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December 12, 2018 by

Our investment process includes regular presentations from the analysts on themes that will influence the future performance of companies and credit spreads. Two years ago, we presented 5G and how that will affect companies’ strategic plans in the Telecom, Media and Technology (TMT) industries. Even though 5G was not something we had expected to be deployed meaningfully in the near term, it was a technology that would influence decision making across the TMT space. We have found the investment community to be split on whether 5G will succeed, and perhaps Verizon’s recent success in its test markets may start to increase investor confidence. With the arrest of Huawei’s CFO, it is difficult to dispute the importance of the technology.

There are critical questions to be answered such as: What is 5G, and why do we need it? How will the industry be structured given the tremendous increase in capacity? And, in the quest for returns on the capital deployed, what industries and companies will be disrupted? We will address these questions and more in this report. An important conclusion is that while this technology will take some time to fully implement, the path towards 5G is important and the benefits it could provide to companies and economies are meaningful.

Why are wireless companies investing in 5G?

With four national wireless carriers in the U.S., competition is intense, and aggressive promotions like unlimited data have filled up the networks. Unfortunately for the carriers, they have not captured much of the upside economically. Technology companies like Facebook and Netflix have driven much of the increased usage on the network, profiting nicely, while the wireless carriers have seen little change in consumers’ average monthly payment or ARPU (average revenue per user). Wireless carriers are faced with a problem of increasing capacity on the network because of these strains while earning a return on that investment. The migration from 4G/LTE to 5G is necessary to increase capacity and return potential. The technology will address problems that exist today while providing revenue opportunity associated with new use cases. It also changes the competitive playing field.

What exactly is 5G?

Exhibit 1

5G is the fifth generation of wireless technology. It differs from predecessor technologies in many ways. Most notably, it requires upgrading the core network in addition to the radio technology. To offer true 5G speeds, a network must be densified, requiring fiber and small cells to be deployed as well as the addition of technology such as Massive MIMO. A 5G network will ultimately allow very low latency (1ms vs. ~20ms in LTE), faster speeds (gigabytes), and the ability for wireless carriers to manage networks in a more efficient and flexible way. Importantly, while a fixed wireless 5G network leverages high band spectrum (>3.5GHz, mmWave), mobile 5G can be deployed on all spectrum bands. Lower bands may not provide the bandwidth necessary to replace a high bandwidth fixed offering (i.e., from a cable company or fiber provider), but will be sufficient to deliver applications for internet of things (IoT), industry automation and other business critical use cases. Also, the advantage over 4G/LTE should be sufficient to cover more rural areas of the U.S., approximately 40% of which do not have speeds of 25Mbps. Furthermore, the path towards 5G allows wireless carriers to upgrade their current mobile offerings. For example, AT&T is expecting to offer speeds over 400 Mbps to mobile subscribers with newer handsets (e.g., iPhone 8, X) next year given the upgrades to their 4G/LTE network as they work towards 5G.

Can 5G be deployed profitably?

This is the big question that is difficult to answer at this stage. As we explained, wireless carriers need to invest in their networks just to meet the demands today. We believe the additional investment will be made according to use case. The image below shows how various network architectures can be utilized based on the ultimate need and return potential. Lower frequency spectrum provides wider area coverage but cannot provide the very high speeds of a mmWave based 5G network. However, this type of network is not needed for every use case. A true 5G network will likely be deployed in areas like stadiums and smart cities that need to support more devices per area (5G can support 1 million devices per square kilometer vs. 4GLTE’s 2,000). Therefore, we expect carriers to be selective with how they upgrade their networks from a capital investment standpoint. European carriers are already talking about sharing infrastructure to deploy 5G more profitably.

Exhibit 2

In terms of capital spending, we expect carriers to invest at a pace consistent with historic periods. We also believe the investment period will be more gradual and prolonged given the significance. Positively, carriers expect to reduce their operating costs as they migrate to 5G. This is not only a selling point for the wireless carriers but for their end users as well. We believe the benefits of the network will allow enterprise and/or public services to increase their productivity and lower costs. This should have a positive impact on inflationary pressures longer term.

Exhibit 3

Revenue upside for telecom providers is expected to be realized over time. Initially, we expect the wireless carriers to gain market share in video and broadband as consumers “cut the cord” and replace their wired solution with wireless. True 5G will be competitive with modern cable offerings; therefore, the competitive advantage will no longer be speed and reliability but functionality. We believe the wireless companies should have the advantage in the residential market.

