Corporate Credit

Strong Start to the Year

The Positive Role of the LTRO

Risk assets have rallied in 2012, fueled by European Central Bank (ECB) stimulus via the Longer Term Refinancing Operation (LTRO). The liquidity provided by the LTRO gives banks and sovereigns more time to deleverage their balance sheets, avoiding a liquidity crunch and softening the impact to the economies of such deleveraging. Importantly, the increased liquidity has reduced the risk of a bank failure in the near term, decreasing the likelihood of a sovereign bailout of such banks, thereby decreasing sovereign risk. In effect, the LTRO has reversed the negative feedback loop in the second half of 2011.

Certainly, tail risk that existed prior to  the LTRO has fallen. And, as the costs of a Greek bankruptcy and departure from the European Union are increasingly externalized to the European core, the likelihood that the core allows Greece to default decreases. Accordingly, the risk premium in Investment Grade credit associated with Europe has fallen (we wrote in our 2012 Outlook[1] that it was approximately 60 basis points (bps) or one third of the market Option Adjusted Spread at that time). Corporate spreads year-to-date as of February 29, 2012 have tightened 53 bps, with Finance outperforming (92 bps tighter) Utilities (26 bps tighter) and Industrials (37 bps tighter). Spreads have tightened to the mean over the last year (Exhibit 1).

Exhibit 1

Source: Barclay’s Capital, AAM

Sovereign Risk Has Not Disappeared

Liquidity aside, risk remains in Europe over the next 12 to 18 months mainly due to the likelihood of weaker than expected economic growth, resulting in missed deficit targets, etc, possibly creating another funding crisis for the sovereigns of mainly Spain and Italy, igniting systemic fears. Spain recently announced that it will miss its deficit target and the market took it in stride. We are aware that the market’s expectation is for growth in the Eurozone to improve after a weak first quarter in 2012; therefore, we believe that the second half 2012 will be the appropriate time to test the market’s response. The unknown is how growth will be affected by the austerity measures and resulting political action. Eurozone leaders have strongly indicated that they will continue to provide financial support as long as a funding country remains committed.

Secondly, Ireland and Portugal debt restructuring fears are likely to re-emerge. Portugal will need to access the debt markets in the second half 2012 to pre-fund its September 23, 2013 maturity (IMF (International Monetary Fund) involvement requires funding assurance twelve months ahead). Eurozone leaders have been adamant that PSI (Private Sector Involvement) is unique to Greece and should not be expected for other countries, and willing to be patient as long as Portugal remains committed. This is something the market will likely test especially if Portugal’s progress is underwhelming. That said, we understand the incentives Eurozone leaders have to keep this contained, mainly the fear that would spread again to Spain and Italy.

In summary, we acknowledge the reduced sovereign and thus systemic risk in the near term, but remain concerned about this risk in the intermediate term. Economic growth and greater fiscal integration is critical for this risk to be contained. While economic growth in emerging markets and the U.S. may prove beneficial for European exports and ultimately growth, the Middle East tensions and the rising price of oil is a concern for Europe’s progress as well as the rest of the world.

Higher Risk Corporate Securities Have Outperformed

In the Investment Grade Corporate market, we have seen the risk premium for European credits fall this year, as investors take advantage of the near term respite from sovereign related volatility. Similarly, lower rated credits have outperformed as well as Financials (Exhibits 2-5). Investors are not looking to increase yield by moving out the curve, fearful of a rise in Treasuries. With spreads of intermediate maturities falling more than long, credit curves remain fairly steep. Broker/dealer inventories remain very low; therefore, it is not surprising that new issue Corporate deals have been in high demand. New issue concessions have fallen to levels witnessed in bullish market environments, and deals are greatly oversubscribed.

Source: Credit Suisse LUCI Index, Barclays Capital, AAM

AAM’s View of the Market Remains Cautiously Optimistic

Over two thirds of companies have reported financial results, and while the fourth quarter was lackluster as expected, management forecasts (albeit lighter than usual on details) were constructive and comments about first quarter have been quite positive. For instance, capital expenditures forecasted for 2012 have increased 5% over the last two months for virtually all industries, especially those that are most meaningful (Energy, Metals & Mining, Telecom).

We remain prepared for another year of heightened market volatility given the risks and the very low rates of economic growth forecasted for countries around the globe. The technical environment is modestly negative right now after a strong rally and the expectation for a heavy new issue month in March. Corporate securities have performed well so far (Exhibits 6 and 7), reaching the tighter end of our “fair value” range. In particular, we have seen outperformance from Insurance, Energy – Refining and Oil Services, Pipelines, Media and Finance as well as subordinated bank securities.

Our focus year-to-date has remained one of defensive optimism. We are avoiding Europe, low quality investment grade companies, and companies that will struggle to grow in the near term. As well, we are neutral on banks, investing in those that are higher quality with a domestic focus, while avoiding brokers and finance companies (excluding GE). We are very mindful of expected volatility, investing in securities we believe will produce the highest risk adjusted returns.

Exhibit 6

Exhibit 7

Source: Credit Suisse LUCI Index, AAM (Note: the Electric Utility and BBB Telecom sectors are heavily

Weighted towards European issuers in the LUCI index); Data as of March 1, 2012.

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

[1] AAM Corporate Credit View – January 2012

2012 Outlook

Overview

Performance in 2011 departed from our outlook of positive excess returns largely due to the heightened systemic risk emanating from Europe, causing a flight to quality rally. In 2012, we expect spread volatility will continue, as Europe remains in the headlines, affecting economies in Asia and the U.S. Although not what we expect, a fracturing of the European Union (EU) is certainly a possibility with some economists[1] using it as their base case. We anticipate investor concern will reignite, stemming from weaker than expected economic growth, debt restructurings (Greece, Ireland, Portugal) and resistance to more austerity.

