The final quarter of 2018 was extremely volatile, and no asset class was spared, whether it was corporate credit, Treasuries, commodities or equities. The spread on the corporate index finished the quarter a whopping 47 basis points wider, having opened the quarter at 106 before finishing at 153, the widest level of 2018. Treasury bonds were one of the few positive performing asset classes during the fourth quarter as the 10-year Treasury started the quarter at 3.06%, before finishing the year substantially lower, at 2.69%. The 10-year began 2018 at 2.41%, and it rose as high as 3.24% on November 8, before dropping 58 basis points during the last 8 weeks of the year. On the commodity front, West Texas Crude peaked at $76.41 on October 3, before it endured an elevator-like collapse to $45.41, a 40% move in less than a full quarter. Equities also suffered in the final quarter of 2018. The S&P500 was flirting with year-to-date highs at the beginning of the fourth quarter before losing more than 13.5% of its value in the last quarter of the year. All told, the S&P500 finished the year in the red, with a total return of -4.4%.
2018 was the worst year for corporate credit since 2008, when the corporate index returned -4.94%. For the fourth quarter, the Bloomberg Barclays Corporate Index posted a total return of -0.18%. This compares to CAM’s quarterly gross total return of +0.71%. For the full year 2018, the corporate index total return was -2.51% while CAM’s gross return was -1.44%. CAM outperformed the corporate index for the full year due in part to our cautious stance toward BBB-rated credit and due to our duration, which is shorter relative to the index. BBB-rated credit underperformed A-rated credit in 2018. In late January and early February, the spread between the A-rated portion of the index and the BBB portion was just 43 basis points, but that spread continued to widen throughout the year and especially late in the year. The spread between A-rated and BBB-rated finished the year at 79 basis points as lower rated credit performed especially bad on a relative basis amidst the heightened volatility of year end.
Revisiting BBB Credit, again…
We have written much about the growth in BBB credit and our structural underweight relative to the index. CAM seeks to cap its exposure to BBB-rated credit at 30% while the index was 51.21% BBB at year end 2018. Our underweight is born out of the fact that we are looking to 1.) Position the portfolio in a more conservative manner that targets a high credit quality with at least an A3/A- rating and 2.) While it is our long-established style to position the portfolio conservatively, we do not believe there are currently enough attractive opportunities within the BBB universe that would even warrant a consideration for increased exposure to BBB credit.
The BBB growth storyline has received tremendous focus from the mainstream financial press in recent months. Hardly a day goes by without multiple stories or quips from market commentators. Some have gone as far as to predict that the growth in lower quality investment grade bonds will “trigger the next financial crisis”i or that it is akin to “subprime mortgages in 2007.”ii While we at CAM are extremely cautious with regard to lower quality credit, these statements and headlines are hyperbole in our view. We welcome the increased attention on the bond market from the financial press as we often feel like our market is ignored despite the fact that the total value of outstanding bonds in the U.S. at the end of 2017 was $37.1 trillion while the U.S. domestic equity market capitalization was smaller, at $32.1 trillion. iii What the press and pundits are missing is that, if BBB credit truly hits the skids, it has the potential to be far more damaging to equity holders than it does to bondholders. A few of the reasons an investor may own investment grade corporate bonds as part of their overall asset allocation are for preservation of capital, income generation and most importantly, for diversification away from riskier assets, primarily equities. High quality investment grade corporate bonds are meant to be the ballast of a portfolio. Bondholders are ahead of equity holders and get paid first in the capital structure waterfall. Many BBB-rated companies pay dividends or spend some of their cash flow from operations on share repurchases. Equity holders of these companies should be aware that dividends and share buybacks are levers that can be pulled if necessary in order to pay off debt that the company borrowed from bond holders. To that end, the following chart shows the 10 largest BBB-rated corporate bond issuers in The Bloomberg Barclays U.S. Corporate Index. We calculated how much each of these companies has spent on dividends and share repurchases during the last 12 months through 09/30/2018. If any of these companies were to endure financial stress (and some already are under stress) then we would expect that the majority, if not all of the funds that were previously allocated to dividends and share repurchases would instead be diverted to debt repayment.
CAM currently has exposure to just three of these ten largest BBB issuers. As an active manager that is not beholden to an index, CAM can pick and choose which credits it adds to its portfolio based on risk/reward and valuation relative to credit metrics.