The advantage of a 5G network is the ability to use it more broadly – not just for consumers. Use cases even in the initial investment period will involve IoT (smart homes, cities, buildings) and entertainment offerings like advanced augmented reality, virtual reality, connected/autonomous vehicles (infotainment, navigation), industrial and vehicular automation, and mission critical/emergency services. As standalone 5G networks are deployed longer term, the ability to leverage the network for autonomous vehicles is more likely. Verizon and AT&T are involved in the planning phase with vendors, auto manufacturers, and suppliers to ensure their involvement beyond infotainment and navigation. Moreover, the flexibility of the network should allow the carriers to structure various business models depending on the use case. The network will be able to be customized depending on the vertical (healthcare, auto, manufacturing). It also will help support Artificial Intelligence (AI).

It is expected that the initial period will last through 2021, as radio and other equipment is added, with the ramp in investment occurring from 2021-2025, as international standards are finalized and operators have a better understanding of the ROI. Handsets with 5G capabilities should be available by 2020, with 5G expected to become the lead mobile technology in the U.S. by 2025. Longer term, standalone networks will be built to enable full usage of 5G, which is expected by 2035. For this to occur, we believe carriers will need to rationalize the capacity in a way to manage the economics associated with the return. Accordingly, we believe the U.S. needs to become a three carrier market and are keenly interested in the success of the Sprint/T-Mobile merger and the future of Dish and its spectrum portfolio.

Which companies will win or lose?

In the near term, technology, tower, and construction companies will benefit. Their ability to manage this cycle of investment is critical. Crown Castle has been investing in 5G via fiber and small cells, a strategy we like as macro tower revenue growth is likely to flat line or potentially decrease as more small cells are deployed and utilized longer term. Wireless companies in the U.S. must also approach this investment cycle cautiously, especially as virtually all of them have little financial flexibility given their dividend payouts and debt leverage. Conversely, we like the structural benefits of the Canadian wireless industry (more fiber to homes, benign regulatory environment, converged carriers with both cable and telecom) and believe these carriers will benefit from a more disciplined 5G rollout and investment cycle. European carriers are also taking a much more cautious approach but are dealing with pro-consumer regulatory bodies that need to bend to foster 5G investment.

We believe cable, rural telecom providers, and smaller media networks will need to restructure and/or transform their businesses to survive. The regional telecom operators like Frontier and Windstream have suffered in the equity market as investors appreciate the risk to longer term cash flows as their rural markets are vulnerable to wireless substitution. As we noted earlier, rural markets do not need a true 5G solution. Simple upgrades to existing networks, as Sprint/T-Mobile have promised as part of their push to regulators to approve the merger, will disrupt these companies as well as other smaller “mom and pop” cable/telecom companies. We believe the same pressure will be applied to cable companies as they lose their competitive advantage and need to invest and possibly re-engineer their business models around these changes in the marketplace. If they become “broadband only” businesses, do they need media holdings and/or investment grade ratings to maximize returns for shareholders?

From another perspective, will wireless carriers need to offer more than connectivity to maximize their 5G return on investment (ROI)? AT&T clearly believes it will need to participate as a media company with its acquisition of Time Warner, but Verizon does not. We believe the advantage of an integrated offering (content plus distribution) is not truly known today, and as this becomes apparent, will determine future M&A activity for companies like Verizon and Charter. As consumers access media in ways that expand beyond video, using AR and VR capabilities, media network companies (e.g., CBS, Discovery, Viacom) will need to invest and restructure their businesses around their strengths and not simply look to maximize programming to push through linear and virtual channels as they have done to date. In the meantime, with the amount spent on programming expected to reach over $100B in 2020 vs. $65B in 2016 – mostly from new entrants like Apple, Hulu, Facebook, Amazon and Netflix – what does that mean for traditional networks that do not have strong brands or a platform that allows them to directly interact with the consumer?

We expect more M&A activity in the cable and media space in anticipation of pressure to their business models in the intermediate term (2021-2025). This is because the benefits of 5G related technology enhancements enable fixed to wireless substitution, which should pressure cable/satellite cash flows and revenue streams for media networks that rely on payments from cable providers. Notably, critical sports rights expire beyond 2020 (e.g., 2021-2022 Monday and Sunday night football rights), and with 5G technology improving the mobile experience, technology companies like Amazon and Google are likely to be more aggressive in the bidding process. We believe smaller networks like CBS will be unable to support these higher prices. An economic recession could pull forward the destruction of value for cable and media networks, as consumers look to rationalize their media/telecom spend.

