Spreads are tighter on the week amidst positive vibes in risk markets and the lack of meaningful new corporate supply. The OAS on the Bloomberg Barclays Corporate Index is 113 on Friday morning after having closed at 115 the week prior. Treasury rates have risen substantially since the beginning of October and the 10yr spent much of the week wrapped around 1.75%.
The primary market was subdued during the shortened week as the bond market was closed Monday for a federal holiday. Weekly new issue volume was $10bln pushing the monthly total to $25.8bln according to data compiled by Bloomberg. 2019 issuance stands at $949bln.
According to Wells Fargo, IG fund flows during the week of October 10-16 were +$4.3bln. This brings YTD IG fund flows to +$238bln. 2019 flows are up 9% relative to 2018.
(Bloomberg) Chief of Exelon Utility Business Retires Amid Federal Probe
The head of Exelon Corp.’s utility unit has abruptly retired amid a federal probe involving its lobbying in Illinois.
Anne Pramaggiore, senior executive vice president and chief executive officer of Exelon Utilities, is leaving “effective immediately,” the company said in a statement Tuesday. Calvin Butler Jr., chief of Exelon’s Baltimore Gas and Electric utility, was named as her interim replacement.
Pramaggiore’s departure comes less than a week after Exelon disclosed in a regulatory filing that it received a subpoena from federal prosecutors asking for information related to communications with Illinois State Senator Martin Sandoval. In July, Exelon disclosed it received a subpoena related to its lobbying activities in Illinois.
The Chicago Tribune reported earlier this month that federal agents had raided Sandoval’s office and were searching for information related to concrete and construction businesses and lobbyists and public officials. Officials were also looking for “items related to any official action taken in exchange for a benefit,” the Tribune reported, citing documents released by the Illinois Senate.
Exelon’s statement on Pramaggiore’s retirement Tuesday didn’t reference the subpoenas. Nor did it give a reason for her departure.
“We thank Anne for her valuable service,” Exelon CEO Chris Crane said in the statement. “We are confident this will be a smooth transition.”
(Bloomberg) High-Grade Corporate Bonds Trade Tighter as New Debt Sales Slump
Spreads on new high-grade corporate bonds tightened in secondary trading as debt issuance missed estimates for the fourth straight week.
Further outperformance in a market that has already enjoyed a 13% return this year should continue given the dearth of new supply and consistent fund inflows
Investors added $2.9 billion for the week ended Oct. 16, Refinitiv’s Lipper US Fund Flows data show, adding to $1.8 billion the prior period
All eight of the fixed-rate tranches sold this week are trading tighter, according to Trace data reviewed around 10 a.m. on Friday
Primary market sales disappointed again this week, with just $10 billion priced against estimates calling for $15 billion to $20 billion
40% of this week’s volume was from one borrower — Bank of America’s $4 billion priced in two parts
Seven of eight bonds sold this week were from financial companies
Next week’s preliminary forecast calls for a total in the $15 billion area, with the possibility for an upside surprise should more banks come to the market
With 27% of the S&P 500 index companies reporting earnings next week, more corporate issuance is expected
Investment grade credit markets have continued to enjoy strong performance in 2019, although spreads showed little movement during the third quarter. The Bloomberg Barclays US Corporate Index closed the quarter at an option adjusted spread of 115, which is exactly where it opened. Coupon income and lower Treasury yields were the driving forces of positive returns during the quarter as the 10yr Treasury finished the quarter at 1.66% after having opened at 2.01%. While Treasuries finished lower, the path was not linear and there was volatility along the way: the 10yr closed at a low of 1.45% on September 3, before rocketing higher to close at 1.89% on September 13, a massive move of 44 basis points over the course of just eight trading days. Corporate bond returns are off to the best start through the first three quarters of any calendar year dating back to 2009 when the US Corporate Index posted a total return of +17.11%. Through the first 9 months of 2019 the Bloomberg Barclays US Corporate Index had a total return of +13.20%. This compares to CAM’s gross total return of +11.69% for the Investment Grade Strategy.
The Primary Market is Back, Bigly
Lower Treasuries, retail fund flows and foreign buyers who were faced with increasingly negative yields in many local markets combined to lead a resurgence in the primary market during the quarter.
September was one for the record books as companies issued $158bln in debt, making it the 3rd largest volume month in the history of the corporate bond market. According to data compiled by Bloomberg, issuance through the end of the third quarter stood at $923.6bln, trailing 2018’s pace by 3.9%.
Portfolio Positioning
While we at CAM are pleased with the year‐to‐date performance of our investment grade strategy, we would like to remind our investors that this performance has occurred over a very short timeframe. We strategically position our clients’ portfolios with a longer term focus and an emphasis on providing a superior risk‐adjusted return over a full market cycle. Amid such a strong start to the year for credit, we would like to illustrate to our investors how we are positioning portfolios for the longer term. While we do not seek to replicate or manage to an index, we do use the Bloomberg Barclays US Corporate Index as a benchmark for the performance of our strategy so this discussion will refer to that index as a tool to compare our relative positioning.
