Corporate Credit

April 20, 2017 by

By Elizabeth Henderson, CFA
Director of Corporate Credit

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Market Summary and Outlook

The Investment Grade (IG) Corporate bond market delivered a 1% total return in the first quarter 2017, with spreads tightening 5 basis points (bps) since year-end 2016. Risk assets outperformed, as the S&P Index increased close to 6% in the first quarter, high yield returned approximately 3%, and Emerging Markets also returned approximately 3%. After outperforming in the fourth quarter 2016, corporate bonds with maturities greater than ten years underperformed in the first quarter.

We continued to see strong demand from bond funds for investment grade securities despite volatility in high yield fund flows. Foreign buying of IG debt has fallen from the very strong levels in 2015-2016, but we continue to expect it to remain a source of demand given the yield advantage (net of hedging costs) of U.S. IG bonds. New issue supply was higher than expected to start the year, with companies accessing the market in anticipation of higher rates, a modest headwind for spreads.

The Option-Adjusted Spread (OAS) is approaching our target for the year; therefore, we expect returns to be generated largely from income over the near term. Our base case expects stable to improving commodity prices, approximately 2% domestic economic growth, containment of risks overseas, regulatory relief in the U.S., and some tax relief. If risks to our base case increase to the downside, we would expect spreads to widen as Treasury yields fall. However, we believe the risk of material spread widening due to an increase in default risk is low given the availability of credit and low probability of a recession. Uncertainty should keep event (and ratings) risk more subdued as well.

Source: Bloomberg Barclays, AAM

Performance Summary and Year-to-Date

The driver of returns for Investment Grade Corporates in the first quarter 2017 was primarily coupon income with spreads starting the year at relatively low levels. Performance has been driven primarily by the higher yielding sectors, Energy and Basic Materials, as well as Financials that tightened due to the prospect of higher interest rates and regulatory relief. For Metals and Mining, metals prices stabilized due to supply disruptions caused by weather and political issues and solid Chinese economic data. This coupled with credit rating upgrades drove tighter spreads for Metals and Mining issuers. The risk of debt funded acquisitions caused the Telecom/Media/Technology sector to underperform even though it is one of the wider spread sectors.

Source: Bloomberg Barclays Index (as of 3/31/2017), AAM

Credit Fundamentals Expected to Improve From Cyclically Weak Levels

Credit metrics continued to weaken in 2016, as EBITDA growth did not keep up with rising debt levels, resulting in debt leverage to increase once again. That said, companies became more parsimonious with debt leverage in the second half of 2016 in response to the capital markets closing and spreads widening meaningfully with a rising probability of a recession earlier in 2016.

We project improving revenue and EBITDA growth in 2017 driven mainly by:
Higher commodity prices, benefitting energy and basic material issuers
Higher interest rates relative to 2016 and modest loan growth, benefitting banks
Improving emerging market economies, consumer demand for PCs and smartphones (iPhone 8, new features), and investment in cloud infrastructure, benefitting technology issuers.

Optimism remains elevated post the election, and analyst estimates for EBITDA and capital spending for the majority of sectors remains higher as well. Entering 2017, our outlook for credit fundamentals was generally positive except for a handful of sectors where we expected growth to disappoint (e.g., Autos, Retail, Cable). Growth disappointments related to secular challenges or cyclical slowdowns keep event risk (and thus, ratings risk) elevated. For example, after a disappointing fourth quarter and forecast, S&P downgraded Under Armour from investment grade to high yield.

Default Risk Falls

We expect the default rate to fall in 2017 due to higher commmodity prices and a much improved credit market. Bank standards have loosened, yields have fallen (high yield, investment grade and emerging markets), and the leveraged loan market is wide open after being closed for a period of time in 2015-2016. Demand is especially strong for leveraged loans, causing spreads to tighten in CLOs and bank loans. This has resulted in loan refinancings and investor willingness to accept looser covenants (“covenant lite”). Lastly, the Credit Manager Index continues to reflect a favborable environment for non-bank lenders.

The credit cycle, which had appeared to have peaked in late 2015, has been rejuvenated. Until we see evidence of credit contraction, we expect spreads to remain range bound (OAS between 110 – 140 bps).

Rating Stability Expected

The credit rating of the IG Corporate market has fallen over the last ten years as the percentage of BBB rated securities has increased due primarily to: (1) rating downgrades as companies take advantage of lower rates to increase shareholder returns (share repurchase, M&A), (2) changes in rating methodologies in the Finance sector post the financial crisis, and (3) an increase in the number of non-Financial issuers, which tend to be capitalized with more debt.

Source: Bloomberg Barclays (based on market values); AAM

Tax policy is uncertain, and the changes being discussed have varying consequences to IG issuers. While we have an understanding of how this may affect firms in various industries, we (and management teams) are at a standstil until there is more clarity on what is likely to pass. At this point, we do not expect meaningful changes to the tax code with a modest reduction in the corporate tax rate most likely. Except for industries that face structural issues such as Retail, we expect ratings to remain largely stable in this period of uncertainty despite a historically flat WACC curve by credit rating.

