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January 26, 2017 by

Volatility Happens

On Tuesday, January 24, 2017, AAM hosted an Investment Outlook webinar titled, “Volatility Happens.” The webinar included a general economic overview and our sector experts shared their insights regarding Corporates, Structured Products, Municipals, High Yield, and Convertibles.

Slides Only

Volatility Happens_Sector Webinar

Outlook Commentary by:

Greg Bell, CFA, CPA
Director of Municipal Bonds

Marco Bravo, CFA
Senior Portfolio Manager

Scott Edwards, CFA, CPA
Director of Structured Products

Elizabeth Henderson, CFA
Director of Corporate Credit

Reed Nuttall, CFA
Chief Investment Officer

Tim Senechalle, CFA
Senior Portfolio Manager

Scott Skowronski, CFA
Senior Portfolio Manager

30 W Monroe St
3rd Floor
Chicago, IL 60603-2405
312.263.2900

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.

January 19, 2017 by

INVESTMENT ACCOUNTING CHANGES
EVERY INSURANCE INVESTMENT OFFICER NEEDS TO KNOW

2016 Statement and statutory accounting changes

Quarterly and Annual Filings

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Schedule D Part 1 Guidance (2016-02BWG)

In December 2015, the Statutory Accounting Working Group issued a document to provide guidance on how to complete the description, issuer, issue, and capital structure information on Schedule D Part 1. In February 2016, the document was modified and added to the Annual Statement instructions. For Annual 2016 Schedule D parts 1 through 6 will have electronic only columns for Issuer, Issue, and ISIN to create consistency across the schedules. The electronic only column on Schedule D Part 1 for the Capital Structure Code was reduced to 4 categories shown below:

1. Senior Secured Debt
2. Senior Unsecured Debt
3. Subordinated Debt
4. Other

Effective Annual 2016.

Schedule D Part 1A Section 1 and Schedule D Part 1B (2015-25BWG)

For Schedule D, Part 1A, Section 1 (annual) and Schedule D, Part 1B (quarterly), the reference to “non-rated” was removed from the instructions and clarification instructions were added for Footnote “d” of Schedule D, Part 1A, Section 1 and Footnote “a” of Schedule D, Part 1B. The footnotes should include the total book/adjusted carrying value amount of securities reported in Schedule DA and Schedule E, Part 2 for the current statement filing by NAIC category.

Effective Annual 2016.

Foreign Codes (2016-06BWG)

The number of foreign codes on Schedule D have been reduced from 12 to 4 (see below) and the foreign code matrix has been removed.

A. For Canadian securities issued in Canada denominated in U.S. Dollars
B. For those securities that meets the definition of foreign provided in the Supplemental Investment Risk Interrogatories and pays in currency other than U.S. dollars
C. For foreign securities issued in the U.S. and denominated in U.S. dollars
D. For those securities that meet the definition of foreign provided in the Supplemental Investment Risk Interrogatories denominated in U.S. dollars (e.g. Yankee bonds, Eurodollar bonds)

Effective Annual 2016.

Bond Characteristics (2016-07BWG MOD)

The Schedule D Part 1 Annual Statement Instructions have added clarification to the Bond Characteristics Code column. If bonds have more than one characteristic, then the characteristics should be separated with a comma. If none of the characteristics apply, then leave it blank. The new bond characteristics are below:

Bonds that are callable at the discretion of the issuer and the call price will never be below par based on a specified formula for the payoff amount generally referred to as a “make whole call provision.”
Bonds that are callable at the discretion of the issuer and the call price will never be below par with a specified payoff amount based on a fixed schedule.
Bonds that are callable at the discretion of the issuer at a price that can be less than par.
Bonds in which the timing of payments of principal, as well as the amounts and timing of payments of interest can vary based on a pool of underlying assets or an index. This should include agency and non-agency residential mortgaged-backed securities (RMBS); some commercial mortgaged-backed securities (CMBS); as well as similar Loan-backed or Structured Securities. This excludes those flagged with #1, 2, or 3.
Variable coupon bonds where the interest payments vary during the life of the transaction, but NOT as is typically based on a fixed spread over a well-established interest rate index such as LIBOR, prime rate or a government bond yield. This includes coupons that vary based on the performance of indices that are not interest rate related such as equity indices, commodity prices or foreign exchange rates. This also includes coupons where the spread to the index is not fixed for the entire life of the transaction. This excludes basic floating rate and adjustable rate notes with fixed spreads over an interest rate index.
Terms that may result in principal (or initial investment) not being repaid in full for reasons other than a payment default by the issuer or defaults within a pool of assets underlying a Loan-backed or Structured Security. (This includes Insurance-Linked securities such as catastrophe bonds, Interest Only Strips (IOs), mortgage-referenced transactions or other issuer obligations that are not actually backed by a pool of assets but where the obligation to pay is tied to an index or performance or a pool of assets).
Bonds where the issuer’s obligation to make payments is determined by the performance of a different credit other than that of the issuer, which could be either affiliated or unaffiliated. (These securities are often referred to as credit-linked notes. This does not include Loan-backed or Structured Securities).
Mandatory convertible bonds. Bonds that are mandatorily convertible into equity, or, at the option of issuer, convertible into equity, or whose terms provide for payment in the form of equity instead of cash.
Other types of options solely at the discretion of the issuer that could affect the timing or amount of payments of principal and interest, not otherwise reported in 1-8.

