Category: Investment Grade Quarterly

11 Apr 2022

2022 Q1 Investment Grade Quarterly

It was an extremely painful start to the year for credit markets as performance suffered due to wider spreads and higher interest rates. During the first quarter, the option adjusted spread (OAS) on the Bloomberg US Corporate Bond Index widened by 24 basis points to 116 after having opened the year at an OAS of 92. Interest rates finished the first quarter higher across the board. The 10yr Treasury opened the quarter at 1.51% and closed 83 basis points higher, at 2.34%. The move in the 5yr Treasury was even more dramatic as it rocketed higher by 120 basis points, from 1.26% to 2.46%. The 2yr Treasury saw the most movement of all with a 160 basis point increase from 0.73% to 2.33%. The extreme move higher in interest rates led to negative returns for fixed income products across the board. The Corporate Index posted a quarterly total return of ‐7.69%, its second worst quarterly return in history. The only quarter that was worse than this one was the 3rd quarter of 2008 in the midst of the Great Recession when the index posted a quarterly return of ‐7.80%. CAM’s net of fees 1st quarter total return was ‐6.75%.

You own bonds, now what?

 Is now the time to panic? While we are certainly disappointed with short term negative performance we believe investors that are committed to the asset class will be rewarded over a longer time horizon. The thesis for owning investment grade credit as part of an overall diversified portfolio has not changed. Investors look to highly rated corporate bonds for diversification, income, and to decrease the volatility of their overall portfolio. While higher Treasury yields have led to negative performance for the past quarter it has also led to opportunity with investment grade yields that are now at their highest levels since the spring of 2019. Higher yields mean that newly issued corporate bonds will have larger coupons and more income generation.

For those who may view recent returns as a signal to either enter or exit certain asset classes, we would caution against such an attempt at market timing that currently might lead one to exit the investment grade corporate bond market. This is especially true when credit conditions are strong and the loss of value that occurred during the quarter was almost entirely driven by interest rates and not by the general creditworthiness of the investment grade universe. It is important to remember that bonds are a contractual obligation by the issuer – the bonds will continue to inch closer to maturity and pay coupons along the way. An investor who has seen a bond decrease in value will recapture some portion of that value over time in the form of coupon payments and an increase in principal value as the bond rolls down the yield curve toward maturity and its price converges toward par.

During the first quarter we experienced dramatically higher Treasury rates along with wider credit spreads. To put it into historical context, it was the second worst quarter for the Corporate Index since its inception in 1973. It is not easy to step in and buy here amid negative sentiment regarding the Fed and interest rates but we believe that is precisely what investors should be doing.

Credit Conditions

 The investment grade credit markets were in very good health at the end of the first quarter. The secondary market has been liquid and the primary market was fully functioning, even during the volatile period for risk assets that coincided with early days of Russia’s invasion of Ukraine. Cash on investment grade non‐financial firms’ balance sheets was at all‐time highs at the end of 2020 and 2021.i Leverage ratios for IG‐rated issuers spiked during the early innings of the pandemic but leverage has since come down substantially and is now below pre‐pandemic levels.ii In 2020, due to the early severity of the pandemic, there were $186bln in downgrades from investment grade to high yield. That trend reversed sharply in 2021 with just $7bln in downgrades during the entire year while there were $35bln in upgrades from HY to IG. 2022 will go down in history as the “year of the upgrade” and there were $31bln in upgrades during the first quarter of 2022 alone.

J.P. Morgan has identified an additional $230bln of HY‐rated debt that could make its way to investment grade by the end of 2022. There is a high probability that 2022 will shatter records for the most upgrades during a calendar year. As far as the new issue market is concerned, the numbers have been very strong. March was the 4th busiest month on record for the primary market with $229.9bln in volume. There was $453.4bln of new issuance through the end of the first quarter, which was 4% ahead of the pace set in 2021.iii In aggregate, the investment grade universe is strongly positioned from the standpoint of credit worthiness and access to capital. We believe this is supportive of credit spreads.

Inflation, Interest Rates, the Fed: Impact on Credit

 Inflation and interest rates are understandably a hot topic in our discussions with investors. Inflation is a problem, and headline PCE, which is the Fed’s preferred inflation gauge showed a year‐over‐year increase of

+6.4% for its February reading.iv Chairman Powell has responded with forceful rhetoric that the FOMC will do everything in its control to reign in price increases and the market has bought in. The consensus view is that inflation will slow throughout 2022. Along those same lines, it is widely anticipated that economic growth will slow throughout 2022 as well. At this point it seems likely that the Fed will raise its target rate by 50 basis points at its May and June meetings and then it could raise by 25 basis points in July, September, November and December. This is largely priced in at this point.v The risk with the Fed’s stance on inflation is that it could start to aggressively tighten monetary policy just as consumer spending begins to decline thus lighting the fire for a recession. History shows that it is very difficult for monetary policy to fight inflation and avoid a recession at the same time, thus the odds of a recession at some point over the next two years has increased substantially. Note that a recession simply means the economy has had two consecutive quarters of negative GDP growth –it is not a good thing, but a modest shallow recession does not necessarily mean economic disaster.

For credit, slower or negative growth likely means wider spreads but we would expect investment grade to outperform other risk assets in such a scenario. Investment grade balance sheet fundamentals are very strong and margins had been expanding until very recently and are near their peak. At some point, inflation will start to take a bite out of margins for some industries but in aggregate corporate credit is in very good health and well positioned to weather a storm. If the Fed manages to achieve its goal of a soft landing then that would be a scenario where risk assets perform reasonably well, but it could be accompanied by interest rates that inch higher from here, which would be a headwind for longer duration credit. An additional risk is that neither inflation nor economic growth decline in line with expectations throughout the rest of 2022; although we believe that this is the less likely of the two scenarios, it does remain a possibility that this path comes to fruition. If this happens then the Fed will have to become uber‐hawkish and may have no choice but to force the economy into recession to cool inflation.

What Does an Inverted Yield Curve Mean for Credit?

 As a reminder, at CAM we position client portfolios in intermediate maturities. We typically purchase bonds that mature in 8‐10 years and then allow those bonds to roll down the yield curve, holding them for 3‐5 years before we sell and redeploy the proceeds into another bond investment. We do this because the 5/10 portion of both the Treasury curve and the corporate credit curve have been historically typically steep relative to the other portions of both of those curves. We prefer a steep 5/10 Treasury curve but at the end of the 1st quarter that curve was ‐12 basis points. Our strategy still works when there is an inverted Treasury curve because there is a corporate credit curve that trades on top of the Treasury curve that classically steepens when the Treasury curve flattens resulting in extra compensation for incremental duration. See the below chart that compares the Treasury curve at quarter end against the corporate credit curves of two bond issuers:

Note that the curve for Charter is steeper than Progressive. This is typical given that Charter is a lower quality credit than Progressive; the curve should be steeper for incremental credit risk. Curves are moving all the time and change by the day or even by the hour. To provide some recent historical context, the 5/10 Treasury curve was 80+ basis points just one year ago, which was its steepest level at any time in the previous 5 years –things can change quickly. Corporate curves also vary by industry with fast changing industries like technology typically having steeper curves than stable more predictable industries. It is the constant monitoring of these curves and the subsequent implementation of trades where an active manager adds value to the bond investment management process.

There are a variety of reasons that Treasury curves invert but the main reason comes down to Federal Reserve policy and its impact on the front end of the Treasury curve. Increasing the Federal Funds Rate has a disproportionate impact on Treasuries that mature in 5 years or less and especially those that mature in 2 years. Longer term Treasuries like the 10yr are much more levered to investor expectations for economic growth and longer term inflation expectations. We would note that this Treasury curve inversion is still very fresh and corporate credit curves have steepened moderately in the meantime. Over time, if Treasuries remain inverted, we expect to see more steeping of corporate credit curves.

Looking Ahead

 It has been a tough start to the year but it is only April and there is still much to be written before we close the book on 2022. There are significant unknowns and risk factors that loom large as we navigate the rest of the year. The largest geopolitical uncertainty is the Russo‐Ukrainian War but China’s “zero‐Covid” policies are another risk that may not be fully appreciated by the markets as a slow‐down in China could have significant ramifications for global economic growth. Domestically, Federal Reserve policy is at the forefront and there are also mid‐term elections in the fall.

We believe higher Treasury yields and reasonable valuations for credit spreads along with healthy credit conditions for investment grade issuers have made the investment grade asset class as attractive as it has been in several years. The risk to our view is that Treasury yields could go even higher from here creating additional performance headwinds for credit.

We will be doing our best to navigate the credit markets in a successful manner the rest of this year and we appreciate the trust you have placed in us as a manager. Thank you for your business and please do not hesitate to contact us with any questions or comments.

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.

 The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein

i Goldman Sachs Global Investment Research, March 28 2022, “IG capital management: Deleveraging is the exception, not the rule”

ii Bloomberg, Factset, Goldman Sachs Global Investment Research

iii Bloomberg, March 31 2022, “IG ANALYSIS: Corebridge Debut Closes Out Record $230bln Month”

iv CNBC, April 1 2022, “The Fed’s preferred inflation gauge rose 5.4% in February, the highest since 1983”

v Bloomberg, March 14 2022, “Fed Traders Now Fully Pricing In Seven Standard Hikes for 2022”

11 Jan 2022

2021 Q4 Investment Grade Quarterly

Investment grade corporate credit spreads finished the year little changed. For the full year 2021, the option adjusted spread (OAS) on the Bloomberg US Corporate Bond Index tightened by 4 basis points to 92 after having opened the year at an OAS of 96. The 4th quarter saw more movement, with the spread on the index moving wider, opening the quarter at 84 and closing at 92.

Treasuries finished the 4th quarter nearly unchanged. The 10yr Treasury opened the 4th quarter at 1.49% and closed at 1.51%. There was much more movement within the full year number with the benchmark 10yr opening 2021 at 0.91% and closing as high as 1.74% at the end of the first quarter before receding into the close of the second quarter and then trading higher from there, closing the full year 60 basis points higher at 1.51%.

The Corporate Index eked out a positive return during the fourth quarter, posting a total return of +0.23%. This compares to CAM’s net 4th quarter total return of -0.30%.

For the full year 2021, although spreads were slightly tighter, it was not enough to offset the move higher in interest rates. The Corporate Index posted a full year total return of -1.04%. This compares to CAM’s net full year total return of -1.38%.

Few Things Worked in 2021
Broadly speaking it was a tough year for investment grade credit. The Long portion (10+ years to maturity) of the US Corporate Index underperformed the Intermediate portion by 13 basis points on the back of higher Treasury rates. The “risk-on” trade has been in full effect since mid-2020 and that theme continued in 2021 with lower quality IG credit outperforming higher quality during 2021.

Recall that CAM has a structural underweight in Baa-credit and targets a ceiling of 30% exposure to this riskier segment of the market while the index is >50% Baa-rated. CAM also targets an A rating for its client portfolios
while the index is rated A3/Baa1.

