Rich Balestra – Portfolio Manager – Page 30

29 Jun 2018

High Yield Weekly Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were -$1.5 billion and year to date flows stand at -$33.4 billion. New issuance for the week was $4.2 billion and year to date HY is at $100.8 billion, which is -27% over the same period last year.

(Bloomberg) High Yield Market Highlights

The yield on the Bloomberg Barclays US Corporate High Yield Bond Index jumped to the highest since December 2016 as issuance surged and funds saw outflows.
Yesterday was busiest day for issuance this year, marking the busiest week of supply since early March
Stars Group, a CCC-credit, got orders over $2b, priced at tight end of talk, increased size of the offering, cut size of TLB
Nationstar, a low single-B credit, priced in middle of talk on orders of more than $3b
AmWINS, also single-B, priced at tight end of talk
June on track to be slowest sixth month since 2013
2018 issuance expected to be lower than last year’s $275b
BB and single-B yields jumped to 20-month high after rising most in more than 2 months

(Bloomberg) Community Health Continues Debt Revamp With $1 Billion of Senior Notes

Community Health Systems Inc. is raising $1.027 billion by selling new senior notes to pay down more than$1 billion in term loans.
The new first lien debt due in 2024 would be used to pay off Community’s Term Loan G, according to a statement. The sale would put off a near-term maturity and give the hospital operator a respite from refinancing for more than two years, at an incremental cost of $50 million in interest, Mike Holland, a Bloomberg Intelligence analyst, said in an interview.
The offering follows Community’s debt exchange of unsecured notes for secured bonds with longer maturities. The Franklin, Tennessee-based company is unwinding a debt-fueled acquisition binge and cutting costs as it confronts tepid admissions, low margins and the industry’s high expenses. Community sold 30 hospitals last year, and it’s trying to strengthen results at the hospitals it’s keeping by focusing on more profitable treatments and getting out of low-margin treatments.
Moody’s Investors Service rated the new first lien notes at B3, six steps below investment grade, on the expectation that Community will continue to operate with “very high financial leverage” of over eight times. The ratings firm expects negative free cash flow over the next 12 to 18 months as a result of high interest costs and “significant capital requirements” of the business.

(Moody’s) Moody’s upgrades Diamondback Energy’s debt by one notch, positive outlook

(CAM Notes) The Moody’s upgrade was based on the expected production and reserve growth over the next year and a half. Additionally, Moody’s likes the generated top-tier margins of Diamondback.

(PR Newswire) Steel Dynamics Announces Columbus Flat Roll Division’s New Galvanizing Line Expansion

Steel Dynamics announced plans to expand its offering of value-added flat roll steel products through the addition of a new galvanizing line in Columbus, Mississippi. The company plans to invest approximately $140 millionand create 45 new jobs, adding a third galvanizing line at its Columbus Flat Roll Division. After the planned completion of this new facility, the company will have nine value-added galvanizing lines located throughout the eastern half of the United States, with a total annual coating capacity of approximately 3.8 million tons. Upon the closing of the recently announced planned Heartland acquisition, the company will have ten flat roll steel galvanizing lines with approximately 4.2 million tons of coating capacity, solidifying Steel Dynamics as the largest provider of non-automotive galvanized flat roll steel in the United States.
“This investment is another step of further diversification into higher-margin products for our Columbus Flat Roll Division,” said Mark D. Millett, President and Chief Executive Officer. “In recent years, Columbushas transformed its product offerings through the addition of painting and Galvalume® coating capability, as well as through the introduction of more complex grades of flat roll steel, some of which serve the automotive sector. These value-added improvements have reduced the amount of volume available to our existing galvanized customer base. The addition of a third galvanizing facility will allow Columbus to serve these existing customers, as well as new customers in the region, and will also further reduce its exposure to the more cyclical hot roll market.”
Construction is planned to take place during the next 24 months, with operations expected to begin mid-year 2020.
Additionally, Steel Dynamics was recognized as the “2018 Steel Producer of the Year” on Tuesday, June 26, 2018, during the AMM Awards for Steel Excellence ceremony.
Finalists were selected by senior American Metal Market editors, and those entries were scored by steel industry veterans who serve as judges to select the winners.

(CNBC) Conagra Brands to acquire Pinnacle Foods for about $8.1 billion

Conagra Brands on Wednesday announced plans to acquire Pinnacle Foods in a cash-and-stock deal valued at about $8.1 billion that furthers Conagra’s transformation under CEO Sean Connolly and its push into frozen foods.
Including debt, the deal is valued at $10.9 billion.
The pairing of Healthy Choice-owner Conagra and Bird’s Eye-owner Pinnacle would create the second-largest U.S. frozen food company behind Nestle, analysts at RBC Capital Markets have written. Conagra has poured money into its frozen business, with an eye toward repackaging and reformulating its products to cater to younger diners.
Under the agreement, Pinnacle shareholders will receive $43.11 per share in cash and 0.6494 shares of Conagra’s common stock for each share of Pinnacle. Pinnacle shareholders are expected to own approximately 16 percent of the combined company.
The deal is the culmination of on-again, off-again talks the two have had for years. It comes months after activist investor Jana Partners disclosed a roughly 9 percent stake in Pinnacle and said it planned to talk with the company about a possible sale.