Credit Quality
CAM targets a 30% limitation for BBB exposure, the riskiest portion of the investment grade universe. There is an additional target of maintaining an overall portfolio credit quality rating of at least A3/A‐. The US Corporate Index was 50.39% BBB‐rated at the end of the third quarter with an average rating of A3/Baa1. While this high‐quality bias can cause CAM’s portfolio to underperform during periods of excessive risk taking, it should tend to outperform during periods of market stress. One of the tenets of our strategy is preservation of capital and our BBB‐underweight is helpful in achieving this goal for our investors.
Interest Rate Sensitivity
CAM avoids the fool’s errand of attempting to make tactical bets on the direction of interest rates. Instead we manage interest rate risk by positioning the portfolio in intermediate bonds that range in maturity from 5‐10 years. CAM will occasionally hold a security that is shorter than 5 years or longer than 10, but very rarely does so. By always investing in intermediate maturities, CAM’s seasoned portfolio is more conservatively positioned than the corporate index with a shorter duration and fewer average years to maturity.
Liquidity
Liquidity is always on our minds at CAM. Maintaining an intermediate maturity profile requires that we sell bonds prior to maturity so we must be sure that we will be able to effectively exit positions. CAM targets SEC‐registered securities that have $300 million minimum par amount outstanding.
Additionally CAM attempts to cap its ownership exposure to 5% of any particular issue. By investing in larger more liquid issues and by limiting exposure to any particular issue it makes it easier to achieve best execution when it comes time to sell. CAM’s US Corporate average ownership exposure per issue held at the $869 million end of the third quarter was 0.7%.
Diversification & Industry Sector Limitations
CAM diversifies client accounts by populating individual separately managed accounts with 20‐25 positions. Additionally CAM imposes a 20% exposure limitation at the “sector” level and a 15% limitation at the “industry” level. As an example, “Capital Goods” is at the sector level and beneath that sector there are individual buckets at the industry level, such as Building Materials.
CAM invests in bonds that we believe will add value to the performance of the portfolio. Because CAM does not manage to, or attempt to, replicate an index it does not encounter the problem of over‐diversification or of owning the bonds of an issuer simply because the issuer represents a large weighting within an index.
The Fed Strikes Again, Now What?
The FOMC lowered its target for the Federal Funds Rate twice during the quarter, once at its July meeting and then again in September. The current implied probability of a cut at its meeting at the end of October is around 60% but closer to 75% for the December meeting, as market participants’ views remain mixed on the possibility of further cuts in 2019. We believe that the Fed will abide by its commitment to data dependency. Economic data showing strength or resiliency will result in no further cuts in 2019, but data showing a deteriorating economic picture could mean that more cuts are on the horizon.
In our view, the biggest factor for the performance of risk markets through year end hinges on trade. We believe that the markets are pricing in a China trade resolution over the medium term. If this does not come to fruition or if the U.S. and China become more antagonistic then a negative market reaction becomes more likely. Aside from being positioned more conservatively than the market as a whole, with considerably less BBB exposure and a markedly shorter duration, we believe that we are furthermore better positioned regarding general economic sensitivity as well as, more specifically, Chinese trade exposure.
While the investment grade credit market has performed well, caution still rules the day. We will continue to position portfolios accordingly with an eye toward the longer term. Thank you for entrusting us with the responsibility of helping you to achieve your financial goals.
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.
Spreads and Treasuries were range bound during the week and look likely to finish the week relatively unchanged. It was a quiet week for credit which is unsurprising given that we are headed into quarter end.
The primary market kicked off September with its busiest week ever but the torrid pace of issuance has cooled considerably heading into month end. Weekly new issue volume was $14.5bln pushing the monthly total to $154.9bln according to data compiled by Bloomberg, the fifth busiest month of all time. 2019 issuance trails 2018 by 3.9% on a year over year basis.
According to Wells Fargo, IG fund flows during the week of September 19-25 were +$2.9bln. This brings YTD IG fund flows to +$216bln. 2019 flows are up 8.2% relative to 2018.
(Bloomberg) Sizzling Bond Market Draws Record Number of Blue-Chip Companies
This month has seen a record number of bond sales by blue-chip companies, incentivized by low interest rates and supercharged investor demand to refinance debt.
The market priced 127 deals, surpassing September 2017’s 110 offerings as the busiest month, based on Bloomberg records began going back 20 years. Total volume of $154.9 billion is still short of the $177 billion record set in May 2016. But with two days remaining in September, sales are poised to be the third-highest ever.
The surge in supply came as a growing pile of bonds offer negative yields overseas, driving investors desperate for higher returns into the U.S. corporate credit market. It marks a rare spike in borrowing that’s fueled by a broad-based rush to extend maturities, not driven by large M&A financing.
The first week of the month saw the highest weekly sales volume ever. Almost $75 billion was priced, led by bond sales for Walt Disney Co. and Apple Inc.
September is by far the most popular month for issuers, accounting for the top three months by deal count over the past 20 years. This month’s 127 total high-grade sales compares with 110 in 2017 and 100 in 2016, the second and third busiest months over the past 20 years.
The average deal count for September over the last 10 years is 88.
Spreads are tighter on the week and Treasuries are lower. The OAS on the corporate index opened the week at 116 and is 114 as we go to print on Friday morning while the 10yr Treasury is at 1.767%, 12 basis lower from the previous Friday close. In other news, as expected, the Fed cut the target rate on Wednesday by a quarter-point to 2%. The direction of future cuts is much less clear with plenty of debate as to whether or not the Fed will cut again this year. We tend to think it comes down to economic data and the Fed has been quite clear about this in our view. The Repo market made headlines throughout the week due to a spike in repo-rates amid a supply-demand mismatch. The Fed has since intervened and gotten the rates under control. It remains to be seen as to whether this is much ado about nothing but so long as the Fed liquidity injections can manage to keep rates within the targeted range then we believe that this topic will go by the wayside.
