Corporate Credit

Out Like a Lion

May brought a steep reversal of the spread tightening over the previous few months. After 44 basis points of spread widening in May, excess returns turned negative for the year (-99 basis points excess return year-to-date and -260 basis points in May for the Barclays Corporate Index). The widening occurred in all three sectors, Industrials, Utilities, and Finance although defensive sectors generally outperformed, as shown in Table 1 (e.g., Aerospace/Defense, Railroads, Consumer Noncyclical sectors).

In addition to widening credit spreads, Treasury yields rallied among other signs of increased risk, reflecting three primary concerns:

Economic uncertainty in Europe – The market seems to be taking a “prove it” stance towards the Eurozone periphery countries, also known as PIIGS (Portugal, Italy, Ireland, Greece, Spain), and other European countries, as government liquidity and austerity measures are not resulting in positive market reaction. Fears of a public to private transition for GDP growth worldwide and the uncertainties relating to fiscal deficits and debt burdens are high, and the Eurozone periphery countries represent proof and consequence. In addition, there continue to be questions surrounding the stability of the banking sector in Europe. The contagion to the domestic economy is a concern if this weakness continues. While U.S.

exports are a small component of GDP growth, there are many indirect economic consequences if this region deteriorates economically. For instance, a weaker Euro would likely cause the Chinese export market to weaken, resulting in slower Chinese and emerging market growth, which would negatively affect U.S. growth. The indicators that we will be watching closely include: confidence, manufacturing, auto and retail sales, railcar loads, and various European GDP and banking related reports. The economic fragility coupled with limited monetary and fiscal alternatives remain our primary concerns, if the U.S. does enter another recession.

Stock market correction – In addition to many other consequences, a continued decline in the stock market has the potential to weaken consumer and business confidence, which is essential for our economy to continue to grow. As the government stimulus is withdrawn and the early drivers of GDP growth wane (e.g., inventory reduction), U.S. GDP growth will become increasingly more reliant on traditional sources of growth – fixed investment and the consumer. So far in 2010, the consumer has been stronger than expected as reflected in the latest confidence report. Consumer confidence has increased largely due to the expectations factor, highlighting the vulnerability of the consumer in light of high unemployment and a weak housing market. If expectations from the consumer and business leaders deteriorate, it puts the progress in these areas at risk. There are many other direct and indirect effects that would negatively impact not only GDP but individual company results (e.g., annuity writers).

Financial regulatory reform – The primary risk facing bank credit investors is the possibility of rating downgrades associated with a reduced ability on the part of the government to provide extraordinary support in the future. For a handful of “systemically important” institutions, the ratings currently reflect a level of implicit and explicit support from the U.S. government. Should regulators be legislatively prohibited from providing extraordinary support to struggling financial institutions (as they did during the 2008 liquidity crisis), the rating agencies have signaled that they could potentially downgrade a number of large banks from the A category to BBB. While the rating agencies appear to be taking a measured approach to assessing the impact of financial regulatory reform, rating downgrades remain a possibility in the intermediate-term. From a bank Balance Sheet perspective, unlike three years ago, banks are very liquid and have deleveraged, leaving them better able to manage a downgrade to the BBB rating level. However, this is significant not only because it increases funding costs, but it also reduces the availability of funds (Commercial Paper, Repurchase Agreements). This has a negative impact at an economic level because it constricts lending and therefore, the velocity of funds, which is already low. At this point, we remain comfortable with the financial sector from a fundamental standpoint (improving asset quality/strong capital and liquidity), but raise the concern more at an economic level.

Entering 2010 vigilantly, we had advocated a defensive position in credit. We have been concerned about the economic fragility around the world and the limitations governments face due to the burdensome debt obligations and strained fiscal balances. Although we have witnessed improving company fundamentals, the possibility of an exogenous shock to the economic system puts the sector at risk of underperformance in the near term. Our cautious approach to the sector has reduced the volatility of our portfolios and puts us in good position to take advantage of spread widening in the high quality sectors over the next few quarters.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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

A Greek Tragedy?

