Investment Outlook

February 2, 2021 by

Economic Outlook – Marco Bravo, CFA | Senior Portfolio Manager

Market Outlook – Reed Nuttall, CFA | Chief Investment Officer

Corporate Credit – Elizabeth Henderson, CFA | Director of Corporate Credit

Structured Products – Scott Edwards, CFA | Director of Structured Products

Municipal Market – Gregory Bell, CFA, CPA | Director of Municipal Bonds

High Yield – Scott Skowronski, CFA | Senior Portfolio Manager

Convertibles – Tim Senechalle, CFA | Senior Portfolio Manager

Economic Outlook

With 2020 now in the rearview mirror, we look forward to a resurgence in economic growth for 2021. After falling an estimated 2.5% on a Q4/Q4 basis in 2020, U.S. real GDP is projected to increase by 3.8% in 2021 (Bloomberg survey consensus estimates). As shown on exhibit 1, consumer spending and private investment are expected to lead the way this year. Consumers are starting the year with a large degree of savings, improving employment prospects, and the potential for additional COVID-related aid out of Washington, all of which will be supportive for consumer spending. On the private investment side, low mortgage rates should continue to support a strong housing market, and a rebound in corporate earnings should lead to increased investment. Downside risks are largely centered around COVID and a slower than anticipated rollout of vaccines. At AAM, we view the risks to GDP growth as skewed to the upside for 2021 and expect the U.S. economy to outperform consensus estimates.

Exhibit 1: Contribution to GDP Growth

*Source: Bureaus of Economic Analysis, Bloomberg. Data excludes residual component*

Market implied inflation expectations have moved higher recently, likely the result of the potential for increased fiscal stimulus from the Biden administration, as well as weakness in the US dollar. Since the end of Q3 2020, the 10yr breakeven TIPs rate has increased by 46 basis points to a current rate of 2.09% (US Treasury, Bloomberg). Given excess global supply and slack in the economies, we don’t expect actual inflation to move above 2% this year.

The Federal Reserve last year introduced its new Flexible Average Inflation Target (FAIT) framework for monetary policy. Under this new framework, the Federal Reserve will be more focused on achieving full employment versus price stability. We believe this means that the Fed will no longer preemptively raise rates in order to stave off inflation. In fact, the Fed has made it clear that they will tolerate inflation moving above their 2% target for a period of time. With inflation expected to remain relatively benign, and the unemployment rate projected to remain above 5% this year, we expect monetary policy to remain accommodative. We think the earliest that the Fed will begin tapering their purchases of Treasury and MBS securities is 2022, and expect no change in the Fed Funds rate at least through the next two years.

Treasury yields, according to consensus forecasts, are expected to move modestly higher from current levels with a steeper yield curve. With Fed policy on hold, it’s expected for short-term Treasury rates to remain anchored to the Fed Funds rate. The benchmark 10-year Treasury yield is forecasted to end 2021 at 1.3% based on the median forecast among economists surveyed by Bloomberg. Increased federal spending and rising inflation expectations present upside risks to forecast. These risks can be offset by the continued low level of sovereign bond yields in Europe and Japan. Any significant widening in the yield differential between U.S. and non-U.S. sovereign debt will likely attract demand from foreign investors, limiting the rise in U.S. rates. Perceived weakness in the US dollar does have the potential to hamper demand from foreign investors. We are calling for the 10-year Treasury yield to end the year in a range of 1.25% to 1.5%.

Market Outlook

Exhibit 2: Asset Class Returns

2020

As we began 2020, markets had performed well in the previous year, spreads were tight and valuations stretched. But, the Federal Reserve had cut rates to accommodative levels, and it looked like it would be an okay year for risk assets. Our 2020 recommendation was that with limited upside left in the market, the focus should be on moving up in quality across our portfolios.

As the number of known Covid-19 cases began to rise in late February, investors began to panic and across the country companies were putting together work from home plans for all employees. By mid-March, our office buildings were empty, and most sadly the death toll began to rise so quickly that in a panic we effectively locked down the entire country. Highways and grocery store shelves were empty (How could the store be out of toilet paper?), restaurants closed, and the capital markets were in free fall. On March 16, the Federal Reserve cut the Funds rate to zero and promised to do whatever it takes to keep liquidity in the system. On March 23, Congress passed a $2 trillion aid package, known as the CARES Act. These efforts were designed to keep businesses open and provide individuals with enough money to weather the storm of rising unemployment and shuttered businesses.

These efforts gave confidence to the markets. Accordingly, the low in the stock market occurred on March 23rd and quickly rose to finish the year up 18% (Bloomberg). We had unanswered questions about when these lockdowns could end, but it was clear that keeping the economy going was a clear priority.

The government was also working to address the health crisis at hand. It partnered with a number of pharmaceutical companies to prefund vaccine purchases and help cover the cost of research and manufacturing dubbed “Operation Warp Speed.” By mid-November, announcements were made about the success of the vaccines and the markets were off to the races, reaching record highs.

2021

Just like last year, we begin this year with a very accommodative Fed, strong markets and tight credit spreads. There is uncertainty related to when we might get back to work and how many office buildings or stores or hotels we’ll need after this is all over. The markets seem to be once again reflecting the best-case scenario with little upside from spread tightening and some downside should the vaccine rollout be less than smooth. We’ll repeat our mantra from last year. Although we have a benign credit outlook, with spreads at these tight levels we believe there is limited upside in taking an aggressive position by adding the riskiest of credits. We still see some pockets of value within the corporate market and believe the positive technicals will provide a backstop to volatility.

The continued buying by the Fed in Agency MBS has created a dislocation in that sector. Our models suggest that on an option adjusted basis, this sector’s expected return is below Treasuries. We have reduced our exposure and plan to continue to underweight this sector.

Our fixed income portfolios are built to maximize income while reducing downside risk. We consistently overweight spread sectors but we strive to be flexible in our allocations. We use long Treasuries and Taxable municipals to reduce price volatility. We have seen that since 2014 the benchmark Corporate bond sector has underperformed duration matched Treasuries three of the last seven years while agency MBS four of seven and CMBS two of seven (Bloomberg Barclays). On the other hand, the ABS sector has outperformed Treasuries every year during this period (Bloomberg Barclays).

We use short high quality ABS to add stability and positive convexity versus Treasury and Agency MBS positions. We have reduced volatility by adding longer Taxable munis and Treasuries to our portfolios and limit call risk by underweighting the MBS sector. The ability to be nimble in corporates and construct yield enhanced portfolios with the use of taxable municipals and ABS has enabled the AAM managed portfolios to be consistent top quartile performers.

Since we expect a stable economy and strong technical factors, this should be a good year for the equity markets. However, after the significant run-up in valuations, we are working with our clients to ensure that portfolios have been rebalanced in accordance with strategic targets.

Corporate Credit

2020 was the quintessential roller coaster year for investment grade (IG) corporate bond spreads. The Corporate market OAS using the Bloomberg Barclays Corporate Index ended the year at the virtually the same level it started after widening over 300 bps in March.

Exhibit 3: Corporate OAS

*Source: Bloomberg Barclays Index, AAM as of 12/31/2020 (OAS=Option Adjusted Spread; Std dev = standard deviation)*

As companies faced a high level of uncertainty in the spring, they issued a record amount of debt to raise cash. This additional debt coupled with EBITDA pressure resulted in debt leverage spiking, and close to 30 issuers or 3% of the Corporate Index experienced rating downgrades to high yield (Barclays Corporate Index). After a year of fundamental weakness due to the virus and related lockdowns, AAM expects credit fundamentals to rebound solidly in 2021 alongside the global economy. We expect debt leverage to improve due to falling debt levels and EBITDA growth (10-15% expected). Consequently, rating actions are expected to be more favorable this year as companies execute on deleveraging plans. Capital spending growth is expected to resume to an aggregate level that is essentially unchanged versus 2019 (“pre-COVID”). Fiscal stimulus and low interest rates are expected to fuel the economic recovery expected in 2021, as herd immunity is reached, placing us in the “recovery” phase of the cycle. Companies will have engines for growth other than financial engineering in 2021, which should be constructive for the IG market.

In addition to a favorable fundamental outlook, we expect market technicals to support spreads, with gross and net debt issuance expected to be lower in 2021 vs. years past. The liquidity in the market, low yields outside the U.S. and expectation for rates to remain low in the U.S. are supportive for IG Corporate bond demand.

Exhibit 4: Composition of Gross Investment Grade Debt Supply

*Source: AAM, Morgan Stanley, Dealogic, Bloomberg*

Unfortunately, spreads are very tight, and while our OAS target for year-end is 95bps, our Bull case is for the OAS to move to the 10-year minimum level of 85 reached in 2018, which we deem more likely than a Bear case in which it widens to 140 (10-year average). We expect spread curves to flatten and the premium in spread for BBB rated issuers to compress further versus higher rated issuers. Risks to our forecast includes: (1) issuers’ unwillingness to reduce debt, using liquidity for more shareholder friendly activity, (2) pace of vaccination rollout materially underwhelms expectations (3) Fed changes its accommodative stance and (4) the Biden Administration’s policy objectives threaten near term growth expectations.