22 Jun 2018

High Yield Weekly Rich Balestra - Portfolio Manager 0 comment

CAM High Yield Weekly Insights

Fund Flows & Issuance: According to a Wells Fargo report, flows week to date were -$0.5 billion and year to date flows stand at -$31.8 billion. New issuance for the week was $1.7 billion and year to date HY is at $96.5 billion, which is -28% over the same period last year.

(Bloomberg) High Yield Market Highlights

Junk bond yields are up slightly with equity weakness and rising VIX, while lack of supply is supportive.
Yield to worst on Bloomberg Barclays US Corporate High Yield Bond Index rose to 6.26%
VIX saw the biggest jump in more than three weeks, closed at a 3-week high
DJIA dropped in nine of the last 10 sessions, closed at a 3-week low amid continuing tensions over tariffs
New issuance has been quite sparse
Junk bond YTD returns are 0.69%, the best performing in U.S. fixed income
CCCs continue to top BB, single-Bs with YTD returns of 3.52%
CCCs also beat investment grade bonds, which are down 3.58%

(Moody’s) Moody’s Upgrades AES Corporation’s Corporate Family Rating to Ba1 from Ba2; Rating Outlook is Stable

(CAM notes) Moody’s upgrade was based on the business diversity, lowering of carbon risk exposure, and an improving credit profile.

(Bloomberg) Cheniere to Buy Unit for $30.93 a Share in Streamlining Move

Cheniere Energy Inc., the first U.S. company to export shale gas overseas, will buy the remaining stake in a holding company it already controls for $30.93 a share, moving to simplify amid a U.S. tax overhaul that’s pummeling natural gas partnerships.
Investors in Cheniere Energy Partners LP Holdings LLC will receive 0.475 of a share in Cheniere Energy Inc. for each share of the holding company, of which Cheniere already controls 91.9 percent. The deal values the acquired company at about $7.2 billion.
The pact comes as companies from Williams Cos. to Enbridge Inc. take steps to tighten their structures as changes in U.S. tax law upend the master limited partnerships often used to own pipelines. Units in MLPs plunged in March after regulators said they can no longer charge customers for taxes they don’t pay.
“This has been the plan all along,” for Cheniere, Pavel Molchanov, an analyst at Raymond James Financial Inc., said by phone “This is part and parcel of a broader theme across the MLP landscape: companies are cleaning up, simplifying their structures.”
The holding company has a stake in Cheniere Energy Partners LP — the business that owns and operates Sabine Pass, the terminal that was first to export U.S. shale gas overseas.

(Moody’s) Moody’s downgrades U.S. Concrete’s Corporate Family Rating to B2 from B1; outlook remains stable

(CAM Notes) Moody’s downgrade was based on leverage being elevated from the expected level. Moody’s does see value in the Company’s ability to generate free cash flow. Additionally, the private non-residential commercial segment of the construction market is favorable.

(CNBC) Conagra has approached Pinnacle Foods about a potential deal

Conagra Brands has approached Pinnacle Foods about a potential acquisition, sources familiar with the situation told CNBC on Thursday.
A pairing of Healthy Choice-owner Conagra and Bird’s Eye-owner Pinnacle would combine two companies with a large presence in frozen foods at a time when the category is seeing a resurgence. Food companies, including Conagra, have poured money into previously neglected brands to highlight their healthiness, affordability and ease of use.
Pinnacle has a market capitalization of $7.9 billion, while Conagra’s is $15.1 billion. A combination of Conagra and Pinnacle would create the second-largest U.S. frozen food company, analysts at RBC Capital Markets recently wrote. The other major players include Kraft Heinz and Nestle, the latter of which is the largest in the U.S., according to RBC.
The deal talks come after activist hedge fund Jana Partners recently disclosed a roughly 9 percent stake in Pinnacle and said it planned to talk with the company on a range of subjects, including a possible sale.

(Street Insider) Frontier Communications CFO R. Perley McBride Resigns

Frontier Communications announced that R. Perley McBride, its Executive Vice President and Chief Financial Officer, will be resigning from the company for personal reasons, and to return to Atlanta where his family resides. Mr. McBride will remain in his position until August 31, 2018 to help transition responsibilities. A search for his successor is being conducted.
Frontier’s President and Chief Executive Officer Daniel J. McCarthy stated, “We announce Perley’s resignation with regret. Perley has done a tremendous job managing our balance sheet. He has negotiated improvements in the terms of our credit agreements, raised $1.6 billion of new second lien debt, and retired approximately $1.7 billion of unsecured notes. These steps, together with the stabilization in our business as reflected in our most recent quarterly results, have placed Frontier on a positive path forward. On behalf of everyone at Frontier, I wish Perley and his family the best in the future.”

09 Apr 2018

High Yield Quarterly, Insight Rich Balestra - Portfolio Manager 0 comment

Q1 2018 High Yield Commentary

During the first quarter of 2018, the High Yield Market gave back a modest amount of the gains seen in 2016 & 2017. The first quarter return of the Bloomberg Barclays US Corporate High Yield Index (“Index”) return was ‐0.86%. While the total return was negative, the return still bested most of the other asset classes within fixed income.i As seen last year, once again the lowest quality portion of high yield, CCC rated securities, outperformed their higher quality counterparts. As we have stated many times previously, it is important to note that during 2008 and 2015, CCC rated securities recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC rated cohort may not be appropriate for many clients’ risk profile and tolerance levels. During the quarter, the Index option adjusted spread widened 11 basis points moving from 343 basis points to 354 basis points. While the Index spread did break the multi‐year low of 323 basis points set in 2014 by reaching 311 basis points in late January, it is still a ways off from the 233 basis points reached in 2007. Every quality grouping of the High Yield Market participated in the spread widening as BB rated securities widened 26 basis points, B rated securities widened 21 basis points, and CCC rated securities widened 28 basis points.

