Corporate Bond investors are compensated for two risks; interest rate risk and credit risk. The first, interest rate risk, is approximated by US Treasury yields. The second, credit risk, is the remuneration for the business risk of the underlying company; this remuneration is expressed as the premium received in excess of the US Treasury yield. In our experience, investors spend a large portion of their time focusing on the risk they can’t control ‐ interest rate risk, and very little time on the risk that can be controlled – credit risk. We as a manager believe that we can provide the most value in terms of assessing credit risk. In our view, the key to earning a positive return over the long‐term is not dependent on the path of interest rates but a function of: (1) time (a horizon of at least 5 years), (2) an upward sloping yield curve ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital.
The fourth quarter of 2016 saw a substantial increase in Treasury yields as they generally trended higher at the beginning of the quarter and moved sharply higher towards the end of the quarter. The movement higher in Treasury yields did not begin on November 8th (election day in the US) but accelerated at that point before peaking in mid ‐December. Offsetting the higher yields in Treasuries, corporate credit spreads continued their persistent tightening since the mid‐February widest levels of the year and ended near the tightest levels of the year. Specifically, the 10 Year Treasury began the quarter at 1.60%, peaked at 2.60% (up 100 bps) on December 15th and ended the quarter at 2.45% (up 85 bps). The A Rated Corporate credit spread tightened from 1.12% to 1.01% (down 11bps) and the BBB Rated Corporate credit spread tightened from 1.78% to 1.60% (down 18bps). When looking at movement of interest rates and credit spreads together, the sharp rise in Treasury yields was only partially offset by tighter credit spreads, thus yields for Investment Grade corporate bonds ended the quarter higher than where they started. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with higher yields, Investment Grade corporate bonds outperformed by a considerable margin.
During the quarter, Investment Grade corporate bonds provided some protection to investors as US Treasury yields rose. The Barclays US Investment Grade Corporate Index returned ‐2.83% vs ‐4.47% for the Barclays US Treasury 5‐10 year index i. When looking at the performance of US Investment Grade corporate bonds the two primary factors that led to their outperforming comparable US Treasuries during the quarter were:
- higher starting yields
- tightening of credit spreads across the corporate credit curve
Our Investment Grade Corporate Bond composite provided a gross total return of ‐3.62%, which trailed the Barclays US Investment Grade Corporate Index, but outperformed the comparable US Treasury index. For the quarter, our underperformance relative to the US Investment Grade corporate benchmark can be primarily attributed to our focus on the 5 – 10 year part of the credit curve, the much shorter end of the curve was less impacted by increasing rates, and our underweight to the BBB credit quality segment relative to the benchmark.
For 2016 our Investment Grade Corporate Bond composite provided a gross total return of +4.03% vs the Barclays Investment Grade Corporate Index total return of +6.11%. Our limiting of bonds rated BBB to 30% of a portfolio vs approximately 53% for the benchmarkii, was a primary factor for the full year underperformance. The dispersion of performance in the benchmark across credit quality is highlighted below:
Since our portfolios tend to hold fewer BBB rated bonds and more A & AA rated bonds, one can see how this influenced our performance relative to the benchmark. This contrasts with our 2015 outperformance of the benchmark (+1.01% vs ‐0.68%) which can be partially attributed for the exact opposite reason of widening credit spreads and our long time policy of limiting BBB rated bonds.
As the year ended, we saw a continuation of many of the same themes we have written about in our previous commentaries. The continual tightening of credit spreads, which has provided better relative returns than US Treasuries, continued unabated since mid‐February. New corporate bond issuance set a new record in 2016 with nearly $1.3 Trillion of new Investment Grade issuance providing the supply to meet robust investor demand iii. Companies have been very eager and aggressive to issue bonds to lock in coupon rates near all‐ time historic lows (chart above).
As we enter 2017 a great deal of concern and speculation has centered on the future direction of interest rates due to potential new policy actions by a new administration in Washington DC. We as a firm do not utilize interest rate anticipation or forecasting in our investment process thus, we do not have an official firm view on the direction of rates. We do understand the concern investors have with the uncertainty of the direction of interest rates, but it is a risk we have no control over. What we do have control over is the composition of a portfolio as it relates to the credit quality it exhibits and assessing the risks associated with each company’s capacity to pay its future interest payments and ultimately return of principal to investors. As an investment manager solely focused on assessing this credit risk, this is where believe we have the ability to add value to a fixed income portfolio where an allocation to US corporate credit has been made. It is important to note that credit spreads are at levels that are tighter than their 30 year average. There is risk of potential corporate bond volatility due to these credit spreads mean reverting, which is something investors should be aware of as we move forward. If this credit spread widening were to unfold, we believe a portfolio with a corporate bond manager like CAM that underweights the riskiest credit quality of Investment Grade bonds and focuses on understanding the credit risks of the companies it owns, should help alleviate some of the potential volatility relative to other Investment Grade fixed income sectors. It is important to note that higher Treasury yields have historically provided a buffer to adverse interest rate movements ‐‐with absolute yields at the lower end of long‐term ranges, small rate changes can have a larger impact on bond values as there is less cushion to absorb adverse outcomes.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates.
When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.
i Bloomberg Barclays Indices: Global Family of Indices December 2016
ii Bloomberg Barclays Indices: Global Family of Indices December 2016