2021 is likely a year in which performance is driven by how much risk is in the portfolio versus being driven by idiosyncratic risk. That said, when the cycle moves into its next phase, it will be important to have protected the portfolio from issuers with negative fundamental outlooks because that risk will start to materialize. To help with that process, the following was compiled by our experienced analyst team, recognizing that opportunities exist in all sectors and strong credit research is an important part of that process.

Exhibit 5

Structured Products

Structured products experienced mixed returns in 2020 as both CMBS and ABS outperformed their Treasury benchmarks by 51bp and 106bp respectively while agency RMBS underperformed Treasuries by 17bp (Bloomberg index returns). We’d consider that performance pretty pedestrian based upon historical averages however when accounting for the sharp downturn in risk assets earlier in the year due to the growing pandemic, we believe the overall performance was actually quite good. Looking to 2021, we start the year with spreads that are at or below levels where we began 2020 and quite low on a historical basis as well. This certainly limits the extent to which structured products can outperform Treasuries this year. Despite these tight levels however, we do expect some incremental spread compression in both ABS and CMBS generating reasonable excess returns but once again expect agency RMBS excess returns to disappoint.

It was quite a roller coaster ride for agency RMBS in 2020. We began the year expecting a flood of mortgage issuance as the Federal Reserve unwound their latest quantitative easing program only to have to reverse course and expand their balance sheet once again. Initial expectations were for the Fed to shrink their RMBS holdings by $220B in 2020 but instead they were increased by over $850B (BankAmerica for the 850B, JPM), a multiple of the net new issuance for the market for the entire year. This steady and consistent buying drove down mortgage rates, causing homeowners to rush to prepay their loans, eroding the entire incremental yield of the RMBS securities over and above Treasuries. Although rates have risen a bit in January, roughly 60-70% of all outstanding mortgage loans carry interest rates that are higher than current borrowing rates (Case Shiller, BofA, Citi, JPM). We expect prepayments to remain elevated over the course of 2021, reducing expected return for RMBS securities below that of Treasuries.

Non-Agency RMBS looks much more compelling to us as we believe the higher yields offered by non-government guaranteed securities more than offsets the risk of higher prepayments afflicting agency guaranteed securities. Credit risk seems quite manageable as one surprising consequence of the pandemic has been an increase in demand for larger suburban housing, the type backing many non-agency securitizations. Homeowners looking to escape urban settings and the need to create home office space have driven the demand for housing well above supply in many parts of the country. Home prices nationwide rose by nearly 6% in 2020 and are expected to increase another 3-4% in 2021 (JPM, BofA). Continued fiscal support from Congress in the form of additional stimulus payments, supplemental unemployment insurance and a recovering employment market along with home price appreciation should contribute to solid credit fundamentals for non-agency securitizations over the coming year.

There remain many questions concerning the long-term impact of the coronavirus on commercial property markets. In particular the acceleration of online shopping replacing brick and mortar retail outlets and the need for expensive downtown office properties as employers embrace more work from home strategies. The pressure brought by these fundamental changes to key parts of the commercial property market are going to place significant downward pressure on valuations and operating metrics for marginal B and C properties in a wide variety of subsectors. Well placed, Class A properties, we believe will continue to thrive however. The old adage about location, location, location holds today more so than ever. We believe that by carefully stress testing properties underlying securitizations, we can identify those securities that will exhibit the best overall credit performance. We believe Senior, Aaa rated bonds remain the best value as high levels of credit enhancement should provide ample protection against the volatility in credit fundamentals we expect in the coming year. While we expect spreads to compress to Treasuries, it will be somewhat dependent on the performance of single A corporate bonds. CMBS tracks corporate bonds spreads closely and without a similar tightening in corporate spreads, CMBS will likely have difficulty following through on their own.

Exhibit 6: CPPI Growth is Decelerating

*Source: Real Capital Analytics, Bloomberg*

ABS have always been one of the most consistent performers within the structured products universe. They provide high credit quality and stable cash flows making them a staple in our portfolios for shorter maturity needs in lieu of Treasuries. While we expect ABS to outperform other asset classes at the short end of the yield curve, valuations are strained for the larger, more generic sectors of the market. Spreads to Treasuries are as low as 10-15bp for large auto and credit card issuers making them fairly unappealing compared to Agency CMBS and Taxable Municipals. The demand for very short-term assets based on market expectations for higher yields and a steeper yield curve have driven short term spreads to extremely low levels. We do see value in more esoteric sectors, such as railcar, container and equipment securitizations, where spreads north of 100bp have the ability to generate returns well in excess of Treasuries particularly those yielding only 15-20bp.

Municipal Market

After a tumultuous year in which the pandemic-induced recession generated record low interest rates, massive volatility in relative valuations for the taxable and tax-exempt municipal sectors and a record surge in municipal new issue supply, our outlook for the municipal sector in 2021 is very similar to our outlook going into 2020. For tax-exempt municipals, we are maintaining a negative bias for the sector based in large part on the very expensive relative valuation profile of the sector versus taxable alternatives. Based on data from Thomson Municipal Market Data, ‘AAA’ rated municipal nominal yield levels as a percentage of Treasury yields during January fell to a 29-year low of 68%.

The overvalued condition for tax-exempts has primarily been driven by positive technical and credit factors over the last few months. From a technical perspective, tax-exempt new issue supply during the year has largely been manageable. In a year in which the Bond Buyer reported overall municipal supply reached a new record of $474 billion, 2020 tax-exempt supply actually saw a decline of 4% from 2019 levels to $319 billion. The demand profile, however, has been building in momentum since the implementation of fiscal stimulus that helped the sector weather the largest liquidity and economic concerns related to the pandemic. Although questions remain as to the extent that state and local governments will see additional stimulus, the general election and senate run-off races that produced Democratic control across both houses of congress and the White House has provided a more constructive view of municipal credit. The Biden/Harris administration has already targeted $350 billion in direct aid to state and local governments within a new $1.9 trillion stimulus package. If the measure passes, this aid should help address revenue shortfalls at the state level that Standard and Poor’s estimates will reach a cumulative total of $467 billion over the fiscal years 2020 to 2022. The potential for these positive credit developments, combined with the very favorable year-end reinvestment flows of coupons/calls/maturities, has produced one of the most relatively expensive environments for the tax-exempt market on record. Consequently, we are maintaining a negative bias for the sector and advocating a significant underweight position.

The taxable municipal market has also exhibited a similar build in performance momentum over the last few months. The same themes outlined in the tax-exempt space from a credit perspective benefitted the taxable sector; however, one area of significant difference is in the new issue supply performance. The Bond Buyer reported record taxable muni issuance of $185 billion, which incorporated $145 billion of municipal cusips and an additional $40 billion issued under corporate cusips by municipalities. Most of this issuance was tied to refinancing supply executed as advance refundings, which came in at ~$140 billion. The majority of this issuance was shoved into the market during the six-month period from May to October to avoid any potential market dislocations related to the presidential election in November. Post-election, new issuance has been muted, while demand has been incredibly strong across both retail and institutional investors. Consequently, in looking at data compiled by AAM, ‘AAA’ taxable muni spread levels during 2020 have compressed by 10 to 21 basis points (bps) across the yield curve, with the 10yr area providing the strongest performance. Going into 2021, these spreads represent the tightest relationship to Treasuries in the last 15 years. However, when comparing the sector’s yields to other spread sectors like corporates, spread levels remain modestly attractive relative to historical average relationships to ‘A’ rated industrial corporate bonds. Although we believe the taxable muni sector exhibits very limited potential toward further tightening in spread levels, we view the taxable municipal sector as fairly valued.

In looking forward to supply technicals during 2021, coming into the year, broker/dealer expectations for new issue supply ranged from $470 to $525 billion, with taxable supply incorporating ~$175 billion of this amount (Barclays, Citigroup, JP Morgan, Bank of America). Of the taxable issuance, $125 billion were expected to be refinancings executed as advance refundings (Barclays, Citigroup, JP Morgan, Bank of America). However, most of these estimates were derived before the Georgia senate run-off elections that resulted in Democrats taking majority control of the chamber. Under this new development, there could be substantial changes in the makeup of issuance during the year between the tax-exempt and taxable markets, especially as it relates to any potential Biden/Harris administration initiatives tied to infrastructure and tax reform.

Under tax reform, the market expects that tax-exempt advance refundings, which were abolished under the Tax Cut and Jobs Act of 2017 (TCJA), will likely be reinstated to the tax-exempt sector. The market also expects that an infrastructure plan will be introduced that will be funded in part within the taxable muni market through the use of direct-pay bonds. This approach would emulate the Build America Bond program that was utilized during the Obama/Biden administration in 2009 and 2010 to fund capital spending. If tax reform and infrastructure are addressed later in the year, we would expect that supply expectations going into 2021 would remain in place. However, if these measures are addressed early this year, the risk is that we could see much higher issuance levels this year, with tax-exempt issuance surprising to the upside. Taxable muni supply would not be expected to change dramatically, as any reduction in advance refunding issuance is expected to be supplanted by direct-pay issuance from infrastructure-related supply.

