lower today than in 2003.

Exhibit 1 and 2

1. Sovereign risk relating to not only the peripheral European countries but in all parts of the globe, as countries either face rising inflation or fiscal challenges. In particular:
   • China is an important source of global growth (see Exhibit 3), and the government has made it clear that growth is its top priority while fighting inflation is only the third priority.
   • Europe will go through another round of stress testing its banks, using more stringent criteria. Moody’s estimates the global speculative default rate could increase from an estimated 2% in 2011 to 6% if significant sovereign and financial problems develop[note]Moody’s December Default Report, January 6, 2011.[/note]. Additionally, the austerity measures and weak economies drain credit fundamentals of companies exposed to consumers in that region.
   • The U.S. faces its own challenges this year as municipalities look to fill a $125 billion budget gap for fiscal year 2012[note]Center on Budget and Policy Priorities[/note]. It is difficult to quantify the potential consequences, directly and indirectly, to jobs and growth as municipalities cut spending and some raise taxes.

Exhibit 3

2. Increased event risk, as companies continue to operate in an economy that is recovering with high unemployment in the U.S. and Europe and face more difficult year-over-year comparisons with 2010 vs. 2009. Productivity improvements are more difficult today and with raw material costs, healthcare and capacity increasing, inflation is likely to increase. For companies serving consumers, this may result in margin erosion as consumers balk at picking up the tab and/or price competition ensues. We expect companies to become more active with mergers and acquisitions to exploit revenue and cost synergies and spend their cash on dividends and share buybacks.

3. Rising raw material costs and labor costs abroad and their affects on company margins, leading to increased event risk (see Risk #2). Due to firms’ limited pricing power and high unemployment, we are not yet concerned about inflation in the U.S., but in emerging markets. As we are witnessing in the Middle East, this increases political instability, which increases market volatility, commodity prices volatility, etc.

4. Weaker than expected economic growth in the U.S. and/or Europe, including sustained high unemployment and/or a weaker than expected housing market. This would put pressure on the Federal Reserve to keep rates low and continue to stimulate the economy, an increasingly difficult decision.

Our industry recommendations reflect these themes in addition to others that are relevant for various credits and industries. Similar to 2010, we expect excess returns to be driven from spread tightening in the Finance sector and BBB rated credits and income generated (“carry”). That said, while we believe there is value in credits rated in the BBB category, in some cases, BBBs are well inside their historic averages vs. credits in the A rating category (Exhibits 4 & 5). This highlights the need for bottom up credit research, as it will be more difficult to outperform using only a top down approach. In summary, we expect outperformance will be driven by the Finance and Utility sectors, and select Industrial sectors.

 Exhibit 4

Source: Credit Suisse LUCI Index, 08/02/02 – 1/31/11, 7 – 10 year maturities Note: The bars represent the minimum to maximum spread range for the period.

Exhibit 5

Source: Credit Suisse LUCI Index, 08/02/02 – 1/31/11, 7 – 10 year maturities Note: The bars represent the minimum to maximum spread range for the period.

Finance

Banks – We continue to expect this sector to outperform, as fundamentals are improving and, in contrast to last year, regulatory risk has decreased. Profitability should continue to improve as the cost of credit falls. Sector credit quality also continues to be supported by strong capital levels in the wake of recapitalization that began in 2009 and continued in 2010. Liquidity remains robust as deposits exceed loan books for most of the sector, and while loan books appear to have stabilized, loan growth is expected to be modest during 2011. As a result, new issuance is expected to modest relative to the high levels of the past. Accordingly, net debt outstanding for the sector is expected to contract. That said, Finance related issuance is expected to comprise a little over half of the gross Corporate bond issuance for 2011, evenly split between Yankee and domestic banks. Despite this modestly negative technical, we expect bank spread tightening will continue, as volatility decreases and fundamentals improve. We believe bank spreads should compress meaningfully with credits with similar risk profiles.