Summary

5G is a critical technology not just for the industries and companies involved but for economies around the world. With projections of trillions of dollars being added to global economic activity by 2035 (per IHS Markit), we believe this will continue to drive decisions not only in board rooms but by government officials as well. China has been pushing to be the first with 5G, and Huawei is an important part of that strategy. We are maintaining our bias towards high quality Communications and Technology companies. We continue to expect heightened event risk (asset sales, M&A) and financial disappointments from lower quality, secularly challenged companies.

November 7, 2018 by

Post tax reform, investors expected debt supply would decline. Year-to-date, gross debt issuance is on track to be 8% lower than 2017, as companies are working down debt used to fund acquisitions and/or higher interest costs and the new tax law are discouraging debt financed share repurchases. But despite higher rates of EBITDA growth, debt leverage has declined very little. To work their way out of higher levels of debt leverage, companies need growth to continue at these higher rates or shareholders will see less return via curtailed share repurchase programs or, worse yet, dividends.

With debt leverage as high as it is today, credit ratings are at risk of falling if an economic slowdown occurs earlier than expected. We believe about 5-10% of the Investment Grade (IG) market is at risk of falling to high yield (HY) if a recession occurs in the next 12-24 months. This is expected to have a meaningful impact on portfolio performance given the spread widening and potential other costs for investors who hold “index like” portfolios or those with a higher level of credit risk.

Why has leverage increased?

In 2009, the number of firms with more than 3.5x debt-to-EBITDA leverage doubled versus 2005 due to the contraction in EBITDA caused by recessionary conditions. Companies worked to improve their balance sheets by 2012. After this, as economies stabilized (albeit at relatively low growth rates) and debt costs were extremely low, companies added debt at a fairly aggressive pace. The majority of this debt was added to fund: (1) acquisitions in order to reduce expenses and add businesses with growth potential and (2) share repurchase programs to enhance shareholder return (and likely meet performance targets for management teams). Today, there are more firms with leverage in the 2-3.5x range, commensurate with BBB ratings, and fewer firms with leverage less than 1x, which is typically reflective of AA or AAA ratings. Unless interest rates meaningfully increase, we do not expect companies to return to the days of pristine balance sheets.

Exhibit 1: Composition of Debt Leverage for Non-Financial Companies

**Source**: Factset, AAM
(Includes over 350 IG issuers as of 6/2018, excluding Utilities, Financials, Autos and Construction Machinery); Leverage is measured as: Debt/EBITDA(x) and percentages based on issuer count.

Are some industries safer than others?

Looking at the issuers in the market today, excluding those with naturally high leverage such as Utilities, Financials, and companies with Captive Finance companies, we note that the number of issuers with elevated leverage is similar to 2009. While we recognize the increase in BBB rated debt in the marketplace, we note that many firms that have increased debt leverage commensurate with weak BBB ratings (i.e., leverage greater than 3.5x) are consumer related, which should have less cyclical cashflows. That said, these firms are relying on growth and, for some, asset sales to reduce debt over the near to intermediate term. This strategy will be placed at risk if the economy slows materially and/or asset values fall, as we witnessed in October with the drop in the stock market. Therefore, even the most “defensive” credits are not immune to downgrade risk.

Exhibit 2: Highly Leveraged IG Issuers by Sector vs. Prior Cycle

**Source**: Factset, AAM
(Includes over 350 IG issuers as of 6/2018, excluding Utilities, Financials, Autos and Construction Machinery) “Highly leveraged” = firms with Debt/EBITDA exceeding 3.5x

What is the downgrade risk to portfolios?

Today, as we review this list of approximately 60 issuers with elevated debt leverage, we estimate about one third will be downgraded to high yield if a recession were to occur in the next one to two years. Adding Financials to our analysis, we believe the sectors and issuers most vulnerable if a recession were to occur are low BBB rated and, in the REIT, Finance and asset management sectors as well as low BBB rated subordinate debt. Utilities are not likely to be materially impacted. In total, we estimate $225 billion is at risk of falling to high yield with $445 billion as a bear case estimate (which includes low BBB rated subordinated bank debt, Charter, Ford and GM). That would imply 5-10% of the IG market falling to high yield. That is not outsized relative to the total IG or HY market versus prior recessionary periods. S&P states on average 5% of U.S. companies rated BBB have been downgraded to high yield, increasing in recessionary periods with 8% in 2009 and 9% in 2002.*

Exhibit 3: Downgrades from IG to HY ($B)

**Source**: Morgan Stanley (downgrade history), AAM credit team for recession base and bear case estimates

What is the impact?