The nearly $1 trillion aid package announced by the Eurozone policy makers on May 10, 2010 appears to be stabilizing investment grade bond markets in the US and Europe for the moment.  The need for extraordinary action was clear. In the past month, concern over the Greek fiscal condition had evolved into fears about that nation’s ability to refinance its sovereign debt maturities. The implications of a disorderly Greek debt restructuring (default) are two-fold.  Firstly, financial institutions holding Greek sovereign debt (banks/insurers/pensions) would be faced with large write-downs, possibly impacting solvency of some institutions.  Second, the evolution of fiscal concerns about Greece into funding concerns served to focus the market’s attention on other fiscally challenged sovereigns with large funding needs, including Portugal, Ireland and Spain.  The aid package provides a refinancing backstop for the sovereign issuers that were faced with spiking funding costs, if not outright roll-risk on upcoming refinancing of their debt issuances.  At the same time, the announcement of extraordinary measures by the European Central Bank, including purchase of public and private debt, as well as reinstating term lending facilities and U.S. Dollar swap lines with the Federal Reserve Bank, should counter rising pressures on European banks that had manifested themselves in the interbank funding markets in the two weeks prior to May 10^th.

However, the challenges facing the Eurozone remain daunting.  While near-term refinancing risks appear to be addressed via the aid package, the persistent fiscal imbalances underlying the recent market fears remain.  A number of the Eurozone economies continue to spend in excess of their ability to grow revenue resulting in growing indebtedness.  This issue is exacerbated by structural rigidity in certain economies that makes labor market and government spending adjustments challenging, thus further depressing economic growth (particularly in Greece and Spain).  While the Maastricht Treaty which formalized the European Monetary Union laid out budget deficit and debt-to-GDP limits, numerous members of the Eurozone have violated these criteria over the years, with several members doing so in an unsustainable manner.  Until Greece, Portugal and Spain (and potentially Italy) are able to get control of their persistent budget deficits and stabilize their debt levels, the markets will continue to be cautious of the sovereign debt and the issues of banks domiciled in those countries.

So what are the implications for global bank credit?  Given the impediments to successfully addressing the Greek fiscal imbalances, some form of restructuring of Greece’s sovereign debt seems likely, as it is hard to see how Greece can “grow into” its current and future projected debt load.  Furthermore, other members of the Eurozone may face similar choices if they are unable to overcome their persistent deficits and rising indebtedness.  Perhaps the least bad option, a managed restructuring of Greek obligations, might go a long way towards stabilizing the rest of the Euro area and giving countries such as Portugal, Ireland and Spain time to address their own fiscal imbalances.  While the likelihood of default appears low, given the support mechanisms put in place this past weekend, individual banks that are exposed to the sovereign debt of Greece would face write-downs in the event of a restructuring.  As such, we recommend avoiding banks in the affected countries (Greece, Portugal, Spain, Italy and Ireland) and confining Eurozone bank exposure to national champions in the fiscally stable and supportive Eurozone countries (i.e., France/BNP Paribas, Netherlands/Rabobank).  Despite the underlying strong fundamentals at banks such as BBVA and Banco Santander in Spain, the risk-adjusted returns on their bonds are not compelling, given the macro risk facing their sovereign hosts.

However, we are not changing our overweight recommendation on global banks more broadly, despite the challenges facing the southern European banks.  We believe the U.S. and global economic recovery continues to take hold and that the fundamental improvement of the bank sector will follow as bank balance sheet quality improves.  Furthermore, the global banking system has taken concrete steps to recapitalize and strengthen liquidity over the past two years.  While sovereign concerns will continue to cause spread volatility, we believe the fundamentals for banks in the most developed countries justify continued overweight to this sector.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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

In Like a Lamb?

Spring is starting off on a good note with Corporate bond option adjusted spreads (OAS) 23 basis points (bps) tighter per the Barclays Corporate Index, generating 128 bps of excess returns for the month and returning year-to-date excess returns to positive territory (114 bps).  Finance outperformed Industrials and Utilities, generating 193 bps of excess returns in March (171 bps year-to-date) vs. 94 bps (80 bps YTD) and 81 bps (93 bps YTD) respectively.  This is consistent with our 2010 forecast for the three broad sectors.  Sub-sector performance is proving itself as well with Metals & Mining posting a strong 212 bps of return in March (99 bps YTD), Energy- Oil Field Services 78 bps (152 bps YTD), Banking 180 bps (112 bps YTD), and Life Insurance 431 bps (439 bps YTD).  Unlike 2009, in which all sectors gapped tighter, credit selection has been more important thus far, and we expect this to continue.  For example, in terms of investment opportunities over the course of 2010, the Kraft new 10-year issue has tightened more than 55 bps and the Telefonica 10-year 60 bps from purchase amidst the Greek fears.  We continue to believe there are attractive opportunities within the Corporate sector and that it will outperform Treasuries in 2010.