In what seems to be a recurring theme, the primary market had yet another strong week. Monthly volume has topped $140bln for September making it the 8th busiest month in history with more than a full week to go. Year-to-date supply is now $905bln which is down a smidge less than 4% relative to 2018 supply at this juncture. While it was a busy week in the primary market it was not quite as robust as the previous two –if $37bln manages to price by the end of the month then September 2019 would become the busiest month on record but with just 6 trading days left and quarter end looming we are probably not likely to see enough supply to topple the all-time high.
According to Wells Fargo, IG fund flows during the week of September 12-18 were +$2.5bln. This brings YTD IG fund flows to +$213bln. 2019 flows are up 8 % relative to 2018.
(Bloomberg) The Repo Market’s a Mess. (What’s the Repo Market?): QuickTake
When plumbing works well, you don’t need to think about it. That’s usually the case with a vital but obscure part of the financial system known as the repo market, where vast amounts of cash and collateral are swapped every day. But when it springs a leak, as it did this week, it rivets the attention of the U.S. Federal Reserve, the nation’s largest banks, money-market funds, corporations and other big investors. The Fed calmed things down by pumping in billions of dollars, but it may have a lot more work to do on the pipes.
What’s the repo market?
It’s where piles of cash and pools of securities meet. Repo is short for repurchase agreements, transactions that amount to collateralized short-term loans, often made overnight. Repo deals let big investors — such as mutual funds — make money by briefly lending cash that might otherwise sit idle, and enable banks and broker dealers to get needed financing by loaning out securities they hold in return. A healthy repo market is more than the world’s biggest pawn shop: It helps a wide range of other transactions go more smoothly — including trading in the over $16 trillion U.S. Treasury market.
How is the Fed involved in it?
In a number of ways. For years, central banks around the globe have used their own repo markets to extend credit in tight markets, stabilize financing costs and guide interest rates. But the relationship changed when the U.S. repo market melted down in September 2008, a crucial part of that year’s financial panic. Since then, the Fed has worked with other regulators to put in new rules to prevent a recurrence. And since 2013, the Fed has entered the repo market on a large scale, using transactions there to put a floor under rates.
What happened this week?
A lot of cash flowed out of the repo pipes just as more securities were flowing in — meaning that suddenly there wasn’t enough cash for those who needed it. That mismatch drove overnight repo rates from about 2% last week to over 10% on Tuesday. Perhaps more alarming for the Fed was the way volatility in the repo market pushed the effective federal funds rate to 2.30%, above the 2.25% upper limit of the Fed’s target range — just as the Fed was preparing to drop that ceiling to 2%.
Why did that all happen?
In one view, different events that acted as catalysts just happened to land at the same time and push in the same direction. A big swath of new Treasury debt settled into the marketplace, landing on dealers’ balance sheets just as cash was being sucked out by quarterly tax payments companies needed to send to the government.
What did the Fed do?
In its first direct injection of cash to the banking sector since the financial crisis, it laid out about $200 billion in temporary cash over several days to quell the funding crunch and push the effective fed funds rate down. In what are known as overnight system repos, the Fed lent cash to primary dealers against Treasury securities or other collateral.
Was that enough?
It did calm the markets, eventually bringing the rates down around 2% on Thursday. And the action may be sufficient for a temporary patch, if the liquidity squeeze really just reflected the corporate tax payments and Treasury settlements falling on the same date. But most strategists and economists believe the turmoil is a sign of a longer-term problem. To some, one factor is that the rules regulators imposed to make the market safer led dealers to pull back on their involvement, reducing overall liquidity. And many think these distortions will continue as long as government spending and Treasury’s debt issuance continues to rise. More broadly, some observers say that the repo troubles show that there aren’t enough reserves — excess money that banks park at the Fed — in the banking system to give markets the buffers they need at times of stress.
What does that mean?
To some market observers, it might mean that bank reserves, which currently top $1 trillion, still don’t amount to having enough money in the system. They think the Fed may have to start buying bonds again as a way of boosting reserves. This time the purchases would not be like the quantitative easing of the past, meant to support the broader economy, but just to clear up the mechanics of its balance sheet. As with any corporation, the Fed’s assets and liabilities must balance. The Fed’s liabilities mainly come in the form of currency in circulation and bank reserves. As the nation’s economy expands, as it has since 2009, the amount of currency in use has been growing, too. Without action by the Fed to add to its assets, the growth of currency would reduce the liability represented by reserves.
What can the Fed do about the repo squeeze?
It did one thing at its September meeting, and two other steps are being discussed. It lowered the interest rate it pays on so-called excess reserves — the cash banks park at the Fed beyond what’s needed to meet regulatory requirements — to 1.8% from 2.1%. Lowering the IOER rate — interest on excess reserves — gives banks an incentive to lend out more of their money, which would keep repo and the effective federal funds rate more within the Fed’s target range. The Fed has also considered introducing a new tool, called a standing overnight repo facility, which would amount to a standing offer to lend a certain amount of cash to repo borrowers every day. The most drastic step would be for the Fed to create more bank reserves by expanding its balance sheet and thereby buoying bank reserves. Fed Chairman Jerome Powell said Wednesday that the central bank is monitoring when it’s appropriate to start expanding the balance sheet.