While 5-10% appears to be relatively immaterial as a percentage of the IG market, it is material to the holder of the securities when they become HY rated especially if that holder is an insurance company.

First, the risk of default meaningfully increases when a bond falls to HY (from an average of 21 bps to 78 bps from BBB to BB respectively per S&P*), which requires an increase in the credit spread to compensate for that risk. In a period of increased risk of default, low quality IG bonds are not the only ones to widen. The correlation in Fixed Income is high, which means widening will occur in all rating categories to various degrees (e.g., A/higher credits may widen 50 bps vs. BBBs that widen 100-300bps). This will have an impact on the market value of the entire Corporate bond portfolio.

As it relates to the bonds that fall to HY, not only will spreads widen due to increased default risk, but they will widen for a period of time due to a supply and demand imbalance (see Exhibit 4). Many investors are forced to sell debt that falls to HY due to portfolio restrictions and/or guidelines. Exhibit 4 shows the typical pattern when an issuer is downgraded to HY. Spreads widen over 300 bps and then tighten from the point of being downgraded as supply and demand normalizes.

Now, what does this mean for a portfolio? Assuming a portfolio holds 10 year maturities with 50% in Corporate bonds, of which 5-10% are downgraded to HY, that would imply a fall in portfolio market value of approximately 1%. The widening in the other A and BBB bonds would add to that market value loss. Diversification in the portfolio is important, and this analysis assumes issuer weightings in the portfolio that are commensurate with the Corporate market as reflected by the Bloomberg Barclays Corporate Index.

In addition to these economics, there are rating agency and/or regulatory implications for insurance companies. Both RBC and BCAR will be negatively impacted by an increase in high yield holdings. This is especially true for companies with Equity holdings, as an increase of downgrades is likely to coincide with a sell off in the Equity market, will impacting capital levels. Moreover, life companies will be subject to higher asset valuation reserve (AVR) balances for HY bonds (exponential). Depending on current capital levels, meaningful downgrades to HY could place a strain on surplus for some insurers, particularly in the P&C space. This would be suboptimal since surplus is being impacted at a time when presumably investment and potentially business related opportunities are more plentiful.

Exhibit 4: Cost of Downgrade: Fallen Angels

**Source**: Morgan Stanley Research, Bloomberg

Is this risk being priced into the market?

Despite recent spread widening, it is clear that the difference in spread between issuers rated BBB vs. high yield is at multi-year tights. We believe now is the time to position the portfolio to avoid credits at risk of being downgraded (see sample of issuers in table below). We have been reducing our BBB exposure and are avoiding credits we believe are at risk of falling to high yield.

Exhibit 5: BBB and BB Spread Differential

**Source:** AAM, Bloomberg Barclays Index as of 10/26/2018 (Corporate Index vs. BB High Yield Index)

Sample of Credits at Risk

*S&P Report: Per S&P, the ‘BBB’ long-term, one-year weighted average default rate (since 1981) is 0.21%, less than a third of the one-year weighted averaged default rate for the ‘BB’ category (0.78%). CreditTrends: When The Cycle Turns: As U.S.’BBB’ Debt Growth Sparks Investor Concern, Near-Term Risks Remain Low Jul 25, 2018 Diane Vazza, Managing Director, New York

July 17, 2018 by

February 23, 2018 by

Sources

Exhibit #1 – Vehicle Sales: Bloomberg

Exhibit #2 – Average Incentive Per Vehicle: JPMorgan

Exhibit #3 – Average Loan Term: JPMorgan

Exhibit #4 – Leasing Penetration: JPMorgan

Exhibit #5 – Market Share By Segment: Bloomberg

Exhibit #6 – Market Share By Segment #2: Bloomberg

Exhibit #7 – US Passenger Rideshare Example: General Motors

February 20, 2018 by

With all the news surrounding recent tax reform and the municipal market, we wanted to get a better understanding of how those changes affected our clients. We sat down with Peter Wirtala, CFA, AAM’s Insurance Strategist, to discuss how tax reform has reshaped the investment landscape for insurers.

Q: We’ve all heard that the new tax regime is making insurers rethink their strategy towards tax-exempt municipal bonds. Can you sum up what has changed and what it means?