The Other Financial, Transportation, and Other Industrial Sectors were the best performers during the quarter posting returns of 1.03%, .06%, and .00%, respectively. On the other hand, Banking, Consumer Cyclical, and REITs were the worst performers posting returns of ‐2.49%, ‐1.15%, and ‐1.13%, respectively. At the industry level, tobacco, wirelines, retailers, and healthcare all posted strong returns. The tobacco industry (1.92%) posted the highest return. However, restaurants, wireless, supermarkets, and food & beverage had a rough go of it during the quarter. The restaurant industry (‐2.75%) posted the lowest return.

During the first quarter, the high yield primary market posted $72.7 billion in issuance. Importantly, almost three‐quarters of the issuance was used for refinancing activity. That was the highest level of refinancing since 2009. Issuance within Energy comprised just over a quarter of the total issuance. The 2018 first quarter level of issuance was relative to the $98.7 billion posted during the first quarter of 2017. The full year issuance for 2017 was $328.1 billion, making 2017 the strongest year of issuance since the $355.7 posted in 2014.

The Federal Reserve increased the Federal Funds Target Rate three times during 2017. In the first quarter of 2018, Chairman Jerome Powell took over for outgoing Chair Janet Yellen. So far, the Fed has increased the Target Rate just once in 2018 at the March meeting. While the outlook is for three increases this year, Chair Powell plans to “strike a balance between the risk of an overheating economy and the need to keep growth on track.”ii Naturally, the Fed is quite data dependent and the outlook can change as 2018 progresses. While the Target Rate increases tend to have a more immediate impact on the short end of the yield curve, yields on intermediate Treasuries increased 33 basis points over the quarter, as the 10‐year Treasury yield was at 2.74% at March 31st, from 2.41% at the beginning of the quarter. The 5‐year Treasury increased 34 basis points over the quarter, moving to 2.56% at March 31st, from 2.21% at the start of the year. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. It was the cropping up of inflation concern that was the main driver of the intermediate term yield increase.iii The revised fourth quarter GDP print was 2.9%, and the consensus view of most economists suggests a GDP for 2018 in the upper 2% range with inflation expectations at or above 2%.

Digging into the monthly details a bit should be beneficial in understanding the dynamics of the quarter. January and February were almost entirely about higher rates and inflation fears, with spreads hitting tights at the end of January and then correcting quite a bit in early February. Mid to late February saw spreads begin to come back down to help offset the continued increase of higher Treasury rates. The return of higher spreads in March was more about tempered growth enthusiasm as retail sales growth continued to be sluggish, January durable goods were weak, Atlanta FED’s GDPNow forecasts continued to slide lower, and fears that global trade wars would slow growth further. Interestingly, the 10 year Treasury yield peaked on February 21st versus the 5 year Treasury peaking a month later on March 20th. That flattening is telling as growth expectations came down while the Fed continues a less accommodative posture. According to Wells Fargo, global quantitative easing has been reduced by 50% from the fourth quarter of 2017 to the first quarter of 2018. Lower rated CCC credits underperformed in March after the outperformance displayed in January and February. As the second quarter gets under way, Treasuries are down from the highs, high yield spreads are off the lows, and higher quality credit seems compelling as lower rated credit has finally started to underperform.

The chart to the left is sourced from Bloomberg and is the Chicago Board Options Exchange Volatility Index (“VIX”). The VIX is a market estimate of future volatility in the S&P 500 equity index. It is quite clear that the market has entered a period of higher volatility. In fact, the equity market through the first quarter of 2018 is already much more volatile than all of 2017 as measured by the number of positive and negative 1% days.iv In addition to the volatility witnessed throughout the markets during the first quarter, there have been a few transitions in high profile government posts as well. Jerome Powell began a four‐year term as Chair of the Federal Reserve following the end of Janet Yellen’s single term in that role; economist Larry Kudlow succeeded to director of the National Economic Council after Gary Cohn’s resignation; and Mike Pompeo and John Bolten were nominated as Secretary of State and National Security Adviser, respectively, after Rex Tillerson and HR McMaster were dismissed from the roles.

See Accompanying Endnotes

The Administration has taken action to impose tariffs on steel and aluminum. These actions were taken after a US Department of Commerce report on section 232 of the Trade Expansion Act suggested that the tariffs were justified. Several countries are currently exempt from the tariffs, including Canada and Mexico, likely because of the ongoing NAFTA negotiations. However, there seems to be a fair amount of flexibility going forward to manage the duties as the Administration sees fit. China is taking exception to the tariffs and has responded by imposing their own tariffs on 128 different products.v While 128 products is a seemingly high number, it only amounts to about $3 billion which is just a fraction of total trade between the US and China. This appears to be a negotiation tactic and clearly a developing story over the balance of 2018.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly underweight CCC and lower rated securities. For the first quarter, that focus on higher quality credits was a detriment as our High Yield Composite gross total return underperformed the return of the Bloomberg Barclays US Corporate High Yield Index (‐1.83% versus ‐0.86%). The higher quality credits that were a focus tended to react more negatively to the interest rate increases. This was an additional consequence also contributing to the underperformance. Our credit selections in the food & beverage and home construction industries were an additional drag on our performance. However, our credit selections in the cable & satellite and leisure industries were a bright spot in the midst of the negative first quarter return.