Market supply and demand technicals remain supportive

Insurance and Pension Funds, traditional holders of corporate bonds, increased purchases in 2016, on the prospect of increased rates and because competing asset classes were less attractive. Comparatively, money market funds sold corporate bonds due to money market reform. But, the real story was the increase in demand from foreign investors. Foreign ownership of corporate bonds has been rising over the past twenty years with an acceleration over the past couple years given very low (or negative) interest rates in overseas markets. Buying was especially strong from European investors, as the ECB included corporate bonds in its bond buying program, causing yields and supply to fall.

Source: Morgan Stanley

What do we expect this year from foreign buyers? We believe the political and geopolitical uncertainty in Europe will support an accomodative ECB and keep rates low over the near term. The risk is that the ECB becomes more hawkish due to higher than expected economic growth or inflation. We do not believe that risk is incorrectly priced today.

The other technical benefit to IG corporate bonds today is the relative attractiveness to fixed income asset classes such as Structured Products and Municipals, which have experienced spread tightening year-to-date. Moreover, with equity valuations rising and credit spreads tightening in risk sectors such as high yield and emerging markets, it increases the relative attractiveness of IG corporate bonds.

One risk over the near-to-intermediate term is related to balance sheet management by the Fed. Mutual Funds reduced their holdings of MBS after 2008 (per Fed Flow of Funds data), increasing their allocation to credit. If a Federal Reserve unwind of its QE program makes Treasuries and/or Mortgage Backed Securities (MBS) more attractive then a subsequent rotation out of credit and into MBS by fund managers would likely put pressure on corporate spreads.

Written by:

Elizabeth Henderson, CFA

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. Registration does not imply a certain level of skill or training. 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.

December 8, 2016 by

how do you watch tv?

By Elizabeth Henderson, CFA
Director of Corporate Credit

Last week, AT&T launched its long awaited video product, DirecTV Now. This service allows people in the U.S. to watch network television anywhere, anytime using an internet or mobile connection vs. traditional cable or satellite service. The promotion is very attractive, offering over 60 channels for $35/month. If you pre-pay for three months, AT&T will send you a 4th generation Apple TV box ($139 value), allowing you to watch the service on your television. It includes all the popular channels except for CBS and NFL Sunday Ticket (however, we expect both to be available next year). The user interface is easy to use, the picture quality is very good, and from our initial testing (using an iPhone), the latency and reliability is similar if not better than other over-the-top services (NFLX, MLB Network). Not only is the price attractive versus traditional cable offerings as well as competing products such as Sling, AT&T is allowing its mobile customers to stream the video without counting against their monthly data allowance.

This is the first potential real disruptor to the traditional video bundle. While it is not at the same quality as traditional video service, it is considerably cheaper and mobile. We are reminded of the quality of service differences of mobile phones and landlines years ago, with mobile subscribers sacrificing quality for flexibility . AT&T believes video is moving to mobile just like voice did decades ago. As mobile networks get better, the quality of service should improve. Verizon and AT&T are aggressively working to upgrade to 5G wireless networks so that mobile customers have access to 1 gigabit per second (Gbps) speeds, which is similar to fiber network speeds today. This will also enable connected cars and other devices. That said, AT&T is not waiting for a better network to launch this product. They realize that younger audiences are not watching as much traditional television, as viewing options and habits are changing, and many believe that trend will continue.

Exhibit 1: Generational TV Viewing

Source: Barb, Nielsen

What are the implications to the industry? We believe there is a movement away from traditional cable/satellite television and believe in the merits of a mobile, internet based product.

The “winners” are:

Wireless providers such as AT&T and Verizon that have the financial capacity to be a first mover in 5G as well as having the scale (operating and financial) to offer mobile video to consumers. Verizon has the ability to craft a similar package as DirecTV Now since it has relationships with media companies given its FiOS product. Verizon has also been acquiring firms to offer a more unique video solution. Will this push Comcast to buy a mobile company or spectrum? We think so.
Media companies with solid programming such as Time Warner, 21st Century Fox, Disney and most likely CBS. Their distribution could increase after falling over the last three years. They should have access to a larger number of subscribers, given that a lower price point may entice younger viewers to pay for something other than just Netflix, for example. Over 20 million US consumers do not pay or pay very little for cable television today. According to a survey by UBS¹, over 70% stated they would be interested in an internet pay TV service. The primary reasons were cost (cheaper than traditional cable) and mobility. With Netflix, Amazon and other subscription based providers creating their own programming, creating content for television has gotten more competitive. We believe this creates a barrier to entry, as larger firms especially those with studios can compete while smaller ones cannot.

The “losers” are:

Smaller wireless providers including Sprint, T-Mobile and perhaps resellers like TracFone that lack the ability to offer mobile video either because of financial constraints (i.e., AT&T is likely losing money on its low priced DirecTV Now offering) or the lack of operating scale (no relationships with media companies, fewer subscribers which make it more expensive). As well, this removes the advantage Sprint and T-Mobile had by offering unlimited data. This was attractive to users that wanted to stream video, and now, with DirecTV Now streaming for free and Netflix allowing subscribers to download programming, this advantage is minimized.
Cable operators which have earned economic rents for years under the traditional bundle. We are concerned for pure-play cable companies because they will need to upgrade their networks to be competitive in a 5G world, have a first class user interface (no more clunky cable box!), and lower the pricing on their products. While they should be able to demand a higher price because of the quality of service, they will need to pay media companies for the right to offer the same level of service to their customers using mobile devices. While some analysts are positive on the prospect of cable companies only providing the broadband connection vs. cable television, we would highlight the different capital structure that should accompany that business model. With a smaller, cash generative business, we would not expect management teams to prioritize investment grade ratings. Companies in this category include Time Warner Cable, Cox Communications, Dish Network, and Comcast but to a lesser extent given its ownership of NBC and its X1 platform.
Media networks that lack the scale of their larger peers will find it more difficult to maintain the same level of economics given the shift from linear to binge watching. This affects the demand for their programming and then the money they receive from cable/satellite providers and advertisers. These cable networks include Scripps, Discovery, AMC Networks and Viacom (see graph below that shows the steep decline in traditional kids programming) as well as much smaller ones such as Hallmark Channel. The new user interface will help direct the viewer to programming or offer the opportunity to watch an entire season over a shorter period of time instead of a guide that limits one to what is available at that particular time. This has been the trend, and we expect it to accelerate.

Exhibit 2: Linear ProgrammingSource: UBS, Nielsen; Top 50 channels includes 12 factual entertainment networks (e.g., Discovery, History); 18 scripted networks (e.g., AMC, FX, USA, TBS); 7 kids networks (e.g., Nickelodeon, Disney Channel); 4 news networks; 3 sports networks; 2 music networks.

It’s harder to produce great programming because of the cost associated with it, as demand has increased by Netflix, Amazon and others for original programming. As fewer people watch programming that is “mediocre,” the premium paid by advertisers as well as cable/satellite providers to carry the network should decrease. Advertisers will have the ability to target a person instead of a group of people. In other words, advertising is moving from being able to target a group of individuals like those that watch Food Network to an individual based on the location and activity on one’s mobile device (Exhibit 3). This allows advertising to become more successful in a mobile environment. Will this advertising dollar be taken from the media networks or at least shared by the platform or mobile provider? Will this direct relationship with the customer push Disney to buy Netflix? We believe the burgeoning importance of the platform will be the catalyst for major acquisitions in 2017.

Exhibit 3: The Lifecycle of Targeted Advertising

Source: AAM

Sports teams and networks have benefited from skyrocketing sports rights values. The rights to view sports programming have increased in value at a 2-3 times multiple in the past ten years. This was because of the increased use of time shifted programming (e.g., DVRs), causing commercial skipping. Since most people watch sports live, it increased the value of the advertising slots. However, this programming is the most expensive to carry, and if we start to see a real shift towards packages that allow people to customize, and/or cable/satellite providers get more selective with what they want to carry, it should negatively affect the distribution and overall value of this programming. Networks with long term rights agreements that are unable to change the economics of the agreements will likely be losers. However, we believe if the value of sports programming materially falls, the major networks like Fox will seek to renegotiate so they pay fair value. The teams may have no choice but to negotiate in order to avoid the risk of the network defaulting on the agreements.

Exhibit 4: Sports Rights Values

Source: Liberty Media
¹Excludes values of international media rights contracts, ²Excludes value of Thursday Night Football and Sunday Ticket

We are just beginning to see real change in this sector, and expect investors will start to differentiate between the winners and losers in 2017.

Written By:
Elizabeth Henderson, CFA

¹UBS, Doug Mitchelson, “Will 2017 be the year of Internet Pay TV? UBS Evidence Lab survey indicates robust demand”, 9/20/2016

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.

October 17, 2016 by

Remain Disciplined

By Elizabeth Henderson, CFA
Director of Corporate Credit

We are in the late stage of the credit cycle and anticipate an increase in credit rating downgrades to put pressure on spreads for investment grade issuers. These negative fundamentals are partially offset by strong market technicals. We advocate remaining defensive and selective while maintaining the flexibility to take advantage of opportunities that we expect will arise over the near-to-intermediate term.

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The Investment Grade Corporate bond market delivered a 1% total return in the third quarter, tightening 18 basis points (bps), as defined by the Bloomberg Barclays index. Risk assets outperformed, as the S&P Index increased close to 4% in the third quarter, and high yield returned approximately 5%. Investors largely shrugged off oil price volatility, heavy new debt issuance, weaker than expected economic data, and a lackluster earnings season. China’s stimulus, dovish monetary policy and resilient economic growth have likely supported risk assets and commodity prices. Energy and Basic Materials have been significant outperformers this year due to higher commodity prices.

Exhibit 1: U.S. Corporate Investment Grade Option-Adjusted Spread (OAS)

Source: Bloomberg Barclays, AAM

For spreads to tighten meaningfully next year, fundamentals need to improve and market volatility needs to remain low. The cost of equity continues to surpass the cost of debt, incentivizing companies to reduce their equity base to drive growth. We expect this to continue until the cost of debt reprices, which will not likely come unless the probability of a recession increases and the market grows more concerned about future growth prospects. We recognize that in general, favorable market technicals, not broad credit fundamentals, have been the primary driver of tighter spreads. Thus, we remain disciplined as we build corporate bond portfolios.