As far as individual sectors go, there were a couple winners. At the sector level, only Energy and the Other Industrial sectors posted positive total returns on the year, of +1.39% and +0.88%, respectively. While Energy represented a major sector with a 7.72% index weighting, Other Industrial is quite small and represented just 0.48% of the Corporate Index. As far as individual industries were concerned, those industries under the Energy umbrella led the way with Independent Energy, Oil Field Services, Refining and Midstream posting total returns of +1.60%, +2.45%, +2.48% and +2.46%, respectively. The best performing individual industry was Airlines with a +4.48% total return.

The sectors that posted the biggest losses were Utilities, Technology and Consumer Noncyclical with returns of -2.15%, -1.98% and -1.30%, respectively. It may seem counterintuitive but while these industries are some of the most stable, high quality was not in favor during 2021 and instead risk taking ruled the day. Outside of the various utility sub-industries, the worst performing individual industries were Tobacco and Cable & Satellite with returns of -2.32% and -2.12%, respectively.

A Year of Little Change
2021 was one of the least volatile years for IG credit—the index OAS traded in a range of just 21 basis points. To find a less volatile year we have to go all the way back to 2006 when the range was just 12 basis points.

Ironically, the low volatility of 2006 continued well into 2007, just prior to the two most chaotic years in the history of investment grade credit. Please note that we do not expect a repeat performance of this in 2022 given the exogenous factors that were in play back in 2008-2009. In fact we predict quite the opposite, and our opinion is that 2022 will be a year of spread stability similar to 2021. There have been sustained periods of time in the history of our market where spreads have traded at levels beneath or near 100, and barring a geopolitical crisis or unexpected shock to the global economy, we see little reason that spreads should move meaningfully over the course of the next year. They may move wider or they may move tighter but we feel pretty comfortable pegging a spread of 100 +/- 20bps type of valuation target for the end of 2022.

Predicting fund flows is always a difficult but, even after $323.8 billion of inflows during 2021 into IG credit, making it the second largest year on record, we expect demand to remain positive going into 2022i. After such a strong performance for equities in 2021, pension funds will continue to look to rebalance and demand from institutional investors both domestic and foreign should remain strong. Additionally, IG credit will likely benefit from “flattish” gross new issuance supply and most Wall Street prognosticators are predicting substantially less net new issue supply as the amount of debt that matures in 2022 is larger than what we have experienced in recent years. Less supply of new bonds creates a more supportive environment for credit spreads in the secondary market and for the market as a whole. One factor that could make a difference at the margin is the amount of high yield debt that is upgraded to investment grade during the course of the year. Current expectations are calling for a robust upgrade cycle in 2022 and these companies will often issue new debt when they achieve investment grade status. Past experience tells us that much of this debt ends up being “leverage neutral” as lower interest rate investment grade debt is used to retire higher interest rate legacy high yield debt. However, the debt is still net new for the investment grade market since these companies were previously part of the high yield market. If we experience even more upgrades than the upper limit of the rosiest predictions then that could make for higher new issue supply numbers within the IG market.

In our view, the biggest potential driver of benign spread volatility during 2022 is that the economy is likely to continue to grow at above average levels and that the typical investment grade company is in good health from a balance sheet perspective. The median real GDP forecast is predicting growth of +3.9% in 2022 which is solidly above trendii. Companies are still sitting on elevated cash balances but as we have written about in past commentaries this will not last forever. As we move into 2022, it becomes increasingly likely that this cash will start being deployed for shareholder returns and M&A will move to the forefront. 2022 is shaping up to be much more of a credit pickers market instead of a market that generically rewards all risk-taking.

The Return of Dispersion

We have seen erosion in the quality of the investment grade universe, especially over the course of the last dozen years. That data set below is representative of just the past 10 years but the trend really started to manifest itself at the end of 2008, when the Corporate Index was just 33.15% Baa-rated compared to today when it is north of 50%.

Since 2008, the proportion of Baa-rated credit has crept higher with each passing year. There is some noise in these numbers, given the wave of downgrades from investment grade to high yield that occurred in 2020 and that is precisely why the percentage of Baa-rated debt decreased from 2019-2020 –those companies exited the investment grade universe entirely and joined the high yield universe. So the IG universe increased its quality by subtraction, not by improving its credit metrics. Many of these companies that were downgraded to junk have since repaired their balance sheets and some will earn upgrades and will be returning to investment grade in 2022, boosting the number of lower rated IG companies by the end of the year. Additionally, there are a relatively large number of rising stars within the high yield ranks currently that were not previously rated IG, many of which will be earning upgrades throughout the year. Taking it altogether, there is a good chance that year end 2022 will mark a new high for the proportion of Baa-rated credit within the Corporate Bond Index.

The purpose of this example is not to show that all Baa-risk is bad, because that is not the case. Consistently, the worst performers in IG credit are those companies that move from Aa or A rated down to Baa. On the other hand, some of the best performing credits are those companies that are currently high yield or split rated (half high yield, half investment grade) with the potential to improve their credit metrics and earn a full investment grade rating. We believe that 2022 will offer opportunity, both in the form of identifying such companies and by avoiding those weakly positioned A-rated credits that will join the ranks of the growing Baa-rated cohort. This is one of the reasons that you will see us occasionally invest in companies with just one IG rating and up to 1 or 2 HY ratings. It is usually because we expect the company to become fully IG-rated and we want to take advantage of associated spread compression for our clients. We also do not hamper ourselves with “automatic sale” rules in the event that a current portfolio holding loses IG ratings by getting downgraded to HY. Instead we will rely on our credit research to determine if it makes sense to continue to hold the bonds of a downgraded company and if it has a chance to regain IG status over our investment time horizon. The Baa-universe is chock full companies with bonds that trade at unattractive valuations from a risk reward standpoint. We are looking to provide our clients with a return that is equal to or greater than the Corporate Index but we want to do so by incurring less volatility –hence our structural underweight of Baa-rated credit versus the index. At the end of the day the only way an investor can identify these opportunities is by blocking and tackling and good old fashioned credit work which is one of the cornerstones of our investment grade program and but one of the ways we will look to add value for our clients in the year ahead.

The Federal Reserve & The “I” Word

At its November meeting, the Fed signaled its intent to complete the tapering of its asset purchases by the end of June. However, the landscape had changed by the time the December 15 meeting came around, and in a move to combat rising inflation, the Fed accelerated its tapering timeline. The Fed now expects to finish its taper by the end of March which would create the potential for a Fed Funds rate hike as soon as its March 16 2022 meetingiii. With the end of tapering occurring in the near term, it will be quite interesting to hear the Fed’s plans for the central bank’s $8.76 trillion asset portfolio. Discussions are ongoing and will continue at the January 2022 FOMC meeting but Chairman Powell and other Fed officials have hinted that shrinking the asset portfolio could be another arrow in the quiver that it may use to rein in inflationiv. It could be that the Fed elects to play it very slow with increases in the Fed Funds Rate, instead relying on balance sheet reduction to slow the economy and cool inflation toward its long term target level of 2%. The Fed believes that inflation will slow in the second half of 2022 and this is in line with the consensus view of most economists. In short, we believe the Fed will use all the tools at its disposal to make this a reality even if it means they must use some measures to slow economic growth.

Wrap It Up
2022 is poised to be an interesting year for the credit markets. Although we don’t expect wild swings in the level of credit spreads there could be some pockets of rate-driven volatility at times throughout the year as the Fed embarks on its first tightening cycle since 2018. Inflation will remain at the forefront and time will tell if those pressures ease in the second half of the year. The pandemic enters its third year and geopolitical uncertainty looms as it pertains to Russian and the Ukraine, both of which could impact risk assets or spark a flight to quality. The case for Investment Grade as an asset class today is for its downside protection, diversification and income generation. The time will come when total returns move back to the forefront but it is hard to make an argument for more than coupon-like returns in the current environment. Investors with strategic goals and medium to long time horizons have recognized the benefits of a permanent allocation to IG credit.

We wish you a happy and healthy 2022. We will be doing our best to navigate the credit markets in a successful manner and we appreciate the trust you have placed in us as a manager of your hard earned capital. As always, thank you for your business and please do not hesitate to reach out to us with any questions or comments.

i Wells Fargo Securities, January 3 2022 “Credit Flows | Special FY 2021 Edition”
ii Bloomberg, January 3 2022 “US GDP Economic Forecast Real GDP (YoY%) (78 responses)
iii Federal Reserve Open Market Committee, December 15 2021 “Statement Release”
iv The Wall Street Journal, January 4 2022 “Fed Weights Proposals for Eventual Reduction in Bond Holding”

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.

15 Oct 2021

2021 Q3 Investment Grade Quarterly

Investment grade corporate credit finished the third quarter little changed from where it began the period. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index ended the third quarter at 84 just modestly wider from where it started at a spread of 80.

Treasuries finished the quarter nearly unchanged as well. The 10yr Treasury opened the 3rd quarter at 1.47% and closed at 1.49%. There was some volatility along the way, as the benchmark rate closed as low as 1.17% near the beginning of August with much of its move higher coming in the last week of September.

It has been a relatively low volatility year for investment grade credit spreads with the Corporate Index having traded so far this year within its narrowest band since 2006, with a spread range of just 20 basis points. The index saw its tightest level when it closed at 80 the last day of June and its widest level of 100 in early March. For context, during the volatile year of 2020, the index saw a range of 280 basis points. The index traded in a range of 64 and 68 basis points in 2019 and 2020, respectively.

There are several reasons why we believe volatility has been subdued thus far in 2021. First, demand for investment grade credit as an asset class has been very strong which can be supportive of lower volatility and tighter credit spreads. According to data compiled by Wells Fargo Securities, there has been over $300bln in fund flows into investment grade credit through September 29.i A second reason we believe there has been less volatility is due to low net new issue supply. Gross supply has exceeded $1.1 trillion in 2021, the second busiest year on record.ii However, a closer examination of the numbers reveals that much of 2021’s supply has been for the replacement of existing higher cost debt. After subtracting tenders, refinancing and maturities, that $1.1 trillion gross supply figure gets whittled down to less than $300bln in net new issue supply through the end of the third quarter.iii Simply put, demand for credit has overwhelmed available supply. Finally, investment grade companies have strong balance sheets and high cash balances. Combining this strength with a yield starved environment and a “risk-on” sentiment has created a feeling among some investors that there is very little risk at the moment in IG credit and we believe this is the largest factor that has contributed to low volatility

Although most companies in IG credit are well positioned, this is an environment where investors need to tread especially lightly and do their homework on each individual company. Yes IG credit is generally in good or even great condition. Many companies issued debt during the worst of the pandemic because they wanted to shore up liquidity in the face of uncertainty. As a result, gross leverage is still elevated from pre-pandemic levels. Much of the cash that was borrowed is sitting idle on company balance sheets. As an additional consequence of the pandemic, there are scores of companies that paused share buybacks in 2020 or even dividends and have yet to resume them. There will be pressure from shareholders to resume these activities as well as additional shareholder remuneration. Management teams and boards have stockpiles of cash and may be tempted by ample M&A opportunities at some of the richest valuations the market has ever seen. It is important for a bond manager to identify those companies that are committed to maintaining or repairing the health of their balance sheets and to avoid those that will use excess liquidity for pursuits that are negative for bondholders. Shareholder rewards and M&A are fine as long as they are done within the confines of the balance sheet. It is when these activities rise to excess levels resulting in downgrades from A to BAA or from BAA to junk that it starts to impair total return potential for bondholders.