Exhibit 7: Tax-Exempt Relative Valuation Levels Remain Unattractive for Insurers

*Source: Thomson Reuters Municipal Market Data, Bloomberg*

Exhibit 8: Taxable Munis: Compelling Alternative to Tax-Exempts

*Source: Thomson Reuters Municipal Market Data, Bloomberg, AAM*

High Yield

Exhibit 9: US Below Investment Grade Valuations

After a challenging start in the first quarter of last year, US High Yield ended 2020 with strong positive returns as the sector benefited from swift Fed and Monetary policy response to the pandemic, as well as investor demand for higher income alternatives. At the height of the market dislocation, broad market credit spreads widened to a peak +1082 in late March, but then subsequently tightened almost 700 basis points to end the year at +390 as liquidity and sentiment improved (ICE BofA High Yield Index H0A0 Spread to Worst). Total returns were 6.21% for US High Yield, with the higher quality BB-B rated segment performing slightly better at 6.32%, while the lowest quality CCC and lower rated issuers fared the worst at only 2.78% (ICE BofA US Cash Pay High Yield Index J0A0, ICE BofA BB-B US Cash Pay High Yield Constrained Index, ICE BofA CCC & Lower US Cash Pay High Yield Index). Syndicated Loan returns were 2.78% which lagged High Yield given their shorter duration, floating rate profile which fell out of favor as the Fed took short term rates to zero (Credit Suisse Leveraged Loan Index).

Leverage for high yield issuers moved higher during 2020 and finish the year at 5x Debt/EBITDA which compares with pre-COVID multiples near 4x (Muzinich & Co.). Liquidity improved significantly, however, as corporations rushed to raise cash in the new issue market as a precaution for a prolonged downturn. Cash to debt levels improved to almost 20% by year end which is almost double the same measure pre-COVID (Muzinich & Co.). Given the weakness experienced early in the year, the annualized default rate rose to 6.5% (Muzinich & Co.) but appears to have stabilized as there were no defaults in November and only one to report in December. In addition, credit rating upgrades now outnumber downgrades by a ratio of 1.2:1 as further evidence of improving fundamentals (Muzinich & Co.). Assuming the recovery from COVID continues, the default rate is expected to drop precipitously to an annualized rate of 2-3% by year end 2021 (Muzinich & Co.).

We expect technicals to be favorable in the coming year as demand for higher yielding instruments should persist while new issue supply is expected to be lower than 2020. While valuations appear tight with credit spreads recently falling below the long-term averages, spreads remain 50 basis points wide of the most recent lows in 2018. Opportunities in the market still exist, but we believe it’s critical to evaluate the appropriate levels of risk and reward in portfolios with an actively managed approach and disciplined underwriting process to avoid defaults.

Income has consistently been the largest component of total return for High Yield over time as the additional carry helps to offset any short term price moves. As prices have improved materially, we expect coupon to be the largest driver of returns in 2021. Given a backdrop of improving fundaments and lower defaults, we expect High Yield bonds to provide returns in the range of 4-5%. Loans have the potential for higher returns of 5-7% as the average price of Loans remains at a discount and a pull to par in prices could supplement the income return. Loans could also benefit from a recent resurgence in CLO issuance which has accounted for as much as 50% of the investor base in recent years (Muzinich & Co.). Additionally, there has been increased demand from investors seeking floating rate coupons as a hedge against the prospects of higher interest rates. Finally, as you can see in Figure 3, both US High Yield and Loans continue to offer attractive yields that can enhance the income of broad market investment grade strategies.

Exhibit 10: Fixed Income Yields per Corporate credit and Treasuries sub-segments

Source: Muzinich, Credit Suisse Leveraged Loans Index USD, Western European Lever aged Loans Index non-USD denominated, ICE BAML indices, H0A0, HEC0,EMNF, CF0X, CF00, EN00, EF00, G402, G102, EG14, EG11, as of December 15th, 2020

Convertible Securities

The asymmetric risk/return proposition offered by balanced convertibles demonstrated its worth in 2020 as Covid-19 related volatility shook financial markets. With equities tumbling 35-40% into late March, balanced convertibles experienced less than half of the decline, this including market illiquidity and gapping credit spreads that led to Fed intervention. Capital preservation at the March lows provided a strong investment base for the confluence of events that followed: 1) consistent and heavy new issuance, 2) a dramatic rally across equity markets, and 3) collapsing credit spreads. These factors helped to produce the strongest run for convertible investors in decades with Barclays Index data pegging the broad convertible market return at +89% from March 23rd through year-end (Barclays Capital convertible research)

Exhibit 11: U.S. Equities and Convertibles – Cumulative 2020 Total Return

*Source: Bloomberg Barclays Index Data, Bloomberg L.P.*

While volatility may have been the biggest story of 2020, new issue supply in U.S. convertible markets is noteworthy for the likely sustained impact it will have on the sector’s ability to deliver compelling absolute and risk-adjusted returns into the future. For the full year, 194 deals priced in the U.S. market with proceeds of nearly $115 billion (Barclays Capital convertible research) – higher than 2018 and 2019 combined. Sustained deal flow and market gains, as indicated in Exhibit 2 below, contributed to a convertible market that has increased in size by approximately 50%. While technology and healthcare sector issuers continue to lead in deal volumes, the market also provided access to capital for issuers across a wide variety of market sectors looking to raise funds or build liquidity to endure Covid-related uncertainty. Breadth of issuance and an expanded balanced opportunity set affords investors the ability to diversify risks across industries, an important factor given how far technology shares have come in recent quarters.

Exhibit 12: U.S. Convertible Market Size and Structure ($Min)

*Source: BofA Global Research, ICE Data Indices, LLC*

Broad measures of credit health within the convertible market are stable and improving, which is likely to provide stability to balanced sector convertibles should equity markets surprise to the downside. New deal flow is expected to continue at above average levels, yielding another year of organic growth in market size. Critically important in this market, we observe a high level of concentration risk and equity sensitivity in the market which can expose high delta investors and passive index ETF shares to significantly greater levels of volatility relative to actively managed balanced strategies. Our partners at Zazove Associates have been actively rebalancing portfolios through this rally with current portfolios well positioned with proper diversification and equity risk control.

AAM’s outlook for strong economic growth and favorable monetary and fiscal policy in 2021 bodes well for convertible returns in absolute and relative terms. Should our forecast prove accurate, corporate earnings growth will likely yield a favorable environment for equity investors, particularly in cyclically sensitive and financial segments and small/mid cap issuers. While it is difficult to imagine a repeat performance of 2020, we believe mid-to-high single digit returns in equities are achievable. In such an environment, balanced convertible models indicate returns which capture the majority of stock market gains.

February 4, 2020 by

Economic Outlook – Marco Bravo, CFA | Senior Portfolio Manager

Market Outlook – Reed Nuttall, CFA | Chief Investment Officer

Corporate Credit – Elizabeth Henderson, CFA | Director of Corporate Credit

Structured Products – Scott Edwards, CFA | Director of Structured Products

Municipal Market – Gregory Bell, CFA, CPA | Director of Municipal Bonds

High Yield – Scott Skowronski, CFA | Senior Portfolio Manager

Convertibles – Tim Senechalle, CFA | Senior Portfolio Manager

Economic Outlook

AAM’s macro-economic outlook for 2020 is centered around four key themes: (i) moderate U.S. economic growth, (ii) subdued inflation, (iii) a Federal Reserve on hold, and (iv) Treasury yields staying low. Consensus forecasts have real GDP growth in the U.S. slowing to 1.8% for 2020 from 2.3% in 2019. As shown in Exhibit 1, the projected moderation in GDP growth is due to slightly weaker spending from the consumer, a deterioration in net trade, and lower government spending. Fixed private investment, which includes business spending and residential investment, is expected to improve in 2020 and contribute positively to overall GDP growth.

Exhibit 1: Contribution to GDP Growth

*Source: Bureaus of Economic Analysis, Bloomberg*

Downside risks to economic growth include uncertainties caused by the U.S./China trade dispute, slowing growth in Europe and China, weaker corporate profits, U.S. elections, and an increase in geopolitical risks. These risks are largely expected to negatively impact manufacturing activity and business spending. The signing of the U.S.-China Phase 1 trade deal along with indications that the weakness in manufacturing activity may be stabilizing are both positive developments as we start 2020. Consumer spending, which is the largest contributor to GDP growth, continues to be supported by a tight labor sector, modest wage gains, low interest rates and household balance sheets that are still in good shape. We expect GDP in the U.S. to increase between 1.5% to 2.5% for 2020 and view the risks to GDP growth as modestly skewed to the upside.

Both headline inflation (Consumer Price Index) and the core PCE Price Index were below the Fed’s 2% target in 2019. After averaging 1.8% last year, the CPI is expected to tick higher and average 2.1% in 2020. Core PCE, the Fed’s preferred measure of inflation, is expected to remain below the Fed’s target and average 1.9% for 2020. With average hourly earnings increasing around 3%, in line with productivity growth and underlying inflation, we don’t see much pressure on inflation to move significantly above the Fed’s 2% target.

The Federal Reserve cut rates three times last year in order to “protect the U.S. expansion in the face of rising downside risks from trade tensions and slowing global growth.” With those risks having subsided to some degree and inflation expected to remain subdued, we see no impetus for the Fed to either lower rates further or reverse course and begin raising rates under its current monetary policy framework. This view is not shared by the consensus which is calling for one rate cut this year, most likely following the November elections. Moreover, around mid-year 2020, the Fed is expected to finish a review of its “monetary policy strategy, tools and communication practices,” which could present new factors for the market to digest, increasing uncertainty and volatility.