Effective Annual 2016.

Note 5 – Restricted Assets (2016-12BWG MOD)

The disclosure for Restricted assets was renamed “Gross Admitted and Non-admitted Restricted” and a column was added for “Total Non-admitted restricted assets.”

Effective Annual 2016.

Note 5 – 5* Securities (2016-14BWG MOD)

A new disclosure has been added for 5* Securities. The disclosure will include a comparison of the annual reporting period to the prior annual reporting period and will include the following:

The number of 5* securities
Investment type
Book adjusted carrying value
Fair value

Effective Annual 2016.

SVO Identified Funds (2016-18BWG MOD)

As part of the Investment Classification Project to clearly identify securities, Bond Mutual Funds and Bond Exchange Traded Funds that are approved to be reported as bonds on Schedule D Part 1 and DA Part 1, will have a separate reporting category section called “SVO Identified Funds”. The new category lines are as follows:

Exchange Traded Funds – as Identified by the SVO
Bond Mutual Funds – as Identified by the SVO

With the addition of the new category, the column 3 code {*} for Bond Mutual Funds and {#} Exchange Traded Funds have been removed from Schedule D Part 1.

A new section for SVO Identified Funds was added to the Schedule D Part 1A Section 1 along with a new column for “No Maturity Date.”

Effective Annual 2016.

General Interrogatories (2016-22BWG)

The General Interrogatories Part 1 question regarding investment managers and broker dealers has been modified to highlight the extent of an insurer’s use of investment managers. This includes identification of all investment managers, advisors, broker/dealers, and individuals making investment decisions on behalf of the insurer. The new requirements are below:

Both Internal and External
Affiliated or Unaffiliated
% of investments handled

Effective Annual 2016.

Removal of the Class 1 List from the P&P Manual (2016-05) and Movement of Money Market Mutual Funds (2016-33 BWG)

Effective October 14, 2016, under regulations recently adopted by the U.S. Securities and Exchange Commission (SEC), institutional prime money market funds are required to report a floating net asset value (NAV) instead of a stable net asset value (NAV). The money market mutual funds included in the NAIC’s Class 1 List in Part Six, Section 2 (b) (ii) of the Purposes and Procedures Manual (P&P Manual) fit the SEC definition of institutional prime funds. Therefore, such money market funds can no longer report stable NAV and accordingly will no longer be eligible for bond treatment under statutory accounting. For this reason, the Class 1 List has been removed from the P&P Manual. For Annual 2016, all money market mutual funds will be considered short-term and be reported on Schedule DA. The former Class 1 money market mutual funds will be renamed to “All other money market mutual funds” and accounted for under SSAP No. 30—Investments in Common Stock (excluding investments in common stock of subsidiary, controlled or affiliated entities). There will be no change to the accounting for the money market mutual funds on the ‘NAIC U.S. Direct Obligations/Full Faith and Credit Exempt List’ that are accounted for under SSAP No. 26—Bonds, excluding Loan-backed and Structured Securities. Going forward, effective Annual 2017, all money market mutual funds will be reported on Schedule E Part 2.

Statutory Accounting Updates Adopted for 2017

Prepayment Penalties and Presentation of Callable Bonds (2015-23)

After much discussion and review, there are revisions to SSAP No. 26—Bonds, excluding Loan-backed and Structured Securities and SSAP No. 43R—Loan-backed and Structured Securities to clarify the amount of investment income and/or realized capital gains/losses to be reported upon disposal of an investment. Below is a summary of the revisions:

Prepayment penalties or acceleration fees should be reported as investment income when received.
The amount of investment income should be calculated as total proceeds less par value.
The amount of realized gain/loss should be calculated as the difference between book adjusted carrying value and par value.