In a move that was largely expected at its September meeting the Federal Reserve said that it could start to reduce its $120 billion in monthly asset purchases as soon as its next scheduled meeting in early November. The tapering messaging has been deliberate and carefully crafted, and although there has not yet been a formal decision, Chairman Powell said that it would be a gradual process “that concludes around the middle of next year is likely to be appropriate.”iv
It has received much less press coverage but we would argue that the Fed began the tapering process back in July when it started selling down its corporate credit facilities. Recall that during the height of the crisis in March of 2020, the Fed went to extraordinary measures and began to purchase corporate bond ETFs as well as individual corporate bonds. The maximum size of the facility was $750bln, but at its peak the facility only grew to $14bln. The Fed quietly exited all of these positions by September 1 with no discernible market impact.v Clearly, the program was a success and it did much to reinstall confidence in the credit markets at a time when it was desperately needed.
As far as the federal funds rate is concerned, the September meeting was slightly more hawkish than expectations but again the message was clear that tapering will come first and any rate hikes will come thereafter. The committee was split on the timing of the first rate hike, with half of 18 Fed officials expecting at least one increase by the end of 2022 with additional increases forthcoming during 2023. We also expect that this will be a slow and steady process. The Fed Funds rate is a very short term interest rate and its impact is limited to the front end of the yield curve, while maturities further out the curve, like the 10yr and 30yr Treasury are much more impacted by the overall direction of the economy and inflation expectations. We think incremental increases in the Fed Funds rate are entirely manageable for corporate credit so long as the Fed keeps a watchful eye on the economy to prevent it from overheating.

We often receive questions from clients about our intermediate positioning, as our portfolios are typically invested in bonds that range from 5-10 years until maturity. A bond portfolio is generally seeking to accomplish four goals: income generation, preservation of capital, inflation protection and diversification. We believe positioning the portfolio within an intermediate maturity range helps to accomplish all of these goals but it is especially useful in limiting downside and preserving purchasing power. Intermediate maturities give the portfolio a chance to benefit if Treasury rates go lower but it also provides much more protection from rising interest rates than if the portfolio were invested in longer maturities 20 to 30 years out the curve. More importantly, it gives the portfolio a chance to generate a positive total return in environments where rates exhibit little movement, even if absolute yields are low like they are currently. The 5/10 curve is one of the most reliably steep portions of both the Treasury curve and the corporate credit curve, which is the spread that one is afforded for owning a corporate bond on top of a Treasury.

As you can see from the chart, the steepness afforded from the 5/10 portion of these curves is attractive relative to the longer portions. Take the corporate yield curve as an example (green). We get 91 basis points of additional yield by selling a bond at 5yrs and using the proceeds to buy a bond that matures in 10yrs. The way that bond math works, all else being equal, in a static rate and spread environment, we would collect 91 basis points of roll down from holding a generic investment grade corporate bond from 10yrs selling it at 5yrs. The mere 68 basis points of compensation afforded from extending from 10yrs to 30yrs pales in comparison to the intermediate positioning. The extension from 10/30 is also accompanied by substantially more interest rate risk.

Now let’s take a look at duration to provide some more context to this discussion. At September 30 2021, the modified duration of the Bloomberg Barclays US Corporate 5-10yr index was 6.47 and the OAS was 80. The modified duration of the US Corporate 10+yr index was 15.19 and the OAS was 122. One very basic measure of risk/reward we like to use is yield per unit of duration. In this instance we are receiving 12.4 basis points per year of duration if we invest in the 5-10yr index but only 8 basis points per year of duration if we invest in the 10+ portion of the index. Given the way that we at CAM view the world, by investing in the 10+ year portion of the index, we would be receiving significantly less compensation in exchange for more interest rate risk.

The big themes that will carry us into year-end are the ongoing pandemic, the domestic economy, China and the FOMC; on these topics there are more questions than answers at this point. Will the economy continue to recover or will new variants take the wind out of its sails? Will policy makers be able to offer targeted relief to those sectors of the economy that have not come close to recovering lost earnings without offering relief that is so broad that it leads to overheating? Will problems with China’s domestic economy lead to systemic issues for the global economy – for the record we think not –but could there be ramifications for certain industries? And finally, the FOMC’s November meeting looms large with the potential for an announcement on tapering asset purchases.
As we stated earlier in this missive, corporate credit is generally in solid shape but this is not a risk free asset class. Mistakes will be made by some management teams that become too aggressive amid an environment that is still rife with uncertainty and it is our job to do our best to avoid those issues for our client portfolios. We are still positioning our portfolio in a more defensive manner than the market as a whole and we do not see that changing in the near term. Please feel free to contact us with any comments, questions or concerns. Thank you for your business and continued interest.

This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.

i Wells Fargo Securities, September 30 2021 “Credit Flows | Supply & Demand: 9/23-9/29”
ii Bloomberg, September 30 2021 “IG ANALYSIS: CNO FABN Debut Leads Docket; $90-$100bn October”
iii Credit Suisse, September 13 2021 “CS Credit Strategy Daily Comment”
iv The Wall Street Journal, September 22 2021 “Fed Tees Up taper and Signals Rate Rises Possible Next Year”
v Federal Reserve Statistical Release, September 2 2021 “H. 4. 1 statistical release”

11 Jul 2021

2021 Q2 Investment Grade Quarterly

Investment grade corporate credit experienced positive performance during the quarter with a one-two punch of lower Treasury rates and tighter credit spreads. As a result, investors were able to claw back some of the losses that were incurred during the first quarter of 2021. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index compressed 11 basis points during the quarter, opening at 91 and closing at 80.

Lower Treasury rates benefited returns during the quarter as the 10yr Treasury opened at 1.74%, drifting lower throughout the stanza before finishing at 1.47%. Recall that the 10yr moved 83 basis points higher during the first quarter which was the primary driver of negative performance during that period. The Corporate Index posted a total return of +3.55% during the second quarter. This compares to CAM’s gross quarterly total return of +2.78%. Through the first six months of 2021, the Corporate Index total return was -1.27%, while CAM’s gross year-to-date total return was -0.81%.

Portfolio Management & Positioning

We often find ourselves fielding questions from investors regarding the difference between our portfolio and the investment grade universe so we will walk through and refresh some of the ways that we differentiate. We build our investors highly customized separately managed accounts. Unlike a mutual fund or ETF, our clients know what they own within their portfolios down to the exact issuer and quantity. This is important for the individual investor because of the complete transparency it provides. Each individual account will be built with 20-25 positions. The invest-up period will occur over what we like to refer to as an abbreviated economic cycle, generally a period of 8-10 weeks that allows us to invest over a myriad of rate and spread environments.

Relative to the Bloomberg Barclays Corporate Index, we would best be described as “index aware” rather than looking to track or hug the benchmark. At the end of the day, we aim to provide our investors with a return that is as good or better than the Corporate Index but we would like to get there by taking less credit risk and less interest rate risk while incurring limited volatility along the way.

We manage credit risk through our bottom up research process. We thoroughly study each holding within the portfolio, evaluating individual credit metrics, looking to populate our investor portfolios with stable to improving credits that provide an opportunity to benefit from credit spread compression. Our composite consists of 100 issuers and 340 individual bond issues. The Corporate Index had 6,817 individual issues at the end of the second quarter, 4,290 of which would be classified as intermediate maturities, where we primarily invest. Simply put, we are highly selective while populating our investor portfolios and our research process dismisses a large percentage of the investable universe. We also have some hard and fast rules on the quality of our portfolio, the biggest of which is our 30% limitation to BAA-rated credit. BAA-rated bonds represent the riskier portion of the investment grade universe and the corporate index was 51.4% BAA-rated at the end of the second quarter, leaving CAM with a material underweight in lower quality credit relative to the index. Our up-in-quality bias allows us to target a solid A3 rating for each individual separately managed account.

As far as interest rate risk is concerned, we limit ourselves to intermediate maturities. During the invest-up period, we will populate new portfolios with maturities that range from 8 to 10 years. Then we will take advantage of the steepness of the 5/10 Treasury curve as well as the slope of the intermediate corporate credit curve, allowing those bonds to season, rolling down to the 5 year mark, at which point they will be ripe for sale and opportunistic redeployment of proceeds back into the 8-10 year range. This is one of the reasons we advise our investors to look at our portfolios with a 3-5 year time horizon, at a minimum, if they would like to get the most out of the strategy. As a result of our intermediate positioning, our composite modified duration at the end of the second quarter was 6.4 while the Corporate Index had a modified duration of 8.7.i We wrote at length on curves in our 1st quarter 2021 commentary and would encourage you to revisit if you would like to learn more.

As always, although we are attempting to maximize total return, the primary focus of our strategy is preservation of capital. We are not infallible but rarely will you see us pick up pennies in front of the proverbial steam roller to eke out a few extra basis points of return. Our decision process always comes down to risk and reward and although we will certainly take risks for the right reasons, our investors must be appropriately compensated.

Current Market Conditions

2020 will be a year that was remembered for liquidity runway, something that is not often associated with investment grade rated borrowers. Due to the uncertainty surrounding the depth and severity of the pandemic, we saw issuers rush to the new issue market in 2020 in an effort to bolster their balance sheets. In many cases, these were extremely high quality issuers who did not necessarily need to borrow, but at that time the mentality had become “borrow when you can, not when you have to”. Records for new issuance volume were shattered in 2020 as a result of this borrowing binge and the Corporate Index (excluding Financials) net leverage ratio rose from 2.5x at the end of Q1 2020 to 3.6x at the end of Q4 2020.ii There is evidence that the peak has passed as net leverage has since ticked down to 3.5x at the end of Q1 2021.iii It stands to reason that now, as North American economies are largely re-opened or getting more open by the day, we will continue to see an increase in earnings by those sectors most affected by the pandemic. There is reason to be optimistic about credit conditions as earnings rebound, borrowing abates and debt pay down follows suit. That said there are several risks that continue to loom through 2021 and beyond: lingering worries regarding inflation, Federal Reserve tapering and tight spread valuations amid a backdrop of eager lenders.