Insurance – Our preference has moved from Property & Casualty to Life operators from both a fundamental and valuation standpoint. Investment portfolios have strengthened post the economic and financial market recovery. Property & Casualty companies face pricing pressure and have a much higher exposure to municipal bonds (average 30% with some having up to 80%), an asset class that has a high degree of headline risk given the fundamental uncertainties.

REITs – Fundamentals are improving in this sector, benefitting from an improving economy and aggressive capital raising efforts to deleverage and recapitalize. Strong investment grade rated REITs, especially those exposed to central business district (CBD) office and residential (apartment) properties, are well positioned to take advantage of the continued economic improvement and the consolidation that we expect. We are more cautious on the retail REITs. Compared with a stabilization in CBD and apartment REITs, retail rental rates continue to decrease and with high unemployment and a debt laden consumer, retail occupancy rates are not expected to improve dramatically.

Industrials

Energy – We are maintaining our constructive view of oil in 2011 as fundamentals have actually improved from last year when we established our intermediate forecast of $90 per barrel. We are also keeping our subdued outlook for natural gas as prices remain stubbornly below $5 per thousand cubic feet, despite domestic consumption reaching all time highs in 2010. These views on commodity prices contribute to our preference for credits levered to oil in 2011 as was the case in 2010. We believe Integrateds (companies with exploration & production and refining & marketing) and Independents (companies with only exploration & production) levered to oil are likely to report similar results in the upcoming year with more cash flow devoted to capital expenditures and dividends. We anticipate Independents that focus more on natural gas will experience flat margins and cash flow. However, we anticipate more of their cash flow will be directed toward shareholder friendly endeavors rather than capital expenditures as their shares have underperformed oil-levered peers. We have a favorable view of the oil service sector in 2011 for several reasons. First, capital spending by the Integrateds and Independents, the lifeblood of the Service Sector, is expected to increase by 10% in 2011. Secondly, activity in the oil patch is becoming more service intense (i.e., longer lateral drilling, more hydraulic fracturing, deeper offshore, etc.), which results in greater revenue and margins for service companies. Also, the consequences of civil unrest are less for service companies relative to Independents and Integrateds. Lastly, we are cautious on contract drillers due to excess supply created by the moratorium or the non-existent permitting process in the Gulf of Mexico and a substantial number of new rigs entering the marketplace in 2011 and 2012.

Metals/Mining – We expect this sector to outperform in 2011, as most commodity prices remain strong and margins benefit from improved cost structures. Demand across the globe for base metals, especially in China, will remain the main driver of prices. Going forward, we expect a big increase in capital spending, which will be funded with strong cash flow. Debt reduction will become a lower priority and acquisition activity should pick up given strong balance sheets, low rates, and significant growth opportunities. We favor the more diversified companies in lieu of single focused commodity companies, which have more volatile cash flows and hence, more risk in a down market.

Cable/Media – We have become more constructive on this sector, and expect BBB rated Cable credits in particular to outperform. The economy and consumer confidence are strengthening, which is supportive for advertising revenues and consumer spending on telecommunications and entertainment related products and services. The content companies (e.g., Liberty Media-Starz, Time Warner) understand that “cord cutting” (e.g., using Hulu, Netflix, Apple TV to get programming over the Internet) could be damaging to their business models, a risk they had not accurately modeled when entering these agreements. Therefore, they are taking a tougher stance in these negotiations and are being more thoughtful about what rights are being sold into what windows. Conversely, content companies are working more closely with the cable operators to give customers more control over the accessibility of the programming (e.g., video on demand, “TV everywhere”). It’s in the content companies’ best interest to maintain the health of the existing distribution system. We believe the fear of ad skipping has reduced and the fear of cord cutting has increased. Time shifted TV viewing continues to be modest at less than 10% of time spent per Nielsen. We continue to believe this is a risk, at least for programming that is not time sensitive (e.g., dramas), but believe the slow progression will allow the content companies to deal with the issue. Lastly, shareholder pressure has decreased, exemplified by the higher stock prices, due to the reduced uncertainty relating to aforementioned factors. Moreover, acquisitions has been very modest given wide bid/ask spreads and the lack of opportunities. We expect event risk to remain high, but companies are better positioned today with higher cash balances and stock prices. While we expect leverage to increase as company’s are currently underleveraged, we do not believe current management teams are looking to materially increase leverage in a prospective rising rate and uncertain technological and competitive environment. We prefer more diverse media companies (e.g., NewsCorp), chiefly those with strong production studios as the value of content is rising with the proliferation of new technology and devices (e.g., iPad), driving increased media usage and spending.