Spreads are set to finish the week modestly tighter while Treasuries are at the forefront with the 10yr now 30 basis points higher from last Friday’s close of 1.560%. The OAS on the corporate index closed at 117 on Thursday after closing the prior week at a spread of 119. Equity indices are trading near or above all-time highs as risk markets cling to any glimmer of hope or positive headline that might indicate U.S.-China trade progress. At CAM we remain skeptical of a near term trade resolution and are cautious in our positioning as a result.
The primary market had another strong week after posting its busiest week ever in the previous weekly session. Nearly $42bln of new corporate debt was brought to the market making it the 3rd busiest week of the year according to data compiled by Bloomberg. Monthly volume has topped $116bln while year-to-date corporate supply stands at $882bln. After having trailed 2018 issuance by as much as 13% in June, 2019 year-to-date issuance is now down just 2% from the prior year. It will be interesting to see how the violent move higher in rates may affect the primary market going forward as higher rates may serve to delay some issuance as borrowers weigh funding costs relative to long term capital allocation plans.
According to Wells Fargo, IG fund flows during the week of September 5-11 were +$7.2bln, the second largest inflow on record. This brings YTD IG fund flows to +$209bln. 2019 flows to this juncture are up 8 % relative to 2018.
(Bloomberg) Investment Grade New Issues Trade Tighter Despite Supply Surfeit
Demand for U.S. investment-grade credit is robust, with this month’s avalanche of high-grade bond sales trading mostly stronger, data compiled by Bloomberg show. Spreads on the vast majority of deals priced last week and sized at $1 billion or more are tighter.
20 out of 21 bonds sampled were tighter as of Friday morning
Average change in spread was 8 basis points
(Bloomberg) Fed Seen Cutting Rates Twice More in 2019 Before Holding Steady
U.S. central bankers will trim interest rates by a quarter percentage point next week, and again in December, before leaving the target range for their benchmark rate at 1.5%-1.75% for an extended period, according to economists surveyed by Bloomberg.
In the Sept. 9-11 poll of 35 economists, respondents lowered their projections for the path of U.S. rates compared to a similar survey in July. However, they firmly rejected the idea the Federal Reserve had begun a series of moves that will prove more prolonged than the “mid-cycle adjustment” that Chairman Jerome Powell predicted in July, when the Federal Open Market Committee cut for the first time in more than a decade.
(Bloomberg) Elliott’s $3.2 Billion AT&T Bet Signals ‘There Will Be a Fight’
AT&T Inc.’s sweeping transformation from Ma Bell to a multimedia titan has gone both too far and not far enough for Elliott Management Corp.
Billionaire Paul Singer’s New York hedge fund disclosed a new $3.2 billion position in AT&T, taking on one of the nation’s biggest and most widely held companies with a plan to boost its share price by more than 50% through asset sales and cost cutting.
Elliott outlined a four-part plan for the company in a letter to its board Monday. The proposal calls for the company to explore divesting assets, including satellite-TV provider DirecTV, the Mexican wireless operations, pieces of the landline business, and others.
AT&T is the most indebted company in the world — not counting financial firms and government-backed entities — with $194 billion in total debt as of June, a legacy of Stephenson’s steady clip of large acquisitions. The CEO used to keep a spreadsheet of a few dozen companies that he studies on his tablet to plan his next big deal, people familiar with the matter told Bloomberg in 2016.
Spreads are set to finish the week tighter, a remarkable feat considering the tsunami of new issue supply. The OAS on the corporate index closed at 120 on Thursday after closing the prior week at a spread of 120 but as we go to print on Friday afternoon spreads have ground tighter throughout the day. The 10yr Treasury is 1.54%, essentially unchanged on the week but it had traded as low at 1.45% on Wednesday before positive headlines related to trade sparked a sell-off into the Thursday open.
The primary market just capped off the busiest week in its entire history, and in a holiday shortened week with a jobs report to boot. Corporate borrowers brought over $75bln in new debt during the week, smashing the previous 2013 record of $66bln. According to data compiled by Bloomberg, year-to-date corporate supply stands at $840bln. After having trailed 2018 issuance by as much as 13% in June, 2019 year-to-date issuance is now down just 2% from the prior year. The fact that secondary market spreads tightened amid such staggering supply speaks to the insatiable demand for IG U.S. corporate credit.
According to Wells Fargo, IG fund flows during the week of August 29-September 4 were +$4.4bln. This brings YTD IG fund flows to +$202bln. 2019 flows to this juncture are up 7.7% relative to 2018.
Spreads are likely to finish wider for the second consecutive week. The OAS on the corporate index is at 124 this morning after closing the prior week at a spread of 120. Spreads opened the previous week at 113, so the move wider in credit has been meaningful over the course of the past two weeks, but this move has largely been overshadowed by lower Treasuries. The 10yr is wrapped around 1.54% as we go to print after having closed the week prior at 1.74%. The 10yr closed the month of July at 2.01%. The move lower in rates has been quick and intraday ranges have been volatile with the 10yr trading below 1.5% on Thursday while the 30yr traded below 2% for the first time in history. For all the volatility in rates and spreads the corporate market has a positive tone as we go to print Friday morning. There are not many sellers of corporate credit while buyers are plentiful. This has made it difficult to find attractive bonds in recent weeks but we at CAM are chipping away and finding select opportunities in credit.