A new disclosure will be added to Note 5 that will require the reporting entity to identify the amount of investment income generated as a result of a prepayment penalty and/or acceleration fee, such as with a make-whole call. This update will be effective January 1, 2017 with prospective treatment. Since some companies are already using this method, early adoption is permitted.

GAAP Updates

Classification and Measurement

In January 2016, the Financial Accounting Standards Board (FASB) issued Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01). The FASB has been working on this project for over 3 years and ultimately has issued guidance that does not significantly change the existing classification and measurement model. It is effective for public entities fiscal years and interim periods beginning after December 15, 2017. For non-public entities, it is effective for fiscal years beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2019. Below is a summary of the key components:

The current classification model will remain in place, except for equity securities.
Equity securities, including funds that are invested in debt instruments, will be measured at fair value through net income, with the following two exceptions:
- Equity securities that qualify for Equity Method accounting
- Equity securities that do not have readily determinable fair values may qualify for the “practicability exception” and therefore will be measured at cost, less any impairments, plus or minus any price changes observed from an orderly transaction.
The new standard establishes qualitative indicators to consider when determining if an equity security that is, accounted for under the “practicability exception” is impaired and would therefore be written down to its estimated fair value. These qualitative indicators include:
- A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee
- A significant adverse change in the regulatory, economic, or technological environment of the investee
- A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates
- A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment
- Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.
Eliminates some fair value disclosures found in ASC 825-10-50-10 related to financial instruments not measured at fair value:

Requires entities to present financial assets and liabilities separately by measurement category (available-for-sale, trading and held-to-maturity) and form (securities, loans, and receivables).
Clarifies that entities should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in conjunction with other deferred tax assets.

Bifurcation of Embedded Derivatives – Contingent Put and Call Options

In March 2016, the FASB issued Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments (ASU 2016-06). This standard outlines a four step approach (see below) to determine if an embedded contingent put or call option should be bifurcated from its host and accounted for separately. When evaluating a contingent put or call option, one shall not take into account the event that triggers the contingent option. Assume a bond contains an option where the investor can put the bond at 101 when the Dow Jones Index breaches 20,000, the feature related to being able to put the bond at 101 would be assessed in the four step process. The feature related to the Dow Jones Index breaching 20,000 would not be assessed. In practice, entities had reviewed both of these components, which led to reporting variations and ultimately led the FASB to issue this clarification.

Four Step Method:

Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.
Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.
Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.
Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.

For public entities it is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. For non-public entities, it is effective for fiscal years beginning after December 15, 2017 and interim periods within beginning after December 15, 2018. Early adoption is permitted.

Equity Method

In March 2016, the FASB issued Investments –Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting (ASU 2016-07). This amendment removes the requirement that entity retrospectively make financial adjustments when an available-for-sale or cost method investment subsequently qualifies for Equity Method accounting. The new guidance allows an entity to adjust the basis to account for the additional interest, if applicable, and recognize any OCI unrealized gain/loss in earnings. It is effective for all entities for fiscal years beginning after December 15, 2016.

Credit Losses/Impairments

In June 2016, the FASB issued Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13). This standard includes the current expected credit loss (CECL) method, which requires reporting entities to establish an allowance for credit losses that are expected to be incurred over the lifetime of the assets. At each reporting period, the allowance should represent Management’s current estimate of the expected credit losses. The estimate should be calculated after grouping the financial assets into pools based on their risk characteristics. If a financial asset cannot be grouped into a pool, it can be evaluated individually. The movement in this allowance would be recognized in income. Therefore, this model allows for an immediate reversal of credit losses recognized on assets that have an improvement in expected cash flows.