Performance Summary Year-to-Date

Performance has been fairly widespread among the non-financial corporate bond sectors year-to-date. Energy and Basic Materials rebounded strongly and would have driven returns even higher if $33 billion of debt had not been downgraded to high yield in January and February of this year. Longer maturity corporate bonds have outperformed year-to-date given overall spread tightening and the demand from yield focused accounts, especially in Asia. Financials have lagged because of the prospect of lower rates for longer and the rally in commodity based sectors. Lastly, shorter maturity corporate bonds have underperformed in recent months in part due to money market reform in the US. The imposition of a floating NAV for institutional Prime Money Market Funds (MMF) has resulted in an outflow from these funds. As a result, issuers that had previously relied on CP issuance to Prime MMFs to fund working capital needs have instead tapped the corporate bond market in the 2-3 year space, thus pressuring this part of the corporate curve.

Exhibit 2: U.S. Contributors to IG Corporate Excess Returns YTD 2016

Source: Bloomberg Barclays Index (as of 9/30/2016), AAM

Credit Fundamentals Remain Lackluster

Credit metrics did not improve in the second quarter. Revenue growth (for non financials, excluding commodity related firms) was flat while EBITDA grew a modest 2%. This is not expected to change much in the third quarter, as reflected by analyst estimates. Debt growth at 7% continued to outpace EBITDA growth, as share buybacks accelerated. Shareholders continue to reward firms for using their balance sheets to buyback shares. Other credit metrics deteriorated as well, including cash interest coverage and cash as a percentage of debt.

Option-Adjusted Spread (OAS) per unit of debt leverage is nearing a historically low point. To approach the median (77), OAS needs to widen 55 bps which is about 60% of a one standard deviation move. Otherwise, fundamentals would need to meaningfully improve. This theme is consistent in U.S. high yield as well as European credit. Unless the cost of debt rises (or the cost of equity falls), we do not expect companies to change their behavior radically as it is in the best interest of shareholders to continue to de-equitize unless growth prospects improve.

Exhibit 3: Median OAS/Debt Leverage

Source: Bloomberg Barclays, CapIQ using median figures for IG non-Financials as of 6/30/2016, AAM

Regarding growth prospects, economists are not expecting global growth to accelerate much next year, with global GDP expected to increase from 2.9% in 2016 to 3.1% per Bloomberg estimates.

GDP Estimates	2016 (%)	2017 (%)
United States	1.5	2.2
European Union	1.8	1.4
China	6.6	6.3
Japan	0.6	0.8
Latin America	-1.7	1.7
United Kingdom	1.8	0.7

Source: Bloomberg (Economist estimates) as of 10/12/2016

M&A Still Preferred Over Capital Investment

Companies continue to use debt and cash to fund acquisitions versus increasing capital expenditures despite increased resistance from regulators and the U.S. Treasury. Reduced investment spending as a percentage of GDP has been driving productivity lower.

Exhibit 4: (1) North America M&A Volume and (2) Business Investment

Source: St Louis Fed, Bloomberg, AAM

When analyzing 2017 capital spending estimates for the universe of investment grade companies, we expect spending next year to be approximately flat vs. 2016 on the aggregate with less than ten industries growing at a rate faster than (1) they did in 2016 and (2) the economy overall (2% assumed). While acquisitions have slowed since the peak in 2015, share repurchases have only accelerated. Given the relative performance of companies that have pursued this strategy, per Bank of America’s study, we would expect this behavior to continue.

Exhibit 5: Cumulative Stock Performance of Companies Repurchasing Shares Relative to the Market

Market Supply and Demand Technicals Remain Supportive

Unlike fundamentals, it is difficult to predict a change in technical related behavior. We note that while valuations look expensive relative to fundamentals, we believe it will take a major shock to increase credit spreads meaningfully in an environment where central banks are buying fixed income securities, reducing available supply. Demand continues to come from yield hungry foreign investors.

Exhibit 6: Foreign Ownership of USD Corporate Bonds

Investing in the Late Stage of the Credit Cycle

Defaults have increased this year largely due to commodity related issuers. We continue to monitor the contagion effects of weak economic growth and tighter credit standards. We expect the default cycle will be longer and recoveries lower than they have been historically given the (1) amount of debt outstanding is relatively high, (2) low level of interest rates, making it more difficult to lower the cost of debt via monetary policy, and (3) structural changes in the market post financial crisis affecting liquidity (and the ability to access the market for refinancing). That said, defaults are expected to decline over the near term with the improvement in commodity prices. Moody’s expects the U.S. default rate to be 5.9%, declining to 4.1% by third quarter 2017. But as its forecast indicates, the pessimistic rate rivals the rate in 2009.

Exhibit 7: Moody’s US Speculative-Grade Default Rates (Actual and Forecast)

Source: Moody’s “September Default Report” 10/10/2016

We are in the late stage of the credit cycle and anticipate an increase in credit rating downgrades to put pressure on spreads for investment grade issuers. These negative fundamentals are partially offset by strong market technicals. We advocate remaining defensive and selective with opportunities in intermediate maturity domestic banks, high quality short insurance and autos, electric utilities, M&A related new issuance (e.g., pharma), and select telecom/tower and energy credits. We want the flexibility to take advantage of opportunities that we expect will arise over the near-to-intermediate term, while investing in credits with more predictable cash flows that offer a yield advantage. We recognize the importance of earning sufficient income to not only satisfy the needs of our clients but to cushion the spread volatility that is likely to increase from a very low level over the last six months.