Cable credit spreads are wide of other BBBs with similar risk profiles, including media credits. They have underperformed over the last few months given the cord cutting concerns and the expectation for new issue supply. Cable operators will be more frequent issuers than media companies given their higher leverage and capital needs, but cash flows should be more stable.

Consumer Products – We expect this sector to underperform and exhibit a heightened level of event risk in 2011. The very large household names, such as Pepsi and Proctor & Gamble, are still doing fine from a fundamental perspective. Having said that, spreads in these bonds are tight and will underperform as the higher yielding credits compress. Smaller sized companies will struggle with higher input costs, intense competition, and a growing and more concentrated retail marketplace. Innovation and consolidation would help offset low growth prospects. We have already seen leveraged buyout (LBO) rumors stir in the market and watched a diversified company (e.g., Fortune Brands) breakup its assets in an effort to extract better value for shareholders. In this sector we like those companies who have completed large debt financed acquisitions and are aiming for higher credit ratings (e.g., Anheuser Busch, Kraft).

Utilities

Electrics – We expect 2011 to be a transformative year for the electric utility sector as the industry gets clarity on several regulatory issues that have stalled strategic initiatives. The Environmental Protection Agency (EPA) will issue its proposed rules for hazardous air pollutants in March with the final rules scheduled for later this year. Additionally, the EPA has indicated that it expects to issue clean water proposals in March with final rules expected in mid-2012.

The implications to the industry are enormous as utilities will decide on retiring and or upgrading coal fired plants (up to 15% of coal plant capacity could be retired), which could lead to regulatory driven demand for natural gas plants. This comes on the heels of many efficient natural gas fired plants supplanting older inefficient coal plants in the past year due to natural gas/coal economics.

As we suggested earlier, outside of financials, we expect excess returns to be driven from BBB rated credits, which does not bode well for the higher rated, regulated first mortgage bonds of the electric utility sector. Additionally, our lackluster view of natural gas, the marginal fuel in most major competitive power markets, suggests that unregulated power providers probably will have another rather weak year.

Pipes – We have a favorable view of the BBB-rated Utility sector, largely due to our expectation of a reasonably positive year from the Pipelines/MLP (Master Limited Partnership) sub-sector, which currently trades wide of its historical average. We see several factors contributing to the strength in the sector for the upcoming year. First, for non-fee based MLP businesses, performance generally tracks the U.S. economy, which we expect to grow by 3% in 2011. Secondly, several recently completed multi-billion dollar projects (Fayetteville Express, Gulf Crossing, Midcontinent Express) will begin to generate substantial cash flows this year. Thirdly, the massive build out of the past five years will slow and more capital will be devoted to maintenance projects. This should allow credit profiles to stabilize or improve in 2011.