The primary market continues to show resiliency amid a volatile tape. Corporate borrowers brought $23bln in new debt during the week, pushing the month to date total north of $64bln. According to data compiled by Bloomberg, year-to-date corporate supply stands at $754.7bln, which trails 2019 supply by 6%. The primary is set to enter a quiet period for the final two weeks of August before ramping up after Labor Day. September has historically been among the strongest months for the new issue calendar.
Fund flows into investment grade corporates were strong for the second consecutive week. According to Wells Fargo, IG fund flows during the week of August 8-14 were +$5.4bln. This brings YTD IG fund flows to +$174bln. 2019 flows to this juncture are up 6.7% relative to 2018.
(Bloomberg) Investors Rushed to High Grade as Recession Fear Spooked Markets
Investors dove into U.S. investment-grade corporate bond funds during a week when fears of a global economic slowdown rose and trade-related headlines brought wild swings in stocks, credit and Treasuries.
Investors plowed $4 billion into high-grade funds for the week ended Aug. 14, according to Refinitiv’s Lipper. It was the biggest inflow since June, as U.S.-China trade headlines continued to rattle markets and concerns about a slowing global economy inverted a key portion of the U.S. Treasury yield curve for the first time in 12 years. High-yield funds posted a modest inflow of $346 million.
Investment grade has become the best performing asset class in fixed income with returns of over 13% so far this year, according to the Bloomberg Barclays US Corporate Total Return index.
The high-grade primary market has also remained steadfast during the volatility in recent weeks. With the exception of Wednesday, when issuers sidelined themselves during the rout, debt borrowers have been able to sell bonds at cheaper funding costs.
Last week investors yanked over $4 billion from junk bond funds, the most since October, while adding $2.8 billion to high-grade funds.
Spreads in the corporate market are set to finish the week meaningfully wider as the OAS on the index opened at 113 on Monday and is trading at 119 as we go to print on Friday morning. Rate volatility was as the forefront this week as the rates market has more carefully considered the impact of a full blown trade war. The 10yr Treasury closed at 1.85% last Friday and is wrapped around 1.70% as we go to print this morning. Spreads opened the month of August at year-to-date tights of 108 and have now moved 11 wider, but at the same time the 10yr Treasury is 30 basis points lower, so the net effect is lower yields for corporate credit. While the Fed cut the federal funds rate by 25bps last Wednesday, the market expectation is that this is merely the beginning of a multi-cut easing cycle. Federal funds futures are now implying 2 additional cuts by the end of 2019 and 2 more by the end of 2020. At CAM, we are of the belief that it is quite possible that markets are underestimating the probability of a lack of near term trade resolution and the associated impact that a prolonged trade dispute could have on risk assets.
Even amid heightened volatility and uncertainty, the primary market was quite active during the week. In fact it was the fifth busiest week of the year that also saw Occidental Petroleum print the 4th largest bond deal of the year which was met with robust investor demand. While spreads are set to finish the week meaningfully wider it is clear that there is solid demand for corporate credit, particularly higher quality issuers. According to data compiled by Bloomberg, year-to-date corporate supply stands at $731.9bln, which trails 2019 supply by 6%. It is worth noting that for most of 2019 supply has trailed 2018 by 10-12% but this gap has narrowed in recent weeks. The M&A pipeline continues to grow and it would not surprise us at CAM if issuance were robust through the end of September which could continue to push issuance totals toward 2018 levels.
Fund flows into investment grade corporates escalated throughout the week. There was a clear bifurcation between the high yield and investment grade credit markets as flows during the week were driven by a flight to quality. According to Wells Fargo, IG fund flows during the week of August 1-August 7 were +$3.3bln while high yield funds experienced losses of -$3.7bln over the same time period and leveraged loan funds posted outflows of -$963 million. This brings YTD IG fund flows to +$169bln. 2019 flows to this juncture are up 6.5% relative to 2018. The fact that flows are up while new issue supply is down is but one factor that has led to a supportive environment for credit spreads.
The corporate market was modestly wider on the week with the spread on the index 1 basis point wider week over week as we go to print on Friday morning. Spreads have largely been in a holding pattern for the month of July, as the index opened the month at an OAS of 115 versus a 113 close yesterday evening. The 10yr Treasury continues to hover just above 2% amid dovish commentary from Federal Reserve officials. Media blackout begins tomorrow for Fed officials so we will get a respite from commentary until after the July 31 FOMC decision.
It was a quiet for the primary market as less than $15bln in new corporate debt was brought to the market which was underwhelming relative to the $30bln consensus figure. According to data compiled by Bloomberg, year-to-date corporate supply has topped $600bln, which trails 2019 supply by 10%.
Fund flows into U.S. corporates escalated throughout the week. According to Wells Fargo, IG fund flows during the week of July 11-July 17 were +$4.8bln. This brings YTD IG fund flows to +$158bln. 2019 flows to this juncture are up 6.1% relative to 2018.