Written by:
Elizabeth Henderson, CFA

Elizabeth Henderson is a Principal and the Director of Corporate Credit at AAM with 19 years of investment experience. She joined the firm in 2002. Elizabeth graduated with Honors and Distinction from Indiana University with a BS in Finance and earned an MBA in Finance, Analytical Consulting and Marketing from Northwestern University’s Kellogg School of Management.

For more information about AAM or any of the information in the Corporate Credit View, please contact:

Colin T. Dowdall, CFA, Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John J. Olvany, Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer, Vice President of Business Development
neelm.hameer@aamcompany.com

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.

March 10, 2016 by

The Bank sector has experienced a reversal of its strong relative performance vs. the Corporate Index during the first quarter of 2016. In this white paper, AAM’s bank analyst examines the drivers of performance in the sector and looks at trades that have outperformed during the recent volatility.

In fiscal year 2015, the Bank sector was one of the best performing subsectors of the Barclays Capital U.S. Corporate Investment Grade Index (“the Index”), reflecting strong capital, improving asset quality and expectations of an impending rate hike cycle.

This trend reversed abruptly in the first two months of 2016 with banks participating in the sharp acceleration of negative excess returns in the Index. As of February month end, the bank sector had generated year-to-date negative excess returns of -227 basis points (bps) as compared to -248 bps for the Index. While broad corporate bond performance has retraced some of this performance in March, the bank sector has actually lagged the overall Index, having generated 40 bps of positive excess returns month-to-date vs. 94 bps for the Index.

However, a more granular examination of the performance in the bank sector better illustrates what trades have helped or hurt performance in the space. If we break out performance of senior bank bonds vs. subordinated bonds (the latter representing the riskier portion of the bank capital structure), it quickly becomes clear that the bulk of the negative excess returns were driven by the subordinated bonds (-498 bps through February). In contrast, senior bank bonds actually outperformed the Index with negative excess returns of -163 bps through February (Exhibit 1).

Exhibit 1:

Source: Barclays, AAM

Additionally, the performance in the bank sector has been depressed by the non-domestic (Yankee) banks (-203 bps excess returns YTD for Yankee banks vs. -186 bps for banks overall). The negative performance in Yankee banks was driven in particular by the sharp sell-off in European banks in February as fears about capital adequacy and the ability to continue paying coupons on capital securities were sparked by poor financial results and diminished return on equity prospects for several of the continent’s largest banks (Deutsche Bank, Credit Suisse and Unicredit were all subject to material sell-offs).

Anecdotally, many total return managers were also hurt by their overweighting of Additional Tier 1 /Contingent Convertible (CoCo) securities, which represents an investment in the most junior layer of the bank capital structure. While CoCos are not included in the Index (because they are generally not investment grade rated), they generated very strong performance in fiscal year 2015 (+6.3% total return), and were a top recommendation of most sell-side credit strategists heading into 2016. However, through February AT1/CoCos delivered a -8.6% total return as fears about coupon sustainability grew.

So how is AAM positioned within the bank space?

We have been overweight the bank sector since mid-2009 based on improving fundamentals and an increasingly benign economic outlook. However, within the bank sector we have retained a strong preference for senior vs. subordinated bonds, reflecting a preference for downside protection and a desire for clarity on Total Loss Absorbing Capacity/Capital (TLAC) rules. We have also increasingly weighted regional and community banks vs. universal banks, reflecting the potential for increased issuance by universal banks to meet TLAC minimum debt requirements, as well as our view that the traditional banking model of the regional space was likely to have better fundamental momentum in a slow growth environment and less residual regulatory liability.

Finally, we have been underweight Yankee banks, and particularly European banks, since macro-political instability in Greece, Italy and Spain sparked the European sovereign crisis in 2011. Although fears of a Euro or EU break-up have receded somewhat, we have remained underweight as we feel the underlying causes of that crisis (lack of political consensus and stagnant economic growth) remain unresolved. Additionally, we view the European universal banks as having a much greater restructuring burden with regard to meeting TLAC requirements as compared to the U.S. universal banks.

While our underweight to subordinated debt and Yankee banks constrained investment performance during 2014 and 2015, the benefits of this credit selection can be seen in the downside protection in periods such as the first quarter of 2016. Conversely, we began selectively investing in subordinated bank debt of the U.S. universal banks in late February, as we felt that the spread widening over the previous two months had made certain credits attractive given our fundamental outlook (Exhibit 2).

Exhibit 2:

Source: Barclays, AAM

Written by:

N. Sebastian Bacchus, CFA
Senior Analyst, Corporate Credit

For more information, contact:

Colin T. Dowdall, CFA
Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John Olvany
Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer
Vice President of Business Development
neelm.hameer@aamcompany.com

March 7, 2016 by

The start of the year ushered in a heightened level of spread volatility. Markets reacted to lower commodity prices and an increased risk of a global recession. The Investment Grade Corporate market experienced spread widening of 50 basis points at the wide point in mid-February. Defensive industries have outperformed, with non commodity sectors contributing more to the market widening this year.

Is It Over?