Although this standard includes most debt instruments, securities classified as available-for-sale (AFS) are not included in the CECL model. However, the credit loss guidance for AFS securities will be moved from Topic 320 to Topic 326, along with some targeted changes that are mentioned below:

An allowance for credit losses would be calculated at the individual security level each reporting period. The allowance would be equal to the amount that amortized cost exceeds the present value of expected future cash flows. However, the valuation allowance for credit losses shall not exceed the unrealized holding loss.
This approach allows for impairment losses to be reversed as credit losses or the impaired status evaporates.
The requirement to consider the length of time a security has been underwater to determine if a credit loss exists would be removed.
The requirement to consider additional declines in fair value or recoveries subsequent to the balance sheet date would no longer be required when estimating if a credit loss exists.
An allowance for credit losses roll-forward disclosure will be required each reporting period

In addition to AFS securities, the FASB decided to remove the following financial assets from the proposal’s scope:

Loans made to participants by defined contribution employee benefit plans
Policy loan receivables of an insurance entity
Pledge receivables of a not-for-profit entity
Related party loans and receivables

ASU 2016-13 will be effective for public, SEC filing entities for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For public, non-SEC filing entities, it will be effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. For all other entities, it will be effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years beginning after December 15, 2021.

Statement of Cash Flows – Restricted Cash

In November 2016, the FASB issued Statement of Cash Flows (Topic 230): Restricted Cash (ASU 2016-18). This amendment requires entities to include restricted cash and cash equivalents with the cash and cash equivalents reported on the Statement of Cash Flows. In addition, the standard requires a reconciliation of cash, cash equivalents, and restricted cash reported on the Statement of Financial Position that agrees with the total cash, cash equivalents, and restricted cash reported on the Statement of Cash Flows.

ASU 2016-18 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted.

Written by:

Joe Borgmann, CPA, Director of Investment Accounting
and
Stacy Crook, Vice President Investment Accounting

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.

January 6, 2017 by

“While 2016 was full of surprises causing significant volatility, we expect more of the same in 2017.”

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Economic Overview

Economic growth in the U.S., as measured by real GDP, is projected to increase by 2.4% in 2017 based on consensus forecasts. This would be a marginal improvement from the 2.0% growth rate for 2016. The improvement is primarily predicated on an increase in business and residential investment as consumer spending is forecasted to increase at a marginally slower pace. The labor market is expected to continue to improve in 2017, albeit more slowly than in the previous year. A combination of a tighter labor market and fiscal stimulus from the new Trump administration has the potential to increase inflation. Market implied inflation expectations have increased by 27 basis points since the November election. Stronger growth and higher inflation will allow the Federal Reserve to keep normalizing rates in 2017. The Fed raised rates 25 basis points at their December meeting to a 0.50%-0.75% range and provided an outlook which calls for three additional rate increases in 2017.

AAM views the risks to economic growth in 2017 as slightly skewed to the downside as we expect continued weak fixed investment. As such, we don’t believe inflation will move significantly above the Fed’s long-term target resulting in less than three rate hikes in 2017.

2016 Returns by Asset Class
Investment Grade
Bloomberg Barclays US Aggregate	2.7%
Treasuries	1.0%
Corporates	6.1%
CMBS	3.3%
Tax Exempt Municipals	0.25%
Surplus Growth
High Yield	14.3%
US Equities	12.0%
Convertibles	14.0%

Source: Bloomberg Barclays Index Series, S&P 500, Barclay’s Global High Yield Index, V0A1 (Merrill Lynch IG Convertibles Ex-Mandatory)

Fixed Income Outlook

During 2016 the fixed income markets experienced significant volatility. 10 year treasury yields hit a low of 1.36% in July and rose to 2.60% post-election in December. Investment grade Corporate credit spreads widened to 200 basis points over Treasuries in February then rallied to finish the year at 118. The corporate spread volatility was driven primarily by the energy sector caused by oil falling to $26 per barrel in February then roaring back to close the year above $53.

While 2016 was full of surprises, (see Trump, Brexit, lackluster Q1 and Q2 GDP growth) causing significant volatility, we expect more of the same in 2017. The search for yield has driven valuations higher, making credit risk look expensive across all sectors. Security selection becomes key in this environment. We are going to focus on corporate bonds issued by the strongest companies that can weather what may lie ahead, high quality ABS securities issued by strong underwriters and backed by high quality borrowers, and MBS securities with superior cash flow profiles.

There is uncertainty in China and Europe that may cause some bumps in the road here in the U.S. In our portfolios, we will look to sell securities where the risk is mispriced by those buyers focused solely on a small yield advantage. We will target those securities that perform better during volatile times, and expect that we will have opportunities to add risk at more distressed prices during the year.