Treasury yields, according to consensus forecasts, are expected to move modestly higher from current levels. The benchmark 10-year Treasury yield is forecasted to end 2020 at 2.0% based on the median forecast among economists. With manufacturing sentiment indicators outside the U.S. showing signs of stabilizing, sovereign bond yields have moved off their lows and could put pressure on U.S. yields to move higher. In addition, higher yields outside the U.S. could weaken the U.S. dollar and reduce the deflationary impact from a strong currency, which could steepen the yield curve. We are calling for the 10-year Treasury yield to end the year around the consensus estimate of 2%.

Market Outlook

Exhibit 2

2019 – WOW, what a great year to be an investor! 2019 started with a bang, after a horrible 4Q2018 driven primarily by the Federal Reserve raising rates for the fourth time in the year all while economic indicators slowed. The Fed seemed tone deaf as they expected four more hikes in 2019, sending the market into a late-year panic in 2018. However, the Fed quickly backtracked in early 2019. This accommodative posture from the Fed effectively reversed the spread widening and equity market sell-off in 4Q2018, putting all U.S. markets on track for stellar returns. With the Fed cutting rates three times in July, September, and October respectively, the outlook for risk assets improved significantly. There were several factors of concern; Primary among them was the effect of the tariffs and the tweets about tariffs. As the U.S.-China Phase 1 trade deal was nearing completion, the last major hurdle for performance in 2019 was put aside. This resulted in a strong Q4 and put 2019 equity market returns over 30%, while the broad fixed income market returned 8.72% with the corporate bond sector leading the way.

2020 – We’re off to a good start. However, the coronavirus outbreak and the resulting selloff in equities, commodities, and other risk assets sends a clear message that the markets are fragile; With the markets seemingly priced to perfection, it doesn’t take much to disrupt them. We expect stable albeit low GDP growth this year and a Fed that will be accommodative should U.S. growth falter. Although we have a benign credit outlook, with spreads at these tight levels there is limited upside in taking an aggressive position by adding low quality credits. We continue to recommend the focus on security selection and credit quality in this tight spread environment.

With a stable economy, very low interest rates, and limited inflation, we are particularly cautious about Treasury yield fluctuations due to a flight to quality or change in inflation expectations. We have positioned our portfolios with limited call or extension risk to take advantage of sudden changes in the yield curve. Over the last two years, having an underweight to MBS has been profitable as yield levels have been volatile.

Since we expect a stable economy and strong technical factors, this should be a good year for the equity markets. We are working with our clients to ensure that portfolios have been rebalanced in accordance with strategic targets.

Corporate Credit

2019 was a record year for markets, and the investment grade (IG) corporate bond market was no exception. Its 6.8% excess return over similar maturity Treasuries exceeded expectations, due largely to the technical support related to more dovish central banks in the U.S. and Europe as well as China. The corporate IG Option Adjusted Spread (OAS) tightened 60 basis points (bps) to 93 bps, nearing its 10-year minimum of 85 bps realized in early 2018 and approaching 1.5 standard deviations below its 10-year average.

Exhibit 3: U.S. Corporate Investment Grade OAS

*Source: Bloomberg Barclays Index, AAM as of 12/31/2019*

While the 25-year adjusted corporate market OAS averages 135, in times of technical support (rates, QE/liquidity) and fundamental stability, it is lower. Those periods are often in the later stage of the economic cycle; for example, 2003-2006 and 1995-1997. We expect this dynamic to largely repeat itself in 2020, due to our expectation for lower net corporate bond supply, stable interest rates, and ample central bank support and liquidity globally. However, there are outsized risks that are likely to increase market volatility including but not limited to uncertainty regarding the U.S. election and foreign policy as well as the Federal Reserve’s monetary policy goals. The coronavirus is a recent example, and IG spreads to start the year are close to 10 bps wider. Our expectation is for slightly wider spreads by year-end 2020, with an OAS ranging from 103-123.

Exhibit 4: OAS and VIX Highly Correlated

AAM expects credit fundamentals to be largely stable in 2020. After years of increasing and elevated debt leverage, we expect leverage to marginally improve as companies work to deleverage in line with rating agency targets and uncertainty keeps companies financially disciplined. Companies with higher credit ratings and lower projected growth are more likely to take advantage of low rates to increase debt leverage vs. those rated in the ‘BBB’ category. The uncertainty in regards to the U.S. election and foreign policy should keep M&A activity muted at least for the first nine months. For example, the latest Duke CFO Survey continues to point to a high risk of a U.S. recession in the next 12-18 months, causing firms to focus on building liquidity and lowering debt balances and costs while remaining cautious on capital investment. We expect continued asset sales and divestitures for investment grade companies, which could increase debt issuance in markets such as high yield and loans. Lastly, we expect increased shareholder activism and investor attention on ESG related matters to continue in 2020.

We expect revenue growth to increase in 2020 by 4-5% on average as industrial, manufacturing, and technology sectors benefit from stable-to-improved economies globally and a normalization of inventory levels. Consumer related sectors are expected to grow 1-3% given the high degree of competition and supply for the level of demand. EBITDA and earnings are projected to grow 8-9%, with capital spending growing 2-3%. Technology oriented firms should grow at a much faster pace after the rationalization of inventories in 2019 vs. orders as well as the ramp expected in 5G related spending. Conversely, the other end of the growth spectrum includes industries that are still oversupplied for the level of demand – industries such as autos and construction machinery. Accordingly, we expect more capital investment from technology and communication services companies with little to no growth in capital investment from traditional industries like manufacturing and energy. The main risk to this forecast is lower than expected growth from overseas and/or the U.S., reigniting recession concerns.

The technical outlook for the corporate market remains favorable, with gross and net debt issuance expected to be lower in 2020 vs. 2019. This is consistent with our fundamental outlook related to deleveraging and capital spending. Lower debt supply coupled with strong demand from foreign investors and insurance companies suffering from low relative yields should support spreads. A risk to this forecast relates to rate volatility and/or the shape of the yield curve (bear flattening in particular). We are biased to the intermediate part of the curve given the lack of absolute value on the long end. ‘BBB’ rated firms remain fairly valued on average vs. higher rated peers. This, in addition to our expectation for deleveraging and modest spread widening for the market, causes us to prefer higher rated BBB securities.

After two years of systemic risk driving credit spreads, we expect idiosyncratic risk to drive portfolio performance in 2020. In general, we recommend prioritizing defensive sectors due to our expectation for modestly wider spreads from low levels to start 2020.

Exhibit 5: AAM Sector Outlook for 2020

Structured Products

Unlike 2018 when most sub-sectors of the structured product universe underperformed Treasuries, 2019 was a year when you were well-rewarded for taking risk. All sectors of the structured market outperformed similar maturity Treasuries some by the widest margins in years. Commercial mortgage backed securities (CMBS) were the best performing sub-sector far outpacing agency mortgage backed securities (RMBS) and asset backed securities (ABS). As we look to 2020, generating excess returns over Treasury benchmarks and other risk assets is going to be far more challenging as spreads have compressed to multi-year lows leaving risk priced at much less attractive levels.

After trailing its Treasury benchmarks through much of 2019, RMBS had a stellar fourth quarter generating 63bps of excess returns, the highest annual excess return since 2013. Fed easing and an overall drop in volatility helped propel returns. We believe last year’s performance has left valuations in a relatively unattractive range and anticipate significantly lower returns in the coming year. In addition to poor valuations, the market must also contend with the significant supply generated from the runoff of the Federal Reserve’s $1.4 trillion mortgage portfolio. It’s anticipated that their portfolio will contribute $238 billion in new RMBS, representing over 80% of the forecast net new supply for the year. Given the poor technical positon of the market and tight spread to Treasuries, we will continue to underweight agency RMBS in our portfolios.

Non-agency RMBS, however, remain an important component of our portfolios despite valuations being somewhat less compelling than prior years. Credit fundamentals in the sector still look very good, and since underwriting continues to be very conservative, we anticipate the sector outperforming agency RMBS and, to a lesser extent, Treasuries this year. Housing price appreciation should slow to roughly 3.0% from roughly 3.5% last year; however, we don’t anticipate that it will negatively impact the market. With the consumer being in such excellent financial shape due to low unemployment of 3.5% and wage growth of 2.9%. As a result, delinquency and default rates should remain at very low levels. If we have a concern about the sector it would be the relatively rapid prepayments experienced during the fourth quarter of last year. With mortgage rates stabilizing, we expect prepayments to slow relative to agency securities supporting non-agency valuations.

Commercial real estate fundamentals remain in relatively good shape following multiple years of property price appreciation and domestic economic strength. Overall price levels for commercial properties increased in excess of 8% last year, lead by multifamily and industrial properties, and operating income increased on average by 3% or more. While CMBS was the best performing sector within structured products, they could not keep pace with A-rated corporate bonds which generated more than twice the excess return. In most years, senior conduit CMBS securities tend to track spreads on single A-rated corporate bonds fairly closely. We are anticipating heightened volatility within the corporate sector this coming year and expect CMBS will track corporate bond spreads but with less volatility. When combined with current valuation, we expect CMBS should modestly outperform both Treasuries and single A-rated corporate bonds. Our investment of choice within the sector continues to be conservatively underwritten single asset transactions with low leverage. With spread concessions to conduit securities of approximately 10-15bps, they represent better value at this time. As in prior years we remain concerned about the retail sector, particularly regional malls in less populated areas, which must be carefully analyzed in any conduit securitization.