The Bloomberg Barclays US Corporate High Yield Index ended the first quarter with a yield of 6.19%. This yield is an average that is barbelled by the CCC rated cohort yielding 9.24% and a BB rated slice yielding 5.09%. The Index yield has become more and more attractive since the third quarter of 2017. While the volatility discussed earlier does lend itself to spread widening and higher yields, there are still positives in the environment to keep in mind. First, the current administration is viewed as pro‐business and the tax reform bill that was passed should provide benefits throughout 2018. Additionally, High Yield has displayed a fundamental backdrop that is stable to improving.vi The default volume did tick up during the first quarter, and the twelve month default rate is currently 2.36%.vii However, the current default rate is still significantly below the historical average. Also, a total of twelve issuers defaulted in the first quarter. Three of those issuers accounted for 74% of the default total. iHeart Communications was the largest to default accounting for 55% of the total. Separate from the uptick in the default ratio, the volume of distressed bonds did tick down in March. That was only the seventh downtick within the past two years. Finally, from a technical perspective, the high yield market generates close to $80 billion in coupon income every year. That is a nice supporting demand factor when facing a more volatile market environment. Due to the historically below average default rates and the higher income available in the High Yield market, it is still an area of select opportunity relative to other fixed income products.

Over the near term, we plan to stay rather selective. The selectiveness should serve our clients well as we navigate the higher volatility environment. Further, if the High Yield market begins to break down, our clients should accrue the benefit of our positioning in the higher quality segments of the market. The market needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

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 Credit Sights April 1, 2018: “US Monday Meeting Notes”
ii Reuters February 27, 2018: “First Congressional Testimony by Fed Chair Powell”
iii USA Today February 12, 2018: “U.S. Treasury yields rise to a new 4‐year high as inflation concerns drag on” iv Marketwatch March 28, 2018: “The Dow and S&P 500 have already doubled the number of 1% moves seen in all of 2017”
v CNN April 2, 2018: “China hits the United States with tariffs on $3 billion of exports”
vi Bloomberg March 20, 2018: “Historical Fundamentals – High Yield Corporates”
vii JP Morgan April 2, 2018: “Default Monitor”

30 Jan 2018

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q4 2017 High Yield Commentary

During the fourth quarter of 2017, albeit at a slower pace, the High Yield Market continued the positive return trend of the first three quarters. The Bloomberg Barclays US Corporate High Yield Index return was 0.47% for the fourth quarter. For the year, the Index returned 7.50% which leads many asset classes in the fixed income world. The lowest quality cohort, CCC rated securities and lower, once again outperformed their higher quality counterparts. The widely observed reach for yield continues unabated with highest risk, Ca‐D, followed by Caa‐rated bonds returning 13.76% and 10.38%, respectively, the highest returns of all high yield rating categories1 . It is important to note that during 2008 and 2015, the lowest quality cohort of CCC rated securities recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC rated cohort may not be appropriate for many clients’ risk profile and tolerance levels.

While the 10 year US Treasury finished the quarter and year essentially where it started, the 5 year US Treasury was noticeably higher on the quarter and year. The 5 and 10 year US Treasury ended 2016 at 1.928% and 2.447%, ended 3Q17 at 1.920% and 2.327% and finished 2017 at 2.210% and 2.411%, respectively. Offsetting the 29 basis point higher 5 year US Treasury during the fourth quarter was 3 basis points of tightening of spreads in the high yield index, suggesting much of the return was attributed to coupons. For the year however, the 28 basis point rise in the 5yr US Treasury was more than offset with 66 basis points of tightening in spread. While high yield spreads (343 basis points at year end) continue to grind tighter toward the multi‐year low of 323 basis points reached in 2014, it is still a ways off from the 233 basis points reached in 20071,2. Each quality cohort behaved in a similar fashion.

For the year, the U.S. High Yield Index generated a total return of 7.50% leading many other fixed income markets. This compares to a 10‐year U.S. Treasury return of 2.14%. Also, the Investment Grade Corporate Bond Index return was 6.42% with spreads tightening 30 bps over the year 1.

To consider the high yield performance in a broader context, a comparison to the total returns of other major asset classes is in this chart. (The returns may differ slightly due to the publisher’s selection of indices.) Equities delivered spectacular returns. Riskier classes outperformed, while the least risky asset classes lagged. Omitted is the frequently overlooked performance of gold, which rallied 14% in 20174. Intensifying geopolitical risks may be the catalyst. North Korea’s unbridled nuclear ambitions and Iran’s similar pursuits, as recently exemplified in its test launches of medium range ballistic missiles, are grave concerns. Both paths are troubling: forcing a change in behavior may be achieved only through armed conflict and the development of nuclear arsenals by these two rogue regimes and how they might eventually be deployed in light of their rhetoric is unimaginable. Considering the importance to the proper functioning of the global economy of oil exports from the Middle East, the threat of political instability and armed conflict is a major factor driving investment behavior.

Industry sector analysis reveals the top three 2017 performers in descending order were utilities, chemicals and gaming/leisure. The worst performer was retail followed by telecommunications and then consumer products (source: JP Morgan 1/2/18).