Technicals

We believe Technicals will remain supportive for spreads. We are expecting new issuance to be down slightly versus 2010, with Financials dominating the calendar. Yankee issuers are also expected to be prevalent. Gross new issuance for 2011 is expected to be down about 14% to $565 billion. Financials are expected to be unchanged at about $310 billion while Industrials are expected to be down 31% to $205 and Utilities (Electrics and Natural Gas) unchanged at $50 billion. Within Financials, Yankee Banks are expected to be about 52% of the total, issuing about $160 billion in new debt. Within Industrials, increases are expected only from Capital Goods (+33%) and Technology (+13%). Capital spending is forecasted to be relatively unchanged, merger and acquisition activity should be higher, debt tenders and opportunistic interest rate related issuance should be lower, and some sectors are benefiting from the bonus depreciation provision in the recent tax bill, reducing their issuance needs (lower cash taxes increases free cash flow). Merger and acquisition activity will be the wildcard this year with respect to changes in the issuance estimates. We expect companies will continue to raise dividends and repurchase shares, reducing their large cash coffers. The secondary market has been active as well despite a more difficult market in which to buy bonds, as dealers hold less inventory due to more stringent regulatory requirements.

Investor demand continues to be robust for Corporate bonds. International demand is increasing but remains quite low relative to past periods (Exhibit 6). Asian demand in particular has increased for high quality, longer duration Corporate bonds. Retail investors have been selling Municipal bonds, possibly decreasing any selling pressure on Corporates as a fixed income asset class in the face of rising rates and an increased appetite for risk. Investors have been concerned about an asset allocation shift from fixed income into equities which could place pressure on Corporate spreads. However, we have yet to see this transpire. The tight supply of bonds and the demand from insurance companies, foreign investors and traditional buyers should limit the impact on spreads. Another risk in the near term is a shift from Corporates into Municipals; however, the lack of supply in that Municipal market limits the downside.

Exhibit 6 Source: Department of the Treasury

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.

2010 in Review

The Corporate market as represented by Barclays Capital Corporate Index posted positive excess returns of 229 basis points (bps). While it pales in comparison to the 2,276 bps of excess return earned last year, it is higher than the 10-year average of 78 bps. The excess return was driven more from the carry associated with the wider than average spread and less from spread tightening (14 bps).

The Finance sector outperformed strongly with 326 bps of excess returns versus 175 bps for Industrials and 181 bps for Utilities. Finance spreads compressed versus Industrials and Utilities, sectors that outperformed last year. The 5 to 7 year part of the Corporate maturity curve outperformed (+343 bps excess returns) and 10+ year underperformed (+1.76 bps). From a total return perspective, the long end outperformed as Treasury yields fell (Exhibit 1) and spreads only widened 1 basis point (Exhibit 2). In summary, performance largely came from A and BBB rated Financial issuers, BBB rated Industrial issuers and/or bonds in the middle of the curve (5 to 10 year maturities). That said, it was a good year overall as the vast majority of Corporate sectors posted positive excess returns.

Exhibit 1: Change in Treasury Yields in 2010

Source: Bloomberg

Exhibit 2: Change in Spreads in 2010 (basis points)

Source: Barclays Capital

Going into the second quarter, spreads widened mid-year after the U.S. economy’s recovery was questioned. The stock market dropped on European concerns, consumer and business confidence waned and economic data releases were weaker than expected. The spread rally began in August after the Fed reiterated its support, which would later become “QE2” (Exhibit 3).

Exhibit 3: Barclays Corporate Index Option Adjusted Spread (OAS)

Source: Barclays Capital

2010 was a year that was largely in line with our expectations. Specifically, the Corporate bond market posted positive excess returns, and economic growth was weaker than economists were forecasting earlier in the year. The economic and political uncertainties caused companies to be defensive, hoarding cash in lieu of expansion and/or distributions to shareholders. Profits for investment grade companies were better than expected, as revenues grew, costs remained highly scrutinized and productivity increased. Companies invested in technology and took advantage of lower interest rates to refinance debt. Excluding Energy, cyclical sectors outperformed the more defensive Industrial and Utility sectors due to their wider spreads entering 2010, reflecting the economic uncertainty especially relating to the consumer (Exhibit 4).