Sectors

Corporates

Positive

Fiscal stimulus and a roll back in regulations are expected to propel the U.S. economy, lengthening the credit cycle by an estimated 12-18 months. However, a potential risk factor is higher than expected inflation and specifically, the Fed’s response to that risk. While there is a high degree of uncertainty related to the Trump administration’s policies, companies’ outlooks for earnings reflect higher commodity prices, higher interest rates, an improving manufacturing sector, and a healthy consumer spending. In 2017, we expect firms to continue pursuing mergers and acquisitions and other shareholder friendly actions, keeping leverage largely unchanged. We expect market technicals will remain strong in 2017 with yield oriented investors focused more on investment grade credit and new issue supply similar to 2016, with tax reform a major swing factor.

Despite spreads which are near cyclical tights, given the strong technicals and our marginally positive fundamental outlook, we propose a modest overweight to the Corporate sector. Since we are in the late stage of the cycle, we continue to be selective (credit/sector).

Agency MBS

Negative

The Federal Reserve reinvestment program continues to distort agency MBS valuations making them particularly unattractive. As the Fed raises rates in 2017, we expect they will address the timing of bringing the reinvestment program to a conclusion. The loss of a consistent buyer of $300 billion or more of mortgage pass-throughs will negatively impact valuations in a fairly dramatic way. In addition, any increase in longer term interest rates make MBS less attractive to banks and foreign investors who have largely supported the market for the past few years. We’ll maintain a significant underweight position in the portfolios until valuations adjust to reflect higher interest rate volatility and the eventual Fed exit. Investments will focus on specified pools with more consistent prepayment profiles to manage prepayment uncertainty and extension risk from higher interest rates. Selecting specified pools with attractive loan characteristics generates higher yields than those earned from investing in generic, TBA securities. We continue to view non-agency mortgage backed securities as a better alternative based upon their more attractive yields and an improving credit profile from rising housing prices.

Tax-Exempt Municipals

Neutral

During the course of 2017, the tax-exempt sector could experience similar levels of market volatility that the sector weathered during the last two months of 2016. Since the presidential elections on November 8th, 10 year municipal yields rose by 89 basis points (bps), before retracing 30 bps of that move during the first week of December. Most of this volatility was a direct result of both massive outflows from municipal mutual funds and the uncertainties surrounding the prospects for tax-reform and its potential to reduce the relative value of tax-exempts versus taxable alternatives.

As we enter 2017, these uncertainties are expected to remain a cloud over the market until President-elect Trump and Congress clarifies the scale and scope of their comprehensive reform efforts. Given these uncertainties, we remain cautious in our outlook for the sector. However, one bright spot for the sector is the expectation that market technicals should remain fairly positive for much of 2017. With 10yr tax-exempt rates now over 103 bps higher versus the lows of 2016, many of the refinancing opportunities that drove record levels of new issuance in 2016 are no longer viable. The market expects issuance to drop by $95 billion to $350 billion in 2017. On the demand side, the market expects very robust reinvestment flows of call proceeds resulting from the record levels of refinancings that have occurred over the past two years. However, the market should see some continued headwinds from mutual fund outflows that have averaged over $2 billion per week since the presidential elections. The combination of persistent fund outflows and market apprehension related to tax-reform will provide some dampening effect to the expected positive technicals this year. Consequently, we are maintaining a neutral bias for the sector.

ABS

Positive

Consumer credit has performed at or above historical levels the past few years and we anticipate that this will continue in 2017 backed by stronger economic growth and rising income levels. ABS is an important investment option at the short end of the maturity spectrum and we maintain a significant weighting in portfolios relative to most benchmark weights. High credit quality and stable cash flows make them an attractive alternative to shorter maturity corporate bonds, Treasuries and high coupon mortgage pass-throughs.

CMBS

Neutral

Improving real estate fundamentals continue to support the CMBS market however valuations tend to reflect this so we remain neutral on the sector in 2017. Both underwritten and stressed LTVs and DSCR have improved as new risk retention rules have forced loan originators to become more conservative since they now bear more of the risk from their underwriting decisions. Prices of properties in non-major markets continue to lag overall national pricing levels however they have finally surpassed levels seen at the height of the market in 2006. Transactions backed by single properties located in major markets with extensive operating histories and conservatively underwritten conduit deals continue to represent the best value.

Treasuries

Neutral

Treasury yields have moved higher since the election as optimism about tax and regulatory reform has ignited the equity market. The US dollar and US Treasuries remain the standard for global risk reduction. It’s possible that there will be economic challenges in either China or Europe (or both) which will drive yields lower here in the US as global investors seek a safe haven.