The first two risks really go hand in hand –mounting inflationary pressures and the associated FOMC response. It is likely that each of our readers has experienced price increases in one way or another but the Fed insists that much of these will be “transitory” in nature. We tend to agree with the Fed on this one and we revert to the official definition of inflation which is an unrelenting broad-based and sustainable increase in prices across the board. We, like the Fed, would argue that just because the cost of some goods have increased due to things like inventory and production shortages or a disruption of the semiconductor supply chain, it does not mean the table is set for runaway inflation. We believe that as inventory levels are right-sized and household balance sheets deploy excess capital, supply and demand will find equilibrium over time. Additionally, there are still millions of Americans that are unemployed and as federal unemployment assistance reverts to more normalized historical levels it will result in easing price pressures as workers rejoin the labor force. As far as the FOMC response is concerned, the results from the June meeting showed that the median projection is for an unchanged Fed funds rate in 2021 and 2022 with two rate hikes in 2023. While rate hikes are important for the front end of the yield curve, it is tapering that is the more immediate concern, in our view. We argue that technically the Fed has already begun tapering with its exit from the corporate bond market and the sale of its holdings which began in June of this year.iv Its corporate bond holdings, however, were miniscule in the grand scheme of things, at less than $14 billion total. Much larger pieces to this puzzle are its monthly purchases of Treasury securities at $80 billion and mortgage-backed securities at $40 billion. The Fed has yet to supply a timeline of when it will start to normalize its policy, perhaps dialing back on these purchases, but the market is now expecting a possible announcement on tapering at the end of August during the Fed’s Jackson Hole policy symposium. We think that the Fed will continue to be deliberate and cautious in its messaging and that it will be able to avoid a taper-tantrum like event, but we do acknowledge the risks associated with this view.

As far as the credit market goes, we do have some concerns about current valuations in some portions of the market but we also believe spreads can go tighter from here, especially in more non-discretionary sectors. The areas of uneasiness are largely corners of the market that are highly levered to reopening such as automotive, unsecured airlines, leisure, gaming, lodging and restaurants. The bonds of many of these companies are priced to perfection and some of the companies have borrowed to fund their way through the pandemic. It will take time to repair these balance sheets and unless the rosiest of reopening scenarios come to fruition these companies will not be able to remain investment grade rated entities. We are taking little to no exposure for our portfolio in these areas and ironically they have been some of the best performing portions of the bond market year to date. This illustrates our point about lenders and investors that are perhaps too eager to lend to such entities and what we would classify as classic “reach” in the search for yield. We may sacrifice some near term performance by not participating in these riskier areas of the market but we manage the portfolio with an eye on the long term and will continue to do so. While there is a risk that we could be wrong and these sectors will in fact live up to the most optimistic predictions, we remain skeptical.

Halfway Home

We have a sense of guarded optimism as we enter the second half of the year but risks remain. Unfortunately, the pandemic is not over and continues to rage on in some portions of the world. Thankfully, vaccination progress has the potential to achieve global normalization over the course of the next year, but variants and vaccine-resistant strains could threaten this timeline. The FOMC will remain in the spotlight as it attempts to manage investor expectations and craft its moves carefully. We at CAM plan to stick to the script. We will not be making wholesale changes to our strategy and we will likely be taking less risk than usual in the coming months given the current risk reward backdrop we are seeing in our market. Please reach out to us with any questions or concerns. We thank you for your continued interest and for placing your trust and confidence in us to manage your money.

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 A representative sample of a newly invested individual separately managed account had a modified duration of 8.4 at 06/30/2021
ii Barclays, June 23 2021 “US Investment Grade Credit Metrics Q1 21 Update”
iii Barclays, June 23 2021 “US Investment Grade Credit Metrics Q1 21 Update”
iv Reuters, June 2 2021 “NY Fed says it will begin to sell corporate bond ETFs on June 7”

09 Apr 2021

2021 Q1 Investment Grade Quarterly

It was a challenging first quarter for corporate bonds as rising interest rates were a headwind for performance across the fixed income universe. Investment grade credit spreads were a bright spot, having shown resiliency during the quarter, but tighter spreads could not overcome volatile interest rates. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index compressed 5 basis points during the quarter, opening at 96 and closing at 91. It was only a little more than a year ago when the global pandemic had roiled markets, sending the spread on the index all the way out to 373. The tone has improved substantially since last March and spreads are now tighter than their narrowest levels of last year when the index opened 2020 at an OAS of 93.

Higher Treasuries were the negative driver of performance for credit during the quarter. The 10yr Treasury opened 2021 at 0.91% and was volatile along the way before closing the quarter at 1.74%. This 83 basis point move in the 10yr over such a short time period was too much to overcome for coupon income and spread compression. The Corporate Index posted a total return of -4.65% during the first quarter. This compares to CAM’s gross quarterly total return of -3.50%.

First Quarter Recap

Excess return presents a picture of the performance of credit spread and coupon income, excluding the impact of Treasuries. The sector that posted the best excess returns to start the year was Energy. This should come as no surprise as oil prices were up over 20% during the quarter and Energy was the worst performing sector for the full year 2020. It was ripe for a rally. Packaging was the lone major industry to post a negative excess return during the quarter of just -0.05%. This is in line with the larger theme in the market currently that has made more cyclical sectors in vogue as the pandemic recovery trade was in full force. This has left some more stable and defensive industries as out of favor at the moment. The recovery trade theme has also led to outperformance for riskier BBB-rated credit versus higher quality A-rated credit. BBB-rated credit outperformed A-rated during the quarter to the tune of 85 basis points on a gross total return basis – a significant number to be sure. We will see, as the year plays out, if this reach for yield can sustain its outperformance over a longer time horizon. We believe that some of the move in cyclicals has been overdone and as a result the portfolio is positioned with a more defensive posture than the index.

Investing in a High Rate World

After the corporate index posted a cumulative gain of almost 25% over the previous two years through the end of 2020, most of it on the back of tighter spreads and lower rates, it is fair to expect a pull-back at some point. The current quarter’s performance can almost entirely be defined by Treasuries reclaiming some of the ground that they gave up during the pandemic. Recall that the 10yr Treasury closed as high as 1.88% in the early months of 2020 before falling as low as 0.51% in August of last year and now closing the first quarter of 2021 at 1.74%. But there is more to the story than a higher 10yr Treasury and a closer look at the Treasury curve reveals some more interesting details, particularly the spread between the 5yr and 10yr Treasury. As you can see from the below chart, the 5/10 Treasury curve has steepened substantially over the course of the past year.

CAM consistently positions the portfolio in maturities generally ranging from 5-10 years and there are several reasons that we have structured our investment grade program around this intermediate positioning. First, our customers will know precisely what they are going to get from us in that they can see the exact quantity of each individual company bond that they own and they can count on us to be positioned within a certain maturity band. This allows the client to more effectively manage other portions of their asset allocation accordingly without worrying that we might engage in interest rate speculation or a wholesale change in strategy. The second reason we have settled on this maturity positioning is that it exposes clients to less interest rate risk than the benchmark and far less interest rate risk than if we went further out the curve by purchasing 30yr bonds. We are good at credit work; building customized portfolios, populating them with individual credits based on our analysis of their credit worthiness and reaping those rewards over a 3-5 year time horizon. Our intermediate positioning allows our returns to be driven by credit spread compression and not by our ability to accurately time interest rates. The third and perhaps most important reason that we settled on this intermediate positioning as part of our core strategy has to do with the steepness of both the Treasury curve and the corporate credit curve from 5 to 10 years. Over long time periods this tends to be the steepest portion of both of those curves relative to the curve as a whole.i To provide some context, at quarter end, the 10/30 Treasury curve was 67 basis points; that is, the compensation afforded for selling a 10yr Treasury and buying a 30 year Treasury was an additional 67 basis points in yield, or 3.35bps of yield per year for each year of the 20 year maturity extension. If we compare this to the 5/10 curve at quarter end when that particular curve was 80 basis points, or 16 basis points of extra yield for each of the 5 years between 5 and 10yrs, you can see that the 5/10 curve is significantly more steep than the 10/30 curve. You are extracting much more compensation from selling a 5yr bond and extending to 10yrs than you would get from selling a 10yr bond and moving all the way out to 30 years. Not only is an investor being much better compensated for each additional year from 5/10 but they are taking substantially less interest rate risk by limiting their extension to just 10 years in lieu of 30 years. As you can see from the above chart, the 5/10 curve flattened all the way down to 7 basis points during the worst of the pandemic-related market dislocation but it has since steadily risen, and is now at its highest level since the 3rd quarter of 2014.

To say we are excited about this newfound steepness in the Treasury curve would be an understatement –we are ecstatic, as it allows us to do two things. First, it allows seasoned accounts (those who have been with us at least 3-5 years) to extract attractive compensation by selling their 5yr corporate bonds and using those proceeds to purchase bonds that mature in 8 to 10 years. For those accounts that have been with us for less time or for new accounts it provides an attractive entry point for new money that can take advantage of the roll-down afforded by the steep yield curve. The roll-down to which we refer is the aforementioned 16 basis points per year that a bond was receiving at quarter end for each year that it declined in maturity.
But the bond math doesn’t stop there. On top of the Treasury curve is another curve, the corporate credit curve. Since corporate bonds trade with spread on top of Treasuries they also have their own curve that varies with steepness over time. The shape of the corporate credit curve is more consistently upward sloping than the Treasury curve. Treasury curves, at times, can flatten or even invert. The corporate credit curve on the other hand is almost always upward sloping.ii It only rarely flattens or inverts on a temporary basis during times of extreme market stress or dislocation, and we are happy to take advantage of those fleeting opportunities when they do appear.

As you can see from the chart above, the yield curve for investment grade corporates shares some of the current qualities of the Treasury curve with a pronounced steepness in the belly of the curve and a much flatter slope beyond 10 years. The beauty of these curves is that, even in the unlikely event that Treasuries and credit spreads stay static over the next 5 years we can still generate a positive total return from coupon income and capital appreciation through the roll-down of bonds currently held. Additionally, the steepness afforded by curves currently offers us some protection from rising rates and/or wider credit spreads.

Our proven strategy seeks to provide clients with a transparent separately managed account that provides a return that is good as or better than the Bloomberg Barclays U.S. Corporate Index. We also want to get them there with less volatility through diminished interest rate risk and credit risk along the way. One of the reasons we outperformed the index by 115 basis points during the first quarter was by virtue of our intermediate positioning. Our portfolio ended the quarter with duration of 6.30 while the index had duration of 8.48.

Looking Ahead

Preservation of capital is at the forefront of our strategy so we hate to post a quarter with a negative total return and we know that our investors feel the same way. Thankfully, given the way that bond math works, and especially for investment grade rated credit, such impairments are typically temporary in nature. Take for example a bond that is trading at a discount to par –as time passes and it gets closer to its maturity date, its price gets closer to par, all else being equal. Discount bonds eventually recapture their value as time goes by – it is just a function of the way that the math works. As regular readers know, even in good times after we post a great quarter, we are loath to focus on such short term performance. Investment grade rated corporate credit is at its best when it is treated as a strategic long term allocation that is part of a well-diversified portfolio. In fact, one of the reasons to own this asset class is to aid in that goal of achieving diversification due to its low correlation with other asset classes and its often negative correlation with equities. Bottom line, if an investor is looking for income, diversification and capital preservation as well as a chance to keep up with and/or beat inflation, then investment grade credit is among the ideal asset classes for helping to achieve those goals. After a volatile first quarter we have a guarded optimism and believe there is an attractive opportunity set for our investment philosophy going forward. We thank you for your continued interest and for placing your trust and confidence in us to manage your money.