Exhibit 4: Sub-Sector Performance in 2010

Source: Barclays Capital

Most banks returned to profitability as a result of improving asset quality and falling credit costs.  However, top-line revenues were challenged by weak loan growth, low interest rates, subdued capital markets activity levels and restrictions on fees for overdraft and interchange imposed by the Dodd-Frank Act.  Our view of this sector as providing a source of outperformance due to wide spreads and improving fundamentals was borne out over the course of the year.  However, the combination of macroeconomic uncertainty and continued headline/event risk (e.g., SEC inquiries/mortgage-related litigation/regulatory risks) made this one of the more volatile sectors, despite its outperformance over the course of the year.

The European contagion that many feared late in the spring of 2010 is a risk that remains unresolved.  While U.S. investors tend to underestimate the political will power of Europe’s elected leaders to sustain the European Union (EU) and the common currency, the underlying structural deficiency of a common currency without an integrated fiscal policy must ultimately be addressed.  Until it becomes clearer whether the EU’s structural issue will be addressed in an organized or disorganized manner, bank, utility and telecommunication credit spreads will remain wide for those issuers domiciled in the peripheral countries (most notably Spain, Italy, Portugal, Greece and Ireland).

In terms of idiosyncratic events, the most significant was the Macondo oil spill in the Gulf of Mexico.  The most liquid ten-year bond from British Petroleum (BP) was quoted at a spread to Treasury of 25 bps pre-Macondo spill and widened to 450 bps in late June 2010 when rumors of a BP bankruptcy surfaced.  However, those bonds have recovered the majority of the spread widening (now 75 bps over the Treasury) as BP has established the liquidity necessary to meet any cash calls in the near term.

Bonds issued by other involved parties witnessed similar volatility.  The most liquid ten-year bond from Anadarko, a partner with BP in the Macondo well, was quoted at a spread to Treasury of 110 bps pre-Macondo spill and widened to 570 bps in late June 2010, when it was downgraded to Ba1 by Moody’s.  Recent rumors of a possible acquisition of Anadarko have helped this bond recover to 170 bps over the Treasury.  The most liquid ten-year bond from Transocean, the contract driller at the Macondo well, was quoted at a spread to Treasury of 62 bps pre-spill and widened to 500 bps over the Treasury in mid-June.  The bond is now quoted at 153 bps over the Treasury as the market is comfortable that the contract driller will be able to meet any penalties or negotiated settlements and maintain solvency.

From a technical perspective, demand remained high for Corporates despite dealers reducing their inventories of Corporate bonds (Exhibit 5). Mutual fund inflows into high grade Corporates remained very strong in 2010, increasing 16.7% per AMG Data Services, as investors rotated out of money markets and into riskier asset classes once again. U.S. life insurance companies increased their holdings of corporate bonds as of September 30, 2010[1], owning more than $2 trillion for the first time.

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).

On the supply side, gross new issuance for 2010 was $659 billion, which was nearly unchanged versus 2009 and about 32% higher than estimates. Issuers took advantage of attractive rates to refinance future maturities as well as investors’ continued appetite for Corporate credit. While gross issuance was unchanged, net new issuance, which includes maturities and redemptions, was down 15% to $422 billion. With respect to sectors, Financial issuance led the charge up 52% ($313 billion) versus 2009. However, Industrial issuance was down 23% ($295 billion) and Utility down 27% ($50 billion).

Exhibit 5

Source: Bloomberg

In summary, despite the economic uncertainty, regulatory and political issues around the world, and Macondo spill, 2010 was fairly benign for the Corporate market. The standard deviation of the OAS last year was 13 bps versus a mean of 170 bps for the Barclays Capital Corporate Index. This compares to a 10-year history of 110 bps and 174 bps respectively. Even the 10-year period from 1997-2007, which excludes the financial crisis, was more volatile at 45 bps versus a mean of 129 bps. So, what do we expect for 2011? We will answer that next month.

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] Federal Reserve

If You Build It, Will They Come?