High Yield

Neutral

We expect defaults in US High Yield to decline in 2017 given the improved outlook for commodity sensitive sectors that drove defaults in 2016. Fundamentally, the continued increase in leverage bears watching, however proceeds of new debt have focused on refinancing rather than acquisition related activity. Accordingly, interest coverage remains favorable and maturity needs are manageable for the near future. Credit spreads are modestly below long-term averages, however there is room for further tightening as
technicals remain favorable given supply was lower for the third consecutive year while demand for higher income securities has been persistent.

Convertible Securities

A favorable environment for investors in domestic credit and equity markets provided a strong backdrop for 2016 performance within the US convertible market. The sector continues to exhibit limited sensitivity to changes in interest rates as recent upward movement in yields has coincided with higher equity markets. Portfolios are positioned with limited duration risk and, in our view, rising rates are a positive development for future issuance in the asset class. Prospective issuers may view higher borrowing costs in straight debt markets coupled with rising equity prices and improved growth prospects as providing an ideal environment for routing issuance to the convertible market. With redemption activity expected to hold steady, the US convertible market may see meaningfully positive net new issuance which enhances our opportunity set. From a valuation perspective, convertible models indicate that the balanced segment of the market is fairly valued, resulting in the continued opportunity for strong upside capture in rising equity markets with excellent downside risk control.

Equities

The five year return for the S&P 500 is over 14% a year. The small cap sector has outperformed the large cap sector, while the value style outperformed growth. With the bull market near the 8 year mark, we believe that the cycle is long in the tooth, and valuations are above long term averages. The trailing P/E ratio is at 21.3x relative to the 50 year long term average of 16.6x. If the new administration is successful in lowering the corporate tax rate, we would expect further gains in the market. At these valuation levels, caution in the US equity market is warranted.

Sources: AAM, Bloomberg Barclays Index Series, S&P 500

Outlook Commentary Written by:

Marco Bravo, CFA
Senior Portfolio Manager

Reed Nuttall, CFA
Chief Investment Officer

Elizabeth Henderson, CFA
Director of Corporate Credit

Scott Edwards, CFA, CPA
Director of Structured Products

Greg Bell, CFA, CPA
Director of Municipal Bonds

For more information, contact:

Colin 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

30 W Monroe St
3rd Floor
Chicago, IL 60603-2405
312.263.2900

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.

October 25, 2016 by

Given our outlook and the currently attractive relative valuation levels, we are moving to an overweight bias for the municipal sector.

Supply technicals were expected to drive volatility in relative valuations this year, and so far, that’s played out in the second half of the year. With 10-yr Treasury rates plunging at the beginning of the 3rd quarter to 1.36% following Britain’s decision to leave the European Union, munis followed suit, with rates moving to a record low of 1.29%. These low nominal yields have induced state and local governments to execute refinancings to levels that are running in tandem with 2015’s record level of issuance. The surge in refinancings during the quarter helped produce record levels of issuance in August and September, resulting in yields rising across the yield curve. Tax-exempt yields in 10-yrs moved higher by 16 basis points (bps) versus a 12 bps move in Treasuries. The long-end of the municipal curve exhibited the worst performance, with yields in 20 and 30-yrs increasing by 27 and 29 bps, respectively. Treasury rates in 30-yrs were higher by only 3 bps.

The front end of the muni yield curve also faced poor performance as the market adjusted to the new regulations surrounding money market reform. New standards that went into effect on October 14th now require that money market funds sold to institutions move to a floating valuation and adopt restrictions that limit investor withdrawal access if the fund’s liquidity falls below certain levels. These reform measures have resulted in year-to-date municipal money market fund outflows of $126 billion as of October 19th.

Consequently, relative valuations of bonds with maturities from 1 to 3-yrs have moved to some of the most attractive levels the market has experienced in over three years. Since August 29th, tax-adjusted spreads for these maturities moved wider by 39, 49 and 44 bps in 1, 2, and 3-yrs, respectively. These adjustments in spread levels have moved our relative valuation bias to a neutral position for this area of the curve from a negative bias that was in place during the first 9 months of the year.

Similarly, the balance of the yield curve is also facing significantly weaker relative valuation levels resulting from weaker technicals. Mutual fund flows, which were experiencing very strong weekly inflows through September with an average of ~$700 million per week, have now moved to outflows of $136 million as of October 19th.