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 Federal Reserve Board, June 2006 “The U.S. Treasury Yield Curve: 1961 to the Present”
ii Robert C. Merton, May 1974 “On The Pricing of Corporate Debt: The Risk Structure of Interest Rates

08 Jan 2021

Q4 2020 INVESTMENT GRADE COMMENTARY

Investment grade corporate bonds rode a roller coaster in 2020 so it should be no surprise that, after peaks and valleys, spreads finished the year nearly right where they started. The option adjusted spread (OAS) on the Bloomberg Barclays US Corporate Bond Index opened the year at 93, but soon thereafter, pandemic induced uncertainty gave way to panic stricken selling, sending the OAS on the index all the way out to 373 by the third week of March– its widest level since 2009, during the depths of The Great Recession. On March 23, the Federal Reserve announced extensive measures to support the economy and liquidity within the bond market and spreads reacted in kind, grinding tighter. There were pockets of volatility along the way, but absent a few hiccups it has been a one-way trade of tighter spreads since the end of March, with the OAS on the index finishing 2020 at 96; a mere 3 basis points wider on the year.

Lower Treasuries were the biggest driver of performance for credit during the year. The 10yr Treasury opened 2020 at 1.92% and closed as low as 0.51% at the beginning of August before finishing the year at 0.91%. The Corporate Index posted a total return of +3.05% during the fourth quarter and a full year total return of +9.89% for 2020. This compares to CAM’s gross quarterly total return of +1.86% and full year gross return of +8.73% for 2020.

2020 Investment Grade Returns – What Worked & What Didn’t?

The big winner in 2020 was duration, with lower rates leading to higher prices for bonds, all else being equal. Although the Corporate Index was up almost 10% for the year, excess returns, which measure the performance of corporate credit excluding the benefit of lower Treasury rates, were modest. The sectors that posted the best excess returns in 2020 were Basic Industry, Technology and Financials. At the sector level, Energy was the worst performer with an excess return of -5.97%, with particular underperformance for Independent Energy, which as an industry posted a 2020 excess return of -11.27%. Also at the industry level, Airlines predictably underperformed, with a 2020 excess return of -8.91%.

What to Expect in 2021?

With equity indices at all-time highs and yields on corporate bonds at all-time lows, where do we go from here? In our opinion, the theme for 2021 should be one of guarded optimism. Vaccinations have been approved and are being administered and there are more in the pipeline. Healthcare providers have become more adept at managing care and therapeutic treatments are more readily available. The policy response from the Federal Reserve has been strong and the Fed stands ready and willing to lend more support if it is needed.

As far as investment grade bonds are concerned, we expect a transition to occur as we enter 2021 and that the script will flip from 2020’s broad based risk rally to more of a credit pickers environment in 2021, where bottom up fundamentals become more important and investment managers must carefully evaluate the risks and potential rewards for each individual position within a portfolio. Credit spreads and Treasuries are beginning the year at levels that do not set-up well for the type of returns we experienced in 2019 and 2020, when the corporate index tallied gains of +14.54% and +9.89%, respectively. But outsize returns over short time horizons are not the best case for owning investment grade corporate bonds. Advisors and clients that we talk to favor investment grade corporate bonds for their low volatility, the diversification benefit they provide to an overall portfolio or their ability to generate income in a safer manner than relatively more risky asset classes. These traits are magnified over longer time horizons and thus the asset class lends itself to being more strategic in nature as an allocation within a portfolio.

As we turn the page to the New Year we see several factors that could lend support to credit spreads in 2021.

  • Lower New Issue Supply in 2021 – Investment grade borrowers issued nearly $1.75 trillion of new debt in 2020 which shattered the previous record by 58%i. Bond dealers are expecting as much as $1.3 trillion of issuance in 2021, but most estimates are falling around $1.1 trillion. Even at the high end of the estimated range, the expectation is for substantially less supply. Demand overwhelmed supply the last several months of 2020 as evident by oversubscribed order books and narrow new issue concessions (the extra compensation/yield that issuers use to compensate investors in order to entice them to buy their new bonds versus their existing bonds). An environment with excess investor demand is supportive of spreads in the secondary market.
  • It’s Just Math: Global Edition – Even though US nominal yields are low, they are still meaningfully higher than foreign investors can find elsewhere. There was $17.8 trillion in negative yielding debt around the globe at the end of 2020ii. The following developed countries had negative 10yr sovereign bonds at conclusion of the year: France, Germany, Netherlands, and Switzerland. Sweden had a 10yr yield at year end of 0.009% and Japan was at 0.013%. Simply put, foreign investors have very few options, and many, such as pensions and insurance companies, must generate a return by investing in high quality assets. The U.S. investment grade credit market is the largest, deepest and most liquid bond market in the world by an order of magnitude. There is some nuance at play here in that these investors must account for hedging costs and that can cause demand to ebb and flow at times but they will remain an important fixture in our market for the foreseeable future and their demand is a technical tailwind for spreads.
  • Improving Economy – We expect that the economy will see solid improvement in 2021 but that it will be highly industry/company specific. Some industries are still significantly impaired, and some will be impaired permanently. There will be some opportunities in industries that are facing temporary headwinds. As earnings recover it will be important for an investment manager to differentiate among those companies who will use the earnings recovery for balance sheet repair versus those who may choose to engage in M&A, shareholder rewards or adopt a more aggressive financial policy by operating with higher leverage.
  • Yields are Low, but Curves are Steep – Of particular importance to an intermediate manager like CAM, is the steepening that we have seen in the 5/10 Treasury curve. If you are a repeat reader, you know that we are interest rate agnostic and that we typically buy 8-10yr bonds and allow those bonds to roll down the curve to 4-5yrs before we sell and redeploy the proceeds back out the curve. The 5/10 curve ended the year at 55 basis points which was near its highest levels of the year, after averaging less than 35 basis points during 2020. For context, the 5/10 curve closed above 30 on only one day for the entire two year period from the beginning of 2018 to the end of 2019. A steeper curve allows for more attractive extension trades and offers better roll-down potential for current holdings. It is a mechanism that allows a manager to generate a positive total return despite a low rate environment.

Like any investment process, there are risks to our view as well.

  1. Inflation – We think that 2021 will be a year that is rife with inflation scares and that it could lead to volatility in Treasuries and corporate bond valuations. In fact, the first trading day of 2021 generated a headline as the 10yr breakeven rate surpassed 2% for the first time in over 2 yearsiii. The breakeven rate implies what market participants expect inflation to be in the next 10 years, on averageiv. We do think that we will see inflation in 2021 but that it will be isolated pockets of higher prices confined to specific sets of circumstances. We have already seen this happen for some goods, such as lumber and building materials and we expect to see the same when demand increases for items like airline travel and indoor dining. The official definition of inflation, however, is a broad based and sustainable increase in prices. The U.S. consumer has been resilient, but consumer spending has been biased toward upper middle class and high income households who have been less affected financially by the pandemic. The overall unemployment rate remains high at 6.7% and it is significantly worse for those workers with lower educational attainment. The unemployment rate for those 25 years and over with less than a high school diploma is 9% and those with a high school diploma and no college is 7.7% while those with a bachelor’s degree or higher have a 4.2% unemployment ratev. In our view, without a more complete recovery across the entirety of the labor market, it is unlikely that the economy will experience significant inflation.
  2. Slower Economic Recovery – Risk assets are at all-time highs and it appears that good news surrounding vaccines and economic recovery is fully priced as far as valuations are concerned. This leaves little room for error if expected outcomes do not meet lofty expectations. Domestically, the initial vaccine rollout fell short of its goal, having administered only 4.2 million doses by year end versus a target of 20 millionvi. The scientific community is also concerned with new variants of Covid-19, with the UK strain having recently been identified in the U.S.vii and some epidemiologists’ are questioning vaccine efficacy on a newly identified strain found in South Africaviii. We are also concerned about the lingering economic impact that the pandemic may have on small business. While small business optimism has rebounded smartly from the depths of the crisis, many of these firms do not have the financial wherewithal to survive a more prolonged recoveryix.

CAM’s Portfolio Positioning

Our investment strategy has remained consistent in its approach, with a focus on bottom-up fundamentals. It was a challenging year that required constant adaptation to market conditions and the investable opportunity-set at any given point in time. In March and April, we were extremely involved in the new issue market, as concessions rose and high quality borrowers tapped the market to shore up their balance sheets. We were also able to invest in shorter maturities as forced selling caused dislocation across corporate credit curves creating opportunities to buy shorter bonds at yields that were equal or greater to longer maturities. As market conditions normalized throughout the second half the year, we took a more balanced approach between the new issue market and the secondary market. Our focus remained biased toward higher quality credit and sectors of the market that were less levered to the re-opening of the economy and those industries that benefited from more work and leisure time spent at home. As we head into the first quarter of 2021 we continue to favor companies with strong balance sheets and stable credit metrics as the entire market has continued to rally into the New Year. As spreads and yields compress, the incremental compensation afforded from taking additional credit risk has skewed risk-reward to the downside. The “buy the dip” trade has played out in our view and we are scrutinizing the capital allocation strategies of each of the companies in our portfolio. 2021 could be the year were there is a more clear bifurcation between those companies who will exit the pandemic stronger and those who will languish because the business is saddled with too much leverage and unable to effectively compete in the marketplace. As always, preservation of capital will continue to be at the forefront of our decision process.

We wish you a happy, healthy and prosperous New Year. Thank you for your business and continued interest.

This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness.

i Bloomberg, December 15, 2020 “Freeze to Frenzy, Corporate Bonds Bounce Back”
ii Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value USD
iii Bloomberg News, January 4, 2021”Treasuries Inflation Gauge Exceeds 2% for First Time Since 2018”
iv Federal Reserve Bank of St. Louis (T10YIE)
v U.S. Bureau of Labor Statistics, December 4, 2020 “Employment status of the civilian population 25 years and over by educational attainment”
vi The Hill, January 4, 2021, “Operation Warp Speed chief adviser admits to ‘lag’ in vaccinations”
vii The Wall Street Journal, January 4, 2021, “Highly Contagious Covid-19 Strain Has Been Found in New York State, Gov. Cuomo Says”
viii Bloomberg, January 4, 2021, “South African Covid Strain Raises Growing Alarm in the U.K.”
ix NFIB, December 8, 2020, “NFIB Small Business Economic Trends – November”

08 Oct 2020

2020 Q3 Investment Grade Commentary

Corporate credit turned in a solid performance during the third quarter. Spreads were tighter, with the option adjusted spread on the Bloomberg Barclays U.S. Corporate Index opening the quarter at 150 and closing the quarter at 136. Treasuries were almost unchanged on the quarter with the 10yr Treasury opening at 0.66% and closing at 0.68%, but that does not tell the whole story of the volatility that was experienced throughout the period. The 10yr closed as low as 0.51% on August 4th and as high as 0.75% on August 27th with the average coming in at 0.64%. The Corporate Index posted a total return of +1.54% during the quarter with a year-to-date tally of +6.64%. This compares to CAM’s gross quarterly total return of +1.76% and year-to-date gross return of +6.74%.