The elevated mood of the markets continued in October. The Corporate bond market, using the Barclays Corporate Index, generated 55 basis points (bps) of excess returns in October with all maturities posting positive excess returns, and the long end finally outperforming (99 bps long vs. 39 bps intermediate). This has not been the case for most of this year, as reflected in Exhibit 1. The long end has negatively affected the overall market return. Corporate treasurers have been taking advantage of the low yields and improved market sentiment, as new issuance has been very robust over the last couple months. We expect this trend to continue throughout 2011. We believe the deleveraging is largely completed, and companies will look to issue next year primarily to refinance maturing debt and fund acquisitions and shareholder friendly actions.

Exhibit 1

 Source: Barclays

Typically, in December, we provide a recap of corporate supply for the year and a preliminary forecast. This exercise is important for portfolio managers to proactively manage their credit and industry exposures along the Treasury curve. And, at times, supply is a primary driver of spreads. This has been the case over the past two months. To review, investment grade new issue supply was much greater than expected in 2009 as: 1) deals were pushed back following a 2008 shutdown, 2) companies sought to term-out short-term debt and commercial paper, and 3) spreads, at historical wides, were very attractive to buyers. The original estimate for 2009 was for new issuance to drop by 38%. However, due to the above factors, supply increased by more than 50%. Yet, the heavy issuance was easily absorbed. For 2010, like the beginning of 2009, it was expected to see lower supply due to: 1) higher rates, 2) increased cash balances at corporations, 3) improving corporate profits, and 4) low refinancing needs. The estimate for this year was for gross new issue, excluding noncorporates/144a, to be down 24% (including noncorporates/144a down 18%). However, supply will again be higher than estimates, as reflected in Exhibit 2.  

Exhibit 2

Source: Barclays

There has been about $560 billion in gross new issuance (excluding noncorporates/144a) this year. Annualized, that would make 2010 about 2% higher than 2009 and about 34% higher than the 2010 estimate. However, the breakdown by sector is important. The majority of issuance this year has been in Financials, as seen in Exhibit 3. Annualized, Financial issuance will be up 59% this year while Industrials and Utilities will be down 25% and 28%, respectively. Meanwhile, Financials will make up 50% of the 2010 gross issuance while Industrials will be 43% and Utilities 7%. Why is this important? Fixed income investors need diversification, particularly as allocations to high grade Corporates have remained heavy throughout 2010. Exhibit 4 shows the allocation to Corporates in High Grade mutual bond funds while Exhibit 5 shows how insurance companies have been struggling to deal with the lack of diversified credit supply, having to allocate more of their heavy cash balances to Treasuries. At the end of the third quarter this year, High Grade funds and insurance companies together held about 40% of outstanding high grade bonds.

Exhibit 3

Source: Barclays

Exhibit 4: Allocations to corporate bonds within High Grade bond mutual funds

Source: Company filings, JP Morgan

Note the Barclays Capital Aggregate Index is comprised of 19% Corporates, 36% Structured Products, 46% Treasuries and other government bonds

Exhibit 5: Insurance Companies are Struggling to Deal With This Lack of Credit Supply, Increasing Demand for Treasuries

Source: NAIC Statutory filings, JP Morgan

Note: Corporate Credit includes both High Grade and High Yield bonds; Structured Products include ABS, CMBS, and RMBS; Mortgages = Mortgage Loans

Supply seemed to come in clusters this year. Yet, it was easily absorbed. Exhibit 6 shows the 2010 monthly gross issuance versus 2009, while Exhibit 7 depicts the 2010 monthly net (including maturities and redemptions) issuance versus 2009, along with spread performance of the Barclays Corporate Bond Index. Focusing on the two busiest months this year, March and September, we see that spread performance was actually positive (e.g. spreads tighter) both months. March 2010 saw $67 billion of net new issue but spreads were 23 bps tighter on the month. September saw $86 billion of net new issue and spreads were 11 bps tighter. Yet, spreads were wider in April, May, and June when net new issue was slow. Macro factors concerning slower economic growth, sovereign credit risk, and financial sector regulation occupied the market’s psyche during this period. These underlying factors drive both issuance and spreads, which is why one cannot prove a causal relationship between supply and option adjusted spread (OAS). If one regresses supply with OAS, it is a positive relationship and statistically significant, but supply does not explain the movement in OAS (a low R squared). As more variables are presented, supply becomes statistically insignificant and the relationship is negative.