Additionally, seasonal reinvestment flows for coupons/calls/maturities are also near lows for the year during October and November. The drop in demand flows, combined with the recent surge in new issuance, has produced substantial curve steepening pressure. The slope of the yield curve from 5 to 20-yrs has steepened by 13 bps since August 29th and tax-adjusted spreads in 15 and 20-yrs have widened by 43 and 41 bps, respectively, providing that area of the curve with a very compelling entry point for investment.

In looking at the supply outlook for the year, the market is expecting the sector to produce a new record of $445 billion. Both August and September have already reached record levels for their months, with issuance of $45 billion and $35.6 billion, respectively. The market also expects that October and November could approach record levels of over $50 billion per month. Consequently, key relative valuation metrics of municipal/Treasury ratios and tax-adjusted yield spreads to Treasuries have adjusted to near 6-month highs as of this writing.

Looking forward, we expect to see a dramatic slowdown in issuance going into December. In a comparable fashion to the issuance cycle that developed during the latter portion of 2015, it’s expected that state and local governments will curtail issuance, especially rate-sensitive refinancings, to avoid any potential market volatility surrounding the Federal Reserve’s next rate increase. Going into potential Federal Reserve rate hikes in September and December last year, new issuance supply plunged 24% during the last 6 months of the year. Similarly, with the market consensus of at least one rate hike for the balance of this year, the market projects issuance in December this year to decline by 33% relative to the average expected monthly issuance of $41 billion from August to November. This dramatic drop in issuance, combined with the anticipated improvement in demand technicals from robust reinvestment flows of coupon/calls/maturities in December and January, should produce solid muni relative performance going into the new year. Given our outlook and the currently attractive relative valuation levels, we are moving to an overweight bias for the municipal sector. Our objective will be to gradually build up our sector exposure level into the projected supply surge and to further extend our overweight exposure if further dislocations in relative valuations develop.

Written by:

Greg Bell, CFA
Director of Municipal Products

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.

August 2, 2016 by

Within the investment grade fixed income market, there are four primary ways to enhance return: credit quality, liquidity, duration, or structure. All of these strategies introduce additional risk to the insurer’s balance sheet. We believe that there is one more lever for a taxable P&C insurer to pull, the crossover trade between taxable and tax-exempt securities. This trade does not involve adding incremental risk to the organization, rather it involves closely watching the spread relationship between taxable and tax-exempt securities, to exploit the opportunity as it presents itself.

Why an opportunistic strategy emphasizing average life, structure and liquidity is optimal.

Let’s begin by stating the obvious – the tax exempt municipal bond sector is illiquid and concentrated in high quality issues. From Exhibit 1 below, there are 49,372 issues in the Barclays’ Municipal Bond Index with a market value of $1.43 trillion.

By comparison, there are 5,735 issues in the Barclays’ Corporate Index with a market value of $4.91 trillion as outlined in Exhibit 2. Thus, the Corporate Index has 11.6% of the number of issues and 3.4 times the market value of the Municipal Index.

Also note that the Barclays’ Municipal Index (by market value) contains 26% and 6% of ‘A’ and ‘BAA’ rated issues, respectively. By contrast, the Barclays’ Corporate Index contains 39% and 53% of ‘A’ and ‘BAA’ rated issues. To put the market value of the ‘A’ rated municipal bonds into perspective, it is slightly less than the market value of Exxon Mobil common stock.

To summarize, constructing diversified municipal bond portfolios with a down-in-credit, yield-oriented focus involves investing in a small corner of an illiquid municipal bond market. The constraints of the investable municipal universe preclude any ability to scale across a large asset base.

A Scalable Alternative

Taxable insurance companies seek to optimize after-tax yield and total return opportunities across the yield curve within the duration, quality and other constraints of their policy statement. As outlined in Exhibit 3 below, the relative attractiveness of tax exempt municipal bond yields (relative to comparable maturity Treasury issues) varies greatly across the yield curve. Using seven year weekly averages, the yield spread advantage (pre-tax equivalent yield for insurance companies) of ten year municipal bonds is 86 basis points greater than in three year bonds. In addition, the range of yield spreads is far greater in the ten year area.