Events and news in March were largely positive.  First, Greece was able to issue debt and get a back-stop from certain EU countries and the International Monetary Fund (IMF), if it is unable to borrow from the markets.  The European Central Bank (ECB) also helped Greece by extending the acceptance of collateral rated at least BBB- instead of its plan to reinstate the former A- threshold in 2011.  Greece sovereign debt is rated A2/BBB+/BBB+.  Second, domestic economic news was better than expected especially relating to the consumer, which appears to be spending at a faster rate than many had anticipated.  If the consumer continues to show strength and the ISM non-manufacturing index extends its recovery, our unemployment forecast may prove too conservative.  Third, after taking a brief hiatus in February, liquidity in the market re-emerged despite the continued fall in primary dealer positions in Corporate bonds with maturities greater than 1 year.  Aside from money market funds, AMG Mutual fund flows were positive for both debt and equities.  High yield debt and bank loans were in great demand, new issues regardless of credit quality were very well received in both the investment grade and high yield markets, and finally the talk of LBOs had the Street and investors dusting off models used to determine feasibility.

Last, but not least, at the government level, the Administration was able to get its Healthcare bill passed under reconciliation rules.  It appears more likely that a Financial Reform bill will get passed as well with the Republicans in a difficult position given the broad voter angst against the banks and Wall Street.  The Fed kept its rate language unchanged, signaling to the market that low rates are here to stay for the near term.  Finally, the Treasury auctions received more tepid demand in March, bringing into the forefront the discussion and forecasting of Treasury yields and what that means from an investment standpoint– specifically, what markets will outperform in an inflationary environment.

As it relates to Corporate bonds, we look to Exhibit 1 to remind us that spreads are not highly correlated to rates, but to data that may or may not move Treasury rates.

Given that the industrial capacity utilization rate is only 72.7%, well below the historical average of 81%, we are not concerned with near term inflationary pressures.  That said, our industry and credit analysis takes into account the prospect of rising rates over the intermediate term in various economic environments.  While commodity based industries may perform well in not only the current environment but that environment as well, others are likely to underperform as higher rates stymie the rate of consumer borrowing and thus, spending for example.  Hence, we continue to prefer “investing in growth,” namely manufacturing and commodity based industries, those that are non-discretionary in the consumer space, and certain Finance sectors versus a blind grab for spread product/yield as many investors are advocating.

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¹ AAM Corporate Credit View, January 6, 2010

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This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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

The Barclays Corporate Bond Index modestly underperformed Treasuries in February (-5 basis points (bps) of excess return), leaving the Option Adjusted Spread (OAS) 1 basis point wider than where it ended in 2009, and the yield 26 bps lower.  The year of mixed sentiment certainly continued in February.  Sovereign related fears dominated discussions and the media but did not affect spreads, as they had in January (correlation between Barclays Corporate Index OAS and Greece 5-yr Credit Default Swaps (CDS) dropped from 0.6 in January to 0.2 in February).  Companies continued to report improved earnings and sales while management voiced

caution regarding the strength of the economic recovery.  Moreover, domestic economic data was mixed, M&A activity remained low (Exhibit 1), cash continued to build at the corporate level, and of course, political and regulatory issues remained unresolved. Regarding technicals, the new issue calendar has been slow, new issue concessions lack- luster, and most accounts are long credit, including the  primary dealers, which finally stopped adding to positions in mid-January.  In short, this is what we expect in 2010 – a year driven by economic data and idiosyncratic events.  Therefore, unlike the broad based spread tightening in 2009, we continue to expect 2010 to be a year where sector and credit selection and curve positioning are paramount for outperformance.

The much anticipated Greek bond issue continues to get delayed, but it’s a matter of time since €23 billion is due by the end of May.  The capital markets expect assistance from either France, Germany, the European Union (EU) and/or International Monetary Fund (IMF) in order to not only prevent a Greek default, but to decrease funding costs and implement conditions that will force structural reforms and tougher fiscal policies.  This does not necessarily apply only to Greece, as other countries in the region and outside the region face the same challenges.  Therefore, we expect sovereign and municipal related headlines to continue throughout 2010, periodically affecting spreads especially for those institutions directly exposed (e.g., local banks in Southern Europe as opposed to large, diverse European utilities or telecoms).  We took advantage of the contagion in early/mid February and recommended buying two strong, diverse credits based in Spain, Telefonica and Iberdrola.  Specifically, the Telefonica 2019 bonds were purchased at +165 to the 10-year Treasury (+165/10) and are offered today at +139/10.  We also recommended selling select highly rated Industrials, as the spreads are lackluster relative to other risk-adjusted investment alternatives.  We expect others may do the same if sovereign issuance is attractive and mortgage spreads widen after the Fed terminates its Mortgage Backed Securities (MBS) purchase program.