We are selectively positive on Corporate credit given our expectation for ECB support and low defaults in the U.S.

Our base case is that the EU remains intact after debt monetization by the European Central Bank (ECB) due to the high direct and indirect costs to Germany and France of a departure; however, we do not believe this intervention will be immediate. Therefore, we are expecting spread volatility to be similar or higher than 2011. We recognize company fundamentals are very strong and the U.S. economy continues to grow albeit at a low rate. That said, the downside risk (which is largely political) and overall vulnerability of economic growth coupled with high sovereign debt levels tempers our optimism. We are selectively positive on investment grade Corporate credit and are avoiding Europe, growth challenged sectors and low quality credits. Our view is the market is fairly valued, and risk adjusted income is particularly attractive in higher quality BBB cyclical Industrials, pipelines, domestic banks, and REITs. Although fundamentals may have peaked last year, we believe the uncertainty associated with Europe will cause most management teams to remain cautious when deploying capital and committed to a strong and liquid balance sheet.

From a technical standpoint, our views are mixed. Although we expect a healthy new issue calendar and dealer inventories of corporate bonds are low, investors have increased their overweight to U.S. corporate credit[2] and the cost of liquidity associated with the Volcker Rule could be significant. We are less bearish on long duration Corporate bonds than this time last year due to the spread widening and slight steepening of the credit curves (10 year to 30 year spread basis widened by approximately 10 basis points), but we continue to prefer the intermediate part of the curve due to the anticipated market volatility and current spread levels.

The Corporate Market Underperformed in 2011

Spreads underperformed in 2011 due to the flight to quality rally as a result of increased systemic and political risk.

Despite the domestic economy and company fundamentals performing as we had expected in 2011, heightened systemic and political risk resulted in a flight to quality with 5+ year Treasury yields falling over 100 bps, and investment grade credit spreads widening 78 bps. Financials underperformed more defensive Industrial and Utility sectors, and longer duration securities performed exceptionally badly, -846 bps of excess return vs. the market’s -367 bps (defined by Barclays Capital U.S. Corporate Index). The differential between BBB and A-rated Industrial credits widened from 74 bps at year-end 2010 to 121 bps, which is wide of its 98 bps historic mean and reflective of the differential in mid-2009. Generally, European financial and infrastructure credits underperformed domestic peers, exemplified by the spread differential (“basis”) between European and domestic banks, widening from 104 to 143 bps per the Credit Suisse LUCI Index. As shown in Exhibit 1, performance did not rest on the macro call alone. The Metals and Mining industry is a good example of credit selection. While Southern Peru Copper, Anglogold (shown in Exhibit 1), and Commercial Metals (which was downgraded to high yield, falling out of the investment grade market) underperformed significantly, BHP Billiton and Rio Tinto outperformed the market.

Despite the domestic economy and company fundamentals performing as we had expected in 2011, heightened systemic and political risk resulted in a flight to quality with 5+ year Treasury yields falling over 100 bps, and investment grade credit spreads widening 78 bps. Financials underperformed more defensive Industrial and Utility sectors, and longer duration securities performed exceptionally badly, -846 bps of excess return vs. the market’s -367 bps (defined by Barclays Capital U.S. Corporate Index). The differential between BBB and A-rated Industrial credits widened from 74 bps at year-end 2010 to 121 bps, which is wide of its 98 bps historic mean and reflective of the differential in mid-2009. Generally, European financial and infrastructure credits underperformed domestic peers, exemplified by the spread differential (“basis”) between European and domestic banks, widening from 104 to 143 bps per the Credit Suisse LUCI Index. As shown in Exhibit 1, performance did not rest on the macro call alone. The Metals and Mining industry is a good example of credit selection. While Southern Peru Copper, Anglogold (shown in Exhibit 1), and Commercial Metals (which was downgraded to high yield, falling out of the investment grade market) underperformed significantly, BHP Billiton and Rio Tinto outperformed the market.

Exhibit 1: Top and Bottom Performers in 2011

Source: Barclays Capital, AAM (Note: Duration and Excess Returns are market value weighted averages of year-to-date figures; Credits included in the Barclays Capital U.S. Corporate Index as of 12/31/11)

Spreads are Wide but Volatility is High

Spread volatility increased significantly in 2012, 40 bps vs. 13 bps in 2010. That said, 38 bps is the average over the last decade. As shown in Exhibit 2, the market is expecting the current rate of volatility to continue. While this is our base case, we believe there is a greater probability that volatility will be higher in 2012. Fiscal problems in Europe and the U.S. remain unsolved while GDP growth rate expectations are fairly dismal, and emerging markets are cooling. Positively, if the year is benign, we could see systemic risk premiums decrease a considerable amount (one third of the market OAS[3]) especially in Financials.

Exhibit 2
Source: Barclays Capital U.S. Corporate Index, AAM

Spread volatility is expected to remain high and defaults to increase in Europe.

One would assume in an environment of rising volatility, especially tail risk, yields would increase to compensate investors. That did not happen for U.S. credit. The very strong fundamentals of domestically domiciled companies and the containment of risk in Europe kept defaults very low in the U.S. (1.5%[4]) and recoveries better than average, yielding a very low loss rate (0.6%). Defaults are expected to increase in 2012 in the U.S. (4.8%) albeit remaining lower than the historic average[5]. Europe should see another year of higher defaults, remaining very vulnerable to bank deleveraging since the banks have provided the majority of credit vs. the public capital markets in the U.S. Moreover, European firms are more leveraged and face lower growth prospects. Therefore, it will be evident in 2012 if the two markets can decouple as many market pundits are expecting. We believe it is very difficult for significant deleveraging to occur and not affect other economies world wide. China, for instance, was a primary beneficiary of the bank expansion in the European Union and the United Kingdom.