(Bloomberg) After Times Square Goes Dark, NYC’s ConEd Faces More Heat
It lasted all of five hours — and hit just the spot on New York’s power system to take out the lights in Times Square, force the evacuation of Madison Square Garden in the middle of a Jennifer Lopez concert and bring parts of the city’s subway system to a screeching halt.
The Saturday evening blackout on Consolidated Edison Inc.’s grid — extending from about Fifth Avenue to the Hudson River and from the 40s to 72nd Street — was so widespread that it took out much of Midtown, Hell’s Kitchen, Rockefeller Center and the lower reaches of Manhattan’s Upper West Side. Now ConEd, already under fire because of other mechanical breakdowns in recent years, is facing renewed calls to overhaul its network.
The power failure struck on the anniversary of the historic 1977 blackout that led to widespread looting and other crimes across New York City. And it peeled back disparities between old technology and new: halted subways meant a $2.75 fare ballooned to a $57 Uber primed to surge pricing.
Just over six months ago, ConEd was facing an investigation after an electrical fire at a substation turned New York City’s night sky blue, temporarily disrupting flights and subway services. In July 2018, it was the subject of a probe after an asbestos-lined steam pipe ruptured in Manhattan’s Flatiron district. And a power failure in 2017 led to significant delays on the subway during a morning commute, triggering an investigation that cost the company hundreds of millions of dollars.
ConEd Chief Executive Officer John McAvoy told reporters late Saturday that the company would investigate the root cause of the event and “restore the system to a fully normal condition once we understand what exactly occurred.” He said the power failure didn’t appear to be weather-related. Hot weather typically sends power demand surging as people blast air conditioners.
(WSJ) Cellphone Tower Companies Race Higher
As the biggest wireless companies in the U.S. prepare to bring 5G to more customers, cellphone-tower operators are shaping up to be big winners in the stock market. They could be ready to get another boost if or when the deal between T-Mobile US Inc. TMUS -0.37% and Sprint Corp. S +0.37% closes, some analysts say.
Shares of Crown Castle International Corp., American Tower Corp. and SBA Communications Corp. all hit records in 2019, and are currently up at least 20% from where they traded six months ago. Cellphone companies like Verizon, AT&T and T-Mobile pay these tower companies fees to use their high-up real estate.
A concern among some investors is that these companies soared too high too fast. Of the trio, only shares of SBA Communications have risen in the past month. Part of the reason for that is a slowdown in talks between T-Mobile and Sprint.
While final conditions for the merger deal remain to be seen, a key component of the Federal Communications Commission’s conditions is an accelerated 5G rollout in rural areas, UBS notes. That stands to benefit American Tower most, as about 65% of its macro portfolio covers the most rural part of the U.S., according to a research report by UBS last month that looked at the FCC’s antenna registration database of tower locations throughout the U.S.
Another potential overhang has been worries that private operators could be competition for these three big public tower owners as wireless carriers seek out lower rents. However, UBS’s report also found that the big three public tower companies remain the dominant players in a hot business, with the largest private owner of tower sites accounting for just about 2% of all towers. That bodes well for SBA Communications, American Tower and Crown Castle.
“While the private operators have increased their tower counts…this competitive threat is far more limited in practice at this time,” UBS said in its note.
(Bloomberg) A Leveraged Loan Collapses and Reveals Key Risk in Credit Market
Operating out of a Chicago suburb, in a low-slung, red-brick building wedged between a Hyatt and a Radisson, Clover Technologies is in the mundane business of recycling everything from inkjet cartridges to mobile phones.
But in the past week it abruptly — and alarmingly — caught the attention of Wall Street. Almost overnight, a $693 million loan Clover took to the market five years ago lost about a third of its value. The startling nosedive stung even sophisticated investors, people who deal in the arcane business of trading corporate loans.
Clover’s loan isn’t especially large by Wall Street standards, yet its stark and swift decline set off fresh alarm bells — bells that regulators have been sounding for months. It immediately became a real life example of the perils of investing these days in the $1.3 trillion market for leveraged loans, where a global chase for yield has allowed an explosion in borrowing and lax underwriting. In a market where trading can be thin — and at a time when illiquidity is suddenly becoming a prominent concern in credit circles — the episode shows how loans to highly leveraged companies can quickly implode when fortunes change.
Using the leveraged loan market as a wallet, the company took loans that funded dividend payments totaling at least $278 million — $100 million in 2013 and $178 million in 2014. (Portions of the overall proceeds went to shareholders as well as to refinance the company’s existing debt and certain fees, according to a Moody’s report.) Clover also asked lenders for a further $100 million in 2014 to pay for an acquisition.
Those loans, as is typically done, were bought mostly by mutual funds and collateralized loan obligations, which bundle such leveraged debt into higher-rated securities that are pitched to more risk-averse investors. There’s been little trouble finding buyers for CLOs in recent years. With yields on high-grade bonds hovering near zero across much of the world, investors have been hungry for the juicy returns that these loans offer and, more and more, tend to overlook the lack of protection afforded.
Moody’s now predicts a higher likelihood Clover will default on its debt obligations. The ratings agency cites concerns over long-term viability of the business and “unexpected” operational developments. Its debt is just over 6 times its earnings, a level that typically raises lender concerns about the company’s ability to meet its financial obligations. Another warning sign came in May when the company pulled a seemingly attractive refinancing plan that offered a high yield of nearly 9% with a short, three-year maturity.