Regarding economic data, February was a difficult month to analyze given the severe weather in many parts of the country and other unexpected events (e.g., Toyota scandal resulted in plant shut downs).   On the negative side, consumer confidence was lower than expected and initial jobless claims were higher than expected.  At this point, we believe such noneconomic factors caused the miss and may further influence other reports in the near term (e.g., government’s monthly employment report released on March 5).  That said, if initial claims do not begin to improve over the next several weeks, it would potentially indicate layoffs are beginning to accelerate and the recovery is stalling.  Positively in February, manufacturing related data was strong according to the two regional manufacturing surveys and robust industrial production growth, although we expect the pace will slow in coming months as goods production settles into a more sustainable growth path. Pricing pressures remained low, and with the surplus of production capacity and slack in the labor market, should remain low this year at a minimum.  In addition, credit costs seemed to have stabilized in the fourth quarter, Mortgage Bankers Association mortgage delinquency rates edged lower, retail sales were up albeit modestly, temp hiring continued, and employment related advertising spending increased.  We believe economic data will be the ultimate driver of spreads in 2010.  Our forecast is muted GDP growth, hampered by a weak consumer and housing market and the lack of credit for consumers and small businesses.  Banks, especially smaller community and regional banks, are still fragile, and governments are not in a position to continue subsidizing growth.

Lastly, the technical back-drop entering 2010 was not as positive as a year ago.  In the second half of 2009, investors’ risk appetite returned. This is best shown in the regression results of primary dealer net Corporate security positions and Corporate Index OAS. Historically, dealer positions have explained very little (R squared 6% since 2001), but over the last six months (November and December in particular), they have explained 80% of the variability in spreads (Exhibit 2).  Also, dealer surveys are showing investors are long credit and the flow into investment grade mutual funds, while still positive, has slowed (Exhibit 3).  While new issuance has been slow year-to-date, we expect it to pick-up especially as M&A activity increases.  That said, we expect new issue concessions and issuance from Industrials will be lower in 2010 versus 2009.  We believe the current level of uncertainty regarding political, regulatory, economic and sovereign related issues does not bode well for a big change in these positions, keeping investors cautious and expecting coupon income to be the predominant source of return in 2010.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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

Volatility re-emerged in January. It started strong with Corporate intermediate spreads tightening 10 basis points (bps) and long spreads 6 bps by January 11. On January 12, they reversed course and widened 5 bps and 18 bps respectively over the remaining days of January. This pressure on the long end caused the Corporate Index (Barclays) to post negative excess returns for January (-11 bps overall, +16 bps intermediate, -92 bps long).   All three broad sectors (Finance, Industrials, Utilities) exhibited this type of performance (positive 1-7 years, negative 8+ years) and BBBs and AAAs outperformed AAs and As. The drivers were diverse: sovereign, political and economic.

Sovereign risk was front and center this month. China increased its reserve requirement for banks by 50 bps from 15.5% to 16%. The market viewed this as the Central Bank taking action to cool potential asset price inflation, namely in the property and equity markets. In short, we believe China’s structural changes bring organic growth opportunities, and view the largely symbolic action as supportive of that outlook.

The other sovereign issue was and remains in Europe, namely Portugal, Ireland, Greece and Spain, and the potential systemic effects they could have economically and technically given their fiscal issues. Regarding technicals in particular, one reason for concern is the correlation between the Sovereign and Corporate sectors of the Index. It has historically been high (0.92 over 10 years per the Barclays Index data), but has ranged from 0.24 to 0.98, which shows decoupling does take place. The European Commission recognizes the downside risks of letting countries like Greece fail, and while we acknowledge the risk of sovereign weakness over the longer term for market returns, we do not view that as a material driver of spreads in 2010. We do expect spreads to remain vulnerable to this news until uncertainties are addressed.