ABS has been a consistent performer year in and year out, and we don’t envision 2020 being any different. Concerns have been raised about the overall level of consumer debt and the increase in delinquencies, particularly within the auto sector over the past year. Our view is that the consumer is in good shape financially. They continue to maintain healthy balance sheets due to strong job growth, and wage gains while the cost of servicing the growing debt burden is well within historical norms. Delinquencies are normalizing from low levels, returning to levels similar to those experienced well before the Financial Crisis and do not reflect the early stages of a consumer credit crisis. We’ll continue to maintain significant portfolio weightings relative to most benchmarks, particularly at the short end of the yield curve. High credit quality and stable cash flows make ABS an attractive alternative to short corporate credit, taxable municipals, and Treasuries. Our favorite sub-sectors continue to be prime and some select subprime auto, credit card, and equipment transactions.

Exhibit 6

*Source: Real Capital Analytics, Wells Fargo Securities, CoStar*

Municipal Market

Our outlook for the tax-exempt municipal sector is negative based on their very expensive valuation levels relative to the taxable fixed income sectors. After exceptionally strong performance to end 2019, municipal-to-Treasury ratios in 10-years started 2020 at 75%, which is 13.5 percentage points below the 5-year average. Additionally, on a tax-adjusted yield basis (21% corporate tax rate adjusted), 10-year tax-exempt yields are 19 basis points (bps) through maturity-matched Treasuries. We view both of these valuation metrics as considerable indicators of the overvalued condition for the sector and, in our view, warrant a significant underweight of the sector for 2020.

Very favorable technicals have provided the major underpinning to the sector’s expensive valuations, and the Tax Cut and Jobs Act of 2017 (TCJA) has been one of the most influential events in exacerbating supply/demand imbalances within the sector since its passage in late 2017. On the supply side, the tax reform’s repeal of tax-exempt advance refundings of existing tax-exempt debt reduced overall tax-exempt issuance in 2019 by $54 billion relative to 2017, per data reported by the Bond Buyer. On the demand side, the TCJA’s imposition of a $10,000 cap on state and local tax (SALT) deductions increased the tax burden on wealthier investors in high-tax states. The higher tax burden, combined with already high marginal tax rates, resulted in an increase in the value of the tax-exemption. The ensuing demand for tax-advantaged assets culminated with a record of $95.5 billion in inflows into tax-exempt mutual funds during 2019, per Lipper Fund Flow data.

We expect many of the drivers for tax-exempt valuation to largely remain in place during 2020, as the probability of any change in the tax code during the year is low given the current split legislative control of Congress. However, for insurance company portfolios, we believe that there are better alternatives in the taxable fixed income sectors, which would include taxable municipals.

We have a more constructive view on the outlook for the taxable municipal sector primarily because of the sector’s significant yield advantage relative to tax-exempt bonds and absolute yield levels that are comparable to the other taxable sectors. When comparing yields of similarly rated taxable municipals to that of tax-exempt bond yields (tax-adjusted at 21% corporate tax), taxable municipals provided compelling additional carry of 80 and 85 bps in 5 and 10-year maturities, respectively. Additionally, in those same maturities, ‘AAA’-rated taxable municipal yields were at comparable yield levels to ‘A’-rated industrial corporate bonds.

We believe that the relative attractiveness of the taxable municipal sector should largely be in place for most of 2020 due to the heavy amount of issuance that’s expected. Estimates from the broker/dealer community is for projected issuance of ~$115 billion, with the majority of this supply a direct result of taxable advance refundings of tax-exempt debt. The dramatic plunge in Treasury rates during 2019 (77bps in 10 years) has helped generate significant savings for refinancings, and issuers have been aggressively pursuing this type of issuance since August. As long as rates remain range bound around current levels, there should be ample opportunities to add exposure to this sector during 2020.

From a fundamental perspective, we do not expect any headline risk to create selling pressure in the space, as we expect credit conditions to remain solid during the year. Income and property tax revenues have been growing at a solid rate during 2019 and are expected to continue going forward. That should bode well for solid fiscal performance for state and local governments.

Exhibit 7: Tax-Exempt Relative Valuation Levels Remain Unattractive for Insurers

Exhibit 8: Taxable Munis: Compelling Alternative to Tax-Exempts

Source: Thomson Reuters Municipal Market Data, Bloomberg
*Tax-exempt yields are grossed-up using a factor of 1.19968, which corresponds to a 21% corporate tax rate.

High Yield

2019 was a strong year for U.S. high yield overall. The sector benefited from stable fundamentals, an improved economic outlook, and strong technicals as the high yield market shrinks while the appetite for yield persists. Credit spreads tightened significantly during the year to levels nearing the five year low of +300. Total returns were 14.3% for the U.S. high yield broad market, with higher quality and longer duration segments outperforming as the BB-B-rated index returned 15.1% for the year while CCC-rated, and lower only returned 9.3%. Loans returned 9% in 2019 which significantly trailed bonds given their limited duration amid falling rates and slowing demand for the floating rate asset class.

Exhibit 9: Historical High Yield Credit Spreads (OAS)

*Source: Bloomberg Barclays Index Series Data; ICE BofA BB-B Cash Pay (JUC4), and CCC & Lower (H0A3)*

Fundamentally, leverage rose in 2019 but was limited to a few sectors, and interest coverage overall remains healthy. The twelve month U.S. speculative grade default rate increased modestly to 4.2% in 2019. However, it remains below the long-term average of 4.9%. The outlook improves in 2020 as defaults are expected to decline modestly to a rate of 3.5%. In addition, ‘rising stars’ continue to outnumber ‘fallen angels.’ We believe investors should avoid the lowest quality credits as the bifurcation between the lowest and highest quality issuers is likely to continue. It’s imperative to actively manage credit risk to in this environment in order to minimize exposure to issuers and sectors that are likely to be pressured in periods of slower economic growth.

Exhibit 10: Historical Global High Yield Fallen Angels and Rising Stars

*Source: BofAML Global Research, Muzinich & Co*; *LTM – Last twelve months; Fallen Angels – investment grade ratings downgrade to below investment grade; Rising Stars – below investment grade ratings upgraded to investment grade*

While valuations appear tight, further spread compression may be possible as we expect the strong technical backdrop to continue in 2020, with persistent demand for positive yielding credit in a world where negative yielding assets are abundant. Nevertheless, a large proportion of credit market performance in 2019 came from interest rate duration, which benefited from the fall in yields; a repeat performance in 2020 is unlikely. BB-B bond yields have fallen closer to 4.5%, while bank loans yields remain near 5.5%. We believe the relative value argument may be more balanced in favor of loans in 2020, as there is less to gain from long duration positioning and more focus on carry going forward.

Convertible Securities

The record setting rally in equity and credit markets fueled outstanding 2019 performance for balanced convertible investors. The Barclays Balanced Convertible Composite rallied 22.1% as an underlying equity advance of 32.8% pushed conversion values higher during the period. The asset class continues to benefit from its significant exposure to technology companies which represent approximately 35% of the U.S. convertible market as of 12/31/2019 and were the top performing subsector during the year.

Exhibit 11: U.S. Convertibles and Underlying Equity Performance By Sector

*Source: Bloomberg Barclays Indices*
*Total return values do not incorporate fees and other advisory expenses.*

New issue supply in the convertible market has been robust, with nearly $60B of issuance during 2019 – the largest annual total since 2008. Increased supply coupled with reduced redemption activity led to an increase in notional convertibles outstanding in the U.S. market, a healthy indicator for those seeking balanced risk/reward structures. High equity prices, low rates, and reduced interest deductibility for high yield borrowers have been supportive of this increased deal flow, and AAM’s market outlook suggests another year of sizeable issuance. A number of U.S. and European banks have recently issued synthetic convertibles. This structure consists of the bank as the credit and a conversion feature into a different underlying equity. These sizeable investment grade issues are a welcome addition to the market, but the synthetic nature results in new issue pricing that is generally less attractive to traditional issuance and non-rated secondaries.

The incredible momentum in technology and growth names during the rally has increased certain risks in the convertible market as a whole, which should favor active and disciplined portfolio managers if negative surprises emerge:

Equity sensitivity has increased with an average investment premium of 66% for the broad market indicating greater downside risk in a market decline
Continued technology issuance and rising share prices have increased concentration risks in the broad market
The broad market’s average rating has gradually declined to an estimated mid/low BB

Diversified portfolios of balanced convertible securities offer a unique value proposition that falls in the favor of investors: better upside participation relative to downside risk exposure. Through market cycles, this asymmetry produced equity-like average returns with substantially reduced volatility relative to underlying stocks. We recognize that the post-crisis capital market environment of the past decade has lacked sustained downward movements. Only three of the past forty quarters have registered a negative S&P 500 total return.

Our base case market outlook suggests a stable environment for risk investors in 2020, which should result in positive equity market returns and corresponding gains for convertible investors. In this environment, convertible returns will likely exceed fixed income but trail direct equity returns. Should negative surprises occur, diversified and balanced convertible strategies will dramatically outperform equities and likely broad convertible indices. We will remain patient and disciplined in our approach, continuing to harvest gains where appropriate and using new issue supply to maintain the asymmetry that we desire.