Here are a few examples of how the bondholders of some of these companies were given priority over equity holders in 2018:
•Anheuser-Busch InBev reported disappointing third quarter results that showed a lack of progress in deleveraging the balance sheet stemming from its 2016 acquisition of SAB Miller. In conjunction with its lackluster earnings print, management slashed the dividend by 50% in order to divert more funds toward debt repayment. Anheuser-Busch InBev stock traded off sharply on the news and the stock posted a price change of -38.04% in 2018. Comparatively, one of the most actively traded bonds in the capital structure, ABIBB 3.65% 02/01/2026, posted a total return of -4.74% in 2018, per Bloomberg.
• CVS was once a prolific buyer of its own shares. The company bought back an average of $4bln per year of its own shares over the five year period from 2013-2017, but it did not buy back any shares in 2018. That is because CVS closed on the acquisition of Aetna in 2018, which required it to bring a $40 billion dollar bond deal in March; the largest deal of 2018 and the third largest bond deal of all time. In order to provide an incentive for bondholders to purchase its new debt offering, CVS had to promise that it would divert free cash flow to debt repayment in lieu of share repurchases. Although CVS stock underperformed the S&P500 by more than 3% in 2018, this example is not one of a company that is undergoing stress but a very typical example of a company which undergoes transformational M&A and pauses shareholder rewards in order to repair the balance sheet. Bondholders would have demanded much more compensation from CVS’s new debt deal if it did not halt its share buybacks.
• General Electric’s issues are well publicized and yet another example of cash being diverted toward debt repayment. First, the company slashed its dividend by 50% in November 2017, moving it from $0.24 to $0.12 per share. The second cut came in October 2018, as GE all but eliminated the dividend, moving it to a mere penny per share. GE intermediate bonds, specifically the GE 4.65% 10/17/2021, were performing extremely poorly until mid-November but then they rebounded in price on news of GE’s commitment to debt repayment. The bonds ended the year with a total return of -2.34% per Bloomberg, but this pales in comparison to the performance of GE equity, which finished the year down -56.62%.
The purpose of these examples is not to make the case for bonds over stocks, but to illustrate that BBB-rated companies have levers to pull in order to assist in the repayment of debt. In times of stress, shareholder rewards are typically the first things to go so that cash flow can then be diverted to balance sheet repair. At CAM we feel that an actively managed bond portfolio that picks and chooses BBB credit in a prudent manner can navigate potential landmines in lower quality credit and can selectively choose BBB-rated issues which can aid in outperformance.
As we look toward 2019, we expect continued volatility, especially in lower quality credit, but we think that our portfolio is well positioned due to its high quality bias. Two of our top macroeconomic concerns are Fed policy and the continued economic impact of global trade wars. As far as the Federal Reserve is concerned, it just completed the fourth rate hike of 2018 and the 9th of this tightening cycle. FOMC projections were updated at the December meeting and now show two rate hikes in 2019 and one more after that in 2020 or 2021. This suggests that we are nearing the end of this tightening cycle. What concerns us is that European and Chinese growth are both slowing, and if the U.S. economy slows as well we could see a situation where we have a domestic U.S. economy that is not supportive of further hikes. In other words, there is a risk that the Fed goes too far in its quest to tighten, bringing about a recession, which is negative for risk assets. Corporate bonds in general are more attractive today than their recent historical averages. The spread on the corporate index finished the year at 153, while the three and five year averages were 124 and 125 respectively. Going back to 1988, which was index inception, the average spread on the index was 133. New issue supply could play an outsized role in the spread performance of corporates in 2019. 2018 new issue supply was down 10.7% from 2017 and most investment banks are calling for a further decrease of 5-10% in new issue volume in 2019.iv If this decrease in issuance comes to fruition but is coincident with good demand for IG credit then we could find ourselves in a situation where there is not enough new issue supply to satiate credit investors, which would make for an environment that is very supportive of spreads. In what seems to be a recurring theme in our commentaries, caution will continue to rule day for our portfolio as we head into 2019. We will continue to prudently manage risk within our portfolios and strive for outperformance but not at the sake of taking undue chances by reaching for yield.
We wish you a happy and prosperous new year and we thank you for your business and continued interest.
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 USA Today, September 14, 2018, “Ten year after financial crisis: Is corporate debt the next bubble?”
ii DiMartino, Danielle (DiMartinoBooth). “A lot of BBB is toxic. I am watching this more closely than anything. You must put “investment grade” in quotes. This is the sector that has grown to be a $3 trillion monster. Where’s the parallel? Subprime mortgages circa 2007.” November 29, 2018, 9:00 AM. Tweet.
iii SIFMA. September 6, 2018. “SIFMA U.S. Capital Markets Deck.”
iv Bloomberg, January 2, 2019, “High-Grade Bond Sales Hurt by Repatriation, Higher Costs in 2018”