At AAM, we track spread relationships and Z scores on a daily basis. A trading strategy that involves purchasing ten year tax exempt municipal bonds when spreads (versus Treasury notes) are at a Z score of +2.0 and selling at -2.0 produced five round-trip opportunities for purchase and sale over the past seven years. Because both the average yield change and duration are much greater for the ten year municipal bond in comparison with the three year issue, the total return opportunity from the trading strategy is greater in the ten year part of the yield curve and produces a return advantage of 18.99% over the seven year period (2.51% on an annualized basis). Please see Exhibit 3 and the footnotes below for details.

One additional comment should be made about three year municipal bond yields. With an average spread over a three year Treasury bond of only 33 BP (based on seven years of data), there are much higher yielding opportunities in the taxable bond market. Thus, short municipal bonds should be viewed as a source of funds for yield enhancement opportunities in other taxable bond sectors.

A high quality approach leads to a stable credit profile

As of July 15, 2016 per Thomson Reuters, the average yield spread between ‘A’ and ‘AA’ rated tax exempt ten year municipal bonds is 29 basis points (114 basis points over the yield of a ten year U.S. Treasury bond). This yield differential is at the very narrow end of the range over the past 7 years and was as much as 106 basis points in July 2009. A comparison of the 29 basis point yield advantage of ‘A’ rated issues (which will more likely be part of a buy and hold strategy due to the illiquidity of ‘A’ rated bonds) with the annualized total return from the trading strategy of 2.51% annually highlights why an opportunistic trading strategy is superior.

At AAM, we believe it is critically important to analyze relative value at each and every point along the yield curve.

An opportunistic trading strategy requires investing in liquid bonds, which generally leads to high quality credits. Maintaining liquidity in municipal portfolios also requires a focus on coupon to avoid the negative tax consequences from a municipal bond trading at a discount price. Lastly, liquidity and tradability are enhanced by avoiding certain call structures.

To be clear, there are select ‘A’ rated issuers that offer value. But in our view, the opportunistic trading strategy that we have outlined is a better and more sustainable investment framework for managing taxable insurance company portfolios.

An important consideration is that the ability to trade fixed income securities is challenged in today’s market. This is especially the case for tax exempt municipal bonds. Investors looking to employ an opportunistic trading strategy must be large enough to fully participate in the primary market. Conversely, investors must be small enough to meaningfully execute purchase and sale programs within the narrow time windows when these opportunities are available. Due to these constraints, large municipal bond managers will likely have difficulty employing an opportunistic strategy.

We’ve discussed relative trading opportunities in tax exempt municipals, but it is important to point out that

Characteristics of An Opportunistic Trading Strategy

1. Focus on liquidity: Liquidity allows for the portfolio to be repositioned without significant transaction costs.

2. Focus on 10 year durations: The ten year part of the yield curve provides the better total return opportunity.

3. Focus on high quality credits: An opportunistic trading strategy requires investing in liquid bonds, generally leading to high quality credits.

insurance companies have other reasons to sell tax exempt bonds. With all credits, avoiding downgrades and impairment are critical factors for successful investing.

A high quality approach leads to a stable credit profile. This is very important in the municipal market as the availability of financial information is generally on an annual basis with a lag. In addition, the ability to fully benefit from the tax exemption of municipal income depends on underwriting profitability, which is subject to change based on each company’s underwriting experience. Maintaining a highly liquid municipal portfolio enables a company to reposition its portfolio without significant transaction costs (bid-offer spreads) when its tax situation changes.

Footnotes

The calculations are based on weekly yields from Thomson Reuters and Bloomberg over the seven year period ending July 15, 2016 using a 1.4577 tax adjustment factor on municipal yields to reflect the pre-tax equivalent yield of municipal bonds for insurance companies. This pre-tax equivalent yield on a ten year municipal bond is compared to comparable maturity Treasury yields to determine the yield spread. The standard deviation and range are also calculated from this relationship.

The Z score is calculated on a one year trailing basis using the pre-tax equivalent yield spread relationships outlined in (1) above.

The number of ‘round trips of going from -2.0 to +2.0 Z scores over this period and vice versa. This captures the number of round trip trading opportunities at extreme valuations.

The pre-tax return advantage from relative bond price movements versus comparable maturity Treasury notes over a seven year period is calculated by taking the nominal yield movements from purchases and sales when the municipal bond yield Z score is +2.0 and -2.0, respectively and calculating a price move based on the duration of three and ten year municipal bonds. The cumulative seven year number is annualized.

Written by:

Gregory Bell, CFA
Director of Municipal Bonds, Principal

John Schaefer, CFA
President, Principal

Additional Contributor:
Daniel Nagode

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