November 6, 2019 by

In the Fall of 2007, a new neighbor asked me what I do for a living. When I told him that I manage portfolios for insurance companies primarily consisting of investment grade bonds, he replied, “That has to be the most boring thing I have ever heard.”

His view point is one that is shared by many. Investment grade bonds are considered the “boring” part of your portfolio intended to be a safe haven asset class. Bonds generally represent the vast majority of investment holdings on risk pool balance sheets; they are there primarily to support the liabilities of the organization. Further, stability in the asset class and consistent income can support the risk pool mission of serving members through efforts such as grant programs, rate stability, wellness programs and other avenues. Over time, it can be easy to become complacent with the risks inherent in bonds, especially given the solid returns from investment grade fixed income since the global financial crisis of 2007-2008.

In this article we briefly review the two principal risks in risk pool bond portfolios: interest rate risk and credit risk. As we are late in the economic cycle, there is an increased likelihood that these risks will manifest themselves in a significant way, leading to heightened price volatility. Being aware of these risks is critical for all insurance entities, but especially for risk pools. The commercial market carries most bonds at amortized cost, so changing market values in their bond portfolios do not directly impact surplus or net position. However, since most pools are subject to GASB accounting standards, they carry bonds at fair market value. Thus, changes in value directly impact pools’ capital position.

Interest Rate Risk

With the substantial drop in US Treasury yields this year through September 30, 2019, fixed income returns have been tremendous, especially for long maturity assets. The magnitude of the impact from changing interest rates is measured by duration.

Setting the duration of a portfolio can have a significant impact on portfolio returns over time. If it is too short, pools sacrifice long term investment income. If duration is too long interest rate volatility may create more price volatility than pools are comfortable with or can financially support. In setting your portfolio duration target, AAM recommends reviewing your claims payment patterns, member contributions, and cash flows to support member services. These factors not only impact cash flows but also the stability and growth of net position. The ultimate goal is to budget an amount of interest rate risk that allows you to comfortably meet the obligations of your pool while maximizing investment income.

Credit Risk

The other meaningful risk for bond investors is credit risk. Investors vividly remember the global financial crisis of 2007-2008 and the concomitant volatility in the bond market. Recently, headlines are plentiful about the potential risks in the corporate bond market. With persistently low interest rates, companies have been willing to borrow and add leverage to their balance sheet. This has contributed to dramatic growth of the investment grade bond market since the last downturn.

Figure 1: Size of Investment Grade Bond Market

*Source: Bloomberg Barclays through 9/30/2019*

Since the end of 2007, total investment grade debt outstanding has increased from $10 trillion to $23 trillion. A significant portion of that is due to US Treasury borrowing, but corporate debt has also grown significantly from $2 trillion to $6 trillion outstanding. Not only has the bond market grown, it has generally migrated down in credit ratings. Now over 50% of the US Investment Grade Corporate bond market is rated in the BBB category, the lowest investment grade level. This is up from 35% at the end of 2007.

Figure 2: Corporate Bond Ratings

For an investor who maintains even a market weight to corporate bonds, their allocation to lower quality bonds has grown over the last decade. As a result, it’s highly likely that most pools are holding more corporate bonds, and more bonds with weaker credit ratings today than before the financial crisis.

With more debt outstanding, and debt that is lower rated, many investors are concerned about significant credit volatility in the next downturn. While defaults in investment grade bonds are rare, market valuations can become volatile when the economy slows as the market reprices the risk of downgrade to below investment grade or eventual default. This volatility would negatively impact the income and surplus of most risk pools. Further, ratings downgrades to below investment grade may have implications for compliance with a pool’s investment policy statement.

Action Items

Despite concerns about heightened risk in the corporate bond market, and an uncertain economic outlook, valuations in the market are not offering significant value today. Against this backdrop, what steps should your pool consider?

At AAM, we are reducing risk in pool portfolios. We have been reducing our exposure to the corporate bond sector and redeploying cash in other high quality sectors such as Agency MBS, US Treasury obligations and senior Asset Backed and Commercial Mortgage Backed Securities. We have also reduced risk by transitioning holdings within the corporate bond sector to higher quality, more defensive companies and industries.
We are also cautioning our pool clients that rating volatility may increase in the near term. Through prudent portfolio management downgrades should be infrequent, however it is possible that securities may fall below a minimum rating threshold. As a result, it is important to understand the steps mandated by your Investment Policy if a security is downgraded below investment grade. Clear Investment Policy language allows all parties to make decisions that are in the best long term interest of the pool and its members. One pool we work with took an interesting approach following the downgrades of the 2008-2009 period. The policy allows the lower of 2% of total invested assets or 5% of surplus in downgraded securities. This language allows a manager to be flexible in an effort to maximize value with regard to holding or selling securities in a downgrade situation. However, at these small sizes, it does not put undo stress on the balance sheet of the pool, and provides a clear avenue to maximizing value over time.
Regarding portfolio duration, review your pool’s projected cash needs, contributions and current net position to be sure the duration target set in the past is still appropriate. Often duration targets are set and are not consistently reviewed. This is a good time to undertake that review.

At this stage in the economic cycle, it’s critical to prepare for a downturn or recession. While reviewing the entire investment portfolio, pools will benefit from considering the risks in both their allocations to stocks and bonds. With bond prices at or near historic highs, many holdings can likely be sold at attractive prices. Ensure you and your board are cognizant of the risk profile for your pool’s investment portfolio and consider its suitability for your specific circumstances.

AAM works with 11 of Risk Pooling clients. Dan is the lead portfolio manger for our pooling clients.

May 14, 2019 by

Industry transitions

The medical professional liability (MPL) industry has been going through a period of tightening margins, soft pricing, and decreasing investment yields as detailed in AAM Insurance Strategist Peter Wirtala’s AAM Insight published in February 2019. As these factors are pressuring profitability throughout the industry, there are ways to improve the investment income generated from the fixed income portfolio that could benefit MPL insurers. The industry owns an allocation to tax exempt municipal bonds that have become unattractive versus other taxable sectors after the tax law change in 2018.

Tax law change

As part of the Tax Cuts and Jobs Act that was passed at the end of 2017, the tax rate for corporations was lowered from 35% to 21%. This change reduced the after tax yield on tax exempt municipal securities, making them unattractive for insurance companies in relation to other taxable fixed income sectors. The largest buyers of the tax exempt municipal debt are retail investors. Since individual tax payers have a higher tax rate relative to corporations, they receive a larger tax advantage for owning tax exempt securities. Exhibit 1 shows the difference in tax adjusted yields for AAA rated tax exempt municipals for individuals and corporations.

Exhibit 1: Market Yield – Individuals vs. Corporations

*Tax Exempt Yields are grossed up to the taxable equivalent using a 1.1994 factor. **40.8% tax rate includes 37% federal tax rate and 3.8% Medicare surtax. Tax Exempt Yields are grossed up to taxable equivalent using a 1.68919 factor. Yields as of 4/31/2019. Source: AAM, Bloomberg, Thompson Reuters.

The new tax rate for corporations translates to tax adjusted yields that are lower than U.S. Treasury securities for maturities that are 20 years and shorter while the tax benefit at the highest tax bracket for individuals makes the sector attractive across the curve.

MPL fixed income allocations

At the end of 2018, the MPL industry had an allocation of 20.6% to tax exempt municipal securities in their fixed income portfolios. Exhibit 2 details the investment grade fixed income allocations of the industry according to their year end statutory filings.

Exhibit 2: MPL Sector Breakdown

*Source: S&P Global Market Intelligence, Bloomberg, Factset. Data as of 12/31/2018.*

Given the current unattractive yields in tax exempt municipal bonds, the MPL industry would benefit by redeploying assets into high quality taxable sectors such as Asset Backed Securities (ABS), Commercial Mortgage Backed Securities (CMBS), and Corporate bonds, which provide a substantial yield advantage versus tax exempt securities today. If you dissect the tax exempt allocation of the MPL industry further, there is 4.5% of the fixed income portfolio that is under yielding U.S. Treasuries as of 04/30/2019. Exhibit 3 illustrates the yield advantage of 3-5 year AAA rated ABS and 5-10 year AAA rated CMBS versus similar tenor tax exempt securities.

Exhibit 3: Market Yield – ABS/CMBS vs. Tax Exempt Securities

*Yields as of 4/30/2019. Source: AAM, Bloomberg, Thompson Reuters.*

ABS and CMBS are high quality sectors that are under allocated in the MPL industry. Their yield advantage over tax exempt municipals offers a way to improve the income profile of the fixed income portfolio. As of 4/30/19, 3-5 year AAA rated ABS securities provide an additional 75-100 bps and 7-10 year CMBS provides 100+ bps of additional yield versus AAA tax exempt securities. There are other factors to consider, such as each company’s tax situation and the effect of realizing gains/losses from sales, but the MPL industry should be reviewing their tax exempt holdings due the unattractive nature of the sector today.

Conclusion

Lower corporate tax rates have reduced the benefit of tax exempt municipal bonds for insurance companies. With the challenging underwriting environment, MPL insurers can increase investment income by reviewing their allocation to tax exempt municipal bonds and reallocating to higher yielding taxable sectors.