Investors may recall similar blowups in the credit market. American Tire Distributors’ bonds and loans plunged into distress less than a month after it announced the loss of two key suppliers, Goodyear and Bridgestone. ATM-maker Diebold Nixdorf Inc. also saw its bonds fall to almost half their face value after it posted an unexpected second quarter loss.
The investment grade credit market continued to perform well during the second quarter of the year. The Bloomberg Barclays US Corporate Index opened the quarter at an option adjusted spread of 119 and traded as tight as 109 by mid-April before ending the last trading day of June at a spread of 115. Lower quality credit modestly outperformed during the quarter with the BBB-rated portion of the index tightening by 7 basis points relative to the A-rated portion which tightened by 3 basis points. The bigger story of this quarter was lower Treasury yields as the 10yr Treasury finished the quarter 40 basis points lower than where it started. The 10yr ended the first 6 months of 2019 at 2.005% after closing as high as 2.78% in the first few weeks of January. Tighter spreads and lower Treasuries have combined to yield strong performance for investment grade creditors. The Bloomberg Barclays US Corporate Index posted a total return of +9.85% through the first 6 months of the year. This compares to CAM’s gross return of +9.20% for the Investment Grade Strategy.
When Doves Cry
As longtime clients and readers know, at Cincinnati Asset Management we avoid speculating on the direction of interest rates. Instead we direct our efforts to bottom up credit research, thoroughly studying individual credits and diligently following industry trends, then opportunistically sourcing bonds which can add the most value to the overall portfolio. By positioning the portfolio with intermediate maturities ranging from five to ten years, we mitigate a significant portion of interest rate risk as investors are generally rewarded over medium and longer term time horizons by avoiding tactical positioning and the downside that can come about from being too short or too long with duration bets gone awry. However, while we may be interest rate agnostic, we are not interest rate blind. We would be remiss if we did not comment on the policy actions that we have seen out of the Federal Reserve thus far in 2019. Simply put, the Fed continues to exceed the dovish expectations of the market, a remarkable feat given the extent that the market is pricing in rate cuts, with Fed Funds futures data implying a 100% probability of a rate cut at next FOMC decision on July 31i. We take this as a sign from the Fed that it is extremely concerned with managing a so called “soft landing” when the current economic expansion finally runs out of steam.
The actions of the Fed do not occur in a vacuum and they can have a significant impact on risk assets such as corporate credit. Lower Fed Funds rates coupled with the potential for future slowing economic growth can lead to lower risk-free rates (Treasury rates). When risk-free rates are low, yield starved investors from around the globe turn to large liquid markets in order to satiate their thirst for income thus setting their sights on the corporate credit market. Defaults remain nearly non-existent in the investment grade universe, and when coupled with a still growing economy, this can be a recipe for complacency and a tendency to “reach” for yield. Investors can reach for yield in two ways in IG credit; they can either extend duration or they can take on additional credit risk, but they usually do both. These are ill-advised strategies in our view, especially for investors concerned with capital preservation over a long time horizon. As far as extending duration is concerned, the compensation afforded for extending from a 10yr bond to a 30yr bond typically pales in comparison to the additional interest rate risk that is incurred. What most investors fail to realize is that most duration extensions also contain a significant dose of credit risk. Take the following example with Comcast’s 10yr and 30yr bonds:
An investor receives just 87 basis points of extra compensation for purchasing Comcast’s 30yr bond versus its 10yr bond, and in exchange, the investor takes on an additional 9.4yrs of duration risk. This means that if there is a linear shift in the yield curve and interest rates increase by 100 basis points, the investor in the 30yr bond will capture an additional nine points of downside. However, duration alone does not tell the whole story, as this is not just a story about interest rate risk as much as it is also a story about credit risk. Our hypothetical investor could purchase the risk-free rate instead of the corporate bond, and as you can see from the example above, the spread between the 10 and 30 year Treasury is 53 basis points. If we subtract this 53 basis points from the 87 basis points in spread between the Comcast 10yr and 30yr the difference is 34 basis points. Therefore, 34 basis points is the compensation that the investor receives for the additional credit risk incurred for the purchase of the 30yr Comcast bond in lieu of the 10yr Comcast bond. We like Comcast as an in investment. It is a best-in-class operator in its industry and it generates tremendous free cash flow. But we do not like it enough to lend it money for an additional 20 years in exchange for just 34 basis points of compensation for that credit risk. It simply does not make much sense to us from a risk-reward standpoint.
If you have not yet nodded off from this exercise in corporate credit, the other aforementioned avenue for increasing yield is to simply take on more credit risk by buying shorter maturity bonds of companies with marginal credit metrics. Usually the bonds of companies with marginal credit metrics will offer outsize compensation relative to the bonds of companies with stable or improving credit metrics. There is almost always a reason that the bonds of a marginal company will offer more yield but an investor really has to dig into the numbers and the industry to understand why. Sometimes it may simply be a case of a company that has too much debt or perhaps the business is showing signs of deterioration. Sometimes these investments may well work out but it only takes one or two permanent impairments (downgrade to high yield, structural subordination, default or fraud) to severely impact the performance of a bond portfolio. Taking on more credit risk is not worth it in the current environment in our opinion and is one of the reasons we are significantly structurally underweight the BBB and lower-rated portion of the investment grade universe. We cannot accurately predict when the business cycle will contract but we most assuredly are viewing all new and current investments through a late-cycle lens as we populate the portfolio with companies that have durable business models and the ability to generate free cash flow and comfortably service debt in a recessionary environment.