Investment Grade Bonds – Where is The Value?
We have been at this a long time and the lightning quick risk reversal we have experienced in 2020 is the type of thing that only comes around once every decade or so. Going back to March 20, the Corporate Index closed that day with a year-to-date total return of -10.58%, but quickly rebounded over +17.2% through the end of the third quarter, a period of just over 6 months from the low. In March, the risk reward for corporate credit was very attractive, especially for extremely high quality A-rated credit. The spread on the Corporate Index traded north of 370 during the spring malaise, a level not seen since the financial crisis in early 2009, which is the last time we saw such a tremendous spread rally.

Now that the market has rallied so far so fast, clients are asking about the valuation of IG credit. Some clients are even wondering if it is worth owning IG bonds at all. For most investors, it is important to remember that IG credit is but one part of a well-diversified portfolio. Most of our clients own IG credit as a way to generate income, diversify away from equities or dampen overall portfolio volatility. We think that IG credit is still attractive for a few reasons and that the asset class still has a key part to play in an investor’s overall asset allocation.

Spreads still present opportunity in our view, particularly when looking at the percentage of yield that is comprised of credit spread. Remember that there are two components of yield as a corporate bond investor: the yield of the underlying Treasury at the time of purchase and the corporate credit spread on top of that Treasury yield. For example if the purchase of a security occurred while the 10yr Treasury was 0.70% and the corporate credit spread of the security was trading at 200 basis points then the yield to maturity for that particular bond purchase would be 2.70%. In this case we would calculate the spread component of our overall yield by dividing 200/270bps arriving at a figure of 0.74%, which is very high by historical standards.

As you can see from the above charts, as the yield on the index has fallen, the percentage of yield that is comprised of credit spread has risen. This gives us two items that make us feel reasonably optimistic about the current level of spreads. If the economy is slow to recover from the pandemic, and Treasury rates remain near historical lows for an extended period, then spreads could well grind tighter, to a ratio that is more in line with the historical level of compensation relative to interest rates. On the other hand, if the economy recovers more quickly than the market currently anticipates, then we would expect a gradual increase in interest rates toward pre-pandemic levels. In the “quicker recovery” scenario, because the economy would be improving, then the path of least resistance would be tighter credit spreads which would help to offset rising interest rates. Recall that the spread on the index opened the year at 93 versus 136 at the end of the third quarter, so it is not hard to imagine tighter credit spreads from current levels amid an environment of more robust economic growth.

We are also monitoring several technical tailwinds that could be supportive of credit spreads for the remainder of 2020 and beyond. First, investor demand for corporate credit has been robust in 2020, with over $203 billion in net inflows into high grade funds through the end of the third quarteri. Second, there has been a resurgence in the foreign bid for $USD credit. The Bloomberg Barclays Global Aggregate Negative Yielding Debt Index closed September at -$15.5 trillion, not terribly far from its all-time high of -$17 trillion in August of 2019. Asia is one of the largest buyers of $USD IG credit and overnight Asian buying has been substantially positive every month for the past year and Asian demand was especially large in March, April and May of this yearii. Third and finally, we are looking for supply to slow substantially going forward. 2020 has seen a tidal wave of new issue supply as companies have been keen to meet the aforementioned investor demand with new corporate bond issuance. Through the end of the third quarter, companies had issued a record breaking $1.542 trillion in new debt, +67% ahead of 2019’s paceiii. The level of issuance has been so robust that it is unlikely to keep pace going forward as companies have largely completed their liquidity boosting and refinancing endeavors. We expect that companies in certain sectors that are more exposed to the economic slowdown will continue to tap the market for liquidity, but we do not anticipate nearly as much supply from those in less affected sectors. Not only that, but M&A activity is typically a large driver of supply, and it has dwindled to a standstill amid pandemic-related uncertainly. Of 200 IG deals in the 3rd quarter, fewer than 10 were tied to acquisitions bringing the year-to-date total to 20 acquisition-related deals versus 31 over the same time period in 2019<sup>iv</sup>. Less new issue supply often creates an environment that is supportive of credit spreads as investors must put their money to work in existing bonds.

Understanding the Risks
Opportunities are not without risk. Some risks loom large, like presidential and congressional elections that are just around the corner that will determine the direction of the country for the next several years. Risks related to the elections are less about the market as a whole and more about individual securities and how they may be impacted by things like tightening or loosening of restrictions related to climate change, financial regulation or changes at the Federal Reserve which could ultimately affect monetary policy. This is where bottom up credit research comes in. Our thorough research process and relatively concentrated portfolio means we are well aware of how current and potential investments might be impacted and we eschew those investments that are exposed to adverse outcomes. As far as the Federal Reserve is concerned, there is little worry about near term changes in policy as Chairman Jerome Powell’s term does not expire until February 2022 and the prevailing thought is that he would be nominated for an additional 4-year term by either presidential candidate.

An emerging risk for passive fixed income investors that has received little attention in our opinion is the increasing duration of the investment grade corporate bond universe. In the past decade, the Bloomberg Barclays Corporate Index has seen its modified duration increase from 6.7 to 8.7 years. Revisiting the concept of duration, all else being equal, if the duration is 8.7 years, then a 100 basis point linear increase in interest rates would yield an 8.7% loss of value for a portfolio invested in the index. Investors in passively managed index portfolios probably do not realize that they are exposed to almost 30% more interest rate risk than they were incurring for the same investment just 10 years ago.

CAM’s modified duration change over the past 10 years was unchanged at 6.2 years and CAM’s duration was 2.5 years shorter than the index at the end of the third quarter. Now, CAM’s duration did exhibit slight fluctuations over the most recent 10 years, but the average during that period was 6.4 years and the range of change over the preceding 10 years was just 0.9, less than half the index range of 2.2 years. The duration gap has clearly grown between CAM’s IG composite and the Index, especially over the past 2 years, as the Index has gradually seen its duration creep higher.

Why has the Corporate Index duration increased? Low interest rates have helped, but much of the change is driven by what we call reverse inquiry. That is, demand from long term institutional investors in the corporate bond space such as pensions, insurance companies and endowments who are extremely thirsty for yield. Company Treasury departments recognized this demand and happily obliged by issuing a higher percentage of longer term debt at rates that were attractive to the company and with enough yield to satiate the institutional investors. Debt maturing in 10 years or more now makes up one-third of the overall IG Index while debt maturing in 20 years or more has grown to 22.4%v.

Why has CAM’s duration exhibited such little change by comparison? As we have discussed many times before in these commentaries, you know exactly what you are going to get when it comes to our portfolio: intermediate maturities positioned in the 5-10 year portion of the yield curve. Rather than try and “guess” the direction of interest rates we will always position the portfolio in intermediate maturities as it has historically been the best place to be from a risk reward standpoint. For example, the 5/10 Treasury curve at the end of the third quarter was 41 basis points, or about 8.2 basis points of compensation or “roll down” per year earned from holding a 10 year security until the 5 year mark. The 10/30 Treasury curve was 77 basis points, or about 3.8 basis points of compensation per year from the 30 year to the 10 year mark. Thus the 5/10 curve was significantly steeper than the 10/30 curve, and this steepness is one of the reasons CAM favors intermediate maturities. The compensation afforded for the duration risk incurred by extending beyond 10 years does not offer good risk reward in our view. Additionally, there are corporate credit curves that trade on top of these Treasury curves and these corporate curves tell a similar story. At the end of the third quarter the average A2 rated industrial bond traded at a credit spread of +45 to the 5yr, +89 to the 10yr and +125 to the 30yr. Thus the A2 industrial 5/10 curve was 44 basis points while the 10/30 curve was 36 basis pointsvi. This illustrates that an investor was being better compensated by moving from a 5yr corporate bond to a 10yr corporate bond than they were by moving from a 10yr corporate bond to a 30yr corporate bond. The major take away from this exercise is that Cincinnati Asset Management will not speculate on interest rates. Instead, we will continue to focus on the intermediate portion of the yield curve where we can add value through our robust bottom up research process and opportunistic credit selection.

Going forward we plan to stick to our script, as disciplined investors of your hard earned capital. We thank you for your interest and support. As always, please do not hesitate to contact us with any questions.

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 Wells Fargo Securities, October 1 2020, “Credit Flows: Supply & Demand: September 24-September 30”
ii Credit Suisse, October 2 2020, “CS Credit Strategy Daily Comment (IG September Recap)”
iii Bloomberg, September 30 2020, “IG ANALYSIS US: Mondelez Brings 5th Deal, Month Cracks Top Seven”
iv The Wall Street Journal, October 3 2020, “Credit Markets: Corporate Bond Sales Reach Record”
v Deutsche Bank Research, August 18 2020, “Is Duration Risk The New Credit Risk In IG?”
vi Raymond James, October 2 2020, “Fixed Income Spreads”

12 Jul 2020

2020 Q2 INVESTMENT GRADE COMMENTARY

What a difference a quarter makes. The investment grade credit market has experienced a reversal of fortune since the dark days of late March, with both spreads and returns rebounding smartly from the levels seen earlier this year.

The resumption of risk appetite led to a sharp tightening in spreads for the Bloomberg Barclays Corporate Index which closed the quarter 122 basis points tighter, moving to an OAS of 150 at the end of June versus 272 at the end of March. Spreads are still well off the lows that we saw in the first quarter of the year when the Corporate Index closed at 93 for several days in a row back in late January. Recall that tighter spreads lead to higher valuations for corporate bonds. Investment grade corporate bonds have also been a beneficiary of the increasing value of Treasuries as lower interest rates have provided a tailwind that has led to higher total returns for investment grade credit. The 10yr Treasury closed 2019 at 1.92%, 0.67% on March 31 and it saw little change in the second quarter, closing at 0.66% on June 30.

The reversal in returns is really something to behold, most especially the speed with which the move has occurred. The total return for the Bloomberg Barclays Corporate Index was as low as -10.58% on March 23, and since that time it has rallied all the way back, and then some, closing the second quarter at a year-to-date total return of +5.02%. This compares to CAM’s year-to-date gross total return of +4.89% for the Investment Grade Strategy. For context, the S&P 500 closed the second quarter with a year-to-date total return of -3.09%. CAM’s gross performance was 54 basis points better than the Corporate Index at the end of the first quarter but now trails the index by 13 basis points year-to-date. CAM’s modest under-performance year-to-date is largely a result of conservative positioning and our structural underweight to the lower rated BAA-portion of the investment grade universe. As is normally the case when markets snap back, the lower quality portion of the Corporate Index tends to outperform, so this caused CAM to give up some ground versus the benchmark.