January 24, 2019 by

Economic Outlook

Following two strong quarters of economic activity, U.S. real GDP growth for Q4 2018 and for all of 2019 appears to be slowing towards the economy’s long-term trend rate. On a year-over-year basis (q4/q4), real GDP growth is forecasted to slow from a 3.1% pace for 2018 to 2.2% for 2019. Reduced impact from the tax cuts and fiscal stimulus are reasons for the forecasted slowdown. Consumer spending, which increased around 2.8% in 2018, is projected to moderate to 2.4% for 2019. A strong labor market and rising wages should continue to support spending. Also driving the slower growth projection for 2019 is weaker business spending/investment. Recent declines in business sentiment suggest manufacturers and service-sector businesses are becoming less confident with the economic outlook. Additional downside risks to growth include a Fed policy mistake, slowing global growth, trade tensions, and geopolitical risks. We are calling for below-consensus GDP growth in 2019 as we view the risks to growth as skewed to the downside. We do not expect the U.S. economy to fall into a recession in 2019.

The Federal Reserve seems to have become more dovish as downside risks to economic growth have increased. Recent comments from Fed officials suggest they will be more “patient” with future rate hikes, with Fed policy becoming more data dependent. We believe the Fed will be closely monitoring incoming data for signs of increasing inflation (CPI, core PCE), strengthening labor markets (unemployment rate, wages), increases in market based inflation expectations (forward breakeven rates), and increases in survey based measures of inflation (ISM prices paid, consumer inflation expectations). With economic growth slowing and inflation expected to remain near the Fed’s target of 2%, we expect them to increase the Fed Funds target range one time this year, or 25 basis points.

Treasury yields, according to consensus forecasts, are expected to move modestly higher from current levels. The benchmark 10-year Treasury yield is forecasted to end 2019 at 3.15% based on the median forecast among economists. The yield spread between the 10 year and 2 year Treasury notes is expected to remain in a tight range of 20bps. We are calling for the 10 year Treasury yield to end the year modestly higher but below 3%. Exhibit 1 lists our risks to U.S. GDP Growth, Inflation, and Treasury Yields.

Exhibit 1: GDP Growth, Inflation, and Treasury Yield Risks

Fixed Income

2018 – Going into 2018 we anticipated the Fed to raise the Funds rate, causing the economy to slow and the yield curve to flatten. The Fed raised the Funds rate by 1.0% with the final nail in the coffin coming in December. We saw the economy slowing in Q4 which, when coupled with apparent Fed indifference to the current state of the economy and the market’s gyrations, caused a significant selloff. In December, equities fell, credit spreads widened, and we finished the year with losses and uncertainty across a number of sectors.

2019 – We expect that the Fed will have significantly less impact on the markets in 2019. Recently, they have indicated more of a “wait and see” approach while the market is pricing in zero rate hikes for 2019. Just as investors could only see bad news after the December 19th Fed meeting, it seems that there is nothing but roses since the new year.

Our expectation for interest rates is that the yield curve will not invert, and 10 year Treasury yields will stay below 3.0%. There are number of risks to this benign forecast that include but are not limited to: failed Chinese tariff negotiations, stalling economic growth in Europe, a hard Brexit, or a spike in wage driven inflation.

AAM expects that 2019 will be a positive environment for spread product and equities. However, given the potential impediments to growth, risk assets are NOT attractive enough to aggressively overweight. We recommend that risk allocations be maintained at a conservative level in order to allow flexibility to add should the markets stumble. Once again, we anticipate individual security selection and a focus on risk will prove to be the right call in 2019.

Exhibit 2: 2018 Returns by Asset Class

Source: Bloomberg Barclays Index Series, S&P 500, Barclays Global High Yield Index, VOA0 (Merrill Lynch Convertibles Ex-Mandatory)

Corporate Credit

2018 was a disappointing year for the markets despite record revenue and profit growth. After a period of credit creation in 2016-2017, the unwind of QE programs and higher rates caused a sharp slowdown in credit creation from both the private sector and central banks in 2018. The Investment Grade (IG) market also suffered from idiosyncratic events related to GE, Goldman Sachs, Comcast, PCG and the tobacco companies. The spread to Treasuries for the IG market (OAS) closed the year 60 basis points wider with BBBs and longer maturities underperforming.

Exhibit 3: Global central bank securities purchases, rolling 12 months ($T)

Source: National Central Banks, Citi Research

We expect revenue and EBITDA growth rates to decelerate in 2019 to approximately 5% and 8% respectively on average. Capital spending is also expected to decelerate to 2-3%. Debt leverage for IG companies on aggregate changed very little in 2018, but given the focus on debt by the equity community and rating agencies today, we expect companies with over-leveraged balance sheets to work more proactively to reduce debt leverage in 2019. However we do not expect this to be widespread since: (1) lower growth rates make it more difficult to reduce leverage organically, as the equity market has become accustomed to companies using the majority of their excess cash to repurchase stock, and (2) historically, the C-suite does not get more aggressive with credit improvement unless the cost of debt approaches the cost of equity, which has not yet occurred. Therefore, we believe material fundamental credit improvement will be challenging in 2019, with companies facing uncertain growth outlooks and higher costs (labor, transport, interest, trade).

From a technical or supply/demand perspective, we expect net supply of IG bonds to be down materially in 2019 due to the high level of debt maturing, and gross debt supply to be down modestly. This environment of uncertainty/volatility does not support increased M&A activity, and despite improved economics from year-end 2017 (i.e., the spread between earnings yield and the after tax cost of debt), we would not expect an acceleration of debt financed share repurchase activity. Therefore, net supply should be related to refinancing upcoming maturities and tendering others. We believe the demand for IG debt could be lackluster again in 2019 due to higher short term rates and the shape of the Treasury curve. Therefore, we expect another year of less supportive technicals.

Valuations have improved with the IG OAS widening to a point at year end 2018 that reflects an approximate 25% probability of a recession, and the spread premium for BBBs vs. A/higher rated securities widening towards its historic average of 88 bps. Our credit cycle signals related to the shape of the Treasury curve and access to funding have weakened but do not flag the end of the credit cycle. However, given our economic outlook which has risks skewed to the downside, we do not consider current spreads to be “attractive.” Therefore, we would recommend maintaining a neutral position vs. a benchmark in the IG credit sector, investing cautiously in the asset class, preferring shorter duration bonds, sectors with stable cash flows through the economic cycle, and credits we consider to be higher quality from a balance sheet perspective. We have a constructive view on the following sectors: Banks, Pharmaceuticals, Midstream, Capital Goods, Food/Beverage, and Insurance. On the contrary, we are concerned with the fundamental performance of: Chemicals, Cable, Autos, Tobacco, Consumer Products, and lower quality Media credits. It is important to stress that security selection is critical at this late stage of the credit cycle.

Our market and sector outlooks are supported by expectations of: (1) positive albeit lackluster economic growth in the US and EU (2) geopolitical events (i.e., trade talks with China, a hard Brexit, and Italy leaving the EU) remaining at a simmer point (3) Federal Reserve pausing its rate hike cycle. If growth disappoints, the biggest upside surprise for all markets would be a reversal in the unwind of various QE programs to support and stimulate growth. We are not assigning a material probability to that in the US in 2019, since the labor market is far tighter than it was three years ago with unemployment below the natural rate.

Structured Products

With the exception of shorter duration Asset Backed Securities (ABS), structured products performed relatively poorly in 2018. The prospect of slowing domestic growth and dislocations in global trade caused risk assets to underperform less risky Agency and Treasury securities. We’re cautiously optimistic that structured securities will perform better in 2019, although we do anticipate a fair amount of volatility over the course of the year. We expect non-agency mortgage backed securities, Commercial Mortgage Backed Securities (CMBS), and consumer backed ABS securities to outperform lower risk assets.

Agency Residential Mortgage Backed Securities (RMBS) experienced their worst yearly performance relative to Treasuries since 2011 as spreads widened 25bps. Unlike in prior years when Federal Reserve asset purchases materially reduced the available supply of RMBS, balance sheet normalization which began in the second half of 2018, will provide an incremental $170b to $180B of supply which the market will struggle to absorb. Traditionally, domestic banks have been big purchasers of agency RMBS, but with the relaxation of liquidity rules for small and mid-sized banks and since money managers have generally been avoiding the sector, we don’t see the market being able to absorb the supply without some spread concession. In the most recent release of the FOMC minutes there was some discussion of selling securities from the mortgage portfolio, but we do not believe the Fed will follow through with any sales. Given the poor technical environment, we favor allocating investments elsewhere within structured products and to other spread sectors.

Non-agency RMBS still represents an attractive investment option. Credit fundamentals in the sector still look very good and since underwriting continues to be very conservative, we anticipate the sector outperforming agency RMBS and to a lesser extent Treasuries this year. Housing price appreciation should slow to roughly 3.5% as compared to levels of 5% and 6% in prior years; however, we don’t anticipate that it will negatively impact the market. With the consumer being in such excellent financial shape due to low unemployment of 3.9% and wage growth of 3.2%, delinquency and default rates should remain at very low levels.

Commercial real estate fundamentals remain in relatively good shape following multiple years of property price appreciation and domestic economic strength. Conduit CMBS supply is estimated to be $70B this year which should prove to be very manageable including only $7.5B of maturing conduit loans in need of refinancing. Ordinarily this type of environment would lead us to conclude that CMBS spreads should tighten in 2019, however, we see more risk to the CMBS market from global economic risks and trade dislocations rather than technical and fundamental factors. Spreads of senior conduit CMBS securities tend to track single A rated corporate bonds fairly closely and we’re anticipating heightened volatility within the corporate sector this year. We expect spread levels to closely track corporate bond spreads but with slightly less volatility which should allow them to modestly outperform Treasuries and single A corporate bonds. Our investment of choice within the sector continues to be conservatively underwritten single asset transactions with low leverage. As in prior years we remain concerned about the retail sector, particularly regional malls in less populated areas, which must be carefully analyzed in any conduit securitization.