A: Big changes are definitely taking place. Historically, P&C insurers have been major buyers of tax-exempts, with about two-thirds of them owning at least a few, and typical allocations ranging from 30-40% of investment grade bond holdings. But with the lower corporate tax rate in place, taxable bonds are now much more attractive relative to tax-exempt bonds. Insurers typically “gross up” the yield on a tax-exempt bond to compare it to taxable yields, and the magnitude of that gross-up just got a lot smaller.

A simple example: previously a tax-exempt bond yielding 2.50% and a taxable bond yielding 3.64% produced the same after-tax income. Now, the tax-exempt bond would need to yield 3.00% to compete. Unfortunately, muni spreads haven’t widened 50 bps to compensate, so a large swath of the market has ceased to be appealing to insurance investors.

Q: Can you further quantify what you mean when you say tax-exempt munis are less appealing now?

A: Another quick illustration should help: at this writing, a representative 10yr AA-rated municipal bond yields about 2.63%, or 3.15% after the gross-up factor is applied. That’s a spread of 28 bps over the 10yr US Treasury. At the old tax rate, this bond would’ve had a grossed-up yield of 3.83%, or a spread of 96 bps.

The Bloomberg Barclays Corporate Index currently shows a spread of about 65 bps on 10yr AA-rated corporate bonds. You can see that at the old tax rate, the muni bond would’ve looked appealing by comparison, but at the new one it does not.

Q: I take it thus far you’ve been talking about P&C insurers, but what about the Life industry?

A: That’s right, the comments above apply to P&C companies. However, the situation for Life insurers has changed dramatically as well. These companies mostly avoided tax-exempt munis in the past (though they bought plenty of taxable munis). Historically, only around 10% of Life companies reported any tax-exempt bond income, and usually just small amounts. This is because under the previous law, the degree of tax exemption Life insurers could get on these bonds was both complicated to calculate, and frequently too small to be worthwhile.

That’s now changed. Life insurer treatment of tax-exempt income has been greatly simplified, the uncertainty about being able to use the tax exemption has been removed, and overall their rules are now very similar to P&C insurers’.

At first glance this would suggest Life companies could now start adding muni allocations, but they face the same issue mentioned above: yields on most tax-exempts can no longer compete with taxable alternatives.

Q: How about Health insurers, where do they fit in?

A: They’re probably the ones least affected here. Their tax rules have traditionally worked similarly to P&C insurers’, but they’ve mostly avoided the sector. To put a number to it, in 2016 only about 5% of health insurers reported more than a negligible amount of tax-exempt bond income. The main reason has to do with asset-liability matching. Health insurers usually have short liabilities that turn over very quickly, so their assets mostly need to be invested in shorter-duration securities; for example, at 12/31/16 the industry reported less than 10% of their bond holdings had maturities of over 10 years. But munis have always been most attractive at longer maturities, from around 7 year maturities and out. Health companies don’t have much appetite for that part of the yield curve, and that is unlikely to change in the foreseeable future.

Q: So are insurers just going to stop buying munis, unless spreads widen?

A: Not necessarily. It’s true that most tax-exempt muni bonds’ spreads are no longer attractive to insurers, and this appears unlikely to change in the near future since top individual tax rates didn’t change nearly as much as corporate rates, and retail investors make up the bulk of muni buyers. Still, there are pockets of value, at least relatively speaking.

The key is to break the market out by maturity and quality buckets. Broadly speaking, muni bonds rated AA and above, and/or maturing in 10yrs or less, have experienced the largest relative decline in attractiveness. Munis rated A or BBB, or maturing in >20yrs, have spreads significantly closer to those on comparable taxable bonds.

The table below compares representative spreads to Treasuries on some selected quality/maturity buckets:

Source: Bloomberg Barclays indexes. Values are indicative. As of 2/8/2018

This suggests that insurers should consider investing in longer and lower-quality munis than they have in the past. Complicating this is the fact that A and BBB rated munis are much rarer than higher-rated bonds, making up only 24% and 8% respectively of the overall Bloomberg Barclays Municipal index by market value.

By contrast, A and BBB bonds make up 42% and 48% of the Corporate index (which is also over 3x larger than the Municipal index). This could make bonds difficult to source for larger insurance companies, and creates a risk that a large-scale shift into these ratings buckets by insurers could drive down spreads, defeating the point of the exercise.

In any case, insurers with large legacy allocations to tax-exempt municipals should now consider reducing those exposures in favor of taxable alternatives, which now offer superior tax-adjusted spreads for most maturities and ratings buckets.