 

Supply of Spread Product is Expected to Decrease (Again) in 2012

We expect corporate supply to fall slightly from 2011 levels.

The new issue market for investment grade corporate issuers was active in 2011, but lower than 2010 with gross issuance $630 billion vs. $659 billion. Financial issuance decreased in 2011 due to deleveraging that continued in the U.S. and the buyer’s strike that occurred for European financials in the second half of the year. Industrial issuance was up in 2011, generally related to increased share buyback and merger and acquisition (M&A) activity as well as the continued pre-funding of maturities. Despite the high level of systemic risk and volatility, M&A was up in 2011 ($2.3 trillion globally vs. $2.2 trillion in 2010), and acquisition premiums remained in the low-mid 20% range per Bloomberg. Domestically, corporate fundamentals, liquidity in particular, are very strong, and with low interest rates and weak growth, heightened M&A activity is to be expected.

The new issue market for investment grade corporate issuers was active in 2011, but lower than 2010 with gross issuance $630 billion vs. $659 billion. Financial issuance decreased in 2011 due to deleveraging that continued in the U.S. and the buyer’s strike that occurred for European financials in the second half of the year. Industrial issuance was up in 2011, generally related to increased share buyback and merger and acquisition (M&A) activity as well as the continued pre-funding of maturities. Despite the high level of systemic risk and volatility, M&A was up in 2011 ($2.3 trillion globally vs. $2.2 trillion in 2010), and acquisition premiums remained in the low-mid 20% range per Bloomberg. Domestically, corporate fundamentals, liquidity in particular, are very strong, and with low interest rates and weak growth, heightened M&A activity is to be expected.

We expect 2012 new issuance of investment grade corporate bonds to be $545 billion gross, $250 billion net of redemptions, slightly less than 2011 levels. Since coupon payments for investment grade corporate securities are expected to be $240 billion[6] in 2012, and net supply is expected to be negative for all other spread sectors (Exhibit 3), technicals should be supportive in 2012. We have witnessed increased issuance from European industrial issuers in the high yield market this month. Although less likely in the investment grade market, it could provide an upside to our estimate.

Exhibit 3: 2012 Net Supply Estimate All Spread Product

Source: Barclays Capital, JPMorgan

In addition to falling new issuance, secondary supply has continued to contract with primary dealer corporate bond inventory falling to levels not seen since 2003 (Exhibit 4). We wrote about this dynamic in early 2011[7], explaining the regulatory and structural changes. Market volatility increased mid-year, forcing dealers to reduce positions further. JPMorgan estimates that dealer inventory is now less than 1% of the investment grade market vs. the peak in 2007 of 10%.[8] The reduction of liquidity is a real challenge for large asset managers and insurance companies. Importantly, for asset managers who are able to access both markets, a trader must consider the following when buying or selling bonds: liquidity, amortization of high dollar prices, and curve placement (due to the very steep Treasury curve) to name a few. The uncertainty relating to the Volcker Rule is material, reducing liquidity and widening bid-ask spreads.

Exhibit 4: Dealer Inventory of Corporates With a Maturity of Greater Than One Year

Source: Bloomberg, AAM

Sector Outlooks

Banks – Fair (Prefer U.S., Avoid Europe)

The Bank sector is left facing unresolved macro-political headwinds in 2012. The dual uncertainties of political/regulatory risk in the United States and sovereign crisis in Europe completely overshadow a continued strengthening of underlying fundamentals. These persistent macro-political risks, as well as our more cautious outlook for economic growth in 2012, have led us to lower our sector view to “Fair” from “Attractive.” We continue to prefer strong domestic banks and avoid those in Europe and Asia. Furthermore, while the regulatory reforms enacted over the past two years have the potential to transform the sector into a much more stable, utility-like sector, the high-beta characterization of the sector was affirmed in 2011 and should be assumed to continue over the intermediate-term.

Real Estate Investment Trusts (REITs) – Attractive

This sector is largely domestic, benefitting from the economic recovery, low interest rates and lack of new construction. We have preferred apartment and central business district (CBD) office REITs vs. retail, healthcare, and warehouse. While economic uncertainty in the second half of 2011 has weighed on spreads, fundamentals for the sector are much stronger than they were heading into 2008. REITs have materially improved liquidity, balance sheet leverage, occupancy and net operating income over the past three years, making the sector more attractive on a stand alone basis, and leaving public REITs much better positioned vs. private real estate owners as new properties become available. While heavy recurring funding needs are an ever present concern for the sector, most REIT issuers have successfully entered/renewed credit lines on favorable terms over the past six months, and liquidity availability is reasonable relative to maturity and operating needs over the next twelve months. We believe this sector offers attractive value especially versus lower yielding CMBS and BBB cyclical Industrials.

Insurance – Fair

Risks for life insurance companies increased last year, as equity volatility and systemic risk increased and the prospect for rising yields in the near term dimmed. Operationally, property and casualty companies performed worse than expected given the higher level of claims. This should normalize, increasing the prospect for improved pricing. Fundamentally, we continue to prefer the health insurance sector. Notwithstanding the new legislation, this sector is highly profitable with structural benefits. In this environment, we prefer only the highest quality companies and senior positions in the capital structure.

Basic Industries – Fair (Prefer Strong BBBs)

Chemicals – This sector has reduced its cyclicality by becoming more of a specialty products industry where pricing power is easier to maintain. It benefits from its limited exposure to Europe and growth from the U.S., Asia and Latin America. This coupled with the benefit of lower natural gas prices for North American chemicals allowed us to become more positive on the industry. The sector outperformed last year, and we view it as fairly valued with a risk adjusted income profile similar to the broad Industrial Index.