As of early March, the market has recovered about half of that widening due to the bounce in commodities and more favorable economic data. The economic data points we follow have signaled a slight improvement from the deterioration we have seen since September 2015. Market anxiety remains in regards to China, “Brexit,” and the trajectory of commodity prices. AAM entered the year expecting volatility to be higher and economic growth to be lower than expected but not negative. We have been communicating that we believe we have been in the late stage of the credit cycle since mid-2014. After reviewing fourth quarter results and listening to earnings calls during which management teams provides their guidance for the year and discuss capital allocation, we do not believe the cycle has turned, and thus, do not expect Investment Grade credit spreads to meaningfully tighten.

Fundamentally, credit risk is elevated. At a market or median level and excluding commodity related sectors, revenue and EBITDA growth rates remain abysmal. There are certainly exceptions at an industry level. We highlight sectors such as Pharmaceuticals that are expected to grow nicely this year. That sector is one we expect will continue to be active with mergers and acquisitions, and we anticipate attractively priced new debt issues to be the result.

During earnings calls, we did not hear management teams become more balance sheet focused unless they were in the midst of deleveraging from a prior transaction or in a stressed sector like Energy. We heard much of the same – cash flow and capital allocated to share repurchase programs, increased dividends, and the pursuit of M&A opportunities. With the cost of debt still well below the cost of equity, we don’t anticipate a change. Until markets reprice risk, we expect to remain in this trading range, more likely resetting higher as economic risk increases given the tightening of financial conditions.

Is There Value in the Investment Grade Market Today?

Yes. We entered the year, expecting the corporate OAS to trade within a range of 145-215 basis points (“The Future Ain’t What It Used to Be” – AAM 2016 Investment Outlook), and we remain on the wider end of that range. We highlight the following opportunities:

1. New debt issuance from:

a. issuers funding M&A transactions that we project will add value to the enterprise

i.Examples include credits in the Beverage and Pharmaceutical industries (Anheuser-Busch InBev N.V. (ABIBB), Molson Coors Brewing Company (TAP), Teva Pharmaceutical Industries Limited (TEVA), Pfizer, Inc. (PFE), Mylan N.V. (MYL))

b. high quality companies financing share repurchase programs

i. Examples include companies with stable cash flows and a sensitivity to credit quality because of their need to fund working capital (Lowe’s Companies, Inc. (LOW), Wal-Mart Stores, Inc. (WMT), 3M Company (MMM), Walt Disney Company (DIS))

c. high quality credits in sectors that have cheapened with the increasing risk of recession and “lower for longer” interest rates

i. Examples include Autos, Retail, Insurance Brokers, Banks (subordinated)

2. Secondary opportunities in credits with the financial flexibility to maintain investment grade ratings in a downside scenario. We also note the improvement in value on the short end of the corporate curve (1-5 years) relative to the last five years (Exhibit 1).

Exhibit 1:

Source: Barclays and AAM

We do not see value everywhere; however, and are largely avoiding sectors and credits we believe are most vulnerable in a low growth environment. The Technology sector is one that has raised a lot of debt and now faces lower return prospects. We are avoiding credits rated BBB in that sector. Another is Healthcare REITs, a sector we have avoided because of concerns about rapid consolidation and competition amongst the largest operators, and given our view that not all of the operators will thrive once the sector stabilizes. We are also cautious about the aggressive push into operating businesses under RIDEA (REIT Investment Diversification and Empowerment Act) by the largest Healthcare REITs. Lastly, the Food and Consumer Products sectors are filled with household names that have failed to execute and are vulnerable to shareholder activist pressure or debt financed M&A to increase shareholder returns. Looking at various spreads in these sectors (Exhibit 2), we fail to find value in the single-A rated credits vs. Industrial peers. For BBB Tech and Healthcare REITs, we believe the rationalization that needs to occur will push spreads wider, towards BB levels.

Exhibit 2:

Source: Barclays (as of 2/29/16), AAM [Note: Total = Barclays Industrial sector]

For more information, contact:

Colin T. Dowdall, CFA
Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John Olvany
Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer
Vice President of Business Development
neelm.hameer@aamcompany.com

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.

February 18, 2016 by

We believe investors should be aware of distressed exchanges given the increased number of fallen angels in the energy space and the negative influence that this liability management tool is having on bond prices and the high yield sector. In the following pages, we detail how an exchange typically takes place and why they are becoming more prevalent. We also provide a list of items that investors must consider when evaluating an exchange offer, review how the exchanges are influencing the high yield market, and review past exchanges. Unfortunately, there is no template for investors to use when deciding to exchange or not. Each exchange is unique, and a careful evaluation of many factors is necessary. This opinion is supported by the ultimate success of an exchange, which is slightly greater than 50/50 according to a New York University study¹.

Distressed Debt Exchange Description

In a distressed debt exchange (DDE), a company proposes that existing debt holders take a haircut on their principal amount in exchange for moving up in payment priority in the form of secured debt. Generally, a distressed exchange is proposed by a company to avoid a bankruptcy, improve liquidity, reduce debt, manage its maturity dates (by exchanging debt securities that are coming due for debt securities with an extended maturity) and to reduce or eliminate onerous covenants.