While corporate and muni spreads will fluctuate relative to each other as time goes by, with both offering value at certain points in the cycle, it is likely that insurers will need to consider longer, lower-rated munis if they want to obtain the best tax-adjusted yields available from the sector.

Written by: Peter Wirtala, 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 22, 2017 by

2017 Summary

Markets surpassed expectations in 2017, supported by synchronized global growth, low volatility, and the prospect of tax reform. The Investment Grade (IG) Corporate Credit Market, as represented by the Bloomberg Barclays Index, generated a return of over 3% in excess of Treasuries. The high yield default rate improved from 6% to 3%. Moreover, after two years of rating downgrades to high yield outpacing upgrades to IG, the trend reversed in 2017. All IG sectors performed well, especially Energy, Basic Materials, and Insurance. Companies took advantage of the strong demand for IG bonds, issuing a record breaking $1.3 trillion. Revenue and cash flow growth accelerated in 2017, due to increasing commodity prices, interest rates, and worldwide growth. Companies took a pause from merger and acquisition (M&A) activity, waiting for policy clarity from the new Administration. This activity started to pick up later in the year. Median debt leverage for IG companies declined in 2017, driven mainly by commodity related firms, as leverage excluding commodity related sectors remained essentially unchanged.

Source: FactSet as of 9/30/2017, AAM (317 IG credits, excluding financials, autos, construction machinery)

2018 Outlook

For 2018, we expect continued worldwide growth to support revenues with corporate tax reform in the US enhancing cash flows for the majority of IG companies. Those with domestic focused operations are expected to benefit the most from tax reform, as they have higher effective tax rates. Importantly, while we expect most of the benefits to accrue to equity holders, there will be companies that will use the tax savings to deleverage (i.e., Pharmaceuticals). We will monitor the potential negative consequences of this reform, such as the reduction in financial flexibility for growth challenged, highly leveraged companies and/or consumers in high property and income tax states or conversely, higher than expected inflation causing the Federal Reserve to raise rates more aggressively to dampen growth.

We expect Sales growth to be around 5% with EBITDA growth approaching 10% on average in 2018. Capital spending is expected to return to the levels experienced before the commodity correction (6%+). We expect M&A activity to pick up meaningfully next year, as technology and other catalysts drive companies to vertically or horizontally consolidate. Similar to 2017, we are not expecting a material reduction in debt leverage despite positive fundamental trends due to the low cost of debt relative to equity. Given the number of companies with elevated debt leverage relative to other cycles, the credit market remains vulnerable to an unexpected shock to revenues or cash flows. This is not only an IG issue but a high yield and loan market issue as well given the percentage of credits rated B3 and lower. Due to the positive top line trend, our fundamental outlook for the corporate sector overall is stable with the most dispersion in non-financials.

The demand from investors for corporate credit remained very strong in 2017. Inflows into IG bond funds and ETFs was two to five times higher than the annual flows of the last three years respectively. In addition, demand from foreign investors remained elevated, as yields net of hedging costs remained attractive in USD denominated IG bonds. For 2018, we believe corporate credit will remain attractive to investors seeking yield (pension, insurance), but with higher hedging costs, increased supply of alternatives related to QE unwinds, and the likelihood of lower prospective total return given the expectation for higher rates, the risks are skewed to the downside. We expect credit curves to flatten, with the short end underperforming.

Developed Market fixed income supply to increase meaningfully in 2018

Our expectation is for volatility to remain historically low in 2018, with little movement in the average option adjusted spread (OAS) for the market, generating projected excess returns vs. Treasuries in IG corporate credit of between 75-125 basis points. Corporate bond spreads vs. Treasuries are ending 2017 at very low levels historically, especially for higher rated credits, reflecting the expectation for low defaults and volatility. In this environment, we are prioritizing fundamentals and credit selection. We believe identifying idiosyncratic risk at the sector and especially credit level will be very important to portfolio returns in 2018.

The sectors we believe will outperform include: Metals & Mining, Diversified Manufacturing, Wireline, Supermarkets, Pharma, Tobacco, Independent Energy, Midstream, Rail, Electric Utility, Natural Gas, Life Insurance, and P&C Insurance. Those we believe will underperform the market overall include: Health Insurance, Technology, Integrated Energy, Consumer Products, Food/Beverage, Healthcare, Auto, Cable, Media, and Chemicals.

Written by: Elizabeth Henderson, CFA

Director of Corporate Credit