BBB, Leading the Way
The lowest quality component of the investment grade universe has significantly outperformed the higher quality portion thus far in 2019. The OAS for the index as a whole was 38 basis points tighter through the end of the second quarter. If we segment that by credit quality, the A-rated portion of the index was 30 basis points tighter while the BBB-rated portion of the index was 51 basis points tighter.
Much has been written about the growth of BBB-rated credit, and for good reason. At the end of 2008 it represented 33.15% of the index but at the end of 2018 that figure had swollen to 51.21%. We cap the exposure of our portfolios to BBB-rated credit at 30%, thus we are much more conservatively positioned than the index. We think that this conservative positioning is especially crucial in times like these and we have no intention of increasing our exposure in the near term.
What Happened to Regulators Looking out for the Little Guy?
We typically avoid commenting on regulatory matters but an SEC proposal that was greenlighted in the second quarter has us flummoxed. Regulators recently approved a pilot program that shows a blatant disregard for retail investors and financial advisorsii. Trade disclosure in the corporate bond market has come a very long way in the past 15 years. It is still an over-the-counter market but there was a time in the not too distant past when it was rife with opacity in that there was simply no record of the price at which a bond was traded. The market has slowly but surely evolved and today there is an electronic record of where all corporate bonds trade within 15 minutes of when the trade was completed.
An SEC committee comprised mostly of the largest asset managers and broker dealers on the street voted to enact a 1-year pilot proposal that would roll back much of the progress that has been made with trade disclosureiii. The proposal centers on “block” or large bond trades. The current rule for IG corporate bonds caps trade size dissemination at $5 million but the trade must be posted within 15 minutes. So, as the rule stands today, a trade could have been completed for $50 million of a specific bond issue but unless you are privy to the details you will only know that at least $5 million traded and you will know at what price and you will know this information within 15 minutes of trade completion. This provides some (and we would argue more than adequate) protection to dealers who can buy a large block of a bond from an asset manager and then sell the bond to other asset managers over time without other market participants knowing that the dealer owns a large amount of that particular bond issue. The pilot proposal would increase the dissemination cap to $10 million, and unbelievably, would allow for up to a 48-hour delay (!) before the trade is reported. We oppose the proposal in its entirety as we believe markets are more efficient with more, not less, information, but we take particular issue with the reporting delay. Ironically, the proposal arguably helps us at CAM because it makes the professional management we provide even more valuable. It will not impact our ability to affect best execution because we are in the corporate market all day every day and have many resources and relationships at our disposal to determine where bonds should trade but the proposal is debilitating to the ability of an individual investor or advisor to engage in price discovery.
To understand the potential real-world implications imagine a scenario where Cincinnati Asset Management (CAM) sells $12 million of a particular bond to a dealer at $100. Remember, the trade does not need to be posted for two days. In the interim you, the reader, log into your brokerage account intending to purchase that same bond. You see a price of $105 offered to you, and see no other trades have posted for this particular bond. CAM’s hypothetical $12 million trade has yet to be reported, and you have no way of knowing about it. That $105 price looks fair to you so you purchase the bond. Shortly thereafter the broker-dealer sells the bonds they bought from CAM at $100.25 and both trades are publicly posted. Now you can see that the bond just traded $100-$100.25 and suddenly it appears that you overpaid. But how could you have known if you are not armed with adequate information? This is the proposal in a nutshell – temporarily hiding data from public view for the benefit of a privileged few.
As far as we can tell the only purpose of this proposal is to provide liquidity to large asset managers at the expense of small investors and to enrich the largest broker dealers on the street. Even if it may help us we are still against this proposal as it stands today because it is simply unfair and it is a step back for the corporate credit market. We believe that transparency is necessary for healthy and fully functioning capital markets and that this transparency is the only way to make the market fair to investors of all types, both large and small.
Looking Ahead
As we turn the page to the second half of the year we see more uncertainty ahead. Global trade continues to dominate the headlines and investors are becoming increasingly concerned about economic growth in the Eurozone. As we go to print with this letter the German 10yr Bund is trading at a record low of -0.36%iv. Geopolitical risk too is at the forefront as tensions between the U.S. and Iran remain high. Although the investment grade credit market has performed quite well to start the year we plan to remain conservative in the positioning of our portfolio. We welcome any questions, comments or concerns. Thank you for your continued interest and support.
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, July 1, 2019, 2:08 PM EDT, World Interest Rate Probability (WIRP)
ii FINRA Requests Comment on a Proposed Pilot Program to Study Recommended Changes to Corporate Bond Block Trade Dissemination, April 12, 2019, https://www.finra.org/industry/notices/19-12, Accessed July 1, 2019
iii The Wall Street Journal, June 27, 2019, Bond Fight Pits Main Street Against Wall Street
iv CNBC, July 2, 2019, German 10-year bund yield falls to record low, US Treasurys stable amid softer GDP outlook
(Bloomberg) The Repo Market’s a Mess. (What’s the Repo Market?): QuickTake