Second, President Obama’s speech regarding his support of the Volcker Rule disrupted the financial markets due to both the direct and indirect consequences of a more aggressive regulatory approach. The public’s outrage toward large banks increases the uncertainty regarding the reform of the financial system, and the possibility that the issue will become more political. We had believed that financial reform would decrease the risk in the system (good for creditors), but the shift in tone was worrisome from the standpoint that too much regulation can be harmful to economic growth, potentially slowing down the velocity of funds and destroying value. This risk continues to be front and center in our minds, but we are optimistic after time has passed since the President’s speech and the rhetoric has not increased but has been assuaged.

Lastly, fears emerged once again that the economy was not as strong as it seemed at the end of 2009. We have communicated our expectation for muted domestic GDP growth, which we believe is supportive for Corporate bonds. Our tracking of the data, including but not limited to: specific industry related data (see Exhibit 1) that serves as leading economic indicators, the improvement in 30 and 90 day delinquencies at the banks, the improvement in consumer confidence and spending, temporary hiring, not to mention the positive results this earnings season especially at the revenue level, is encouraging. Moreover, the Administration’s focus on job growth we view positively for the economy, as these stimulus efforts should help to support GDP growth in 2010 and reduce the risk of a “double dip.”

Exhibit 1:

In summary, we believe January is reflective of what Corporate bond investors can expect this year. Investors are wary that spreads are not compensating them for downside scenarios that can easily be painted due to all of the uncertainty that exists, politically, economically, financially, globally. That being said, after nearly 12 months of supportive behavior and actions at many different levels (private and public sectors), our outlook is not skewed to the downside based on higher probabilities assigned to more draconian scenarios. We are taking an objective approach, analyzing and tracking the data, and continue to believe that a portfolio that is invested in particular industries and credits will outperform Treasuries in 2010.

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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

Year 2009 closed as an exceptional year for the Corporate Bond sector with 2276 basis points (bps) of excess return per the Barclays Corporate Bond Index. This compares to 2008, which posted an excess return of -1988 bps. In terms of broad sector performance, Industrials and Utilities outperformed the Finance sector. Spreads remain wide of historical averages, reflecting the various uncertainties we face in the near term. Exhibit 1 depicts spreads for higher quality bonds in the three broad sectors.

Exhibit 1: A Rated Bonds (Z spread, bps)

	5-year			10-year			30-year
	12/30/2009	Average	std dev	12/30/2009	Average	std dev	12/30/2009	Average	std dev
Utilities	92	74	80	105	85	78	128	109	109
Industrials	71	67	69	93	82	70	126	110	110
Finance	148	130	169	171	142	164	204	163	163

Source: Barclays; Index data as of 5/31/1994 to 12/30/2009

Spreads reflect the fundamental health and technical dynamics of the market. Compression in 2009 was due to an improvement in both, as the government stimulus and financial related initiatives shortened the tail risk in the market especially for Financials. Technical support returned to the market, as shown in the Exhibits 2 and 3, as funds flowed back into Corporate Credit.

 

We enter 2010 with a different set of variables. Fundamentally, we continue to expect a muted economic recovery in the U.S. while other countries (“BRIC” – Brazil, Russia, India and China) grow more rapidly. The U.S. continues to face serious issues despite the improvements of late. Job creation and hiring must take place, foreclosures remain manageable, and real estate related loan modifications be successful, not to mention the government must continue to be involved and support the transition from the public to the private sector. As long as we remain on the path of recovery, a slow growth environment is not necessarily a negative for Corporate Credit (See Exhibit 4).

Exhibit 4: Credit Performance in Various GDP Environments
(Quarterly Median US IG Excess Returns vs. Real GDP Cohorts)

This “slow growth” environment should result in good old fashioned merger and acquisition activity, innovation to differentiate, and industry participant bifurcation where industries are cleansed of weak operators that benefited from the earlier days of easy money. We are seeing the latter in the Finance sector, as hundreds of small banks and other weak financial institutions like CIT have failed. Our approach for 2010 is not an unfettered “grab for yield” as many others are proposing, but a prudent “invest in growth,” which we believe will be a winning strategy over a longer period of time. Security selection remains critical, although we do not expect 2010 to be a year of high idiosyncratic risk like we have seen in previous years (e.g., LBO phenomenon). Therefore, both the industry and security calls are important.