For example, XYZ Company has $100 million principal of 7.0% senior unsecured bonds due June 30, 2018. Due to market conditions, these distressed bonds are trading for $30, yielding 66% with a par value of $100. The company has little liquidity and external capital options are limited, so refinancing or repaying this upcoming maturity is doubtful. In order to avoid a costly bankruptcy, XYZ may offer to its bond holders the chance to exchange 100% of its 7.0% senior unsecured bonds maturing in 2018 for 80% of the original principal for new, 8% secured second lien debt maturing June 30, 2022. The new second lien debt will be issued at $50; yielding 25% based on peer trading levels and have a par value of $100. If all $100 million of principal is exchanged, the issuer will have eliminated the need to refinance in the near term (from 2018 to 2022), delayed a bankruptcy, reduced debt by $20 million (from $100 million to $80 million, also known as a Cancellation of Debt), and reduced annual interest expense by $0.6 million ($100 million x 7% – $80 million x 8%). Investors will forgo $20 million of principal, but will move to a secured position in the capital structure and see the price of its holding increase to $50 from $30. A secured position offers higher recovery values relative to an unsecured position if the company were to ultimately file for bankruptcy (See Exhibit 1).

Exhibit 1:
Source: AAM

The rating agencies play a role in DDEs as well. Based on their respective methodologies, if the exchange is viewed as effectively allowing the issuer to avoid bankruptcy or payment default, the rating agencies will take action to reflect the loss expected to be incurred by participating debt holders (e.g., Caa3, Ca, or C, using Moody’s scale). Otherwise, the agency will view it to be an opportunistic refinancing. Moody’s explains that often, the rating of the issuer is the determining factor of whether or not it is opportunistic. Debt exchanges from issuers rated B1 and higher are typically deemed as opportunistic refinancings vs. those rated Caa1 being viewed as distressed exchanges. This likely causes companies to pull forward the timing of the DDE, so the downgrade is less onerous.

Why are They Being Discussed Now?

DDEs are not new and have been used for decades. They have become more common in the last year following the surge in distressed energy companies. In fact, we are aware of at least a dozen energy companies that have employed this tactic since the beginning of 2015. Upon the completion of a DDE, the issuer will likely have reduced total debt and interest expense without using cash, thereby improving its credit profile modestly.

Reduced cash flows combined with inflated capital structures have contributed to an increase in liability management as a tool to delay or prevent a costly Chapter 11 default. In the Energy sector, lower commodity prices reduce companies’ borrowing bases, since banks use frequently updated asset values based on discounted cash flow analysis to determine borrowing-base availability. These updates, which generally occur every six months, are known as redeterminations. Exploration and Production (E&P) companies with unhedged production volumes leave themselves entirely exposed to low commodity prices, and risk significant borrowing-base reductions when the redetermination takes place. Banks generally give E&P companies some time to improve their liquidity, rather than take over the E&P assets themselves, but will take action if necessary.

Additionally, there are tax reasons for the increased use of this tool. Historically, if companies repurchased bonds at a discount, the difference between the par amount and the purchase price was a gain and taxed accordingly, significantly offsetting the benefits of the exchange. However, this changed in 2009 when the American Reinvestment and Recovery Act allowed deferral of most cancellation of debt (COD) income for five years and then allowed amortization of that COD over a five year period. Presently, section 108(a) of the Tax Code provides that in insolvency and bankruptcy the COD income is permanently excluded from taxation.

Evaluating a DDE Offer

When faced with a DDE offer, an investor must first determine the probability of default. Analyzing the issuer’s existing liquidity and the amount of time that the company can operate in the existing stressed environment should provide direction on whether or not a default is likely in the near term. If the investor is confident that a bankruptcy is unlikely and the issuer is simply attempting to take advantage of market conditions to reduce leverage via an exchange, then declining the exchange is the best course of action.

If a bankruptcy is more likely, investors should closely analyze and stress the company’s cash flows and multiples to determine a reasonable amount of debt that the company could support and receive court approval to emerge from Chapter 11. If the restructured company will only be able to support the amount of senior secured debt being offered as part of the exchange, then accepting an exchange offer should be strongly considered.

DDEs are usually voluntary and some holders of the debt may not exchange, which presents a holdout issue that investors must consider when deciding whether or not to accept the exchange offer. Importantly, debt exchange offers may be conditioned on the tender of a high percentage (e.g., 90% or more) of the debt sought in the offer. Such a minimum condition can provide comfort to holders who may otherwise be wary of exchanging debt securities at a discount if other holders who do not participate will reap the economic benefits of the exchange (i.e., the borrower’s improved balance sheet and ability to pay debts) without the cost. A minimum condition provides assurance that there will be, at most, a limited number of such free riders. Additionally, debt exchange offers can be structured to include various incentives such as secured debt and early tender premiums to holders to participate. Moreover, debt exchange offers can be combined with consent solicitations that propose, through an indenture amendment, to strip covenants and other protections from the debt sought in the exchange offer.

Another item to evaluate when considering an exchange is the influence of credit default swaps (CDS) owners on the issuer. Holdouts and the acceptance rate of the exchange will certainly be affected by those investors who own CDS. Bondholders that buy protection under CDS will be incentivized to force the issuer into bankruptcy in order to collect under their CDS contracts and therefore will likely not participate in efforts by the issuer to improve liquidity, extend maturities or reduce debt. The problem is increased if an issuer requires a high acceptance rate in order to make the debt exchange offer economically viable.