Metals/Mining – As mentioned earlier in the article, this sector is a combination of diversified and pure play companies; therefore, commodity price forecasts and geographic exposures (including an assessment of political risk) are important factors in the analysis. Metals prices were very high coming into 2011, and as they dropped, pure play companies underperformed. We prefer the diversified operators because of this volatility, and the reduced probability of balance sheet damaging, transformational acquisitions. Moreover, with China comprising approximately 40% of the demand for metals, its continued growth is critical. Spreads widened in 2011, taking into account the concerns about slowing economic growth especially in China. We expect this sector to remain volatile, preferring the higher quality, diversified operators.

Capital Goods (Avoid credits reliant on government funding)

Aerospace/Defense – This sector underperformed last year, as risk premiums were assigned to reflect the pressure on revenues due to the defense spending cuts forecasted which will impact credit metrics. We expect lower top line growth in addition to compressing margins from more competitive pricing to challenge management teams and increase event risk and shareholder friendly actions. Despite the spread widening, we remain negative on this sector, expecting downward rating migration.

Construction Machinery and Diversified Manufacturing – U.S. manufacturing remains solid as reflected by indications of expansion through favorable PMI (Purchasing Manufacturing Index) readings since 2009. Companies in both sectors are highly rated, and diversified, geographically and by end market. Weakness in Europe should be offset by especially strong growth in mining and agriculture. We expect companies to finance acquisitions conservatively to preserve their ratings due to the necessity of funding working capital. Spreads are tight relative to other Industrials, but we believe this is appropriate given the fundamental outlook and positive technicals (little issuance).

Communications (Prefer Media and high quality Telecom)

Telecommunications – This sector continues to converge with media and telecom operators becoming more interdependent. We remain negatively disposed to the European telecom operators due to ratings risk, revenue and margin pressure from economic malaise and pro-consumer regulatory changes, and compressing free cash flow as EBITDA remains flat or decreases while dividends are high and capital spending needs to increase. In North America, especially the U.S., we believe consolidation is imperative as there are too many operators for a maturing industry. We are only investing in the largest and strongest due to these structural challenges that will pressure fundamentals for all.

Cable – In 2012, we expect the cable operators to get more aggressive with marketing their broadband service and new video interface technology to help them retain customers. That said, we believe if the consumer remains weak, voice revenues will remain under pressure and we could see DVR and other premium services get canceled as new technology is utilized (e.g., internet/video on demand instead of DVR). Capital spending is not going up, and continues to fall slowly which is good for equity holders. That said, companies are looking to consolidate the industry, so that will be a use of free cash flow and balance sheet capacity. Accordingly, we don’t expect the cable companies to reduce leverage in 2012 but to remain within ranges consistent with their rating categories. Given the high degree of operating leverage, we are largely avoiding the sector until this uncertainty is reduced.

Media/Entertainment – Benefitting from the Olympics and elections in 2012, advertising growth is expected to exceed GDP growth. Even though media is a cyclical sector due to its reliance on advertising and is exposed to the consumer via products, film entertainment (movies, DVDs) and theme parks, the fees they collect for content provide a revenue stream that should be resilient in a soft economy. The media sector benefits from its low capital intensity, and as we saw in the last recession, companies increase their financial flexibility by slowing share repurchases and M&A. They have improved their balance sheets over the last five years, operating with more discipline from a cost perspective. We believe media companies are best capitalized as BBB entities, requiring financial flexibility to invest in content creation. Spreads widened last year, and with the favorable forecast for advertising, we believe the sector should outperform other cyclical sectors this year. That said, companies differ in regards to exposure to various segments of the media market. We prefer those that produce content for television and are geographically diversified (skewed towards growth markets) with strong brands. We are avoiding companies with exposure to “old media” like textbooks, newspapers, and radio due to the technology and secular changes taking place.

Consumer Discretionary – Unattractive

Consumer Products – This is a mature sector with highly rated, diversified companies. Investors view it as one that is defensive despite the high level of event risk. Companies have benefited from growth in developing economies, and as global growth slows, we are concerned that it will result in leveraging M&A and/or shareholder friendly actions. That said, many companies rely on the commercial paper market to fund working capital, providing management with a real incentive to remain focused on their ratings (A1/P1 requires mid-A ratings at a minimum). Credits in this sector have very low yields, and we believe the risk adjusted income is not attractive relative to other investment alternatives.

Food/Beverage – Another defensive sector with similar characteristics and challenges as Consumer Products. Although commodity prices are down from their 2011 highs, we expect them to remain volatile and pressure margins if pricing gets challenged by consumers. We invest in companies that have recently entered into a large transaction, have significant advantages in terms of brand equity and/or are large and diversified with power over both suppliers and customers. Spreads are inside of the Industrial Index, appropriate in our view, but given our expectation of heightened event risk, we remain buyers on this new issuance.

Pharmaceuticals – This industry has performed very well with strong free cash flow and balance sheets. The patents associated with over $120 billion of branded drugs will expire between 2011-2015. This will pose a challenge for credits lacking diversification and/or a new product pipeline. Replacing lost revenue may result in another wave of M&A, which given already high credit ratings, will be largely debt financed. We prefer those companies that are diversified away from branded drugs and have solid pipelines. Similar to Food/Beverage, we take advantage of new issuance associated with large acquisitions, a trend we expect will continue in this sector.

Consumer Nondiscretionary – Fair

Retail – Holiday sales were better than expected, and luxury sales continued to be supported by a higher income demographic that that recovered more quickly from the recession. In 2012, we expect the consumer to remain cautious. Headlines and market volatility could cause the high end consumer to pause after an active year of spending in 2011. Lower commodity costs are likely to be offset from heavy promotion activity, resulting in very little margin expansion over last year. We expect companies that are underperforming (e.g., Lowe’s, Safeway) to seek shareholder return via debt financed activity. Our bias is to invest in the leaders in their respective categories (e.g., Walmart, Home Depot, Nordstrom’s, CVS), as low economic growth will be sufficient for these operators to perform well.

Energy – Fair to Attractive

Our more cautious outlook for economic growth and expectation for supply coming from Libya and shale offset by a reduction of supply from the Gulf of Mexico are main contributors to our outlook for oil of $85/barrel (WTI). Given this more pessimistic GDP outlook relative to 2011, we expect revenue and cash flow for Independents and Integrated energy companies to be weaker in 2012 versus 2011. Since our view differs from the market, we are taking advantage of the lack of differentiation among credits from a valuation perspective, investing in those we project will have positive free cash flow. Our more defensive bias causes us to prefer the Integrated sector, viewing valuations as attractive for large, diversified operators.

Future revenue and cash flow from the Oil Service sector is dependent on the capital spending of the Independents and Integrateds (collectively, the  “Upstream”).  Our less optimistic view of commodity prices results in a lower revenue projection for the industry. We are forecasting that Upstream capital spending will increase by 5% in 2012, rather than the 10-15% most are expecting.  The reduction in revenue is manageable for most companies from a credit quality perspective. Therefore, despite our more pessimistic outlook, we are investing in the sector, preferring the higher quality oil field service companies (Schlumberger) and those focused on balance sheet improvement (Ensco). Spreads are compelling for the sector today versus Industrials due to the overhang related to the Gulf spill (affecting Transocean) and the lower credit quality nature of the sector (risk premiums increased for BBB Industrials especially deep cyclicals in 2011).

Technology – Unattractive

This sector has benefited from the economic recovery and investment from the business sector to increase productivity. We expect IT (Information Technology) spending to grow at a pace of 4% in 2012, slightly lower than 2011. Less discretionary items (storage, security, servers) should be in higher demand after spending on more discretionary items. We expect the trend of tablet replacement of PCs and data center outsourcing to continue, and for more companies to turn to the cloud for non-critical applications. The lack of risk adjusted income for low quality credits, keeps us investing defensively in this sector. We believe the downside risk is too great in challenged companies such as HP and Dell, preferring to invest in proven leaders with exposure to growth segments such as Oracle and IBM.

Transportation – Attractive: Rails

The structural challenges associated with the airline industry continue, as exemplified by American Airlines bankruptcy last year, causing us to avoid the Airline sector. However, we do like the Railroad sector and have a very favorable view of fundamentals. The industry has benefited from the diversity of product moved on the railcars and ability to gain market share from competition given strong service levels, attractive rates, and regulatory changes. After the recession, the rails were able to accommodate increased volumes without increasing expenses. Credit metrics are the strongest they have been in five years. We expect revenue growth to remain strong in 2012 (6% (4% from pricing, 2% from volume)) vs. the 9% we expect in 2011, as economic growth slows, fewer legacy contracts are renegotiated and price increases are more difficult to implement. Spreads have widened and are attractive relative to where they have traded over the last couple of years. Compelling valuation and our positive fundamental outlook makes this an attractive investment opportunity.

Electric Utilities – Unattractive

We believe fundamentals for 2012 are neutral for electric utilities.  We expect revenue and cash flow to be slightly weaker in the upcoming year based on flat demand, weaker electricity prices and slightly weaker margins.  We expect demand to be flat based on domestic GDP growth of 1%-2% and flat weather related demand. Moreover, electricity prices are expected to be softer based on lower prices for both natural gas and Powder River Basin coal, the raw materials used to generate electricity.  Margins are expected to be flat for regulated utilities, but slightly weaker for unregulated power producers due to weaker power prices and flat operating expenses. From a leverage perspective, we expect it to continue to creep higher as companies are unable to meaningfully reduce debt. Importantly, the regulatory environment is somewhat more certain than it was at this time last year.

Viewed as a defensive sector, the electric utility industry performed very well in 2011. Following the strong results of 2011, the Electric Utility OAS started 2012 at 89% of the Industrial OAS, which is substantially richer than its 1-yr and 5-yr averages, of 97% and 99%, respectively. This has been driven by strong demand for regulated operating company first mortgage paper, which tends to be rated in the single-A category. We prefer to take advantage of the discount currently offered by issuers at the holding company or unregulated operating company, and view the sector largely as unattractive on a risk adjusted basis.

Pipelines – Fair to Attractive

We believe the fundamentals for the pipeline segment are positive. Volumes of oil, refined products, natural gas and natural gas shipments are largely determined by domestic GDP, which should increase slightly. Notably, volumes of natural gas liquids should probably increase faster than GDP growth given the heightened demand from the chemical sector. We believe another positive fundamental is the expanding number of resource basins, which will lead to greater size and cash flow generating capability. Thirdly, we expect balance sheets to continue to improve because many large projects are now generating cash flows after numerous quarters under construction. The one somewhat negative item affecting Master Limited Partnerships (MPLs) is heightened M&A risk. We could see more mergers as the pipeline companies recognize the benefits of diversifying their operations. Spreads widened in 2011, due to the sector’s reliance on external sources of financing. On a risk adjusted basis, expecting volatility to remain high in 2012, we believe spreads are Fair. That said, there are attractive opportunities in our preferred MLPs (Kinder Morgan Partners (KMP), Enterprise Products Partners (EPD)).

Summary of Sector Views

As shown in Exhibit 5, A rated Industrial credit spreads are slightly wider than one year ago with very little differentiation among sectors. Unlike last year when we had more pessimistic views on A rated retailers, consumer product companies, pharmaceuticals and media, after the spread widening that took place, valuations are more in line. We are more favorably disposed to the A rated Energy (Integrated) and domestic Telecom companies in the Industrial segment and continue to prefer domestic banks and Insurance companies within Finance.

Looking at Exhibits 5-7, especially Exhibit 7, it is evident that the basis between A and BBB rated Industrials widened due to the increased systemic risk and default risk in Europe. The spread widening in the Electric Utility, Telecom and Bank sectors was also due to the European credit spread widening. We noted the widening of the European and U.S. bank basis of 39 bps, and this was similar for European and domestic telecom (56 bps).   Spreads have widened, especially for BBB issuers; therefore, the market is pricing in a level of uncertainty related to Europe and economic growth. Our expectation is for heightened volatility but with support from the ECB; therefore, we are investing defensively in the BBB rating category, preferring higher quality companies in cyclical sectors where the risk premiums are more significant. The same is true for Pipelines and REITs.

Exhibit 5

Exhibit 6

Exhibit 7

Source: Credit Suisse LUCI Index, AAM (Note: the Electric Utility Index is heavily weighted towards European issuers in the LUCI index); Data as of January 17, 2012.

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

Michael Ashley
Vice President

N. Sebastian Bacchus, CFA
Vice President

Bob Bennett, CFA
Vice President

Patrick McGeever
Vice President

Hugh McCaffrey, CFA
Vice President

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

[1] Loynes, Jonathan, “European Economics Focus – How and When will the Euro-zone break up?,” Capital Economics, November 28, 2011.

[2] Melentyev, Oleg, Bank of America, “Jan ’11 Credit Investor Survey: Near term bullish,” 4.

[3] Shoup, Jason; Citi “US Credit Outlook 2012 Outlook: Another Year on the Edge”, page 8 (80 of 240 bps)

[4] Verde, Mariarosa; Fitch “US High Yield Default Insight – 2011 Review” page 1

[5] Goldman Sachs “High Yield 2012 High Yield Credit Outlook & Best Ideas” page 1, 12/13/2011.

[6] JPMorgan

[7] AAM Corporate Credit View – May 2011

[8] Beinstein, Eric, JPMorgan “Credit Market Outlook and Strategy,” 5.

Is European Central Bank Monetization the Answer?

Corporate Bonds Underperformed Again in November

It did not take investors long to turn cynical, selling risk assets once again in November. Corporate bonds underperformed Treasuries, widening 41 basis points (bps), generating -288 bps of excess returns in November with Financials posting the worst performance (-367 bps) and Utilities the best (-156 bps) per the Barclays Capital U.S. Corporate Index. Similarly, longer duration bonds (10+ year maturities) suffered most with 47 bps of spread widening, producing -566 bps of excess returns. Not surprising, the worst performing issuers included European credits (Telefonica, Telecom Italia, Eksportfinans ASA[1]) as well as credits with heightened credit risk (Amgen, Jefferies).

This did not keep issuers from the new issue market, as November marked the highest month of issuance from Industrial companies ($59 billion), bringing the gross supply for Corporate bonds to a healthy $75.4 billion for the month or $604.3 billion for the year[2]. Net supply is $352.1 billion year-to-date. This reflects lower Financial issuance, as banks in the U.S. are over funded with deposits and European bank issuance is being shunned by the market.

December is starting off well with excess returns of 71 bps month-to-date as of December 9, 2011 per the Barclays Capital U.S. Corporate Index. That said, the lack of real progress made at the latest European Union (EU) Summit will likely result in waning performance through year-end as liquidity worsens.

Little Solved at the Summit Leading to Negative Rating Agency Press

The statements made from the European Central Bank (ECB) and European Banking Authority (EBA) were among the most scrutinized. The ECB announced that it would substantially increase its liquidity provision to EU banks in order to avoid a liquidity crunch. Included in the announced measures were unlimited three year funding (via its Long Term Refinancing Operation), relaxed collateral requirements, and a target rate cut for good measure. What was not included was a ramp-up in outright sovereign bond purchases through the Securities Market Program (SMP). In fact, European Central Bank President Mario Draghi explicitly repeated that the ECB would not act as the back-stop lender to the sovereigns, and he re-emphasized that it was up to the national leaders to come up with a fiscal solution to a fiscal problem.

The seventeen Euro members agreed in principal to a new treaty, outside of the framework of the existing EU treaties which preceded them.  The new treaty would enshrine greater fiscal integration and automatic penalties for those that violate budgetary rules (to be administered by the EU bureaucracy).  Specific details will be forthcoming by March 2012, and nine of the ten non-Euro members of the EU will likely also be signatories to the new proposed treaty (the United Kingdom has explicitly rejected further integration, very much in keeping with past precedent, citing encroachment on its sovereignty).  Additionally, the EU central banks also agreed to contribute €200 billion, via the International Monetary Fund (IMF), in order to supplement the remaining capacity in the European Financial Stability Facility (EFSF), which was roughly €250 billion. Lastly, the EU leaders agreed to move forward the debut of the permanent replacement for the EFSF, the €500 billion European Stability Mechanism (still unfunded).

Standard & Poor’s and Moody’s reacted negatively to the Summit by reiterating their views that Eurozone countries could be downgraded by the end of first quarter of 2012 due to politicians’ inaction in the face of rising constraints, increasing the risk of adverse economic conditions. Specially, Moody’s stated[3]:

The announced measures therefore do not change Moody’s previously expressed view that the crisis is in a critical and volatile stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While Moody’s central scenario remains that euro area will be preserved with out further widespread defaults, the shocks that are likely to materialize even under this ‘positive’ scenario carry negative rating implications in the coming months. Moreover, the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.

The timeframe imposed by the rating agencies for policy initiatives in the near future that stabilize credit market conditions effectively is too aggressive in our opinion, which increases the risk of rating downgrades and hence the risk of further shocks.

Liquidity is Important but Solvency is Critical

While the support by the ECB is a positive for the banking sector and we look to the ECB for eventual monetization of sovereign debt, it is not a panacea if sovereigns are insolvent. We are increasingly more concerned about the trajectory of Italy and Spain not to mention Greece, Portugal and Ireland (bank related debt specifically). The Financial Times highlighted the risk of low growth and high debt in an article in late November, pointing out that with borrowing costs of 4% and debt/GDP of 120%, Italy needs to grow at 4.8% just to avoid increasing its debt burden when it has a balanced budget. At 2% growth, its budget surplus will have to be 5% per year for 10 years to reduce its debt/GDP to 90% or begin to sell state assets. Even Germany will need to grow at 2.4% to avoid increasing its debt levels, and France even higher[4]. This problem becomes worse as liabilities are increased to fund weaker EU members. We remain concerned that without true fiscal integration, the stop gap measures taken by the politicians and/or ECB will not appease the markets, increasing the risk of default at the credit and/or sovereign level.

AAM’s Corporate Investment Strategy is Defensive

We took advantage of the short lived rally to further reduce our holdings in Financials, a sector that will continue to ebb and flow with the news emanating from Europe. Our investment thesis is that Europe will remain volatile and the ECB will be forced to step in and monetize sovereign debt. At this point, our base case does not assume a departure from the EU, but we are aware that the risk is increasing. We expect lower than expected economic growth for Europe, as banks shrink their balance sheets to meet new capital requirements, governments become more austere and investors look outside of Europe to invest. Therefore, we continue to avoid European credit and invest in higher quality, liquid credits exposed to the U.S. and growing Asian and Latin American countries. At this point, we are comfortable with the economic landscape in China, but are watching that closely, cognizant of the ties the country has to Europe and domestic construction activity to fuel its growth.

Written by:
Elizabeth Henderson, CFA
Director of Corporate Credit

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

[1] Eksportfinans ASA was downgraded to Ba1 from Aa3 by Moody’s after the unexpected decision by the Norwegian government to wind it down.

[2] Jeffrey Meli, “November 2011 U.S. Credit Index Performance” ,Barclays Capital Credit Research: U.S. Investment Grade Corporate Update, December 1, 2011, page 2.

[3] Alastair Wilson, “Moody’s: Euro Area Sovereigns Remain Under Pressure In Absence of Decisive Initiatives” Moody’s Investor Service Announcement, December 12, 2011, https://www.moodys.com/research/Moodys-Euro-Area-Sovereigns-Remain-Under-Pressure-In-Absence-of–PR_233208, accessed December 12, 2011.

[4] Das, Satyajit, “Low Growth and High Debt is the Sovereign Curse,” Financial Times, November 28, 2011, https://www.ft.com/cms/s/0/aba480e4-110b-11e1-a95c-00144feabdc0.html#axzz1gQwwwIai, Accessed November 29, 2011.

Sovereign Risk Decreased But Not Diminished

Results were Favorable for Corporate Bonds in October

After months of debate, European leaders finalized their plan, and investors didn’t wait to see the details. The tail risk resulting from a disorderly Greek default appears to have been reduced in the near term, and the domestic economy performed better than the markets expected. Hence, the increased appetite for risk by the markets. Corporate credit spreads tightened 36 basis points (bps) in October, generating 273 bps of excess return per Barclays Corporate Bond Index. Despite outperforming in October, the Finance sector has underperformed year-to-date, 93 bps wider compared to the Industrial and Utility sectors that are 27 and 22 bps wider, respectively. New issue supply has picked up in both investment grade and high yield, and new issue spread concessions have begun to normalize as deals are oversubscribed. Dealer inventories remain very low historically, a technical that should support spread tightening based on current demand.

AAM’s Corporate Investment Outlook Remains Constructive Yet Selective

Because we were more optimistic about the domestic economy and did not believe a tail event would occur in Europe, we did not feel it was appropriate to reduce our Corporate positions meaningfully, as it becomes a strategy of market timing, which is dangerous given volatile Treasury yields and poor liquidity (Exhibit 1).  Instead, we have reduced credits vulnerable to weakening economies and sovereigns or funding needs, believing the right security selection over time in this low growth environment will lead to outperformance. The reality that rates will remain low for some time should result in spread compression between higher and lower rated credits, as seen earlier this year. Unfortunately, for 2011, we are no longer expecting to exit with positive excess returns for the market given the risk premiums that will remain in various sectors to compensate for the volatility and uncertainties.

Exhibit 1

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

Fundamentals remain very strong for U.S. domiciled investment grade companies. Case in point, third quarter earnings reports have been better than expected with most industries surprising to the upside and reporting both earnings and revenue growth. That said, sovereign risk remains elevated in the U.S., as we face our own fiscal challenges (Exhibit 2).

In Europe, the environment from both a sovereign and an economic perspective is more concerning. While the European banks reported better than expected loan growth and credit costs in the third quarter 2011, bank balance sheets are likely to contract over the near term due to the requirement for capital improvement and the austerity measures will take hold, both dampening economic growth. Moreover, according to a recent Goldman Sachs study, European company fundamental improvement is lagging, providing less of a cushion for creditors. Whereas, the U.S. nonfinancial corporate sector’s credit quality is close to its highest level in decades, European firms have only reverted about two thirds back to pre-crisis strength[note]Himmelberg, Charles P., “European credit fundamentals: Not so good,” Goldman Sachs Global Investment Research, Page 1, November 7, 2011[/note].

Exhibit 2

Source: AAM, Bloomberg, International Monetary Fund

Sovereign Risk Remains in the Forefront

This month, we thought it worthwhile to review the European plan, and provide our thoughts on the details. Our investment strategy in the region remains unchanged: avoiding European financial, infrastructure, and economically sensitive companies. We expect continued volatility until we see greater economic and fiscal stabilization in Italy and Spain.

Greek Debt Restructuring

Private investors (i.e., banks/insurance companies) agreed in principal to a 50% reduction in their holdings of Greek sovereign bonds.  This haircut would apply to the approximately €210 billion of privately held debt but not to the €150 billion International Monetary Fund (IMF) or European Central Bank(ECB) held debt. The IMF estimates that this would result in a debt/GDP ratio of 120% as of 2020 (vs. currently projected 180%).  This strikes us as a half measure, but it avoids, for the moment, a disorderly default in Greece. We await details of the new government, recognizing the elevated uncertainty and thus risk, but are reassured that despite angst over austerity measures and their national sovereignty, more than seven of ten voters said they favored Greece remaining in the Eurozone per a poll two weeks ago in the To Vima newspaper.

Bank Recapitalization/Liquidity

European banks will be required to achieve a 9% “core” Tier 1 capital ratio no later than June 2012 after a mark-to-market of all sovereign holdings (using sovereign prices and exposure as of September 2011).  The European Banking Authority (EBA – engineers of the Euro Stress Tests) estimate a Eurozone capital deficit of €106 billion based on the figures and marks as of September 30, 2011. The recapitalization plan calls for banks found to require capital to first attempt to tap private markets (for common equity or “strictly underwritten contingent capital instruments”), followed by withholding of dividends and bonuses, reduction of high risk weighted assets, and only if these measures are insufficient, capital injections from the national governments or the European Financial Stability Facility (EFSF) if the national governments do not have the means (i.e., Greece, and possibly Spain and Italy).  The banks must submit a capital raising plan to their national regulators and the EBA no later than December 25, 2011.  The bulk of the €106 billion recap falls on Greece (€30 billion), Spain (€26 billion) and Italy (€15 billion). It should be noted that the €106 billion capital shortfall estimate is based on the July 2011 EBA stress test base case (which already appears somewhat optimistic), and does not take into account the prospect of further GDP slowdowns in either broader Europe or those countries most affected by fiscal consolidation measures (i.e., Greece, Italy, Spain).

The Eurogroup announcement also contemplated a sovereign guarantee scheme for bank term funding from 2012 on in order to prevent either a buyers’ strike or “excessive deleveraging” by banks that are trying to achieve the Tier 1 targets through balance sheet reduction.  This would be separate from the ECB liquidity provision efforts (and likely would aim to replace it ultimately).  Details of this program are completely to be determined, but should be supportive of Euro area bank spreads as it further reinforces bank access to term funding over an intermediate period and reduces fears of a liquidity squeeze.

“Upsized” EFSF

While there is explicitly no increase to the €440 billion contribution of the Aaa/AAA countries (Germany, France, Netherlands, Finland), the Eurogroup will continue to explore two options for leveraging the structure in order to facilitate approximately €1 trillion of new sovereign issuance:

1. Insurance Option – This would see the EFSF offering a partial wrap on new sovereign issuance (20% first loss absorption has been the amount rumored).  This would effectively allow a €200 billion commitment from the EFSF to backstop the contemplated €1 trillion of issuance (roughly equivalent to the issuance needs of Spain and Italy over the next 18 months).  The Eurogroup contemplates such insurance being discretionary (i.e., provided only if investors explicitly request it) and there has been no discussion of pricing.
2. Special Purpose Vehicle – This would see the EFSF fund a Special Purpose Vehicle (SPV) with a first-loss equity piece that would then purchase new issue sovereign debt and sell a senior tranche of bonds to private investors. This is the closest structure yet to a “common Eurobond” issuance and is the structure that market participants seem most enthusiastic about.  A good way to think of this approach conceptually is that it is using cash Collateralized Debt Obligation (CDO) architecture.

The Eurogroup has promised details on both of these options in November 2011 and may use either or both approaches.  Still to be determined is the market’s receptivity to a 20% first-loss protection (on assets that had previously been treated as 100% risk-free/0% risk weighted).  Additionally, we note that the EFSF has raised less than €20 billion of the contemplated €440 billion funding capacity. The latest €3 billion 10-year bond was downsized from the originally planned €5 billion 15-year after demand was tepid. It was sold today at a spread of 177 bps over German bunds with Central Banks accounting for 35%, Banks 30%, Insurance companies 20% and Fund Managers 15%.

Our Thoughts on the Credit Implications

This plan appears to nominally address many of the outstanding issues (i.e., Greek restructuring, bank capitalization, EFSF mechanism for supporting sovereign liquidity), but the key to resolving the Eurozone crisis is the ability of Italy and Spain to achieve a more stable fiscal trajectory (Exhibit 3).  In that respect, the actions announced by the Eurogroup are really just treatments of the symptoms, rather than curing the underlying ailment.  Ultimate resolution of the crisis depends on Spain’s, and especially Italy’s ability to implement their fiscal consolidation plans (without backsliding) and to achieve the projected (or at least reasonable) levels of GDP growth in the face of fiscal austerity and considerable domestic political resistance.  Their success or failure in these efforts will likely not become apparent for another twelve-to-twenty four months.  Until we see clear evidence that Italy and Spain are demonstrating political commitment to fiscal consolidation and clear economic and fiscal progress, we will remain very cautious of the continental European sector.

Exhibit 3

Source: AAM, Bloomberg, as of November 7, 2011

Written by:

Elizabeth Henderson, CFA
Director of Corporate Credit

Sebastian Bacchus, CFA
Vice President

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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