Moody’s reports that 18% of rated debt of retailers is rated Caa and lower, exceeding that during the “great recession” of 2007 – 2009. They estimate the speculative grade default rate of retailers to peak at 10.5% in March 2018, up from 8.9% at year‐end 2017 5. High profile retailers, Toys‐R‐Us filed in October and Sears Canada filed in December. Very weak retailers include luxury retailer Neiman Marcus, Sears Holdings and JC Penny. The seminal shift to online retailing will continue to cause disruptions across the “brick and mortar” retailing industry and related real estate industry.

High yield issuance (excluding emerging markets) continued to be fairly robust at $282.4 billion across 525 deals, versus $226.8 billion across 359 deals in 2016. For the third quarter, issuance by broad rating category was essentially divvied up in line by market size of each broad rating category. Issuance from emerging markets based entities added $81.7 billion and 147 more deals. This was up significantly from 2016’s emerging markets’ $46.2 billion across 75 deals. The largest deals included $3.25 billion by Valeant Pharmaceuticals, $1.5 billion by Hilton Worldwide Holdings, $2.2 billion by Community Health Systems and $1.25 billion by Equinix 6. Most dealers interviewed by Prospect News expect high yield issuance to increase in 2018.

Even with the Federal Reserve’s third 0.25% rate increase in the Federal Funds Target Rate on December 13, yields on intermediate Treasuries are slightly changed with the 10‐year Treasury at 2.41% at the end of 2017, roughly flat from 2.44% at the beginning of the year 7. The 10 year Treasury was the “pivot point” as the yield curve flattened as the FED raised the Fed Funds Target Rate with the 30‐year bond yield falling from 3.07% to 2.74%, while the 2‐year note yield climbed from 1.19% to 1.88% and the 5‐year note rose from 1.93% to 2.21% 8.

Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Although the revised third quarter GDP print was 3.2% following the second quarter’s 3.1%, the consensus view of economists reported in The Wall Street Journal, forecasts a GDP of 2.7% for 2018 up from 2% at the end of September ( with Wall Street Journal’s consensus estimate of economists 12/1/2017 inflation expectations at 2.2% for 2018). It is easy to understand that the “search for yield” that we have witnessed continues and that the high yield market is benefitting from that search.

Top of mind for bond investors is the tax bill recently signed into law. S&P’s analysis concludes, “the details of the proposal suggest the legislation will be a positive for overall credit quality, although less so for highly

leveraged speculative‐grade issuers”9.
The recently signed tax bill has significant changes that affect corporate earnings. The major elements impacting the majority of high yield issuers are: 1. The decline in the income tax rate from 35% to 21%, 2. The interest expense deductibility limit of 30% of adjusted taxable income (defined as EBITDA through 2021 and EBIT thereafter) and 3. The full expensing of qualifying capital expenditures. The chart to the left by S&P estimates that the new tax bill will have at most just slightly negative impact on companies with lower interest coverage ratios (those with more debt), “as the negative effect of lower interest deductibility would offset the positive effect of lower tax rates and the full expensing of capital expenditures” 10.

The chart below on the left shows the percentage of investment grade and high yield issuers impacted to any degree by the new law’s limit on interest expense deductibility. Logically, a larger proportion of high yield companies are impacted, however, the impact in most cases is entirely manageable, as the chart above illustrates. Also, the percentage of high yield companies adversely impacted increases after 2021 with the change in the definition from EBITDA to EBIT, as shown in the chart below on the left. Furthermore, the chart below on the right shows the percentage of rated companies impacted by leverage ratio. The higher the leverage ratio, the greater the number of companies impacted.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly concentrated in less leveraged high yield companies. We limit our purchases to those companies rated single‐B or better, so we are underweight CCC and lower rated securities. So the changes in the tax law will have less of an impact on our portfolios than those of the broader high yield market, in which approximately 15% are rated CCC and lower11. This underweight contributed to our High Yield Composite performance lagging the return of the Bloomberg Barclays US Corporate High Yield Index (6.86% gross versus 7.50%) in 2017. Over the year, we continued to be cautious in our investment strategy, maintaining higher cash balances as we become more selective in our security purchases. Given the positive market performance, these cash balances served as a drag on our performance.

The Bloomberg Barclays US Corporate High Yield Index ended 2017 with a yield of 5.72%. This yield is an average that is barbelled by the CCC and lower rated cohort yielding about 8.5% and a BB rated cohort yielding about 4.4% 12. These yields are being earned in an environment that is fairly attractive. S&P forecasts that the trailing 12‐month default rate of 3.0% as of 12/31/17 will fall to 2.7% by September 2018, significantly below the 36‐year historical average of 4.1%. S&P also observed that “nearly all market‐based measures of future default pressure are now at benign levels” 13. Due to the higher income available in the High Yield market, it is still an area of select opportunity relative to other fixed income products.

The continued tightening of credit spreads needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

1.Bloomberg, Bloomberg Barclays Indices

2.Wall Street Journal historical US Treasury rates

3.Credit Sights 1/1/2018

4.Wall Street Journal 1/2/2018

5. Moody’s Investor Service, U. S. Retail, Apparel, Restaurants:2018 Outlook 12/14/2017

6.The Prospect News, High Yield Daily 1/2/2018 Bloomberg Barclay’s Indices Statistics

7.ibid

8.S&P Global Ratings, U.S. Tax Reform: An Overall (But Uneven) Benefit For U.S. Corporate Credit Quality

9. S&P Global Ratings, U.S. Tax Reform: An Overall (But Uneven) Benefit for U.S. Corporate Credit Quality 12/18/2018

10. ibid
11. Bloomberg Barclays
12. ibid
13. S&P Global Ratings 11/14/2017

30 Oct 2017

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q3 2017 High Yield Commentary

During the third quarter of 2017, albeit at a slower pace, the High Yield Market continued the positive return trend of the first and second quarters. The Bloomberg Barclays US Corporate High Yield Index return was 1.98% for the third quarter. Positive returns of 2.70% and 2.17% were posted for the first and second quarters of 2017, respectively. Year to date the Index has returned 7.00% which leads many asset classes in the fixed income world. As seen in the first quarter of 2017, the lowest quality cohort of CCC rated securities once again outperformed their higher quality counterparts. The widely discussed reach for yield was once again on display. It is important to note that during 2008 and 2015, the lowest quality cohort of CCC rated securities recorded negative returns of 49.53% and 12.11%, respectively.
We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC rated cohort may not be appropriate for many clients’ risk profile and tolerance levels. While the 10 year US Treasury finished the quarter essentially where it started, the Index spread tightened 17 basis points moving from 364 basis points to 347 basis points over Treasuries. While the Index spread continues to grind tighter toward the multi‐year low of 323 basis points reached in 2014, it is still a ways off from the 233 basis points reached in 2007. Each quality cohort participated in the spread tightening as BB rated securities tightened 21 basis points, B rated securities tightened 21 basis points, and CCC rated securities tightened 33 basis points.

The Energy Sector was back to its winning ways of 2016 during the third quarter of 2017. The Independent Energy and Oil Field Services Industries provided the tailwind that the Energy Sector needed after the negative returns posted in the second quarter. The Transportation, Utility, and Industrial Sectors were other top performers. The Communications Sector had a bit of tough time during the quarter as the Wireline Industry was the major drag on performance. Finally, the Consumer Non‐Cyclical Sector was one of the bottom performers as Amazon’s takeover of Whole Foods injected much uncertainty into the future landscape of the Supermarket Industry. Additionally, the Healthcare Industry saw more credit specific weakness in some of the hospital operators.

During the third quarter, high yield issuance continued to be fairly robust at $79.8 billion versus $98.7 billion and $77.2 billion during the first and second quarters, respectively. For the third quarter, issuance by broad rating category was essentially divvied up in line by market size of each broad rating category. Year to date issuance stood at $255.6 billion. This pace is very likely to exceed 2016’s total issuance of $286.2 billion.

Even as the Federal Reserve has increased the Federal Funds Target Rate twice this year, yields on intermediate Treasuries have declined with the 10‐year Treasury at 2.33% at September 30, roughly flat from 2.31% at the beginning of the quarter and down from 2.45% at the beginning of the year.

Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the Target Rate. Although the revised second quarter GDP print was 3.1%, the consensus view of most economists suggests a GDP in the 2% range with inflation expectations at or below 2%. It is easy to understand that the “search for yield” that we have witnessed continues and that the high yield market is benefitting from that search.

The most recent FOMC meeting was on September 20th 2017. While the Committee voted to maintain the current Fed Funds Target Rate, they did note that they will initiate a balance sheet normalization program in October i. We expect the program to be a very long and slow process as to best mitigate the risk of riling the markets. The Fed’s current “dot plot” is projecting one hike in December and three additional hikes in 2018. While not all of the projected hikes might come to fruition, the Fed continues to move in the direction of easing up on the accelerator. This is unique relative to the other major central banks. The ECB, BOE, and BOJ have all continued to increase their balance sheets since 2015.

As we have discussed previously, high yield spreads continue to tighten at the same time the restrictive covenant protections contained in the indentures became more relaxed. The weakening of covenant protections has made its way to the loan market as large companies are increasingly able to finance their business with covenant‐lite terms ii. Additionally, weakened covenants are not simply a US phenomenon. International debt deals are increasingly covenant‐lite as well iii. This type of activity is not without consequences. J.Crew Group took advantage of covenants in their indenture to remove collateral value from some creditors. This type of activity is not happening across the board. Some creditors are successful in pushing back against companies while other creditors are not as lucky iv. More and more, a professional manager is needed to select bonds of quality – bonds that compensate the investor for the risks he undertakes in a high yield portfolio.

Being a more conservative asset manager, Cincinnati Asset Management remains significantly underweight CCC and lower rated securities. This underweight contributed to our High Yield Composite performance lagging the return of the Bloomberg Barclays US Corporate High Yield Index (1.66% versus 1.98%) during the third quarter. Over the quarter, we continued to be cautious in our investment strategy, maintaining higher cash balances as we become more selective in our security purchases. Given the positive market performance, these cash balances served as a drag on our performance. We were also underweight the Energy Sector which was the best performing sector for the third quarter. On the other hand, some top contributors of our performance were our credit selections across the Capital Goods Sector as well as the Technology Sector.

The Bloomberg Barclays US Corporate High Yield Index ended the third quarter with a yield of 5.45%. This yield is an average that is barbelled by the CCC rated cohort yielding about 8.5% and a BB rated cohort yielding about 4%. These yields are being earned in an environment that is fairly attractive. There has been a significant amount of central bank stimulus. High Yield has displayed a fundamental backdrop that is stable to improving. The default rate of 1.27% is significantly below the historical average and expected to remain low over the next year. Additionally, the default volume during the third quarter was the lowest amount since the fourth quarter of 2013v. Due to the higher income available in the High Yield market, it is still an area of select opportunity relative to other fixed income products.

Over the near term, we plan to be rather selective. Changes to the Affordable Care Act are on the back burner at best, but tax reform is now front and center. Tax reform does have the ability to be a positive factor for the High Yield Market. That said, the continued tightening of credit spreads needs to be carefully monitored to evaluate that the given compensation for the perceived level of risk remains appropriate on a security by security basis. It is important to focus on credit research and buy bonds of corporations that can withstand economic headwinds and also enjoy improved credit metrics in a stable to improving economy. As always, we will continue our search for value and adjust positions as we uncover compelling situations.

i FOMC Statement September 20, 2017
ii Bloomberg September 26, 2017: “That Junk Loan is Now Basically a Junk Bond”
iii Bloomberg September 29,2017: “High Yield Investors Sweat for Return in Europe Sellers Market”
iv Wall Street Journal September 21, 2017: “Deal to Save J.Crew from Bankruptcy Angers High Yield Debt Investors”
v J.P. Morgan October 2, 2017: “Default Monitor”

30 Jul 2017

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q2 2017 High Yield Commentary

The Bloomberg Barclays High Yield Index returned 2.17% during the second quarter of 2017 and 4.93% for the first half of the year, continuing, although at a slower pace, the robust 2016 performance (+17.13%) which was the best since the 2009 recovery performance of 58.21%. Unlike Q1 and all of 2016, the highest rated credit sector (BB rated) outperformed the weaker sectors (i.e., BB rated bonds outperformed B and CCC rated bonds). While the highest rated credits within the universe outperformed the lower quality credits, the entire market was characterized by continued spread tightening – the Index spread tightened from 383 to 364, or 21 basis points over Treasuries and BB rated credits tightened from 252 to 227 or 25 basis points over Treasuries. Spreads are now near their tightest in almost a decade, and while performance during Q2 was positive across all credit subsectors, it is important to note that during 2008 and 2015, the lowest rated credit subsector (CCC) recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of the CCC credit subsector may not be appropriate for many clients’ risk profile and tolerance levels.

Unlike calendar 2016’s performance that was, in great measure, attributable to the robust recovery of the Energy Sector, Q2 witnessed positive performance by almost all Sectors, led by the Financial Institutions Sector, which was up 3.67%. That Sector accounts for over 9% of the Index, so its performance had a positive impact on the Index performance, but clearly not the significant impact that Energy played during 2016. In fact, Energy posted negative returns of 1.16% for Q2 as oil traded below $50 in the area of $45 per barrel for most of the quarter.

Even as the FED has increased the Federal Funds Target Rate twice this year, yields on intermediate Treasuries have declined with the 10‐year Treasury at 2.31% at June 30, down from 2.39% at the beginning of the quarter and from 2.45% at the beginning of the year. Intermediate term yields more often reflect GDP and expectations for future economic growth rather than actions taken by the FOMC to adjust the Target Rate. The consensus view of most economists suggests a sluggish GDP in the 2% range with inflation expectations at or below 2%. It is easy to understand that the “search for yield” that we have witnessed for several years continues and that the high yield market is benefitting from that search. This search for yield has also been observed in the investment grade universe where the lowest credit rated debt has outperformed the investment grade index as a whole. During Q2, high yield issuance continued to be fairly robust at $76.7BB versus $98.7BB during Q1. Year to date issuance stood at $175.3BB. This pace could see us easily exceeding 2016’s total issuance of $286BB.

Discussed at length during the year by many high yield observers was the fact that, while spreads were tightening, the restrictive covenants contained in the indentures under which the bonds were being issued were becoming more and more “relaxed”. In other words, while investors were searching for yield, issuers were able to negotiate with investors to remove covenants that previously were provided as standard protection for the investor: namely leverage constraints, disposition of assets, etc. More and more, a professional manager is needed to select bonds of quality – bonds that compensate the investor for the risks he undertakes in a high yield portfolio.

Cincinnati Asset Management buys only B3/B‐ and higher rated securities, and, given that the CCC sector underperformed the Index as a whole, it is easily understood that our performance exceeded the Index for the 2nd Quarter (2.24% gross total return vs. 2.17%). During this period, we remained cautious in our investment strategy, maintaining higher than normal cash balances as we become more selective (higher credit quality) in our security purchases. Given the market performance, these cash balances served as a drag on our performance as well.

Further addressing the issue of performance by credit sub-sector, the following table highlights the impact of the performance of the several credit sub‐sectors in the high yield universe on the aggregate high yield performance:

An additional observation: The Index yield for the High Yield Market is 5.62%. Default rates have been low since the Energy sector “crisis” of 2015/16; however, there will always be defaults in the high yield universe. Historically, those defaults have come principally from the CCC and lower subsectors. So pricing needs to reflect that eventuality. With respect to 2017, we continue to be cautious. Many potentially positive factors could favorably impact corporations in the high yield space (changes in the tax code, relaxed and fewer regulations, etc.); however, the impact of changes in trade agreements and the health of the global economy need to be carefully monitored. Defaults, excluding Energy, have remained lower than the long‐term average default rate – a positive sign with respect to the current health of the asset category. On the other hand, the “shrinking” spreads (i.e., implied premium to Treasury bonds) is of concern given that the “search for yield” may have resulted in an overvalued market. The tightening of spreads implies the expectation of a robust recovery in corporate performance.

In this uncertain environment, it is important to focus on credit research and to attempt to buy bonds of corporations that we believe can withstand economic headwinds and can enjoy improved credit metrics in a stable to improving economy.

30 Mar 2017

High Yield Quarterly, Market Commentary Rich Balestra - Portfolio Manager 0 comment

Q1 2017 High Yield Commentary

The High Yield Market returned 2.70% during the first quarter of 2017, continuing, although at a slower pace, the robust 2016 performance (+17.13%) which was the best since the 2009 recovery performance of 58.21% (Bloomberg Barclays Indices). As was the case for all of 2016, Q1 performance was characterized by outsized performance of the weakest credit sectors within the Index, i.e., the CCC and lower rated credits, which currently account for approximately 15% of the high yield universe. These lowest rated credits returned slightly less than 5% during Q1 (they returned over 30% during 2016). In fact, if we were to exclude the CCC rated credit sub‐sector, the Index would have posted a 1.44% return, lower than our gross return performance of 2.00%. It is important to note that during 2008 and 2015, that lowest rated credit subsector recorded negative returns of 49.53% and 12.11%, respectively. We highlight these returns to point out that with outsized positive returns come outsized possible losses, and the volatility of that credit subsector may not be appropriate for many clients’ risk profile and tolerance levels.

Unlike calendar 2016’s performance that was, in great measure, attributable to the robust recovery of the Energy Sector, Q1 witnessed positive performance by all Sectors, led by the Utility Sector, which was up 4.37%. That Sector accounts for less than 2.76% of the Index, so its performance had a positive impact on the Index performance, but clearly not the significant impact that Energy played during 2016 (The Energy Sector was up over 37% during 2016 and comprised approximately 15% of the Index at year end.) In fact, Energy’s 3.0% return approximated the overall Index as oil traded in a $50‐$55 range for most of the quarter, although it did drop to a low of $47.34 late in the quarter.

The performance of the least credit‐worthy within the high yield universe represented the continuing “search for yield” that we have witnessed for several years as interest rates on Treasury bonds, in general, fell to their lowest levels in a decade during July ‘16 and then increased to a level at year end (2.45%) that was only marginally higher than where it began the year. After the FOMC increased the Federal Funds Target Rate by 25bps in December, the 10‐year Treasury yield declined from 2.60% mid‐December ’16 to 2.39% at March 31. (This search for yield has also been observed in the investment grade universe where the lowest credit rated debt has outperformed the investment grade index as a whole.) The result of this “search” has been the tightening of spreads, i.e. the premium yield of bonds relative to the risk free Treasury rate. At year‐end 2015, the premium yield on BB, B, and CCC rated bonds was 417, 654, and 1,351 basis points, respectively. We ended 2016 with those premia at 270, 382, and 807, respectively; and by March 31, spreads had tightened even more – to 252, 375, and 692, respectively. So, while Treasury rates over the first 3 months of 2017 declined, the premium demanded by the investor for “risk compensation” continued to fall considerably. We make note of this only to inform the investor of the market dynamics surrounding both yield movement (up and down) and premia movement: both impact bond prices.

The demand for yield was met by $98.7BB in new issuance during Q1 2017; total 2016 issuance was $286BB. The Energy and Metal & Mining Sectors were the largest issuers, accounting for 13% and 10% of total volume, respectively. It is interesting to note that the several years prior to 2015, 17‐19% of new issuance came from the lowest rated credits, and that percentage declined dramatically during 2015‐2016, to just over 10% in 2016. However, Q1 2017 saw that percentage increase to almost 16%.

Given that Cincinnati Asset Management does not buy CCC rated securities, it is easily understood that our performance trailed that of the Index for 1st Quarter (2.00% gross total return vs. 2.70%). We have remained cautious in our investment strategy, maintaining higher than normal cash balances as we become more selective (higher credit quality) in our security purchases. Given the market performance, these cash balances served as a drag on our performance as well.

With respect to 2017, we continue to be cautious. Many potentially positive factors could favorably impact corporations in the high yield space (changes in the tax code, relaxed and fewer regulations, etc.); however, the impact of changes in trade agreements and the health of the global economy need to be carefully monitored. Defaults, excluding Energy, have remained lower than the long‐term average default rate – a positive sign with respect to the current health of the asset category. On the other hand, the “shrinking” spreads (i.e., premium to Treasury bonds) is of concern given that the “search for yield” may have resulted in an overvalued market. While CCC spreads have tightened considerably, BB and B spreads remain modestly tighter on the year, although they had tightened considerably during 2016. The tightening of spreads implies the expectation of a robust recovery in corporate performance. In this uncertain environment, it is important to focus on credit research and to attempt to buy bonds of corporations that we believe can withstand economic headwinds and can enjoy improved credit metrics in a stable to improving economy.

Cincinnati Asset Management’s High Yield Strategy remains conservatively positioned. The construction of the portfolio is driven by our bottom‐up analysis and our restriction from CCC‐rated securities adds an additional level of conservatism.

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