Exhibit 6

Source: Barclays

Exhibit 7

Source: Barclays

The $560 billion issued this year is about $56 billion per month or $14 billion per week. As of this writing, there is only about 6 more weeks left in 2010 for active markets. As such, we may see only about $84 billion more in gross issuance, which would put 2010 at $645 billion or down about 2% versus 2009. However, as fixed income investors remain overweight credit, we expect any remaining supply to be easily absorbed. It is still too early for 2011 projections as our team is still pouring through third quarter earnings announcements and company estimates. However, the early read shows that gross issuance could be flat to moderately higher versus 2010.

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. 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.

How Contagious is It?

The Corporate market experienced a modest pullback in late November driven by credit spread widening associated with concerns surrounding Europe, wiping out the positive excess returns for the month. We reduced our European credit positions prior to the widening, namely regulated entities in the region (Exhibit 1).

Exhibit 1

Source:  Barclay’s; Note: 10-year bonds

We have witnessed European governments not only raising costs for the banks, but non-financial companies as well. For example, in regard to the utility sector, Germany proposed a nuclear fuel tax and Spain postponed its scheduled tariff increase and embarked on a wholesale review of the electricity sector’s costs. Moreover, the Greek government imposed special contributions on Greek profitable entities calculated on their total net income for the fiscal year 2009 based on a progressive scale up to 10% of their total net income. Regulated entities are particularly vulnerable not only due to revenue pressure, but also because they have high operating leverage and are very large employers. Therefore, as revenues are pressured by miscellaneous levies and the sour economy, costs are not easily adjusted to protect profit margins. In addition, credits that benefit from ratings uplift due to sovereign support are experiencing credit rating downgrades as sovereign ratings are downgraded and/or notching is widened (between the sovereign and credit), with support being viewed as less likely given governments’ reduced financial flexibility. Our optimism earlier this year has clearly waned regarding Europe. We await important events this week such as the European Central Bank’s Long-term Refinancing Option (LTRO) full allotment decision and Portugal and Spain debt issuance, but appreciate the market’s concern, which is chiefly how the underlying structural problems will be addressed.

Except for the banking sector and select European utility and telecom credits, we have not witnessed broad based spread widening or systemic risk increasing in the Corporate market. While the stock market has sold off modestly, three-month Treasury-bill Eurodollar (TED) and LIBOR Overnight Indexed Swap (OIS) spreads have remained low (Exhibits 2 and 3). We would expect this to continue unless the market’s fears concerning Spain or other large sovereigns (e.g., Italy) are stoked.

Exhibit 2

Source: Bloomberg

Exhibit 3

Source: Bloomberg

We remain constructive on Corporate credit, but at current spread levels, credit selection is paramount. Spreads for high quality credits are tight, yields are low, and while BBB Industrials are attractive given the stabilization of the U.S. economy (see Exhibit 4), we are investing carefully given our expectation for continued high spread volatility.

Exhibit 4

Source: Barclays

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. 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.

How Should I Spend My Cash?

While not as strong as the equity market, the investment grade credit market as represented by the Barclays Corporate Bond Index posted positive excess returns in September (78 basis points (bps)).  This returns the Index, once again, to positive territory for the year (39 bps).  Despite the positive excess returns in 2010, idiosyncratic (firm specific) risk remains high, as reflected by the histograms in Exhibit 1.  Although the means of excess returns from 2010 and 2006 are approximately the same, the volatility is almost three times greater so far in 2010.  The outperformers in 2010 have been primarily finance credits, while the underperformers reside in many different industries.  We expect idiosyncratic risk to remain high for the next 12-18 months and anticipate companies to become more active with their large cash coffers.  Unlike 2009-2010, where sector/industry selection was key for outperformance, we expect credit selection and the ability to wait for new issues will be the keys for outperformance going forward.