Portfolio Construction in a Recession
The U.S. officially entered a recession in February according to the National Bureau of Economic Research.i So what does this mean for the way that we manage the portfolio? You may be surprised to find that our behavior has really only changed at the margins. Unlike an ETF or broad market mutual fund, we are looking to construct well diversified portfolios of individual bonds for our clients. Because we build separately managed accounts, our clients will know exactly what they own, in what quantity and its current valuation. No matter where we are in the economic cycle, we will always look to invest in companies that have the ability to manage through a downturn because past experience has taught us that there will always be a recession at some point, and usually when it is least expected. Cyclical sectors and industries tend to get hit the hardest in a recessionary environment and although we have some of this risk in the portfolio we are significantly underweight relative to the Corporate Index. And of course we always operate with a structural underweight on the lower echelon of riskier BAA-rated credit. If anything has changed with our behavior and thinking it is that we are cautious on businesses that have significant exposure to China as we believe that there is risk to U.S.-China trade that could manifest itself at any time.

What’s the Fed been up to?
The Federal Reserve has been quite active in its support of the corporate bond market. The Fed made its first foray into the market by dipping its toe into investment grade credit ETFs in mid-May and by mid-June the Fed had moved on to outright purchases of the individual bonds of 794 companies.ii What may prove to be interesting is where the Fed goes from here. When the original plans were announced on March 23, it was a bleak time for the capital markets. The credit markets were not functioning in a healthy manner and the fixed income ETF model had broken the very first time it faced stress. Since the Fed has made its announcement however, things have improved markedly and the market is back to behaving in a highly efficient manner.

The terms of the Fed’s current program allow it to purchase up to $250 billion of corporate debt on the secondary market. Per the most recent Fed release, it has just over $10bln in corporate bonds on its balance sheet, but the program expires on September 30, at which time the Fed will either hold the bonds it bought, allowing them to mature or it will sell them on the open market. At the current run rate of its purchases, the Fed will get nowhere close to $250 billion as the current rate implies less than $70bln in purchases per year. There are only 63 trading days between July 1 and the expiration date of the current program and it seems unlikely that the Fed’s pace of purchasing will accelerate to the point that it will be able to use almost $240bln of dry powder in just 63 trading days. So one of two things will happen: 1.) The Fed will continue to purchase bonds at its current run rate of less than $300 million per day which would put its balance sheet at approximately $29bln by September 30, less than 12% of its total $250bln capacity or 2.) The Fed will extend the expiration date of the program beyond September 30. We think that the second scenario seems the most likely and that the Fed may in fact not come anywhere close to approaching its $250bln capacity if it does not need to. If there is a spike in volatility then certainly the Fed can buy more but if things remain relatively calm, as they are now, then we believe that the Fed will continue to purchase bonds at or near the current run rate and it will reserve the right to purchase more beyond that only if it needs to do so in order to subdue fear within the markets. The market seems to be operating under the assumption that it is a foregone conclusion that the Fed will use the full amount of its facilities no matter what, but we simply disagree.

Keep on Rollin’
The new issue market has been highly topical this year as 2020 will assuredly smash the all-time issuance record which was $1.3 trillion in 2017. At quarter end, 2020 supply was running 98% ahead of 2019’s pace with $1,176.9bln in new corporate debt having been priced in the first half of the yeariii. So you may be wondering why are borrowers, in many cases extremely high quality ones with plenty of liquidity, rushing to borrow more debt? The answer really comes down to uncertainty. If the pandemic gets worse, if we don’t get a vaccine, if growth does not rebound as quickly as expected, these are all the types of questions that companies must ask themselves as they plan for the future. If a large global multinational can afford to borrow today at rates that are reasonably attractive relative to historical standards in order to shore up liquidity amid uncertainty then it is prudent to do so. As for opportunities in the new issue market, they still exist and we are still finding what we consider good value but the times of extraordinary opportunity that we saw in March and April are no longer with us for the time being. It could well be that those opportunities are, as we suspected at the time, the type that only come along once every decade or so.

Second Half Outlook
We believe valuations have recovered to the extent that pockets of volatility in the credit markets may now start to occur with more frequency. Immense demand has largely kept volatility at bay since the end of March, so that is really the wildcard. Individual credits will continue to trade choppy surrounding news on vaccines, virus case counts and the various failures and successes of “re-openings.” From a spread perspective, although spreads are significantly tighter from the widest levels, valuations are reasonably compelling. The spread on the index closed the quarter at an OAS of 150. This compares to the 5yr average of 131, the 10yr average of 141 and the average since 1988 inception of 134. We continue to find compelling opportunities in individual bonds through our bottom up research process.

The Federal Reserve has injected confidence into the fixed income markets. While the actions of the Fed were drastic and unprecedented they were also much needed. Words can hardly describe the extreme malaise that was occurring within the markets over the course of the trading days from March 9 through March 20, up until March 23, the day when the Fed announced its initial plans. A side effect of the confidence that the Fed instilled is that it has created an atmosphere of exuberance and has encouraged more risk taking by market participants. We are at odds with this feeling of euphoria as we believe that this is a great time to take less risk, not more. There are plenty of opportunities to take smart calculated risks by purchasing bonds of companies with solid balance sheets that can navigate an extended downturn in the economy. We have positioned the portfolio accordingly. Not only are we underweight BAA-rated credit but we are also underweight the energy sector and zero weight the leisure, gaming, lodging and restaurant industries, which are becoming correspondingly riskier by the day as the economic uncertainty wears on. We will continue to manage your capital in a prudent manner and we thank you for your continued interest and partnership.

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 The Wall Street Journal, June 8, 2020 “Recession in U.S. Began in February, Official Arbiter Says”
ii The Wall Street Journal, June 28, 2020 “Automakers, Technology Firms Are Largest Components of Fed’s Corporate-Bond Purchases”
iii Bloomberg, June 30, 2020 “IG ANALYSIS US: June Ends in Top 6 With July Bringing $100B More”

06 Apr 2020

2020 Q1 Investment Grade Commentary

Investment grade credit just endured one of the most volatile quarters in the history of its existence. Most market participants would agree that only the 2007-2008 global financial crisis can compare to what we have experienced the past month. Spreads were humming along for the first two months of the year before they spiked to levels that had only been seen once since the 1988 inception of the Bloomberg Barclays US Corporate Index.

At its nadir on March 20, the index was down -10.58% year-to-date. For investment grade, in our view, this violent sell off was much less about credit than it was about liquidity and fund flows. Investors pulled a record amount of funds from bond markets over a two week period and the unbridled panic selling coupled with the proliferation of the liquidation of exchange traded funds led to a liquidity vacuumi. As a result there was very little in the way of orderly price discovery. It was perhaps, in our estimation, one of the worst times to sell in the history of the investment grade credit market and this was reflected in the prices of bonds that did sell during this time periodii. The tone in the market shifted substantially on Monday, March 23 as it seemed investors came to terms with the fact that yes, the challenges in front of us are enormous, and the economic data could be quite bad for some time, but humanity will persevere and the world will not end. The shift in tone led to a reversal in risk appetite and the Bloomberg Barclays US Corporate Index finished the quarter with a total return -3.63% while the S&P500 finished with a total return of -19.60%. This compares to CAM’s gross total return of -3.09%. We believe that policy actions by the Federal Reserve, and to a lesser extent, the passage of stimulus by lawmakers did much to restore confidence within the credit markets.

While we are not satisfied that the value of our portfolio declined during the quarter we feel that we are well positioned to weather an economic downturn. The portfolio has a significant structural underweight in BAA-rated credit and it is also underweight the energy sector and zero weight the leisure, gaming, lodging and restaurant industries, which have been particularly hard hit by the cessation of economic activity.

Overwhelming Supply and Outsize Compensation

We frequently speak of new issuance in our commentaries because it is the lifeblood of the corporate credit markets and one of the fundamental ways that fixed income investors acquire new investment opportunities. At CAM, during the invest-up process we will typically populate a new account with 20-30% new issuance as long as concessions from borrowers are attractive and we will also use these opportunities to add exposure for fully invested accounts that have cash available for reinvestment. There are companies constantly borrowing in the corporate bond market to fund capital allocation plans such as property, plant and equipment, liquidity or even shareholder returns. The month of March was one of the most interesting time periods for issuance that we have ever seen in our market and it was really a dichotomy of two halves. In first half of the month the primary market battled volatile treasury rates and record outflows from investment grade funds. According to data compiled by Bloomberg, through Friday, March 13, issuance stood at $37 billion. This was modestly lighter than street expectations to that point as volatility in both spreads and rates had kept issuers at bay. This all changed on March 17, as a myriad of high quality companies elected to take advantage of historically low Treasury rates and push through with issuance even despite historically high credit spreads. The new issue concessions offered during the two week period that would follow were the most attractive that the market has seen in over a decade with many concessions approaching 50-100bps relative to secondary offerings. As a colleague put it, the primary market was being dominated by borrowers who don’t need credit. What we saw were dozens of companies with extremely strong balance sheets borrowing to bolster liquidity in the face of economic uncertainty and they were willing to pay up to do so, but even if spreads where high, the borrowing costs that they were paying were still quite low when viewed through a historical lens. By the time the month had ended, March had rocketed to the top of the leaderboard for the busiest month in the history of the primary market with $259.2 billion in new supply. This was 46% higher than the previous record of $177.7 billioniii. Below you will find a table of all of the primary deals that CAM purchased for client accounts during the month of March.

As we turn the page to April we are still finding attractive concessions, but they are not what they were two weeks ago. We expect that volatility in credit spreads will come and go as the world battles through the current crisis but it is entirely possible that we may go a decade or more before we see primary market opportunities like the ones we saw the third and fourth week of March. This is why we constantly preach the need to have a long term strategic view for this asset class. A permanent allocation of capital is ideal in order to take advantage of opportunities like these when they do arise.

Fallen Angels and the Growth of BAA-rated Credit

One of the favorite topics of the financial press is back at the forefront, and for good reason, as it is a legitimate concern that could have a significant impact on the credit markets. In our discussions with investors we tend to find that there is fear surrounding fallen angels as it relates to the investment grade credit market but this is really a high yield problem, and it comes down to the size, depth and liquidity of the high yield universe relative to the investment grade universe. The face value of the investment grade universe is $6.7 trillion while the high yield universe is just over $1.2 trillion. The investment grade BAA-rated universe is over $3.4 trillion, almost three times the size of the
entire high yield universeiv. According to research by J.P. Morgan, they expect a record $215 billion in high grade debt could fall to high yield in 2020, driven predominantly by the energy and automotive sectorsv. This is not a problem for investment grade in general as these bonds are simply leaving the investment grade universe. It could be a problem for the bondholders of those companies who are downgraded and for high yield investors who are beholden to an index and must purchase the downgraded bonds of investment grade companies whether they like them or not.

