Q2 2017 Investment Grade Commentary

Q2 2017 Investment Grade Commentary

The second quarter of 2017 saw a continuation of the prevailing trend of tighter credit spreads across the US corporate bond market. This trend of tighter spreads, which has been unabated for nearly 16 months, has been a significant contributing factor to the overall positive performance of the Investment Grade corporate bond market during that time frame. Specifically, during the quarter the A Rated Corporate credit spread tightened from 0.97% to 0.88% (down 9bps), the BBB Rated Corporate credit spread tightened from 1.51% to 1.41% (down 10bps) and the Bloomberg Barclays US Investment Grade Corporate Index credit spread tightened from 1.18% to 1.09% (down 9bps)i. Along with this credit spread tightening the movement in Treasury yields were generally lower as the as the 10 Year Treasury yield began the quarter at 2.39% and ended it at 2.31% (down 8bps). This continuation of lower treasury yields and tighter credit spreads have seen the overall yields of corporate bonds end the first half of the year lower than where they started the year. While both US Treasuries and Investment Grade corporate bonds both ended the quarter with lower yields, thus both achieving positive performance, Investment Grade corporate bonds outperformed Treasuries due to the tightening of credit spreads and higher coupon income collected. The Bloomberg Barclays US Investment Grade Corporate Index returned +2.54% for the quarter, outperforming the Bloomberg Barclays US Treasury 5‐10 year index return of +1.24%ii. The CAM Investment Grade Corporate Bond composite provided a gross total return of +2.08% which slightly underperformed the Investment Grade index but outperformed the US Treasury index.

New issuance in the quarter was a robust $344 billion in new Investment Grade corporate bonds, yet slowing down from the record pace in the first quarter, bringing the YTD total to $760 billion iii. We are well on our way to the sixth straight year of over $1 trillion in new issuance, which speaks to the persistent, global demand from investors searching for yield and income for their portfolios. This demand is partially driven by the fact there still exists $6.5 trillion of negative yielding securities in the Bloomberg Barclays Global benchmark index, a sum that has shrunk from a peak of $12 trillion in June 2016 (see chart)iv. With low‐to‐negative yields in global fixed income securities, the US Investment Grade corporate bond market still provides a good alternative for global investors.

The Federal Open Market Committee (FOMC) acted again during the quarter by boosting the target range for the Federal Funds rate by another 25bps at their June 14th meeting v. At the time of the FOMC action the 10yr US Treasury yield was 2.17% and the move up in short term rates influenced by the policy move has flattened the yield curve even further, something we discussed extensively in our Q1 2017 commentary. (A copy of that and all of our previous commentaries can be found on our website at www.cambonds.com.) Central Banks around the world have been hinting at ending their ultra‐ loose monetary policy and begin to wind down their active quantitative easing (QE) programs vi. While the FOMC has not been actively adding to its balance sheet via QE, it has been maintaining it around $4.5 trillion by reinvesting proceeds from maturing bonds in its portfolio. Members of the Federal Reserve board, including Janet Yellen, have openly discussed starting to unwind its $4.5 trillion balance sheet sometime this fall by letting some of its maturing securities run off and not be reinvested. However, as of yet, no set timetable has been established vii. As with most FOMC policy shifts, investors are best served to watch what the FOMC does and not what they say as they make these changes. The unwinding of trillions of dollars of securities will be difficult to execute, and will be closely watched by investors around the world. While the FOMC is looking to reduce the size of its balance sheet, the European Central Bank and Bank of Japan have been significantly adding to theirs over the past several years with both recently surpassing the size of the balance sheet of the Federal Reserve (see graph)viii. While neither of the two have definitive plans to end QE it would seem that halting open market purchases would be the first step in the direction of policy normalization.

With potentially significant central bank policy shifts on the horizon US Investment Grade corporate bond markets have exhibited a strange sense of calm in the first half of 2017. This could be attributable to the lack of volatility exhibited across nearly all asset classes along with the prevailing market perception that nearly any disruption in credit markets would be met with a large dose of liquidity from the Federal Reserve. While the Fed is close to meeting its unemployment mandate, it is failing to meet its desired inflation mandate. This is giving the market the sense that the Fed will feel that it has the flexibility to deliver more liquidity into the market if deemed necessary. With the persistent tightening of credit spreads and decline in overall interest rates, performance has been stable, consistent and fairly robust. With yields and credit spreads below their long term averages investors should not grow too complacent to think these trends will continue in perpetuity. A change in QE policy by global central banks or deterioration in credit conditions due to the onset of recession may alter the path of both interest rates and credit spreads rather quickly. While we are not predicting the imminent commencement of either of these events, investors should be prepared for potential volatility in corporate bonds that a reversion to the long term mean in rates and credit spreads would bring about. This volatility may not come for some time, but it is something to consider when thinking about expectations for the asset class. While this may, or may not, occur during the timeframe of anyone’s investment horizon, when it does, it will be imperative to understand the impact higher yields will have on the corporate bond market especially as it relates to a corporation’s balance sheet, cash flows and credit quality. Corporate bond investors are compensated for two risks; interest rate risk and credit risk. 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 (not only the treasury curve but also the credit curve) ‐ to roll down the yield curve, and (3) avoiding credit events that result in permanent impairment of capital. Understanding and assessing credit risk is at the core of what Cincinnati Asset Management has provided their clients for nearly 28 years.

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 Barclay’s Credit Research: Daily Credit Call
ii Bloomberg Barclay’s Indices: Global Family of Indices June 2017
iii CreditSights: US IG Credit Monitor Q2 2017
iv Bloomberg Markets July 11, 2017: “Pool of Negative‐Yield Debt Shrinks Rapidly as Bond Market Turns” v FOMC statement dated 6/14/2017
vi Bloomberg Markets June 28, 2017: “Central Bankers Tell the World Borrowing Costs Are Going Up”
vii Janet Yellen semiannual Humphrey‐Hawkins testimony to US House Financial Services committee 7/12/2017
viii Yardeni Research, Inc. 7/7/2017: “Global Economic Briefing: Central Bank Balance Sheets”