A final consideration in the exchange decision is estimating what liquidity there will be for the non-exchanged unsecured bonds. A significantly reduced total issue size will reduce liquidity of that issue, negatively affecting prices and likely incentivize holders to exchange. However, this concern is somewhat mitigated for holders of debt maturing prior to the secured notes offered as part of the exchange. The logic is that the improved credit profile of the issuer subsequent to the exchange could actually improve the likelihood that the original debt will be repaid. It will obviously mature first and the total funds required to repay or refinance the original debt that remains outstanding will be reduced significantly due to the exchange.

Influence on Today’s Market

We believe the threat of more DDEs with potentially new senior secured debt has contributed to rapidly declining prices in the high yield energy market (Exhibit 2) for two reasons. The first result of this potential threat is an increase in the number of sellers of any issuer that has capacity to take on senior secured debt, regardless of whether or not there is an impending need for liquidity or solvency issue. The second result is that there are few investors willing to buy unsecured debt given the lack of confidence in the future capital structure of the investment. We believe this environment will persist until unsecured investors involved in exchanges demand more favorable terms, issuers provide assurances that there is no need for an exchange in the foreseeable future, and/or macroeconomic conditions improve.

Exhibit 2: High Yield Energy Yield to Worst

Source: Bank of America Merrill Lynch High Yield Energy Index (HOEN)

Evaluation of DDEs

We believe that the success of a distressed exchange should be viewed from the perspectives of the original investor, the distressed investor and the issuer. It is too early to determine the outcome of the exchanges from the investors’ perspectives in the recent energy related transactions. However, it appears as though those companies have merely delayed the inevitable default at this point, which probably favors those investors that accepted the exchange offer.

If a DDE is eventually followed by a bankruptcy, the restructuring efforts could be characterized as unsuccessful. However, we believe that the exchanges have achieved several of the companies’ goals. The exchanges have in fact partially extended near term maturities, reduced total debt and interest expense, allowing the companies to postpone a costly default in hopes of a recovery in the operating environment.

Studies of the outcomes of previous exchanges have to be viewed cautiously because few such transactions have taken place. Out of 57 DDEs to take place from 1984- 2008, 26 (46%) were followed by a bankruptcy filing (20 Chapter 11 reorganizations and six Chapter 7 liquidations), seventeen (30%) firms were eventually acquired, while 11 (24%) were still operating in 2009 (Exhibit 3). Additionally, the recovery rate of the exchanged debt that eventually defaulted was 52%, whereas, the recovery rate for the 875 non-DDE defaults in that same period was 42%.

Exhibit 3: Subsequent Development of Distressed Exchanges (1984 – 2007)

Source: The Reemergence of Distressed Exchanges in Corporate Restructurings (2009), AAM

Conclusion

Market participants believe debt exchanges are going to accelerate in the upcoming year as distressed energy companies attempt to reduce debt, improve liquidity, and delay a costly bankruptcy. Other companies may seek to take advantage of the weak environment and offer an exchange despite not having a liquidity or solvency issue in the near term. We have outlined several critical factors to analyze when deciding to accept an exchange offer or decline. We believe this knowledge prepares us to make disciplined investment decisions in the event we are faced with deciding against an exchange offer or accepting less than the original promised principal.

Written by:

Patrick McGeever
Senior Analyst Corporate Credit

¹ Edward I. Altman and Brenda Karlin, “The Reemergence of Distressed Exchanges in Corporate Restructurings,” (March 2009) accessed February 11, 2016, https://people.stern.nyu.edu/ealtman/Reemergence%20of%20Distressed%20Exchanges.pdf
² Edward I. Altman and Brenda Karlin, “The Reemergence of Distressed Exchanges in Corporate Restructurings,” (March 2009)
Lenny Aizenman et al., “Distressed Exchanges: Implications for Probability of Default Ratings, Corporate Family Ratings and Debt Instrument Ratings,” Moody’s Global Corporate Finance, (March 2009)
³ Ze’-ev D. Eiger et al., Liability Management Handbook 2015 Update, International Financial Law Review, 82, accessed February 11, 2016, https://media.mofo.com/files/Uploads/Images/MofoLiabMan.pdf
⁴ “Debt Exchange Offers in the Current Market,” The Bankruptcy Strategist, Law Journal Newsletters, Volume 26, Number 9 (July 2009)
⁵ “Debt Exchange Offers: Legal Strategies for Distressed Issuers – Navigating Complex Securities Laws When Restructuring Convertible Debt Securities,” 7, (April 15, 2010). Accessed February 11, 2016, https://media.straffordpub.com/products/debt-exchange-offers-legal-strategies-for-distressed-issuers-2010-04-15/presentation.pdf
⁶ Edward I. Altman and Brenda Karlin, “The Reemergence of Distressed Exchanges in Corporate Restructurings,” (March 2009)

For more information, contact:

Colin T. Dowdall, CFA
Director of Marketing and Business Development
colin.dowdall@aamcompany.com

John Olvany
Vice President of Business Development
john.olvany@aamcompany.com

Neelm Hameer
Vice President of Business Development
neelm.hameer@aamcompany.com

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.