As far as CAM’s positioning, we limit our exposure to BAA-rated credit at 30%, while the investment grade universe is more than 50%. Although we are significantly underweight BAA-rated credit we do allow the portfolio to hold split rated credits. Most often this is because it is a credit with just one or two investment grade ratings that is on its way to becoming fully investment grade but sometimes it is a fallen angel that we will continue to hold. There are two reasons we would continue to hold a fallen angel, it could be that we expect a full recovery to investment grade or we could be positioning for a more opportunistic sale. It is important, in our view, to never put the portfolio in a
position where it is a forced seller of a bond as a forced sale usually amounts to an ill-timed sale. We did have one credit in our portfolio get downgraded to fallen angel status during the month of March and we have elected to hold it for the time being as our research indicates that the pricing of the bonds is significantly below the fair market value. We expect more volatility in the BAA-rated portion of investment grade as we navigate economic uncertainty and
we expect our underweight will serve us well from a relative performance perspective.

Fed to the Rescue

The actions of the Federal Reserve have been extremely beneficial to the restoration of confidence in the bond markets. On Monday, March 23 the Fed announced a primary market and a secondary market corporate credit
facility. These actions were in response to turmoil within the commercial paper market and lack of liquidity for bond ETF redemptions. The timing could not have been better as the market ended the previous week with an extremely heavy tone so it was a moment of much needed confidence and the Fed stepped up and delivered exactly what was needed.

Tomorrow and Beyond

Tomorrow brings uncertainty; of that much we are certain. We expect continued volatility, particularly in the energy sector and in lower quality BAA rated credit. We are also optimistic and hopeful. We believe that we will come together, not just as a country, but as a civilization, to defeat the global pandemic. We take comfort in the fact that thousands of the smartest people in the world are currently working on solutions. We do not expect it to be easy and it may even take longer than expected but we know that we will eventually prevail. We believe now that a recession is inevitable so our credit selection is even more discerning than it usually is though we always look to position the portfolio in a manner to ensure it can perform through a full market cycle. A big question on investors’ minds is what will the recovery look like? Our view is that it will probably be less of a “V” and more of a “U” making credit selection paramount as it is important that companies within the portfolio have the balance sheet wherewithal to navigate an extended recovery.

We are sanguine on the current valuation of credit spreads. After closing at a high of 373 on March 23, the OAS on the corporate index ended the quarter at 272. This compares to the 5yr average of 128, the 10yr average of 140 and the average since 1988 inception of 135. Clearly credit has been repriced for the challenges that lie ahead and it has become a “credit pickers” market where a skilled active manager can make a difference.

As always please do not hesitate to call or write us with questions or concerns. We hope that you and your loved ones remain in good health during this difficult time.

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.

The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

i The Financial Times, March 19, 2020 “Asset manager rocked by record bond outflows”

ii Institutional Investor, March 19, 2020 “The corporate bond market is “basically broken” Bank of America says”

iii Bloomberg, April 1, 2020 “IG ANALYSIS US: Record setting March ends with $13 billion bang”

iv ICE BAML Index Data, April 1, 2020

v J.P. Morgan, March 23, 2020 “Fallen angel risk in this crisis”

23 Jan 2020

2019 Q4 Investment Grade Commentary

Investment grade credit ended 2019 on a high note with another quarter of positive total returns. The Bloomberg Barclays US Corporate Index closed the year at an option adjusted spread of 93, a whopping 22 basis points tighter on the quarter. Treasuries of all stripes sold off during the quarter which mitigated the impact of tighter spreads. The 10yr Treasury closed 2019 at 1.92% after opening the 4th quarter at 1.66%, an increase of 26 basis points. The dichotomy of returns between 2018 and 2019 was stark. While 2018 was a disappointing year with the worst returns for corporate credit in a decade, 2019 was a complete reversal with the best returns in over a decade. For the full year 2019 the Bloomberg Barclays US Corporate Index had a total return of +14.54%. This compares to CAM’s gross total return of +12.78% for the Investment Grade Strategy. 

2020 Outlook 

As long-time readers know, our specialty at CAM is bottom-up credit research. We seek to invest in the most attractive corporate credit opportunities for our clients at any given time with the goal of generating superior risk adjusted returns. Preservation of capital is always at the forefront of our decision making process, which is one of the reasons we are always structurally underweight the riskier BBB portion of the investment grade credit market. We are not in the businesses of making speculative market bets, such as wagering on the direction of interest rates, but we certainly do have a framework and house view that we use to aid in our decision making process. To that end, we thought it would be helpful to explore some of the themes that we believe could influence the direction of the market in 2020. We expect four distinct factors could impact the fortune of the investment grade corporate credit market in the coming year: issuance, fund flows, foreign demand and fundamentals. 

Issuance is Key 

Net issuance is a metric that we track to gauge the availability of new investment opportunities. Net issuance is simply the gross amount of new corporate bond issuance less the amount of debt that matures or that is redeemed through call options or tender offers. Both gross and net issuance have been falling since 2017. 

The net issuance forecast for 2020 is substantially lower relative to 2019 and some predictions have 2020 net issuance coming in at or near 2012 levels A few of the major investment banks are particularly bearish in their forecasts: Morgan Stanley expects net issuance to be down 22%, Bank of America down 21% and J.P. Morgan down a staggering 36%. i The decline in net issuance could be meaningful for the support of credit spreads. If continued inflows into corporate credit meet substantially lower new issuance this could create a supply-demand imbalance. This imbalance would create an environment that lends support to tighter credit spreads. 

Inflows & the Incremental Buyer 

IG fund flows have been broadly positive dating back to the beginning of 2016. The only period of sustained outflows from investment grade in the past four years was during the fourth quarter of 2018 which was a time of peak BBB hysteria.ii iii Over $300bln of new money flowed into IG mutual funds, ETFs and total return funds in 2019, according to data compiled by Wells Fargo Securities. The biggest story of 2019 as it relates to flows is the reemergence of the foreign investor, who has become the most important incremental buyer of IG corporates. 

Foreign investors were largely quiet in 2018 but in 2019 they poured $114bln into the U.S. IG market through the end of the 3rd quarter.iv Two factors have led to resurgence in foreign demand: First, for those investors that hedge foreign currency, the three Fed rate cuts in 2019 have made hedging much more attractive, as hedging costs are closely tied to short-term rates. Second, and perhaps the larger factor, is the negative yields that foreign investors have faced in their domestic markets. Negative yielding debt reached its zenith in August of 2019 at over $17 trillion. Although it has come down substantially, it remained over $11 trillion at year-end relative to $8 trillion at the beginning of 2019.

Obtaining precise information on foreign holdings is difficult due to the myriad of ways that this group can invest in the U.S. markets; but what was once a bit player in our market has now become the single largest class of investor, holding an estimated 30-40% of outstanding dollar denominated IG corporate bonds. To put that into perspective the next largest holder is life insurance companies at just over 20%.vi Simply put, inflows are important in order to provide technical support to the credit market, but the real bellwether for flows is the foreign buyer. If foreign money continues to flow into the $USD market, we would expect continued support for credit spreads. However, if foreign investor sentiment sours, it will create a headwind for spreads. 

Best of Times & Worst of Times 

Although corporate credit performed well in 2019, credit metrics for the index at large have deteriorated and leverage ratios are near all-time highs. We would typically be apt to view such a development through a bearish lens; but the reality is that much of the increase in leverage reflects conscious choices by firms rather than a weakening of business fundamentals. Incentivized by the minimal additional cost incurred for funding a BBB-rated balance sheet relative to an A-rated one, many firms have sacrificed their higher credit ratings to fund priorities such as acquisitions and share repurchases. Investor demand for credit and a prolonged period of historically low interest rates have reduced the financial penalty for moving down the credit spectrum. 

Interestingly, a vast majority of BBB-rated debt has remained in the upper notches of that category. According to data compiled by S&P, just 16% of BBB- rated debt is in the lowest BBB minus category while 47% is mid-BBB and 36% is rated BBB+.vii There will surely be some losers in this bunch which makes the BBB story an idiosyncratic one; managers need to choose credits carefully in this space and focus on those which can weather a downturn without putting credit metrics in serious peril. The median GDP forecast for 2020 is 1.8%.viii If this comes to fruition then most IG-rated companies will be able to maintain stable to improving credit metrics for the year which would be another positive for credit spreads. If growth underwhelms, it would not surprise us to see spread widening in more cyclical sectors and in the lower tier of investment grade credit. This is where our individual credit selection factors in heavily. 

Risky Business 

At over a decade in length, we are in the midst of the longest credit cycle on record yet the current backdrop suggests that it may have more room to run. Investment grade as an asset class is still compelling as part of an overall asset allocation but even the most bullish investor cannot expect 2020 to be a repeat of 2019 as far as returns are concerned. The fact is that there is not much room for error and there are several risks that will continue to loom large on the horizon in 2020. 

  • Private equity companies are starting the year with a record $1.5 trillion in unspent capital. This is not a new story and remarkably this same “record” headline could have been written at the start of each of the last four years!ix Private equity is not bad, per se, but when they become involved with investment grade rated companies it is usually to the detriment of bond investors. Understanding the intricacies of each business in the portfolio and the covenants within each bond indenture can help to avoid a bad outcome. 
  • Policy risk remains high. The Federal Reserve has telegraphed a relatively neutral policy in 2020, which is typically the stance that is taken in an election year, but any deviation from this path could be a shock for markets. The events leading up to the November election and its results both have the ability to effect the direction of credit spreads and the risks are skewed to the downside at current valuations. 
  • Trade disputes have serious potential to derail domestic and global economic growth. The reality is that until uncertainty is removed, the market is subject to volatility and headline risk associated with global trade. The implications at the sector level are particularly severe in some instances and we are positioning the portfolio to mitigate this risk accordingly. 

As always please do not hesitate to call or write us with questions or concerns. We will continue to provide the best customer service possible and to prudently manage your portfolios to the best of our ability. Thank you for your partnership and continued interest. We wish you a happy and prosperous new year. 

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 News, December 30, 2019 “U.S. Corporate Bond Sales to Slow in 2020 With Speed Bumps Ahead”
ii The Wall Street Journal, September 20, 2019 “There Have Never Been So Many Bonds That Are Almost Junk”
iii Bloomberg, October 11, 2018 “A $1 Trillion Powder Keg Threatens the Corporate Bond Market”
iv Bloomberg News, December 26, 2019 “The Corporate Bond Market’s $100 Billion Buyer Is Here to Stay”
v Bloomberg Barclays Global Aggregate Negative Yielding Debt Index
vi Federal Reserve System
vii S&P Global Ratings, December 16, 2019 “U.S. Corporate Credit Outlook 2020 Balancing Act”
viii Bloomberg Terminal, January 2, 2020 “US GDP Economic Forecast”
ix Bloomberg News, January 2, 2020 “Private Equity Is Starting 2020 With More Cash Than Ever Before”