Many economists are citing the large cash balances on company balance sheets as a source for economic stimulus.  We believe the peak of the cash balances may be the second half of 2010.  After the setback experienced in the second quarter of 2010, consensus seems to be forming around a slow growth economic environment.  The probability of a double dip varies depending on the economist, but even a bear like Dr. Nouriel Roubini is assigning a 40% chance compared to others that are in the 20-33% range.  The Federal Reserve’s recent actions and comments also serve to reduce the economic uncertainty.  This leaves regulatory and political uncertainty, acting as implicit costs for companies.

In this environment of low growth and political sensitivity towards the economy, we expect companies will start spending their cash.  That said, we expect the cash to be spent primarily on the following in lieu of growth related investments which would provide more of a catalyst for hiring (not in any particular order):

• Capital spending related to productivity enhancements
• Repurchasing shares and/or debt
• Increasing or initiating dividends
• Mergers and acquisitions (M&A)

Technology related companies are among those that have benefited from the investment in productivity.  For instance, in its recent investor meeting, Kroger, a retail supermarket chain, commented that its current capital expenditure strategy continues to focus on projects that will either help drive improvement in sales productivity or costs versus spending on new development.

We expect more companies to make announcements relating to share repurchases or increased dividends.  Cisco, a global technology company, was not alone in its plan to issue the company’s first dividend.  Companies have also been active in tendering for short maturity, high coupon, or structurally superior debt or using cash to retire maturing debt in lieu of refinancing.  This is being reflected by the banks as well, with corporations reducing their revolving credit facilities.  Total commercial and industrial loans outstanding for the U.S. banking system fell 23% from January 2009 through August 2010, while the amounts drawn under the revolvers fell from 42% to 35% during the same time period.

Lastly, mergers and acquisitions (M&A) appear to be picking up after companies paused in the second quarter of 2010 to assess the sovereign and economic risk (Exhibit 2).  Given the backdrop of low economic growth, we expect the M&A pace to accelerate as regulatory and political uncertainty decreases.  Most sectors are participating in M&A for consolidation benefits relating to synergies, as opposed to investing in revenue growth opportunities.

At an equity telecommunications/media conference in late September, Verizon’s CEO, Ivan Seidenberg, stated he expected another consolidation wave over the next three to five years among content, cable, and telecommunications companies given the overcapacity.  At this same conference, AT&T’s CEO, Randall Stephenson, was more positive towards M&A after shying away earlier this year given the regulatory risk.  Although this is one industry that is ripe for consolidation, such M&A could lead to spread widening due to cash deals and the debt issuance and leverage that would result.  Another industry that is faced with too much supply for the level of demand, in addition to heightened regulatory risk and the associated costs, is Banking.  We would expect consolidation to accelerate in this sector as well via acquisitions made by both domestic and international banks.  However, this is likely to be dominated by FDIC assisted deals in the near term.

Although good for the long term, these activities are first, not conducive to job growth in the near to intermediate term and second, will likely face mixed reactions from investors and rating agencies as not all will be creditor friendly.  Debt issuance relating to M&A should be readily absorbed as investors continue to look to investment grade credit as a defensive investment alternative.  As companies deplete their cash coffers, we expect investments to be made within current rating parameters.  However, this lessens financial strength and flexibility in an environment where the risk of a double dip is not miniscule.  For companies that are cyclical and have volatile cash flows, fixed income investors should be cautious of management teams that are too aggressive at this stage of the recovery.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.
 
This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates.  It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists.  Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient.