Corporate Credit

More Buyers than Sellers – Is it Really that Simple?

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

Exhibit 1

Source: Barclays

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

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

Exhibit 2

Source: Federal Reserve, AAM

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

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

Exhibit 3

Source: Bank of America Merrill Lynch Global Research

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

Exhibit 4

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

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

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

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

Exhibit 5
Source: Bloomberg

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

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

Will Higher Commodity Prices Result in Wider Spreads?

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

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

Exhibit 1: Excess Returns Year-to-Date 2011

Source: Barclays Capital

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

    Exhibit 2 Commodity Prices are Increasing

Source: Bloomberg

         Exhibit 3

Source: CRU International; Brook Hunt; GS&PA

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

Exhibit 4

Exhibit 5

Source: Bloomberg

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

This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and

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