Specifically, as it relates to industries, we continue to advocate sectors such as: (1) Banks and Insurance, including owning select subordinated securities of stronger banks given the right structure and economics, (2) commodity based cyclical industries and those related to them, and (3) defensive consumer based sectors like Food and Beverage, as opposed to Homebuilding/Building products. We are cautious on industries and companies that face growth obstacles over the near-to-intermediate term, making them more susceptible to shareholder friendly actions and event risk. At an industry level, this includes REITs, Media, Telecom, and Utilities. Specific industry and company related commentary that fall within these categories is included on page 3.

In summary, we expect the investment grade Corporate bond sector to post positive excess returns in 2010 driven by carry and spread tightening, as spread compression continues among industries and ratings.

Supplemental Commentary

Finance Insurance Insurance, like Banks, is a sector that continues to face challenges but we believe offers investors compensation for the risk. Like all Financial sectors, Insurance spreads continue to be wide of their historic average relative to other Industrial/Utility sectors. The OAS of the Barclays insurance segment of the Index was 250 bps at year-end 2009, or 155% and 180% of the Utility and Industrial sectors, respectively vs. historic averages of 115% and 119%, respectively. We can support the stronger credits in the Life and P&C sectors given the improvements that have been made, regulatory support shown, and the recovery that is underway at the macro and market levels. The U.S. life insurers raised approximately $10 billion of capital in 2009 to manage downward rating migration and capital pressure from investment asset write-downs. The U.S. P&C insurers experienced lower catastrophe losses and improved investment portfolios in 2009, but still face heavy competition and decreased premium levels. Reinsurers in the U.S. and Bermuda performed strongly in 2009, but the sector’s strong equity position and its ability to access the capital markets will be tested if a large catastrophe event occurs. The U.S. health insurance sector continues to be hurt by weak economic conditions and the ongoing uncertainty regarding health care reform. Commodity Related Sectors Metals & Mining In 2010, we expect commodity prices to remain off the lows of early 2009. We anticipate a general improvement in demand as consumption grows in emerging markets. The pace of recovery will depend on how certain challenged global end markets recover, including automotive and commercial construction. Many companies in the sector have improved their liquidity positions as debt and equity markets re-opened in 2009. Most of the larger more diversified companies entered 2009 with strong balance sheets, helping stem some of the pressure from free cash flow leakage. We also continue to expect consolidation of the industry in 2010, as the larger, more diversified companies buy the more specialized, lower rated companies. We expect issuance to be light/moderate in 2010 depending on M&A activity. Energy In 2010, we believe oil should be in the $65 – $70 per barrel range and natural gas should approximate $5 per thousand cubic feet.  As a result, we have a positive view of the credit fundamentals for the independent and oil field service segments.  We believe that in a $70 oil and $5 gas environment, the vast majority of the energy sector should be able to fund capital expenditures and dividends internally.  However, we believe total debt will increase in the sector in 2010, due to debt-funded share repurchase activity and M&A related issuance.  Additionally, refinancing activity in the Energy sector is expected to exceed $5 billion in 2010.  We expect ConocoPhillips to be an active refinancer with more than $1.4 billion maturing in the second quarter of 2010. Consumer Defensive Food & Beverage In 2010, we expect the Food & Beverage industry to perform well fundamentally. Consumers continued to spend their dollars on food and beverage products despite the deep global recession. Having said that, we expect consumers to remain focused on price and there are numerous cases of “trading down” from premium brands.   Diversification and economies of scale for investment grade companies in this sector help to alleviate pressure from changing consumer activity. Overall, we would expect a very minor pick-up in consumption as the global economy recovers. We are focused on those companies with strong brands that have (Anheuser-Busch Inbev), or are expected to (Kraft), engage in M&A activity and intend to capitalize on the new issuance that will be needed to fund those deals. We expect to see consolidation in this industry with the potential transaction between Kraft and Cadbury serving as the catalyst. We anticipate a moderate amount of issuance for the sector in 2010. Growth Obstacles Electric Utilities We have a negative view of the Electric Utility sector in 2010 given the defensive characteristics of the industry, the capital requirements necessary in the next several years and political threats (EPA pollutant rules, Cap and Trade legislation, etc). We believe that the credit profiles for much of the sector could deteriorate moderately as the sector in aggregate will be free cash flow negative. We expect that issuance in 2010 should be in the $50 billion range and would not be surprise if some issuers pre-funded their 2011 requirements given the low interest rate environment.

 

This information is developed using publicly available information, internally developed data and outside sources believed to be reliable.  While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as ‘AAM’), and their respective officers and employees.  Any opinions and/or recommendations expressed are subject to change without notice.

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