ABS was the only structured products sector to outperform Treasuries last year, and we believe they will outperform again in 2019. Healthy consumer balance sheets due to strong job growth and healthy wage gains will support credit performance. We’ll continue to maintain significant portfolio weightings in the asset class particularly in structures backed by consumer receivables. High credit quality and stable cash flows make ABS an attractive alternative to short Corporate Credit, Taxable municipals and Treasuries. Our favorite sub-sectors continue to be prime and some select subprime auto, credit card, and equipment transactions.

Municipal Market

We are maintaining a constructive bias for the tax-exempt sector. During the tumultuous level of volatility that stressed the capital markets during the latter half of 2018, the municipal sector held its ground and performed very well due to very favorable technical conditions. As we enter 2019, we remain constructive on the sector due to similar themes that are expected to see municipal relative valuations continue to improve, especially in the near term.

Tax-reform will once again play a large role in providing a solid technical environment for the tax-exempt sector. The Tax Cut and Jobs Act (TCJA) that passed late in 2017, eliminated the use of tax-exempt advanced refundings, which is a process that allowed issuers to effectively refinance their debt more than 90 days before the actual call date. Its absence resulted in a year-over-year decline in issuance of approximately $100 Billion during 2018 to $339 Billion and, in 2019, its repealed status will continue to suppress supply conditions. We expect to see only a 10% increase in new issuance to $375 Billion, and that level would be 14% below the average annual issuance produced in the three years before tax reform was implemented.

On the demand side, reinvestment flows of coupons/calls/maturities are expected to remain sizable during the year and provide ample support. The record level of refundings that were executed from 2015 to 2017 is expected to result in a large number of maturities during the year that will lead to net supply levels of negative $69 Billion. Although that’s not as extreme as the negative $121 Billion in net supply during 2018, it should remain as a major underpinning to the sector’s solid relative performance during the year.

In looking at the different market segments of demand, we expect that the muted investment behavior from institutional investors (primarily banks and insurance companies) in 2018 will continue to be in play during 2019. Municipal tax-adjusted yield levels at the new 21% corporate rate remain below that of Treasuries inside of 10 years and are well below that of taxable spread product across the yield curve. The Federal Reserve’s Flow of Funds data reported that banks reduced their exposure to municipals by approximately $40 Billion during the first three quarters of 2018, and we expect to see more right-sizing of institutional portfolios during the course of 2019.

However, we are also expecting the retail segment to remain fully engaged in the market. These investors will be flush with cash from reinvestment flows, and tax-adjusted yield levels for investors in the highest tax bracket of 40.8% (37% plus 3.8% Medicare surtax) look very compelling versus taxable alternatives. At the start of the year, grossed-up yields of tax-exempts were 116 basis points north of Treasuries in the 10 year maturity and were at comparable levels to corporates in maturities 10 years and shorter.

Additionally, we do not expect any headline risk to create selling pressure in the space, as we expect credit fundamentals to remain solid during the year. Individual and corporate tax revenues have been growing at a robust rate during 2018 and are expected to continue going forward. That should bode well for solid fiscal performance for state and local governments.

For our insurance portfolios, we believe that tax-adjusted yield levels remain unattractive versus taxable alternatives. However, the relative slope of the municipal curve remains steep from 2 to 20 years and we view the 11 to 20 year relative curve steepness as attractive. We will continue to look at underweighting the sector into any relative outperformance in favor of taxable alternatives that provide a better after-tax yield profile.

The risks to the upside include:

Stronger than consensus economic growth that would lead to even stronger tax revenue growth.

The risks to the downside include:

A continued downward move in oil prices could pressure the fiscal performance of the heavy oil-producing states.
Sharply higher Treasury rates could lead to heavy mutual fund outflows.
Potential passage of federally-sponsored infrastructure spending that leads to higher-than-expected new issuance.

High Yield

After credit spreads fell to a post financial crisis low in early October, the high yield market re-priced significantly in Q4 2018 with spreads widening 223 basis points (bps). This resulted in returns of -2.08% for that year. To put that in perspective, 2018 marks only the 7th time in 35 calendar years of index data the high yield asset class experienced negative total returns. Broad market yields ended the year at 7.95% with credit spreads at +526 bps, both metrics exceeding their 5 year average. Valuations for the sector have become more attractive given the underlying fundamentals as 2019 default rates are expected to remain below the long-term average.

Exhibit 4: High Yield Market Credit Spreads

Source: Bloomberg Barclays US Corporate High Yield Index

Unlike the investment grade market, high yield issuers have generally deleveraged their balance sheets since 2015, as evidenced by a continued positive upgrade/downgrade ratio and the percentage of CCC rated issuers in the market, which has declined to a decade low at 13% of the index. Further, interest coverage ratios remain high, and the level of future debt maturities to be refinanced is manageable.

Exhibit 5: Default Rates

Note: 2018 data is through November 30.
Source: J.P. Morgan

Technicals for the asset class are supportive as the high yield market debt outstanding has been shrinking since 2016. New issue supply for High Yield was $187 billion or -43% year-over-year which was the lowest volume since 2009. In contrast, the loan market has been a funding alternative for high yield corporates, as issuance of $697 billion ranked as the second highest annual total on record despite a 28% drop from 2017. It bears watching that acquisition-related issuance has drifted higher to 21% of volume, but that level remains below the long-term average of 24% which is well below the highs of over 50% in 2007. Additional headwinds for the sector will likely persist if macroeconomic declines exceed expectations. Increased hedging costs have weighed on foreign demand as US monetary policy has diverged from global central banks, and further rate hikes would likely extend this trend. A recession could also impact valuations as BBB issuers are downgraded to high yield, increasing supply. However, higher yields and spreads overall improve break-evens and provide more downside protection around interest rate risks and potential credit concerns. We continue to believe credit risk is best managed with an active approach that emphasizes credit quality and diversification to reduce risk in portfolios. Long-term investors with the ability to act as liquidity providers to the market during periods of volatility are likely to be rewarded.

Convertibles

While convertibles outperformed most asset classes in 2018, the year is best viewed as two distinct periods – the first nine months of the year, and the last three months of the year.

First quarter 2018 through the third quarter saw a continuation of the longest equity bull market on record, and many convertibles moved further “up the curve” becoming ever more equity-like. However, the market capitulation in the fourth quarter highlighted the lack of downside protection afforded by equity-like convertibles. As some individual stocks dropped by a magnitude of 50% or more, equity-like convertibles linked to those shares fell virtually in lockstep with the underlying stock price.

Balanced convertible portfolios, on the other hand, offered downside protection during the fourth quarter as bond floors held up and provided support.

In the aggregate, balanced convertibles did their job in 2018, providing upside participation as equities climbed during the first three quarters, and delivering downside protection as markets fell in the fourth quarter. Over a complete market cycle – which we have not seen in nearly ten years – we expect the “ratchet” effect provided by balanced convertibles will result in equity-like returns with less volatility.

U.S. primary market activity was strong with convertible issuance of $53 billion during 2018. That made 2018 the biggest year for convertible issuance since 2008 (when issuance was $59 billion). The Technology and Healthcare sectors represented 60% of new issuance at 43% and 17%, respectively.

Convertible issuance combined with the fourth quarter equity market decline allowed us to counteract two fundamental issues associated with the convertible market today: technology sector concentration and equity sensitivity.

The sector breakdowns below highlight the Technology concentration in the broader market (using the V0A0 index as a proxy) versus a balanced convertible composite (using the Zazove Associates Blend Strategy Composite as a proxy).

Exhibit 6: V0A0 Sector Breakdown as of 12/31/18

Source: ICE BofAML Convertible Index Data

Exhibit 7: Zazove Associates Blend Composite Sector Breakdown as of 12/31/18

Further, the weighted average investment premium (a measure of downside risk exposure) of the V0A0 Convertible Index is 49.4% versus 20.5% for the Zazove Blend Composite. For investors in convertibles, active management of portfolio investment premium mitigates downside risk and leads to superior risk-adjusted returns over market cycles.

To the extent interest rates continue to increase in 2019, the low duration of convertibles (~2 years or less) will insulate our portfolios from the headwinds typically associated with a rising interest rate environment.

Further, if the fourth quarter of 2018 portends renewed 2019 market volatility that would be a positive development for investors in AAM/Zazove balanced convertible strategies. As an active manager of balanced convertible portfolios, volatility provides abundant trading opportunities and allows us to rebalance, take advantage of attractive valuations, and continue to optimize portfolios. As an aside, volatility increases the value of the embedded option of convertibles.

The opportunity set and trading environment for convertibles is as strong as it has been in years, and we are excited about the prospects for 2019.

Contributions 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
Scott Skowronski, CFA | Senior Portfolio Manager
Stephen Bard, CFA | Chief Operating Officer, Zazove Associates
Gene Pretti | Chief Executive Officer, Zazove Associates

October 19, 2018 by